SECTION 1- BASIC FINANCIAL ACCOUNTING

CHAPTER-1 INTORDUCTION TO ACCOUNTING

ACCOUNTING AS AN INFORMATION SYSTEM

Accounting is generally taken in the sense of financial accounting. It represents a field of

accounting that focuses primarily on reporting a company’s financial information to meet the
information need of shareholders, creditors, investors, bankers, government agencies like tax
departments, etc. Financial accounting is concerned with recording and reporting the results of
financial transactions of an enterprise (business or non-business) to interested users of such
information. It is described as a process of collecting, summarising and reporting financial
information of an entity according to established standards and principles.

Accounting is thus a part of information system of an enterprise. The Accounting

Principles Board of AICPA (American Institute of Certified Public Accountants) states that “the
function of accounting is to provide quantitative information, primarily financial in nature, about
economic entities that is intended to be useful in making economic decisions”. Accounting
information is useful to many persons, both within and outside the business enterprise.

Accounting is often called the ‘language of business’ because accounting terms and concepts are
used to describe the events that make up the existence of business. As you gain knowledge of
accounting, you also increase your understanding of the ways businesses are conducted. Like
other languages, accounting is also a man made art. Changes and improvements are continually
being made in it.

Broadly speaking, on the basis of type of accounting information and the purpose for which
such information is used, accounting may be divided into three categories

1. Financial Accounting (or General Accounting),

2. Cost Accounting, and

3. Management Accounting.

1 Financial Accounting: Financial accounting is mainly concerned with recording business

transactions in the books of account for the purpose of computing profit or loss for a specified
period (generally one year) and also to show the financial position of the business at the end of
the period. It is historical in nature as it records only past transactions. Financial accounting is
mainly for use by the outside parties such as shareholders, creditors, bankers, public, government
agencies and others. Thus at the end of the financial year, the following two financial statements
are prepared for a business enterprise:
 A) Profit and Loss Account -showing the net profit or loss during the period.
B) Balance Sheet - showing the financial position of the firm.

2 Cost Accounting: Cost accounting provides information about the cost of goods produced or
services provided. Cost accounting provides detailed cost information to various levels of
management for efficient performance of their functions. The information supplied by cost
accounting acts as a tool of management for making optimum use of scarce resources and
ultimately add to the profitability of business.

Cost accounting mainly consists of principles and rules which are used for determining:

(a) The cost of manufacturing a product, e.g., motor car, furniture, chemical, steel, paper, etc.,
and

(b) The cost of providing a services, e.g., electricity, transport, education, etc.

Cost accounting information is mainly for internal use i.e., for management. It is not to be
provided to external parties such as shareholders, creditors, potential investors, etc. Neither do
outsiders have any claim on this information, except government agencies, to whom cost
information may have to be submitted

3 Management accounting - is concerned with financial and non-financial information for

planning, controlling and decision making. The term management accounting is applied to the
provision of accounting information for management activities such as planning, controlling and
decision-making, etc.

It encompasses techniques and processes that are intended to provide financial and non financial
information to people within an organisation to make better decisions to achieve business
objectives. The management accountant needs to be dynamic and forward looking and his role is
determined by the requirements of business. Clearly, the management accounting information is
only for internal users i.e., management at all levels. It is not published for general public.

Users of Accounting Information

Accounting information is useful to many users, both within and outside the business enterprise.
In other words, users of accounting information may be divided into two broad categories ;

 Internal users
  External users

1. Internal Users: Internal users of accounting information are insiders of the enterprise
who need information to effectively manage the activities of the business.
These include owners and partners in the case of sole tradership and partnerships and in
the case of corporate business, these include managers and directors, etc.

2 External Users: External users are individuals and organisations who have present and future
economic interest in the business but are not part of the management team. These include:

1 Shareholders and Investors

2 Potential Investors
3 Bankers and Creditors
4 Govt. Agencies like SEBI, Tax Deptts.
5 Labour Unions and Employees Etc

OBJECTIVES AND FUNCTIONS OF FINANCIAL ACCOUNTING

Accounting performs the following functions:
1. Recording: This is the basic function of accounting. Accounting keeps a systematic
record
of financial transactions in the sequence of their dates. In this process, it passes through
journal,
ledger, work sheets and ultimately to final statements.
2. Ascertaining Profit/Loss and Financial Position of Business: The information
supplied
by financial accounting is summarised in the following two statements at the end of the
period,
generally one year:
(a) Profit and Loss Account showing the net profit or loss during the period; and
(b) Balance Sheet showing the financial position of the firm at a point of time.
Thus, the objective of financial accounting is to present a true and fair view of company’s
income and financial position at regular intervals of one year.
3. Communicating: Recording function loses much of its importance if recorded facts
are not
communicated to those who have to make use of them, i.e., business managers, owners,
creditors,
etc.
4. Meeting legal requirements: Accounting performs the function of fulfilling the
requirements of law as a business has to file income tax return, sales tax return, etc.
5. Interpreting: Interpreting of accounting records is an attempt to determine the
meaning
of the data in financial statements. The interpretation pinpoints the strengths and
weaknesses of
a business undertaking. The various devices used for this purpose are ratio analysis,
trend, percentage, etc.
SYSTEMS OF ACCOUNTING
There are two systems of accounting – single entry system and double entry system.

Single Entry System

For a small business like grocery shop, market stall, etc. it may not be feasible to keep
books using a full double entry system. Owner of such a business may not even know
how to write double entry records, even if he wanted to. However, small firms keep only
necessary accounts like cash book, personal accounts etc. but not in double entry form.
Such an incomplete double entry system is called single entry system.
In the words of Kohler, single entry system ‘ is a system of book keeping in which as a
rule, only records of cash and personal accounts are maintained, it is always
incomplete double entry, varying with circumstances.’
In such a system, only records of cash and personal accounts of debtors and creditors are
maintained. This type of system does not have a definite form and varies with
circumstances such as size of business, requirements of the businessman, etc.

Double entry system

In accounting, double entry system is the standard system used for recording financial
transactions. This system is called double entry system because each transaction has two
aspects, one is in the form of receiving some benefit and the other is giving or sacrificing
some benefit at the same time. Both of these aspects are properly recorded, one is debited
and other is credited. That is why it is called double entry system.
In this system, two aspects of a transaction are recorded in two or more accounts with
equal debits and credits.
In other words, each transaction results in at least one account being debited and at least
one account being credited, with total debits of the transaction equal to the total credits.
Two sided effect of a transaction is recorded in appropriate accounts.

ACCOUNTING EQUATION

Double entry system is governed by fundamental accounting equation, i.e.,

Assets = Equity
Or Assets = Liabilities + Owners’ Equity
It may also be stated as:
Owners’ Equity = Assets – Liabilities
 Equity represents the claims of the owners on the assets of the enterprise. In other words,
equity is what is left if all assets are sold and all liabilities have been paid off.
It is important to note that the accounting equation equality is maintained after recording
each transaction.

MEANING OF ACCOUNT

An account is a summarized record of business transactions pertaining to a particular item like

person, asset, liability, income item, expense item, etc. It is prepared in a standard format in T
shape having two sides left side and right side. An account is used to record increases and
decreases in the item.

ADVANTAGES OF ACCOUNTING
The main advantages of accounting are stated below:

1. Maintains systematic records. Basic advantage of accounting is that it maintains proper

and systematic records of all financial transactions and events that take place in a
business. As it is not possible for businessman to remember all business transactions,
accounting furnishes all information as and when required.

2. Meets legal requirements. Accounting helps to comply with legal requirements. For
example, in the case of joint stock companies it is mandatory to prepare and maintain
proper books of accounts as per the provisions the Companies Act, 1956.

3. Ascertains profit / loss. Accounting ascertains net profit or loss in the business at the end
of each year by preparing Profit and Loss Account.

4. Ascertains financial position. In accounting a Balance Sheet is prepared at the end of

each year which explains the financial position of the business.

5. Acts as legal evidence. Properly maintained books of accounts may prove as good
evidence in court of law to settle certain disputes.

6. Facilitates rational decision making. Accounting provides necessary data to

management in planning and controlling business operations and also making business
decisions.

7. Facilitates comparative study. Accounting provides necessary data to make a comparative

study of business performance in terms of sales, profit etc with its own past performance to know
the progress. Comparison of figures with other firms i.e. inter firm comparison also makes an
interesting study.

LIMITATIONS OF ACCOUNTING

The main limitations of accounting are as follows:

1Records only monetary matters. One of the major limitations of financial accounting is that it
records only transactions and events which can be expressed in money terms. It does not take
into account the non-monetary facts of the business, such as relations with customers,
competitive position of business, quality of products, quality of labour force, etc.

2. Element of subjectivity. Accounting is also affected by personal judgments and bias of the
accountant. For example, in inventory valuation, an accountant has to choose a method (out of
FIFO, LIFO, etc). Similarly, in providing depreciation, a method has to be chosen out of various
methods available. Thus different accountants choose different methods and profit/loss will vary
according to the methods used. Due to lack of objectivity, the financial statements may not
reflect true picture.

3. Ignores price level changes. Fixed assets such as land and building, plant, etc are shown in
the books at their actual cost less depreciation. But over the years these values keep on changing
and there may be a great difference between the original costs and the present replacement
values of these assets. Thus balance sheet does not reflect the true financial position of the
business.
4. Provides only historical information. Financial accounting is historical in nature in the sense
that it records only past transactions. It has no provision for future estimates which is very
important for managerial control and decision making.

5. Danger of window dressing. There is always a danger of companies practicing window

dressing in accounts i.e. manipulating accounting information to make it more attractive to its
users.

2 ACCOUNTING PRINCIPLES

INTRODUCTION

Accounting principles are the rules and guidelines which are necessary for recording the business
transactions in such a way so as to bring about a uniformity in the computation of profit/loss (Le.
preparation of Profit and Loss Account) and showing the financial position (in the form of
Balance Sheet). Accounting principles refer to accounting concepts and conventions and
accounting standards.
Generally Accepted Accounting Principles (GAAP) GAAP is the standard framework of
guidelines for financial accounting. It includes concepts, conventions, assumptions, standards,
etc. which the accountants follow in recording transactions and in preparing financial statements.
These principles have been developed to ensure uniformity and easy understanding of the
accounting information. When everyone follows GAAP, it results in accounting information
which is consistent, reliable and comparable to earlier years and among business firms.

Accounting is a social science and not a natural science like physics or chemistry. Therefore,
accounting principles are man made and not as exact and rigid as that of natural sciences.
Accounting principles are constantly evolving and are influenced by changes in economic, social
and legal environment so as to keep the reporting of accounting information relevant to the
current practices.

GAAP are the pillars on which the structure of accounting is resting. It is very essential that the
accountants and the users of accounting information understand GAAP.

ACCOUNTING CONCEPTS

Accounting concepts define the assumptions on the basis of which financial statements of a
business entity are prepared. Certain concepts are perceived, assumed and accepted in accounting
to provide a unifying structure and internal logic to accounting process.These accounting
concepts lay the foundation on the basis of which the accounting principles are formulated.

1. Accounting Entity Concept

For accounting purpose, it is assumed that business has a separate existence and its entity
different from the person or persons who own it. The affairs of the individual behind a business
must be kept separate from the affairs of the business. Accounting is done for the business entity
as distinguished from the persons who own the entity. The best example can be taken of a sole
trader or a one man business. A sole trader takes money from his business by way of drawings
for his personal use. Despite it being his own business and apparently his own money, there are
still two aspects of this transaction of drawings - the business is giving money and the individual
is receiving money. This concept of accounting does not permit a businessman to intermingle his
personal transactions with those of his business. In other words, entity concept requires that for
accounting purposes, a distinction has to be made between personal transactions and business
transactions.

This concept of a separate entity is applicable to all forms of business organisations

proprietorship, partnership, joint stock company, etc. Although for legal and many other
purposes, sole traders and partners may not be distinguished from their respective business, yet
for accounting purposes they are regarded as different entities.

2. Money Measurement Concept

Accounting records only those transactions or events which can be measured in terms of money
and money means currency of the country. In other words, any event or transaction which cannot
be expressed in terms of money is not recorded in the account books. But there may be some
events w a very important for the business enterprises but cannot be measured or expressed in
money terms, and therefore, are not recorded in the books of account. For example, if the general
health of the executive chairman the company has suddenly deteriorated.

The money measurement concept puts a serious handicap on the utility of accounting records and
the users of accounting information should be aware that they do not get a complete pictureof the
business events.

