Accounting For Managers

Accounting for
Managers
Accounting for Managers
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Introduction to Accounting Information
C
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A
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INTRODUCTION
Rapid growth in cross-border investments over the past two
decades has resulted in an increasing demand for high quality
and uniform financial reporting. Investment decisions are
made based primarily on the publicly available information.
Given, it is imperative to ensure credible, comparable and
transparent financial reporting on part of the listed firms so as
to make sure that investors belief in the efficiency of the
capital markets remains intact.
This Chapter introduces a conceptual framework for preparing
financial statements, defining the objectives of financial
reporting and the qualitative characteristics and elements of
financial statements.
OBJECTIVES
After reading this chapter, you should be able to:
Assess the need for Accounting Information
Determine the need for a conceptual framework
Recognize the elements of financial statements
Identify the Principal Financial Statements
3
Section 1
The Need for Accounting Information
We live in the information age,
where every decision that we make
requires collecting relevant data
per t ai ni ng t o t he deci si on,
analyzing and converting them into
usable information, identifying the
various alternatives, considering
their consequences and zeroing in
on a decision. Take for instance a
decision to purchase a car. We
collect all the relevant information
such as types of cars, makes,
manufacturers, mileage, etc. Next
we decide which car is suitable and
best for us. It consumes resources
in terms of money, time and mental
work. Now, think of individuals and
enterprises which manage billion-
r u p e e b u s i n e s s e s . I f t h e
information provided to them is not
accurate, timely, etc., it could lead
to poor decisions and, in turn, cost
organizations billions of rupees.
In an organization different people
need di f f er ent i nf or mat i on,
collected from different sources for
making different decisions. For
example, investors and creditors
use information to assess the
future risks to and return on their
pot ent i al i nvest ment s. Thus
depending on the information
needs, i nf or mat i on may be
quantitative or non-quantitative.
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The above figure clearly states that information can be
quantitative or/and non-quantitative. Quantitive information
can be accounting information and non-accounting
information. Further, accounting information can be divided
into Operating Information, Financial Accounting Information,
Management Accounting Information and Tax Accounting
Information. They are defined as follows:
Operating information: Information about the day-to-day
operations of the business is referred to as operating
information.
Management accounting: Accounting information specifically
prepared to help managers make decisions and to manage
the business.
Financial Accounting: Information relating to the financial
performance and financial position of a firm/business is given
by financial accounting. It is concerned with providing
relevant financial information
to various external users.
Ta x a c c o u n t i n g : Th i s
information helps in filing tax
returns. In some countries
such as USA, companies
need to maintain separate
records for tax accounting
p u r p o s e s o w i n g t o
differences in rules for tax
accounting and financial
accounting.
Operating information and
management accounting information is generated only for
people internal to the organization, but financial accounting
information is useful both for internal as well as external
users. For example, investors, suppliers, customers, financial
institutions and government make use of Financial
Accounting Information extensively for decision-making
purposes.
5
Keynote 1.1.1: Quantitative and Non-quantitative Informa-
tion
Video 1.1.1:
Financial Accounting vs
Managerial Accounting
CONCEPTUAL FRAMEWORK
The conceptual framework is a very important prerequisite to
understand the financial statements. It describes the basic
concepts that underlie the preparation of financial statements. It
is designed to prescribe the nature, functions and limits of
financial accounting and can be used as guidelines for
maintaining consistency in standards. The objective of the
framework is to narrow down the diverse accounting principles
and procedures being followed, resulting in harmonized
regulations, transparency and comparability. While the Financial
Accounting Standards Board (FASB) has issued conceptual
framework for companies listed in the US capital markets, the
International Accounting Standards Board (IASB) has issued
equivalent framework to be followed globally. The Institute of
Chartered Accountants of India (ICAI) has issued framework to
be complied by the companies operating in India.
Here we deal with the conceptual framework issued by the
FASB of the US which constitutes foundation of Financial
Reporting.
The objectives of the conceptual framework are:
To serve as the foundation upon which the Board (FASB)
can construct standards that are both sound and internally
consistent.
Intended for use by the business community to help
understand and apply standards to assist in their
development.
Provide guidance in analyzing new or emerging problems of
financial accounting and reporting.
Solve complex financial accounting and reporting process by
providing a set of common premises as a basis for
discussion.
Solve complex financial accounting and reporting processes
by limiting areas of judgment and discretion and exclude
from consideration potential solutions that are in conflict with
it.
Impose intellectual discipline on what traditionally has been
a subjective and ad hoc reasoning process.
6
C o n c e p t u a l
framework issued by
ICAI is provided here.
T h e C o n c e p t u a l
Framework issued by
the IASB is provided
here
We shall limit our discussion here to only a few components of
the conceptual framework. The scope of the Conceptual
Framework is applicable to General Purpose Financial
Statements. Financial statements may be general purpose
financial statements and special purpose financial statements.
General purpose financial statements are prepared for the
common needs of the users of the financial statements. Some
users need additional information for their decision-making, so
while preparing these statements their need should be kept in
mind. Additional information is provided in the form of notes,
schedules and explanatory notes, etc. Special purpose
financial statements are prepared for special purposes like tax
computations, for submitting it to financial institutions, etc.
These special purpose financial statements are not covered
by the said framework.
7
ICAI
IFRS
The components of the conceptual
framework given by FASB include:
! Objectives of Financial Report-
ing by Business Enterprises.
! Qualitative Characteristics of
Accounting Information.
! Elements of Financial State-
ments of Business Enterprises.
! Objectives of Financial Report-
ing by Non-Business Organiza-
tions.
! Recognition and Measurement
in Financial Statements of En-
terprises.
! Elements of Financial State-
ments.
! Using Cash Flow Information
and Present Value in Account-
ing Measurements.
ICAI
IFRS
http://220.227.161.
86/238acc_bodies
_framework_ppfs.
pdf
http://www.ifrs.org/NR/
rdonlyres/363A9F3B-D4
1C-41E7-9715-79715E815
BB1/0/EDConceptualFra
meworkMar10.pdf
REVIEW 1.1.1
Check Answer
Question 1 of 3
FASB conceptual framework is applica-
ble to
A. Financial statements pre-
pared for tax purposes
B. Financial statements pre-
pared for registration pur-
poses
C. General purpose financial
statements
D. Financial statements pre-
pared for cost audit purposep-
poses
8
Section 2
Components of Conceptual Framework
Objectives of Financial
Reporting
As per the Statement of Financial
Accounting Concepts (SFAC) 1 of
the FASB, the objectives of
financial reporting are:
Financial reporting provides
information that is useful in
ma k i n g b u s i n e s s a n d
economic decisions. For this
purpose, the users of financial
statements may be internal to
the organization such as
management and directors of
the business, or may be
external to the enterprise such
as lenders, suppliers, potential
investors, etc.
Financial reporting provides
understandable information
that will aid investors and
creditors in predicting future
cash flows of a firm. Investors
a n d c r e d i t o r s r e q u i r e
information to evaluate the
t i m i n g , a m o u n t a n d
uncertainties of future cash
flows.
It provides information relative
to an enterprises economic
resources, claims to those
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resources/ obl i gat i ons, and t he eff ect of t hose
transactions, events and circumstances that change
resources and claims to resources, etc.
Users of financial reporting require information so as to
ascertain:
The Economic Position of the Enterprise: Financial
Reporting information provides the users with the information
on the economic resources, obligations and owners equity
that indicates the firms strengths, weaknesses, liquidity and
solvency.
The Economic Performance of the Enterprise: Financial
Reporting information provides the users with information
about the economic performance and earnings of the
enterprise that help in predicting the future performance of
the firm. This information helps in assessing the changes in
the economic resources and predicting the companys ability
to generate cash flows in the future based on the current
resources.
The Liquidity and Solvency of the Firm: Financial
Reporting information about cash and other funds flows such
as cash flows from borrowings, repayment of borrowings,
changes in economic resources, obligations, owners equity
and earnings help in assessing the firms liquidity and
solvency.
Management Stewardship and Performance: An
enterprises efficient and profitable utilization of resources,
which is reflected in its economic performance and position,
speaks of the management stewardship and performance,
circumstances, uncertainties, etc., enhances the usefulness
of financial information.
Qualitative Characteristics of Financial
Statements
Information to be useful to the users should possess certain
characteristics. The qualitative characteristics are the criteria
to be used in choosing and evaluating the accounting and
reporting policies. These characteristics help to evaluate the
strengths and weaknesses of accounting and its relevance to
effective analysis and
decision-making.
SFAC 2 identifies the
f o l l o w i n g
charact eri st i cs t hat
mak e i nf or mat i on
useful.
RELEVANCE
Information should be
r e l e v a n t t o t h e
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Video 1.2.1: Objectives and Qual-
ity of Financial Reporting
decision-making needs of the user. Information is said to be
relevant when it influences the economic decision of the
users. Relevance of information is said to be affected by its
nature and materiality. Information is said to be relevant when
it provides feedback value and predictive value. Feedback
value is derived from information concerning past events.
Predictive value is derived from information concerning future
events. Information to the relevant must be timely.
RELIABILITY
Information must be reliable. Reliability means the extent to
which information is representationally faithful, verifiable and
neutral. Representational faithfulness implies that information
must represent faithfully the transactions and events it
purports to represent. The quality of verifiability means that
several independent measures obtain the same accounting
measure. This quality helps to reduce and mitigate
measurement bias. The quality of neutrality implies free from
bias and material errors.
COMPARABILITY
It enhances the ability of investors and creditors to compare
information across companies to make their resource
allocation decisions. The financial statement users must be
able to compare the statements of an entity through time in
order to identify trends in financial position and compare the
financial statements of different entities in order to evaluate
their relative financial position and performance. Lack of
consistency threatens the comparability of the financial
statements.
CONSISTENCY
The quality of consistency requires the use of same
accounti ng pri nci pl es from one peri od to another.
Consistency contributes to information usefulness. This does
not in any way imply that a change in accounting principle
cannot and should not be made. A change in accounting
principle leads to inconsistency, but it is acceptable if the
disclosure is made and the change was imperative.
Elements of Financial Statements
Financial statements portray the effects of financial
transactions by grouping these into broad classes according
to their economic characteristics termed as the elements of
financial statements. SFAC 6 defines ten interrelated
elements as follows:
11
Keynote 1.2.1: Elements of Financial State-
ments
ASSETS
Probable future economic benefits obtained or controlled by a
particular entity as a result of past transactions or events.
LIABILITIES
Probable future sacrifices of economic benefits arising from
present obligations of a particular entity to transfer assets or
provide services to other entities in the future as a result of
past transactions or events.
EQUITY
The residual interest that remains in the assets after deducting
its liabilities. In a business enterprise, the equity is the
ownership interest.
REVENUES
Inflows or other enhancements of assets of an entity or
settlement of its liabilities (or a combination of both) from
delivering or producing goods, rendering services, or other
activities that constitute the entitys ongoing major and central
operations.
EXPENSES
Outflows or other using up of assets or occurrences of
liabilities (or a combination of both) from delivering or
producing goods, rendering services, or carrying out other
activities that constitute the entitys ongoing major and central
operations.
GAINS
Increases in equity (Net Assets) from peripheral or incidental
transactions of an entity and from all other transactions and
other events and circumstances affecting the entity except
those that result from expenses or distribution to owners.
LOSSES
Decrease in equity (Net Assets) from peripheral or incidental
transactions of an entity and from all other transactions and
other events and circumstances affecting the entity except
those that result from expenses or distribution to owners.
COMPREHENSIVE INCOME
The change in equity of a business enterprise during a period
from transactions and other events and circumstances from
sources other than investments by owners or distribution to
owners.
INVESTMENTS BY OWNERS
Increases in equity of a particular business enterprise resulting
from transfers to it for the purpose of increasing ownership
interests.
DISTRIBUTION TO OWNERS
Decreases in the equity of a particular business enterprise
resulting from transferring assets, rendering services, or
incurring liabilities to owners.
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Recognition Criteria of Elements of Financial
Statements
The principles of recognition help determine as to when an
element is to be included in the statements, while measuring
principles determine the valuation of such elements. There are
four revenue recognizing criteria: definitions, measurability,
relevance and reliability. In case an element meets the
definition of an element, is capable of being reliably measured,
and makes a difference in the decision of the user and is
verifiable, neutral and representationally faithful, it needs to be
included in the financial statements.
Measurement Criteria of Elements of Financial
Statements
Measurement is the process of determining the amount of
elements to be recognized and carried to the income statement
and bal ance sheet. There are fol l owi ng four basi c
measurement described in the framework:
HISTORICAL COST (HISTORICAL PROCEEDS)
Assets such as plant, property and equipment and most of the
inventories are reported at their historical values. These are the
amounts of cash or its equivalents that are paid in order to
acquire such assets and are commonly adjusted after the
acquisition for amortization or other allocations. Liabilities are
reported at cash or its equivalent that is received when the
obligation was incurred and may be adjusted after acquisition
for the purpose of amortization or other such allocations.
CURRENT COSTS
This is used for some inventories and represents the cash or its
equivalent that would have to be paid for acquiring the assets
currently. Certain assets like investments are to be reported at
their current market values. In the case of liabilities that involve
marketable securities and commodities, these are to be
reported at their current market value.
NET REALIZABLE (SETTLEMENT) VALUE
In the case of short-term receivables and some inventories,
reporting is done on the basis of their net realizable values.
Liabilities that are incurred and which are known or estimated
and payable at future dates are reported at their net settlement
values.
PRESENT (OR DISCOUNTED) VALUE OF FUTURE CASH
FLOWS
In the case of long-term receivables, reporting is done at their
present or discounted values which is the present value of the
future cash inflows which an asset is expected to be converted
in due course of the business less the present value of the cash
outflows that are expected to be converted in the due course of
the cash outflows that are necessary to obtain those funds.
Users of Financial Statements
The basic objective of preparation of financial statements is to
provide information to the users of the statements. The users
may be the internal people or external people to the
organization.
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SHAREHOLDER/INVESTORS/OWNERS
The shareholders/owners are the investors who provide
capital or resources to an enterprise in exchange for a share
in ownership of the enterprise. The information provided in
the financial statements help them to arrive at various
investment decisions such as whether to invest further, or to
withdraw the existing investments, etc. Similarly, potential
investors use the financial statements to arrive at
investment decisions.
MANAGEMENT
Since management has the ultimate responsibility for the
financial performance, they periodically compile and
interpret the financial statements. An analysis of the
financial figures is essential for the smooth and efficient
functioning of the enterprise.
LENDERS
Banks, financial institutions and other lenders provide funds
to the business entity They would be willing to part their
money only if they are assured a periodical return in the
form of interest and ultimate return of their principal. The
financial statements reflect the profitability and long-term
solvency of the business and provide the assurance which
the lenders look out for.
SUPPLIERS/CREDITORS
The suppliers look for the short-term liquidity and solvency
of the business for judging the credibility of the firm through
the analysis of the statements. The financial statements
facilitate the creditors in ascertaining the capacity of the
organization to pay on time consideration for the goods and
services supplied.
EMPLOYEES
Employees have vested interest in the continued and
profitable operations of the organization in which they work.
Most of the incentive plans of large number of enterprises
are directly related to the profitability of their businesses.
This further magnifies the interests of the employees in their
companys future profitability and health.
CUSTOMERS
They comprise groups such as producers, wholesalers and
retailers and final consumers. Legal obligations associated
with guarantees, warranties and after sales service
contracts tend to establish long-term relationship between
the business and its customers. The financial statements
may be used by the customers to draw inferences about the
long-term viability of the firm.
GOVERNMENT AND OTHER REGULATORY AGENCIES
Governments and other regulatory agencies plans and
policies in respect of taxation, subsidies and incentives are
guided by the requirements of the industries and also their
past performances. A lot of information in this regard can be
gathered from a scrutiny of the financial statements of
business enterprises.
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RESEARCH
Scholars undertaking research into management science
covering diverse facets of business practices look into the
financial statements for the information eventually used for
analysis.
OTHERS
Diverse persons such as academicians, researchers and
analysts may approach business firms for information regarding
the financial performance. The public, in general, also examine
the financial statements for employment opportunities, health of
the business concerns, in particular, and the economy as a
whole.
Additional resources to this section
15
REVIEW 1.2.1
Check Answer
Question 1 of 3
Which among the following is the
objective of the FASB conceptual
framework
A. Intended to serve as the foun-
dation upon which the Board
(FASB) can construct stan-
dards that are both sound and
internally consistent.
B. Intended for use by the busi-
ness community to help under-
stand and apply standards to
assist in their development.
C. Provide guidance in analyzing
new or emerging problems of
financial accounting and re-
porting.
D. All of the above.
Video 1.2.2:
Conceptual Framework
Section 3
Principal Financial Statements
Basi cal l y there are three
principal financial statements,
viz., the balance sheet, the
income statement and the
st at ement of cash f l ows.
However, some count ri es
r e q u i r e p r e p a r a t i o n o f
additional statements such as
preparation of changes in
s h a r e h o l d e r s e q u i t y ,
explanatory notes, etc.
Balance Sheet
It is also called the Statement
of Financial Position. It depicts
the financial position of a
company on a particular date.
It gives the information of how
t he c ompany has been
financed and how that money
has been invested in various
pr oduct i ve r esour ces. A
company can obtain finance
from owners and outsiders.
The balance sheet is prepared
based upon the fundamental
accounting equation of
Assets = Liabilities + Equity
Thus, the balance sheet has
three major sections, viz.,
assets (i.e., the resources of
the company), liabilities (i.e.,
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the debts of the company) and shareholders equity (i.e., the
amount invested by owners). We have already defined it in the
previous section.
The values given in the balance sheet change from time to
time, hence the values appearing in the balance sheet pertain
to a specific date, generally, the end of the business financial
year (for example, March 31).
Income Statement
It is also called the Profit & Loss account or Income and
Expenditure Statement. It indicates the amount of net income
or loss obtained by the company during a particular period.
The preparation of the income statement is governed by the
matching principle which states that the performance can be
measured only if revenues and related costs are accounted
for during the same time period. As per SFAC 6, revenues are
the inflows of an entity and expenses are the outflows of an
entity as a result of delivering or producing goods, rendering
services, or carrying out other activities that constitute the
entitys ongoing major or central operations.
The main beneficiaries of this statement are the investors,
creditors, management and other interested parties who are
interested in knowing the financial performance of the entity.
We have already dealt with the users of financial statements
in the earlier section.
Statement of Shareholders Equity
Statement of shareholders equity consists of change in
shareholding pattern of the company during a specified
per i od. Thi s s t at ement
provides information about the
changes in owners interest in
the company during the year.
For example, an increase in
equity resulting from profits is
reflected in this statement.
Si mi l ar l y, di st r i but i on of
earnings to shareholders in
the form of di vi dends i s
reflected in this statement.
More specifically, this statements shows information about
Preferred shares, Common shares, Additional paid in capital,
Retained earnings, Treasury shares, Employee stock
ownership plan adjustments, Minimum pension liability,
Valuation allowance, Cumulative translation allowance, etc. In
India, the statement of shareholders equity is not separately
shown, but it forms a part of the Reserves and Surplus section
on the Balance Sheet. This statement is useful for identifying
reasons for changes in shareholders claims on assets of the
company.
Some changes in assets and liabilities bypass the income
statement and appear in the statement of changes in
stockholders equity, viz., foreign currency translation
adjustments, minimum pension liability adjustments and
unrealized gains or losses on available-for-sale investments.
Such adjustments and other non-recurring items make it
difficult to discern the operating results of an enterprise. The
FASB requi res fi nanci al statement recogni ti on and
measurement of many financial instruments at fair value. This
17
Video 1.3.1:
Statement of changes in
Shareholders Equity
results in unrealized gains and losses on these instruments.
The concept of comprehensive income offers a solution to
these problems and this item appears as part of the
Statement of Shareholders Equity.
Statement of Cash Flows
It is also called the Cash Flow Statement. It explains where
the cash has come from, how that cash has been utilized and
effects of all these transactions on the cash balance of the
firm. It gives information on a companys cash flows relating to
operating, financial and investing activities. Investing cash
flows are those which result from acquisition or sale of
property, plant and equipment; acquisition or sale of a
subsidiary or segment and purchase or sale of investments in
other firms. Financing cash flows are those which result from
issuance or retirement of debt and equity securities and
dividends paid to stockholders. Operating cash flows are
those resulting from the revenue producing activities, or from
operating activities of the firm.
Others
In addition to information provided by mandatory financial
statements, both financial and non-financial information are
provided in the Annual report of a firm under different heads.
SUGGESTED READINGS/REFERENCE MATERIAL
Gerald I. White, Ashwinpaul C. Sondhi, Dov Fried, The
Analysis and Use of Financial Statements, John Wiley &
Sons Inc.
Meigs and Meigs, Financial Accounting, McGraw Hills Inc.
How to Read a Balance Sheet, Oxford and IBH Publishing
Co. P. Ltd.
Additional Resources
18
Video 1.3.2:
Core Financial Statements
Video 1.3.3:
How to read Financials
19
REVIEW 1.3 .1
Check Answer
Question 1 of 4
The three principal financial statements are
A. Balance sheet, income statement
and statement of cash flows.
B. Balance sheet, statement of
changes in shareholders equity and
income statement.
C. Balance sheet, statement of
changes in shareholders equity and
explanatory notes.
D. Balance sheet, income statement
and explanatory notes.
Income Statement
C
H
A
P
T
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2
INTRODUCTION
The purpose of the income statement is the determination of
profits of the business. This statement is also helpful in
predicting the future profitability of the concern and the future
cash generating ability of the enterprise. This statement
reports the change in the owners capital or the shareholders
equity as a result of operations of the enterprise.
OBJECTIVES
After going through the chapter, you should be able to:
Differentiate between the capital and revenue expenditure.
Describe briefly the concepts and principles governing
Income Statement.
Explain the meaning of Income statement.
State the General format and contents of Income
statement.
Prepare Income statement.
21
Section 1
Performance Statement
The Income Statement is also
cal l ed the Profi t and Loss
Account. It indicates the amount
of net income or loss obtained by
a company during a particular
period. Net income is the excess
of revenues over expenses, and
the net loss is the excess of
expenses over revenues. It gives
t he summar i zed oper at i ng
information about the sales,
costs, i ncomes, profi ts and
losses of the company during a
particular period. It is the best
me a s u r e t o a s s e s s t h e
profitability and performance of a
company.
The performance of a company
captured in the Profit and Loss
Account reveals the relationship
between revenue, expenses and
Profit/Loss:
Income Expenses = Profit
22
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Significance of Profit and Loss Account
i. It helps to know the overall net profit or loss earned or suffered
by the firm during a particular period. This is the index of the
profitability of the firm.
ii. It is very useful for inter-firm or intra-firm comparison.
iii. Comparison of various expenses in different periods is
possible so that management can take effective control over
various expenses.
iv. It helps in calculating cash from operations. Cash flow
information is very important to security analysts and other
users of financial statements.
v. The various profitability ratios help the users analyze/assess
the profitability of the firm better.
Distinguish Between Capital and Revenue Items
The concept of capital and revenue is of fundamental importance
in correctly determining the accounting profits of a business and
recognizing the assets of an enterprise.
Capital and Revenue Expenditure
Expenses can be classified into capital or revenue expenditure
based on their utility to the business entity. Capital expenditure
relates to those expenses which generate benefits and assist the
entity in earning revenue over a period of time (e.g., more than 12
months). Revenue expenditure relates to those expenses which
are incurred in earning the revenues and the benefits of which get
exhausted within the accounting period.
Table 1: Distinction between Revenue and Capital Expenditure
23
Video 2.1.1:
What is an Income Statement?
Deferred Revenue Expenditure
Expenditure that is basically of revenue nature for which
payment has been made or liability incurred but the benefits
are presumed to result in subsequent periods can be treated
as deferred revenue expenditure. The guidance note issued
by the ICAI defines deferred revenue expenditure as
expenditure for which the payment has been made or a
liability incurred but which is carried forward on the
presumption that it will be of benefit over a subsequent period
or periods.
! The expenditure must be of revenue nature.
! The exact amount and the period of time for which the
benefit will be available cannot be precisely determined.
! The expenditure does not result in acquisition of any
tangible or intangible asset.
! The expenditure is written off over a period of time during
which benefits are assumed to result. Example: Heavy
advertisement expenditure incurred to launch a new
product.
Capital Receipts and Revenue Receipts
The receipts, which do not affect the profits earned or losses
incurred during the course of the year, are called Capital
Receipts. These take the following forms:
! Contributions made by the proprietor towards the capital
of the business in the case of sole proprietorships. In the
case of companies, the receipts from the issue of shares
are considered as capital receipts.
! Receipts from the sale of fixed assets, previously not
intended for resale.
Receipts from sale of goods to customers or from rendering
of services in the ordinary course of business are termed
Revenue Receipts. These directly add to the profits of the
business or decrease the losses of the business. The net
profits remaining after deducting the revenue expenses are
available for distribution to shareholders.
CONCEPTS RELATING TO PROFIT DETERMINATION
Determination of profit or net income is important in financial
accounting. Accountants need to measure the business
income or net income or profit. There are some concepts
which guide the accountants while determining the income. A
brief explanation of these concepts is given in this section as
follows:
Accounting Period Concept
24
Video 2.1.2: Capital vs Revenue
Determination of a definite period is very essential to measure
net income or profit. Users of financial statements periodically
would like to know the net income generated on the resources
invested by them. Thus, they want regular reports about
financial results and the financial position. Accountants may
prepare reports for a particular period or after the completion of
a particular project depending on the type of business. If the
interval between the reports is one year, it will be helpful to the
businessman and the users.
Realization Concept
The timing of revenue recognition is critical in profit
determination. It ensures that proper cut-off is made to each
reporting period. If this criterion is followed, it results in
avoidance of overstatement or understatement of revenues.
Revenue should be recognized in the period in which it is
earned, not necessarily when cash is received.
Matching Concept
This concept helps in matching the revenues with the
expenses. Determination of profit involves recognition of
revenue and allocation of costs. As per this concept, the
expenses are to be recognized in the period of their related
revenue. Thus, matching concept requires the recognition of
revenue and expenses on a comparable basis.
Conservatism Concept
According to this concept, accountants require to underplay
favorable prospects until they are actually realized. They should
Anticipate no profits, but provide for all possible losses. Thus,
revenues are to be recognized only when they are reasonably
certain and expenses as soon as they are reasonably possible.
This concept must be applied prudently so as not to result in
secret profits and reserves which contravenes the convention
of full disclosure.
25
REVIEW 2.1.1
Check Answer
Question 1 of 2
Capital expenditure is an expenditure which
A. Benefits the current accounting period.
B. Will benefit the next accounting period.
C. Results in the acquisition of a perma-
nent asset.
D. Results in the acquisition of a current as-
set.
Section 2
Format of Income Statement
No specific format exists for
the presentati on of the
Income Statement. Hence
c o m p a n i e s t a k e
considerable leeway while
presenting this statement,
resulting in a variety of
presentations. Nonetheless,
two distinct types can be
identified: Multiple Step
Format and Single Step
Format. The multiple step
format reports the results in
a series of sub-totals such
as Gross Profit, Operating
Profit Before Interest and
Depreci ati on, Operati ng
Pr of i t Bef or e Tax and
Exceptional items and Net
Pr of i t Bef or e Tax and
except i onal i t ems. For
ex ampl e, t he i nc ome
s t a t e me n t o f I n f o s y s
Technologies is a multiple
step income statement. In
contrast, the single step
format groups all revenues
and deducts expenses in a
single step, doing away with
speci fi c sub-total s. For
ex ampl e, t he i nc ome
statement of Tata Steel
Limited is a single step
presentation.
Traditionally, the income
statement (referred to as
Trading and Profit and Loss
Account) was presented in
t he f or m of a Ledger
Account (also known as T
26
Source:www.img.ehowcdn.com
form) with expenses and losses being shown on the left side
and the incomes and gains on the right side of the account.
Also, traditionally Income Statement was sub-divided into
manufacturing account, Trading and Profit and Loss Account.
In the case of Corporate entities, Part II of the Schedule VI of
the Companies Act, 1956 does not prescribe any format for the
profit and loss account, but only outlines the information to be
included. The Companies Act does not require the preparation
of Manufacturing Account or the Trading Account. Only the
requirement of Profit and Loss has been specified. Most
companies prepare Profit and Loss Account in Vertical Format.
Profit and Loss Account for the Year ended 31st March,
xxxx
(Figures in Rs.)
COMPONENTS OF INCOME STATEMENT
Total Revenue: Total revenue represents the sales revenue
generated from sale of goods or services to customers. The
firm earns revenue from the sale of its principal products.
Sales are usually shown net of any discounts, returns and
allowances. Brokerage, commission paid to selling agents and
cash discount other than the usual trade discounts are
exhibited separately in other expenses. In the case of a
service organization like Infosys, income generated from
services can be the total revenue.
Costs of Revenue: The first expense deduction from sales
is the cost the seller incurs while selling his products sold
to customers. This expense is called cost of goods sold or
cost of services rendered. For a retailing firm, the cost of
goods sold equals beginning inventory plus purchases
minus ending inventory. In case of a manufacturing
concern, the cost of goods manufactured replaces
purchases since the goods are produced rather than
purchased. A service firm will not have cost of goods sold
27
or cost of sales, but will often have cost of development or
rendering of services.
Gross Profit: The difference
between net sales and cost
of goods sold is called gross
profit or gross margin. Gross
profit is the first step in
measurement of profit on the
multi step income statement
and is a key analytical tool in
assessing a firms operating
performance. The gross profit indicates how much profit the
firm is generating after deducting the cost of products sold.
Operating Expenses: Operating expenses can be broadly
classified into five categories selling, administrative,
depreciation and amortization, lease payments and repairs
and maintenance:
Selling Expenses They
r el at e t o t he expenses
resulting from the companys
effort to make sales including
advertising, traveling, sales
commission, sales supply
and so on. Di st ri but i on
expenses like advertisement,
samples given to customers,
storage expenses, etc., are expenses in the profit and loss
account.
Administrative Expenses These relate to the expenses
of general administration of the companys operations.
They include salaries, rent, taxes, insurance, printing,
stationary, postage and telephone, legal fees, audit fees,
other general expenses, bad debt expenses and other
costs difficult to allocate.
Abnormal Losses: Losses, which arise on account of
abnormal reasons, are termed abnormal losses. For
example, loss due to theft, fire, accident, etc. These losses,
to the extent not covered by insurance claims, are losses/
expenses in the profit and loss account.
Profit or Loss on Sale of Assets: Loss on sale of assets
is loss/expense in the profit and loss account. Gain or profit
arising on sale of fixed assets is taken as income/gain in
the profit and loss account.
Cash Discount: It is the amount of cash discount given to
the customers. It is a loss and is shown as an expense.
The amount of cash discount received from creditors is an
income and is shown on the credit side of the profit and
loss account.
Bad Debts and Bad Debts Recovered: The amount,
which cannot be recovered from customers, is termed as
bad debt. It is a loss and is shown under expenses. If the
amount which was previously written off as bad debt, is
received, it is treated as income.
Lease Payments Lease payments include the costs
associated with operating rentals of leased facilities for
retail outlets. A Lease can be either an operating lease or a
28
Video 2.2.2: Enhancement
of Income Statement
Video 2.2.1: More details on
computation of Gross Profit
finance lease. Operating lease is a conventional rental
agreement with no ownership rights conferred on the
lessee. If a lease agreement satisfies four conditions
(transfer of ownership to lessee, contains a bargain
purchase option, has a lease term of 75% or more of the
leased propertys economic life or has minimum lease
payments with a present value of 90% or more of the
propertys fair value), it is called as finance lease. Each
lease payment is apportioned partly to reduce the
outstanding liability and partly to interest expense.
Depreciation and Amortization The cost of assets that
will benefit a business enterprise for more than a year is
allocated over the assets service life rather than expensed
in the year of purchase. The cost allocation procedure is
determined by the nature of long-lived assets. Depreciation
is used to allocate the cost of tangible fixed assets such as
buildings, machinery, equipment, fixtures and fittings, motor
vehicles, etc. Amortization is the process applied to the cost
expiration of intangible assets such as patents, copyrights,
trademarks, licenses, franchisees and goodwill. The cost of
acquiring and developing natural resources like oil and gas,
other minerals and standing timber is allocated through
depletion.
Repairs and Maintenance These are the costs of
maintaining the firms property, plant and equipment.
Expenditures in this area should correspond to the level of
investment in capital equipment and to the age and
condition of the companys fixed assets.
Operating Profit: It is a companys profit from its core
business operations. It is arrived at after deducting
operating expenses from operating revenues. Operating
profit does not include interest expenses or other financing
costs. Nor does it include income generated outside the
normal activities of the company, such as income on
investments or foreign currency gains, or extraordinary
incomes and other non-operating incomes. Operating
income is a measure of profitability based on a companys
operations.
Non-Operating Incomes and Expenses: Non-operating
incomes and expenses are those which are not related to
the company core business. Items such as dividend and
interest earned on investments, rental income, hire
charges, lease rentals, abnormal losses, profit and sale of
assets, profit or loss on sale of investments, etc. are
considered non-operating items.
29
Video 2.2.3: Income Statement
Profit Before Interest and Tax (PBIT): It measures the
gross performance of the company. As the term indicates,
it is the profit of the company (both operating and non-
operating) excluding the interest expenses and taxation
expenses. This measure is generally used to measure the
performance of the company with reference to its total
capital employed.
Interest: Interest paid on loans, overdrafts and to creditors
is an expense. Any amount received in the form of interest
is an income. For example, interest received on
investment, interest received on deposits, etc. Interest paid
on capital should be shown separately on the expense
side of the profit and loss account and interest received on
drawings should be shown on the income side of the profit
and loss account in the case of sole proprietor and
partnership firm.
Profit Before Tax (PBT): This indicates the profits
available after interest but before charging tax. This is to
understand the impact of tax which is a compulsory charge
(expense) on the net profit of the company.
Profit After Tax (PAT): This is a measure of net profit of
the company. It is the net profit earned by the company
after deducting all expenses like interest, depreciation and
tax. PAT can be fully retained by a company to be used in
the business. Dividends, if declared, are paid to the
shareholders from this residue.
Profits Available to Equity Shareholders: This indicates
the amount of current profits plus the accumulated profits
available to equity shareholders after appropriating
dividends to preference shareholders. These profits can be
fully distributable to equity shareholders or fully retained or
partly distributed and partly retained according to the
company policy.
Special Items:
Extraordinary items Extraordinary items may be
defined as material events and transactions distinguished
by their unusual nature and by the infrequency of their
occurrence. Extraordinary income or expenses in a
particular period should be separately stated in the
statement of profit and loss in a manner that its impact on
current profit or loss can be perceived. Examples include a
major casualty such as fire; prohibition under a newly
enacted law, etc. These items net of their tax should be
shown separately.
Prior period items The term refers to expenses and
incomes which arise in the current period as a result of
errors or omissions in the preparation of financial
statements of one or more periods. Errors may occur as a
result of mathematical mistakes, mistakes in applying
accounting policies, misinterpretation of facts, or oversight.
Prior period items may be disclosed separately to
ascertain the effect of such transactions on the profit/loss
for the period.
In the Vertical form of Profit and Loss Account, appropriations
are shown at the bottom of the Profit and Loss Account.
Details such as appropriations made from the profits in
30
respect of preference dividend, interim and final equity
dividends and transfer to reserves, etc. are shown here.
The balance in the Profit and Loss Appropriation Account, if
any, is taken to the liability side of the balance sheet under
the heading Reserves and Surplus. If there is any short fall
(very rare) in Profit and Loss Appropriation Account (that is, a
loss), then the shortfall is shown on the Asset side under the
heading Miscellaneous Expenditure.
See Exhibit
Profit is not Cash Flow
Profit is not cash flow. Adequate cash is essential to keep
business running. Inadequate cash increases the risk of not
being able to meet current obligations as and when they arise
which is dangerous to the company. There are many
instances when businesses failed because of lack of cash
inflows even though their operations were profitable.
Similarly, a loss making enterprise may be holding huge cash
reserves due to its inability to deploy funds for productive
purpose. Under accrual system of accounting net income
(revenue less expenses) does not equate net positive cash
flows. The difference is the timing of sale; expenses and
profits do not coincide with their associated cash flows.
Hence there is always a discrepancy between profit and net
cash flow.
A statement of Cash Flows is an essential component of
Financial Statements. As the profit and loss account and the
balance sheet are prepared on accrual basis, the profits
disclosed by the profit and loss account do not indicate the
liquidity of the firm. A firm may be highly profitable but may
find itself with hardly any cash or working capital to continue
the operating cycle. On the contrary, a loss making firm may
have sufficient cash flows.
31
PROFIT & LOSS
ACCOUNT
TATA STEEL LTD
Video 2.2.4:
Multi Step Income State-
ment
Video 2.2.5:
Profit vs Cash flow
http://www.ntpc.co
.in/annualreports/
2010-11/Profit-Loss
-Account.pdf
http://www.tatasteel
.com/investors/pdf/
Q4-FY11.pdf
REViEW 1.2.1
Check Answer
Question 1 of 3
For the purpose of calculating depreciation,
cost of the asset means
A. Residual value
B. Market price
C. Cost + Transport + Installation ex-
penses
D. Cost Price or Market Price which-
ever is less
32
Section 3
Preparation of Profit and Loss Account
Preparation of Profit and
L o s s Ac c o u n t / I n c o me
Statement is easy. In the
hor i zont al f or m al l t he
expenses pertaining to the
period for which it is drawn
are taken to the left hand
side of the account and
Incomes & Gains as appear
in the Trial Balance are
taken to the right hand side
of t he account . I f t he
Incomes and Gains exceed
the expenses & losses, the
enterprise has made profit,
but it makes losses for the
period if the expenses and
losses exceed incomes and
gains. In the vertical form of
Income Statement all the
i ncomes and gai ns are
shown first and there from
the expenses are deducted.
The balance is profit.
As already seen, the trial
balance is the outcome of
transaction analysis using
Fundamental Equation, by
taking all the expenses,
losses on one side and
i ncomes and gai ns on
another side of account.
However, there may be
some year-end adjustments
which have not been given
affect to and do not appear
in the trial balance. These
adjustments are needed to
adhere to the concepts such
as accrual concept, going
c o n c e r n c o n c e p t ,
conservatism concept and
33
matching concept. These appear as adjustments required to be
made and integrated in the Income statement or the Balance
Sheet. These adjustments call for transaction analysis through
Fundamental Equation which imply they affect at least two items
already appearing in the Income Statement or/and Balance
Sheet.
Adjusting entries
Even when the events effecting the enterprise have been
properly recorded using Fundamental Equation and transaction
analysis, there are certain account balances which need to be
updated before an accountant can proceed to prepare the
Financial Statements from the Trial Balance. Such entries are
called the Adjusting Entries. Adjusting entries are required to
implement the accrual concept, more specifically, the realization
concept and the matching concept. Adjusting entries help to
ensure that all revenues earned in the period are recognized in
the period regardless of when the exchange of cash took place.
Similarly in the case of expenses, the adjusting entries ensure
that the enterprise recognizes all the expenses incurred in the
period regardless of when the payment for the expenses is
made. This results in the Income statement reflecting a more
compl ete measurement of the enterpri ses operati ng
performance and the Balance Sheet reflecting a more complete
measurement of the financial position of the enterprise.
Some of the areas where adjustment entries are required
include:
i. Accrued income.
ii. Income received in advance.
iii. Outstanding expenses.
iv. Prepaid expenses.
v. Closing stock.
vi. Depreciation.
vii. Bad debts.
viii. Bad debts provision.
ix. Provision for discount on debtors and creditors.
x. Interest on capital.
xi. Interest on drawings.
Accrued Income
Accrued income involves the recognition of revenue earned
before it is actually received. It implies that if a portion of an
income has been earned but it has not yet been received as the
due date of payment falls in the next accounting period, then the
income must be brought into account. Few examples of accrued
34
Video 2.3.1:
P & L Preparation
or accruing incomes in
r e s p e c t o f wh i c h
adj ust ment ent r i es
may have to be made
a r e i n t e r e s t o n
gover nment l oans,
di scount s on bi l l ,
i n t e r e s t o n
investments, rents and
premium on leases,
etc.
Income Received in Advance
Income received in advance results when the enterprise
receives cash from customers in one accounting period for
goods or services to be provided in the next accounting period.
While preparing the financial statements adjustment entries are
required for this item. Rent received in advance, subscriptions
received in advance in
the case of clubs, etc.,
ar e f ew exampl es
where income may be
received in advance
for which adjustment
are required.
O u t s t a n d i n g
Expenses
Outstanding expenses
refers to expenses
incurred but not yet paid. Before the preparation of the financial
statements it must be
ensured that all the
expenses which have
fallen due to be paid
but which have not
been paid during the
accounting period are
brought to account.
Rent out s t andi ng,
interest outstanding,
wages outstanding are
examples of expenses
outstanding.
Prepaid Expenses
Prepaid expenses result when the cash outflow precedes the
actual expense. In other words, these are amounts paid in the
accounting period for
services to be received
i n t he subsequent
accounting period. It is
important to identify
t hat port i on of t he
expenditure for which
the payment has been
made but the benefit is
yet to be received and
make an adj ust i ng
entry. Rent pai d i n
advance, I nsurance
35
Keynote 2.3.1: Illustration
prepaid, etc., are a few examples where an adjusting entry is
required.
Closing Stock
Under the periodic verification method, the closing inventory of
every item is arrived at by physically counting the inventory
available and assigning a value to the same. In concerns
adopting the periodic verification method, the value of the
closing inventory will be shown in the Balance Sheet as an
asset and goes into Income statement as a component of Cost
of Goods sold.
Depreciation
We will deal with depreciation in detail in the chapter on Fixed
Assets. An adjustment for depreciation needs to be made. This
results in decrease in the value of the asset which is shown in
balance sheet at Cost. And since depreciation is an expense it
appears in the Income statement.
Bad Debts
Debts which are uncollectible or irrecoverable are a loss to the
business. Hence an adjustment is needed in the books in
respect of this loss. Bad debts decrease the amount due from
debtors to a business, in other words, accounts receivable are
reduced from the Balance Sheet and are shown as an expense/
loss in the Income Statement.
Bad Debts Provision
When it is feared that
some of the amounts
due from customers
are uncollectible or
i r r ecover abl e i t i s
prudent to provide for
the expected loss in
t he bus i nes s . An
adj ust i ng ent r y i s
needed to create a
provision for these
ant i ci pat ed l osses.
This creation is a loss/expense in the Income Statement and
the same is reduced from Debtors or Accounts receivable in the
balance Sheet.
Provision for Discount on Debtors
The organization which allows the facility of making payments
before the due date and enable their debtors to avail of cash
discounts, must take into account the possible amount of
discounts that may be allowed on closing debtors in the
forthcoming year. This is necessary to show the closing sundry
debtors at their realizable value.
The principles for creation and maintenance of the provision for
discounts for debtors are the same as those discussed in the
provision for bad debts. The only point to be noted is that
discounts will be estimated on debts considered good. i.e. net
36
accounts receivable balance after the bad debts are reduced
from it.
The above provision shall be shown in the balance sheet as a
deduction from the Sundry Debtors/ Accounts Receivable
Illustration:
The following is trial balance of X Ltd., as on March 31, 2011.
Other Information:
l. Stock on March 31, 2011 was valued at Rs.41,500.
m. Total bad debts to be written off during the year were Rs.
20,000.
n. A new machine was installed on December 31, 2010
costing Rs.20,000, but it was not recorded in the books
and no payment was made for it. Wages of Rs.2,000 paid
for its erection have been considered as Salaries.
o. An item of Rs.100 for bank charges appears in the bank
statement but has not yet been entered and is not
reflected in the bank account of X Ltd..
p. Provide depreciation at 10% per annum on furniture and
building and 20% on plant and machinery.
q. No rent has been paid on the small business building
during the year because of a dispute with the landlord. The
rental agreement provides for a rent of Rs.24,000
r. A provision for doubtful debts is to be made at 5% on
sundry debtors.
You are required to prepare an Income Statement for the
period 2010-11.
Solution:
37
Particulars
Expenses/
Assets (Rs.)
Incomes/
Liabilities (Rs.)
Equity share capital (Rs.10 each) 3,50,000
Sundry creditors 1,23,000
Sundry debtors 2,85,000
Bills receivable 72,000
Salaries 2,50,000
Advertisement expenses 50,000
Investment (@ 12% interest acquired on
October 1, 2010)
2,55,000
Plant and machinery 3,80,000
Provision for doubtful debts 12,000
Bills payable 55,000
Electricity 42,000
Telephone bills 16,000
Auditors fees 16,500
Purchases 3,20,000
Sales 9,80,000
Cash at bank 38,000
Opening stock (April 1st, 2010) 38,000
Bad debts 17,500
Furniture & Fixtures 3,62,300
Interest on investment 6,300
Building 2,70,000
Preference shares capital (Rs.100 each) 6,00,000
11% debenture 3,00,000
Repairs 14,000
24,26,300 24,26,300
Income Statement of X Ltd. for the year ended 31.3.2011:
38
Schedule Rs.
a) Net Sales / Income from Operations 980000
b) Other Operating Income 0
Total Operating Income [ 1(a) + 1(b) ] 9,80,000
Total Expenditure
a) (Increase) / decrease in stock-in-trade -3500
b) Purchases of finished, semi-finished steel
& other products
320000 320000
c) Staff Cost 1 248000
d) Advertisement 50,000
e)Electricity 42,000
f) Telephone Charges 16,000
g) Auditor's Fees 16,500
h)Repairs 14,000
i) Bad debts 2 20,000
j) Bank Charges 100
k) Depreciation 3 140330
l)Rent 24,000
m) Provision for Bad Debts 2,125
Total Expenditure 889555
Profit Before Other Income, Finance Charges
and Taxes
90,445
Other Income 4 15,300
Profit before Interest and Tax 1,05,745
Finance Charges 33,000
Profit Before Tax 72,745
Schedule 1: Staff Costs Schedule 1: Staff Costs Schedule 1: Staff Costs
Salary 2,50,000
Less: Wages for
machinery
2,000 2,48,000
Schedule 2:Bad Debts Schedule 2:Bad Debts Schedule 2:Bad Debts
Bad debts 17,500
Add: Additional 2,500 20,000
Schedule 3 : Depreciation Schedule 3 : Depreciation Schedule 3 : Depreciation
Depreciation on
Furniture @ 10% 36,230
Building @ 10% 27,000
Machinery @ 20%
Old
76,000
New 1,100 1,40,330
Schedule 4 : Other Income Schedule 4 : Other Income Schedule 4 : Other Income
interest on investment 6,300
Add: Accrued
9,000 15,300
Problems 1
On 31.3.2011 Mr. X has the following balances in his books
Debtors Rs.40,000; Bad debts Rs.600. Mr. X decided to
maintain the provision for doubtful debts at 5%. How much is
the Provision for doubtful debts that needs to be maintained?
Solution
Since Rs.600 appears in trial balance as bad debts, it implies
the transaction analysis is complete. Hence the provision to be
ma i n t a i n e d w i l l b e
40,000 x 5% = Rs.2,000.
Problems 2
On 31.3.2011 Mr. X has the following balances in his books
Debtors Rs.40,000; Bad debts Rs.600. At the end of the year
Mr. X decided to write off additional bad debts of Rs.500 (for
which no transactional analysis has been made) and maintain
the provision for doubtful debts at 5%. How much is the
Provision for doubtful debts that needs to be maintained?
Solution
Since Rs.600 appears in trial balance as bad debts, it implies
the transaction analysis is complete. However, transactional
analysis for additional bad debts of Rs.500 has not been
performed. On performing the transactional analysis, debtors
will reduce by Rs.500.
REVIEW 2.3.1
Check Answer
Question 1 of 2
The adjustment to be made for income re-
ceived in advance is
A. Added to respective income and
show it as a liability.
B. Deducted from respective income
and show it as an asset.
C. Added to respective income and
show it as an asset.
D. Deducted from respective income
and show it as a liability.

