MASTER OF BUSINESS ADMINISTRATION
(INDUSTRY INTEGRATED)
TWO YEAR FULL TIME INDUSTRY INTEGRATED
M.B.A PROGRAMME
SELF LEARNING MATERIAL
FINANCIAL, COST AND MANAGEMENT ACCOUNTING
Detailed Curriculum
Annamalai University Courses
LESSON – 1
ACCOUNTING – THE LANGUAGE OF BUSINESS
1.INTRODUCTION
Accounting is called the "language of business". It is as old as money itself. Initially meant to meet the needs of a relatively few owners, it gradually expanded its function to a public role of meeting the needs of a variety of interested parties. Accounting is also viewed as a profession with accountants engaging in private and public accounting. The task of learning accounting is essentially the game as the task of learning a new language. But the acceleration of change in business organisation has contributed to increasing the complexities in this language. Like other languages, it is undergoing continuous change in an attempt to discover better means of communicating.
2.OBJECTIVES
After reading this lesson the student should be able to:
• know the evolution and meaning of accounting,
• understand the nature and role of accounting.
• appreciate the importance of accounting as an information system and
• understand the profession of accounting and its specialized branches.
3.CONTENT
Evolution of accounting
Definition of accounting
Scope and functions of accounting
Accounting as an information system
Users of accounting information
The profession of accounting
Specialised accounting fields
EVOLUTION OF ACCOUNTING
Accounting is as old as money itself. It has evolved as have medicine, law and most other fields of human activity in response to the social and economic needs of society. For the most part early accounting dealt only with limited aspects of the financial operations of private or governmental enterprises. Complete accounting system for an enterprise which came to be called as "Double Entry System" was developed in Italy in the 15th century. The first known description of the system was published there in 1494 by a Franciscan monk by the name Luca Pacioli.
The expanded business operations initiated by the Industrial Revolution required increasingly large amounts of money which in turn resulted in the development of the corporation form of organisations. As corporations became larger, an increasing number of individuals and institutions looked to accountants to provide economic information about these enterprises. For e.g. prospective investors and creditors sought information about a corporation's financial status. Government agencies required financial information for purposes of taxation and regulation. Thus accounting began to expand its function of meeting the needs of relatively few owners to a public role of meeting the needs of a variety of interested parties.
DEFINITION OF ACCOUNTING
Before attempting to define accounting, it may be made clear that there is no unanimity among accountants as to its precise definition. Anyhow, let us examine three popular definitions on the subject.
Accounting has been defined by the American Accounting Association Committee as: ".... the process of identifying measuring and communicating economic information to permit informed judgements and decisions by users of the information." This may be considered as a good definition because of its focus on accounting as an aid to decision making.
The American Institute of Certified, and Public Accountants Committee on Terminology defined accounting in 1961 as : "Accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money, transaction and events which are, in part at least of financial character and interpreting the results thereof." Of all definitions available, this is the most acceptable one because it encompasses all the functions which the modern accounting system performs.
SCOPE AND FUNCTIONS OF ACCOUNTING
Individuals engaged in such areas of business as finance, production, marketing, personnel and general management need not be expert accountants but their effectiveness is no doubt increased if they have a good understanding of accounting principles. Everyone engaged in business activity, from the bottom level employee to the chief executive and owner, comes into contact with accounting. The higher the level of authority and responsibility, the greater is the need for an understanding of accounting concepts and terminology.
A recent study conducted in United States revealed that the most common background of chief executive officers in United States Corporations was finance and accounting. Interviews with several corporate executives drew the following comments.
My training in accounting and auditing practice has been extremely valuable to me throughout."
"A knowledge of accounting carries with it understanding of the establishment and maintenance of sound financial controls – an area which is absolutely essential to a chief– executive to a chief executive officer."
Though accounting is generally associated with business, it is not only business which makes use of accounting, but also many individuals in non–business areas make use of accounting data and need to understand accounting principles and terminology. For e.g. an engineer responsible for selecting the most desirable solution to a technical manufacturing problem may consider cost accounting data to be the decisive factor. Lawyers use accounting data in tax cases and damages from breach of contract. Governmental agencies rely on accounting data in evaluating the efficiency of government operations and for approving the feasibility of proposed taxation and spending programs. Accounting thus plays an important role in modem society and broadly speaking all citizens are affected by accounting in some way.
Accounting which is so important to all discharges the following vital functions:
1 Keeping Systematic Records: This is the fundamental function of accounting. The transactions of the business are properly recorded, classified and summarised into final financial statements income statement and the balance sheet.
2 Protecting the Business Properties: The second function of accounting is to protect the properties of the business by maintaining proper record of various assets and thus enabling the management to exercise proper control over them.
3 Communicating the results: As accounting has been designated as the language of business, its third function is to communicate financial information in respect of net profits, assets, liabilities, etc, to the interested parties.
4 Meeting Legal Requirements: The fourth and last function of accounting is to devise such a system as well meet the legal requirements. The provisions of various laws such as Companies Act, Income Tax Act, etc., require the submission of various statements like Income Tax Returns, Annual Accounts and so on. Accounting system alms at fulfilling this requirements of law.
It may be noted that the functions stated above are those of financial accounting alone. The other branches of accounting, about which we are going to see later in this chapter, have their special functions with the common objective of assisting the management in its task of planning, control and coordination of business activities. Of all the branches of accounting, management accounting is the most important from the management point of view.
ACCOUNTING AS AN INFORMATION SYSTEM
As accounting is the language of business, the primary aim of accounting like any other language is to serve as a means of communication. Most of the world's work is done through organisation–groups of people who work together to accomplish one or more objectives. In doing its work, an organisation uses resources–men, material, money and machine and various services. To work effectively the people in an organisation need information about these resources and the results achieved by using them. People outside the organisation need similar information to make judgements about the organisation. Accounting is the system that provided such information. Any system has three features, Viz. input, processes and output Accounting as a social science can be viewed as an information system, since it has all the three features, i.e., inputs (raw data) processes (men and equipment) and outputs (reports and information). Accounting information is composed principally of financial data about business transactions. The mere records of transactions are of little use in making informed judgements and decisions." The recorded data must be sorted and summarized before significant reports and analyses can be prepared. Some of the reports to enterprise manager and to others who need economic information may be made frequently. Other reports are issued only at longer intervals. The usefulness of reports is often enhanced by various types of percentages and trend analyses. The "basic raw materials" of accounting are composed of business transactions data. Its "primary end products" are composed of various summaries, analyses and reports.
The information needs of a business enterprise can be outlined and illustrated with the help of the following Chart: 1.1
Chart 1.1
Chart Showing Types of Information
The chart clearly presents the different types of information that might be useful to all sorts of individuals interested in the business enterprise. As seen from the chart accounting supplies the quantitative information. The special feature of accounting as a kind of quantitative information and as distinguished from other types of quantitative information is that it usually is expressed in monetary terms. In this, connection it is worthwhile to recall the definitions of accounting as given by the American Institute of Certified and Public Accountants and by the American Accounting Principles Board.
The types of accounting Information may be classified into four categories: 1) Operating information, 2) Financial accounting information, 3) Management accounting information, and 4) Cost accounting information.
1 Operating Information: By operating information we mean the information which is required to conduct day–to–day activities. Examples of operating information are: Amount of wages paid and payable to employees. Information about the stocks of finished goods available for sale and each one's cost and selling price, information about amounts owed to and by the business enterprise, information about stocks of raw materials, spare parts and accessories and so on. By far the largest quantity of accounting information consists of operating information. This is well suggested by the arrows at the bottom of the chart as operating information provides the raw data (input) for financial accounting, management accounting and cost accounting.
2 Financial Accounting: Financial accounting information is intended both for owners and managers and also for the use of individuals and agencies external to the business. This accounting is concerned with the recording of transactions for a business enterprise and the periodic preparation of various reports from such records. The records may be general purposes or for a special purpose. A detailed account of the function of financial accounting has been given earlier in this chapter.
3 Management Accounting: Management accounting employs both historical and estimated data in assisting management in daily operations and in planning for future operations. It deals with specific problems that confront enterprise managers at various organizational levels. The management accountant is frequently concerned with identifying alternative courses of action and then helping to select the best one. For e.g. the accountant may help the finance manager in preparing plans for future financing or may help the sales manager in determining the selling price to be placed on a new product by providing suitable data. Generally management accounting Information is used in three important management functions: l) control 2) co–ordination 3) planning.
4 Cost Accounting: The Industrial Revolution in England posed a challenge to the development of accounting as a tool of industrial management. This necessitated the development of costing techniques as guides to management action. Cost accounting emphasizes the determination and the control of costs.
It is concerned primarily with the cost of manufacturing processes. In addition one of the principal functions of cost accounting is to assemble and interpret cost data, both actual and prospective for the use of management–in controlling current operations and in planning for the future.
All of the activities described above are related to accounting and in all of them the focus is on providing accounting information to enable decisions to be made.
USERS OF ACCOUNTING INFORMATION
There are several groups of people who are interested in the accounting information relating to the business enterprise. Following are some of them:
1 Shareholders: Shareholders as owners are interested in knowing the profitability of the business transactions and the distribution of capital in the forms of assets and liabilities. In fact accounting developed several centuries ago to supply information to those who had invested their funds in business enterprise.
2 Management: With the advent of joint stock company form of organisation the gap between ownership and management widened. In most cases the shareholders act merely as renters of capital and the management of the company passes into the hands of professional managers. The accounting disclosures greatly help them in knowing about what has happened and what should be done to improve the profitability and financial position of the enterprise.
3 Potential Investors: An Individual who is planning to make an investment in a business would like to know about its profitability and financial position. An analysis of the financial statements would help him in this respect.
4 Creditors: As creditors have extended credit to the company, they are much worried about the repaying capacity of the company. For this purpose they require its financial statements an analysis of which will tell about the solvency position of the company.
5 Government: Any popular Government has to keep a watch on big businesses regarding the manner in which they build business empires without regard to the interests of the Community. Restricting monopolies is something that Is common even in capitalist countries. For this, it is necessary that proper accounts are made available to the Government. Also, accounting data are required for collection of sales–tax, income–tax, excise duty, etc.
6 Employees: Like creditors, employees are interested in the financial statements in view of various profit sharing and bonus schemes, Their interest may further increase when they hold shares of the companies in which they are employed.
7 Researchers: Researchers are interested in interpreting the financial statements of the concern for a given objectives.
8 Citizens: Any citizen may be interested in the accounting records of business enterprises including public utilities and Government companies as a voter and tax payer.
THE PROFESSION OF ACCOUNTING
Accounting can very well be viewed as a profession with stature comparable to that of law or medicine or engineering. The rapid development of accounting theory and technique especially after the late thirties of this century has been accompanied by an 'expansion of the career opportunities in accounting and an increasing number of professionally trained accountants. Among the factors contributing to this growth have been the increase in number, size and complexity of business enterprises, the imposition of new and increasingly complex taxes and other governmental restrictions on business operations.
Coming to the nature of accounting function, it is no doubt a service function. The chief of accounting department holds a staff position which is quite in contradistinction to the roles played by production or marketing executives who hold line authority. The role of the accountant is advisory in character. Although accounting is a staff function performed by professionals within an organisation, the ultimate responsibility for the generation of accounting information, whether financial or managerial rests with management. That is why one of the top officers of many businesses is the controller. The controller is the person responsible for satisfying other managers' demands for management accounting information and for complying with the regulatory demands of financial reporting. With these ends in view, the controller employs accounting professionals in both management and financial accounting. These accounting professionals employed in a particular business firm are said to be engaged in private accounting. Besides there are
also accountants who render accounting services on a fee basis through staff accountant employed by them. These accountants are said to be engaged in
public accounting.
SPECIALISED ACCOUNTINGFIELDS
As in many other areas of human activity, a number of specialized fields in accounting also have evolved besides financial accounting, management accounting and cost accounting as a result of rapid technological advances and accelerated economic growth. The most important among them are explained below:
1 Tax Accounting: Tax accounting covers the preparation of tax returns and the consideration of the tax implications of proposed business transaction on alternative courses of action. Accountants specializing in this branch of accounting are familiar with the tax administrative regulations and court decisions on tax cases.
2 International Accounting: This accounting is concerned with the special problem associated with the international trade of multinational business organisations. Accountants specializing in this area must be familiar with the influences that custom, law and taxation of various countries bring to bear on international operations and accounting principles.
3 Social Responsibility Accounting: This branch is the newest field of accounting and is the most difficult to describe concisely. It owes its birth to increasing social awareness which has been particularly noticeable over the last two decades or so. Social responsibility accounting is so called because it not only measures the economic effects of business decisions but also their social effects, which have previously been considered to be immeasurable. Social responsibilities of business can no longer remain as a passive chapter in the text books of commerce but are increasingly coming under greater scrutiny. Social workers, people welfare organisations and consumer protection societies all over the world have been drawing the attention of all concerned towards the social effects of business decisions. The management is being held responsible not only for efficient conduct of business as reflected by Increased profitability also for what it contributes to social well being and progress.
4 Inflation Accounting: Inflation has now become a world–wide phenomenon. The consequences of inflation are dire in case of developing and under developed countries. At this juncture when financial statements or reports are based on historical costs, they would fail to reflect the effect of changes in purchasing power on the financial position and profitability of the firm. Thus the utility of the accounting records not taking care of price level changes is seriously lost. This imposes a demand on the accountants for adjusting financial accounting for inflation to know the real financial position and profitability of a concern and thus, emerged a further branch of accounting called inflation accounting or accounting for price level changes. It is a system of accounting which regularly records all items in financial statements at their current values. The system recognizes the fact that the purchasing power of money is decreasing day–by–day due to Inflation and reveals profit or loss or states the financial position of the business on the basis of the current prices prevailing in the economy.
5 Human resources Accounting: Human Resources Accounting is yet another new field of accounting which seeks to report and emphasise the importance of human resources in a company's earning process and total assets.
It is based on the general agreement that the only real long lasting asset which an organisation possesses is the quality and calibre of the people working in it. This system of accounting is concerned with" the process of identifying and measuring data about human resources and communicating this information to interested parties."
4. REVISION POINTS
Language of Business: Accounting is the language of business.
Accounting: Accounting is the art of recording, classifying, summarizing and interpreting business transactions.
Accounting to an information system: As an information system accounting provides operating information, financial accounting information, management accounting information and cost accounting information.
Accounting is a service function: Accounting function is a service function. The role of accountant is advisory in character.
Tax Accounting: Deals with preparation of tax returns and analyses tax implications.
International Accounting: Concerned with the special problems associated with the international trade of multi – national business organisations.
Social responsibility accounting: This branch of accounting measures the social effects of business decisions.
Inflation Accounting: This system of accounting regularly records all items in financial statements at their current values.
Human resources accounting: The importance of human resources in a company's earning process and total assets is reported in this kind of accounting.
5. INTEXT QUESTIONS
1) Why accounting is called the language of business?
2) What are the functions of accounting?
3) Accounting as a social science can be viewed as an information system. Examine.
4) Distinguish between Public accounting and private accounting.
5) Is accounting a staff function or line function? Explain with reasons.
6) Give an account of the various branches of accounting.
7) "Accounting is a service function' Discuss this statement in the context of a modern manufacturing business.
8) Distinguish between Financial Accounting and Management Accounting.
6. SUMMARY
Accounting is rightly called the "language of business". It is as old as money itself. It is concerned with the collecting, recording, evaluating and communicating the results of business transactions. Initially meant to meet the needs of a relatively few owners, it gradually expanded its function to a public role of meeting the needs of a variety of interested parties. Broadly speaking all citizens are affected by accounting in some way. Accounting as an information system possesses all the three features of a system. Accounting is also viewed as a profession with accountants engaging in private and public accounting. As in many other areas, of human activity a number of specialised fields in accounting also have evolved as a result of rapid changes in business and social needs.
7. TERMINAL EXERCISES
1. Accounting is a:
a. Language of business
b. Used by investors, government and non-profit organisations.
c. Both a. and b.
d. All of the above.
2. Financial Accounting information is:
a. A summary of historical events.
b. The result obtained from inexact and appropriate measures.
c. Enhanced by management explanation.
d. None of the above.
3. Management Accounting information is irrelevant to the:
a. Competitors
b. Chief Executive officer.
c. Chief Financial Officer.
d. Creditor.
8. SUPPLEMENTARY MATERIALS
Websources
http://acct.tamu.edu/giroux/history.html
http://en.wikipedia.org/wiki/Accountancy
9. SUGGESTED READING/REFERENCE BOOKS/SET BOOKS
1) Antony and Reece: 'Accounting Principles', Richard D. Irwin, Inc. Home wood, Illinois.
2) Fess/Warren: 'Financial Accounting', South Western Publishing Company, Ohio.
3) Shukia, M.C. & T.S. Grewal: Advanced Accounts, S. Chand & Company,
New Delhi.
10. KEYWORDS
Language of Business: Accounting is the language of business.
Accounting: Accounting is the art of recording, classifying, summarizing and interpreting business transactions.
Accounting to an information system: As an information system accounting provides operating information, financial accounting information, management accounting information and cost accounting information.
Accounting is a service function: Accounting function is a service function. The role of accountant is advisory in character.
Tax Accounting: Deals with preparation of tax returns and analyses tax implications.
International Accounting: Concerned with the special problems associated with the international trade of multi – national business organisations.
Social responsibility accounting: This branch of accounting measures the social effects of business decisions.
Inflation Accounting: This system of accounting regularly records all items in financial statements at their current values.
Human resources accounting: The importance of human resources in a company's earning process and total assets is reported in this kind of accounting.
LESSON – 2
FINANCIAL ACCOUNTING – BASIC POSTULATES,
CONVENTIONS AND CONCEPTS
1. INTRODUCTION
Since accounting is the language to communicate business information, it should be made to convey the same meaning to all people as far as practicable. This requires that the accounting language should be made standard. To make it standard certain accounting principles, concepts, conventions and standards have been developed over a period of time. These accounting principles, by whatever name they are called, serve as a general law or rule that is to be used as a guide to action.
2. OBJECTIVES
After reading this lesson the student should be able to:
• understand the nature of accounting principles
• appreciate the importance of accounting principles
• develop an understanding of the various accounting concepts and
• conventions
• realise the need for accounting standards developed by IASC and ICAI
3. CONTENT
Nature and meaning of accounting principle
Accounting concepts
Accounting conventions
Accounting Standards and International Accounting
Standards Committee
India and Accounting Standards
NATURE AND MEANING OF ACCOUNTING PRINCIPLE
What is an accounting principle or concept or convention or standard? Do they mean the same thing? Or Does each one had its own meaning? These are all questions for which there is no definite answer because there is ample confusion and controversy as to the meaning and nature of accounting principle. We do not want to enter into this controversial discussion because the reader may fall a prey to the controversies and confusions and lose the spirit of the subject.
The rules and conventions of accounting are commonly referred to as principles. The American institute of Certified public Accountants have defined the accounting principle as "a general rule adopted or professed as a guide to action: a settled ground or basis' of conduct on practice. It may be noted that (he definition describes the accounting principle as a general law or rule that is to be used as a guide to action.
The peculiar nature of accounting principles is that they are man–made. Unlike the principles of physics, chemistry etc., they were not deducted from basic axiom. Instead they have evolved. Since the accounting principles are man made they cannot be static and are bound to change in response to the changing needs of the society. It may be stated that accounting principles are changing but the change in them is permanent.
Accounting principles are judged on their general acceptability to the makers and users of financial statements and reports. They represent a generally accepted and uniform view of the accounting profession in relation to good accounting practice and procedures. Hence the name generally accepted accounting principles.
Accounting principles, rules of conduct and action are described by various terms such as concepts conventions, doctrines, tenets, assumptions, axioms postulates etc. But for our purpose we shall use all these terms synonymously except for a little difference between the two terms concepts and conventions. The term "concept' is used to connote accounting postulates i.e. necessary assumptions or conditions upon which accounting is based. The term convention is used to signify customs or traditions as guide to the preparation of accounting statements.
The Financial Accounting Standards Board (FASB) is currently the dominant body in the development of accounting principles.
ACCOUNTING CONCEPTS
The important accounting concepts are discussed here under:
1 Business entity concept: It is generally accepted that the moment a business enterprise is started it attains a separate entity as distinct from the persons who own it.
This concept is extremely useful in keeping business affairs, strictly free from the effect of private affairs of the proprietors. In the absence of this concept the private affairs and business affairs are mingled together in such a way that the true profit or loss of the business enterprise cannot be ascertained nor its financial position. To quote an example if the proprietor has taken Rs.5000/– from the business for paying house tax for his residence, the amount should be deducted from the capital contributed by him. Instead if it is added to the other business expenses then the profit will be reduced by Rs.5000/ and also his capital more by the same amount. This affects the results of the business and also its financial positions. Not only this since the profit is lowered, the consequential tax payment also will be less which is against the provisions of the Income tax Act.
2 Going Concern Concept: This concept assumes that unless there is valid evidence to the contrary a business enterprise will continue to operate for a fairly long period in the future. The significance of this concept is that the accountant while valuing the assets of the enterprise does not take into account their current resale values as there is no immediate expectation of selling it. Moreover, depreciation on fixed assets is charged on the basis of their expected lives rather than on their market values.
When there is conclusive evidence that the business enterprise has a limited life the accounting procedures should be appropriate to the expected terminal date of the enterprise. In such cases, the financial statements should clearly disclose the limited life of the enterprise and should be prepared from the quitting concern point of view rather than from a 'going concern' point of view.
3 Money Measurement Concept: Accounting records only those transactions which can be expressed in monetary terms. This feature is well emphasized in the two definitions on accounting as given by the American Institute of Certified Public Accountants and American Accounting Principles Board. The importance of this concept is that money provides a common denomination by means of which heterogeneous facts about a business enterprises can be expressed and measured in a much better way. For e.g. when it is stated that a business owns Rs. 1,00,000 cash, 500 tons of raw materials, 10 machinery items, 3000 square meters of land and building etc., these amounts cannot be added together to produce a meaningful total of what the business owns. However, by expressing these items in monetary terms Rs 1,00,000 cash Rs 5,00,000 worth of raw materials, Rs 10,00,000 worth of machinery items and Rs 30,00,000 worth of land and building – such an addition is possible.
A serious limitation of this concept is that accounting does not take into account pertinent non–monetary items which may significantly affect the enterprise. For instance accounting does not give information about the poor health of the President, serious misunderstanding between the production and sales manager etc., which have serious bearing on the prospects of the enterprise. Another limitation of this concept is that money is expressed in terms of its value at the time a transaction is recorded in the accounts. Subsequent changes in the purchasing power of money are not taken into account.
4 Cost Concept: This concept is yet another fundamental concept of accounting which is closely related to the going concern concept. As per this concept:
i) an asset is ordinarily entered in the accounting records at the price paid to acquire it i.e., at its cost and ii) this cost is the basis for all subsequent accounting for the asset.
The implication of this concept is that the purchase of an asset is recorded in the books at the price actually paid for it irrespective of its market value. For e.g. if a business buys a building for Rs.3,00.000 'the asset would be recorded in the books at Rs.3.00,000' even if its market value at that time happens to be Rs.4,00,000. However this concept does not mean that the asset will always be shown at cost. This cost becomes the basis for all future accounting for the asset. It means that the asset may systematically be reduced in its value by charging depreciation. The significant advantage of this concept is that it brings in objectivity in the preparations and presentation of financial statements. But like the money measurement concept this concept also does not take into account subsequent changes in the purchasing power of money due to inflationary pressures. This is' the reason for the growing importance of inflation accounting.
5 Dual aspect concept: This concept is the core of accounting. According to this concept every business transaction has a dual aspect. This concept is explained in detail below:
The properties owned by a business enterprise are referred to as assets and the rights or claims to the various parties against the assets are referred to as equities. The relationship between the two may be expressed in the form of an equation as follows;
Equities = Assets
Equities may be subdivided into two principal types: the rights of creditors and the rights of owners. The rights of creditors represent debts of the business and are called liabilities. The rights of the owners are called capital. Expansion of the equation to give recognition to the two types of equities results in the following which is known as the accounting equation:
Liabilities + Capital = Assets
It is customary to place 'liabilities' before 'capital' because creditors have priority in the repayment of this claims as compared to that of owners. Sometimes greater emphasis is given to the residual claim of the owners by transferring liabilities to the other side of the equation as:
Capital = Assets – Liabilities
All business transactions, however simple or complex they are result in a change in the three basic elements of the equation. This is well explained with the help of the following series of examples:
i) Mr.Prasad commenced business with a capital of Rs.30, 000. The result of this transaction is that the business being a separate entity gets cash–an asset of Rs.30, 000 and has to pay to Mr. Prasad Rs.30, 000 him capital. This transaction can be expressed in the form of the equation as follows:
Capital = Assets
Prasad 30000 Cash 30000
ii) Purchased furniture for Rs.5000: The effect of this transaction is that cash is reduced by Rs.5, 000 and a new asset viz furniture worth Rs.5, 000 comes in thereby rendering no change in the total assets of the business. The equation after this transaction will be:
(iii) Borrowed Rs.20, 000 from Mr.Gopal: As a result of this transaction both the sides of the equation increase by Rs.20, 000 –cash balance is increased and a liability to Mr.Gopal is created. The equation will appear as follows:
Liabilities + Capital = Assets
Creditors + Prasad = Cash + Furniture
20,000 + 30,000 = 45,000 + 5,000
(iv) Purchased goods for cash Rs.30, 000: This transaction does not affect the liabilities side total nor the asset side total. Only the composition of the total assets changes i.e. cash is reduced by Rs.30, 000 and a new asset viz. stock worth Rs.30, 000 comes in. The equation after this transaction will be as follows:
Liabilities + Capital = Assets
Creditors + Prasad = Cash + Stock + Furniture
20,000 + 30,000 = 15,000+30,000 + 5,000
(v) Goods worth Rs.10, 000 are sold on credit to Mr.Ganesh for Rs. 12,000. The result is that stock is reduced by Rs.10,000 a new asset namely debtor (Mr.Ganesh) for Rs. 12,000 comes into picture and the capital of Mr.Prasad increases by Rs.2,000 as the profit on the sale of goods belongs to the owner. Now the accounting equation will look as under:
Liabilities + Capital = Assets
Creditors + Prasad = Cash + Debtors + Stock + Furniture
20,000 + 32,000 = 15,000 + 12,000 + 20,000 + 5,000
(vi) Paid electricity charges Rs.300: This transaction reduces both the cash balance and Mr. Prasad’s capital by Rs.300. This is so because the expenditure reduces the business profit which in turn reduces the owner's equity. The equation after this will be:
Liabilities + Capital = Assets
Creditors + Prasad = Cash + Debtors + Stock + Furniture
20,000 + 31,700= 14,700 + 12,000 + 20,000 + 5,000
Thus it may be seen that whatever is the nature of transaction, the accounting equation always tallies and should tally.
The system of recording transactions based on this concept is called double entry system.
6 Accounting period concept: In accordance with the going concern concept it is usually assumed that the life of a business is indefinitely long. But owners and other interested parties cannot wait until the business has been wound up for obtaining information about its results and financial position. For e.g. if for ten years no accounts have been prepared and if the business has been consistently incurring losses, there may not be any capital at all at the end of the tenth year which will be known only at that time. This would result in the compulsory winding up of the business. But if at frequent intervals information are made available as to how things are going then corrective measures may be suggested and remedial action may be taken. That is why, Pacioli wrote as early as in 1494: "frequently accounting makes for long friendship". This need leads to the accounting period concept.
According to this concept accounting measures activities for a specified interval of time called the accounting period. For the purpose of reporting to various interested parties one year is the usual accounting period. Though Pacioli wrote that books should be closed each year especially in a partnership, it applies to all types of business organisations.
7 Periodic matching of costs and revenues: This concept is based on the accounting period concept. It is widely accepted that desire of making profit is the most important motivation to keep the proprietors engaged in business activities. Hence a major share of attention of the accountant is being devoted towards evolving appropriate techniques for measuring profits. One such technique is periodic matching of costs and revenues.
In order to ascertain the profits made by the business during a period, the accountant should match the revenues of the period with the costs (expenses) of that period. By 'matching' we mean appropriate association of related revenues and expenses pertaining to a particular accounting period. To put it in other words, profits made by a business in a particular accounting period can be ascertained only when the revenues earned during that period are compared with the expenses incurred for earning that revenue. The question as to when the payment was actually received or made is irrelevant. For e.g. in a business enterprise which adopts calendar year as accounting year, if rent for December 1989 was paid in January 1990, the rent so paid should be taken as the expenditure of the year 1989, revenues of that year should be matched with the costs incurred for earning that revenue including the rent for December 1989, though paid in January 1990. It is on account of this concept that adjustments are made for outstanding expenses, accrued incomes, prepaid expenses etc. while preparing financial statements at the end of the accounting period.
The system of accounting which follows this concept is called as mercantile system. In contrast to this there is another system of accounting called as cash system of accounting where entries are made only when cash is received or paid, no entry being made when a payment or receipt is merely due.
8 Realization Concept: Realization refers to Inflows of cash or claims to cash like bills receivables, debtors etc. arising from the sale of assets or rendering of services. According to realization concept, revenues are usually recognized in the period in which goods were sold to customers or in which services were rendered. Sale is considered to be made at the point when the property in goods passes to the buyer and he becomes legally liable to pay. To illustrate this point, let us consider the case of A, a manufacturer who produces goods on receipt of orders. When an order is received from B, A starts the process of production and delivers the goods to B when the production is complete. B makes payment on receipt of goods. In this example, the sale will be presumed to have been made not at the time of receipt of the order but at the time when goods are delivered to B. But there are certain exceptions to this aspect of the concept Two among them are:
(i) Sale on hire purchase basis wherein the ownership of the goods passes to the hire purchaser only when the last hire is paid but still sales are presumed to have been made to the extent of installments received and installments outstanding; and
(ii) Contract accounts – though the contractor is liable to pay only when the whole contract is complete as per terms of the contract, yet the profit is calculated on the basis of work certified year after year according to certain accepted accounting norms.
A second aspect of the realization concept is that the amount recognized as revenues is the amount that is reasonably certain to be realized. However, lot of reasoning has to be applied to ascertain as to how certain 'reasonably certain' is. Yet, one thing is clear, that is, the amount of revenue to be recorded may be less than the sales value of the goods sold and services rendered. For e.g. when goods are sold at discount, revenue is recorded not at the list price but at the amount at which sale is made. Similarly, It is on account of this aspect of the concept that when sales are made on credit though entry is made for the full amount of sales, the estimated amount of bad debts is treated as an expense and the effect on net income is the same as if the revenue were reported as the amount of sales minus the estimated amount of bad debts. For instance, if a businessman makes credit sales ofRs.50,000/– during a period and if the estimated amount of bad debts is Rs.2500, revenue is reported as Rs.50,000 and there is a bad debt expense of Rs.2,500. The effect on net income is the same as if the revenue were reported as Rs.47, 500.
ACCOUNTING CONVENTIONS
1 Convention of Conservatism: It is a world of uncertainty. So it is always better to pursue the policy of playing safe. This is the principle behind the convention of conservatism. According to this convention the accountant must be very careful while recognizing increases in an enterprise's profits rather than recognizing decreases in profits. For this the accountants have to follow the rule, anticipate no profit but provide for all possible losses' while recording business transactions. It is on account of this convention that the inventory is valued 'at cost or market price whichever is less', i.e., when the market price of the Inventories has fallen below its cost price it is shown at market price i.e., the possible loss is provided and when it is above the cost price it is shown at the cost price i.e., the anticipated profit is not reduced. It is for the same reason that provision for bad and doubtful debts, provision for fluctuation in investments, etc, are created. This concept affects principally the current assets.
The main function of accounting is to provide correct and full information about the business enterprise. But this is affected by the convention of conservatism as pointed out by the critics of this convention. They argue that it encourages the accountant to build secret reserves by resorting to excess provision for bad and doubtful debts etc. as a result of which not only the Income is affected but also the financial state of affairs of the business. Further it is also against the convention of full disclosure about which we are going to see right now.
2 Convention of full disclosure: The emergence of joint stock company form of business organisation resulted in the divorce between ownership and management. This necessitated the full disclosure of accounting Information about the enterprise to the owners and various other interested parties. Thus it became the 'convention of full disclosure' is very important. By this convention it is implied that accounts must be honestly prepared and all material information must be adequately disclosed therein. But it does not mean that all information that someone desires are to be disclosed in the financial statements. It only implies that there should be adequate disclosure of information which is of considerable importance to owners, investors, creditors. Governments, etc. In Sachar Committee Report (1978) it has been emphasized that openness in Company affairs is the best way to secure responsible behaviour. It is in accordance with this convention that Companies Act, Banking Companies Regulation Act, Insurance Act etc., have prescribed performance of financial statements to enable the concerned companies to disclose sufficient information. The practice of appending notes relative to various facts on items which do not find place in financial statements is also in pursuance to this convention. The following are some examples:
(a) Contingent liabilities appearing as a note
(b) Market value of investment appearing as a note
(c) Schedule of advances in case of banking companies.
3 Convention of Consistency: According to this concept it is essential that accounting procedures, practices and methods should remain unchanged from one accounting period to another. This enables comparison of performance in one accounting period with that in the past. For e.g. if material Issues are priced on the basis of FIFO method the same basis should be followed year after year. Similarly, if depreciation is charged on fixed assets according to diminishing balance method it should be done in subsequent year also. But consistency never implies inflexibility as not to permit the Introduction of improved techniques of accounting. However if Introduction of a new technique results in inflating or deflating the figures or profit as compared to the previous periods, the fact should be well disclosed in the financial statement.
4 Convention of Materiality: The implication of this convention is that accountant should attach importance to material details and ignore insignificant ones. In the absence of this distinction accounting will unnecessarily be overburdened with minute details. The question as to what is a material detail and what is not is left to the discretion of individual accountant. Further an item which is material for one purpose may become Immaterial for another. According to American Accounting Association, an item should be regarded as material if there is reason to believe that knowledge of it would influence the decision of informed investor'. Some examples of material financial information are: fall in the value of stock, loss of markets due to competition, change in the demand pattern due to change in Government regulations etc. Examples of insignificant financial information are: ignoring of paise while preparing company financial statement, rounding of income to nearest ten for tax–purposes etc. Sometimes if it is felt that an immaterial item must be disclosed, the same may be shown as footnotes or in parenthesis according to its relative importance.
ACCOUNTING STANDARDS AND INTERNATIONAL ACCOUNTING
STANDARDS COMMITTEE
The information revealed by the published financial statements is of considerable Importance to shareholders, creditors and other interested parties. Hence it is the responsibility of the accounting profession to ensure that the required information is properly presented. If the accountants present the financial information using their own discretion and in their own way, the information may not be valid and hence may not serve the purpose. There is, therefore, the urgent need that certain standards should be followed for drawing up the financial statements so that there is the minimum possible –ambiguity and uncertainty about the information contained in them. The International Accounting Standards Committee (IASC) has undertaken this task of drawing up the standards.
The IASC was established in 1973. It has its headquarters at London.
At present, the IASC has two classes of membership:
(a) Founder members, being the professional accounting bodies of the following nine countries:
Australia
Canada
France
Germany
Japan
Mexico
Netherlands
U.K. and Ireland*
U.S.A.
* treated as one country for this purpose.
(b) Members, being accounting bodies from countries other than the nine above which seek and are granted membership.
The need for an IAS Programme has been attributed to three factors:
The growth in international investment: Investors in international capital markets are to make decisions based on published accounting which are based on accounting policies and which again vary from country to country. The International Accounting Statements will help investors to make more efficient decisions.
The increasing prominence of multinational enterprises: Such enterprises render accounts for the countries in which their shareholders reside in local country in which they operate. Accounting standards will help to avoid confusion.
The growth in the number of accounting standard setting bodies: It is hoped that the IASC can harmonise these separate rule making efforts. The objective of the IASC is "to formulate and publish in the public interest standards to be observed in the presentation of audited financial statements and to promote their world–wide acceptance and observance". The formulation of such standards will bring uniformity in terminology, procedure, method, approach and presentation of results. Since its inception, the IASC has so far issued 26 International Accounting Statements.
INDIA AND ACCOUNTING STANDARDS
The Institute of Chartered Accountants of India (ICAI) and the Institute of Cost and Works Accountants of India (ICWAI) are associate members of the IASC. But the enforcement of the standards issued by the IASC has been deferred in our country. Instead, the ICAI is drawing up its own standards. The Accounting Standards Board (ASB) which was established by the council of the ICAI In 1977 is formulating accounting standards so that such standards will be established by the council of the ICAI. So far the following eleven standards have been issued:
– AS–1: Disclosure of Accounting Policies
– AS–2: Valuation of Inventories
– AS–3: Changes in Financial Position
– AS–4: Contingencies and Events Occurring After the
Balance Sheet Data
– AS–5: Prior Period and Extraordinary Items and
Changes in Accounting Policies
– AS–6: Depreciation Accounting
– AS–7: Accounting for Construction Costs
– AS–8 : Accounting for Research and Development
– AS–9 : Revenue Recognition
– AS–10: Accounting for Fixed Costs
– AS–11: Accounting for foreign exchange transactions
The ICAI has issued a mandate to its members to adopt uniform accounting system for the corporate sector w.e.f. 1/4/91 in view of the fact that the International Accounting Standards are being followed all over the world and so, the auditor of companies will now insist on compliance of these mandatory accounting standards.
4. REVISION POINTS
i. Business Entity Concept
ii. Going Concern Concept
iii. Cost Concept
iv. Money Measurement Concept
v. Duality Concept
vi. Accounting Period Concept
vii. Matching Concept
viii. Realisation Concept
ix. Convention of Conservatism
x. Convention of Full Disclosure
xi. Convention of Consistency
xii. Convention of Materiality
xiii. Convention of Objectivity
5. INTEXT QUESTIONS
1. What are accounting concepts and conventions? Is there any difference between them?
2. What is the significance of dual aspect concept?
3. Explain money measurement concept.
4. Write a short note on Accounting Standards
5. What is the position in India regarding the formulation and enforcement of accounting standards?
6. SUMMARY
Accounting information should be made standard to convey the same meaning to all interested parties. To make it standard certain accounting principles, concepts, conventions and standards have been developed over a period of time. These accounting principles, by whatever name they are called, serve as a general law or rule that is to be used as a guide to action. Without accounting principles, accounting information becomes incomparable. Inconsistent and unreliable. The FASB is developing accounting principles. The IASC is another professional body which is engaged in the development of accounting standards. The ICAI is an associate member of the IASC and ASB started by the ICAI is formulating accounting standards in our country.
7. TERMINAL EXERCISES
1. Omission of paise and showing round figures in financial statements is based on -----
a. Conservatism concept
b. Consistency concept
c. Materiality concept
d. Realization concept
e. Cost concept
2. Under which of the following concepts are shareholders treated as creditors for the amount they paid on the shares they subscribed to?
a. Cost Concept
b. Duality concept
c. Business Entity Concept
d. Going concern concept
e. Since the shareholders own the business, they are not treated as creditors.
3. Sales are recognized as income:
a. At the point of sale or at the performance of a service.
b. After the expiry of the credit period allowed to debtors.
c. After the money collected from the debtors.
4. Matching principle results from the
a. Accounting period principle
b. Duality principle
c. Historical cost principle
8. SUPPLEMENTARY MATERIAL
Web Resources:
www.moneyinstructor.com/lesson/accountingconcepts.asp
www.tutor2u.net/business/accounts/accounting_conventions_concepts.htm
9. ASSIGNMENT
The Warren Buffet Investment Club’s board is composed of six students from a new school of management. These six members are usually the most active members of the club and take care of the management of the student’s pool of funds. These members complete a full qualitative and quantitative analysis of a chosen industry, and finally, recommend a company each, from 10 different industries. The project is concluded with the completion of an investment recommendation and final presentation.
This year, the students selected for the committee were Jackson, Veerabhadraiah, Venu Madhav , Namrata and Manu. So, the goal of the team was clear-that they wanted to invest in companies that were successful and were expected to be successful in the future. During the discussion, various ideas were suggested for identifying the industries, such as industries with successful products, industries with cheap raw materials costs, industries with less competition and industries with high-technology inputs.
Prepare a set of five decisive factors (not measures) that you would use while selecting the 10 industries in which to invest. Give supporting reasons for each of the factors.
10. FURTHER READINGS
1) Antony and Reece, “Accounting Principles”, Richard D.Irwin. INC Homewood, Illinois.
2) Das Gupta, N. “Accounting Standards”, Indian and International, Sultan Chand & Sons, New Delhi.
3) M.C Shukla X.T.S 'General, Advanced Accounts', S.Chand & Co. Delhi.
11. LEARNING ACTIVITIES
1. Briefly explain the circumstances under which each one of the following bases are used for recognition of revenue:
a. Upon delivery to the buyer,
b. Upon collection of the entire selling price,
c. In proportion of collections made,
d. Upon the completion of the entire work, and
e. In proportion of the work completed.
2. What inspires an account to:
a. Value stock at the end at market price or cost price, whichever is less.
b. Ignore the market value of fixed assets, and
c. Make provision for doubtful debt in advance of the actual bad debts?
12. KEY WORDS
Accounting Principles: It denotes necessary assumptions upon which accounting is based.
Accounting Convention: It signifies customs or traditions as guide to the preparation of accounting statements.
Business entity concept: The business enterprise is distinct from the persons who own it.
Going concern concept: A business enterprise will ordinarily continue to operate for a fairly long period in the future.
Money measurement concept: Accounting records only those transactions which can be expressed in monetary terms.
Cost concept: An asset is ordinarily entered in the accounting records at the price paid to acquire it.
Dual aspect concept: This is the core concept. According to this every business transactions has a dual aspect.
Accounting period concept: Accounting means activities for a specified Interval of time called the accounting period.
Periodic matching of costs and revenues: To ascertain the profits made by the business during a period, revenues of the period should be matched with the costs of that period.
Realization concept: Revenues are usually recognized in the period in which goods were sold to customers or in which services were rendered.
IASC: International Accounting Standards Committee.
FASB: Financial Accounting standards Board.
ABB: Accounting standards Board.
LESSON – 3
ACCOUNTING CYCLE – RECORDING, SUMMARISING,
INTERPRETING AND REPORTING
1. INTRODUCTION
During the accounting period the accountant records transactions as and when they occur. At the end of each accounting period the accountant summarizes the Information recorded and prepares the Trial Balance to ensure that the double entry system has been maintained. When the recording aspect has been made as complete and upto–date as possible, the accountant prepares financial statements reflecting the financial positions and the results of business operations. The success of the accounting process can be judged from the responsiveness of financial reports to the needs of the users of accounting information.
2. OBJECTIVES
After reading this lesson the student should be able to:
• understand the rules of debit and credit
• apply the rules of debit and credit in journalizing the transactions
• prepare ledger accounts and balance them
• prepare a trial balance
• realise the importance of adjustment entries and closing entries
3. CONTENT
The account
Debit and credit
The ledger
Journal
The trial balance
Closing entries
Adjustment entries
Preparation of financial statements
Interpretation of financial statements
The accounting process consists of three major parts:
i) the recording of business–transactions, during the period;
ii) the summarizing of information at the end of the period and
iii) the reporting and interpreting of the summary information
The success of the accounting process can be judged from the responsiveness of financial reports to the needs of the users of accounting information.
THE ACCOUNT
The transactions that take place in a business enterprise during a specific period may effect Increases and decreases in assets, liabilities, and capital, revenue and expense items. To make upto–date information available when needed and to be able to prepare timely periodic financial statements, it is necessary to maintain a separate record for each item. For e.g. it is necessary to have a separate record devoted exclusively to record increases and decreases in cash, another one to record Increases and decreases in supplies, a third one to machinery, etc. The types of record that is traditionally used for this purpose is called an account. Thus an account is a statement wherein Information relating to an item or a group of similar items are accumulated. The simplest form of an account has three parts;
i) a title which give the name of the item recorded in the account.
ii) a space for recording increases in the amount of the item and
iii) a space for recording decreases in the amount of the item.
This form of an account known as a T account, because of its similarity to the letter T is illustrated below.
Title
Left side (Debit Side) Right side (Credit side)
1 Kinds of Accounts
Accounts are of various types as shown below:
Rules for Debit and Credit or Rules of Double Entry System
Sr. No. Kind of Account Debit Credit
1 Personal Accounts The Receiver The Giver
2 Real Accounts What comes in What goes out
3 Nominal Accounts Expenses and Losses Incomes and Gains
DEBIT AND CREDIT
The left–hand side of any account is called the debit side and the right–hand side is called the credit side. Amounts entered on the left hand side of an account, regardless of the title of the account, are called debits and the amounts entered on the right hand side of an account are called credits. To debit (Dr–) an account means to make an entry on the left–hand side of an account and to credit (Cr.) an account means to make an entry on the right– hand side. The words debit and credit have no other meaning in accounting, though in common parlance; debit has a negative connotation, while credit has a positive connotation.
Double entry system of recording business transactions is universally followed. In this system for each transaction the debit amount must equal the credit amount. If not, the recording of transactions is incorrect. The equality of debits and credits is maintained in accounting simply by specifying that the left side of asset accounts is to be used for recording increases and the right side to be used for recording decreases, the right side of a liability and capital accounts is to be used to record increases and the left side to be used for recording decreases. The account balances when they are totalled, will then conform to the two equations:
1. Assets = Liabilities + Owners equity
2. Debits = Credits
From the above arrangement we can state the rules of debits and credits are as follows:
Debit signifies Credit signifies
1. Increase in asset accounts 1. Decrease in asset accounts.
2. Decrease in liability accounts 2. Increase in liability accounts
3. Decrease in owners equity accounts 3. Increase in owners equity accounts
From the rule that credit signifies increase in owners equity and debit signifies decreases in it, the rules of revenue accounts and expense accounts can be derived. While explaining the dual aspect concept in an earlier lesson we have seen that revenues increase the owners equity as they belong to the owners. Since owners equity accounts increases on the credit side, revenue must be credits. So, if the revenue accounts are to be decreased they must be debited. Similarly, we have seen that expenses decrease the owners equity. As owners equity accounts decrease on the debit side expenses must be debits. Hence to increase the expenses accounts they must be debited and to decrease it they must be credited. From the above we can arrive at the rules for revenues and expenses as follows:
Debit signifies Credit signifies
Increase in expenses Decrease in expenses
Decrease in revenues Increase in revenues
JOURNAL
When a business transaction takes place the first record of it is done in a book called journal. The journal records all the transactions of a business in the order in which they occur. The journal may therefore be defined as a Chronological records of accounting transaction. It shows names of accounts that are to be debited or credited, the amounts of the debits and credits and any additional but useful information about the transaction. A journal does not replace but precedes the ledger. A proforma of a journal is given in illustration 4.5.1.
Illustration 1
Journal
Date Particulars L.F. Débit Crédit
1994 Cash a/c (Dr.) 3 30,000
August 2 To Sales a/c (Cr.) 9 30,000
In the illustration 1, the debit entry is listed first, the debit amount appears in the left–hand amount column; the account to be credited appears below the debit entry and is indented and the credit amount appears in the right–hand amount column. The data in the journal entry are transferred to the appropriate accounts in the ledger by a process known as posting. Any entry in any account can be made only on the basis of a journal entry. The column L.F. which stands for ledger folio gives the page number of accounts in the ledger wherein posting for the journal entry has been made. After all the journal entries are posted in the respective ledger accounts, each ledger account is balanced by subtracting the smaller total from the bigger total. The resultant figure may be either debit or credit balance depending upon which total, debit or credit is bigger. If debit total is bigger the account will show a debit balance and vice–versa.
Thus the transactions are recorded first of all in the journal and then they are posted to the ledger. Hence the journal is called the book of original or prime entry and the ledger is the book of second entry. While the journal records transactions in a chronological order, the ledger records transactions in an analytical order.
THE LEDGER
A ledger is a set of accounts. It contains all the accounts of a specific business enterprise. It may be kept in any of the following two forms:
I. Bound ledger and
II. Loose Leaf Ledger
A bound ledger is kept in the form of book which contains all the accounts. These days it is common to keep the ledger in the form of loose–leaf cards. This helps in posting transactions particularly when mechanized system of accounting is used.Example:
Dr. Cash A/c Cr.
Date Particulars JF Amount Date Particulars JF Amount
To Capital a/c 3,000 By Purchases 2,000
To Sales a/c 1,200 By Salaries a/c 210
To Receivables a/c 1,300 By Balance c/d 3,340
To Interest 50
5,550 5,550
THE TRIAL BALANCE
The Trial Balance is simply a list of the account names and their balances as on a given time with debit balances in one column and credit balances in another column. It is prepared to ensure that the mechanics of the recording and posting of the transactions have been carried out accurately. If the recording and posting have been accurate then the debit total and credit total in the Trial Balance must tally thereby evidencing that an equality of debits and credit has been maintained. It also serves as a basis for preparing the financial statements. In this connection it is but proper to caution that mere agreement of the debit and credit totals in the Trial Balance is not conclusive proof of account recording and posting. There are many errors which may not affect the agreement of Trial Balance like total omission of a transaction, posting the right amount on the right side but of a wrong account etc.
The points which we have discussed so far can very well be explained with the help of the following simple illustration (Illustration 2).
Illustration 2
January 1 — Started business with Rs.3000
January 2 — Bought goods worth Rs.2000
January 9 — Received order for half of the good from 'G'
January 12 — Delivered the goods, G invoiced Rs. 1300
January 15 — Received order for remaining half of the total
goods purchased.
January 21 — Delivered goods and received cash Rs. 1200
January 30 — G makes payment
January 31 — Paid salaries Rs. 210
— Received interest Rs.50
Let us now analyse the transactions one by one.
January 1–Started business with Rs.3000
The two accounts Involved are cash and owners equity. Cash, an asset increases and hence it has to be debited. Owners' equity, a liability also increases and hence it has to be credited.
January 2–Bought goods worth Rs.2000
The two accounts affected by this transaction are cash and goods (purchases). Cash balance decreases and hence it is credited and goods on hand, an asset. Increases hence it is to be debited.
January 9 – Received order fox half of goods from ‘G'
No entry is required as realization of revenue will take place only when goods are delivered (Realization concept).
January 12 –Delivered the goods, 'G’ invoiced Rs.1300
This transaction affects two accounts–Goods (Sales) a/c and Receivables a/c. Since it is a credit transaction receivables increase (asset) and hence is to be debited. Sales decreases goods on hand and hence Goods (Sales) a/c is to be credited. Since the term 'goods' is used to mean purchase of goods and sale of goods, to avoid confusion purchase of goods is simply shown as Purchases a/c and Sale of goods as Sales a/c.
