FINANCE &

COSTING

Prepared by
A.Veeramani

31.12.2014

1
 Finance involves obtaining, using and managing funds to achieve the entity’s financial
objectives.
 Financial Accounting is to ascertain the result ( Profit or Loss) of business operations during
a particular period and state the financial position ( Balance sheet)
 Accounting – is an art of recording, classifying and summarizing the transactions and
events and interpreting results thereof.
 Science - is a systematic body of knowledge based on certain principles which have
universal application and it is based on observation, experiments and testing of facts.
o Science establishes relationship of cause and effect.
 Art – is application of knowledge comprising of some accepted theories, principles, rules,
concepts and conventions.
 Book keeping - is an art and science of recording business transactions in a systematic and
chronological order.
 Accounting - is the art of recording, classifying and summarizing in terms of money
transactions and events of financial character and interpreting the results thereof.
 Accounting -is an art of correctly recording the day-to-day business transactions.
 Single entry system personal aspects of transactions are recorded ( i.e., personal account)
– only cash aspect.
 Double entry system Evolved by Luca Paciolin – who was a Franciscan Monk of Italy –
o recognizes two fold aspect of every business transactions.
o It adheres to the rule that for each transaction the debit amount must equal the
credit amount and that is why it is called double entry system.
 Accounting Vs Accountancy:
o Accounting is body of knowledge ( principles, assumptions, concepts and rules)
governing recording, classifying and analysing financial transactions.
o Accountancy is the practice of accounting.
 Cost Accounting is to find out the cost of goods produced or services rendered by a
business.
 Management Accounting is to supply relevant information at appropriate time to the
management to take decision & control.
 A company is required to include in its Annual Report
 A balance sheet – reveals what a company owns and owes.
 Balance sheet is a statement of the financial position of the business at a given date.
 On the Assets side – current assets, long term investments, property, plant &
equipments ( tangible ) & intangible ( patents, etc).
 On the Liabilities side – current liabilities ( within one year) non-current liabilities,
shareholders equity.
 Income statement – revenues and expenditure
 Statement of cash flows – sources and uses of cash.
 Profit & Loss a/c is a summary of a business’s transactions for a given period.
 ACCOUNTING CYCLE
 When complete sequence of accounting procedure is done which happens frequently
and repeated in same directions during an accounting period, the same is called an
accounting cycle.
 Steps/Phases of Accounting Cycle -The steps or phases of accounting cycle can be
depicted as under:

2
 o a) Recording of Transaction:- As soon as a transaction happens it is at first
recorded in subsidiary books.
o b) Journal :- The transactions are recorded in Journal chronologically.
o c) Ledger:- All journals are posted into ledger chronologically and in a classified
manner.
o d) Trial Balance:- After taking all the ledger account closing balances, a Trial
Balance is prepared at the end of the period for the preparation of financial
statements.
o e) Adjustment Entries :- All the adjustments entries are to be recorded properly
and adjusted accordingly before preparing financial statements.
o f) Adjusted Trial Balance:- An adjusted Trail Balance may also be prepared.
o g) Closing Entries:- All the nominal accounts are to be closed by transferring to
Trading Account and Profit and Loss Account.
o h) Financial Statements:- Financial statement can now be easily prepared which
will exhibit the true financial position and operating results.
 A COMPANY’s ANNUAL REPORT – main sections.
o Chairman’s message
o Business portfolio
o Board of directors
o Board committees
o Corporate information
o Director’s report
o Corporate governance
o Management discussions and analysis
o Financial statements
o Auditors report
o Note to accounts
o Notice of the AGM
o Other details.
 Principles of Accounting:
o 1.Principles:- A general law or rule adopted or professed as a guide to action.
o 2.Postulates:- Mean to assume without proof, to take for granted or positive
consent ( assumptions)
o 3.Doctrines:- Principles of belief ( established principles)
o 4.Axion :- Statement of truth which can not be questioned by anyone.
o 5.Standards:- Basis expected in accounting practice under different circumstances.
o 6.Conventions:- Established usage
o 7.Concept:- Logical consideration and a notion which is generally and widely
accepted.
o 8.Assumptions:- Certain fundamental accounting assumptions underlie the
preparation and presentation of financial statements they are going concern,
consistency and accrual.
 Institute of Chartered Accountants of India treat the following accounting assumptions (
AS-1)
o 1. GOING CONCERN:- Assumes that business will continue to exist and carry on
its operation for an indefinite period. The value of assets will be on current worth.
o 2. CONSISTENCY:- Assumes there should be uniformity in accounting
processes and policies from one period to another. Only when accounting

3
 procedures are adhered consistently from year to year results disclosed in financial
statements will be uniform.
o 3. ACCRUAL:- Attempts to recognise non-cash events & circumstances as they
occur. It is concerned with expected future cash receipts and payments. It
recognises assets, liabilities or income expected to be received or paid in future.
 ACCOUNTING CONCEPTS AND CONVENTIONS:
 The three basic financial statements are
o (i) The Profit & Loss Account that shows net business result i.e. profit or loss for a
certain periods
o (ii) The Balance Sheet that exhibits the financial strength of the business as on a
particular dates
o (iii) The Cash Flow Statement that describes the movement of cash from one date
to the other.
 BASIC ASSUMPTIONS
o Business Entity concept:- For accounting purposes business enterprise & its owners
are two separate entities.
 E.g, owner investing in business- it is recorded as liability of the business to
owner and when owner takes money, it is not business expense.
o Money measurement concept: – all business transactions must be in terms of
money. i.e., in currency of the country. (other elements like loyalty, sincerity are
not recorded in the books of account.
o Going concern concept:-Firms will continue to carry on its activities for an indefinite
period of time. It will not be dissolved in the near future – for showing the value of
assets in the balance sheet ( e.g assets and depreciation – only small portion in
revenue and balance in asset).
o Accounting period concept:- All transactions are recorded in the books of account
on the assumption that profits on these transactions are to be ascertained for a
specified period. This is known as accounting period concept. That is, the
indefinite life of a business is divided into parts.
o Accounting cost concept:- All assets are recorded in the books of account at their
purchase price, which includes cost of acquisition, transportation & installation and
not at its market price. This is known as historical cost.
o Dual aspect concept:- Every transaction has a dual effect. i.e., it affects 2 accounts
in their respective opposite sides. Therefore transactions are to be recorded at two
places. E.g. purchase of goods for cash – one is giving cash and other is receiving
goods.
 Thus, the fundamental duality concept is commonly expressed in terms of
fundamental accounting equation
 Assets = Liabilities + Capital.
 As per the above, the assets of a business is always equal to the claims of
owner and the outsiders.
 Every transaction has an equal impact on assets and liabilities in such a way
that total assets are always equal to total liabilities.
 E.g. capital brought in by owner. 1- receipt of cash & 2. Increase in capital.
 E.g. purchase of machinery by cheque- 1. Reduction in bank balance & 2.
Owning machinery.
o Realisation concept:- Revenue from any business transaction should be included in
the accounting records only when it is realized. Realisation means = creation of

4
 legal right to receive money. Selling goods is realization whereas receiving order is
not realization.
o Accrual concept:- Something that becomes due especially an amount of money that
is yet to be paid or received at the end of the accounting period. This means,
revenues are recognized when they become receivable. i.e whether paid or not and
whether received or not in the same year in which the transaction takes place.
o Matching concept:- The revenue and expenses incurred to earn revenue must
belong to the same accounting period.
 Accounting Equation:-
o Dual concept may be stated as “ for every debit, there is a credit”. Every
transaction should have two sided effect to the extent of same amount.
 A-L= P where A = Assets of the entity, L= Liabilities & P= Prop’s claim.
 Rule of Debit & Credit: ( Equation based)
o 1. Increases in asset account are debits, decreases are credits.
o 2. Increases in liability account are credits, decreases are debits.
o 3. Increases in owners’ equity accounts are credit, decreases are debits.
o 4. Increases in expenses or losses account are debit. – When incurred lead to
reduction in the capital and decreases in owners’ equity account which are debits.
o 5. Increase in revenue or profit account are credits. When earned will lead to
increase in the capital and increase in owner’s equity account are credits.
 Classification of Accounts:
o 1. Personal A/c:- Accounting transactions relating to individuals or firms or
company are known as personal accounts. It is further classified into a) natural
person’s personal account ( Suresh, AVM) & artificial person’s personal account (
bank, firm, company)
o 2. Real A/c:- Accounts recording transactions relating to tangible things (
goods,building, machinery) & intangible things ( trade mark, goodwill) which can be
sold or bought.
o 3. Nominal A/c:- Accounts recording transactions relating to loss, gain, expenses &
income.
 RULES OF DEBIT AND CREDIT ( CLASSIFICATION BASED)
o 1. Personal A/c:- Debit the receiver and Credit the giver.
o 2. Real A/c:- Debit what comes in and Credit what goes out.
o 3. Nominal A/c:-debit all expenses and losses and Credit all incomes and gains.
 Accounting Ledger:
o Ledger is the most important book of accounting. It contains summarised,
classified description of all the business transactions and it is the collection of all 3
types of accounts. Per, Real & Nominal.
o In ledger, on the left hand side of the account – record according to the journal
what is to be debited and on the right hand side record what is to be credited.
o In ledger a/c, each entry on debit side commences with TO and credit side with BY.
o Recording the entries in the ledger will in fact amount to this. The a/c receiving the
benefit in shape of cash or goods will receive the debits and the a/c giving away
the benefit will receive the credits.
 Balancing the Accounts:
o Whenever it is desired to balance an a/c, the two sides are added up and if the
totals of the 2 sides are unequal then the difference is put on the side having lesser
total – thus both the sides are equal. The amount of the difference inserted is

5
 known as balance of the a/c. It is written as balance C/d ( carried down). In
subsequent period, it is known as balance B/d (brought down).
o If the total of the credit side of the a/c is less, the balance will be inserted on credit
side with “ By Balance c/d” This balance is known as debit balance and after closing
a/c, it will be shown on the debit side with the words “ To Balance b/d”.
o If the total of the debit side of the a/c is less, the balance will be inserted on debit
side with “ To Balance c/d”. This balance is known as credit balance and after
closing the a/c, it will be shown on the credit side with “ By Balance b/d”.
 Personal Account:-
o Receiver is debited and giver is credited.
 Debit balance as per personal a/c signifies that the person is debtor. i.e
owes an amount equal to the balance.
 Credit balance as per personal a/c signifies that the person is creditor. i.e
business owes an amount equal to the balance.
 Real Account:-
o Debit what comes in and credit what goes out.
 All incoming are recorded on the debit side and are debited and all
outgoing are credited.
 These are relating to property or possession.
 These a/c should have debit balance representing the worth of the item.
 These balances are shown on the assets side of the statement of position or
Balance sheet.
 These a/c do have debit balances which signifies the book value or WDV or
going concern value of the assets.
 Nominal Account:-
o Shows various heads of expenses and sources of income.
o These accounts are closed by transfer to P&L a/c.
 Purchase Book:-
o Credit the personal a/c of the suppliers with the individual amount and debit the
purchases a/c.
 Sales Book:-
o Debit the personal a/c of the customers with the value and credit the sales a/c.