20 3
22, 000x x
100 12
! "
# $
% &

Schedule 4 : Other Income
interest on investment 6,300
Add: Accrued
12 6
2, 55, 000x x
100 12
! "
# $
% &

9,000 15,300

"#$%&'((#(()#*+ ,-#(+./*( 0 1
1. The adjustment to be made Ior income received in advance is
a. Add to respective income and show it as a liability
b. Deduct Irom respective income and show it as an asset
c. Add to respective income and show it as an asset
d. Deduct Irom respective income and show it as a liability
e. Deduct Irom respective income and add to expenditure.

2. On 31.3.2011 Mr. X has the Iollowing balances in his books Debtors Rs.40,000; Bad debts
Rs.600. Mr. X decided to maintain the provision Ior doubtIul debts at 5. How much is the
Provision Ior doubtIul debts that needs to be maintained?
3. On 31.3.2011 Mr. X has the Iollowing balances in his books Debtors Rs.40,000; Bad debts
Rs.600. At the end oI the year Mr. X decided to write oII additional bad debts oI Rs.500 (Ior which
no transactional analysis has been made) and maintain the provision Ior doubtIul debts at 5. How
much is the Provision Ior doubtIul debts that needs to be maintained?
.
4. Ravi paid salaries Ior the period ended March 31, 2010 amounting to Rs.1,50,000. The salaries
paid are in respect oI services rendered during 2009-10. Salaries outstanding on March 31,
2010 is Rs.25,000. The total amount to be considered as expense in ProIit and Loss account
is
a. Rs.1,75,000
b. Rs.1,25,000
c. Rs.1,50,000
d. Rs.1,00,000
e. Rs.50,000.

5. The Admirable Company Limited was registered with a nominal capital oI Rs.5,00,000 divided
into shares oI Rs.10 each, oI which 20,000 shares had been issued and Iully paid.
Expenses/Assets
Amount
Rs.
Incomes/Liabilities
Amount
Rs.
39
Hence Net debtors = Rs.40,000 Rs.500 = Rs.39,500.
On t h i s p r o v i s i o n o f 5 % wi l l b e
(40,000 500) x 5/100 = Rs.1,975
into shares of Rs.10 each, of which 20,000 shares had been
issued and fully paid.
Problems 3
The Admirable Company Limited was registered with a nominal
capital of Rs.5,00,000 divided
You are required to prepare Income Statement for the year
ended December 31, 2011 after taking into consideration the
following adjustments.
a. Write off one-third preliminary expenses
40
b. Depreciation on plant and machinery at 20% and on office
furniture at 10%
c. Manufacturing wages Rs.945 and office salaries Rs.600
had accrued due
d. Provide for interest on Bank loan for 6 months
e. The stock was valued at Rs.62,420 and Loose Tools at Rs.
5,000
f. Reserve Rs.4,250 on debtors for doubtful debts
g. Reserve further Rs.1,560 for discounts on debtors
h. The directors recommend dividend at 5% for the year
ending December 31, 2011 after providing for taxes
amounting to Rs.11,500.
Solution
Income statement of Admirable Company Limited for the period
ended 31st March 2011
41
Schedule Rs.
a) Net Sales / Income from Operations 1 5,78,630
b) Other Operating Income 0
Total Operating Income [ 1(a) + 1(b) ] 5,78,630
Total Expenditure
a) (Increase) / decrease in stock-in-trade 30,790
b) Purchases of finished, semi-finished
other products
2 4,05,825
c) Manufacturing Wages 3 55,815
d) Manufacturing Expenses 9,620
e)Carriage Inwards 2,455
f) Power 7,105
g) Repairs 4,305
h) Carriage Outwards 4,630
i) Rates & Electricity 1,700
j) Directors fees & Remuneration 6,000
k)Office salaries and expenses 4 7,100
l) Auditors fees 625
m)Commission 4,320
n)Preliminary expenses written off 5 1,000
o) Depreciation on Plant & Machinery 6 9,340
p) Provision for bad debts 4,250
q)Provision for discount on debtors 1,560
r) Interest on Bank Loan 7 1,250
Total Expenditure 5,57,690
Profit Before Other Income and Taxes 20,940
Other Income 20
Profit before Tax 20,960
Provision For Taxation 11,500
Net Profits 9,460
42
Schedule 1: Schedule 1: Schedule 1:
sales 5,84,950
Less: Returns 6,320
5,78,630
Schedule 2: Schedule 2: Schedule 2:
Purchases 4,10,730
Less: Returns 4,905
4,05,825
Schedule 3 : Manufacturing
Wages
Wages
Wages
Manufacturing wages 54,870
Add: Due 945 55,815
schedule 5: Preliminary
Expenses
Expenses
Expenses
Preliminary
expenses written off
1,000
Schedule 4: Office Salaries Schedule 4: Office Salaries Schedule 4: Office Salaries
Office salaries and
expenses
6,500
Add: Outstanding 600 7,100
Schedule 6: Depreciation Schedule 6: Depreciation Schedule 6: Depreciation
Depreciation on
Plant & Machinery
39,200 x 20% 7,840
Loose Tools (6,250 5,000) 1,250
Furniture 2,500 x 10% 250
Schedule 7: Interest Schedule 7: Interest Schedule 7: Interest
Interest on Bank loan 625
Add: Outstanding 625 1,250
Balance Sheet
C
H
A
P
T
E
R

3
INTRODUCTION
Every businessman is interested in knowing two facts about
his business. One is whether he has earned a profit or
suffered a loss during a particular period and the other is his
financial position on a particular date. For this purpose,
financial statements are prepared at the end of the accounting
period. Balance Sheet is a statement that captures the
financial position of the business at a certain point of time.
OBJECTIVES
After going through the chapter, you should be able to:
State the concept of Balance Sheet.
Describe the concepts and principles governing the
presentation of Balance Sheet.
Explain the brief contents of Balance Sheet.
Explain the Preparation of Balance Sheet.
State the Limitations of Balance Sheet.
44
Section 1
Statement of Financial Position
Balance Sheet is also known as
St at ement of Fi nanc i al
Position. It depicts the financial
position of a company on a
particular date. It gives the
information of how the company
has been financed and how that
money has been invested in
various productive resources.
The financial position of the
enterprise, captured in the
Balance Sheet, reveals the
r el at i onshi p bet ween t he
economic resources of the
enterprise and its claims against
the said enterprise (obligations
of t he s ai d ent er pr i s e) .
Ec o n o mi c r e s o u r c e s i n
accounting terminology are
called the Assets and the claims
are called Liabilities, pertaining
t o credi t or s cl ai ms whi l e
owners equity pertains to
owners claims. This can be
depicted in the form of an
equation as follows:
45
Video 3.1.1:
Introduction to Balance
Sheet
Assets = Liabilities + Owners equity.
Assets
Assets are the probable future economic benefits obtained or
controlled by a particular entity as a result of past transactions
and events as stated in the Statement of Financial
Accounting Concepts No.6, FASB. Assets simply mean what
the enterprise owns.
Liabilities
Liabilities are probable future sacrifices of economic benefits
arising from present obligations of a particular entity to
transfer assets or provide services to other entities in the
future as a result of past transactions or events. Liabilities
simply mean amounts the enterprise owes to others.
Equity
Equity or owners equity is the residual interest in the assets
of an entity that remains after deducting its liabilities. Simply
put, equity or owners equity is the difference between the
enterprises assets and its liabilities.
Some of the definitions of balance sheet are provided as
follows:
The Balance sheet is a statement at a given date showing on
one side the traders property and possessions and on the
other side his liabilities.
Palmer
A Balance sheet is an itemized list of the assets, liabilities
and proprietorship of the business of an individual at a certain
date.
Freeman
A list of balances in the asset and liability accounts. This list
depicts the position of assets and liabilities of a specific
business at a specific point of time.
American Institute of CPA
Thus, balance sheet lists down the assets, liabilities and
capital of the business on a
specific date.
Concepts Relating to
Balance Sheet
Generally, all accounting statements are prepared based on
some concepts and conventions. Balance sheet is also an
accounting statement. There are no specific rules for
preparing a balance sheet. It is prepared based on certain
46
Video 3.1.2:
Why balance sheet mat-
ters?
concepts and conventions. Let us reiterate some important
concepts and conventions, which help prepare a balance sheet:
Going Concern Concept
Going concern concept implies that a business entity is
assumed to carry on its operations indefinitely. This concept
helps in categorizing assets into fixed and current. The Going
concern concept implies that the resources of the concern
would continue to be used for the purpose for which they are
meant to be used. If the organization is not a going concern,
then the fixed assets are recorded at their realizable values.
Cost Concept
As per this concept, the assets should be recorded in the books
of accounts at a price which forms the basis for its subsequent
accounting. Assets are recorded at the cost price at the time of
purchase and subsequently their value is reduced by charging
depreciation. Thus, according to this concept assets shown in
the balance sheet are either at their cost price or at their written
down value. This concept actually flows from the going concern
concept.
Convention of Consistency
This convention requires a business enterprise to follow
consistent accounting procedures and practices from time to
time. This is required to enable a comparative study of the
performance of the business over a period of time and also to
make objective comparison within the industry.
Convention of Full Disclosure
The purpose of financial accounting is to provide information to
the users for decision-making. This convention implies that all
material information that could affect the decision of the user
must be disclosed. Full disclosure ensures complete, fair and
adequate disclosure of business transactions in financial
reports.
Format of Balance Sheet
There is no specific form of
balance sheet for non-corporate
entities like sole proprietorship
f i rms and part nershi p f i rms.
However, the assets and liabilities
may be shown in the order of:
a. Liquidity, or
b. Permanency.
a. Liquidity Order: The assets, which are easily convertible
into cash (called as liquid assets), come first and those,
which cannot be readily converted, come next and so on.
Similarly, liabilities are also arranged in this manner. The
liabilities which are payable on a priority basis come first and
those payable later come next and so on.
b. Permanency Order: In the order of permanency, permanent
assets are shown first and those of less permanence are
shown next and so on. In other words, fixed assets are
shown first, followed by liquid assets. On the liabilities side,
permanent liabilities are shown first and less permanent
ones are shown next and so on. In other words, capital is
47
Video 3.1.3:
Classified balance sheet
shown first followed by long-term liabilities, short-term
liabilities and current liabilities in that order.
In India, the Balance Sheets of companies is required to be
set out in the forms prescribed under Part I of Schedule VI.
Part I of Schedule VI contains two forms of Balance Sheet
(1) Horizontal Form and (2) Vertical Form.
Format of Horizontal Form of Balance Sheet of xxx Ltd, as
on March 31, 20xx
For a more detailed study of the Horizontal Form of
Balance sheet visit
Vertical form of Balance Sheet is currently the most popular
and is an outcome of demand for a more understandable
and satisfactory format.
Most companies in India follow the Vertical Form of Balance
Sheet because it holds the following advantages:
Easily Comprehensible: The traditional form of balance
sheet was difficult to understand by a wide variety of
users most of whom were not conversant with the
principles of accounting. The Vertical form of Balance
Sheet can be easily comprehended by all.
A Birds Eye View: Only broad heads are shown in the
Balance Sheet without too many details. These details
are shown in schedules and are cross referenced against
the Balance Sheets broad heads. This helps the readers
to get a birds eye view of the position of the company
and at the same time get more details through the
schedules.
Classification: The Balance Sheet is classified as
Sources of Funds and Application of Funds. The
Sources of Funds comprise Shareholders equity and
Long-term debt. The Application of Funds comprise
application towards Fixed Assets and Working Capital.
Such nomencl at ur es al so f aci l i t at e a bet t er
understanding of the concept. Further, in the traditional
form of Balance Sheet the net working capital of the
company could not be easily figured; however, this has
been taken care of in the Vertical form of Balance Sheet.
The introduction of schedules which form a part of the
Financial Statements has given scope for more
disclosure and inclusion of details giving a better picture
of the items being analyzed.
48
For a more detailed
study of the Horizontal
Form of Balance
sheet
Format of Vertical Form of Balance Sheet

49
REVIEW 3.1.1
Check Answer
Question 1 of 4
The balance sheet gives information regarding
the
A. Results of operations for a particular
period.
B. Financial position during a particular
period.
C. Profit earning capacity for a particu-
lar period.
D. Financial position as on a particular
date.
Section 2
Understanding Balance Sheet
SOURCES OF FUNDS
The sources of funds is
divided and disclosed under
the heads:
Shareholders Funds
Loan Funds
Shareholders Funds
T h e y r e p r e s e n t t h e
ownership interest in the
company. It is the residual
i nt erest i n asset s t hat
remains after meeting all
liabilities. The owners bear
the greater risk because
their claims are subordinate
to creditors in the event of
liquidation, but owners also
benefit from the rewards of
a successful enterprise.
The ownership interest may
be further sub-divided into:
Share Capital
Reserves and Surplus
Share Capital: The capital
raised by the company
through the issuance of
shares is known as Share
50
Source:www.4.bp.blogspot.com
Capital. The Companies Act
basically provides for two
classes of shares Equity
shar es and Pr ef er ence
shares. Preference shares
enjoy preferential treatment
with regard to the payment of
dividends and repayment of
capital. Equity shareholders
enjoy voting rights. But there
is no obligation to the company to pay dividends at a fixed
rate every year. Even at the time of winding up of the
company, they receive their capital only after the payment to
preference shareholders is made.
Further details of Share Capital are as below:
Authorized capital It must mention the total number of
shares and the face value of each share.
Issued capital It must distinguish between the various
classes of shares issued to the public and in respect of
each class of shares, the total number of shares issued
and the face value per share should be specified.
Subscribed capital It must distinguish between the
various classes of shares actually taken up by the public
and in respect of each class, the number of shares
actually taken up and the face value should be disclosed.
If shares have been allotted as fully paid-up for
consideration other than cash (say, shares issued in the
takeover of a business), then the number of such shares
so allotted must be disclosed. Also, the number of shares
which have been allotted as fully paid-up by way of
bonus shares should also be disclosed.
The called-up capital and any calls unpaid or in arrears
should be shown as a deduction from the called-up
capital to arrive at the paid-up capital.
In respect of calls-in-arrears, the calls unpaid by directors
and by others must be shown distinctly.
Any forfeited shares to the extent they have not been
reissued and to the extent of the value originally paid-up
must be shown as an addition to the capital.
The particulars of different classes of preference shares
should be provided. These include
Terms of redemption or conversion (if any), of any
redeemable preference share capital should be stated
together with earliest date of redemption or conversion.
The source from which the bonus shares have been
issued, for example, capitalization of profits or reserves
or from share premium account, should also be specified.
Reserves and Surplus: Reserves and surplus are profits the
firm retains. Revenue reserves represent accumulated
retained earnings from profits from normal business
operations. These take several forms such as general
reserve, investment allowance reserve, capital redemption
reserve, dividend equalization reserve, etc. Capital reserves
arise out of gains which are not related to the normal
51
Video 3.2.1:
Share Capital/ Stock
business operations. Examples of such gains are the
premium on issue of shares or gains on revaluation of assets.
Surplus is the balance in the profit and loss account which
has not been appropriated (transferred) to any particular
reserve account. It may be noted that reserves and surplus
along with equity capital represents an owners equity.
The following items appear under Reserves and Surplus:
i. Capital Reserves
ii. Capital Redemption Reserve
iii. Share Premium Account
iv. Other Reserves specifying the nature of each reserve and
the amount, less any debit balance in the Profit and Loss
Account (if any)
v. Surplus, that is, balance in the Profit and Loss Account
after providing for dividend, bonus or reserves
vi. Proposed additions to reserves
vii. Sinking funds
In respect of each of the item listed under Reserves and
Surplus, the additions and deductions since the last balance
sheet would be shown.
The word fund in relation to any Reserve should be used
only where such reserve is specifically represented by
earmarked investments.
The share premium account should include details of its
utilization in the manner specified under the Companies Act.
Loan Funds
These represent the creditorship interest in the concern. Loan
Funds are further divided and disclosed under the heads:
Secured Loans
Unsecured Loans
Secured Loans: Secured loans refer to loans wholly or partly
secured against an asset. This
head includes loans secured
by hypothecation of fixed
assets or current assets of the
company. The nat ure of
security is to be disclosed
al ong wi t h get t i ng t he
hypothecation registered with
the Registrar of Companies
under t he pr ovi si ons of
Section 125 of the Companies
Act. The following items are
included under the category of secured loans:
i. Debentures (Companies sometimes disclose Debentures
separately in the body of the Balance Sheet itself under
the head of Loan Funds after Secured Loans)
ii. Loans and Advances from Banks
52
Source:www.thinkplaninvest.com
iii. Loans and Advances from
Subsidiaries
iv. Other Loans and Advances
Unsecured Loans: Loans taken
by the company for which no
securi t y i s f urni shed are
cl assi f i ed as Unsecured
loans. Under the Schedule to
Unsecured Loans, the following items should be shown:
i. Fixed Deposits
ii. Loans and Advances from Subsidiaries
iii. Short-term Loans and Advances:
a. From Banks
b. From Others
iv. Other Loans and Advances:
a. From Banks
b. From Others
The similar details required to be disclosed in respect of
Secured Loans should be disclosed in respect of Unsecured
Loans also. The short-term loans will include those which
are due for not more than one year as at the date of the
balance sheet.
APPLICATION OF FUNDS
The Application of Funds are disclosed in the balance sheet
under the heads
Fixed Assets
Investments
Net Current Assets
Miscellaneous Expenditure
Fixed Assets A fixed asset is an asset held with the
intention of being used for the purpose of producing or
providing goods and services and is not held for sale in the
normal course of business.
The term fixed assets shall consist of the following:
53
Video 3.2.2:
Bonds/ Debentures
Keynote 3.2.1: Fixed Assets
a. Goodwill
b. Land
c. Buildings
d. Leasehold
e. Railway Sidings
f. Plant and Machinery
g. Furniture and Fittings
h. Development of Property
i. Patents, Trade Marks and Designs
j. Livestock, and
k. Vehicles, etc.
Under each of the categories mentioned above, the original
cost, additions during the accounting period and deductions
therefrom during the period should be shown. Also, the total
depreciation written-off or provided up to the end of accounting
period should also be stated.
Where the fixed assets have been written up on revaluation or
have been reduced in value either due to a reduction of capital
or revaluation, each balance sheet for the first five years
subsequent to the revaluation or reduction should show the
amount of increase effected or the reduction made as the case
may be. Also every balance sheet subsequent to the writing up
or reduction must show the
increased or decreased value of
the asset as the original cost.
Fi x ed as s et s ar e t o be
presented as Gross Block and
Net Bl oc k . Gr os s Bl oc k
represents the original cost of
the assets and additions and
adjustments arising due to the purchase, sale or transfer of
assets. Net Block is the net value of the assets after providing
for depreciation. In other words, it represents Gross Block minus
depreciation.
Capital Work-in-progress It includes assets awaiting
completion/installation, on-site inventories, net pre-operative
expenses, including difference in income and expenditure in
respect of production during trial run and interest capitalized in
respect of assets not yet commissioned.
Investments Investments are the assets held by an enterprise
for earning income by way of dividends, interest and rentals, for
capital appreciation, or for
other benefits to the investing
enterprise. Some represent
long-term commitment of funds
called long-term investments.
Other investments by their very
nature are readily realizable
and are intended to be held for
not more than one year and
are called short-term investments.
54
Source:www.calgarylistings.com
The investments held by a company as on the date of the
balance sheet are classified into:
i. Investments in Government or Trust Securities
ii. Investments in shares, debentures or bonds
iii. Immovable properties
iv. Investments in the capital of partnership firms
v. Balance of unutilized monies raised by issue
While listing the investments in shares, debentures or
bonds, the following additional information is also given:
i. The shares which are fully paid-up and those which
are partly paid-up are shown separately
ii. Th e s h a r e s a r e
di st i ngui shed i nt o
different classes
iii. I n t h e c a s e o f
i n v e s t me n t s i n
shares, debentures
o r b o n d s o f
s u b s i d i a r y
c o m p a n i e s ,
information in respect of (i) and (ii) above is shown
separately
iv. The mode of valuation of investments (whether cost
or market value) is disclosed
v. In the case of quoted investments, the aggregate
amount of such investments and also their market
value is shown
vi. The aggregate value of the unquoted investments is
also disclosed
vii. A separate disclosure is made of unutilized monies
indicating the form in which such unutilized funds
have been invested
Deferred Tax Assets: A deferred tax asset is recognized for
temporary differences that will result in deductible amounts
in future years and for carry forwards. For example, a
temporary difference is created between the reported
amount and the tax basis of a liability for estimated
expenses if, for tax purposes, those estimated expenses are
not deductible until a future year. Settlement of that liability
will result in tax deductions in future years and a deferred
tax asset is recognized in the current year for the reduction
in taxes payable in future years. A valuation allowance is
recognized if, based on the weight of available evidence, it
is more likely than not that some portion or all of the
deferred tax asset will not be realized.
Net Current Assets The Components of Net Current
Assets are disclosed in the Balance Sheet under the heads:
Current Assets, Loans and Advances
Less: Current Liabilities
55
Video 3.2.3:
Investment in securities
Current Assets Cash and
other resources which get
converted into cash during
the operating cycle of the
firm are defined as current
assets. These are held for a
short period of time as
against fixed assets which
are held for relatively longer
periods. The major components of current assets are cash,
debtors, inventories, loans and advances and pre-paid
expenses.
Cash denotes funds readily disbursable by the firm. The
bulk of it is usually in the form of bank balance while the
rest comprises of currency held by the firm.
Debtors (also called accounts receivable) represent the
amounts owed to the firm by its customers who have
bought goods or services on credit. Debtors are shown in
the balance sheet as the amount owed, less an allowance
for the bad debts.
Inventories consist of stocks of raw materials, work-in-
progress, finished goods, stores and spares. They are
usually reported at the lower of cost or market value.
Loans and advances are the amounts given to
employees, advances given to suppliers and contractors
and deposits made to governmental and other agencies.
They are shown at the actual amount.
Prepaid expenses are expenditures incurred for services
to be rendered in the future. These are shown at the cost
of unexpired reserve.
Under the category of Current Assets, the following should be
listed individually under broad heads:
i. St ores and Spare
parts
ii. Loose Tools
iii. Stock-in-Trade
iv. Work-in-Progress
v. Sundry debtors
vi. Cash bal ance on
hand
vii. Bank balances, and
viii. Other current Assets
Under the category of Loans and Advances, the following
should be shown:
a. Advances and Loans to subsidiaries
b. Advances and Loans to partnership firms in which the
company or any of its subsidiaries is a partner
c. Bills of Exchange
56
Source:www.belmet.fr
Current Assets Carousels
d. Advances recoverable in
cash or in kind or for
value to be received; for
example, Rates, Taxes,
Insurance, etc.
e. Balances with Customs,
Port Trust, etc.
The cl assi f i cat i ons and
details shown with respect to sundry debtors should also
be followed and disclosed in schedule for Loans and
Advances.
Current Liabilities and Provisions: Current liabilities may be
defined as all obligations arising from operations related to
an operating cycle and payable within the course of such a
cycle and includes all other obligations which are to be
repaid within the same accounting year in which they were
incurred. The following items are classified under this
category:
i. Acceptances;
ii. Sundry creditors;
iii. Subsidiary companies;
iv. Advance payment s
a n d u n e x p i r e d
discount;
v. Unclaimed dividends;
vi. Other liabilities; and
vii. Interest accrued but not due on loans.
Provision has been defined as any amount written off or
retained by way of providing for depreciation, renewals or
diminution in value of assets, or retained by way of
providing for any known liability of which the amount cannot
be determined with substantial accuracy. The following list
of provisions can be disclosed under this category:
i. Provision for taxation.
ii. Provision for proposed dividends.
iii. Provision for contingencies.
iv. Provision for provident fund scheme.
v. Provision for insurance, pension and similar staff benefit
schemes.
vi. Other provisions.
Miscellaneous Expenditure It includes the following:
i. Preliminary expenses,
ii. Expenses including commission or brokerage on
underwriting or subscription of shares or debentures,
iii. Discount allowed on the issue of shares or debentures,
iv. Interest paid out of capital during construction (also
stating the rate of interest),
57
Video 3.2.4:
Current Liabilities
Video 3.2.5: Provisions:
v. Development expenditure not adjusted, and
vi. Other items (specifying nature).
The amounts shown against all the items listed above should
be amounts to the extent they have not been written-off to the
Profit and Loss Account or adjusted in any other manner.
The other general instructions for preparation of the balance
sheet include the following:
i. Corresponding amounts for the immediately preceding
financial year for all the items shown in the balance sheet
should also be given in the balance sheet.
ii. In the case of subsidiary companies, the number of shares
held by the holding company as well as by the ultimate
holding company and its subsidiaries must be separately
stated.
iii. Depreciation written-off or provided should be allocated
under the different asset heads and deducted in arriving at
the value of fixed assets.
iv. Dividends declared by subsidiary companies after the date
of the balance sheet should not be included unless they
are in respect of a period which closed on or before the
date of the balance sheet.
v. Particulars of any redeemed debentures which the
company has power to issue should be given.
vi. All investments must be classified into trade and other
investments and the names of the companies in which
such investments have been made should also be
disclosed.
Additional Resources: Gallery
58
Video 3.2.6:
Balance Sheet Details
Video 3.2.7:
Contingent Liabilities
Video 3.2.8: Special Report-
ing and Disclosures
REVIEW 3.2 .1
Check Answer
Question 1 of 4
Which of the following are/is not a fixed
asset?
A. Stock
B. Vehicle
C. Fixed deposit in bank
D. Both (a) and (c) above
59
Section 3
Preparation of Balance Sheet
It is necessary to understand the
linkage between Trial Balance,
Profit and Loss Account and
Bal ance Sheet as shown i n
Balance Sheet Diagram (given on
the next page) to be familiar with
the preparation of Balance Sheet
and Profit and Loss Account.
60
Source:www.tutorsonnet.com
In other words,
We start with a tallied trial balance.
We give double-entry effect (transaction analysis) to all
adjustments outside trial balance.
We take some of the trial balance items (including
adjustments) to Profit and Loss Account.
We take the result of profit and loss Account (net profit
or net loss) to Balance Sheet (Reserves or Capital).
We take the rest of the items of trial balance (including
adjustments) to Balance Sheet.
Hence in a Balance Sheet, the Assets side should be equal
to liabilities side. Application of Funds (Assets) should be
equal to sources of funds (Liabilities).
The following adjustments are explained with respect to
preparation of financial statements i.e. Profit and Loss
Account and Balance Sheet. The adjustments call for
transaction analysis via the fundamental equation, the
outcome of which is
capt ur ed i n t he
following table 1.
61
Keynote 3.3.1: Balance Sheet Diagram
Video: 3.3.1 Trial Balance
Video 3.3.2:
Need for adjustments
Keynote 3.3.2
62
Adjustment Treatment Reasons
1. Closing Stock
a. I f i t i s gi ven as an adj ust ment
(not included in trial balance)
i. Deducted from Cost of Goods sold or
treated as Income no profit component.
ii. Show as Current Asset in Balance Sheet
Since it is an adjustment double with effect is
to be given as per transaction analysis
concept.
b. If it is already shown as an expense in
Trial Balance
Show only as a current asset in Balance
Sheet.
It is included in Trial Balance means it is
already adjusted (transaction analysis is done)
in cost of goods sold.
Note
If market value of stock is also given
Take cost or market value whichever is less.
2. Bad debts recovered
Treat it as Income in profit and loss account.
Since it is considered as expense in the year
of occurrence, it should be taken as income in
the year of recovery.
3. Income tax provision
(Relating to current year)
i. Treated as expense in profit & loss
account i.e. above the line.
ii. Show as a current liability in Balance
Sheet.
It is not an appropriation of profits.
4. Live Stock Show as fixed asset in Balance Sheet. As per Schedule VI of the Companies Act.
5. Investments
Cost value is to be shown in the Balance
Sheet as Asset.
Market value is to be shown in the inner
col umn f or i nf ormat i on (Schedul e VI
requirement).
63
6. Secured loans
a. I nt er est due and
accrued
i. Considered as expenses in profit & loss account.
ii. Interest due and accrued is to be added to loan amount in Balance Sheet
(Liability side).
As per Schedul e VI of the
Companies Act.
b. Interest due but not
accrued
i. Considered as expenses in profit & loss account.
ii. Interest due but not accrued is to be added to current liabilities in Balance
Sheet.
As per Schedul e VI of the
Companies Act.
7. Depreciation
i. Is an expense in profit and loss account.
ii. Reduced from fixed assets in Balance Sheet.
As per Accounting Standard
guidelines.
8. Insurance prepaid i. Out of total insurance paid the amount prepaid is to be deducted as
ultimately only the expense pertaining to the current period is reflected in
profit and loss account.
ii. Amount prepaid will be shown as current asset in Balance Sheet.
Since it does not belong to the
current year.
9. O u t s t a n d i n g
Expenditure
i. Added to existing amount of appropriate expenditure in profit and loss
account as expense pertaining to current period.
ii. Shown as current liability in Balance Sheet.
Since it is an expenditure relating
to that particular year.
64
10. Ma n a g e r s a n d
Managing Directors
Salary.
i. Ta k e n a s e x p e n s e i n p r o f i t a n d l o s s a c c o u n t .
It should be shown separately in profit and loss account without clubbing with
Administrative Salaries.
ii. It should be shown as a current liability in the balance sheet if still remains unpaid.
Since it is a charge against
the profits of the company.
11. Dividends
I n t e r i m a n d F i n a l
Dividend
i. Taken as expense in profit and loss appropriation account. It should be calculated
on the paid- up amount of capital i.e., issued and called up capital minus calls in
arrears.
ii. To the extent unpaid taken as liability in the Balance Sheet.
12. P r o v i s i o n f o r
doubtful debts and
bad debts
i. Bad debts is an expense in profit and loss account.
ii. For calculation of provision for doubtful debts first reduce bad debts given as
adjustment from debtors and then calculate provision for doubtful debts.
iii. Consider the same as an expense in profit and loss account.
iv. In the Balance Sheet the presentation should be on the asset side as
Debtors
XXX
Less : Bad debts XXX
Less : Provision for doubtful debts Balance

