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Accounting and Auditing

Accounting – It is an art of recording, classifying and summarizing in
significant manner and in terms of money, transactions and events
which are in part, at least of financial character and interpreting the
result thereof.”

Characteristics of Accounting-

1) Accounting is science as well as an art.

2) It analyses the results of all transaction in detail.

3) All transactions and events are recorded in monetary terms.

4) It maintains complete, accurate, permanent and legible records of

all transaction in systematic manner.

5) Comparability.

6) Relevance- The information should be relevant in order to

influence the economic decisions of users by helping them to
evaluate the events at all times. It has bearing on decision making
by helping investors, creditors and other users to evaluate past
and future events.

7) Reliability- It relates to the confidence in the accounting

information in the sense that the information must faithfully
represent what it intends to present, It must be factual.

8) 7) Understandability- the concept that financial information

should be presented so that a reader can easily comprehend it.

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Objectives of Accounting-
The objectives of accounting can be given as follows-

a) Systematic recording of transaction- Basic objective of

accounting is to systematically record the financial aspects of
business transactions i.e., book-keeping. These recorded
transactions are later on classified and summarized logically for
the preparations of financial statements and for their analysis and
interpretation.
b) Ascertainment of results of above recorded transaction-
Accountant prepares profit and loss account to know the results
of business operations for a particular period of time. If revenue
exceeds expenses then it is said that business is running under
loss. The profit and loss account helps the management and
different stakeholders in taking rational decisions.
c) Ascertainment of financial position of the business- Businessman
is not only interested in knowing the results of business in terms
of profit or loss for a particular period but is also anxious to know
that what he owes (liability) to the outsiders and what he owns on
a certain date. To know this, accountant prepares a financial
position statement popularly known as Balance Sheet. The
balance sheet is a statement of assets and liabilities of the
business at a particular point of time and helps in ascertaining the
financial health of the business.
d) Providing information to the users for rational decision- making-
Accounting as a language of businesses communicates the
financial results of an enterprise to various stakeholders by means
of financial statements. Accounting aims to meet the information
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needs of the decision makers and helps them in rational decision-

making.
e) To know the solvency position- By preparing the balance Sheet,
management not only reveals what is owned and owned by the
enterprise, but also it gives the information regarding concern’s
ability to meet its liabilities in the short run(liquidity position) and
also in the long run(solvency position) as and when they fall due.

Types of Accounts

a) Personal Accounts-

• It includes Natural Person i.e., Ram, Sita, etc.

• It includes Artificial Person i.e., person created by law and winding

up by law. Eg- Videocon A/c, charitable trusts A/x, etc.

• It includes Liabilities i.e, It represents amount of money that the

business owes to the other parties. Eg- When goods are bought
on credit etc.

• It also includes ‘Accrual, outstanding, Advance, Unearned’

incomes and expenditure, it is said to be Personal Accounts

b) Real Accounts-

• These account types are related to assets or properties. They are

further classified as Tangible real account and Intangible real
accounts.

Tangible Real Accounts

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These include assets that have a physical existence and can be touched.
For example – Building A/c, cash A/c, stationery A/c, inventory A/c,
etc.

Intangible Real Accounts

These assets do not have any physical existence and cannot be touched.
However, these can be measured in terms of money and have value. For
Example – Goodwill, Patent, Copyright, Trademark, etc.

c) Nominal Accounts-

• These accounts are related to expenses or loses and incomes or

gains.

• Eg- rent is paid to landlord, Salary paid, etc.

Accounting Principles (Standards)

It includes those basic assumptions or conditions upon which the
science of account is based.

➢ To avoid confusion and to achieve uniformity, accounting process

is applied within the conceptual framework of “Generally
Accepted Accounting Principles” (GAAPs)

➢ The term GAAPs is used to describe rules developed for the

preparation of the financial statements and is called concepts,
conventions, postulates, principles etc.

Nature and characteristics of Accounting Principles-

a) These accounting principles are man- made.

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b) These principles are not universally applicable.

c) They are designed to make accounting data provide objectivity,

application, usefulness and simplicity to its users.

Kinds of accounting principles

a) Accounting Concepts or Consumptions or Postulates

b) Accounting Conventions

Separate Entity Concepts-

❖ It is also known as Business Entity Concept.

❖ In Accounting business is considered to be separate entities form

the proprietor. This concept is applicable to all business firms.

❖ Entity concept means that the enterprise is liable to the owner for
capital investment made by the owner. Since the owner invested
capital, which is also called risk capital he has claim on the profit
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of the enterprise. A portion of profit which is apportioned to the

owner and is immediately payable becomes current liability in the
case of corporate entities.

❖ Eg- In a monopoly firm or in partnership business, through

partners or individuals are not considered as separate entities in
the eyes of law, but for accounting purposes the will be
considered as separate entities.

❖ All the transaction of the business is recorded in the point of view

of business.

❖ The personal assets of the owners or shareholders are not

considered while recording and reporting the assets of the
business entity.

Going Concern Concept-

❖ According to this concept it is assumed that the business will

continue for a fairly long time to come.

❖ It should be noted that the ‘going concern concept’ does not

imply permanent continuance of the enterprise.

❖ It is on this concept that a clear distinction is made between

assets and expenses. Fixed assets are valued on the basis of cost
less proper depreciations keeping in mind their expected useful
life.

❖ If it is certain that a business will continue for a limited period,

then the accounting records will be kept on the basis of expected
life of business.
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❖ If the assumptions of the going concern are not valid, the financial
statements should clearly state these facts.

Money measurement Concept-

❖ Accounting records only monetary transaction events or

transactions which can’t be measured in money is not included in
accounts books.

❖ Non- monetary events like, death, disputes, efficiency etc., are

not recorded in the books even though these may have great
effect on the accounting records.

❖ This concept ignores that money is an inelastic yardstick for

measurement as it is based on the implicit assumption that
purchasing power of the money is not of sufficient importance as
to require adjustment. Also, many material transactions and
events are not recorded in the books of accounts just because it
cannot be measured in monetary terms. Therefore it is recognized
by all the accountants that this concept has its own limitations
and inadequacies. Yet it is used for accounting purposes because
it is not possible to adopt a better measurement scale.

❖ Eg- Efficient and trusted employee is an asset for the company but
they do not find place in accounts book, although they are useful.

Cost Concept-

❖ It is also known as Historical Cost Concept.

❖ An asset is ordinarily entered in the accounting records at the

price paid to acquire it.
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❖ This cost is the basis for all subsequent for all subsequent
accounting for the assets.

❖ Cost concept is not much relevant for investors and other user
because they are more interested in knowing what the business is
actually worth today rather than the original cost.

❖ However, the cost concept creates a lot of distortion too as

outlined below:

a) In an inflationary situation when prices of all commodities go

up on an average, acquisition cost loses its relevance. For
example, a piece of land purchased on 1.1.1995 for Rs 2000
may cost Rs 100,000 as on 1.1.2011. So if the accountant
makes valuation of assets at historical cost, the accounts will
not reflect the true position.
b) Historical Cost- based accounts may lose comparability. Mr X
invested Rs 100,000 in a machine on 1.1.1995 which produces
Rs 50,000 cash inflow during the year 2011, while Mr Y
invested Rs 5, 00,000 in a machine on 1.1.2005 which produced
Rs 50,000 cash inflows during the year. Mr X earned at the rate
20% while Mr Y earned at the rate 10%. Who is more efficient?
Since the assets are recorded at the historical cost, the results
are not comparable. Obviously it is corollary to (a)
c) Many assets do not have acquisition costs. Human assets of an
enterprise are an example. The cost concept fails to recognize
such asset although it is very important asset of any
organization.

Dual Aspects Concepts-

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❖ Every business transaction has a dual effect.

❖ This concept expresses the relationship that exists among assets,

liabilities and the capital in the form of an accountancy i.e.,

Assets= Liabilities + Capital

❖ This is also referred to as “Balance Sheet Equation Concept”.

❖ Every concept or event has two aspects:-

a) It increases one Asset and decreases other Assets.

b) It increases an Asset and simultaneously increases Liability.
c) It decreases one Asset, increases another Asset.
d) It decreases one Asset, decreases a Liability Alternatively.
e) It increases one Liability, decreases other Liability
f) It increases a liability, increases an Asset
g) It decreases Liability, increases other Liability
h) It decreases Liability, decreases an Asset.

Accounting Period Concept-

❖ According to this concept, the life of a business is divided into

appropriate segments for studying the results shown by the
business after each segment.

❖ Ex- Annual, Semi-Annually or Half yearly and Quarterly etc

Periodic Matching of Costs and Revenue Concept-

❖ The objective and motive of business is to earn profit.

❖ As per going concern concept and indefinite life of the entity is

assumed. For a business entity it causes inconvenience to
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measure performance achieved by the entity in the ordinary

course of business.

❖ In order to determine the profit earned or less suffered by the

business in particular defined accounting period, it is necessary
that expenses should be matched with the revenue of that period.

❖ According to this concept, adjustments should be made for all

outstanding expenses, accrued incomes, unexpired expenses and
unearned incomes etc., while preparing final accounts at the end
of accounting period.

❖ Thus, the periodicity concept facilitates in:

a) Comparing of financial statements of different periods

b) Uniform and consistent accounting treatment for ascertaining
the profit and assets of the business.
c) Matching periodic revenues with expenses for getting correct
results of the business operations.

Realization Concept-

❖ Also known as Revenue Recognition Concept

❖ According to this concept revenue is recognized when a sale is

made.

❖ Revenue is the gross inflow of cash arising forms the sales of

goods and services.

❖ Incomes such as rent, interest, commission, etc, these are

recognized on a time basis.

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❖ Now-a- days the revaluation of assets has become a widely

accepted practice when the change in value is of permanent
nature. Accountants adjust such value change through creation of
revaluation (capital reserve).

❖ Thus the going concern, cost concept and realization concept

gives the valuation criteria.

Accrual Concept-

❖ Accrual means recognition of revenue and costs as they are

earned or incurred and not as money is received or paid. The
accrual concept relates to measurement of income, identifying
assets and liabilities.

❖ It is the most fundamental principle of accounting which requires

recording revenues when they are earned and not when they are
received in cash, and recording expenses when they are incurred
and not when they are paid.

❖ It is not necessary that there is an immediate settlement in cash

for any transaction or event therefore accrued revenues and costs
are recognized.

❖ Business transactions are recorded when they occur and not

when the related payments are received or made.

❖ As per Accrual Concept- Revenue-Expenses= Profit.

❖ It provides the foundation on which the structure of present day

accounting has been developed.

Objective Concept-
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❖ The objectivity principle is the concept that the financial

statements of an organization be based on solid evidence.

❖ The intent behind this principle is to keep the management and

the accounting department of an entity from producing financial
statements that are slanted by their opinions and biases.

Substance over Form-

❖ It is an accounting principle used to ensure that financial

statements give a complete, relevant, and accurate picture of
transactions and events.

It is an accounting concept which means that the economic substance

of transactions and events must be recorded in the financial statement
rather than just their legal form in order to present a true and fair view
of the affairs of the entity

Accounting conventions
❖ Accounting Conventions refers to common practices which are
universally followed in recording and presenting accounting
information of the business entity.

❖ These Conventions help in comparing accounting data of different

business units or of the same unit for different periods.

Convention of Consistency-

❖ It means that same accounting principles should be used for

preparing financial statements year after year.

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❖ A meaningful conclusion can be drawn from financial statements

of the same enterprise when there is comparison between them
over a period of time.

❖ But this can be possible only when accounting policies and

practices followed by the enterprise are uniform and consistent
over a period of time.

❖ But the concept of consistency does not imply non- flexibility as

not to allow the introduction of improved method of accounting.

❖ An enterprise should change its accounting policy in any of the

following circumstances only:

a) To bring the books of accounts in accordance with the issued

Accounting Standards
b) To compliance with the provision of law.
c) When under changed circumstances it is felt that new method
will reflect more true and fair picture in the financial
statement.

Convention of Full Disclosure-

❖ It requires that all material and relevant facts concerning financial

statements should be fully disclosed.

❖ All information which is of material interest to proprietor,

creditors and investors should be disclosed in accounting
statement.

❖ Full disclosure means that there should be full, fair and adequate
disclosure of accounting information.
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i) Adequate means sufficient set of information of users

ii) Fair means equal treatment to users

iii) Full refers to complete and detailed information.

Convention of Materiality-

❖ It states that, to make financial statements meaningful, only

material facts i.e., important and relevant information should be
supplied to the users of accounting information.

❖ The materiality depends not only upon the amount of the item
but also upon the size of the business, nature and level of
information, level of the person making the decision etc.
moreover an item material to one person may be immaterial to
another person. What is important is that omission of any
information should not impair the decision- making of various
users.

❖ Materiality should be judged in relation to the profits shown by

the profit and loss account.

Convention of Conservatism-

❖ This convention is based on principle that “Anticipate no profit,

but provide for all possible losses.”

❖ The main objective of this convention is to show minimum profit.

Profit should not be overstated.

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❖ If profit shows more than actual, it may lead to distribution of

dividend out of capital. This is not fair policy and it will lead to the
reduction in the capital of the enterprise.

❖ The Realization Concept also states that no change should be

counted unless it has materialized. The Conservatism Concept
puts a further brake on it. It is not prudent to count unrealized
gain but it is desirable to guard against all possible losses.

❖ For this concept there should be atleast three qualitative

characteristics of financial statements namely,

a) Prudence i.e., judgment about the possible future losses which

are to be guarded, as well as gains which are uncertain
b) Neutrality, i.e., unbiased outlook is required to identify and
record such possible losses, as well to exclude uncertain gains.
c) Faithful representation of alternative values.

Capital Expenditure and Revenue Expenditure

❖ Capital expenditure is an expenditure which has been incurred for

the purpose of obtaining a long term benefits for the firm.

❖ It is placed on the asset side of balance sheet as it generates

benefits for more than one accounting period and will also be
transferred to profit and loss account.

❖ Some examples of Capital expenditure-

a) Cost of purchased goodwill

b) Preliminary expenditure

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c) Purchase of land, building, machinery or furniture.

d) Expenditure incurred for substitution of a new assets for an

existing assets.

e) Cost of leasehold land and building, etc

❖ Revenue Expenditure is an expenditure which arises out of and in

the course of regular business transaction of a business firm.

❖ This expenditure temporarily influences only the profit earning

capacity of the business.

❖ These are shown in the profit and loss account as their benefit are
for one accounting period i.e., in which they are incurred.

❖ Some examples of revenue expenditure-

a) Depreciation on plant and machinery

b) Rent and rates for the factories or office premises

c) Insurance premium

d) Salaries and wages paid to the employees

e) Taxes and legal expenses, etc

The Basic Consideration in distinction in determining Capital and

Revenue Expenditures.

a) Nature of business- For a trader dealing in furniture, purchase of

furniture is revenue expenditure but for any other trade, the
purchase of furniture should be treated as capital expenditure
and shown in the balance sheet as asset. Therefore, the nature of
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business is a very important criteria in separating an expenditure

between capital and revenue.
b) Recurring nature of expenditure- If the frequency of an expense
is quite often in an accounting year then it is said to be an
expenditure of revenue nature while non- recurring expenditure is
infrequent in nature and do not occur often in an accounting
year. Monthly salary or rent is the example of revenue
expenditure as they are incurred every month while purchase or
assets is not the transaction done regularly therefore, classified as
capital expenditure unless materiality criteria defines it as
revenue expenditure.
c) Purpose of expenses- Expenses for repairs of machine may be
incurred in course of normal maintenance of the assets. Such
expenses are revenue in nature. On the other hand, expenditure
incurred for major repair of the asset so as to increase its
productive capacity is capital in nature. However, determination
of the cost of maintenance and ordinary repairs which should
expensed, as opposed to a cost which ought to be capitalized, is
not always simple.
d) Effect on revenue generating capacity of business- The expenses
which help to generate income/revenue in the current period are
revenue in nature and should be matched against the revenue
earned in the current period. On the other hand, if expenditure
helps to generate revenue over more than one accounting period,
it is generally called capital expenditure.
e) Materiality of the amount involved- Relative proportion of the
amount involved is another important consideration in distinction
between revenue and capital. Even, if expenditure does not
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increase the productive capacity of an asset, it may be capitalized

because the amount is material or expenditure may increase the
asset value and yet to be expensed because the amount is
immaterial.

Deferred Revenue Expenditure

❖ It is an expenditure which is incurred during an accounting period,
but is applicable either wholly or in part to future periods.

❖ These expenses are usually large in amount and benefits are

consumed for future accounting periods too.

❖ Eg- Huge amount is spent on advertisement of new product in the

market.

❖ A thin line of difference exists between deferred expenses and

prepaid expenses. The benefits available from prepaid expenses
can be precisely estimated but that is not so in case of deferred
revenue expenses. For example, insurance premium paid say, for
the year ending 30th June, 2011 when the accounting year ends on
31st March 2011 will be an example of prepaid expense to the
extent of premium relating to three months’ period i.e. from 1st
April 2011 to 30th June 2011, Thus the insurance protection will be
available precisely for three months after the close the Year and
amount of the premium to be carried forward can be calculated
exactly.

Distinction between Contingent Liabilities and Liabilities-

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• The distinction between a liability and contingent liability is

generally based on the judgment of the management. A liability is
defined as the present financial obligation of an enterprise, which
arises from past events. The settlement of a liability results in an
outflow from the enterprises of resources embodying economic
benefits.
• On the other hand, in the case of contingent liability, either
outflow of resources to settle the obligation is not probable or the
amount expected to be paid to settle the liability cannot be
measured with sufficient reliability.
• Example of contingent liabilities are claims against the enterprise
not acknowledge as debts, guarantees gives in respect of third
parties, liabilities in respect of bills discounted and statutory
liabilities under dispute etc. In addition to present obligations that
are recognized as liabilities in the balance sheet, enterprises are
required to disclose contingent liability in their balance sheets by
ways of notes.

Distinction between Contingent Liabilities and Provisions-

Provision means “any amount written off or retained by way of

providing for depreciation, renewal or diminution in the value of assets
or retained by way of providing for any known liability of which the
amount cannot be determined with substantial accuracy.

It is important to know the difference between provisions and

contingent liabilities. The distinction between both of them are
explained as follows-

Provision Contingent Liability

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1. Provision is a present liability of

1. A Contingent liability is a
uncertain amount, which can be possible obligation that may or
measured reliably by using a may not crystallize depending on
substantial degree of estimation. the occurrence or non- occurrence
of one or more uncertain future
events.
2. A provision meets the 2. A contingent liability fails to
recognition criteria meet the same.
3- Provision is recognized when (a) 3- Contingent liability includes
and enterprise has a present present obligations that do not
obligation arising from past meet the recognition criteria
events, an outflow of resources because either it is not probable
embodying economic benefits is that settlement of those
probable and (b) a reliable obligations will require outflow of
estimate can be made of the economic benefits, or the amount
amount of the obligation. cannot be reliably estimated.

Depreciation
It is the process of allocation of cost of assets over its useful life.

 Reduction in Book Value of assets.

 Main objective of depreciation is to provide funds for

replacement of fixed assets at the end of its useful life.

 Depreciation is non-cash expenditure.

 Applicable on fixed asset not on current asset.

 Arises due to-

a) Natural wear and tear

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b) Use

c) Consumption

Objectives of Providing Depreciation-

a) To ascertain true results of operations

b) To present true and fair view of the financial position.
c) To accumulate funds for the replacement of assets.
d) To ascertain true costs of production.

Basic Terms in depreciation

❖ Historical Cost/Original Cost- Amount actually spent for

purchasing the asset.

❖ Estimated Net Residual Value- Expected Sale Value-Expenses for

making the sale/ disposal/ repairs.

❖ Depreciable Amount- Historical Value- Scrap Value

❖ Written Down Value/Book Value- Historical Cost- Depreciable till

date.

Useful life- No. of years benefit will be received

Methods of Depreciation

 Straight line Method

 Written Down Method

 Sum of Years Digit Method

 Annuity Method

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 Sinking fund Method

 Machine Hour Method

 Production Unit Method

 Depletion Method

a) Straight Line Method-

❖ It is also known as fixed installment method.

❖ In this method the value of an asset is reduced uniformly over

each period until it reaches its salvage value. Straight line
depreciation is the most commonly used and
straightforward depreciation method for allocating the cost of
a capital asset. It is calculated by simply dividing the cost of an
asset, less its salvage value, by the useful life of the asset.
𝑐𝑜𝑠𝑡 𝑜𝑓 𝐴𝑠𝑠𝑒𝑡 − 𝑆𝑐𝑟𝑎𝑝 𝑉𝑎𝑙𝑢𝑒
𝑆𝑡𝑟𝑎𝑖𝑔ℎ𝑡 𝐿𝑖𝑛𝑒 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 =
𝑢𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒
𝑆𝑡𝑟𝑎𝑖𝑔ℎ𝑡 𝐿𝑖𝑛𝑒 𝐷𝑒𝑝𝑟𝑖𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 =
𝑆𝑡𝑟𝑎𝑖𝑔ℎ𝑡 𝑙𝑖𝑛𝑒 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
= × 100
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐴𝑠𝑠𝑒𝑡
b) Written Down Value Method-

❖ Under this system, a fixed percentage of the diminishing value of

the asset is written off each year so as to reduce the asset to its
breakup value at the end of its life, repairs and small renewals
being charged to revenue.

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❖ It used to determine a previously purchased asset's current worth

and is calculated by subtracting accumulated depreciation or
amortization from the asset's original value. The resulting figure
will appear on the company's balance sheet.

❖ The rate of depreciation under this method may be determined

by the following formula-

𝑛 𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑣𝑎𝑙𝑢𝑒
1 − √( ) × 100
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡

Accounting Entries under Straight Line and Reducing Balance

Methods-

❖ There are two alternative approaches for recording accounting

entries for depreciation-
• First alternative

A provision for depreciation account is opened to accumulate the

balance of depreciation and the assets are carried at historical cost

Accounting entry-

Profit and Loss Account Dr

To Provision for depreciation Account

Second Alternative-

Amount of depreciation is credited to the Asset Account every year and

the Asset Account is carried at historical cost less depreciation.

Accounting entries-
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Depreciation Account Dr

To Asset Account

Profit and Loss Account Dr

To Depreciation Account

c) Sum of Year of Digit Method-

❖ It is a method of accelerated depreciation. Similar to the double

declining balance. It is frequently used to depreciate fixed assets
more heavily in the early years, which allows the company to
defer income taxes to later years.
𝑇ℎ𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 (𝑖𝑛𝑐𝑙𝑢𝑑𝑖𝑛𝑔 𝑡ℎ𝑒 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑦𝑒𝑎𝑟)𝑜𝑓 𝑟𝑒𝑚𝑎𝑖𝑛𝑖𝑛𝑔 𝑙𝑖𝑓𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡
=
𝑇𝑜𝑡𝑎𝑙 𝑜𝑓 𝑎𝑙𝑙 𝑑𝑖𝑔𝑖𝑡𝑠 𝑜𝑓 𝑡ℎ𝑒 𝑙𝑖𝑓𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑎𝑠𝑠𝑒𝑡 (𝑖𝑛 𝑦𝑒𝑎𝑟𝑠)

d) Annuity Method-

❖ The annuity method of depreciation is a process used to calculate

depreciation on an asset by calculating its rate of return as if it
was an investment. This method requires the determination of
the internal rate of return (IRR) on the cash inflows and outflows
of the asset.

e) Sinking Fund method-

❖ The sinking fund method is a technique for depreciating an asset

while generating enough money to replace it at the end of its
useful life. As depreciation charges are incurred to reflect the
asset's falling value, a matching amount of cash is invested.
These funds sit in a sinking fund account and generate interest.

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❖ The interest on these securities, when received, would be re-

invested and the amount thereof would be credited to Sinking
fund Account.

❖ When the asset is due for replacement, the securities are sold,
and the new assets are purchased with the proceeds of their sale.

Relevant Journal entries are-

❖ For charging interest on asset account

Asset account Dr
To interest Account
❖ For charging depreciation on asset
Depreciation account Dr
To Asset account
❖ For transferring depreciation to Profit and Loss Account
Profit and Loss Account Dr
To Depreciation account
❖ For transferring interest to Profit and Loss Account
Interest Account Dr
To Profit and Loss Account

f) Machine Hour Method-

❖ Under this method, hourly rate of depreciation is calculated. The

cost of the asset (less residual value if any) is divided by the
estimated working hours. The actual depreciate for any given
period depends upon the working hours during that year.

g) Production Unit Method-

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❖ It becomes useful when an asset's value is more closely related to

the number of units it produces rather than the number of years
it is in use. This method often results in greater deductions being
taken for depreciation in years when the asset is heavily used,
which can then offset periods when the equipment experiences
less use.
Depreciation for the period
𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑
= Depreciable Amount ×
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑡𝑜𝑡𝑎𝑙 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛

h) Depletion Method-

❖ Depletion is an accrual accounting technique used to allocate the

cost of extracting natural resources such as timber, minerals, and
oil from the earth. Like depreciation and
amortization, depletion is a non-cash expense that lowers the cost
value of an asset incrementally through scheduled charges to
income.

Introduction of Partnership
❖ Partnership is the relation that exists between or among persons
carrying on business in common with a view to earn profit.

❖ The partnership form of enterprise is very common and popular

because-

a) It is easy to form.

b) It allows several individuals to combine their talents and skills

in particular business venture.
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c) It provides a means of obtaining more capital than a single

individual can obtain.

d) It allows the sharing of risks for rapidly growing businesses.

In India Partnership is governed by The Indian

Partnership Act 1932. Section 4 of this act defines partnership as
‘relation between persons who agreed to share the profits of a business
carried on by all or any of them acting for all.

General and Limited Partners

❖ Ordinarily each partner is equally liable for any debts or other

obligation incurred by any of the partners in the name of the
business that is each partner is personally liable to creditors for all
debts of the general partner and the partnership, a general
partnership.

❖ Active or Ordinary Partner- are those who take active part in the
conduct of the business.

❖ Sleeping, Dormant or Silent Partner- are those partner who do

not take part in conduct of the business. They only provide money
to the business as capital and share profits and losses in the
agreed ratio.

❖ Nominal or Ostensible Partner- are those who do not contribute

any capital and without having any interest in the business, lend
their names to the business.

❖ Minor Partner- A Partner, who has not attained the age of

maturity. A minor partner can be admitted only into the benefit of
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the partnership but is not personally liable, like other partners for
any debt of the firm.

❖ Partner’s Capital Accounts- with the formation of the partnership,

the partnership deed provides for a fixed amount of capital to be
contributed by each partner from his beware resources. In the
balance sheet of a partnership firm, there are several capital
accounts- one for each partner

Key Points
❖ Agreement- It is not necessary that such agreement is in written
form, an oral agreement is equally valid.

❖ Business- Mere co-ownership of a property does not amount no

partnership

❖ Two or More Persons- According to Section 464 of the companies

Act 2013, Central Government is empowered to prescribe
maximum number of partners in a firm, but number can not be
more than 100.

Central Government has prescribed the maximum

number of partners in a firm to be 50 as per Rule 10 of the Companies
Rules 2014.

❖ Liability of Partnership- Each partner is liable jointly and severally

to the third party for acts done as a partner. Even personal assets
of partner can be used.

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❖ Sharing of Profit- Partnership as relation between people who

agree to share the profits of a business the sharing of loss is
implied.

Partnership Deed
A partnership is formed by an agreement. Through the law does not
expressly require that there should be an agreement in writing but the
absence of a written agreement may be source of trouble in managing
the affairs of the partnership firm.

❖ Therefore, a partnership deed should be written, assented and

signed by all the partners

❖ Elements of Partnership Deed-

a) Name of the firm

b) Names and addresses of all partners

c) Nature and place of the business

d) Date of commencement of partnership

e) Duration of partnership if any

f) Amount of capital contributed or to be contributed by each

partner

g) Rules regarding operation of bank accounts

h) Ratio in which profits are to be shared

i) Interest, if any on partner’s capital and drawing

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Registration of the firm is not compulsory , but non- registration

restricts the partners or the firms from taking any legal action.

Some important points-

1) The ratio of partner's capital may be changed y mutual consent. It
generally changes when there is a change in the constitution that
is change in the profit sharing ratio; admission, retirement or
death of a partner.

2) A partner, on the strength of his expert knowledge or qualification

may not bring in any physical capital.

3) Capital formation by the partners may not be equal as per their

profit sharing ratio, the ratio of the capital contribution is to be
decided by the partners mutually or as per the partnership Deed.

4) Along with other physical assets (also goodwill) if a partner brings

any liabilities to the business the net amount (asset- liabilities)
well represent his capital contribution.

5) Capital contribution may not only be in the form of cash, it can be

in the shape of other asset also.

Provisions in absence of Partnership Deed

❖ No interest on drawing is to be charged.

❖ No interest on capital is to be paid.

❖ On amount advance by a partner to the firm in excess of his

agreed share of capital, the partners entitled to receive interest
on such excess at the rate of 6% per annum.
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❖ Sharing profit and losses equally

Interest on drawing
❖ No interest is allowed on Partner’s Capital Account, no interest on
drawings is to be charged, in the absence of any provision in the
Partnership Deed.

