MMS SEM - I

MASTERS IN MANAGEMENT
STUDIES

FINANCIAL ACCOUNTING
 © UNIVERSITY OF MUMBAI
Dr. Suhas Pednekar
Vice Chancellor,
University of Mumbai

Dr. Dr. Prakash Mahanwar Dr. Madhura Kulkarni

Director, Institute of Distance Incharge Study Material Section,
and Open Learning, Institute of Distance and
University of Mumbai. Open Learning,
University of Mumbai.

Programme :
Co-ordinator

Course Writer : Dr. Madhura Kulkarni

Lecturer-Cum. Asst. Director
IDOL, Universityof Mumbai
: Mr. Subhash Dalvi
Alkesh Dinesh Mody Institute
Universityof Mumbai
: Dr. Natika Poddar
Associate Professor,
St. Francis Institute of Mgmt. and Research
Borivali (W), Mumbai
: Mr. Nalai Rama Subramanian
Chennai

August 2021, MMS SEM - I, M a st e r s i n M a n ag e m e n t S t u d i e s ,

Financial Accounting

Published by : Incharge Director

Institute of Distance and Open Learning ,
University of Mumbai,

DTP Composed : Ashwini Arts

Gurukripa Chawl, M.C. Chagla Marg, Bamanwada,
Vile Parle (E), Mumbai - 400 099.

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 MMS – Masters in Management Studies
Semester – I

Financial Accounting
Syllabus

Module
Sr.
Content Activity Learning outcomes
No.
Introduction to Accounting Lecture and
Meaning and necessity of accounting discussion Clarity and understanding of the basic
1 Accounting cycle concepts of accounting and financial
An overview of Financial Statements – statements
Income Statement and Balance Sheet
Introduction and meaning of GAAP, IFRS Theoretical
and Ind AS discussion
Important Accounting Standards and
Ability to apply the principles and
Concepts used in accounting explanation
2 concepts of accounting in preparing the
Concepts related to Income Statement and
financial statements
Balance Sheet
Accounting Equation and its relation to
accounting mechanics
Theoretical Ability to execute the accounting process-
Accounting mechanics and process
discussion Recording- Classifying and Summarizing.
3 leading to preparation of Trial Balance and
and Understanding the use of accounting
Financial Statements
exercises Software
Preparation of Financial Statements with Theoretical
Adjustment - ‘T’ form and vertical form of discussion
financial statements and Detailed and in depth understanding of all
4 Detailed discussion and understanding of problem the items in the corporate financial
various items in Schedule III solving statements
Preparation of Corporate Financial
Statements and Notes to Accounts
Theoretical Understanding the principles of revenue
Revenue recognition and measurement
discussion recognition and ability to distinguish
Capital and revenue items
and between revenue and capital income and
5 Treatment of R & D expenses
exercises expenditure and their treatment in
Preproduction cost
corporate financial statements
Deferred revenue expenditure etc.
Sr. Content Activity Learning outcomes
No.
Theoretical
discussion Understanding different methods of
6 Fixed Assets and Depreciation Accounting and depreciation and their impact on
problem profitability and asset valuation
solving
Theoretical
discussion Understanding the concepts of inventory
7 Evaluation and accounting of Inventory and valuation and their effect on profit and
problem cost of goods sold.
solving
Problems
and
Ability to prepare a statement of changes
Fund Flow Statement exercises
8 in financial position with respect to
Cash Flow Statement with
working capital and cash flow.
theoretical
discussion
Corporate Financial Reporting – Reading of Assignment
Annual Report, Presentation and analysis of discussion
Ability to read Annual Reports,
audit reports and directors report. (Students
9 Presentation and analysis of audit reports
should be exposed to reading of Annual
and directors’ report
Reports of companies both detailed and
summarized version)
Theoretical Understanding basic cost concepts and
10 Basics of Cost Accounting
discussion ability to prepare a simple cost sheet
Theoretical Understanding the difference between
11 Ethical Issues in accounting discussion errors and frauds; creative accounting and
the Corporate Governance Report.

Text Books

1 Financial Accounting for Management – Dinesh D Harsolekar

2 Financial Accounting –Text and Cases – Dearden and Bhattacharyya
3 Accounting- Text and Cases – Robert Anthony, david Hawkins and Kenneth Merchant

Reference Books

1 Financial Accounting - Reporting & Analysis – Stice and Diamond

2 Full Text of Indian Accounting standard – Taxmann Publication
3 Financial Accounting for Managers – T.P. Ghosh
4 Financial Accounting – R. Narayanaswamy

Assessment

Internal 40%
Semester end 60%
 MODULE – I

1
ACCOUNTING: AN INTRODUCTION

Unit Structure
1.1 Accounting: the language of business
1.2 Accounting: an information system.
1.2.1 Definitions
1.2.2 Objectives of accounting
1.2.3 Function of accounting
1.3 Users of accounting information:
1.4 Branches of accounting
1.5 Book-keeping
1.5.1 Accounting cycle
1.5.2 Basic accounting terms

1.1 INTRODUCTION TO ACCOUNTING

Accounting is a business language. We can use this language

to communicate financial transactions and their results. Accounting is
a comprehensive system to collect, analyzes, and communicates
financial information.

The origin of accounting is as old as money. In early days, the

number of transactions was very small, so every concerned person
could keep the record of transactions during a specific period of time.
Twenty-three centuries ago, an Indian scholar named Kautilya alias
Chanakya introduced the accounting concepts in his book
Arthashastra. In his book, he described the art of proper account
keeping and 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.

Business is an economic activity undertaken with the motive

of earning profits and to maximize the wealth for the owners. Business
cannot run in isolation. Largely, the business activity is carried out
by people coming together with a purpose to serve a common cause.
This team is often referred to as an organization, which could be in
different forms such as sole proprietorship, partnership, body
corporate etc. The rules of business are basedon general principles
of trade, social values, and statutory framework encompassing
national or international boundaries. While these variables could be
different for different businesses, different countries etc., the basic
purpose is to add value to a product or service to satisfy customer
demand.

A bookkeeper may record financial transactions according to

certain accounting principles and standards and as prescribed byan
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. As the basic
purpose of business is to make profit, one must keep an ongoing track
of the activities undertaken in course of business.

1.2 ACCOUNTING: AN INFORMATION SYSTEM

1.2.1 DEFINITIONS
Definition of Accounting
Definition by the American Institute of Certified Public Accountants
(Year 1961):
"Accounting is the art of recording, classifying and summarizing in a
significant manner and in terms of money, transactions and events
which are, in part at least, of a financial character, and interpreting the
result thereof".
Definition by the American Accounting Association (Year 1966):
"The process of identifying, measuring and communicating economic
information to permit informed judgments and decisionsby the users
of accounting".

1.2.2 OBJECTIVES OF ACCOUNTING

To Providing Information
The primary objective of accounting is to provide useful
information for decision-making to stakeholders such as owners,
management, creditors, investors, etc. Various outcomes of business
activities such as costs, prices, sales volume, value under ownership,
return of investment, etc. are measured in the accounting process.

To keep systematic records:

Accounting is done to keep systematic record of financial
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.

Ascertainment of Results
‘Profit/loss' is a core accounting measurement. It is measured
by preparing profit and loss account for a particular period. Various
other accounting measurements such as different types of revenue
expenses and revenue incomes are considered for preparing this profit
and loss account. Difference between these revenue incomes and
revenue expenses is known as result of business transactions identified
as profit/loss.

To ascertain the financial position of the business:

A balance sheet or a statement of affairs indicates the financial
position of a company as on a particular date. A properly drawn
balance sheet gives us an indication of the class and value of assets,
the nature and value of liability, and also the capitalposition 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.

To Know the Solvency Position :

Balance sheet and profit and loss account prepared as above give
useful information to stockholders regarding concerns potential to
meet its obligations in the short run as well as in the long run.

1.2.3 FUNCTION OF ACCOUNTING

The main functions of accounting are as follows:

Measurement: Accounting measures past performance of the

business entity and depicts its current financial position.

Forecasting: Accounting helps in forecasting future performance

and financial position of the enterprise using past data.
Decision-making: Accounting provides relevant information to the
users of accounts to aid rational decision-making.
Comparison & Evaluation: Accounting assesses performance
achieved in relation to targets and discloses information regarding
accounting policies and contingent liabilities which play an
important role in predicting, comparing and evaluating the financial
results.
Control: Accounting also identifies weaknesses of the operational
system and provides feedbacks regarding effectiveness of measures
adopted to check such weaknesses.
Government Regulation and Taxation: Accounting provides
necessary information to the government to exercise control on die entity
as well as in collection of tax revenues.

1.3 USERS OF ACCOUNTING INFORMATION:

Generally users of accounts are classified into two categories:

a) Internal User
b) External User

Following are the various users of accounting information:

i) Investor: They provide capital to business. They need information

to assess whether to buy, hold or sell their investment. Also they are
interested to know the ability of the business to survive, prosper and
to pay divided.

ii) Employees: Growth of employees is directly related to the growth

of the organisation and therefore, they are interest to know the
stability, continuity and growth of the enterprise and its ability to
provide remuneration, retirement and other benefits and to enhance
employment opportunities.

iii) Lenders: They are interested to know whether their loan- principal
and interest will be paid when due.

iv) Supplier and Creditors: They are also interested to know the
ability of the enterprise to pay their dues that helps them to decide
the credit policy for the relevant concern, rates to be charged and so
on. Sometime, they also become interested in long term continuation
of the enterprise if their existence becomes dependent on the survival
of the business. Suppose, small ancillary units supply their products
to a big enterprise, if the big enterprise collapses, the fate of the small
units also becomes sealed.

v) Customers: Customers are also concerned with the stability and

profitability of the enterprise because their functioning is more or less
dependent on the supply of goods, suppose, a company produces
some chemicals used by pharmaceutical companies and supplies
chemicals on three months credit. If all a sudden it faces some trouble
and is unable to supply the chemical, the customers will also be in
trouble.

vi) Government and their agencies: They regulate thefunctioning

of business enterprise for public good, allocated scarce resources
among competing enterprise, control price,change excise duties and
taxes, and so they have continued interest in the business enterprise.

vii) Public: The public at large is interested in the functioning of the

enterprise because it may make a substantial contribution to the
local economy in many ways including the number of people
employed and their patronage to local suppliers.

viii) Management: On the basis of Accounts, management

 determine the effects of their various decisions on the functioning of
the organisation. This helps them to make further managerial
decisions.

External users of External users include

accounting information Investors
Creditors
Customers
Suppliers
Employees
Government organizations
Internal users of Internal users include
accounting information Management Managers of
operations

1.4 BRANCHES OF ACCOUNTING

Following are various branches of Accounting.

1.4.1 Financial Accounting

It is commonly termed as Accounting. The American Institute

of Certified Public Accountants defines Accounting as "an art of
recoding, classifying and summarizing in a significant manner and
in terms of money, transactions and events which are in part at
least of a financial character, and interpreting the results thereof."

1.4.2 Cost Accounting

According to the Chartered Institute of Management
Accountants (CIMA), Cost Accountancy is defined as "application of
costing and cost accounting principles, methods and techniques to the
science, art and practice of cost control and the ascertainment of
profitability as well as the presentation of information for thepurpose
of managerial decision-making."

1.4.3 Management Accounting

Management Accounting is concerned with the use of
Financial and Cost Accounting information to managers within
organizations, to provide them with the basis in making informed
business decisions that would allow them to be better equipped in their
management and control functions.

1.4.4 Social responsibility Accounting

Social responsibility accounting is concerned with accounting
for social costs incurred by the enterprise and social benefits created.

1.4.5 Human Resource Accounting

Human resource accounting is an attempt to identify,quantify
and report investment made in human resource of an organisation that
are not presently accounted for under conventional accounting
practice.
1.4.6 Difference between Management Accounting
andFinancial Accounting

Management Accounting Financial Accounting

1. Management Accounting is 1. Financial Accounting is based
primarily based on the data on the monetary transactions of
available from Financial the enterprise.
Accounting.
2. It provides necessary 2. Its main focus is on recording
information to the management and classifying monetary
to assist them in the process of transactions in the books of
planning, controlling, accounts and preparation of
performance evaluation and financial statements at the end
decision making. of every accounting period.
3. Reports prepared in 3. Reports as per Financial
Management Accounting are Accounting are meant for the
meant for management and as management as well as for
per management requirement. shareholders and creditors of
the concern.
4. Reports may contain both 4. Reports should always be
subjective and objective figures. supported by relevant figuresand it
emphasizes on the objectivity of
data.
5. Reports are not subject to 5. Reports are always subject to
statutory audit. statutory audit.
6. It evaluates the sectional as well as 6. It ascertains, evaluates and
the entire performance of the exhibits the financial strength of the
business. whole business.

1.5 BOOK-KEEPING

As defined by Carter, ‘Book-keeping is a science and art of

correctly recording in books-of accounts all those business
transactions that result in transfer of money or money's worth'.
Book-keeping is an activity concerned with recording and classifying
financial data related to business operation in order of its occurrence.

Book-keeping is a mechanical task which involves:

• Collection of basic financial information.
• Identification of events and transactions with
financialcharacter i.e., economic transactions.
• Measurement of economic transactions in terms of money.
• Recording financial effects of economic transactions in orderof
its occurrence.
• Classifying effects of economic transactions.
• Preparing organized statement known as trial balance.
The distinction between book-keeping and accounting is given below:

Book-Keeping Accounting
Output of book-keeping is an Output of accounting permit
input for accounting. informed judgments and
decisions by the user of
accounting information.
Purpose of book-keeping is to Purpose of accounting is to find
keep systematic record of results of operating activity of
transactions and events of business and to report financial
financial character in order of its strength of business.
occurrence.
Book-keeping is a foundation of Accounting is considered as a
accounting. language of business.

Book-keeping is carried out by Accounting is done by senior staff

junior staff. with skill of analysis and
interpretation.
Objects of book-keeping is to Object of accounting is not only
summarize the cumulative effect of bookkeeping but also analyzing and
all economic transactions ofbusiness interpreting reported financial
for a given period by maintaining information for informed decisions.
permanent record of each business
transaction with its evidence and
financial effects on accounting
variable.

1.5.1 ACCOUNTING CYCLE

When complete sequence of accounting procedure is done
which happens frequently and repeated in same directions during
an accounting period, the same is called an accounting cycle.

Steps/Phases of Accounting Cycle

The steps or phases of accounting cycle can be developedas

under:

Recording of Transaction: As soon as a transaction happens it is at

first recorded in subsidiary book.

Journal: The transactions are recorded in Journal chronologically.

Ledger: All journals are posted into ledger chronologically and in a

classified manner.

Trial Balance: After taking all the ledger account closing balances,
a Trial Balance is prepared at the end of the period for the preparations
of financial statements.

Adjustment Entries: All the adjustments entries are to be recorded

properly and adjusted accordingly before preparing financial
statements.

Adjusted Trial Balance: An adjusted Trail Balance may also be

prepared.

Closing Entries: All the nominal accounts are to be closed by the

transferring to Trading Account and Profit and Loss Account.

Financial Statements: Financial statement can now be easily

prepared which will exhibit the true financial position and operating
results.

1.5.2 BASIC ACCOUNTING TERMS

In order to understand the subject matter clearly, one must
grasp the following common expressions always used in business
accounting.

Transaction: It means an event or a business activity which involves

exchange of money or money's worth between parties.

Goods/Services: These are tangible article or commodity in which

a business deals. These articles or commodities are either bought and
sold or produced and sold.

Profit: The excess of Revenue Income over expense is called profit.

It could be calculated for each transaction or for business as a whole.

Loss: The excess of expense over income is called loss. It could

be calculated for each transaction or for business as a whole.

Asset: Asset is a resource owned by the business with the purpose of

using it for generating future profits. Assets can be tangible and
intangible. Tangible Assets are the Capital assets which have some
physical existence. The capital assets which have no physical existence
and whose value is limited by the rights and anticipated benefits that
possession confers upon the owner are known as intangible Assets.
They cannot be seen or felt although they help to generate revenue in
future.

Liability: It is an obligation of financial nature to be settled at a future

date. It represents amount of money that the business owes to the other
parties.

Contingent Liability: It represents a potential obligation that could

be created depending on the outcome of an event.

Capital: It is amount invested in the business by its owners. It may be

in the form of cash, goods, or any other asset which the proprietor or
partners of business invest in the business activity. From business
point of view, capital of owners is a liability which is to be settled
only in the event of closure or transfer of the business. Hence, it is not
classified as a normal liability.

Drawings: It represents an amount of cash, goods or any other assets

which the owner withdraws from business for his or herpersonal use
Debtor : The sum total or aggregate of the amounts which the
customer owe to the business for purchasing goods on credit or
services rendered or in respect of other contractual obligations, is
known as Sundry Debtors or Trade Debtors, or Trade Payable, or
Book-Debts or Debtors.

Creditor: A creditor is a person to whom the business owes money

or money's worth. E.g. money payable to supplier of goods or provider
of service. Creditors are generally classified as Current Liabilities.

Trade Discount: It is the discount usually allowed by the

wholesaler to the retailer computed on the list price or invoice price.

Cash Discount: This is allowed to encourage prompt payment by

the debtor. This has to be recorded in the books of accounts. Thisis
calculated after deducting the trade discount.

1.6 MEANING AND TYPES OF FINANCIAL

STATEMENTS

Meaning :
Financial statements are plain statements based on historical
records, facts and figures. They are uncompromising in their objectives,
nature and truthfulness. They reflect a judicious combination of recorded
facts, accounting principles, concepts and conventions, personal
judgments and sometimes estimates.

Financial statements consist of ‘Revenue Account’ and ‘Balance

Sheet’.

1. Revenue Account / Income Statement:

Revenue Account refers to ‘Profit and Loss Account’ or ‘Income
and Expenditure Account’ or simply ‘Income Statement’. Revenue
Account may be split up or divided into ‘Manufacturing Account’,
’Trading Account’, ’Profit and Loss Account’ and ‘Profit and Loss
Appropriation Account’, Revenue Account is prepared for a period,
covering one year. This statement shows the expenses incurred on
production and distribution of the product and sales and other business
incomes. The final result of this statement may be profit of loss for a
particular period.

2. Balance Sheet:
Balance sheet shows the financial position of a business as on a
particular date. It represents the assets owned by the business and the
claims of the owners and creditors against the assets in the form of
liabilities as on the date of the statement.

3. Funds Flow Statement –

 It describes the sources from which the additional funds were
derived and the use of these funds. Funds flow statement helps to
understand the changes in the distribution of resources between two
balance sheet periods. The statement reveals the sources of funds and their
application for different purposes.

4. Cash flow Statement:

A cash flow statement shows the changes in cash position from
one period to another. It shows the inflow and outflow of cash and helps
the management in making plans for immediate future.An estimated
cash flow statement enables the management to ascertain the availability
of cash to meet business obligations. This statement is useful for short
term planning by the management.

5. Schedules:
Schedule explains the items given in income statement and balance
sheet. Schedules are a part of financial statements which give detailed
information about the financial position of a business organization.

1.7 OBJECTIVES OF FINANCIAL STATEMENTS

The main object of financial statements is to provide information

about the financial position, performance and changes taken place in an
enterprise. Financial statements are prepared to meet the common needs
of most users. The important objectives of financial statements are given
below:

1. Providing information for taking Economic decisions:

The economic decisions that are taken by users of financial
statements require an evaluation of the ability of an enterprise to generate
cash and cash equivalents and of the timing and certainty of their
generation. This ability ultimately determines the capacity of an
enterprise to pay its employees and suppliers meet interest payments,
repay loans and make distributions to its owners.

2. Providing information about financial position:

The financial position of an enterprise is effected by the economic
resources it controls, its financial structures its liquidity and solvency
and its capacity to adapt to changes in the environment in which it
operates.

Information about financial structure is useful in predicting future

borrowing needs and how future profits and cash flows will be
distributed among those with an interest in the enterprise. This
information is useful in predicting how successful the enterprise is likely
to be in raising further finance. Information about liquidity and solvency
is useful to predicting the ability of the enterprise to meet the financial
commitments as fall due.

3. Providing information about performance (working

results) of an enterprise:
Another important objective of the financial statements is that it
provides information about the performance and in particular its
profitability, which requires in order assessing potential changesin the
economic resources that are likely to control in future. Information about
performance is useful in predicting the capacity of the enterprise to
generate cash inflows from its existing resource base as well in forming
judgment about the effectiveness with which the enterprises might
employ additional resources.

4. Providing Information about changes in financial position:

The financial statements provide information concerning changes
in the financial position of an enterprise, which is useful in order to assess
its investing, financing and operating activities during the reporting
periods. This information is useful in providing the user with a basis to
assess the ability of the enterprise to generate cash and cash equipments
and the needs of the enterprise to utilize those cash flows.

1.8 AN OVERVIEW OF FINANCIAL STATEMENTS

Each business firm has to prepare two main financial statements

viz. Income Statement and Balance sheet. The income statement reveals
the profit of loss during a particular period generated from the activities
of a business. Balance sheet shows the financial position of a business
on a particular date.

• Income statement
Income statement summaries the incomes /gains and expenses /losses
of a Business for a particular financial period. The format of Income
statement explains in detail the items to be included in the statement. It is
presented in the traditional T Format and also in the vertically statement form.

1. Horizontal Form T form

Manufacturing Trading and Profit and Loss Account For the year
ending
Dr. Cr.

Particulars Rs. Particulars Rs.

To Opening stock By Closing stock
Raw materials Raw Material
Work in progress Work in progress
To Purchase of raw By Cost of finished
materials goods c/d
To Manufacturing wages By Sales
To Carriage/ Freight By Closing stock of
inwards Finished Goods
To Custom duty By Gross Loss c/d
To Other factory Expenses By Gross profit b/d
To Opening stock By Business incomes
and Gains
Finished Goods By Net Loss c/d
To Cost of finished By Balance b/d from
Previous year
Goods b/d By Net Profit b/d
To Gross profit c/d
To Gross loss b/d
To Office and
administration Expenses
To Interest and financial
Expenses
To Provision for Incometax

To Net Profit c/d

To Net loss b/d
To Transfer to Generalreserve

To Dividend
To Balance c/f
 Particulars Rs. Rs.
Gross Sales xxx
Less : Sales returns xxx
Sales tax / Excise duty
Net Sales xxx
Less : Cost of goods sold
(Materials consumed + xxx
Direct Labour + xxx
Manufacturing Expenses) xxx
Add / Less : Adjustment for change in stock xxx xxx
Gross Profit xxx
Less : Operating expenses xxx
a. Office and administration Expenses xxx
b. Selling and distribution Expenses xxx xxx
Add : Operating Income xxx
Operating Profit xxx
Add : Non Operating Income xxx
Less : Non Operating expenses (includinginterest) xxx

Profit before interest and tax xxx

Less : Interest xxx
Profit before tax xxx
Less : Appropriations : xxx xxx
a. Transfer to reserves xxx xxx
b. Dividends declared / paid xxx
Surplus carried to Balance Sheet xxx

• Balance sheet:
It is one of the major financial statements which presents a
company's financial position at the end of a specified date. Balance sheet
has been described as a "snapshot" of the company's financial position
at a moment for e.g. the amounts reported on a balance sheet dated March
31st, 2016 reflects that all the transactions throughout December 31st have
been recorded. The balance sheet provides information related to the
assets, liabilities and the shareholders’ equity of the company as on a
specific date.

Total Assets = Total Liabilities + Share holders’ equity

 The companies Act, 1956 stipulates that the balance sheetof a joint
stock company should be prepared as per Part I of Schedule VI of the Act.
However, the statement form has beenemphasized upon by accountants for
the purpose of analysis and interpretation.
 MODULE - II

2
ACCOUNTING PRINCIPLES

Unit Structure
2.1 Introduction
2.2 Accounting Concepts
2.3 Accounting Principles
2.4 Accounting Conventions
2.5 Widely Accepted Accounting Concepts

2.1 INTRODUCTION

Accounting is the language of the business. Accounting Principles

are the rules or guidelines which are developed to maintain a uniformity
and consistency in accounting records. This generally accepted
accounting principles (GAAP’s) provides unity of understanding and
unity of approach in the practice of accounting and also in better
preparation of financial statements.

Let us imagine a situation where you give copies of your books of

accounts to three different accountants and you ask themto prepare
financial statements and to compute the income from business for the
financial year on the basis of books of accounts given to them. All three
accountants are ready with the financial statements and all three
accountants have computed different figure of income i.e. profit from
the business and that too with very wide variations among them. Guess in
such a situation what impact would it leave on you about accounting
profession. To avoid this, a generally accepted set of accounting
principles/rules have been developed.

Financial statements prepared by the accountants to communicate

financial information to the various users of financial statements for
decision making purpose. Therefore, it is important that financial
statements prepared by different business entities should be prepared on
uniform basis. Also there should be
 consistency over a period of time in the preparation of these financial
statements. If every accountant starts following his own methods and
concepts for accounting different items then there will be confusion.

To avoid confusion and to achieve uniformity, accounting process

is applied within the conceptual framework of ‘Generally Accepted
Accounting Principles’ (GAAPs).

The term GAAPs is used to describe rules developed for the preparation of the
financial statements and are called

1. Accounting Concepts;

2. Accounting Conventions;

3. Accounting Postulates ;

4. Accounting Principles

2.2 ACCOUNTING CONCEPTS

Accounting Concepts are certain rules that accountant should

follow while recording business transactions and preparing accounts.

E.g. in India there is a basic rule to be followed by everyone that

one should walk or drive on his/her left hand side of the road. It helps in
the smooth flow of traffic. Similarly, there are certain rules that an
accountant should follow while recording business transactions and
preparing accounts.

Accounting concepts lay the foundation on the basis of which

the accounting principles are followed. Concepts constitutethe very
basis of accounting. There are various concepts of accounting and all have
been developed over the period of time from experience and thus, they
are university accepted rules.

2.3 ACCOUNTING PRINCIPLES

Meaning of Principles:

A general law or rule followed or adopted as a guide toaction is

known as a principle.
Definitions of Accounting Principles:

1. According to American Institute of Certified Public Accountants

(AICPA) : “The accounting principles are general law or rule adopted or
preferred as a guide to action, a settled ground or basis of conduct or
practice.”

2. According to R.N Antony: “The rules and conventions of accounting

are commonly referred to as Principles.”

Accounting principles must satisfy following conditions:

1. They should be based on real assumptions;

2. They must be simple, understandable & self explanatory;

3. They must be followed consistently;

4. They should be able to reflect future predictions;

5. They should be informational for the users.

2.4 ACCOUNTING CONVENTIONS

An accounting convention refers to common practices which are

universally followed in recording and presenting accounting statements
of the business entity. Accounting conventions are followed like customs,
traditions, etc. in a society. They make accounting information more clear
and useful. They have evolved through the regular and consistent practice
over the years. They facilitate uniform recording in the books of accounts.

2.5 WIDELY ACCEPTED ACCOUNTING CONCEPTS

1. Business Entity Concept

2. Money Measurement Concept
3. Accounting Period(Periodicity) Concept
4. Cost Concept
5. Realization Concept or Revenue recognition Concept
6. Matching Concept
7. Accrual Concept
8. Dual Aspect Concept
9. Materiality Concept
10. Conservatism or Prudence Concept
1) Business Entity Concept: Entity Concept states that Business
Enterprise is separate entity from its owner. As per this concept business
transactions to be recorded in business books andowner’s transactions to
be recorded in his personal books.

Entity concept means that enterprise owes to the owner for capital
provided by the owner.

Example: Mr. A Commenced business by investing Rs.

12,00,000/- with which he purchased Equipments & other Fixed
assets required in business for Rs. 10,00,000/- & kept balance
in hand. i.e. Rs. 2,00,000/- The financial position(Balance sheet)
of business is as follows:

Balance Sheet
Liabilities Amount(Rs.) Assets Amount(Rs.)
Capital 1200000 Equipment & 1000000
Fixed Assets
Cash in Hand 200000
1200000 1200000

This means that Business Enterprise owes to Mr. A

Rs.12,00,000/- now if Mr. A Spends/ uses Rs. 50,000/- for Household
Expenses from business capital Fund then as per business entity
concept it should not be classified/recorded as business expenses but
should be charged to capital account i.e. Capital will get reduced by
Rs. 50,000/- & revised Balance sheet will show following position

Balance Sheet
Liabilities Amount(Rs.) Assets Amount(Rs.)
Capital 12,00,000 Equipment 10,00,000
& Fixed
Assets
Less: (50,000) 11,50,000 Cash in 1,50,000
Drawings(Personal Hand
Expenses.)

11,50,000 11,50,000

2) Money Measurement Concept: This Concept states that only

monetary transactions i.e. which can be measured in terms of money are
to be recorded. In accounting, a record is made only
 of those facts or transactions that can be expressed in monetary terms. It
provides a common unit for measurement, i.e., money for measuring,
recording and summarizing the transaction. Events, which cannot be
expressed in money terms, do not find a place in account books.
Example, salary paid to manager is recorded in account books but
his competence is has no place in account books.

3) Accounting Period / Periodicity Concept: All the transactions are

recorded in the books of accounts on the assumption that profits on these
transactions are to be ascertained for a specified period. This is known
as periodicity or accounting period concept. Thus, this concept requires
that a balance sheet and profit and loss account should be prepared at
regular intervals. This is necessary for different purposes like,
calculation of profit, ascertaining financial position, tax computation etc.
Usually one year is taken as one accounting period which may be a
calendar year or a financial year.

Thus, the periodicity concept facilitates in:

(a) Comparing of financial statements of different periods

(b) Uniform and consistent accounting treatment for ascertaining the
profit and assets of the business
(c) Matching periodic revenue with expenses for getting correctresults
of the business operations.

4) Cost Concept: As per cost concept value of asset recorded atits

acquisition/purchase cost, in other words, at its historical cost.
For example, if a plot of land is purchased for Rs. 1,50,000 then
as per this concept, the asset will be recorded in the books at Rs.
1,50,000, even if its market value at that time is Rs. 2,00,000.
5) Realization Concept or Revenue recognition Concept: This
Concept deals with the problem, when the revenue should be recognized?
According to this concept, the sale should be recognised at the point,
when the property in goods passes to the buyer and he becomes legally
liable to pay and other income is recognised, when they accrue.
Example: Mr. A places an order with Mr. B for supply of certain
goods, which are yet to be manufactured. On receipt of order, Mr. B
purchases raw materials employs workers, produces the goods and
delivers finished goods to Mr.A. Mr. A makes payment on receipt of
goods. In this case, the sale will be presumed to have been made not
at the time of receipt of the order for the goods, but at the time, when
goods are delivered to Mr. A.
6) Matching Concept: In this concept, all expenses matched with
revenue of that period should only be taken into consideration. The
objective of running business is to earn profit in order to ascertain the
profit made by the business during a period. It is necessary that the
revenues of the period should be matched with the cost (Expenses) of
the period. The term matching means appropriate association of related
revenues and expenses.

Example: ABC Ltd. purchases a large appliance from wholesalers for

Rs.5,000 and resells it to a local restaurant for Rs.8,000. At the end of
the period, ABC Ltd. should match the Rs.5,000 cost with the
Rs.8,000 revenue.

7) Accrual Concept: Under Accrual concept/ Accrual basis of

accounting, income must be recorded in the accounting periodin which
it is earned. Therefore, accrued income must be recognized in the
accounting period in which it arises ratherthan in the subsequent period
in which it will be received. Conversely, prepaid income must be not be
shown as income in the accounting period in which it is received but
instead it mustbe presented as such in the subsequent accounting periods
in which the services or obligations in respect of the prepaid income
have been performed.

Example: Suppose Mr. Ramesh rents a house from Suresh at

Rs.100,000 per year. Now consider the following three cases in which
Ramesh pays cash to Suresh and records rent expense.

Cash Paid by Mr. Ramesh

Rs. 100000 Rs. 80000 Rs. 150000

(a) (b) (c)

Cash Paid by Mr. Ramesh

Expenses recorded by Mr. Ramesh

(b)
Rs. 100000 Rs. 100000 Rs. 100000

(a) (b) (c)

 In above example, even though cash paid is different in all the
three cases but the rent expense recorded is Rs.1,00,000 in each case.
Justification behind that is the accrual concept of accounting in which
expenses must be recorded in the accounting period in which they are
incurred not in the period in which they are paid.

Notice that in case “b” Mr. Ramesh has paid Rs.80,000 cash but has
recorded Rs.100,000 expense during the period because the annual rent is
Rs.100,000 not Rs.80,000. The remaining Rs.20,000 will be paid
subsequently. Also notice that in case “c” Mr. Ramesh has paid
Rs.1,50,000 but has recorded Rs.100,000 expense, the balance of
Rs.50,000 will be adjusted against the rent of subsequent period.

8) Dual Aspect Concept: This is a basic concept of accounting.