65
13. Compulsory transfer of
profits to reserves
i. Transfer 2.5% of current year profits to reserves.
ii. Transfer 5%. of current year profits to reserves.
iii. Transfer 7.5% of current year profits to reserves.
iv. Transfer 10% of the current year profits to reserves account.
This transfer, is to be made through profit and loss
appropriation account.
i. If dividend proposed exceeds 10% but less
than 12.5% of the paid-up capital.
ii. If dividend proposed exceeds 12.5% but not
15%.
iii. If dividend proposed exceeds 15% but not
20%.
iv. If dividend proposed exceeds 20%.
14. G o o d s s e n t t o
customers on Sale or
return basis
Should be taken as closing stock only when the
confirmation from the customer is received
treating the same as sale.
15. Calls-in-arrears Deduct from called up amount share capital on the liabilities of
side of the Balance Sheet.
As per Schedule VI of the Companies Act.
16. Auditors fees Should be clearly mentioned wherever possible as fees, paid
i. As auditor
ii. As advisor in respect of
Taxation matter
Company law matter
Management services
In any other manner.
As per Schedule VI of the
66
17. Sundry debtors
I n t he Bal anc e Sheet wher ev er i nf or mat i on i s av ai l abl e i t s houl d
be mentioned as sundry debtors
a. Debts outstanding for a period exceeding six months.
b. Other debts.
c. Amounts due from directors should be separately shown.
As per Schedule VI.
18. M i s c e l l a n e o u s
Expenses
T h e f o l l o wi n g e x p e n s e s t o t h e e x t e n t n o t wr i t t e n - o f f s h o u l d b e
p r e s e n t e d a s mi s c e l l a n e o u s
expenses in the Balance Sheet
i. Preliminary expenses.
ii. Expenses including brokerage, commission on underwriting of shares, debentures.
iii. Discount on issue of shares/debentures
iv. Interest paid out of capital during construction.
The total of above expenses should not be debited to profit and loss account, whereas they
can be written-off i.e., debited to P&L account on a fixed percentage basis.
As per Schedule VI.
19. R a i l w a y s i d i n g s ,
patents, trade marks
a n d d e s i g n s a n d
live stock
All these will appear as fixed assets in the Balance Sheet. As per Schedule VI.
20. Importance of Period
the year of accounting
Expenditure/Revenue to be taken into profit and loss account should relate to the year of
accounting Income/Expenditure relating to prior year or future year or of capital nature
should be excluded.
Illustration 1
From the following Trial Balance of Evergreen and Company
prepare the Balance Sheet of Evergreen and Company.
Trial Balance as on December 31, 2010
Additional information:
Closing Inventory as on December 31, 2010, Rs.50,000.
O u t s t a n d i n g w a g e s R s . 5 , 0 0 0 .
Depreciation on Plant & Machinery at 10% and Furniture
at 5%.
The companys profit for the period ended 31.12.2010
was Rs.31,900.
Solution
Schedule 1 Fixed Assets:
Category of fixed
assets
Gross
block
(Rs)
Depreciation
(Rs)
Net block
(Rs)
Plant and machinery 1,20,000 12,000 1,08,000
Furniture 30,000 1,500 28,500
Total 1,50,000 13,500 1,36,500
Schedule 2 Current Liabilities
Current Liabilities
Amount
(Rs)
Outstanding Wages 5000
Bills Payable 44,000
Accounts payable 48,000
Total 97,000
67
Illustration 2
From the following Trial Balance of Sun Shine and Company
prepare Balance Sheet (horizontal form).
Trial Balance as on 31.12.2010
Additional Data:
Closing Inventory Rs.8,000.
Depreciation on Plant & Machinery at 15% and 10% on
Buildings.
Provision for doubtful receivables Rs.500.
Insurance prepaid Rs.50.
Outstanding rent Rs.100.
68
Schedule
No.
1 2 3 4
I. Sources of funds
1. Shareholders funds
a. Capital
b. Reserves and surplus
2. Loan funds
a. Secured loans
b. Unsecured loans
2,00,000
31,900
II.
TOTAL
Application of funds
1. Fixed assets:
a. Gross block
b. Less depreciation
c. Net block
d. Capital work-in-progress
1
1,50,000
13,500
2,31,900
1,36,500
2. Investments
3. Current assets, loans and advances:
a. Inventories
b. Sundry debtors
c. Cash and bank balances
d. Other current assets
e. Loans and advances
Less:
Current liabilities and provisions:
a. Liabilities
b. Provisions
2
50,000
1,00,000
2,400
40,000
97,000
4. a. Miscellaneous expenditure to the extent
not written-off or adjusted
b. Profit and loss account
TOTAL 2,31,900
Current Liabilities:
Outstanding wages 5,000
Bills Payable 44,000
Accounts Payable 48,000
97,000
The Net Profit of the firm for the period was Rs.6,150.
Solution
Sun Shine and Company
Balance Sheet as on 31.12.2010
LIMITATIONS OF BALANCE SHEET
At this stage it may be
worthwhile to come to grips
wi t h s o me i mp o r t a n t
limitations of balance sheet.
Just because a bal ance
sheet is tallied or because
the auditors have certified the
balance sheet it does not
however mean that a balance
s h e e t i s wi t h o u t a n y
limitations.
Balance Sheet is considered to be a static document and it
reflects the position of the concern at a moment of time. The
real position of the concern may be changing day-to-day and
the same is not depicted in the Balance Sheet.
69
Video 3.3.3:
Limitations of Balance
Sheet
The Balance Sheet is not a valuation statement. The values
shown in it are not real values of assets. Thus, the exact
position of the business cannot be gauged from the balance
sheet.
We have noted earlier that a balance sheet is prepared based
on certain accounting policies. Such policies relate to
inventory valuation (i.e., closing stock), depreciation, etc.
Inventory may be valued using several methods like First-In-
First-Out (FIFO), Last-In-First-Out (LIFO), weighted average
cost, etc. Similarly, depreciation may be provided using
straight line method or written down value method. The
management may select a rate of depreciation (which is not
less than the statutory minimum rate) suitable to its own
business needs.
Similarly, accounting policies may differ from company to
company in respect of accounting for prepaid expenses, prior
period adjustments, classification between revenue and
capital expenditure, writing-off preliminary expenses, etc.
However, the auditors do insist that the same accounting
policies are consistently used by management from year to
year. Whenever there is a change in a companys accounting
policy, the effect of such a change is indicated in the notes to
balance sheet.
In addition to such basic differences relating to accounting
policies, we come across here and there deliberate window-
dressing of balance sheets to forecast a better picture to
shareholders, bankers and financial institutions. It presents a
rosier picture than what it actually is.
Window-dressing is accomplished in general ways by not
making adequate provisions (though prudence would require
them) for expenses and potential losses, by taking into
account income even before its actual accrual, by playing
around with inter-corporate adjustments, etc.
70
REVIEW 3.3.1
Check Answer
Question 1 of 2
Which of the following is a limitation of financial
statements?
A. Assets are shown at historical cost value.
B. It does not consider non-monetary as-
sets.
C. It is based on certain accounting policies
and estimates.
Problem
1. From the following information, prepare the balance sheet as
at March 31, 2011.
Additional Information:
i. Closing Stock of taw materials Rs.60,000; Work-in-progress
Rs.18,000; Finished goods Rs.12,000.
ii. Provide 5% reserve for doubtful debts on debtors.
iii. Provide 10% depreciation on Machinery and Furniture.
iv. Salaries outstanding Rs.3,600.
v. Insurance prepaid Rs.900.
vi. The Net Profit of the business for the period was Rs.51,000.
Solution
Balance Sheet as on 31-03-2011
71
Schedule 1: Fixed Assets
Schedule 2 : Inventory
Schedule 3: Sundry Debtors
Schedule 4: Other Current Assets
Schedule 5: Current Liabilities
72
Category
Gross block
(Rs)
Depreciatio
n
Net block
(Rs)
Furniture 8,000 800 7,200
Machinery 60,000 6,000 54,000
68,000 6,800 61,200
Sche
dule
No.
Figures as at the end
of current Financial
Year(Rs.)
1 2 3 4
I. Sources of funds
1. Shareholders funds
a. Capital
b. Reserves and surplus
2. Loan funds
a. Secured loans
b. Unsecured loans
1,08,000
51,000
II.
TOTAL
Application of funds
1. Fixed assets:
a. Gross block
b. Less depreciation
c. Net block
d. Capital work-in-progress
1
68,000
6,800
1,59,000
61,200
2. Investments
3. Current assets, loans and advances:
a. Inventories
b. Sundry debtors
c. Cash and bank balances
d. Other current assets
e. Loans and advances
Less:
Current liabilities and provisions:
a. Liabilities
b. Provisions
2
3
4
90,000
85,500
900
78,600
97,800
4. a. Miscellaneous expenditure to the
extent not written-off or adjusted
b. Profit and loss account
TOTAL 1,59,000
Raw Material 60,000
Work-in-progress 18,000
Finished goods 12,000
Debtors 90,000
Less: Provision for bad debts 4,500 85,500
Insurance prepaid 900
Creditors 75,000
Salaries outstanding 3,600
78,600
73
Balance Sheet
Revenue Recognition
C
H
A
P
T
E
R

4
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INTRODUCTION
The objective of any economic enterprise, whether dotcom or
age old commodity business, is to maximize profit. Profit is
used as a measure of performance or as the basis for other
measures, such as return on investment or earnings per
share. The elements directly related to the measurement of
profit are income and expenses. The key to income
measurement is the timing of the revenue recognition. Hence
the recognition, timing and measurement of income and
expenses has a direct and most significant bearing on
determining profit.
Revenue is the gross inflow of cash, receivables or other
consideration arising in the course of the ordinary activities of
an enterprise from the sale of goods, from the rendering of
services, and from the use by others of enterprise resources
yielding interest, royalties and dividends. Revenue is
measured by the charges made to customers or clients for
goods supplied and services rendered to them and by the
charges and rewards arising from the use of resources by
them. In an agency relationship, the revenue is the amount of
commission and not the gross inflow of cash, receivables or
other consideration.
- Accounting Standard 9 (Revenue Recognition)
Revenue arises in the course of the ordinary activities of an
enterprise and is referred to by a variety of different names
including sales, fees, interest, dividends, royalties, rent, etc.
OBJECTIVES
After reading this chapter, you should be able to:
Explain revenue recognition and the concepts relating to
revenue recognition;
Describe the Methods of recognizing revenue;
Measure the amount of revenue to be recognized; and
Examine the significance and measurement of
receivables, bad debts and provisions for doubtful debts.

Video 4.1: Basic Elements of Revenue
Recognition
75
Section 1
Concepts Pertaining to Revenue Recognition
Recognition is the process of
incorporating in the balance
sheet or statement of profit and
loss an item that meets the
definition of an element and
s at i s f i es t he c r i t er i a f or
recognition.
An item that meets the definition
of an el ement shoul d be
recognized if:
a. It is probable that any future
economic benefit associated with
the item will flow to or from the
enterprise; and,
b. The item has a cost or
value that can be measured with
reliability.
Sal es Recogni ti on: In a
transaction involving the sale
of goods, per f or mance
should be regarded as being
achieved when the following
conditions have been fulfilled:
i. The seller of goods has
transferred to the buyer the
property in the goods for a price
or al l si gni fi cant ri sks and
rewards of ownership have been
transferred to the buyer and the
seller retains no effective control
of the goods transferred to a
degree usually associated with
ownership; and,
ii. No significant uncertainty
exists regarding the amount of
the consideration that will be
derived from the sale of the
goods.
The transfer of property in
goods, in most cases, results in
or coincides with the transfer of
significant risks and rewards of
ownership to the buyer.
76
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However, there may be situations where transfer of property
in goods does not coincide with the transfer of significant
risks and rewards of ownership. Revenue in such situations
is recognized at the time of transfer of significant risks and
rewards of ownership to the buyer.
Such cases may arise where delivery has been delayed
through the fault of either the buyer or the seller and the
goods are at the risk of the party at fault as regards any loss
which might not have occurred but for such fault.
Further, sometimes the parties may agree that the risk will
pass at a time different from the time when ownership
passes.
Revenue from Service: In a transaction involving the
rendering of services, performance should be measured
under either:
The proportionate completion method,
The completed service contract method, or
Whichever relates the revenue to the work accomplished.
Such performance should be regarded as being
achieved when no significant uncertainty exists regarding the
amount of the consideration that will be derived from
rendering the service.
Revenue from use of Enterprise Resources: Revenue
arising from the use by others of enterprise resources
yielding interest, royalties and dividends should only be
recognized when no significant uncertainty as to
measur abi l i t y or
collectability exists.
! I nt er est can be
defined as charges
for the use of cash
r e s o u r c e s o r
amounts due to the
enterprise;
! Royal t i es can be
defined as charges for the use of such assets as know-
how, patents, trademarks and copyrights;
! Dividends can be defined as rewards from the holding of
investments in shares.
For ensuring comparability and consistency in accounting,
certain specific procedures are to be followed. This principle
applies for recognizing and accounting revenues also. There
are various methods of revenue recognition which are
detailed below. Whatever method the entity follows
consistency is most important for easy comparability and
understanding of financial statements. It also reflects the true
picture of the entitys financial position.
There are mainly three accounting concepts which are
related with revenue recognition:
1. Conservatism Concept;
2. Realization Concept; and
3. Matching Concept.
77
Video 4.1.1:
Concept of Revenue
1. Conservatism Concept
The conservatism concept has two aspects:
Recognize revenues only when they are reasonably
certain.
Recognize expenses as soon as they are reasonably
possible.
There are obvious problems in deciding what is meant by
reasonably certain and reasonably possible in various
situations and accounting principles give guidance for many
specific problems. For example, the principle that revenue is
recognized in the period in which goods are delivered applies
to most sales transactions, because this is the earliest period
in which it is reasonably certain that revenue has been
earned.
Revenue from the sale of goods is recognized in the period in
which goods were delivered to customers.
Revenue from the performance of services is recognized
in the period in which the services were performed.
If cash is received at the time of delivery or performance,
it means that the revenue has been earned. It can
happen, however, that the cash is received in either an
earlier period or a later period than that in which the
revenue is recognized.
Examples of pre-collected revenues are as under:
Publishing companies sell subscriptions that the
subscriber pays for in advance; that is, the company
receives the cash before it renders the service of
providing the magazine. If subscription money is received
this year for magazines to be delivered next year, the
revenue belongs in next year.
Rent on property is often paid in advance. When this
happens, the revenue is properly recognized in the
period in which the services of the rented property are
provided, not the period in which the rent payment is
received.
2. The Realization Concept
The conservatism concept insists on the period when revenue
should be recognized whereas the realization concept
indicates the amount of revenue that should be recognized
from a given transaction.
Realization refers to inflows of cash or claims to
cash arising from the sale of goods or
services. Thus, if a customer buys
Rs.500 worth of items at
a provision store, paying
cash, the store realizes
Rs.500 from the sale. If
a department store sells
a pressure cooker for Rs.2 800, and the purchaser agrees to
pay within 30 days, the store realizes Rs.2800 (in receivables)
from the sale, provided that the purchaser has a good credit
record so that payment is reasonably certain. The realization
78
Source:www.elmundo.com.
concept states that the amount recognized as revenue is the
amount that is equal to or reasonably certain to be realized.
If the sale of goods or services is made on credit the amount
of revenue recognized is the total value of sale minus the
estimated amount of unrealized receivables i.e. bad debts.
Such an estimate can be made by previous records or
experience. But in practice the entire amount of sale is taken
as income and bad debts, if any, is shown separately as an
expense in the income statement.
3. The Matching Concept
The items for which revenues are
recognized both by conservatism
concept and realization concept
are identified and the costs of such items a r e
also accounted for in the same period in which the accounting
for revenues is made. This practice is called matching
concept. For example, if goods are sold at Rs.10000 and cost
of the same being Rs.8000, as per matching concept Rs.8000
is booked as an expense in the same period when Rs.10000
is booked as an income.
The conservatism concept and the realization concept
suggest that revenue should be recognized in the earliest
period in which:
The entity has substantially performed what is required in
order to earn income; and,
The amount of income can be reliably measured.
The above criteria are expressed in terms of earning and
measuring income rather than in terms of revenue, because
both the revenue and expense components of a transaction
need to be reliably measurable in order to recognize the
revenue. Because of the matching concept, both components
are recognized in the same period and the difference accrues
as income.
79
Video 4.1.2: Basic Elements
of Expense Recognition
Revenue Recogni-
tion
Revenue
http://www.iasb.or
g/NR/rdonlyres/1
A3771B8-5627-44E
4-984E-AC90FEE1
http://220.22
7.161.86/25
1as9new.pdf
REVIEW 4.1
Check Answer
Question 1 of 2
The accounting concept/s closely associated
with the revenue recognition criteria is/are
A. Conservative concept and cost con-
cept.
B. Realization concept.
C. Dual concept and entity concept.
D. Conservative concept and realization
concept.
80
Section 2
Revenue Realization
Under cash basis accounting, realization (earning) of
revenue occurs simply when cash is
collected for sales of goods or
servi ces. Under accrual basi s
accounting, however, realization of
revenue takes place in three phases:
Goods or services must be
delivered to customers (passing
o f r i s k a n d r e wa r d s o f
ownership);
In exchange for an asset (such as an account
receivable); and,
It is virtually assured of being converted soon into
cash (certainty).
The main four practical ways of realizing revenues are:
Delivery method;
Percentage completion method;
Production method; and
Installment method.
Delivery Method
Revenue is earned by a business entity either by selling
goods or rendering services. Under this method, revenue
is recognized in the period in which goods are delivered or
services actually provided. Even if a reliable estimate can
be made about the realization of revenue, the accounting
is made only when the actual shipment is made and goods
delivered. Similarly, in case of service provided, the
revenue is recognized only after the performance of
service. Revenues from renting hotel rooms are
recognized each day the room is rented. Revenues from
maintenance contracts are recognized in each month
covered by the contract.
In the real life situation, the amount of income that will be
earned can be reliably estimated when goods are delivered
or services provided. When goods are delivered, title
usually is transferred from the seller to the buyer, but
transfer of title is not a necessary condition for revenue
recognition. When goods are sold on the installment credit
81
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tock-investing.us
basis, the buyer does not have a clear title until the
installment payments have been completed. If, however, there
is a reasonable certainty that these payments will be made,
revenue is recognized at the time of delivery.
Revenue from the sale of goods shall be recognized when all
the following conditions have been satisfied:
The entity has transferred to the buyer the significant
risks and rewards of ownership of the goods;
The entity retains neither continuing managerial
involvement to the degree usually associated with
ownership nor effective control over the goods sold;
The amount of revenue can be measured reliably;
It is probable that the economic benefits associated with
the transaction will flow to the entity; and
The costs incurred or to be incurred in respect of the
transaction can be measured reliably.
In case of consignment shipment, the supplier, or consignor,
ships goods to the consignee, who attempts to sell them. The
consignor retains title to the goods until they are sold; the
consignee can return any unsold goods to the consignor. In
these circumstances, performance has not been substantially
completed until the goods are sold by the consignee. Thus,
the consignor does not recognize revenue until that time.
Percentage-of-Completion
Method
Long-term proj ects whi ch
involve years for completion
follow this method of revenue
recognition. Examples of such
p r o j e c t s a r e h i g h - r i s e
buildings, bridges, aircrafts,
shi ps, space expl orat i on
hardwares and certain other
items which involve a design
or development and construction sequence, etc. Such
projects are performed under contracts in which the customer
provides the product specifications. The contract also
stipulates either (1) predetermined amounts the customer
must pay at various points during the project, called a fixed-
price contract, or (2) some sort of formula that will determine
customer payments as a function of actual project costs plus
a reasonable profit, called a cost- reimbursement contract.
The amount of r evenue
recognized under percentage
completion method is related to
the percentage of the total
p r o j e c t wo r k t h a t wa s
performed during that period. If
the amount of income to be
earned on the contract cannot
be reliably estimated, then
revenue must be recognized
only when the project has been
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Video 4.2.1: Criteria for Rec-
ognizing Revenue
compl et ed. Thi s i s t he
completed-contract method
and costs incurred on the
project are held as assets,
Contract Work-in-Progress,
until the period in which
revenue is recognized.
Production Method
This method is followed by
those where the income can be
reliably measured only after the completion of production.
Agriculturists who are confident to sell their produce at
government support prices can as per GAAP (Generally
Ac c e p t e d Ac c o u n t i n g
Pr i n c i p l e s ) r e c o g n i z e
revenue at the ti me of
harvest only. GAAP also
permits revenue recognition
when gold, silver and other
precious metals have been
produced from the make
even though they have not
yet been sold.
Installment Method
Revenue in case of goods sold on installments is recognized
when the installment payments are received. In the pure
installment method, the installment payment is counted as
revenue and a proportional part of the cost of sales is counted
as a cost in the same period.
In a more conservative variation, the cost-recovery method,
cost of sal es i s
r e c o r d e d a t a n
amount equal to the
installment payment.
The result is that no
income is reported
until the installment
p a y me n t s h a v e
recouped the total
cost of sales.
The effect of the
installment method
is to postpone the recognition of revenue and income to later
periods as compared with the delivery method. If a company
wants to report as much income as it legitimately can in the
current period, it will, therefore, prefer to report in its income
statement the full amount of the transaction at the time of
sale. If it wants to postpone the recognition of taxable income
for income tax purposes, it will use the installment method in
calculating its taxable income.
Hence the question is - how do accountants measure
revenue? Generally, accountants assume a reasonable
certainty and approximate the net realizable value of the
asset(cash) resulting from inflow from customer. That is, the
revenue is the present cash equivalent value of the asset
received. Obviously, if a cash sale is made, the value of the
83
Video: 4.2.2 Revenue Rec-
ognition for Services
Revenue Recognition
2

This method is followed by those where the income can be reliably measured at
the completion of production itself. Agriculturists who are confident to sell their
produce at government support price can as per GAAP (Generally Accepted
Accounting Principles) recognize revenue at the time of harvest only. GAAP also
permits revenue recognition when gold, silver and other precious metals have been
produced from the make even though they have not yet been sold.
4. Installment Method
Revenue in case of goods sold on installments is recognized when the installment
payments are received. In the pure installment method, the installment payment is
counted as revenue, and a proportional part of the cost of sales is counted as a cost
in the same period.
In a more conservative variation, the cost-recovery method, cost of sales is
recorded at an amount equal to the installment payment. The result is that no
income is reported until the installment payments have recouped the total cost of
sales.
The effect of the installment method is to postpone the recognition of revenue and
income to later periods as compared with the delivery method. If a company wants
to report as much income as it legitimately can in the current period, it will,
therefore, prefer to report in its income statement the full amount of the transaction
at the time of sale. If it wants to postpone the recognition of taxable income for
income tax purposes, it will use the installment method in calculating its taxable
income.