❖ If there is a provision in the partnership deed, only then the

interest on drawing is to be charged..

❖ Interest on drawings is calculated at a fixed rate percent from the

date of drawings till the last day of the accounting period.

Journal Entries

(i) Interest on drawing A/c Dr

To P&L appropriation A/c

(ii) Partner’s Capital/ Current A/c Dr

To interest on drawing A/c

(iii) Partner’s capital/ Current A/c Dr

To P&L appropriation A/c

For calculating interest on drawing every month

(a) When Fixed Amounts is Withdrawn Every Month, interest on total

drawings will be equal to earliest of 6.5 months at an agreed rate
per annum.

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(b) When fixed amount is withdrawn at the end of each

months, interest on total drawings will be equal to interest of 5.5
months at an agreed rate per annum.

(c) When partner withdraws a fixed sum at the end of each month,
interest of 6 months at an agreed rate per annum.

(d) When the dates of drawings are given and interest is to be

charged at an agreed rate per annum, interest will be calculated
on the basis of terms.

(e)When the dates of drawing are not given and the interest is to be
charged at an agreed rate per annum, interest will be calculated
for 6 months.

(f) When the rate is given without the word “per annum” interest
will be charged without considering the time factor.

When fixed amount is withdrawn Quarterly

(a) When fixed amount is withdrawn at the beginning of Quarterly,

interest on total amount will be calculated for 7.5 months

(b) When fixed amount is Withdrawn at the mid of the Quarter,

interest on total amount will be calculated for 6 months

(c) When fixed amount is withdrawn at the end of Quarter, interest on

total amount will be 4.5 months.

Amount Withdrawn at Different Intervals

Conditions-

a) Amount should not be same throughout the period

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b) Date of Drawings should not be same throughout the period

c) Drawings should not be made throughout the period regularly

without any gap.

➢ Profit and Loss appropriation account is an extension of profit

and loss account

❖ To provide for interest on capital of partners

❖ To provide for salary or Commission to partners

❖ To transfer profit to general reserve or specific reserve

❖ To distribute profit among partner in their profit sharing ratio.

Fixed Capital Account-

Under this method, two accounts are made-

a) Capital Account

b) Current account

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1- If only Capital Account Balance is given then fluctuating method

will be used.

2- If in the question, Current Account Balance is given then fixed

method will be used.

3- The Current account may show a debit or credit Balance.

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Interest on Capital
❖ Interest on partner’s capital will be allowed only when it has been
specifically mentioned in the partnership deed.

❖ Interest on Capital is calculated with due allowances for any

addition or withdrawal of capital during the accounting period.

❖ Interest on Capital is always on the OPENING CAPITAL.

❖ Interest on Capital: An appropriation of Profits:

a) In Case of Loses- Interest on Capital is NOT allowed

b) In Case of Sufficient Profits- Allowed

c) In Case of Insufficient Profits- Allowed at extent of profit in the

ratio of interest on capital of each partner

Treatment of New Profit Sharing Ratio and Sacrificing Ratio

❖ Sacrificing Ratio- It is a ratio in which old partners agree to

sacrifice their share of profit in favor of the new partner is called
sacrificing ratio.
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Old ratio- New Ratio

Different Cases in new profit sharing ratio.

Case 1: When the share of new or incoming partner is giving without

giving the details of the sacrifice made by the old or existing partners

In this case, we will assume that old partners will make the sacrifice in
their old profit sharing ratio. Therefore, sacrificing ratio will always be the
old profit sharing ratio.

Of course, the new profit sharing ratio will be different but there will be
no change in profit sharing ratio of the old partners.

Case 2: When new partner purchases his share from the old partners
in a particular ratio

In this case, new partners will purchase his share from old partners in a
particular ratio. So we will deduct the amount that the new partner will
purchase old partners in their particular ratio and then we will calculate
the new profit sharing ratio of all the partners.

Case 3: When new partner acquires the share by the surrender of a

particular fraction of share by old partners

In this case, we will deduct the share surrender from each old partner to
determine his share in the reconstituted firm.

The share that old partners will surrender in favour of the new partner
will be added. It will be the share of the new partner.

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Case 4: When new partner acquires his entire share from one partner
of the firm

In this case, the new partner will acquire his entire share from one
partner. We will calculate the sacrificing share of that partner and hat
share will be deducted from his ratio and the deducted ratio will be
added to the new partner.

That will be his profit sharing ratio. There will be no change in profit
sharing ratio of other partners as they are not sacrificing any share.

Case 5: When new partner acquires his share from old partners in a
certain ratio

The new partner may acquire a part of the share of profits from one
partner and balance part of the profit from another partner.

In such a case, old partners share of profit will change to the extent of
share sacrificed by them. We will deduct the share sacrificed by old
partners and will add to the new partner.

Sacrificing Partner
The partner whose share decreases by the change in profit sharing ratio
is sacrificing partner.

Admission of Partner
❖ Section 31 of the Partnership Act deals with the statutory
provision regarding the admission of new partner.

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❖ When a new partner is admitted he acquires his share in profits

from the old partners.

❖ The new partner has to contribute an agreed amount of capital to

the business.

❖ The admission of a partner constitutes the termination of old

partnership and commencement of new.

On admission of new partner can be put as follows:

a) Adjustment in profit sharing ratio

b) Adjustment for goodwill

c) Adjustment for revaluation of asset and liabilities

d) Adjustment for reserves and accumulated profit

e) Adjustment for capital

Goodwill
• An intangible asset arising from business connections, trade name
or reputations of an enterprise.
• This help the business earn some extra profits as compared to a
newly set up busyness.
• Goodwill cannot be seen but felt. Therefore goodwill is called an
Intangible asset.
• Only purchased Goodwill is shown in the financial statement.
Excess of Net Assets over Purchase consideration as Purchased
goodwill.

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• The necessity for valuation of goodwill in a firm arises in the

following cases-
a) When the profit sharing ratio amongst the partners is changed.
b) When a new partner is admitted
c) When a partner retires or dies; and
d) When the business is dissolved or sold.
• Two types:

(a) Purchased Goodwill (Actually brought)- It is type of goodwill which

is acquired by firm for a consideration, whether paid in cash or in kind.
If the purchase consideration is more than the value of net Assets, the
“excess” is considered to be a ‘Goodwill’.

Feature of Purchased Goodwill-

• It can be shown in the balance sheet as an asset.

• It can be recorded in the books, since consideration has been paid
for it.
• It arises out of an agreement between the purchaser and the
seller.
• IAS 26 prescribes that purchased goodwill be shown as an asset.

(b) Self generated Goodwill- It is a goodwill which is not purchased but

is earned by the efforts of the management. It is generated internally.

Feature of Self-generated Goodwill-

• Generated internally
• It cannot be shown in the books of accounts as per AS26
• Valuation is subjective to the valuer.

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Need for Valuation of Goodwill

❖ Change in the profit- sharing ratio amongst the existing partners

❖ Admission of New Partners

❖ Retirement of a Partner

❖ Death of a Partner

❖ Dissolution n of firm

❖ Amalgamation of Partnership firms

Classification of Goodwill

a) Dog Goodwill- this type of goodwill mostly found in professions.

Like Dog is attached to the persons than to the place. He will
follow the owner. Customers depend on leadership of company.

b) Cat Goodwill- This goodwill represents the person who goes to

the old shop whoever keeps it. Cat always prefer the old home
rather than owner. Customers are more loyal to the brand.

c) Rat Goodwill- this goodwill tells those customers who are neither
attached to any owner of the business nor to any shop. Like, Rat is
interested in filling its stomach no matter where things come.

d) Rabbit Goodwill- There are customers who neither attract value

to the owner nor shop but to its nearness of the shop. Like rabbit,
it has the habit of living close and is afraid of going too far.
Customers buy their product if it is available in their acceptable
radius.

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Methods of Valuation of Goodwill

Average Profits Method-

❖ Goodwill is valued at agreed number of ‘years’ purchase of the

average profits of the past few years.

❖ Goodwill is calculated on the basis of average on the basis of

average profit due to future expectations of earning capacity of
the firm.

❖ Under average profit method, goodwill is calculated by

multiplying the average profit by a certain number of years
purchases as agreed by the partners.
𝑇𝑜𝑡𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 𝑜𝑓 𝑎𝑙𝑙 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑟𝑜𝑓𝑖𝑡 =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠

𝐺𝑜𝑜𝑑𝑤𝑖𝑙𝑙 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑟𝑜𝑓𝑖𝑡 𝑥 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟 ′ 𝑠𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒

❖ Weighted Average Profit=
Calculate Weighted Average Profit=
𝑇𝑜𝑡𝑎𝑙 𝑜𝑓 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑠
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑟𝑜𝑓𝑖𝑡 =
𝑇𝑜𝑡𝑎𝑙 𝑊𝑒𝑖𝑔ℎ𝑡𝑠

𝐺𝑜𝑜𝑑𝑤𝑖𝑙𝑙
= 𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑟𝑜𝑓𝑖𝑡 𝑥 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟 ′ 𝑠 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒
Super Profit method-

❖ Under this method, if firms earn higher profit in comparison with

normal profit then the difference is called Super Profit.

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❖ Goodwill is calculated on the basis of Super- Profit due to future

expectations of learning capacity of the firms.

❖ The steps to be followed are given below-

a) Identify the capital employed by the partnership firm

b) Identify the average profit earned by the partnership firm base
on past five years’ figures
c) Determine normal rate of return prevailing in the locality of
similar firms
d) Apply normal rate of return on capital employed to arrive at
normal profit.
e) Deduct normal profit from the average profit of the firm. If the
average profit of the firm is more than the normal profit, there
exists super profit and goodwill/

Steps-

1- Normal Profit= Capital Employed x Normal rate of return/100

2- Super Profit= Average Profit – Normal Profit

3- Goodwill = Super profit x Number of years purchased.

Calculation of Capital Employed=

a) All assets- external Liabilities ( All Assets except goodwill)

b) Capital + Reserve- Fictitious Assets (if any)

Capitalization method-

Under this basis, value of whole business is determined applying

normal rate of return. If such value (arrived at by applying normal rate
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of return) is higher than the capital employed in the business, then the
difference is goodwill. The steps to be followed under this method are
given below:

i. Determine the normal rate of return

ii. Find out the average profit of the partnership firm for which
goodwill is to be determined.
iii. Determine the capital employed by the partnership firm for
which goodwill is to be determined.
iv. Find out normal value of the business by dividing average profit
by normal rate of return.
v. Deduct average capital employed from the normal value of the
business to arrive at goodwill.

There are two methods to calculate capitalization method.

a) Average Profit Base=

Goodwill= [Average Profit/NRR x 100] – Capital Employed

b) Super Profit Base=

Super profit/NRR x 100

Annuity Method- In the super profit method explained above,

time value of money is not considered. Although ist was expected tht
super profit would be earned in five future years, still no devaluation
was done on the value of money for the time difference. In fact when
money will be received in different point of time, its value should be
different depending upon the rate of interest.

Goodwill= Super Profit x Present value of annuity

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Purchase consideration Method-

Goodwill= Purchase Consideration- Net Assets

Net Assets= Assets- Liabilities.

Hidden Goodwill
❖ Hidden goodwill is the excess of desired total capital of the firm
over the actual combined capital of all partners'.

❖ It is calculated with reference to the total capital of the firm and

the profit sharing ratio.
Incoming partner’s capital x Reciprocal of share of incoming partner xxx

Less: Total capital after taking into consideration the capital brought
in by incoming partner= xxx

Value of Goodwill= xxx

Revaluation Account
It is a process of placing a different valuation on an asset or a
liability from its book value in case of admission, retirement of a
partner etc. When a number of assets and liabilities are revalued,
the adjustments are made through a temporary account, known
as Revaluation Account.

Assets and Liabilities revalued at the time of admission of partner-

At the time a new partner is admitted, it is found necessary to

revalue the assets and liabilities of the firm as because the book
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value of assets and liabilities may be far from their market value
and thus the equity will be affected and a partner may be put to a
disadvantage. For this reason, revaluation is necessary.

1. Revaluation A/c Dr
To Assets A/c

To the Liabilities Accounts

2- Assets Account(individually) Dr

Liabilities Accounts Dr (with the increase

in the value of the assets)

To Revaluation Account

3- Revaluation Account Dr (with the profit in the

old profit sharing ratio)

To Capital A/c of the old partners

OR

Capital Accounts of the old partners Dr

To Revaluation A/c

Why is goodwill sometimes recorded in the books and then

immediately eliminated?

When there is a change in profit sharing ratio of partners is

admitted or retires or dies, goodwill is brought into account so
that equities between the partners are not affected. However the
partner desire that goodwill shall continue to remain as an

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unrecorded asset, then goodwill shall continue to the partners in

the new profit sharing ratio.

Why is General Reserve and accumulated profit and loses distributed

amongst the old partners before a new partner is admitted?

The new partner should not get the share accumulated profit or
loses because these arose before the admission of new partner.

Retirement of Partner
Section 32 of Partnership Act deals with the statutory provisions
relating to retirement of a partner form partnership firm.

❖ On retirement, the existing partnership deed comes to an end.

❖ A new partnership deed need to be framed whereby, the

remaining partners continue to do their business on changed
terms and conditions.

❖ A retiring partner may carry on business competing with that of

the firm and may advertise such business. But he has no right to:
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a) Use the name of the firm

b) Represent him as carrying on the business of the firm.

❖ A retiring partner will not be liable for liabilities incurred by the

firm after his retirement. However, he must give a public notice to
that effect.

❖ Retirement of a partner by death or insolvency also does not

require any public notice.

Gaining Ratio

After retirement of a partner, the Combined share of the

remaining partners will be increased. The ration in which the
remaining partners are acquiring the share of the retiring partner
is called gaining ratio.

The problems of calculating gaining ratio arises primarily when

the new profit sharing ratio of the continuing partners is specified.

How can a partner retire from partnership?

❖ In three ways-

a) With the consent of all other partners

b) In case of partnership at will, by giving notice to all partners

c) In accordance with an express agreement by the partners when

the partnership is at will by giving ratio in writing to all the other
partners of his intension to retire.

Adjustments required at the time of retirement of a partner-

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a) Change in Profit sharing Ratio

b) Goodwill

c) Revaluation of assets and liabilities

d) Reserves and Surplus

e) Partner’s Capital

Goodwill may be adjusted in any one of the following ways-

a) Only the retiring partner’s share of goodwill my be credited to him

and debited to existing/ continuing partner in the gaining ratio

b) Goodwill may be raised in the books at its full value and

immediately written off.

The journal Entry for distribution of profit or loss on revaluation

which appear in the balance sheet also is as follows-

Revaluation A/c Dr

To Partner’s Capital A/c

(For profit on revaluation )

OR

Partners’ Capital A/c Dr

To Revaluation A/c

(For loss on revaluation)

Assets and Liabilities revalued at the time of retirement of a partner

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❖ At the time of retirement of a partner it is necessary to revalue

the assets and liabilities of the firm so that he gets his fair share of
the firm’s net assets. The revaluation should be made in the
interest of the retiring partner as well as of the remaining partner.

❖ The amount is transferred to the capital account of all partner

including retiring partner in old profit sharing ratio.

Adjustment of Accumulated Profits/ Losses

When a person retires from a firm he has a share in the

accumulated profits and losses of the firm because such profit and
losses arose when he was a partner in the firm. Thus, General
Reserve, debit/credit balance of profit & loss. Account should be
transferred to Capital Accounts.

Mode of payment to a retired partner-

While deciding the mode of payment to the retiring partner the

provisions of partnership deed is to be taken into consideration. If
there is no deed the partner should decide it manually, otherwise

i) By one lump sum

ii) In Installation

iii) By way of annuity

Joint Life Policy-

A partnership firm may decide to take a Joint Life Insurance Policy on
the lives of all partners. The firm pays the premium and the amount of
policy is payable to the firm on the death of any partners or on the
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maturity of policy whichever is earlier. The objective of taking such a

policy is to minimize the financial hardships to the event of payment of
a large sum to the legal representatives of a deceased partner or to the
retiring partner.

The accounting treatment for the premium paid and the JLP may be on
any of the following ways:-

1. When premium paid is treated as an expense- When premium is

treated as an expense then it is closed every year by transferring
to profit and loss account. In this case complete amount received
from the insurance company either on a surrender of policy or on
death of partner becomes a gain.

Accounting entries are-

(a) On payment of premium

Joint Life Policy Insurance Premium A/c Dr
To bank A/c
(b) On charging to Profit and Loss Account
Profit and Loss Account Dr
To JLP insurance premium Account
(c) On maturity of the policy
Insurance Company/Bank Account Dr
To Partner’s Capital A/c (individually)

(Including the account of the representative of deceased partner)

2. When premium paid is treated as an asset- In this case insurance

premium paid is first debited to life policy account and credited to
bank account. At the end of the year the amount in excess of
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surrender value is treated as a loss and is transferred to Profit and

Loss Account. In this case the amount received from the insurance
company in excess of the surrender value results in a gain at the
time of receipt of such amount which is transferred to Capital
Accounts of the partners in the profit sharing ratio.
3. Creation of Joint Policy Reserve Account- Under this method,
premium paid is debited to policy account and credited to bank
account. At the end of the year amount equal to premium is
transferred from Profit and Loss Appropriation Account to Policy
Reserve Account.

Death of Partner
❖ Accounting Treatment of death of partner is same as retirement
of partner.

❖ In case of death, his claim is transferred to executives and settled

as same as retired partner.

❖ If there is life insurance policy it is to be realized.

Executors of the deceased partner are entitled to the following

a) Capital standing to the credit of the deceased partner on the date

of his death.

b) Share of goodwill

c) Profit on revaluation of asset and liabilities as reduced by any loss

on any such revaluation

d) Share out of proceeds of a joint life insurance policy.

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Share out of reserves or other undistributed profit.

The deceased partner’s capital account will be charged with his share
of the following amounts.-

i) Drawings and interest thereon form the beginning of the

accounting years to date of his death

ii) Loss on revaluation of assets and liabilities

iii) Loss in the business from the beginning of the account year till
date of his death.

Two method to calculate share of profit of deceased partner-

a) Time Basis- Profit for the year can be divided between 2 periods.

i) beginning of accounting year to the date of death

ii) Form the date of death till the end of account year

c) Sales Basis- The deceased partner’s share in profits upto the date
of his death can be determined on the basis of sales.

Special Transactions in case of Death:- Separate Life Policy-

In the event of death of partner, the policy of the deceased partner will
get mature and the firm will receive the assured value of the policy. In
this case, the legal representative of the deceased partner is entitled to
get the proportionate share of (a) assured value of the matured policy
of the deceased partner (b) surrender values of other life policies of the
remaining partners taken by the firm.

Bank A/c Dr (Assured Value)

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To Separate Life policy of Deceased partner A/c

(Policy value received on death of a partner)

Separate Life Policy of Deceased Partner A/c Dr (Assured

value)

Separate Life Policy of Remaining Partners A/c (Surrender value)

To Executor’s A/c (Total value distributed in profit sharing

ratio)

To Remaining partners A/c (Total value distributed in profit

sharing ratio)

(Being the total of assured value of deceased partner’s life policy and
surrender value of other partner’s life policy(s) distributed in the profit
and loss sharing ratio)

Rights of Outgoing Partner:

Section 37 of the partnership At provides that where any partner

of a firm has died or otherwise ceased to be partner and the
surviving or continuing partners carry on the business with the
property of the firm without falling setting the accounts of the
outgoing partner, such partner or his legal representatives, in the
absence of any contract to the contrary can claim at his options.

i) Interest at the rate of 6% per annum on the amount of his share

in the property of the firm.

ii) Such share of the profits after his leaving the firm as may be
attributable to the use of his share of property of the firm.
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Dissolution
Dissolution means discontinuation. There are two types of
dissolution

a) Dissolution of Partnership- It refers to admission, retirement and

death of partner of a firm.

b) Dissolution of firm- It means the termination of partnership

business.

Section 39 of Partnership Act 1932, the dissolution of

partnership between all the partners of a firm is dissolution of
firm. Dissolution of partnership firm may take place without the
intervention of court or by the order of court.

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Reasons by which the partnership firm may be dissolved by the

partners firm may be dissolved by the partners mutually

i) Sudden death or retirement of a key partner

ii) When the business of the firm has become illegal

Ways by which court may order for dissolution

i) Where a partner becomes of an unsound mind

ii) Where a partner is guilty of misconduct.

Cases in which a partnership firm will have to be compulsorily

dissolved.

i) By adjudication of all partners or all but one as insolvent.

ii) The business of the firm becomes unlawful due to

happening of any event.

Realization Account

When a firm is dissolved the books of account of the firm need to

be closed and for this a special account called realization account
is used to record the closing transaction showing profits and
losses on realization of assets and settlements of liabilities.

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How will you deal with realization expenses when a partnership firm
is dissolved

Realization account is debited and bank account is credited with

amount of realization expenses. The capital account is credited
instead of bank id the expenses are paid by a partner.

Corporate Accounting
Meaning of shares

❖ Section 2 (84) of the companies Act 2013, “means a share in the

share capital of a company and its stock.

❖ Total capital of the company is divided into number of small

indivisible units of fixed amount of each such unit is called is
called share.
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❖ Shares are used to raise the capital of a company and each share
constitutes a unit of ownership which offered for sale.

Kinds of Share Capital

❖ Equity Share Capital- It means all share capital that does not
come under preference right as to payment of dividend and
repayment of capital on winding up.

❖ Preference share Capital- It carries preferential right with regard

to payment of dividend and repayment of capital on winding up of
a company.

a) These share satisfy the following two conditions-

i) As regards dividends it must carry a preferential right to a

fixed rate.

ii) As regards of winding up there must be a preferential

right to repaid for the amount of capital paid up on shares.

Disclosure of Share Capital

Share capital of a company is divided into following categories-

i) Authorized Share Capital- A Company its maximum capital

requirement. This amount of capital is mentioned in ‘Capital Clause’ of
the ‘Memorandum of Association’ registered with the registrar of
Companies.

❖ It puts limits on the amount of capital, which a company is

authorized to raise during its lifetime and it is called Authorized
Capital.
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❖ It is also called ‘Nominal Capital’ or ‘Registered Capital’.

❖ It is shown in the balance sheet at face value.

2- Issued Share Capital- A company need not issue total authorized

capital.

❖ Whatever portion of the share capital is issued by the company, it

is called ‘Issued Capital’.

❖ Issued capital means and includes the nominal value of shares

issued by the company for:

i) Cash, and

ii) Consideration other than cash, promoters.

❖ Issued Capital is shown in the balance sheet at nominal value.

❖ The remaining portion of authorized capital which is not issued

either in cash or in consideration is called Un-Issued Capital. It is
not shown in Balance Sheet.

3- Subscribed Share Capital- It is that part of issued share capital, which

is subscribed by the public i.e., applied by the public and allotted by the
company.

❖ It also includes the face value of shares issued by the company for
consideration other than cash.

4- Called up Share Capital- Companies generally receive the issue of

shares in installments.

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❖ The portion of the issue price of shares which a company has

demanded or called form shareholders is known as Called-up
Share capital.

❖ And the balance, which the company has decided to demand in

future may be referred to as Uncalled Capital.

5- Paid-up Share Capital- It is the portion of called ip capital which is

paid by the shareholders.

❖ Whenever a particular amount is called by the company and

shareholder fails to pay the amount fully or partially, it is known
as ‘unpaid calls’ or Calls in Arrears’.

❖ To calculate paid-up capital, the amount of installment in arrears

is deducted from called up capital.

❖ In balance sheet, called-up and paid up capital are shown

together.

6- Reserve Share Capital- As per Section 99 of the Companies Act 1956,

a company may decide by passing a special resolution that a certain
portion of its subscribed uncalled capital shall not be called up except in
the event of winding up of the company.

❖ Portion of uncalled capital which a company has decided to call

only in case of liquidation of the company is called Reserve
Liability/ Reserve Capital.

❖ Reserve Capital is different from Capital reserve, Capital reserve

are part of ‘Reserves and Surplus’ and refer to those reserves
which are not available for declaration of dividend. These reserves
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may be used to write off capital losses such as discount on issue

of shares.

Issue of Shares
➢ A company may issue shares at their face value or at a price other
than the face value.

➢ When shares are issued at a price equal to their face value it is

termed as Shares, issued at par.
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➢ When issue price of share is more than its face value it is known
as share issued at a premium.

➢ If the issue price of share is less than its face value it is called as
shares issued at a discount.

➢ The shares become fully paid up only on receipt of all money due
on

Issue of shares at Premium

❖ When the shares are issued a premium, the amount of premium is

credited to a new account named as share premium on issue of
share account.

❖ Generally premium money is received along with allotment

money
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❖ The Companies Act does not impose any restriction on the issue
of shares at a premium.

❖ As per provisions of companies Act, the premium must be

credited to a separate account called Share premium Account.

Under Section 78 of Act, the amount share premium can use wholly or
in part for:

a) Paying up unissued shares of the Company to be issued to

members of the company as bonus shares.

b) Writing off the preliminary expenses of the company

c) Writing off the expenses of or the commission paid or discount

allowed on shares or debentures of the company.

d) Providing for the premium payable on the redemption of

redeemable preference shared or debentures of the company

Journal Entry-

(a) Premium amount called with Application money

(i) Bank A/c Dr (Total Application money + Premium Amt)
To Share Application A/c (Amount received)

[Money received on applications for …… Shares @ Rs ……. Per share

including premium]

(ii) Shares Application A/c Dr (No. of Shares applied for x

Application Amount per share)
To Securities Premium A/c (No. of Shares allotted x
Premium Amount per share)
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To Share capital A/c (No. of shares allotted x per share

for capital)
(b) Premium Amount called with Allotment money
(i) Share Allotment A/c Dr (No. of shares Allotted x Allotment
and Premium Money per share)
To Share Capital A/c (No. of Shares Allotted x
Allotment Amount per share)
To Securities Premium A/c (No. of Share Allotted x
Premium Amount per share)

(Amount due on allotment of shares @ Rs …….. per share including

premium)

(ii) Bank A/c Dr

To Share Allotment A/c

(Money received including premium consequent upon allotment)

Issue of Shares at Discount

❖ A company can issue shares at a discount only when the following

conditions are laid down in Companies Act satisfies-

1) The shares must belong to a class already issued

2) The issued is authorized by an ordinary resolution in the general

meeting and sanctioned by the company law board.

3) The issue is made at a discount which is specified in the resolution

but in no case the rate of discount should exceed 10% or such
higher percentage as the central government may permit.

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4) At least one year has elapsed since the company entitled to

commence the business

5) Issues are made within two months after receiving the sanction of
the Company Law Board.

The clear implications of the restrictions placed on the issue of shares

at a discount are that

- A new company cannot issue shares at a discount, and

- A new class of shares cannot be issued at a discount.

Journal Entry-

Share Allotment a/c Dr

Discount on the issue of shares A/c Dr

To Share Capital A/c

(Amount due on allotment of …….. Shares @Rs……..

Subscription of shares- Accounting for issue of shares depends upon

the type of subscription. Whenever a company decides to issue shares
of public, it invites applications for subscription by issuing a prospectus.
It is not necessary that company receives applications for the number
of shares to be issued by it there are three possibilities:-

1) Full Subscription- Issue is fully subscribed if the number of shares

offered for subscription and the number of shares actually
subscribed by the public are same.

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2) Under Subscription- It means the number of shares offered for

subscription is more than number of shares subscribed by the
public.

3) Over Subscription- When the application money is received for

more number of shares that the number of shares offered to the
public by a company . It is called over-subscription. The entries
are-

(1) On refund of application money to applicants to whom shares

have not been allotted:
Share Application A/c Dr
To Bank Account
(2) When only a part of shares applied for are allowed:
Share Application A/c Dr (with the amount received in
advance for allotment)
To Share allotment A/c
To Share Calls-in Advance Account

Pro-rata Allotment

 Pro-rata allotment means that the applicants are allotted shares

proportionally such that no applicants are refused of shares and
no applicant allotted share in full.

 Eg- If an applicant applied for 8000 shares and it allotted only

5000 shares, then his application is said to be partially accepted.

 In such a case, the company adjusts the excess share money

received on application towards share allotment money due on
partially accepted applicants.
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Journal Entry-

(a) For rejected application

Share Application Account Dr
To Bank Account
(b) For pro- rata allotment
Share application Account Dr
To Share Allotment Account`

Calls in Advance
 Some shareholders may sometimes pay part, or whole, of the
amount not yet called up, such amount is known as Calls in
Advance.

 The money received on Calls- in- advance does not become part
of share Capital. It is shown under a separate heading, calls-in-
advance under “Current Liabilities” in the Balance Sheet.

 It is to be noted that no dividend can be paid on calls-in-advance.

Generally the articles of the company specify the rate at which
interest will be payable on Calls-in- Advance

 If the articles do not contain such rate, table F of the companies

Act 2013 will be applicable which leaves the matter to the Board
of directors to decide rate of such interest, subject to maximum of
12% p.a.

