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1 OSN ACADEMY www.osnacademy.com LUCKNOW 0522-4006074
1
OSN ACADEMY
www.osnacademy.com LUCKNOW
0522-4006074
2
SUBJECT – COMMERCE
SUBJECT CODE – 08
UNIT - II
9935977317 0522-4006074
3
Chapters Titles
1 Basic Accounting Concepts
2 Capital, Revenue & Financial Statements
3 Partnership Accounts
4 Advanced Company Accounts
5 Accounting for Mergers & Takeovers
6 Cost & Management Accounting
7 Ratio Analysis
8 Fund Flow & Cash Flow
9 Marginal Costing
10 Standard Costing
11 Budgetary Control
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CHAPTER 1
BASIC ACCOUNTING CONCEPTS
Accounting “Accounting is the art of recording, classifying and summarizing in significant manner and in terms of
money, transactions and events which are in part, at least of a financial character and interpreting the result
thereof”.
Accounting Principles (Accounting Standards)
Accounting concepts Accounting Conventions
(Accounting postulates)
1. Separate Entity Concept 1. Convention of Consistency
2. Going Concern Concept 2. Convention of full disclosure
3. Money Measurement Concept 3. Convention of Materiality
4. Cost Concept 4. Convention of Conservatism
5. Dual Aspect Concept
6. Accounting Period Concept
7. Periodic Matching of Cost &
Revenue Concept
8. Realisation Concept
Accounting Concepts It includes those basic assumptions or conditions upon which the science of account is based.
1. Separate Entity Concept: In Accounting business is considered to be a separate entity from the proprietor(s). This concept is
applicable to all forms of business organizations.
Ex-In case of partnership business or sole proprietorship business, though partners or sole
proprietors are not considered as separate entities is the eyes of law, but for accounting purposes
they will be considered as separate entities.
2. Going Concern Concept:
According to this concept it is assumed that the business will continue for a fairly long time to come.
It should be noted that the ‘going concern concept’ does not imply permanent continuance of the
enterprise. It rather presumes that the enterprise will continue in operation long enough to charge
against income, the cost of fixed assets over their useful lives, to amortize over appropriate period other
costs which have been deferred under the actual or matching concept to pay liabilities which they
become due and to meet the contractual commitments.
3. Money Measurement Concept: Accounting records only monetary transactions events or transaction which can’t be measured in money do
not find place in the accounts book.
Ex- Dedicated and trusted employee is an asset for company but they do not find place in accounts
book, although they are very useful for business.
4. Cost Concept:
According to this concept – a) an asset is ordinarily entered in the accounting records at the price paid to
acquire it, and b) this cost is the basis for all subsequent accounting for the assets.
5. Dual Aspect Concept:
According to this concept every business transaction has a dual effect. Ex- If A starts a business with a
capital of 10,000, there are two aspects of the transaction. On the one hand the business has set of
10,000, while on the other hand the business has to pay to proprietor a sum of 10,000 which is taken as
proprietor capital.
Capital (Equities) = Cash (Assets)
10,000 = 10,000
6. Accounting Period Concept:
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According to this concept, the life of a business is divided into appropriate segments for studying the results
shown by the business after each segment.
Example -Annual, Semi-Annually or Half Yearly and Quarterly etc.
Accounting period generally starts from 01st April and end to 31
st March.
7. Periodic Matching of Costs and Revenue Concept: The objective and motive of business is to earn profit. In order to ascertain the profit made by the business
during a period it is necessary that revenues of the period should be matched with the costs (expenses) of
the period.
8. Realisation Concept: According to this concept revenue is recognized when a sale is made. Sale is considered to be made at the
point when the property in goods passes to the buyers and become legally liable to pay.
Accounting Conventions An Accounting Convention refers to common practices which are universally followed in recording
and presenting accounting information of the business entity. They are followed like customs, tradition, etc. in a
society. Accounting conventions are evolved through the regular and consistent practice over the years to
facilitate uniform recording in the books of accounts. Accounting Conventions help in comparing accounting
data of different business units or of the same unit for different periods. These have been developed over the
years. The most important conventions which have been used for a long period are :
i. Convention of consistency.
ii. Convention of full disclosure.
iii. Convention of materiality.
iv. Convention of conservatism.
1. Convention of Consistency:
The convention of consistency means that same accounting principles should be used for preparing
financial statements year after year. A meaningful conclusion can be drawn from financial statements of the
same enterprise when there is comparison between them over a period of time. But this can be possible
only when accounting policies and practices followed by the enterprise are uniform and consistent over a
period of time. If different accounting procedures and practices are used for preparing financial statements
of different years, then the result will not be comparable.
2. Convention of Full Disclosure:
It requires that all material and relevant facts concerning financial statements should be fully disclosed. Full
disclosure means that there should be full, fair and adequate disclosure of accounting information.
i. Adequate means sufficient set of information to be disclosed.
ii. Fair indicates an equitable treatment of users.
iii. Full refers to complete and detailed presentation of information.
Thus, the convention of full disclosure suggests that every financial statement should fully disclose all
relevant information. Let us relate it to the business. The business provides financial information to all
interested parties like investors, lenders, creditors, shareholders etc. The shareholder would like to know
profitability of the firm while the creditor would like to know the solvency of the business. In the same
way, other parties would be interested in the financial information according to their requirements. This is
possible if financial statement discloses all relevant information in full, fair and adequate manner.
3. Convention of Materiality :
It states that, to make financial statements meaningful, only material fact i.e. important and relevant
information should be supplied to the users of accounting information. The question that arises here is what
a material fact is. The materiality of a fact depends on its nature and the amount involved. Material fact
means the information which will influence the decision of its user.
4. Convention of Conservatism:
This convention is based on the principle that “Anticipate no profit, but provide for all possible losses”.
It provides guidance for recording transactions in the books of accounts. It is based on the policy of playing
safe in regard to showing profit. The main objective of this convention is to show minimum profit. Profit
should not be overstated. If profit shows more than actual, it may lead to distribution of dividend out of
capital. This is not a fair policy and it will lead to the reduction in the capital of the enterprise.
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CHAPTER 2
CAPITAL & REVENUE AND FINANCIAL STATEMENTS
CLASSIFICATION OF INCOME
Capital Income: The term ‘Capital Income’ means an income which does not grow out of pertain to the running of the
business proper. It is synonymous to the turn ‘Capital Gain’.
Example: If a building costing 10,000 purchased by a business for its use is sold for 15,000,
5,000 will be taken as capital profit.
However, it should be noted that only the profit realized over and above the cost of the fixed asset
should be taken as a capital profit.
The profit realized over and above book value of asset till it does not exceed the original cost of the
asset should be taken as a revenue project.
Example – If plant originally purchased for 10,000/- standing in the book as 6,000 (on account of
charging depreciation) is sold for 12,000, there is a profit of 6,000 on the sale of this plant. Out
of this profit 2,000 should be taken as capital gain and balance of 4,000 should be taken as a
‘revenue profit’.
Revenue Income: Revenue Income means an income which arises out of and in the course of the regular business
transactions of a concern.
Example – In the course of running business the profit is made on sale of goods, income is received
from letting out the business property, dividend are received on business investments etc. All such
incomes are ‘Revenue Income’.
Classification of Expenditure
1. Capital Expenditure: It means an expenditure which has been incurred for the purpose of
obtaining a long-term advantage for the business - Such expenditure is either incurred for
acquisition of an asset, which can be sold and converted into cash.