3. Going Concern Concept

As per this concept, it is assumed that the business will continue to operate for an indefinite
period of time in the future unless there is good evidence to the contrary. In other words, going
concern concept means that business has continuity of life and there is no intention or necessity
of liquidating the business in the near foreseeable future, When a business will continue in the
foreseeable future, it implies that it will be able to meet its contractual obligations and sets
resources according to its plans. Due to going concern assumption that business assets are
classified between fixed assets and current assets, whereby fixed assets are valued at cost minus
depreciation and current assets (which have a short life) are valued at cost or market value,
whichever is less

The going concern concept provides a sound basis for proper measurement of profit. In the
absence of assumption, an accountant will be compelled to determine the current value of assets
and liabilities every time he prepares financial statements.

4. Cost Concept

According to this concept, an asset is recorded in the books of account at the cost paid to acquire
it. This cost is the basis for all subsequent accounting for this asset

The cost concept does not mean that assets remain on the accounting record at their original cost.
This actual cost figure is systematically reduced over its life by the process of depreciation. In
future if the asset is sold, the profit or loss on sale would be calculated on the basis of cost price
less depreciation. If no cost has been paid to acquire any asset, it would not appear in the books
of account. For example, goodwill appears in the books only when it is purchased for a price but
not otherwise The acquisition cost of the asset is absolutely objective and the application of the
cost concept ensures that subjective judgments play no part in the values of assets shown in the
books.

5. Dual Aspect Concept (Accounting Equation Concept)

This is the very foundation of the universally applicable double entry book keeping system, it
stems from the fact that every transaction has a twofold effect and this is called dual (or double)
aspect or duality of a transaction.
In a business, the resources owned are called assets and the claims of various parties against
these assets are called equities. According to this dual aspect concept, total assets must be equal
to the claims of various parties against these assets. This has been earlier explained in the forms
an accounting equation as follows:

Asset = Equities
or

Assets = Capital+ Liabilities

When a transaction takes place, it may change the total of assets and equities but their relative
position remains unchanged.
In other words, every financial transaction behaves in a dual way. For example, when an asset
(e.g. machine) is purchased, another asset (cash or bank) is simultaneously decreased. Similarly,
when goods are sold, an asset (Le. stock of goods) is decreased, but the asset of cash is increased.

6. Accounting Period Concept

As per the going concern concept, a business is assumed to have an indefinitely long period of
life. But the owner of the business cannot wait for such a long time for the determination of
profit or loss from the operations of the business. Thus, there is felt a need to determine the profit
or loss at regular intervals of time. This means accounting period concept is related to going
concern concept.

The accountants generally choose some convenient segment of time, generally one year, for
determining the amount of profit or loss. This segment of time is known as accounting period.
The accounting period is defined as the interval of time at the end of which Profit and Loss
Account and Balance Sheet are prepared. This accounting period may be also be of shorter or
longer duration than one year. It may begin on any day of the year.
For example, it may be from 1st Jan. to 31st Dec. or from 1st April to 31st March. In India,
accounting period is of 12 months starting from 1st April each year. This is also required for tax
purposes.

7. Matching Concept (Accruals)

In the ascertainment of profit/loss of a business during an accounting period, it is necessary that

the revenues realised in the period should be 'matched with the expenses of the same period on a
comparable basis. In other words, when revenue is realised on goods sold during a period, all
costs attributes to those goods should also be charged as expenses to that very period.

Thus revenues and the relevant expenses should be correlated and matched so that a clear picture
is available. The essence of matching concept is that the revenues and expenses shown in the
Profit and Loss Account must belong to the same accounting period for which profit/loss is being
ascertained.
In simple words, all revenues earned during an accounting period, whether received or not, and
all expenses incurred, whether paid or not, must be taken into consideration when preparing
Profit and Loss Account for the period. Similarly, all amounts received or paid during the current
period but pertaining to either next year or previous year, should not be considered in
computation of profit or loss of the current period. One should understand that this is what
accrual basis of accounting states, i.e. adjustments have to be made for prepaid expenses,
outstanding expenses, unearned income and accrued incomes.

ACCOUNTING CONVENTIONS

The term accounting conventions is used to signify customs or traditions as a guide to the
preparation of accounting statements. These have emerged out of accounting practices over a
period of time. Some of the important accounting conventions are:

1. Convention of Consistency

In accounting, varied procedures and methods prevail for recording the same transaction or
event. This convention of consistency ensures that the same accounting method or procedure will
be followed for similar items year after year. This helps to achieve comparability of the financial
statements of an enterprise over the time. For example, depreciation on fixed assets may be
provided by straight line method or written down value method or any other method. Each
method has its own merits and demerits. The consistency convention requires that once a
company has decided on one of these methods, it should treat the same event in all subsequent
transactions in the same fashion. For example, if a company has adopted written down value
method of depreciation, the same method must be used in all subsequent years and the method of
depreciation should not be changed from year to year. If frequent changes are made in the
manner of handling a given class of transactions in the accounting records, comparison of
accounting figures of one period with that of the other period becomes difficult.

This convention does not imply that once a particular method of accounting has been adopted
then it cannot be changed. As stated earlier that accounting is a social science and therefore,
desirable changes can be made in it once in a while whenever the circumstances so demand but
not every now and then. Changes in accounting policy can also be made to comply with the
provisions of law and also to make accounts in accordance with the Accounting Standards.

2. Convention of Conservatism (Prudence Convention)

Prudence means policy of playing safe and avoiding risks. Convention conservatism implies
financial prudence. This convention requires that while preparing accounts and computing profit/
loss, the accountant should take into account the prospective or likely future losses but should
ignore prospective profits. Convention of conservatism is often stated as, "Anticipate no profits
but provide for all probable losses". This convention makes provision for anticipated future loses
but no provision is made for unrealized future profits. This means that this convention makes
early recognition of unfavourable events so as to play safe. For example, valuation of inventory
is at 'cost or market price, whichever is less'. This means that when value of inventory goes down
in market, the inventory value would be written off to the extent of reduction in value. But if
market value of inventory increases, the increase would not be recorded unless the profit is
actually realised by selling the stocks. Examples of the use of this convention are:

(1) Making provision for bad and doubtful debts

2) Not providing for discount on credit

(3) Showing the joint life policy at surrender value

(4) Valuing Inventory at cost or market price, whichever is less.

(5) Create Investment fluctuations reserve.

This conservatism convention is sometimes criticised on the ground that it may lead to window
dressing, encourage accountants to create secret reserves (eg by creating excess prov for bad and
doubtful debts). Thus, there is need to apply this convention with greater caution and care so that
there is no understatement of income and wealth

3. Convention of Materiality

This convention states that accounting should focus on only important and material Information
and should not waste resources in recording insignificant and irrelevant information. According
to AAA (American Accounting Association), "an item should be regarded as material if there is
a reason to believe that knowledge of it would influence the decision of an informed investor.
The term materiality is in fact a subjective term and whether an item is material or not should be
left to the discretion of the accountant. For example small items pen, pencil, calculator, etc. are,
no doubt, assets of the business in the technical sense. Every time press or pencil is used, a part
of the asset is used up. Theoretically, it may be possible to ascertain the depreciated value of the
pen or pencil, but the cost of such computation and recording is so disproportionate to the utility
of such computation that this exercise is not worthwhile. Therefore, such small items are shown
as consumed on the date of their purchase and treat their cost as revenue expenses because this is
not a material event. But this treatment is not extended to plant and machinery on which
depreciation is provided year after year because time is a material item.There is no exact line of
separating material events from immaterial events. The decision depends upon judgment and the
common sense.

4. Convention of Full and Fair Disclosure

The financial statements must disclose all the relevant and material Information about the
financial activities of a business enterprise in conformity with the generally accepted accounting
principles. The information disclosed should be full, fair and adequate. Full disclosure implies
that no information of substance should be omitted while fair disclosure means that accounting
principles have been applied in a fair manner so that financial statements report true and fair
view of the results of the business. Adequate disclosure means minimum set of information to
ensure that anything which influences the decision of the user must be reported.
This convention is vigorously applied in the company form of business organisation because of
separation of management and ownership. In pursuant of full disclosure, the companies Act has
prescribed a format of Balance Sheet and Profit and Loss Account. All major accounting policies
and other information are to be provided in the footnotes and annexes, etc. For example, in the
Balance Sheet, the basis of valuation of assets such as inventory, investments, etc should be
clearly stated. Similarly, change in the method of providing depreciation during the year, if any,
must also be disclosed.

ACCOUNTING STANDARDS

As explained earlier, Generally Accepted Accounting Principles (GAAP) is the collection of

basic concepts, conventions and standards that have been developed over a period of time and
accepted by accounting profession. But the problem with concepts and conventions is that they
are optional and permit the use of alternative policies and practices for treatment of various
items, such as depreciation, Inventory valuation, etc. Resultantly, different companies adopt
different accounting policies and practices for treatment of similar transactions. Interpretation of
financial Information is complicated by much diversity in accounting policies and practices.
Thus there is need to standardise these diverse accounting policies and practices by the
development of Accounting Standards.

Accounting standards may be defined as the written statements of accounting rules and
guidelines issued by an expert accounting body or by the Government or other regulatory body
covering the aspects of recognition, measurement, treatment, presentation and disclosure of
accounting transactions in the financial statements.

The objective of accounting standards is to standardise the diverse accounting policies and
practices, by curbing flexibility,

Advantages of Accounting Standards

1. It facilitates comparison of financial statements of different companies in the same industry.

2. Accounting standards reduce or eliminate any confusion regarding the variation in the
accounting treatment of different items appearing in financial statements.
3. Accounting standards improve the reliability and creditability of the financial statements and
create a sense of confidence in the minds of the users.

4. Accounting standards facilitate informed decision making in lending and investment.

5. Accounting standards may call for disclosure of certain information which may not be
required by law to be disclosed.
Accounting Standards In India

Every country has its own accounting standards. In India, Accounting Standard Board (ASB)
was constituted by the Institute of Chartered Accountants of India (ICAI) on 21st April, 1977.

The ICAI is a member of the International Accounting Standards Board (LASB), headquartered
in London. The IASB performs the function of publishing International Accounting Standards
(LAS) for published financial statements. In India, the ASB formulates accounting standards and
these are then issued under the authority of ICAL. The Accounting Standards (AS) will be
mandatory from the respective dates mentioned in the AS. It is the responsibility of the
management of the enterprise to ensure compliance with the Accounting Standard. The ICAI has
so far issued 32 accounting standards. The Companies Act states that Board of
Directors in their responsibility statement should state that in the preparation of the annual
accounts, the applicable accounting standards had been following with proper explanations
relating to material departure

Various accounting standards are listed below with the dates of their becoming mandatory. The
mandatory status of an accounting standard implies that it will be the duty of the auditor to
examine whether the accounting standard is complied with the presentation of the financial
statement covered by the audit.

INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS)

Introduction

Different countries employ different accounting standards while preparing balance sheet and
profit and loss account of companies. These financial statements may appear similar from
country to country but there may me differences caused by a number of economic or legal
circumstances This results in profit/loss figures of a company in a country being not comparable
with prof loss of similar companies in other countries. This means that if profit is computed as
per accounting standards of USA, the profits are $ 20 billion but when the same profit is
computed as per accounting laws of UK, the profit may turn out to be $12 billion and when
computed as per Indian Accounting Standards, it may be $ 14 billion. These are hypothetical
figures but the point is that profit computed as per accounting laws of different countries may
result in different amounts. In order to remove this discrepancy and bring uniformity across the
globe, the countries world over have decided to apply uniform standards of accounting. It is
common saying that accounting is the language of business. Thus, financial Information is a kind
of language. Now IFRS is the common language of financial reporting through which global
companies communicate with global investors rather than countries having a divergent set of
accounting standards applied differently in different countries.

Thus IFRS are global accounting standards for preparing financial statements of public
companies. These are the high quality financial accounting rules. An IFRS Foundation has been
set up in the private sector, which is a non-profit organization, being governed by a board of
trustees

International Accounting Standards Committee (IASC). It came into existence on 29th June,
1973 through an agreement by the professional accountancy bodies of a number of countries
including USA, Canada, Australia, Germany, France, Japan, UK, Netherland, Mexico, etc. It was
a London based body established for the purpose of setting International Accounting Standards
(IAS). In April 2001, this IASC was replaced by International Accounting Standards Board
(IASB).

International Accounting Standards Board (LASB). As stated above, the LASB was set up to
replace IASC. On 20 April, 2001, the IASB passed the following resolution: "All standards and
interpretations issued under the previous constitutions continue to be applicable unless they are
amended or withdrawn. The International Accounting Standards Board may amend or withdraw
International Accounting Standards and SIC Interpretations issued under the previous
constitutions of IASC as well as issue new standards and interpretations."

International Financial Reporting Interpretations Committee (IFRIC) and Standing Interpretation

Committee (SIC). The function of IFRIC is to provide a timely guidance on financial reporting
issues that arise in the context of current IFRC and prepare interpretations of IFRS for approval
by the IASB. This IFRIC has replaced the former SIC which was set up in 2002.