asset is the cash inflow. If a credit sale is made, the value of
the asset is often recorded on the same basis as a cash sale.
However, the realizable value of a credit sale is not really the
same as a cash sale. For example, some credit customers
may never pay.
The need for recognizing bad debts, sales discounts, sales
returns and allowances arises because of the one aspect of
the realization concept that is, revenues should be reported at
the amount that is reasonably certain to be collected. This
concept would seem to require that these amounts be
subtracted from gross revenues in order to determine the net
revenue of the period. The effect of the some of the practices
described above is to report the amounts as expenses rather
than as adjustments to revenues.
Whether companies report these amounts as expenses or as
adjustments to revenues, the effect on income is exactly the
same. The difference between the two methods is the way
they affect revenue and gross margin. The consistency
concept requires that a company follow the same method
from one year to the next and thus comparisons within a
company are not affected by these differences in practice.
84
REVIEW 4.2.1
Check Answer
Question 1 of 3
Which of the following methods is not a
practical way of realizing revenue?
A. Delivery Method
B. Percentage of Completion
Method
C. Production Method
D. Moving Average Method
Section 3
Bad Debts
The criteria which are common among the recognition
norms of various streams of revenue discussed in earlier
sections are:
a. Revenue should be measurable.
b. It should be collectible.
If there is significant uncertainty on any of the above fronts,
recognition is postponed till the period in which the
uncertainty is reasonably resolved.
When the uncertainty relating to collectibility arises
subsequent to the time of sale or the rendering of the
service, it is more appropriate to make a separate provision
to reflect the uncertainty rather than to adjust the amount of
revenue originally recorded.
Giving credit to customers entails costs and benefits. One
cost is the possibility that some credit customers will never
pay. Another is the cost of administration and collection.
The benefit is the boost in sales and profit that would
otherwise be lost if credit
sales were not extended.
That is, many potential
customers would not buy
if credit sales were not
available. The accountant
often labels the major
c o s t a s b a d d e b t
expenses and the benefit
as the additional gross
profit on credit sales.
The extent of non-payment of debts varies from industry to
industry. It depends on the credit risks that managers are
willing to accept. For instance, many small retail
establishments will accept a higher level of risk than large
stores such as Bata showrooms. Accompanying the risks
are corresponding collection expenses.
85
Video 4.3.1: Costs and bene-
fits of Credit sales
How to Measure Bad Debts
Measuring bad debts of a firm can be generally done in two ways:
Specific Write-off Method, and
Allowance Method.
Specific Write-off Method
The measurement of i ncome
becomes complicated because
some debtors are either unable or
unwilling to pay their debts. Such
bad debt s ar e al so cal l ed
uncollectible accounts.
Suppose a firm has credit sales of
Rs.100000 near the end of 2010 and predicts on the basis of
experience that Rs.2000 will never be collected.
How should we account for this situation? There are two basic
ways. First, consider the specific write-off method (also called
specific charge-off method). Assume that during the next year,
2011, the firm identifies customers who are expected to never pay
Rs.2000 that they owe from sales of 2010. See the analysis below
with the help of balance sheet equation:
When the chances of collection from specific customers become
doubtful the amounts in the particular accounts are written down
and bad debts expense or uncollectible accounts expense is
recognized.
The specific write-off method has been criticized because it fails
to apply the matching principle of accrual accounting. That is, the
cause of the bad debts expense was the making of the sale.
Accrual accounting maintains that bad debts expense relates to
the period of sale rather than the period of actual write-off. In this
example, the specific write-off method produces two mistakes. In
2010, the amount of Rs.100000 for assets and revenue is
overstated by Rs.2000 because only Rs.98000 is actually
expected to be collected.
In 2011, expenses are correspondingly overstated by Rs.2000.
The Rs.2000 of bad debts expenses should be recognized in
2010 and not in 2011, because it was caused by 2010 sales. The
principal arguments in favor of the specific write-off method are
based on cost-benefit and materiality. This method is simple.
Moreover, no great error in measurement occurs if amounts of
86
Specic Write-off Method Specic Write-off Method Specic Write-off Method
Balance sheet equation !Assets=Liabilities+(Revenue-Expenses) Balance sheet equation !Assets=Liabilities+(Revenue-Expenses) Balance sheet equation !Assets=Liabilities+(Revenue-Expenses)
2010 Sales
+100000 (Increase in accounts
receivables)
+100000 (Increase in
sales)
2011 Write-
off
2000 (Decrease in accounts
receivables)
2000 (Increase bad
debts expenses)
Video 4.3.2:
Treatment of Bad debts
bad debts are small or do not vary considerably from year to
year.
Allowance Method
The allowance method uses estimates and a contra asset
(deduction from receivables) account, often called allowance for
bad debts. It is also called provision for Bad Debts. A summary
of its effects on the balance sheet equation is as follows:
The allowance method, also called provision method, would
result in the following presentation in the balance sheet, as on
December 31, 2010:
In the following table the journal entries for the specific write-off
method and the allowance method are given. The principal
argument in favor of the allowance method is its superiority in
measuring accrual accounting income in any given year.
A contra asset account is created under the allowance method
because of the inability to write down a specific account at the
time bad debts expense is recognized. In our example, at the
end of 2010 the firm has, say, Rs.70000 in Accounts Receivable.
Based on past experience, a bad debts expense is recognized at
a rate of 2% of total credit sales, or 0.02 x Rs.100000 or Rs.
2000.
87
Allowance Method Allowance Method Allowance Method
Balance sheet equation !Assets=Liabilities+(Revenue-Expenses) Balance sheet equation !Assets=Liabilities+(Revenue-Expenses) Balance sheet equation !Assets=Liabilities+(Revenue-Expenses)
2010 Sales
+100000 (Increase in accounts
receivables)
+100000
(Increase in
sales)
2010
Allowance
2000 (Increase in allowance for
uncollectible accounts receivables)
2000 (Increase
bad debts
expenses)
2011 write-
off
2000 (Decrease in allowance for
uncollectible accounts receivables)
+2000 (Increase bad debt expenses)
No effect
Accounts receivable Rs.100000
Less: Provision for Bad Debts 2000
Net accounts receivable Rs.98000
Before
Write-off
After write-off
Accounts Receivable Rs.70000 Rs.68000
Allowance for uncollectible
accounts
2000 -
Book value (net realizable value) Rs.68000 Rs.68000
88
REVIEW 4.3
Check Answer
Question 1 of 2
M/s. Book Paradise is a well established book stores in Hydera-
bad. The balance of sundry debtors as on April 01, 2010 and
March 31, 2011 was Rs.400000 and Rs.300000, respectively.
During the year 2010-2011, an amount of Rs.10000 was written
off as bad debts. If the firm makes a provision for bad debts at
5% on debtors, the amount debited to Profit and loss account for
the year ended March 31, 2011 is:
A. Rs.500
B. Rs.5000
C. Rs.10000
D. Rs.15000
Section 4
Cash Discount and Warranty Costs
Cash Discounts Allowed
Cash Discounts are al-
lowed by a business to its
customers when they pay
their accounts quickly. A
business may reduce a
smaller sum (often in per-
cent age of t he t ot al
amount) from the full set-
tlement amount, if the
payment is made within a
certain period of time.
The amount of reduction
from the sum to be paid
is known as cash dis-
count. For example, if a
business sells goods on
terms of 2/10, net/30, it
permits customers to de-
duct 2% from the invoice
amount if they pay within
10 days; otherwise the full
(net) amount is due within
30 days. The cash dis-
89
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Video 4.4.1: Cash Discount
vs Trade Discount
count is recorded as an expense of the period and it is not a part
of cost of goods sold (cash discounts always appear in the profit
and loss section of the income statement).
Warranty Costs
Companies usually have an obli-
gation to repair or replace defec-
tive goods. This obligation
arises either because it is an ex-
plicit part of the sales contract
or because there is an implicit
legal doctrine that says that cus-
tomers have a right to receive
satisfactory products. In either
case, the obligation is called a
warranty.
If it is likely that a material amount of cost will be incurred in fu-
ture periods in replacing or repairing goods sold in the current
period, both the conservatism and matching concepts require
that the income in the current period be adjusted accordingly.
The amount of adjustment is usu-
ally estimated as a percentage of
sales revenue (Allowance for
Warranties - shown in the liability
side of the balance sheet) and
this amount is recorded as an ex-
pense (operating expense) in the
period. When the costs are in-
curred in the future in repairing or
replacing the goods, the corre-
sponding amount will be deducted from the Allowance for War-
ranties and at the same time Cash or Parts Inventory will be de-
ducted from the assets side of the balance sheet.
90
Source:www.touchartists.com
Video 4.4.2: Warranty costs
REVIEW 4.4.1
Check Answer
Question 1 of 3
Cash Discount is referred to as
A. Discount given by the vendor for bulk pur-
chase made.
B. Discount given by vendor for immediate
transfer of risk and reward in the property.
C. Discount given for prompt payment
D. Discount given for placing a number of or-
ders at a time.
91
Accounting For Inventories
C
H
A
P
T
E
R

5
Source:www.unirelo.com
INTRODUCTION
Inventory is defined as ...those items of tangible personal
property that are held for sale in the ordinary course of
business, are in the process of production for such sale or are
due to be currently consumed in the production of goods or
services to be available for sale.
- ARB 43, FASB
The importance of inventories in the financial statement lies in
the fact that it is reflected both in the Income Statement as
well as in the Balance Sheet. Complexities arise in the
accounting of inventories basically because of the high
volume of their activity, the various cash flow alternatives
associated with them and their classification. Broadly
speaking, there are two types of entities for which such
accounting of inventories is generally undertaken. The first
type are the retailers and wholesalers whose inventory is
generally categorized as the merchandise inventory whose
main idea behind holding inventory is that it is meant for
resale and the other is the manufacturer whose inventory is
generally in the form of raw material, work-in-process and
finished goods.
OBJECTIVES
After going through this chapter, you should be able to:
Explain the significance of Inventory valuation;
Describe the components of Inventory Cost; and
Describe the maintenance of inventory records under
perpetual and periodic Inventory Systems;
Describe the principal methods of inventory costing; and
Explain the Valuation Principles with regard to Inventory.
93
Section 1
Inventory Pricing
For conducting business, all
manufacturing and trading
organizations carry stocks or
inventories. Such stocks or
i nventori es are i n three
different forms:
1. Raw Material Inventory;
2. Wo r k - i n - P r o c e s s
Inventory; and
3. F i n i s h e d G o o d s
Inventory.
All inventories are held for
conversi on i nto fi ni shed
goods or finished goods
which are awaiting sale. In
both cases, the intention is to
convert the inventory into
cash. Sales take place not
only from goods currently
produced and put in stock,
but also from goods which
might have been produced in
earlier periods and were
retained in stock. Similarly,
there is no certainty that all
goods produced during the
current accounting period
would be sold during that
period. Since all sales during
an account i ng per i od,
whether they arise from sale
of goods produced from an
ear l i er per i od or f r om
production in the current
per i od, ar e t r eat ed as
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revenue, it is necessary to identify (in addition to the cost of
goods produced currently) the cost or price of the goods sold
from inventory. Similarly, the value of goods produced during
the current period but carried over to the next period as
inventory has to be identified for drawing up meaningful
income statements or profit and loss accounts. The basis for
pricing finished and other goods from inventories is cost,
which is generally defined in terms of production cost, for
those goods which are produced internally, or acquisition cost,
for those goods which are purchased from outside. The
inventory cost is the sum of the applicable expenditures and
charges directly or indirectly incurred in bringing an article to
its existing condition and location.
The finished goods which have been produced internally for
inventory should be priced at production cost. However, there
are certain difficulties in
application, particularly in
relation to inventories of
wor k- i n- pr ocess and
f i ni shed goods. I t i s
generally followed that
only expenditure incurred
i n producti on of such
goods, or such expenses
which may be clearly related to production should be
considered as cost in this context. Following this convention,
general, administrative and selling expenses are not treated as
part of inventory cost, as they are neither directly nor indirectly
incurred in bringing the article in inventory to its existing
condition and location. However, not all accountants agree
with this convention. There are individual situations where the
characteristics of operational costs are sufficiently different
from the normal situation to require a departure from this
principle.
If the general or administrative expenses include large
expenses which have a production connotation, it might be
justifiable in such special circumstances to include portions of
such administrative expenses in the inventory.
It can, therefore, be said that while the principle stated earlier
is generally a sound one, its application requires exercise of
judgment in individual situations with reference to the
operating characteristics of the business, the accounting
system in use and trade and industry practices.
After the costs to be included in
inventory are decided upon, the
problem arises is how to value
inventory in aggregate. Cost of
i nvent ory produced duri ng
different periods would not tally.
However, if the number of units
produced by the firm are less in
the accounting period, it would
not be difficult to identify the cost
of each unit of inventory.
However, in situations where the number of units held in
inventory is very large and the units are identical in their
physical characteristics, it might be impossible to identify the
cost of each unit. For example, it is impossible to identify at
95
Source:www.thegeminigeek.com
Video 5.1.1: Components of
inventory cost
any point of time whether the coal that is being currently sold
relates to a particular sequence of mining operations which
could be identified with a particular aggregate production cost.
In trading operations, this problem has a different dimension.
Suppose a trader in rice buys stocks at different prices at
different times. He goes on adding his purchases to his current
stocks, while at the same time selling his stocks, to his
customers. It would be impossible to identify the cost price of the
rice sold by pinpointing the time of its purchase and hence the
related purchase price.
In most business situations, materials kept in inventory are
interchangeable and purchased in various lots at various prices
and at various times. It is thus necessary to develop a method of
pricing which is based on assumptions about the identity of the
goods sold in relation to the identity of the goods purchased.
There are several methods for identification of costs of goods
held in inventory, primarily with a view to match the cost of
goods sold against the revenue derived during an accounting
period.
96
REVIEW 5.1.1
Check Answer
Question 1 of 2
Which of the following is not classified as inventory
in the financial statements?
A. Finished goods
B. Work-in-process
C. Raw-materials and components
D. Advance payments made to suppliers for
raw materials
Section 2
Flow of Inventory Costs
Here, we outline how raw
material costs flow through as
a part of work in process to
finished goods.
Materials: Various items of
materials are issued from a
storage area to the production
facilities for conversion into
goods. Materials used is thus
the sum of all materials issued
during the period.
For determining the cost of
materials used, the periodic
method may be used. That is,
the assumption is made that
the amount of materials used
is the difference between the
materials available for use
during the period (the total of
the beginning inventory and
the periods net purchases)
and the ending inventory.
Material used becomes a part
of work in process along with
m a n u f a c t u r i n g c o s t s
accumulated to form cost of
goods manufactured.
Cost of Production: Cost of
producti on i s the sum of
Materials used, direct labor
and other manufacturing costs.
T h e c o s t o f g o o d s
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manufactured is the balancing figure obtained by adding to
the opening work-in-process inventory, the materials used
and other manufacturing expenses and then deducting the
closing work in process inventory. Other manufacturing
expenses include all other expenditure involved directly for
production.
Cost of Goods Sold: Ultimately the goods transferred to
finished goods inventory account are sold and appear as
sales. The cost of goods sold is obtained by adding the cost
of production to the opening inventory of finished goods and
then subtracting the closing finished goods inventory.
From the finished goods inventory the cost of goods sold is
transferred to the cost of goods sold inventory account and
the cost of goods sold inventory account is closed by
transferring the same to income and expenditure account or
profit and loss account.
98
Video 5.2.1:
Cost flow of Inventory
REVIEW 5.2.1
Check Answer
Question 1 of 2
The cost of goods sold is equal to
A. Total purchases minus total sales
B. Opening stock plus total purchases
C. Opening stock plus total purchases
minus closing stock + Direct Costs
D. Closing stock plus total purchases
Section 3
Principal Methods of Inventory Costing
There are four major methods of inventory
Costing:
1. Specific Identification method:
This method concentrates on the physical
identification and linking of the particular items
sold. This method provides a great latitude for
measuring result at any given point of time. An
obvious way to
a c c o u n t f o r
i n v e n t o r y
t h r o u g h t h i s
method i s vi a
p h y s i c a l
observation or
the labeling of
items in stock
wi th i ndi vi dual
n u m b e r s o r
codes. Such an approach i s easy and
economically justifiable for relatively expensive
merchandise like diamond jewelry. However,
most organizations have vast segments of
i nventori es that are too numerous and
insufficiently valuable per unit to warrant such
individualized attention.
Specific identification requires the linkage of
individual inventory items with the exact
purchase costs of each unit. This kind of
identification is practically impossible for vast
inventories. Hence the specific identification
met hod
99
Video 5.3.1:
Inventory Demonstration
Source:www.thehindu.com
continues to be largely confined to expensive individualized
merchandise.
Its major drawback in many
cases i s i t s expense.
Moreover, many critics claim
that income measurements
first concern should not be
with physical flows but with
the economic flows.
Howev er , t hi s met hod
permits management to manipulate income and inventory values
by filling a sales order from a number of physically equivalent
items bearing various inventory cost prices.
2. First-In First-Out (FIFO): This method assumes that the
goods purchased first or manufactured first are issued/sold
first. That is the goods issued or sold currently are those
which represent the earliest purchases amongst the goods
held in inventory. This would mean that the goods which
remain in stock after the sales are those which represent the
most recent purchases. The same is explained under:
Example:
Suppose a trader purchased the following units during the month
of March.
Let us also assume that he sold the following units of goods from
the inventory during March.
If FIFO method of valuation were to be applied the cost of goods
issued or sold out of inventory would be as follows:
100
March 1-500 units at the rate of Rs.120/unit
March, 2 210 units
March, 5 150 units
March, 7 135 units
March, 11 220 units
March, 18 70 units
March, 21 310 units
March, 25 115 units
Adherents of FIFO maintain that it is the most practical way to
describe what operating managers actually do. That is, most
managers deliberately attempt to move their merchandise on a
first-in, first-out basis. This approach avoids spoilage, and
obsolescence. Thus the inventory flow assumption underlying
FIFO corresponds most closely with the actual physical flows of
inventory items in most businesses. Furthermore, the asset
balance for inventories is a close approximation of the actual
rupees invested, because the inventory is carried at the most
recent purchase prices paid. Such prices are not likely to differ
much from current prices at the balance sheet date. Consequently,
its proponents maintain that FIFO properly meets the objectives of
both the income statement and the balance sheet.
Critics of FIFO claim that FIFO increases profits. They claim that
FIFO based income is deceiving in the sense that some of the
corresponding increase in net assets is merely an inventory profit.
That is, an inventory
profit is fictitious because for a going concern, part of it is needed
for replenishing the inventory.
Consequently, it is not profit in the
laypersons sense of the term; it
does not indicate an amount that is
entirely available to pay dividends.
3. Last-In First-Out (LIFO):
This method is just the opposite of
FI FO Met hod. Thi s met hod
assumes that the goods issued or
sold out of the inventory are the
ones most recently purchased or manufactured. Therefore, the
goods held in stock represent the earliest purchases or produced.
If LIFO method is applied for valuing inventory instead of FIFO in
the earlier example, the effect would be as under:
Advocates of LIFO point out that there will not be any inventory
profit if LIFO is followed. They also stress that in times of rising
prices there may be greater pressure from shareholders to pay
unjustified higher cash dividends under FIFO than LIFO.
Critics of LIFO point to absurd balance sheet valuations. Under
LIFO, older and older prices, and hence less-useful inventory
values, are reported, especially if physical stocks grow through the
years. LIFO companies can offset this criticism to some extent by
disclosing FIFO inventory values in a footnote to the financial
statement.
Another criticism of LIFO is that, unlike FIFO, it permits
management to influence immediate net income by the timing of
purchases. For instance, if prices are rising and a company
desires, for income tax or other reasons, to report less income in a
given year, managers may be inclined to buy a large amount of
inventory near the end of the year, that is, to accelerate the
101
Video 5.3.2:
Methods of inventory cost-
ing
replacement of inventory that would normally not occur until early
in the next year.
4. Weighted Average Method:
This method assumes that all inventory available are best
represented by a weighted average cost.
The average cost of goods held in inventory is recalculated every
time a fresh purchase is made and goods issued or sold out of
inventory are priced at such average price till such time as the next
lot is purchased. If this method in valuing Inventory in the earlier
example is applied, the effect would be as under:
The weighted average method
produces given profit somewhere
between that obtained under FIFO
and LIFO. Advocates of thi s
method feel that the smoothing of
purchase costs achieved by the
weighted average method enable
them to even out the erratic movements in the purchase prices to
the best extent possible.
For valuation of inventory according to standards issued by ICAI,
see below
102
Valuation of Inventories
Video 5.3.3: FIFO vs LIFO
vs Wt.Average
Keynote 5.3.1: Illustrations
http://220.227.16
1.86/243as_2new.
pdf
103
REVIEW 5.3.1
Check Answer
Question 1 of 4
Which of the following methods for stock valuation
for normal inventory is recommended by AS-2?
A. FIFO Method
B. LIFO Method
C. Weighted Average Method
D. Both (a) and (c)
Section 4
Perpetual and Periodic Inventory Systems
There are two systems of maintaining Inventory Records:
1. Perpetual
2. Periodic
The perpetual inventory system keeps a
running, continuous record that tracks
inventories and the cost of goods sold on a day-to-day
basis. Such a record facilitates managerial control and
the preparation of interim financial statements. However,
physical inventory counts should be taken at least once a
year to check the accuracy of the clerical records.
The periodic inventory
system, unlike perpetual
inventory system, does
not involve a day-to-day
record of inventories or of
the cost of goods sold.
Instead the cost of goods
sol d and an updat ed
i nventory bal ance are
computed only at the end
of an accounting period, or any other reporting period
decided upon when a physical count of inventory is taken.
The cost of goods purchased is accumulated by
recording the individual purchase transactions throughout
any gi ven r epor t i ng
period, such as a year.
T h e a c c o u n t a n t
computes the cost of
g o o d s s o l d b y
subtracting the ending
inventories (determined
by the physical count)
from the sum of the
opening inventory plus
purchases.
The periodic system computes cost of goods sold as a
residual amount. First, the beginning inventory is added
to the purchases to obtain the total cost of goods
available for sale. Then the ending inventory is counted
and its cost is deducted from the cost of goods available
for sale to obtain the cost of goods sold. That is:
104
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Video 5.4.1:
Perpetual Inventory System
Physical count of inventory is a must whether perpetual or
periodic inventory systems is followed. Such a count is
necessary for calculating the cost of goods sold in a periodic
inventory system. However, it can be just as important in a
perpetual system, providing a check on the accuracy of the
inventory records. Suppose, on physically counting the
inventory the quantum differs from the perpetual inventory
amount reflected in records the gap maybe due to pilferage or
incorrect recording etc, which calls for attention.
Suitability of perpetual and periodic system depends on the
relative costs and benefits of each. Perpetual systems are
becoming more popular because they increase managements
control over operations and also because their data-
processing costs have dropped substantially. Computers and
optical scanning equipment have become more versatile and
less costly.
Small enterprises favor the periodic inventory system. As
businesses grow and become more complex, perpetual
inventory systems are installed. Given, many unhappy
surprises can be avoided if managers keep a closer watch on
inventories, instead of depending on periodic systems.
On the flip side, though the perpetual system is comparatively
more accurate, it is quite expensive. The periodic system is
less accurate, especially for monthly or quarterly statements,
but it is less costly because
there is no day-to-day data
processing regarding cost of
goods sold. However, if theft
or t he accumul at i on of
obsolete merchandise is likely,
periodic systems often prove
to be more expensive in the
long run.
105
Video 5.4.2: FIFO Perpetual
Amount in Rs.
Beginning Inventory 4,00,000
Purchases 5,00,000
Cost of goods available for sale 9,00,000
Less : Ending Inventory 2,50,000
Cost of goods available for sale 9,00,000
Less : Ending Inventory 2,50,000
Cost of goods sold 6,50,000
REVIEW 5.4.1
Check Answer
Question 1 of 3
Jojo Ltd. uses a periodic inventory system. The
beginning inventory was Rs.50,000 and year-
end inventory was Rs.60,000. Purchase of
goods and sal es duri ng the year were
Rs.2,00,000 and Rs.3,00,000 respectively. The
companys cost of goods sold during the year is
A. Rs.2,00,000
B. Rs.1,90,000
C. Rs.1,50,000
D. Rs.1,40,000
106
Section 5
Valuation of Inventory
I n v e n t o r y c o n s t i t u t e s
substantial part of the assets
of a business entity. Hence
the value you put against it
has significant impact on the
working results and financial
posi t i on of t he ent i t y.
Inventories are valued at the
l ower of cost and net
realizable value. The cost of
inventories should comprise
all costs of purchase, costs
of conversion and other
costs incurred in bringing the
inventories to their present
location and condition.
While the costs of conversion
of inventories include costs
directly related to the units of
production, such as direct
labor. They also include a
107
systematic allocation of variable and fixed (based on the
normal capacity of the production facilities) production
overheads that are incurred in converting materials into
finished goods. The cost of inventories specifically excludes:
a. Abnormal amounts of wasted materials, labor, or other
production costs;
b. Storage costs, unless those costs are necessary in the
production process prior to a further production stage;
c. Administrative overheads that do not contribute to
bringing the inventories to their present location and
condition; and
d. Selling and distribution costs.
In the Retail trade, the retail method is often used to measure
inventory cost. The cost of the inventory is determined by
reducing the appropriate percentage gross margin from the
sales value of the inventory.
Net realizable value is the estimated selling price in the
ordinary course of business less the estimated costs of
completion and the estimated costs necessary to make the
sale. Inventories are usually written down to net realizable
value on an item-by-item basis. In some circumstances,
however, it may be appropriate to group similar or related
items.
In United States, inventories are valued at lower of cost and
market value. The term market means current replacement
cost, whether by purchase or by reproduction, but is limited to
the following maximum and
minimum amounts:
i. Maximum: The estimated
selling price less any
costs of completion and
disposal, referred to as
net realizable value. The
purpose of maximum is
to prevent a loss in
future periods by at least
valuing the inventory at its
estimated selling price less costs of completion and
disposal.
ii. Minimum: Net realizable value less an allowance for
normal profit. The purpose of minimum prevents any
future periods from realizing any more than a normal
profit.
The practice of writing down inventories below cost to net
realizable value is consistent with the view that assets should
not be carried in excess of amounts expected to be realized
from their sale or use.
When the utility of the goods in the ordinary course of
business is no longer as great as their cost, a departure from
the cost principle of measuring the inventory is required.
Whether the cause is obsolescence, physical deterioration,
changes in price levels, or any other, the difference should be
recognized by a charge to income in the current period.
Video 5.5.1: lower of Cost
or Market Value
108
Additional resources to this chapter: Gallery
Video 5.5.2:
Inventory Management
109
REVIEW 5.5.1
Check Answer
Question 1 of 3
Recent developments have made much of a
companys inventory obsolete. This obsolete
inventory should be
A. Written down to zero or its scrap value.
B. Shown in the balance sheet at its replace-
ment cost.
C. Shown in the balance sheet at cost, but
classified as a non-current asset.
D. Carried in the accounting records at cost
until it is sold.
Inventory valuation
for investors LIFO
and FIFO
Current practices
in inventory valua-
tion
A review of the ef-
fects of LIFO valua-
tion upon
profits
http://search.proquest.
com/business/docview/
199152773/1362A09B5
4D1012DDFC/10?accou
ntid=38647
http://search.proquest.c
om/business/docview/1
99142497/1362A09B54
D1012DDFC/19?account
id=38647
http://search.proquest.c
om/business/docview/1
99142497/1362A09B54
D1012DDFC/19?account
id=38647
Accounting for Fixed Assets
C
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6
Source:www.theaccagroup.files.wordpress.com
INTRODUCTION
Fixed assets are assets held with an intention to use them for
the production or manufacturing of goods or providing of
services and are not held for resale in the normal course of
business. These are also referred to as long-lived assets.
Long-lived assets refer to those assets whose economic
benefits last for a number of future periods as opposed to
revenue expenditure whose economic benefits exhaust within
a year. The provisions of GAAP regarding these assets
involve the determination of the appropriate cost at which the
asset is to be recorded, appropriate method to be used to
allocate that cost over the periods, the measurement of
impairment losses and accounting for assets to be disposed
off. These assets are primarily operational assets which can
be segregated into two basic types tangible and intangible
assets.
Tangible assets are those assets which have physical
existence and substance and are categorized as:
Depreciable assets, depeletable assets and other
tangible assets.
Intangible assets have no physical existence but their
value is recorded in the Financial Statement. They are:
patents, goodwill, trademarks, rights, grants, privileges
to the business enterprise, etc.
OBJECTIVES
Determine the Cost of Fixed Assets.
Explain the Concept of Depreciation and Methods of
Providing Depreciation.
Account for the Acquisition of Fixed Assets and
Depreciation.
Analyze the Implications of Change in the Method of
Depreciation.
111
Video 6.1: Assets
Section 1
Acquisition of Fixed Assets and Determination of Cost
All fixed assets are shown in
the books of accounts of the
business enterprise at their
c o s t o f a c q u i s i t i o n o r
construction.
In addition to acquisition
costs, it is conventional to
capi tal i ze al l other costs
necessary to bring the asset
to a state where it is ready to
operate or to provide the
services envisaged. This is
because, the benefits of such
expenditure are expected in
the future years and the costs
are treated as assets hence
s uc h ex pendi t ur es ar e
capitalized. For example, The
cost price of land includes the
purchase pri ce, broker s
commission, legal fees and
the cost of grading or of
t e a r i n g d o wn e x i s t i n g
structures so as to make the
land ready for its intended
use.
112
Video 6.1.1:
Learn Accounting: Fixed Asset
The cost includes:
i. Amount paid at the date of
acquisition.
ii. N o r ma l e x p e n d i t u r e
incurred to put the asset
ready for use. Examples:
Installation cost, Wage cost,
etc.
iii. Improvement expenditures, on depreciable assets to the
extent it goes to increase the capacity, operating
efficiency, utility or extend the useful life of the assets, if
they are substantial, are capitalized. Minor expenditures
usually are treated as period costs, though of capital
nature.
Cost of fixed assets can be those incurred at the time of
acquisition and costs incurred subsequent to the initial
acquisition. The initial acquisition costs of fixed assets include
the purchase price and reasonable cost involved in bringing
the asset to the buyer and costs incurred prior to using the
asset in actual production. Such costs are to be capitalized.
Examples include sales taxes, finders fees, freight costs,
installation costs, breaking-in-costs and set-up costs. These
costs are to be added to the cost of the fixed assets and
capitalized and therefore should not be expensed in the
period in which they are incurred.
Self-Constructed Assets
These refer to the depreciable assets constructed by the
business for its own use. All direct costs of labor, materials
and variable overhead of constructing an entitys own fixed
assets should be capitalized. However, a controversy exists
regarding the proper treatment of fixed overhead. Two
different views are:
i. Charge the asset with its fair share of fixed overhead, i.e.,
use the same basis of allocation used for inventory.
ii. Charge the fixed asset account with only the identifiable
incremental amount of fixed overhead.
Basket Purchases
Sometimes an entity acquires in one transaction several
capital assets. This is called a basket purchase. The company
must divide the baskets cost between the categories on some
reasonable basis. Usually this requires an appraisal of the
relative value of each asset included in the basket purchase.
Such a separation is always required when land and a
building are purchased in a single transaction; this is because
the building will subsequently be depreciated, whereas the
land will remain on the books at its cost. A separation may
also be necessary if the capital assets in the basket have
different useful lives, because they will be depreciated at
different rates.
However, the distinction between expenditures that are
capitalized and expenditures that are expensed as period
costs is not entirely clear-cut. Some borderline cases are
described below.
113
Video 6.1.2: Cost Assign-
ment to Fixed Assets
LOW-COST-ITEMS
In accordance wi th the
materiality concept, items
that have a low unit cost,
such as hand tools, are
charged i mmedi atel y as
expenses even though they
may hav e a l ong l i f e.
Nevertheless, the capitalized cost of a new facility may
include the cost of the initial outfit of small items that do not
individually meet the criteria for capitalization. Examples
are the initial outfits of small tools in a factory, books in a
library and tableware and kitchen utensils in a restaurant.
When these items are replaced, the cost of the replacement
items is charged as an expense, but not capitalized.
BETTERMENTS
Repairs and maintenance are work done to keep an asset
in good operating condition or to bring it back to good
operating condition if it has broken down. Repair and
maintenance costs are ordinarily period costs; they are not
added to the capitalized cost of the asset. A betterment is
added to the cost of the asset. The distinction between
maintenance expenses and betterments is that the
maintenance keeps the asset in good condition but in no
better condition than when it was purchased; a betterment
makes the asset better than when it was purchased or
extends its useful life beyond the original estimate.
REPLACEMENTS
Replacements may be either assets or expenses,
depending on how the asset unit is defined. The
replacement of an
entire asset results in the writing off of the old asset and the
recording of the new asset. The replacement of a
component part of an asset is maintenance expense. For
example, assume that one company treats a complete
airplane as a single asset unit and another company treats
the airframe as one unit and the engines as another. The
replacement of an engine results in a maintenance charge
in the first company and in a new asset in the second. In
general, the broader the definition of the asset unit, the
greater will be the amount of costs charged as maintenance
and, hence, expensed in the year the replacement parts are
installed.
To conclude, the governing principle is that the cost of an
item such as property, plant, or equipment includes all
expenditures that are necessary to make the asset ready
for its intended use.
114
Source:www.static.tumblr.com
Source:www.sciencephoto.com
Source:www.rtiintl.com
Reference Material
Accounting standard issued by the ICAI
115
REVIEW 6.1.1
Check Answer
Question 1 of 3
The cost of Self constructed Assets is taken as
A. Prime cost + Indirect cost
B. Construction cost + Interest cost on funds
borrowed
C. Cost that relates directly to specific assets
and those that are attributable and can be
allocated to that specific asset
D. Construction cost + interest on borrowings
- loss due to strike
Accounting for
Fixed Assets
Section 2
Depreciation
A provi si on i s created i n a
company s account t owards
depreciation to account for the
wear and tear of its assets caused
by usage, passage of time,
technological obsolescence, etc.
Depreciation is the acquisition
cost of an asset (l ess t he
expected salvage value) spread
over i ts economi c l i fe. The
purpose of charging depreciation
over the economic life of the asset
is to match the cost of the asset
over the period for which revenue
is earned by using the asset.
DEPRECIATION METHODS
There are mainly four methods
whi ch ar e wi del y used f or
cal cul at i ng t he depreci at i on
expenditure, i.e., the value of the
fixed assets, its useful economic
life and the salvage value.
116
Video 6.2.1: Depreciation Concept
1. Straight-line method;
2. Declining balance method (also called Reducing
balance method or Written down value method);
3. Sum-of-the-years digits method; and
4. Units-of-production method.
Straight-line Method
Under the straight-line method, the net acquisition cost or
construction cost is charged
off in equal proportion during
the useful economic life and
t h e q u a n t u m o f t h e
depreciation is arrived at by
dividing the net acquisition
or construction cost by the
number of years of useful
economi c l i f e. The net
acquisition or construction
c os t i s c al c ul at ed by
deducting salvage value
f r om t he acqui si t i on or
construction cost.
Depreciation =
Asset Value Salvage Value
Depreciation =
Estimated useful life (in no. of years)
For example, if the cost of an asset is Rs.1,00,000, the
expected salvage value is Rs.20,000 and the estimated useful
life is 8 years, the annual depreciation would be = Rs.10,000
or 10% per annum.
This method has the following advantages:
1. The calculation is relatively simple; and
2. It realistically matches cost and revenue.
Diminishing Balance Method
Under t he di mi ni s hi ng
balance method, also known
as reducing or declining
balance or written down value
method, the depreciation
charged off during the year is
deducted from the cost of the
asset at the beginning of the
accounting period and the
balance is known as the book value or written down value
(WDV). Thus depreciation is charged at a specified rate on the
original cost of the asset in the first year and on book value or
written down value of the previous year from 2nd year
onwards.
For example.
At the end of the 1st year, the depreciation is calculated by
applying the rate to the original cost. Then the written down
117
Video 6.2.2:
Methods of Depreciation
Source:www.forum4finance.com
value is arrived at by deducting the depreciation so arrived at
from the original cost. At the end of the 2nd year, the
depreciation rate is applied to the written down value at the
end of the 1st year. This depreciation amount is again
deducted to arrive at the written down value at the end of the
2nd year. In the above mentioned asset the depreciation
calculations, say for next 6 years, will be as follows:
The following are the advantages of Diminishing Balance
Method:
I t mat ches t he
service of the asset
in the sense that
higher depreciation
is charged in the
initial years, when
t he machi ne i s
mo s t e f f i c i e n t
compared to later
years.
It recognizes the
risk of obsolescence by concentrating the major part of
the depreciation in the early years of the life of the asset.
It equalizes the expenses of depreciation and repair
charges taken together. It is assumed that repairs are the
lowest in the initial years and higher in the later years; the
depreciation under this method is higher in the initial
years, but lower in the later years.
Sum-of-the-Years Digits Method
The sum-of-the-years digits method is an accelerated
method of depreciation that provides higher depreciation
expenses in the early years and lower charges in later years.
To find the sum-of-the-years
digits, the digit of each year is
progressively numbered and
then added up. For example,
the sum-of-the-years digits for
a five-year life would be:
5 + 4 + 3 + 2 + 1 = 15
The sum of the years digits
becomes the denominator,
and the digit of the highest year becomes the first numerator.
For example, the first years depreciation for a five-year life
would be 5/15 of the depreciable base of the asset, the
second years depreciation would be 4/15 and so on.
118
Video 6.2.3:
Reducing Balance Depreciation
Video 6.2.4:
Sum of digits method
Example:
A machinery costing $11,000 has a salvage value of $1,000
and an estimated useful life of four years.
The first step is to determine the depreciable base:
Cost asset $11,000
Less: Salvage value 1,000
Depreciable base
The sum of the years digits for four years is: 4 + 3 + 2 + 1 =
10
The first years depreciation is 4/10, the second years 3/10,
the third years 2/10 and the fourth years 1/10 as follows:
4/10 of $10,000 = $4,000
3/10 of $10,000 = 3,000
2/10 of $10,000 = 2,000
1/10 of $10,000 = 1,000
Total depreciation
Units-of-Production Method
The depreciation rate under this method is acquisition or
c ons t r uc t i on c os t ( i . e.
acquisition or costs minus
salvage value) divided by the
estimated number of units
that are likely to be produced
during its useful economic
life. This rate is then applied
t o t he number of uni t s
p r o d u c e d d u r i n g a n
a c c o u n t i n g p e r i o d t o
determine the depreciation to
be provided during that period.
For example.
A machine is purchased at a cost of $850,000 and has a
salvage value of $100,000. It is estimated that the machine
has a useful life of 75,000 hours.
In an accounting period during which the machine was used
for 12,500 hours, depreciation would be $125,000 (12,500 x
$10).
119
Video 6.2.5:
Straight line method vs
Units of production method
The units-of-production method is used in situations in which
the usage of the depreciable asset varies considerably from
period to period and in those circumstances in which the
service life is more a function of use than passage of time.
RECORDING DEPRECIATION
Assume that Tina Chemicals purchased a Machinery for Rs
1,00,000 on April 1, 2008 with an estimated life of 10 years
and zero residual value. The company decided to depreciate
the machinery on a straight-line basis, i.e., Rs.10,000 per
year. Lets see how this amount of depreciation should be
recorded.
It would be possible to reduce the asset value by Rs. 10,000
a year and show on the balance sheet only the remaining
amount. Thus on 31st March 2009, the Machinery will appear
in the balance sheet at Rs. 90,000 (1,00,000-10,000), on 31st
March 2010 at Rs. 80,000 (90,000-10,000), on 31st March
2011 at Rs. 70,000 ( 80,000-10,000) and so on.
However, this is not ordinarily done. Instead, the amount of
depreciation is accumulated every year and the amount of
accumulated depreciation is deducted from the original cost of
the assets at the end of every year. Thus as far as the net
amount shown in the balance sheet for the given asset is
concerned, it would remain the same. Thus on 31st March
2009, the Machinery will appear in the balance sheet at Rs.
90,000 (1,00,000-10,000), on 31st March 2010 at Rs. 80,000
(1,00,000-20,000), on 31st March 2011 at Rs. 70,000
(1,00,000-30,000) and so on.
CHANGE IN THE METHOD OF DEPRECIATION
The depreciation that is charged under the straight line
method remains the same every year, however, under the
WDV method it reduces gradually. This gives rise to variations
in the depreciation charges calculated as per the two different
methods. For instance, let us assume that the following
particulars relate to an asset X:
Original Cost, as on 1st April 2010 = Rs.10,000
Salvage Value = Rs.1,000
Useful Life = 2 years
Depreciation percentage as per diminishing
balance method = 68.35%
Depreciation as per straight line method
= 10,000-1000/2
= Rs.4,500 per annum
The company has decided to follow diminishing balance
method and the Accounting period is 1st April to 31st March.
Suppose on April 1, 2011 the company decides to change the
method of depreciation from diminishing balance method to
straight line method. What would happen?
The book value of asset X as on 1st April 2011 would be
10,000 - 6835 = 3165
120
If you change the method from diminishing balance to straight
line method, the book value of asset X as on 1st April 2011
should be 10,000 - 4500 = 5500
Thus the book value of the asset would increase by Rs 2335
(5500-3165).
If we put it in the basic accounting equation, we observe
increase in the asset side of the equation, but no change in
the liabilities of the firm. Therefore, the owners equity has to
increase, which means the profit of Rs.2335.
DISPOSAL OF FIXED ASSETS
If a fixed asset is sold before the end of its useful life, then
both its original cost and its accumulated depreciation should
be removed from the accounts. The profit or loss on such
disposal should be accounted for in the books of accounts.
Example:
Let us:
a. Calculate the provision for depreciation of plant and
machinery for the year ended 31st December, 2010.
b. Prepare a statement showing Plant and Machinery and
accumulated depreciation as at 31st December, 2010.
c. Prepare a statement showing effect of disposal of Plant
and Machinery on Gross Value of Plant and Machinery,
Accumulated Depreciation and Profit /Loss .
The data for this purpose is as follows:
A companys plant and machinery account on December 31,
2009 and the corresponding depreciation provision account,
broken down by year of purchase are as follows:
Depreciation is at the rate of 10% per annum on cost. It is the
companys policy to assume that all purchase, sales or
disposal of plant occurred on 30th June in the relevant year
for the purpose of calculating depreciation, irrespective of the
precise date on which these events occurred.
During 2010 the following transaction took place:
1. Purchase of plant and machinery for Rs.5,25,000.
2. Plant that had been bought in 1999 for Rs.59,500 was
scrapped.
121
Year of
Purchase
Plant and
machinery at
cost
Depreciation
provision
1993 70,000 70,000
1999 1,05,000 1,05,000
2000 3,50,000 3,32,500
2001 2,45,000 2,08,250
2008 1,75,000 26,250
2009 1,05,000 5,250
10,50,000 7,47,250
sold for Rs.1,750.
sold for Rs.5,250.
Solution
a. Calculation of provision for depreciation of plant for the
year ended 31st December, 2010.
b. Plant and Machinery and Accumulated Depreciation as at
31st December, 2010.
c. Statement showing effect of disposal of Plant & Machinery
Account 2010.
Plant and Machinery = 10,50,000 (opening balance) +
5,25,000 (purchase) 1,75,000 (disposal/sale)
= 14,00,000
Accumul at ed Depreci at i on = Openi ng + addi t i ons
(depreciation during the year) - deductions (disposal/sale)
= 7,47,250 + 92,050 1,66,600
= 6,72,700
122
Year of
purchase of
plant
Workings
Depreciation
(RS)
1993 nil
1999 nil
2000 17,500
2001
1/2 year at 10% on 84,000 - 4,200
1year at 10% on 1,61,000 - 16.100
20,300
2008 10% on 1,75,000 17,500
2009 10% on 1,05,000 10,500
2010 1/2 year at 10% on 5,25,000 26,250
92,050
Year of
purchase
Cost Depreciation
1993 70,000 70,000
1999 45,500 45,500
2000 3,18,000 3,18,500
2001 1,61,000 1,52,950
2008 1,75,000 43,750
2009 1,05,000 15,750
2010 5,25,000 26,250
14,00,000 6,72,700
Profit/(Loss) = Sale of Assets Net Book Value of the asset at
the time of sale ( Cost - Accumulated Depreciation)
= 7000 {(59500-59500) + (31500 -31500) + (84000-75600)}
=7000 - 8400
= (1400)
Partial-Year Depreciation
When an asset is placed in service during the year, the
depreciation expense is taken only for the portion of the year
that the asset is used. For example, if an asset (of a company
on a calendar-year basis) is placed in service on July 1, only
six months depreciation is taken.
Depletion is the process of allocating the cost of a natural
resource over its estimated useful life in a manner similar to
depreciation. An estimate is made of the amount of natural
resources to be extracted, in units or tons, barrels, or any
other measurement. The estimate of total recoverable units is
then divided into the total cost of the asset to arrive at a
depletion rate per unit. The annual depletion expense is the
rate per unit times the number of units extracted during the
fiscal year. If at any time there is a revision of the estimated
number of units that are expected to be extracted, a new unit
rate is computed. The cost of the natural resource property is
reduced each year by the amount of the depletion expense
for the year. This process is similar to the units-of-production
depreciation explained earlier.
Reference Material
Accounting standard issued by the ICAI
123
Depreciation
Accounting
http://220.227.161.8
6/248as6new.pdf
124
REVIEW 6.2 .1
Check Answer
Question 1 of 8
Snigdha Industries depreciates its machinery at 10% p.a. on straight-line basis. On
April 01, 2009 the balance in the machinery account of the firm was Rs.8,50,000
(original cost Rs.12,00,000). On July 01, 2009 a new machine was purchased for
Rs.25,000. On December 31, 2009, an old machine having a written down value of
Rs.40,000, as on April 01, 2009 (original cost Rs.60,000) was sold for Rs.30,000.
The balance sheet will show machinery at Rs .......... as on March 31, 2010
A. Rs.7,19,125
B. Rs.7,91,500
C. Rs.7,92,125
D. Rs.7,18,500
Section 3
Intangible Assets
Intangible Assets
Dictionary meaning of the adjective
intangible is lacking substance or
reality; incapable of being touched
or seen; i ncapabl e of bei ng
perceived by the senses especially
the sense of touch.
Intangible assets thus mean assets
which have no physical presence,
nevertheless are of economic
value, sometimes more than all
tangible assets taken together, to
the business entity.
From the above defi ni ti on of
intangible assets, the items that
easily come to mind are:
Patents
goodwill
copyrights
customer database
mortgage servicing rights
fishing licenses
franchises
marketing rights
Any perceived improvement
in brand equity, corporate
image from an advertising
or publicity campaign
Knowledge gained from
research activities
125
Video: 6.3.1 Intangible Assets
Please note that though the above items can be perfectly valid
examples of intangible assets from a laymans point of view, not
all will qualify as so when the tests of accepted accounting
principles and criteria are applied to them, as we will discuss in
subsequent paragraphs.
AMORTIZATION
Amortization is the systematic allocation of the depreciable
amount of an intangible asset over its useful life.
Depreciable amount is the cost of an asset less its residual
value.
Useful life is either:
a. The period of time over which an asset is expected to
be used by the enterprise; or
b. The number of production or similar units expected to
be obtained from the asset by the enterprise.
Residual value is the amount which an enterprise expects to
obtain for an asset at the end of its useful life after deducting
the expected costs of disposal.
Amortization Period
The depreciable amount of an intangible asset should be
allocated on a systematic basis over the best estimate of its
useful life. There is a rebuttable presumption that the useful life
of an intangible asset will not exceed ten years from the date
when the asset is available for use. Amortization should
commence when t he asset i s avai l abl e f or use.
Factors which need to be considered for determining the useful
life of an intangible asset include:
a. The expected usage of the asset by the enterprise;
b. Typical product life cycles for the asset and public
information on estimates of useful lives of similar types of
assets that are used in a similar way;
c. Technical, technological or other types of obsolescence;
d. The stability of the industry in which the asset operates and
changes in the market demand for the products or services
output from the asset;
e. Expected actions by competitors or potential competitors;
f. The level of maintenance expenditure required to obtain the
expected future economic benefits from the asset and the
companys ability and intent to reach such a level;
g. The period of control over the asset and legal or similar
limits on the use of the asset, such as the expiry dates of
related leases; and
h. whether the useful life of the asset is dependent on the
useful life of other assets of the enterprise.
Given the history of rapid changes in technology, computer
software and many other intangible assets are susceptible to
technological obsolescence. Therefore, it is likely that their
useful life will be short.
126
In some cases, there may be persuasive evidence that the
useful life of an intangible asset will be a specific period
longer than ten years. In these cases, the enterprise
amortizes the intangible asset over the best estimate of its
useful life.
Reference Material - (in ICAI logo)
127
Intangible As-
sets
Video 6.3.2: Asset Ex-
change
Video 6.3.3:
Asset Impairment
Video 6.3.4:
Natural Resources as Asset
http://220.227.1
61.86/270accou
nting_standards
_as26new.pdf
Cash Flow Statement
C
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Source:www.tutor2u.net
INTRODUCTION
Cash Flow Statement provides information regarding the cash
inflows and outflows of an organization during a particular
period. It provides a valuable analytical tool along with the
financial statements. The economic decisions that have to be
taken by users of financial statements include, to a large
extent, an estimation of the
cash and cash equivalents
that the organization may
generate and the timing and
certainty of such a
generation. This is
regardless of the
enterprises activities and
irrespective of whether cash
can be viewed as the
product of the enterprise, as may be the case with a financial
enterprise. In many senses it is a narrower definition of the
term Funds. In a broader sense, it means the net working
capital of the company, and in its narrow sense, the word
conveys the meaning of cash and its equivalents, excluding
all other current items.
Profit and liquidity for a normal firm preparing its accounts on
the accrual basis does not mean the same thing. A firm may
be highly profitable but may find itself with hardly any cash or
working capital to continue the operating cycle, alternatively a
heavily loss making firm may find itself flush with funds. Only
in case of a firm that prepares its accounts on the cash basis
will find its profits and cash flow to be the same. This is the
reason for preparing the cash flow statement to understand a
firms actual requirements
of cash and cash
equivalents. In this unit, we
shall deal with the
objectives of preparation of
Cash Flow Statement, how
it is constructed and what
each section of the cash
flow signifies.
OBJECTIVES
After going through the unit, you should be able to:
Explain the Meaning of Cash Flows, Cash Flows from
Operating, Financial and Investing Activities;
Discuss the objectives of the preparation of Cash Flow
Statements;
Differentiate between Funds Flow and Cash Flow
Statements; and
Prepare Cash Flow Statements as per Accounting
Standard - 3.
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Video 7.1:
Evaluation of Cash flows
Section 1
Operating Activities
NEED FOR CASH FLOW
STATEMENT
The basic objective of a cash flow
statement is to provide relevant
information about cash inflows and
outflows of an enterprise during the
accounting period. The cash flow
statements help investors, creditors
and analysts to:
Assess a companys ability to
generate cash flows from
operations in the future.
Assess its ability to meet its
obligations, any requirement of
external financing and to pay
dividends to shareholder.
Analyze the reasons for the
difference between the net profit
and cash flows.
Analyze the effects on the
organizations financial position -
its cash and non-cash investing
and financing activities.
Cash and Cash Equivalents
Cash and Cash equipments are
defined as follows in AS-3:
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Cash comprises cash on hand and demand deposits with
banks.
Cash equivalents are short-term, highly liquid
investments that are readily convertible into known
amounts of cash and which are subject to an insignificant
risk of changes in value.
Cash equivalents are held for the purpose of meeting
short-term cash commitments rather than for investment
or other purposes. For an investment to qualify as a cash
equivalent, it must be readily convertible into a known
amount of cash and be subject to an insignificant risk of
changes in value. Therefore, an investment normally
qualifies as a cash equivalent only when it has a short
maturity of, say, three months or less from the date of
acquisition. Investments in shares are excluded from
cash equivalents unless they are, in substance, cash
equivalents; for example, preference shares of a
company acquired shortly before their specified
redemption date (provided there is only an insignificant
risk of failure of the company to repay the amount at
maturity).
TYPES OF CASH FLOWS
Cash Flow Statement explains
the flow of cash under three
different heads. These are:
i. Cash Flow from
Operating Activities;
ii. Cash Flow from
Investing Activities; and
iii. Cash Flow from Financing Activities.
Operating Activities may be described as the principal
revenue producing activities of the enterprise and other
activities that are not investing or financing [as per AS-3 and
IAS-7].
These activities are what may be described as the cash that
is generated or used in the core business of the entity.
Generally, there are two ways in which Cash Flow from
Operati ng Acti vi ti es can be
calculated:
Direct Method, whereby major
classes of gross cash receipts
and gross cash payments are
disclosed. Under the direct
method, i nformati on about
major classes of gross cash
r ecei pt s and gr oss cash
payments may be obtai ned
either:
a. From the accounting records of the enterprise; or
b. By adjusting sales, cost of sales (interest and similar
income and interest expense and similar charges for a
financial enterprise) and other items in the statement of
profit and loss for:
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Video 7.1.1: Direct Method
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i. Changes during the period in inventories and operating
receivables and payables;
ii. Other non-cash items; and
iii. Other items for which the cash effects are investing or
financing cash flows.
Indirect Method: In this method,
net profit or loss is adjusted for
the effects of transactions of a
non-cash nature, any deferrals or
accrual s of past or f ut ure
operat i ng cash recei pt s or
payments and items of income or
ex pens e as s oc i at ed wi t h
investing or financing cash flows.
The net cash flow from operating activities is determined by
adjusting net profit or loss for the effects of:
Changes during the period in inventories and operating
receivables and payables;
Non-cash items such as depreciation, provisions, deferred
taxes and unrealized foreign exchange gains and losses;
and
All other items for which the cash effects are investing or
financing cash flows.
Alternatively, the net cash flow from operating activities may be
presented under the indirect method by showing the operating
revenues and expenses excluding non-cash items disclosed in
the statement of profit and loss and the changes during the
period in inventories and operating receivables and payables.
Under the indirect method, net profit is adjusted for the
following:
i. Non-cash items: These include depreciation, loss/profit on
sale of assets, goodwill written off, etc.
Net Profit for the Year
Add: Non-cash expenses
Depreciation
Goodwill written off
Loss on sale of assets
Provision for taxation
Shares discount written off
Less: Non-cash incomes
Profit on sale of assets, etc.
Net Profit after adjustment of Non-cash items
ii. Current assets and current liabilities related to
operating activities: This includes debtors, bills receivable,
stock, credi tors, bi l l s payabl e, prepai d expenses,
outstanding expenses, etc.
132
Video 7.1.2: Indirect Method
Net Profit (after adjustment of Non-cash items)
Add: De c r e a s e i n
Current Assets (Other
than cash and cash
equivalents); Increase in
Current Liabilities
Less: I nc r eas e i n
Current Assets (Other
than cash and cash equivalents); Decrease in Current
Liabilities.
The following illustration will explain the concept clearly (also
see Appendix I to the Accounting Standard 3, reproduced at
the end of the chapter.)
Illustration 1
Determine the cash flow from operating activities from the
Profit and Loss Account and additional information given
below.
Profit and Loss Account for the year ended 31st March, 2011.
Other Information:
Solution
133
Items 2010 2011
Debtors 10,000 16,000
Bills
receivable
10,000 6,000
Creditors 16,000 15,000
Outstanding
Expenses
2,500 1,500
REVIEW 7.1 .1
Check Answer
Question 1 of 4
The primary purpose of a statement of cash flows
is to provide relevant information about
A. An enterprises ability to meet cash oper-
ating needs.
B. An enterprises ability to generate future
positive net cash flows.
C. The cash receipts and cash disburse-
ments of an enterprise during a period.
D. Difference between net income and as-
sociated cash receipts and disburse-
ments.
134
Section 2
Investing Activities
Investing Activities pertain to
acquisition and disposal of
long-term assets and other
investments not included in
cash equivalents [as per
AS- 3 a n d I AS- 7 ] . An
analysis of cash flows from
i nvest i ng act i vi t i es i s
important because the cash
flows represent the extent to
which expenditures have
been made for resources
intended to generate future
income and cash flows.
The following are some of
the elements of investing
activities as described by
Para 15 of AS-3 and Para
16 of IAS-7:
135
Video 7.2.1:
Investing activities detailed
136
Description of Investing Cash Flows as per AS-3, Para 15 Description of Investing Cash Flows as per IAS-7, Para 16
1. Cash payments for acquisitions of fixed assets including
intangibles.
Cash payments to acquire property, plant and equipment,
intangibles and other long-term assets including payments for
development costs that are capitalized and self-constructed
property, plant and equipment.
2. Cash receipts from disposal of fixed assets.
Cash receipts from sale of property, plant and equipment,
intangibles and other long-term assets.
3. Cash payments to acquire shares, warrants or debt
instruments of other enterprises or interest in joint ventures
(excluding those held for trading or dealing purposes or
which are cash equivalents).
Cash payments for acquisition of equity and debt instruments
of other enterprises and interests in joint ventures.
This does not include an item covered in cash equivalents.
4. Cash receipts from disposal of shares, warrants and debt
instruments of other enterprises and interest in joint
ventures (excluding those held for trading or dealing
purposes or which are cash equivalents).
Cash receipts from sale of equity and debt instruments of
other enterprises and interests in joint ventures.
This does not include an item covered in cash equivalents.
5. Cash advances and loans made to third parties (excluding
loans, etc. made by financial institutions in ordinary course
of business which is operating cash flow).
Cash advances and loans made to other parties (excluding
loans, etc. made by financial institutions in ordinary course of
business which is operating cash flow).
6. Cash receipts from repayments of advances and loans
made to third parties (excluding loans, etc. made by
financial institutions in ordinary course of business which is
operating cash flow).
Cash receipts from advances and loans made to other parties
(excluding loans, etc. made by financial institutions in
ordinary course of business which is operating cash flow).
Notes:
i. In item (1), AS-3 does not talk about capitalized expenditure
like expenses during construction period and portion of
operating expenses that are allocated to self-constructed
assets.
ii. In items (3) and (4), IAS-7 is much less specific than AS-3.
137
Description of Investing Cash
Flows as per AS-3, Para 15
Description of Investing Cash
Flows as per IAS-7, Para 16
7. Cash payments for futures,
swaps, forward and option
cont r act s ( excl udi ng,
contracts held for dealing
or trading purposes which
are classified as financing
activities).
Same as AS-3.
8. Cash receipts for futures,
swaps, forward and option
cont r act s ( excl udi ng,
contracts held for dealing
or trading purposes which
are classified as financing
activities).
Same as AS-3.
REVIEW 7.2 .1
Check Answer
Question 1 of 4
A company acquired a building, paying a portion of the purchase price in cash
and issuing a mortgage note payable to the seller for the balance. In a statement
of cash flows what amount is included in investing activities for the above
transaction?
A. Cash payment
B. Acquisition price
C. Zero
D. Mortgage amount
138
Section 3
Financing Activities
Fi nanci ng Act i vi t i es ar e
activities that result in changes
in the size and composition of
the owners capital (including
preference share capital) and
t h e b o r r o wi n g s o f t h e
ent er pr i se [ AS- 3] . I AS- 7,
however, states that financing
activities are activities that
result in the changes in the size
and composition of the equity
capital and borrowings of the
enterprise [emphasis added].
AS-3 speci fi cal l y i ncl udes
preferred capital. Some of the
elements of investing activities
as described by Para 17 of
AS-3 and Para 17 of IAS-7 are
provided in the accompanying
table.
They account for cash flows
gener at ed f r om i ssue of
shares, issue of debentures,
loans raised, redemption of
139
debentures, repayment of
loans, etc. Redemption of
shares and repayment of
borrowi ngs resul t i n an
outflow of cash. Thus inflows
and outflows related to the
amount of capi t al and
borrowings of the enterprise are shown under this head and the
net effect of these investing activities is determined. A
disclosure of the cash from financing activities helps in
predicting the claims of the providers of finance on the future
cash flows of the company. In the case of enterprises other
than Financial enterprises, cash flows arising from interest paid
should be classified as cash flows from financing activities while
interest and dividends received should be classified as cash
flows from investing activities. Dividends paid should be
classified as cash flows from financing activities.
Illustration:
You are the Senior Accounts Officer of Little Flower Ltd. The
Comparative Balance sheet as on March 31, 2010 and March
31, 2011 and the Income Statement for the Financial year
2010-11 are given below:
Little Flower Ltd.s Comparative Balance Sheets
December 31, 2003 and 2002
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Income Statement for the Financial year 2010-11
Additional Information:
i. During the period 2010-11, Little Ltd. purchased
investments amounting to Rs.3,90,000.
ii. The book value of the investments sold was Rs.4,50,000.
iii. During the period, plant amounting to Rs.6,00,000 were
purchased.
iv. A machinery costing Rs.50,000 with accumulated
depreciation of Rs.10,000 was sold for Rs.25,000.
v. On March 31, 2011, Little Ltd. issued bonds of Rs.5,00,000
at face value in exchange for a plant.
vi. The company repaid Rs.2,50,000 worth of bonds at face
value on maturity.
vii. The company issued 75,000 common stock of Rs.10
each.
viii. Cash dividends paid during 2010-11 amount to Rs.40,000.
You are required to Prepare a Statement of Cash Flow (using
indirect method) for the period ended March 31, 2011.
141
Little Flower Ltd. Statement of Cash Flows
for year ended December 31, 2011
Reference material:
Accounting Standard issued by ICAI
142
ICAI
IFRS
http://www.iasb.org/N
R/rdonlyres/CB22235
8-B86E-44D5-A047-22
9EA40C1FA8/0/IAS7.
http://220.227.
161.86/244as3_
allnew.pdf
REVIEW 7.3 .1
Check Answer
Question 1 of 5
Net cash provided by operating activities was
A. Rs.1,160,000
B. Rs.1,040,000
C. Rs.9,20,000
D. Rs.7,05,000
143
The Annual Report
C
H
A
P
T
E
R