Examples of capital expenditure –
1. Expenditure incurred in increasing the quality of fixed assets.
2. Expenditure incurred in increasing the quantity of a fixed asset.
3. Expenditure incurred for substitution of a new asset for an existing asset.
4. Expenditure incurred in connection with purchase receipt.
5. Expenditure incurred for acquiring the right of carrying on a business. Eg. Purchase of
patent right, copyrights, goodwill etc.
Revenue Income Capital Income
Revenue
Expenditure
Capital
Expenditure
Deferred Revenue
Expenditure
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Note: An expenditure cannot be taken as a capital expenditure merely because the amount is large or
the amount has been paid in lump sum or the amount has been paid out of the proceeds received on
account of sale of a fixed asset or the receiver of the amount is going to use it for purchase of a fixed
asset.
2. Revenue Expenditure: An expenditure that arises out of and in the course of regular
business transactions of a concern is termed as a revenue expenditure. It may be simply termed as
“expense”.
Examples of Revenue Expenditure:
1. Expenditure incurred in the normal course of running the business like administration
expenses etc.
2. Expenditure incurred to maintain the business.
3. Cost of goods purchased for resale.
4. Depreciation on fixed assets, interest on loans for the business.
3. Deferred Revenue Expenditure: It is that class of revenue expenditure which is incurred during an accounting period, but is
applicable either wholly or in part to future periods.
Pickles & Dunkerley classified it into 4 distinct types:
i. Expenditure wholly paid for in advance, where no service has yet been rendered, necessitating
its being carried forward.
ii. Expenditure partly paid in advance, where no portion of the benefit has been derived within
the period under review, the balance being as yet ‘unused’, and therefore shown in balance
sheet as an asset.
iii. Expenditure in respect of service rendered which for any such reason is considered as an
asset, or more properly, is not considered to be allocable to the period in question.
iv. Amount representing losses of an exceptional nature. Eg. Property confiscated in a foreign
country etc.
Capital Expenditure Vs. Revenue Expenditure
Capital Expenditure Revenue Expenditure
i.
Incurred either for acquiring new fixed
asset or for improving the existing ones.
i.
Incurred either for maintaining the existing
fixed assets or for meeting the routine
expenses of the business
ii. Increases the earning capacity of the
business
ii Does not do so, simply helps in maintaining
the existing earning capacity of the business.
iii. Benefit is available over a period of
time
iii. Benefit is restricted only to the Accounting
period in which it has been incurred.
Circumstances under which Revenue Expenditure become capital expenditure:
1. Repairs – Amount spent on repairs of plant, furniture, building etc.
2. Wages – Amount spent for erection of new plant or machinery or wages paid to worker engaged
in construction of a fixed asset.
3. Legal Charges – Legal charges incurred in connection with purchase of fixed assets should be
taken as part of the cost of fixed asset.
4. Interest on Capital – Interest on capital paid during the construction of works or buildings or
plant.
5. Transportation Charges – Incurred for a new plant and machinery are taken as expenditure of a
capital nature.
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6. Raw Materials and Stores – RIM and stores consumed in construction of fixed assets should be
treated as capital expenditure and be taken as a part of cost of such fixed asset.
7. Development Expenditure: In case of some concern such as tea, rubber, plantations, horticulture
a long period is required for development. They start earning only after expiry of a long period
which can be termed as development period. The expenditure incurred during such periods is
termed as development expenditure and may be treated as capital expenditure.
8. Advertising – Cost of advertising for purpose of introducing new product.
a. Preliminary Expenses- Expenses incurred in formation of a new company.
Note 8 & 9 are generally deferred Revenue Expenditure.
Revenue Loss:
• Revenue losses are those losses which arise during the normal course of running the business
because of fall in the value of the current assets of the business.
• The term ‘Revenue Loss’ is similar to the term ‘Revenue Expenditure’ in this respect that it is
also charged to the P/L A/C of business like Revenue Expenditure.
Classification of Receipts
1. Capital Receipts: consist of additional payment made to the business either by shareholders
of the company or by the proprietors of the business or receipts from sales of fixed assets of a
business.
Ex- Amount raised by the company by way of share capital is a capital receipt.
2. Revenue Receipts: Any receipt which is not a capital receipt is a revenue receipt.
Ex- If the goods costing 20,000 are sold for 25,000, there is a revenue receipt of 25,000
but revenue profit or income is only of 5,000.
Capital Receipts Revenue Receipts
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CHAPTER-3
PARTNERSHIP ACCOUNTS
Partnership is the relation that exists between or among persons carrying on business in
common with a view to earn profit. The partnership form of enterprise is very common and popular
because:
1) It is easy to form.
2) It allows several individuals to combine their talents and skills in particular business venture.
3) It provides a means of obtaining more capital than a single individual can obtain.
4) It allows the sharing of risks for rapidly growing businesses.
In India partnership is governed by The Indian Partnership Act, 1932. Section 4 of this act
defines partnership as "the relationship between persons who have agreed to share the profits of a
business carried on by all or any of them acting for all.
General and Limited Partners Ordinarily each partner is equally liable for any debts or other obligations incurred by any of
the partners in the name of the business, that is each partner is personally liable to creditors for all
debts of the partnership if the other partner fails to meet their obligations under the agreement. Such
partners are known as general partner and the partnership, a general partnership.
But by the virtue of the provisions of the Partnership Act, some partner or partners may have
limited liability-to the extent of their respective capital contribution. Such partners are called limited
partners and the firm is known as limited partnership. It goes without saying that liability of only
some of the partners can be unlimited. In other words, every limited partnership must have at least one
general partner.
Active or Ordinary Partner – are those who take active part in the conduct of the business.
Sleeping, Dormat or Silent Partner – are those partners who do not take part in conduct of the
business. They only provide money to the business as capital and share profits and losses in the
agreed ratio.
Nominal or Ostensible Partner – are those who do not contribute any capital and without having
any interest in the business, lend their names to the business.
Minor Partner – A partner, who has not attained the age of maturity. A minor partner can be
admitted only into the benefits of the partnership but is not personally liable, like other partners for
any debt of the firm.
Partner's Capital Accounts – with the formation of the partnership, the partnership deed provides
for a fixed amount of capital to be contributed by each partner from his beware resources. In the
Balance Sheet of a partnership firm, there are several capital accounts – one for each partner.
In this connection the following important points may be noted:
1) Capital formation by the partners may not be equal as per their profit sharing ratio, the ratio of the
capital contribution is to be decided by the partners mutually or as per the Partnership Deed.
2) Capital contribution may not only be in the form of cash, it can be in the shape of other asset also.
3) A partner, on the strength of his expert knowledge or qualification may not bring in any physical
capital.
4) The ratio of the partner's capital may be changed by mutual consent. It generally changes when
there is a change in the constitution that is change in the profit sharing ratio; admission, retirement
or death of a partner.
5) Along with other physical assets (also goodwill) if a partner brings any liability to the business,
the net amount (asset – liabilities) well represent his capital contribution.
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The Appropriation of Net Income In case of a sole proprietorship, the whole of the net profit is credited to proprietor's capital
and the capital Account is debited for any drawings.
A distinction is required in case of partnership business for compiling and demonstrating the
division of the profit or loss among the partners.
Therefore, a new section known as Profit and Loss Appropriation Account, is an essential part
of the partnership accounts. (Assuming that there are two partners : A and B. A is entitled to salary
and B is entitled to commission).
Profit and Loss Appropriation Account for the year ended……………
Particulars Amt. Particulars Amt.