SOME OF THE TERMS:

R
 Amortization - Intangible assets such as goodwill, trademarks and patents are written off
over a number of accounting periods covering their estimated useful lives.
o This periodic write off is known as Amortization similar to depreciation of tangible
assets. The term amortization is also used for writing off leasehold premises.
o Amortization is normally recorded as a credit to the asset account directly or to a
distinct provision for depreciation account;
 Depletion - This method is specially suited to mines, oil wells, quarries, sandpits and similar
assets of a wasting character. In this method, the cost of the asset is divided by the total
workable deposits of the mine etc.
o Depletion can be distinguishable from depreciation in physical shrinkage or
lessening of an estimated available quantity and the latter implying a reduction in
the service capacity of an asset.
 Obsolescence – The term ‘Obsolescence’ refers to loss of usefulness arising from such
factors as

6
 technological changes, improvement in production methods, change in market demand for
the product output of the asset or service or legal or medical or other restrictions.
o It is different from depreciation or exhaustion, wear and tear and deterioration in
that these terms refer to functional loss arising out of a change in physical
condition.
 Dilapidation - In one sentence Dilapidation means a state of deterioration due to old age
or long use.
o This term refers to damage done to a building or other property during tenancy.
 Assets: Revenue: The monetary value of the products or services sold to customers.
o Asset – something owned by a business available for use in business.
o Equity: Total claims against the enterprise – 2 ( owners and outsiders)
o Anything of use to future operations of the enterprise.
o Anything of use to future operations of the enterprise and belonging to the
enterprise ( land, building, machinery, cash, debtors, goodwill, etc)
 Net Assets -- a business’s total assets less total liabilities
 Net worth – sum capital plus retained earnings.
 Fixed Assets – assets acquired for use in business with a view to earn profits.
 Current Assets – assets acquired for conversion into cash in the ordinary course of
business.
 Expense / Cost: Expenditure incurred by the enterprise to earn revenue is termed as
expenses or costs.
 Net worth: It is the difference between total assets minus outside liabilities. Alternatively,
net worth is the sum of capital plus retained earnings.
 Current Liabilities – amount owed by business payable within one year
 Revenue – monetary value of the product/service sold to customers
 Expenses – Expenditure incurred by enterprise to earn revenue
 Liability – the amount owed by the business.
 Fund – amount equal to reserve is invested in outside securities
 Reserve- amount set aside from profit but not invested in outside securities.
 Provision – amount set aside as charge against profits or surplus to meet the depreciation
& other known liability and provisions are termed specific reserves.
 Material – items the knowledge of which might influence the decision of the users of the
financial statements.
 Data – a raw fact or figures.
 Information – a processed data
 Ratio – is one figure expressed in terms of another figure.
o Accounting ratio is an expression relating to two figures/accounts
 Four Key Areas where ratios are used for analysis.
1. Profitability
2. Liquidity
3. Leverage
4. Activity or Management Effectiveness.

Profitability –

Sales – Cost of goods sold

a. Gross Profit/Margin = ----------------------------------
Sales

7
 Profit After Tax
b. Net Profit/Margin = -------------------
Sales
Profit before Tax & Interest
c. Return on Capital Employed = ------------------------------------- x 100
Capital Employed
Liquidity- Current Assets
a. Current ratio = -----------------------
Current Liabilities
Current Assets – Inventory ( Stock)
b. Quick Ratio/Acid Test Ratio/Liquidity ratio = ------------------------------------------------
Current Liabilities
RATIOS:-

o Current Ratio = current assets / current liabilities

o Quick Ratio = current assets minus inventory / current liabilities

o Net working capital ratio = current assets minus current liabilities / total assets.

o Current liabilities to inventory ratio= current liabilities/ inventory

o Cash ratio= cash & cash equivalents / current liabilities

o Operating ratio = operating expenses/ operating income

o Advertisement to sales = advt. Expenses / total sales

o Marketing expenses to Sales = Marketing expenses / total sales

ASSET RATIOS:-

o Inventory T.O ratio= total sales / average inventory

o Fixed assets T.O ratio = total sales / fixed assets

o Total assets ratio= total sales / total assets

o Asset to equity ratio = total assets / owners equity

PROFITABILITY RATIOS:-

o Return on Asset ratio = net income / average total assets.

o Return on equity ratio= net income/ average owner’s equity

o Profit margin ratio = net income/ total sales

o Earning per share ratio= net income / average no. of common shares

DEBT RATIOS:-

o Total Debt ratio = total liabilities/ total assets

o Debt equity ratio= total liabilities / owners equity.

8
DEPRECIATION:

 Depreciation is defined as the permanent decrease in the value of an asset due to use and
or the lapse of time.
o Permanent decrease in the value of an asset due to use or lapse of time.
o An item acquired for immediate consumption or sale is a short lived asset and an
item meant for prolonged use is a long lived asset though both produce revenue.

o A short lived asset expires within one year of its acquisition and therefore the entire
expenditure is matched against current years’ revenue.

o A long lived asset wears out or depreciates over a long period and only a fraction
thereof expires annually.

o This fraction called expired cost or depreciation is charged against current revenues
and the rest termed unexpired cost, is carried forward for future expiration.

 Need for Depreciation:

o To ascertain true Profit or loss. Depreciation is loss and it is to be considered like all
other expenses and losses.
o To ascertain true cost of production. Goods are produced with the help of plant
and machinery which incurs depreciation in the process of production. The
depreciation must be considered as a part of cost of production.
o True valuation of assets. If depreciation is not taken into a/c, the value of the asset
shown which will be higher than its true value.
o Replacement of Assets. To replace an old item large sum of money is needed and if
it is withdrawn from profit, necessary sum may not be available for buying new
assets.
o Keeping capital intact.
o Legal restriction. Section 205 of Companies Act 1956 ( dividend can not be declared
without charging depreciation) on fixed assets.
 Characteristics of Depreciation:-
o It is charged on fixed assets only ( building, plant & machinery, furniture) and not
on current assets ( stock , debtors, bills receivables, etc)
o It is a charge against revenue
 Basic factors of determining depreciation :-
o Original cost plus freight and installation expenses.
o Estimated amount of expenditure on repairs during useful life.
o Estimated useful life of assets after which it will be discarded
o Estimated scrap value.
 Types of Depreciation:-
o 1. Fixed Installment or original cost or straight line method / reducing /
diminishing method. Depreciation is not calculated on cost of assets. It is calculated
on the book value of asset. The book value of asset gradually reduces on a/c of
depreciation charge and since depreciation percent rate is applied on reducing
balance of asset, it is called reducing method.
o 2. Accelerated Depreciation Method:- Sum of the year’s digits (SYD) –
Depreciation accelerates depreciation expenses so that the amount recognised in
the earlier period or an asset’s useful life are greater than those recognised in latter
periods.

9
 o 3. Annuity Method:- It recognises time value (interest) of money & regards the
real cost of using a long lived asset equivalent to the actual amount invested
thereon plus the interest lost on the acquisition of asset plus the interest lost on
acquisition of asset.
o 4. Depreciation Fund or Sinking Fund Method:- A fixed amount is charged as
depreciation evey year and investing a fixed sum in readily realisable securities to
earn interest to provide required lump sum at the retirement of long lived asset.
o 5. Insurance Policy method:- Contribution of periodic premium “ capital
redemption Insurance policy from an insurance company after maturity the policy
money will take care of the replacement.
o 6. Revaluation method:- Each year the asset is valued and the value is
compared with that in the beginning of the year. The fall is treated as depcreiation.
o 7. Depletion method:- Natural resources get exhausted by exploitation. Either
periodic depletion is calculated or cost per unit is calculated.
o 8. Machine hour rate:- Used for those assets whose useful life depends upon
the fact that how many kilometre they have been driven bus, car, etc.
o 9. Global method:- The value of the assets irrespective of their nature is
added together and depreciation is charged at an average rate on aggregate value.
 DEPRECIATION METHODS:
o 1. Straight Line Method ( SLD): - Equal amount is written off every year.
 When an asset’s usage is uniform from period to period. The formula is

Cost – Salvage Value

 Depreciation Expense = ----------------------------
No. of years of useful life
o 2. Reducing Balance Method : - A fixed % of the diminishing value is written
off.
o 3. Sum-of-the-Year Digits Method (SYD):-
 If life of a machine’s expectancy is 8 years, then write in reverse. i.e.,. 8, 7,
6, 5, 4, 3, 2, 1. The sum of these digits is 36, ( i.e., 8=7=6……). Thus the
fraction for the first year is 8/36, 7/36 for the second year and 1/36 for the
last year.
 The sum of eight fractions equals 36/36 or 1. Therefore, at the end of 8 th
year, the machine is completely written down to its salvage value.

 The formula to find SYD is S-(N) (N+1)

---------------
2
where N is the no. of years of expected life.
 4. Double Declining Method (DBB):-
 Depreciation is highest in earlier years and lowest in later years.
 The double declining rate for a 10 year asset is 20% ( 10% x2)
 Depreciation equals the rate multiplied by the book value of the
assets at the beginning.
 Balance Sheet:
o It is a statement of financial position of a concern at a given date.

o Prepared from the TB after all the balances of nominal a/cs are transferred to P&L
and corresponding a/cs in the ledger are closed.

10
 o The balances of either personal or real a/cs represent asset or liability and are
displayed in the balance sheet as per the following principles.

1. All real and personal a/c having debit balances should be shown on the
assets side of Balance sheet ( right side)

2. All the real and personal a/c having credit balances should be shown on the
liabilities side of balance sheet ( left side)

o The excess of assets over liabilities represents the capital of the owner.

 Classification of Assets:
1. Fixed Asset:- The assets of a durable nature which are used in business and are
acquired and intended to be retained permanently for the purpose of carrying on
the business like land building, machinery, furniture. Fixed assets are collectively
known as “ BLOCK”

2. Floating or Circulation Asset:- Temporarily held assets meant for resale or

frequently undergo change like cash, stock, store, drs, bills receivables. Again 2
categories – liquid assets ( cash) & non-liquid assets ( stock & stores).