The IFRS Includes standards and interpretations approved by IASB and International
Accounting Standards (IASs) and SIC interpretations issued under the previous constitution.
Thus, International Financial Reporting Standards (IFRS) comprise of by IASB.

International Financial Reporting Standards (IFRS)- standards issued after 2001 International
Accounting Standards (IAS)- standards issued before 2001 by IASC.

Interpretations originated from the International Financial Reporting Interpretations Committee

(IFRIC) issued after 2001. Interpretations by Standing Interpretations Committee (SIC)-issued
before 2001.

The IASB has issued 15 IFRS and earlier IASC had issued 41 International Accounting
Standards (IASS). This means that 15 IFRS issued by IASB and 41 IASs issued by LASC are
part of IFRS.

Scope of IFRS

IFRS apply to all general purpose financial statements of profit-oriented entities engaged in
industrial, commercial, financial and other similar activities. These profit-oriented entities may
be, in corporate or other forms, include organizations such as mutual insurance companies and
other mutual cooperative entities which provide economic benefits such as dividends etc.,
directly or proportionately, to members/owners. IFRS are not designed to apply to not-for-profit
organizations in the private or public sectors or government sector.
The general purpose financial statements to which IFRS apply include a complete set of financial
statements are given below:

1. Statement of financial position

2. Statement of Income,

3. Statement of changes in equity. 4. Statement of cash flows, and~

5. Accounting policies and explanatory notes.

IFRS Interpretations Committee and SIC provide interpretations on the standards and
authoritative guidance on issues that may receive divergent views or unacceptable treatment

Objectives of IASB

The IASB has stated that the objectives of IFRS are to develop in the public interest.

a single set of high quality, understandable and enforceable global accounting standards that
require high quality, transparent and comparable information in financial statements and other
financial reporting to help participants in the various capital markets of the world and other users
of information to make economic decisions." Thus objectives are:

1. To promote the use and application of IFRS 2. To facilitate the adoption of IFRS through the
convergence of national accounting

standards of countries with IFRS.

Advantages of IFRS

Reliable, consistent and uniform financial reporting is important part of good corporate
governance practices worldwide in order to enhance the credibility of the businesses in the eyes
of investors to take informed investment decisions. The following benefits are derived from the
adoption of IFRS:

1 It produces reliable, timely and better quality financial information for the stakeholders and
regulators

2. It enhanced global comparability

3 It improved transparency of results

4. It helps to decreased cost of capital as the industry is able to raise capital from foreign markets
at a lower cost.

5: The ability to secure cross border listing is increased

6. It facilitates better management of global operations

7. It increases the growth of international business

IFRS has now become a universal financial reporting language and has gained recognition in
many parts of the world. As of now more than 100 countries have introduced IFRS for domestic
listed companies. It is encouraging to note that India will soon join the club as it has already set a
road map to converge with IFRS. Convergence will bring both opportunity and challenges for
companies in India.

Convergence of Indian Accounting Standards (Ind-AS) with IFRS

The terms 'adoption of IFRS' and 'convergence with IFRS are often used interchangeably, but
one needs to understand the technical difference between the two. Adoption of IFRS means that
the country adopting IFRS will be implementing IFRS in the form as issued by IASB and would
be 100% compliant of IFRS. However, convergence with IFRS means the Accounting Standard
Board (ASB) of the country applying IFRS will work together with IASB to develop high quality
Accounting Standards for its own use which are compatible with IFRS. Thus converged
Accounting Standards may be in variation with IFRS to some extent. In India, the Ministry of
Corporate Affairs (MCA) had originally planned to implement International Financial Reporting
Standards (IFRS) in a phased manner, starting from April 1 2011. However, owing to legal and
tax issues raised by companies, the implementation was deferred. Now, the Companies Act
2013, contains many requirements aligned to IFRS

India has now two parallel set of financial reporting standards the existing Indian

Accounting Standards (AS) and Indian Accounting Standards converged with Rs (nd- AS) , The
government has said the adoption of new Indian Accounting Standards (Ind AS)-converged with
IFRS-by domestic companies should voluntarily start from the 2015-16 fiacal and the same
would be mandatory from 2016-17.

MANAGEMENT ACCOUNTANTS AND IFRS

The management accountant is the financial controller of the company. He need to play a key
role in a smooth transition from the current Indian GAAP to a higher quality IFRS. The
management accountant has to play a significant role in making IFRS compatible with Indian
Accounting Standards by demonstrating his skill and expertise when full IFRS will be applicable
in Indian industries in not so distant future.

IFRS has also posed an academic challenge. There has to be sufficient manpower that should be
able to prepare, use and audit financial reports based on IFRS. In fact, the successful
implementation of IFRS in a vast country like India depends on the quality of academic input.
The Institute of Chartered Accountants of India and The Institute of Cost Accountants of India
have to contribute in this respect by supplying sufficient trained manpower for smooth transition
to IFRS regime
3 ACCOUNTING PROCESS (JOURNAL , LEDGER, TRIAL BALANCE)

JOURNAL

Journal is a book of first entry or original entry because all transactions are first recorded in this
book. It is a preliminary book to provide a chronological record i.e. in the order of dates of
transactions in which each transaction is recorded with relevant explanation of transaction i.e.,
narration. Journal is also known as journal proper or general journal or day book. The process of
recording transactions in journal is known as journalising. Transactions entered in journal are
then transferred (or posted) to ledger.

1. Date This column records the date when transaction is entered in journal.

2. Particulars In this column the accounts to be debited and credited are entered. The name of the
account to be debited is written first and in the next line, the account to be credited is written
preceded by the word To'. A brief explanation of the transaction known as Narration is also
given below the account to be credited. (see Illustration 3.1)

3. L.F. i.e. Ledger Folio means the page numbers of the ledger in which these accounts appear in
the ledger.

4. Debit (Dr) Amount In this column, amount to be debited is entered.

5. Credit (Cr) Amount In this column, amount to be credited is entered.

Recording In Journal

The transactions in journal are recorded on the basis of rules of debit and credit of double entry
system. All financial transactions are classified into three categories:

(i) transactions relating to persons,

(ii) transactions relating to business assets and properties, and
(iii) transactions relating to business expenses and incomes.
TRIAL BALANCE

When all ledger accounts have been prepared and balanced off, a list of all debit balances and
credit balances is prepared. In double entry system, the debits must be equal to credits. In other
words, the total of the debit balances must be equal to the total of the credit balances. The proof
of the equality of debit balances and credit balances is called a Trial Balance. Thus, a trial
balance may be defined as a two-column schedule listing the balances of all the accounts as they
appear in the ledger. The debit balances are listed in the left hand column and the credit balances
in the right hand column. The total of the two columns should agree. If the debit vide and credit
side of the trial balance are equal, it is proved that the account books are arithmetically correct.
But it is not a conclusive proof that there are no errors.

Objectives

The main objectives of preparing a trial balance are follows:

1. To test the arithmetic accuracy -When a trial balance agrees, it is taken as a proof that
double entry of all transactions is complete and arithmetically the books of account are correct.
But it should not be taken as a conclusive proof that there no errors because certain errors are not
disclosed by trial balance.

2. To detect errors - When the total of the debit balances is not equal to the total of the credit
balances, it means that there are certain errors.

3To provide data for preparing financial statements- Profit and Loss Account and Balance
Sheet are prepared on the basis of trial balance data and additional information.

FINAL ACCOUNTS (FINANCIAL STATEMENTS)

Introduction

The transactions of a business enterprise are first recorded in the journal, posted there from into
the ledger and then a trial balance prepared. The next step after preparation of the trial balance is
to prepare final accounts. The final accounts consist of the following basic financial statements:

1. Trading and Profit and Loss Account to ascertain the profit or loss of the business during
the financial year, and

2. Balance sheet to show the financial position of the business at the end of financial year.

Trading and Profit and Loss Account is split into (a) Trading Account (to show the gross
profit), and (b) Profit and Loss Account (to show the net profit). This is explained below.
 1. TRADING ACCOUNT

At the end of the year, the net profit/loss is to be ascertained. But before ascertaining net profit,
first of all gross profit is ascertained by preparing a trading account. Thus, trading account is
prepared to know the amount of gross profit or gross loss. Gross profit is the difference between
sales and cost of goods sold.

Thus, Gross Profit= Sales- Cost of goods sold

or Gross Profit + Cost of goods sold = Sales

2 PROFIT AND LOSS ACCOUNT

After preparing the Trading Account, the next step is to prepare Profit and Loss Account. The
purpose of preparing Profit and Loss Account is to calculate the net profit or net loss of the
business for a given accounting period. It was stated above that gross profit or loss as per trading
account is transferred to Profit and Loss Account. Thus, profit and loss account starts with gross
profit or gross loss, as the case may be. After this, all other expenses and losses (which have not
appeared in trading account) are shown on the debit side of the Profit and Loss Account. These
expenses may be classified as follows:

1. Office and Administrative Expenses : These include salaries paid to office staff, rent and
rates of office premises, office lighting, printing and stationary, postage, audit fee, legal
expenses, etc.

2. Selling and Distribution Expenses : These comprise of advertising expenses, salesmen's

salaries and commission, packing expenses, warehousing, freight on sales, export expenses,
upkeep of delivery vehicles, bad debts, insurance of finished stock, etc.

3. Financial changes: These include interest paid on bank or other loans and public deposits, etc.

4. Miscellaneous Expenses: Items like loss by theft or fire, donations, depreciation of fixed
assets, etc.

Other Incomes: On the credit side of Profit and Loss Account is shown incomes and gains,
other than sales. These include interest income, dividend income, rent received, discount
received, bad debts recovered, etc

CLOSING ENTRIES

At the end of the accounting year, all nominal accounts relating to expenses and incomes stand
closed because these are transferred to Trading Account or Profit and Loss Account. In other
words, all nominal accounts in the Trial Balance are transferred to Trading Account or Profit and
Loss Account with the help of closing entries. After all these accounts are transferred to Trading
and Profit and Loss Account, the balance of this account will show the net profit or loss.

A journal entry made for the purpose of closing an expense or income account is known as a
closing entry. The principal purpose of the year end process of closing income and revenue
accounts is to reduce their balances to zero. Since the incomes and expenses accounts provide the
information for preparing the Trading and Profit and Loss Account of a given accounting period,
it is essential that these accounts have zero balances at the beginning of each new period. The
closing entries have the effect of wiping the slate clean and preparing the ground for recording of
income and expense accounts during the succeeding accounting period.

BALANCE SHEET

After preparation of Trading and Profit and Loss Account, the next step is to prepare Balance
Sheet. The Balance Sheet is defined as a statement which sets out the assets and liabilities of firm
as at a certain date. The purpose of balance sheet is to show the financial position of the business
at the end of the accounting period. The balance sheet is not an account and the two sides are not
the debit and credit sides.
Trading and Profit and Loss Account is prepared by transferring all nominal accounts to either
Trading Account or Profit and Loss Account. The remaining real and personal accounts are used
for preparing Balance Sheet. Real accounts represent various assets and personal accounts relate
to capital, liabilities and assets.

Characteristics: The following characteristics of balance sheet should be noted for its better
understanding:

1. Balance Sheet is prepared as at a particular date and not for a period. It is on the last day of the
accounting year.

2. Balance Sheet is always prepared after preparing Trading and Profit and Loss account
prepared an

3. Balance sheet is not an account (unlike trading and profit and loss account). It is statement
portraying financial position of the business at a point of time.

4. Balance Sheet is based on the fundamental accounting equation i.e.

Assets= Capital + Liabilities.

Actually, a Balance Sheet is an elaboration of this equation in which the assets, liabilities and
owner's equity are listed and the sum of assets is shown to be equal to the sum on liabilities and
owner's equity. If it is not equal, there is certainly an error somewhere.
 FINANCIAL RATIO ANALYSIS

INTRODUCTION

Ratio analysis is a very powerful and most commonly used tool of analysis and interpretation of
financial statements. It concentrates on the Inter-relationship among the Figures appearing in the
financial statements. Ratio analysis helps to analyse the past performance of a company and to
make future projections. It allows various interested parties like management, shareholders,
potential investors, creditors, government and other analysts to make an evaluation of the various
aspects of company's performance from their own point of view and interest. For example
management and shareholders may be interested in the company's profitability while creditors
and debenture holders may be interested in the solvency of the company,

CLASSIFICATION OF RATIOS

Ratios may be classified as given below:

(A) Classification according to the nature of accounting statement from which the ratios
are derived

1. Balance Sheet Ratios. These ratios deal with the relationship between two items
appearing in the balance sheet, e.g., current ratio, liquid ratio, debt equity ratio, etc.

2. Profit and Loss Account Ratios. This type of ratios show the relationship between two items
which are in the profit and loss account itself, e.g. gross profit ratio, net profit ratio. operating
ratio, stock turnover ratio, etc.