To reserve A/c – transferred to reserve xxx By Profit and Loss A/c Net
Profit
xxx
To interest on capital A/c
A --- xx
B --- xx
By interest on Drawing A/c
A --- xx
B --- xx
xxx
To interest on Partners Loan A/c xxx
To Partners Salary A/c - A xxx
To Partners Salary A/c – B xxx
To share of profit A/c (balancing figure)
A - xx B - xx
xxx
xxx xxx
In the this connection, we must remember that; Any amount payable to a partner (except rent)
such as interest on capital, interest on loan, salaries, commission etc. should be treated as
appropriation and it should not be charged against profit.
Interest on Capital As already stated, partners are not entitled to any interest on capital, unless specifically
provided in the Partnership Deed.
The idea for providing the interest on capital is to compensate the opportunity cost suffered
by the partners by not investing the money elsewhere in securities with little or no risk.
The amount of interest on capital is to calculated on time basis after taking into consideration
the withdrawn or introduction of capital.
Partners are not entitled to any interest on capital, unless specifically provided in the
Partnership Deed.
The idea for providing the interest on capital is to compensate the opportunity cost suffered
by the partners by not investing the money elsewhere in securities with little or no risk. When the
partners contribute unequal capitals but profit are shared equally or where the profit sharing ratio is
different from capital contribution ratio, the charge of interest against the firm on capital contributed
by each partner is justified to mitigate differential advantage of one partner over the other.
The amount of interest on capital is to be calculated on time basis after taking into consideration
the withdrawal or introduction of capital. The Profit and Loss Appropriation Account is debited
and Partner's Capital / Current Account is credited with the interest on capital.
In this context, it should be noted that interest on capital is chargeable to a firm to the extent of
available profits only. Since interest on capital is an appropriation of profits.
For Example – X and Y are partners sharing profit and losses in the ratio of 3:2. They earn Rs.
15,000 as profit before allowing interest on capital @10% p.a. X's capital was, Rs. 1,20,000 and Y's
capital was Rs. 60,000
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Now interest payable to partners comes to Rs. 18000 (X-12000 and Y-6000). In the absence of
any special provisions in this regard in the Partnership Deed, X will get Rs. 10,000 and Y will Rs.
5000 only, ie: Rs. 15000 will be divides in ratio of interest actually payable to partners.
However, by arrangement, partners may waive the above limitations and in such the resultant loss
after providing whole into would be borne by the partners in the profit Sharing Ratio.
The Profit and Loss Appropriation A/c a) When there is no agreement between partner.
Particulars Amt. Particulars Amt.
To interest on capital
X 10000
Y 5000
15000
By Profit and Loss A/c –
Net Profit
15000
15000 15000
b) When there is an agreement between partner.
Particulars Amt. Particulars Amt.
To interest on capital
X 12000
Y 6000
18000
By Profit and Loss A/c –
Net Profit
By share of Loss
X 1800
Y 1200
1500
300
18000 18000
Interest on Drawings Since no interest is allowed on Partner's Capital Account, no interest on drawings is to be
charged, in the absence of any provision in the Partnership Deed. In other words, if there is a
provision in the partnership deed, only then the interest on drawing is to charged. The interest on
drawings is calculated at a fixed rate per cent from the date of drawings till the last day of the
accounting period.
Journal Entries (i) Interest on drawings A/c Dr. To P&L appropriation A/c
(ii) Partner's Capital / Current Account Dr. To interest on drawings A/c
(i) Partners capital / Current account Dr. To P&L appropriation A/c
For calculating interest on drawings (i) When a partner draws a fixed sum at the beginning of each month for 12 months, interest on
total drawings will be equal to earliest of 6.5 months at an agreed rate per annum.
(ii) When a partner draws a fixed sum at the end of each month for 12 months, interest on total
drawings will be equal to interest of 5.5 months at an agreed rate per annum.
(iii) When a partner draws a fixed sum at the middle of each month for 12 months, interest of 6
months at an agreed rate per annum.
(iv) When the dates of drawings are given and the interest is to be charged at an agreed rate per
annum, interest will be calculated on the basis of terms.
(v) When the dates of drawings are not given and the interest is to be charged at an agreed rate
per annum, interested will be calculated for 6 months.
(vi) When the rate is given without the word "per annum", interest will be charged without
considering the time factor.
For example-
Suppose A, B and C are partners sharing profits equally. During the year 2002 the following
amounts were withdrawn by partners in anticipation of profits:
A @Rs. 100 p.m. at the beginning of each month;
B @Rs. 100 p.m. at the beginning of each month;
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C @Rs. 100 p.m. at the beginning of each month;
and the rate of interest on drawings is 10% p.a.
Now applying the above rates the interest on drawings will be as follow S:
A: 1200 x 10/100 x 6.5/12 = Rs. 65
B: 1200 x 10/100 x 5.5/12 = Rs. 55
C: 1200 x 10/100 x 6/12 = Rs. 60
Sharing of profits Generally, the partnership deed provides the ratio in which profits and losses of the firm
should be shared by the partners. If the partnership deed is silent on this point, the profits should be
shared equally, irrespective of capital contribution.
Q. A and B are partners sharing profit and losses in the ratio of their effective capital. They
had Rs. 40,000 and Rs. 60,000 respectively in their capital accounts as on January 1,
2002.
A introduced a further capital of Rs. 10,000 as on 1st April 2002 and another Rs. 5000 on 1
st
July 2002, on 30th September 2002. A withdraw Rs. 40,000.
On 1st July 2002 B introduced further capital of Rs. 30,000. The partners draw the following
amounts in anticipation of profits.
A drew Rs. 1000 per month at the end of each month beginning from January, 2002 B draw
Rs. 1000 on 30th June, and Rs. 5000 on 30
th September, 2002.
12% p.a. interest on capital is allowable and 10% p.a. interest on drawing is chargeable. Date
of closing is 31.12.2002.
Calculate (a) Profit Sharing Ratio
(b) Interest on Capital
(c) Interest on drawings
(d) Calculation of effective capital.
A
Rs. 100,000 inverted for 3 months ie: Rs. 3,00,000 invested for / one month
Rs. 1,10,000 inverted for 3 months ie: Rs. 3,30,000 invested for / one month
Rs. 1,15,000 inverted for 3 months ie: Rs. 3,45,000 invested for / one month
Rs. 75,000 inverted for 3 months ie: Rs. 2,25,000 invested for / one month
Rs. 12,00,000
B
Rs. 60,000 inverted for 6 months ie: Rs. 3,60,000 invested for / one month
Rs. 90,000 inverted for 6 months ie: Rs. 5,40,000 invested for / one month
Rs. 9,00,000
The profit sharing ratio will be 12:9 or 4:3
Calculation Interest on Capital A
Rs. 12,00,000 x 12/100 x 1/12 = Rs. 12000
B
Rs. 9,00,000 x 12/100 x 1/12 = Rs. 9000
(c) Calculation of Interest on Drawings A
Rs. 12,000 x 10/100 x 5.5/12 = Rs. 550
B
Rs. 1000 x 10/100 x 6/12 = Rs. 50
Rs. 5000 x 10/100 x 3/12 = Rs. 125
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ADMISSION OF A PARTNER
Subsequent to the formation of a partnership, a new partner may be admitted with the consent
of all existing partners. A new partner may be admitted for different reasons such as more capital,
influence or special skill. A new partner may be admitted by any one of following ways:
by investing additional capital in the partnership.
by purchase of an interest from one or more of the old partners.
At the time of admission of a new partner, certain adjustments are necessary in the books of
accounts in respect of followings:
Adjustment in regard to Profit-sharing Ratio.
Adjustment in regard to goodwill.
Adjustment in regard to revaluation of assets and liabilities.
Adjustment in regard to reserve and capital.
Adjustment in regard to partner's capital.