January 15 –Received order for remaining half of goods.
No entry.
January 21 –Delivered goods and received cash Rs.1200
This transaction affects cash a/c and Sale a/c. Since cash is realized, the cash balance will increase and hence cash accounts is to be debited. Since the stock of goods becomes Nil due to sale. Sales a/c is to be credited (as asset in the form of goods on hand has reduced due to sales).
January 30 – ‘G' makes Payment
Both the accounts affected by this transaction are asset accounts–cash and receivables. Cash balance Increases and hence it is to be debited and receivables balance decreases and hence it is to be credited.
January 31 –Paid Salaries Rs.210
Because of payment of salaries cash balance decreases and hence cash account is to be credited. Salary is an expense and since expense has the effect of reducing owners' equity and as owners' equity account decreases on the debit side, expenses account is to be debited.
January 31 –Received Interest Rs.50
The receipt of Interest Increases cash balance and hence cash a/c is to be debited. Interest being revenue which has the effect of increasing the owners' equity, it has to be credited as owners equity account increases on the credit side.
When journal entries for the above transactions are passed, they would be as follows:
Date Particulars L.F Debit Credit
January –1 Cash a/c
Capital a/c (Dr)
(Cr) 3000
3000
January –2 Purchase a/c
Cash a/c (Dr)
(Cr) 2000
2000
January – 12 Receivables a/c
Sales a/c (Dr)
(Cr) 1300
1300
January – 21 Cash a/c
Sales a/c (Dr)
(Cr) 1200
1200
January – 30 Cash a/c
Receivables a/c (Dr)
(Cr) 1300
1300
January – 31 Salaries a/c
Cash a/c (Dr)
(Cr) 210
210
January – 31 Cash a/c
Interest a/c (Dr)
(Cr) 50
50
Now the above journal entries are posted into respective ledger accounts which in turn are balanced.
Debit Cash a/c Credit
Capital a/c 3,000 Purchases 2,000
Sales a/c 1,200 Salaries a/c 210
Receivables a/c 1,300 Balance 3,340
Interest 50
5,550 5,550
Dr. Capital a/c Cr.
Balance 3,000 Cash 3,000
Dr. Purchases a/c Cr.
Cash a/c 2,000 Balance 2,000
Dr. Receivable a/c Cr.
Sales a/c 1,300 Cash 1,300
Dr. Sales a/c Cr.
Balance 2,500 Receivable a/c 1,300
Cash a/c 1,200
2,500 2,500
Dr. Salaries a/c Cr.
Cash a/c 210 Balance 210
Dr. Interest a/c Cr.
Balance 50 Cash a/c 50
Now a Trial Balance can be prepared and when prepared it would appear as follows:
Trial Balance
Date Name of the Ledger Account LF Amount (Rs.)
Debit Credit
Cash
Purchases
Salaries
Capital
Sales
Interest
3340
2000
210
5550
3000
2500
50
5550
CLOSING ENTRIES
Periodically, usually at the end of the accounting period, all revenue account balances are transferred to an account called Income Summary or Profit and Loss. account and are then said to be closed. (A detailed discussion on Profit and Loss account can be had in a subsequent chapter). The balance in the Profit and Loss account, which is the net income or net loss for the period, is then transferred to the capital account and thus Profit and Loss account is also closed. In the case of corporation the net Income or net loss is transferred to retained earnings account which is a part of owner's equity. The entries which are passed for transferring these accounts are called as closing entries. Because of this periodic closing of revenue and expense accounts, they are called as temporary or nominal accounts whereas assets, liabilities and owners equity accounts, the balances of which are shown on the balance sheet and are carried forward from year to year are called as permanent or real accounts.
The principle of framing a closing entry is very simple. If a account is having a debit balance then it is credited and the Profit and Loss account is debited. Similarly if a particular account is having a credit balance, it is closed by debiting it and crediting the Profit and Loss account.
In our example Sales account and interest account are revenues and Purchases account and Salaries account are expenses. Purchases account is an expense because the entire goods have been sold out in the accounting period itself and hence they become cost of goods sold out. This aspect would become more clear when the reader proceeds to the Chapter on Profit and Loss account. The closing entries would appear as follows:
(1) Profit and Loss a/c (Dr) 2,210
Salaries a/c (Cr) 210
Purchases a/c (Cr) 2,000
(2) Sales a/c (Dr) 2,500
Profit and Loss a/c (Cr) 2,500
(3) Interest a/c (Dr) 50
Profit and Loss a/c (Cr) 50
Now Profit and Loss a/c. Retained Earnings a/c and Balance Sheet can be prepared which would appear as follows:
Dr. Profit and Loss Account Cr.
Purchases a/c 2,000 Sales a/c 2,500
Salaries a/c 210 Interest a/c 50
Retained Earnings a/c 340
2,550 2,550
Dr. Retained Earnings a/c Cr.
Balance a/c 340 Profit and Loss a/c 340
340 340
Dr. Balance Sheet Cr.
Cash 3,340 Profit and Loss a/c 3,000
Retained Earnings 340
3,340 3,340
ADJUSTMENT ENTRIES
Because of the adoption of accrual accounting, after the preparation of Trial Balance, adjustments relating to he accounting period have to be made in order to make the financial statements complete. These adjustments are needed for transactions which have not been recorded but which affect the financial position and operating, results of the business. They may be divided into four kinds: two in relation to revenues and the other two in relation to expenses. The two in relation to revenue are:
(i) Unrecorded Revenues: i.e. income earned for the period but not received in cash. For e.g. interest for the last quarter of the accounting period is yet to be received though fallen due. The adjustments entry to be passed is:
Accrued interest a/c (Dr)
Interest a/c (Cr)
(ii) Revenues Received in Advance: i.e. income relating to next period received in the current accounting period, e.g. rent received in advance. The adjustment entry is:
Rent a/c (Dr)
Rent received in advance a/c (Cr)
The two relating to expenses are:
(i) Unrecorded Expenses: i.e. expenses were incurred during the period but no record of them as yet been made. e.g. Rs.500 wages earned by an employee during the period remaining to be paid. The adjustment entry would be:
Wages a/c (Dr)
Accrued wages a/c (Cr)
(ii) Prepaid Expenses: i.e., expenses relating to the subsequent period paid in advance in the current accounting period. An example which frequently cited is insurance paid in advance. The adjustment entry would be:
Prepaid Insurance a/c (Dr)
Insurance a/c (Cr)
In the above four cases unrecorded revenues and prepaid expenses are assets and hence debited (as debit may signify increase in assets) and revenues received in advance and unrecorded expenses are liabilities and hence credited (as credit may signify increase in liabilities).
Besides the above four adjustments, some more are to be done before preparing the financial statements. They are:
1) Inventory at the end.
2) Provision for Depreciation.
3) Provision for Bad Debits.
4) Provision for Discount on receivables and payables.
5) Interest on capital and Drawings.
PREPARATION OF FINANCIAL STATEMENTS
Now everything is set ready for the preparation of financial statements for the accounting period and as on the last day of the accounting period.
GAAP require that three such reports be prepared:
(i) A Balance Sheet
(ii) A Profit and Loss Account (or) Income Statement
(iii) A Fund Flow Statement
INTERPRETATION OF FINANCIAL STATEMENTS
Financial statements as such do not convey the requisite information. They must be suitably analyzed and interpreted so as to elicit quality information for managerial decision – making.
A detailed discussion on these three financial statements including their interpretation follow in the succeeding chapters.
4.REVISION POINTS
i. JOURNAL
ii. LEDGER
iii. TRIAL BALANCE
iv. FINANCIAL STATEMENT
5.INTEXT QUESTIONS
1) Explain the following:
i. A Journal
ii. An Account
iii. A Ledger
2) Bring out relationship between a journal and a ledger.
3) Explain the significance of Trial Balance.
4) Why adjustments entries are necessary?
5) Narrate the rules of debit and credit.
6) Distinguish nominal accounts from real accounts.
7) Explain the mechanism of balancing an account.
8) How and why closing entries are made?
9) The following transactions relate to a business concern for the month of March 1994. Journalize them, post into ledger accounts, balance and prepare the Trial Balance.
March 1 – Started business with a capital of Rs. 9000.
March 2 – Purchased furniture Rs. 300
March 3 – Purchased goods Rs. 6000.
March 11 – Received order for half–of goods from ‘C’
March 15 – Delivered goods, 'C' Invoiced Rs. 4000.
March 17 – Received order for the remaining half of goods.
March 21 – Delivered goods, cash received Rs. 3800.
March 31 – Paid wages Rs. 300.
10) Enter the following transactions in Journal post them into ledger accounts, balance the ledger accounts and prepare the Trial Balance:
1994 July I Mr. S. Aravanan commenced his business with the following assets:
June 1. Plant and Machinery 2, 50,000
2. 65,000 90,000
3. Stock 65,000
4. Cash 5,000
July 2. Sold goods to Mr. K.C. Rao 40,000
3. Bought goods from Mr. N. Rao 65,000
4. Mr.K.C. Rao paid cash 25,000
5. Returned damaged goods to Mr. N. Rao 1,800
10. Paid Mr. N. Rao on account 28,200
15. Bought goods from Mr–Annamalai 54,000
17. Sold goods to Mr. Rajagopal 75,000
20. Mr. D. Rajagopal returned damaged goods 2,000
20. Received cash from Mr. Rajagopal in full
settlement 72,500
25. Paid Mr. Annamalai 36,000
26. Bought Typewriter 6,000
27. Received commission 1,000
31. Paid Salaries 7,500
31. Paid rent 2,500
31. Deposited into U.Co. Bank 5,000
6.SUMMARY
The following steps are involved in the accounting cycle:
1. The first and most important part of the accounting process is the analysis of the transactions to decide which account is to be debited and which account is to be credited.
2. Next comes Journalizing the transactions i.e. recording the transactions in the journal.
3. The journal entries are posted into respective accounts in the ledger and the ledger accounts are balanced.
4. At the end of the accounting period, a Trial Balance is prepared to ensure equality of debits and credits.
5. Adjustment and closing entries are made to enable the preparation of financial statements.
6. As a last step financial statements are prepared.
These six steps taken sequentially complete the accounting process during an accounting period and are repeated in each subsequent period.
7.TERMINAL EXERCISE
1 XYZ Ltd. paid wages of Rs. 8,000 for erection of machinery. The journal entry for the transaction is ---------------
a. Debit wages and Credit cash
b. Debit machinery and Credit cash
c. Debit wages and Credit erection charges
d. Debit machinery and Credit erection charges
e. Debit wages and Credit machinery account
2.Which of the following is true ?
a. The payment of a liability causes an increase in owners’ equity
b. The collection of an account receivable will cause total assets to increase
c. The accounting equation may be stated as: Assets + Liabilities = Owners’ equity
d. The purchase of an asset such as office equipment, either for cash or on credit, does not change the owners’ equity
3.Goods returned by customers is entered by ----------------
a. Debit purchases a/c; Credit customers a/c
b. Debit customers a/c; Credit sales a/c
c. Debit sales return a/c; Credit customers a/c
d. Debit customers a/c; Credit goods a/c
e. Debit purchases a/c; Credit sales a/c
8. SUPPLEMENTARY MATERIALS
Web Resources
www.indialedger.com
www.accountingweb.com
9. ASSIGNMENTS
Visit the Website of 2 companies of your choice and find out the Profit and Loss account of the company, the same should be analyzed for the entries made. You should identify each account.
10. SUGGESTED READING
1) Gupta, R.L. and M. Radhaswamy, Advanced Accounts, Vol.1, Sultan Chand & Sons, New Delhi.
2) Shukla, M.C. & T.S. Grewal, Advanced Accounts. S.Chand & Company,
New Delhi.
11.KEY WORDS
Account: It is a statement wherein information relating to an item or a group of similar items are accumulated.
Debit: Debit signifies increase in asset accounts, decrease in liability accounts and decrease in owners equity accounts.
Credit: Credit signifies decrease in asset accounts, increase in liability accounts and increase in owners equity accounts.
Double Entry System: In this system which is universally followed for each transaction the debit amount must equal the credit amount.
Ledger: A ledger is a set of accounts of a specific business enterprise.
Journal: Journal is a book in which the first record of business transactions is done in a chronological order.
Trial Balance: The Trial Balance is simply a list of the balances of accounts as of a given moment of time with debit balances in one column and credit balances in another column.
Closing Entries: These are the entries which are passed for transferring the revenue accounts to Profit and Loss account.
Adjustment Entries: These are the entries which are passed for transactions which have been recorded but which affect the financial position and operating results of the business.
LESSON – 4
FINANCIAL STATEMENTS – I PROFIT AND LOSS ACCOUNT
1 INTRODUCTION
Ascertainment of the periodic income of a business enterprise is perhaps the foremost objective of the accounting process. This objective is achieved by the preparation of profit and loss account or the income statement. Profit and loss account is generally considered to be of greatest interest and importance to end–users of accounting information. Usually the profit and loss account is accompanied by the balance sheet as on the last date of the accounting period for which the profit and loss account is prepared.
2.OBJECTIVES
After reading this lesson the student should be able to:
• understand the meaning of income and expense
• prepare a Profit and Loss account
• appreciate the linkage between Profit and Loss account and Balance Sheet.
• understand the various methods of inventory valuation
3.CONTENT
Basic ideas about income and expense
Form and presentation of Profit and Loss account/ Income Statement.
Explanation of items on the Income Statement
Statement of Retained Earnings
Relationship between Balance Sheet and Income Statement.
Concepts underlying Profit and Loss Account
Depreciation of Fixed Assets
Profit and loss account is generally considered to be of greatest interest and importance to end–users of accounting information. Whereas the balance sheet enable them to know the financial position of the business enterprise as of a particular date, the profit and loss account enables them to find out whether the business operations have been profitable or not during a particular period. The important distinctions which one needs to make between the balance sheet and the income statement is that the balance sheet is on a particular date while the profit and loss account is for a particular period. It is for this reason that the balance sheet is categorized as a status report (as on a particular date) while the profit and loss account as a flow report (for a particular period). Usually the profit and loss account is accompanied by the balance sheet as on the last date of the accounting period for which the profit and loss account is prepared.
BASIC IDEAS ABOUT INCOME AMD EXPENSE
Income statement (or) profit and loss account consists of two elements: One reports the inflows that result from the sale of goods and services to customers which are called as revenues. The other reports the outflows that were made in order to generate these revenues; these are called as expenses. Income is the amount by which revenues exceed expenses. The term "net income" is used to indicate the excess of all the revenues over all the expenses. The basic equation is:
Revenues – Expenses = Net Income
1 Relation Between Income and Owners' Equity: The net income of an accounting period increases owners equity because it belongs to the owner. This was already explained in lesson 3 under "dual aspect concept". To quote the same example goods costing Rs. 10,000 are sold on credit for Rs. 12,000. The result is that stock is reduced by Rs. 10,000 a new asset namely debtor for Rs. 12.000 is created and the total assets increased by the difference Rs.2, 000. Because of the dual aspect concept we know that the equity side of the balance sheet would also increase by Rs.2, 000 and the increase would be in owners equity because the profit on sale of goods belongs to the owner. It is clear from the above example that income increases the owners equity.
2 Income is not the same as Receipt: Income of a period Increases the owners equity but it need not result in increase in cash balance. Loss of a period decreases owners equity but it need not result in decrease in cash balance. Similarly increase in cash balance need not result in increased income and owners equity and decrease in cash balance need not denote loss and decrease in owners equity. All these are due to the fact that income is not the same as cash receipt. The following examples make clear the above point:
i. When goods costing Rs. 10,000 are sold on credit for Rs. 12,000 it results in an income of Rs.2, 000 but the cash balance does not increase.
ii. When goods costing Rs.9, 000 are sold on credit for Rs.7, 000 there is a loss of Rs.2, 000 but there is no– corresponding decrease in cash.
iii. When a loan of Rs.3, 000 is borrowed the cash balance increases but there is no impact on income.
iv. When a loan of Rs.3, 000 is repaid it decreases only the cash balance and not the income.
3 Expenses: An expense is an item of cost applicable to an accounting period. It represents economic resources consumed during the current period. When an expenditure is incurred the cost involved is either an asset or an expense. If the benefits of the expenditure relate to future periods it is an asset. If not. It is an expense of the current period. Over the entire life of an enterprise, most expenditure become expenses. But according to accounting period concept accounts are prepared for each accounting period. Hence we get the following four types of transactions relating to expenditure and expenses.
Expenditures that are also expenses: This is the simplest and most common type of transaction to account for. If an item, is acquired during the year it is expenditure. If the item is consumed in the same year then the expenditure becomes expense. E.g. raw materials purchased are converted into saleable goods and are sold in the same year.
Assets that become expenses: When expenditures incurred result in benefits for the future period they become assets. When such assets are used in subsequent years they become expenses of the year in which they are used. For e.g. inventory of finished goods are assets at the end of a particular accounting year. When they are sold in the next accounting year they become expenses.
Expenditures that are not expenses: As already pointed out when the benefits of the expenditure relate to future periods they become assets and not expenses This applies not only to fixed assets but also to inventories which remain unsold at the end of the accounting year. For e.g. the expenditure incurred on Inventory remaining unsold is asset until it is sold out.
Expenses not yet paid. Some expenses would have been incurred in the accounting year but payment for the same would not have been made within the accounting year. These are called as accrued expenses and are shown as liabilities at the year end.
FORM AND PRESENTATION OF PROFIT AND LOSS ACCOUNT/INCOME STATEMENT
In practice there is considerable variety in the formats and degree of detail used in income statements. The profit and loss account is usually prepared in "T' shape. The following (Illustration 6–A) is the summarized profit and loss account of a distillery.
Illustration
Pondicherry Distilleries Ltd.
Profit and Loss Account for the year ended 31st March...
Dr. Cr.
Rs. in ‘000
Cost of goods sold 47,42 Sales (Schedule XIII) 1,59,22
Establishment Expenses (Schedule IX} 34,14 Interest (Schedule XV) 2,13
Maintenance Expenses (Schedule X) 17,97 Miscellaneous Receipts (Schedule XVI) 1,86
Administrative and Other Expenses (Schedule XI) 3,17 Profit on sale of assets 31
Depreciation 15,45
Provision for Taxation 21,09
Net Profit 24,28
1,63,52 1,63,52
In the "T" shaped profit and loss account expenses are shown on the left hand side i.e., the debit side and revenues are shown on the right hand side i.e., the credit side. Net profit or loss is the balancing figure.
The profit and loss account can also be presented in the form of a statement when it is called as income statement. There are two widely used forms of income statement: single step form and multiple–step form.
The single – step form of Income statement derives its name from the fact that the total of all expenses is deducted from the total of all revenues. Illustrations 6–A can be presented in the single–step form as given in illustration 6–B.
Illustration
Pondicherry Distilleries Ltd.
Income statement for the year ended 31st March
(Rs. in '000)
Revenues
Net Sales (Schedule XIII) 1,59,22
Interest (Schedule XV) 2,13
Miscellaneous Receipts (Schedule XVI) 1,86
Profit on Sale of assets 31 1,63,52
Expenses
Cost of goods sold 47,42
Establishment Expenses (Schedule IX) 34,14
Maintenance Expenses (Schedule X) 17,97
Administrative and other Expenses (Schedule XI) 3,17
Depreciation 15,45
Provision for Taxation 21,09 1,39,24
Net Income 24,28
The single–step form has the advantage of simplicity but it is inadequate for analytical purpose.
The multi–step form income statement is so called because of its numerous sections, sub–sections and intermediate balances. Illustrations 6–C is a typical proforma of multi–step income statement.
Illustration
Proforma of a Multiple–step Income Statement
Gross sales XXX
Less Sales returns XXX
Net sales XXX
Less Cost of goods sold Raw material Cost
Opening Stock of Raw Material XXX
Add: Purchase of Raw Material XXX
Freight XXX
Raw material available XXX
Less: Closing stock of raw material XXX
Raw material consumed XXX
Direct Labour Cost XXX
Manufacturing Expenses XXX
Total Production Cost XXX
Add: Opening work–in–progress XXX
Total XXX
Less: Closing work–in–progress XXX
Cost of goods manufactured XXX
Add: Opening Finished goods XXX
Cost of goods available for sale XXX
Less: Closing Finished Goods XXX
Cost of Goods sold XXX
Gross Profit XXX
Less Operating Expenses
Administrative Expenses XXX
Selling and Distribution expenses XXX XXX
Operating Profit XXX
Add Non–operating Income
(Such as dividends, interest received etc.) XXX
XXX
Less Non–Operating Expenses
(such as discount on issue of shares written off,
loss on sale of assets etc.) XXX
Profit (or) Earnings Before Interest and Tax (EBIT) XXX
Less: Interest XXX
Profit (or) Earnings Before Tax (EBT) XXX
Less: Provision for Income–Tax XXX
Net Profit (or) Earnings After Tax (EBT) XXX
Earnings Per share of Common stock XXX
The multiple–step form of illustration 6–C would be as given under illustration 6–D.
Illustration
Pondicherry Distilleries Ltd.
Income Statement for the Tear ended 31st March...
(Rs. in '000)
Net Sales (Schedule XIII) 1, 59, 22
Less Cost of goods sold 47, 42
Gross Profit 1, 11, 80
Less Operating Expenses
Establishment Expenses (Schedule IX) 34, 14
Maintenance Expenses (Schedule X) 17, 97
Administrative and Other Expenses (Schedule XI) 3, 17
Depreciation 15, 45 70, 73
Operating Profit 41, 07
Add Non–Operating Income
Interest (Schedule XV) 2, 13
Miscellaneous receipts (Schedule XVI) 1, 86
Profit on sale of assets 31 4, 30
Profit or Earnings Before Tax (EBT) 45, 37
Less: Provision for Income–Tax 21, 09
Net Profit or Earnings After Tax (EAT) 24, 28
__________________________________________________________________________________
The advantage of multiple–step form of income statement over single–step form and the "T' shaped profit and loss account is that there are a number of significant sub totals on the road to net income which lend themselves for significant analysis.
Income statements prepared for use by the managers of an enterprise usually contains more detailed information than that shown in the above illustrations.
EXPLANATION OF ITEMS ON THE INCOME STATEMENT
The heading of the income statement must show:
i. the business enterprise to which it relates (Pondicherry Distilleries Ltd.)
ii. the name of the statement (income statement)
iii. the time period covered (year ended 31st March of the relevant year)
The balance sheet and income statement are generally followed by various schedules that give detailed account of the items, listed on them. Information about these schedules are given against each item on the financial statements.
Statement is to disclose the major source of revenue and to separate it from miscellaneous sources. For most companies the major source of revenue is the sale of goods and services.
Sales Revenue: An income statement often reports several separate items in the sales revenue section, the net of which is the net sales figure. For e.g. the Pondicherry Distilleries income statement might have shown:
Rs.
Gross Sales 1,59,21,806
Less: Sales Returns XXX
1,59,21,806
Since there are no sales returns, gross sales and net sales are one and the same.
Gross Sales: Gross sales is the total invoice price of the goods sold or services rendered during the period. It should not include sales taxes or excise duties that may be charged to the customers. Such taxes are not revenues but rather represent collections that the business makes on behalf of the government and are liabilities to the government until paid. To illustrate Pondicherry Distilleries sales shows as follows:
Schedule XIII – Sales
Rs.
Total Turnover 4,10,76,127
Less: Excise duty 2,51,54,321
Sales (Gross) 1,59,21,806
In the income statement, sales is shown at Rs. 1, 59, 21,806 only i.e., after deduction of excise duty. Similarly, postage, freight or other items billed to the customers at cost are not revenues. These items do not appear in the sales figure but instead are an onset to the costs the company incurs for them.
Sales returns and Allowances: These items represent the sales values of goods that were returned by customers or allowance made to customers because the goods were defective. The amount can be subtracted from the sales figure directly without showing it as a separate item on the income statement. But it is always better to show them separately.
Sales Discounts: Sometimes called as cash discounts sales discount are the amount of discounts allowed to customers for prompt payment. For e.g. if a business offers a 3% discount to customers who pay within 7 days from the date of the invoice and it sells Rs.20,000 of goods to a customer who takes advantage of this discount the business receives only Rs. 19,400 in cash and records the balance Rs.600 as sales discount. There is another kind of discount called as trade discount which is given by the wholesaler or manufacturer to the retailers to enable them to sell at catalogue price and make a profit: e.g. List less 40 percent. Trade discount does not appear in the accounting records at all.
Miscellaneous or Secondary Sources of Revenues: These are revenues earned from activities not associated with the sale of the enterprise's goods and services. Interest or dividends earned on marketable securities, royalties, rents and gains on disposal of assets are examples of this type of revenues. For e.g. in the case of Pondicherry Distilleries one of the miscellaneous receipts is rent from staff quarters amounting to Rs. 14,592 out of the total of Rs. 1,86,359. These revenues are called as non–operating income.
Cost of Goods sold: When income is increased by the sale value of goods or services sold, it is also decreased by the cost of these goods or services. The cost of goods or services sold is called the cost of sales. In manufacturing firms and retailing business it is often called the cost of goods sold. The complexity of calculation of cost of goods sold varies depending upon the nature of the business. In the case of a trading concern which deals in commodities it is very simple to calculate the cost of goods sold and it is done as follows:
Opening Stock XXX
Add: Purchase XXX
Freight XXX
Goods available for sale XXX
Less: Closing stock XXX
Cost of goods sold XXX
when a number of products are manufactured because it involves the calculation of the work in progress and valuation of inventory. The methods of valuation of inventory are explained separatel0y at the end of this chapter. The cost of goods sold as shown in the income statement of the Pondicherry Distilleries would have been calculated as follows:
Illustration
Cost of Goods Sold
(Rs.in’000)
Raw Materials Cost:
Opening stock 4, 49
Add Purchase 24, 12
28, 61
Less Closing Stock 8, 06
Raw material consumed 20, 55
Power Fuel 39, 05
59, 60
Add Opening work–in–progress 9
59, 69
Less Closing work–in–progress 17
Cost of goods manufactured 59, 52
Add Opening Furnished Goods 6, 08
Cost of goods available for Sale 65, 60
Less Closing Furnished goods 18, 18
Cost of goods sold 47, 42
Gross Profit: The excess of sales revenue over cost of goods sold is the gross margin or gross profit. In the case of multiple–step income statement it is shown as a separate item. Significant managerial decisions can be taken by calculating the percentage of gross profit on sale. This percentage indicates the average mark up obtained on products sold. The percentage varies widely among industries, but healthy companies in the same industry tend to have similar gross profit percentages.
Operating Expenses: Expenses which are incurred for running the business and which are not directly related to the company's production or trading are collectively called as operating expenses. Usually operating expenses include administration expenses, finance expenses, depreciation and selling and distribution expenses. Administration expenses generally include personnel expenses also.
However sometimes personnel expenses may be shown separately under the heading 'Establishment Expenses' as is done in the case of Pondicherry Distilleries under Schedule IX.
Schedule IX: Establishment Expenses
(Rs. in 'OOO)
Salaries and Wages 24, 27
Bonus and Incentive 4, 67
P.F. Contribution 1, 46
Gratuity 1, 48
Pension 51
Employees Welfare Expenses 1, 75
34, 14
The important methods of providing depreciation are given in a separate section at the end of this chapter.
Until recently most companies included expenses on research and development as part of general and administrative expenses. But nowadays the FASB requires that this amount should be shown separately. This is so because the expenditure on research and development could provide an important clue as to how cautious the company is in keeping its products and services upto date.
Operating Profit: Operating profit is obtained when operating expenses are deducted from gross profit.
Non–operating Expenses: These are expenses which are not related to the activities of the business e.g. loss on sale of asset, discount on shares written off etc. These expenses are deducted from the income obtained after adding other Incomes to the operating profit. Other Incomes or miscellaneous receipts have already been explained. The resultant profit is called as profit (or) earning before interest and tax (EBIT)
Interest Expenses: Interest expense arises when part of the expenses are met from borrowed funds. The FASB requires separate disclosure of interest expense. This item of expense is deducted from income or earnings before interest and tax. The resultant figure is profit (or) earnings before tax (EBT)
Income Tax: The provision for tax is estimated based on the quantum of profit before tax. As per the corporate tax laws the amount of tax payable is determined not on the basis of reported net profit but the net profit arrived at has to be recomputed and adjusted for determining the tax liability. That is why the liability is always shown as a provision.
Net Profit: This is the amount of profit finally available to the enterprise for appropriation. Net profit is reported not only in total but also per share of stock. This per share amount is obtained by dividing the total amount of net profit by the number of shares outstanding. The net profit is usually referred to as profit or earnings after tax. This profit could either be distributed as dividends to shareholders or retained in the business. Just like gross profit percentage, net profit percentage on sales can also be calculated which will be of great use for managerial analysis.
STATEMENT OF RETAINED EARNINGS
The term retained earnings means the accumulated excess of earnings over losses and dividends. The statement of retained earnings is generally included with almost any set of financial statements although it is not considered to be one of the major financial statements. A typical statement of retained earnings starts with the opening balance of retained earnings, the net income for the period as an addition, the dividends as a deduction and ends with the closing balance of retained earnings. The statement may be prepared and shown on a separate sheet or included at the bottom of the income statement. The balance shown by the income statement is transferred to the balance sheet through the statement of retained earnings after making necessary appropriations. This statement thus links the income statement to the retained earning item on the balance sheet. This statement can be prepared in “T” shape also when it is called as Profit and Loss Appropriation Account. Illustration 6–F gives the statement of retained earnings of Pondicherry Distilleries.
Illustration
PONDICHERRY DISTILLERIES LTD
Statement of Retained Earnings
For the Tear Ended 31st March....
(Rs. in '000)
Retained earnings at the beginning of the year 84, 03
Add: Net Income 24, 28
1,08,31
Less: Dividends 4, 50
Retained earning at the end of the year 1, 03, 81
RELATIONSHIP BETWEEN BALANCE SHEET AND INCOME STATEMENT
The amount of net Income reported on the income statement together with the amount of dividends, explains the change in retained earnings between the two balance sheets prepared as of the beginning and end of the accounting period. For e.g. in the balance sheet of Pondicherry Distilleries the retained earnings as on 1st April stood at Rs.84,03,260 whereas it amounted to Rs. 1,03,81,683 in the balance sheet as on 31st March. The reason for this increase is explained in the statement of retained earnings which is a part of income statement. Thus it can be stated that there exists a definite and close relationship between balance sheet and income statement.
CONCEPTS UNDERLYING PROFIT AND LOSS ACCOUNT
As in the case of balance sheet, many concepts are involved to the preparation of income statement also. For example, the income statement is prepared for a particular accounting period. Here the concept involved is accounting period concept. Similarly revenues are recognized to the period to which goods were sold to customers or to which services were rendered. This is to accordance with realization concept. Another concept which has to be followed is the concept of conservatism. It is because of this concept that provision for bad and doubtful debts, provisions for fluctuation to investments. etc. are created. It is to accordance with the concept of consistency that material issues are priced on the basis of the same method year by year and so is the case with depreciation methods.
The simple equation which is followed to ascertain income is Revenues– Expenses = Income and this equation is to accordance with yet another important concept known as concept of periodic matching of costs and revenues.
DEPRECIATION ON FIXED ASSETS
With the passage of time, all fixed assets lose their capacity to render services, the only exception being land. Accordingly a fraction of the cost of the asset is chargeable as an expense in each of the accounting periods in which the asset renders services. The accounting process for this gradual conversion of capitalized cost of fixed assets into expense is called depreciation. Two factors contribute to the decline in the usefulness of fixed assets: One is deterioration, the other is obsolescence. Deterioration is the physical process wearing out whereas obsolescence refers to loss of usefulness due to the development of improved equipment or processes, changes in style or other causes not related to the physical condition of the asset.
The International Accounting Standards Committee defines depreciation as follows: "Depreciation is the allocation of the depreciable amount of an asset over the estimated useful life".
The useful life in turn is defined as:
Useful life is the period over which a depreciable asset is expected to be used by the enterprise."
The depreciable amount is defined as:
"Depreciable amount of a depreciable asset is its historical cost in the financial statements, less the estimated residual value."
Residual value or salvage value is the expected recovery or sales value of the asset at the end of its useful life.
Methods of Depreciation: The amount of depreciation of a fixed asset is determined taking into account the following three factors: its original cost, its recoverable cost at the time it is retired from service and the length of its life. Out of these three factors the only factor which is accurately known is the original cost of the asset. The other two factors cannot be accurately determined until the asset is retired. They must be estimated at the time the asset is placed in service. The excess of cost over the estimated residual value is the amount that is to be recorded as depreciation expense during the asset's lifetime. There are no hard and fast rules for estimating either the period of usefulness of an asset or its residual value at the end of such period. Hence these two factors which are inter– related are affected to a considerable extent by management policies.
The following four frequently used methods of computing depreciation.
i) Straight line method.
ii) Units of production method.
iii) Diminishing balance method.
iv) Sum–of–the–years–digits method.
It is not necessary that an enterprise employ a single method of calculating depreciation for all classes of its depreciable assets. But in accordance with the convention of consistency, once a method of depreciation is selected the same method should be followed throughout.
4.REVISION POINTS
Profit and Loss Account: Summarizes the revenues and expenses of a business enterprise for an accounting period.
Cost of goods sold: Opening stock + Purchase + Freight – Closing stock
Gross Profit: Excess of sales revenue over cost of goods sold
Depreciation: The allocation of the depreciable amount of an asset over the estimated useful life.
5. INTEXT QUESTIONS
1) What is an expenditure? When it becomes an expense?
2) What is income? Can we say that an increase in owners' equity is always due to generation of income?
3) Does a substantial balance in retained earnings indicate the presence of a large cash balance? Explain.
4) Explain the important methods of depreciation.
5) Explain the concepts underlying the preparation of Profit and Loss account.
6) Distinguish the following:
i. Gross Profit.
ii. Operating Profit.
iii. Earnings before interest and tax.
iv. Earnings after tax.
7) 'Depreciation is a process of valuation of fixed assets'– Do you agree with this statement Discuss.
8) Bring out the relationship between the following:
i. Owners' equity and income.
ii. Profit and Loss account and Balance Sheet.
9) Distinguish between cash discount and trade discount.
10) Bring out a distinction between:
i. Straight line method and Diminishing value methods of depreciation.
ii. FIFO and LIFO methods of inventory valuation.
6. SUMMARY
The profit and loss account or income statement summarizes the revenues and expenses of a business enterprise for an accounting period. The information on the income statement is regarded by many to be more important than information on the balance sheet because the income statement reports the results of operations and enables to analyse the reasons for the enterprises' profitability or lack thereof. A close relationship exists between income statement and balance sheet; the statement of retained earnings which is a concomitant of income statement explains the change in retained earnings between the balance sheets prepared at the beginning and the end of the period.
7. TERMINAL EXERCISE
3. What is P& L A/c
4. What are expenses?
5. What do you understand by Net Profit?
6. What is Non operating expenses?
7. The profit and Loss Account is a summary of __________ and ___________ for an accounting period.
8. Expenses result in ________ of the owner(s) equity.
8. SUPPLIMENTORY MATERIAL
Web Resources
www.bizhelp24.com/accounting/profit_and _lass_account.html
http://encyclopedia.laborlawtalk.com/profit_and_lass_account
9. SUGGESTED READINGS
Gupta, R.L. and M. Radhaswamy, Advanced Accounts, Vol. I, Sultan Chand & Sons. New Delhi.
ShukIa, M.C. and T.S. Grewal, Advanced Accounts, S.Chand & Company, New Delhi.
10. ASSIGNMENTS
Collect the Profit and Loss Account of any organisation for two consecutive years. Based on the same answer the following:
1. Discuss the significant changes that had happened in the companies income statement during the second financial year.
2. What is the important reason for the company seeing an increase in its financial profits in the second year, as compared to the first year?
11. KEYWORDS
Status Report: Position on a particular date
Flow Report: Financial position for a particular period
Income: Revenues – Expenses
Expense: Item of cost applicable to an accounting period
Cost of goods sold: Opening stock + Purchase + Freight – Closing stock
Gross Profit: Excess of sales revenue over cost of goods sold
Operating Expenses: Expenses incurred for running the business
Operating profit: Gross profit – Operating expenses
Non operating expenses: Expenses which are not related to the activities of the business.
Net Profit: Amount of profit finally available to the enterprise for appropriation.
Retained Earnings: The term retained earnings means the accumulated excess of earnings over losses and dividends.
Depreciation: The allocation of the depreciable amount of an asset over the estimated useful life.
LESSON – 5
FINANCIAL STATEMENTS – I BALANCE SHEET
1. INTRODUCTION
The basic objective of accounting is to convey information. This is achieved by different financial statements prepared by a business enterprise. One of the most important financial statements is the Balance Sheet. A balance sheet shows the financial position of a business enterprise as of a specified moment of time. That is why it is very often called a statement of financial position. It contains a list of the asset and liabilities and capital of a business entity as of a specified date. Usually at the close of the last day of a month or a year.
2. OBJECTIVES
After reading this lesson the student should be able to:
• understand the conceptual basis of a balance sheet
• comprehend the form and method of presentation of a balance sheet
• classify the different assets and liabilities
• prepare a balance sheet from the given balances of accounts of
• a business enterprise
3. CONTENT
Conceptual basis of a balance sheet
Form and presentation of balance sheet
Accounting concepts underlying the balance sheet
Classification of items in the balance sheet
CONCEPTUAL BASIS OF A BALANCE SHEET
The balance sheet is basically a historical report showing the cumulative effect of past transactions. It is often described as a detailed expression of the following fundamental accounting equation which has already been explained in detail in an earlier chapter:
Assets = Liabilities + Owners' Equity (capital)
Assets are costs which represent expected future economic benefits to the business enterprise. However, the rights to assets have been acquired by the enterprise as a result of past transactions. Liabilities also result from past transactions; they represent obligations which require settlement in the future either by conveying assets or by performing services. Implicit in these concepts of the nature of assets and liabilities is the meaning of owners' equity as the residual interest in the assets of the enterprise.
FORM AND PRESENTATION OF A BALANCE SHEET
Two objectives are dominant in presenting information in a balance sheet. One is clarity and readability; the other is disclosure of significant facts within the framework of the basic assumptions of accounting. Balance sheet classification, terminology and the general form of presentation should be studied with these objectives in mind.
It is proposed to explain the various aspects of the balance sheet with the help of the following typical summarised balance sheet of an Imaginary partnership firm:
Illustration 1
SAU & SONS
Balance Sheet as at 31st December 1993
(Rupees in ‘000)
Assets Liabilities & Capital
Current Assets: Current Liabilities:
Cash 100 Bills payable 700
Bank 200 Creditors 700
Marketable Securities 300 Outstanding Expenses 700
Bills Receivables 300 Income received in advance 100
Debtors 1000 Provision for Income tax 1000
Total current liabilities 3200
Less Provision for Doubtful Debts 100 900
Long-term Liabilities:
Inventory 1200 Mortgage Loan 2000
Prepaid Expenses 300
Total current assets 3300
Investments: Owners Equity:
S’s capital 1000
Long term securities at cost 300 A’s capital 1500
Fixed Assets: U’s capital 2000
Furniture and Fixtures 100 General Reserve 1000
Less Accumulated depreciation 10 90
Plant and Machinery 2000
Less Accumulated depreciation 200 1800
Land 2000
Buildings 2000
Intangible Assets
Patents 210
Trade Marks 100
Goodwill 900
Total Assets 10,700 Total Liabilities and Owners Equity 10,700
2 Conventions of Preparing the Balance Sheet: There are two conventions of preparing the balance sheet –– the American and the English. According to the American convention assets are shown on the left hand side and the liabilities and the owners' equity on the right hand side. Under the English convention just the opposite is followed i.e. assets are shown on the right hand side and the liabilities and owners' equity are shown on the left hand side. In the Illustration 5.3.1 the American convention has been followed.
3 Form of Presenting the Balance Sheet: There are two forms of presenting the balance sheet – account form and report form. When the assets are listed on the left hand side and liabilities and owners equity on the right hand side we get the account form of balance sheet. It is so called because it is similar to an account. An alternative practice is the report form of balance sheet where the assets are listed at the top of the page and the liabilities and owners equity are listed beneath them. In Illustration 5.3.1 we have followed the account form of balance sheet. When the above balance sheet is prepared in report form it will appear as follows:
ASSETS
Current Assets Rs.
Cash 100
Bank 200
Marketable Securities 300
Bills receivables 300
Debtors 1000
Less Provision
For Doubtful Debts 100 900
Inventory 1200
Prepaid Expenses 300
Total current assets 3300
Investments
Long term securities at cost 300
Fixed Assets
Furniture and Fixtures 100
Less accumulated depreciation 10 90
Plant and Machinery 2000
Less accumulated depreciation 200 1800
Land 2000
Buildings 2000
Intangible Assets
Patents 210
Trade marks 100
Goodwill 900
Total Assets 10,700
LIABILITIES & CAPITAL
Current Liabilities
Bills Payable 700
Creditors 700
Outstanding Expenses 700
Income received in advance 100
Provision for Income tax 1000
Total current liabilities 3200
Long Term Liabilities
Mortgage Loan 2000
Owners Equity
S’s capital 1000
A’s capital 1500
U’s capital 2000
General Reserve 1000
Total Liabilities Owner’s Equity 10,700
4 Listing of Items on the Balance Sheet: Assets in balance sheet are generally listed in two ways –
i) According to time i.e. in the order of the degree of ease with which they can be converted into cash or 11) in the order of permanence or according to purpose i.e., in the order of the desire to keep them in use. Some assets cannot be easily classified. For e.g. investments can be easily sold but the desire may be to keep them. Investments may therefore be both liquid and semi–permanent that is why they are shown as a separate item in the balance sheet. Liabilities can also be grouped in two ways either in the order of urgency of payment or in the reverse order. The various assets and liabilities grouped in the two orders will appear as follows:
Order of Liquidity
Assets Liabilities
Cash Bills payable
Bank Creditors
Marketing securities Outstanding expenses
Bills revivable Income received in advance
Debtors Provision for Income–Tax
Inventory Mortgage loan
Prepaid Expenses Debentures
Investments Owner's equity
Owner's equity
Furniture and Fixtures
Plant and Machinery
Land and Buildings
Patents
Trade marks
Good wills
Order of Permanence
Assets Liabilities
Goodwill Owners equity
Trade Marks Debentures
Patents Mortgage loan
Land and Buildings Provision for Income–tax
Plant and Machinery Income received in advance
Furniture and Fixtures Outstanding expenses
Investments Creditors
Prepaid expenses Bills payable
Inventory
Debtors
Bills receivable
Marketable Securities
Bank
Cash
Whatever is the order, it is always better to follow the same order for both assets and liabilities. In the illustration the order of liquidity has been followed.
ACCOUNTING CONCEPTS UNDERLYING THE BALANCE SHEET
In the balance sheet of SAU and Sons under illustration the amounts are expressed in money and reflect only those matters that can be measured in monetary terms. The entity involved SAU and Sons and the balance sheet pertains to that entity rather than to any of the individuals associated with it. The statement assumes that SAU and Sons is a going concern. The asset amounts stated are governed by cost concept. The dual aspect concept is evident from the fact that the assets listed on the left hand side of this balance sheet are equal in total to the liabilities and owners equity listed on the right hand side. Thus in the balance sheet the following five accounting concepts are involved: business entity concept, money measurement concept, going concern concept, cost concept and dual–aspect concept.
CLASSIFICATION OF ITEMS IN THE BALANCE SHEET
Although each individual asset or liability can be listed separately on the balance sheet, it is more practicable and more informative to summarise and group related items into categories called as account classifications. The classifications or group headings will vary considerably depending on the size of the business, the form of ownership, the nature of its operations and the users of the financial statements. For e.g. while listing assets, the order of liquidity is generally used by sole traders, partnership firms and banks whereas joint stock companies by law follow the order of permanence. As a generalization which is subject to many exceptions, the following classification of balance sheet items is suggested as representative.
Assets
Current Assets
Investments
Fixed Assets
Intangible Assets
Other Assets
Liabilities
Current Liabilities
Long term liabilities
Owners Equity
Capital
Retained Earnings
1 Classification of Assets
Current Assets: Current assets are those which are reasonably expected to be realized in cash or sold or consumed during the normal operating cycle of the business enterprise or within one year, whichever is longer. By operating cycle we mean the average period of time between the purchase of goods or raw materials and the realization of cash from the sale of goods or the sale of products produced with the help of raw materials. Current assets generally consists of cash, marketable securities, bills receivables, debtors, inventory and prepaid expenses.
Cash: Cash consists of funds that are readily available for disbursement. It includes cash kept in the cash chest of the enterprise as also cash deposited on call or current accounts with banks.
Marketable securities: These consist of investments that are both readily marketable and are expected to be converted into cash within a year. These investments are made with a view to earn some return on cash that otherwise would be temporarily idle.
Account Receivable: Accounts receivables consist of amounts owed to the enterprise by its consumers. This represents amounts usually arising out of normal commercial transactions. These amounts are listed on the balance sheet at the amount due less a provision for portion that may not be collected. This provision is called as provision for doubtful debts. Amounts due to the enterprise by someone other than a customer would appear under the heading other receivables rather than accounts receivables. If the amounts due are evidenced by written promises to pay, they are listed as bills receivables. Accounts receivables are expected to be realized in cash.
Inventory: Inventory consists of: i) goods that are held in stock for sale in the ordinary course of business, ii) work–in–progress that are to be currently consumed in the production of goods or services to be available for sale. Inventory is expected to be sold either for cash or on credit to customers to be converted into cash. It may be noted in this connection that inventory relates to goods that will be sold in the ordinary course of business. A van offered for sale by a van dealer is inventory. A van used by the dealer to make service calls is not inventory;' it is an item of equipment which is a fixed asset.
Prepaid expenses: These items represent expenses which are usually paid in advance such as rent, taxes, subscriptions and insurance. For e.g., if rent for three months for the building is paid in advance then the business acquires a right to occupy the building for three months. This right to occupy is an asset. Since this right will expire within a fairly short period of time it is a current asset.
Long Term Investments: The distinction between a marketable security shown under current asset and as an investment is entirely based on time factor. Those investments like investments in shares, debentures .bonds etc. that will be retained for more than one year or one operating cycle will appear under this classification.
Fixed Assets: Tangible assets used in the business that are of a permanent or relatively fixed nature are called plant assets or fixed assets. Fixed assets include furniture, equipment, machinery, building and land. Although there is no standard criterion as to the minimum length of life necessary for classification as fixed assets, they must be capable of repeated use and are ordinarily expected to last more than a year. However the asset need not actually be used continuously or even frequently. Items of spare equipments held for use in the event of breakdown of regular equipment or for use only during peak periods of activity are included in fixed assets.
With the passage of time, all fixed assets with the exception of land lose their capacity to render services. Accordingly the cost of such assets should be transferred to the related expense amounts in a systematic manner during their expected useful life. This periodic cost expiration is called depreciation. While showing the fixed assets in the balance sheet the accumulated depreciation as on the date of balance sheet is deducted from the respective assets.
Intangible Assets: While tangible assets are concrete items which have physical existence such as buildings, machinery etc., intangible assets are those which have no physical existence. They cannot be touched and felt. They derive their value from the right conferred upon their owner by possession. Examples are: goodwill patents, copyrights and trademarks.
Fictitious Assets: These items are not at all assets. Still they appear in the asset side simply because of a debit balance in a particular account not yet written off e.g. debit balance in current account of partners, profit and loss account etc.
2 Classifications of Liabilities
Current liabilities: When the liabilities of a business enterprise are due within an accounting period or the operating cycle of the business, they are classified as current liabilities. Most of current liabilities are incurred in the acquisition of materials or services forming part of the current assets. These liabilities are expected to be satisfied either by the use of current assets or by the creation of other current liabilities. The one year time interval or current operating cycle criterion applies to classifying current liabilities also. Current liabilities generally consist of bills payable, creditors, outstanding expenses, income–received in advance, provision for income–tax etc.
Accounts payable: These amounts represent the claims of suppliers related to goods supplied or services rendered by them to the business enterprise for which they have not yet been paid. Usually these claims are unsecured and are not evidenced by any formal written acceptance or promise to pay. When the enterprise gives a written promise to pay money to a creditor for the purchase of goods or services used in the business or the money borrowed then the written promise is called as bills payable or notes payable. Amounts due to financial institutions which are suppliers of funds, rather than of goods or services are termed as short–term loans or some other name that describes the nature of the debt Instrument, rather than accounts payable.
Outstanding expenses: These are expenses or obligations incurred in the previous accounting period but the payment for which will be made in the next accounting period. A typical example is wages or rent for the last month of the accounting period remaining unpaid. It is usually paid in the first month of the next accounting period an4 hence It is an outstanding expense.
Income received in advance: These amounts relate to the next accounting period but received in the previous accounting period. This item of liability is frequently found in the balance sheet of enterprises dealing in the publication of newspapers and magazines.
Provision for Taxes: This is the amount owed by the business enterprise to the Government for taxes. It is shown separately from other current liabilities both because of the size and because the amount owed may not be known exactly as on the date of balance sheet. The only thing known is the existence of liability and not the amount.
Long term Liabilities: All liabilities which do not become due for payment In one year and which do not require current assets for their payment are classified as long–term liabilities or fixed liabilities. Long term liabilities may be classified as secured loans or unsecured loans. When the long–term loans are obtained against the security of fixed assets owned by the enterprise they are called as secured or mortgage loans. When any asset is not attached to these loans they are called as unsecured loans. Usually long–term liabilities include debentures and bonds, borrowings from financial institutions and banks, public debts, etc. Interest accrued on a particular secured long term loan, should be shown under the appropriate sub–heading.
Contingent Liabilities: Contingent liabilities are those liabilities which may or may not result in liability. They become liabilities only on the happening of a certain event. Until then both the amount and the liability are uncertain. If the event happens there is a liability; otherwise there is no liability at all. A very good example for contingent liability is a legal suit pending against the business enterprise for compensation. If the case is decided against the enterprise the liability arises and in the case of favourable decision there is no liability at all. Contingent liabilities are not taken into account for the purpose of totalling of balance sheet.