3. Combined or Composite Ratios. These ratios show the relationship between items one of
which is taken from Profit and Loss Account and the other from the Balance Sheet, eg, Rate of
return on capital employed, debtors turnover ratio, stock turnover ratio, capital turnover ratio etc.

(B) Classification from the point of view of financial management or objective

1 Liquidity Ratios reveal the ability of a company to pay off its short term obligations

2.Capital Structure Ratios show the long-term solvency of a company.

3. Turnover Ratios measure the efficiency with which various assets are utilised.

4. Profitability Ratios indicate the success of a business in terms of profits.

In this Book, discussion of ratios is on the basis of this classification according to objectives.

LIQUIDITY RATIOS (Short Term Solvency)

Liquidity means ability of a firm to meet its current liabilities. The liquidity ratios, therefore, try
to establish a relationship between current liabilities, which are the obligations soon becoming
due and current assets, which presumably provide the source from which these obligations will
be met. In other words, the liquidity ratios 2. Quick ration answer the question: "Will the
company probably be able to meet its obligations when they become due ?" The failure of a
company to meet its obligations due to lack of adequate liquidity will result in bad credit ratings,
loss of creditor's confidence or even in law suits against the company. The following ratios are
commonly used to indicate the liquidity of business.

Important Liquidty ratios are:

1. Current Ratio
2. Quick Ratio

1. Current Ratio (Working Capital Ratio)

This ratio is most commonly used to perform the short-term financial analysis. Also known as
the working capital ratio, this ratio matches the current assets of the firm to its current liabilities.

Current Ratio = Current Assets / Current Liabilities

Significance and Objective: Current ratio throws good light on the short-term financial position
and policy. It is an indicator of a firm's ability to promptly meet its short-term liabilities.

A relatively high current ratio indicates that the firm is liquid and has the ability to meet its
current liabilities. On the other hand, a relatively low current ratio indicates that the firm will
find it difficult to pay its bills.

Normally a current ratio of 2:1 is considered satisfactory. In other words, current assets
should be twice the amount of current liabilities. If the current ratio is 1: 1, it means that funds
yielded by current assets are just sufficient to pay the amounts due to various creditors and there
will be nothing left to meet the expenses which are being currently incurred. Thus the ratio
should always be more than 1: 1. A very high current ratio is also not desirable because it
indicates idleness of funds which is not a sign of efficient financial management.

3.Quick ratio

This ratio is also known as acid test ratio or liquid ratio. It is a more severe test of liquidity of a
company than the current ratio. It shows the ability of a business to meet its immediate financial
commitments. It is used to supplement the information given by the current ratio.
 Quick Ratio= Quick Assets / Quick Liabiities

Normally a quick ratio of 1:1 is considered satisfactory

CAPITAL STRUCTURE RATIOS (Long Term Solvency)

Capital structure Ratios are also known as gearing ratios or Solvency ratios or leverage ratios.
These are used to analyse the long term Solvency of any particular business concern. There are
two aspects of long term Solvency of a firm (1) ability to repay the principal amount when due,
and (6) regular payment of interest. In other words long term creditors like debenture holders,
financial institution etc. are interested in the security of their loan amount as well as the ability of
the company to meet interest costs. They therefore, also consider the earning capacity of the
company to know whether it will be able to pay off interest on loan amount. Liquidity ratios
discussed earlier indicate short term financial strength whereas solvency ratios judge the ability
of a firm to pay off its long term liabilities.

Important solvency ratios are discussed below:

1. Debt-Equity Ratio

This ratio attempts to measure the relationship between long term debts and shareholders' funds.
In other words, this ratio measures the relative claims Financial Ratio Analysis of long term
creditors on the one hand and owners on the other hand, on the assets company. This ratio is
calculated by any of the two methods:

Method I

Debt Equity Ratio = Long term debts / Shareholders' funds.

Long term debts include debentures, long term loans, say from financial institutions etc.
Shareholders' funds, on the other hand, include share capital (both equity and preference) and
accumulated profits in the form of general reserve, capital reserve and any other fund that
belongs to the shareholders. Past accumulated losses and deferred expenditure like preliminary
expenses should be deducted while computing shareholders' funds.

Method II

Debt Equity Ratio =Total debts (Short term+Long term) / Shareholders funds
The debt equity ratio of 1: 1 is generally acceptable. From the point of view of the
company,the lower this ratio, the less the company has to worry in meeting its fixed obligations.
This ratio also indicates the extent to which a company has to depend upon outsiders for its
financialrequirements. In the long term financial condition of a business, the debt equity ratio
enjoys the same importance as the current ratio in the analysis of short term financial position.

2. Proprietary Ratio

This is a variant of debt equity ratio. It measures the relationship between shareholders funds and
total assets. Its formula is :

Proprietary ratio = Shareholders' funds /Total assets

Shareholders' funds comprise of ordinary share capital, preference share capital and all items of
reserves and surplus. Total assets include all tangible assets and only those intangible assets
which have a definite realisable value.

Significance and objective. Proprietary ratio shows the extent to which shareholders own the
business and thus indicates the general financial strength of the business. The higher the
proprietary ratio, the greater the long term stability of the company and consequently greater
protection to creditors. However, a very high proprietary ratio may not necessarily be good
because if funds of outsiders are not used for long term financing, a firm may not be able to take
advantage of trading on equity.

3. Interest Coverage Ratio (Debt Service Ratio or Fixed Charges Cover)

This ratio indicates whether the business earns sufficient profit to periodically pay the interest
charges.

Formula:
Interest Coverage Ratio= Earnings before tax and interest(EBIT) / Fixed interest charges
(Le. interest on debentures and long term loans)

Significance and Objective

This ratio is very important from lender's point of view because it indicates the ability of A
company to pay interest out of its profits. This ratio also indicates the extent to which the profits
of the company may decrease without in any way affecting its ability to meet its interest
obligations. The standard for this ratio for an industrial company is that interest charges should
be covered six to seven times.

4. Capital Gearing Ratio

This is the ratio between the fixed interest bearing securities and equity share capital. Fixed
income securities include debentures and preference share capital. Thus the ratio is:

Capital Gearing Ratio = Fixed Income securities /Equity shareholders' fund

A company is highly geared if this ratio is more than one. If it is less than one, it is low geared.
If the ratio is exactly one, it is evenly geared. A highly geared company has the advantage of
trading on equity.

TURNOVER RATIOS (Performance Ratios or Activity Ratios)

Turnover ratios are used to indicate the efficiency with which assets and resources of the firm are
being utilized. These ratios are known as turnover ratios because they indicate the speed with
which assets are being converted or turned over into sales. These ratios, thus, express the
relationship between sales and various assets. A higher turnover ratio generally indicates better
use of capital resources which in turn has a favourable effect on the profitability of the firm.

1 Inventory Turnover Ratio (Stock Turnover Ratio)

This ratio is calculated by dividing the cost of goods sold by average inventory
Inventory Turnover Ratio = Cost of goods sold / Inventory Turnover Ratio Average Stock
(or Inventory)

This ratio thus establishes the relationship between the cost of goods sold during a given period
and the average amount of stock carried during the period. Alternative Method. However, when
cost of goods sold figure is not available, inventory turnover ratio may be calculated by the
following methods.

Inventory Turnover Ratio= Sales / Average stock (at selling prices)

Inventory Turnover Ratio= Sales / Average stock at cos

Significance and Objectives. Inventory or stock turnover ratio indicates the efficiency of a
firm's inventory management. This ratio gives the rate at which stocks are converted into sales
and then into cash. A low inventory turnover ratio is an indicator of dull business, accumulation
of inventory, over investment in inventory or unsaleable goods etc. Generally speaking, a high
stock turnover ratio is considered better as it indicates that more sales are being produced by
each rupee of investment in stock but a higher stock turnover ratio may not always be an
indicator of favourable results. It may be the result of a very low level of stock which results in
frequent out-of-stock positions. Such a situation prevents the company from meeting customers'
demands and the company cannot earn maximum profits.

Thus too high and too low inventory turnover ratio may not be good and should be investigated
further. A company should have a proper inventory turnover ratio so that it is able to earn a
reasonable margin of profit. Turnover Ratio (Receivables

2 Debtor Turnover Ratio

This ratio indicates the relationship between net credit sales and trade debtors. It shows the ate at
which cash is generated by the turnover of debtors. It is computed

Debtors Turnover Ratio =Credit Sales /Average Debtors

The term debtors includes trade debtors and bills receivables. Doubtful debts are not deducted
from debtors. Moreover, debtors that do not arise from regular sales should be excluded,
Significance and Objectives. The significance of this ratio lies in the fact that debtors constitute
one of the important items of current assets and this ratio indicates as to how many days average
sales are tied up in the amount of debtors. The efficiency of debt collection is also indicated by
this ratio. A higher debtors turnover ratio indicates that debts are being collected more quickly.
Changes in this ratio show the changes in the company's credit policy or changes in its ability to
collect from its debtors. This ratio is an excellent supplement to the information provided by
current ratio.

3 Fixed Assets Turnover Ratio

This ratio indicates the efficiency with which the firm is utilising its investments in fixed assets
such as plant and machinery, land and building etc. It is computed as under:

Fixed Assets Turnover = Sales (or Cost of Sales) / Net Fixed Assets

The term net fixed assets means depreciated value of fixed assets.

Significance and Objectives.

Generally speaking, a high ratio indicates efficient utilisation of fixed assets in generating sales
and a low ratio may signify that the firm has an excessive Investment in fixed assets.

4. Capital Turnover Ratio

This ratio shows the relationship between cost of sales (or sales) and the total capital employed.

Capital Turnover Ratio =Cost of Sales (or Sales) / Total Capital Employed

The term capital employed includes the long term liabilities and total of shareholders funds.
From this are deducted non-operating assets (e.g., investments) and fictitious assets like
preliminary expenses, discount on the issue of shares, debit balance of Profit and Loss Account,

Significance and Objectives. This ratio shows the efficiency with which capital employed in a
business is used. A high capital turnover ratio indicates the possibility of greater profit and a
 PROFITABILITY RATIOS

Every business should earn sufficient profits to survive and grow over a long period of time. In
fact, efficiency of a business is measured in terms of profits. Profitability ratios are calculated to
measure the efficiency of a business.

Profitability of a business may be measured in two ways:

1. Profitability in relation to sales

2. Profitability in relation to investment.

Profitability in relation to sales indicates the amount of profit per rupee of sales, Similarly,
profitability in relation to investment indicates the amount of profit per rupee invested in assets.
If company is not able to earn a satisfactory return on investment, it will not be able to pay a
reasonable return to its investors and the survival of the company may be threatened.

Profitability Ratios Based on Sales. These ratios are:

1. Gross Profit Ratio. 2. Net Profit Ratio. 3. Operating Ratio.

1. Gross Profit Ratio (Gross Profit Margin)

This ratio expresses the relationship between gross profit and sales. It is calculated as

Gross Profit Ratio = Gross profit / Net sales * 100

Net sales means sales minus sales returns. Gross profit is sales minus cost of goods sold. This
ratio, thus may also be computed as

Gross Profit Ratio = Net sales-Cost of goods sold / Net sales * 100

This ratio is usually expressed in percentage.

Significance.

Gross profit ratio indicates the average margin on the goods sold. It shows whether the selling
prices are adequate or not. It also indicates the extent to which selling prices may be reduced
without resulting in losses.
A low gross profit ratio may indicate a higher cost of goods sold due to higher cost of
production. It may also be due to low selling prices. A high gross profit ratio, on the other
hand,Indicates relatively lower cost and is a sign of good management.

2 Net profit ratio ( Net profit margin )

There are two variations of this ratio:

1 Net Operating Profit Ratio,

2 Net Profit Ratio.

1 Net Operating Profit Ratio

This is the ratio of net operating profit to net sales.

Net Operating Profit Ratio = Net operating profit / Net sales *100

2 Net Profit Ratio

This is the ratio of net profit to net sales. It is computed as:

Net Profit Ratio = Net profit / Net sales x 100

Significance and Objectives. The net profit ratio is the overall measure of a firm's ability to turn
each rupee of sales into profit. It indicates the efficiency with which a business is managed. A
firm with a high net profit ratio is in an advantageous position to survive in the face of rising cost
of production and falling selling prices. Where the net profit ratio is low, the firm will find it
difficult to withstand these types of adverse conditions. Comparison of net profit ratio with other
firms in the same industry or with the previous years will indicate the scope for improvement.
This will enable the firm to maximise its efficiency.

3 Operating Ratio
This is also an important profitability ratio. This ratio explains the relationship between cont of
goods sold and operating expenses on the one hand and net sales on the other.

