Account Final

8/8/2019 Account Final

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SYLLABUSACCOUNTING FOR MANAGERSMBA1st SEMESTER, M.D.U., ROHTAK

External Marks : 70 Internal Marks : 30Time : 3 hrs.

UNIT-I

Financial Accounting-concept, importance and scope,accounting principles, journal, ledger, trial balance, depreciation (straight lineanddiminishing balance methodology), preparation of final accountswithadjustments.

UNIT-II

Ratio analysis, fund flow analysis, cash flowanalysis.

UNIT-IIIManagement accounting-concept, need, importance and scope;costac c ountin g- me aning, importanc e, me thods, tec hniq ue s andclassification of costs, inventoryvaluation.

UNIT-IV

Budgetary control-meaning, need, objectives, essentials of budgeting,different types of budgets; standard costing and varianceanalysis(materials, labour); marginal costing and its application inmanagerialdecisionmaking.

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ACCOUNTING FOR MANAGERSMBA 1st Semester

(DDE)

UNIT I

Q. Define Accounting. Explain itsNature.Ans. Accounting is often called the language of business.The

Accounting :- basic function of any language is to communicate. Accountingcommunicatesthe results of the business to the users of accounting information toenablethem to make effective decisions. To communicate information,accountingfollows a systematic process of recording, classifying and summarizingof numerous business transactions resulting in creation of financialstatements.The two most important financial statementsare : (i) Trading, Profit & Loss

Account.(ii) BalanceSheet.

Definition of Accounting

:

According to American Institute of Certified PublicAccountants: Accounting is the art of recording, classifying and summarizing in asignificantmanner and in terms of money, transactions and events which are, in

partatleast, of a financial character, and interpreting the resultsthereof.According to R.N. Anthony :

Nearly every business enterprise has accounting system. It is a meansof collecting, summarizing, analyzing and reporting in monetaryterms,informations about

business.Feature or Characteristics or Nature of Accounting

:

(1) Recording of Financial Transactionsonly :

Only thosetransactionsand events are recorded in accounting which can be expressed in terms

of money. Those transactions which cannot be expressed in terms of

moneyare not recorded in accounting like the value of human resource, strike byemployees, and change in managerial policiesetc.

(2)Recording :

Accounting is the art of recording of businesstransactionsaccording to some specified rules. In a small business where number

of transactions is quite small, all transactions are first of all recordedin a

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ACCOUNTING FOR MANAGERS

book called Journal. But in a big business where the number of transactions is quite large, the Journal is further sub-divided intovarioussubsidiary books such

as:- (i) Cash Book (ii) PurchaseBook (iii) SalesBook (iv) Purchase ReturnBook (v) Sales ReturnBook.The number of subsidiary books to be maintained depends on the size

andnature of the business.(3)Classifying :

After recording the transactions in journal or subsidiary books, the transactions are classified. Classification is the process

of grouping the transactions of one nature at one place, in aseparateaccount. The books in which various accounts are opened iscalledLedger.

(4)Summarising :

Summarising involves the balancing of Ledger accountsand the preparation of Trial Balance with the help of such

Balances.Financial Statements are prepared with the help of trial balance.Financialstatements areincludes:-(i) Trading, Profit & LossAccount(ii) BalanceSheet.

(5) Interpretation of theResults :

In accounting the results of businessare presented in such a manner that the parties interested in the

businesssuch as proprietors, managers banks, creditors etc. can havefullinformation about the profitability and the financial position of the business.(6)

Communicating : It refers to transmission of summarizedandinterpreted information to a variety of users. The users

are:- (i)Creditors(ii)Investors(iii)Lenders(iv)Government(v)Proprietors(vi)Management(vii) Banksetc.Q. Define Accounting. Also explain its

Importance.Ans. Accounting is often called the language of business.The

Accounting : basic function of any language is to communicate. Accountingcommunicates

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the results of the business to the users of accounting information toenablethem to make effective decisions. To communicate information,accountingfollows a systematic process of recording, classifying and summarizingof numerous business transactions resulting in creation of financialstatements.The two most important financial statementsare:- (i) Trading, Profit & Loss

Account.(ii) BalanceSheet.Definition of

Accounting : According to American Institute of Certified PublicAccountants : Accounting is the art of recording, classifying and summarizing in

asignificant manner and in terms of money, transactions and events whichare,in part atleast, of a financial character, and interpreting the resultsthereof.Importance of

Accounting : (1) Helpful in Management of Business :

Management needs a lotof information for the efficient running of the business. All such

informationis provided by the accounting which helps the management inthefollowing:-(i) Helpful inPlanning :

Management would like to know whether thesales are increasing or decreasing and also the speed of increase

inthe cost of production. All such information is provided bytheaccounting, which helps the management in estimating thefuturesales and expenses. It also helps them to estimate the cashreceiptsand cash disbursements during the next accounting

period.(ii) Helpful in Decision-Making :

At times, the Management hastotake a number of decisions. Accounting provides all the

informationsrequired for making suchdecisions.

(iii) Helpful inControlling :

Management would like to see that thecostincurred is reasonable and that no department is

overspending.Accounting provides information to the management in thisregard.

(2) Provides Complete and SystematicRecord :

Businesstransactionshave grown in size and complexity and it is not possible to remember

eachand every transaction. Accounting keeps a prompt and systematicrecordof all the transactions and summarizes them in order to provide atrue picture of the activities of the businessentity.

(3) Information regarding Profit orLoss : Accounting reports thenetresult of business activities of an accounting period. For this purposeTrading and Profit & Loss Account of the business is prepared at the endof each accounting period. All the items relating to purchase, sales,expensesand revenues (Income) of the business are recorded in Trading, Profit&Loss Account.

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If Revenues >Expenses- ProfitIf Revenues< Expenses- Loss

(4) Information Regarding Financial

Position :

For a

businessman,merely ascertaining profit or loss of the business is not sufficient.The businessman must also know the financial health of the business. For this purpose a statement called Balance Sheet is prepared which showstheassets on the one hand and the liabilities and capital on the other hand.Balance Sheet describe thefollowing : (i) How much the business has to recover from

Debtors?(ii) How much the business has to pay toCreditors?(iii) How much the business has in the formof (a) Cash-in-hand (b) Cash at

Bank (c) Closing Stock (d) FixedAssets.

(5) Enables Comparative

Study :

By keeping a systematic

recordaccounting helps the owners to compare one years costs, expenses,salesand profit etc. with those of other years. Such a comparison providestheuseful information on the basis of which important decisions can betakenmore

judiciously.(6) Provide Informations to VariousParties :

Another main objectivesof accounting is to communicate the accounting information to

varioususerslike: (i)

Creditors(ii)Investors(iii)Lenders(iv)

Government(v)Proprietors(vi)Management(vii) Banksetc.

(7) To Know the LiquidityPosition :

Another objective of accounting isto provide information about liquidity position. For this purpose it

preparesa Cash Flow Statement. It depicts inflows and outflows of cashfromoperating, investing and financingactivities.(8) To File Tax

Returns : One of the main objectives of accounting isto provide bases for filing tax returns relating to income tax, sales tax,

valueadded tax, service tax,etc.

(9) Facilitates Sale of Business : If a business entity is being sold,theaccounting information can be utilized to determine the proper purchase price.(10) Helpful in Raising

Loans : Accounting information is of great helpwhileraising loans from banks or other financial institutions. Such

institutions

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before sanctioning loan screen various financial statements of thefirmsuch as final accounts, fund flow statement, cash flow statementetc.

(11) Helpful in Prevention and Detection of Errors and

Frauds.Q. Define Accounting. Also explain itsScope.Ans. Accounting is often called the language of business.The

Accounting : basic function of any language is to communicate. Accountingcommunicatesthe results of the business to the users of accounting information toenablethem to make effective decisions. To communicate information,accountingfollows a systematic process of recording, classifying and summarizingof numerous business transactions resulting in creation of financialstatements.The two most important financial statementsare:- (i) Trading, Profit & Loss

Account.(ii) BalanceSheet.

Definition of Accounting : According to American Institute of Certified PublicAccountants : Accounting is the art of recording, classifying and summarizing in asignificantmanner and in terms of money, transactions and events which are, in

partatleast, of a financial character, and interpreting the resultsthereof.Scope of Accounting :

In order to appreciate the exact nature and scopeof accounting, we must understand the following aspects of

accounting:(1) EconomicEvents :

Accounting records only economic events.Aneconomic event is a transaction which can be measured and expressed

interms of

money.(2)Identification :

It means determining what transactions are to berecorded. It involves observing events and selecting those events that

areof financial character and relate to theorganization.(3)

Measurement : It means quantification of business transactionsintofinancial terms by using monetary

units.(4)Recording :

Accounting is the art of recording of businesstransactionsaccording to some specified rules. In a small business where number

of transactions is quite small, all transactions are first of all recordedin a book called Journal. But in a big business where the number of transactions is quite large, the Journal is further sub-divided intovarioussubsidiary books suchas:- Cash Book Purchase Book Sales Book Purchase Return

Book Sales ReturnBook.