 This amount is credited in Calls in Advance Account. The following

entry is recorded-

Bank A/c Dr
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To Call in Advance a/c

When calls become actually due, calles in advance account is

adjusted at the time of the call. For this the following journal entry is
recorded:

Calls in Advance A/c Dr (Call amount due)

To particular Call A/c

The accounting treatment of interest on calls- Advance is as follows:

(a) Interest Due

Interest on Calls-in-Advance A/c Dr (Amount of interest due
for payment)
To Shareholder’s A/c
(b) Payment of Interest
Shareholder’s A/c Dr (Amount of interest paid)
To Bank A/c
( Interest paid on calls in advance)
Calls in Arrear
 When shareholders fail to pay the amount due on allotment or
calls. The total unpaid amount on one or more installments is
known as Calls-in-arrear or Unpaid Calls.

 Such amount represents the uncollected amount of capital from

the shareholders; hence it is shown by way of deduction from
Called-up-capital to arrive at paid up value of the share capital.

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 The interest is recoverable according to the provisions in this

regard in articles of the company. If articles are silent, as per Table
F up to 10% p.a. interest can be charged.

 Call in arrear is shown on the liability side of the Balance sheet by

way of deduction from called up capital.

For recording “Calls-in- Arrears’, the following journal entry is

recorded:

Calls- in- Arrears A/c Dr ( Amount of Unpaid Calls)

To Share Allotment A/c

To Share Calls A/c

(i) For interest receivables on calls in arrears

Shareholders’ A/c Dr
To interest on calls in arrears A/c
(ii) For receipts of interest
Bank A/c Dr
To Shareholders’ A/c

Issue of Bonus Shares

 A company may issue fully paid up bonus shares to its members,

in any manner out of its free reserves; securities premium
account; or capital redemption reserve account.

 However, no issue of bonus shares shall be made by capitalizing

reserves created by the revaluation of assets. The bonus shares
shall not be; issued in lieu of dividend.

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Journal Entry-

On issue of Bonus Share-

Bonus to Shareholders A/c Dr

To Share Capital A/c

Conditions of Bonus Share-

a) It is authorized by its articles

b) It has on the recommendations of the Board, been authorized in

the general meeting of the company.

c) No company shall capitalizes its profit or reserves for the purpose

of issuing fully paid up bonus shares under above, unless.

d) Partly paid up shares, if any outstanding on the date of allotment,

are made fully paid up.

Forfeiture of Shares
❖ If a shareholders does not pay the allotment money or call money
in time, the company, in accordance with the provisions of the
articles of association, may proceed to forfeit the shares held by
such a defaulting shareholders upon forfeiture of shares by the
company, the person ceases to be the shareholders of the
company and money paid by him on the shares is forfeited to the
company.

❖ Procedure of forfeiture of shares

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a) Articles of association of the company provide the authority to

forfeit shares to the Board of directors

b) Notice must also state that if the shareholders fail to remit the
amount mentioned therein within the stipulated period, their
shares will be forfeited.

c) Board has to give at least 14 days notice to the defaulting

members calling upon them to pay outstanding amount

❖ Forfeiture Shares account is to be shown in the balance Sheet by

way of addition to the paid up capital on the liabilities side, until
the concerned share are reissued

Forfeiture of Shares which were issued at Par

❖ In this case, Share Capital Account will be debited with the called
up value of share forfeited.

❖ Allotment or Calls Account will be credited with amount due but

not paid by shareholder.

Journal Entry

Share Capital A/c Dr ( No. of shares x called-up value per share)

To Forfeited Share (Amount already received on forfeited

shares)

To Share allotment Account (If amount due, but not paid)

To Share First Call ( If amount due, but not paid)

To Share final call account (If amount due, but not paid)

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When amount due on allotment, first call and final call have been
transferred to Calls in arrears Account

Share capital Account Dr (No. of share x called up value per share)

To Calls-in-arrears account (Total amount due, but not paid)

To Forfeited Shares Account (Amount received)

Forfeiture of shares which are issued at a Discount

❖ In this case also Share Capital Account will be debited with the
called-up value of shares forfeited, allotment or Calls Account will
be credited with the amount due but not paid by the
shareholders.

❖ When shares are issued at a discount, the Discount Account is

debited. Therefore, at the time of forfeiture of such share,
Discount Account will be credited to cancel it.

Journal Entry-

Share Capital Account Dr (no. of shares x called up value)

To Share Allotment Account ( if amount due, but not paid)

To Share first Call Account ( if amount due, but not paid)

To Share Final Call Account ( if amount due, but not paid)

To forfeited Share (Amount received on forfeited shares)

To Discount on issue of Shares Account ( No. of shares x discount

per share)

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Forfeiture of shares which were issued at a premium

❖ If the premium has already by the company, it cannot be

cancelled even if the shares are forfeited in the future.

Journal Entry-

❖ If premium not received-

Share capital A/c Dr (called up value)

Securities premium A/c Dr (Amount of security not received)

To share allotment account ( if amount due, but not paid)

To share first call account ( if amount due, but not paid)

To share final call account ( if amount due, but not paid)

To Forfeiture Shares account (amount received on forfeited

shares)

❖ If premium received-

Share capital A/c Dr (called up value)

To share allotment account ( if amount due, but not paid)

To share first call account ( if amount due, but not paid)

To share final call account ( if amount due, but not paid)

To Forfeiture Shares account (amount received on forfeited

shares)

Re- issued of Forfeited Shares

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❖ A forfeited share is merely a share available to the company for

sale and remains vested in the company for that purpose only.
Reissue of forfeited shares is not allotment of shares but only a
sale.

Total profit on forfeiture of xxx

share/no of shares forfeited x No.
of shares reissued

(-) Further discount on reissue (x)

Transfer to Capital Reserve =xxx

Points of Consideration-

In context of re-issue, the following point is important-

a) Loss on re-issue should not exceed the forfeited amount

b) The forfeited amount on shares not yet reissued should be shown

under the heading ‘share capital’

c) When the shares are re-issued at a loss, such loss is to be debited

to ‘forfeited share account’

d) If the loss on re-issue is less than the amount forfeited, the

surplus should be transferred to Capital Reserve.

e) If the shares are re-issued at a price which is more than the face
value of shares, the excess amount will be credited to Securities
Premium Account.

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f) When the shares are re-issued at a loss, such loss is to be debited

to “Forfeited Shares Account”.

Issue of Shares for consideration other than cash

Public limited companies, generally, issue their shares for cash and use
such cash to buy the various types of assets needed in the business.
Sometimes, however, a company may issue shares in a direct exchange
for land, buildings or other assets. Shares may also be issued in
payment for services rendered by promoters, lawyers in the formation
of the company. These shares should be shown separately under the
heading “Share Capital”

Accounting Entries-

(a) Assets Account Dr

To Share Capital Account
(b) When shares are issued to promoters
Goodwill Account Dr
To Share Capital Account

Liquidation of companies
 Liquidation is a process through which a company which is
running is shut down and its existence comes to an end.

 This often happens when the companies are unable to pay its
creditors and hence need to sell off its assets to pay of them.
Though in another version this could be a voluntary act as well
where law ensures that all the debts of a company into existence
is paid before it is closed or shut down.
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Modes of Liquidation-

Section 425 (1) of the Companies Act provides that a company can be
liquidated in any of the following three ways-

a) Compulsory winding up by the court

b) Voluntary winding up by the members or creditors

c) Winding up under the supervision of the court.

Parameters Compulsory winding Voluntary Voluntary

up by the court winding up by winding up by
members Creditors
1- Grounds for i) Special If fixed period Creditor’s
winding up resolution to is expired voluntary
wind up by Special winding up
court. resolution for
ii) Default in wind up by
delivering members
status report
iii) If company
suspend
business
iv) If company is
unable to pay
debts
2- Who may The company Meeting of Meeting of
present petition i) Any creditor Members creditors pass
ii) Registrar pass resolution
iii) Contributory resolution
iv) Authorized
person by CG.
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3- Time of presentation Time of Time of

Commencement of petition by court meeting meeting
of windup

Committee of Court may No committee Creditors may

Inspection appoint appoint
Settlement of Court settles Liquidator Liquidators
contributors settles settles
Dissolution of Court pass order By member and Liquidator
company for dissolution liquidator and settles.
report to court

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Payments are made by the liquidator in the following order-

a) Payment to fully secured creditors

b) Legal expenses

c) Remuneration of liquidator

d) Remuneration on asset realized

e) Debenture holders (including interest up to the date of winding

up if the company is insolvent to date of payment if it is solvent)

f) Equity Shareholders

g) Preferential Shareholders ( Arrears of dividends on cumulative

preference shares should be paid up to the date of
commencement of winding up).

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Statement of Affairs-

❖ Include assets on which there is no fixed charge at the value they

are expected to realize.

❖ Includes assets on which there is fixed charge. The expected

amount expected to be realized would be compared with the
amount due to the creditor concerned.

❖ A deficit is to be added to unsecured creditors.

❖ If a minus balance emerges, there would be deficiency as regards

creditors otherwise there would be a surplus.

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Statement of Affairs should accompany 8 lists-

List A- full particular of every description of property not specifically

pledged

List b- Assets specifically pledged and creditors fully or partly secured

List C- Preferential Creditors

List D- List of debenture holders secured by a floating charge

List E- Unsecured Creditors

List F List of preferential shareholders

List G- List of equity shareholders

List H- Deficiency or surplus account

Deficiency Account
❖ An account supplementing the balance sheet of a financially weak
enterprise showing estimated realization values of assets and
their insufficiency to meet creditors' claims and occasionally
indicating the causes of the difficulty.

❖ When company becomes insolvent deficiency

accounts is prepared. This account shows the reason of
company deficiency. A company deficiency is because of losses,
decrease in the value of assets or any other such reasons.
This account is not made on double entry system but it is
statement of simple calculation.

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B list of Contributories

❖ It includes the past members of the company, i.e., those who

have ceased to be members within one year preceding the
commencement of the winding-up. Liability of the Past Members:

 A member in List B (i.e., a past member) is not liable to

contribute:

(i) If he has ceased to be a member, for one year or upwards before

the commencement of the winding-up;

(ii) In respect of any debt or liability of the company contracted after he

ceased to be a member; and

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(iii) Unless it appears to the court that the present members are unable
to satisfy the contributions required to be made by them

Corporate Restructuring
 Restructuring is the corporate management term for the act of
reorganizing the legal, ownership, operational, or other structures
of a company for the purpose of making it more profitable, or
better organized for its present needs.

 Corporate restructuring is an action taken by the corporate entity

to modify its capital structure or its operations significantly.
Generally, corporate restructuring happens when
a corporate entity is experiencing significant problems and is in
financial jeopardy

5 Different Forms of Corporate Restructuring

 Mergers & Acquisitions. One of the best ways of increasing

profitability in a business quickly is to incorporate an existing
company into yours.

 Divestment and Spin-Offs.

 Debt Restructuring.

 Cost Reduction.

 Legal Restructuring.

Need and objectives of corporate restructuring-

Objectives include the following:

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❖ orderly redirection of the firm’s activities;

❖ deploying surplus cash from one business to finance profitable

growth in another;

❖ exploiting inter-dependence among present or prospective

businesses within the corporate portfolio;

❖ risk reduction; and

❖ development of core competencies.

Need-

❖ To reduce risk

❖ To expand marketing and management capabilities

❖ To increase operating efficiency

❖ To improve access to financial markets

❖ To obtain tax benefit.

❖ To revive a sick company

❖ To provide synergistic benefits

❖ To allow new products development.

Types of Restructuring-

a) Financial Restructuring- involves restructuring the assets and

liabilities of corporations, including their debt-to-equity
structures, in line with their cash-flow needs to promote

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efficiency, support growth, and maximize the value to

shareholders, creditors and other stakeholders.
b) Market and Technological Restructuring- occurs when a
new technology has been developed that changes the way an
industry operates. This type of restructuring usually affects
employees, and tends to lead to new training initiatives, along
with some layoffs as the company improves efficiency.
c) Organizational Restructuring- can be driven by a need for change
in the organizational structure or business model of a company, or
it can be driven by the necessity to make financial adjustments to
its assets and liabilities.

Mergers
 A merger usually involves combining two companies into a single
larger company.

 Mergers combine two separate businesses into a single new legal

entity. True mergers are uncommon because it's rare for two
equal companies to mutually benefit from combining resources
and staff, including their CEOs. Unlike mergers, acquisitions do
not result in the formation of a new company.

Merger= (A+B=A)

Types of Merger

 Horizontal Merger- A horizontal merger is a merger or business

consolidation that occurs between firms that operate in the same
industry. Competition tends to be higher among companies

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operating in the same space, meaning synergies and potential

gains in market share are much greater for merging firms.

 Vertical merger- A vertical merger is the merger of two or more

companies that provide different supply chain functions for a
common good or service. Most often, the merger is effected to
increase synergies, gain more control of the supply chain process,
and ramp up business.

 Conglomerate Merger- A conglomerate merger is "any merger

that is not horizontal or vertical; in general, it is the combination
of firms in different industries or firms operating in different
geographic areas". Conglomerate mergers can serve various
purposes, including extending corporate territories and extending
a product range.

 Congeneric Merger- A congeneric merger is a type

of merger where two companies are in the same or related
industries or markets but do not offer the same products. In
a congeneric merger, the companies may share similar
distribution channels, providing synergies for the merger.

Synergy
Synergy is an interaction or cooperation giving rise to a whole that is
greater than the simple sum of its parts. The term synergy comes from
the Attic Greek word synergos,, meaning "working together“

❖ The companies remain independent and separate; this is only a

change in control of the companies.

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❖ When acquisition is forced or willing it is called takeover.

Acquisition
 An acquisition is the act of getting or receiving something, or the
item that was received. An example of an acquisition is the
purchase of a house.

 An acquisition involves buying a company and changing it to fit

the way you do business. The goal is to create a new company
made of the best parts of your business and the proven parts of
another. A startup would buy another business for various
reasons.

Acquisitions takeover-
• A friendly takeover is a scenario in which a target company is
willingly acquired by another company. Friendly takeovers are
subject to approval by the target company's shareholders, who
generally green light deals only if they believe the price per
share offer is reasonable.
• A hostile takeover is the acquisition of one company (called the
target company) by another (called the acquirer) that is
accomplished by going directly to the company's shareholders
or fighting to replace management to get the acquisition
approved.

Takeover Defense Tactics

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1) Poison Pill- it is shareholder rights plan is a distribution to the

target’s shareholders of the rights to purchase shares of the
target or the merging acquirer at a substantially reduced price.

2) Golden parachutes are additional compensations to the target’s

top management in the case of termination of its employment
following a successful hostile acquisition.

3) Greenmail is a buyout by the target of its own shares from the

hostile acquirer with a premium over the market price, which
results in the acquirer’s agreement not to pursue obtaining
control of the target in the near future.

4) Crown jewels are options under which a favored party can buy a
key part of the target at a price that may be less than its market
value.

5) White knight is a strategic merger that does not involve a change

of control and relieves the target’s management of the
responsibility to seek the best price available.

Amalgamation
An amalgamation is a combination of two or more companies
into a new entity. Amalgamation is distinct from a merger
because neither company involved survives as a legal entity.
Instead, a completely new entity is formed to house the combined
assets and liabilities of both companies.

❖ An example of an amalgamation is the merger between Kmart

and Sears.
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Advantages of Amalgamation:

 Increase in R&D facilities.

 Competition between the companies gets eradicated.

 Stability in the prices of the goods is maintained.

 Reduction in operating cost.

Types of amalgamation

Accounting Standard recognizes two types of amalgamation-

a) Amalgamation in the nature of merger.

b) Amalgamation in the nature of purchase.

An amalgamation should be considered to be an amalgamation in

the nature of merger when all the following conditions are
satisfied.

i) All assets and liabilities of the transferor company become, after

amalgamation, the assets and liabilities of the transferee
company.

ii) Share holders holding not less than 90% of the face value of the
equity shares of the transferor company (other than equity shares
already held therein, immediately before the amalgamation, by
the transferee company or its subsidiaries or their nominees)
become equity shareholders of the transferee company by virtue
of the amalgamation.

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iii) The business of the transferor company is intended to be carried

on, after the amalgamation by the transferee company.

iv) The consideration for the amalgamation receivable by those

equity shareholders of the transferor company who agree to
become equity shareholders of the transferee company is
discharged by the transferee company wholly by the issue of
equity shares in the transferee company, except that cash may be
paid in respect of any fractional shares.

v) No adjustments is intended to be made to the books values of the

assets and liabilities of the transferor company when they are
incorporated in the financial statements of the transferee
company except to ensure uniformity of accounting principles.

If these conditions are not satisfied the amalgamation is

considered as amalgamation in the nature of purchase.

Methods of Accounting for Amalgamation

The Pooling method

 This method is followed in case of an amalgamation in the nature

of merger. Under this method, the assets, liabilities and reserves
of the transferor company are recorded by the transferee
company at their existing carrying amounts and in the same form
as at the date of the amalgamation.

 The balance of the Profit and Loss Account of the transferor

company is aggregated with the balance of the Profit and Loss
Account of the transferee company or transferred to the General
Reserve, if any.
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 The difference between the amount recorded as share capital

issued plus any additional consideration in the form of cash or
other assets on the one hand and the amount of share capital of
the transferor company on the other hand is adjusted in reserves.

 If, at the tune of the amalgamation, the transferor and transferee

companies have conflicting accounting policies, a uniform set of
accounting policies is adopted following the amalgamation.

Purchase method-

❖ This method is followed in case of an amalgamation in the nature

of purchase. Under this method, the transferee company
accounts for the amalgamation either by incorporating the assets
and liabilities of the transferor company at their existing carrying
amounts or by allocating the consideration to individual
identifiable assets and liabilities of the transferor company on the
basis of their fair values at the date of amalgamation.

 For example, the transferee company may have a specialized use

for an asset. Also, the transferee company may intend to effect
changes in the activities of the transferor company which may
necessitate the creation of specific provisions for the expected
cost, for example, planned employee termination and plant
relocation costs.

 The reserves (whether capital or revenue or arising on

revaluation) of the transferor company, other than the statutory
reserves, are not included in the financial statements of the
transferee company.

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Holding Company Account

A holding company is one which controls one or more companies either
by means of holding shares in that company or companies or by having
powers to appoint—directly or indirectly—the whole, or a majority, of
the Board of Directors of those companies.

A company controlled by a holding company is known as a subsidiary

company. Practically, it is a part and parcel of the combination
movement in business and is operated for the purpose of controlling
companies engaged in a similar line of business.

A company, viz., X Ltd., may control another company, viz., Y Ltd., by

any one of the three ways:
(i) By holding more than half the shares—having voting rights in Y Ltd.;

(ii) By controlling the composition of the Board of Directors of Y Ltd.;

and

(iii) By controlling a holding company which actually controls Y Ltd. i.e.,

if Y Ltd. becomes the subsidiary of Z Ltd., and Z Ltd. becomes the
subsidiary of X Ltd., in that case, Y Ltd. will also be the subsidiary of X
Ltd

Statutory Definition—Subsidiary Company:

There is no statutory definition of holding company in the Companies
Act, 1956. But, Section 4 of the Companies Act, 1956, defines a

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subsidiary company. According to this section, a company is subsidiary

company of another if, but only if,

(a) that other company controls the composition of the Board of

Directors, or,

(b) that other

i) where the first-mentioned company is an existing company in respect

of which the holders of preference shares issued before the
commencement of this Act have the same voting rights in all respects
as the holders of equity shares, exercises or controls more than half of
the total voting power of such company;

ii) where the first-mentioned company is any other company, which

holds more than half in nominal value of its equity share capital;

(c) the first-mentioned company is a subsidiary of any company which is

that other company’s subsidiary.

For the purpose of Subsection (a) stated above, the company is said to
be in control or composition of its Board of Directors if, but only if—
’the other company by the exercise of some power exercisable by it at
its discretion without the consent or concurrence of any other person,
can appoint or remove the holders of all or a majority of the
directorships; but for the purpose of this provision that other company
shall be deemed to have power to appoint to a directorship with

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respect to which any of the following conditions is satisfied, that is to

say—

(a) That a person cannot be appointed thereto without the exercise in

his favor by that other company of such a power as aforesaid;

(b) That a person’s appointment thereto follows necessarily from his

appointment as Director, or manager of, or to any other office of
employment in, that other company; or

(c) That the directorship is held by an individual nominated by that

other company or a subsidiary thereof.

A company shall be deemed to be the holding company of another if,

but only if, that other is its subsidiary.

Advantages of Holding Companies:

Formation of a holding company offers many advantages some of
which are:
(a) Since the subsidiary company can maintain its own separate entity,
it can retain its own individual existence, i.e., goodwill cannot be
damaged as a result of the amalgamation.

(b) The subsidiary company can carry forward its losses for income-tax
purposes as it possesses its own separate entity.

(c) Economic and/or financial trend and rate of earning profit of

subsidiary companies can be known since they prepared their individual
accounts.
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(d) If a particular process is found to be unprofitable, the same can be

recognized and, if necessary, may be dissolved. Necessary arrangement
may be made for the same.

(e) Expenses and costs may be reduced as a result of the combination

of different general charges and overheads.

Disadvantages:
Formation of a holding company is also not free from snags. Some of
them are :
(a) There is a greater possibility of the exploitation of ‘outside’
shareholders, i.e., interest of minority shareholders are not properly
protected.

(b) It invites manipulation of accounts since the system of accounting is

a complicated one, particularly when the financial accounts of both the
holding and subsidiary companies are prepared at different dates.

(c) Valuation of share of a holding company is not so easy to calculate;

as a result, the shareholders find it very difficult to ascertain the value
of their holdings.

(d) Since the companies are connected with a number of companies,

creditors are easily misleaded.

(e) The financial conditions of the subsidiary companies may not be

expressed properly to the shareholders of the holding company.

Consolidation of Financial Statement:

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Although, in India, it is not mandatory to prepare a consolidated

financial statement other than to fulfill the requirement of the
Companies Act, 1956 (which has been discussed earlier), the Indian
holding companies prepare the consolidated final statement in order to
take the benefit of consolidation.

However, in developed countries (i.e., UK, USA, Japan, etc.) the

financial statements are to be consolidated with the subsidiary
company since it is mandatory.

International Accounting Standard (IAS 27) supplies “Consolidated

Financial Statements and Accounting for Investment in
Subsidiaries” which has been presented at the end of this chapter.
Consolidated Balance Sheet:
A Consolidated Balance Sheet is the Balance Sheet of both holding
company and its subsidiary or subsidiaries which is prepared in order to
show the assets and liabilities in a consolidated form. Its purpose is to
show the financial position of a group consisting of a holding and one or
more subsidiary companies. In India, as per Companies Act, 1956,
however, it is not required to make a Consolidated Balance Sheet. The
same is prepared only for the sake of convenience, i.e., in India, it is not
obligatory. But in U.K. the publication of the Consolidated Balance
Sheet is obligatory.

Before discussing the principles of consolidation certain other

adjustments relating to Consolidated Balance Sheet are to be discussed.
In short, all assets and liabilities should be classified in the same
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manner, valuation is to be made on the same principles and the date of

preparing accounts must also be the same.

Cost and Management Accounting

Marginal Costing

The ascertainment of marginal cost and of the effect on profit of changes

in volume or type of output by differentiating between fixed costs and
variable costs- ICMA

❖ It is the change in the total cost when the quantity produced is

incremented by one. That is, it is the cost of producing one more
unit of a good.
❖ The technique of costing is also known as “Variable Costing”,
Differential Costing” or Out of Pocket” costing.

Marginal Cost- The amount at any given volume of output by which

aggregate costs are changed if the volume of output is increased or
decreased by one unit.

Marginal Cost= Increase in Total Cost/ Increase in Total Units

Formula of Marginal Costing-

S-V= F+P

OR
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S-V= C

Features of Marginal Costing

 Features of marginal costing are as follows:

 Marginal costing is used to know the impact of variable cost on the
volume of production or output.
 Break-even analysis is an integral and important part of marginal
costing.
 Contribution of each product or department is a foundation to
know the profitability of the product or department.
 Addition of variable cost and profit to contribution is equal to
selling price.
 Marginal costing is the base of valuation of stock of finished
product and work in progress.
 Fixed cost is recovered from contribution and variable cost is
charged to production.
 Costs are classified on the basis of fixed and variable costs only.
Semi-fixed prices are also converted either as fixed cost or as
variable cost.

Need of Marginal Costing-

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 Variable cost per unit remains constant; any increase or decrease in

production changes the total cost of output.
 Total fixed cost remains unchanged up to a certain level of
production and does not vary with increase or decrease in
production. It means the fixed cost remains constant in terms of
total cost.
 Fixed expenses exclude from the total cost in marginal costing
technique and provide us the same cost per unit up to a certain
level of production.

CVP Analysis

❖ Cost- Volume Profit analysis is a study of the relationship between

a business’s costs, volume and their impact on profits.
❖ It is a tool used extensively in both planning and control functions
of an organization.
❖ It is as a planning tool when the management wants to find out the
desired profit, when the sales are known. Alternatively, the
management ma begin with a target profit and then work out the
level of sales needed to reach that profit level.
❖ As a control technique, CVP Analysis is used to measures the
performance of different departments in a company.
❖ This analysis is static as it is based on a given set of factors.
❖ The technique is also based on several assumptions like fixed costs
remain constant for the time period being examined, variable cost
and selling cost price per unit are constant for the time period
analyzed.
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There are several assumptions made, including:

 Sales price per unit is constant.

 Variable costs per unit are constant.
 Total fixed costs are constant.
 Everything produced is sold.
 Costs are only affected because activity changes.
 If a company sells more than one product, they are sold in the same
mix.

Break- even Analysis

❖ A basic application of CVP analysis is the break even analysis.

❖ It studies the relationship among the factors affecting profits, it is a
simple and easy method to understand the effects of change in
volume on profits.
❖ It is performed to determine the sales volume at which total
revenue equates total costs.
❖ The breakeven point is the sales level at which a company neither
earns a profit nor incurs a loss.
❖ It can compute algebraically and graphically and is expressed in
either unit of output or sales rupees.

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The break-even analysis is done under two conditions, which are as

follows:

i) Linear cost and revenue relationship-

a) Graphic Method

b) Algebraic Method

ii. Non-linear cost and revenue relationship-

a) Contribution Analysis

b) Profit Volume ratio

i. Graphical Method:

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 Shows a linear break-even analysis. When price of a product

remains the same, the organization expands its production, thus,
total revenue is linear to the output.

Let us learn this method through Graph

 As shown in Figure, TFC is equals to FE, which is a fixed cost

line. The vertical distance between TC and TFC line equals TVC.
As quantity of output increases, the vertical distance between TC
and TFC increases. This implies that TVC increases with change in
TC and TFC.
 Until Qb of the quantity is produced, total cost exceeds the total
revenue, which implies that an organization will suffer losses if it
produces less than Qb. At Qb output level, total revenue equals
total cost. At this point, an organization never makes profit nor loss
implying that it is a break-even point. Thus, Qb is a break-even
level of output. Producing more than Qb will be profitable for
organizations as TR is greater than TC.

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Break-even point (in units) = total fixed cost / (selling price per unit –
variable cost per unit )

Or

Total fixed costs/ Contribution per unit

Break even point ( in Rs ) = Fixed cost / P/V ratio

Or

= Break even point (unit ) * selling price per

Equation Technique

It is based on an income equation i.e.

Sales – Total costs = Net profit.

Breaking up total costs into fixed and variable,

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Sales – Fixed costs – Variable cost = Net profit

Sales = Fixed costs + Variable cost + Net profit

i.e.

SP(S) = FC + VC(S) + P

where

SP = Selling price per unit

S = Number of units required to be sold to break-even

FC = Total fixed costs

VC = Variable cost per unit

P = Net profit (Zero)

SP(S) = FC + VC(S) + Zero

SP(S) = FC + VC(S) + 0

SP(S) – VC(S) = FC

or

S(SP – VC) = FC

S= FC/SP- VC

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To calculate the level of sales required to earn a particular

level of profit, the formula is:

Required sales ( in Rs. ) = fixed cost + Desired profit / P/V ratio

Uses and Limitations of Break-Even Analysis:

 In break-even analysis; the costs of an organization are compared

with the level of sales volume to find out the point at which the
business likes non-profit no loss situation. It is a useful tool for
management to make various business decisions and deal with
uncertainty.

The limitations of break-even analysis are as follows:

i. Fails to be applied effectively in the multiple products situation

ii. Fails to be implemented in the situation where cost and price cannot
be ascertained and where historical data is not available

iii. Assumes fixed costs to be constant

iv. Assumes that quantity of goods produced is equal to the quantity of

goods sold, which may not be always true

v. Ignores changes in selling prices

vi. Ignores market conditions.

b. Profit volume (PV) ratio:

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 Refers to another method to find break-even point. The formula for

profit volume ratio is:
 PV ratio = (S-V)/S* 100
 S = Selling price
 V = Variable costs

Uses of P/V Ratio:

(i) It helps in the determination of Break-even-point [BEP = Fixed cost ÷

P/V ratio]

(ii) It helps in the determination of profit at any volume of sales

 [Sales x P/V ratio = Contribution, Profit = Contribution – Fixed

Cost]

(iii) It helps in the determination of sales to earn a desired amount of

profit

(vi) It helps in determining margin of safety

[Margin of safety = Profit ÷ P/V ratio]

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Margin of Safety

Margin of safety (MOS) is the difference between actual sales and

break even sales. In other words, all sales revenue that a company
collects over and above its break-even point represents the margin of
safety.

