MBA 1ST SEM ACCOUNTS SYLLABUS NOTES
Q 1. What do you mean by classification of accounts? Explain different types of accounts as used in books of original entry with their rules?
Accounting is a business language. We can use this language to communicate financial transactions and their results. Accounting is comprehensive systems to collect, analyzes, and communicate financial information.
The origin of accounting is as old as money. In early days, the number of transactions were very small, so every concerned person could keep the record of transactions during a specific period of time. Twenty-three centuries ago, an Indian scholar named Kautilya alias Chanakya introduced the accounting concepts in his book Arthashastra. In his book, he described the art of proper account keeping and methods of checking accounts. Gradually, the field of accounting has undergone remarkable changes in compliance with the changes happening in the business scenario of the world.
A book-keeper may record financial transactions according to certain accounting principles and standards and as prescribed by an accountant depending upon the size, nature, volume, and other constraints of a particular organization.
With the help of accounting process, we can determine the profit or loss of the business on a specific date. It also helps us analyze the past performance and plan the future courses of action.
Definition of Accounting
The American Institute of Certified Public Accountant has defined Financial Accounting as: “the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which in part at least of a financial character and interpreting the results thereof.”
Objectives and Scope of Accounting
Let us go through the main objectives of Accounting:
• To keep systematic records - Accounting is done to keep systematic record of financial transactions. The primary objective of accounting is to help us collect financial data and to record it systematically to derive correct and useful results of financial statements.
• To ascertain profitability - With the help of accounting, we can evaluate the profits and losses incurred during a specific accounting period. With the help of a Trading and Profit & Loss Account, we can easily determine the profit or loss of a firm.
• To ascertain the financial position of the business - A balance sheet or a statement of affairs indicates the financial position of a company as on a particular date. A properly drawn balance sheet gives us an indication of the class and value of assets, the nature and value of liability, and also the capital position of the firm. With the help of that, we can easily ascertain the soundness of any business entity.
• To assist in decision-making - To take decisions for the future, one requires accurate financial statements. One of the main objectives of accounting is to take right decisions at right time. Thus, accounting gives you the platform to plan for the future with the help of past records.
• To fulfill compliance of Law - Business entities such as companies, trusts, and societies are being run and governed according to different legislative acts. Similarly, different taxation laws (direct indirect tax) are also applicable to every business house. Everyone has to keep and maintain different types of accounts and records as prescribed by corresponding laws of the land. Accounting helps in running a business in compliance with the law.
It is necessary to know the classification of accounts and their treatment in double entry system of accounts. Broadly, the accounts are classified into three categories:
• Personal accounts
• Real accounts
o Tangible accounts
o Intangible accounts
Personal Accounts
Personal accounts may be further classified into three categories:
Natural Personal Account
An account related to any individual like David, George, Ram, or Shyam is called as a Natural Personal Account.
Artificial Personal Account
An account related to any artificial person like M/s ABC Ltd, M/s General Trading, M/s Reliance Industries, etc., is called as an Artificial Personal Account.
Representative Personal Account
Representative personal account represents a group of account. If there are a number of accounts of similar nature, it is better to group them like salary payable account, rent payable account, insurance prepaid account, interest receivable account, capital account and drawing account, etc.
Real Accounts
Every Business has some assets and every asset has an account. Thus, asset account is called a real account. There are two type of assets:
• Tangible assets are touchable assets such as plant, machinery, furniture, stock, cash, etc.
• Intangible assets are non-touchable assets such as goodwill, patent, copyrights, etc.
Accounting treatment for both type of assets is same.
Nominal Accounts
Since this account does not represent any tangible asset, it is called nominal or fictitious account. All kinds of expense account, loss account, gain account or income accounts come under the category of nominal account. For example, rent account, salary account, electricity expenses account, interest income account, etc.
Double Entry System
Double entry system of accounts is a scientific system of accounts followed all over the world without any dispute. It is an old system of accounting. It was developed by ‘Luco Pacioli’ of Italy in 1494. Under the double entry system of account, every entry has its dual aspects of debit and credit. It means, assets of the business always equal to liabilities of the business.
Assets = Liabilities
If we give something, we also get something in return and vice versa.
Rules of Debit and Credit under Double Entry System of Accounts
The following rules of debit and credit are called the golden rules of accounts:
Example
Mr A starts a business regarding which we have the following data:
Introduces Capital in cash Rs 50,000
Purchases (Cash) Rs 20,000
Purchases (Credit) from Mr B Rs 25,000
Freight charges paid in cash Rs 1,000
It is very clear from the above example how the rules of debit and credit work. It is also clear that every entry has its dual aspect. In any case, debit will always be equal to credit in double entry accounting system.
As already stated every transaction involves give and take aspect. In double entry accounting, every transaction affects and is recorded in at least two accounts. When recording each ransaction, the total amount debited must equal to the total amount credited. In accounting, the terms — debit and credit indicate whether the transactions are to be recorded on the left hand side or right hand side of the account. In its simplest form, an account looks like the letter T. Because of its shape, this simple form called a T-account . Notice that the T format has a left side and a right side for recording increases and decreases in the item. This helps in ascertaining the ultimate position of each item at the end of an accounting period. For example, if it is an account of a customer all goods sold shall appear on the left (debit) side of customer’s account and all payments received on the right side. The difference between the totals of the two sides called balance shall reflect the amount due to the customer. In a T account, the left side is called debit (often abbreviated as Dr.) and the right side is known as credit (often abbreviated as Cr.). To enter amount on the left side of an account is to debit the account. To enter amount on the right side is to credit the account. Rules of Debit and Credit All accounts are divided into five categories for the purposes of recording the transactions:
(a) Asset
(b) Liability
(c) Capital
(d) Expenses/Losses, and
(e) Revenues/Gains.
Two fundamental rules are followed to record the changes in these accounts:
(1) For recording changes in Assets/Expenses (Losses):
(i) “Increase in asset is debited, and decrease in asset is credited.”
(ii) “Increase in expenses/losses is debited, and decrease in expenses/losses is credited.”
(2) For recording changes in Liabilities and Capital/Revenues (Gains):
(i) “Increase in liabilities is credited and decrease in liabilities is debited.”
(ii) “Increase in capital is credited and decrease in capital is debited.”
(iii) “Increase in revenue/gain is credited and decrease in revenue/gain is debited.”
The rules applicable to the different kinds of accounts have been summarised in the following chart:
The transactions in Example will help you to learn how to apply these debit and credit rules. Observe the analysis given carefully to be sure that you understand before you go on to the next one.
To illustrate different kinds of events, three more transactions have been added
1. Rohit started business with cash Rs. 5,00,000
Analysis of Transaction : The transaction increases cash on one hand and increases capital on the other hand. Increases in assets are debited and increases in capital are credited. Therefore record the transaction with debit to Cash and credit to Rohit’s Capital.
2. Opened a bank account with an amount of Rs. 4,80,000
Analysis of Transaction: The transaction increases the cash at bank on one hand and decreases cash in hand on the other hand. Increases in assets are debited and a decreases in assets are credited. Therefore, record the transactions with debit to Bank account and credit to Cash account.
Q2 . What do you mean by posting? What are the rules of posting?
Accounting is a business language. We can use this language to communicate financial transactions and their results. Accounting is comprehensive systems to collect, analyzes, and communicate financial information.The origin of accounting is as old as money. In early days, the number of transactions were very small, so every concerned person could keep the record of transactions during a specific period of time. Twenty-three centuries ago, an Indian scholar named Kautilya alias Chanakya introduced the accounting concepts in his book Arthashastra. In his book, he described the art of proper account keeping and methods of checking accounts. Gradually, the field of accounting has undergone remarkable changes in compliance with the changes happening in the business scenario of the world.
Definition of Accounting
The American Institute of Certified Public Accountant has defined Financial Accounting as: “the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which in part at least of a financial character and interpreting the results thereof.”
This process of analysing transactions and recording their effects directly in the accounts is helpful as a learning exercise. However, real accounting systems do not record transactions directly in the accounts. The book in which the transaction is recorded for the first time is called journal or book of original entry. The source document, as discussed earlier, is required to record the transaction in the journal. This practice provides a complete record of each transaction in one place and links the debits and credits for each transaction. After the debits and credits for each transaction are entered in the journal, they are transferred to the individual accounts. The process of recording transactions in journal is called journalising. Once the journalizing process is completed, the journal entry provides a complete and useful description of the event’s effect on the organisation. The process of transferring journal entry to individual accounts is called posting. This sequence causes the journal to be called the Book of Original Entry and the ledger account as the Principal Book of entry.
The ledger is the principal book of accounting system. It contains different accounts where transactions relating to that account are recorded. A ledger is the collection of all the accounts, debited or credited, in the journal proper and various special journal A ledger may be in the form of bound register, or cards, or separate sheets may be maintained in a loose leaf binder.In the ledger, each account is opened preferably on separate page or card.
Utility
A ledger is very useful and is of utmost importance in the organisation. The net result of all transactions in respect of a particular account on a given date can be ascertained only from the ledger. For example, the management on a particular date wants to know the amount due from a certain customer or the amount the firm has to pay to a particular supplier, such information can be found only in the ledger. Such information is very difficult to ascertain from the journal because the transactions are recorded in the chronological order and defies classification. For easy posting and location, accounts are opened in the ledger in some definite order. For example, they may be opened in the same order as they appear in the profit and loss account and in balance sheet. In the beginning, an index is also provided. For easy identification, in big organisations, each account is also allotted a code number.
According to this format the columns will contain the information as given below:
An account is debited or credited according to the rules of debit and credit already explained in respect of each category of account.
Title of the account : The Name of the item is written at the top of the format as the title of the account. The title of the account ends with suffix ‘Account’.
Dr./Cr. : Dr. means Debit side of the account that is left side and Cr. Means Credit side of the account, i.e. right side.
Date : Year, Month and Date of transactions are posted in chronological order in this column.
Particulars : Name of the item with reference to the original book of entry is written on debit/credit side of the account.
Journal Folio : It records the page number of the original book of entry on which relevant transaction is recorded. This column is filled up at the time of posting.
Amount : This column records the amount in numerical figure, corresponding to what has been entered in the amount column of the original book of entry. We have seen earlier that all ledger accounts are put into five categories namely, assets, liabilities, capital, revenues/gains and expense losses. All these accounts may further be put into two groups, i.e. permanent accounts and temporary accounts. All permanent accounts are balanced and carried forward to the next accounting period. The temporary accounts are closed at the end of the accounting period by transferring them to the trading and profit and loss account. All permanent accounts appears in the balance sheet. Thus, all assets, liabilities and capital accounts are permanent accounts and all revenue and expense accounts are temporary accounts. This classification is also relevant for preparing the financial statements.
Posting from Journal
Posting is the process of transferring the entries from the books of original entry (journal) to the ledger. In other words, posting means grouping of all the transactions in respect to a particular account at one place for meaningful conclusion and to further the accounting process. Posting from the journal is done periodically, may be, weekly or fortnightly or monthly as per the requirements and convenience of the business. The complete process of posting from journal to ledger has been discussed below:
Step 1 : Locate in the ledger, the account to be debited as entered in the journal.
Step 2 : Enter the date of transaction in the date column on the debit side.
Step 3 : In the ‘Particulars’ column write the name of the account through which it has been debited in the journal. For example, furniture sold for cash Rs. 34,000. Now, in cash account on the debit side in the particulars column ‘Furniture’ will be entered signifying that cash is received from the sale of furniture. In Furniture account, in the ledger on the credit side is the particulars column, the word, cash will be recorded. The same procedure is followed in respect of all the entries recorded in the journal.
Step 4 : Enter the page number of the journal in the folio column and in the journal write the page number of the ledger on which a particular account appears.
Step 5 : Enter the relevant amount in the amount column on the debit side. It may be noted that the same procedure is followed for making the entry on the credit side of that account to be credited. An account is opened only once in the ledger and all entries relating to a particular account is posted on the debit or credit side, as the case may be.
Give some examples of Journal entry and ledger posting
Posting of the Single Column Cash Book
As evident , the left side of the cash book shows the receipts of the cash whereas the right side of the cash book shows all the payments made in cash. The accounts appearing on then debit side for the cash book are credited in the respective ledger accounts because cash has been received in respect of them. Thus, in our example, an entry ‘cash received from Gurmeet‘ appears on the debit side of the cash book conveys that the cash has been received from Gurmeet. Therefore, in the ledger, Gurmeet’s account will be credited by writing ‘Cash’ in the particulars column on the credit side. Similarly, all the account names appearing on the credit side of the cash book are debited as cash/cheque has been paid in respect of them.
Posting of the Double Column Cash Book
When the bank column is maintained in the cash book, the bank account also is not opened in the ledger. The bank column serves the purpose of the bank account. Entries marked C (being contra entries as explained earlier) are ignored while posting from the cash book to the ledger. These entries represent debit or credit of cash account against the bank account or viceversa. We will now see how the transactions recorded in double column cash book are posted to the individual accounts.
Posting from the Petty Cash Book
The petty cash book is balanced periodically. The difference between the total receipts and total payments is the balance with the petty cashier. The balance is carried to the next period and the petty cashier is paid the amount actually spent. A petty cash account is opened in the ledger. It is debited with the amount given to petty cashier. Each expense account is individually debited with the periodic total as per the respective column by writing “petty cash account” and the petty cash account is credited with the total expenditure incurred during the period by writing sundries as per petty cash book. The petty cash account is balanced. It reflect the actual cash with the petty cashier.
Balancing of Cash Book
On the left side, all cash transactions relating to cash receipts (debits) and on the right side all transactions relating to cash payments (credits) are entered date-wise. When a cash book is maintained, a separate cash book in the ledger is not opened. The cash book is balanced in the same way as an account in the ledger. But it may be noted that in the case of the cash book, there will always be debit balance because cash payments can never exceed cash receipts and cash in hand at the beginning of the period. The source document for cash receipts is generally the duplicate copy of the receipt issued by the cashier. For payment, any document, invoice, bill, receipt, etc. on the basis of which payment has been made, will serve as a source document for recording transactions in the cash book. When payment has been made, all these documents, popularly known as vouchers, are given a serial number and filed in a separate file for future reference and verification.
Purchases (Journal) Book
Posting from the purchases journal is done daily to their respective accounts with the relevant amounts on the credit side. The total of the purchases journal is periodically posted to the debit of the purchases account normally on the monthly basis. However, if the number of transactions is very large, this total may be done and posted at some other convenient time interval such as daily, weekly or fortnightly.
Purchases Return (Journal) Book -Posting from the purchases returns journal requires that the supplier’s individual accounts are debited with the amount of returns and the purchases returns account is credited with the periodical total.
Sales (Journal) Book - Posting from the sales journal are done to the debit of customer’s accounts kept in the ledger. Like the purchases journal, individual customer’s accounts are generally posted daily, with the amount involved. The sales journal is also totaled periodically (generally monthly), and this total is credited to sales account in the ledger.
Sales Return (Journal) Book - Posting to the sales return journal requires that the customer’s account be credited with the amount of returns and the sales return account be debited with the periodical total in the same way as is done in case of posting from the purchases journal
Balancing the Accounts
Accounts in the ledger are periodically balanced, generally at the end of the accounting period, with the object of ascertaining the net position of each amount. Balancing of an account means that the two sides are totaled and the difference between them is shown on the side, which is shorter in order to make their totals equal. The words ‘balance c/d’ are written against the amount of the difference between the two sides. The amount of balance is brought (b/d) down in the next accounting period indicating that it is a continuing account, till finally settled or closed.
In case the debit side exceeds the credit side, the difference is written on the credit side, if the credit side exceeds the debit side, the difference between the two appears on the debit side and is called debit and credit balance respectively. The accounts of expenses losses and gains/revenues are not balanced but are closed by transferring to trading and profit and loss account. The balancing of the an account is illustrated below with the help of an example explaining the complete process of recording the transactions, posting to ledger and balancing thereof.
Accounting Conventions and concepts are foundation of accounting principles Explain this statement?
In 1941, The American Institute of Certified Public Accountants (AICPA) had defined accounting as the art of recording, classifying, and summarising in a significant manner and in terms of money, transactions and events which are, in part at least, of financial character, and interpreting the results thereof’.With greater economic development resulting in changing role of accounting, its scope, became broader. In 1966, the American Accounting Association (AAA) defined accounting as ‘the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of information .Accounting is concerned with the recording, classifying and summarising of financial transactions and events and interpreting the results thereof. It aims at providing information about the financial performance of a firm to its various users such as owners, managers employees, investors, creditors,suppliers of goods and services and tax authorities and help them in taking important decisions. The investors, for example, may be interested in knowing the extent of profit or loss earned by the firm during a given period and compare it with the performance of other similar enterprises. The suppliers of credit, say a banker, may, in addition,be interested in liquidity position of the enterprise. All these people look forward to accounting for appropriate, useful and reliable information.
For making the accounting information meaningful to its internal and external users, it is important that such information is reliable as well as comparable. The comparability of information is required both to make inter-firm comparisons, i.e. to see how a firm has performed as compared to the other firms, as well as to make inter-period comparison, i.e. how it has performed as compared to the previous years. This becomes possible only if the information provided by the financial statements is based on consistent accounting policies, principles and practices. Such consistency is required throughout the process of identifying the events and transactions to be accounted for, measuring them, communicating them in the book of accounts, summarising the results thereof and reporting them to the interested parties. This calls for developing a proper theory base of accounting.
The basic accounting concepts are referred to as the fundamental ideas or basic assumptions underlying the theory and practice of financial accounting and are broad working rules for all accounting activities and developed by the accounting profession. The important concepts have been listed as below:
• Business entity;
• Money measurement;
• Going concern;
• Accounting period;
• Cost
• Dual aspect (or Duality);
• Revenue recognition (Realisation);
• Matching;
• Full disclosure;
• Consistency;
• Conservatism (Prudence);
• Materiality;
• Objectivity.
Business Entity Concept
The concept of business entity assumes that business has a distinct and
separate entity from its owners. It means that for the purposes of accounting,the business and its owners are to be treated as two separate entities. Keeping this in view, when a person brings in some money as capital into his business,in accounting records, it is treated as liability of the business to the owner. Here, one separate entity (owner) is assumed to be giving money to another distinct entity (business unit). Similarly, when the owner withdraws any money from the business for his personal expenses(drawings), it is treated as reduction of the owner’s capital and consequently a reduction in the liabilities of the business.The accounting records are made in the book of accounts from the point of view of the business unit and not that of the owner. The personal assets and liabilities of the owner are, therefore, not considered while ecording and reporting the assets and liabilities of the business. Similarly, personal transactions of the owner are not recorded in the books of the business, unless it involves inflow or outflow of business funds.
Money Measurement Concept
The concept of money measurement states that only those transactions and happenings in an organisation which can be expressed in terms of money such as sale of goods or payment of expenses or receipt of income, etc. are to be recorded in the book of accounts. All such transactions or happenings which can not be expressed in monetary terms, for example, the appointment of a manager, capabilities of its human resources or creativity of its research department or image of the organisation among people in general do not find a place in the accounting records of a firm. Another important aspect of the concept of money measurement is that the records of the transactions are to be kept not in the physical units but in the monetary unit. For example, an organisation may, on a particular day, have a factory on a piece of land measuring 2 acres, office building containing 10 rooms, 30 personal computers, 30 office chairs and tables, a bank balance of Rs.5 lakh, raw material weighing 20-tons, and 100 cartons of finished goods.These assets are expressed in different units, so can not be added to give any meaningful information about the total worth of business. For accounting purposes, therefore, these are shown in money terms and recorded in rupees and paise. In this case, the cost of factory land may be say Rs. 2 crore; office building Rs. 1 crore; computers Rs.15 lakh; office chairs and tables Rs. 2 lakh; raw material Rs. 33 lakh and finished goods Rs. 4 lakh. Thus, the total assets of the enterprise are valued at Rs. 3 crore and 59 lakh. Similarly, all transactions are recorded in rupees and paise as and when they take place. The money measurement assumption is not free from limitations. Due to the changes in prices, the value of money does not remain the same over a period of time. The value of rupee today on account of rise in prices is much less than what it was, say ten years back. Therefore, in the balance sheet,when we add different assets bought at different points of time, say building purchased in 1995 for Rs. 2 crore, and plant purchased in 2005 for Rs. 1 crore, we are in fact adding heterogeneous values, which can not be clubbed together. As the change in the value of money is not reflected in the book of accounts, the accounting data does not reflect the true and fair view of the affairs of an enterprise.
Going Concern Concept
The concept of going concern assumes that a business firm would continue to carry out its operations indefinitely, i.e. for a fairly long period of time and would not be liquidated in the foreseeable future. This is an important assumption of accounting as it provides the very basis for showing the value of assets in the balance sheet. An asset may be defined as a bundle of services. When we purchase an asset, for example, a personal computer, for a sum of Rs. 50,000, what we are buying really is the services of the computer that we shall be getting over its estimated life span, say 5 years. It will not be fair to charge the whole amount of Rs. 50,000, from the revenue of the year in which the asset is purchased. Instead, that part of the asset which has been consumed or used during a period should be charged from the revenue of that period. The assumption regarding continuity of business allows us to charge from the revenues of a period only that part of the asset which has been consumed or used to earn that revenue in that period and carry forward the remaining amount to the next years, over the estimated life of the asset. Thus, we may charge Rs. 10,000 every year for 5 years from the profit and loss account. In case the continuity assumption is not there, the whole cost (Rs. 50,000 in the present example) will need to be charged from the revenue of the year in which the asset was purchased.
Accounting Period Concept
Accounting period refers to the span of time at the end of which the financial statements of an enterprise are prepared, to know whether it has earned profits or incurred losses during that period and what exactly is the position of its assets and liabilities at the end of that period. Such information is required by different users at regular interval for various purposes, as no firm can wait for long to know its financial results as various decisions are to be taken at regular intervals on the basis of such information. The financial statements are, therefore, prepared at regular interval, normally after a period of one year, so that timely information is made available to the users. This interval of time is called accounting period. The Companies Act 1956 and the Income Tax Act require that the income statements should be prepared annually. However, in case of certain situations, preparation of interim financial statements become necessary. For example, at the time of retirement of a partner, the accounting period can be different from twelve months period. Apart from these companies whose shares are listed on the stock exchange, are required to publish quarterly results to ascertain the profitability and financial position at the end of every three months period.
Cost Concept
The cost concept requires that all assets are recorded in the book of accounts at their purchase price, which includes cost of acquisition, transportation,installation and making the asset ready to use. To illustrate, on June 2005,an old plant was purchased for Rs. 50 lakh by Shiva Enterprise, which is into the business of manufacturing detergent powder. An amount of Rs. 10,000 was spent on transporting the plant to the factory site. In addition, Rs. 15,000 was spent on repairs for bringing the plant into running position and Rs. 25,000 on its installation. The total amount at which the plant will be recorded in the books of account would be the sum of all these, i.e. Rs. 50,50,000.The concept of cost is historical in nature as it is something, which has been paid on the date of acquisition and does not change year after year. For example, if a building has been purchased by a firm for Rs. 2.5 crore, the purchase price will remain the same for all years to come, though its market value may change. Adoption of historical cost brings in objectivity in recording as the cost of acquisition is easily verifiable from the purchase documents. The market value basis, on the other hand, is not reliable as the value of an asset may change from time to time, making the comparisons between one period to another rather difficult. However, an important limitation of the historical cost basis is that it does not show the true worth of the business and may lead to hidden profits. During the period of rising prices, the market value or the cost at (which the assets can be replaced are higher than the value at which these are shown in the book of accounts) leading to hidden profits.
Dual Aspect Concept
Dual aspect is the foundation or basic principle of accounting. It provides the very basis for recording business transactions into the book of accounts. This concept states that every transaction has a dual or two-fold effect and should therefore be recorded at two places. In other words, at least two accounts will be involved in recording a transaction. This can be explained with the help of an example. Ram started business by investing in a sum of Rs. 50,00,000 The amount of money brought in by Ram will result in an increase in the assets (cash) of business by Rs. 50,00,000. At the same time, the owner’s equity or capital will also increase by an equal amount. It may be seen that the two items that got affected by this transaction are cash and capital account. Let us take another example to understand this point further. Suppose the firm purchase goods worth Rs. 10,00,000 on cash. This will increase an asset (stock of goods) on the one hand and reduce another asset (cash) on the other. Similarly, if the firm purchases a machine worth Rs. 30,00,000 on credit from Reliable Industries. This will increase an asset (machinery) on the one hand and a liability (creditor) on the other. This type of dual effect takes place in case of all business transactions and is also known as duality principle. The duality principle is commonly expressed in terms of fundamental Accounting Equation, which is as follows :
Assets = Liabilities + Capital
In other words, the equation states that the assets of a business are always equal to the claims of owners and the outsiders. The claims also called equity of owners is termed as Capital(owners’ equity) and that of outsiders, asLiabilities(creditors equity). The two-fold effect of each transaction affects in such a manner that the equality of both sides of equation is maintained. The two-fold effect in respect of all transactions must be duly recorded in the book of accounts of the business.
Revenue Recognition (Realisation) Concept
The concept of revenue recognition requires that the revenue for a business transaction should be included in the accounting records only when it is realised. Here arises two questions in mind. First, is termed as revenue and the other, when the revenue is realised. Let us take the first one first. Revenue is the gross inflow of cash arising from (i) the sale of goods and services by an enterprise; and (ii) use by others of the enterprise’s resources yielding interest, royalties and dividends. Secondly, revenue is assumed to be realised when a legal right to receive it arises, i.e. the point of time when goods have been sold or service has been rendered. Thus, credit sales are treated as revenue on the day sales are made and not when money is received from the buyer. As for the income such as rent, commission, interest, etc. these are recongnised on a time basis. For example, rent for the month of March 2005, even if received in April 2005, will be taken into the profit and loss account of the financial year ending March 31, 2005 and not into financial year beginning with April 2005. Similarly, if interest for April 2005 is received in advance in March 2005, it will be taken to the profit and loss account of the financial year ending March 2006.There are some exceptions to this general rule of revenue recognition. In case of contracts like construction work, which take long time, say 2-3 years to complete, proportionate amount of revenue, based on the part of contract completed by the end of the period is treated as realised. Similarly, when goods are sold on hire purchase, the amount collected in installments is treated as realised.
Matching Concept
The process of ascertaining the amount of profit earned or the loss incurred during a particular period involves deduction of related expenses from the revenue earned during that period. The matching concept emphasises exactly on this aspect. It states that expenses incurred in an accounting period should be matched with revenues during that period. It follows from this that therevenue and expenses incurred to earn these revenues must belong to the same accounting period.As already stated, revenue is recognised when a sale is complete or service is rendered rather when cash is received. Similarly, an expense is recognized not when cash is paid but when an asset or service has been used to generate revenue. For example, expenses such as salaries, rent, insurance are recognised on the basis of period to which they relate and not when these are paid. Similarly, costs like depreciation of fixed asset is divided over the periods during which the asset is used. Let us also understand how cost of goods are matched with their sales revenue. While ascertaining the profit or loss of an accounting year, we should not take the cost of all the goods produced or purchased during that period but consider only the cost of goods that have been sold during that year. For this purpose, the cost of unsold goods should be deducted from the cost of the goods produced or purchased. You will learn about this aspect in detail in the chapter on financial statement. The matching concept, thus, implies that all revenues earned during an accounting year, whether received during that year, or not and all costs incurred, whether paid during the year, or not should be taken into account while ascertaining profit or loss for that year.
Full Disclosure Concept
Information provided by financial statements are used by different groups of people such as investors, lenders, suppliers and others in taking various financial decisions. In the corporate form of organisation, there is a distinction between those managing the affairs of the enterprise and those owning it. Financial statements, however, are the only or basic means of communicating financial information to all interested parties. It becomes all the more important, therefore, that the financial statements makes a full, fair and adequate disclosure of all information which is relevant for taking financial decisions. The principle of full disclosure requires that all material and relevant facts concerning financial performance of an enterprise must be fully and completely disclosed in the financial statements and their accompanying footnotes. This is to enable the users to make correct assessment about the profitability and financial soundness of the enterprise and help them to take informed decisions. To ensure proper disclosure of material accounting information, the Indian Companies Act 1956 has provided a format for the preparation of profit and loss account and balance sheet of a company, which needs to be compulsorily adhered to, for the preparation of these statements. The regulatory bodieslike SEBI, also mandates complete disclosures to be made by the companies, to give a true and fair view of profitability and the state of affairs.
Consistency Concept
The accounting information provided by the financial statements would be useful in drawing conclusions regarding the working of an enterprise only when it allows comparisons over a period of time as well as with the working of other enterprises. Thus, both inter-firm and inter-period comparisons are required to be made. This can be possible only when accounting policies and practices followed by enterprises are uniform and are consistent over the period of time. To illustrate, an investor wants to know the financial performance of an enterprise in the current year as compared to that in the previous year. He
may compare this year’s net profit with that in the last year. But, if the accounting policies adopted, say with respect to depreciation in the two years are different, the profit figures will not be comparable. Because the method adopted for the valuation of stock in the past two years is inconsistent. It is, therefore, important that the concept of consistency is followed in preparation of financial statements so that the results of two accounting periods are comparable. Consistency eliminates personal bias and helps in achieving results that are comparable. Also the comparison between the financial results of two enterprises would be meaningful only if same kind of accounting methods and policies are adopted in the preparation of financial statements. However, consistency does not prohibit change in accounting policies. Necessary required changes are fully disclosed by presenting them in the financial statements indicating their probable effects on the financial results of business.
Conservatism Concept
The concept of conservatism (also called ‘prudence’) provides guidance for recording transactions in the book of accounts and is based on the policy of playing safe. The concept states that a conscious approach should be adopted in ascertaining income so that profits of the enterprise are not overstated. If the profits ascertained are more than the actual, it may lead to distribution of dividend out of capital, which is not fair as it will lead to reduction in the capital of the enterprise. The concept of conservatism requires that profits should not to be recorded until realised but all losses, even those which may have a remote possibility are to be provided for in the books of account. To illustrate, valuing closing stock at cost or market value whichever is lower; creating provision for doubtful debts, discount on debtors; writing of intangible assets like goodwill, patents, etc. from the book of accounts are some of the examples of the application of the principle of conservatism. Thus, if market value of the goods purchased has fallen down, the stock will be shown at cost price in the books but if the market value has gone up, the gain is not to be recorded until the stock is sold. This approach of providing for the losses but not recognising the gains until realised is called conservatism approach. This may be reflecting a generally pessimist attitude adopted by the accountants but is an important way of dealing with uncertainty and protecting the interests of creditors against an unwanted distribution of firm’s assets. However, deliberate attempt to underestimate the value of assets should be discouraged as it will lead to hidden profits, called secret reserves.
Materiality Concept
The concept of materiality requires that accounting should focus on material facts. Efforts should not be wasted in recording and presenting facts, which are immaterial in the determination of income. The question that arises here is what is a material fact. The materiality of a fact depends on its nature and the amount involved. Any fact would be considered as material if it is reasonably believed that its knowledge would influence the decision of informed user of financial statements. For example, money spent on creation of additional capacity of a theatre would be a material fact as it is going to increase the future earning capacity of the enterprise. Similarly, information about any change in the method of depreciation adopted or any liability which is likely to arise in the near future would be significant information. All such information about material facts should be disclosed through the financial statements and the accompanying notes so that users can take informed decisions. In certain cases, when the amount involved is very small, strict adherence to accounting principles is not required. For example, stock of erasers, pencils, scales, etc. are not shown as assets, whatever amount of stationery is bought in an accounting period is treated as the expense of that period, whether consumed or not. The amount spent is treated as revenue expenditure and taken to the profit and loss account of the year in which the expenditure is incurred.
Objectivity Concept
The concept of objectivity requires that accounting transaction should be recorded in an objective manner, free from the bias of accountants and others. This can be possible when each of the transaction is supported by verifiable documents or vouchers. For example, the transaction for the purchase of materials may be supported by the cash receipt for the money paid, if the same is purchased on cash or copy of invoice and delivery challan, if the same is purchased on credit. Similarly, receipt for the amount paid for purchase of a machine becomes the documentary evidence for the cost of machine and provides an objective basis for verifying this transaction. One of the reasons for the adoption of ‘Historical Cost’ as the basis of recording accounting transaction is that adherence to the principle of objectivity is made possible by it. As stated above, the cost actually paid for an asset can be verified from the documents but it is very difficult to ascertain the market value of an asset until it is actually sold. Not only that, the market value may vary from person to person and from place to place, and so ‘objectivity’ cannot be maintained if such value is adopted for accounting purposes.
What do you mean by Single entry system? In what types it differ from double entry system?
Single entry accounting is a simple form of bookkeeping and accounting in which each financial transaction is a single entry in a journal or transaction log. As a result, the accounting system is called, not surprisingly, a single entry system. And, the approach is also known as single entry bookkeeping. The single entry approach contrasts with double entry accounting, in which every financial event brings at least two equal and offsetting entries, one a debit (DR) and the other a credit (CR). As a result:
§ Firms using the double entry approach report financial results with an accrual reporting system.
§ Firms using single entry approach are effectively limited to reporting on a cash basis.
The Single entry approach is simpler than double entry
On the positive side, single entry accounting is simpler and much easier to use than the double entry approach. And, the single entry approach does not require background or training in accounting. Nevertheless, the overwhelming majority of firms, worldwide, use double entry not single entry—accounting.
Sections below illustrate single entry transactions and further explain:
§ Advantages and disadvantages of both systems.
§ Reasons that most firms choose double entry accounting
§ Business settings where single entry accounting can be sufficient for planning, record-keeping and financial reporting.
Single entry bookkeeping and accounting can be adequate for a small business practicing cash basis accounting. Small firms may in fact prefer single entry accounting over a double-entry system when all or most of these conditions apply:
§ The company uses cash basis accounting, not accrual accounting.
§ The company has few financial transactions per day.
§ The company does not sell on its own credit. Customers must pay at the time of the sale either in cash, by bank transfer, by 3rd-party debit card, or by writing a check. The firm does not deliver goods or services and then invoice customers for payment later.
§ The company has very few employees.
§ The company owns few expensive business-supporting physical assets. For example, it may own product inventory, office supplies, and cash in a bank account. But it does not own buildings, substantial office furniture, large computer systems, production machinery, or vehicles.
§ The company is privately held or operates as a sole proprietorship or partnership. As a result, the firm need not publish an income statement, balance sheet, or other financial statements that are mandatory for public companies.
Firms that may use single entry accounting
Under such conditions, a single entry system may meet the firm's planning and reporting needs. As a result, the single entry system may be adequate for
§ Supporting income tax reporting for the company. The primary data for this are outgoing expenses and incoming revenues.
§ Proving that the company collects and pays government sales taxes for goods or services sold.
§ Proving that the company pays its own income taxes.
§ Forecasting future budgetary needs and sales revenues.
§ Proving that the company complies with minimum wage and employee tax withholding requirements.
§ Providing real-time visibility and control of incoming and outgoing funds. The firm must be able to avoid over spending budgets or overdrawing bank accounts.
Single entry system advantages
Single entry bookkeeping and accounting have the great advantage of simplicity over double entry bookkeeping and accounting.
§ People with little or no background in finance or accounting readily understand single entry records and reports.
§ Small companies create and use single entry systems without hiring a professional accountant or bookkeeper.
§ The single entry approach does not require complex accounting software. The examples above show, for instance, that firms can create and maintain a single entry system easily in a written notebook or simple spreadsheet.
Single entry system disadvantages
Single entry accounting provides insufficient records and insufficient control for public companies and other organizations that must file audited financial statements. Nor can it—by itself—give owners and managers crucial information for evaluating the company's financial position.
Some of the important differences between the two approaches illustrate disadvantages of the single entry approach:
Double entry system: Built in error checking
A double entry system provides several forms of error checking that are absent in a single entry system. In the double entry system, every financial transaction results in both a debit (DR) in one account and an equal, offsetting credit (CR) in another account. For each reporting period, total debits must equal total credits. That is:
Total DR = Total CR
Moreover, a double entry system works so that the balance sheet equation always holds:
Assets = Liabilities + Equities
These equations together are known as the accounting equation. Any departure from these equalities in a double entry system is a signal that account histories include an error.
Single entry system: Error checking is not built in
This kind of error checking is missing from the single entry system.
If the single-entry bookkeeper mistakenly enters, say, a revenue inflow as $10,000 when the correct value is $1,000, the error may go unnoticed until the firm receives a bank statement with an unexpected low account balance.
In a double-entry system, however, the $1,000 cash deposit entry (a debit to an asset account, cash on hand) will be accompanied by another entry recognizing the source, for example, a credit to a liability account (e.g., bank loan) or a credit to another asset account (accounts receivable). If the second entry were not made, the sums of credits and debits in the system would differ, immediately revealing the error.
Double entry system: Focus on Revenues, Expenses, Assets, Liabilities, and Equities.
A double entry system keeps the firm's entire chart of accounts in view. The chart of accounts for a double entry system has in fact five kinds of accounts in two categories:
§ Firstly, Income statement accounts: (1) Revenue accounts, and (2) expense accounts.
§ Secondly, Balance sheet accounts: (3) Asset accounts, (4) Liability accounts, and (5) Equity accounts.
All transactions in a double entry system result in entries in at least two different accounts. When the company receives cash through a bank loan, the double entry system records:
§ Firstly, a debit for an asset account, e.g., Cash on hand. For an asset account, a debit is an increase.