3 Capital or Owners Equity
As mentioned earlier in this chapter owners equity is the residual interest in the assets of the enterprise. Therefore the owners equity section of the balance sheet shows the amount the owners have invested in the entity. However, the terminology 'owners' equity varies with different forms of organisations depending upon whether the enterprise is a joint stock company or sole proprietorship / partnership concern.
Sole Proprietorship / Partnership Concern: The ownership equity in a sole proprietorship or partnership Is usually reported on the balance sheet as a single amount for each owner rather than distinction between the owner's initial investment and the accumulated earnings retained in the business. For e.g. in a sole–proprietor's balance sheet for the year 1993, the capital account of the owner may appear as follows.
Rs.
Owner's capital as on 1/1/1993 50,000
Add 1993–Proflt 30,000
80,000
Less 1993–Drawlngs 5,000
Owner's capital as on 31/12/1993 75,000
Joint Stock Companies: In the case of Joint stock companies, according to the legal requirements, owners equity is divided into two main categories. The first category called share capital or contributed capital is the amount the owners have invested directly in the business. The second category of owners equity is called retained earnings.
Share capital is the capital stock pre–determined by the company at the time of registration. It may consist of ordinary share capital or preference share capital or both. The capital stock is divided into units called as shares and that is why the capital is called as share capital. The entire predetermined share capital called as authorized capital need not be raised at a time. That portion of authorized capital which has been issued for subscription as of a date is referred to as issued capital.
Retained earnings is the difference between the total earning to date and the amount of dividends paid out to the shareholders to date. That is, the difference represents that part of the total earnings that have been retained for use in the business. It may be noted that the amount of retained earnings on a given date is the accumulated amount that has been retained In the business from the beginning of the Company's existence upto that date. The owners equity Increases through retained earnings and decreases when retained earnings are paid out In the form of dividends.
4. REVISION POINTS
Balance Sheet
Assets
Liabilities
5. INTEXT QUESTIONS
a. What are the accounting concepts involved in a balance sheet?
b. Explain the conceptual basis of a balance sheet.
c. What are the two forms of presenting a balance sheet?
d. Why the joint stock companies follow the order or permanence while listing the assets and liabilities on the balance sheet?
e. What is meant by operating cycle?
f. What is a contingent liability? Why is it not to be included in the total of the balance sheet?
g. Why investments are neither shown under current assets nor under fixed assets?
h. Explain owners, equity. How is it to be presented on the Balance Sheet of a concern?
i. Distinguish with suitable examples the following
a) Fixed assets and current assets
b) Contingent liabilities and current assets.
6. SUMMARY
Balance sheet is one of the most important financial statements which shows the financial position of a business enterprise as of a particular date. It lists as on a particular date, usually at the close of the accounting period, the assets and liabilities and capital of the enterprise. An analysis of balance sheet together with profit and loss account will give vital information about the financial position and operations of the enterprise. The analysis becomes all the more useful and effective when a series of balance sheets and profit and loss accounts are studied.
7. TERMINAL EXERCISE
1) Explain the following
a) Assets
b) Liabilities
c) Factious assets
d) Income received in advance
e) marketable securities
8. SUPPLIMENTORY MATERIAL
Web Resource:
www.finance.yahoo.com
www.moneycentral.msn.com/home.asp
www.carolworld.com
9. ASSIGNMENT
From the following balances relating to Rolta India Limited prepare the Balance Sheet as at 30th June 1993.
(a) Equity capital 36, 42, 58,510
(b) Reserves & surplus 23, 58, 26,861
(c) Debentures 1, 03, 36,000
(d) Secured Loans 21, 27, 57,441
(e) Fixed assets 37, 07, 93,048
(f) Investments 5, 94, 80,459
(g) Inventories 20, 78, 28,095
(h) Sundry Debtors 10, 21, 66,468
(i) Cash & Bank balances 1, 49, and 87,264
(j) Other current assets 57, 75,568
(k) Loans and advances 12, 49, 59,370
(l) Current liabilities 4, 71, 71,358
(m) Provisions 4, 64, 19,410
(n) Miscellaneous Expenditure 3, 07, 79,308
The balance sheet may be prepared in account form and report form.
10. SUGGESTED READINGS
1) Gupta, R.L. and M. Radhaswamy, Advanced Accounts, Vol.1, Sultan Chand & Sons, New Delhi.
2) Shukia, M.C. and T.S. Grewal, Advanced Accounts, S.Chand and Company, New Delhi.
11. LEARNING ACTIVITIES
To give a practical insight to the students about the various aspects of a Balance Sheet, we give the Balance Sheet as at 31–3–1993 of a leading South Indian textile mill – The Vijayakumar Mills Limited. This Palani based textile mill is part of the famous Kongarar Group. The Balance Sheet is presented in the report form. The students while they go through the Balance Sheet would notice that there is an additional column which gives the corresponding figure for every item for the previous year also. This is mandatory for Joint Stock Companies as per the Companies Act. Further against each item in the Balance Sheet a schedule number is given. If one goes through the respective schedules necessary detailed information pertaining to the concerned item may be obtained. This information is very much useful for the analysis and interpretation of financial statements. Right now we give the Balance Sheet of The Vijayakumar Mills Limited:
Particulars Schedule As at 31.03.’93 As at 31.03.’92
(Rs. in Lakhs)
SOURCES OF FUNDS:
Share Holders Funds:
a. Share Capital I 156.00 78.00
b. Reserves and Surplus II 575.87 626.79
731.87 704.79
Loan Funds:
a. Secured Loans III 1275.50 1255.53
b. Deferred Credits IV 1.61
c. Unsecured V 1577.64 200.11
Loans 2853.14 1457.25
Total Funds Employed 3585.01 2162.04
APPLICATION OF FUNDS:
Fixed Assets VI
Gross Block 2148.02 1904.13
Less: 997.08 1150.94 844.47 1059.66
DEPRECIATION:
INVESTMENTS VII 14.43 14.15
CURRENT ASSETS, LOANS & ADVANCES VIII
a. Inventories 1519.48 1119.69
b. Sunday Debtors 525.03 386.54
c. Cash & Bank Balances 105.35 63.94
d. Loans & Advances 766.87 369.73
2916.73 1939.90
LESS: CURRENT LIABILITIES & PROVISIONS IX 510.79 2405.94 871.78 1068.12
MISSCELLANEOUS EXPENDITURE TOTAL FUNDS APPLIED X 13.70 20.11
3585.01 2162.04
12. KEY WORDS
Asset: Costs which represent expected future economic benefits to the business enterprise.
Liabilities: Represent obligations which require settlement in the future.
Current Assets: Assets which are reasonably expected to be realized in cash or sold or consumed during the normal operating cycle of the business enterprise or within one year, whichever is longer.
Operating cycle: The average period of time between the purchase of goods or raw materials and the realization of cash from the sale of goods
Fixed Assets: Tangible assets used in the business that are of a permanent or relatively fixed nature.
Intangible Assets: Those assets which have no physical existence.
Fictitious Assets: Not assets but appear in the asset side simply because of a debit balance in a particular account not yet written off.
Current liabilities: Liabilities due within an accounting period or the operating cycle of the business.
Long Term Liabilities: Liabilities that become due for payment after one year.
Contingent Liabilities: Items which become a liability only on the happening of a certain event.
Capital or Owners Equity: This is the residual interest in the assets of the enterprise.
LESSON – 6
COST ACCOUNTING: MEANING AND SCOPE
1. INTRODUCTION
In the initial stages cost accounting was merely considered to be a technique for ascertainment of costs of products or services on the basis of historical data. In course of time due to competitive nature of the market it was realised that ascertainment of cost is not so important as controlling costs. Hence, cost accounting started to be considered more as a technique for cost control as compared to cost ascertainment. Due to technological developments in all fields, now cost reduction has also come within the ambit of cost accounting. Cost accounting is thus concerned with recording, classifying and summarizing costs to determination of costs of products or services; planning, controlling and reducing sub costs and furnishing of information to management for decision-making.
2. OBJECTIVES
• To differentiate between different branches of accounting;
• To explain the meaning of financial accounting and management accounting;
• To name the different tools of management accounting;
• The meaning of cost accounting;
• Differentiate cost accounting from financial. accounting and management accounting;
• The objectives and importance of cost accounting;
• appreciate the difficulties and problems involved in installation of a costing system;
• understand the status and functions of a cost accountant;
• identify interrelationship between cost accounting department and other departments; and
• explain the meaning of certain key terms.
3. CONTENT
• Classification of accounting
• Meaning of cost accounting
• Cost accounting activities
• Cost accounting and financial accounting
• Cost accounting and management accounting
• Cost accounting and cost accountancy
• Objectives of cost accounting
• Importance of cost accounting
• Objections to cost accounting
• Status of cost accountant
• Functions of cost accountant
CLASSIFICATION OF ACCOUNTING
Accounting has rightly been termed as the language of the business. The basic function of a language is to serve as a means of communication. Accounting also serves this Unction. It communicates the results of business operations to various interested parties both in (i.e., management) and outside (i.e., shareholders, creditors, banks, financial institutions, etc.) the business. Based on the respective interest of the parties, accounting can broadly be classified into two categories as shown by the following chart:
FINANCIAL ACCOUNTING
Meaning. This means accounting designed to serve parties external to the operating responsibility of the firm, e.g., creditors, investors, employees, banks etc. It is basically concerned with the recording, classifying and summarizing in a significant manner and in terms of money transactions and events which are in part at least of a financial character and interpreting the results thereof.'
Functions. The basic functions of financial accounting are as follows:
(i) Recording. Financial accounting ensures that all financial transactions are properly recorded Recording is-done in the book called Journal
(ii) Classifying : Classification is concerned with the systematic analysis often recorded data with a view to group transactions or entries of one nature at one place. The Work of classification is done in a book termed as Ledger.
(iii)Summarising : This involves presenting the classified data in a manner which is understandable and useful to the internal as well as external end-users of accounting statements. This process leads the preparation of the following statements:
(a) Trial Balance, (b) income Statement, and (c) Balance Sheet.
(iv)Interpreting :This is the final function of financial accounting. The recorded financial data is interpreted in a manner that end-users can make a meaningful judgment about the financial condition and profitability of business operations.
Limitations of financial Accounting. Financial accounting well answered the nods of business In the initial stages when the business was not so complex. The growth and complexities of modern business brought out the following limitations of Financial Accounting:
1. Provides only limited information: There are now no set patterns of business on account of radical changes in business activities. An expenditure may not bring an immediate advantage to the business but it be incurred because it may bring advantages to the business the long-run or may be necessary simply to sell the name of the business.The management needs a lot of varied information to decide whether on the whole it will be justifiable to incur a particular expenditure or not. Financial accounting fails to provide such information.
2. Treats figures as single, simple and silent items. Financial accounting fails to make the people realise that accounting figures are not mere isolated phenomena but they represent a chain of purposeful and pertinent events. The role of accountant these days is not only of a book-keeper and auditor, but also that of a financial adviser. Recording of transactions is now the secondary function of the accountant. His primary function now is to analyst and Interpret the results.
3. Provides only a post-mortem record of bossiness transactions. Financial accounting provides only a post-mortem record of business transactions since it records transactions only on historical basis These days business decisions are made on the basis of estimates and projections rather than historical facts. Of course, past records are helpful in making future projections but they alone are not sufficient. Thus, needs of modern management demand a break-up from the principles and practice of traditional accounting.
4. Considers only quantifiable information. Financial accounting considers only those factors which are capable of being quantitatively expressed. In modern times, the concept of welfare state has resulted in increased government interference in all sectors of the national economy. The management as, therefore, to take into account government decisions over and above purely commercial considerations. Some of these factors are not capable of being quantitatively expressed and hence their impact is not reflected in financial state meats.
5. Fails to provide informational needs of different levels of management: Company horn of business organisation has divorced ownership from management. The shareholders are only rentiers of capital. The business is run in reality by different executives, each an experts in his area. These executives have powers based on the level of management to which they belong. There are usually three levels of management—Top Management, Middle Management and Lower Management. The type of information required by each level of management is different. The top management is mainly concerned with the policy decisions They. therefore, are interested in knowing about the soundness of the plans, proper structuring of the organization, proper delegation of authority and its effectiveness. The Diddle management executives function as co-ordinators. They must know: (i) What happened?(ii) Where happened? and (iii) Who is responsible? The lower management people Scion as operating supervisors. They should get information regarding effectiveness of their operations. The reports submitted to them should give details about the planned performance, actual performance and the deviations with their reasons. Financial accounting does not have a built-in system to provide all such information.
Management accounting is to a large extent free from the above limitations. It makes Of information that is drawn from financial accounting. However, it may, to assist the Cement, extent beyond the boundaries of accounting to areas such as economics, finance, logistics, operations research and other disciplines, if necessary.
MANAGEMENT ACCOUNTING
Mining. This means accounting designed for the management, i.e., accounting which provides necessary information to the management for discharging its functions. It is basically concerned with presentation of accounting information in a manner which can assist Management in the creation of policy and in the day-to-day operations of an undertaking. Its aim primarily is to assist the management in performing its functions effectively.
The Chartered institute of Management Accountants (CIMA) London', defines Management Accounting as follows:
"The application of professional knowledge and skill in the preparation accounting information in such a way as to assist management in the formation of policies and in the panning and control ofthe operations ofthe undertaking."
The definition given by the Management Accounting Team of the Anglo-American Council of Productivity seems to be more precise. It reads:
"Management accounting is the presentation of accounting information in such a way ~ to assist management in the creation of policy and in the day-to-day operations of an undertaking."
The above definitions clearly indicate that management accounting is concerned with accounting information which is useful to the management. Efficiency ofthe various phases of Management is, as a matter of fact, the common thread which underlies all these definitions. However, it should be clearly understood that it does not supplant financial accounting but rather it supplements it in order to serve the diverse requirements of modern management.
Tools of Management Accounting. Management accounting uses the following tools ortechniques to faithfully discharge its duty towards management:
(i) Financial Accounting. Management accounting is mainly concerned with rearranging the information provided by the financial accounting in a way most suitable for nanagerial decision-making. Hence, it cannot effectively discharge its functions without a properly designed financial accounting system.
(ii) Financial Statement Analysis. Financial statement analysis is concernedly methodical classification and evaluation ofthe information provided by the income statement and the balance sheet so as to afford full diagnosis of the profitability and fining soundness ofthe business. Hence, financial statement analysis is also a useful tool of management accounting.
(iii) Funds Plow Analysis. Funds flow analysis is based on funds flow statement which reveals the changes in the working capital position over a period of time. Dodd capital is considered to be the life-blood of the business and hence its effective and each management is necessary for the very survival ofthe business. Funds flow analysis is, therefore , an important tool of management accounting.
(iv) Cash Flow Analysis. Cash flow analysis helps the business in its liquid planning. It tells the management about the sources and applications of cash. It enablers enterprise for adjusting the liquidity cushion, rearranging the maturity structure of its debts and making arrangements for availability of cash at the times desired.
(v) Budgetary Control. This involves framing of budgets, comparison of acid performance with the budgeted performance, computation of variances, and undertaking remedial measures for minimising the variances or revising the budgets, if necessary. Ilk technique of budgetary control helps the management in planning their operations and M, proving their performance. Hence, it is an important tool of management accounting
(vi) Management Reporting. The efficiency of a business to a large extent is govern by the pertinence and regularity of the information provided to the managerial persona As a matter of fact, the ultimate effectiveness of information is itself dependent upend form and timing of its presentation. As such, an effective and efficient management information a reporting system is one of the important tools of management accounting
(vii) Cost Analysis. In today's world of competition, the importance of cost anally cannot be underemphasized. Cost analysis includes applications of both costing method viz., job costing, process costing, etc., and costing techniques, vi ., marginal costin8,at sorption costing, uniform costing etc. All these methods and techniques come in the anti of "Cost Accounting" which forms the subject-matter of this book.
MEANING OF COST ACCOUNTING
In the initial stages cost accounting was merely considered to be a technique for ascertainment of costs of products or services on the basis of historical data. In course of time due to competitive nature of the market it was realised that ascertainment of cost is not so important as controlling costs. Hence, cost accounting started to be considered more as a technique for cost control as compared to cost ascertainment. Due to technological developments in all fields, now cost reduction has also come within the ambit of cost accounting Cost accounting is thus concerned with recording, classifying and summarizing costs to determination of costs of products or services; planning, controlling and reducing sub costs and furnishing of information to management for decision-making.
According to Charles T. Horngren cost accounting is "a quantitative method accumulates, classifies, summarizes, and interprets information for three major purposes: (i) operational planning and control, (ii) special decisions, and (iii) product decisions'."
According to the Chartered institute of Management Accountants (CIMA), Londa, cost accounting is "the process of accounting for costs from the point at which the expenditure is incurred or committed to the establishment of its ultimate relationship with cost units. In its widest sense, it embraces the preparation of statistical data, the application of cost control methods and the ascertainment of the profitability of the activities carried out or planned".
According to Morse, "Cost accounting is the processing and evaluation of monetary and non-monetary data to provide information for external reporting, internal planning and control of business operations and special analysis and decisions".
COST ACCOUNTING ACTIVITIES
Cost Accounting, as explained above, refers to the process of determining the cost of Particular product or activity. It provides useful data both for internal and external reporting. Internal report presents details of cost information regarding cost of specific products or services while external reports contain cost data in a summarised and aggregate form. For instance, in case of a company manufacturing electrical goods, cost of each product, for example a lamp, a tubelight, a bulb is separately calculated with all details for internal reporting purposes. While for external reporting, the total cost of goods sold appears as a single item in income statement.
In order that cost accounting satisfies the requirements of both internal and external reporting, the following are the different activities which are undertaken under cost accounting system:
1. Cost Determination. This is the first step in the cost accounting system. It refers to determining the cost for a specific product or activity. This is a critical activity since the other three activities, explained below, depend on it.
2. Cost Recording. It is concerned with recording of costs in the cost journal and their subsequent posting to the ledger. Cost recording may be done according to integral or non integral systems. In case of a non-integral system a separate set of books is maintained for costing and financial transactions. While in case of an integral system, both costing and financial transactions are recorded in the same set of books.
3. Cost Analysing. It is concerned with critical evaluation of cost information to assist the management in planning and controlling the business activities. Meaningful cost analysis depends largely upon the clear understanding of the cost finding methods used in cost accounting.
4. Cost Reporting it is concerned with reporting cost data both for internal and external reporting purposes. In order to use cost information intelligently and effectively it is necessary for the managers to have good understanding of different cost accounting concepts.
COST ACCOUNTING AND FINANCIAL ACCOUNTING
As explained in the preceding pages accounting can broadly be classified into two categories: (i) Financial or General Accounting, and (ii) Management Accounting. Management Accounting embraces within its fold several subjects and cost accounting is one of them. Though Financial Accounting and Cost Accounting each rests on the same principles of debits and credits and uses the same records, but each deals with matters special to itself. Financial Accounting reveals the profit or loss ofthe business as a whole during a particular period while Cost Accounting shows, by analysis and localization. the unit costs and profits and losses of different product lines. Take, for instance, a factory manufacturing four products A, B. C and D. Financial accounts will tell about the overall profit or loss made bog factory on these products. They cannot explain whether product A is more profitable than B, or the production of product C should be stopped because the enterprise is suffering a loss on its production. If proper cost accounts are maintained the management can come to know not only about the profitability or non-profitability of a product, but also about the profitability or non-profitability of each process involved in the production of the product Such detailed information facilitates better control over the business which ultimately helps in achieving maximum efficiency at every point.
The points of difference between cost accounting and financial accounting may be summarised as follows:
I . Objectives. Financial accounting aims at safeguarding the interest of the business and its proprietors and others connected with it. This is done by providing suitable information to various parties such as shareholders or partners, present and prospective creditors. Cost accounting, on the other hand, renders information for the guidance of the management for proper planning, operational control and decision-making. For example, if the materials have been purchased, financial accounts will only tell whether they have been correctly accounted and paid for, while cost accounts will reveal whether the quantity
purchased was reasonable, whether the purchase was at all necessary, and whether the quantity of material utilised was reasonable. Similar considerations also apply to the utilization of labour and capital resources.
2. Mode of presentation. Financial accounts are prepared according to some accepted accounting concepts and conventions. They are kept in a manner so as to comply with the requirements of the Companies Act, income Tax Law, Excise and other statutes. Maintenance of cost records is purely voluntary and therefore there are no statutory forms regarding their presentation. However, the Central Government has the power to require by notification any company engaged in production, manufacturing or mining activities to maintain proper cost records. '
3. Recording in case of financial accounts the emphasis is on the ascertainment and exhibition of profits earned or losses incurred in the business. On account of this reason in financial accounts the transactions are recorded, classified and analysed in a subjective manner, i.e., according to the nature of expenditure. In cost accounts the emphasis is more on aspects of planning and control and, therefore, transactions are recorded in an objective manner, i.e., according to the purpose for which costs are incurred. For example, if Rs 5,000, Rs 8,000 and Rs 7,000 have been paid as wages for products A, B and C, financial accounts will record the total wages paid, while cost accounts will record wages separately for each product. Besides that in cost accounts a difference will also be made between direct and indirect wages, etc.
4. Analysing profit. Financial accounting reveals the profit of the business as a whole, while cost accounting shows the profit made on each product, job or process. This enables the management to eliminate less profitable product lines and maximise the profits by concentrating on more profitable ones.
5. Periodicity of reporting. Financial accounting is largely concerned with the transactions between the undertaking and the third parties and therefore it has to observe
The accounting period convention which is usually a year. The income statement and the balance sheet are therefore, prepared and presented before the members usually once at the end of the accounting period. While cost accounting is mainly concerned with the people in the organization and, therefore, it is not subject to the domination of this convention The cost reports are frequently submitted to the management and in some cases they are submitted every week.
6. Degree of accuracy. Since financial accounting provides information useful to the outsiders. the information has to be absolutely accurate. Cost accounting provides information to the insiders, i.e., the management, and hence the information may be fairly accurate. Thus, degree of accuracy is more in financial accounting as compared to cost accounting.
It may be noted that in spite of these differences, cost accounting does not totally discard the basic principles and procedures used in financial accounting. As a matter of fact. cost accounting is concerned with a more adequate and detailed recording, measurement and analysis of cost elements as they originate and flow through the Productive processes.
COST ACCOUNTING AND MANAGEMENT ACCOUNTING
Cost accounting is the process of accounting for costs. It embraces the accounting procedures relating to recording of all incomes and expenditures and the preparation of Periodical statements and reports with the object of ascertaining and controlling costs. It is, thus, the formal mechanism by means of which the costs of products or services are ascertained and controlled. On the other hand, management accounting involves collecting, analysing, interpreting and presenting all accounting information which is useful to the management. It is closely associated with management control which comprises planning, executing, measuring and evaluating the performance of an organisation. Thus, management accounting draws heavily on cost data and other information derived from cost accounting. Today cost accounting is generally indistinguishable from the so-called management accounting or internal accounting because it serves multiple purposes.
However, management accounting can be distinguished from cost accounting is one important respect. Management accounting has a wider scope as compared to cost accounting. Cost accounting deals primarily with cost data while management accounting involves the considerations of both cost and revenue. Management accounting is an all inclusive accounting information system which covers financial accounting, cost accounting and all aspects of financial management. But it is not a substitute for other accounting functions. It involves a continuous process of reporting cost, financial and other relevant dab in an analytical and informative way to management.
We should not be very much concerned with the boundaries of cost accounting and management accounting since they are complementary in nature. In the absence of suitable system of cost accounting, management will not be in a position to have detailed cost information and their function is bound to lose significance. On the other hand, the management cannot effectively use the cost data unless it has been reported to them in a meaningful and informative form.
COST ACCOUNTING AND COST ACCOUNTANCY
In the preceding pages we have explained the meaning of cost accounting. The meaning of the term 'cost accounting' is different from 'cost accountancy'. The term cost accountancy has a wider meaning as compared to the term cost accounting. According to the Chartered Institute of Management Accountants (CIMA). London, cost accountancy means "the application of costing and cost accounting principles, methods and techniques to the science art and practice of cost control. It includes the presentation of information derived there from for the purpose of managerial decision-making". Cost accountancy is thus these once, art and practice of a cost accountant. It is a science because it consists of organized or systematic knowledge, which a cost accountant must possess for proper discharge of his functions. As a matter of fact, the cost accountant's knowledge should not remain restricted only to such subjects which cost accountancy embraces but it should also extend to such subjects like production control, operations research, linear programming which will help him in application of his cost accountancy knowledge to the problems of the business.
Cost accountancy is also an art because it involves costing techniques and methods, such as those of differential or marginal costing, standard costing, etc. The application of these techniques help the cost accountant in deciding how to control costs, whether to go for replacement of the existing plant by a new one or not etc.
Cost accountancy is also the practice of a cost accountant because he has to make constant efforts in the field of cost accountancy. He has to endeavour constantly for reducing costs, present cost information in a condensed but informative way to the management so that the management may take proper action at the opportune time.
Cost accountancy includes several subjects. They are as follows:
Cost Accounting
Cost accounting is the process of accounting for costs. It embraces the accounting procedures relating to recording of all income and expenditure and the preparation of periodical statements and reports with the object of ascertaining and controlling costs. It is thus the formal mechanism by means of which costs of products or services are ascertained and controlled.
Costing
Costing is "the technique and process of ascertaining cost".' Cost accounting is different from costing in the sense that the former provides only the basis and information for ascertainment of cost. Once the information is made available, the costing can be carried out arithmetically, by means of memorandum statements or by method of integral accounts.
However, the two terms costing and cost accounting—are often used interchangeably. No such distinction has also been observed for the purpose of this book.
Wheldon has given an exhaustive definition of costing after expanding the ideas contained in the definitions of the terms 'costing' and 'cost accounting'. According to him, costing is "the classifying recording and appropriate allocation of expenditure for the determination of the costs of products or services; the relation of these costs to sales values and the ascertainment of profitability".
Wilmot has summarized the nature of cost accounting as "the analysing, recording, standardizing, forecasting, comparing, reporting and recommending," and the role of a cost accountant as that of "a historian, news agent and prophet. As a historian he must be meticulously accurate and sedulously impartial. As a news agent he must be up-to-date, selective and pithy. As a prophet he must combine knowledge and experience with foresight and courage”.
Cost Control
A cost accountant now is not only concerned with the ascertainment of costs and fixing selling prices of the products but also with burn furnishing such information as to enable the management to control the costs of operating the business. As a matter of fact, the latter function has become the prime function of the cost accountant these days. Cost control is exercised by a variety of techniques such as those of standard costing, budgetary control and quality control, etc. Submission of periodical reports by him also helps management in exercising better control over costs. For example, a statement of value of stocks (raw materials, finished goods and work- in-progress) on hand together with relevant ratios will show whether there is any tendency of over or under-stocking.
Cost Reduction
This is a new dimension to the functions of a cost accountant. Cost reduction is concerned with real and permanent reduction in the unit cost of goods manufactured or services rendered. In this era of liberalization and competition only the best would survive. Hence, the cost accountant has to make continuous efforts to reduce per unit cost. The techniques used for this purpose are value analysis, design analysis, technological forecasting, simplification and standardization etc.
Cost Audit
Cost audit is the verification of cost accounts and a check on the adherence to the cost accounting plan. Thus cost audit involves checking up the arithmetical accuracy of cost accounts and verifying whether the principles laid down have been followed or not. It becomes essential in case of a business where cost accounting is carried out on a large scale.
OBJECTIVES OF COST ACCOUNTING
The main objectives of cost accounting can be summarised as follows:
(i) Ascertainment of cost. This used to be the primary function of a cost accountant in good old days. The cost accountant was basically concerned with the computation of the cost of a job, product or process on the basis of historical data. In other words, having incurred the expenditure, the cost accountant was simply required to add up the expenditure and find out the total and/or per unit cost. However, these days, with growing competition and the realization that only "the fittest will survive", cost ascertainment has become only a secondary objective of cost accounting.
(ii) Estimation of cost. In today's competitive world, it is not only enough to know "what has been the cost". it is more important to know "what is likely to be the cost", or
rather "what should be the cost" of a job, product or process. The technique of a standard costing which is now widely used by large professionally managed companies mainly emphasises on this aspect.
(iii) Cost control. This has now become the primary objective of cost accounting. Controlling cost requires (i) determination of standard costs (i.e., cost which should be there), (ii) analysing the causes of variations between the standard costs and the actual costs. The techniques of budgetary control and standard costing considerably facilitate this work and increase the operating efficiency of an enterprise.
(iv) Cost reduction. This is a recent function or objective of cost accounting. Costs are not only to be controlled (i.e., to be kept within limits) but constant efforts are to be made for reducing them. Constant reduction in cost through research and development widens the market for the company's products which enables an organization to enjoy the economies of scale and other consequential benefits.
(v) Determining selling price. Business enterprises are run on a profit-making basis. It is thus necessary that the revenue should be greater than the costs incurred in producing goods and services from which the revenue is to be derived. Cost accounting provides information regarding the cost to make and sell such products or services. Of course, many other factors, such as the condition of the market, the area of distribution, the quantity which can be supplied, etc., are also be given due consideration by the management before deciding upon the price, but the cost plays a dominating role.
(vi) Facilitating preparation off nancial and other statements. One main objective of cost accounting is to produce statements at such short intervals as the management may require. The financial statements prepared under financial accounting generally once a year, or half-year, are spaced too far apart in time to meet the needs of the management. In order to operate the business at a high level of efficiency, it is essential for the management to have a frequent review of production, sales and operating results. Cost accounting provides daily, weekly or monthly volumes of units produced, accumulated costs together with appropriate analysis. A developed cost accounting system provides immediate information regarding stock of raw materials, work-in-progress and finished goods. This helps in speedy preparation of financial statements.
(vii) Providing basis for operating policy. Cost accounting helps the management in formulating operating policies. These policies may relate to any of the following matters:
(i) Determination of cost-volume-profit relationship.
(ii) Shutting down or operating at a loss.
(iii) Making or buying from outside suppliers.
(iv) Continuing with the existing plant and machinery or replacing by improved and economical models.
IMPORTANCE OF COST ACCOUNTING
The limitations of financial accounting have made the management to realise the importance of cost limitations Whatever may be the type of business, it involves expenditure on materials, labour, and other items required for manufacturing and disposing of the product. Moreover, a big business requires delegation of responsibility, division of labour and specialization. Management has to avoid the possibility of wastage at each stage. It has to see that no machine remains idle, efficient labour gets due initiative, proper utilization of by-products is made and costs are properly ascertained. Besides management, creditors and employees are also benefited in numerous ways by installation of a goods costing system in an industrial organization. Cost accounting increases the overall productivity of an industnal establishment and. therefore, serves as an important tool in bringing prosperity to the nation. Thus, the importance of cost accounting in various spheres can be summarised underthe following headings:
Cost Accounting and Management
Cost accounting provides invaluable aid to management. It is so closely allied to management that it is difficult to indicate where the work of the cost accountant ends and managerial control begins. Adequate costing data helps management in reaching certain important decisions such as, whether hand labour should be replaced by the machinery or not; whether a particular product line should be discontinued or not etc.
Costing checks recklessness and avoids occurrence of mistake. Costs can be reduced by proper organization of the plant and executive personnel. As an aid to management it also provides invaluable information to enable management, to maintain effective control over stores and inventory, to increase efficiency of the business, and to check wastage and losses. it facilitates delegation of responsibility for important tasks and rating of employees. However, for all this it is necessary for the management to be capable of using in a proper way the information provided by the cost accounts. The various advantages derived by management on account of a good costing system can be put as follows:
1. Aids in price fixation. Though economic law of supply and demand and activities ofthe competitors to a great extent, determine the price of the article, cost to the producer does play an important part. The producer can take necessary guidance from his costing records.
2. Helps in estimates. Adequate costing records provide a reliable basis upon which tenders and estimates may be prepared. The chances of losing a contract on account of over-rating or suffering loss in the execution of a contract due to under-rating can be minimised. Thus, "ascertained costs provide a measure for estimates, a guide to policy and a control over current production. "'
3. Wastages are eliminated. As it is possible to know the cost of the article at every stage, it,becomes possible to check various forms of waste, such as oftime, expense etc., or in the use of machinery, equipment and tools.
4. Costing makes comparison possible. If the costing records are regularly kept, comparative costs data for different periods and various volumes of production will be available. It will help the management in forming future lines of action.
5. Provides dab a for periodical prod t and loss accounts. Adequate costing records supply to the management such data as may be necessary for preparation of profit and loss accounts and balance sheets, at such intervals as may be desired by the management.
It also explains in details the sources of profit or loss revealed by the financial accounts; thus, helps in presentation of better information before the management.
6. A ids in determining and enhancing efficiency. Losses due to wastage of materials, idle time of workers, poor supervision, etc., will be disclosed if the various operations involved in manufacturing a product are studied by a cost accountant. The efficiency can be measured and costs controlled and through it various devices can be formed to increase the efficiency.
7. Helps in inventory control. Costing furnishes control which management requires in respect of stock of materials, work-in-progress and finished goods.
8. Helps in determining break-even point. The term break-even point means "point of no profit no loss". in other words, it is that level of activity where the concern neither makes a profit nor suffers a loss. Every industrial concern is interested in determining this point, since it starts making profit only after reaching the break-even level. Sooner the break-even level is attained, the better it is for the organization.
Example
Selling Price per unit Rs 10
Variable Cost per unit (i.e., cost which varies with production) Rs 6
Fixed Cost Rs 2,000
Capacity of the firm 1,000 units
The above data indicate that on every unit, the concern earns a sum of Rs 4 over and above its variable cost. This earning is termed as "contribution". in order to recover the total fixed cost of Rs 2,000 the concern must produce and sell 500 units (i.e., 2,000/4). The formula for computation of the break-even point can be put as follows:
= Rs 2,000/4 = 500 units
In case the concern manufactures more than 500 units, the entire contribution of Rs. 4 per unit will be its profit. Thus, if it manufactures and sells 700 units, the amount of profit would be Rs 800 (i.e., 200 units x Rs 4).
9. Helps in determining the level of output for a desired profit. A firm must earn sufficient profits to pay dividends to its shareholders or provide sufficient return to its proprietors. Cost accounting helps in determining this level. For instance, if in the example given above, the desired profit is a sum of Rs 500, the level of output for this profit can be determined as follows:
.
= 625 units
10. It helps in periods of trade depression and competition. In periods of trade depression and trade competition, a firm may have to sell its products even below the total cost. It has to choose between closing of the production and continuing of production. This can be understood with the help of the fo1lowing example:
Selling Price per unit Rs 10
Variable Cost per unit (i.e., cost which varies with production) Rs 6
Fixed Cost Rs 2,000
Capacity of the firm 1,000 units
Total cost of article per unit comes to Rs. 8 (i. e., variable cost Rs. 6 + fixed cost Rs 2). In case the demand for the product falls and presuming that the people are prepared to buy the product only for a sum of Rs 7 and the situation is going to continue for at least 3 months, a cost accountant has to advise the management whether to shut-down the production or sell the units at Rs 7 per unit. In the present case, apparently there seems to be a loss of Re 1 per unit (i.e., total cost of Rs 8 less selling price of Rs 7), but it will be advisable to continue the production and sell the product even below the total cost of Rs. 8. This is because in any case during this period the fixed cost will have to be incurred. The selling of the article at Rs 7 will provide a contribution of Rs 1,000 towards meeting of the fixed cost. This will reduce the amount of loss from Rs 2,000 (if the factory is closed down) to Rs 1,000. It could not be incorrect to say that even if the product is sold in the market for Rs 6 per unit on account of some temporary difficulties, the firm should continue to sell because in any use the variable costs are fully recovered. The question of stopping the production should attract the attention of the management only when the market price falls below Rs 6 per unit. Even in such a case, the management, before closing down the production, must look to other factors such as payment of compensation to the retrenched workers, probability of development of a substitute product, losing of goodwill, etc.
11. Channelising production in right lines. Cost accounting makes possible for the management to distinguish between profitable and non-profitable activities. Profits can be maximised by concentrating on profitable operations and eliminating non-profitable ones.
Example
A company is manufacturing three products A, B and C. The data regarding output, costs and sales are as follows:
A B C
Output and Sales (Units)
Selling price per unit (Rs)
Cost per unit (Rs) 1,000
10
8 1,000
10
6 1,000
10
12
In case detailed cost accounts are not maintained, the financial accounts will show a profit of Rs 4,000 calculated as follows:
Product A Rs 2,000
Product B Rs 4,000
Product C Rs 2,000 (loss)
The trading and profit and loss account of the firm will show an overall profit of Rs 4,000. It will not disclose that a loss of Rs 2,000 is being suffered by the firm on product C. In case detailed cost accounts are maintained, the firm can know which product is profitable and which product is not profitable. In this case the firm can immediately stop the production of product C and thus increase its profit from Rs 4,000 to Rs 6,000 (i. e., a 50 per cent increase). it can further increase its profit by utilising those resources which were used for product C for manufacturing and selling of product A or B.
Cost Accounting and Employees
Workers have a vital interest in their employer's enterprise and the industry in which they are employed. Workers are benefited by a number of ways by the installation of an efficient costing system in their enterprise. They are benefited because of systems of incentives, bonus plans, etc. They get benefit indirectly through increase in consumer goods and directly through continuous employment and larger remuneration.
Cost Accounting and Creditors
Investors, banks and other financial institutions have a stake in the success of the business concern and, therefore, are benefited immediately by installation of an efficient costing system. They can base their judgment about the profitability and further prospects of the enterprise upon the studies and reports submitted by the cost accountant.
Cost Accounting and National Economy
An efficient costing system brings prosperity to the concerned business enterprise resulting into stepping up of the government-revenue. The overall economic development of a country takes place due to increase in efficiency of production. Control of costs, elimination of wastages and inefficiencies lead to the progress of the industry and in consequence of the nation as a whole.
OBJECTIONS TO COST ACCOUNTING
Some people are averse to cost accounting. They put forward the following argument against the installation of a costing system in an industrial establishment:
(i) The system is quite expensive because analysis, allocation and apportionment of costs and absorption of overheads require considerable amount of clerical work.
(ii) The results shown by the cost accounts differ materially from those shown byte financial accounts. Preparation of reconciliation statements frequently is necessary to vend their accuracy. This leads to unnecessary increase in work load.
(iii) Costing system itself does not control costs or improve efficiency. If the manage ment is alert and efficient, it can control costs without the aid of this system. This is, there fore, unnecessary.
These arguments are untenable. The system will not prove to be expensive if it is introduced after taking into account technical details and advice of the technical personnel of the business. Moreover, as stated above, costing helps in minimising costs by avoiding waste at all stages. Thus, it will be a profitable investment and it will be wrong to call it expensive. Difference between results shown by cost accounts and financial accounts arises on account of over and under-absorption of overheads, method of material pricing used and treatment of other incomes. An integrated system of accounts can help in elimination of these differences. Costing is a must for each manufacturer because each manufacturing process requires use of materials, labour, etc. In this age of competition a manufacturer must know the exact cost not only of each article made but also of each process involved in its production so that he may be in position to avoid waste and minimise its cost. It is possible only when proper costing records are maintained. Hence, it is wrong to say that it is unnecessary.
STATUS OF COST ACCOUNTANT
The status of a Cost Accountant in the organization will largely affect his effectiveness. In case he is subordinate to the Accounts Manager or Production Manager, his area of operations will be very much restricted. It will be appropriate, if the size 0 f the concern permits to have an independent Cost Accounting Department with a qualified Cost Accountant as it head. He should have access to all information pertaining to costs and he should report directly to the Chief Executive of the Organisation or Financial Controller, as the case may be. As a matter of fact due to increasing competition, the importance of cost accountant is gradually increasing. In order to have a larger market share every concern is interested in controlling and reducing costs. This is possible only when the cost accountant is allowed to function independently and given all support by the top management in performing his functions.
FUNCTIONS OF COST ACCOUNTANT
The main functions of a cost accountant can be summarised as follows:
1. Determining cost and analyzing income. A cost accountant determines the cost of a job, product or process as the case may be. He analyses and classifies costs according to different cost elements, viz., materials, labour and expenses. Such analysis enables him to tell the management the significance of the different cost elements and fixation of the sell ing prices of the products manufactured by the business. He advises the management about the profitability or otherwise of each job, product, or process. Thus, he helps the management in maximizing business profits.
2. Providing cost donator planning and control. A cost accountant collects, classifies, and presents in appropriate form suitable data to the management for planning and controlling the operations of the business. He makes constant endeavour to control and reduce the cost by the fo110wing techniques:
(i) He submits regular reports to the management regarding wastage of material, idle time, idle capacity, etc. He identifies the causes and suggests suitable controlling measures to prevent or reduce losses on account of these causes.
(ii) He makes product-wise or process-wise comparisons to identify non-profitable products or processes.
(iii) He develops cost consciousness in the organisation by adoption of budgetary control and standard costing techniques.
(iv) He maintains an even flow of materials and at the same time prevents unnecessary investment of materials through different material control techniques, e.g. ABC Analysis, Perpetual inventory System, Materials Turnover Ratios, fixation of different levels of materials etc.
(v) He organises various cost reduction programmes with the co-operation and coordination of different departmental heads.
3. Undertaking special cost studies for managerial decision-making. A cost accountant undertakes special cost studies and carries out investigation for collecting and presenting suitably data to the management for decision-making regarding the following areas:
(a) introduction of new products, replacement of manual labour by machines, etc.
(b) Make or buy decisions, replacing or repairing old machines. accepting orders below cost, etc.
(c) Expansion plans, installation of new capital project, etc.
(d) Utilisation of idle capacity and development of a proper information system to provide prompt and correct cost information to the management.
(e) installation of a cost audit system.
4. INTEXT QUESTIONS
a. Define Cost Accounting. How does it differ from Management Accounting and Financial Accounting?
b. “Costing is an aid to the management”. Discuss.
c. Describe the role of cost accountant in the area of operating efficiency.
5. SUMMARY: In this chapter we learned that, ascertainment of cost is not so important as controlling costs. Hence, cost accounting is considered as a technique for cost control as compared to cost ascertainment. Cost accounting is thus concerned with recording, classifying and summarizing costs to determination of costs of products or services; planning, controlling and reducing sub costs and furnishing of information to management for decision-making.
6. TERMINAL EXERCISE:
a. Accounting may be classified into financial accounting and …………
b. Financial accounting provides only a ……………. Record of business transactions
c. Cost accounting is a tool of ………………accounting
d. The technique and process of ascertaining cost is termed as …………
7. ASSIGNMENTS
a. Write a note on Organisation of a Cost Accounting Department.
b. Enumerate the matters which will investigate and the problems which you expect to face before installing a costing system in a manufacturing company.
8. KEY TERMS
Accounting: The process of identifying, measuring and communicating economic information to permit informed judgments and decisions by the users of information.
Cost Accountant: The official concerned with ascertaining, controlling and reducing costs.
Cost Accounting: The accounting mechanism through which the costs of the products or services are a and controlled.
Financial Accounting: The art of recording classifying and summarizing in a significant manner and in terms of money transactions and events which are at least in part of a financial character and interpreting the results thereof.
Management Accounting: The presentation of accounting information in such a way as to assist management in the creation of the policy and in the day-to-day operations of the undertaking.
LESSON – 7
BASIC COST CONCEPTS
1. INTRODUCTION
This chapter introduces the concept of cost; The term cost refers to the amount of resources given up in exchange for some of goods services. It will also help you identify the different elements of cost, components of cost and prepare a cost sheet. The concept of Cost centre and cost unit, cost estimation and cost ascertainment. The chapter also explains the different methods, systems and techniques and emerging cost concepts.
2. OBJECTIVES
• Understand the concept of cost;
• Identify the different elements of cost;
• State the different components of cost;
• Prepare a cost sheet;
• Appreciate the classification of cost into different categories ;
• Differentiate between cost centre and cost unit; cost estimation and cost ascertainment;
• Differentiate between certain important terms relevant to ascertainment of cost viz. cost centre and cost unit, cost allocation and cost apportionment and cost reduction and cost control, etc,
• Explain different methods, systems and techniques and emerging cost concepts.
3. CONTENT
Concept of Cost
Cost, Expense and Loss
Elements of Cost
Components of Total Cost
Computation of Profit
Cost Sheet
Classification of Costs
Methods of Costing
Systems of Costing
CONCEPT OF COST
The term cost refers to the amount of resources given up in exchange for some of goods services. The resources so given up are always expressed in terms of money. According the Chartered institute of Management Accountants (CIMA), London, the term cost in general means "the amount of expenditure (actual or notional) incurred on or attributable to given thing or activity."' However, the term cost cannot be exactly defined. Its interpretation depends upon:
(a) The nature of business, or industry, and
(b) The context in which it is used.
In a business where selling and distribution expenses are -quite nominal, the cost of the article may be calculated without considering the selling and distribution overheads While in business where the nature of the product requires heavy selling and distribution expenses, calculation of cost without taking into account selling and distribution expenses may prove very costly to the business. Then cost may be—factory, office cost, cost of sales and even an item of expense is also termed as cost. For example, prime cost includes expenditure on direct materials, direct labour and direct expenses. Money spent on material is termed as cost of materials, that spent on labour as cost of labour and so on. Thus, the use of the term cost without qualification is also quite misleading. Again, different costs are found out for different purposes. The work-in-progress is valued at factory cost' while stock of finished goods is valued at office cost. Numerous other examples can be given to show that be lean 'cost' does not mean the same thing under all circumstances.
The fact that word 'cost' cannot be fixed with a definite meaning was well illustrated in Vardon v. The Commonwealth case. In this case the price of made-to-order goods or services sold by a trader was fixed by a notification from the Price Commissioner at "the cost of those goods or services, plus 20% thereof". The goods in question were suits of clothes and other garments, the material for which was provided by the retailer who rendered certain service in measuring the customer, and arranged for the making of the suit by another person who supplied other material required. It was held that cost of a suit of clothes might be ascertained in different ways for different persons. For example, it might include factory cost only, or might include also costs of distribution and merchandising. Therefore, he word 'cost' being uncertain and ambiguous in meaning, the notification could not be regarded as declaring a price.
It may also be noted that there is no such thing as exact cost or a true cost because no figure of cost is true in all circumstances and for all purposes. Many items of cost of production are handled in an optional manner which may give different costs for the same product or job without in any way going against the accepted principles of cost accounting. Depreciation is one such item. its amount varies in accordance with the method of depreciation being used. However, endeavour should be to obtain as far as possible accurate cost of a product or service.
COST, EXPENSE AND LOSS
As explained above, the term cost refers to the resources sacrificed or forgone to achieve a specific objective. It represents the expenditure which has been made or incurred for an economic benefit. There can be three situations regarding such benefit: (i) benefit may have already been received; (ii) benefit is yet to be received; and (iii) the possibility of receiving he benefits may have been lost. For example, an organization takes a fire insurance policy on its building on 1st August, 1998 by paying a premium of Rs 2,400. As on 3 I st December, the organisation has already used the insurance cover for five months. While the benefit of insurance cover for remaining seven months is yet to be received. In this case, the total cost of He insurance policy is Rs 2,400. However, the amount of expense is only Rs 1,000 i.e. 2,400 x 5/12. The amount of unexpired or deferred cost is Rs 1,400.
However, if at the end of 1998, it is found that the insurance company has gone into liquidation and it will not be possible to get the insurance benefit for the next set months, amount of unexpired cost will be treated as loss.
Thus, the term cost refers to the total resources forgone which may or may not bring matching economic benefits. In the former case, it will be termed as an expense while in the latter case it will be termed as a loss. Both the expense and loss are charged to the profit and loss account while deferred cost or unexpired cost is shown as an asset in the Balance Sheet.
In brief, it can be said that the term expense is a 'timing concept’ while the term cost is 'valuation concept'.
ELEMENTS OF COST
There are three broad elements of cost :
Each of these elements is explained below:
1. Material
The substance from which the product is made is known as material. It may be in
raw, semi-manufactured or a manufactured state. It can be direct as well as indirect.
(a) Direct Material: All material which becomes an integral part of the finished product and which can be conveniently assigned to specific physical units is termed as "Direct Material". Following are some examples of direct material:
(i) All material or components specifically purchased, produced or requisitioned from stores.
(ii) Primary packing material (e g., carton, wrapping, cardboard boxes, etc.)
(iii) Purchased or partly produced components.
Direct material is also described as process material, prime cost material, production material, stores material, constructional material, etc.
(b) Indirect Material: All material which is used for purpose ancillary to the busing and which cannot be conveniently assigned to specific physical units is termed as "Indirect Material". Consumable stores, oil and waste, printing and stationery material, etc. are a few examples of indirect material.
Indirect material may be used in the factory, the of flee or the selling and distribution divisions.
2. Labour
For conversion of materials into finished goods, human effort is needed, such hum effort is called labour. Labour can be direct as well as indirect:
(i) Direct Labour: Labour which takes an active and direct part in the production of particular commodity is called direct labour Direct labour costs are, therefore, specifically and conveniently traceable to specific products.
Direct labour is also described as process labour, productive labour, operating labour etc.
(ii) Indirect Labour: Labour employed for the purpose of carrying out tasks incidental
To goods, or services provided, is indirect labour Such labour does not alter the construction composition or condition of the product. It cannot be practically traced to specific units of output. Wages of store-keeper, foremen, time-keepers, directors' fees, salaries of salesmen, etc., are all examples of indirect labour costs.
Indirect labour may relate to the factory, the office or the selling and distribution divisions.
3.Expenses
Any other cost besides material and labour is termed as expense. Expenses may be
direct or indirect.
(i) Direct Expenses. These are expenses which can be directly, conveniently and wholly| allocated to specific cost centres or cost units. Examples of such expenses are: hire of some special machinery required for a particular contract, cost of defective work incurred in connection with a particular job or contract, etc.
Direct expenses are sometimes also described as "chargeable expenses".
(ii)Indirect Expenses: These are expenses which cannot be directly, conveniently and wholly allocated to cost centres or cost units.
The examples of indirect expenses are rent, rates, insurance, salaries, lighting charges, etc.
Overhead
The term overhead includes indirect material, indirect labour and indirect expenses. Thus, all indirect costs are overheads.
A manufacturing organization can broadly be divided into three divisions:
(i) Factory or Works where production is done;
(ii) Office and Administration, where routine as well as policy matters are decided: and
(iii) Selling and Distribution where products are sold and finally despatched to the customer.
Overheads may be incurred ha the factory or office or selling and distribution divisions. Thus, overheads may be of three types:
a) Factory overheads: They include:
(i) Indirect material used in the factory such as lubricants, oil, consumable stores etc.