According to this concept, every business transactions has dual effect-
1st Aspects 2nd Aspects
(i) It increases on Asset and decreases other Asset,
[Purchase of Machinery] [Payment of Cash]

(ii) It increases an Asset and simultaneously increase liability,

[Purchase of Machinery] [Payment at future date
(on credit basis)]

(iii) It decreases one Asset, and decreases one Liability

[Payment of Cash] [Settlement of Liability]

(iv) It increase liability, and decreases simultaneously liability

[Bank Loan Obtained] [Payment to Creditors
(Using Loan Amount)]

For example, suppose Mr. Rahul purchases Assets of Rs. 100000 in

cash. In this business transaction, Mr. Rahul receives the assets of Rs.
100000, but on the other hand, Cash balance will decrease by Rs.
100000 So, Assets Account and Cash Account shall be affected by
this transaction.

Thus in every business transaction, one aspect represents the assets or

expenses other represents the claim or income and these two expects
are always equal. This approach generates the concept of accounting
equation, which can be summarized as below:
Liabilities = Assets
External Liabilities + Capital = Assets
 For example, if A starts a business with a capital of Rs. 1,00,000.
There are no aspects of this transaction. On the one hand, the business
has asset (in the form of cash) of Rs. 1,00,000, while on the other hand
the business has to pay to the proprietor a sum of Rs. 1,00,000, which
is known as proprietor’s capital. This expression can be shown in the
form of accounting equation as follows:
Capital (Liability) = Cash (Assets)
1,00,000 = 1,00,000

In the example given above, if the Machinery worth Rs. 50,000 is

purchased, the situation will be as follows:
Capital (Rs. 1,00,000) = Cash (Rs. 50,000) + Machinery (Rs.
50,000)

Thus, this concept develops a relationship between liabilities and

assets. The Accounting Equation can be technically started as “for
every debit, there is an equivalent credit”. As a matter of fact, the
entire Double Entry System of Book-Keeping is based on this
concept.

9) Materiality Concept: As per the concept of materiality, all the items

having significant economic effect on the business of the enterprise
should be disclosed in the financial statements and any insignificant item
which will only increase the work of accountant but will not be relevant
to the users need should not be disclosed in the financial statements.

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

10) Conservatism or Prudence Concept: Conservatism states that

the accountant should not anticipate income and shouldprovide for all
possible losses. When there are many alternative values of an asset, an
accountant should choose the method which leads to the lesser value.
Later on we should see that the golden rule of current asset valuation –
‘cost or market price ‘whichever is lower originated from this concept.
 3
BASICS OF ACCOUNTING STANDARDS
Unit Structure
3.1 Meaning & Introduction
3.2 Accounting Standards in Brief

3.1 MEANING & INTRODUCTION

Accounting standards are the written policy documents issued by the

regulatory authority, experts accounting body or bythe government covering
various aspects of recognition, treatment, measurement, presentation &
disclosure of accounting transactions and events in the financial statements.
The accountant has to adhere to various accounting standards while
preparing financial statements of the entities.

Accounting standard provide framework and standard accounting policies so

that the financial statement of different enterprises become comparable.

The accounting standards deals with the issues of –

i. Recognition of events and transactions in the financial statements;

ii. Measurement of these transactions and events;

iii. Presentation of these transactions and events in the financial

statements in a manner that is meaningful and understandableto the
reader; and

iv. The disclosure requirements which should be there to enable public at

large and the stakeholders and the potential investorsin particular, to
get insight into what these financial statement are trying to reflect and
thereby facilitating them to take prudent and informed business
decisions.
 3.2 ACCOUNTING STANDARDS IN BRIEF

AS-1-Disclosure of Accounting Policies: Accounting Policies refer to

specific accounting principles and the method of applying those principles
adopted by the enterprises in preparation and presentation of the financial
statements.

AS-2-Valuation of Inventories: The objective of this standard is to formulate

the method of computation of cost of inventories / stock, determine the value
of closing stock / inventory at which the inventory is to be shown in balance
sheet till it is not sold and recognized as revenue.

AS 3-Cash Flow Statements: Cash flow statement is additional information

to user of financial statement. This statement exhibits the flow of incoming
and outgoing cash. This statement assessesthe ability of the enterprise to
generate cash and to utilize the cash. This statement is one of the tools for
assessing the liquidity and solvency of the enterprise.

AS 4-Contingencies and Events occurring after the balance sheet date:

In preparing financial statement of a particular enterprise, accounting is done
by following accrual basis of accounting and prudent accounting policies to
calculate the profit or loss for the year and to recognize assets and liabilities
in balance sheet. While following the prudent accounting policies, the
provision is made for all known liabilities and losses even for those liabilities /
events, which are probable. Professional judgment is required to classify the
likehood of the future events occurring and, therefore, the question of
contingencies and their accounting arises. Objective of this standard is to
prescribe the accounting of contingencies and the events, which take place
after the balance sheet date but before approval of balance sheet by Board
of Directors. The Accounting Standard deals with Contingencies and Events
occrring after the balance sheet date.

🕮 AS 5-Net Profit or Loss for the Period, Prior Period Items and change
in Accounting Policies: The objective of this accounting standard is to
prescribe the criteria for certain itemsin the profit and loss account so that
comparability of the financial statement can be enhanced. Profit and loss
account being a period statement covers the items of the income and
expenditure of the particular period. This accounting standard also deals with
change in accounting policy, accounting estimates and extraordinary items.
🕮 AS 6-Depreciation Accounting: It is a measure of wearing out,
consumption or other loss of value of a depreciable asset arising from use,
passage of time. Depreciation is nothing but distribution of total cost of asset
over its useful life.

🕮 AS 7-Construction Contracts: Accounting for long term construction

contracts involves question as to when revenue should be recognized and
how to measure the revenue in the books of contractor. As the period of
construction contract is long, work of construction starts in one year and is
completed in another year or after 4-5 years or so. Therefore question arises
how the profit or loss of construction contract by contractor should be
determined. There may be following two ways to determine profit or loss: On
year-to-year basis based on percentage of completion or on completion of
the contract.

🕮 AS 8-Accounting for Research & Development: Accounting for

research & development, is withdrawn from the date of AS 26, Intangible
assets, becoming mandatory for respectiveenterprises.

🕮 AS 9-Revenue Recognition: The standard explains as to when the

revenue should be recognized in profit and loss account and also states the
circumstances in which revenue recognition can be postponed. Revenue
means gross inflow of cash, receivable or other consideration arising in the
course of ordinary activities of an enterprise such as the sale of goods,
rendering of services, and use of enterprises resources by other yielding
interest, dividend and royalties. In other words, revenue is acharge made to
customers / clients for goods supplied and services rendered.

🕮 AS 10-Accounting for Fixed Assets: AS 10 prescribesaccounting for

fixed assets used by entity in the business. AS defines term fixed asset. It is
an asset, which is held with intention of being used for the purpose of
producing or providing goods and services not held for sale in the normal
course of business and expected to be used for more than one accounting
period.

🕮 AS 11-The Effects of changes in Foreign Exchange Rates

: Effect of Changes in Foreign Exchange Rate shall be applicable in Respect
of Accounting Period commencing on or after 01-04-2004 and is mandatory
in nature. This accounting Standard applicable to accounting for transaction
in foreign currencies in translating in the financial statement of foreign
operations. Effect of changes in foreign exchange rate, an enterprises should
disclose following aspects:
 a) Amount Exchange Difference included in Net profit or Loss;
b) Amount accumulated in foreign exchange translation reserve;
c) Reconciliation of opening and closing balance of Foreign
Exchange translation reserve;

🕮 AS 12-Accounting for Government Grants: Accounting standard 12

deals with accounting for government grants both capital and revenue from
government. Government Grants are assistance by the Govt. in the form of
cash or kind to an enterprise in return for past or future compliance with certain
conditions. Government assistance, which cannot be valued reasonably, is
excluded from Govt. grants,. Those transactions with Government, which
cannot be distinguished from the normal trading transactions of the
enterprise, are not considered as Government grants.

🕮 AS 13-Accounting for Investments: AS 13 provides accounting

principles for investments in the financial statement and related disclosure
requirements. As per AS 13 Investment means the assets held for earning
income by way of dividend, interest and rentals, for capital appreciation or for
other benefits.

🕮 AS 14-Accounting for Amalgamation: This standard prescribes

accounting for amalgamation. This accounting standard deals with accounting
to be made in books of Transferee Company in case of amalgamation. The
standard is applicable when acquired company is dissolved and separate
entity ceased exist and purchasing company continues with the business of
acquired company

🕮 AS 15-Employee Benefits: Accounting Standard 15 prescribes the

accounting and disclosure for employee benefits. This Standard covers all
forms of employee benefits i.e. Short term employee benefits (Salaries,
Leave, bonus, housing, mediclaim etc.), Post employment benefits (gratuity,
pension, post employment medical care etc.) and other long term employee
benefits and termination benefits.

🕮 AS 16-Borrowing Costs : Enterprises are borrowing the funds to acquire,

build and install the fixed assets and other assets, these assets take time to
make them useable or saleable, therefore the enterprises incur the interest
(cost on borrowing)to acquire and build these assets. The objective of the
Accounting Standard is to prescribe the treatment of borrowing cost (interest
+ other cost) in accounting, whether the cost of borrowing should be included
in the cost of assets or not.
🕮 AS 17-Segment Reporting: An enterprise needs in multiple
products/services and operates in different geographical areas. Multiple
products / services and their operations in different geographical areas are
exposed to different risks and returns. Information about multiple products
/ services and their operation in different geographical areas are called
segment information. Such information is used to assess the risk andreturn
of multiple products/services and their operation in different geographical
areas. Disclosure of such information is called segment reporting.

🕮 AS 18-Related Party Disclosure: Sometimes business transactions

between related parties lose the feature and character of the arms length
transactions. Related party relationship affects the volume and decision of
business of one enterprise for the benefit of the other enterprise. Hence
disclosure of related party transaction is essential for proper understanding
of financial performance and financial position of enterprise.

🕮 AS 19-Accounting for leases: Lease is an arrangement by which the

lesser gives the right to use an asset for given period of time to the lessee
on rent. It involves two parties, a lessor and a lessee and an asset which
is to be leased. The lessor who owns the asset agrees to allow the lessee
to use it for a specified period of time in return of periodic rent payments.

🕮 AS 20-Earning Per Share: Earning per share (EPS) is afinancial ratio

that gives the information regarding earning available to each equity share.
It is very important financial ratio for assessing the state of market price of
share. This accounting standard gives computational methodology for the
determination and presentation of earning per share, which will improve
the comparison of EPS. The statement is applicable to the enterprise
whose equity shares or potential equity shares are listed in stock
exchange.

🕮 AS 21-Consolidated Financial Statements: The objective of this

statement is to present financial statements of a parent and its subsidiary
(ies) as a single economic entity. In other wordsthe holding company and
its subsidiary (ies) are treated as one entity for the preparation of these
consolidated financial statements. Consolidated profit/loss account and
consolidatedbalance sheet are prepared for disclosing the total profit/loss
of the group and total assets and liabilities of the group. As per this
accounting standard, the conslidated balance sheet if preparedshould
be prepared in the manner prescribed by this statement.

🕮 AS 22-Accounting for Taxes on Income: This accounting standard

prescribes the accounting treatment for taxes on income. Traditionally,
amount of tax payable is determined on the profit/loss computed as per
income tax laws.

🕮 AS 23-Accounting for Investments in Associates in consolidated

financial statements: The accounting standard was formulated with the
objective to set out the principles and procedures for recognizing the
investment in associates in the consolidated financial statements of the
investor, so that the effect of investment in associates on the financial
position of the group is indicated.

🕮 AS 24-Discontinuing Operations: The objective of this standard is to

establish principles for reporting information about discontinuing
operations. The focus of the disclosure of the Information is about the
operations which the enterprise plans to discontinue rather than disclosing
on the operations which are already discontinued. However, the disclosure
aboutdiscontinued operation is also covered by this standard.

🕮 AS 25-Interim Financial Reporting (IFR): Interim financial reporting

is the reporting for periods of less than a year generally for a period of 3
months.

🕮 AS 26-Intangible Assets : An Intangible Asset is an Identifiable non-

monetary Asset without physical substance held for use in the production
or supplying of goods or services for rentals to others or for administrative
purpose

🕮 AS 27-Financial Reporting of Interest in joint ventures: Joint

Venture is defined as a contractual arrangement whereby two or more
parties carry on an economic activity under 'joint control'. Control is the
power to govern the financial and operating policies of an economic
activity so as to obtain benefit from it. 'Joint control' is the contractually
agreed sharing of control over economic activity.

🕮 AS 28 Impairment of Assets: The dictionary meaning of 'impairment

of asset' is weakening in value of asset. In other words when the value of
asset decreases, it may be called impairment of an asset. As per AS-28
asset is said to be impaired when carrying amount of asset is more
than its recoverable amount. Carrying Amount means book value of Asset
Recoverable Amount means Market value of Asset

🕮 AS 29-Provisions, Contingent Liabilities And Contingent Assets:

Objective of this standard is to prescribe the accounting for Provisions,
Contingent Liabilities, Contingent Assets, Provision for restructuring cost
.
Provision: It is a liability, which can be measured only by using a
substantial degree of estimation
.
Liability: A liability is present obligation of the enterprise arising from past
events the settlement of which is expected to result in an outflow from the
enterprise of resources embodying economic benefits.
 4
INTRODUCTION TO IFRS

Unit Structure

4.1 Introduction
4.2 Purpose
4.3 Scope
4.4 International Financial Reporting Standards

4.1 INTRODUCTION

IFRS stands for International Financial Reporting Standards. IFRS are

developed by International Accounting standards boards (IASB). IFRS is
set of standards used in many parts of the world, including the European
Union, Hong Kong, Australia, Malaysia, Russia, South Africa, Singapore
etc. for preparation of financial statements. Different Countries uses
different set of accounting standards while preparation of financial
statements for e.g. India uses its own set of Accounting standards issued
by the ICAI, United states have their US GAAP, Canada has its Canadian
GAAP and United Kingdom has its UK GAAP.
Conceptual Framework
Introduction: Financial statements are prepared and presented for
external users by many entities around the world. Although such financial
statements may appear similar from country to country, there are
differences which have probably been caused by a variety of social,
economic and legal circumstances and by different countries having in
mind the needs of different users of financial statements when setting
national requirements.
The International Accounting Standards Board is committed to narrowing
these differences by seeking to harmonize regulations, accounting
standards and procedures relating to the Preparationand presentation of
financial statements. It believes that further harmonization can best be
pursued by focusing on financial statements that are prepared for the
purpose of providing information that is useful in making economic
decisions.

The Board believes that financial statements prepared forthe purpose of

making economic decisions meet the common needs of most users. This
is because nearly all users are making economic decisions, for example:
(a) to decide when to buy, hold or sell an equity investment.
(b) to assess the stewardship or accountability of management.
(c) to assess the ability of the entity to pay and provide other
 benefits to its employees.
(d) to assess the security for amounts lent to the entity.
(e) to determine taxation policies.
(f) to determine distributable profits and dividends.
(g) to prepare and use national income statistics.
(h) to regulate the activities of entities.
The Board recognises, however, that governments, in particular, may
specify different or additional requirements for their own purposes. These
requirements should not, however, affect financial statements published for
the benefit of other users unless they also meet the needs of those other
users.

4.2 PURPOSE

This Conceptual Framework sets out the concepts that underlie the
preparation and presentation of financial statements for external users.
The purpose of the Conceptual Framework is:
(a) To assist the Board in the development of future IFRSs and
inits review of existing IFRSs;
(b) To assist the Board in promoting harmonization of regulations,
accounting standards and procedures relating to the
presentation of financial statements by providing a basis for
reducing the number of alternative accounting treatments
permitted by IFRSs;
(c) To assist national standard-setting bodies in developing
national standards;
(d) To assist preparers of financial statements in applying IFRSs
and in dealing with topics that have yet to form the subject of
an IFRS;
(e) To assist auditors in forming an opinion on whether financial
statements comply with IFRSs;
(f) To assist users of financial statements in interpreting the
information contained in financial statements prepared in
compliance with IFRSs; and
(g) To provide those who are interested in the work of the IASB
with information about its approach to the formulation of IFRSs.

4.3 SCOPE

The Conceptual Framework deals with:

(a) the objective of financial reporting;
(b) the qualitative characteristics of useful financial information;
(c) the definition, recognition and measurement of the elements
from which financial statements are constructed; and
(d) concepts of capital and capital maintenance.

4.4 INTERNATIONAL FINANCIAL

 REPORTING STANDARDS

International Financial Reporting Standards in a broad sensecomprise:

4.4.1 Conceptual Framework for Financial Reporting —stating
basic principles and grounds of IFRS
4.4.2 IAS—standards issued before 2001
4.4.3 IFRS—standards issued after 2001
4.4.4 SIC—interpretations of accounting standards,
giving specificguidance on unclear issues
4.4.5 IFRIC—newer interpretations, issued after 2001

IFRSs
IFRS 1: First time Adoption of International Financial ReportingStandards
IFRS 2: Share-based Payment IFRS
3: Business CombinationsIFRS 4:
Insurance Contracts
IFRS 5: Non-current Assets Held for Sale and DiscontinuedOperations
IFRS 6: Exploration for and Evaluation of Mineral ResourcesIFRS 7:
Financial Instruments: Disclosures
IFRS 8: Operating Segments IFRS
9: Financial Instruments
IFRS 10: Consolidated Financial StatementsIFRS 11:
Joint Arrangements
IFRS 12: Disclosure of Interests in Other EntitiesIFRS
13: Fair Value Measurement
IFRS 14: Regulatory Deferral Accounts
IFRS 15: Revenue from Contracts with Customers

IASs
IAS 1: Presentation of Financial StatementsIAS
2: Inventories
IAS 7: Statement of Cash Flows
IAS 8: Accounting Policies, Changes in Accounting Estimates andErrors
IAS 10: Events after the Reporting PeriodIAS
11: Construction Contracts*
IAS 12: Income Taxes
IAS 16: Property, Plant and EquipmentIAS
17: Leases
IAS 18: Revenue*
IAS 19: Employee Benefits
IAS 20: Accounting for Government Grants and Disclosure ofGovernment
Assistance
IAS 21: The Effects of Changes in Foreign Exchange Rates
Note: IAS 3, 4, 5, 6, 9, 13, 14, 15, 22, 25, 30, 31 and 35 have
been superseded SICs
SIC 7: Introduction of the Euro
SIC 10: Government Assistance – No Specific Relation toOperating
Activities
SIC 15: Operating Leases – Incentives
SIC 25: Income Taxes – Changes in the Tax Status of an Entity orits
Shareholders
SIC 27: Evaluating the Substance of Transactions Involving theLegal
Form of a Lease
SIC 29: Service Concession Arrangements: Disclosures
SIC 31: Revenue – Barter Transactions Involving AdvertisingServices
SIC 32: Intangible Assets – Web Site Costs
Note: SIC 1, 2, 3, 4, 5, 6, 8, 9, 11, 12, 13, 14, 16, 17, 18, 19, 20, 21,
22, 23, 24, 26, 28, 30, 33 have been superseded
*Will be superseded by IFRS 15 as of 1 January 2017
IFRICs
IFRIC 1: Changes in Existing Decommissioning, Restoration andSimilar
Liabilities
IFRIC 2: Members' Shares in Co-operative Entities and SimilarInstruments
IFRIC 4: Determining whether an Arrangement contains a Lease
IFRIC 5: Rights to Interests Arising from Decommissioning,Restoration
and Environmental Rehabilitation Funds
IFRIC 6: Liabilities Arising from Participating in a Specific Market -Waste
Electrical and Electronic Equipment
IFRIC 7: Applying the Restatement Approach under IAS 29Financial
Reporting in Hyperinflationary Economies
IFRIC 10: Interim Financial Reporting and ImpairmentIFRIC 12:
Service Concession Arrangements
IFRIC 13: Customer Loyalty Programmes*
IFRIC 14: IAS 19 – The Limit on a Defined Benefit Asset, MinimumFunding
Requirements and their Interaction
FRIC 15: Agreements for the Construction of Real Estate* IFRIC 16:
Hedges of a Net Investment in a Foreign Operation IFRIC 17:
Distributions of Non-cash Assets to Owners
IFRIC 18: Transfers of Assets from Customers*
IFRIC 19: Extinguishing Financial Liabilities with Equity Instruments
IFRIC 20: Stripping Costs in the Production Phase of a SurfaceMine
IFRIC 21: Levies
Note: IFRIC 3, 8, 9 & 11 have been withdrawn
 MODULE - III

5
BASICS OF BALANCE SHEET AND
PROFIT AND LOSS ACCOUNT
Unit structure :

5.1 Objectives
5.2 Introduction
5.3 Meaning and Types of Financial Statements
5.4 Parties Interested In Financial Statements
5.5 Basics of Income Statement and Balance Sheet
5.6 Limitation of financial statement
5.7 Exercise

5.1 OBJECTIVE

After studying the unit, the students will be able to -

• Understand the meaning and types of financial statement.
• Know the parties interested in Financial statements
• Understand the objectives of Financial statements
• Explain the basics of Financial statements

5.2 INTRODUCTION

Government legislations require certain organizations to maintain proper

accounts and draw financial statement. Public can understand from the
financial statement the extent to which a company is discharging its social
responsibilities. While issuing shares, bonds, financial statement become
necessary as prospective investors can judge the financial position of the
organization and able to take a proper decision. Workers union may study the
financial statement and ascertain whether they can enforce their demand.
Tax legislature makes it obligatory for the business entities to draw fair and
objective financial statement. The financial statement serves as instruments
to regulate equity and debentures issued by companies.
 5.3 MEANING AND TYPES OF FINANCIAL
STATEMENTS

Meaning :
Financial statements are plain statements based on historical records, facts
and figures. They are uncompromising in their objectives, nature and
truthfulness. They reflect a judicious combination of recorded facts,
accounting principles, concepts and conventions, personal judgements and
sometimes estimates.

Financial statements consist of ‘Revenue Account’ and ‘Balance Sheet’.

1. Revenue Account / Income Statement:

Revenue Account refers to ‘Profit and Loss Account’ or ‘Income and
Expenditure Account’ or simply ‘Income Statement’. Revenue Account may
be split up or divided into ‘Manufacturing Account’, ’Trading Account’, ’Profit
and Loss Account’ and ‘Profit and Loss Appropriation Account’, Revenue
Account is prepared fora period, covering one year. This statement shows the
expenses incurred on production and distribution of the product and sales and
other business incomes. The final result of this statement may be profit of loss
for a particular period.

2. Balance Sheet:
Balance sheet shows the financial position of a business as on a particular
date. It represents the assets owned by the business and the claims of the
owners and creditors against the assets in the form of liabilities as on the date
of the statement.

3. Funds Flow Statement –

It describes the sources from which the additional funds were derived and
the use of these funds. Funds flow statement helps to understand the
changes in the distribution of resources between two balance sheet periods.
The statement reveals the sources of funds and their application for different
purposes.
4. Cash flow Statement:
A cash flow statement shows the changes in cash position from one period to
another. It shows the inflow and outflow of cash and helps the management
in making plans for immediate future.An estimated cash flow statement
enables the management to ascertain the availability of cash to meet
business obligations. This statement is useful for short term planning by the
management.
5. Schedules:
Schedule explains the items given in income statement and balance sheet.
Schedules are a part of financial statements which give detailed information
about the financial position of a business organization.
 5.4 PARTIES INTERESTED IN FINANCIAL
STATEMENTS

In recent years, the ownership of capital of many public companies has

become truly broad based due to dispersal of shareholding. Therefore, one
may say that the public in general has become interested in financial
statements. However, in addition to the share holders, there are other persons
and bodies who are also interested in the financial results disclosed by the
annual reports of companies. Such persons and bodies include:
1. Creditors, potential suppliers or others doing business with the
company;
2. Debenture-holders;
3. Credit institutions like banks;’
4. Potential Investors;
5. Employees and trade unions;
6. Important customers who wish to make a long standing contract
with the company;
7. Economists and investment analyst;
8. Members of Parliament, the Public Accounts Committee and the
Estimates Committee in respect of Government Companies;
9. Taxation authorities;
10. Other departments dealing with the industry in which the
company is engaged; and
11. The Company Law Board

Financial Statement analysis, therefore, has become of general interest.

5.5 OBJECTIVES OF FINANCIAL STATEMENTS

The main object of financial statements is to provide information about the

financial position, performance and changes taken place in an enterprise.
Financial statements are prepared to meet the common needs of most users.
The important objectives of financial statements are given below:

1. Providing information for taking Economic decisions:

The economic decisions that are taken by users of financial statements
require an evaluation of the ability of an enterprise to generate cash and cash
equivalents and of the timing and certainty of their generation. This ability
ultimately determines the capacity of an enterprise to pay its employees and
suppliers meet interest payments, repay loans and make distributions to its
owners.
 2. Providing information about financial position:
The financial position of an enterprise is effected by the economic resources
it controls, its financial structures its liquidity and solvency and its capacity
to adapt to changes in the environment in which it operates.

Information about financial structure is useful in predicting future borrowing

needs and how future profits and cash flows will be distributed among those
with an interest in the enterprise. This information is useful in predicting how
successful the enterprise is likely to be in raising further finance. Information
about liquidity and solvency is useful to predicting the ability of the enterprise
to meet the financial commitments as fall due.

3. Providing information about performance(working results)

of an enterprise:
Another important objective of the financial statements is that it provides
information about the performance and in particular its profitability, which
requires in order assessing potential changesin the economic resources that
are likely to control in future. Information about performance is useful in
predicting the capacity of the enterprise to generate cash inflows from its
existing resource base as well in forming judgment about the effectiveness
with which the enterprises might employ additional resources.

4. Providing Information about changes in financial position:

The financial statements provide information concerning changes in the
financial position of an enterprise, which is useful in order to assess its
investing, financing and operating activities during the reporting periods. This
information is useful in providing the user with a basis to assess the ability of
the enterprise to generate cash and cash equipments and the needs of the
enterprise to utilize those cash flows.

5.6 BASICS OF INCOME STATEMENT AND BALANCE

SHEET

Each business firm has to prepare two main financial statements viz. Income
Statement and Balance sheet. The income statement reveals the profit of loss
during a particular period generated from the activities of a business. Balance
sheet shows the financial position of a business on a particular date.
• Income statement
Income statement summaries the incomes /gains and expenses /losses of a
Business for a particular financial period. The format of Income statement
explains in detail the items to be included in the statement. It is presented in
the traditional T Format and also in the vertically statement form.
1. Horizontal Form T form

Manufacturing Trading and Profit and Loss Account For the yearending
Dr. Cr.

Particulars Rs. Particulars Rs.

To Opening stock By Closing stock
Raw materials Raw Material
Work in progress Work in progress
To Purchase of raw By Cost of finished
materials goods c/d
To Manufacturing wages By Sales
To Carriage/ Freight By Closing stock of
inwards Finished Goods
To Custom duty By Gross Loss c/d
To Other factory Expenses By Gross profit b/d
To Opening stock By Business incomes
and Gains
Finished Goods By Net Loss c/d
To Cost of finished By Balance b/d from
Previous year
Goods b/d By Net Profit b/d
To Gross profit c/d
To Gross loss b/d
To Office and
administration Expenses
To Interest and financial
Expenses
To Provision for Incometax

To Net Profit c/d

To Net loss b/d
To Transfer to General
reserve
To Dividend
To Balance c/f
 Particulars Rs. Rs.
Gross Sales xxx
Less : Sales returns xxx
Sales tax / Excise duty
Net Sales xxx
Less : Cost of goods sold
(Materials consumed +Direct xxxxxx
Labour + xxx
Manufacturing Expenses)
Add / Less : Adjustment for change in stock xxx xxx
Gross Profit xxx
Less : Operating expenses xxx
a. Office and administration Expenses xxx
b. Selling and distribution Expenses xxx xxx
Add : Operating Income xxx
Operating Profit xxx
Add : Non Operating Income xxx
Less : Non Operating expenses (including xxx
interest)
Profit before interest and tax xxx
Less : Interest xxx
Profit before tax xxx
Less : Appropriations : xxx xxx
a. Transfer to reserves xxx xxx
b. Dividends declared / paid xxx
Surplus carried to Balance Sheet xxx

• Balance sheet:
It is one of the major financial statements which presents a company's
financial position at the end of a specified date. Balance sheet has been
described as a "snapshot" of the company's financial position at a moment
for e.g. the amounts reported on a balance sheet dated March 31st, 2016
reflects that all the transactions throughout December 31st have been
recorded. The balance sheet provides information related to the assets,
liabilities and the shareholders’ equity of the company as on a specific date.

Total Assets = Total Liabilities + Share holders’ equity

The companies Act, 1956 stipulates that the balance sheetof a joint stock
company should be prepared as per Part I of Schedule VI of the Act. However,
the statement form has been emphasized upon by accountants for the
purpose of analysis and interpretation.
Understanding Corporate Balance Sheet:
A. Assets side:
1. Fixed Assets :
Fixed Assets are called long-term assets. These assets are used over
several periods. They are major sources of revenue to the business. They
are intended for long term use in the business. They are called “bundle of
future services” or “Sunk Costs”. The group of fixed assets is explained in the
proforma. Generally the Fixed assets are classifies as:
a) Tangible movable assets;
b) Tangible immovable assets; and
c) Intangible assets.
a) Tangible movable assets are the assets which can be seen,
touched and moved from one place to another place. Plant and
Machinery, furniture and fixtures, transportation equipments
etc. are tangible movable assets.
b) Tangible immovable assets are the assets which can be
seen and touched but cannot be moved from one place to
another place. Such assets include land, buildings, mines, oil
wells, etc.
c) Intangible assets are the assets which cannot be seen and
touched. However, their existence can only be imagined such
as patents, trademarks, copyrights, goodwill, etc.
The Fixed Assets are presented as:
Gross Block - Provision for Depreciation = Net Blocks
2. Investments :
Investments may be short-term or long term. Short-term investments are
marketable securities and they represent temporary investments of idle
funds. These investments can bedisposed off by the company at any time.
Investments are shown at cost. Cost includes brokerage, fees and all other
expenses incurred on acquisition of investments. However, the market value
is shown by way of a note.
Long-term investments are held for a long time. They are required to be held
by the business by the very nature and conditions of the business. For
example, a company engaged in generating electricity may be required to
hold the bonds of the Electricity Board. These bonds are retained by the
company so long as the company uses electric power.

As per Schedule VI of the Indian Companies Act 1956, investments are

shown separately, showing the nature of investments and the mode of
valuation of various classes of securities.
Long term Investments are grouped under fixed assets and short term
investments under current assets.
 3. Current Assets, Loans and Advances:
The item, “Current Assets, Loans and Advances” is divided intotwo parts:
a. Current Assets, and
b. Loans and Advances.
a. Current Assets and Quick assets:
“Current Assets include cash and the other assets that are likely to be
converted into cash and the cash thus generated is available to pay current
liabilities. Current assets are not intendedfor long-term use in business.
Current assets represent employment of money by the company on a short-
term basis. They circulate within the group. For example, cash becomes
raw material when material is purchased, material becomes finishedgoods,
finished goods become cash or debtors when sold and so on.
Current Assets = Stock + Debtors + Cash & Bank + Loans &Advances
+ Marketable Securities + Other Current Assets
In fact, total current assets are known as “Gross Working Capital”. Current
assets less current liabilities are known as ‘net working capital’.
Quick Assets are known as ‘near cash’ assets. In other words, quick assets
are those which can be converted into cash quickly. Therefore, they are also
known as liquid assets. Cash and bank balances are the most liquid assets.
Debtors and cash advances can be converted into cash at a short notice.
Therefore, they are also regarded as quick assets. Marketable investments
can be converted into cash, fall into the category of quick assets. Inventory
does not fall in this category of quick assets, since itcannot be converted into
cash quickly, as material is to be converted into finished goods and then
they should be sold. Expenses paid in advance do not satisfy the criteria of
quick assets. They cannot be converted into cash. They can be received in
the form of services.
Therefore Quick Assets = Current Assets – Inventory –
Prepayments
b. Loans and Advances :
Loans and advances given are current assets. It includes different types of
advances such as advances against salary, advances against machinery,
advances to subsidiary, prepaid expenses on account of rent, taxes,
insurance, etc.

4. Miscellaneous Expenditures and losses :

This heading covers Fictitious Assets and other expenses which are made
for future on a mass basis. These expenses are really not assets but the
whole balance on the account of these items is not charged to current year’s
Profit and Loss A/c therefore the amount to the extent not written off or
adjusted is shown onthe Assets side as Miscellaneous expenditures.

The examples of fictitious assets are :

a. Preliminary expenses.
b. Brokerage on issue of shares and debentures.
c. Discount on issue of shares and debentures.
d. Share or debenture issue expenses.
e. Heavy Advertisement and Publicity expenditure.
f. Profit and Loss A/c debit balance.

Liquidity means easy convertibility into cash. Though ultimately all assets are
converted into cash, the term liquidity refers not only to the nature of assets
but also to the purposes of holding the assets. Assets are normally arranged
in order of permanency i.e., from least liquid to most liquid.

B. Liabilities Side
The term ‘liability’ when used in accounting, means a debt. A debt is
something that a person or an organization owes to another person or
organization. In other words, Liabilities are the claims of outsiders against the
business. Technically speaking, all liabilities shown in a balance sheet are
claims against all assets shown in it. But, there may be certain cases where
a liability has a claim against a specific asset. Even under such
circumstances, the liabilities are shown separately, not as a deduction from
the specific assets.