§ Secondly, a credit to a liability account, e.g., bank loans. A credit to a liability account increases account balance.
Single entry system: Focus on Revenues and Expenses only
A single entry system tracks Revenue and Expense accounts, but does not track Asset accounts, Liabilities accounts, or Equities accounts
With a single-entry system, however, the company may receive cash from a bank loan and record that as incoming cash. In this case, however, there is no easy way to record the corresponding increase in liability (bank loan debt).
Singly entry system does not support accrual accounting
Single entry systems, moreover, work hand-in-glove with cash basis accounting, where firms record inflows and outflows only when cash actually flows. Single entry systems cannot easily support the alternative, accrual accounting. When the delivery of goods and services and customer payments come at different times, for instance, accrual accounting provides mechanisms for implementing the matching concept. Consequently, the firm recognizes revenues and the expenses that brought them in the same accounting period.
If the vendor delivery and the customer payment fall in different time periods, however, the single entry system has no way of matching the two events and thus presents a misleading picture of earnings for either period.
In conclusion: Single entry accounting is inadequate for public companies
Because of such disadvantages, it is extremely difficult to build a single entry system that conforms to GAAP requirements in most countries (Generally accepted accounting principles).This lack may not concern sole proprietorships, partnerships, or very small privately held corporations. This is because accounting system for such firms must support only the tax and employment reporting requirements.
It is nearly impossible to build a single entry system, however, that by itself supports the reporting needs of public corporations (companies that sell shares of stock to the public). A single entry system, in fact, is inadequate, for any firm that must report statements of income, financial position (balance sheet), retained earnings, or cash flow (changes in financial position).
What is trial balance? IS trial balance a proof of arithmetical accuracy? Explain .
A trial balance is a statement showing the balances, or total of debits and credits, of all the accounts in the ledger with a view to verify the arithmetical accuracy of posting into the ledger
accounts. Trial balance is an important statement in the accounting process. which shows final
position of all accounts and helps in preparing the final statements. The task of preparing the
statements is simplified because the accountant can take the account balances from the trial
balance instead of looking them up in the ledger.
It is normally prepared at the end of an accounting year. However, an organisation may prepare a trial balance at the end of any chosen period, which may be monthly, quarterly, half yearly or annually depending upon its requirements.
In order to prepare a trial balance following steps are taken:
• Ascertain the balances of each account in the ledger.
• List each account and place its balance in the debit or credit column, as the case may be. (If an account has a zero balance, it may be included in the trial balance with zero in the column for its normal balance).
• Compute the total of debit balances column.
• Compute the total of the credit balances column.
• Verify that the sum of the debit balances equal the sum of credit balances.
If they do not tally, it indicate that there are some errors. So one must check the correctness of the balances of all accounts. It may be noted that all assets expenses and receivables account shall have debit balances whereas all liabilities, revenues and payables accounts shall have credit balances
Objectives of Preparing the Trial Balance
The trial balance is prepared to fulfill the following objectives :
1. To ascertain the arithmetical accuracy of the ledger accounts.
2. To help in locating errors.
3. To help in the preparation of the financial statements.
To Ascertain the Arithmetical Accuracy of Ledger Accounts
As stated earlier, the purpose of preparing a trial balance is to ascertain whether all debits and credit are properly recorded in the ledger or not and that all accounts have been correctly balanced. As a summary of the ledger, it is a list of the accounts and their balances. When the totals of all the debit balances and credit balances in the trial balance are equal, it is assumed that the posting and balancing of accounts is arithmetically correct. However, the tallying of the trial balance is not a conclusive proof of the accuracy of the accounts. It only ensures that all debits and the corresponding credits have been properly recorded in the ledger.
To Help in Locating Errors
When a trial balance does not tally (that is, the totals of debit and credit columns are not equal), we know that at least one error has occured. The error (or errors) may have occured at one of those stages in the accounting process:
(1) totalling of subsidiary books,
(2) posting of journal entries in the ledger,
(3) calculating account balances,
(4) carrying account balances to the trial balance, and
(5) totalling the trial balance columns.
It may be noted that the accounting accuracy is not ensured even if the totals of debit and credit balances are equal because some errors do not affect equality of debits and credits. For example, the book-keeper may debit a correct amount in the wrong account while making the journal entry or in posting a journal entry to the ledger. This error would cause two accounts to have incorrect balances but the trial balance would tally. Another error is to record an equal debit and credit of an incorrect amount. This error would give the two accounts incorrect balances but would not create unequal debits and credits. As a result, the fact that the trial balance has tallied does not imply that all entries in the books of original record (journal, cash book, etc.) have been recorded and posted correctly. However, equal totals do suggest that several types of errors probably have not occured.
To Help in the Preparation of the Financial Statements
Trial balance is considered as the connecting link between accounting records and the preparation of financial statements. For preparing a financial statement, one need not refer to the ledger. In fact, the availability of a tallied trial balance is the first step in the preparation of financial statements. All revenue and expense accounts appearing in the trial balance are transferred to the trading and profit and loss account and all liabilities, capital and assets accounts are transferred to the balance sheet It is important for an accountant that the trial balance should tally. Normally a tallied trial balance means that both the debit and the credit entries have been made correctly for each transaction. However, as stated earlier, the agreement of trial balance is not an absolute proof of accuracy of accounting records. A tallied
trial balance only proves, to a certain extent, that the posting to the ledger is arithmetically correct. But it does not guarantee that the entry itself is correct. There can be errors, which affect the equality of debits and credits, and there can be errors, which do not affect the equality of debits and credits. Some common errors include the following:
• Error in totalling of the debit and credit balances in the trial balance.
• Error in totalling of subsidiary books.
• Error in posting of the total of subsidiary books.
• Error in showing account balances in wrong column of the trial balance, or in the wrong amount.
• Omission in showing an account balance in the trial balance.
• Error in the calculation of a ledger account balance.
• Error while posting a journal entry: a journal entry may not have been posted properly to the ledger, i.e., posting made either with wrong amount or on the wrong side of the account or in the wrong account.
• Error in recording a transaction in the journal: making a reverse entry, i.e., account to be debited is credited and amount to be credited is debited, or an entry with wrong amount.
• Error in recording a transaction in subsidiary book with wrong name or wrong amount.
Classification of Errors
Keeping in view the nature of errors, all the errors can be classified into the following four categories:
• Errors of Commission
• Errors of Omission
• Errors of Principle
• Compensating Errors
Errors of Commission
These are the errors which are committed due to wrong posting of transactions, wrong totalling or balancing of the accounts, wrong casting of the subsidiary books, or wrong recording of amount in the books of original entry, etc.For example: Raj Hans Traders paid Rs. 25,000 to Preetpal Traders (a supplier of goods). This transaction was correctly recorded in the cashbook. But while posting to the ledger, Preetpal’s account was debited with Rs. 2,500 only. This constitutes an error of commission. Such an error by definition is of clerical nature and most of the errors of commission affect in the trial balance.
Errors of Omission
The errors of omission may be committed at the time of recording the transaction in the books of original entry or while posting to the ledger. There can be of two types:
(i) error of complete omission
(ii) error of partial omission
When a transaction is completely omitted from recording in the books of original record, it is an error of complete omission. For example, credit sales to Mohan Rs. 10,000, not entered in the sales book. When the recording of transaction is partly omitted from the books, it is an error of partial omission. If in the above example, credit sales had been duly recorded in the sales book
but the posting from sales book to Mohan’s account has not been made, it would be an error of partial omission.
Errors of Principle
Accounting entries are recorded as per the generally accepted accounting principles. If any of these principles are violated or ignored, errors resulting from such violation are known as errors of principle. An error of principle may occur due to incorrect classification of expenditure or receipt between capital and revenue. This is very important because it will have an impact on financial statements. It may lead to under/over stating of income or assets or liabilities, etc. For example, amount spent on additions to the buildings should be treated as capital expenditure and must be debited to the asset account. Instead, if this amount is debited to maintenance and repairs account, it has been treated as a revenue expense. This is an error of principle. Similarly, if a credit purchase of machinery is recorded in purchases book instead of journal proper or rent paid to the landlord is recorded in the cash book as payment to landlord, these errors of principle. These errors do not affect the trial balance.
Compensating Errors
When two or more errors are committed in such a way that the net effect of these errors on the debits and credits of accounts is nil, such errors are called compensating errors. Such errors do not affect the tallying of the trial balance. For example, if purchases book has been overcast by Rs. 10,000 resulting in excess debit of Rs. 10,000 in purchases account and sales returns book is undercast by Rs. 10,000 resulting in short debit to sales returns account is a case of two errors compensating each other’s effect. One plus is set off by the other minus, the net effect of these two errors is nil and so they do not affect the agreement of trial balance.
Searching of Errors
If the trial balance does not tally, it is a clear indication that at least one error has occured. The error (or errors) needs to be located and corrected before preparing the financial statements.
If the trial balance does not tally, the accountant should take the following steps to detect and locate the errors :
• Recast the totals of debit and credit columns of the trial balance.
• Compare the account head/title and amount appearing in the trial balance, with that of the ledger to detect any difference in amount or omission of an account.
• Compare the trial balance of current year with that of the previous year to check additions and deletions of any accounts and also verify whether there is a large difference in amount, which is neither expected nor explained.
• Re-do and check the correctness of balances of individual accounts in the ledger.
• Re-check the correctness of the posting in accounts from the books of original entry.
• If the difference between the debit and credit columns is divisible by 2,there is a possibility that an amount equal to one-half of the difference may have been posted to the wrong side of another ledger account. For example, if the total of the debit column of the trial balance exceeds by Rs. 1,500, it is quite possible that a credit item of Rs.750 may have been wrongly posted in the ledger as a debit item. To locate such errors, the accountant should scan all the debit entries of an amount of Rs. 750.
• The difference may also indicate a complete omission of a posting. For example, the difference of Rs. 1,500 given above may be due to omissions of a posting of that amount on the credit side. Thus, the accountant should verify all the credit items with an amount of Rs. 1,500.
• If the difference is a multiple of 9 or divisible by 9, the mistake could be due to transposition of figures. For example, if a debit amount of Rs. 459 is posted as Rs. 954, the debit total in the trial balance will exceed the credit side by Rs. 495 (i.e. 954 – 459 = 495). This difference is divisible by 9. A mistake due to wrong placement of the decimal point may also be checked by this method. Thus, a difference in trial balance divisible by 9 helps in checking the errors for a transposed mistake.
Rectification of Errors which do not Affect the Trial Balance
These errors are committed in two or more accounts. Such errors are also known as two sided errors. They can be rectified by recording a journal entry giving the correct debit and credit to the concerned accounts.
Examples of such errors are – complete omission to record an entry in the books of original entry; wrong recording of transactions in the book of accounts; complete omission of posting to the wrong account on the correct side, and errors of principle.
The rectification process essentially involves:
• Cancelling the effect of wrong debit or credit by reversing it; and
• Restoring the effect of correct debit or credit.
For this purpose, we need to analyse the error in terms of its effect on the accounts involved which may be:
(i) Short debit or credit in an account ; and/or
(ii) Excess debit or credit in an account.
Therefore, rectification entry can be done by :
(i) debiting the account with short debit or with excess credit,
(ii) crediting the account with excess debit or with short credit.
Rectification of Errors Affecting Trial Balance
The errors which affect only one account can be rectified by giving an exaplanatory note in the account affected or by recording a journal entry with the help of the Suspense Account. Suspense Account is explained later in this chapter. Examples of such errors are error of casting; error of carrying forward; error of balancing; error of posting to correct account but with wrong amount; error of posting to the correct account but on the wrong side; posting to the wrong side with the wrong amount; omitting to show an account in the trial balance. An error in the books of original entry, if discovered before it is posted to the ledger, may be corrected by crossing out the wrong amount by a single line and writing the correct amount above the crossed amount and initialing it. An error in an amount posted to the correct ledger account may also be corrected in a similar way, or by making an additional posting for the difference
in amount and giving an explanatory note in the particulars column. But errors should never be corrected by erasing or overwriting reduces the authenticity of accounting records and give an impression that something is being concealed. A better way therefore is by noting the correction on the appropriate side for neutralising the effect of the error.
A Trial Balance in which the credit and debit accounts match does not prove that, all transactions have been recorded in the proper accounts. To conclude, we can say that a trial balance should not be recorded as a conclusive proof of the correctness of the books of account.
What us depreciation? What are the methods of depreciation? What factors to be taken into account while determining the amount of depreciation?
Matching principle requires that the revenue of a given period is matched against the expenses for the same period. This ensures ascertainment of the correct amount of profit or loss. If some cost is incurred whose benefits extend for more than one accounting period then it is not justified to charge the entire cost as expense in the year in which it is incurred. Rather such a cost must be spread over the periods in which it provides benefits. Depreciation, which is the main subject matter of the present chapter, deals with such a situation.
Further, it may not always be possible to ascertain with certainty the amount of some particular expense. Recall that the principle of conservatism (prudence) requires that instead of ignoring such items of expenses, adequate provision must be made and charged against profits of the current period. Moreover, a part of profit may be retained in the business in the form of reserves to provide for growth, expansion or meeting certain specific needs of the business in future. Fixed assets are the assets which are used in business for more than one accounting year. Fixed assets (technically referred to as “depreciable assets”) tend to reduce their value once they are put to use. In general, the term “Depreciation” means decline in the value of a fixed assets due to use, passage of time or obsolescence. In other words, if a business enterprise procures a machine and uses it in production process then the value of machine declines with its usage. Even if the machine is not used in production process, we can not expect it to realise the same sales price due to the passage of time or arrival of a new model (obsolescence). It implies that fixed assets are subject to decline in value and this decline is technically referred to as depreciation. As an accounting term, depreciation is that part of the cost of a fixed asset which has expired on account of its usage and/or lapse of time. Hence, depreciation is an expired cost or expense, charged against the revenue of a given accounting period. For example, a machine is purchased for Rs.1,00,000 on April 01, 2005. The useful life of the machine is estimated to be 10 years. It implies that the machine can be used in the production process for next 10 years till March 31, 2015. You understand that by its very nature, Rs. 1,00,000 is a capital expenditure during the year 2005. However, when income statement (Profit and Loss account) is prepared, the entire amount of Rs.1,00,000 can not be charged against the revenue for the year 2005, because of the reason that the capital expenditure amounting to Rs.1,00,000 is expected to derive benefits (or revenue) for 10 years and not one year. Therefore, it is logical to charge only a part of the total cost say Rs.10,000 (one tenth of Rs. 1,00,000) against the revenue for the year 2005. This part represents, the expired cost or loss in the value of machine on account of its use or passage of time and is referred to as ‘Depreciation’. The amount of depreciation, being a charge against profit, is debited to the profit and loss account Depreciation may be described as a permanent, continuing and gradual shrinkage in the book value of fixed assets. It is based on the cost of assets consumed in a business and not on its market value.
According to Institute of Cost and Management Accounting, London (ICMA) terminology “ The depreciation is the diminution in intrinsic value of the asset due to use and/or lapse of time.” Accounting Standard-6 issued by The Institute of Chartered Accountants of India (ICAI) defines depreciation as “a measure of the wearing out, consumption or other loss of value of depreciable asset arising from use, effluxion of time or obsolescence through technology and market-change. Depreciation is allocated so as to charge fair proportion of depreciable amount in each accounting period during the expected useful life of the asset. Depreciation includes amortization of assets whose useful life is pre-determined”. Depreciation has a significant effect in determining and presenting the financial position and results of operations of an enterprise. Depreciation is charged in each accounting period by reference to the extent of the depreciable
amount. It should be noted that the subject matter of depreciation, or its base, are ‘depreciable’ assets which:
• “are expected to be used during more than one accounting period;
• have a limited useful life; and
• are held by an enterprise for use in production or supply of goods and
services, for rental to others, or for administrative purposes and not for the purpose of sale in the ordinary course of business.” Examples of depreciable assets are machines, plants, furnitures, buildings, computers, trucks, vans, equipments, etc. Moreover, depreciation is the
allocation of ‘depreciable amount’, which is the “historical cost”, or other amount substituted for historical cost less estimated salvage value. Another point in the allocation of depreciable amount is the ‘expected useful life’ of an asset. It has been described as “either
(i) the period over which a depreciable asset is expected to the used by the enterprise,
(ii) the number of production of similar units expected to be obtained from the use of the
asset by the enterprise.”
Features of Depreciation
Above mentioned discussion on depreciation highlights the following features of depreciation:
1. It is decline in the book value of fixed assets.
2. It includes loss of value due to effluxion of time, usage or obsolescence.
For example, a business firm buys a machine for Rs. 1,00,000 on April 01, 2000. In the year 2002, a new version of the machine arrives in the market. As a result, the machine bought by the business firm becomes outdated. The resultant decline in the value of old machine is caused by obsolescence.
3. It is a continuing process.
4. It is an expired cost and hence must be deducted before calculating taxable profits. For example, if profit before depreciation and tax is Rs. 50,000, and depreciation is Rs. 10,000; profit before tax will be: (Rs.)Profit before depreciation & tax 50,000 (-) Depreciation (10,000)
Profit before tax 40,000
5. It is a non-cash expense. It does not involve any cash outflow. It is the process of writing-off the capital expenditure already incurred.
Causes of Depreciation
These have been very clearly spelt out as part of the definition of depreciation in the Accounting Standard 6 and are being elaborated here
Wear and Tear due to Use or Passage of Time
Wear and tear means deterioration, and the consequent diminution in an assets value, arising from its use in business operations for earning revenue. It reduces the asset’s technical capacities to serve the purpose for, which it has been meant. Another aspect of wear and tear is the physical deterioration. An asset deteriorates simply with the passage of time, even though they are not being put to any use. This happens especially when the assets are exposed
to the rigours of nature like weather, winds, rains, etc.
Expiration of Legal Rights
Certain categories of assets lose their value after the agreement governing their use in business comes to an end after the expiry of pre-determined period. Examples of such assets are patents, copyrights, leases, etc. whose utility to business is extinguished immediately upon the removal of legal backing to them.
Obsolescence
Obsolescence is another factor leading to depreciation of fixed assets. In ordinary language, obsolescence means the fact of being “out-of-date”. Obsolescence implies to an existing asset becoming out-of-date on account of the availability of better type of asset. It arises from such factors as:
• Technological changes;
• Improvements in production methods;
• Change in market demand for the product or service output of the asset;
• Legal or other description.
Abnormal Factors
Decline in the usefulness of the asset may be caused by abnormal factors such as accidents due to fire, earthquake, floods, etc. Accidental loss is permanent but not continuing or gradual. For example, a car which has been repaired after an accident will not fetch the same price in the market even if it has not been used.
Need for Depreciation
The need for providing depreciation in accounting records arises from conceptual, legal, and practical business consideration. These considerations provide depreciation a particular significance as a business expense.
Matching of Costs and Revenue
The rationale of the acquisition of fixed assets in business operations is that these are used in the earning of revenue. Every asset is bound to undergo some wear and tear, and hence lose value, once it is put to use in business.Therefore, depreciation is as much the cost as any other expense incurred in the normal course of business like salary, carriage, postage and stationary,
etc. It is a charge against the revenue of the corresponding period and must be deducted before arriving at net profit according to ‘Generally Accepted Accounting Principles’.
Consideration of Tax
Depreciation is a deductible cost for tax purposes. However, tax rules for the calculation of depreciation amount need not necessarily be similar to current business practices,
True and Fair Financial Position
If depreciation on assets is not provided for, then the assets will be over valued and the balance sheet will not depict the correct financial position of the business. Also, this is not permitted either by established accounting practices or by specific provisions of law.
Compliance with Law
Apart from tax regulations, there are certain specific legislations that indirectly compel some business organisations like corporate enterprises to provide depreciation on fixed assets.
Methods of Recording Depreciation
In the books of account, there are two types of arrangements for recording depreciation on fixed assets:
• Charging depreciation to asset account or
• Creating Provision for depreciation/Accumulated depreciation account.
Charging Depreciation to Asset account
According to this arrangement, depreciation is deducted from the depreciable cost of the asset ( credited to the asset account) and charged (or debited) to profit and loss account. Journal entries under this recording method are as follows:
1. For recording purchase of asset (only in the year of purchase)
Asset A/c Dr. (with the cost of asset including installation, freight, etc.)
To Bank/Vendor A/c
2. Following two entries are recorded at the end of every year
(a) For deducting depreciation amount from the cost of the asset.
Depreciation A/c Dr. (with the amount of depreciation)
To Asset A/c
(b) For charging depreciation to profit and loss account.
Profit & Loss A/c Dr. (with the amount of depreciation)
To Depreciation A/c
3. Balance Sheet Treatment
When this method is used, the fixed asset appears at its net book value (i.e. cost less depreciation charged till date) on the asset side of the balance sheet and not at its original cost (also known as historical cost).
Creating Provision for Depreciation Account/Accumulated Depreciation Account
This method is designed to accumulate the depreciation provided on an asset in a separate account generally called ‘depreciation provision’ or ‘accumulated depreciation’. Such accumulation of depreciation enables that the asset account need not be disturbed in any way and it continues to be shown at its original cost over the successive years of its useful life. There are some basic characteristic of this method of recording depreciation, which are given below:
• Asset account continues to appear at its original cost year after year over its entire life;
• Depreciation is accumulated on a separate account instead of being adjusted into the asset account at the end of each accounting period.
The following journal entries are recorded under this method:
1. For recording purchase of asset (only in the year of purchase)
Asset A/c Dr. (with the cost of asset including installation, expenses etc.)
To Bank/Vendor A/c (cash/credit purchase)
2. Following two journal entries are recorded at the end of each year:
(a) For crediting depreciation amount to provision for depreciation account
Depreciation A/c Dr. (with the amount of depreciation)
To Provision for depreciation A/c
(b) For charging depreciation to profit and loss account
Profit & Loss A/c Dr. (with the amount of depreciation)
To Depreciation A/c
3. Balance sheet treatment
In the balance sheet, the fixed asset continues to appear at its original cost on the asset side. The depreciation charged till that date appears in the provision for depreciation account, which is shown either on the “liabilities side” of the balance sheet or by way of deduction from the original cost of the asset concerned on the asset side of the balance sheet.
Factors Affecting the Amount of Depreciation
The determination of depreciation depends on three parameters, viz. cost, estimated useful life and probable salvage value.
Cost of Asset
Cost (also known as original cost or historical cost) of an asset includes invoice price and other costs, which are necessary to put the asset in use or working condition. Besides the purchase price, it includes freight and transportation cost, transit insurance, installation cost, registration cost, commission paid on purchase of asset add items such as software, etc. In case of purchase of a second hand asset it includes initial repair cost to put the asset in workable condition. According to Accounting Standand-6 of ICAI, cost of a fixed asset is “the total cost spent in connection with its acquisition, installation and commissioning as well as for addition or improvement of the depreciable asset”.
For example, a photocopy machine is purchased for Rs. 50,000 and Rs. 5,000 is spent on its transportation and installation. In this case the original cost of the machine is Rs. 55,000 (i.e. Rs. 50,000 + Rs.5,000 ) which will be written off as depreciation over the useful life of the machine.
Estimated Net Residual Value
Net Residual value (also known as scrap value or salvage value for accounting purpose) is the estimated net realisable value (or sale value) of the asset at the end of its useful life. The net residual value is calculated after deducting the expenses necessary for the disposal of the asset. For example, a machine is purchased for Rs. 50,000 and is expected to have a useful life of 10 years. At the end of 10th year it is expected to have a sale value of Rs. 6,000 but expenses related to its disposal are estimated at Rs. 1,000. Then its net residual value shall be Rs. 5,000 (i.e. Rs. 6,000 – Rs. 1,000).
Depreciable Cost
Depreciable cost of an asset is equal to its cost less net residual value Hence, in the above example, the depreciable cost of machine is Rs. 45,000 (i.e., Rs. 50,000 – Rs. 5,000.) It is the depreciable cost, which is distributed and charged as depreciation expense over the estimated useful life of the asset. In the above example, Rs. 45,000 shall be charged as depreciation over a period of 10 years. It is important to mention here that total amount of depreciation charged
over the useful life of the asset must be equal to the depreciable cost. If total amount of depreciation charged is less than the depreciable cost then the Depreciation, Provisions and Reserves 235 capital expenditure is under recovered. It violates the principle of proper matching of revenue and expense.
Estimated Useful Life
Useful life of an asset is the estimated economic or commercial life of the asset. Physical life is not important for this purpose because an asset may still exist physically but may not be capable of commercially viable production. For example, a machine is purchased and it is estimated that it can be used in production process for 5 years. After 5 years the machine may still be in good physical condition but can’t be used for production profitably, i.e., if it is still used the cost of production may be very high. Therefore, the useful life of the machine is considered as 5 years irrespective of its physical life. Estimation of useful life of an asset is difficult as it depends upon several factors such as usage level of asset, maintenance of the asset, technological changes, market changes, etc. As per Accounting Standard – 6 useful life of an asset is normally the “period over which it is expected to be used by the enterprise”. Normally, useful life is shorter than the physical life. The useful life of an asset is expressed in number of years but it can also be expressed in other units, e.g., number of units of output (as in case of mines) or number of working hours. Useful life depends upon the following factors :
• Pre-determined by legal or contractual limits, e.g. in case of leasehold asset, the useful life is the period of lease.
• The number of shifts for which asset is to be used.
• Repair and maintenance policy of the business organisation.
• Technological obsolescence.
• Innovation/improvement in production method.
• Legal or other restrictions.
Methods of Calculating Depreciation Amount
The depreciation amount to be charged for during an accounting year depends up on depreciable amount and the method of allocation. For this, two methods are mandated by law and enforced by professional accounting practice in India. These methods are straight line method and written down value method. Besides these two main methods there are other methods such as – annuity method, depreciation fund method, insurance policy method, sum of years digit method, double declining method, etc. which may be used for determining the amount of depreciation. The selection of an appropriate method depends upon the following :
• Type of the asset;
• Nature of the use of such asset;
• Circumstances prevailing in the business;
As per Accounting Standard-6, the selected depreciation method should be applied consistently from period to period. Change in depreciation method may be allowed only under specific circumstances.
Straight Line Method
This is the earliest and one of the widely used methods of providing depreciation. This method is based on the assumption of equal usage of the asset over its entire useful life. It is called straight line for a reason that if the amount of depreciation and corresponding time period is plotted on a graph, it will result in a straight line .
It is also called fixed installment method because the amount of depreciation remains constant from year to year over the useful life of the asset. According to this method, a fixed and an equal amount is charged as depreciation in every accounting period during the lifetime of an asset. The amount annually charged as depreciation is such that it reduces the original cost of the asset to its scrap value, at the end of its useful life. This method is also known as fixed
percentage on original cost method because same percentage of the original cost (infact depreciable cost) is written off as depreciation from year to year.
The depreciation amount to be provided under this method is computed by using the following formula:
Estimated useful life of the asset
Cost of asset Estimated - net residential value
Depreciation − Rate of depreciation under straight line method is the percentage of the total cost of the asset to be charged as deprecation during the useful lifetime of the asset. Rate of depreciation is calculated as follows:
Acquisition cost/Annual depreciation amount
Rate of Depreciation
Consider the following example, the original cost of the asset is Rs. 2,50,000. The useful life of the asset is 10 years and net residual value is estimated to be Rs. 50,000. Now, the amount of depreciation to be charged every year will be computed as given below:
Annual Depreciation Amount
Estimated life of asset
Acquisition cost of asset − Estimated net residential value
Rs. (2,50,000 - Rs. 50,000)/10
Rs. 20,000
Written Down Value Method
Under this method, depreciation is charged on the book value of the asset. Since book value keeps on reducing by the annual charge of depreciation, it is also known as reducing balance method. This method involves the application of a pre-determined proportion/percentage of the book value of the asset at the beginning of every accounting period, so as to calculate the amount of depreciation. The amount of depreciation reduces year after year. For example, the original cost of the asset is Rs. 2,00,000 and depreciation is charged @ 10% p.a. at written down value, then the amount of depreciation will be computed as follows:
As evident from the example, the amount of depreciation goes on reducing year after year. For this reason, it is also known reducing installment or diminishing value method. This method is based upon the assumption that the benefit accruing to business from assets keeps on diminishing as the asset becomes old This is due to the reason that a predetermined percentage is applied to a gradually shrinking balance on the asset account every year. Thus, large amount is recovered depreciation charge in the earlier years than in later years. Under written down value method, the rate of depreciation is computed by using the following formula
What is diminishing balance method of charging depreciation? Discuss its merits and demerits ? How does it differ from fixed installment system?
Matching principle requires that the revenue of a given period is matched against the expenses for the same period. This ensures ascertainment of the correct amount of profit or loss. If some cost is incurred whose benefits extend for more than one accounting period then it is not justified to charge the entire cost as expense in the year in which it is incurred. Rather such a cost must be spread over the periods in which it provides benefits. Depreciation, which is the main subject matter of the present chapter, deals with such a situation.
Further, it may not always be possible to ascertain with certainty the amount of some particular expense. Recall that the principle of conservatism (prudence) requires that instead of ignoring such items of expenses, adequate provision must be made and charged against profits of the current period. Moreover, a part of profit may be retained in the business in the form of reserves to provide for growth, expansion or meeting certain specific needs of the business in future. Fixed assets are the assets which are used in business for more than one accounting year. Fixed assets (technically referred to as “depreciable assets”) tend to reduce their value once they are put to use. In general, the term “Depreciation” means decline in the value of a fixed assets due to use, passage of time or obsolescence. In other words, if a business enterprise procures a machine and uses it in production process then the value of machine declines with its usage. Even if the machine is not used in production process, we can not expect it to realise the same sales price due to the passage of time or arrival of a new model (obsolescence). It implies that fixed assets are subject to decline in value and this decline is technically referred to as depreciation. As an accounting term, depreciation is that part of the cost of a fixed asset which has expired on account of its usage and/or lapse of time. Hence, depreciation is an expired cost or expense, charged against the revenue of a given accounting period. For example, a machine is purchased for Rs.1,00,000 on April 01, 2005. The useful life of the machine is estimated to be 10 years. It implies that the machine can be used in the production process for next 10 years till March 31, 2015. You understand that by its very nature, Rs. 1,00,000 is a capital expenditure during the year 2005. However, when income statement (Profit and Loss account) is prepared, the entire amount of Rs.1,00,000 can not be charged against the revenue for the year 2005, because of the reason that the capital expenditure amounting to Rs.1,00,000 is expected to derive benefits (or revenue) for 10 years and not one year. Therefore, it is logical to charge only a part of the total cost say Rs.10,000 (one tenth of Rs. 1,00,000) against the revenue for the year 2005. This part represents, the expired cost or loss in the value of machine on account of its use or passage of time and is referred to as ‘Depreciation’. The amount of depreciation, being a charge against profit, is debited to the profit and loss account Depreciation may be described as a permanent, continuing and gradual shrinkage in the book value of fixed assets. It is based on the cost of assets consumed in a business and not on its market value.
According to Institute of Cost and Management Accounting, London (ICMA) terminology “ The depreciation is the diminution in intrinsic value of the asset due to use and/or lapse of time.” Accounting Standard-6 issued by The Institute of Chartered Accountants of India (ICAI) defines depreciation as “a measure of the wearing out, consumption or other loss of value of depreciable asset arising from use, effluxion of time or obsolescence through technology and market-change. Depreciation is allocated so as to charge fair proportion of depreciable amount in each accounting period during the expected useful life of the asset. Depreciation includes amortization of assets whose useful life is pre-determined”. Depreciation has a significant effect in determining and presenting the financial position and results of operations of an enterprise. Depreciation is charged in each accounting period by reference to the extent of the depreciable
amount. It should be noted that the subject matter of depreciation, or its base, are ‘depreciable’ assets which:
• “are expected to be used during more than one accounting period;
• have a limited useful life; and
• are held by an enterprise for use in production or supply of goods and
services, for rental to others, or for administrative purposes and not for the purpose of sale in the ordinary course of business.” Examples of depreciable assets are machines, plants, furnitures, buildings, computers, trucks, vans, equipments, etc. Moreover, depreciation is the
allocation of ‘depreciable amount’, which is the “historical cost”, or other amount substituted for historical cost less estimated salvage value. Another point in the allocation of depreciable amount is the ‘expected useful life’ of an asset. It has been described as “either
(i) the period over which a depreciable asset is expected to the used by the enterprise,
(ii) the number of production of similar units expected to be obtained from the use of the
asset by the enterprise.”
Diminishing balance method
Under this method, depreciation is charged on the book value of the asset. Since book value keeps on reducing by the annual charge of depreciation, it is also known as reducing balance method. This method involves the application of a pre-determined proportion/percentage of the book value of the asset at the beginning of every accounting period, so as to calculate the amount of depreciation. The amount of depreciation reduces year after year. For example, the original cost of the asset is Rs. 2,00,000 and depreciation is charged @ 10% p.a. at written down value, then the amount of depreciation will be computed as follows:
As evident from the example, the amount of depreciation goes on reducing year after year. For this reason, it is also known reducing installment or diminishing value method. This method is based upon the assumption that the benefit accruing to business from assets keeps on diminishing as the asset becomes old This is due to the reason that a predetermined percentage is applied to a gradually shrinking balance on the asset account every year. Thus, large amount is recovered depreciation charge in the earlier years than in later years. Under written down value method, the rate of depreciation is computed by using the following formula
Advantages of Written Down Value Method
Written down value method has the following advantages:
• This method is based on a more realistic assumption that the benefits from asset go on diminishing with the passage of time. Hence, it calls for proper allocation of cost because higher depreciation is charged in earlier years when asset’s utility is more as compared to later years when it becomes less useful;
• It results into almost equal burden on profit or loss account of depreciation and repair expenses taken together every year;
• Income Tax Act accept this method for tax purposes;
• As a large portion of cost is written-off in earlier years, loss due to obsolescence gets reduced;
• This method is suitable for fixed assets, which lasts for long and which require increased repair and maintenance expenses with passage of time.
• It can also be used where obsolescence rate is high.
Limitations of Written Down Value Method
Although this method is based upon a more realistic assumption it suffers from the following limitations.
• As depreciation is calculated at fixed percentage of written down value, depreciable cost of the asset cannot be fully written-off. The value of the asset can never be zero;
• It is difficult to ascertain a suitable rate of depreciation.
Straight Line Method and Written Down Method: A Comparative Analysis
Straight line and written down value methods are generally used for calculating depreciation amount in practice. Following are the points of differences between these two methods.
Basis of Charging Depreciation
In straight line method, depreciation is charged on the basis of original cost or (historical cost). Whereas in written down value method, the basis of charging depreciation is net book value (i.e., original cost less depreciation till date) of the asset, in the beginning of the year.
Annual Charge of Depreciation
The annual amount of depreciation charged every year remains fixed or constant under straight line method. Whereas in written down value method the annual amount of depreciation is highest in the first year and subsequently declines in later years. The reason for this difference, is the difference in the basis of charging depreciation under both methods. Under straight line method depreciation is calculated on original cost while under written down value method it is calculated on written down value.
Total Charge Against Profit and Loss Account on Account of Depreciation and Repair Expenses
It is a well-accepted phenomenon that repair and maintenance expenses increase in later years of the useful life of the asset. Hence, total charge against profit and loss account in respect of depreciation and repair expenses increases in later years under straight line method. This happens because annual depreciation charge remains fixed while repair expenses increase. On the other hand, under written down value method, depreciation charge declines in later years, therefore total of depreciation and repair charge remains similar or equal year after year. Recognition by Income Tax Law
Straight line method is not recognised by Income Tax Law while written down value method is recognised by the Income Tax Law.
Suitability
Straight line method is suitable for assets in which repair charges are less,the possibility of obsolescence is less and scrap value depends upon the time period involved. Such as freehold land and buildings, patents, trade marks, etc. Written down value method is suitable for assets, which are affected by technological changes and require more repair expenses with passage of time such as plant and machinery, vehicles, etc.
Explain Final Accounts with its differences with other accounts?
Final Accounts Preparation of final account is the last stage of the accounting cycle. The basic objective of every concern maintaining the book of accounts is to find out the profit or loss in their business at the end of the year. Every businessman wishes to ascertain the financial position of his business firm as a whole during the particular period. In order to achieve the objectives for the firm, it is essential to prepare final accounts which include Manufacturing and Trading, Profit and Loss Account and Balance Sheet. The determination of profit or loss is done by preparing a Trading, Profit and Loss Account. The purpose of preparing the Balance Sheet is to know the financial soundness of a concern as a whole during the particular period.
Purpose Of Preparing
1. Determine Gross Profit and Gross loss
2. Determine Net Profit and Net Loss
3. Comparison with the Previous year's profit.
4. Details of Indirect Expenses
5. Ascertaining Financial Position.
The following procedure and important points to be considered for preparation of Trading, Profit and Loss Account and Balance Sheet.
Trading, Profit and Loss Account
Trading Account and Profit and Loss Account are the two important parts of income statements. Trading Account is the first stage in the final account which is prepared to know the trading results of gross profit or loss during a particular period. In other words, it is a summary of the purchases, and sale of a business or production cost of goods sold and the value of sales. The difference between the elements establishes the gross profit or loss which is then carried forward to the profit or loss account for calculation of net profit or net loss. Accordingly, if the sales revenue is higher than the cost of goods sold the difference is known as 'Gross Profit,' Similarly, if the sales revenue is less than the cost of goods sold the difference is known as 'Gross Loss.'