(ii) Indirect labour such as gate-keeper s salary time- keeper’s salary, works manager’s salary etc.
(iii) Indirect expenses such as factory rent, factory insurance, factory lighting, etc.
b) Office and Administration Overheads: They include:
(i)Indirect material used in the office such as printing and stationery material, brooms and dusters, etc.
(ii) Indirect labour such as salaries payable to office manager, office accountant, clerks, etc.
(iii) Indirect expenses such as rent, insurance, lighting of the office.
c) Selling and distribution Overheads: They include:
(i) Indirect material used such as packing material, printing and stationery material, etc.
(ii) Indirect labour such as salaries of salesmen and sales manager, etc.
(iii) Indirect expenses such as rent, insurance, advertising expenses, etc.
COMPONENTS OF TOTAL COST
A component of cost comprises of two or more elements of cost. The various components of total cost are as follows:
1. Prime Cost: It consists of cost of direct material, direct labour and direct expenses. It is also known as basic, first or flat cost.
= + +
Adjustment for Raw Material Stocks
The term "Direct Material" here refers to the "cost of direct materials consumed". it isnot necessary that all materials purchased during a period are also consumed during the same period. Some materials may remain in stock. Hence, cost of materials consumed will have to be ascertained by making appropriate adjustments for opening and closing stock of materials.
Illustration 3.2. From the following compute the value of raw materials consumed.
Raw Material purchased 50,000
Opening Stock 10,000
Closing Stock 8,000
Solution:
Value of Raw Materials Consumed = Opening Stock + Purchases - Closing Stock
= Rs. 10,000 + 50,000 - 8.000 = Rs. 52,000
2.. Factory Cost. It comprises of prime cost plus works or factory overheads. The cost is also known as Works Cost, Production or Manufacturing Cost.
= +
Adjustment for Scrab
Scrap is the incidental residue from certain types of manufacturing operations usually of small amount and low value; recoverable without further processing. The amount realised from sale of scrap should be deducted either from works overheads or gross works cost.
In case certain materials (before being used) are found to be defective and therefore sold the value of materials used should be reduced by the cost of such materials. Any loss on sale of such materials should be charged to costing profit and loss account.
Adjustment for Work-in-progress
Work-in-progress means units which are not yet complete but on which some work has been done. Thus it represents goods which are in the process of manufacturing Generally such goods bear a proportionate part of factory overheads besides raw materials and direct wages and therefore opening and closing stock of work-in-progress are taken into consideration in the cost sheet while computing the works cost of goods manufactured during the year. Some concerns however follow the practice of valuing stock of work-in-progress at prime cost. In such a case the stock of work-in-progress should be taken note of while calculating the prime cost.
The practice of valuing work-in-progress at prime cost does not seem to be very correct because after all some works expenses have been incurred on such goods. "The Accountants Cost Hand Book” edited by Professor Robert I Dickey also states, "The value of work-in progress consists of direct materials. direct labour and manufacturing overheads accumulated to the stage of completion reached at the end of a period." Thus, the factory overheads should be generally included in the valuation of work-in-progress.
However, in the following circumstances, purely on financial considerations, works overheads may not be included while valuing work-in-progress:
(1) In case certain manufacturing departments are not in a position to bear their full shore of overhead cost, they will not be charged with their full share of overheads. The practice is resorted to on the consideration that if the goods were to be charged with their full share of factory overheads, their sale would be continuingly at a loss.
(a) Factory overheads are also not taken into account if the goods are produced for highly sensitive or competitive market (e g . fashion goods). The demand of such goods may come down any moment and, therefore. they may have to be sold even at prime cost.
(3) In case of building contracts in order to have a margin for contingencies, overheads may not be considered while valuing uncertified work-in-progress.
(4) Where stocks have to be held for a long period for maturing, usually overhead expenses are not added because the ultimate selling price may or may not be adequate for the purpose.
(5) Where levels of production and sales are subject to material fluctuations, overheads are not added to cost of work-in-progress. In such a case if overheads are added to the cost of work-in-progress, they would have the effect of relieving the profit and loss account of overheads in the period when they were incurred and would be charged to the profit and loss account of the period to which they do not relate.
Thus, the object of excluding works overheads or any other overheads from being included in the cost of work-in-progress is to prevent the work-in-progress. from being valued at a price higher than the price which such goods may fetch on being sold. This is only a financial consideration. However, from the costing point of view a proportionate part of all overheads should be added to for valuing work-in-progress. But, in practice, only a proportionate part of factory overheads is considered for this purpose.
Illustration
From the following calculate the Works Cost:
Rs.
Materials 60,000
Labour 40,000
Direct Expenses 10,000
Factor Overheads 50,000
Work-in-progress: Opening Stock 10,000
Closing Stock 8,000
Solution:
Computation of Works Cost
Materials
Labour
Direct Expenses
PRIME COST
Factory Overheads
GROSS WORKS COST
Add: Opening Stock of Work-in-progress
Less: Closing Stock of Work-in-progress
WORKS or FACTORY COST Rs.
60,000
40,000
10,000
1,10,000
50,000
1,60,000
10,000
1,70,000
8,000
1,62,000
3.Office Cost: If office and administrative overheads are added to factory cost, office cost is arrived at. This is also termed as administrative cost or cost of production.
The inclusion of office cost and administrative overheads in the cost of production is based on the presumption that such overheads solely relate to production. The amount of office and administration overheads relating to sales are a part of selling overheads and unless otherwise specified, must have already been included in them.
= +
Illustration
From the following particulars compute the Cost of Production of a product:
Materials used 120
Labour employed 80
Salary of inspector engaged on this product 10
Proportionate lighting and heating (factory and office 3:2) 5
Proportionate depreciation, repairs and rent (50% is related to factory) 10
Municipal taxes and insurance of building (40% relates to office) 8
Trade subscription 1
Solution
STATEMENT SHOWING TOTAL COST OF PRODUCTION
Direct Materials: Materials used
Direct Labour: Labour employed
Salary of inspector engaged
for production of this article
Add: Factory Overheads:
Lighting and heating
Depreciation, repairs and rent
Municipal taxes and insurance of building
Factory Cost
Add: Office and Administration Overheads:
Lighting and heating
Depreciation, repairs and rent
Municipal taxes and insurance of building
Trade subscriptions
Total Cost of Production
Rs.
80
10 Rs.
120
90
3.00
5.00
4.80
2.00
5.00
3.20
1.00
Rs.
210.00
12.80
222.80
11.20
234.00
Adjustments for Finished Goods Stocks
In the cost of production relating to a particular commodity or unit of production, the opening stock of finished goods is added and closing stock subtracted to find out the cost of goods sold.
Stock of finished goods is generally valued at the total cost of production. The selling and distribution overheads are charged on units sold and not on units produced and, there-fore, the value of stock at the end takes into account the total production costs. The current cost is considered while valuing closing stock on the assumption that the stocks are being disposed of on “first in, first out” basis; thus the last year’s stocks must have been sold first and whatever remains is of the current year’s production lot.
Example
From the following calculate the cost of production of goods sold:
Rs
Cost of production 1,00,000
Opening stock 10,000
Closing stock 15,000
Cost of production
Of goods sold = cost of production + opening stock-closing stock
=1,00,000 +10,000 – 15,000
= Rs 95,000
4. Total Cost or Cost of sales. Total cost is ascertained by adding selling and distribution overheads to cost of production of goods sold.
= +
The various components of total cost can be depicted through the help of the following chart:
Direct Material plus
Direct Labour plus Prime Cost or Direct or First Cost
Direct Expenses
Prime Cost plus Works Cost or Factory Cost or Production Cost
Works Overheads or Manufacturing Cost
Works cost plus
Office and Administration Office Cost or Total Cost of Production
Overheads
Office Cost plus
Selling and Distribution Cost of Sales or Total Cost
Overheads
COMPUTATION OF PROFIT
While preparing a cost sheet profit may have to be calculated either as a percentage of cost or as a percentage of selling price. The easiest course for a student will be to take that figure as 100 on which percentage of profit has been give and then to proceed with the calculations.
Example 1
Cost price is Rs 10,000
Profit is 10% of cost
Take cost price as 100.The profit is Rs10 on a cost of Rs100.Therefore, the profit on a cost of Rs 10,000 will be:
10,000 x 10\100 =Rs 1,000
Example 2
Cost price is Rs 10,000
Profit is 10% on selling price.
The selling price as 100. Cost price will be Rs. 90 (Rs.100-Rs.10) .Since profit is Rs.10 on a cost of Rs 90, the profit on a cost price of Rs. 10,000 will be:
10,000x10\90=Rs 1,111(appox.)
Example 3
Selling Price is Rs 10,000.
Profit is 10% on cost.
Take cost price as Rs100. The selling price will be Rs.110 (Rs. 100+Rs. 10).The Profit on a selling price of Rs 110 is Rs. 10, the profit on a selling price of Rs 10,000 will be:
10,000x10\110 Rs 909 (appox.)
COST SHEET
In the preceding pages, we have explained the different elements which constitute the cost of a product, job or a process. All these elements of cost can be put in the form of a statement which is technically called as a Cost Sheet or a Cost Statement. According to CIMA, London cost sheet is "a document which provides for the assembly of the estimated detailed cost in respect of a cost centre or a cost unit".' it analyses and classifies in a tabular form the expenses on different items tot- a particular period. Additional columns may also be provided to show the cost per unit pertaining to each item of expenditure and the total per unit cost. Variations of stock are also recorded and proper adjustments made to arrive at the correct figures of raw materials consumed and the cost of goods sold.
Cost sheet may also depict data for the preceding period along with the data for the present period so as to have quick appraisal of trends and tendencies in a single statement of I cost, Cost data for Stare than two periods can also be depicted in a cost sheet for a comparative study. It may also be prepared for snaking inter-firm comparison by including cost data for different firms. Such a single statement will facilitate inter-firm comparison of costs for taking decision about the policy formulation in the event of market competition.
Types of Cost Sheet
Cost sheet may be prepared on the basis of actual data (Historical Cost Sheet) or on the basis of estimated data (Estimated Cost Sheet) depending on the technique of costing employed and the purpose to be achieved. Thus cost sheet may be of two types:
Historical cost sheet. Such a cost sheet is prepared periodically after the costs have been incurred. The period may be a year, half-year, a quarter or a month, Actual costs are complied and presented through such a cost statement
Estimated cost sheet. Such a cost sheet is prepared before the actual commencement of production. The estimating process is repeated at regular intervals. Estimated cost sheets may be prepared on a yearly, half-yearly, quarterly or monthly basis. The estimated costs are compared with the actual costs every time whenever estimates are prepared so that costs can be controlled effectively since the ultimate aim of adoption of estimated costing technique is effective cost control. Costs are predetermined having regard to the present conditions and the circumstances likely to prevail in future, besides the past performances.
Importance of Cost Sheet
A cost sheet helps both in ascertainment and control of costs. It also provides data on the basis of which the selling prices of the products can be fixed. Thus , a cost sheet performs the following functions:
(i) Ascertainment of cost. A cost sheet helps in ascertainment of total cost, cost per unit at different stages of production. The information provided by the cost sheet helps the management in taking various decisions, viz., to make or buy a product, to sell or not to sell in a foreign market, to process a product completely in the factory or to purchase in a semi-finished form outside, etc.
(ii) Controlling costs. A cost sheet presents the cost data for two or more periods in a comparative form. Such a presentation helps in identifying the elements whose costs have gone up and where control is required.
Terminology adopted by Chartered Institute of Management Accountants, London.
(iii) Fixation of selling price. A cost sheet provides data about the cost of a job, product or process. The business can fix appropriate selling prices for its products on the basis of such data.
(iv) Submitting of tenders. Costs have to be ascertained for submitting of tenders, giving price quotations, etc. Preparation of an estimated cost sheet the relevant products or job considerably facilitates this work.
IIustration
The cost of sale of product A is made up as follows:
Rs
Materials used in manufacturing 5,500
Materials used in packing materials 1,000
Materials used in selling the product 150
Materials used in the factory 75
Materials used in the office 125
Labour required in producing 1,000
Labour required for supervision
Of the management-Factory 200
Expenses-Direct-Factory 500
Expenses-Indirect-Factory 100
Expenses-Office 125
Depreciation-office Building and Equipment 75
Depreciation-Factory 175
Selling Expenses 350
Freight 500
Advertising 125
Assuming that all the products manufactured are sold ,What should be the selling price to obtain a profit of 25% on selling price?
Illustrate in a chart form for presentation to your manager, the division of costs for product A.
Solution:
STATEMENT OF COST FOR PRODUCT A
Direct material
Materials used in manufacturing
Add: Freight
Materials used in packing materials
Direct labour:
Labour required in producing
Direct Expenses Factory
Prime Cost
Add Factory Overheads:
Material used in the factory
Labour for supervision of management – Factory
Expenses-Indirect-Factory
Depreciation-Factory
Works Cost
Add: Office Overheads:
Materials used in the office
Expenses-Office
Depreciation-Office Building and Equipment
Cost of Production
Add Selling and Distribution Overheads:
Material used in Selling the product
Selling expenses
Advertisement
Total Cost
Profit (25% on selling price)
Selling Price Rs.
5,500
500
1,000 Rs.
7,000
1,000
500
75
200
100
175
125
125
75
150
350
125 Rs.
8,500
550
9,050
325
9,375
625
10,000
3,333
13,333
Note: It has been assumed that the freight has been paid on raw materials purchased.
Chart Showing Elements of Cost of Product A
Working Notes
The element of cost have been shown by means of a pie diagram:
Direct Materials 360 x 7,000/10,000 =252
Direct Expenses 360 x 500/10,000 =18
Selling Overheads 360 x 625/10,000 =22.5
Factory Overheads 360 x 550/10,000 =19.8
Direct Labour 360 x 1,000/10,000 =36
Office Overheads 360 x 325/10,000 =11.7
Classification of Costs
Fixed, Variable, Semi-variable and Step Costs
The cost which varies directly in proportion to every increase or decrease in the volume of output or production is known as variable cost. The cost which does not vary but remains constant within a given period of time and range of activity in spite of the fluctuations in production, is known as fixed cost. Such range of activity over which fixed costs do not change is called relevant range. The cost which does not vary proportionately but simultaneously cannot remain stationery at all times is known as semi-variable cost. It can also be named as semi-fixed cost.
The fixed, variable and semi-variable costs if depicted on a graph paper will appear as follows:
(a)total fixed costs (rs.1,000) do not increase as the volume of production increases.
Product Costs and Period Costs
Cost which becomes part of the cost of the product rather than an expense of the period in which they are incurred are called as “Product costs”. They are included in inventory values. In financial statements such costs are treated as assets until the goods they are assigned to are sold. They become an expense at that time. These costs may be fixed as well as variable, e.g., cost of raw materials and direct wages, depreciation on plant and equipment, etc.
Costs which are not associated with production are called “Period Costs”. They are treated as an expense of the period in which they are incurred. They may also be fixed as well as variable. Such costs include general administration costs, salesman salaries and commission, depreciation on office facilities, etc. They are changed against the revenue of relevant period.
It may be noted that though period costs are necessary to generate revenue but they cannot be assigned to specific products. Hence. they are charged to the period in which they are incurred as expenses of that period.
As stated above administration and selling and distribution costs are treated as period costs on account of the following reasons:
(i) Most of the expenses are of a fixed nature.
(ii) Apportionment of these costs to specific products equitably is a difficult task.
(iii) it is difficult to ascertain the relationship between such costs and the products.
(iv) The benefits arising from these costs cannot be easily established.
Differences of opinion exist regarding whether certain costs should be considered as product or period costs. Some accountants are of the opinion that fixed manufacturing costs are closely related to the passage of time than to the manufacturing of the product. Thus according to them, variable manufacturing costs are product costs, while fixed manufacturing and other costs are period costs. However, their view does not seem ro have been yet widely accepted.
Direct and indirect Costs
The expenses on material and labour economically and easily traceable to a product, service or j ob are considered as direct costs. In the process of manufacture or production of articles. materials are purchased, labourers are employed and the wages are paid to them certain other expenses are also incurred directly. All of these take an active and direct pan in the manufacture of a particular commodity. hence are called direct costs'.
The expenses incurred on those items which are not directly chargeable to production are known as indirect costs. For example. in production, salaries of timekeepers, storekeepers, foremen are paid, certain expenses for nothing the administration are incurred—all of these cannot be conveniently allocated to production and hence are called 'indirect costs'.
Decision-making Costs and Accounting Costs
Decision-making costs are special purpose costs that are applicable only in the situation in which they are compiled. They have no universal application. "They need not tie into routine financial accounts. They do not and should not conform to the accounting rules ' ' Accounting costs are compiled primarily from financial statements. They have to be altered before they can be used for decision-making. Moreover they are historical costs and show what has happened under an existing set of circumstances, while decision-making costs are future costs. They represent what is expected to happen under an assumed set of conditions. For example accounting costs may show the cost of the product when the opens lions arc manual, while decision-making costs might be calculated to show the costs when the operations are mechanised.
Relevant and irrelevant Costs
Relevant costs are those costs which would be changed by the managerial decision, while irrelevant costs are those which would not be affected by the decision. For example,
If a manufacturer is considering closing down of an unprofitable retail sales shop. wages payable to the workers of the shop ate relevant in this connection since they will disappear on closing down of the shop. But prepaid rent for the shop or unrecovered costs of any equipment which will have to be scrapped will be irrelevant costs which must be ignored. They are expected future costs'' that will differ under alternatives.
Shutdown and Sunk Costs
A manufacturer or an organization rendering service may have to suspend its operations for a period on account of some temporary difficulties. e g.. shortage of raw material non-availability of requisite labour, etc. During this period though no work is done yet certain fixed costs, such as, rent and insurance of buildings, depreciation. maintenance, etc..
For the entire plant will have to be incurred. Such costs of the idle plant ate known as tan costs.
Sunk costs are historical or past costs. These ate costs which have been created by a on that was made in the past that cannot be changed by any decision that will be made future. Investment in plant and machinery building. etc.. are prime examples of such Since sunk costs cannot be altered by later decisions. they are irrelevant for decision making.
According to National Association of Accountants (USA) sunk cost means "an expenditure for equipment or productive resources which has no economic relevance to the present decision-making process''. On account of this reason all past costs. since they ate ant for decision-making. come in the category of sunk costs.'
An individual may regret having made a purchase or constructing an asset but having purchased or constructed it cannot avoid it by taking any subsequent action. Of course. the asset can be sold, in which case the cost of the asset will be matched against the proceeds sale of the asset for the purpose of determining gain or loss. The person may decide to continue to own the asset in which case the cost of the asset will be matched against the revenue realised over its effective life. However, he cannot avoid that cost which has already been incurred by him for the acquisition of the asset. It is as a matter of fact the sunk cost for all present and future decisions.
Example
Jolly Ltd. purchased a machine for Rs 30,000. The machine has an operating life of five years without any scrap value. Soon after making the purchase the management of Jolly Ltd. Feels that the machine should not have been purchased since it cannot yield the operating advantage originally contemplated. Of course. it is expected to result is saving in operating costs of Rs 18,000 over a period of five years. The machine can be sold immediately for a sum of Rs 22,000.
In taking the decision whether the machine should be sold or be used. the relevant taunts to be compared ate Rs 18,000 in cost savings over five years and Rs 22,000 that can be realised in case it is immediately disposed of Rs 30.000 invested in the asset is not event since it is the same in both cases. The amount is the sunk cost. Jolly Ltd. should, Phone, sell the machinery for Rs 22,000 since it will result in an extra profit of Rs 4,000 compared to keeping and using it.
2.
3.
Controllable and Uncontrollable Costs
Controllable costs are those costs which can be influenced by the action of a specified member of an undertaking. Costs which cannot be so influenced are termed as uncontrollable costs. A factory is usually divided into a number of responsibility centres each of which is in charge of a specified level of management. The officer-in-charge of a particular department or cost centre can control costs only of those matters which come directly under his control but not of other matters. For example, the expenditure incurred by the Tool Room is controllable by the Foreman-in-charge of that section but the share of the tool room expenditure which is apportioned to a machine shop cannot be controlled by a m. chine shop foreman. Thus, the difference between controllable and uncontrollable costs is only in relation to particular individual or level management. An expenditure which is controllable by one individual may be uncontrollable as far as another individual is concerned.
The difference between controllable and uncontrollable costs is important from the point of view of cost control and responsibility accounting. The concerned executives should be held responsible for escalation of such costs only which are controllable by them.
Avoidable or Escapable Costs and Unavoidable or Inescapable costs
Avoidable costs are those which will be eliminated, if a segment of the business (e.g., a product or department) with which they are directly related, is discontinued. Unavoidable costs are those which will not be eliminated with the segment. Such costs are merely reallo¬cated if the segment is discontinued. For example, in case a product is discontinued, the salary of the factory manager or factory rent cannot be eliminated. It will simply mean that certain other products will have to absorb a higher amount of such overheads. However, salary of clerks attached to the product or bad debts traceable to the product would be eliminated. Certain costs are partly avoidable and partly unavoidable, e.g., closing of one department of a store might result in decrease in delivery expenses but not in their alto¬gether elimination.
It is to be noted that only avoidable costs are relevant for deciding whether to continue or eliminate a segment of the business.
Imputed or Hypothetical Costs
These are costs which do not involve any cash outlay. They are not included in cost accounts but are important for taking into consideration while making management decisions. Examples of such costs are: interest on internally generated funds, salaries of the proprietor or partner of a partnership firm, rented value of company's own property, etc. Since these costs are notional costs, they do not enter into traditional system. However, they are important, as stated above, for managerial decisions. For example, where two projects require unequal, outlays of cash, the management must take into consideration interest on capital for judging the relative profitability of the projects though the company may use internally generated funds for the purpose.
Differential, Incremental or Decremental Costs
The difference in total costs between two alternatives is termed as 'differential costs'.
In case the choice of an alternative results in increase in total costs such increase in costs is known as 'incremental costs'. In case the choice results in decrease in total costs, such decrease in total costs is termed-as 'decremental costs'. While assessing the profitability of aproposed change the incremental costs are matched with the incremental revenue or dec¬remental costs are matched with decremental revenue. The proposed change is taken only when it is profitable.
Out-of-pocket Cost
Out-of-pocket cost means the present or future cash expenditure regarding a certain decision which varies depending upon the nature of decision made. For example, a company has its own trucks for transporting raw materials and finished products from one place to another. It seeks to replace these trucks by employment of public carrier of goods. In making this decision of course, the depreciation of the trucks is not to be considered, but the management must take into account the present expenditure on fuel, salary to drivers, and maintenance. Such costs are termed as out-of-pocket costs.
Opportunity Cost
Opportunity cost refers to the advantage in measurable terms which has been for gone on account of not using the facilities in the manner originally planned. For example, if an owned building is proposed to be utilized for housing a new project plant, the likely revenue which the building could fetch if rented out is the opportunity cost which should be taken into account while evaluating the profitability of the project. Similarly, if a manufacturer is confronted with the problem of selecting any one of the following two alternative:
(a) selling a semi-finished product at Rs 2 per unit, and
(b) Introducing it into a further process to make it more refined and variable. Alternative (b) Will prove to be remunerative only when after paying the cost of further processing the amount realized by the sale of the product is more than Rs 2 per unit—the revenue which could have otherwise been realized. The revenue of Rs 2 per unit is forgone in case alternative (b) is adopted. The term opportunity cost' refers to this alternative revenue forgone.
Traceable, Untraceable or Common Costs
Costs which can be easily identified with a department, process or product are termed as traceable costs. e.g. the cost of direct material, direct labour, etc. Costs which cannot be so identified are termed as untraceable or common costs. In other words, common costs are costs incurred collectively for a number of cost centers, and are to be suitably apportioned for determining the cost of individual cost centres e.g . Overheads incurred for a factory as a whole, combined purchase cost for purchasing several materials in one consignment, etc.
Joint costs as discussed below are a sort of common costs. When two or more products are produced out of one and the same material or process, the costs of such material or process are called Joint costs. For example, when cotton seeds and cotton fibre are produced from the same raw materials, the cost incurred till split-off or separation point will be joint costs.
Joint Costs and Common Costs
Sometimes out of the same manufacturing operations two or more products are produced. The cost incurred till the split-off point of these product, is known as 'joint cost'. The National Association of Accountants, USA, defines joint costs as follows:
'Joint costs relate to two or more products produced from a common product process or element-material, labour or overhead or any combination thereof or so locked together that one cannot be produced without producing the other. "
For instance, while refining crude oil a number of products, viz . wax, coal tar and petroleum, are produced, the costs incurred till these various products are separated from each other are termed as joint costs'. Joint costs can be apportioned over different products only by adopting a suitable basis of apportionment.
Common costs as stated above, are those which are incurred for more than one product, Job, territory or any other specific costing unit. They are not capable of being identified with individual product and therefore are apportioned on a suitable basis.
TheNational Association of Accountants, U.S.A. defines common costs as follows: "The cost of services employed in the creation of two or more outputs which is not allocable to those outputs on a clearly justified basis. "
For instance rent, Lighting and supervision costs are common costs to all departments located in the factory.
The basic difference between Joint costs and common costs is that Joint costs are incurred only in case of process industries where a product cannot be independently produced, i e.. the nature of manufacturing is such that out of the same process, two or more products will be produced, while common costs may be incurred for all types of industries whether job or process. They may be incurred in addition to joint costs in the same industry.
Conversion Cost
The cost of transforming direct material into the finished product, exclusive of direct material cost is known as the conversion cost. It is usually taken as the aggregate of the cost of direct labour, direct expenses and factory overheads.
Production, Administration and Selling and Distribution Costs etc.
A business organization performs a number of functions. e.g., production, administration, selling and distribution, Research and Development. Costs are to be ascertained for each of these functions. The Chartered Institute of Management Accountants (CIMA). London, has defined each of the above costs as follows:
1. Production cost: The cost at the sequence of operations which begins with supplying materals, labour and services and ends with the primary packing of the product. Thus, it includes the cost of direct material, direct labour, direct expenses and factory overheads.
2. Administration cost: The cost of formulating the policy, directing the organisation and controlling the operations of an undertaking, which is not related directly to a production, selling distribution, research or development activity or function.
3. Selling cost: The cost of seeking to create and stimulate demand (sometimes termed as marketing) and of securing orders.
4. Distribution cost: The cost of sequence of operations which begins with making packed product available for dispatch and ends with making the reconditioned returned empty package, if any, available for re-use.
5. Research cost: The cost of searching for new or improved products, new application of materials, or new or improved methods.
6. Development cost: The cost of the process which begins with the implementation of the decision to produce a new or improved product or to employ a new or improved method and ends with the commencement of formal production of that product or by that method.
7. Pre-production cost: That part of development cost incurred in making a trial production run preliminary to formal production.
COST ASCERTAINMENT
The technique of costing involves: (i) collection and classification of expenditure according to cost elements and (ii) allocation and apportionment of the expenditure to the cost centres or cost units, or both. The elements of costs have already been discussed in the previous pages. The meaning of the terms cost unit' and cost centre' are as follows:
Cost Unit
In preparing cost accounts it becomes necessary to select a unit with which expenditure may be identified. The quantity upon which cost can be conveniently allocated is known as a unit of cost or cost unit. The Chartered institute of Management Accountant (CIMA), London, defines a unit of cost as " a unit of quantity of product, service or time in relation to which costs may be ascertained or expressed".
Unit selected should be unambiguous, simple and commonly used. Following are some examples of units of cost:
(i) Brick kilns —- per 1,000 bricks made
(ii) Collieries —per tonne of coal raised
(iii) Textile Mills -—per yard or per lb. of cloth manufactured or yam spun
(iv) Electricity Companies — per unit of electricity generated
(v) Transport Companies — per passenger. km., per tonne km.
(vi) Steel mills —per tonne of steel made.
Cost Centre
According to the Chartered Institute of Management Accountants (CIMA) London, cost centre means, "a location, person or item of equipment (or group of these) for which costs may be ascertained and used for the purpose of cost control." Thus, cost centre refers to one of those convenient units into which the whole factory organization has been appropriately divided for costing purposes. Each such unit consists of a department or a sub department or item of equipment or machinery or a person or a group of persons. Sometimes, closely associated departments are combined together and considered as one unit for costing purpose. For example, in a laundry, activities such as collecting, sorting, marking and washing of clothes are performed. Each activity may be considered as a separate cost centre and all costs relating to a particular cost centre may be found out separately.
Cost centre may be classified as follows:
(i) Productive, unproductive and mixed cost centres.
(ii) Personal and Personal cost centres.
(iii) Operation and process cost centres.
Productive cost centers are those which are actually engaged in making the products. Service or unproductive cost centers do not make the products but are essential aids to the productive centers. Examples of such service centers are those of administration, repairs and maintenance, stores and drawing office departments. Mixed cost centers, are those which are engaged sometimes on productive and other times of service works. For example, a tool shop serves as a productive cost centre when it manufactures dies and jigs to be charged to specific jobs or orders but serves as service cost centre when it does repairs for the factory.
Impersonal cost centre is one which consists of a department, plant or item of equipment, while a personal cost centre is one which consists of a person or group of persons. In case a cost centre consists costs of those machines and/or persons which carry out the same operation it is termed as operation cost centre if a cost centre consists of a continuous sequence of operations, it is called process cost centre.
In case of an operation cost centre all machines or operators performing the same operation are brought together under one centre. The objective of such an analysis is to ascertain the cost of each operation irrespective of its location inside the factory. In the
process type cost centre the cost is analyzed and related to a series of operations in sequence as in chemical industries, oil refineries and other process industries.
Profit Center and Cost Centre
A center whose performance is measured in terms of both the expenses it incurs and revenue it earns is called as profit centre. Thus, the profit centre is that segment of the activity of a business with which both the revenues and expenses are identified and profit or loss made by that particular segment of activity is ascertained. Profit centre is different from a cost centre as follows: (i) A cost centre is created for accounting convenience for ascertaining and controlling cost. Whereas the profit centre is created because of decentralization of business operations. (ii) A cost centre does not have target cost. Of course, efforts are made to minimize the cost. However, a profit centre has a profit target and it enjoys authority to adopt such policies which are necessary for achieving its target.
COST ESTIMATION AND COST ASCERTAINMENT
Cost estimation is the process of predetermining the costs of a certain product, job or order. Such predetermination may be required for several purposes such as budgeting, measurement of performance efficiencies, preparation of financial statements (valuation of stocks, make or buy decisions, fixation of the sale prices of the products, etc. Cost ascertainment is the process of determining costs on the basis of actual data. Hence computation of historical costs is cost ascertainment while computation of future costs is cost estimation.
Cost estimation and cost ascertainment are both interrelated. They are of immense use to the management. In case a concern has a sound costing system, the ascertained costs will greatly help the management in the process of estimation of rational accurate costs which are so necessary for a variety of purposes stated above. Moreover the ascertained cost may be compared with the predetermined costs on a continuing basis and proper and timely steps are taken for controlling costs and maximizing profits.
COST OBJECTIVE AND COST ACCUMULATION
Cost objective may be defined as any activity for which a separate measurement of a cost is desired. It may be in the form of a cost unit or a cost centre. For example, cost may be calculated for a product, a process, a machine hour, a social welfare project or a conceivable activity. Cost objective greatly helps in deciding whether a particular cost item should be taken as a direct or indirect cost. In case the cost item can be directly identified with the cost objective, the cost will be taken as direct. However, if this cannot be done, the cost item will be taken as an indirect or an overhead cost.
Cost objective should not be confused with costing objective. The latter is concerned with reference to the overall objective for which cost collection, cost analysis and cost control exercise is carried out. Such exercise may be necessary for the management for planning, control and decision making. For example, a cost exercise may be carried by a company for giving quotation in a foreign market. This is the costing objective. However, in this process, the cost of a unit or cost of a product or a process may have to be calculated. This is a cost objective.
Cost accumulation is the collection of data in a organized manner through an accounting system. It is basically concerned with routine complication of historical data in a regular and orderly manner. The other cost data may be collected on the occasion as and when required. For example, Cost of manufacturing a component may be computed on a regular basis. However, in order to decide whether the component should be manufactured in the factory or should be purchased from outside, the information about the purchase price can be computed as and when desired.
COST ALLOCATION AND COST APPORTIONMENT
Cost allocation and cost apportionment are the two produces which describe the identification and allotment of cost centers or cost units. Cost allocation refers to the allotment of the whole items of cost to cost centers or cost units. While the cost apportionment refers to the allotment of proportions of item of cost to cost centers or cost units. Thus, the former involves the process of charging direct expenditure to cost centers or cost units while the latter involves the process of charging indirect expenditure to cost centers or cost units. For example, the cost of labour engaged in a service department can be charged wholly and directly to it but the canteen expenses of the factory cannot be charged directly and wholly to it. Its proportionate share will have to be found out. Charging of cost in the former case will be termed as allocation of cost while in the latter has apportionment of cost.
COST REDUCTION AND COST CONTROL
Cost reduction and cost control are two different concepts. Cost control has achieving the cost target as its objective while cost reduction is directed to explore the possibilities or improving the target themselves. Thus, cost control ends when targets are achieved while cost reduction has no visible end. It is a continuous process. The difference between the two can be summarized as follows:
(i) Cost Control aims at maintaining the cost in accordance with established standard, while cost reduction is concerned with reducing cost. It challenges all standards and endeavours to better them continuously.
(ii) Cost control seeks to attain lowest possible cost under existing conditions. While cost reduction recognized no condition as permanent since a change will result in lower cost.
(iii) In case of cost control emphasis is on past and present, while in case of cost reduction it is on the present and future.
(iv) Cost control is a preventive function, while cost reduction is a corrective function. It operates even when an efficient cost control system exist.
METHODS OF COSTING
Costing has been defined as “the technique and process of ascertaining costs".
The principles in every type of costing are the same but the methods of analyzing and presenting the costs differ with the nature of business.
Job Costing
Where production is not highly repetitive and, in addition, consists of distinct jobs or lots so that material and labour costs can be identified by order number, the method of job costing is used. This method of costing is very common in commercial foundries and drop forging shops and in plants making specialised industrial equipments. In all these cases an account is opened for each job and all appropriate expenditure is charged thereto.
Contract Costing
Contract costing does not in principle differ from job costing. A contract is a big job while a job is a small contract. The term is usually applied where at different sites large scale contracts are carried out. In case of ship-builders, printers, building contractors, etc., this method of costing is used.
Job or contract costing is also termed as “Terminal Costing''.
Cost Plus Costing
In contracts where besides ‘cost’ an agreed sum or percentage to cover overheads and profit is paid to the contractor, the method is termed as cost plus costing. The term cost' here includes material, labour, and expenses incurred directly in the process of production. The method used generally in cases where Government happens to be the contractee.
Batch Costing
Where order or jobs are arranged in different batches after taking into account the convenience of producing articles, batch costing is employed. Thus, in this method the cost of a group of products is ascertained. The unit of cost is a batch or group of identical products, instead of a single job order or contract. The method is particularly suitable for general engineering factories which produce components in convenient economic batches and pharmaceutical industries.
Process Costing
If a product passes through different stages, each distinct and well-defined, it is desired to know the cost of production at each stage. In order to ascertain the same, process costing is employed under which separate account is opened for each process.
This method of costing is suitable for the extractive industries. e.g., chemical manufacture, paints, foods, explosives, soap making etc.
Operation Costing
Operation costing is a further refinement of process costing. This method is employed in industries where mass or repetitive production is carried out or where articles or components have to be stocked in semi-finished stage, to facilitate the execution of the special orders, or for convenience of issue for later operations. The procedure of costing is broadly the same as for process costing except that cost unit is an operation instead of a process. For example, the manufacturing of handles for bicycles involves a number of operations such as those of cutting steel sheets into proper strips, moulding, machining and finally polishing. The cost of each of these operations may be found out separately.
Unit Costing (Output Costing or Single Costing)
In this method cost per unit of output or production is ascertained and the amout of each element constituting-such cost is determined. Where the products can be expressed in identical quantitative units and where manufacture is continuous this type of costing is applied. Cost statements or cost streets are prepared under which the various items of expenses are classified and the total expenditure is divided by total quantity produced in order to arrive at per unit cost of production. The method is suitable in industries such as brick making, collieries, flour mills, paper mills, cement manufacturing, etc.
Operating Costing
This method is employed where expenses are incurred for providing services such as those rendered by bus companies, electricity companies, or railway companies. The total expenses regarding operation are divided by the units as may be appropriate (e g., in case of bus company, total number of passenger kms.) and cost per unit of service is calculated.
Departmental Costing
Ascertainment of the cost of output of each department separately is the objective of department costing. Where a factory is divided into a number of departments, this method is adopted.
Multiple Costing (Composite Costing)
Under this method the costs of different sections of production are combined after finding out the cost of each and every part manufactured. The method of ascertaining cost in this way is applicable where a product comprises many assembled parts, e g., motor cars, engines, machine tools, typewriters, radios, cycles, etc.
As various components differ from each other in a variety of ways such as to price, materials used and manufacturing process, a separate method of costing is employed in respect of each component. It is multiple costing in the sense that more than one method of costing is employed.
It is to be noted that basically there are only two methods of costing, viz.., Job costing and Process costing. Job costing is employed in cases where the items of prime cost (i.e., direct malarial direct labour and direct expenses) are traceable to specify jobs or orders, e.g.,house building, ship-building, etc. But where it is impossible to trace the items of prime cost to a particular order because their identity is lost in manufacturing operations, process costing is used. For example, in a refinery where several tonnes of oil are being produced at the same time, the prime cost of a specific order of 10tonnes cannot he traced. The cost can he found out only by finding out the cost per tonne of total oil produced and then multiplying it by ten. It may, therefore, be concluded that the methods of batch, contract and cost plus costing are only the variants of Job costing', while the methods of unit, operation and operating costing are only the variants of process costing'.
This has been shown by the following chart:
TECHNIQUES OF COSTING
Besides the above methods of costing, the following types of costing techniques are used by management only for controlling costs and making some important managerial decisions.
As a matter of fact they are not independent methods of cost finding such as job or process resting but are basically costing techniques which can be used with advantage with any of the methods discussed above.
Marginal Costing
It is a technique of costing in which allocation of expenditure to production is restricted to those costs which arise as a result of production, i.e. costs which vary with production, e.g. costs of direct material, direct labour, direct expenses (variable) and variable overheads. Fixed costs are excluded on the ground that in cases where production varies, the inclusion of fixed costs may give misleading results
The technique is useful in manufacturing industries with varying level of output.
Direct Costing
The practice of charging all direct costs to operations, processes of products, leaving all indirect costs to be written off against profits in the period in which they arise, is termed as direct costing.
The technique differs from marginal costing because some fixed costs can be considered as direct costs in appropriate circumstances. For example in case of a company manufacturing a single product, the factory rent is a direct cost but not a variable cost.
Absorption or Full Costing
The practice of charging all costs both variable and fixed to operations, products or processes is termed as absorption costing.
Uniform Costing
A technique where standardized principles and methods of cost accounting are employed by a number of different companies and firms, is termed as uniform costing. Standardization may extend to method of costing, accounting classification including codes, methods of defining costs and charging depreciation, methods of allocating or apportioning overheads to cost, centres or cost units. The system thus facilitates inter-firm comparisons, establishment of realistic pricing policies etc.
SYSTEMS OF COSTING
It has already been stated that there are two main methods used to determine costs:
1. The Job Cost Method, and
2. The Process Cost Method.
It is possible to ascertain the costs under each of the above methods by two different systems as shown by the following diagram:
Historical Costing
Historical costing (conventional or costing) is the determination of cost by actual. It may be in the nature of (i) Post costing, or (ii) Continious costing.
(i) Post costing: It means ascertainment of cost after the production is completed. This is done by analyzing the financial accounts at the end of the period in such a way as to disclose the cost of the units which have been produced.
(ii) Continuous costing: In case this system cost is ascertained as soon as the job is completed or even when the job is in progress. This is done charging to the job or product actual expenditure on materials and wages and estimated share of overheads. Hence, the figure of cost ascertained in this case is not exact. But it has an advantage of providing cost information to the management promptly thereby enabling it to take the necessary corrective action in time. However, it neither provides any standard for judging current efficiency nor does it disclose what the cost of the job ought to have been.
Standard Costing:
Standard costing is a system under which
(a)costs are predetermined on the basis of carefully laid down standards
(b)actual costs are compared with the predetermined costs
(c)variances are found out as to their causes
(d)remedial measures including revision of standards undertaken if necessary.
The system of standard costing immensely facilitates controlling cost which has now become a primary function of cost accountant. As a result this system is becoming more and more popular these days.
4. INTEXT QUESTIONS
1. Differentiate between
a. Cost Unit and Cost Centre
b. Direct Cost and Indirect Cost
c. Operating Cost and Process Cost
2. What is Direct Cost? Explain its significance.
3. Write short notes on:
a. Opportunity Cost
b. Cost Center
c. Operating Cost
d. Controllable and Uncontrolable Costs.
4. Distinguish clearly between direct and indirect materials. Under what circumstances may direct materials be charged indirectly to the finished product.
5. SUMMARY:
A Cost sheet is a document which provides for assembly of different costs in respect of a cost centre or a cost unit. Using the various elements of cost like Material, labour and Expenses and Overheads, the total cost of production can be computed.
6. TERMINAL EXERCISES:
1. Incremental cost is a type of
a. differential cost
b. out-of-pocket cost
c. conversion cost.
2. Variable cost per unit
a. remains fixed
b. fluctuates with the volume of production
c. varies in sympathy with the volume of sales
7.ASSIGNMENTS
1. The Indian Engineering Company Ltd., manufactured and sold 1,000 sewing machines in 1999. Following are the particulars obtained from the records of the company.
Cost of materials 80,000
Wages paid 1,20,000
Rent 10,000
General Expenses 20,000
Manufacturing Expenses 50,000
Salary (Office) 60,000
Selling expenses 30,000
Sales 4,00,000
The company plans to manufacture 1,200 sewing machines in the year 2000. You are required to submit a statement (Estimate Cost Sheet) showing the price at which the machines should be sold to show a profit of 10% on sales. The following information is given.
The price of material rise by 20% on previous year’s level.
Wages will rise by 5%
Total manufacturing expenses will rise by 10%
Selling expenses per unit decrease by 10%
Other expenses will be unaffected by the rise in output.
8. KEY TERMS
Cost Sheet: A document which provides for assembly of different costs in respect of a cost center or a cost unit.
Direct labour: Labour which takes active and direct part in the production of a particular commodity.
Direct material: Material which becomes an integral part of the finished product and which can be conveniently assigned to specific physical units.
Fixed Cost: A cost that remains constant within a given period of time and range of activity in spite of fluctuations in production.
Indirect Cost: The expenditure on labour, materials or services which cannot be economically identified with specific saleable cost unit.
Semi-variable Cost: A cost containing both fixed variable components and which is thus partly affected by fluctuations in the level of activity.
Variable Cost: A cost which tends to vary in direct proportion to the level of activity.
LESSON – 8
ACCOUNTING FOR MANAGERIAL DECISION MAKING – ACONCEPTUAL APPROACH
1. INTRODUCTION
Accounting can no longer be considered a mere language of business.
The need for maintaining the financial chastity of business operations, ensuring the reliability of recorded experience resulting from these operations and conducting a frank appraisal of such experience has made accounting a prime activity along with such other activities as marketing, production and finance. Accounting may be broadly classified into two categories – accounting which is meant to serve all parties external to the operating responsibility of the firms and the accounting which is designed to serve Internal parties who take care of the operational needs of the firm. The first category, which is conventionally referred to as "Financial Accounting," looks to the interest of those who have primarily a financial stake in the organisation's affairs – creditors, investors, employees, etc. On the other hand the second category of accounting is primarily concerned with providing information relating to the conduct of the various aspects of a business like cost or profit associated with some portions of business operations to the internal parties viz., management. This category of accounting is called as "Management Accounting."
2. OBJECTIVES
After reading this lesson the student should be able to:
• understand the meaning of management accounting
• understand the objectives of management accounting
• appreciate the importance of management accounting in decision making
• distinguish management accounting from cost–accounting and financial accounting
• realize the limitations of management accounting
• comprehend the role of management accountant
3. CONTENT
Evolution of Management Accounting
Meaning of Management Accounting
Functions or Objectives of Management Accounting
Utility of Management Accounting
Limitations of Management Accounting
Management Accounting Vs Financial Accounting
Management Accounting Vs Cost Accounting
EVOLUTION OF MANAGEMENT ACCOUNTING
A perusal of the Accounting History from the very beginning to some recent years reveals that accounting has primarily been developed to meet those needs which arise from the fiduciary relationships between parties like firm, owners, creditors, management etc.
But the last few decades have witnessed a dramatic change in the development of accounting from a mere device of recording business transactions to a formidable instrument of forecasting, planning and regulating business activity. No longer an accountant could remain a mere book–keeper. He is something more than that. The change in his duty is being associated with the change in the objectives of the accounting as such. At present the objective of accounting is not only to keep records and prepare final accounts but also to help management in its basic functions which are becoming day–by–day more complex and complicated. But it was found that the traditional accounting i.e. financial accounting could not meet the requirements of the management today due to many reasons. The first and foremost reason is that financial accounting provides information only about past records i.e. a post–mortem of what has already happened. It could give a story of how a business has fared financially during a given period of trading or how its affairs stand at a particular point of time. It does not tell the management as to how the business has fared at each stage of operation. It also does not tell what should be the future policy of the management in order to achieve the targets set or to set new targets. Further there are many 'no’s in financial accounting – no analysis and interpretation of data, no modern approach, no standards for comparison, no provision for control measures, no accountancy for price level changes, etc. Thus financial accounting cannot cope with the varied & business problems. So to overcome the. defects and limitations of financial accounting which is said to be static, management accounting which is a dynamic process has been evolved.
MEANING OF MANAGEMENT ACCOUNTING
The term management accounting is of very recent origin. As already stated it evolved due to Inherent limitations of financial accounting. It is a tool of Management in contrast to the conventional annual or half–yearly accounts prepared mainly for information of proprietor. Top management wants concise but distilled information for decision – making. Management is the task of planning, organizing, directing and controlling. It constantly needs accounting information to base its decisions upon. Management accounting provides this information. The essence of the subject can be simply expressed that management accounting saves the needs of management.
1 Definition of Management Accounting: A number of definitions are available on the subject management accounting. Before attempting to see the various definitions it may be added that there is no unanimity among the management accountants as to its precise definition.
The Institute of Chartered Accountants of England has defined management accounting as: "Any form of accounting which enables a business to be conducted more efficiently can be regarded as Management Accounting". This definition is of a general nature and hence it is not of much use.
Robert N. Anthony has defined it as: "Management Accounting is concerned with accounting information that is useful to management". Anthony's sweet and simple definition does not shed much light on all phases of Management Accounting.
As per American Accounting Association, "Management Accounting includes the methods and concepts necessary for effective planning, for choosing among alternative business actions and for control through the evaluation and interpretation of performances". As compared to other definitions this definition is broader in nature covering three vital areas of management. Viz. planning, decision–making and controlling.
Some other standard definitions on the subject are given below:
Institute of Chartered Accountants of India
"Such of its techniques and procedures by which accounting mainly seeks to aid the management collectively have come to be known as management accounting".
John Sizer
"Management Accounting may be defined as the application of accounting techniques to the provision of information designed to assist all levels of management in planning and controlling the activities of the firm".
FUNCTIONS OR OBJECTIVES OF MANAGEMENT ACCOUNTING
The following excerpt taken from "Management through Accounts" the second treatise of James H. Bliss prescribes functions of management accounting which also becomes its objectives.
"The real function of all accounting work is to render a service to business management. The service lies in placing before business executives the most complete information on their affairs analyzed and interpreted so as to be readily understood and used effectively in guiding and controlling their operations and transactions more profitably, economically and conservatively".
From the above statement we get the following two functions:
(a) Operating functions: To present the required facts and information for the use of management in a quantitative form.
(b) Theoretical functions: To help in effective performance of managerial functions i.e. planning, organizing, control etc.
The first category i.e. operating functions is discussed under the heading functions of management accounting and the second category. viz. theoretical functions is discussed under the heading objectives of management accounting.
1 Functions of Management Accounting
Modification of data: The main function of any accounting system is recording of business transactions. Management accounting system is not an exception to this. It supplies the accounting data required for decision making purpose. For this purpose it modifies the data furnished by financial accounting to serve the managerial needs. This is done through resort to a process of classification and combination which enables to retain similarities of details without eliminating dissimilarities.
Validating the data: In the present day competitive and complex business world quick decision alone is not enough, the decision must also be a reliable one. To make decisions reliable valid data should be made available to managers.
The effectiveness of managerial function depends too much upon the accuracy and adequacy of the data. It is the function of management accounting to present before the management the required data with some sort of reasonable accuracy. It may be noted in this connection that management accounting provides the required data with reasonable accuracy and not with perfect accuracy.
Analysis and interpretation of data: Though management accounting is concerned with recording of business transactions, the analysis and interpretation of such data, in analysing and Interpreting the data lies the essence of management accounting. Data as such are mere figures and would not speak anything. Unless these are analyzed quantitatively or qualitatively management cannot take any step. Analysis and interpretation of data opens up new directions for its use by management and makes data more meaningful; To discharge this function management accounting uses a number of tools like Ratio analysis. Funds flow analysis. Cash flow analysis, etc.
Communicating the data: The collected and interpreted data must be communicated to those who are interested in it or to whom it has some meaning. Otherwise these data may not yield any meaningful result and the whole process of collecting, validating and interpreting would amount to be a futile exercise. The communication of the data should be done within a reasonable time. Data delayed is decision delayed and a delayed decision may delay the prosperity of its concern. To accomplish this function of management accounting several reports and statements are being used. Thus accounting reporting or managerial reporting is also an important function.
2 Objectives of Management Accounting: The primary object of management accounting is to help the management. It helps the management in the areas of planning, organizing, controlling, co–ordinating and decision making.
To help in planning: Planning is the primary function of management. Management accounting assists the management in this vital area by making forecasts about the production, the selling, the inflow and outflow of cash i.e. in planning a very wide range of activities of the business. Not only that, it may also forecast how much may be needed for alternative courses of action or the expected rate of return there from and at the same time decides upon the programme of activities to be undertaken.
To assist in organizing: The main function of organisation is to establish structural relationship among various segments in an enterprise. It is done through division of responsibility and delegation of authority. By preparing budgets and ascertaining specific cost centre, it delivers the resources to each centre and delegates the respective responsibilities to ensure their proper utilization. As a result, an inter–relationship grows among the different parts of the enterprise.