Classification of Liabilities :
The liabilities of an enterprise may be classified into threecategories
1. Permanent Funds or Proprietors’ Funds.
2. Semi-permanent Funds or Long-term Borrowings.
3. Current liabilities and Provisions.

1. Proprietor’s Funds :
These are the funds provided by the proprietors (owners) or the
shareholders. Proprietors’ fund represents the interest of the proprietors in
the business. This is the amount belonging to the proprietors. Proprietors’
fund is also called as ‘Proprietors’ Equity’, ‘Owners’ Funds’, or
‘Shareholders’ Funds’. This is also known as the ‘Net Worth’ of the
business. Owners’ Equity refers to the claimof the owners it includes :

Owners’ Equity = Capital (May be Equity Share Capital only or Equity and
Preference Share Capital) + Reserves + Profit and Loss A /c credit balance
– Accumulated losses and Fictitious assets.

Owners’ equity increase either through fresh investments by the owners or

by way of increasing the earnings retained i.e., profits not distributed.
(Retained earnings are that part of the total earnings which have been
retained for use in the business)

a. SHARE CAPITAL :
Share capital is the amount that is raised by a companyfrom the public
at large, through the issue of shares. There are different concepts of share
capital from the legal and accounting points of view.

The following chart details the different concepts of capital :

Company’s Share Capital

Authorised Capital (Registered or

Nominal Capital)

1. Issued Capital
+ 2.
Unissued Capital

1. Subscribed Capital + 2. Unsubscribed Capital

1. Called up Capital + +
2. Uncalled Capital 3. Reserve Capital

+ 1. Paid up Capital Calls-in-Arrears or Calls Unpaid

i. Authorised Capital : Authorised Capital is the maximum

capital a company can raise as mentioned in the Memorandum
of Association under its Capital Clause.

ii. Issued Capital : A company usually does not need the entire
registered capital. Issued capital is that part of the Authorised
capital; which is actually offered to the prospective investors for
subscription. The balance of the Authorised capital which is not
issued is called the ‘unissued capital.’

iii. Subscribed Capital : Subscribed capital is that part of the

issued capital which has been subscribed or taken up by the
public. Therefore, the subscribed capital may be equal to or
less than the issued capital.

Called up Capital Uncalled Capital: The company, therefore, may collect

the capital in several instalments as per its need. The called- up capital is
that portion of the subscribed capital which has been called or demanded by
the company to be paid. The capital that is not demanded from the
shareholders is called uncalled capital.

iv. Paid up Capital: Paid up capital is that part of the called up

capital which has been actually paid by the members. The paid-
up capital is the called-up amount less calls not paid. (Calls
unpaid or calls-in-arrears).

v. Reserve Capital : It is that part of the uncalled capital which

may only be demanded on winding up or liquidation, but not
when the company is a going on. A company may determine
 this amount by a Special Resolution.

b. RESERVES AND SURPLUS :

A business may have to meet certain compulsory or voluntary, foreseen or
unforeseen, recurring or non-recurring obligations in future. It is
advantageous to for the organization to make provision in advance to meet
them. If not sudden payment may adversely affect the financial health of the
company. In orderto avoid such situations some part of profit are retained
in each year which is termed as ‘Retained Earnings’ or ‘Plough Back of
profits’. It means the reserves represent amounts set aside out of divisible
profits. They are appropriations of profits. Indian Companies Act requires
every company to transfer a specific percentage (upto 10%) of the profits to
“Reserve” accounts.

Reserve created for a specific purpose is called as a “Specific Reserve” and

a reserve created for a general purpose is called as a “General Reserve.”
General reserves are free and can be utilized for Payment of Dividends,
Development and expansion purpose or for any other purpose the company
thinks proper.
According to Companies Act “Reserve shall not include any amount written
off by way of providing for depreciation, renewals or diminution in value of
assets or retained by way of providing for any known liability.”

It is compulsory for the business organization to disclose each individual

head of the reserves in the balance sheet with its opening balance as per last
balance sheet, additions thereto and deductions there from in the current
yare.

2. LONG-TERM LIABILITIES :
A company raises finance either from owners or throughexternal borrowings.
External borrowings of a company which constitute its “owed funds” are
important sources of long-term finance. These borrowings are termed as
‘fixed liabilities’ or ‘term liabilities’ or ‘long term-loans’. They may take
various forms suchas debentures, public deposits, bank loans, deferred
payments,etc. They may be fully secured or partly secured or unsecured.

3. CURRENT LIABILITIES AND PROVISIONS:

a. Current Liabilities :
Current liabilities are those short-term obligations of an enterprise which
mature within one year or within the operating cycle. They constitute short-
term sources of finance. It includesSundry Creditors, Bills Payable, Interest
accrued but not due, outstanding expenses, Unclaimed dividends and Bank
Overdraft.

These liabilities are not normally secured and no interest is payable on them
with the exception of bank overdrafts. These liabilities, are generally paid off
by utilizing current assets or by creating a current liability.

Actually all current liabilities are payable within a short period of time.
However, Bank Overdraft is the current liability which is not paid immediately
or in a very short-time, in practice. Therefore, Bank Overdraft is not
considered as a quick liability. It is a permanent arrangement with the
banker. Hence
Quick Liabilities = Current Liabilities – Bank Overdraft
 b. Provisions :
‘Provision’ means any amount retained by way of providing for any known
liability of which the amount cannot be determined with substantial accuracy.
Provisions have to be made for maintaining the integrity of assets or for
known liabilities. Although the amount of liability is not certain organization
has to made provision on best estimates. The examples of provisions are
Provision for depreciation on assets, Provision for doubtful debts, Provision
for proposed dividends, Provision for taxation.
4. CONTINGENT LIABILITIES :
According to ICAI, Contingent liability refers to an obligation relating to an
existing condition or situation which may arise in future depending on the
occurrence or non-occurrence of one or more uncertain future events. These
liabilities may or may not be converted into actual liabilities at some future
date. It is a liability which may or may not occur. But on the date of the
Balance Sheet,it is not known definitely whether the liability would arise or
not. But as a matter of caution, it is indicated in the balance sheet for the
sake of information and disclosure, under the head “Contingent Liabilities.
Some of the examples of Contingent Liabilities are Discounted Bills of
Exchange, Disputed liability on account of income-tax, etc., about which
appeal has been filed, Uncalled amount on partly paid-up shares and
debentures held by the company as investments, Cumulative preference
dividend in arrears, Matters referred to arbitration, Claims not acknowledged
as debts, Estimated amount of contracts remaining to be executed on capital
account and not provided for, Guarantees given by the company, Bonds
executed. and debentures held by the company as investments, Cumulative
preference dividend in arrears, Matters referred to arbitration, Claims not
acknowledged as debts, Estimated amount of contracts remaining to be
executed on capital account and not provided for, Guarantees given by the
company, Bonds executed.

Following are the proforma of the Balance sheet

1) Horizontal Form :

Liabilities Rs Assets Rs

Share Capital Fixed Assets

(with all particulars of 1. Goodwill
authorized, issued, 2. Land and Building
subscribed and Called up 3. Lease hold Property
capital) 4. Plant and Machinery
Less: Calls in arrears 5. Furniture and fixture
Add: Forfeited shares
6. Patents and trade marks
7. Vehicles

Investments
Reserve and Surplus
1. Capital Reserve Current assets, Loans and
2. Capital Redemption Advances
Reserve
a. Current assets
3. Share premium 1. Interest accrued on
4. Other Reserves Investment
2. Loose tools
Less: P&L a/c Debit balance
3. Stock in Trade
5. Profit and Loss
4. Sundry debtors
appropriation A/c
Less Provision for Bad debts
6. Sinking fund A/c
5. Cash in Hand
6. Cash at Bank
 Long term loans b. Loans and Advances
a. Secured loan 1. Advances to
Debentures subsidiaries
Add: Outstanding Interest 2. Bills receivables
Loan from Banks 3. Prepaid expenses

b. Unsecured loans Miscellaneous expenditure

Fixed deposits 1. Preliminary expenses
Short term loans andadvances 2. Discount on issue of
shares and Debentures
Current liabilities and 3. Underwriting commission
Provisions 4. Profit and Loss a/c (debit
a. Current liabilities balance)
1. Bills payables
2. Sundry creditors
3. Bank overdraft
4. Income received in
advance
5. Unclaimed Dividends
6. Other liabilities
b. Provisions
1. Provision for taxation
2. Proposed dividends
3. Provident fund and
Pension fund

Contingent Liabilities

2. Vertical Form

Income Statement of …….. for the year ending ……….

Previous Particulars Schedule Current Year

I. Sources of Funds
1. Shareholders’ Funds
a. Capital
b. Reserves and surplus
2. Loan funds
a. Secured loan
b. Unsecured loans

TOTAL
II. Application of Funds
1. Fixed Assets
a. Gross Block
Less Depreciation
 b. Net Block
2. Investments
3. Current Assets, Loans and
Advances
Less Current Liabilities and
Provisions
Net Current Assets
4. Miscellaneous expenditure to
the extent not written off or
adjusted Profit and Loss a/c
debit balance
TOTAL

• Statement of Retained Earnings:

The Statement of Retained Earnings is prepared to showhow the balance in
Profit and Loss accounts is appropriated for various purposes like provision for
dividend, transfer to reservesetc. The balance on this account is finally shown
on the Balance sheet Under the heading Reserve and Surplus.

5.7 LIMITATION OF FINANCIAL STATEMENT

Following are the limitations of financial statements:

1. The information being of historical nature does not reflect the future.
2. It is the outcome of accounting concept, convention combined with
personal judgement.
3. The statement portrays the position in monetary term. The profit or
loss position excludes from their purview things which cannot be
expressed or recorded in term of money.
To overcome from the limitations it becomes necessary to analyse the financial
statements.
 Module - IV

6
ACCOUNTING RECORDS

Unit Structure
6.1 Introduction
6.2 Process of Transaction and Its Record Generation
6.3 What is an Account?
6.4 Final Accounts
6.5 Horizontal or ‘T’ Format of Trading & P&L A/C
6.6 Vertical Format of Balance Sheet

6.1 INTRODUCTION

Accounting involves a series of processes like measuringeconomic value of a

transaction, recording it and reporting it to various stake holders. Accounting
information is used by a varietyof users, like investors, creditors, workers,
management, and government.

Accounting can be divided into financial accounting, management accounting,

auditing, and tax accounting. Financial accounting focuses on the reporting of
an organization's financial information, including the preparation of financial
statements, to external users of the information, such as investors, regulators
and suppliers and management accounting focuses on the measurement,
analysis and reporting of information for internal use by management. The
recording of financial transactions, so that summaries of the financials may
be presented in financial reports,is known as bookkeeping, of which double-
entry bookkeeping is the most common system.
Accounting records means internal or external documentary evidence
maintained within the organisation to record the economic transaction which
has taken place. These are important sources of information and evidences
that are used to prepare the financial statements.
In book keeping and accountancy we will be recording only monetary
transactions.
Accounting records can take on many forms and include:
i. Invoices
ii. Vouchers
iii. Ledgers
 iv. Journals
v. Bank statements
vi. Contracts and agreements
vii. Verification statements
viii. Transportation receipts etc.

Vouchers are most important document in accounting records. Vouchers form

basis for recording any transaction. Account voucher is an accounting
document representing an internal intent to make a payment to an external
entity, such as a vendor or service provider. A voucher is produced usually
afterreceiving a vendor invoice, after the invoice is successfully matched to a
purchase order. A voucher will contain detailed information regarding the
payee, the monetary amount of the payment, a description of the transaction,
and more.

6.2 PROCESS OF TRANSACTION AND ITS RECORD

GENERATION

Let us see the entire process of accounting with the help of a chart

Economic transactions occurs

Vouchers are created

Transaction is recorded in primary books i.e.

Journal or subsidiary books

Transactions are posted in Ledger account

At the end of the year ledger accounts areclosed

and balances are found out

Using the closing balances of the ledger accounts

a trial balance is drawn as on last day of the
financial year

Closing Adjustment entries are recorded

Final accounts are drawn

Now let us discuss the entire procedure in the order of flow chart

1. Economic transactions occurs: In accounts we record only

those transaction which has some monetary value. Accountancy
is more of a historical record as it records whatever happens in
money terms. One should not get confused with non cash and
non-monetary transactions. A non cash transaction can be a
monetary transaction e.g providing depreciation on fixed assets, is
a non cash transaction but it is a monetary transaction as we know
the amount of depreciation in money terms.

2. Vouchers are created: Whenever any transaction takes placea

voucher is created depending upon the nature of transaction.
Vouchers may be of following types

1. Receipt voucher
2. Payment vouchers
3. Journal vouchers
4. Cash memo
5. Contra entry vouchers
6. Purchase and returns invoice vouchers
7. Sales and returns vouchers

A voucher complete in all respects forms basis for recording the transaction.
To be called a complete document it should be properly dated, amounted,
authorised and signed by the party.

Any documentary evidence supporting the entries recordedin the books of

accounts, establishing the arithmetic accuracy of the transaction, may also be
referred to as a voucher for example, a bill, invoice, receipt, salary and
wages sheet, memorandum of association, counterfoil of paying-in slip,
counterfoil of cheque book, or trust deed.

Normally the following types of vouchers are used:

(i) Receipt Voucher
(ii) Payment Voucher
(iii) Journal Voucher
(iv) Supporting Voucher

Let us discuss each of these:

( i ) Receipt Voucher:
A Receipt voucher is used to record cash or bank receipt.
Receipt vouchers are of two types which are as follows:

(a) Cash receipt voucher – These vouchers are created

whenever any cash generation transaction occurs. E.g. sale of
scrap for cash.
 (b) Bank receipt voucher – it indicates receipt of a cheque or
demand draft i.e. money is not received in the form of cash in hand,
instead, the money will be credited to the bank account of the
assesse.

Contents of Receipt/Credit Voucher:

The following information are usually available from a receipt/creditvoucher:

(a) Names and address of the parties;
(b) Date of preparing the voucher;
(c) Voucher Number;
(d) Amount of the transaction;
(e) Heads of account;
(f) Signature of the person who is preparing the voucher;
(g) Authorized Signatory;
(h) Narrations, i.e., short description of the transaction, and
(i) Number of Supporting Voucher.

ii). Payment/debit Voucher:

A payment voucher is just the opposite of a receipt voucher. In the above,
cash/ bank was debited, while in this case, cash or bank will be credited. In
the above case, there was an inflow of funds, while in this case, there is an
outflow of funds. A Payment voucher is used to record a payment of cash
or cheque. Payment vouchersare also of two types which are:

(a) Cash Payment voucher – it denotes payment of cash

(b) Bank Payment voucher – it indicates payment by cheque or
demand draft i.e. money is not paid in the form of cash in hand,
instead, the money will be debited from the bank account of the
assesse
Contents of payment/debit Vouchers:

The following information are normally available from a debit voucher:

(a) Names and Addresses of the Party (b) Date of voucher;

(c) Voucher Sr. Number; (d) Amount or value of the transaction; (e) Heads of
Account; (f) Signature of the person who is preparing the voucher; (g)
Authorized signatory; (h) Narration i.e., short description of the transaction
and (i) Number of supportingVouchers.

The format of a Debit Voucher is presented:

( If the amount of transaction exceeds Rs. 500 a revenue stamp valued Re 1.

should be affixed.)

iii) Journal Voucher:

These vouchers are used for non-cash transactions, they are basically used
as a documentary evidence. e.g., Goods sold on credit. In such cases, the
cash or the bank account of the assesseis unaffected. In the case of Goods
sold on credit, the Voucherwould debit the Debtor to whom the goods are
sold on credit, while sales on credit account would be credited further.
 iv) Supporting documents vouchers:
These vouchers are the documentary evidence of transactions that have
happened. For example, you can attach the bill of an expense along with the
original voucher just to further support the primary voucher. Petrol Bills
attached with the conveyance vouchers are a good example of Supporting
Vouchers. Supporting Vouchers are the documentary evidence of business
transactions which have happened.

They are of two types:

(i) External Supporting Vouchers; and
(ii) Internal Supporting Vouchers.
(i) External Supporting Vouchers:

These vouchers are prepared by the third parties who are associated with the
firm.

For example:(a) Debit Note Received; (b) Credit Note Received;

(c) Cash Memo Received from the Sellers, etc.

The format of a Supporting Voucher is presented:

(ii) Internal Supporting Vouchers:

These vouchers are prepared by the internal staff on behalfof ‘the firm which
are accepted by the third parties for the transaction so happened.
For example:
(a) Counterfoil-of Challan for payment of income tax to a bank;
(b) Counterfoil of pay-in-slip when money is deposited into bank,
etc.

3. Transaction is recorded in primary books i.e. Journal books:

There are two sets of books maintained in any organisation viz.
primary set of books and secondary set of books. Primary set of books
is the one where initial transaction is recorded. It is the first
instance of the recording of any economic transaction it includes
journal and subsidiary books.

In order to record journal entries, one needs to have knowledgeabout

following basics of accounting

6.3 WHAT IS AN ACCOUNT?

ACCOUNT: An account is a record of all transaction under one room relating

to a particular person, income, expense, property etc.

Types of accounts:
There are three type of accounts in accounting:

A] Personal account: Ashok, Anil, Dena Bank, Abcd ltd, prepaid or

outstanding incomes or expenses. Personal accounts consist of
all those accounts which are related to a person, business, firm etc.
There are also subtypes of personal account:
I] Natural Personal Any person like Peter Account, Ram account etc.
II] Artificial Personal: Any company or group of people like Microsoft
account, Hindustan Petroleum account etc.
III] Representative Personal this type of Personal a/c represents
owner like. Capital a/c, drawings a/c etc.

B] Real account: Real accounts consist of all those accounts which

are related to assets. For example: Plant and Machinery account,
Stock account, Furniture & Fixture, cash etc.
C] Nominal account: Nominal accounts consist of all those
accounts which are related to expenses, losses, Income and
Gains.For example: Rent account, wages account, printing &
stationary etc.

Golden rules of accounting

There are three golden rules in accounting to record journal entries.Each of
these rules is associated with separate account.

Personal accounts
"Debit the Receiver, Credit the Giver"

Real accounts
"Debit what Comes In, Credit what Goes out"
Nominal accounts
"Debit all Expenses and Losses, Credit all Income and Gains"

How to record a journal entry

First understand the format of a journal

A journal has five vertical columns

JOURNAL
DEBIT CREDIT
DATE PARTICULARS L. F. Rs. Rs.

1.4.2-16 Account to be debited A/c Dr xxx

To Account to be credited xxx
(Being..narrate the
transaction)

Date column records date of the transaction

Particulars column records the two effects of a given transaction, by using

at least two ledger accounts, one of which will be debited and other one
credited.

Below these two accounts we write brief description of transaction in

brackets prefixing the word ‘Being’, called as narration.

L.F. column records ledger folio or page number where that account is
opened in a leger book.

Debit (Amount) and Credit (Amount) columns records amountagainst each

ledger account.

Steps to record a journal entry

1. Identify which accounts are involved
2. Identify types of accounts
3. Apply golden rules according to the type of account to determine
which account will be Debited and which account will be Credited.

Example: You are writing in the books of Ganesh

Transaction : Cash received from Jagdish Rs5,000,
for this transaction we will pass journal entry by using above mentioned

1 Identify which accounts are involved : a) Cash b) Jagdish

2 Identify types of accounts:
a) Cash : real account
b) Jagdish: personal account
3 Apply golden rules according to the type of account to determine
which account will be Debited and which account will be Credited.
a) Cash : real account so: Debit what comes in
b) Jagdish: personal account : credit the giver
Therefore Cash A/c will be debited and Jagdish A/c will be credited The
entry will be as follows
Cash a/c ----------------------------- Dr 5,000
To Jagdish a/c------------------------- Cr 5,000
(Being cash received from Jagdish)

Example : Journalise the following transactions:

2016 Rs.
April. 1 Started business with cash 50,000
April. 3 Deposited cash into Bank 40,000
April. 5 Sold goods to Ganesh 22,000
April. 9 Goods returned by Ganesh 2,000
April. 11 Goods purchased from Kishore 30,500
April. 15 Goods returned to Kishore 1,500
April. 18 Bought Furniture & Fixture for office use by 9,000
April. 22 cheque 1,000
April. 22 Purchased goods for cash 50
April. 30 Paid carriage 500
Paid interest on loan

Solution: Journal
Date Particulars L.F Dr.(Rs.) Cr. (Rs.)
.
2012
April. 1 Cash A/c …Dr. 50,000
To Capital A/c 50,000
(Being the business started with cash)
April 3 40,000
Bank A/c …Dr.
To Cash A/c 40,000
(Being the amount deposited into the bank)
April 5
Ganesh
22,000
To sales A/c
22,000
(Being the goods sold to Ganesh)
April 9
Sales Returns A/cTo 2,000
Ganesh 2,000
April 11 (Being the goods returned by Ganesh)
Purchases A/c …Dr. 30,500
To Kishore 30,500
April 15 (Being the goods purchased from Kishore)
1,500
Kishore …Dr.
1,500
To purchases Return a/c
(Being the goods returned to Kishore)
April 18
 Furniture & Fixture a/c …Dr.
To bank a/c 9,000
April 22 (Being the Furniture & Fixture bought andpaid 9,000
by cheque)
Purchases A/c 1,000
April 26 …Dr. 1,000
To cash a/c
(Being the goods purchased against cash)
April 30 Carriage a/c TO …Dr. 50
cash a/c 50
(Being the carriage paid)
500
Interest on Loan A/c …Dr.
500
To Cash A/c
(Being the payment of interest on Loan)

1,57,550 1,57,550
Total

4. Transactions are posted in Ledger account: Secondary set

of books includes ledger accounts. Now let us see format of a
ledger account.
Dr. LEDGER ACCOUNT Cr.
DATE PARTICULARS J.F. AMOUNT DATE PARTICULARS J.F. AMOUNT

To Account By Account debited

1.4.16 credited in Journal xxx 5.4.16 in Journal Xxx
against this against this
ledger a/c ledger a/c

The process of transferring the information contained in a Journalto a

Ledger is called Posting.

i. Posting of debited item in a Journal Entry: The steps to be

followed are :

Identify in the ledger the account to be debited. Then enter the date of the
transaction in the ‘Date’ column on the debit side of the account. Then write
the name of the account which has been credited in the respective entry in
the ‘Particulars’ column on the debit side of the account as “To (name of
account credited)”. Then record the page number of the Journal where the
entry exists in the Journal folio (J.F.) column. Then rnter the relevant amount
in the ‘Amount’ column on the debit side.
 ii. Posting credit item in a journal entry: The steps to be followed
are :
Identify in the ledger the amount to be credited then Enter the date of the
transaction in the ‘Date’ column on the credit side of the account. Then write
the name of the account which has been debited in the respective entry in the
‘Particulars’ column on the credit side of the account as ‘By (name of account
debited)’. Then record the page number of the Journal where the entry exists
in the Journal folio (J.F.) column. Then enterthe relevant amount in the
‘Amount’ column on the credit side.

Thus every transaction has two effects viz debit and credit. Ina journal entry
theses are either debited or credited. One should always remember that total
of debit should always match the total of credit.

Consider the simple Journal entry to illustrate the above:

On April 16, 2014 Motor car Purchased for cash Rs. 12000

April 16 Motor car A/c ….Dr. Rs. 12,000

To cash Rs. 12,000
(Being the Motor car purchased)

An amount of Rs. 12,000 will be debited to the Motor car account and credited
to cash account. The manner will be: in the Motor car account in the
‘Particulars’ column we shall write to cash a/c . In the account of cash will
be written : ‘By Motor car a/c’. The two accounts will, thus appear as under.:

Motor car A/c

Dr. Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs.
April 16 To Cash 12,000
A/c

Cash a/c
Dr Cr.
Date Particulars J.F. Rs. Date Particulars J.F. Rs
April 16 By Motor car A/c 12,000

Example 2: Received Rs.14,000 in full settlement of a debt of Rs.15,000 from

Ram on Aug 8, 2014.
SULUTION - Journal Entry
Rs. Rs.
Cash A/c Dr. 14,000
Discount allowed A/c Dr 1,000
To Anant 15,000
(Cash received and
discount allowed)

Ledger A/c
Cash A/c
Dr Cr
Date Particulars L.F Rs. Date Particulars L.F Rs.
2014
Aug.8 To Anant 14,000

Discount Allowed A/c

Dr Cr
Date Particulars L.F Rs. Date Particulars L.F Rs.
2014
10
Aug.8 To Anant 00

Anant’s Account
Dr Cr
Date Particulars L.F Rs. Date Particulars L.F Rs.
2014
Aug. 8 By cash A/c 14,000
By Discount 1,000
Allowed A/c

5. At the end of the year ledger accounts are closed and

balances are found out

Dr. LEDGER ACCOUNT Cr.

DATE PARTICULARS J.F. AMOUNT DATE PARTICULARS J.F. AMOUNT

1.4.16 To abc Account Xxx 5.4.16 By opq account Xxx

Xxx To xyz Account Xxx xxx By rst Account xxx

Xxx To Balance c/d Xxx

Xxxx xxxx
Using the closing balances of the ledger accounts a trial balance is
drawn as on last day of the financial year : A trial balance is a list of all the
general ledger accounts of a business.This list will contain the name of
ledger account and the balance of that ledger. Each nominal ledger account
will hold either a debit balance or a credit balance. The debit balance values
will be listed in the debit column of the trial balance and the credit value
balance will be listed in the credit column. A trial balance always tallies. Ledger
A/Cs which shows a debit balance is put on the Debit side of the trial
balance.

The A/c’s Showing credit balance are put on the Credit side of the Trial
Balance. Accounts which show no balance i.e. whose Debit and Credit totals
are equal are not entered in Trial Balance.
Then the two sides of the Trial Balance are totaled. If they are equal it is
assumed that there are no arithmetical error in the posting and balancing of
Ledger A/cs.

Normally at the year end or whenever a businessman is interestedin knowing

the position of various A/C s, the accounts are balanced. Various steps for
this purpose are

(1) Debit and Credit sides of each A/c are totaled.

(2) The difference between the two sides is written on the side
which is shorter so as to make their totals equal.
(3) The words “Balance C/d” i.e. the balance carried down and
written against the amount of difference.
(4) In the next period, the balance is brought down on the other
side by writing the words ‘Balance b/d’.
(5) If the Debit side exceeds the Credit Side the difference is a
Debit Balance whereas.
(6) If the Credit side exceeds the Debit side the difference is a
Credit Balance.

Objectives or Functions of Trial Balance

It helps in ascertaining the arithmetical accuracy of ledger
accounts.
Helps in locating errors.
Provides the summary of Ledger A/cs.Helps in
the preparation of Final A/cs.
 6. Closing Adjustment entries are recorded Closing entries are
journal entries made at the end of an accounting period to
transfer temporary accounts to permanent accounts. adjusting
entries are journal entries usually made at the end of an
accounting period to allocate income and expenditure to theperiod
in which they actually occurred. The revenue recognition principle
is the basis of making adjusting entries that pertain to unearned
and accrued revenues under accrual-basis accounting. Eg
Charging depreciation, providing for outstanding incomes and
expenses etc.

Treatment of items of Adjustment outside the Trial Balance

Adjustment Effects

Closing Stock Trading A/c Credit Side and Asset Side of

balance sheet.

Outstanding Added with concerned item in trading or profita

expenses loss a/c and liabilities side of BALANCE SHEET
as a current liability.

Prepaid expenses Less from concerned item in trading or profit and

loss a/c and assets side of BALANCE SHEET as
a current assets.

Accrued Income Add with concerned income in P&L and Assets

(income earned but side of BALANCE SHEET as a current assets
not received)

Income received in Less from concerned item in P&L and Liabilities

advance Side of BALANCE SHEET as current liabilities.
 Depreciation Dr. side of P&L A/C & Deduct from concerned
assets.

Bad Debts Dr. side of P&L A/C & Deduct from debtors in
Balance sheet.

Provision for Dr. side of P&L A/C & Deduct from debtors
doubtful debts

Provision for Dr. side of P&L A/C & Deduct from debtors
discount on debtors

7. Final accounts are drawn

From the derived trial balance an accountant can prepare final accounts for
the year for which information is available.

Format of final accounts differ from organisation to organisation. Let us see

format of final accounts for some trading commercial organisations.

An organisation can adopt either horizontal or vertical format, but vertical

format is compulsory for joint stock companies.

6.4 FINAL ACCOUNTS

Trading Account
Trading account is prepared to know the gross profit or gross loss arising or
incurred as a result of the trading activities of a business. In other worlds, in
case of a manufacturing concern a Manufacturing A/c is prepared to show the
result of manufacturing activity,trading account indicates buying and selling of
goods. If the amount of sales exceeds the amount of purchases and the
expenses directly connected with such purchases, the difference is termed as
gross profit. On the contrary, if the purchases, and direct expenses exceed
the sales, the difference is called gross loss. The purpose of preparing the
Trading Account is to find out the Gross Profit or Gross Loss of a concern
during a particular period. The following equations are highly useful for
determination of Gross Need and Importance of Trading Account
Preparation of Trading Account serves the following objectives:
1. It provides information about Gross Profit and Gross Loss: It
informs of the gross profit or gross loss as a result of buying
and selling the goods during the year. The percentage of
Current Year’s gross profit on the amount of sales can be
calculated and compared with those of the previous years.
Thus, it provides data for comparison, analysis and planning
for a future period.
 2. It provides information about the direct expenses: All the
expenses incurred on the purchase and manufacturing of
goods are recorded in the trading account in a summarised
form. Percentage of such expenses on sales can be calculated
and compared with those of the previous years. In this way it
enables the management to control and rationalise the
expenses.

3. Comparison of closing stock with those of the previous years:

closing stock has to be valued and recorded in a trading
account. This stock can be compared with the closing stock
of the previous years and if the stock shows an increasing
trend, the reasons may be inquired into.

4. It provides safety against possible losses: If the ratio of gross

profit has decreased in comparison to the preceding year, the
businessman can take effective measures to safeguard
himself against future losses. For example, he may increase
the sale price of his gods or may proceed to analyse and
control the direct expenses.

6.4 (a) Preparation of Trading Account

Trading Account is a Nominal Account and all expenses which relate to either
purchase or manufacturing of goods are written on the Debit side of the
Trading Account.

Item written on the Debit side of the Trading Account:

1. Opening Stock: The stock of goods remaining unsold at the

end of the previous year is termed as the opening stock of the current
year. In other words, the closing stock of the last year becomes the
opening stock of the current year. Opening Stock will include the
following:
I. Opening Stock of Raw Material.
II. Opening Stock of Semi-finished goods, and
III Opening Stock of Finished goods.

2. Purchases and Purchases Returns: Goods which have been

bought for resale are termed as Purchases and goods which are
returned to suppliers are termed as purchase returns or returns
outwards. Purchase Account will be given on the debit side of thetrial
balance and Purchase Return Account on the credit side of the trial
balance. Purchase returns will be shown as a deduction from
Purchases on the debit side of the trading account. Purchases include
cash as well as credit purchases.

3. Direct Expenses: All expenses incurred in purchasing the goods,

bringing them to the godown and manufacture of goods are called
direct expenses. Direct expenses include the following:
 I. Wages: Wages are paid to workers who are directly engaged in
the loading, unloading and production of goods and as such are
debited to the trading account. It should be noted that:

(i) If the item ‘Wages and Salaries’ is given in the question it will
be shown on the trading account. On the contrary, if ‘Salaries and
Wages’ is given it will be shown on the profit & loss account.

(ii) If wages are paid for bringing a new machine or for its installation
it will be added to the cost of the machine and hence will not be shown
in the trading account.

II. Carriage or Carriage Inwards or Freight: These expenses should

be debited to trading account because these are generally paid for
bringing the goods to the factory or place of business. However, if any
carriage or freight is paid on bringing an asset, the amount should be
added to the asset account and must not be debited to trading
account.

III. Manufacturing Expenses: All expenses incurred in the

manufacture of goods are shown on the debit side of the trading
account such as Coal, Gas, Fuel, Water, Power, Factory Rent,
Factory Lighting etc.

Items written on the Credit Side of the Trading Account:

1. Sales and Sales Returns: Both Cash and Credit sales will be
included in sales. The sales account will be a credit balance whereas,
the sales return account or returns inwards account willbe a debit
balance. Sales return will be deducted out of Sales onthe credit
side of the trading account.

2. Closing Stock: The goods remaining unsold at the end of the

year is known as Closing Stock. It is valued at cost price or market
price whichever is less. It includes the closing stock of raw material,
Closing Stock of semi-finished goods and Closing Stock of finished
goods.
Normally, the Closing Stock is given outside the Trail Balance. This is so
because its valuation is made after the accounts have been closed. It is
incorporated in the books by means of the following entry:
Closing Stock
A/c Dr.
To Trading A/c
(Closing Stock transferred to Trading A/c)

When the above entry is passed, the Closing Stock Accountis opened. On
the one hand, it will be posted to the credit side ofthe trading account and
on the other hand, will be shown on the
Assets side of the Balance Sheet, in order to complete the double entry.
Sometimes, the Closing Stock is given inside the Trail Balance. This mean
that the entry to incorporate the closing stockin the books has already been
passed. It would imply that the Closing Stock must have been deducted out
of Purchases Account. Hence, in such a case, Closing Stock will not be shown
in theTrading Account but will appear on the Assets side of the Balance Sheet
only.