Operating Ratio = Cost of goods sold+Operating expenses / Net sales*100

Significance and Objective. The operating ratio is the yardstick to measure the efficiency with
which a business is operated. It shows the percentage of net sales that is absorbed by cost of
goods sold and operating expenses. A high operating ratio is considered unfavourable because it
leaves a smaller margin of profit to meet non-operating expenses. On the other hand, a lower
operating ratio is considered a good sign.

4. Return of Equity (ROE)

This ratio has two variations.

(1) Return on Proprietors Equity.

This is also known as Return on Shareholders' Funds. It shows the ratio of net profit to
owners' capital.

Return on Proprietor's Equity=Net profit after taxes and interest / Shareholders' Funds *
100

Net profit for the purpose of this ratio is calculated after charging interest on long term liabilities
and payment of taxes. Shareholders' funds include equity capital, preference capital, capital
reserve, general reserve and other undistributed profits. For the purpose of this ratio, average of
the figure relating to shareholders' funds in the beginning and at the end of the period is taken.

Significance and Objectives. Return on shareholders funds is a very effective measure of the
profitability of an enterprise. This ratio measures the return on the total equity of the
shareholders. It should be compared with the ratios of other similar companies to determine
whether the rate of return is attractive. In fact, this ratio is one of the most important
relationships in financial statement analysis.

(b) Return on Equity Capital

This ratio establishes the relationship between the net profit available to equity shareholder and
the amount of capital invested by them.

Return on Equity Capital =Net Profit after interest, taxes and preference dividend / Equity
shareholders' funds * 100

Net profit for the purpose of this ratio is taken after dividend payable to preference shareholders,
if any. Equity shareholders funds include equity capital, reserves and other undistributed profits.

Significance and Objectives. This ratio shows the profit percentage for equity shareholders. A
high rate of return on equity shareholders funds is favoured by investors and a higher market
valuation is placed on such shares. This ratio is used for inter-firm comparison to judge the
comparative profitability of different firms.

Earning Per Share (EPS)

This ratio measures the earnings per equity share Le it measures the profitability of the firm on a
per share basis. It is calculated as follows:

Earning per share = Net profit after taxes - Preference dividend / No. of equity shares

EPS is one of the most commonly quoted and widely publicised ratio. Accounting standard (AS)
20-Earning Per Share has been made mandatory in nature by the Institute of Chartered
Accountant of India. Accordingly, each company should show earning per share in its Profit and
Loss Account

Dividend Pay-out Ratio (Pay-out Ratio)

It indicates the percentage of equity share earnings distributed as dividends to equity

shareholders. Its formula is :

Dividend Pay-out Ratio = Dividend per share / Earning per share (EPS)

Dividend Yield Ratio

Dividend is declared by a company as a percentage of par value or paid up value of shares but
yield is calculated in the market value of shares.

Dividend yield ratio = Dividend per equity share / Market price per equity share

This ratio is important for those investors who make investment decisions for the purpose of
earning a reasonable yield on the amount of investment.

Price Earning Ratio (P/E Ratio)

This ratio is the market price of shares expressed as multiple of earning per share (IPS).

P/E ratio = Market price per equity share / Earning per share

This ratio guides investors to decide whether to buy shares of a company or not. A high P/E ratio
is an indicator of confidence of investors in the earnings growth potential.

ADVANTAGES AND LIMITATIONS OF RATIO ANALYSIS

Advantages: As stated earlier, ratio analysis is one of the most important tools of financial
analysis. Financial health of a business can be diagnosed by this tool. Such an analysis offers the
following advantages :

1. Useful in analysis of financial statements. Ratio analysis is the most important tool
available for analysing the financial statements i.e. Profit and Loss Account and Balance Sheet.
Such analysis is made not only by the management but also by outside parties like bankers
creditors, investors

2. Useful in improving future performance. Ratio analysis indicates the weak spots of the
business. This helps management in overcoming such weaknesses and improving the overall
performance of the business in future.

3. Useful in inter-firm comparison. Comparison of the performance of one firm with another
can be made only when absolute data is converted into comparable ratios.

4. Useful in judging the efficiency of a business. As stated earlier, accounting ratios help in
judging the efficiency of a business. Liquidity, solvency, profitability etc. of a business can be
easily evaluated with the help of various counting ratios like current ratio, liquid ratio, debt
equity ratio, net profit ratio, etc. Such an evaluation enables the management to judge the
operating efficiency of the various aspects of the business.

5. Useful in simplifying accounting figures. Complex accounting data presented in Profit and
Loss Account and Balance Sheet is simplified, summarised and systematised with the help of
ratio analysis so as to make it easily understandable. For example, gross profit ratio, net profit
ratio, operating ratio etc. give a more easily understandable picture of the profitability of a
business than the absolute profit figures

Limitations of Ratio Analysis

Ratio analysis is a very useful technique. But one should be aware of its limitations as
well.The following limitations should be kept in mind while making use of ratio analysis in
interpreting financial statements.

1. Reliability of ratios depends upon the correctness of the basic data. Ratios obviously will
be only as reliable as the basic data on which they are based. If the balance sheet or profit and
loss account figures are themselves unreliable, it will be a mistake to put any reliance on the
ratios worked out on the basis of that Balance Sheet or Profit and Loss Account.

2. An individual ratio may by itself be meaningless. Except in a few cases, an accounting ratio
may by itself be meaningless and acquires significance only when compared with relevant ratios
of other firms or of the previous years. In fact, ratios yield their best advantage on comparison
with other similar firms; also if ratios for a year are compared with ratios in the previous years, it
will be a useful exercise. Comparison is the essential requirement for using ratios for interpreting
a given situation in a firm or industry.

3 . Ratios are not always comparable. When the ratios of two firms are being compared, it
should be remembered that different firms may follow different accounting practices. For
example, one firm may charge depreciation on straight line basis and the other on diminishing
value. Similarly, different firms may adopt different methods of stock valuation. Such
differences will not make some of the accounting ratios strictly comparable. However, use of
accounting standards makes ratio comparable.

4. Ratios sometimes give misleading picture. One company produces 500 units in one year and
1,000 units the next year; the progress is 100%. Another firm produces 4,000 units in one year
and 5,000 in the next year, the progress is 25%. The second firm will appear to be less active
than the first firm, if only the rate of increase or ratio is compared. It will be much more useful if
absolute figures are also compared along with rate of increase-unless the firms being compared
are equal in all respects. In fact, one should be extremely careful while comparing the results of
one firm with those of another firm if the two figures differ in any significant manner, say in
size, location, degree of automation or mechanisation.

5 Ratios ignore qualitative factors. Ratios are as a matter of fact, tools of quantitative analysis.
It ignores qualitative factors which sometimes are equally or rather more important than the
quantitative factors. As a result of this, conclusions from ratio analysis may be distorted.

6. Change in price levels makes ratio analysis ineffective. Changes in price levels often make
comparison of figures for a number of years difficult. For example, the ratio of sales to fixed
assets in 2010 would be much higher than in 2004 due to rising prices because fixed assets are
still being expressed on the basis of cost incurred a number of years ago while sales are being
expressed at their current prices.

7. There is no single standard for comparison. Ratios of a company have meaning only when
they are compared with some standard ratios. Circumstances differ from firm to firm and the
nature of each industry is different. Therefore, the standards will differ for each industry and the
circumstances of each firm will have to be kept in mind. It is difficult to find out a properbasis of
comparison. Therefore, the performance of one industry may not be properly comparable with
that of another. Usually it is recommended that ratios should be compared with the average of
the industry. But the industry averages are not easily available.

8. Ratios based on past financial statements are no indicators of future. Accounting ratios
are calculated on the basis of financial statements of past years. Ratios thus indicate what has
happened in the past. Since past is quite different from what is likely to happen in future, it is
difficult to use ratios for forecasting purposes. The financial analyst is more interested in what
will happen in future. The management of a company has information about the company's
future plans and policies and is, therefore, able to predict future to a certain extent. But an
outsider analyst has to rely only on the past ratios which may not necessarily reflect the firm's
future financial position and performance.
FUND FLOW STATEMENT

MEANING OF FUNDS FLOW STATEMENT

The funds flow statement is an attempt to report the flow of funds between various assets and
Liabilities and owner's capital during an accounting period. In the words of Smith and Brown,
Funds Flow Statement is prepared to indicate in summary form, changes (and trends, if prepared
regularly) occurring in items of financial position between two different balance sheet dates."
Such a statement is prepared to indicate the increases and utilisation of resources of a business
during an accounting period. A funds flow statement is also known by various other names such
as Statement of Sources and Application of Funds, Where Got Where Gone Statement' Statement
of

Funds Generated and Expanded, etc. In order to clearly understand the meaning of Funds Flow
Statement, it is necessary to understand the meaning of the terms Funds' and Flow

Meaning of 'Funds'

The term funds has different meanings. However, for the purpose of funds flow statement, the
term funds' means Net Working Capital' also known as Net Current Assets. It is defined as the
difference between current assets and current liabilities. Thus:

Fund = Current Asset - Current Liabilities

WHAT IS 'FLOW OF FUND' ?

Taking fund' in the sense of 'net working capital', flow of fund arises when the net effect of a
transaction is to increase or decrease the amount of working capital. When a transaction results
in the increase of fund, such a transaction is said to be a source of fund. On the other hand, if a
transaction results in the decrease of fund, such a transaction is said to be an application of fund.
A transaction that does not result in either increase or decrease of fund does not result in the flow
of funds.

STATEMENT OF CHANGES IN WORKING CAPITAL

The statement of sources and application of funds shows the difference between the aggregate of
sources and total applications as either increase or decrease in working capital. This variation in
working capital can be verified by preparing a statement of changes in working capital. This
statement, unlike statement of sources and applications, is prepared with the help of only current
assets and liabilities. A proforma of such a statement of changes in working capital is given
below. It should be remembered that such a statement is prepared only from the information
given in the balance sheets and there is no effect on this statement of any additional information
supplied outside the balance sheet.

DISTINCTION BETWEEN FUNDS FLOW STATEMENT AND PROFIT AND LOSS

ACCOUNT

The main points of difference between the two are as follows:

1. Legal requirement. Preparation of Profit and Loss Account of a company is compulsory

under law and has to be published as a part of Final Accounts. Preparation of Panda Flow
Statement is not compulsory under law.

2. Purpose. Purpose of preparing Profit and Loss Account is to calculate

net profit or loss. On the other hand, the purpose of Funds Flow Statement is to calculate net
increase or decrease in working capital of business during a period. In other words, Profit and
Loss account reveals profitability while Funds Flow Statement reveals liquidity.

3. Items recorded. Profit and Loss Account records items of revenues and expenses while Funds
Flow Statement records source and applications of funds Le. net working capital.

4. Types of activities. Profit and Loss Account provides information about operating activities
of a business while Funds Flow Statement provides information about its financial and investing
activities.

5. Types of accounts. Profit and Loss Account deals with nominal accounts while Flow
Statement deals with non-current accounts Funds

DISTINCTION BETWEEN FUNDS FLOW STATEMENT AND BALANCE SHEET

The main points of distinction between Funds Flow Statement and Balance Sheet are as follows:

1. Legal requirements. Preparation of Balance Sheet of a company is compulsory and it has to

be prepared as per schedule VI of the companies Act. Preparation of Funds Flow Statement is
not compulsory under law.

2. Purpose of preparing Balance Sheet is to show the financial position of a business at

particular date while the purpose of Funds now Statement is to show net increase or decrease in
working capital during a period

3. Basis of preparation. Balance sheet is prepared on the basis of trial balance and additional
information while Funds Flow Statement is prepared on the basis of two consecutive balance
sheets and additional Information.
4. Type of information. Balance Sheet shows assets, liabilities and capital at a point of time
while Funds Flow Statement reveals flow of funds during a period of time Le movement of
resources

5. Types of accounts. Balance Sheet contains balance of personnel and real accounts while
Funds Flow Statement deals with those accounts which affect working capital ie non-current
accounts.

ADVANTAGE AND USES OF FUNDS FLOW STATEMENT

The Funds Flow Statement is an extremely useful tool for the management. It gives a clear
picture of the of changes in the working capital position of the company during a period. It
shows the various sources from which funds are obtained and also the uses to which these funds
are put to. The information given by funds flow statement is not apparently available from other
financial statements. The main uses of Funds Flow Statement are listed below

1. Guides proper use of available funds. For the continued financial health or well-being of a
firm, it is necessary to use available working capital carefully and properly. The Funds Flow
Statement shows up boldly how the funds made available in a year were used. Thus, the wisdom
or otherwise of management's decisions in this regard will be revealed in the Funds Flow
Statement.

2. Acts as a basis for financial plan and budgeting. The Funds Flow Statement can be used
easily as a basis for preparing financial plans for the coming period. On an estimated basis, it
becomes the financial budget for the next year. In fact, when large sums are borrowed and
repayment is made by annual instalments. Funds Flow Statements prepared in anticipation for
future years will help determine the amount that can be paid each year. Thus the Statement can
serve as a tool for planning also.