Adjustment in regard to Profit-sharing Ratio When a new partner is admitted, according to partnership agreement, he is entitled to a share
of future profits. In effect, the combined shares of the old partners will be reduced. The new partner
may acquire his share of future profits either from one partner or from all the partners. It should be
noted in this context that, unless otherwise agreed, the profit sharing ratio between the old partners
will remain the same.
Example
A and B are in partnership sharing profits and losses in the ratio of 3:2, C is admitted as a
partner for 1/4th share. Now, after admission, the new profit sharing ratio will be as under:
Let the total share be 1. C is coming for 1/4th share. So 1 – ¼ = ¾ remains for A and B which
they will share in the ratio of 3:2 (ie: old ratio).
The final profit sharing ratio will be
A = 3/5 of 3/4 = 9/20
B = 2/5 of 3/4 = 6/20
C = 1/4 = 5/20
or A : B : C = 9 : 6 : 5
In the above example if C is coming for 1/3rd
share but A and B or between themselves,
decide to share profits and losses equally.
Here after giving 1/3 to C, the remaining 2/3rd
will be shared by A and V equally (newly
agreed ratio). Therefore the final profit sharing ratio will be:
A = ½ of 2/3 = 1/3
B = ½ of 2/3 = 1/3
C = 1/3 = 1/3
or A : B : C = 1 : 1 : 1
Example-2
A and B are partners sharing profits and losses in the ratio of 3:2. They admit C into the firm
for 3/7 the share of profit which he takes 2/7 from A and 1/7 from B.
Now after admission the new profit sharing ratio will be as under:
A = 3/5 – 2/7 = (21 – 10) / 35 = 11/35
B = 2/5 – 1/7 = (14 – 5) / 35 = 9/35
C = 3/7
= 11 : 9 : 15
Adjustment in Regard to Goodwill Goodwill may be described at the aggregate of those intangible attributes of a business which
contributes to its superior earnings capacity over a normal return on investment.
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Purchased Goodwill It arise when one business buys another and the purchase consideration paid is more than the
value of the net tangible assets received.
Treatment of Purchased Goodwill Following accounting treatments are possible for purchased goodwill :-
(a) Carry it as an asset in the balance sheet indefinitely.
(b) amortize against capital reserve on acquisition.
(c) adjust against capital reserve on acquisition.
(d) change as an expense against profits in the year of acquisition.
Valuation of non-purchased goodwill a) average profit method
b) super profit method
c) capitalisation of average profit method
d) capitalisation of super profit method
a) Calculation of average profit – take simple average or weighted average of previous year profit.
After calculating profit, it is multiplied by a number (3or4) as agreed. The product will be the
value of goodwill.
Q. A and B are partners sharing profits and losses in the ratio of 4:3 for last four years
they have been entitled to an annual salaries of Rs. 90,000 and Rs. 150,000 respectively.
The annual accounts have shown the following net profits before charging salaries:
Year ended on 31st March 2001 – Rs. 352360; 2002-Rs. 2,20,000; 2003-Rs. 4,20,000. On 1
st
April 2003, C is admitted to partnership for 2/9th share. The goodwill to be raised in books.
The goodwill to be valued 4 years' purchase of last three years (after allowing for salaries),
profits to be weighted 1:2:3, the greatest weight being gives to the last year. Calculate the value of
goodwill.
15
CHAPTER – 4
ADVANCED COMPANY ACCOUNTS
Share capital means the capital raised by the issue of shares. The amounts invested by the shareholders
towards the face value of shares are collectively known as 'share capital' which is quite distinct from the capital
put in by individual shareholders.
The share capital is divided under 3 heads.
(a) Authorised capital
(b) Issued capital
(c) Subscribed capital
(a) Authorised capital Authorised capital refers to that amount which is stated in the 'capital clause' of memorandum of
Association as the share capital of the company. This is the maximum limit of the company to which it is
authorised to raise and beyond which the company cannot raise unless the capital clause in the memorandum is
altered according with the provisions of Sec-94 of the companies Act, 1956.
(b) Issued capital Issued capital refers to the nominal value of that part of authorised capital, which has been (i)
subscribed for by the signatories to the memorandum of Association, (ii) alloted for cash or for consideration
other than cash and (iii) alloted as Bonus shares.
(c) Subscribed capital Subscribed capital refers to the paid-up value of the issued capital. Other terms sed under the
companies Act 1956, are :
(i) Unissued capital :- It refers to the paid-up value of the issued capital.
(ii) Uncalled capital :- It refers to that portion of the authorised capital which has not yet been issued.
(iii) Reserve capital :- It refers to that portion of uncalled share capital which shall not be capable of
being called up except in the event and for the purposes of the company being wound up (sec. 99)
Types of Shares 1) Preference shares
2) Equity of ordinary shares
1) Preference shares :-
These are those shares which carry two Preferential rights namely:
i) right to receive dividend before any dividend is given on ordinary shares.
ii) right to reserve back capital before any amount is to be paid to ordinary shareholders by way of
refund of capital.
The preference shares may be further subdivided as
i) cumulative and non cumulative preference shares
ii) redeemable and irredeemable shares,
iii) participating and non participating.
I. Cumulative and non cumulative preference shares :- Cumulative preference share is that share on which arrears of dividend accumulate, where as non-
cumulative preference shares are those shares on which arrears of dividend do not accumulative i.e. the dividend
will be lapses if not paid which a year.
II. Participating and Non Participating A participating preference share are those which in addition to two basic preferential rights, also carries
one or more of the following rights as the articles:
16
(a) A right to participate in the surplus assets left after the repayment of capital to equity shareholders on
the winding up of the company.
(b) A right to participate in the surplus profit left after paying dividend to equity shareholders.
Non participating preference shares are those shares which do not carry any such right. If the articles of
the company are silent preference shares are assumed to be non-participating preference shares.
III. Redeemable or irredeemable preference shares:- Irredeemable preference share capital are those shares which cannot be redeemed only in the event of
company's winding up. On the other hand redeemable preference shares are redeemed within a stipulated time
period in accordance with the terms of issue. After the amendment of companies Act in 1988, companies cannot
issue irredeemable preference shares.
2) Equity or Ordinary shares :- An Equity share is one which is not a preference shares. In other words, it has no priority as to the
payment of dividend or refund of capital at winding up. These are normally risk bearing shares. They are
entitled to all surplus of assets and profits after payment of creditors and preference shareholders.
Issue of Shares A company may issue shares at their face value or at a price other than the face value. When shares are
issued at a price equal to their face value it is termed as shares issued at par. When issue price of a share is more
than the face value, it is known as shares issued at premium. If issue price of a share is less than its face value, it
is called shares issued at discount.
The issue price of a share is normally collected in stages alongwith application, on allotment and later
by making are or two calls. The shares became fully paid-up only on the receipt of all the money due on them.
The accounting entries pertaining to the issue of shares are as follows:-
ISSUE OF SHARES AT PAR
(1) On receipt of applications money
Bank A/c Rs.
To share application A/c
(being share application money received)
(2) On allotment of shares:
(a) Share application A/c Dr. Rs.
To share capital A/c
(being appropriation of application money towards share capital)
(b) Share allotment A/c Dr. Rs.
To share capital A/c
(being allotment money due on shares @.......... Rs. per share)
(3) When allotment money is received, the following entries are passed:
Bank A/c Dr. Rs.
To share allotment A/c
(being allotment money received)
(4) (a) If any call is made on the shares, the following entries are passed:
Share call A/c Dr. Rs.
To share capital A/c
(b) On receipt of call money.
Bank A/c Dr. Rs.
To share call A/c
Issue of Shares at Premium Section 78 of the companies Act as amended by the companies amendment Act 1999 provides that the
amount of premium on searches issued by the company shall be transferred to searches premium account (a
separate A/c). Generally premium money is received along with allotment money. In such a case the following
entries are passed.