PROFIT AND LOSS ACCOUNT
The determination of Gross Profit or Gross Loss is done by preparation of Trading Account. But it does not reveal the Net Profit or Net Loss of a concern during the particular period. This is the second part of the income statement and is called as Profit and Loss Account. The purpose of preparing the profit and loss account to calculate the Net Profit or Net Loss of a concern. Net profit refers to the surplus which remains after deducting related trading expenses from the Gross Profit. The trading expenses refer to inclusive of office and administrative expenses, selling and distribution expenses. In other words, all operating expenses such as office and administrative expenses, selling and distribution expenses and nonoperating expenses are shown on the debit side and all operating and non operating gains and incomes are shown on the credit side of the Profit and Loss Account. The difference of two sides is either Net Profit or Net Loss. Accordingly, when total of all operating and non-operating expenses is more than the Gross Profit and other non-operating incomes, the difference is the Net Profit and in the reverse case it is known as Net Loss. This Net Profit or Net Loss is transferred to the Capital Account of Balance Sheet. Specimen Proforma of a Profit and Loss Account The following Specimen Proforma which is used for preparation of Trading, Profit and Loss Account.
BALANCE SHEET
According to AICPC (The American Institute of Certified Public Accountants) defines Balance Sheet as a tabular Statement of Summary of Balances (Debit and Credits) carried forward after an actual and constructive closing of books of accounts and kept according to principles of accounting. The purpose of preparing balance sheet is to know the true and fair view of the status of the business as a going concern during a particular period. The balance sheet is on~ of the important statement which is used to owners or investors to measure the financial soundness of the concern as a whole. A statement is prepared to show the list of liabilities and capital of credit balances of the business on the left hand side and list of assets and other debit balances are recorded on the right hand side is known as "Balance Sheet." The Balance Sheet is also described as a statement showing the sources of funds and application of capital or funds. In other words, liability side shows the sources from where the funds for the business were obtained and the assets side shows how the funds or capital were utilized in the business. Accordingly, it describes that all the assets owned by the concern and all the liabilities and claims it owes to owners and outsiders. Specimen Form of Balance Sheet Companies Act 1956 has prescribed a particular form for showing assets and liabilities in the Balance Sheet for companies registered under this Act. There is no prescribed form of Balance Sheet for a sole trader and partnership firm. However, the assets and liabilities can be arranged in the Balance Sheet into (a) In the Order of Liquidity (b) In the Order of Performance (a) In the Order of Liquidity: When assets and liabilities are arranged according to their order of liquidity and ability to meet its short-term obligations, such an arrangement of order is called "Liquidity Order."
The Specimen form of Balance Sheet arranged in the Order of Liquidity is given below:
Format
This statement can be reported in two different formats: account form and report form. The account form consists of two columns displaying assets on the left column of the report and liabilities and equity on the right column. You can think of this like debits and credits. The debit accounts are displayed on the left and credit accounts are on the right.
The report form, on the other hand, only has one column. This form is more of a traditional report that is issued by companies. Assets are always present first followed by liabilities and equity.
In both formats, assets are categorized into current and long-term assets. Current assets consist of resources that will be used in the current year, while long-term assets are resources lasting longer than one year.
Liabilities are also separated into current and long-term categories.
Let's look at each of the balance sheet accounts and how they are reported.
Asset Section
Similar to the accounting equation, assets are always listed first. The asset section is organized from current to non-current and broken down into two or three subcategories. This structure helps investors and creditors see what assets the company is investing in, being sold, and remain unchanged. It also helps with financial ratio analysis. Ratios like the current ratio are used to identify how leveraged a company is based on its current resources and current obligations.
The first subcategory lists the current assets in order of their liquidity. Here’s a list of the most common accounts in the current section:
• Current
• Cash
• Accounts Receivable
• Prepaid Expenses
• Inventory
• Due from Affiliates
The second subcategory lists the long-term assets. This section is slightly different than the current section because many long-term assets are depreciated over time. Thus, the assets are typically listed with a total accumulated depreciation amount subtracted from them. Here’s a list of the most common long-term accounts in this section:
• Long-term
• Equipment
• Leasehold Improvements
• Buildings
• Vehicles
• Long-term Notes Receivable
Many times there will be a third subcategory for investments, intangible assets, and or property that doesn’t fit into the first two. Here are some examples of these balance sheet items:
• Other
• Investments
• Goodwill
• Trademarks
• Mineral Rights
According to the historical cost principle, all assets, with the exception of some intangible assets, are reported on the balance sheet at their purchase price. In other words, they are listed on the report for the same amount of money the company paid for them. This typically creates a discrepancy between what is listed on the report and the true fair market value of the resources. For instance, a building that was purchased in 1975 for $20,000 could be worth $1,000,000 today, but it will only be listed for $20,000. This is consistent with the balance sheet definition that states the report should record actual events rather than speculative numbers.
Liabilities Section
Liabilities are also reported in multiple subcategories. There are typically two or three different liability subcategories in the liabilities section: current, long-term, and owner debt.
The current liabilities section is always reported first and includes debt and other obligations that will become due in the current period. This usually includes trade debt and short-term loans, but it can also include the portion of long-term loans that are due in the current period. The current debts are always listed by due dates starting with accounts payable. Here’s a list of the most common current liabilities in order of how they appear:
• Current Liabilities
• Accounts Payable
• Accrued Expenses
• Unearned Revenue
• Lines of Credit
• Current Portion of Long-term Debt
The second liabilities section lists the obligations that will become due in more than one year. Often times all of the long-term debt is simply grouped into one general listing, but it can be listed in detail. Here are some examples:
• Long-term Liabilities
• Mortgage Payable
• Notes Payable
• Loans Payable
A lot of times owners loan money to their companies instead of taking out a traditional bank loan. Investors and creditors want to see this type of debt differentiated from traditional debt that’s owed to third parties, so a third section is often added for owner’s debt. This simply lists the amount due to shareholders or officers of the company.
Equity Section
Unlike the asset and liability sections, the equity section changes depending on the type of entity. For example, corporations list the common stock, preferred stock, retained earnings, and treasury stock. Partnerships list the members’ capital and sole proprietorships list the owner’s capital.
Like all financial statements, the balance sheet has a heading that display's the company name, title of the statement and the time period of the report. For example, an annual income statement issued by Paul's Guitar Shop, Inc. would have the following heading:
• Paul's Guitar Shop, Inc.
• Balance Sheet
• December 31, 2015
Example
Here is an example of how to prepare the balance sheet from our unadjusted trial balance and financial statements used in the accounting cycle examples for Paul's Guitar Shop.
Account Format Balance Sheet
Report Format Balance Sheet
As you can see, the report format is a little bit easier to read and understand. That is why most issued reports are presented in report form. Plus, this report form fits better on a standard sized piece of paper.
One thing to note is that just like in the accounting equation, total assets equals total liabilities and equity. This is always the case. If you are preparing a balance sheet for one of your accounting homework problems and it doesn't balance, something was input incorrectly. You'll have to go back through the trial balance and T-accounts to find the error.
Now that the balance sheet is prepared and the beginning and ending cash balances are calculated, the statement of cash flows can be prepared.
Analysis
Now that you can answer the question what is a balance sheet. Let's look at how to read a balance sheet. Investors, creditors, and internal management use the balance sheet to evaluate how the company is growing, financing its operations, and distributing to its owners. A single sheet won’t tell you that much about the company, but a comparative report that shows two to three years of trend will tell you how cash is being spent, the amount of debt being paid off, and the level of investments being made each year. It will also show the if the company is funding its operations with profits or debt.
Cash Flow Statement
Cash plays a very important role in the economic life of a business. A firm needs cash to make payment to its suppliers, to incur day-to-day expenses and to pay salaries, wages, interest and dividends etc. In fact, what blood is to a human body, cash is to a business enterprise. Thus, it is very essential for a business to maintain an adequate balance of cash. For example, a concern operates profitably but it does not have sufficient cash balance to pay dividends, what message does it convey to the shareholders and public in general. Thus, management of cash is very essential. There should be focus on movement of cash and its equivalents. Cash means, cash in hand and demand deposits with the bank. Cash equivalent consists of bank overdraft, cash credit, short term deposits and marketable securities. Cash Flow Statement deals with flow of cash which includes cash equivalents as well as cash. This statement is an additional information to the users of Financial Statements. The statement shows the incoming and outgoing of cash. The statement assesses the capability of the enterprise to generate cash and utilize it. Thus a Cash-Flow statement may be defined as a summary of receipts and disbursements of cash for a particular period of time. It also explains reasons for the changes in cash position of the firm. Cash flows are cash inflows and outflows. Transactions which increase the cash position of the entity are called as inflows of cash and those which decrease the cash position as outflows of cash. Cash flow Statement traces the various sources which bring in cash such as cash from operating activities, sale of current and fixed assets, issue of share capital and debentures etc. and applications which cause outflow of cash such as loss from operations, purchase of current and fixed assets, redemption of debentures, preference shares and other long-term debt for cash. In short, a cash flow statement shows the cash receipts and disbursements during a certain period.The purpose of the cash flow statement or statement of cash flows is to provide information about a company's gross receipts and gross payments for a specified period of time.The gross receipts and gross payments will be reported in the cash flow statement according to one of the following classifications: operating activities, investing activities, and financing activities. The net change from these three classifications should equal the change in a company's cash and cash equivalents during the reporting period. For instance, the cash flow statement for the calendar year 2013 will report the causes of the change in a company's cash and cash equivalents between its balance sheets of December 31, 2012 and December 31, 2013.In addition to the cash amounts being reported as operating, investing, and financing activities, the cash flow statement must disclose other information, including the amount of interest paid, the amount of income taxes paid, and any significant investing and financing activities which did not require the use of cash.The statement of cash flows is to be distributed along with a company's income statement and balance sheet.
The statement of cash flow serves a number of objectives which are as follows :
l Cash flow statement aims at highlighting the cash generated from operating activities.
2 Cash flow statement helps in planning the repayment of loan schedule and replacement of fixed assets, etc. l Cash is the centre of all financial decisions. It is used as the basis for the projection of future investing and financing plans of the enterprise.
3 Cash flow statement helps to ascertain the liquid position of the firm in a better manner. Banks and financial institutions mostly prefer cash flow statement to analyse liquidity of the borrowing firm.
4,Cash flow Statement helps in efficient and effective management of cash.
5 The management generally looks into cash flow statements to understand the internally generated cash which is best utilised for payment of dividends
6 Cash Flow Statement based on AS-3 (revised) presents separately cash generated and used in operating, investing and financing activities.
7 It is very useful in the evaluation of cash position of a firm
Cash flow statements – benefits
Cash flow information provided in the statement of cash flows can be beneficial, for example:
• Cash flow information is harder to manipulate as it just reflects cash in and cash out, it isn’t affected by accounting policies or accruals.
• The statement of cash flows provides information about all cash inflows and outflows, from all sources.
• Cash flow information can provide more detail about the quality of the entity’s revenue, for example, whether customers are (in general) paying their bills.
• Cash accounting methods used in the statement of cash flows can be easier for non-accountants to understand.
Cash flow statements – limitations
We’ve looked at all the benefits of a statement of cash flows, but there are limitations and drawbacks.
One of the major drawbacks is how information can be manipulated in the statement of cash flows:
• Management can delay paying suppliers to increase the net cash inflows
• Management can buy goods using leasing arrangements, to avoid paying cash
Cash flows also don’t reflect the earnings of the entity, although a company should be cash positive to trade in the short term, if it is doing this at the expense of sales, or is lossmaking, it may eventually cease trading.
None of the individual financial statements on their own show a full view of the entity’s performance.
Users of the financial statements should consider all parts of the financial statements together, and also other non-financial information about the company to assess its performance.
Cash and relevant terms as per AS-3 (revised) As per AS-3 (revised) issued by the Accounting Standards Board 1.
(a) Cash fund : Cash Fund includes
(i) Cash in hand
(ii) Demand deposits with banks, and (iii) cash equivalents.
(b) Cash equivalents are short-term, highly liquid investments, readily convertible into cash and which are subject to insignificant risk of changes in values.
2. Cash Flows are inflows and outflows of cash and cash equivalents. The statement of cash flow shows three main categories of cash inflows and cash outflows, namely : operating, investing and financing activities.
(a) Operating activities are the principal revenue generating activities of the enterprise.
(b) Investing activities include the acquisition and disposal of longterm assets and other investments not included in cash equivalents.
(c) Financing activities are activities that result in change in the size and composition of the owner’s capital (including Preference share capital in the case of a company) and borrowings of the FIRM.
PREPARATION OF CASH FLOW STATEMENT
Step -I
(i) Operating Activities Cash flow from operating activities are primarily derived from the principal revenue generating activities of the enterprise. A few items of cash flows from operating activities are (i) Cash receipt from the sale of goods and rendering services.
(ii) Cash receipts from royalties, fee, Commissions and other revenue.
(iii) Cash payments to suppliers for goods and services.
(iv) Cash payment to employees
(v) Cash payment or refund of Income tax.
Determination of cash flow from operating activities There are two stages for arriving at the cash flow from operating activities
Stage-1 Calculation of operating profit before working capital changes, It can be calculated in the following manner.
Net profit before Tax and extra ordinary Items
Add Non-cash and non operating Items which have already been debited to profit and Loss Account i.e. Depreciation xxx
Amortisation of intangible assets xxx
Loss on the sale of Fixed assets. xxx
Loss on the sale of Long term Investments xxx
Provision for tax xxx
Dividend paid xxx xxx xxx
Less : Non-cash and Non-operating Items which have already been credited to Profit and Loss Account i.e.
Profit on sale of fixed assets xxx
Profit on sale of Long term investment xxx xxx
Operating profit before working Capital changes. xxx
Stage-II
After getting operating profit before working capital changes as per stage I, adjust increase or decrease in the current assets and current liabilities. The following general rules may be applied at the time of adjusting current assets and current liabilities.
A. Current assets
(i) An increase in an item of current assets causes a decrease in cash inflow because cash is blocked in current assets
(ii) A decrease in an item of current assets causes an increase in cash inflow because cash is released from the sale of current assets.
B. Current liabilities
(i) An increase in an item of current liability causes a decrease in cash outflow because cash is saved. (ii) A decrease in an item of current liability causes increase in cash out flow because of payment of liability. Thus,
Cash from operations = operating profit before working capital changes + Net decrease in current assets + Net Increase in current liabilities – Net increase in current assets – Net decrease in current liabilities
Step - II - Investing Activities
Investing Activities refer to transactions that affect the purchase and sale of fixed or long term assets and investments. Examples of cash flow arising from Investing activities are
1. Cash payments to acquire fixed Assets
2. Cash receipts from disposal of fixed assets
3. Cash payments to acquire shares, or debenture investment.
4. Cash receipts from the repayment of advances and loans made to third parties. Thus, Cash inflow from investing activities are
– Cash sale of plant and machinery, land and Building, furniture, goodwill etc.
– Cash sale of investments made in the shares and debentures of other companies
– Cash receipts from collecting the Principal amount of loans made to third parties.
Cash outflow from investing activities are :
– Purchase of fixed assets i.e. land, Building, furniture, machinery etc.
– Purchase of Intangible assets i.e. goodwill, trade mark etc.
– Purchase of shares and debentures
– Purchase of Government Bonds
– Loan made to third parties
Step- III - Financing Activities
The third section of the cash flow statement reports the cash paid and received from activities with non-current or long term liabilities and shareholders Capital. Examples of cash flow arising from financing activities are
– Cash proceeds from issue of shares or other similar instruments.
– Cash proceeds from issue of debentures, loans, notes, bonds, and other short-term borrowings
– Cash repayment of amount borrowed Cash Inflow from financing activities are
- Issue of Equity and preference share capital for cash only.
– Issue of Debentures, Bonds and long-term note for cash only
Cash outflow from financing activities are :
– Payment of dividends to shareholders
– Redemption or repayment of loans i.e. debentures and bonds
– Redemption of preference share capital
– Buy back of equity shares.
TREATMENT OF SPECIAL ITEMS
(i) Payment of Interim Dividends The following procedure is followed
(i) The amount of interim dividend paid during the year is shown as outflow of cash in cash flow statement.
(ii) It will be added back to the profits for the purpose of calculating cash provided from operating activities.
(iii) No adjustment is necessary if the cash provided from operating activities is calculated on the basis of revised figure of net profit
(ii) Proposed dividend The dividend is always declared in the general meeting after the preparation of Balance Sheet. It is therefore, a non-operating item which should not be permitted to affect the calculation of cash generated by operating activities. Thus, the amount of proposed dividends would be added back to current years profit and payments made during the year in respect of dividends would be shown as an outflow of cash.
(iii) Share Capital The increase in share capital is regarded as inflow of cash only when there is a increase in share capital. For example, if a company issues 10000 equity shares of Rs.10 each for cash only, Rs. 100,000 would be shown as inflow of cash from financing activities. Similarly, the redemption of preference share is an outflow of cash. But where the share capital is issued to finance the purchase of fixed assets or the debentures are converted into equity shares there is no cash flow. Further, the issue of bonus shares does not cause any cash flows.
(iv) Purchase or sale of fixed Assets The figures appearing in the comparative balance sheets at two dates in respect of fixed assets might indicate whether a particular fixed asset has been purchased or sold during the year. This would enable to determine the inflows or outflows of cash. For example, If the plant and machinery appears at Rs 60,000 in the current year and Rs.50,000 in the previous year, the only conclusion, in the absence of any other information is that there is a purchase of fixed assets for Rs.10000 during the year. Hence, Rs.10000 would be shown as outflow of cash.
(v) Provision for Taxation It is a non-operating expenses or an item of appropriation in the Income statement/Profit and Loss Account and therefore should not be allowed to reduce the cash provided from operating activities. Hence, if the profit is given after tax and the amount of the provision for tax made during the year is given, the same would be added back to the current year profit figure. In the cash flow statement, the tax paid would be recorded separately as an outflow of cash. The item of provision for taxation, would not be treated as current assets. Sometimes, the only information available about provision for taxation is two figures appearing in the opening balance sheet and closing balance sheet. In such a case the figure in the opening balance sheet is treated as an outflow of cash while the figure in the closing balance sheet is treated as a non-cash and non-operating expense and thus is added back to net Income figure to find out the cash provided from operating activities.
Funds Flow Statement
Meaning of Funds Flow Statement:
Funds flow statement is a statement which discloses the analytical information about the different sources of a fund and the application of the same in an accounting cycle. It deals with the transactions which change either the amount of current assets and current liabilities (in the form of decrease or increase in working capital) or fixed assets, long-term loans including ownership fund.
It gives a clear picture about the movement of funds between the opening and closing dates of the Balance Sheet. It is also called the Statement of Sources and Applications of Funds, Movement of Funds Statement; Where Got—Where Gone Statement: Inflow and Outflow of Fund Statement, etc. No doubt, Funds Flow Statement is an important indicator of financial analysis and control. It is valuable and also helps to determine how the funds are financed. The financial analyst can evaluate the future flows of a firm on the basis of past data.
This statement supplies an efficient method for the financial manager in order to assess the:
(a) Growth of the firm,
(b) Its resulting financial needs, and
(c) To determine the best way to finance those needs.
In particular, funds flow statements are very useful in planning intermediate and long-term financing.
Objective of Preparing a Fund Flow Statement:
The main purpose of preparing a Funds Flow Statement is that it reveals clearly the important items relating to sources and applications of funds of fixed assets, long-term loans including capital. It also informs how far the assets derived from normal activities of business are being utilized properly with adequate consideration.
Secondly, it also reveals how much out of the total funds is being collected by disposing of fixed assets, how much from issuing shares or debentures, how much from long-term or short-term loans, and how much from normal operational activities of the business.
Thirdly, it also provides the information about the specific utilization of such funds, i.e. how much has been applied for acquiring fixed assets, how much for repayment of long-term or short-term loans as well as for payment of tax and dividend etc.
Lastly, it helps the management to prepare budgets and formulate the policies that will be adopted for future operational activities.
Significance and Importance of Funds Flow Statement:
Since traditional reports (i.e. Income Statement/Profit and Loss Account, and Balance Sheet) are not very informative, a financial analyst has to depend on some other report—Funds Flow Statement. In other words, along with the traditional sources of information, some other sources of information are absolutely required in order to take the challenge offered by modern business.
Funds Flow Statement, no doubt, caters to the needs of management. This is because a Funds Flow Statement not only presents the Balance Sheet values for consecutive two years, it also ascertains the changes of working capital—which is a very important indicator.
It not only reveals the source from which additional working capital has been financed but also, at the same time, the use of such funds. Moreover, from a projected funds flow statement the management can easily ascertain the adequacy or inadequacy of working capital, i.e., it helps in decision-making in a number of ways.
The significance and importance of Funds Flow Statements may be summarized as:
(a) Analysis of Financial Statement:
The traditional financial statements, viz. Profit and Loss Account and Balance Sheet, exhibit the result of the operation and financial position of a firm. Balance Sheet presents a static view about the resources and how the said resources have been utilized at a particular date with recording the changes in financial activities. But Funds Flow Statement can do so, i.e., it explains the causes of changes so made and effect of such change in the firm accordingly.
(b) Highlighting Answers to Various Perplexing Questions:
Funds Flow Statement highlights answers of the following questions:
(i) Causes of changes in Working Capital;
(ii) Whether the firm sells any Non-Current Asset; if sold, how were the proceeds utilized?
(iii) Why smaller amount of dividend is paid in spite of sufficient profit?
(iv) Where did the net profit go?
(v) Was it possible to pay more dividend than the present one?
(vi) Did the firm pay-off its scheduled debts? If so, how, and from what sources?
(vii) Sources of increased Working Capital, etc.
(c) Realistic Dividend Policy:
Sometimes it may so happen that a firm, instead of having sufficient profit, cannot pay dividend due to lack of liquid sources, viz. cash. In such a circumstance, Funds Flow Statement helps the firm to take decision about a sound dividend policy which is very helpful to the management.
(d) Proper Allocation of Resources:
Resources are always limited. So, it is the duty of the management to make its proper use. A projected Funds Flow Statement helps the management to take proper decision about the proper allocation of business resources in a best possible manner since it highlights the future.
(e) As a Future Guide:
A projected Funds Flow Statement acts as a business guide. It helps the management to make provision for the future for the necessary funds to be required on the basis of the problem faced. In other words, the future needs of the fund for various purposes can be known well in advance which is a very helpful guide to the management. In short, a firm may arrange funds on the basis of this statement in order to avoid the financial problem that may arise in future.
(f) Appraising of the Working Capital:
A projected Funds Flow Statement, no doubt, helps the management to know about how the working capital has been efficiently used and, at the same time, also suggests how to improve the working capital position for the future on the basis of the present problem faced by it, if any.
Preparing Funds Flow Statement: Steps, Rules and Format
Steps for Preparing Funds Flow Statement:
The steps involved in preparing the statement are as follows:
1. Determine the change (increase or decrease) in working capital.
2. Determine the adjustments account to be made to net income.
3. For each non-current account on the balance sheet, establish the increase or decrease in that account. Analyze the change to decide whether it is a source (increase) or use (decrease) of working capital.
4. Be sure the total of all sources including those from operations minus the total of all uses equals the change found in working capital in Step 1.
General Rules for Preparing Funds Flow Statement:
The following general rules should be observed while preparing funds flow statement:
1. Increase in a current asset means increase (plus) in working capital.
2. Decrease in a current asset means decrease (minus) in working capital.
3. Increase in a current liability means decrease (minus) in working capital.
4. Decrease in a current liability means increase (plus) in working capital.
5. Increase in current asset and increase in current liability does not affect working capital.
6. Decrease in current asset and decrease in current liability does not affect working capital.
7. Changes in fixed (non-current) assets and fixed (non-current) liabilities affects working capital.
Format of Funds Flow Statement:
A funds flow statement can be prepared in statement form or ‘T’ form.
Both the formats are given below:
Schedule of Changes in Working Capital:
Many business enterprises prefer to prepare another statement, known as schedule of changes in working capital, while preparing a funds flow statement, on a working capital basis. This schedule of changes in working capital provides information concerning the changes in each individual current assets and current liabilities accounts (items).
This schedule is a part of the funds flow statement and increase (decrease) in working capital indicated by the schedule of changes in working capital will be equal to the amount of changes in working capital as found by funds flow statement. The schedule of changes in working capital can be prepared by comparing the current assets and current liabilities at two periods.
The format of schedule of changes in working capital is as follows:
Bank Reconciliation
Have you ever balanced your checkbook? Why did you do that? Was it to make sure that you didn't make any mistakes when you were adding deposits or subtracting expenses? I bet it was because you wanted to make sure that your balance in your checkbook was the same as the balance in the bank, right? Everything that we just talked about refers to what we in accounting commonly call doing a bank reconciliation. A bank reconciliation is the balancing of a company's cash account balance to its bank account balance.
Need for Reconciliation
It is generally experienced that when a comparison is made between the bank balance as shown in the firm’s cash book, the two balances do not tally.Hence, we have to first ascertain the causes of difference thereof and then reflect them in a statement called Bank Reconciliation Statement to reconcile (tally) the two balances. In order to prepare a bank reconciliation statement we need to have a bank balance as per the cash book and a bank statement as on a particular day along with details of both the books. If the two balances differ, the entries in both the books are compared and the items on account of which the difference has arisen are ascertained with the respective amounts involved so
that the bank reconciliation statement may be prepared..
Reconciliation of the cash book and the bank passbook balances amounts to an explanation of differences between them. The differences between the cash book and the bank passbook is caused by:
1. timing differences on recording of the transactions
2. errors made by the business or by the bank.
Timing Differences
When a business compares the balance of its cash book with the balance shown by the bank passbook, there is often a difference, which is caused by the time gap in recording the transactions relating either to payments or receipts. The factors affecting time gap includes :
1(a) Cheques issued by the bank but not yet presented for payment
When cheques are issued by the firm to suppliers or creditors of the firm, these are immediately entered on the credit side of the cash book. However, the receiving party may not present the cheque to the bank for payment immediately. The bank will debit the firm’s account only when these cheques are actually paid by the bank. Hence, there is a time lag between the issue of a cheque and its presentation to the bank which may cause the difference between the two balances.
1(b) Cheques paid into the bank but not yet collected
When firm receives cheques from its customers (debtors), they are immediately recorded in the debit side of the cash book. This increases the bank balance as per the cash book. However, the bank credits the customer account only when the amount of cheques are actually realised. The clearing of cheques generally takes few days especially in case of outstation cheques or when the cheques are paid-in at a bank branch other than the one at which the account of the firm is maintained. This leads to a cause of difference between the bank balance shown by the cash book and the balance shown by the bank passbook.
1(c) Direct debits made by the bank on behalf of the customer
Sometimes, the bank deducts amount for various services from the account without the firm’s knowledge. The firm comes to know about it only when the bank statement arrives. Examples of such deductions include: cheque collection charges, incidental charges, interest on overdraft, unpaid cheques deducted by the bank – i.e. stopped or bounced, etc. As a result, the balance as per passbook will be less than the balance as per cash book.
1(d) Amounts directly deposited in the bank account
There are instances when debtors(customers) directly deposits money into firm’s bank account. But, the firm does not receive the intimation from any source till it receives the bank statement. In this case, the bank records the receipts in the firm’s account at the bank but the same is not recorded in the firm’s cash book. As a result, the balance shown in the bank passbook will be more than the balance shown in the firm’s cash book.
1(e) Interest and dividends collected by the bank
When the bank collects interest and dividend on behalf of the customer, then these are immediately credited to the customers account. But the firm will know about these transactions and record the same in the cash book only when it receives a bank statement. Till then the balances as per the cash book and passbook will differ.
1(f) Direct payments made by the bank on behalf of the customers
Sometimes the customers give standing instructions to the bank to make some payment regularly on stated days to the third parties. For example, telephone bills, insurance premium, rent, taxes, etc. are directly paid by the bank on behalf of the customer and debited to the account. As a result, the balance as per the bank passbook would be less than the one shown in the cash book.
1(g) Cheques deposited/bills discounted dishonoured
If a cheque deposited by the firm is dishonoured or a bill of exchange drawn by the business firm is discounted with the bank is dishonoured on the date of maturity, the same is debited to customer’s account by the bank. As this information is not available to the firm immediately, there will be no entry in the firm’s cash book regarding the above items. This will be known to the firm when it receives a statement from the bank. As a result, the balance as per the passbook would be less than the cash book balance.
Differences Caused by Errors
Sometimes the difference between the two balances may be accounted for by an error on the part of the bank or an error in the cash book of the business. This causes difference between the bank balance shown by the cash book and the balance shown by the bank statement.
2(a) Errors committed in recording transaction by the firm
Omission or wrong recording of transactions relating to cheques issued, cheques deposited and wrong totalling, etc. committed by the firm while recording entries in the cash book cause difference between cash book and passbook balance.
2(b) Errors committed in recording transactions by the bank
Omission or wrong recording of transactions relating to cheques deposited and wrong totalling, etc. committed by the bank while posting entries in the passbook also cause differences between passbook and cash book balance.
Preparation of Bank Reconciliation Statement without adjusting Cash Book Balance
To prepare bank reconciliation statement, under this approach, the balance as per cash book or as per passbook is the starting item. The debit balance as per the cash book means the balance of deposits held at the bank. Such a balance will be a credit balance as per the passbook. Such a balance exists when the deposits made by the firm are more than its withdrawals. It indicates the favourable balance as per cash book or favourable balance as per the passbook. On the other hand, the credit balance as per the cash book indicates bank overdraft. In other words, the excess amount withdrawn over the amount deposited in the bank. It is also known as unfavourable balance as per cash book or unfavourable balance as per passbook.
We may have four different situations while preparing the bank reconciliation statement. These are :
1. When debit balance (favourable balance) as per cash book is given and the balance as per passbook is to be ascertained.
2. When credit balance (favourable balance) as per passbook is given and the balance as per cash book is to be ascertained.
3. When credit balance as per cash book (unfavourable balance/overdraft balance) is given and the balance as per passbook is to ascertained.
4. When debit balance as per passbook (unfavourable balance/overdraft balance) is given and the cash book balance as per is to ascertained.
.1(a) Dealing with favourable balances
The following steps may be initiated to prepare the bank reconciliation statement:
(i) The date on which the statement is prepared is written at the top, as part of the heading.
(ii) The first item in the statement is generally the balance as shown by the cash book. Alternatively, the starting point can also be the balance as per passbook.
(iii) The cheques deposited but not yet collected are deducted.
(iv) All the cheques issued but not yet presented for payment, amounts directly deposited in the bank account are added.
(v) All the items of charges such as interest on overdraft, payment by bank on standing instructions and debited by the bank in the passbook but not entered in cash book, bills and cheques dishonoured etc. are deducted.
(vi) All the credits given by the bank such as interest on dividends collected, etc. and direct deposits in the bank are added.
(vii) Adjustment for errors are made according to the principles of rectification of errors.
(viii) Now the net balance shown by the statement should be same as shown by the passbook.
It may be noted that treatment of all items shall be the reverse of the above if we adjust passbook balance as the starting point.
1(b) Dealing with overdrafts
So far we have dealt with bank reconciliation statement where bank balances has been positive – i.e., there has been money in the bank account. However, businesses sometimes have overdrafts at the bank. Overdrafts are where the bank account becomes negative and the businesses in effect have borrowed from the bank. This is shown in the cash book as a credit balance. In the bank statement, where the balance is followed by Dr. (or sometimes OD) means that there is an overdraft and called debit balance as per passbook.
An overdraft is treated as negative figure on a bank reconciliation statement.
Preparation of Bank Reconciliation Statement with Adjusted Cash Book
When we look at the various items that normally cause the difference between the passbook balance and the cash book balance, we find a number of items, which appear only in the passbook. Why not first record such items in the cash book to work out the adjusted balance (also known as amended balance) of the cash book and then prepare the bank reconciliation statement. This shall reduce the number of items responsible for the difference and have the correct figure of balance at bank in the balance sheet. In fact, this is exactly what is done in practice whereby only those items which cause the difference on account of the time gap in recording appear in bank reconciliation statement. These are as (i) cheques issued but not yet presented, (ii) cheques deposited but not yet collected, and (iii) due to an error in the passbook.
Ratio Analysis: Meaning, Classification and Limitation of Ratio Analysis!Meaning:
Ratio analysis is the process of determining and interpreting numerical relationships based on financial statements. A ratio is a statistical yardstick that provides a measure of the relationship between two variables or figures.
This relationship can be expressed as a percent or as a quotient. Ratios are simple to calculate and easy to understand. The persons interested in the analysis of financial statements can be grouped under three heads,
i) owners or investors
ii) creditors and
iii) financial executives.
Although all these three groups are interested in the financial conditions and operating results, of an enterprise, the primary information that each seeks to obtain from these statements differs materially, reflecting the purpose that the statement is to serve.
Investors desire primarily a basis for estimating earning capacity. Creditors are concerned primarily with liquidity and ability to pay interest and redeem loan within a specified period. Management is interested in evolving analytical tools that will measure costs, efficiency, liquidity and profitability with a view to make intelligent decisions.
Ratio analysis is useful in many ways to different concerned parties according to their respective requirements. Ratio analysis can be used in the following ways:
To know the financial strength and weakness of an organization.
To measure operative efficiency of a concern.
For the management to review past year’s activity.
To assess level of efficiency.
To predict the future plans of a business.
To optimize capital structure.
In inter and intra company comparisons.
To measure liquidity, solvency, profitability and managerial efficiency of a concern.
In proper utilization of assets of a company.
In budget preparation.
In assessing solvency of a firm, bankruptcy position of a firm, and chances of corporate sickness.
Classification of Ratios:Financial ratios can be classified under the following five groups:1) Structural
2) Liquidity
3) Profitability
4) Turnover
5) Miscellaneous.
1. Structural group:The following are the ratios in structural group:i) Funded debt to total capitalisation:The term ‘total’ capitalisation comprises loan term debt, capital stock and reserves and surplus. The ratio of funded debt to total capitalisation is computed by dividing funded debt by total capitalisation. It can also be expressed as percentage of the funded debt to total capitalisation. Long term loans
Total capitalisation (Share capital + Reserves and surplus + long term loans)
ii) Debt to equity:
Due care must be given to the; computation and interpretation of this ratio. The definition of debt takes two foremost. One includes the current liabilities while the other excludes them. Hence the ratio may be calculated under the following two methods:
Long term loans + short term credit + Total debt to equity = Current liabilities and provisions Equity share capital + reserves and surplus (or)
Long-term debt to equity =
Long – term debt / Equity share capital + Reserves and surplus
iii) Net fixed assets to funded debt:
This ratio acts as a supplementary measure to determine security for the lenders. A ratio of 2:1 would mean that for every rupee of long-term indebtedness, there is a book value of two rupees of net fixed assets:
Net Fixed assets funded debt
iv) Funded (long-term) debt to net working capital:The ratio is calculated by dividing the long-term debt by the amount of the net working capital. It helps in examining creditors’ contribution to the liquid assets of the firm.
Long term loans Net working capital
2. Liquidity group:
It contains current ratio and Acid test ratio.
i) Current ratio:It is computed by dividing current assets by current liabilities. This ratio is generally an acceptable measure of short-term solvency as it indicates the extent to which he claims of short term creditors are covered by assets that are likely to be converted into cash in a period corresponding to the maturity of the claims. Current assets / Current liabilities and provisions + short-term credit against inventory
ii) Acid-test ratio:It is also termed as quick ratio. It is determined by dividing “quick assets”, i.e., cash, marketable investments and sundry debtors, by current liabilities. This ratio is a bitterest of financial strength than the current ratio as it gives no consideration to inventory which may be very a low- moving.
3. Profitability Group:The results of business operations can be calculated through profitability ratios. These ratios can also be used to know the overall performance and effectiveness of a firm. Two types of profitability ratios are calculated in relation to sales and investments.
It has five ratio, and they are calculated as follows: 4. Turnover group:Activity ratios are also called turnover ratios. Activity ratios measure the efficiency with which the resources of a firm are employed.
It has four ratios, and they are calculated as follows: 5. Miscellaneous group:It contains four ratio and they are as follows: Standards for comparison:For making a proper use of ratios, it is essential to have fixed standards for comparison. A ratio by itself has very little meaning unless it is compared to some appropriate standard. Selection of proper standards of comparison is a most important element in ratio analysis. The four most common standards used in ratio analysis are; absolute, historical, horizontal and budgeted.
Absolute standards are those which become generally recognised as being desirable regardless of the company, the time, the stage of business cycle, or the objectives of the analyst. Historical standards involve comparing a company’s own’ past performance as a standard for the present or future.
In Horizontal standards, one company is compared with another or with the average of other companies of the same nature.
The budgeted standards are arrived at after preparing the budget for a period Ratios developed from actual performance are compared to the planned ratios in the budget in order to examine the degree of accomplishment of the anticipated targets of the firm.
Advantages of Ratio Analysis
• It is powerful tool to measure short and long-term solvency of a company.
• It is a tool to measure profitability and managerial efficiency of a company.
• It is an important tool to measure operating activities of a business.
• It helps in analyzing the capital structure of a company.
• Large quantitative data may be summarized using ratio analysis.
• It relates past accounting performances with the current.
• It is useful in coordinating the different functional machineries of a company.
• It helps the management in future decision-making.
• It helps in maintaining a reasonable balance between sales and purchase and estimating working capital requirements.
Limitations:
The following are the limitations of ratio analysis:1. It is always a challenging job to find an adequate standard. The conclusions drawn from the ratios can be no better than the standards against which they are compared.