3. Fictitious Asset:- Assets not represented by any concrete or tangible preliminary

expenses, debit balances of P&L.

 Classification of Liabilities:-
1. Fixed Liabilities:- Those liabilities which are to be redeemed after a long period of
time. i.e, long term loans.

2. Current Liabilities:- To be redeemed in near future ( i year) credit, bank loan, bills
payable.

3. Contingent Liabilities:- Which are not actual but their becoming actual liability is
contingent on the happening of an event.

 Form of Balance Sheet:

o A balance sheet has 2 sides the left hand side and the right hand side. These 2 sides
are not comparable with debit side or credit side of a ledger a/c because balance
sheet is not an a/c.
o The left hand side is liabilities side and contains credit balances of all real and
personal a/c & on the right hand side which is assets side are listed the debit
balances of real and personal a/c.
o The assets & liabilities should be arranged in balance sheet in some specific order.
Arrangement of assets & liabilities in the balance sheet is called “ Marshalling of
assets & liabilities.
o There are 2 systems.
1. Order of liquidity – most easily realisable assets are shown first followed by less
easily and in the liabilities most pressing will be shown first.

2. Order of permanence.

 P&L a/c: The P&L a/c is opened by recording the gross profit on credit side or gross loss on
debit side.

11
 Capital & Revenue:
o Revenue:
 Total expenditure incurred by the business is divided into 2 categories.

 One portion is charged against revenue while the other is shown in the
balance sheet as assets. The former is known as revenue expenditure and
the latter as capital expenditure.

 While preparing final a/cs, all revenue items are included in the revenue a/c.
i.e., Profit & Loss Account and all the capital items in the Balance Sheet.

 Any error committed in distinguishing between capital and revenue will

affect the ascertainment of profit.

o Expenditure:
 Expenditure are the using or consuming of goods & services in the process
of obtaining revenues.

 Expired cost directly or indirectly related to given fiscal period.

 Expenditure are two types.

1. Capital &

2. Revenue

 Capital Expenditure:
o The benefit of which is not fully enjoyed in one accounting period but spread over
several accounting periods.

o It includes assets acquired for the purpose of earning income or increasing the
earning capacity of the business or effecting economy in the operation of an asset.

o These are not meant for sale.

o Expenditure incurred for improving assets and extending an existing asset is also
capital expenditure.

o The sum of invoice price, freight, insurance charges, installation and erection cost,
customs duty, etc will be capitalised in the books. They appear on the asset side of
the balance sheet.

 E.g: 1.Interest on capital paid during construction of co.

2.Expenses for purchase & installation of asset

3. Acquisition of assets.

4.Interest & financial charges paid, brokerage, commission paid.

5. Betterment of fixed assets or improvement of an asset to produce
more.

 The cost of assets will be written off by way of depreciation.

12
 The amount of depreciation is a revenue expenditure & is debited to P&L a/c.. The reason
for charging depreciation to revenue i.e., Profit & Loss a/c is the asset used for earning
revenue.

 Revenue Expenditure:
o It consists of expenditure incurred in one period of accounting, the full benefit of
which is enjoyed in that period only.

o This does not increase the earning capacity of the business but in order to maintain
the existing earning capacity.

 E.g:

1. Purchase of raw material

2. Selling & distribution expenses

3. Establishment expenses like salaries, wages, rent, taxes, insurance &

depreciation

o All these items appear on debit side of P&L a/c.

 Deferred Revenue Expenditure:

o It is revenue expenditure which has been incurred during one accounting year
which is applicable either wholly or in part to further accounting years.

o It is a quasi capital nature.

o The benefit of which may be extended to no. of years and charged to P&L a/c over
a period of defined years.

o Sometimes losses may be suffered of an exceptional nature. Loss of asset

(uninsured) due to accident/fire.

 Development Expenditure:
o In certain units like mines, plantations and housing colonies, initially heavy
expenditure has to be incurred and such expenditure are to be treated as capital
expenditure.

o P&L a/c is debited with revenue expenditure and credited with revenue income.

o If the revenue income is higher than revenue expenditure, it will be profit and if it is
less than revenue expenses, it will be loss.

o Capital expenditure is shown on the asset side of Balance sheet.

o Capital and liabilities are shown on the liabilities side of balance sheet.

 Revenue:-
o Revenue is the product of the entity which refers to the goods and services created
during a specific time span by an enterprise.

 Capital & Revenue Receipts:

13
 o Capital receipts of business comprise of capital contributed by
partners/shareholders, loan, sale proceeds of any fixed asset.

o Revenue receipts of a business are cash from sales, discount received, commission,
interest on investment.

o Revenue receipts are treated in the revenue i.e, P&L a/c.

o Capital receipts are treated in the Balance Sheet.

o A receipt on a/c of fixed asset is a capital receipt and a receipt on a/c of current
asset is revenue receipt.

 Revenues & Provisions:-

o Provisions out of current profits for meeting an anticipated liability, redeeming an
asset of for some other important business purpose

o Depreciation is a provision

o Bad debts is provision

 Provisions must be created, whether there is any profit or not.

 Nature of Reserves / funds for Provisions:-

o Fund  If amount equal to the reserve is invested in outside securities, the reserve
will be termed as Reserve Fund.
o Reserve If amount set aside from profit is not invested in outside securities, it is
termed as Reserve.
o Provision If amount set aside as charge against profits or surplus to meet
 1.Depreciation for renewal of asset
 2. Any unknown liability- the amount can not be termed as “Specific
Reserves” and are created even there are no profits.
o Provisions are not surplus
o Provisions in excess of requirement is a surplus. When any provision becomes
redundant, it should be credited back to P&L appropriation a/c.

 Types of Provisions (Specific Reserves):-

o Provisions are of the following types.
1. Provision for doubtful debts.

2. Reserve for discount on debtors

3. Reserve for discount on creditors

4. Reserve for repairs and renewals

 General Reserve:-
o Reserves are retained profits plus part of surplus.

o There can be no reserves if there are no profits

o Reserves are undistributed profits.

o Provisions are a pre-profit matters and reserves are a post profit matters.

14
 Capital Reserves:-
o It is created out of capital profits ( reserves created out of revenue profits are
revenue reserves) and are rare transactions; They are profits on
1. Sale of fixed assets

2. Profit prior to incorporation

3. Profit on redemption of debentures

4. Profit on forfeiture of shares

5. Profit on acquisition of business.

 Revenue Reserve:-
o It is created out of revenue profits.

Reserves VS Provisions

Created by debiting P&L & appropriation a/c Created by debiting P&L

Created to meet unknown liability Created to meet known liability

Created only when there is profit Created irrespective of profit or loss

Can be distributed as dividend Not available for dividend distribution

Shown on the liability side of BS Shown on assets side of Balance sheet.

 Sinking fund:-
o It is built up by annual contribution and invested outside in readily realisable
securities.
 Secret Reserves:-
o Any reserve which is not apparent on the face of the balance sheet. It is hidden
reserve or internal reserve. This represents the surplus of assets over liabilities and
capital. It does not appear in the ledger. This is practised by banking, insurance
and financial concerns.
o How:
1. Under valuation of assets

2. Creating excessive reserve for bad and doubtful debts

3. By providing excessive depreciation on fixed assets

4. By omitting some assets altogether in balance sheet.

o Objectives:-
 Strengthen financial position of a concern

 Can be utilised for equilisation of dividend

 Withhold information of the progress of company to its competitors

 Cash Flow Management:-

o Cash flow control is a simple method of projecting your future needs of cash.

15
 o It is an income statement covering future periods of time that has been charged to
show only cash.
o Cash coming in and cash going out and what your balance of cash is at the end of
designated period of time.
 Budgeting & forecasting:
o To provide standards for evaluating performance. It covers
1. Profit planning – forecast of revenue and expenses

2. Cash budgeting – forecast of cash needs and sources

3. Balance sheet forecasting- anticipating future assets, liability and networth

position of the business.

FIANANCIAL MANAGEMENT

 Financial Management deals with

o Procurement of funds.
o Effective utilization of funds in the business.
 Procurement by

1. Equity shares
2. Debenture
3. Banks & FI
4. Instruments like commercial paper, discount bonds, ADR, GDR
5. Short term funds – trade creditors, CC, bank overdrafts.
 Utilisation
1. Projects and assets – shall generate adequate income
2. Should not remain idle.
 The objectives of Financial Management:
o 1. Profit maximization
o 2. Return maximization
o 3. Wealth maximization.

 Key Decision of Financial Management:

1. Investment Decisions:
a. New project / expansion
b. Acquisition
c. Working capital
2. Financing decisions:
a. Proper balance between equity and debt at lower cost
b. Short term funds
c. Capital market
d. Debt
e. Bank term loans
f. Reserves
3. Dividend decisions:
a. Whether to pay dividend or retain for future growth
b. How much to pay.

 Wealth maximization VS profit maximization.

16
 o WM – It aims at increasing the net worth of the shareholders in the long run.
It aims at increasing the market price of the shares in the stock market.
It aims to increase the wealth of the firm.
o PM – Often aims at increasing the profitability.
 Capitalisation = means the valuation of capital (owners funds, long term loans & other
reserves represented by assets) and will include owners funds, borrowed funds, long term
loans and reserves and any surplus earnings.

 What are the wealth maximization strategy

1. Increasing the net worth of shareholders in the long run.
2. Increasing the market price of shares.
 What is factoring : It is a source of liquid finance for the company.
o It is a process wherein trade receivables ( sundry debtors) is transferred to the
factor.
o That is the factor purchase the trade receivables of the company for cash and takes
the responsibility of collecting from debtors on the due dates.
o With factoring the company is relieved of the collection responsibilities and risk of
bad debts.
o The factor takes all responsibility. The accounts receivable is sold to a financial
institution ( a subsidiary of commercial bank called Factor) who charges
commission.