 It is the portion of sales revenue that generates profit for the

business because the sales volume achieved up to break-even point
can just cover the costs and does not bring any profit.
 It is an important figure for any business because it tells
management how much reduction in revenue will result in break-
even.
 A higher MOS reduces the risk of business losses. Generally,
the higher the margin of safety, the better it is.

The formula or equation of MOS is given below:

 Margin of safety = Actual or budgeted sales – Sales required to

break-even
 Margin of safety is also expressed in the form of ratio or
percentage that is calculated by using the following
formulas/equations:
 MOS ratio = MOS/Actual or budgeted sales
 MOS percentage = (MOS/Actual or budgeted sales) × 100

Application of Marginal Costing

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1- Profit Planning

2- Presentation of Cost Data for Control Purposes

3- Make or Buy Decision

4- Optimizing Product Mix

5- Alternative Use of Production Facilities

6- Evaluation of Performance

Profit Planning

 The concept of breakeven can be extended further to include profit

planning.
 The objective of a business is not just to breakeven but also to earn
profits.
 To calculate the profitability of the business, it is possible to
calculate the sales revenue required to provide the desired profits.
 The equation of break event point adding the desired profit to the
fixed assets.

It should be noted that determination of required activity

level will involve working out how that level will yield specified profit.
In this exercise, sale, cost and production activities are all reviewed in
harmony with each other to determine how they will yield the desired
profit figure. Marginal costing technique helps in profit planning,
because it is based on behavioural study of cost.
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Presentation of Cost Data for Control Purposes

 Marginal costing can be called a distinctly fine method of cost

analysis and cost presentation. Under marginal costing, cost data is
presented in such a way that it conforms to all the requirements of
management to effect control. Data presentation is based on the
behavioural study of cost.
 This leads the management to exercise relatively better control
over cost. An effort has been made to illustrate this point by the
following example. Readers should note how marginal costing
helps the management to grasp the actual state of affairs by better
presentation. Under absorption costing, cost data may be
misleading for the purpose of decision-making.

Make or Buy Decision

 Sometimes, a company has to decide, whether it should make the

component of its product or it should buy it from the market. On
the face of it, decision to make or buy should involve comparison
of seller’s price with marginal cost of that component. But this
approach will lead to wrong conclusion. When a component is
produced, a part of plant capacity is utilized, i.e., some
contribution is earned. If a company is running at its full capacity
the contribution thus earned will be lost by not manufacturing the
component.
 Of course, if company is not working at its full capacity the
question of lost contribution will become irrelevant. Thus this “lost
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contribution” becomes another factor of consideration in taking

decision, whether to manufacture a component or to buy it from
outside. This factor of ‘lost contribution’ will assume importance
only when the company is running at its full capacity.
 Consideration for the company to decide whether to manufacture
the product or to buy from the market-
 i) Seller’s price.
 ii) Marginal cost of producing the component.
 iii) Lost contribution
 iv) Government policy etc. may influence the decision of the
company
 v) Company may not like to depend on contractor for supply of
component.

Optimizing Product Mix

 When a concern manufactures a number of products, a problem

arises as to which product or sale mix will yield maximum profit.
Such a problem can be solved by marginal contribution analysis.
Product mix, which gives the maximum contribution, will be the
optimum mix.

Alternative Use of Production Facilities

 When an alternative method of manufacturing a product or

alternative is available, marginal contribution analysis should be

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made to arrive at the decision. The alternative yielding the highest

contribution will be selected.

Evaluation of Performance:

 A company may have different departments or product lines. All

these departments and product lines may have different revenue
earning potential. A company always concentrates on the
departments or the product-lines which yield more contribution
than others. The relative performance of each department or
product is studied by marginal contribution analysis. This analysis
will help the company to take decision that will maximise the
profits.

The following are some of the more popular areas of application of

marginal costing:

(i) Key factor (or) limiting factor

(ii) Make or buy decision
(iii) Fixation of selling prices
(iv) Export decision
(v) Sales mix decision
(vi) Product elimination decision
(vii) Plant merger decision
(viii) Plant purchase decision
(ix) Further processing decision
(x) Shut down decision

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Standard Costing
 Standard costing is the practice of estimating the expense of a
production process. It's a branch of cost accounting that's used by a
manufacturer, for example, to plan their costs for the coming year
on various expenses such as direct material, direct labor or
overhead. These manufacturers will also be able to compare the
standard cost to the actual costs.
 The difference between the standard cost and actual cost is known
as a variance. The presence of a variance indicates a deviation
from what was recorded in the profit plan. If actual costs are
greater than standard costs, it's likely that management can
anticipate a lower profit than expected. If actual costs are less than
standard costs, however, management might anticipate a higher
profit than they originally planned for.

Need of Standard Costing

 Future cost estimation: Standard Costs are determined after

considering all the possibilities that may arise in the future. It also
helps in deciding whether a particular project is to be undertaken,
by determining its profitability.
 Performance check: Standard cost acts as targets to the cost
centres which should not be transcended. In such a situation, these
targets are helpful in checking the performance through
comparison with the actual results.

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 Budgeting: The standard costs are used to prepare budgets, and

evaluate the performance of the executive staff on the basis of
these budgets.
 The basic objective of standard costing is to measure the
differences between standard costs and actual costs, and analyzing
them to maintain the productivity of the organization.

Advantages of standard costing

Standard costing provides managers with several advantages that can

help their business operate more efficiently. Here are a few examples:

 Efficiency- A standard costing system provides a quick estimate of

projected costs. Though accurate reports are nice to have, they are
not timely. A good estimate of costs provided in a timely manner is
highly preferable.
 Allows for cost control- In the event of variances, managers are
given the opportunity to rectify any discrepancies. This will then
allow them to improve cost control. This means they can be more
aware of spending habits in the future and strive for little to no
variances.
 Helps management make decisions- Standard costing can also
affect the way a business operates as a whole. Once managers have
determined any variances, this gives them the opportunity to act
and improve on current business practices and spending.
 Accurate budgets
 Lower production costs
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Disadvantages of standard costing

Though standard costing can be beneficial for business operations, it

also has some drawbacks. Here are some disadvantages of implementing
a standard costing system:

 Slow feedback- Because variance reports are only prepared

monthly and it takes time for this information to be released, by the
time it finally is released, the information might not be of pertinent
use anymore. This can be avoided by creating timely and more
frequent reports.
 Low morale- Most managers tend to focus on problem areas rather
than success. In regards to standard cost, they could be spending
more time rectifying any variances than congratulating employees
for a job well done
 Employee backlash- Because of low morale, employees could
potentially hide any unfavorable variance reports to avoid any
future repercussions. This would give managers a false sense of
their profit plan. Knowing the results of past variance reports could
also lead employees to take actions that would affect the business.
This could include employees putting in an increase in output at
the end of the month in order to avoid an unfavorable report. This
could then lead to a lower quality product.

Process of Standard Costing-

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 Establishing Standards: First and foremost, the standards are to

be set on the basis of management’s estimation, wherein the
production engineer anticipates the cost. In general, while fixing
the standard cost, more weight is given to the past data, the current
plan of production and future trends. Further, the standard is fixed
in both quantity and costs.
 Determination of Actual Cost: After standards are set, the actual
cost for each element, i.e. material, labour and overheads is
determined, from invoices, wage sheets, account books and so
forth.
 Comparison of Actual Costs and Standard Cost: Next step to
the process, is to compare the standard cost with the actual figures,
so as to ascertain the variance.
 Determination of Causes: Once the comparison is done, the next
step is to find out the reason for the variances, to take corrective
actions and also to evaluate the overall performance.
 Disposition of Variances: The last step to this process, is the
disposition of variances by transferring it to the costing profit and
loss account.

Types of Standard

Following are different types of standards:

 Basic standards
 Normal standards
 Current standards
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 Attainable (expected) standards

 Ideal (theoretical) standards

Basic Standard

 These are standards established considering those factors that are

basic in nature and remain unchanged over a long period of time
and are altered only when the business operations change
significantly affecting the very basic foundations of the entity and
nature of business.
 These standards help compare business operations over a longer
period of time. Basic standards are used not only to evaluate actual
results but also current expected results (current standards).
 We can say that basic standards work as a standard for other
standards. As basic standards are not updated according to latest
circumstances thus they are not used often as they cannot help in
short term period variance analysis.

Normal Standard

 These are such standards which are expected if normal

circumstances prevail. Term normal represents the normal
conditions of the business in the absence of any unexpected
fluctuations (either favorable or unfavorable).
 Even through normal standards are more of a theoretical in nature
as reality cannot be sufficiently predicted with all its fluctuations in
advance. Also, circumstances may change in such a way that

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factors which were expected to be controllable are not so

controllable by the mangers.
 Thus it has limited application in today’s business environment.
However, normal standards acts as a good yardstick that represents
challenging yet attainable results and can be used by management
in such environment which is simple in nature and is not prone to
great fluctuations.

Current standards

 These standards are representative of current business

conditions. These are mostly short term in nature and are widely
used as they are the most relevant standards to be used for
control purposes. These standards represent the state that
business currently achieving or must achieve.

Attainable standards / Expected standards

 These standards are based on current conditions and

circumstances and represents what can be attained with the
present setup in place and if the current conditions prevail.

 Current standards may be set lower or easier than expected

standards but good managers always try to achieve what is
attainable so that no resource is left unused.

 It means that attainable standards are representative of the

potential that business is capable to achieve.

Ideal standards / Theoretical standards.

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 These standards represents what business operations would be

under ideal set of circumstances where everything is running at
the optimum level with an ideal balance.

 These standards are representative of long term goals rather than

for short term performance measurement. But with the
advancement of technology and inventions even the ideal
standards become attainable over the period of time but with
every step taken forward and every question answered, more
questions and more complexities pop up and its in human nature
that it always extends the way forward with every milestone
achieved.

 Therefore, ideal standards are not meant to be achieved rather to

act like a guiding star.

Variance Analysis

 It helps companies in identifying the differences between actual

performance and standard performance and help to identify the
efficient and inefficient area.

 It help to isolate the cause of differences between the actual costs

and standard cost.

 For proper control both favorable and unfavorable variances

should be analyzed . The cause of the occurrence of variances
along with the individuals responsible for variances should also be
identified and analyzed thoroughly.

Kinds of variances-

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1- Material Variance

2- Labor Variance

3- Overhead Variance.

1- Material Variance-

The following constitutes material variances-

I- Material Cost Variance:

 Material cost variance is the difference between the actual cost of

direct material used and standard cost of direct materials
specified for the output achieved. This variance results from
differences between quantities consumed and quantities of
materials allowed for production and from differences between
prices paid and prices predetermined.

This can be computed by using the following formula:

 Material cost variance = (AQ X AP) – (SQ X SP)

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 Where AQ = Actual quantity

 P = Actual price

 SQ = Standard quantity for the actual output

 SP = Standard price

Material Usage Variance:

 The material quantity or usage variance results when actual

quantities of raw materials used in production differ from
standard quantities that should have been used to produce the
output achieved. It is that portion of the direct materials cost
variance which is due to the difference between the actual
quantity used and standard quantity specified.

As a formula, this variance is shown as:

 Materials quantity variance = (Actual Quantity – Standard

Quantity) x Standard Price

 A material usage variance is favorable when the total actual

quantity of direct materials used is less than the total standard
quantity allowed for the actual output.

(a) Material Mix Variance:

 The materials usage or quantity variance can be separated into

mix variance and yield variance.

 For certain products and processing operations, material mix is an

important operating variable, specific grades of materials and
quantity are determined before production begins. A mix variance
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will result when materials are not actually placed into production
in the same ratio as the standard formula.

 Materials mix variance is that portion of the materials quantity

variance which is due to the difference between the actual
composition of a mixture and the standard mixture.

It can be computed by using the following formula:

 Material mix variance = (Standard cost of actual quantity of the

actual mixture – Standard cost of actual quantity of the standard
mixture)

Or

 Materials mix variance = (Actual mix – Revised standard mix of

actual input) x Standard price

Revised standard mix or proportion is calculated as follows:

 Standard mix of a particular material/Total standard quantity x

Actual input

(b) Materials Yield Variance:

 Materials yield variance explains the remaining portion of the

total materials quantity variance. It is that portion of materials
usage variance which is due to the difference between the actual
yield obtained and standard yield specified (in terms of actual
inputs). In other words, yield variance occurs when the output of
the final product does not correspond with the output that could
have been obtained by using the actual inputs. In some industries

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like sugar, chemicals, steel, etc. actual yield may differ from
expected yield based on actual input resulting into yield variance.

 The total of materials mix variance and materials yield variance

equals materials quantity or usage variance. When there is no
materials mix variance, the materials yield variance equals the
total materials quantity variance. Accordingly, mix and yield
variances explain distinct parts of the total materials usage
variance and are additive.

The formula for computing yield variance is as follows:

 Yield Variance = (Actual yield – Standard Yield specified) x

Standard cost per unit

Materials Price Variance:

 A materials price variance occurs when raw materials are

purchased at a price different from standard price. It is that
portion of the direct materials which is due to the difference
between actual price paid and standard price specified and cost
variance multiplied by the actual quantity. Expressed as a formula,

Materials price variance = (Actual price – Standard price) x Actual

quantity

 Materials price variance is un-favorable when the actual price

paid exceeds the predetermined standard price. It is advisable
that materials price variance should be calculated for materials
purchased rather than materials used. Purchase of materials is an
earlier event than the use of materials.

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 Therefore, a variance based on quantity purchased is basically an

earlier report than a variance based on quantity actually used.
This is quite beneficial from the viewpoint of performance
measurement and corrective action. An early report will help the
management in measuring the performance so that poor
performance can be corrected or good performance can be
expanded at an early date.

 Recognizing material price variances at the time of purchase lets

the firm carry all units of the same materials at one price—the
standard cost of the material, even if the firm did not purchase all
units of the materials at the same price. Using one price for the
same materials facilities management control and simplifies
accounting work.

 If a direct materials price variance is not recorded until the

materials are issued to production, the direct materials are carried
on the books at their actual purchase prices. Deviations of actual
purchase prices from the standard price may not be known until
the direct materials are issued to production.

2- Labour Variance

 Direct labor variances arise when actual labor costs are different
from standard labor costs. In analysis of labor costs, the emphasis
is on labor rates and labor hours.

Labour variances constitute the following:

 Labour Cost variance:-

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 Labour cost variance denotes the difference between the actual

direct wages paid and the standard direct wages specified for the
output achieved.

This variance is calculated by using the following formula:

Labour cost variance = (AH x AR) – (SH x SR)

Where:

AH = Actual hours

AR = Actual rate

SH = Standard hours

SR = Standard rate

1. Labour Efficiency Variance:

 The calculation of labour efficiency or usage variance follows the

same pattern as the computation of materials usage variance.
Labour efficiency variance occurs when labour operations are
more efficient or less efficient than standard performance. If
actual direct labour hours required to complete a job differ from
the number of standard hours specified, a labour efficiency
variance results; it is the difference between actual hours
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expended and standard labour hours specified multiplied by the

standard labour rate per hour.

Labour efficiency variance is computed by applying the following

formula:

 Labour efficiency variance = (Actual hours – Standard hours for

the actual output) x Std. rate per hour.

ii) Labour Yield Variance:

 The final product cost contains not only material cost but also
labour cost. Therefore, gain or loss (higher or lower output than
the standard output) should take into account labour yield
variance also. A lower output simply means that final output does
not correspond with the production units that should have been
produced from the hours expended on the inputs.

It can be computed by applying the following formula:

Labour yield variance = (Actual output – Standard output based

on actual hours) x Av. Std. Labour Rate per unit of output.

Or

Labour yield variance = (Actual loss – Standard loss on actual

hours) x Average standard labour rate per unit of output

Labour yield variance is also known as labour efficiency sub-

variance which is computed in terms of inputs, i.e., standard
labour hours and revised labour hours mix (in terms of actual
hours).

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Labour efficiency sub-variance is computed by using the following

formula:

 Labour efficiency sub-variance = (Revised standard mix – standard

mix) x Standard rate

2. Labour Rate Variance:

 Labour rate variance is computed in the same manner as

materials price variance. When actual direct labour hour rates
differ from standard rates, the result is a labour rate variance. It is
that portion of the direct wages variance which is due to the
difference between actual rate paid and standard rate of pay
specified.

The formula for its calculation is:

Labour rate variance = (Actual rate – Standard rate) x Actual hours

3. Idle Time Variance:

 Idle time variance occurs when workers are not able to do the
work due to some reason during the hours for which they are
paid. Idle time can be divided according to causes responsible for
creating idle time, e.g., idle time due to breakdown, lack of
materials or power failures. Idle time variance will be equivalent
to the standard labour cost of the hours during which no work has
been done but for which workers have been paid for
unproductive time.

3- Overhead Variances-

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The analysis of factory overhead variances is more complex than

variance analysis for direct materials and direct labour. There is no
standardization of the terms or methods used for calculating
overhead variances. For this reason, it is necessary to be familiar
with the different approaches which can be applied in overhead
variances.

Generally, the computation of the following overhead variances is

suggested:

(1) Total Overhead Cost Variance:

 This overall overhead variance is the difference between the

actual overhead cost incurred and the standard cost of overhead
for the output achieved.

This can be computed by applying the following formula:

 (Actual overhead incurred) – (Standard hours for the actual

output x Standard overhead rate per hour)
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 Or

 (Actual overhead incurred) – (Actual output x Standard overhead

rate per unit)

(2) Variable Overhead Variance:

 It is the difference between actual variable overhead cost and

standard variable overhead allowed for the actual output
achieved.

The formula for computing this variance is as follows:

(Actual Variable Overhead Cost) – (Actual Output x Variable

Overhead rate per unit)

Or

(Actual Variable Overhead Cost) – (Std. hours for actual output x

Std. Variable overhead rate per hour)

3) Fixed Overhead Variance:

 This variance indicates the difference between the actual fixed

overhead cost and standard fixed overhead cost allowed for the
actual output.

This variance is found by using the following formula:

Fixed Overhead Variance = (Actual Fixed Overhead Cost – Fixed

Overhead absorbed)

Or

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(Actual Fixed Overhead Cost) – (Actual Output x Fixed Overhead

rate per unit)

Or

(Actual fixed overhead cost) – (Std. hours for actual output x Std.
fixed overhead rate per hour)

(4) Variable Overhead Expenditure (Spending or Budget) Variance:

 This variance indicates the difference between actual variable

overhead and budgeted variable overhead based on actual hours
worked.

This variance is found by using the following:

 (Actual variable overhead – Budgeted variable overhead)

(5) Variable Overhead Efficiency Variance:

 This variance is like labour efficiency variance and arises when

actual hours worked differ from standard hours required for good
units produced. The actual quantity produced and standard
quantity fixed might be different because of higher or lower
efficiency of workers employed in the manufacturing of goods.

This variance is found by using the following formula:

(Actual hours – Standard hours for actual output) x Standard

variable overhead rate per hour

(6) Fixed Overhead Expenditure (Spending or Budget) Variance:

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 This variance indicates the difference between actual fixed

overhead and budgeted fixed overhead.

The formula for computing this variance is as follows:

 (Actual fixed overhead – Budgeted fixed overhead)

(7) Fixed Overhead Volume Variance:

 Volume variance relates to only fixed overhead. This variance

arises due to the difference between the standard fixed overhead
cost allowed (absorbed) for the actual output and the budgeted
fixed overhead based on standard hours allowed for actual output
achieved during the period. The variance shows the over-or-
under-absorption of fixed overheads during a particular period. If
the actual output is more than the standard output, there is over-
absorption and variance is favourable. If actual output is less than
the standard output, the volume variance is unfavorable.

The formula for computing this variance is as follows:

(Budgeted fixed overhead applied to actual output – Budgeted fixed

overhead based on standard hours allowed for actual output)

Or

(Actual production – Budgeted production) x Std. fixed overhead

rate per unit

8) Fixed Overhead Calendar Variance:

 It is that portion of volume variance which is due to the difference

between the number of actual working days in the period to
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which the budget is applicable and budgeted number of days in

the budget period.

 If actual working days is more than the budgeted working days,

the variance is favorable as work has been done on days more
than budgeted or allowed and vice-versa.

The formula is as follows:

(No. of actual working days – No. of budgeted working days) x Std.

fixed overhead rate per day. Calendar variance can be computed
based on hours or output.

Then the formulae are:

 Hours Basis:

Calendar Variance = (Revised Budget Capacity hours – Budget

Hours) x Std. Fixed Overhead rate per hour

 If revised budgeted capacity hours are more than the budgeted

hours, the variance will be favourable. In the reverse situation,
the variance will be unfavourable.

Output Basis:

 Calendar Variance = (Revised budgeted quantity in terms of actual

number of days worked – Budgeted quantity) x Standard fixed
overhead rate per unit

 If revised budgeted quantity is more than the budgeted quantity;

the variance is favourable; if revised budgeted quantity is less, the
variance will be unfavourable.
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(9) Fixed Overhead Efficiency Variance:

 It is that portion of volume variance which arises when actual

hours of production used for actual output differ from the
standard hours specified for that output. If actual hours worked
are less than the standard hours, the variance is favourable and
when actual hours are more than the standard hours, the
variance is unfavourable.

The formula is:

Fixed Overhead Efficiency Variance = (Actual hours – Standard hours for

actual production) x Fixed overhead rate per hour

 Fixed Overhead Efficiency Variance = (Actual production –

Standard production as per actual time available) x Fixed
overhead rate per unit

(10) Fixed Overhead Capacity Variance:

 It is that part of fixed overhead volume variance which is due to

the difference between the actual capacity (in hours) worked
during a given period and the budgeted capacity (expressed in
hours). The formula is

 Capacity Variance = (Actual Capacity Hours – Budgeted Capacity) x

Standard fixed overhead rate per hour

 This variance represents idle time also. If actual capacity hours are
more than the budgeted capacity hours, the variance is favorable
and if actual capacity hours are less than the budgeted capacity
hours the variance will be unfavourable.
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Two-way, Three-way and Four-way Variance Analysis:

 The above overhead variances are also classified as Two-way,

Three-way and Four-way variance.

The different variances under these categories are listed below:

(A) Two-way Variance Analysis:

 The two-way analysis computes two variances budget variance

(sometimes called flexible budget or controllable variance) and
volume variance, which means:

 (i) Budget variance = Variable spending variance + Fixed spending

(budget) Variance + Variable efficiency variance

 (ii) Volume variance = Fixed volume variance

(B) Three -Way Variance Analysis:

The three-way analysis computes three variances spending, efficiency

and volume variances. Therefore,

 (i) Spending variance = Variable spending variance + Fixed

spending (budget) variance

 (ii) Efficiency variance = Variable efficiency variance

 (iii) Volume variance = Fixed volume variance

(C) Four-way Variance Analysis:

 The four-way analysis includes:

 (i) Variable spending variance

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 (ii) Fixed spending (budget) variance

 (iii) Variable efficiency variance

 (iv) Fixed volume variance.

Budget, Budgetary and Budgetary Control

Budget

 A budget is a financial plan for a defined period, often one year. It

may also include planned sales volumes and revenues, resource
quantities, costs and expenses, assets, liabilities and cash flows.
Companies, governments, families and other organizations use it
to express strategic plans of activities or events in measurable
terms.

 A budget is the sum of money allocated for a particular purpose

and the summary of intended expenditures along with proposals
for how to meet them. It may include a budget surplus, providing
money for use at a future time, or a deficit in which expenses
exceed income.

Budgeting

Budgeting is the complete process of designing, implementing and

operating budgets. The main emphasis in this is short-term budgeting
process involving the provision of resources to support plans which are
being implemented.

Budgetary Control

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Budgetary control is the process by which budgets are prepared for the
future period and are compared with the actual performance for
finding out variances, if any. The comparison of budgeted figures with
actual figures will help the management to find out variances and take
corrective actions without any delay.

Objectives of Budgetary Control

The main objectives of budgetary control are given below:

1. Defining the objectives of the enterprise.

2. Providing plans for achieving the objectives so defined.

3. Coordinataing the activities of various departments.

4. Operating various departments and cost centers economically and

efficiently.

5. Increasing the profitability by eliminating waste.

6. Centralizing the control system.

7. Correcting variances from sit standards.

8. Fixing the responsibility of various individuals in the enterprise.

Advantages of Budgetary Control

Budgetary control has become an important tool of an organization to

control costs and to maximize profits. Some of the advantages of
budgetary control are:

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1- It defines the goals, plans and policies of the enterprise. If there is no

definite aim then the efforts will be wasted in achieving some other
aims.

2- Budgetary control fixes targets. Each and every department is forced

to work efficiently to reach the target. Thus, it is an effective method of
controlling the activities of various departments of a business unit.

3. It secures better co-ordination among various departments.

4. In case the performance is below expectation, budgetary control

helps the management in finding up the responsibility.

5. It helps in reducing the cost of production by eliminating the

wasteful expenditure.

6. By promoting cost consciousness among the employees, budgetary

control brings in efficiency and economy.

7. Budgetary control facilitates centralized control with decentralized

activity

Disadvantages or Limitations of Budgetary Control

The following are the limitations of budgetary control:

1. It is really difficult to prepare the budgets accurately under

inflationary conditions.

2. Budget involves a heavy expenditure which small business concerns

cannot afford.

3. Budgets are prepared for the future period which is always

uncertain. In future, conditions may change which will upset the
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budgets. Thus, future uncertainties minimize the utility of budgetary

control system.

4. Budgetary control is only a management tool. It cannot replace

management in decision-making because it is not a substitute for
management.

5. The success of budgetary control depends upon the support of the

top management. If there is lack of support from top management,
then this will fail.

Implementation of Budgetary Control

The following points highlight the seven necessary steps for successful
implementation of a budgetary control system, i.e,

1) Organization for Budgetary Control,

2) Budget Centers,

3) Budget Manual,

4) Budget Officer,

5) Budget Committee,

6) Budget Period, and

7) Determination of Key Factor.

1. Organization for Budgetary Control:

 The proper organization is essential for the successful

preparation, maintenance and administration of budgets. A
Budgetary Committee is formed which comprises the
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departmental heads of various departments. All the functional

heads are entrusted with the responsibility of ensuring proper
implementation of their respective departmental budgets.

2. Budget Centres:

 A budget centre is that part of the organisation for which the

budget is prepared. A budget centre may be a department,
section of a department or any other part of the department. The
establishment of budget centres is essential for covering all parts
of the organisation. The budget centres are also necessary for cost
control purposes. The appraisal of performance of different parts
of the organisation becomes easy when different centres are
established.

3- Budget Manual-

 A budget manual is a document which spells out the duties and

the also the responsibilities of the various executives concerned
with the budgets. It specifies the relations among various
functionaries.

A budget manual covers the following matters:

(i) A budget manual clearly defines the objectives of budgetary control

system. It also gives the benefits and principles of this system.

(ii) The duties and responsibilities of various persons dealing with

preparation and execution of budgets are also given in a budget
manual. It enables the management to know of persons dealing with
various aspects of budgets and clarify their duties and responsibilities.

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(iii) It gives information about the sanctioning authorities of various

budgets. The financial powers of different managers are given in the
manual for enabling the spending of amount on various expenses.

(iv) A proper table for budgets including the sending of performance

reports is drawn so that every work starts in time and a systematic
control is exercised.

(v) The specimen forms and number of copies to be used for preparing
budget reports will also be stated. Budget centres involved should be
clearly stated.

(vi) The length of various budget periods and control points is clearly
given.

4- Budget Officer:

 The Chief Executive who is at the top of the organization, appoints

some person as Budget Officer, The budget officer is empowered
to scrutinize the budgets prepared by different functional heads
and to make changes in them, if the situation so demands. The
actual performance of different departments is communicated to
the Budget Officer.

 He determines the deviations in the budgets and takes necessary

steps to rectify the deficiencies, if any. He works as a coordinator
among different departments and monitors the relevant
information. He also informs the top management about the
performance of different departments. The budget officer will be
able to carry out his work fully well only if he is conversant with
the working of all the departments.
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5. Budget Committee:

 In small scale concerns, the accountant is made responsible for

preparation and implementation of budgets. In large scale
concerns a committee known as Budget Committee is formed.
The heads of all the important departments are made members of
this committee. The committee is responsible for preparation and
execution of budgets. The members of this committee put up the
case of their respective departments and help the committee to
take collective decisions, if necessary. The Budget Officer acts as
coordinator of this committee.

6. Budget Period:

 A budget period is the length of time for which a budget is

prepared. The budget period depends upon a number of factors.
It may be different for different industries or even it may be
different in the same industry or business.