2. When the two companies are of substantially different size, age and diversified products,, comparison between them will be more difficult.
3. A change in price level can seriously affect the validity of comparisons of ratios computed for different time periods and particularly in case of ratios whose numerator and denominator are expressed in different kinds of rupees.
4. Comparisons are also made difficult due to differences of the terms like gross profit, operating profit, net profit etc.
5. If companies resort to ‘window dressing’, outsiders cannot look into the facts and affect the validity of comparison.
6. Financial statements are based upon part performance and part events which can only be guides to the extent they can reasonably be considered as dues to the future.
7. Ratios do not provide a definite answer to financial problems. There is always the question of judgment as to what significance should be given to the figures. Thus, one must rely upon one’s own good sense in selecting and evaluating the ratios.
Marginal costs
Introduction
The costs that vary with a decision should only be included in decision analysis. For many decisions that involve relatively small variations from existing practice and/or are for relatively limited periods of time, fixed costs are not relevant to the decision. This is because either fixed costs tend to be impossible to alter in the short term or managers are reluctant to alter them in the short term.
Marginal costing - definition
Marginal costing distinguishes between fixed costs and variable costs as convention ally classified.
The marginal cost of a product –“ is its variable cost”. This is normally taken to be; direct labour, direct material, direct expenses and the variable part of overheads.
Marginal costing is formally defined as:
‘the accounting system in which variable costs are charged to cost units and the fixed costs of the period are written-off in full against the aggregate contribution. Its special value is in decision making’. (Terminology.)
The term ‘contribution’ mentioned in the formal definition is the term given to the difference between Sales and Marginal cost. Thus
MARGINAL COST = VARIABLE COST DIRECT LABOUR
+
DIRECT MATERIAL
+
DIRECT EXPENSE
+
VARIABLE OVERHEADS
CONTRIBUTION SALES - MARGINAL COST
The term marginal cost sometimes refers to the marginal cost per unit and sometimes to the total marginal costs of a department or batch or operation. The meaning is usually clear from the context.
Note
Alternative names for marginal costing are the contribution approach and direct costing In this lesson, we will study marginal costing as a technique quite distinct from absorption costing.
Theory of Marginal Costing
The theory of marginal costing as set out in “A report on Marginal Costing” published by CIMA, London is as follows:
In relation to a given volume of output, additional output can normally be obtained at less than proportionate cost because within limits, the aggregate of certain items of cost will tend to remain fixed and only the aggregate of the remainder will tend to rise proportionately with an increase in output. Conversely, a decrease in the volume of output will normally be accompanied by less than proportionate fall in the aggregate cost.
The theory of marginal costing may, therefore, by understood in the following two steps:
1. If the volume of output increases, the cost per unit in normal circumstances reduces. Conversely, if an output reduces, the cost per unit increases. If a factory produces 1000 units at a total cost of 3,000 and if by increasing the output by one unit the cost goes up to 3,002, the marginal cost of additional output will be 2.
2. If an increase in output is more than one, the total increase in cost divided by the total increase in output will give the average marginal cost per unit. If, for example, the output is increased to 1020 units from 1000 units and the total cost to produce these units is $1,045, the average marginal cost per unit is 2.25. It can be described as follows:
Additional cost =
Additional units 45 = $2.25
20
The ascertainment of marginal cost is based on the classification and segregation of cost into fixed and variable cost. In order to understand the marginal costing technique, it is essential to understand the meaning of marginal cost.
Marginal cost means the cost of the marginal or last unit produced. It is also defined as the cost of one more or one less unit produced besides existing level of production. In this connection, a unit may mean a single commodity, a dozen, a gross or any other measure of goods.
For example, if a manufacturing firm produces X unit at a cost of $ 300 and X+1 units at a cost of $ 320, the cost of an additional unit will be $ 20 which is marginal cost. Similarly if the production of X-1 units comes down to $ 280, the cost of marginal unit will be $ 20 (300–280).
The marginal cost varies directly with the volume of production and marginal cost per unit remains the same. It consists of prime cost, i.e. cost of direct materials, direct labor and all variable overheads. It does not contain any element of fixed cost which is kept separate under marginal cost technique.
Marginal costing may be defined as the technique of presenting cost data wherein variable costs and fixed costs are shown separately for managerial decision-making. It should be clearly understood that marginal costing is not a method of costing like process costing or job costing. Rather it is simply a method or technique of the analysis of cost information for the guidance of management which tries to find out an effect on profit due to changes in the volume of output.
There are different phrases being used for this technique of costing. In UK, marginal costing is a popular phrase whereas in US, it is known as direct costing and is used in place of marginal costing. Variable costing is another name of marginal costing.
Marginal costing technique has given birth to a very useful concept of contribution where contribution is given by: Sales revenue less variable cost (marginal cost)
Contribution may be defined as the profit before the recovery of fixed costs. Thus, contribution goes toward the recovery of fixed cost and profit, and is equal to fixed cost plus profit (C = F + P).
In case a firm neither makes profit nor suffers loss, contribution will be just equal to fixed cost (C = F). this is known as break even point.
The concept of contribution is very useful in marginal costing. It has a fixed relation with sales. The proportion of contribution to sales is known as P/V ratio which remains the same under given conditions of production and sales.
The principles of marginal costing
The principles of marginal costing are as follows.
a. For any given period of time, fixed costs will be the same, for any volume of sales and production (provided that the level of activity is within the ‘relevant range’). Therefore, by selling an extra item of product or service the following will happen.
§ Revenue will increase by the sales value of the item sold.
§ Costs will increase by the variable cost per unit.
§ Profit will increase by the amount of contribution earned from the extra item.
b. Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item.
c. Profit measurement should therefore be based on an analysis of total contribution. Since fixed costs relate to a period of time, and do not change with increases or decreases in sales volume, it is misleading to charge units of sale with a share of fixed costs.
d. When a unit of product is made, the extra costs incurred in its manufacture are the variable production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased.
Features of Marginal Costing
The main features of marginal costing are as follows:
1. Cost Classification
The marginal costing technique makes a sharp distinction between variable costs and fixed costs. It is the variable cost on the basis of which production and sales policies are designed by a firm following the marginal costing technique.
2. Stock/Inventory Valuation
Under marginal costing, inventory/stock for profit measurement is valued at marginal cost. It is in sharp contrast to the total unit cost under absorption costing method.
3. Marginal Contribution
Marginal costing technique makes use of marginal contribution for marking various decisions. Marginal contribution is the difference between sales and marginal cost. It forms the basis for judging the profitability of different products or departments.
Advantages and Disadvantages of Marginal Costing TechniqueAdvantages
1. Marginal costing is simple to understand.
2. By not charging fixed overhead to cost of production, the effect of varying charges per unit is avoided.
3. It prevents the illogical carry forward in stock valuation of some proportion of current year’s fixed overhead.
4. The effects of alternative sales or production policies can be more readily available and assessed, and decisions taken would yield the maximum return to business.
5. It eliminates large balances left in overhead control accounts which indicate the difficulty of ascertaining an accurate overhead recovery rate.
6. Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed overhead, efforts can be concentrated on maintaining a uniform and consistent marginal cost. It is useful to various levels of management.
7. It helps in short-term profit planning by breakeven and profitability analysis, both in terms of quantity and graphs. Comparative profitability and performance between two or more products and divisions can easily be assessed and brought to the notice of management for decision making.
Disadvantages
1. The separation of costs into fixed and variable is difficult and sometimes gives misleading results.
2. Normal costing systems also apply overhead under normal operating volume and this shows that no advantage is gained by marginal costing.
3. Under marginal costing, stocks and work in progress are understated. The exclusion of fixed costs from inventories affect profit, and true and fair view of financial affairs of an organization may not be clearly transparent.
4. Volume variance in standard costing also discloses the effect of fluctuating output on fixed overhead. Marginal cost data becomes unrealistic in case of highly fluctuating levels of production, e.g., in case of seasonal factories.
5. Application of fixed overhead depends on estimates and not on the actuals and as such there may be under or over absorption of the same.
6. Control affected by means of budgetary control is also accepted by many. In order to know the net profit, we should not be satisfied with contribution and hence, fixed overhead is also a valuable item. A system which ignores fixed costs is less effective since a major portion of fixed cost is not taken care of under marginal costing.
7. In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the assumptions underlying the theory of marginal costing sometimes becomes unrealistic. For long term profit planning, absorption costing is the only answer.
Presentation of Cost Data under Marginal Costing and Absorption CostingMarginal costing is not a method of costing but a technique of presentation of sales and cost data with a view to guide management in decision-making.
The traditional technique popularly known as total cost or absorption costing technique does not make any difference between variable and fixed cost in the calculation of profits. But marginal cost statement very clearly indicates this difference in arriving at the net operational results of a firm.
Following presentation of two Performa shows the difference between the presentation of information according to absorption and marginal costing techniques:
MARGINAL COSTING PRO-FORMA
£ £
Sales Revenue xxxxx
Less Marginal Cost of Sales
Opening Stock (Valued @ marginal cost) xxxx
Add Production Cost (Valued @ marginal cost) xxxx
Total Production Cost xxxx
Less Closing Stock (Valued @ marginal cost) (xxx)
Marginal Cost of Production xxxx
Add Selling, Admin & Distribution Cost xxxx
Marginal Cost of Sales (xxxx)
Contribution xxxxx
Less Fixed Cost (xxxx)
Marginal Costing Profit xxxxx
ABSORPTION COSTING PRO-FORMA
£ £
Sales Revenue xxxxx
Less Absorption Cost of Sales
Opening Stock (Valued @ absorption cost) xxxx
Add Production Cost (Valued @ absorption cost) xxxx
Total Production Cost xxxx
Less Closing Stock (Valued @ absorption cost) (xxx)
Absorption Cost of Production xxxx
Add Selling, Admin & Distribution Cost xxxx
Absorption Cost of Sales (xxxx)
Un-Adjusted Profit xxxxx
Fixed Production O/H absorbed xxxx
Fixed Production O/H incurred (xxxx)
(Under)/Over Absorption xxxxx
Adjusted Profit xxxxx
Reconciliation Statement for Marginal Costing and Absorption Costing Profit
Marginal Costing Profit xx
ADD
(Closing stock – opening Stock) x OAR xx
= Absorption Costing Profit xx
Where OAR( overhead absorption rate) = Budgeted fixed production overhead
Budgeted levels of activities
Marginal Costing versus Absorption Costing
After knowing the two techniques of marginal costing and absorption costing, we have seen that the net profits are not the same because of the following reasons:1. Over and Under Absorbed Overheads
In absorption costing, fixed overheads can never be absorbed exactly because of difficulty in forecasting costs and volume of output. If these balances of under or over absorbed/recovery are not written off to costing profit and loss account, the actual amount incurred is not shown in it. In marginal costing, however, the actual fixed overhead incurred is wholly charged against contribution and hence, there will be some difference in net profits.
2. Difference in Stock Valuation
In marginal costing, work in progress and finished stocks are valued at marginal cost, but in absorption costing, they are valued at total production cost. Hence, profit will differ as different amounts of fixed overheads are considered in two accounts.
The profit difference due to difference in stock valuation is summarized as follows:
a. When there is no opening and closing stocks, there will be no difference in profit.
b. When opening and closing stocks are same, there will be no difference in profit, provided the fixed cost element in opening and closing stocks are of the same amount.
c. When closing stock is more than opening stock, the profit under absorption costing will be higher as comparatively a greater portion of fixed cost is included in closing stock and carried over to next period.
d. When closing stock is less than opening stock, the profit under absorption costing will be less as comparatively a higher amount of fixed cost contained in opening stock is debited during the current period.
The features which distinguish marginal costing from absorption costing are as follows.
a. In absorption costing, items of stock are costed to include a ‘fair share’ of fixed production overhead, whereas in marginal costing, stocks are valued at variable production cost only. The value of closing stock will be higher in absorption costing than in marginal costing.
b. As a consequence of carrying forward an element of fixed production overheads in closing stock values, the cost of sales used to determine profit in absorption costing will:
i. include some fixed production overhead costs incurred in a previous period but carried forward into opening stock values of the current period;
ii. exclude some fixed production overhead costs incurred in the current period by including them in closing stock values.
In contrast marginal costing charges the actual fixed costs of a period in full into the profit and loss account of the period. (Marginal costing is therefore sometimes known as period costing.)
c. In absorption costing, ‘actual’ fully absorbed unit costs are reduced by producing in greater quantities, whereas in marginal costing, unit variable costs are unaffected by the volume of production (that is, provided that variable costs per unit remain unaltered at the changed level of production activity). Profit per unit in any period can be affected by the actual volume of production in absorption costing; this is not the case in marginal costing.
d. In marginal costing, the identification of variable costs and of contribution enables management to use cost information more easily for decision-making purposes (such as in budget decision making). It is easy to decide by how much contribution (and therefore profit) will be affected by changes in sales volume. (Profit would be unaffected by changes in production volume).In absorption costing, however, the effect on profit in a period of changes in both:
i. production volume; and
ii. sales volume;
is not easily seen, because behaviour is not analysed and incremental costs are not used in the calculation of actual profit.
Limitations of Absorption Costing
The following are the criticisms against absorption costing:
1. You might have observed that in absorption costing, a portion of fixed cost is carried over to the subsequent accounting period as part of closing stock. This is an unsound practice because costs pertaining to a period should not be allowed to be vitiated by the inclusion of costs pertaining to the previous period and vice versa.
2. Further, absorption costing is dependent on the levels of output which may vary from period to period, and consequently cost per unit changes due to the existence of fixed overhead. Unless fixed overhead rate is based on normal capacity, such changed costs are not helpful for the purposes of comparison and control.
The cost to produce an extra unit is variable production cost. It is realistic to the value of closing stock items as this is a directly attributable cost. The size of total contribution varies directly with sales volume at a constant rate per unit. For the decision-making purpose of management, better information about expected profit is obtained from the use of variable costs and contribution approach in the accounting system.
MARGINAL COSTS, CONTRIBUTION AND PROFIT
A marginal cost is another term for a variable cost. The term ‘marginal cost’ is usually applied to the variable cost of a unit of product or service, whereas the term ‘variable cost’ is more commonly applied to resource costs, such as the cost of materials and labour hours.
Marginal costing is a form of management accounting based on the distinction between:
a. the marginal costs of making selling goods or services, and
b. fixed costs, which should be the same for a given period of time, regardless of the level of activity in the period.
Suppose that a firm makes and sells a single product that has a marginal cost of £5 per unit and that sells for £9 per unit. For every additional unit of the product that is made and sold, the firm will incur an extra cost of £5 and receive income of £9. The net gain will be £4 per additional unit. This net gain per unit, the difference between the sales price per unit and the marginal cost per unit, is called contribution.
Contribution is a term meaning ‘making a contribution towards covering fixed costs and making a profit’. Before a firm can make a profit in any period, it must first of all cover its fixed costs. Breakeven is where total sales revenue for a period just covers fixed costs, leaving neither profit nor loss. For every unit sold in excess of the breakeven point, profit will increase by the amount of the contribution per unit.
C-V-P analysis is broadly known as cost-volume-profit analysis. Specifically speaking, we all are concerned with in-depth analysis and application of CVP in practical world of industry management.
Cost-Volume-Profit (C-V-P) Relationship
We have observed that in marginal costing, marginal cost varies directly with the volume of production or output. On the other hand, fixed cost remains unaltered regardless of the volume of output within the scale of production already fixed by management. In case if cost behavior is related to sales income, it shows cost-volume-profit relationship. In net effect, if volume is changed, variable cost varies as per the change in volume. In this case, selling price remains fixed, fixed remains fixed and then there is a change in profit.
Being a manager, you constantly strive to relate these elements in order to achieve the maximum profit. Apart from profit projection, the concept of Cost-Volume-Profit (CVP) is relevant to virtually all decision-making areas, particularly in the short run.
The relationship among cost, revenue and profit at different levels may be expressed in graphs such as breakeven charts, profit volume graphs, or in various statement forms.
Profit depends on a large number of factors, most important of which are the cost of manufacturing and the volume of sales. Both these factors are interdependent. Volume of sales depends upon the volume of production and market forces which in turn is related to costs. Management has no control over market. In order to achieve certain level of profitability, it has to exercise control and management of costs, mainly variable cost. This is because fixed cost is a non-controllable cost. But then, cost is based on the following factors:
• Volume of production
• Product mix
• Internal efficiency and the productivity of the factors of production
• Methods of production and technology
• Size of batches
• Size of plant
Thus, one can say that cost-volume-profit analysis furnishes the complete picture of the profit structure. This enables management to distinguish among the effect of sales, fluctuations in volume and the results of changes in price of product/services.In other words, CVP is a management accounting tool that expresses relationship among sale volume, cost and profit. CVP can be used in the form of a graph or an equation. Cost-volume- profit analysis can answer a number of analytical questions. Some of the questions are as follows:
1. What is the breakeven revenue of an organization?
2. How much revenue does an organization need to achieve a budgeted profit?
3. What level of price change affects the achievement of budgeted profit?
4. What is the effect of cost changes on the profitability of an operation?
Cost-volume-profit analysis can also answer many other “what if” type of questions. Cost-volume-profit analysis is one of the important techniques of cost and management accounting. Although it is a simple yet a powerful tool for planning of profits and therefore, of commercial operations. It provides an answer to “what if” theme by telling the volume required to produce.Following are the three approaches to a CVP analysis:
• Cost and revenue equations
• Contribution margin
• Profit graph
Objectives of Cost-Volume-Profit Analysis
1. In order to forecast profits accurately, it is essential to ascertain the relationship between cost and profit on one hand and volume on the other.
2. Cost-volume-profit analysis is helpful in setting up flexible budget which indicates cost at various levels of activities.
3. Cost-volume-profit analysis assist in evaluating performance for the purpose of control.
4. Such analysis may assist management in formulating pricing policies by projecting the effect of different price structures on cost and profit.
Assumptions and Terminology
Following are the assumptions on which the theory of CVP is based:
1. The changes in the level of various revenue and costs arise only because of the changes in the number of product (or service) units produced and sold, e.g., the number of television sets produced and sold by Sigma Corporation. The number of output (units) to be sold is the only revenue and cost driver. Just as a cost driver is any factor that affects costs, a revenue driver is any factor that affects revenue.
2. Total costs can be divided into a fixed component and a component that is variable with respect to the level of output. Variable costs include the following:
o Direct materials
o Direct labor
o Direct chargeable expenses
Variable overheads include the following:
o Variable part of factory overheads
o Administration overheads
o Selling and distribution overheads
3. There is linear relationship between revenue and cost.
4. When put in a graph, the behavior of total revenue and cost is linear (straight line), i.e. Y = mx + C holds good which is the equation of a straight line.
5. The unit selling price, unit variable costs and fixed costs are constant.
6. The theory of CVP is based upon the production of a single product. However, of late, management accountants are functioning to give a theoretical and a practical approach to multi-product CVP analysis.
7. The analysis either covers a single product or assumes that the sales mix sold in case of multiple products will remain constant as the level of total units sold changes.
8. All revenue and cost can be added and compared without taking into account the time value of money.
9. The theory of CVP is based on the technology that remains constant.
10. The theory of price elasticity is not taken into consideration.
Many companies, and divisions and sub-divisions of companies in industries such as airlines, automobiles, chemicals, plastics and semiconductors have found the simple CVP relationships to be helpful in the following areas:
• Strategic and long-range planning decisions
• Decisions about product features and pricing
In real world, simple assumptions described above may not hold good. The theory of CVP can be tailored for individual industries depending upon the nature and peculiarities of the same.For example, predicting total revenue and total cost may require multiple revenue drivers and multiple cost drivers. Some of the multiple revenue drivers are as follows:
• Number of output units
• Number of customer visits made for sales
• Number of advertisements placed
Some of the multiple cost drivers are as follows:
• Number of units produced
• Number of batches in which units are produced
Managers and management accountants, however, should always assess whether the simplified CVP relationships generate sufficiently accurate information for predictions of how total revenue and total cost would behave. However, one may come across different complex situations to which the theory of CVP would rightly be applicable in order to help managers to take appropriate decisions under different situations.
Limitations of Cost-Volume Profit Analysis
The CVP analysis is generally made under certain limitations and with certain assumed conditions, some of which may not occur in practice. Following are the main limitations and assumptions in the cost-volume-profit analysis:
1. It is assumed that the production facilities anticipated for the purpose of cost-volume-profit analysis do not undergo any change. Such analysis gives misleading results if expansion or reduction of capacity takes place.
2. In case where a variety of products with varying margins of profit are manufactured, it is difficult to forecast with reasonable accuracy the volume of sales mix which would optimize the profit.
3. The analysis will be correct only if input price and selling price remain fairly constant which in reality is difficulty to find. Thus, if a cost reduction program is undertaken or selling price is changed, the relationship between cost and profit will not be accurately depicted.
4. In cost-volume-profit analysis, it is assumed that variable costs are perfectly and completely variable at all levels of activity and fixed cost remains constant throughout the range of volume being considered. However, such situations may not arise in practical situations.
5. It is assumed that the changes in opening and closing inventories are not significant, though sometimes they may be significant.
6. Inventories are valued at variable cost and fixed cost is treated as period cost. Therefore, closing stock carried over to the next financial year does not contain any component of fixed cost. Inventory should be valued at full cost in reality.
Sensitivity Analysis or What If Analysis and Uncertainty
Sensitivity analysis is relatively a new term in management accounting. It is a “what if” technique that managers use to examine how a result will change if the original predicted data are not achieved or if an underlying assumption changes.
In the context of CVP analysis, sensitivity analysis answers the following questions:
a. What will be the operating income if units sold decrease by 15% from original prediction?
b. What will be the operating income if variable cost per unit increases by 20%?
The sensitivity of operating income to various possible outcomes broadens the perspective of management regarding what might actually occur before making cost commitments.A spreadsheet can be used to conduct CVP-based sensitivity analysis in a systematic and efficient way. With the help of a spreadsheet, this analysis can be easily conducted to examine the effect and interaction of changes in selling prices, variable cost per unit, fixed costs and target operating incomes.
Example
Following is the spreadsheet of ABC Ltd.,
Statement showing CVP Analysis for Dolphy Software Ltd.
Revenue required at $. 200 Selling Price per unit to earn Operating Income of
Fixed cost Variable cost
per unit 0 1,000 1,500 2,000
2,000 100 4,000 6,000 7,000 8,000
120 5,000 7,500 8,750 10,000
140 6,667 10,000 11,667 13,333
2,500 100 5,000 7,000 8,000 9,000
120 6,250 8,750 10,000 11,250
140 8,333 11,667 13,333 15,000
3,000 100 6,000 8,000 9,000 10,000
120 7,500 10,000 11,250 12,500
140 10,000 13,333 15,000 16,667
From the above example, one can immediately see the revenue that needs to be generated to reach a particular operating income level, given alternative levels of fixed costs and variable costs per unit. For example, revenue of $. 6,000 (30 units @ 200 each) is required to earn an operating income of 1,000 if fixed cost is 2,000 and variable cost per unit is 100. You can also use exhibit 3-4 to assess what revenue the company needs to breakeven (earn operating income of Re. 0) if, for example, one of the following changes takes place:
• The booth rental at the ABC convention raises to 3,000 (thus increasing fixed cost to $. 3,000)
• The software suppliers raise their price to 140 per unit (thus increasing variable costs to 140)
An aspect of sensitivity analysis is the margin of safety which is the amount of budgeted revenue over and above breakeven revenue. The margin of safety is sales quantity minus breakeven quantity. It is expressed in units. The margin of safety answers the “what if” questions, e.g., if budgeted revenue are above breakeven and start dropping, how far can they fall below budget before the breakeven point is reached? Such a fall could be due to competitor’s better product, poorly executed marketing programs and so on.Assume you have fixed cost of 2,000, selling price of 200 and variable cost per unit of 120. For 40 units sold, the budgeted point from this set of assumptions is 25 units (2,000 ÷ $. 80) or 5,000 ( 200 x 25). Hence, the margin of safety is 3,000 ( 8,000 – 5,000) or 15 (40 –25) units.
Sensitivity analysis is an approach to recognizing uncertainty, i.e. the possibility that an actual amount will deviate from an expected amount.
Marginal Cost Equations and Breakeven Analysis
From the marginal cost statements, one might have observed the following:
Sales – Marginal cost = Contribution ......(1)Fixed cost + Profit = Contribution ......(2)
By combining these two equations, we get the fundamental marginal cost equation as follows:
Sales – Marginal cost = Fixed cost + Profit ......(3)
This fundamental marginal cost equation plays a vital role in profit projection and has a wider application in managerial decision-making problems.The sales and marginal costs vary directly with the number of units sold or produced. So, the difference between sales and marginal cost, i.e. contribution, will bear a relation to sales and the ratio of contribution to sales remains constant at all levels. This is profit volume or P/V ratio. Thus,
P/V Ratio (or C/S Ratio) = Contribution (c) ......(4)
Sales (s)
It is expressed in terms of percentage, i.e. P/V ratio is equal to (C/S) x 100.
Or, Contribution = Sales x P/V ratio ......(5)
Or, Sales = Contribution ......(6)
P/V ratio
The above-mentioned marginal cost equations can be applied to the following heads:1. Contribution
Contribution is the difference between sales and marginal or variable costs. It contributes toward fixed cost and profit. The concept of contribution helps in deciding breakeven point, profitability of products, departments etc. to perform the following activities:
• Selecting product mix or sales mix for profit maximization
• Fixing selling prices under different circumstances such as trade depression, export sales, price discrimination etc.
2. Profit Volume Ratio (P/V Ratio), its Improvement and Application
The ratio of contribution to sales is P/V ratio or C/S ratio. It is the contribution per rupee of sales and since the fixed cost remains constant in short term period, P/V ratio will also measure the rate of change of profit due to change in volume of sales. The P/V ratio may be expressed as follows:
P/V ratio = Sales – Marginal cost of sales = Contribution = Changes in contribution = Change in profit
Sales Sales Changes in sales Change in sales
A fundamental property of marginal costing system is that P/V ratio remains constant at different levels of activity.
A change in fixed cost does not affect P/V ratio. The concept of P/V ratio helps in determining the following:
• Breakeven point
• Profit at any volume of sales
• Sales volume required to earn a desired quantum of profit
• Profitability of products
• Processes or departments
The contribution can be increased by increasing the sales price or by reduction of variable costs. Thus, P/V ratio can be improved by the following:
• Increasing selling price
• Reducing marginal costs by effectively utilizing men, machines, materials and other services
• Selling more profitable products, thereby increasing the overall P/V ratio
3. Breakeven Point
Breakeven point is the volume of sales or production where there is neither profit nor loss. Thus, we can say that:
Contribution = Fixed cost
Now, breakeven point can be easily calculated with the help of fundamental marginal cost equation, P/V ratio or contribution per unit.
a. Using Marginal Costing Equation
S (sales) – V (variable cost) = F (fixed cost) + P (profit) At BEP P = 0, BEP S – V = F
By multiplying both the sides by S and rearranging them, one gets the following equation:
S BEP = F.S/S-V
b. Using P/V Ratio
Sales S BEP = Contribution at BEP = Fixed cost
P/ V ratio P/ V ratio
Thus, if sales is $. 2,000, marginal cost $. 1,200 and fixed cost $. 400, then:
Breakeven point = 400 x 2000 = 1000
2000 - 1200
Similarly, P/V ratio = 2000 – 1200 = 0.4 or 40%
800
So, breakeven sales = 400 / .4 = $. 1000
c. Using Contribution per unit
Breakeven point = Fixed cost = 100 units or 1000
Contribution per unit
4. Margin of Safety (MOS)
Every enterprise tries to know how much above they are from the breakeven point. This is technically called margin of safety. It is calculated as the difference between sales or production units at the selected activity and the breakeven sales or production.
Margin of safety is the difference between the total sales (actual or projected) and the breakeven sales. It may be expressed in monetary terms (value) or as a number of units (volume). It can be expressed as profit / P/V ratio. A large margin of safety indicates the soundness and financial strength of business.
Margin of safety can be improved by lowering fixed and variable costs, increasing volume of sales or selling price and changing product mix, so as to improve contribution and overall P/V ratio.
Margin of safety = Sales at selected activity – Sales at BEP = Profit at selected activity
P/V ratio
Margin of safety is also presented in ratio or percentage as follows: Margin of safety (sales) x 100 %
Sales at selected activity
The size of margin of safety is an extremely valuable guide to the strength of a business. If it is large, there can be substantial falling of sales and yet a profit can be made. On the other hand, if margin is small, any loss of sales may be a serious matter. If margin of safety is unsatisfactory, possible steps to rectify the causes of mismanagement of commercial activities as listed below can be undertaken.
a. Increasing the selling price-- It may be possible for a company to have higher margin of safety in order to strengthen the financial health of the business. It should be able to influence price, provided the demand is elastic. Otherwise, the same quantity will not be sold.
b. Reducing fixed costs
c. Reducing variable costs
d. Substitution of existing product(s) by more profitable lines e. Increase in the volume of output
e. Modernization of production facilities and the introduction of the most cost effective technology
Problem 1A company earned a profit of 30,000 during the year 2000-01. Marginal cost and selling price of a product are 8 and 10 per unit respectively. Find out the margin of safety.
Solution
Margin of safety = Profit
P/V ratio
P/V ratio = Contribution x 100
Sales
Problem 2
A company producing a single article sells it at 10 each. The marginal cost of production is 6 each and fixed cost is 400 per annum. You are required to calculate the following:
• Profits for annual sales of 1 unit, 50 units, 100 units and 400 units
• P/V ratio
• Breakeven sales
• Sales to earn a profit of 500
• Profit at sales of 3,000
• New breakeven point if sales price is reduced by 10%
• Margin of safety at sales of 400 units
Solution Marginal Cost Statement
Particulars Amount Amount Amount Amount
Units produced 1 50 100 400
Sales (units * 10) 10 500 1000 4000
Variable cost 6 300 600 2400
Contribution (sales- VC) 4 200 400 1600
Fixed cost 400 400 400 400
Profit (Contribution – FC) -396 -200 0 1200
Profit Volume Ratio (PVR) = Contribution/Sales * 100 = 0.4 or 40%
Breakeven sales ($.) = Fixed cost / PVR = 400/ 40 * 100 = 1,000
Sales at BEP = Contribution at BEP/ PVR = 100 units
Sales at profit 500
Contribution at profit $. 500 = Fixed cost + Profit = $. 900
Sales = Contribution/PVR = 900/.4 = $. 2,250 (or 225 units)
Profit at sales 3,000
Contribution at sale $. 3,000 = Sales x P/V ratio = 3000 x 0.4 = $. 1,200
Profit = Contribution – Fixed cost = 1200 – 400 = 800
New P/V ratio = 9 – 6/ 9 = 1/3
Sales at BEP = Fixed cost/PV ratio = 400 = 1,200
1/3
Margin of safety (at 400 units) = 4000-1000/4000*100 = 75 %
(Actual sales – BEP sales/Actual sales * 100)
Breakeven Analysis-- Graphical Presentation
Apart from marginal cost equations, it is found that breakeven chart and profit graphs are useful graphic presentations of this cost-volume-profit relationship.
Breakeven chart is a device which shows the relationship between sales volume, marginal costs and fixed costs, and profit or loss at different levels of activity. Such a chart also shows the effect of change of one factor on other factors and exhibits the rate of profit and margin of safety at different levels. A breakeven chart contains, inter alia, total sales line, total cost line and the point of intersection called breakeven point. It is popularly called breakeven chart because it shows clearly breakeven point (a point where there is no profit or no loss).
Profit graph is a development of simple breakeven chart and shows clearly profit at different volumes of sales.
Construction of a Breakeven Chart
The construction of a breakeven chart involves the drawing of fixed cost line, total cost line and sales line as follows:
1. Select a scale for production on horizontal axis and a scale for costs and sales on vertical axis.
2. Plot fixed cost on vertical axis and draw fixed cost line passing through this point parallel to horizontal axis.
3. Plot variable costs for some activity levels starting from the fixed cost line and join these points. This will give total cost line. Alternatively, obtain total cost at different levels, plot the points starting from horizontal axis and draw total cost line.
4. Plot the maximum or any other sales volume and draw sales line by joining zero and the point so obtained.
Uses of Breakeven ChartA breakeven chart can be used to show the effect of changes in any of the following profit factors:
• Volume of sales
• Variable expenses
• Fixed expenses
• Selling price
ProblemA company produces a single article and sells it at 10 each. The marginal cost of production is 6 each and total fixed cost of the concern is 400 per annum.
Construct a breakeven chart and show the following:
• Breakeven point
• Margin of safety at sale of 1,500
• Angle of incidence
• Increase in selling price if breakeven point is reduced to 80 units
Solution
A breakeven chart can be prepared by obtaining the information at these levels:
Output units 40 80 120 200
Sales .
400 800 1,200 2,000
Fixed cost 400 400 400 400
Variable cost 240 480 400 720
Total cost 640 880 1,120 1,600
Fixed cost line, total cost line and sales line are drawn one after another following the usual procedure described herein:
This chart clearly shows the breakeven point, margin of safety and angle of incidence.
a. Breakeven point-- Breakeven point is the point at which sales line and total cost line intersect. Here, B is breakeven point equivalent to sale of 1,000 or 100 units.
b. Margin of safety-- Margin of safety is the difference between sales or units of production and breakeven point. Thus, margin of safety at M is sales of (1,500 - 1,000), i.e. 500 or 50 units.
c. Angle of incidence-- Angle of incidence is the angle formed by sales line and total cost line at breakeven point. A large angle of incidence shows a high rate of profit being made. It should be noted that the angle of incidence is universally denoted by data. Larger the angle, higher the profitability indicated by the angel of incidence.
d. At 80 units, total cost (from the table) = 880. Hence, selling price for breakeven at 80 units = 880/80 = 11 per unit. Increase in selling price is Re. 1 or 10% over the original selling price of 10 per unit.
Limitations and Uses of Breakeven Charts
A simple breakeven chart gives correct result as long as variable cost per unit, total fixed cost and sales price remain constant. In practice, all these facto$ may change and the original breakeven chart may give misleading results.
But then, if a company sells different products having different percentages of profit to turnover, the original combined breakeven chart fails to give a clear picture when the sales mix changes. In this case, it may be necessary to draw up a breakeven chart for each product or a group of products. A breakeven chart does not take into account capital employed which is a very important factor to measure the overall efficiency of business. Fixed costs may increase at some level whereas variable costs may sometimes start to decline. For example, with the help of quantity discount on materials purchased, the sales price may be reduced to sell the additional units produced etc. These changes may result in more than one breakeven point, or may indicate higher profit at lower volumes or lower profit at still higher levels of sales.
Nevertheless, a breakeven chart is used by management as an efficient tool in marginal costing, i.e. in forecasting, decision-making, long term profit planning and maintaining profitability. The margin of safety shows the soundness of business whereas the fixed cost line shows the degree of mechanization. The angle of incidence is an indicator of plant efficiency and profitability of the product or division under consideration. It also helps a monopolist to make price discrimination for maximization of profit.
Multiple Product Situations
In real life, most of the firms turn out many products. Here also, there is no problem with regard to the calculation of BE point. However, the assumption has to be made that the sales mix remains constant. This is defined as the relative proportion of each product’s sale to total sales. It could be expressed as a ratio such as 2:4:6, or as a percentage as 20%, 40%, 60%.
The calculation of breakeven point in a multi-product firm follows the same pattern as in a single product firm. While the numerator will be the same fixed costs, the denominator now will be weighted average contribution margin. The modified formula is as follows:
Breakeven point (in units) = Fixed costs
________________________________________
Weighted average contribution margin per unit
One should always remember that weights are assigned in proportion to the relative sales of all products. Here, it will be the contribution margin of each product multiplied by its quantity.
Breakeven Point in Sales Revenue
Here also, numerator is the same fixed costs. The denominator now will be weighted average contribution margin ratio which is also called weighted average P/V ratio. The modified formula is as follows:
B.E. point (in revenue) = Fixed cost
________________________________________
Weighted average P/V ratio
Problem Ahmedabad Company Ltd. manufactures and sells four types of products under the brand name Ambience, Luxury, Comfort and Lavish. The sales mix in value comprises the following:
Brand name Percentage
Ambience 33 1/3
Luxury 41 2/3
Comfort 16 2/3
Lavish 8 1/3
------
100
The total budgeted sales (100%) are . 6,00,000 per month.The operating costs are:
Ambience 60% of selling price Luxury
Luxury 68% of selling price Comfort
Comfort 80% of selling price Lavish
Lavish 40% of selling price
The fixed costs are 1,59,000 per month.
a. Calculate the breakeven point for the products on an overall basis.
b. It has been proposed to change the sales mix as follows, with the sales per month remaining at . 6,00,000:
Brand Name Percentage
Ambience 25
Luxury 40
Comfort 30
Lavish 05
---
100
Assuming that this proposal is implemented, calculate the new breakeven point.Solution
a. Computation of the Breakeven Point on Overall Basis
b. Computation of the New Breakeven Point
Profit GraphProfit graph is an improvement of a simple breakeven chart. It clearly exhibits the relationship of profit to volume of sales. The construction of a profit graph is relatively easy and the procedure involves the following:
1. Selecting a scale for the sales on horizontal axis and another scale for profit and fixed costs or loss on vertical axis. The area above horizontal axis is called profit area and the one below it is called loss area.
