MANAGERIAL

ACCOUNTING
(Compiled by Prof. Prasad Bhat)

Compiled by Prof. Prasad Bhat Page 1

 MANAGERIAL ACCOUNTING

INDEX

Sr. Topic Page No.

1 Business Concepts 03

2 Accounting Basics 07

3 Accounting Terminologies 15

4 Concepts and Conventions 26

5 Accounting Rules & Process 31

6 Books of Accounts 40

7 Financial Statements 49

8 Cost Accounting Basics (Cost Sheet) 105

9 Budgetary Control 123

10 Marginal Costing 137

Compiled by Prof. Prasad Bhat Page 2

1. BUSINESS CONCEPTS
1. INTRODUCTION

 Every person carries out some kind of commercial / money activity. An employee gets
salary, bonus and he spend money to buy grocery, food, clothing, school fees etc.
 A trader purchases and sells goods to earn profits. A doctor treats his patients and earns
money, a lawyer advises his clients, a chartered accountant provides taxation guidance,
event manager plans grand parties etc.
 All such economic / monetary activities should be properly recorded to know whether
there is profit or loss, amount of savings, cash inflows and outflows etc.

2. BUSINESS TRANSACTIONS

 Business can be defined as any commercial / monetary activity carried on for the
purpose of earning profits.
 Following are the features of a business –
 commercial / economic activity,
 involving goods and / or services,
 having money value, and
 with profit motive
 Further, such business activities are performed through ‘transactions.’
 Transaction includes an exchange of goods and/or services having monetary value.
Transaction involves the following –
 purchase / sale of goods and services and money is paid / received immediately,
 purchase / sale of goods and services and money will be paid / received in the future,
 exchange of goods and services against goods and services (i.e., barter),
 providing money / funds as loans or advance,
 transfer of goods or services as a gift or donation etc.

Every business undertakes number of transactions. It depends upon the size of a business
entity. Each day numerous business transactions are carried out, in hundreds / thousands.
Whether a businessman can remember all transactions – not at all. Hence, all such business
transactions should be recorded in systematic manner. Recording of business transactions
in a systematic manner in the books of account is known as bookkeeping and accounting.

Compiled by Prof. Prasad Bhat Page 3

3. FORMS OF BUSINESS ORGANIZATIONS

 A business organisation is an establishment intended to carry commercial business by

producing goods or services and meet the customers’ needs.
 A business organization is a formal body / association created for carrying out business
activities. It is structured and operated in an authorized form of ownership.
 The focus of business organizations is the systematic management of men, material, and
machines for the purpose of earning huge profits.
 A business organization may consist of a single individual (sole proprietor), partnership
firm (two or more individuals), or a company form of organization.
 The different forms of business organizations are based on the size of the business,
funds involved and decision-making criteria. Success of every business is based on the
quality of decisions. Such decisions affect the ultimate objective – profits!

The various forms of business organizations are given below –

A) Sole Proprietor
 A business which is totally owned by an individual is known as sole proprietorship or
a sole trading concern. This is the most popular form of business organization. It is
the easiest mode of doing business. A single individual is the owner of business.
 Formation of sole proprietorship is simple. It does not require statutory registrations.
 The proprietor puts his own money in the business and controls entire operations of
a business and is liable for all financial burdens and debts.
 Sole proprietorship concerns include shops / retail business, home-based businesses,
individual consulting firms, commission agents, etc.
 No Separate Legal Entity: in case of sole proprietorship, there is no separate legal
entity. In the eyes of law, the owner and business are one and the same. If the owner
dies or becomes insolvent, the business dies.
 Unlimited Liability: the sole proprietor is the only person liable for the business. If the
financial obligations (liabilities) of the business cannot be paid out of its properties, a
sole owner shall use his personal property to repay the obligations of the business.
 Profits Sharing: there is no sharing of profits or losses, since the entire gain or loss
belongs to the sole proprietor.
 No Legal Formalities: to start sole proprietary business, no separate registration is
needed. However, very few legal formalities are needed, such as basic licenses.

Compiled by Prof. Prasad Bhat Page 4

B) Partnership Firm
 In a partnership firm, two or more individuals come together to start a business.
 Each individual partner gives his share of money, property, or experience and expects
some profits from the business. The partners are the joint owners of the business.
 Basically, partnership is defined as an agreement between persons who have agreed
to share profits of a business, carried on by all, or any of them acting for all.
 As per the Partnership Act, 1932, there should be minimum 2 partners and maximum
50 partners in a firm. All the partners share profits / losses in their pre-decided ratio.
 Partnership Agreement: a partnership firm is created on the basis of an agreement
between all the partners. The agreement (partnership deed) contains details of capital
contribution, rights and duties, profit sharing ratio etc.
 No Separate Legal Entity: a partnership firm is not a separate legal entity. In the eyes
of law, the partners and the business are one and the same. If all the partners die or
becomes insolvent, the business dies.
 Unlimited Liability: all partners are jointly and severally liable for the business debts.
If financial obligations (liabilities) of the business cannot be paid out of its properties,
all partners shall use their personal property to repay the obligations of the business.
 Profits Sharing: all the profits or losses of the business are shared by the partners in
their pre-decided ratio. If no ratio is fixed, the profits or losses are equally shared.
 Mutual Agency: every partner acts as the principal as well as agent of the firm. This is
known as doctrine of mutual agency. Partnership is based on good faith and trust.
Every partner must act in the best interests of the firm.

C) Joint Stock Company

 Post Industrial Revolution, trade, commerce and manufacture became highly complex
due to large scale of operations, huge funds requirements, manpower needs, rising
taxation etc. This gave rise to the concept of ‘Joint Stock Company’.
 A Joint Stock Company (i.e., a company) is a voluntary association, where capital is
contributed by a large number of people.
 A company is a body corporate and a legal entity having separate status and an
identity apart from its members.
 A company is created only through registration (incorporation) process carried out
under the Companies Act, 2013. A company can be described as an artificial person
created by law, having a common seal and perpetual succession.

Compiled by Prof. Prasad Bhat Page 5

  Today, a company is a professional and respected form of business organization. On
the basis of membership, it is classified under following categories –
o Public Limited Company – minimum 7 members and maximum unlimited,
o Private Limited Company – minimum 2 members and maximum 200 members,
o One Person Company (OPC) – only one individual member.

 Separate Legal Entity: due to registration, a company becomes an artificial person

having a separate personality which is distinct from the members constituting it.
Thus, a company is a separate legal entity having its own corporate name. Properties
and obligations are recorded in the name of company and not its members.
 Limited Liability: a company is separate legal entity and hence liability of its members
is limited to the amount unpaid on the shares held by them. If shares fully paid-up,
members’ liability is zero.
 Perpetual Succession: a company is a separate entity and it does not depend upon its
members. A company is created by law and it can be terminated only by law. A
company has perpetual life and continues forever, even it all members die or change.
 Transferability of Shares: the capital of a company is divided into parts called shares.
The shares are movable property and transferable from one person to another.

D) Limited Liability Partnership (LLP)

 Limited Liability Partnership (LLP) is a hybrid form of organization having features of
a partnership as well as a company
 In an LLP, there is benefits of limited liability (like a company) but allows its members
the flexibility of organizing their internal structure (like a partnership).
 Due to flexibility in its formation and operation, LLP is a suitable form of organization
for small enterprises.
 LLP is a body corporate, artificial legal person, having a legal entity separate from its
partners. It has perpetual succession and any change, death, insanity, retirement of
partners does not affect the existence of the LLP.
 LLP is a separate legal entity, liable to the full extent of its assets, with limited liability
of the partners. The liability is limited to their agreed contribution in the LLP.
 Every partner of a LLP is an agent of the LLP, but not of other partners. The liability of
the partners will be limited to their agreed contribution in the LLP.
 Every LLP is formed for carrying on a lawful business with a view to earn profit.

Compiled by Prof. Prasad Bhat Page 6

2. ACCOUNTING BASICS
1. INTRODUCTION

 Accounting is as old as money itself. People in all civilizations have maintained various
types of records of business activities. In India, accounting was practiced since centuries.
Kautilya’s book ‘Arthshastra’ clearly mentions existence of accounting and audit.
 Whether it is sole proprietor, partnership firm, company or even Government, everybody
keeps records of transactions to have adequate information about the economic activity.
 Accounting deals with measurement of monetary activities involving inflow and outflow
of funds, which helps in managerial decision-making process.
 Accounting is the language of business. It helps a business in finding out profits / losses
for a period as well as its financial position on a particular date.
 Accounting has its own established principles which are guided by certain concepts and
conventions.

2. MEANING OF ACCOUNTING

 As per the American Institute of Certified Public Accountants (AICPA), ‘ Accounting is the
art of recording, classifying, and summarising in a significant manner and in terms of
money, transactions and events which are, in part at least, of a financial character, and
interpreting the result thereof.’
 Traditionally speaking, accounting is a process of systematically recording, classifying
and summarizing business financial transactions (also known as book-keeping).
 However, modern day functions of accounting include analysing and interpreting the
financial results of a business. Further, the present scenario consists of globalization of
business, multinational companies, separation of ownership & management. The scope
of accounting has increased to include communication of results to various stakeholders.
 We can say that the function of accounting is to provide quantitative information,
financial nature, about the economic entities, that is useful in economic decisions.
 Thus, accounting may be defined as the process of recording, classifying, summarising,
analysing and interpreting the financial transactions and communicating the results
thereof to the persons interested in such information.
 The entire process can be divided into two parts, viz. bookkeeping and accounting.

Compiled by Prof. Prasad Bhat Page 7

3. BOOK-KEEPING vs. ACCOUNTING

 In a business, each day there are hundreds/ thousands of business financial transactions.
Practically, it is not possible to remember all these transactions. Hence, it is necessary to
record these business transactions in detail and in a systematic manner.
 Recording of all business transactions in a proper manner in the various books of
account is called book-keeping. Book-keeping is the branch of knowledge which tells us
how to keep records of business transactions. It includes systematic record of various
business transactions.
 Book-keeping is the art of recording all money transactions, so that the financial position
of a business and its relationship to its owners and outside world can be ascertained.
 The main objective of business is to earn profits. In order to find the profit earned during
a period, simply recording of business transactions is not enough. Accounting involves
not only book keeping but also many other activities.
 Accounting is a system of recording business financial transactions that provide vital
information about business enterprises to facilitate decision making. Accounting is a
wider term than book-keeping.

 Differentiation between Book-Keeping and Accounting:

Sr. Book-Keeping Accounting

1 Book-keeping involves only Accounting includes recording
recording transactions transactions as well as its
analysis and interpretation
2 Maintenance of proper records Facilitate managerial decision
in systematic manner making through analysis
3 Repetitive, routine, clerical Analytical, thought process
4 Book-keeper’s knowledge level Accounting requires expert
is basic to moderate knowledge level
5 Book-keeping is a sub-set of Accounting includes book-
accounting; it complements keeping as well as process of
the accounting process. designing accounting system
6 Initial / first stage of recording Later stage of recording

Compiled by Prof. Prasad Bhat Page 8

4. OBJECTIVE / NEED / PURPOSE OF ACCOUNTING

1) Systematic Recording of Transactions – Basic objective of accounting is the systematic

recording the financial aspects of business transactions. These recorded transactions are
later classified and summarized logically for the preparation of financial statements and
for their analysis and interpretation.

2) Ascertainment of Financial Performance – Preparation of Profit & Loss (P&L) Statement

to know the financial results (profit or loss) of business operations for a particular period.

If Sales Revenue > Expenses = Profit

If Sales Revenue < Expenses = Loss

The P&L statement helps stakeholders to know the financial performance of the business

3) Ascertainment of Financial Position – Preparation of Balance Sheet to know the financial

position of a business as on a particular date. Balance Sheet is a statement of assets and
liabilities of a business at a particular point of time and helps in ascertaining the financial
health of the business Balance sheet shows the assets / property of a business as well as
the financial obligations (liabilities) of the business.

4) Rational Decision-making – Accounting communicates financial results of a business to

various stakeholders. Accounting helps stakeholders in taking rational decisions.

5) Planning & Forecasting – Accounting helps in planning and forecasting future events and
desired financial performance and financial position. Analysis of past data, identifying
trends and proper interpretation helps in better planning.

6) Taxation – Accounting records provides accurate information for computation of various

taxes and duties.

7) Cost Control & Reduction – Accounting helps to identify areas of expenses / cost control
and reduction. Such cost reduction helps in enhancing future profits.

8) Legal Compliance – Maintenance of proper accounting records and reports is needed as

per Companies Act, 2013. Hence, accounting serves to comply statutory requirements.

9) Communication of Financial Results – Various stakeholders have diverse interests in a

business concern. Hence, communication of true and fair financial results is vital for
good corporate governance practices.

10) Evidence – Accounts are admissible as documentary evidence in the Court of Law.
Hence, proper accounts can be used in case of suits relating to disputes, frauds etc.

Compiled by Prof. Prasad Bhat Page 9

5. FEATURES / NATURE OF ACCOUNTING

 Monetary Transactions – Accounting is concerned with recording business transactions

having monetary value. Transactions should be capable of expressing in money terms.
 Historical Nature – Accounting process starts only after a transaction or event has
occurred (i.e., in the past). Future events are not recorded in accounting process.
 Systematic Records – The business transactions are properly recorded, classified and
summarized into two financial statements – Profit & Loss Statement and Balance Sheet.
 Communicating Results – Since accounting is a language of business, financial
information shall be communicated to the interested parties (stakeholders).
 Legal Requirement – Accounting is a legal requirement. For a company, it is mandatory
to have proper accounting records of all monetary transactions of its business. As per
section 128 of the Companies Act, 2013, every company shall maintain proper books of
accounts and financial statements for every financial year, to show true and fair nature of
its financial performance and financial position.

6. PROCESS OF ACCOUNTING

a) Transaction – the first step of accounting is financial transaction where there is exchange
of benefits, goods, services, transfer of funds, borrowings, etc. Cash transaction refers to
a business deal where immediate payment is made or received. Credit Transaction is a
business deal where payment or receipt of money is postponed to a future date.

b) Document – every business transaction shall be supported by valid documents. Such

documents include bill, invoice, receipt, challan, delivery slip, note, voucher etc. Every
monetary business transaction is recorded on the basis of such documentary evidence.

c) Recording – this is the basic function of accounting. All business monetary transactions
are recorded in the books of account. Recording is done in a book called ‘Journal.’ A
Journal may further be divided into several subsidiary books according to the nature and
size of the business.

d) Classifying – classification is based on the systematic analysis of the recorded data, with
to group similar transactions at one place. This makes information compact and usable.
Such classification is done in a ‘Ledger’ book. In a ledger, all financial transactions of
similar nature are collected. E.g., transactions related to salary payments, rent received,
sales, purchases etc.

Compiled by Prof. Prasad Bhat Page 10

e) Summarising – at the end of accounting period (financial year) all the classified data is
summarized and reports are prepared. All the account balances are summarized and
listed in a report known as ‘Trial Balance’. Summarization deals with preparation and
presentation of records in a useful manner. This process leads to preparation of the
financial statements.

f) Finalization – at the end of accounting period (financial year), a summary of transactions

and account balances is prepared in the form of Trial Balance. On the basis of such Trial
Balance, the Financial Statements are prepared viz. Profit & Loss Statement and Balance
Sheet. In case of certain companies, Cash Flow Statement is also prepared.

g) Analysing – once financial statements (P&L Statement & Balance Sheet) are prepared,
the next step is analysis. Analysis means methodical study and understanding of given
financial statements. Financial Statements are simplified for better understanding.

h) Interpreting – once financial statements are studied & analysed, interpretation is needed.
Interpretation deals with explaining the meaning and significance of various financial
relationships. Proper analysis and interpretation will help end-users to make meaningful
judgement about the financial condition and profitability of the business operations.

i) Communicating – the entire process of accounting ends with proper communication

with the concerned parties. Financial statements should be transmitted to the end-users
for decision-making. Various accounting reports are prepared and distributed.

3. Recording
1. Transaction 2. Document
(Journal)

6. Financial
4. Classifying 5. Summarizing Statements
(Ledger) (Trial Balance)
(P&L / Bal. Sheet)

9.
7. Analysis 8. Interpretation
Communication

Compiled by Prof. Prasad Bhat Page 11

7. STAKEHOLDERS / USERS OF ACCOUNTING INFORMATION

 Stakeholders are those persons who are interested in a business or those parties who
are affected by a business (users of financial information).
 Stakeholders use the financial information of a business for decision-making purposes
 Accounting includes meaningful analysis and interpretation of financial statements for
the parties who require such financial information.
 It is a user-oriented approach. Various parties are interested in the financial information
and operating results of an enterprise.
 Stakeholders are classified into two categories, viz. internal users (Sr. 1-4) and external
users (Sr. 5-12). Following are various users of accounting information and their interest:

Sr. Stakeholders Need for Accounting Information

1 Existing Shareholders Money invested in company, need to
assess current and future profitability
2 Prospective Investors Plans to invest money in a company,
need to study financial position
3 Promoters / Board of Directors / Assess operational efficiencies and
Top Management profitability, for decision-making
4 Employees Assess job security, regular salaries and
increments, incentives
5 Bankers / Financial Institutions / Assess long-term solvency, ability to
Debenture-Holders repay loans along with interest
6 Suppliers of Goods & Services Assess short-term liquidity position,
(Creditors) continuity of business relationship
7 Buyers / Customers (B2B) Ensure regular supply of goods and
services, continuous availability
8 Government Payment of taxes and duties
9 Research Analysts To assess and advice investment
opportunities
10 Competitors Assess market share, profitability, threat
to survival
11 Society Corporate Social Responsibility (CSR)
12 Auditors Audit of financial statements

Compiled by Prof. Prasad Bhat Page 12

8. BRANCHES / SUB-FIELDS OF ACCOUNTING

A) Financial Accounting
 Financial Accounting covers the preparation and interpretation of financial statements
and communication to the users of accounts.
 It is historical in nature as it records transactions which had already been occurred.
 The last step of financial accounting is the preparation of Profit & Loss Statement and
Balance Sheet.
 Purpose of financial accounting is determination of financial performance for an
accounting period and financial position as on the given date.

B) Management Accounting
 Management Accounting is concerned with internal reporting to the top management
of a business unit.
 Top management requires accurate and timely information for planning, control and
decision- making.
 Management accounting includes different ways of grouping information, preparing
reports and disseminating vital facts as desired by managers.

C) Cost Accounting
 Cost Accounting deals with process of finding the cost, recording the cost, preparing
reports for managerial decisions.
 Information about various costs helps in cost control in the short-term and cost
reduction in the long-term

D) Social Responsibility Accounting

 Social Responsibility Accounting involves creating social awareness about the
undesirable by-products of economic activities.
 It is concerned with accounting for social costs incurred by the enterprise and social
benefits created.

E) Human Resource Accounting –

 Human Resource Accounting attempts to identify, quantify and report investments
made in human resources of an organisation
 It emphasizes on importance of human resources in company’s profit earning process

Compiled by Prof. Prasad Bhat Page 13

9. MERITS & DEMERITS OF ACCOUNTING

Sr. Merits / Advantages Demerits / Limitations

1 Systematic record of business Non-monetary transactions are
transactions (substitute to memory) not recorded
2 Knowledge of financial performance Only historical (original) cost is
of business for a period recorded. Current values ignored
3 Knowledge of financial position of Possibility of manipulation via
business as on particular date gimmicks / window-dressing
4 Comparison with other businesses Use of estimates / assumptions
as well as own performance reduces accuracy
5 Accurate computation of taxes and Accounting does not consider
duties payable to Government factors such as inflation
6 Admissible as evidence in Courts Subjective interpretations
7 Facilitates valuation of a business in Accounting principles may be
case of strategic decisions. conflicting with each other
8 Helps in managerial decision Possibility of mistakes in records
making, planning, forecasting. due to human error

Compiled by Prof. Prasad Bhat Page 14

3. ACCOUNTING TERMINOLOGY
1. FINANCIAL STATEMENTS

Financial Statements

Profit & Loss

Balance Sheet
Statement

Income Expenses Assets Liabilities Capital

2. TERMINOLOGY

1) Balance Sheet
 Balance Sheet is a statement showing assets, liabilities and capital of a business as
on a particular date.
 Balance Sheet depicts the financial position of a business as on a particular date.
 In India, financial year / accounting year starts on 1st April and ends on 31st March.
 Hence, generally, Balance Sheet is prepared as on 31st March, i.e., year-end.
 However, for companies which are listed on Stock Exchange, financial statements are
prepared and communicated every quarter-end (30 June, 30 Sept, 31 Dec, 31 March).

2) Assets
 assets denote property / ownership of a business
 used for business purposes
 have monetary value
 helps in generating sales revenue / profits

Assets

Based on Tangibility Based on Time Period

Tangible Assets Intangible Assets Non-Current Assets Current Assets

Compiled by Prof. Prasad Bhat Page 15

3) Tangible Assets are those assets which can be seen or physically touched. For example:
building, land, furniture, vehicles etc.

4) Intangible Assets are those assets which cannot be seen or physically touched, but they
are owned by a business and useful for generating revenue and profits. For example:
goodwill, patent, trademarks, copyrights and other Intellectual Property Rights (IPR) etc.

5) Non-Current Assets
 assets held for long-term purposes
 useful life of more than 12 months (i.e., greater than 1 year)
 not held for resale purpose in ordinary course of business
 non-current assets can be classified into fixed assets and long-term investments
 for example: machinery, equipment, goodwill, vehicles, patents, etc.

6) Fixed Assets
 used for long-term purposes (more than 12 months)
 held for carrying out the main operations of a business
 not held for resale purpose in ordinary course of business
 can be classified into tangible assets and intangible assets

7) Goodwill
 value of image, reputation, brand value of a business
 goodwill helps in customer acquisition and retention
 it facilitates premium pricing and adds to higher revenues and profit
 KFC, Nike, BMW, Starbucks etc.

8) Patent
 exclusive legal right to use certain invention, technology, manufacturing process etc.
 patent holder gets ultimate power to use his invention and nobody else can use it
 patent creates domination in the specific product market, thereby higher profits
 especially prominent in pharmaceutical and technology industry

9) Trademark
 exclusive legal right to use certain logo, pictures, design etc.
 customer identifies the logo with the quality / value of the product or service
 trademarks help in premium pricing and adds to higher revenues and profit

Compiled by Prof. Prasad Bhat Page 16

10) Copyright
 exclusive legal right to use creative work – literature, programs, music, films etc.
 nobody else can reproduce / imitate / copy the books, songs, music, etc.
 the copyright holder can sell or assign his creation and earn profits.

11) Royalty
 a holder of IPR (patent, trademark, copyrights etc.) may transfer his rights
 where such owner of IPR transfers his exclusive rights, he earns money for the same
 royalty is a contractual amount (money) received by the owner of IPR
 royalty is paid by a person for using the assets belonging to another person.

12) Investment
 investment is a cash outflow for buying monetary assets
 investment denotes such assets which are held not for business purposes
 purpose of investment is to earn interest, profit, dividend or other benefits.
 held for earning passive income / other income
 for example: long term investments in Bank FD, mutual funds, deposits etc.

13) Current Assets

 assets held for short-term purposes, held for day-to-day business operations
 supposed to be converted into money / cash upto 12 months (i.e., upto 1 year)
 example: cash, bank balance, inventory, debtors, bills receivables, prepaid expenses,
accrued income, short-term investments, short-term loans given etc.

14) Inventory / Stock

 material held for sale in ordinary course of business
 material used in business operations for manufacturing / trading activities
 includes raw material, work-in-progress, finished goods, spares etc.
 inventory or stock is a constituent of current assets

15) Debtors
 customers to whom goods / services are sold on credit
 customers from whom money is receivable by the business
 debtors are a constituent of current assets

Compiled by Prof. Prasad Bhat Page 17

16) Bills Receivables (B/R)
 bills receivables are similar concept to debtors, and it is a part of current assets
 persons / customers from whom money is receivable by the business
 a separate document known as ‘bill of exchange’ is created for higher safety of funds

17) Prepaid Expenses

 these are expenses which are paid in advance
 benefit of such expense will be received in future (next accounting year)
 prepaid expense is a constituent of current assets

18) Accrued Income

 these are incomes which are earned but not received yet
 for example: interest on Bank Fixed Deposit is receivable at end of financial year, but
received in the next year.
 accrued income is a constituent of current assets

19) Liability
 liability denote a financial obligation of a business
 amount payable (owed) to outsiders (money value)
 liability also known as ‘debt’ of a business owed to third parties
 classified into non-current liability and current liability

Liabilities

Based on Time Period

Non-Current Liabilities Current Liabilities

20) Non-Current Liability

 long-term liability
 payable after 12 months (i.e., later than 1 year)
 for example: Bank Loan, Borrowings from Financial Institution, Corporate Debentures,
Deposits Accepted from public / members, trade payable (beyond 1 year) etc.

Compiled by Prof. Prasad Bhat Page 18

21) Debentures
 debentures are a type of long-term borrowing from general public and other lenders,
 generally, debentures are secured by a collateral
 maximum tenure (maturity) of secured debentures is 10 years
 company pays annual interest and repayment (redemption) of funds are maturity

22) Deposits
 deposits are a type of medium-term borrowing from general public / members,
 generally, deposits are secured by a collateral
 maximum tenure (maturity) of deposits is 36 months
 company pays annual interest and repayment of funds are maturity

23) Current Liabilities

 liabilities which are payable within a short period of time,
 supposed to be paid upto 12 months (i.e., upto 1 year)
 for example: creditors, bills payable, outstanding (unpaid) expenses, bank overdraft,
short-term loans taken, provision for tax, proposed dividend etc.

24) Creditors
 suppliers from whom goods / services are purchased on credit
 suppliers to whom money is payable by the business
 creditors are a constituent of current liabilities

25) Bills Payable (B/P)

 bills payable are similar to creditors
 persons / suppliers to whom money is payable by the business
 a separate document known as ‘bill of exchange’ is created for commitment to pay
 bills payable (B/P) is a constituent of current liabilities

26) Outstanding (Unpaid) Expenses

 these are expenses which are incurred during the financial year, but not paid yet
 for example: unpaid salary, unpaid rent, unpaid electricity bill etc.
 outstanding expenses are a constituent of current liabilities

Compiled by Prof. Prasad Bhat Page 19

27) Bank Overdraft (BOD)
 short-term borrowing from a bank
 a businessman is allowed to withdraw additional funds over and above bank balance
 such additional funds are in the form of loan, which is repayable with interest
 bank overdraft is a constituent of current liabilities

28) Provisions
 expenses which are payable by a business, but the actual amount is not certain
 provision is a type of liability created for approximate amount
 example: provision for income tax, provision for employee compensation etc.

29) Proposed Dividend

 dividend means profits which are distributed by a company to its members
 once a company declares dividend, it becomes a commitment to pay within 30 days
 proposed dividend is a constituent of current liabilities

30) Contingent Liability

 a financial obligation relating to an existing event or future event which may or may
not arise, depending on occurrence or non-occurrence of uncertain future happening
 contingent liability is not recorded in a Balance Sheet
 contingent liability is recorded outside the Balance Sheet (notes to accounts), as a
part of disclosure requirements to investors
 Example: disputed cases pending in Courts, guarantees given to others etc.

