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ACCOUNTING FOR MANAGERS
MBA–1st SEMESTER, M.D.U., ROHTAK
SYLLABUS
External Marks : 70
Time : 3 hrs.
Internal Marks : 30
143
UNIT-I
UNIT-II
UNIT-III
UNIT-IV
Financial Accounting-concept, importance and scope, accounting
principles, journal, ledger, trial balance, depreciation (straight line and
diminishing balance methodology), preparation of final accounts with
adjustments.
Ratio analysis, fund flow analysis, cash flow analysis.
Management accounting-concept, need, importance and scope; cost
accounting-meaning, importance, methods, techniques and
classification of costs, inventory valuation.
Budgetary control-meaning, need, objectives, essentials of budgeting,
different types of budgets; standard costing and variance analysis
(materials, labour); marginal costing and its application in managerial
decision making.
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Q. Define Accounting. Explain its Nature.
:-
:–
According to American Institute of Certified Public Accountants:–
According to R.N. Anthony :–
:–
(1) Recording of Financial Transactions only :–
(2) Recording :–
Ans. Accounting is often called the language of business. The
basic function of any language is to communicate. Accounting communicates
the results of the business to the users of accounting information to enable
them to make effective decisions. To communicate information, accounting
follows a systematic process of recording, classifying and summarizing of
numerous business transactions resulting in creation of financial statements.
The two most important financial statements are :–
(i) Trading, Profit & Loss Account.
(ii) Balance Sheet.
“Accounting is the art of recording, classifying and summarizing in a significant
manner and in terms of money, transactions and events which are, in part
atleast, of a financial character, and interpreting the results thereof”.
“Nearly every business enterprise has accounting system. It is a means of
collecting, summarizing, analyzing and reporting in monetary terms,
informations about business”.
Only those transactions
and events are recorded in accounting which can be expressed in terms of
money. Those transactions which cannot be expressed in terms of money
are not recorded in accounting like the value of human resource, strike by
employees, and change in managerial policies etc.
Accounting is the art of recording of business transactions
according to some specified rules. In a small business where number of
transactions is quite small, all transactions are first of all recorded in a
Accounting
Definition of Accounting
Feature or Characteristics or Nature of Accounting
MBA 1st Semester (DDE)
UNIT – I
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book called “Journal”. But in a big business where the number of
transactions is quite large, the Journal is further sub-divided into various
subsidiary books such as:-
(i) Cash Book
(ii) Purchase Book
(iii) Sales Book
(iv) Purchase Return Book
(v) Sales Return Book.
The number of subsidiary books to be maintained depends on the size and
nature of the business.
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 a separate
account. The books in which various accounts are opened is called
“Ledger”.
Summarising involves the balancing of Ledger accounts
and the preparation of Trial Balance with the help of such Balances.
Financial Statements are prepared with the help of trial balance. Financial
statements are includes:-
(i) Trading, Profit & Loss Account
(ii) Balance Sheet.
In accounting the results of business are
presented in such a manner that the parties interested in the business
such as proprietors, managers banks, creditors etc. can have full
information about the profitability and the financial position of the
business.
It refers to transmission of summarized and
interpreted information to a variety of users. The users are:-
(i) Creditors
(ii) Investors
(iii) Lenders
(iv) Government
(v) Proprietors
(vi) Management
(vii) Banks etc.
(3) Classifying :–
(4) Summarising :–
(5) Interpretation of the Results :–
(6) Communicating :–
Q. Define Accounting. Also explain its Importance.
:–
Accounting
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The two most important financial statements are:-
(ii) Balance Sheet.
“Accounting is the art of recording, classifying and summarizing in a
significant manner and in terms of money, transactions and events which are,
in part atleast, of a financial character, and interpreting the results thereof”.
Management needs a lot of
information for the efficient running of the business. All such information
is provided by the accounting which helps the management in the
following:-
Management would like to know whether the
sales are increasing or decreasing and also the speed of increase in
the cost of production. All such information is provided by the
accounting, which helps the management in estimating the future
sales and expenses. It also helps them to estimate the cash receipts
and cash disbursements during the next accounting period.
At times, the Management has to
take a number of decisions. Accounting provides all the informations
required for making such decisions.
Management would like to see that the cost
incurred is reasonable and that no department is overspending.
Accounting provides information to the management in this regard.