17
(a) Bank A/c Dr. Rs.
To share application A/c
(being application money received)
(b) Share Application A/c Dr. Rs.
To share capital A/c
(being application appropriated towards capital A/c)
(c) Share allotment A/c Dr. Rs.
To share capital A/c
To Securities premium A/c
(being allotment money and premium money due on shares)
(d) Bank A/c Dr. Rs.
To share allotment A/c
(being allotment money received)
Issue of shares at Discount A company can issue shares at a discount only when the following, conditions
as laid down in companies Act are sales field:
(a) The share must belong to a class already issued.
(b) The issue is authorised by an ordinary resolution in the general meeting and sanctioned by the company law
board.
(c) The issue is made at a discount which is specified in the resolution but in no case the rate of discount should
exceed 10% or such higher percentage as the central government may permit:
(d) At least one year has elapsed since the company become entitled to commerce the business.
(e) Issues are made within 2 months after receiving the sanction from the company law board.
Journal Entry:- Share allotment A/c Dr. Rs.
Discount on issue of shares A/c Dr. Rs.
To share capital A/c
Discount on issue is a loss and is shown on the asset side of the balance sheet till it is written off.
Over subscription of the issue of shares.
When shares are over subscriped in certain cases, applications may be rejected and application money
refunded, and in certain other cases allotment may be made for fewer shares than applied for. In the later case,
application money paid in excess is generally adjusted against money due on allotment. The relevant entries are
:-
(a) For refund of application money
Share capital A/c Dr. Rs.
To Bank A/c
(b) For adjustment of excess amount
Share application A/c Dr. Rs.
To share allotment A/c
To calls-in-advance A/c
(c) On adjustment of call-in-advance (if any)
Share call A/c Dr.
To call-in-advance A/c
Forfeiture of shares: If a shareholder does not pay the allotment money or call money in time, the company, in accordance
with the provisions of the articles of association may proceed to forfeit the shares held by such a defaulting
shareholders. Upon forfeiture of shares by the company, the person ceases to be the shareholder of the company
and the money paid by him on the shares is forfeited by the company.
Accounting Entry for forfeiture of shares issued at par: When shares have been issued at par and are forfeited by the company, the following entry is passed:
Share capital A/c Dr. Rs. (with called up amount)
To forfeited shares A/c (with the amount paid by the member)
To share call A/c (with the amount due but not paid)
18
Example: X holds 100 shares of Rs. 10 each issued at par, on which he paid Rs. 2 on application but
could not pay Rs. 3 on allotment and Rs. 2 on first call. His share were forfeited by the
company. Pass necessary entry to record the forfeiture of shares.
Solution:
Share capital A/c Dr. Rs. 700
To forfeited shares A/c. 200
To share allotment A/c 300
To share first call A/c 200
(being the forfeiture of 100 shares of Rs. 10 each Rs. 7 per share called up, on account of non-payment of
allotment money and first call @Rs. 3 and Rs. 2 respectively).
Forfeiture of shares which were issued at discount When share which were issued at discount are forfeited, the discount allowed on the issue of shares has
to be cancelled, which is done by crediting the discount on issue of shares A/c.
Example: Y was holding 100 shares of Rs. 10 each issued at 10% discount. He paid Rs. 2 on
applications but could not pay allotment money Rs. 3 per share and first and final call Rs. 4
per shares. The director forfeited his shares. Pass the entry to record the forfeited of shares.
19
CHAPTER – 5
ACCOUNTING FOR MERGERS AND TAKEOVERS
Amalgamation and Absorption and Reconstruction: The term Amalgamation is used when a new company is formed with a view to
purchase the business of two or more existing companies which go into liquidation.
Ex. A Ltd.
+ AB Ltd.
B Ltd.
In Absorption, one or more existing companies go into liquidation and some existing
company takes over or purchases their businesses.
‘A’ Ltd. Purchased by ‘B’ Ltd.
Calculation of Purchase consideration:
Price payable by the purchasing company to the vendor company for acquiring the
business of the latter is called purchase consideration.
Methods Lumpsum Method
Net Asset Method
Net Payment Method
Methods of Accounting :
Pooling of Interest Network In this method of accounting, the balance sheet items and the profit and loss items of the
merged firms are combined without recording the effect of merger. This implies that assets, liabilities
and other items of the acquiring and the acquired firm are simply added at the book values without
making any adjustments. There is no revaluation of assets or creation of good-well.
Q. Firm T merges with Firm S. Firm S issues shares worth Rs. 15 crore to Firm T's
shareholders. The balance sheet of both the firms are:
Particulars Firm T Firm S Combined Firms
Assets
Net fixed Asset 24 37 61
Current Asset 8 13 21
Total 32 50 82
Shareholder fund 10 18 28
Borrowings 16 20 36
Current liabilities 6 12
Total 32 50 82
20
The balance sheet of Firm S after merger is constructed as the addition of the book values of
the assets and liabilities of the merged firms.
It may be noticed that the shareholders funds are recorded at the book value, although T's
shareholders received shares worth Rs. 15 crore in Firms. They now own firms along with its existing
shareholders.
Purchase Method In this method, the assets and liabilities of the acquiring firm after the acquisition of the target
firm are adjusted for the purchase price paid to the target company. Thus the assets and liabilities after
merges are re-valued. If the acquires pays a price greater than the firm market value of assets and
liabilities, the excess amount is shown as goodwill in the acquiring company's book.
On the contrary, if the fair value of assets and liabilities is less than the purchase price paid,
then this difference is referred to as capital reserves.
Q. Firm S acquires Firm T by assuming all its assets and liabilities. The fall value of Firm
T's fixed assets and current assets is Rs. 26 and Rs. 7. crores respectively. Current
liabilities are valued at book value while the fair value of debt is estimated to be Rs. 15
crore. Firm's raises cash of Rs. 15 crores to pay T's shareholders by issuing shares work
Rs. 15 crore to its own shareholders. The balance sheet of both the firm is given below:
Firm T Firm S
Assets
Net fixed Asset 24 37
Current Asset 8 13
Goodwell - -
Total 32 50
Shareholder fund 10 18
Borrowings 16 20
Current liabilities 6 12
Total 32 50
Work out the balance sheet of firm S (acquires) after acquisition and adjusting, assets,
liabilities and equity.
21
CHAPTER - 6
COST AND MANAGEMENT ACCOUNTING
Nature of Financial Statement
1) Records Facts:- It means those transactions which are recorded in the books of accounts.
Such transaction relate to cash in hand, bills receivable, debtors, creditors, fixed assets,
sales, purchase, wages, capital etc.
2) Accounting Convention:- These relates to accounting principles which are applied as a
long standing practice for example the convention relating to conservatism, a provision is
made for anticipated loss but not for anticipated profit.
3) Postulates :- It relates to assumptions which accountant makes while adopting
conventions. One such assumption is relating to continuation of business even beyond the
period which is covered by financial statements. This is known as "going concern of the
business".
4) Personal Judgement:- The application of conventions or postulates depend upon the
personal judgment of the accountant. For example, the method of depreciating an asset,
the method of valuation of stock etc.
5) Accounting Standards and Guiding Notes:- It help to a large extent in preparing
financial statements. Certain accounting standards such as disclosure of accounting
policies.
Financial Statement Analysis its Importance
1) Any decision taken on the basis of intuition may prove to be wrong. To avoid wrong
decision making it is always desirable to analyse and interpret the quantitative data.
2) All people may not posses knowledge and experience of understanding the financial
statements in its raw-form. It be can be easily understood even by layman when they are
analysed and interpreted.