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ACCOUNTING FOR MANAGERSThe number of subsidiary books to be maintained depends on the sizeandnature of the

business.(5)

Classification :

After recording the transactions in journal or

subsidiary books, the transactions are classified. Classification is the processof grouping the transactions of one nature at one place, in aseparateaccount. The books in which various accounts are opened iscalledLedger.(6)

Summarising : Summarising involves the balancing of Ledger accountsand the preparation of Trial Balance with the help of such

Balances.Financial Statements are prepared with the help of trial balance.Financialstatements areincludes:-(i) Trading, Profit & LossAccount(ii) BalanceSheet.

(7)Communication :

It refers to transmission of summarizedandinterpreted information to a variety of users. The users

are:-(i)Creditors(ii)Investors(iii)Lenders(iv)Government(v)Proprietors(vi)Management(vii) Banksetc.

(8) Interpretation of theResults :

In accounting the results of businessare presented in such a manner that the parties interested in the

businesssuch as proprietors, managers banks, creditors etc. can havefullinformation about the profitability and the financial position of the business.Q. Define Accounting. Explain its Objectives Or Functions and

BranchesOr Types.

Ans. Accounting is often called the language of business.The

Accounting : basic function of any language is to communicate. Accountingcommunicatesthe results of the business to the users of accounting information toenablethem to make effective decisions. To communicate information,accountingfollows a systematic process of recording, classifying and summarizingof numerous business transactions resulting in creation of financialstatements.The two most important financial statementsare:- (iii) Trading, Profit & Loss

Account.(iv) BalanceSheet.Definition of

Accounting : According to American Institute of Certified PublicAccountants :

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Accounting is the art of recording, classifying and summarizing in asignificantmanner and in terms of money, transactions and events which are, in

partatleast, of a financial character, and interpreting the resultsthereof.Objectives or Functions of Accounting:-

The following are themainobjectives, functions or utility of

accounting:-(1) To keep a Systematic record of businesstransactions :

The mainobjective of accounting is to maintain complete record of

businesstransactions according to some specified rules. For this purpose allthe business transactions are first of all recorded in Journal or SubsidiaryBooks and then posted intoLedger.

(2) To Calculation Profit orLoss :

The second main objective of accountingis to calculate the net profit earned or loss suffered during a

particular period. For this purpose Trading and Profit & Loss Account of the

businessis prepared at the end of each accounting period. All the items relatingto purchase, sales, expenses and revenues (Income) of the businessarerecorded in Trading, Profit & LossAccount.

If Revenues >Expenses - ProfitIf Revenues< Expenses- Loss(3) To know the exact reasons leading to net profit or net

loss.(4) To Know the Financial Position of thebusiness :

For a businessman,merely ascertaining profit or loss of the business is not sufficient.

The businessman must also know the financial health of the business. For this purpose a statement called Balance Sheet is prepared which showstheassets on the one hand and the liabilities and capital on the other hand.(5) To ascertain the progress of the business from year to

year.(6) To prevent and detect errors andfrauds.(7) To Provide Informations to VariousParties :

Another mainobjectivesof accounting is to communicate the accounting information to

varioususers.(8) To Know the Liquidity

Position : Another objective of accounting isto provide information about liquidity position. For this purpose it

preparesa Cash Flow Statement. It depicts inflows and outflows of cashfromoperating, investing and financingactivities.

(9) To File TaxReturns : One of the main objectives of accounting isto provide bases for filing tax returns relating to income tax, sales tax,valueadded tax, service tax,etc.Branches OR Types of

Accounting: Branches of accounting

are : (1) FinancialAccounting :

It covers the preparation and interpretationof

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financial statements and communication to the users of accounts.Thefinal step of financial accounting is the preparation of Trading and Profit&Loss Account and the Balance

Sheet.(2) ManagementAccounting :

The main purpose of ManagementAccounting is to present the accounting information in such a way as

toassist the management in planning and controlling the operations of a business. The management accountant uses various techniquesandconcepts to make the accounting data more useful for managerialdecisionmaking.

(3) Tax Accounting : The branch of accounting which is used for tax purpose is called tax accounting. Income Tax and Sale Tax are

computedon the basis of thisaccounting.

(4) Cost

Accounting :

The main purpose of cost accounting is to

calculatethe total cost and per unit cost of goods produced and services rendered bya business. It also estimates the cost in advance and helpsthemanagement in exercising strict control over cost.

(5) Social ResponsibilityAccounting :

The society providestheinfrastructure and the facilities without which business cannot operate

atall. Hence the business also has a responsibility to the society. Thereis agrowing demand for reports on activities which reflect the contributionof an enterprise to the society. Social responsibility accounting isthe process of identifying, measuring and communicating the contributionof a business to the society. In social responsibility accountingtechniqueshave been developed for measuring the cost of these contribution and

the benefits to thesociety.Q. What do you mean by Accounting Principles or (GAAP)? Explainand illustrate

fully.Ans. The accounting statements are needed by

AccountingPrinciple

: various parties who have interest in the business, namely,

proprietors,investors, creditors, government and many other. Accountingstatementsdisclose the profitability and solvency of the business to various parties. Itistherefore, necessary that such statements should be prepared accordingtosome standard language and set rules. These rules are usually calledGeneralAccepted Accounting Principles(GAAP).Kinds of AccountingPrinciples : Accounting principles are described byvarious terms such as assumptions, conventions, concepts,doctrine, postulate etc. These principles can be classified mainly into twocategories:-(A) Accounting Concepts or

Assumptions(B) AccountingConventions.

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Kinds of AccountingPrinciples

AccountingConcepts

Accountingor Assumptions

Conventions

Business EntityConcept

Convention of FullDisclosureConvention of Consistency

Money MeasurementConcept

Convention of Conservatism

Going Concern Concept

Convention of Materiality

Accounting PeriodConceptHistorical Cost

ConceptDual AspectConceptRevenue RecognitionConceptMatchingConceptAccrualConceptObjectivityConcept

(A) Accounting Concepts orAssumptions :

Accounting conceptsdefinethe assumptions on the basis of which financial statements of a

businessentity are prepared. The word concept means idea or notion, whichhasuniversal application. These accounting concepts provide a foundationfor accounting process. No enterprise can prepare its financialstatementswithout considering these basic concepts or assumptions. Theseconceptsguide how transactions should be recorded and reported. Followingmay be treated as basic concepts or assumptions :

(1) The Business EntityConcept :

Entity concept states that businessenterprise is a separate identity apart from its owner. Accountants

shouldtreat a business as distinct from its owner. Business transactionsarerecorded in the business books of accounts and owners transactionsinhis personal books of accounts. Business unit should have acompletelyseparate set of books and we have to record business transactionsfromfirms point of view and not from the point of view of the

proprietor.Example :

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(i) The proprietor is treated as a creditor of the business to the extentof capital invested by him in the business. The capital is treated as

aliability of the firm because it is assumed that the firm has borrowedfunds from its own proprietors instead of borrowing fromoutside parties. It is for the reason that we also allow interest on capitalandtreat it as an expense of the

business.(ii) Similarly, the amount withdrawn by the proprietor from the businessfor his personal use is treated as his

drawings.(iii) The proprietors house, his personal investment in securities,his personal car and personal income and expenditure are kept

separatefrom the accounts of the businessentity.(iv) If the proprietor has some other business entity doing

another business, the records of that business should also be keptseparate.The concept of separate entity is applicable to all forms of

businessorganizations, i.e. sole proprietorship, partnership or acompany.(2) Money MeasurementConcept :

As per this concept, onlythosetransactions, which can be measured in terms of money are

recorded.Transactions, even if, they affect the results of the business materially,arenot recorded if they are not convertible in monetary terms.Transactionsand events that cannot be expressed in terms of money are not recordedinthe business books. For example, accounting does not record aquarrel between the production manager and sales manager; it does notreportthat a strike is beginning and it does not reveal that a competitor has placed a better product in the market. These facts or happeningscannot be expressed in money terms and thus are not recorded in the

books.Example : A business on a particular day has 5000 Kilograms of rawmaterials, 5 Machines, 100 Chairs and 20 Fans. All these things cannot

beadded up unless expressed in terms of money. In order to make a recordof these items, these will have to be expressed in monetary terms such asRawMaterials Rs. 25000, Machines Rs. 200000, Chairs Rs. 5000 and FansRs.8000. As such, to make accounting records relevant, simple,understandableand homogeneous, they are expressed in a common unit of measurementi.e.,money.

(3) Going ConcernConcept :

As per this concept it is assumed thatthe business will continue to exist for a long period in the future.

Thetransactions are recorded in the books of the business on the

assumptionthat it is a continuingenterprise.Example :

(i) It is on this concept that we record fixed assets at their originalcost and depreciation is charged on these assets without reference to

their marketvalue.