6.4 (b) Profit And Loss Account

Trading account only discloses the gross profit earned as a result of buying
and selling of goods. However, a businessman has to incur a number of
expenses which are not taken to trading account. Hence, a businessman is
more interested in knowing the net profit earned or net loss incurred during
the year. As such, a Profit & Loss Account is prepared which contains all the
items of losses and gains pertaining to the accounting period. According to
Prof. Carter, “A Profit & Loss Account is an account into which all gains and
losses are collected, in order to ascertain the excessgains over the losses or
vice-versa”.

Need and Importance of Profit & Loss A/c

1. To determine the Net Profit or Net Loss: A Trading Account
only discloses the Gross Profit earned as a result of trading activities,
whereas the Profit & Loss Account discloses the net profit (or net loss)
available to the proprietor and credited to his capital account.

2. Comparison with previous years’ profit: The net profit of the

current year can be compared with that of the previous years. It
enables the businessman to know whether the business is being
conducted efficiently or no.

3. Control on Expenses: Profit & Loss Account helps in

comparing various expenses with the expenses of the previous year.
Also the percentage of each individual expenses to net profit is
calculated and compared with the similar ratio of previous years. Such
comparison will be helpful in taking concrete steps for controlling the
unnecessary expenses.

4. Helpful in the preparation of Balance Sheet: A Balance Sheet

can only be prepared after ascertaining the Net Profit through the
preparation of Profit and Loss Account.

Preparation of Profit and Loss Account

A Profit and Loss Account is started with the amount of gross profit or gross
loss brought down from the Trading Account. As such, all those expenses and
losses which have not been debited to the Trading Account are now debited
to Profit &
Loss Account. These expenses include administrative expenses, selling
expenses, distribution expenses etc. These are called ‘Indirect Expenses’.
Profit and Loss Account is a Nominal Account and as such, all the expenses
and losses are shown on its debit side and all the incomes and gains are
shown on its credit side.

Items written on the Debit side of Profit & Loss Account

1. Gross Loss: If trading account discloses Gross Loss, it is shown
on the debit side first of all.
2. Office and Administrative Expenses: Such as salary of office
employees, office rent, lighting, postage, printing, legal charges,
audit fee etc.
3. Selling and Distribution Expenses: Such as advertisement
charges, commission, carriage outwards, bad-debts, packing
charges etc.
4. Miscellaneous Expenses: Such as interest on loan, interest on
capital, repair charges, depreciation, charity etc.

Items written on the Credit side of Profit & Loss Account

1. Gross Profit: the starting point of the Cr. side of Profit and Loss
Account is the gross profit brought down from the Trading
Account.

2. Other Incomes and Gains: All items of incomes and gains are
shown on the credit side of the Profit & Loss Account, such as
income from investments, rent received, discount received,
commission earned, interest received, dividend received etc.

If the credit side of the profit and loss account exceeds thatof debit side, the
difference is termed as net profit. On the other hand, the excess of the debit
side over the credit side is termed as net loss. Net profit is added to the capital
whereas net loss is deducted from the capital.
6.5 HORIZONTAL OR ‘T’ FORMAT OF TRADING &P&L A/C
E.g. Prepare Trading Account for the year ended 30st March, 2013from the
following balances.
Rs Rs.
Stock(1st April, 2012) 10,000 Purchases 1,00,000
Wages 5,000 Carriage Inwards 1,000
Sales 1,70,000 Returns Inward 5,000
Returns Outward 8,000 Sales Tax paid 20,000
Freight 500 Octroi duty 2,500

Closing stock as on 30st March, 2013 was valued at Rs. 20,000Also,

pass the Closing Entries.

Soluion: TRADING ACCOUNT

Dr. for the year ended 30st March, 2013 Cr.
Particulars Rs Particulars Rs
To opening stock 10,000 By Sales
To Purchases 1,70,000 1,60,000
1,00,000 90,000 Less : Sales tax
Less: Returns Outward 5,000 10000 20,000
10,000 1,000

To Wages 500 By Closing Stock

To Carriage Inwards 2,500
To freight 71,000
To Octroi Duty
To Profit and loss A/c 1,80,000 1,80,000
(Gross profit)

VERTICAL FORMAT OF REVENUE STATEMENT TRADING &

P&L A/C
HORIZONTAL OR ‘T’ FORMAT OF BALANCE SHEET
6.6 VERTICAL FORMAT OF BALANCE SHEET
FINAL ACCOUNTS AS PER REVISED SCHEDULE VI FORMATBALANCE
SHEET

Balance Sheet as at 31st March, 2011

Figures as Figures as at
at the end of the end of
Note
Particulars current previous
No
reporting reporting
period period

I. EQUITY AND LIABILITIES

(1) Shareholder's Funds

(a) Share Capital
(b) Reserves and Surplus
(c) Money received against share warrants
(2) Share application money pending
allotment

(3) Non-Current Liabilities

(a) Long-term borrowings
(b) Deferred tax liabilities (Net)
(c) Other Long term liabilities
(d) Long term provisions

(4) Current Liabilities

(a) Short-term borrowings
(b) Trade payables
(c) Other current liabilities
(d) Short-term provisions
Total
II.Assets
(1) Non-current assets
(a) Fixed assets
(i) Tangible assets
(ii) Intangible assets
(iii) Capital work-in-progress
(iv) Intangible assets under development
(b) Non-current investments
(c) Deferred tax assets (net)
(d) Long term loans and advances
(e) Other non-current assets

(2) Current assets

(a) Current investments
(b) Inventories
(c) Trade receivables
(d) Cash and cash equivalents
(e) Short-term loans and advances
(f) Other current assets
Total
STATEMENT OF PROFIT AND LOSS

Profit and Loss statement for the year ended 31st March, 2011
Figures as at Figures as
the end of at the endof
Particulars Note No current previous
reporting reporting
period period

I. Revenue from operations

II. Other Income
III. Total Revenue (I +II)
IV. Expenses:
Cost of materials consumed
Purchase of Stock-in-Trade
Changes in inventories of finished goods,
work-in-progress and Stock-in-Trade
Employee benefit expense
Financial costs
Depreciation and amortization expenseOther
expenses
Total Expenses

V. Profit before exceptional and

extraordinary items and tax (III - IV)

VI. Exceptional Items

VII. Profit before extraordinary items and

tax (V - VI)

VIII. Extraordinary Items

IX. Profit before tax (VII - VIII)

X. Tax expense:
(1) Current tax
(2) Deferred tax

XI. Profit(Loss) from the perid from

continuing operations (VII-VIII)

XII. Profit/(Loss) from discontinuing

operations

XIII. Tax expense of discounting

operations

XIV. Profit/(Loss) from Discontinuing

operations (XII - XIII)

XV. Profit/(Loss) for the period (XI + XIV)

SUMS FOR PRACTICE

Example : Journalize the following transactions:

2016 Rs.
May. 1 Ajay Started business with cash 50,000
May. 3 Deposited cash into Bank 40,000
May. 5 Sold goods to Ganesh 22,000
May. 9 Goods returned by Ganesh 2,000
May. 11 Goods purchased from Kishore 30,500
May. 15 Goods returned to Kishore 1,500
May. 18 Bought Furniture & Fixture for office 9,000
May. 22 use by cheque 1,000
May. 22 Purchased goods for cash 50
May. 30 Paid carriage 500
Paid interest on loan

Journal

Solution:

Date Particulars L.F. Dr.(Rs.) Cr. (Rs.)

2012 Cash A/c …Dr.
May. 1 To Ajay’s Capital A/c 50,000
(Being the business started with cash) 50,000

May 3 Bank A/c 40,000

To Cash A/c
40,000
(Being the amount deposited into the bank)
May 5 Ganesh …Dr.
To sales A/c 22,000
(Being the goods sold to Ganesh) 22,000
May 9 Sales Returns A/cTo
Ganesh 2,000
(Being the goods returned by Ganesh) 2,000
May 11
Purchases A/c
To Kishore 30,500
(Being the goods purchased from Kishore) 30,500

Kishore
May 15 1,500
To purchases Return a/c
1,500
(Being the goods returned to Kishore)
May 18 Furniture & Fixture a/c 9,000
To bank a/c 9,000
(Being the Furniture & Fixture bought and
paid by cheque)
 Purchases A/c To
May 22 cash a/c 1,000
(Being the goods purchased against cash) 1,000
Carriage a/c TO
May 26 50
cash a/c
(Being the carriage paid) 50

May 30 Interest on Loan A/c 500

To Cash A/c
500
(Being the payment of interest on Loan)

Total 1,57,550 1,57,550

 MODULE - V

7
CAPITAL AND REVENUE EXPENDITURE-
DEFERRED REVENUE EXPENDITURE-
CAPITAL AND REVENUE RECEIPTS
Unit Structure
7.1 Objectives
7.2 Introduction
7.3 Misclassification and effect of error
7.4 Capital and Revenue-
7.5 Revenue expenditure
7.6 Distinction between capital expenditure and Revenue
expenditure
7.7 Distinction between capital receipt and Revenue receipt
7.8 Tests to be applied to transactions
7.9 For Capital Receipt/ Revenue Receipt
7.10 Deferred Revenue Expenditure-(DRE)

7.1 OBJECTIVES

❖ To help the learner understand the concept of Capital and

Revenue

❖ To help the learner distinguish between capital and revenue

transactions

❖ To help the learner understand the importance of correctly

identifying the capital and revenue transactions, the effect of
errors due to misclassification and its presentation in the
financial statements

❖ To help the learner know about the deferred revenue

expenditure and its presentation in financial statements.
 7.2 INTRODUCTION

The Final Accounts prepared at the end of the year consistsof Profit and
Loss account and Balance sheet. The final accounts are prepared from Trial
balance which gives a list of accounts showing debit balances and credit
balances. The accounts appearing in the trial balance are to be taken to the
trading, profitand loss account or balance sheet. The profit and loss account
(also known as Revenue Statement) shows the income and gainson the
credit side and the various expenses and losses are shownon the debit side.
The balance sheet is a statement showing the financial position as on a
particular date and shows the capital and liabilities and assets.

It is necessary to classify the items appearing in the trial balance as capital

or revenue so that they can be correctly shownin the trading, profit and loss
account or balance sheet as the case may be. Such classification is necessary
to comply with the concept of matching costs and revenue in a given period.

7.3 MISCLASSIFICATION AND EFFECT OF ERROR

Any misclassification impacts the correctness and accuracyof the financial

statements – the profit and loss account will not show the correct Profit/ Loss
and the Balance Sheet will not show the true position of assets and liabilities.
Thus due to misclassification, the accuracy of the financial statements are
affected and the statements do not depict the true and fair view of the state
of affairs of the business enterprise.

For example- A computer is purchased and the accountant records the

purchase along with purchase of raw materials in the trading account. The
error will affect the profit or loss position as the transaction has been wrongly
shown in trading account. The computer purchased should have been
recorded as an asset in the balance sheet. In this way the error due to
misclassification affects both the revenue statement and the balance sheet.

Effect of error in classification

1) Trading account will not show correct gross profit/ gross loss.

2) Profit and loss account will not disclose true net profit/ net loss.
 3) Balance sheet will not disclose true value of Assets and
Liabilities.

4) Financial statements will not disclose True and Fair view of the
state of Affairs of the organization.

5) It will be difficult to understand the capitalization of business.

6) These errors affect the accounts of the subsequent years

Error in classification Impact on profit and impact

on balance sheet/ value of
asset
1) Revenue expenditure is wrongly Profit will be inflated ,
treated as capitalexpenditure Value of asset will be inflated.

2) Capital receipt is treated as Profit will be inflated ,

revenue receipt Value of asset will be inflated.
3) Capital expenditure treated as Profit will be deflated ,
revenue expenditure Value of asset will be deflated.
4) Revenue receipt wrongly Profit will be deflated.
treated as capital receipt

It is thus clear that any error in classification or misclassification impacts the

accuracy and correctness of the financial statements and hence it is very
important to classify the transactions as capital or revenue and disclose the
same correctly in the financial statements.

7.4 CAPITAL AND REVENUE

Receipt or Expenditure transactions are to be classified as capital or

revenue and further classified as capital expenditure, revenue
expenditure capital receipt or revenue receipts.
 TRANSACTIONS

Expenditure or receipt

Expenditure transactions Receipt transactions

( involves outflow of cash) ( involves inflow of cash)

Capital expenditure / Capital receipt/

Revenue expenditure Revenue receipt

Capital transactions are further classified as capital expenditure and capital

receipt and revenue transactions are classified as revenue expenditure and
revenue receipt.

Capital expenditure is any expenditure which has any one or all ofthe
following-

❖ It is a non- recurring expenditure

❖ The benefit of such expenditure is seen for more than one year.

❖ The expenditure increases the revenue earning capacity of the

organization.

In short, if the benefits of the expenditure are expected to accrue for a long
time, the expenditure is capital expenditure. Thus capital expenditure is that
expenditure which results in the acquisition of an asset, tangible or intangible.

Some common examples of capital expenditure are-

1) Purchase of an asset

Any expenditure that is incidental to the purchase of an asset or has been

incurred to put the asset in working condition for example – installation
charges or commissioning expenses incurred with reference to purchase of
asset is also to be treated as capital expenditure. All the expenses incurred
on the assets till they yield income are capital in nature.

2) Expenditure during construction-

Any expenditure incurred during construction period or capital work in

progress is considered as a capital expenditure.

3) Expenditure that improves the standard of performance of an

existing asset.
Any expenditure which extends the useful life of the asset or improves the
efficiency of the asset is to be capitalized and addedto the cost of the fixed
asset

4) Cost of an addition or extension to an existing asset

5) Investment in shares, debentures, immoveable properties

6) Cost of acquiring intangible assets like goodwill, patents,

copyrights.

7) Cost of acquisition and development of wasting assets like

mines, oil-wells.

Accounting of capital expenditure- Capital expenditures are shownin the

asset side of Balance sheet

7.5 REVENUE EXPENDITURE

Revenue expenditure is any expenditure which has any one or allof the
following-
❖ The expenditure is incurred in the day to day conduct of business
and necessary to carry on the business.
❖ The expenditure is recurring in nature
❖ The benefit of such expenditure usually lasts for a short period
of time
Kohler defines Revenue expenditure as an expenditure charged against
operations.
Any expenditure which is not a capital expenditure and which is incurred for
carrying out the day to day activities of business is called revenue
expenditure.
Some common examples of revenue expenditure are-
1) Expenses relating to business activities-
Expenses of production-Purchase of raw materials,
Expenses of administration -Payment of Office salaries
Expenses of selling and distribution
Finance expenses
2) Expenses which are incurred to maintain the asset in a
working condition-
Repairs and maintenance expenses
 3) Expenses incurred to earn income- -Interest on loan taken
for purchase of shares
Accounting of Revenue expenditure-Revenue expendituresare shown on the
debit side of Trading/ profit and loss account.
Capital Receipt-

Any receipt or cash inflow which has any one or all of the following
❖ The receipt is non- recurring in nature
❖ The receipts do not arise through normal activities of business
❖ Some common examples of capital receipt are-
a) Amount received on account of issue of fresh share capital/
debentures
b) Amount of loans raised
c) Proceeds on sale of fixed assets
d) Deposits
Accounting of capital receipt- Capital receipts are shown in the balance sheet.

Revenue receipt
Revenue receipts are those items of income which are received or accrued in
the ordinary course of business.
Any cash inflow generated in the normal course of business activities are to
be treated as revenue receipts- Income generated from cash/ credit sales, or
from services rendered.
Accounting of revenue receipt-Revenue receipts are shownon the credit
side of trading/ profit and loss account
Concept of capital and revenue can be summarized as under-
Capital transactions will be recorded in the balance sheet while revenue
transactions will be shown in the revenue statements- Trading, profit and
loss account
.Trading, Profit and loss account( Trading, Profit and loss
debit side) account( credit side)
Revenue expenditure Revenue receipts

To Salary By sale of goods

To rent

Balance sheet( Liability side) Balance sheet (asset side)

Capital receipt Capital expenditure

Loan from bank Plant and Machinery purchased

7.6 DISTINCTION BETWEEN CAPITAL EXPENDITURE

AND REVENUE EXPENDITURE

CAPITAL EXPENDITURE REVENUE EXPENDITURE

It is non- recurring in nature It is recurring in nature
It is shown in the Balance sheet It is shown in the revenue
account
It is incurred for acquiring fixed It is incurred for carrying out the
assets intended for use in business day to day activities of the business

It increases the revenue earning It does not increase the revenue

capacity of the concern earning capacity of the concern.
Benefit of this expenditure The benefit of this expenditure is
extends for more than one year for a short period
Example- purchase Of fixed Example – Payment of salaries
asset

7.7 DISTINCTION BETWEEN CAPITAL RECEIPT AND

REVENUE RECEIPT

CAPITAL RECEIPT REVENUE RECEIPT

They are non recurring in nature They are recurring in nature
They appear in the balance sheet- They appear in Revenueaccount-
It is disclosed as a liability in the It is disclosed as an income in the
balance sheet P&L A/c
Capital receipts which are Revenue receipts are not to be
liabilities are to be repaid repaid as they are not liabilities.
 They are not gains to the They are gains to the concern
concern
It represents capital brought inby It represents income such as sale
the proprietor which are not of of goods, interest received
recurring nature
Example-Amount received on Example-Interest received,
issue of debentures recovery of bad debts

7.8 TESTS TO BE APPLIED TO TRANSACTIONS

To classify a transaction as capital or revenue, one may use the

following tests as indicators-

FOR CAPITAL/ REVENUE EXPENDITURE

1) What is the period of benefit from expenditure?

2) What is the effect of expenditure?

3) What is the amount of expenditure?

Period of benefit from expenditure- if the benefit is for short period and
recurring in nature, it is generally treated as Revenue expenditure.
Expenditure which will give benefit for a long period of time and which is non-
recurring in nature will be generally classified as Capital expenditure. A non-
recurring expenditure is always capital in nature unless materiality concept
emphasizes the importance of recognizing it as revenue expenditure.

Effect of Expenditure- If the expenditure gives rise to a tangible asset or

right, treat it as capital expenditure

Amount of expenditure- Generally the capital expenditures involve huge

amounts but this cannot always be treated as a conclusive, reliable test for
classification

7.9 FOR CAPITAL RECEIPT/ REVENUE RECEIPT

1) What is the source or cause of receipt or profit?

2) What is the nature of the receipt?

3) What is the impact of the receipt transaction on the profit / loss?

Source of receipt- If the receipt is from trading transaction, then itshould be

treated as revenue receipt. Eg -sale of goods. If the receipt is from other
transactions, then it should be considered as capital receipt. eg Loan taken from
bank, amount realized on sale of fixed assets. Thus if receipt arises in the
course of business activity, then it is to be treated as revenue receipt. If it arises
out of financing activity, it is to be treated as Capital receipt.

Nature of receipt- Non- recurring receipts are capital receipts while recurring
receipts are revenue receipts.

Impact of the transaction on profit/ loss during the year- Capital receipts have
no bearing on the profit made or loss incurred during the year. Only revenue
receipts are taken into account to ascertain the profit made by the business.
This is a fairly reliable indicator/ parameter for classifying transactions as
capital receipt/ revenue receipt.

In case of receipts, the general rule is that if the receipt is against the supply
of goods or services and related to period under review, the receipt is revenue
receipt. This will be shown in the P&L A/C .Capital receipts are to be shown
as liability or reduced from assets appearing in Balance sheet.

Sometimes a part of the receipt may be capital and a part ofit may be
revenue-

For example proceeds on sale of asset-

1) If the sale proceeds is less than book value of asset , the receipt
is capital receipt to be deducted from asset

2) If the sale proceeds is more than book value but less than cost ,
the receipts is to be segregated as-

a) equal to book value of asset is capital receipt to be reduced

from asset

b) excess as revenue receipt giving rise to revenue profit.

3) If sale proceeds is more than cost, the receipts are to be

accounted for as under-

a) equal to book value capital receipt to be reduced from asset

b) between book value and cost, revenue receipt giving rise to

revenue profit

c) excess over cost, revenue receipt giving rise to capital profit

.

However it is not always easy to classify transactions as capital/ revenue.

There is a good deal of difference of opinion in deciding whether a particular
item is capital or revenue. Hence it has to be decided based on the facts of
the case on a case to case basis.

For example- Purchase of motor car is a capital expenditure as it involves

acquisition of an asset. However purchase of Motor car bya car dealer who
deals with purchase and sale of motor cars on a regular basis is not a capital
expenditure. In the second case the purchase of car is to be treated as
revenue.

Expenditure incurred in converting an ordinary screen in a cinema hall to a

cinemascope – It is difficult to accurately ascertain the nature of this
transaction. It may be argued that as the seating capacity of the hall has not
changed, it should be treated as revenue expenditure. However, the second
argument could be cinemascope pictures attract large audience and as the
expenditure will result in higher earnings, it is to be treated as capital
expenditure.

7.10 DEFERRED REVENUE EXPENDITURE-(DRE)

According to the Guidance note issued by ICAI, “Deferred Revenue

Expenditure is that expenditure for which payment has been made or a liability
incurred but which is carried forward on the presumption that it will be of
benefit over a subsequent period/periods.”

For example- Normal annual advertising expenses is considered as

revenue expenditure and debited to the profit and loss a/c. If the heavy
expenses are incurred on advertising campaign to launch a new product, then
the whole amount should not be debited to P&L a/c of that year. The benefit
accrues for a long period of time.Hence so much of the expenditure as
benefits the current year may be considered as revenue and debited to profit
and loss a/c the balance to be shown as deferred expenditure- revenue
expenditure which is deferred or postponed.

There are some transactions which may appear revenue in nature but the
benefits of such expenditure are seen for a long period of time .Such
expenses are treated as deferred revenueexpenditure. For example- Heavy
advertisement expenses orpromotion expenses to launch a product- As such
expenditure yields the benefit for a long period,it is necessary to spread
the amount over such number of years . If not spread over the years, then the
revenue statement of the year in which the expenditure was incurred may
not show the true picture of Profit/ loss. Hence in order to have more credible
financial statements the expenditure is deferred and a part of the expenditure
is shown in the current year Profit and loss account. The balance amount (not
yet written off) is shown as a debit balance in the asset side of the balance
sheet.

Other common examples of Deferred revenue expenditure are-

• Preliminary expenses
• Cost of market research for a new product
• Commission on issue of debentures
• Cost of issuing shares / debentures or raising loans
Accounting for Deferred Revenue expenditure-For eg -
Association fees paid Rs 60,000 for three years (2016-17, 2017-18,2018-
19).

1st year-Accounting for the year 2016-17-This expenditurehas to be shown

in Profit and loss a/c. However it is evident that the expenditure is incurred
in the financial year 2016-17, but the benefit of the expenditure is enjoyed in
the subsequent periods too. Hence the amount of Rs 60,000 should be spread
over three years and the annual amount to be determined ( 60000/3) Rs
20,000 .The profit and loss account of the year 2016-17 will be debited with
Rs 20,000. The balance (60,000-20,000) Rs 40,000 not written off will be
shown in the asset side of balance sheet . Here the expenditureis – deferred
and hence known as DRE.

2nd year-Accounting for the year 2017-18- The amount of Rs 20,000 will be
debited to profit and loss account and the balance Rs 20,000 (40000-20000)
not written off will be shown in the asset side of balance sheet

3rd year-Accounting for the year 2018-19- The amount of Rs 20,000 will be
debited to profit and loss account and there is no balance to be shown in the
balance sheet

Thus the amount has been spread over three years andaccounted for in the
books.

The following revenue expenses under certain circumstances becomes

capital expenditure

Expenses Circumstances
1) Repairs Amount spent on repairs of plant and
machinery, furniture, building whichare
regular in nature and incurred to
maintain the asset in a working
condition are to be considered as
revenue expenditure. However repairs
to the second hand assets to improve
the operational efficiency is to be
treated as capital expenditure.
2) Wages Wages paid is a revenueexpenditure.
Wages paid for installation of
machinery or construction of fixed
assets is considered as capital
expenditure.
3) Legal charges Legal charges are basically revenue in
nature and are shown in the debit side
of P&L a/c. Legal charges incurred in
connection with purchase of fixed asset
are capital in nature
4) Transport charges Transport charges are basically
revenue in nature. Transport charges
incurred for purchase of machinery,
furniture are capital in nature.
5) Interest on capital Interest on capital paid during the
construction of works, building and
plant is capital in nature.
 6) Raw material and This is basically a revenue expenditure
stores but if it is used forconstruction of fixed
assets, it is considered as capital and
added to the cost of the asset

7) Developmentexpenditure The development expenditure incurred

during the development period with
reference to tea and rubber plantations
should be treated as capital
expenditure

To summarize the revenue expenditure incurred inconnection with purchase

of asset or which is incidental to the purchase of asset, expenses incurred in
development of asset is to be treated as capital expenditure.

Problems-

Q1- Error in classification or misclassification-

The following is the Trading account for the year ended 31 st March2016

Particulars Amt( Rs) Particulars Amt (Rs)

To opening stock 60,000 By Sales 4,00,000
To purchases 3,00,000 By Closing stock 1,00,000
To wages 1,00,000
To Gross Profit 40,000
5,00,000 5,00,000

Additional Information-

1) Sales included sales of old furniture Rs 10,000

2) Purchases included purchase of machinery Rs 70,000

3) Some workers were employed for construction of a gallery to

the office building. Wages of these workers amounting to Rs
30,000 were included in the above wages.

Redraft the trading account to arrive at the correct profit afterconsidering the
above additional information-

Solution- There has been an error in the classification of items ascapital/

revenue.

1) Sale of old furniture is a capital receipt. The same has been

wrongly shown as revenue receipt. Hence Rs 10,000 has to be
deducted from sales.

2) Purchase of Machinery is a capital expenditure. It has been

wrongly shown as revenue and included in the purchases. Rs 70,000
has to be deducted from purchases and shown in the asset side of
 Balance sheet.

3) The wages of workers who have been employed for construction

of gallery to office building are of capital nature .Rs 30,000 should
be deducted from wages and added to the cost of office building.

The corrected trading account will be redrafted as under-

Particulars Amt ( Rs) Particulars Amt ( Rs)

To opening stock 60,000 By sales
To Purchases Less sale of old furniture 3,90,000
Less machinery purchased 2,30,000 By closing stock 1,00,000
To wages
Less capitalized 70,000
To gross profit 1,30,000
4,90,000 4,90,000

Q2 How would you treat the following items?

1) Carriage paid on purchases Rs 1,000- Revenue

expenditure

2) Expenditure on advertising campaign Rs 500-Revenue

expenditure

3) Freight and carriage of a new machinery purchased

Rs 2,000- Capital expenditure

4) Spent Rs 6,000 as legal expenses for abuse of trademark –

Revenue expenditure

5) Received Rs 1,00,000 on issue of equity shares-Capital

receipt

6) Paid to the government excise duty Rs 50,000- Revenue

expenditure

7) Paid Rs 70,000 for construction of railway sidings- Capital

expenditure

8) Purchased Land Rs 1,00,000-Capital expenditure

9) Labour charge on plant and Machinery Rs 3,000-Capital

expenditure

10) Repairs to furniture Rs 1,500- Revenue expenditure

Q3 State with reasons whether the following are capital

,Revenue or Deferred revenue expenditure

1) Legal expenses in issuing shares and debentures Rs 12,500

2) Legal expenses incurred in an action for infringement of

 trademarks

3) Rs 25,000 spent on air-conditioning the office of the

Managing Director

4) Rs 7,000 spent on registration of design

5) Legal expenses incurred in an Income tax appeal

6) Legal expenses Rs 5,000 incurred in connection the

purchase of business premises

7) Rs 1,00,000 paid for the application and allotment of a plot

of land

8) Legal expenses Rs 8,000 incurred in defending a suit for

breach of contract to supply of goods

(Mumbai University April 2008)

Solution

1) Deferred Revenue expenditure-These expenses should be

written off over certain number of years. These expenses
benefit the organization for many years

2) Revenue expenditure-These expenses are incurred in the

normal course of operation

3) Capital expenditure-It is capitalized as per AS-10

4) Capital expenditure-It is to be added to the cost of design

which is an asset

5) Revenue expenditure These expenses are incurred in the

normal course of operation

6) Capital Expenditure It increases the cost of business

premises

7) Capital Expenditure It increases the cost of land

8) Revenue expenditure These expenses are incurred in the

normal course of business operations.The benefit is exhausted
within one year.

Q4 State with reasons the nature of the following expenses/receipts

1) Sold investments 4% government securities for Rs 1,40,000

 2) Preliminary expenses paid Rs 42,000

3) Carriage outward paid Rs 40,000

4) Import duty paid on purchase of computer equipment Rs

85,000 to be used in the office

5) Received Rs 5,00,000 on the issue of 5% Debentures

6) Paid Rs 10,000 underwriting commission on issue of shares

7) Legal expenses Rs 6,000 paid in connection with purchase

of land

8) Repairing charges Rs 15,000 paid for keeping the machinery

in working condition

(Mumbai University March 2006)

Solution

1) Capital receipt-The amount is received on sale of investment

and not from normal business activity

2) Deferred Revenue expenditure -The expenditure benefits the

current year and subsequent years and hence the amount has
to be written off over a certain number of years.

3) Revenue expenditure- It is incurred in normal business

operations

4) Capital expenditure- It is a direct cost on acquiring of fixed

assets and hence has to be capitalized as per AS-10

5) Capital receipt- The amount is received on issue of Debentures

and not from normal business activity

6) Deferred Revenue expenditure--The expenditure benefits the

current year and subsequent years and hence the amount
has to be written off over a certain number of years.

7) Capital expenditure-It is a cost incurred in acquisition of fixed

asset

8) Revenue expenditure-it is incurred for keeping the machinery

in working condition
Summary-

An organization has to incur various expenses and receives different incomes.

Some expenses are regular while some are onetime expenses .The expenses
whose benefits will be enjoyed over a long period are called capital
expenditure. Revenue expenditure refers to those expenses which are
incurred for the day to day operations of business.

Receipts whose benefits will be enjoyed over a long periodare classified

as capital receipts while day to day operational receipts such as sales are
revenue receipts.

ONLY MAIN POINTS (for revision)

Capital expenditure- Large amount, Increases cost of fixed asset, increases

life of fixed asset, non- recurring in nature, increasesprofit earning capacity
of the business enterprise, brings the fixed asset into working condition,
benefit of expenditure is not exhausted within one year, shown in balance
sheet

Revenue expenditure- smaller amount, recurring in nature, benefitis

exhausted within the year, shown in P&L A/c

Capital receipts do not arise in the normal course of operation Revenue

receipts are received in the normal course of operation

Deferred revenue expenditure- basically revenue in nature, benefit not

exhausted within one year, expenditure to be written off over certain number
of years.

Key terms-

Capital expenditure- It is the expenditure which is incurred to raiseearning

capacity of an organization.

Revenue expenditure – It is the expenditure which is recurring in nature

incurred in connection with day to day operations of an organization.

Capital receipt- It is a receipt which is not received in the normalcourse of

operation

Revenue receipt- Revenue receipt is the receipt which is recurringand

received in the normal course of operation.

Deferred Revenue expenditure –It is the revenue expenditure thebenefit of

which is not exhausted within one year.
 MODULE – VI

8
DEPRECIATION
Unit Structure
8.1 Objectives
8.2 Meaning, Definition and Features of Depreciation
8.3 Depreciation, Depletion and Revaluation

8.1 OBJECTIVES

⮚ To help the learner understand the concept of Depreciation

⮚ To help the learner understand the need for providing
depreciation
⮚ To help the learner understand the causes of depreciation
⮚ To help the learner understand the calculation of depreciation,
the methods of providing depreciation and accounting in thebooks
of accounts

8.2 MEANING, DEFINITION AND FEATURES OF

DEPRECIATION

The word depreciation has been derived from the Latin word ‘Depretium’
which means decline or reduction in price or value. Fixed assets have a
definite life but they lose their value due to usage or passage of time.
Depreciation refers to this decline in value due to usage, passage of time or
due to obsolescence.

According to William Pickles, Depreciation is the gradual and permanent

decrease in the value of the asset. Depreciation refers to the decline or
reduction in the value of fixed asset. Depreciation is the permanent and
continuing diminution in the quality, quantityor value of an asset.

The Institute of Chartered Accountants of India ( ICAI) defines depreciation

as” a measure of the wearing out , consumption or other loss of a value of a
depreciable asset arising from use, efflux of time or obsolescence through
technology and market changes”
Reduction in the value of the asset due to their productive use is called
Depreciation. Depreciation in the value of asset is also due to natural wear
and tear.

Features of Depreciation-
Depreciation is a gradual reduction in the value of an asset.The reduction
could be due to various reasons.
Depreciation is charged on assets- fixed assets

Depreciation is a part of operating expenses. It is non cashin nature as

there is no real cash outflow even if it is accounted asan expense. It is to be
provided on fixed assets which are used in the process of production and in
the conduct of business. It is charged to profit and loss account.