3) Analysis and interpretation is necessary to verify the correctness and accuracy of the
decision made which must have been taken on the basis of intuition.
Tools or Techniques or Methods of Financial Analysis
1) Comparative Financial statements
2) Common-size statement analysis
3) Trend analysis
4) Ratio analysis
5) Cash flow analysis
6) Fund flow analysis
1) Comparative Financial statements It enables comparison of financial information for two or more years placed side by
side. From this it is possible to appraise, the performance, position and efficiency of
business.
22
Illustration
The following are the balance sheets for the year 1991 and 1992. Prepare comparative
balance sheet and comment on the financial position.
Liabilities 1991 1992
6% Preference shares 30,000 30,000
Equity share capital 40,000 40,000
Reserves 20,000 24,000
Outstanding Tax 10,000 15,000
Sundry creditors 15,000 20,000
Bills Payable 5000 7500
Debentures 10,000 15,000
1,30,000 1,52,000
Assets 1991 1992
Land 10,000 10,000
Building 30,000 27,000
Plant 30,000 27,000
Furniture 10,000 14,000
Stock 20,000 30,000
Debtors 20,000 30,000
Cash 10,000 14,000
1,30,000 1,52,000
Comparative Balance Sheet
Assets: 1991 1992 Absolute change % change
1) Current Assets
Stock
Debtors
Cash
Total current Asset
20000
20000
10000
50000
30000
30000
14000
74000
10000
10000
4000
24000
50%
50%
40%
48%
2) Fixed Assets
Land
Building
Plant
Furniture
Total Fixed Asset
10000
30000
30000
10000
80000
10000
27000
27000
14000
78000
-
-3000
-3000
4000
-2000
-
-10%
-10%
40%
-2.5%
Total Asset (1 + 2) 1,30,000 1,52,000 22,000 16.92%
Liabilities: 1991 1992 Absolute change % change
1) Current Liabilities
Creditors
Bills payable
........ Tax
Total current liabilities
15000
5000
10000
30000
20000
7500
15000
42500
+5000
2500
5000
12500
33.33%
50%
50%
41.66%
23
2) Long term loans
Debentures
Total Fixed Asset
10000
10000
15000
15000
5000
5000
50%
50%
3) Shareholder's Funds:
Preference share capital
Equity share capital
Reserves
Total share holder's fund
30000
40000
20000
90000
30000
40000
24500
94500
-
-
4500
4500
-
-
22.5%
5%
Total liabilities (1 + 2 + 3) 1,30,000 1,52,000 22,000 16.92%
Working Notes:
Calculation of % change =
Interpretation
As there is a slight rise in current assets over current liabilities (48% - 41.66% =
6.33%) the financial position can be stated as satisfactory.
Question:- Following are the Balance sheet of a company for the year 1997 and 1998.
Prepare a comparative balance sheet and explain the financial position of the
concern.
: 1997 1998
Share Capital 3,00,000 4,00,000
Reserve and Surplus 1,65,000 1,11,000
Debentures 1,00,000 1,50,000
Long term loans 75,000 1,00,000
Bills Payable 25,000 12,500
Creditors 50,000 60,000
Other Current Liabilities 2,500 5,000
7,17,500 8,48,500
Assets: 1997 1998
Land & Building 1,85,000 1,35,000
Plant & Machinery 2,00,000 3,00,000
Furniture's Fixtures 10,000 12,500
Other Fixed Assets 12,500 15,000
Cash at Bank 10,000 40,000
Bills Receivable 75,000 46,000
Debtors 1,00,000 1,25,000
Stocks 1,25,000 1,75,000
7,17,500 8,48,500
24
CHAPTER – 7
RATIO ANALYSIS
Ratios are indicators, sometime they serve as pointers but not in themselves powerful tool of
management. The ratios help to summarize the large quantities of financial data to make qualitative
judgement about the firm's financial performance.
Classification of Ratio's Analysis 1. Analysis of short term financial position or tests of liquidity.
2. Analysis of long term financial position or test of solvency.
3. Activity Ratios
4. Profitability Ratios
1. Liquidity Ratios:- It is used to test the liquidity position of the business or a firm. It
enables to know whether a firm has adequate working capital to carryout routine business
activity as well as to know that whether the short-term liabilities can be paid out of short
term assets.
(a) Current Ratio:- It is also called working capital ratio, it establish the relationship
between total current asset and current liabilities.
A current ratio of 2:1 is considered ideal as a rule of thumb.
(b) Quick Ratio or Acid ratio or Liquid Ratio:- It is concerned with the relationship
between liquid assets and liquid liabilities.
A quick ratio of 1:1 is usually considered to be ideal.
(c) Absolute liquidity Ratio or Cash Position Ratio:- It establishes a relation between
absolute liquid assets to quick liabilities.
The ideal absolute liquid ratio is 1:2.
Q. The following is the Balance Sheet of super star company Ltd. on 31 Dec. 1995. Calculate
the liquidity group ratios and comment on the same.
Equity share capital 10,00,000 Land & Building 7,00,000
Profit & Loss A/c 1,50,000 Plant & Machinery 17,50,000
General Reserves 3,00,000 Stock 10,00,000
Bank Overdraft 20,00,000 Sundry Debtors 500,000
Sundry Creditors 5,00,000 B/R 50,000
25
Bills Payable 2,50,000 Cash at Bank 2,00,000
42,00,000 42,00,000
Current Assets: Current Liabilities
Stock 10,00,000 Bank OD 20,00,000
Sundry Debtors 5,00,000 Sundry Creditors 5,00,000
Bills Receivable 50,000
Cash at Bank 2,00,000 Bills Payable 2,50,000
17,50,000 27,50,000
Interpretation The current ratio is 0.636:1. Which is much below the standard ratio of 2:1.
Quick Assets: Quick Liabilities:
Sundry Debtors 5,00,000 Sundry Creditors 5,00,000
Bills Receivable 50,000 Bills Payable 2,50,000
Cash at Bank 2,00,000
7,50,000 7,50,000
Interpretation: The quick ratio is 1:1 and the standard ratio is also 1:1 so it can meet its current obligations.
Absolute liquid asset = Cash at bank
Interpretation The absolute liquid ratio is 0.26 and the standard ratio is 1:2. It means that the liquidity position of
the company is not satisfactory.
2. Analysis of Long-term Financial Position or Test of Solvency
(a) Debt Equity Ratio or External Internal Equity Ratio:- It establishes a relationship
in between debt and equity. Debt include all long term and short term debt. Equity
consist of shareholders funds, reserves and accumulated profits.
The standard debt equity ratio is 2:1. It means for every 2 shares there is 1 debt.
26
Q. The comparative figures of X Ltd. and Y Ltd. are given below:
X Ltd. Y Ltd.
Total Assets 2,00,000 3,00,000
Total Liabilities 40,000 1,00,000
Owner's Equity 1,60,000 2,00,000
Calculate Debt-Equity ratio for each company.
Debt Equity ratio =
X Ltd. =
Y Ltd. =
Interpretation X Ltd. is more dependent on equity than on debt as its borrowed capital is 25% of its equity.
Whereas Y Ltd. is said to be satisfactory in term of its capital structure as its borrowed capital is 50%
of its equity.
(b) Proprietary Ratio or Net worth Ratio:- It establishes a relationship between proprietary Fund
and total asset:
Proprietary Fund = [Equity + Preference + Capital Reserves + free reserves + undistributed profit]
or
Higher the proprietary ratio, stronger the financial position and vice versa. A ratio of 0.5:1 is
considered ideal.