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(ii) It is also because of the going concern concept that outside partiesenter into long-term contracts with the enterprise, gives loans

and purchase the debentures and shares of the

enterprise.(iii) Another example of this concept is that Prepaid Expenses,which have no realizable value are shown as assets in the balance

sheet, because the benefits of such expenses will be received infuture.(4) Accounting Period

Concept : According to this conceptaccountsshould be prepared after every period & not at the end of the life of

theentity. Usually this period is one calendar year i.e. 1 Jan to 31December

sts t

or from 1 April to 31 March. According to Amended Income Tax Law,a

s t s t

business has compulsorily to adopt financial year beginning on 1April

st

and ending on 31 March. Apart from this, companies whose sharesare

s t

listed on the stock exchange are required to publish quarterly resultstodepict the profitability and financial position at the end of three

months period.(5) Historical Cost Concept or CostConcept :

According to thisconcept,an asset is ordinarily recorded in the books of accounts at the price

atwhich it was purchased or acquired. This cost becomes the basis of allsubsequent accounting for the asset. Since the acquisition cost relatestothe past, it is referred to as historical cost. This cost is the basisof valuation of the assets in the financialstatements.Example : If a business purchases a building for Rs. 500000, it would

berecorded in the books at this figure. Subsequent increase or decreaseinthe market value of the building would not be recorded in the booksof accounts.Benefits :

(i) It is highly objective and free from bias.(ii) Market values of assets are difficult to bedetermined.(iii) Market values of the assets may change from time to time and itwill be extremely difficult to keep track of up and down of the

market price.

Limitations : (i) Assets for which nothing is paid will not be recorded. Thusa favourable location, brand name and reputation of the

business,knowledge and technological skill built inside the enterprisewillremain unrecorded though these are valuableassets.(ii) Historical cost-based accounts may lose

comparability.(iii) Many assets do not have acquisitioncost.(iv) During periods of inflation, the figure of net profit disclosed by

profit and loss account will be seriously distorted becausedepreciation

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based on historical costs will be charged against revenues atcurrent prices.(v) Information based upon historical cost may not be useful

tomanagement, investors, creditorsetc.

(6) Dual AspectConcept :

According to this concept, every businesstransaction is recorded as having a dual aspect. In other words,

everytransaction affects atleast two accounts. If one account is debited,anyother account must be credited. The system of recordingtransactions based on this concept is called as Double Entry System. It is becauseof this principle that two sides of the Balance Sheet are always are equalandthe following accounting equation will always hold good at any pointof time:-

Assets = Liabilities +Capital

OR

Capital = Assets -Liabilities

Example : X commences business with Rs. 5 Lacs in cash and takesaloan of Rs. 1 Lac from the bank, and these 6 Lacs are used in buying

someassets, say, plant & machinery. The equation will be asfollows: Assets = Liabilities +

CapitalRs. 6 Lacs = Rs. 1 Lac + Rs. 5Lacs

(7) Revenue Recognition (Realisation)Concept :

Revenue meanstheamount which is added to the capital as a result of business

operations.Revenue is earned by sale of goods or by providing a service. Conceptof revenue recognition determines the time or the particular period inwhichthe revenue is realized. Revenue is deemed to be realized when the titleor ownership of the goods has been transferred to the purchaser andwhenhe has legally become liable to pay the amount. It should berememberedthat revenue recognition is not related with the receipt of cash.Example : For example, if a firm gets an order of goods on 1

January,st

supplies the goods on 20 January and receives the cash on 1 April,the

th s t

revenue will be deemed to have been earned on 20 January, asthe

th

ownership of goods was transferred on thatday.

(8) MatchingConcept :

This concept is very important for correctdetermination of net profit. According to this concept, all expense

arematched with the revenue of that period should only be takenintoconsideration. This principle is based on accrual concept as itconsidersthe occurrence of expenses and income and do not concentrate onactualinflow or outflow of cash. This principle helps us in finding Net profitor Loss. Following points must be considered while matching costswithrevenue:

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(i) When an item of revenue is included in the profit and loss account,all expenses incurred on it, whether paid or not, should be show

asexpenses in the profit and lossaccount.

(ii) When some expenses, say insurance premium is paid partly for the next year also, the part relating to next year will be shown as

anexpense only next year and no thisyear.(iii) Similarly, income receivable must be added in revenues and

incomesreceived in advance must be deducted fromrevenues.

(9) AccrualConcept :

In accounting, accrual basis is used for recordingtransactions. It provides more appropriate information about

the performance of business enterprise as compared to cash basis.Accrualconcept applies equally to revenues and expenses. In accrualconceptrevenue is recorded when sales are made whether cash is received or not.Similarly, according to this concept, expenses are recorded in

theaccounting period in which they assist in earning the revenueswhether the cash is paid for them or not.(10) Objectivity

Concept : This concept requires thataccountingtransaction should be recorded in an objective manner, free from

the personal bias of either management or the accountant who preparestheaccounts.(B) Accounting

Conventions : An accounting convention may be definedasa custom or generally accepted practice which is adopted either by

generalagreement or common consent among accountants .Accountingconventions differ from concept in respect to thefollowing:(i) Accounting concepts are established by law while

accountingconventions are guidelines based upon generalagreement.(ii) There is no role of personal judgment or individual bias in

the adoption of accounting concepts whereas they may play a crucialrolein following accountingconventions.(iii) There is uniform adoption of accounting concepts in

differententerprise while it may not be so in case of accountingconventions.Following are the main accounting

conventions : (1) Conventions of FullDisclosure :

This principle requires thatallsignificant information relating to the economic affairs of the

enterpriseshould be completely disclosed. The principle is so important that

thecompanies Act makes ample provisions for the disclosure of essentialinformation in the financial statements of a company. The proformaandcontents of Balance Sheet and Profit and Loss Account are prescribed

byCompanies Act. Various items or facts which do not find placeinaccounting statements are shown in the Balance Sheet by wayof footnotes. Suchas :

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(i) ContingentLiabilities.(ii) If there is a change in the method of valuation of stock, or for providing depreciation or in making provision for doubtful debts,

itshould be disclosed in the Balance Sheet by way of afootnote.(iii) Market value of investments should be given by way of a

footnote.(2) Convention of Consistency :

According to this principle,accounting principles and methods should remain consistent from one year

toanother. These should not be changed from year to year. If a firmadoptsdifferent accounting principles in two accounting periods, the profitsof current period will not be comparable with the profits of the

preceding period.

(3) Convention of Conservatism :

According to this principle,allanticipated losses should be recorded in the books of accounts, but

allanticipated gains should be ignored. In other words, conservatism is

the policy of playing safe. When there are many alternative values of anasset,an accountant should choose the method which leads to the lesser value.Examples of the application of the principle of conservatism : (i) Valuation of closing stock cost or market price whichever isless.(ii) Provision for Doubtful Debts onDebtors.(iii) Joint Life Policies are recorded at Surrender Values.Effects of Principle of Conservatism : (i) Profit & Loss account will disclose lower profits in comparison tothe actual

profits.(ii) Balance sheet will discloses understatement of assetsand overstatement of liabilities in comparison to the actual

values.(4) Convention of Materiality :

This convention is an exception totheconvention of full disclosure. According to this convention, all the

itemshaving significant economic effect should be disclosed infinancialstatements and any insignificant item which will only increase the work of the accountant should not be disclosed in the financial statements.Itshould be noted that what is material for one concern may beimmaterialfor another. Thus, the accountant should judge the important of eachtransaction to determine itsmateriality.Q. Give Classification Of Accounts. What are the Rules of

Journalising?Ans. Classification of Accounts

are:

Classification of

Accounts

:

Classification of Accounts

Personal Accounts Impersonal Accounts

Real Accounts Nominal Accounts

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1. PersonalAccounts :

The accounts which relate to an individual,firm,company or an institution are called personal accounts. Account

of Mohan, Account of D.C.M. Limited, Capital Account of proprietor, etc.

arethe examples of Personal Accounts. This account is further classifiedintothreecategories:-(i) It relates to transactions of human

Natural PersonalAccounts : beings like Ram, Rita,etc.(ii

)Artificial PersonalAccount :

These accounts do not havea physical existence as human beings but they work as

personalaccounts. For example: Government, Companies (private or limited),Clubs, Co-operative Societiesetc.

(iii)

Representative PersonalAccounts :

These are not in the nameof any person or organization but are represented as personal

account.For Example: Outstanding liability account or prepaidaccount,capital account, drawingsaccount.Golden Rule of PersonalAccount : Debit the

Receiver Credit theGiver

2. ImpersonalAccount :

Accounts which are not personal suchasmachinery account, cash account, rent account etc. These can be

further sub-divided asfollows : (i) Accounts which relate to assets of the firm butnot

Real Account : debt. For example accounts regarding Land, Building,Investment,Fixed Deposits etc., are real accounts Cash-in-hand and Cash

atBank are alsoreal.Golden Rule of RealAccount : Debit what comes

in.Credit what goesout.(ii) Accounts which relates to expenses,

losses,NominalAccount : gains, revenue etc. like salary account, interest paidaccount,commission receivedaccount.Golden Rule of NominalAccount : Debit all expense &

Losses.Credit all Incomes &Gains.