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Source:www.thp.org
INTRODUCTION
An Annual Report consists of various contents which
represent a companys performance during the previous year,
managements discussion of the companys strategy for the
future, etc. An annual report is one of the most important
documents a company produces and is often the first
document someone consults when researching a company. It
reports how the companies fare financially and often explains
the scope of its business mission and management
philosophy.
It is an important communication that a companys annual
report provides to the investor and analyst. A public company
produces an annual report for its stakeholders - shareholders,
owners, creditors, analysts, regulators, etc. Other interested
parties such as customers and potential investors too read
this report.
OBJECTIVES
Understand the significance of Annual Reports;
List down the contents of Annual Reports and the
significance of each component;
Describe the qualities required to make the Financial
Statements more useful; and
Descri be the di scl osure practi ces that i ncrease
transparency, understandability of Financial Information of
a company.
145
Section 1
Understanding Annual Report
Need f or Fi nanci al
Accounting System
All businesses maintain a
financial accounting system
with the objective to track all
the economic transactions
that the business undertakes
and record them logically in a
dat a bas e. The maj or
purposes basically are:
Pr ovi di ng i nf or mat i on
which in turn becomes the
basi s f or exer ci si ng
decisions and actions by
the potential users.
Reflecting the financial
progress and present
health of the business.
Aiding in the formulation
of policies and procedures
f or t he s moot h and
efficient conduct of the
business.
Enabling the management
t o d i s c h a r g e t h e i r
o b l i g a t i o n s a n d
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stewardship functions effectively.
Earlier, there was no distinction between the ownership and
the management and was concerned only with providing
information to the owners. But with their separation and an
increasing emphasis on the business being managed by
qualified and competent professionals, the role and the
purpose of financial accounting has undergone a paradigm
shift to that of stewardship, thereby highlighting the
accountability aspect of managing the enterprise. The cause
of the new orientation is the increasing reliance by the
interested entities such as stakeholders, investors, trade
creditors, employees, customers, statutory authorities like
Income tax and Excise departments, the Government and
other agencies. They do not have any participation in the
management of the affairs of the organization and as such
collect the required information from the financial statements.
Such interests displayed by a varied group of constituents
necessitate the presentation of a true and fair portrayal of the
financial conduct of the business. This has underscored the
need for developing accounting concepts, principles and
standards to ensure that accounting information serves the
needs of various users.
Regulatory requirements
In India, Companies incorporated under the Companies Act of
1956 are required to keep proper books and records that
reflect the true and fair view of the companys business affairs.
Also, to impart credibility to the reported financial statements,
these are required to be attested by professional accountants
who perform the task of auditing (which involves examination
and verification) before expressing their opinions on the
financial statements. Auditors are required to present a report
on t he company s
a c c o u n t s t o i t s
s h a r e h o l d e r s .
Compani es whose
sal es exceed Rs.4
mi l l i o n a r e a l s o
required to undergo a
tax audit. Tax audit
matters are governed
by the Income Tax Act.
Annual reports are widely distributed to shareholders and are
provided to domestic researchers upon request. The Annual
report of the company is also generally available at the
website of the company or any other websites which provide
the information about the company. Company secretaries are
responsible for responding to inquiries by investors.
In India, The Accounting Standard Board of ICAI conducts
research and develops accounting standards taking into
consideration the related laws, the business environment,
business practices and other reasonable factors that would
depict a true and fair view of corporate financial reporting. But
the Global companies have problems because national
accounting differs from country to country. In this context,
there is a great need of a reporting system which is capable of
delivering uniform data worldwide for management purpose
and for the investor, while also providing potential and different
data in each country to suit the local tax requirements. There
is a major effort to codify a set of accounting principles that
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would apply internationally; over 40 statements known as
International Accounting Standards (IAS) have been
published by the International Accounting Standards
Committee (IASC) - now recognized as the International
Accounting Standard Board (IASB) - located in London,
England. The standards issued by the IASB are known as
International Financial Reporting Standards (IFRS).
Purpose of Annual Report
The basic objective of creating and distributing annual reports
is to:
Present an overview of a company, managements
discussion of its preceding year performance and its
plans for the future.
Report the companys financial performance for the
previous year and compare it with its performances in the
prior years.
Fulfill part of its obligations for
public financial reporting as
mandat ed by r egul at or y
authorities.
Apart from these annual reports
o f t e n i n c l u d e a v i s u a l
representation of key financial
i ndi cat or s and per f or mance
highlights of a company. This
allows management to effectively
showcase some selected aspects
of the companys performance.
However, an annual report is only one of the many possible
sources of information for making informed investment
decisions.Other sources include business press, investment
analysts reports, company press releases, industry
association reports, etc.
148
Video 8.1.1:
Why Annual Reports
REVIEW 8.1 .1
Check Answer
Question 1 of 3
The purpose of Financial Accounting Systems
is
A. To provide information for decision-
making.
B. To report the financial progress and
health of the company.
C. To aid in formulating policies and pro-
cedures for smooth and efficient con-
duct of business.
Section 2
Contents of an Annual Report
The contents of an Annual
report differ from company to
company. While most annual
report s cont ai n opt i onal
elements, all reports contain
i nf ormat i on t he pri mary
securities regulatory body
requires.
Optional elements include:
! Financial highlights
! Letter to stockholders
! Corporate message
! Board of Directors
and management
! S t o c k h o l d e r
information.
149
Video 8.2.1:
Key Sections of an Annual Report
Primary Securities Regulatory Body in most countries,
including India, requires annual reports to contain the
following information:
! Income Statement
! Balance Sheet
! Cash Flow Statement
! Statement of Accounting Policies
! Auditors Report
! Management Discussion and Analysis
! Notes to the Accounts
! Selected Financial Data
Financial Highlights
The section on Financial Highlights offers a quick summary of
a companys financial performance. The figures appear in
short tables, usually accompanied by supporting graphs. The
section also highlights other important indicators such as rise/
decline in a firms consolidated revenues, earnings per share
and cumulative dividend growth.
Letter to Stockholders
This letter may be from the Chairperson of the Board of
Directors, the Chief Executive Officer, or both. It can provide
an analysis and a play-by-play review of the years events,
including any problems/issues and successes the company
had. It usually reflects the business philosophy and
management style of a firms companys executives and often
lays out direction for the firm for the next financial year.
Stakeholders refer to all the people with an interest in the
success and activities of a firm. This includes everyone from
share owners and employees to members of the communities
in which the company maintains operations. The notion of
stakeholders reflects the impact firms have beyond their
share owners.
The section - Letter to stockholders - in annual reports of
several multinational companies, operating in India, generally
discusses various revenues as per the US GAAP and the
Indian GAAP and their expected growth of earning based on
the economic forecast and the business environment. It also
forewarns of any impending risks/challenges the company
might face in the forthcoming fiscal which could have adverse
impacts on the firms financial performance and the remedial
measures the top management has already put in place or
intends to take.
Corporate Message
While some analysts, business executives and stockholders
consider this message as an advertisement for the company
others find it more useful. Nonetheless, it almost always
reflects how a company sees itself or how it would like others
to see it. A firm can use this section to communicate
effectively about its operational/focus areas, the various
business segments it operates in, markets, its mission,
management philosophy, corporate culture and strategic
direction, among others.
150
Board of Di rectors and
Management
This list gives the names and
position titles of the companys
Board of Directors and the top
management team.
Stockholder Information
This information covers the basics
the companys corporate office
headquarters, the exchanges on
which the companys stocks are
listed and traded, the location and
t he t i me of t he next annual
st ockhol der s meet i ng, ot her
gener al st ockhol der ser vi ce
i nf ormat i on, et c. St ockhol der
information is usually given at the back of the annual report.
Directors Report
Directors Report can be said as the Responsibility and
Accountability statement of the management towards the
owners. is an annual score card of the management of the
company of thei r performance as refl ected by the
accountability of the company to its owners. It is Responsibility
and Accountability Report card to owners.
The companies Act clearly lays down the requirements of a
company shall attach to the Balance Sheet a Report by the
Board of Directors. The Directors Report in speaks of the state
of company affairs, Amount proposed to be carried forward to
reserves, amount recommended as dividends , any material
changes and commitments affecting the financial position of
the company which have occurred between the end of financial
year and the date of report.
It shall include Directors Responsibility statement compliance
of accounting standards consistency in accounting policy
reasonable estimates adherence to going concern
responsibility for maintenance of proper record in compliance
with Statutory requirements responsibility to safeguard
assets responsibility to prevent and detect frauds and other
irregularities.
The Report captures the duty of directors to give the fullest
information and explanation to every qualification, remarks of
auditors in the Auditors Report.
The Directors report reports the name of employees who draw
more than Rs.25 lacs per annum.
Chairmans Statement
Corporate annual reports generally
begin with a statement from the
CEO and the chairperson. The
statement is generally an overview
of the company's year, and may
detail the highlights of the year, how
t he company i s handl i ng or
overcomi ng chal l enges and a
statement about the future of the
c o m p a n y .
151
Video 8.2.3:
Chairmans statement
Video 8.2.2:
Board of Directors Role
This letter may be from the Chairperson of the Board of
Directors, the Chief Executive Officer, or both. It can provide an
analysis and a play-by-play review of the years events,
including any problems, issues, and successes the company
had. It usually reflects the business philosophy and
management style of the companys executives, and often it
lays out the companys direction for
the next year.
Financial Statement
The most important section in a
corporate annual report is the basic
set of financial statement. Financial
statements present a summary of
the financial situation of a firm
based on the total sales and
expenses (statement of earnings),
assets, liabilities and share owners
equi ty (statement of fi nanci al
position) and the flow of cash in and
out of the company (statement of cash flows). These
statements help analysts determine the financial health of a
company. The sectional also offers information about the
following - whether the company has sufficient cash flow to
keep operating successfully; whether the cash flow position of
the company improves or deteriorates over time; whether the
liabilities (monies owed) are less (exceed) relative to the assets
(things owned); whether the company is profitable and whether
the profitability increases or decreases over time.
Financial statement consists of the following:
! Balance Sheet
! Income Statement (Profit and Loss Account)
! Statement of Cash flow
! Statement of Stakeholders equity
! Footnotes
! Contingencies
! Supplementary Schedule
Schedules to the Balance Sheet, Profit and Loss
Account and Cash Flow
Schedules to the balance sheet present assets, liabilities and
shareholders equity what the firm owns and what it owes to
creditors and owners at a particular date, generally at the end of
the year. Schedules to the profit and loss account show the
result of a break-up of a firms operation, i.e., break-up of
revenues and expenses and other sources of income and
expenditure. The Schedules to the cash flow statement
provide information about sources and uses of cash during the
accounting period, category-wise, as follows:
Net cash provided (or used) by operating activities.
Net cash provided (or used) by investing activities.
Net cash provided (or used) by financing activities.
! Fixed Assets
152
Video 8.2.4:
Financials in Annual Report
This schedule provides the break-up of assets, i.e., assets
purchased/sold, types of assets, etc. This section provides
information about the actual investment in fixed assets.
! Investments
Under this schedule, the company provides the break-up of
investment. Investor can get information like how much
investment of the company is in a particular company and
how much of this is in traded securities, etc.
! Deferred Tax Assets
Deferred tax assets result from (temporary) difference
between the recognition of revenue and expense for taxation
purposes and the reported income.
! Sundry Debtors
Sundry debtors are the customer balance outstanding on the
credit sales. This schedule provides the break-up of sundry
debtors - which is good and which is doubtful - and also the
provisions during the year.
! Cash and Bank Balances
In this schedule, the break-up of cash and bank balance is
provided, i.e., bank deposit in various banks and cash in
hand.
! Loans and Advances
Under this category, information regarding loans and
advances (good and doubtful), advances to subsidiary
companies under the same management, advance income
tax, loans and advances to employee etc., is provided.
! Current Liabilities and Provisions
Current liabilities are divided into sundry creditors, various
provisions and outstanding expenses.
! Expenses
Expenses of a company are generally subdivided into various
categories like selling and distribution, administrative
expenses, general expenses, etc. Some companies also give
break-ups of major expenses in the profit and loss account.
For example, Infosys provides in the schedule, the break-up
value of software development expenses, which are major
expenses incurred by any software
company.
Si gni f i cant Account i ng
Policies
Under thi s head, a company
gener al l y pr ovi des t he br i ef
discussion of its accounting policy.
In India, financial statements are
prepared in accordance with the
I ndi an Gener al l y Ac c ept ed
Accounting Principles (GAAP) under the historical cost
convention on the accruals basis. GAAP comprises
mandatory accounting standards issued by the Institute of
Chartered Accountants of India (ICAI) and the provisions of
the Companies Act, 1956. These accounting policies have
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been consistently applied, except for recently issued
accounting standards made mandatory by the ICAI. However,
some companies also provide statements in the US GAAP and
their reconciliation with the Indian GAAP.
Notes on Accounts
The Notes on Accounts are an integral part of the financial
statement and are also major disclosure materials. The
following table includes some of the notes on accounts that
companies generally provide in their annual reports.
Auditors Report
This summary of the findings
of an independent firm of
certified public accountants
shows whether the financial
statements are complete,
reasonable and consistent
with the Generally Accepted
Accounting Principles (GAAP)
at a set time.
There are four types of
auditor opinions Unqualified opinion, qualified opinion,
adverse opinion and disclaimer of opinion. In unqualified
opinion, auditors present fairly a companys financial
performance and position. When an auditor gives an opinion
subject to certain reservation, he is said to have given a
qualified opinion. A qualified opinion implies that the auditor
states that the financial statement reflects a true and fair view
subject to certain reservations. A qualification should always be
preceded by the word subject to. Adverse opinion does not
present fairly a companys financial performance and position.
When an auditor is insufficient in scope to render an opinion,
this opinion is called disclaimer of opinion. Some situation of
unqualified opinion such as consistency departure due to
change in accounting policies, contingency item and the items
that effect the business risk of the company may be shown as
additional information.
154
Source:www.media.freeola.com
Management Discussion and Analysis
This series of short, detailed
reports discusses and analyzes a
companys performance. It covers
results of operations and the
adequacy of liquid and capital
resources to fund operations of the
companys future plans. This
section can be a valuable tool in
evaluating a company because it contains some quantitative
information that may not be covered in the financial statement
of the company. The Management Discussion and Analysis
(MD&A) section provides an opportunity to the company
management to analyze the companys performance through a
series of discussion points like:-
! Operations
! Financial Resources and Liquidity
! Selected Financial Data
! Critical Accounting Policies
! Deferred tax assets
! Detailed discussion on net profit
! Sundry debtors
! Sundry creditors
! Cash and cash equivalents
! Loans and advances
! Current liabilities
! Unearned revenue
! Provisions
! Segregation of income and expenses
! Disclosure of debt
! Depreciation and amortization
! Provision for investment
! Stock option plans
Risk Management Report
The report lists out various risk management activities taken up
by the management in respect of certain key risks facing the
company. This report contains statements which are forward-
looking in nature. Such statements are subject to uncertainties
that could cause actual results to differ materially from those
reflected in the forward-looking statements. The report also
discusses the remedial measures taken by the company to
minimize these risks. The risk management report generally
covers the following risks/areas:
! Risk management structure
! Risk management framework
! Macro economic factors
155
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! Competition
! Concentration of revenues
! Service offerings
! Clients
! Industry
! Geography
! Political environment
! Organizational management
! Finance
! Exchange rates movement
! Liquidity
! Regulatory and legal compliance
! Contractual Commitments
! Statutory compliance
! Conformity with the local laws
! Intellectual property
! Immigration
! System and process
! Leadership development
! Human resource management
! Process and project management
! Internal control system
! Security and business continuity
Shareholder Information
Information about corporate
strategies and plans are
increasingly communicated
via the annual reports. In
order to enhance the quality
of reporting, a number of
n e w f i n a n c i a l a n d
operational measures of
performance (such as economic value added, value of human
resources, etc.) have been reported by some blue chip
companies including Dr. Reddys Labs and GE capital.
Under Shareholder information head, Infosys Technologies
discloses the following information:
! Frequently asked questions
! Share performance chart
! Intangible assets score sheet
! Human resources accounting and value-added
statement
! Brand valuation
156
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! Balance sheet (including intangible assets)
! Current-cost-adjusted financial statements
! Economic Value-Added (EVA) statement
! Ratio analysis
! Statutory obligations
! Value Reporting
! Management structure
Additional Resources:
157
Video 8.2.5:
Corporate Governance
REVIEW 8.2 .1
Check Answer
Question 1 of 6
The auditor of a company gives a report that the fi-
nancial statements of the company reflect a true
and fair view subject to certain reservations. Such
a report is known as
A. Clean report
B. Qualified opinion
C. Unqualified opinion
D. Provisional report subject to issue of final
report
Section 3
Quality of Financial Reporting
A g o o d f i n a n c i a l
statement should reflect
the clear picture of the
company. The financial
statement shoul d be
useful in both assessing
the past performance as
well as in predicting the
f ut ur e per f or mance.
Information should be in
a clearly understandable
manner. Some of the
i mpor t ant i ssues i n
Financial Reporting are
discussed hereunder:
158
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Accounting Policies and Estimates Choice and Changes
In preparing financial statement,
the management makes choices
wi th respect to accounti ng
policies and makes estimations
in the application of those
p o l i c i e s . An y c h a n g e i n
appl i cat i on of account i ng
principles from one fiscal to
another may affect the profit of
the company. Companies must
report material effects on their
income when they adopt new
accounting standards or change
from one accounting method to another. In most cases, when a
change in accounting methods is made, the income that has
been reported differs from that which would have been
reported in earlier periods if the new method had been used.
The cumulative effect of the accounting change on income of
earlier periods is reported in the income statement.
An accounting change is reported as a separate item on the
income statement, net of taxes. This reporting requirement
calls attention to the change. Remember that consistency is an
important characteristic of accounting methods. A company
should not change accounting methods unless that change is
justified by the companys economic circumstances or the need
to adopt a new accounting standard. A change in accounting
method generally alters the way income or expense is
calculated. Net income computed using a particular accounting
method in one year is not comparable with income computed
using a different method in the next year. Accordingly,
companies must disclose the effects of the changes and
restate, when possible, previous financial statement amounts
that are affected by the change so that they are comparable to
those reported in the current year.
A change in accounting method is different from a change in
accounting estimate. Many transactions require a company to
make estimates.
Timing of Revenue and Expense Recognition
One of the important accounting principles that provides the
foundation for preparing financial statement is the matching
principle. To assess maintainable income, one needs the
information to be presented using the matching concept. Indian
GAAP states that one cannot recognize income or expenses
unless the related assets or liabilities can be recognized. There
are many instances where expenses incurred in the current
year, which relate to revenue to be generated in a future year,
cannot be capitalized because of the constraints contained in
the definition of an asset, for example, advertising expenses.
There are also many instances where expenses should be
accounted in a year but could not because of the constraints
contained in the definition of a liability, for example, costs of
collecting debtors provided for in the selling price of the goods.
Let us assume the selling price and cost per product are Rs.10
and Rs.6 respectively, depending upon whether the sale is
recognized at production or dispatch or collection, the revenue
would be Rs.90, or Rs.70 or Rs.50 respectively. Further, the
cost of good sold under the three situations will be Rs.54, Rs.
42, and Rs.30 respectively. Thus it is clear that the cost
159
Video 8.3.1:
Accounting Policies
derives its relevance only from the sale and not vice-versa. It
is for this reason that revenue recognition always precedes the
matching of cost. If revenue for sale is not defined, the cost
cannot be defined either.
In recent years the accounting practices of many companies
have been in question and in some cases shareholders have
filed lawsuits as a result of alleged abuses in financial reporting.
Discretionary Items
The financial analyst should carefully scrutinize managements
policies with respect to these discretionary items through
examination of trend in expenditure and compare it with
Industry competitors. Expenditure made by a company consists
of many discretionary items in nature. Discretionary items are
mainly of the following types:
Research and Development: Research and development cost
is one of the major types of discretionary items and the most
difficult to analyze for the purpose of earnings analysis. The
main issue in the research and development cost is its
successful completion. There are a number of examples of
successful completion of research activity in several areas and
at the same time there are numerous failures as also. The
failure of research results means forgoing the benefits availed
against earlier expenses. So, there is a need to carefully
analyze the quality of the research and development such as
caliber of staff and organization reputation of its leaders,
historical result and its commercial applicability. Analysts should
carefully analyze how the investment was applied for research
and development activities by the company in question.
Repair and Maintenance: Repair and maintenance cost is
another item for disclosure in a quality financial statement.
Analysts should carefully analyze the trend in repair and
maintenance cost. The main purpose of this analysis is to
determine whether repairs and maintenance are at normal
levels or have risen abnormally, thereby hurting the earnings of
the company. A good financial reporting system should disclose
the trend in repair and maintenance cost in terms of index
number.
Advertising and Marketing: Advertisement cost is defined as
the cost incurred by a firm to promote its product(s) in the
market. Advertisement cost is fluctuating in nature; also, there
is a weak relation between the outlay (cost incurred) and short-
term returns. Companies like Coke and Pepsi invest
consistently in advertisement without consideration of short-
term profits. Some companies may spend too much initially for
promoting their products. Analysts must look at year-to-year
variation in advertising costs incurred by a company to assess
their impact on its future sales and earnings quality.
Non-recurring and Non-operating Items: Financial analysts
need to analyze non-recurring items such as restructuring and
impairment charges to estimate economic-value-added
earnings. These earnings should be used to estimate a more
accurate measure of a firms intrinsic value.
There might be revenues and expenses, but which are not
directly related to a companys primary operating activities.
These are reported separately. The item listed in this category
most often is interest expense. Borrowing money frequently is
necessary for an organizations operations; however, except for
160
financial institutions, it is not part of its primary operating
activities. Accordingly, other expenses and revenues are
reported in the income statement after operating income. This
separate listing distinguishes them from revenues and
expenses that result from operating activities. The revenues
and expenses described so far
a r e c o m m o n t o m o s t
corporations.
Oc c a s i o n a l l y, h o w e v e r ,
companies must account for
special revenues and expenses.
Those special items are reported
separately from other items and
require special disclosure as they
affect net income during the
current fiscal period; though they will not affect net income in
future periods.
Analyst should evaluate special items differently from activities
that are expected to affect income in future periods, especially
when forecasting income. There are three types of special
items: discontinued operations, extraordinary items and
accounting changes.
A company expects to derive income from its continuing
operations in future years. In contrast, discontinued operations
are product lines or segments from which a company will no
longer derive income because it has sold or closed (or is in the
process of selling or closing) that product line or segment of its
operations. Discontinued operations differ in size and type of
activity from restructuring, which are reported as operating
revenues or expenses.
Discontinued operations involve large segments of a
companys operations, such as a major product line or
geographic region. Discontinued operations are rare events
because a company cannot close many major segments and
remain in business.
A gain or loss from the sale or closing of a discontinued
operation is reported in the income statement net of income
taxes. Like the gain or loss from discontinued operations, the
related income tax effect is a onetime event.
Publicity Aspect of Reporting
Several accounting scandals all over the world, notably the
dramatic collapse of the US energy giant Enron, have
prompted investors to demand greater transparency in
corporate reporting. Given, companies are responding by
expanding their annual reports. However, every company has
its own unique disclosure challenges. Multinational companies
face a different challenge in presenting financial statement. In
addition to statutory and contractual requirements, an MNC
has obligation to publish annual report because of its economic
importance, overseas listings, etc. These obligations are
usually very stringent. Misleading information may cause
suspicion to the investor and he may not invest or can demand
higher return for money invested. Disclosure by MNCs should
meaningfully communicate, through the annual report, to FIIs,
customers, suppliers and venture-partners on how the
161
Video 8.3.2: Non-recurring
items and non-core activi-
ties
company is maximizing value for their shareholders and
various other stakeholders.
Other areas of increased disclosures include retirement-
related benefits, global financing, non-recurring events and
trends. For example, the annual report provides information
about the combined impact of all retirement-related benefit
plans (pension, 401(k) and retiree medical plans) and the
related assumptions, including a comparison of historical and
expected rates of return. The section on global financing
includes a graph of assets and debt to show how most of the
companys debt is used and the notes to the consolidated
financial statements include expanded disclosures about such
items as workforce rebalancing charges and equity write-
downs. Some annual reports also contain a road map at the
beginning of the MD&A to help the reader easily find the
information he or she is searching for in this section.
Though accounting policies differ from country to country, most
of the accounting rules remain the same all over the world;
although they might vary from country to country in terms of
depth or levels. Also within the country, there may be different
types of disclosure norms that vary from sector to sector. For
example: accounting in the private sector is generally different
from that in the public sector. Basically, private sector
accounting is concerned with measuring profit and source of
finance for an enterprise while a public sector accounting
focuses on the source of fund like the government subsidies
and the government aids and its way of expenditure. Standard
of reporting mainly depends on the user of the financial
statement.
Additional Reading Materials