31) Capital
 capital means the funds / money contributed by owner of a business
 in case of sole proprietor, capital is introduced by the single owner
 in case of partnership firm, capital is introduced by the partners
 in case of company, capital is contributed by multiple shareholders. In a company,
capital is classified into equity share capital and preference share capital.

Compiled by Prof. Prasad Bhat Page 20

32) Authorized Share Capital
 in a company, the total capital is divided into equal parts, each part known a ‘share’.
Every share has a face value, generally ₹ 10 / 5 / 2 / 1 or any number (except fraction)
 where a company is legally registered / incorporated, the Board of Directors decide
the maximum number of shares that can be issued by the company
 such maximum number of shares is known as ‘Authorized Share Capital’
 at any point of time, the total capital of a company cannot go beyond the authorized
share capital. However, a company may increase its authorized share capital through
approval from its shareholders.
 example: Auth. Capital ₹ 10,00,000 divided into 100000 shares of face value ₹ 10 each

33) Equity Share Capital

 in a company, the total capital is divided into equal parts, each part known a ‘share’.
Every share has a face value, generally ₹ 10 / 5 / 2 / 1 or any number (except fraction)
 every company has equity share capital, hence it is called common / ordinary capital
 equity shareholders are the real owners of a company, they share the risks and enjoy
the profits of the company. Dividend is optional at the decision of Board of Directors.
 for public limited company, equity shares can be listed on recognized stock exchange
via SEBI approval. Thereafter, shares are traded (buy / sell) on the stock exchange.
The price at which shares are traded is known as market price / value.

34) Preference Share Capital

 a company may have another type of share capital known as preference share capital
(although not mandatory)
 preference shareholders get priority over equity shareholders for dividend payments
as well as repayment of capital. Fixed rate dividend is paid every year, if profits.
 further, where a company has sufficient profits, dividend to preference shareholders
is always compulsory, whereas dividend to equity shareholders is always optional

35) General Reserves / Retained Earnings

 where a company earns profits, it may set-aside certain profits for future purposes
 such set-aside profits are known as ‘reserves’ or ‘retained earnings’
 reserves or retained earnings belong to equity shareholders of a company

Compiled by Prof. Prasad Bhat Page 21

36) Security Premium
 where a company issues / sells shares at a price, higher than its face value, the extra
amount received by the company is known as ‘premium’.
 such extra amount collected is recorded under the heading ‘security premium’
 example: face value ₹ 10 / share and IPO price ₹ 90, hence premium ₹ 80 per share
 security premium belongs to equity shareholders of a company

Financial Statements

Profit & Loss

Balance Sheet
Statement

Income Expenses Assets Liabilities Capital

37) Profit & Loss (P&L) Statement

 Profit & Loss (P&L) Statement shows the income and expenses of a business, for a
certain period of time
 Profit & Loss Statement depicts the financial performance of a business for a period
If Income > Expenses = Profit

If Income < Expenses = Loss

 In India, financial year / accounting year starts on 1st April and ends on 31st March.
 Hence, generally, P&L Statement is prepared for the year ended 31st March.
 However, for companies which are listed on Stock Exchange, financial statements are
prepared and communicated every quarter-end (30 June, 30 Sept, 31 Dec, 31 March).

38) Income
 income means sales, revenue, turnover or any other sources of earning money
 in the ordinary course of business, income represents an amount earned from sale of
goods, rendering of services, receipt of interest, commission, royalty, dividends etc.
 income can be classified into two parts – revenue from operations and other income

Compiled by Prof. Prasad Bhat Page 22

39) Revenue from Operations
 income earned from the primary / main activities of a business (goods & services)
 revenue from operations is the main source of income for a business
 it pertains to core business activities as well correlated to main business
 example: for stationery business, sale of books, notebooks, pens, pencils etc.

40) Other Income

 income earned from activities which are not related to the main business
 generally, other income is passive income, which are earned alongside main business
 example: for stationery business, rent received, interest on bank FD etc.

41) Expenses
 expenses include various costs relating to a business
 expenses are recorded for an accounting period, say a financial year
 total expenses are compared with total income to measure profit or loss
 as per Companies Act, 2013, total expenses are classified into various categories

42) Cost of Material Consumed

 cost of raw material used in business operations for an accounting period
 cost of raw material purchased includes its buying cost, duties, and taxes, carriage
inwards (transport cost)
 cost of raw material consumed requires adjustment with opening stock and closing
stock of material, to compute actual material used (consumed) during the year
 material consumed = opening stock (+) purchases (-) returns (-) closing stock

43) Purchases of Stock in Trade (SIT)

 trading means such goods which is bought for the sole purpose of re-selling as it is
 purchases of stock-in-trade means such goods which are purchased for resale

44) Changes in Inventory of Finished Goods, Work-in-Progress and Stock-in-Trade

 changes in inventory means difference between opening stock & closing stock
 changes in inventory (stock) = opening stock (-) closing stock
 opening stock means material in hand at the start of financial year, 1 st April
 closing stock means material in hand at the end of financial year, 31 st March

Compiled by Prof. Prasad Bhat Page 23

45) Employee Benefit Expenses
 employee benefit expenses include all costs incurred for workers and staff
 example: salary, wages, provident fund contribution, bonus, incentives, employees’
health insurance premium, pension, staff welfare costs etc.

46) Finance Cost

 basically, finance cost includes the interest paid on borrowings / loans
 finance costs include interest expense and bank charges

47) Depreciation and Amortization

 depreciation means reduction in value of tangible fixed assets due to usage, damage,
wear and tear, change in technology or passage of time
 amortization is reduction in value of intangible assets such as goodwill, patent etc.
 depreciation and amortization are non-cash expenses, i.e., there is no cash outflow

48) Other Expenses

 the last heading in expenses is other expenses, which are not covered above
 example: rent, electricity, advertisement, commission, printing, stationery, internet,
postage, insurance premium, telephone charges, repairs, maintenance, bad debts etc.

49) Bad Debts

 where a customer to whom we sold goods on credit commits default in payment, it is
known as bad-debts
 bad-debt is a loss due to non-receipt of money from customers

50) Net Profit / Net loss

 the difference between total revenue and total expenses during an accounting period.
 where difference is positive, it is known as net profit and where such difference is
negative, it is referred to as net loss. This is after deducting all expenses and tax.

51) Account (A/c)

 account is summarized record of all business transactions relating to a person, assets,
income or expense.
 all business transactions are recorded at one place relating to a particular head.
 example: Rent A/c, Salary A/c, Bank A/c, Cash A/c, Furniture A/c, Investment A/c etc.

Compiled by Prof. Prasad Bhat Page 24

52) Gross Profit
 gross profit is the difference between total income and total manufacturing expenses
during an accounting period.
 the aggregate cost of raw material consumed along with all the manufacturing costs
is known as ‘Cost of Goods Sold (COGS)’
 hence, gross profit = Total Income (-) COGS
 expenses related to administrative, marketing, selling, distribution, interest etc. is not
considered while computing gross profit.

53) Operating Profit

 operating profit is difference between total income and COGS as well as operating
expenses during an accounting period.
 operating profit = Total Income (-) COGS (-) Operating Expenses
 operating expenses include administrative, marketing, selling, distribution etc.
 operating profit is also known as Earnings / Profit before Interest and Tax (EBIT / PBIT)

3. TYPES OF EXPENDITURE

Sr. Revenue Expenditure Capital Expenditure

1 Expenditure for short-term benefits Expenditure for long-term benefits
(upto 1 year) (more than 1 year)
2 Day-to-day expenses, routine Non-recurring expenses
nature
3 Incurred for operating activities Incurred for creation of non-current
assets / fixed assets
4 Recorded in Profit & Loss Recorded in Balance Sheet
Statement
5 Generally, small amount expenses Generally, high value expenditure
6 E.g., rent paid, raw material bought, E.g., purchase of land, machinery,
salary, interest on loan, postage, long-term investment, acquiring
depreciation etc. patents etc.

Compiled by Prof. Prasad Bhat Page 25

4. ACCOUNTING CONCEPTS & CONVENTIONS
1. INTRODUCTION

 In previous chapters, we have understood the meaning of business transactions and

objectives of financial accounting.
 Accounting is known as the language of business. Every language in the world has its
own vocabulary and well-established rules of usage, to ensure proper communication.
 Similarly, accounting has also developed a set of its own rules, own terminologies, so
that people can understand all the financial statements in the same sense.
 In order to maintain uniformity and consistency in preparing and maintaining books of
accounts, certain rules or principles have been evolved.
 These principles are classified as Concepts and Conventions. These are basic principles
used in preparing and maintaining accounting records.
 The principles are rules and regulations adopted by an accountant while recording
business transactions. It consists of –
a) Concepts: are assumptions or conditions, followed during recording transactions
b) Conventions are customs and practices which guide accountants while preparing
accounting statements.

2. ACCOUNTING CONCEPTS

1) Business Entity Concept

 The essence of this concept is that a business is a separate entity and it is different
from the owner or proprietor.
 Thus, for the purpose of accounting, all the transactions should specifically relate to
the business operations only. Hence, personal transactions of the owner are not to be
recorded in the books of account of the business.
 This concept applies to all forms of organizations such as sole trader, partnership
firm, a company etc.
 Business entity concept helps in ascertaining profit / loss of a business as only the
business incomes and expenses are recorded and all personal expenses are ignored.
 This concept is the very basis of accounting rules and principles.

Compiled by Prof. Prasad Bhat Page 26

2) Going Concern Concept
 The fundamental assumption is that a business entity will continue for a long time.
There is no intention to clos the business in the near future.
 Assets and liabilities of a business are valued with an assumption that the business is
going to last till eternity
 Where an enterprise is going to wind-up soon, nobody will enter into any financial
transactions with such business.
 Every business is valued with respect to its future profit earning capacity. Such
assumption is called ‘going concern concept’.

3) Money Measurement Concept

 Accounting records only the transactions which can be expressed in money terms.
 An event or a transaction that cannot be expressed in money terms, is not recorded in
the books of account. Money is the common denominator for accounting purposes.
 For example: honesty of employees, dynamism of selling agents, integrity of cashier
cannot be recorded in the books of accounts.
 Money is common denominator in which all business transactions are expressed

4) Cost Concept
 Cost concept means that business transactions shall be accounted in the books at the
cost at which they have been acquired or actual amount paid for such benefit.
 An asset is recorded in accounting books at the price paid to acquire it i.e., at its cost
 The implication of this concept is that purchase of an asset is recorded in the books at
the price actually paid for it irrespective of its market value
 Example: a car is purchased by paying ₹ 200,000 and actual market price is ₹ 500,000,
then the transaction will be recorded at ₹ 200,000 only (actual cost paid).

5) Periodicity Concept (Accounting Period)

 Going concern principle assumes that a business will continue forever.
 However, financial statements shall be prepared at the end of certain period / interval,
known as accounting period (generally, one year)
 A Profit & Loss Statement and Balance Sheet should be prepared at the end of each
accounting year, so that financial performance and financial position is understood by
the stakeholders at regular intervals.

Compiled by Prof. Prasad Bhat Page 27

6) Dual Aspect Concept
 Dual Aspect concept is based on the principle that every transaction has a two-fold
effect, i.e., receiving a benefit and sacrificing some benefit (or cost)
 Hence, benefit received and benefit given should always match and balance
 Dual aspect concept is the origin of ‘Double Entry System’ of accounting
 Example: 5 kg rice purchased for ₹ 1000, i.e., benefit received is rice and benefit given
is ₹ 1000 to the shop-keeper.
 This dual aspect concept provides the following fundamental accounting equation –
Assets = Liabilities (+) Capital
 The above accounting equation states that the assets of a business are always equal
to the claims of owners (i.e., capital) and the outsiders (i.e., liabilities).
 The knowledge of dual aspect helps in identifying the two aspects of a transaction
which helps in applying the rules of recording the transactions in books of accounts.
 The two accounting effects are known as Debit and Credit. Basically, Debit and Credit
are increase and decrease in the value of assets, liabilities, expenses, income as per
the nature of the business transaction.

7) Accrual Concept
 Accrual concept recognizes all revenues and expenses as they are earned or incurred,
without money consideration to their actual receipts or payments.
 It means that revenues and expenses are recorded in the books of account even if
they are not received or paid in cash terms.
 Basically, accrual means some amount has become ‘due’ at the end of the accounting
period. A transaction is recorded whether cash is paid / received or not.
 Example: credit sales, credit purchases, electricity, office rent etc. are recorded even
though they are paid at a later date.

8) Matching Concept
 As per matching concept, the income for an accounting period is should be co-related
(matched) with the expenses for that period only.
 In other words, revenue and expenses incurred to earn the profits must belong to the
same accounting period. Otherwise, the profit / loss computed will be incorrect.
 Example: for computing profit or loss, income earned in 2020 cannot be compared
with expenses incurred in 2018, since there is no co-relation between them

Compiled by Prof. Prasad Bhat Page 28

9) Realization Concept
 Realization concept says that revenue from a business transaction should be included
in accounting records only when it is realized.
 The term realisation means creation of legal right to receive money. Thus, revenue
should be recorded in books of account on the date when ownership of goods and
services is transferred to customers either for cash or credit basis.
 Example: sales should be recorded in books when a TV is sold and delivered to a
customer. Simply, enquiry from a customer is not realization.

3. ACCOUNTING CONVENTIONS

Accounting Conventions refer to the common practices which are universally followed in
recording & presenting accounting information of a business entity. Basically, conventions
are followed like customs, practices, etc. in a society. Accounting conventions are evolved
through the regular and consistent practice over the years to facilitate uniform recording in
the books of accounts. Accounting conventions are the practical guidelines which facilitate
application of accounting practices.

1) Materiality
 As per Materiality principle, all matters and events which have a significant economic
effect on the business should be disclosed separately.
 Hence, any small, trivial, insignificant transaction should be recorded, but need not be
disclosed separately in books of accounts. The purpose of this principle is to reduce
the burden of the accountant.
 An item is material (important) or not will depend on the impact on decision-making
of users of financial statements (stakeholders).
 Example: envelopes, ball pens, erasers, stapler pins etc. can be recorded under the
heading ‘Stationery’, but valuation of raw material should be shown separately.

2) Consistency
 Consistency implies that an enterprise should follow the same accounting principles
and procedures from each accounting period to period.
 Consistency makes financial statements comparable and users can make meaningful
interpretation and facilitates decision-making.
 If there are any changes made in the accounting policies (e.g., rate of depreciation)
the accountant must disclose such changes separately.

Compiled by Prof. Prasad Bhat Page 29

3) Conservatism (Prudence)
 As per Conservatism / Prudence principle, assets and profits should not be overstated
and anticipated income should not be recognized.
 However, all anticipated liabilities and losses to be considered and provision for the
same should be made in the books.
 The golden rule is “Anticipate no profits, but provide for all anticipated losses”
 Conservative principle helps in ascertaining true profit. It is useful in case of doubts
and uncertainties. It avoids over-confidence of the investors.
 Example: inventory is shown at cost or market value, whichever is less.

4) Full Disclosure
 Full Disclosure principle requires that all material and relevant facts concerning
financial statements should be fully disclosed. The financial statements must reveal
all material information to all interested parties dealing with the enterprise.
 Disclosure should be full (complete) in all respects and fair for the benefit of users.
 Even vital information after Balance Sheet date, but before presentation of accounts
should be disclosed. Disclosure depends on the materiality of information.
 The Companies Act, 2013 also requires that P & L Statement and Balance Sheet of a
company should give a true and fair view of the state of affairs of the company. This
is even more important since the owners and management are separate.

Compiled by Prof. Prasad Bhat Page 30

5. ACCOUNTING RULES & PROCESS
1. INTRODUCTION

 Accounting process begins with creation of business transaction. A business transaction

is a monetary transaction, which involves exchange of goods, services or money.
 In an accounting period, an accountant records transactions as and when they occur.
 At the end of accounting period, the accountant summarizes the information recorded
and prepares the Trial Balance to ensure that double entry system has been maintained.
 When the recording aspect is complete, the accountant prepares financial statements
reflecting the financial performance and financial position of the business.
 Thus, the accounting process consists of three major parts:
i. recording of business transactions during an accounting period;
ii. summarizing of information at the end of the accounting period; and
iii. reporting and interpreting of the financial information.

2. PROCESS FLOW

1) Business Transaction – first step of accounting is financial transaction where there is

exchange of benefits, goods, services, transfer of funds, borrowings, etc.

2) Document – every business transaction shall be supported by valid documentary

evidence. E.g., bill, invoice, receipt, challan, delivery slip, note, voucher etc.

3) Recording – all business monetary transactions are recorded in the books of account.
Recording is done in a book called ‘Journal.’

4) Classifying – classification is based on the systematic analysis of the recorded data,

with to group similar transactions at one place. Classification is done in a ‘Ledger’

5) Summarising – at the end of accounting period (financial year) all the classified data
is summarized. All account balances are summarized in a ‘Trial Balance’.

6) Finalization – on basis of such Trial Balance, the Financial Statements are prepared
viz. Profit & Loss Statement and Balance Sheet. In case of certain companies, Cash
Flow Statement is also prepared.

Compiled by Prof. Prasad Bhat Page 31

3. ACCOUNTING EQUATION

 Recording of business transactions in the books of account is based on a fundamental

relationship called as ‘Accounting Equation.’
 Assets of a business are either financed by owners’ funds or by outsiders’ funds. This
relation expresses the equality of assets on the one side and capital and liabilities on the
other side.
 In mathematical form, Assets = Liabilities + Capital

Illustration:
 Ganesh Traders started a new business with own funds ₹ 3,00,000. The business has
assets (cash) and contributed by owners (capital). There are no outside funds.
Accounting equitation would be:
Assets (₹ 3,00,000 cash) = External Liabilties (Nil) + Owners’ Capital (₹ 3,00,000)

 Ganesh Traders acquired bank loan of ₹ 1,00,000. In this case, asset is increased
(cash) and liability is created (bank loan). The accounting equation would be:
Assets (₹ 4,00,000 cash) = Liabilties (₹ 1,00,000 bank loan) + Capital (₹ 3,00,000)

 Ganesh Traders purchased goods ₹ 2,00,000 on credit from Shiva Traders. This
transaction created a new asset in the form of inventory and created a new liability in
the form of creditors. The accounting equation would be:
Assets (₹ 4,00,000 cash + ₹ 2,00,000 inventory)
= Liabilties (₹ 1,00,000 bank loan + ₹ 2,00,000 creditors) + Owners’ Capital (₹ 3,00,000)

 Ganesh Traders paid ₹ 1,00,000 cash to Shiva Traders. Here, the asset (cash) would
reduce and liability (creditors) would also reduce. The accounting equation would be:
Assets (₹ 3,00,000 cash + ₹ 2,00,000 inventory)
= Liabilties (₹ 1,00,000 bank loan + ₹ 1,00,000 creditors) + Owners’ Capital (₹ 3,00,000)

 Ganesh Traders sold goods of ₹ 2,00,000 for ₹ 3,00,000 cash. There is reduction of
inventory, increase in cash and rise in profit. The accounting equation would be:
Assets (₹ 6,00,000 cash) = Liabilties (₹ 1,00,000 bank loan + ₹ 1,00,000 creditors)
+ Owners’ Capital (₹ 3,00,000 + ₹ 1,00,000 profit)

Compiled by Prof. Prasad Bhat Page 32

4. DOUBLE ENTRY SYSTEM OF ACCOUNTING

 As discussed earlier, one of the fundamental principles of accounting is the ‘Dual Aspect’
concept, which states that every transaction has two-fold effect.
 The Double Entry System of accounting is based on the dual aspect concept, which says
that every financial transaction has two effects, receiving a benefit and giving a benefit.
 The knowledge of dual aspect helps in identifying the two aspects of a transaction which
helps in applying the rules of recording the transactions in books of accounts.
 The two accounting effects are known as Debit and Credit, derived from Latin words
‘debere’ and ‘credere’ respectively. Basically, Debit and Credit are increase / decrease in
value of assets, liabilities, expenses, income as per nature of the business transaction.
 The Double Entry System of accounting was designed by Italian mathematician name
Luca De Bargo Pacioli, and he is known as the ‘Father of Accounting.’

5. MEANING OF ACCOUNT

 An Account (A/c) is a summary record of all business transactions relating to a person,

asset, liability, income or expense.
 All business transactions are recorded at one place relating to the particular head.
 Example: Rent A/c, Salary A/c, Bank A/c, Cash A/c, Furniture A/c, Investment A/c etc.
 Format of Account:
Name / Title of the Account
debit side (left) credit side (right)
Date Particulars Amount ₹ Date Particulars Amount ₹

 The left side of an account is called the debit side and right side is called the credit side.
 Amounts entered on the left side of an account, are called debits and amounts entered
on the right side of an account are called credits.
 To debit (Dr.) an account means to make an entry on the left side of an account and to
credit (Cr.) an account means to make an entry on the right side.
 Simply, the words debit and credit denote increase and decrease in the value of assets,
liabilities, expenses, income as per nature of the business transaction.
 In the Double Entry System of accounting, in every transaction, the debit amount must
equal the credit amount. Double Entry System of accounting is universally followed.

Compiled by Prof. Prasad Bhat Page 33

6. CLASSIFICATION OF ACCOUNTS – TRADITIONAL APPROACH

 As discussed earlier, for every business transaction, there is debit effect and credit effect.
 However, the debit and credit effects are based on the nature / type of account.
 Traditionally speaking, an account is classified into 3 types viz. Real Account, Personal
Account and Nominal Account.

Types of Accounts
Real Personal Nominal
Account Account Account

Natural Artificial Represent Expenses: Incomes:

Tangible Intangible
person: person: Person: Rent paid, Sales,
Assets: Assets:
Mr. Amit, ICICI Bank, Debtors, salary, tax, Services
Machinery, Goodwill,
Ms. Sapna Infosys Ltd. Creditors electricity, provided
Vehicle etc. Patent etc.
etc. etc. etc. etc. etc.

1) Real Accounts: represent the assets, which belong to a business. Further classified into:
a. Tangible Asset, which we can touch, see, e.g., land, building, inventory, cash,
machinery, vehicles, furniture, etc.
b. Intangible Asset, which we cannot see or touch, but can be measured in monetary
terms. E.g., Goodwill, patent, copyright, etc.

2) Personal Accounts include accounts of persons / parties with whom business deals.
a. Natural persons are human being such as Mr. Ram, Ms. Sita etc.
b. Artificial persons are companies, banks, firms etc. E.g., SBI, Tata Motors etc.
c. Representative persons are group of persons E.g., debtors, creditors etc.

3) Nominal Accounts are related to expenses, incomes, losses and gain of a business.
a. Expense account include rent paid, salary paid, commission paid, tax paid etc.
b. Income account include sale of goods, interest received, dividend received etc.
c. Loss account include loss by fire, loss by theft etc.
d. Gain account include profit on sale of investment etc.

Compiled by Prof. Prasad Bhat Page 34

Illustration – Classification of accounts into Real A/c, Personal A/c and Nominal A/c:

Sr. Account Name Nature of Transaction Nature of Account

1 Cash A/c Asset Real Account
2 Salary paid A/c Expenses Nominal Account
3 ICICI Bank A/c Artificial Person Personal Account
4 Machinery A/c Asset Real Account
5 Legal Fees A/c Expenses Nominal Account
6 Sale of Goods A/c Income Nominal Account
7 Debtors A/c Representative Person Personal Account
8 Dividend received A/c Income Nominal Account
9 Share Capital A/c Representative Person Personal Account
10 Building A/c Asset Real Account
11 Bad-Debts A/c Loss Nominal Account
12 Interest paid A/c Expenses Nominal Account
13 Equipment A/c Asset Real Account
14 Services Provided A/c Income Nominal Account
15 Commission paid A/c Expenses Nominal Account
16 SBI Loan A/c Artificial person Personal Account
17 Trademark A/c Asset Real Account
18 Tata Motors A/c Artificial person Personal Account
19 Laptop A/c Asset Real Account
20 Repairs A/c Expenses Nominal Account
21 Rent received A/c Income Nominal Account
22 Creditors A/c Representative Person Personal Account
23 Bank charges A/c Expenses Nominal Account
24 Loss by Fire A/c Loss Nominal Account
25 Goodwill A/c Asset Real Account
26 MBA College A/c Artificial Person Personal Account
27 Inventory A/c Asset Real Account
28 Discount given A/c Loss Nominal Account
29 Transport cost A/c Expenses Nominal Account
30 Prasad Bhat A/c Natural person Personal Account

Compiled by Prof. Prasad Bhat Page 35

7. GOLDEN RULES OF ACCOUNTING – TRADITIONAL APPROACH

 For every business transaction, there is debit effect and credit effect. However, the debit
and credit effects are based on the nature / type of account.
 Following are the Golden Rules of Accounting based on traditionally nature of accounts:

Nature of Account Debit (Dr.) Credit (Cr.)

Real Account ‘What Comes In’ ‘What Goes Out’
Personal Account ‘The Receiver’ ‘The Giver’
Nominal Account ‘All Expenses & Losses’ ‘All Gains & Incomes’

Debit: what comes in

Real Account
Credit: what goes out
Golden Rules

Debit: the receiver / debtor

Personal Account
Credit: the giver / creditor

Debit: all expenses and losses

Nominal Account
Credit: all incomes and gains

Illustrations of Golden Rules of Debit & Credit

Sr. Transaction Nature of 1st Debit Nature of 2nd Credit

A/c Affected A/c Affected
1 Cash received from Cash: Cash A/c Share Capital: Share Cap. A/c
share-holders Real A/c (what comes in) Personal A/c (the Giver)

2 Furniture purchased Furniture: Furniture A/c Cash: Cash A/c

by paying cash Real A/c (what comes in) Real A/c (what goes out)

3 Rent paid by cheque Rent paid: Rent A/c Bank: Bank A/c
Nominal A/c (expenses) Personal A/c (the Giver)

4 Sold goods to Ram Ram: Ram A/c Sales: Sales A/c

on credit basis Personal A/c (the Receiver) Nominal A/c (income)

5 Purchased material Purchases: Purchases A/c Amar: Amar A/c

on credit from Amar Nominal A/c (expenses) Personal A/c (the Giver)

Compiled by Prof. Prasad Bhat Page 36

 Sr. Transaction Nature of 1st Debit Nature of 2nd Credit
A/c Affected A/c Affected
6 Interest received by Bank: Bank A/c Interest recd. Interest A/c
cheque Personal A/c (the Receiver) Nominal A/c (income)

7 Loan taken from Cash: Cash A/c ICICI Bank Loan ICICI Loan A/c
ICICI Bank Real A/c (what comes in) Personal A/c (the Giver)

8 Insurance Premium Insurance: Insurance A/c Bank: Bank A/c

paid by cheque Nominal A/c (expenses) Personal A/c (the Giver)

9 Cheque recd. from Bank: Bank A/c Mohan: Mohan A/c

Mohan (debtor) Personal A/c (the Receiver) Personal A/c) (the Giver)

10 Commission Commission: Commission A/c Dealer: Dealer A/c

payable to Dealer Nominal A/c (expenses) Personal A/c (the Creditor)

8. CLASSIFICATION OF ACCOUNTS – MODERN APPROACH

As per modern thought process, an account is classified into five types viz. Asset Account,
Liability Account, Capital Account, Income Account and Expenses Account.