Q. Define Accounting Cycle OR Process of Accounting.Ans. An accounting cycle is a complete sequenceof

AccountingCycle

: accounting procedures which are repeated in the same order duringeachaccounting period. The accounting cycle may be shown as

below:-

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Transactions

Books of Original Entry:

1. Cash Book 2. Purchase Book

3. Sales Book Trading, Profit &Loss A/c and 4. Purchase Return Book JournalBalance Sheet

5. Bills Receivable Book

6. Bills Payable Book

7. Journal Proper

Ledger Trial Balance

Diagram : AccountingCycle

(1) Identification of Transaction :

Accounting deals with businesstransactions which are monetary in nature. In other words,

thetransactions which cannot be measured and expressed in terms of moneycannot be recorded inaccounting.

(2) Journal : Journal is one of the basic book of original entry inwhichtransactions are recorded in a chronological (day-to-day) order

accordingto the principles of double entry system. When the size of business is

asmall one, it may be possible to record all transactions in the journal butwhen the size of the business grows and the number of transactions isverylarge journal is sub-divided into a number of books calledsubsidiaryBooks.

There are five columns in journal whichare:- PROFORMA OF JOURNAL

Date Particulars L.F. Amount Dr. AmountCr.

(1) (2) (3) (4)(5)

(i) In the first column, date of transaction is entered. Theyear

Date : and month is written only once, till theychange.

(ii) Each transactions affects two accounts out of which

Particulars : one account is debited and other account iscredited.

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(iii) All entries from the journal are later posted

Ledger Folio or L.F. : into the ledger accounts. The page number of the ledger accountwhere the posting has been made from the journal is recorded in

theL.F. column of the journal.(iv) In the fourth column, the amount of the account

beingAmount Dr. : debited iswritten.

(v) In the fifth column, the amount of the account being

Amount Cr. : credited iswritten.

(3)Ledger :

Business transactions are first recorded in journalor Subsidiary books. The next step is to transfer the entries to

respectiveaccounts in ledger. This process is calledledger Dr. Cr.

Date Particulars J.F. Amount Date Particulars J.F.Amount

Each ledger account is divided into two equal parts. The left-hand sideisknown as the debit side and the right-hand side as the creditside.As shown above, there are four columns on each side of anaccount:-(i) The date of the transaction is recorded in thiscolumn.

Date :

(ii) Each transaction affects twoaccounts.

Particulars : (iii) In this column page number of the journal

or Journal Folio or J.F. : subsidiary book from which the particular entry is transferred,isentered.

(iv) The amount is entered in thiscolumn.

Amount :

(4) TrialBalance :

When posting of all the transactions into ledger iscompleted and the accounts are balanced off, it becomes necessary

tocheck the arithmetical accuracy of the accounting work. For this purpose,the balance of each and every account in the ledger is put on a list. Thelistso prepared is called a trial

balance.PROFORMA OF TRIAL BALANCE

Name of the Accounts L.F. Dr. Balances Cr.

Balances

Features of a TrialBalance : (i) It is a list of balances of all ledger accounts and the cash

book

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(ii) It is just a statement and not anaccount.(iii) It is neither a part of double entry system, nor does it appear inthe actual books of accounts. It is just a working

paper.(iv) It can be prepared at any time during the accounting period, say,at the end of every month, every quarter, every half year or everyyear.(v) It is always prepared on a particular date and not for a

particular period.(vi) It is prepared to check the arithmetical accuracy of theledger accounts

.(vii) If the books are arithmetically accurate, the total of all debit balancesof a trial balance will be equal to the total of all credit

balances.Objectives of Preparing TrialBalance : (i) To ascertain the arithmetical accuracy of the ledger

accounts.(ii) To help in locating

errors(iii) To obtain a summary of the ledger accounts(iv) To help in the preparation of finalaccounts.

(5) Trading, Profit & Loss Account And BalanceSheet

: After havingchecked the accuracy of the book of accounts through preparation of

TrialBalance, businessman wants to ascertain the profit earned or losssuffered during the year and also the financial position of his businessatthe end of the year. For this purpose he prepares Final Accountswhichare also termed as Financial Statements. These include thefollowing:- Trading Account. Profit and Loss

Account. Balance

Sheet.Q. Write a Short Note On Double EntrySystem.Ans. According to Double Entry System,every

Double EntrySystem

: transaction has two fold-aspects- debit and credit and both the aspects areto be recorded in the books of accounts. We may define the Double EntrySystemas the system which records both the aspects of transactions. This

principle proves accounting equation i.e. both sides of Balance Sheet alwaysequal.

Assets = Liabilities +CapitalAdvantages of Double Entry

System : This system affords theunder mentioned

advantages : (1) ScientificSystem(2) Complete Record of EveryTransaction(3) Preparation of TrialBalance(4) Preparation of Trading & Profit & LossA/c(5) Knowledge of financial position of theBusiness(6) Knowledge of VariousInformations.

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(7) ComparativeStudy(8) Lesser possibility of Fraud.(9) Help management in decision

making.(10) LegalApproval(11) Suitable for All types of Businessmen.

Q. Define Depreciation. What are the Causes & Methodsof Depreciation

?Ans. In every business there are certain assets of afixed

Depreciation

: nature that are needed for the conduct of business operations. Someexamplesof such assets are Building, Plant & Machinery, Motor Viechles,Furniture,office Equipments etc. These assets have a definite span of life after theexpiryof which the assets will lose their usefulness for the business operations. Fallinthe value & utility of such assets due to their constant use and expiry of timeistermed as

depreciation.Definition of Depreciation

:

According to WilliamPicklesDepreciation may be defined as the permanent and

continuingdiminution in the quality, quantity or the vale of anasset.Features of Depreciation

:

1. Depreciation is decline in the value of fixed assets (exceptLand)2. Such fall is of a permanentnature.3. Depreciation is a continuous process because value of assetswill decline by their constant

use.4. Depreciation decreases only the book value of the asset, notthe market

value.5. Depreciation is a non-cash expense. It does not involve anycash outflow.

Causes of Depreciation

:

1. By Constant Use.2. ByObsolescence3. By expiry of time.4. By Accident.5. By expiry of legalrights.6. By Depletion

7. By permanent fall in market price.Need, Importance or objects of providingdepreciation

:

1. For ascertaining the truth profit or loss.2. For showing the truth true and fair view of the financial

position.3. To ascertain the accurate cost of production.

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4. To provide funds for replacement of assets.5. To prevent the distribution of profits out of capital.6. For avoiding over payment of Income

tax.7. Other objectives.Factors determining the amount of Depreciation

:

1. Total Cost of theAsset.2. Estimated life of Asset.3. Estimated ScrapValue.

Methods of providing or AllocatingDepreciation

:

1. Straight LineMethod.2. Written Down ValueMethod.3. Annuity Method.4. Depreciation Fund

Method.5. Insurance PolicyMethod.6. RevaluationMethod.7. Depletion Method.8. Machine hour rateMethod.

Q. Explain Straight Line Method of Depreciation with the help of an Example.

Ans. This method is also termed as OriginalCost

Straight LineMethod

: Method because under this method depreciation is charged at afixed percentage on the original cost of the asset. The amount of depreciationremains equal from year to year and as such this method is also knownasEqual Installment Method, or Fixed Installment Method. Under this

method,the amount of depreciation is calculated by deducting the scrap value fromtheoriginal cost of the asset and then by dividing the remaining balance bythenumber of years of its estimatedlife. Original Cost of the Asset Estimated Scrap

ValueYearly Depreciation=

Estimated Life of the

Asset.Merits of Straight LineMethod : 1. Calculation of Depreciation under this method isvery

Simplicity : simple and as such the method is widely popular.2. Equality of Depreciation

Burden :

Under this method, equal amount

of depreciation is debited to profit & loss account of each year. Hence,the burden of depreciation on each years net profit isequal.

3. Assets can be completely writtenoff :

Under this method, the book value of an asset can be reduced to net scrap value or zero value, whichisnot possible under some other methods.

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4. Knowledge of original cost and upto datedepreciation :

under thismethod, the original cost of the asset is shown in the Balance Sheetandthe upto-date depreciation is shown as a direct deduction from

it.Demerits of Straight LineMethod

: 1. When there are different machineshaving

Difficulty inComputation : different life-span, the computation of depreciation becomescomplicated because depreciation on each machine will have to becalculatedseparately.2. Unequal pressure in lateryears :

Repairs charges go on increasingyear by year as the asset becomes older but as the equal depreciation

ischarged under this method eachyear.3. Omission of Interestfactor :

This method does not takeintoconsideration the loss of interest on the amount invested in the

asset.4. Unrealistic to write off the vale of asset to

zero : Sometimes, evenafter the value of an asset is reduced to zero in the books, it continues to be

usedin the business in actual practice5. Difficulty in the determination of scrapvalue :

It is quite difficulttoassess the true scrap value of the asset after a long period, say 15 or

20years from the date of itsinstallation.