3. It gives early warning of coming financial dangers. To Judge whether a firm faces any
danger of becoming sick, i.e., ef facing financial difficulties, it is essential to know the amount of
funds generated by operations. Le, the inflow from operations. If the flow is not big enough, the
firm will not enjoy good financial position: if it is minus, it will face great difficulties. The fund
Flow Statement thus may give early warning of coming financial dangers if the inflow is small
and the use of funds is not proper.

4. It reveals the net result of business operations during the year in terms of cash. The profit
shown by the Profit and Loss Account can be manipulated by the management by changing the
amount of depreciation and the amount of other write offs. It is because these amounts are the
results of the personal decisions of the management. For example, if amount of depreciation is
increased the profit will decrease and vice versa. Similarly, if amount of goodwill written off, the
profit will reduce to that extent. This means it larger not easy to compare profit in two years or of
two firms. But profit plus depreciation and other write offs will be the same and comparable.
This means inflow from operations Le. the total profit before various write offs is quite reliable f
comparison purposes The Funds Flow Statement always shows prominently the funds from
operations and is thus useful.
5. Helps in borrowing. Banks and other financial institutions like IDBI, State Finance
Corporations etc. like to satisfy themselves about the ability of the company to repay the loans
Before lending, these institutions like to see projected Funds Flow Statements which indicates
ability or otherwise of the company to pay off the loan as per the terms of repayment.

CASH FLOW STATEMENT

INTRODUCTION AND MEANING

A statement of changes in financial position may be made out in two ways:

(a) Working capital basis ie. Funds Flow Statement, and

(b) Cash basis ie. Cash Flow Statement.

A cash flow statement is statement of changes in cash position between the beginning and end of
the period. It is a statement which summarises the sources of cash from which cash payments are
made during a particular period of time, say a month or a year. In other words, a cash flow
statement shows the various sources of cash inflow and uses of cash outflow during a period thus
explaining the changes in cash position of the business.

A cash flow statement is not very much different from a funds flow statement. In fact, the maim
difference between funds flow statement and cash flow statement relates to meaning and concept
of the term 'fund. The term 'fund' as used in funds flow statement means net working capital i.e.
the difference between current assets and current liabilities. But in a cash flow statement the term
'cash' means cash fund as defined by AS-3

.
ACCOUNTING STANDARD-3 (AS-3): CASH FLOW STATEMENT

The Institute of Chartered Accountants of India (ICAI) issued AS-3 (Revised): Cash Flow
Statement in March 1997. This standard supercedes AS-3: Changes in Financial Position which
was issued in June 1981. It is in tune with international trends because Cash Flow Statements ha
replaced Statement of Changes in Financial Position in almost every country.

This AS-3 has become mandatory w.e.f. 1-4-2001 for the following enterprises : (1) Enterprises
whose equity or debt securities are listed or going to be listed on a recognized stock exchange in
India. (1) All other commercial, industrial and business reporting enterprises whose turnover for
the accounting period exceeds 50 crores.

The companies in respect of which AS-3 is mandatory are required to comply with AS-3 under
Sec. 211 of the Companies Act, 1956. This means that statutory auditors of such companies are
required to give an assertion in respect of companies with AS-3.
OBJECTIVES AND USES OF CASH FLOW STATEMENT

1. Useful in cash planning. A cash flow statement proves very useful to management by
providing a basis to evaluate the ability of a company to generate cash. A cash flow statement
prepared on a estimated basis for the next accounting period enables the management to know
how much cash ca be generated internally and how much it should arrange from outside. Such
estimated amounts are used for preparing cash budget.

2. Assesses cash flow from operating activities, Cash flow statement provides information
about cash generated from operating activities. It provides explanation for the difference net
profit and cash from operations. Cash provided by operating activities is very important to assess
the ca generated by internal sources.

3. Payment of dividends. Decisions to pay dividends cannot be based on net profit only
Availability of profit in the form of cash is also important for dividend disbursement. Thus cash
provided by operating activities assumes importance for declaration of dividend.

4. Cash from investing and financing activities. Cash flow statement provides information not
only about cash provided by operating activities but also by non-operating activities under 2
heads, namely investing activities and financing activities. This helps to explain the overall
liquidity position of the enterprise and its ability to meet its cash commitments.
5. Explains reasons for surplus or shortage of cash. A business may have made profit and yet
running short of cash. Similarly a business may have suffered a loss and still has sufficient cash
at the bank. A cash flow statement discloses reasons for such increases or decreases of cash
balance.

MANAGEMENT ACCOUNTING

MEANING AND DEFINITION

The term 'management accounting is the modern concept of accounts as a tool of management.
In the words of Robert Anthony. "Management accounting is concerned with accounting
information that is useful to management." In simple words, the term management accounting is
applied to the provision of accounting information for management activities such as planning,
controlling and decision-making, etc.

According to the Institute of Chartered Accountants of England, "any form of accounting which
enables a business to be conducted more efficiently may be regarded as management accounting.
Management accounting information can help managers identify problems, solve problems and
evaluate performance.

CHARACTERISTICS OR NATURE OF MANAGEMENT ACCOUNTING

It is clear from the definitions of management accounting that it is concerned with accounting
that is useful in decision making. The main characteristics of management accounting are as
follows:

1 Useful in decision making. The essential aim of management accounting is to assist

management in decision making and control. It is concerned with all such information which can
have useful to management in decision making.

2. Financial and cost accounting information. Basic accounting information useful for
management accounting s derived from financial and cost accounting records.
3. Internal use. Information provided by management accounting is exclusively for use by
management for internal use. Such information is not to be given to parties external to the
business like shareholders, creditors, banks, etc.

4. Purely optional Management accounting is a purely voluntary technique and there is no

statutory obligation. Its adoption by any firm depends upon its utility and desirability.

5. Concerned with future. As management accounting is concerned with decision making, it is

related with future because decisions are taken for future course of action and not the past.
6. Flexibility in presentation of information. Unlike financial accounting, in management
accounting there are no prescribed formats for presentation of information to management. The
form of presentation of information is left to the wisdom of the management accountant who
decides which is the most useful format of providing the relevant information, depending upon
the utility of each type of form and information.

SCOPE OF MANAGEMENT ACCOUNTING

Management accounting has a very wide scope. It includes not only financial accounting and
cost accounting but also all types of internal financial controls, internal audit, tax accounting,
office services, cost control and other methods and control procedures. Thus scope of
management accounting, inter alia includes the following:

1. Financial accounting. Financial accounting provides basic historical data which helps
management to forecast and plan its financial activities for the future period. Thus for an
effective and successful management accounting, there should be a proper and well designed
financial accounting system.

2. Cost accounting. Many of the techniques of cost control like standard costing and budgetary
control and techniques of profit planning and decision-making like marginal costing, CVP
analysis and differential cost analysis are used by the management accounting.

3. Budgeting and forecasting. In order to plan business activities for the future, forecasting and
budgeting play a very significant role. Forecasting helps in the preparation of budgets and
budgeting helps management accountant in exercising budgetary control.

4. Tax planning. In order to take advantage of various provisions of tax laws, management
accountant has to depend upon tax accounting and planning to minimise its tax liabilities and
save more funds for the business.

5. Reporting to management. For effective and timely decisions, there should be a system of
prompt and intelligent reporting to management. Both routine and special reports are prepared
for submission to top management, middle order management and operating level management
depending on their requirements.

6. Cost control procedures. Any system of management accounting is incomplete without

effective cost control procedures like inventory control, labour control, overhead control,
budgetary control, etc.

7. Statistical tools. Various tools of analysing and presenting statistical tables, charts, etc., are
used in preparing reports for use by the management. 8. Internal control and internal audit.
Management accountant heavily depends on internal data like graphs, financial controls like
internal audit and internal check to plug loop holes in the financial system of the concern.

9. Financial analysis and interpretation. Management accountant employs various techniques

to analyse and interpret financial data to make it understandable and useable to the management.
 Such analysis helps management to achieve objectives of management in a more efficient
manner.

10. Office services. Management accountant is expected to maintain and control office routines
and procedures like filing, copying, communicating, electronic data processing and other allied
services.

FINANCIAL ACCOUNTING AND MANAGEMENT ACCOUNTING COMPARISON

Financial accounting and Management accounting are two major sub-systems of accounting F
information system. Both are concerned with revenues and expenses, assets and liabilities and
cash flows. Both therefore involve financial statements. But the major differences between the
two arise because they serve different audiences. The main points of difference between the two
are as follows:

Basis Financial Accounting Management Accounting

External and internal Financial accounting information is mainly Management accounting information
users intended for external users like investors, is mainly meant for internal user, i.e.
shareholders creditors, Govt. authorities, management.
etc.
Accounting method It is based on double entry system for It is not based on double entry
recording system.

Past and future data It represents past or historical data It may use past data for future
projection
Accounting standard Companies are required to prepare It is not bound by accounting
financial account according to accounting standard it may use any practice
standard issued by ICAI which generates useful information
to management
Type of statement It prepare general purpose statement like Special purpose reports are prepared
prepared profit and loss account and balance sheet
Periodic and continuous Profit and loss account and balance sheet Reports are prepared frequently
reporting are prepared usually in a year to year basis
Monetary and non It provides information in terms of money It may apply monetary and non
monetary monetary units of measurement
measurements

COST ACCOUNTING AND MANAGEMENT ACCOUNTING

An examination of the meaning and definitions of cost accounting and management accounting
indicates that the distinction between the two is quite vague. Some writers even consider the two
areas as synonymous while others distinguish between the two. Horngren, a renowned author on
the subject, has gone to the extent of saying, "Modern cost accounting is often called
management accounting. Why? Because cost accountants look at their organisation through
manager's eyes. Thus managerial aspects of cost accounting are inseparable from manageme
accounting. One point on which all agree is that these two types of accounting do not have c cut
territorial boundaries. However, distinction between cost accounting and management
accounting may be made on the following points:
LIMITATIONS OF MANAGEMENT ACCOUNTING

Management accounting is a very useful tool of management. However, it suffers from certain

limitations as stated below:

1. Based on historical data. Management accounting helps management in making decisions for
the future but it is mainly based on the historical data supplied by financial accounting and cost
accounting. This implies that historical data is used for making future decisions. The accuracy
and dependability of such data will leave their mark on the quality of managerial decisions. In
other words, if past data is not accurate, management decisions may not be correct.

1. Lack of wide knowledge. The management accountant should have knowledge of not only
financial and cost accounting but also many allied subjects like economics, management,
taxation, statistical and mathematical techniques etc. Lack of knowledge of these subjects on the
part of management accountant limits the quality of management accounting.
2. Complicated approach. Management accounting provides mass of data using various
accounting and non-accounting subjects for decision making purpose. But sometimes
management avoids this complicated and lengthy course of decision making and makes decisions
based on intuition. This leads to unscientific approach to decision making.

3. Not a substitute of management. Management accounting only provides information to

management for decision making but it is not a substitute of management and administration.

4. Costly system. The installation of management accounting system in an organisation is a

costly affair as it requires a wide network of management information system, rules and
regulation All this requires heavy investment and small concerns may not be able to afford it.

5. Developing stage. Management accounting is a relatively recent development and it has not
fully developed as yet. This limits the utility of this system to management in making perfect and
correct decisions.

7. Lack of objectivity. The interpretation of information provided by management accounting

may be influenced by personal bias of the interpreter of data. This tells upon the quality of
managerial decisions.

8. Resistance from staff. The existing accounting and management staff may not welcome the
introduction of management accounting system. This may be because they look at the system
with suspicion that it will add to their work and responsibilities.

BUDGETING AND BUDGETORY CONTROL

MEANING AND DEFINITION OF BUDGET

Budget refers to a plan relating to a definite future period of time expressed in monetary and/or
quantitative terms. In relation to business, a budget is a formal expression of the expected
incomes and expenditures for a definite future period. The Chartered Institute of Management
Accountants (C.L.M.A.) London, has defined a budget as "a financial and/or quantitative
statement, prepared prior to a defined period of time of the policy to be pursued during that
period for the purpose of attaining a given objective." It may include income, expenditure and
employment of capital.
In this words of Gorden Shillinglaw, a business budget is "a pre-determined detailed plan of
action, developed and distributed as a guide to current operations and as a partial basis for
subsequent evaluation of performance."
According to Brown and Howant, "A budget is a pre-determined statement of management
policy during a given period which provides a standard for comparison with the results actually
achieved”

Characteristics:

1) A budget is primarily a planning device but it also serves as a basis for performance
evaluation and control

2) A budget is prepared either in money terms or in quantitative terms or in both

3) A budget is prepared for a definite future period.

