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1MODULE -I
1
ACCOUNTING: AN INTRO DUCTION
Unit Structure
1.1 Accounting: the language of business
1.2 Accounting: an information system.
1.2.1 Definitions
1.2.2 Objectives of accounting
1.2.3 Function of accounting
1.3 Users of accounting informatio n:
1.4 Branches of accounting
1.5 Book -keeping
1.5.1 Accounting cycle
1.5.2 Basic accounting terms
1.1ACCOUNTING: THE LANG UAGE OF BUSINESS
Accounting is a business language. We can use this language to
communicate financial transactions and their res ults. Accounting is a
comprehensive system to collect, analyzes, and communicates financial
information.
The origin of accounting is as old as money. In early days, the
number of transactions was very small, so every concerned person could
keep the record of transactions during a specific period of time. Twenty -
three centuries ago, an Indian scholar named Kautilya alias Chanakya
introduced the accounting concepts in his book Arthashastra . In his book,
he described the art of proper account keeping and meth ods of checking
accounts. Gradually, the field of accounting has undergone remarkable
changes in compliance with the changes happening in the business
scenario of the world.
Business is an economic activity undertaken with the motive of
earning profits and to maximize the wealth for the owners. Business
cannot run in isolation. Largely, the business activity is carried out by
people coming together with a purpose to serve a common cause. This
team is often referred to as an organization, which could be in d ifferent
forms such as sole proprietorship, partnership, body corporate etc. The
rules of business are based on general principles of trade, social values,
and statutory framework encompassing national or internationalmunotes.in
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2boundaries. While these variables cou ld be different for different
businesses, different countries etc., the basic purpose is to add value to a
product or service to satisfy customer demand.
A bookkeeper may record financial transactions according to
certain accounting principles and standar ds and as prescribed by an
accountant depending upon the size, nature, volume, and other constraints
of a particular organization.
With the help of accounting process, we can determine the profit or
loss of the business on a specific date. It also helps u s analyze the past
performance and plan the future courses of action. As the basic purpose of
business is to make profit, one must keep an ongoing track of the activities
undertaken in course of business.
1.2 ACCOUNTING: AN INFOR MATION SYSTEM
Accounting a s an information system collects data and communicates
economic information, regarding the enterprise, to different internal users
and external users, whose decisions are depended upon the enterprises
performance.
Identification of transactions, is the sta rting point of accounting process
and the preparation of financial statements is the end of accounting
process.
Each and every step, in the accounting process, generates information
which is communicated to the various users.
Such information helps the use rs to take right decisions, at the right time.
Accounting is the business language, which acts as a means of
communication.
Accounting is used to communicate business information to different
interested parties i.e. the internal users and external users of accounting
information.
The external users are investors, creditors, consumers, government, non -
profit organization members and research scholars.
The internal users are owners, management and employees.
Accounting as an information system, converts inpu ts into outputs through
processes.
The figure given below shows the accounting information systemmunotes.in
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3
Fig. Accounting Information System
Source: Financial Accounting A managerial Perspective R.
Narayanaswamy Sixth Edition PHI Pg. 23
1.2.1 DEFINITIONS
Defini tion of Accounting
Definition by the American Institute of Certified Public Accountants
(Year 1961):
"Accounting is the art of recording, classifying and summarizing in a
significant manner and in terms of money, transactions and events which
are, in part at least, of a financial character, and interpreting the result
thereof".
Definition by the American Accounting Association (Year 1966):
"The process of identifying, measuring and communicating economic
information to permit informed judgments and decision s by the users of
accounting".munotes.in
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41.2.2 OBJECTIVES OF ACCOUNTING
To Providing Information
The primary objective of accounting is to provide useful information for
decision -making to stakeholders such as owners, management, creditors,
investors, etc. Variou s outcomes of business activities such as costs,
prices, sales volume, value under ownership, return of investment, etc. are
measured in the accounting process.
To keep systematic records:
Accounting is done to keep systematic record of financial transac tions.
The primary objective of accounting is to help us collect financial data and
to record it systematically to derive correct and useful results of financial
statements.
Ascertainment of Results
‘Profit/loss' is a core accounting measurement. It is m easured by preparing
profit and loss account for a particular period. Various other accounting
measurements such as different types of revenue expenses and revenue
incomes are considered for preparing this profit and loss account.
Difference between these revenue incomes and revenue expenses is
known as result of business transactions identified as profit/loss.
To ascertain the financial position of the business: A balance sheet or a
statement of affairs indicates the financial position of a company as on a
particular date. A properly drawn balance sheet gives us an indication of
the class and value of assets, the nature and value of liability, and also the
capital position of the firm. With the help of that, we can easily ascertain
the soundness of any busi ness entity.
To assist in decision -making: To take decisions for the future, one
requires accurate financial statements. One of the main objectives of
accounting is to take right decisions at right time. Thus, accounting gives
you the platform to plan for the future with the help of past records.
To fulfill compliance of Law: Business entities such as companies, trusts,
and societies are being run and governed according to different legislative
acts. Similarly, different taxation laws (direct indirect tax) are also
applicable to every business house. Everyone has to keep and maintain
different types of accounts and records as prescribed by corresponding
laws of the land. Accounting helps in running a business in compliance
with the law.
To Know the Solvency Position : Balance sheet and profit and loss
account prepared as above give useful information to stockholders
regarding concerns potential to meet its obligations in the short run as well
as in the long run.munotes.in
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51.2.3 FUNCTION OF ACCOUNTI NG
The main functio ns of accounting are as follows:
Measurement: Accounting measures past performance of the business
entity and depicts its current financial position.
Forecasting: Accounting helps in forecasting future performance and
financial position of the enterprise u sing past data.
Decision -making: Accounting provides relevant information to the users
of accounts to aid rational decision -making.
Comparison & Evaluation: Accounting assesses performance achieved
in relation to targets and discloses information regarding accounting
policies and contingent liabilities which play an important role in
predicting, comparing and evaluating the financial results.
Control: Accounting also identifies weaknesses of the operational system
and provides feedbacks regarding effectiven ess of measures adopted to
check such weaknesses.
Government Regulation and Taxation: Accounting provides necessary
information to the government to exercise control on die entity as well as
in collection of tax revenues.
1.3 USERS OF ACCOUNTING INFORMATIO N:
Generally users of accounts are classified into two categories:
a)Internal User
b)External User
Following are the various users of accounting information:
i)Investor: They provide capital to business. They need information to
assess whether to buy, hold or s ell their investment. Also they are
interested to know the ability of the business to survive, prosper and
to pay divided.
ii)Employees: Growth of employees is directly related to the growth of
the organisation and therefore, they are interest to know the st ability,
continuity and growth of the enterprise and its ability to provide
remuneration, retirement and other benefits and to enhance
employment opportunities.
iii)Lenders: They are interested to know whether their loan -principal
and interest will be paid wh en due.
iv)Supplier and Creditors: They are also interested to know the ability
of the enterprise to pay their dues that helps them to decide the credit
policy for the relevant concern, rates to be charged and so on.
Sometime, they also become interested in long term continuation ofmunotes.in
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6the enterprise if their existence becomes dependent on the survival of
the business. Suppose, small ancillary units supply their products to a
big enterprise, if the big enterprise collapses, the fate of the small
units also becom es sealed.
v)Customers: Customers are also concerned with the stability and
profitability of the enterprise because their functioning is more or less
dependent on the supply of goods, suppose, a company produces
some chemicals used by pharmaceutical compani es and supplies
chemicals on three months credit. If all a sudden it faces some trouble
and is unable to supply the chemical, the customers will also be in
trouble.
vi)Government and their agencies: They regulate the functioning of
business enterprise for pu blic good, allocated scarce resources among
competing enterprise, control price, change excise duties and taxes,
and so they have continued interest in the business enterprise.
vii)Public: The public at large is interested in the functioning of the
enterprise because it may make a substantial contribution to the local
economy in many ways including the number of people employed and
their patronage to local suppliers.
viii)Management: On the basis of Accounts, management determine the
effects of their various decis ions on the functioning of the
organisation. This helps them to make further managerial decisions.
External users of accounting
informationExternal users include
Investors
Creditors
Customers
Suppliers
Employees
Government organizations
Internal users of accounting
informationInternal users include
Management
Managers of operations
1.4 BRANCHES OF ACCOUNTING
Following are various branches of Accounting.
1.4.1 Financial Accounting
It is commonly termed as Accounting. The American Institute of
Certified Public Accountants defines Accounting as "an art of recoding,
classifying and summarizing in a significant manner and in terms of
money, transactions and events which are in part at least of a financial
character, and interpreting the results thereo f."munotes.in
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71.4.2 Cost Accounting
According to the Chartered Institute of Management Accountants
(CIMA), Cost Accountancy is defined as "application of costing and cost
accounting principles, methods and techniques to the science, art and
practice of cost contr ol and the ascertainment of profitability as well as the
presentation of information for the purpose of managerial decision -
making."
1.4.3 Management Accounting
Management Accounting is concerned with the use of Financial
and Cost Accounting information to managers within organizations, to
provide them with the basis in making informed business decisions that
would allow them to be better equipped in their management and control
functions.
1.4.4 Social responsibility Accounting
Social responsibility acc ounting is concerned with accounting for
social costs incurred by the enterprise and social benefits created.
1.4.5 Human Resource Accounting
Human resource accounting is an attempt to identify, quantify and
report investment made in human resource of an organisation that are not
presently accounted for under conventional accounting practice.
1.4.6 Difference between Management Accounting and Financial
Accounting
Management Accounting Financial Accounting
1. Management Accounting is
primarily based on t he data
available from Financial
Accounting.1. Financial Accounting is based on
the monetary transactions of the
enterprise.
2. It provides necessary information
to the management to assist them in
the process of planning, controlling,
performance evalua tion and
decision making.2. Its main focus is on recording
and classifying monetary
transactions in the books of
accounts and preparation of
financial statements at the end of
every accounting period.
3. Reports prepared in Management
Accounting are mean tf o r
management and as per
management requirement.3. Reports as per Financial
Accounting are meant for the
management as well as for
shareholders and creditors of the
concern.
4. Reports may contain both
subjective and objective figures.4. Reports sho uld always be
supported by relevant figures and it
emphasizes on the objectivity of
data.munotes.in
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85. Reports are not subject to
statutory audit.5. Reports are always subject to
statutory audit.
6. It evaluates the sectional as well
as the entire performance of the
business.6. It ascertains, evaluates and
exhibits the financial strength of the
whole business.
1.5 BOOK -KEEPING
As defined by Carter, ‘Book -keeping is a science and art of
correctly recording in books -of accounts all those business transactions
that result in transfer of money or money's worth'.
Book -keeping is an activity concerned with recording and classifying
financial data related to business operation in order of its occurrence.
Book -keeping is a mechanical task which involves:
Collection of basic financial information.
Identification of events and transactions with financial character i.e.,
economic transactions.
Measurement of economic transactions in terms of money.
Recording financial effects of economic transactions in order of its
occur rence.
Classifying effects of economic transactions.
Preparing organized statement known as trial balance.
The distinction between book -keeping and accounting is given below:
Book -Keeping Accounting
Output of book -keeping is an input
for accounting.Outp ut of accounting permit
informed judgments and decisions
by the user of accounting
information.
Purpose of book -keeping is to keep
systematic record of transactions
and events of financial character in
order of its occurrence.Purpose of accounting is to find
results of operating activity of
business and to report financial
strength of business.
Book -keeping is a foundation of
accounting.Accounting is considered as a
language of business.
Book -keeping is carried out by
junior staff.Accounting is done b y senior staff
with skill of analysis and
interpretation.
Objects of book -keeping is to
summarize the cumulative effect ofObject of accounting is not only
bookkeeping but also analyzing andmunotes.in
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9all economic transactions of
business for a given period by
maintaining permanent record of
each business transaction with its
evide nce and financial effects on
accounting variable.interpreting reported financial
information for informed decisions.
1.5.1 ACCOUNTING CYCLE
When complete sequence of accounting proce dure is done which
happens frequently and repeated in same directions during an accounting
period, the same is called an accounting cycle.
Steps/Phases of Accounting Cycle
The steps or phases of accounting cycle can be developed as under:
Recording of Tra nsaction: As soon as a transaction happens it is at first
recorded in subsidiary book.
Journal: The transactions are recorded in Journal chronologically.
Ledger: All journals are posted into ledger chronologically and in a
classified manner.
Trial Balance: After taking all the ledger account closing balances, a
Trial Balance is prepared at the end of the period for the preparations of
financial statements.
Adjustment Entries: All the adjustments entries are to be recorded
properly and adjusted accordingly b efore preparing financial statements.
Adjusted Trial Balance: An adjusted Trail Balance may also be
prepared.
Closing Entries: All the nominal accounts are to be closed by the
transferring to Trading Account and Profit and Loss Account.
Financial Statement s:Financial statement can now be easily prepared
which will exhibit the true financial position and operating results.
1.5.2 BASIC ACCOUNTING TERMS
In order to understand the subject matter clearly, one must grasp
the following common expressions always used in business accounting.
Transaction: It means an event or a business activity which involves
exchange of money or money's worth between parties.
Goods/Services: These are tangible article or commodity in which a
business deals. These articles or co mmodities are either bought and sold or
produced and sold.munotes.in
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10Profit: The excess of Revenue Income over expense is called profit. It
could be calculated for each transaction or for business as a whole.
Loss: The excess of expense over income is called loss. It could be
calculated for each transaction or for business as a whole.
Asset: Asset is a resource owned by the business with the purpose of
using it for generating future profits. Assets can be tangible and intangible.
Tangible Assets are the Capital asse ts which have some physical
existence. The capital assets which have no physical existence and whose
value is limited by the rights and anticipated benefits that possession
confers upon the owner are known as intangible Assets. They cannot be
seen or felt although they help to generate revenue in future.
Liability: It is an obligation of financial nature to be settled at a future
date. It represents amount of money that the business owes to the other
parties.
Contingent Liability: It represents a potential obligation that could be
created depending on the outcome of an event.
Capital: It is amount invested in the business by its owners. It may be in
the form of cash, goods, or any other asset which the proprietor or partners
of business invest in the busin ess activity. From business point of view,
capital of owners is a liability which is to be settled only in the event of
closure or transfer of the business. Hence, it is not classified as a normal
liability.
Drawings: It represents an amount of cash, good s or any other assets
which the owner withdraws from business for his or her personal use
Debtor : The sum total or aggregate of the amounts which the customer
owe to the business for purchasing goods on credit or services rendered or
in respect of other c ontractual obligations, is known as Sundry Debtors or
Trade Debtors, or Trade Payable, or Book -Debts or Debtors.
Creditor: A creditor is a person to whom the business owes money or
money's worth. E.g. money payable to supplier of goods or provider of
service. Creditors are generally classified as Current Liabilities.
Trade Discount: It is the discount usually allowed by the wholesaler to
the retailer computed on the list price or invoice price.
Cash Discount: This is allowed to encourage prompt payment b yt h e
debtor. This has to be recorded in the books of accounts. This is calculated
after deducting the trade discount.munotes.in
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111.6MEANING AND TYPES OF FINANCIAL
STATEMENTS
Meaning:
Financial statements are plain statements based on historical records,
facts and figures. They are uncompromising in their objectives, nature and
truthfulness. They reflect a judicious combination of recorded facts, accounting
principles, concepts and conventions, personal judgements and sometimes
estimates.
Financial statements co nsist of ‘Revenue Account’ and ‘Balance Sheet’.
1.Revenue Account / Income Statement:
Revenue Account refers to ‘Profit and Loss Account’ or ‘Income and
Expenditure Account’ or simply ‘Income Statement’. Revenue Account may
be split up or divided into ‘Manuf acturing Account’, ’Trading Account’,
’Profit and Loss Account’ and ‘Profit and Loss Appropriation Account’,
Revenue Account is prepared for ap e r i o d ,c o v e r i n go n ey e a r .T h i ss t a t e m e n t
shows the expenses incurred on production and distribution of the produ ct
and sales and other business incomes. The final result of this statement may
beprofit of loss for a particular period.
2.Balance Sheet:
Balance sheet shows the financial position of a business as on a particular
date. It represents the assets owned by th eb u s i n e s sa n dt h ec l a i m so ft h e
owners and creditors against the assets in the form of liabilities as on the
date of the statement.
3.Funds Flow Statement –
It describes the sources from which the additional funds were derived
and the use of these funds. Fu nds flow statement helps to understand the
changes in the distribution of resources between two balance sheet periods.
The statement reveals the sources of funds and their application for
different purposes.
4.Cash flow Statement:
A cash flow statement shows the changes in cash position from one
period to another. It shows the inflow and outflow of cash and helps the
management in making plans for immediate future. An estimated cash flow
statement enables the management to ascertain the availability of cash t om e e t
business obligations. This statement is useful for short term planning by the
management.
5. Schedules:
Schedule explains the items given in income statement and balance
sheet. Schedules are a part of financial statements which give detailed
informa tion about the financial position of a business organization.munotes.in
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121.7OBJECTIVES OF FINANCIAL STATEMENTS
The main object of financial statements is to provide information
about the financial position, performance and changes taken place in an
enterprise. Finan cial statements are prepared to meet the common needs of
most users. The important objectives of financial statements are given below:
1. Providing information for taking Economic decisions:
The economic decisions that are taken by users of financial state ments
require an evaluation of the ability of an enterprise to generate cash and cash
equivalents and of the timing and certainty of their generation. This ability
ultimately determines the capacity of an enterprise to pay its employees and
suppliers meet interest payments, repay loans and make distributions to its
owners.
2.Providing information about financial position:
The financial position of an enterprise is effected by the economic
resources it controls, its financial structures its liquidity and solve ncy
and its capacity to adapt to changes in the environment in which it operates.
Information about financial structure is useful in predicting future
borrowing needs and how future profits and cash flows will be distributed
among those with an interest in the enterprise. This information is useful in
predicting how successful the enterprise is likely to be in raising further
finance. Information about liquidity and solvency is useful to predicting the
ability of the enterprise to meet the financial commitm ents as fall due.
3.Providing information about performance(working results) of an
enterprise:
Another important objective of the financial statements is that it
provides information about the performance and in particular its
profitability, which requires i n order assessing potential changes in the
economic resources that are likely to control in future. Information about
performance is useful in predicting the capacity of the enterprise to
generate cash inflows from its existing resource base as well in for ming
judgment about the effectiveness with which the enterprises might
employ additional resources.
4. Providing Information about changes in financial position:
The financial statements provide information concerning changes in
the financial position of a n enterprise, which is useful in order to assess its
investing, financing and operating activities during the reporting periods.
This information is useful in providing the user with a basis to assess the
ability of the enterprise to generate cash and cash equipments and the
needs of the enterprise to utilize those cash flows.munotes.in
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131.8AN OVERVIEW OF FINANCIAL STATEMENTS
Each business firm has to prepare two main financial statements viz.
Income Statement and Balance sheet. The income statement reveals the pro fit
of loss during a particular period generated from the activities of a
business. Balance sheet shows the financial position of a business on a
particular date.
Income statement
Income statement summaries the incomes /gains and expenses
/losses of a Busi ness for a particular financial period. The format of Income
statement explains in detail the items to be included in the statement. It
is presented in the traditional T Format and also in the vertically statement
form.
1. Horizontal Form T form Manufactur ing Trading and Profit and
Loss Account For the year ending
Dr. Cr.
Particulars Rs. Particulars Rs.
To Opening stock By Closing stock
Raw materials Raw Material
Work in progress Work in progress
To Purchase ofrawmaterialsBy Cost offinishedgoods c/dTo Manufacturing wages By Sales
To Carriage/ FreightinwardsBy Closing stock ofFinished GoodsTo Custom duty By Gross Loss c/d
To Other factoryExpensesBy Gross profit b/d
To Opening stock By Business incomesand GainsFinished Goods By Net Loss c/d
To Cost of finished By Balance b/dfromPrevious yearGoods b/d By Net Profit b/d
To Gross profit c/d
To Gross loss b/d
To Office andadministration ExpensesToInterest andfinancialExpensesTo Provision forIncometaxTo Net Profit c/d
To Net loss b/dmunotes.in
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14To Transfer toGeneralreserveTo Dividend
To Balance c/fParticularsRs. Rs.
Gross Sales xxx
Less : Sales returns xxxSales tax / Excise dutyNet Salesxxx
Less : Cost of goods sold
(Materials consumed + Direct Labour+Manufacturing Expenses)xxx
xxx
xxx
Add / Less : Adjustment for change in stock xxx xxx
Gross Profit xxx
Less : Operating expenses xxx
a.Office and administration Expenses xxx
b.Selling and distrib ution Expenses xxx xxx
Add : Operating Income xxx
Operating Profit xxx
Add : Non Operating Income xxxLess :Non Operating expenses (including
interest)xxx
Profit before interest and tax xxx
Less : Interest xxx
Profit before tax xxx
Less : Appropriations: xxx xxx
a.Transfer to reserves xxx xxx
b.Dividends declared / paidxxx
Surplus carried to Balance Sheet xxx
Balance sheet:
It is one of the major financial statements which presents a company's
financial position at the end of a spec ified date. Balance sheet has been
described as a "snapshot" of the company's financial position at a momentmunotes.in
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15for e.g. the amounts reported on a balance sheet dated March 31st,2 0 1 6
reflects that all the transactions throughout December 31sthave been
recor ded. The balance sheet provides information related to the assets,
liabilities and the shareholders’ equity of the company as on a specific date.
Total Assets = Total Liabilities + Share holders’ equity
The companies Act, 1956 stipulates that the balance s heetof a joint
stock company should be prepared as per Part I of Schedule VI of the Act.
However, the statement form has been emphasized upon by accountants for the
purpose of analysis and interpretation.
munotes.in
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16MODULE -II
2
ACCOUNTIN GP R I N C I P L E S
Unit Structure
2.1 Introduction
2.2 Accounting Concepts
2.3 Accounting Principles
2.4 Accounting Conventions
2.5 Widely Accepted Accounting Concepts
2.1 INTRODUCTION
Accounting is the language of the business. Accounting Principles
are the rul es or guidelines which are developed to maintain a uniformity
and consistency in accounting records. This generally accepted
accounting principles (GAAP’s) provides unity of understanding and
unity of approach in the practice of accounting and also in bett er
preparation of financial statements.
Let us imagine a situation where you give copies of your books of
accounts to three different accountants and you ask them to prepare
financial statements and to compute the income from business for the
financial yea r on the basis of books of accounts given to them. All three
accountants are ready with the financial statements and all three
accountants have computed different figure of income i.e. profit from the
business and that too with very wide variations among t hem. Guess in
such a situation what impact would it leave on you about accounting
profession. To avoid this, a generally accepted set of accounting
principles/rules have been developed.
Financial statements prepared by the accountants to communicate
financial information to the various users of financial statements for
decision making purpose. Therefore, it is important that financial
statements prepared by different business entities should be prepared on
uniform basis. Also there should be consistency o ver a period of time in
the preparation of these financial statements. If every accountant starts
following his own methods and concepts for accounting different items
then there will be confusion.munotes.in
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17To 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 are called
1.Accounting Concepts;
2.Accounting Con ventions;
3.Accounting Postulates ;
4.Accounting Principles
2.2 ACCOUNTING CONCEPTS
Accounting Concepts are certain rules that accountant should
follow while recording business transactions and preparing accounts.
E.g. in India there is a basic rule to be foll owed by everyone that
one should walk or drive on his/her left hand side of the road. It helps in
the smooth flow of traffic. Similarly, there are certain rules that an
accountant should follow while recording business transactions and
preparing accounts.
Accounting concepts lay the foundation on the basis of which the
accounting principles are followed. Concepts constitute the very basis of
accounting. There are various concepts of accounting and all have been
developed over the period of time from experie nce and thus, they are
university accepted rules.
2.3 ACCOUNTING PRINCIPLES
Meaning of Principles:
A general law or rule followed or adopted as a guide to action is
known as a principle.
Definitions of Accounting Principles:
1.According to American Institute of Certified Public Accountants
(AICPA) : “The accounting principles are general law or rule adopted
or preferred as a guide to action, a settled ground or basis of conduct
or practice.”
2.According to R.N Antony: “ The rules and conventions of accounting
are commonly referred to as Principles.”
Accounting principles must satisfy following conditions:
1.They should be based on real assumptions;
2.They must be simple, understandable & self explanatory;munotes.in
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183.They must be followed consistently;
4.They should be able to r eflect future predictions;
5.They should be informational for the users.
2.4 ACCOUNTING CONVENTIONS
An accounting convention refers to common practices which are
universally followed in recording and presenting accounting statements of
the business entity. Accounting conventions are followed like customs,
traditions, etc. in a society. They make accounting information more clear
and useful. They have evolved through the regular and consistent practice
over the years. They facilitate uniform recording in the books of accounts.
2.5 WIDELY ACCEPTED ACCOUNTING CONCEPTS
1.Business Entity Concept
2.Money Measurement Concept
3.Accounting Period(Periodicity) Concept
4.Cost Concept
5.Realization Concept or Revenue recognition Concept
6.Matching Concept
7.Accrual Concept
8.Dual Aspec tC o n c e p t
9.Materiality Concept
10.Conservatism or Prudence Concept
1)Business Entity Concept : Entity Concept states that Business
Enterprise is separate entity from its owner. As per this concept
business transactions to be recorded in business books and owner’s
transactions to be recorded in his personal books.
Entity concept means that enterprise owes to the owner for capital
provided by the owner.
Example: Mr. A Commenced business by investing Rs. 12,00,000/ -
with which he purchased Equipments & other Fixed assets required in
business for Rs. 10,00,000/ -& kept balance in hand. i.e. Rs. 2,00,000/ -
The financial position(Balance sheet) of business is as follows:munotes.in
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19Balance SheetLiabilitiesAmount(Rs.)AssetsAmount(Rs.)
Capital 1200000 Equipment & Fixed
Assets1000000
Cash in Hand 200000
1200000 1200000
This means that Business Enterprise owes to Mr. A Rs.12,00,000/ -
now if Mr. A Spends/ uses Rs. 50,000/ -for Household Expenses from
business capital Fund then as per business entity concept it should n ot be
classified/recorded as business expenses but should be charged to capital
account i.e. Capital will get reduced by Rs. 50,000/ -& revised Balance
sheet will show following position
Balance SheetLiabilitiesAmount(Rs.)AssetsAmount(Rs.)
Capital 12,00,000 Equipment
&F i x e d
Assets10,00,000
Less:
Drawings(Personal
Expenses.)(50,000) 11,50,000 Cash in
Hand1,50,000
11,50,000 11,50,000
2)Money Measurement Concept: This Concept states that only
monetary transactions i.e. which can be meas ured in terms of money
are to be recorded. In accounting, a record is made only of those facts
or transactions that can be expressed in monetary terms. It provides a
common unit for measurement, i.e., money for measuring, recording
and summarizing the tran saction. Events, which cannot be expressed
in money terms, do not find a place in account books. Example, salary
paid to manager is recorded in account books but his competence is
has no place in account books.
3)Accounting Period / Periodicity Concept: Allthe transactions are
recorded in the books of accounts on the assumption that profits on
these transactions are to be ascertained for a specified period. This is
known as periodicity or accounting period concept. Thus, this concept
requires that a balance sheet and profit and loss account should be
prepared at regular intervals. This is necessary for different purposesmunotes.in
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20like, calculation of profit, ascertaining financial position, tax
computation etc. Usually one year is taken as one accounting period
which may be a calendar year or a financial year.
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 p eriodic revenue with expenses for getting correct results
of the business operations.
4)Cost Concept: As per cost concept value of asset recorded at its
acquisition/purchase cost, in other words, at its historical cost.
For example, if a plot of land is pur chased for Rs. 1,50,000 then as
per this concept, the asset will be recorded in the books at Rs.
1,50,000, even if its market value at that time is Rs. 2,00,000.
5)Realization Concept or Revenue recognition Concept: This
Concept deals with the problem, when the revenue should be
recognized? According to this concept, the sale should be recognised
at the point, when the property in goods passes to the buyer and he
becomes legally liable to pay and other income is recognised, when
they accrue.
Example: Mr. A pl aces an order with Mr. B for supply of certain
goods, which are yet to be manufactured. On receipt of order, Mr. B
purchases raw materials employs workers, produces the goods and
delivers finished goods to Mr.A. Mr. A makes payment on receipt of
goods. In this case, the sale will be presumed to have been made not at
the time of receipt of the order for the goods, but at the time, when
goods are delivered to Mr. A.
6)Matching Concept: In this concept, all expenses matched with
revenue of that period should onl y be taken into consideration. The
objective of running business is to earn profit in order to ascertain the
profit made by the business during a period. It is necessary that the
revenues of the period should be matched with the cost (Expenses) of
the peri od. The term matching means appropriate association of related
revenues and expenses.
Example: ABC Ltd. purchases a large appliance from wholesalers for
Rs.5,000 and resells it to a local restaurant for Rs.8,000. At the end of
the period, ABC Ltd. should m atch the Rs.5,000 cost with the
Rs.8,000 revenue .
7)Accrual Concept: Under Accrual concept/ Accrual basis of
accounting, income must be recorded in the accounting period in
which it is earned. Therefore, accrued income must be recognized in
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21period in which it will be received. Conversely, prepaid income must
be not be shown as income in the accounting period in which it is
received but instead it must be presented as such in the subsequen t
accounting periods in which the services or obligations in respect of
the prepaid income have been performed.
Example: Suppose Mr. Ramesh rents a house from Suresh at
Rs.100,000 per year. Now consider the following three cases in which
Ramesh pays cash to Suresh and records rent expense.
In above example, even though cash paid is different in all the
three cases but the rent expense recorded is Rs.1,00,000 in each case.
Justification behind that is the accrual concept of accounting in which
expenses mu st be recorded in the accounting period in which they are
incurred not in the period in which they are paid.
Notice that in case “b” Mr. Ramesh has paid Rs.80,000 cash but has
recorded Rs.100,000 expense during the period because the annual rent is
Rs.100, 000 not Rs.80,000. The remaining Rs.20,000 will be paid
subsequently. Also notice that in case “c” Mr. Ramesh has paid
Rs.1,50,000 but has recorded Rs.100,000 expense, the balance of
Rs.50,000 will be adjusted against the rent of subsequent period.
8)Dual A spect Concept: This is a basic concept of accounting.
According to this concept, every business transactions has dual effect -
1stAspects 2ndAspects
(i)It increases on Asset and decreases other Asset,
[Purchase of Machinery] [Payment of Cash]
(ii)It increases an Asset and simultaneously increase liability,
[Purchase of Machinery] [Payment at future date
(on credit basis) ]munotes.in
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22(iii)It decreases one Asset, and decreases one Liability
[Payment of Cash] [Settlement of Liability]
(iv)It increase liability, and decreases simultaneously liability
[Bank Loan Obtained] [Payment to Creditors
(Using Loan Amount) ]
For example, suppose Mr. Rahul purchases Assets of Rs. 100000 in cash.
In this business transaction, Mr. R ahul receives the assets of Rs. 100000,
but on the other hand, Cash balance will decrease by Rs. 100000 So,
Assets Account and Cash Account shall be affected by this transaction.
Thus in every business transaction, one aspect represents the assets or
expen ses other represents the claim or income and these two expects are
always equal. This approach generates the concept of accounting equation,
which can be summarized as below:
For example, if A starts a business with a capital of Rs. 1,00,000. There
are no aspects of this transaction. On the one hand, the business has asset
(in the form of cash) of Rs. 1,00,000, while on the other hand the business
has to pay to the propr ietor a sum of Rs. 1,00,000, which is known as
proprietor’s capital. This expression can be shown in the form of
accounting equation as follows:
Capital (Liability) = Cash (Assets)
1,00,000 = 1,00,000
In the example given above, if the Machinery wort h Rs. 50,000 is
purchased, the situation will be as follows:
Capital (Rs. 1,00,000) = Cash (Rs. 50,000) + Machinery (Rs. 50,000)
Thus, this concept develops a relationship between liabilities and assets.
The Accounting Equation can be technically started a s “for every debit,
there is an equivalent credit”. As a matter of fact, the entire Double Entry
System of Book -Keeping is based on this concept.
9)Materiality Concept: As per the concept of materiality, all the items
having significant economic effect on t he business of the enterprise
should be disclosed in the financial statements and any insignificant
item which will only increase the work of accountant but will not be
relevant to the users need should not be disclosed in the financial
statements.Liabilities = Assets
External Liabilities + Capital = As sets
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23The te rm materiality depends not only upon the amount of the item but
also upon the size of the business, nature & level of information, level of
the person making 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.
10)Conservatism or Prudence Concept: Conservatism states that the
accountant should not anticipate income and should provide for all
possible losses. When t here are many alternative values of an asset, an
accountant should choose the method which leads to the lesser value.
Later on we should see that the golden rule of current asset valuation –
‘cost or market price ‘whichever is lower originated from this co ncept.
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243
BASICS OF ACCOUNTING STANDARDS
Unit Structure
3.1Meaning & Introduction
3.2 Accounting Standards in Brief
3.1 MEANING & INTRODUCTION
Accounting standards are the written policy documents issued by
the regulatory authori ty, experts accounting body or by the government
covering various aspects of recognition, treatment, measurement,
presentation & disclosure of accounting transactions and events in the
financial statements. The accountant has to adhere to various accountin g
standards while preparing financial statements of the entities.
Accounting standard provide framework and standard accounting
policies so that the financial statement of different enterprises become
comparable.
The accounting standards deals with the iss ues of –
i.Recognition of events and transactions in the financial statements;
ii.Measurement of these transactions and events;
iii.Presentation of these transactions and events in the financial
statements in a manner that is meaningful and understandable to the
reader; and
iv.The disclosure requirements which should be there to enable public at
large and the stakeholders and the potential investors in particular, to
get insight into what these financial statement are trying to reflect and
thereby facilitating them to take prudent and informed business
decisions.