2. Plotting the profits of corresponding sales and joining them. This is profit line.
.
Accounting is a business language. We can use this language to communicate financial transactions and their results. Accounting is comprehensive systems to collect, analyzes, and communicate financial information.
The origin of accounting is as old as money. In early days, the number of transactions were very small, so every concerned person could keep the record of transactions during a specific period of time. Twenty-three centuries ago, an Indian scholar named Kautilya alias Chanakya introduced the accounting concepts in his book Arthashastra. In his book, he described the art of proper account keeping and methods of checking accounts. Gradually, the field of accounting has undergone remarkable changes in compliance with the changes happening in the business scenario of the world.
A book-keeper may record financial transactions according to certain accounting principles and standards and as prescribed by an accountant depending upon the size, nature, volume, and other constraints of a particular organization.
With the help of accounting process, we can determine the profit or loss of the business on a specific date. It also helps us analyze the past performance and plan the future courses of action.
Definition of Accounting
The American Institute of Certified Public Accountant has defined Financial Accounting as: “the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which in part at least of a financial character and interpreting the results thereof.”
Objectives and Scope of Accounting
Let us go through the main objectives of Accounting:
• To keep systematic records - Accounting is done to keep systematic record of financial transactions. The primary objective of accounting is to help us collect financial data and to record it systematically to derive correct and useful results of financial statements.
• To ascertain profitability - With the help of accounting, we can evaluate the profits and losses incurred during a specific accounting period. With the help of a Trading and Profit & Loss Account, we can easily determine the profit or loss of a firm.
• To ascertain the financial position of the business - A balance sheet or a statement of affairs indicates the financial position of a company as on a particular date. A properly drawn balance sheet gives us an indication of the class and value of assets, the nature and value of liability, and also the capital position of the firm. With the help of that, we can easily ascertain the soundness of any business entity.
• To assist in decision-making - To take decisions for the future, one requires accurate financial statements. One of the main objectives of accounting is to take right decisions at right time. Thus, accounting gives you the platform to plan for the future with the help of past records.
• To fulfill compliance of Law - Business entities such as companies, trusts, and societies are being run and governed according to different legislative acts. Similarly, different taxation laws (direct indirect tax) are also applicable to every business house. Everyone has to keep and maintain different types of accounts and records as prescribed by corresponding laws of the land. Accounting helps in running a business in compliance with the law.
It is necessary to know the classification of accounts and their treatment in double entry system of accounts. Broadly, the accounts are classified into three categories:
• Personal accounts
• Real accounts
o Tangible accounts
o Intangible accounts
Personal Accounts
Personal accounts may be further classified into three categories:
Natural Personal Account
An account related to any individual like David, George, Ram, or Shyam is called as a Natural Personal Account.
Artificial Personal Account
An account related to any artificial person like M/s ABC Ltd, M/s General Trading, M/s Reliance Industries, etc., is called as an Artificial Personal Account.
Representative Personal Account
Representative personal account represents a group of account. If there are a number of accounts of similar nature, it is better to group them like salary payable account, rent payable account, insurance prepaid account, interest receivable account, capital account and drawing account, etc.
Real Accounts
Every Business has some assets and every asset has an account. Thus, asset account is called a real account. There are two type of assets:
• Tangible assets are touchable assets such as plant, machinery, furniture, stock, cash, etc.
• Intangible assets are non-touchable assets such as goodwill, patent, copyrights, etc.
Accounting treatment for both type of assets is same.
Nominal Accounts
Since this account does not represent any tangible asset, it is called nominal or fictitious account. All kinds of expense account, loss account, gain account or income accounts come under the category of nominal account. For example, rent account, salary account, electricity expenses account, interest income account, etc.
Double Entry System
Double entry system of accounts is a scientific system of accounts followed all over the world without any dispute. It is an old system of accounting. It was developed by ‘Luco Pacioli’ of Italy in 1494. Under the double entry system of account, every entry has its dual aspects of debit and credit. It means, assets of the business always equal to liabilities of the business.
Assets = Liabilities
If we give something, we also get something in return and vice versa.
Rules of Debit and Credit under Double Entry System of Accounts
The following rules of debit and credit are called the golden rules of accounts:
Example
Mr A starts a business regarding which we have the following data:
Introduces Capital in cash Rs 50,000
Purchases (Cash) Rs 20,000
Purchases (Credit) from Mr B Rs 25,000
Freight charges paid in cash Rs 1,000
It is very clear from the above example how the rules of debit and credit work. It is also clear that every entry has its dual aspect. In any case, debit will always be equal to credit in double entry accounting system.
As already stated every transaction involves give and take aspect. In double entry accounting, every transaction affects and is recorded in at least two accounts. When recording each ransaction, the total amount debited must equal to the total amount credited. In accounting, the terms — debit and credit indicate whether the transactions are to be recorded on the left hand side or right hand side of the account. In its simplest form, an account looks like the letter T. Because of its shape, this simple form called a T-account . Notice that the T format has a left side and a right side for recording increases and decreases in the item. This helps in ascertaining the ultimate position of each item at the end of an accounting period. For example, if it is an account of a customer all goods sold shall appear on the left (debit) side of customer’s account and all payments received on the right side. The difference between the totals of the two sides called balance shall reflect the amount due to the customer. In a T account, the left side is called debit (often abbreviated as Dr.) and the right side is known as credit (often abbreviated as Cr.). To enter amount on the left side of an account is to debit the account. To enter amount on the right side is to credit the account. Rules of Debit and Credit All accounts are divided into five categories for the purposes of recording the transactions:
(a) Asset
(b) Liability
(c) Capital
(d) Expenses/Losses, and
(e) Revenues/Gains.
Two fundamental rules are followed to record the changes in these accounts:
(1) For recording changes in Assets/Expenses (Losses):
(i) “Increase in asset is debited, and decrease in asset is credited.”
(ii) “Increase in expenses/losses is debited, and decrease in expenses/losses is credited.”
(2) For recording changes in Liabilities and Capital/Revenues (Gains):
(i) “Increase in liabilities is credited and decrease in liabilities is debited.”
(ii) “Increase in capital is credited and decrease in capital is debited.”
(iii) “Increase in revenue/gain is credited and decrease in revenue/gain is debited.”
The rules applicable to the different kinds of accounts have been summarised in the following chart:
The transactions in Example will help you to learn how to apply these debit and credit rules. Observe the analysis given carefully to be sure that you understand before you go on to the next one.
To illustrate different kinds of events, three more transactions have been added
1. Rohit started business with cash Rs. 5,00,000
Analysis of Transaction : The transaction increases cash on one hand and increases capital on the other hand. Increases in assets are debited and increases in capital are credited. Therefore record the transaction with debit to Cash and credit to Rohit’s Capital.
2. Opened a bank account with an amount of Rs. 4,80,000
Analysis of Transaction: The transaction increases the cash at bank on one hand and decreases cash in hand on the other hand. Increases in assets are debited and a decreases in assets are credited. Therefore, record the transactions with debit to Bank account and credit to Cash account.
Q2 . What do you mean by posting? What are the rules of posting?
Accounting is a business language. We can use this language to communicate financial transactions and their results. Accounting is comprehensive systems to collect, analyzes, and communicate financial information.The origin of accounting is as old as money. In early days, the number of transactions were very small, so every concerned person could keep the record of transactions during a specific period of time. Twenty-three centuries ago, an Indian scholar named Kautilya alias Chanakya introduced the accounting concepts in his book Arthashastra. In his book, he described the art of proper account keeping and methods of checking accounts. Gradually, the field of accounting has undergone remarkable changes in compliance with the changes happening in the business scenario of the world.
Definition of Accounting
The American Institute of Certified Public Accountant has defined Financial Accounting as: “the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which in part at least of a financial character and interpreting the results thereof.”
This process of analysing transactions and recording their effects directly in the accounts is helpful as a learning exercise. However, real accounting systems do not record transactions directly in the accounts. The book in which the transaction is recorded for the first time is called journal or book of original entry. The source document, as discussed earlier, is required to record the transaction in the journal. This practice provides a complete record of each transaction in one place and links the debits and credits for each transaction. After the debits and credits for each transaction are entered in the journal, they are transferred to the individual accounts. The process of recording transactions in journal is called journalising. Once the journalizing process is completed, the journal entry provides a complete and useful description of the event’s effect on the organisation. The process of transferring journal entry to individual accounts is called posting. This sequence causes the journal to be called the Book of Original Entry and the ledger account as the Principal Book of entry.
The ledger is the principal book of accounting system. It contains different accounts where transactions relating to that account are recorded. A ledger is the collection of all the accounts, debited or credited, in the journal proper and various special journal A ledger may be in the form of bound register, or cards, or separate sheets may be maintained in a loose leaf binder.In the ledger, each account is opened preferably on separate page or card.
Utility
A ledger is very useful and is of utmost importance in the organisation. The net result of all transactions in respect of a particular account on a given date can be ascertained only from the ledger. For example, the management on a particular date wants to know the amount due from a certain customer or the amount the firm has to pay to a particular supplier, such information can be found only in the ledger. Such information is very difficult to ascertain from the journal because the transactions are recorded in the chronological order and defies classification. For easy posting and location, accounts are opened in the ledger in some definite order. For example, they may be opened in the same order as they appear in the profit and loss account and in balance sheet. In the beginning, an index is also provided. For easy identification, in big organisations, each account is also allotted a code number.
According to this format the columns will contain the information as given below:
An account is debited or credited according to the rules of debit and credit already explained in respect of each category of account.
Title of the account : The Name of the item is written at the top of the format as the title of the account. The title of the account ends with suffix ‘Account’.
Dr./Cr. : Dr. means Debit side of the account that is left side and Cr. Means Credit side of the account, i.e. right side.
Date : Year, Month and Date of transactions are posted in chronological order in this column.
Particulars : Name of the item with reference to the original book of entry is written on debit/credit side of the account.
Journal Folio : It records the page number of the original book of entry on which relevant transaction is recorded. This column is filled up at the time of posting.
Amount : This column records the amount in numerical figure, corresponding to what has been entered in the amount column of the original book of entry. We have seen earlier that all ledger accounts are put into five categories namely, assets, liabilities, capital, revenues/gains and expense losses. All these accounts may further be put into two groups, i.e. permanent accounts and temporary accounts. All permanent accounts are balanced and carried forward to the next accounting period. The temporary accounts are closed at the end of the accounting period by transferring them to the trading and profit and loss account. All permanent accounts appears in the balance sheet. Thus, all assets, liabilities and capital accounts are permanent accounts and all revenue and expense accounts are temporary accounts. This classification is also relevant for preparing the financial statements.
Posting from Journal
Posting is the process of transferring the entries from the books of original entry (journal) to the ledger. In other words, posting means grouping of all the transactions in respect to a particular account at one place for meaningful conclusion and to further the accounting process. Posting from the journal is done periodically, may be, weekly or fortnightly or monthly as per the requirements and convenience of the business. The complete process of posting from journal to ledger has been discussed below:
Step 1 : Locate in the ledger, the account to be debited as entered in the journal.
Step 2 : Enter the date of transaction in the date column on the debit side.
Step 3 : In the ‘Particulars’ column write the name of the account through which it has been debited in the journal. For example, furniture sold for cash Rs. 34,000. Now, in cash account on the debit side in the particulars column ‘Furniture’ will be entered signifying that cash is received from the sale of furniture. In Furniture account, in the ledger on the credit side is the particulars column, the word, cash will be recorded. The same procedure is followed in respect of all the entries recorded in the journal.
Step 4 : Enter the page number of the journal in the folio column and in the journal write the page number of the ledger on which a particular account appears.
Step 5 : Enter the relevant amount in the amount column on the debit side. It may be noted that the same procedure is followed for making the entry on the credit side of that account to be credited. An account is opened only once in the ledger and all entries relating to a particular account is posted on the debit or credit side, as the case may be.
Give some examples of Journal entry and ledger posting
Posting of the Single Column Cash Book
As evident , the left side of the cash book shows the receipts of the cash whereas the right side of the cash book shows all the payments made in cash. The accounts appearing on then debit side for the cash book are credited in the respective ledger accounts because cash has been received in respect of them. Thus, in our example, an entry ‘cash received from Gurmeet‘ appears on the debit side of the cash book conveys that the cash has been received from Gurmeet. Therefore, in the ledger, Gurmeet’s account will be credited by writing ‘Cash’ in the particulars column on the credit side. Similarly, all the account names appearing on the credit side of the cash book are debited as cash/cheque has been paid in respect of them.
Posting of the Double Column Cash Book
When the bank column is maintained in the cash book, the bank account also is not opened in the ledger. The bank column serves the purpose of the bank account. Entries marked C (being contra entries as explained earlier) are ignored while posting from the cash book to the ledger. These entries represent debit or credit of cash account against the bank account or viceversa. We will now see how the transactions recorded in double column cash book are posted to the individual accounts.
Posting from the Petty Cash Book
The petty cash book is balanced periodically. The difference between the total receipts and total payments is the balance with the petty cashier. The balance is carried to the next period and the petty cashier is paid the amount actually spent. A petty cash account is opened in the ledger. It is debited with the amount given to petty cashier. Each expense account is individually debited with the periodic total as per the respective column by writing “petty cash account” and the petty cash account is credited with the total expenditure incurred during the period by writing sundries as per petty cash book. The petty cash account is balanced. It reflect the actual cash with the petty cashier.
Balancing of Cash Book
On the left side, all cash transactions relating to cash receipts (debits) and on the right side all transactions relating to cash payments (credits) are entered date-wise. When a cash book is maintained, a separate cash book in the ledger is not opened. The cash book is balanced in the same way as an account in the ledger. But it may be noted that in the case of the cash book, there will always be debit balance because cash payments can never exceed cash receipts and cash in hand at the beginning of the period. The source document for cash receipts is generally the duplicate copy of the receipt issued by the cashier. For payment, any document, invoice, bill, receipt, etc. on the basis of which payment has been made, will serve as a source document for recording transactions in the cash book. When payment has been made, all these documents, popularly known as vouchers, are given a serial number and filed in a separate file for future reference and verification.
Purchases (Journal) Book
Posting from the purchases journal is done daily to their respective accounts with the relevant amounts on the credit side. The total of the purchases journal is periodically posted to the debit of the purchases account normally on the monthly basis. However, if the number of transactions is very large, this total may be done and posted at some other convenient time interval such as daily, weekly or fortnightly.
Purchases Return (Journal) Book -Posting from the purchases returns journal requires that the supplier’s individual accounts are debited with the amount of returns and the purchases returns account is credited with the periodical total.
Sales (Journal) Book - Posting from the sales journal are done to the debit of customer’s accounts kept in the ledger. Like the purchases journal, individual customer’s accounts are generally posted daily, with the amount involved. The sales journal is also totaled periodically (generally monthly), and this total is credited to sales account in the ledger.
Sales Return (Journal) Book - Posting to the sales return journal requires that the customer’s account be credited with the amount of returns and the sales return account be debited with the periodical total in the same way as is done in case of posting from the purchases journal
Balancing the Accounts
Accounts in the ledger are periodically balanced, generally at the end of the accounting period, with the object of ascertaining the net position of each amount. Balancing of an account means that the two sides are totaled and the difference between them is shown on the side, which is shorter in order to make their totals equal. The words ‘balance c/d’ are written against the amount of the difference between the two sides. The amount of balance is brought (b/d) down in the next accounting period indicating that it is a continuing account, till finally settled or closed.
In case the debit side exceeds the credit side, the difference is written on the credit side, if the credit side exceeds the debit side, the difference between the two appears on the debit side and is called debit and credit balance respectively. The accounts of expenses losses and gains/revenues are not balanced but are closed by transferring to trading and profit and loss account. The balancing of the an account is illustrated below with the help of an example explaining the complete process of recording the transactions, posting to ledger and balancing thereof.
Accounting Conventions and concepts are foundation of accounting principles Explain this statement?
In 1941, The American Institute of Certified Public Accountants (AICPA) had defined accounting as the art of recording, classifying, and summarising in a significant manner and in terms of money, transactions and events which are, in part at least, of financial character, and interpreting the results thereof’.With greater economic development resulting in changing role of accounting, its scope, became broader. In 1966, the American Accounting Association (AAA) defined accounting as ‘the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of information .Accounting is concerned with the recording, classifying and summarising of financial transactions and events and interpreting the results thereof. It aims at providing information about the financial performance of a firm to its various users such as owners, managers employees, investors, creditors,suppliers of goods and services and tax authorities and help them in taking important decisions. The investors, for example, may be interested in knowing the extent of profit or loss earned by the firm during a given period and compare it with the performance of other similar enterprises. The suppliers of credit, say a banker, may, in addition,be interested in liquidity position of the enterprise. All these people look forward to accounting for appropriate, useful and reliable information.
For making the accounting information meaningful to its internal and external users, it is important that such information is reliable as well as comparable. The comparability of information is required both to make inter-firm comparisons, i.e. to see how a firm has performed as compared to the other firms, as well as to make inter-period comparison, i.e. how it has performed as compared to the previous years. This becomes possible only if the information provided by the financial statements is based on consistent accounting policies, principles and practices. Such consistency is required throughout the process of identifying the events and transactions to be accounted for, measuring them, communicating them in the book of accounts, summarising the results thereof and reporting them to the interested parties. This calls for developing a proper theory base of accounting.
The basic accounting concepts are referred to as the fundamental ideas or basic assumptions underlying the theory and practice of financial accounting and are broad working rules for all accounting activities and developed by the accounting profession. The important concepts have been listed as below:
• Business entity;
• Money measurement;
• Going concern;
• Accounting period;
• Cost
• Dual aspect (or Duality);
• Revenue recognition (Realisation);
• Matching;
• Full disclosure;
• Consistency;
• Conservatism (Prudence);
• Materiality;
• Objectivity.
Business Entity Concept
The concept of business entity assumes that business has a distinct and
separate entity from its owners. It means that for the purposes of accounting,the business and its owners are to be treated as two separate entities. Keeping this in view, when a person brings in some money as capital into his business,in accounting records, it is treated as liability of the business to the owner. Here, one separate entity (owner) is assumed to be giving money to another distinct entity (business unit). Similarly, when the owner withdraws any money from the business for his personal expenses(drawings), it is treated as reduction of the owner’s capital and consequently a reduction in the liabilities of the business.The accounting records are made in the book of accounts from the point of view of the business unit and not that of the owner. The personal assets and liabilities of the owner are, therefore, not considered while ecording and reporting the assets and liabilities of the business. Similarly, personal transactions of the owner are not recorded in the books of the business, unless it involves inflow or outflow of business funds.
Money Measurement Concept
The concept of money measurement states that only those transactions and happenings in an organisation which can be expressed in terms of money such as sale of goods or payment of expenses or receipt of income, etc. are to be recorded in the book of accounts. All such transactions or happenings which can not be expressed in monetary terms, for example, the appointment of a manager, capabilities of its human resources or creativity of its research department or image of the organisation among people in general do not find a place in the accounting records of a firm. Another important aspect of the concept of money measurement is that the records of the transactions are to be kept not in the physical units but in the monetary unit. For example, an organisation may, on a particular day, have a factory on a piece of land measuring 2 acres, office building containing 10 rooms, 30 personal computers, 30 office chairs and tables, a bank balance of Rs.5 lakh, raw material weighing 20-tons, and 100 cartons of finished goods.These assets are expressed in different units, so can not be added to give any meaningful information about the total worth of business. For accounting purposes, therefore, these are shown in money terms and recorded in rupees and paise. In this case, the cost of factory land may be say Rs. 2 crore; office building Rs. 1 crore; computers Rs.15 lakh; office chairs and tables Rs. 2 lakh; raw material Rs. 33 lakh and finished goods Rs. 4 lakh. Thus, the total assets of the enterprise are valued at Rs. 3 crore and 59 lakh. Similarly, all transactions are recorded in rupees and paise as and when they take place. The money measurement assumption is not free from limitations. Due to the changes in prices, the value of money does not remain the same over a period of time. The value of rupee today on account of rise in prices is much less than what it was, say ten years back. Therefore, in the balance sheet,when we add different assets bought at different points of time, say building purchased in 1995 for Rs. 2 crore, and plant purchased in 2005 for Rs. 1 crore, we are in fact adding heterogeneous values, which can not be clubbed together. As the change in the value of money is not reflected in the book of accounts, the accounting data does not reflect the true and fair view of the affairs of an enterprise.
Going Concern Concept
The concept of going concern assumes that a business firm would continue to carry out its operations indefinitely, i.e. for a fairly long period of time and would not be liquidated in the foreseeable future. This is an important assumption of accounting as it provides the very basis for showing the value of assets in the balance sheet. An asset may be defined as a bundle of services. When we purchase an asset, for example, a personal computer, for a sum of Rs. 50,000, what we are buying really is the services of the computer that we shall be getting over its estimated life span, say 5 years. It will not be fair to charge the whole amount of Rs. 50,000, from the revenue of the year in which the asset is purchased. Instead, that part of the asset which has been consumed or used during a period should be charged from the revenue of that period. The assumption regarding continuity of business allows us to charge from the revenues of a period only that part of the asset which has been consumed or used to earn that revenue in that period and carry forward the remaining amount to the next years, over the estimated life of the asset. Thus, we may charge Rs. 10,000 every year for 5 years from the profit and loss account. In case the continuity assumption is not there, the whole cost (Rs. 50,000 in the present example) will need to be charged from the revenue of the year in which the asset was purchased.
Accounting Period Concept
Accounting period refers to the span of time at the end of which the financial statements of an enterprise are prepared, to know whether it has earned profits or incurred losses during that period and what exactly is the position of its assets and liabilities at the end of that period. Such information is required by different users at regular interval for various purposes, as no firm can wait for long to know its financial results as various decisions are to be taken at regular intervals on the basis of such information. The financial statements are, therefore, prepared at regular interval, normally after a period of one year, so that timely information is made available to the users. This interval of time is called accounting period. The Companies Act 1956 and the Income Tax Act require that the income statements should be prepared annually. However, in case of certain situations, preparation of interim financial statements become necessary. For example, at the time of retirement of a partner, the accounting period can be different from twelve months period. Apart from these companies whose shares are listed on the stock exchange, are required to publish quarterly results to ascertain the profitability and financial position at the end of every three months period.
Cost Concept
The cost concept requires that all assets are recorded in the book of accounts at their purchase price, which includes cost of acquisition, transportation,installation and making the asset ready to use. To illustrate, on June 2005,an old plant was purchased for Rs. 50 lakh by Shiva Enterprise, which is into the business of manufacturing detergent powder. An amount of Rs. 10,000 was spent on transporting the plant to the factory site. In addition, Rs. 15,000 was spent on repairs for bringing the plant into running position and Rs. 25,000 on its installation. The total amount at which the plant will be recorded in the books of account would be the sum of all these, i.e. Rs. 50,50,000.The concept of cost is historical in nature as it is something, which has been paid on the date of acquisition and does not change year after year. For example, if a building has been purchased by a firm for Rs. 2.5 crore, the purchase price will remain the same for all years to come, though its market value may change. Adoption of historical cost brings in objectivity in recording as the cost of acquisition is easily verifiable from the purchase documents. The market value basis, on the other hand, is not reliable as the value of an asset may change from time to time, making the comparisons between one period to another rather difficult. However, an important limitation of the historical cost basis is that it does not show the true worth of the business and may lead to hidden profits. During the period of rising prices, the market value or the cost at (which the assets can be replaced are higher than the value at which these are shown in the book of accounts) leading to hidden profits.
Dual Aspect Concept
Dual aspect is the foundation or basic principle of accounting. It provides the very basis for recording business transactions into the book of accounts. This concept states that every transaction has a dual or two-fold effect and should therefore be recorded at two places. In other words, at least two accounts will be involved in recording a transaction. This can be explained with the help of an example. Ram started business by investing in a sum of Rs. 50,00,000 The amount of money brought in by Ram will result in an increase in the assets (cash) of business by Rs. 50,00,000. At the same time, the owner’s equity or capital will also increase by an equal amount. It may be seen that the two items that got affected by this transaction are cash and capital account. Let us take another example to understand this point further. Suppose the firm purchase goods worth Rs. 10,00,000 on cash. This will increase an asset (stock of goods) on the one hand and reduce another asset (cash) on the other. Similarly, if the firm purchases a machine worth Rs. 30,00,000 on credit from Reliable Industries. This will increase an asset (machinery) on the one hand and a liability (creditor) on the other. This type of dual effect takes place in case of all business transactions and is also known as duality principle. The duality principle is commonly expressed in terms of fundamental Accounting Equation, which is as follows :
Assets = Liabilities + Capital
In other words, the equation states that the assets of a business are always equal to the claims of owners and the outsiders. The claims also called equity of owners is termed as Capital(owners’ equity) and that of outsiders, asLiabilities(creditors equity). The two-fold effect of each transaction affects in such a manner that the equality of both sides of equation is maintained. The two-fold effect in respect of all transactions must be duly recorded in the book of accounts of the business.
Revenue Recognition (Realisation) Concept
The concept of revenue recognition requires that the revenue for a business transaction should be included in the accounting records only when it is realised. Here arises two questions in mind. First, is termed as revenue and the other, when the revenue is realised. Let us take the first one first. Revenue is the gross inflow of cash arising from (i) the sale of goods and services by an enterprise; and (ii) use by others of the enterprise’s resources yielding interest, royalties and dividends. Secondly, revenue is assumed to be realised when a legal right to receive it arises, i.e. the point of time when goods have been sold or service has been rendered. Thus, credit sales are treated as revenue on the day sales are made and not when money is received from the buyer. As for the income such as rent, commission, interest, etc. these are recongnised on a time basis. For example, rent for the month of March 2005, even if received in April 2005, will be taken into the profit and loss account of the financial year ending March 31, 2005 and not into financial year beginning with April 2005. Similarly, if interest for April 2005 is received in advance in March 2005, it will be taken to the profit and loss account of the financial year ending March 2006.There are some exceptions to this general rule of revenue recognition. In case of contracts like construction work, which take long time, say 2-3 years to complete, proportionate amount of revenue, based on the part of contract completed by the end of the period is treated as realised. Similarly, when goods are sold on hire purchase, the amount collected in installments is treated as realised.
Matching Concept
The process of ascertaining the amount of profit earned or the loss incurred during a particular period involves deduction of related expenses from the revenue earned during that period. The matching concept emphasises exactly on this aspect. It states that expenses incurred in an accounting period should be matched with revenues during that period. It follows from this that therevenue and expenses incurred to earn these revenues must belong to the same accounting period.As already stated, revenue is recognised when a sale is complete or service is rendered rather when cash is received. Similarly, an expense is recognized not when cash is paid but when an asset or service has been used to generate revenue. For example, expenses such as salaries, rent, insurance are recognised on the basis of period to which they relate and not when these are paid. Similarly, costs like depreciation of fixed asset is divided over the periods during which the asset is used. Let us also understand how cost of goods are matched with their sales revenue. While ascertaining the profit or loss of an accounting year, we should not take the cost of all the goods produced or purchased during that period but consider only the cost of goods that have been sold during that year. For this purpose, the cost of unsold goods should be deducted from the cost of the goods produced or purchased. You will learn about this aspect in detail in the chapter on financial statement. The matching concept, thus, implies that all revenues earned during an accounting year, whether received during that year, or not and all costs incurred, whether paid during the year, or not should be taken into account while ascertaining profit or loss for that year.
Full Disclosure Concept
Information provided by financial statements are used by different groups of people such as investors, lenders, suppliers and others in taking various financial decisions. In the corporate form of organisation, there is a distinction between those managing the affairs of the enterprise and those owning it. Financial statements, however, are the only or basic means of communicating financial information to all interested parties. It becomes all the more important, therefore, that the financial statements makes a full, fair and adequate disclosure of all information which is relevant for taking financial decisions. The principle of full disclosure requires that all material and relevant facts concerning financial performance of an enterprise must be fully and completely disclosed in the financial statements and their accompanying footnotes. This is to enable the users to make correct assessment about the profitability and financial soundness of the enterprise and help them to take informed decisions. To ensure proper disclosure of material accounting information, the Indian Companies Act 1956 has provided a format for the preparation of profit and loss account and balance sheet of a company, which needs to be compulsorily adhered to, for the preparation of these statements. The regulatory bodieslike SEBI, also mandates complete disclosures to be made by the companies, to give a true and fair view of profitability and the state of affairs.
Consistency Concept
The accounting information provided by the financial statements would be useful in drawing conclusions regarding the working of an enterprise only when it allows comparisons over a period of time as well as with the working of other enterprises. Thus, both inter-firm and inter-period comparisons are required to be made. This can be possible only when accounting policies and practices followed by enterprises are uniform and are consistent over the period of time. To illustrate, an investor wants to know the financial performance of an enterprise in the current year as compared to that in the previous year. He
may compare this year’s net profit with that in the last year. But, if the accounting policies adopted, say with respect to depreciation in the two years are different, the profit figures will not be comparable. Because the method adopted for the valuation of stock in the past two years is inconsistent. It is, therefore, important that the concept of consistency is followed in preparation of financial statements so that the results of two accounting periods are comparable. Consistency eliminates personal bias and helps in achieving results that are comparable. Also the comparison between the financial results of two enterprises would be meaningful only if same kind of accounting methods and policies are adopted in the preparation of financial statements. However, consistency does not prohibit change in accounting policies. Necessary required changes are fully disclosed by presenting them in the financial statements indicating their probable effects on the financial results of business.
Conservatism Concept
The concept of conservatism (also called ‘prudence’) provides guidance for recording transactions in the book of accounts and is based on the policy of playing safe. The concept states that a conscious approach should be adopted in ascertaining income so that profits of the enterprise are not overstated. If the profits ascertained are more than the actual, it may lead to distribution of dividend out of capital, which is not fair as it will lead to reduction in the capital of the enterprise. The concept of conservatism requires that profits should not to be recorded until realised but all losses, even those which may have a remote possibility are to be provided for in the books of account. To illustrate, valuing closing stock at cost or market value whichever is lower; creating provision for doubtful debts, discount on debtors; writing of intangible assets like goodwill, patents, etc. from the book of accounts are some of the examples of the application of the principle of conservatism. Thus, if market value of the goods purchased has fallen down, the stock will be shown at cost price in the books but if the market value has gone up, the gain is not to be recorded until the stock is sold. This approach of providing for the losses but not recognising the gains until realised is called conservatism approach. This may be reflecting a generally pessimist attitude adopted by the accountants but is an important way of dealing with uncertainty and protecting the interests of creditors against an unwanted distribution of firm’s assets. However, deliberate attempt to underestimate the value of assets should be discouraged as it will lead to hidden profits, called secret reserves.
Materiality Concept
The concept of materiality requires that accounting should focus on material facts. Efforts should not be wasted in recording and presenting facts, which are immaterial in the determination of income. The question that arises here is what is a material fact. The materiality of a fact depends on its nature and the amount involved. Any fact would be considered as material if it is reasonably believed that its knowledge would influence the decision of informed user of financial statements. For example, money spent on creation of additional capacity of a theatre would be a material fact as it is going to increase the future earning capacity of the enterprise. Similarly, information about any change in the method of depreciation adopted or any liability which is likely to arise in the near future would be significant information. All such information about material facts should be disclosed through the financial statements and the accompanying notes so that users can take informed decisions. In certain cases, when the amount involved is very small, strict adherence to accounting principles is not required. For example, stock of erasers, pencils, scales, etc. are not shown as assets, whatever amount of stationery is bought in an accounting period is treated as the expense of that period, whether consumed or not. The amount spent is treated as revenue expenditure and taken to the profit and loss account of the year in which the expenditure is incurred.
Objectivity Concept
The concept of objectivity requires that accounting transaction should be recorded in an objective manner, free from the bias of accountants and others. This can be possible when each of the transaction is supported by verifiable documents or vouchers. For example, the transaction for the purchase of materials may be supported by the cash receipt for the money paid, if the same is purchased on cash or copy of invoice and delivery challan, if the same is purchased on credit. Similarly, receipt for the amount paid for purchase of a machine becomes the documentary evidence for the cost of machine and provides an objective basis for verifying this transaction. One of the reasons for the adoption of ‘Historical Cost’ as the basis of recording accounting transaction is that adherence to the principle of objectivity is made possible by it. As stated above, the cost actually paid for an asset can be verified from the documents but it is very difficult to ascertain the market value of an asset until it is actually sold. Not only that, the market value may vary from person to person and from place to place, and so ‘objectivity’ cannot be maintained if such value is adopted for accounting purposes.
What do you mean by Single entry system? In what types it differ from double entry system?
Single entry accounting is a simple form of bookkeeping and accounting in which each financial transaction is a single entry in a journal or transaction log. As a result, the accounting system is called, not surprisingly, a single entry system. And, the approach is also known as single entry bookkeeping. The single entry approach contrasts with double entry accounting, in which every financial event brings at least two equal and offsetting entries, one a debit (DR) and the other a credit (CR). As a result:
§ Firms using the double entry approach report financial results with an accrual reporting system.
§ Firms using single entry approach are effectively limited to reporting on a cash basis.
The Single entry approach is simpler than double entry
On the positive side, single entry accounting is simpler and much easier to use than the double entry approach. And, the single entry approach does not require background or training in accounting. Nevertheless, the overwhelming majority of firms, worldwide, use double entry not single entry—accounting.
Sections below illustrate single entry transactions and further explain:
§ Advantages and disadvantages of both systems.
§ Reasons that most firms choose double entry accounting
§ Business settings where single entry accounting can be sufficient for planning, record-keeping and financial reporting.
Single entry bookkeeping and accounting can be adequate for a small business practicing cash basis accounting. Small firms may in fact prefer single entry accounting over a double-entry system when all or most of these conditions apply:
§ The company uses cash basis accounting, not accrual accounting.
§ The company has few financial transactions per day.
§ The company does not sell on its own credit. Customers must pay at the time of the sale either in cash, by bank transfer, by 3rd-party debit card, or by writing a check. The firm does not deliver goods or services and then invoice customers for payment later.
§ The company has very few employees.
§ The company owns few expensive business-supporting physical assets. For example, it may own product inventory, office supplies, and cash in a bank account. But it does not own buildings, substantial office furniture, large computer systems, production machinery, or vehicles.
§ The company is privately held or operates as a sole proprietorship or partnership. As a result, the firm need not publish an income statement, balance sheet, or other financial statements that are mandatory for public companies.
Firms that may use single entry accounting
Under such conditions, a single entry system may meet the firm's planning and reporting needs. As a result, the single entry system may be adequate for
§ Supporting income tax reporting for the company. The primary data for this are outgoing expenses and incoming revenues.
§ Proving that the company collects and pays government sales taxes for goods or services sold.
§ Proving that the company pays its own income taxes.
§ Forecasting future budgetary needs and sales revenues.
§ Proving that the company complies with minimum wage and employee tax withholding requirements.
§ Providing real-time visibility and control of incoming and outgoing funds. The firm must be able to avoid over spending budgets or overdrawing bank accounts.
Single entry system advantages
Single entry bookkeeping and accounting have the great advantage of simplicity over double entry bookkeeping and accounting.
§ People with little or no background in finance or accounting readily understand single entry records and reports.
§ Small companies create and use single entry systems without hiring a professional accountant or bookkeeper.
§ The single entry approach does not require complex accounting software. The examples above show, for instance, that firms can create and maintain a single entry system easily in a written notebook or simple spreadsheet.
Single entry system disadvantages
Single entry accounting provides insufficient records and insufficient control for public companies and other organizations that must file audited financial statements. Nor can it—by itself—give owners and managers crucial information for evaluating the company's financial position.
Some of the important differences between the two approaches illustrate disadvantages of the single entry approach:
Double entry system: Built in error checking
A double entry system provides several forms of error checking that are absent in a single entry system. In the double entry system, every financial transaction results in both a debit (DR) in one account and an equal, offsetting credit (CR) in another account. For each reporting period, total debits must equal total credits. That is:
Total DR = Total CR
Moreover, a double entry system works so that the balance sheet equation always holds:
Assets = Liabilities + Equities
These equations together are known as the accounting equation. Any departure from these equalities in a double entry system is a signal that account histories include an error.
Single entry system: Error checking is not built in
This kind of error checking is missing from the single entry system.
If the single-entry bookkeeper mistakenly enters, say, a revenue inflow as $10,000 when the correct value is $1,000, the error may go unnoticed until the firm receives a bank statement with an unexpected low account balance.
In a double-entry system, however, the $1,000 cash deposit entry (a debit to an asset account, cash on hand) will be accompanied by another entry recognizing the source, for example, a credit to a liability account (e.g., bank loan) or a credit to another asset account (accounts receivable). If the second entry were not made, the sums of credits and debits in the system would differ, immediately revealing the error.
Double entry system: Focus on Revenues, Expenses, Assets, Liabilities, and Equities.
A double entry system keeps the firm's entire chart of accounts in view. The chart of accounts for a double entry system has in fact five kinds of accounts in two categories:
§ Firstly, Income statement accounts: (1) Revenue accounts, and (2) expense accounts.
§ Secondly, Balance sheet accounts: (3) Asset accounts, (4) Liability accounts, and (5) Equity accounts.
All transactions in a double entry system result in entries in at least two different accounts. When the company receives cash through a bank loan, the double entry system records:
§ Firstly, a debit for an asset account, e.g., Cash on hand. For an asset account, a debit is an increase.
§ Secondly, a credit to a liability account, e.g., bank loans. A credit to a liability account increases account balance.