Q. Total assets Rs. 8,00,000
Proprietor's Equity 4,00,000
Calculate Proprietary Ratio
(c) Solvency Ratio:- It expresses the relationship between total assets and total liabilities of a
business.
27
CHAPTER – 8
FUND FLOW & CASH FLOW STATEMENTS
The flow of fund refers to the changes in the existing financial position of a business
caused by in-flow of resources owing to receipts and payments. It is generally taken to mean
a change in working capital of a business. If a transaction result in an increase in funds, it is
known as application of funds. Where there is no change in the funds, there is no flow of
fund.
Meaning of fund flow statement
It refers to a statement which incorporates working capital that brings about changes
in assets, liabilities and capital of owners between two consecutive balance sheets.
Steps involved in preparation of fund flow statement
1. Prepare a schedule showing changes in working capital.
It is prepared with the help of current assets and current liabilities of the two (period)
balance sheets.
Schedule of change in working capital
Previous year Current year Increase Decrease
(A) Current Assets:
Cash in hand
Cash at Bank
Debtors
Marketable Securities
Bills Receivables
Stock
Prepaid Expenses
Total (A)
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
(B) Current Liabilities:
Creditors
Bills payable
O/S ing Expenses
Total (B)
Working capital (A-B)
Net increase / Decrease in
working capital
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
2. Preparation of Adjusted Profit and Loss A/c to calculate funds from operation
Adjusted Profit & loss A/c
To Depreciation and depletion of
fictitious & intangible assets such as
goodwill, patent, trade marks etc.
xxx By opening balance of P&L
A/c
xxx
28
To Appropriation of Retained Earnings
such as transfer to general reserves,
Sinking funds etc.
xxx By transfer from excess
provision
xxx
To loss on sale of any current or fixed
asset
xxx By appreciation in the value
of fixed assets
xxx
To dividend paid xxx By dividend received xxx
To proposed dividend xxx By profit on sale of fixed
assets
xxx
To provision for taxation (if not taken
as a current liability)
xxx By funds from operation
(Balancing figure)
xxx
To closing balance of profit & loss A/c xxx
To fund lost on operation (Balancing
figure if credit side exceeds the debit
scale
xxx
xxx xxx
3. Reconstruction of all non funds accounts:
The various non fund accounts which have changed between the two balance sheet period
in respect of which additional information is given is to be reconstructed. Such
reconstruction is done by recording of opening and closing balances along with additional
information given.
4. Preparation of a statement of source and application of funds:
Sources of Funds
Funds from operation xxx
Issue of share capital xxx
Raising of long term loans xxx
Receipts from party paid shares called up xxx
Sale of fixed assets xxx
Non trading receipts such as dividend received xxx
Sale of long term investment xxx
Decrease in working capital xxx
Total xxx
Application of Funds
Funds lost in operation xx
Redemption of Preference share capital xx
Redemption of debentures xx
Repayment of long-term loans xx
Purchase of fixed assets xx
Purchase of long-term investment xx
Non trading payments xx
Payment of tax xx
Increase in working capital xx
Total xx
Q.1 Prepare a statement showing changes in working capital:
29
Assets 1990 (Rs.) 1991 (Rs.)
Cash 60,000 94,000
Debtors 2,40,000 2,30,000
Stock 1,60,000 1,80,000
Land 1,00,000 1,32,000
5,60,000 6,36,000
Liabilities 1990 (Rs.) 1991 (Rs.)
Share capital 4,00,000 5,00,000
Creditors 1,40,000 90,000
Retained Earning 20,000 46,000
5,60,000 6,36,000
Schedule showing change in WC.
1990 1991 Increase Decrease
(A) Current Assets:
Cash
Debtors
Stock
Total (A)
60,000
2,40,000
1,60,000
4,60,000
94,000
2,30,000
1,80,000
5,04,000
34,000
-
20,000
-
10,000
(B) Current Liabilities:
Creditors
Total (B)
Working capital (A-B)
Net increase in WC
1,40,000
1,40,000
3,20,000
94,000
90,000
90,000
4,14,000
50,000
94,000
4,14,000 4,14,000 1,04,000 1,04,000
Q.2 The balance sheet of Prasad Ltd. showed a net profit of Rs. 40,000 and Rs. 50,000
for the years 2000 and 2001 respectively. During the year 2001, proposed
dividend was Rs. 30,000 and Rs. 20,000 was transferred to general reserve,
Depreciation on fixed asset was Rs. 30,000. These was loss on sale of furniture to
the extent of Rs. 5000 and on plant was Rs. 10000. Investments were sold for Rs.
40,000 and profit of Rs. 20,000 was made. Preliminary expenses charged to profit
and loss account was Rs. 5,000. Calculate the funds from operation.
Adjusted Profits Loss A/c
To Proposed By balance
Dividend 30,000 B/d 40,000
To transfer to general reserve 20,000 By Profit on sale of
investment
20,000
To Depreciation or fixed assets 30,000 By funds from operation 90,000
To Loss on sale of furniture 5000
To loss on sale of plant 10000
To preliminary Expenses 5000
To balance C/d 50,000
1,50,000 1,50,000
30
CHAPTER – 9
MARGINAL COSTING & BREAKEVEN ANALYSIS
Total cost of an article is made up of variable and fixed expenses. If the fixed cost is deducted from
the total cost, what remains is the variable cost. Variable costing is a costing technique in which only
variable manufacturing cost is considered. The variable cost includes direct material, direct labour
and variable factory overheads. Fixed manufacturing cost are treated as period costs in variable
costing. Variable costing is referred by different names as direct costing and also marginal costing.
Marginal costing is used for taking various business decisions such as profit planning, evaluation of
performance, make or buy decisions, fixing of selling price etc.
Marginal cost is one where the cost per unit changes if the volume of output is changed by one unit.
CVP Analysis
Cost Volume Profit analysis is a study of the relationship between a business's costs, volume and
their impact on profits. It is a tool used extensively in both planning and control functions of an
organisation.
An organisation may use CVP analyses as a planning tool when the management wants to find out
the desired profit, when the sales are known. Alternatively, the management may begin with a
target profit and then work out the level of sales needed to reach that profit level. As a control
technique, CVP analysis is used to measures the performance of different departments in a
company.
The analysis of CVP is static as it is based on a given set of factors. The technique is also based on
several assumptions like fixed costs remain constant for the time period being examined, variable
cost and selling price per unit are constant for the time period analysed. If any of the assumption
changed the analysis will not correct and will lead misleading results.
Break Even Analysis
A basic application of CVP analysis is the break-even analysis. Break-even analysis studies the
relationship among the factors affecting profits, it is a simple and easy method to understand the
effects of change in volume on profits.
The break even analysis is performed to determine the sales volume at which total revenue equates
total costs. The breakeven point is the sales level at which a company neither earns a profit nor
incurs a loss.
A breakeven point can be computed algebraically and graphically and is expressed in either units of
output or sales rupees. In order to compute the breakeven point the following important concepts
used to be noted.
Contribution Margin
It is the amount of revenue in excess of variable costs and contributes towards the fixed cost and
profit of the company. It provides the operating profit of the company. It can be calculated as:
CM or contribution = Selling Price – Variable Cost
(SP) (VC)
31
Contribution Margin Ratio
The CM ratio is the contribution margin as percentage of sales.
Operating Profit = Contribution – Fixed Cost.
Equation for Break Even Point in Units
The breakeven (BE) points in unit can be computed by dividing the total fixed costs by the
contribution marginal per unit.
Equation for Break Even Points in Rupees-
The breakeven (BE) points in rupees can be computed by dividing total fixed costs by the
contribution margin expressed as a percentage of Sales revenue.