To help in controlling: It is because of controlling function that management accountant is called as 'controller'. Management accounting helps in the controlling function through the techniques of 'standard costing' and 'budgetary control'.
To control is the systematic examination of business results with a view to ensure that actual result has been according to the planned one. In case of variances the reasons for the same are ascertained and corrective action is suggested to prevent the recurrence of such variances.
To help in co–ordination: Management accounting helps the management in the over–all co–ordination of various operational activities. This coordination work it does, by preparing the functional budgets then by integrating all functional budgets into one which goes by the name of "Master Budget". Thus the technique of 'budgetary control is used by the management accountant to help in coordinating the different segments of the enterprise. Without coordination it is not possible to achieve the set objectives of the enterprise.
To help in decision–making: Like planning, decision making also is an important and prime function of top–management. By decision–making is meant the choosing of such an alternative amongst various alternatives which would yield the maximum return. Management accounting helps the management in the process of decision–making by providing significant information relating to various alternatives in term of costs and revenues. The techniques of 'marginal costing', 'break–even analysis', "capital budgeting' etc are used by the management accountant for this purpose.
UTILITY OF MANAGEMENT ACCOUNTING
As management accounting has emerged to overcome the limitations of financial accounting it is needless to point out that many advantages which are not associated with financial accounting are available with management accounting. These are already discussed while explaining the objects and functions of management accounting. However for ready reference the advantages of management accounting are summarized below:
1) Through efficient planning and effective organization management accounting brings systematic regularity in the business activities
2) Management accounting increases the efficiency of the concern by comparing actual performance with expected performance and suggesting remedial action to avoid the recurrence of adverse variances.
3) The application of various types of controls in accounting areas results in cost reduction and finally in price reduction. This increases the competitive power of the concern.
4) Management accounting acts as a binding force in bringing about coordination among various accounting departments. This enables greater total achievement of the set objectives of each accounting department.
5) The 'control' function of management accounting eliminates various types of wastages, production defectives and increases workers' efficiency.
6) Management accounting removes the unacceptable or sub– standards which often are responsible for stained relations between management and labour class. This improves industrial relations.
7) The overall effect of installation of management accounting system is that return on capital employed is maximized.
LIMITATIONS OF MANAGEMENT ACCOUNTING
No system in the universe is perfect. This applies to accounting system also. This applies to management accounting system also. The management accounting system suffers from certain limitations. Unless these limitations are taken into account the so–called benefits or advantages cannot be reaped. The various limitations of management accounting are listed below:
1) Most of the data used in management accounting are derived from financial accounting records or cost accounting records or other records. Just as the title of a transferee of a property depends upon the title of the transferor similarly the conclusions arrived at by management accountants depend to a large extent on the accuracy of the data provided by financial accounting and cost accounting. The flaws which are there in these two records are also reflected in management accounting. In other words the merits and demerits of management accounting depends upon the merits and demerits of these two records.
2) Management accounting is of recent origin. It is only a few decades old. Still it is in a state of evolution. Consequently it comes across the same difficulties which any new discipline will have to face. The analytical tools used by it are to be sharpened, the techniques adopted by it are to be improved and the uncertainty prevailing about the application of its concepts is to be removed.
3) Intuitive decision–making still dominates the scene i.e. there is a consistent tendency to replace scientific decisions with intuitive decisions despite the fact that management accounting provides for rational analysis based on facts. There always prevails a temptation to take an easy course of arriving at decisions by intuition rather than taking the tortuous path of scientific decision making. Even if an analysis and Interpretations of data is done it is affected by the personal prejudice and bias of the accounting people. This limits the utility of management accounting.
4) Management accounting has a very wide and diverse scope. It unites two broad areas–management and accounting–each of which is very broad in itself. It makes use of both accounting as well as non–accounting sources and also quantitative as well as qualitative information. This wide and diverse scope of management accounting creates many difficulties.
5) It follows from the above i.e. in view of the wide scope of the subject, for taking decisions; the management should have a thorough knowledge in different fields such as accounts, finance, statistics, taxation, audit, etc. But in practice, it is found that the persons entrusted with taking some decisions do not have the required knowledge. This dearth of knowledge affects the quality of the decision taken by them.
6) Resistance to change is a common phenomenon. Whenever any new system is introduced people who are acquainted with the old or traditional system tend to resist it. The installation of a system of management accounting involve s a radical transformation in the established state of affairs. If the people concerned are not psychologically ready to adopt themselves resist to any change.
7) The introduction of management accounting system in a concern requires an elaborate organisation structure which is very costly. Therefore, small concerns cannot afford to adopt this system.
8) Conclusions derived or decisions taken by the management accountant are of little value unless these are properly executed at various levels of the organisation. Thus there is a consistent and constant need for the execution of the various decisions at each management level.
MANAGEMENT ACCOUNTING VS FINANCIAL ACCOUNTING
Financial accounting and management accounting are two interrelated facets of the accounting system. They are not independent of each other. They are interdependent. They are supplementary in nature.
Financial accounting provides the basic data which are analyzed and interpreted suitably and in the required manner by management accounting.
Even though in the words of Robert N. Anthony a close relationship exists between financial accounting and management accounting yet there are certain fundamental differences between the two. A distinction is always drawn between financial accounting and management accounting since they differ in their emphasis and approaches. Some of the points of differences between these two accounting systems are given below:
(1) The essential difference between financial accounting and management accounting lies in their objective. The primary object of financial accounting is to make periodical reports to shareholders, creditors, debenture holders and the Government. The primary object of management accounting is to provide information for internal management.
(2) Financial accounting is concerned with assessing the results of a business as a whole, whereas management accounting is concerned with assessing the activities of different sections or divisions or departments i.e. financial accounting is general in nature whereas management accounting is analytical in nature.
(3) Financial accounting is concerned almost exclusively with historical records whereas management accounting is concerned with the future plans and policies. Financial accounting reports tell what has happened in the past. Through financial statements, investors are revealed the manner, in which the resources entrusted by them to the firm have been utilized, Management accounting being a decision–making process, focuses on future. It analyses past data and adjusts them in the light of future expectations to make plans.
(4) In management accounting there is more emphasis on furnishing information quickly than in the case with financial accounting.
(5) In management accounting there is less emphasis on precision; approximate figures which are promptly available are considered to be more valuable than very precise data received too late.
(6) In financial accounting records are maintained in the form of personal, property and nominal accounts. In management accounting costs and revenues are mostly reported by responsibility centres or cost centres.
(7) The generally accepted accounting principles and conventions govern the financial accounts and statements. These accounting principles and conventions are not binding on management accounting, information outside the debit and credit structure is often as valuable as
(8) For every business, financial accounting has become more or less compulsory indirectly, if not directly, due to a number of factors. It is obligatory for joint stock companies to satisfy statutory provisions. It is not mandatory to install a system of management accounting but its usefulness makes it highly desirable,
(9) They also differ in the period of reporting. Financial accounting adopts twelve months period for reporting financial performance to shareholders and other Investors. In contrast management accounting reports are for shorter durations. Management accounting information is also collected for preparing long term plans for five or more years. Capital expenditure plans, for example, cover a longer duration.
(10) Financial accounting limits the role of the accountant to a book–keeper. Management accounting transcends the role of the accountant beyond book–keeping into the managerial process of planning, organizing, control and evaluating and also to different functional areas.
MANAGEMENT ACCOUNTING Vs COST ACCOUNTING
Costing has been defined as classifying, recording and appropriate allocation of expenditure for the determination of the costs of products or services.
Cost accounting will tell the management as to how the business has fared at each stage of operation. But cost accounting will not tell them anything about the future policy to be adopted. It is here that management accounting differs from cost accounting. The aim of management accounting is not to collect information as such but to utilize the information collected in order to help the management to formulate their future policy and to make important policy decisions.
Though there is a difference between management accounting and cost accounting in their objective yet their functions are complementary in nature. Management accounting depends heavily on cost data and other information derived from cost records. In one way, management accounting is an expansion of cost accounting. Like cost accounting, management accounting involves reporting at frequent intervals rather than at the end of a year or half–year.
Cost accounting deals primarily with cost data. But management accounting involves the consideration of both costs and revenues. It is a broader concept than cost accounting. It not only reports costs but also uses them to assist management in planning possible alternate courses of action.
Conceptually speaking management accounting is a blending together of cost accounting, financial accounting and all aspects of financial management. It has a wider scope as a tool of management. But it is not a substitute for other accounting functions. It is a continuous process of reporting cost and financial data as well as other relevant information to management.
4.REVISION POINTS
Management Accounting: Such of its techniques and procedures by which accounting mainly seeks to aid the management collectively have come to be known as management accounting.
5.INTEXT QUESTIONS
1) What is management accounting? How does it help management?
2) In what respect does management accounting differ from financial accounting? Is there any difference between cost accounting and management accounting?
3) Explain the functions of a controller. What is the status of a controller in an organisation?
4) a) Discuss the objectives of management accounting.
b) What are the important characteristics of management accounting?
5) “The terms Financial accounting and Management Accounting are not precise descriptions of the activity they comprise. Despite, their close interrelationship, there are some fundamental differences". Discuss.
6) What has accounting to do with management? Why is it necessary to make distinction between management accounting and financial accounting?
7) Differentiate 'Management Accounting' from both Financial Accounting' and 'Cost Accounting'.
8) What is management accounting? Explain its scope and functions.
9) "Management Accounting begins where Financial Accounting ends". With reference to the above statement, explain the functions of management accounting and financial accounting.
6.SUMMARY
Accounting can no longer be considered as a mere language of business.
Now a need has arisen for accounting to provide information relating to the conduct of the various aspects of a business like cost or profit associated with some portions of business operations to the internal parties viz. management. Traditional accounting i.e. financial accounting cannot provide this. Hence management accounting was evolved to fulfill this need. Thus the objectives of management accounting are to present the required facts and Information for the use of management in a quantitative form and to help in effective performance of managerial functions i.e. planning, organizing, controlling, decision–making etc.
A concern will derive many advantages with the help of management accounting like systematic regularity in the business activities through efficient planning and effective organisation, increase in efficiency of the concern by comparing actual performance with expected performance and suggesting remedial measures to avoid the recurrence of adverse variances, cost reduction and consequent price reduction by the application of various types of controls in accounting areas, etc. Of course management accounting is not without limitations. But the advantages which one will derive from management accounting far outweigh the limitations.
7.TERMINAL EXERCISE
1. What do you understand by management accounting?
2. Mention two uses of Management accounting?
8.ASSIGNMENTS
1) "Management accounting is concerned with accounting information that assists management". Explain
2) "Management Accounting emerged out of the limitations of financial accounting". Do you agree? Explain in detail.
3) "Management Accounting has been evolved to meet the needs of management". Explain this statement fully.
9.FURTHER READINGS
1) Khan, M.Y. and P.K. Jain, 'Management Accountancy', Tata McGraw Hill Publishing, New Delhi.
2) Maheswari, S.N. 'Management Accounting and Financial Control", Sultan Chand & Sons, New Delhi.
10.KEY WORDS
Management Accounting: Such of its techniques and procedures by which accounting mainly seeks to aid the management collectively have come to be known as management accounting.
Modification of Data: Management accounting modifies its data furnished by financial accounting to serve the managerial needs.
Validating the Data: Management accounting presents before the management the required data with some sort of reasonable accuracy.
Analysis and interpretation of Data: Management accounting analyses and interprets data to open up new directions for their use by management and makes data more meaningful.
Communicating the Data: Management accounting through several reports and statements communicates the collected and interpreted data to those who are interested in it or to whom it has some meaning.
LESSON – 9
FINANCIAL STATEMENT ANALYSIS: A MANAGERIAL APPROACH
1. INTRODUCTION
By now we are clear about the Important financial statements of a business, viz., the Balance Sheet or Statement of Financial Position reflecting the assets, liabilities and capital as on a particular date; the Profit and Loss Account or the Income Statement, showing the operating results during a specific period. These two statements convey a lot of Information to both the inside managers as well as to the outside– interested parties on the working of the Enterprise. Further, a careful examination of the data across various heads for years do express the direction of operations of the Enterprise.
2.OBJECTIVES
After reading this Lesson the student should be able to
• Understand the implications of Financial Statements as performance records of an enterprise
• Identify the users of Financial Statements as members external to the enterprise and internal managers.
• Appreciate the methods to carryout Financial Statement Analysis
• Learn the procedure to prepare Comparative Financial Statements, Trend Percentages and Common Size Statements
3.CONTENT
Users of Financial Statements
A. External users
B. Internal users
Methods of Financial Statement Analysis
Comparative Financial Statement
A. Comparative Balance Sheet
B. Comparative Profit and Loss Account
Trend Percentages
Common–size Statements
A. Common size Income Statement
B. Common size Balance Sheet
USERS OF FINANCIAL STATEMENTS
The Financial Statement information used by different decision makers differ based on the decision that they make. The major users of the said information are:
1) External users
2) Internal users
A. External Users
The external users of Financial Statements primarily include the investors, creditors or short term and long term lenders. A potential investor is basically interested in his returns in the form of cash dividend as well as the capital gain that he can realise from eventually selling the stock. These returns depend upon how profitable is the company currently and how profitable it will be in future. Therefore, a potential shareholder is interested in the relationships within the company that indicate the present and future profitability of the enterprise and how such profitability could be translated into cash dividend.
A creditor, who supplies goods on credit, is interested in the recovery of the cash during the short period. His interest is on events that will occur during an operating period and how much cash will be available and how many claims there will be to that cash.
The long term creditors, such as debenture holders, are interested in getting the coupon rate of interest in the short run and recovery of their investment in the long run. Therefore, they are interested in some of the indicators of current and potential profitability and good asset management. Further they are Interested in the size of their claim on company assets.'
The other interested parties on the company's performance include the Tax Authorities, Government Agencies, Trade Unions and Competitors. These parties show interest in different aspects of the working of the company based on their particular Interest.
B. Internal Users
The internal management gets sizable information on the company from Financial Statements. Their interest comes from two sources. First, decisions made by external users of financial statements significantly affect the firm in different ways. Investor's decision speaks on the availability of funds for future diversification. Creditors' expectations affect the assets available for use by the management of the company and flexibilities of the manager in using certain assets. Secondly, some relationships within the Financial Statements provide 'bench marks' against which one can compare performance.
METHODS OF FINANCIAL STATEMENT ANALYSIS
It is now clear that the analysis of financial statements provide necessary Insights towards establishing relationships and trends to determine whether or not the financial position and length of operations as well as financial progress of the company are satisfactory or not. Some of the analytical methods used to analyse Financial Statements are:
a) Comparative Financial Statements;
b) Trend Percentages;
c) Common size Financial Statements;
d) Ratio Analysis;
e) Funds Flow Analysis;
The methods specified last in the list (d, and e) would be elaborated in Unit IV.
COMPARATIVE FINANCIAL STATEMENTS
The two Financial Statements traditionally prepared are Profit and Loss Account and the Balance Sheet. These two column (T–form) statements are generally converted into a single column statement (vertical) to provide a meaningful information in an easily understandable form. This process of rearrangement of the traditional statements is a pre– requisite to carryout any analysis of the Financial Statements. Therefore, let us spend some time on looking into the said new proforma before getting into the work of preparing a comparative financial statement.
TABLE
a) PROFORMA POSITION STATEMENT (OR BALANCE SHEET) AS ON...
Sl.No. Particulars Current
Year Figures
Rs. Previous
Year Figures
Rs.
I. Liquid Assets :
Cash at Bank
Cash in Hand
Bills receivable
Marketable Securities
----
----
----
----
----
----
----
----
Total (1)
II. Inventories :
Raw materials
Finished goods
----
----
----
----
Total (2)
III. Total current assets (1+2) = 3
IV. Current Liabilities
Bills payable
Creditors
Bank overdraft
Outstanding
----
----
----
----
----
----
----
----
Total (4)
V. Provisions
Provision for taxation
Proposed Dividends
Other Provisions
----
----
----
----
----
----
Total (5)
VI. Total current Liabilities and provisions (4+5) = 6
VII. Net working capital (6–3) = 7
VIII. Net Block
Land and Buildings
Plant and Machinery
Furniture and Fixtures Equipment and Tools
----
----
----
----
----
----
Total (8)
Total capital Employed (7+8)=9
IX. Capital employed as represented by Equity
Equity share capital
Reserves and profit & Loss account Balance
Less Balance
----
----
----
----
----
----
Total (10)
X. Capital employed as represented by Bonds and Debentures
Debentures
LT Loans
Other secured loans
----
----
----
----
----
----
TABLE
B) PROFORMA OF INCOME STATEMENT (PROFIT & LOSS a/c) AS ON...
Particulars Current Year
Figures Rs. Previous Year Figures Rs.
Sales ---- ----
Less : Cost of goods sold (cost of materials consumed + direct wages + other direct expenses)
Gross Profit
Less : Overhead Expenses
Admn. overhead expenses
Distribution overhead expenses
Selling overhead expenses
Financial overhead expenses
----
----
----
----
----
----
Net Profit
Having seen the new proformas for two Financial Statements, let us carry out the Comparative Financial Statement analysis.
Comparative Financial Statements is nothing but arranging a company's two or three year Financial Statements in a comparative order to arrive at meaningful insights into the company's performance over the years. Often, the comparative presentation of data is followed by the presentation of increase or decrease in 'absolute' financial data either in percentage form or in ratio form.
A. Comparative Balance Sheet
Concurrent changes in Assets, Liabilities, Proprietor's Funds due to the conduct of business operations can be observed by preparing a Comparative Balance Sheet. Such a comparison provides sufficient light on the direction and progress of the Enterprise over years. To illustrate a Comparative Balance Sheet, let us consider the Financial Statements recently brought out by Modi Rubber Limited, as on 31st March 1991.
TABLE
COMPARATIVE BALANCE SHEET Of M/S. MODI RUBBER LTD AS ON 31.3.91
Description As at
31.03.90 As at
31.03.91 Absolute Difference Percentage Charge
Sources of Funds:
1. Share Holder’s Funds
(a) Share Capital
(b) Reserves & Surpluses 1038.00
5598.82 1038.00
6023.54 ----
424.72 ----
7.58
6636.82 7061.54 424.75 6.40
2. Loan Funds
(a) Secured loans
(b) Unsecured loans 4732.39
2233.83 4378.99
3321.39 - 353.40
1087.56 - 7.47
48.69
6966.22 7700.38 734.16 10.54
13603.04 14802.11 1199.07 8.82
Application of Funds:
3. Fixed Assets
(a) Cross Block
(b) Less: Depreciation 16681.84
10017.68 17320.29
10842.84 638.45
825.16 3.83
8.24
Net Block
(c) Capital W-I-P 6664.16
164.94 6477.45
89.61 - 186.71
- 75.33 - 2.80
- 45.67
6829.10 6567.06 - 262.04 3.84
4. Investments 2710.38 2750.42 40.04 1.48
5. Current Assets, Loans &
Advances
(a) Inventories
(b) S. Debtors
(c) Cash & Bank Balances
(d) Loans & Advances 6253.50
3013.71
2717.79
6695.54 6612.36
3262.57
2842.05
8877.10 358.86
248.86
124.26
2181.56 5.74
8.26
4.57
32.58
18680.54 21594.08 2913.54 15.64
Less: Current Liabilities and
Provision
(a) Liabilities
(b) Provision 9780.69
4830.29 10427.48
5681.97 640.79
851.68 6.55
17.63
Total 14610.98 16109.45 1492.47 10.21
Net Current Assets 4063.56 5484.63 1421.07 34.97
13603.04 14802.11 1199.07 8.81
The analysis and Interpretation of the above Comparative Balance Sheet gives the following conclusions:
i. Although the firm's share capital has not changed during the said years of analysis, the additional Internal resources in the form of Reserves and Surpluses have added about Rs.425 lakhs to the equity base. These additions have totally made the Reserves to constitute 5.8 times of Equity Capital.
ii. Among the Long Term Loans that the company mobilized possibly to reap the advantages of leverage, the unsecured loans have gone up by almost 50 percent to the previous year balance. On the other hand, the secured loans are found to have been retired to the extent of Rs.350 lakhs. The shift from secured loans to unsecured loans would bring flexibility in using the funds.
iii. From the additional resources mobilized both internally and externally, about 55 percent have been utilized in creating additional Fixed Assets amounting to Rs.638 lakhs.
iv. While the Gross Current Assets fairly indicate the size of working capital in the organisation, the rising net current assets indicate the diversion of long term funds for current uses. Funds mobilized from long term external sources naturally require necessary servicing, almost commensurate to the market rate. Therefore, the rising net current asset balances signal the unproductive deployment of such funds in non– income earning assets. M/s. Modi Rubber have clearly fallen in the trap of additional working capital of as much as Rs.1421 lakhs amounting to 34 percent of previous year balance.
Thus the comparative balance sheets show that the company's performance in managing a good Capital Structure is commendable but the deployment of such costly funds lost the sight of profitability requirements.
B. Comparative Profit & Loss Account
A Comparative Profit and Loss account or Income Statement provides the information on respective changes in revenues and costs during the study period. While It is profitable to the company when the percentage change in revenue is larger than the percentage change in expenses, the vice versa indicates the poor management of costs. Firms trying for competitive advantage naturally keep their costs under control as well as try to get cost–leadership.
In order to illustrate a Comparative Income Statement, let us consider the latest Income Statements of Bharti Telecom Limited, the India's No. 1 'Push Button' Telephone manufacturer.
TABLE
COMPARATIVE INCOME STATEMENT OF BHAJRTI TELECOM LIMITED
Particulars
AS on 31.03.92
Rs.
As on 31.03.93
Rs. Percentage Change
Rs.
Income :
(a) Sales / Services Rendered 14,02,88,948 26,89,48,410 92%
(b) Interest 87,26,186 29,18,658 - 66.5%
(c) Other Income 1,06,92,426 1,03,55,072 3.2%
15,97,07,560 28,22,22,140 76.7%
Particulars
AS on 31.03.92
Rs.
As on 31.03.93
Rs. Percentage Change
Rs.
Expenditure :
(a) Cost of materials consumed 8,98,85,653 17,99,61,928 100.2%
(b) Manufacturing Expenses 2,24,27,324 4,19,51,547 87.1%
(c) Salaries, Wages and other
employee benefits 95,34,806 1,45,87,925 52.9%
(d) Managerial remuneration 2,08,881 2,19,695 5.2%
(e) Depreciation 39,74,955 66,88,931 53.2%
(f) Auditor’s Remuneration 86,014 1,92,230 123.5%
(g) Selling and other expenses 1,51,14,877 2,33,27,621 54.3%
(h) Interest 97,30,902 1,00,37,148 3.2%
15,09,63,412 27,68,67,025 83.1%
Profit before Tax 87,44,148 53,55,115 33.1%
The possible interpretation from the analysis of Comparative Income Statements of Bharti Telecom Limited could be as follows:
i. Company's revenues have grown up almost double the size of its proceeds during 1992. It is rather clear that the sales rose from Rs. 14 Cr to Rs. 27 Crores during the two years of study. However, the receipts from interest declined possibly due to reduction in investments made. The other income has marginally declined by 3 lakhs.
ii. On Expenditure side, the prime cost of material cost and manufacturing expenses jointly rose by 97.6 percent. If one compares the rise in the expenditure with the size of sales generated, the percentage change in direct costs are more than percentage change in Sales (92% only). To that extent the profit margin clearly falls in spite of the increased sales.
iii. The Overhead expenses of salaries, managerial remuneration, depreciation, auditor's fee have increased by 57 percent during the two year period. Some of these overheads are expected to be 'fixed' in nature in the short run and are not supposed to rise with the volume of production. If one takes general inflation rate of 10 to 15 percent, these overheads rose by an additional amount of 40 percent. This rise definitely cuts into the profit margins.
iv. The Selling and Distribution Overhead is expected to vary with the increased levels of production and turnover. However, the rise in this respect to only 54 percent can be appreciated as being under control.
v. Interest expenses, the Financial Overhead also seems to have not exhibited much change indicating greater control on such expenses.
vi. The more than proportionate rise in direct expenses and uncontrolled overhead expenses have resulted in leaving the net profits to rise only by 33 percent in spite of the fact that the turnover of the company recorded 92 percent increase during the two year comparison period.
TREND PERCENTAGES
Trend Percentage analysis is carried out to analyse a series of Financial Statements to draw Inferences on possible trends in various aspects of a company. The trend percentages are calculated considering one of the years as base year.
The trend percentages, relative to the base year, emphasize changes in the financial operations of the enterprises over the years.
If the size of operations, assets and other expenses are on the rise, the subsequent year shows figures higher than 100. Similarly if there is a reduction in the said expenditure, the trend value works out to be lower than 100. Trend ratios are generally not computed to all the items in the statements as the fundamental objective is to make comparisons between items having some logical relationship to one another. To illustrate the computation of trend percentages let us consider the four year Financial Statements of Anglo–French Textiles of Pondicherry.
TABLE
ANGLO FRENCH TEXTILES LTD.
COMPARATIVE TREND PERCENTAGE OF 4 – YEAR BALANCE SHEET DURING 1990 – 1993
Particulars As on
31-12-90 As on
31-12-91 As on
31-12-92 As on
31-12-93 Trend Movements
31-12-91 31-12-91 31-12-92 31-12-93
Rs. Rs. Rs. Rs. ( Base Year)
I. SOURCES OF FUNDS
1. Shareholders’ Funds:
a) Capital 128,494,456 153,494,456 178,494,456 20,34,94,456 100 119.46 138.91 158.37
b) Reserves & Surplus 209,921,836 247,543,724 251,592,135 45,06,74,274 100 117.92 119.85 214.69
Total (a) 338,416,292 401,038,180 430,086,591 65,41,68,730 100 118.50 127.09 193.30
2. Loan Funds
a) Secured Loans 170,671,789 17,20,91,911 195,993,987 29,37,61,373 100 108.83 114.84 172.12
b)Unsecured Loans 34,748,753 51,854,685 89,466,532 6,58,98,919 100 149.23 257.47 189.64
Total (b) 205,420,542 223,946,596 285,460,519 35,96,60,292 100 109.02 138.96 175.08
(a) + (b) 543,836,834 624,984,776 715,547,110 1,01,38,29,022 100 114.92 131.57 186.42
II. APPILICATION OF FUNDS
1. Fixed Assets
a) Gross Block 236,163,053 275,462,668 2,92,287,981 59,10,85,823 100 116.64 124.19 250.29
b) Less Depreciation 40,050,580 69,917,486 97,382,578 12,40,45,575 100 174.57 243.15 309.73
c) Net Block 191,112,473 205,545,262 195,905,403 46,70,40,248 100 107.55 102.51 244.38
Capital 14,013,644 6,185,277 10,252,468 24,89,528 100 44.14 73.16 17.77
205,126,117 211,730,539 206,157,871 46,95,29,776 100 103.22 100.50 228.90
2. Investments 30,000 30,000 30,000 30,000 100 100.00 100.00 100.00
3. Current Assets Loans & Advances
a) Inventories 310,950,329 382,605,785 495,952,853 51,49,48,480 100 123.04 159.50 165.60
b) Sundry Debtors 39,633,516 71,025,356 73,004,369 9,93,42,186 100 179.21 184.20 250.65
c) Cash & Bank Balance 26,517,030 20,273,847 18,180,734 4,02,18,139 100 76.46 68.56 151.67
d) Other Current Assets 18,731,340 14,833,381 1,265,191 8,61,722 100 79.19 6.75 4.60
e) Loans and Advances 26,688,309 49,239,189 53,750,314 6,42,87,233 100 165.89 181.09 216.58
Total 425,520,524 537,977,558 642,153,461 71,96,57,769 100 126.43 150.91 169.12
Less: Current Liabilities and Provisions
a) Current Liabilities 83,653,601 120,854,545 130,734,830 19,17,54,900 100 144.05 156.28 229.23
b) Provisions 3,197,654 3,908,316 2,067,024 35,00,627 100 122.22 64.64 109.47
c) Net Current Assets 338,669,269 413,214,697 509,351,607 65,44,02,242 100 122.01 150.40 154.84
4.
a) Miscellaneous Expenditure (to
the extent not written off (or)
adjusted 11,448 9,540 7,632 5,247 100 83.33 66.67 45.83
b) Profit & Loss Account – – – 1,98,61,757 100 – – –
543,836,834 624,984,776 715,547,110 1,10,68,29,022 100 114.92 131.57 186.42
TABLE
ANGLO FRENCH TEXTILES LTD.
TREND PERCENTAGES IN INCOME STATEMENTS DURING 1990 - 1993
Particulars As on
31-12-90 As on
31-12-91 As on
31-12-92 As on
31-12-93 Trend Movements
31-12-91 31-12-91 31-12-92 31-12-93
Rs. Rs. Rs. Rs. ( Base Year)
I. INCOME
Sales 728,625,198 736,534,925 809,489,069 1,09,25,70,317 100 101.10 111.10 149.95
Export Incentives 28,779,619 19,495,406 – – 100 67.74 – –
Premium on Exim Scrips – 6,559,975 5,835,200 – 100 – – –
Other Income 6,781,711 12,061,876 10,073,845 1,56,16,825 100 177.86 148.5 250.3
7,64,186,528 774,652,182 825,398,134 1,10,81,87,142 100 101.37 107.90 144.90
Net Increase / Decrease in finished and Process Stock 46,247,327 5,89,57,001 128,185,888 2,20,90,253 100 127.48 277.2 47.75
Total (A) 8,10,443,855 833,609,183 953,584,022 1,08,60,96,889 100 102.86 117.66 134.00
II. EXPENDITURE
Manufacturing and other Expenses 706,644,194 726,798,985 861,289,352 1,06,71,32,410 100 102.85 121.88 151.00
Interest 45,225,649 43,077,017 59,856,666 7,42,97,774 100 95.25 132.35 164.30
Depreciation 24,358,867 24,932,034 27,626,290 3,41,64,963 100 102.33 113.41 140.03
Total 776,228,710 794,808,036 948,772,308 1,17,55,95,147 100 102.39 122.30 151.45
Profit / Loss for the year 3,42,15,145 4,811,147 4,811,714 4,,94,98,256 100 113.45 14.10 - 261.65
The possible Inferences that can be drawn from the Four year performance of Anglo–French Textiles Limited is as follows:
i. The size of internal capital constitutes 60 percent of total capital employed and it has risen gradually by about 2 times during the 4 year period. The rise in internal resources is more pronounced through the reserves and surpluses which accounted for 2.15 times to the base year.
ii. Of the two external sources of debt capital, the rise is more or less equal and together working out to 1.86 times during the 4 year period. A cursory glance at the debt/equity relationship shows that the size of debt works out to 1/3 of the total capital employed in the business.
iii. Among various items in which the funds have been deployed, a large chunk goes to fixed assets. The size of fixed assets has grown by 2.5 times. The long term Investments–record no change all through the 4 year period.
iv. Among the current assets, the inventory and debtors report a sizable rise of 1.6 times to 2.5 times respectively giving doubts on the efficient management of current assets in the organisation. Further, the rising balances of loans and advances at the rate of 2.2 times demand an enquiry into the impact of such large advances on the profitability of the enterprise as well as the recovery performance.
v. The current liabilities and provisions rose to an extent of 2.29 and 1.1 times leaving a rise in net working capital to the extent of 1.54 times. This rise in net working capital is justifiable only when the overall performance of the Enterprise reports positive result.
vi. The income statements show that the sales is very slow, growing slowly over the years and record 1.5 times by 4th year. The non –operating income reports a satisfactory rise to 2.3 times.
vii. The direct as well as the overhead costs seem to report marginally high percentage growth compared to sales. The manufacturing expenses record 1.51 times rise, interest expenditure by 1.64 times and the depreciation by 1.4 times.
viii. The slow growth in sales and more than proportionate rise in expenditure coupled with poor working capital management report a negative profit by the fourth year end.
COMMON–SIZE STATEMENTS
The above said two methods of analysing Financial Statements broadly provide the direction of change but do not provide required interrelationship between various items within each Financial Statement. For example, if expenses are expressed to a common 'Base' value of sales figure it would convey the fact that the size of expenses as a proportion of Rs. 100 sales figure over the years. Similarly if Total Assets are considered as 'Base' to examine the trend in changes In working capital, one can easily notice the direction of working capital balance in an organisation. Therefore, an additional dimension is needed for more in–depth analysis of Financial Statements. It is done through the 'Common Size Statements'. The Common Size Statements are often called as 'Component Percentage', '100 Percent' Statements since each Individual item is expressed as a percentage to total of 100.
The computation of common size statements requires us to identify the possible 'Bases' to begin with. For purposes of Income Statement 'sales turnover' could become the 'Base' to express the direct expenses, overheads as well as profit in terms of sales. Similarly, the total liabilities and capital or total assets could be considered as 'Base' for comparing the annual Balance Sheets of a company for possible year–wise trends to examine.
For example, if the Overhead (Administrative) expenses in a company are working out to a figure of Rs. 90,000 when the Sales value of the said company is Rs.600,000, then the Common Size value of the Overhead Expenditure is as follows:
This means that the administration expenses are working out to Rs. 15 for every Rs. 100 sales done by the enterprise. A comparison of this figure over the years tells us about the level of control on the said expenditure. Further, a possible comparison of this figure with the competitive enterprises or the industry average provides a more meaningful information on the stage of the company with respect to Its cost control and management of affairs of business.
A. Common Size Income Statement
To illustrate the features of a Common Size Income Statement let us consider the income particulars of M/s. DCL Polyesters Limited for the years ending 31st March 1991 and 1992.
TABLE
DCL POLYESTERS LIMITED
COMMONSIZE INCOME STATEMENTS FOR THE TEARS ENDING 31–3–91 AND 31–3– 1992
Particulars As on
31.3.91
Rs. Percentage of
Sales As on
31.3.92
Rs. Percentage of
Sales
Income
Sales 11668.17 100.00 36493.71 100.00
Other Income 60.60 0.52 211.43 0.58
11728.77 100.52 36705.14 100.58
Expenditure
Payments to employees 118.58 0.95 208.38 0.57
Manufacturing Expenses 3399.12 29.13 11690.49 32.00
Excise Duty Administration, Selling and other expenses 633.10 5.43 1809.94 5.00
Interest 932.87 7.99 2507.36 6.87
Depreciation 993.45 8.51 1678.50 4.60
Miscellaneous Expenses 24.77 0.21 24.75 0.07
11599.11 99.41 35962.553 98.55
129.66 1.11 742.69 2.03
A closer look at the Common Size Income Statements of M/s. DCL Polyesters Limited reveals the following:
i. Over the two year period under study the sales turnover rose by more than 3 times from Rs.116 crores to Rs.365 crores. The profits during the corresponding period rose from Rs.1.3 crores to Rs.7.4 crores recording a rise of 5.7 times.
ii. When different items of Income Statement are recast in terms of sales the profit margin works out to be a measure figure of Re. 1.11 to Rs.2.03 for every hundred rupees sales carried out in the company.
iii. If one glances at the size of expenditure being incurred by the company, it is clear that the manufacturing expenses and excise duties constitute three–fourths of the total revenue generated. Further, the proportion of these items are on the rise from 76.3 to 81.44 per cent during the said years of analysis.
iv. A large majority of the remaining overhead expenses like the payments to employees, administration, selling and other expenses, interest, depreciation although sizable in absolute terms during the current year. these expenses seem to be declining when expressed in terms of sales revenue.
B. Common size Balance Sheet
It is not customary not to use the entire Balance sheet for constructing Common–size Statements. If one is interested in examining the movement of current assets and current liabilities with a view to keeping track of the changes in Working Capital Balances only that part of the Balance Sheet is considered for Common size Analysis.
Let us consider a Financing Company which deviates from a traditional Manufacturing company with respect to the type and nature of items in their list of Current Assets and Current Liabilities. To illustrate as an example for the construction of Common–Size Statements, the case of M/s. Sakthi Finance Limited is given below:
TABLE
M/s. SAKTHI FINANCE LTD
COMMON–SIZE DETAILS OF CHANGES IN CURRENT ASSETS AND CURRENT LIABILITIES
Particulars As on
31.3.93
Rs. As on
31.3.94
Rs. % of Current Assets
1993 1994
Current, Assets, Loans and Advances
a) Stocks in hire 8165.90 12162.32 68.16 74.02
b) Stock of Stationery, Stamps etc. 18.35 9.81 0.15 0.06
c) Cash and Bank Balance 927.32 981.52 7.74 5.97
d) Income receivable 1015.17 843.92 8.47 5.14
e) Loans and advances 1853.67 2433.23 15.47 14.80
Total Current Assets 11980.41 16430.80 99.99 99.99
Less Current Liabilities and Provisions
a) Current Liabilities 1706.68 2238.77 14.25 13.63
b) Provisions 77.20 140.88 0.64 0.85
Total Current Liabilities 1783.88 2379.65 14.89 14.48
Net Current Assets 10196.53 14051.15 85.11 85.52
The analysis on the Common Size Statements made on Current Asset balances of Sakthi Finance Limited is as follows:
i. The total size of Current Assets indicate the size of operating assets in any business enterprise. Further, the case of Financing companies largely differs from manufacturing companies. The current asset balances in case of a manufacturing company works to a relatively smaller size when compared to Fixed Assets. However, the case of Financing Company Is just opposite. The size of current assets over the past year has increased by about 37 percent in case of the given company.
ii. Among various Current Assets, the Stock–in–Hire Purchase Agreements constitutes approximately 3/4th of the Total Current Asset Balances. While it is 68 percent in 1993, the same works out to 74 percent in 1994. Among the remaining assets the stock of Stationery, Stamps, Income receivables decrease both in absolute terms as well as in percentage terms indicating the reduction in locking up of capital in the said assets.
iii. The size of loans and advances as well as cash and bank balance seems to grow with the operations of the enterprise. However, their proportion seems to decline during the current year.
iv. Current Liabilities are expected to finance a part of Current Assets. In case of Sakthi Finance Ltd., it is observed that the proportion of current liabilities to current assets seems to maintain at 15 percent leaving about 85 per cent of current assets to be financed by long terms funds. Although there is a very marginal decline in respect of these accounts it is not seriously recording any improvement in reducing the net working capital balance during the study period.
Thus this Chapter provides the preliminary methods of analysing the Financial Statements. The more advanced aspects of constructing Ratios, and examining the Flow of Funds position can be seen in future lessons.
4. REVISION POINTS
Financial Statement Analysis is the study of relationships among various financial factors as disclosed in two Financial Statements with a view to draw trends and inferences about the operating performance of the enterprise.
5. INTEXT QUESTIONS
1. Bring out the importance of Financial Statement Analysis for different decision makers in an organisation.
2. Compare and contrast the three different Financial Statement Analysis methods and examine the relative merits of each method.
6. SUMMARY
Financial Statements convey a lot of information to both the external as well as internal users. Meaningful comparison can be drawn from a systematic analysis of the Financial Statements by carrying out the Comparative Analysis, Trend Percentages as well as constructing Common Size Statements. The construction of Comparative Statements explores the periodic changes in various items listed in both Balance Sheet as well as in Profit and Loss Account. These periodic changes could be analyzed either in absolute values or in terms of percentage changes.
The Trend Percentage method tries to explore into the possible trends in the operating performance of 'the enterprise through the construction of – Trend Percentages keeping one of the years' performance as the 'Base'. Therefore, this method examines more number of years of Information compared to the earlier one. The Common Size Statement Analysis tries to provide an
in-depth examination of each of the Financial Statements by developing inter-relationships between various Items with one 'base' figure. In case of Income Statement the annual 'Sales' figure acts as the 'Base' to find the proportionate changes in different costs and the profit margins annually. Thus, these analyzed figures of Financial Statements are more meaningful
for decision making.
7. TERMINAL EXERCISE
1. What do you understand by Trend Percentages?
2. What are Common–size Statements?
8. LEARNING ACTIVITIES
1) The Balance Sheet of Rolta India Limited for the years ending 30th June 1993. 30th June 1992 are given below. Prepare a comparative Balance Sheet and comment.
BALANCE SHEET
30th JUNE'93
(Rs. in lakhs) 30th JUNE'94
(Rs. in lakhs)
I. SOURCES OF FUNDS
1. Share Holders Funds
a) Equity Capital 36,42,58,510 25,87,75,620
b) Reserves & Surplus
i. General Reserves 57,93,460 27,30,852
ii. Share Premium 18,30,76,220 –
iii. Surplus in Profit & Loss Account 4,69,57,181 3,51,87,049
60,00,85,371 29,66,93,521
2. Loan Funds
a) Debentures 1,03,36,000 6,90,00,000
b) Secured Loans (other than debentures) 21,27,57,441 20,26,46,926
Total 1 and 2 22,30,93,441 27,16,46,926
82,31,78,812 56,83,40,447
II. APPLICATION OF FUNDS
1. Fixed Assets
a) Net Block (original cost less dep.) 36,93,52,868 35,56,06,728
b) Capital work in progress 11,40,180 4,19,180
37,07,93,048 35,60,25,908
2. Investments in Subsidiary Companies
a) Quoted – –
b) Unquoted 4,56,85,056
Others
a) Quoted 1,23,55,803 1,04,47,580
b) Unquoted 14,39,600 14,39,600
5,94,80,459 1,18,87,180
3.(i) Current Assets, Loans & Advances
a) Inventories 20,78,28,095 13,51,56,124
b) Sundry debtors 10,21,66,468 6,11,30,707
c) Cash & Bank balance 1,49,87,264 2,28,64,793
d) Other Cr. Assets 57,75,568 48,34,500
e) Loans & advance 12,49,59,370 3,24,92,946
45,57,16,765 25,64,79,070
(ii) Current Liabilities & Provisions
a) Liabilities 4,71,71,358 3,71,39,573
b) Provisions 4,64,19,410 3,88,31,681
9,35,90,768 7,59,71,254
Net Current Assets (1 + 11) 36,21,25,997 18,05,07,816
4. Miscellaneous Expenditure 3,07,79,308 1,99,19,544
Total of 1 to 4 82,31,78,812 56,83,40,448
2) From the following accounting statements of the Great Eastern Shipping Company Limited for the year ended 31st March, 94, carry out a common–size analysis.
BALANCE SHEET
31th MARCH'94
(Rs. in lakhs) 31th MARCH'93
(Rs. in lakhs)
I. SOURCE OF FUNDS
Share Holders* Funds:
Capital 2083,808,111 1749,046,803
Reserves & Surplus 6249,722,819 2412,056,956
8333,530,930 4161,103,759
Loan Funds
Secured Loans 3235,506,882 1601,974,666
Unsecured Loans 60,143,510 2941,658
3295,650,392 1604,916,324
Due to a foreign ship builder under
Deferred payments agreement – 134,343,958
11629,181,851 5900,364,021
II. APPLICATION OF FUNDS
Fixed Assets:
Less from block depreciation 9654,639,759 6947,303,325
Net Block 3519,091,916 2864,473,128
6135,547,843 4082,830,197
Ship under acquisition/capital W.I.P 437,269,202 6067,280
6572,817,045 4088,897,477
Investment
Current Assets, Loans & Advances 3173,906,987 52,028,898
Inventories 332,657,612 291,159,224
Sundry Debtors 1007,786,669 388,686,264
Cash & Bank Balance 446,179,214 770,771,427
Other Current Assets 126,322,823 50,081,738
Loans & Advances 1451,616,854 1298,900,655
Incomplete Voyages 27,052,497 37,198,435
3391,615,669 2836,797,743
Less Current Liabilities & Provisions
Current Liabilities 1103,162,681 627,087,902
Provision 472,108,670 375,885,057
Incomplete Voyage 70,382,513 91,237,868
1645,653,864 1094,210,827
Net Current Assets 1745,961,805 1742.586,916
Misc. exp. (to the extent not written off) exp. on issue of shares 136,495,485 16,850,730
11629,181,322 5900,364,021
PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDING 31ST MARCH 1994
31th MARCH'94
(Rs. in lakhs) 31th MARCH'93
(Rs. in lakhs)
Income
Operating Earnings
4093,960,402
3431,821,687
Turnover
– Real Estate Development 337,606,504 17,979,787
– Commodities Trading 266,827,173 78,544,044
Profit on Sale of Ships 222,863,190 385,659,981
Other Income 383,104,348 594,256,775
5304,361,617 4508,262,274
Expenditure
Operating Expenses 2237,885,637 2360,969,573
Cost of Sales – Real Estate Development
159,327,749
3,964,794
Cost of sales – Commodities Trading
260,520,106
78,434,301
Administration & Other Expenses
230,412,599
166,048,346
Interest & Guarantee Charges 233,550,307 192,944,637
Depreciation 814,844,917 3936,541,315
3416,488,076
Profit before Tax 1367,820,302 1091,744,198
Less Provision for Wealth Tax –– 2,009,000
Profit after Tax 1367,820,302 1089,735,198
Add Price Year Adjustments 3,567,771 5,924,885
1371,388,073 1095,660,083
9. KEY WORDS
1) Financial Statement Analysis: It is the study of relationships among various financial factors as disclosed in two Financial Statements with a view to draw trends and inferences about the operating performance of the enterprise.
2) Comparative Financial Statements: Statements of Financial position of a business is so designed to provide the time perspective.
3) Trend Percentages: Percentage relationship of an item in a Financial Statement with that of the same item in a 'Base' year.
4) Common–size Statements: A common–size Financial Statement is one in which each item of information is expressed as a percentage to a specific 'target' items' value.
LESS0N – 10
FUNDS FLOW ANALYSIS
1. INTRODUCTION
Owing to the limitations of financial statements, need was felt for designing an additional financial statements which could provide information on the major financing and investing activities of the firm during the period. Such a statement is called the statement of changes in financial position. It summarizes the sources from which funds have been obtained and uses to which they have been applied. This statement, it may be noted, is not intended to be a substitute for the profit and loss account or the balance sheet; it is prepared to show additional useful information not covered by the traditional statements.
2. OBJECTIVE
• To understand the meaning of fund flow statement
• To understand uses of Fund Flow Statement
• To know the Techniques of preparing Fund Flow Statement
3. CONTENT
Introduction
Meaning of funds flow statement
Managerial uses of fund flow Analysis
Preparation of funds flow statement
Techniques of preparing a funds flow statement
Introduction
It has been the salient features of the evolution of accounting theory and practice that the preparation and presentation of final accounts and statement is undertaken with the Object of providing as much information as possible for public gaze. From this point of view, the 'traditional package* of final accounts and statements, consisting of the balance sheet and income statement (or P/L A/c), fulfils this objective very well. The balance sheet portrays the financial position of the undertaking, the assets side showing the development of resources in various types of properties and the liabilities side indicating the manner in which these resources were obtained. The income statement measures the change in the owner's equity as a result of period's productive and commercial activities. Though these are highly significant functions, especially in terms of the principal goals of the enterprise, there are certain other fruitful relationships between the balance sheets at the commencement and at the end of the accounting period on which these two statements of financial position fall to throw any light.
Owing to these limitations of financial statements, need was felt for designing an additional financial statements which could provide information on the major financing and investing activities of the firm during the period. Such a statement is called the statement of changes in financial position. It summarizes the sources from which funds have been obtained and uses to which they have been applied. This statement, it may be noted, is not intended to be a substitute for the profit and loss account or the balance sheet; it is prepared to show additional useful information not covered by the traditional statements.
Initially, the statement began from a simple analysis called the "Where-Got and Where-Gone Statement". It was merely concerned with listing of increases or decreases in various items of the company's balance sheet. After some years, the title of the statement was changed to "The Funds Statement". In 1961, the American Institute of Certified Public Accountants (AICPA), recognizing the overwhelming significance of this statement, sponsored research in the area. On the basis of the recommendation of their study in 1963, the Accounting Principles Board (APB) Opinion No.3 was issued. It recommended that the name be changed to "Statement of Source and Application of Funds" and such a statement should be included as supplementary information in corporate annual reports. The inclusion of such a report, however, was not made mandatory; it was kept optional. The recommendation was well received by the business community. In 1969, the Securities and Exchange Commission began requiring firms to include audited funds statements in periodic reports filed with it. Then, In 1971. APB. Opinion No. 19 made it mandatory to include such a statement as an integral part of the financial statements to be presented in the company's annual reports and recommended that it be given the new title of "Statement of Changes in Financial Position".
The Statement of Changes in Financial Position is a statement of flows, i.e. it measures the changes that have taken place in the financial position of a firm between two balance sheet dates. The changes in financial position could be related to several different concepts of “funds". The two most common usages of the term "funds" are cash and working capital. Working capital is the difference between current assets and current liabilities. Viewed in this sense. Statement of Changes in Financial Position would explain the changes in cash or working capital. Accordingly, we have two statements. i.e., Statement of Changes in Cash (popularly called Cash Flow Statement) and Statement of Changes in Working Capital (popularly known as Sources and Uses Statement or Funds Flow Statement). This lesson deals with the Funds Flow Statement.
Meaning of funds flow statement
It will be appropriate to explain the meaning of the term 'Funds' and the term 'Flow of Funds' before explaining the meaning of the term 'Funds Flow Statement'.
Meaning of Funds
The term 'Funds' has a variety of meanings. There are people who take it synonymous to cash and to them there is no difference between a Funds Flow Statement and Cash Flow Statement. While others include marketable securities besides cash in the definition of the term 'Funds'. The International Accounting Standard No. 7 on "Statement of Changes in Financial Position" also recognizes the absence of single generally accepted, definition of the term. According to the Standard, the term "fund" generally refers to cash, to cash and cash equivalents, or to working capital. Of these, the last definition of the term is by far the most common definition of 'fund'. .
There are also two concepts of working capital-gross concept and net concept. Gross working capital refers to the firm's Investment in current asset while the term net working capital means excess of current assets over current liabilities. It is in the latter sense in which the term 'funds' is generally used.
The terms 'current assets', 'current liability', 'non- current assets' and non-current liability are explained below for better clarity.
Current assets
These are assets which are expected to be realized in cash or sold or consumed or turned over within one operating cycle of the unit normally not exceeding 12 months. These current assets can be of two types:
Chargeable current assets are those which are appearing as security against bank finance, such as (i) inventory (ii) spares (iii) receivables etc. The word inventory shall include stocks of raw-materials and consumable stores, stock-in-process and finished goods.
Other current assets will include the following:
• Cash and bank balances.
• Investment by way of government and trustee securities other than for long term purposes e.g., sinking fund, gratuity fund etc.