The budget period depends upon the following considerations:

(a) The type of budget i.e., sales budget, production budget, raw
materials purchase budget, capital expenditure budget. A capital
expenditure budget may be for a longer period i.e., 3 to 5 years:
purchase, sale budgets may be for one year.

(b) The nature of demand for the products.

(c) The timings for the availability of the finances.

(d) The economic situation of the cycles.

(e) The length of trade cycles.

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7. Determination of Key Factor:

 The budgets are prepared for all functional areas. These budgets
are inter-dependent and inter-related. A proper co-ordination
among different budgets is necessary for making the budgetary
control a success. The constraints on some budgets may have an
effect on other budgets too. A factor which influences all other
budgets is known as Key Factor or Principal Factor.

 There may be a limitation on the quantity of goods a concern may

self In this case, sales will be a key factor and all other budgets will
be prepared by keeping in view the amount of goods the concern
will be able to sell. The raw material supply may be limited; so
production, sales and cash budgets will be decided according to
raw materials budget. Similarly, plant capacity may be a key factor
if the supply of other factors is easily available.

Classification of Budget

Budgets classified according to 4 bases;

 Based on Time;

 Based on Condition;

 Based on Functions;

 Based on Flexibility;

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Types of Budget Based on Time

Based on time factor budgets can be classified into two types;

 Long-term Budget, and

 Short-term Budget.

Long-term Budget

 This budget is related to the planning operations of an

organization for a period of 5 to 10 years. The long-term budget
may be adversely affected due to unpredictable factors.
Therefore, from a control point of view, the long-term budget
should be supplemented by short-term budgets.

 Example: Research and Development Budget, Capital Expenditure

Budget, etc.

Short-term Budget

 This budget is drawn usually for one year. Sometimes a budget

may be prepared for a shorter period (like monthly budget,

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quarterly budget, etc.). Shortterm budgets are prepared in detail

and these budgets help to exercise control over day-to-day
operations.

 Example: Material Consumption Budget, Labor Utilization Budget,

Cash Budget, etc.

Types of Budget Based on Condition

 Based on conditions prevailing, a budget can be classified into 2

types;

 Basic Budget, and

 Current Budget.

Basic Budget

 A budget that is established for use as unaltered over a long

period is called Basic Budget.

 This budget does not take into consideration changes occurring

from the external environment which are beyond the control of
management. This budget is more useful for top-level
management for formulating policies.

Current Budget

 A budget that is established for use over a short period and is

related to the current conditions is called the Current Budget. This
budget is adjusted to the current conditions prevailing in the
business.

Types of Budget Based on Functions

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 Based on activities or functions of a business, budgets can be

classified into 2 types

 Master Budget, and

 Functional Budgets.

Master Budget

 The final integration of all functional budgets by the Budget

Officer provides the Master Budget. When functional budgets
have been completed, the Budget Officer prepares the Master
Budget.

 Master Budget is the summary budget incorporating its

component functional budgets, which is finally approved, adopted
and employed. [C. I. M. A. (London)l.

 Master Budget shows the operating profit of the business for the
budget period and budgeted balance sheet at its close. This
Budget portrays the overall plan for the budget period.

 The master budget consists of several separate but

interdependent budgets. The first step in the budgeting process is
the preparation of the sales budget, which is a detailed schedule
showing the expected sales for the budget period. An accurate
sales budget is the key to the entire budgeting process.

 If the sales budget is inaccurate, the rest of the budget will be

inaccurate. The sales budget is based on the company’s sales
forecast, which may require the use of sophisticated
mathematical models and statistical tools.
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 We will not go into the details of how sales forecasts are made.
This is a subject that is most appropriately covered in marketing
courses.

 The sales budget helps determine how many units need to be

produced.

 Thus, the production budget is prepared after the sales budget.

The production budget, in turn, is used to determine the budgets
for manufacturing costs including the direct materials budget, the
direct labor budget, and the manufacturing overhead budget.

 These budgets are then combined with data from the sales
budget and the selling and administrative expense budget to
determine the cash budget.

 A cash budget is a detailed plan showing how cash resources will

be acquired and used. After the cash budget is prepared, the
budgeted income statement and then the budgeted balance sheet
can be prepared.

Functional Budgets

Functional Budgets relate to functions of the business such as product

sales etc. In other words,

These are prepared in respect of various functions performed in a

business.

Functional Budgets which are commonly found in a business concern

are as follows;

 Sales Budget;
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 Production Budget;

 Material Budget;

 Labor Budget;

 Production Overhead Budget;

 Administration Overhead Budget;

 Selling & Distribution Overhead Budget;

 Plant Utilization Budget;

 Cash Budget

 Research & Development Budget and more.

Sales Budget

 The sales budget is the starting point in preparing the master

budget. The sales budget is constructed by multiplying budgeted
unit sales by the selling price.

 A schedule of expected cash collections is prepared after the sales

budget. This schedule will be needed later to prepare the cash
budget.

 Cash collections consist of collections on credit sales made to

customers in prior periods plus collections on sales made in the
current budget period.

Production Budget

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 The production budget is prepared after the sales budget. The

production budget lists the number of units that must be
produced to satisfy sales needs and to provide for the desired
ending inventory.

Production needs can be determined as follows:

 Budgeted unit sales……………… XXXX

 Add the desired ending inventory… XXXX

 Total needs………………………….. XXXX

 Less beginning inventory……….. XXXX

 Required production……………… XXXX

 Note that production requirements are influenced by the desired

level of the ending inventory. Inventories should be carefully
planned. Excessive inventories tie up funds and create storage
problems.

 Insufficient inventories can lead to lost sales or last-minute, high-

cost production efforts. At Hampton Freeze, management
believes that an ending inventory equal to 20% of the next
quarter’s sales strikes the appropriate balance.

Cash Budget

 The cash budget is composed of four major sections:

 The receipts section.

 The disbursements section

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 The cash excess or deficiency section.

 The financing section.

 The receipts section lists all of the cash inflows, except for
financing, expected during the budget period. Generally, the
major source of receipts is from sales.

 The disbursements section summarizes all cash payments that are

planned for the budget period.

 These payments include raw materials purchases, direct labor

payments, manufacturing overhead costs, and so on, as contained
in their respective budgets.

 Also, other cash disbursements such as equipment purchases and

dividends are listed.

 The budget is the forecast of expected cash receipts and cash

disbursement during the budget period. The importance of cash
budget need not be overemphasized. Cash is the lifeblood of the
business. Without sufficient cash, a business can not be run
smoothly.

 Cash is required for the purchase of raw material, payment of

wages and other expenses, acquisition of assets, fulfillment of
commitment to investors and so on.

 The preparation of functional budgets will be a useless job unless

the requisite amount of cash is made available to implement
them.

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 That is why; the cash budget has assumed enormous importance.

It reflects possible receipts of cash from various sources and the
expected requirement of cash for meeting various obligations.

 In this way, it highlights well in advance neither the need for

taking necessary measures to streamline the cash flows so that
there is neither any cash shortage nor the surplus of cash.

 A cash budget is prepared for the budget period, however, for

effective cash management, it is generally divided monthly,
weekly or even daily.

Purpose of Cash Budget

 The principal purposes of the cash budget may be outlined as

follows:

 It indicates the probable cash position as a result of planned

operations.

 Indicates cash excess or shortages.

 It indicates the need to arrange for short-term borrowing, or the

availability of idle cash for investment.

 It makes provision for the co-ordination of cash about (i) total

working capital (ii) sales, (iii) investment, and debt.

 It establishes a sound basis for obtaining credit.

 It establishes a sound basis for current control of the cash

position.

Types of Budget based on Flexibility

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 Based on flexibility budgets can be classified into two types;

 Fixed Budget, and

 Flexible Budget.

Fixed Budget (or Static Budget)

 Fixed Budget is a budget which is designed to remain unchanged

irrespective of the level of activity attained. This type of budget is
most suited for Fixed expenses, which have no relation to the
volume of output. Fixed -Budget is ineffective as a tool for cost
control. Fixed Budget is based on the assumption that the volume
of output and sales can be anticipated with a fair degree of
accuracy.

Flexible Budget (or Sliding Scale Budget)

 Flexible Budget is a budget which is designed to change by the

level of activity attained.

 This budget recognizes the difference in behavior between fixed

and variable costs about fluctuations in output. This budget serves
as a useful tool for controlling costs. It is more realistic, practical
and useful than Fixed Budget.

 A flexible budget that can be used to estimate what costs should

be for any level of activity within a specified range. A flexible
budget shows what costs should be for various levels of activity.

 The flexible budget amount for a specific level of activity is

determined differently depending on whether a cost is variable or
fixed.
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 If a cost is variable, the flexible budget amount is computed by

multiplying the cost per unit of activity by the level of activity
specified for the flexible budget. If a cost is fixed, the original total
budgeted fixed cost is used as the flexible budget amount.

Characteristics of a Flexible Budget

 Flexible budgets take into account how changes in activity affect

costs. A flexible budget makes it easy to estimate what costs
should be for any level of activity within a specified range.

 When a flexible budget is used in performance evaluation, actual

costs are compared to what the costs should have been for the
actual level of activity during the period rather than to the
budgeted costs from the original budget.

 This is a very important distinction— particularly for variable

costs. If adjustments for the level of activity are not made, it is
very difficult to interpret discrepancies between budgeted and
actual costs.

Zero Based Budgeting

 It is a new approach to budgetary planning and control. It was
successfully developed and implement in the 1970s by Peter A.
Pyhre

 Zero based budgeting in management accounting involves

preparing the budget from the scratch with a zero-base. It
involves re-evaluating every line item of cash flow statement and

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justifying all the expenditure that is to be incurred by the

department.

Zero Based Budgeting Steps

 1) Identification of a task

 2) Finding ways and means of accomplishing the task

 3) Evaluating these solutions and also evaluating alternatives of

sources of funds

 4) Setting the budgeted numbers and priorities

Advantages

 Accuracy: Against the regular methods of budgeting that involve

just making some arbitrary changes to the previous year’s budget,
zero-based budgeting makes every department relook each and
every item of the cash flow and compute their operation costs.
This to some extent helps in cost reduction as it gives a clear
picture of costs against the desired performance.

 Efficiency: This helps in efficient allocation of resources

(department-wise) as it does not look at the historical numbers
but looks at the actual numbers

 Reduction in redundant activities: It leads to the identification of

opportunities and more cost-effective ways of doing things by
removing all the unproductive or redundant activities.

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 Budget inflation: Since every line item is to be justified, zero-

based budget overcomes the weakness of incremental budgeting
of budget inflation.

 Coordination and Communication: It also improves coordination

and communication within the department and motivates
employees by involving them in decision-making.

Disadvantages

 Time-Consuming: Zero-based budgeting is a very time-intensive

exercise for a company or a government-funded entities to do
every year as against incremental budgeting, which is a far easier
method.

 High Manpower Requirement: Making an entire budget from the

scratch may require the involvement of a large number of
employees. Many departments may not have an adequate time
and human resource for the same.

 Lack of Expertise: Explaining every line item and every cost is a

difficult task and requires training the managers.

Zero-based budgeting aims at reflecting true expenses

to be incurred by a department or a state. Although time-consuming,
this is a more appropriate way of budgeting. At the end of the day, it is
a company’s call as whether it wants to invest time and manpower in
the budgeting exercise to provide more accurate numbers or go for an
easier method of incremental budgeting.

Performance Budgeting
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Performance budget also referred to as performance-

based budgeting is a practice of preparing the budget based on the
evaluation of the productivity of the different operations in an
organization. Operations which are contributing the most to the
profitability, the larger share of the budget is allocated to that division.
It leads to optimum utilization of resources such as finance, skills of the
staff, use of the productive time etc.

EXAMPLE OF PERFORMANCE BUDGETING

 30% reduction in death ratio of HIV-Positive patients by the end of

2020.

 20% increase in production in 2018 by staff training on a monthly

basis.

 50% reduction in infant mortality rate by implementing robust

vaccination centers in all different parts of the country by 2022.

ADVANTAGES OF PERFORMANCE BUDGET

In the advanced world, the management of money becomes one of the

important factors for any organization. The performance budget plays
an important role to achieve efficiency.

 Set accountability

 Clear purpose

 Improvement in performance

 Transparency

DISADVANTAGES OF PERFORMANCE BUDGET

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 Subjective

 Strong system of evaluation

 Manipulation of data

 Difficult for long-term

Process Accounting
 Process accounting is a security method in which an administrator
may keep track of system resources used and their allocation
among users, provide for system monitoring, and minimally track
a user's commands.

 Process accounting has both positive and negative points. One of

the positives is that an intrusion may be narrowed down to the
point of entry. A negative is the amount of logs generated by
process accounting, and the disk space they may require. This
section walks an administrator through the basics of process
accounting.

Meaning of Process Accounting

 Process costing is a method of costing under which all costs are

accumulated for each stage of production or process, and the cost
per unit of product is ascertained at each stage of production by
dividing the cost of each process by the normal output of that
process.

 CIMA London defines process costing as “that form of operation

costing which applies where standardize goods are produced”

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 According to Eric Kohler, “Process costing is a method of Cost

Accounting whereby costs are charged to processes or operations
and averaged over units produced.”

Features of Process Accounting-

(1) The production of goods is continuous, except where the plant

is shut-down for repairs, until the final product.

(2) The finished product is the result of two or more processes.

(3) The product of the first process becomes the raw material for
the second process and so on.

(4) Each process is distinct and is pre-determined.

(5) Costs are accumulated by processes.

(6) The products are standardized and homogeneous.

(7) It is not possible to distinguish finished products while they are

in the stage of processing.

(8) The cost of production of one process is transferred to

subsequent process or processes just as output on one process is
transferred as input of other process.

(9) The production of main product is often accompanied by

secondary products which are termed as point and bye-products.

(10) The semi-finished products are expressed in terms of

complete products. This is technically termed as equivalent
production.

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(11) The production is undertaken on a continuous and large scale

basis in anticipation of demand.

(12) Cost of production is ascertained at each process and finally

after completion of production.

Types of Process Costing Method:

There are three types of process costing method. They are:

(1) Sequential Process Cost Method:

 Under this method, all products pass through a series of processes

in sequence. Under this method of process costing, output and
cost of production is transferred from process to process until
finished products are obtained. This method is used by industries
which manufacture a single uniform product or products that are
uniformly processed.

(2) Parallel Process Cost Method:

 Under this method, two or more products pass through two or

more separate sets of processes. The different sets of processes
may be carried on simultaneously or one set may be run for a
while and then another started.

(3) Selective Process Cost Method:

 Under this method, cost is accumulated from various processes

for various products. They are used where the products pass
through only some of the processes but not all the processes of
the industry. Thus, the process cost vary for different products.

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Meat packing industry is an example of this type of process

costing.

(4) Suitability of Process Costing Method:

Process costing method is most suitable in the following cases:

(1) Where production is continuous and on large scale.

(2) Where products are homogeneous or identical.

(3) Where goods pass through two or more distinct processes to

completion.

(4) Where output of one process becomes the input of the subsequent
processes.

5. Process Costing is Applicable in Industries:

(1) Iron and Steel Industry

(2) Automobile Industry

(3) Cement Industry

(4) Chemical Industry

(5) Sugar Industry

(6) Plastic Industry

(7) Textile Industry

(8) Paper Industry

(9) Paints and Varnish Industries

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(10) Industries Producing Drugs and Medicines

Objects of Process Costing:

Following are the main objects of process costing:

(1) To Ascertain the Cost of Each Process:

 It is necessary to know the cost at every stage of production and

this is fulfilled by process costing method. On this basis
management is able to take decision in respect of make or buy
the required commodities.

(2) To Ascertain the Cost of Bye-Product:

 Bye-product is that which is obtained with the main product in the

course of production.

(3) To Know the Wastage in Each Process of Production:

 During the courage of production, different wastages, such as,

loss in weight, normal wastage and abnormal wastage, etc. may
arise. Management of any concern may know about these
wastages by Process Costing Account.

(4) To Ascertain the Profit or Loss of Each Process:

 The output or the part of output at the stage of every process can
be sold out either at profit or loss. Thus the management can
know about the profit or loss at every process by preparing
Processes Account.

(5) Base of the Valuation of Opening and Closing Stock of Each Next
Process:
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 If the total cost of production of any process is divided by the

number of units, we get cost of production per unit of that
particular process and on this basis opening and closing stock of
next process is valued.

Elements of Process Cost Accounting:

Under process costing, the cost of materials, labor, direct expenses

and overheads are collected as follows:

(1) Materials:

 Raw materials and sundry supplies required for each process are
obtained from stores through stores requisitions. So, the costs of
materials and sundry supplies chargeable to any process can be
ascertained from stores requisitions.

 In case, the materials are issued in bulk to any process, the

process concerned intimates to the cost office the exact quantity
of materials consumed in the process during the particular period,
and with the help of this data, the cost of materials chargeable to
the process is ascertained.

(2) Labour:

 Wages paid to workers engaged in a particular process are

ascertained through the pay-rolls maintained for the concerned
process, and are allocated directly to the process concerned.

 However, where workers are engaged in two or more processes,

their wages, ascertained through the relevant wage records, are

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apportioned among the different processes on the basis of time

spent.

(3) Direct Expenses:

 All direct expenses incurred on a particular process are directly

allocated to that process.

(4) Overheads:

 Overheads incurred on two or more processes are apportioned on

the basis of direct wages or on any other suitable basis.
Sometimes overheads are recorded at pre-determined rate based
on direct wages, prime cost, etc.

Principles of Process Costing or Process Costing Procedure:

The essential stages in process costing are:

(1) The factory is divided into a number of processes and an

account is maintained for each process.

(2) Each Process Account is debited with material cost, labour

cost, direct expenses and overheads allocated or apportioned to
the process.

(3) The output of a process is transferred to the next process in

the sequence. In other words, finished output of one process
becomes input (materials) of the next process.

(4) The production records of each process are kept in such a way
as to show the quantity of production and the wastage and scrap
and the cost of production of each process for each period.
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(5) The total cost of production of each process for a particular

period is divided by the number of units produced in that process
during that period, and the average cost per unit of production for
a period is obtained.

(6) The finished output of the last process is transferred to the

Finished Goods Account.

Process Losses
In most of the industries which employ process costing method,
process losses of the nature of wastage, scrap, spoilage, etc., occur at
different stages of the manufacturing cycle.

(a) Wastage:

 According to terminology of cost accounting I.C.M.A., London,

“Waste is discarded substance having no value.” Charles T.
Horngren says “wastage is material that either is lost, evaporates
or shrinks in a manufacturing process or is a residue that has no
measurable recovery value.” Thus, wastage has neither recovery
value nor has any use.

(b) Scrap:

 According to I.C.M. A terminology, Scrap is discarded material

having some recovery value which is usually disposed of without
further treatment. Wastage and scrap receive similar accounting
treatment. The cost of wastage and scrap are merged with the
process cost so that the good units produced bear their cost

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through averaging. Recovery from scrap reduces the cost of the

process.

(c) Normal Process Loss or Normal Wastage:

 It is the process loss which is unavoidable and uncontrollable. It is

to be expected in normal conditions of the process. As a part of
cost control, management estimates such loss in advance on the
basis of past experience. The normal loss should be absorbed by
good units produced.

Accounting Treatment

 The quantity of normal loss is computed and credited to the

process account in the unit’s column. If the material scrap has
some realizable value that is also credited to the process account
in the amount column.

 A separate normal loss account is opened in the cost ledger. It is

debited with the normal loss of different processes. Cash realised
from the normal scrap and the scrap value of abnormal gain units
are credited to the account. This is necessary because abnormal
gain results in reduction of the normal scrap receipts. The account
shows no balance.

(d) Abnormal Process Loss or Abnormal Wastage:

 When process loss is in excess of predetermined loss, such

additional loss is called abnormal loss or abnormal wastage. Such
loss may be caused by abnormal reasons such as substandard
material, faulty tools and equipment, plant breakdown, etc.

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 Quantity of abnormal loss – Normal output -Actual output

 Normal output = Input – Normal Loss

 If actual output is less than normal output the balance is a positive

figure, representing abnormal loss in units.

 Normal cost of normal output- Expenditure of the process – Scrap

value of normal loss

Accounting Treatment of Abnormal Loss:

 The units of abnormal loss and their value are both credited to
the process account concerned in the respective columns.

 A separate account is opened in the cost ledger for abnormal loss.

The quantities and values of abnormal loss from different
processes are debited to this account. It is credited with the
quantity and amount realised from sale of units of abnormal loss
as scrap. To this extent, the abnormal loss is reduced. Balance in
abnormal loss account represents total irrecoverable loss and is
transferred to costing profit & Loss Account.

(e) Abnormal Gain or Abnormal Effectives:

 When process loss is less than the predetermined normal loss, the
additional output resulting there from is called abnormal gain or
Abnormal Effectives. Abnormal gain can occur because of superior
quality material, better workmanship, improved method, tools
and equipment, etc. As a part of cost control process, the causes
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for abnormal effectives should also be investigated. Where it is

warranted, the normal loss percentage can be revised for future
operations.

Computation of Abnormal Gain:

 Quantity of abnormal gain = Normal output – Actual output

 Normal output = Input – Normal loss

 If actual output is more, the balance is a negative figure,

representing abnormal gain in units.

 Normal cost of normal output = Expenditure of the process –

Scrap value of normal loss

Accounting Treatment of Abnormal Gain:

 The units of abnormal gain and their value are-both debited to

the process account concerned in the respective columns.

 A separate account is opened in the cost ledger for abnormal,

gain. The account is credited with units and value of abnormal
gains in different processes. It is debited with the loss in scrap
value of normal loss which did riot materialise because of the
occurrence of abnormal gain. The balance in the account is
transferred to costing profit & Loss Account.

Valuation of Work- In- Progress

Meaning of Work- in- Progress

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 It would be rare to find that there are no partly finished units in a

process of manufacture. There is always some quantity of partly
finished units or work-in-process or work-in-progress. The
valuation of work-in-progress presents good deal of difficulty
because there are units in various stages of completion—from
those on which work has just begun to those which are only a
step short of completion.

 Work-in-process can be valued on actual basis, i.e., an attempt

may be made to find out how much materials have been used on
the unfinished units and how much actual amount of labour and
expenses has been spent on them. But the degree of accuracy
cannot be always satisfactorily ascertained.

The technique of calculating equivalent production is below:

1. Firstly the opening incomplete or work-in-progress units should

be converted into equivalent units as complete.

2. To above units, add units started and finished during the period or
units completed in the process. These will be new units
introduced less closing units and units scrapped.

3. Thereafter, add equivalent units of closing units.

4. The total of all these will be equivalent production. Following

illustrations explain this technique.

Valuation of Work-in-Progress under FIFO Method:

 Under this method it is assumed that new units issued to the

work-in-progress pass through the finished goods on the FIFO
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basis which means that unfinished work in the opening stock is

completed first and thereafter new units introduced in the
process are taken up. This method is suitable when prices of raw
materials and rates of direct labour and overheads are relatively
stated.

 The cost-added in each process during the period is pro-rated to

the production necessary to complete the opening work-in-
process, to complete the units introduced and completed during
the period and to partially completed units in the closing work-in-
Progress. Thus closing stock is valued at current cost.

Valuation of Work-in-Progress under Average Method:

 Under FIFO Method opening WIP are completed by adding cost of

completing incomplete units and thereafter newly introduced
units are completed. When average method of valuation of WIP is
followed no distribution is made between partly completed units
of proceeding period (opening WIP) and those units which we
introduced and completed during the period. Cost of opening
inventory is added to cost incurred during inventory current
period element wise.

 Thus under average method the average process cost is obtained

by adding the cost of opening WIP and current cost and dividing
the total by total equivalent units. It is not presumed that opening
units will be completed first.

Valuation of Work-in-Progress under Last-in-First out Method:

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 According to this method, units entering in the process at last are

first to be completed. The completed units will be shown at the
current cost and closing inventory of work-in progress will be
valued at the cost of opening inventory of work in progress
because units representing opening inventory are to be
completed at last.

 The closing inventory will be, thus, divided into two categories
when number of units of closing inventory is more than opening
inventory (i) units of opening WIP lying as closing WIP (ii) Newly
introduced units lying in closing WIP.

Advantages of Process Costing-

(1) Process costing helps in the computation of costs at shorter

intervals, which is usually a week, a fortnight or a month.

(2) It helps in the computation of costs of processes as well as the

finished product.

(3) The computation of costs under process costing involves less clerical
work and expenses.

(4) The computation of costs per unit at any one process is very easy, as
the units are homogeneous, and as such, the cost per unit can be found
out easily by averaging.

(5) It ensures a chooser control over production and costs.

Disadvantages of Process Costing

(1) When costs are recorded at the end of the period, it is not possible
to exercise control over costs.
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(2) It is difficult to apportion total cost among joint products and bye-
products.

(3) Under this method of costing, it is difficult to value work-in-

progress.

(4) It is difficult to value losses, wastes and scraps, under this method of
costing.

(5) There is also the difficulty of ascertaining the value of closing stock
where output of one process is transferred to another process at
market price.

Activity Based Costing

 Activity-based costing (ABC) is a costing method that
assigns overhead and indirect costs to related products and
services. This accounting method of costing recognizes the
relationship between costs, overhead activities, and
manufactured products, assigning indirect costs to products less
arbitrarily than traditional costing methods. However, some
indirect costs, such as management and office staff salaries, are
difficult to assign to a product.

 The ABC system of cost accounting is based on activities, which

are considered any event, unit of work, or task with a specific
goal.

 An activity is a cost driver, such as purchase orders or machine

setups.

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 The cost driver rate, which is the cost pool total divided by cost
driver, is used to calculate the amount of overhead and indirect
costs related to a particular activity.

Features of Activity Based Costing

a) The total cost is divided into two types i.e., fixed cost and variable
cost which is necessary to provide quality information to design a
suitable cost system in manufacturing concern.

b) The proper distinction is made between the cost behavior

patterns.

c) The cost behavior patterns are volume related, diversity related,

events related and time related.

d) The appropriate cost driver has to be identified for tracing the

overhead to a product.

Activity-based costing steps

 To use activity-based costing, you must understand the process

for assigning costs to activities.

 First, identify which activities are necessary to create a product.

 Then, separate each activity into its own cost pool, which is a
group of individual costs associated with an activity. Determine
the total overhead of each cost pool. For example, purchasing
could be its own cost pool.

 Next, assign activity cost drivers to each cost pool. Cost drivers are
things (e.g., units, hours, parts, etc.) that control the changes in
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costs. For example, purchasing costs are driven by the number of

parts purchased.

 Divide the total overhead in each cost pool by the total cost
drivers to get your cost driver rate.

 Lastly, compute how many hours, parts, units, etc. that the
activity used and multiply it by the cost driver rate.

 ABC systems can be complicated. Check out this example to help

further illustrate the process.

Allocation of Overheads under Activity Based Costing

 Under Activity Based Costing, the costs are classified as short term
variable costs and long term variable costs.

 The short term variable costs are allocated to the products on the
basis of volume related cost drivers. Direct labour hour, Direct
material cost and machine hours are some of the examples of
volume related cost drivers.

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Objectives of Activity Based Costing

The objectives of Activity Based Costing are given below.

1. To rectify the inaccurate cost information.

2. To allocate the overheads on activity basis.

3. To help the management in taking quality and timely decision.

Development of Activity Based Costing

The development of Activity Based Costing involves the following steps.

1. The main functional areas of the organization have been

identified. For example production, sales, distribution etc.

2. Each functional area has separate activities. Out of many

activities, the main activities of each functional areas have been
identified. For example: Purchase of raw materials, purchase of
packing materials etc.

3. The support activities of main activities have been identified.

For example: repairs and maintenance of machine, maintaining
power supply, testing of quality etc.

4. The factors which are influencing the main activities and

support activities identified i.e. cost drivers.

5. The data relating to direct labour, material and overhead costs

have been collected accurately.

Implementation of Activity Based Costing

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The following steps are involved in implementing Activity Based Costing

to achieve the desired results.

1. Identify the functional areas of organization.

2. Identify the main activities of each functional areas.

3. Allocate common indirect costs to each functional areas on

suitable basis.

4. Identify the most suitable cost driver in each activity under

functional areas.

5. Preparing the statement of expenditure on activity wise.

6. Compare this statement with the value addition activity wise.

7. Find the activities which are to be eliminated or improved for

better performance of the organization.

Life Costing Activity

• Life cycle costing, or whole-life costing, is the process of
estimating how much money you will spend on an asset over the
course of its useful life. Whole-life costing covers an asset’s costs
from the time you purchase it to the time you get rid of it.
• Buying an asset is a cost commitment that extends beyond its
price tag. For example, think of a car. The car’s price tag is only
part of the car’s overall life cycle cost. You also need to consider
expenses for car insurance, interest, gas, oil changes, and any
other necessary maintenance to keep the car running. Not
planning for these additional costs can set you back.