 What is GDR.
o GDRs mean global depository receipts. It is negotiable and transferable from one body to
another. It is also evidence of ownership of a company's shares . When a bank purchases
shares of foreign company, at that time it issues a certificate, that certificate is called global
depository receipt.
o Suppose A USA based company wants to buy the shares of Indian company, then it only
possible by getting GDRs. USA Company can buy Indian company shares by the help of his
bank. Bank takes some charges and issues GDR.
o If any company gets GDRs for his purchased shares, then these can be sold in any stock
market of world through global network of banks and financial institutions.
o Global Depositary Receipts (GDRs) give power to investors and companies access to two or
more markets, most frequently the US market and the Euromarkets, with one security.
GDRs are most commonly used when the company is raising capital in the local market as
well as in the international and US markets, either through private placement or public
offerings.
o Securities and Exchange Commission of USA has allowed USA companies and also foreign
companies to buy and sell shares through GDRs
Among the Indian Companies, Reliance Industries Ltd. was the first company to get funds
through a GDR issue , after this many other Indian Companies like Infosys,WIPRO AND ICICI
have started to raise funds via GDRs. It is the good way for getting foreign investment for
developing economy.

 What is ADR.
o Every company is interested to get investment from developed countries investors. Simply,
I can say that if my company name is Accounting Education Corporation and I have
registered this company in Indian Company registrar by making small association of my
friends.

17
 o After this I can sell my company’s shares in Indian share market. But If I want to make large
scale company, for fulfill my other business aims like spreading quality accounting
education at international level, I need to buy high infrastructure.
o For this I need money. Money can be received from selling large number of shares in
developed countries. USA is also developed country. Every dollar will become in India Rs.
45, suppose if I sell 100 shares of $ 1 each, then it means I have received Rs. 4500. But USA
does not allow every company to trade in USA. For trading in USA, I need ADR.
o American depository receipt is the receipt for trading of non US Company in the stock
market of USA. IF any non USA company is interested to trade in USA stock market, then it
can receive ADR level one, ADR level two and ADR level three. ADR for level one can easily
get after accepting the conditions of SEC of USA but major problem is that this ADR can
only use for getting investment from USA and it can not be used for getting investment
money from any other country. It is the reason that Indian company prefers to get GDR
instead of ADR.
o Students who are studying finance should understand one thing that ADRs is compulsory to
sell shares in USA. No one can sell shares with GDRs as the substitute of ADRs. Any
company can start trading in USA stock exchange after buying ADRs from New York Stock
exchange or NASDAQ.
 What is European depositary receipt

o EDR means European depositary receipt. If any company wants to sell his shares in
European countries, you need European depositary receipt. This receipt is provided by
European banks. Suppose, an Indian company want to sell the shares in France. For this,
Indian company has to acquire EDR after paying its minimum money. This is usable in the
limited countries in Europe. Many European countries accept GDRs as substitute of EDRs.
o Commodity market is the oldest market in which consumable commodities are purchased
and sold. This market had been started after starting of agricultural product marketing. The
modern commodity market has become the part of financial market like stock market,
bond market and foreign exchange market. Large numbers of commodity vendors have
physical shops, retail hubs (like More of Aditya Birla Retail Limited) in different cities of
different countries. Commodities can purchased for direct consumption for further
production. You can listen daily commodity rates on radio or read from your national news
paper. Prices of commodities are fixed on the actual supply and demand of market. So far it
may possible that today rates will differ from yesterday prices.

 What is Bridge Finance.

o It refers normally to loans taken by the business, usually from commercial banks for
a short period pending term loans by financial institutions.
 What is Commercial Paper.
o To give a boost to the money market and reducing the dependence of highly rated
corporate borrowers on bank finance for meeting their working capital
requirements, corporate borrowers are permitted to arrange short term borrowing
by issue of CP.
o It is regulated by RBI.
o A company must have net worth of Rs. 10 crore with permissible bank finance of >
Rs. 25 crore and listed on stock exchange.
 CRR- Cash Reserve Ratio - A CRR is the % of bank reserve to deposit and notes, CRR is the
amount of funds that banks have to keep with RBI. If RBI decides to increase the %, the
available amount with the banks comes down. RBI increases CRR to pull out the excessive
money from the banks. CRR is also known as Cash Assets Ratio(CAR) or Liquidity Ratio.
 SLR- Statutory Liquidity Ratio is the % of deposits the banks has to maintain in the form of
gold, cash, or other approved securities.
18
 PLR- Prime Lending Rate is the interest rate that commercial banks charge their best, most
credit worthy customers. It is minimum lending rate offered to prime borrowers.
 REPO rate- When banks are having shortages of funds, they borrow it from RBI. REPO rate
is the rate at which banks borrow funds from RBI.
 Reverse repo rate --> The rate at which RBI borrows money from banks.
 Sub Prime Lending --> is lending at a higher rate than the prime rate.
 NOSTRO & VOSTRO--> In order to carry out foreign exchange transactions, banks normally
maintain stocks of foreign currencies in the form of Bank a/c with their overseas branches.
Such a foreign currency a/c maintained by a bank at an overseas centre is NOSTRO a/c. ( i.e
our a/c with you). Conversely, if a foreign bank is to deal in a local currency of another
country, it would maintain a VOSTRO a/c ( i.e your a/c with us)
 NOSTRO is our a/c of our money held by you.
 VOSTRO is our a/c of your money held by us.
 NRO a/c--> ( Non Resident Ordinary A/c)The funds in this a/c can not be repatriated
outside India in foreign exchange without prior permission of RBI. Interest earned is
repatriable. Joint a/c with resident is possible.
 NRE a/c.--> ( Non Resident External Rupee a/c)- The funds in this a/c and interest earned
are remittable outside India in free foreign exchange without permission of RBI.
 LIBOR --> London Inter Bank Offered Rate- is the rate of interest at which commercial
banks offer deposit/lending to other banks.
 SWIFT--> Society for World wide Interbank Financial Telecommunications - Allows member
financial institutions worldwide to electronically exchange information among each other.
 RTGS--> Real Time Gross Settlement - Settlement of payments on an individual order basis
done on continuous basis ( for large transactions and minimum Rs. 2 lakhs).
 NEFT--> National Electronic Fund Transfer --> On differed net settlement which settles
transactions in batches (even without bank a/c, one can transfer/deposit fund thru NEFT)
the limit is Rs. 50000 per transaction.
 CRR = Cash Reserve Ratio – is the % of the amount of funds that the banks have to keep
with RBI ( say 4.75%).
 SLR= Statutory Liquidity Ratio – is the % of deposits the bank has to maintain in form of
gold, cash or other approved securities. ( say 25%)
 PLR= Prime Lending Rate – the interest rate that commercial banks charge their most
credit worthy customers/prime borrowers.
 REPO rate = the rate(interest) at which banks borrow money from RBI during shortages.
 Reverse REPO rate = the rate at which RBI borrows money from banks.
 Sub prime Lending = is lending at a higher rate than the prime rate.
 Scheduled bank= RBI used to include all banks in its schedule- Scheduled bank can carry
out extensive banking operations including foreign exchange. A non-scheduled bank can
not operate foreign exchange operations.

ACCOUNTING STANDARS:
 The Indian Accounting Standards (AS) are a set of accounting standards notified by Ministry
of Corporate Affairs converged with International Financial Reporting Standards ( IFRS).
o These AS’s are formulated by ICAI. MCA notified 35 IND AS.
o AS issued by ICAI.
o Mandatory – AS 1 to AS29 except AS8.
o Non- Mandatory – AS 30, 11, 21, 23, 26, 27, 28, 29 31 & 32.

19
 o Revised Schedule VI applicable w.e.f April 2011.
o AS are needed so that financial statements will fairly and consistently describe
financial performance.
o Without AS’s comparison of companies will be difficult.
o AS’s used today are referred on Generally Accepted Accounting Principles (GAAP)
and they are generally accepted because an authoritative body has set them.
o Since Accounting is a process of recording and communicating financial data (
CURRENT DEFINITION), the generators, regulators and users, standards like AS are
needed.

AS 1 Disclosure of Accounting All significant accounting policies adopted in the

Policies preparation of financial statements should be disclosed.
Like Going concern, Consistency & Accrual
AS 2 Valuation of Inventories Inventories should be valued at the lower of cost & net
realizable value. It should disclose the accounting policies
adopted in measuring inventories including the cost
formula. The total carrying amount of inventories & its
classification
AS 3 Cash Flow Statements Deals with provision of information about the historical
changes in cash and cash equivalent and classification of
cash flows during the period from operating, investing and
financial activities.
AS 4 Contingencies & Events Amount of contingent loss should be provided for by a
occurring after the Balance charge in P&L a/c. Existence of a contingent loss should be
sheet date disclosed. Contingent gain not to be shown in P&L a/c
AS 5 Net Profit or Loss for the Classification of these aspects
period
AS 6 Depreciation Accounting Depreciable amount of an asset to be allocated to each
accounting period during the useful life of an asset.
Consistent method. Depreciation methods are disclosed
AS 7 Construction Contracts Accounting treatment of revenue and costs associated with
construction contracts
AS 8 R&D This standard is not in force since it is merged with AS 26
AS 9 Revenue Recognition Bases for recognition of revenue in P&L account. Sale of
Goods, Rendering services, other income, Gross Turn over,
Less Excise Duty and Net turn over are disclosed
AS 10 Accounting of fixed assets Gross book value of fixed assets – either historical costs or a
revaluation. Cost of fixed assets to include purchase prices,
other cost to bring the asset to working condition.
Subsequent cost to be added.
AS 11 Effects of changes in Transactions in foreign currency, operation ( foreign),
Foreign Exchange Rates decide on foreign exchange rate, average, closing rate,
exchange differences, date of such transactions.
AS 12 Accounting for Govt. grants Subsidies, cash incentives, duty drawbacks, capital vs
income approach, non-monetary assets ( land, etc) received
from Govt as free of cost are recorded at nominal value,
refundable grants, disclosures.
AS 13 Accounting for Investments Investments – i.e., are assets held by an enterprise for
earning income by way of dividends, interest rentals for
capital appreciation. Assets held in stocks-in-trade are not
investments. Current and long term investments and
disclosures.