Types of Accounts

Asset A/c Liability A/c Capital A/c Expenses A/c Income A/c

Tangible / Non-Current Equity Capital, Purchases, Tax, Sales, Revenue,

Intangible Liability Preference Cap Wages etc. Turnover etc.

Non-Current & Reserves, Depreciation, Interest recd.

Current Liability
Current Assets Retained Profits loss by fire etc. Dividend recd.

1) Asset Accounts: represent the assets, which belong to a business. Further classified into:
a. Tangible Asset, which we can touch, see and Intangible Asset, which we cannot
see or touch, but can be measured in monetary terms.
b. Non-Current Asset, is long-term nature and Current Asset, short-term nature

Compiled by Prof. Prasad Bhat Page 37

2) Liability Accounts include financial obligations which are payable by a business.
a. Non-Current Liabilities are long term-nature, payable after 12 months.
b. Current Liabilities are short term-nature, payable within 12 months

3) Capital Account, represents the amount contributed by the owners of the business. In a
company, capital can be equity share capital and preference share capital.

4) Expenses Account are related to expenses and losses of a business. It includes expenses
related to the main business operations as well as other expenses.

5) Income Account are related to various incomes and gains of a business. Incomes include
revenue from main business operations as well as other incomes.

9. RULES OF ACCOUNTING – MODERN APPROACH

 For every business transaction, there is debit effect and credit effect. However, the debit
and credit effects are based on the nature / type of account.
 Following are the Modern Rules of Accounting based on nature of accounts:

Nature of Account Debit (Dr.) Credit (Cr.)

Asset A/c Increase in Asset Decrease in Asset
Liability A/c Decrease in Liability Increase in Liability
Capital A/c Decrease in Capital Increase in Capital
Expenses, Loss A/c Increase in Expenses, Loss Decrease in Expenses, Loss
Income, Gain A/c Decrease in Income, Gain Increase in Income, Gain

Modern Rules

Asset A/c Liability A/c Capital A/c Expense A/c Income A/c

Debit: Debit: Debit: Debit: Debit:

increase in asset decrease liability decrease capital increase expens decrease income

Credit: Credit: Credit: Credit: Credit:

decrease asset increase liability increase capital decrease expens increase income

Compiled by Prof. Prasad Bhat Page 38

Illustrations of Modern Rules of Debit & Credit

Sr. Transaction Nature of 1st Debit Nature of 2nd Credit

A/c Affected A/c Affected

1 Cash received from Cash: Cash A/c Share Capital: Share Cap. A/c
share-holders Asset A/c (asset increase) Capital A/c (capital increase)

2 Furniture purchased Furniture: Furniture A/c Cash: Cash A/c

by paying cash Asset A/c (asset increase) Asset A/c (asset decrease)

3 Rent paid by cheque Rent paid: Rent A/c Bank: Bank A/c

Expense A/c (expense increase) Asset A/c (asset decrease)

4 Sold goods to Ram on Ram: Debtor: Ram A/c Sales: Sales A/c
credit basis Asset A/c (asset increase) Income A/c (income increase)

5 Purchased material on Purchases: Purchases A/c Amar: Creditor Amar A/c

credit from Amar Expense A/c (expense increase) Liability A/c (liability increase)

6 Interest received by Bank: Bank A/c Interest recd. Interest A/c

cheque Asset A/c (asset increase) Income A/c (income increase)

7 Loan taken from ICICI Cash: Cash A/c ICICI Loan ICICI Loan A/c
Bank Asset A/c (asset increase) Liability A/c (liability increase)

8 Insurance Premium Insurance: Insurance A/c Bank: Bank A/c

paid by cheque Expense A/c (expense increase) Asset A/c (asset decrease)

9 Cheque recd. from Bank: Bank A/c Mohan: debtor Mohan A/c
Mohan (debtor) Asset A/c (asset increase) Asset A/c (asset decrease)

10 Commission payable Commission: Commission A/c Dealer: Dealer A/c

to Dealer Expense A/c (expense increase) Liability A/c (liability increase)

10. RELATIONSHIP BETWEEN GOLDEN RULES & MODERN RULES

Golden Rules (Nature of Account) Modern Rules (Nature of Account)

Real Account Asset Account

Personal Account Liability Account

Capital Account

Nominal Account Expenses Account

Income Account

Compiled by Prof. Prasad Bhat Page 39

6. BOOKS OF ACCOUNTS
1. INTRODUCTION

 The accounting process begins with business transactions. A business transaction is a

monetary transaction, which involves exchange of goods, services or money.
 As discussed in earlier chapters, accounting involves various concepts, conventions,
rules, regulations and procedures for correct recording of business transactions.
 Hence, there should be proper recording of business transactions so that the financial
statements show true and fair view of the business.
 This chapter covers the various books of accounts and specific system to be followed for
recording transactions. It takes you through four stages of accounting cycle viz. Journal,
Ledger, Trial Balance and Financial Statements.

2. JOURNAL

 Whenever a business transaction takes place, its details should be recorded as per the
principles of double entry accounting. Based on nature of account, an accountant shall
record the proper debit and credit effects.
 The first record of business transaction is in a book known as ‘Journal.’
 The word journal is derived from French word ‘jour’, which means ‘a day.’ In a journal,
all daily business transactions are recorded in chronological order i.e., in order of time.
 When a transaction is recorded in a journal, it is known as journal ‘entry.’
 Journal is the book in which transactions are recorded for the first time. Journal is also
known as ‘Book of Original Record’ or ‘Book of Primary Entry’.
 Business transactions are classified into various categories of accounts such as assets,
liabilities, capital, income and expenses.
 Every business transaction affects two accounts. These are debited or credited according
to the rules of debit and credit, applicable to the specific accounts.
 Applying the principle of double entry, one account is debited and the other account is
credited. Every transaction can be recorded in journal.
 This process of recording transactions in the journal is’ known as ‘Journalising’.
 Journal serves the purpose of maintenance of permanent record of accounting, available
at one convenient place, maintained with the required data and description, date-wise, in
a chronological order, in the sequential order that the transactions keep taking place.

Compiled by Prof. Prasad Bhat Page 40

 Format of Journal:

Date Particulars Ledger Debit Amount Credit Amount

Folio

1) Paid rent paid for June 2023. Here, there is increase in Expense (rent), hence Rent
A/c is debited and decrease in Asset (Bank balance) and hence it is credited.
01 July 2023 Rent A/c Dr. 20,000
To Bank A/c 20,000
(Being rent paid for month
of June 2023)

2) Received cash by selling goods. Here, there is increase in Asset (Cash), so Cash A/c
is debited and increase in Income (Sale of Goods) and hence it is credited.
02 July 2023 Cash A/c Dr. 5,000
To Sales A/c 5,000
(Being goods sold for cash)

3) Furniture purchased on credit from Home Ltd. Here, there is increase in Asset
(furniture), so Furniture A/c is debited and increase in Liability, hence credited
16 Oct 2023 Furniture A/c Dr. 30,000
To Home Ltd. 30,000
(Being furniture purchased
on credit)

4) Depreciation on Furniture charged. Here, depreciation is a loss, hence debited and

decrease in value of Furniture, hence credited
30 Sep 2023 Depreciation A/c Dr. 1,500
To Furniture A/c 1,500
(Being deprecation charged
on furniture)

5) Money received by issue of equity shares. Here, there is increase in Asset (Bank),
hence it is debited and increase in Share Capital, hence it is credited
1 Jan 2024 Bank A/c Dr. 50,000
To Equity Capital A/c 50,000
(Being amount received by
issue of equity shares)

Compiled by Prof. Prasad Bhat Page 41

3. SUBSIDIARY BOOKS

 Generally, for a small business, a journal book is maintained in which all the transactions
are recorded, as per the nature of accounts.
 However, in case of big businesses, there are large number of transactions. Hence, the
single journal book may not be sufficient for systematic record. In modern book-keeping
practices, the journal is divided into a number of separate journals and a particular
journal is used for recording particular type of transactions.
 These are known as Special Journals or Subsidiary Books.
 Such books are known as Subsidiary Books, since they do not provide final accounting
information themselves but they simply help to prepare ledger accounts.
 Similar to journal, subsidiary books are also called as books of original entry or prime
entry because the transaction is first recorded in one of these books according to the
type of the transaction and then they are posted in the Ledger.
 Recording transactions of similar nature in respective subsidiary books greatly reduces
the work and facilitates convenience of journalizing every transaction.
 Following are the subsidiary books –
1) Purchases Book (also known as Bought Book, Invoice Book or Purchases Day Book)
2) Returns Outward or Purchases Returns Book
3) Sales Book (also known as Sold Book or Sales Day Book)
4) Returns Inward or Sales Returns Book
5) Cash & Bank Book
6) Bills Receivable Book
7) Bills Payable Book
8) Journal Proper

 Merits of Subsidiary Books

 Due to separate books, the duty of recording transactions can be divided among the
staff members. This helps to maintain books and keep then updated at all times.
 The Ledger Keeper can post the transactions at his convenience and thus the work of
writing up of subsidiary books is not held up.
 Duplication of work is avoided. This results in saving time, labour and stationery.
 Because of separate books for particular type of transactions the volume of business
in any one direction may be ascertained at a glance.
 Details are easily available, facilitates smooth references to any particular transaction.

Compiled by Prof. Prasad Bhat Page 42

 Details of Subsidiary Books:
1) Purchases Book is used for recording all purchases of goods only on credit basis.
Goods means articles meant for trading or the articles in which the business deals,
goods which are bought by a business for reselling. Hence, in a purchase book, items
such as machinery, computer, stationery, etc. are not recorded.

2) Purchase Returns or Returns Outward Book – When goods which are purchased by a
business are returned to the supplier, it is recorded in Purchases Returns Books.
Goods are returned due to reasons such as bad quality, excess quantity etc. Purchase
Returns books is also known as Returns Outward Book.

3) Sales Book is used for recording all sale of goods only on credit basis. Goods mean
the items meant for selling purposes, i.e., articles in which a business deals in. Hence,
credit sale of items other than goods are not recorded in Sales Book. E.g., sale of old
furniture, sale in investment, etc. are not entered in the Sales Book.

4) Sale Returns or Returns Inward Book – When good which are sold by a business are
returned by the customer, it is record in the Sales Return Book. The customer may
return the goods due to defect, wrong specification etc. Sales Returns book is also
known as Returns Inward Book.

5) Cash & Bank Book is used for recording all cash transactions i.e., all cash receipts and
all cash payments of the business. This book helps us to know the balance of cash as
well as bank balance, at any point of time. For example: goods purchased on cash,
goods sold and cheque received, rent paid by cheque, interest received in bank etc.

6) Bill Receivables Book – When goods are sold on credit and due date of payment is
agreed upon between seller and buyer, this is duly signed by both parties. A legal
stamped document is created, known as a ‘Bill of Exchange.’ For seller, it is recorded
in Bill Receivable Book, since he will receive money in future.

7) Bill Payable Book – When goods are purchased on credit and due date of payment is
agreed upon between seller and buyer, this is duly signed by both parties. A legal
stamped document is created, known as a ‘Bill of Exchange.’ For buyer, it is recorded
in Bill Payable Book, since he will pay money in future.

Compiled by Prof. Prasad Bhat Page 43

 8) Journal Proper is used for recording all such transactions which are not recorded in
any of the above subsidiary books. In other words, there is no specific book for such
transactions. Examples of transactions recorded in Journal Proper –
a. machinery purchased on credit, (since it is not goods and not cash payment)
b. depreciation on furniture, vehicles (since it is a loss and non-cash basis)
c. sale of investments
d. outstanding expenses
e. bad debts losses etc.

4. LEDGER

 In above topics, we discussed about journal and subsidiary books, which are books of
original entry. Business transactions are recorded in a journal, in order of time, i.e., on a
day-to-day basis.
 Ledger is a principal book of records and contains all accounts of a business arranged in
an orderly manner. A book containing all ‘accounts’ is a ledger – a book of final entry.
 All transactions are transferred from Journal to Ledger, known as ledger posting.
 Basically, ledger is a book where the classification function of accounting is performed. It
is the ‘reference book of accounting system and is used to classify and summarise
transactions to facilitate the preparation of financial statements.
 In a ledger, different types of accounts relating to assets, liabilities, capital, income and
expenses are maintained. It is a permanent record of business transactions.

 Benefits of Ledger
 systematic record maintained in a ledger provides classified information on various
accounts like accounts of assets, persons, expenses, losses, gains, incomes, etc. Such
information provided by the ledger is useful for controlling function of a business.
 trial balance can be easily prepared on the basis of closing balance shown by ledger
 various statements of accounts can be prepared on the basis of balance shown by the
ledger accounts.
 ledger has great use to a businessman as it gives information about a particular
account at a glance and at one place. E.g., total salary paid in an year, total amount
recoverable from a debtor, total amount repayable towards bank loan, commission
receivable on goods sold etc.

Compiled by Prof. Prasad Bhat Page 44

 Format of Ledger
Asset Account
Debit side (left) Credit side (right)
Date Particulars Amt ₹ Date Particulars Amt ₹
1 April To balance b/d 10,000
30 May By Decrease in Asset 5,000
25 Aug To Increase in Asset 25,000
31 Mar By balance c/d 30,000
Total 35,000 Total 35,000

Liability Account
Debit side (left) Credit side (right)
Date Particulars Amt ₹ Date Particulars Amt ₹
1 April By balance b/d 18,000
12 May To Decrease in Liab. 8,000
25 April By Increase in Liab. 13,000
31 Mar To balance c/d 23,000
Total 31,000 Total 31,000

Capital Account
Debit side (left) Credit side (right)
Date Particulars Amt ₹ Date Particulars Amt ₹
1 April By balance b/d 15,000
08 Nov To Decrease in Cap. 10,000
06 June By Increase in Cap. 25,000
31 Mar To balance c/d 30,000
Total 40,000 Total 40,000

Income Account
Debit side (left) Credit side (right)
Date Particulars Amt ₹ Date Particulars Amt ₹
10 May To Decrease in Income 5,000 04 Apr By Increase in Income 100,000
31 Mar To Closing balance 95,000
Total 100,000 Total 100,000

Expenses Account
Debit side (left) Credit side (right)
Date Particulars Amt ₹ Date Particulars Amt ₹
02 Apr To Increase in Expense 55,000 11 Apr By Decrease in Expenses 5,000
31 Mar By Closing Balance 50,000
Total 55,000 Total 55,000

Compiled by Prof. Prasad Bhat Page 45

 Balancing of a Ledger Account:

 balancing of an account is the process of finding out the difference between the total
of debits and total of credits of an account.
 the process of ascertaining and writing the balance of each account in the ledger is
called balancing of an account. An account has two sides: debit and credit.
 at the end of financial year (i.e., 31st March), if the debit (left) side total is more than
the credit (right) side total, the closing balance is called a debit balance.
 at the end of financial year (i.e., 31st March), if the credit (right) side total is more than
the debit (left) side total, the closing balance is called a credit balance.
 The excess / balance amount is carried forward to next financial year. It is recorded as
‘balance carried down (c/d)’ at the end of the financial year.
 At the start of next financial year, the excess / balance carried forward from the last
financial year is recorded as ‘balance brought down (b/d)’
 If the debit side and the credit side totals are equal, the balance is zero and nothing is
carried down or carried forward to the next financial year.
 Asset Accounts always have a debit balance and recorded in Balance Sheet
 Liability Accounts always have a credit balance and recorded in Balance Sheet
 Capital Accounts usually has a credit balance and recorded in Balance Sheet
 Income Accounts are simply totalled, and recorded in P&L Statement
 Expenses Accounts are simply totalled, and recorded in P&L Statement

Compiled by Prof. Prasad Bhat Page 46

5. TRIAL BALANCE

 Basically, ‘Trial Balance’ is a list of the account names and their balances as on a given
point of time with debit balances in one column and credit balances in another column.
 In other words, Trial Balance is a statement in which the balances of all the ledgers are
compiled into debit balances and credit balances.
 Trial Balance is prepared at the end of accounting period, i.e., 31 st March.
 Trial Balance is prepared to ensure that the process of recording in journal and posting
in ledger of the transaction have been carried out accurately.
 If the journal entries and ledger postings are accurate, then the debit total and credit total
in the Trial Balance must tally / match thereby evidencing mathematical accuracy.
 It shall be noted that matching of Trial Balance only verifies arithmetical accuracy, and
not the accuracy of accounting principles, rules and regulations.

 Objectives of Trial Balance

a) Check arithmetical accuracy – arithmetical accuracy in ledger posting means writing
correct amount, in the correct account and on its correct side (debit or credit).
b) Facilitate preparing Financial Statements – the ultimate purpose of accounting is to
prepare financial statements i.e., Profit & Loss Statement and Balance Sheet of a
business enterprise at the end of an accounting year. Trial Balance contains balances
of all ledger accounts, which in-turn are reflected in the financial statements.
c) Helps in locating errors – If total of two columns of a Trial Balance matches, it is a
proof of arithmetical accuracy in the ledger posting. However, if such totals do not
tally it indicates that there is some mistake in the ledger accounts. Generally, a Trial
Balance is generally prepared at the end of the year. However, it can be prepared at
any time during the accounting year to check the accuracy of the posting.
d) Assists in comparison – Comparison of ledger account balances of one year with the
corresponding balances with the previous year helps the management taking some
important decisions. This is possible by using the Trial Balances of the two years.
e) Facilitates in Making Adjustments – While making financial statements, adjustments
regarding closing stock, prepaid expenses, outstanding expenses etc are to be made.
Trial balance helps in identifying the items requiring adjustments in preparing the
financial statements.

Compiled by Prof. Prasad Bhat Page 47

 Trial Balance – Illustration 1

Particulars Debit balance (₹) Credit balance (₹)

Equity Share Capital --- 10,00,000
Revenue from Operations --- 21,00,000
Machinery & Equipment 15,00,000 ---
Purchases of Raw Material 10,00,000 ---
Employee Benefit Expenses 8,00,000 ---
Other Income --- 1,00,000
Cash and Bank Balance 2,00,000 ---
Creditors & Bills Payable --- 3,00,000
Total 35,00,000 35,00,000

 Trial Balance – Illustration 2

Particulars Debit (₹) Particulars Credit (₹)

Land & Building 7,00,000 Equity Share Capital 9,00,000
Debtors & Bills Receivable 1,00,000 Creditors 3,00,000
Purchases of Raw Material 8,00,000 Sales Turnover 15,00,000
Cash & Bank balance 3,00,000 Dividend received 50,000
Long Term Investments 2,50,000 ICICI Bank Loan 2,00,000
Salaries & Wages 1,50,000 Discount received 25,000
Interest paid 25,000 Rent received 25,000
Administration expenses 1,00,000
Furniture 3,25,000
Transport expenses 1,50,000
General expenses 1,00,000

Total 30,00,000 Total 30,00,000

Compiled by Prof. Prasad Bhat Page 48

7. FINANCIAL STATEMENTS
1. INTRODUCTION

 Financial statements are formal and structured records that show financial activities of a
business. Financial Statements show the financial performance and financial position of
a business entity.
 They provide a summary of the financial transactions, and resources of the entity over a
specific period. These statements are crucial tools for assessing the entity's financial
health, profitability, and overall performance.
 Financial Statements facilitate financial analysis of past data as well as future projections
of a business. The main types of financial statements are:
1. Profit & Loss Statement (Income Statement): The primary objective of any business
is to earn profits. The income statement shows the revenues, expenses, and profits or
losses of an entity over a specific period, generally a year or a quarter. It shows how
much money the business earned (revenues) and the costs incurred to generate those
revenues (expenses). The difference between revenues and expenses is net income
or net loss. Profit & Loss Statement is considered as the most important document
for the various stakeholders.

2. Balance Sheet (Statement of Financial Position): Balance Sheet provides a summary

of an entity's financial position at a specific point in time. It lists a company's assets,
liabilities, and shareholders' funds.

3. Cash Flow Statement: Cash Flow statement tracks the inflows and outflows of cash
and cash equivalents (bank balance) during a specific period. It categorizes cash flows
into operating activities, investing activities, and financing activities, providing
insights into how cash is generated and used by the entity. Cash Flow Statement is
prepared to highlight the liquidity position of a business. It helps to understand the
various sources of funds (inflows) and utilization of funds (outflows).

 Each financial statement serves specific purpose and together provides a comprehensive
overview of an entity's financial performance, position, and liquidity. These statements
are essential for stakeholders’ decision-making. Financial statements are prepared as per
applicable accounting standards and generally accepted principles of accounting.

Compiled by Prof. Prasad Bhat Page 49

2. OBJECTIVES / IMPORTANCE OF FINANCIAL STATEMENTS

1) Provide Financial Information: The primary purpose of financial statements is to offer

relevant and reliable financial information about a company's performance, financial
position, and cash flows. This information is crucial for decision-making by various
stakeholders, such as investors, creditors, management, employees, and regulators.
2) Assessing Financial Performance: Financial statements allow stakeholders to assess
how well a company has performed over a specific period. Key components, such as
income, and profit margins, help in evaluating company's profitability and efficiency.
3) Evaluating Financial Position: Balance Sheet provides an overview of a company's
assets, liabilities, and capital as on a date. It helps stakeholders understand the
organization's financial health, solvency, and liquidity.
4) Facilitate Investment Decisions: Investors (existing and potential) rely on financial
statements to evaluate the company's potential for growth and profitability. These
statements provide insights into the company's historical financial performance and
can be used to make informed investment decisions.
5) Facilitate Credit Decisions: Lenders (Banks, Fin. Inst.) and creditors use financial
statements to assess a company's creditworthiness and ability to repay debt. They
analyze financial ratios and cash flow patterns to evaluate the risk associated with
lending money to the company.
6) Facilitate Regulatory Compliance: Financial statements are essential for complying
with various legal and regulatory requirements, such as tax reporting, auditing, and
disclosure standards.
7) Monitoring Operational Performance: Financial statements help company's top-level
management monitor its own performance and make informed decisions about
resource allocation, cost management, and business strategy.
8) Benchmarking & Comparisons: Stakeholders use financial statements to benchmark a
company's performance against its competitors, industry standards, or prior periods.
This comparison helps identify areas of improvement or potential areas of concern.
9) Assisting in Valuation: Financial statements are vital in determining the value of a
company. Valuation analysts and potential buyers use financial information to assess
the company's worth during mergers, acquisitions, or sales.
10) Disclosure of Information to Public: Listed companies are required to publish their
financial statements for transparency & accountability to shareholders and the public.

Compiled by Prof. Prasad Bhat Page 50

3. LIMITATIONS OF FINANCIAL STATEMENTS

Even though financial statements are useful for understanding financial performance and
position of a business, they have certain limitations that stakeholders should be aware of
while using them for decision-making and analysis.

Following are key limitations –

1) Historical Nature: Financial statements are based on past transactions and events.
They reflect the financial position and performance of the entity up to a specific date
in the past. They may not fully show future financial health of the organization.
2) Non-Financial Information: Basically, financial statements measure financial data and
may not provide complete picture of non-financial factors that impact an entity's
operations, such as customer satisfaction, employee morale, innovation, etc.
3) Based on Estimates: Preparation of financial statements involves making estimates
and judgments. These estimates can be subject to biases, errors, or assumptions,
which can affect the accuracy and reliability of the financial information.
4) Omission of Intangible Assets: Basically, financial statements do not include valuable
intangible assets like intellectual property, goodwill, or human capital. These assets
significantly contribute to a company's profits but may not reflected in Balance Sheet.
5) Non-Disclosure of Sensitive Information: Certain sensitive information, such as
pending legal disputes, or upcoming strategic initiatives, may not be disclosed in the
financial statements, which may pose as critical risks or opportunities.
6) Lack of Real-time Information: Financial statements are prepared at the end of
reporting periods (quarterly or annually). Important events in-between these dates,
may result in outdated information for decision-making.
7) Ignorance of Future Events: Financial statements do not account for future events or
changes that may impact the company's financial position and performance. Factors
like changes in the economic environment, technological advancements, or industry
disruptions are not reflected in the statements.

Despite these limitations, financial statements remain valuable tools for understanding an
entity's financial performance and position. To reduce such limitations, stakeholders often
use supplementary information, such as management discussions and analysis, footnotes
to the financial statements, and other non-financial parameters, to get comprehensive view
of the entity's overall health and prospects.

Compiled by Prof. Prasad Bhat Page 51

4. PROFIT & LOSS STATEMENT

 A Profit and Loss Statement (P&L), also known as ‘Income Statement’, is one of the three
primary financial statements.
 The P&L Statement is used to assess the financial performance of a business over a
specific period of time, i.e., a year or a quarter.
 The P&L Statement provides a summary of company's revenues, expenses, and profits
or losses during that period. It is a crucial tool for investors, creditors, management, and
other stakeholders to evaluate the company's profitability and operating efficiency.
 Key Components of a Profit and Loss Statement:

1. Revenue from Operations (Sales / Turnover): This section represents the total income
generated from a company's primary business activities. It includes revenue from
sale of goods or services, as well as other operating income, related to main business

2. Other Income: This section represents the income earned from activities which are
not related to main business. Generally, other income is a passive income, which is
earned alongside main business activities. Example – for a textile business, income
from interest on Bank Fixed Deposit is other income.

3. Cost of Material Consumed: Cost of raw material used in business operations for an
accounting period. This cost includes its buying cost, duties, and taxes, carriage
inwards (transport cost). Raw Material consumed = opening stock (+) purchases (+)
expenses on purchase (-) purchase returns (-) closing stock.

4. Purchases of Stock in Trade (SIT): Trading goods means the goods which are bought
for the sole intention of re-selling it. Purchases of stock-in-trade means such material
which is purchased for resale purposes.

5. Changes in Inventory of Finished Goods (FG), Work-in-Progress (WIP) and Stock-in-

Trade (SIT): Changes in inventory means difference between opening stock & closing
stock. In simple words, changes in inventory (stock) = opening stock (-) closing stock.

6. Employee Benefit Expenses: This head includes expenses incurred for workers and
employees. Example – salary, wages, bonus, incentives, employees’ health insurance
premium, pension, staff welfare costs, provident fund contribution, etc.

Compiled by Prof. Prasad Bhat Page 52

 7. Finance Cost: Basically, finance cost means the interest paid on borrowings / loans.
Further, finance costs also include bank charges

8. Depreciation and Amortization: Depreciation means reduction in value of tangible

fixed assets. Amortization is reduction in value of intangible assets such as goodwill,
patent etc. Depreciation and amortization are non-cash expenses.

9. Other Expenses: The last section under expenses is ‘other expenses.’ Other expenses
include rent, electricity, advertisement, commission, printing, stationery, internet,
postage, insurance premium, telephone charges, repairs, maintenance, bad debts etc.

10. Profit Before Tax (PBT): Profit before Tax (taxable profit) is calculated by subtracting
all the expenses from the total income. It represents the profit earned by a company
before paying income tax.