Business transactions
have grown in size and complexity and it is not possible to remember each
and every transaction. Accounting keeps a prompt and systematic record
of all the transactions and summarizes them in order to provide a true
picture of the activities of the business entity.
Accounting reports the net
result of business activities of an accounting period. For this purpose
Trading and Profit & Loss Account of the business is prepared at the end of
each accounting period. All the items relating to purchase, sales, expenses
and revenues (Income) of the business are recorded in Trading, Profit &
Loss Account.
Definition of Accounting :–
According to American Institute of Certified Public Accountants :–
Importance of Accounting :–
(1) Helpful in Management of Business :–
(i) Helpful in Planning :–
(ii) Helpful in Decision-Making :–
(iii) Helpful in Controlling :–
(2) Provides Complete and Systematic Record :–
(3) Information regarding Profit or Loss :–
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If Revenues >Expenses-—————————————Profit
If Revenues< Expenses-—————————————Loss
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 shows the
assets on the one hand and the liabilities and capital on the other hand.
Balance Sheet describe the following :–
(i) How much the business has to recover from Debtors?
(ii) How much the business has to pay to Creditors?
(iii) How much the business has in the form of
(a) Cash-in-hand (b) Cash at Bank
(c) Closing Stock (d) Fixed Assets.
By keeping a systematic record
accounting helps the owners to compare one year’s costs, expenses, sales
and profit etc. with those of other years. Such a comparison provides the
useful information on the basis of which important decisions can be taken
more judiciously.
Another main objectives of
accounting is to communicate the accounting information to various
users like:
(i) Creditors
(ii) Investors
(iii) Lenders
(iv) Government
(v) Proprietors
(vi) Management
(vii) Banks etc.
Another objective of accounting is to
provide information about liquidity position. For this purpose it prepares
a Cash Flow Statement. It depicts inflows and outflows of cash from
operating, investing and financing activities.
One of the main objectives of accounting is to
provide bases for filing tax returns relating to income tax, sales tax, value
added tax, service tax, etc.
If a business entity is being sold, the
accounting information can be utilized to determine the proper purchase
price.
Accounting information is of great help while
raising loans from banks or other financial institutions. Such institutions
(4) Information Regarding Financial Position :–
(5) Enables Comparative Study :–
(6) Provide Informations to Various Parties :–
(7) To Know the Liquidity Position :–
(8) To File Tax Returns :–
(9) Facilitates Sale of Business :–
(10) Helpful in Raising Loans :–
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before sanctioning loan screen various financial statements of the firm
such as final accounts, fund flow statement, cash flow statement etc.
(ii) Balance Sheet.
In order to appreciate the exact nature and scope of
accounting, we must understand the following aspects of accounting:
Accounting records only economic events. An
economic event is a transaction which can be measured and expressed in
terms of money.
It means determining what transactions are to be
recorded. It involves observing events and selecting those events that are
of financial character and relate to the organization.
It means quantification of business transactions into
financial terms by using monetary units.
Accounting is the art of recording of business transactions
according to some specified rules. In a small business where number of
transactions is quite small, all transactions are first of all recorded in a
book called “Journal”. But in a big business where the number of
transactions is quite large, the Journal is further sub-divided into various
subsidiary books such as:-
Cash Book
Purchase Book
Sales Book
Purchase Return Book
Sales Return Book.
(11) Helpful in Prevention and Detection of Errors and Frauds.
Q. Define Accounting. Also explain its Scope.
:–
Scope of Accounting :–
(1) Economic Events :–
(2) Identification :–
(3) Measurement :–
(4) Recording :–
Accounting
Ø
Ø
Ø
Ø
Ø
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The number of subsidiary books to be maintained depends on the size and
nature of the business.
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 a separate
account. The books in which various accounts are opened is called
“Ledger”.
Summarising involves the balancing of Ledger accounts
and the preparation of Trial Balance with the help of such Balances.
Financial Statements are prepared with the help of trial balance. Financial
statements are includes:-
(i) Trading, Profit & Loss Account
(ii) Balance Sheet.
It refers to transmission of summarized and
interpreted information to a variety of users. The users are:-
(i) Creditors
(ii) Investors
(iii) Lenders
(iv) Government
(v) Proprietors
(vi) Management
(vii) Banks etc.
In accounting the results of business
are presented in such a manner that the parties interested in the business
such as proprietors, managers banks, creditors etc. can have full
information about the profitability and the financial position of the
business.