20
AS 14 Accounting for Accounting of amalgamations & treatment of resultant
amalgamations goodwill or reserves. Amalgamation - pooling of interest
method, purchase method, treatment of goodwill &
reserves.
AS 15 Employees Benefits Disclosure of employee benefits
AS 16 Borrowing costs Disclosure of accounting policies for borrowing cost.
Disclosure of borrowing cost capitalized.
AS 17 Segment Reporting Establish principles for reporting financial information about
different types of products and enterprise produces,
different geographical areas in which it operates. Enterprise
should comply with all requirements of this AS fully and not
selectively.
Business segment is a distinguishable component of an
enterprise that is engaged in providing individual product or
a group of products that is subject to risks and returns that
are different from those of other business segments.
Factors are 1. Nature of product.2.nature of production
process.3. type of customers for the products.4. methods
used to distribute products.5. applicable regulatory
environment.
Geographical segment is a distinguishable component of an
enterprise that is engaged in providing product within a
particular economic environment subject to risks and
returns different from other segment’s environment.
Factors are 1. Economic & political conditions, 2.
Relationship among different geographical segment 3.
Proximity 4. Special risks.
Segment revenue is the portion of enterprise revenue that
is directly attributable to a segment.
Reportable segments 1. If revenue from sales is > 10% of
total income. 2. If segment profit/loss >10% of total P/L. 3. If
segment assets is > 10% of total assets.
Other disclosures like segment assets, liabilities segment
revenue and expenses.
APPLICABILITY: Listed company, Turn over more than .50
crore.
AS 18 Related party disclosure Disclosure of related party relationship, transactions
between reporting enterprise & its related parties. An
enterprise is considered to have substantial interest in
another if it owns 20% or more interest in the voting of that
enterprise. ( Individual 20%)
AS 19 Leases Disclosure of leases
AS 20 Earnings Per share Disclosure of EPS
AS 21 Consolidated Financial Parent/Holding company to provide financial information
Statements about economic activities of its group where ½ of voting
power of another company.
AS 22 Accounting for Taxes on Accounting income, taxable income, tax expense, current
income tax, deferred tax.
AS 23 Accounting for investments
in associates in
consolidated financial
statements
AS 24 Discontinuing operations

21
 AS 25 Interim Financial Reporting
AS 26 Intangible Assets Intangible asset is an identifiable non-monetary asset
without physical substance, held for use in the production
or supply of goods or services, for rental to others.
Research is original and planned investigation undertaken
with the prospect of gaining new scientific or technical
knowledge and understanding.
Development is the application of research findings or other
knowledge to a plan or design for the production or new or
substantially improved material, devices, product, process,
system or service prior to the commencement of
commercial production or use.
Amortisation is the systematic allocation of the depreciable
amount of an intangible asset over its useful life.
Impairment loss is the amount by which the carrying
amount of an asset exceeds its recoverable amount.
AS 27 Financial reporting of
interests in Joint Ventures
AS 28 Impairment of Assets Assets are carried at no more than their recoverable
amount.
Impairment means if an asset is carried at more than its
recoverable amount if its carrying amount exceeds the
amount to be recovered through the use or sale of that
asset--- This asset is described as impaired and this standard
requires the enterprise to recognize an impairment loss.
AS 29 Provisions, Contingent Provision is a liability measured by estimation.
Liabilities & Contingent Liability is a present obligation arising from past events –
assets results –outflow.
Contingent liability is a possible obligation – past events –
uncertain or present obligation.
Contingent asset is possible asset – paste events –
uncertain.
Decision Tree is used here – Purpose is to summarise the
main recognition.
AS 30 Financial instruments Recognition & measurement
AS 31 Financial Instruments Presentation
AS 32 Financial Instruments Disclosure

 What is Revised Schedule VI.

o Ministry of Corporate Affairs vide notification dt 28.02.2011 introduced the revised
schedule VI.
o By another notification dt 30.03.2011, MCA made it applicable to all companies
w.e.f. 1.4.2011.
o Schedule VI was implemented in 1960 and is outdated in its presentation and
structure – e.g. Licensed capacity, CIF value of imports, etc.
o Financial statements should speak a global language and harmonization with IFRS
and international best practices.
o It was introduced to align with Accounting Standards.
o Disclosure as per AS – e.g EPS, retirement benefits, lease, MSMED act.
o Classification as current and non-current assets.

22
 o Fixed assets under non-current assets should be shown as tangible, intangible,
capital WIP, etc.
o Heading source of funds replaced by equity and liabilities and application of funds
replaced by assets
o P&L name changed to statement of profit and loss.
o Revenue should be disclosed as revenue from sale of products / sale of services,
other operating revenue.
o New disclosure requirements introduced
o Only vertical form of balance sheet and no T form.
o Significant disclosures regarding ownership of the company.
o Sundry debtors replaced with trade receivables.

 PROJECT APPRAISAL:
o Most important business project is to be selected.
o They are
1. Payback Period
2. Present value of cash inflows
a. NPV
b. IRR
c. Discounted payback period
d. Benefit Cost Ratio/Profitability Index.
3. Accounting Rate of Return/Avg. Rate of Return.
1. Pay Back Period :-
o It refers to the period in which the project generates necessary cash to
recoup initial investments generally expressed in years.
o It is the time period required for the amount invested in as asset to be
repaid by the net cash flow generated by the asset.
o The payback period is expressed in years and fraction of years.
o In this method, the period during which the cash inflow of a project repay
its cost is calculated.
o Whichever project repays the cost earlier is considered as better.
o Accept a shortest payable payback .
o Payback period is no. of years required to recover the cost of investment.
Initial Investment
Pay Back Period = -------------------------
Annual Cash inflow

- e.g. If the initial outlay of Project A is Rs. 1,00,000 and cash inflows are estimated
@ Rs. 20,000 p.a, the payback period is 5 years.
- But the projected inflow may not be equal always. If the inflows are not equal, we
have to calculate the cumulative inflows and interpolate and find out the exact
payback period.

- E.g. 2. If the initial investment is Rs.1,00,000 and inflows during the first 4 years are
Rs.25,000, Rs. 70,000, Rs. 20,000 & Rs. 50,000. The cumulative cash inflows are.
Year cash inflow cumulative cash
1 25000 25000
2 70000 95000

23
 3 20000 115000
4 50000 165000
It is apparent that investment of Rs.1,00,000 is recovered during 3 rd year. Therefore
the payback period is 2. 1/4 year ( 95000 during 2nd year + Rs.5000 during 3rd
year).
o This payback period method is layman’s method and has no scientific
background since it does not take into account the important interest factor
which may have major impact on the real value of inflows.
o To overcome this adverse feature, the concept “ Time Value of money”
should be considered and this concept is used in methods using PV wherein
inflows are considered after adjusting the effects of cost of capital.
2. Present Value of Cash inflows:
o The present value of Rs. 11,000 that one is going to get after one year at a
cost of capital of 10% is Rs.10,000
o This is used to create the present value factor of 0.909( i.e., 10000/11000)
o Cost of Capital – The rate at which the capital is obtained by the person who
has started the project.
o Bank charging interest on borrowing is the cost of capital.
o For a person invested his own money, it is the opportunity cost of capital.
o Formula to find present value when you know Future Value, Interest & No. of
period.
o PV= (FV/1+r)n
o Formula to find Interest rate when you know PV, FV & No. of periods
o r=(FV/PV)1/n-1
o Formula to find no. of periods, when you know PV, FV & Interest rates
o n=1n(FV/PV)/1n(1+r)
o Formula for simple interest I= Prt
o where I= Interest, P= Principal, r= rate of Interest, t= time
o E.g X borrows Rs. 3000 for 1 year @ 10% = 3000x10/100 = 300
o E.g X borrows Rs.3000 for 4 years @ 10% = 3000x10/100x4=1200
o Formula for Compound Interest: FV=PV(1+r)n ( r will be Interest as decimal
only)
Where FV = Future Value, PV = Present Value, r= rate of interest, n= no. of
periods
o Present Value --- Money now is more valuable than money later on.
o Instead of adding 10% to each year, multiply by 1.10.
 Rs.1000 x 1.10 = 1100
 Rs. 1100 x 1.10 = 1210
 To see what money in the future is worth now, divide by 1.1
 Rs. 1000/1.1= 909

2.a Net Present Value:-

o In this method, the PV of all the cash inflows and outflows are found out
and totaled to arrive at what is known as NPV.
o A project which gives a positive NPV is accepted and one which gives
negative is rejected.
o When two are compared, the one with more NPV is accepted.
o E.g. Rs. 1000 can earn 1000 x 10 = 100 in an year.

24
 o So Rs. 1000 now would become Rs.1100 by next year
o So Rs. 1100 next year is the same as Rs.1000 today
o PV = Rs.1000, FV=Rs.1100
- E.g. a friend needs Rs. 500 now and will pay back Rs.570 next year.
- Is it a good investment when your get 10% elsewhere.
- Money now Rs. 500 So PV= Rs. 500.
- Money next year Rs.570 so FV Rs. 570

PV = 570/(1+0.10)1 =570/1.10 = 518.18

The net amount is NPV = Rs. 518.18 – Rs. 500 = Rs.18.18

So at 10% interest, that investment is worth Rs. 18.18. In other words, it is 18.18is
better than a 10% investment in today ‘s money.

A net present value (NPV) that is positive is good & negative is bad.

But the choice of interest rate can change things.

Now the same investment, but let us try it at 15% instead of 10%

PV = Rs.500, money next year Rs. 570

PV = 570/1+0.15) 1 =570/1.15 = 495.65

Now the net amount is NPV = Rs. 495.65 – Rs. 500=Rs. -4.35

So at 15% interest, that investment is worth –Rs. 4.35

It is a bad investment. But since we are demanding it to earn 15%.

o The interest rate that makes the NPV zero ( in the previous example, it would be
around 14%) is called the IRR ( i.e., 570/1.14 = 500).

E.g. Invest Rs. 2000 now. Receive 3 yearly payment of 100 each. Plus Rs. 2500 in
the 3 rd year. Use 10% interest rate.

Now PV = 2000

Year 1 : PV = 100/1.10 = 90.91

Year 2 : PV = 100/1.102 = 82.64

Year 3 : PV = 100/1.103 = 75.13

Year 4 ( final payment) PV=2500/1.103 = 1879.29

Now add all NPVs NPV = 90.91+82.64+75.13+1879.29=2126.97 – 2000=126.97

Looks like a good investment.

Now same e.g. with 6%.

Now PV = 2000

Year 1 : PV = 100/1.06 = 94.34

25
 Year 2 : PV = 100/1.062 = 89.00

Year 3 : PV = 100/1.063 = 83.96

Year 4 ( final payment) PV=2500/1.063 = 2099.05

Now add all NPVs NPV = 94.34+89.00+83.96+2099.05=2366.35– 2000=366.35

Looks even better at 6%.

o Why is the NPV bigger when the interest rate is lower?:

o Because, the interest rate is like the team you are playing against ( foot ball), play
an easy team (6%) and you look good, a tougher team (10%) and you are not good
and find it difficult.
o Therefore work out the PV of each item and then total them upto get the NPV.
Amount that go out should be subtracted and add amount that come in.
o While comparing investments, add up all the money you receive and subtract all
the money you spend.