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Characteristics of Life Cycle Costing:

a. Product life cycle costing involves tracing of costs and revenues of a

product over several calendar periods throughout its life cycle.

b. Product life cycle costing traces research and design and

development costs and total magnitude of these costs for each
individual product and compared with product revenue.

c. Each phase of the product life-cycle poses different threats and

opportunities that may require different strategic actions.

d. Product life cycle may be extended by finding new uses or users or by

increasing the consumption of the present users.

Life cycle costing process

Conducting a life cycle cost assessment helps you better predict how
much your business will pay when you acquire a new asset.

To calculate an asset’s life cycle cost, estimate the following expenses:

 Purchase

 Installation

 Operating

 Maintenance

 Financing (e.g., interest)

 Depreciation

 Disposal

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Life Cycle Costing Process-

 Life cycle costing is a three-staged process.

 The first stage is life cost planning stage which includes planning
LCC Analysis, Selecting and Developing LCC Model, applying LCC
Model and finally recording and reviewing the LCC Results.

 The Second Stage is Life Cost Analysis Preparation Stage followed

by third stage Implementation and Monitoring Life Cost Analysis.

Stages of Product Life Cycle Costing:

Following are the main stages of Product Life Cycle:

(i) Market Research:

 It will establish what product the customer wants, how much he is

prepared to pay for it and how much he will buy.

(ii) Specification:

 It will give details such as required life, maximum permissible

maintenance costs, manufacturing costs, required delivery date,
expected performance of the product.

(iii) Design:

 Proper drawings and process schedules are to be defined.

(iv) Prototype Manufacture:

 From the drawings a small quantity of the product will be

manufactured. These prototypes will be used to develop the
product.
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(v) Development:

 Testing and changing to meet requirements after the initial run.

This period of testing and changing is development. When a
product is made for the first time, it rarely meets the
requirements of the specification and changes have to be made
until it meets the requirements.

(vi) Tooling:

 Tooling up for production can mean building a production line;

building jigs, buying the necessary tools and equipment’s
requiring a very large initial investment.

(vii) Manufacture:

 The manufacture of a product involves the purchase of raw

materials and components, the use of labour and manufacturing
expenses to make the product.

(viii) Selling

(ix) Distribution

(x) Product support

(xi) Decommissioning:

 When a manufacturing product comes to an end, the plant used

to build the product must be sold or scrapped.

Target Costing

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 Target costing is not just a method of costing, but rather a

management technique wherein prices are determined by market
conditions, taking into account several factors, such as
homogeneous products, level of competition, no/low switching
costs for the end customer, etc. When these factors come into the
picture, management wants to control the costs, as they have
little or no control over the selling price.

 Target costing is a formal process that attempts to match a

proposed product’s features (benefits) with a viable market price
that achieves the company’s profitability goals by:

a) Determining a price point (or range of prices) for an

approximate combination of features and benefits.

(b) Subtracting a desired profit from the market price to

determine the maximum bearable level of costs.

(c) Iterating the product design—eliminating or reducing

unnecessary attributes with costs that can’t be recovered in
higher prices—until the cost target is met.

(d) Revising the market price for the redesigned product in view of
changed market conditions.

Key Features of Target Costing:

 The price of the product is determined by market conditions. The

company is a price taker rather than a price maker.

 The minimum required profit margin is already included in the

target selling price.
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 It is part of management’s strategy to focus on cost reduction and

effective cost management.

 Product design, specifications, and customer expectations are

already built-in while formulating the total selling price.

 The difference between the current cost and the target cost is
the “cost reduction,” which management wants to achieve.

 A team is formed to integrate activities such as designing,

purchasing, manufacturing, marketing, etc., to find and achieve
the target cost.

Advantages of Target Costing:

 It shows management’s commitment to process improvements

and product innovation to gain competitive advantages.

 The product is created from the expectation of the customer and,

hence, cost is also based on similar lines. Thus, the customer feels
more value is delivered.

 With the passage of time, the company’s operations improve

drastically, creating economies of scale.

 The company’s approach to designing and manufacturing

products becomes market-driven.

 New market opportunities can be converted into real savings to

achieve the best value for money rather than to simply realize the
lowest cost.

Steps of Target Costing

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 Determine selling price for the new product and estimated output
from market analysis and target profit.

 Ascertainment of the target cost by deducting the profit from the

selling price.

 Functional cost analysis for specific components and processes

 Decide the estimated product cost.

 Make comparison between estimated cost and target cost.

 If the estimated cost is greater than the targeted one, then repeat
cost analysis, to reduce the estimated cost.

 Final decision to be taken, on the introduction of the product,

once the estimated cost is on target.

 Cost management while production is performed.

Target Costing Principles

 Price-led costing

 Cross functional teams

 Customer focus

 Focus on product design and process

 Lifecycle cost reduction

 Value Chain involvement

Target Costing is all about planning or projecting the cost of

a product prior to its introduction, to make sure that products with low
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margin are not introduced, as they are not able to reap sufficient
returns. It is also used for controlling the design specification and
production techniques, and encouraging a focus on the customer.

Kaizen Costing
Kaizen costing is a technique of controlling the cost incurred over
unproductive activities and resources which does not add any value to
the organization. In simple words, it is a practical approach to solving
cost-related problems to improve the overall efficiency of the
organization.

Types of Kaizen Costing

Kaizen costing can be on a mass level for any fixed asset or the whole
organization. Or it can be product-based, i.e., transforming the product
or its process of manufacturing. Let us understand each of these types
in details below:

 Asset Specific: The asset and organization-specific kaizen costing

focuses on the need for a particular deal or the business unit.

 Product Specific: The activity which is project or product-oriented,

aiming at value analysis is termed as product-specific kaizen
costing.

Process-

 The organization together with its employees of all the

departments (such as customer support, finance, human
resource, production, design, etc.), needs to find out the various

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problems in the organization with the help of techniques like 360-

degree feedback.

 The next step is solving the identified problems. This step needs a
lot of brainstorming and tactical approach; therefore, managers
form a team of ingenious employees to find out a practical
solution to each question.

 Implementing any change involves cost and risk simultaneously.

Therefore to be on a safer side, the new idea must be testified on
a small part of the organization.

 The managers need to look after the proper implementation of

the kaizen costing. That is, a new idea should not just remain in
words; instead, it should be practically applied to the business
process.

 After being satisfied with the results, the organization needs to

set this change as a standard procedure for all the departments
and across the whole organization.

 A standardized procedure becomes the organizational culture

when continuously practiced over a period.

Advantages of Kaizen Costing

 Customer Satisfaction: The kaizen costing is a customer-oriented

technique which focuses on providing better service to the
consumers.

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 Forming Work Teams: Every employee involved in the

implementation of the kaizen practice needs to perform in a work
team with a common aim of improvement.

 Continuous Improvement: Kaizen costing is a technique which

emphasizes on improvement and betterment of the product,
process, project and the organization.

 Creates Better Work Environment: It also promotes a positive

work environment for the employees and the management. Like,
sharing canteen and the dress code, is a part of work culture in
many organizations.

 Problem Solving: One of the crucial functions of kaizen costing is

to solve the identified problem to achieve perfection in business
operations.

Disadvantages of Kaizen Costing

 The burden on Lower Level Management: It becomes confusing

and tedious for the bottom level management to adopt the
change in process or product so implemented through kaizen
costing.

 Lack of Training: Kaizen costing requires a lot of expertise and

training, and if not implemented strategically, it may even lead to
adverse effects.

 Permanent Change System: The change so implemented through

kaizen costing is irreversible, and it requires a lot of efforts and
cost in withdrawing such decisions.

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Just- In- Time

 Just-in-time (JIT) inventory management, also known as lean
manufacturing and sometimes referred to as the Toyota
production system (TPS), is an inventory strategy that
manufacturers use to increase efficiency. The process involves
ordering and receiving inventory for production and customer
sales only as it is needed to produce goods, and not before.

Advantages of JIT Inventory

There are a multitude of improvements related to JIT inventory,

particularly in relation to reduced cash requirements and the ease with
which manufacturing problems can be uncovered. Advantages of JIT
inventory include:

 Working capital. This inventory is designed to be exceedingly low,

so the investment in working capital is minimized.

 Obsolete inventory. Since inventory levels are so low, there is

little risk of having much obsolete inventory.

 Defects. With so little inventory on hand, defective inventory

items are easier to identify and correct, resulting in lower scrap
costs.

 Process time. A thoroughly implemented JIT system should

shorten the amount of time required to manufacture products,
which may decrease the quoted lead times given to customers
placing orders.

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 Engineering change orders. It is much easier to implement

engineering change orders to existing products, because there are
few existing stocks of raw materials to draw down before you can
implement changes to a product.

Objectives of JIT

 JIT Manufacturing tries to smooth the flow of materials from the

suppliers to the customers, thereby increasing the speed Of the
manufacturing process.

The objectives of JIT is to change the manufacturing system gradually

rather than drastically:

1. To be more responsive to customers,

2. To have better communication among departments and

suppliers,

3. To be more flexible,

4. To achieve better quality,

5. To reduce product cost

Financial Statement Analysis

Ratio Analysis
 It is a process of drawing meaningful interpretation form the
calculated ratio and taking decisions based on same. Ratio
Analysis is an accounting tool utilized in analysis. Interpretation

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the various items in financial statements and reporting in

understandable term to its use.

 Ratio may be expressed in the following three ways:

a) Ratio- Simple division of one number by another. Eg-liquidity

ratio- 2:1

b) Rate-The ratio between two numerical facts, usually over a period

of time. Eg- Stock turnover is three times a year.

c) Percentage- A special type of rate which expresses the relation in

hundredth. Eg- gross profit is 25% on sale.

 Nature of Ratio Analysis-

Ratios are designed to show how one number is related to another. It is

worked out by dividing one number by another. Ratios are customarily
presented either in the form of a coefficient or a percentage or as a
proportion.

 Interpretation of Ratio-

The interpretation of ratios is an important factor. Though calculation

of ratios is also important but it is only a clerical task whereas
interpretation needs skill, intelligence and foresightedness.

a) Inter- firm Comparison-Ratios of one firm can also be compared with

the ratios of some other selected firms in the same industry at the
same point of time. This kind of comparison helps in evaluating relative
financial position and performance of the firm.

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b) Historical Ratio- One of the easiest and most popular ways of

evaluating the performance of the firm is to compare its present ratios
with the past ratios called comparison overtime.

c) Group Ratio- Ratios may be interpreted by calculating a group of

related ratios. A single ratio supported by other related additional
ratios becomes more understandable and meaningful. For example, the
ratio of current assets to current liabilities may be supported by the
ratio of liquid assets to liquid liabilities to draw more dependable
conclusions.

d) Single Absolute Ratio- Generally speaking one cannot draw any

meaningful conclusion when a single ratio is considered in isolation. But
single ratios may be studied in relation to certain rules of thumb which
are based upon well proven conventions as for example 2: 1 is
considered to be a good ratio for current assets to current liabilities.

Classification of Ratio

A. Profitable Ratios

i) Gross Profit

ii) Net/operating profit ratio

iii) Expenses Ratio

iv) Operating ratio

v) Net profit to net worth ratio

vi) Net profit to fixed assets ratio

vii) Return on investment or capital employed

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vii) Return on equity capital

viii) Earning per share

B. Activity or Performance or Turnover Ratio

i) Total capital turnover ratio

ii) Fixed assets turnover ratio

iii) Working capital turnover ratio

iv) Debtors turnover ratio

C. Financial Ratios

i) Liquid Ratio or short term financial or solvency ratios

a) Current ratio

b) Liquid ratios

ii) Solvency ratios or long term financial ratios

a) Debt equity ratio

b) Total coverage or debt service ratio

c) Interest coverage or debt service ratio

d) Fixed assets ratio

e) Proprietary ratio

f) Solvency ratio or debt to total funds ratio

g) Capital gearing ratio

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I- Profitability Ratios-
General Profitability Ratio=

a) Gross Profit Ratio= It expresses the relationship of gross profit to

net sales and is expressed in terms of percentage.
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡
× 100
𝑁𝑒𝑡 𝑆𝑎𝑙𝑠
b) Operating Ratio= It establishes a relationship between cost of
goods sold plus other operating expenses and net sales. Operating
expenses consist of administrative expenses, financial expenses,
selling and distribution expenses. The following formula is used:-
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 + 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠
𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
c) Operating Profit Ratio= This ratio establishes the relationship
between operating profit and net sales and is calculated as
follows-
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡
× 100
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
d) Expense Ratio= these ratios supplement the information given by
the operating on sales expenses by net sales revenue.
𝑀𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝐶𝑜𝑛𝑠𝑢𝑚𝑒𝑑
a. Material Consumed Ratio = × 100
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
𝑂𝑓𝑓𝑖𝑐𝑒& 𝐴𝑑𝑚𝑛 𝐸𝑥𝑝
b. Office and Administration Expense Ratio= ×
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
100
𝑆𝑒𝑙𝑙𝑖𝑛𝑔 & 𝐷𝑖𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠
c. Selling & Dist. Expense Ratio= × 100
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
𝑁𝑜𝑛−𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠
d. Financial Expense Ratio= × 100
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
e) Net Profit Ratio= It expresses the relationship between net profit
after taxes to sales. The following formula is used.
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𝑁𝑜𝑛−𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠
× 100
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
Test of overall Profitability=
a. Return on shareholder investment or Net worth Ratio=
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 (𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑎𝑛𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡)
𝑃𝑟𝑜𝑝𝑟𝑖𝑒𝑡𝑜𝑟 ′ 𝑠𝐹𝑢𝑛𝑑
b. Return on Equity Capital= It establishes a relationship in between
the net profit available to equity shareholders and the amount of
capital invested by them.
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 − 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑑𝑢𝑒 𝑡𝑜 𝑝𝑟𝑒𝑓. 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠
𝐸𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 (𝑃𝑎𝑖𝑑 𝑢𝑝)
c. Return on Capital Employed= This ratio is most appropriate
indicator of the earning power of the capital employed in the
business.
𝐸𝐵𝐼𝑇
=
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
The term capital employed refers to the long- term funds used in
a business. It is calculated as shown below:
Net fixed Asset xxx
Add: Trade investment, Investment xxx
Made in associated concern to Promote trade xxx
Add: Net working capital xxx
xxx

The standard return on capital employed is approx 15%

d. Return on Total Resources- It indicates or acts as a yardstick to

assess the efficiency of the operations of the business as it
indicates the extent to which assets employed in the business are
utilized to result in net profit.
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𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡
× 100
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
e. Dividend Yield Ratio= It refers to the percentage or ratio of
dividend paid per share to the market price per share.
𝐷𝑖𝑣𝑖𝑑𝑒𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 (𝐸𝑞𝑢𝑖𝑡𝑦)
𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 (𝐸𝑞𝑢𝑖𝑡𝑦)
f. Preference Divided Cover Ratio= This ratio measures the margin
of safety for preference shareholders.
𝑃𝑟𝑜𝑓𝑖𝑡 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥
𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑔𝑟𝑎𝑚𝑚𝑒 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
g. Equity Divided Cover:- This ratio indicates the number of times
the dividend is covered by the amount of profit available to equity
share holders.
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠 − 𝑃𝑟𝑒𝑓𝑒𝑟𝑛𝑐𝑒 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
=
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑖𝑑 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒

OR
𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑝𝑒𝑟 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒
h. Price Earnings Ratio= This ratio indicates the proportion of
earnings available which equity shareholders actually receive in
the form of dividend
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
i. Dividend Payout Ratio= This ratio indicates the proportions of
earnings available which equity shareholders actually receives in
the for of dividend.
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑎𝑖𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
=
𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
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j. Earnings per share- This ratio indicates the earnings per equity
share-
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑓𝑜𝑟 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠.
𝑁𝑜. 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒𝑠
II- Activity Ratios or Performance Ratios-
This ratio indicates the performance of a n organization. This
indicates the effective utilization of the various assets of the
organization.
i. Stock Turnover ratio- It tells us to how many time s stock has
turned (sold) over the period. It indicates the operational and
marketing efficiency of the business.
𝑐𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑
Stock Turnover Ratio=
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑆𝑡𝑜𝑐𝑘
𝑂𝑝𝑒𝑟𝑖𝑛𝑖𝑛𝑔 𝑆𝑡𝑜𝑐𝑘 + 𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝑆𝑡𝑜𝑐𝑘
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑆𝑡𝑜𝑐𝑘 =
2

The ideal Stock turnover ratio- A good inventory turnover ratio is

between 5 and 10 for most industries, which indicates that you sell and
restock your inventory every 1-2 months.

ii. Debtors Turnover Ratio or Debtors velocity Ratio= This ratio

explains the relationship of net (credit) sales of a firm to its
book debts indicating the rate at which cash is generated by
turnover receivables or debtors. The following is used-
𝑁𝑒𝑡 𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠
=
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑒𝑏𝑡𝑜𝑟𝑠
The purpose of this ratio is to measure the liquidity of the
receivables or to find out the period which receivables remain
in collected.
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iii. Debt collection Period Ratio= This ratio is helpful in knowing

the speed at which debts are collected. It refers to time
involved in collecting the debts by a business enterprise. The
following formula is used to calculate debt collection peiod
ratio=
𝑁𝑜 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
𝐷𝑒𝑏𝑡𝑜𝑟𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟

OR
𝐷𝑒𝑏𝑡𝑜𝑟𝑠
× 100
𝑁𝑒𝑡 𝑎𝑎𝑛𝑢𝑎𝑙 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠

OR
𝑁𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠
× 100
𝑁𝑜. 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
iv. Creditor’s turnover Ratio or ceditors or creditors velocity=
This ratio indicates the number of times the creditors are paid
in a year. The following
𝑁𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑟𝑒𝑑𝑖𝑡 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠
Net annual credit purchase = Purchase – Purchase Return
Creditors Include (Average)=
[(𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝑠𝑢𝑛𝑑𝑟𝑦 𝑐𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠 + 𝑜𝑝𝑒𝑛𝑖𝑛𝑔 𝐵𝑖𝑙𝑙𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒) + 𝑐𝑙𝑜𝑠𝑖𝑛𝑔 𝑆𝑢𝑛𝑑𝑟𝑦 𝑑𝑒𝑏𝑡𝑜𝑟𝑠
+𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝐵𝑖𝑙𝑙𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠)]
2
v. Working Capital Turnover Ratio= This ratio establishes a
relationship between working capital and sales. The following
formula is used:
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𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
vi. Fixed Asset Turnover Ratio= It establishes a relationship
between fixed assets and sales. The following formula is used:
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
A Standard fixed turnover ratio is slimes.
vii. Current Asset Turnover Ratio= It establishes a relationship
between current assets and sales. The following formula is
used.
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
viii. Total Asset Turnover Ratio- The ratio establishes a relationship
between total assets and sales. It indicates the efficient
utilization of total assets of a business the following formula is
used-
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
A total asset turnover ratio of & times or more indicates that
assets are utilized efficiently.
𝐸𝐵𝐼𝑇
Net Profitability Ratio= × 100
𝑆𝑎𝑙𝑒𝑠
The ratio indicates profit earned.
III- Liquidity Ratio= It is used to test the liquidity position of the
business or a firm. It enables to know whether a firm has
adequate working capital to carryout routine business activity
as well as to know that whether the short-term liabilities can
be paid out of short term assets.

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i. Current Ratio= It is also called working capital ratio, it establish

the relationship between total current asset and current
liabilities.
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
A current ratio of 2:1 is considered ideal as a rule of thumb.

ii. Quick Ratio or Acid ratio or Liquid Ratio= It is concerned with

the relationship between liquid assets and liquid liabilities.
𝑄𝑢𝑖𝑐𝑘 𝐴𝑠𝑠𝑒𝑡𝑠
𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 =
𝑄𝑢𝑖𝑐𝑘 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
A quick ratio of 1:1 is usually considered to be ideal.
iii. Absolute Liquidity ratio or Cash Position Ratio= It establishes a
relation between absolute liquid assets to quick liabilities.
𝐴𝑏𝑠𝑜𝑙𝑢𝑡𝑒 𝐿𝑖𝑞𝑢𝑖𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
𝐴𝑏𝑠𝑜𝑙𝑢𝑡𝑒 𝐿𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 =
𝑄𝑢𝑖𝑐𝑘 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
IV- Analysis of Long- term financial Position or Test of
Solvency-
i. Debt equity Ratio or External Internal Equity Ratio= It
establishes a relationship in between debt and equity. Debt
includes all long term and short term debt. Equity consists of
shareholders funds, reserves and accumulated profits.
𝐷𝑒𝑏𝑡 𝑒𝑞𝑢𝑖𝑡𝑦
𝐷𝑒𝑏𝑡 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 =
𝐸𝑞𝑢𝑖𝑡𝑦
OR
𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑖𝑒𝑠
𝐼𝑛𝑡𝑒𝑟𝑛𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑖𝑒𝑠

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The standard debt equity ratio is 2:1. It means for every 2

shares there is 1 debt.
ii. Proprietary Ratio or Net Worth ratio- It establishes between
proprietary fund and Total assets.

Proprietary Ratio or Net Worth Ratio= [ Equity + preference + Capital

Reserves+ free reserves +undistributed profit]
𝑃𝑟𝑜𝑝𝑟𝑖𝑒𝑡𝑜𝑟 ′ 𝑠 𝐹𝑢𝑛𝑑
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
OR
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑
𝑇𝑜𝑡𝑎𝑙 𝐿𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Higher the proprietary ratio, stronger the financial position and vice
versa. A ratio of 0.5:1 is considered ideal.

iii. Solvency ratio= It expresses the relationship between total

assets and total liabilities of a business.
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝑆𝑜𝑙𝑣𝑒𝑛𝑐𝑦 𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
iv. Fixed Asset to Net Worth Ratio= It is obtained by dividing the
depreciated book value of fixed assets by the amount of
proprietors funds.
𝑁𝑒𝑡 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
𝑁𝑒𝑡 𝑊𝑜𝑟𝑡ℎ 𝑜𝑟 𝑃𝑟𝑜𝑝𝑒𝑟𝑖𝑡𝑜𝑟𝑠 ′ 𝑠𝑓𝑢𝑛𝑑
A ratio of 0.75: 1 (or 65%) is deemed to be desirable.
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡
v. Current Asset to Net worth Ratio=
𝑃𝑟𝑜𝑝𝑟𝑒𝑖𝑡𝑜𝑟 ′ 𝑠 𝐹𝑢𝑛𝑑

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The purpose of this ratio is to show the percentage of proprietor’s

Fund investment in current assets.
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑒𝑖𝑠
vi. Current Liabilities to Net Worth Ratio=
𝑁𝑒𝑡 𝑊𝑜𝑟𝑡ℎ
This ratio indicates the relative contribution of sort-term
creditors and owners to the capital of an enterprise. The
standard ratio is fixed is 1/3
vii. Capital gearing ratio= It expresses the relationship between
equity capital and fixed interest bearing security and fixed
dividend bearing shares:
𝐹𝑖𝑥𝑒𝑑 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑏𝑒𝑎𝑟𝑖𝑛𝑔 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠 + 𝐹𝑖𝑥𝑒𝑑 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝐵𝑒𝑎𝑟𝑖𝑛𝑔 𝑆ℎ𝑎𝑟𝑒𝑠
=
𝐸𝑞𝑢𝑖𝑡𝑦 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝐹𝑢𝑛𝑑𝑠
When the fixed interest bearing securities and fixed dividend
bearing shares are higher than equity shareholders funds, the company
is said to be ‘highly geared’. If capital gearing ratio is higher, further
raising of long term loans may be difficult & issue of equity shares bay
be attractive & vice versa.

viii. Fixed Charge Cover Ratio or Debt Service Ratio- It expresses

the relationship between total assts and total liabilities of a
business.
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑑𝑒𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑖𝑛𝑐𝑜𝑚𝑒 𝑇𝑎𝑥
𝐹𝑖𝑥𝑒𝑑 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐶ℎ𝑎𝑟𝑔𝑒𝑠
The ideal Debt service cover is 6 or 7 times. If the ratio is high it
means there is higher margin of safety for the long term lenders and as
such it is not difficult for the business to obtain further long term funds
& vice versa.
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ix. Dividend Cover Ratio= It is the ratio between disposable profit

and dividend. Disposable profit refer to profit left over paying
interest or long term borrowing and income tax.
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑎𝑥𝑒𝑠
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝐶𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜 =
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝐷𝑒𝑐𝑙𝑎𝑟𝑒𝑑
x. Fixed Asset Ratio= It establishes the relationship between
Fixed Assets and capital employed.
𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
Fixed Asset Ratio =
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑

Return on investment
Return on investment is a ratio between net profit and cost of
investment. A high ROI means the investment's gains compare
favorably to its cost. As a performance measure, ROI is used to evaluate
the efficiency of an investment or to compare the efficiencies of several
different investments.

ROI Pros

 Simple. The ROI formula only requires a few inputs and provides a
single output value, making it a very straightforward way to track
efficiency and profitability.

 Clear. A positive number indicates a positive return, whereas a

negative number indicates a loss.

 Flexible. ROI works for a variety of investments such as marketing

campaigns, stock purchases, vehicles, home renovations, and
beyond.

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 Versatile. ROI can be used for a number of applications like

tracking efficiency, measuring profitability, analyzing business
decisions, and more.

 Divisional. Since ROI measures the return of a single investment,

companies can track the profitability of each business unit to
optimize their operation and increase earnings.

ROI Cons

 Room for error. Using the wrong input values can result in an
inaccurate ROI. One of the most common mistakes people make
when calculating ROI is confusing cash flow and profit (resulting in
a much higher expected return). In addition, to calculate a useful
ROI you need to first determine your baseline in order to calculate
any incremental profit. In the marketing example above, this
would mean trying to determine how much of the increase in
sales was truly due to the marketing campaign.

 Variance. The standard formula for ROI is profit / cost, but the
definition of those inputs can vary, depending on a company’s
accounting policies. Factors like interest, tax, and net profit
vs. gross profit can influence the outcome, making it hard to
accurately compare companies.

 Potential bias. ROI is a great indicator of profit, but it doesn’t

always consider the full picture. Investments that have a lower
ROI (but improve the business as a whole) could be disregarded if
the company only focuses on increasing their ROI.

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 Manipulation. Business unit managers can manipulate ROI by

changing accounting policies & calculations, reducing spending on
inputs, or even discarding old yet functional equipment. This
practice can decrease cost or increase return to give the illusion of
strong performance even if the actions are detrimental to the
company as whole.

 The basic ROI formula can be used in a number of situations, but

there are other variations that can be used for other applications.

 Real Rate of Return (RRR)- Measures the return of an investment

after adjusting for inflation, taxes, and other external factors.

 Annualized ROI. Measures the return an investment generates in

a single year. It’s calculated by dividing the ROI by the number of
years the investment is held.

 Net Present Value (NPV)- Allows the reader to calculate the

present-day value of an investment based on inflation-adjusted
projections of its future earnings.

 Return on Assets (ROA)- Measures a company's profit for every

$1 of assets it owns.

 Return on Equity (ROE)- Measures how much profit a company

generates for every $1 of company equity held by shareholders.

The uses of ROI are there in every business and investments that any
person does or make.

 It is the simplest measurement of the percentage of profit made

by the investor in his investment.
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 ROI helps in deciding between different investment opportunities.

 It can be used for calculating or comparing the returns of the past

as well. For example, if you are going to invest in a share, you
would like to check how it had performs in the previous 5-10
years and the first thing you would check about the company is
their ROI. ROI changes from time to time depending on various
factors; it can be used as the signal for monitoring the investment.
When a positive ROI is good for an investment, a negative ROI
might call for a selloff of the investment.

 For taking investment decision, ROI plays a great role. It helps in

comparing the high and the low performing investment. This, in
turn, helps the investors and the financial planners, advisors and
the managers to optimize their investment returns by investing in
the investments with the higher returns.

Fund Flow Analysis

 The flow of fund refers to the changes in the existing financial
position of the business caused by in-flow of resources owing to
receipt and payments.

 It refers to a statement which incorporates working capital that

brings about changes in assets, liabilities and capital of owners
between two consecutive balance sheets.

 It is generally taken to mean a change in working capital of a

business.

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 If a transaction result in an increase in funds, it is known as

application of funds.

 Where there is no change in the funds, there is no flow of fund.

Steps involved in preparation of fund flow statement

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3- Reconstruction of all non funds accounts-

The various non funds account which have changed between the two
balance sheet period in respect of which additional information is given
is to be reconstructed. Such reconstruction is done by recorded of
opening and closing balances along with additional information given.

4- Preparation of statement of source and application of funds:

Sources of funds

Funds from operation xxx

Issue of Share Capital xxx

Raising of long term loans xxx

Receipts from party paid shares called up xxx

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Sales of fixed assets xxx

Non trading receipts such as dividend received xxx

Sales of long term investment xxx

Decrease in working capital xxx

Total XXX

Application of Funds

Funds lost in operation xx

Redemption of preference share capital xx

Redemption of Debentures xx

Repayment of long term loans xx

Purchase of fixed assets xx

Purchase of long- term investment xx

Non trading payments xx

Payments of tax xx

Increase in working capital xx

Total XX

Cash Flow Statements

It is one of the analytical tools used by the management. Accountant to
interpret the financial soundness of business. It shows the changes in
the cash position between two dates of the Balance Sheet
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Objectives –

(a) Measurement of Cash:

 Inflows of cash and outflows of cash can be measured annually

which arise from operating activities, investing activities and
financial activities.