Single entry system: Focus on Revenues and Expenses only
A single entry system tracks Revenue and Expense accounts, but does not track Asset accounts, Liabilities accounts, or Equities accounts
With a single-entry system, however, the company may receive cash from a bank loan and record that as incoming cash. In this case, however, there is no easy way to record the corresponding increase in liability (bank loan debt).
Singly entry system does not support accrual accounting
Single entry systems, moreover, work hand-in-glove with cash basis accounting, where firms record inflows and outflows only when cash actually flows. Single entry systems cannot easily support the alternative, accrual accounting. When the delivery of goods and services and customer payments come at different times, for instance, accrual accounting provides mechanisms for implementing the matching concept. Consequently, the firm recognizes revenues and the expenses that brought them in the same accounting period.
If the vendor delivery and the customer payment fall in different time periods, however, the single entry system has no way of matching the two events and thus presents a misleading picture of earnings for either period.
In conclusion: Single entry accounting is inadequate for public companies
Because of such disadvantages, it is extremely difficult to build a single entry system that conforms to GAAP requirements in most countries (Generally accepted accounting principles).This lack may not concern sole proprietorships, partnerships, or very small privately held corporations. This is because accounting system for such firms must support only the tax and employment reporting requirements.
It is nearly impossible to build a single entry system, however, that by itself supports the reporting needs of public corporations (companies that sell shares of stock to the public). A single entry system, in fact, is inadequate, for any firm that must report statements of income, financial position (balance sheet), retained earnings, or cash flow (changes in financial position).
What is trial balance? IS trial balance a proof of arithmetical accuracy? Explain .
A trial balance is a statement showing the balances, or total of debits and credits, of all the accounts in the ledger with a view to verify the arithmetical accuracy of posting into the ledger
accounts. Trial balance is an important statement in the accounting process. which shows final
position of all accounts and helps in preparing the final statements. The task of preparing the
statements is simplified because the accountant can take the account balances from the trial
balance instead of looking them up in the ledger.
It is normally prepared at the end of an accounting year. However, an organisation may prepare a trial balance at the end of any chosen period, which may be monthly, quarterly, half yearly or annually depending upon its requirements.
In order to prepare a trial balance following steps are taken:
• Ascertain the balances of each account in the ledger.
• List each account and place its balance in the debit or credit column, as the case may be. (If an account has a zero balance, it may be included in the trial balance with zero in the column for its normal balance).
• Compute the total of debit balances column.
• Compute the total of the credit balances column.
• Verify that the sum of the debit balances equal the sum of credit balances.
If they do not tally, it indicate that there are some errors. So one must check the correctness of the balances of all accounts. It may be noted that all assets expenses and receivables account shall have debit balances whereas all liabilities, revenues and payables accounts shall have credit balances
Objectives of Preparing the Trial Balance
The trial balance is prepared to fulfill the following objectives :
1. To ascertain the arithmetical accuracy of the ledger accounts.
2. To help in locating errors.
3. To help in the preparation of the financial statements.
To Ascertain the Arithmetical Accuracy of Ledger Accounts
As stated earlier, the purpose of preparing a trial balance is to ascertain whether all debits and credit are properly recorded in the ledger or not and that all accounts have been correctly balanced. As a summary of the ledger, it is a list of the accounts and their balances. When the totals of all the debit balances and credit balances in the trial balance are equal, it is assumed that the posting and balancing of accounts is arithmetically correct. However, the tallying of the trial balance is not a conclusive proof of the accuracy of the accounts. It only ensures that all debits and the corresponding credits have been properly recorded in the ledger.
To Help in Locating Errors
When a trial balance does not tally (that is, the totals of debit and credit columns are not equal), we know that at least one error has occured. The error (or errors) may have occured at one of those stages in the accounting process:
(1) totalling of subsidiary books,
(2) posting of journal entries in the ledger,
(3) calculating account balances,
(4) carrying account balances to the trial balance, and
(5) totalling the trial balance columns.
It may be noted that the accounting accuracy is not ensured even if the totals of debit and credit balances are equal because some errors do not affect equality of debits and credits. For example, the book-keeper may debit a correct amount in the wrong account while making the journal entry or in posting a journal entry to the ledger. This error would cause two accounts to have incorrect balances but the trial balance would tally. Another error is to record an equal debit and credit of an incorrect amount. This error would give the two accounts incorrect balances but would not create unequal debits and credits. As a result, the fact that the trial balance has tallied does not imply that all entries in the books of original record (journal, cash book, etc.) have been recorded and posted correctly. However, equal totals do suggest that several types of errors probably have not occured.
To Help in the Preparation of the Financial Statements
Trial balance is considered as the connecting link between accounting records and the preparation of financial statements. For preparing a financial statement, one need not refer to the ledger. In fact, the availability of a tallied trial balance is the first step in the preparation of financial statements. All revenue and expense accounts appearing in the trial balance are transferred to the trading and profit and loss account and all liabilities, capital and assets accounts are transferred to the balance sheet It is important for an accountant that the trial balance should tally. Normally a tallied trial balance means that both the debit and the credit entries have been made correctly for each transaction. However, as stated earlier, the agreement of trial balance is not an absolute proof of accuracy of accounting records. A tallied
trial balance only proves, to a certain extent, that the posting to the ledger is arithmetically correct. But it does not guarantee that the entry itself is correct. There can be errors, which affect the equality of debits and credits, and there can be errors, which do not affect the equality of debits and credits. Some common errors include the following:
• Error in totalling of the debit and credit balances in the trial balance.
• Error in totalling of subsidiary books.
• Error in posting of the total of subsidiary books.
• Error in showing account balances in wrong column of the trial balance, or in the wrong amount.
• Omission in showing an account balance in the trial balance.
• Error in the calculation of a ledger account balance.
• Error while posting a journal entry: a journal entry may not have been posted properly to the ledger, i.e., posting made either with wrong amount or on the wrong side of the account or in the wrong account.
• Error in recording a transaction in the journal: making a reverse entry, i.e., account to be debited is credited and amount to be credited is debited, or an entry with wrong amount.
• Error in recording a transaction in subsidiary book with wrong name or wrong amount.
Classification of Errors
Keeping in view the nature of errors, all the errors can be classified into the following four categories:
• Errors of Commission
• Errors of Omission
• Errors of Principle
• Compensating Errors
Errors of Commission
These are the errors which are committed due to wrong posting of transactions, wrong totalling or balancing of the accounts, wrong casting of the subsidiary books, or wrong recording of amount in the books of original entry, etc.For example: Raj Hans Traders paid Rs. 25,000 to Preetpal Traders (a supplier of goods). This transaction was correctly recorded in the cashbook. But while posting to the ledger, Preetpal’s account was debited with Rs. 2,500 only. This constitutes an error of commission. Such an error by definition is of clerical nature and most of the errors of commission affect in the trial balance.
Errors of Omission
The errors of omission may be committed at the time of recording the transaction in the books of original entry or while posting to the ledger. There can be of two types:
(i) error of complete omission
(ii) error of partial omission
When a transaction is completely omitted from recording in the books of original record, it is an error of complete omission. For example, credit sales to Mohan Rs. 10,000, not entered in the sales book. When the recording of transaction is partly omitted from the books, it is an error of partial omission. If in the above example, credit sales had been duly recorded in the sales book
but the posting from sales book to Mohan’s account has not been made, it would be an error of partial omission.
Errors of Principle
Accounting entries are recorded as per the generally accepted accounting principles. If any of these principles are violated or ignored, errors resulting from such violation are known as errors of principle. An error of principle may occur due to incorrect classification of expenditure or receipt between capital and revenue. This is very important because it will have an impact on financial statements. It may lead to under/over stating of income or assets or liabilities, etc. For example, amount spent on additions to the buildings should be treated as capital expenditure and must be debited to the asset account. Instead, if this amount is debited to maintenance and repairs account, it has been treated as a revenue expense. This is an error of principle. Similarly, if a credit purchase of machinery is recorded in purchases book instead of journal proper or rent paid to the landlord is recorded in the cash book as payment to landlord, these errors of principle. These errors do not affect the trial balance.
Compensating Errors
When two or more errors are committed in such a way that the net effect of these errors on the debits and credits of accounts is nil, such errors are called compensating errors. Such errors do not affect the tallying of the trial balance. For example, if purchases book has been overcast by Rs. 10,000 resulting in excess debit of Rs. 10,000 in purchases account and sales returns book is undercast by Rs. 10,000 resulting in short debit to sales returns account is a case of two errors compensating each other’s effect. One plus is set off by the other minus, the net effect of these two errors is nil and so they do not affect the agreement of trial balance.
Searching of Errors
If the trial balance does not tally, it is a clear indication that at least one error has occured. The error (or errors) needs to be located and corrected before preparing the financial statements.
If the trial balance does not tally, the accountant should take the following steps to detect and locate the errors :
• Recast the totals of debit and credit columns of the trial balance.
• Compare the account head/title and amount appearing in the trial balance, with that of the ledger to detect any difference in amount or omission of an account.
• Compare the trial balance of current year with that of the previous year to check additions and deletions of any accounts and also verify whether there is a large difference in amount, which is neither expected nor explained.
• Re-do and check the correctness of balances of individual accounts in the ledger.
• Re-check the correctness of the posting in accounts from the books of original entry.
• If the difference between the debit and credit columns is divisible by 2,there is a possibility that an amount equal to one-half of the difference may have been posted to the wrong side of another ledger account. For example, if the total of the debit column of the trial balance exceeds by Rs. 1,500, it is quite possible that a credit item of Rs.750 may have been wrongly posted in the ledger as a debit item. To locate such errors, the accountant should scan all the debit entries of an amount of Rs. 750.
• The difference may also indicate a complete omission of a posting. For example, the difference of Rs. 1,500 given above may be due to omissions of a posting of that amount on the credit side. Thus, the accountant should verify all the credit items with an amount of Rs. 1,500.
• If the difference is a multiple of 9 or divisible by 9, the mistake could be due to transposition of figures. For example, if a debit amount of Rs. 459 is posted as Rs. 954, the debit total in the trial balance will exceed the credit side by Rs. 495 (i.e. 954 – 459 = 495). This difference is divisible by 9. A mistake due to wrong placement of the decimal point may also be checked by this method. Thus, a difference in trial balance divisible by 9 helps in checking the errors for a transposed mistake.
Rectification of Errors which do not Affect the Trial Balance
These errors are committed in two or more accounts. Such errors are also known as two sided errors. They can be rectified by recording a journal entry giving the correct debit and credit to the concerned accounts.
Examples of such errors are – complete omission to record an entry in the books of original entry; wrong recording of transactions in the book of accounts; complete omission of posting to the wrong account on the correct side, and errors of principle.
The rectification process essentially involves:
• Cancelling the effect of wrong debit or credit by reversing it; and
• Restoring the effect of correct debit or credit.
For this purpose, we need to analyse the error in terms of its effect on the accounts involved which may be:
(i) Short debit or credit in an account ; and/or
(ii) Excess debit or credit in an account.
Therefore, rectification entry can be done by :
(i) debiting the account with short debit or with excess credit,
(ii) crediting the account with excess debit or with short credit.
Rectification of Errors Affecting Trial Balance
The errors which affect only one account can be rectified by giving an exaplanatory note in the account affected or by recording a journal entry with the help of the Suspense Account. Suspense Account is explained later in this chapter. Examples of such errors are error of casting; error of carrying forward; error of balancing; error of posting to correct account but with wrong amount; error of posting to the correct account but on the wrong side; posting to the wrong side with the wrong amount; omitting to show an account in the trial balance. An error in the books of original entry, if discovered before it is posted to the ledger, may be corrected by crossing out the wrong amount by a single line and writing the correct amount above the crossed amount and initialing it. An error in an amount posted to the correct ledger account may also be corrected in a similar way, or by making an additional posting for the difference
in amount and giving an explanatory note in the particulars column. But errors should never be corrected by erasing or overwriting reduces the authenticity of accounting records and give an impression that something is being concealed. A better way therefore is by noting the correction on the appropriate side for neutralising the effect of the error.
A Trial Balance in which the credit and debit accounts match does not prove that, all transactions have been recorded in the proper accounts. To conclude, we can say that a trial balance should not be recorded as a conclusive proof of the correctness of the books of account.
What us depreciation? What are the methods of depreciation? What factors to be taken into account while determining the amount of depreciation?
Matching principle requires that the revenue of a given period is matched against the expenses for the same period. This ensures ascertainment of the correct amount of profit or loss. If some cost is incurred whose benefits extend for more than one accounting period then it is not justified to charge the entire cost as expense in the year in which it is incurred. Rather such a cost must be spread over the periods in which it provides benefits. Depreciation, which is the main subject matter of the present chapter, deals with such a situation.
Further, it may not always be possible to ascertain with certainty the amount of some particular expense. Recall that the principle of conservatism (prudence) requires that instead of ignoring such items of expenses, adequate provision must be made and charged against profits of the current period. Moreover, a part of profit may be retained in the business in the form of reserves to provide for growth, expansion or meeting certain specific needs of the business in future. Fixed assets are the assets which are used in business for more than one accounting year. Fixed assets (technically referred to as “depreciable assets”) tend to reduce their value once they are put to use. In general, the term “Depreciation” means decline in the value of a fixed assets due to use, passage of time or obsolescence. In other words, if a business enterprise procures a machine and uses it in production process then the value of machine declines with its usage. Even if the machine is not used in production process, we can not expect it to realise the same sales price due to the passage of time or arrival of a new model (obsolescence). It implies that fixed assets are subject to decline in value and this decline is technically referred to as depreciation. As an accounting term, depreciation is that part of the cost of a fixed asset which has expired on account of its usage and/or lapse of time. Hence, depreciation is an expired cost or expense, charged against the revenue of a given accounting period. For example, a machine is purchased for Rs.1,00,000 on April 01, 2005. The useful life of the machine is estimated to be 10 years. It implies that the machine can be used in the production process for next 10 years till March 31, 2015. You understand that by its very nature, Rs. 1,00,000 is a capital expenditure during the year 2005. However, when income statement (Profit and Loss account) is prepared, the entire amount of Rs.1,00,000 can not be charged against the revenue for the year 2005, because of the reason that the capital expenditure amounting to Rs.1,00,000 is expected to derive benefits (or revenue) for 10 years and not one year. Therefore, it is logical to charge only a part of the total cost say Rs.10,000 (one tenth of Rs. 1,00,000) against the revenue for the year 2005. This part represents, the expired cost or loss in the value of machine on account of its use or passage of time and is referred to as ‘Depreciation’. The amount of depreciation, being a charge against profit, is debited to the profit and loss account Depreciation may be described as a permanent, continuing and gradual shrinkage in the book value of fixed assets. It is based on the cost of assets consumed in a business and not on its market value.
According to Institute of Cost and Management Accounting, London (ICMA) terminology “ The depreciation is the diminution in intrinsic value of the asset due to use and/or lapse of time.” Accounting Standard-6 issued by The Institute of Chartered Accountants of India (ICAI) defines depreciation as “a measure of the wearing out, consumption or other loss of value of depreciable asset arising from use, effluxion of time or obsolescence through technology and market-change. Depreciation is allocated so as to charge fair proportion of depreciable amount in each accounting period during the expected useful life of the asset. Depreciation includes amortization of assets whose useful life is pre-determined”. Depreciation has a significant effect in determining and presenting the financial position and results of operations of an enterprise. Depreciation is charged in each accounting period by reference to the extent of the depreciable
amount. It should be noted that the subject matter of depreciation, or its base, are ‘depreciable’ assets which:
• “are expected to be used during more than one accounting period;
• have a limited useful life; and
• are held by an enterprise for use in production or supply of goods and
services, for rental to others, or for administrative purposes and not for the purpose of sale in the ordinary course of business.” Examples of depreciable assets are machines, plants, furnitures, buildings, computers, trucks, vans, equipments, etc. Moreover, depreciation is the
allocation of ‘depreciable amount’, which is the “historical cost”, or other amount substituted for historical cost less estimated salvage value. Another point in the allocation of depreciable amount is the ‘expected useful life’ of an asset. It has been described as “either
(i) the period over which a depreciable asset is expected to the used by the enterprise,
(ii) the number of production of similar units expected to be obtained from the use of the
asset by the enterprise.”
Features of Depreciation
Above mentioned discussion on depreciation highlights the following features of depreciation:
1. It is decline in the book value of fixed assets.
2. It includes loss of value due to effluxion of time, usage or obsolescence.
For example, a business firm buys a machine for Rs. 1,00,000 on April 01, 2000. In the year 2002, a new version of the machine arrives in the market. As a result, the machine bought by the business firm becomes outdated. The resultant decline in the value of old machine is caused by obsolescence.
3. It is a continuing process.
4. It is an expired cost and hence must be deducted before calculating taxable profits. For example, if profit before depreciation and tax is Rs. 50,000, and depreciation is Rs. 10,000; profit before tax will be: (Rs.)Profit before depreciation & tax 50,000 (-) Depreciation (10,000)
Profit before tax 40,000
5. It is a non-cash expense. It does not involve any cash outflow. It is the process of writing-off the capital expenditure already incurred.
Causes of Depreciation
These have been very clearly spelt out as part of the definition of depreciation in the Accounting Standard 6 and are being elaborated here
Wear and Tear due to Use or Passage of Time
Wear and tear means deterioration, and the consequent diminution in an assets value, arising from its use in business operations for earning revenue. It reduces the asset’s technical capacities to serve the purpose for, which it has been meant. Another aspect of wear and tear is the physical deterioration. An asset deteriorates simply with the passage of time, even though they are not being put to any use. This happens especially when the assets are exposed
to the rigours of nature like weather, winds, rains, etc.
Expiration of Legal Rights
Certain categories of assets lose their value after the agreement governing their use in business comes to an end after the expiry of pre-determined period. Examples of such assets are patents, copyrights, leases, etc. whose utility to business is extinguished immediately upon the removal of legal backing to them.
Obsolescence
Obsolescence is another factor leading to depreciation of fixed assets. In ordinary language, obsolescence means the fact of being “out-of-date”. Obsolescence implies to an existing asset becoming out-of-date on account of the availability of better type of asset. It arises from such factors as:
• Technological changes;
• Improvements in production methods;
• Change in market demand for the product or service output of the asset;
• Legal or other description.
Abnormal Factors
Decline in the usefulness of the asset may be caused by abnormal factors such as accidents due to fire, earthquake, floods, etc. Accidental loss is permanent but not continuing or gradual. For example, a car which has been repaired after an accident will not fetch the same price in the market even if it has not been used.
Need for Depreciation
The need for providing depreciation in accounting records arises from conceptual, legal, and practical business consideration. These considerations provide depreciation a particular significance as a business expense.
Matching of Costs and Revenue
The rationale of the acquisition of fixed assets in business operations is that these are used in the earning of revenue. Every asset is bound to undergo some wear and tear, and hence lose value, once it is put to use in business.Therefore, depreciation is as much the cost as any other expense incurred in the normal course of business like salary, carriage, postage and stationary,
etc. It is a charge against the revenue of the corresponding period and must be deducted before arriving at net profit according to ‘Generally Accepted Accounting Principles’.
Consideration of Tax
Depreciation is a deductible cost for tax purposes. However, tax rules for the calculation of depreciation amount need not necessarily be similar to current business practices,
True and Fair Financial Position
If depreciation on assets is not provided for, then the assets will be over valued and the balance sheet will not depict the correct financial position of the business. Also, this is not permitted either by established accounting practices or by specific provisions of law.
Compliance with Law
Apart from tax regulations, there are certain specific legislations that indirectly compel some business organisations like corporate enterprises to provide depreciation on fixed assets.
Methods of Recording Depreciation
In the books of account, there are two types of arrangements for recording depreciation on fixed assets:
• Charging depreciation to asset account or
• Creating Provision for depreciation/Accumulated depreciation account.
Charging Depreciation to Asset account
According to this arrangement, depreciation is deducted from the depreciable cost of the asset ( credited to the asset account) and charged (or debited) to profit and loss account. Journal entries under this recording method are as follows:
1. For recording purchase of asset (only in the year of purchase)
Asset A/c Dr. (with the cost of asset including installation, freight, etc.)
To Bank/Vendor A/c
2. Following two entries are recorded at the end of every year
(a) For deducting depreciation amount from the cost of the asset.
Depreciation A/c Dr. (with the amount of depreciation)
To Asset A/c
(b) For charging depreciation to profit and loss account.
Profit & Loss A/c Dr. (with the amount of depreciation)
To Depreciation A/c
3. Balance Sheet Treatment
When this method is used, the fixed asset appears at its net book value (i.e. cost less depreciation charged till date) on the asset side of the balance sheet and not at its original cost (also known as historical cost).
Creating Provision for Depreciation Account/Accumulated Depreciation Account
This method is designed to accumulate the depreciation provided on an asset in a separate account generally called ‘depreciation provision’ or ‘accumulated depreciation’. Such accumulation of depreciation enables that the asset account need not be disturbed in any way and it continues to be shown at its original cost over the successive years of its useful life. There are some basic characteristic of this method of recording depreciation, which are given below:
• Asset account continues to appear at its original cost year after year over its entire life;
• Depreciation is accumulated on a separate account instead of being adjusted into the asset account at the end of each accounting period.
The following journal entries are recorded under this method:
1. For recording purchase of asset (only in the year of purchase)
Asset A/c Dr. (with the cost of asset including installation, expenses etc.)
To Bank/Vendor A/c (cash/credit purchase)
2. Following two journal entries are recorded at the end of each year:
(a) For crediting depreciation amount to provision for depreciation account
Depreciation A/c Dr. (with the amount of depreciation)
To Provision for depreciation A/c
(b) For charging depreciation to profit and loss account
Profit & Loss A/c Dr. (with the amount of depreciation)
To Depreciation A/c
3. Balance sheet treatment
In the balance sheet, the fixed asset continues to appear at its original cost on the asset side. The depreciation charged till that date appears in the provision for depreciation account, which is shown either on the “liabilities side” of the balance sheet or by way of deduction from the original cost of the asset concerned on the asset side of the balance sheet.
Factors Affecting the Amount of Depreciation
The determination of depreciation depends on three parameters, viz. cost, estimated useful life and probable salvage value.
Cost of Asset
Cost (also known as original cost or historical cost) of an asset includes invoice price and other costs, which are necessary to put the asset in use or working condition. Besides the purchase price, it includes freight and transportation cost, transit insurance, installation cost, registration cost, commission paid on purchase of asset add items such as software, etc. In case of purchase of a second hand asset it includes initial repair cost to put the asset in workable condition. According to Accounting Standand-6 of ICAI, cost of a fixed asset is “the total cost spent in connection with its acquisition, installation and commissioning as well as for addition or improvement of the depreciable asset”.
For example, a photocopy machine is purchased for Rs. 50,000 and Rs. 5,000 is spent on its transportation and installation. In this case the original cost of the machine is Rs. 55,000 (i.e. Rs. 50,000 + Rs.5,000 ) which will be written off as depreciation over the useful life of the machine.
Estimated Net Residual Value
Net Residual value (also known as scrap value or salvage value for accounting purpose) is the estimated net realisable value (or sale value) of the asset at the end of its useful life. The net residual value is calculated after deducting the expenses necessary for the disposal of the asset. For example, a machine is purchased for Rs. 50,000 and is expected to have a useful life of 10 years. At the end of 10th year it is expected to have a sale value of Rs. 6,000 but expenses related to its disposal are estimated at Rs. 1,000. Then its net residual value shall be Rs. 5,000 (i.e. Rs. 6,000 – Rs. 1,000).
Depreciable Cost
Depreciable cost of an asset is equal to its cost less net residual value Hence, in the above example, the depreciable cost of machine is Rs. 45,000 (i.e., Rs. 50,000 – Rs. 5,000.) It is the depreciable cost, which is distributed and charged as depreciation expense over the estimated useful life of the asset. In the above example, Rs. 45,000 shall be charged as depreciation over a period of 10 years. It is important to mention here that total amount of depreciation charged
over the useful life of the asset must be equal to the depreciable cost. If total amount of depreciation charged is less than the depreciable cost then the Depreciation, Provisions and Reserves 235 capital expenditure is under recovered. It violates the principle of proper matching of revenue and expense.
Estimated Useful Life
Useful life of an asset is the estimated economic or commercial life of the asset. Physical life is not important for this purpose because an asset may still exist physically but may not be capable of commercially viable production. For example, a machine is purchased and it is estimated that it can be used in production process for 5 years. After 5 years the machine may still be in good physical condition but can’t be used for production profitably, i.e., if it is still used the cost of production may be very high. Therefore, the useful life of the machine is considered as 5 years irrespective of its physical life. Estimation of useful life of an asset is difficult as it depends upon several factors such as usage level of asset, maintenance of the asset, technological changes, market changes, etc. As per Accounting Standard – 6 useful life of an asset is normally the “period over which it is expected to be used by the enterprise”. Normally, useful life is shorter than the physical life. The useful life of an asset is expressed in number of years but it can also be expressed in other units, e.g., number of units of output (as in case of mines) or number of working hours. Useful life depends upon the following factors :
• Pre-determined by legal or contractual limits, e.g. in case of leasehold asset, the useful life is the period of lease.
• The number of shifts for which asset is to be used.
• Repair and maintenance policy of the business organisation.
• Technological obsolescence.
• Innovation/improvement in production method.
• Legal or other restrictions.
Methods of Calculating Depreciation Amount
The depreciation amount to be charged for during an accounting year depends up on depreciable amount and the method of allocation. For this, two methods are mandated by law and enforced by professional accounting practice in India. These methods are straight line method and written down value method. Besides these two main methods there are other methods such as – annuity method, depreciation fund method, insurance policy method, sum of years digit method, double declining method, etc. which may be used for determining the amount of depreciation. The selection of an appropriate method depends upon the following :
• Type of the asset;
• Nature of the use of such asset;
• Circumstances prevailing in the business;
As per Accounting Standard-6, the selected depreciation method should be applied consistently from period to period. Change in depreciation method may be allowed only under specific circumstances.
Straight Line Method
This is the earliest and one of the widely used methods of providing depreciation. This method is based on the assumption of equal usage of the asset over its entire useful life. It is called straight line for a reason that if the amount of depreciation and corresponding time period is plotted on a graph, it will result in a straight line .
It is also called fixed installment method because the amount of depreciation remains constant from year to year over the useful life of the asset. According to this method, a fixed and an equal amount is charged as depreciation in every accounting period during the lifetime of an asset. The amount annually charged as depreciation is such that it reduces the original cost of the asset to its scrap value, at the end of its useful life. This method is also known as fixed
percentage on original cost method because same percentage of the original cost (infact depreciable cost) is written off as depreciation from year to year.
The depreciation amount to be provided under this method is computed by using the following formula:
Estimated useful life of the asset
Cost of asset Estimated - net residential value
Depreciation − Rate of depreciation under straight line method is the percentage of the total cost of the asset to be charged as deprecation during the useful lifetime of the asset. Rate of depreciation is calculated as follows:
Acquisition cost/Annual depreciation amount
Rate of Depreciation
Consider the following example, the original cost of the asset is Rs. 2,50,000. The useful life of the asset is 10 years and net residual value is estimated to be Rs. 50,000. Now, the amount of depreciation to be charged every year will be computed as given below:
Annual Depreciation Amount
Estimated life of asset
Acquisition cost of asset − Estimated net residential value
Rs. (2,50,000 - Rs. 50,000)/10
Rs. 20,000
Written Down Value Method
Under this method, depreciation is charged on the book value of the asset. Since book value keeps on reducing by the annual charge of depreciation, it is also known as reducing balance method. This method involves the application of a pre-determined proportion/percentage of the book value of the asset at the beginning of every accounting period, so as to calculate the amount of depreciation. The amount of depreciation reduces year after year. For example, the original cost of the asset is Rs. 2,00,000 and depreciation is charged @ 10% p.a. at written down value, then the amount of depreciation will be computed as follows:
As evident from the example, the amount of depreciation goes on reducing year after year. For this reason, it is also known reducing installment or diminishing value method. This method is based upon the assumption that the benefit accruing to business from assets keeps on diminishing as the asset becomes old This is due to the reason that a predetermined percentage is applied to a gradually shrinking balance on the asset account every year. Thus, large amount is recovered depreciation charge in the earlier years than in later years. Under written down value method, the rate of depreciation is computed by using the following formula
What is diminishing balance method of charging depreciation? Discuss its merits and demerits ? How does it differ from fixed installment system?
Matching principle requires that the revenue of a given period is matched against the expenses for the same period. This ensures ascertainment of the correct amount of profit or loss. If some cost is incurred whose benefits extend for more than one accounting period then it is not justified to charge the entire cost as expense in the year in which it is incurred. Rather such a cost must be spread over the periods in which it provides benefits. Depreciation, which is the main subject matter of the present chapter, deals with such a situation.
Further, it may not always be possible to ascertain with certainty the amount of some particular expense. Recall that the principle of conservatism (prudence) requires that instead of ignoring such items of expenses, adequate provision must be made and charged against profits of the current period. Moreover, a part of profit may be retained in the business in the form of reserves to provide for growth, expansion or meeting certain specific needs of the business in future. Fixed assets are the assets which are used in business for more than one accounting year. Fixed assets (technically referred to as “depreciable assets”) tend to reduce their value once they are put to use. In general, the term “Depreciation” means decline in the value of a fixed assets due to use, passage of time or obsolescence. In other words, if a business enterprise procures a machine and uses it in production process then the value of machine declines with its usage. Even if the machine is not used in production process, we can not expect it to realise the same sales price due to the passage of time or arrival of a new model (obsolescence). It implies that fixed assets are subject to decline in value and this decline is technically referred to as depreciation. As an accounting term, depreciation is that part of the cost of a fixed asset which has expired on account of its usage and/or lapse of time. Hence, depreciation is an expired cost or expense, charged against the revenue of a given accounting period. For example, a machine is purchased for Rs.1,00,000 on April 01, 2005. The useful life of the machine is estimated to be 10 years. It implies that the machine can be used in the production process for next 10 years till March 31, 2015. You understand that by its very nature, Rs. 1,00,000 is a capital expenditure during the year 2005. However, when income statement (Profit and Loss account) is prepared, the entire amount of Rs.1,00,000 can not be charged against the revenue for the year 2005, because of the reason that the capital expenditure amounting to Rs.1,00,000 is expected to derive benefits (or revenue) for 10 years and not one year. Therefore, it is logical to charge only a part of the total cost say Rs.10,000 (one tenth of Rs. 1,00,000) against the revenue for the year 2005. This part represents, the expired cost or loss in the value of machine on account of its use or passage of time and is referred to as ‘Depreciation’. The amount of depreciation, being a charge against profit, is debited to the profit and loss account Depreciation may be described as a permanent, continuing and gradual shrinkage in the book value of fixed assets. It is based on the cost of assets consumed in a business and not on its market value.
According to Institute of Cost and Management Accounting, London (ICMA) terminology “ The depreciation is the diminution in intrinsic value of the asset due to use and/or lapse of time.” Accounting Standard-6 issued by The Institute of Chartered Accountants of India (ICAI) defines depreciation as “a measure of the wearing out, consumption or other loss of value of depreciable asset arising from use, effluxion of time or obsolescence through technology and market-change. Depreciation is allocated so as to charge fair proportion of depreciable amount in each accounting period during the expected useful life of the asset. Depreciation includes amortization of assets whose useful life is pre-determined”. Depreciation has a significant effect in determining and presenting the financial position and results of operations of an enterprise. Depreciation is charged in each accounting period by reference to the extent of the depreciable
amount. It should be noted that the subject matter of depreciation, or its base, are ‘depreciable’ assets which:
• “are expected to be used during more than one accounting period;
• have a limited useful life; and
• are held by an enterprise for use in production or supply of goods and
services, for rental to others, or for administrative purposes and not for the purpose of sale in the ordinary course of business.” Examples of depreciable assets are machines, plants, furnitures, buildings, computers, trucks, vans, equipments, etc. Moreover, depreciation is the
allocation of ‘depreciable amount’, which is the “historical cost”, or other amount substituted for historical cost less estimated salvage value. Another point in the allocation of depreciable amount is the ‘expected useful life’ of an asset. It has been described as “either
(i) the period over which a depreciable asset is expected to the used by the enterprise,
(ii) the number of production of similar units expected to be obtained from the use of the
asset by the enterprise.”
Diminishing balance method
Under this method, depreciation is charged on the book value of the asset. Since book value keeps on reducing by the annual charge of depreciation, it is also known as reducing balance method. This method involves the application of a pre-determined proportion/percentage of the book value of the asset at the beginning of every accounting period, so as to calculate the amount of depreciation. The amount of depreciation reduces year after year. For example, the original cost of the asset is Rs. 2,00,000 and depreciation is charged @ 10% p.a. at written down value, then the amount of depreciation will be computed as follows:
As evident from the example, the amount of depreciation goes on reducing year after year. For this reason, it is also known reducing installment or diminishing value method. This method is based upon the assumption that the benefit accruing to business from assets keeps on diminishing as the asset becomes old This is due to the reason that a predetermined percentage is applied to a gradually shrinking balance on the asset account every year. Thus, large amount is recovered depreciation charge in the earlier years than in later years. Under written down value method, the rate of depreciation is computed by using the following formula
Advantages of Written Down Value Method
Written down value method has the following advantages:
• This method is based on a more realistic assumption that the benefits from asset go on diminishing with the passage of time. Hence, it calls for proper allocation of cost because higher depreciation is charged in earlier years when asset’s utility is more as compared to later years when it becomes less useful;
• It results into almost equal burden on profit or loss account of depreciation and repair expenses taken together every year;
• Income Tax Act accept this method for tax purposes;
• As a large portion of cost is written-off in earlier years, loss due to obsolescence gets reduced;
• This method is suitable for fixed assets, which lasts for long and which require increased repair and maintenance expenses with passage of time.
• It can also be used where obsolescence rate is high.
Limitations of Written Down Value Method
Although this method is based upon a more realistic assumption it suffers from the following limitations.
• As depreciation is calculated at fixed percentage of written down value, depreciable cost of the asset cannot be fully written-off. The value of the asset can never be zero;
• It is difficult to ascertain a suitable rate of depreciation.
Straight Line Method and Written Down Method: A Comparative Analysis
Straight line and written down value methods are generally used for calculating depreciation amount in practice. Following are the points of differences between these two methods.
Basis of Charging Depreciation
In straight line method, depreciation is charged on the basis of original cost or (historical cost). Whereas in written down value method, the basis of charging depreciation is net book value (i.e., original cost less depreciation till date) of the asset, in the beginning of the year.
Annual Charge of Depreciation
The annual amount of depreciation charged every year remains fixed or constant under straight line method. Whereas in written down value method the annual amount of depreciation is highest in the first year and subsequently declines in later years. The reason for this difference, is the difference in the basis of charging depreciation under both methods. Under straight line method depreciation is calculated on original cost while under written down value method it is calculated on written down value.
Total Charge Against Profit and Loss Account on Account of Depreciation and Repair Expenses
It is a well-accepted phenomenon that repair and maintenance expenses increase in later years of the useful life of the asset. Hence, total charge against profit and loss account in respect of depreciation and repair expenses increases in later years under straight line method. This happens because annual depreciation charge remains fixed while repair expenses increase. On the other hand, under written down value method, depreciation charge declines in later years, therefore total of depreciation and repair charge remains similar or equal year after year. Recognition by Income Tax Law
Straight line method is not recognised by Income Tax Law while written down value method is recognised by the Income Tax Law.
Suitability
Straight line method is suitable for assets in which repair charges are less,the possibility of obsolescence is less and scrap value depends upon the time period involved. Such as freehold land and buildings, patents, trade marks, etc. Written down value method is suitable for assets, which are affected by technological changes and require more repair expenses with passage of time such as plant and machinery, vehicles, etc.
Explain Final Accounts with its differences with other accounts?
Final Accounts Preparation of final account is the last stage of the accounting cycle. The basic objective of every concern maintaining the book of accounts is to find out the profit or loss in their business at the end of the year. Every businessman wishes to ascertain the financial position of his business firm as a whole during the particular period. In order to achieve the objectives for the firm, it is essential to prepare final accounts which include Manufacturing and Trading, Profit and Loss Account and Balance Sheet. The determination of profit or loss is done by preparing a Trading, Profit and Loss Account. The purpose of preparing the Balance Sheet is to know the financial soundness of a concern as a whole during the particular period.
Purpose Of Preparing
1. Determine Gross Profit and Gross loss
2. Determine Net Profit and Net Loss
3. Comparison with the Previous year's profit.
4. Details of Indirect Expenses
5. Ascertaining Financial Position.
The following procedure and important points to be considered for preparation of Trading, Profit and Loss Account and Balance Sheet.
Trading, Profit and Loss Account
Trading Account and Profit and Loss Account are the two important parts of income statements. Trading Account is the first stage in the final account which is prepared to know the trading results of gross profit or loss during a particular period. In other words, it is a summary of the purchases, and sale of a business or production cost of goods sold and the value of sales. The difference between the elements establishes the gross profit or loss which is then carried forward to the profit or loss account for calculation of net profit or net loss. Accordingly, if the sales revenue is higher than the cost of goods sold the difference is known as 'Gross Profit,' Similarly, if the sales revenue is less than the cost of goods sold the difference is known as 'Gross Loss.'