3.2 ACCOUNTING STANDARDS IN BRIEFAS-1-Disclosure of Accounting Policies:Accounting Policies refer tospecific accounting principles and the method of applying those principlesadopted by the enterprises in preparation and presentation of the financialstatements.munotes.in
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25AS-2-Valuation of Inventories:The objective of this standard is toformulate the method of computation of cost of inventories / stock,determine the value of closing stock / inventory at which theinventory isto be shown in balance sheet till it is not sold and recognized as revenue.AS 3 -Cash Flow Statements:Cash flow statement is additionalinformation to user of financial statement.This statement exhibits the flowof incoming and outgoing ca sh.This statement assesses the ability of theenterprise to generate cash and to utilize the cash.This statement is one ofthe tools for assessing the liquidity and solvency of the enterprise.AS 4 -Contingencies and Events occurring after the balance sheetdate:In preparing financial statement of a particular enterprise,accounting is done by following accrual basis of accounting and prudentaccounting policies to calculate the profit or loss for the year and torecognize assets and liabilities in balance sheet. While following theprudent accounting policies, the provision is made for all known liabilitiesand losses even for those liabilities / events, which are probable.Professional judgment is required to classify the likehood of the futureevents occurring and, therefore, the question of contingencies and theiraccounting arises.Objective of this standard is to prescribe the accountingof contingencies and the events, which take place after the balance sheetdate but before approval of balance shee t by Board of Directors.T h eAccounting Standarddeals with Contingencies and Events occrring afterthe balance sheet date .AS 5 -Net Profit or Loss for the Period, Prior Period Items and changein Accounting Policies: The objective of this accounting standard is toprescribe the criteria for certain items in the profit and loss account so thatcomparability of the financial statement can be enhanced. Profit and lossaccount being a period statement covers the items of the income andexpenditure of the part icular period. This accounting standard alsodealswith change in accounting policy, accounting estimates and extraordinaryitems.AS 6 -Depreciation Accounting:It is a measure of wearing out,consumption or other loss of value of a depreciable asset arising from use,passage of time.Depreciation is nothing but distribution of total cost ofasset over its useful life.AS 7 -Construction Contracts:Accounting for long term constructioncontracts involves question as to when revenue should be recognized and
how to measure the revenue in the books of contractor. As the period ofconstruction contract is long, work of construction starts in one year and iscompleted in another year or after 4 -5 years or so. Therefore questionarises how the profit or loss of construction contract by contractor shouldbe determined. There may be following two ways to determine profit orloss: On year -to-year basis based on percentage of completion or oncompletion of the contract.munotes.in
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26AS 8 -Accounting for Research & Development :A c counting forresearch & development, is withdrawn from the date of AS 26, Intangibleassets, becoming mandatory for respective enterprises.AS 9 -Revenue Recognition: The standardexplains as to when therevenue should be recognized in profit and loss accou ntand also states thecircumstances in which revenue recognition can be postponed. Revenuemeans gross inflow of cash, receivable or other consideration arising in thecourse of ordinary activities of an enterprise such as the sale of goods,rendering ofservices, and use of enterprises resources by other yieldinginterest, dividend and royalties. In other words, revenue is a charge madeto customers / clients for goods supplied and services rendered.AS 10 -Accounting for Fixed Assets: AS 10 prescribes accounting forfixed assetsused by entity in the business. AS defines term fixed asset. Itis an asset, which is held with intention of being used for the purpose ofproducing or providing goods and services not held for sale in the normalcourse of business and expected to be used for more than one accountingperiod.AS 11 -The Effects of changes in Foreign Exchange Rates :Effect ofChanges in Foreign Exchange Rate shall be applicable in Respect ofAccounting Period commencing on or after 01 -04-2004 and ismandatoryin nature.This accounting Standard applicable to accounting fortransaction in foreign currencies in translating in the financial statementof foreign operations.Effect of changes in foreign exchange rate, anenterprises should disclose follow ing aspects:
a)Amount Exchange Difference included in Net profit or Loss;
b)Amount accumulated in foreign exchange translation reserve;
c)Reconciliation of opening and closing balance of Foreign Exchangetranslation reserve;AS 12 -Accounting for Government Gran ts:Accounting standard 12deals with accounting for government grants both capital and revenue
from government.Government Grants are assistance by the Govt. in theform of cash or kind to an enterprise in return for past or futurecompliance with certain conditions. Government assistance, which cannotbe valued reasonably, is excluded from Govt. grants,. Those transactionswith Government, which cannot be distinguished from the normal tradingtransactions of the enterprise, are not considered as Governme nt grants.AS 13 -Accounting for Investments:AS 13 provides accountingprinciples for investments in the financial statement and related disclosurerequirements. As per AS 13 Investment meansthe assets held for earningincome by way of dividend, interestand rentals, for capital appreciation orfor other benefits.munotes.in
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27AS 14 -Accounting for Amalgamation:This standard prescribesaccounting for amalgamation .This accounting standard deals withaccounting to be made in books of Transferee Company in case ofamalgamation. The standard is applicable when acquired company isdissolved and separate entity ceased exist and purchasing companycontinues with the business of acquired companyAS 15 -Employee Benefits:Accounting Standard 15 prescribes theaccounting and d isclosure for employee benefits.This Standard covers allforms of employee benefits i.e. Short term employee benefits (Salaries,Leave, bonus, housing, mediclaim etc.), Post employment benefits(gratuity, pension, post employment medical care etc.) and other long termemployee benefits and termination benefits.AS 16 -Borrowing Costs :Enterprises are borrowing the funds to acquire,build and install the fixed assets and other assets, these assets take time tomake them useable or saleable, therefore theenterprises incur the interest(cost on borrowing) to acquire and build these assets.The objective of theAccounting Standard is to prescribe the treatment of borrowing cost(interest + other cost) in accounting, whether the cost of borrowing shouldbe in cluded in the cost of assets or not.AS 17 -Segment Reporting:An enterprise needs in multipleproducts/services and operates in different geographical areas. Multipleproducts / services and their operations in different geographical areas areexposed to different risks and returns.Information about multiple products/ services and their operation in different geographical areas are calledsegment information. Such information is used to assess the risk and returnof multiple products/services and their operation in different geographicalareas. Disclosure of such information is called segment reporting.AS 18 -Related Party Disclosure:Sometimes business transactionsbetween related parties lose the feature and character of the arms lengthtransactions. Related party relationship affects the volume and decision ofbusiness of one enterprise for the benefit of the other enterprise. Hencedisclosure of related party transaction is essential for properunderstanding of financial performance and financial position ofenterprise.AS 19 -Accounting for leases:Lease is an arrangement by which thelesser gives the right to use an asset for given period of time to the lesseeon rent. It involves two parties, a lessor and a lessee and an asset which isto be leased.The lessor who owns the asset agrees to allow the lessee touse it for a specified period of time in return of periodic rent payments.AS 20 -Earning Per Share: Earning per share (EPS) is afinancial ratiothat gives the information regarding earning available to each equityshare.It is very important financial ratio for assessing the state of marketprice of share. This accounting standard gives computational methodologyfor the determination and presentation of earning per share, which willmunotes.in
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28improve thecomparison of EPS. The statement is applicable to theenterprise whose equity shares or potential equity shares are listed in stockexchange.AS 21 -Consolidated Financial Statements: Theobjective of thisstatement is to present financial statements of aparent and its subsidiary(ies) as a single economic entity.In other words the holding company andits subsidiary (ies) are treated as one entity for the preparation of theseconsolidated financial statements. Consolidated profit/loss account andconsolidated balance sheet are prepared for disclosing the total profit/lossof the group and total assets and liabilities of the group. As per thisaccounting standard, the conslidated balance sheet if prepared should beprepared in the manner prescribed by this statement.AS 22 -Accounting for Taxes on Income:This accounting standardprescribes the accounting treatment for taxes on income. Traditionally,amount of tax payable is determined on the profit/loss computed as perincome tax laws.AS 23 -Accounting for Investments in Associates in consolidatedfinancial statements:The accounting standard was formulated with theobjective to set out the principles and procedures for recognizing theinvestment in associates in the consolidated financial statements of theinvestor, so that the effect of investment in associates on the financialposition of the group is indicated.AS 24 -Discontinuing Operations:The objective of this standard is toestablish principles for reporting information about discontinuingoperati ons.The focus of the disclosure of the Information is about theoperations which the enterprise plans to discontinuerather than disclosingon the operations which are already discontinued. However, the disclosureabout discontinued operation is also cove red by this standard.AS 25 -Interim Financial Reporting (IFR):Interim financial reporting isthereporting for periods of less than a yeargenerally for a period of 3months.AS 26 -Intangible Assets : An Intangible Asset is an Identifiable non -
monetary Asset without physical substanceheld for use in the productionor supplying of goods or services for rentalsto others or for administrativepurposeAS 27 -Financial Reporting of Interest in joint ventures:Joint Ventureis defined as a contractual arran gement whereby two or more parties
carry on an economic activity under 'joint control' .Control is thepower togovern the financial and operating policies of an economic activityso asto obtain benefit from it. 'Joint control' is the contractually agreedsharingof control over economic activity.munotes.in
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29AS 28 Impairment of Assets:The dictionary meaning of 'impairment ofasset' is weakening in value of asset. In other words when the value ofasset decreases, it may be called impairment of an asset. As per AS -28asset is said to be impaired when carrying amountof asset is more than itsrecoverable amount .
Carrying Amount means book value of Asset
Recoverable Amount means Market value of AssetAS 29 -Provisions, Contingent Liabilities And ContingentAssets: Obje ctive of this standard is to prescribe theaccounting forProvisions, Contingent Liabilities, Contingent Assets, Provision forrestructuring cost
Provision: It is a liability, which can be measuredonly by using asubstantial degree of estimation
.
Liabili ty:A liability is present obligationof the enterprise arising frompast events the settlement of which is expected toresult in an outflowfrom the enterprise of resources embodying economic benefits.
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304
INTRODUCTION TO IFRS
Unit Stru cture
4.1 Introduction
4.2 Purpose
4.3 Scope
4.4 International Financial Reporting Standards
4.1 INTRODUCTION
IFRS stands for International Financial Reporting Standards.
IFRS are developed by International Accounting standards boards (IASB).
IFRS is set o f standards used in many parts of the world, including the
European Union, Hong Kong, Australia, Malaysia, Russia, South Africa,
Singapore etc. for preparation of financial statements. Different
Countries uses different set of accounting standards while preparation of
financial statements for e.g. India uses its own set of Accounting standards
issued by the ICAI, United states have their US GAAP, Canada has its
Canadian GAAP and United Kingdom has its UK GAAP.
Conceptual Framework
Introduction: Financia l statements are prepared and presented for
external users by many many entities around the world. Although such
financial statements may appear similar from country to country, there are
differences which have probably been caused by a variety of social,
economic and legal circumstances and by different countries having in
mind the needs of different users of financial statements when setting
national requirements.
The International Accounting Standards Board is committed to narrowing
these differences by seeking to harmonize regulations, accounting
standards and procedures relating to the Preparation and presentation of
financial statements. It believes that further harmonization can best be
pursued by focusing on financial statements that are prepared fo rt h e
purpose of providing information that is useful in making economic
decisions.
The Board believes that financial statements prepared for the purpose of
making economic decisions meet the common needs of most users. This is
because nearly all users are making economic decisions, for example:
(a) to decide when to buy, hold or sell an equity investment.
(b) to assess the stewardship or accountability of management.munotes.in
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31(c) to assess the ability of the entity to pay and provide other benefits to its
employees .
(d) to assess the security for amounts lent to the entity.
(e) to determine taxation policies.
(f) to determine distributable profits and dividends.
(g) to prepare and use national income statistics.
(h) to regulate the activities of entities.
The Board recognises, however, that governments, in particular, may
specify different or additional requirements for their own purposes. These
requirements should not, however, affect financial statements published
for the benefit of other users unless they also mee t the needs of those other
users.
4.2 PURPOSE
This Conceptual Framework sets out the concepts that underlie the
preparation and presentation of financial statements for external users. The
purpose of the Conceptual Framework is:
(a) To assist the Board in the development of future IFRSs and in its
review of existing IFRSs;
(b) To assist the Board in promoting harmonisation of regulations,
accounting standards and procedures relating to the presentation of
financial statements by providing a basis for reduci ng the number of
alternative accounting treatments permitted by IFRSs;
(c) To assist national standard -setting bodies in developing national
standards;
(d) To assist preparers of financial statements in applying IFRSs and in
dealing with topics that have y et to form the subject of an IFRS;
(e) To assist auditors in forming an opinion on whether financial
statements comply with IFRSs;
(f) To assist users of financial statements in interpreting the information
contained in financial statements prepared in com pliance with IFRSs;
and
(g) To provide those who are interested in the work of the IASB with
information about its approach to the formulation of IFRSs.munotes.in
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324.3 SCOPE
The Conceptual Framework deals with:
(a) the objective of financial reporting;
(b) the qua litative characteristics of useful financial information;
(c) the definition, recognition and measurement of the elements from
which financial statements are constructed; and
(d) concepts of capital and capital maintenance.
4.4 INTERNATIONAL FINANCIAL REPORTING
STANDARDS
International Financial Reporting Standards in a broad sense comprise:
Conceptual Framework for Financial Reporting —stating basic
principles and grounds of IFRS
IAS—standards issued before 2001
IFRS —standards issued after 2001
SIC—interpretations of accounting standards, giving specific
guidance on unclear issues
IFRIC —newer interpretations, issued after 2001
IFRSs
IFRS 1: First time Adoption of International Financial Reporting
Standards
IFRS 2: Share -based Payment
IFRS 3: Business C ombinations
IFRS 4: Insurance Contracts
IFRS 5: Non -current Assets Held for Sale and Discontinued Operations
IFRS 6: Exploration for and Evaluation of Mineral Resources
IFRS 7: Financial Instruments: Disclosures
IFRS 8: Operating Segments
IFRS 9: Financial Instruments
IFRS 10: Consolidated Financial Statements
IFRS 11: Joint Arrangementsmunotes.in
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33IFRS 12: Disclosure of Interests in Other Entities
IFRS 13: Fair Value Measurement
IFRS 14: Regulatory Deferral Accounts
IFRS 15: Revenue from Contracts with Customers
IASs
IAS 1: Presentation of Financial Statements
IAS 2: Inventories
IAS 7: Statement of Cash Flows
IAS 8: Accounting Policies, Changes in Accounting Estimates and Errors
IAS 10: Events after the Reporting Period
IAS 11: Construction Contracts*
IAS 12: Income T axes
IAS 16: Property, Plant and Equipment
IAS 17: Leases
IAS 18: Revenue*
IAS 19: Employee Benefits
IAS 20: Accounting for Government Grants and Disclosure of
Government Assistance
IAS 21: The Effects of Changes in Foreign Exchange Rates
Note: IAS 3, 4, 5 ,6 ,9 ,1 3 ,1 4 ,1 5 ,2 2 ,2 5 ,3 0 ,3 1a n d3 5h a v eb e e n
superseded SICs
SIC 7: Introduction of the Euro
SIC 10: Government Assistance –No Specific Relation to Operating
Activities
SIC 15: Operating Leases –Incentives
SIC 25: Income Taxes –Changes in the Tax Status of an Entity or its
Shareholders
SIC 27: Evaluating the Substance of Transactions Involving the Legal
Form of a Lease
SIC 29: Service Concession Arrangements: Disclosures
SIC 31: Revenue –Barter Transactions Involving Advertising Servicesmunotes.in
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34SIC 32: Intangible Assets –Web Site Costs
Note: SIC 1, 2, 3, 4, 5, 6, 8, 9, 11, 12, 13, 14, 16, 17, 18, 19, 20, 21, 22,
23, 24, 26, 28, 30, 33 have been superseded
*Will be superseded by IFRS 15 as of 1 January 2017
IFRICs
IFRIC 1: Changes in Existing Decommissio ning, Restoration and Similar
Liabilities
IFRIC 2: Members' Shares in Co -operative Entities and Similar
Instruments
IFRIC 4: Determining whether an Arrangement contains a Lease
IFRIC 5: Rights to Interests Arising from Decommissioning, Restoration
and Envi ronmental Rehabilitation Funds
IFRIC 6: Liabilities Arising from Participating in a Specific Market -
Waste Electrical and Electronic Equipment
IFRIC 7: Applying the Restatement Approach under IAS 29 Financial
Reporting in Hyperinflationary Economies
IFRIC 10: Interim Financial Reporting and Impairment
IFRIC 12: Service Concession Arrangements
IFRIC 13: Customer Loyalty Programmes*
IFRIC 14: IAS 19 –The Limit on a Defined Benefit Asset, Minimum
Funding Requirements and their Interaction
FRIC 15: Agreements for the Construction of Real Estate*
IFRIC 16: Hedges of a Net Investment in a Foreign Operation
IFRIC 17: Distributions of Non -cash Assets to Owners
IFRIC 18: Transfers of Assets from Customers*
IFRIC 19: Extinguishing Financial Liabilities with Equity Instruments
IFRIC 20: Stripping Costs in the Production Phase of a Surface Mine
IFRIC 21: Levies
Note: IFRIC 3, 8, 9 & 11 have been withdrawn
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35MODULE -III
5
BASICS OF BALANCE SHEET AND
PROFIT AND LOSS ACCOUNT
Unit structure:
5.1 Objectives
5.2 Introduction
5.3 Meaning and Types of Financial Statements
5.4 Parties Interested In Financial Statements
5.5 Basics of Income Statement and Bal ance Sheet
5.6 Limitation of financial statement
5.7 Exercise
5.1 OBJECTIVE
After studying the unit, the students will be able to -
Understand the meaning and types of financial statement.
Know the parties interested in Financial statements
Understand the objectives of Financial statements
Explain the basics of Financial statements
5.2 INTRODUCTION
Government legislations require certain organizations to maintain proper
accounts and draw financial statement. Public can understand from the
financial stateme nt the extent to which a company is discharging its social
responsibilities. While issuing shares, bonds, financial statement
become necessary as prospective investors can judge the financial
position of the organization and able to take a proper decision. Workers
union may study the financial statement and ascertain whether they can
enforce their demand. Tax legislature makes it obligatory for the business
entities to draw fair and objective financial statement. The financial statement
serves as instrument st or e g u l a t ee q u i t ya n d debentures issued by companies.munotes.in
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365.3 MEANING AND TYPES OF FINANCIAL
STATEMENTS
Meaning:
Financial statements are plain statements based on historical records,
facts and figures. They are uncompromising in their objectives, nature a nd
truthfulness. They reflect a judicious combination of recorded facts, accounting
principles, concepts and conventions, personal judgements and sometimes
estimates.
Financial statements consist of ‘Revenue Account’ and ‘Balance Sheet’.
1.Revenue Account / Income Statement:
Revenue Account refers to ‘Profit and Loss Account’ or ‘Income and
Expenditure Account’ or simply ‘Income Statement’. Revenue Account may
be split up or divided into ‘Manufacturing Account’, ’Trading Account’,
’Profit and Loss Account’ an d ‘Profit and Loss Appropriation Account’,
Revenue Account is prepared for ap e r i o d ,c o v e r i n go n ey e a r .T h i ss t a t e m e n t
shows the expenses incurred on production and distribution of the product
and sales and other business incomes. The final result of this statement may
beprofit of loss for a particular period.
2.Balance Sheet:
Balance sheet shows the financial position of a business as on a particular
date. It represents the assets owned by the business and the claims of the
owners and creditors against the assets in the form of liabilities as on the
date of the statement.
3.Funds Flow Statement –
It describes the sources from which the additional funds were derived
and the use of these funds. Funds flow statement helps to understand the
changes in the distribu tion of resources between two balance sheet periods.
The statement reveals the sources of funds and their application for
different purposes.
4.Cash flow Statement:
Ac a s hf l o ws t a t e m e n ts h o w st h ec h a n g e si nc a s hp o s i t i o n from one period
to another. It shows the inflow and outflow of cash and helps the
management in making plans for immediate future. An estimated cash flow
statement enables the management to ascertain the availability of cash to meet
business obligations. This statement is useful for short te rm planning by the
management.
5. Schedules:
Schedule explains the items given in income statement and balance
sheet. Schedules are a part of financial statements which give detailed
information about the financial position of a business organization.munotes.in
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375.4PARTIES INTERESTED IN FINANCIAL
STATEMENTS
In recent years, the ownership of capital of many public companies has
become truly broad based due to dispersal of shareholding. Therefore, one
may say that the public in general has become interested in financia l
statements. However, in addition to the share holders, there are other persons
and bodies who are also interested in the financial results disclosed by the annual
reports of companies. Such persons and bodies include:
1.Creditors, potential suppliers or ot hers doing business with the
company;
2.Debenture -holders;
3.Credit institutions like banks;’
4.Potential Investors;
5.Employees and trade unions;
6.Important customers who wish to make a long standing contract with the
company;
7.Economists and investment analyst;
8.Members of Parliament, the Public Accounts Committee and the
Estimates Committee in respect of Government Companies;
9. Taxation authorities;
10. Other departments dealing with the industry in which the
company is engaged; and
11. The Company Law Board
Financial Statement analysis, therefore, has become of general interest.
5.5 OBJECTIVES OF FINANCIAL STATEMENTS
The main object of financial statements is to provide information about the
financial position, performance and changes taken place in an enterpris e.
Financial statements are prepared to meet the common needs of most users.
The important objectives of financial statements are given below:
1. Providing information for taking Economic decisions:
The economic decisions that are taken by users of financi al statements require
an evaluation of the ability of an enterprise to generate cash and cash
equivalents and of the timing and certainty of their generation. This ability
ultimately determines the capacity of an enterprise to pay its employees and
supplie rs meet interest payments, repay loans and make distributions to its
owners.munotes.in
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382.Providing information about financial position:
The financial position of an enterprise is effected by the economic resources
it controls, its financial structures its liquidity and solvency and its
capacity to adapt to changes in the environment in which it operates.
Information about financial structure is useful in predicting future
borrowing needs and how future profits and cash flows will be distributed
among those with an i nterest in the enterprise. This information is useful in
predicting how successful the enterprise is likely to be in raising further
finance. Information about liquidity and solvency is useful to predicting the
ability of the enterprise to meet the financi al commitments as fall due.
3.Providing information about performance(working results) of an
enterprise:
Another important objective of the financial statements is that it provides
information about the performance and in particular its profitability, which
requires in order assessing potential changes in the economic resources
that are likely to control in future. Information about performance is
useful in predicting the capacity of the enterprise to generate cash inflows
from its existing resource base as w ell in forming judgment about the
effectiveness with which the enterprises might employ additional
resources.
4. Providing Information about changes in financial position:
The financial statements provide information concerning changes in the
financial pos ition of an enterprise, which is useful in order to assess its
investing, financing and operating activities during the reporting periods.
This information is useful in providing the user with a basis to assess the
ability of the enterprise to generate cas ha n dc a s he q u i p m e n t sa n dt h e
needs of the enterprise to utilize those cash flows.
5.6 BASICS OF INCOME STATEMENT AND BALANCE
SHEET
Each business firm has to prepare two main financial statements viz. Income
Statement and Balance sheet. The income statemen t reveals the profit of loss
during a particular period generated from the activities of a business.
Balance sheet shows the financial position of a business on a particular
date.
Income statement
Income statement summaries the incomes /gains and expenses /losses of a
Business for a particular financial period. The format of Income statement
explains in detail the items to be included in the statement. It is
presented in the traditional T Format and also in the vertically statement
form.munotes.in
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391. Horizontal Form Tf o r m Manufacturing Trading and Profit and
Loss Account For the year ending
Dr. Cr.
Particulars Rs. Particulars Rs.
To Opening stock By Closing stock
Raw materials Raw Material
Work in progress Work in progress
To Purchase ofrawmaterialsBy Cost offinishedgoods c/dTo Manufacturing wages By Sales
To Carriage/ FreightinwardsBy Closing stock ofFinished GoodsTo Custom duty By Gross Loss c/d
To Other factoryExpensesBy Gross profit b/d
To Opening stock By Business incomesand GainsFinished Goods By Net Loss c/d
To Cost of finished By Balance b/dfromPrevious yearGoods b/d By Net Profit b/d
To Gross profit c/d
To Gross loss b/d
To Office andadministration ExpensesToInterest andfinancialExpensesTo Provision forIncometaxTo Net Profit c/d
To Net loss b/d
To Transfer toGeneralreserveTo Dividend
To Balance c/fmunotes.in
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40ParticularsRs. Rs.
Gross Sales xxx
Less : Sales returns xxxSales tax / Excise dutyNet S ales xxxLess :Cost of goods sold(Materials consumed + DirectLabour+Manufacturing Expenses)xxx
xxx
xxx
Add / Less : Adjustment for change in stock xxx xxx
Gross Profit xxx
Less : Operating expenses xxx
a.Office and administration Expenses xxx
b.Selling and distribution Expenses xxx xxx
Add : Operating Income xxx
Operating Profit xxx
Add : Non Operating Income xxxLess :Non Operating expenses (including
interest)xxx
Profit before interest and tax xxx
Less : Interest xxx
Profit be fore tax xxx
Less : Appropriations: xxx xxx
a.Transfer to reserves xxx xxx
b.Dividends declared / paidxxx
Surplus carried to Balance Sheet xxx
Balance sheet:
It is one of the major financial statements which presents a company's
financial positio n at the end of a specified date. Balance sheet has been
described as a "snapshot" of the company's financial position at a moment
for e.g. the amounts reported on a balance sheet dated March 31st,2 0 1 6
reflects that all the transactions throughout Decembe r3 1sthave been
recorded. The balance sheet provides information related to the assets,
liabilities and the shareholders’ equity of the company as on a specific date.
Total Assets = Total Liabilities + Share holders’ equitymunotes.in
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41The companies Act, 1956 stipul ates that the balance sheet of a joint stock
company should be prepared as per Part I of Schedule VI of the Act.
However, the statement form has been emphasized upon by accountants for the
purpose of analysis and interpretation.
Understanding Corporate Bal ance Sheet: A. Assets side:
1. Fixed Assets:
Fixed Assets are called long -term assets. These assets are used over several
periods. They are major sources of revenue to the business. They are
intended for long term use in the business. They are called “bund le of future
services” or “Sunk Costs”. The group of fixed assets is explained in the
proforma. Generally the Fixed assets are classifies as:
a)Tangible movable assets;
b)Tangible immovable assets; and
c) Intangible assets.
a)Tangible movable assets are the assets which can be seen, touched and
moved from one place to another place. Plant and Machinery, furniture
and fixtures, transportation equipments etc. are tangible movable
assets.
b)Tangible immovable assets are the assets which can be seen and
touched bu t cannot be moved from one place to another place. Such
assets include land, buildings, mines, oil wells, etc.
c) Intangible assets are the assets which cannot be seen and touched.
However, their existence can only be imagined such as patents,
trademarks, copyrights, goodwill, etc.
The Fixed Assets are presented as:
Gross Block -Provision for Depreciation = Net Blocks
2. Investments:
Investments may be short -term or long term. Short -term investments are
marketable securities and they represent temporary in vestments of idle
funds. These investments can be disposed off by the company at any time.
Investments are shown at cost. Cost includes brokerage, fees and all other
expenses incurred on acquisition of investments. However, the market value
is shown by way of a note.
Long -term investments are held for a long time. They are required to be
held by the business by the very nature and conditions of the business. For
example, a company engaged in generating electricity may be required to
hold the bonds of the Electricity Board. These bonds are retained by the
company so long as the company uses electric power.munotes.in
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42As per Schedule VI of the Indian Companies Act 1956, investments
are shown separately, showing the nature of investments and
the mode of valuation of vario us classes of securities.
Long term Investments are grouped under fixed assets and short term
investments under current assets.
3.Current Assets, Loans and Advances:
The item, “Current Assets, Loans and Advances” is divided into two
parts:
a.Current Assets, and
b.Loans and Advances.
a.Current Assets and Quick assets:
“Current Assets include cash and the other assets that are likely to
be converted into cash and the cash thus generated is available to
pay current liabilities. Current assets are not intended for l ong-term
use in business. Current assets represent employment of money by
the company on a short -term basis. They circulate within the group.
For example, cash becomes raw material when material is
purchased, material becomes finished goods, finished goods
become cash or debtors when sold and so on.
Current Assets = Stock + Debtors + Cash & Bank + Loans &
Advances + Marketable Securities + Other Current Assets
In fact, total current assets are known as “Gross Working Capital”.
Current assets less current li abilities are known as ‘net working
capital’.
Quick Assets are known as ‘near cash’ assets. In other words,
quick assets are those which can be converted into cash quickly.
Therefore, they are also known as liquid assets. Cash and bank
balances are the mos tl i q u i da s s e t s .D e b t o r sa n dc a s h advances can
be converted into cash at a short notice. Therefore, they are also
regarded as quick assets. Marketable investments can be converted
into cash, fall into the category of quick assets. Inventory does not fall
int h i sc a t e g o r yo fq u i c ka s s e t s ,s i n c ei t cannot be converted into
cash quickly, as material is to be converted into finished goods
and then they should be sold. Expenses paid in advance do not satisfy
the criteria of quick assets. They cannot be converted into cash. They
can be received in the form of services.
Therefore Quick Assets = Current Assets –Inventory –
Prepayments
b.Loans and Advances:
Loans and advances given are current assets. It includes different
types of advances such as advances against sa lary, advancesmunotes.in
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43against machinery, advances to subsidiary, prepaid expenses on account
of rent, taxes, insurance, etc.
4. Miscellaneous Expenditures and losses:
This heading covers Fictitious Assets and other expenses which are made
for future on a mass bas is. These expenses are really not assets but the
whole balance on the account of these items is not charged to current year’s
Profit and Loss A/c therefore the amount to the extent not written off or
adjusted is shown on the Assets side as Miscellaneous ex penditures.
Theexamples of fictitious assets are:
a.Preliminary expenses.
b.Brokerage on issue of shares and debentures.
c.Discount on issue of shares and debentures.
d.Share or debenture issue expenses.
e.Heavy Advertisement and Publicity expenditure.
f.Profit and L oss A/c debit balance.
Liquidity means easy convertibility into cash. Though ultimately all
assets are converted into cash, the term liquidity refers not only to the
nature of assets but also to the purposes of holding the assets. Assets are
normally arran ged in order of permanency i.e., from least liquid to most
liquid.
B. Liabilities Side
The term ‘liability’ when used in accounting, means a debt. A debt is
something that a person or an organization owes to another person or
organization. In other words, Liabilities are the claims of outsiders against the
business. Technically speaking, all liabilities shown in a balance sheet are
claims against all assets shown in it. But, there may be certain cases where
al i a b i l i t yh a sac l a i m against a specific asset. Even under such
circumstances, the liabilities are shown separately, not as a deduction from
the specific assets.
Classification of Liabilities:
The liabilities of an enterprise may be classified into three categories
1.Permanent Funds or Proprietors’ Funds.
2.Semi -permanent Funds or Long -term Borrowings.
3. Current liabilities and Provisions.
1. Proprietor’s Funds:
These are the funds provided by the proprietors (owners) or the shareholders.
Proprietors’ fund represents the interest of the proprietors in the b usiness. This
is the amount belonging to the proprietors. Proprietors’ fund is also called asmunotes.in
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44‘Proprietors’ Equity’, ‘Owners’ Funds’, or ‘Shareholders’ Funds’. This is also
known as the ‘Net Worth’ of the business. Owners’ Equity refers to the
claim of the owners it includes:
Owners’ Equity = Capital (May be Equity Share Capital only or Equity
and Preference Share Capital) + Reserves + Profit and Loss A /c credit
balance –Accumulated losses and Fictitious assets.
Owners’ equity increase either through fres hi n v e s t m e n t sb y the
owners or by way of increasing the earnings retained i.e., profits not
distributed. (Retained earnings are that part of the total earnings which have
been retained for use in the business)
a. SHARE CAPITAL:
Share capital is the amount that is raised by a company from the
public at large, through the issue of shares. There are different concepts of
share capital from the legal and accounting points of view.
The following chart details the different concepts of capital :
Company’s Share Capital
i.Authorised Capital : Authorised Capital is the maximum capital a
company can raise as mentioned in the Memorandum of Association
under its Capital Clause.
ii.Issued Capital : A company usually does not need the entire registered
capital. Issued c apital is that part of the Authorised capital; which is
actually offered to the prospective investors for subscription. The balance of
the Authorised capital which is not issued is called the ‘unissued
capital.’munotes.in
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45iii.Subscribed Capital : Subscribed capital is t hat part of the issued
capital which has been subscribed or taken up by the public.
Therefore, the subscribed capital may be equal to or less than the
issued capital.
Called up Capital Uncalled Capital: The company, therefore, may collect
the capital in se veral instalments as per its need. The called -up capital is that
portion of the subscribed capital which has been called or demanded by the
company to be paid. The capital that is not demanded from the
shareholders is called uncalled capital.
iv.Paid up Capit al:Paid up capital is that part of the called up capital
which has been actually paid by the members. The paid -up capital is the
called -up amount less calls not paid. (Calls unpaid or calls -in-arrears).
v.Reserve Capital : It is that part of the uncalled ca pital which may only
be demanded on winding up or liquidation, but not when the company
is a going on. A company may determine this amount by a Special
Resolution.
b. RESERVES AND SURPLUS:
Ab u s i n e s sm a yh a v et om e e tc e r t a i nc o m p u l s o r yo r voluntary,
forese en or unforeseen, recurring or non -recurring obligations in future. It
is advantageous to for the organization to make provision in advance to
meet them. If not sudden payment may adversely affect the financial
health of the company. In order to avoid such situations some part of
profit are retained in each year which is termed as ‘Retained Earnings’
or ‘Plough Back of profits’. It means the reserves represent amounts set
aside out of divisible profits. They are appropriations of profits. Indian
Companies A ct requires every company to transfer a specific percentage
(upto 10%) of the profits to “Reserve” accounts.
Reserve created for a specific purpose is called as a “Specific
Reserve” and a reserve created for a general purpose is called as a
“General Reserv e.” General reserves are free and can be utilized for
Payment of Dividends, Development and expansion purpose or for any other
purpose the company thinks proper.
According to Companies Act “Reserve shall not include any amount written
off by way of providi ng for depreciation, renewals or diminution in value of
assets or retained by way of providing for any known liability.”
It is compulsory for the business organization to disclose each individual
head of the reserves in the balance sheet with its opening b alance as per last
balance sheet, additions thereto and deductions there from in the current
yare.
2.LONG -TERM LIABILITIES:
Ac o m p a n yr a i s e sf i n a n c ee i t h e rf r o mo w n e r so rt h r o u g h external
borrowings. External borrowings of a company which constitute its
“owe df u n d s ”a r ei m p o r t a n ts o u r c e so fl o n g -term finance. Thesemunotes.in
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46borrowings are termed as ‘fixed liabilities’ or ‘term liabilities’ or ‘long
term-loans’. They may take various forms such as debentures, public
deposits, bank loans, deferred payments, etc. They ma y be fully secured
or partly secured or unsecured.
3.CURRENT LIABILITIES AND PROVISIONS:
a.Current Liabilities:
Current liabilities are those short -term obligations of an enterprise which
mature within one year or within the operating cycle. They constitute
short-term sources of finance. It includes Sundry Creditors, Bills Payable,
Interest accrued but not due, outstanding expenses, Unclaimed dividends and
Bank Overdraft.
These liabilities are not normally secured and no interest is payable on them
with the exc eption of bank overdrafts. These liabilities, are generally paid
off by utilizing current assets or by creating a current liability.
Actually all current liabilities are payable within a short period of
time. However, Bank Overdraft is the current liabilit ywhich is not paid
immediately or in a very short -time, in practice. Therefore, Bank Overdraft
is not considered as a quick liability. It is a permanent arrangement with
the banker. Hence
Quick Liabilities = Current Liabilities –Bank Overdraft
b.Provisions :
‘Provision’ means any amount retained by way of providing for any
known liability of which the amount cannot be determined with substantial
accuracy. Provisions have to be made for maintaining the integrity of
assets or for known liabilities. Although the amount of liability is not
certain organization has to made provision on best estimates. The
examples of provisions are Provision for depreciation on assets, Provision
for doubtful debts, Provision for proposed dividends, Provision for
taxation.
4. CONTI NGENT LIABILITIES:
According to ICAI, Contingent liability refers to an obligation relating to an
existing condition or situation which may arise in future depending on the
occurrence or non -occurrence of one or more uncertain future events. These
liabilit ies may or may not be converted into actual liabilities at some future
date. It is a liability which may or may not occur. But on the date of the
Balance Sheet, it is not known definitely whether the liability would arise
or not. But as a matter of caution , it is indicated in the balance sheet for the
sake of information and disclosure, under the head “Contingent
Liabilities. Some of the examples of Contingent Liabilities are
Discounted Bills of Exchange, Disputed liability on account of
income -tax, etc., a bout which appeal has been filed, Uncalled amount
on partly paid -up shares and debentures held by the company as
investments, Cumulative preference dividend in arrears, Matters referredmunotes.in
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47to arbitration, Claims not acknowledged as debts, Estimated amount of
contracts remaining to be executed on capital account and not provided for,
Guarantees given by the company, Bonds executed. and debentures held
by the company as investments, Cumulative preference dividend in arrears,
Matters referred to arbitration, Clai ms not acknowledged as debts,
Estimated amount of contracts remaining to be executed on capital account
and not provided for, Guarantees given by the company, Bonds executed.
Following are the proforma of the Balance sheet
1) Horizontal Form:
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48
2. Verti cal Form
Income Statement of ........... for the year ending .............
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49
Statement of Retained Earnings:
The Statement of Retained Earnings is prepared to show how
the balance in Profit and Loss accounts is appropriated for various
purposes like provision for dividend, tr ansfer to reserves etc. The
balance on this account is finally shown on the Balance sheet Under the
heading Reserve and Surplus.
5.6 LIMITATION OF FINANCIAL STATEMENT
Following are the limitations of financial statements:
1.The information being of historica ln a t u r ed o e sn o tr e f l e c tt h e
future.
2.It is the outcome of accounting concept, convention combined with
personal judgement.
3. The statement portrays the position in monetary term. The profit or
loss position excludes from their purview things which cannot be
expressed or recorded in term of money.
To overcome from the limitations it becomes necessary to analyse the
financial statements.
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50MODULE -IV
6
ACCOUNTING RECORDS
Unit Structure
6.1 Introduction
6.2 Process of Transaction and Its Record Gen eration
6.3 What is an Account?
6.4 Final Accounts
6.5 Horizontal or ‘T’ Format of Trading & P&L A/C
6.6 Vertical Format of Balance Sheet
6.1 INTRODUCTION
Accounting involves a series of processes like measuring economic value of
a transaction, recording it and reporting it to various stake holders.
Accounting information is used by a variety of users, like investors,
creditors, workers, management, and government.
Accounting can be divided into financial accounting, management
accounting, auditing, and ta x accounting. Financial accounting focuses on the
reporting of an organization's financial information, including the preparation
of financial statements, to external users of the information, such as investors,
regulators and suppliers and management acco unting focuses on
themeasurement, analysis and reporting of information for internal use by
management. The recording of financial transactions, so that summaries of
the financials may be presented in financial reports, is known as
bookkeeping, of which d ouble -entry bookkeeping is the most common
system.
Accounting records means internal or external documentary evidence
maintained within the organisation to record the economic transaction which has
taken place. These are important sources of information an de v i d e n c e st h a ta r e
used to prepare the financial statements.