11. Tax Expense: Tax expenses shows the income tax amount as computed as per the
provisions of the Income Tax Act, 1961.

12. Exceptional Items: Exceptional or Extraordinary items are transactions, events which
are non-recurring or non-operating. Basically, they are beyond company’s control.
Hence, these items are reported separately in P&L Statement. For Example: legal
settlements, refunds, losses from natural disasters, effects of war or terrorism etc.

13. Profit After Tax (PAT): Profit after Tax (net profit) is calculated by subtracting income
tax expense from Profit before Tax (PBT). Net profit belongs to the shareholders and
is available for payment of dividends.

14. Earnings per Share (EPS): Earnings per Share is financial parameter used to measure
a company's profitability on a per-share basis. EPS is a critical indicator for investors
and analysts as it helps them assess a company's earnings relative to the number of
outstanding shares. To calculate EPS, the formula is –

EPS = (Net Profit – Preference Dividends)

Number of Equity Shares Outstanding

Compiled by Prof. Prasad Bhat Page 53

 Significance / Importance of the Profit and Loss Statement:

1. Profitability Assessment: P&L Statement is a primary tool for evaluating a company's

profitability during a specific period. It helps stakeholders determine if the company's
operations are generating profits or incurring losses.
2. Performance Comparison: By comparing P&L Statements of different periods or with
industry benchmarks, stakeholders can assess company's financial performance.
3. Financial Decision-making: Investors and creditors use the P&L Statement to make
informed decisions about investing in or lending to the company.
4. Management Evaluation: Managers use P&L Statement to analyze cost structures,
identify areas of inefficiency, and make strategic decisions to improve profitability.
5. Financial Reporting: The P&L statement is a vital component of a company's financial
reporting, providing a clear picture of its financial performance to external parties.

Profit and Loss Statement of ABC Ltd. for the year ended 31st March 2023

Particulars Note No. Amount ₹

Income
Revenue from Operations (Net)
Other Income
Total Revenue / Income

Expenses
Cost of Material Consumed
Purchases of Stock in Trade (SIT)
Changes in inventories of FG, WIP and SIT
Employee Benefit Expenses
Finance Cost
Depreciation and Amortization Expenses
Other Expenses
Total Expenses

Profit / (loss) for the period before exceptional items

Adjustment for Exceptional Items

Profit / (Loss) Before Tax

Tax Expense

Profit After Tax

Earnings Per Share (EPS)

Compiled by Prof. Prasad Bhat Page 54

 Classification examples of items of the Profit and Loss Statement:

Revenue from Operations Other Income

 Sale of Goods  Rent received,
(depending on nature of business)  Interest received,
 Providing of Services  Commission received,
 Other Operating Revenue  Dividend received,
 Bad Debts Recovered,
 Discount received,
 Sale of Scrap,
 Royalty received etc.

Cost of Material Consumed Employee Benefit Expenses

(+) Opening Stock of Raw Material  Salary to Employees
(+) Purchases of Raw Material  Wages to Workers
(+) Expenses on Purchases  Staff Welfare Expenses
(carriage inwards, freight inwards)  Provident Fund Contribution
(-) Purchase Returns (defective)  Employees’ Insurance premium
(-) Closing Stock of Raw Material  Bonus to Workers
 Incentives to Employees etc.

Purchase of Stock in Trade Changes in Inventory

Purchases of Trading Goods (+) Opening Stock of FG / WIP / SIT
(+) Expenses on Purchases (-) Closing Stock of FG / WIP / SIT
(carriage inwards, freight inwards) = Changes in Inventory

Depreciation & Amortization Finance Cost

Depreciation of Tangible Assets Interest on Borrowings
(machinery, furniture, plant, vehicle etc) (bank loan, debentures, etc)
Amortization of Intangible Assets Bank Charges
(patent, goodwill, trademark etc) (processing fees, etc)

Other Expenses
Rent payment Audit Fees Bad Debts Transport cost
Electricity charges Carriage outwards Repairs Director sitting fees
Printing, Stationery Advertisement Maintenance Delivery charges
Insurance premium Sales promotion Royalty payment Power & Fuel cost
Postage, Telephone Commission payment Manufacturing cost Internet charges
Legal charges Discount given Travelling cost Etc. Etc. Etc.

Compiled by Prof. Prasad Bhat Page 55

5. BALANCE SHEET

 A Balance Sheet is one of the fundamental financial statements that provides a summary
of a company's financial position at a specific point in time.
 It presents a summary of the company's assets, liabilities, and shareholders' equity,
helping stakeholders assess the financial health and stability of the business.

 Key Components of a Balance Sheet:

1. Assets: Assets are the ownership / properties of a company. Assets are categorized
into two main types –
a) Non-Current Assets (Long-term Assets): Non-current assets are expected to be
held or used for more than 1 year. Non-Current assets used for business purposes
and not held for resale in the ordinary course. They include items like property,
plant, and equipment (PP&E), intangible assets, long-term investments, etc.

b) Current Assets: Current assets are short term assets which are expected to be
converted into cash or used within 1 year. Examples are cash, bank balance,
debtors, receivables, inventory, and short-term investments etc.

2. Liabilities: Liabilities represent the financial obligations of a company. It is amount

which a company owes to outsiders. They are categorized into two main types –

a) Non-Current Liabilities (Long-term Liabilities): Non-current liabilities long-term

obligations, that are not due within one year. These can include long-term loans
from banks and financial institutions, debentures, deposits etc.

b) Current Liabilities: Current liabilities are short-term obligations which are to be

paid within one year. Examples include creditors, payable, short-term borrowings,
outstanding expenses, bank overdraft etc.

3. Equity (Owner's Capital): Shareholders' equity represents the shareholders’ funds

invested in a company as on a particular date. It is classified into two parts –
a) Equity Share Capital: This is the actual amount of full paid-up equity shares
contributed by the members of a company.
b) Other Equity: Other equity includes retained earnings (past accumulated profits),
general reserve, security premium and other reserves of the company.

Compiled by Prof. Prasad Bhat Page 56

 Significance / Importance of the Balance Sheet:

1. Financial Position: A Balance Sheet provides a comprehensive view of a company's

financial position, showing the total value of its assets, the sources of funds (liabilities
and equity) used to finance those assets, and the relationship between the two.
2. Liquidity Assessment: By comparing current assets to current liabilities, stakeholders
can measure a company's short-term ability to meet its financial obligations.
3. Solvency Evaluation: Non-current assets and long-term liabilities in a Balance Sheet
help assess company's long-term solvency & capacity to meet long-term obligations.
4. Debt and Equity Mix: Balance Sheet shows the proportion of borrowed funds and
owned funds used to finance the company's assets, which is crucial for financial risk.
5. Investor Decision-making: Investors use Balance Sheet to understand a company's
financial health and make informed investment decisions.
6. Creditworthiness: Lenders and Creditors use Balance Sheet to evaluate a company's
creditworthiness and assess the risk of lending to or transacting with the company.

Balance Sheet of ABC Ltd. as on 31 st March 2023

PARTICULARS Note No. Amount ₹

ASSETS

Non-Current Assets
Property, Plant & Equipment (PPE)
Capital Work in Progress (CWIP)
Intangible Assets
Financial Assets
Investments
Trade Receivables
Other Financial Assets
Other Non-Current Assets
Total Non-Current Assets

Current Assets
Inventories
Financial Assets
Investments
Trade Receivables
Cash and Cash Equivalents
Other Bank Balances
Other Financial Assets
Other Current Assets
Total Current Assets

Total Assets

Compiled by Prof. Prasad Bhat Page 57

 PARTICULARS Note No. Amount ₹

EQUITY & LIABILITIES

EQUITY
Equity Share Capital
Other Equity

Total Equity

NON-CURRENT LIABILITIES

Financial Liabilities
Borrowings
Trade Payables
Other Financial Liabilities

Provisions
Other Non-Current Liabilities

Total Non-Current Liabilities

CURRENT LIABILITIES

Financial Liabilities
Borrowings
Trade Payables Due to MSME
Trade Payables Due to Others
Other Financial Liabilities

Provisions
Other Current Liabilities

Total Current Liabilities

Total Equity and Liabilities

Compiled by Prof. Prasad Bhat Page 58

 Classification examples of items of the Balance Sheet:

Non-Current Assets – Property Plant Equip Non-Current Assets – Intangible Assets

 Factory Building, Land  Goodwill, Brand Value
 Plant & Machinery  Patents, Copyrights, Trademarks
 Furniture & Fixtures, Vehicles etc.  Software Licenses etc.

Non-Current Assets – Financial Assets Non-Current Assets – Other Fin. Assets

 Long Term Investment in Fixed Deposits  Security Deposits, Lease receivable
 Long Term Invt. Subsidiary & Associates  Subsidy receivable from Govt.
 Long Term Investment Mutual Funds etc.  Term Deposits against Bank Guarantee

Non-Current Assets – Other Assets Current Assets – Inventory

 Capital Advances  Raw Material, Finished Goods
 Loans granted  Work-in-Progress, Stock in Trade

Current Assets – Receivables Current Assets – Cash & Cash Equivalents

 Trade Debtors  Cash in Hand
 Bills Receivable  Bank Balances

Current Assets – Other Financial Assets Current Assets – Other Current Assets
 Security deposits  Prepaid Expenses
 Interest receivable  Accrued Income

Equity – Equity Share Capital Equity – Other Equity

 Authorized Share Capital  General Reserves, Retained Earnings
 Issued, Subscribed and Paid-up Capital  Security Premium, Other Reserves

Non-Current Liabilities – Borrowings Current Liabilities – Borrowings

 Loans from Bank / Financial Institutions  Bank Overdraft
 Debentures from Public  Cash Credit Facility
 Loans from Governments  Short-term Lease

Current Liabilities – Trade Payables Current Liabilities – Other Financial Liab.

 Creditors, Bills Payable  Unpaid Interest
 Due to MSME and other than MSME  Dividend payable

Compiled by Prof. Prasad Bhat Page 59

 Illustration / Example: Classify the following items into various categories / heads based
on Profit & Loss Statement, Balance Sheet and sub-heading.

Account Fin. Statement Nature / Head Sub-Heading

Land & Building Balance Sheet Non-Current Asset Property, Plant, Equip
Bank Loan
Cash in hand
Equity Capital
Sales Turnover
Debentures Balance Sheet Non-Current Liability Borrowings
Debtors
Closing Stock
Rent received Profit & Loss Income Other Income
Salary paid
Income tax paid
Sale of Scrap
Legal Expense
Goodwill
Bills Payable
Bonus to workers
Amortization
Contri to PF
Interest paid Profit & Loss Expenses Finance Cost
Prepaid expense
Gen. Reserves
Bank charges
Audit fees
Insurance premium
Creditors
Bank balance
Revenue Operations
Discount given
Bad Debts
Short-Term Invest
Patents
Discount received
5-year Bank FD

Compiled by Prof. Prasad Bhat Page 60

6. ADJUSTMENTS

 For every business entity, financial statements are prepared end of an accounting period,
i.e., end of financial year or end of a quarter etc.
 The Profit & Loss Statement and Balance Sheet should show a true and fair view of the
accounting information the financial year.
 Hence, all the relevant information / transactions / events should be recording while
preparing the financial statements.
 Hence, after preparation of trial balance, certain adjustments relating to the accounting
period have to be made in order to make the financial statements complete.
 These adjustments are needed for transactions which have not been recorded but which
affect the financial position and operating results of the business. In few cases, the actual
and exact amount is not available, and hence adjustments are to be made.
 Since, accounting is based on double entry principle, all adjustments are to be given
double effect, i.e., recorded at two places.

 Common examples of adjustments –

i. Unrecorded Income: Income earned for the period but not received yet. Example:
interest for quarter ending 31st March not received yet

ii. Income Received in Advance: Income relating to next period received in the current
accounting period

iii. Unpaid Expenses: Expenses were incurred during the period but not recorded in the
accounting books

iv. Prepaid Expenses: Expenses relating to the subsequent period paid in advance in the
current accounting period. A common example is insurance premium paid advance.

v. Closing Inventory / Stock at the end of accounting period

vi. Provision of depreciation and amortization

vii. Reserve for bad debts

viii. Provision for Income Tax

ix. Proposed Dividend etc.

Compiled by Prof. Prasad Bhat Page 61

ADJUSTMENTS - EFFECTS

CLOSING STOCK / INVENTORY OF FINISHED GOODS, WIP, STOCK-IN-TRADE

1) Balance Sheet under Current Assets under heading Inventory
2) Profit & Loss under the heading Changes in Inventory (subtract from opening stock)

CLOSING STOCK OF RAW MATERIAL (RM)

1) Balance Sheet under Current Assets under heading Inventory
2) Profit & Loss under the heading Cost of Material Consumed (subtract at the end)

DEPRECIATION
1) Balance Sheet – Subtract from Non-Current Assets
2) Profit & Loss under the heading Depreciation & Amortization

OUTSTANDING / UNPAID EXPENSES

1) Profit & Loss Statement – Add under respective Expenses
2) Balance Sheet – show under Current Liabilities – Other Current Liabilities

PROVISION FOR TAX

1) Profit & Loss Statement under the heading Tax Expense
2) Balance Sheet under Current Liability under heading Provisions

DIVIDEND ON EQUITY CAPITAL (Dividend = Equity Paid-Up Capital * Dividend Rate)

1) Balance Sheet under Other Equity: Subtract from current year profit
2) Balance Sheet under heading Other Current Liabilities

UNPAID / OUTSTANDING INTEREST ON BORROWINGS (Debentures, Loan, Deposits etc.)

1) Profit & Loss Statement under the heading Finance Cost
2) Balance Sheet under heading Other Financial Liabilities

TRANSFER TO GENERAL RESERVE

1) Balance Sheet under Other Equity: Subtract from current year profit
2) Balance Sheet under Other Equity: Add in General Reserves

Compiled by Prof. Prasad Bhat Page 62

PREPAID EXPENSES
1) Profit & Loss: subtract from respective expense
2) Balance Sheet under the heading Other Current Assets

ACCRUED INCOME
1) Profit & Loss: add in the respective income
2) Balance Sheet under the heading Other Current Assets

BAD DEBTS
1) Balance Sheet: Subtract from Debtors / Receivables (in Current Assets)
2) Profit & Loss: add under the heading Other Expenses

INCOME RECEIVED IN ADVANCE

1) Profit & Loss: Deduct from the respective Income head
2) Balance Sheet: under the heading other Current Liabilities

Compiled by Prof. Prasad Bhat Page 63

Prepare Financial Statements

Q1. Financial details of Foss Bottling Ltd. are provided for the year ending 31 March 2023.
Prepare Statement of Profit & Loss as per revised schedule of Companies Act, 2013.

Particulars Debit ₹ Particulars Credit ₹

Salary to Employees 7,80,000 Sale of scrap 1,45,000

Bonus to workers 1,20,000 Sale of Bottles 23,40,000

Legal Expenses 34,000 Dividend received 65,000

Depreciation 67,000 Revenue from Bottle designs 3,56,000

Bad Debts 11,000 Rental income received 4,80,000

Postage & Internet 24,000 Interest received on Bank FD 70,000

Management remuneration 5,60,000

Repairs to Machinery 34,000

Staff Welfare Expenses 79,000

Raw material consumed 9,23,000

Printing and Stationery 2,10,000

Discount to Customers 29,000

Auditors' fees 25,000

Sales Promotion Expenses 51,000

Interest paid on loans 90,000

Insurance Premium paid 19,000

Additional Information – Income tax payment at 30% of profits.

Compiled by Prof. Prasad Bhat Page 64

Solution Q1:

Profit & Loss Statement of _______________________ for the year ended ______________

PARTICULARS Note No. Amount ₹

Income

Revenue from Operations

Other Income

Total Revenue / Income

Expenses

Cost of Material Consumed

Purchases of Stock in Trade (SIT)

Changes in inventories of FG, WIP and SIT

Employee Benefit Expenses

Finance Cost

Depreciation and Amortization Expenses

Other Expenses

Total Expenses

Profit / (loss) for the period before exceptional items

Adjustment for Exceptional Items

Profit / (Loss) Before Tax

(-) Tax Expense

Profit After Tax

Earnings Per Share (EPS)

Compiled by Prof. Prasad Bhat Page 65

Q2. From the financial information given below, prepare a Statement of Profit & Loss for the
year ended 31 March 2013 for Amrut Garments Traders Ltd. Prepare working notes.

Particulars Debit ₹ Particulars Credit ₹

Purchases of Garments 18,25,000 Sale of Men’s Garments 18,20,000

Rent paid 6,00,000 Sale of Women’s Garments 27,46,000

Salaries & Wages 9,45,000 Interest received 20,000

Electricity charges 1,75,000 Sale of Children’s Garments 8,00,000

Telephone expenses 22,000 Closing Stock of Garments 6,85,000

Accounting fees 31,000 Dividend received 25,000

Carriage Inwards 18,000 Sale of Scrap Cloths 11,000

Interest paid on Bank Loan 1,20,000

Depreciation 85,000

Opening Stock of Garments 7,95,000

Sales Promotion Expenses 7,50,000

Bad Debts 20,000

Insurance Premium paid 28,000

Bonus to Staff 2,10,000

Audit Fees 50,000

Carriage Outwards 32,000

Additional Information – Income tax payment at 30% of profits.

Compiled by Prof. Prasad Bhat Page 66

Solution Q2:

Profit & Loss Statement of _______________________ for the year ended ______________

PARTICULARS Note No. Amount ₹

Income

Revenue from Operations

Other Income

Total Revenue / Income

Expenses

Cost of Material Consumed

Purchases of Stock in Trade (SIT)

Changes in inventories of FG, WIP and SIT

Employee Benefit Expenses

Finance Cost

Depreciation and Amortization Expenses

Other Expenses

Total Expenses

Profit / (loss) for the period before exceptional items

Adjustment for Exceptional Items

Profit / (Loss) Before Tax

(-) Tax Expense

Profit After Tax

Earnings Per Share (EPS)

Compiled by Prof. Prasad Bhat Page 67

Q3. Wish-Wash Ltd. was registered with authorized capital of ₹ 800,000 divided into 80,000
equity shares of face value ₹ 10 each. Prepare Statement of Profit & Loss for the year
ended 31st March, 2023. The following balances are extracted:

Debit Balances Amount (₹) Credit Balances Amount (₹)

Purchases of Raw Material 2,53,000 Sales Revenue 5,00,000

Opening Stock of Raw Material 11,900 Purchase Returns 13,000

Carriage outwards 4,800 Interest received 2,500

Salaries and Wages 64,400 Misc. income received 2,700

Staff welfare 9,100 Other operating revenue 10,000

Audit fees 8,400 Bank interest received 48,000

Carriage inward 5,100 Commission received 9,000

Bad debts 3,100

Advertisement 7,000

Interest on Debentures 7,000

Bonus to employees 16,000

Insurance premium paid 13,800

Rent and Taxes 8,000

Sales Return 9,000

Other Information (record only the Profit & Loss Statement) –

1) Closing Stock of Raw Material as on 31 st March, 2023 amounted to ₹ 17,000.
2) Employee bonus unpaid ₹ 4,000.
3) Provide depreciation on building ₹ 9,000 and Motor vehicles ₹ 2,000.
4) Provision for tax for the year is to be made at 30% of the profits.

Compiled by Prof. Prasad Bhat Page 68

Solution Q3:

Profit & Loss Statement of _______________________ for the year ended ______________

PARTICULARS Note No. Amount ₹

Income

Revenue from Operations

Other Income

Total Revenue / Income

Expenses

Cost of Material Consumed

Purchases of Stock in Trade (SIT)

Changes in inventories of FG, WIP and SIT

Employee Benefit Expenses

Finance Cost

Depreciation and Amortization Expenses

Other Expenses

Total Expenses

Profit / (loss) for the period before exceptional items

Adjustment for Exceptional Items

Profit / (Loss) Before Tax

(-) Tax Expense

Profit After Tax

Earnings Per Share (EPS)

Compiled by Prof. Prasad Bhat Page 69

Q4. Following extract of Trial Balance as on 31.03.2023 belongs to Amanda Plastics Ltd. You
are required to prepare Statement of Profit & Loss as per Companies Act, 2013.

Debit Balances Amount (₹) Credit Balances Amount (₹)

Opening Stocks (01.04.2022) Sales 6,30,000

Finished Goods 35,000 Purchase Return 5,000

Work-in-Progress 27,500 Commission received 4,000

Raw Material 12,500 Dividend received 10,000

Purchases of RM 5,25,000

Sales Return 10,000

Travel & Conveyance 1,000

Carriage Outward 2,000

Salaries paid 12,000

Bonus to Employees 14,000

Discount to Customers 2,000

Rent, Rates and Taxes 3,000

Repairs & Maintenance 600

Wages to Direct Workers 8,000

Insurance 3,600

Staff Welfare Expenses 1,200

Sales Promotion Expenses 1,400

Bad Debts 1,000

Adjustments (record only for Profit & Loss Statement):

1) Closing Stock as on 31.03.2023:
 FG – ₹ 28,000
 WIP – ₹ 7,500
 RM – ₹ 6,500
2) Depreciation on Assets – Building ₹ 6,000; Motor Vehicles – ₹ 2,000.
3) Income tax rate 20%

Compiled by Prof. Prasad Bhat Page 70

Solution Q4:

Profit & Loss Statement of _______________________ for the year ended ______________

PARTICULARS Note No. Amount ₹

Income

Revenue from Operations

Other Income

Total Revenue / Income

Expenses

Cost of Material Consumed

Purchases of Stock in Trade (SIT)

Changes in inventories of FG, WIP and SIT

Employee Benefit Expenses

Finance Cost

Depreciation and Amortization Expenses

Other Expenses

Total Expenses

Profit / (loss) for the period before exceptional items

Adjustment for Exceptional Items

Profit / (Loss) Before Tax

(-) Tax Expense

Profit After Tax

Earnings Per Share (EPS)

Compiled by Prof. Prasad Bhat Page 71

Q5. Pinnacle Ltd. was registered with authorized capital of ₹ 20,00,000 divided into 200,000
equity shares of face value ₹ 10 each. Prepare Balance Sheet as on 31st March, 2023:

Particulars Debit Balance Credit Balance

Short Term Advance given to Suppliers 23,000

Bank Balance (Current Account) 3,78,000

Unpaid Expenses 1,83,000

Bills Payable 54,000

Cash balance 2,35,000

Creditors 2,10,000

Debentures 5,00,000

Debtors 1,21,000

Deposits accepted from Public 1,50,000

Proposed Dividend 75,000

Plant and Equipment 9,80,000

Equity Share Capital 20,00,000

General Reserves 6,50,000

Trademarks 22,00,000

Inventory of Finished Goods 2,89,000

Long Term Investment in Govt. Bonds 7,60,000

Long Term Security Deposit given 1,00,000

P & L Opening Balance (as on 1 April 2022) 5,00,000

Prepaid Expenses 23,000

Security Premium 12,00,000

Short Term Provisions 75,000

Short Term Unsecured Loans given 2,34,000

Short-Term Advance taken from Customers 2,43,000

Stock of Raw Material 47,000

Goodwill 4,50,000

Compiled by Prof. Prasad Bhat Page 72

Solution Q5:

Balance Sheet of ___________________________ as on ______________

PARTICULARS Note No. Amount ₹

ASSETS

Non-Current Assets

Property, Plant & Equipment (PPE)

Capital Work in Progress (CWIP)

Intangible Assets

Financial Assets

Investments

Trade Receivables

Other Financial Assets

Other Non-Current Assets

Total Non-Current Assets

Current Assets

Inventories

Financial Assets

Investments

Trade Receivables

Cash and Cash Equivalents

Other Bank Balances

Other Financial Assets

Other Current Assets

Total Current Assets

Total Assets

Compiled by Prof. Prasad Bhat Page 73

 PARTICULARS Note No. Amount ₹

EQUITY & LIABILITIES

EQUITY

Equity Share Capital

Other Equity

Total Equity

NON-CURRENT LIABILITIES

Financial Liabilities

Borrowings

Trade Payables

Other Financial Liabilities

Provisions

Other Non-Current Liabilities

Total Non-Current Liabilities

CURRENT LIABILITIES

Financial Liabilities

Borrowings

Trade Payables Due to MSME

Trade Payables Due to Others

Other Financial Liabilities

Provisions

Other Current Liabilities

Total Current Liabilities

Total Equity and Liabilities

Compiled by Prof. Prasad Bhat Page 74

Q6. Harbottle Trading Ltd. was registered with authorized capital of ₹ 10,00,000 with face
value ₹ 10 each. Prepare Balance Sheet as on 31st March, 2023:

Particulars Debit ₹ Particulars Credit ₹

Advance to Suppliers 31,000 Advance from Customers 45,600

Cash in Bank 1,23,400 Outstanding Expenses 31,400

Cash in Hand 24,700 Trade Creditors 1,54,000

Trade Debtors 3,12,000 10% Debentures 4,00,000

Plant & Machinery 2,36,700 Deposits Accepted – Public 1,00,000

Copyrights 99,000 Provision for Tax 76,000

Inventory of Finished Goods 65,400 Paid-up Equity Share Capital 5,00,000

Capital Work in Progress 1,11,000 General Reserves 1,25,000

Trademarks 75,100 Deposit Taken (5 years) 2,00,000

Bills Receivables 1,32,000 Long Term Provisions 56,000

Long Term Investments 46,000 Bank Overdraft 20,000

Stock of Raw Material 1,65,700

Software Licenses 2,86,000

Total 17,08,000 Total 17,08,000

Compiled by Prof. Prasad Bhat Page 75

Solution Q6:

Balance Sheet of ___________________________ as on ______________

PARTICULARS Note No. Amount ₹

ASSETS

Non-Current Assets

Property, Plant & Equipment (PPE)

Capital Work in Progress (CWIP)

Intangible Assets

Financial Assets

Investments

Trade Receivables

Other Financial Assets

Other Non-Current Assets

Total Non-Current Assets

Current Assets

Inventories

Financial Assets

Investments

Trade Receivables

Cash and Cash Equivalents

Other Bank Balances

Other Financial Assets

Other Current Assets

Total Current Assets

Total Assets

Compiled by Prof. Prasad Bhat Page 76

 PARTICULARS Note No. Amount ₹

EQUITY & LIABILITIES

EQUITY

Equity Share Capital

Other Equity

Total Equity

NON-CURRENT LIABILITIES

Financial Liabilities

Borrowings

Trade Payables

Other Financial Liabilities

Provisions

Other Non-Current Liabilities

Total Non-Current Liabilities

CURRENT LIABILITIES

Financial Liabilities

Borrowings

Trade Payables Due to MSME

Trade Payables Due to Others

Other Financial Liabilities

Provisions

Other Current Liabilities

Total Current Liabilities

Total Equity and Liabilities

Compiled by Prof. Prasad Bhat Page 77

Q7. Given below is Trial Balance of Magna Tubes Traders Ltd. Authorized capital ₹ 5,00,000.
Prepare a Statement of Profit and Loss and Balance Sheet as on that date.
Particulars Debit (₹) Credit (₹)
Opening Stock of Tubes 50,000
Sales of Tubes 4,25,000
Wages to workers 70,000
Purchases of Tubes 3,00,000
Discount Allowed 4,200
Discount Received 3,150
Insurance premium paid 6,720
Salaries to Employees 18,500
Rent paid 6,000
General Expenses 8,950
Short Term Provisions 6,220
Printing and Stationery 2,400
Advertisement 3,800
Bonus to employees 10,500
Debtors 38,700
Creditors 35,200
Plant and Machinery 80,500
Furniture 17,100
Cash at Bank 1,34,700
General Reserve 25,000
Loan from Bank 15,700
Bad Debts 3,200
Equity Paid-up Share Capital 2,45,000
7,55,270 7,55,270

Other Information:
a. Closing stock of tubes ₹ 91,500 as on 31st March 2023
b. Depreciation on Plant and Machinery and Furniture at 10% and 15% respectively.
c. Dividend for the year ended 31 March 2023 is proposed at 5% of paid-up capital.
d. Provision for Taxation is at 20% of the Taxable Profit.