162
AS 1 Disclosure of
Accounting
Policies
AS 4 Contingencies
and Events Occurring
after the Bal-
ance Sheet
Date
Infosys Annual
Report(2010-
11)
http://www.infosys.co
m/investors/reports-fil
ings/annual-report/an
nual/Documents/AR-2
011/index.html
http://220.22
7.161.86/242
as_1new.pdf
http://220.22
7.161.86/245
as4new.pdf
Others
Additional resources to
this chapter
163
Video 8.3.3: Changes in Cor-
porate Reporting
AS 5 Net Prot or Loss for
the period,Prior Period
Items and
Changes in Ac-
counting Policies-
AS 17 Segment Re-
porting-
AS 21 Consolidated
Financial
Statements
IAS 8 Accounting Poli-
cies, Changes in
Accounting Esti-
mates and Errors
AS 29 Provisions, Con-
tingent` Liabili-
ties and Con-
tingent Assets
IAS 1 Presentation
of Financial
Statements
http://220.227.1
61.86/247accoun
ting_standards_
as5new.pdf
http://220.227.16
1.86/260accounti
ng_standards_as1
7new.pdf
http://220.227.16
1.86/265accounti
ng_standards_as
21new.pdf
http://220.2
27.161.86/27
3as29new.pd
http://www.ia
splus.com/en/
standards/stan
http://www.ias
plus.com/en/st
andards/standa
REVIEW 8.3 .1
Check Answer
Question 1 of 3
Incomes that are not normally arising from the
usual operations of the firm are referred to as
A. Extraordinary Items
B. Discretionary Items
C. Non-recurring Items
D. Non-Cash Items
164
Marginal Costing and CVP Analysis
C
H
A
P
T
E
R