In book keeping and accountancy we will be recording only monetary
transactions.
Accounting records can take on many forms and include:
Invoices
Vouchers
Ledgersmunotes.in
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51Journals
Bank statements
Contrac ts and agreements
Verification statements
Transportation receipts etc.
Vouchers are most important document in accounting records.
Vouchers form basis for recording any transaction. Account voucher is
an accounting document representing an internal intent to make a payment
to an external entity, such as a vendor or service provider. A voucher is
produced usually after receiving a vendor invoice, after the invoice is
successfully matched to a purchase order. A voucher will contain detailed
information regard ing the payee, the monetary amount of the payment, a
description of the transaction, and more.
6.2 PROCESS OF TRANSACTION AND ITS RECORD
GENERATION
Let us see the entire process of accounting with the help of a chart
Economic transactions occurs
Vouche rs are created
Transaction is recorded in primary books i.e.
Journal or subsidiary books
Transactions are posted in Ledger account
At the end of the year ledger accounts are
closed and balances a e found out
Using the closing balances ofthe ledger
accounts a trial balance is drawn as on last
day of the financial year
Closing Adjustment entries are recorded
Final accounts are drawnmunotes.in
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52Now let us discuss the entire procedure in the order of flow chart
1.Economic transactions occurs: In account s we record only those
transaction which has some monetary value. Accountancy is more of a
historical record as it records whatever happens in money terms. One should
not get confused with non cash and non-monetary transactions. A non cash
transaction can be a monetary transaction e.g providing depreciation on
fixed assets, is a non cash transaction but it is a monetary transaction as we
know the amount of depreciation in money terms.
2.Vouchers are created: Whenever any transaction takes place a
voucher is c reated depending upon the nature of transaction. Vouchers may be
of following types
1. Receipt voucher
2. Payment vouchers
3. Journal vouchers
4. Cash memo
5. Contra entry vouchers
6. Purchase and returns invoice vouchers 7. Sales and returns
vouchers
A voucher complete in all respects forms basis for recording the
transaction. To be called a complete document it should be properly dated,
amounted, authorised and signed by the party.
Any documentary evidence supporting the entries recorded in the books of
accounts, establish ing the arithmetic accuracy of the transaction, may also be
referred to as a voucher for example, a bill, invoice, receipt, salary and
wages sheet, memorandum of association, counterfoil of paying -in slip,
counterfoil of cheque book, or trust deed.
Normall y the following types of vouchers are used:
(i)Receipt Voucher
(ii)Payment Voucher
(iii)Journal Voucher
(iv)Supporting Voucher
Let us discuss each of these:
(i ) Receipt Voucher:
A Receipt voucher is used to record cash or bank receipt. Receipt
vouchers are of two types w hich are as follows:
(a) Cash receipt voucher –These vouchers are created whenever any
cash generation transaction occurs. E.g. sale of scrap for cash.munotes.in
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53(b) Bank receipt voucher –it indicates receipt of a cheque or demand
draft i.e. money is not received in the form of cash in hand, instead, the
money will be credited to the bank account of the assesse.
Contents of Receipt/Credit Voucher:
The following information are usually available from a receipt/credit
voucher:
(a)Names and address of the parties;
(b)Date o f preparing the voucher;
(c) Voucher Number;
(d)Amount of the transaction;
(e)Heads of account;
(f)Signature of the person who is preparing the voucher;
(g)Authorized Signatory;
(h)Narrations, i.e., short description of the transaction, and
(i)Number of Supporting Voucher.
ii). Payment/debit Voucher:
Ap a y m e n tv o u c h e ri sj u s tt h eo p p o s i t eo far e c e i p tv o u c h e r .I nt h e above,
cash/ bank was debited, while in this case, cash or bank will be credited.
In the above case, there was an inflow of funds, while in this case, there
isa no u t f l o wo ff u n d s .AP a y m e n tv o u c h e ri s used to record a payment
of cash or cheque. Payment vouchers are also of two types which are:
(a)Cash Payment voucher –it denotes payment of cash
(b)Bank Payment voucher –it indicates payment by cheque or demand
draft i.e. money is not paid in the form of cash in hand, instead, the
money will be debited from the bank account of the assesse
Contents of payment/debit Vouchers:
The following information are normally available from a debit
voucher:munotes.in
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54(a) Names and Address es of the Party (b) Date of voucher; (c)
Voucher Sr. Number; (d) Amount or value of the transaction; (e) Heads of
Account; (f) Signature of the person who is preparing the voucher; (g)
Authorized signatory; (h) Narration i.e., short description of the
transaction and (i) Number of supporting Vouchers.
The format of a Debit Voucher is presented:
( If the amount of transaction exceeds Rs. 500 a revenue stamp valued Re
1. should be affixed.)
iii) Journal Voucher:
These vouchers are used for non -cash transact ions, they are basically used
as a documentary evidence. e.g., Goods sold on credit. In such cases, the
cash or the bank account of the assesse is unaffected. In the case of
Goods sold on credit, the Voucher would debit the Debtor to whom the
goods are sol do nc r e d i t ,w h i l e sales on credit account would be credited
further.
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55iv) Supporting documents vouchers:
These vouchers are the documentary evidence of transactions
that have happened. For example, you can attach the bill of an expense
along with the ori ginal voucher just to further support the primary
voucher. Petrol Bills attached with the conveyance vouchers are a good
example of Supporting Vouchers. Supporting Vouchers are the documentary
evidence of business transactions which have happened.
They are of two types:
(i)External Supporting Vouchers; and
(ii)Internal Supporting Vouchers. (i) External Supporting Vouchers:
These vouchers are prepared by the third parties who are associated with
the firm.
For example:
(a)Debit Note Received; (b) Credit Note Receiv ed;(c) Cash Memo
Received from the Sellers, etc.
The format of a Supporting Voucher is presented:
(ii) Internal Supporting Vouchers:
These vouchers are prepared by the internal staff on behalf of ‘the firm
which are accepted by the third parties for the transaction so
happened.munotes.in
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56For example:
(a)Counterfoil -of Challan for payment of income tax to a bank;
(b)Counterfoil of pay -in-slip when money is deposited into bank, etc.
3. Transaction is recorded in primary books i.e. Journal books:
There are two sets of boo ks maintained in any organisation viz. primary set
of books and secondary set of books. Primary set of books is the one where
initial transaction is recorded. It is the first instance of the recording of
any economic transaction it includes journal and sub sidiary books.
In order to record journal entries, one needs to have knowledge about
following basics of accounting
6.3 WHAT IS AN ACCOUNT?
ACCOUNT: An account is a record of all transaction under one room
relating to a particular person, income, expense, property etc.
Types of accounts:
There are three type of accounts in accounting:
A]Personal account: Ashok, Anil, Dena Bank, Abcd ltd, prepaid or
outstanding incomes or expenses. Personal accounts consist of all those
accounts which are related to a perso n, business, firm etc. There are also
subtypes of personal account:
I]Natural Personal Any person like Peter Account, Ram account etc.
II]Artificial Personal: Any company or group of people like Microsoft
account, Hindustan Petroleum account etc.
III] Represent ative Personal this type of Personal a/c represents owner
like. Capital a/c, drawings a/c etc.
B]Real account: Real accounts consist of all those accounts which are
related to assets. For example: Plant and Machinery account, Stock
account, Furniture & Fi xture, cash etc.
C]Nominal account: Nominal accounts consist of all those accounts
which are related to expenses, losses, Income and Gains.For example: Rent
account, wages account, printing & stationary etc.
Golden rules of accounting
There are three gold en rules in accounting to record journal entries. Each of
these rules is associated with separate account.
Personal accounts
"Debit the Receiver, Credit the Giver"munotes.in
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57Real accounts
"Debit what Comes In, Credit what Goes out"
Nominal accounts
"Debit all Expens es and Losses, Credit all Income and Gains"
How to record a journal entry
First understand the format of a journal
Date column records date of the transaction
Particulars column records the two effects of a given transaction, by
using at least two ledger accounts, one of which will be debited and
other one credited.
Below these two accounts we write brief description of transaction in
brackets prefixing the word ‘Being’, called as narration.
L.F. column records ledger folio or page number where that accou nt
is opened in a leger book.
Debit (Amount) and Credit (Amount) columns records amount against
each ledger account.
Steps to record a journal entry
1.Identify which accounts are involved
2.Identify types of accounts
3.Apply golden rules according to the ty pe of account to determine which
account will be Debited and which account will be Credited.
Example: You are writing in the books of Ganesh
Transaction : Cash received from Jagdish Rs5,000, for this transaction
we will pass journal entry by using above mentioned
1 Identify which accounts are involved : a) Cash b) Jagdish
2 Identify types of accounts:
a)Cash : real account
b)Jagdish: personal accountmunotes.in
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583 Apply golden rules according to the type of account to determine which
account will be Debited and which acco unt will be Credited.
a)Cash : real account so: Debit what comes in
b)Jagdish: personal account: credit the giver
Therefore Cash A/c will be debited and Jagdish A/c will be credited The
entry will be as follows
Cash a/c ----------------------- Dr5,000
To Jagdish a/c ------------------- Cr 5,000
(Being c ash received from Jagdish)
Example: Journalise the following
transactions:
munotes.in
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59
4. Transactions are posted in Ledger account: Secondary set of
books includes ledger accounts. Now let us see format of a ledger account.
The process of transferring the infor mation contained in a Journal to a
Ledger is called Posting.
i.Posting of debited item in a Journal Entry: The steps to be
followed are:
Identify in the ledger the account to be debited. Then enter the date of the
transaction in the ‘Date’ column on the d ebit side of the account. Then write
the name of the account which has been credited in the respective entry
in the ‘Particulars’ column on the debit side of the account as “To
(name of account credited)”. Then record the page number of the
Journal where t he entry exists in the Journal folio (J.F.) column.
Then rnter the relevant amount in the ‘Amount’ column on the debit
side. Posting credit item in a journal entry: The steps to be followed
are:
Identify in the ledger the amount to be credited then Enter t hedate of the
transaction in the ‘Date’ column on the credit side of the account. Then
write the name of the account which has been debited in the respective entry
in the ‘Particulars’ column on the credit side of the account as ‘By (name
of account debit ed)’. Then record the page number of the Journal where
the entry exists in the Journal folio (J.F.) column. Then enter the relevant
amount in the ‘Amount’ column on the credit side.munotes.in
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60Thus every transaction has two effects viz debit and credit. In aj o u r n a l
entry theses are either debited or credited. One should always remember
that total of debit should always match the total of credit.
Consider the simple Journal entry to illustrate the above: On April 16,
2014 Motor car Purchased for cash Rs. 12000
April 16 Motor car A/c ....Dr. Rs. 12,000
To cash Rs. 12,000
(Being the Motor car purchased)
An amount of Rs. 12,000 will be debited to the Motor car account and
credited to cash account. The manner will be: in the Motor car account in
the ‘Particulars’ column we shall write to cash a/c . In the account of
cash will be written : ‘By Motor car a/c’. The two accounts will, thus
appear as under.:
Motor car A/c
Dr. Cr.DateParticularsJ.F.Rs.DateParticularsJ.F.Rs.April 16 To CashA/c12,000
Cash a/c
Dr Cr.DateParticularsJ.F.Rs.DateParticularsJ.F.RsApril16ByMotorcarA/c12,000Example 2: Received Rs.14,000 in full settlement of a debt of Rs. 15,000
from Ram on Aug 8, 2014.
SULUTION -Journal Entry
Rs. Rs.
Cash A/c Dr. 14,000
Discount allowed A/c Dr 1,000
ToAnant 15,000
(Cash received and
discount allowed)munotes.in
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61Ledger A/c
Cash A/c
Dr Cr
Date Particulars L.FRs. DateParticularsL.F Rs.
2014
Aug.8 ToAnant 14,000
Discount Allowed A/c
Dr Cr
Date Particulars L.F Rs.Date Particulars L.F Rs.2014Aug.8 ToAnant 10 00
Anant’s Account
Dr CrDateParticularsL.FRs.DateParticularsL.FRs.2014
Aug. 8 By cash A/c 14,000
ByDiscount1,000
AllowedA/c5. At the end of the year ledger accounts are closed and
balances are found out
Dr. LEDGERACCOUNT Cr.
DATEPARTICULARS J.F. AMOUNTDATEPARTICULARSJ.F. AMOUNT1.4.16To abc Account )(xx 5.4.16By opqaccount)(xx
)(xxTo xyz Account)(xx xxx ByrstAccountxxx
)(xx To Balance c/d )(xx
)(xxx xxxx
Using the closing balances of the ledger accounts a trial balance is
drawn as on last day of the financial year : A trial balance is a list of all
the general ledger accounts of a business. This list will contain the name of
ledger account and the balance of that ledger. Each nominal ledger account
will hold either a debit balance or a credit balance. The debit balancemunotes.in
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62values will be listed in the debit column of the trial balance and the credit
value balance will be listed in the credit column. A trial balance always
tallies. Ledger A/Cs which shows a debit balance is put on the Debit side
of the trial balance.
The A/c’s Showing credit balance are put on the Credit side of the Tria l
Balance. Accounts which show no balance i.e. whose Debit and Credit totals
are equal are not entered in Trial Balance.
Then the two sides of the Trial Balance are totaled. If they are equal it
is assumed that there are no arithmetical error in the postin ga n d
balancing of Ledger A/cs.
Normally at the year end or whenever a businessman is interested in
knowing the position of various A/C s, the accounts are balanced.
Various steps for this purpose are
(1)Debit and Credit sides of each A/c are totalled.
(2)The di fference between the two sides is written on the side which is
shorter so as to make their totals equal.
(3)The words “Balance C/d” i.e. the balance carried down and written
against the amount of difference.
(4)In the next period, the balance is brought down on the other side by
writing the words ‘Balance b/d’.
(5)If the Debit side exceeds the Credit Side the difference is a Debit
Balance whereas.
(6)If the Credit side exceeds the Debit side the difference is a Credit
Balance.
Objectives or Functions of Trial Balance
Ith e l p si na s c e r t a i n i n gt h ea r i t h m e t i c a la c c u r a c yo fl e d g e r
accounts.
Helps in locating errors.
Provides the summary of Ledger A/cs.
Helps in the preparation of Final A/cs.munotes.in
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63
6. Closing Adjustment entries are recorded Closing entries are
journal entries made at the end of an accounting period to transfer
temporary accounts to permanent accounts. adjusting entries are journal
entries usually made at the end of an accounting period to allocate
income and expenditure to the period in which they actually occur red.
The revenue recognition principle is the basis of making adjusting entries
that pertain to unearned and accrued revenues under accrual -basis
accounting. Eg Charging depreciation, providing for outstanding
incomes and expenses etc.
Treatment of items o f Adjustment outside the Trial Balance
munotes.in
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64
7. Final accounts are drawn
From the derived trial balance an accountant can prepare final accounts
for the year for which information is available.
Format of final accounts differ from organisation to organisatio n. Let us see
format of final accounts for some trading commercial organisations.
An organisation can adopt either horizontal or vertical format, but vertical
format is compulsory for joint stock companies.
6.4 FINAL ACCOUNTS
Trading Account
Trading accoun t is prepared to know the gross profit or gross loss arising or
incurred as a result of the trading activities of a business. In other worlds,
in case of a manufacturing concern a Manufacturing A/c is prepared to show
the result of manufacturing activity, trading account indicates buying and
selling of goods. If the amount of sales exceeds the amount of
purchases and the expenses directly connected with such purchases, the
difference is termed as gross profit. On the contrary, if the purchases, and
direct ex penses exceed the sales, the difference is called gross loss. The
purpose of preparing the Trading Account is to find out the Gross Profit or
Gross Loss of a concern during a particular period. The following equations
are highly useful for determination of Gross Need and Importance of
Trading Account
Preparation of Trading Account serves the following objectives:
1. It provides information about Gross Profit and Gross Loss: It informs
of the gross profit or gross loss as a result of buying and selling the
goods during the year. The percentage of Current Year’s gross profit on
the amount of sales can be calculated and compared with those of the
previous years. Thus, it provides data for comparison, analysis and
planning for a future period.
2.It provides inform ation about the direct expenses: All the expenses
incurred on the purchase and manufacturing of goods are recorded in
the trading account in a summarised form. Percentage of suchmunotes.in
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65expenses on sales can be calculated and compared with those of the
previous y ears. In this way it enables the management to control
andrationalise the expenses.
3.Comparison of closing stock with those of the previous years:
closing stock has to be valued and recorded in a trading account.
This stock can be compared with the closing stock of the previous
years and if the stock shows an increasing trend, the reasons may be
inquired into.
4. It provides safety against possible losses: If the ratio of gross
profit has decreased in comparison to the preceding year, the
businessman can ta ke effective measures to safeguard himself against
future losses. For example, he may increase the sale price of his gods
or may proceed to analyse and control the direct expenses.
6.4 (a) Preparation of Trading Account
Trading Account is a Nominal Account and all expenses which
relate to either purchase or manufacturing of goods are written on the
Debit side of the Trading Account.
Item written on the Debit side of the Trading Account:
1. Opening Stock: The stock of goods remaining unsold at the end of
theprevious year is termed as the opening stock of the current year. In
other words, the closing stock of the last year becomes the opening stock of
the current year. Opening Stock will include the following:
I.Opening Stock of Raw Material.
II.Opening Stock of S emi-finished goods, and
III Opening Stock of Finished goods.
2. Purchases and Purchases Returns: Goods which have been
bought for resale are termed as Purchases and goods which are returned to
suppliers are termed as purchase returns or returns outwards. P urchase
Account will be given on the debit side of the trial balance and Purchase
Return Account on the credit side of the trial balance. Purchase returns will
be shown as a deduction from Purchases on the debit side of the trading
account. Purchases inclu de cash as well as credit purchases.
3. Direct Expenses: All expenses incurred in purchasing the goods,
bringing them to the godown and manufacture of goods are called direct
expenses. Direct expenses include the following:
I. Wages: Wages are paid to work ers who are directly engaged in the
loading, unloading and production of goods and as such are debited to the
trading account. It should be noted that:
(i)If the item ‘Wages and Salaries’ is given in the question it will be
shown on the trading account. On th e contrary, if ‘Salaries and Wages’ is
given it will be shown on the profit & loss account.munotes.in
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66(ii)If wages are paid for bringing a new machine or for its
installation it will be added to the cost of the machine and hence will not be
shown in the trading account.
II. Carriage or Carriage Inwards or Freight: These expenses should be
debited to trading account because these are generally paid for bringing the
goods to the factory or place of business. However, if any carriage or
freight is paid on bringing an asset, the amount should be added to the
asset account and must not be debited to trading account.
III. Manufacturing Expenses: All expenses incurred in the manufacture of
goods are shown on the debit side of the trading account such as Coal, Gas,
Fuel, Water, P ower, Factory Rent, Factory Lighting etc.
Items written on the Credit Side of the Trading Account:
1.Sales and Sales Returns: Both Cash and Credit sales will be included in
sales. The sales account will be a credit balance whereas, the sales return
account o r returns inwards account will be a debit balance. Sales return
will be deducted out of Sales on the credit side of the trading account.
2.Closing Stock: The goods remaining unsold at the end of the year is
known as Closing Stock. It is valued at cost price or market price whichever
is less. It includes the closing stock of raw material, Closing Stock of semi -
finished goods and Closing Stock of finished goods.
Normally, the Closing Stock is given outside the Trail Balance. This is so
because its valuation is made after the accounts have been closed. It is
incorporated in the books by means of the following entry:
Closing Stock
A/c Dr.
To Trading A/c
(Closing Stock transferred to Tradin gA / c )
When the above entry is passed, the Closing Stock Account is opened.
On the one hand, it will be posted to the credit side of the trading account
and on the other hand, will be shown on the Assets side of the Balance
Sheet, in order to complete the double entry. Sometimes, the Closing Stock
is given inside the Trail Balance. This mean that the entry to incorporate
the closing stock in the books has already been passed. It would imply
that the Closing Stock must have been deducted out of Purchases Acc ount.
Hence, in such a case, Closing Stock will not be shown in the Trading
Account but will appear on the Assets side of the Balance Sheet only.
6.4 (b) Profit And Loss Account
Trading account only discloses the gross profit earned as a result of buying
and selling of goods. However, a businessman has to incur a number of
expenses which are not taken to trading account. Hence, a businessman is
more interested in knowing the net profit earned or net loss incurred during
the year. As such, a Profit & Loss Ac count is prepared which contains all
the items of losses and gains pertaining to the accounting period. Accordingmunotes.in
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67toProf. Carter, “A Profit & Loss Account is an account into which all
gains and losses are collected, in order to ascertain the excess gains over
the losses orvice -versa”
Need and Importance of Profit & Loss A/c
1.To determine the Net Profit or Net Loss: A Trading Account only
discloses the Gross Profit earned as a result of trading activities,
whereas the Profit & Loss Account discloses the net profit (or net loss)
available to the proprietor and credited to his capital account.
2.Comparison with previous years’ profit: The net profit of the current year
can be compared with that of the previous years. It enables the
businessman to know whether the business is being conducted efficiently
or no.
3.Control on Expenses: Profit & Loss Account helps in comparing
various expenses with the expenses of the previous year. Also the
percentage of each individual expenses to net profit is calculated and
compared with the similar ratio of previous years. Such comparison will
be helpful in taking concrete steps for controlling the unnecessary
expenses.
4.Helpful in the preparation of Balance Sheet: A Balance Sheet can
only be prepared after ascertaining the Net Profit through the
preparation of Profit and Loss Account.
Preparation of Profit and Loss Account
AP r o f i ta n dL o s sA c c o u n ti ss t a r t e dw i t ht h e amount of gross profit or
gross loss brought down from the Trading Account. As such, all those expenses
and losses whi ch have not been debited to the Trading Account are now
debited to Profit &
Loss Account. These expenses include administrative expenses, selling
expenses, distribution expenses etc. These are called ‘Indirect Expenses’.
Profit and Loss Account is a Nomin al Account and as such, all the expenses
and losses are shown on its debit side and all the incomes and gains are
shown on its credit side.
Items written on the Debit side of Profit & Loss Account
1.Gross Loss: If trading account discloses Gross Loss, it is shown on the
debit side first of all.
2.Office and Administrative Expenses: Such as salary of office employees,
office rent, lighting, postage, printing, legal charges, audit fee etc.
3.Selling and Distribution Expenses: Such as advertisement charges,
commissi on, carriage outwards, bad -debts, packing charges etc.
4.Miscellaneous Expenses: Such as interest on loan, interest on capital,
repair charges, depreciation, charity etc.munotes.in
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68Items written on the Credit side of Profit & Loss Account
1.Gross Profit: the starting po int of the Cr. side of Profit and Loss Account
is the gross profit brought down from the Trading Account.
2.Other Incomes and Gains: All items of incomes and gains are shown on
the credit side of the Profit & Loss Account, such as income from
investments, re nt received, discount received, commission earned, interest
received, dividend received etc.
If the credit side of the profit and loss account exceeds that of debit side,
the difference is termed as net profit. On the other hand, the excess of the
debit si de over the credit side is termed as netloss. Net profit is added to the
capital whereas net loss is deducted from the capital.
6.5 HORIZONTAL OR ‘T’ FORMAT OF
TRADING & P&L A/C
munotes.in
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69E.g. Prepare Trading Account for the year ended 30stMarch, 2013 from the
following balances.
Rs Rs.
Stock(1stApril, 2012) 10,000 Purchases 1,00,000
Wages 5,000 Carriage Inwards 1,000
Sales 1,70,000 Returns Inward 5,000
Returns Outward 8,000 Sales Tax paid 20,000
Freight 500 Octroi duty 2,500
Closing stock as on 30stMarch, 2013 was valued at Rs. 20,000 Also, pass
the Closing Entries.
Solution:
TRADING ACCOUNT
Dr. for the year ended 30stMarch, 2013 Cr.
Particulars Rs Particulars RsTo opening stock10,000BySalesTo Purchases 1,70,000 1,60,0001,00,00090,000Less:SalestaxLess: Returns Outward 5,000 10000 20,00010,0001,000To Wages 500 By Closing StockTo Carriage Inwards2,500To freight71,000To Octroi DutyTo Profit and loss A/c1,80,0001,80,000(Gross profit)munotes.in
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70VERTICAL FORMAT OF REVENUE STATEMENT TRADING
&P&L A/C
HORIZONTAL OR ‘T’ FORMAT OF BALANCE
SHEET
munotes.in
Page 71
716.6 VERTICAL FORMAT OF BALANCE SHEET
munotes.in
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75
munotes.in
Page 76
76MODULE -V
7
CAPITAL AND REVENUE EXPENDITURE -
DEFERRED REVENUE EXPENDITURE -
CAPITAL AND REVENUE RECEIPTS
Unit Structure
7.0Objectives
7.1Introduction
7.2Misclassification and effect of error
7.3Capital and Revenue -
7.4Revenue expenditure
7.5Distinction between capital expenditure and Revenue expenditure
7.6Distinction between capital receipt and Revenue receipt
7.7Tests to be applied to transactions
7.8For Capital Receipt/ Revenue Receipt
7.9Deferred Revenue Expendit ure-(DRE)
7.0 OBJECTIVES
To help the learner understand the concept of Capital and Revenue
To help the learner distinguish between capital and revenue
transactions
To help the learner understand the importance of correctly identifying
the capital and reve nue transactions, the effect of errors due to
misclassification and its presentation in the financial statements
To help the learner know about the deferred revenue expenditure and
its presentation in financial statements.
7.1 INTRODUCTION
The Final Ac counts prepared at the end of the year consists of Profit and
Loss account and Balance sheet. The final accounts are prepared from
Trial balance which gives a list of accounts showing debit balances andmunotes.in
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77credit balances. The accounts appearing in the trial balance are to be taken
to the trading, profit and loss account or balance sheet. The profit and loss
account (also known as Revenue Statement) shows the income and gains
on the credit side and the various expenses and losses are shown on the
debit side. The balance sheet is a statement showing the financial position
as on a particular date and shows the capital and liabilities and assets.
It is necessary to classify the items appearing in the trial balance as capital
or revenue so that they can be corre ctly shown in the trading, profit and
loss account or balance sheet as the case may be. Such classification is
necessary to comply with the concept of matching costs and revenue in a
given period.
7.3MISCLASSIFICATION AND EFFECT OF ERROR
Any misclassif ication impacts the correctness and accuracy of the
financial statements –the profit and loss account will not show the correct
Profit/ Loss and the Balance Sheet will not show the true position of assets
and liabilities. Thus due to misclassification, th e accuracy of the financial
statements are affected and the statements do not depict the true and fair
view of the state of affairs of the business enterprise.
For example -A computer is purchased and the accountant records the
purchase along with purchas e of raw materials in the trading account. The
error will affect the profit or loss position as the transaction has been
wrongly shown in trading account. The computer purchased should have
been recorded as an asset in the balance sheet. In this way the er ror due to
misclassification affects both the revenue statement and the balance sheet.
Effect of error in classification
1)Trading account will not show correct gross profit/ gross loss.
2)Profit and loss account will not disclose true net profit/ net loss.
3)Balance sheet will not disclose true value of Assets and Liabilities.
4)Financial statements will not disclose True and Fair view of the state
of Affairs of the organization.
5)It will be difficult to understand the capitalization of business.
6)These errors affe ct the accounts of the subsequent yearsmunotes.in
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78It is thus clear that any error in classification or misclassification impacts
the accuracy and correctness of the financial statements and hence it is
very important to classify the transactions as capital or reven ue and
disclose the same correctly in the financial statements .
7.4CAPITAL AND REVENUE
Receipt or Expenditure transactions are to be classified as capital or
revenue and further classified as capital expenditure, revenue
expenditure capital receipt or r evenue receipts.
TRANSACTIONS
Expenditure or receipt
Expenditure transactions Receipt transactions
( involves outflow of cash) ( involves inflow of cash)
Capital expenditure / Capital receipt/
Revenue expenditure Revenue receipt
Capital transactions are further classified as capital expenditure and capital
receipt and revenue transactions are classified as revenue expenditure and
revenue receipt.
Capital expenditure is any expenditure which has any one or all of the
following -
It is a non -recurring expenditure
The benefit of such expenditure is seen for more than one year.Error in classification Impact on profit and impact on
balance sheet/ value of asset
1)Revenue expenditure is wrongly
treated as capital expenditureProfit will be inflated ,
Value of asset will be inflated.
2)Capital receipt is treated as
revenue receiptProfit will be inflated ,
Value of asset will be inflated.
3)Capital expenditure treated as
revenue expenditureProfit will be deflated ,
Value of asset will be deflated.
4)Revenue receipt wrongly treated
as capital receiptProfit will be deflated.
munotes.in
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79The expenditure increases the revenue earning capacity of th e
organization.
In short, if the benefits of the expenditure are expected to accrue for a long
time, the expenditure is capital expenditure. Thus capital expenditure is
that expenditure which results in the acquisition of an asset, tangible or
intangible.
Some common examples of capital expenditure are -
1)Purchase of an asset
Any expenditure that is incidental to the purchase of an asset or has been
incurred to put the asset in working condition for example –installation
charges or commissioning expenses incurred with reference to purchase of
asset is also to be treated as capital expenditure. All the expenses incurred
on the assets till they yield income are capital in nature.
2) Expenditure during construction -
Any expenditure incurred during constructi on period or capital work in
progress is considered as a capital expenditure.
3) Expenditure that improves the standard of performance of an existing
asset.
Any expenditure which extends the useful life of the asset or improves the
efficiency of the asset is to be capitalized and added to the cost of the
fixed asset
4) Cost of an addition or extension to an existing asset
5) Investment in shares, debentures, immoveable properties
6) Cost of acquiring intangible assets like goodwill, patents, copyrights.
7) Cost of acquisition and development of wasting assets like mines, oil -
wells.
Accounting of capital expenditure -Capital expenditures are shown in the
asset side of Balance sheet
7.5REVENUE EXPENDITURE
Revenue expenditure is any expenditure which has an y one or all of the
following -
The expenditure is incurred in the day to day conduct of business and
necessary to carry on the business.
The expenditure is recurring in nature
The benefit of such expenditure usually lasts for a short period of time
Kohler defines Revenue expenditure as an expenditure charged against
operations.munotes.in
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80Any expenditure which is not a capital expenditure and which is incurred
for carrying out the day to day activities of business is called revenue
expenditure.
Some common examples of revenue expenditure are -
1)Expenses relating to business activities -Expenses of production -
Purchase of raw materials, Expenses of administrat ion-Payment of Office
salaries, Expenses of selling and distribution
Finance expenses
2)Expenses which are incurr ed to maintain the asset in a working
condition -
Repairs and maintenance expenses
3)Expenses incurred to earn income --Interest on loan taken for purchase
of shares
Accounting of Revenue expenditure -Revenue expenditures are shown on
the debit side of Tradi ng/ profit and loss account.
Capital Receipt -
Any receipt or cash inflow which has any one or all of the following
The receipt is non -recurring in nature
The receipts do not arise through normal activities of business
Some common examples of capital recei pt are -
a) Amount received on account of issue of fresh share capital/ debentures
b) Amount of loans raised
c) Proceeds on sale of fixed assets
d) Deposits
Accounting of capital receipt -Capital receipts are shown in the balance
sheet.
Revenue receipt
Revenue receipts are those items of income which are received or accrued
in the ordinary course of business.
Any cash inflow generated in the normal course of business activities are
to be treated as revenue receipts -Income generated from cash/ credit sales,
or from services rendered.
Accounting of revenue receipt -Revenue receipts are shown on the credit
side of trading/ profit and loss account
Concept of capital and revenue can be summarized as under -munotes.in
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81Capital transactions will be recorded in the balance sh eet while revenue
transactions will be shown in the revenue statements -Trading, profit and
loss account
.Trading, Profit and loss account (
debit side)Trading, Profit and loss account(
credit side)
Revenue expenditure
To Salary
To rentRevenue receipts
By sale of goods
Balance sheet( Liability side) Balance sheet (asset side)
Capital receipt
Loan from bankCapital expenditure
Plant and Machinery purchased
7.6DISTINCTION BETWEEN CAPITAL
EXPENDITURE AND REVENUE EXPENDITURE
CAPITAL EXPENDITURE REVE NUE EXPENDITURE
It is non -recurring in nature It is recurring in nature
It is shown in the Balance sheet It is shown in the revenue account
It is incurred for acquiring fixed
assets intended for use in businessIt is incurred for carrying out the
dayto day activities of the business
It increases the revenue earning
capacity of the concernIt does not increase the revenue
earning capacity of the concern.
Benefit of this expenditure extends
for more than one yearThe benefit of this expenditure is
foras h o r tp e r i o d
Example -purchase of fixed asset Example –Payment of salariesmunotes.in
Page 82
827.6 DISTINCTION BETWEEN CAPITAL RECEIPT AND
REVENUE RECEIPT
CAPITAL RECEIPT REVENUE RECEIPT
They are non recurring in nature They are recurring in nature
They appear in the balance sheet -It
is disclosed as a liability in the
balance sheetThey appear in Revenue account -It
is disclosed as an income in the P&L
A/c
Capital receipts which are liabilities
are to be repaidRevenue receipts are not to be repaid
as they are not liabilities.
They are not gains to the concern They are gains to the concern
It represents capital brought in by
the proprietor which are not of
recurring natureIt represents income such as sale of
goods, interest received
Example -Amount rece ived on issue
of debenturesExample -Interest received, recovery
of bad debts
7.8TESTS TO BE APPLIED TO TRANSACTIONS
To classify a transaction as capital or revenue, one may use the
following tests as indicators -
FOR CAPITAL/ REVENUE EXPENDITURE
1) What is the period of benefit from expenditure?
2) What is the effect of expenditure?
3) What is the amount of expenditure?
Period of benefit from expenditure -if the benefit is for short period and
recurring in nature, it is generally treated as Revenue expenditure.
Expenditure which will give benefit for a long period of time and which is
non-recurring in nature will be generally classified as Capital
expenditure. A non -recurring expenditure is always capital in nature
unless materiality concept emphasizes the impor tance of recognizing it as
revenue expenditure.
Effect of Expenditure -If the expenditure gives rise to a tangible asset or
right, treat it as capital expendituremunotes.in
Page 83
83Amount of expenditure -Generally the capital expenditures involve huge
amounts but this can not always be treated as a conclusive , reliable test for
classification
7.9FOR CAPITAL RECEIPT/ REVENUE RECEIPT
1)What is the source or cause of receipt or profit?
2)What is the nature of the receipt?
3)What is the impact of the receipt transaction on the pr ofit / loss ?
Source of receipt -If the receipt is from trading transaction, then it should
be treated as revenue receipt. Eg -sale of goods. If the receipt is from other
transactions, then it should be considered as capital receipt. eg Loan taken
from ban k, amount realized on sale of fixed assets. Thus if receipt arises
in the course of business activity, then it is to be treated as revenue receipt.
If it arises out of financing activity, it is to be treated as Capital receipt.
Nature of receipt -Non-recurring receipts are capital receipts while
recurring receipts are revenue receipts.
Impact of the transaction on profit/ loss during the year -Capital receipts
have no bearing on the profit made or loss incurred during the year . Only
revenue receipts are taken into account to ascertain the profit made by the
business. This is a fairly reliable indicator/ parameter for classifying
transactions as capital receipt/ revenue receipt.
In case of receipts, the general rule is that if the receipt is against the
supply of goods or services and related to period under review, the receipt
is revenue receipt. This will be shown in the P&L A/C .Capital receipts
are to be shown as liability or reduced from assets appearing in Balance
sheet.
Sometimes a part of the receip t may be capital and a part of it may be
revenue -
For example proceeds on sale of asset -
1)If the sale proceeds is less than book value of asset , the receipt is
capital receipt to be deducted from asset
2)If the sale proceeds is more than book value but less than cost , the
receipts is to be segregated as -
a) equal to book value of asset is capital receipt to be reduced from
asset
b) excess as revenue receipt giving rise to revenue profit.
3) If sale proceeds is more than cost, the receipts are to be account ed for as
under -
a) equal to book value capital receipt to be reduced from assetmunotes.in
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84b) between book value and cost, revenue receipt giving rise to
revenue profit
c) excess over cost, revenue receipt giving rise to capital profit.
Howev er it is not always easy to classify transactions as capital/ revenue .
There is a good deal of difference of opinion in deciding whether a
particular item is capital or revenue. Hence it has to be decided based on
the facts of the case on a case to case b asis .
For example -Purchase of motor car is a capital expenditure as it involves
acquisition of an asset. However purchase of Motor car by a car dealer
who deals with purchase and sale of motor cars on a regular basis is not a
capital expenditure In the s econd case the purchase of car is to be treated
as revenue.