Suitability

: This method is suitable for those assets whose useful life can berenewals

.Example :

Birla Cotton Mills purchased a machinery on 1 May, 1991 for Rs. 90,000. On

1

s t s t

July, 1992 it purchased another machinery for Rs.40,000.On 31 March, 1993 it sold off the first machine purchased on 1991 for Rs.

st

58,000 and on the same date purchased a new machinery for Rs.1,00,000.Depreciation is provided at 20% p.a. on the original cost method. Accountsareclosed each year on 31 December. Show the Machinery Account for threeyears

s t

Dr. Machinery AccountCr.

Date Particulats J.F. Amount Date Particulars J.F. Amount

1991 1991

May 1 To Bank A/c 90,000 Dec.31 By depreciation A/c 12,000

(for 8 months)

Dec.31 By Balance C/d 78,000

90,000 90,000

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1992 1992

Jan1 To Balance B/d 78,000 Dec31 By Depreciation A/c

July1 To Bank A/c 40,000 (i) 18,000

(ii) 4,000 22,000

(for 6 months)

Dec31 By Balance C/d

(i) 60,000

(ii) 36,000 96,000

1,18,000 1,18,000

1993 1993

Jan1 To Balance B/d Mar.31 By Bank A/c 58,000

(i) 60,000 Mar.31 By Dep. A/c 4,500

(ii) 36,000 96,000 (for 3 months)

Mar. To Bank A/c 1,00,000 Dec. 31 By Dep. A/c

31 (ii) 8,000 23,000

Mar. To Profit & Loos ( iii) 15,000

31 A/c (Profit On

machine)

Rs. 58,000+

4,500-60,000 2,500 Dec.31 By Bal. C/d

(ii) 28,000

(iii) 85,000 1,13,000

1,98,500 1,98.500

1994

Jan.1 To Bal. B/d 1,13,000

(ii) 28,000

(iii) 85,000

Q. Discuss the Merits And Demerits Of Providing DepreciationBy Diminishing Balance

Method?Ans. Under this method, as the value of asset

Written Down ValueMethod

: goes on diminishing year after year, the amount of depreciation chargedeveryyear also goes ondeclining.

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For Example if a machine is purchased for Rs. 10,000 and depreciation is to becharged at 10% p.a. according to written down value method, the

depreciationwill be charged as

under:-1 Year on Rs. 10,000 @ 10% =1,000s t

2 Year on Rs. 9,000 (10,000-1,000) @ 10% = 900nd

3 Year on Rs. 8,100 (9,000-900) @ 10% = 810rdand so on.

It will be observed from the above calculations that each years depreciationiscalculated on the book value of the asset at the beginning of that year,rather than on the original cost. As the value of asset and also thedepreciationcharged on its goes on reducing year after year, this method is knownasReducing InstallmentMethod.Merits of Written Down Value

Method

:

1. It is easy to calculate the depreciation under this

Easy Calculation : method, even if some new assets are purchased year after year.2. Equal Charge againstincome :

In this method, the total burdenon profit & Loss account in respect of depreciation and repairs put

together remains almost equal year after year.3. No induce pressure in lateryears :

The efficiency of machine is moreinthe earlier years than in later years. Hence, the depreciation in first

fewyears should be more in comparison to the later years.4. Balance of asset is never written off tozero :

This method ensuresthatthe assets is never reduced to

zero.5. Approved method by Income TaxAuthorities :

This method of providing depreciation is permissible under Income TaxRegulations.Demerits of Written Down Value

Method:

1. Asset can not be completely writtenoff. :

Under this method, thevalueof an asset, even if it becomes obsolete and useless, cannot be reduced

tozero and some balance, however small, would continue on assetaccount.2. Omission of InterestFactor :

This method does not takeintoconsideration the loss of interest on the amount invested in the

asset.3. Difficulty in determining the rate of depreciation :

Under thismethod, the rate of providing depreciation cannot be easily

decided.4. Knowledge of original cost & up to date depreciation notpossible : Under this method, the original cost of various assets is not shown intheBalanceSheet.

Example : A company had bought machinery for Rs. 100000 includingthere

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ACCOUNTING FOR MANAGERSin a boiler worth Rs 10000 depreciation was charged on reducing

balancemethod at the rate of 10% p.a. for first five year and machinery accountwascredited accordingly. During the fifth year, the boiler becomes uselessonaccount of damages. The damaged boiler is sold for Rs. 2000 preparesthemachinery account for fiveyears.

MACHINERY ACCOUNTDr. Cr.

Date Particulars Amount Date Particulars Amount

Year To Bank A/c 90000 Year By Dep.Ist To Bank A/c 10000 Ist (i) 9000 10000

(Boiler) (ii) 1000By Bal. C/d(i) 81000(ii) 9000 9000

100000 100000Year To Bal. B/d Year By Dep.II (i) 81000 II (i) 8100

(ii) 9000 (ii) 900 900090000 By Bal. C/d

(i) 72900 81000(ii) 8100

90000 90000

Year To Bal. B/d Year By Dep.III (i) 72900 III (i) 7290

(ii) 8100 (ii) 81081000 By Bal. C/d 8100

(i) 65,610(ii) 7290

81000 81000

Year To Bal. B/d Year By Dep.IV (i) 65610 72900 IV (i) 6561 7290

(ii) 7290 (ii) 729By Bal. C/d(i) 59049 65610(ii) 6561

72900 72900

Year To Bal. B/d Year By Bank 2000V (i) 59049 V By P & L A/c 4561

(ii) 6561 65610 (6561-2000)By Dep. 5905By Bal. C/d 53144

65610 65610

Year To bal B/d 53144VI

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Q. What do you mean by Final Accounts? What is theirNecessity?Ans. Financial Statements refers to such statementswhich

FinalAccounts

: report the profitability and the financial position of the business at the end

of accounting period. The term financial statements include thefollowing:-(1) Trading

Account(2) Profit and LossAccount.(3) BalanceSheet(1) Trading account is prepared for calculating the

grossTrading Account :

profit or gross loss arising or incurred as a result of the trading activitiesof a business. In other words, it is prepared to show the resultof manufacturing, buying and selling of goods.Need and Importance of TradingAccount

:

(i) It provides information about Gross Profit and Gross

Loss.(ii) It provides information about the directexpenses.(iii) Comparison of closing stock with those of the previousyears.(iv) It provides safety against possiblelosses. Format of a Trading Account: Trading

Account(for the year ending )Dr. Cr.

Particulars` Amount Particulars Amount

Rs. Rs.To Opening Stock By SalesTo Purchases Loss Sales Return

Less : Purchase Reture OR

OR Return Outward Returns In wardsTo Wages By Closing Stock To Wages & Salaries By Gross Loss (if any)To Direct Expenses Transferred to P & L A/cTo Carriage or (Balancing Figure)To Carriage Inwards or To Carriage on PurchaseTo Gas, Fuel and Power To Freight, Octroi and CartageTo Manufacturing Expensesor Productive Expenses.To Factory Expense, Such as

Factory Lighting, Factor Rent Etc.To Dock ChargesTo Import duty or Custom DutyTo RoyaltyTo Gross ProfitTransferred to P & L A/c(Balancing Figure)

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ACCOUNTING FOR MANAGERS(2) Trading account only disclose the gross

profitProfit & LossAccount

: earned as a result of buying and selling of goods. However, a

businessmanhas to incurr a number of expenses which are not taken into

tradingaccount. Hence a businessman is more interested in knowing thenet profit earned or net loss incurred during theyear.A profit and loss account is an account into which all gains and lossesarecollected, in order to ascertain the excess of gains over the losses or vice-versa.

Need and Importance of Profit & LossAccount

:

(i) To Ascertain the Net Profit & NetLoss(ii) Comparison with previous years

profit.(iii) Control onExpenses(iv) Helpful in preparation of the balanceSheetFormat of Profit And Loss Account : Profit And Loss

A/c ( for the year ending __________________)


Rs. Rs.To Gross Profit B/d By Gross Prfit B/d(transferred from trading A/c) (Transferred from trading

A/c)To Office Expenses :To Salaries By Rent form tenantTo Salaries & Wages By Discount ReceivedTo Rent, Rate and Taxes By Commission ReceivedTo Printing & Staionery By Any Other IncomeTo Lighting By Net Loss (if any)

To Telephone Charges Transferred to Capital A/cTo Audit Fees etc.

To Selling & DistributionExpense:To Carriage outward or Carriageon salesTo AdvertisementTo CommissionTo Bed-DebtsTo Export DutyTo Parcking Exp etc.