PROFIT AND LOSS ACCOUNT
The determination of Gross Profit or Gross Loss is done by preparation of Trading Account. But it does not reveal the Net Profit or Net Loss of a concern during the particular period. This is the second part of the income statement and is called as Profit and Loss Account. The purpose of preparing the profit and loss account to calculate the Net Profit or Net Loss of a concern. Net profit refers to the surplus which remains after deducting related trading expenses from the Gross Profit. The trading expenses refer to inclusive of office and administrative expenses, selling and distribution expenses. In other words, all operating expenses such as office and administrative expenses, selling and distribution expenses and nonoperating expenses are shown on the debit side and all operating and non operating gains and incomes are shown on the credit side of the Profit and Loss Account. The difference of two sides is either Net Profit or Net Loss. Accordingly, when total of all operating and non-operating expenses is more than the Gross Profit and other non-operating incomes, the difference is the Net Profit and in the reverse case it is known as Net Loss. This Net Profit or Net Loss is transferred to the Capital Account of Balance Sheet. Specimen Proforma of a Profit and Loss Account The following Specimen Proforma which is used for preparation of Trading, Profit and Loss Account.
BALANCE SHEET
According to AICPC (The American Institute of Certified Public Accountants) defines Balance Sheet as a tabular Statement of Summary of Balances (Debit and Credits) carried forward after an actual and constructive closing of books of accounts and kept according to principles of accounting. The purpose of preparing balance sheet is to know the true and fair view of the status of the business as a going concern during a particular period. The balance sheet is on~ of the important statement which is used to owners or investors to measure the financial soundness of the concern as a whole. A statement is prepared to show the list of liabilities and capital of credit balances of the business on the left hand side and list of assets and other debit balances are recorded on the right hand side is known as "Balance Sheet." The Balance Sheet is also described as a statement showing the sources of funds and application of capital or funds. In other words, liability side shows the sources from where the funds for the business were obtained and the assets side shows how the funds or capital were utilized in the business. Accordingly, it describes that all the assets owned by the concern and all the liabilities and claims it owes to owners and outsiders. Specimen Form of Balance Sheet Companies Act 1956 has prescribed a particular form for showing assets and liabilities in the Balance Sheet for companies registered under this Act. There is no prescribed form of Balance Sheet for a sole trader and partnership firm. However, the assets and liabilities can be arranged in the Balance Sheet into (a) In the Order of Liquidity (b) In the Order of Performance (a) In the Order of Liquidity: When assets and liabilities are arranged according to their order of liquidity and ability to meet its short-term obligations, such an arrangement of order is called "Liquidity Order."
The Specimen form of Balance Sheet arranged in the Order of Liquidity is given below:
Format
This statement can be reported in two different formats: account form and report form. The account form consists of two columns displaying assets on the left column of the report and liabilities and equity on the right column. You can think of this like debits and credits. The debit accounts are displayed on the left and credit accounts are on the right.
The report form, on the other hand, only has one column. This form is more of a traditional report that is issued by companies. Assets are always present first followed by liabilities and equity.
In both formats, assets are categorized into current and long-term assets. Current assets consist of resources that will be used in the current year, while long-term assets are resources lasting longer than one year.
Liabilities are also separated into current and long-term categories.
Let's look at each of the balance sheet accounts and how they are reported.
Asset Section
Similar to the accounting equation, assets are always listed first. The asset section is organized from current to non-current and broken down into two or three subcategories. This structure helps investors and creditors see what assets the company is investing in, being sold, and remain unchanged. It also helps with financial ratio analysis. Ratios like the current ratio are used to identify how leveraged a company is based on its current resources and current obligations.
The first subcategory lists the current assets in order of their liquidity. Here’s a list of the most common accounts in the current section:
• Current
• Cash
• Accounts Receivable
• Prepaid Expenses
• Inventory
• Due from Affiliates
The second subcategory lists the long-term assets. This section is slightly different than the current section because many long-term assets are depreciated over time. Thus, the assets are typically listed with a total accumulated depreciation amount subtracted from them. Here’s a list of the most common long-term accounts in this section:
• Long-term
• Equipment
• Leasehold Improvements
• Buildings
• Vehicles
• Long-term Notes Receivable
Many times there will be a third subcategory for investments, intangible assets, and or property that doesn’t fit into the first two. Here are some examples of these balance sheet items:
• Other
• Investments
• Goodwill
• Trademarks
• Mineral Rights
According to the historical cost principle, all assets, with the exception of some intangible assets, are reported on the balance sheet at their purchase price. In other words, they are listed on the report for the same amount of money the company paid for them. This typically creates a discrepancy between what is listed on the report and the true fair market value of the resources. For instance, a building that was purchased in 1975 for $20,000 could be worth $1,000,000 today, but it will only be listed for $20,000. This is consistent with the balance sheet definition that states the report should record actual events rather than speculative numbers.
Liabilities Section
Liabilities are also reported in multiple subcategories. There are typically two or three different liability subcategories in the liabilities section: current, long-term, and owner debt.
The current liabilities section is always reported first and includes debt and other obligations that will become due in the current period. This usually includes trade debt and short-term loans, but it can also include the portion of long-term loans that are due in the current period. The current debts are always listed by due dates starting with accounts payable. Here’s a list of the most common current liabilities in order of how they appear:
• Current Liabilities
• Accounts Payable
• Accrued Expenses
• Unearned Revenue
• Lines of Credit
• Current Portion of Long-term Debt
The second liabilities section lists the obligations that will become due in more than one year. Often times all of the long-term debt is simply grouped into one general listing, but it can be listed in detail. Here are some examples:
• Long-term Liabilities
• Mortgage Payable
• Notes Payable
• Loans Payable
A lot of times owners loan money to their companies instead of taking out a traditional bank loan. Investors and creditors want to see this type of debt differentiated from traditional debt that’s owed to third parties, so a third section is often added for owner’s debt. This simply lists the amount due to shareholders or officers of the company.
Equity Section
Unlike the asset and liability sections, the equity section changes depending on the type of entity. For example, corporations list the common stock, preferred stock, retained earnings, and treasury stock. Partnerships list the members’ capital and sole proprietorships list the owner’s capital.
Like all financial statements, the balance sheet has a heading that display's the company name, title of the statement and the time period of the report. For example, an annual income statement issued by Paul's Guitar Shop, Inc. would have the following heading:
• Paul's Guitar Shop, Inc.
• Balance Sheet
• December 31, 2015
Example
Here is an example of how to prepare the balance sheet from our unadjusted trial balance and financial statements used in the accounting cycle examples for Paul's Guitar Shop.
Account Format Balance Sheet
Report Format Balance Sheet
As you can see, the report format is a little bit easier to read and understand. That is why most issued reports are presented in report form. Plus, this report form fits better on a standard sized piece of paper.
One thing to note is that just like in the accounting equation, total assets equals total liabilities and equity. This is always the case. If you are preparing a balance sheet for one of your accounting homework problems and it doesn't balance, something was input incorrectly. You'll have to go back through the trial balance and T-accounts to find the error.
Now that the balance sheet is prepared and the beginning and ending cash balances are calculated, the statement of cash flows can be prepared.
Analysis
Now that you can answer the question what is a balance sheet. Let's look at how to read a balance sheet. Investors, creditors, and internal management use the balance sheet to evaluate how the company is growing, financing its operations, and distributing to its owners. A single sheet won’t tell you that much about the company, but a comparative report that shows two to three years of trend will tell you how cash is being spent, the amount of debt being paid off, and the level of investments being made each year. It will also show the if the company is funding its operations with profits or debt.
Cash Flow Statement
Cash plays a very important role in the economic life of a business. A firm needs cash to make payment to its suppliers, to incur day-to-day expenses and to pay salaries, wages, interest and dividends etc. In fact, what blood is to a human body, cash is to a business enterprise. Thus, it is very essential for a business to maintain an adequate balance of cash. For example, a concern operates profitably but it does not have sufficient cash balance to pay dividends, what message does it convey to the shareholders and public in general. Thus, management of cash is very essential. There should be focus on movement of cash and its equivalents. Cash means, cash in hand and demand deposits with the bank. Cash equivalent consists of bank overdraft, cash credit, short term deposits and marketable securities. Cash Flow Statement deals with flow of cash which includes cash equivalents as well as cash. This statement is an additional information to the users of Financial Statements. The statement shows the incoming and outgoing of cash. The statement assesses the capability of the enterprise to generate cash and utilize it. Thus a Cash-Flow statement may be defined as a summary of receipts and disbursements of cash for a particular period of time. It also explains reasons for the changes in cash position of the firm. Cash flows are cash inflows and outflows. Transactions which increase the cash position of the entity are called as inflows of cash and those which decrease the cash position as outflows of cash. Cash flow Statement traces the various sources which bring in cash such as cash from operating activities, sale of current and fixed assets, issue of share capital and debentures etc. and applications which cause outflow of cash such as loss from operations, purchase of current and fixed assets, redemption of debentures, preference shares and other long-term debt for cash. In short, a cash flow statement shows the cash receipts and disbursements during a certain period.The purpose of the cash flow statement or statement of cash flows is to provide information about a company's gross receipts and gross payments for a specified period of time.The gross receipts and gross payments will be reported in the cash flow statement according to one of the following classifications: operating activities, investing activities, and financing activities. The net change from these three classifications should equal the change in a company's cash and cash equivalents during the reporting period. For instance, the cash flow statement for the calendar year 2013 will report the causes of the change in a company's cash and cash equivalents between its balance sheets of December 31, 2012 and December 31, 2013.In addition to the cash amounts being reported as operating, investing, and financing activities, the cash flow statement must disclose other information, including the amount of interest paid, the amount of income taxes paid, and any significant investing and financing activities which did not require the use of cash.The statement of cash flows is to be distributed along with a company's income statement and balance sheet.
The statement of cash flow serves a number of objectives which are as follows :
l Cash flow statement aims at highlighting the cash generated from operating activities.
2 Cash flow statement helps in planning the repayment of loan schedule and replacement of fixed assets, etc. l Cash is the centre of all financial decisions. It is used as the basis for the projection of future investing and financing plans of the enterprise.
3 Cash flow statement helps to ascertain the liquid position of the firm in a better manner. Banks and financial institutions mostly prefer cash flow statement to analyse liquidity of the borrowing firm.
4,Cash flow Statement helps in efficient and effective management of cash.
5 The management generally looks into cash flow statements to understand the internally generated cash which is best utilised for payment of dividends
6 Cash Flow Statement based on AS-3 (revised) presents separately cash generated and used in operating, investing and financing activities.
7 It is very useful in the evaluation of cash position of a firm
Cash flow statements – benefits
Cash flow information provided in the statement of cash flows can be beneficial, for example:
• Cash flow information is harder to manipulate as it just reflects cash in and cash out, it isn’t affected by accounting policies or accruals.
• The statement of cash flows provides information about all cash inflows and outflows, from all sources.
• Cash flow information can provide more detail about the quality of the entity’s revenue, for example, whether customers are (in general) paying their bills.
• Cash accounting methods used in the statement of cash flows can be easier for non-accountants to understand.
Cash flow statements – limitations
We’ve looked at all the benefits of a statement of cash flows, but there are limitations and drawbacks.
One of the major drawbacks is how information can be manipulated in the statement of cash flows:
• Management can delay paying suppliers to increase the net cash inflows
• Management can buy goods using leasing arrangements, to avoid paying cash
Cash flows also don’t reflect the earnings of the entity, although a company should be cash positive to trade in the short term, if it is doing this at the expense of sales, or is lossmaking, it may eventually cease trading.
None of the individual financial statements on their own show a full view of the entity’s performance.
Users of the financial statements should consider all parts of the financial statements together, and also other non-financial information about the company to assess its performance.
Cash and relevant terms as per AS-3 (revised) As per AS-3 (revised) issued by the Accounting Standards Board 1.
(a) Cash fund : Cash Fund includes
(i) Cash in hand
(ii) Demand deposits with banks, and (iii) cash equivalents.
(b) Cash equivalents are short-term, highly liquid investments, readily convertible into cash and which are subject to insignificant risk of changes in values.
2. Cash Flows are inflows and outflows of cash and cash equivalents. The statement of cash flow shows three main categories of cash inflows and cash outflows, namely : operating, investing and financing activities.
(a) Operating activities are the principal revenue generating activities of the enterprise.
(b) Investing activities include the acquisition and disposal of longterm assets and other investments not included in cash equivalents.
(c) Financing activities are activities that result in change in the size and composition of the owner’s capital (including Preference share capital in the case of a company) and borrowings of the FIRM.
PREPARATION OF CASH FLOW STATEMENT
Step -I
(i) Operating Activities Cash flow from operating activities are primarily derived from the principal revenue generating activities of the enterprise. A few items of cash flows from operating activities are (i) Cash receipt from the sale of goods and rendering services.
(ii) Cash receipts from royalties, fee, Commissions and other revenue.
(iii) Cash payments to suppliers for goods and services.
(iv) Cash payment to employees
(v) Cash payment or refund of Income tax.
Determination of cash flow from operating activities There are two stages for arriving at the cash flow from operating activities
Stage-1 Calculation of operating profit before working capital changes, It can be calculated in the following manner.
Net profit before Tax and extra ordinary Items
Add Non-cash and non operating Items which have already been debited to profit and Loss Account i.e. Depreciation xxx
Amortisation of intangible assets xxx
Loss on the sale of Fixed assets. xxx
Loss on the sale of Long term Investments xxx
Provision for tax xxx
Dividend paid xxx xxx xxx
Less : Non-cash and Non-operating Items which have already been credited to Profit and Loss Account i.e.
Profit on sale of fixed assets xxx
Profit on sale of Long term investment xxx xxx
Operating profit before working Capital changes. xxx
Stage-II
After getting operating profit before working capital changes as per stage I, adjust increase or decrease in the current assets and current liabilities. The following general rules may be applied at the time of adjusting current assets and current liabilities.
A. Current assets
(i) An increase in an item of current assets causes a decrease in cash inflow because cash is blocked in current assets
(ii) A decrease in an item of current assets causes an increase in cash inflow because cash is released from the sale of current assets.
B. Current liabilities
(i) An increase in an item of current liability causes a decrease in cash outflow because cash is saved. (ii) A decrease in an item of current liability causes increase in cash out flow because of payment of liability. Thus,
Cash from operations = operating profit before working capital changes + Net decrease in current assets + Net Increase in current liabilities – Net increase in current assets – Net decrease in current liabilities
Step - II - Investing Activities
Investing Activities refer to transactions that affect the purchase and sale of fixed or long term assets and investments. Examples of cash flow arising from Investing activities are
1. Cash payments to acquire fixed Assets
2. Cash receipts from disposal of fixed assets
3. Cash payments to acquire shares, or debenture investment.
4. Cash receipts from the repayment of advances and loans made to third parties. Thus, Cash inflow from investing activities are
– Cash sale of plant and machinery, land and Building, furniture, goodwill etc.
– Cash sale of investments made in the shares and debentures of other companies
– Cash receipts from collecting the Principal amount of loans made to third parties.
Cash outflow from investing activities are :
– Purchase of fixed assets i.e. land, Building, furniture, machinery etc.
– Purchase of Intangible assets i.e. goodwill, trade mark etc.
– Purchase of shares and debentures
– Purchase of Government Bonds
– Loan made to third parties
Step- III - Financing Activities
The third section of the cash flow statement reports the cash paid and received from activities with non-current or long term liabilities and shareholders Capital. Examples of cash flow arising from financing activities are
– Cash proceeds from issue of shares or other similar instruments.
– Cash proceeds from issue of debentures, loans, notes, bonds, and other short-term borrowings
– Cash repayment of amount borrowed Cash Inflow from financing activities are
- Issue of Equity and preference share capital for cash only.
– Issue of Debentures, Bonds and long-term note for cash only
Cash outflow from financing activities are :
– Payment of dividends to shareholders
– Redemption or repayment of loans i.e. debentures and bonds
– Redemption of preference share capital
– Buy back of equity shares.
TREATMENT OF SPECIAL ITEMS
(i) Payment of Interim Dividends The following procedure is followed
(i) The amount of interim dividend paid during the year is shown as outflow of cash in cash flow statement.
(ii) It will be added back to the profits for the purpose of calculating cash provided from operating activities.
(iii) No adjustment is necessary if the cash provided from operating activities is calculated on the basis of revised figure of net profit
(ii) Proposed dividend The dividend is always declared in the general meeting after the preparation of Balance Sheet. It is therefore, a non-operating item which should not be permitted to affect the calculation of cash generated by operating activities. Thus, the amount of proposed dividends would be added back to current years profit and payments made during the year in respect of dividends would be shown as an outflow of cash.
(iii) Share Capital The increase in share capital is regarded as inflow of cash only when there is a increase in share capital. For example, if a company issues 10000 equity shares of Rs.10 each for cash only, Rs. 100,000 would be shown as inflow of cash from financing activities. Similarly, the redemption of preference share is an outflow of cash. But where the share capital is issued to finance the purchase of fixed assets or the debentures are converted into equity shares there is no cash flow. Further, the issue of bonus shares does not cause any cash flows.
(iv) Purchase or sale of fixed Assets The figures appearing in the comparative balance sheets at two dates in respect of fixed assets might indicate whether a particular fixed asset has been purchased or sold during the year. This would enable to determine the inflows or outflows of cash. For example, If the plant and machinery appears at Rs 60,000 in the current year and Rs.50,000 in the previous year, the only conclusion, in the absence of any other information is that there is a purchase of fixed assets for Rs.10000 during the year. Hence, Rs.10000 would be shown as outflow of cash.
(v) Provision for Taxation It is a non-operating expenses or an item of appropriation in the Income statement/Profit and Loss Account and therefore should not be allowed to reduce the cash provided from operating activities. Hence, if the profit is given after tax and the amount of the provision for tax made during the year is given, the same would be added back to the current year profit figure. In the cash flow statement, the tax paid would be recorded separately as an outflow of cash. The item of provision for taxation, would not be treated as current assets. Sometimes, the only information available about provision for taxation is two figures appearing in the opening balance sheet and closing balance sheet. In such a case the figure in the opening balance sheet is treated as an outflow of cash while the figure in the closing balance sheet is treated as a non-cash and non-operating expense and thus is added back to net Income figure to find out the cash provided from operating activities.
Funds Flow Statement
Meaning of Funds Flow Statement:
Funds flow statement is a statement which discloses the analytical information about the different sources of a fund and the application of the same in an accounting cycle. It deals with the transactions which change either the amount of current assets and current liabilities (in the form of decrease or increase in working capital) or fixed assets, long-term loans including ownership fund.
It gives a clear picture about the movement of funds between the opening and closing dates of the Balance Sheet. It is also called the Statement of Sources and Applications of Funds, Movement of Funds Statement; Where Got—Where Gone Statement: Inflow and Outflow of Fund Statement, etc. No doubt, Funds Flow Statement is an important indicator of financial analysis and control. It is valuable and also helps to determine how the funds are financed. The financial analyst can evaluate the future flows of a firm on the basis of past data.
This statement supplies an efficient method for the financial manager in order to assess the:
(a) Growth of the firm,
(b) Its resulting financial needs, and
(c) To determine the best way to finance those needs.
In particular, funds flow statements are very useful in planning intermediate and long-term financing.
Objective of Preparing a Fund Flow Statement:
The main purpose of preparing a Funds Flow Statement is that it reveals clearly the important items relating to sources and applications of funds of fixed assets, long-term loans including capital. It also informs how far the assets derived from normal activities of business are being utilized properly with adequate consideration.
Secondly, it also reveals how much out of the total funds is being collected by disposing of fixed assets, how much from issuing shares or debentures, how much from long-term or short-term loans, and how much from normal operational activities of the business.
Thirdly, it also provides the information about the specific utilization of such funds, i.e. how much has been applied for acquiring fixed assets, how much for repayment of long-term or short-term loans as well as for payment of tax and dividend etc.
Lastly, it helps the management to prepare budgets and formulate the policies that will be adopted for future operational activities.
Significance and Importance of Funds Flow Statement:
Since traditional reports (i.e. Income Statement/Profit and Loss Account, and Balance Sheet) are not very informative, a financial analyst has to depend on some other report—Funds Flow Statement. In other words, along with the traditional sources of information, some other sources of information are absolutely required in order to take the challenge offered by modern business.
Funds Flow Statement, no doubt, caters to the needs of management. This is because a Funds Flow Statement not only presents the Balance Sheet values for consecutive two years, it also ascertains the changes of working capital—which is a very important indicator.
It not only reveals the source from which additional working capital has been financed but also, at the same time, the use of such funds. Moreover, from a projected funds flow statement the management can easily ascertain the adequacy or inadequacy of working capital, i.e., it helps in decision-making in a number of ways.
The significance and importance of Funds Flow Statements may be summarized as:
(a) Analysis of Financial Statement:
The traditional financial statements, viz. Profit and Loss Account and Balance Sheet, exhibit the result of the operation and financial position of a firm. Balance Sheet presents a static view about the resources and how the said resources have been utilized at a particular date with recording the changes in financial activities. But Funds Flow Statement can do so, i.e., it explains the causes of changes so made and effect of such change in the firm accordingly.
(b) Highlighting Answers to Various Perplexing Questions:
Funds Flow Statement highlights answers of the following questions:
(i) Causes of changes in Working Capital;
(ii) Whether the firm sells any Non-Current Asset; if sold, how were the proceeds utilized?
(iii) Why smaller amount of dividend is paid in spite of sufficient profit?
(iv) Where did the net profit go?
(v) Was it possible to pay more dividend than the present one?
(vi) Did the firm pay-off its scheduled debts? If so, how, and from what sources?
(vii) Sources of increased Working Capital, etc.
(c) Realistic Dividend Policy:
Sometimes it may so happen that a firm, instead of having sufficient profit, cannot pay dividend due to lack of liquid sources, viz. cash. In such a circumstance, Funds Flow Statement helps the firm to take decision about a sound dividend policy which is very helpful to the management.
(d) Proper Allocation of Resources:
Resources are always limited. So, it is the duty of the management to make its proper use. A projected Funds Flow Statement helps the management to take proper decision about the proper allocation of business resources in a best possible manner since it highlights the future.
(e) As a Future Guide:
A projected Funds Flow Statement acts as a business guide. It helps the management to make provision for the future for the necessary funds to be required on the basis of the problem faced. In other words, the future needs of the fund for various purposes can be known well in advance which is a very helpful guide to the management. In short, a firm may arrange funds on the basis of this statement in order to avoid the financial problem that may arise in future.
(f) Appraising of the Working Capital:
A projected Funds Flow Statement, no doubt, helps the management to know about how the working capital has been efficiently used and, at the same time, also suggests how to improve the working capital position for the future on the basis of the present problem faced by it, if any.
Preparing Funds Flow Statement: Steps, Rules and Format
Steps for Preparing Funds Flow Statement:
The steps involved in preparing the statement are as follows:
1. Determine the change (increase or decrease) in working capital.
2. Determine the adjustments account to be made to net income.
3. For each non-current account on the balance sheet, establish the increase or decrease in that account. Analyze the change to decide whether it is a source (increase) or use (decrease) of working capital.
4. Be sure the total of all sources including those from operations minus the total of all uses equals the change found in working capital in Step 1.
General Rules for Preparing Funds Flow Statement:
The following general rules should be observed while preparing funds flow statement:
1. Increase in a current asset means increase (plus) in working capital.
2. Decrease in a current asset means decrease (minus) in working capital.
3. Increase in a current liability means decrease (minus) in working capital.
4. Decrease in a current liability means increase (plus) in working capital.
5. Increase in current asset and increase in current liability does not affect working capital.
6. Decrease in current asset and decrease in current liability does not affect working capital.
7. Changes in fixed (non-current) assets and fixed (non-current) liabilities affects working capital.
Format of Funds Flow Statement:
A funds flow statement can be prepared in statement form or ‘T’ form.
Both the formats are given below:
Schedule of Changes in Working Capital:
Many business enterprises prefer to prepare another statement, known as schedule of changes in working capital, while preparing a funds flow statement, on a working capital basis. This schedule of changes in working capital provides information concerning the changes in each individual current assets and current liabilities accounts (items).
This schedule is a part of the funds flow statement and increase (decrease) in working capital indicated by the schedule of changes in working capital will be equal to the amount of changes in working capital as found by funds flow statement. The schedule of changes in working capital can be prepared by comparing the current assets and current liabilities at two periods.
The format of schedule of changes in working capital is as follows:
Bank Reconciliation
Have you ever balanced your checkbook? Why did you do that? Was it to make sure that you didn't make any mistakes when you were adding deposits or subtracting expenses? I bet it was because you wanted to make sure that your balance in your checkbook was the same as the balance in the bank, right? Everything that we just talked about refers to what we in accounting commonly call doing a bank reconciliation. A bank reconciliation is the balancing of a company's cash account balance to its bank account balance.
Need for Reconciliation
It is generally experienced that when a comparison is made between the bank balance as shown in the firm’s cash book, the two balances do not tally.Hence, we have to first ascertain the causes of difference thereof and then reflect them in a statement called Bank Reconciliation Statement to reconcile (tally) the two balances. In order to prepare a bank reconciliation statement we need to have a bank balance as per the cash book and a bank statement as on a particular day along with details of both the books. If the two balances differ, the entries in both the books are compared and the items on account of which the difference has arisen are ascertained with the respective amounts involved so
that the bank reconciliation statement may be prepared..
Reconciliation of the cash book and the bank passbook balances amounts to an explanation of differences between them. The differences between the cash book and the bank passbook is caused by:
1. timing differences on recording of the transactions
2. errors made by the business or by the bank.
Timing Differences
When a business compares the balance of its cash book with the balance shown by the bank passbook, there is often a difference, which is caused by the time gap in recording the transactions relating either to payments or receipts. The factors affecting time gap includes :
1(a) Cheques issued by the bank but not yet presented for payment
When cheques are issued by the firm to suppliers or creditors of the firm, these are immediately entered on the credit side of the cash book. However, the receiving party may not present the cheque to the bank for payment immediately. The bank will debit the firm’s account only when these cheques are actually paid by the bank. Hence, there is a time lag between the issue of a cheque and its presentation to the bank which may cause the difference between the two balances.
1(b) Cheques paid into the bank but not yet collected
When firm receives cheques from its customers (debtors), they are immediately recorded in the debit side of the cash book. This increases the bank balance as per the cash book. However, the bank credits the customer account only when the amount of cheques are actually realised. The clearing of cheques generally takes few days especially in case of outstation cheques or when the cheques are paid-in at a bank branch other than the one at which the account of the firm is maintained. This leads to a cause of difference between the bank balance shown by the cash book and the balance shown by the bank passbook.
1(c) Direct debits made by the bank on behalf of the customer
Sometimes, the bank deducts amount for various services from the account without the firm’s knowledge. The firm comes to know about it only when the bank statement arrives. Examples of such deductions include: cheque collection charges, incidental charges, interest on overdraft, unpaid cheques deducted by the bank – i.e. stopped or bounced, etc. As a result, the balance as per passbook will be less than the balance as per cash book.
1(d) Amounts directly deposited in the bank account
There are instances when debtors(customers) directly deposits money into firm’s bank account. But, the firm does not receive the intimation from any source till it receives the bank statement. In this case, the bank records the receipts in the firm’s account at the bank but the same is not recorded in the firm’s cash book. As a result, the balance shown in the bank passbook will be more than the balance shown in the firm’s cash book.
1(e) Interest and dividends collected by the bank
When the bank collects interest and dividend on behalf of the customer, then these are immediately credited to the customers account. But the firm will know about these transactions and record the same in the cash book only when it receives a bank statement. Till then the balances as per the cash book and passbook will differ.
1(f) Direct payments made by the bank on behalf of the customers
Sometimes the customers give standing instructions to the bank to make some payment regularly on stated days to the third parties. For example, telephone bills, insurance premium, rent, taxes, etc. are directly paid by the bank on behalf of the customer and debited to the account. As a result, the balance as per the bank passbook would be less than the one shown in the cash book.
1(g) Cheques deposited/bills discounted dishonoured
If a cheque deposited by the firm is dishonoured or a bill of exchange drawn by the business firm is discounted with the bank is dishonoured on the date of maturity, the same is debited to customer’s account by the bank. As this information is not available to the firm immediately, there will be no entry in the firm’s cash book regarding the above items. This will be known to the firm when it receives a statement from the bank. As a result, the balance as per the passbook would be less than the cash book balance.
Differences Caused by Errors
Sometimes the difference between the two balances may be accounted for by an error on the part of the bank or an error in the cash book of the business. This causes difference between the bank balance shown by the cash book and the balance shown by the bank statement.
2(a) Errors committed in recording transaction by the firm
Omission or wrong recording of transactions relating to cheques issued, cheques deposited and wrong totalling, etc. committed by the firm while recording entries in the cash book cause difference between cash book and passbook balance.
2(b) Errors committed in recording transactions by the bank
Omission or wrong recording of transactions relating to cheques deposited and wrong totalling, etc. committed by the bank while posting entries in the passbook also cause differences between passbook and cash book balance.
Preparation of Bank Reconciliation Statement without adjusting Cash Book Balance
To prepare bank reconciliation statement, under this approach, the balance as per cash book or as per passbook is the starting item. The debit balance as per the cash book means the balance of deposits held at the bank. Such a balance will be a credit balance as per the passbook. Such a balance exists when the deposits made by the firm are more than its withdrawals. It indicates the favourable balance as per cash book or favourable balance as per the passbook. On the other hand, the credit balance as per the cash book indicates bank overdraft. In other words, the excess amount withdrawn over the amount deposited in the bank. It is also known as unfavourable balance as per cash book or unfavourable balance as per passbook.
We may have four different situations while preparing the bank reconciliation statement. These are :
1. When debit balance (favourable balance) as per cash book is given and the balance as per passbook is to be ascertained.
2. When credit balance (favourable balance) as per passbook is given and the balance as per cash book is to be ascertained.
3. When credit balance as per cash book (unfavourable balance/overdraft balance) is given and the balance as per passbook is to ascertained.
4. When debit balance as per passbook (unfavourable balance/overdraft balance) is given and the cash book balance as per is to ascertained.
.1(a) Dealing with favourable balances
The following steps may be initiated to prepare the bank reconciliation statement:
(i) The date on which the statement is prepared is written at the top, as part of the heading.
(ii) The first item in the statement is generally the balance as shown by the cash book. Alternatively, the starting point can also be the balance as per passbook.
(iii) The cheques deposited but not yet collected are deducted.
(iv) All the cheques issued but not yet presented for payment, amounts directly deposited in the bank account are added.
(v) All the items of charges such as interest on overdraft, payment by bank on standing instructions and debited by the bank in the passbook but not entered in cash book, bills and cheques dishonoured etc. are deducted.
(vi) All the credits given by the bank such as interest on dividends collected, etc. and direct deposits in the bank are added.
(vii) Adjustment for errors are made according to the principles of rectification of errors.
(viii) Now the net balance shown by the statement should be same as shown by the passbook.
It may be noted that treatment of all items shall be the reverse of the above if we adjust passbook balance as the starting point.
1(b) Dealing with overdrafts
So far we have dealt with bank reconciliation statement where bank balances has been positive – i.e., there has been money in the bank account. However, businesses sometimes have overdrafts at the bank. Overdrafts are where the bank account becomes negative and the businesses in effect have borrowed from the bank. This is shown in the cash book as a credit balance. In the bank statement, where the balance is followed by Dr. (or sometimes OD) means that there is an overdraft and called debit balance as per passbook.
An overdraft is treated as negative figure on a bank reconciliation statement.
Preparation of Bank Reconciliation Statement with Adjusted Cash Book
When we look at the various items that normally cause the difference between the passbook balance and the cash book balance, we find a number of items, which appear only in the passbook. Why not first record such items in the cash book to work out the adjusted balance (also known as amended balance) of the cash book and then prepare the bank reconciliation statement. This shall reduce the number of items responsible for the difference and have the correct figure of balance at bank in the balance sheet. In fact, this is exactly what is done in practice whereby only those items which cause the difference on account of the time gap in recording appear in bank reconciliation statement. These are as (i) cheques issued but not yet presented, (ii) cheques deposited but not yet collected, and (iii) due to an error in the passbook.
Ratio Analysis: Meaning, Classification and Limitation of Ratio Analysis!Meaning:
Ratio analysis is the process of determining and interpreting numerical relationships based on financial statements. A ratio is a statistical yardstick that provides a measure of the relationship between two variables or figures.
This relationship can be expressed as a percent or as a quotient. Ratios are simple to calculate and easy to understand. The persons interested in the analysis of financial statements can be grouped under three heads,
i) owners or investors
ii) creditors and
iii) financial executives.
Although all these three groups are interested in the financial conditions and operating results, of an enterprise, the primary information that each seeks to obtain from these statements differs materially, reflecting the purpose that the statement is to serve.
Investors desire primarily a basis for estimating earning capacity. Creditors are concerned primarily with liquidity and ability to pay interest and redeem loan within a specified period. Management is interested in evolving analytical tools that will measure costs, efficiency, liquidity and profitability with a view to make intelligent decisions.
Ratio analysis is useful in many ways to different concerned parties according to their respective requirements. Ratio analysis can be used in the following ways:
To know the financial strength and weakness of an organization.
To measure operative efficiency of a concern.
For the management to review past year’s activity.
To assess level of efficiency.
To predict the future plans of a business.
To optimize capital structure.
In inter and intra company comparisons.
To measure liquidity, solvency, profitability and managerial efficiency of a concern.
In proper utilization of assets of a company.
In budget preparation.
In assessing solvency of a firm, bankruptcy position of a firm, and chances of corporate sickness.
Classification of Ratios:Financial ratios can be classified under the following five groups:1) Structural
2) Liquidity
3) Profitability
4) Turnover
5) Miscellaneous.
1. Structural group:The following are the ratios in structural group:i) Funded debt to total capitalisation:The term ‘total’ capitalisation comprises loan term debt, capital stock and reserves and surplus. The ratio of funded debt to total capitalisation is computed by dividing funded debt by total capitalisation. It can also be expressed as percentage of the funded debt to total capitalisation. Long term loans
Total capitalisation (Share capital + Reserves and surplus + long term loans)
ii) Debt to equity:
Due care must be given to the; computation and interpretation of this ratio. The definition of debt takes two foremost. One includes the current liabilities while the other excludes them. Hence the ratio may be calculated under the following two methods:
Long term loans + short term credit + Total debt to equity = Current liabilities and provisions Equity share capital + reserves and surplus (or)
Long-term debt to equity =
Long – term debt / Equity share capital + Reserves and surplus
iii) Net fixed assets to funded debt:
This ratio acts as a supplementary measure to determine security for the lenders. A ratio of 2:1 would mean that for every rupee of long-term indebtedness, there is a book value of two rupees of net fixed assets:
Net Fixed assets funded debt
iv) Funded (long-term) debt to net working capital:The ratio is calculated by dividing the long-term debt by the amount of the net working capital. It helps in examining creditors’ contribution to the liquid assets of the firm.
Long term loans Net working capital
2. Liquidity group:
It contains current ratio and Acid test ratio.
i) Current ratio:It is computed by dividing current assets by current liabilities. This ratio is generally an acceptable measure of short-term solvency as it indicates the extent to which he claims of short term creditors are covered by assets that are likely to be converted into cash in a period corresponding to the maturity of the claims. Current assets / Current liabilities and provisions + short-term credit against inventory
ii) Acid-test ratio:It is also termed as quick ratio. It is determined by dividing “quick assets”, i.e., cash, marketable investments and sundry debtors, by current liabilities. This ratio is a bitterest of financial strength than the current ratio as it gives no consideration to inventory which may be very a low- moving.
3. Profitability Group:The results of business operations can be calculated through profitability ratios. These ratios can also be used to know the overall performance and effectiveness of a firm. Two types of profitability ratios are calculated in relation to sales and investments.
It has five ratio, and they are calculated as follows: 4. Turnover group:Activity ratios are also called turnover ratios. Activity ratios measure the efficiency with which the resources of a firm are employed.
It has four ratios, and they are calculated as follows: 5. Miscellaneous group:It contains four ratio and they are as follows: Standards for comparison:For making a proper use of ratios, it is essential to have fixed standards for comparison. A ratio by itself has very little meaning unless it is compared to some appropriate standard. Selection of proper standards of comparison is a most important element in ratio analysis. The four most common standards used in ratio analysis are; absolute, historical, horizontal and budgeted.
Absolute standards are those which become generally recognised as being desirable regardless of the company, the time, the stage of business cycle, or the objectives of the analyst. Historical standards involve comparing a company’s own’ past performance as a standard for the present or future.
In Horizontal standards, one company is compared with another or with the average of other companies of the same nature.
The budgeted standards are arrived at after preparing the budget for a period Ratios developed from actual performance are compared to the planned ratios in the budget in order to examine the degree of accomplishment of the anticipated targets of the firm.
Advantages of Ratio Analysis
• It is powerful tool to measure short and long-term solvency of a company.
• It is a tool to measure profitability and managerial efficiency of a company.
• It is an important tool to measure operating activities of a business.
• It helps in analyzing the capital structure of a company.
• Large quantitative data may be summarized using ratio analysis.
• It relates past accounting performances with the current.
• It is useful in coordinating the different functional machineries of a company.
• It helps the management in future decision-making.
• It helps in maintaining a reasonable balance between sales and purchase and estimating working capital requirements.
Limitations:
The following are the limitations of ratio analysis:1. It is always a challenging job to find an adequate standard. The conclusions drawn from the ratios can be no better than the standards against which they are compared.