4) Purpose of a budget is to implement the policies formulated by management for attaining the
given objectives

Budgeting

The act of preparing budgets is called budgeting. In the words of J. Betty. "The entire process of
preparing the budgets is known as budgeting”

MEANING AND DEFINITION OF BUDGETARY CONTROL

Budgetary control is a system of controlling costs through preparation of budgets. Budgeting is

thus only a part of the budgetary control.

According to CIMA, London, “Budgetary control is the establishment of budgets relating to the
responsibilities of executives of a policy and the continuous comparison of the actual with the
budgeted results, either to secure by individual action the objective of the policy or to provide a
basis for its revision”
In the words of Brown and Howard, “Budgetary control system is a system of controlling costs
which includes the preparation of budgets co-ordinating the departments and establishing
responsibilities, comparing actual performance with the budgeted and acting upon results achieve
maximum profitability”

Characteristics-The main characteristics of budgetary control are :

(a) Establishment of budgets for each function/department of the organisation

.
(b) Comparison of actual performance with the budgets on a continuous basis
(c) Analysis of variations of actual performance from that the budgeted performance to know the
reasons thereof.

(d) Taking suitable remedial action, where necessary.

(e) Revision of budgets in view of changes in conditions.

The technique of budgetary control is now widely used in the business world. Mary businesses
fail because of lack of efficient planning which could have revealed that the business should not
have been started or that one should have been prepared to face serious dangers ahead.

OBJECTIVES OF BUDGETARY CONTROL

The following are the main objectives of a budgetary control system.

1 Planning. A budget provides a detailed plan of action for a business period of time Detailed
plans are drawn up relating to production requirements, labour needs, advertising and sales
promotion performance med at development activities, capital additions, etc. Planning helps in
anticipating many problems long before they may arise and solutions can be sought though
careful study. This most business emergencies can be avoided by planning. In brief, budgeting
forces management to think ahead, to anticipate and prepare for the situation.

2 Co-ordination. Budgeting aids managers in co-ordinating their effects so that objectives the
organisation as a whole harmonize with the objectives of its divisions, effective planning and
organizing contribute a lot in achieving coordination. There should be coordination in the
budgets of various departments.

3. Communication. A budget is a communication device. The approved budget copies are

attributed to all management personnel which provides not only adequate understanding and
knowledge of the programmes and policies to be followed but also alerts about the restrictions to
be adhered to. It is not the budget itself that facilitates communication, but the vital information
communicated in the act of preparing budgets and participation of all responsible individual in
this act.

4. Motivation. A budget is a useful device for motivating managers to perform inline with the
company objectives. If individuals have actively participated in the preparation of budgets, it acts
as a strong motivating force to achieve the targets

5. Control. Control is necessary to ensure that plans and objectives as laid down in the budgets
are being achieved. Control, as applied to budgeting, is a systematised effort to keep the
management informed of whether the planned performance is being achieved or not. For this
purpose, a comparison is made between plans and actual performance. The difference between
the two is reported to the management for taking corrective action
6. Performance evaluation. A budget provides a useful means of informing manager how well
they are performing in meeting targets they have previously helped to set in y companies there is
a practice of rewarding employees on the basis of their achieving the budget targets or promotion
of a manager may be linked to his budget achievement record.
Accounting for Management

ADVANTAGES OF BUDGETARY CONTROL

Budgetary control provides the following advantages

1. Budgeting compels managers to think ahead-to anticipate and prepare for changing conditions.

2. Budgeting co-ordinates the activities of various departments and functions of the business

3. It increases production efficiency, eliminates waste and controls the casts

4 It pinpoints efficiency or lack of it.

5 Budgetary control aims at maximisation of profits through careful planning control

6 It provides a yardstick and against which actual results be compared.

7. It shows management where action is needed to remedy a situation &. It ensures that working
capital is available for the efficient operation of can business.

8. It directs capital expenditure in the most profitable direction.

9. It instills into all levels of management a timely, careful and adequate consideration of all
factors before reaching important decisions.

10. A budget motivates executives to attain the given goals.

11. Budgetary control system creates necessary conditions for the introduction of standard
costing technique.

12. Budgeting also aids in obtaining bank credit.

13. A budgetary control system assists in delegation of authority and assignment of

responsibility.

14. Budgeting creates cost consciousness and introduces an attitude of mind in which waste and
efficiency cannot thrive.

LIMITATIONS OF BUDGETARY CONTROL

The list of advantages given above is impressive, but a budget is not a cure all for organisation
ills. Budgetary control system suffers from certain limitations and the system should be fully
aware of them. The main limitations are:

1. The budget plan is based on estimates. Budgets are based on forecasts and forecasting
cannot be an exact science. Absolute accuracy, therefore, is not possible in forecasting and
budgeting. The strength or weakness of the budgetary control system depends to a large extent,
on the accuracy with which estimates are made. Thus, while using the system, the fact that
budget is based on estimates must be kept in view.

2. Danger of rigidity. A budget programme must be dynamic and continuously the changing
business conditions. Budgets will lose much of their usefulness if they acquire rigidity and are
not revised with the changing circumstances.

3 Budgeting is only a tool of management. Budgeting cannot take the place of management but
is only a tool of management. The budget should be regarded not as a master, but as a servant."
Sometimes it is believed that introduction of a budget programme is sufficient to ensure its
success. Execution of a budget will not occur automatically. It is necessary that the entire
organisation must participate enthusiastically in the programme for the realisation of the
budgetary goals.

4 Opposition from staff. Employees may not like to be evaluated and thus oppose introduction
of budgetary control system. As such, inefficient managers may try to create difficulties in the
way of introducing and operating this system.

5. Expensive technique. The installation and operation of a budgetary control system is a costly
affair as it requires the employment of specialised staff and involves other expenditure which
small concerns may find difficult to incur. However, it is essential that the cost of introducing
and operating a budgetary control system should not exceed the benefits derived therefrom.

FIXED AND FLEXIBLE BUDGETS

Based on level of activity or capacity utilisation, budgets are classified into fixed budget and
flexible budget.

Fixed Budget

A fixed budget is one which is prepared keeping in mind one level of output. It is defined as a
budget which is designed to remain unchanged irrespective of the level of activity attained." If
actual output differs from budgeted level of output, variances will arise. Fixed budget is prepared
on the assumption that output and sales can be estimated with a fair degree of accuracy. This
means that in those situations where sales and output cannot be accurately estimated, fixed
budget does not suit.

Flexible Budget
In contrast to a fixed budget, a flexible budget is one which is designed to change in relation to
the level of activity attained." The underlying principle of flexible budget is that a budget is of
little use unless cost and revenue are related to the actual volume of production. Flexible
budgeting has been developed with the objective of changing the budget figures to correspond
with the actual output achieved.

garments, etc. 3. Where sales are affected by changes in fashion, e.g., ready made garments. 4.
Where company frequently introduces new products.

5. Where large part of output is intended for export.

Uses of Flexible Budgets

The figures in flexible budgets are adaptable to any given set of operating conditions. It is,
therefore, more realistic than a fixed budget which is true only in one set of operating conditions
.
Flexible budgets are also useful from control point of view. Actual performance of an executive
should be compared with what he should have achieved in the actual circumstances and not with
what he should have achieved under quite different circumstances.

In brief, flexible budgets are more realistic, practical and useful. Fixed budgets, on the other
hand, have a limited application and are suited only for items like fixed costs

Questions

1 )W Company uses flexible budgets. At normal capacity of 10,000 units, budgeted

manufacturing overhead is: $50,000 variable and $135,000 fixed. If W Company had actual
overhead costs of $187,500 for 11,000 units produced, what is the difference between actual and
flexible budget costs?

2) Prepare a flexible budget for production at 80 percent and 100 percent

Production at 50 % capacity - rs 5000 units
Raw materials - rs 80 per unit
Direct labour - rs 50 per unit
Direct expense- rs 15 per unit
Factory expense - rs 50000 (50 % fixed)
Administration expense - rs 60000 (60% variable)

3): For the production of 10000 units of a product, the following are the budgeted expenses: $
(per unit)
Direct material 30
Direct Labour 15
Variable overhead 12.50
Fixed overhead ($ 75000) 7.50
Variable expenses (direct) 2.50
Selling expenses (10% fixed) 7.50
Administration expenses ($ 25000 rigid for all production levels) 2.50 Distribution expenses
(20% fixed) 2.50
Total cost of sale per unit 80.00

Prepare a budget for production of 12000, 14000 & 16000 units showing distinctly marginal cost
& total cost.

.
ZERO BASE BUDGETING (ZBB)

ZBB is a recent development in the area of management control system and is steadily gaining
importance in the business world.Zero base budgeting (ZBB) is an alternative to incremental
budgeting. ZBB was introduced at Texas Instruments in USA in 1969 by Peter Phyrr, who is
known as the father of 288. It is not based on incremental approach and previous year's figures
are not taken as the base for preparing next year's budget.
Instead, the budget figures are developed with zero as the base, which means that a budget will
be prepared as if it is being prepared for a new company for the first time. peter Phyrr has
defined ZBB as "a planning and budgeting process which requires each manager to justify his
entire budget request in detail from scratch (hence zero base). Each manager states why he
should spend any money at all. This approach requires that all activities be identified as decision
packages which will be evaluated by systematic analysis ended in order of importance."

According to C.L.M.A., London, BB is defined as a method of budgeting whereby all Activities

are revaluated each time a budget is set. Discrete levels of each activity are valued and a
combination chosen to match funds available.

In simple words, ZBB is a system whereby each budget item, regardless of whether it is new or
existing. must be justified in its entirety each time a new budget is prepared. It is formalised
system of budgeting for the activities of an enterprise as if each activity were being performed
for the first time, Le, from zero base.

The novel part of the ZBB is the requirement that the budgeting process starts at zero with all
expenditures to be completely justified.

Main Features of Zero Base Budgeting (ZBB)

1. All budget items, both old and newly proposed, are considered totally afresh.

2. Amount to be spent on each budget item is to be totally justified.

3. A detailed cost benefit analysis of each budget programme is undertaken and each programme
has to compete for scarce resources.

4 Departmental objectives are linked to corporate goals.

5 . The main stress in not on how much' a department will spend but on why it needs to spend.
6. Managers at all levels participate in ZBB process and they have corresponding
accountabilities.

Advantage

1. In ZBB, all activities included in the budget are justified on cost benefit considerations which
promote more effective allocation of resources.

2. ZBB discards the attitude of accepting the current position in favour of an attitude questioning
and challenging each item of budget.

3 In the course of ZBB process, inefficient and loss making operations are identified and may be
removed.

4. It adds psychological push to employees to avoid wasteful capture.

5. It is an educational process and can promote a management team of talented and skillful
people who tend to promptly respond to changes in the business environments

6 Cost behaviour patterns are more closely examined.

7 Deliberately inflated budget requests get automatically weeded out in the ZBB process.

Disadvantages:

1. ZBB leads to an enormous increase in paper work and results in high cost of preparing budgets
every year.

2. Managers may resist new ideas and changes.

3. In ZBB, there is danger of emphasizing short-term gains the expense of long-term benefits.

4. It has a tendency to regard any activity not foreseen and sanctioned in the most recent ZBB as
illegitimate.

5. For introducing Z8B, managers need to be given proper training and education regarding this
new concept, its pros and cons and implementation.

6. It may not always be easy to properly rank decision packages and this may give rise to
conflicts
PERFORMANCE BUDGETING

Performance budget is also a recent development which tries to overcome the limitations of
traditional budgeting.
. Performance budgets are established in such a manner that each item of expenditure related to a
specific responsibility centre is closely linked with the performance of that centre. Thus
performance budgeting lays stress on activities and programmes.
The Government of India has now decided to introduce performance budgeting in all its
departments in a phased manner. An example of performance budgeting in government system
of accounting may be that generally expenditure is classified under the heads like pay and
allowances, transport, repairs and maintenance, etc. In performance budgeting, the classification
of expenditure may be setting up of a steel mill, construction of a railway station,
computerisation of railway booking system, purchase of an aircraft carrier, etc. and other
physical targets. When work on these activities is started, funds are obtained against these
physical targets. Reports are then prepared for any under-spending or over-spending which are
then analysed for corrective action to be taken.

Performance budgeting is sometimes called Programme Budgeting or Planning, Programme and

Budget System (PPBS).

Steps in Performance Budgeting

1. Establishment of responsibility centre. First of all, responsibility centres are established. A

responsibility centre is a segment of an organisation where an individual manager is held
responsible for the performance of the segment.

2. Establishment of performance targets. For each responsibility centre, targets are set in terms
of physical performance to be achieved. For example, for sales department, which is a
responsibility centre, targets may be set in terms of number of units to be sold during the budget
period. For production department, the target would then be the number of units to be produced.

3. Estimating financial requirements. In this step, the financial support needed to achieve the
physical targets is estimated. In other words, the amount of expenditure involved under various
heads to meet the physical performance is forecasted.