To Miscellaneous Expenses :To Discount/Discount AllowedTo RepairsTo DepreciationTo InterestTo Bank Charges etc.To Net Profit(Transferred to Capital A/c)

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(3) After ascertaining the net profit or net loss of the

BalanceSheet : business enterprise, the businessman would also like to know theexactfinancial position of his business. For this purpose a statement

is prepared which contains all the assets and liabilities of the businessenterprise. The statement so prepared is called a BalanceSheet. Balance

Sheet(As on Or As At--------------)


Rs. Rs.Current Liabilities : Current Assets :Bank Overdraft Cash-in-HandBill Payable Cash at Bank Sundry Creditors Bills ReceivablesOutstanding Expenses Short Term InvestmentsUnearned Income Sundry Debtors

Closing Stock FixedLiabilities :

Prepaid ExpensesLong Term Loans Accrued Income

Reserves: Fixed Assets:Furniture

Capital: Loose ToolsAdd: Net profit Motor VehicleLess: Drawings Long-term investmentsLess: Income Tax Plant & machineryLess: Life Insurance Premium Land & BuildingLess: Net Loss Patents

Goodwill

Need and Importance of BalanceSheet : 1. The main purpose of preparing balance sheet is to ascertain thetrue financial position of the business at a particular point of

time.2. It gives exact information about the exact amount of capital at the endof the year and the addition or deduction made into it in the current

year 3. It helps in finding out whether the firm is solvent or not.4. It helps in preparing the opening entries at the beginning of the nextyear.Q. What is the necessity of doing adjustments? Give some

adjustmententries with theirexplanation.Ans. In order to ascertain the true profit or loss of the

businessAdjustments

: for a particular year, it is necessary that all expenses and incomes relatingtothat year are taken into consideration. For example, if we want to ascertainthenet profit for the year ended on 31 December and rent for the monthof

st

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ACCOUNTING FOR MANAGERSDecember has not yet been paid, it would be proper to include such rentalongwith the other expenses of the year. Similarly, it often happens thatcertainincomes, like interest, dividend, etc. are earned but not received duringtheyear. Adjustment for such incomes must be made in the current year itself,sothat the profit and loss account may disclose the correct amount of net profitor loss and the balance sheet may present the true financial position of the business.Simply stated, while preparing final accounts it must be detected whether thereis atransaction(i) Which has been omitted to be recorded in the books,

or (ii) Which has been wrongly recorded in the books,or (iii) Of which only one aspect has been recorded in the

books.Entries passed for such transactions are called adjustmententries.Need of Adjustments

:

(1) To ascertain the true Net Profit or loss of the business.(2) To ascertain the true financial position of the business.(3) To make a record of the transactions omitted from the books(4) To rectify the errors committed in the books of accounts(5) To make a record of such expenses which have been accrued

but have not been paid.(6) To make a record of such incomes which have accrued but havenot been

received.(7) To provide for depreciation and other provisions.Explanation of Important

Adjustments:

(1) The amount of goods unsold at the end of the year is

Closing Stock : called closing stock. It is valued at Cost Price or RealisableValue,whichever is less. The basic principle underlying the valuation of closingstock is that anticipated losses should be taken into account, butallunrealized gains should beignored.Treatment in FinalAccounts : (i) If the closing stock appears outside the Trial Balance, it will beshown at two places, i.e., on the Credit side of the Trading A/c and on

theAssets side of the BalanceSheet.(ii) If the closing stock appears inside the Trial Balance, it will be

shown only on the Assets side of the BalanceSheet.

(2) Outstanding Expenses Or Expenses Due but notPaid : These aretheexpenses which have been incurred during the year but have beenunpaidon the date of preparation of finalaccounts.

Treatment in FinalAccounts : (i) If outstanding expenses have been mentioned inside the

Trial

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Balance, they will be shown on the liabilities sideonly.(ii) If outstanding expenses have been mentioned outside the

Trial Balance, then on the one hand, it will be added to the

concernedexpenses on the debit side of Trading or Profit and Loss Accountandon the other hand, will also be shown on the liabilities side of theBalanceSheet.(3) Prepaid expenses Or Unexpired Expenses Or Expenses Paid

inAdvance : These are the expenses which have been paid in advance for thenext year during the current year

itself. Treatment in FinalAccounts : (i) If Prepaid expenses have been mentioned inside the TrialBalance,they will be shown on the Assets side

only.(ii) If Prepaid expenses have been mentioned outside the Trial

Balance,then on the one hand, it will be deducted from theconcernedexpenses on the debit side of Trading or Profit and Loss Accountandon the other hand, will also be shown on the Assets side of theBalanceSheet.(4) Depreciation is the loss or fall in the value of fixed

assetsDepreciation :

due to their constant use and expiry of time.Treatment in FinalAccounts :

Depreciation on the one hand, will beshown on the debit side of the Profit and Loss Account and on the

other hand, will also be deducted from the value of the concerned asset ontheAsset side of the BalanceSheet.(5) Accrued Income or IncomeReceivable :

It is quite common thatcertainitems of income such as interest, commission etc are earned during

thecurrent year but have not been actually received by the end of thecurrentyear. Such incomes are known as Accrued Incomes or EarnedIncomesTreatment in FinalAccounts : (i) If accrued incomes have been mentioned inside the TrialBalance,they will be shown on the Assets side

only.(ii) If Accrued incomes have been mentioned outside the TrialBalance,then on the one hand, It will be shown on the credit side of the Profit

&Loss Account and on the other hand, will be shown on the assetssideof the Balance

Sheet.(6) Unearned Income Or Income Received inAdvance :

It mayalsohappen that a certain income is received in the current year but the

wholeamount of it does not belong to the current year. Such portion of thisincome which belongs to the next year is known as Unearned Incomeor Income received but notearned.

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Treatment in FinalAccounts : (i) If Unearned incomes have been mentioned inside the Trial

Balance,they will be shown on the Liabilities side

only.(ii) If Accrued incomes have been mentioned outside the TrialBalance,then on the one hand, It will be deducted from the concernedincomeon the Credit side of the Profit & Loss Account and on the other hand,will be shown on the Liabilities side of the BalanceSheet.(7) Usually in order to ascertain the true efficiency

of Interest onCapital : the business, interest at a normal rate is charged on the capitalinvested by the proprietor in the

business.Treatment in FinalAccounts :

Interest on capital is an expense for the business and hence it is shown on the debit side of Profit & Loss

Account.At the same time, it is a gain to the proprietor and hence is added tohiscapital.(8) Occasionally, the proprietor draws cash or

goodsInterest onDrawings : for his personal use. Such withdrawals are terms as Drawings. If thefirm pays interest on capital, it is fully justified that it should alsochargeinterest ondrawings.Treatment in FinalAccounts :

Interest on drawings is a gain tothe business and hence it is shown on the credit side of Profit & Loss

Account.At the same time, it is an expense from the proprietors view and hencewill be deducted from thecapital.(9) Interest onLoan : (i) Generally, item of Loan appears on the credit side of theTrial Balance. It means that the amount has been borrowed from

some person or the bank etc. Loan is a liability of the firm and theintereston such loan will be an expense. It up-to-date interest has not

been paid on the Loan, the unpaid interest will have to be calculatedandwill be treated just like outstandingexpenses.Treatment in Final Accounts : When Loan appears on the creditsideof the Trial Balance, interest on it will be an expense and hence will

berecorded on the debit side of Profit & Loss Account.Outstandingamount of such interest will also be added to Loan Account ontheLiabilities side of the BalanceSheet.(ii) On the contrary, if the item of loan appears on the debit side of

Trial Balance, it will mean that the amount has been lent to outsider. Itwill be an asset in this case and interest on such loan will be anincomefor thefirm.Treatment in FinalAccounts :

When Loan appears on theDebitside of the Trial Balance, interest on it will be an income and

hencewill be recorded on the credit side of Profit & Loss Account andwillalso be added to Loan Account on the assets side of theBalanceSheet.

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(10) Persons to whom goods have been sold on credit areknown

Bad Debts : as Debtors. Sometimes due to the dishonesty, death or insolvency of adebtor, full amount is not received from him. When it becomes

certainthat a particular amount will not be recovered it is known a s B a d-Debts.Treatment in FinalAccounts : (i) If Bad-debts are given in the adjustments or outside theTrial Balance, they will be shown on the debit side of the Profit &

LossAccount and will also be deducted from the Debtors on the assetssideof the BalanceSheet.(ii) If Bad-Debts are given inside the trial balance, it will be shown on

the debit side of the Profit & LossAccount.(11) Provisions for Bad and Doubtful

Debts : Even after deductingtheamount of actual bad-debts from the debtors, the list of debtors at the

endof the year include some debts which are either bad or doubtful.A provision is created to cover any possible loss on account of bad-debtslikely to occur in future. Such a provision is created at a fixed

percentageon debtors every year and is called provisions for bad and doubtfuldebts.Treatment in Final Accounts : The amount of provision for doubtfuldebtson the one hand, is shown on the debit side of the Profit andLossAccount and on the other hand, is deducted from Sundry debtors ontheassets side of the BalanceSheet.(12) Provisions for Discount onDebtors :

It is a normal practice inthe business to allow cash discount to those debtors from whom the

paymentis received promptly or with a fixed period. Discount thus allowed will bean expense of the business. It should be noted that discount will beallowed only to those debtors who will make prompt payment.Treatment in FinalAccounts :

Such provision is shown on thedebitside of the profit & loss account and is also deducted from

SundryDebtors on the Assets side of the BalanceSheet.(13) Provisions for Discount onCreditors :

Such provision is shown on thecredit side of the Profit & Loss account and is also deducted fromtheSundry Creditors on the Liabilities side of the BalanceSheet.