9
Source:www.upload.wikimedia.org
INTRODUCTION
Managers are continuously involved in monitoring various
operations in an organization. Their need to ascertain past
revenues, forecast future revenues, estimate precise costs
and estimate profits of the organization to enhance their
decision-making ability cannot be overemphasized. Cost -
Volume - Profit (CVP) analysis helps managers to make
optimal decisions, identify the steps needed to avoid losses,
the activity levels to be reached to achieve targeted profits, all
of which result in improved organizational performance and
mitigation of losses and risks.
OBJECTIVES
Differentiate between Marginal Costing and Absorption
Costing;
State the features of Marginal Costing and Absorption
Costing;
Determine the significance of CVP Analysis;
Compute the Break Even Point and Margin of Safety;
Apply CVP Analysis for decision-making, taking account of
key limiting factors in the organization.
166
Section 1
Marginal Costing and Absorption Costing
T h e r e a r e t w o m a i n
techniques for estimating
product cost and profit. They
are:
(a) Absorption Costing
(b) Marginal Costing
ABSORPTION COSTING
Absorption costing is a cost
a c c o u n t i n g me t h o d o f
charging all direct costs and
all production costs of an
organization to specific units
of production. Absorption
costing is also known as Total
Cost Method, Tradi ti onal
Me t h o d , Co n v e n t i o n a l
method, or Cost-plus method.
Absorpti on costi ng i s an
approach to product costing,
wherein the total cost is
considered. The product cost
comprises of both fixed and
variable cost. In absorption
costing most of the fixed cost
is treated as part of product
167
Video 9.1.1:
Absorption Costing Explained
cost and inventory values are arrived at accordingly.
Merits of Absorption Costing
The following are the merits of absorption costing:
a. Under absorption costing all costs should be charged to
units manufactured. Thus price based on absorption costing
ensures that all costs are covered.
b. It helps to confirm accrual and matching concepts which
require matching costs with revenue for a particular period.
c. It makes calculation of gross profit and net profit
separately in income statement possible.
d. It discloses the efficient or inefficient utilization of
production resources by indicating under-absorption or over-
absorption of factory overheads.
e. This method has been recognized by various bodies like
FASB (USA), ASC (UK), ASB (India) for the purpose of
preparing external reports and for the valuation of inventory.
MARGINAL COSTING.
It is also known as variable costing or direct costing. This
technique takes into consideration only the variable costs as
product cost. Under this method, the fixed manufacturing
costs are considered as period cost and charged directly to
P&L Account.
According to CIMA (Chartered Institute of Management
Account ant s) , London, Mar gi nal Cost i ng i s t he
ascertainment of marginal costs and the effect on profit of
changes in volume or type of output by differentiating
between fixed cost and variable cost.
Important Concepts
Features of Marginal Costing
The important features of marginal costing are as follows:
i. All the costs are classified into fixed and variable costs.
Variable cost varies according to the level of activity, but
per unit variable cost remains fixed. Fixed cost is fixed at
any level of activity.
168
Keynote 9.1.1: Meaning of Fixed cost, Variable cost, Mar-
ginal cost and Contributions
ii. Under marginal costing, the fixed cost is treated as period
cost and variable cost is treated as product cost.
iii. Inventories are valued at marginal cost.
iv. When marginal costing is used in process costing, the
products are transferred from process to process at
marginal cost.
v. The product is priced on the basis of marginal cost and
contribution.
vi. The profitability of products and divisions are determined
on the basis of contribution margin.
vii. Under marginal costing, the importance will be given to
total contribution and contribution from each product while
presenting the data.
viii. There is no effect of differences in the amount of opening
stock and closing stock on unit cost of production in
marginal costing.
Advantages of Marginal Costing
Marginal Costing has the following advantages:
i. Marginal costing, by separating the costs into fixed and
variable costs, exercises effective control over it and also
facilitates responsibility-oriented control.
ii. Marginal costing, by analyzing the cost data and showing
the variable cost and contribution for each product and
product line, aids the management in taking appropriate
decisions.
iii. It leads to greater accuracies in calculation of profits as the
valuation of closing stock of finished goods and work-in-
progress are easy and simple.
iv. The data presented is more reliable and more acceptable,
as it excludes the fixed cost and also avoids allocation and
apportionment. Usually the fixed costs are not allocated
and apportioned on scientific basis.
v. The cost information presented under marginal costing is
si mpl er, meani ngful and an effecti ve ai d to the
management for decision-making.
Limitations of Marginal Costing
So me o f t h e i mp o r t a n t
limitations of marginal costing
are as follows:
i. Separation of all expenses
into fixed and variable is
practically difficult, because
neither the variable cost is
absolutely variable nor the
f i x e d e x p e n s e s a r e
absol ut el y f i xed. Thi s
problem of classification
becomes more complicated with the presence of semi-
variable and semi-fixed expenses.
169
Video 9.1.2:
Limitation of Marginal Cost-
ing
ii. Time factor is not given due importance in marginal costing
and all those expenses connected to time are excluded.
Therefore, the pricing decision based on marginal costing is
useful for short run but not for the long run. The long run
decisions are based on total cost and not on variable cost
alone.
iii. Marginal cost understates the stock of finished goods and
work-in-progress because of which the Balance Sheet does
not exhibit the true and fair view.
iv. As the closing stock is valued at variable cost under
marginal costing technique, the full loss on account of
goods destroyed cannot be recovered from the insurance
company.
v. The other cost techniques such as budgetary control and
s t andar d c os t i ng c an
achieve better control when
compar ed t o mar gi nal
costing, as marginal costing
deals with cost behavior but
it does not provide any
standard for evaluation of
performance.
vi. It fails to reveal the impact
of change of manufacturing
practice, for example, replacement of labor force by
machine.
DIFFERENCE BETWEEN ABSORPTION COSTING AND
MARGINAL COSTING
The following are the main points of difference between the
absorption costing and marginal costing:
i. Under marginal costing, the distinction between the period
cost and product cost determines when costs are matched
with revenues. Direct or variable or product costs are
assigned to products and matched with revenues when
they are recognized while period costs are matched with
revenues in the period in which the costs are incurred. But
in absorption costing, fixed costs are treated as part of
production cost and accordingly inventory is valued.
ii. In absorption costing, arbitrary apportionment of fixed costs
over the products results in under-absorption or over-
absorption of such cost, whereas, in marginal costing since
fixed costs are excluded, there is no under-absorption or
over-absorption of overheads.
iii. In absorption costing, managerial decision-making is based
on profit, which is the difference between the sales value
and the total cost of the product. But in marginal costing,
the managerial decisions are based on contribution and not
profit. Contribution is the difference between the sales
value and the marginal cost of the product.
170
Video 9.1.3: Marginal Cost-
ing vs Absorption Costing
REVIEW 9.1 .1
Check Answer
Question 1 of 5
The method of costing that leads itself to break-
even analysis is
A. Standard Costing
B. Marginal Costing
C. Absorption Costing
D. Absolute Costing
171
Section 2
Cost-Volume-Profit Analysis
Cost-Volume-Profit (CVP)
a n a l y s i s s t u d i e s t h e
relationship of cost, volume
and prof i t . These t hree
factors are interrelated. The
c o s t o f t h e p r o d u c t
determines its selling price
and selling price determines
the profit.
According to CIMA, London,
CVP analysis is the study of
the effects on future profits of
changes i n f i xed cost ,
variable cost, sales price,
quantity and mix. This is the
most important technique,
which is used in managerial
decision-making and profit
planning.
This technique summarizes
the effects of changes in an
organizations volume of
act i vi t y on i t s cost s,
revenue and profit. CVP
analysis can be extended to
cover the effects on profit of
changes in selling prices,
service fees, costs, income
t a x r a t e s a n d t h e
o r g a n i z a t i o n s m i x
of products or services. It
provides management with a
172
Video 9.2.1: CVP Relationship
comprehensive overview of the effects on revenue and
costs of all kinds of short run financial changes.
Although, the word profit appears in the term, CVP analysis
is not confined to profit-seeking enterprises alone. Managers
in non-profit organizations also routinely use CVP analysis
to examine the effects of activity and other short run changes
on r ev enue and c os t s . I t i s bei ng us ed as
a regular organizational tool. In CVP analysis, it is necessary
that expenses should be categorized according to their cost
behavior, i.e., fixed or variable.
Mathematical relationship between cost-volume-profit requires
the understanding of the marginal cost equation.
Marginal Cost Equation
Sales Revenue = Variable Cost + Fixed Expenses Profit /
Loss [S = V + F P] (or)
Sales Revenue Variable Cost = Fixed Expenses Profit/
Loss [S V = F + P] (or)
Sales Revenue Variable cost = Contribution Margin [S V =
C]
In order to understand the mathematical relationship between
cost, volume and profit, it is desirable to understand the
following concepts, their calculation and application:
a. Contribution/Sales (C/S) or Profit Volume (P/V) Ratio
b. Break-even Point
c. Margin of Safety
CONTRIBUTION/SALES RATIO OR P/V RATIO
Profit/volume ratio establishes the relationship between
contribution and sales. P/V ratio shows the profitability of the
organization. Hence organizations can improve their P/V ratio
without an increase in fixed cost. P/V ratio can be increased or
improved by taking any of the following steps:
! By increasing the sales price or selling price per unit.
! By reducing the variable or marginal cost and ensuring the
efficient utilization of men, material and machines.
! By changing the sales mix. It means selling those products
more which have higher P/V values.
The Profit/volume ratio is expressed in percentage. It is
expressed in the following ways:
Desired sales, variable cost and contribution can be found out
with the help of P/V Ratio. The formulae are as follows:
173
Desired Sales = Desired Contribution/P/V Ratio (or)
= (Fixed Cost + Desired Profit) / P/V Ratio
Variable Cost = Sales (1 P/V ratio)
Contribution = Sales x P/V Ratio
THE BREAK-EVEN POINT
A break-even point is a point at
which a firm earns no profit and
does not bear any loss. It is a
point at which the total sales are
equal to total costs. A break-
even point is calculated with the
help of the following formula:
Usefulness of Break Even Analysis
! Prediction: Break-even Analysis is useful in predicting
what sales volume has to be achieved in order to start
earning profits. For example, in the above case sales
should be at least 40,000 units or Rs.4 lakh before the
firm starts earning profit.
! Margin of Safety: Break-even
analysis can also be used to
answer the question - How low
can the sales fall before the
firm will begin to incur losses?
! Scale of Operations: An
important decision is to decide
the scale of operations of a firm.
In practical terms, this would mean deciding upon the
capacity of the firm to produce and sell its products.
! Changes in Underlying Factors: Break-even analysis can
also be used to study the effects of changes in underlying
factors at the Break-even Point and Margin of Safety.
MARGIN OF SAFETY
Margin of safety is the difference between the actual sales and
the sales at the break-even point or, the excess of actual sales
over the break-even sales. Margin of safety can also be
expressed in percentage.
174
Video 9.2.4:
Break Even Charts
Video 9.2.2:
Computation of BEP
Video 9.2.3:
Break Even Analysis
The formula for calculating the margin of safety is:
Margin of safety = Actual Sales Break-even Sales
Margin of safety measures the
soundness of the business. If
the margin of safety is high, it
indicates the concerns strength,
while a low margin of safety
indicates the weakness of the
concern. So, in order to earn
more profits, efforts should be
made by the management to
increase the margin of safety.
The following steps increase or
improve the margin of safety:
i. Increase the level of production or selling price or both.
ii. Reduce the fixed cost or variable cost or both.
iii. Substitute the existing unprofitable product with the
profitable ones.
iv. Change the sales mix in order to increase the contribution.
Keynote 9.2.1 Illustrative Problems with Solutions
Comprehensive Illustration
The sales and profits during the two periods are given as
follows:
Calculate
i. P/V Ratio,
ii. Fixed Cost,
iii. Break-even Point,
175
Video 9.2.5:
Margin of Safety
Years Sales (in Rs.) Profit (in Rs.)
2010 20,00,000 2,00,000
2011 30,00,000 4,00,000
iv. Sales to earn a profit of Rs.5,00,000,
v. Profit when sales are Rs.40,00,000,
vi. Margin of safety at a profit of Rs.4,50,000,
vii. Variable cost in 2005.
Solution
i. P/V Ratio
ii. Fixed Expenses
Since the P/V Ratio is 20%, the Variable Cost will be 80% (i.e.
100 20) of sales.
Variable Cost = 80% of Rs.20,00,000 = Rs.16,00,000
We know that S V = F + P
Therefore, Fixed Cost = Sales Variable Cost Profit
= Rs.20,00,000 Rs.16,00,000 Rs.2,00,000
= Rs.2,00,000
iii. Break-even Point
iv. Sales required to earn a profit of Rs.5,00,000
= Rs.35,00,000.
v. Profit when sales is Rs.40,00,000
Contribution = Sales x P/V Ratio
= Rs.40,00,000 x 20%
= Rs.8,00,000
Profit = Contribution Fixed Cost
= Rs.8,00,000 Rs.2,00,000
= Rs.6,00,000
vi. Margin of Safety at a profit of Rs.4,50,000
= Rs.32,50,000
Margin of Safety = Actual Sales Break-even Sales = Rs.
32,50,000 Rs.10,00,000
= Rs.22,50,000
176
vii. Variable Cost in 2005
Since the P/V Ratio is 20%, the Variable Cost will be 80% (i.e.
100 20) of sales.
Therefore, Total Variable Cost = 80% of Rs.30,00,000 = Rs.
24,00,000.
Assumpt i ons of CVP
Analysis
Following are the important
assumptions of cost-volume-
profit analysis:
! The analysis presumes that
all costs can be easily
di vi ded i nt o f i xed and
variable cost.
! It presumes the ability of predicting cost at different levels
of activity or volumes.
! It assumes that variable cost fluctuates with volume
proportionally.
! Efficiency and productivity is assumed to be constant.
! It presumes that production and sales are synchronized at
a point of time, or, in other words, changes in the opening
and closing inventory levels will remain insignificant in
amount.
! Prices of the input factors are assumed to be constant.
! Analysis assumes that the influence of managerial
policies, technology and efficiency of men, material and
machines will remain constant and cost control will be
neither strengthened nor weakened.
Uses of CVP Analysis
CVP analysis is an important tool to the management. It is
useful to the management in the following areas:
! It helps in planning and forecasting profit at various levels
of activity.
! It is useful in preparing flexible budget for cost control
purposes.
! Helps the management in decision-making in the following
typical areas:
Identification of the minimum volume of activity that
the enterprise must achieve to avoid incurring loss.
Identification of the minimum volume of activity that
the enterprise must achieve to attain its profit
objectives.
Provision of an estimate of the probable profit or
loss at different levels of activity within the range
reasonably expected.
The provision of data on relevant costs for special
decisions relating to pricing, keeping or dropping
product lines, accepting or rejecting particular
orders, make or buy decision, sales mix planning,
177
Video 9.2.6:
Assumptions of CVP
altering plant layout, channels of distribution
specifications, promotional activity, etc.
! Guides in fixation of selling price where the volume has a
close relationship with the price level.
! Helps in evaluating the impact of cost factors on profit.
! Where a company is manufacturing more than one
product of varying profitability, a change in the
profitability of one product will lead to a change in the
profitability of the group as a whole. The profit-volume
chart may be used to illustrate the effect of changes in
product mix by drawing a product profit path or separate
profit lines are drawn for each of the assumed profit mix
for each individual product.
Limitations of CVP Analysis
Following are the main limitations of CVP analysis:
i. This analysis presumes the ability to predict the cost and
sales at different levels of activity with certainty. In
practice, these variables are uncertain and require them
to incorporate the uncertainty effect into the information.
ii. A series of break-even chart is necessary when
alternative pricing policies are under consideration. This
differential price policy makes break-even analysis a
difficult exercise.
iii. It assumes that product mix will be constant, whereas
the sales mix will continually change owing to the change
of demand. A change in mix may significantly change the
result.
iv. It assumes that costs are affected by the output only, but
in real life situation other factors affecting cost such as
economic factors, political factors, technological
methods, efficiency, cost control, etc., are not
considered.
v. This analysis disregards that selling price is not constant
at all levels of sales. A high level of sales may be
obtained by offering substantial discounts, depending on
the competition in the market.
vi. This analysis presumes that fixed cost remains constant
over a given volume. It is true that fixed costs are fixed
only in respect of a given capacity, but each fixed cost
has its own capacity. This factor is completely
disregarded in the analysis.
vii. Another assumption is that there is no stock, or if stock
exists then there is no change in the stock level and
profit depends on sales volume only. But, in practice, a
change in stock level affects the profit.
KEY OR LIMITING FACTOR
Key or limiting factor is the factor, which limits the level of
activity or the volume of output of a firm at a particular point
of time. The objective of every business is to earn maximum
profit. There are a number of factors, which limit the profit
earning capacity of an undertaking. The management of the
organization has to assess the influence of these factors on
178
the profitability. In normal course of operation the product mix
will be decided upon by contribution. But in case of limiting
factor, the contribution must be assessed in terms of
contribution per limiting factor. For a company, sales cannot
exceed beyond a limit, hence the sales will be the key factor.
In some cases, there will be sufficient sales and employees,
but materials will not be available to produce to fully meet the
orders. In such cases material becomes the key factor. The
key factor can be defined as the factor in the activities of an
undertaking, which at a particular point in time or over a period
will limit the volume of output.
If there is a key factor for the undertaking, the profitable
position of the undertaking can be reached by computing the
maximum contribution per unit of key factor. The profitability
can be measured by using the following formula:
Profitability = Contribution / Key factor
Some of the examples of key factors are sales, labor, finance,
material, plant capacity, etc.
Keynote 9.2.1: KEY FACTOR RAW MATERIAL
Keynote 9.2.2: KEY FACTOR MACHINE HOURS
Keynote 9.2.3: KEY FACTOR ONE OF THE FACTORS OF
PRODUCTION LAND
179
180
Video 9.2.7:
CVP for Multiple products
Video 9.2.8: Analysis of Be-
havior of Costs
Video 9.2.9:
BEA for Target Income
181
Section 3
Case Study: Costing in Pepe Denim
This case study was written by Kavita Wadhwa, under the
direction of D Satish, IBS Hyderabad. It is intended to be
used as the basis for class discussion rather than to illustrate
either effective or ineffective handling of a management
situation. The case was compiled from generalized
experience.
2011, IBSCDC.
No part of this publication may be copied, stored, transmitted, reproduced or distributed in any form or medium whatsoever
without the permission of the copyright owner.
Source:www.waityk.files.wordpress.com
Kesar Bajaj (Bajaj), chairman of
Pepe Denim, a manufacturer and
retailer of jeans in India, was facing
tremendous pressure to improve
t he f i nanci al posi t i on of t he
company and its market valuation.
Bajaj and his younger brother
Dinkar had floated Pepe Denim as
a private limited company in Ahmedabad, Gujarat, in 1984. In
1994, the brothers decided to convert the company into a public
limited company. Pepe Denim began manufacturing operations
with just one factory in Ahmedabad district but the brothers put in a
lot of hard work and took the company to a level where in 2011, it
had 300 stores spread throughout the country and a workforce of
20,000. It also used to export its jeans to China, Brazil, and Nepal.
Till 2007, the company did very good business with its sales
increasing every year. It earned exceptional growth in valuation
resulting from an increase in the companys stock prices. After
2007, however, the stock prices of the company started to decline
even though sales continued to be consistent. Though there was
no decrease in sales, the profits began to fall. The brothers thought
that the decline in the stock prices and profits was due to the
economic slowdown and recession. Since there was consistency in
sales, they concluded that the profits were declining because of the
increase in costs due to inflation. But the stock prices of the
company remained flat and profits continued to decline even after
2010 when the economy had started reviving, stock indices had
started rising, and the stock prices of other companies had also
started soaring.
The shareholders of the company raised concerns over the
declining profits of the company. As a result of a heated
shareholders meeting, Bajaj came under pressure to improve the
companys financial position and its market valuation. In order to
understand the present status of production, costs, sales, and the
future prospects of the companys product in the market, he
immediately called Vipin, the companys cost accountant, and
Sneha, the marketing manager. Vipin furnished the following cost
information (Refer to Exhibit I) for the year ending March 31, 2010,
and the changes in costs which were expected in the coming year:
On account of intense competition, the following changes were
estimated in the subsequent year:
182
Exhibit I Exhibit I
Production and Sales 15,00,000 units (in 000s)
Sales 15,00,000
Direct Wages 2,70,000
Direct Materials 3,30,000
Factory Overheads 3,25,000
Administration overheads 2,05,000
Sales overheads 90,000
??
Video 9.3.1: Absorption
Costing
1. Production and sales activity would be increased by one third.
2. Material rate would be lowered by 25%. However, there would be
a 20% increase in consumption which would take care of the
increase in production level.
3. Direct wages cost would be reduced by 20% due to automation.
4. Out of the above factory overheads (given in Exhibit I), Rs.
45000 were fixed in nature. The remaining factory expenses
would be variable in proportion to the number of units produced.
5. Total administration expenses would be lowered by 40%.
6. Sales overhead per unit would remain the same.
On the basis of cost and profit estimation for the years ending
March 31, 2010, and March 31, 2011, Vipin told Bajaj that 6 %
decline in profit on sales was expected in 2011. Bajaj realized from
Vipins report that the reason for the decline in profits despite the
consistent increase in sales volume was the heightening
competition from other brands in the market. Since Sneha was in
direct contact with the market, Bajaj asked her to carefully analyze
the potential of the companys product in the market and suggest
the options available to overcome the problem. He gave Sneha 10
days time to do this. After 10 days, Sneha reported back to Bajaj.
In order to carry out a formal analysis of the options available with
regard to business opportunities, Bajaj immediately called a
meeting with the board of directors and asked Vipin and Sneha to
be present.
Addressing the meeting, Sneha said that in order to overcome the
problem, Pepe Denim needed to attract new customers and sell
mo r e g o o d s t o r e p e a t
cust omer s. She sai d t he
company needed to add new
product lines; however, in order
to keep costs down, the product
lines had to be such that they
woul d not r equi r e muc h
additional cost. She suggested
two new products which would
r equi r e t he same t ype of
material and similar labor, and
would serve the female segment
of the market. Sneha said the two products which could be added
easily were Denim Skirts and Denim Handbags for women as
these two items would require the same raw materials. Besides,
with a little training, the same tailors could undertake the stitching
activity.
After examining the suggestion, Bajaj thought that the two products
would be a good strategic fit for the existing product line. He sought
the opinion of the board of directors and they too gave a favorable
response. With this, it was decided that the company would add
these two products as soon as possible.
After one year of the introduction of the two products i.e. on March
31, 2011, Kesar called Nihit the CFO (Chief Finance Officer) of the
company, to find out about the companys profitability and asked
him to present Pepe Denims income statement. Nihit brought a
summarized income statement which was as follows:
183
Video 9.3.2: Variable &
Full Costing Overview
184
Exhibit - II
Income Statement of Pepe Denim for the year ending
March 31, 2011
Exhibit - II
March 31, 2011
Exhibit - II
March 31, 2011
Particulars Details
Amount
(in Rs. 000s)
Sales 20,00,000
Less: Cost of goods sold 12,63,450
Gross Profit 7,36,550
Less: Indirect expenses
Office expenses 1,29,150
Selling and distribution expenses 1,26,000 2,55,150
Net Profit before depreciation 4,81,400
Less: Depreciation 16,400
Net Profit after depreciation 4,65,000
Less: Tax (40%) 1,86,000
Profit after tax 2,79,000
???
Exhibit - III
Amount (in Rs. 000s)
Exhibit - III
Exhibit - III
Exhibit - III
Particulars Jeans
Denim
Skirts
Denim
Handbags
Stock of materials as on April 1,
2010
2,00,000 - -
Stock of materials as on March
31, 2011
1,50,000 75,000 25,000
Material purchased during the
year
6,00,000 3,00,000 1,00,000
Sale of material (not suitable) 25,000 - -
Work-in-progress as on April 1,
2010
1,00,000 - -
Work-in-progress as on March
31, 2011
35,000 10,000 5,000
Finished Stock as on April 1,
2010
3,50,000 - -
Finished Stock as on March 31,
2011
4,50,000 2,00,000 1,20,000
Salaries (Factory) 15,350 10,000 5,000
Contd... Contd... Contd... Contd...
From the income statement, Bajaj calculated the profit before tax
percentage on sales and it worked out to be 23.25 4.25 per cent
higher than the previous years profit. This improvement in profit
gave him some satisfaction and he was eager to know how the
new products were performing and what their cost structures were.
He asked Vipin to present the cost sheet of Denim Skirts and
Denim Handbags. Vipin was not ready with the cost sheets and so
presented the following cost details of all the products:
Required:
185
Exhibit - III
Exhibit - III
Exhibit - III
Exhibit - III
Particulars Jeans
Denim
Skirts
Denim
Handbags
Office salaries 25,000 15,000 5,000
Carriage on purchases 12,000 6,000 2,000
Carriage on sales 13,000 5,000 2,000
Cash discount allowed 1800 550 400
Bad debts written off 8000 1500 500
Repairs of plant, machinery, and
tools
8000 4000 1600
Rent, rates, taxes, and insurance
(factory)
12000 6000 2000
Rent, rates, taxes, and insurance
(office)
2000 700 300
Traveling expenses 7000 5000 3000
Travelers salaries and
commission
20000 13000 7000
Productive wages 300000 120000 180000
Depreciation written off on plant,
machinery, tools
9000 3000 2000
Depreciation written off on office
furniture
1800 400 200
Contd... Contd... Contd... Contd...
Exhibit - III
Exhibit - III
Exhibit - III
Exhibit - III
Particulars Jeans
Denim
Skirts
Denim
Handbags
Directors fees 15000 7000 3000
Dyeing and water charges
(factory)
3000 1500 500
Gas and water charges (office) 850 300 100
General charges 12750 5000 3000
Managers salary (Office) 8000 5000 2000
Managers salary (factory) 10000 6900 5000
Advertising 28000 21000 8750
????
1) Vipin told Kesar Bajaj that a 6 % decline in profit on sales
was expected in 2011. If the given information is correct
then what would be the selling price of a pair of jeans for
the year ending March 31, 2011?
2) Can you help Kesar Bajaj in getting the total cost estimate
of all the three products Jeans, Denim Skirts, and Denim
Handbags? If yes, what is the total cost of all three
products?
3) You are required to reconcile the profit with the Income
Statement.
4) Do you think the decision of the company to add two new
products was beneficial? If yes, how?
186
187
Full Cost Concepts
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Source:www.cdn.geckoandfly.com
INTRODUCTION
Cost means economic sacrifice, measured in terms of
standard monetary unit, incurred or potentially to be incurred,
as a consequence of a business decision to achieve a
specific objective. Understanding the meaning of the term
cost is important as it is used with a modifier or an adjective
according to its purpose of use and should be construed in
the context in which it is referred to.
The main focus of any organization will be their products or
services which finally lead to profitability. There is also a need
to manage cost of products or services in order to achieve the
goal of overall profitability in the business. Activity Based
Costing is a modern technique that fulfills the need for
accuracy in enhancing the decision-making ability of
managers. It is generally used as a tool for planning and
control.
As competition increases and supply exceeds demand,
market forces influence prices significantly. To achieve a
sufficient margin over its costs, a company must manage
those costs relative to the prices the market allows or the
prices the firm sets to achieve certain market penetration
objectives. In the context of these characteristics, the practice
of target costing has evolved.
OBJECTIVES
Understand the different types of classification of costs;
Explain the preparation of Cost Sheet;
Construct a Cost Sheet;
Explain the significance of Activity Based Costing;
Distinguish between Activity Based Costing and
Traditional Costing; and
Explain the significance of Target Costing.
189
Section 1
Introduction to Costs and Costing
According to CIMA, London,
cost i s, the amount of
expendi t ur e ( act ual or
n o t i o n a l ) i n c u r r e d o r
attributable to a given thing.
According to the Committee
on Cost Concept s and
St andar ds of Amer i can
Account i ng Associ at i on,
Cost means economi c
sacrifice, measured in terms
of standard monetary unit,
incurred or potentially to be
incurred, as a consequence
of a business decision to
achieve a specific objective.
Types of Costs
Cost classification is the
process of grouping costs
according to their common
characteristics. A suitable
classification of costs is very
helpful in identifying a given
cost with cost centers or cost
u n i t s . Co s t s ma y b e
190
Source:www.referenceforbusiness.com
classified according to their nature, i.e., material, labor and
expenses and a number of other characteristics. Depending
upon the purpose to be achieved and requirements of a
particular concern the same cost figures may be classified
into different categories. Costs can be classified in the
following ways:
BY NATURE OR ELEMENT OR ANALYTI CAL
CLASSIFICATION
Under this classification, costs are divided into three
categories, i.e., Materials, Labor and Factory Overheads.
Each element can undergo further sub-classification; for
example, material into raw material, components and spare
parts, consumable stores, packing material, etc.
Materials
Materials are the principal substances that go into the
production process and are transformed into finished goods.
They are further classified as direct materials and indirect
materials. Direct materials can be easily and directly identified
and easily traced with the production of finished goods. The
cost of direct materials generally comprises the major cost of
the finished product. All the other materials that go into the
production of the finished goods are called indirect material
costs. They generally form a part of the manufacturing
overheads.
Labor
Labor is the human physical and mental effort that goes into
the production of a product. It is further classified as direct
and indirect labor. Direct labor is directly involved in the
production of the product. Direct labor cost generally
comprises major labor cost. The residual labor, which cannot
be categorized as direct labor, is indirect labor. It forms a part
of factory overhead. For example, continuing with the above
example in a furniture manufacturing unit, the cost of the
workers who directly expend their energy on the direct
material with the help of tools and machines are considered
as direct labor. The supervisor who is in charge of overseeing
the work of ten workers is considered as indirect labor.
Overheads
All other costs that are incurred by the company other than
direct materials and direct labor are called overheads. Hence
overheads consist of indirect materials, indirect labor and
other expenses. The overheads are further sub-divided into
factory overheads, office and administrative overheads and
selling and distribution overheads. Continuing with the above
example, factory lighting, rent of the factory, rent of
administrative building, wages of administrative staff,
managers, depreciation of machinery, etc., constitute
overheads.
BY FUNCTIONS
Under this classification costs are grouped according to the
broad divisions of functions of a business undertaking or
basic managerial activities, i.e., production, administration,
selling and distribution. According to this classification costs
are divided as follows:
191
Manufacturing and Production Costs
Production costs include the total of costs incurred in
manufacture, construction and fabrication of units of
production. The manufacturing and production costs comprise
direct materials, direct labor and factory overheads.
Administrative Costs
Administrative costs include costs incurred in planning,
directing, controlling and operating a company. For example,
salaries paid to managers and other administrative staff.
Selling And Distribution Costs
Selling costs and distribution costs are most often confused to
be of the same type. However, there is a distinction between
the two. Selling costs are defined as the cost of seeking to
create and stimulate demand and of securing orders.
Example of selling costs are advertisement, salesmen
salaries, etc. Distribution costs are defined as the cost of
sequence of operations which begin with making the packed
product available for dispatch and ends with making the
reconditioned, returned empty packages, if any, available for
re-use. Examples of distribution costs are insurance on
goods-in-transit, warehousing, etc.
BY TRACEABILITY
According to this classification, total cost is divided into direct
costs and indirect costs. Direct costs are incurred for and
may be conveniently identified or easily traceable with a
particular cost center or cost unit. The common examples are
materials used and labor
employed in manufacturing
an article or in a particular
pr ocess of pr oduct i on.
Indirect costs are incurred
for the benefit of a number of
cost centers or cost units and
cannot be conveni ent l y
identified with a particular
cost center or cost unit.
Examples include rent of
b u i l d i n g , ma n a g e me n t
s a l a r i e s , m a c h i n e r y
depreciation, etc.
The nature of the business and the cost unit chosen will
determine the costs as direct and indirect. For example, the
hire charges of a mobile crane used onsite by a contractor
would be regarded as a direct cost since it is identifiable with
the project/site on which it is employed, but if the crane is
used as a part of the services of a factory, the hire charges
would be regarded as indirect cost because they will probably
benefit more than one cost center or department. The
distinction between these two costs is essential because the
direct costs of a product or activity can be accurately identified
with the cost object while the indirect costs have to be
apportioned on the basis of certain assumptions about their
incidence.
BY VARIABILITY
192
Video 10.1.1:
Direct vs Indirect
T h e b a s i s f o r t h i s
classification is the behavior
of costs in relation to changes
in the level of activity or
volume of production. On this
basis, costs are classified into
t hree groups, vi z. f i xed,
variable and semi-variable.
Fixed Costs
Fixed costs remain fixed in total with increase or decrease in
the volume of output or activity for a given period of time or
for a given range of output. Fixed costs per unit vary
inversely with the volume of production, i.e., fixed cost per
unit decreases as production increases and increases as
production decreases. Examples are rent, insurance of
factory building, factory managers salary, etc. These costs
are constant in total amount but fluctuate per unit as
production level changes. They are also termed as capacity
costs.
Variable Costs
Variable costs vary in total
directly in proportion to the
volume of output. These costs
per unit remain relatively
constant with changes in
vol ume of product i on or
activity. Thus variable costs
fluctuate in total amount but
tend to remain constant per unit as production level changes.
Examples are direct material costs, direct labor costs, power,
repairs, etc.
Semi-Variable Costs
Semi-variable costs are partly fixed and partly variable. For
example, telephone expenses include a fixed portion of
monthly charge plus variable charge according to the
number of calls made; thus total telephone expenses are
semi- variable. Other examples of such costs are
depreciation, repairs and maintenance of building and plant,
etc. These are also called semi-fixed costs or mixed costs.
BY CONTROLLABILITY
On the basis of controllability costs are classified into two
categories, i.e., controllable costs and uncontrollable costs.
Controllable Costs
If the costs are influenced by the action of a specified
member of an undertaking, that is to say, costs, which are at
least partly within the control of management, they are called
controllable costs. An organization is divided into a number
of responsibility centers and controllable costs incurred in a
particular cost center can be influenced by the action of the
manager responsible for the center. Generally speaking, all
direct costs including direct material, direct labor and some
of the overhead expenses are controllable by lower level of
management.
Uncontrollable Costs
193
Video 10.1.2: Cost Behavior
Video 10.1.3: By Variability
If the costs cannot be influenced by the action of a specified
member of an undertaking, that is to say, costs which are not
wi thi n the control of the management are cal l ed
uncontrol l abl e costs. Most of the fi xed costs are
uncontrollable. For example, rent of the building is not
controllable and so are managerial salaries. Overhead cost,
which is incurred by one service section or department and is
apportioned to another, which receives the service, is also not
controllable by the latter.
Controllability of costs depends on the level of management
(top, middle or lower) and the period of time (long-term or
short-term).
BY NORMALITY
On the basis of normality, the costs are classified into two
categories, i.e., normal cost and abnormal cost.
Normal Cost
It is the cost which is normally incurred at a given level of
output in conditions which are favorable for that level of
output. This cost forms the cost of production of a product.
Abnormal Cost
It is the cost, which is normally incurred at a given level of
output in conditions which are not favorable for that level of
output. It is not considered as a part of cost of production and
charged to Costing Profit and Loss Account.
BY CAPI TAL AND REVENUE OR FI NANCI AL
ACCOUNTING CLASSIFICATION
Accor di ng t o f i nanci al
accounti ng termi nol ogy,
costs are of two types, i.e.,
capital costs and revenue
costs.
Capital Costs
If the cost is incurred in
purchasing assets either to
earn income or increase the earning capacity of the business,
it is called capital cost. For example, the cost of a rolling
machine in a steel plant. Though the cost is incurred at one
point of time the benefits accruing from it are spread over a
number of accounting years.
Revenue Costs
Revenue expenditure is any expenditure incurred to maintain
the earning capacity of the concern, such as cost of
maintaining an asset or running a business. Example, cost of
materials used in production, labor charges paid to convert
the material into production, salaries, depreciation, repairs
and maintenance charges, selling and distribution charges,
etc. While calculating cost, revenue items are considered,
whereas capital items are completely ignored.
BY TIME
Costs can be classified as (i) Historical costs, and (ii)
Predetermined costs.
Historical Costs
194
Video 10.1.4:
Capital vs Revenue
The costs, which are ascertained after being incurred, are
called historical costs. Such costs are available only when a
particular thing has already been produced. Such costs are
only of historical value and not at all helpful for cost control
purposes.
Predetermined Costs
Such costs are estimated costs, i.e., computed prior to
production taking into consideration the previous periods
costs and the factors affecting such costs. If they are
determined on scientific basis they become standard costs
Such costs when compared with actual costs will give the
variances and reasons of variance and will help the
management to fix the responsibility and to take remedial
action to avoid its recurrence in future.
Historical costs and predetermined costs are not mutually
exclusive. Even in a system when historical costs are used,
predetermined costs have a very important role to play
because a figure of historical cost by itself has no meaning
unless it is related to some other standard figure to give
meaningful information to the management.
BY IDENTIFICATION AS PART OF INVENTORY
Costs on this basis are classified as product costs and period
costs. This distinction is required for the purpose of profit
determination. That is because product costs are carried
forward to the next accounting period in the form of unsold
finished stock, whereas period costs are written off in the
accounting period in which they are incurred.
Product Costs
Product costs are associated with the unit of output. They are
absorbed by or attached to the units produced. They go into
the determination of inventory valuation (finished goods and
partly completed goods) hence are called inventoriable costs.
They consist of direct materials, direct labor and factory
overheads (partly or fully). The extent of inclusion of factory
costs depends on the type of
costing system in force
absorption and direct costing.
Where the absorption costing
method is adopted, factory
overheads - both fixed and
variable content - are
included as part of product
cost. Where the direct costing
met hod i s adopt ed, onl y
variable factory overheads are
included as part of inventoriable
cost.
Period Costs
Period costs are costs associated with time period rather than
the unit of output or manufacturing activity. These costs are
not treated as part of inventory and hence are treated as
expenses in the period in which they are incurred.
Administrative, Selling and Distribution costs are treated as
period costs and are deducted as an expense for the
determination of income and are not regarded as a part of
inventory.
195
Video 10.1.5:
Product vs Period Costs
ACCORDING TO PLANNING AND CONTROL
Cost accounting furnishes information to the management
which is helpful in discharging the two important functions of
management, i.e., planning and control. For the purpose of
planning and control, costs are classified as budgeted costs
and standard costs.
Budgeted Costs
Budgeted costs represent an estimate of expenditure for
different phases or segments of business operations, such as
manufacturi ng, admi ni strati on, sal es, research and
development, for a period of time in future which subsequently
becomes the written expression of managerial targets to be
achieved. Various budgets are prepared for different phases/
segments of business, such as sales budget, raw material cost
budget, labor cost budget, cost of production budget,
manufacturing overhead budget, office and administration
overhead budget, etc. Continuous comparison of actual
performance (i.e., actual cost) with that of the budgeted cost is
made so as to report the variations from the budgeted cost to
t h e ma n a g e me n t f o r
corrective action.
Standard Cost
The Institute of Cost and
Management Accountants,
London, defines standard
cost as the predetermined
cost based on a technical
estimate for materials, labor
and overhead for a selected period of time and for a prescribed
set of working conditions. Thus standard cost is a
determination, in advance of production, of what should be its
cost under a set of conditions.
Budgeted costs and standard costs are similar to each other to
the extent that both of them represent estimates of cost.
FOR MANAGERIAL DECISIONS
On this basis, costs may be classified into the following
categories:
Marginal Costs
It is the additional cost to be incurred if an additional unit is
produced. In other words, marginal cost is the total of variable
costs, i.e., prime cost plus variable overheads. It is based on
the distinction between fixed and variable costs.
Out of-Pocket Cost
It is that portion of the cost which involves payment, i.e., gives
rise to cash expenditure as opposed to such costs as
depreciation, which do not
involve any cash expenditure.
Such costs are relevant for
price fixation during recession
or when make or buy decision
is to be made.
Differential Costs
If there is a change in costs
196
Video 10.1.6:
Why Standard Cost
Video 10.1.7:
Differential costs
due to change in the level of activity or pattern or method of
production they are known as differential costs. If the change
increases the cost, it will be called incremental cost and if the
change results in the decrease in cost it is known as
decremental cost.
Sunk Cost
Sunk cost is another name for
historical cost. It is a cost that
has already been incurred and
is irrelevant to the decision-
maki ng process. A good
example is, depreciation on a
fixed asset because the cost
(of purchasing the asset) has
already been incurred (when it was purchased) and it cannot
be affected by any future action. Though we allocate the
depreciation cost to future periods, the original cost of the
asset is unavoidable. What is relevant in this context is the
salvage value of the asset, not the depreciation. Thus sunk
costs are not relevant for decision-making and are not
affected by increase or decrease in volume.
Imputed (or Notional) Cost
These costs appear in cost accounts only. For example,
notional rent charged on business premises owned by the
proprietor, interest on capital for which no interest has been
paid, etc. When alternative capital investment projects are
being evaluated it is necessary to consider the imputed
interest on capital before a decision is arrived as to which is
the most profitable project.
Opportunity Cost
It is the maximum possible alternative earnings that will be
foregone if the productive capacity or services are put to some
alternative use. For example, if an owned building is proposed
to be used for a project, the likely rent of the building is the
opportunity cost which should be taken into consideration
while evaluating the profitability of the project. Since
opportunity costs are not the actual costs incurred but only the
benefits foregone, they are not
recorded in the accounting
books. However, they are
relevant costs for decision-
making purposes and are
considered while evaluating
different alternatives.
Replacement Cost
It is the cost at which there
could be purchase of an asset
or material identical to that which is being replaced or
revalued. It is the cost of replacement at current market price.
Avoidable and Unavoidable Costs
Avoidable costs can be eliminated if a particular product or
department, with which they are directly related to, is
discontinued. For example, salary of the clerks employed in a
particular department can be eliminated, if the department is
197
Video 10.1.8: Cost Charac-
teristics Sunk relevant
Video 10.1.9:
Replacement Cost
discontinued. Unavoidable cost will not be eliminated with
the discontinuation of a product or department. For example,
salary of factory manager or factory rent cannot be
eliminated even if a product is eliminated.
OTHER TYPES OF COSTS
Future Costs
These costs are expected to be incurred at a later date.
Programmed Costs
Certain decisions reflect the policies of the top management
which result in periodic appropriations and are referred to as
programmed costs. For example, the expenditure incurred
by the company under the Jawahar Rojgar Yojana program
initiated by the Prime Minister is a programmed cost which
reflects the policy of the top management.
Joint Costs
It is the cost of manufacturing joint products up to or prior to
the split-off point. Cost incurred after the split-off point is
called separable cost. Joint cost is common to the
processing of joint products and by-products till the point of
separation and cannot be traced to a particular product
before the point of split-off.
Conversion Costs
It is the cost incurred in converting the raw material into
finished product. It can be calculated by deducting the cost
of direct materials from the production cost or it is the sum of
direct labor and factory overheads.
Discretionary Costs
These costs do not have any obvious relationship with the
levels of capacity or output activity and are determined as
part of the periodic planning process. In each planning
period the management decides on how much to spend on
certain discretionary items such as advertising, research and
development, employee training, etc. These costs are
amenable to alteration by the management.
Committed Costs
It is a fixed cost, which results from the decisions of the
management in the prior period and is not subject to the
management control in the present on a short run basis. It
arises from the possession of production facilities,
equipment, organization set-up etc.
Some examples of committed costs are: plant and
equipment depreciation, taxes, insurance premium and rent
charges.
STATEMENT OF COST OR COST SHEET
Cost Sheet is a statement which provides for assembly and
depiction of the detailed cost in respect of cost centers and
cost units. Data is collected from various sources to
incorporate in the cost sheet. Cost sheet is only a statement.
It is not a part of double entry cost accounting records.
198
According to ICMA, London,
the cost sheet is a statement
which provides for the assembly
of the detailed cost of a cost
center or a cost unit.
There is no specific format for
preparing a cost sheet. Gener-
ally, it is presented in a colum-
nar form. The columns are for
the total cost and per unit cost of current period and previous
period. Sometimes budgeted total cost and per unit column are
also incorporated in the cost sheet. If the cost sheet is pre-
sented in the ledger account format, then it is called Produc-
tion Account.
Specimen of Cost Sheet
Treatment of Stock
Stock may be raw material, work-in-progress and finished
goods. These are to be adjusted in the cost sheet.
Stock of Raw Materials
If the opening, closing and purchase of raw materials are
given, then the material consumed can be determined in the fol-
lowing way.
Stock of Work-in-Progress
Semi-finished or uncompleted units are called work-in-
progress. Generally it is valued at works cost. Opening and
Closing stock of work-in-progress is adjusted in the following
way.
Stock of Finished Goods
Opening and closing stock of finished goods are adjusted in
the following way before calculating the cost of goods sold:
199
Video 10.1.10:
Cost Sheet Components
Treatment of Scrap
Scrap may be defined as an unavoidable residue material
arising in certain types of manufacturing processes. Generally
it has small realizable value. It is deducted either from factory
overheads, or factory cost while preparing cost sheet.
The proforma of the Comprehensive Cost Sheet, i.e., with
stocks, is as under:
200
Opening Stock Raw Materials
Purchases (including Carriage
Inwards, Transit Insurance etc.)
Closing Stock of Raw Materials
Add
Less
Direct Materials Consumed
Add Direct Labor
Add Direct Expenses
Prime Cost
Add
Factory Overheads (Works OH /
Manufacturing OH / Production OH)
Add Opening Stock of Work in Progress
Less Closing Stock of Work in Progress
Factory Cost / Work Cost
Add Administration Overheads
Cost of Production
Add Opening Stock of Finished Goods
Less Closing Stock of Finished Goods
Cost of Goods Sold
Add Selling and Distribution Overheads
Cost of Sales
Add Profit/Loss (Balancing Figure)
Sales
201
REVIEW 10.1 .1
Check Answer
Question 1 of 4
An example of a production overhead would be
A. Labor costs
B. Rent
C. Supervisory costs
D. Materials
Section 2
Activity-Based Costing (ABC) and Activity-Based Management
MEANING OF ACTIVITY-BASED
COSTING
Activity-based costing is a commonly
used appr oach t o i mpr ove a
traditional costing system. Activity-
based costing is a costing method
that first assigns costs to activities
and then to goods and services
based on how much quantum of
activity is used in the production of
goods. Basically, ABC is a cost
accounting system that focuses on
the various activities performed in an
organization and collects costs on
the basis of primary nature and
extent of those activities. There are
three fundamental components of
act i vi t y- based cost i ng, i . e. ,
recognizing the several levels of
costs exist, accumulating costs into
cost pools and using multiple cost
drivers to assign costs to products
and services. This costing method
focuses on attachi ng costs to
products and services based on the
activities conducted to produce,
perform, distribute, or support those
products and services. An activity is
202
Video 10.2.1:
Activity-Based Costing
any discrete task that an organization undertakes to make or
deliver a good or service. ABC is primarily used to establish
product costs primarily for decision-making purposes.
What Drives ABC?
Activity-based costing is based
on the following ideas. First,
desi gni ng, produci ng and
di st ri but i ng product s and
services require many activities
to be performed. Performing
t hese act i vi t i es r equi r es
resources to be purchased and
used. Purchasing and using
resources causes costs to be
incurred. Restated in reverse
order, the ABC logic is that resources generate costs,
activities consume resources and products consume
activities. Thus a companys activities are identified and then
costs are traced to these activities (or activity cost pools)
based on the resources that they require. Then, costs are
assigned, or traced from each of these activity cost pools to
the companys products (or services) in proportion to the
demands that each product (or service) places on each
activity. In ABC, a measure of the relevant activity volume is
used to trace each type of costs, rather than exclusively using
measurements (or allocation bases) related to the volume of
the products or services produced. There are still two stages
in assigning costs to products in a manufacturing
environment, i.e., (i) from service departments (activities) to
producing departments, and
( i i ) f r o m p r o d u c i n g
department activity cost pools
to products.
Cost Driver Analysis
A c o s t d r i v e r i s a
characteristic of an activity or
event that causes costs to be
incurred by that activity or
event. Companies engage in
many activities that consume
resources and, thus, cause
costs to be incurred. Many cost
drivers can be found for an individual business unit. Cost
drivers are classified as volume-related and non-volume-
related. Examples of volume-related cost drivers are machine
hours and non-volume-related include set-ups, work orders,
or distance traveled. Cost drivers selected by management
should be limited and also easy to understand, directly related
to the activity being performed and appropriate for
performance management.
Cost driver analysis identifies the activities causing costs to
be incurred. It also investigates, qualifies and explains the
relationships of drivers and their related costs. Traditionally,
cost drivers create only unit-level costs, meaning that they are
caused by the production or acquisition of a single unit of
product or the delivery of a single unit of service. Other
drivers and their costs are incurred for broader-based
categories or levels of activity. The categories are classified
203
Video 10.2.2: Traditional vs
Activity-Based Costing
Video 10.2.3:
Activity Based Drivers
as batch, product or process and organizational or facility
levels. Examples of the kinds of costs that occur at the various
levels are as follows:
Costs that are caused by a group of things being made,
handled, or processed at a single time are referred to as batch-
level costs. A good example of a batch level cost is the cost of
setting up a machine. A cost caused by the development,
production, or acquisition of different items is called a product-
level (or process-level) cost. Costs that are incurred at the
organization level for the singular purpose of supporting
continuing facility operations are referred to as organizational-
level costs.
Value-Added versus Non-Value-Added Activities
Value-added activities enhance the value of products and
services in the eyes of the organizations customers for which
the customer is willing to pay while meeting its own goals.
Customers can be either external or internal to the
organization. Non-value-added activities do not contribute to
customer-perceived value and increases the time spent on a
product or service. These are unnecessary from the
perspective of the customer. The companys goal is to eliminate
non-value-added activities while making value-added activities
more efficient. In a competitive environment, an organization
should try to reduce the waste quantum of resources on non-
value-added activities because competitors are continuously
striving to get more customer value at lower cost.
All organizations have some non-value-added activities that
can be reduced or eliminated. The following are the most likely
sources of the non-value-added
activities:
Producing to build up
inventory;
Waiting for processing;
Spending time and effort
to move products from
place to place;
Transporting workers to
work sites;
Producing defective products.
Process of Activity-Based Costing System
Activity-based costing has maintained a high profile as a cost
management innovation. Four steps can be used to determine
the cost of goods and services using ABC analysis.