4 Comparison of actual with budgeted performance. This is a usual step control to evaluate
the actual performance.

5. Reporting and action. Variances from budgeted performance are analysed and reported in
budgetary for corrective action to be taken.

MARGINAL COSTING AND BREAK EVEN ANALYSIS

INTRODUCTION

There are mainly two techniques of product costing and income determination: Absorption
costing and Marginal costing. For clear understanding of marginal costing, it is better to first
understand absorption costing

Absorption Costing.

This is a total cost technique under which total cost (ie, fixed cost as well as variable cost) is
charged as production cost. In other words, in absorption costing, all manufacturing costs are
'absorbed in the cost of the products produced. In this system, fixed factory overheads are
absorbed on the basis of a predetermined overhead rate based on normal capacity. Under/over
absorbed overheads are adjusted before computing profit for a particular period. Inventory is also
valued at production cost which includes fixed factory overhead (and sometimes administration
overhead also). Absorption costing approach is the same as used in Cost Sheet. Absorption
costing is a traditional approach and is also known as Conventional Costing' or 'Full Costing.

Marginal Costing.

An alternative to absorption costing is marginal costing, also known as variable costing' or

'direct costing. Under this technique, only variable costs are charged as product costs and
included in inventory valuation, Fixed manufacturing costs are not allotted to products but are
considered as period costs and thus charged directly to the Profit and Loss Account of that year.
Fixed costs also do not enter in inventory valuation.

MEANING OF MARGINAL COSTING

Marginal costing is the ascertainment of marginal cost and the effect on profit of changes in
volume or type of output by differentiating between fixed costs and variable costs. It is defined
by CIMA as "The accounting system in which variable costs are charged to cost units and fixed
costs of the period are written off in full against the aggregate contribution. Its special value is in
decision-making Characteristics. The essential characteristics and mechanism of marginal
costing technique may be summed up as follows:

1. Segregation of costs into fixed and variable elements. In marginal costing, all costs are
classified into fixed and variable. Semi-variable costs are also segregated into fixed and variable
elements.

2 Marginal costs as product costs. Only marginal (variable) costs are charged to products
produced during the period. In other words, marginal costs are treated as product cost.

3. Fixed costs as period costs. Fixed costs are treated as period costs and are charged to the
Costing Profit and Loss Account of the period in which they are incurred.
4 Valuation of inventory. The work-in-progress and finished stocks are valued at marginal cost
only.

5. Contribution. Contribution is the difference between sales value and marginal cost of sales.
The relative profitability of products or departments is based on a study of 'contribution made by
each of the products or departments.

6. Pricing. In marginal costing, prices are based on marginal cost plus contribution.

DISTINCTION BETWEEN ABSORPTION COSTING AND MARGINAL COSTING

The points of distinction between marginal costing and absorption costing are as follows:

1. Treatment of fixed and variable costs. In marginal costing, only variable costs are charged
to products. Fixed costs are treated as period costs and charged to Profit and Loss Account of the
period.
In absorption costing, all costs (both fixed and variable) are charged to the product.
The fixed factory overhead is absorbed in units produced at a rate predetermined on the basis of
normal capacity utilisation (and not on the basis of actual production).

2 Valuation of stock. In marginal costing, stock of work-in-progress and finished goods are
valued at marginal cost only.
In absorption costing, stocks are valued at total cost which includes both fixed and variable
costs. Thus, stock values in marginal costs are lower than that in absorption costing.

3. Measurement of profitability. In marginal costing, relative profitability of products or

departments is based on a study of relative contribution made by respective products or
departments. The managerial decisions are thus guided by contribution.
In absorption costing, relative profitability is judged by profit figures which is also a
guiding factor for managerial decisions.
.

COST-VOLUME-PROFIT ANALYSIS

Cost-volume-profit analysis (CVP analysis) is an extension of the principles of variable costing.

This means that principles derived and applied in variable costing are applicable here. Every
company must earn profits to stay in business. CVP analysis helps management in profit
planning. Managers make various plans to increase company profitability. CVP analysis studies
the inter-relationship of three basic factors of business operations:

(a) Cost of production,

(b) Volume of production/sales, and

(c) Profit.
These three factors are inter-connected in such a way that they act and react on one another
because of cause and effect relationship among them. The cost of a products determines its
selling price and the selling price determines the level profit. The selling price also affects the
volume of sales which directly affects the volume of production and volume of production in
turn influences cost.

In brief, variations in volume of production results in changes in cost and profit. CIMA London
has defined CVP analysis as, "the study of the effects on future profits of changes in fixed cost,
variable cost, sales price, quantity and mix. An understanding of CVP analysis is extremely
useful to management in budgeting an profit planning. It explains the impact of the following on
the net profit:

1 Changes in selling prices,

2Changes in volume of sales,
3 Changes in variable cost,
4 Changes in fixed cost.

In fact, CVP analysis helps in determining the probable effect of change in any one of these
factors on the remaining factors.

BREAK-EVEN ANALYSIS

Break-even analysis is a widely used technique to study the CVP relationship. It is interpreted in
narrow as well as broad sense.

Narrow meaning. In its narrow sense, break-even analysis is concerned with determining break-
even point, Le., that level of production and sales where there is no profit and no loss. At this
point total cost is equal to total sales revenue.
Broad meaning. When used in broad sense, break-even analysis is used to determine probable
profit/loss at any given level of production/sales. It also helps to determine the amount or volume
of sales to earn a desired amount of profit. Assumptions underlying Break-even Analysis

The break-even analysis is based on the following eight assumptions:

1. All costs can be separated into fixed and variable components.

2. Variable cost per unit remains constant and total variable cost varies in direct proportion to the
volume of production.
3. Total fixed cost remains constant.
4. Selling price per unit does not change as volume changes.
5. There is only one product or in the case of multiple products, the sales mix does not change. In
other words, when several products are being sold, the sale of various products will always be in
some predetermined proportion.
6. There is synchronisation between production and sales. In other words, volume of production
equals volume of sales.
7. Productivity per worker does not change.
8. There will be no change in the general price level.

Contribution and marginal cost equation

Contribution is the differences between sales and marginal cost

Contribution =Sales - variable cost(C=S-V)

Contribution = Fixed cost + Profit (C=F+P)
Contribution= Fixed cost - Loss (C= F-L)

Questions

1 From the following data, you are required to calculate:

(a) P/V ratio

(b) Break-even sales with the help of P/V ratio.

(c) Sales required to earn a profit of Rs. 4,50,000

Fixed Expenses = Rs. 90,000

Variable Cost per unit:

Direct Material = Rs

Direct Labour = Rs. 2

Direct Overheads = 100% of Direct Labour

Selling Price per unit = Rs. 12.

2 From the following data, you are required to calculate break-even point and net sales
value at this point:
If sales are 10% and 25% above the break even volume, determine the net profits.

3 From the following particulars, find out the break-even-point:

What should be the selling price per unit, if the break-even point should be brought down to
6,000 units?

4Calculate:

(i) The amount of fixed expenses.

(ii) The number of units to break-even.

(iii) The number of units to earn a profit of Rs. 40,000.

The selling price per unit can be assumed at Rs. 100.

The company sold in two successive periods 7,000 units and 9,000 units and has incurred a loss
of Rs. 10,000 and earned Rs. 10,000 as profit respectively.

5 The fixed costs amount to Rs. 50,000 and the percentage of variable costs to sales is given
to be 66 ⅔%.

If 100% capacity sales are Rs. 3,00,000, find out the break-even point and the percentage
sales when it occurred. Determine profit at 80% capacity:

PROFIT - VOLUME RATIO (P/V RATIO)

PV ratio is also known as the contribution/sales ratio

P/V ratio= Contribution /Sales = C/S = S-V/S

 OR

P/V Ratio = Change in contribution /Change in sales

Ie, = Change in profit/ Change in sales

Uses of PV ratio

P/V ratio is one of the most important nation to watch in business. It is an indicator of the rate at
which profit is being earned. A high P/V ratio indicates high profitability and a low ratio
indicates low profitability in the business.

METHODS OF BREAK EVEN ANALYSIS

Break even analysis is performed by 2 methods,

1. Algebric calculations
2. Graphic presentation

Algebric calculations

Break even point - it is the volume of output or sales at which total cost is exactly equal to sales.
It is the point of no profit and no loss.

Break even point (in units)=Total fixed cost / contribution per unit
Ie= ,F/(S-V)

Break even point (in rs)=Total fixed cost/ contribution * Sales

Or Break even point (in rs)=Total fixed cost/pv ratio

MARGIN OF SAFETY
It may be defined as the difference between actual sales and sales at break even point. in other
words , it is the amount by which actual volume of sales exceeds the break-even point, It is
expressed in absolute money terms or as a percentage f sales

Margin of safety = Actual sales - Break even point

LIMITING (OR KEY) FACTOR

The objective of a business is to earn maximum profit. However, it is not always easy to achieve
this objective because profit earning is affected by a variety of factors. For example an
undertaking may have sufficient orders in hand, ample skilled labour and production capacity,
but may be unable to obtain all the quantity of material it needs for the manufacture of maximum
quantities which could be sold. Thus, material is the factor which limits the size of output and
prevents an undertaking from maximising its profit. Similarly, sometimes a business is not able
to sell all that it can produce. In such a case, sales is the limiting factor.
A limiting key factor may thus be defined as the factor in the activities of an undertaking which
at a particular point in time or over a period will limit the volume of output. Examples of limiting
factors are:

(i) Sales

(ii) Materials

(iii) Labour of particular skill

(iv) Production capacity or machine hours

(v) Financial resources.

The purpose of the limiting factor technique is to indicate the most profitable course of action in
all such cases where alternatives are possible.

ANGLE OF INCIDENCE

This angle is formed by the intersection of sales line and total cost line at the break-even point.
This angle shows the rate at which profits are being earned once the break-even point has been
reached. The wider the angle, the greater is the rate of earning profits. Therefore, the aim of
management will be to have as large an angle as possible. The angle of incidence is of particular
importance in boom periods when sales are expanding.Taking in conjunction with margin of
safety, therefore, a large angle of incidence with a high margin of safety indicates and extremely
favourable position.

COST INDIFFERENCE POINT

Cost indifference point refers to that level of output where the total cost or the profit of the two
alternatives are equal. Such a level may be calculated where two or more alternative methods of
production or machines are considered and the use of one machine involves higher fixed cost and
lower variable cost per unit while the other machine involves lower fixed cost and higher
variable cost per unit. The calculation of point of cost indifference helps in a cost minimisation
exercise and identifies the alternative which is more profitable for a given level of output or
sales. A machine with a lower fixed cost and a higher variable cost per unit is more profitable
when actual sales are below the point of cost indifference and vice versa, a machine with a
higher fixed cost and a lower variable cost per unit is more profitable when actual sales are more
than the point of cost indifference. The formula for calculation is as follows:

Cost indifference point (in unit)= Difference in fixed cost / Difference in contribution per
unit

Cost indifference point (in rs)= Difference in fixed cost/Difference in PV ratio

GRAPHIC PRESENTATION OF BREAK-EVEN ANALYSIS

Break-even Chart

Break-even chart is a graphic presentation of break-even analysis. This chart takes its name from
the fact that the point at which the total cost line and the sales line intersect is the break-even
point. A break-even chart not only shows the break-even point but also shows profit and loss at
various levels of activity.

Thus a break-even chart portrays the following information : (1) Break-even point the point at
which neither profit nor loss is made.

(i) The profit/loss at different levels of output.

(iii) The relationship between variable cost, fixed cost and total cost.

(iv) The margin of safety.

(v) The angle of incidence, indicating the rate at which profit is being made.
(v) The amount of contribution at various levels of sales. (This can be shown only on a specially
designed 'contribution break-even chart.)
 EFFECT OF CHANGE IN THE PROFIT FACTORS
The break even chart can as shown the effect of change in any of the following factors which
affect profit,

1 change in fixed asset

2 change in variable cost
3 change in selling price
4 change in sales volume
 PROFIT-VOLUME CHART

The profit-volume chart or profit graph portrays the profit and loss at different levels of

sales and is an alternative presentation of the facts illustrated in the break-even chart. Such a
chart can be constructed from the same basic data from which a break-even chart can be drawn.

Construction of Profit-Volume Chart

The following steps should be taken to construct a profit-volume chart.

1. Select a scale on horizontal axis. The horizontal axis in the profit-volume graph represents
sales. This horizontal line, known as sales line, divides the graph into two parts.
2. Select a scale on vertical axis. The vertical axis shows fixed cost and profit. The fixed costs
are market below the sales line on the left hand vertical line and profit is shown above the sales
line on the right hand vertical line.

3. Plot fixed cost and profit. Points are plotted for the given fixed cost and profit. These points
are connected by a diagonal line which crosses the sales line at break even point.
Introduction