2.b. Internal Rate of Return:-

o It is the rate at which the project is generating the inflows.

o It is the interest rate that makes the NPV zero.
o IRR is a good way of judging an investment. The bigger the IRR, the better.
o It is an interest rate.
o That can be 10%, 9% 8% and so on.
o In this method, the cost of capital will not be given. We have to find out
the rate at which the project generates the funds.
o It is the rate at which the discounted cash inflows = discounted cash
outflows. i.e., NPV=0
o When a project is being evaluated, it has to be accepted if the IRR is greater
than the cost of capital or the expectancy rate.
o When two projects are compared, the one with higher IRR should be
accepted.
o IRR vs NPV.
 When IRR & NPV of two projects are furnished both may give a
different conclusion.
 This is so especially in cases where cost of capital is different in both
the projects.

e.g. A starts a bakery.

He calculates all the costs and earnings for next 2 years and calculates the NPV

At 6% A gets an NPV of 2000 ( But NPV should be zero)

At 8% A gets an NPV of – 1600 ( Now it is the negative & tries)

At 7% A gets and NPV of 15 ( close enough to zero ) and need not calculate further
since here the IRR is about 7%.

Another e.g. – Invest Rs.2000 now, receive 3 yearly payment of Rs.100 each & Rs. 2500 in
the 3rd year.

26
 Now PV = - 2000

Year 1 : PV = 100/1.10 = 90.91

Year 2 : PV = 100/1.102 = 82.64

Year 3: PV = 100/1.103 = 75.13

Year 3 (final payment) PV=2500/1.103 = 1878.29

Add these gets NPV = -2000+90.91+82.64+75.13+1878.29=126.97

Now try at 12%

Now PV = - 2000

Year 1 : PV = 100/1.12 = 89.29

Year 2 : PV = 100/1.122 = 79.92

Year 3: PV = 100/1.123 = 71.18

Year 3 (final payment) PV=2500/1.123 = 1779.45

Add these gets NPV = -2000+89.29+79.92+71.18+1779.45=19.64

Therefore this is close but try with 12.4%

Now PV = - 2000

Year 1 : PV = 100/1.124 = 88.97

Year 2 : PV = 100/1.1242 = 79.15

Year 3: PV = 100/1.1243 = 70.42

Year 3 (final payment) PV=2500/1.1243 = 1760.52

Add these gets NPV = -2000+88.97+79.15+70.42+1760.52=0.94

Therefore IRR is 12.4% & this investment could earn 12.4%

 USING IRR:
o IRR should be higher than the cost of fund. If it costs you 8% to borrow money, then
an IRR of only 6% is not good enough.

Another e.g.

One can invest 3 yearly sum of Rs. 1000 to gain Rs. 4000 in 4th year @ about 10%

Year 0 : 1000 – 1.00 = -1000 PV

Year 1 : 1000 - 1.1 = -909.09 PV

Year 2 : 1000 – 1.21 = -826.45 PV

Year 4 : 4000 – 1.4641 = 2732.05 PV

27
So 2735.54 – 2732.05= - 3.48

At 10% interest rate NPV = 3.48 So IRR is about 10%

2.c Discounted Pay back Period:

o In this method, the features of the above two concepts are combined and
used.
o First cash inflows are discounted at the cost of capital rate & then after
finding the cumulative discounted cash flows ( as per previous e.g.) the
payback period is arrived at which is much more reliable than the payback
period.

2.d Cost Benefit Ratio/Profitability Index:

PI = Present value of inflows

-------------------------------- x100
Present value of outflows

If the NPV is zero, PI will be equal to 1

3. Accounting Rate of Return:-

o It is known as the accounting rate of return as it considers only the
accountants’ profit. i.e., profit after depreciation and tax.
o It is also called average rate of return as it considers the average profit after
depreciation and tax.
o Also known as Return on Investment or Return on Capital employed.
o It is impossible to understand IRR without NPV.
o NPV is the sum of all cash flows at a discount rate that represents your
alternative investment potential.

Average Annual Profit after Tax

ARR = ------------------------------------------ x 100
Average Investment
Initial Investment + Salvage Value
Average Investment = -----------------------------------------------
2
COSTING

 Cost means the amount of expenses (actual or notional ) incurred on or attributable to

specified thing or activity.
 ICWA – cost is measurement in monetary terms of the amount of resources used for the
purpose of production of goods or services.
 Elements of cost
o 1. Material
o 2. Labour
o 3. Expenses
 1. Material : All material which become an integral part of finished product and can be
conveniently assigned to specific physical unit termed as Direct.
o Direct : Can be easily identified and related to specific product, job or process.

28
 o Indirect: Can not be easily identified. Consumables, stores, oil, printing, stationery,
fuel for boiler.
 2. Labour: Human resources are termed as labour.
o Direct : takes active and direct part in the production of a commodity. Easily
identifiable to product, job or process. This is also known as direct wages,
manufacturing wages. Direct labour varies directly with volume of output.
o Indirect: can not be easily identified to a product, job or process. Not engaged in
the conversion of raw material into finished product. Used in office, factory, gate,
marketing, etc.
 3. Expenses: All costs incurred in the production of finished goods other than material cost
and Labour cost.
o Direct: Expenses which are directly, easily and wholly allocated to specific cost
centers or units.
 They are also known as chargeable expenses. E.g., cost of special designs,
inward carriage, freight charges, etc.
 Cost center is a location, person, or item of equipment or group of these for
which costs may be ascertained and used for the purpose of cost centers.
o Indirect : Can not be directly, easily allocated to specific cost centers.
 All indirect costs other than indirect material and indirect labour are treated
as part of overheads. E.g. rent, taxes of building, repair, insurance and
depreciation.
 Overheads. – Overhead is the aggregate sum of indirect material, indirect labour and
indirect expenses. ( three categories)
o Factory / production overheads.
o Office and Administration overheads
o Selling & Distribution overheads.
 Factory overheads=
o Indirect material = Grease, oil, lubricants, cotton waste
o Indirect Wages = Salary of factory manager, clerks, storekeeper, salary of directors,
ESI, PF, etc.
o Indirect Expenses = rent for factory, insurance, taxes(municipal) power, fuel,
telephones( factory)
 Office & Administration overheads
o Related to management and administration, printing, stationery, postage, office
manager salary, clerks, telephone, furniture, office lighting, etc
 Selling & Distribution overheads
o Marketing of a product, order booking, dispatch, salary and wages of sales people,
advertisement, bad debts, TA, etc.
o Cost of packing material
o Vehicle maintenance ( delivery ) expenses.
 CLASSIFICATION OF COSTS:
 On cost behaviour basis.
o Fixed:
 remains constant within a given period of time irrespective of fluctuations in
production.
 Per unit cost varies with the change in the volume of production ( rent,
depreciation, salary)
o Variable:

29
  Cost which vary directly in proportion to the change in volume of production
( direct material, direct labour and direct expenses, variable overheads)
o Semi-Variable: both fixed and variable component and partly affected by
fluctuations in the level of activity.
 E.g. telephone expenses for which rent portion is fixed and call charges may
vary.
 Opportunity Cost is the benefit forgone as a result of pursuing one course of action rather
than pursuing the best alternative course of action.
o The opportunity costs are always relevant. For, they reflect the choice of
alternatives to arrive at a decision.
o For each alternative course of action, one needs to study the net relevant cost or
benefit before making a recommendation. It’s an imputed cost reflecting the
greatest benefit forgone as a result of using a particular alternative course of
action.
o If the net benefits of 3 different alternative courses of action are ` 5000, ` 7500 and
` 3500. If the alternative 2 is chosen, it means the benefit of the next best
alternative (` 5000 in this case) is forgone.
o Thus the opportunity cost of selecting 2nd alternative is ` 5000. Although notional
in nature, it helps management to decide a course of action more conservatively.

 Marginal Cost is an amount by which aggregate costs change if volume of output is

increased or
decreased by one unit.
o It follows from this that the marginal cost resembles to a variable cost.
o If only one additional unit is to be produced, it is necessary to incur only variable
costs as fixed costs do not change with the change in output levels.
o Thus marginal cost is also defined as cost of producing one additional unit. This is
explained later in this study material.
o Marginal Costing represents the increase or decrease in total cost, which occurs
with a small change in output
o Variable cost represents marginal cost.
o Marginal costing is a technique of costing in which allocation of expenditure to
production is restricted to those expenses which arise as a result of production.
E.g., material, direct labour expense. Fixed overheads are excluded.
 Marginal cost is = marginal cost of a product = its variable cost..
o It is variable costs charged to cost units and fixed cost of the period is written off in
full against the aggregate contribution.
o Contribution is the profit before recovery of fixed cost.
o Based on “ To a given volume of output, additional output can normally be
obtained at less than proportionate cost”
o MC is also defined as the cost of one more or one less unit produced besides
existing level of production.
o MC is not a method of costing but a technique of presentation of sales and cost
data for managerial decision making.
o Marginal cost is another term for a variable cost.
 Formula of MC : contribution = Sales – Variable cost. The contribution what
ever will slowly take care of fixed cost.

30
MARGINAL COSTING –
 In general marginal cost is variable cost. It is the cost of producing one additional unit of
product.
o Take for example, Variable cost per unit is ` 25, Fixed cost for the month are `
50,000, Present volume of activity is 1,000 units of production.
o At this volume what is the total cost? It will be Variable cost (25*1000) + fixed cost
(50,000) = ` 75,000.
o Now if it is decided to produce 1 unit more. What will be the total cost?
o It will be Variable cost (25*1001) + fixed cost (50,000) = ` 75,025. (fixed cost will not
change)
o Or if it is decided to reduce the production by 1 unit. What will be the total cost?
o It will be Variable cost (25*999) + fixed cost (50,000) = ` 74975. (fixed cost will not
change)
o What do we notice here? The total costs in both situations have changed by an
amount
exactly equal to the variable cost of 1 unit. This is called as marginal cost.
o Here, the change in the level of output would mean either increase or decrease by
1 unit.
o In the above example when the production was increased by one unit, the
aggregate costs changed from ` 75,000 to ` 75,025 i.e. increased by ` 25. When
production was reduced by 1 unit the aggregate costs changed from ` 75,000 to `
74,975 i.e. reduced by ` 25.
o Hence the figure of ` 25 per unit is called the marginal cost of the product.
o A point to note here is the behaviour of fixed costs. Just because the volume has
changed, the fixed costs have not changed. They remain at ` 50,000. They will
remain so within the relevant range of volume of activity.
o It can be observed that when decisions about the volume of activity are to be made
the manager must understand the impact of such decision on the costs. He would
rather concentrate on the variable costs and try to control them, as none of his
decisions would influence the fixed costs.
o Now let us see the definition of marginal costing.
o Marginal costing is defined as ‘the ascertainment, by differentiating between fixed
and variable costs, of marginal costs and of the effect of changes in the volume of
output.’
o It comprises of the ascertainment of marginal cost for the purpose of
understanding the effect of changes in the level of output. This technique
advocates charging of variable costs to cost units and fixed costs for the period to
the profit and loss account.