• Fixed deposit with banks.
• Advance payment for tax.
• Prepaid expenses.
• Advances for purchase of raw materials, components and spares etc.
Current Liabilities
These denote liabilities which would be payable or expected to be turned over within one year from the date of balance sheet. These include;
Short term borrowings (including bills purchased and discounted) from (a) Banks (b) others.
• Unsecured loans.
• Public deposits maturing within one year.
• Sundry creditors (trade) for/raw materials and consumable stores and spares.
• Interest and other charges accrued but not due for payment.
• Advance/progress payments from customers;
• Installments of term loans, debentures, redeemable preference shares and long term deposits payable within- one year.
• All statutory liabilities like PP. provision for taxation, sales-tax, excise etc.
Miscellaneous current liabilities like dividends, liabilities for expenses, gratuity payable within one year. other provisions, other payments due within 12 months etc.
Non-Current Assets
All assets other than current assets come within the category of non-current assets. Such assets include goodwill, land, building, machinery, furniture, long-term investments, patent rights, trade marks, debit balance of the Profit and Loss Account, discount on issue of shares and debentures, preliminary expenses, etc.
Non-Current Liabilities
All liabilities other than current liabilities come within the category of non-current liabilities. They include share capital, long-term loans, debentures, share premium, credit balance in the Profit and Loss Account, revenue and capital reserves (e.g., general reserve, dividend equalization fund, debentures sinking fund, capital redemption reserve) etc.
Concept of flow
The 'Flow' of funds refers to transfer of economic values from one asset to another, from one equity to another, from an asset to equity or vice versa or a combination of any of these. According to working capital concept of funds, the 'flow' of funds refers to movements of funds described in terms of the flow in and out of the working capital area. This occurs when changes occurring in non-current accounts (e.g., fixed assets, fictious assets, long-term liabilities. Internal reserves, etc.) are off-set by corresponding changes in current accounts (current assets or current liabilities) and vice versa, e.g., when a cash purchase of machinery is effected, debentures are redeemed by payment in cash, creditors are paid by raising long-term loan, cash dividend is distributed among shareholders or permutations and combinations of any of these.
In other words in business, several transactions take place. Some of these transactions Increase the funds, while others decrease the funds. Some may not make any change in the funds position. In case a transaction results in increase of funds, it will be termed as a "source of funds". For example, if the funds are Rs. 10,000 and on account of a business transaction, say, issue of shares, they become Rs. 15,000, "Issue of Shares" will be taken as a source of funds. In case a transaction results in decrease of funds it will be taken as an application or use of funds. For example, if the funds are Rs.10.000 and on account of a transaction, say, purchase of furniture of Rs. 5,000, they stand reduced to Rs.5, 000 the purchase of furniture will be taken as an "application of funds". In case a transaction does not make any change in the funds position that existed just before the happening of the transaction, it is said that it is a non-fund transaction. For example, if the funds are Rs. 10,000 and a fixed asset of Rs.5, 000 is purchased by issuing shares of Rs.5, 000, the funds position will not change, and therefore, this transaction will be taken as a non-fund transaction.
The funds-flow-statement is a report on financial operations. changes, flows or movements of funds taken place between two accounting periods. It is a statement which shows the sources and application of funds or how the activities of a business is financed during a particular period. In other words, such a statement shows how the financial resources have been used during a particular period of time. It is, thus, a historical statement showing sources and application of funds between the two dates designed especially to analyse the changes in the financial conditions of an enterprise. In the words of Foulke. it is,
"A statement of Sources and Application of Funds is a technical device designed to analyse the changes in the financial condition of a business enterprise between two dates".
Funds Flow Statement is not an income statement. Income statement shows the items of Income and expenditure of a particular period, but the funds flow statement is an operating statement as it summarizes the financial activities for a period of time. It covers all movements that involve an actual exchange of assets.
The funds flow statement is also not a supporting schedule to the final accounts of the concern to be submitted to the shareholders although technically, it is based upon the same accounting data. It Is, Instead, a complementary statement showing the analysis of sources and uses of funds which cannot be obtained from the other financial statements.
Various titles are used for this statement such as 'Statement of Source and Application of Funds', 'Summary of Financial Operations', 'Changes in Financial Position', 'Fund Received and Disbursed', 'Fund, Generated and Expended', 'Changes in Working Capital', 'Statement of Fund', etc. Title of Funds Flow Statement has been modified from time to time. Really it is very difficult to find a short title for such statement which carries much to the readers regarding its contents and functions.
Thus the basic purpose of preparing Funds Flow Statement is to account for the changes in working capital during the period covered by the statement.
General Rules
Let us formulate some general rules to ascertain which transactions give rise to a source or a use of working capital and which not. This exercise is useful for the preparation of the funds flow statement. The changes in the individual components of working capital are separately shown in a statement called "The Statement of Changes in Working Capital". Symbolically,
WC = CA—CL
where,
WC = Working capital .
CA = Current Assets
CL = Current Liabilities
From the above equation the following may be deduced:
(a) Transactions affecting WC:
i) An increase in CA causes an increase in WC.
ii) A decrease in CA causes a decrease in WC.
iii) An Increase In CL causes a decrease in WC.
iv) A decrease in CL causes an Increase in WC.
(b) Transactions not affecting WC:
i) An Increase in CA and increase in CL does not affect WC.
ii) A decrease in CA and decrease in CL does not affect WC.
Concrete examples corresponding to each General Rule
i. Issue of equity shares causes an Increase in cash (CA) and increase in non-current liability (NCL).
ii. Purchase of non-current asset (NCA) causes decrease in cash (CA) and increase In (NCA).
iii. Bank overdraft to repay long-term loans causes an increase in, CL and decrease in NCL.
iv. Bank overdraft paid by issue of debentures causes a decrease; in bank overdraft (CL) and an increase in NCL.
v. Purchase of Inventories on credit causes an increase in inventory (CA) and an Increase in creditors (CL).
vi. Payment of creditors causes a decrease in cash (CA) and a decrease in creditors (CL).
A close examination of the above rules and illustrations shows that a transaction which gives rise to a source or use of working capital should affect: (i) current account (CA and CL) and (ii) non-current account (NCA or NCL) simultaneously. However, if a transaction occurs where either only current accounts (as shown in rules v and vi) are affected, working capital is not changed and the transaction will not appear on the funds statement. Likewise, if both non-current accounts are affected, as a result of the transaction, it does not bring about any change in the working capital. For instance, a conversion of debentures into equity increases one component of NCL (equity) and decreases another component of NCL (debentures). The fact. however, that such a transaction does not appear on the funds statement does not make the transaction unimportant. On the contrary, the knowledge of large amount of debt conversion into equity would be very useful for management as well as outside investors. Though the definition of funds excludes such a transaction, keeping in view the importance of such items, they would be shown in our statement of changes in financial position (on both sides).
Managerial uses of Funds Flow Analysis
The statement of sources and applications of funds is a useful tool in the financial manager's analytical kit. Because, from it. emerges a better as well as more detailed analysis and understanding of changes in the distribution of resources between balance sheet dates. The uses of fund flow statement are:
1) The basic purpose of preparing the statement is to have a rich insight into the financial operations of the concern. It analyses how the funds were obtained and used in the past. In this sense, it is a valuable tool for the finance manager for analysing the past and future plans of the firm and their impact on the liquidity. He can deduce the reasons for the imbalances in uses of funds in the past and take necessary corrective actions. In analysing the financial position of the firm, the Funds Flow Statement answers to such questions as
1) Why were the net current assets of the firm down, though the net Income was up or vice versa?
2) How was it possible to distribute dividends in absence of or in excess of current Income for the period?
3) How was the expansion in plants and equipment financed?
4) How was the sale proceeds of plant and machinery used?
5) How were the debts retired?
6) What became to the proceeds of share issue or debenture issue?
7) How was the increase in working capital financed?
8) Where did the profits go?
Though it is not an easy Job to find the definite answer to such questions because funds derived from a particular source are rarely used for a particular purpose. However, certain useful assumptions can often be made and reasonable conclusions are usually not difficult to arrive at.
2) It acts as an instrument for the allocation of resources. In modem large scale business, as the need for resources is always more than their availability, productive enterprises have to evolve an order of priorities for putting through their expansion programmes, which are phased accordingly, and funds have to be arranged as different phases of the programmes get into their stride. The amount of funds to be available from current business operations for meeting the needs of such programmes is estimated by the financial manager through the projection of the funds flow analysis. Frequently forward projected funds, flow statements are- tied into the capital budget by indicating the estimated amounts of funds available for this purpose. This prevents the business from becoming a helpless victim of unplanned action and enables management to acquire control over the destiny of an enterprise.
3) It is a test as to effective or otherwise use of working capital. Funds flow statement is a test of effective use of working capital by the management during a particular period. The adequacy or Inadequacy of working capital will tell the financial analyst about the possible steps that the management should take for effective use of surplus working capital or make arrangement in case of Inadequacy of working capital.
4) Funds Flow Statement helps in gathering the financial states of business. It gives an insight into the evaluation of the present financial position and. gives answer to the problem "where have our resources been moving? It enables the readers to obtain necessary information on the methods used dividend policies followed and contribution of funds to the growth of the company. In the present world of credit financing, it provides a useful Information to bankers, creditors, financial Institutions and government etc. regarding amount of loan required. Its purposes, the terms of repayment and sources for repayment of loan etc. The financial manager gains a confidence born out of a study of Funds Flow Statement. In fact, it carries information regarding the firm's financial policies to the outside world. In India, the financial institutions such as IFCI, IDBI, ICICI, etc. require funds flow statement to be submitted to them along with application for loan and other relevant papers.
5) Funds statement also evaluates the urgency of operational issues. Problems faced by a business do not arise all of a sudden. They take time to assume serious proportions invariably implying a financial commitment to which the management has to measure itself. While the problem is thus developing, it is affected by a number of factors. The real contribution of the funds flow analysis is in bringing all these factors in a delicate balance for determining the time limit within which the problem would reach a critical stage. This is done by projecting the funds flow statement which then provides a perspective for the proper consideration of the financial implications of evolving issues and enables suitable action to be initiated to reverse an unfavourable trend. All this provides an insight into the intricate's of the managerial job.
Preparation of Funds Flow Statement
In order to prepare a Funds Flow Statement, it is necessary to find out the "sources" and "applications" of funds.
Sources of funds: The sources of funds can be both internal as well as external.
1. Internal sources
Funds from operations is the only internal source of funds.
The profit or loss figure, as shown in the profit and loss account of the firm, does not Indicate the quantum of working capital provided by business operations because the revenue and expenses shown do not run parallel to the inflow of working capital. The profit and loss account contains a variety of write-offs and other adjustments which do not involve any corresponding movement of funds. The reason for this discrepancy is to be found In the fact that while funds movements are related to current decisions, accounting statements are the combined results of past and current decisions. Therefore, appropriate adjustments are to be made to the profit disclosed by the profit and loss account to arrive at the funds from business operations. For this purpose: (i) all such expenses which have been deducted from revenue but which do not reduce working capital are to be added back, (ii) such items which have been added to revenue but have not contributed to the working capital are to be subtracted, and (iii) all such revenues which are not directly caused by business operations should also be deducted and shown separately in the statement.
Thus the following adjustments will be required in the figure of Net Profit for finding out real funds from operations:
Add the following items as they do not result in outflow of funds:
i) Depreciation on fixed assets.
ii) Preliminary expenses or good will, etc. written off.
iii) Contribution to debenture redemption fund, transfer to general reserve, etc... if they have been deducted before arriving at the figure of net profit.
iv) Provision for taxation and proposed dividend are usually taken as appropriations of profits only and not current liabilities for the purposes of Funds Flow Statement. Tax or dividends actually paid are taken as applications of funds. Similarly, Interim dividend paid is shown as an application of funds. All these items will be added back to net profit, if already deducted, to find funds from operations.
v) Loss on sale of fixed assets.
Deduct the following items as they do not increase funds:
i) Profit on sale of fixed assets since the full sale proceeds are taken as a separate source of funds and inclusion here will result in duplication.
ii) Profit on revaluation of fixed assets.
iii) Non-operating incomes such as dividend received or accrued dividend, refund of income tax, rent received or accrued rent. These items increase funds but they are non-operating Incomes. They will be shown under separate heads as "sources of funds" in the Funds Flow Statement.
In case the Profit and Loss Account shows 'Net Loss', this should be taken as an item which decreases the funds.
Illustration
Following are the extracts from the Balance Sheets of a company as on 31st December, 1992 and 31st December, 1993. You are required to calculate funds from operations:
As on 31st December
1992 1993
Profit and Loss Appropriation Account 30,000 40,000
General Reserve 20,000 25,000
Goodwill 10,000 5,000
Preliminary Expenses 6,000 4,000
Provision for Depreciation on Machinery 10,000 12,000
Solution
FUNDS FROM OPERATIONS
Rs.
Profit and loss appropriation account balance as on
31st December 1993 40,000
Add: Items which do not decrease funds:
Transfer to general reserve 5,000
Goodwill written off 5,000
Preliminary expenses written off 2,000
Provision 'for depreciation on machinery 2,000
54,000
Less: Profit and loss appropriation account balance as on
31.12.1992 30,000
Funds from operations 24,000
The funds from operations can also be found out by preparing an Adjusted Profit and Loss Account:
ADJUSTED PROFIT AND LOSS ACCOUNT
Rs. Rs.
To Transfer to general Reserve 5,000 By Balance b/d 30,000
To Goodwill written off 5,000 By Funds from Operation (bal.fig) 24,000
To Preliminary expenses
written off 2,000
To Provision for depreciation 2,000
To Balance c/d 40,000
54,000 54,000
(2) External sources
These sources include:
Long Term Financing
Either in terms of Issuing debentures or preference shares or equity shares constitutes another major source of working capital. For example, a company Issues Rs.2, 00,000 equity shares at a premium of 10%; Rs.2, 20,000 constitutes a source of working capital as it increases cash (CA) and Increases NCL. It is important to remember here that the face value of the security is immaterial; it is net amount received (increase in CA) from the transaction that constitutes the source.
Sale of Non-Current Assets
It is not unusual for a business form to sell one or more of its non-current assets particularly in the case of plants and equipment either because they have become useless or more efficient plant and machinery equipment have appeared in the market. If the sale is made for cash or a receivable, current assets Increase. Therefore, the sale proceeds from the disposition of non-current assets is the source of funds. Whether the non-current asset is sold at a profit or at a loss, is irrelevant for the purpose. The amount is received or receivable in the near future constitutes the source. For Instance, a plant and equipment having a net book value of Rs.30, 000 has been sold for Rs.20, 000; Rs.20.000 would constitute the source of funds; the cost (loss) of Rs. 10,000 would be transferred to the profit and loss account. If it is sold for Rs.40, 000, Rs.40, 000 would constitute the source of funds and Rs. 10,000, being profit, transferred to the profit and loss account.
Funds from increase in share capital
Issue of shares for cash or for any other current asset results in increase in working capital and hence there will be a How of funds.
Applications of Funds
The uses to which funds are put are called 'applications of funds'. Following are some of the purposes for which funds may be used:
Redemption of Preference Shares and/or Debentures
The retirement of long-term liabilities such as payment to preference shareholders and debenture holders Involves the use of cash (CA). There is a corresponding decrease in long-term liabilities. It should be borne in mind that it is not the face value of the security redeemed that is important; the important thing is to know the actual payment made to retire such securities.
Recurring Payments to Investors
Dividends and interest constitute the recurring payments to investors. In most cases, the transactions giving rise to these items involve decrease in NCL and decrease in cash (i.e. CA) or increase in CL (dividends payable or interest payable). Clearly, recurring payments to investors represent another use of funds.
Purchase of fixed assets
Purchase of fixed assets such as land, building, plant, machinery, long-term Investment, etc., results in decrease of current assets without any decrease in current liabilities. Hence, there will be a flow of funds. But in case shares or debentures are issued for acquisition of fixed assets, there will be no flow of funds.
Payment of tax liability
Provision for taxation is generally taken as an appropriation-of profits and not as an application of funds. But if the tax has been paid, it will be taken as an application of funds.
Technique of preparing a Funds Flow Statement
Preparation of statement of sources and applications of funds is a time consuming task. Depending upon the object of analysis, it may range from casual observation of the changes in the various items summarised in the beginning and ending balance sheets to the elaborate worksheet reconstructions of fund transactions. In any case, however, adequate information can be extracted from an approximate analysis without going through the long arduous and cumbersome exercise involved in adjustments necessary for refining the analysis. The financial manager may find it adequate and very convenient to make a 'rough and ready analysis' from time to time, for himself to appraise the trends of developments relating to some aspects of the financial conditions of his own unit. A comprehensive funds statement may. however, be prepared by the staff of the financial manager as and when need is felt for the same. Thus, there is no prescribed format for the funds "flow statement. The only important point to be borne in mind is that the items should be arranged and described in such a way as to exhibit clearly the important financial events of the period.
PROFORMA OF A FUNDS FLOW STATEMENT
STATEMENT OF SOURCES AND APPLICATIONS OF FUNDS
Rs.
Sources:
(a) Issue of Share Capital
(b) Issue of Debentures
(c) Institutional Loans
(d) Sale of Investments and other fixed assets
(e) Trading profit or Funds from operations
(f) Non-trading Items, e.g., dividend received Total
Applications:
(a) Payment of Share Capital (Redeemable)
(b) Repayment of Institutional Loans
(c) Redemption of Debentures
(d) Purchase of Investments and Other Fixed Assets
(e) Non-trading payments, e.g., payment of dividends
Total
Increase/Decrease in Working Capital as per statement of changes in Working Capital.
AN ALTERNATIVE PROFORMA
STATEMENT OF SOURCES AND APPLICATIONS OF FUNDS
Sources Rs. Applications Rs.
1. Issue of share capital 1. Redemption of Redeemable Preference share capital
2. Issue of debentures 2. Redemption of debentures
3. Institutional obtained Loan 3. Repayment of Institutional Loans
4. Sale of investments and other fixed assets 4. Purchase of investments and other fixed assets
5. Trading Profits or funds from assets operations 5. Payment of dividend (for last year and interim)
6. Non-trading Income 6. Non-trading expenses
Total Total
Decrease in working capital as per statement of changes in working capital Increase in working capital as per statement of changes in working capital
Total Total
Variation In Working Capital
In the funds statement the usual practice is to show the difference between the aggregate of sources and total applications as either increase or decrease in working capital or funds over the period covered by the statement. This variation in working capital should be verified by calculating the working capital separately also. Working capital represents the excess of current assets over current liabilities. Since several items, i.e... all current assets and current liabilities are the components of working capital. It is necessary, in order to ascertain the working capital or 'fund' at the beginning and at end of the period and to measure the Increase or decrease therein, to prepare what may be called 'A Statement or Schedule of changes in Working Capital'.
A proforma is given below:
STATEMENT OF CHANGES IN WORKING CAPITAL
Effect on working Capital
Previous
year Rs. Current
year Rs. Increase
Rs. Decrease
Rs.
Current Assets:
Stock
Debtors
Cash
Bank
B/R
Prepaid expenses
Total (a) Rs.
Current Liabilities
Creditors
B/P
Outstanding
Expenses
Total (b) Rs.
Working Capital:
(Difference between Decrease in Working Capital
Total Rs.
While preparing a schedule of changes in working capital it should be noted that:
a. An increase in current assets increases working capital;
b. A decrease in current assets decreases working capital;
c. An increase in current liabilities decreases working capital and
d. A decrease in current liabilities increases working capital
Treatment of Provision for Taxation and Proposed Dividends. Provision of taxation "provision for tax" is a current liability. While preparing a Funds Flow Statement, there are two options available:
(i) Provision for tax may be taken as a current liability. In such a case when provision for tax is made the transaction Involves Profit & Loss Appropriation Account which is a fixed liability and Provision for Tax Account, which Is a current liability. It will thus decrease the working capital. On payment of tax there will be no change In working capital because It will involve one current liability (i.e... Provision for Tax) and the other a current asset (i.e., Bank or Cash balance).
(ii) Provision for tax may be taken only as an appropriation of profit. It means there will be no change in working capital position when provision for tax is made since It will involve two fixed liabilities, i.e., Profit and Loss Appropriation Account and Provision for Tax Account However, when tax is paid, it will be taken as application of funds, because it will then involve "provision for tax account' which has been taken as a fixed liability and "bank account* which Is a current asset.
Proposed Dividends
Whatever has been said about the "provision for taxation" is also applicable to "proposed dividends". Proposed dividends can also be dealt with in two ways:
i. Proposed dividends may be taken as a current liability since declaration of dividends by the shareholders is simply a formality. Once the dividends are declared in the general meeting, they will have to be paid within 42 days of their declaration. In case proposed dividend is taken as a current liability. It will appear as one of the items decreasing working capital in the "schedule of changes in working capital". It will not be shown as an application of funds when dividend is paid later on.
ii. Proposed dividends may simply be taken as an appropriation of profits. In such a case proposed dividend for the current year will be added back to current year's profits in order to find out funds from operations if such amount of dividend has already been charged to profits. Payment of dividend will be shown as an "application of funds”.
Comprehensive Funds Flow Statement
Illustration
From the following balance sheets as at 31st December 1992 and 1993 and additional Information relating to Precision Tools Ltd., prepare: -
(1) Statement showing the changes in the Working Capital, and
(2) Statement of Sources and Applications of funds for the year ended 31st December 1993.
(Rupees in thousands)
Liabilities
1992
Rs. 1993Rs. Assets 1992
Rs 1993
Rs.
Sundry creditors
1000
1030
Cash
1600
1776
Bills payable 200 250 Sundry Debtors 400 740
Debentures 880 880 Stock of raw materials 220 248
Depreciation Fund 200 112 Stock of finished goods 280 240
Reserves & Surplus 600 780 Stock of work in progress 100 200
Share Capital 1400 1740 Land 100 160
Buildings 860 640
Plant and Machinery 600 680
Debenture discount 80 72
Patents 40 36
4280 4792 4280 4792
Additional information
Rs.
(a) Net profit reported 4,00,000
(b) Dividend paid 80,000
(c) Depreciation charged to profits 32,000
(d) The company issued equity shares for Rs.2,00,000 and
bonus shares for Rs. 1,40,000
(e) A building was sold for Rs.56, 000, the cost and book value
being Rs.1, 60,000 and Rs.40, 000 respectively.
Solution
Sources and Applications of Funds during the year ending 31st December 1993.
(Rupees in thousands)
Sources Rs. Applications Rs.
Profit from operation 428 Additions to Plant 80
Sale of building 56 Dividend paid 80
Issue of shares 200 Increase in working Capital 524
684 684
Workings
State showing changes in the Working Capital
(Rupees in thousands)
1992 1993 Increase Decrease
Rs. Rs. Rs. Rs.
Cash 1,600 1,776 176 —
Sundry Debtors 400 740 340 —
Stock - R.M 220 248 28 —
" -F.G. 280 240 — 40
" -W.LP 100 200 100 —
Total (A) 2,600 3,204
Sundry creditors 1,000 1,030 — 30
Bills payable 200 250 — 50
Total (B) 1,200 1,280
Working capital (A-B) 1,400 1,924
Increase In working capital 524 — — 524
1,924 1,924 644 644
Adjusted Profit and Loss Account
(Rupees in thousands)
Rs. Rs.
To Depreciation 32 By Balance 600
To Dividend 80 By Profit on sale of building 16
To Patent 4 By Profit (or) [FFO] 428
To Bonus shares 140
To Debenture discount 8
To Balance 780
1,044 1,044
Building Account
Rs. Rs.
To Balance 800 By Cash 56
To Profit & Loss 16 By Depreciation fund 120
By Balance 640
816 816
Depreciation Fund
Rs. Rs.
To Building 120 By Balance 200
To Balance 112 By Depreciation 32
232 232
4. REVISION POINTS
1. Funds - It means working capital i/c the excess of current asset over current liabilities.
2. Working capital: Excess of current assets over current liability
3. Source of funds: Business transaction which cause an increase in the working capital.
4. Uses of funds: Business transaction which cause an decrease in the working capital.
5. INTEXT QUESTIONS
1) What is a Funds Flow Statement? Examine its managerial uses.
2) "A funds flow statement is a better substitute for an income statement" - Discuss.
3) Explain the various concepts of funds in the context of funds flow statement.
4) Explain the main sources of flow of funds in a business.
5) Is depreciation a source of fund? Explain.
6. SUMMARY
In business concern, funds flow from different sources and similarly funds are invested in various sources of investment. It is a continuous process. The study and control of its funds flow process is the main objective of financial statement to assess the soundness and the solvency of the firm. The effectiveness of financial management in generating funds from various sources and using them effectively for generating income without sacrificing the financial health of the entity is reflected in the statement of funds.
7. TERMINAL EXERCISE
1. Funds flow refers to changes in …………..capital.
2. Building sold on credit is a …………….of funds.
3. Depreciation is sometimes treated as a ……….of funds.
8. LEARNING ACTIVITIES
From the following Balance Sheet you are required to prepare Schedule of Changes in Working Capital of 1993 and 1994.
Liabilities 31 Dec 1992 Rs. 31 Dec 1993 Rs. 31 Dec 1994 Rs. Assets 31 Dec 1992 Rs. 31 Dec 1993 Rs. 31 Dec 1994 Rs.
Share Capital
9 per cent Debentures
Sundry Creditors
Outstanding Expenses
Tax payable
Retained Earnings
40,000
20,000
20,000
10,000
10,000
20,000
1,20,000 50,000
20,000
20,000
20,000
15,000
30,000
1,55,000 50,000
30,000
40,000
20,000
20,000
20,000
1,80,000 Cash
Inventories
Accounts Receivables
Land
Plant
30,000
10,000
20,000
20,000
40,000
1,20,000 40,000
15,000
20,000
20,000
60,000
1,55,000 45,000
10,000
25,000
30,000
70,000
1,80,000
9. KEYWORDS
1. funds - It means working capital i/c the excess of current asset over current liabilities.
2. flow of fund: It means change in funds (or) change in working capital.
3. working capital: Excess of current assets over current liability
4. Non-current assets: All assets other than current assets
5. Non - current liabilities: All liabilities other than current liability
6. Source of funds: Business transaction which cause an increase in the working capital.
7. uses of funds: Business transaction which cause an decrease in the working capital.
LESS0N – 11
CASH FLOW STATEMENT
1. INTRODUCTION
A Cash Flow Statement is a statement depicting change in cash position from one period to another. The cash flow statement explains the reasons for inflows or outflows of cash. It also helps management in making plans for the immediate future. A Projected Cash Flow Statement or a Cash Budget will help the management in ascertaining how much cash will be available to meet obligations to trade creditors, to pay bank loans and to pay dividend to the shareholders.
2. OBJECTIVES
Meaning of cash flow statement;
Understand the concept of funds in cash flow analysis;
Identify the sources and applications of cash;
Differentiate between cash flow analysis and funds flow analysis; Explain the utility and limitations of cash flow analysis;
Prepare cash flow statement
3. CONTENT
Meaning of Cash Flow Statement
Preparation of Cash Flow Statement
Sources of Cash
Applications of Cash
Difference between Cash Flow Analysis and Funds Flow Analysis
Utility of Cash Flow Analysis
Limitations of Cash Flow Analysis
A Cash Flow Statement is a statement depicting change in cash position from one period to another. For example, if the cash balance of a business is shown by its Balance Sheet on 31 December, 1997 at Rs 20,000 while the cash balance as per its Balance Sheet on 31 December, 1998 is 30,000, there has been an inflow of cash of Rs 10,000 in the year 1998 as compared to the year 1997. The cash flow statement explains the reasons for such inflows or outflows of cash, as the cash might be. It also helps management in making plans for the immediate future. A Projected Cash Flow Statement or a Cash Budget will help the management in ascertaining how much cash will be available to meet obligations to trade creditors, to pay bank loans and to pay dividend to the shareholders. A proper planning of the cash resources will enable the management to have cash available whenever needed and put it to some profitable or productive use in case there is surplus cash available.
The term "Cash" here stands for cash and bank balances. It has already been explained in the previous chapter that the term "Funds", in a narrower sense, is also used to denote cash. In such a case, the term "Funds" will exclude from its purview all other current assets and currents liabilities and the term "Funds Flow Statement" Flow Statement" and “Cash Flow Statement” will have synonymous meanings. However, for the purpose of this study, we are calling this part of study as Cash Flow Analysis and not Funds Flow Analysis.
PREPARATION OF CASH FLOW STATEMENT
The Cash Flow Statement can be prepared on the same pattern on which a Funds Flow Statement is prepared. The change in the cash position from one period to another by taking in account "Sources" and "Applications" of cash.
SOURCES OF CASH
Sources of Cash can be internal as well as external
Internal Sources: Cash from operations is the main internal source. The Net Profit shown by the Profit and Loss Account will have to be adjusted for non-cash items for finding out cash from operations. Some of these items are as follows:
(i) Depreciation: Depreciation does not result in outflow of cash and, therefore, net profit will have to be increased by the amount of depreciation or development rebate charged, in order to find out the real cash generated from operations.
(ii) Amortization of intangible assets: Goodwill, preliminary expenses, etc., when written off against profits, reduce the net profits without affecting the cash balance. The amounts written off should, therefore, be added back to profits to find out the cash from operations.
(iii) Loss on sale of fixed assets: It does not result in outflow of cash and, therefore, should be added back to profits.
(iv) Gain from sale of fixed assets: Since sale of fixed assets is taken as a separate source of cash, it should be deducted from net profits.
(v) Creation of reserves. If profit for the year has been arrived at after charging transfers to reserves, such transfers should be added back to profits. In case operations show a net loss, such net loss after making adjustments for non-cash items will be shown as an application of cash.
Thus, cash from operations is computed on the pattern of computation of 'Funds'
from operations, as explained in the earlier chapter. However, to find out real cash from operations, adjustments will have to be made for 'changes' in current assets and current liabilities arising on account of operations, viz. Trade debtors, trade creditors, bills receivable, bills payable, etc.
For the sake of convenience, computation of cash from operations can be studied by taking two different situations: (1) when all transactions are cash transactions, and (2) when all transactions are not cash transactions.
When all transactions are Cash Transactions. The computation of cash from operations will be very simple in this case. The net profit as shown by the Profit and Loss Account will be taken as the amount of cash from operations as shown in the following example:
Example:
PROFIT AND LOSS ACCOUNT
for the year ended 31 December 1998
Particulars Rs. Particulars Rs.
To Purchases
To Wages
To Rent
To Stationery
To Net Profit
15,000
10,000
500
2,500
22,000
50,000 By Sales 50,000
.
50,000
In the example given above, if all transactions are cash transactions, i. e., all purchases have been paid for in cash and all sales have been realized in cash, the cash from operations will be Rs 22,000 i.e., the net profit as shown by the Profit and Loss Account.
Thus. in case of all transactions being cash transactions, the equation for computing C&lh from operations can be put as follows:
Cash from Operations = Net Profit
When all transactions are not cash transactions. In the example give above, we have computed cash from operations on the basis that all transactions are cash transactions. It does not really happen in actual practice. The business sells goods on credit. It purchases goods on credit. Certain expenses are always outstanding and some of the incomes are not immediately realized. Under such circumstances, the net profit made by a firm cannot generate equivalent amount of cash. The computation of cash from operations in such a situation can be done conveniently if it is done in two stages:
(i) Computation of funds (i.e., working capital) from operations as explained in the preceding chapter; and
(ii) Adjustments in the funds so calculated for changes in the current assets (excluding cash) and current liabilities.
We are giving below an illustration for computing 'Funds' from operations. However, since there are no credit transactions, hence the amount of 'Funds' from operations is as a matter of cash from operations as shown in the illustration.
Illustration
TRADING AND PROFIT AND LOSS
For the year ended 31 March 1998
Particulars Rs Rs
To Purchases
To Wages
To Gross Profit cld
To Salaries
To Rent
To Depreciation on Plant
To Loss on sale of Furniture To Goodwill written off
To Net Profit
20,000
5,000
5,000
30,000
1,000
1,000
1,000
500
1,000
5,500
10,000 By Sales
By Gross Profit b/d
By Profit on sale of Building
Book Value Rs.10,000
Sold For 15,000 30,000
.
30,000
5,000
5,000
.
10,000
Calculate the Cash from Operations.
Solution:
CASH FROM OPERATIONS
Net Profit as per P & L A/c
Add: Non-cash items (i.e. items
which do not result in outflow of cash):
Depreciation 1,000
Loss on sale of furniture 500
Goodwill written off 1,000
Less: Non-cash items (items which do not result inflow of cash):
Profit on sale of building
(Rs. 15,000 will be taken as a source of cash)
Cash from Operations 5,500
2,500
8,000
5,000
3,000
Adjustments for Changes in Current Assets and Current Liabilities
In the illustration given above, the cash from operations has been computed on the same pattern on which funds from operations are computed. As a matter of fact, the funds from operations is equivalent to cash from operations in this case. This is because of the presumption that all are cash transactions and all goods have been sold. However, there may be credit purchases, credit sales, outstanding and prepaid expenses, etc. In such a case, adjustments will have to be made for each of these items in order to find out cash from operations.
(i) Effects of credit sales. In business, there are both cash sales and credit sales. In case, the total sales are Rs 30,000 out of which the credit sales are Rs 10,000. It means sales have contributed only the extent of Rs 20,000 in providing cash from operations. Thus, while computing cash from operations, it will be necessary that suitable adjustments for outstanding debtors are also made. Consider the following example:
Example 1
Net Profit for the year Rs 20,000
Total Sales 40,000
Debtors Outstanding at the end of the accounting year 10,000
The above figures show that out of total sales of Rs 40,000 which must have been considered from computing net profit, Rs 10,000 has still to be realised in cash from debtors. Therefore, cash from operations should be computed as follows:
Net Profit for the year Rs 20,000
Less: Debtors Outstanding at the end of the accounting year 10,000
Cash from Operations 10,000
In case, there were outstanding debtors in the beginning of the accounting year amounting to Rs 15,000, it can safely be presumed that they must have been realised during the course of the year. The amount of cash from operations will therefore be computed as follows:
Net Profit for the year 20,000
Less: Debtors Outstanding at the end of the accounting year 10,000
10,000
Add: Debtors Outstanding at the end of the accounting year 15,000
Cash from operations 25,000
Thus, cash from operations can be calculated on the basis of the following equation if there are debtors outstanding at the end as in the beginning of the accounting year:
+ Debtors Outstanding at the beginning of the accounting year.
Cash from Operations = Net Profit Or
- Debtors Outstanding at the end of the accounting year.
Or
+ Decrease in Debtors.
Cash from Operations = Net Profit Or
- Increase in Debtors
For example, in the above case, cash from operations can be computed as follows:
Rs 20,000 + Rs 5,000 = Rs 25,000
(ii) Effect of Credit Purchases. Whatever have been stated regarding credit sales is also applicable to credit purchases. The only difference will be that decrease in creditors from one period to another will result in decrease of cash from operations because it means more cash payments have been made to the creditors which will result in outflow of cash. On the other hand, increase in creditors from one period to another will result in increase of cash from operations because less payment has been made to the creditors for goods supplied which will result in increase of cash balance at the disposal of the business.
Example 2
Purchases for the year (including credit purchases of Rs 10,000) 30,000
Sales for the year 40,000
Expenses 5,000
The amount of Net Profit comes to:
Sales 40,000
Less:
Purchases 30,000
Expenses 5,000 35,000
Net Profit 5,000
Though the net profit is Rs 5,000, the cash operations will be Rs 15,000 (Rs 5,000 + Rs 10,000 for credit purchases). This is because though Purchases of Rs 30,000 have been considered for calculating the Net Profit, the actual cash which has been paid for purchases is only Rs 20,000. Thus, cash from operations stands increased by Rs 10.000, the amount of creditors outstanding at the end of the year.
Example 3
Sales 40,000
Purchases 30,000
Expenses 5,000
10
Creditors Outstanding in the beginning of the accounting year 10,000
Creditors Outstanding at the end of the accounting year 15,000
The Cash from Operations will be computed as follows:
Sales 40,000
Less: Purchases 30,000
Expenses 5,000 35,000
Net Profit 5,000
Add: Creditors Outstanding at the end of the accounting year 15,000
20,000
Less: Creditors Outstanding at the beginning of the accounting year 10,000
Cash from operations 10,000
Alternatively, cash from operations can be computed as follows:
Net Profit for the year Rs 5,000
Add: Increase in Creditors (Rs 15.000 - Rs 10.000) 5,000
Cash from Operations 10,000
Thus, the effect of credit purchases can be shown with the help of the following equation in computing cash from operations:
+ Increase in Creditors
Cash from Operations = Net Profit Or
- Decreases in Creditors
Effect of Opening and Closing Stocks. The amount of opening stock is charged to the debit side of the Profit and Loss Account. It thus reduces the net profit without reducing the cash from operations. Similarly, the amount of closing stock is put on the credit side of the Profit and Loss Account. It thus increases the amount of net Profit without increasing the cash from operations. This will be clear with the help of the following example:
Example 4
Opening Stock 5,000
Purchases 20,000
Sales 35,000
Closing Stock 10,000
Expenses 5,000
The amount of net profit can be computed as follows:
PROFIT AND LOSS ACCOUNT
Particulars Rs Particulars Rs
Opening Stock
Purchases
Expenses
Net Profit
5,000 20.000 5,000 15,000 45,000 Sales
Closing Stock
35,000
10,000
.
45,000
The net profit for the year is Rs 15,000. The cash from operations will be computed as follows:
Net Profit for the year Rs 15,000
Add: Opening Stock 5,000
20,000
Less: Closing Stock 10,000
Cash from Operations 10,000
The effect of change in stock on cash from operations can now be put up as follows:
+ Decrease in Stock
Cash from Operations = Net Profit Or
- Increase in Stock
Effect of Outstanding Expenses, Incomes received in Advance, etc. The effect of these items on cash from operations is similar to the effect of creditors. This means any increase in these items will result in increase in cash from operations while any decrease means decrease in cash from operations. This is because net profit from operations is computed after charging to it all expenses whether paid or outstanding. In case certain expenses have not been paid, this will result in decrease of net profit without a corresponding decrease in cash from operations. Similarly, income received in advance is not taken into account while calculating profit from operations, since it relates to the next year. It, therefore, means cash from operations will be higher than the actual net profit as shown by the Profit and Loss Account. Consider the following example:
Exam
Example 5
Gross Profit Rs 30,000.
Expenses paid Rs 10,000
Interest received Rs 2,000
Rs 2,000 are outstanding on account of expenses while Rs 500 has been received as interest for the next year. The net profit will be computed as follows:
PROFlT AND LOSS ACCOUNT
Particulars Rs Particulars Rs
To Expenses paid 10,000
Add Outstanding 2,000
To Net Profit
12,000
19,500
.
31,500 By Gross Profit
By Interest received 2,000
Less: Interest received
in advance 500
30,000
1,500
31,500
The Cash from Operations will now be calculated as follows:
Net Profit for the year 19,500
Add: Expenses Outstanding at the end of the year 2,000
Interest received in advance 500
Cash from Operations 22,000
Example 6
Net Profit for the year 1993 10,000
Expenses Outstanding as on 1 January, 1993 2,000
Expenses Outstanding as on 3 December, 1993 3,000
Interest received in Advance 1 January, 1993 . 1,000
Interest received in Advance 31 December, 1993 2,000
The cash from operations will be computed as follows:
Net Profit for the year 10,000
Add: Expenses Outstanding on 31 December. 1993 3,000
Income received in Advance on 31 December, 1993 2,000
15,000
Less: Expenses Outstanding on 1 January, 1993 . 2,000
Interest received in Advance. on I January, 1993 1,000 3,000
Cash from Operations 12,000
Alternatively, cash operations can be computed as follows:
Net Profit for the year Rs 10,000
Add: Increase in Outstanding Expenses 1,000
Add: Increase in interest received in Advance 1,000
Cash from Operations 12,000
Thus, the income received in advance and outstanding expenses on cash operations can be shown as follows:
+ Increase in Outstanding Expenses
Cash from Operations = Net Profit + Increase in Income received in Advance
- Decrease in' Outstanding Expenses
- Decrease in Income received in Advance
Effect of Prepaid Expenses and Outstanding Income. The effect of prepaid expenses and outstanding income of cash from operations is similar to the effect of debtors. While computing net profit from operations, the expenses only for the accounting year are charged to the Profit and Loss Account. Expenses paid in advance are not charged to the Profit and Loss Account. Thus, prepayment of expenses does not decrease net profit for the year but it decreases cash from operations. Similarly, income earned during a year is credited to the Profit and Loss Account whether it has been received or not. Thus, income, which has not been received but which has become due, increase the net profit for the year without increasing cash from operations. This will be clean with the help of the following example:
Example 7
Gross Profit Rs 30,000
Expenses paid 10,000
Interest received 2,000
The expenses paid include Rs 1,000 paid for the next year. While interest of Rs.500 has become due during the year, but it has not been received so far. The net profit for the year will be computed as follows:
PROFIT AND LOSS ACCOUNT
Particulars Rs Particulars Rs.
To Expenses paid 10,000 By Gross Profit 30,000
Less: Prepaid Exp. 1,000 9,000 By Interest received 2,000
To Net Profit 23,500 Add: Interest due 500 2,500
32,500 32,500
Now, the cash from operations
Net Profit for the year 23,500
Less: Prepaid Expenses 1,000
Less: Outstanding Interest 500 1,500
22,000
Example 8
Net Profit for the year 1993 20,000
Prepaid expenses I January. 1993 2,000
Outstanding (accrued) Income 1 January. 1993 1,000
Prepaid Expenses 3 I December. 1993 3,000
Outstanding Income 31 December, 1993 2,000
Cash from Operations will be computed as follows:
Net Profit for the year 20,000
Less: Prepaid Expenses on 31 Dec. 1993 3,000
Outstanding Income on 3 I Dec.1993 2,000 5,000
15,000
Add: Prepaid Expenses on I Jan., 1993 2,000
Income Outstanding on I Jan., 1993 1,000 3,000
18,000
Alternatively, Cash from Operations can be computed as follows:
Net Profit for the year 20,000
Less: Increase in Prepaid Expenses 1,000
Increase in Outstanding Income 1,000 2,000
18,000
Thus the effect of prepaid expenses and accrued income on cash from operations can be shown in the form of following equation:
+ Decrease in Prepaid Expenses
+ Decrease in Accrued Income
Operations = Net Profit - Increase in Prepaid Expenses
- Income in Accrued Income
The overall effect of stock, debtors, creditors, outstanding expenses, income received in advance, prepaid expenses and accrued can be shown in the form of the following formula
+ Decrease in Debtors
+ Decrease in Stock
+ Decrease in Prepaid Expenses
+ Decrease in Accrued Income
+ Increase in Creditors
Cash from Operations = Net Profit + Increase in Outstanding Expenses
- Increase in Debtors
- Increase in Stock
- Increase in Prepaid Expenses
- Increase in Accrued Income
- Decrease in Creditors
- Decrease in Outstanding Expenses
The above formula may be summarized in the form of following general rules:
Increase in a Current Asset
Decrease in a Current Liability
results in
Decrease in Cash
AND
Decrease in a Current Asset
Increase in a Current Liability
results in
Increase in Cash
Illustration 2
Continuing the figures given as Illustration 1 calculate the cash rations with the following additional information:
Stock
Debtors
Creditors
Bills Receivable
Outstanding Expenses
Bills Payable
Prepaid Expenses
31 March 1995 Rs
12,000
20,000
7,500
8,000
5,000
2,000
500
March, Rs 10,000 15,000
5,000
5,000
3,000
4,000
1,000
Balance as on
Solution:
The computation of cash from operations can be done conveniently if it is done as explained before in two stages:
(i) Computation of 'Funds' from operations, taking the meaning of 'Funds' as working capital.
(ii) Adjustment in the amount of 'Funds' so computed on the basis of "current assets" and "current liabilities".
The funds from operations amount Rs 3,000 (as computed in Illustration 1). However, adjustments will have to be made in this amount for current assets and current liabilities in order to compute cash from operations. This has to be done by taking each item of current assets and current liabilities independently as explained below:
(i) The investment in stock has increased by Rs 2,000 as compared to the previous year. This means cash must have gone out to the extent of Rs 2,000. It will, therefore, decrease the cash balance.
(ii) Debtors have gone up from Rs 15,000 on March, 1994 to Rs 20,000 on 31 March, 1995. There is an increase of Rs 5,000. It shows that sales to the extent of Rs 5,000 have not been realised in cash. Hence, cash from operations will be reduced by Rs 5,000.
(iii) Creditors have gone up by Rs 2,500. Thus, purchases to the extent of this amount have not been paid in cash. It is, therefore, a 'source' of cash.
(iv)Bills Receivable have increased by Rs 3,000. Thus, sales to the extent of Rs 3,000 have not been paid in cash. Hence cash, on account of operations will be reduced by Rs 3,000.
(v) Bills Payable have come down by Rs 2,000. It shows more payments of cash. The cash from operations will stand reduced by Rs 2,000.
(vi) Outstanding Expenses have increased by Rs 2,000. Thus, expenses to this extent have not been paid resulting in increase of cash from operations by this amount.
(vii) Prepaid Expenses have come down by Rs 500. This shows less of payment and hence cash operations will increase by Rs 500.
Cash from operations now can be computed as follows:
Increase (+) Decrease (-)
Cash from Operations as per P. & L. A/c 3,000
(Illustration 1)
Increase in Stock 2,000
Increase in Debtors 5,000
Increase in Creditors 2,500
Increase in Bills Receivable 3,000
Decrease in Bills Payable 2,000
Increase in Outstanding Expenses 2,000
Decrease in Prepaid Expenses 500
5,000 12,000 (7,000)
(Inflow) of cash on account of operations (4,000)
External Sources. The external sources of cash are:
(i) Issue of New Shares.' In case shares have been issued for cash, the net cash received (i. e., after deducting expenses on issue of shares or discount on issue of shares) will be taken as a source of cash.
(ii) Raising Long-term Loans. Long-term loans such as issue of debentures, loans from Industrial Finance Corporations, State Financial Corporation, IDBI, etc., are sources of cash. They should be shown separately.
(iii) Purchase of Plant and Machinery on deferred payments. In case plant and machinery has been purchased on a deferred payment system, it should be shown as a separate source of cash to the extent of deferred credit. However, the cost of machinery purchased will be shown as an application of cash.
(iv) Short-term Borrowings-cash credit from banks. Short-term borrowing, etc., from banks increase cash available and they have to be shown separately under this head.
(v) Sale of Fixed Assets, Investments, etc. It results in generation of cash and therefore, is, a source of cash.
Decrease in various current assets and increase in various current liabilities (discussed before) may be taken as external sources of cash, if they are not adjusted while computing cash from operations.
Applications of Cash
Applications of cash may take any of the following forms:
(i) Purchase of Fixed Assets. Cash may be utilised for additional fixed assets or renewals or replacement of existing fixed assets.
(ii) Payment of Long-term Loans. The payment of long-term loans such as loans from financial institutions or debentures results in decrease in cash. It is, therefore, an application of cash.
(iii) Decrease in Deferred Payment Liabilities. Payments for plant and machinery purchased on deferred payment basis has to be made as per the agreement. It is, therefore, an application of cash.
(iv) Loss on account of Operations: Loss suffered on account of business operations will result in outflow of cash.
(v) Payment of Tax. Payment of tax will result in decrease of cash and hence it is an application of cash.
(vi) Payment of Dividend. This decreases the cash available for business and hence it is an application of cash.
(vii) Decrease in Unsecured Loans, Deposits, etc. The decrease in these liabilities denotes they have been paid off to that extent. It results, therefore, in outflow of cash.
Increase in various current assets or decrease in various current liabilities may be shown as applications of cash, if changes, in these items have not been adjusted while finding out cash from operations.
Format of A Cash Flow Statement*
A cash flow statement can be prepared in the following form:
3.
CASH FLOW STATEMENT
for the year ending on. ...
Balance as on 1 January ………
Cash Balance
Bank Balance
Add: Sources of Cash:
Issue of Shares
Raising of Long-term loans
Sale of Fixed Assets
Short-term Borrowings
Cash from Operations:
Profit as per Profit and Loss A/c
Add/Less: Adjustment for Non-cash Items
Add: Increase in Current Liabilities
Decrease in Current Assets
Less: Increase in current assets
Decrease in current liabilities
Total Cash available (1)
Less: Applications of Cash:
Redemption of Redeemable Preference Shares
Redemption of Long-term Loans
Purchase of Fixed Assets
Decrease in Deferred Payment Liabilities
Cash Outflow on Account of Operations
Tax paid
Dividend paid
Decrease in unsecured Loans, Deposits, etc.
Total Applications (2)
Closing Balance*
Cash balance
Bank balance
*It should tally with the balance as shown by (1)-(2).
DIFFERENCE BETWEEN CASH FLOW ANALYSIS AND FUNDS FLOW ANALYSIS
Following are the points of difference between a Cash Flow Analysis and a Funds Flow Analysis:
1. A Cash Flow Analysis is concerned only with the change in cash position while a Fund Flow Analysis is concerned with change in working capital position, between two balance sheet dates. Cash is only one of the constituents of working capital besides several other constituents such as inventories, accounts receivable, prepaid expenses.
2. A Cash Flow Statement is merely a record of cash receipts and disbursements. Of course, it is valuable in its own way but if fails to bring to light many important changes involving the disposition of resources. While studying the short-term solvency of a business one is interested not only in cash balance but also in the assets which can be easily converted into cash.
3. Cash flow analysis is more useful to the management as a tool of financial analysis in short-periods as compared to funds flow analysis. It has rightly been said that shorter the period covered by the analysis, greater is the importance of cash flow analysis. For example, if it is to be found out whether the business can meet its obligations maturing after 10 years from now, a good estimate can be made about the firm's capacity to meet its long-term obligations if changes in working capital position on account of operations are observed. However, if the firm's capacity to meet a liability maturing after one month is to be seen, the realistic approach would be to consider the projected change in the cash position rather than an expected change in the working capital position.
4. Cash is part of working capital and, therefore, an improvement in cash position results in improvement in the funds position but the reverse is not true. In other words "inflow of cash" results in "inflow of funds" but inflow of funds may not necessarily result in "inflow of cash". Thus, sound funds position does not necessarily means sound cash position but a sound cash position generally means sound funds position.