(14) Sometimes losses occur due to someabnormal

Abnormal Loss : circumstances such as accident, fire, flood, earthquakes etc. Such

lossesare called abnormal losses. These may be divided into twocategories:(i) Loss of Goods : It will be that on the one hand, the loss of goodswill deducted from the purchase on the Debit side of Trading Account

andit will also be shown on the debit side of Profit & LossAccount(ii) Loss of Fixed Assets : If some fixed assets of the firm is destroyed

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some accident, then the loss will be shown on the debit side of P&LA/c and also deducted from the value of Asset on the assets sideof the BalanceSheet.

(15) Occasionally, certain amount of goodsis

Charity in the Form of Goods : given away as charity. On the one hand, the amount will be deductedfrom purchase and on the other hand it will also be shown on the debit sideof P&L A/c.

(16) Goods Distributed as FreeSamples :

Sometimes the goods whichthe business deals in are distributed as free samples for the purpose

of advertising these goods. On the one hand, the amount will bedeductedfrom purchase and on the other hand it will also be shown on thedebitside of P&LA/c.(17) If the proprietor of the business has taken

someDrawings in Goods : goods for his personal use from the business, it is known as Drawings

inGoods. It will be deducted from purchase in the Trading Account andwillalso be deducted from the Capital on the liabilities side of theBalanceSheet asDrawings.(18) Deferred RevenueExpenditure :

There are certain expenditureswhichare revenue in nature but the benefit of which is likely to be derived over

anumber of years. Such Expenditures are termed as DeferredRevenueExpenditure. As such, the whole of such expenditure is not debited totheProfit and Loss Account of the current year but spread over the yearsfor which the benefit is likely to last. Thus, only a part of such expenditureistaken to Profit & Loss Account every year and the unwritten off portionisallowed to stand on the assets side of the BalanceSheet.

(19) Managers Commission on NetProfit :

Sometimes, in addition tohisregular salary, the manager is entitled to a commission on net profit.Treatment in FinalAccounts :

On the one hand, it will be recordedonthe debit side of P& L A/c and on the other hand, shown on the

liabilitiesside as an outstandingexpense.Methods of Calculating theCommission : (i) On Profits before charging such commission: The formulais: Rat

eManagers Commission = Net Profit x 100

(ii) On Profits after charging such commission: The formulais: Rat

eManagers Commission = Net Profit x 100 + Rate

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ACCOUNTING FOR MANAGERSMBA 1st Semester

(DDE)

UNIT II

Q. What is Ratio Analysis? Explain its Objectives and Limitations.Also give its

classification.Ans. Absolute figures expressed in monetary terms infinancial

Ratio : statements by themselves are meaningless. These figures often do not

conveymuch meaning unless expressed in relation to other figures. Thus, we cansaythat the relationship between two figures, expressed in arithmetical termsiscalled aratio.According to R.N. Anthony

A ratio is simply one number expressed in terms of another. It found bydividingone number into theother.Ratio Analysis discloses the position of business, so it is a very important toolof financial analysis. But ratio analysis suffers from a no. of limitations.Theselimitations should be kept in mind while making use of the RatioAnalysis.Objectives of RatioAnalysis : (1) Helpful in Analysis of Financial

Statements : Ratio analysis isanextremely useful device for analyzing the financial statement. It helps

the bankers, creditors, investors, shareholder etc. in acquiringenoughknowledge about the profitability and financial health of the

business.(2) Simplification of Accounting

Data : Accounting ratio simplifiesandsummarizes a long array of accounting data and makes

themunderstandable. It discloses the relationship between two suchfigureswhich have a cause and effect relationship with eachother.

(3) Helpful in ComparativeStudy :

With the help of ratioanalysiscomparison of profitability and financial soundness can be made

betweenone firm and another in the same industry. Similarly, comparisonof current year figures can also be made with those of previous years withthehelp of ratioanalysis.

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ACCOUNTING FOR MANAGERS(4) Helpful in Locating the Weak Spots of the

Business : Currentyearsratios are compared with those of the previous years and if some

weak spots are thus located, remedial measures are taken to correctthem.

(5) Accounting ratios are very helpfulin

Helpful inForecasting : forecasting and preparing the plans for thefuture.

(6) Estimate about the Trend of theBusiness :

If accounting ratiosare prepared for a number of years, they will reveal the trend of costs,

sales, profits and other importantfacts.

(7) Fixation of IdealStandards :

Ratio helps us in establishingidealstandards of the different items of the business. By comparing the

actualratios calculated at the end of the year with the ideal ratios, the

efficiencyof the business can be easilymeasured.

(8) Ratio Analysis discloses the liquidity, solvencyand

EffectiveControl : profitability of the business enterprise. Such informationenablesmanagement to assess the changes that have taken place over a periodof time in the financial activities of the business. It helps them indischargingtheir managerial functions, e.g. planning, organizing,directing,communicating and the controlling moreeffectively.

(9) Study of Financial Soundness : Ratio analysis discloses the positionof business with different view-points. It discloses the position of

businesswith the liquidity point of view, solvency point of view, profitability pointof view etc. With the help of such a study we can draw conclusionsregardingthe financial health of the businessenterprise.

Limitations of RatioAnalysis

:

1. False accounting date gives falseratios :

Accounting ratiosarecalculated on the basis of data given in profit & Loss account and

balance-sheet. There are certain limitations of financial statements, and hencetheratios calculated on the basis of such, financial statements will alsohavethe samelimitation.

2. Comparison not possible if different firms adopt differentaccountingpolicies :

There may be different accounting policies adopted bydifferentfirms with regard to providing depreciation etc. For example, one firm

may

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adopt the policy of charging dep. On Straight Line Method, whileother may charge on written-down-value method. Such difference makestheaccounting ratiosincomparable.

3. Ratio Analysis becomes Less Effective Due to Price LevelChanges : Price level over the years goes on changing, therefore, the ratios of variousyears cannot becompared.

4. Ratios may be misleading in the absence of absolutedata :

For e.g. XCo. produces 10 Lakh meters of cloth in 1992 and 15 Lakh meters in1993,the progress is 50%. Y Co. raises production from 10 thousand metersin1992 to 20 thousand meters in 1993, the progress is 100%. Comparisonof these two firms made on the basis of ratio will disclose that the secondfirmis more active that the first firm. Such conclusion is quitemisleading because of the difference in size of the two firms, it is therefore essentialtostudy the ratios along-with the absolute data on which they are

base.5. Limited Use of a Single

Ratio : The analyst should not merely rely onasingle ratio. He should study several connected ratios before reaching

aconclusion.

6. Circumstances differ from firm to firmhence

Lack of Proper Standard : no single standard ratio can be fixed for all the firms against whichtheactual ratio may becompared.

7. Ratios alone are not adequate for ProperConclusions :

Ratiosderivedfrom analysis of statements are not sure indicators of good or

badfinancial position and profitability of a firm. They merely indicatethe probability of favorable or unfavorable position. The analyst has tocarryout further investigations and exercise his judgment in arriving atacorrectdiagnosis.

8. Effect of Personal ability and bias of theAnalyst :

Another important point to keep in mind is that different persons draw different meaning

of different terms. One analyst persons draw different meaning of differentterms. One analyst may calculate ratios on the basis of profit after interestand tax, while other may consider profit after interest but beforetax

Classification of Ratios

: Ratios may be classified into the four categories.Classification of ratios can be explained with the help of following

diagram:178

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Classification of Ratios

Liquidity Ratios Leverage Or Activity Or ProfitabilityOr Short-term Capital Structure Turnover RatiosSolvency Ratios RatiosRatios

Current Ratio Stock Turnover RatioLiquid Ratio Debtors Turnover Ratio Average Collection

PeriodDebt Equity Ratio Creditors Turnover RatioDebt to Total Funds Average PaymentPeriodRatio Fixed AssetsTurnover Proprietary Ratio

RatioFixed Assets to WorkingCapitalProprietors fund Ratio Turnover RatioCapital GearingRatioInterest CoverageRatio

Profitability Ratios Profitability Ratios based based on Sales onInvestment

Gross Profit Ratio Return on CapitalEmployed Net Profit Ratio Return on ShareholdersFundOperating Ratio (i) Return on

TotalExpenses Ratios ShareholdersFunds (ii) Return on

EquitysShareholdersfunds(iii) Earning Per Share(iv) Dividend per Share(v) Price EarningRatio

Q. Explain the Important Ratios calculated for Evaluating theShort-Term Solvency Position of a Company.

OR

Q. Explain the Liquidity Ratios indetail.Ans. Liquidity refers to the ability of the firm to meetits

LiquidityRatios

: current liabilities. The liquidity ratios, therefore, are also called Short-termSolvency Ratios. These ratios are used to assess the short-termfinancial position of theconcern.