STEP 1: IDENTIFICATION AND CLASSIFICATION OF MAIN
ACTIVITIES
Identify and classify the main activities related to the product
performed in the organization, such as manufacturing,
assembly, etc., as well as support activities, including
purchasing, packing and dispatching.
STEP 2: ASSIGNING COSTS TO ACTIVITY CENTERS

204
Video 10.2.4: Intro to Activ-
ity Based Costing System
After the activities have been identified and classified, the
cost of resources consumed over a process must be
assigned to each activity. The main aim of the organization is
to identify that how much they are spending on each of its
activities.
STEP 3: SELECTING COST DRIVERS
Selecting appropriate cost drivers for assigning the cost of
activities to cost objects is the next step in Activity-Based
Costing System. Cost drivers used at this stage are called
activity cost drivers. Several factors are taken in consideration
while selecting a suitable cost driver. Activity cost drivers
consist of three types:
i. Transaction drivers;
ii. Duration drivers; and
iii. Intensity drivers.
Transaction Drivers
Transaction drivers are the least expensive and are likely to
be least accurate because they assume that same quantity of
resources is required every time an activity is performed. It
counts the number of times an activity is performed such as
number of purchase orders processed, number of customer
orders processed, etc.
Duration Drivers
Duration drivers represent the time duration required to
perform an activity. Duration drivers should be used when
significant variation exists in the amount of activity required
for different outputs. For example, simple product may require
only 10-15 minutes to set-up, while complex, high-precision
products may require 6 hours to set-up. Using a transaction
drivers, like number of set-ups, will over cost the resources
required to set-up simple products and under cost the
resources required for complex products. To avoid this
distortion, ABC designers would use a duration drivers.
Example of duration drivers includes set-up hours and
inspection hours.
Intensity Drivers
Intensity drivers charge for the resources used each time an
activity is performed. They are
the most accurate activity cost
dri vers but are the most
expensive to implement; in
effect they requi re di rect
changi ng vi a a j ob order
costing system to keep track of
all the resources used each
time an activity is performed.
STEP 4: ASSIGNING COSTS
TO PRODUCTS
Assigning the cost of the activities to products is the final
stage in the process of Activity-Based Costing.
Activity-Based Management
205
Video 10.2.5:
ABC Illustration
ABC is not only a cost allocation system but also extended to
other costing and management techniques. It can be used as
an alternative to traditional costing systems such as Absorption
and Marginal Costing. ABC can also be extended to
performance measurement systems such as Activity-Based
Management. Activity-Based Management (ABM) evaluates
the costs and values of process activities to identify
opportunities to improve efficiency. ABM combines activity
based costing analysis and value-added analysis to make
process improvements that improve customer value and
reduce waste resources.
Activity-based management focuses on the activities incurred
during the production or performance process as a way to
improve the value received by a customer and the resulting
profit achieved by providing this value. The concepts covered
by activity-based management are activity analysis, cost driver
analysis, activity-based costing, continuous improvement,
operational control, performance evaluation and business
process re-engineering. These concepts help companies to
produce more efficiently, determine costs more accurately and
control and evaluate performance more effectively. The
primary component of activity-based management is activity
analysis, which is the process of studying activities to classify
them and to devise ways of minimizing or eliminating non-
value-added activities. Activity-based-cost management
systems trace indirect and support expenses accurately to
individual products, services and customers. ABM includes
cost-driver analysis, activity analysis and performance
analysis.
What managers actually do in an activity-based
management?
Managers use information collected by the ABC system at the
activity level to identify promising opportunities for reducing
costs in indirect and support activities.
Features of Activity-Based Management
Activity-based management involves the following stages:
Identifying the major activities that take place in an
organization.
Assigning costs to cost pools/cost centers for each activity.
Determining the cost driver for each activity.
Omits the fourth stage required for product costing ABC.
ABM focuses on managing the business on the basis of the
activities that make up the organization by managing the
activities costs are managed in the long-term.
Traditional control reports analyze costs by types of
expenses for each responsibility centre whereas ABM
analyzes costs by activities.
Knowing the cost of activities is a catalyst for triggering
action to become competitive.
Activity cost information is useful for prioritizing those
activities that need to be studied more closely.
Activities can be classified as value-added or non-value-
added.
206
Activity-based systems can also be used to manage costs
at the design stage using behavioral drivers.
Surveys also suggest that many organizations use cost
driver rates as measures of cost efficiency.
CRITICISM OF ACTIVITY-BASED COSTING/ ACTIVITY-
BASED MANAGEMENT
ABC requires a significant amount of time, and thus, cost
to implement.
ABC/ABM simply assumes that functional activities are
separable to an extent that they can be linked to
output/products.
ABC/ABM fails to seize long-term purposes of activities
rather it takes a very narrow view, only concerned with the
cost. Some activities, in the short run, may be costly but in
the long run they are highly profitable to the company such
as building relationship with suppliers.
ABC also falls in the category of traditional cost allocation
because ABC too accepts some common costs not
traceable to products.
By threatening to reduce expenditure, ABM denies space
for developmental activities indigenous to the staff
department. Armstrong (2002) argued that The problem
with ABM is that it is programmed to deny and exterminate
anything which is not on its list of routine activities, whether
it is of genuine value or not.
ABM and ABC hinder improvisation, imagination and
search for better ways of doing things.
ABM becomes redundant when ABC method is inaccurate.
207
REVIEW 10.2 .1
Check Answer
Question 1 of 5
Which of the following is a sign that an ABC system
may be useful?
A. There are small amounts of support costs.
B. Products make diverse demands on re-
sources because of differences in volume,
process steps, batch size, or
complexity.
C. Products a company is less suited to pro-
duce.
D. Operations throughout the plant are fairly
similar.
Section 3
Target Costing
Introduction
The long-term financial success
of any business depends on
whether its prices exceed its
costs; are adequate to finance
g r o w t h ; p r o v i d e f o r
r e i n v e s t me n t ; y i e l d a
sat i sf act or y r et ur n t o i t s
s t a k e h o l d e r s , e t c . A s
compet i t i on i ncreases and
supply exceeds demand, market
f o r c e s i n f l u e n c e p r i c e s
si gni fi cantl y. To achi eve a
sufficient margin over its costs, a
company must manage those
costs relative to the prices the
market allows or the price the
firm sets to achieve certain
market penetration objectives. In
t h e c o n t e x t o f t h e s e
characteristics, the practice of
target costing has evolved.
Effective management of cost
makes an organization more
strong, more stable and helps in
improving the potential of a
business. The organization calls
for a system that would monitor
the full economic impact of the
b u s i n e s s o n r e s o u r c e
acquisition and consumption.
208
Video 10.3.1: Target Costing
Target costing is defined as a cost management tool for
reducing the overall cost of a product over its entire life cycle
with the help of the production, engineering, R&D. Target
costing process starts with determining market-based prices
based on market and competitive conditions and then subtract
the required margin to determine the product or service level
target costs. Such aggregate level target costs can be useful
in designing value delivery processes and determining the
relative cost contribution of people, process and technology
elements in such a manner as to achieve target cost before
costs are incurred.
Target costing is fundamentally a different approach. It is
based on three premises: (i) orienting products to customer
affordability or market-driven pricing, (ii) treating product cost
as an independent variable during the definition of a products
requirements, and (iii) proactively working to achieve target
cost during product and process development. It is a profit and
cost management system that helps a company to achieve
market and financial success by planning the portfolio of
services, designing the products, processes and related cost
structures that provide value to customers.
Objectives of Target Costing
The fundamental objective of target costing is to enable
management to use practical cost planning, cost management
and cost reduction practices whereby costs are planned and
managed out of a product and business early in the design
and development cycle, rather than during the latter stages of
product development and production. It obviously applies to
new products, but can also be applied to product modifications
or succeeding generations of
products. It might also be used
for existing products, but costs
are more difficult to reduce
once a product is in production.
The cost s most t ypi cal l y
emphasi zed i n the target
costi ng process are such
t hi ngs as: mat er i al and
purchased parts, conversion
costs (such as labor and
identifiable overhead expenses), tooling costs, development
expenses and depreciation. However, all costs and assets that
may be affected by early product planning decisions should be
considered. This would include more indirect overhead
expenses through the production stage and beyond, such as
service costs, and, assets like inventory. Target costing is
i nt ended t o get manager s t hi nki ng ahead and
comprehensively about the cost and other implications of the
decisions they made.
Target costing is as much a significant business philosophy as
it is a process to plan, manage and reduce costs. It
emphasizes understanding the markets and competition; it
focuses on customer requirements in terms of quality,
functions and delivery as well as price; it recognizes the
necessity to balance the trade-offs across the organization and
establishes teams to address them early in the development
cycle; and it has, at its core, the fundamental objective to
make money, to be able to reinvest, grow and increase value.
209
Video 10.3.2: Objectives
Different Phases of Target Costing
There are several phases to the methodology of target costing:
Planning Phase
Development Phase
Production Phase
PLANNING PHASE
Based upon i t s st r at egi c
business plans, a company must
first establish what type of
product it wishes to manufacture.
Tradi t i onal l y (bef ore t arget
costi ng), once the type of
product was determined, its
development was assigned to
the product design department.
Then the produced product was sent to the costing department,
which assessed the cost of the design and frequently found it
more expensive to produce than the market would tolerate.
The design was then returned to the design department with
instructions to reduce its costs, usually by compromising its
quality. The product design was sent back and forth between
the two departments until a consensus was reached. The
product was then sent to the manufacturing department, which
often concluded that it was impossible to manufacture it in its
proposed state. It was then sent back to the design department
and so on. Much time, money and effort were spent before the
product reached the production stage. As a result, profit
suffered.
Under target costing, a products design begins at the opposite
end. It first establishes a price at which the product can be
competitive and then assigns a team to develop cost scenarios
and search for ways to design and manufacture the product to
meet those cost constraints. Several steps must be taken in
order to establish a reasonable target cost.
Market research should be done to determine several factors.
First, the products of competitors should be analyzed with
regard to price, quality, service and support, delivery and
technology. After a preliminary test of competitors product, it is
necessary to establish the features consumers value in this
type of product and the important features that are lacking.
After preliminary testing, a company should be able to pinpoint
a market niche it believes is undersupplied, and, in which it
believes it might have some competitive advantage. Only then
can a company set a target cost close to competitors products
of similar functions and value. The target cost is bound to
change in the development and design stages. However, the
new target costs should only be allowed to decrease unless the
company can provide added features that add value to the
product.
DEVELOPMENT PHASE
The company must find ways to attain the target cost. This
involves a number of steps.
210
Video 10.3.3:
Target Cost: Value Strategy
First, an in-depth study of the most competitive product on the
market must be conducted. This study will show what materials
were used and what features are provided and it will give an
indication of the manufacturing process needed to complete
the product.
Once a better understanding of the design has been achieved,
the organization can target the costs against this best design.
But its competitors will probably be engaged in similar analysis
and will further improve its product toward this best design. It
is necessary when performing comparative cost analysis, and
trying to establish the competitors cost structure, that adequate
attention be paid to the competitive advantages of the
competitor, such as technology, location and vertical
integration.
After trying to identify the cost structure of the competitor, the
company should develop estimates for the internal cost
structure of its own products. This is most effectively done by
analyzing internal costs of similar products already being
produced by the company and should take into account the
different needs of the new product in assessing these costs.
After preliminary analysis of the cost structures of both the
competitor and itself, the company should further define these
cost structures in terms of cost drivers. Focusing on cost
drivers can help reduce waste, improve quality, minimize non-
value-added activities and identify ineffective product design.
The use of multiple drivers leads to better understanding of the
inputs and resources required to produce products and a better
cost analysis through more detailed cost information.
When enough cost information is available, the product
development team is able to generate cost estimates under
different scenarios. After this, the designers, manufacturers,
marketers, and engineers on the team should conduct a
session of brainstorming to generate ideas on how to
substantially reduce costs (by smoothing the process, using
different materials, and so on) or add a number of different
features to the product without increasing target costs. In these
brainstorming sessions, no idea is rejected, and the best ideas
are integrated into the development of the product.
PRODUCTION PHASE
In this stage, target costing becomes a tool for reducing costs
of existing products. It is highly unlikely that the design,
manufacturing and engineering groups will develop the optimal,
cost efficient process at the beginning of production. The
search for better, less expensive products should continue in
the framework of continuous improvement.
The ABC technique can be useful as a tool for target costing of
existing products. ABC assists in identifying non-value-added
activities and can be used to develop scenarios on how to
minimize them. Target costing at the activity level makes
opportunities for cost reduction highly viable.
Target costing is also strongly linked to consumer requirements
and tries to identify the features such as performance
specifications, services, warranties and delivery consumers
want products to provide. These consumers may also be
questioned about which features they prefer in products and
how much they are worth to them. The surveys on preferable
211
features and value of these features help management do
cost-benefit-analysis on different features of a product and
then try to reduce costs on features that are not ranked
highly.
Target costing also provides incentives to move towards less
expensive means of production as well as production
techniques that provide a more even flow of goods. JIT
provides an environment where there is better monitoring of
costs and product quality as well as access to ideas for
continuous improvement and better production strategies.
Factors to be considered while Implementing Target
Costing System
The following factors should be taken by the organization
before implementing the target costing system:
i. Target costing program begins with the management
commitment and their support. The objectives of the
target costing must be communicated to the remaining
people in the organization.
ii. Team-Based Organization is to be established to support
development program.
iii. A target Costing process needs to be defined and
established.
iv. Target costs must be established based on the analysis
of markets, analysis of customers requirements and
analysis of cost-volume relationships.
v. Product cost models or cost tables are required to
evaluate concept and design alternatives and support
decision-making.
vi. Value analysis and design for manufacturability are
needed to provide focus on functions of value to the
customer, the associated and the DFM principles to
reduce cost.
vii. In product costs 40%-70% is spent for materials. Thus
supplier involvement is required for development of
pricing programs.
viii. Introduction of business process re-engineering is
needed for eliminating non-value-added activities and to
establish activity-based costing system.
ix. Moni t ori ng of t arget
c o s t i n g i s k e y t o
s u c c e s s f u l
i mpl ementati on. It i s
r equi r ed t o devel op
tracking systems, design
review guidelines and
ensur e appr opr i at e
management focus to a
target costing system.
Benefits of Target Costing
Target costing have the following benefits:
212
Video 10.3.4: Launching
product below target cost
i. The process of target costing provides detailed information
on the costs involved in producing a new product as well
as a better way of testing different cost scenarios through
the use of ABC.
ii. Target costing reduces the development cycle of a product.
Costs can be targeted at the same time the product is
being designed, bringing in the resources of the
manufacturing and finance departments to ensure that all
avenues of cost reduction are being explored and that the
product is designed for manufacturability at an early stage
of development.
iii. The internal costing model, using ABC, can provide an
excellent understanding of the dynamics of production
costs and can detail ways to eliminate waste, reduce non-
value-added activities, improve quality, simplify the process
and attack the root cause of costs (cost drivers). It can also
be used for measuring different cost scenarios to ensure
that the best ideas available are incorporated from the
outset into the production design.
iv. The profitability of new products is increased by target
costing through promoting reduction in costs while
maintaining or improving quality. It also helps in promoting
the requirements of consumers, which leads to products
that better reflect consumer needs and find better
acceptance than existing products.
v. Target costing is also used to forecast future costs and to
provide motivation to meet future cost goals.
vi. Target costing is very attractive because it is used to
control costs before the company even incurs any
production costs, which save a great deal of time and
money.
vii. Although target costing in its simplest form is merely a
calculation target price minus margin todays
competitive environment can make target costing an
indispensable, strategic management technique.
Additional resources to this chapter
213
Video 10.3.5: Modern
cost management
Video 10.3.6: Standard cost
vs Actual cost
214
REVIEW 10.3 .1
Check Answer
Question 1 of 2
What is the name of the costing approach used
where the products selling price is identified and
ways are established of meeting production costs
and making an acceptable profit?
A. Benchmarking
B. Activity based costing
C. Total life cycle costing
D. Target costing
Decisions Involving Alternate Choices
C
H
A
P
T
E
R

1
1
INTRODUCTION
Managerial decision-making is the process of choosing one
among alternative courses of action. The manager chooses
that course of action, which he considers as the most effective
for achieving goals and solving problems. Decision-making is
an integral part of all management functions planning,
organization, coordination, and control. All decisions are
futuristic in nature, involving a forecast of what management
thinks is likely to occur. But future is highly uncertain. Thus
business decisions have to be made with the full realization
that there is some probability of the prediction, which
underlies the decision taken, going off the mark. Some
decisions are routine in nature. These decisions take up very
little of the managers time either because there is very little
uncertainty or because the cost is insignificant. On the other
hand, managers have to take nerve-racking decisions. The
manager has to spend a considerable amount of time and
thought on these decisions because they are crucial to the
organization.
In this chapter, we will be
discussing about the meaning of
Relevant Cost and Irrelevant
Cost, Marginal Costing and
Differential Cost Analysis and
explain the various production
decisions.
OBJECTIVES
Distinguish between relevant and irrelevant cost;
Explain the marginal costing and differential costing
analysis;
Explain the various production decisions such as make or
buy, accept or reject a foreign order, purchase or lease,
sell or further process, closing down the factory or a
segment;
216
Video 11.1:
Intro to Business Decisions
Section 1
Decisions: Related Concepts
STEPS I N DECI SI ON-
MAKING PROCESS
Let us now take a look at the
process of decision-making
while this process is complex
a n d n o t a m e n a b l e t o
standardization, the following
steps seem useful for most of
the problems:
Defining the Problem:
This is the first step in any
decision-making situation.
In this step a complete
study to find out what the
p r o b l e m r e a l l y i s
undertaken. All possible
causes and effects of the
problem should be studied.
It should be remembered
that defining the problem
correctly takes more time at
first, but saves time in the
decision process. Once the
problem is defined the next
step i s to anal yze the
problem in detail. In this
process, the decision maker
collects all possible facts
close to the problem. The
facts should be separated
based on the definition of
the problem. It should be
noted that the problem-
defining step should be fair
and unbiased.
Developing Alternative
Sol ut i ons: Onc e t he
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problem is defined and analyzed, the next step is to think
about the alternatives. Here, the decision maker should list
out all the available alternatives. He can go for new and
innovative ideas or think about the alternatives available.
The alternatives collected should be in relation to the
defined problem.
Evaluating the Alternatives: The listed out alternatives
should be evaluated with the defined problem to arrive at
the suitability of the alternatives. In this step, the decision
maker can ask some basic questions like whether the
decision will help to reach the objectives; Is the decision
time- and cost-effective?; Whether we have enough
resources to implement the decision?; Is there any
negative consequences of the decision which may affect
the business in future?, etc. The decision maker has to
consider all the evaluation factors like, risk, resources,
feasibility, viability, etc.
Arrive at a Decision: The steps discussed above will
guide the decision maker to narrow down his problem to a
few choices. In this step, he will select the best alternative
from the selected choices. After selecting the best decision
and implementing it, there should be a regular follow up in
order to see whether the decision is serving the defined
purpose. This is done at the implementation stage of the
decision.
CONCEPT OF RELEVANT COST AND IRRELEVANT
COST
Rel evant Costs: The
relevant costs are given
the utmost importance in
manager i al deci si on-
making. Their magnitude
will affect a decision being
m a d e . T h e m a i n
manager i al deci si on-
mak i ng i nv ol v es t he
planning for the future of the business in terms of new
products, entry in new markets, etc., and other decisions
like alternative course of action. During the course of such
decision-making, the management has to consider various
cost aspects involved. These costs are also called relevant
costs as they are relevant for the future decision-making.
Therefore, a cost can be considered as relevant cost if it
helps the management to take a right decision to achieve
the objectives of the company. For example, a company
now has two types of products and the direct material cost
per unit is Rs.25 and direct labor per unit is Rs.20. It wants
to make some changes in its product line. The new product
line requires direct material at Rs.25 per unit and labor
cost of Rs.22 per unit. In this case, the cost of material is
constant and it is not relevant for decision-making. Hence
the labor cost is changing from the present level in case of
the proposal. Thus the labor cost is relevant.
218
Video 11.1.1: Relevant Cost
Irrelevant costs are those costs which will not be affected
by any decision made by the management.
CHARACTERISTICS OF RELEVANT COST
We are already familiar with the concept of relevant costs.
Relevant costs are the costs that will make difference when one
alternative is selected over the competing alternatives.
Essentially, relevant costs have the following two characteristics:
They are Expected Future Costs: All future costs are not
necessarily relevant to decision-making purposes, but no
costs are relevant unless they pertain to the future. Expected
future costs mean that the costs are expected to occur
during the time period covered by the decision. Past or
historical costs are relevant to the decision only if they are
expected to continue in the future.
They Differ between Alternatives: If the same costs are
incurred for both the alternatives, then they are not relevant.
If the costs incurred for the alternatives are different, then
they become relevant costs.
For example, if the manager is evaluating the purchase of either
a manual or an automated drill press, both of which require
skilled labor costing Rs.80 per hour, the labor rate is not relevant
since it is the same under both alternatives. If however, the
manual drill press requires only semi-skilled labor at Rs.60 per
hour whereas the automatic drill press requires skilled labor at
Rs.80 per hour, then the labor rate is relevant because it is
different for the two alternatives. The difference between the
amounts of the two costs is called differential cost or incremental
cost.
COSTS FOR DECISION-MAKING
Typically, in cost accounting system, each product is charged
with a portion of indirect costs, which are not traceable to the
product. Hence cost figures drawn from the cost accounting
system are often not relevant since they are historical costs.
Remember that costs, which differ between the alternatives in
future alone, are seen as relevant.
Sunk Cost
A sunk cost is an expenditure made in the past that cannot be
changed. These are past costs not future costs. Thus these
costs are not relevant for decision-making. For example, the
cost of machinery purchased in 1995 is not relevant now in
deciding whether to sell the machinery or not.
Variable Cost
Variable costs are the costs that vary with the level of activity. If
they vary with different alternatives they are relevant for
decision-making. Thus it should be remembered that all variable
costs are not relevant for decision-making.
Fixed Cost
For the purposes of short-term
decision-making, fixed costs may
be either relevant or irrelevant.
When a fixed cost is incurred
only if a certain decision is taken,
it is relevant. For example, the
manufacture of a new product
219
Video 11.1.2: Relevant
costs for Decision-Making
may entail the salary of a production supervisor. His salary, a
fixed cost that will be incurred only if the new product is
manufactured, is a relevant cost. If a fixed cost is incurred
irrespective of whatever decision is taken in a certain situation,
it is an irrelevant cost. For example, the salary of chief
executive is incurred whether or not a new product is
manufactured. Hence in the context of a decision relating to
the manufacture of the new product, the salary of chief
executive, a fixed cost, is not relevant. Thus it should be
remembered that all fixed costs are not irrelevant for decision-
making.
Opportunity Cost
This cost represents the benefit foregone in sacrificing the best
alternative. To illustrate, consider the use of a machine for
manufacturing the product A. If product A is not manufactured,
the best alternative use of the machine is to manufacture
product B that generates certain revenue. The revenue of
Product B forgone to manufacture Product A is the opportunity
cost. Opportunity cost is a pure decision-making cost. It is an
imputed cost, which does not require cash outlay, and it is not
entered in the accounting books.
Out-of-Pocket Cost
There are certain costs, which require cash payment to be
made (like salaries and wages, rent) whereas many costs do
not require cash outlay (like depreciation). Out-of-pocket costs
involve cash outlays or require the utilization of current
resources. These may include direct cost or indirect cost or
variable cost or fixed cost. These are relevant for making
decisions like make or buy, price fixation during depression,
etc.
Differential Cost
In management accounting, differential cost is used as a
synonym to relevant cost. This can be defined as the change
in the cost due to change in the level of activity or pattern or
method of production. In other words, it is the difference
between the cost resulting from the contemplated change. If
the change in the cost is in the increasing form, it is called
incremental cost, if it is decreasing with the decrease in output,
it is called decremental cost. For the proper analysis of
differential cost, we should know the concept of incremental
revenue, incremental costs, decremental revenue and
decremental costs. Incremental cost increases between two
alternatives, whereas decremental cost decreases between
two alternatives. Incremental revenue increases between two
alternatives, while decremental revenue decreases between
two alternatives.
FEATURES OF DIFFERENTIAL COST
The following are the important features of differential cost:
Differential cost differs from one course of action to
another.
It is a future cost and does not include all variable
costs. Variable costs are considered as differential
depending upon the situation.
220
The differential cost data is related to costs, revenue
and investment factors.
Differential cost considers only incremental cost or
d e c r e me n t a l c o s t s a n d n o t t h e
cost per unit.
While selecting an alternative, the proposal with
positive difference between the revenue and cost is
considered.
Differential costing technique is used to analyze and
present data for decision-making and it is not a
regular or routine accounting work.
221
REVIEW 11.1 .1
Check Answer
Question 1 of 4
Costs that are not relevant for decision-
making and are not affected by increase or
decrease in volume are
A. Out-of-pocket costs
B. Differential costs
C. Imputed costs
D. Sunk costs
Section 2
Decision-Making Using Differential Cost Analysis-1
While making decisions, management
compares two or more alternatives.
Differential cost analysis or differential
costing is a special technique to help
management in decision-making
which shows how costs and revenues
would differ under different alternative
courses of action.
MAKE OR BUY DECISIONS
A firm that is presently buying a
product or part from outside may
consider manufacturing that product
or part in the firm itself. Such a
decision-making alternative requires
the firm to know through marginal
costing what contribution to fixed
costs will result from a make
decision.
Make or buy decisions will be taken
with the help of marginal costing in
the following manner:
When the capacity is available
and it cannot be utilized for
manufacture of other products,
t hen t he pur chase cost i s
compared with the marginal cost
or the total cost is compared with
the purchase cost plus fixed cost
of manufacture to take the
decision to make or buy.
Wh e n t h e c a p a c i t y i s
avai l abl e and i t can be
utilized for manufacture of
other products, the purchase
price should be compared
with the marginal cost of the
product plus opportunity cost,
i.e., the loss of contribution of
other product replaced.
When there is no additional
capacity available and it is
p r o p o s e d t o a c q u i r e
addi t i onal f aci l i t i es f or
manufacture, the purchase
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price should be compared with the marginal cost plus
fixed cost likely to be incurred for manufacturing with
additional facility.
Make or buy decision is important for the company. So before
taking any decision one should consider certain things as:
The capacity of the company in terms of people,
plant, space, etc.,
t o achi eve t he
required quantity
and quality.
The di fferenti al
cost of making or
buying the item.
The opportunity
c o s t o f u s i n g
existing capacity
t o manuf act ure
alternative items.
The level of variable overheads, which are
charged to the item.
Illustration 1
RMS Ltd. manufactures sewing machines which have three
components. The following are the data pertaining to these
components:
The market offers a good demand for the companys
products, but the company is not able to supply the products
due to the machine capacity limitation. So the management
decided to purchase one component from outside supplier
and produce maximum products with the capacity of the
bought product. The purchase price of the three components
is: P at Rs.150, Q at Rs.180 and R at Rs.240. You are
required to help the company management decide which
component to buy from outside.
Solution
223
PURCHASE MACHINE HOUR MACHINE HOUR % UTILIZATION % UTILIZATION
Nil - 69 100
P 69-15 54 69/54 128
Q 69-24 45 69/45 153
R 69-30 59 69/39 177
COMPONENT
MACHINE
HOURS
VARIABLE
COST (RS)
FIXED
COST
(RS)
TOTAL (RS)
P 15 72 24 96
Q 24 90 30 120
R 30 90 90 180
Packing 150 60 210
Total 402 204 606
Selling Price 750
Video 11.2.1:
Make or Buy Decision
As the contribution of Q is highest, the
component Q should be purchased
from the suppliers
Accept or Rej ect an Order/
Foreign orders or Exploring New Markets
The companies may get special orders from their customers for
the supply of their regular products. In such cases they have to
decide whether the order should be accepted or rejected. The
special orders may be either from the domestic or foreign
customers. The customers will be quoting a price lesser than the
normal selling price for such special orders. The companies
usually take decision in such circumstances on the basis of
differential cost analysis. So, they compare the incremental
revenue with the differential cost. A company should consider the
following factors before taking the accept/reject decision:
The effect on the future revenue due to temporary reduction
in selling price.
The impact of reduced selling price on the existing
customers when they come to know the price reduction for
special order.
Possibility of selling extra
units for new customers
other than the special order.
Rel i abi l i t y of t he cost
estimates for the special
order.
The effect of the present
and future capacity in terms
of plant expansion, finance,
human resources, etc.
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PARTICULARS PRESENT
IF P
PURCHASED
IF Q
PURCHASED
IF R
PURCHAS
ED
Variable Cost Rs.
P 72 150 72 72
Q 90 90 180 90
R 90 90 90 240
Packing 150 150 150 150
Total Variable
cost Rs.
402 480 492 552
Selling Price Rs. 750 750 750 750
Contribution Rs. 348 270 258 198
Capacity
Utilization %
100 128 135 177
Contribution 116 345.6 394.7 350.5
Video 11.2.2: Accept or Re-
ject a Special Order
Illustration
A factory manufacturing mechanical toys presents the following
information for the year 2011:
The available capacity is a production of 40,000 units per year.
The firm has an offer for the purchase of 10,000 additional
units at a price of Rs.30 per unit. It is expected that by
accepting this offer, there will be a saving of Re.1 per unit in
material cost on all units manufactured; the fixed overheads
will increase by Rs.40,000 and the overall efficiency will drop
by 3% on production.
Prepare a statement showing the variation of net profits
resulting from the acceptance of the order.
Solution
PARTICULARS
(RS) (PRESENT 30,000
UNITS LEVEL)
Material Cost 2,40,000
Labor Cost 4,80,000
Fixed Overheads 2,40,000
Variable Overheads 1,20,000
Units produced 30,000 units
Selling price per unit Rs.40
NO. PARTICULARS
30,000
UNITS
40,000
UNITS
VARIATIO
N
Material 2,40,000 2,80,000 40,000
Labor 4,80,000 6,59,794 1,79,794
Variable
Overheads
1,20,000 1,60,000 40,000
i. Total variable cost 8,40,000 10,99,794 2,59,794
ii. Sales 12,00,000 15,00,000 3,00,000
(30000 @ Rs.40 per
unit)
(30000 @ Rs.40 per
unit+ 10000 @ Rs.
30 per unit)
iii.
Contribution (ii) -
(i)
3,60,000 4,00,026 40.026
iv. Fixed cost 2,40,000 2,80,000 40,000
v. Prot 1,20,000 1,20,206 206
The net prot will increase byRs.206 by the acceptance of
additional order of 10,000 units
225
Statement Showing the Variation of Net Profit resulting
from the acceptance of the order
In process industries different products are seen at every stage
of process. The companies can dispose off these products in
the market directly or they can further process these products
and sell it at a higher price. Differential cost analysis can be
used for this purpose to know whether the product can be sold
profitably or it requires further processing to charge a premium.
If there is no further capital investment, the decision can be
taken by comparing differential cost for processing and the
incremental revenue.
Illustration
Deccan Agro Products Ltd. produces two joint products. The
following cost information is available for the year 2011:
The product Y can be processed further and product Z can be
produced. Product Z can be sold in the market at Rs.85 per kg.
It requires an additional cost of Rs.10,000 to process 24,000 kg.
of product Y and the output of this process will be 12,000 kg. of
Z. You are required to help the management decide in this
respect.
Solution
As the incremental profit is more than the differential cost, the
company should further process the product Y into product Z.
PRODUCTS
PRODUCTION IN
KGS
SALE PRICE (RS)
X 12,000 30
Y 24,000 40
PARTICULARS RS.
Incremental Revenue:
Product Z = 12,000 x 85 9,84,000
Product Y = 24,000 x 40 9,60,000
Incremental Revenue: 24,000
Differential Cost:
Additional processing cost 10,000
Incremental proft 14,000
226
REVIEW 11.2 .1
Check Answer
Question 1 of 5
A company has an idle plant capacity. It gets a
bulk order, which will not affect prices of
company products in the market. Such a bulk
order may be accepted at a price which is more
that its
A. Total Cost
B. Variable Cost
C. Fixed Cost
D. Contribution
227
Section 3
Decision-Making Using Differential Cost Analysis-2
CLOSING DOWN OF
F A C T O R Y O R
SEGMENT
Somet i mes i t becomes
necessary for a firm to
temporarily closedown its
factory or a segment due to
t r ade r ec es s i on. The
decision regarding closing
down wi l l depend on
whet her pr oduct s ar e
maki ng a cont r i but i on
towards fixed costs or not. If
the products are making a
contribution towards fixed
cost, it is not advisable to
close the factory or segment
to minimize the losses. Even
though the factory is closed
down, some fixed costs
could not be avoided, for
instance maintenance of
plant or overhauling, etc. So
these must be taken into
account whi l e maki ng
decision.
In addi ti on to the cost
consideration, some non-
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cost considerations should be taken into account before
deciding to close down a
f act or y or segment . The
following are relevant in this
respect:
Once t he busi ness i s
c l o s e d d o w n , t h e
competitors may take the
advantage to establish
their products and capture
more market share. At a
later stage it is difficult to
recapture the market from
our competitors. Heavy advertisement costs have to be
incurred to recapture the market.
Once the workers are discharged it may be difficult to get
experienced and skilled laborers again to restart the
business.
If some segment or activities are closed down, it may
affect the reputation of the firm.
Temporary closure may not be advisable if the
relationship with the suppliers is adversely affected.
Fear of non-collection of dues from debtors in case of
closure of the business may not go in its favor.
Illustration
Moon Ltd. manufactures 60,000 units of A in a year at its
normal production capacity. The unit cost as to variable costs
and fixed costs at this level are Rs.13 and Rs.4 respectively.
The selling price of the A is Rs.20. Due to trade depression, it
is expected that only 6,000 units of A can be sold during the
next year. The management plans to shut down the plant. The
fixed cost for the next year then is expected to be reduced to
Rs.99,000. Additional costs of plant shut-down are expected
at Rs.36,000. Should the plant be shut down? What is shut
down point?
Solution
Comparative Statement
229
PARTICULARS
PLANT IS
OPERATED (RS)
PLANT IS SHUT
DOWN (RS)
Variable cost 6,000 units @
Rs.13
52,000 -
Fixed cost (60,000 x Rs.4) 2,40,000 99,000
Additional shutdown cost - 36,000
Total cost (a) 2,92,000 1,26,000
Sales (6,000 x Rs.20) (b) 1,20,000 -
Loss (b) (a) 1,72,000 1,26,000
Video 11.3.1:
Closing Down of Segment
Recommendation: A comparison
of f i gur es r el at i ng t o t wo
alternatives points out that loss is
reduced by Rs.46,000 if the plant
is shutdown.
Calculation of shut down point:
Shutdown point = Total fixed cost
Shutdown cost/Contribution per
unit
= Rs.2,40,000 Rs.1,26,000/Rs.
20 Rs.13 = 16,285 units.
DROPPING OR ADDING PRODUCT LINE
In a multi-product company, the management may have to decide
on adding or dropping a product line. If a new product line is
added, its sales and certain costs will also increase, the reverse
will happen when a product line is dropped. In order to arrive at
such a decision, the management should compare the differential
cost and incremental revenue and study its effect on the overall
profit position of the organization.
A decision concerning the discontinuation of a product should be
taken after considering the following:
Competitive nature of the products of the company.
Value of resources released on discontinuation.
Contribution margin earned from that product.
Any contribution from that product will reduce the burden of
total fixed costs of the firm and this will help in better profits
than if such product is discontinued.
Illustration
Excel Ltd. is engaged in 3 distinct lines of production. Their
production cost per unit and selling prices are as under:
230
PARTICULARS
PRODUCT X
(RS)
PRODUCT Y
(RS)
PRODUCT Z (RS)
Production units 6,000 4,000 10,000
Cost:
Material 36 52 60
Wages 14 18 20
Variable
overheads
4 6 6
Fixed overheads 10 16 18
Total cost 64 92 104
Selling price 80 120 122
Prot 16 28 18
Video 11.3.2:
Dropping a Product Line
The management wants to discontinue one line and gives the
assurance that production in two other lines shall rise by 50%.
They intend to discontinue the line, which produces Product
X, as it is less profitable.
a. Do you agree to the scheme in-principle? If so, do you think
that the line which produces X should be discontinued?
b. Offer your comments and show the necessary statements to
support your decisions.
Solution
If Product X is dropped
Sale
231
Total Fixed Cost Rs.
X 6,000 units @ Rs.
10
60,000
Y 4,000 units @ Rs.
16
64,000
Z 10,000 units @
Rs.18
1,80,000
3,04,000
Contribution
Selling Price - Variable Cost
X - Rs.80-54 Rs.26 per unit
Y - Rs.120-76 Rs.44 per unit
Z - Rs.122- 86 Rs.36 per unit
Total Contribution Rs.
Product Y: 6,000 units @ Rs.44 per unit 2,64,000
Product Z: 15,000 units @ Rs.36 per unit 5,40,000
8,04,000
Less: Fixed Cost 3,04,000
Prot 5,00,000
Product X: 9,000 units @ Rs.26 per unit 2,34,000
Product Z: 15,000 units @ Rs.36 per unit 5,40,000
7,74,000
Prot 4,70,000
Product X: 9,000 units @ Rs.26 per unit 2,34,000
Product Y: 6,000 units @ Rs.44 per unit 2,64,000
4,98,000
Prot 1,94,000
of Y and Z will increase by 50%. Then the sales would be Y
6,000 units, and Z 15,000 units.
If Product Y is dropped
Sale of X and Z will increase by 50%. Then the sales would be
X 9,000 units, and Z 15,000 units.
If Product Z is dropped
Sale of X and Y will increase by 50%. Then the sales would be
X 9,000 units, and Y 6,000 units.
From the above, it is clear that among the three alternatives,
the highest amount of profit is earned when X line of production
is discontinued. Thus the management decision to discontinue
X is correct.
Other Decisions
SELL OR PROCESS DECISION
In process type of industries there will
be different products at every stage of
process. The companies can dispose
these products in the market directly or they can further process
these products and sell it at a higher price. Differential cost
analysis can be used for this purpose to know whether the
product can be sold profitably, or it requires further processing
to charge a premium for the product. If there is no further capital
investment, the decision can be taken by comparing differential
cost for processing and the incremental revenue.
PURCHASING OR LEASING
In case of capital investment decision, the management of the
company will consider two alternatives. That is, whether the
asset should be purchased, or it should be leased. For the
decision-making purpose, the total cost of the two alternatives
will be compared to know the additional savings. If there is a
saving on purchase, then it should be considered and vice-
versa.
LEVEL OF ACTIVITY PLANNING
Marginal costing would help the management in planning the
level of activity. Maximum contribution at a particular level of
activity will show the position of maximum profitability.
EQUIPMENT REPLACEMENT
One of the important decisions is whether to buy a new capital
equipment or not. This type of decision is called capital
expenditure decision or capital replacement decision.
The following factors will affect the decision:
The benefits that the firm is likely to derive in the long run by
replacing the old one;
Loss on disposal of old asset;
Investment of the new asset; and
Increase or decrease in operating costs.
232
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epositphotos.com
The decision should be taken after considering the resultant
savings in operating costs and the incremental investment in
the new equipment.
233
REVIEW 11.3 .1
Check Answer
Question 1 of 2
While deciding about replacement of a capital
equipment, the firm should take into consideration
A. The resultant savings in operating costs.
B. The incremental investment in the new
equipment.
C. The benefits of the firm is likely to derive
in the long run.
This document is authorized for internal use only at IBS campuses- Batch of 2012-2014 - Semester I. No part of this publication may be re-
produced, stored in a retrieved system, used in a spreadsheet, or transmitted in any form or by any means - electronic, mechanical, photo-
copying or otherwise - without prior permission in writing from IBS Hyderabad.

Accounting For Managers

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STEP 2: ASSIGNING COSTS TO ACTIVITY CENTERS

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