(b) Generating Inflow of Cash:

 Timing and certainty of generating the inflow of cash can be

known which directly helps the management to take financing
decisions in future.

(c) Classification of Activities:

 All the activities are classified into: operating activities, investing

activities and financial activities which help a firm to analyze and
interpret its various inflows and outflows of cash.

(d) Prediction of Future:

 A Cash Flow Statement, no doubt, forecasts the future cash flows

which helps the management to take various financing decisions
since synchronization of cash is possible.

Main advantages are:

1. Evaluation of Cash Position

2. Planning and Control

3. Performance Evaluation

4. Framing Long-term Planning

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5. Capital Budgeting Decision

Limitations are:

1. Since cash flow statement does not consider non-cash items, it

cannot reveal the actual net income of the business.

2. Cash flow statement cannot replace fund flow statement or

income statement. Each of them has a separate function to
perform which cannot be done by the cash flow statement.

3. The cash balance as disclosed by the projected cash flow

statement may not represent the real liquid position of the
business since it can be easily influenced by the managerial
decisions, by making certain payments in advance or by post
pending payments.

4. It cannot be used for the purpose of comparison over a period

of time. A company is not better off in the current year than the
previous year because its cash flow has increased.

5. It is not helpful in measuring the economic efficiency in certain

cases e.g., public utility service where generally heavy capital
expenditure is involved.

The Structure of the Cash Flow Statement

The main components of the cash flow statement are:

 Cash from operating activities- It include cash activities related to

net income. For example, cash generated from the sale of goods
(revenue) and cash paid for merchandise (expense) are operating

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activities because revenues and expenses are included in net

income.

 Investing activities include cash activities related to noncurrent

assets. Noncurrent assets include (1) long-term investments; (2)
property, plant, and equipment; and (3) the principal amount of
loans made to other entities. For example, cash generated from
the sale of land and cash paid for an investment in another
company are included in this category. (Note that interest
received from loans is included in operating activities.)

 Financing activities include cash activities related to noncurrent

liabilities and owners’ equity. Noncurrent liabilities and owners’
equity items include (1) the principal amount of long-term debt,
(2) stock sales and repurchases, and (3) dividend payments. (Note
that interest paid on long-term debt is included in operating
activities.)

Elements of Operating Cash Flow-

 Cash receipts from sale of goods and rendering services.

 Cash receipts form royalty, fees, commission and other revenue

 Cash payments to suppliers for goods and services

 Cash payments to and on behalf of employees

 Cash receipts and cash payments by an insurance enterprise for

premium and claims, annuities and other policy benefits

 Cash-payments and refunds of income taxes unless these are

specifically identified as cash flow from financing or investment
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 Cash receipts and payments relating to contracts held for dealing

or trading purposes.

 Cash flow arising from dealing in securities when an enterprise

holds securities for such purpose

Elements of Investment activities

 Cash payments for acquisition of fixed assets including intangibles

 Cash receipts from disposal of fixed assets

 Cash payments to acquire shares, warrants or debt instrument of

other enterprises and interests in joint venture.

 Cash receipts from disposal of shares, warrants or debt

instruments of other enterprises and interests in joint venture

 Cash advances and loans made to third parties. This foes not
include loans and advances made by financial institutions as these
fall under operating cash flow.

 Cash receipts from future, forward, options and swap contracts.

This does not include contracts held for dealing or trading
purposes or contracts which are classified financing activities.

 Cash payments from future, forward, options and swap contracts.

This does not include contracts held for dealing or trading
purposes or contracts which are classified financing activities

Elements of financing activities-

 Cash proceeds from issuing shares or other equity instruments

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 Cash payments to owners to acquire or redeem the enterprise’s

shares

 Cash proceeds from issuing debentures, loans notes, bonds,

mortgages, and other short term and long term borrowings

 Cash repayments of amounts borrowed

 Cash payments by a lease for the reduction of the outstanding

liability relating to a finance lease.

Human Resource Accounting

 It is a term applied by the Accountancy Profession to quantify the
cost and value of employees of their employing organization.

 It is an attempt to identify and report the investments made in

Human Resource of an organization that are currently not
accounted for in the Conventional Accounting Practices.

Objective-

 The human resource process was established to fulfill a number of

objectives within the organization. These include:

 To furnish cost value information for making proper and effective

management decisions about acquiring, allocating, developing,
and maintaining human resources in order to achieve cost
effective organizational objectives.

 To monitor effectively the use of human resources by the

management.

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 To have an analysis of the Human Asset, i.e. whether such assets

are conserved, depleted, or appreciated.

 To aid in the development of management principles and proper

decision making for the future, by classifying the financial
consequences of various practices.

Advantages of HRA-

 It provides useful information about the cost and the value of

human resources. It shows the strengths and weakness of human
resources.

 Investors would like to know the value of a firm’s human asset.

Moreover, they want to know about an organization’s investment
in human resources.

 It allows management personnel to monitor effectively the use of

human resources.

 It offsets uncertainty and change, as it enables the organization to

have the right person for the right job at the right time and place.

 It provides scope for advancement and development of

employees by effective training and development.

 It helps the individual employee to aspire for promotion and

better benefits.

 It aims to see that human involvement in the organization is not

wasted and brings high returns to the organization.

Disadvantages of HRA-
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 There is no specific guideline for measuring the cost and value of

human resources.

 While valuing the human assets, demand for rewards and

compensation might be higher.

 The nature of amortization to be followed is yet to be fixed up.

 Tax laws do not recognize human assets and in that sense, it

might be theoretically only.

 It is a difficult task to value human asset.

 Human Resource Accounting is full of measurement problems.

 Employees and unions may not like the ideas.

 The life of a human being is uncertain. So its value is also

uncertain.

 All the methods of accounting for human assets are based on

certain assumptions, which can go wrong at any time. For
example, it is assumed that all workers continue to work with the
same organization until retirement, which is far from possible.

Methods of Valuation of Human Assets:

 There are a number of methods suggested for the valuation of

human assets. Many of these methods are based on the valuation
of physical and financial assets while others take into account
human consideration.

(1) Historical Cost Method,

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(2) Replacement Cost Method,

(3) Economic Value Method,

(4) Standard Cost Method,

(5) Present Value Method,

(6) Current Purchase Power Method, and

(7) Opportunity Cost Method.

Historical Cost-

Historical cost is based on actual cost incurred on human resources.

Such a cost may be of two types – acquisition cost and learning cost.

Acquisition cost is the expense incurred on training and development.

This method is very simple in its application but it does not reflect the
true value of human assets.

For example, an experienced employee may not require much training

and, therefore, his value may appear to below though his real value is
much more than what is suggested by historical cost method.

Replacement Cost

 As against historical cost method which takes into account the

actual cost incurred on employees, replacement cost takes into
account the national cost that may be required to acquire a new
employee to replace the present one.

 In calculating the replacement cost, different types of expenses

are taken into account which may be in the form of acquisition

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and learning cost. Replacement cost is generally much higher than

the historical cost.

Standard Cost

 Instead of using historical or replacement cost, many companies

use standard cost for the valuation of human assets just as its
used for physical and financial assets.

 For using standard cost, employees of an organization are

categorized into different groups based on their hierarchical
positions.

 Standard cost is fixed for each category of employees and their

value is calculated. This method is simple but does not take into
account differences in employees put in the same group. In many
cases, these differences may be quite vital.

Economic Value method

The economist’s concept of the value of an asset is equal to the present

worth of its estimated future economic benefits. This approach has a
strong theoretical appeal.

But this method involves the following steps:

(a) Estimation of the future benefits, and

(b) Ascertaining the present value of such benefits by using an

appropriate interest (discount) rate.

Competitive Bidding Method

This is also known as the opportunity cost method.

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 Opportunity cost is defined as the measurable value of benefits

that could be obtained by choosing an alternative course of
action. In the case of HRA.

 Opportunity costs are determined by a process of competitive

bidding in which various divisions and departments bid for the
services of various officers.

 The amount of bid is added to the capital employed of the

successful bidder for determining the return on investment.

Models of Human Resource Accounting-

 The Lev and Schwartz Model.

 The Eric Flamholtz Model

 Morse Model.

 Likert Model

 Ogan’s Model

1- The Lev and Schwartz Model

 Lev & Schwartz advocated the estimation of future earnings

during the remaining service life of the employee and then
arriving at the present value by discounting the estimated
earnings at the cost of capital. The assumptions in this method are
realistic and scientific.

According to this model, the value of human resources is ascertained

in the following ways:

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 All employees are classified into specific groups according to their

age, experience, and skill.

 Average annual earnings are determined for various ranges of

age.

 The total earnings which each group will get up to retirement age
are calculated.

 The total earnings calculated as above are discounted at the rate

of the cost of capital.

 The value thus arrived at will be the value of human

resources/assets.

Limitation

 This method does not indicate the accounting treatment of

human resources.

 This method only considers wages and salaries, but wages and
salaries are not only the costs associated with the employees.
Other costs are associated with the employees.

 The model ignores the possibility and probability that an

individual may leave an organization for a reason other than
death or retirement.

2- The Eric Flamholtz Model

 Flamholtz (1996) developed this model.

 This is an improvement on the present value of future earnings

model’ since it takes into consideration the possibility or
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probability of an employee’s movement from one role to another

in his career and also of his leaving the firm earlier, that is, death
or retirement.

The model suggests a five-step approach for assessing the value of an

individual to the organization:

 Forecasting the period will remain in the organization, i.e., his

expected service life;

 Identifying the services states, i.e., the roles that they might
occupy including, of course, the time at which he will leave the
organization;

 Estimating the value derived by the organization when a person

occupies a particular position for a specified period;

 Estimating of the probability of occupying each possible mutually

exclusive state at specified future times; and

 Discounting the value at a predetermined rate to get the present

value of human resources.

3- Morse Model

 Under this model, the value of human resources is equivalent to

the present value of the net benefits derived by the enterprise
from the service of its employees. The following steps are
involved in this approach:

 The gross value of the services to be rendered in the future by the

employees in their individual and collective capacity.

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 The value of direct and indirect future payments to the employees

is determined.

 The excess of the value of future human resources over the value
of future payments is ascertained. This represents the net benefit
to the enterprise because of human resources.

4- Likert Model

 Rensis Likert in the 1960s was the first to research in HRA(Human

Resource Accounting) and emphasized the importance of strong
pressures on HR’s qualitative variables and on its benefits in the
long-run.

 The Likert Model is a non-monetary value-based model.

According to Likert’s model, the human variable can be divided
into three categories:

 Causal variables;

 Intervening variables; and

 End-result variables.

 The interaction between the causal and intervening variables

affect the end-result variables by way of job satisfaction, costs,
productivity, and earnings.

5- Ogan’s Model

 Pekin Ogan (1976) was the pioneer of the Net benefit model. This,
as a matter of fact, is an extension of the “net benefit approach,”
as suggested by Morse.
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 According to this approach, the certainty with which the net

benefits in the future will accrue should also be taken into
account while determining the value of human resources. The
approach requires the determination of the following:

 Net benefit from each employee.

 Certainty factors at which the benefits will be available.

 The net benefits from all employees multiplied by their certainty

factor will give certainty-equivalent net benefits.

Inflation Accounting
 Inflation accounting is a special technique used to factor in the
impact soaring or plummeting costs of goods in some regions of
the world has on the reported figures of international companies.

 Financial statements are adjusted according to price indexes,

rather than relying solely on a cost accounting basis, to paint a
clearer picture of a firm’s financial position
in inflationary environments.

 This method is also sometimes referred to as price

level accounting.

Need for Inflation Accounting:

 Accounting is based on the traditional concept of cost and

revenue.

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 Money is the yardstick for measuring profits and losses and

financial health of the business — operating results and financial
position.

 The basic objective of accounting is the preparation of financial

statements in a way that they give a true and fair view of the
business. That is, the income statement should disclose the true
profit or loss made by the business during a particular period
while the balance sheet must show a true and fair view of the
financial position of the business on a particular date.

 Financial statements are prepared in monetary units i.e., rupee.

The medium of expression is the money value.

Advantages of Inflation Accounting

 The following are the advantage of Inflation Accounting

 It reflects the current and not the historical cost of the balance
sheet.

 It is highly effective in times of general inflation or hyperinflation.

 Depreciation of the business is valued and cost on the current

price and not on the historical or the carrying value of the asset
which is the correct method.

 Profit and loss will reflect the true condition of the company.

 Financial ratios based on figures, adjusted to the current value,

are more meaningful.

Disadvantages of Inflation Accounting

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 The following are the disadvantage of Inflation Accounting

 Changing in price is a never-ending process hence it becomes

difficult every time to reinstate the figures of the company and
present the financial statements.

 Inflation accounting is a complicated process and it involves too

much calculation and the data gathering process.

 In times of deflation, the depreciation cost will be on a lower side

hence it does not reflect the true picture.

Methods for valuation of Inflation Accounting

Inflation Accounting Methods

 There are two main methods used in inflation accounting

 1. Current Purchasing Power Technique (CPP)

 2. Replacement Cost Accounting Technique (RCA)

 3. Current Value Accounting Technique (CVA)

 4. Current Cost Accounting (CCA).

1- Current Purchasing Power (CPP)

 Under the CPP method, monetary items and non-monetary items

are separated. The accounting adjustment for monetary items is
subject to the recording of a net gain or loss. Non-monetary items
(those that do not carry a fixed value) are updated into figures
with a conversion factor equivalent to price index at the end of
the period divided by price index at the date of transaction.

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 In this method the various items of financial statements, i.e.

balance sheet and profit and loss account are adjusted with the
help of recognized general price index. The consumer price index
or the wholesale price index prepared by the Reserve Bank of
India can be taken for conversion of historical costs.

 The main objective of this method is to take into consideration

the changes in the value of money as a result of changes in the
general price levels. It helps in presenting the financial statements
in terms of a unit of measurement of constant value when both
cost and revenue have been changing due to changes in the price
levels.

The major weaknesses of these techniques are as follows:

 (i) As it takes into account the general price index, it does not
account for changes in the individual assets of the company.
Sometimes it is possible that there may be an increase in the
general price index, but there may not be any increase (rather
there might be a decrease) in the value of a particular asset of a
certain company.

 (ii) The technique seems to be more of theoretical nature than of

any practical utility.

 (iii) In a country like India, even the price indices may not be
correct and it may further cause inaccurate presentation of the
financial statements.

Profit under Current purchasing Power (CPP) accounting can be

ascertained in two ways:
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(i) Net Change Method:

 This method is based on the normal accounting concept that

profit is the change in equity during an accounting period. Under
this method, the openings as well as closing balance sheets are
converted into CPP terms by using appropriate index numbers.
The difference in the balance sheet is taken as reserves after
converting the equity capital also.

 If equity capital is not converted, it may be taken as the balancing

figure. It must be remembered that in the closing balance sheet,
the monetary items will remain unchanged. Profit is calculated as
the net change in reserves, where equity capital is also converted;
and will be equal to net change in equity, where equity is not
converted.

(ii) Conversion of Income Method:

 Under this method, the historical income statement is converted

in CPP terms. Purchases, sales and other expenses which are
incurred throughout the year are converted at average index.

2. Replacement Cost Accounting Technique:

 Replacement Cost Accounting (RCA) Technique is an improvement

over Current Purchasing Power Technique (CPP). One of the major
weaknesses of Current Purchasing Power technique is that it does
not take into account the individual price index related to the
particular assets of a company.

 In the Replacement Cost Accounting technique the index used are

those directly relevant to the company’s particular assets and not
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the general price index. In this sense the replacement cost

accounting technique is considered to be a improvement over
current purchasing power technique.

Depreciation and Replacement of Fixed Assets:

 Another problem posed by the price level changes (and more so

by inflation) is that how much depreciation should be charged on
fixed assets.

The purpose of charging depreciation is twofold:

(i) To show the true and fair view of the financial statements and the
profitability of the concern, and

(ii) To provide sufficient funds to replace the assets after the expiry of
the life of the asset. Depreciation charged on historical or original cost
does not serve any of the two purposes.

The main difficulties are as follows:

(1) It is not possible to find accurately the replacement cost till the
replacement is actually made.

(2) The replaced new assets are not of the same type and quality as old
assets because of new developments and improved qualities.

(3) Income Tax Act. 1961 does not provide for any other method than
the actual cost method.

(4) The fixed assets should not be written-up in the balance sheet when
the prices are not stable.

4. Current Cost Accounting Technique:

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 The British Government had appointed a committee known as

Sandilands Committee under the chairmanship of Mr. Francis C.P.
Sandilands to consider and recommend the accounting for price
level changes. The committee presented its report in the year
1975 and recommended the adoption of Current Cost Accounting
Technique in place of Current Purchasing Power of Replacement
Cost Accounting Technique for price level changes.

 The crux of the current cost accounting technique is the

preparation of financial statements (Balance Sheet and Profit and
Loss Account) on the current values of individual items and not on
the historical or original cost.

The essential characteristics of current cost accounting

technique are as follows:

1. The fixed assets are shown in the balance sheet at their current
values and not on historical costs.

2. The depreciation is charged on the current values of the fixed

assets and not on original costs.

3. Inventories or stocks are valued in the balance sheet at their

current replacement costs on the date of the balance sheet and
not cost or market price whichever is lower.

4. The cost of goods sold is calculated on the basis of their

replacement cost to the business and not on their original cost.

There are many difficulties in the operation of CCA technique:

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(a) It is very difficult to determine the ‘value to the business’ of a

real asset.

(b) There is an element of subjectivity in this technique.

(c) It does not hold good during the periods of depression.

Some Important Adjustments Required under the CCA Technique:

(i) Current Cost of Sales Adjustment (COSA):

 Under the CCA technique, cost of sales are to be calculated on the

basis of cost of replacing the goods at the time they are sold. The
important principle is that current costs must be matched with
current revenues.

(ii) Backlog Depreciation:

 Whenever an asset is revalued, the profit on revaluation is

transferred to Revaluation Reserve Account. But, the revaluation
also gives rise to backlog depreciation. This backlog depreciation
should be charged to Revaluation Reserve Account.

(iii) Monetary Working Capital Adjustment (MWCA):

 Working capital is that part of capital which is required to meet

the day to day expenses and for holding current assets for the
normal operations of the business. It is referred to as the excess
of current assets over current liabilities.

(iv) Current Cost Operating Profit:

 Current cost operating profit is the profit as per historical cost

accounting before charging interest and taxation but after
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charging adjustments of cost of sales, depreciation and monetary

working capital.

(v) Gearing Adjustment:

 During the period of rising prices, shareholders are benefitted to

the extent fixed assets and net working capital are financed while
the amount of borrowings to be repaid remains fixed except
interest charges.

Environmental Accounting
Environmental accounting (EA)is a subset of accounting proper, which
incorporates both economic and environmental information.

 It can be conducted at the corporate level or at the level of a

national economy through the System of Integrated
Environmental and Economic Accounting, a satellite system to the
National Accounts of Countries.

 EA analyzes economic and environmental information in order to

make prudent decisions based on a resource use and the related
costs.

 At a corporate level, environmental accounting can be defined as

a set of organizational activities that deal with the measurement
and analysis of the environmental performance of corporations
and the reporting of such results to concerned groups, both
within and outside the corporation.

Benefits of Environmental Accounting

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 While environmental accounting can focus on environmental

management accounting or financial accounting, the most
prominent benefits come from the application of environmental
management accounting methods.

 This type of accounting focuses on gathering, estimating and

analyzing costs associated with the use of energy and physical
materials like timber, metal or coal.

 Standard accounting practices tended to place these costs in the

catch all category of overhead, but environmental management
accounting allows accountants to apply activity based cost
principles to more accurately associate these costs to various
projects or events.

 Decision makers who can see exactly where these natural

resources are used across various projects can locate areas of
synergy that allow them to reduce the amount of wasted
materials at the program or enterprise level.

Functions and Roles of Environmental Accounting

The functions of environmental accounting are divided into internal and

external functions.

(1) Internal Functions -As one step of a company’s environmental

information system, internal function makes it possible to manage
environmental conservation cost and analyze the cost of
environmental conservation activities versus the benefit obtained,
and promotes effective and efficient environmental conservation
activities through suitable decision-making. It is desirable for
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environmental accounting to function as a business management

tool for use by managers and related business units.

(2) External Functions -By disclosing the quantitatively measured

results of its environmental conservation activities, external
functions allow a company to influence the decision-making of
stakeholders, such as consumers, business partners, investors, local
residents, and administration. It is hoped that the publication of
environmental accounting results will function both as a means for
companies to fulfill their responsibility for accountability to
stakeholders and, simultaneously, as a means for appropriate
evaluation of environmental conservation activities

Structural Elements of Environmental Accounting

Environmental accounting as defined under these guidelines consists of

the following structural elements with the purpose of attaining two
types of benefits derived from costs incurred from environmental
conservation activities during the regular course of business.

1) Environmental Conservation Cost - Investments and expense related

to the prevention, reduction, and/or avoidance of environmental
impact, removal of such impact, restoration following the occurrence of
a disaster, and other activities are measured in monetary value.

 Investment amounts are expenditures allocated during a target

period for the purpose of environmental conservation. The
benefits from these investments are seen over several periods
and are recorded as expense during the depreciation period (the
amount of depreciable assets recorded during the period).

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(2) Environmental Conservation Benefit Benefits obtained from the

prevention, reduction, and/or avoidance of environmental impact,
removal of such impact, restoration following the occurrence of a
disaster, and other activities are measured in physical units.

(3) Economic Benefit Associated with Environmental Conservation

Activities Benefits to a company’s profit as a result of carrying forward
with environmental conservation activities are measured in monetary
value.

Environmental conservation Cost Categories-

 Pollution Prevention Cost Pollution is defined as the creation of

harmful impacts by business or other activities which damage
public health or degradation of the living environment. Specific
types of pollution include air, water, ground, noise, vibration,
odor, and ground sinkage. Pollution prevention costs are those
costs related to the reduction of a production facility’s
environmental impact or spending for end-of-pipe solutions,
facilities or equipment attached to the end of production
facilities.

1) Cost for preventing air pollution (including acid rain)

2) Cost for preventing water pollution

3) Cost for preventing ground contamination

4) Cost for preventing noise pollution

5) Cost for preventing vibration pollution

6) Cost for preventing odor pollution

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7) Cost for preventing ground sinkage

8) Cost for preventing other types of pollution

Business Area Cost –

 This cost is for activities to reduce environmental impact which

occurs within the business area due to key business operations.

 The business area is the region where the company can directly
manage environmental impacts.

 Business area cost associated with environmental conservation is

divided into three categories, pollution prevention cost, global
environmental conservation cost and resource recycling cost.

Global Environmental Conservation Cost - Global environmental

conservation costs are those costs associated with negative
environmental impacts on the global environment or a wide portion of
it, resulting from human activities. Costs are allocated for the
prevention of global warming, to prevent the ozone depletion and
other global environmental conservation efforts.

1) Cost for preventing global warming and energy conservation

2) Cost for preventing the ozone depletion

3) Cost for other global environmental conservation activities

Indian Accounting Standards

 It is a Accounting standard adopted by companies in India and
issued under the supervision of Accounting Standards Board (ASB)

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which was constituted as a body in the year 1977. ASB is a

committee under Institute of Chartered Accountants of
India (ICAI) which consists of representatives from government
department, academicians, other professional bodies viz. ICAI,
representatives from ASSOCHAM, CII, FICCI, etc. ICAI is an
independent body formed under an act of parliament.

 India followed accounting standards from Indian Generally

Acceptable Accounting Principle (IGAAP) prior to adoption of the
Ind-AS.

 IND- AS did not applicable from the single date. It was applied
partially on various types of companies.

 National Advisory Committee on Accounting Standards (NACAS)

recommend these standards to the Ministry of Corporate Affairs (
MCA)

 This shall be applied to the companies of financial year 2015-

2016 voluntarily and from 1st April 2017 on a mandatory basis.

 For the banks, insurance companies, the respective regulators (

RBI and IRDA) will separately notify the date of implementation
of IND AS.

The main objectives of forming these standards.

 The main aim is to improve the reliability of financial statements.

Now because the financial statements have to be made following
the standards the users can rely on them. They know that not
conforming to these standards can have serious consequences for
the companies.
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 Then there is comparability. Following these standards will allow

for inter-firm and intra-firm comparisons. This allows us to check
the progress of the firm and its position in the market.

 It also looks to provide one set of accounting policies that include

the necessary disclosure requirements and the valuation methods
of various financial transactions.

Benefits of Accounting Standards

 Accounting Standards are the ruling authority in the world of

accounting. It makes sure that the information provided to
potential investors is not misleading in any way. Let us take a look
at the benefits of AS.

1] Attains Uniformity in Accounting

2] Improves Reliability of Financial Statements

3] Prevents Frauds and Accounting Manipulations

4] Assists Auditors

5] Comparability

6] Determining Managerial Accountability

Limitations of Accounting Standards

 There are a few limitations of Accounting Standards as well. The

regulatory bodies keep updating the standards to restrict these
limitations.

1] Difficulty between Choosing Alternatives

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2] Restricted Scope

Ind AS- 101= First time adoption of Ind AS

Ind AS 102 = Share Based Payment

Ind AS 103 = Business Combination

Ind AS 104 = Insurance Contracts

Ind AS 105 = Non-Current Assets Held for Sale and Discontinued

Operations

Ind AS 106 = Exploration for and Evaluation of Mineral Resources

Ind AS 107 = Financial Instruments: Disclosures

Ind AS 108 = Operating Segments

Ind AS 109 = Financial Instruments

Ind AS 110 = Consolidated Financial Statements

Ind AS 111 = Joint Arrangements

Ind AS 112 = Disclosure of Interests in Other Entities

Ind AS 113 = Fair Value Measurement

Ind AS 114 = Regulatory Deferral Accounts

Ind AS 115 = Revenue from Contracts with Customers(Applicable from

April 2018)

Ind AS 116 = Leases (Applicable from April 2019)

Ind AS 1 = Presentation of Financial Statements

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Ind AS 2 = Inventories

Ind AS 7 = Statement of Cash Flows

Ind AS 8= Accounting Policies, Changes in Accounting Estimates and

Errors

Ind AS 10= Events occurring after Reporting Period

Ind AS 11= Construction Contracts (Omitted by the Companies (Indian

Accounting Standards) Amendment Rules, 2018)

Ind AS 12 = Income Taxes

Ind AS 16= Property, Plant and Equipment

Ind AS 17= Leases (Omitted by the Companies (Indian Accounting

Standards) Amendment Rules,2019)

Ind AS 18= Revenue (Omitted by the Companies (Indian Accounting

Standards) Amendment Rules, 2018)

Ind AS 19 = Employee Benefits

Ind AS 20 = Accounting for Government Grants and Disclosure of

Government Assistance

Ind AS 21 = The Effects of Changes in Foreign Exchange Rates

Ind AS 23 = Borrowing Costs

Ind AS 24 = Related Party Disclosures

Ind AS 27 = Separate Financial Statements

Ind AS 28 = Investments in Associates and Joint Ventures

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Ind AS 29 = Financial Reporting in Hyper inflationary Economies

Ind AS 32 = Financial Instruments: Presentation

Ind AS 33 = Earnings per Share

Ind AS 34 = Interim Financial Reporting

Ind AS 36 = Impairment of Assets

Ind AS 37 = Provisions, Contingent Liabilities and Contingent Assets

Ind AS 38 = Intangible Assets

Ind AS 40 = Investment Property

Ind AS 41 = Agriculture

International Financial Reporting Standards ( IFRS)

 International Financial Reporting Standards (IFRS) were
established to bring consistency to accounting standards and
practices, regardless of the company or the country.

 They are issued by the Accounting Standards Board (IASB) and

address record keeping, account reporting and other aspects of
financial reporting.

 IFRS benefit companies and individuals alike in fostering greater

corporate transparency.

 The downside of IFRS are that they are not universal, with the
United States using GAAP accounting, and a number of other
countries using other methods.

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Standard IFRS Requirements

 IFRS covers a wide range of accounting activities. There are

certain aspects of business practice for which IFRS set mandatory
rules.

 Statement of Financial Position: This is also known as a balance

sheet. IFRS influences the ways in which the components of a
balance sheet are reported.

 Statement of Comprehensive Income: This can take the form of

one statement, or it can be separated into a profit and loss
statement and a statement of other income, including property
and equipment.

 Statement of Changes in Equity: Also known as a statement of

retained earnings, this documents the company's change in
earnings or profit for the given financial period.

 Statement of Cash Flow: This report summarizes the company's

financial transactions in the given period, separating cash flow
into Operations, Investing, and Financing.

Some important terms

 IFRS set common rules so that financial statements can be

consistent, transparent and comparable around the world.

 IFRS ( after 2001) and IAS ( 1973 to 2001) are same.