Expenditure incurred in converting an ordinary screen in a cinema hall to a
cinemascope –It is difficult to accurately ascertain the nature of this
transaction. It may be argued that as the seat ing capacity of the hall has
not changed, it should be treated as revenue expenditure. However, the
second argument could be cinemascope pictures attract large audience and
as the expenditure will result in higher earnings, it is to be treated as
capital e xpenditure.
7.10DEFERRED REVENUE EXPENDITURE -(DRE)
According to the Guidance note issued by ICAI, “Deferred Revenue
Expenditure is that expenditure for which payment has been made or a
liability incurred but which is carried forward on the presumption th at it
will be of benefit over a subsequent period/ periods.”
For example -Normal annual advertising expenses is considered as
revenue expenditure and debited to the profit and loss a/c. If the heavy
expenses are incurred on advertising campaign to launch a new product,
then the whole amount should not be debited to P&L a/c of that year. The
benefit accrues for a long period of time. Hence so much of the
expenditure as benefits the current year may be considered as revenue and
debited to profit and loss a/c the balance to be shown as deferred
expenditure -revenue expenditure which is deferred or postponed.
There are some transactions which may appear revenue in nature but the
benefits of such expenditure are seen for a long period of time .Such
expenses are t reated as deferred revenue expenditure. For example -Heavy
advertisement expenses or promotion expenses to launch a product -As
such expenditure yields the benefit for a long period ,it is necessary to
spread the amount over such number of years . If not spread over the
years, then the revenue statement of the year in which the expenditure was
incurred may not show the true picture of Profit/ loss Hence in order to
have more credible financial statements the expenditure is deferred and a
part of the expen diture is shown in the current year Profit and lossmunotes.in
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85account. The balance amount ( not yet written off) is shown as a debit
balance in the asset side of the balance sheet.
Other common examples of Deferred revenue expenditure are -
Preliminary expenses
Costo fm a r k e tr e s e a r c hf o ran e wp r o d u c t
Commission on issue of debentures
Cost of issuing shares / debentures or raising loans
Accounting for Deferred Revenue expenditure -For eg -Association fees
paid Rs 60,000 for three years ( 2016 -17, 2017 -18,2018 -19).
1styear-Accounting for the year 2016 -17-This expenditure has to be
shown in Profit and loss a/c. However it is evident that the expenditure is
incurred in the financial year 2016 -17, but the benefit of the expenditure is
enjoyed in the subsequent peri ods too. Hence the amount of Rs 60,000
should be spread over three years and the annual amount to be determined
( 60000/3) Rs 20,000 .The profit and loss account of the year 2016 -17
will be debited with Rs 20,000. The balance( 60,000 -20,000) Rs 40,000
notwritten off will be shown in the asset side of balance sheet . Here the
expenditure is –deferred and hence known as DRE.
2ndyear-Accounting for the year 2017 -18-The amount of Rs 20,000 will
be debited to profit and loss account and the balance Rs 20,0 00 (40000 -
20000) not written off will be shown in the asset side of balance sheet
3rdyear-Accounting for the year 2018 -19-The amount of Rs 20,000 will
be debited to profit and loss account and there is no balance to be shown
in the balance sheet
Thus the amount has been spread over three years and accounted for in the
books.
Revenue expenditure that becomes capital expenditure -
The following revenue expenses under certain circumstances becomes
capital expendituremunotes.in
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86Expenses Circumstances
1)Repairs Amount spent on repairs of plant and
machinery, furniture, building which are
regular in nature and incurred to
maintain the asset in a working
condition are to be considered as
revenue expenditure. However repairs to
the second hand assets to improve the
operational efficiency is to be treated as
capital expenditure.
2)Wages Wages paid is a revenue expenditure.
Wages paid for installation of machinery
or construction of fixed assets is
considered as capital expenditure.
3)Legal charges Legal charges are ba sically revenue in
nature and are shown in the debit side of
P&L a/c. Legal charges incurred in
connection with purchase of fixed asset
are capital in nature
4)Transport charges Transport charges are basically revenue
in nature. Transport charges incurred for
purchase of machinery , furniture are
capital in nature.
5)Interest on capital Interest on capital paid during the
construction of works, building and
plant is capital in nature.
6)Raw material and
storesThis is basically a revenue expenditure
but if it is used for construction of fixed
assets, it is considered as capital and
added to the cost of the asset
7)Development
expenditureThe development expenditure incurred
during the development period with
reference to tea and rubber plantations
should be treated as capital expenditure
To summarize the revenue expenditure incurred in connection with
purchase of asset or which is incidental to the purchase of asset, expenses
incurred in development of asset is to be treated as capital expenditure.munotes.in
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87Prob lems-
Q1-Error in classification or misclassification -
The following is the Trading account for the year ended 31 st March 2016
Particulars Amt( Rs) Particulars Amt (Rs)
To opening stock
To purchases
To wages
To Gross Profit60,000
3,00,000
1,00,0 00
40,000By Sales
By Closing stock4,00,000
1,00,000
5,00,000 5,00,000
Additional Information -
1)Sales included sales of old furniture Rs 10,000
2)Purchases included purchase of machinery Rs 70,000
3)Some workers were employed for construction of a ga llery to the
office building. Wages of these workers amounting to Rs 30,000
were included in the above wages.
Redraft the trading account to arrive at the correct profit after
considering the above additional information -
Solution -There has been an error in the classification of items as capital/
revenue.
1) Sale of old furniture is a capital receipt. The same has been wrongly
shown as revenue receipt. Hence Rs 10,000 has to be deducted from
sales.
2) Purchase of Machinery is a capital expenditure. It ha sb e e nw r o n g l y
shown as revenue and included in the purchases. Rs 70,000 has to be
deducted from purchases and shown in the asset side of Balance sheet.
3) The wages of workers who have been employed for construction of
gallery to office building are of c apital nature .Rs 30,000 should be
deducted from wages and added to the cost of office building.munotes.in
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88The corrected trading account will be redrafted as under -
Particulars Amt ( Rs) Particulars Amt(R s )
To opening stock
To Purchases
Less machiner y
purchased
To wages
Less capitalized
To gross profit60,000
2,30,000
70,000
1,30,000By sales
Less sale of old
furniture
By closing stock3,90,000
1,00,000
4,90,000 4,90,000
Q2 How would you treat the following items?
1) Carriage paid on purchases Rs 1,000 -Revenue expenditure
2) Expenditure on advertising campaign Rs 500 -Revenue
expenditure
3) Freight and carriage of a new machin ery purchased Rs 2,000 -
Capital expenditure
4) Spent Rs 6,000 as legal expenses for abuse of trademar k–
Revenue expenditure
5) Received Rs 1,00,000 on issue of equity shares -Capital receipt
6) Paid to the government excise duty Rs 50,000 -Revenue
expenditure
7) Paid Rs 70,000 for construction of railway sidings -Capital
expenditure
8) Purchased Land Rs 1,00,000 -Capi tal expenditure
9) Labour charge on plant and Machinery Rs 3,000 -Capital
expenditure
10) Repairs to furniture Rs 1,500 -Revenue expenditure
Q3 State with reasons whether the following are capital ,Revenue or
Deferred revenue expenditure
1) Legal expenses in issuing shares and debentures Rs 12,500
2) Legal expenses incurred in an action for infringement of
trademarksmunotes.in
Page 89
893) Rs 25,000 spent on air -conditioning the office of the Managing
Director
4) Rs 7,000 spent on registration of design
5) Legal expenses incurred in an Income tax a ppeal
6) Legal expenses Rs 5,000 incurred in connection the purchase of
business premises
7) Rs 1,00,000 paid for the application and allotment of a plot of
land
8) Legal expenses Rs 8,000 incurred in defending a suit for breach of
contract to supply of goods
(Mumbai University April 2008)
Solution
1) Deferred Revenue expenditure -These expenses should be written
off over certain number of years. These expenses benefit the
organization for many years
2) Revenue expendi ture-These expenses are incurred in the normal
course of operation
3) Capital expenditure -It is capitalized as per AS -10
4) Capital expenditure -It is to be added to the cost of design which
is an asset
5) Revenue expenditure These expenses are incurred in the norm al
course of operation
6) Capital Expenditure It increases the cost of business premises
7) Capital Expenditure It increases the cost of land
8) Revenue expenditure These expenses are incurred in the normal
course of business operations. The benefit is exhausted within one
year.
Q4 State with reasons the nature of the following expenses/ receipts
1) Sold investments 4% government securities for Rs 1,40,000
2) Preliminary expenses paid Rs 42,000
3) Carriage outward paid Rs 40,000
4) Import duty paid on purchase of computer equ ipment Rs 85,000 to
be used in the office
5) Received Rs 5,00,000 on the issue of 5% Debentures
6) Paid Rs 10,000 underwriting commission on issue of sharesmunotes.in
Page 90
907) Legal expenses Rs 6,000 paid in connection with purchase of land
8) Repairing charges Rs 15,000 paid for kee ping the machinery in
working condition
(Mumbai University March 2006)
Solution
1) Capital receipt -The amount is received on sale of investment and
not from normal business activity
2) Deferred Revenue expend iture -The expenditure benefits the
current year and subsequent years and hence the amount has to be
written off over a certain number of years.
3) Revenue expenditure -It is incurred in normal business operations
4) Capital expenditure -It is a direct cost on a cquiring of fixed assets
and hence has to be capitalized as per AS -10
5) Capital receipt -The amount is received on issue of Debentures
and not from normal business activity
6) Deferred Revenue expenditure --The expenditure benefits the
current year and subseque nt years and hence the amount has to be
written off over a certain number of years.
7) Capital expenditure -It is a cost incurred in acquisition of fixed
asset
8) Revenue expenditure -it is incurred for keeping the machinery in
working condition
Summary -
An organ ization has to incur various expenses and receives different
incomes. Some expenses are regular while some are onetime expenses
.The expenses whose benefits will be enjoyed over a long period are called
capital expenditure. Revenue expenditure refers to th ose expenses which
are incurred for the day to day operations of business.
Receipts whose benefits will be enjoyed over a long period are classified
as capital receipts while day to day operational receipts such as sales are
revenue receipts.
ONLY MAIN PO INTS (for revision)
Capital expenditure -Large amount, Increases cost of fixed asset,
increases life of fixed asset, non -recurring in nature, increases profit
earning capacity of the business enterprise, brings the fixed asset into
working condition, ben efit of expenditure is not exhausted within one
year, shown in balance sheetmunotes.in
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91Revenue expenditure -smaller amount, recurring in nature, benefit is
exhausted within the year, shown in P&L A/c
Capital receipts do not arise in the normal course of operation
Revenue receipts are received in the normal course of operation
Deferred revenue expenditure -basically revenue in nature, benefit not
exhausted within one year, expenditure to be written off over certain
number of years.
Key terms -
Capital expenditure -It is the expenditure which is incurred to raise
earning capacity of an organization.
Revenue expenditure –It is the expenditure which is recurring in nature
incurred in connection with day to day operations of an organization.
Capital receipt -It is a re ceipt which is not received in the normal course
of operation
Revenue receipt -Revenue receipt is the receipt which is recurring and
received in the normal course of operation.
Deferred Revenue expenditure –It is the revenue expenditure the benefit
of whic h is not exhausted within one year.
munotes.in
Page 92
92MODULE VI
8
DEPRECIATION
Unit Structure
8.1 Objectives
8.2 Meaning, Definition and Features of Depreciation
8.3 Depreciation, Depletion and Revaluation
8.1OBJECTIVES
To help the learner understand the concept of Depreciation
To help the learner understand the need for providing depreciation
To help the learner understand the causes of depreciation
To help the learner understand the calculation of depreciation, the
methods of providing depreciation and accounting in the books of
accounts
8.2MEANING, DEFINITION AND FEATURES OF
DEPRECIATION
The word depreciation has been derived from the Latin word ‘Depretium’
which means decline or reduction in price or value. Fixed assets have a
definite life but they lose their value due to usage or passage of time.
Depreciation refers to this decline in value due to usage , passage of time
or due to obsolescence.
According to William Pickles, Depreciation is the gradual and permanent
decrease in the value of the ass et. Depreciation refers to the decline or
reduction in the value of fixed asset. Depreciation is the permanent and
continuing diminution in the quality, quantity or value of an asset.
The Institute of Chartered Accountants of India ( ICAI) defines
depreci ation as” a measure of the wearing out , consumption or other loss
of a value of a depreciable asset arising from use, efflux of time or
obsolescence through technology and market changes”
Reduction in the value of the asset due to their productive use is called
Depreciation. Depreciation in the value of asset is also due to natural wear
and tear.munotes.in
Page 93
93Features of Depreciation -
Depreciation is a gradual reduction in the value of an asset
The reduction could be due to various reasons.
Depreciation is charged on assets -fixed assets
Depreciation is a part of operating expenses. It is non cash in nature as
there is no real cash outflow even if it is accounted as an expense. It is to
be provided on fixed assets which are used in the process of prod uction
and in the conduct of business. It is charged to profit and loss account.
The amount of Depreciation charged to P&L Account has to be deducted
from value of asset shown in the balance sheet.
Depreciation is to be provided even if the business is in curring a loss.
Depreciation is a gradual and permanent decrease in the value of asset
which is to be accounted for in the financial statements to arrive at the
correct profit/ loss.
Thus, Depreciation means a fall in the quality or value of an asset.
Accounting Standard (AS) -6 (Revised) deals with Depreciation
Accounting.
Depreciation is to be provided on pro -rata basis for the period for which
the asset was used in a particular year at the specified rate.
The company adopts a policy regarding depreciat ion and as per AS -1-
namely, disclosure of Accounting Policies, the method adopted in
providing depreciation should be disclosed in the notes to accounts.
8.3DEPRECIATION, DEPLETION AND
REVALUATION
Depreciation refers to a decrease in the value of the as set while depletion
refers to the decrease in the value of wasting assets like oil wells, mines.
Revaluation refers to a revision in the value of the asset which could mean
a decrease or an increase in the value of the asset.
8.2 (A) Need for depreciation -The Companies Act requires companies to
write off or provide for depreciation in a specified manner.
1)To ascertain true and correct profit/ loss -Depreciation is an
operating expense which is provided on assets used in the process of
production. Thus it is an expense to be included in the cost of production.
It is therefore logical that it must be matched with the income earned and
charged to P&L Account to calculate the true and real profit/ loss of the
business. Unless depreciation is charged to P&L Ac count, the correct
profit/ loss cannot be arrived at.munotes.in
Page 94
942)To present a true financial position of business -Balance sheet is a
statement which shows the financial position of the business enterprise as
on a particular date. The fixed assets are to be shown at their true values.
The balance sheet shows the true financial position only if the depreciation
is deducted from the value of the asset. If the depreciation is not provided
on assets, the assets will be overvalued and the balance sheet will not
reflec t the true financial position.
3)Replacement of asset -Every asset has a useful life. At the end of the
useful life of the asset, it needs to be replaced. Providing the depreciation
enables the business to replace the asset.
4)Statutory requirement -It is necessary to charge depreciation to
comply with the provisions made under the Companies Act and the
Income Tax Act. Providing the depreciation enables the business to
compute and pay correct tax on taxable profit.
8.2 (B) Causes of Depreciation
1)Natural wear and tear -Wear and tear is the main cause of
depreciation. Wear and tear takes place in case of tangible fixed assets like
furniture, machinery due to its use. It the asset is used more, the wear and
tear is also more.
2)Efflux of time -Even if t he asset is not used and kept idle, its value
falls over a period of time. Hence depreciation is provided on idle
machinery too.
3)Obsolescence -A loss or reduction on account of new invention is
called as obsolescence. With the new technological improve ments,
inventions and improvements in techniques of production, the old
machinery becomes outdated and needs to be replaced.
4)Depletion -An asset like mines, oil wells may get exhausted due to
continuous extraction due to which the value of the asset goe so n
diminishing. There comes a stage when the asset has been completely
utilized and there is nothing left to be extracted. Such a decrease in the
value of the asset is depletion.
5)Natural calamities -An asset may be damaged due to fire, flood and
lose its value and may be disposed off as scrap. The loss of value is
written off as depreciation.
8.2 (C) Factors affecting Depreciation
a)Cost of the asset -The cost of the asset refers to the purchase price of
the asset. The expenses related to the purchas eo ft h ea s s e ta r et ob ea d d e d
to the purchase price to arrive at the cost of the asset. Incidental expenses
like installation charges, wages for erection of asset, freight and transport
charges are to be added to the purchase price. For example -purchase price
of machinery is Rs 1,00,000 and Rs 5,000 were incurred on installation of
machinery. The total cost of the asset is Rs 1,00,000+5,000= 1,05,000munotes.in
Page 95
95b)Residual value or estimated scrap value -Residual value refers to the
value that can be realized at the end of the useful life of the asset when the
asset will be sold as scrap .Such scrap value is to be deducted from the
cost of the asset.
c)Estimated useful life of the asset -The useful life of the asset in terms
of number of years that the asset can be put into productive use needs to
be estimated for calculating depreciation.
8.2 (D) Formula for calculating depreciation -After considering the
above factors, the amount of depreciation can be calculated by using
formula -
Depreciation per annum=Original c ost of the asset -estimated scrap value
Estimated useful life of the asset.
Depreciation = original cost of the asset x rate of depreciation ( where the
estimated scrap value is zero)
Where the original cost of the asset = Purchase price +incidental charge s.
A company purchased machinery for Rs 44,000 and spent Rs 1,000 on
the installation. It is estimated that the useful life of the asset is 10 years
and at the end of the useful life the residual value is Rs 5,000. The
depreciation per year will be worked out as under Cost of the asset=
44,000+1,000= 45,000
Depreciation p.a = 45,000 -5,000 =4,000
10
Depreciation as per Companies Act 2013 for Financial year 2014 -15 and
thereafter. (These provisions are applicable from 01.04.2014 vide
notification dated 27.03.2014. )
a)Depreciation is calculated by considering useful life of asset, cost and
residual value.
b)Any m ethod WDV or SLM can be used.
c)Schedule –II contains a list of useful life according to class of assets
and the residual value shall not be more than five percent of the original
cost of asset. However companies are free to adopt a useful life differe nt
from what specified in Schedule II and residual value more than 5%. The
financial statements shall disclose such difference and provide justification
in this behalf duly supported by technical advice.
8.2 ( E) Methods for providing depreciation -
Straigh t line method or fixed instalment method Reducing balance method
or Written down value method Annuity methodmunotes.in
Page 96
96Depreciation fund method Insurance fund method Revaluation method
Sum of the digits method Depletion method Machine hour rate method
Repairs provi sion method.
The first two methods are discussed.
Straight line method (SLM) or fixed instalment method (FIM) or
original cost method
Meaning -Under this method a fixed percentage of the original value of the
asset is written off every year. The value of t he asset is reduced to zero at
the end of the useful life of the asset. As the amount of depreciation
remains constant every year, this method is called as fixed instalment
method.
Reducing balance method (RBM) or Written down method(WDV)
Meaning -Under th is method, depreciation is charged at a certain
percentage each year on the balance of the asset which is brought forward
from the previous year . The amount of depreciation charged in each year
is not fixed but goes on reducing at the later years . As the amount of
depreciation keeps reducing , it is known as reducing balance method.
The depreciation is charged on the written down value of the asset hence
known as written down value method.
8.2 (F) Distinction between FIM and WDV methods –
The following i llustration will help to bring out the distinction between the
two methods -
Let us assume the machinery was purchased for Rs 1,00,000 and
Depreciation is to be provided @10% p.a.
Year Depreciation as per FIM
@10%Depreciation as per WDV
@10%
1 1,00,000 x 10% for 1
year=10,000
Value of asset at the end of
the first year is 1,00,000 -
10,000= 90,0001,00,000x10%for 1 year=10,000
Value of asset at the end of the
first year is 1,00,000 -10,000=
90,000
2Depreciation @ 10% on
1,00,000= Rs 10,000. Value
ofasset at the end of the
second year is 90,000 -
10,000=80,000Depreciation @ 10% on 90,000=
Rs 9,000. Value of asset at the
end of the second year is 90,000
-9,000=81,000
3 Depreciation @ 10% on
1,00,000= Rs 10,000. Valueof asset at the end of the thirdyear is 80,000 -10,000=70,000Depreciation @ 10% on 81,000=
Rs 8,100. Value of asset at the
end of the third year is 81,000 -
8,100=72,900munotes.in
Page 97
974 Depreciation @ 10% on
1,00,000= Rs 10,000. Value
of asset at the end of the
fourth year is 70,000 -
10,000=60,000 Thus
depreciation is always @ 10%
of original costDepreciation @ 10% on 81,000=
Rs 8,100. Value of asset at the
end of the fourth year is 72,900 -
7,290=65,610
Thus depreciation is always on
10% on the balance or WDV
The following points are observed from t he above table -
The amount of depreciation remains same for all the years as per the FIM
method while it keeps decreasing as per the WDV method.
The value of asset at the end of the tenth year would be zero as per the
FIM while the asset value will never b ecome zero as per the WDV
method.
There is no difference in the amount of depreciation and the value of asset
after charging depreciation in the first year under both the methods.
Fixed instalment or straight line
methodWritten down value or Reducing
balance method
1)It is a method of depreciation in
which depreciation at fixed
percentage ( rate) is charged every
year on original cost of fixed asset
and the amount of depreciation
remains the same ( constant) every
year1)It is a method of depreciation in
which depreciation at fixed
percentage ( rate) is charged everyyear . The amount of depreciationgoes on reducing every year
2)The amount of depreciation is
charged on the original cost of the
asset2)The amount of depreciation is
charged on the writte nd o w nv a l u e
of the asset
3)After certain number of years the
value of the asset becomes zero3) The book value of the asset
never becomes zero
4)This method of depreciation is not
accepted for Income tax purposes4)This method of depreciation is
accept ed for calculation and
payment of Income tax
5)This method of depreciation is easy
to calculate and more suitable for
assets of lower value5)This method of depreciation is
suitable for assets of higher value
having longer life requiring heavy
expenditu re in later life of the
assetmunotes.in
Page 98
988.2 (G) Accounting treatment of Depreciation -The transactions relating
to purchase of asset and depreciation are recorded through journal entries
and later posted in the relevant ledger accounts. Journal entries
A)When Pro vision for depreciation account is not maintained -
The transactions of purchase of asset, providing depreciation on asset,
sale of asset, profit/ loss on sale of asset are recorded in the asset
account.
For purchase of asset for cash - Asset a/c Dr
To cash/ bank a/cFor purchase of asset on creditAsset a/c Dr
To supplier/party a/c
For payment of installationchargesAsset a/c Dr
To cash/ bank a/cFor providing depreciationDepreciation a/c Dr
To Asset a/c
For transfer of depreciation to
Profit and Loss a/cProfit and Loss a/c Dr
To DepreciationFor sale of assetCash/ bank a/c Dr
To Asset a/c
For loss on sale of asset Profit and Loss a/c Dr
---To Asset a/cFor profit on sale of assetAsset a/c DrTo Profit and Loss a/cAfter passing the journal entries the relevant ledger accounts are to be
prepared. The balance in the asset account will be carried down to the next
accounting period and the balance in the depreciation account will be
transferred to profit and loss a/c.
At the end of the year, while preparing final accounts, Depreciation
amount will be shown on the debit side of profit and loss account.
The asset will a ppear in the balance sheet at the written down value (value
after providing for depreciation on the asset)munotes.in
Page 99
99When the above entries are posted in the asset a/c the entries will be
appearing in the asset account as under
Dr ASSET A/C Cr
Date Particulars AmtDateParticulars Amt
To cash/ bank a/c
(cash Purchase)By Depreciation
( yearly depreciation )
To suppliers a/c
( Credit purchase)By cash/ Bank
( sale of asset)
To cash/ Bank
(installation charges)By profit and loss a/c
(loss on sale)
To profit and loss a/c
( profit on sale)
To balance c/d
( balancing figure)
B)When provision for depreciation account is maintained -
For purchase of asset for cas h-
Asset a/c Dr
To cash/ bank a/c
For purchase of asset on credit
Asset a/c Dr
To supplier/ partys a/c
For payment of installation charges
Asset a/c Dr
To cash/ bank a/c
For providing depreciation -
Depreciation a/c Dr
To Provision for Depreciation a/c
For transfer of depreciation to Profit and Loss a/c
Profit and Loss a/c Dr
To Depreciation
For sale of asset
Cash/ Bank a/c Dr
To Asset a/cmunotes.in
Page 100
100On sale of asset, the amount of provision created for the asset sold is to
be transferred to Asset a/c
Provision for Depreciation a/c Dr
To Asset a/c
For profit on sale of asset
Asset a/c Dr
ToProfit and Loss a/c
For loss on sale of asset ----
Profit and Loss a/c Dr
To Asset a/c
Under this method, the amount of depreciation to be provided i sn o t
recorded in the Asset a/c but is shown in the Provision for Depreciation
a/c.
The asset account will always show a debit balance and the provision for
depreciation account will show a credit balance.
The Asset a/c appears in the Balance sheet at its original value on the
Asset side and the provision for depreciation appears in the balance sheet
on the liability side.
Solved Problems -straight line method
1)M/s Raj and Sons purchased Machinery on 1stOctober 2007 at Rs
90,000 and spent Rs 10,000 on its installation. The firm provides
depreciation at 10% p.a .under straight line method.
Show machinery a/c and depreciation a/c for the years 2007 -08,2008 -09
and 2009 -10 assuming books of accounts are closed on 31stMarch every
year.
Solution -In the books of Raj and Sons
Working note for calculation of depreciation under SLM @ 10% p.a.
1O c t2 0 0 7 -cost of asset (90,000+10,000) = 1,00,000
Less depreciation @ 10% for 6 months = -5,000
WDV as on 31 March 2008 =9 5 , 0 0 0
Less depreciation @ 10% for 1 year = -10,000
WDV as on 31stMarch 2009 = 85,000
Less depreciation @ 10% for 1 year = -10,000
WDV as on 31stMarch 2010 = 75,000munotes.in
Page 101
101Dr Machinery account Cr
Date Particulars Amt Date Particulars Amt
2007
1octTo Bank
To Bank90,000
10,0002008
31marchBy
Depreciation
By balance c/d5,000
95,000
1,00,000 1,00,000
2008
1 AprilTo balance c/d 95,000 2009
31marchBy depreciation
By balance c/d10,000
85,000
95,000 95,000
2009
1 AprilTo balance b/d 85,000 2010
31marchBy
Depreciation
By balance c/d10,000
75,000
85,000 85,000
2010
1AprilTo balance b/d 75,000
Dr Depreciation account Cr
Date Particulars Amt Date Particulars Amt
2008
31marchTo Machinery
a/c5,000 2008
31marchBy P&La/c 5,000
5,000 5,000
2009
31marchTo Machinery
a/c10,000 2009
31marchBy P&La/c 10,000
10,000 10,000
2010
31marchTo Machinery
a/c10,000 2010
31marchBy P&La/c 10,000
10,000 10,000
2)Written down value method -
On 1st April 2005,Karan Bros purchased furniture for Rs 40,000.On 1st
October, 2005,additional furniture was purchased for Rs 20,000.
On 1stOctober 2007, they sold furniture which was purchased on 1stApril
2005 for Rs 28,000.The accounts were closed on 31stMarch every year
.Depreciation was provided @10% p.a. by WDV method
Prepare Furniture account and Depreciation account.munotes.in
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102Solution -Working note for calculation of Depreciation @ 10% p.a. on
WDV
Particulars Furniture1 Furniture 2 Depreciation
Cost of furniture
Less depreciation( on F -2
for 6 months)40,000
4,00020,000
1,000 5,000
WDV 36,000 19,000
Less Depreciation 3,600 1,900 5,500
WDV 32,400 17,100
Less Depreciation ( on F -1
for 6 months)1,620 1,710 3,330
WDV 30,780 15,390
Sold for
Loss on sale28,000
2,780
In the books of Karan Bros
Dr Furniture a/c Cr
Date Particulars Amt Date Particulars Amt
2005
1
April
1O c tTo Cash/ Bank
To Cash/ Bank40,000
20,0002006
31marchBy Depreciation
By balance c/d5,000
55,000
60,000 60,000
2006
1
AprilTo balance b/d 55,000 2007
31marchBy Depreciation
By balance c/d5,500
49,500
55,000 55,000
2007
1AprilTo balance b/d 49,500 2007
1o c t
2008
31MarchBy Depreciation
By cash/ bank
By P& La/c
By Depreciation
By balance c/d1,620
28,000
2,780
1,710
15,390
49,500 49,500
2008
1AprilTo balance b/d 15,390munotes.in
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103Dr Depreciation a/c Cr
Date Particulars Amt Date Particulars Amt
2006
31marchTo Furniture 5,000 2006
31marchBy P&La/c 5,000
5,000 5,000
2007
31marchTo Furniture 5,500 2007
31marchBy P&La/c 5,500
5,500 5,500
2007
1o c t
2008
31marchTo Furniture
To Furniture1,620
1,7102008
31marchBy P&La/c 3,330
3,330 3,330
3)Provision for depreciation -
On 1stApril 2009, following balances appeared in the books of Mangesh
Traders
Machinery a/c Rs 4,00,000 Provision for Depreciation a/c Rs 1,60,000
On the above date , they decided to sell the machinery for Rs 1,00,000
which was purchased on 1stApril 2006 for Rs 1,50,000.The firm provides
Depreciation on 31 March every year@ 10% p.a. under straight line
method.
Show Machinery account and Provision for de preciation account as on 31
march 2010.
Solution -Working note Depreciation @10% on SLM
Original cost of the machinery sold -1,50,000 and depreciation at 10%
p.a.is 15,000
Depreciation for three years ( 1 -april 2006 to 31 march 2009) is 15000x 3
years =4 5,000
WDV as on 31 march 2009 = 150000 -45,000= 105000
Sold for 1,00,000
Loss on sale of machinery 5,000
In the books of Mangesh Tr adersmunotes.in
Page 104
104Dr Machinery account Cr
Date Particulars Amt Date Particulars Amt
2009
1aprilTo balance
b/d4,00,000 2009
1april
2010
31marchBy cash/bank
By Provision for
Depreciation a/c
By P&L a/c (
Loss on sale)
By balance c/d1,00,000
45,000
5,000
2,50,000
4,00,000 4,00,000
2010
1aprilTo balance
b/d2,50,000
Dr Provision for Depreciation a/c Cr
Date Particulars Amt Date Particulars Amt
2009
1 april
2010
31marchTo
Machinery
a/c
To balance
c/d45,000
1,40,0002009
1april
2010
31marchBy balance b/d
By
Depreciation1,60,000
25,000
1,85,000 1,85,000
2010
1april By balance
b/d1,40,000
Summary
Depreciation is the gradual and permanent decrease in the value of the
asset. Depreciation refers to the decline or reduction in the value of fixed
asset. Depreciation is the permanent and continuing diminution in the
quality, quantity or value o f an asset. Depreciation is required to be
provided on fixed assets and charged to Profit and loss account so that the
correct profit or loss can be ascertained and the balance sheet reflects the
true financial position .Depreciation is caused due to natur al wear and tear,
efflux of time, obsolescence, depletion, natural calamities .The three
factors affecting depreciation are -cost of the asset, estimated useful life of
the asset and the residual or scrap value of the asset at the end of its useful
life. T hus, Formula for calculating depreciation ----munotes.in
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105Depreciation per annum=Original cost of the asset -estimated scrap value
Estimated useful life of the asset.
There are two methods of calculating depreciation . They are -
Straight line method (SLM) o r fixed instalment method (FIM) or
original cost method -Under this method a fixed percentage of the
original value of the asset is written off every year. The value of the asset
is reduced to zero at the end of the useful life of the asset. As the amount
of depreciation remains constant every year, this method is called as fixed
instalment method.
Reducing balance method (RBM) or Written down method(WDV) -
Under this method, depreciation is charged at a certain percentage each
year on the balance of the ass et which is brought forward from the
previous year . The amount of depreciation charged in each year is not
fixed but goes on reducing at the later years . As the amount of
depreciation keeps reducing , it is known as reducing balance method.
The deprecia tion is charged on the written down value of the asset hence
known as written down value method.
Accounting Standard (AS) -6(Revised ) deals with Depreciation
Accounting.
Depreciation is to be recorded in the debit side of Profit and Loss account
and ded ucted from the value of the asset in the balance sheet.
Key terms
Depreciation -Depreciation is the gradual and permanent decrease in the
value of the asset
Cost of the asset -The cost of the asset refers to the purchase price of the
asset. The expenses r elated to the purchase of the asset are to be added to
the purchase price to arrive at the cost of the asset.
Residual value -Residual value refers to the value that can be realized at
the end of the useful life of the asset when the asset will be sold as scrap
.Such scrap value is to be deducted from the cost of the asset.
Straight line method -It is a method of providing depreciation where the
amount of depreciation remains constant or fixed every year . The
depreciation is charged at a certain rate on the original cost of the asset.
Written down value method -It is a method of providing depreciation
where the amount of depreciation goes on reducing every year. The
depreciation is charged on the written down value of the asset.
munotes.in
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106MODULE -VII
9
INVENTORY CONTROL
Unit structure
9.1Objectives
9.2Introduction
9.3Definition ofInventory
9.4Purchase ofMaterials
9.5Methods ofStock Taking
9.6Inventory /Material Control Systems orTechniques
9.7Stock Levels
9.8Economic Re-Order Quantity Solved Problems
9.9Inventory Turnover Ratio
9.10Questions
9.1OBJECTIVES
After studying the unit the students will be able to
•Define the concept Inventory and explain the various costs related to
Inventory.
•Explain the material purchase procedure.
•Discuss about the function in storing the m aterial.
•Know the techniques of Material Control.
•Solve the practical problems related to Stock Levels, EOQ and
Inventory Turnover Ratio.
9.2INTRODUCTION
Inventory means stock ofitems kept inreserve forcertain period of time.
It includes raw materials, wor k-in-progress or semi -finished goods,
finished goods and spare parts for the maintenance ofequipment etc.Raw
materials arethose inputs that areconverted into finished products. Work
in progress represents semi -finished goods that requires some work b efore
they are ready for sale. Finished products arethose which are ready for
sale. Inventory isthephysical stock ofitems thatabusiness orproduction
organisation keeps in hand for efficient running of its production function.munotes.in
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1079.3DEFINITION OFINVENTOR Y
9.3.1Meaning andDefinition
According to Gordon B. Carson , inventory includes raw materials and
component parts. Inventories consist of raw material, component parts,
supplies and finished assemblies which an organisation purchases from an
outside source and parts, assemblies and finished products which the
company manufactures itself. In simple words inventory means 'stock
items' or items in stock.
It is very essential that material of the correct quantity and quality is made
available as and when required, w ith due regard to economy in storage and
ordering costs, purchase prices and working capital. Inventory control
involves (i) Assessing the items to be held in stock. (ii) Deciding the
extent of stock holding of items individually and collectively. (iii)
Regulating the input of stock into the store houses and (iv) Regulating the
issue of stock from the stores houses.
9.3.2 COST OF INVENTORY
Inventory control is generally concerned with the procurement of raw -
materials and purchased parts (i.e. components) a nd their supply to the
production departments. Supplies and stores are the indirect materials.
They do not form a part of the finished products. They are closely related
to the maintenance services and so they should be controlled by the
maintenance depart ment. Work -in-progress is primarily concerned with
the manufacturing department, because it is results from the various
operations performed on the shop. It is proper to assign the control
functions of work -in-progress to manufacturing department.
Every b usiness organisation, however big or small, has to maintain
inventory and it constitutes as integral part of the working capital. It has
been estimated that inventory in Indian industries constitutes more than
60% of current assets. Inventories are signifi cant elements in cost process.
Inventories require a significant investment, not only in acquiring them
but also in holding them. The various types of cost of inventory are as
follows :
Cost of Inventory
Ordering Stockout Acquisition Start -up Quality
Costs Costs Costs Costs
1. Ordering Costs: Each time we purchase a batch of raw material from a
supplier, a cost is incurred for processing the purchase order, expediting,
record keeping, and receiv ing the order into the warehouse. Each time we
produce a production lot, a changeover cost is incurred for changing
production over from a previous product to the next one. The larger the lotmunotes.in
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108sizes, the more inventory we hold, but we order fewer times duri ng the
year and annual ordering costs are lower.
2. Stockout Costs: Each time we run out of raw materials or finished -
goods inventory, costs may be incurred. In finished -goods inventory,
stockout costs can include lost sales and dissatisfied customers. In raw-
materials inventory, stockout costs can include the cost of disruptions to
production and sometimes even lost sales and dissatisfied customers.
Additional inventory, called safety stock , can be carried to provide
insurance against excessive stockouts.