Compiled by Prof. Prasad Bhat Page 78

Solution Q7:

Profit & Loss Statement of _______________________ for the year ended ______________

PARTICULARS Note No. Amount ₹

Income

Revenue from Operations

Other Income

Total Revenue / Income

Expenses

Cost of Material Consumed

Purchases of Stock in Trade (SIT)

Changes in inventories of FG, WIP and SIT

Employee Benefit Expenses

Finance Cost

Depreciation and Amortization Expenses

Other Expenses

Total Expenses

Profit / (loss) for the period before exceptional items

Adjustment for Exceptional Items

Profit / (Loss) Before Tax

(-) Tax Expense

Profit After Tax

Earnings Per Share (EPS)

Compiled by Prof. Prasad Bhat Page 79

Solution Q7:

Balance Sheet of ___________________________ as on ______________

PARTICULARS Note No. Amount ₹

ASSETS

Non-Current Assets

Property, Plant & Equipment (PPE)

Capital Work in Progress (CWIP)

Intangible Assets

Financial Assets

Investments

Trade Receivables

Other Financial Assets

Other Non-Current Assets

Total Non-Current Assets

Current Assets

Inventories

Financial Assets

Investments

Trade Receivables

Cash and Cash Equivalents

Other Bank Balances

Other Financial Assets

Other Current Assets

Total Current Assets

Total Assets

Compiled by Prof. Prasad Bhat Page 80

 PARTICULARS Note No. Amount ₹

EQUITY & LIABILITIES

EQUITY

Equity Share Capital

Other Equity

Total Equity

NON-CURRENT LIABILITIES

Financial Liabilities

Borrowings

Trade Payables

Other Financial Liabilities

Provisions

Other Non-Current Liabilities

Total Non-Current Liabilities

CURRENT LIABILITIES

Financial Liabilities

Borrowings

Trade Payables Due to MSME

Trade Payables Due to Others

Other Financial Liabilities

Provisions

Other Current Liabilities

Total Current Liabilities

Total Equity and Liabilities

Compiled by Prof. Prasad Bhat Page 81

Q8. Mather Pipes Trading Ltd. registered with authorized capital ₹ 10,00,000 and FV ₹ 10. On
31st March, 2023 following were ledger balances. Prepare a Statement of Profit and Loss
and Balance Sheet as per Companies Act, 2013.
Particulars Debit (₹) Particulars Credit (₹)
Opening Stock of SIT 50,000 Sales 6,00,000
Wages 70,000 General Reserve 2,00,000
Purchases of SIT 2,00,000 Creditors 2,50,000
Audit Fees 2,000 10% Debentures 5,00,000
Telephone & Internet 3,000 Equity paid-up Capital 10,00,000
Insurance 3,000 Commission received 5,000
Salaries 20,000 Bills Payable 12,000
Petrol expenses 7,000
Printing and Stationery 4,000
Advertisement 7,000
Debtors 2,00,000
Plant and Machinery 30,000
Cash at Bank 12,000
Bad Debts 6,000
Commission to Agents 8,000
Transport cost 19,000
Goodwill 11,00,000
Bills Receivable 70,500
Land Property 6,30,000
Electricity charges 13,500
Maintenance expenses 12,000
Furniture and Fittings 1,00,000
25,67,000 25,67,000

Adjustments:
a. Depreciate Plant and Machinery at 10% p.a. and Furniture and Fittings at 15% p.a.
b. Interest on Debentures are outstanding ₹ 50,000
c. Stock on 31st March, 2023 is ₹ 100,000.
d. Provide for Taxation ₹ 30,000.
e. The Board has decided to give 8% equity dividend.

Compiled by Prof. Prasad Bhat Page 82

Solution Q8:

Profit & Loss Statement of _______________________ for the year ended ______________

PARTICULARS Note No. Amount ₹

Income

Revenue from Operations

Other Income

Total Revenue / Income

Expenses

Cost of Material Consumed

Purchases of Stock in Trade (SIT)

Changes in inventories of FG, WIP and SIT

Employee Benefit Expenses

Finance Cost

Depreciation and Amortization Expenses

Other Expenses

Total Expenses

Profit / (loss) for the period before exceptional items

Adjustment for Exceptional Items

Profit / (Loss) Before Tax

(-) Tax Expense

Profit After Tax

Earnings Per Share (EPS)

Compiled by Prof. Prasad Bhat Page 83

Solution Q8:

Balance Sheet of ___________________________ as on ______________

PARTICULARS Note No. Amount ₹

ASSETS

Non-Current Assets

Property, Plant & Equipment (PPE)

Capital Work in Progress (CWIP)

Intangible Assets

Financial Assets

Investments

Trade Receivables

Other Financial Assets

Other Non-Current Assets

Total Non-Current Assets

Current Assets

Inventories

Financial Assets

Investments

Trade Receivables

Cash and Cash Equivalents

Other Bank Balances

Other Financial Assets

Other Current Assets

Total Current Assets

Total Assets

Compiled by Prof. Prasad Bhat Page 84

 PARTICULARS Note No. Amount ₹

EQUITY & LIABILITIES

EQUITY

Equity Share Capital

Other Equity

Total Equity

NON-CURRENT LIABILITIES

Financial Liabilities

Borrowings

Trade Payables

Other Financial Liabilities

Provisions

Other Non-Current Liabilities

Total Non-Current Liabilities

CURRENT LIABILITIES

Financial Liabilities

Borrowings

Trade Payables Due to MSME

Trade Payables Due to Others

Other Financial Liabilities

Provisions

Other Current Liabilities

Total Current Liabilities

Total Equity and Liabilities

Compiled by Prof. Prasad Bhat Page 85

Q9. Godavari Clock Mfg. Ltd was registered with nominal capital of ₹ 10,00,000. Prepare
Profit & Loss and Balance Sheet as on 31 March 2023 from Trial Balance given below:
Particulars Amount (₹) Amount (₹)
Opening Stock of RM 1,86,420
Purchases of Raw Material 7,18,210
Sales of Finished Goods 11,69,900
Sales Return 12,680
Purchase Return of RM 9,850
Wages to workers 1,09,740
Manufacturing Expenses 19,240
Carriage Inwards 4,910
18% Bank Loan (Secured) 50,000
Interest on Bank Loan 4,500
Salaries to employees 17,870
Auditor’s Fees 8,600
Carriage Outward 26,250
Free samples distribution 6,000
Land Premises 1,64,210
Plant and Machinery 1,28,400
Furniture 5,000
Loose Tools and Spares 12,500
Debtors 1,05,400
Creditors 62,220
Cash in Hand 19,530
Bank Balance 96,860
Advances given to Suppliers 84,290
Profit and Loss Account (01.04.2022) 38,640
Equity Share Capital 4,00,000
17,30,610 17,30,610

1. Stock at the end of the year was valued at ₹ 124,840

2. Unpaid Interest on Bank Loan.
3. Depreciation on Plant & Machinery is to be provided at 15% and on Furniture at 10%.
4. Provision for Income Tax at 20%. Directors recommended 15% dividend at 15%.

Compiled by Prof. Prasad Bhat Page 86

Solution Q9:

Profit & Loss Statement of _______________________ for the year ended ______________

PARTICULARS Note No. Amount ₹

Income

Revenue from Operations

Other Income

Total Revenue / Income

Expenses

Cost of Material Consumed

Purchases of Stock in Trade (SIT)

Changes in inventories of FG, WIP and SIT

Employee Benefit Expenses

Finance Cost

Depreciation and Amortization Expenses

Other Expenses

Total Expenses

Profit / (loss) for the period before exceptional items

Adjustment for Exceptional Items

Profit / (Loss) Before Tax

(-) Tax Expense

Profit After Tax

Earnings Per Share (EPS)

Compiled by Prof. Prasad Bhat Page 87

Solution Q9:

Balance Sheet of ___________________________ as on ______________

PARTICULARS Note No. Amount ₹

ASSETS

Non-Current Assets

Property, Plant & Equipment (PPE)

Capital Work in Progress (CWIP)

Intangible Assets

Financial Assets

Investments

Trade Receivables

Other Financial Assets

Other Non-Current Assets

Total Non-Current Assets

Current Assets

Inventories

Financial Assets

Investments

Trade Receivables

Cash and Cash Equivalents

Other Bank Balances

Other Financial Assets

Other Current Assets

Total Current Assets

Total Assets

Compiled by Prof. Prasad Bhat Page 88

 PARTICULARS Note No. Amount ₹

EQUITY & LIABILITIES

EQUITY

Equity Share Capital

Other Equity

Total Equity

NON-CURRENT LIABILITIES

Financial Liabilities

Borrowings

Trade Payables

Other Financial Liabilities

Provisions

Other Non-Current Liabilities

Total Non-Current Liabilities

CURRENT LIABILITIES

Financial Liabilities

Borrowings

Trade Payables Due to MSME

Trade Payables Due to Others

Other Financial Liabilities

Provisions

Other Current Liabilities

Total Current Liabilities

Total Equity and Liabilities

Compiled by Prof. Prasad Bhat Page 89

Q10. Following is Trial Balance of Deepak Electronics Traders Ltd as on 31 st March, 2023.
Authorized capital ₹ 10 lakhs. Prepare Statement of Profit & Loss and Balance Sheet.

Debit Balances Amount (₹) Credit Balances Amount (₹)

Stock of SIT (1-4-2022) 1,50,000 5% Debentures 2,00,000
Land Property 2,00,000 Consulting Fees recd. 40,000
Plant and Machinery 2,50,000 General Reserve 40,000
Sundry Debtors 1,20,000 Creditors 1,50,000
Sales Promotion Expenses 15,000 Profit and Loss (Op. Bal) 54,000
Salaries 50,000 Sales of Electronics 8,90,000
Wages 1,20,000 Bills Payable 49,000
Travel & Conveyance 3,000 Equity Share Capital 8,00,000
Interest on Debentures 5,000 Sundry Receipts 8,000
Insurance premium paid 17,000 Interest received 25,000
Power & Fuel expenses 25,000 Bank Overdraft 1,55,000
Postage and Internet 15,000
Printing and Stationery 1,000
Repairs to machine 4,000
Travelling Expenses 2,000
Purchases of SIT 4,07,000
Director’s sitting fees 20,000
Cash in Hand 16,000
Investment (5-year FD) 2,50,000
Plant & Equipment 4,00,000
Goodwill 2,00,000
Loose Tools 41,000
Furniture 1,00,000
24,11,000 24,11,000

1. Closing Stock of electronics on 31 st March, 2023 was ₹ 300,000.

2. 5% Debtors defaulted on payment.
3. Provide 25% income tax on profits. Dividend at 10% on Share Capital.
4. Depreciate Plant and Machinery at 10%, Furniture at 5% and Equipment at 15%
5. Interest on Debentures is outstanding for 6 months.

Compiled by Prof. Prasad Bhat Page 90

Solution Q10:

Profit & Loss Statement of _______________________ for the year ended ______________

PARTICULARS Note No. Amount ₹

Income

Revenue from Operations

Other Income

Total Revenue / Income

Expenses

Cost of Material Consumed

Purchases of Stock in Trade (SIT)

Changes in inventories of FG, WIP and SIT

Employee Benefit Expenses

Finance Cost

Depreciation and Amortization Expenses

Other Expenses

Total Expenses

Profit / (loss) for the period before exceptional items

Adjustment for Exceptional Items

Profit / (Loss) Before Tax

(-) Tax Expense

Profit After Tax

Earnings Per Share (EPS)

Compiled by Prof. Prasad Bhat Page 91

Solution Q10:

Balance Sheet of ___________________________ as on ______________

PARTICULARS Note No. Amount ₹

ASSETS

Non-Current Assets

Property, Plant & Equipment (PPE)

Capital Work in Progress (CWIP)

Intangible Assets

Financial Assets

Investments

Trade Receivables

Other Financial Assets

Other Non-Current Assets

Total Non-Current Assets

Current Assets

Inventories

Financial Assets

Investments

Trade Receivables

Cash and Cash Equivalents

Other Bank Balances

Other Financial Assets

Other Current Assets

Total Current Assets

Total Assets

Compiled by Prof. Prasad Bhat Page 92

 PARTICULARS Note No. Amount ₹

EQUITY & LIABILITIES

EQUITY

Equity Share Capital

Other Equity

Total Equity

NON-CURRENT LIABILITIES

Financial Liabilities

Borrowings

Trade Payables

Other Financial Liabilities

Provisions

Other Non-Current Liabilities

Total Non-Current Liabilities

CURRENT LIABILITIES

Financial Liabilities

Borrowings

Trade Payables Due to MSME

Trade Payables Due to Others

Other Financial Liabilities

Provisions

Other Current Liabilities

Total Current Liabilities

Total Equity and Liabilities

Compiled by Prof. Prasad Bhat Page 93

Q11. Mukund Grains Trading Ltd was registered with authorized capital ₹ 15,00,000. Prepare
P & L Statement and Balance Sheet from following ledger balances:

Particulars Amount Dr. (₹) Amount Cr. (₹)

Opening Stock of SIT 1,87,500
Furniture & Fixtures 18,000
Debtors 2,17,500
Warehouse Premises 16,50,000
Purchases of Trading Goods 5,00,000
Debentures Interest paid 22,500
General Reserve 62,500
Profit and Loss Account Bal. 36,250
Equity Share Capital 11,50,000
Electricity Expenses 36,750
Carriage inwards 32,000
Trademarks 62,500
Cash in Hand 5,875
Cash at Bank 96,500
Festival gift to staff 14,350
Commission paid 23,275
Salaries to staff 2,48,250
6% Debentures 7,50,000
Sales of Traded Goods 10,37,500
Long Term Investment 1,50,000
Interest recd. on investments 8,750
Creditors 2,20,000
32,65,000 32,65,000

Additional Information:
a. Closing Stock was valued at ₹ 2,52,500.
b. Depreciate Premises by 10% and Fixtures by 5%.
c. Bad Debts at 5% on Sundry Debtors.
d. Provision for Income Tax is to be made to the extent of 20% on profits.
e. Interest on Debentures to be recorded at 6% on value of Debentures.

Compiled by Prof. Prasad Bhat Page 94

Solution Q11:

Profit & Loss Statement of _______________________ for the year ended ______________

Particulars Note No. Amount ₹

Income

Revenue from Operations

Other Income

Total Revenue / Income

Expenses

Cost of Material Consumed

Purchases of Stock in Trade (SIT)

Changes in inventories of FG, WIP and SIT

Employee Benefit Expenses

Finance Cost

Depreciation and Amortization Expenses

Other Expenses

Total Expenses

Profit / (loss) for the period before exceptional items

Adjustment for Exceptional Items

Profit / (Loss) Before Tax

(-) Tax Expense

Profit After Tax

Earnings Per Share (EPS)

Compiled by Prof. Prasad Bhat Page 95

Solution Q11:

Balance Sheet of ___________________________ as on ______________

PARTICULARS Note No. Amount ₹

ASSETS

Non-Current Assets

Property, Plant & Equipment (PPE)

Capital Work in Progress (CWIP)

Intangible Assets

Financial Assets

Investments

Trade Receivables

Other Financial Assets

Other Non-Current Assets

Total Non-Current Assets

Current Assets

Inventories

Financial Assets

Investments

Trade Receivables

Cash and Cash Equivalents

Other Bank Balances

Other Financial Assets

Other Current Assets

Total Current Assets

Total Assets

Compiled by Prof. Prasad Bhat Page 96

 PARTICULARS Note No. Amount ₹

EQUITY & LIABILITIES

EQUITY

Equity Share Capital

Other Equity

Total Equity

NON-CURRENT LIABILITIES

Financial Liabilities

Borrowings

Trade Payables

Other Financial Liabilities

Provisions

Other Non-Current Liabilities

Total Non-Current Liabilities

CURRENT LIABILITIES

Financial Liabilities

Borrowings

Trade Payables Due to MSME

Trade Payables Due to Others

Other Financial Liabilities

Provisions

Other Current Liabilities

Total Current Liabilities

Total Equity and Liabilities

Compiled by Prof. Prasad Bhat Page 97

7. CASH FLOW STATEMENT

 Cash Flow Statement is an important financial statement that provides an overview of a

company's cash inflows and outflows over a specific period.
 Cash Flow Statement is essential for assessing the company's ability to generate cash,
meet its financial obligations, and understand the sources and uses of cash.
 It measures the liquidity position of the company over a period of time, accounting year.
 The Balance Sheet and Profit & Loss Statement provide a firm’s assets-liabilities and its
performance, respectively. However, both these statements fail to explain the changes
(with reasons) in the liquidity position of the firm.
 Cash Flow Statement discloses the changes in cash / bank position between two or more
periods. Cash Flow Statement provides reasons for such changes and also clarifies the
modes in which cash is generated as well as utilized by the firm during the period.

Classification of Cash Flow Statement

As per Accounting Standard, a Cash Flow Statement is classified into three main categories
of cash inflows and cash outflows. Such classification provides information that allows its
users to assess the impact of those activities on the financial position of the company. This
facilitates better utilization of financial statements by its users, viz. shareholders, creditors,
financial institutions. Following are the three activities under Cash Flow Statement –

1) Cash Flows from Operating Activities

Operating Activities are the primary / main revenue generating activities of a company.
Operating activities include cash effects of those transactions and events that enter into
the determination of net profit or loss. Cash receipts from selling goods and providing
services. Cost of goods sold and other operative expenses result in cash disbursements.
Following are examples of Cash Flows from Operating Activities:
a) Cash receipts from the sales of goods and the rendering of services:
b) Cash receipts from royalties, fees, commissions, and other revenues.
c) Cash payments to suppliers for goods and services;
d) Cash payments to and on behalf of employees;
e) Cash payments or refunds of income taxes; and
f) Changes in working capital

Compiled by Prof. Prasad Bhat Page 98

2) Cash Flows from Investing Activities
Investing Activities represent cash flows related to a company's investments in long-
term assets and long-term investments. It includes cash used for purchasing or selling
property, plant, and equipment (fixed assets), acquiring or selling other businesses, and
buying or selling investments in securities. The following are examples of cash flows
arising from investing activities:
a) Payment to acquire fixed assets (including intangibles);
b) Receipt from sale of fixed assets (including intangibles);
c) Payments to acquire shares of other companies, joint ventures etc.;
d) Receipts from sale of long-term investment, shares;
e) Payment towards long-term advances and loans made to third parties;
f) Receipts from repayment of long-term advances and loans made to third parties.
g) Interest received on investments; and
h) Dividend received on investments.

3) Cash Flows from Financing Activities

Financing activities show the cash flows related to a company's financing activities,
including transactions with shareholders and creditors. It includes cash received from
issuing shares or debentures, as well as cash paid for dividends, share buy-back, and
debt repayments. Financing activities are activities that result in changes in the size and
composition of the owner’s capital (including preference share capital) and borrowings
of the company. Following are examples of cash flows arising from financing activities:
a) Receipts from issuing shares or other similar instruments;
b) Receipts from issuing debentures, loans notes, bonds, long-term borrowing;
c) Repayments of amounts borrowed i.e., redemption of debentures, bonds etc.
d) Payments towards redeem preference shares;
e) Payment towards buy-back of equity shares;
f) Payment of Interest on Borrowings; and
g) Payment of Dividend on Share Capital.

Compiled by Prof. Prasad Bhat Page 99

Importance / Benefits / Merits Cash Flow Statement

1. Cash Management: Cash Flow Statement helps companies monitor their cash inflows
and outflows, allowing them to manage cash effectively and ensure sufficient liquidity
for daily operations.

2. Financial Health: Investors use Cash Flow Statement to evaluate company's financial
health. A company with positive operating cash flows and adequate cash reserves is
generally considered more financially stable.

3. Assessing Cash Generation: Cash Flow Statement provides inputs about a company's
ability to generate cash from core business activities. Ideally, cash flow from operating
activities should be positive which indicates a healthy and sustainable business model. A
net-positive cash flow denotes surplus day-to-day activities, which facilitates operating
capabilities. Surplus funds can be used for paying dividends and repaying loans, short-
term investments and less dependency on borrowed funds.

4. Investment Decisions: Investors use Cash Flow Statement to assess a company's capital
expenditure and investment decisions. Net-negative cash flow from investing activities
indicates higher capex, which results in future growth by increasing production capacity.
Long term investments signify surplus fund generation.

5. Financing Decisions: Cash Flow Statement reveals how the company raises capital and
manages its financing activities. It helps stakeholders understand the company's capital
structure and debt management practices.

6. Detecting Cash Flow Issues: A negative cash flow, especially in operating activities, may
signal potential financial problems or indicate that the company is relying on external
financing to fund its operations.

7. Comparing Profit & Cash Flows: Cash Flow Statement complements the P & L Statement
by providing inputs into the actual cash movements underlying reported profits. It helps
identify differences between reported profit and actual cash flow.

Hence, Cash Flow Statement is a crucial tool for assessing liquidity position of a company
and understanding its ability to generate and manage cash, necessary for sustainable
growth and financial stability.

Compiled by Prof. Prasad Bhat Page 100

Changes in Working Capital

Event Result Reason

Increase in Current Asset Cash Outflow Blockage of Funds
Decrease in Current Assets Cash Inflow Release of Funds

Increase in Current Liability Cash Inflow Release of Funds

Decrease in Current Liability Cash Outflow Blockage of Funds

Increase in Net Working Capital Cash Outflow Blockage of Funds

Decrease in Net Working Capital Cash Inflow Release of Funds

Illustrations:

Current Assets 2022-23 2021-22 Increase / Amount Inflow /

(current year) (last year) decrease (₹) Outflow
Inventory 1,50,000 1,25,000
Debtors 40,000 60,000
Bills Receivable 25,000 15,000
Advance given 10,000 15,000

Current Liabilities 2022-23 2021-22 Increase / Amount Inflow /

(current year) (last year) decrease (₹) Outflow
Creditors 85,000 75,000
Bills Payable 15,000 20,000
Outstanding Exp. 10,000 25,000
Bank Overdraft 20,000 40,000

Compiled by Prof. Prasad Bhat Page 101

Prepare Cash Flow Statements

Q1. Prepare Cash Flow Statement for Jackal Ltd. for the year ended 31st March, 2023. The
cash & cash equivalent at start of year ₹ 110,000 and at end of the year was ₹ 520,000.

Particulars Amount ₹
Income Tax paid 45,000
Equipment purchase 1,20,000
Decrease in creditors 65,000
Increase in inventory 95,000
Issue of Equity Shares 5,00,000
Long term investment sold 35,000
Cash generated from Operations 2,00,000
Machinery bought 2,10,000
Interest received 25,000
Dividend paid 15,000
Bank Loan taken 2,00,000

Q2. Prepare Cash Flow Statement for Wolf Ltd. for year ended 31st March, 2023. The cash &
cash equivalent at start of year was ₹ 48,000 and end of the year was ₹ 195,000.

Particulars Amount ₹
Increase in Debtors 32,000
Proceeds from Issue of Equity Shares 2,00,000
Sale of long-term Mutual funds 78,000
Repayment of Loans 72,000
Decrease in Creditors 41,000
Interest payment 18,000
Cash generated from Operations 75,000
Income Tax payment 23,000
Dividend received 10,000
Purchase of Factory Building 1,00,000
Increase in Outstanding Expenses 15,000
Decrease in Inventory 55,000

Compiled by Prof. Prasad Bhat Page 102

Q3. Prepare Cash Flow Statement of Tiger Ltd. for 31st March, 2023. Cash & cash equivalent
at start of year was ₹ 19,500. Compute cash & cash equivalent at the end of year.

Particulars Amount ₹
Increase in Inventory 45,500
Proceeds from Bank Loan 1,75,500
Cash generated from Operations 20,000
Sale of old machinery 21,500
Buy Back of Equity Shares 34,500
Decrease in Bills Payables 11,500
Dividend paid 29,500
Income tax paid 21,500
Interest received 9,500
Purchase of Plant & Machinery 79,500
Increase in Bank Overdraft 14,500
Decrease in Debtors 32,500

Q4. Prepare Cash Flow Statement for Lion Ltd. for 31st March, 2023. Cash & cash equivalent
at start of year was ₹ 15,000. Compute cash & cash equivalent at the end of year.

Particulars Amount ₹
Cash generated from Operations 56,000
Purchase of Machinery 1,20,000
Increase in Bank Overdraft 3,000
Repayment of Corporate Bonds 50,000
Sale of Long-term Investments 1,02,000
Dividend payment 8,000
Decrease in Prepaid Expenses 4,000
Sale of old Furniture 5,000
Increase in Bills Payable 7,000
Investment in Subsidiary Company 78,000
Interest payment 23,000
Increase in Inventory 34,000
Decrease in Bills Receivable 8,000
Issue of Preference Shares 1,50,000

Compiled by Prof. Prasad Bhat Page 103

Q5. Given below is financial information of Canter Ltd. Prepare a statement of changes in
working capital. Also, comment on the liquidity position of the company.

Particulars FY 2021-22 FY 2022-23

Equity Share Capital 10,00,000 15,00,000
Property, Plant & Equipment 8,00,000 9,00,000
Trade Debtors 1,00,000 90,000
10% Debentures 5,00,000 7,00,000
Inventory of Finished Goods 1,50,000 1,80,000
Intangible Assets 4,00,000 4,00,000
Trade Creditors 80,000 60,000
Long-Term Investments 90,000 1,20,000
Prepaid Expenses 25,000 10,000
Outstanding Expenses 30,000 50,000
Bank Overdraft 70,000 40,000
Inventory of Raw Material 60,000 80,000
Cash & Cash Equivalents 20,000 30,000
General Reserves 2,00,000 5,00,000
8% Preference Share Capital 5,00,000 5,00,000
Marketable Securities 60,000 70,000
Bills Payable 10,000 20,000
Bills Receivable 30,000 20,000

Compiled by Prof. Prasad Bhat Page 104

8. COST ACCOUNTING CONCEPTS
1. INTRODUCTION

 Basically, it is necessary to record all business transactions for the proper functioning of
the enterprise. Accounting is a science as well as an art of recording the business
transactions in the books of accounts systematically and scientifically.
 Financial Accounting was used to record the business transaction and preparation of
financial statements – Profit & Loss Account and Balance Sheet.
 These financial statements were prepared mainly for the purpose of outside users such
as investors, banks, creditors, debtors, Govt., employees etc.
 However, managers needed much more information for the purpose of decision making
and smooth running of the business operations. They required in-depth and analytical
information, which were not available in Financial Accounting.
 This led to the birth of a new system of accounting known as Cost Accounting.