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Liquidity ratios include tworatios : 1. This ratio explains the relationship between currentassets

CurrentRatio: and current liabilities of a business. The formula for calculating the ratio

is: CurrentAssetsCurrent Ratio =

CurrentLiabilitiesCurrent

Assets : Current assets include those assets which can beconvertedinto cash within a years

time.CONSTITUENTS OF CURRENT ASSETS

1. Cash-in-hand and Bank balances2. BillsReceivables3. Sundry Debtors (less provision for baddebts)4. Short-term Loans andAdvances5. Inventories of Stock,as :

(a) Rawmaterials,(b) Work-in

process(c) Stores andspares(d) Finished goods

7. PrepaidExpenses8. AccruedIncomes

Current Liabilities : All liabilities which are payable within one year areknown as currentliabilities.

CONSTITUENTS OF CURRENTLIABILITIES1. Bills

Payables2. Sundry Creditors or AccountsPayable3. Accrued or OutstandingExpenses4. Short-term Loans, Advances and

Deposits.5. DividendsPayables.6 . Bank Overdraft7. Provision for Taxation, if it does not amountto appropriation of

profits

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ACCOUNTING FOR MANAGERSIdealRatio :

According to accounting principle, a current ratio of 2:1issupposed to be an ideal ratio. It means that current assets of a

businessshould, atleast, be twice of its current liabilities. The reason of assuming 2: 1asthe ideal ratio is that the current assets include such assets as stock,debtorsetc., from which full amount cannot be realized in case of need. Hence,evenhalf the amount is realized from the current assets on time, the firm canstillmeet its current liabilities infull.Significance :

This ratio is used to assess the firms ability to meet itsshort-term liabilities on time. According to accounting principle, a current ratio of

2:1is assumed to be an ideal ratio. If the current ratio is less than 2:1, itindicateslack of liquidity and shortage of working capital. But a much higher ratio,eventhough it is beneficial to the short-term creditors, is not necessarily good for thecompany. A much higher ratio than 2:1 may indicate the poor investment policies of the management. A much higher ratio may be considered to

beadverse from the view point of management on account of thefollowingreasons:2. Liquid ratio explains the relationship betweenliquid

Liquid Ratio : assets and current liabilities of a business. The formula for calculatingtheratiois : Liquid

AssetsLiquid Ratio = -Current

LiabilitiesLiquidAssets :

Liquid assets include those assets which will yield cashveryshortly. All current assets except stock and prepaid expenses are included

inliquid

assets. CONSTITUENTS OF LIQUID ASSETS

1. Cash-in-hand and Bank balances2. BillsReceivables3. Sundry Debtors (less provision for baddebts)4. Short-term Loans andAdvances5. Temporary Investment of SurplusFunds6. AccruedIncomes

OR Liquid Assets= Current Assets- Stock PrepaidExpensesIdealRatio :

According to accounting principle, a liquid ratio of 1:1issupposed to be an ideal ratio. It means that liquid assets of a business

should,atleast, be equal to its current liabilities. The higher the ratio, the better itis, because the firm will able to pay its current liabilities moreeasily.

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Significance :

An ideal Liquid ratio is said to be 1:1. If it is more, itisconsidered to be better. The idea is that for every rupee of current

liabilities,there should atleast be one rupee of liquid assets. This ratio is a better test

of short-term financial position of the business other than the current ratio, asitconsiders only those assets which can be easily and readily convertedintocash. Liquid ratio thus is a more rigorous test of liquidity than the currentratioand, when used together with current ratio, it gives a better picture of theshort-term financial position of the

business.Q. Explain the Important Ratios Calculated for Evaluating the Long- Term Solvency Position of a Company.

OR

Q. Explain the Capital Structure Ratios indetailAns. These ratios are calculated to assess

the

Capital Structure

Ratios

:

ability of the firm to meet its long term liabilities when they become due.Longterm creditors including debenture holder and primarily interested toknowwhether the co. has ability to pay regular interest due to them and to repaythe principal amount when it become due. These ratios includes thefollowingratios:- These ratios include the

following:1. Debt Equity Ratio :

Debt Long termLoansDebt Equity Ratio= OR

Equity Shareholdersfunds

Debt : These refer to long-term liabilities which mature after one year.Theseinclude Mortgage Loan, Debenture, Bank Loan, Loan from

financialinstitutions, Public Depositsetc.ShareholdersFunds :

Equity Share Capital, Preference Sharecapital,Securities premium, General Reserve, Capital Reserve, other reserves

andcredit balance of profit & lossa/c.However, accumulated losses and fictitious assets remaining to the writtenoff like preliminary expenses, underwriting commission, share issue expenseetc,should be deducted.

Significance :

This ratio is calculated to assess the liability of the firm tomeetits long-term liabilities. Generally, debt equity ratio of 2:1 is considered safe.

If the debt equity ratio is more that that, it shows a rather risky financial positionfrom the long term point of view, as it indicates that more and morefundsinvested business are provided by long-term lenders. A high debt equity ratioisa danger-signal for long-termlenders.

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ACCOUNTING FOR MANAGERS2. Debt to Total Funds Ratio :

Debt Long term loansDebt to total funds ratio= OR

Debt+ Equity long term loans+ shareholders Funds

Significance :

Generally, debt to total fund ratio is (.67:1) isconsideredsatisfactory. In other words, the proportion of long term loans should not

morethan 67% of total funds. A high ratio than this is generally treated anindicator of risky financial position from the long-term point of view, because itmeansthat the firm depends too much upon outside loans for itsexistence.3. Proprietary

Ratios : EquityProprietary Ratio =

Equity + Debt

Significance :

This ratio should be 33% or more than that. In other words,the proportion of shareholders funds to total funds be 33% or more. A

higher proprietary ratio is generally treated an indicator of sound financial positionfrom long-term point of view.4. Fixed Assets to Proprietors

Ratio : FixedAssetsFixed Assets to Proprietors Ratio=

Proprietors funds (networth)

Significance :

The ratio indicates the extent to which proprietors fundsaresunk into fixed assets. Normally, the purchase of fixed assets should

befinanced by proprietors funds. If this ratio is less than 100%, it wouldmeanthat proprietors funds are more than fixed assets and a part of workingcapitalis provided by the

proprietors.5. Capital Gearing

Ratio : Equity Share Capital+ Reserves + P&L (Cr.) BalanceCapital Gearing Ratio=

Fixed Cost bearing capital

Fixed Cost bearing capital = Preference share capital+ Debenture+LongtermloansSignificance : A high gearing will be beneficial to equity shareholders whentherate of interest/dividend payable on fixed cost bearing capital is lower thantherate of return on investment in

business.

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6. Interest CoverageRatio : Net Profit before interest &

taxInterest Coverage Ratio =

Fixed InterestCharges

Significance :

This ratio indicates how many times the interest chargesarecovered by the profits available to pay interest charges. A long term lenders

infinding out whether the business will earn sufficient profits to pay theinterestcharges regularly. The higher ratio more secure the lender is in respectof payment of interest regularly. An interest coverage ratio of 6 to 7 timesisconsideredappropriate.Q. Explain the Activity Ratios Or Turnover Ratios indetail.Ans. These ratios are calculated on the basis of cost of sales

ActivityRatios

: or sales, therefore, these ratios are also called as Turnover Ratios.Turnover indicates the speed or number of items the capital employed has beenrotatedin the process of doing business. In other words, these ratios indicatedhowefficiently the capital is being used to obtain sales; how efficiently thefixedassets are being used to obtain sales; and how efficiently the workingcapitaland stock is being used to obtain sales. Higher turnover ratios indicatethe better use of capital or resources and in turn lead to higher

profitability.Turnover ratios include thefollowing:1) This ratio indicates whether inventoryhas

Inventory TurnoverRatio : been efficiently used or not. This ratio indicates the relationship

betweenthe cost of goods sold during the year and average stock kept duringthatyear. The formula for calculating the ratio is: Cost of Goods SoldInventory Turnover Ratio =

AverageStock Cost of goods sold can be calculated by two

ways : Cost of Goods Sold = Sales GrossProfit OR

Cost of Goods Sold = Opening Stock + Purchases + Carriage +Wages+ Other Direct Expenses ClosingStock Opening Stock + Closing

Stock Average Stock = 2

Significance :

This ratio shows the speed with which the stock is rotatedintosales or the number of times the stock is turned into sales during the year.

Thehigher the ratio, the better it is, since it indicates that stock is selling quickly.In

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ACCOUNTING FOR MANAGERSa business where stock turnover ratio is high, goods can be sold at a lowmarginof profit and even then the profitability may be q

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