3. Acquisition Costs: For purchased materials, ordering larger batches
may increase raw -materials inventories, but unit costs may be lower
because of quantity discounts and lower freight and materials -handling
costs. For produced materials, larger lot size s increase in -process or
finished -goods inventories, but average unit costs may be lower because
changeover costs are amortized over larger lots.
4. Start -up Quality Costs: When we first begin a production lot, the risk
of defectives is great. Workers may be learning, materials may not feed
properly, machine settings may need adjustment, and a few products may
need to be produced before conditions stabilize. Larger lot sizes mean
fewer changeovers per year and less scrap.
9.4PURCHASE OF MATERIALS
There is a purchase department which carries out the function of purchases
of materials. The purchase manager is responsible for ensuring the items
ordered are of the standard quality, lower cost and received in time. The
purchase procedure vary with different bus iness firms. The purchase
procedure is given below:
a) Purchase Requisition:
Purchase requisition is the formal request made by the storekeeper to the
purchase department for giving order of raw materials or stores. It serves
the dual purpose of authorizin g the purchase department to make
purchases and provides a record of the description and quantity of
materials required. It also fixes the responsibility of the department or
personnel making purchase requisition.
b) Purchase order: -
After receiving the du ly approved requisition, the purchase department has
to place an order with a supplier. It is an offer to buy certain materials at
stated price and terms. For routine purchases, the order is placed through
established supplies. In other cases, the purchase department may ask for
bids or send out request for quotation before placing an order. The
purchase order is a formal contract for the supply of materials. Copies of
the purchase order are sent to the departments concerned.munotes.in
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109c) Receiving and Inspection of materials:
The stores department is responsible for taking delivery of packages and
to get a physical verification of the contents. When the materials are
received, the stores official gets the packages, open them and make a
detailed verification of the c ontents. After the contents of the packages are
checked, the details are entered into a Goods Received Note. Copies of the
G.R.Note are issued to the supplier, purchase and accounts department,
where the factory has to test the materials received for quali ty and
specifications. It has to ensure that the quality of materials is as per
purchase order.
d)Approval of Invoices and Payment
Invoice received by the purchase department is forwarded to the Accounts
department for payment with their recommendation. A ccounts department
has to check the authenticity, arithmetical accuracy and G. R. Note in
order to make sure that the goods are as per purchase order. When it is
found that everything is in order, it is passed for payment by the
Accountant. Then the cashie r will draw the cheque as per terms and
conditions of the purchase order and invoice and finally payment is made
to the supplier.
9.5METHODS OF STOCK TAKING
9.5.1 Meaning
Methods of taking inventories / stockMethod of Inventory(2) Perpetual inventory Method (1) Periodic inventory method.
1.Periodic invent ory method :
Under this method of taking inventories, value of stock is determined by
physical counting of the stock on the accounting date of preparation of the
final accounts. It is possible that stock taking may take a week or so in
large enterprises an d purchases and sales may have to be suspended for
that period to get correct figure of closing inventory. This method of
ascertaining the value of stock at the end of the year is also known as
annual stock taking. Thus this method is based physical stock taking. It
provides data once in a year is simple and economical method of
stocktaking can be adopted in small concerns, but it does not provide basis
for control.
2.Perpetual Inventory Method :
Perpetual inventory defined as a system if records maintained b yt h e
controlling department, which reflects the physical movements of stock
and their current balance. Under this method stock registers are
maintained to make a record of the physical movements of stock and theirmunotes.in
Page 110
110current balance. Stores ledger is maintai ned to keep a record of the receipt
and issue of the materials and also reflects the balance in store. Similarly,
work -in-progress ledger is maintained to give the value of work -in-
progress on hand and a finished goods ledger is maintained to know the
value of finished goods on hand. Thus this system provides a running
record of inventories on hand at any time. To ensure the accuracy of
perpetual inventory records physical verification of the inventory is made
by a program of continuous stock taking.
It is possible that the balance of stock by the perpetual inventory may
differ from the actual balance of stock as ascertained by physical
verification. Any difference noted between actual stocks as disclosed by
the physical verification and the stocks shown by stock records should be
investigated and rectification made then and there. If the physical
verification reveals that actual balance of stock, is more that the balance
shown by the stores ledger or work -in-progress ledger or finished goods
ledger debit not e is prepared and stock record are adjusted accordingly so
that balance may reconcile with actual balance. A Stock Adjustment
Accounts is prepared and debited with the shortage of stock and credited
with surplus.
Continuous stock taking is an essential fea ture of the perpetual inventory
system. But the two terms, perpetual inventory and continuous stock
taking should not be taken as one; perpetual means the system of stock
records and continuous stock taking whereas continuous stock taking
means only the ph ysical verification of stock records with actual stocks.
In continuous stock taking, physical verification is spread throughout the
year. Every day 10 to 15 items are taken at rotation and checked so that
surprise, element in short verification is maintai ned and each item is
checked for a number of times during the year. On the other hand, surprise
element is missing in case of periodical checking because checking is
usually done at the end of the year. In short this method is based on
records. It requires a lot of recording and is thus expensive. It can be
adopted only in big concerns. It provides data on running basis and thus
facilitates the preparation of financial statements at shorter intervals. It
also provides basis for control by investigation the basis for control by
investigation the discrepancies arising from the comparison of physical
stock with their book values.
Difference between Periodic inventory and Perpetual inventory.
The following are the main differences between the two methods of tak ing
inventory.munotes.in
Page 111
111Periodic Inventory Perpetual Inventory
1.It is based on physical
stocktaking1. It is based on records.
2.It provides data periodically
i.e. once in year.2.It provides the data on running
basis and thus facilitates the
preparation o f financial statements
at shorter intervals.
3.It does not provide basis
control.3.It provides basis for control by
investigating the discrepancies
arising from the comparison of
physical stock with book values.
4.It is simple and economical
method of taking inventory
and can be adopted in small
concern.4.It is expensive as it requires a lot of
recording due to an elaborate
method of taking inventory. It can
be adopted by big concerns only.
9.6INVENTORY CONTROL SY STEMS OR
TECHNIQUES :
9.6.1 Meaning
Material control isthefunction ofensuring thatthesufficient stocks are
maintained to meet all requirement without any problem. Italso includes
toavoid carrying unnecessary stock. Itisforsafeguarding company’s
priority in the form of material s by keeping systematic records and
maintaining them atoptimum level considering requirements andfinancial
resources ofcompany’s business. It needs proper planning organising and
controlling the receipt andissues ofmaterial anditsstorage toachieve the
objectives ofthecompany efficiently.
9.6.2 Objectives ofmaterial control
a)Tomaintain continuous supply of material.
b)Toavoid over stocking ofmaterials
c)Toobtain minimum quantity ofmaterials from reliable sources.
d)Tominimize total cost.
e)Toavoid wasteandlossofstock during storage period.
f)Tomaintain updated stock level.
g)Tosupply required information tothemanagement indecision
making anditsexecution process.munotes.in
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1129.6.3 Techniques ofMaterial Control
Various techniques are used in controlli ng the inventories. Some popular
and important techniques are as under :
A. Re -order Point (ROP).
B. Economic Ordering Quantity (EOQ).
C. ABC Analysis.
A.RE-ORDER POINT (ROP) :
Receiving and issuing of inventories are the common and recurring
phenomena in a manufacturing organisation. When the inventories fall
below a particular point, they are replenished by the fresh purchases. Re -
order point (ROP) is the point when the inventories have to be replenished
by fresh order. It fundamentally deals with ‘when to order’ or to replenish
the inventories.
Re-order point is a stock level at which fresh supplies of materials
should be ordered. The level is fixed between somewhere between
minimum level and maximum level. It is fixed in such a way that fresh
supply of ma terials are received before the level reaches the minimum
level. The re -order point also called re -order level depends upon two
factors:
(a) Maximum consumption and (b) Lead time i.e. the anticipated time lag
between the dates of issuing orders and receivi ng supplies. The formula
for calculating re -order level is :
Re-order Level = Maximum usage × Minimum re -order period.
Re-order Quantity : Re-order quantity is the quantity for which an order
is placed when stock reaches the re -order level. The term is use d generally
in synonymous with the Economic Order Quantity since order is placed
only in such size which will be economical for the enterprise in all respect.
B.ECONOMIC ORDER QUANT ITY :
The Economic Order Quantity (also known as re -order quantity)
refers to the size of the order which gives the maximum economy in
purchasing any material. It is an optimum or standard order size. When the
stock reaches the recorder level, the company should give a fresh order of
optimum size.
This quantity is also called "Econ omic Purchase Quantity, or Economic lot
size, or optimum lot size or Minimum Cost Inventory."
In fixing the economic order quantity, the following costs are considered:
1. Ordering Cost : This is the cost of placing an order with the supplier
and includes cost of stationery, salary of those who are engaged in placingmunotes.in
Page 113
113a order and in receiving and inspecting the materials. It is a fixed cost and
therefore cost of placing an order varies from time to time depending upon
the number of order placed and the quant ity of items ordered. The number
of orders increase, the ordering cost goes up and vice -versa.
2. Inventory Carrying Cost : It is the cost of holding the stock in storage
and includes interest on investment, obsolescence losses, store keeping
cost, such as rent of warehouse, salary of store keeper, stationery used in
maintaining records of stores, etc, insurance cost, deterioration and
wastage of material. The larger the volume of inventory, the great will the
inventory carrying cost and vice -versa.
The abo ve two costs are of opposite nature. If for example, an attempt is
made to reduce of inventory carrying cost by holding the stores as low as
possible, the number of orders will increase and consequently the ordering
cost will go up. On the other hand, if o rders are placed for a larger
quantity, the inventory carrying cost will increase and ordering cost, the
economic order quantity (EOQ) is fixed to keep the aggregate cost to the
minimum.
Assumptions of Economic Order Quantity (EOQ) : The EOQ model is
based on the following assumptions:
(i) There is only one product involved; (ii) Annual usage (demand)
requirements are known; (iii) Usage is spread evenly throughout the year
so that the usage rate is reasonably constant; (iv) Lead time does not vary;
(v) Each order is received in a single delivery and (vi) There are no
quantity discounts.
Precautions in Applying EOQ : The following precautions are necessary
in applying E.O.Q.
1. Simplification of Routine : If the E.O.Q. formula tells us that 13 orders
have to be placed in a year, we may place 12 orders, i.e. once a month.
2. Ordering in Package Sizes : Many goods are packed in units of one
gross. If figure shows a quantity of 11 dozens, it should be changed to 12
dozens.
3. Economical Freight Rates : If the mat hematical figure gives 9/10th of
a lorry or rail wagon load, it is better to increase the quantity to have one
full lorry load or one full wagon load. This would be cheaper, because the
full wagon load rates would be lower than transporting the material as
smalls.
4. Perishable Articles : For perishable articles whose shelf -life is very
low, E.O.Q. should be very much less than the theoretical figure and
should be based on practical considerations.
5. Seasonal Articles : For articles of a seasonal nature, e .g., cotton or
groundnuts or oilseeds, bulk purchases during the season will be cheaper
than purchases based on E.O.Q.munotes.in
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1146. Bulk Purchases : In certain cases, considerable discounts would be
available for bulk purchases. This should be compared to the saving sa sa
result of the application of E.O.Q. formula and a decision should be taken
based on which is creeper.
7. Import of Materials : E.O.Q. cannot be successfully applied in the
case of imports of materials which is based on import licences.
Importance of Economic Order Quantity (EOQ) : If re-order quantity
is determined in advance and adjusted it en sures the following advantages
1. The cost of storage can be kept at a minimum.
2. Purchase orders can be easily prepared at intervals.
3. The advantages of pl acing large orders can be derived as far as possible.
Limitations of Economic Order Quantity (EOQ) : The following are
the limitations of EOQ:
(a) Where rate of consumption fluctuates very often ordering a fixed
quantity may lead to over or under stocking.
(b) Very often, consumption rate cannot be anticipated because of certain
unavoidable reasons such as power failure, slackening of customers’
demand etc.
(c) Sometimes, estimating of carrying cost and ordering cost in advance is
not easy.
C.A.B.C. ANALYSIS:
A most useful guide to devising stock control system is often known as
'Pareto Analysis' (after the name of an Italian Philosopher). The term is
also known as ABC analysis because it analyses the range of stock items
held into three sectors, known as A, B and C.
ABC analysis is a new technique of classifying and controlling production
and store inventories both purchased and manufactured in accordance with
value of the item. It is the starting point for material management. It is the
basic analytical manag ement tool which enables top management to place
the effort where the results will be greatest. The technique is popularly
known as Always Better Control or the Alphabetical approach. The
technique tries to analyse the distribution of any characteristic by money
value of importance in order to determine its priority. In materials
management the technique has been applied in areas needing selective
control such as inventory, criticality of items, obsolete stocks, purchasing
orders, receipt of materials, insp ection, store -keeping and verification of
bills.
ABC analysis or classification is the principle of Selective Control of
inventories and a technique of grouping thousands of stock items handled
by an organisation. The principle involved is that the degree of control onmunotes.in
Page 115
115stock items and amount of safety stock carried should vary directly with
the consumption value of the item involved.
Advantages of ABC Analysis : The following are the advantages of ABC
Analysis :
1. Selective Control : This approach helps th e materials manager to
exercise selective control and focus his attention only on a few items when
he is concerned with lakhs of store items.
2. Control Inventories : By concentrating on 'A' class items, the materials
manager is able to control inventories and show visible results in a short
span of item.
3. Obsolete Stocks : By controlling the 'A' items obsolete stocks are
automatically pin pointed.
4. Clerical Cost : The system also helps in reducing the clerical cost and
better planning and improved inve ntory turnover.
5. Equal Attention : ABC Analysis has to be resorted to because equal
attention to A, B and C items will not be worthwhile and would be very
expensive.
Material cost is defined as cost of material of any kind or nature used for
the purpose of production of goods or services. Direct materials arethe
materials whose cost canbeattributed toa cost object in economical
feasible way and indirect materials are those whose cost cannot be directly
attributed to a particular cost object.
9.7 STOCK LEVELS
9.7.1 Meaning
Stock levels is the technique which fixes the stock control level in terms of
quantity for ensuring the optimum quantity of materials purchased and
stored. This raise the questions when to buy and where from tobuyand
helps themana gement while preparing budget andschedule ofpurchases.
A.Maximum Level :-
This level of stock indicates the maximum figure of inventory quantity
held in stock at any time. The quantity of stock should not exceed the
level.
Following factors should beconsi dered while fixing themaximum level of
various stock.
1.Re-order level :-Theproduct ofmaximum consumption ofinventory
item andits maximum delivery period.
2.Minimum Consumption: -Minimum Consumption andminimum
delivery period for each stock should beknown.munotes.in
Page 116
1163.Adequacy ofworking capital :-Itshould know tomaintain
maximum level ofinventory.
4.Storage space :-Itshould bestored properly instores.
5.Additional storage cost:-Cost required foradditional storage should
beconsidered.
6.Additional insurance costshould be considered.
7.Regular supply :-Incase ofimportance materials due totheir
irregular supply, the maximum level should behigh.
Maximum Level = (Reorder level) +(Reorder quantity) –(Maximum
consumption xMinimum Reorder period)
B.Minimum Leve l:-
Minimum level shows the lowest figure of inventory balance, which must
bemaintained inhand atalltimes, sothat there isnostoppage of
production due tonon-availability inventory. This level is possible to
maintain fixed level after takking into consideration the rate of
consumption and the time required to acquire sufficient material toavoid
dislocation of production.
Factors responsible tomaintain minimum level ofinventory.
a.Average rateofconsumption foreach inventory items.
b.Maximum consum ption andmaximum delivery period inrespect of
each item to determine itsre-order level.
c.Average re-order level toeach item. This period canbecalculated
by averaging minimum and maximum period.
Minimum level =(Reorder level) –
(Average consumption xAverage/Normal Reorder Period)
C.Re-order level
This level is between the minimum and maximum levels in such away at
which purchase requisition should be made out for fresh supply. The
object of maintaining this level is to place order so that stock isnot
reduced to alevel lessthan the minimum level.
Following factors areconsidered white maintain thisre-order level.
1.Maximum consumption
2.Maximum Re-order period
3.Minimum level
Re-order level =M i n i m u m level +(Normal Consumption xNormal
Reorder Period)munotes.in
Page 117
117OR
= (Maximum Consumption xMaximum Re-order Period)
C.Average stock/ inventory level :-
Itisthelevel ofaverage ofminimum level and Maximum level. It
means theaverage level ismaintained instates.
Average stock level =Maximum level Minimum le
2
E.Danger level :-OR
=M i n i m u m level + ½ reorder quantity
This is the level below the minimum stock level. When stock reaches this
level, immediate action is need to take for replacement of stock. If the
stock is reached at this level, the normal lead time is not available and
hence regular purchase procedure can not be adopted. This may results in
high cost remedial action only. If this is fixed below the re -order level and
above minimum level it will be possible to takepreventive action.
Danger level =(Average rateof consumption) xurgent supply time
OR
=(Normal consumption) x(maximum re-order
period foremergency purchases)
9.3.2SOLVED PROBLEMS
1)In Aniket and Co, weekly minimum and maximum consumption of
material ‘A’are50and120units respectively. Thereorder quantity as
fixed bythecompany is350units. Thematerial isreceived within 4to
6weeks from issue of supply order.
Calculate thefollowing.
a)Minimum level
b)Maximum level
c)Re-Order level
Solution : -Average consumption = (50+120)/2 =170=85
2
Average re-order period =(4+6 )x2=5weeks
a)Re-order level =Maximum consumption xMaximum Re-order
period
=85x6munotes.in
Page 118
118=510 units
b)Minimum level =(reorder level)
(Average consumption xAverage re-order period)
=510 (85x5)
=510-425
=85units
c)Maximum level= Re-order level +R e-order quantity
(minimum consumption xminimum Re-order period)
=510+350 (50units x4weeks)
=860-200
=660units.
2)The following information isavailable inrespect ofmaterial in
ABC Co.LtdofAurangabad,
a)Re-order quantity =2 , 5 0 0 units
b)Re-orderperiod =6to8weeks
c)Maximum consumption =6 0 0 units per week
d)Normal consumption =300 units per week
e)Minimum consumption = 200 units per week calculate
i) Re-order level
ii)Minimum level
iii)Maximum level
iv)Average stock level
Solution
i)Re-order level =Maximum consumption xMaximum Reorder period
=600x8=4800 units
ii)Minimum level =(Re-order level) (Normal consumption x
(Average Reorder period)
=4800(300 x86)
2
=4800 (300 x7)munotes.in
Page 119
119=4800 -2100
=2700 units
iii)Maximum level=Re-order le velxReorder quantity
(Minimum consumption =Minimum Re-order period)
=4800 +2500 -(200 x6)
=7300 (1200)
=7300 -1200
=6100 units
iv)Average stock level =Minimum level Maximum level
2
=2700+6 100/2
=8800/2
=4400 units
9.8ECONOMIC RE-ORDER QUANTITY SOLVED
PROBLEMS
9.8.1 Formula tocalculate EOQ
Economic order Quantity =
Where A= Annual unit consumed / used O=Ordering costper
order
C=Annual carrying costofoneuniti.e.Carrying costpercentage p.ax
costperunit.
9.3.3Solved Problems Illustration 3
From the following particulars, calculate Economic Order Quantity and
number oforder tobeplaced intheyearbyusing
a)Tabulation method
b)Formula method
i)Annual consumption ofmaterial -6000 kg
ii)Cost ofplacing an order -`602A0cmunotes.in
Page 120
120iii)Cost perkg-`5
iv)Storage andcarrying cost-10%anaverage inventory.
Ans.
a)Tabulation method
Particulars Formula 1 2 3 4 5 6 7 8 9 10
Annual usageA 6000 6000 6000 6000 6000 6000 6000 6000 6000 6000
Order size Q 6000 3000 2000 15001200 1000 857 750 667 600
Ordering
cost p.u.O 60 60 60 60 60 60 60 60 60 60
Carrying
cost p.u.C=1 0 %
of`50.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50
No.
of
ordersN=A/Q 1 2 3 4 5 6 7 8 9 10
Total
carrying
costTC=Q
C1500 750 500 375 300 250 214 188 167 150
Total
Ordering
costTO=N
O60 120 180 240 300 360 420 480 540 600
Total
Annual
costTAC =
TC+TO 1560 570 680 615 600 610 634 668 707 750
Box indicates EOQ = 1200 unit. When 5 order of 1 200 kg each are placed,
the carrying cost 300 and the total cost 600 is thelowest.
Tabulation method is useful for computing EOQ when the order size / lot
is shifted, ii) Supplier offers volume discount that higher discount for
large quantities.
b)Form ulamethod
EOQ =
Where, A=Annual consumption –6000
kgO=costing ofplacing anorder –`602AOCmunotes.in
Page 121
1212600060
0.502600060100
50C= storage andcarrying costperunit =5x10=`0.50
100
EOQ = = =
=1 2 0 0 unit
Illustration 4
From thefollowing figures, calculate Economic order Quantity and
order tobeplaced fornumber kgineach year.
Annual consumption ofmaterial :4000 kgCost per unit =Rs.20Perkg
Cost ofBuying perorder =Rs5/-
Storage andcarrying cost =8 7 . 0a v e r a g e inventory
Ans. EOQ =
Where A=Annual usage –4000 kg
O=cost ofbuying per order =5/-
C=cost perunit=2/-
S=storage andcarrying cost
EOQ =
=
=
= 500kg
Illustration 5
From the following information, calculate EOQ Semi -Annual
consumption –6000 units Purchase price ofinput unit–`25/-
Ordering costperorder –`45/-Quarterly carrying cost–3%1440000
2AOCS
24000 58%of2400000.16250000munotes.in
Page 122
122EOQ =
=
= 600 units
Illustration 6
PQR Ltdproduces aproduct which hasmonthly demand of52,000 units.
The product requires a component xwhich purchased at 15 / -per unit. For
every finished product, 2 unit of component xare required. The ordering
cost is 350 / -per order and carrying cost is12%p.a.
You arerequired
a)Calculate Economic Order Quantity forcomponent ‘X”.
b)Ifminimum lotsize issupplied 52000 units what istheextra cost,
thecompany hastoincur?
c)What istheminimum carrying cost, thecompany has toincur?
Ans. Annual consumption ofcomponent “x”
52000 units x12months x2 =12,48,000 unitsEOQ = 2A
O
C
Where, A=Annual consumption =6000 x2=12000 units
O=Ordering costperorder = `45/-
C=Annual carrying cost ofoneunit =3%of25x4
=3x25
100x4=`3
21200045
3
3,60,000
2AOCmunotes.in
Page 123
12312310020515a)Economic order Quantity =
Where A=Annual consumption=12,48,000 units O=Ordering cost Due
order =`350/-
C=Annual carrying cost= x3
xEOQ =
=
=
=22030 units
Illustration 7
A manufacturer has to supply to hi s customer 600 units of his produce per
year. Storage is not allowed and the inventory carrying cost amounts to
`0.60 perunitperyear. Thesetupcostperrunis`80
Find the
a)Economic order Quantity,
b)Minimum average yearly cost,
c)Optimum number oforder peryear and
d)Optimum period of supply peroptimum order.
a) Economic order Quantity =
Where A =Annual usage -600 units
S =set–up cost per run -`80
C =carrying cost per unit -`0.60
xEOQ =21248000 `350`151210087,36,0000018010087,36,00000108
260080
0.60munotes.in
Page 124
124=
=400 units
Optimum number of orders p.a
Optimum number of order per year =Annual usag
EOQ
=600
400
=1.5
Since number of order can not be fractional we round it off to the next
whole number. Thus, optimum number of order per year = 2
Minimum Average yearly cost
Minimum Average yearly cost = set up cost + carrying cost
= `160 + `120
= `280
xset–up cost = `80x2=`160
Carrying cost =Average inventory xcarrying cost per unit
= 400x0.60
2
= `120
Optimum supply period per optimu mo r d e r
Optimum supply period per optimum order =EOQ /Average
monthly requirement
=
= 4001,60,000
400600munotes.in
Page 125
125Illustration 8
Afirm’s inventory planning period isoneyear. Itsinventory requirement
for this period is 1,600 units. Assume that its order costs are`50/-order.
Thecarrying cost expected to be
`1perunit per year foranitem.
Thefirm canproduce inventories inthevarious lots asfollows :
i)1,600 units ii)800 units iii)900 units iv)200 units and
v)100 units
Which ofthese order quantities is the economic order quantity ?Use
a)Equation method b)Tabulation method.
Ans:a)Equation method
EOQ =
Where, A=Annual usage –1600 units
O= Ordering cost per order -`50
C= Carrying costper unit perannum. `1
EOQ =
=
=400 units
b)Tabulat ionmethod
Inventory costfordifferent order Quantities
Particulars Formula 1 2 3 4 5
Annual usage A 160016001600 1600 1600
Order size Q 1600800400 200 1002AOC
2160050
11,60,000munotes.in
Page 126
126Ordering costperorder O 50 50 50 50 50
Carrying costp.u.p.a. C 1 1 1 1 1No.oforders N=A/Q 1 2 4 8 16
Total Ordering cost TO=NO 50100200 400 800
Total carrying cost TC=QC 800400200 100 50
Total Annual cost TAC =TC+TO 850500400 500 850
It can be seen from the table that the carrying and ordering cost taken
together arethelowest fortheorder size400 units. Therefore, Economic
order Quantity is 400units.
9.9INVENTORY TURNOVER RATIO
9.9.1 Meaning
There are several items in the stores which are issued to the production
after long gap from the date of purchases. There are several other items
which arenever issuedtotheproduction asthey have become outdated
which needs to be disposed off. These items need tobeidentified sothat
management canavoid thecapital locked up in such items. It is necessary
to compute the inventory turn over ration forfinding theseitems. This
ratio indicates not only replacement of stock during theyear butthe
efficiency orinefficiency with inventories are maintained inthe
organisation. This ratio measures how quick sales of inventories is done. It
isthetestofefficient inventory management. Ahigher inventory turnover
ratio indicates good inventory management. A low inventory turnover
ratio may adversely affect the ability of an organisation to meet
consumer’s demand and not cope up with requirement.
9.9.2 Formula
This ratiomeasures relationship between cost ofgoods sold andthe
inventory level. Inventory turnover ratio iscalculated as follows :
Inventory turnover ratio =Cost ofgoods sold or material consumed
/Average Inventory orStock
=................................ ................................ .............. times
Where, costofmaterial co nsumed=opening stock +purchases -
closing stock
Average Inventory =Opening stock +Closing stock
2munotes.in
Page 127
127This ratio canalsobecalculate indays asfollows :
Inventory turnover ratio =Number o fdays inayear
Inventory Turnover Ratio
=Number ofdays
However serious limitation of this approach is that detailed data may not
beavailable inrespect ofinventory level and cost ofgoods. In or der to
overcome this difficulties another approach for computation of inventory
turnover Ratio is used which is based on therelationship between sales
and closing inventory. Alternatively,
Inventory turnover Ratio =Sales
Closing Inventory
In short, of the two approach of calculating inventory turnover ratio, the
first which relates tothecost ofgoods sold toaverage inventory and
theoretically itissuperior whereas advantages ofsecondapproach isthatit
isfreefrom practical problems ofcomputations.
9.9.3 Solved Problems Illustration 9
The following date areavailable inrespect ofmaterial ‘Y’fortheyear
ended 31stmarch 2015
Particulars
Opening stock 1,10,000
Closing stock 1,50,000
Purchases during theyear 320000
Calculate )Inventory turnover Ratio
ii)Number of days for which average inventory is held.
Ans:-
Cost ofmaterial consumed =Opening stock +Purchases –
closing stock
=11,0000 + 32,0000 1,50,000
=2,80, 000munotes.in
Page 128
128Average Inventory=Opening stock +Closing stock
2
=110000 +150000
2
=260000
2
= 130000
Inventory turnover Ratio =Cost ofmaterial consumed
Average Inventory
=280000
130000
= 2.15 times
ii)Number of days for which average inventory isheld
=Number days in a year Inventory turnover ratio
=280000
130000
= 169. 76days OR 170days
Illustration 10
Inventory records ofAishwarya Ltd.Shows asfollowing information
:Particulars Material A MaterialBMaterial C
Opening stock 1400 kg 400 l iters 200kg
Purchases 23,000 kg 2200 liters 3600 kg
Closing stock 400kg 2400 liters 2400 kg
Inventory isvalued of`perkg and `2.5 per liter. Calculate material
turnover ratio foreach ofthematerials.
Ans:Material consumed =opening stock +purchases –closing stockmunotes.in
Page 129
129Material A= 1400 +2300 -400=2400 kg
Material B= 400+22000 -2400 =20,000 liter
Material C= 200+3 6 0 0 -2400 =1400 kgAverage Inventory=
Opening stock + Closing stock
Material A =(1400 +4 0 0 )/ 2=9 0 0 kg
Material B =(400 +2400) /2=1400 liter
Material C =(200 +2400) / 2=1 3 0 0 kg
Material turnover ratio =Cost ofmaterial consumed
Average Inventory orStock
Material Inventor =Number days inayear
I.T.ratio
Material A365
2.67
Material B =365
14.29
Material C365
1.08
Illustration 11
From the following data for the year ended 31stMarch 2015, calculate the
inventory turnover ratio of two items and put forward your comments on
them.
ParticularsMaterial ‘X’ Material ‘Y’
Opening Stock (01.04.2014) 30,00 0 27,000
Purchases (01.04.2014 to
31.05.2014)1,56,000 81,000
Closing Stock (31.03.2014) 18,000 33,000= 136.704 or137 days
= 25.542 or26days
= 337.962 or338 days
munotes.in
Page 130
130Ans:Cost ofMaterial consumed=Opening stock +Purchase -closing
stock
Material X Material Y
Average Inventory=
=
=30,000 +1 5 6 0 0 0 18000 =`168,000
27000 +81000 33000 =`75000
(opening stock + closing stock) x2
Material ‘X’ = (30,000 +18000) x2= `24,000
Material ‘Y’ = (27000 +33000) x2 = `30,000
Inventory turnover ratio =Cost ofmaterial consumed
Average Inventory orStock
Material ‘X’ =`168000 x`24000
=7Times
Material ‘Y’ =`75000 x`30,000
=2.5times
Comment :
Result :Comparatively inventory turnover ratio ofmaterial ‘X’is
higher than thatofmaterial Y(4.5times)
Decision : -Themanagement ofthisorganisation needs toconcentrate on
material yasitsturnover is2.5times only. Ithastoanalysis thecauses
and take remedial measures forremaining material idle forlong
time /period inwarehouse.
Illustration 12
From thefollowing information supplied bySanket Ltd,calculate
i)Inventory turnover Ratio
ii)Number of days for which theinventory is held.
Particulars Material ‘P’(E) Material ‘Q’(i)
Opening stock 30,000 45000
Purchases 2,00,000 3,00,000
Closing stock 45,000 50,000
Sales 36,000 4,50,000munotes.in
Page 131
131Ans:-
Cost of Material consumed=opening stock +Purchases closing stock
Material P =30,000 +2 0 0 0 0 0 45000 = `185000
Material Q =45000 +300000 50,000 = `29,5000
Average Inventory= (Opening stock +Closing stock) x2Material P
=(30,000 +45000) x2 =`375000
Material Q =(45000 +50000) x2 =`47,500
i)nventory turnover ratio =costofmaterial consumed
Average Inventor
Material ‘P’ =1,85,000 x37500 =4.93 =5
times
Material ‘Q’ =2,95,000 x47500 =6.21 =6
times Alternatively, Inventory turnover ratio isas follows :Inventory
turnover ratio = sales /closing inventory Material ‘P’ =
360000 /45000 =8times
Material ‘Q’ =450000 /50,000 =9 times
ii) Number of days for which theinventory isheld
xNumber ofdays =Number ofdays inayear
Inventory Turnover Ratio
Material ‘P’=365 =7 3 d a y s
5
Material ‘Q’ =365=6 1d a y s
6
9.10QUESTIONS
1.Define Inventory and explain the various costs of inventory? 2.Why we
donotwant tohold inventories?
3.What doyouunderstand byinventory control? Explain itsobjectives
andimport ance.munotes.in
Page 132
132
4.What are the selecting techniques of inventory control? 5.What is the
significance ofEconomic Order Quantity?
6.What are theobjectives ofInventory Control?
7.Write short notes onthefollowing :
a.Inventory,
b.Inventory control
c.Cost ofinventory,
d.ABCanalysis/Pareto analysis.
e.Inventory Turnover Ratio
8.Practical Problems
1)Following information isavailable from thebooks ofmanufacturing
company for material ‘X’ for the year ending 2015.
Normal usage 900 units perweek each
Maximum usage 1200 units per week each
Minimum usage 600 units perweek each
Reorder quantity 850 units
Reorder period 4to 6week
Calculate Re -order level, Minimum level, Maximum level and Average
stock level.
(Ans. Reorder level -7200 units, Minimum level –2700 units Maximum
level -5650 units, Average level -4,175 units)
2)From thefollowing information calculate
a)Re-order stock level
b)Minimum stock level
c)Maximum stock level
d)Average stock level
Re-order quantity -36000 units Time required for delivery -2to4months
Maximum consumptio n-9000 units per month Normal consumption -6000
units permonth
Ans:
a)Re-order -36000 units,
b)Minimum level -18000 units,
c)Maximum level -66000 units,
d)Average level -42000 unitsmunotes.in
Page 133
1333)Amanufacturing company produces aspecial product ‘Sorbina’ the
monthly deman d for which is 500 units. The following particulars are
available inrespect ofthematerial used formanufacturing product.
Compute :a)Economic Re-order quality
b)Re-order level
c)Minimum level
d)Maximum level and
e)Average level
(Ans. EOQ –250 units, Re -orders level –540 units. Minimum level –
240unts, maximum level –670units, Average level –455units.)
4)The following information is available from the books of a company
where two types of materials are used, namely A andB.
Normal usage – 300 units perweek each
Maximum usage– 450units per week each
Minimum usage – 150 units perweek each
Re-order quantity -A-2400 units, B -3600 units
Re-order period - A-4to6weeks, B-2to4weeks
Compute 1)Re-order level 2)Minimum level 3)Maximum level and
4)Average stock level
Ans.:
Material A Mate rialB
a)Reorder level 2700 units 1800 units
b)Minimum level 1200 units 900units
c)Maximum level 4500 units 5100 units
d)Average stock level 2850 units 3000 units
5)From the following particulars, compute Economic order quantity
Annual consumption -405000 units
Orderplacing andreceiving cost -`20per order Annual stock holding -20
%ofconsumption
(Ans. EOQ -9,000)Cost ofplacing an order - `120
Annual carrying costper unit - `12
Normal usage per week - 60units
Minimum usage per week - 30units
Maximum usage per week - 90units
Delivery period - 4to6weeks
munotes.in
Page 134
1346)X ltd. Produces a product that has monthly demand of 4000 units. The
product requires acomponent A,which ispurchased at`10 for every
finished pr oduct one unit at component, is required. The ordering cost is `
60 and the holding cost is 10% of per annum consumption.
Calculate Economic order Quantity
(Ans. EOQ =6,928)
7)From the following information, calculate Economic order Quantity by
using formul aandtabulation method.
Annual Requirement (unit) 6400
Ordering cost(perorder `) 100
Carrying costper unit (`) 8
Perunitprice( `) 80
Thefirm canproduce inventories in various lots such as
(T.Y.B.Com. M. U.Nov. 14)
8)Find theEconomic order Quantity from thefollowing information by
Tabulation andFormula method.
Annual Demand - 20000 units
Cost perarticle - `1
Inventory carrying cost - 15%
Cost per order - `15
(Ans. EOQ =2000 units.)
9)The following information relating toatype ofmater ialis
available.
Annual demand - 2000 units
Ordering cost - `20/-per order
Storage cost - `2%
Unit Price - `20/-
Interest due - 8%
Lead Time - .½monthi) 6400 units ii)3200 units iii) 1600 units
iv) 800 units v)400 units vi) 200 units
and vii) 100 units
(Ans. EOQ =400 units)
munotes.in
Page 135
135Calculate Economic order Quantity andInventory cost ofrawmaterial.
(Ans. EOQ= 200 units, Inventory cost=40400)
10) From thefollowing information, calculate Economic order Quantity
and the number of orders to be placed in one quarter of theyear.
i) Quarterly consumption ofmaterials -2000 kg
ii)Cost ofplacing anorder -`50
iii)Cost perunit-`40
iv)Storag eandCarrying cost-8%onaverage inventory
(Ans. EOQ -500units, No.oforders perquarter –04orders)
11) A manufacturer requires 9600 units of a certain commodity
annually. This is currently purchased from a regular supplier at `50per
unit. The cost of placing an order is `60 per order and annual carrying
costis`5perpiece. What is EOQ for placing an order ?