5. Another distinction between a cash flow analysis and a funds flow analysis can be made on the basis of the techniques of their preparation. An increase in a current liability or decrease in a current asset results in decrease in working capital and vice versa. While an increase in a current liability or decrease in a current asset (other than cash) will result in increase in cash and vice versa.
Some people, as stated before, use term 'funds' in a very narrow sense of 'cash' only. In such an event the two terms 'Funds' and 'Cash' will have synonymous meanings.
UTILITY OF CAH FLOW ANALYSIS
A Cash Flow Statement is useful for short-term planning. A business enterprise needs sufficient cash to meet its various obligations in the near future such as payment for purchase of fixed assets, payment of debts maturing in the near future, expenses of the business, etc. A historical analysis of the different sources and applications of cash will enable the management to make reliable cash flow projections for the immediate future. In may then plan out for investment of surplus or meeting the deficit, if any. Thus, a cash flow analysis is an important financial tool for the management. Its chief advantages are as follows:
1. Helps in efficient cash management. Cash flow analysis helps in evaluating financial policies and cash position. Cash is the basis for all operations and hence a projected cash flow statement will enable the management to plan and coordinate the financial operations properly. The management can know how much cash is needed, from which source it will be derived, how much can be generated internally and how much could be obtained from outside.
2. Helps in internal financial management. Cash flow analysis provides information about funds which will be available from operations. This will help the management in determining policies regarding internal financial management, e.g., possibility of repayment of long-term debts, dividend policies, planning replacement of plant and machinery, etc.
3. Discloses the movements of cash. Cash flow statement discloses the complete story of cash movement. The increase in or decrease of cash and the reasons therefore can be known. It discloses the reasons for low cash balance in spite of heavy operating profits or for heavy cash balance in spite of low profits. However, comparison of original forecast with the actual results highlights the trends of movements of cash which may otherwise go undetected.
4. Discloses success or failure of cash planning. The extent of success or failure of cash planning can be known by comparing the projected cash flow statement with the actual cash flow statement and necessary remedial measures can be taken.
LIMITATIONS OF CASH FLOW ANALYSIS
Cash flow analysis is a useful tool of financial analysis. However, it has its own limitations. These limitations are as under:
1. Cash flow statement cannot be equated with the Income Statement. An Income Statement takes into account both cash as well as non-cash items and; therefore, net cash-does not necessarily mean net income of the business.
2. The cash balance as disclosed by the cash flow statement may not represent the real liquid position of the business since it can be easily influenced by postponing purchases and other payments.
3. Cash flow statement cannot replace the Income Statement or the Funds Flow Statement. Each of them has a separate function to perform.
In spite of these limitations it can be said that cash flow statement is a useful supplementary instrument. It discloses the volume as well as the speed at which the cash flows in the different segments of the business. This helps the management in knowing the amount of capital tied up in a particular segment of the business. The technique of cash flow analysis, when used in conjunction with ratio analysis, serves as a barometer in measuring the profitability and financial position of the business.
The concept and technique of preparing a Cash Flow Statement will be clear with the help of illustrations given in the following pages.
Cash from Operations
Illustration 3. From the following balances you are required to calculate cash from operations:
31 December
1993
Rs. 1994
Rs.
Debtors
Bills Receivable
Creditors
Bills Payable
Outstanding Expenses
Prepaid Expenses
Accrued Income
Income received in advance
Profit made during the year 50,000
10,000
20,000
8,000
1,000
800
600
300
-- 47,000
12,500
25,000
6,000
1,200
700
750
250
1,30,000
Particulars Rs.
Profit made during the year
Add: Decrease in Debtors
Increase in Creditors
Increase in Outstanding Expenses
Decrease in Prepaid Expenses
Less: Increase in Bills Receivable
Decrease in Bills Payable
Increase in Accrued Income
Decrease in Income received in Advance
Cash from Operations
3,000
5,000
200
100
2,500
2,000
150
50 1,30,000
8,300
1,38,300
4,700
1,33,600
AS 3 (REVISED): CASH FLOW STATEMENTS'
The following are the salient features of the Revised Accounting Standard (AS) 3, Cash Flow Statements, issued by the Council of the Institute of Chartered Accountants of India in March 1997. This Standard supersedes AS 3, Changes in Financial Position, issued in June, 1981.
The standard has been mandatory for all enterprises from accounting period commencing or after 1.4.2001.
1. Objectives
Information about the cash flows of an enterprise is useful in providing users of financial statements with a basis to assess the ability of the enterprise to generate cash and cash equivalents and needs of the enterprise to utilize those cash flows. The economic decisions that are taken by users require an evaluation of the ability of an enterprise to generate cash and cash equivalents and the timings and certainty of their generation.
The Statement deals with the provisions of information about the historical changes in cash and cash equivalents of an enterprise by means of a cash flow statement which classifies cash flows during the period from operating, investing and financing activities.
2. Scope
(1) An enterprise should prepare a cash flow statement and should present it for each period for which financial statements are presented.
(2) Users of an enterprise's financial statements are interested in how the enterprise generates and uses cash and cash equivalents. This is the case regardless of the nature of the enterprise's activities and irrespective of whether cash can be viewed as the product of the enterprise, as may be the case with a financial enterprise. Enterprises need cash for essentially the same reasons, however different their principal revenue-producing activities might be. They need cash to conduct their operations, to pay their obligations, and to provide returns to their investors.
3. Benefits of Cash Flow Information
(1) A cash flow statement, when used in conjunction with the other financial statements, provides information that enables users to evaluate the changes in net assets of an enterprise, its financial structure (including its Liquidity and solvency), and its ability to affect the amounts and timing of cash flow in order to adapt to changing circumstances and opportunities. Cash flow information is useful in assessing the ability of the enterprise to generate cash and cash equivalents and enables users to develop models to assess and compare the present value of the future cash flows of different enterprises.
(2) It also enhances the comparability of the reporting of operating performance by different enterprise because it eliminates the effects of using different accounting treatments for the same transactions and events.
(3) Historical cash flow information is often used as an indicator of the amount timing and certainty of future cash flows. It is also useful in checking the accuracy of past assessments of future cash flows and in examining the relationship between profitability and net cash flow and the impact of changing prices.
(4) Definitions
The following terms are used in this Statement with the meanings specified:
(1) Cash comprises cash on hand and demand deposits with banks.
(2) 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.
(3) Cash flows are inflows and outflows of cash and cash equivalents.
(4) Operating activities are the principal revenue-producing activities of the enterprise and other activities that are not investing or financing activities.
(5) Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents.
(6) Financing activities are activities that result in changes in the size and com¬position of the owner's capital (including preference share capital in the case of a company) and borrowings of the enterprise.
,
(5) Presentation of A Cash Flow Statement
The cash flow statement should report cash flows during the period classified by operating investing and financing activities.
(I) Operating activities. Cash flows from operating activities are primarily derived from the principal revenue-producing activities of the enterprise. Therefore, they generally result from the transactions and other events that enter into the determination of net profit or loss. Examples of cash flows from operating activities are:
(a) cash receipts from the sale of goods and the rendering of services;
(b) cash receipts from royalties, fees, commissions, and other revenue;
(c) cash payments to suppliers for goods and services;
(d) cash payments to and on behalf of employees;
(e) Cash receipts and cash payments of an insurance enterprise for premiums and claims, annuities and other policy benefits;
(f) cash payments or refunds of income taxes unless they can be specifically identified with financing and investing activities; and
(g) cash receipts and payments relating to futures contracts, forward contracts, option contracts and swap contracts when the contracts are held for dealing or trading purposes.
(II) Investing Activities
(a) Cash payments to acquire fixed assets (including intangibles). These payments include those relating to capitalized research and development costs and self constructed fixed assets;
(b) Cash receipts from disposal of fixed assets (including intangibles);
(c) Cash payments to acquire shares, warrants, or debt instruments of other enterprises and interests in joint ventures (other than payments for those instruments considered to be cash equivalents and those held for dealing or trading purposes.
(d) Cash receipts from disposal of shares, warrants, or debt instruments of enterprises and interests in joint ventures (other than receipts from instruments considered to be cash equivalents and those held for dealing or trading purposes);
(e) Cash advances and loans made to third parties (other than advances and loans made by financial enterprise);
(f) Cash receipts from the repayment of advances and loans made to third parties (other that than advances and loans of a financial enterprise);
(g) Cash payments for futures contracts, forward contracts, option contracts. swap contract except when the contracts are held for dealing or trading purposes or the payments and classified as financing activities; and
(h) Cash receipts from futures contracts, forward contracts, option contracts, swap contracts except when the contracts are held for dealing or trading purposes, or the receipts are classified as financing activities.
(III) Financing activities. Examples of cash flows arising from financing activities
(a) Cash proceeds from issuing shares or other similar instruments;
(b) Cash proceeds from issuing debentures, loans, notes, bonds, and other short or long-term borrowings; and
(c) cash repayments of amounts borrowed.
Reporting Cash Flows from Investing and Financing Activities
An enterprise should report separately major classes of gross cash receipts and gross cash payments arising from investing and financing activities, except to the extent that cash flows described in paragraph 6 are reported on a net basis.
6. Reporting Cash Flows on a Net Basis
(I) Cash flows arising from the following operating, investing or financing activities may reported on a net basis:
(a) Cash receipts and payments on behalf of customers when the cash flows reflect the activities of the customer rather than those of the enterprise.
Examples of cash receipts and payments referred above are as follows:
(a) the acceptance and repayment of demand deposits by a bank;
(b) funds help for customers by an investment enterprise; and
(c) rents collected on behalf of, and paid over to, the owners of properties
(d) cash receipts and payments for items in which the turnover is quick, the amounts large, and the maturities are short.
Examples of cash receipts and payments referred above are advances made for, and the repayments of:
(a) Principal amounts relating to credit card customers;
(b) the purchase and sale of investments; and
(c) other short-term borrowings, for example, those which have a maturity period of three months or less.
Cash flows arising from each of the following activities of a financial enterprise may be reported on a net basis:
(a) cash receipts and payments for the acceptance and repayment of deposits with a fixed maturity date:
(b) the placement of deposits with and withdrawal of deposits from other financial enterprises; and
(c) cash advances and loans made to customers and the repayment of those advances and loans.
7. Disclosure
(1) Components of cash and cash equivalents. An enterprise should disclose the components of cash and cash equivalents and should present a reconciliation of the amounts in its cash flow statement with the equivalent items reported in the balance sheet.
(2) Other disclosures. An enterprise should disclose, together with a commentary by management, the amount of significant cash and cash equivalent balances held by the enterprise that are not available for use by it.
Note. As a result of AS: 3 (Revised) discussed above, the presentation of a Cash Flow Statement has undergone a change. In the following pages illustration involving presentation of Cash Flow Statement cash by the Traditional Approach and Modern Approach as per AS: 3 (Revised) are given.
The students should prepare cash flow statement as per AS : 3 (Revised).
We have given traditional approach only for making the subject more intelligible.
Comprehensive Cash Flow Statements
Illustration 5. Balance Sheet of A and B on 1 January, 1993 and 31 December 1993 were as follows:
BALANCE SHEET
Liabilities 1 Jan., 1993 31 Dec .. 1993 Assets 1 Jan.. 1993 Dee .. 1993
Rs Rs Rs Rs
Creditors 40,000 44,000 Cash 10.000 7,000
Mrs. A"s Loan 25,000 Debtors 30.000 50.000
Loans from Bank 40.000 50.000 Stock 35.000 25.000
Capital 1.25.000 1.53,000 Machinery 80,000 55.000
Land 40,000 50,000
Building 35.000 60.000
2.30,000 2.47.000 2.30,000 2,47.000
During the year a machine costing Rs 10,000 (accumulated depreciation Rs 3,000) was sold for Rs 5,000. The provisions depreciation against Machinery as 'on 1 January, 1993 was Rs 25,000 and on 31 December, 1993 was Rs 40,000. Net profit for the year 1993 amount to Rs 45,000. You are required to prepare Cash Flow Statement.
Solution
(i) Traditional Approach
CASH FLOW STATEMENT
RS.
Cash Balance as on January 1993
Add: Sources:
Cash from operations
Loan from Bank
Sale of Machinery
Less: Applications:
Purchase of land
Purchase of Building
Mrs. A’s Loan repaid
Drawings
Cash Balance as on 31 December 1993
59,000
10,000
5,000
10,000
25,000
25,000
17,000 10,000
74,000
84,000
77,000
7,000
Working Notes
Cash from Operations 45,000
Profit made during the year
Add: Depreciation on Machinery 18,000
Loss on sale of machinery 2,000
Decrease in Stock 10,000
Increase in Creditors 4,000 34,000
79,000
Less: Increase in Debtors 20,000
Cash from Operations 59,000
MACHINERY ACCOUNT (AT COST)
Particulars Rs. Particulars Rs.
To balance b/d 1,05,000
.
1,05,000 By Bank
By Loss on sale of Machinery
By Provision for Depreciation
By Balance c/d
5,000
2,000
3,000
95,000
1,05,000
PROVISION FOR DEPRECIATION
Particulars Rs. Particulars Rs.
To Machinery A/c
To balance c/d
3,000
40,000
.
43,000 By Balance b/d
By P & L A/c (Deprn. Charged – balancing figure) 25,000
18,000
43,000
(ii) Modern Approach
CASH FLOW STATEMENT
Net Cash Flows from Operating Activities
Cash flows from investing Activities
Sale of Machinery
Purchase of Land
Purchase of Building
Net Cash flows from Investing Activities
Cash flows from Financing Activities
Loan from Bank
Mrs. A’s Loan repaid
Drawings
Net Cash Flow from Financing Activities
Net Increase (Decrease) in cash and cash equivalents
Cash and Cash Equivalents on Jan 1, 1993
Cash and Cash Equivalents on Dec 31, 1993
5,000
(10,000)
(25,000)
10,000
(25,000)
(17,000) 59,000
(30,000)
32,000
3,000
10,000
7,000
4.INTEXT QUESTIONS
1.Explain the meaning of Cash Flow Statement. Discuss its utility
2.Distinguish between Funds Flow Statement and Cash Flow Statement.
3. What are the sources and uses of Cash.
5.SUMMARY
Cash Flow Statement are very useful tools in the hands of both the internal and the external parties, particularly to the financial analyst and the financial institutions which are extending loan facility to the corporate sector. A proper planning of the cash resources will enable the management to have cash available whenever needed and put it to some profitable or productive use in case there is surplus cash available.
6. TERMINAL EXERCISE
1. Cash from operation is equal to:
a. Net profit plus increase in outstanding expense
b. Net profit plus increase in Debtors
c. Net Profit plus increase in stock
2. Increase in the amounts of debtors results in:
a. Decrease in cash
b. Increase in cash
c. No change in cash
3. Increase in the amount of bills payable results in:
a. Increase in cash
b. Decrease in cash
c. No change in cash
7. ASSIGNMENTS
The following are the summarized Balance Sheet of a company as on December 1992 and 1993. (Amount in thousands)
Liabilities 1992 1993 Assets 1992 1993
Share Capital
General Reserve
Profit and Loss
Bank Loan (Long Term)
Sundry Creditors
Provision for taxation
200
50
30.5
70
150
30
530.5 250
60
30.6
-
135.2
35
510.8 Land and Building
Machinery
Stock
Sundry Debtors
Cash
Bank
Goodwill 200
150
100
80
.5
-
-
.
530.5 190
169
74
64.2
.6
8
5
.
510.8
Additional Information
During the year ended 31 December 1993:
1. Dividend of Rs.23,000 was paid.
2. Assets of another company were purchased for a consideration of Rs 50,000 payable in shares. The following assets were purchased: Stock Rs 20,000: Machinery Rs 25,000.
3. Machinery was further purchased for Rs 8,000.
4. Depreciation written off machinery Rs 12,000.
5. Income tax provided during the year Rs 33,000.
6. Loss on sale of machinery Rs 200 was written off to General Reserve.
You are required to prepare a cash flow statement.
8. KEY TERMS
Cash: The term stands for cash and bank nalance
Cash Flow Analysis: A technique involving analysis of the causes of flows of cash from one period to another.
Cash Flow Statement: A statement depicting change in cash position from one period to another.
LESSON - 12
MARGINAL COSTING
1. INTRODUCTION
Materials, labour and other expenses constitute the different elements of cost. These elements of cost can broadly be put into two categories: Fixed costs and Variable costs. The cost of product or process can be ascertained using the different elements of cost according to any of the following two techniques: Absorption Costing, and Marginal Costing. In this chapter we will understand that under the marginal costing technique, only variable costs are taken into account for purposes of product costing, inventory valuation and other important management decisions and no attempt is made to find suitable bases of apportionment of fixed costs.
2. OBJECTIVES
• To learn the importance and application of Marginal Costing
• To understand Marginal costing and Decision Making
• To understand Profit Planning
3. CONTENT
Concept of marginal cost
Concept of marginal costing
Which technique is preferable
Marginal costing - Role of contribution
Fixed and variable cost
Segregation of semi - variable cost
Marginal costing and decision making
Profit planning
Advantages of marginal costing
Materials, labour and other expenses constitute the different elements of cost. These elements of cost can broadly be put into two categories: Fixed costs and Variable costs. Fixed costs are those costs which do not vary but remain constant within a given period of time and range of activity in spite of fluctuations in production. Just contrary to this variable costs are those costs which may increase or decrease in proportion to increase or decrease in output. The cost of product or process can be ascertained using the different elements of cost according to any of the following two techniques:
1. Absorption Costing, and
2. Marginal Costing.
Absorption costing technique is also termed as Traditional or Full Cost Method. According to this method, the cost of a product is determined after considering both fixed and variable costs. The variable costs, such as those of direct materials, direct labour etc., are directly charged to the products while the fixed costs are apportioned on a suitable basis over different products manufactured during a period. Thus in case of absorption costing all costs are identified with the manufactured products.
Under the marginal costing technique, only variable costs are taken into account for purposes of product costing, inventory valuation and other important management decisions and no attempt is made to find suitable bases of apportionment of fixed costs. Marginal costing is also known as Direct Costing or Variable Costing. It is the most useful technique which guides the management in pricing, decision-making and assessment of profitability.
Concept of Marginal Cost
'Marginal Cost' derived from the word 'Margin' is a well known concept of economic theory. Thus, quite in tune with the economic connotation of the term. it is described in simple words as the cost which arises from the production of additional increments of output and it does not arise in case the additional increments are not produced.
The Institute of Cost and Works Accountants, London, in the publication "A Report on Marginal Costing" defines marginal cost as the amount at any given volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit". For instance, suppose that 100 units of a commodity can be produced at a cost of Rs.2000. If we produce 101 units at a total cost of Rs.2010, the marginal cost (i.e. increase in aggregate cost for additional unit) would be Rs. 10 (i.e. Rs.2010 - Rs.2000).
In the above definition, the word 'Unit' needs elucidation. Practically it may mean a single item of a product, a process, an operation, a batch of production, a department or a stage of production capacity. The costs which increase or decrease in response to change In any of these factors may be called as its marginal costs.
Marginal costs in the short run is the total variable cost because with in the capacity of the organisation, an increase of one unit in production will cause an Increase In variable cost only. The variable cost consists of direct materials, direct labour, variable direct expenses and other variable overheads. It must be noted here that even variable portion of semi variable costs are included in marginal cost. However, in the long run marginal costs will also include fixed costs in planning production activities involving an Increase in the production capacity. Thus, marginal costs are related to change in output under particular circumstances of a case.
However, where an increase in fixed costs is envisaged in the wake of an accretion to the productive capacity and consequently to the level of activity, fixed costs are dealt with as a part of what are called 'Differential Costs' so that the usage of the term 'Marginal Cost' is restricted in actual practice only to cases involving a more effective utilization of the existing installed capacity intended for a better recovery of fixed costs per unit of output.
Concept of Marginal Costing
As already pointed out marginal costing is a technique where only the variable costs are considered while computing the cost of a product? The fixed costs are met against the total fund arising out of the excess of selling price over total variable cost. This fund is known as contribution in marginal costing. According to the Institute of Cost and Works Accountants, London, "Marginal Costing is the ascertainment by differentiating between fixed costs and variable costs, of marginal costs and of the effect on profit or changes in the volume and type of output". According to the Chartered Institute of Management Accountants, London, "Marginal costing Is a technique where only the variable costs are charged to cost units, the fixed cost attributable being written off in full against the contribution for that period". This will be clear with the help of the following illustration.
Illustration
A company is manufacturing three products A, B and C. The costs of their manufacture are as follows:
Details Products
A B C
Rs. Rs. Rs.
Direct materials per unit 3 4 5
Direct labour per unit 2 3 4
Selling price per unit 10 15 20
Output (units) 1000 1000 1000
The total overheads are Rs.6000 out of which Rs.3000 are fixed and rest are variable. Prepare a statement of cost and profit according to the marginal costing technique.
Solution
Statement of Cost and Profit
(under marginal coating technique)
Details Product A Product B Product C
Per
Unit Rs. Total
Rs. Per Unit Rs. Total Rs. Per Unit Rs. Total Rs.
Direct Materials 3 3000 4 4000 5 5000
Direct Labour 2 2000 3 3000 4 4000
Variable Overheads 1 1000 1 1000 1 1000
(6000-3000=3000+3)
Total Marginal Cost 6 6000 8 8000 10 10000
Contribution (Sales-variable cost) 4 4000 7 7000 10 10000
Selling Price 10 10000 15 15000 20 20000
Thus the total contribution from the three products A, B and C amounts to Rs. 21,000 (4000 + 7000 + 10000). The profit will now be computed as follows:
Rs.
Total contribution 21,000
Fixed costs 3,000
18,000
Hence it is clear that marginal costing is not a system of cost finding such as job, process or operating costing, but it is a special technique concerned particularly with the effect of fixed overheads on running the business. In other words, it has been designed simply as an approach to the presentation of accounting Information meaningful to the management from the view point of adjudging the profitability of an enterprise by carefully studying the impact of the entire range of costs according to their respective nature.
The concept of marginal costing-is a formal recognition of ideas underlying flexible budgets, break even analysis and cost volume profit relationship. It is an application of these relationship which Involves a change in the conventional treatment of fixed overheads in relation to income determination.
Characteristic Features of Marginal Coating
1. It is a technique of analysis and presentation of cost rather than an independent method of costing. It can be applied with any method of costing.
2. The concept of marginal costing is based on the important distinction between product costs and period costs, the former being related to the volume of output and latter to the period of time.
3. Marginal costing regards as product costs only those manufacturing cost which have a tendency to vary directly with the volume of output i.e... It considers only variable costs in its analysis and fixed costs are excluded from computation though they may be reported separately.
4. It guides pricing and other managerial decisions on the basis of 'Contribution' which is the difference between sales value and variable cost of sales. Contribution is also known as 'gross margin* or 'marginal income'.
5. The stock of finished goods and work in progress are valued at marginal cost only.
6. The difference between the contribution and fixed cost represents either profit or loss. Excess of contribution over fixed cost is the profit and the deficiency of contribution to fixed cost is the loss.
Marginal Coating Vs Absorption Coating
Since marginal costing Is an alternative to absorption costing, it is necessary to compare the two and suggest if possible, the technique which is more appropriate in routine costing. Following are the important points of distinction between absorption costing and marginal costing:
1. Absorption/Total cost technique is the practice of charging all costs, both variable and fixed to operations, processes or products, i.e., both fixed and variable overheads are charged to production.
In marginal costing only variable overheads are charged to production while fixed overheads are transferred in full to the costing profit and loss account. Thus in marginal costing there is under recovery of overheads since only variable overheads are charged to production.
2. In case of absorption costing, stocks of work in progress and finished goods are valued at works cost and total cost of production respectively. The works cost or cost of production so used Includes the amount of fixed overheads also. In case of marginal costing only variable costs are considered while computing the value of work in progress or finished goods. Thus the closing -stock in - marginal costing is undervalued as compared to absorption costing.
3. In the case of absorption costing, profit is the difference between sales revenue and total cost. As such managerial decision making is wholly dependent upon this concept of profit.
In the case of marginal costing, the excess of sales revenue over marginal cost is known as contribution and decision making centres round this concept of profit.
4. In total cost technique, there is the problem of apportionment of fixed costs since fixed costs are also treated as product costs.
Marginal costing excludes fixed costs. Therefore there is no question of arbitrary apportionment.
The above points of difference between absorption costing and marginal costing will be clear with the help of the following Illustration:
A company has a production capacity of 2, 00,000 units per year. Normal capacity utilization is reckoned as 90%. Standard variable production costs are Rs. 11 per unit. The fixed costs are Rs. 3.60,000 per year. Variable selling costs are Rs.3 per unit and fixed selling costs are Rs.2, 70.000 per year. The selling price per unit is Rs. 20. In the year just ended on 30th June 1993. the production was 1, 60,000 units and sales were 1, 50,000 units. The closing inventory on 30.06.1993 was 20,000 units. The actual variable production costs for the year were Rs.35, 000 higher than the standard.
Calculate the profit for the year:
(a) by the absorption costing method, and
(b) by the marginal costing method.
Also explain the difference in the profits.
Solution
(a) Profit Statement for the year ended 30th June 1993 (under absorption costing method)
Particulars Amount Rs. Amount Rs.
Sales: 1,50,000 units at Rs. 20 per unit 30,00,000
Less: Cost of production:
Variable production cost for 1,60,000 units at Rs. 11 per unit 17,60,000
Increase in fixed cost 35,000
Fixed costs 3,60,000
21,55,000
Add: Opening Stock: 10,000 units
(i.e... Sales 1.50.000 units + Closing
stock 20,000 units - production,1.60,000 units) at Rs. 13 (i.e., variable normal capacity utilization) 1,30,000
22,85,000
Less: Closing Stock: 20,000 units values
At current cost
=2,69,375 20,15,625
9,84,375
Gross Profit
Less: Selling expenses:
Variable 4,50,000
Fixed 2,70,000
7,20,000
Net Profit 2,64,375
(b) Profit Statement for the year ended 30th June 1993. (Under marginal costing method)
Particulars Amount Amount
Rs. Rs.
Sales: 1,50,000 units at Rs. 20 per unit 30,00,000
Less: Marginal Cost:
Variable production cost for
1,60.000 units at Rs. 11 per unit 17,60,000
Additional variable production cost 35,000
Variable cost of opening stock of finished goods 1,10,000
19,05,000
Less: Closing Stock of finished goods:
20.000 units valued at current variable production cost
2,24,375
Variable production cost of 1,50,000 units 16,80,625
Add: Variable selling cost of 1,50,000 units (1,50,000x3) 4,50,000 21,30,625
Contribution 8,69,375
Less: Fixed costs:
Fixed production costs 3,60,000
Fixed selling costs 2,70,000
6,30,000
Net Profit 2,39,375
The difference in profits Rs.25.000 (i.e., Rs.2, 64.375 - 2.39.375) as arrived at under absorption and marginal costing methods Is due to the element of fixed cost included In the valuation of opening and closing stock under the absorption costing method.
Which technique is preferable?
Since absorption costing and marginal costing are alternative techniques in the routine cost accounting system. It is necessary to say word about their appropriateness for product costing. Absorption costing may be preferred on the following grounds:
1. In modern times fixed costs constitute a substantial portion of total cost. Production is impossible without incurring fixed costs. As such they are a part of cost of production.
2. Inclusion of fixed costs in inventory valuation becomes absolutely necessary if building up of stocks is a necessary part of business operations. For instance. In the case of timbers and fire works stocks have to be built up. If fixed costs are excluded from inventory valuation fictions losses have to be shown in earlier years and excessive profits when goods are actually sold.
3. Profit fluctuations are less when production is constant- but sales fluctuate.
4. This technique enables matching of costs and revenue, in the period In which revenue arises and not when costs are incurred.
5. The inclusion of fixed costs does not give room for fixation of price below total cost although some contribution is generated.
Marginal Costing may be preferred on the following grounds:
1. This technique is simple to understand and easy to operate.
2. Indivisible fixed costs need not be apportioned on an arbitrary basis.
3. It avoids the contingency of over/under absorption of overheads.
4. Fixed costs accrue on time basis. Hence they should be written off in the period of accrual.
5. Accounts prepared under this technique more nearly approach the actual cash flow position.
In the light of the above arguments in favour of each of the techniques, If is not possible to lay down any general rule regarding the use of a particular technique. It is the cost accountant who is the right person to decide in favour of either of the two having regard to its appropriateness to a particular organisation. While absorption costing Is the basis of financial accounting, it is equally so in the routine cost ascertainment procedure. since the use of full marginal Costing system for product costing is very rare in modem times. However, for purposes of planning and decision making, marginal costing is the only technique which is universally recognized.
Marginal Costing - Role of Contribution
Contribution is of vital importance for the system of marginal costing. The rationale of contribution lies in the fact that, where a business manufacturers more than one product, the profits realized on individual products cannot possibly be calculated due to the problem of apportionment of fixed costs to different products which is done away with under marginal costing. Therefore, some method is required for the treatment of fixed costs and marginal casting’s answer to the challenge is contribution.
Contribution is the difference between sales and variable cost of sales and is therefore sometimes referred to as 'gross margin'. It is called as contribution because it enables to meet fixed costs and contributes to the profit. It is visualized as some sort of a 'fund' or 'pool* out of which all fixed costs, irrespective of their nature are to be met and to which each product has to contribute its share. The difference between contribution and fixed costs is either profit or loss as the case may be.
The concept of contribution is useful in the fixation of selling prices, determination of break even point, selection of product mix for profit maximization and ascertainment of the profitability of products, departments, etc.
Fixed and Variable costs
In marginal costing, apart from 'contribution' the concepts of 'fixed costs' and 'variable costs' are also important. The term variable cost is defined as "A cost which in the aggregate tends to vary in direct proportion to changes in the volume of output or turnover" (ICMA Terminology).
The definition of the term variable cost given by the Terminology relates variable cost to activity i.e., any expense that is expected to change with the volume of production is treated as variable overhead. All supplies, indirect manufacturing labour, expenses of receiving, storing and maintenance of plant and machinery are all Included under this classification. Thus variable costs tends to vary with the volume of production or sales. Further the change is supposed to be in direct proportion to the level of activity. But the variable cost per unit remains constant.
The term fixed cost is defined as "A cost which accrues in relation to the passage of time and which, within certain output or turnover limits, tends to be unaffected by fluctuations in volume of output or turnover".
This definition of ICMA makes it clear that they are time based and within certain limits, they are unaffected by changes in activity. In other words, fixed costs are costs of time. They accumulate with the passage of time irrespective of the volume of output or turnover. It is this point that distinguishes variable costs from fixed costs. Conventional items such as depreciation of plant and machinery, factory insurance, salaries etc., represent fixed overheads.
However, to say that fixed costs do not vary is wrong. Accordingly, even fixed costs become variable beyond a particular point. If production increases substantially, additional accommodation and additional executive staff cause an Increase in rent, insurance, salaries etc. There are also other factors such as Inflation, government policies, and management decisions which bring about a change in the level of fixed costs. Since fixed costs, do not, in total, respond to changes in the level of activity, an increase in volume will result in a decrease in the fixed cost per unit.
According to the ICMA Terminology, Semi variable cost is "A cost containing both fixed and variable elements which therefore are partly affected by fluctuations In the volume of output or turnover".
In other words, Semi variable expenses possess both fixed and variable characteristics. Salaries of foremen and supervisors, electricity charges, telephone charges etc., fall under this category. Semi variable cost is also known as semi fixed cost since it contains both fixed and variable elements i.e., semi variable costs are costs which are mainly variable with a significant fixed element or mainly fixed with a significant variable element. Very rarely, a cost would be wholly fixed or wholly variable. In a large number of cases it includes both the elements.
Although, what is variable, fixed or semi variable cost depends upon the nature of business, it is usual to distinguish four types of semi variable costs. They are:
(a) Fixed and Variable elements combined
Electricity charges, for Instance, contain a fixed charge and a variable element viz., cost per unit consumed. Similarly, telephone charges. The same is true of indirect labour when a minimum force Is necessary to operate but is easily supplemented when need arises.
(b) Cost increasing in steps
Also known as step costs. They remain constant for a particular range of activity. When activity increases beyond the range, cost increases significantly. A typical example is supervision cost. If one foreman could supervise the work of eight labourers, any increase in the number of labourers would be beyond the control of one foreman. In such a case the labourers should be split into two groups necessitating the appointment of an additional foreman.
(c) Seasonal Costs
Some items of costs tend to be higher during certain months than during other months owing to climatic conditions or any other reason unconnected with the volume of output. For example, heating and lighting.
(d) Costs increasing at a fluctuating rate
Sometimes the cost curve may be curvilinear increasing more rapidly at some points on the volume of output scale than others. This happens very often when a particular department reaches or exceeds its practical capacity. For example, when electricity consumption charge per unit may increase at a fluctuating rate.
Segregation of Semi-variable Cost
Marginal costing requires segregation of all costs between two parts fixed and variable. This means that the semi-variable cost will have to be segregated into fixed and variable elements. This may be done by any one of the following methods;
1. Accounts classification
An examination of the cost code used by a business facilities the identification of costs as fixed or variable. To decide whether a cost tends to be wholly fixed or wholly variable requires the exercise of judgement. One has to decide whether there is a large variable or fixed element in an item of cost. It is also possible to investigate the make-up of each item of cost by examining invoices, vouchers and other documents, noting separately the fixed costs and the variable costs.
This method, though simple, is a time-consuming method. Further if an account classification cannot be identified as fixed or variable by inspection, it becomes necessary to rely upon any of the following methods.
2. Levels of output compared to levels of expenses method
According to this method, the output at two different levels is compared with corresponding level of expenses. Since the fixed expenses remain constant, the variable overheads are arrived at by the ratio of change in expense to change in output.
Illustration
Year 1992
Month Production
(in units) Semi-variable
Expenses (Rs.)
July 50 250
August 30 132
September 80 200
October 60 170
November 100 230
December 70 190
During the month of January 1993, the production is 40 units only. Calculate the amount of fixed, variable and total semi variable expenses for the month.
Solution
Computation of fixed and variable overheads
(Figures of September and November taken as the base)
Month Production Semi-variable
Expenses
(Rs.) Fixed Variable
September 80 200 80* 120*
November 100 230 80** 150**
Difference 20 30
Therefore, variable element
* Variable overheads for September = 80 1.50 = Rs.120
Fixed overheads for September = 200 - 120 = Rs.80
** Variable overheads for November = 100 1.50 = Rs. 150
Fixed overheads for November = 230 - 150 = Rs.80
Variable overheads for January = 40 1.50 = Rs.60
Fixed overheads for January = Rs.80
Total semi variable overheads = Rs.60 + Rs.80 = Rs. 140
3. The High-Low points method
This method establishes the relationship between cost and volume on a historical basis. It thus involves the examination of previous results. Under this method, the cost of a particular item of expenditure for a given number of past costing periods is taken into consideration and the level of activity for each of the periods is ascertained. The level of activity may be expressed in terms of the number of units produced, the number of labour hours worked of the number of machine hours. At two extreme levels of activity, the related costs are picked out and the rate of change between the two points is worked out. This rate of change is assumed to be the variable cost per unit. The total variable cost for one of the points is then calculated by multiplying the level of activity by the variable cost per unit. It is then deducted from the total cost for that level of activity. The balance is the fixed cost. In selecting the periods and in dealing with costs incurred during such periods, care should be taken to see that figures are not distorted by any abnormal factors.
This method can be elucidated by the following examples of costs incurred in the maintenance of plant by a business undertaking:
Activity level in terms of
direct labour (hours) Costs
No. Percentage
High 13,680 100 5552
Low 5,472 40 3500
Range of variation 8,208 60 2052
The fixed element of maintenance cost of plant at two points of activity can then be arrived at as thus
High Low
Total costs 5552 3500
Variable costs @ Re. 0.25 per direct labour hour 3420 1368
Fixed cost component 2132 2132
Sometimes, this is also expressed by means of a formula which is:
Where
C1 = Cost at high level of activity
C2 = Cost at low level of activity
L1 = High level of activity
L2 = Low level of activity
Therefore
Fixed cost component = Rs. 5552 - Rs. 3420
= Rs. 2132
4. Scatter graph Method
This is a statistical technique by which a line is fitted to a series of data. The steps in the construction of a scatter diagram are:
i. Plot of the costs at various levels of output, taking output along the horizontal axis and costs along the vertical axis.
ii. Draw a line which links as many points as possible and which has an equal number of points on either side of the line. Ignore the points which indicate abnormal results. The line thus drawn is known as the 'line of best fit'.
iii. Extend the line to the vertical axis.
iv. The point at which the line Intersects the vertical axis indicates, the fixed cost element. Draw a line representing the fixed cost parallel to the horizontal axis.
v. The gap between the total cost line and the fixed line indicates the variable cost element for a particular level of activity.
vi. Divide the variable cost for a certain level of activity by the number of units. This gives the variable cost per unit.
5. Method of least squares
This method is based on the mathematical technique of fitting an equation with the help of a number of observations. This method which is also known as the regression analysis, makes use of the equation of straight line, Y = a + bx for fitting a straight line trend. The linear equation, i.e., a straight line equation, can be assumed as:
y = a + bx and the various sub equations shall be
y = na + bx;
y = ax + bx2
6. Engineering estimates
The statistical methods outlined above are of limited use if historical data are not available or the data are unreliable owing to technological changes. Even if historical data are available, the relationship between cost and volume will be imperfect if cost is influenced by a number of factors. In such cases, the assistance of industrial engineers who, along with the members of the accounting department, determine the physical inputs necessary to achieve certain levels of output and then convert these into money costs. Not only do they separate the fixed and variable elements, they also establish efficiency standards for different levels of activity.
Each of the methods outlined above has its own limitations. As such, none of these is said to be the best from the point of view of segregation of fixed and variable elements. In a number of cases, it becomes necessary to use the methods together. When it is known that there is strong evidence of correlation the least square method will be the best. In the absence of correlation, the least square method, like the scatter diagram and the high and low point’s methods will merely establish an overhead recovery rate consisting of the fixed and variable elements. In such cases engineering estimates will be accurate.
Marginal coating and decision making
Decision making is one of the most important activities of management. When faced with the problem of choosing a particular course of action from amongst a number of alternative courses, a manager has to predict the possible outcome of each course. All decisions thus relate to the future. Consequently, he needs Information regarding future costs and revenues. Although future cannot be foretold, an understanding of behaviour of costs absolutely necessary. He has, therefore, to fall back upon Information pertaining to past costs, records of performance, future costs and revenue', likely state of the market etc. It is, in this context, that the technique of marginal costing assists management in making predictions about the future in relation to alternative courses of action. Therefore, it is essential to study as to how the technique of marginal costing is applied to practical problems.
(i) Fixation of seizing prices
Although prices are more controlled by market conditions and. other economic factors than by decisions of management, yet the fixation of selling prices is one of the most important functions of management. This function is to be performed:
(a) Under normal circumstances,
(b) In times of competition,
(c) In times of trade depression,
(d) In accepting additional orders for utilizing idle capacity, and
(e) In exporting and exploring new markets.
In normal circumstances, the price fixed must cover total cost as otherwise profits cannot be earned. It can also be fixed on the basis of marginal cost by adding a high margin to marginal cost which may be sufficient to contribute towards fixed expenses and profits. But under other circumstances, products may have to sell at a price below total cost, if such a step is necessary to meet the situation arising due to competition, trade depression, additional orders for utilizing spare capacity, exploring new markets etc. Thus in special circumstances, price may be below the total cost and it should be equal to marginal cost plus a certain amount (if possible).
Pricing in depression
Prices fall during depression and the product may be sold below the total cost. In case there is a serious but temporary fall in the demand on account of depression leading to the need for a drastic reduction in prices temporarily, the minimum selling price should be equal to the marginal cost. If the selling price at which the goods can be sold is equal to marginal cost or more than marginal cost, the product should be continued. Fixed expenses will be incurred even if the-product is discontinued during depression for a short period. If the product can be sold at a price which is a little more than marginal cost, loss on account of fixed expenses will reduce because price will recover fixed expenses to some extent. This can be made clear by giving the following example:
A statement of cost prepared under absorption costing shows the following situation prevailing in an engineering firm facing depression:
Rs.
Direct material (2,100) 31,500
Direct Wages 14,700
Overheads:
Variable 6,300
Fixed 10,500 16,800
Total Cost 63,000
Sales 2100 pieces at Rs. 26 per piece 54,600
Loss 8,400
There is no sign of improvement in the situation and the losses have been chronic. Therefore the management wants to know whether it is desirable to stop production. Give your views on this matter. What should be the minimum price at which you would like to suggest shut down? What would be your suggestion if price falls to Rs.23/- per piece?
Solution
Even if the factory is shut down fixed expenses Rs. 10,500 will have to be incurred and the loss would be equal to fixed costs Rs. 10,500 which is more than the present loss of Rs.8,400. Therefore it is advisable not to close the factory. The present loss is less, because the price is more than the marginal costs and it contributes towards recovery of fixed costs.
Marginal Cost Per Price Rs. Total Rs.
Direct Material 15 31,500
Direct Labour 7 14,700
Variable expenses 3 6,300
Marginal Cost 25 52,500
Sale price of 2100 units at Rs. 26 per unit 26 54,600
Contribution 1 2,100
Fixed Cost - Contribution = Loss
10500-2100 =Rs. 8400
Therefore, so long as the price is above marginal cost the contribution goes to recover fixed costs which have to be incurred when production is stopped.
So minimum price at which production may be discontinued should be equal to marginal cost. In this case, Rs.25 being marginal cost can be the minimum price. Any price below Rs.25 will not recover even the marginal cost. Hence the loss would be more than the fixed cost and in such case stopping production would limit the loss to fixed cost only.
Thus if the price is Rs.23, the loss would be more than the fixed cost Rs.10,500
Rs.
Sales price 2100×23 = 48,300
Less: Marginal cost 2100×25 = 52,500
Loss = 4,200
Add: Fixed cost = 10,500
Total Loss = 14,700
Since the loss would be Rs. 14,700, it is advisable to stop production in order to limit losses.
(ii) Accepting additional orders, exploring additional markets and exporting
Bulk orders may be received from large scale buyers or foreign dealers asking for a price which is below the market price. This calls for a decision to accept or reject the order. If the price is below the total cost, it may tempt to reject such offer. But marginal costing takes a different view. It recommends for accepting the order, provided that the quoted price is more than the marginal costs. If reasons that since the local market price provides contribution sufficient to recover fixed costs and a margin of profit, any contribution from the foreign offers would be net addition to the profits. However, if the quoted price is less than the marginal cost it is not advisable to accept the order. Care should be taken to see that low quotations should not have any adverse impact on the local market.
Illustration
The cost sheet of a product is given as under:
Rs.
Direct materials 5.00
Direct wages 3.00
Factory Overheads:
Fixed Re. 0.50 1.00
Variable Re. 0.50 0.75
Administrative expenses
Selling and distribution overheads:
Fixed Re. 0.25
Fixed Re. 0.50 0.75
The selling price per unit is Rs. 12. 10.50
The above figures are for an output of 50,000 units the capacity for the firm is 65,000 units. A foreign customer is desirous of buying 15000 units at a price of Rs.10 per unit. Advise the manufacturers whether the order should be accepted. What will be your advice if the order were from a local merchant?
Solution
Marginal cost or additional cost for additional 15000 units.
Per Unit Per 1500 Units
Direct materials 5.00 75,000
Direct wages 3.00 45,000
Prime Cost 8.00 1,20,000
Variable Overheads: Factory 0.50 7,500
Variable Overheads: Factory 0.50 7,500
Selling and distribution 0.50 7,500
Marginal cost 9.00 1,35,000
Sales 10.00 1,50,000
Contribution 1.00 15,000
The order from the foreign customer will give an additional contribution of Rs.15,000. Hence the order should be accepted because the additional contribution of Rs.15,000 will increase the profit by this amount because fixed expenses have already been met from the internal market.
The order from the local merchant should not be accepted at a price of Rs. 10/- which is less than normal price of Rs. 12/- This price will affect relationship with other customers and there will be a general tendency of reduction in the price.
(iii) Profit planning
Profit planning is the planning of future operations to attain maximum profit or to maintain a specified level of profit. Marginal costing, through the calculation of contribution ratio enables the planning of future operations in such a way as to attain either minimum profit or to maintain a specified level of profit. Thus it is helpful in profit planning.
Illustration
A toy manufacturer earns an average net profit of Rs.3 per piece in a selling price of Rs.15 by producing and selling 60,000 pieces at 60% of the potential capacity.
Composition of his cost of sales is:
Direct materials Rs.4.00
Direct wages Rs. 1.00
Works overhead Rs.6.00 (50% fixed)
Sales overhead Re. 1.00 (25% varying)
During the current year, he Intends to produce the same number but anticipates that:
(a) his fixed charge will go up by 10%
(b) rates or direct labour will increase by 20%
(c) rates or direct material will Increase by 5%
(d) selling price cannot be increased.
Under these circumstances, he obtains an order for a further 20% of his capacity. What minimum price will you recommend for accepting the order to ensure the manufacturer an overall profit of Rs. 1,80,500?
Solution
Marginal cost statement for Current Year
(Prior to acceptance of 20% excess order)
Per Piece
(Rs.) Total amount
(Rs.)
Variable cost:
Direct material 4.20
Direct labour 1.20
Works overhead 3.00
Sales overhead 0.25
8.65 5,19,000
Sales Value 15.00 9,00,000
6.35 3,81,000
Fixed Cost:
Works Overhead 1,80,000
Add: 10% 18,000 1,98,000
Sales Value 45,000
Add: 10% 4,500 49,500 2,47,500
Profit 1,35,500
Planned profit = 1,80,000
Increase in profit = 1,80,500 - 1,33,500
= 47,000
The minimum price for 20.000 toys (order for 20% of capacity) can be worked out as under:
Variable cost at Rs. 8.65 = 1.73,000
Add: Increase in profit = 47,000
2,20,000
2,20,000
Minimum sale price per unit = 20,000 units Rs.11
(iv) Decision to make or buy
The technique of marginal costing enables management to decide whether to make a particular product or component or buy it from outside. Such decisions become necessary when unutilized production facilities exist, and the product being produced has a component which can either be made in the factory itself or purchased from outside.
It is also possible that a concern manufacturing more products than one, but each is complimentary to the other, may decide to give up the production of one of them on the ground that it is less profitable, and buy the same from outside. Such a situation may exist in the case of concerns manufacturing primary packing materials.
While deciding to make or buy, the cost comparison should be between the marginal cost of manufacture and the cost because these will be incurred even if the part is not produced. Thus, additional cost of the part will be as follows:
Rs.
Materials 3.50
Direct labour 4.00
Other Variable Expenses 1.00
Total 8.50
The company should produce the part even if the part is available in the market at Rs.9.00 because the production of every part will give to the company a contribution of 50 paise (i.e.. Rs.9.00 - Rs.8.50).
The company should not manufacture the part if it is available in the market at Rs.8 because additional cost of producing the part is 50 paise (i.e., Rs.8.50-8.00) more than the price at which it is available in the market.
(v) Problem of Key or Limiting Factor
Under the marginal cost concept, profitability of a product or process is measured with reference to its contribution. This is based on the assumption that it is possible to increase the manufacture of the product yielding the highest marginal contribution to any desired extent and there is no limitation in this regard. In practice however this assumption is not valid and the management is confronted with factors which put a limit on their efforts to produce as many units of the selected products as they would like to. Such factor which is equally important in the determination of profitability is called 'Key Factor' or 'Limiting Factor', or 'Governing Factor', or 'Principal Budget Factor', or 'Scarce Factor'.
A limiting or key factor is defined as the factor which over a period, will limit the volume of output. Usually sales is the limiting factor, but it may sometimes arise due to the shortage of one or more of the factors of production such as materials, labour, capital and plant capacity. When both contribution and key factors are known, the relative profitability of different products or processes can be assessed with the help of the following formula
Illustration
From the following data relating to products X and Y for which certain materials used is in shortage, find out which is more profitable from the point of view of economical use of scarce resources.
Product X Product Y
Rs. Rs.
Materials;
3 units at Rs.5 per unit 15 ---
5 units at Rs. 5 per unit --- 25
Labour 10 15
Overheads:
Variable 5 5
Fixed 12 20
42 65
Selling price 50 75
Profit 8 10
Solution
Particulars Product X Product Y
Rs. Rs.
Marginal cost
(Material + Labour + variable expenses) 30 45
Selling price 50 75
Contribution 20 30
Contribution per unit
X = 20 + 3 6.67 --
Y = 30 + 5 – 6.00
Since contribution per unit of material In X is more than that of Y the available material should be used first for X and when its demand is met, Y should be produced.
(vi) Choice of profitable product mix
When a concern manufactures more than one product, a problem is faced by the management as to which product mix will give maximum profits. The best product mix is that which yields the maximum contribution. The products which give the maximum contribution are to be retained and their production should be increased. The products which give comparatively less contribution should be reduced or closed down altogether.
Illustration
The following three alternative plans are being considered for the next account year by a company:
Plan A: Sell 1000 units of product X and 500 units of product Y.
Plan B: Sell 800 units of product X and 700 units of product Y.
Plan C: Sell 750 units of each product.
The budget figures are:
X Y
Rs. Rs.
Selling price 8 7
Direct materials 3 3
Direct wages 2 2
Variable overhead 0.50 0.25
Calculate the budgeted profit that would result from each of the three alternatives and suggest the most profitable alternative. The budgeted fixed costs are Rs. 1500.
Solution
X Y
Rs. Rs.
Selling price 8 7
Direct materials 5.50 5.25
Direct wages 2.50 1.75
Plan A : 1000 units of product X and 500 units of product Y
Contribution:
X: 1000 × 2.50 = 2,500
Y: 500 × 1.75 = 875
Total contribution = 3,375
Less: Fixed cost = 1,500
Net Profit = 1,875
Plan B: 800 units of Product X and 700 units of Product Y
Contribution:
X: 800 × 2.50 = 2,000
Y: 700 × 1.75 = 1,225
Total Contribution = 3,225
Less: Fixed cost = 1,500
Net profit = 1,725
Plan C: 750 units of each Products
Contribution:
X: 750×2.50 = 1,875.00
Y: 750 × 1.75 = 1,312.50
Total contribution = 3,187.50
Less: Fixed cost = 1,500.00
Net profit = 1,687.50
Plan A with 1000 units of product X and 500 units of Product Y is the best mix since the contribution and the profit are the highest. However before taking the decision, consideration should be paid to the limiting factor.
iv) Evaluation of alternative methods of products
Marginal costing is helpful in comparing the alternative methods of production i.e. machine work and hand work. The method which gives the greatest contribution is to be adopted, keeping of course the limiting factor view.