The amount of Depreciation charged to P&L Account has to be deducted from

value of asset shown in the balance sheet.

Depreciation is to be provided even if the business is incurring a loss.

Depreciation is a gradual and permanent decrease in the value of asset which

is to be accounted for in the financial statements to arrive at the correct profit/
loss.

Thus, Depreciation means a fall in the quality or value of an

asset.

Accounting Standard (AS) -6 (Revised) deals with Depreciation Accounting.

Depreciation is to be provided on pro-rata basis for the period for which the
asset was used in a particular year at the specified rate.

The company adopts a policy regarding depreciation and as per AS-1-

namely, disclosure of Accounting Policies, the method adopted in providing
depreciation should be disclosed in the notesto accounts.

8.3 DEPRECIATION, DEPLETION AND

REVALUATION

Depreciation refers to a decrease in the value of the asset while depletion

refers to the decrease in the value of wasting assets like oil wells, mines.

Revaluation refers to a revision in the value of the assetwhich could mean a

decrease or an increase in the value of the asset.

8.3 (A) Need for depreciation-The Companies Act requires companies to

write off or provide for depreciation in a specified manner.

1) To ascertain true and correct profit/ loss-Depreciation is an

operating expense which is provided on assets used in the
process of production. Thus it is an expense to be included in
the cost of production. It is therefore logical that it must be matched
with the income earned and charged to P&L Accountto calculate
the true and real profit/ loss of the business. Unless depreciation
is charged to P&L Account, the correct profit/ loss cannot be
 arrived at.

2) To present a true financial position of business-Balance sheet

is a statement which shows the financial position of the business
enterprise as on a particular date. The fixed assets are to be
shown at their true values. The balance sheet shows the true
financial position only if the depreciation is deducted from the
value of the asset. If the depreciation is not provided on assets,
the assets will be overvalued and the balance sheet will not reflect
the true financial position.

3) Replacement of asset-Every asset has a useful life. At the end of

the useful life of the asset, it needs to be replaced. Providing the
depreciation enables the business to replace the asset.

4) Statutory requirement-It is necessary to charge depreciation to

comply with the provisions made under the Companies Act and
the Income Tax Act. Providing the depreciation enables the
business to compute and pay correct tax on taxable profit.

8.3 (B) Causes of Depreciation

1) Natural wear and tear-Wear and tear is the main cause of
depreciation. Wear and tear takes place in case of tangible fixed
assets like furniture, machinery due to its use. It the asset is used
more, the wear and tear is also more.

2) Efflux of time-Even if the asset is not used and kept idle, its value
falls over a period of time. Hence depreciation is provided on idle
machinery too.

3) Obsolescence- A loss or reduction on account of new invention

is called as obsolescence. With the new technological
improvements, inventions and improvements in techniques of
production, the old machinery becomes outdated and needs tobe
replaced.
4) Depletion-An asset like mines, oil wells may get exhausted due
to continuous extraction due to which the value of the asset goes
on diminishing. There comes a stage when the asset has been
completely utilized and there is nothing left to beextracted. Such
a decrease in the value of the asset is depletion.

5) Natural calamities- An asset may be damaged due to fire, flood

and lose its value and may be disposed off as scrap. The loss of
value is written off as depreciation.

8.3 (C) Factors affecting Depreciation

a) Cost of the asset-The cost of the asset refers to the purchase

price of the asset. The expenses related to the purchase of the
asset are to be added to the purchase price to arrive at the cost
of the asset. Incidental expenses like installation charges, wages
for erection of asset, freight and transport charges are to be added
to the purchase price. For example- purchase price of machinery
is Rs 1,00,000 and Rs 5,000 were incurred on installation of
 machinery. The total cost of the asset is Rs 1,00,000+5,000=
1,05,000

b) Residual value or estimated scrap value-Residual value refers

to the value that can be realized at the end of the usefullife of the
asset when the asset will be sold as scrap .Such scrap value is
to be deducted from the cost of the asset.

c) Estimated useful life of the asset-The useful life of the assetin

terms of number of years that the asset can be put into productive
use needs to be estimated for calculatingdepreciation.

8.3 (D) Formula for calculating depreciation- After consideringthe above

factors, the amount of depreciation can be calculated by using formula-

Depreciation per annum=Original cost of the asset-estimatedscrap value

Estimated useful life of the asset.

Depreciation = original cost of the asset x rate of depreciation (where the

estimated scrap value is zero)

Where the original cost of the asset = Purchase price + Incidental charges.
A company purchased machinery for Rs 44,000 and spentRs 1,000 on the
installation. It is estimated that the useful life of the asset is 10 years and at
the end of the useful life the residual valueis Rs 5,000. The depreciation per
year will be worked out as under Cost of the asset= 44,000+1,000= 45,000

Depreciation p.a =45,000-5,000 =4,000

10

Depreciation as per Companies Act 2013 for Financial year 2014-

15 and thereafter. (These provisions are applicable from
01.04.2014 vide notification dated 27.03.2014.)

a) Depreciation is calculated by considering useful life of asset, cost

and residual value.

b) Any method WDV or SLM can be used.

c) Schedule – II contains a list of useful life according to class of

assets and the residual value shall not be more than five percent
of the original cost of asset. However companies are free to adopt
a useful life different from what specified in Schedule II and
residual value more than 5%. The financial statements shall
disclose such difference and providejustification in this behalf
duly supported by technical advice.

8.3 (E) Methods for providing depreciation-

Straight line method or fixed instalment method Reducing

Balance method or Written down value methodAnnuity method
Depreciation fund method
Insurance fund method
Revaluation method
Sum of the digits method
Depletion method Machine hour
rate methodRepairs provision
method.
The first two methods are discussed.

• Straight line method (SLM) or fixed instalment method (FIM)

or original cost method

Meaning-Under this method a fixed percentage of the original value of the

asset is written off every year. The value of the asset is reduced to zero at the
end of the useful life of the asset. As the amount of depreciation remains
constant every year, this method is called as fixed instalment method.

• Reducing balance method (RBM) or Written down

method(WDV)
Meaning- Under this method, depreciation is charged at a certain percentage
each year on the balance of the asset which is brought forward from the
previous year. The amount of depreciation charged in each year is not fixed
but goes on reducing at the later years. As the amount of depreciation keeps
reducing, it is known as reducing balance method. The depreciation is
charged on the written down value of the asset hence known as written down
value method.

8.3 (F) Distinction between FIM and WDV methods –

The following illustration will help to bring out the distinction between the two
methods-
Let us assume the machinery was purchased for Rs 1,00,000 and
Depreciation is to be provided @10% p.a.

Year Depreciation as per FIM Depreciation as per WDV

@10% @10%
1 1,00,000x10%for 1 1,00,000x10%for 1
year=10,000 year=10,000
Value of asset at the end of Value of asset at the end of the
the first year is 1,00,000- first year is 1,00,000- 10,000=
10,000= 90,000 90,000
Depreciation @ 10% on Depreciation @ 10% on
2 1,00,000= 90,000=
Rs 10,000. Value of assetat Rs 9,000. Value of asset atthe
the end of the second year end of the second year is
is 90,000- 90,000 -9,000=81,000
10,000=80,000
3 Depreciation @ 10% on Depreciation @ 10% on
1,00,000= 81,000= Rs 8,100. Value of
Rs 10,000. Value of assetat asset at the end of the third year
the end of the third year is is 81,000-8,100=72,900
80,000-10,000=70,000
4 Depreciation @ 10% on Depreciation @ 10% on
1,00,000= 81,000=
Rs 10,000. Value of assetat Rs 8,100. Value of asset atthe
the end of the fourth year end of the fourth year is 72,900-
is 70,000- 7,290=65,610
10,000=60,000 Thus Thus depreciation is always on
depreciation is always @ 10% on the balance or WDV
10% of original cost
The following points are observed from the above table-

The amount of depreciation remains same for all the years as per the FIM
method while it keeps decreasing as per the WDV method.

The value of asset at the end of the tenth year would be zero as per the FIM
while the asset value will never become zero as per the WDV method.

There is no difference in the amount of depreciation and the value of asset

after charging depreciation in the first year under both the methods.

Fixed instalment or straight line Written down value or

method Reducing balance method
1)It is a method of depreciation in 1)It is a method of depreciation in
which depreciation at fixed which depreciation at fixed
percentage ( rate) is charged every percentage ( rate) is charged
year on original cost of fixed asset every year . The amount of
and the amount of depreciation depreciation goes on reducing
remains the same ( constant) every every year
year
2)The amount of depreciation is 2)The amount of depreciation is
charged on the original cost of the charged on the written down
asset value of the asset
3)After certain number of years the 3) The book value of the asset
value of the asset becomes zero never becomes zero

4)This method of depreciation is not 4)This method of depreciationis

accepted for Income tax purposes accepted for calculation and
payment of Income tax
5)This method of depreciation is 5)This method of depreciationis
easy to calculate and more suitable suitable for assets of higher value
for assets of lower value having longer life requiring heavy
expenditure in later life of the
asset

8.3 (G) Accounting treatment of Depreciation- The transactionsrelating

to purchase of asset and depreciation are recorded throughjournal entries
and later posted in the relevant ledger accounts. Journal entries

A) When Provision for depreciation account is not maintained-

The transactions of purchase of asset, providing depreciation on asset,

sale of asset, profit/ loss on sale ofasset are recorded in the asset
account.

For purchase of asset for cash- Asset a/c Dr

To cash/ bank a/c
 For purchase of asset on credit Asset a/c Dr
To supplier/party a/c
For payment of installation Asset a/c Dr
charges To cash/ bank a/c
For providing depreciation Depreciation a/c Dr
To Asset a/c
For transfer of depreciation to Profit and Loss a/c Dr
Profit and Loss a/c To Depreciation
For sale of asset Cash/ bank a/c Dr
To Asset a/c
For loss on sale of asset Profit and Loss a/c Dr
---To Asset a/c
For profit on sale of asset Asset a/c Dr
To Profit and Loss a/c

After passing the journal entries the relevant ledger accounts are to be
prepared. The balance in the asset account will be carried down to the next
accounting period and the balance in the depreciation account will be
transferred to profit and loss a/c.

At the end of the year, while preparing final accounts, Depreciation amount
will be shown on the debit side of profit and loss account.

The asset will appear in the balance sheet at the written down value (value
after providing for depreciation on the asset)

When the above entries are posted in the asset a/c the entries will be
appearing in the asset account as under
Dr ASSET A/C Cr

Date Particulars Amt Date Particulars Amt

To cash/ bank a/c By Depreciation
(cash Purchase) ( yearly depreciation )
To suppliers a/c By cash/ Bank(
( Credit purchase) sale of asset)
To cash/ Bank By profit and loss a/c
(installationcharges) (loss on sale)

To profit and lossa/c

( profit on sale)
To balance c/d
( balancing figure)

B) When provision for depreciation account is maintained-

• For purchase of asset for cash-
Asset a/c Dr
To cash/ bank a/c
• For purchase of asset on credit
Asset a/c Dr
To supplier/ partys a/c
• For payment of installation charges
Asset a/c Dr
To cash/ bank a/c
• For providing depreciation-

Depreciation a/c Dr
To Provision for Depreciation a/c
• For transfer of depreciation to Profit and Loss a/c
Profit and Loss a/c DrTo Depreciation
• For sale of asset
Cash/ Bank a/c Dr
To Asset a/c
• On sale of asset, the amount of provision created for the asset
sold is to be transferred to Asset a/c
Provision for Depreciation a/c DrTo Asset a/c
• For profit on sale of asset
Asset a/c Dr
To Profit and Loss a/c
• For loss on sale of asset----
Profit and Loss a/c DrTo Asset a/c
Under this method, the amount of depreciation to be provided is not recorded
in the Asset a/c but is shown in the Provision for Depreciation a/c.

The asset account will always show a debit balance and the provision for
depreciation account will show a credit balance.

The Asset a/c appears in the Balance sheet at its original value on the Asset
side and the provision for depreciation appears in the balance sheet on the
liability side.

Solved Problems- straight line method

1) M/s Raj and Sons purchased Machinery on 1st October 2007 at Rs
90,000 and spent Rs 10,000 on its installation. The firmprovides
depreciation at 10% p.a .under straight line method.

Show machinery a/c and depreciation a/c for the years 2007- 08,2008-09 and
2009-10 assuming books of accounts are closed on 31st March every year.

Solution- In the books of Raj and Sons

Working note for calculation of depreciation under SLM @ 10% p.a.

1 Oct 2007- cost of asset (90,000+10,000) = 1,00,000

Less depreciation @ 10% for 6 months = -5,000
WDV as on 31 March 2008 = 95,000
Less depreciation @ 10% for 1 year = - 10,000
WDV as on 31st March 2009 = 85,000
Less depreciation @ 10% for 1 year = - 10,000
WDV as on 31st March 2010 = 75,000

Dr Machinery account Cr
Date Particulars Amt Date Particulars Amt
2007 To Bank 90,000 2008 By DepreciationBy 5,000
1oct To Bank 10,000 31march balance c/d 95,000
1,00,000 1,00,000
2008 To balance c/d 95,000 2009 By depreciationBy 10,000
1 April 31march balance c/d 85,000
95,000 95,000
2009 To balance b/d 85,000 2010 By DepreciationBy 10,000
1 April 31march balance c/d 75,000

85,000 85,000
2010 To balance b/d 75,000
1 April
Dr Depreciation account Cr
Date Particulars Amt Date Particulars Amt
2008 To 5,000 2008 By P&La/c 5,000
31march Machinery 31march
a/c
5,000 5,000
2009 To 10,000 2009 By P&La/c 10,000
31march Machinery 31march
a/c
10,000 10,000
2010 To 10,000 2010 By P&La/c 10,000
31march Machinery 31march
a/c
10,000 10,000

2) Written down value method-

On 1st April 2005, Karan Bros purchased furniture for Rs 40,000.On 1st
October, 2005, additional furniture was purchased for Rs 20,000.

On 1st October 2007, they sold furniture which was purchased on 1st April
2005 for Rs 28,000.The accounts were closed on 31st March every year
.Depreciation was provided @10%
p.a. by WDV method

Prepare Furniture account and Depreciation account.

Solution-Working note for calculation of Depreciation @ 10%
p.a. on WDV

Particulars Furniture1 Furniture 2 Depreciation

Cost of furniture 40,000 20,000
Less depreciation( on F-2 4,000 1,000 5,000
for 6 months)
WDV 36,000 19,000
Less Depreciation 3,600 1,900 5,500
WDV 32,400 17,100
Less Depreciation ( on F-1 1,620 1,710 3,330
for 6 months)
WDV 30,780 15,390
Sold for 28,000
Loss on sale 2,780
In the books of Karan Bros

Dr Furniture a/c Cr
Date Particulars Amt Date Particulars Amt
2005 To Cash/ Bank 40,000 2006 By Depreciation 5,000
1 April To Cash/ Bank 20,000 31march By balance c/d 55,000
1 Oct
60,000 60,000
2006 To balance b/d 55,000 2007 By Depreciation 5,500
1 April 31march By balance c/d 49,500
55,000 55,000
2007 To balance b/d 49,500 2007 By Depreciation 1,620
1April 1 oct By cash/ bank 28,000
By P& La/c 2,780
2008 By Depreciation 1,710
31March By balance c/d 15,390
49,500 49,500
2008 To balance b/d 15,390
1April

Dr Depreciation a/c Cr
Date Particulars Amt Date Particulars Amt
2006 To Furniture 5,000 2006 By P&La/c 5,000
31march 31march
5,000 5,000
2007 To Furniture 5,500 2007 By P&La/c 5,500
31march 31march
5,500 5,500
2007 To Furniture 1,620 2008 By P&La/c 3,330
1 oct 31march
2008 To Furniture 1,710
31march
3,330 3,330

3) Provision for depreciation-

st
On 1 April 2009, following balances appeared in the booksof Mangesh
Traders
Machinery a/c Rs 4,00,000 Provision for Depreciation a/cRs 1,60,000

On the above date , they decided to sell the machinery forRs 1,00,000
which was purchased on 1st April 2006 for Rs 1,50,000.The firm provides
Depreciation on 31 March every year@ 10% p.a. under straight line method.

Show Machinery account and Provision for depreciation account as on 31

march 2010.

Solution- Working note Depreciation @10% on SLM

Original cost of the machinery sold - 1,50,000 and depreciation at 10% p.a.is
15,000

Depreciation for three years (1-april 2006 to 31 march 2009) is 15000x 3 years
=45,000

WDV as on 31 march 2009 = 150000-45,000= 105000

Sold for 1,00,000
Loss on sale of machinery 5,000
In the books of Mangesh Traders

Dr Machinery account Cr
Date Particulars Amt Date Particulars Amt
2009 To balance 4,00,000 2009 By cash/bank 1,00,000
1april b/d 1april By Provision for
Depreciation 45,000
a/c
By P&L a/c 5,000
( Loss on sale)
2010
31march By balance c/d 2,50,000

4,00,000 4,00,000
2010 To balance 2,50,000
1april b/d
Dr Provision for Depreciation a/c Cr
Date Particulars Amt Date Particulars Amt
2009 2009
1 april To Machinery 45,000 1april By balance b/d 1,60,000
2010 a/c 2010
31march To balance c/d 1,40,000 31march By Depreciation 25,000
1,85,000 1,85,000
2010
1april By balance b/d 1,40,000

Summary
Depreciation is the gradual and permanent decrease in the value of the asset.
Depreciation refers to the decline or reduction in the value of fixed asset.
Depreciation is the permanent and continuing diminution in the quality, quantity or
value of an asset. Depreciation is required to be provided on fixed assets and
charged to Profit and loss account so that the correct profit or loss can be
ascertained and the balance sheet reflects the true financial position .Depreciation
is caused due to natural wear and tear, efflux of time, obsolescence, depletion,
natural calamities .The three factors affecting depreciation are- cost of the asset,
estimated useful life of the asset and the residual or scrap value of the asset at
the end of its useful life. Thus, Formula for calculatingdepreciation ----

Depreciation per annum=Original cost of the asset-estimated scrap value

Estimated useful life of the asset.

There are two methods of calculating depreciation. They are-

Straight line method (SLM) or fixed instalment method (FIM) or original cost
method -Under this method a fixed percentage of the original value of the asset is
written off every year. The value of the asset is reduced to zero at the end of the
useful life of the asset. As the amount of depreciation remains constant every year,
this method is called as fixed instalment method.

Reducing balance method (RBM) or Written down method (WDV)- Under this
method, depreciation is charged at acertain percentage each year on the balance
of the asset which is brought forward from the previous year . The amount of
depreciation charged in each year is not fixed but goes on reducing at the later
years. As the amount of depreciation keeps reducing, it is known as reducing
balance method. The depreciation is charged on the written down value of the
asset hence known as written down value method.

Accounting Standard (AS) -6 (Revised) deals with Depreciation Accounting.

Depreciation is to be recorded in the debit side of Profit and Loss account and
deducted from the value of the asset in the balance sheet.

Key terms
Depreciation- Depreciation is the gradual and permanent decrease in the value of
the asset
Cost of the asset- The cost of the asset refers to the purchase price of the asset.
The expenses related to the purchase of the asset are to be added to the purchase
price to arrive at the cost of the asset.

Residual value - Residual value refers to the value that can be realized at the end
of the useful life of the asset when the asset will be sold as scrap .Such scrap value
is to be deducted from the costof the asset.

Straight line method- It is a method of providing depreciation where the amount

of depreciation remains constant or fixed every year. The depreciation is charged
at a certain rate on the original cost of the asset.

Written down value method- It is a method of providing depreciation where the

amount of depreciation goes on reducing every year. The depreciation is charged
on the written down value of the asset.
 MODULE - VII

9
INVENTORY CONTROL

Unit structure
9.1 Objectives
9.2 Introduction
9.3 Definition of Inventory
9.4 Purchase of Materials
9.5 Methods of Stock Taking
9.6 Inventory / Material Control Systems or Techniques
9.7 Stock Levels
9.8 Economic Re-Order Quantity Solved Problems
9.9 Inventory Turnover Ratio
9.10 Questions

9.1 OBJECTIVES

After studying the unit the students will be able to

 Define the concept Inventory and explain the various costs
related to Inventory.
 Explain the material purchase procedure.
 Discuss about the function in storing the material.
 Know the techniques of Material Control.
 Solve the practical problems related to Stock Levels, EOQ
and Inventory Turnover Ration.

9.2 INTRODUCTION

Inventory means stock of items kept in reserve for certain period of time. It
includes raw materials, work-in-progress or semi- finished goods, finished
goods and spare parts for the maintenance of equipment etc. Raw materials
are those inputs that areconverted into finished products. Work in progress
represents semi-finished goods that requires some work before they are ready
for sale. Finished products are those which are ready for sale. Inventory is the
physical stock of items that a business or production organisation keeps in
hand for efficient running of its production function.

9.3 DEFINITION OF INVENTORY

9.3.1 Meaning and Definition

According to Gordon B. Carson, inventory includes raw materials and

component parts. Inventories consist of raw material, component parts,
supplies and finished assemblies which an organisation purchases from an
outside source and parts, assemblies and finished products which the
company manufacturesitself. In simple words inventory means 'stock items' or
items in stock.

It is very essential that material of the correct quantity andquality is made

available as and when required, with due regard to economy in storage and
ordering costs, purchase prices and working capital. Inventory control involves
(i) Assessing the items tobe held in stock. (ii) Deciding the extent of stock
holding of items individually and collectively. (iii) Regulating the input of
stock intothe store houses and (iv) Regulating the issue of stock from the
stores houses.

9.3.2 COST OF INVENTORY

Inventory control is generally concerned with the procurement of raw-
materials and purchased parts (i.e. components) and their supply to the
production departments. Supplies and stores are the indirect materials. They
do not form a part of the finished products. They are closely related to the
maintenance services and so they should be controlled by the maintenance
department. Work-in- progress is primarily concerned with the manufacturing
department,because it is results from the various operations performed on the
shop. It is proper to assign the control functions of work-in-progress to
manufacturing department.

Every business organisation, however big or small, has to maintain inventory

and it constitutes as integral part of the working capital. It has been estimated
that inventory in Indian industries constitutes more than 60% of current assets.
Inventories are significant elements in cost process. Inventories require a
significant investment, not only in acquiring them but also in holdingthem. The
various types of cost of inventory are as follows :
 Cost of Inventory

Ordering Stockout Acquisition Costs Start-up Quality

Costs Costs Costs
Costs
1. Ordering Costs : Each time we purchase a batch of raw
material from a supplier, a cost is incurred for processing the
purchase order, expediting, record keeping, and receiving the order
into the warehouse. Each time we produce a production lot, a
changeover cost is incurred for changing production over from a
previous product to the next one. The larger the lot sizes, the more
inventory we hold, but we order fewer times during the year and
annual ordering costs are lower.

2. Stockout Costs : Each time we run out of raw materials or

finished-goods inventory, costs may be incurred. In finished-goods
inventory, stockout costs can include lost sales and dissatisfied
customers. In raw-materials inventory, stockout costs can include
the cost of disruptions to production and sometimes even lost sales
and dissatisfied customers. Additional inventory, called safety
stock, can be carried to provide insurance against excessive
stockouts.

3. Acquisition Costs : For purchased materials, ordering larger

batches may increase raw-materials inventories, but unit costs may
be lower because of quantity discounts and lower freight and
materials-handling costs. For produced materials, larger lot sizes
increase in-process or finished-goods inventories, but average unit
costs may be lower because changeover costs are amortized over
larger lots.

4. Start-up Quality Costs : When we first begin a production lot,

the risk of defectives is great. Workers may be learning, materials
may not feed properly, machine settings may need adjustment, and
a few products may need to be produced before conditions
stabilize. Larger lot sizes mean fewer changeovers per year and
less scrap.
 9.4 PURCHASE OF MATERIALS

There is a purchase department which carries out the function of purchases

of materials. The purchase manager is responsible for ensuring the items
ordered are of the standard quality, lower cost and received in time. The
purchase procedure vary with different business firms. The purchase
procedure is given below:

a) Purchase Requisition:
Purchase requisition is the formal request made by the storekeeper to the
purchase department for giving order of rawmaterials or stores. It serves the
dual purpose of authorizing the purchase department to make purchases and
provides a record of the description and quantity of materials required. It also
fixes the responsibility of the department or personnel making purchase
requisition.

b) Purchase order:-
After receiving the duly approved requisition, the purchase department has to
place an order with a supplier. It is an offer to buy certain materials at stated
price and terms. For routine purchases, the order is placed through
established supplies. Inother cases, the purchase department may ask for
bids or send out request for quotation before placing an order. The purchase
orderis a formal contract for the supply of materials. Copies of the purchase
order are sent to the departments concerned.

c) Receiving and Inspection of materials:

The stores department is responsible for taking delivery of packages and to
get a physical verification of the contents. When the materials are received,
the stores official gets the packages, open them and make a detailed
verification of the contents. After the contents of the packages are checked,
the details are entered into a Goods Received Note. Copies of the G.R.Note
are issued to the supplier, purchase and accounts department, where the
factory has to test the materials received for quality and specifications. It has
to ensure that the quality of materials is as per purchase order.

d) Approval of Invoices and Payment

Invoice received by the purchase department is forwarded to the Accounts
department for payment with their recommendation. Accounts department has
to check the authenticity, arithmetical
accuracy and G. R. Note in order to make sure that the goods areas per
purchase order. When it is found that everything is in order,it is passed for
payment by the Accountant. Then the cashier will draw the cheque as per
terms and conditions of the purchase order and invoice and finally payment is
made to the supplier.

9.5 METHODS OF STOCK TAKING

9.5.1 Meaning
Methods of taking inventories / stock

Method of Inventory

(1)Periodic inventory method (2) Perpetual inventory Method

1. Periodic inventory method :

Under this method of taking inventories, value of stock is determined by
physical counting of the stock on the accountingdate of preparation of the
final accounts. It is possible that stock taking may take a week or so in large
enterprises and purchases and sales may have to be suspended for that
period to get correct figure of closing inventory. This method of ascertaining
the value of stock at the end of the year is also known as annual stock taking.
Thus this method is based physical stock taking. It provides data once in a
year is simple and economical method of stocktaking can be adopted in small
concerns, but it does not provide basis for control.

2. Perpetual Inventory Method :

Perpetual inventory defined as a system if records maintained by the
controlling department, which reflects the physical movements of stock and
their current balance. Under this method stock registers are maintained to
make a record of thephysical movements of stock and their current balance.
Stores ledger is maintained to keep a record of the receipt and issue of the
materials and also reflects the balance in store. Similarly, work-in- progress
ledger is maintained to give the value of work-in-progress on hand and a
finished goods ledger is maintained to know the value of finished goods on
hand. Thus this system provides a running record of inventories on hand at
any time. To ensure the accuracy of perpetual inventory records physical
verification of the inventory is made by a program of continuous stock taking.
It is possible that the balance of stock by the perpetual inventory may differ
from the actual balance of stock as ascertained by physical verification. Any
difference noted between actual stocks as disclosed by the physical
verification and the stocks shown by stock records should be investigated and
rectification made then and there. If the physical verification reveals that actual
balance of stock, is more that the balance shown by the stores ledger or work-
in-progress ledger or finished goods ledger debit note is prepared and stock
record are adjusted accordingly so that balance may reconcile with actual
balance. A Stock Adjustment Accounts is prepared and debited with the
shortage of stock and credited with surplus.

Continuous stock taking is an essential feature of the perpetual inventory

system. But the two terms, perpetual inventory and continuous stock taking
should not be taken as one; perpetual means the system of stock records and
continuous stock taking whereas continuous stock taking means only the
physical verification of stock records with actual stocks.

In continuous stock taking, physical verification is spreadthroughout the year.

Every day 10 to 15 items are taken at rotation and checked so that surprise,
element in short verification is maintained and each item is checked for a
number of times during the year. On the other hand, surprise element is
missing in case of periodical checking because checking is usually done at
the end of the year. In short this method is based on records. It requires a
lotof recording and is thus expensive. It can be adopted only in big concerns.
It provides data on running basis and thus facilitates the preparation of
financial statements at shorter intervals. It also provides basis for control by
investigation the basis for control by investigation the discrepancies arising
from the comparison of physical stock with their book values.

9.5.2 Difference between Periodic inventory and Perpetual

inventory.

The following are the main differences between the two methods of taking
inventory.
 Periodic Inventory Perpetual Inventory
1. It is based on physical 1. It is based on records.
Stocktaking
2. It provides data
2. It provides the data on running
periodically i.e. once in year.basis and thus facilitates the
preparation of financial
statements at shorter intervals.
3. It does not provide basis 3. It provides basis for control by
control. investigating the discrepancies
arising from the comparison of
physical stock with book values.
4. It is simple and economical 4. It is expensive as it requires a lotof
method oftaking inventory and recording due to an elaborate method
can be adopted in small of taking inventory. It can be adopted
concern. by big concerns
only.

9.6 INVENTORY / MATERIAL CONTROL SYSTEMS OR

TECHNIQUES

9.6.1 Meaning
Material control is the function of ensuring that the sufficient stocks are
maintained to meet all requirement without any problem. It also includes to
avoid carrying unnecessary stock. It is for safeguarding company’s priority in
the form of materials by keeping systematic records and maintaining them at
optimum level considering requirements and financial resources of company’s
business. It needs proper planning organising and controlling the receipt and
issues of material and its storage to achieve the objectives of the company
efficiently.
9.6.2 Objectives of material control
a) To maintain continuous supply of material.
b) To avoid over stocking of materials
c) To obtain minimum quantity of materials from reliable
sources.
d) To minimize total cost.
e) To avoid waste and loss of stock during storage period.
f) To maintain up dated stock level.
g) To supply required information to the management in
decision making and its execution process.
 9.6.3 Techniques of Material Control
Various techniques are used in controlling the inventories.
Some popular and important techniques are as under :
A. Re-order Point (ROP).
B. Economic Ordering Quantity (EOQ).
C. ABC Analysis.

A. RE-ORDER POINT (ROP) :

Receiving and issuing of inventories are the common and recurring
phenomena in a manufacturing organisation. When the inventories fall below
a particular point, they are replenished by the fresh purchases. Re-order point
(ROP) is the point when the inventories have to be replenished by fresh order.
It fundamentally deals with ‘when to order’ or to replenish the inventories.

Re-order point is a stock level at which fresh supplies of materials should be

ordered. The level is fixed between somewhere between minimum level and
maximum level. It is fixed in such a way that fresh supply of materials are
received before the level reaches the minimum level. The re-order point also
called re-order level depends upon two factors:

(a) Maximum consumption and (b) Lead time i.e. the

anticipated time lag between the dates of issuing orders and
receiving supplies. The formula for calculating re-order level is :

Re-order Level = Maximum usage × Minimum re-order period.

Re-order Quantity : Re-order quantity is the quantity for which an order is

placed when stock reaches the re-order level. The term is used generally in
synonymous with the Economic Order Quantity since order is placed only in
such size which will be economical for the enterprise in all respect.

B. ECONOMIC ORDER QUANTITY :

The Economic Order Quantity (also known as re-order quantity) refers to the
size of the order which gives the maximum economy in purchasing any
material. It is an optimum or standard order size. When the stock reaches the
recorder level, the companyshould give a fresh order of optimum size.

This quantity is also called "Economic Purchase Quantity, or Economic lot

size, or optimum lot size or Minimum Cost Inventory."
In fixing the economic order quantity, the following costs are considered:

1. Ordering Cost : This is the cost of placing an order with the

supplier and includes cost of stationery, salary of those who are
engaged in placing a order and in receiving and inspecting the
materials. It is a fixed cost and therefore cost of placing an order
varies from time to time depending upon the number of order
placed and the quantity of items ordered. The number of orders
increase, the ordering cost goes up and vice-versa.

2. Inventory Carrying Cost : It is the cost of holding the stock in

storage and includes interest on investment, obsolescence losses,
store keeping cost, such as rent of warehouse, salary of store
keeper, stationery used in maintaining records of stores, etc,
insurance cost, deterioration and wastage of material. The larger
the volume of inventory, the great will the inventory carrying cost
and vice-versa.
The above two costs are of opposite nature. If for example, an attempt is made
to reduce of inventory carrying cost by holding the stores as low as possible,
the number of orders will increase and consequently the ordering cost will go
up. On the other hand, if orders are placed for a larger quantity, the inventory
carrying cost will increase and ordering cost, the economic order quantity
(EOQ) is fixed to keep the aggregate cost to the minimum.

Assumptions of Economic Order Quantity (EOQ) : The EOQ model is

based on the following assumptions:
(i) There is only one product involved; (ii) Annual usage
(demand) requirements are known; (iii) Usage is spread evenly
throughout the year so that the usage rate is reasonably constant;
(iv) Lead time does not vary; (v) Each order is received in a single delivery and
(vi) There are no quantity discounts.

Precautions in Applying EOQ : The following precautions are necessary in

applying E.O.Q.