(Ans. EOQ -480units)
12) The following information is available from the books of M/s Mahi
Enterprises for the year 2015.
Particulars Material s‘A’(`) Material ‘B’ (`)Opening
stock 2000 3000
Purchases 26000 7000
Closing stock3000 3500
Calculate the material Turnover Ratio and determine which material is
moving fast.
(Ans. Material /Inventory Turnover Ratio –A–10times, B-2times)
13) From the following for the year ending 31stMarch 2015.
Compute
a)Cost ofmaterial consumed
b)Average inventory
c)Inventory Turnover Ratio
d)Number ofdays for which material is held.
e)Which material is moving fast.Particulars Materials No. 1( `)
Materials No. 2( `)Openin g stock (01.04.14) 10000 15000
Closing stock
(31.03.15)25000
5000
Purchases during the
year100000 75000munotes.in
Page 136
136(Ans. Materials No.1() Materials No.2(`)
a) Material Consumed 85000
b) Average Inventory 10000
c) Inventory Turnover ratio 4.85times 8.5timesd) No.ofdays formaterial
held75.25 days
75days 42.94 days
43days
e) Material 1ismoving fast)
14)Calculate stock holding period formaterial if,Opening stock
`12000, Closing stock -`10,000 andPurchases during theyear
`53000
Assumption :No.ofworking days inayear –364
(Ans. Material /Stock period –73days.)
15)From the following information, calculate
a)EOQ andb)Total annual carrying ordering cost atthat
quantity.
Semi annual consumption - 6000 units
Purchase price ofinput unit - `25
Quarterly carrying cost - 3%
Order costperorder - `45
(Ans. EOQ –600units, Total Annual carrying andOrdering Cost -`
1800)
16)From the following information, calculate EOQ and Total Annual
carrying and ordering cost at that quantity and material holding period
also.
Quarterly consumption -750units
Purchase price per unit -`25/-
Semi –Annual carrying cost-6%
Order costperorder -`45/-
(Ans. EOQ –300units, carrying andordering cost-`900)munotes.in
Page 137
13717)Calculate the stock turnover rat io from the following
Opening stock -`80000
Closing stock -`160000
Sales -`620000
Sales Return -`20000
Gross Profit Ratio -20% on sales
(Ans. Stock Turnover Ratio =4times)
Netsales 62000 -20000 `600000 ( ˜)
G.P.20%ofsales`12000
Cost ofGoods sold -480000
18)Calculate stock turnover Ratio and stock of material holding period in
days
Opening stock -`60000
Closing stock -`140000
Netsales -`300000
Gross profit @ -20%o n sales
Working days ofyear -365
(Ans. Stock turnover ratio –4times, Stock holding period –91.25 or91
days)
munotes.in
Page 138
13810
INVENTORY ACCOUNTING
Unit Structure:
10.1Objectives
10.2Stores Records
10.3Issue ofMaterials
10.4Pricing ofMaterials Issued
10.5First In First Out (Fifo)
10.6Average Cost
10.7Solved Problems
10.8Exercise
10.1OBJECTIVES
Afterstudying the unitstudents willbeableto:
Know theimportant store records.
Explain about issue of material.
Explain themethods of stock valuation.
Know the advantages and disadvantages ofFIFO method and
Average costmethod.
Solve theproblems of stock valuation.
10.2STORES RECORDS
The important function ofthestorekeeper istomaintain records of
receipts, issues andbalances ofvarious items ofmaterials. BinCard and
store ledger aretwoimportant stores records that are kept for making a
record of the various items at stores,
I)BINCARD :
A bin is a place where the materials are stored. It may be a shelf, an
aluvarch, open space etc. depending upon the nature of the commodity. A
bin card provides a quantitative record of the receipts, issues and balance
of materials. The bin cards are usually attached to or placed near to the
bin so that receipts and issues may beentered therein assoon astheymunotes.in
Page 139
139take place. Separate bin cards are prepared for each item of stores. Thus,
bin card provides acontinu ousrecord ofthestock ineach binandassist
thestorekeeper to control the stock. For each materials, the maximum
stock to be held are noted on the card. An ordering level is also indicated
therein so that fresh supplies may be ordered before the minimu m is
reached. As p e c i m e n ofthe bin card isgiven below:
II)Stores Ledger
Stores ledger is a continuous record of stores received and issued and
discloses thebalance inhand atanytime both inquantity and value. It
includes an account of each class o f materials and facilitates ascertainment
of all details relating to the material in minimum time. It provides
management with a perpetual inventory. Aspecimen ofthestores ledger is
given below:
10.3ISSUE OFMATERIALS
All materials in the stores are mean t for issue to various departments. The
procedure for the issue is normally laid down by themanagement. Themunotes.in
Page 140
140storekeeper issues materials tovarious department against material
requisition note, the specimen of which isgiven below: -
On receipt of materi al requisition, the storekeeper issues the necessary
materials after obtaining thesignature oftheperson receiving the
materials. Materials requisitioned from thestorekeeper andnotneeded
orfound tobedefective arereturned to the storeroom and a ret urned
materials report is prepared by the concerned person upon receipt of the
materials. Sometimes, it is necessary to return any rejected, excess or
damaged materials to thesupplier after making correct entries inthestores
ledger.
Materials are issued from stores on properly prepared and approved
materials requisition. Itisawritten order tothestorekeeper to deliver
materials to the place and the department. The materials requisition note
includes date, requisition number, department charged, name ofthestores,
ledger account tobecredited, description of materials, quantity, unit price,
total value, delivery point and the signature of the person requisitioning
thematerial and signature of the departments executive approving the
requisition or co mparatively fixed list of materials generally use a special
form ofmaterial requisition which iscalled as`bill ofmaterials’.
Materials requisitioned from thestores andnotrequired or found tobe
defective arereturned tothestores, where areturned material report is
prepared by the concerned person. The amount and value of materials
returned to the stores are deducted from total value of materials issued.
Similarly, the amount shown by materials returned is deducted from the
total amount charged to each department. Itmay benecessary toreturn
any rejected, excess ordamage materials tothesupplier. This also
requires some correction entries inthestores ledger.munotes.in
Page 141
14110.4PRICING OFMATERIALS ISSUED
When materials are purchased they are recorded at price atwhich they are
purchased after asking necessary adjustments for discounts, transportation
charges, cost of containers etc. But, when it comes to the issue of
materials, the problem arises with regard to theprice atwhich each issue
should berecorded because thedifferent quantities ofmaterials are
purchased atdifferent prices. Forthispurpose, anumber ofmethods of
pricing theissue ofmaterials areused which areasfollows: -
a) FIFO Method : -The first in first out method is used when the
materials received butaretobeissued first. Theprice oftheearliest lot/
quantity is taken first and then for the next lot. The value of closing stock
confirms more or less, to the current market price. This method issuitable
for falling price.
b) LIFO Method : -The last in first out method, is used when
materials received last are issued first. The storekeeper will charge the cost
price of the latest lot purchased. This is suitable in the times ofrising
prices.
c) Average Rate Method: -Under this method the materials are
issued ataprice which isanaverage price ofmaterials purchased. The
simple average is an average of prices without having regard to the
quantities involved. Weighted average price is used in order to avoid
fluctuation in price and reduce the number of calculations. Weighted
average of the total cost and total quantities ofmaterials purchased. is
calculated each time apurchase ismade.
10.5 FIRST IN FIRST OUT (FIFO)
10.5.1MEANING
Under the method the earliest lot of materials or goods p urchased
or goods manufactured are exhausted first and closing stock is out of the
latest consignments received or goods manufactured and is valued at the
cost of such goods. In other words: cost of goods sold is calculated
keeping in view the earliest lot s exhausted on the presumption that units
are sold in which they were acquired. In short under this method it is
assumed that goods or materials which are purchased first are issued first
stock consist of latest purchase. Hence items lying in the stock sho uld be
valued at latest purchase price.munotes.in
Page 142
14210.5.2ADVANTAGES
(1)This method is simple to understand and easy to operate.
(2)It is logical method because it takes a into consideration the normal
procedure of utilizing first those items of inventory which are received
or manufactured first.
(3)This method is very useful when prices are falling because cost of
goods so sold will be high on account of using earliest lots which are
costly.
(4)Closing stock is valued nearer the market price as it would cons ist of
recent purchase of units.
(5)This method is useful when transactions are not too many and prices
are fairly steady.
(6)This method is useful when inventory is subject to deterioration and
obsolescence.
10.5.3DISADVANTAGES
(1)This method incr eases the possible of clerical errors if the price
fluctuates, considerably as every time as issue of material is sold, the
store ledger clerk will have to go through his asctain the price to be
changed.
(2)If the prices fluctuate, comparison between dif ferent jobs executed by
the concern becomes difficult because one job started a few minutes
later than another of the same nature may have consumed the supply of
lower priced or higher priced stock.
(3)Market prices as it is calculated keeping in view the earliest last which
were purchased at lower rate.
10.6 AVERAGE COST
The principal on which the average cost method is based is that all items
on the store are so mixed up that consumption of material or sale of
finished goods cannot at the average cost of the various items onhand.
Average may beoftwotypes :
(a) Simple Average Method (not in syllabus)
(b) Weighted Average Method
.Weighted average method isquite superior toother methods
and it is better to follow this method. This method can be used with
advantage inthose cases where price and quantity vary widely. Themunotes.in
Page 143
143average rate does not change with issue but would vary with a fresh
supply of materials received when a new average will have to be
calculated, in a period of fluctuating price this method wil le v e n out the
fluctuations. This method is also goods as the weighted average rate lies in
between the extreme rates as shown by FIFO and LIFO method. However
the difficulty is that fresh calculations areneeded atevery purchase of
materials or goods.
10.7 SOLVED PROBLEMS
Illustration No. 1
From the following particulars prepared Stores ledger for the month of
Mar 08
(a) FIFO to “ABC”, (b) Weighted average to “XYZ”.
ABC XYZ
Stocks (kgs) on1 -3-2008 2000 @ Rs. 28 4,000 @ Rs. 13
Purchases (kgs)
[i]On11-3-2008 1,800 @ Rs. 27 2,500 @ Rs. 14
[ii]On 21 -3-2008 1,700 @ Rs. 25 2,000 @ Rs. 18
Sales (kgs)
[i]On 6 -3-2008 1,300 2,500
[ii]On 15 -3-2008 1,400 2,000
[iii]On 18 -3-2008 700 1,300
[iv]On 29 -3-2008 1,100 1,70
(IDE, Nov. 1999, adapted)
Solution :
(A) FIFO to “ABC”
STOCK LEDGER OF ABC
Date Receipts Issues Balance
Units Price Amt. Units Price Amt. Units Price value
01-3-2008 Opening - - - - - 2,000 28.00 56,000
06-3-2008 - - -1,300 28.00 36,400 700 28.00 19,600
11-3-2008 1,800 27.00 48,600 - - -700
1,80028.00
27.0019,600
48,600
15-3-2008 - - -700
70028.00
27.0019,600
18,9001,100 27.00 29,700
18-3-2008 - - - 700 27.00 18,900 400 27.00 10,800munotes.in
Page 144
144Date Receipts IssuesBalance
Units Price Amt. Units Price Amt. Units Price Amt.
21-3-2008 1,700 25.00 42,500 - - -400
1,70027.002
5.0010,800
42,500
29-3-2008 - - -400
70027.002
5.0010,8001
7,5001,000 25.00 25,000
Therefore, the value of stock of ABC as on 31 -3-2004 : 1,000 units @ Rs.
25.00 = Rs. 25,000
(B) Weighted Average (Under Perpetual System of Inventory)
STOCK LEDGER OF XYZ
Date Receipts IssuesBalance
Units Price Amt. UnitsWt. Avg.
RateAmt. Units Value
01-3-2008 Opening - - - - - 4,000 52,000
06-3-2008 - - - 2,500 13.00 32,500 1,500 19,500
11-3-2008 2,500 14 35,000 - - - 4,000 54,500
15-3-2008 - - - 2,000 13.63 27,250 2,000 27,250
18-3-2008 - - - 1,300 13.63 17,712 700 9,538
21-3-2008 2,000 18 36,000 - - - 2,700 45,538
29-3-2008 - - - 1,700 16.87 28,671 1,000 16,867
Working Notes :
1]Issued of XYZ on March 15 is valued at Rs. 13.63 which is the
weighted average rate, arrived at as follows :
19,500 35,000 54,50013.625r / o13.631, 5 0 0 2, 5 0 0 4 , 0 0 0
2]Issue of XYZ on March 29 is valued at Rs. 16.87 per kg. which is the
weighted average rate arrived at as follows :
9,538 36,000 45,53816.865r / o16.87700 2,000 2,700
Therefore, the value of stock as on 31 -3-2008 : 1,000 units @ Rs.
16.87 = Rs. 16,867munotes.in
Page 145
145Illustration : 2
From the following information relating A to Z item, value closing
stock on 31 -12-2008 applying –(a) FIFO, (b) Weighted average
Stocks (kgs) on 1 -12-2008 5,000 units @ Rs. 14
Purchases (kgs)
[i]On 18 -12-2008 4,200 units @ Rs. 13
[ii]On 23 -12-2008 3,800 units @ Rs. 9
Sales (kgs)
[i]On 7 -12-2008 1200 units
[ii]On 16 -12-2008 2600 units
[iii]On 19 -12-208 1800 units
[iv]On 30 -12-2008 3400 units
(IDE, Apr il 1999, adapted)
Solution :
(A)FIFO
STOCK LEDGER
Date Receipts Issues Balance
Units Price Amt. Units Price Amt. Units Price value
01-12-2008 Opening - - - - - 5,000 14.00 70,000
07-12-2008 - - - 1,200 14.00 16,800 3,800 14.00 53,200
16-12-2008 - - - 2,600 14.00 36,400 1,200 14.00 16,800
18-12-2008 4,200 13.00 54,600 - - -1,200
4,20014.001
3.0016,800
54,600
19-12-2008 - - -1,2006
0014.001
3.0016,8007
,8003,600 13.00 46,800
23-12-2008 3,800 9.00 34,200 - - -3,600
3,80013.009
.0046,800
34,200
30-12-2008 - - - 3,400 13.00 44,200200
3,80013.009
.002,600
34,200
Therefore, the value of stock as on 31 -12-2008 : 4,000 units @ Rs. 36,800munotes.in
Page 146
146B]Weighted Average (Perpetual Inventory system)
STOCK LEDGER
Date Receipts Issues Balance
Units Price Amt. UnitsWt. Avg.
RateAmt. Units Value
01-12-2008 Opening - - - - - 5,000 70,000
07-12-2008 - - - 1,200 14.00 16,800 3,800 53,200
16-12-2008 - - - 2,600 14.00 36,400 1,200 16,800
18-12-2008 4,200 13.00 54,600 - - - 5,400 71,400
19-12-2008 - - - 1,800 13.22 23,796 47,607 47,604
23-12-2008 3,800 9.00 34,200 - - - 7,400 81,804
30-12-2008 - - - 3,400 11.05 37,570 4,000 44,234
Working Notes :
[1]Issue on December 19 is valued at Rs. 13.22 which is the weighted
average rate, arrived at as follows :
16,800 +54,600 71,400== 1 3 . 2 2 2 r / o 1 3 . 2 21, 200 + 4, 200 5,400
[2]Issue on December 30 is valued at Rs. 11.05 per kg. which is the
weighted average rate arrived at as follows :
47,604 34,200 81 ,80411.054r / o11.053,600 3,800 7, 400
Therefore, the value of stock as on 31 -12-2003 : 4,000 units @ Rs.
11.05 = Rs. 44,2 34
Illustration : 3
Sumit Ltd. has purchased and issued the materials in the following order :
Month Date Particulars Units Cost Per Unit Rs.
August, 2003 01 Purchases 300 3
04 Purchases 600 4
06 Issues 500 -
10 Purchases 700 4
15 Issues 800 -
20 Purchases 300 5
23 Issues 100 -munotes.in
Page 147
147Ascertain the quantity of closing stock as on 31stAugust, 2003 and
sales what will be the value under the following methods.
[i]First in first out method. [ii] Weighted Average method.
(IDE, Nov. 2000, adapted)
Solution :
(A) FIFO
STOCK LEDGER
Date Receipts Issues Balance
Units Price Amt. Units Price Amt. Units Price value
1-8-2003 Opening - - - - - Nil Nil Nil
1-8-2003 300 3.00 900 - - - 300 3.00 900
4-8-2003 600 4.00 2,400 - - -300
6003.00
4.00900
2,400
6-8-2003 - - -300
2003.00
4.00900
800400 4.00 1,600
10-8-2003 700 4.00 2,800 - - -400
7004.00
4.001,600
2,800
15-8-2003 - - -400
4004.00
4.001,600
1,600300 4.00 1,200
20-8-2003 300 5.00 1,500 - - -300
3004.00
5.001,200
1,500
23-8-2003 - - - 100 4.00 400200
3004.00
5.00800
1,500
Therefore, the value of stock as on 31 -8-2003 : Rs. 2,300
[B]Weighted Average (Perpetual Inventory System)
STOCK LEDGER
Date Receipts Issues Balance
Units Price Amt. UnitsWt. Avg.
RateAmt. Units Value
01-8-2003 Opening - - - - - Nil Nil
01-8-2003 300 3.00 900 - - - 300 900
04-8-2003 600 4.00 2,400 - - - 900 3,300
06-8-2003 - - - 500 3.67 1,835 400 1,465
10-8-2003 700 4.00 2,800 - - - 1,100 4,265
15-8-2003 - - - 800 3.88 3,104 300 1,161
20-8-2003 300 5.00 1,500 - - - 600 2,661
23-8-2003 - - - 100 4.44 444 500 2,217munotes.in
Page 148
148Working Notes :
[1] Issue on August 6 is valued at Rs. 3.67 which is the weighted average
rate, arrived at as follows :
900 2,400 3,3003.666r / o3.67300 600 900
[2] Issue on August 15 is valued at R s. 3.88 per kg. which is the weighted
average rate arrived at as follows :
1, 4 6 5 2 , 8 0 0 4 , 2 6 53.877r / o3.88400 700 1 ,100
[3]Issue on August 23 is valued at Rs. 4.44 per kg. which is the weighted
average rate arrived at as follows:
1 ,161 1 ,500 2,6614.435r / o 4.44300 300 600
Therefore, th e value of stock as on 31 -8-2002 : 500 units @ Rs. 4.44 =
Rs. 2,217
Illustration : 4
Keep stock record on FIFO, and Weighted Average basis from the
following transactions:
Purchases : March 2004 .
Date Units Rate Per unit (Rs.)
01 500 18
04 700 20
09 900 18
15 300 25
25 200 20
31 500 25
Sales : March 2004
02 200 22
07 500 25
11 400 21
18 800 28
27 500 25
Find out the goods sold and the profit.munotes.in
Page 149
149Solution :
FIFO METHOD
STOCK LEDGER
Date Purchases Sales Stock
March, 2004 Units Rate Units Units × Rate = Amount
01 500 18 - 500x18 = 9,000
02 - - 200 300x18 = 5,400
04 700 20 - 300x18 = 5,400
700x20 = 14,000
19,400
07 - - 500 500x20 = 10,000
09 900 18 - 500x20 = 10,000
900x18 = 16,200
26,200
11 - - 400 100x20= 2,000
900x18 = 16,000
18,200
15 300 25 - 100x20 = 2,000
900x18 = 16,200
300x25 = 7,500
25,700
18 - - 800 200x18 = 3,600
300x25 = 7,500
11,100
25 200 20 - 200x18 = 3,600
300x25 = 7,500
200x20 = 4,000
15,100
27 - - 500 200x20 = 4,000
31 500 25 - 200x20 = 4,000
500x25 = 12,500
16,500
Value of stock under FIFO is Rs. 16,500.munotes.in
Page 150
150Profit when stock is valued under FIFO basis.
Opening Stock Nil Rs.
Add : Purchases
500 x18=9,000
700 x20=14,000
900 x18=16,200
300 x25=7,500
200 x20=4,000
500 x25=12,500 63,200
63,200
Less : Closing Stock (as valued under FIFO) 16,500
Cost of Goods Sold (A)46,700
Sales
200×22=4,400
500 ×25=12,500
400 ×21=8,400
800 ×28=22,400
500 ×25=12,500
(B) 60,200
Profit (B-A) 13,500
[B] Weighted Average (Perpetual Inventory System)
STOCK LEDGER
Date Receipts Issues Balance
Units Price Amt. UnitsWt.
Avg.
RateAmt. Units Value
01-3-2004 500 18.00 9,000 - - - 500 9,000
02-3-2004 - - - 200 18.00 3,600 300 5,400
04-3-2004 700 20.00 14,000 - - -1,000 19,400
07-3-2004 - - - 500 19.40 9,700 500 9,700
09-3-2004 900 18.00 16,200 - - -1,400 25,900
11-3-2004 - - - 400 18.50 7,400 1,000 18,500
15-3-2004 300 25.00 7,500 - - -1,300 26,000
18-3-2004 - - - 800 20.00 16,000 500 10,000
25-3-2004 200 20.00 4,000 - - - 700 14,000
27-3-2004 - - - 500 20.00 10,000 200 4,000
31-3-2004 500 25.00 12,500 - - - 700 16,500
Total 63,200 46,700munotes.in
Page 151
151Working Notes :
[1]Issue on March 7 is valued at Rs. 19.40 which is the weighted average
rate, arrived at as follows :
5, 400 14,000 19, 40019.40300 700 1 ,000
[2]Issue on March 1 1 is valued at Rs. 18.50 which is the weighted
average arrived at as follows :
9,700 16,200 25,90018.50500 900 1 ,400
[3]Issue on March 18 is valued at Rs. 20 which is the weighted average
rate on arrived at as follows :
18,500 7,500 26,000201, 0 0 0 3 0 0 1, 3 0 0
[4]Issue on Marc h 27 is valued at Rs. 20.00 which is the weighted
average rate, arrived at as follows :
10,000 4,000 14,00020500 200 700
Therefore, the value of stock as on 31 -3-2000 : 700 units Rs. 16,500.
[5]Cost of Goods sold = Opening Stock + Purchases –Closing Stock =
63,200 –16,500 = 46,700
[6]Profit = Sale –Cost of goods sold = 60,200 –46,700 = 13,500
Illustration : 7
Following are the purchases and sales of wheat in the months of March,
2004. Prepare a statement showing valuation of stock on the basis of (i)
FIFO and (ii) Weighted Average Cost method.
Date Purchases Rate Sales
2004 (Kg.) (Rs.) (Kg.)
March 1 600 4 -
4 - - 300
5 300 3.80 -
10 - - 200
18 200 4.20 -
23 - - 400
29 400 4.40 -
31 - - 300munotes.in
Page 152
152Out of purchases March 5, 50 Kgs. were returned to the s upplier on
March 8.
Out of Sales on March 23, a customer returned 20 Kgs. on March 26.
Solution :
FIFO
STOCK LEDGER
Date Purchases / ReturnsSales /
ReturnsStock
2004 Units (Kg.)Rate
(Rs.)Units
(Kg)Units × Rate = Amt.
Mar. 1 600 4 - 600x4= 2,400
04 - - 300 300x4= 1,200
05 300 3.80 - 300x4= 1,200
300x3.8 = 1,140
2,340
08 - - 50 300x4= 1,200
(Returns) 250x3.8 = 9,50
2,150
(Note –1)
10 - - 200 100x4= 400
250x3.8 = 9,50
1,350
18 200 4.20 - 100x4= 400
250x3.8 = 9,50
200x4.2 = 840
2,190
23 - - 400 150x4.2 = 630
26 20 4.20 - 170x4.2 = 714
(returns) (Note –2)
29 400 4.40 - 170x4.2 = 714
400x4.4 = 1,760
2,474
31 - - 300 270x4.4= 1,188
Value of Stock under FIFO is Rs. 1,188.munotes.in
Page 153
153Note : 1
50 Kgs. returned on March, 8 are out of March 5 Purchases, hence they
are shown as issued at a rate of 3.8 per Kg. and accordingly stock is
calculated.
Note : 2
Sales returns on March 26 are out of March 23 Sales. Under FIFO method
Sales on March 23 are out of Kg. 100 @ Rs. 4 + Kg. 250 @ Rs. 3.8 + Kg.
50 @ Rs. 4.2. Hence 20 Kg. received are priced at Rs. 4.20 per Kg.
B] Weighted Average (Perpetual Inventory System)
STOCK LEDGER
Date Receipts Issues Balance
Units Price Amt. UnitsWt. Avg.
RateAmt. Units Value
01-3-2004 600 4.00 2,400 - - - 600 2,400
04-3-2004 - - - 300 4.00 1,200 300 1,200
05-3-2004 300 3.80 1,140 - - - 600 2,340
05-3-2004 - - - 50 3.90 195 550 2,145
10-3-2004 - - - 200 3.90 780 350 1,365
18-3-2004 200 4.20 840 - - - 550 2,205
23-3-2004 - - - 400 4.01 1,604 150 601
26-3-2004 20 4.01 80 - - - 170 681
29-3-2004 400 4.40 1,760 - - - 570 2,441
31-3-2004 - - - 300 4.28 1,284 270 1,157
Working Notes :
[1] Issue on March 5 & M arch 10 is valued at Rs. 3.90 which is the
weighted average rate, arrived at as follows :
1, 2 0 0 1, 1 4 0 2, 3 4 03.90300 300 600
[2] Purchase returns of 50 kg. are out of the total stock of 600 kg. which
was valued at Rs. 3.90 per kg.
[3] Issue on March 23 is valued at Rs. 4.01 per kg. which is the weighted
average rate arrived at as follows :
1, 3 6 5 8 4 0 2, 2 0 54.01350 200 550
[4] Sales on March 23 are out of stock valued at Rs. 4.01 per kg. Hence
returns of 20 kg. are also taken at a rate of Rs. 4.01 per kg.munotes.in
Page 154
154[5] Weighted Average Rate on March 31 is arrived at as follows :
681 1 ,760 2,4414.28170 400 570
Therefore, the value of stock as on 31 -3-2008 : 270 units @ Rs. 4.28 = Rs.
1,157
Illustration : 8
A company deals in 3 products viz. A, B and C. The details for
purchases and sales for January 2004 are as under.
Product A B C
Units Rs. Units Rs. Units Rs.
Selling Price per Unit 100 200 250
Opening Stock 100 60 100 100 50 120
Purchases :
Jan9 300 65 200 110 50 135
Jan20 100 64 50 120 100 140
Jan29 50 68 50 125 20 130
Closing Stock 140 70 60
You are required to prepare a trading and profit and loss account for the
month assuming the selling and distribution expenses to be Rs. 63,000.
Use FIFO method for stock valuation.
Solution
Stock Ledger (FIFO Method)
Product –A
Date Purchases Sales Closing Stock
Qty. Rs. Qty. Qty. × Rs. = Amount
01-1-2004 - - 100 × 60 = 6,000
09-1-2004 4300 × 65 - 100 × 60 = 6,000
300 × 65 = 19,500
25,500
20-1-2004 100 × 64 - 100 × 60 = 6,000
300 × 65 = 19,500munotes.in
Page 155
155100 × 64 = 6,400
31,900
29-1-2004 50 × 68 - 100 × 60 = 6,000
300 × 65 = 19,500
100 × 64 = 6,400
50 × 68 = 3,400
35,300
Total Sales 100 ×60 90 × 64 = 5,760
During 300 ×65 50 × 68 = 3,400
January 10 × 64 9,160
410
Product –B
Date Purchases Sales Closing Stock
Qty. Rs. Qty. Qty. × Rs. = Amount
01-1-2004 - - 100 × 100 = 10,000
09-1-2004 200 × 110 - 100 × 100 = 10,000
200 × 110 = 22,000
32,000
20-1-2004 50 × 120 100 × 100 = 10,000
200 × 110 = 22,000
50×1 2 0 = 6,000
38,000
29-1-2004 50 × 125 100 × 100 = 10,000
200 × 110 = 22,000
50 × 120 = 6,000
50 × 125 = 6,250
44,250
Total Sales 100× 100 20 × 120 = 2,400
During 200 × 110 50 × 125 = 6,250
January 30 × 120 8,650
330munotes.in
Page 156
156Product C
Date Purchases Sales Closing Stock
Qty. Rs. Qty. Qty. × Rs. = Amount
01-1-2004 - - 50 × 120 = 6,000
02-1-2004 50 × 135 50 × 120 = 6,000
50 × 135 = 6,750
12,750
20-1-2004 100 × 140 - 50 × 120 = 6,000
50 × 135 = 6,750
100 × 140= 14,000
26,750
29-1-2004 20 × 130 - 50 × 120 = 6,000
50 × 135 = 6,750
100 × 140 = 14,000
20 × 130 = 2,600
29,350
Total Sales 50 × 120 40 × 140 = 5,600
During 50 × 135 20 × 130 = 2,600
January 60 × 140 8,200
160
Note:1
Number of units sold during January :
Product
A B C
Opening Stock 100 100 50
Add : Total Purchase 450 300 170
550 400 220
Less : Closing Stock 140 70 60
Units Sold 410 330 160munotes.in
Page 157
157Dr. Trading Account Cr.
ParticularsRs. Particulars Rs.
To Opening StockBy sales
A1 0 0×6 0= 6 , 0 0 0 A4 1 0×1 0 0=4 1 , 0 0 0
B1 0 0×1 0 0=1 0 , 0 0 0 B3 3 0×2 0 0=6 6 , 0 0 0
C5 0×1 2 0= 6,000 22,000 C1 6 0×2 5 0=4 0 , 0 0 0 1,47,000
To Purchases By Closing Stock
A 29,300 A 9,160
B 34,250 B 8,650
C 23,350 86,900 C 8,200 26,010
To Gross Profit c/d 64,110
1,73,010 1,73,010
Dr. Profit & Loss Account Cr.
Particulars Rs. Particulars Rs.
To Selling &
Distribution Expenses63,000 By Gross Profit b/d 64,110
To Net Profit 1,110
64,110 64,110
10.6 EXERCISE
1. Write short Notes
a.FIFO Method
b.Weighted average method
2. Practical problems
Problem I
Prepare a Stores Ledger Account from the following transactions
assuming that issue of stores have been made on the principle of and also
on “First in First Out”.munotes.in
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1582000
January 2 Purchased 2000 units at Rs. 4.00 per unit
January 20 Purchased 250 units at Rs. 5.00 per unit
February 5 Issued 1000 units
February 10 Purchased 3000 units at Rs. 6.00 per unit
February 12 Issued 2000 units
March 2 Issued 500 units
March 15 Purchased 2500 units at Rs. 5.50 per unit
March 20 Issued 1500 units (P.U.)
Ans. FIFO Stock :150 units at Rs. 5.50 =R s .8 , 2 5 0
Problem 15
Value the stock under Simple Average & Weighte dA v e r a g em e t h o d .
Receipt
01-1-2000 Opening stock 200 units at Rs. 3.50 per unit
03-1-2000 Purchased 300 units at Rs. 4.00 per
13-1-2000 Purchased 900 units at Rs. 4.30 per unit
23-1-2000 Purchased 600 units at Rs. 3.80 per unit
Issues
05-10-2000 Issued 400 units
15-10-2000 Issued 600 units
25-10-2000 Issued 600 units
Ans.
Issue Price rate 5th15th25thClosing Stock
a] Weighted
Average3.80 4.25 3.98 400 units Rs. 1,592munotes.in
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1593.Select thecorrect alternative:
1.In times of rising prices, the pricing of issues will be at a more recent
current market prices in
i)FIFO iii)LIFO
ii)Weighted Average iv)Simple Average
2.When prices fluctuate widely, the method that will smooth outthe
effect offluctuations is
i)Simple Average iii)FIFO
ii)Weighted Averag e iv)LIFO
3.The total cost of goods available for sale with a company during the
current year is Rs.12, 00,000 and the total sales during the period are
Rs.13, 00,000. Ifthegross profit margin ofthecompany is33%on
cost, theclosing inventory during thecurrent year is
i.Rs.4,00,000 ii. Rs.3,00,000
iii.Rs.2,25,000 iv.Rs.2, 60,000.
4.Consider the following for Alpha Co.for the year 2010 -11:Cost of
goods available forsaleRs.1, 00,000
Total sales Rs.80,000
Opening stock of goods Rs. 20,000 Gross profitmargin 25%
Closing stock ofgoods fortheyear 2010 -11 was i.Rs.80,000
ii.Rs.60,000
iii.Rs.40,000 iv. Rs.36, 000.
5.Record ofpurchase ofT.V. sets.
Date Quantity Price per unit
Units Rs.
March 4 900 5
March 10 400 5.50
Record ofissues March 5 600
March 12 400
Thevalue of T.V. sets on 15March, as perFIFO will be i.Rs.1,500
ii.Rs.1,650
iii.Rs.1, 575.
iv.None ofthethree.munotes.in
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1606.Afirm dealing incloth has15000 meters ofcloth onApril 1,
2005 valued atRs.1, 50,000 according toFIFO. Thefirm purchased
20000 meters @ Rs.12 per meter during the year ending 31st March,
2006 and sold 30000 meters @ Rs.25 per meter during the same
period. As per FIFO, the closing stock willbevalued at:
i.Rs.60,000
ii.Rs.1,25,000
iii.Rs.50,000
iv.None of the above.
7.Aminimum quantity ofstock always held asprecaution against outof
stock situation iscalled
i. Zero stock.
ii.Risk stock.
iii.Base stock.
iv.None of the above.
8.Opening stock oftheyear isRs.20, 000, Goods purchased during the
year is Rs.1, 00,000, Carriage Rs.2, 000 an d Selling expenses
Rs.2, 000.Sales during the year is Rs.1, 50,000 and closing stock is
Rs.25, 000. The gross profit willbe
i. Rs.53, 000.
ii.Rs.55, 000.
iii.Rs.80, 000.
iv.Rs.51, 000.
9.The cost of stock as per physical verification of Bharat Ltd. on 10th
April, 2011 was Rs.1, 20,000. The following transactions took place
between 1st April, 2011 to 10th April, 2011:
Cost ofgoods sold Rs.10, 000, Cost ofgoods purchased Rs.40,000,
Purchase returns Rs.6, 000
Thevalue ofinventory as perbooks on 31st March, 2011 willbe
i. Rs.1,56,000.
ii. Rs.1,51,000.
iii. Rs. 1, 50,000.
iv. Rs.1, 52,000.
Answers: 1-i,2-ii,3-iii,4-ii,5-ii,6-ii,7-iii,8-iv,9-i.
munotes.in
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161MODULE VIII
11
INTRODUCTION TO FUND FLOW
STATEMENT
Unit Structure
11.0 Learning Objectives:
11.1 Fund Flow Statement
11.2Benefits of Fund Flow Statement
11.3 Procedure of Preparation of Fund Flow Statement
11.4 Importance of Fund Flow Analysis
11.0 LEARNING OBJECTIVES
Understanding the concept of fund
Calculation of fund from operation
Calculation of changes in working capi tal
Preparation of statement of Sources & Application of Funds
11.1 FUND FLOW STATEMENT
Funds flow statement is a financial statement which shows as to
how a business entity has obtained its funds and how it has applied or
employed its funds between the op ening and closing balance sheet dates
(during the particular year/period). It can be described as –WHERE GOT -
WHERE GONE statement Funds usually refers to cash resources and funds
statement is prepared to show the net effect of various business events on
the current resources of the organization. In this topic fund should be
understood as working capital & funds flow as to mean any change in
working capital.
Funds Flow Statement is a statement prepared to analyse the
reasons for changes in the financial pos ition of a company between 2
Balance Sheets. It shows the inflow & outflow of funds i.e. SOURCES and
APPLICATIONS of funds for a particular period. In other words Funds flow
statement is prepared to explain the changes in the working capital position
of acompany. There are two types of inflows of funds –munotes.in
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162a.Long term funds raised by issue of Shares, Debentures or sale of
Fixed Assets
b.Funds generated from operations
If the long term fund requirements of a company are met just out of
the Long term Sources of f unds, then the whole fund generated from
operations will be represented by increase in working capital. However if
the funds generated from operations are not sufficient to bridge a gap of
long term fund requirement, then there will be a decline in working
capital.
11.2 BENEFITS OF FUND FLOW STATEMENT
Funds flow statement is useful for long term analysis. It is very
useful tool in the hands of the management for judging the financial &
operating performance of the company. The Balance Sheet and the Profit &
Loss A/c (Income Statement) fails to provide the information which is
provided by the funds flow statement i.e. changes in Financial Position of an
enterprise. Such an analysis is of great help to the management,
shareholders, creditors etc.