Limitations of Financial Accounting

o It does not show product-wise or activity-wise performance,

o It provides only historical data, i.e., it is a post-mortem of the past,
o Does not facilitate control of costs,
o Inadequate information to management for decision making,
o High possibility of manipulation etc.

 Basically, cost accounting was used in manufacturing organizations.

 Large scale operations and the complex nature of production activities needed
specialized study and analysis.
 However, with development of new principles, methods & techniques, Cost Accounting
is now integral part of various types of organizations including manufacturing, service
industry, education, Govt. departments etc.

Compiled by Prof. Prasad Bhat Page 105

2. KEY CONCEPTS

 Cost
 Cost is a loss of resources for achieving certain objectives or benefits. Cost refers to
the expenditure incurred for producing a product or providing a service.
 According to the Chartered Institute of Management Accountants (CIMA), ‘ Cost is the
amount of expenditure (actual or notional) incurred on or attributable to a specified
thing or activity.’
 Actual expenditure refers to the amount spent, while notional expenditure does not
involve in any cash outflow. However, notional cost is important for the purpose of
comparison of cost and in decision making.

 Costing
 Costing is the technique and process of ascertaining costs. In other words, costing
means to find the cost.
 Costing includes all the principles, rules and processes for finding the costs.

 Cost Accounting
 Cost Accounting is the process of collecting, classifying and recording costs and
preparation of periodical reports.
 Cost Accounting relates to preparation of various reports, statistical data etc. for each
product or service.

 Cost Accountancy
 Cost Accountancy is the application of Costing and Cost Accounting principles,
methods and techniques for the purpose of managerial decision making.
 It is the art and science of cost control and profitability study. It helps management in
understanding the cost scenario and thereby resulting in good decisions.

 Cost Accountant
 A Cost Accountant is the professional person engaged in the Cost Accountancy
profession.
 In India, this profession is administered by ‘The Institute of Cost Accountants of India
(ICAI)’.

Compiled by Prof. Prasad Bhat Page 106

 Cost Object
 A Cost Object is anything for which a separate measurement of cost is desired. For
example – a product / a service / a project etc.
 Cost Object is the reason for which cost ascertainment is done by an organization.

 Cost Unit
 A Cost Unit is quantitative unit of product of service or time in relation to which costs
are ascertained or expressed.
 Cost ascertainment is always related to a particular object, which is measured in cost
unit, i.e., difficult to assess any cost in isolation. E.g., cost of 1 apple, ticket cost, etc.
 The unit of measurement must be clearly defined and selected. The cost unit may be
single unit (e.g., per kg) or a composite cost unit (person / room) etc. Examples:

Product / Service / Activity Cost Unit

Milk Litre
Steel Tonne
Shoes Pair
Wire Metres
Building Square feet
Cars Number
Land Acre, hectare
Paper Rim

 Cost Centre
 Every organization is divided into sub-units for better management and control.
 A Cost Centre is defined as a location, person or an item of equipment on which costs
may be ascertained and used for the purpose of control.
 Cost centres are created for accounting convenience, main purpose is minimizing
costs. Types of Cost centres are:
o Personal Cost Centre – consisting of person or group of persons e.g., accountant
o Impersonal Cost Centre – consisting of location or an equipment e.g., library
o Production Cost Centre – location connected with production activities e.g., cutting
shop, welding shop, painting area, assembly area etc.
o Service Cost Centre – location which provides services, e.g., canteen, security etc.

Compiled by Prof. Prasad Bhat Page 107

 Profit Centre
 A Profit Centre is that segment of activity of a business which is responsible for both
revenue and expenses and discloses the profit of a particular segment of activity.
 A Profit Centre has the responsibility of generating and maximizing profits.

3. OBJECTIVES / MERITS / IMPORTANCE OF COST ACCOUNTING

1) Cost Ascertainment – the main objective of cost accounting. It involves collection of

cost information, recording them under proper heads and reporting such information
on a periodical basis.

2) Determination of selling price – cost information facilitates fixing the selling price of a
product or service. Generally, selling price is never less than cost (with exceptions).

3) Profitability analysis – finding the cost and setting the selling price results in profit
computation and facilitates analysis.

4) Cost Control – controlling costs means ensuring that the actual costs do not exceed the
pre-determined costs. Control is day-to-day exercise and helps to eliminate wastages.

5) Cost Reduction – cost reduction implies reducing the unit cost of a product or activity.
It is a long-term exercise which may involve extra investments, better technology,
process changes etc.

6) Ascertainment of profit of each activity – profits of each product / service / activity /

department can be determined by comparing its costs with its revenues.

7) Helps in planning & budgeting – cost accounting information serves as the basis for
future planning and budgeting.

8) Measuring & improving efficiency – cost accounting computes the use of resources
and hence facilitates measuring as well as improving the level of efficiency.

9) Assists management in decision making – business decisions are taken after doing a
detailed Cost-Benefit Analysis of various alternative options.

10) Cost Comparison – periodical comparison of costs facilitates better analysis and
taking preventive and corrective steps to resolve an anomaly, if any.

Compiled by Prof. Prasad Bhat Page 108

4. LIMITATIONS / DEMERITS OF COST ACCOUNTING

a) Expensive – installation of cost accounting system is an expensive exercise.

b) Complex – cost accounting system involves many complex steps in finding the cost.
c) Variety – different costing methods and techniques are to be used for different types
of organizations as per their business models, i.e., there is lack of uniformity.
d) Assumptions – certain assumptions need to be made in ascertaining the costs, thus
compromising on the accuracy of costs.
e) Subjective – distribution of common costs over different products / services requires
a reasonable basis, which is subjective nature, thus affecting the cost ascertainment.

5. DISTINCTION

Sr. Basis Financial Accounting Cost Accounting

1. Purpose Finding the profit/ loss and Finding the cost of a product or
financial position of business. service.
2. User group Financial reports available to Cost reports only for internal
banks, investors, Govt. etc. management.
3. Legal As per legal requirement of Mostly for requirements of
Requirement Companies Act 2013, Income Tax management. Except some
Act 1961 etc. industries as per Law.
4. Audit Compulsory for every company. Compulsory for few companies.
5. Coverage Covers all the commercial Cost Accounting covers specific
transactions, shows overall transactions, and shows product-
profits of business. wise / activity-wise profits
6. Efficiency Financial reports insufficient to Cost reports are better for
measure efficiency. measuring efficiency.
7. Recording Financial Accounts contain only Cost Accounts contain actual
rules actual historical costs. historical costs and estimates
8. Periodicity Financial reports prepared and Cost reports is continuous
reported periodically, e.g. annual process i.e. daily, weekly,
basis monthly, annually etc.
9. Function Basic function involves recording Basic function is cost finding and
and reporting. controlling.
10. Stock Stock is valued at cost or market Stock is valued always at cost.
valuation price, whichever less.

Compiled by Prof. Prasad Bhat Page 109

6. CLASSIFICATION OF COST

Basis of Classification

Decision
Elements Functions Identity Nature
Making

Material Cost Factory Cost Direct Cost Fixed Cost Sunk Cost

Labour Cost Office Cost Indirect Cost Variable Cost Relevant Cost

Semi-Fixed or
Opportunity
Expenses S & D Cost Semi-
Cost
Variable

Out of Pocket
R & D Cost
Cost

A. Based on Elements

a) Material Cost – the cost of physical, tangible articles, (except fixed assets) used in
production or consumed in the operations of an organization. Material cost may be
Direct Material or Indirect Material. E.g., raw material, consumables, spares parts,
fuel, cotton waste, maintenance etc.

b) Labour Cost – Cost incurred in relation to human resources of the enterprise. It is the
remuneration for employee’s efforts and skills used in the product or service. Labour
cost may be Direct or Indirect Labour. E.g., wages to workers, salary to office staff,
training expenses etc.

c) Expenses – Cost of operating a company, other than materials and labour. Expenses
denote the cost of services provided to the organization. E.g., Factory Rent, power,
postage, lighting, welfare expenses, royalty, designs and drawings etc.

Compiled by Prof. Prasad Bhat Page 110

B. Based on Time

i. Historical Cost – Costs relating to the past period, which has already been incurred.
They are recorded after the production / activity is completed.

ii. Pre-determined Cost - Costs relating to the future period, i.e. costs which are
computed in advance, on the basis of specification of all factors affecting it. Pre-
determined costs include Estimated cost (random basis) or Standard cost (analytical)

C. Based on Functions

a) Factory Cost – The costs incurred for all the production operations, i.e., starting with
supply of materials, labour and services and ending with primary packing of product.
Thus, factory cost is equal to total of Materials, Labour and Expenses (including direct
and indirect costs). Factory costs are also known as Production Cost, Manufacturing
Cost, Technical Cost and Works Cost. E.g., raw material, direct wages, oil & fuel,
power, indirect material, factory heating & lighting, factory insurance etc.

b) Office Cost – The costs incurred for managing administrative functions of a business
is known as Office Cost or Administrative Cost. It includes cost of accounting and
secretarial work, which is not related to production or marketing functions. E.g., office
salary, printing, postage, office rent, Directors’ fees, stationery, legal exp. etc.

c) Selling & Distribution Cost – The costs incurred for attracting new customers,
maintaining existing customers and ensuring delivery of the product in the market
are known as Selling & Distribution Costs. Selling costs include costs for creating
demand, getting new orders, e.g., advertisement, publicity, salesman commission
etc. Distribution cost means cost for making the product available in the market, e.g.,
carriage outward, special packing, delivery van rent, finished goods warehouse etc.

d) Research & Development Cost – Research cost means finding new or improved
products, new applications of materials or improved methods. Development costs
means the cost incurred for developing the new product which was created through
research. Development costs are necessary to ensure production of the new
products. E.g., scientists’ salary, laboratory stores, catalysts, salary of technicians etc.

Compiled by Prof. Prasad Bhat Page 111

D. Based on Relationship / Identification

i. Direct Cost – The costs which are directly related or directly identifiable with the cost
centre or cost unit (product or service) is called as Direct Cost. All direct costs are
known as Prime Cost. E.g., raw material in a product (refill in a pen), direct wages
(teacher in class) etc.

ii. Indirect Cost – The costs which cannot be directly identified with the cost centre or
cost unit (product or service) are known as Indirect Cost. Such indirect costs are
distributed over the cost centre/ cost unit using some appropriate basis. E.g., factory
rent, accountants’ salary, heating & lighting, printing, carriage outward, stationery
etc. All such Indirect Costs (material, labour, expenses) are called as ‘Overheads’.
Overheads are further classified as –
 Factory Overheads – indirect costs related to production operations, e.g., oil,
factory insurance, consumables etc.

 Office Overheads – indirect costs related to admin operations, e.g., salary,

postage, telephone expenses etc.

 Selling & Distribution Overheads – indirect costs related to selling, distribution of

product / service, e.g., advertisement, publicity, commission etc.

iii. Product Cost – Costs which are traceable to the product and included in inventory
valuation. Generally, product cost is a combination of direct material, direct labour
and variable manufacturing overheads.

iv. Period Cost – Costs which are incurred on the basis of time are known as Period
Cost. For example, rent, salaries, insurance premium etc. Period costs are not
associated with the product (cost unit). Thus, period costs are not to be included in
computation of cost per unit of product. Instead, period costs are charged to Costing
P & L A/c. Generally, fixed costs are period costs.

Compiled by Prof. Prasad Bhat Page 112

E. Based on Controllability

i. Controllable Cost – The costs which can be influenced or controlled by management

decisions. Controllable costs may be based on various factors such as time period,
location (transport cost) or product or service itself.

ii. Uncontrollable Cost – The costs which cannot be influenced by the actions / decisions
of the management. Generally, all fixed costs are uncontrollable.

F. Based on Normality

a) Normal Cost – Costs which are normally incurred for a given level of output, under
normal conditions. Normal cost is a part of cost of production. E.g., raw material,
direct expenses, overheads.

b) Abnormal Cost – Costs which are not normally incurred at a given level of output
under normal conditions. Abnormal costs are not incurred in normal production and
hence they are not taken as a part of cost of production. E.g., fines, penalty.

G. Based on Nature

a) Fixed Cost – The costs which remain fixed irrespective of the change in the level of
activity / output. These costs are not affected by volume of production e.g., factory
rent, insurance, supervisor fees, advertising and publicity etc.
 Total Fixed Costs are always constant for a given capacity and Fixed Cost per unit
changes according to the level of output.
 Fixed Costs vary inversely with volume of production i.e., if production increases
fixed costs per unit decreases and vice-versa.
 Fixed costs depend on installed capacity & hence also known as Capacity Costs.
 Fixed costs relate to a certain time period and hence also known as Period Cost.

b) Variable Cost – The costs which tend to change as per the volume of production or
the level of activity. E.g., direct factory, direct wages, direct expenses etc.
 Total Variable Costs increase with the increase in production and total variable
costs decrease with the fall in production.
 Variable cost per unit is constant.
 Variable costs depend on actual capacity utilized.

Compiled by Prof. Prasad Bhat Page 113

 c) Semi–fixed / Semi–variable Cost – Costs which are partially fixed and partially
variable are called as semi-fixed or semi-variable costs. They are fixed upto a certain
level of output and become variable thereafter. Also called as Step Costs. For
example – electricity, landline telephone, postpaid mobile connection etc.

H. Based on Relevance / Decision Making

a) Sunk Cost – The costs which are already incurred in the past are called as Sunk costs.
They are not relevant for decision making. E.g. a mobile phone purchased for Rs.
10,000 in the past has no relevance in deciding its resale value after 3 years of usage.
In this case, Rs. 10,000 is a sunk cost.

b) Committed Cost – The costs which have been already committed by the management
are not relevant for decision making, as they are already fixed and will not change as
per future decision.

c) Relevant Cost – The costs which are influenced by the actions / decisions of
management are known as relevant costs.

d) Out of Pocket Cost / Explicit Cost – A cost which results in immediate cash payment
or a future cash outflow is called as Out-of-Pocket or Explicit costs. Such costs are
used in decision making.

e) Opportunity Cost – It is the value of benefit sacrificed or advantage foregone in

accepting an alternative course of action. E.g. a piece of land can be used for
cultivating wheat or rice. If rice is cultivated, then the wheat profits forgone are
opportunity cost.

f) Differential Cost - It is the change in total costs due to change in the level of activity
or pattern or method of production. Where the change results in increase in cost it is
called incremental cost, whereas if costs are reduced due to increase of output, the
difference is called decremental costs. Differential costs are relevant costs.

g) Marginal Cost – Marginal cost are the total variable costs, i.e., prime cost + variable
overheads. Marginal cost is a result of additional units of output, and hence it is the
relevant cost for decision making.

Compiled by Prof. Prasad Bhat Page 114

7. DISTINGUISH

Sr. Cost Control Cost Reduction

1. Cost Control aims at achieving the set Cost Reduction aims reducing
cost standards. the set standards itself.
2. It is a preventive function, i.e., excess It is a corrective function, i.e.,
costs are prevented. cost standard is itself reduced
3. Variance analysis between actual and Challenges standards, finds new
standard costs ways to doing things
4. Lacks dynamic approach, it is a post- Dynamic process as there is
mortem of costs continuous improvements.

8. COMPONENTS OF COST

TOTAL COST = PRIME COST + OVERHEADS

Material = Direct Material + Indirect Material

(+) Labour = Direct Labour + Indirect Labour

(+) Expenses = Direct Expenses + Indirect Expenses

 Prime Cost – Prime Cost is total of Direct Material, Direct Labour and Direct Expenses.
It is the main cost that can be directly related / identified with the product or service.
 Overheads – Overheads costs are total of Indirect Material, Indirect Labour and
Indirect Expenses. Overheads are the operating costs of a business that cannot be
identified with particular units of output.
 Factory Overheads are indirect costs which are related to production, manufacturing
activities. E.g., fuel, power, machine depreciation, factory repairs, indirect wages etc.
 Office Overheads are the indirect costs related to the general administration functions
of an organization. E.g., accountant salary, postage, printing, bank charges etc.
 Selling Overheads are indirect costs which are related to acquiring new customers,
retaining existing customers and expanding the market share etc. E.g., free samples,
commission to agents, advertisement, publicity, depreciation on advertisement
hoardings etc.
 Distribution Overheads are the indirect costs which are related to delivery of finished
products to the customers. E.g., carriage outward, delivery van expenses, special
packing.

Compiled by Prof. Prasad Bhat Page 115

9. TECHNIQUES OF COSTING

Costing Techniques are those means, which are used for managerial decision making and
controlling costs –

1. Marginal Costing
 Marginal Costing is a technique of costing which is based on bifurcation of total cost
into fixed costs and variable costs for the purpose of decision making.
 Marginal Costing computes the effect of change in volume of production on the
overall cost and profit.
 For decision making, only variable costs are considered while calculating cost.
 Fixed costs are not considered in the production units. This technique is effectively
used for decision making in areas like make or buys decisions, optimizing of product
mix, key factor analysis, fixation of selling price, accepting export offer etc.

2. Standard Costing
 Standard costs are predetermined costs relating to material, labour and overheads.
 Such standard costs are computed on basis of scientific study and detailed analysis.
 The main objective of fixation of standard cost is to have benchmark against which
the actual performance can be compared.
 This means that the actual costs are compared with the standards. The difference is
called as ‘variance’.
 If actual costs are more than the standard, the variance is ‘adverse’ while if actual
costs are less than the standard, the variance is ‘favourable’.
 The adverse variance is analyzed and reasons for the same are found out. Favourable
variances may also be analyzed to find out the reasons behind the same.
 Thus, standard costing is an important technique for cost control and reduction.

3. Budgetary Control
 Budgetary Control involves establishment of budgets relating to various functions
and continuous comparison of actual with budgeted results.
 One of the important aspects of budgeting is that it lays down the objective to be
achieved during the defined period of time and for achieving the objectives.

4. Uniform Costing is the usage of similar method of costing by different organizations in

the same industry. Its purpose is a meaningful comparison.

Compiled by Prof. Prasad Bhat Page 116

5. Activity Based Costing (ABC)
 ABC is a modern technique for distribution of common resource costs to various
products and services, on the basis of activities required for their completion.
 It is a technique of costing for assignment of costs to cost units on the basis of
benefits received from indirect activities.
 ABC ensures high level of accuracy in distribution of common costs over the cost
units. It helps in precise cost computation, selling price fixation, identification of value
adding activities, and better decision making.

10. COST SHEET

 Cost sheet is a statement prepared to show the total cost of a product or service.
 It is a statement which shows the break-up of the total cost. It is generally presented
in a tabular form and pertains to a certain period, i.e., week, month year etc.
 It is a summary of all costs ascertained for a cost unit or a cost centre.
 It is a document prepared for recording actual costs or estimated costs.
 A Cost Sheet analyze and classifies different costs as per their functions, i.e., factory,
office and selling-distribution.
 Cost Sheets may be prepared for two or more periods for comparative studies.
 Total Cost = Prime Cost + Overheads.

Advantages of Cost Sheet:

o Presentation of cost information
o Discloses total cost as well as cost per unit
o Classification of cost as per its functions
o Determination of selling price
o Ascertaining profitability
o Intra-firm cost comparison
o Preparation of estimates and budgets
o Basis for cost control

Compiled by Prof. Prasad Bhat Page 117

Items not considered in Cost Sheet –
 Incomes of purely financial nature, E.g., dividends received, interest on investments,
discount received etc.
 Expenses of purely financial nature, e.g., interest on debentures, interest on bank
loans, dividends paid to shareholders, underwriting commission, discount on issue of
shares & debentures etc.
 Charges and appropriation e.g., preliminary expenses written off, income tax, wealth
tax, charity, donations, transfer to reserves, loss on sale of assets etc.
 Abnormal items such as loss by fire, fines, penalty, abnormal loss etc.

COST SHEET FORMAT

Particulars Rs. Rs.

Direct Material
Opening stock of RM 70,000
(+) Purchases of RM 4,00,000
(+) Direct Expenses on purchases 20,000
(-) Closing Stock of RM (50,000)
Hence, Material Consumed 4,40,000

(+) Direct Labour (Wages) 2,00,000

(+) Direct Expenses 30,000

Hence, Prime Cost 6,70,000

(+) Factory Overheads 90,000

Hence, Gross Factory Cost 7,60,000

(+) Opening stock of Work in progress (WIP) 40,000

(-) Closing stock of Work in progress (WIP) (50,000) (10,000)

Hence, Net Factory Cost 7,50,000

(+) Office Overheads 1,00,000

Gross Office Cost (Cost of Production) 8,50,000

(+) Opening stock of Finished Goods (FG) 80,000

(-) Closing stock of Finished Goods (FG) (60,000) 20,000

Net Office Cost (Cost of Goods Sold COGS) 8,70,000

(+) Selling Distribution Overheads 1,30,000

Hence, Cost of Sales 10,00,000

(+) Profit 2,50,000

Sales 12,50,000

Compiled by Prof. Prasad Bhat Page 118

Cost Sheet Illustrations:

Prime Cost: Direct Wages Royalty Direct Material

Patterns Designs & Drawings Surveyor Fees

Factory Overheads: Indirect Wages RM Godown Rent Power

Heating Repairs to Plant Machine Depreciation
Lighting Normal Wastage Supervisor Salary
Oli & Fuel Indirect Material Insurance of Machine
Workshop Rent Consumables Foreman Bonus
Coal & Coke General Packing etc.

Office Overheads: Salaries Postage Printing

Stationery Furniture Depreciation Legal Expenses
General Expenses Accountant Salary Repairs to furniture
Office Electricity Insurance of Furniture Branch Expenses
Audit Fees Office Manager Telephone & Internet
Etc.

Selling Distribution Free Samples FG Warehouse Rent Showroom Expenses

Overheads Demand Survey Depreciation of Advt. Sales Promotion
Branding cost Agent Commission Salesman Salary
Carriage Outward Delivery Van Insurance Special Packing
Exhibition expenses etc.

Not Applicable Donation Abnormal loss Dividend paid

Interest paid Income Tax paid Loss on sale of asset
Dividend received Commission on shares preliminary expenses
Penalty, fine Transfer to reserves etc.

Compiled by Prof. Prasad Bhat Page 119

 Cost Sheet Practical Questions

Q1. Bizcon Ltd. has provided following data for the January 2023. Prepare Cost Sheet.

Particulars ₹ Particulars ₹
Opening stock (01.01.2023) Loss on sale of plant 5,000
Raw Material 10,000 Depreciation machinery 6,400
Work In Progress (WIP) 6,750 Depreciation Office furniture 2,300
Finished Goods (FG) 40,000 Depreciation Advt. Boards 900

Direct Wages 70,000 Factory insurance 2,100

Indirect Wages 12,000 Office stationery 1,400
Purchases RM 1,12,000 Sales Promotion Expenses 2,700
Factory Lighting 3,250 Office Salaries 18,000
Closing stock (31-01-23) Advertisement Expenses 9,000
Raw Material 8,000 Income Tax paid 2,675
Work In Progress (WIP) 7,800 Net Sales 3,00,000
Finished Goods (FG) 26,000 Dividends received 3,000

Q2. Prepare a Cost Sheet and determine the sales if profit is computed at 20% on total cost.

Particulars Amt. ₹ Particulars Amt. ₹

Purchases 1,00,000 Factory rent 2,500
Direct wages 50,000 Salary 3,000
Power 2,000 Branch expenses 3,200
Office rent 5,000 Income tax 2,000
Fuel 7,000 Factory Depreciation 5,000
Internet charges 1,500 Depreciation office Building 1,700
Lighting office 1,400 Commission 3,200
Opening RM stock 50,000 Closing RM stock 60,000
Selling expenses 2,000 Indirect material 21,000
Opening WIP stock 15,000 Closing WIP stock 25,000
Director Fees 12,500 Carriage outward 2,500
Carriage inward 3,000 Indirect wages 11,000
Opening FG stock 45,000 Closing FG stock 35,000

Compiled by Prof. Prasad Bhat Page 120

Q3. Prepare a Cost Sheet and determine the sales if profit is computed at 10% on total cost.
Particulars Amt. ₹. Particulars Amt. ₹
Opening RM stock 32,760 Carriage inward 6,000
Closing RM stock 37,820 Depreciation on machinery 10,000
Purchases of RM 1,65,060 Repairs to Plant 2,000
Direct wages 80,000 Sundry wages 10,600
Patterns & Drawings 2,500 Factory rent 6,400
Fuel and Power 15,000 Factory lighting 1,000
Indirect materials 7,500 Office Salaries 6,000
Factory insurance 600 Office rent 3,000
Factory stationery 1,400 Income Taxes 600
Managers’ remuneration 2,800 Branch expenses 2,500
Sales distribution material 600 Sundry office expenses 700
Legal expenses 500 Salesman salary 5,000
Audit fees 1,000 Showroom expenses 3,000
Advt. expenses 4,000 General packing expenses 3,600
Carriage outward 1,500 Furniture Depreciation 800
Office Stationery 600 Sundry selling expenses 800

Q4. Prepare a Cost Sheet and determine the sales if profit is computed at 25% on total cost.
Particulars Amt. ₹ Particulars Amt. ₹
Opening RM stock 12,000 Freight inward 1,000
Closing RM stock 10,000 Depreciation on Machinery 8,000
Purchases of RM 1,30,000 Repairs to Machinery 4,000
Direct wages 32,000 Carriage outward 5,000
Royalty 6,000 After-Sales Services 8,000
Power & Fuel 5,000 Income Tax 5,000
Indirect material 12,000 Sale of Scrap 1,000
Opening WIP stock 6,000 Accounting charges 3,000
Closing WIP stock 7,000 Discount on Issue of Shares 8,000
Works Manager Salary 9,000 Charity 11,000
Printing charges 2,000 Agent Commission 6,000
Workshop Rent 7,000 Showroom expenses 3,000
Advertisement 13,000 Primary packaging 1,000

Compiled by Prof. Prasad Bhat Page 121

Q5. Inasa Ltd. provides following data for August 2022. Prepare a Cost Sheet.
Particulars ₹ Particulars ₹
Opening stock FG warehouse rent 2,589
Raw Material 12,530 Salesman conveyance 12,369
Work In Progress (WIP) 2,564 Commission 8,987
Finished Goods (FG) 9,879 Machine Depreciation 9,874
Manager Salary 11,236
Foreman's bonus 1,597 Telephone Charges 2,658
Direct Wages 56,978 Sale of Scrap 147
Interest on Bank Loan 9,821 Royalty 6,982
Designs & Drawings 2,569 Coal & Coke 8,974
Indirect Wages 6,589 General expenses 2,370
Oil & Fuel 8,787 Dividends paid 12,000
Consumables 1,234 Directors Fees 13,658
Purchases RM 98,652 Delivery Van petrol 2,589
Repairs to Furniture 2,369 Publicity expenses 7,896
Closing stock Indirect material 1,111
Raw Material 8,978 Net Sales 4,25,698
Work In Progress (WIP) 3,654 Preliminary Expenses 236
Finished Goods (FG) 10,256 Exhibition fees 5,645

Additional Information

 Director devotes 20 % of his time to Marketing activities and 25 % towards Factory

 Advertising charges are outstanding – 5 % of Sales
 General Expenses are to be divided evenly among factory, office and selling
 Manager handles Administration & Sales in the ratio 7:3

Compiled by Prof. Prasad Bhat Page 122

9. BUDGETARY CONTROL
1. INTRODUCTION

 To achieve goals of an organization it is necessary to have coordination between various

activities of the organization.
 Determination of objectives (short-term or long-term) and goals of an organization are
primary steps taken by any management. Such objectives must be clearly defined.
 However, it is necessary to prepare a comprehensive plan to transform these objectives
into reality. Thus, there is a need for precise planning mechanism and thorough control
systems to fulfill the pre-determined objectives.
 Planning facilitates systematic work towards achieving the objectives and controlling
helps to review the progress and to monitor whether the work is progressing as per plan.
 Budgeting is a technique that helps in planning as well as controlling. It is a technique of
cost accounting with the twin objectives of facilitating planning and ensuring controlling.