APPLICATION OF MARGINAL COSTING FOR DECISION MAKING

 Decision making means choosing or selecting a course of action from a given set of
alternatives.
o Application of marginal costing plays a very significant role in this regard
particularly for managerial decisions.
o Fixation of Selling Price:
 The techniques of marginal costing is very useful in fixation of selling prices
of product, particularly in case of a multi-product company as the fixed
overhead, under the circumstances, is not an excessive one.

31
  During trade depression or acute competition or exploring foreign markets,
pricing of the product may be fixed at below the total cost for some time.
The price should be fixed in such a manner that the same will cover the
managerial cost plus a certain amount of fixed overhead.
o Make or Buy Decisions:
 Decisions depends on the comparing the market price of the component
and the marginal cost of producing the component by the company.
 if outside market price is more in comparison with the marginal cost of the
component, then it is profitable to purchase the component.
 In short, if the marginal cost of the component is lower than the purchase
price it may be suggested to produce that article is the factory itself.
o Shut-down or continue decision:
 Sometimes, it becomes necessary to stop production due to: (i) lack of
funds; (ii) shortage or irregular supply of raw materials; (iii) labour troubles
etc.
 This shut down is practically temporary in nature and start its function as
soon as condition improves.
o Accepting Additional Orders and exploring Foreign Market:
 Sometimes the firm is not working at its full capacity, there remains more
spare capacity which can be used for carrying extra revenue or extra
contribution, although at present capacity is used without increasing the
fixed overheads, existing fixed cost per unit will decrease by the additional
production which earn extra contribution.
 No doubt, there will increase the amount of total profit i.e. fixed overheads
are fully recovered. For this purpose, the firm may accept additional order
from outsiders or explore foreign markets to boost up its sells.
o Diversification of Products:
 Sometimes a firm may introduce a new product in the market along with
the existing one to capture increased market share. Whether the said new
product will be a profitable one or not depends on the contribution per unit
of a product and the fi ed overhead.
 Usually, fixed overhead is recovered against the existing products, so the
cost of new products will include only the marginal/ variable cost. As such,
whatever will be the contribution the same will be treated as revenue.
 But, if any extra fixed overhead has to be incurred for such new product, the
same must carefully be considered.
 Whenever the question of diversification of product will arise, it may be
assumed that there will not be any additional fixed cost. Whether, the
diversification of product is profitable or not, it depends on its contribution.
 If there is negative contribution, question of diversification of product
should not arise.
o Alternative Course of Action:
 If there are more alternative course of action regarding the manufacture of
a product, the management has to face a decision-making problem.
 The problem can be solved by the application of Marginal costing.
 The solution of such a problem depends on the contribution. In short, the
alternative which will present highest contribution should be selected and
vice – versa i.e. the alternative which will yield lowest contribution will be
rejected.

32
HOW COST REDUCTION HAPPENS:

 By using suitable techniques like

o Value engineering
o Work study
o Standardization and simplification
o Variety reduction
o Market research
o Job evaluation
o Improvement in design
o Mechanization and automation.

INVENTORY:
o Inventory refers to the stockpile of production of firm is offering for sale and the
components that make up the production.
o Inventory constitutes most significant part of current assets.
o In India
 57% of current assets.
 60% in CPSUs.

o Ideally, inventory shall be in the range of 10-20% without any adverse effect on
production or sales.
o Maintenance of inventory means
 Blocking of funds
 Involves interest
 Opportunity cost to the firm
 Cost of store building
 Insurance
 Obsolescence
o In Japan, JIT is adopted.
 As and when needed, components, material are delivered by suppliers
directly at assembly point that too only for 3-4 hours requirements at a
time.
o Objectives of Inventory Management
 Primary:
 To minimize the possibility of disruption in the production schedule
for want of raw material to production
 To keep down capital investment in inventories.
 Secondary:
 Maintain sufficient stock of raw material
 Ensure continuous supply of material to production
 Minimize the carrying cost
 Maintain sufficient stock of finished products
 Minimize the investment in inventories
 Protect the inventory ( deterioration, obsolescence and
unauthorized use)
o Inventory control is concerned with the system of acquisition, storage, handling and
use of inventories to ensure the availability of inventory whenever needed,

33
 providing adequate provision for contingencies, deriving maximum economy and
minimize waste and loss.
o In short, an inventory control system is to secure the best balance between too
much and too little.
o Control of Inventory:
 ABC analysis
 Fixation of norms
 Re-order points

ABC ANALYSIS
o ABC analysis or ‘selective control’ is a technique whereby the measure of control
over an item of inventory varies directly with ‘its usage value’. In other words, the
high value items are controlled more than the items of low value.

o This method is known as “Always Better Control or the Alphabetic Approach”.

o Techniques of inventory costing like EOQ and stock levels are to be set up for the
items individually. Setting up of these is a very complex task. Is it always worthwhile
to adopt an extensive control mechanism for all items? The cost of control should
not be more than the cost of item itself.
o ABC method is an analytical method of inventory control which aims at
concentrating efforts in those areas where attention is required the most. It is not a
control technique in the stricter sense of the term but it provides a sound basis to
decide the degree of control required. It is based on the principle of “vital few
trivial many”.
o Empirical studies have revealed that in any organisation that uses materials (which
refers to all physical items) there are only a few items that together constitute a
very high value of consumption and there are a very large number of others which
have a very small value of consumption.
o The ABC method uses this phenomenon as its logical bases and recommends
stricter & detailed controls for the ‘high value – low number items’ and relatively
less stringent controls on “low value – high volume’ items.
o Generally the
o ‘high value – low number items’ are classified as “A” category and
o “low value – high volume items’ are classified as “C” category,
o while “moderate value – moderate volume items” constitute “B” category.
o Different organisations may use different variables when measuring ‘volume’ here.
These variables could be:
 (a) Value of stock held on an average
 (b) Value of consumption
 (c) Critical nature & requirement of inventory item
 (d) Availability based on seasons, restrictive production governed by law
o Irrespective of the value of items, items which are critical could be classified as ‘A’.
The ABC classification process is an analysis of a range of items, such as finished
products or customers into three categories:
o A - outstandingly important; B - of average importance; C - relatively unimportant
as a basis for a control scheme. Each category can and sometimes should be
handled in a different way, with more attention being devoted to category A, less
to B, and less to C.

34
 o Consider an engineering industry that uses steel to fabricate parts of a pressure
vessel. These parts are then welded together to produce a vessel. The welding wire
is a very less costly item but the supply & availability of the wire very critical for if it
is not in stock the inventory of high cost parts fabricated will start mounting. Thus
in such case the welding wire will also constitute as ‘A’ class item.
o The ABC technique resembles to Pareto analysis that owes its existence to Vifredo
Pareto, an Italian economist of the nineteenth century. He observed that 80 % of
the wealth was in the hands of 20% people.
o The bifurcation of the stock items could follow the following break up:
 A - 10- 70
 B - 20 - 20
 C - 70 - 10

o Advantages of ABC Techniques:

 (a) This approach enables a selective control so that efforts can be
concentrated only where required.
 (b) It reduces clerical and administrative costs of managing inventory.
 (c) Investment in inventory can be regulated to ensure optimum utilisation
of funds.
 Application of ABC in deciding stock control systems could be done as
follows:
 For A Items: Very strict control
 Very low level of safety socks
 Controlled by senior management
 Rigorous follow up & planning
 For B Items: Moderate control
 Some level of safety stocks
 Less frequent follow up
 For C items: A broad level control
 High safety stocks
 Follow up only in exceptional cases.

 Modern Techniques of Inventory Control

o The inventory control methods and techniques have been evolving in different
parts of the world. These have emerged out of necessity and ever changing
conditions of business environment.
o The newly developed techniques are more of management control systems rather
than only inventory related control mechanisms. But their application to field of
inventory management is done very effectively.
o The basic principle of these techniques is reduction in wastage, removal of non-
value adding activities and time management.
o Japan was mainly responsible for intruding many of these path breaking
techniques.
o Many countries have adapted these techniques to various countries. Let us see
some of these.
 (a) Just in Time (JIT)
o It is an approach and not a system. The approach is “inventory is a waste”.
o This waste must be reduced to earn a better return on investment.

35
 o It talks about interlocking of production process not only of an organisation but also
of its suppliers and customers; so that an item should not be waiting for an action
at all.
o A raw material when arrives, should not stored but directly taken to production
line where the machines are already set up to process that material.
o Similarly, when production is finished, the item should not be waiting to be
dispatched, it should be immediately loaded for shipment. The crux is the
arrangement of entire logistics on an ongoing basis.
o Although first adopted in Ford Motor Company in 1920s, the adoption of JIT by
Toyota Corporation of Japan was so effective in the 1950s that it started getting
known as a Japanese technique. With the help of kanban i.e. early signal systems
for small improvements, lean manufacturing methods, MAN (material as needed),
ZIPS (zero inventory production system) and such other variants of waste reduction,
the JIT system became a very successful tool for manufacturing sector.
o The philosophy of JIT is to reduce the throughput time (i.e. time between the first
stage of production to the point where finished product is complete). There is a
drastic reduction in inventory holding costs and improves productivity. The
throughput time is a sum total of Added value time and non-added value time.
o The aim is to eliminate the non-value added time which is basically the time taken
in waiting either for movement or inspection or set up.
o It basically involves Just-In-Time-Purchasing and Just-In-Time-Production. The JIT
purchase channelizes the purchasing in such way as to deliver the material
immediately preceding the demand for material.
o This will reduce the level of inventory. The success of this largely depends upon
how well the partnership with suppliers works. The processes of suppliers will have
to closely align with the organisation processes.
o The production planning data is shared with the suppliers to enable them to
schedule their production.
o Procurement contracts are done with staggered deliveries. This also reduces
paperwork and other administrative costs. The ordering is done in tune with the
fluctuations in demand unlike traditional model of EOQ that assumes existence of a
constant demand.
o The JIT production applies to the production at all intermediary stages as well i.e.
including parts, semi-finished goods, sub-assemblies etc. The operations are
planned & scheduled with the intent of zero waiting time at all stages. The
machines are kept running without stoppage. This helps drastic reduction in the
work in process inventories and also the throughput time.
o For successful application of JIT the pre-requisites are:
 Robust computerised systems
 Perfect planning system
 Trained workers and staff
 Excellent logistics
 Transportation facilities
 (b) Bar Coding and RFID Tools
o In modern days with revolution in the fields of electronics new tools have been
developed that assist the organisations to track the physical movement of goods.
These are quite useful not only in mass manufacturing companies but also in retail
sector like shopping malls, and super- markets etc.