Illustration
Product X can be produced either by machine A or by machine B. Machine A can produce 100 units of X per hour and machine B 150 units per hour. Total machine hours available during the year are 2500. Taking into account the following data determine the profitable method of manufacture:
Per unit of Product X
Machine A Machine B
Rs. Rs.
Marginal cost 5 6
Selling price 9 9
Fixed cost 2 2
Solution
PROFITABILITY STATEMENT
Machine A Machine B
Rs. Rs.
Selling price per unit 9 9
Less: Marginal cost 5 6
Contribution per unit 4 3
Output per hour 100 150
Contribution per hour 400 450
Machine hours per year 2,500 2,500
Annual contribution 10,00,000 11,25,000
Hence production by Machine B is preferable
viii) Determination of optimum activity level
One of the very common confronting a business is regarding the level of activity for which it should have plans in hand. Such plans may envisage an expansion or contraction of productive activities depending upon the qualitative conditions in the market. The expansion or contraction has to be arranged before the events overtake the business. In this context, management would like to have an idea of the contribution at different levels of activities and marginal proves very useful from point of view.
Illustration
Following is the cost structure of an electronics company:
Level of activity
50% 70% 90%
Output (in units) 10,000 14,000 18,000
Costs (in Rs.)
Materials 1,00,000 1,40,000 1,80,000
Labour 30,000 42,000 54,000
Factory Overheads 50,000 60,000 70,000
Factory cost 1,80,000 2,42,000 3,04,000
Solution
Marginal cost statement
(At 100% level of activity with 20,000 units)
Total Cost Cost Per Unit
Rs. Rs.
Materials 2,00,000 10.00
Labour 60,000 3.00
Factory Overheads (Variable) 50,000 2.50
Marginal factory cost 3,10,000 15.50
Fixed factory overheads ** 25,000 --
3.35,000
Thus the marginal factory cost per unit is Rs. 15.50 and the total production cost per unit is Rs. 16.75 (Rs.3, 35,000 + 20.000).
Working
Calculation of variable factory overheads per unit:
**Calculation of fixed factory overheads:
Factory overheads - (no. of units at certain level of activity × Variable Factory Overheads per unit)
= Rs.50, 000-(10,000 x 2.50)
= Rs.50, 000-Rs.25, 000
= Rs.25, 000
This amount can be verified by making calculation at any other level of activity.
Variable Factory Overheads at 100% level of activity:
20,000 × Rs.2.50 = Rs.50, 000
Advantages of Marginal Costing
1. It assists in taking decisions such as pricing, accepting foreign orders at low price; to make or buy; profit planning; deciding about profitable product mix etc., as explained earlier.
2. Elimination of fixed overheads from the cost of production means that finished goods and work in progress are valued at their original cost and therefore the valuation is more realistic and uniform as compared to the one when they are valued at their total cost. There is no problem of arbitrary apportionment of fixed overheads.
3. It enables effective cost control through flexible budgeting by dividing costs into fixed and variable component.
4. By differentiating fixed and variable costs and by means of break even charts it depicts convincingly the Inter relationship between costs. Volume and profits and thereby aids in optimizing the level of activity and helps in profit planning.
5. Marginal costing has a unique approach in reporting cost data to the management. The reports are based on figures of marginal costs and sales rather than on total cost and production. So fixed costs and stocks do not vitiate appraisal as well as comparison of profitability or performance efficiency.
4. REVISION POINTS
Marginal cost is the Cost incurred in raising the level of output beyond the original target. Marginal costing is a technique of analysis and presentation of cost rather than an independent method of costing.
5.INTEXT QUESTIONS
1. Distinguish marginal costing from absorption costing.
2. "Marginal costing is the administrative tool for the management to achieve higher profits and efficient operations" - Elaborate.
3. Are there pit falls in the application of marginal costs? Explain.
4. Explain the managerial uses of marginal costing.
5. Explain how semi variable costs could be spilt into fixed and variable costs.
6. SUMMARY
Marginal costing is not a method of cost ascertainment like job costing as contact costing for decision making. It is more helpful to the management. The other names for marginal costing are direct costing differential costing and comparative costing. Only variable items of cost are taken into account.
7. TERMINAL EXERCISES
1. Which of the following factor equated to the contribution at the level of Break Even Point?
i. Fixed Cost
ii. Sales
iii. Variable Cost
iv. Semi-variable cost
2. What is the change to be made on the BEP formula to find out the volume of sales at the desired level of profit?
i. Desired profit
ii. Fixed cost
iii. Desired profit with fixed cost
iv. Desired cost + Fixed profit
8. SUGGESTED READING/REFERENCE BOOKS/SET BOOKS
1) J.Madegowda ‘Management Accounting’, Himalaya Publishing House
2) M.P.Pandikumar ‘Management Accounting’ Excel Books.
9. Keywords
1. Marginal cost: Cost incurred in raising the level of output beyond the original target.
2. Marginal costing: It is a technique of analysis and presentation of cost rather than an independent method of costing.
3. Fixed cost: Cost that does not vary with short - term changes in the level of output.
4. Variable cost: Costs that may vary with short-term changes in the level of output
5. Contribution: It is money paid as an addition to another sum. It is difference between sales and variable cost of sales.
LESSON –13
BREAK EVEN ANALYSIS AND PROFIT PLANNING
1 INTRODUCTION
Planning is the essence of business management. It is only by planning that management can realistically view future problems, analyse them, study their Impact on the activities of business and decide on the policy to be followed for achieving the objective of making profits.
Profit planning is necessarily a part of operations planning. It is the basis of planning cash, capital expenditure and pricing. It involves the prediction of most aspects of a firm's operations. While an enterprise usually plan its sales, activities and costs and then calculates the profit it hopes to make, in the case of profit planning, however, a target of profit is laid down in advance and then decision is taken regarding sales, activities and costs required to achieve the targets. Thus, "Profit planning is the planning of future operations to attain maximum profit or to maintain a specified level of profit".
2. OBJECTIVE
• To understand the fundamental of breakeven analysis.
• To understand the presentation of break even analysis.
• To learn the Effects of Changes in Cost, Price and Volume on Break-Even Point, Profit, etc.
3. CONTENT
Cost volume profit analysis
Concept of cost volume profit relationship
Break-even analysis
Presentation of Break - Even analysis
Cash - Break Even chart
Angle of Incidence
Profit - Volume - graph
Assumption underlying CVP analysis / Break even chart.
Advantages and Limitation of Break Even chart.
Cost Volume Profit Analysis
Herman C Helser In his book 'Budgeting - Principles and Practice' writes that, "the most significant single factor in profit planning of the average business is the relationship between the volume of business, cost and profit". These days in management accounting, a great deal of importance is being attached to cost volume profit relationship which, as its name implies, is an analysis of three different factors - costs; volume and profit. In this case an analysis is made to find out:
What would be the cost of production under different circumstances?
What has to be the volume of production?
What profit can be earned?
What is the difference between the selling price and cost of production?
Concept of Cost Volume Profit Relationship
Most business decisions are an exercise in the selection of alternatives - whether to accept a certain business at the specified price or not, whether to aggressively push the sales of one product or other. Whether to exploit more intensively one or the other of the territories. In a scheme of cost volume profit analysis, an attempt is made to measure variations of cost with volume. Cost may depend on volume which in turn depends on demand; profits depend on the price that can be obtained for the goods manufactured and placed in the market less the cost thereof. Moreover, a business must incur certain minimum expenditure on fixed and semi-variable charges. Such expenditure must be paid out of marginal profit earned on each unit of production with the result that a minimum volume of business become essential, the direct variable cost of each article sold being covered by the sale proceeds.
CVP analysis is an extension of marginal costing. It makes use of the principles of marginal costing and is an important tool of short term planning. It is more relevant where the proposed changes in the level of activity are relatively small.
CVP analysis is useful to the finance manager in the following respects:
1. It helps him in forecasting the profit fairly accurately.
2. It is helpful in setting up flexible budgets, since on the basis of this relationship, he can ascertain the cost, sales-and profits at different levels of activity.
3. Since costs and profits depend upon volume, the effects of changes in volume should be considered while reviewing costs and profits achieved. Thus, performance evaluation which is necessary for cost control is rendered possible by a study of the relationship of these variables.
4. It helps in formulating price policy by projecting the effect which different price structures will have on cost and profits.
5. It helps in determining the amount of overhead cost to be charged at various levels of operations, since overhead rates are generally pre-determined on the basis of a selected volume of production.
Thus CVP analysis is an important medium through which the management can have an Insight into effects on profit on account of variations in costs (both fixed and variable) and sales (both volume and value) arid take appropriate, decisions. A widely used technique which facilitates the study of CVP relationship is the Break Even Analysis.
Break Even Analysis
A logical extension of marginal costing is the concept of break even analysis. It is based on the same principle of classifying the operating expenses into fixed and variable. Now a days it has become a powerful instrument in the hands of policy makers to maximize profits.
The term "break even analysis' is interpreted in the narrower as well as broader sense. Used in its narrower sense, it is concerned with finding out the break even point i.e., the level of activity where total cost equals total selling price. In other words, break even point is the level of sales volume at which there is neither profit nor loss. Considered, therefore in its literal sense, the term break even analysis seems to be misleading. It implies that the only concern of management is that level of activity at which no profit is made and no loss is suffered. Accordingly, the term-is considered by some as a misnomer. However, some feel that the term break even analysis is appropriate upto the point at which costs become equal to the revenue and beyond this point it is the study of the cost volume profit relationship. In its broader sense, break even analysis means the system of analysis which determines the probable profit at any level of activity.
Presentation of break even analysis
Usually, 'break even analysis' is presented graphically as this method of visual presentation is particularly well suited to the needs of business owing to the manager being able to appraise the situation at a glance. A visual representation of the relationship between costs volume and profit is known as the break even chart. Such a chart not only depicts the level of activity where there will be neither loss nor profit but also shows the profit or loss at various levels of activity. According to the Chartered Institute of Management Accountants. London, the break even chart means "a chart which shows profit or loss at various levels of activity, the level at which neither profit nor loss is shown being termed the break even point". This may also take the form of a chart on which is plotted the relationship either of total cost of sales to sales or of fixed costs to contribution. Thus it is a graphical presentation of cost and revenue data so as to show their inter relationship at different levels of activity.
Break even charts are frequently used and needed where a business is new or where it is experiencing trade difficulties. In these cases the chart assists the management in considering the advantages and disadvantages of marginal sales. However in a highly profitable enterprise, there is little need of Weak even charts except when studying the implications of a major expansion scheme involving a heavy increase in fixed charges.
There are three methods of drawing a break even chart. These have been explained with the help of the following Illustration:
Illustration
Calculate the Break Even Point and Profit If output is 50,000 units by drawing a break even chart.
Production
(units) Fixed Expenses Variable cost per unit Selling price per unit Total
cost Total sales
Rs. Rs. Rs. Rs. Rs.
0 1,50,000 10 15 1,50,000 —
10,000 1,50,000 10 15 2,50,000 1,50,000
20,000 1,50,000 10 15 3,50,000 3,00,000
30,000 1,50,000 10 15 4,50,000 4,50,000
40,000 1,50,000 10 15 5,50,000 6,00,000
50,000 1,50,000 10 15 6,50,000 7,50,000
60.000 1,50,000 10 15 7,50,000 9,00,000
Solution
First Method
On the X axis of the graph is plotted the number of units produced, sold and on the Y axis are shown costs and sales revenues.
The fixed cost line is drawn parallel to X axis. This line indicates that fixed expenses remain the same with any volume of production. The variable costs for different levels of activity are plotted over the fixed cost line at zero volume of production. This line can also be regarded as the total cost line because it starts from the point where fixed cost has been incurred and variable cost is zero. Sales values at various levels of output are plotted joined and the resultant line is the sales line. The sales line will cut the .total cost line at a point where the total costs are equal to the total revenues and this point of Intersection of two lines is known as break even point - the point of no profit no loss. The number of units to be produced at the break even point is determined by drawing a perpendicular line to the X axis from the point of intersection and measuring the horizontal distance from the zero point to the point at which the perpendicular line is drawn- The sales value at the break even point is determined by drawing a perpendicular line to the Y axis from the point of intersection and measuring the vertical distance from the zero point to the point at which the perpendicular line is drawn. Loss and profit are as have been shown in the chart which show that lf production is less than the break even point, the business shall be running at a loss and If the production is more than the break even level, profit shall result.
Second Method
Another method of drawing a break even chart is showing the variable cost line first and thereafter drawing the fixed cost line above the variable cost line. The latter line is the total cost line because it is drawn over the variable cost line and represents the total cost (variable and fixed) at various levels of output. The difference under this method from the first method is that the fixed cost line shown above the variable cost line shall be parallel to the latter whereas under the first method, the fixed cost line is parallel to the X axis. The sales line is drawn as usual and therefore the added advantage, of this method is that 'Contributions' at varying levels of output are automatically depicted in the chart. The break even point is indicated by the Intersection of the total cost line and the sales line. The break even chart on the basis of the data given in the illustration will appear as given below according to this method.
Third method
Under this method, fixed cost line is drawn parallel to the X axis. The contribution line is drawn from the origin and this line goes up with increase in output. The sales line is plotted as usual. The question of interaction of sales line with cost line does not arise because the total cost line is not drawn in this method. In this method, break even point is that point where the contribution line cuts the fixed cost line. At this point, contribution is equal to fixed expenses-and there is no profit or loss. If the contribution is more than the fixed expenses, profit shall
Arise and if the contribution is less than the fixed expenses, loss shall arise. The graphical presentation of the given data according to this method is given in the previous page.
Cash Break-Even Chart
Though break even charts are generally based on profit and loss data and are used to estimate earnings most likely to result from a given scale of operations, such charts can also be made to yield information regarding the effect of changes in the scale of operations upon the cash situations of a business. However this requires a slight rearrangement and a few adjustments in the basic approach to the graphical representation of break even analysis.
Following points have to be kept on view in connection with the construction of cash break even charts:
i. Fixed expenses are to be divided into those that Involve cash payments and those that do not involve cash payments, like depreciation.
ii. In view of the fact that cash break even chart is designed to show actual payments, and not expenses incurred, any lag in the payment of the items of variable cost must be taken into account.
iii. Consideration has also to be given to the period of credit allowed to debtors for arriving at cash to be received from them.
Illustration
From the following data, plot a Cash Break Even Chart.
Output and sales 1000 units
Selling price per unit Rs. 15
Fixed costs Rs. 5,000
(Including depreciation Rs. 1000)
Variable cost per unit Rs.5
Assume there is no lag in payments.
Solution
Output
(units) Variable Costs Rs. Cash Fixed
costs
Rs. Total Cash costs
Rs. Sales
Rs.
200 1000 4000 5000 3000
400 2000 4000 6000 6000
600 3000 4000 7000 9000
800 4000 4000 8000 12000
1000 5000 4000 9000 15000
The cash break even point chart is given below.
Angle of Incidence
This is the angle formed at the break even point at which the sales line cuts the cost line. This angle indicates rate at which profits are being made. Large angle of incidence is an indication that profits are being made at a high rate. On the other hand, a small angle indicates a low rate of profit and suggests that variable costs form a major part of cost of production. A large angle of incidence with a high margin of safety indicates the most favourable position of a business and even the existence of monopoly conditions.
Margin of safety represents the amount by which the actual volume of sales exceeds those at the break even point. It is important that there should be a reasonable margin of safety; otherwise a reduced level of activity may prove disastrous. A low margin usually indicates high fixed costs so that profits are not made until there is high level of activity to absorb fixed costs.
Profit Volume Graph
The profit volume analysis graph discloses the relationship of profit to volume. The P/V graph is also referred to as P/V chart. The utility of P/V graph is that it depicts the direct relationship between sales volume and quantum of profit at different levels of activity. It is drawn on the basis of information as is required for the construction of break even chart.
The following steps are required to be adhered for the construction of P/V graph:
1. Profit and the fixed costs are represented on the vertical axis (Y) with appropriate scale. Total fixed costs are represented below the scale line on the left hand side of the vertical axis and the profits are shown on the right hand side above the sales line.
2. Sales are represented on the horizontal line (X) with appropriate scale. More precisely, the horizontal line itself forms the sales line. This line is drawn in the middle of the graph so as to represent losses below this line and the profits above this line.
3. Points are plotted on the P/V graph for the required fixed costs and profits at two or three assumed sales levels. The points should be selected in such a manner that one point plotted must be below the sales line and the other must be above the sales line.
4. The origin of the curve (Profit line) would be a point of total fixed cost (treating the entire amount as loss) at zero sales level.
5. By drawing a line connecting the point of origin with two points already plotted (as per step 3), P/V graph is completed.
The P/V chart does not project the BEP alone. For it contains set of points whereby each point measures the amount of profit or loss in relation to sales volume.
Illustration
X Ltd. reports the following results for one year:
Rs.
Sales 2,00,000
Variable costs 1,20,000
Fixed costs 50,000
Net profits 30,000
Draw up a profit volume graph.
The P/V graph is given below.
Assumptions underlying CVP Analysis/Break-Even Charts
1. All costs can be separated into fixed and variable costs.
2. Fixed costs remain constant at every level and they do not Increase or decrease with change in output.
3. Variable costs fluctuate per unit of output. In other words. They vary in the same proportion in which the volume of output or sales varies.
4. Selling price will remain constant even though there may be competition or change in volume of production.
5. Cost and revenue depend only on volume and not on any other factor.
6. Production and sales figures are either identical or changes in the Inventory at the beginning and at the end of the accounting period are not significant.
7. There is only one product or in the case of many products, product mix will remain unchanged.
Advantages of Break Even Charts
1. Break even chart provides detailed and clearly understandable information to the management. Information provided by the break even chart can be understood by the management more easily than that contained in the profit and loss account and the cost estimates because it is the simple presentation, of cost, volume and profit structure of the company. It summarizes a great mass of detailed information in a graph in such a way that its significance may be grasped even with a cursory glance.
2. Profitability of different products can be known with the help of break even charts, besides the level of no profit/no loss. The problem of managerial decision regarding temporary or permanent shut down of business or continuation at a loss can be solved by break even analysis.
3. A break even chart is useful for studying the relationship of cost, volume and profit. The effect of changes in fixed and variable costs at different levels of production can be demonstrated by the graph more legibly. Effect of changes in selling price can also be grasped quickly by the management by having a look at the break even chart. Thus it is very much useful for quick managerial decisions.
4. A break even chart is a tool for cost control because it shows the relative importance of the fixed cost and the variable cost.
5. A break even chart is helpful for forecasting, long term planning, growth and stability.
6. The profit potentialities can be best judged from a study of the position of the break even point and the angle of incidence in the break even chart. The capacity can be utilized to the fullest extent possible and the economies of scale and capacity utilization can be effected. Comparative plant efficiencies can be studied through the break even chart.
Limitations
1. A break even chart is based on a number of assumptions which may not hold good. Fixed costs vary beyond a certain level of output. Variable costs do not vary proportionately if the law of diminishing or increasing returns is applicable in the business. Sales revenue does not vary proportionately with changes in volume of sales due to reduction in selling price as a result of competition or increased production.
2. Only a limited amount of information can be presented in a single break even chart. If we have to study the changes of fixed costs, variable costs and selling prices, a number of charts have to be drawn.
3. The effect of various product mixes on profits cannot be studied from a single break even chart.
4. A break even chart does not take into consideration capital employed which is a very important factor in taking managerial decisions. Therefore, managerial decisions on the basis of break even chart may not be reliable.
Algebraic Method
The algebraic method of making CVP/BEP analysis is by the use of simple formula developed on the basis of the fundamental marginal costing equation, Sales - Variable cost = Fixed cost + Profit or S - V = F + P. This is the basic formula which is used to find out any one of the factors when the other three are known.
Since contribution is the excess of sales revenue over marginal cost, the right hand side of the equation may be substituted by C. Accordingly, the equation becomes Sales - Variable Cost = Contribution or S-V=C.
At the break even point, profit is nil. Therefore
S-V=F+0
We can find out the sales volume required to break even by multiplying both sides of the equation by S. The equation will then be
S (S-V) = F x S
Since S - V = C the equation can also be written as
Since again fixed cost plus profit must be equal to contribution, the equation can be put as
The BEP can also be shown by the formula
If it is desired to find out the break even point in terms of units, the break even sales may be divided by the price per unit. Alternatively break even sales in terms of units can be found out by the formula,
Illustration
From the following particulars, calculate the level of sales to break even:
Units sold 5000
Selling price Rs.2 per unit
Variable cost Rs. 1.50 per unit
Fixed cost Rs.2000
Solution
Sales revenue for 4000 units at Rs.2 per unit Rs.8000
Less: Variable cost at Rs. 1.50 per unit Rs.6000
Contribution 2000
Fixed cost 2000
Profit/Loss NIL
5. REVISION POINTS
BEP
P/V ratio
Margin of safety
Angle of incidence
6. INTEXT QUESTIONS
1. What is meant by break even analysis? Explain the important assumptions and practical significance of break even analysis.
2. Draw a break even chart with imaginary figures.
3. "Cost-Volume-Profit' relationship provides the management with a simplified framework for an organisation which is thinking on a number of its problems" - Discuss.
4. Discuss the Importance of the following in relation to marginal costing.
i) Break even point
ii) Margin of Safety
iii) Contribution
iv) Profit Volume Ratio
5. "The effect of a price reduction is always to reduce the P/V ratio and to raise the break even point". Explain and illustrate this by a numerical example.
7. SUMMARY
The break-even point and break-even chart are two by-products of break even analysis. It is also known as cost volume profit analysis. The analysis is a tool of financial analysis whereby the impact on profit of the changes in volume, price, cost and mix can be estimated with reasonable accuracy. Profits determining the financial position liquidity and solvency of company. They serve as a yard stick for judging the competence and efficiency of the Management. The profit planning is a fundamental part of management function and is a vital part of the total budgeting process.
8. Keywords
BEP It is equilibrium point or balancing point of no-profit (or) no - loss.
P/V ratio It expresses the relationship of contribution to sales
Margin of safety Excess of normal (or) actual sales over sales at BEP
Angle of incidence The angle to the right of BEP, is formed by intersecting the sales line and the total cost line
LESSON –14
BUDGETARY CONTROL
1. Introduction
Like marginal coating, which is a technique of managerial decision making, budgetary control is also a technique of the managerial functions of planning and control.
Though all managers plan, there are considerable differences in the way in which they plan - some managers may do their planning entirely in their heads, others may make notes and rough estimates on the back of old envelopes and yet others may express their plans in quantitative terms and reduce them to black and white in some orderly and systematic manner. It is this latter group which, drawing its inspiration from the principles of modem scientific management came to the conclusion that methods of fixing performance standard in advance need not necessarily be restricted to a limited number of departments but could be applied as well to the entire field of activity of the enterprise.
These standards, embracing all activities of the organization, together form a 'plan of campaign' or 'budget' giving the directions and indications for future management and providing, at the same time, the standards by which the actual results can be measured. Budgetary control has been inducted into the system as a means aimed at the comparison of the actual outcome with budgeted figures and the analysis of deviations.
2. OBJECTIVES
• To introduce the budgetary control and to explain the terms budget, budgeting and budgetary control.
• To explain the basic aspects of Budgetary Control
• To discuss the Objectives, Merits or Advantages and Demerits or Limitations of Budgetary Control
• To explain the Importance and Preparational aspects of different kinds of Budgets.
3. CONTENT
Concept of Budget and Budgetary control
Nature of Budgets and Budgetary control
Objective of Budgetary control
Budgetary control as a management tool
Limitations
Organisation for Budgetary control
Essentials of Effective Budgeting
Concept of Budgets and Budgetary Control
A budget is a detailed plan of operations for some specific future period. It is an estimate prepared in advance of the period to which it applies. It acts as a business barometer as it is a complete programme of activities of the business for the period covered. According to Gordon and Shilling law budget may be defined as "pre determined detailed plan of action developed and distributed as a guide to current operations and as a partial basis for the subsequent evaluation of performance". A Budget has been defined by ICMA London as "a financial and/or quantitative statement, prepared and approved prior to a defined period of time of the policy to be pursued during that period for the purpose of attaining a given objective. It may include Income, expenditure and the employment of capital".
According to the above definitions, essentials of a budget are:
1. It is a statement defining objectives to be attained in a future period and the course to be followed to achieve them.
2. It may express its targets either in rupees or in physical units or both. For example, a budget may provide for a sale of Rs. 1.00,000 (i.e., monetary units) or for a sale of 10.000 units (i.e., physical units) or for a sale of 10,000 units of Rs. 1, 00,000 (i.e., both).
3. It is prepared for a definite period well in advance.
Different types of budgets are prepared by an industrial concern for different purposes. A Sales Budget is prepared for the purpose of forecasting sales for a future period. A Manufacturing Cost Budget is prepared for forecasting the manufacturing costs. The Master Budget embodies forecasts for the sales and other expenses, for cash and capital requirements besides forecasting the figure of profit or loss.
The budget system is both a 'plan* as well as a 'control' and therefore, it also includes within Its broad scope 'budgetary control' which has been defined by the International Management Institute's Conference on Budgetary Control held at Geneva in 1930 as "an exact and rigorous analysis of the past and the probable and desired future experience with a view to substituting considered intention for opportunism in management". According to J.A. Scott, "Budgetary Control is the system of management control and accounting in which all operations are forecasted and so far as possible planned ahead, and the actual results compared with the forecasted and planned ones".
The ICMA London defines Budgetary Control as -"The establishment of budgets relating the responsibilities of executives to the requirements of a policy, and the continuous comparison of actual with budgeted results, either to secure by individual action the objective of that policy or to provide a basis for its revision".
The above definition brings out the following features of budgetary control which may be considered to be the steps Involved in it.
1. Laying down the objectives to be achieved by the business;
2. Formulating the necessary plans to ensure that the desired objectives are achieved;
3. Translating the plans into budgets;
4. Relating the responsibilities of executives to the budgets or particular sections of the same;
5. Continuous comparison of actual results with the budget and the ascertainment of deviations;
6. Investigating into the deviations to establish the causes;
7. Presentation of information to management relating the variances to individual responsibility; and
8. Corrective action of the management to prevent recurrence of variances.
This broadly speaking, it can be said that budget is concerned with policy making while budgetary control results from the implementation of the policy. Rowland and W.H.Harr observe - "Budgets are the individual objectives of a department whereas Budgeting may be said to be the act of building budgets. Budgetary Control embraces all this and in addition includes the science of planning the budgets themselves and the utilization of such budgets to effect an overall management tool for the business planning and control." Accordingly the preparation of a budget is a planning function and the administration of the budget is a controlling function. Budgetary Control starts with budgeting and ends with control.
Depaula has given the following beautiful analogy to explain the main idea behind the budgetary control: "The position may be likened to the navigation of a ship across the seas. The log is kept written regarding the happenings and the position of the ship from hour to hour and valuable lessons are to be learnt by the captain from a study of the factors which caused the mis-adventure in the past. But to navigate the ship safely over the seven seas the captain requires his navigating officer to work out the course ahead and constantly to check his ship's position against the pre-determined one. If the ship is off its course, the navigating officer must report it immediately so that the captain may take prompt action to regain his course. Exactly so it is with the Industrial ship, the past records represent the log and the auditor is responsible for verifying so far as he can, that those records are correct and reveal a true and fair view of the financial position of the concern. But what modern management requires for day to day operating purposes is forecasts showing in detail the anticipated course of business for (Say) the coming year. During the course of years, the management requires immediate reports of material variance from the predetermined course to the other with explanation of reasons for variations".
It should be noted that a budget or a system of budgetary control is not something rigid or like a strait jacket. There is enough flexibility to provide initiative and drive and also caution against undue recklessness. It is, as a matter of fact, one of the systems through which dynamism is introduced into the organisation.
Nature of Budgets and Budgetary Control
A business budget is a plan covering all phases of operations for a definite period in future. It is a formal expression of policies, plans, objectives and goals laid down in advance by top management for the undertaking as a whole and for every subdivision thereof. Hence there is an overall budget for the unit composed of numerous sub budgets in the form of departmental and divisional budgets which, in turn are generally broken down to still smaller subdivisions consistent with organizational subdivisions. The budget expresses revenue goals in the sales budgets and expense limitations in the expense budgets that must be attained in order to realise the desired net income objective. Moreover budget expresses plans relative to such items as inventory levels, capital additions, cash requirements, financing, production plans, purchasing plans, labour requirements etc.
Budgetary control is achieved through the carrying out of the operational plan which is the budget. It is not the mere matching of estimated expenses with probable income; it also includes the checking up the forecast figures by comparing actual results with them and placing the responsibility for failure to achieve the budget figures. The periodic checking up of incomes, costs and expenses constitutes the administration of the budget which results in budgetary control.
While originally the budget constituted a financial document, it is now concerned with devising a coordinated programme of operation, providing an effective means of communication among managerial personnel for the purpose of, evaluating proposed plans of action, directing the diverse activities towards the accomplishment of predetermined goals and obtaining all requisite approvals. Thus there is an increasing trend towards extending the frontiers of business budgets to include planning. Coordinating and controlling of the entire operations of a business. This has transformed budgets and budgetary control into a valuable tool of purposeful management.
Budgets encourage cogent thinking and help in the avoidance of vague generalizations as all executives concerned have to quantity plans to examine their feasibility in terms of profit potential. They place the problem of profit in proper perspective by emphasizing that the only means of safeguarding the desired margin of profit lies in adapting costs to proceeds which are beyond the control of an enterprise. Then, by maintaining the various activities of a concern in proper relation to one another, business budgets bring a sense of balance and direction in the affairs of an undertaking. Budget is also a psychological device that obtains results. It makes those responsible for the Implementation of the budget proposals 'ever conscious of its existence with the consequence that, though no monetary reward is offered to them, there is stronger probability of their achieving the budget goals than in the absence of predetermined targets. To that extent, budget acts as an impersonal policeman that maintains ordered efforts and brings about efficiency in results.
Objectives of Budgetary Control
Budgetary Control is planned to assist the management in the allocation of responsibilities and authority to aid in making estimates and plans for future, to assist in analysis of variations between estimated and actual results and to develop the basis of measurement or standards with which to evaluate the efficiency of operations. The general objectives of budgetary control are as follows:
1. Planning: A budget is a plan of the policy to be pursued during the defined period of time to attain a given objective. The budgetary control will force management at all levels to plan in time all the activities to be done during the future periods. A budget as a plan of action achieves the following purposes:
a. Action is guided by well thought out plan because a budget is prepared after a careful study and search.
b. The budget serves as a mechanism through which management's objectives and policies are effected.
c. It is a bridge through which communication is established between the top management and the operatives who are to implement the policies of the top management.
d. The most profitable course of action is selected from the various available alternatives.
e. A budget is a complete formulation of the policy of the undertaking to be pursued for the purpose of attaining a given objective.
2. Coordination: Coordination "is the orderly arrangement of group effort to provide unity of action in the pursuit of a common purpose". In other words, it means develop and maintaining various activities within the concern in proper relationship with one another.
Coordination of the various activities is also achieved by operating the technique of budgetary control. This is clear from the fact that the budgets are not prepared by the line and functional managers in isolation. A budget is prepared for the business as a whole. The sales manager, for instance, has to base his budget on the volume of production; the production manager is capable of producing. Similarly the cash manager must take into account the amount and the timing of the revenues to be received from sales. Thus the various departmental budgets are interdependent, and when they are integrated into the master budget, the targets set are capable of achievement only when there is cooperation between the executives. In other words, budgetary control forces the executives think and think as a group.
3. Control: Planning is not the means of control. It generates the need for control. In fact nothing can be achieved by just laying down the objectives and hoping that the desired objectives will be accomplished. It is therefore necessary to provide a mechanism whereby control can be exercised over the activities of the business. This is especially so in the case of a large concern where It is difficult for the chief executive to supervise personally the day to day operations.
Budgetary control makes control possible by continuous comparison of actual performance with that of the budget so as to report the variations from the budget to the management for corrective action. Thus budgeting system integrates key managerial functions as it links top management's planning function with the control function performed at all levels in the managerial hierarchy. The need to keep a strict control over costs is thus impressed upon every manager. Budgetary control makes every manager becomes cost conscious. Since he is continually supplied with information which tells him whether he is accomplishing his target, there is the opportunity to take corrective action before it is too late. Hence proper control can be exercised over expenditure.
Budgetary Control as a Management Tool
Budgetary Control has become an essential tool of management for controlling costs and maximizing profits. It may be conceived as one of the supreme examples of rationality in management. It is a useful management tool for comparing the current performance with pre planned performance with a view to attain equilibrium between ends and means, output and effort. It corrects the deviations from preplanned path through the media of observation, research planning, control and decision making and thus helps in the performance of future activities in an orderly way. It uncovers uneconomies in operations, weaknesses in the organisation structure and minimizes wasteful spending. It acts as a friend, philosopher and guide to the management. Its advantages to management can be summarised as follows:
1. The establishment of divisional and departmental responsibilities involved in budgeting prevents buck-passing when the budget figures are not achieved.
2. It coordinates the various divisions of a business namely the production, marketing, financial and administrative decisions; this facilitates smoother operation and less internal friction which results in the achievement of a budget goal.
3. It forces management to give timely and adequate attention to the effect of expected trend of general business conditions and it stabilizes conditions in industries which are subject to seasonal and cyclical fluctuations.
4. The centralization of budgetary control over all divisions and departments helps in carrying out a uniform policy without the disadvantage of an authoritarian type of business organisations.
5. The use of budget figures as measures of operating performance and financial position makes possible the adoption of the standard costing principles in divisions other than the production division.
6. It facilitates management by exception and the timely correction of significant deviations from the targets set.
7. Advance planning Inherent in the budgets is looked upon with favour by credit agencies as indicative of sound management.
8. Being a means of communication, it enables lower levels of management to understand the basic objectives and policies of the concern.
9. In the presence of an effective budgetary control system, the purchase of stores is based upon predetermined requirements for raw materials and this helps to prevent stock shortages as well as excessive purchases. Work in process inventories are kept to a minimum because of predetermined production requirements. Finished goods inventories are maintained at a level necessary to meet the predetermined schedule of sales. Thus it ensures the availability of sufficient working capital and diverts capital expenditure into the most profitable channels.
10. Budgeting guards against undue optimism leading to over expansion because the targets are fixed by the executives after careful and cool thought.
11. As goals are set up for being attained and achievements or failures are revealed only with reference to these goals, results can be viewed objectively with minimum of personal prejudice.
Limitations of Budgetary Control
1. The usefulness of budgeting depends upon the extent to which forecasts can be relied upon. Since forecasting-cannot be considered to be an exact science, the accuracy of the data on which the estimates are based determines the adequacy or otherwise of a budgetary programme. If forecasts are made on the basis of inadequate and inaccurate data, the budgeted figures would be far removed from reality and the targets set would also be inaccurate.
2. As budgets are prepared by quantifying all relevant data, there is tendency to attach some sort of finality to budget figures but, as they are meant to deal with business conditions which are constantly changing, they would lose much of their usefulness if they acquire rigidity. Therefore it is essential that budgetary programme must be continuously adapted to changing conditions in and off a business unit.
3. Budgetary Control implies 'the preparation of budgets and their administration also. -As such mere preparation of budgets does not mean that their execution is automatic. Since budgets are related to the executives concerned, their implementation demands a unified effort of all the personnel in the organisation. In other words, budgetary control demands active cooperation between the different levels of management. But there will be active and passive resistance to budgetary control as it points to the efficiency or inefficiency of individuals. The opposition is also due to the human nature I.e., the tendency to resist change. Chris Agris, has in his study of "Human Problems with Budget" has pointed out the following reasons for a high degree of negative reaction against budgeting on the part of front line managers.
a. Budgets are evaluation instruments. They tend to set goals against which the people are measured and hence they naturally are complained about.
b. Some of the supervisors tend to use budgets as "whipping posts" in order to release their feelings about many (often totally unrelated) problems.
c. Budgets are thought of as pressure devices. As such they produce the same kind of unfavourable reactions as do other kinds of pressure, regardless of origin.
4. Budget is only a management tool. It cannot substitute management. In other words, a budget is not designed to reduce the managerial function to a formula; it is a managerial tool.
5. Budgeting necessitates the employment of specialised staff and this involves expenditure which small concerns may not attend. Even In the case of big concerns the usefulness of budgetary control should be viewed from the point of view of cost. Hence it is essential that there must be some correlation between the cost of the system and the benefits obtained from it.
Inspite of these limitations, it can be safely said the technique of budgetary control is a must for each business enterprise. It leaves sufficient time for the top management for formulation of overall policy and planning. Much success can be achieved if the top management devotes attention chiefly to unusual or exceptional items that appear in daily, weekly and monthly statements. and reports. In the words of J.R. Batliboi "The success of budgetary control must depend on the adequacy and reliability of records, the'- past and the present performances, on the Interest of all executives and subordinates in the purposes of such control, proper departmentalization and subdivision of, factory activities, a close classification and proper division and analysis of the expenditure and the most suitable system of cost and' financial accounts."
Functional Classification and Preparation of Budgets
Organisation for Budgetary Control
The preparation and implementation of budgets demand a sound and efficient organisation. The creation of a formal organisation is thus necessary for the installation of a budgetary control system. An effective organisation for the system of budgetary control is laid out on the following lines:
(1) Installation of budget centres
A budget centre is located with in the four comers of the organization of an enterprise and is denned as a "Section of the organisation of an undertaking defined for the purposes of budgetary control". Since preparation of budgets and their implementation are both entrusted to the same person, it is necessary to establish budget centers so that a budget may be prepared for each centre by the concerned head. To illustrate, production manager has to be consulted for the preparation of production budget and finance manager for cash budget. Under mechanized accounting system budget centres are also numbered.
(2) Preparation of Organisation Chart
There should be an organization chart for effective budgetary control. It highlights the functional responsibilities of each member of the management and thereby making It possible for him to know his position in the organisation hierarchy as also his relationship to other members. A specimen of the organisation chart is given below:
The above chart shows that the Chief Executive is the head of the budgetary control system. He delegates his authority to the Budget Officer who sees that all budgets are coordinated and drawn in time. The other managers will prepare the budgets shown against them in the chart. Thus budgetary control is a concerted action in which all individuals take part and there must be coordination in order to have proper link among them. When there is a clear cut division of responsibility and authority, no overlapping will be there. It will create team work and a spirit of cooperation among the staff, ultimately leading to high degree of budget consciousness.
(3) Establishment of budget committees
The responsibility for budgeting and implementation is laid down on
(i) Budget Committee and (ii) Budget Officer
Budget Committee is a permanent standing committee consisting of General Manager as the Chairman and other departmental executives. Budget officer will be the secretary of this committee. The functions of the budget committee are:
a) To assist departmental managers in the work of forecasting by supplying past information.
b) To receive instructions concerning the general policy to be followed.
c) To receive and review Individual budget estimates relating to different functions.
d) To suggest budget revisions
e) To approve the revised budgets
f) To receive from time to time budget reports comparing actual results with the budgets
g) To locate responsibilities and recommend corrective action where necessary.
The head of a formal budgetary control organisation is known as the Budget Officer, sometimes designated as Budget Director or Budget Controller. He derives authority from the Chief Executive and is directly responsible to him for the functions assigned to him. It is the duty of the Budget Officer to coordinate the work connected with the budget.
His chief duties are:
a) To advise the Chief executive, departmental managers and budget committee on budgetary matters.
b) To assume responsibility of budgeting and budgeting organisation.
c) To recommend techniques and procedures of budgeting, provide schedules, forms and statements of reports and also the necessary statistical data.
d) To assist in the preparation, revision of budgets and budget manual.
e) To ensure proper system of communication at all levels of management, and
f) To supervise execution of budgets, analyse variances in performance and suggest suitable actions.
(4) Budget Period
It is a period for which a budget is prepared and employed. Since planning, and therefore budgeting must be related to a specific period of time. It Is necessary at the outset, to specify the length of the period for which the budget is prepared and used.
The factors governing the length of the budget period are:
a) Nature of the demand for the product.
b) Length of the trade cycle.
c) The production cycle.
d) Functional area covered by the budget.
e) Need for control of operations.
f) Time interval necessary for financing production well in advance of actual needs.
g) The accounting period.
For example in case of seasonal industries (i.e., food or clothing) the budget period should be a short one and should cover one season. But in case of industries with heavy capital expenditure like heavy engineering works, the budget period should be long enough to meet the requirements of the business. From control point of view. the budget period should be a short one so that the actual results may be compared with the budget each week end or month end and discussed with the Budget Committees. Long term Budgets should be supplemented by short term budgets to make the budgetary control successful, as short term budgets will help in exercising control over day to day operations. In short the budget period should not be top long so that the estimates may not become unreliable. Similarly it should also not be toe short so that there may be sufficient time before budget implementation. For most businesses, annual budget is quite common because it compares with the financial accounting year.
There should be a regular time plan for budget preparation. It may be on the following lines:
I. Long term budgets for three to five years should be prepared for expansion and modernization of the undertaking, introduction of new products or new projects and undertaking heavy advertisement.
II. Annual budgets coinciding with financial accounting year should be prepared for operational activities viz., sales, purchase, etc.
III. For control purposes, short term budgets - monthly or even weekly budget - should be prepared for watching progress of actual performance against targets. Short-term budgets are prepared to see that actual performance is proceeding according to the budgets and early corrective action may be taken if there is any pitfall.
(5) Determination of the Key Factor
The sequence of preparation of budgets is determined by the Key Factor or the Principal Budget Factor. The ICMA London defines it as "The factor, the extent of whose influence must first be assessed in order to ensure that the functional budgets are reasonably capable of fulfillment". Key Factor represents some powerful influence which so dominates business operation as to represent obstacles in the achievement of the ambitions contained in the functional budgets. Therefore, it. becomes necessary to assess its impact right in the beginning of the budgetary process.
Also called 'limiting' or 'governing' factor, the key factor serves as the starting point for the preparation of the budget. After the determination of the Key Factor, the relevant budget is first prepared and integrated with other budgets after being reconciled. It is possible that there may be two or more limiting factors at the same time. Under such conditions, the budget preparation has to reckon the relative impact of these factors which is done with the help of graphs, linear programming, operations, research etc.
For example, a concern has the capacity to produce 50,000 units of a particular item per year. But only 30,000 units can be sold in the market. In this case, low demand for the product is the limiting factor. Therefore, sales budget should be prepared first and other functional budgets such as production budget, labour budget etc., should be prepared in accordance with the sales budget. Suppose another concern has no sales problem and sell whatever it can produce. In this case, plant capacity is limited. Therefore, production budget should be prepared first and other budgets should follow the production budget.
Following are the key factors which can possibly affect budgeting:
i. Materials
a) Shortage due to non availability.
b) Shortage due to restrictions imposed by licenses, quotas etc.
ii. Labour
(a) General shortage.
(b) Shortage of certain grades of labour.
iii. Plant
Insufficiency due to
(a) Shortage of supply.
(b) Lack of capital.
(c) Lack of space,
(d) Bottlenecks in certain key processes.
iv. Sales
(a) Consumer demand.
(b) Insufficient advertising.
(c) Shortage of good salesmen.
v. Management
(a) Overall paucity of capital.
(b) Limited availability of expertise - technical and managerial.
(c) Flogging research effort in respect of methods of production, production design, etc.
The Key factors should be correctly defined and diagnosed. Budgets will be meaningless unless key factors are considered in depth. However the key factors are not of a permanent nature and they can be overcome by the management in the long run if an effort is made in this direction by selecting optimum level of production, dealing in more profitable products, introducing new methods, changing material mix, working over time or extra shifts, providing incentives to workers, hiring new machinery etc.
(6) Budget Manual
As the budgetary system gets into stride, it becomes essential to systematize the procedure for the preparation of various budgets. Generally the practice is to arrange this by means of a budget manual which has been described by ICMA, London, as a "document which sets out the responsibilities of persons engaged in, the routine of and the forms and records required for, budgetary control".
Thus a budget manual specifies in detail the procedures to be followed, the forms to be used and the responsibilities of those who take part in the budgeting process. The manual formalizes budget procedure and avoids misunderstanding. Following are some of the important matters covered In a budget manual:
i. A statement regarding the objectives of the organisation and how they can be achieved through budgetary control.
ii. A statement regarding the functions and responsibilities of each executive by designation both regarding preparation and execution of budgets.
iii. Procedures to be followed for obtaining the necessary approval of budgets. The authority of granting approval should be stated in explicit terms.
iv. Time tables for all stages of budgeting.
v. Reports, statements, forms and other documents to be maintained.
vi. Accounts code in use. It is necessary that the framework within which the costs, revenues and other financial amounts are classified must be identical both in the account and the budget departments.
(7) Preparation of Budgets
The top management should define the objectives and policies in clear terms. The goals set should be realistic and attainable. Then the budget estimates are prepared by the executives in charge of different functions. The budget programme should be comprehensive, covering all activities of the undertaking.
General sales budget is made by the Sales Manager. If there is any other key factor, the budget estimate of such factor may be prepared first. Budget Committee discusses these estimates and gives tentative approval. There upon, other executives submit their estimates relating to production, plant utilization, material, labour expenses etc... Cash budget is prepared on the basis of sales and production cost and other budgets. These are discussed in Budget Committee and with modifications, as necessary, budgets are drawn up. All budgets are incorporated into a 'Master Budget' which will be approved by the top management and put into action. All budgets may be revised from time to time taking into account the current developments.
Essentials for Effective Budgeting
(a) Support of top management
Though a budget programme, in order to be successful, must have the whole hearted support of every member of management, the impetus and direction must come from the top. This requires commitment of top management to the budget idea as well as to the principles, policies and philosophy underlying it.
(b) A clearly defined organisation
There should be a sound plan of organisation with responsibilities denned. The records should be clearly departmentalized and established in such a manner as will indicate definite responsibility on each unit or section of the business. Certain responsible officers must be given the power to carry out the arranged policies, to administer the budgets and to exercise control over the results by authorizing them to take up corrective measure wherever necessary.
(c) Motivational approach
People resist pressure and therefore budgeting should not be a pressure device. Motivational approach towards budgeting should be adopted.
(d) Preparation by responsible executives
Every executive responsible for the implementation of budgets should be given an opportunity to take an active part in the preparation of budgets. In other words subject to the control of the Budget Direct of and the Budget Committee, those who are responsible for performance should be made responsible for the preparation of budgets.
(e) A clearly defined policy
It is imperative for the management to define, in clear and unambiguous terms, its policies and instructions relating to production, price and profit, personnel, advertisement and sales promotion, capital expenditure projects etc. The policies constitute the foundation upon which the budgets are framed.
(f) Accurate accounting system
The system of accounting in the business should be such as to hold each part of the organisation to its responsibilities. The budget fosters coordinated action and wherever this is broken or interfered with, the responsible factor should be unmistakably revealed. The accounting system should make it possible to establish such responsibility beyond doubt.
(g) Logical Sequence in the Budget preparation
It is essential that proper procedure should be evolved for the preparation, submission, examination and review of budget figures in logical sequence. Budget preparation often demands much careful thought and attention on the part of the entire staff of the business unit engaged in the compilation of various figures.
(h) Flexibility
Budgetary programme should be designed to accommodate unforeseen circumstances as well as possible changes in future. The question of flexibility is tackled through 'Flexible Budgets'.
(i) Budget Education
It is equally important that every one in the organisation should know the working of the budget programme and its benefits. 'Budget Manual' is a very useful guide in imparting budget education. If budget education is neglected, the possible result would be "compiling figures or the sake of compiling and framing policies for the sake of policies."
(j) Human factor
The management should not forget that they are dealing with human beings who have since ancient times resented and rebelled against domination, whether in the form of complete slavery or economic and political coercion. The management should therefore prefer 'control through objectives' to 'control through domination'. In other words control should not be influenced by the personality of the superior or subordinate. It should be definite and determinable and verifiable.
Moreover, the control should come from within instead, of being imposed from outside.
(k) Good reporting system
Budget cannot be successful unless there is a proper feed back system. The reporting system should be so devised that it not only tells about major variations but also the persons who are responsible for these variations. For this purpose, periodical statements comparing the actual performance with the budgeted performance should be prepared. The cause of variances should be analyzed and the management should be kept informed about major variances working on the principle of management by exception. Proper remedial measures should* be taken by the management at appropriate level and at appropriate time.
4. Revision Points
Budget
Budgeting
Budgetary Control
Budget Manual
Budget Period
Forecast
Master Budget
5. Intext Questions
1. What do you understand by 'Budgetary Control?' Explain its significance.
2. What are the factors Influencing the selection of a budget period between two firms carrying on diverse activities?
3. Explain the objectives of budgetary control.
4. "Budgetary control improves planning, aids in coordination, and helps in having comprehensive control" - Elucidate.
5. What is a budget manual? What are its contents?
6. Elaborate the main steps involved In budgetary control.
7. What is a principal budget factor? Give a list of such factors.
6. Summary
Planning has become the primary function of management these days. It relates to individual situations and individual proposals. However, this has to be supplemented and reinforced by overall periodic planning followed by continuous comparison of the actual performance with the planned performance. It is an essential tool for management for controlling cost and maximizing profits.
7. Terminal Exercise
1.Sales budget is a
a. functional budget
b. master budget
c. expenditure budget
2. The difference between fixed and variable cost has a special significance in the preparation of
a. flexible budget
b. master budget
c. Cash budget
3. The budget that is prepared first of all is
a. Cash budget
b. Master Budget
c. Budget for the key factor
8. Assignment
Z Ltd had a profit plan approved for selling 5,000 units per month at an average price of Rs.10 per unit. The budgeted variable cost of production was Rs.4 per unit and the fixed costs were budgeted at Rs. 20,000, the planned income being Rs.10,000 per month. Due to shortage of raw materials, only 4,000 units could be produced and the cost of production increased by 50 paise per unit. The selling price was raised by Re.1.00 per unit. In order to improve the production process, an expenditure of Rs.1,000 was incurred for research and development activities.
You are required to prepare a Performance Budget and a a Summary Report.
9. Keywords
Budget: Plan that details expected future income and outgoings, normally over a time span of a year. It is also the sum of money set aside for a given activity (or) Project
Budgetary control: It is the system of Management control and accounting in which all operations are forecasted and so far as possible planned ahead, and the actual results compared with the forecasted and planned ones.
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