Example
Online company manufactures and sells a single product called SPARK. The following financial
projections have been made for the product.
Unit SP – Rs. 25
Unit VC – Rs. 15
Unit Contribution Margin – Rs. 10
The total fixed cost for the company are Rs. 30,000. Presently the sales of the company are Rs.
1,00,000. How many units must be sold by the company to breakeven? Also calculate the breakeven
point for the company in rupees.
= 3000 units
The breakeven point in sales (Rs.) can also be expressed as SP per unit x BE point (in units).
25 x 3000 = Rs. 75,000
Each unit sold contributes Rs. 10 to cover fixed cost and profits. The breakeven point for the online
company is 3000 units ie: if company realizes a level of activity more than 300 units, it will results in
profit, if less, it will result in loss.
Profit Planning
The concept of breakeven can be extended further to include profit planning. The objective of a
business is not just to breakeven but also to earn profits. To calculate the profitability of the
32
business, it is possible to calculate the sales revenue required to provide the desired profits. The
equation for breakeven point can be adjusted to calculate units or volume of sales rupees required
to provide a desired Profits. This is done by adding the desired profit to the fixed costs.
Assume in the above example that the desired profit is Rs. 10,000, the sales revenue required to
produce the desired profit can be calculated as:
P/V Ratio or Contribution Margin as % of sales
As discussed earlier
P/V ratio =
BE in Rs. =
33
CHAPTER 11
BUDGETARY CONTROL
Budget
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.
– ICMA
Budgetary Control: The establishment of budgets relating the responsibilities of executives to the requirements of
a policy, and the continuous comparison of actual with budgeted results either to secure by individual
action the objectives of that policy or to provide a basis for its revision.
–ICMA
Features of Budgetary Control: Requires setting up of different kinds of budgets
Actual performances are compared with the budgeted limits or targets.
Corrective measures may be taken.
Objectives of Budgetary Control: Setting up of objectives
1. Planning
Setting up of organisation
2. Co-ordination
3. Control
4. Policy Formulation
5. Cost Control
6. Economy in Expenditure
7. Corrective Measures
8. Responsibility Control and Coordination
9. Determination of Capital requirements.
10. Control of Research and Development costs
11. Capacity Determination and efficiency Improvement
• Budget is an integral part of the budgetary control system.
• Budgetary control results from the administration of the financial plan.
• Budget is the financial plan.
Precautions in Budgeting:
Following points should be considered while budgeting:
1. Business objectives and policies
2. Budget period
3. Prompt cost Information
4. Budget-makers to be responsible persons
5. Flexibility of Budget
6. Over Budgeting to be avoided
7. Discourage repetition of estimates.
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Kinds of Budget
Functions wise Flexibility wise
Sales Budget - Fixed Budget
Production Budget - Flexible Budget
Raw Material Budget
Labour Budget
Overhead Budget
Development & Research Budget
Plant Budget
Cash Budget
Master Budget
Zero B are Budgeting (ZBB) It is a new approach to budgetary planning and control It was successfully developed and implemented
in the 1970s by Peter A. Pyhre.
It is a method of budgeting in which all expenditure must be justified in each new period, as opposed to
only explaining the amounts requested in excess of the previous period's funding. In zero-base budgeting
approach one reconstructs the operation from zero or scratch. Each activity competes for funds on equal footing
and the funding decisions are as per the relative importance.
Traditional / conventional Budgeting The traditional method takes the current level of operations as the starting point for developing the
future budgets. In traditional approach, it is assumed that all previous activities are essential for achieving the
on-going objectives. However, in case of traditional approach budgets tends to get larger over the years as
inefficiencies of the earlier years are carried forward. New projects receives a raw deal being more susceptible
to be dropped out in case of budget cuts.
Performance Budgeting It involves the development of refined management tools (such as work measurement performance) so
as to achieve the specific goals of the business over a period of time. The emphasis in performance budgeting is
on the improvement of internal management keeping in view the volume of work and its cost, that has to be
accomplished during the financial year.
Costing for decision Making a) Make or Buy Decisions – Management must often decide whether to manufacture a particular product or
whether to purchase the product is usually based on an analysis of both qualitative and quantitative factors.
The quantitative factors deal with cost implications. The qualitative factors are concerned with ensuring the
right product quality and maintaining the necessary business relationships. Make or buy decisions are quite
easily resolved when the decisions are based on the utilisation of the available resources so as to achieve
organisational goals.
Q. A firm is considering whether to manufacture or purchase a particular component. The
manufacturing cost associated with the product based on an annual production of 5000 units is as
follows:
Particulars Rs.
Direct Materials 15000
Direct Labour 11500
Variable overheads 9500
Fixed overheads 14000
Total cost of manufacturing 50,000
Average manufacturing cost per unit =
Rs. 10 per unit
and the same could be purchased for Rs. 9 per unit.
Solution Particulars Decision Make Buy
Direct Materials 15000
Direct Labour 11500
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Variable overheads 9500
Fixed overheads 14000 14000
Purchase price @Rs. 9 45000
Total cost to Acquire 50,000 59000
Savings if poet is made 9000
The manufacturing as purchasing decisions need to be investigated in the context of the following
alternatives to utilise available facilities:
Leaving capacity idle
Purchasing the parts and using the idle capacity for some other purpose
Purchasing the part and renting out idle facilities.
Accepting a special order One of the most significant non-routine decision faced by management is of accepting or rejecting
special orders for their product at a price below the usual selling price. In evaluating the merits of a special order
decision, managers must consider not only then cost structures but also the potential effect of the special order
on sales at regular prices.
Q. A firm produces a product x and it sells for Rs. 40 The current production is at 5000 units per
month, which represents 80% of the capacity currently the fixed costs are Rs. 80.000 per month.
The firm has an opportunity to utilise its spare capacity, if it accepts an offer from a
departmental store. The departmental store is willing to purchase 1250 units of product x at a
price of Rs. 30 per unit. ACCEPTANCE OF THE SPECIAL ORDER WILL INCREASE FIXED
COST BY Rs. 10,000. The variable cost of product x are Rs. 15 per unit. Should the firm accept
the special order?
The present position is a follows:
Units Amt.
Sales @40 5000 200000
Less: variable cost @15 5000 75000
Contribution 1,25,000
Less: fixed cost 80,000
Profit 45,000
The cost structure for the special order is as under:
Amt.
Sales (1250 x 30) 37500
Less: variable cost (1250 x 15) 18750
Contribution 18750
Less: Fixed cost 10000
Net Profit 8750
In this example, accepting the special order increases net income by Rs. 8750. Hence the firm should accept
the special offer as it improves the profit margin.
Thus based on the quantitative data, the offer should be accepted. However, in some situations, certain
qualitative factors also need to be considered, before a final decision is taken.
Dropping a Product Line Frequently managers have to decide whether to discontinue or replace an unprofitable product line so
that the overall productivity of the company can be increased. This is especially applied to firms which have a
range of products one of which is supposed to be unprofitable.
Example
Anu Ltd. manufacturer three products, the income statements for which data's are given as under.
Management is considering whether or not to discontinue product Y as it is showing a loss. Based on this data
should product Y be dropped? What other factors would you take into account before making a final decision?
Particulars Product X Product Y Product Z Total
Sales 60,000 50,000 80,000 1,90,000
Less: variable cost (25,000) (30,000) (35,000) (90,000)
Contribution margin 35,000 20,000 45,000 1,00,000
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Fixed costs
Joint 8000 9000 10,000 27,000
Separate 15,000 15,000 18,000 48,000
Total 23,000 24,000 28,000 75,000
Net Income 12,000 4,000 17,000 25,000