Fund Flow Sta tement answers the following questions
Where have the profits gone?
Why is there an imbalance existing between liquidity position and
profitability position of an enterprise?
Why is the concern financially solid in -spite of losses
Fund flow statement analy sis helps the management to test whether
the working capital has been effectively used or not and the working
capital level is adequate or inadequate for the requirements of the
business. The working capital position helps the management in taking
policy d ecisions regarding payment of dividend etc.
Fund flow statement analysis helps the investors to decide whether the
company has managed the funds properly. It also indicates the credit
worthiness of a company which helps the lenders to decide whether to
lendm o n e yt ot h ec o m p a n yo rn o t .I th e l p st h em a n a g e m e n tt ot a k ep o l i c y
decisions and to decide about the financing policies and capital expenditure
for the future.
11.3PROCEDURE OF PREPARATION OF FUND FLOW
STATEMENT
Step I -Prepare the statement of chang es in working capital
Step II -Analyse the changes in non -current assets and noncurrent liabilities
to find out inflow or outflow of fundsmunotes.in
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163Step III -Find out funds from operation
Step IV -Prepare statement of Sources & Application of Funds (Funds Flow
Statement)
Step –I
Step –II-Working Capital Changes
Increase in Current Assets –Increase in Working Capital -
Outflow
Increase in Current Liabilities –Decrease in Working Capital -
Inflow
Decrease in Current Assets –Decrease in Working Capital -
Inflow
Decrease in Current Liabilities –Increase in Working Capital -
Outflow
Step III –Finding Funds from Operations
In this step, we need to calculate the funds generated only from the
Operating activities of the business and not from the Investing / Fina ncingmunotes.in
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164activities of the business. The funds from operations shall be prepared as
follows:
Step –IV–While preparing the fund flow statement, the sources
and uses of funds are to be disclosed clearly so as to highlight the
sources from where the fund sh a v eb e e ng e n e r a t e da n du s e st o which
these funds have been applied. This statement is also sometimes
referred to as the sources and applications of funds statement or
statement of changes in financial position.munotes.in
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165
Sources of Funds
Issue of Equity & Pref erence Shares
Receipt of Securities Premium
Issue of Debentures
Receipt of Long Term Loans from Banks & Other Financial
Institutions
Receipt of Public Deposits & other Unsecured Loans
Sales of Fixed Assets, Sale of Investments
Extraordinary receipt awarded in legal suit
Income from long term investments
Funds from operations
Decrease in Working Capital
Application of Funds
Redemption of Preference share capital, Redemption of
Debentures
Premium paid on redemption of debentures and preference shares
Repaymen t of temporary loans, secured & unsecured
Purchase of Fixed Assets, Purchase of Investment
Extraordinary payments and non recurring losses like loss by fire &
damages paid
Payment of Dividend & Interim Dividend, Payment of Tax
Increase in Working Capital
Formats of Fund Flow Statement
There is no prescribed format as such for the preparation of Funds
Flow Statement. The only point to be remembered is that it should be
presented in a clear and systematic manner. However, Funds Flow
Statements may be prepared in any of the following formatsmunotes.in
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166Report Form –Remainder Type
Report Form –Self Balancing Type
Report Form –Reconciling Type
Fund Flow Analysis
Flow analysis consists of two different analysis namely
Working Capital Analysis –is the analysis & reporti ng of working capital.
Working capital is the excess of current assets over current liabilities. This
analysis consist of two statements namely
Statement of changes in working capital
Statement of Sources & Application of Funds
Cash Flow Analysis –is thea n a l y s i so fi n f l o w sa n do u t f l o w so f cash.
Cash flow analysis results in separate reports viz. Sources and
Applications of Cash Funds flow statement explains as to what caused the
changes in the balance sheet items between two balance sheet dates
11.4IMPORTANCE OF FUND FLOW ANALYSIS
Funds flow statement is an important financial tool, which analyze
the changes in financial position of a firm showing the sources and
applications of its funds. It provides useful information about the firm's
operating, f inancing and investing activities during a particular period. The
following points highlight the importance of funds flow statement.
1)Helps in identifying the change in level of current assets
investment and current liabilities financing.
2)Helps in analyzing the changes in working capital level of a firm.munotes.in
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1673)Shows the relationship of net income to the changes in
funds from business operation.
4)Reports about past fund flow as an aid to predict future
funds flow.
5)Helps in determining the firms' ability to pay inter est and
dividend, and pay debt when they become due.
6)Shows the firms' ability to generate long -term financing to satisfy the
investment in long -term assets.
7)Helps in identifying the factor responsible for changes in assets, liabilities
and owners' equity a t two balance sheet date.
munotes.in
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171
Important Terms
Fund –It refers to working capital, Flow –It is a movement of
fund
Current Items –It includes current assets and current liabilities
Non Current Items –It includes share capital, reserves, loans , fixed
assets, investments etc
Fund from Operation –it is the cash profit generated from
operationsmunotes.in
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172Working Capital –Excess of current assets over current liabilities is
called as working capital.
Theory Questions
1.Why are funds flow statements important ?
2.Explain –funds from operations
3. Explain the concept of fund & how the funds flow?
Practical Questions
munotes.in
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17312
INTRODUCTION TO CASH FLOW
STATEMENT
Unit Structure
12.0 Learning Objectives
12.1 Cash Flow Statement
12.2 Analysis of Cash Flow Statement
12.3 Cash Flow from Operating Activities
12.4 Cash from Investing Activities
12.5 Cash from Financing Ac tivities
12.6 Benefits/Importance of Cash Flow Analysis
12.7 Limitations of Cash Flow Analysis
12.8 Accounting Standard –AS3 on Cash Flow Statement
12.9 Distinction between Cash Flow V/S Funds Flow
12.0 LEARNING OBJECTIVES
Understanding concept of cash fl ow
Accounting standard for Cash Flow Statement (AS -3)
Preparation of Cash Flow Statement
Importance & Limitations of Cash Flow Statement
12.1 CASH FLOW STATEMENT
In financial accounting, a cash flow statement ,a l s ok n o w n
asstatement ofcash flows , is a f inancial statement that shows how
changes in balance sheet accounts and income affect cash and cash
equivalents, and breaks the analysis down to operating, investing and
financing activities.
Cash Flow Statement gives information about cash receipts
(sources) and cash payments (application). It contains opening balances &
closing balances of cash for a given period and explains how the closing
balance as per last balance sheet changed by various inflows & outflows
of cash to a closing balance of cash as per the next balance sheet. As per
AS-3, cash would include cash in hand and savings, current a/c balances
with banks & cash equivalents. Cash equivalents are short term & highly
liquid investments that are readily convertible into cash. An investmentmunotes.in
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174would normally be called a cash equivalent only when it has a short term
maturity of say 3 months or less from the date of acquisition.
12.2 ANALYSIS OF CASH FLOW STATEMENT
Thecash f low statement is distinct from the income statement and
balance sheet because it does not include the amount of future incoming
and outgoing cash that has been recorded on credit. Therefore, cash is not
the same as net income , which, on the income statement and balance
sheet, includes cash sales andsales made on credit. Cash flow is
determined by looking at three components by which cash enters and
leaves a company: core operations, investi ng and financing ,
12.2 (a) Operations
Measuring the cash inflows and outflows caused by core business
operations, the operations component of cash flow reflects how much cash
is generated from a company's products or services. Generally, changes
made in c ash,accounts receivable ,depreciation ,invento ryandaccounts
payable are reflected in cash from operations.
Cash flow is calculated by making certain adjustments to net
income by adding or subtracting differences in revenue, ex penses and
credit transactions (appearing on the balance sheet and income statement)
resulting from transactions that occur from one period to the next. These
adjustments are made because n on-cash items are calculated into net
income (income statement) and total assets andliabilities (balance sheet).
So, because no t all transactions involve actual cash items, many items
have to be re -evaluated when calculating cash flow from operations .
For e xample, depreciation is not really a cash expense; it is an
amount that is deducted from the total value of an asset that has previously
been accounted for. That is why it is added back into net sales for
calculating cash flow. The only time income from an asset is accounted
for in CFS calculations is when the asset is sold.
Changes in accounts receivable on the balance sheet from
oneaccounting period to the next must also be reflected in cash flow. If
accounts receivable decreases, this implies that more cash has entered the
company from customers paying off their credit accounts -the amount by
which AR has decreased i s then added to net sales. If accounts receivable
increase from one accounting period to the next, the amount of the
increase must be deducted from net sales because, although the amounts
represented in AR are revenue, they are not cash.
An increase in in ventory, on the other hand, signals that a company
has spent more money to purchase more raw materials . If the inventory
was paid with cash, the increase in the value of inventory is dedu cted from
net sales. A decrease in inventory would be added to net sales. If inventory
was purchased on credit, an increase in accounts payable would occur onmunotes.in
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175the balance sheet, and the amount of the increase from one year to the
other would be added to ne ts a l e s .
The same logic holds true for taxes payable, salaries payable
andprepaid insurance . If something has been paid off, then the difference
in the value owed from one year to the next has to be subtracted from net
income. If there is an amount that is still owed, then any differences will
have to be added to net earnings.
12.2 (b) Investing
Changes in equipment, assets or investments relate to cash from
investing. Usually cash changes from investing are a "cash out" item,
because cash is used to buy new equipment, buildings or short -term assets
such as marketable securities . However, when a company div ests of an
asset, the transaction is considered "cash in" for calculating cash from
investing.
12.2 ( c) Financing
Changes in debt, loans or dividends are accounted for in cash from
financin g. Changes in cash from financing are "cash in" when capital is
raised, and they're "cash out" when dividends are paid. Thus, if a company
issues a bond to the public, the company receives cash financing;
however, when interest is paid to bondholders , the company is reducing its
cash.
Major Cash Inflows
•Issue of new shares for cash
•Receipt of short term & long term loans from banks, financial
institutions etc
•Sale of assets & investments, D ividend & Interest received,
•Cash generated from operations
Major Cash Outflows
•Redemption of preference shares, Purchase of fixed assets or
investments
•Repayment of long term and short term borrowings
•Decrease in deferred payment liabilities, Loss from operations
•Payment of tax, dividend etc.
Classification of Activities
As per AS -3 the cash flow statement should report cash flows during the
period classified by
•OPERATING ACTIVITIES
•INVESTING ACTIVITIES
•FINANCING ACTIVITIESmunotes.in
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17612.3 CASH FLOW FROM OPERATING ACTIVITIES
•The cash flows generated from major revenue producing activities of
the entities are covered under this head.
•Cash flow from operating activities is the indicator of the extent to
which the operations of the enterprise have generated sufficient cash to
maintain the operating capability to pay dividend, repay loans & make
new investments. Main Examples are
•Cash receipts from sale of goods & services
•Cash receipts from royalties, fees, commission etc
•Cash payments to employees
•Cash payments or re funds (receipt) of income tax
•Cash receipts & payments relating to future contracts, forward contract
etc
•Cash receipts and payments arising from purchase and sale of trading
securities
12.4 CASH FROM INVESTING ACTIVITIES
•These are the acquisition and dis posal of long term assets and other
investments not included in cash equivalents. This represents the
extent to which the expenditures have been made for resources
intended to generate future incomes & cash flows, Examples are
•Cash payments for purchase o f fixed assets
•Cash receipts from sale of fixed assets
•Cash payments for purchase of shares/debentures etc. in other entities
•Loans and advances given to third parties
•Repayments of loans given
12.5 CASH FROM FINANCING ACTIVITIES
•Financing activities are the activities that result in changes in the size
and composition of the owner’s capital and borrowings of the
enterprise.
•Separate disclosure is important because it is useful in predicting
claims on future cash flows by providers of funds
•Examples
•Cash receipts from issue of share capital , debentures & short term &
long term loans
•Cash Repayments of loans borrowed
•Cash payment to redeem preference sharesmunotes.in
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178
12.6 BENEFITS/IMPORTANCE OF CASH FLOW
ANALYSIS
•Efficient Cash Management –manage the cash r esources in such a
way that adequate cash is available for meeting the expenses
•Internal Financial Management –useful for internal financial
management as it provides clear picture of cash flows from operations
•Knowledge of change in Cash Position –It enables the management
to know about the causes of changes in cash position
•Success or Failure of Cash Planning –Comparison of actual &
budgeted cash flow helps the management to know the success or
failure in cash management
•It is a supplement to fund fl ow statement as cash is a part of fund
•Cash Flow Statement is a better tool of analysis for short term
decisionsmunotes.in
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17912.7 LIMITATIONS OF CASH FLOW ANALYSIS
•Misleading Inter Industry Comparison -Cash flow does not
measure the economic efficiency of one comp any in relation to another
company
•Misleading Inter Firm Comparison -The terms & conditions of
purchases & sales of different firms may not be the same. Hence inter
firm comparison becomes misleading
•Influence of Management Policies –Management policies influence
the cash easily by making certain payments in advance or by
postponing certain payments
•Cannot be equated with Income Statement –Cash flow statement
cannot be equated with income statement. Hence net cash flow does
not mean income of the busines s
•CFS cannot substitute the B/S & Funds Flow .
12.8 ACCOUNTING STANDARD –AS3 ON CASH FLOW
STATEMENT
Objective of AS -3 is to provide desired information about historical
changes in cash & cash equivalents of an enterprise classified in to
Operating, Investi ng and Financing activities.
•An enterprise should disclose the components of cash and cash
equivalents and should present a reconciliation of the amount in the
cash statement with the equivalent items reported in the balance sheet
•An enterprise should disc lose the amount of cash & cash equivalent
balance held by the enterprises that are not available for use by it with
explanation of Managementmunotes.in
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18012.9 DISTINCTION BETWEEN CASH FLOW V/S
FUNDS FLOW
munotes.in
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181Practical Sums
munotes.in
Page 184
184
Key Terms:
Cash –It includes cash and demand deposits with Banks
Cash Equivalents –These are short term and highly liquid investments
Cash Flows –It is movement of cash
Non Cash Expenses –These are the expenses which do not involve any
cash payment
Revenue Activities -These are the activities which are revenue
producing
Investing Activities –These are related to acquisition and disposal of
long term assets
Financing Activities –These are the activities relating to changes in
capital & borrowings
Theory Questions:
1.Explain the technique of cash flow statement?
2.What is utility of cash flow statement to financial management?
3.Explain the concept of “Flow of Cash” & enumerate the sources of
cash?
4.What data would you require to prepare a cash flow statement?
Suggested Rea dings for Fund Flow & Cash Flow Statements
Management Accounting –Bhattacharya Debarshi
Introduction to Management Accounting –Dr.Varsha Ainapure (Manan
Prakashan)munotes.in
Page 185
185Principles of Financial Management –Satish Inamdar (Everest Publishing
House)
Management Accounting –Chopde (Sheth Publishers)
Practical Sums:
munotes.in
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186MODULE -IX
13
INTRODUCTION TOCOST ACCOUNTING
Unit structure
13.1 Objectives
13.2 Introduction
13.3 Meaning ofCost, Costing andCost Accounting
13.4 Objectives ofCost Accounting
13.5 Cost Centre andCost Units
13.6 Classification ofCost
13.7 Elements ofCost
13.8 Summary
13.9 Exerc ise
13.0 OBJECTIVES
After studying this unit students will be able to:
Understand the need of Cost Accounting
Know the meaning of Cost, Costing and Cost Accounting
Explain the objectives of Cost Accounting
Understand the classification of Cost
Discuss ab out the Elements of Cost
Know the methods of Costing
13.2 INTRODUCTION
Cost Accounting is the system of accounting which is concerned
with determination of costs of doing something which can be
manufacturing or rendering service or even conducting any ac tivity or
function. The objective of Cost Accounting is to render detailed and
useful information for guidance to Management.
Financial accounting is developed over the time to record,
summarise and present the financial transaction or events which can be
expressed in terms of money. This function was primarily concerned with
record keeping, leading to preparation of Profit and Loss Account and
Balance Sheet. The information obtained through financial statements ismunotes.in
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187useful to the Management or Owner in se veral respects. However, the
information provided by financial accounting is not sufficient for several
purposes of decision making in many areas such as : determining output
level, determining product selection –addition or dropping or changing
product combination in the case of multi product company, determining or
revising prices of products, whether Profit earned is optimum as compared
with competitors and in comparison to earlier years. The need of data for
such details lead to the development of Cos t Accountancy.
13.3MEANING OF COST, COSTING AND
COST ACCOUNTING
13.3.1 Cost :
Institute of Cost and Works Accountants of India, defines cost as
“measurement, inmonetary terms, oftheamount ofresources used for the
purpose of production of goods or rend ering services”.
Thus the term cost means the amount of expenditure, actual ornotional
incurred orattributable toagiven thing. Itcanberegarded as the price paid
for attaining the objective. For e.g. Material cost is the price of materials
acquired f or manufacturing a product.
13.3.2 Costing :
The term costing has been defined as “the techniques and processes of
ascertainment of costs. Whelden has defined costing as,“the classifying
recording andappropriate allocation ofexpenditure forthedetermin ation
ofcosts therelation ofthese costs to sale value andthe ascertainment of
profitability.”
Therefore costing involves the following steps.
Ascertaining and Collecting ofCosts
Analysis orClassification of Costs
Allocating total costs toaparticula rthing i.e.product, acontract ora
process.
Thus costing simply means cost finding byanyprocess ortechnique.
13.3.3 Cost Accounting :
Cost Accounting is a formal system of accounting by means ofwhich cost
ofproducts or service, are ascertained andcontrolled.
Whelden defines Cost Accounting as, “Classifying, recording and
appropriate allocation ofexpenditure fordetermination ofcosts of
products orservices andforthepresentation of suitably arranged data for
the purpose of control andguidance ofmanagement.”munotes.in
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188Therefore, Cost Accounting istheapplication ofcosting principles,
methods and techniques in the ascertainment of costs and analysis of
savings or/andexcesses ascompared with previous experience or with
standards. It provides, detaile dc o s t information tovarious levels of
management forefficient performance of their functions. The information
supplied by Cost Accounting as a tool of management for making
optimum use of scarce resources and ultimately addtotheprofitability of
busin ess.
13.4OBJECTIVES AND SCOPE OF COST
ACCOUNTING
13.4.1 Objectives of Cost Accounting are as follows:
1)To Ascertain the Cost : To ascertain the cost of product or a services
reveled and enable measurement of profit by proper valuation of
inventory.
2)To Analyse Costs : To analysis costs or to classify the expenses under
different heads of accounts viz. material, labour, expenses etc.
3)To Allocate and Apportion the Costs : To allocate or charge the
direct expenses or specific costs such as Raw Materi al, Labour to
particular product, contract or process and to distribute common
expenses to each product, contract or process on a suitable basis.
4)Cost Reporting : Cost Reporting or presentation includes :
a)What to report i.e. what is the nature of i nformation to be
presented?
b)Whom to Report i.e. to whom the report is to be addressed.
c)When to Report i.e. when the report is to be presented i.e. Daily
weekly monthly yearly etc.
d)How to Report i.e. in what format the report is to be presented.
5)To Assist the Management : Cost Accounting assist the management
in:
a)Indicating to the management any inefficiencies and extent of
various forms of waste of Raw Material, Time, Expenses etc.
b)Fixing of selling price.
c)Providing information to enable man agement to take decision of
various types.
d)Controlling Inventory of Raw Material, goods in process, finished
goods, spares and consumables etc.munotes.in
Page 189
1896)Cost Control : Cost Accounting assist the management in cost
control. Cost control includes the following s tages.
a)Setting up of targets of cast and production for each period.
b)Measuring the actual figures of performance relating to cost,
production etc. for the period concerned.
c)The figures of actual performance are to be compared with the
targets to find out t he variation.
d)Analysing the variance, whether favourable or adverse.
e)Immediate action has to be taken in case of adverse variation.
7)Optimum Product Mix : Advise the management in deciding
optimum product mix merits and demerits of alterative courses of
action viz. make of buy decisions, introduction or Automation
mechanization, rationalization, system of production etc.
8)Future Policies : Advise management on future policies regarding
Expansion, growth, capital investment, etc.
13.5 COST CENTRE ANDCOS T UNITS:
13.5.1 Cost Centre :
It is a location, person or item of equipment for which cost may be
ascertained and used for the purpose of cost control. It is a convenient
unit of the organisation for which cost may be ascertained. The main
purpose of as certainment of cost is to control the cost and fill up the
responsibility of the person who is incharge of the cost centre.
Types of cost centers :
I.Personal Cost Centre :
It consists of a person or group of persons.
e.g. machine operator, salesmen, et c.
II.Impersonal Cost Centre :
It consists of a location or an item of equipment or group of these.
E.g. Factory, Machine etc.
III.Operational Cost Centre :
This consists of machines or persons carrying on similar operations.
IV.Process Cost Centre :
This consists of a continuous sequence of operation or specific
operations.munotes.in
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190V.Production Cost Centre :
This is the centre where actual production takes place or these include,
those departments that are directly engaged in manufacturing activity
and co ntribute to the content and form of finished product.
e.g. Cutting, Assembly and Finishing Departments etc.
VI.Service Cost Centre :
This is the Centre which renders services to production centres. These
contribute to the production process in an indirect manner.
e.g. Stores department, Repairs and Maintenance department, H.R.
Department, Purchase Department.
1.11.2 Cost unit :
It is a unit of product, service or time in terms of which cost are
ascertained or expressed. It is basically, a unit of quanti ty of product or
service in relation to which costs may be ascertained or expressed.
Few examples of cost unit are given below.
Name of Industry Cost unit
Textiles
Transport
Power
Paints
Iron and Steel
Canteen
Chemical
Readymade Garments
PetrolMeter, y ards
Passenger km
Kilowatt –hour
Litre
Tonne
Per meal
Litre, kilogram
Number
Litre
13.6CLASSIFICATION OF COST
Classification is the process of grouping costs according to their
common characteristics. It is a systematic placement of like items
togeth er according to their common features. There are various ways of
classifying costs, according to their common features as given below.munotes.in
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191Chart showing classification of cost :
Classification of Cost
I On the basis of Identification:
On the basis of identification of cost with cost units or jobs or processes,
costs are classified into –
1.Direct Costs : These are the costs which are incurred for and
conveniently identified with a particular cost unit process or
department. These are the expenditures which can be directlyManufacturing
CostAdministrationCostSelling and
Distribution
CostResearch andDevelopment
CostDirect
Cost
Fixed
CostOn the basis ofbehaviour of c ost
Variable
CostSemi -Variab le
CostOn the basis ofIdentification
Indirect
CostOn the basis ofControl liabil ity
ControllableCostUncontrollableCostOn the basisof Time
Historical
CostPredetermined
CostOn the basis offunction
ConversionCostOtherBasisNormal
CostAvoidable
CostUnavoidable
CostProduct
CostPeriod
Costmunotes.in
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192allocated to a particular job, product or an activity. E.g. Cost of Raw
Material used, wages paid to labourers etc.
2.Indirect Costs : These are general costs and are incurred for the
benefit of a number of cost units, processes or departments. These
costs can not be conveniently identified with a particular cost unit or
cost centre. Example : Depreciation of Machinery, Insurance,
Lighting, Power, Rent of Building, Managerial Salaries, etc.
IIOn the basis of behaviour of Cost
Behaviour means change in cost due to change in output. Costs
behave differently when the level of production rises or falls. Certain
costs change in direct proportion with production level while other costs
remain unchanged. As such on the ba sis of behaviour of cost –costs are
classified into
1)Fixed Costs : It is that portion of the total cost which remain constant
irrespective of output upto the capacity limit. It is the cost which does
not very with the change in the volume of activity i n the short run.
These costs are not affected by temporary fluctuation in the activity of
an enterprise. These are also known as period costs as it is concerned
with period. Rent of premises, tax and insurance, staff salaries, are the
examples of fixed cost.
Characteristics of Fixed Cost are :
a.Large in value
b.Fixed amount within an output range
c.Fixed cost per unit decreases with increased output
d.Indirect Cost
e.Lesser degree of controllability
f.Influence Variable Cost and Working CapitalCost(Rs.)Total Fixed CostFixedCostperUnit
Output (Units)Y
X Omunotes.in
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193Behaviour of Fixed Cost
2)Variable Cost : It is that cost which directly very with the volume of
activity. In other words, it is a cost which changes according to the
changes in the volume of output. It tends to very in direct proportion
to output. It means when the volume of output increases, total variable
cost also increases when the volume of output decreases, total variable
cost also decreases. But the variable cost per unit remains same.
Direct material, Direct Labour, Direct Expen ses are the examples of
variable costs.
Characteristics of Variable Cost are :
a.Total cost changes in direct proportion to the change in total
output.
b.Cost per unit remains content.
c.It is quite divisible.
d.It is identifiable with the individual cost unit.
e.Such costs are controlled by functional manager.Cost(Rs.)TotalVariableCostVariable Cost per UnitOutput (in Units)YX
O
Behaviour of Variable Cost
3)Semi -Variable Cost : This is also referred as semi -fixed costs. These
costs include both a fixed and a variable component. i.e. These are
partly f ixed and partly variable. They remain constant upto a certain
level and registers change afterwards. These costs vary in some
degree with volume but not in direct or same proportion. Such costs
are fixed only in relation to specified constant condition.
For example: Repairs and maintenance of machinery, telephone
charges, maintainance of building, supervision, professional tax,
compensation for accidents, light and power etc.munotes.in
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194Cost(Rs.)Semi Variable Cost
Output (in Units)
Behaviour of Semi -Variable Cost
III. On the bas is of Controllability
On the basis of controllability, costs are classified into two types :
1)Controllable Cost
2)Uncontrollable Cost
1)Controllable Cost : These are the costs which can not be influenced
or controlled by the concerned cost centre or r esponsibility centre.
These costs may be directly regulated at a given level of management
authority.
2)Uncontrollable Cost : These are the costs, which can not be
influenced or controlled by the action of a specific member of an
enterprise. For eg. it is very difficult to control costs like factory rent,
managerial salaries etc.
The important points to be noted regarding this classification. First,
controllable cost can not be distinguished from non -controllable costs,
without specifying the level and scope of management authority. It
means cost which is uncontrollable at one level of management may
be controllable at another level of management. Eg. Rent and Factory
Building may be beyond control for the production department but can
be controlled by the administrative department by negotiations.
Secondly all costs are controllable in the long run and at the some
appropriate management level.
IVOn the basis of Functions
An organisation performs many functions. On the basis of
functions costs can b e classified as follows :
1)Manufacturing Costs : It is the cost of all items involved in the
manufacturing of a product or service. It includes all direct costs and
all indirect costs related to the production. It includes cost of direct
materials, dire ct labour, direct expenses, and overhead expenses
related to production. Overhead expenses, means all indirect costsmunotes.in
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195involved in the production process. This is termed as factory overhead
or manufacturing overheads. Eg. Salaries of staff for production
department, technical supervision, Expenses of stores department,
Depreciation of Plant and Machinery, Repairs and maintainance of
Factory Building and Machineries etc.
2)Administration Cost : These are costs incurred for general
management of an organis ation. It is the cost which is incurred for
formulating the policy, directing the organisation of controlling the
operations. These are in the nature of indirect costs and are also
termed as administrative overhead. Eg. Salaries of Administrative
Stall, General Office expenses like rent, lighting, telephone, stationery,
postage etc.
3)Selling and Distribution Costs : Selling costs are the indirect costs
relating to selling of products or services. They include all indirect
cost in sales management for t he organisation. Selling costs include
all expenses relating to regular sales and sales promotion activities.
Examples of expenses which are included in selling costs are :
1)Salaries, Commission and traveling expenses for sales personnel
2)Advertiseme nt cost
3)Legal Expenses for debt realization
4)Market research cost
5)Show room expenses
6)Discount allowed
7)Sample and free gifts
8)Rent on Sales room
9)After sale services
Distribution costs are the costs incurred in handling a product from
thetime it is completed in the works until it reaches the ultimate
consumer. Distribution expenses include all these expenses which are
incurred in connection with making the goods available to customers.
These expenses include the following.
1)Packing ch arges
2)Loading charges
3)Carriage on Sales
4)Rent of warehouse
5)Insurance and lighting of warehouse
6)Transportation costs
7)Salaries of godown keeper, driver, packing staff etc.munotes.in
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1964)Research and Development Cost : Research and development costs
are incurred to discover new ideas, processes, products by experiment.
It includes the cost of the process which begins with the
implementation of the decision to produce or improved product.
VOn the basis of Time
On the basis of time of computation, co sts are classified into
historical costs and predetermined costs.
1)Historical Costs : These are the costs which are ascertained after
these have been incurred. Historical costs are then nothing but actual
costs. They represent the costs of actual opera tional performance.
These costs are not available until after the completion of
manufacturing operations.
2)Pre determined Costs : These are the future costs which are
ascertained in advance of production on the basis of a specification of
all the factor s affecting cost and cost data. Predetermined costs are
future costs determined in advance on the basis of standards or
estimates. These costs are extensively used for the purpose of
planning and control.
VIOther Basis
1)Normal Cost : Normal cost may be defined as a cost which is
normally incurred on expected lines at a given level of output, in the
condition in which that level of output in normally attained. This cost
is a part of production.
2)Abnormal Cost : Abnormal cost is that cost which is not normally
incurred at a given level of output, in the condition in which that level
of output is normally attained. Such cost is over and above the normal
cost and is not treated as a part of the cost of production.
3)Avoidable Cost : The cost which can b e avoided under the present
conditions is an avoidable cost. These are the costs which under given
conditions of performance efficiency should not have been incurred.
They are logically associated with some activity and situation and are
ascertained by t he difference of actual cost with the happening of the
situation and the normal cost. Eg. when spoilage occurs in
manufacturing in excess of normal limit, the resulting cost of spoilage
is avoidable cost.
4)Unavoidable Cost : The cost which can not be av oidable under the
present condition is an unavoidable cost. They are inescapable costs
which are essentially to be incurred within the limits or norms
provided for. It is the cost that must be incurred under a programme of
business restriction.munotes.in
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197CHECK YOUR PROGRESS
Draw the chart showing Classification ofCost.
Define the following terms:
1.Costing
2.Cost Accounting
3.Impersonal cost center
4.Service Cost center
5.Direct Cost
6.Uncontrollable cost
7.Predetermined cost
Give Examples:
1.Fixed cost
2.Variable cost
3.Semi varia blecost
4.Manufacturing cost
5.Administration cost
6.Selling cost
7.Distribution Cost
13.7 ELEMENTS OF COST : -
A manufacturing organisation converts raw materials into finished
products. For that it employs labour and provides other facilities. While
compiling pr oduction cost, amount spent on all these are to be ascertained.
For this purpose, cost are primarily classified into various elements. This
classification is required for accounting and control.
The elements of cost are (i) Direct material (ii) Direct lab our (iii)
Direct expenses and (iv) Overhead expenses.
The following chart depicts the broad headings of costs and this
acts as the basis for preparing a Cost sheet.munotes.in
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198Elements of cost
Materials Labour Other Expenses
Direct Indirec t Direct Indirect Direct Indirect
Overheads
Factory Administrative Selling & Distribution
13.7.1Material Cost
It is the cost of material of any nature used for the purpose of production
of a product or a service. Materials may be Direct Material or Indirect
Material.
Direct material : It is the cost of basic raw material used for
manufacturing a product. Direct materials generally became a part of
the finished product. No finished pro duct can be manufactured
without basic raw material. This cost is easily identifiable and
chargeable to the product. For e.g. Leather in leather products, Steel in
steel furniture, Cotton in textile etc. Direct material includes the
following.
Examples -
i)Material specially purchased for a specific job or process.
ii)Materials passing from one process to another.
iii)Consumption of materials or components manufactured in the same
factory.
iv)Primary packing materials.
v)Freight, insurance and other transport costs, import duty, octroi duty,
carriage inward, cost of storage and handling are treated as direct
costs of the materials consumed.
In certain cases direct materials are used in small quantities and it
will not be feasible to ascertain their c osts and allocate them directly. For
instance, nails used in the manufacture of chairs and tables, glue used in
the manufacture of toys, thread used in stitching garments etc. In such
cases cost of the total quantity consumed for the period will be treated as
Indirect costs.munotes.in
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199Indirect material : It is the cost of material other than direct material
which cannot be charged to the product directly. It can not be treated
as part of the product. These are minor in importance. It is also
known as expenses mat erials. It is the material which cannot be
allocated to the product but can be apportioned to the cost units.
Examples : Lubricants, Cotton waste, Grease, Oil, Small tools, Minor
items like thread in dress making, nails in furniture (nuts, bolts in
furnit ure) etc.
Therefore, indirect materials can not be easily identified with
specific job. They may not vary directly with the output. It is considered
as a part of overheads.
13.7.2Labour Cost
This is the cost of remuneration in the form of wages, Salari es,
Commissions, Bonuses etc. paid to the workers and employees of an
organisation.
Direct Labour Cost : Direct Labour Cost is the amount of wages paid
to those workers who are engaged on the manufacturing line. It
consists of wages paid to workers engage d in converting of raw
materials into finished products. The amount of wages can be
conveniently identified with a particular line, product, job or process.
These workers directly handle machines on the production line. Direct
wages include payment made to the following group of workers.
1)Labour engaged on the actual production of the product
2)Labour engaged in aiding the operation viz. supervisor, foremen, shop
Clerks and worker on internal transport.
3)Inspectors, Analysts, needed for such product ion.
Example : Carpenter in furniture making unit, tailor in readymade wear
unit, Labour in construction work etc.
Indirect Labour Cost : It is the amount of wages paid to those
workers who are not engaged on the manufacturing line. It is of
general chara cter and can not be directly identified with a particular
cost unit. This indirect labour is not directly engaged in the production
operations but such labour assist or help in production operations. It
can not be easily identified with specific job, con tract of work order.
It may not vary directly with the output. It is treated as part of
overheads.
Example : Labour in Human Resource department, Labour in payroll
department, Labour in stores, Labour in Securities Department, Labour in
power house depar tment etc.munotes.in
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20013.7.3Expenses
All costs other than material and labour are termed as expenses. It is
defined as the cost of services provided to an undertaking and the notional
cost of the use of owned assets.
Direct Expenses : It is the amount of expenses which is directly
chargeable to product manufactured or which may be allocated to
product directly. It can be easily identified with the product. These
are the expenses which are specifically incurred in connection with a
particular job or cost unit. Th ey are also called as chargeable
expenses.
Example : Hire of special plant for a particular job, Travelling expenses
in securing a particular contract, Carriage paid for materials purchased for
specific job, Royalty paid in mining or production etc.
Indire ct Expenses (Overheads): All indirect costs other than indirect
materials and indirect labour costs, are termed as indirect expenses. It
is the amount of expenses which can not be charged to the product
directly. These can not be directly identified with particular job,
process or work order and are common to cost units’ or cost centers.
Indirect expenses / Overheads can be sub -divided into following
main groups.
1. Factory or Works Overheads: Also known as manufacturing or
production overheads it consi sts of all costs of indirect materials, indirect
labour and other indirect expenses which are incurred in the factory.
Examples :
Factory rent and insurance. Depreciation of Factory building and
machinery.
2. Office or Administration overheads: All indire ct costs incurred
by the office for administration and management of an enterprise.
Examples:
Rent, rates, taxes and insurance of office buildings, audit fees, directors
fees.
3. Selling and Distribution overheads: These are indirect costs in
relation to m arketing and sale.
Examples :
Advertising, Salary and Commission of sales agents, Travelling
expenses of salesmen.munotes.in
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20113.8SUMMARY
Cost Accounting is the process of accounting for costs from the
point at which expenditure is incurred or committed to the e stablishment
of its ultimate relationship with cost center and cost units. Cost accounting
profession got recognition in 1939 in India. It has been made compulsory
for specified manufacturing companies. Cost Accounting has the
objectives of determining Pro duct costs, facilitate planning and control of
regular business activities and supply information for taking short term
and long -term decisions. Cost Accounting is useful in different areas such
as materials, labour, overheads, stock valuation etc.
13.9 EXERCISE
1.What is cost Accounting? What are its objectives?
2.What are the various elements of costs?
3.What is meant by Cost Accounting? Explain in brief different ways
of Cost Classification.