36
 o The bar code is a computer generated code that stores information about the item.
Bar Coding is a series of parallel vertical lines (bars and space), that can be read by
bar code scanners. It is used worldwide as part of product packages, as price tags,
carton labels, on invoices even in credit card bills and when it is read by scanners, a
wealth of data is made available to the users and when used with GS1.UCC (Global
India one Numbering Uniform Code Council Inc. USA) numbering system.
o The bar code become unique and universal and can be recognized anywhere in the
world. Bar coding is an international concept today. It facilitates unique product
identification through using international symbols/numbering system, promotes
brand image and would enable timely and accurate capture of product information.
o This would result in wide ranging benefits including lowering of inventory costs,
lower overall supply chain costs and hence reduced costs for Indian products,
increasing efficiency of Indian industry and adherence to stringent quality
assurance norms through product traceability.
o Radio Frequency Identification (RFID) allows a business to identify individual
products and components, and to track them throughout the supply chain from
production to point-of-sale. It helps reduce overstocking or under-stocking.
o An RFID tag is a tiny microchip, plus a small aerial, which can contain a range of
digital information about the particular item. Tags are encapsulated in plastic,
paper or similar material, and fixed to the product or its packaging, to a pallet or
container, or even to a van or delivery truck. The tag is interrogated by an RFID
reader which transmits and receives radio signals to and from the tag. Readers can
range in size from a hand-held device to a “portal” through which several tagged
devices can be passed at once, e. g. on a pallet. The information that the reader
collects is collated and processed using special computer software. Readers can be
placed at different positions within a factory or warehouse to show when goods are
moved, providing continuous inventory control.

INCOME TAX IN INDIA:

 In India, Income tax was introduced in 1860.
o Income Tax Act 1961 – w.e.f 1.4.1962
o Income Tax Act consists;
 Income Tax acts.
 Income tax rules
 Finance Act
 Circulars, Notifications.
 Finance Act:
o Every year, Finance ministry presents budgets to the Parliament and once the
Finance bill is approved, it becomes Finance Act.
 Income Tax Rules:
o The Administration of direct taxes is looked after by Central Board of Direct Taxes
and they frame rules – Income Tax Rules 1962.

 Definitions:
o Assessment year: Period from April to March – income of previous year of an
assessee is taxed during the assessment year at the rates prescribed by Finance
Act.

37
 o Previous Year : income earned in a particular year is taxable in the next year. The
year in which income is earned is known as previous year and the next year is
assessment year.
o Person.
 The term person includes.
 An individual
 A Hindu Undivided Family ( HUF)
 A company
 A firm
 An association of persons or a body of individuals whether incorporated or
not.
 A local authority
 Every artificial judicial person.
o Assessee: every person assesseable under this act.
o Deemed Assessee: A person who is deemed to be an assessee for some other
person.
o Assessee in default: when a person is responsible for doing any work under IT act
and he fails to do it.
 Exceptions to the general rule that previous year’s income is taxable:
o Income of NRI from shipping.
o Income of persons leaving India
o Assessment of (Association of persons) AOP/BOI ( body of individuals) or AOP
formed for a particular event of purpose.
o Persons likely to transfer property to avoid tax
o Income of a discontinued operations.
 Residential Status:
o Tax incidence on an assessee depends on his residential status.
o The residential status of an assessee is determined with reference to his residence
in India during the previous year.
o Residential status of an individual – as per Sec. 6 – an individual may be
 Resident and ordinarily resident in India
 Resident but not ordinarily resident in India or
 NRI.
o BASIC CONDITIONS:
 = He is in India in the previous year for a period of 182 days or more OR
 = He is in India for a period of 60 days or more during the previous year and
has been in India for a period of 365 days or more during 4 years
immediately preceeding the PY.
 NOTES:
 In the following 2 cases, an individual need to be present in India for a
minimum 182 days or more in order to become resident in India.
 1. An Indian citizen who leaves India during the PY for the purpose of
taking employment outside India or an Indian citizen as crew of ship.
 2. An Indian citizen or POIO ( Persons of Indian Origin) who comes in
visit to India during PY.
o Additional conditions:
o 1. He has been resident in India in atleast 2 out of 10 PY.
o 2. He has been in India for a period of 730 days or more
during 7 years.
38
 RESIDENT: An individual is said to be resident in India if he satisfies any one
of the basic conditions.
 1. Resident & ordinarily Resident:- An individual is said to be resident
and ordinarily resident in India if he satisfies any of the basic
condition and both of the additional conditions.
 2. Resident but not ordinarily Resident:- An individual is said to be
resident but not ordinarily resident in India if he satisfies any one of
the basic conditions but not satisfies both additional conditions.
 3. Non-Resident:- An individual is a non-resident if he satisfies none
of the basis conditions.
o Heads of Income:
 Income of a person is classified into 5 categories.
 Income belonging to a particular category is taxed under a separate
head of income
 They are;
o Income under the head salaries- Any remuneration paid by
an employer to an employee in consideration of his services.
It includes monetary benefits and facilities.
o Income from house property- Conditions are :
 assessee must be owner of the property
 Composite rent is to be spilit - Owner may receive
rent in respect of building as well as other
services/assets like furniture, etc and it should be
spilit. The sum attributable to use of property ( house)
assessed as income from house property.
 The sum attributable to use of services – taxable
under head profit & gains of business or profession in
income from other sources.
 Determination of annual value. ( 3 steps)
 Determination of gross annual value.
 Form GAV deduct municipal tax paid by owner
during PY
 Balance will be NAV
 Where as assessee own more than one house-
one for self, then at the option of assessee
income of the other property will be assessed (
annual value will be nil for the self occupied
property) and the unoccupied property will be
deemed to be let out.
 Deductions form annual value.
 30 % of NAV &
 Interest on borrowed capital
o Profits and gains from business or profession
o Capital gains
o Income from other sources
 What is Minimum Alternate Tax.
o All companies having book profits under the Companies Act shall have to pay MAT
@ 18.5%.

39
 o Minimum amount of tax to be paid by a company – if the income tax payable as per
IT act is less than 18.5% of book profit, then such book profit id deemed as total
income and pay 18.5% on book profit.
o No tax payer with substantial income can avoid tax liability using exclusion,
deductions and incentives.
o A company is liable to pay tax on the income computed in accordance with
provisions of IT act.
o But P&L account is prepared as per provisions of Companies Act.
o Depreciation allowable under IT act is not the same with Companies act.
o MAT introduced w.e.f 1997-98
o MAT paid can be carried forward and set-off (adjustment) against regular tax
payable during subsequent 5 year period subject to certain conditions.
o MAT is applicable to all companies except infrastructure & power sector
companies, income arising from free trade zones, charitable activities, investment
by venture capital companies.
o E.g.. book profit before depreciation of a company is Rs. 7 lakhs

- After claiming depreciation, other exemption , gross income Rs. 4 lakhs

- The income tax applicable ( 30%) Rs. 1.2 lakhs
- However, MAT would be ( 18.5% on Rs. 7 lakhs) Rs. 1.295 lakhs.

 What is Wealth Tax.

o If the value of personal assets you own exceeds Rs. 30 lakhs ( assets minus liabilities
incurred to acquire the assets).
o WT targets unproductive, non-essential and idle assets.
o 1% of the amount that exceeds Rs. 30 lakhs limit.
o WT - exempted for one home.
o Vehicles, jewellery, cash in hand in excess of Rs. 50000/-

 Agricultural Income tax.

o As per IT act sec. 3, which exempts,
o Rent received from land used for agriculture
o Income attributable to a farm house.
o Any income derived from agriculture operations.

 Gift Tax.
o Any gift received in cash or kind exceeds Rs. 50000/-
o Gift received from specified relatives – no tax irrespective of value.
 Securities Transaction Tax.
o STT on buying or selling of shares on stock exchanges or transactions on Mutual
funds.

 Capital Gains tax.

o Tax levied on profit or gain made on sale of a capital asset such as shares, house,
commercial property, long term capital gains@ 10% and short term at par with IT
rates .

 Dividend Distribution tax.

40
 o Dividends are tax free in the hands of investors but the entity distributing dividends
to investors pays DDT to Govt.

Ex-
zeros Quotation US dollars Rate Indian Rupee Qutoation million billion trillion

0 one 1 60 60 sixty 0 0 0

1 ten 10 60 600 6 hundred 0 0 0

2 1 hundred 100 60 6000 6 thousand 0 0 0

60
3 1 thousand 1000 60 60000 thousand 0 0 0

4 10 thousands 10000 60 600000 6 lakhs 0.6 0 0

5 1 lakh 100000 60 6000000 60 lakhs 6 0 0

6 10 lakhs 1000000 60 60000000 6 crores 60 0 0

7 1 crore 10000000 60 600000000 60 crores 600 0.6 0

8 10 crores 100000000 60 6000000000 600 crores 6000 6 0

9 100 crores 1000000000 60 60000000000 6000 crores 60000 60 0

60000
10 1000 crores 10000000000 60 600000000000 crores 600000 600 0.6
6 lakhs
11 10000 crores 100000000000 60 6000000000000 crores 6000000 6000 6
60 lakhs
12 1 lakh crore 1000000000000 60 60000000000000 crores 60000000 60000 60
600 lakhs
13 10 lakh crore 10000000000000 60 600000000000000 crores 600000000 600000 600
6000 lakhs
14 100 lakh crore 100000000000000 60 6000000000000000 crores 6000000000 6000000 6000
Alternative
zeros terms

6 1000000 10 lakhs 1 million

7 10000000 1 crore 10 million

8 100000000 10 crore 100 million 0.1 billion

9 1000000000 100 crore 1000 million 1 billion

10000
10 10000000000 1000 crore million 10 billion
100000 0.1
11 100000000000 10000 crore million 100 billion trillion
1000000
12 1000000000000 100000 crore million 1000 billion 1 trillion

41