2. BUDGET

 The Chartered Institute of Management Accountants, London, defines a budget as ‘ a

financial and/or quantitative statement prepared prior to a defined period of time, of the
policy to be pursued during that period for the purpose of achieving a given objective .’
 Thus, a budget is a detailed plan of operations for some specific future period. It is an
estimate prepared in advance of the period to which it applies.

Features of Budget

a) Budget is prepared in advance and based upon a future plan of actions.

b) Budget is a prepared either in money terms and / or physical units. For example: sales
budget in sales units and revenue expected.
c) Budget is prepared for the definite future period. E.g., budget for FY 2022-23 etc.
d) Policy must be clear, definite and it must be laid down before the budget is prepared.
e) All departments of an organization co-operate and coordinate to prepare the budgets.
f) Budget is a written formal document.
g) Budget shall be updated at regularly, and at every change in circumstances.
h) Budgets help in planning, coordination and control.

Compiled by Prof. Prasad Bhat Page 123

3. BUDGETARY CONTROL

 The Chartered Institute of Management Accountants, London defines Budgetary Control

as “the establishment of budgets, relating the responsibilities of executive to the
requirements of a policy and the continuous comparison of actual with budgeted results
either to secure by individual action the objectives of that policy or to provide a firm
basis for its revision”.
 It is a system of management control and accounting in which all the operations are
forecasted and planned in advance and results are compared with actual outcome.

Steps of Budgetary Control

1. Study the environment (internal & external) and forecasting,

2. Establish Budgets, for various functions and operations,
3. Collecting and systematically recording actual performance,
4. Compare actual outcome with budgeted data,
5. Fix responsibilities for under-achievement and take corrective action,
6. Revise budgets, if necessary.

Budgeting is the art of planning and budgetary control is the act of adherence to the plan.
In fact, budgetary control involves continuous comparison of actual results with budgets
and taking appropriate remedial action. The success of budgetary control depends on
proper basis of measurement to evaluate performance and efficiency.

Objectives of Budgetary Control

1. Planning: a well-defined plan helps an organization to use the scarce resources in an

efficient manner and thus achieving the predetermined targets becomes easy.
2. Co-ordination: to co-ordinate different levels of management for achievement of the
pre-defined objectives, e.g., sales manager will consult the production manager before
committing any deadlines to the customer.
3. Control: budgets facilitate centralized control with delegated authority & responsibility.
Budgets provide a basis for controlling through comparison of actual with the budgeted
performance.
4. Profitability: to achieve maximum profitability by proper planning & ensuring economic
use of available resources.

Compiled by Prof. Prasad Bhat Page 124

5. Assessment: by laying down responsibilities of executives and other personnel so that
everyone knows what is expected of him and how he will be judged. Budgetary control
is a technique for an objective assessment of executives.
6. Loss reduction: to reduce losses and wastages, through adequate planning and control.
7. Focus: to see that the firm is not diverted from its long-term objectives & ensure focus.

Advantages of Budgetary Control

1. Budgetary control aims at maximization of profits through effective planning & control.
2. Budgetary control ensures smooth functioning of various departments of an entity.
3. There is planned approach to expenditure and financing of the business. This facilitates
optimum utilization of funds and reduces wastages and losses.
4. Budgets provide a clear definition of the objective and policies of the concern.
5. Better managerial co-ordination is facilitated through budgetary control.
6. Effective and efficient utilization of men, materials and resources.
7. Encourages forward thinking habit, forecasting future problems and decisions making.
8. Periodical reporting for continuous control. Doctrine of ‘Management by Exception‘
9. Evaluations and comparisons provide a suitable basis for installing incentive system of
remuneration by identifying people with special qualities of leadership & management.

Limitations of Budgetary Control

1. Based on Estimates: Budgetary control is based upon estimations. Hence, the accuracy
of budgetary control system depends upon the correctness of the estimates made.
2. Volatility: Budgets are prepared for future business conditions, but future is constantly
changing. Thus, budget estimates may lose their usefulness under changing conditions.
Rigid budgets are unsuitable for seasonal businesses.
3. Budgetary control system is based on quantitative data (units and monetary) and does
not include the qualitative factors which affect the business enterprise.
4. Installation a budgetary control system is a costly affair and may not be beneficial for a
small organization.
5. Co-operation at all levels of management is needed for successful implementation of
budgetary control systems. It is human nature that controls are not accepted easily.
Hence, employees may resist to the implementation of such control system.

Compiled by Prof. Prasad Bhat Page 125

4. CLASSIFICATION OF BUDGETS

 Functional Budgets
Budgets for a period are classified according to the various activities / functions of the
organization. All such activities are interrelated. The forecasts for individual activities
are prepared and coordinated with other activities. A consolidated budget is prepared
to show the total effect of all the activities as a whole. Approved targets for individual
functions are known as ‘Functional Budgets’. The consolidation of all functional budgets
is known as the ‘Master Budget’. Principal functional budgets:

1. Sales Budget
The sales budget is a forecast of total sales, expressed in terms of money and
quantity. A sales budget may be prepared product-wise, territory-wise, country-wise,
customer group-wise, month-wise, weekly etc. The first step in preparation of sales
budget is forecast as accurately as possible the sales anticipated during the budget
period. Sales forecasts are influenced by various factors such as past sales figures,
seasonal fluctuations, customer preferences, competition level, data from dealers /
distributors, demography, pricing policy, government policy etc.

2. Production Budget
The production budget is forecast of the production target to be achieved for budget
period. A production budget is prepared in quantity as well as monetary terms, i.e.,
production units’ budget and the production cost budget. The main steps involving
in preparation of a production budget are production planning – after considering
production capacity, integration with sales forecast, inventory-policy and
management’s overall policies. Production budget facilitates optimum utilization of
resources, scheduled production of goods, achievement of customer delivery etc.

3. Materials Purchases Budget

Materials Purchase Budget, commonly known as Materials Budget, facilitates the
Purchase department in suitably planning the material purchases. Production budget
is the base for preparation of material budget. This budget is prepared in quantity as
well as in the monetary terms and helps in planning the funds for purchases of raw
materials. Availability of storage space, financial resources, levels of materials like
maximum, minimum, re-order and economic order quantity are considered.

Compiled by Prof. Prasad Bhat Page 126

 4. Cash Budget
Cash budget is a monthly estimate of cash which would be required and available in
a future period. Generally, this budget has two parts showing detailed estimates of
cash receipts and cash payments. The main purpose of cash budget is to predict the
receipts and payments in cash so that the firm will be able to find out the cash
balance at the end of the budget period.

This will help the firm to know whether there will be surplus cash or deficit at the
end of the budget period. It will help them to plan for either investing surplus or
raise necessary amount to finance the deficit. Also, decisions may be taken on
controlling credit policy, managing seasonal fluctuations etc.

Cash receipts include estimated cash-sales, collections from debtors, sale of assets,
borrowings, issue of shares, dividends received etc. Estimates of cash payments
include cash purchases, payment to creditors, employees’ remuneration, bonus,
advances to suppliers, interest on loan, income tax, fixed asset purchase etc.

5. Manufacturing Overhead Budget

This budget is prepared for planning of the factory overheads to be incurred during
the budget period. In this budget the overheads should be shown department-wise
so that responsibility can be fixed on proper persons. Classification of factory
overheads into fixed and variable components should also be shown in this budget.

6. Direct Labour Budget

The labour required for production process is determined in terms and grades of
workers required and the labour time for each job, operation and process. The rates
of pay, allowances, bonus, etc., of each category are then considered and labour
cost to be set for each budget centre is calculated.

7. Administration Cost Budget

This budget covers the administrative (office) costs for non-manufacturing business
activities. Administrative overheads include office expenses, accounting charges,
office salaries, directors’ remuneration, legal expenses, audit fees, rent, postage,
telephone, telegraph etc. These expenses should be classified under different
headings to determine the responsibilities regarding cost control and reduction.

Compiled by Prof. Prasad Bhat Page 127

 8. Research and Development Budget
R&D budget helps management in planning the research and development activities
in advance and also the justification of the expenditure. R&D is one of important
activities of any firm and hence proper planning and coordination is required for
effectiveness of the same.

9. Selling Expenses Budget

Selling expenses include all items of expenditure on the promotion, maintenance
and distribution of finished products. This budget which is clearly related to the
sales budget is the forecast of the cost of selling and distribution, for the budgeted
period. Selling and distribution expenses may be fixed or variable with regard to the
sales volume, separate budgets are usually established for fixed or variable selling
and distribution expenses.

10. Capital Expenditure Budget

Capital expenditure (capex) budget is related to purchase of fixed assets. Capital
expenditure is a long-term forecast covering over a year to five years. It is essential
that capital expenditure budget properly coordinated with other functions budgets,
so as to form an integral part of the overall plan. The purpose of capital expenditure
is to increase the earning capacity of the firm in the long run. Capex results in either
acquisition of fixed asset or permanent improvement in the existing fixed assets.
Another important feature of capex is that amount involved is very heavy and such
decisions are irreversible. Thus, careful planning is required for capital expenditure.

11. Master Budget

Master budget is a consolidated summary of the various functional budgets. A
master budget is the comprehensive or summary budget incorporating all functional
budgets and which is finally approved, adopted and employed. A Master Budget
shows the budgeted profit and loss account, the balance sheet of the organization.
The master budget is prepared by the budget committee on the basis of coordinated
functional budgets and becomes the target of the company during the budget period
when it is finally approved. The figures contained in master budget are the reflection
of the actual intentions of the company relating to the different areas for the
forthcoming budget period.

Compiled by Prof. Prasad Bhat Page 128

 Classification on the basis of Nature / Capacity Utilization

1) Fixed Budget
A fixed budget is a budget designed to remain unchanged irrespective of the level of
activity actually attained. When budget is prepared by assuming a fixed percentage
of capacity utilization, it is called as a fixed budget. A fixed budget is not adjusted to
the level of activity achieved at the time of comparison between the budgeted and
actual costs. Obviously, fixed budgets can be established only for a small period of
time when the actual output is not anticipated to differ much from the budgeted
output. However, if there is a significant change in the business conditions a fixed
budget is to be revised. Such budgets are not suitable for cost control and hence
fixed budgets are rarely used.

2) Flexible Budgets
A flexible budget is prepared for different levels of capacity utilizations. CIMA,
London defines flexible budget as a budget which ‘by recognizing different cost
behaviour patterns, is designed to change as volume of output changes.’ A flexible
budget recognizes the difference between fixed cost, semi-fixed cost and variable
cost and such budget changes in relation to the activity achieved. It is designed to
furnish budgeted cost at any level of capacity utilized. Thus, a flexible budget
provides a reliable basis for comparisons as it is adaptable to changes in production
activity. Hence, such budget covers a range of activity i.e., easy to change with
variation in production levels and it facilitates performance measurement and better
evaluation. Flexible budget is useful for decision making in terms of selling price
determination and profit planning at different levels of capacity utilization. It
facilitates deciding the discount to be given by maintaining the same profitability.

Features of flexible budgets:

i. They are prepared for a range of activity instead of a single level.
ii. They provide a very dynamic basis for comparison because they automatically
vary to changes in volume.
iii. They provide a tailor-made budget for a particular volume.
iv. These are based upon adequate knowledge of cost behaviour pattern, i.e. fixed,
semi-fixed and variable.

Compiled by Prof. Prasad Bhat Page 129

 Fixed Budget vs. Flexible Budget

Sr. Fixed Budget Flexible Budget

1. It does not change with actual It can be changed on the basis of
volume of activity achieved. activity level to be achieved.
Thus, it is rigid budget. Thus, it is not rigid
2. It operates at one level of activity It consists of various budgets for
and under single set of different levels of activity.
conditions.
3. Here, all costs are related to only Here, analysis of variance
one level of activity, so variance provides useful information as
analysis does not give useful each cost is analysed according
information to its behaviour.
4. It assumes that there will be no It assumes that budget should be
change in prevailing conditions, changed as per changing
which is unrealistic. conditions, hence useful.
5. Not useful for decision making, Useful for decision making, cost
cost control not determination of control as well as selling price
selling price. determination.

 On the basis of Time

1) Long Term
Any budget exceeding three years is known as Long Term Budget. Master Budget is
normally prepared for long term. In the modern days due to uncertainty, very few
budgets are prepared for long term.

2) Short Term Budget

Any budget that is prepared for a period up to one year is known as Short Term
Budget. Functional budgets are normally prepared for a period of one year and then
it is broken down month-wise.

3) Medium Term Budget

Budget prepared for a period 1-3 years is Medium Term Budget. Budgets like Capital
Expenditure, Manpower Planning are prepared for medium term.

Compiled by Prof. Prasad Bhat Page 130

 Zero Base Budgeting (ZBB)
 Zero Base Budgeting is method of budgeting where all activities are determined
each and every time a budget is formulated.
 In ZBB technique, every item of expenditure in budget is justified.
 Thus, ZBB involves budgeting from scratch or zero.
 ZBB is also termed as ‘De-nova budgeting’ or budgeting from the beginning without
any reference to any past budgets.
 ZBB may be defined as ‘a planning and budgeting process which requires each
manager to justify his entire budget in detail from scratch (hence zero base).
 This approach requires that all activities be analyzed and evaluated by systematic
analysis and ranked in order of importance.
 ZBB tries to identify alternative and efficient methods of utilizing scarce resources.
 Thus, ZBB facilitates effective achievement of pre-decided objectives.
 Under Zero-Base Budgeting, there is a detailed analysis and evaluation of each
program in order to justify its inclusion or exclusion from final budget.
 ZBB is based on assumption that every rupee of expenditure requires justification.
The traditional budgeting approach includes previous years’ expenditure which is
automatically included in new budget proposals.
 ZBB concept was developed in U.S.A. by Peter Pyhrr in 1970 and first applied in USA
by President Mr. Jimmy Carter.

Importance / Advantages of Zero-Base Budgeting:

o Emphasis on justification of budget expenditure

o Alternative ways are considered.
o Participation of all levels in decision-making.
o Promotes operational efficiency because it requires managers to review and justify
their activities or the fund requested.
o Responsibility at all levels of management can be ensured.
o ZBB is relatively elastic because budgets are prepared every year on a zero base.
o In this technique, inefficiencies are removed and cost of production is reduced as
every budget proposal is evaluated on the basis of cost-benefit analysis.
o Helpful to management in making optimum allocation of scarce resources because a
unique aspect of ZBB is the evaluation of both current and proposed expenditure
and placing it some order of priority.

Compiled by Prof. Prasad Bhat Page 131

 Budgetary Control Practical Questions

Q1. The installed capacity of the Omega Ltd. is 1000 units. Prepare a Flexible Budget for
300 units, 500 units and 800 units. Compute total cost and cost per unit. Given below
are the details of cost structure of Omega Ltd.

Particulars (₹)
Raw material / unit 15.00
Direct Labour / unit 10.00
Direct Expenses / unit 8.00
Variable Overheads 5.00
Fixed Overheads / unit 4.00
Total 42.00

Q2. AAA Ltd. provides the following estimates at 60% capacity. Semi-Fixed expenses are
unchanged between 55%-75% capacity, they increase by 10% between 75%-85%
capacity and increase by 20% above 85% capacity. Prepare a flexible budget at 70%,
80% and 90% capacity. Find the profits if Sales are ₹ 126,000, ₹ 134,000 and ₹ 142,000
respectively.
Particulars (₹)
Fixed
Expenses:
Workshop salary 9,300
Office Rent 14,700
Variable Expenses:
Basic material 24,000
Direct Wages 9,000
Production expenses 3,000
Semi-Variable
Expenses:
Repairs & Maintenance 10,000
Telephone charges 15,000
Total 85,000

Compiled by Prof. Prasad Bhat Page 132

Q3. Alpha Ltd. has provided the following information about its cost. The maximum
capacity of the company is 5000 units. Prepare a Flexible Budget at 40%, 75% and 90 %
capacity utilization. Determine the SP / unit if desired profit is 20 % on cost per unit.

Particulars (₹)
Direct material / unit 50.00
Direct Wages / unit 20.00
Direct Expenses / unit 12.00
Selling Overheads / unit (25 % variable) 8.00
Distribution Overheads / unit (75 % variable) 6.00
Fixed Overheads / unit 4.00
Total 100.00

Q4. Activa Ltd. produces automotive parts. Fixed Office Overheads estimated ₹ 100,000.
Semi-variable overheads ₹ 50,000 at 100% capacity (20 % fixed). The installed capacity
is 10,000 units. SP/unit ₹ 60 Prepare Flexible Budget at 50%, 70% and 80% capacity.
Find total profit. Estimated cost per unit is given:
Particulars (₹)
Direct material 18.00
Direct Wages 15.00
Variable Overheads 12.00
Total 45.00

Q5. Wiprotech Ltd. provides following estimates at 100% capacity. Prepare flexible budget
for production at 60 % and 80 % capacity. Determine Sales if profit is 20% on Cost.

Particulars (₹)
Direct material 6,00,000
Variable Factory Overheads 2,00,000
Basic Wages 2,00,000
Fixed Production Overheads 80,000
Marginal productive expenses 40,000
Rigid Administrative Overheads 40,000
Selling Overheads (10 % Fixed) 1,20,000
Distribution Overheads (80 % variable) 60,000

Compiled by Prof. Prasad Bhat Page 133

Q6. BBM Ltd. provides the following estimates at 5000 units. Prepare a flexible budget for
production at 4000 units & 6000 units. Determine the selling price per unit if desired
profit is 25 % on selling price.

Particulars (₹) Nature

Material Cost 2,50,000 100 % variable
Labour Cost 1,50,000 100 % variable
Power 12,500 80 % variable
Repairs &
Maintenance 20,000 75 % variable
Stores 10,000 100 % variable
Inspection 5,000 20 % variable
Depreciation 1,00,000 100 % fixed
Office
overheads 50,000 25 % variable
Selling overheads 30,000 50 % variable

Q7. Prepare a flexible budget for the next year for 140,000 units production. Raw material
cost ₹ 7 per unit, direct wages are 4 per unit. Commission is paid at Re. 1 per unit sold.
Fixed S&D expenses are ₹ 85,000 p.a. Manufacturing overheads are given below –

Particulars 1,20,000 units 1,50,000 units

(₹) (₹)
Indirect
material 2,64,000 3,30,000
Indirect labour 1,50,000 1,87,500
Inspection 90,000 1,12,500
Maintenance 84,000 1,02,000
Supervision 1,98,000 2,34,000
Depreciation 90,000 90,000
Engineering
services 94,000 94,000

Compiled by Prof. Prasad Bhat Page 134

Q8. Prepare a Cash Budget for the period April 2022 - June 2022. Following data available –
Particulars Sales Purchases Wages
Feb-08 1,80,000 1,20,000 12,000
Mar-08 1,90,000 1,40,000 14,000
Apr-08 1,50,000 1,30,000 11,000
May-08 1,70,000 1,40,000 10,000
Jun-08 1,20,000 1,10,000 15,000

Additional Information –
 50% of credit sales are realized in next month of the Sales and balance is received
in the subsequent month.
 Creditors are paid in the next month of purchases
 10% of total sales are cash
 Opening balance of cash ₹ 20,000.
 Wages are paid in the same month.

Q9. Income and Expenditure given for March to August 2022. Additional data given below:
Month Cr. Sales Cr. Purchases Wages Mfg. Office S&D
March 60,000 36,000 9,000 4,000 2,000 4,000
April 62,000 38,000 8,000 3,000 1,500 5,000
May 64,000 33,000 10,000 4,500 2,500 4,500
June 58,000 35,000 8,500 3,500 2,000 3,500
July 56,000 39,000 9,000 4,000 1,000 4,500
August 60,000 34,000 8,000 3,000 1,500 4,500

a) New machine costing ₹ 16,000 installed in June

b) Advance tax ₹ 8,000 is payable in March and June each
c) Period of credit allowed, Suppliers 2 months and Customers 1 month
d) Lag in payment of manufacturing expenses half month
e) Lag in payment of all other expenses one month
f) Cash balance on 1st May 2022 is ₹ 8,000
g) Prepare Cash Budget for three months starting from 1 st May 2022

Compiled by Prof. Prasad Bhat Page 135

Q10. Prepare a Cash Budget for GODU Ltd.

Month I Quarter II Quarter III Quarter IV Quarter

Opening Balance 10,000 - - -
Sales Collection 1,25,000 1,50,000 1,60,000 2,20,000
Cash Purchase 20,000 35,000 35,000 55,000
Expenses paid 25,000 20,000 20,000 17,000
Wages Paid 90,000 95,000 95,000 1,10,000
Tax paid 5,000 - - -
Machine Buy - - - 20,000

The company desires to have a minimum cash balance of ₹ 15,000 at the end of each
quarter. Cash can be borrowed and repaid in multiples of ₹ 1,000 only @ 10% p.a. The
management does not want to borrow, unless required and wants to repay as early as
possible. Interest is computed when principal amount is repaid. Borrowings are made
at the beginning of the quarter and repayments are made at end of the quarter.

Compiled by Prof. Prasad Bhat Page 136

10. MARGINAL COSTING
1. MARGINAL COSTING

 Marginal Costing is a technique of cost accounting, which is based on the differentiation

between fixed cost and variable cost. It is a vital management tool for decision making.
 Marginal Costing is a technique which ascertains the marginal cost by bifurcating total
costs into fixed costs and variable costs.
 While total fixed costs remain constant at all levels of production, variable costs changes
with production levels. Total variable cost increases with an increase in production and
vice-versa.
 As per principles of marginal costing, only the variable costs are considered for
production and sales volumes. All fixed costs are written-off over the accounting period.
 According to ICWA London, marginal costing is the ascertainment, by differentiating
between fixed costs and variable costs, of marginal costs and of the effect on profit on
changes in the value and type of output.
 Marginal Costing can be defined as a technique of measuring the impact of the change
in the volume of output on the profits.
 The basic assumption is that fixed cost will remain unchanged irrespective of the change
in output. The purpose of this technique is to provide meaningful information to the
management for maximizing profitability.
 Marginal costing is a technique that considers only variable costs as cost of production,
leaving out the fixed costs as period costs to be absorbed from the contribution.

2. MARGINAL COST

 Marginal Cost is the change in the total cost, due to a change of one unit of output.
 Marginal cost is the cost which arises due to the production of additional units of output.
 For example, suppose total number of units produced is 100 and the total cost of
production is ₹ 2,000. If one unit is additionally produced, total cost of production may
become ₹ 2,010 and if the production quantity is decreased by one unit, the total cost
may come down to ₹ 1,990. Thus, the change in the total cost is by ₹ 10 and hence the
marginal cost is ₹ 10 per unit.
 ‘Marginal Cost’ as the amount at any given volume of output by which aggregate costs
are changed if the volume of output is increased or decreased by one unit.

Compiled by Prof. Prasad Bhat Page 137

 CIMA, London defines ‘Marginal Cost’ as the cost of one unit of product or service
which would be avoided if that unit were not produced or provided.
 ICA, England defines ‘Marginal Cost’ as variable expenses (whether of production,
selling or distribution) incurred by taking a particular decision.

3. FEATURES OF MARGINAL COSTING

1) Under marginal costing, all types of operating costs (factory, office and selling) are
separated into fixed and variable components and are recorded separately.
2) Variable costs are treated as product costs, i.e., they are charged to the product.
Variable costs become a part of closing stock valuation.
3) Fixed costs are treated as period costs, i.e., they are written-off as expenses in the
period in which they are incurred. They do not enter in the stock valuations.
4) Generally, selling prices are based on marginal costs, i.e., selling prices would not be
based on total costs.
5) Profitability of departments or products is determined in terms of contribution.
6) The unit cost of a product is equal to its average variable cost of producing the product.

KEY CONCEPTS:
The concept of marginal cost is based on the important distinction between product cost
and period cost. Marginal costing considers product cost as it varies directly with the
volume of output. Thus, marginal costing analyses the costs into fixed and variable. Even
the semi-variable costs are closely and critically analysed and divided into fixed and
variable components depending upon whether they tend to remain fixed or vary. Some of
these concepts are given below –

Fixed Costs: The costs which remain fixed irrespective of the level of output are known as
Fixed Costs. Such costs depend on the basis of time and also known as Period costs. For
e.g., insurance, rent, salaries etc. Nature of fixed costs –
i. Total fixed cost remains constant irrespective of volume of output,
ii. Total fixed costs depend on the installed (maximum) capacity,
iii. Fixed cost per unit decreases when the production volume increases

Compiled by Prof. Prasad Bhat Page 138

Variable Costs: The costs which change as per the volume of output are known as Variable
Costs. Such cost is also known as Product Cost. E.g., direct wages, raw materials, variable
overheads etc. Nature of variable cost –
i. Per unit variable cost remains the same at any given volume of output.
ii. Total variable cost increases with increase in the volume of output and vice versa.
iii. In the short run and within the installed (maximum) capacity, marginal cost per unit
will be equal to the variable cost per unit. Thus, within the installed capacity,
marginal cost = variable cost = (prime cost + variable overheads)

Semi-Variable Cost: The costs which partly remain fixed and partly variable are known as
semi-variable costs or semi-fixed costs. E.g., telephone bill, electricity expenses etc. If the
cost varies after particular slabs, then such semi-variable costs are known as step-ladder
costs. For the purpose of marginal costing, it is necessary to divide such costs into variable
component and fixed component.

Contribution: Contribution is the difference between sales value and variable (marginal)
cost. It is obtained by subtracting variable cost from sales revenue at a given level of
activity. Contribution serves as a measure of efficiency of operations of various segments
of the business. Contribution is a vital concept in the system of marginal costing.
Contribution is also referred as Gross Margin. Contribution is considered as a fund or pool
out of which all fixed costs, are recovered and to which each product has to contribute its
share. The difference between contribution and fixed cost is either profit and loss.