 IND-AS took birth from the IFRS and IAS

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 IFRS is published by international Accounting Standard Board (

IASB) & IAS is published by International Accounting committee (
IASC)

AUDITING
Auditing refers to financial statement audits or an objective
examination and evaluation of a company’s financial statements –
usually performed by an external third party.

An audit is an "independent examination of financial

information of any entity, whether profit oriented or not, irrespective
of its size or legal form when such an examination is conducted with a
view to express an opinion thereon" It also attempts to ensure that the
books of accounts are properly maintained by the concern as required
by law. Auditing has become such a ubiquitous phenomenon in the
corporate and the public sector that academics have started identifying
an "Audit Society"

Importance of Auditing

 Audit is an important term used in accounting that describes the

examination and verification of a company’s financial records. It is
to ensure that transactions are represented fairly and accurately.

 Also, audits are performed to ensure that financial statements are

prepared in accordance with the relevant accounting standards.
The three primary financial statements are:

 Income statement

 Balance sheet
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 Cash flow statement

Financial statements are prepared internally following relevant

accounting standards, such as International Financial Reporting
Standards (IFRS) or Generally Accepted Accounting Principles (GAAP),
and are developed to provide useful information to the following:

 Shareholders

 Creditors

 Government entities

 Customers

 Suppliers

 Partners

Financial statements capture the operating, investing,

and financing activities of a company through various transactions that
are recorded. Because the financial statements are developed
internally, there is a high risk of fraudulent behavior by the preparers of
the statements.

Types of Audit

1. Internal audits

 Internal audits are performed by internal employees of a

company or organization. The audits are not distributed outside
the company. Instead, they are prepared for the use of
management and other internal stakeholders.

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 Internal audits are used to improve decision-making within a

company by providing managers with actionable items to improve
internal controls. They also ensure compliance with laws and
regulations and maintains timely, fair, and accurate financial
reporting.

 Management teams can also utilize internal audits to identify

flaws or inefficiencies within the company before allowing
financial statements to be reviewed by external auditors.

Internal audit performs a wide spectrum of activities such as:

 Evaluating the accounting and internal control system.

 Examining the routine operational activities.

 Physical verification of inventory at regular intervals.

 Analyzing financial and non-financial information of the

organization.

 Detection of frauds and errors.

The main aim of the internal audit is to increase the

value of an organization's operation and to monitor the internal
control, internal check and risk management system of the entity.

 An Internal audit is conducted by the internal auditors who are

the employees of the organization.

 It is a separate department, within the organization where a

continuous audit is performed throughout the year.

2. External audits
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 Performed by external organizations and parties, external audits

provide an unbiased opinion that internal auditors might not be
able to give. External financial audits are utilized to determine
whether there are any material misstatements or errors in a
company’s financial statements.

 When an auditor provides an unqualified opinion or clean

opinion, it reflects that the auditor provides confidence that the
financial statements are represented with both accuracy and
completeness.

 External audits are important for allowing various stakeholders to

confidently make decisions surrounding the company being
audited.

 The key difference between an external auditor and an internal

auditor is that an external auditor is independent. It means that
they represent a more honest opinion rather than an internal
auditor who may be biased.

 There are many well-established accounting firms that typically

complete external audits for various corporations. The most well-
known are the Big Four – Deloitte, KPMG, Ernst & Young (EY), and
Price water house Coopers (PwC).

 The purpose of external audit is to verify that the annual accounts

provide a true and fair picture of the organization's finances; and
that the use of funds is in accordance with the aims and objects as
outlined in the constitution.

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 It is not the prime role of the audit to detect fraud, although this
may of course come to light during the checks that take place.
Auditors have thus been described as ‘watchdogs not
bloodhounds’.

3. Government audits

 Government audits are performed by entities that relate to

ensuring that financial statements have been prepared accurately
in order not to misrepresent the amount of taxable income of a
company.

 Within the U.S., the Internal Revenue Services (IRS) performs

audits that verify the accuracy of a taxpayer’s tax returns and
transactions. The IRS’s Canadian counterpart is known as the
Canada Revenue Agency (CRA).

 Audit selections are made to ensure that companies are not

misrepresenting their taxable income. Misstating taxable income,
whether intentional or not, is considered tax fraud. The IRS and
CRA now use statistical formulas and machine learning to find
taxpayers that are at high risk of committing tax fraud.

 Performing a government audit may result in a conclusion that

there is:

 No change in the tax return

 A change that is accepted by the taxpayer

 A change that is not accepted by the taxpayer

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 If a taxpayer ends up not accepting a change, the issue will go

through a legal process of mediation or appeal.

Financial Statement Audit

A financial statement audit is the examination of an entity's financial
statements and accompanying disclosures by an independent auditor.
The result of this examination is a report by the auditor, attesting to the
fairness of presentation of the financial statements and related
disclosures. The auditor's report must accompany the financial
statements when they are issued to the intended recipients.

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 The purpose of a financial statement audit is to add credibility to

the reported financial position and performance of a business.
The Securities and Exchange Commission requires that all entities
that are publicly held must file annual reports with it that are
audited.

 Audits have become increasingly common as the complexity of

the two primary accounting frameworks, Generally Accepted
Accounting Principles and International Financial Reporting
Standards, have increased, and because of disclosures of
fraudulent reporting by major companies.

Independent Financial Audit

 The terms “audit" or "audited financial statements” in this

Nonprofit Audit Guide© refer to the work product resulting from
the independent examination of a nonprofit’s financial records by
a licensed certified public accountant (also referred to in this
Guide as the “auditor,” or the "auditing firm").

 An independent audit is an examination of the financial records,

accounts, business transactions, accounting practices, and
internal controls of a charitable nonprofit by an "independent"
auditor. "Independent" refers to the fact that the auditor/CPA is
not an employee of the nonprofits but instead is retained through
a contract for services, and hence is "independent." See YH
Advisors' newsletter on Financial Audit Basics for a helpful
overview of financial audits.

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 During the independent audit, the auditor will review the

organization’s financial statements to determine whether they
adhere to “generally accepted accounting principles” (commonly
referred to as “GAAP”). These accounting principles are created
by the "Financial Accounting Standards Board, known as "FASB."
While not law, these standards carry weight - when they are not
followed, the auditors are required to note that in their report.

1. Objective • Internal Audit: To ensure that the organization

complies with the policies and procedures and also
to satisfy that the resources are utilized
economically by the organization.
• Independent Financial Audit: Studies the actual
operation of internal control to evaluate and decide
about the nature, timing and extent of the
substantive procedures.

2. Evaluation of • Internal Audit: Studies the actual operations of

internal controls the internal controls and evaluate their
effectiveness. The evaluation is in depth by means
of (a) Internal Control questionnaire (b) Flow
charting etc.
• Independent Financial Audit: Studies the actual
operation of internal control to evaluate and decide
about the nature, timing and extent of the
substantive procedures
3- Error or Fraud • Internal Audit: The primary concern of the
internal audit is prevention and detection of error
and fraud.
• Independent Financial Audit: Prevention and
detection of errors and fraud is only a secondary
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objective.

4. Scope of work • Internal Audit: The scope of work is determined

and reporting by the management and the internal audit report is
presented to the management. The nature and
scope may differ from organization to organization.
• Independent Financial Audit: In statutory audit,
the scope of work is governed by the Statutes such
as Companies Act, Income tax Act etc. In statutory
audit, the report is addressed to the shareholders in
the case of companies and to the appointing
authority in the case of others.

5. Report: • Internal Audit: There is no specific format for

reporting and the report is presented as per
the requirement of the management i.e., monthly,
quarterly, half yearly, etc.
• Independent Financial Audit: Report should be in
a specified format and the report is
presented only once i.e., after the completion of
the audit.
6- Time of Audit • Internal Audit: Internal audit is continuous and
carried out throughout the year.
• Independent Financial Audit: Statutory audit is
conducted after closing of accounts and
preparation of financial statements

Vouching
 Vouching is a procedure followed in the auditing process to
authorize the credibility of the entries entered in the books of
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accounts. In simple and easier words, it can be understood as an

investigation by an auditor of the documents presented by the
firm to check the correctness of such documents.

 The documentary evidence such as counterfoil, cash memo,

receipts, pay-in-slips, for recording transactions in books of
accounts is defined as a voucher. The transactions supposed to be
recorded only if the evidence is available.

Example– Purchase transaction should have these supporting

documents for preparing voucher:

 Invoice bill

 Quotation

 Purchase order

Serial number of vouchers and they are filed properly

 Date of voucher

 Addressed to the client and relate to business of client

 Amount shown in figure should match with words

 Signature of official authorizing officer

 Revenue stamp if amount is rupees 5000 and above

 Vouchers originating from outside the business are

 genuine

Types of Vouching

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 Primary Vouchers: The bills or the documents that are available in

the original copy are known as primary vouchers.

 Collateral vouchers: These are the bills that are available in a

duplicate copy.

Objectives of the vouching:

 To ensure that all the transactions took place during the financial
year for the business only (not for personal use) appropriately
recorded in the books of accounts with true and fair evidence.

 To check the accuracy of the totaling and carrying forward

amount recorded in the books.

 To ensure that the person responsible for the business has

verified his records or not.

 To make the financial records free from malpractices.

 To make sure that law has been followed while preparing financial
records.

Vouching of cash transactions

Some entries of the cash book

Recorded in Debit side (Cash Receipts)

 Opening balance: The closing balance for the last financial year
will be the opening balance or cash-in-hand for the current
financial year.

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 Cash received from debtors: Points to be considered for

verification of cash received:

 The actual date and time of cash received should be entered. The
responsible authority should accredit any discount allowed to the
customers.

 Loan repayment: It can be verified in the following steps:

 Interest received on loan should be credited to interest received

account. Substantiation of bank statement: party can directly
deposit amount in the bank; therefore, verification of bank
statement is necessary.

Rent received: It can be verified in the following steps:

 Records of the different rental properties should be maintained

separately to record the rental income earned from various
properties. Tax deducted at source should be properly accounted
for if deducted by the party.

 Commission received: It can be vouched as follows:

 Agreement verification of the commission being received.

Computation of commission receivable.

Recorded in Credit side (Cash payments)

 Opening balance: Credit opening balance represents a bank

overdraft because the cash-in-hand of a company can never be
negative.

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 Payment to Creditors: Examining creditors payment can be done

in the following ways:

The creditor’s account statement should be inspected.

Issue of receipt by creditors. Any advance payment should be evidently
quoted.

 Payment of salaries: It can be examined in the following ways-

The salary register of the employees should be managed month wise.

Amendments in the amount of TDS, advance payment, insurance, funds
should be noted.

 Purchase of Plant and Machinery: It can be vouched as follows-

Excise duty treatment, according to excise rules. Go thoroughly to the

purchase invoice or receipt of the machinery.

Verification of assets
 The verification of assets implies an inquiry into the value
ownership and title existence and possession the presence of any
charge on the assets. Joseph Lancaster has defined verification of
assets as a process by which the auditor substantiates the
accuracy of the right hand side of the balance sheet and must be
considered as having three distinct objects:

The verification of the existence of assets,

The valuation of assets, and

The authority of their acquisition.

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 Hence, verification of assets can be stated as a process of

substantiation of assets recorded in the books of account by
means of physical inspection and examination of legal and official
documents, and then forming expert opinion as to existence,
ownership, possession, classification and valuation of assets of an
entity.

Components of Valuation

 Methods of valuation of assets are as hereunder −

 Cost Price − This is the cost price paid at the time of acquisition of
assets plus the freight charges, octroi charges, and commissioning
and installation charges, etc. to bring that asset in usable
condition.

 Book Value − This is the value as appearing in the books of

accounts; the cost price less depreciation.

 Realizable Value − A Value which can be realized from the sale of

assets.

 Market Value − A value which the asset can fetch at the time of
sale.

 Replacement Value − A value on which an asset can be replaced.

 Conventional Value − It means the cost price less depreciation

written off ignoring any kind of fluctuation in the price.

 Scrap Value − If the asset is not in working condition and sold as

scrap, then the sale value of asset is scrap value.

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The objectives of an auditor in regard to verification of liabilities is

generally to satisfy himself that

 The balances appearing in the balance sheet are really liabilities.

 Unrecorded liabilities, whether by accident or design, are brought

into books.

 They are properly valued, and

 They are properly classified and disclosed as per statutory

requirements or generally accepted principles and policies.

The verification of assets and liabilities achieves two main objects:

1. Propriety of transactions recorded.

2. Expressing an opinion on the financial statements, i.e., whether

the balance sheet reflects a true and fair view of the state of
affairs of the company.

Verification and Valuation of Fixed Assets

 We will discuss the verification and the valuation of different fixed

assets −

 Verification of Freehold Land and Building

 Auditor should examine the title deed of the land and building.

 Land and building shown in the books should be according to the

title deed.

Verification of Mortgage Property

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 The Auditor should confirm that there should be no second or

third mortgage on it.

 The Auditor should obtain certificate from mortgagee that title

deed is in his possession.

Valuation of Building

 Building should always be valued at cost less depreciation.

 Although the market value of building may be much higher than

the cost, still depreciation on building should be provided

Verification of Leasehold Property

 There should be separate accounting for freehold and leasehold

property. Leasehold property is acquired for fix duration on lease.
The Auditor should consider the following −

 Inspection of lease agreement for value and duration.

 Lease agreement should be registered with the registrar.

Verification and Valuation of Liabilities

Let us now understand the verification and valuation of liabilities −

 Trade Creditors

 Auditor should take the following important steps for the

verification and valuation of

Trade Creditors −

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 Auditor should collect schedule of creditors and that should tally

with ledger balances.

 Purchase ledger should be checked and verified with purchase

register, purchase invoices and debit notes etc.

 Auditor should verify the discount received or receivable from

creditors.

Loans

 The Auditor should verify the following important points for

verification and valuation of Loans −

 The Auditor should verify the amount of loan, type of loan, rate of
interest and repayment terms, etc.

 He should collect and examine the agreement and certificate from

bank in case loan is granted by any Bank or financial institutions.

Capital

 Capital of a partnership firm can be verified through partnership

deed, Bank book, cash book, etc. Capital of a company can be
verified through following −

First Audit

 In case of first audit, Memorandum of Association and Article of

Association should be examined to know the maximum
authorized capital.

Subsequent Audit

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 The Auditor should consider the following points for subsequent

audits −

 Any addition in capital by fresh issue should be according to

Sections 61, 64 and 66 of the Companies Act-1956.

 Authorized capital to be shown separately in the balance sheet.

 Issued and subscribed capital should be shown separately

according to each class of shares.

Auditor

 An auditor is a professional who is qualified to conduct an audit of

the company. Such a person evaluates the validity of the
company’s financial statements. This is undertaken to report if the
company adheres to the established set of standards or
procedures.

 Thus, an auditor can render auditing services either as an

independent professional or employee. If an auditor works for an
organization, he is typically referred to as an internal auditor.
Whereas, an auditor rendering auditing services to a company
independently is referred to as an external agency.

Duties of Auditor

The fundamental duty of a company’s auditor is to

make a report regarding accounts and financial statements examined
by him and present the same to the members of the company.

 Such an opinion of the auditor enhances the credibility of the

financial statements.
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1- Provide an Audit Report- The fundamental duty of a company’s

auditor is to make a report regarding accounts and financial statements
examined by him and present the same to the members of the
company. Such an opinion of the auditor enhances the credibility of the
financial statements.

2- Make Proper Enquiry- It is the duty of every auditor to seek access

to books of accounts, vouchers and other information and explanation
from the company.

3- Assist in Branch Audit- The accounts of a branch office can be

audited by:

 a company’s auditor

 any individual appointed as the branch auditor as per the act

 company’s auditor or accountant or any competent person

appointed as per the laws of the foreign country in case of a
foreign branch

4- Compliance With Auditing Standards-

 Compliance With Auditing Standards

 The central government establishes the auditing standards in

consultation with the ICAI and National Financial Reporting
Authority (NFRA).

5- Reporting of Frauds- A company’s auditor while performing his

duties might encounter fraudulent situations. In such circumstances,
the auditor may believe that an offence equivalent to a fraud has been
committed against the company.
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6- Provide Assistance in Investigation- Investigation refers to checking

of specific records of a business systematically and critically.

Audit Procedure

The primary objective in case of contingent liability is to verify the

existence.

1. Representation from management

Obtain a letter of representation from client containing a statement

that management is aware of no undisclosed contingent liability.

2. Review minutes of board meeting

Review the minutes of meetings of board of directors and their

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committees to discover contingency commitments if any.

3.Review contracts, loan agreement for evidence of liabilities

4. Review list of pending legal cases and documentation

This analysis is directed towards the discovery of possible lawsuits and

tax assessment associate with legal fees paid by client.

5.Review terms and conditions of grants and subsidies under various

schemes To see contingent liability due to non-compliance with scheme

6.Check records relating to bills receivable discounted.

7.Ensure that contingent liabilities do not include items such as

product warranties, service contracts, etc.

Audit Report

 For any enterprise, the audit report is a key deliverable which

shows the end result of entire audit process.

 The users of financial statements like Investors, Lenders,

Customers and others base their decisions and plans on audit
reports of any enterprise.

 The auditor should be careful in issuing the audit report as there

are large number of people placing reliance on such report and
taking decisions accordingly.

 An audit report is always critical to influencing the perceived value

of any financial statement’s audit.

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 The report should be issued by being unbiased and objective in

discharging the functions.

Forms of Audit Report

1. Title of the report

 The title of audit report should help the reader to identify the
report. It should disclose the name of the client. The title
distinguishes the audit report from other reports.

2. Name of the Addressee

 The addressee normally refers to the person who appoints the

auditor. If a company appoints the auditor, the addressee should
be shareholders. As per law, the complete address of the
addressee is required. Addressee for the statutory audit shall be
shareholders and in case of Special Audit, it is Central
Government.

3. Introductory Paragraph

 The introductory paragraph should specify that it is the auditor’s

opinion on financial statements audited by him. The period
covered by financial statements should be stated with exact
dates.

4. Scope

 This part should include the matter-of-fact relating to the manner

in which audit examination was made. The audit examination
should cover company’s accounts, Profit and Loss Account,
Balance Sheet and Cash Flow Statements. The examination should
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be as per the relevant law. The auditor should not curtail or limit
any examination task.

5. Opinion

 The auditor’s opinion on the books of account and financial

statements examined by him is based on the information and free
from bias. The auditor has to give his opinion as follows:

Whether the financial statements are arithmetically correct

and correspond to the figures recorded in the books of accounts.

6. Signature

 The signature part should include the manual signature of the

auditor. The personal name and signature of the auditor should
be given. If the auditor is a firm, the signature in the personal
name and firm name should be given.

7. Place of Signature

 This should include the location of the auditor or the auditor firm,
which is ordinarily their city.

8. Date of the Report

 The date of completion of the audit work should be mentioned in

this section.

Types of Audit Report

1- Clear or Unqualified Report-

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An unqualified opinion is considered a clean report. This is the type of

report that auditors give most often. This is also the type of report that
most companies expect to receive. An unqualified opinion doesn’t have
any kind of adverse comments and it doesn’t include any disclaimers
about any clauses or the audit process.

2- Qualified Report

In qualified report the auditor believes that overall financial statements

are not fairly stated. The reasons for giving Qualified Report are be as
follows:

i. The auditor is not able to verify the value and existence of certain
assets,

ii. The information requested by the auditor is not furnished,

iii. Proper books of account are not maintained as required by law,

iv. Part of audit examination done by other auditors.

3- Disclaimer Report

When an auditor issues a disclaimer of opinion report, it means that

they are distancing themselves from providing any opinion at all related
to the financial statements. Some of the reasons that auditors may
issue a disclaimer of opinion are because they felt like the company
limited their ability to conduct a thorough audit or they couldn’t get
satisfactory explanations for their questions.

4- Negative report- When there is sufficient basis for the auditor to

form an opinion that the whole accounts and financial statements, do
not present a true and fair view of the financial condition and results of
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operation, the adverse or negative opinion will be given. The adverse or

negative report will be given on the following grounds:

• When the auditor is not satisfied with the truth and fairness of
financial statements.

Cost Audit

 Cost audit may be defined as “the verification of cost records and

accounts and a check on the adherence to the prescribed cost
accounting procedures and the continuing relevance of such
procedures.”

 Cost audit is the verification of the correctness of cost accounts

and a check on the adherence to the cost accounting plan.

 This is, it involves not only the examination of cost accounts but
also the fact that the plan prepared in this connection has been
duly executed. Cost audit as an audit of the efficiency of minute
details of expenditure in which the work is in progress and not a
post-mortem examination.

Objectives of Cost Audit

 The following are some of the objectives for which cost audit is
undertaken:

 To establish the accuracy of costing data. This is done by verifying

the arithmetical accuracy of cost accounting entries in the books
of accounts.

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 To ensure that cost accounting principles are governed by the

management objectives and these are strictly adhered to in
preparing cost accounts.

 To ensure that cost accounts are correct and also to detect errors,
frauds, and wrong practice in the existing system.

 To check up the general working of the cost department of the

organization and to make suggestions for improvement.

 To help the management in taking correct decisions on certain

important matters

Types of Cost Audit

The following are the important types of Cost Audit:

 Efficiency Audit- Efficiency Audit is directed towards the

measurement of whether corporate plans have been effectively
executed. It is concerned with the utilization of resources in an
economical and most remunerative manner to achieve the
objectives of the concern.

 Propriety Audit- The propriety Audit is concerned with executive

actions and plans bearing on the finance and expenditure of the
company.

 Statutory Audit- It is the compulsory audit that required

maintaining the related books and accounts of specified
establishments. The chief aims of this type of audit are that the
government wants to ascertain the relationship between costs
and prices.
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Advantages of Cost Audit to the Management

 It provides necessary information for prompt decision decisions.

 It helps management to regulate production.

 Errors, omission, fraud, and mistakes can be detected and

prevented due to the effective auditing of cost accounts.

 It reduces the cost of production through plugging loopholes

relating to wastage of material, labor, and overheads.

Advantages of Cost Audit to the Shareholders

 It ensures a true picture of the company’s state of affairs. It

reveals whether resources like plant and machinery are properly
utilized or not.

 It creates an image of the creditworthiness of the concern.

Advantages of Cost Audit to the Government

 It assists the tariff board in deciding whether tariff protection

should be extended to a particular industry or not.

 It helps to ascertain whether any particular industry should be

given any subsidy to develop that industry.

Disadvantages-

a) Expensive

b) Lengthy

c) Lost time

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d) Uncertainty

Management Audit

 A management audit is an independent and systematic analysis

and evaluation of a company’s overall activities and
performances. It is a valuable tool used to determine the
efficiency, functions, accomplishments and achievements of the
company.

 The primary objective of the management audit is to identify

errors in management activities and suggest possible changes. It
guides the management to manage the operations most
effectively and productively.

Objectives of Management Audit:

 Verify Efficiency- It aims at increasing productivity at all the levels

of management and execution of policies.

 Give Recommendation to Increase Efficiency- the management

audit marks the in capabilities in various levels of management
and provides suggestions to enhance the efficiencies.

 Evaluates the Potential of Policies and Planning- It audits and

evaluates the policies and planning structured by the
management and judge if its appropriately implemented.

 Increase Profit- It helps to increase the profit margin by providing

solutions to maximize the company’s resources in a valuable way.

Weaknesses Revealed by Management Audit:

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(a) Weaknesses among the members of the Board of Directors.

(b) Inadequate steps taken to provide adequate finance.

(c) Lack of technical competence of managers.

(d) Retaining authority by managers for matters which ought to

have been delegated.

(e)Lack of proper staff/management training.

Energy Audit

 An energy audit is an inspection survey and an analysis

of energy flows for energy conservation in a building. It may
include a process or system to reduce the amount of energy input
into the system without negatively affecting the output.

 The Principle of energy audit is -When the object of study is an

occupied building then reducing energy consumption while
maintaining or improving human comfort, health and safety are of
primary concern.

Beyond simply identifying the sources of energy use, an

energy audit seeks to prioritize the energy uses according to the
greatest to least cost effective opportunities for energy savings.

The objectives of the Energy Audit are accomplished by:

i. Identifying areas of improvement and formulation of energy

conservation measures requiring no investment or marginal

investment through system improvements and optimization of

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operations.

ii. Identifying areas requiring major investment by incorporation of

modern energy efficient equipment and up-gradation of existing

equipment

Types of Energy Audit

1. Benchmarking

 Consisting of a whole building energy use analysis, based on the

historic utility use and cost and the comparison of the
performances of the buildings to those of similar buildings.
Through this audit method buildings performance, whether good
or poor, can be assessed at a high level and provide broad
evidence for more detailed energy audits.

2. Walkthrough Audit

 This involves a visit of the building in order to identify energy

conservation measures and energy saving opportunities. This
involves analysis of utility billing information, building equipment
and operating data.

3. Detailed Audit

 This energy audit consists of a detailed site walkover to identify

the energy profile of the building by completing surveys in great
detail, detailed analysis of energy conservation measures and
energy saving opportunities.

4. Investment-grade audit
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 This type of energy audit involved detailed analysis of capital

intensive improvements and require rigorous engineering
analysis.

 Energy audits are an excellent way for all staff members of an

organization to learn about energy management in their business,
understand how their activities impact on the costs of energy and
grasp how they can reduce greenhouse gas emissions, helping
their business be more environmentally friendly.

Environment Audit
 Environmental audit is defined as basic management tool which
comprises a systematic, documented, periodic and objective
evaluation of how well organization, management systems and
equipments are performing.

 A good environment management policy requires that there

should be a constant effort to analyze and monitor various various
industrial working system and processes to generate and transmit
this information for the inspecting authority such as exercise
which generates necessary information on analysis of pollution
being generated or will be generated and completion of annual
estimate has been termed as environmental audit.

Objectives:

 Environment audit needs for an industry are internal as well as

external value

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 External needs serve to achieve compliance standards and

establish a report with regulatory bodies for implementation of
environment management policies.

 Internal need serves the industry as well as self evaluation tool for
the process and technology.

 It helps in pollution control, improves production safety and

health conservations of nocturnal resources by the way of
ensuring waste prevention and reduction, assessing compliance
with regulatory requirement, placing environmental information
to the public.

Advantages:

 Environmental Audit report provides the necessary information

on how well the management systems are performing to keep
place with sustainable level of development.

 It provides performance evaluation of industrial working facilities

and its possible effect in the surrounding.

 It refers to compliance with local, regional and national laws and

regulation

 Potential areas for reduction in raw material consumption leads

to cost saving

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Environmental Auditing In India

The Supreme Audit Institution (SAI) in India is headed by

the Comptroller and Auditor General (CAG) of India who is a
constitutional authority. The CAG of India derives his mandate from
Articles 148 to 151 of the Indian Constitution. The CAG’s (Duties,
Powers and Conditions of Service) Act, 1971 prescribes functions,
duties and powers of the CAG. While fulfilling his constitutional
obligations, the CAG examines various aspects of government
expenditure and revenues. The audit conducted by CAG is broadly
classified into Financial, Compliance and Performance Audit.
Environmental audit by SAI India is conducted within the broad
framework of compliance and performance audit.

System Audit
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A system audit is a disciplined approach to evaluate and improve the

effectiveness of a system. Audits are carried out in order to verify that
the individual elements within the system are effective and suitable in
achieving the stated objectives.

System audit is also defined as “A systematic,

independent and documented process for obtaining audit evidence and
evaluating it objectively to determine the extent to which audit criteria
are fulfilled.”

Audit objectives

 System audits are usually carried out for the following objectives.

 To evaluate the organization system against a system standard

 To determine the conformity or non conformity of the system

elements with the specified requirements

 To determine the effectiveness of the implemented system in

meeting the specified objectives

 To offer an opportunity for improvement in the system

 To meet statutory and regulatory requirements

In the latest approach to the systems audit,

the auditors are expected to go beyond mere auditing for the
compliance by focusing on risk, status, and importance. This means
they are expected to make more judgments on what is effective, rather
than merely adhering to what is formally prescribed.

Safety Audit
Bushra Shazli
+918948156741
[email protected]
 Notes For NTA- UGC NET (Commerce)

A safety audit is a structured process whereby information is collected

relating to the efficiency, effectiveness, and reliability of a company's
total health and safety management system.

Safety audits serve two broad purposes:

 They are routinely conducted in order to determine whether the

company is in compliance with safety legislation. These can be
performed by representatives of a regulatory body or by the
company itself.

 They are used to identify weaknesses in their safety programs and

processes. These audits are then used as a guide for designing
safety plans or to identify corrective actions that should be
undertaken.

Objectives of Safety Audit-

a) To identify the potential hazards

b) To assess the safety standards maintained

c) To advice the company the risk involved in plant measure to be

taken to avoid risks.

d) To recommend measures for improving the effectiveness of

existing organization

5 important steps to an effective Safety Audit-

1) Audit Planning

2) Audit Execution

Bushra Shazli
+918948156741
[email protected]
 Notes For NTA- UGC NET (Commerce)

3) Compile the Audit Report

4) Set corrective Action plans and process improvement in motion.

5) Communicate Results

Bushra Shazli
+918948156741
[email protected]