1. Simplification of Routine : If the E.O.Q. formula tells us that 13

orders have to be placed in a year, we may place 12 orders, i.e.
once a month.
2. Ordering in Package Sizes : Many goods are packed in units of
one gross. If figure shows a quantity of 11 dozens, it should be
changed to 12 dozens.
 3. Economical Freight Rates : If the mathematical figure gives
9/10th of a lorry or rail wagon load, it is better to increase the
quantity to have one full lorry load or one full wagon load. This
would be cheaper, because the full wagon load rates would be
lower than transporting the material as smalls.
4. Perishable Articles : For perishable articles whose shelf-life is
very low, E.O.Q. should be very much less than the theoretical
figure and should be based on practical considerations.
5. Seasonal Articles : For articles of a seasonal nature, e.g.,
cotton or groundnuts or oilseeds, bulk purchases during the season
will be cheaper than purchases based on E.O.Q.
6. Bulk Purchases : In certain cases, considerable discounts
would be available for bulk purchases. This should be compared to
the savings as a result of the application of E.O.Q. formula and a
decision should be taken based on which is creeper.
7. Import of Materials : E.O.Q. cannot be successfully applied in
the case of imports of materials which is based on import licences.

Importance of Economic Order Quantity (EOQ) : If re-order quantity is

determined in advance and adjusted it ensures the following advantages :
1. The cost of storage can be kept at a minimum.
2. Purchase orders can be easily prepared at intervals.
3. The advantages of placing large orders can be derived as far
as possible.
Limitations of Economic Order Quantity (EOQ) : The following are the
limitations of EOQ:
(a) Where rate of consumption fluctuates very often ordering a fixed
quantity may lead to over or under stocking.
(b) Very often, consumption rate cannot be anticipated because of
certain unavoidable reasons such as power failure, slackening of
customers’ demand etc.
(c) Sometimes, estimating of carrying cost and ordering cost in
advance is not easy.

C. A.B.C. ANALYSIS:
A most useful guide to devising stock control system is often known as 'Pareto
Analysis' (after the name of an Italian Philosopher). The term is also known
as ABC analysis because it analyses the range of stock items held into three
sectors, known as A, B and C.

ABC analysis is a new technique of classifying and controlling production and

store inventories both purchased and manufactured in accordance with value
of the item. It is the starting point for material management. It is the basic
analytical management tool which enables top management to place the effort
where the results will be greatest. The technique is popularly known as
Always Better Control or the Alphabetical approach. The technique tries to
analyse the distribution of any characteristic by money value of importance in
order to determine its priority. In materials management the technique has
been applied in areas needing selective control such as inventory, criticality of
items, obsolete stocks, purchasing orders, receipt of materials, inspection,
store- keeping and verification of bills.

ABC analysis or classification is the principle of Selective Control of

inventories and a technique of grouping thousands of stock items handled by
an organisation. The principle involved is that the degree of control on stock
items and amount of safety stock carried should vary directly with the
consumption value of the item involved.
Advantages of ABC Analysis : The following are the advantages of ABC
Analysis :
1. Selective Control : This approach helps the materials manager
to exercise selective control and focus his attention only on a few
items when he is concerned with lakhs of store items.
2. Control Inventories : By concentrating on 'A' class items, the
materials manager is able to control inventories and show visible
results in a short span of item.
3. Obsolete Stocks : By controlling the 'A' items obsolete stocks
are automatically pin pointed.
4. Clerical Cost : The system also helps in reducing the clerical
cost and better planning and improved inventory turnover.
5. Equal Attention : ABC Analysis has to be resorted to because
equal attention to A, B and C items will not be worthwhile and
would be very expensive.
Material cost is defined as cost of material of any kind or nature used for the
purpose of production of goods or services. Direct materials are the materials
whose cost can be attributed to a cost object in economical feasible way and
indirect materials are those whose cost cannot be directly attributed to a
particular cost object.

9.7 STOCK LEVELS

9.7.1 Meaning
Stock levels is the technique which fixes the stock control level in terms of
quantity for ensuring the optimum quantity of materials purchased and stored.
This raise the questions when to buy and where from to buy and helps the
management while preparingbudget and schedule of purchases.
 A. Maximum Level :-
This level of stock indicates the maximum figure of inventory quantity held in
stock at any time. The quantity of stock should not exceed the level.
Following factors should be considered while fixing the maximum level of
various stock.
1. Re-order level :- The product of maximum consumption of
inventory item and its maximum delivery period.
2. Minimum Consumption :- Minimum Consumption and
minimum delivery period for each stock should be known.
3. Adequacy of working capital :- It should know to maintain
maximum level of inventory.
4. Storage space :- It should be stored properly in stores.
5. Additional storage cost :- Cost required for additional storage
should be considered.
6. Additional insurance cost should be considered.
7. Regular supply :- In case of importance materials due to their
irregular supply, the maximum level should be high.
Maximum Level= (Reorder level) + (Reorder quantity) –
(Maximum consumption x Minimum Reorder period)
B. Minimum Level :-
Minimum level shows the lowest figure of inventory balance, which must be
maintained in hand at all times, so that there is no stoppage of production
due to non-availability inventory. This levelis possible to maintain fixed level
after takking into consideration the rate of consumption and the time required
to acquire sufficient material to avoid dislocation of production.
Factors responsible to maintain minimum level of
inventory.
a. Average rate of consumption for each inventory items.
b. Maximum consumption and maximum delivery period in respect
of each item to determine its re-order level.
c. Average re-order level to each item. This period can be
calculated by averaging minimum and maximum period.
Minimum level = (Re order level) –
(Average consumption x Average/Normal Reorder Period)
C. Re-order level
This level is between the minimum and maximum levels in such away at which
purchase requisition should be made out for fresh supply. The object of
maintaining this level is to place order so that stock is not reduced to a level
less than the minimum level.
Following factors are considered white maintain this re-order level.
1. Maximum consumption
2. Maximum Re-order period
3. Minimum level
Re-order level = Minimum level + (Normal Consumption x Normal Reorder Period)
OR
= (Maximum Consumption x Maximum Re-order Period)

D. Average stock/ inventory level :-

It is the level of average of minimum level and Maximum level. Itmeans the
average level is maintained in states.
Maximum level  Minimum level
Average stock level =
2
OR
= Minimum level + ½ reorder quantity
E. Danger level :-

This is the level below the minimum stock level. When stock reaches this level,
immediate action is need to take for replacement of stock. If the stock is
reached at this level, the normal lead time is not available and hence regular
purchase procedure can not be adopted. This may results in high cost
remedial action only. If this is fixed below the re-order level and above
minimum level it will be possible to take preventive action.
 Danger level = (Average rate of consumption)  urgent supply time
OR
= (Normal consumption)  (maximum re-order period foremergency
purchases)

9.7.2 SOLVED PROBLEMS

1) In Aniket and Co, weekly minimum and maximum consumption
of material ‘A’ are 50 and 120 units respectively. The reorder
quantity as fixed by the company is 350 units. The material is
received within 4 to 6 weeks from issue of supply order.
Calculate the following.
a) Minimum level
b) Maximum level
c) Re-Order level
170
Solution :- Average consumption = (50 + 120)/2 = = 85
2
Average re-order period = (4 + 6)  2 = 5 weeks
a) Re-order level = Maximum consumption  Maximum Re-
order period
= 85  6
= 510 units
b) Minimum level = (reorder level) 
(Average consumption  Average re-order period)
= 510  (85  5)
= 510  425
= 85 units
c) Maximum level = Re-order level + Re-order quantity 
(minimum consumption  minimum Re-order period)
= 510 + 350  (50 units  4 weeks)
= 860  200
= 660 units.
2) The following information is available in respect of material in
ABC Co. Ltd of Aurangabad,
a) Re-order quantity = 2,500 units
b) Re-order period = 6 to 8 weeks
c) Maximum consumption = 600 units per week
 d) Normal consumption = 300 units per week
e) Minimum consumption = 200 units per week
calculate i) Re-order level
ii) Minimum level
iii) Maximum level
iv) Average stock level

Solution
i) Re-order level = Maximum consumption 
Maximum Reorder period
= 600  8 = 4800 units

ii) Minimum level = (Re-order level)  (Normal consumption 

(Average Reorder period)
86
= 4800  (300  )
2
= 4800  (300  7)
= 4800  2100
= 2700 units

iii) Maximum level = Re-order level + Reorder quantity 

(Minimum consumption Minimum Re-order period)
= 4800 + 2500  (200  6)
= 7300  (1200)
= 7300  1200
= 6100 units

iv) Minimum level  Maximum level

Average stock level =
2
= 2700+6100/2
= 8800/2
= 4400 units
 9.8 ECONOMIC RE-ORDER QUANTITY SOLVED
PROBLEMS

9.8.1 Formula to calculate EOQ

2  A0
Economic order Quantity =

WhereA = Annual unit consumed / used

O = Ordering cost per order
C = Annual carrying cost of one unit i.e. Carrying cost
percentage p.a  cost per unit.

9.8.2 Solved Problems

Illustration 3
From the following particulars, calculate Economic Order
Quantity and number of order to be placed in the year by using
a) Tabulation method
b) Formula method
i) Annual consumption of material - 6000 kg
ii) Cost of placing an order - ` 60
iii) Cost per kg - ` 5
iv) Storage and carrying cost  10 % an average inventory.
Ans.
a) Tabulation method

Particulars Formula 1 2 3 4 5 6 7 8 9 10

Annualusage
A 6000 6000 6000 6000 6000 6000 6000 6000 6000 6000

Order size Q 6000 3000 2000 1500 1200 1000 857 750 667 600

Ordering
O 60 60 60 60 60 60 60 60 60 60
cost p.u.

Carrying C = 10%
0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50
cost p.u. of ` 5

No. of
N = A/Q 1 2 3 4 5 6 7 8 9 10
orders
Total
TC = Q
carrying 1500 750 500 375 300 250 214 188 167 150
 C
cost
Total
TO = N
Ordering 60 120 180 240 300 360 420 480 540 600
 O
cost
Total
TAC = TC
Annual 1560 570 680 615 600 610 634 668 707 750
+ TO
cost

Box indicates EOQ = 1200 unit. When 5 order of 1200 kg each are placed, the
carrying cost 300 and the total cost 600 is the lowest.
Tabulation method is useful for computing EOQ when the order size / lot is
shifted, ii) Supplier offers volume discount that higher discount for large
quantities.
b) Formula method
2AO
EOQ =

Where, A = Annual consumption – 6000 kg

O = costing of placing an order – ` 60
5  10
C = storage and carrying cost per unit = = ` 0.50
100

2  6000  60 2  6000  60  100

 EOQ = = = 1440000
0.50 50
= 1200 unit
Illustration 4
From the following figures, calculate Economic order Quantityand order to
be placed for number kg in each year.
Annual consumption of material : 4000 kgCost per
unit = Rs. 20 Per kg
Cost of Buying per order = Rs 5 /-
Storage and carrying cost = 87.0 average inventory
2AO
Ans. EOQ =

Where A = Annual usage – 4000 kg

O = cost of buying per order = 5 /-
C = cost per unit = 2 /-
S = storage and carrying cost
2  4000  5
 EOQ =
8 % of 2

40000
=
0.16
= 250000
= 500 kg

Illustration 5
From the following information, calculate EOQ Semi -
Annual consumption – 6000 units Purchase price of
input unit – ` 25 /-
Ordering cost per order – ` 45 /-
Quarterly carrying cost – 3 %

EOQ = 2A
O
C
Where, A = Annual consumption = 6000  2 = 12000 units
O = Ordering cost per order = ` 45 /-
C = Annual carrying cost of one unit = 3 % of 25  4
3  25
=  4 = `3
100
 2  12000  45
 EOQ =

= 3,60,000
= 600 units

Illustration 6
PQR Ltd produces a product which has monthly demand of52,000 units. The
product requires a component  which purchasedat 15 /- per unit. For every
finished product, 2 unit of component  are required. The ordering cost is 350
/- per order and carrying cost is 12 % p.a.
You are required
a) Calculate Economic Order Quantity for component ‘X”.
b) If minimum lot size is supplied 52000 units what is the extra
cost, the company has to incur?
c) What is the minimum carrying cost, the company has to incur?
Ans. Annual consumption of component “x”
52000 units  12 months  2 = 12, 48,000 units
2AO
a) Economic order Quantity =

Where A = Annual consumption = 12,48,000 units

O = Ordering cost Due order = ` 350 /-
3
12 3
C = Annual carrying cost =  15
100 20
5
2  1248000  ` 350
 EOQ =
` 15  12  100

87, 36, 00000

=
180  100

87, 36, 00000

=
108
= 22030 units
 b) Calculation of Extra cost if minimum lot size is 52000 units

i) If Lot size is 52000 units


Ordering cost =  1248000  350  = 8400
 
52000 
   
  1  
Carrying cost= 52000   15`  12  100  = 46800
 
 2 
Total Cost = 46800 + 8400 = 55200 (I)

ii) If cost size is 22030 units


Ordering cost=  1248000  350  = 19828
 
22030 
   
Carrying cost =  1 12  
22030   `15   = 19827


 
 

2 100 
 

Total Cost = 19828 + 19827 = 39655 (II)
Extra cost = I – II = 55200  39655 = 15545
c) Minimum Carrying cost :
1 12
22030 units  ` 15  = 19,827
2 100

Illustration 7
A manufacturer has to supply to his customer 600 units of his produce per
year. Storage is not allowed and the inventory carrying cost amounts to ` 0.60
per unit per year. The set up cost per run is
` 80
Find the
a) Economic order Quantity,
b) Minimum average yearly cost,
c) Optimum number of order per year and
d) Optimum period of supply per optimum order.
 2AS
Ans :- a) Economic order Quantity =

Where A = Annual usage - 600 units

S = set – up cost per run - ` 80
C = carrying cost per unit - ` 0.60
2  600  80
 EOQ =
0.60
= 1, 60,000
= 400 units
b) Optimum number of orders p.a
Annual usage
Optimum number of order per year =
EOQ
600
=
400
= 1.5
Since number of order can not be fractional we round it off to thenext whole
number. Thus, optimum number of order per year = 2

c) Minimum Average yearly cost

Minimum Average yearly cost = set up cost + carrying cost
= ` 160 + ` 120
= ` 280
 set – up cost = ` 80  2 = `160
Carrying cost = Average inventory  carrying cost per unit
400
=  0.60
2
= ` 120
d) Optimum supply period per optimum order
Optimum supply period per optimum order =EOQ / Average
monthly requirement
400
=
600
12
400
=
50
= 8 months
Illustration 8
A firm’s inventory planning period is one year. Its inventory requirement for
this period is 1,600 units. Assume that its order costs are ` 50 /- order. The
carrying cost expected to be
` 1 per unit per year for an item.

The firm can produce inventories in the various lots as follows :

i) 1,600 units ii) 800 units iii) 900 units iv) 200 units and
v) 100 units
Which of these order quantities is the economic order quantity ?Use a)
Equation method b) Tabulation method.
Ans : a) Equation method
2AO
EOQ =

Where, A = Annual usage – 1600 units

O = Ordering cost per order - ` 50
C = Carrying cost per unit per annum. ` 1
2  1600  50
 EOQ =
1
= 1, 60,000
= 400 units
b) Tabulation method
Inventory cost for different order Quantities
Particulars Formula 1 2 3 4 5
Annual usage A 1600 1600 1600 1600 1600
Order size Q 1600 800 400 200 100
Ordering cost per order O 50 50 50 50 50
Carrying cost p.u.p.a. C 1 1 1 1 1
No. of orders N = A/Q 1 2 4 8 16
Total Ordering cost TO = N  O 50 100 200 400 800
Total carrying cost TC = Q  C 800 400 200 100 50
Total Annual cost TAC = TC + TO 850 500 400 500 850

It can be seen from the table that the carrying and ordering cost taken together
are the lowest for the order size 400 units. Therefore, Economic order
Quantity is 400 units.
 9.9 INVENTORY TURNOVER RATIO

9.9.1 Meaning
There are several items in the stores which are issued to the production after
long gap from the date of purchases. There are several other items which
are never issued to the production asthey have become outdated which
needs to be disposed off. These items need to be identified so that
management can avoid thecapital locked up in such items. It is necessary to
compute the inventory turn over ration for finding these items. This ratio
indicates not only replacement of stock during the year but the efficiency or
inefficiency with inventories are maintained in the organisation. This ratio
measures how quick sales of inventories is done. It is the test of efficient
inventory management. A higher inventory turnover ratio indicates good
inventory management. A low inventory turnover ratio may adversely affect
the ability of an organisation to meet consumer’s demand and not cope up with
requirement.
9.9.2 Formula
This ratio measures relationship between cost of goods sold andthe
inventory level. Inventory turnover ratio is calculated as follows :
Inventory turnover ratio = Cost of goods sold or material
consumed /Average Inventory or Stock
= ...........................................................................times
Where, cost of material consumed = opening stock + purchases
 closing stock
Opening stock + Closing stock
Average Inventory =
2
This ratio can also be calculate in days as follows :
Number of days in a year
Inventory turnover ratio =
Inventory Turnover Ratio
= Number of days
However serious limitation of this approach is that detailed data may not be
available in respect of inventory level and cost of goods. In order to overcome
this difficulties another approach for computation of inventory turnover Ratio
is used which is based on the relationship between sales and closing
inventory. Alternatively,
Sales
Inventory turnover Ratio =
Closing Inventory
In short, of the two approach of calculating inventory turnover ratio, the first
which relates to the cost of goods sold to average
inventory and theoretically it is superior whereas advantages of second
approach is that it is free from practical problems of computations.

9.9.3 Solved Problems

Illustration 9
The following date are available in respect of material ‘Y’ for theyear ended
31st march 2015

Particulars
Opening stock 1,10,000
Closing stock 1,50,000
Purchases during the year 320000

Calculatei) Inventory turnover Ratio

ii) Number of days for which average inventory is held.

Ans :-
Cost of material consumed = Opening stock + Purchases –
closing stock
= 11,0000 + 32,0000  1,50,000
= 2,80,000
Opening stock + Closing stock
Average Inventory =
2
110000 + 150000
=
2
260000
=
2
= 130000
Cost of material consumed
Inventory turnover Ratio =
Average Inventory
280000
=
130000
= 2.15 times
ii) Number of days for which average inventory is held
Number days in a
=
yearInventory turnover ratio
280000
=
130000
= 169. 76 days OR 170 days

Illustration 10
Inventory records of Aishwarya Ltd. Shows as following information
:
Particulars Material A Material B Material C
Opening stock 1400 kg 400 liters 200 kg
Purchases 23,000 kg 2200 liters 3600 kg
Closing stock 400 kg 2400 liters 2400 kg
Inventory is valued of ` per kg and ` 2.5 per liter. Calculate
material turnover ratio for each of the materials.
Ans : Material consumed = opening stock + purchases – closing
stock
Material A = 1400 + 2300  400 = 2400 kg
Material B = 400 + 22000  2400 = 20,000 liter
Material C = 200 + 3600  2400 = 1400 kg
Opening stock + Closing stock
Average Inventory =
2
Material A = (1400 + 400) / 2 = 900 kg
Material B = (400 + 2400) / 2 = 1400 liter
Material C = (200 + 2400) / 2 = 1300 kg
Cost of material consumed
Material turnover ratio =
Average Inventory or Stock
2400  2 ` 4800
Material A = = = 2.666 or 2.6
900  2 ` 1800

Times
20000  2.50 ` = 50000 =14.285 or 14.29 Times
Material B =
1400  2.50 ` 3500

2400  2 ` 2800
Material C = = = 1.076 or 1.08 Times
1300  2 ` 2600
 Number days in a year
Material Inventory =
I.T. ratio
365
Material A = = 136.704 or 137 days
2.67
365
Material B = = 25.542 or 26 days
14.29
365
Material C = = 337.962 or 338 days
1.08
Illustration 11
From the following data for the year ended 31 st March 2015, calculate the
inventory turnover ratio of two items and put forward your comments on them.
Material ‘X’ Material ‘Y’
Particulars

Opening Stock (01.04.2014) 30,000 27,000

Purchases (01.04.2014 to
1,56,000 81,000
31.05.2014)
Closing Stock (31.03.2014) 18,000 33,000

Ans : Cost of Material consumed = Opening stock + Purchase

 closing stock
Material X = 30,000 + 156000  18000 = ` 168,000
Material Y = 27000 + 81000  33000 = ` 75000
Average Inventory = (opening stock + closing stock)  2
Material ‘X’ = (30,000 + 18000)  2 = ` 24,000
Material ‘Y’ = (27000 + 33000)  2 = ` 30,000
Cost of material consumed
Inventory turnover ratio =
Average Inventory or Stock
Material ‘X’ = ` 168000  ` 24000
= 7 Times
Material ‘Y’ = ` 75000  ` 30,000
= 2.5 times
Comment :
Result : Comparatively inventory turnover ratio of material ‘X’ is
higher than that of material Y (4.5 times)
Decision :- The management of this organisation needs to concentrate on
material y as its turnover is 2.5 times only. It has toanalysis the causes and
take remedial measures for remaining material idle for long time /
period in warehouse.

Illustration 12
From the following information supplied by Sanket Ltd, calculate
i) Inventory turnover Ratio
ii) Number of days for which the inventory is held.
Particulars Material ‘P’ (E) Material ‘Q’ (i)
Opening stock 30,000 45000
Purchases 2,00,000 3,00,000
Closing stock 45,000 50,000
Sales 36,000 4,50,000

Ans :-
Cost of Material consumed =opening stock +Purchases closing stock
Material P = 30,000 + 200000  45000 = ` 185000
Material Q = 45000 + 300000  50,000 = ` 29,5000
Average Inventory = (Opening stock + Closing stock)  2
Material P = (30,000 + 45000)  2 = ` 375000
Material Q = (45000 + 50000)  2 = ` 47,500

cos t of material consumed

i) Inventory turnover ratio =
Average Inventory
Material ‘P’ = 1,85,000  37500 = 4.93 = 5 times
Material ‘Q’ = 2,95,000  47500 = 6.21 = 6 times
Alternatively, Inventory turnover ratio is as follows : Inventory turnover
ratio = sales / closing inventory Material ‘P’ =
360000 / 45000 = 8 times
Material ‘Q’ = 450000 /50,000 = 9 times

ii) Number of days for which the inventory is held

Number of days in a year
 Number of days =
Inventory Turnover Ratio
 365
Material ‘P’ = = 73 days
5
365
Material ‘Q’ = = 61 days
6

9.10 QUESTIONS

1.Define Inventory and explain the various costs of inventory? 2.Why we

do not want to hold inventories?
3. What do you understand by inventory control? Explain its
objectives and importance.
4. What are the selecting techniques of inventory control?
5.What is the significance of Economic Order Quantity?
6.What are the objectives of Inventory Control?
7. Write short notes on the following :
a. Inventory,
b. Inventory control
c. Cost of inventory,
d. ABC analysis/Pareto analysis.
e. Inventory Turnover Ratio

8. Practical Problems

1) Following information is available from the books of

manufacturing company for material ‘X’ for the year ending 2015.
Normal usage 900 units per week each
Maximum usage 1200 units per week each
Minimum usage 600 units per week each
Reorder quantity 850 units
Reorder period 4 to 6 week

Calculate Re-order level, Minimum level, Maximum level and Average stock
level.
(Ans. Reorder level - 7200 units, Minimum level–2700 units
Maximum level - 5650 units, Average level - 4,175 units)

2) From the following information calculate

a) Re-order stock level
b) Minimum stock level
c) Maximum stock level
d) Average stock level
Re-order quantity - 36000 units
Time required for delivery - 2 to 4 months
Maximum consumption - 9000 units per month
Normal consumption - 6000 units per month
Ans :
a) Re-order - 36000 units,
b) Minimum level - 18000 units,
c) Maximum level - 66000 units,
d) Average level - 42000 units

3) A manufacturing company produces a special product

‘Sorbina’ the monthly demand for which is 500 units. The following
particulars are available in respect of the material used for
manufacturing product.

Cost of placing an order - ` 120

Annual carrying cost per unit - ` 12
Normal usage per week - 60 units
Minimum usage per week - 30 units
Maximum usage per week - 90 units
Delivery period - 4 to 6 weeks
Compute : a) Economic Re-order quality
b) Re-order level
c) Minimum level
d) Maximum level and
e) Average level
(Ans. EOQ – 250 units, Re-orders level – 540 units. Minimum level –240unts,
maximum level – 670 units, Average level – 455 units.)

4) The following information is available from the books of a

company where two types of materials are used, namely A
and B.
Normal usage – 300 units per week each
Maximum usage – 450 units per week each
Minimum usage – 150 units per week each
Re-order quantity - A - 2400 units, B - 3600 units
Re-order period- A- 4 to 6 weeks, B - 2 to 4 weeks
Compute 1) Re-order level2) Minimum level
3) Maximum level and 4) Average stock level
Ans. :
Material A Material B
a) Re order level 2700 units 1800 units
b) Minimum level 1200 units 900 units
c) Maximum level 4500 units 5100 units
d) Average stock level 2850 units 3000 units
 5) From the following particulars, compute Economic order
quantity
Annual consumption- 405000 units
Order placing and receiving cost -` 20 per orderAnnual stock holding-
20 % of consumption
(Ans. EOQ - 9,000)

6) X ltd. Produces a product that has monthly demand of 4000

units. The product requires a component A, which is purchased at
` 10 for every finished product one unit at component, is required. The
ordering cost is ` 60 and the holding cost is 10% of per annum consumption.
Calculate Economic order Quantity
(Ans. EOQ = 6,928)

7) From the following information, calculate Economic order

Quantity by using formula and tabulation method.
Annual Requirement (unit) 6400
Ordering cost (per order `) 100
Carrying cost per unit (`) 8
Per unit price(`) 80

The firm can produce inventories in various lots such as

i) 6400 units ii) 3200 units iii) 1600 units
iv) 800 units v) 400 units vi) 200 units
and vii) 100 units
(T.Y.B.Com. M. U. Nov. 14)
(Ans. EOQ =400 units)

8) Find the Economic order Quantity from the following

information by Tabulation and Formula method.
Annual Demand - 20000 units
Cost per article - `1
Inventory carrying cost - 15%
Cost per order - ` 15
(Ans. EOQ =2000 units.)
 9) The following information relating to a type of material is
available.
Annual demand - 2000 units
Ordering cost - ` 20/- per order
Storage cost - ` 2%
Unit Price - ` 20 /-
Interest due - 8%
Lead Time - . ½ month
Calculate Economic order Quantity and Inventory cost of rawmaterial.
(Ans. EOQ =200 units, Inventory cost = 40400)

10) From the following information, calculate Economic order

Quantity and the number of orders to be placed in one quarter of
the year.
i) Quarterly consumption of materials-2000 kg
ii) Cost of placing an order-` 50
iii) Cost per unit -` 40
iv) Storage and Carrying cost- 8% on average inventory
(Ans. EOQ -500 units, No. of orders per quarter – 04 orders)

11) A manufacturer requires 9600 units of a certain commodity

annually. This is currently purchased from a regular supplier at ` 50
per unit. The cost of placing an order is ` 60 per order and annual
carrying cost is ` 5 per piece. What is EOQ for placing an order ?
(Ans. EOQ -480 units)

12) The following information is available from the books of M/s

Mahi Enterprises for the year 2015.
Particulars Materials ‘A’ (`) Material ‘B’ (`)
Opening stock 2000 3000
Purchases 26000 7000
Closing stock3000 3500

Calculate the material Turnover Ratio and determine which material is

moving fast.
(Ans. Material / Inventory Turnover Ratio – A – 10 times, B - 2 times)
 13) From the following for the year ending 31st March 2015.
Compute
a) Cost of material consumed
b) Average inventory
c) Inventory Turnover Ratio
d) Number of days for which material is held.
e) Which material is moving fast.
Particulars Materials No. 1(`) Materials No. 2(`)
Opening stock (01.04.14) 10000 15000
Closing stock (31.03.15) 25000 5000
Purchases during the year 100000 75000
(Ans.
Materials No. 1( ) Materials No. 2(`)
a) Material Consumed 85000 85000
b) Average Inventory 17500 10000
c) Inventory Turnover ratio 4.85 times 8.5 times
d) No. of days for material held 75.25days
75 days 42.94 days
43 days
e) Material 1 is moving fast)

14) Calculate stock holding period for material if, Opening stock
` 12000, Closing stock - ` 10,000 and Purchases during theyear ` 53000
Assumption : No. of working days in a year – 364
(Ans. Material / Stock period – 73 days.)

15) From the following information, calculate

a) EOQ and b) Total annual carrying ordering cost at that
quantity.
Semi annual consumption - 6000 units
Purchase price of input unit - ` 25
Quarterly carrying cost - 3%
Order cost per order - ` 45
(Ans. EOQ – 600 units, Total Annual carrying and Ordering Cost - ` 1800)

16) From the following information, calculate EOQ and Total

Annual carrying and ordering cost at that quantity and material
holding period also.
Quarterly consumption - 750 units
Purchase price per unit - ` 25/-
Semi – Annual carrying cost - 6%
Order cost per order - ` 45/-
(Ans. EOQ – 300 units, carrying and ordering cost - ` 900)
 17) Calculate the stock turnover ratio from the following
Opening stock - ` 80000
Closing stock - ` 160000
Sales - ` 620000
Sales Return - ` 20000
Gross Profit Ratio - 20% on sales
(Ans. Stock Turnover Ratio = 4 times)
Net sales 62000 - 20000 `600000(˜) G.P.
20% of sales `12000
Cost of Goods sold - 480000

18) Calculate stock turnover Ratio and stock of material holding

period in days
Opening stock - ` 60000
Closing stock - ` 140000
Net sales - ` 300000
Gross profit @ - 20 % on sales
Working days of year - 365
(Ans. Stock turnover ratio – 4 times, Stock holding period – 91.25 or91 days)




10
INVENTORY ACCOUNTING

Unit Structure:
10.1Objectives
10.2 Stores Records
10.3 Issue of Materials
10.4 Pricing of Materials Issued
10.5 First In First Out (Fifo)
10.6 Average Cost
10.7 Solved Problems
10.8 Exercise

10.1 OBJECTIVES

After studying the unit students will be able to:

 Know the important store records.
 Explain about issue of material.
 Explain the methods of stock valuation.
 Know the advantages and disadvantages of FIFO method and
Average cost method.
 Solve the problems of stock valuation.

10.2 STORES RECORDS

The important function of the storekeeper is to maintain records of receipts,

issues and balances of various items of materials. Bin Card and store ledger
are two important stores records that are kept for making a record of the
various items at stores,

I) BIN CARD :
A bin is a place where the materials are stored. It may be a shelf, an aluvarch,
open space etc. depending upon the nature of the commodity. A bin card
provides a quantitative record of the receipts, issues and balance of materials.
The bin cards are usually attached to or placed near to the bin so that receipts
and issues may be entered therein as soon as they take place. Separate
bin cards are prepared for each item of stores. Thus, bin card provides a
continuous record of the stock in each bin and assist the storekeeper to control
the stock. For each materials, the maximum stock to be held are noted on the
card. An ordering level is also indicated therein so that fresh supplies may be
ordered before the minimum is reached. A specimen of the bin card is given
below:

BIN CARD

Date Receipts Issues Balance Audit

G.R. No. Qty. Date Req. No. Qty Qty
Date Initials

ii) Stores Ledger

Stores ledger is a continuous record of stores received and issued and
discloses the balance in hand at any time both in quantity and value. It includes
an account of each class of materialsand facilitates ascertainment of all details
relating to the material in minimum time. It provides management with a
perpetual inventory. A specimen of the stores ledger is given below:

STORES LEDGER

Date RECEIPTS ISSUES BALANCE Remarks

G.R. No. Qty. Rate Req. No. Qty Amt. Qty.
Rate Amt.
 10.3 ISSUE OF MATERIALS

All materials in the stores are meant for issue to various departments. The
procedure for the issue is normally laid down by the management. The
storekeeper issues materials to various department against material
requisition note, the specimen of whichis given below:-

Specimen of Materials Requisition

MATERIAL REQUISITON

Code No. Description Quantity Weight Bin Card No. Stores

Ledger Folio Rate Amount

Rs.

On receipt of material requisition, the storekeeper issues the necessary

materials after obtaining the signature of the personreceiving the materials.
Materials requisitioned from the storekeeper and not needed or found to be
defective are returned to the storeroom and a returned materials report is
prepared by the concerned person upon receipt of the materials. Sometimes,
it is necessary to return any rejected, excess or damaged materials to the
supplier after making correct entries in the stores ledger.

Materials are issued from stores on properly prepared and approved materials
requisition. It is a written order to the storekeeper to deliver materials to the
place and the department. The materials requisition note includes date,
requisition number, department charged, name of the stores, ledger account
to be credited, description of materials, quantity, unit price, total value, delivery
point and the signature of the person requisitioning the material and signature
of the departments executive approving the requisition or comparatively fixed
list of materials generally use a special form of material requisition which is
called as `bill of materials’. Materials requisitioned from the stores and not
required
or found to be defective are returned to the stores, where a returned material
report is prepared by the concerned person. The amount and value of
materials returned to the stores are deducted from total value of materials
issued. Similarly, the amount shown bymaterials returned is deducted from the
total amount charged to each department. It may be necessary to return any
rejected, excess or damage materials to the supplier. This also requiressome
correction entries in the stores ledger.