2. When the two companies are of substantially different size, age and diversified products,, comparison between them will be more difficult.
3. A change in price level can seriously affect the validity of comparisons of ratios computed for different time periods and particularly in case of ratios whose numerator and denominator are expressed in different kinds of rupees.
4. Comparisons are also made difficult due to differences of the terms like gross profit, operating profit, net profit etc.
5. If companies resort to ‘window dressing’, outsiders cannot look into the facts and affect the validity of comparison.
6. Financial statements are based upon part performance and part events which can only be guides to the extent they can reasonably be considered as dues to the future.
7. Ratios do not provide a definite answer to financial problems. There is always the question of judgment as to what significance should be given to the figures. Thus, one must rely upon one’s own good sense in selecting and evaluating the ratios.
Marginal costs
Introduction
The costs that vary with a decision should only be included in decision analysis. For many decisions that involve relatively small variations from existing practice and/or are for relatively limited periods of time, fixed costs are not relevant to the decision. This is because either fixed costs tend to be impossible to alter in the short term or managers are reluctant to alter them in the short term.
Marginal costing - definition
Marginal costing distinguishes between fixed costs and variable costs as convention ally classified.
The marginal cost of a product –“ is its variable cost”. This is normally taken to be; direct labour, direct material, direct expenses and the variable part of overheads.
Marginal costing is formally defined as:
‘the accounting system in which variable costs are charged to cost units and the fixed costs of the period are written-off in full against the aggregate contribution. Its special value is in decision making’. (Terminology.)
The term ‘contribution’ mentioned in the formal definition is the term given to the difference between Sales and Marginal cost. Thus
MARGINAL COST = VARIABLE COST DIRECT LABOUR
+
DIRECT MATERIAL
+
DIRECT EXPENSE
+
VARIABLE OVERHEADS
CONTRIBUTION SALES - MARGINAL COST
The term marginal cost sometimes refers to the marginal cost per unit and sometimes to the total marginal costs of a department or batch or operation. The meaning is usually clear from the context.
Note
Alternative names for marginal costing are the contribution approach and direct costing In this lesson, we will study marginal costing as a technique quite distinct from absorption costing.
Theory of Marginal Costing
The theory of marginal costing as set out in “A report on Marginal Costing” published by CIMA, London is as follows:
In relation to a given volume of output, additional output can normally be obtained at less than proportionate cost because within limits, the aggregate of certain items of cost will tend to remain fixed and only the aggregate of the remainder will tend to rise proportionately with an increase in output. Conversely, a decrease in the volume of output will normally be accompanied by less than proportionate fall in the aggregate cost.
The theory of marginal costing may, therefore, by understood in the following two steps:
1. If the volume of output increases, the cost per unit in normal circumstances reduces. Conversely, if an output reduces, the cost per unit increases. If a factory produces 1000 units at a total cost of 3,000 and if by increasing the output by one unit the cost goes up to 3,002, the marginal cost of additional output will be 2.
2. If an increase in output is more than one, the total increase in cost divided by the total increase in output will give the average marginal cost per unit. If, for example, the output is increased to 1020 units from 1000 units and the total cost to produce these units is $1,045, the average marginal cost per unit is 2.25. It can be described as follows:
Additional cost =
Additional units 45 = $2.25
20
The ascertainment of marginal cost is based on the classification and segregation of cost into fixed and variable cost. In order to understand the marginal costing technique, it is essential to understand the meaning of marginal cost.
Marginal cost means the cost of the marginal or last unit produced. It is also defined as the cost of one more or one less unit produced besides existing level of production. In this connection, a unit may mean a single commodity, a dozen, a gross or any other measure of goods.
For example, if a manufacturing firm produces X unit at a cost of $ 300 and X+1 units at a cost of $ 320, the cost of an additional unit will be $ 20 which is marginal cost. Similarly if the production of X-1 units comes down to $ 280, the cost of marginal unit will be $ 20 (300–280).
The marginal cost varies directly with the volume of production and marginal cost per unit remains the same. It consists of prime cost, i.e. cost of direct materials, direct labor and all variable overheads. It does not contain any element of fixed cost which is kept separate under marginal cost technique.
Marginal costing may be defined as the technique of presenting cost data wherein variable costs and fixed costs are shown separately for managerial decision-making. It should be clearly understood that marginal costing is not a method of costing like process costing or job costing. Rather it is simply a method or technique of the analysis of cost information for the guidance of management which tries to find out an effect on profit due to changes in the volume of output.
There are different phrases being used for this technique of costing. In UK, marginal costing is a popular phrase whereas in US, it is known as direct costing and is used in place of marginal costing. Variable costing is another name of marginal costing.
Marginal costing technique has given birth to a very useful concept of contribution where contribution is given by: Sales revenue less variable cost (marginal cost)
Contribution may be defined as the profit before the recovery of fixed costs. Thus, contribution goes toward the recovery of fixed cost and profit, and is equal to fixed cost plus profit (C = F + P).
In case a firm neither makes profit nor suffers loss, contribution will be just equal to fixed cost (C = F). this is known as break even point.
The concept of contribution is very useful in marginal costing. It has a fixed relation with sales. The proportion of contribution to sales is known as P/V ratio which remains the same under given conditions of production and sales.
The principles of marginal costing
The principles of marginal costing are as follows.
a. For any given period of time, fixed costs will be the same, for any volume of sales and production (provided that the level of activity is within the ‘relevant range’). Therefore, by selling an extra item of product or service the following will happen.
§ Revenue will increase by the sales value of the item sold.
§ Costs will increase by the variable cost per unit.
§ Profit will increase by the amount of contribution earned from the extra item.
b. Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item.
c. Profit measurement should therefore be based on an analysis of total contribution. Since fixed costs relate to a period of time, and do not change with increases or decreases in sales volume, it is misleading to charge units of sale with a share of fixed costs.
d. When a unit of product is made, the extra costs incurred in its manufacture are the variable production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased.
Features of Marginal Costing
The main features of marginal costing are as follows:
1. Cost Classification
The marginal costing technique makes a sharp distinction between variable costs and fixed costs. It is the variable cost on the basis of which production and sales policies are designed by a firm following the marginal costing technique.
2. Stock/Inventory Valuation
Under marginal costing, inventory/stock for profit measurement is valued at marginal cost. It is in sharp contrast to the total unit cost under absorption costing method.
3. Marginal Contribution
Marginal costing technique makes use of marginal contribution for marking various decisions. Marginal contribution is the difference between sales and marginal cost. It forms the basis for judging the profitability of different products or departments.
Advantages and Disadvantages of Marginal Costing TechniqueAdvantages
1. Marginal costing is simple to understand.
2. By not charging fixed overhead to cost of production, the effect of varying charges per unit is avoided.
3. It prevents the illogical carry forward in stock valuation of some proportion of current year’s fixed overhead.
4. The effects of alternative sales or production policies can be more readily available and assessed, and decisions taken would yield the maximum return to business.
5. It eliminates large balances left in overhead control accounts which indicate the difficulty of ascertaining an accurate overhead recovery rate.
6. Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed overhead, efforts can be concentrated on maintaining a uniform and consistent marginal cost. It is useful to various levels of management.
7. It helps in short-term profit planning by breakeven and profitability analysis, both in terms of quantity and graphs. Comparative profitability and performance between two or more products and divisions can easily be assessed and brought to the notice of management for decision making.
Disadvantages
1. The separation of costs into fixed and variable is difficult and sometimes gives misleading results.
2. Normal costing systems also apply overhead under normal operating volume and this shows that no advantage is gained by marginal costing.
3. Under marginal costing, stocks and work in progress are understated. The exclusion of fixed costs from inventories affect profit, and true and fair view of financial affairs of an organization may not be clearly transparent.
4. Volume variance in standard costing also discloses the effect of fluctuating output on fixed overhead. Marginal cost data becomes unrealistic in case of highly fluctuating levels of production, e.g., in case of seasonal factories.
5. Application of fixed overhead depends on estimates and not on the actuals and as such there may be under or over absorption of the same.
6. Control affected by means of budgetary control is also accepted by many. In order to know the net profit, we should not be satisfied with contribution and hence, fixed overhead is also a valuable item. A system which ignores fixed costs is less effective since a major portion of fixed cost is not taken care of under marginal costing.
7. In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the assumptions underlying the theory of marginal costing sometimes becomes unrealistic. For long term profit planning, absorption costing is the only answer.
Presentation of Cost Data under Marginal Costing and Absorption CostingMarginal costing is not a method of costing but a technique of presentation of sales and cost data with a view to guide management in decision-making.
The traditional technique popularly known as total cost or absorption costing technique does not make any difference between variable and fixed cost in the calculation of profits. But marginal cost statement very clearly indicates this difference in arriving at the net operational results of a firm.
Following presentation of two Performa shows the difference between the presentation of information according to absorption and marginal costing techniques:
MARGINAL COSTING PRO-FORMA
£ £
Sales Revenue xxxxx
Less Marginal Cost of Sales
Opening Stock (Valued @ marginal cost) xxxx
Add Production Cost (Valued @ marginal cost) xxxx
Total Production Cost xxxx
Less Closing Stock (Valued @ marginal cost) (xxx)
Marginal Cost of Production xxxx
Add Selling, Admin & Distribution Cost xxxx
Marginal Cost of Sales (xxxx)
Contribution xxxxx
Less Fixed Cost (xxxx)
Marginal Costing Profit xxxxx
ABSORPTION COSTING PRO-FORMA
£ £
Sales Revenue xxxxx
Less Absorption Cost of Sales
Opening Stock (Valued @ absorption cost) xxxx
Add Production Cost (Valued @ absorption cost) xxxx
Total Production Cost xxxx
Less Closing Stock (Valued @ absorption cost) (xxx)
Absorption Cost of Production xxxx
Add Selling, Admin & Distribution Cost xxxx
Absorption Cost of Sales (xxxx)
Un-Adjusted Profit xxxxx
Fixed Production O/H absorbed xxxx
Fixed Production O/H incurred (xxxx)
(Under)/Over Absorption xxxxx
Adjusted Profit xxxxx
Reconciliation Statement for Marginal Costing and Absorption Costing Profit
Marginal Costing Profit xx
ADD
(Closing stock – opening Stock) x OAR xx
= Absorption Costing Profit xx
Where OAR( overhead absorption rate) = Budgeted fixed production overhead
Budgeted levels of activities
Marginal Costing versus Absorption Costing
After knowing the two techniques of marginal costing and absorption costing, we have seen that the net profits are not the same because of the following reasons:1. Over and Under Absorbed Overheads
In absorption costing, fixed overheads can never be absorbed exactly because of difficulty in forecasting costs and volume of output. If these balances of under or over absorbed/recovery are not written off to costing profit and loss account, the actual amount incurred is not shown in it. In marginal costing, however, the actual fixed overhead incurred is wholly charged against contribution and hence, there will be some difference in net profits.
2. Difference in Stock Valuation
In marginal costing, work in progress and finished stocks are valued at marginal cost, but in absorption costing, they are valued at total production cost. Hence, profit will differ as different amounts of fixed overheads are considered in two accounts.
The profit difference due to difference in stock valuation is summarized as follows:
a. When there is no opening and closing stocks, there will be no difference in profit.
b. When opening and closing stocks are same, there will be no difference in profit, provided the fixed cost element in opening and closing stocks are of the same amount.
c. When closing stock is more than opening stock, the profit under absorption costing will be higher as comparatively a greater portion of fixed cost is included in closing stock and carried over to next period.
d. When closing stock is less than opening stock, the profit under absorption costing will be less as comparatively a higher amount of fixed cost contained in opening stock is debited during the current period.
The features which distinguish marginal costing from absorption costing are as follows.
a. In absorption costing, items of stock are costed to include a ‘fair share’ of fixed production overhead, whereas in marginal costing, stocks are valued at variable production cost only. The value of closing stock will be higher in absorption costing than in marginal costing.
b. As a consequence of carrying forward an element of fixed production overheads in closing stock values, the cost of sales used to determine profit in absorption costing will:
i. include some fixed production overhead costs incurred in a previous period but carried forward into opening stock values of the current period;
ii. exclude some fixed production overhead costs incurred in the current period by including them in closing stock values.
In contrast marginal costing charges the actual fixed costs of a period in full into the profit and loss account of the period. (Marginal costing is therefore sometimes known as period costing.)
c. In absorption costing, ‘actual’ fully absorbed unit costs are reduced by producing in greater quantities, whereas in marginal costing, unit variable costs are unaffected by the volume of production (that is, provided that variable costs per unit remain unaltered at the changed level of production activity). Profit per unit in any period can be affected by the actual volume of production in absorption costing; this is not the case in marginal costing.
d. In marginal costing, the identification of variable costs and of contribution enables management to use cost information more easily for decision-making purposes (such as in budget decision making). It is easy to decide by how much contribution (and therefore profit) will be affected by changes in sales volume. (Profit would be unaffected by changes in production volume).In absorption costing, however, the effect on profit in a period of changes in both:
i. production volume; and
ii. sales volume;
is not easily seen, because behaviour is not analysed and incremental costs are not used in the calculation of actual profit.
Limitations of Absorption Costing
The following are the criticisms against absorption costing:
1. You might have observed that in absorption costing, a portion of fixed cost is carried over to the subsequent accounting period as part of closing stock. This is an unsound practice because costs pertaining to a period should not be allowed to be vitiated by the inclusion of costs pertaining to the previous period and vice versa.
2. Further, absorption costing is dependent on the levels of output which may vary from period to period, and consequently cost per unit changes due to the existence of fixed overhead. Unless fixed overhead rate is based on normal capacity, such changed costs are not helpful for the purposes of comparison and control.
The cost to produce an extra unit is variable production cost. It is realistic to the value of closing stock items as this is a directly attributable cost. The size of total contribution varies directly with sales volume at a constant rate per unit. For the decision-making purpose of management, better information about expected profit is obtained from the use of variable costs and contribution approach in the accounting system.
MARGINAL COSTS, CONTRIBUTION AND PROFIT
A marginal cost is another term for a variable cost. The term ‘marginal cost’ is usually applied to the variable cost of a unit of product or service, whereas the term ‘variable cost’ is more commonly applied to resource costs, such as the cost of materials and labour hours.
Marginal costing is a form of management accounting based on the distinction between:
a. the marginal costs of making selling goods or services, and
b. fixed costs, which should be the same for a given period of time, regardless of the level of activity in the period.
Suppose that a firm makes and sells a single product that has a marginal cost of £5 per unit and that sells for £9 per unit. For every additional unit of the product that is made and sold, the firm will incur an extra cost of £5 and receive income of £9. The net gain will be £4 per additional unit. This net gain per unit, the difference between the sales price per unit and the marginal cost per unit, is called contribution.
Contribution is a term meaning ‘making a contribution towards covering fixed costs and making a profit’. Before a firm can make a profit in any period, it must first of all cover its fixed costs. Breakeven is where total sales revenue for a period just covers fixed costs, leaving neither profit nor loss. For every unit sold in excess of the breakeven point, profit will increase by the amount of the contribution per unit.
C-V-P analysis is broadly known as cost-volume-profit analysis. Specifically speaking, we all are concerned with in-depth analysis and application of CVP in practical world of industry management.
Cost-Volume-Profit (C-V-P) Relationship
We have observed that in marginal costing, marginal cost varies directly with the volume of production or output. On the other hand, fixed cost remains unaltered regardless of the volume of output within the scale of production already fixed by management. In case if cost behavior is related to sales income, it shows cost-volume-profit relationship. In net effect, if volume is changed, variable cost varies as per the change in volume. In this case, selling price remains fixed, fixed remains fixed and then there is a change in profit.
Being a manager, you constantly strive to relate these elements in order to achieve the maximum profit. Apart from profit projection, the concept of Cost-Volume-Profit (CVP) is relevant to virtually all decision-making areas, particularly in the short run.
The relationship among cost, revenue and profit at different levels may be expressed in graphs such as breakeven charts, profit volume graphs, or in various statement forms.
Profit depends on a large number of factors, most important of which are the cost of manufacturing and the volume of sales. Both these factors are interdependent. Volume of sales depends upon the volume of production and market forces which in turn is related to costs. Management has no control over market. In order to achieve certain level of profitability, it has to exercise control and management of costs, mainly variable cost. This is because fixed cost is a non-controllable cost. But then, cost is based on the following factors:
• Volume of production
• Product mix
• Internal efficiency and the productivity of the factors of production
• Methods of production and technology
• Size of batches
• Size of plant
Thus, one can say that cost-volume-profit analysis furnishes the complete picture of the profit structure. This enables management to distinguish among the effect of sales, fluctuations in volume and the results of changes in price of product/services.In other words, CVP is a management accounting tool that expresses relationship among sale volume, cost and profit. CVP can be used in the form of a graph or an equation. Cost-volume- profit analysis can answer a number of analytical questions. Some of the questions are as follows:
1. What is the breakeven revenue of an organization?
2. How much revenue does an organization need to achieve a budgeted profit?
3. What level of price change affects the achievement of budgeted profit?
4. What is the effect of cost changes on the profitability of an operation?
Cost-volume-profit analysis can also answer many other “what if” type of questions. Cost-volume-profit analysis is one of the important techniques of cost and management accounting. Although it is a simple yet a powerful tool for planning of profits and therefore, of commercial operations. It provides an answer to “what if” theme by telling the volume required to produce.Following are the three approaches to a CVP analysis:
• Cost and revenue equations
• Contribution margin
• Profit graph
Objectives of Cost-Volume-Profit Analysis
1. In order to forecast profits accurately, it is essential to ascertain the relationship between cost and profit on one hand and volume on the other.
2. Cost-volume-profit analysis is helpful in setting up flexible budget which indicates cost at various levels of activities.
3. Cost-volume-profit analysis assist in evaluating performance for the purpose of control.
4. Such analysis may assist management in formulating pricing policies by projecting the effect of different price structures on cost and profit.
Assumptions and Terminology
Following are the assumptions on which the theory of CVP is based:
1. The changes in the level of various revenue and costs arise only because of the changes in the number of product (or service) units produced and sold, e.g., the number of television sets produced and sold by Sigma Corporation. The number of output (units) to be sold is the only revenue and cost driver. Just as a cost driver is any factor that affects costs, a revenue driver is any factor that affects revenue.
2. Total costs can be divided into a fixed component and a component that is variable with respect to the level of output. Variable costs include the following:
o Direct materials
o Direct labor
o Direct chargeable expenses
Variable overheads include the following:
o Variable part of factory overheads
o Administration overheads
o Selling and distribution overheads
3. There is linear relationship between revenue and cost.
4. When put in a graph, the behavior of total revenue and cost is linear (straight line), i.e. Y = mx + C holds good which is the equation of a straight line.
5. The unit selling price, unit variable costs and fixed costs are constant.
6. The theory of CVP is based upon the production of a single product. However, of late, management accountants are functioning to give a theoretical and a practical approach to multi-product CVP analysis.
7. The analysis either covers a single product or assumes that the sales mix sold in case of multiple products will remain constant as the level of total units sold changes.
8. All revenue and cost can be added and compared without taking into account the time value of money.
9. The theory of CVP is based on the technology that remains constant.
10. The theory of price elasticity is not taken into consideration.
Many companies, and divisions and sub-divisions of companies in industries such as airlines, automobiles, chemicals, plastics and semiconductors have found the simple CVP relationships to be helpful in the following areas:
• Strategic and long-range planning decisions
• Decisions about product features and pricing
In real world, simple assumptions described above may not hold good. The theory of CVP can be tailored for individual industries depending upon the nature and peculiarities of the same.For example, predicting total revenue and total cost may require multiple revenue drivers and multiple cost drivers. Some of the multiple revenue drivers are as follows:
• Number of output units
• Number of customer visits made for sales
• Number of advertisements placed
Some of the multiple cost drivers are as follows:
• Number of units produced
• Number of batches in which units are produced
Managers and management accountants, however, should always assess whether the simplified CVP relationships generate sufficiently accurate information for predictions of how total revenue and total cost would behave. However, one may come across different complex situations to which the theory of CVP would rightly be applicable in order to help managers to take appropriate decisions under different situations.
Limitations of Cost-Volume Profit Analysis
The CVP analysis is generally made under certain limitations and with certain assumed conditions, some of which may not occur in practice. Following are the main limitations and assumptions in the cost-volume-profit analysis:
1. It is assumed that the production facilities anticipated for the purpose of cost-volume-profit analysis do not undergo any change. Such analysis gives misleading results if expansion or reduction of capacity takes place.
2. In case where a variety of products with varying margins of profit are manufactured, it is difficult to forecast with reasonable accuracy the volume of sales mix which would optimize the profit.
3. The analysis will be correct only if input price and selling price remain fairly constant which in reality is difficulty to find. Thus, if a cost reduction program is undertaken or selling price is changed, the relationship between cost and profit will not be accurately depicted.
4. In cost-volume-profit analysis, it is assumed that variable costs are perfectly and completely variable at all levels of activity and fixed cost remains constant throughout the range of volume being considered. However, such situations may not arise in practical situations.
5. It is assumed that the changes in opening and closing inventories are not significant, though sometimes they may be significant.
6. Inventories are valued at variable cost and fixed cost is treated as period cost. Therefore, closing stock carried over to the next financial year does not contain any component of fixed cost. Inventory should be valued at full cost in reality.
Sensitivity Analysis or What If Analysis and Uncertainty
Sensitivity analysis is relatively a new term in management accounting. It is a “what if” technique that managers use to examine how a result will change if the original predicted data are not achieved or if an underlying assumption changes.
In the context of CVP analysis, sensitivity analysis answers the following questions:
a. What will be the operating income if units sold decrease by 15% from original prediction?
b. What will be the operating income if variable cost per unit increases by 20%?
The sensitivity of operating income to various possible outcomes broadens the perspective of management regarding what might actually occur before making cost commitments.A spreadsheet can be used to conduct CVP-based sensitivity analysis in a systematic and efficient way. With the help of a spreadsheet, this analysis can be easily conducted to examine the effect and interaction of changes in selling prices, variable cost per unit, fixed costs and target operating incomes.
Example
Following is the spreadsheet of ABC Ltd.,
Statement showing CVP Analysis for Dolphy Software Ltd.
Revenue required at $. 200 Selling Price per unit to earn Operating Income of
Fixed cost Variable cost
per unit 0 1,000 1,500 2,000
2,000 100 4,000 6,000 7,000 8,000
120 5,000 7,500 8,750 10,000
140 6,667 10,000 11,667 13,333
2,500 100 5,000 7,000 8,000 9,000
120 6,250 8,750 10,000 11,250
140 8,333 11,667 13,333 15,000
3,000 100 6,000 8,000 9,000 10,000
120 7,500 10,000 11,250 12,500
140 10,000 13,333 15,000 16,667
From the above example, one can immediately see the revenue that needs to be generated to reach a particular operating income level, given alternative levels of fixed costs and variable costs per unit. For example, revenue of $. 6,000 (30 units @ 200 each) is required to earn an operating income of 1,000 if fixed cost is 2,000 and variable cost per unit is 100. You can also use exhibit 3-4 to assess what revenue the company needs to breakeven (earn operating income of Re. 0) if, for example, one of the following changes takes place:
• The booth rental at the ABC convention raises to 3,000 (thus increasing fixed cost to $. 3,000)
• The software suppliers raise their price to 140 per unit (thus increasing variable costs to 140)
An aspect of sensitivity analysis is the margin of safety which is the amount of budgeted revenue over and above breakeven revenue. The margin of safety is sales quantity minus breakeven quantity. It is expressed in units. The margin of safety answers the “what if” questions, e.g., if budgeted revenue are above breakeven and start dropping, how far can they fall below budget before the breakeven point is reached? Such a fall could be due to competitor’s better product, poorly executed marketing programs and so on.Assume you have fixed cost of 2,000, selling price of 200 and variable cost per unit of 120. For 40 units sold, the budgeted point from this set of assumptions is 25 units (2,000 ÷ $. 80) or 5,000 ( 200 x 25). Hence, the margin of safety is 3,000 ( 8,000 – 5,000) or 15 (40 –25) units.
Sensitivity analysis is an approach to recognizing uncertainty, i.e. the possibility that an actual amount will deviate from an expected amount.
Marginal Cost Equations and Breakeven Analysis
From the marginal cost statements, one might have observed the following:
Sales – Marginal cost = Contribution ......(1)Fixed cost + Profit = Contribution ......(2)
By combining these two equations, we get the fundamental marginal cost equation as follows:
Sales – Marginal cost = Fixed cost + Profit ......(3)
This fundamental marginal cost equation plays a vital role in profit projection and has a wider application in managerial decision-making problems.The sales and marginal costs vary directly with the number of units sold or produced. So, the difference between sales and marginal cost, i.e. contribution, will bear a relation to sales and the ratio of contribution to sales remains constant at all levels. This is profit volume or P/V ratio. Thus,
P/V Ratio (or C/S Ratio) = Contribution (c) ......(4)
Sales (s)
It is expressed in terms of percentage, i.e. P/V ratio is equal to (C/S) x 100.
Or, Contribution = Sales x P/V ratio ......(5)
Or, Sales = Contribution ......(6)
P/V ratio
The above-mentioned marginal cost equations can be applied to the following heads:1. Contribution
Contribution is the difference between sales and marginal or variable costs. It contributes toward fixed cost and profit. The concept of contribution helps in deciding breakeven point, profitability of products, departments etc. to perform the following activities:
• Selecting product mix or sales mix for profit maximization
• Fixing selling prices under different circumstances such as trade depression, export sales, price discrimination etc.
2. Profit Volume Ratio (P/V Ratio), its Improvement and Application
The ratio of contribution to sales is P/V ratio or C/S ratio. It is the contribution per rupee of sales and since the fixed cost remains constant in short term period, P/V ratio will also measure the rate of change of profit due to change in volume of sales. The P/V ratio may be expressed as follows:
P/V ratio = Sales – Marginal cost of sales = Contribution = Changes in contribution = Change in profit
Sales Sales Changes in sales Change in sales
A fundamental property of marginal costing system is that P/V ratio remains constant at different levels of activity.
A change in fixed cost does not affect P/V ratio. The concept of P/V ratio helps in determining the following:
• Breakeven point
• Profit at any volume of sales
• Sales volume required to earn a desired quantum of profit
• Profitability of products
• Processes or departments
The contribution can be increased by increasing the sales price or by reduction of variable costs. Thus, P/V ratio can be improved by the following:
• Increasing selling price
• Reducing marginal costs by effectively utilizing men, machines, materials and other services
• Selling more profitable products, thereby increasing the overall P/V ratio
3. Breakeven Point
Breakeven point is the volume of sales or production where there is neither profit nor loss. Thus, we can say that:
Contribution = Fixed cost
Now, breakeven point can be easily calculated with the help of fundamental marginal cost equation, P/V ratio or contribution per unit.
a. Using Marginal Costing Equation
S (sales) – V (variable cost) = F (fixed cost) + P (profit) At BEP P = 0, BEP S – V = F
By multiplying both the sides by S and rearranging them, one gets the following equation:
S BEP = F.S/S-V
b. Using P/V Ratio
Sales S BEP = Contribution at BEP = Fixed cost
P/ V ratio P/ V ratio
Thus, if sales is $. 2,000, marginal cost $. 1,200 and fixed cost $. 400, then:
Breakeven point = 400 x 2000 = 1000
2000 - 1200
Similarly, P/V ratio = 2000 – 1200 = 0.4 or 40%
800
So, breakeven sales = 400 / .4 = $. 1000
c. Using Contribution per unit
Breakeven point = Fixed cost = 100 units or 1000
Contribution per unit
4. Margin of Safety (MOS)
Every enterprise tries to know how much above they are from the breakeven point. This is technically called margin of safety. It is calculated as the difference between sales or production units at the selected activity and the breakeven sales or production.
Margin of safety is the difference between the total sales (actual or projected) and the breakeven sales. It may be expressed in monetary terms (value) or as a number of units (volume). It can be expressed as profit / P/V ratio. A large margin of safety indicates the soundness and financial strength of business.
Margin of safety can be improved by lowering fixed and variable costs, increasing volume of sales or selling price and changing product mix, so as to improve contribution and overall P/V ratio.
Margin of safety = Sales at selected activity – Sales at BEP = Profit at selected activity
P/V ratio
Margin of safety is also presented in ratio or percentage as follows: Margin of safety (sales) x 100 %
Sales at selected activity
The size of margin of safety is an extremely valuable guide to the strength of a business. If it is large, there can be substantial falling of sales and yet a profit can be made. On the other hand, if margin is small, any loss of sales may be a serious matter. If margin of safety is unsatisfactory, possible steps to rectify the causes of mismanagement of commercial activities as listed below can be undertaken.
a. Increasing the selling price-- It may be possible for a company to have higher margin of safety in order to strengthen the financial health of the business. It should be able to influence price, provided the demand is elastic. Otherwise, the same quantity will not be sold.
b. Reducing fixed costs
c. Reducing variable costs
d. Substitution of existing product(s) by more profitable lines e. Increase in the volume of output
e. Modernization of production facilities and the introduction of the most cost effective technology
Problem 1A company earned a profit of 30,000 during the year 2000-01. Marginal cost and selling price of a product are 8 and 10 per unit respectively. Find out the margin of safety.
Solution
Margin of safety = Profit
P/V ratio
P/V ratio = Contribution x 100
Sales
Problem 2
A company producing a single article sells it at 10 each. The marginal cost of production is 6 each and fixed cost is 400 per annum. You are required to calculate the following:
• Profits for annual sales of 1 unit, 50 units, 100 units and 400 units
• P/V ratio
• Breakeven sales
• Sales to earn a profit of 500
• Profit at sales of 3,000
• New breakeven point if sales price is reduced by 10%
• Margin of safety at sales of 400 units
Solution Marginal Cost Statement
Particulars Amount Amount Amount Amount
Units produced 1 50 100 400
Sales (units * 10) 10 500 1000 4000
Variable cost 6 300 600 2400
Contribution (sales- VC) 4 200 400 1600
Fixed cost 400 400 400 400
Profit (Contribution – FC) -396 -200 0 1200
Profit Volume Ratio (PVR) = Contribution/Sales * 100 = 0.4 or 40%
Breakeven sales ($.) = Fixed cost / PVR = 400/ 40 * 100 = 1,000
Sales at BEP = Contribution at BEP/ PVR = 100 units
Sales at profit 500
Contribution at profit $. 500 = Fixed cost + Profit = $. 900
Sales = Contribution/PVR = 900/.4 = $. 2,250 (or 225 units)
Profit at sales 3,000
Contribution at sale $. 3,000 = Sales x P/V ratio = 3000 x 0.4 = $. 1,200
Profit = Contribution – Fixed cost = 1200 – 400 = 800
New P/V ratio = 9 – 6/ 9 = 1/3
Sales at BEP = Fixed cost/PV ratio = 400 = 1,200
1/3
Margin of safety (at 400 units) = 4000-1000/4000*100 = 75 %
(Actual sales – BEP sales/Actual sales * 100)
Breakeven Analysis-- Graphical Presentation
Apart from marginal cost equations, it is found that breakeven chart and profit graphs are useful graphic presentations of this cost-volume-profit relationship.
Breakeven chart is a device which shows the relationship between sales volume, marginal costs and fixed costs, and profit or loss at different levels of activity. Such a chart also shows the effect of change of one factor on other factors and exhibits the rate of profit and margin of safety at different levels. A breakeven chart contains, inter alia, total sales line, total cost line and the point of intersection called breakeven point. It is popularly called breakeven chart because it shows clearly breakeven point (a point where there is no profit or no loss).
Profit graph is a development of simple breakeven chart and shows clearly profit at different volumes of sales.
Construction of a Breakeven Chart
The construction of a breakeven chart involves the drawing of fixed cost line, total cost line and sales line as follows:
1. Select a scale for production on horizontal axis and a scale for costs and sales on vertical axis.
2. Plot fixed cost on vertical axis and draw fixed cost line passing through this point parallel to horizontal axis.
3. Plot variable costs for some activity levels starting from the fixed cost line and join these points. This will give total cost line. Alternatively, obtain total cost at different levels, plot the points starting from horizontal axis and draw total cost line.
4. Plot the maximum or any other sales volume and draw sales line by joining zero and the point so obtained.
Uses of Breakeven ChartA breakeven chart can be used to show the effect of changes in any of the following profit factors:
• Volume of sales
• Variable expenses
• Fixed expenses
• Selling price
ProblemA company produces a single article and sells it at 10 each. The marginal cost of production is 6 each and total fixed cost of the concern is 400 per annum.
Construct a breakeven chart and show the following:
• Breakeven point
• Margin of safety at sale of 1,500
• Angle of incidence
• Increase in selling price if breakeven point is reduced to 80 units
Solution
A breakeven chart can be prepared by obtaining the information at these levels:
Output units 40 80 120 200
Sales .
400 800 1,200 2,000
Fixed cost 400 400 400 400
Variable cost 240 480 400 720
Total cost 640 880 1,120 1,600
Fixed cost line, total cost line and sales line are drawn one after another following the usual procedure described herein:
This chart clearly shows the breakeven point, margin of safety and angle of incidence.
a. Breakeven point-- Breakeven point is the point at which sales line and total cost line intersect. Here, B is breakeven point equivalent to sale of 1,000 or 100 units.
b. Margin of safety-- Margin of safety is the difference between sales or units of production and breakeven point. Thus, margin of safety at M is sales of (1,500 - 1,000), i.e. 500 or 50 units.
c. Angle of incidence-- Angle of incidence is the angle formed by sales line and total cost line at breakeven point. A large angle of incidence shows a high rate of profit being made. It should be noted that the angle of incidence is universally denoted by data. Larger the angle, higher the profitability indicated by the angel of incidence.
d. At 80 units, total cost (from the table) = 880. Hence, selling price for breakeven at 80 units = 880/80 = 11 per unit. Increase in selling price is Re. 1 or 10% over the original selling price of 10 per unit.
Limitations and Uses of Breakeven Charts
A simple breakeven chart gives correct result as long as variable cost per unit, total fixed cost and sales price remain constant. In practice, all these facto$ may change and the original breakeven chart may give misleading results.
But then, if a company sells different products having different percentages of profit to turnover, the original combined breakeven chart fails to give a clear picture when the sales mix changes. In this case, it may be necessary to draw up a breakeven chart for each product or a group of products. A breakeven chart does not take into account capital employed which is a very important factor to measure the overall efficiency of business. Fixed costs may increase at some level whereas variable costs may sometimes start to decline. For example, with the help of quantity discount on materials purchased, the sales price may be reduced to sell the additional units produced etc. These changes may result in more than one breakeven point, or may indicate higher profit at lower volumes or lower profit at still higher levels of sales.
Nevertheless, a breakeven chart is used by management as an efficient tool in marginal costing, i.e. in forecasting, decision-making, long term profit planning and maintaining profitability. The margin of safety shows the soundness of business whereas the fixed cost line shows the degree of mechanization. The angle of incidence is an indicator of plant efficiency and profitability of the product or division under consideration. It also helps a monopolist to make price discrimination for maximization of profit.
Multiple Product Situations
In real life, most of the firms turn out many products. Here also, there is no problem with regard to the calculation of BE point. However, the assumption has to be made that the sales mix remains constant. This is defined as the relative proportion of each product’s sale to total sales. It could be expressed as a ratio such as 2:4:6, or as a percentage as 20%, 40%, 60%.
The calculation of breakeven point in a multi-product firm follows the same pattern as in a single product firm. While the numerator will be the same fixed costs, the denominator now will be weighted average contribution margin. The modified formula is as follows:
Breakeven point (in units) = Fixed costs
________________________________________
Weighted average contribution margin per unit
One should always remember that weights are assigned in proportion to the relative sales of all products. Here, it will be the contribution margin of each product multiplied by its quantity.
Breakeven Point in Sales Revenue
Here also, numerator is the same fixed costs. The denominator now will be weighted average contribution margin ratio which is also called weighted average P/V ratio. The modified formula is as follows:
B.E. point (in revenue) = Fixed cost
________________________________________
Weighted average P/V ratio
Problem Ahmedabad Company Ltd. manufactures and sells four types of products under the brand name Ambience, Luxury, Comfort and Lavish. The sales mix in value comprises the following:
Brand name Percentage
Ambience 33 1/3
Luxury 41 2/3
Comfort 16 2/3
Lavish 8 1/3
------
100
The total budgeted sales (100%) are . 6,00,000 per month.The operating costs are:
Ambience 60% of selling price Luxury
Luxury 68% of selling price Comfort
Comfort 80% of selling price Lavish
Lavish 40% of selling price
The fixed costs are 1,59,000 per month.
a. Calculate the breakeven point for the products on an overall basis.
b. It has been proposed to change the sales mix as follows, with the sales per month remaining at . 6,00,000:
Brand Name Percentage
Ambience 25
Luxury 40
Comfort 30
Lavish 05
---
100
Assuming that this proposal is implemented, calculate the new breakeven point.Solution
a. Computation of the Breakeven Point on Overall Basis
b. Computation of the New Breakeven Point
Profit GraphProfit graph is an improvement of a simple breakeven chart. It clearly exhibits the relationship of profit to volume of sales. The construction of a profit graph is relatively easy and the procedure involves the following:
1. Selecting a scale for the sales on horizontal axis and another scale for profit and fixed costs or loss on vertical axis. The area above horizontal axis is called profit area and the one below it is called loss area.
2. Plotting the profits of corresponding sales and joining them. This is profit line.
.
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