4.Write short notes on:
a.Cost centers
b.Cost units
c.Elements of costs
5. Choo se the correct alternative
1.Cost accounting is an important system developed for
i)shareholders ii) government
iii)management iv) financial institutions
2.The costing which determines cost after it has been actually incurred is
i)historical ii) standa rd
iii)estimated iv) marginal
3.A cost center is a
i)location for which cost is incurred ii) an organisation
iii)a unit of cost iv) profit center
4.A cost center which is engaged in production activity is called
i)production cost center ii) process cos t center
iii)impersonal cost centre iv) production unitmunotes.in
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2025.Variable cost per unit remains ______.
i)Constant ii) flexible
iii)(i) & (ii) iv) none of the above
6.Cost which is related to capacity iscalled :
i)Fixed cost ii) Capacity cost
iii)Plant cost iv)none of theabove
7.Cost which is unaffected by the change in output is called as :
i)Fixed cost ii) Variable cost
iii)Period cost iv)None of theabove
8.Cost which is relevant for decision -making is
i)Relevant cost ii)Past cost
iii)Opportunity cost iv) Imputed cost89.The cost which remains constant irrespective of output uptocapacity limit is
i)Fixed cost ii) Product cost
iii)Variable cost iv) Sunk cost910.Variable cost is also known as
i)Product cost ii) Period cost
iii)Direct cost iv) Semi fixed cost1011.The cost which is directly chargeable to the product is
i)Indirect cost ii) Direct cost
iii)Overheads iv) Period cost
munotes.in
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203MODULE -X
14
INTRODUCTION TO COST ACCOUNTING
ETHICAL ISSUES IN
ACCOUNTING
Unit Structure
14.0 Objectives
14.1 Frauds and Errors –Meaning and Types.
14.2 Difference or Distinction between Errors and Frauds.
14.3 Ethical Issues in Accounting.
14.4 Corporate Governance and Creative Accounting.
14.5 Reasons / Motivations for Creative Accounting.
14.6 Techniques of Creative Accounting.
14.7 Recommendations / suggestions to detect and prevent fraudulent
practices of creative accounting.
14.8 Conclusion
14.9 Exercise
14.0 OBJECTIVES
After studying this Unit students will be able
To know the meaning and types of errors and frauds.
To understand the difference between errors and frauds.
To know the ethical issues in accounting, meaning of ethics.
To know t he types of unethical issues in accounting.
To understand the meaning of Corporate Governance and Creative
Accounting and the relationship between the two.
To know the parties to creative accounting.
To know the functions of Corporate Governance.
To know t he role of Corporate Governance in detecting creative
accounting practices.
To know the recommendations or suggestions to detect and prevent
fraudulent practices of creative accounting.munotes.in
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20414.1 FRAUDS AND ERRORS –MEANING
AND TYPES
The secondary objective of audit ing is
aTo detect and prevent errors
bTo detect and prevent frauds
If any irregularity is found in the financial statements, it leads to
frauds or errors.
Frauds are intentional mistakes.
Errors are unintentional mistakes.
The difference between errors and f rauds lies in the intention.
Fraud is intentionally done, to benefit a certain person or group of
persons and causes harmful effect on others.
Errors are mistakes, which are made, unintentionally.
Frauds can be done in the following ways (Types of Frauds):
1.Embezzlement ofcash
Manipulation of money is found more in big business houses, as compared
to small business due to direct control, which is missing in big business
houses. In large business houses, there should be an internal check system.
An auditor h as to deal with cash transactions carefully.
Embezzlement or Misappropriation of cash can be done in the
following ways:
a)Omitting to enter cash, which has been received (suppressing receipts).
b)Entering lesser amount than what has been actually received.
c)Making fictitious entries in the cash book, on the payment side.
(Fictitious payments).
d)Entering more amounts, than what has been actually been paid, on the
payment side of the cash book.
Misappropriation of Goods
Misappropriation of goods is another type of fraud, done with regard to
goods. It becomes difficult to detect this type of frauds, in respect of lesser
bulky goods with higher prices (high value).
2.Fraudulent Falsification orManipulation ofAccounts
It is more difficult to detect fraudulent manipula tion of accounts because it
is usually done by directors, managers and other responsible officials with
an intent to:munotes.in
Page 205
205I.Showing more profits than they are to:
(a) If they get commission on profits, they get more commission.
(b) Maintaining shareholders co nfidence by showing efficiency due to
increased profits.
(c) If they hold shares, they may sell at high price, by declaring higher rate
of dividend.
(d) To get further credit or loans by showing the financial position, better
than what actually, it is.
(e)To attract more subscribers for the sale of companies shares.
II.Showing lesser profits, than actually they are, in order to:
aPurchase shares in the market at lower price.
bTo reduce or avoid tax payment.
cTo give a wrong impression about business success, to the
competitors.
III.Falsification of accounts may be resorted by:
aCharging more or less depreciation, as per set objective.
bShowing fictitious purchases or sales or returns, to increase or
decrease the profits, as the case may be.
cUse of secret reser ves, during the period, in which concern has earned
lower profits, without disclosing, this fact to shareholders.
dBy showing revenue expenditure as capital expenditure or capital
expenditure as revenue expenditure.
eBy crediting the revenue account with the income, which will be
received in next year and not crediting the profit and loss account, with
the income which has accrued, but not received.
It is very difficult to detect such frauds because they are done by people at the top
level or people at the he lm of affairs, who are presumed to be honest, trustworthy
and responsible. So, nobody will suspect them. They are made very carefully and
thus the auditor has to be very careful in detecting such frauds.
IV. Misuse (Misappropriation) of company assets / eq uipments is a fraud.
V. Showing personal expense, as a business expense is a fraud.
VI. Using office computers or laptop, by taking it home and using is a fraud.munotes.in
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206VII. Window dressing: When accounts are prepared in such a way that
apparently on the face of it, they indicate a position/picture, much better than
actually, what they are.
VIII. Creating secret reserves.
IX. Stealing money from the company’s resource.
X. Bribery: Taking cash or other consideration in return for doing a favour (or
sometimes for ev en doing ones duty).
XI. Money laundering: Disguising the proceed of crime as legitimate assets.
XII. Accounting fraud: Manipulation of the number in the financial statements
eg. Reporting non -existent revenues and assets
andsuppressing expenses andliabi lities.
MEANING OF ERRORS
Errors means unintentional mistakes made by an accountant or clerk while
recording business transactions in the books of accounts.
Errors may be due to incorrect accounting knowledge or wrong recording
of the transaction in the bo oks of accounts or due to wrong calculations
like wrong totaling, wrong balancing, etc.
TYPES OF ERRORS
They are four types of errors.
1. Compensating Errors / Off -setting Errors:
Compensating Errors are those errors which compensate each other. They
are those errors in which the effect of one error is offset (nullified), by the
effect of another error.
Example (1):
Rent paid Rs.100 is debited to Rent Ac/. as Rs.150 Rent A/c. Dr.150
To cash A/c. 150 (Excess Debit of Rs.50/ -)
Commission received Rs.200 is cr edited to the Commission A/c. as
Rs.250
Cash A/c. Dr. 250
To Commission A/c. 250 (Excess Credit of Rs.50/ -)
The excess debt in rent a/c of Rs.50 is compensated by an excess credit of
Rs.50 in commission a/c.
Example(2):
10th May 2018. An amount of Rs.3000 paid to Ashok is posted as
Rs.300 to the debit of Ashok’s A/c.munotes.in
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207Ashok’s A/c. Dr.300
To Cash A/c. 300 (3000 is less)
20th May 2018. An amount of Rs.300 paid to Kumar is posted as
Rs.3000 to the debit of Kumar’s A/c.
Kumar’s A/c. Dr. 3000
To Cash A/c. 3000 (3000 is more)
The Net Effect of both these errors will be zero.
2) Errors of Principle:
Errors of principle are committed because of the ignorance of accounting
principles. When a transaction is recorded in contravention of accounting
principles, it is kno wn as an error of principle.
Examples:
a)Treating revenue expenditure as a capital expenditure . Rs.250 paid
for the repairs of old machinery, is debited to Machinery a/c. instead of
Repairs a/c.
b)Treating capital expenditure as a revenue expenditure Wages pai d
for the installation of new machinery, debited to Wages a/c., instead of
Machinery a/c.
c)Errors due to inability to make a difference between business
expenses and personal expense.
Proprietor’s Life Insurance Premium paid Rs.500, debited to Insurance
a/c., instead of Drawings a/c.
So, it is considered as a business expenditure and not a personal
expenditure of the proprietor.
3) Errors of Omission:
When a transaction is completely or partially omitted to be recorded in the
books of accounts, it is called an error of omission.
Thus errors of omission are of two types:
a)Error of complete omission
b)Error of partial omissionmunotes.in
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208Example of Error of Complete Omission
Goods sold to Aditya on credit not recorded in the books of accounts.
Aditya’s a/c Dr. To Sales A/c .
Example of Error of Partial Omission
Goods sold to Aditya on credit recorded in Sales Book, but not posted to
Aditya’s a/c. Thus, Sales a/c. is credited but Aditya’s a/c. is not debited.
4) Error of Commission / Clerical Errors
These are the errors which are committed due to wrong recording, wrong
casting totaling, wrong balancing of an account, wrong posting etc.
Examples
(a)Wrong recording
Goods of Rs.5000 purchased on credit from
Mohan isrecorded asRs.50000.
Correct Entry Purchase A/c. Dr5000
To Mohan’ sA / c .5 0 0 0 Wrong Entry Purchase A/c.
DR50000
ToMohan’s A/c. 50000
b)Wrong casting / totalling
This error arises when a mistake is made in totalling or casting.
Example
Purchase book is totaled as Rs.10,000 instead of Rs.1,00,000
c)Wrong Posting
i)Posting to the wrong side, but correct a/c.
Example
Goods sold to Rohan for Rs.900 entered to the credit of Rohan’s a/c.,
instead of posting to the debit of Rohan’s a/c.
Journal Entry Rohan’s A/c. Dr. 900 To Sales A/c. 900
ii)Posting with wrong amount
Entry passed is correct with right amount, but posting is done with wrong
amount.munotes.in
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209iii)Posting twice in an account
The posting is done two times in an account.
d)Wrong balancing of an account
The balancing of an account is done wrongly.
14.2 DIFFERENCE OR DISTI NCTION BETWEEN
ERRORS AND FRAUDS
Errors Frauds
Meaning
1. Errors are unintentional
mistakes1. Frauds are
intentional mistakes
Reason
2. Reason of occurrence is ignorance
of accounting principles or
oversight or incorrect accounting
know -ledge, wr ong transaction
recording, wrong calculation.2. Frauds are made
deliberately.
Offence
3. Generally, errors are not
considered as an offence.3. Frauds are considered as an
offence.
Result
4. Errors can cause undue profit,
loss or even no impact.4. Frauds always results in loss.
Detection
5. Errors are very easy to detect 5. Frauds are difficult to
identify
ETHICAL ISSUES IN ACCOUNTING
Due to globalization there is free movement of goods, services and capital
among the different countries of the world.
The business world requires the accounting profession to give correct and
on time financial reports by observing the topmost standards of ethical,
moral and accounting professional code of conduct.
Chartered Accountants, Cost Accountants and Manage ment Accountants,
who record business transactions have to abide with the guidelines, based
on accepted accounting practices, in their country.munotes.in
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210The governing body of professional accountants have defined and
enumerated the code of conduct in order to attai n the highest integrity
level by an accountant. In India, the governing body for financial
accounting and auditing is the Institute of Chartered Accountants of India
(ICAI) and for cost and management accounting, it is the Institute of Cost
and Works Accou ntant of India (ICWAI).
The institute members have to strictly abide the code of conduct, follow
the standards and have the highest degree of professional integrity.
Integrity means honesty, impartiality and truthfulness. The accountants
have to work with skill, care and diligence.
Overtime, the accounting ethical codes have changed due to two reasons.
a)Whether the accounting rules accepted and applied are appropriate and
reasonable for the public and the firm, who follow them.
b)Whether the practice enumerate d by accounting rules are valid over
the period or need to be changed / challenged.
Fraudulent accounting and weak internal control systems are the main
reasons of many recent corporate scandals like Enron, WorldCom, Xerox,
Reebok India, Tesco, Tyco, Toshi ba, Ricod India, Lehman Brothers, etc.
Ethical standards fall very often due to high pressure for performance and
exceed market expectations. Managerial compensation is connected to
profit and other accounting performance measures. Thus there is
temptation to manipulate the accounting reports, sometimes .
Frauds lead to financial, legal and reputation damage.
Companies should device systems to prevent, detect and report fraud.
Due to fraud, companies have collapsed, leading to customers,
employees, suppliers , shareholders problems.
Fraud and ethical compromises, reduce the value of accounting
information.
Meaning of Ethics
The word ‘ethics’ is derived from the Greek word ‘ethos’ which means
‘character’ and Latin word ‘moras’ which means ‘customs’.
Ethics is a bout choices. It signifies how people act in order to make the
right choice and produce good behavior.
Ethics is a system of moral principles. It is a sense of right and wrong and
goodness and badness of actions and their motives and effects.
Ethics in Acc ounting
It is very crucial for professionals in accounting, to be ethical in their
practices, because of the very, nature of the accounting profession. The
accountants are put in a special position of trust, in relation to their clients,
employees and the general public, who depend on their professionalmunotes.in
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211judgment and guidance, in making decisions. The stakeholders depend on
the accountants due to their professional statutes and ethical standards.
Thus, accountants have to be professional and follow ethics, f or the
clients, public and others to have confidence in them. Public accountants
are in a fiduciary relationship with their clients and business accountant
are in a fiduciary relationship with the employers. In a fiduciary
relationship, it is their respons ibility to see that their duties are done in a
conformity with the ethical values of honesty, integrity, objectivity, due
care, confidentiality and commitment to the public interest, before one’s
own interest. Thus, accountants as professionals, have to ke ep a high level
of ethical conduct that goes beyond society’s laws. This has made the
professional accounting bodies like ICAI, to develop a code of
professional conduct, which sets rules and standards that define right from
wrong, to ensure that members b ehavior, complies with perceived pubic
expectations of ethical standards.
But in recent times, accountants involved with large corporate scandals
shows that they have not complied with the expected ethical standards.
Accountants should observe a high level of ethics due to the nature of their
work, done by them.
The yearly financial statements of the company are depended by the
shareholders, potential shareholders and other users or stakeholders
because they use this information to make an informed decision about /
regarding, investment.
The various stakeholders depend on the accountant’s opinion, who
prepared the financial statements verified it, to present a true and fair view
of the state of affairs of the company. Accountants and auditors can
overcome et hical issues by having a knowledge of ethics, allowing for the
right choice that, although it may not be beneficial for the company, will
be beneficial for the public, who depend on the accountants and auditors
reporting.
Ethical Issues in Accounting
1. Un derreporting Income
An illegal practice which is prevalent is underreporting of income, to
avoid payment of taxes.
When people underreport their income, the government loses tax revenue,
which could be utilized for social security, poverty eradication, edu cation
of poor people, medical help and such other social welfare projects.
Auditors keep a watch on companies due to the large tax bills at stake each
tax year.
Individuals and companies, if caught underreporting (showing less) their
income, penalties wil l be imposed and in extreme cases, criminal charges.
Sometimes, applies to public companies reporting, lower revenues
(incomes) in a fiscal quarter, than were actually recorded.munotes.in
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212If the company has, already been reporting bad news and the share prices
are d own, executives may try to take some revenues from the current
quarter and push it into the next quarter. This way, the bad news can be
“flashed out” and the company can report an upside surprise in the coming
quarter, potentially increasing the share pric e. This is also an illegal
practice.
Alteration of financial statements can be easily done by unethical
accountants and maneuver number to paint false pictures of company’s
success. This may lead to short -term prosperity, but changed financial
figure will finally spell the companies downfall, when the regulators
detect the fraud.
2. Falsifying Document
Falsifying documents is a type of white collar crime. Falsification of
documents is to change details on the original document and try to pass
them off as re al. Falsifying documents involves altering, changing or
modifying a document for deceiving another person. It can also involve
the passing along of document copies, which are known to be false.
In many countries, falsifying a document is a crime punishable as a felony.
Documents which are commonly falsified are as follows:
a)Tax returns and income statements.
b)Personal checks.
c)Bank account records.
d)Business record keeping books.
e)Immigration documents like Visas, Passports etc.
f)Identification cards and Birth Ce rtificates.
Different acts, which can be considered as falsifying ad o c u m e n ta r e
as follows:
a)Forging a signature.
b)Knowingly using or distributing a fake document.
c)Without authority, using official letterheads.
d)Hiding assets/property, especially in bankrupt cy proceedings.
e)Giving false information, when requested to give true
information.
f)Changing or misrepresenting factual information like prices or
monetary amounts.
A person can be held criminally liable if he is acting, with an intention of
deceiving or de frauding another party. So, if a person was using a
document, but did not know it was fake, the person cannot be found guilty
of document falsifying.munotes.in
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2133.Creative Accounting
Creative accounting are the accounting practices that follow required laws
and re gulations but deviate from those standards intend to accomplish.
Creative accounting capitalizes on loopholes in the accounting standards
to falsely show a better corporate image.
Although creative accounting practices are legal, the loopholes they
exploit are, often reformed to prevent such behaviours.
Creative accounting can be used to manage earnings and to keep debt off
the balance sheet.
14.3 CORPORATE GOVERNANCE AND CREATIVE
ACCOUNTING
Corporate Governances is a control system, to reduce the effects o f
creative accounting, on the reliability of accounting information, directed
to the stakeholder interests.
With the rise of Corporate Scandals, confidence of the shareholders and
other stakeholders in the corporate financial statements got weakened /
collapsed.
A need was felt to find solutions to this problem and an effective
regulatory system called ‘corporate governance’ was found.
Creative Accounting is nothing new. It has been a temptation and a
problem, from the time, when accounting principles were first used to
report on business performance.
There is an old joke about the accountant who is asked to add up two and
two and who produces the response ‘What would you like the answer to
be?’
It is an appropriate reminder, that financial measurement is no ta ne x a c t
science . (Kevin, A. Alan, W. 2003:3)
There are other terms for Creative Accounting. They are
Income Smoothing, Earnings Management, Earnings Smoothing,
Financial Engineering, and Cosmetic Accounting.
Definitions of Creative Accounting
1. Barnea et. Al, 1976
“It is the deliberate dampening of fluctuations about “some level of
earnings considered being normal for the firm”.
2. Merchant and Rockness, 1994
“Creative accounting is an action on the part of management which affects
reported income and w hich provides no true economic advantage to the
organization and may in fact, in the long -term be detrimental.
Creative accounting involves using the flexibility in accounting within the
regulatory framework, to manage the measurement and presentation of t hemunotes.in
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214accounts, so that they give primacy to the interests of the preparers and not
the users.
Parties to Creative Accounting
The main or interested parties to creative accounting are managers,
investment analysts auditors, regulators, shareholders, merchant bankers to
other users. All these parties play a key role in creative accounting.
1. The Managers , set the creative accounting agenda, they wish to portray
the accounts, in a light of favourable to themselves, this may be to
increase net assets and the fle xibility in accounting techniques which can,
deliver the profit figure that serves their interests. Managers may take
professional advice from, for example, merchant bank, to devise
creative accounting schemes, while complying with the letter of the law,
transgress its spirit.
2.Regulators seek to control and limit creative accounting by setting
rules and regulations, over time the regulatory framework will be shaped
by creative accounting and will in turn shape creative accounting.
3. Auditors will seek t o ensure that the accounts are true and fair and will
use the regulatory framework as a legitimation tool and reference point.
Whereas the managers set the agenda, the users attempt to detect creative
accounting and cope with its effects.
4.Investment Ana lysts are seeking to price stocks and shares effectively,
they will, therefore, seek to adjust the accounts for creative accounting.
5.For ordinary shareholders, creative accounting can affect the share
price and they will also try to detect it. If a comp any goes into problems or
even worse, goes bankrupt, they will be major losers.
6.Finally, bankers and creditors would worry that creative accounting
could be used to cover poor results and leave them exposed, if the
company collapsed.
All the parties are affected by creative accounting in different ways.
14.4 REASONS / MOTIVATIONS FOR CREATIVE
ACCOUNTING (Why Creative Accounting is resorted to?)
The reasons or motivations for creative accounting are as follows:
1. To meet internal targets
The managers wan t to cook the books for meeting internal targets set by
higher level management regarding sales, profits and share prices.
2. Meet external expectations
A company has to face many expectations from its shareholders. The
employees and customers want, for th eir interests, the long term survival
of the company. Suppliers or sellers on credit want assurance regarding
the payment of their dues on time and long term relationships with the
company. Company wants to meet analysts forecasts and dividend payout
pattern.munotes.in
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2153. Provide income smoothing
In order to impress the investors and to keep the share prices stable,
companies want to reveal steady income flow. Advocates of this approach
favour it due to measure against the short -termism of evaluating an
investment on the basis of the immediate yields. It also avoids raising
expectations too high to be met by the management.
4. Window dressing for an IPO or a loan
Before corporate events like Initial Public Offer (IPO), acquisition or
before taking a loan, window dress ing can be resorted to. (Sweeney [1994]
reports the companies tendency for violation of debt covenants is 2 or 3
times, to make income increasing, assuming accounting policy changes
than other companies).
5. Taxation
A desire for tax benefit especially whe n taxable income is measured
through accounting numbers, can also lead to creative accounting.
6. Management change
New managers have a tendency to show losses due to poor management of
old/previous management by some provisions. Dahi (1996) found this
tendency in US bank managers.
14.5 TECHNIQUES OF CREATIVE ACCOUNTING
The opportunity or potential for creative accounting or the techniques of
creative accounting are as follows:
1. Regulatory Flexibility
Accounting regulation often allows a choice of policy, for example, in
respect of asset valuation. (International Accounting Standards allows a
choice between carrying non -current assets, at either revalued amount or
depreciated historical cost). Business entities may quite validly, change
their accounting po licies. As Schipper (1989) points out, such changes
may be relatively easily to identify in the year of change, but are much
less readily discernible thereafter (a few years later).
2. Dearth / Lack of regulation
Some areas are simply not fully regulated. For example, there are (as yet)
very few mandatory requirements in respect of accounting for stock items.
3. Management can use their discretionary position
In order to obtain the financial position and stability they assumed. For
example, the managers dec ide to increase or reduce provisions for bad
debts (McNichols & Wilson, 1988).
4. The timing of some transactions gives the management an opportunity
to increase the revenues, when the operating profit is not satisfactory and
to create the desired impressi on in the accounts. For example, suppose a
business has an investment at historic cost, which can easily be sold for a
higher sales price, being the current value. The business managers are freemunotes.in
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216to choose in which year, they sell the investment and so incr ease the profit
in the accounts.
5. Artificial transactions can be entered into for manipulating balance
sheet amounts and to more the profits between accounting periods. This is
done, by entering into 2 or more related transactions, with an obliging
third party, normally a bank. The sale price under such a ‘sale and
leaseback’ can be pitched above or below the correct value of the asset,
since the difference can be compensated for by increased or reduced
rentals.
6.Reclassification and presentation of fin ancial numbers are relatively
under explored in the accounting literature.
CORPORATE GOVERNANCE
Meaning
Corporate governance is a set of rules and conduct, as per which
companies are managed and controlled. It usually involves the
mechanisms by means of wh ich, company manager’s answer for the due
and proper running of the corporate performance. The company represents
the assets of all the shareholders and in the long term, the company’s
interests necessarily converge with those of its shareholders.
“Control ” means effective performance evaluation, careful management of
potential risks and proper supervision of agreed procedures and processes.
The emphasis is on monitoring whether robust control systems are
working efficiently, whether potential conflict of i nterests are being
managed and whether sufficient checks are in place, to prevent abuses of
power, that may allow personal interests to prevail over company interests.
(Karine, J. Bertrand M, 2001:9)
Corporate Governance is the mechanism in which companies are
governed in a transparent manner, by rule of law, in which shareholders
participation prevails, in a responsive, efficient and effective way, in order
to ensure sustainability and accountability. The concept of corporate
governance is getting importan t day by day, since, each and every country
in the recent past, has been a disastrous trail of many big corporate failures
/ scandals, that shook the entire economy. With globalization, there is
more deterritorialization and less of govt. control, which le ads in a greater
need of accountability. Thus, corporate governance has become a very
crucial issue in managing organizations, in the current global and complex
environment. So, it is very significant to develop comprehensive corporate
governance policies.
Definitions of Corporate Governance
1. Sir Adrian Cadbury (The father of modern corporate
governance)
“Corporate governance is the system by which companies are directed and
controlled”.munotes.in
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2172.Lavekar and Tayan
“Corporate governance is the collection of con trol mechanism that an
organization adopts to prevent or dissuade potentially self -interested
managers from engaging in activities detrimental to the welfare of
shareholders and stakeholders.”
Corporate governance is very important/crucial for every organ ization,
since good corporate governance improves firms performance.
Every organization has to enforce corporate governance policy, to achieve
a stated goal/objective.
Corporate Governance Functions
Corporate governance is a broad concept, consisting of a set of internal
and external mechanisms, designed to align management interests with
shareholders interests and to have compliance with applicable laws, rules
and standards.
Corporate governance has an important role to play, in improving
customer confiden ce in financial reports and capital markets, by focusing
on three institutional factors –ownership structure, legal system and
capital markets.
The seven essential corporate governance functions are as under:
a)Oversight function
The oversight function i s given to the board of directors, with the fiduciary
duty of overseeing the alignment of the managerial function, with the best
interests of the company and the shareholders.
b)Managerial function
The management is given the authority to run the company and manage its
resources and operations.
C)External Audit function
The external auditors express an opinion, that financial statements truly
and fairly represent, in all material respects, the company’s financial
position and the results of operations, in conformity with accounting
standards and principles.
d) Internal Audit function
It provides both assurance and consulting services to the company in the
areas of operational efficiency, risk management, internal controls,
financial reporting and governanc ep r o c e s s e s .
e) Compliance function
It is a set of laws, best practices developed by the government regulatory
standard -setting bodies and professional organizations, to create a
compliance framework for public companies, in which to operate and
achieve th eir goals.munotes.in
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218f) Legal and financial advisory function
It provides legal advice and helps the company, its directors, officers and
employees in complying, with applicable laws, rules, regulations and other
legal obligations and fiduciary duties.
g) Monitori ng function
It is exercised by shareholders, particularly, institutional shareholders,
who have the power to elect directors and if needed, to remove directors.
The role of Corporate Governance in detecting Creative Accounting
Practices
A company requires effective corporate governance to reduce the
likelihood of creative accounting and, in particular, fraud. It involves
effective internal controls and effective independent scrutiny, of the
executive directors, by non -executives.
The four main areas which a company, has to pay attention, in order to
mitigate the fraud risk are as follows:
1. Effective internal controls
Internal controls includes a control environment and risk assessment and
management, monitoring and control activities. The presence of stron g
controls, avoids the possibility of financial malpractice. The collection of
controls provides a key mechanism, combined with internal audit,
whereby, malpractice can be minimized.
2. Division of the responsibility between chief executive and chairman
Itis very dangerous for one person, to be the chief executive and also the
chairman. It is an essential division of authority in the board room. It
prevents the unmitigated use of powers, by one person.
3. Audit Committee
The audit committee is a relatively new development which is responsible
for supervising the auditors. For the audit committee to be effective, it
should be independent and not staffed by friends, acquaintance or family
members of existing executive directors. It has to meet frequently and has
to be staffed by experienced persons.
4. Independent board of directors
There is a need for the board of directors itself to be strong. To be
effective, there has to be independent non -executive directors. As with the
audit committee, the board of dire ctors should not be friends,
acquaintances or family members of existing executive directors.
Thus, we should have an effective corporate governance system, to limit
or avoid, cases of creative accounting.
In the eyes of law, shareholders are considered su preme and directors are
the agents or representatives of shareholders. In reality, the picture is
totally different. The shareholders are not supreme, but the directors are
supreme due to :munotes.in
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219Boards –Family managed with unchallenged control.
Shareholders –Generally scattered, disinterested, ill organized and
have little voice.
Employees –Financially poor to act.
Since, the high profile collapses of large number of companies and most
of them were involved in accounting fraud, there is a need for better code s
and standards on corporate governance, to overcome the creative
accounting practices.
The various Committee Reports on Corporate Governance are as
follows:
Sir Adrian Cadbury Committee (UK), 1992
Greenbury Committee (UK), 1995
Bosch report (Australia), 1 995
Vienot Report (France), 1995
Calpers Global Corporate Governance Principles (USA), 1995
Hampel Committee on Corporate Governance (UK), 1998
Combined Code of Best Practices (London Stock Exchange), 1998
Blue Ribbon Committee (USA), 1999.
OECD Principles of Corporate Governance (Focus on Disclosures)
1991 and then revised in 2004.
Euro Shareholders Corporate Governance Guidelines, 2000.
Joint Committee on Corporate Governance (Canada), 2001
King -II Report on Corporate Governance for South Africa (2002).
Sarbanes –Oxley (SOX) Act, 2002 (USA).
Smith Report (UK) on Audit Committee (2003)
Higgs Report (UK) (2003).
UNCTAD Guidance on Good Practices in Corporate Governance
Disclosure, UK (2008).
Post liberalization, major corporate governance initiatives in Ind ia
are as follows:
1)CII –Confederation of India Industry Taskforce on Corporate
Governance –1996.
2)Kumar Mangalam Committee Report on Corporate Governance –
1999.
3)Narayan Murthy Committee Report –2002.
4)Naresh Chandra Committee Report –2002.
5)Corporate Gov ernance Voluntary Guidelines 2009.munotes.in
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220Regulatory Framework on Corporate Governance in India
1)The Companies Act, 2013
2)SEBI Guidelines.
3)Standard Listing Agreement of Stock Exchanges.
4)Accounting Standards issued by ICAI.
5)Accounting Standards issued by ICSI.
6)SEBI (Insider Trading) Regulation, 1992.
7)New Takeover Code and SEBI (Substantial Acquisition of Shares
and Takeovers) Regulation, 1997.
8)SEBI (Prohibition of Fraudulent and Unfair Trade
Practices) Regulations, 1995.
9)The Depositories Act, 1996.
RECOMMENDATI ONS / SUGGESTIONS TO DETECT AND
PREVENT FRAUDULENT PRACTICES OF CREATIVE
ACCOUNTING
Corporate Governance Code of Conduct has an important role to play, in
preventing or curbing curative accounting practices.
The following recommendations can help indetec ting and preventing
fraudulent practices of creative accounting.
1.Audit Committee
An audit committee consisting of minimum 3non-executive directors,
should be formed, having authority to investigate.
2.Balance of Directors
The board should have a balan ce of executive director and non -executive
directors (in particular independent non -executive directors).
3.Majority independent non -executive directors
The majority of non -executive directors, should be independent of
management and free from any busine ss or other relationship.
4. Establish formal and transparent arrangements
To consider how they should apply the financial reporting and internal
control principles, the board should establish formal and transparent
arrangements.
5. Accountability of Exter nal Auditors
The external auditors should be accountable to the Board of Directors and
to the Audit Committee.
6. Sufficient Remuneration Level
To attract, motivate and retain directors of the quality required, to
successfully run the company, the remunera tion level should be sufficient.
A company should avoid paying more than is necessary, for their purpose.munotes.in
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2217. Timely and Correct disclosure
The framework of corporate governance should see that correct and on
time, disclosure is done on all important matter s, about the company,
including the financial situation, performance ownership and company
governance.
8. Financial Statements Certification
The company’s chief executive and the chief financial officer, should
certify the financial statements.
9. Disclosu re in financial reports
There should be certain disclosures in financial reports including
information about off balance sheet transaction and orders the SEC to
develop rules regarding proforma disclosure.
10. Criminal Penalties
For corporate fraud and doc ument shredding, there should be criminal
penalties.
11. Recognition of standards established
The SEC should recognize standards established by a private -sector
accounting standard setter, provided that the standard setter is deemed
acceptable by the SEC and consider International Conveyance in
developing standards.
12. Adoption of IFRS
One act of global financial reporting standard called IFRS, should be
adopted by all operators of Accounts or those doing accounting duties.
13. Role of Auditor
In preventi on and detection of creative accounting practices, the auditor
has an important role to play.
The company’s auditor, auditing process can be trusted if he is a well -
established entity and has a good track record. The auditor should not be
the sole auditor of the company. In other words, there should be more than
one auditor and they should be periodically rotated, in order that
familiarity between company and auditor, does not lead to decrease in
objectivity.
14. System for Investor Education
A proper syste m should be there to educate investors about the financial
terms and its probable impact on financial position, by providing, booklet
of methods, adopted by the proposed company, for various items in
different situations and expected changes in special cir cumstances.
15. Reducing alternate choices
The al ternate choices of accounting treatment, in accounting standards,
should be reduced.munotes.in
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22214.6CONCLUSION
The relation between Corporate Governance and Creative Accounting
is two edged sword.
These two terms are two sides of a coin, because the presence of
creative accounting is connected to the weakness of corporate
governance.
The connection between corporate governance and creative accounting
takes place due to conflict between ownership and control i.e. Ag ency
Theory and due to Information Asymmetrical.
Creative Accounting is the process of manipulating accounting figures,
by taking advantage of the loopholes in accounting rules, within the
legal framework. It is not illegal.
It is possible to minimize the negative effects of creative accounting
practices, by adopting accounting standards, giving more importance
to ethical considerations and decreasing the flexibility in the
accounting methods, since flexibility in the accounting method, is the
major reason for creative accounting.
Audit committees play an important role in discouraging creatuve
accounting practices.
There is a need of modification of corporate system, to curb creative
accounting practices, in terms of various codes of conduct.
The disastrous trail of big corporate failures or scandals like Enron,
Satyam, WorldCom, Tyco etc., have led to the initiation of corporate
governance reforms process and lead to passing of the Sarbanes -
Oxley Act to prevent corporate frauds and ensuring transparency an d
disclosures.
India also requires similar type of reforms.
Even though corporate governance mechanisms cannot prevent
unethical activity in top management completely, but they can at least,
act as a means of detecting such activity, before it is too late.
14.7 EXERCISE
1)What are errors and frauds and explain the types of errors and the
types of frauds.
2)Distinguish between : Errors and Frauds.
3)What is ethics? What are the ethical issues in accounting ?
4)What is Corporate Governance?
5)What is Creative Accountin g?
6)What is the relationship between Corporate Governance and Creative
Accounting ?
7)Explain the types of unethical issues in accounting.munotes.in
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2238)State the parties to creative accounting.
9)What are the reasons / motivations for creative accounting ?
10)Ql.10 What are the techniques of creative accounting ?
11)Enumerate the functions of Corporate Governance.
12)Discuss the role of corporate governance in detecting creative
accounting practices.
13)Give suggestions orrecommendations to detect and prevent
fraudulent practices of creative accounting.
14)Choose the correct alternatives:
1. ______________ are intentional mistakes.
a)Errors
b)Frauds
c)Purchases
d)Sales
2.. _____________ are unintentional mistakes.
a)Paying wages
b)Errors
c)Frauds
d)Receiving interest
3. _______________ errors are e rrors in which the effect of one error is
effect, by the effect of another error.
a)Compensating
b)Principle
c)Omission
d)Clerical
4. Errors of _____________ are done due to not knowing the accounting
principles.
a)Clerical
b)Principle
c)Omission
d)Commission
5.When a tr ansaction is completely or partially omitted to be recorded in
the books of account s, it is called an error of _______________ .
a)Omission
b)Principle
c)Compensating
d)Clericalmunotes.in
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2246.Errors which are done due to wrong casting, wrong recording, w rong
posting etc. are errors of________________ .
a)Partial omission
b)Complete omission
c)Commission
d)Principle
7. ______________ accounting is taking undue advantage of the loopholes
in the accounting system
a)Cost
b)Financial
c)Management
d)Creative
8. ______________ is an art of manipulati ng the books of accounts, in a
manner that desired results can be drawn.
a)Creative accounting
b)Financial accounting
c)Cost accounting
d)Management accounting
9. ______________ accounting is also called cosmetic accounting.
a)Creative
b)Cost
c)Financial
d)Branch
10.The w ord ‘ethics’ i s derived from the Greek Word_____________ .
a)ethos
b)etho
c)eth
d)et
11.Falsifying document is a / an _____________ issue in accounting.
a)ethical
b)good
c)better
d)bestmunotes.in
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22512. ____________ is a set of rules and conduct, as per which companies
are managed and controlled.
a)Financial reporting
b)Corporate Governance
c)Ethics
d)Creative Accounting
13. _____________ is a control system to reduce the effects of creative
accounting, on the reliability of accounting information directed to the
stakeholders interest.
a)Corporat e Reporting
b)Corporate Scandals
c)Corporate Governance
d)Corporate Audit
14. ____________ minimizes information asymmetry and answers
compliance with mandated reporting requirements and maintains
credibility of a firm’s financial statements and safeguard agains t
manipulative behavior,
a)Corporate Accounting
b)Corporate Statement
c)Corporate Reporting
d)Corporate Governance
Ans. 1 -b; 2-b; 3-a; 4-b; 5-a; 6-c; 7-d; 8-a; 9-a; 10 -a; 11 -a; 12 -b; 13 -c;
14-d
munotes.in