Contribution = Sales (-) Variable Costs

Contribution per unit = Selling Price per unit (-) Variable Cost per unit

Contribution = Fixed Costs (+) Profit

Benefits of Contribution:
 Provides relation between sales and variable costs
 Helps in fixing selling price per unit
 Facilitates determining suitable product mix
 Helps in critical managerial decision-making

Compiled by Prof. Prasad Bhat Page 139

4. ADVANTAGES OF MARGINAL COSTING

1. Fixing Selling Price: Marginal costing provides a better and logical basis for fixation of
selling prices. The profit margin is added to the product cost (i.e., variable cost per unit)
2. Quick Decision Making: The technique of marginal costing enables the management to
take better and faster decisions for profit maximization.
3. Cost Control: Division of fixed cost and variable cost enables a better cost control.
4. Practical Approach: Fixed costs are not included in production cost and hence valuation
of inventories is done at marginal cost. So, inventory valuation is more realistic.
5. Profit Planning: Marginal costing facilitates preparation of Break-Even Point analysis
and thus helps to plan the profitability of the company.
6. Classified Decisions: Territorial income figures facilitate relative appraisal of products,
territories, classes of customers, and other segments of the business.
7. Tendering: Pricing based on variable cost helps in preparing tenders for new contracts.

5. LIMITATIONS OF MARGINAL COSTING

1. Difficulty is in dividing total costs into fixed and variable components.

2. As marginal costing distinguishes between treatment of fixed and variable components,
it is difficult to adopt this technique in capital intensive industries, where fixed costs are
very large.
3. In marginal costing, it is assumed that fixed costs remain constant in short-term, but
this assumption may not be always true.
4. Selling prices cannot be reasonably fixed on the basis of contribution alone because
then there is a danger of too much sales being fixed at marginal cost resulting in
inadequate contributions.
5. Marginal costing does not provide any standard for performance evaluation. Marginal
contribution data do not reveal many effects which are furnished by variance analysis.
6. Selling price under the marginal costing technique is fixed on the basis of contribution.
This may not be possible in the case of ‘cost plus contracts.’

Compiled by Prof. Prasad Bhat Page 140

6. IMPORTANCE OF MARGINAL COSTING

 Relative profitability – In case of multi-product and multi-line business activities,

marginal costing facilitates the study of relative profitability of different products. It will
show where the sales efforts should be concentrated.

 Basis for pricing / tendering quotation – Marginal costing furnishes a better and more
logical basis for fixation of selling prices and tendering for contracts. In case of export
orders, the selling prices have to be fixed below normal domestic prices. Marginal
costing helps to ascertain the lowest selling price per unit which can be quoted without
incurring any loss.

 Profit Planning – Marginal costing facilitates future planning of operations to attain a

certain level of profits or to maintain the current levels. The contribution ratio indicates
the relative profitability of a product with respect to changes in selling price, variable
cost or product mix.

 Planning Level of Activity – Increase or decrease in production levels has to be

arranged before actual manufacture takes place. In this context, management would
like to have an idea of the contribution and profitability at different levels of capacity
utilization and marginal costing proves very useful in this regard. It is also termed as
Flexible Budgeting.

 Evaluation of Performance – Every department / division / product line have separate

earnings capacities. Comparison and better evaluation of such divisions is possible
based on cost-volume-profit analysis and contribution approach. It will facilitate better
decision making in cases of whether to discontinue the product / division or continue
production.

 Responsibility accounting becomes more effective – Responsibility accounting is more

effective and transparent when based on marginal costing since fixed overheads are
not charged randomly to their departments and hence managers’ responsibilities are
evaluated based on contribution.

 Consistency – in the short-run, the marginal cost per unit of output remains same
irrespective of the level of output, thus facilitating better decision making.

Compiled by Prof. Prasad Bhat Page 141

 Make or Buy decisions – Marginal costing facilitates decision making in problems such
as whether to manufacture components in-house or to purchase from the market. Such
decision making is simplified due to bifurcation of total costs into fixed and variable
components. If variable cost per unit is lower than outside purchase cost, make the
product else purchase. Absorption costing technique would give misleading results in
such cases and hence marginal costing is applied.

 Realistic Valuation of Stock – In marginal costing, finished goods stocks and work-in-
progress inventory is valued at their variable cost only. Therefore, it is more realistic
and uniform. No fictitious profit arises.

 Maintain Desired Level of Profit – External and internal constraints may reduce the level
of profits. Marginal costing provides information about steps to be taken to either
maintain the same level of profits or to achieve a desired level of profits. Steps taken
maybe reduce variable cost, increase selling price etc.

 Facilitates cost control – By separating the fixed and variable costs, marginal costing
provides better means of controlling the costs.

 Key Factor Problems – Key factors are those constraints (restrictions) which limit the
operations of a business. For example, shortage of raw material, shortage of labour
hours, inadequate machine capacity, less demand for a product etc. Key factor is also
known as ‘limiting factor, scarce factor, principal budget factor or governing factor ’. In
such cases, decisions are taken on the basis of highest contribution per unit of key
factor. Thereafter, the product mix is decided according to the best contribution per unit
of key factor.

 Deciding the Product Mix – In a multi-product organization, marginal costing facilitates

deciding the best product mix or sales mix to maximize the profits of the company, as a
whole. The product mix is decided on the basis of contribution earned by each product.
Use of Key factory is vital in deciding the optimal product mix.

Compiled by Prof. Prasad Bhat Page 142

7. COST-VOLUME-PROFIT (CVP) ANALYSIS

 Cost-Volume-Profit (CVP) analysis is a management tool which shows the relationship

between costs, volume of output and the resultant profits achieved.
 The aim of an organization is to earn maximum profits. However, profit depends upon a
large number of factors such as cost of production and the volume of sales attained.
 Sales volume depends on the market demand and pricing policy, whereas cost depend
on production volumes, product-mix, internal efficiency, methods of production, size of
plant etc.

Assumptions of CVP analysis:

i. Any change in level of output results in a change in sales revenues and product costs.
ii. Total costs can be divided into fixed costs and variable costs.
iii. In the short-run and within installed capacity fixed costs remain constant.
iv. Selling price per unit and variable cost per units remain constant.
v. Time value of money is not considered for analysis purposes.

Advantages of CVP analysis:

 CVP indicates the relationship between profits and costs and the volume of production.
 It helps in better profit forecasting.
 It facilitates preparing flexible budgets to indicate costs at various levels of activity.
 CVP relationship assists in formulating pricing policies to suit particular circumstances
by projecting the effect which different price structures have on costs and profits.
 CVP analysis helps in forecasting costs and profits as a result of change in volume.
 Helps to fix sales volume to earn certain level of profits, return on capital employed, or
rate of dividend etc.
 It assists determination of effect of change in volume due to plant expansion or
acceptance of an order, with or without increase in costs or in other words a quantum or
profit to be obtained can be determined with change in volume of sales.
 CVP analysis helps in determining relative profitability of each product.
 Through CVP analysis inter-firm comparison of profitability can be done intelligently.

Compiled by Prof. Prasad Bhat Page 143

Profit Volume Ratio (P/V)

 Profit-Volume (P/V) Ratio is the ratio of Contribution to Sales and is usually expresses
as a percentage. This ratio is also called as ‘margin ratio’.
 P/V ratio shows the profitability (profit earning capacity) of a product.
 Thus, higher the P/V ratio, higher the profitability of a product or service.
 P/V ratio depends on the selling price per unit and marginal (variable) cost per unit.
 P/V ratio can be improved by the either increasing the selling price per unit or reducing
the variable cost per unit (through efficient utilization of factors of production).
 As long as the selling price and variable cost per units are constant, the P/V ratio
remains constant, irrespective of the level of activity.
 P/V ratio is useful for analyzing profitability of a product or service or overall business.
 P/V ratio can be improved by increase SP per unit or reducing VC per unit or both.
 P/V ratio facilitates determining sales volume for achieving desired level of profit.

Break-Even Point (BEP) Analysis

 Break-even point can be defined as that level of production and sales, where there is
neither profit nor loss.
 In other words, at the BEP level, the total sales revenue is equal to and total cost.
 Thus, we can say that contribution equals fixed cost at BEP level.
 Break-Even Point may be expressed in number of units or sales amount or even as a
percentage capacity.
 Break-even Analysis is an analysis that can be used to determine the probable profit at
any level of operation.

Basic assumptions for Break-Even Point Analysis:

i. Costs can be split into fixed and variable components.

ii. Fixed cost remains constant irrespective of level of activity.
iii. Total variable cost changes with change in volume of output.
iv. Selling price per unit does not change with a change in volume.
v. The plant capacity can be predicted.

Compiled by Prof. Prasad Bhat Page 144

A change in any of the above factors will alter the break-even point. Thus, break-even
analysis must be interpreted in the light of limitations of underlying assumptions. The
break-even analysis refers to a system of determination of that level of activity where total
cost equals total sales. The relationship among cost of production, volume of production,
the profit and the sale value are established by break-even analysis. Hence, this analysis is
also known as CVP Analysis.

Margin of Safety

 Margin of Safety is the difference between Actual Sales and Sales at Break-Even Point.
 At any level of margin of safety, the additional fixed costs are zero since fixed costs are
already recovered upto Break Even Point.
 Margin of Safety can also be computed by taking the different between projected future
sales and BEP (Sales).

Importance of Margin of Safety:

Upto the Break-Even point the contribution earned is sufficient to recover only the fixed
costs. However, beyond the Break-Even point, the contribution not only recovers the fixed
costs, but also contributes to the profits of the enterprise. A high margin of safety shows
the strength and sustaining capacity of a product under difficult times. It is a sign of
prosperity. If the margin of safety of an enterprise is high, a reduction in selling price per
unit or rise in variable cost per unit may not convert the profits into losses. Thus, a higher
margin of safety indicated buffer to absorb the uncertain scenarios of the environment. If
the margin of safety is small, it may indicate that the firm has large fixed expenses and is
more vulnerable to changes in sales.

Improvement in Margin of Safety: The margin of safety may be improved through the
following actions –
a) Increase selling prices, provided demand is inelastic so as to sell at increased prices.
b) Reduction in fixed expenses.
c) Reduction in variable expenses.
d) Increasing the sales volume provided capacity is available.
e) Substitution or introduction of a product mix such that more profitable lines are
introduced

Compiled by Prof. Prasad Bhat Page 145

EQUATIONS OF MARGINAL COSTING:

Sr. Concept Equation / Formulae

1. Profit Profit = Sales (-) Total Cost
Profit = Sales (-) Variable Cost (-) Fixed Cost
Profit = Contribution (-) Fixed Cost
Profit = (Sales x P/V ratio) – Fixed Cost
Profit = Margin of Safety (x) P/V ratio

2. Contribution Contribution = Sales (-) Variable Cost

Contribution = Fixed Cost (+) Profit
Contribution = Sales x P/V Ratio
Contribution per unit = Fixed Cost
BEP (units)

3. Sales Sales = Total Cost (+) Profit

Sales = Contribution
P/V Ratio
Sales = Contribution (+) Variable Cost

4. Profit Volume P/V Ratio = Contribution (x) 100

Ratio (P/V) Sales
P/V Ratio = Contribution per unit (x) 100
Selling price per unit
P/V Ratio = Fixed Cost (+) Profit (x) 100
Sales
P/V Ratio = Difference in Contribution (x) 100
Difference in Sales
P/V Ratio = Difference in Profit (x) 100
Difference in Sales
P/V Ratio = Fixed Costs (x) 100
BEP (Sales)
P/V Ratio = Profit (x) 100
Margin of Safety

Compiled by Prof. Prasad Bhat Page 146

 5. Break-Even Point BEP (units) = Fixed Cost
Contribution Per unit
BEP (units) = BEP (Sales)
Selling price per unit
BEP (Sales) = Fixed Cost
P/V Ratio
BEP (Sales) = BEP (units) x Selling price per unit

6. Margin of Safety Margin of Safety = Actual Sales (-) BEP (Sales)

Margin of Safety = Profit
P/V Ratio
Margin Safety (%) = Actual Sales (-) BEP Sales x100
Actual Sales
Margin of Safety (%) = Margin of Safety x 100
Actual Sales

7. Fixed Cost Fixed Cost = Total Cost (-) Variable Cost

Fixed Cost = Contribution (-) Profit
Fixed Cost = BEP (Sales) x P/V Ratio
Fixed Cost = BEP (units) x Contribution per unit

8. Profit for a Profit = [Sales (x) P/V Ratio] (-) Fixed Cost
desired level of
Sales

9. Sales units Sales (units) = Fixed Cost + Desired Profit

required for Contribution Per unit
desired profit

10. Sales units Sales (Rs) = Fixed Cost + Desired Profit

required for P/V Ratio
desired profit

Compiled by Prof. Prasad Bhat Page 147

 Marginal Costing Practical Questions

Q1. Total Fixed Cost ₹ 40,000, Selling price per unit ₹ 10, Variable Cost per unit ₹ 2,
Total Sales ₹ 200,000. Variable Cost as percent of Sales 20%.
Find out the following –
a) P/V Ratio
b) BEP (Sales)
c) Profit when Sales are ₹ 120,000
d) Sales required for earning a profit of ₹ 60,000

Q2. Total Invoice Value ₹ 1,00,000, Total Variable Cost ₹ 60,000, Total Fixed Cost ₹ 30,000.
Find out the following –
a) P/V Ratio
b) BEP (Sales)
c) Profit when Sales are ₹ 140,000
d) Sales required for earning a profit of ₹ 15,000
e) Margin of Safety.

Q3. Sales at 100 % capacity ₹ 12,00,000, Total Fixed Cost ₹ 1,00,000, Direct Expenses 2 % of
Sales, Variable Mfg. Overheads 10 % of Sales, Selling Cost 8 % of Sales, Direct Material
35 % of Sales, Direct Labour 20 % of Sales.
Find out the following –
a) P/V Ratio
b) Sales at Break-Even Point
c) Profit at 100% capacity
d) Profit when Sales are at 80% capacity
e) Profit when Prime Cost increases by 5 %

Q4. A factory produces 300 units of a product per month. The selling price per unit is ₹ 120.
Variable cost ₹ 80 per unit. Fixed Cost per month are ₹ 8000. Compute the following -
a) Estimated profit in a month when 240 units are produced
b) BEP (sales quantity)
c) Sales amount required to earn a profit of ₹ 7,000 per month.

Compiled by Prof. Prasad Bhat Page 148

Q5. A company manufactures two products - Gold & Silver. Total prime cost ₹ 38,400.
Selling price per unit - Gold ₹ 100 & Silver ₹ 50. Prime Cost per unit - Gold ₹ 30 and
Silver ₹ 12. During the year, 800 kgs of Gold and 1200 kgs of Silver were produced and
sold. Total Sales ₹ 140,000. Advertisement cost ₹ 70,000, Direct Expenses ₹ 20,000.
According to company sources, Advertisement expense is a fixed cost. Advertisement
cost to be divided on the basis of sales value achieved. Direct expenses are based on
quantity produced. Find the following –
a) P/V ratio of each product
b) Profit of each product.

Q6. A company has annual fixed cost of ₹ 14,00,000. In the year 2007, total sales amounted
to ₹ 60,00,000 as compared to ₹ 45,00,000 in 2006. The profit in 2007 was ₹ 420,000
more than profit of year 2006. Based on data given answer the following:
a) At what level of sales, the company would break even?
b) Determine the profit / loss on a forecasted sales of ₹ 80,00,000
c) If the selling price is reduced by 10% in the year 2008 and company expects the
same profit as 2007, what should be the required sales value?

Q7. The turnover and profit during two weeks is given below -
Week 1 - Sales ₹ 20 lakh and Profit ₹ 2 lakh and
Week 2 - Sales ₹ 30 lakh and Profit ₹ 4 lakh
Calculate –
(a) P/V ratio,
(b) Sales required to earn a profit of ₹ 5 lakh,
(c) Profit when sales are ₹ 10 lakh.

Q8. Compute the BEP (Sales) and BEP (units), on the basis of given information –
Direct Material per unit ₹ 8.00, Direct Labour per unit ₹ 5.00, Fixed Overheads ₹ 24,000,
Selling Price per unit ₹25 Trade Discount – 4%, Variable overheads are 60 % of labour
cost. If sales are 15% and 20% above the BEP level, determine net profits at these levels.

Compiled by Prof. Prasad Bhat Page 149

Q9. Following data is obtained from the records of an industrial unit –
Sales of 4000 units @ ₹ 25 each (₹) 100,000
Material Consumed (₹) 40,000
Variable Overheads (₹) 10,000
Labour Charges (₹) 20,000
Fixed Overheads (₹) 18,000
Total Cost (₹) 88,000
Net Profit (₹) 12,000
Compute the following –
a) Number of units to be sold, so that the company neither makes a profit or a loss?
b) Sales units and sales amount required to earn a profit of 20% on sales.
c) If the selling price is reduced by 20 %, then how many extra units should be sold to
maintain the same profit?
d) What should be selling price to bring down its BEP to 500 units?

Q10. Following information is provided for a company –

Total Sales (₹) 400,000
Direct Material (₹) 20,000
Direct Wages (₹) 60,000
Variable Overheads (₹) 20,000
Total Fixed Cost (₹) 100,000
Find P/V ratio and BEP (Sales) in each of the following cases -
a) Current scenario
b) 10 % increase in prime cost
c) 5 % increase in sales and 10 % increase total variable cost
d) 2 % fall in sales and 5 % rise in material cost.

Q11. A company sells its product at selling price of ₹ 15 per unit. In 1999, it sells 8000 units
and makes a loss of ₹ 5 per unit. In 2000, it sells 20,000 units and makes a profit of ₹ 4
per unit.
a) Compute BEP (units) and BEP (Sales)
b) What quantity the company should sell to make a profit of ₹ 200,000?
c) If the company produces and sells 30,000 units, what will be its profits?

Compiled by Prof. Prasad Bhat Page 150

Q12. Swojas Ltd. uses raw material ABC in its production process. The company produces
10,000 units of ABC at a cost of ₹ 40 per unit (incl. fixed cost). The total fixed costs are ₹
150,000. Raw material ABC is available in the market at a price of ₹ 30 per unit. Advice
the company whether to continue manufacturing ABC or to buy from market?

Q13. A company makes an average net profit of ₹ 2.50 per unit on a selling price of ₹ 14.30
by producing and selling 60,000 pieces @ 60% of installed capacity. Cost data is –
Direct Material per unit (₹) 3.50
Direct Wages per unit (₹) 1.25
Factory Overheads per unit (₹) 6.25 (50 % fixed)
Selling & Distribution Overheads 0.80 (25 % variable)
Fixed costs at present level remain constant at all levels. During the next year, the
company expects the total fixed cost to increase by 10 % while the rates of direct
material and direct labour will increase by 6 % and 8 % respectively. But there is no
option of increasing the selling price. Under this situation it obtains an offer for an
order equal to 20% of its total capacity. The concerned customer is special customer.
What minimum selling price can be quoted to make an overall profit of ₹ 167,300?

Q14. The plant capacity of a manufacturing company is 400,000 units p.a., current utilization
is 40%. Selling Price p.u. ₹50.00, Material Cost per unit ₹ 20.00, Variable Mfg. cost ₹
15.00, Total Fixed Cost ₹ 27 lakhs. In order to improve capacity utilization, the following
proposals are being considered:
a) Reduce selling price by 10% and
b) Spend additionally ₹ 3 lakhs on sales promotion
How many units should be produced and sold in order to earn a profit of ₹ 5 lakh.

Q15. A company sells a single product. Material cost per unit ₹ 8.00, labour cost ₹ 6.00,
dealer's margin (10 % of SP) ₹ 2.00, SP per unit ₹ 20. Total fixed cost ₹ 250,000, current
sales quantity 80,000 units, Current capacity utilization 60%. There is acute competition
and extra efforts are necessary to sell the product. Following suggestions available:
(i) By reducing sales price by 5%, or
(ii) By increasing dealers’ margin by 25% over the existing rate.
Which of two plans you would recommend if the company desires to maintain the
present profit? Give reasons.

Compiled by Prof. Prasad Bhat Page 151

Q16. A company has earned a contribution of ₹ 200,000 on Sales of ₹ 800,000. The Net
Profit is ₹ 150,000.
a) Find Margin of Safety
b) Fixed Cost
c) BEP Sales

Q17. A company manufactures and sells 3 products A, B and C. Product A is making a loss
and hence the company is thinking to discontinue the production of product A. Advise
the company about their point of view. Fixed Costs are distributed in ratio of sales.

Particulars A B C Total
Sales Value (₹) 1,00,000 2,00,000 3,00,000 6,00,000
Material Cost (₹) 45,000 90,000 1,25,000 2,60,000
Direct Labour Cost (₹) 30,000 45,000 65,000 1,40,000
Variable Overheads (₹) 15,000 20,000 40,000 75,000
Fixed Cost (₹) 15,000 30,000 45,000 90,000
Total Cost (₹) 1,05,000 1,85,000 2,75,000 5,65,000
Profit (₹) (5,000) 15,000 25,000 35,000

Q18. The cost details of a product manufacturing are given below –

Material Cost per unit ₹ 12.00, Labour cost per unit ₹ 9.00, Variable expenses ₹ 6.00,
Fixed expenses per unit ₹ 18. Total Cost per unit ₹ 45.00, Selling price per unit ₹ 51.00.
Current capacity utilization is 80% and installed capacity is 100,000 units. The company
has received an export order to supply 20,000 units at selling price of ₹ 30 per unit.
a) Advice the company, whether to accept the order or not?
b) What is the lowest price at which the order can be accepted?
c) Whether your decision would be same, if the order was domestic?

Q19. A manufacturing company has a P/V ratio of 40 %. The company wants to increase its
SP per unit by 10 % whereas the company's variable cost has increased by 5 %. The
total fixed costs have gone up from ₹ 200,000 to ₹ 258,500.
Compute original BEP (Sales) and revised BEP (Sales) after above changes.

Compiled by Prof. Prasad Bhat Page 152

Q20. A company manufactures the input material required for production of final product.
The manufacturing costs are given below -
Material cost per unit ₹ 2.75
Labour cost per unit ₹ 1.75
Variable overheads ₹ 0.50
Depreciation & Fixed Cost ₹ 1.25
Total Cost per unit ₹ 6.25
The input material is available in the market for ₹ 5.25 per unit.
a) Whether the material should be purchased from the market?
b) What will be your decision if the material is costing ₹ 4.90 in the market?

Q21. Selling price per unit ₹ 69.50 and variable cost ₹ 35.50 per unit. Output 54,000 units.
Total Fixed Costs ₹ 18.02 lakhs. Now, company is operating at 40% capacity. Required:
a) Find the existing profit
b) If the production is doubled what will be additional profit if –
 selling price per unit is reduced by 10 % for 20% rise in capacity, and
 selling price per unit is reduced by 15 % for next 20% rise in capacity.

Q22. A company produces and sells 24,000 small tools every year. The SP ₹ 800 per unit,
variable cost ₹ 600 per unit, Total Fixed Costs comprise of Salaries ₹ 24,00,000 & Office
and Sales distribution ₹ 16,00,000.
a) Compute BEP (qty & Sales) and margin of safety at the current level of operations
b) If the output is increased by 25%, what will be the profit?
c) In next year, Selling Price to rise by 15% and Salaries to increase by ₹ 10,00,000.
What will be the new BEP – units & Sales?

Q23. A single product company sells its product at ₹ 60 per unit. In 2006, the company
operated at margin of safety of 40%. Fixed costs ₹ 3,60,000 and the variable cost ratio
to sales was 80%. In 2007, it is estimated that the variable cost will go up by 10% and
the fixed cost will increase by 5%. For the next year –
(i) Find selling price required to be fixed in 2007 to earn same P/V ratio as in 2006.
(ii) Assuming the same selling price of ₹ 60 per unit in 2007, find the extra units
required to be produced and sold to earn the same profit as in 2006.

Compiled by Prof. Prasad Bhat Page 153

Q24. ABCL Ltd. maintains a margin of safety of 37.5% with contribution to sales ratio of
40%. Its fixed costs ₹ 500,000. Calculate – Total Current Sales, BEP (Sales), Total
Variable Cost, Current Profits, Margin of Safety if sales volume is increased by 7.50 %.

Q25. Black & White Ltd. manufactures 10,000 units at 33.33% capacity utilization. The cost/
unit ₹ 4.00. All the output is sold in the domestic market at a selling price of ₹ 4.25 per
unit. In the next year, the demand is expected to reduce and the current level can be
maintained only if a discount of 12.50% is offered to the domestic customers.
Material cost per unit ₹ 1.50, Wages per unit ₹ 1.10, Variable overheads ₹ 0.60, Total
Fixed Costs ₹ 8,000.
The Mktg. Manager has received an export inquiry in the next year to sell 20,000 units
of their product at a price of ₹ 3.55 p.u. Additional packing equipment of ₹ 1,600 would
be required. Advice, whether the export market should be explored?

Q26. The ratio of variable cost to sales is 70%. The BEP point is at 60 % of max capacity.
Fixed Cost ₹ 90,000. Find:
a) Sales at installed capacity
b) Profit at 75 % of capacity sales
c) What should be the Sales to earn a profit of ₹ 45,000?
d) What will be Margin of Safety at 80 % capacity utilization?

Q27. A company has annual fixed cost of ₹ 400,000. In the year 1981, total sales was to ₹
50,00,000 as compared to ₹ 35,00,000 in 1982. The profit in 1981 was ₹ 200,000 more
than profit of year 1982. Based on above information, answer the following -
a) At what level of sales, the company would break even?
b) Determine the profit / loss on a forecasted sales of ₹ 60,00,000.
c) If the Selling price is reduced by 10% in the year 1983 and company expects the
same profit as 1982, what should be the required sales value ?

Q28. The margin of safety is ₹ 240,000 (40% of sales) and P/V ratio is 30%. Calculate:
(i) Break Even Sales,
(ii) Amount of profit on sales of ₹ 900,000,
(iii) Sales for a profit of ₹ 50,000,
(iv) Total variable costs

Compiled by Prof. Prasad Bhat Page 154

Q29. A company wants to buy a new machine to replace one, which is having frequent
breakdown. It received offers for two models, M1 & M2. Details regarding these two
models are given below –
Particulars M1 M2
Installed Capacity (units) 10,000 10,000
Fixed Overheads per year ₹ 2,40,000 ₹ 1,00,000
Estimated Profit at above capacity ₹ 1,60,000 ₹ 1,00,000

The product manufactured using type of machine, M1 or M2, is sold at ₹ 100 per unit.
You are required to determine,
1. Break Even level of quantity and sales for each model.
2. The level of sales at which both the models will earn the same profit.
3. The model suitable for different levels of demand for the product.

Q30. A company works at 80% capacity with sales of ₹ 800,000 (SP ₹ 25), material cost ₹
7.50, labour cost ₹ 6.25. Total semi-fixed cost ₹ 180,000 (3.75 p.u. variable) F.C ₹ 90,000
upto 80% capacity and extra ₹ 20,000 beyond this level. Compute –
a) BEP Sales and BEP units and level of activity i.e. capacity utilized
b) No of units to be produced and sold to earn a profit of 8% on sales.
c) Sales value needed for a profit of ₹ 95,000 and level of capacity.
d) What will be selling price to achieve BEP if current sales quantity reduced by 50%?

Compiled by Prof. Prasad Bhat Page 155