10.4 PRICING OF MATERIALS ISSUED

When materials are purchased they are recorded at price at which they are
purchased after asking necessary adjustments for discounts, transportation
charges, cost of containers etc. But, when it comes to the issue of materials,
the problem arises with regard to the price at which each issue should be
recorded because the different quantities of materials are purchased at
different prices.For this purpose, a number of methods of pricing the issue of
materials are used which are as follows:-

a) FIFO Method :- The first in first out method is used when the
materials received but are to be issued first. The price of the
earliest lot/ quantity is taken first and then for the next lot. The value
of closing stock confirms more or less, to the current market price.
This method is suitable for falling price.

b) LIFO Method : - The last in first out method, is used when

materials received last are issued first. The storekeeper will charge
the cost price of the latest lot purchased. This is suitable in the
times of rising prices.

c) Average Rate Method:- Under this method the materials

are issued at a price which is an average price of materials
purchased. The simple average is an average of prices without
having regard to the quantities involved. Weighted average price is
used in order to avoid fluctuation in price and reduce the number of
calculations. Weighted average of the total cost and total quantities
of materials purchased. is calculated each time a purchase is
made.
 10.5 FIRST IN FIRST OUT (FIFO)

10.5.1 MEANING
Under the method the earliest lot of materials or goods purchased or goods
manufactured are exhausted first and closing stock is out of the latest
consignments received or goodsmanufactured and is valued at the cost of
such goods. In other words: cost of goods sold is calculated keeping in view
the earliest lots exhausted on the presumption that units are sold in which they
were acquired. In short under this method it is assumed that goods or
materials which are purchased first are issued first stock consist of latest
purchase. Hence items lying in the stock should be valued at latest purchase
price.

10.5.2 ADVANTAGES

(1) This method is simple to understand and easy to operate.

(2) It is logical method because it takes a into consideration the

normal procedure of utilizing first those items of inventory which
are received or manufactured first.

(3) This method is very useful when prices are falling because cost
of goods so sold will be high on account of using earliest lots
which are costly.

(4) Closing stock is valued nearer the market price as it would

consist of recent purchase of units.

(5) This method is useful when transactions are not too many and
prices are fairly steady.
(6) This method is useful when inventory is subject to deterioration
and obsolescence.

10.5.3 DISADVANTAGES
(1) This method increases the possible of clerical errors if the price
fluctuates, considerably as every time as issue of material is
sold, the store ledger clerk will have to go through his asctain
the price to be changed.
(2) If the prices fluctuate, comparison between different jobs
executed by the concern becomes difficult because one job
started a few minutes later than another of the same nature may
have consumed the supply of lower priced or higher priced
stock.
(3) Market prices as it is calculated keeping in view the earliest last
which were purchased at lower rate.
 10.6 AVERAGE COST

The principal on which the average cost method is based is that all items on
the store are so mixed up that consumption of material or sale of finished
goods cannot at the average cost of the various items on hand. Average may
be of two types :

(a) Simple Average Method (not in syllabus)

(b) Weighted Average Method
.
Weighted average method is quite superior to other methods
and it is better to follow this method. This method can be used with advantage
in those cases where price and quantity vary widely.The average rate does
not change with issue but would vary with a fresh supply of materials received
when a new average will have to be calculated, in a period of fluctuating price
this method will even out the fluctuations. This method is also goods as the
weighted average rate lies in between the extreme rates as shown by FIFO
and LIFO method. However the difficulty is that fresh calculations are needed
at every purchase of materials or goods.

10.7 SOLVED PROBLEMS

Illustration No. 1
From the following particulars prepared Stores ledger for the monthof Mar
08
(a) FIFO to “ABC”, (b) Weighted average to “XYZ”.
ABC XYZ
Stocks (kgs) on1-3-2008 2000 @ Rs. 28 4,000 @ Rs. 13
Purchases (kgs)
[i] On 11-3-2008 1,800 @ Rs. 27 2,500 @ Rs. 14
[ii] On 21-3-2008 1,700 @ Rs. 25 2,000 @ Rs. 18
Sales (kgs)
[i] On 6-3-2008 1,300 2,500
[ii] On 15-3-2008 1,400 2,000
[iii] On 18-3-2008 700 1,300
[iv] On 29-3-2008 1,100 1,70
(IDE, Nov. 1999, adapted)
Solution :

(A) FIFO to “ABC”

STOCK LEDGER OF ABC

Date Receipts Issues Balance

Units Price Amt. Units Price Amt. Units Price value

01-3-2008 Opening - - - - - 2,000 28.00 56,000

06-3-2008 - - - 1,300 28.00 36,400 700 28.00 19,600

700 28.00 19,600

11-3-2008 1,800 27.00 48,600 - - -
1,800 27.00 48,600

700 28.002 19,600

15-3-2008 - - - 1,100 27.00 29,700
700 7.00 18,900

18-3-2008 - - - 700 27.00 18,900 400 27.00 10,800

Date Receipts Issues Balance

Units Price Amt. Units Price Amt. Units Price Amt.

400 27.00 10,800

21-3-2008 1,700 25.00 42,500 - - -
1,700 25.00 42,500

400 27.00 10,800

29-3-2008 - - - 1,000 25.00 25,000
700 25.00 17,500

Therefore, the value of stock of ABC as on 31-3-2004 : 1,000 units@ Rs.

25.00 = Rs. 25,000

(B) Weighted Average (Under Perpetual System of Inventory)

STOCK LEDGER OF XYZ

Date Receipts Issues Balance

Wt. Avg.
Units Price Amt. Units Amt. Units Value
Rate

01-3-2008 Opening - - - - - 4,000 52,000

06-3-2008 - - - 2,500 13.00 32,500 1,500 19,500

11-3-2008 2,500 14 35,000 - - - 4,000 54,500

 15-3-2008 - - - 2,000 13.63 27,250 2,000 27,250

18-3-2008 - - - 1,300 13.63 17,712 700 9,538

21-3-2008 2,000 18 36,000 - - - 2,700 45,538

29-3-2008 - - - 1,700 16.87 28,671 1,000 16,867

Working Notes :
1] Issued of XYZ on March 15 is valued at Rs. 13.63 which is the
weighted average rate, arrived at as follows :
19,500  35,000 54,500
 13.625r / o13.63
1,500  2,500 4,000

2] Issue of XYZ on March 29 is valued at Rs. 16.87 per kg. which

is the weighted average rate arrived at as follows :
9,538  36,000 45,538
 16.865r / o16.87
700  2,000 2,700
Therefore, the value of stock as on 31-3-2008 : 1,000 units @Rs. 16.87 =
Rs. 16,867

Illustration : 2
From the following information relating A to Z item, value closingstock on 31-
12-2008 applying – (a) FIFO, (b) Weighted average
Stocks (kgs) on 1-12-2008 5,000 units @ Rs. 14
Purchases (kgs)
[i] On 18-12-2008 4,200 units @ Rs. 13
[ii] On 23-12-2008 3,800 units @ Rs. 9
Sales (kgs)
[i] On 7-12-2008 1200 units
[ii] On 16-12-2008 2600 units
[iii] On 19-12-208 1800 units
[iv] On 30-12-2008 3400 units
(IDE, April 1999, adapted)
Solution :

(A) FIFO
STOCK LEDGER

Date Receipts Issues Balance

Units Price Amt. Units Price Amt. Units Price value
Openin
01-12-2008 - - - - - 5,000 14.00 70,000
g
07-12-2008 - - - 1,200 14.00 16,800 3,800 53,200
16-12-2008 - - - 2,600 14.00 36,400 1,200 14.00 16,800

1,200 14.00 16,800

18-12-2008 4,200 13.00 54,600 - - -
4,200 13.00 54,600
1,200 14.00 16,800
19-12-2008 - - - 3,600 13.00 46,800
600 13.00 7,800

3,600 13.00 46,800

23-12-2008 3,800 9.00 34,200 - - -
3,800 9.00 34,200
200 13.00 2,600
30-12-2008 - - - 3,400 13.00 44,200
3,800 9.00 34,200

Therefore, the value of stock as on 31-12-2008 : 4,000 units @ Rs.36,800

B] Weighted Average (Perpetual Inventory system)

STOCK LEDGER

Date Receipts Issues Balance

Wt. Avg.
Units Price Amt. Units Amt. Units Value
Rate
01-12-2008 Opening - - - - - 5,000 70,000
07-12-2008 - - - 1,200 14.00 16,800 3,800 53,200
16-12-2008 - - - 2,600 14.00 36,400 1,200 16,800
18-12-2008 4,200 13.00 54,600 - - - 5,400 71,400
19-12-2008 - - - 1,800 13.22 23,796 47,607 47,604
23-12-2008 3,800 9.00 34,200 - - - 7,400 81,804
30-12-2008 - - - 3,400 11.05 37,570 4,000 44,234

Working Notes :
[1] Issue on December 19 is valued at Rs. 13.22 which is the
weighted average rate, arrived at as follows :
16,800  54,600 71,400
 13.222r / o13.22
1,200  4,200 5,400
 [2] Issue on December 30 is valued at Rs. 11.05 per kg. which is
the weighted average rate arrived at as follows :
47,604  34,200 81,804
 11.054r / o11.05
3,600  3,800 7,400
Therefore, the value of stock as on 31-12-2003 : 4,000 units @Rs. 11.05 =
Rs. 44,234

Illustration : 3
Sumit Ltd. has purchased and issued the materials in the followingorder :

Month Date Particulars Units Cost Per Unit Rs.

August, 2003 01 Purchases 300 3

04 Purchases 600 4

06 Issues 500 -

10 Purchases 700 4

15 Issues 800 -

20 Purchases 300 5

23 Issues 100 -

Ascertain the quantity of closing stock as on 31st August, 2003 andsales what
will be the value under the following methods.
[i] First in first out method. [ii] Weighted Average method.
(IDE, Nov. 2000, adapted)
Solution :
(A) FIFO
STOCK LEDGER

Date Receipts Issues Balance

Units Price Amt. Units Price Amt. Units Price value
1-8-2003 Opening - - - - - Nil Nil Nil
1-8-2003 300 3.00 900 - - - 300 3.00 900

300 3.00 900

4-8-2003 600 4.00 2,400 - - -
600 4.00 2,400
300 3.00 900
6-8-2003 - - - 400 4.00 1,600
200 4.00 800
 400 4.00 1,600
10-8-2003 700 4.00 2,800 - - -
700 4.00 2,800
400 4.00 1,600
15-8-2003 - - - 300 4.00 1,200
400 4.00 1,600
300 4.00 1,200
20-8-2003 300 5.00 1,500 - - -
300 5.00 1,500

200 4.00 800

23-8-2003 - - - 100 4.00 400
300 5.00 1,500

Therefore, the value of stock as on 31-8-2003 : Rs. 2,300

[B] Weighted Average (Perpetual Inventory System)

STOCK LEDGER

Date Receipts Issues Balance

Wt. Avg.
Units Price Amt. Units Amt. Units Value
Rate

01-8-2003 Opening - - - - - Nil Nil

01-8-2003 300 3.00 900 - - - 300 900

04-8-2003 600 4.00 2,400 - - - 900 3,300

06-8-2003 - - - 500 3.67 1,835 400 1,465

10-8-2003 700 4.00 2,800 - - - 1,100 4,265

15-8-2003 - - - 800 3.88 3,104 300 1,161

20-8-2003 300 5.00 1,500 - - - 600 2,661

23-8-2003 - - - 100 4.44 444 500 2,217

Working Notes :
[1] Issue on August 6 is valued at Rs. 3.67 which is the weighted
average rate, arrived at as follows :
900  2,400 3,300
  3.666r / o 3.67
300  600 900

[2] Issue on August 15 is valued at Rs. 3.88 per kg. which is the
weighted average rate arrived at as follows :
1,465  2,800 4,265
  3.877r / o 3.88
400  700 1,100
 [3] Issue on August 23 is valued at Rs. 4.44 per kg. which is the
weighted average rate arrived at as follows:
1,1611,500 2,661
  4.435r / o 4.44
300  300 600
Therefore, the value of stock as on 31-8-2002 : 500 units @ Rs.
4.44 = Rs. 2,217

Illustration :4
Keep stock record on FIFO, and Weighted Average basis from thefollowing
transactions :

Purchases : March 2004.

Date Units Rate Per unit (Rs.)
01 500 18
04 700 20
09 900 18
15 300 25
25 200 20

31 500 25
Sales : March 2004
02 200 22
07 500 25
11 400 21
18 800 28
27 500 25
Find out the goods sold and the profit.
Solution :

FIFO METHOD

STOCK LEDGER

Date Purchases Sales Stock

March, 2004 Units Rate Units Units × Rate = Amount
01 500 18 - 500  18 = 9,000
02 - - 200 300  18 = 5,400
04 700 20 - 300  18 = 5,400
700  20 = 14,000
19,400
07 - - 500 500  20 = 10,000
09 900 18 - 500  20 = 10,000
900  18 = 16,200
26,200
11 - - 400 100  20 = 2,000
900  18 = 16,000
18,200
15 300 25 - 100  20 = 2,000
900  18 = 16,200
300  25 = 7,500
25,7□0
18 - - 800 200  18 = 3,600
300  25 = 7,500
11,100
25 200 20 - 200  18 = 3,600
300  25 = 7,500
200  20 = 4,000
15,100
27 - - 500 200  20 = 4,000
31 500 25 - 200  20 = 4,000
500  25 = 12,500
16,500

Value of stock under FIFO is Rs. 16,500.

Profit when stock is valued under FIFO basis. Opening Stock
Nil Rs.
Add : Purchases
500  18 = 9,000
700  20 = 14,000
900  18 = 16,200
300  25 = 7,500
200  20 = 4,000
500  25 = 12,500 63,200
63,200
Less : Closing Stock (as valued under FIFO) 16,500 Cost of
Goods Sold (A) 46,700

Sales
200 × 22 = 4,400
500 × 25 = 12,500
400 × 21 = 8,400
800 × 28 = 22,400
500 × 25 = 12,500
(B) 60,200
Profit (B-A) 13,500
[B] Weighted Average (Perpetual Inventory System)
STOCK LEDGER

Date Receipts Issues Balance

Wt.
Units Price Amt. Units Avg. Amt. Units Value
Rate
01-3-2004 500 18.00 9,000 - - - 500 9,000
02-3-2004 - - - 200 18.00 3,600 300 5,400
04-3-2004 700 20.00 14,000 - - - 1,000 19,400
07-3-2004 - - - 500 19.40 9,700 500 9,700
09-3-2004 900 18.00 16,200 - - - 1,400 25,900
11-3-2004 - - - 400 18.50 7,400 1,000 18,500
15-3-2004 300 25.00 7,500 - - - 1,300 26,000
18-3-2004 - - - 800 20.00 16,000 500 10,000
25-3-2004 200 20.00 4,000 - - - 700 14,000
27-3-2004 - - - 500 20.00 10,000 200 4,000
31-3-2004 500 25.00 12,500 - - - 700 16,500
Total 63,200 46,700
Working Notes :
[1] Issue on March 7 is valued at Rs. 19.40 which is the weighted
average rate, arrived at as follows :
5,400 14,000 19,400
 19.40
300  700 1,000
[2] Issue on March 11 is valued at Rs. 18.50 which is the weighted
average arrived at as follows :
9,700 16,200 25,900
 18.50
500  900 1,400
[3] Issue on March 18 is valued at Rs. 20 which is the weighted
average rate on arrived at as follows :
18,500  7,500 26,000
  20
1,000  300 1,300
[4] Issue on March 27 is valued at Rs. 20.00 which is the weighted
average rate, arrived at as follows :
10,000  4,000 14,000
  20
500  200 700
Therefore, the value of stock as on 31-3-2000 : 700 units Rs.16,500.
[5] Cost of Goods sold = Opening Stock + Purchases – Closing
Stock = 63,200 – 16,500 = 46,700
[6] Profit = Sale – Cost of goods sold = 60,200 – 46,700 = 13,500

Illustration : 5
Following are the purchases and sales of wheat in the months of March, 2004.
Prepare a statement showing valuation of stock on the basis of (i) FIFO and
(ii) Weighted Average Cost method.

Date Purchases Rate Sales

2004 (Kg.) (Rs.) (Kg.)
March 1 600 4 -
4 - - 300
5 300 3.80 -
10 - - 200
18 200 4.20 -
23 - - 400
29 400 4.40 -
31 - - 300
Out of purchases March 5, 50 Kgs. were returned to the supplier onMarch 8.
Out of Sales on March 23, a customer returned 20 Kgs. on March26.
Solution :FIFO
STOCK LEDGER
Sales /
Date Purchases / Returns Stock
Returns
Rate Units
2004 Units (Kg.) Units × Rate = Amt.
(Rs.) (Kg)
Mar. 1 600 4 - 600  4 = 2,400
04 - - 300 300  4 = 1,200
05 300 3.80 - 300  4 = 1,200
300  3.8 = 1,140
2,340
08 - - 50 300  4 = 1,200
(Returns) 250  3.8 = 9,50
2,150
(Note – 1)
10 - - 200 100  4 = 400
250  3.8 = 9,50
1,350
18 200 4.20 - 100  4 = 400
250  3.8 = 9,50
200  4.2 = 840
2,190
23 - - 400 150  4.2 = 630
26 20 4.20 - 170  4.2 = 714
(returns) (Note – 2)
29 400 4.40 - 170  4.2 = 714
400  4.4 = 1,760
2,474
31 - - 300 270  4.4 = 1,188

Value of Stock under FIFO is Rs. 1,188.

Note : 1
50 Kgs. returned on March, 8 are out of March 5 Purchases, hence they are
shown as issued at a rate of 3.8 per Kg. and accordingly stock is calculated.
Note : 2
Sales returns on March 26 are out of March 23 Sales. Under FIFO method
Sales on March 23 are out of Kg. 100 @ Rs. 4 + Kg. 250 @ Rs. 3.8 + Kg. 50
@ Rs. 4.2. Hence 20 Kg. received are priced atRs. 4.20 per Kg.

B] Weighted Average (Perpetual Inventory System)

STOCK LEDGER

Date Receipts Issues Balance

Wt. Avg.
Units Price Amt. Units Amt. Units Value
Rate

01-3-2004 600 4.00 2,400 - - - 600 2,400

04-3-2004 - - - 300 4.00 1,200 300 1,200

05-3-2004 300 3.80 1,140 - - - 600 2,340

05-3-2004 - - - 50 3.90 195 550 2,145

10-3-2004 - - - 200 3.90 780 350 1,365

18-3-2004 200 4.20 840 - - - 550 2,205

23-3-2004 - - - 400 4.01 1,604 150 601

26-3-2004 20 4.01 80 - - - 170 681

29-3-2004 400 4.40 1,760 - - - 570 2,441

31-3-2004 - - - 300 4.28 1,284 270 1,157

Working Notes :
[1] Issue on March 5 & March 10 is valued at Rs. 3.90 which is the
weighted average rate, arrived at as follows :
1,200 1,140 2,340
  3.90
300  300 600
[2] Purchase returns of 50 kg. are out of the total stock of 600 kg.
which was valued at Rs. 3.90 per kg.
 [3] Issue on March 23 is valued at Rs. 4.01 per kg. which is the
weighted average rate arrived at as follows :
1,365  840 2,205
  4.01
350  200 550
[4] Sales on March 23 are out of stock valued at Rs. 4.01 per kg.
Hence returns of 20 kg. are also taken at a rate of Rs. 4.01 per kg.

[5] Weighted Average Rate on March 31 is arrived at as follows :

6811,760 2,441
  4.28
170  400 570
Therefore, the value of stock as on 31-3-2008 : 270 units @ Rs.4.28 = Rs.
1,157

Illustration : 6
A company deals in 3 products viz. A, B and C. The details for purchases and
sales for January 2004 are as under.

Product A B C

Units Rs. Units Rs. Units Rs.

Selling Price per

100 200 250
Unit

Opening Stock 100 60 100 100 50 120

Purchases :

Jan 9 300 65 200 110 50 135

Jan 20 100 64 50 120 100 140

Jan 29 50 68 50 125 20 130

Closing Stock 140 70 60

You are required to prepare a trading and profit and loss account for the month
assuming the selling and distribution expenses to be Rs. 63,000. Use FIFO
method for stock valuation.
Solution
Stock Ledger (FIFO Method) Product
–A

Date Purchases Sales Closing Stock

Qty. Rs. Qty. Qty. × Rs. = Amount

01-1-2004 - - 100 × 60 = 6,000

09-1-2004 4300 × 65 - 100 × 60 = 6,000

300 × 65 = 19,500

25,500

20-1-2004 100 × 64 - 100 × 60 = 6,000

300 × 65 = 19,500

100 × 64 = 6,400

31,900

29-1-2004 50 × 68 - 100 × 60 = 6,000

300 × 65 = 19,500

100 × 64 = 6,400

50 × 68 = 3,400

35,300

Total Sales 100 ×60 90 × 64 = 5,760

During 300 ×65 50 × 68 = 3,400

January 10 × 64 9,160

410
 Product – B

Date Purchases Sales Closing Stock

Qty. Rs. Qty. Qty. × Rs. = Amount

01-1-2004 - - 100 × 100= 10,000

09-1-2004 200 × 110 - 100 × 100= 10,000

200 × 110= 22,000

32,000

20-1-2004 50 × 120 100 × 100= 10,000

200 × 110= 22,000

50 × 120 = 6,000

38,000

29-1-2004 50 × 125 100 × 100= 10,000

200 × 110= 22,000

50 × 120 = 6,000

50 × 125 = 6,250

44,250

Total Sales 100× 100 20 × 120 = 2,400

During 200 × 110 50 × 125 = 6,250

January 30 × 120 8,650

330
 Product C

Date Purchases Sales Closing Stock

Qty. Rs. Qty. Qty. × Rs. = Amount

01-1-2004 - - 50 × 120 = 6,000

02-1-2004 50 × 135 50 × 120 = 6,000

50 × 135 = 6,750

12,750

20-1-2004 100 × 140 - 50 × 120 = 6,000

50 × 135 = 6,750

100 × 140= 14,000

26,750

29-1-2004 20 × 130 - 50 × 120 = 6,000

50 × 135 = 6,750

100 × 140= 14,000

20 × 130 = 2,600

29,350

Total Sales 50 × 120 40 × 140 = 5,600

During 50 × 135 20 × 130 = 2,600

January 60 × 140 8,200

160

Note : 1
Number of units sold during January :
Product A B C
Opening Stock 100 100 50
Add : Total Purchase 450 300 170
550 400 220
Less : Closing Stock 140 70 60
Units Sold 410 330 160
Dr. Trading Account Cr.

Particulars Rs. Particulars Rs.

To Opening StockA By sales

100 × 60 =6,000 A 410 × 100 = 41,000
B 100 × 100 = 10,000 B 330 × 200 = 66,000
C 50 × 120 = 6,000 22,000 C 160 × 250 = 40,000 1,47,000
To Purchases By Closing Stock
A 29,300 A 9,160
B 34,250 B 8,650

C 23,350 86,900 C 8,200 26,010

To Gross Profit c/d 64,110

1,73,010 1,73,010

Dr. Profit & Loss Account Cr.

Particulars Rs. Particulars Rs.

To Selling &
63,000 By Gross Profit b/d 64,110
Distribution Expenses

To Net Profit 1,110

64,110 64,110

10.8 EXERCISE

1. Write short Notes

a. FIFO Method
b. Weighted average method
2. Practical problems

Problem 1
Prepare a Stores Ledger Account from the followingtransactions assuming
that issue of stores have been made on the principle of and also on “First in
First Out”.
 2000

January 2 Purchased 2000 units at Rs. 4.00 per unit

January 20 Purchased 250 units at Rs. 5.00 per unit

February 5 Issued 1000 units

February 10 Purchased 3000 units at Rs. 6.00 per unit

February 12 Issued 2000 units

March 2 Issued 500 units

March 15 Purchased 2500 units at Rs. 5.50 per unit

March 20 Issued 1500 units (P.U.)

Ans. FIFO Stock : 150 units at Rs. 5.50 = Rs. 8,250

Problem 2
Value the stock under Weighted Average method.

Receipt

01-1-2000 Opening stock 200 units at Rs. 3.50 per unit

03-1-2000 Purchased 300 units at Rs. 4.00 per

13-1-2000 Purchased 900 units at Rs. 4.30 per unit

23-1-2000 Purchased 600 units at Rs. 3.80 per unit

Issues

05-10-2000 Issued 400 units

15-10-2000 Issued 600 units

25-10-2000 Issued 600 units

Ans.

Issue Price rate 5th 15th 25th Closing Stock

a] Weighted
3.80 4.25 3.98 400 units Rs. 1,592
Average
 3. Select the correct alternative:
1. In times of rising prices, the pricing of issues will be at a more
recent current market prices in
i) FIFO iii) LIFO
ii) Weighted Average iv) SimpleAverage
2. When prices fluctuate widely, the method that will smooth out
the effect of fluctuations is
i) Simple Average iii) FIFO
ii) Weighted Average iv) LIFO

3. The total cost of goods available for sale with a company during
the current year is Rs.12, 00,000 and the total sales during the
period are Rs.13, 00,000. If the gross profit margin of the
company is 33 % on cost, the closing inventory during the
current year is
i. Rs.4,00,000
ii. Rs.3,00,000
iii. Rs.2,25,000
iv. Rs.2, 60,000.

4. Consider the following for Alpha Co. for the year 2010-11:
Cost of goods available for sale Rs.1, 00,000
Total sales Rs. 80,000
Opening stock of goods Rs. 20,000Gross profit
margin 25%
Closing stock of goods for the year 2010-11 wasi.
Rs.80,000
ii. Rs.60,000
iii. Rs.40,000
iv. Rs.36, 000.

5. Record of purchase of T.V. sets.

Date Quantity Price per unit

Units Rs.
March 4 900 5
March 10 400 5.50

Record of issues March 5 600

March 12 400
The value of T.V. sets on 15 March, as per FIFO will bei.
Rs.1,500
ii. Rs.1,650
iii. Rs.1, 575.
iv. None of the three.
 6. A firm dealing in cloth has 15000 meters of cloth on
April 1,2005 valued at Rs.1, 50,000 according to FIFO.
The firm purchased 20000 meters @ Rs.12 per meter
during the year ending 31st March, 2006 and sold
30000 meters @ Rs.25 per meter during the same
period. As per FIFO, the closing stock will be valued at:
i.Rs.60,000
ii. Rs.1,25,000
iii. Rs.50,000
iv. None of the above.

7. A minimum quantity of stock always held as precaution

againstout of stock situation is called
i. Zero stock.
ii. Risk stock.
iii. Base stock.
iv. None of the above.

8. Opening stock of the year is Rs.20, 000, Goods

purchasedduring the year is Rs.1, 00,000, Carriage
Rs.2, 000 and Selling expenses Rs.2, 000.Sales during
the year is Rs.1, 50,000 and closing stock is Rs.25, 000.
The gross profit will be
i. Rs.53, 000.
ii. Rs.55, 000.
iii. Rs.80, 000.
iv. Rs.51, 000.

9. The cost of stock as per physical verification of Bharat

Ltd. on 10th April, 2011 was Rs.1, 20,000. The following
transactions took place between 1st April, 2011 to 10th
April, 2011:
Cost of goods sold Rs.10, 000, Cost of goods purchased Rs.40,000,
Purchase returns Rs.6, 000
The value of inventory as per books on 31st March, 2011 will be

i. Rs. 1, 56,000.
ii. Rs. 1, 51,000.
iii. Rs. 1, 50,000.
iv. Rs.1, 52,000.

Answers: 1-i, 2- ii, 3-iii, 4-ii, 5-ii, 6-ii, 7-iii, 8-iv, 9-i.
 MODULE – VIII

11
INTRODUCTION TO FUND FLOW
STATEMENT

Unit Structure
11.1Learning Objectives:
11.2Fund Flow Statement
11.3 Benefits of Fund Flow Statement
11.4 Procedure of Preparation of Fund Flow Statement
11.5 Importance of Fund Flow Analysis

11.1 LEARNING OBJECTIVES

• Understanding the concept of fund

• Calculation of fund from operation
• Calculation of changes in working capital
• Preparation of statement of Sources & Application of Funds

11.2 FUND FLOW STATEMENT

Funds flow statement is a financial statement which shows as to how a

business entity has obtained its funds and how it has applied or employed its
funds between the opening and closing balance sheet dates (during the
particular year/period). It can be described as – WHERE GOT-WHERE
GONE statement Funds usually refers to cash resources and funds statement
is prepared to show the net effect of various business events on the current
resources of the organization. In this topic fund should be understood as
working capital & funds flow as to mean any change in working capital.

Funds Flow Statement is a statement prepared to analysethe reasons for

changes in the financial position of a company between 2 Balance Sheets.
It shows the inflow & outflow of funds
i.e. SOURCES and APPLICATIONS of funds for a particular period. In other
words Funds flow statement is prepared to explain thechanges in the working
capital position of a company. There are two types of inflows of funds –
 a. Long term funds raised by issue of Shares, Debentures or
sale of Fixed Assets
b. Funds generated from operations

If the long term fund requirements of a company are met just out of the Long
term Sources of funds, then the whole fund generated from operations will be
represented by increase in working capital. However if the funds generated
from operations are not sufficient to bridge a gap of long term fund
requirement,then there will be a decline in working capital.

11.3 BENEFITS OF FUND FLOW STATEMENT

Funds flow statement is useful for long term analysis. It is very useful tool in
the hands of the management for judging the financial & operating
performance of the company. The Balance Sheet and the Profit & Loss A/c
(Income Statement) fails to provide the information which is provided by the
funds flow statement i.e. changes in Financial Position of an enterprise. Such
an analysis is of great help to the management, shareholders, creditors etc.

Fund Flow Statement answers the following questions

- Where have the profits gone?
- Why is there an imbalance existing between liquidity position
and profitability position of an enterprise?
- Why is the concern financially solid in-spite of losses

Fund flow statement analysis helps the management to test whether the
working capital has been effectively used or not andthe working capital level
is adequate or inadequate for the requirements of the business. The
working capital position helpsthe management in taking policy decisions
regarding payment of dividend etc.

Fund flow statement analysis helps the investors to decide whether the
company has managed the funds properly. It also indicates the credit
worthiness of a company which helps the lenders to decide whether to lend
money to the company or not. It helps the management to take policy
decisions and to decide about the financing policies and capital expenditure
for the future.

11.4 PROCEDURE OF PREPARATION OF FUND

FLOWSTATEMENT

Step I - Prepare the statement of changes in working capital

Step II - Analyse the changes in non-current assets and noncurrentliabilities to
find out inflow or outflow of funds
Step III - Find out funds from operation
Step IV - Prepare statement of Sources & Application of Funds(Funds Flow
Statement)

Step – I

Step – II - Working Capital Changes

• Increase in Current Assets – Increase in Working
Capital- Outflow
• Increase in Current Liabilities – Decrease in Working
Capital - Inflow
• Decrease in Current Assets – Decrease in Working
Capital - Inflow
• Decrease in Current Liabilities – Increase in Working
Capital - Outflow

Step III – Finding Funds from Operations

In this step, we need to calculate the funds generated only from the Operating
activities of the business and not from the Investing / Financing activities of
the business. The funds from operations shall be prepared as follows:
Step – IV – While preparing the fund flow statement, the sourcesand uses
of funds are to be disclosed clearly so as to highlight the sources from where
the funds have been generated and uses to which these funds have been
applied. This statement is also sometimes referred to as the sources and
applications of fundsstatement or statement of changes in financial position.
Sources of Funds
• Issue of Equity & Preference Shares
• Receipt of Securities Premium
• Issue of Debentures
• Receipt of Long Term Loans from Banks & Other Financial
Institutions
• Receipt of Public Deposits & other Unsecured Loans
• Sales of Fixed Assets, Sale of Investments
• Extraordinary receipt awarded in legal suit
• Income from long term investments
• Funds from operations
• Decrease in Working Capital

Application of Funds
• Redemption of Preference share capital, Redemption of
Debentures
• Premium paid on redemption of debentures and preference
shares
• Repayment of temporary loans, secured & unsecured
• Purchase of Fixed Assets, Purchase of Investment
• Extraordinary payments and non recurring losses like loss by
fire & damages paid
• Payment of Dividend & Interim Dividend, Payment of Tax
• Increase in Working Capital
Formats of Fund Flow Statement
There is no prescribed format as such for the preparation of Funds Flow
Statement. The only point to be remembered is that it should be presented in
a clear and systematic manner. However, Funds Flow Statements may be
prepared in any of the following formats
• Report Form – Remainder Type
• Report Form – Self Balancing Type
• Report Form – Reconciling Type
Fund Flow Analysis
Flow analysis consists of two different analysis namely

Working Capital Analysis – is the analysis & reporting of working capital.

Working capital is the excess of current assets over current liabilities. This
analysis consist of two statements namely
- Statement of changes in working capital
- Statement of Sources & Application of Funds

Cash Flow Analysis – is the analysis of inflows and outflows of cash. Cash
flow analysis results in separate reports viz. Sources and Applications of
Cash

Funds flow statement explains as to what caused the changes inthe

balance sheet items between two balance sheet dates

11.5 IMPORTANCE OF FUND FLOW ANALYSIS

Funds flow statement is an important financial tool, which analyze the

changes in financial position of a firm showing the sources and applications
of its funds. It provides useful information about the firm's operating, financing
and investing activities during a particular period. The following points
highlight the importanceof funds flow statement.
1. Helps in identifying the change in level of current assetsinvestment
and current liabilities financing.
2. Helps in analyzing the changes in working capital level of a firm.
3. Shows the relationship of net income to the changes
in funds from business operation.
4. Reports about past fund flow as an aid to predict
future funds flow.
5. Helps in determining the firms' ability to pay interest and
dividend, and pay debt when they become due.
6. Shows the firms' ability to generate long-term financing to satisfy
the investment in long-term assets.
7. Helps in identifying the factor responsible for changes in assets,
liabilities and owners' equity at two balance sheet date.
Important Terms
✓ Fund – It refers to working capital, Flow – It is a movement
of fund
✓ Current Items – It includes current assets and current
liabilities
✓ Non Current Items – It includes share capital, reserves,
loans, fixed assets, investments etc
✓ Fund from Operation – it is the cash profit generated from
operations
✓ Working Capital – Excess of current assets over current
liabilities is called as working capital.

Theory Questions
1. Why are funds flow statements important?
2. Explain – funds from operations
3. Explain the concept of fund & how the funds flow?

Practical Questions

❖❖❖❖
 12
INTRODUCTION TO CASH FLOW
STATEMENT
Unit Structure
12.1 Learning Objectives
12.2Cash Flow Statement
12.3 Analysis of Cash Flow Statement
12.4 Cash Flow from Operating Activities
12.5 Cash from Investing Activities
12.6 Cash from Financing Activities
12.7 Benefits/Importance of Cash Flow Analysis
12.8 Limitations of Cash Flow Analysis
12.9 Accounting Standard – AS3 on Cash Flow Statement
12.10 Distinction between Cash Flow V/S Funds Flow

12.1 LEARNING OBJECTIVES

• Understanding concept of cash flow

• Accounting standard for Cash Flow Statement (AS-3)
• Preparation of Cash Flow Statement
• Importance & Limitations of Cash Flow Statement

12.2 CASH FLOW STATEMENT

In financial accounting, a cash flow statement, also known as statement of

cash flows, is a financial statement that shows how changes in balance
sheet accounts and income affect cash and cash equivalents, and
breaks the analysis down to operating, investing and financing activities.

Cash Flow Statement gives information about cash receipts (sources) and
cash payments (application). It contains opening balances & closing balances
of cash for a given period and explains how the closing balance as per last
balance sheet changed by various inflows & outflows of cash to a closing
balance of cash as per the next balance sheet. As per AS-3, cash would
include cash in hand and savings, current a/c balances with banks& cash
equivalents. Cash equivalents are short term & highly liquid
investments that are readily convertible into cash. An investment would
normally be called a cash equivalent only when it has a short term maturity of
say 3 months or less from the date of acquisition.

12.3 ANALYSIS OF CASH FLOW STATEMENT

The cash flow statement is distinct from the income statement and balance
sheet because it does not include the amount of future incoming and outgoing
cash that has been recorded on credit. Therefore, cash is not the same as
net income, which, on the income statement and balance sheet, includes cash
sales and sales made on credit. Cash flow is determined by looking at three
components by which cash enters and leaves a company: core operations,
investing and financing,

12.3 (a) Operations

Measuring the cash inflows and outflows caused by corebusiness operations,

the operations component of cash flow reflects how much cash is generated
from a company's products or services. Generally, changes made in cash,
accounts receivable, depreciation, inventory and accounts payable are
reflected in cash from operations.

Cash flow is calculated by making certain adjustments to net income by

adding or subtracting differences in revenue, expenses and credit
transactions (appearing on the balance sheet and income statement)
resulting from transactions that occur from one period to the next. These
adjustments are made because non-cash items are calculated into net
income (income statement) and total assets and liabilities (balance sheet).
So, because not all transactions involve actual cash items, many items have
to be re- evaluated when calculating cash flow from operations.

For example, depreciation is not really a cash expense; it is an amount that

is deducted from the total value of an asset that has previously been
accounted for. That is why it is added back into net sales for calculating cash
flow. The only time income from an asset is accounted for in CFS calculations
is when the asset is sold.

Changes in accounts receivable on the balance sheet from one accounting

period to the next must also be reflected in cash flow. If accounts receivable
decreases, this implies that more cash has entered the company from
customers paying off their credit accounts - the amount by which AR has
decreased is then added to net sales. If accounts receivable increase from
one accounting period to the next, the amount of the increase must be
deducted
from net sales because, although the amounts represented in ARare
revenue, they are not cash.

An increase in inventory, on the other hand, signals that a company has spent
more money to purchase more raw materials. If the inventory was paid with
cash, the increase in the value of inventory is deducted from net sales. A
decrease in inventory would be added to net sales. If inventory was
purchased on credit, an increase in accounts payable would occur on the
balance sheet, and the amount of the increase from one year to the other
would be added to net sales.

The same logic holds true for taxes payable, salaries payable and prepaid
insurance. If something has been paid off, then the difference in the value
owed from one year to the next hasto be subtracted from net income. If there
is an amount that is still owed, then any differences will have to be added to
net earnings.

12.3 (b) Investing

Changes in equipment, assets or investments relate to cash from investing.

Usually cash changes from investing are a "cash out" item, because cash is
used to buy new equipment, buildings or short-term assets such as
marketable securities. However, when a company divests of an asset, the
transaction is considered "cashin" for calculating cash from investing.

12.3 ( c) Financing

Changes in debt, loans or dividends are accounted for in cash from financing.
Changes in cash from financing are "cash in" when capital is raised, and
they're "cash out" when dividends are paid. Thus, if a company issues a bond
to the public, the company receives cash financing; however, when
interest is paidto bondholders, the company is reducing its cash.

Major Cash Inflows

12.3.1 Issue of new shares for cash
12.3.2 Receipt of short term & long term loans from banks, financial
institutions etc
12.3.3 Sale of assets & investments, Dividend & Interest received,
12.3.4 Cash generated from operations

Major Cash Outflows

12.3.5 Redemption of preference shares, Purchase of fixed assetsor
investments
12.3.6 Repayment of long term and short term borrowings
12.3.7 Decrease in deferred payment liabilities, Loss from
operations
12.3.8 Payment of tax, dividend etc.

Classification of Activities
As per AS-3 the cash flow statement should report cash flowsduring the
period classified by
12.3.9 OPERATING ACTIVITIES
12.3.10 INVESTING ACTIVITIES
12.3.11 FINANCING ACTIVITIES

12.4 CASH FLOW FROM OPERATING ACTIVITIES

• The cash flows generated from major revenue producing activities
of the entities are covered under this head.
• Cash flow from operating activities is the indicator of the extent
to which the operations of the enterprise have generated sufficient
cash to maintain the operating capability to pay dividend, repay
loans & make new investments. Main Examples are
• Cash receipts from sale of goods & services
• Cash receipts from royalties, fees, commission etc
• Cash payments to employees
• Cash payments or refunds (receipt) of income tax
• Cash receipts & payments relating to future contracts, forward
contract etc
• Cash receipts and payments arising from purchase and sale of
trading securities

12.5 CASH FROM INVESTING ACTIVITIES

• These are the acquisition and disposal of long term assets and
other investments not included in cash equivalents. This
represents the extent to which the expenditures have been made
for resources intended to generate future incomes & cash flows,
Examples are
• Cash payments for purchase of fixed assets
• Cash receipts from sale of fixed assets
• Cash payments for purchase of shares/debentures etc. in other
entities
• Loans and advances given to third parties
• Repayments of loans given
12.6 CASH FROM FINANCING ACTIVITIES
• Financing activities are the activities that result in changes in the
size and composition of the owner’s capital and borrowings of the
enterprise.
• Separate disclosure is important because it is useful in predicting
claims on future cash flows by providers of funds
• Examples
• Cash receipts from issue of share capital , debentures & short
term & long term loans
• Cash Repayments of loans borrowed
• Cash payment to redeem preference shares
 12.7 BENEFITS/IMPORTANCE OF CASH
FLOW ANALYSIS
• Efficient Cash Management – manage the cash resources in
such a way that adequate cash is available for meeting the
expenses
• Internal Financial Management – useful for internal financial
management as it provides clear picture of cash flows from
operations
• Knowledge of change in Cash Position – It enables the
management to know about the causes of changes in cash
position
• Success or Failure of Cash Planning – Comparison of actual
& budgeted cash flow helps the management to know the success
or failure in cash management
• It is a supplement to fund flow statement as cash is a part of
fund
• Cash Flow Statement is a better tool of analysis for short term
decisions

12.8 LIMITATIONS OF CASH FLOW ANALYSIS

• Misleading Inter Industry Comparison - Cash flow does not

measure the economic efficiency of one company in relation to
another company
• Misleading Inter Firm Comparison - The terms & conditions of
purchases & sales of different firms may not be the same. Hence
inter firm comparison becomes misleading
• Influence of Management Policies – Management policies
influence the cash easily by making certain payments in advance
or by postponing certain payments
• Cannot be equated with Income Statement – Cash flow
statement cannot be equated with income statement. Hence net
cash flow does not mean income of the business
• CFS cannot substitute the B/S & Funds Flow.

12.9 ACCOUNTING STANDARD – AS3 ON CASH

FLOWSTATEMENT
Objective of AS-3 is to provide desired information about historical changes
in cash & cash equivalents of an enterprise classified in to Operating,
Investing and Financing activities.
12.9.1 An enterprise should disclose the components of cash and cash
equivalents and should present a reconciliation of the amount in the
cash statement with the equivalent items reported in the balance sheet
12.9.2 An enterprise should disclose the amount of cash & cash equivalent
balance held by the enterprises that are not available for use by it with
explanation of Management

12.10 DISTINCTION BETWEEN CASH FLOW V/S

FUNDSFLOW
Practical Sums
Key Terms:
Cash – It includes cash and demand deposits with Banks
Cash Equivalents – These are short term and highly liquid investments
Cash Flows – It is movement of cash
Non Cash Expenses – These are the expenses which do notinvolve
any cash payment
Revenue Activities - These are the activities which are revenueproducing
Investing Activities – These are related to acquisition anddisposal of
long term assets
Financing Activities – These are the activities relating to changesin capital
& borrowings

Theory Questions:
1. Explain the technique of cash flow statement?
2. What is utility of cash flow statement to financial management?
3. Explain the concept of “Flow of Cash” & enumerate the sources
of cash?
4. What data would you require to prepare a cash flow statement?

Suggested Readings for Fund Flow & Cash Flow Statements

Management Accounting – Bhattacharya Debarshi
Introduction to Management Accounting – Dr.Varsha Ainapure(Manan
Prakashan)
Principles of Financial Management – Satish Inamdar (EverestPublishing
House)
Management Accounting – Chopde (Sheth Publishers)
Practical Sums:

❖❖❖❖
 MODULE - IX

13
INTRODUCTION TO COST ACCOUNTING
Unit structure

13.1 Objectives
13.2 Introduction
13.3 Meaning of Cost, Costing and Cost Accounting
13.4 Objectives of Cost Accounting
13.5 Cost Centre and Cost Units
13.6 Classification of Cost
13.7 Elements of Cost
13.8 Summary
13.9 Exercise

13.1 OBJECTIVES

After studying this unit students will be able to:

 Understand the need of Cost Accounting
 Know the meaning of Cost, Costing and Cost Accounting
 Explain the objectives of Cost Accounting
 Understand the classification of Cost
 Discuss about the Elements of Cost
 Know the methods of Costing

13.2 INTRODUCTION

Cost Accounting is the system of accounting which is concerned with

determination of costs of doing something whichcan be manufacturing or
rendering service or even conducting any activity or function. The objective of
Cost Accounting is to render detailed and useful information for guidance to
Management.

Financial accounting is developed over the time to record, summarise and

present the financial transaction or events which can be expressed in terms
of money. This function was primarily concerned with record keeping, leading
to preparation of Profit and Loss Account and Balance Sheet. The information
obtained through financial statements is useful to the Management or Owner
in several respects. However, the information provided by financial
accounting is not sufficient for several purposes of decision making in many
areas such as : determining output level, determining product selection –
addition or dropping or changing product combination in the case of multi
product company, determining or revising prices of products, whether Profit
earned is optimum as compared with competitors and in comparison to earlier
years. The need of data for such details lead to the development of Cost
Accountancy.

13.3 MEANING OF COST, COSTING AND COST

ACCOUNTING

13.3.1 Cost :
Institute of Cost and Works Accountants of India, defines cost as
“measurement, in monetary terms, of the amount of resources used for the
purpose of production of goods or rendering services”.
Thus the term cost means the amount of expenditure, actual or notional
incurred or attributable to a given thing. It can beregarded as the price paid for
attaining the objective. For e.g. Material cost is the price of materials acquired
for manufacturing a product.

13.3.2 Costing :
The term costing has been defined as “the techniques and processes of
ascertainment of costs. Whelden has defined costing as, “the classifying
recording and appropriate allocation of expenditure for the determination of
costs the relation of these costs to sale value and the ascertainment of
profitability.”

Therefore costing involves the following steps.

13.3.2.1 Ascertaining and Collecting of Costs
13.3.2.2 Analysis or Classification of Costs
13.3.2.3 Allocating total costs to a particular
thing i.e. product, acontract or a
process.

Thus costing simply means cost finding by any process ortechnique.

13.3.3 Cost Accounting :

Cost Accounting is a formal system of accounting by means of which cost of
products or service, are ascertained and controlled.

Whelden defines Cost Accounting as, “Classifying, recording and

appropriate allocation of expenditure for determination of costs of products or
services and for thepresentation of suitably arranged data for the purpose of
control and guidance of management.”
Therefore, Cost Accounting is the application of costing principles, methods
and techniques in the ascertainment of costs and analysis of savings or / and
excesses as compared with previous experience or with standards. It
provides, detailed cost information to various levels of management for
efficient performance of their functions. The information supplied by Cost
Accounting as a tool of management for making optimum use of scarce
resources and ultimately add to the profitability of business.

13.4 OBJECTIVES OF COST ACCOUNTING

Objectives of Cost Accounting are as follows :

1) To Ascertain the Cost : To ascertain the cost of product or a

services reveled and enable measurement of profit by proper
valuation of inventory.

2) To Analyse Costs : To analysis costs or to classify the expenses

under different heads of accounts viz. material, labour, expenses
etc.

3) To Allocate and Apportion the Costs : To allocate or charge

the direct expenses or specific costs such as Raw Material,
Labour to particular product, contract or process and todistribute
common expenses to each product, contract or process on a
suitable basis.

4) Cost Reporting : Cost Reporting or presentation includes :

a) What to report i.e. what is the nature of information to be
presented?
b) Whom to Report i.e. to whom the report is to be addressed.
c) When to Report i.e. when the report is to be presented i.e.
Daily weekly monthly yearly etc.
d) How to Report i.e. in what format the report is to be
presented.

5) To Assist the Management : Cost Accounting assist the

management in:
a) Indicating to the management any inefficiencies and extent
of various forms of waste of Raw Material, Time, Expenses
etc.
b) Fixing of selling price.
c) Providing information to enable management to take decision
of various types.
 d) Controlling Inventory of Raw Material, goods in process,
finished goods, spares and consumables etc.

6) Cost Control : Cost Accounting assist the management in cost

control. Cost control includes the following stages.
a) Setting up of targets of cast and production for each period.
b) Measuring the actual figures of performance relating to cost,
production etc. for the period concerned.
c) The figures of actual performance are to be compared with
the targets to find out the variation.
d) Analysing the variance, whether favourable or adverse.
e) Immediate action has to be taken in case of adverse
variation.

8) Optimum Product Mix : Advise the management in deciding

optimum product mix merits and demerits of alterative coursesof
action viz. make of buy decisions, introduction or Automation
mechanization, rationalization, system of production etc.

9) Future Policies : Advise management on future policies

regarding Expansion, growth, capital investment, etc.

13.5 COST CENTRE AND COST UNITS

13.5.1 Cost Centre :

It is a location, person or item of equipment for which cost may be ascertained
and used for the purpose of cost control. It is a convenient unit of the
organisation for which cost may be ascertained. The main purpose of
ascertainment of cost is to control the cost and fill up the responsibility of the
person who is in charge of the cost centre.

 Types of cost centers :

I. Personal Cost Centre :

It consists of a person or group of persons.
e.g. machine operator, salesmen, etc.

II. Impersonal Cost Centre :

It consists of a location or an item of equipment or group ofthese. E.g.
Factory, Machine etc.

III. Operational Cost Centre :

This consists of machines or persons carrying on similaroperations.
 IV. Process Cost Centre :
This consists of a continuous sequence of operation or specific operations.
V. Production Cost Centre :
This is the centre where actual production takes place or these include, those
departments that are directly engaged in manufacturing activity and contribute
to the content and form of finished product.

e.g. Cutting, Assembly and Finishing Departments etc.

VI. Service Cost Centre :

This is the Centre which renders services to production centres. These
contribute to the production process in an indirect manner.

e.g. Stores department, Repairs and Maintainance department,

H.R. Department, Purchase Department etc.

13.5.2 Cost unit :

It is a unit of product, service or time in terms of which cost are ascertained or
expressed. It is basically, a unit of quantity of product or service in relation to
which costs may be ascertained or expressed.

Few examples of cost unit are given below.

Name of Industry Cost unit

Textiles Meter, yards
Transport Passenger km
Power Kilowatt – hour
Paints Litre
Iron and Steel Tonne
Canteen Per meal
Chemical Litre, kilogram
Readymade Garments Number
Petrol Litre

13.6 CLASSIFICATION OF COST

Classification is the process of grouping costs according to their common

characteristics. It is a systematic placement of like items together according
to their common features. There are various ways of classifying costs,
according to their common features as given below.
Chart showing classification of cost :
Classification of Cost

On the basis of On the basis of On the basis

Identification Controlliability of Time

Indirect Controllable Uncontrollable Historical Predetermined

Cost Cost Cost Cost Cost Cost

On the basis of On the basis of

behaviour of cost function

Fixed Variable Semi-Variable

Cost Cost Cost

Manufacturing Administration Selling and Research and

Cost Cost Distribution Development
Cost Cost

Other Basis

ConversionCost Normal Avoidable Unavoidable ProductCost Period

Cost Cost Cost Cost

I On the basis of Identification :

On the basis of identification of cost with cost units or jobs orprocesses, costs
are classified into –

1. Direct Costs : These are the costs which are incurred for and
conveniently identified with a particular cost unit process or
department. These are the expenditures which can be directly
allocated to a particular job, product or an activity. E.g. Cost of
Raw Material used, wages paid to labourers etc.

2. Indirect Costs : These are general costs and are incurred for the
benefit of a number of cost units, processes or departments.
These costs can not be conveniently identified with a particular
cost unit or cost centre. Example : Depreciation of Machinery,
Insurance, Lighting, Power, Rent of Building, Managerial
Salaries, etc.
 II On the basis of behaviour of Cost

Behaviour means change in cost due to change in output. Costs behave

differently when the level of production rises or falls. Certain costs change in
direct proportion with production level while other costs remain unchanged.
As such on the basis of behaviour of cost – costs are classified into

1) Fixed Costs : It is that portion of the total cost which remain

constant irrespective of output upto the capacity limit. It is the cost
which does not very with the change in the volume ofactivity in
the short run. These costs are not affected by temporary
fluctuation in the activity of an enterprise. These are also known
as period costs as it is concerned with period. Rent of premises,
tax and insurance, staff salaries, are the examples of fixed cost.

Characteristics of Fixed Cost are :

a. Large in value
b. Fixed amount within an output range
c. Fixed cost per unit decreases with increased output
d. Indirect Cost
e. Lesser degree of controllability
f. Influence Variable Cost and Working Capital

Y
Cost (Rs.)

Total Fixed Cost

O Output (Units) X

Behaviour of Fixed Cost

2) Variable Cost : It is that cost which directly very with the volume
of activity. In other words, it is a cost which changes according to
the changes in the volume of output. It tends to very in direct
proportion to output. It means when the volume of output
increases, total variable cost also increases when the volume of
output decreases, total variable cost also decreases.
But the variable cost per unit remains same. Direct material, Direct Labour,
Direct Expenses are the examples of variable costs.

Characteristics of Variable Cost are :

a. Total cost changes in direct proportion to the change in
total output.
b. Cost per unit remains content.
c. It is quite divisible.
d. It is identifiable with the individual cost unit.
e. Such costs are controlled by functional manager.

X
Cost (Rs.)

Variable Cost per Unit

O Output (in Units) Y

Behaviour of Variable Cost

3) Semi-Variable Cost : This is also referred as semi-fixed costs.

These costs include both a fixed and a variable component. i.e.
These are partly fixed and partly variable. They remain constant
upto a certain level and registers change afterwards. These costs
vary in some degree with volume but not in direct or same
proportion. Such costs are fixed only in relation to specified
constant condition.

For example: Repairs and maintenance of machinery, telephone charges,

maintainance of building, supervision, professional tax, compensation for
accidents, light and power etc.
Semi Variable Cost

Cost (Rs.)
Output (in Units)
Behaviour of Semi-Variable Cost

III. On the basis of Controllability

On the basis of controllability, costs are classified into two

types :
1) Controllable Cost
2) Uncontrollable Cost

1) Controllable Cost : These are the costs which can not be

influenced or controlled by the concerned cost centre or
responsibility centre. These costs may be directly regulated at a
given level of management authority.

2) Uncontrollable Cost : These are the costs, which can not be

influenced or controlled by the action of a specific member of an
enterprise. For eg. it is very difficult to control costs like factory
rent, managerial salaries etc.

The important points to be noted regarding this classification. First,

controllable cost can not be distinguished from non- controllable costs, without
specifying the level and scope of management authority. It means cost which
is uncontrollable at one level of management may be controllable at another
level ofmanagement. Eg. Rent and Factory Building may be beyond control
for the production department but can be controlled by the administrative
department by negotiations. Secondly all costs are controllable in the long run
and at the some appropriate management level.

IV On the basis of Functions

An organisation performs many functions. On the basis offunctions costs

can be classified as follows :
 1) Manufacturing Costs : It is the cost of all items involved in the
manufacturing of a product or service. It includes all direct costs
and all indirect costs related to the production. It includes cost of
direct materials, direct labour, direct expenses, and overhead
expenses related to production. Overhead expenses, means all
indirect costs involved in the production process. This is termed
as factory overhead or manufacturing overheads. Eg. Salaries
of staff for production department, technical supervision,
Expenses of stores department, Depreciation of Plant and
Machinery, Repairs and maintenance of Factory Building and
Machineries etc.

2) Administration Cost : These are costs incurred for general

management of an organisation. It is the cost which is incurred for
formulating the policy, directing the organisation of controlling the
operations. These are in the nature of indirect costs and are also
termed as administrative overhead. Eg.Salaries of Administrative
Stall, General Office expenses like rent, lighting, telephone,
stationery, postage etc.

3) Selling and Distribution Costs : Selling costs are the indirect

costs relating to selling of products or services. They include all
indirect cost in sales management for the organisation. Selling
costs include all expenses relating to regular sales and sales
promotion activities. Examples of expenses which are included
in selling costs are :
1) Salaries, Commission and traveling expenses for sales
personnel
2) Advertisement cost
3) Legal Expenses for debt realization
4) Market research cost
5) Show room expenses
6) Discount allowed
7) Sample and free gifts
8) Rent on Sales room
9) After sale services
Distribution costs are the costs incurred in handling a product from the time
it is completed in the works until it reachesthe ultimate consumer. Distribution
expenses include all these expenses which are incurred in connection with
making the goods available to customers. These expenses include the
following.
1) Packing charges
2) Loading charges
 3) Carriage on Sales
4) Rent of warehouse
5) Insurance and lighting of warehouse
6) Transportation costs
7) Salaries of godown keeper, driver, packing staff etc.

4) Research and Development Cost : Research and development costs

are incurred to discover new ideas, processes, products by experiment. It
includes the cost of the process which begins with the implementation of the
decision to produce or improved product.

V On the basis of Time

On the basis of time of computation, costs are classified intohistorical costs

and predetermined costs.

1) Historical Costs : These are the costs which are ascertained

after these have been incurred. Historical costs are then nothing
but actual costs. They represent the costs of actual operational
performance. These costs are not available until after the
completion of manufacturing operations.

2) Pre determined Costs : These are the future costs which are
ascertained in advance of production on the basis of a
specification of all the factors affecting cost and cost data.
Predetermined costs are future costs determined in advance on
the basis of standards or estimates. These costs are extensively
used for the purpose of planning and control.
VI Other Basis
1) Normal Cost : Normal cost may be defined as a cost which is
normally incurred on expected lines at a given level of output, in
the condition in which that level of output in normally attained.
This cost is a part of production.

2) Abnormal Cost : Abnormal cost is that cost which is not normally

incurred at a given level of output, in the condition in which that
level of output is normally attained. Such cost is overand above
the normal cost and is not treated as a part of the cost of
production.

3) Avoidable Cost : The cost which can be avoided under the

present conditions is an avoidable cost. These are the costs
which under given conditions of performance efficiency should
not have been incurred. They are logically associated withsome
activity and situation and are ascertained by the
difference of actual cost with the happening of the situation and the normal
cost. Eg. when spoilage occurs in manufacturing in excess of normal limit, the
resulting cost of spoilage is avoidablecost.

4) Unavoidable Cost : The cost which can not be avoidable under

the present condition is an unavoidable cost. They are
inescapable costs which are essentially to be incurred within the
limits or norms provided for. It is the cost that must be incurred
under a programme of business restriction.

CHECK YOUR PROGRESS

 Draw the chart showing Classification of Cost.
 Define the following terms:
1. Costing
2. Cost Accounting
3. Impersonal cost center
4. Service Cost center
5. Direct Cost
6. Uncontrollable cost
7. Predetermined cost
 Give Examples:
1. Fixed cost
2. Variable cost
3. Semi variable cost
4. Manufacturing cost
5. Administration cost
6. Selling cost
7. Distribution Cost

13.7 ELEMENTS OF COST

A manufacturing organisation converts raw materials into finished products.

For that it employs labour and provides other facilities. While compiling
production cost, amount spent on all these are to be ascertained. For this
purpose, cost are primarily classified into various elements. This classification
is required for accounting and control.

The elements of cost are (i) Direct material (ii) Direct labour
(iii) Direct expenses and (iv) Overhead expenses.

The following chart depicts the broad headings of costs andthis acts as the
basis for preparing a Cost sheet.
 Elements of cost

Materials Labour Other Expenses

Direct Indirect Direct Indirect Direct Indirect

Overheads

Factory Administrative Selling & Distribution

13.7.1 Material Cost

It is the cost of material of any nature used for the purpose of production of a
product or a service. Materials may be DirectMaterial or Indirect Material.

 Direct material : It is the cost of basic raw material used for

manufacturing a product. Direct materials generally became a
part of the finished product. No finished product can be
manufactured without basic raw material. This cost is easily
identifiable and chargeable to the product. For e.g. Leather in
leather products, Steel in steel furniture, Cotton in textile etc.
Direct material includes the following.

Examples-
i) Material specially purchased for a specific job or process.
ii) Materials passing from one process to another.
iii) Consumption of materials or components manufactured in the
same factory.
iv) Primary packing materials.
v) Freight, insurance and other transport costs, import duty, octroi
duty, carriage inward, cost of storage and handling are treated as
direct costs of the materials consumed.

In certain cases direct materials are used in small quantities and it will not be
feasible to ascertain their costs and allocate them directly. For instance, nails
used in the manufacture of chairs and tables, glue used in the manufacture of
toys, thread used in stitching garments etc. In such cases cost of the total
quantity consumed for the period will be treated as Indirect costs.

 Indirect material : It is the cost of material other than direct

material which cannot be charged to the product directly. It can
not be treated as part of the product. These are minor in
importance. It is also known as expenses materials. It is the
material which cannot be allocated to the product but can beapportioned
to the cost units.

Examples : Lubricants, Cotton waste, Grease, Oil, Small tools, Minor items
like thread in dress making, nails in furniture (nuts,bolts in furniture) etc.

Therefore, indirect materials can not be easily identified with specific job. They
may not vary directly with the output. It isconsidered as a part of overheads.

13.7.2 Labour Cost

This is the cost of remuneration in the form of wages, Salaries, Commissions,

Bonuses etc. paid to the workers and employees of an organisation.

 Direct Labour Cost : Direct Labour Cost is the amount ofwages

paid to those workers who are engaged on themanufacturing line.
It consists of wages paid to workers engaged in converting of raw
materials into finished products. The amount of wages can be
conveniently identified with a particular line, product, job or
process. These workers directly handle machines on the
production line. Direct wages include payment made to the
following group of workers.

1) Labour engaged on the actual production of the product

2) Labour engaged in aiding the operation viz. supervisor,
foremen, shop Clerks and worker on internal transport.
3) Inspectors, Analysts, needed for such production.

Example : Carpenter in furniture making unit, tailor in readymade wear unit,

Labour in construction work etc.

 Indirect Labour Cost : It is the amount of wages paid to those

workers who are not engaged on the manufacturing line. It is of
general character and can not be directly identified with a
particular cost unit. This indirect labour is not directly engaged
in the production operations but such labour assist or help in
production operations. It can not be easily identified with specific
job, contract of work order. It may not vary directly with the output.
It is treated as part of overheads.

Example : Labour in Human Resource department, Labour in payroll

department, Labour in stores, Labour in Securities Department, Labour in
power house department etc.
 13.7.3 Expenses

All costs other than material and labour are termed as expenses. It is defined
as the cost of services provided to an undertaking and the notional cost of the
use of owned assets.

 Direct Expenses : It is the amount of expenses which is directly

chargeable to product manufactured or which may be allocated
to product directly. It can be easily identified with the product.
These are the expenses which are specifically incurred in
connection with a particular job or cost unit. They are also called
as chargeable expenses.

Example : Hire of special plant for a particular job, Travelling expenses in

securing a particular contract, Carriage paid for materials purchased for
specific job, Royalty paid in mining or production etc.

 Indirect Expenses (Overheads): All indirect costs other than

indirect materials and indirect labour costs, are termed as indirect
expenses. It is the amount of expenses which can not be charged
to the product directly. These can not be directly identified with
particular job, process or work order and are common to cost
units’ or cost centers.

 Indirect expenses / Overheads can be sub-divided into

following main groups.

1. Factory or Works Overheads: Also known as manufacturing

or production overheads it consists of all costs of indirect materials,
indirect labour and other indirect expenses which are incurred in the
factory.

Examples :
Factory rent and insurance. Depreciation of Factory building
and machinery.

2. Office or Administration overheads: All indirect costs

incurred by the office for administration and management of an
enterprise.

Examples:
Rent, rates, taxes and insurance of office buildings, audit fees, directors fees.

3. Selling and Distribution overheads: These are indirect costs

in relation to marketing and sale.
Examples :
Advertising, Salary and Commission of sales agents,
Travelling expenses of salesmen.

13.8 SUMMARY

Cost Accounting is the process of accounting for costs from the point at which
expenditure is incurred or committed to the establishment of its ultimate
relationship with cost center and cost units. Cost accounting profession got
recognition in 1939 in India. It has been made compulsory for specified
manufacturing companies. Cost Accounting has the objectives of determining
Product costs, facilitate planning and control of regular business activities and
supply information for taking short term and long-term decisions. Cost
Accounting is useful in different areas such as materials, labour, overheads,
stock valuation etc.

13.9 EXERCISE

1. What is cost Accounting? What are its objectives?

2. What are the various elements of costs?
3. What is meant by Cost Accounting? Explain in brief different
ways of Cost Classification.
4. Write short notes on:
a. Cost centers
b. Cost units
c. Elements of costs

5. Choose the correct alternative

1. Cost accounting is an important system developed for

i) shareholders ii) government

iii) management iv) financial institutions
2. The costing which determines cost after it has been actually incurred is

i) historical ii) standard

iii) estimated iv) marginal
3. A cost center is a

i) location for which cost is incurred ii) an organisation

iii) a unit of cost iv) profit center

4. A cost center which is engaged in production activity is called

i) production cost center ii) process cost center

iii) impersonal cost centre iv) production unit
 6. Variable cost per unit remains .
i) constant ii) flexible
iii) (i) & (ii) iv) none of the above

7. Cost which is related to capacity is called :

i) Fixed cost ii) Capacity cost
iii) Plant cost iv) none of the above

8. Cost which is unaffected by the change in output is called as :

i) Fixed cost ii) Variable cost
iii) Period cost iv) None of the above

9. Cost which is relevant for decision-making is

i) Relevant cost ii) Past cost
iii) Opportunity cost iv) Imputed cost

10. The cost which remains constant irrespective of output upto capacity limit is
i) Fixed cost ii) Product cost
iv) Variable cost iv) Sunk cost

11. Variable cost is also known as

i) Product cost ii) Period cost
iii) Direct cost iv) Semi fixed cost

The cost which is directly chargeable to the product is 12.
i) Indirect cost ii) Direct cost
iii) Overheads iv) Period cost