(iii) Trading, Profit & Loss Account.
(iv) Balance Sheet.
(5) Classification :–
(6) Summarising :–
(7) Communication :–
(8) Interpretation of the Results :–
Q. Define Accounting. Explain its Objectives Or Functions and Branches
Or Types.
:–
Accounting
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The following are the main
objectives, functions or utility of accounting:-
The main
objective of accounting is to maintain complete record of business
transactions according to some specified rules. For this purpose all the
business transactions are first of all recorded in Journal or Subsidiary
Books and then posted into Ledger.
The second main objective of accounting
is to calculate the net profit earned or loss suffered during a particular
period. For this purpose Trading and Profit & Loss Account of the business
is prepared at the end of each accounting period. All the items relating to
purchase, sales, expenses and revenues (Income) of the business are
recorded in Trading, Profit & Loss Account.
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 shows the
assets on the one hand and the liabilities and capital on the other hand.
Another main objectives
of accounting is to communicate the accounting information to various
users.
Another objective of accounting is to
provide information about liquidity position. For this purpose it prepares
a Cash Flow Statement. It depicts inflows and outflows of cash from
operating, investing and financing activities.
One of the main objectives of accounting is to
provide bases for filing tax returns relating to income tax, sales tax, value
added tax, service tax, etc.
Branches of accounting are :–
It covers the preparation and interpretation of
Objectives or Functions of Accounting:-
(1) To keep a Systematic record of business transactions :–
(2) To Calculation Profit or Loss :–
If Revenues >Expenses-—————————————Profit
If Revenues< Expenses-—————————————Loss
(3) To know the exact reasons leading to net profit or net loss.
(4) To Know the Financial Position of the business :–
(5) To ascertain the progress of the business from year to year.
(6) To prevent and detect errors and frauds.
(7) To Provide Informations to Various Parties :–
(8) To Know the Liquidity Position :–
(9) To File Tax Returns :–
:–
(1) Financial Accounting :–
Branches OR Types of Accounting
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financial statements and communication to the users of accounts. The
final step of financial accounting is the preparation of Trading and Profit &
Loss Account and the Balance Sheet.
The main purpose of Management
Accounting is to present the accounting information in such a way as to
assist the management in planning and controlling the operations of a
business. The management accountant uses various techniques and
concepts to make the accounting data more useful for managerial decision
making.
The branch of accounting which is used for tax
purpose is called tax accounting. Income Tax and Sale Tax are computed
on the basis of this accounting.
The main purpose of cost accounting is to calculate
the total cost and per unit cost of goods produced and services rendered by
a business. It also estimates the cost in advance and helps the
management in exercising strict control over cost.
The society provides the
infrastructure and the facilities without which business cannot operate at
all. Hence the business also has a responsibility to the society. There is a
growing demand for reports on activities which reflect the contribution of
an enterprise to the society. Social responsibility accounting is the
process of identifying, measuring and communicating the contribution of
a business to the society. In social responsibility accounting techniques
have been developed for measuring the cost of these contribution and the
benefits to the society.
Ans. The accounting statements are needed by
various parties who have interest in the business, namely, proprietors,
investors, creditors, government and many other. Accounting statements
disclose the profitability and solvency of the business to various parties. It is
therefore, necessary that such statements should be prepared according to
some standard language and set rules. These rules are usually called ‘General
Accepted Accounting Principles’ (GAAP).
Accounting principles are described by
various terms such as assumptions, conventions, concepts, doctrine,
postulate etc. These principles can be classified mainly into two categories:-
(A) Accounting Concepts or Assumptions
(B) Accounting Conventions.
(2) Management Accounting :–
(3) Tax Accounting :–
(4) Cost Accounting :–
(5) Social Responsibility Accounting :–
Q. What do you mean by Accounting Principles or (GAAP)? Explain and
illustrate fully.
:–
:–
Accounting Principle
Kinds of Accounting Principles
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(A) Accounting Concepts or Assumptions :–
(1) The Business Entity Concept :–
Example :–
Accounting concepts define
the assumptions on the basis of which financial statements of a business
entity are prepared. The word concept means idea or notion, which has
universal application. These accounting concepts provide a foundation for
accounting process. No enterprise can prepare its financial statements
without considering these basic concepts or assumptions. These concepts
guide how transactions should be recorded and reported. Following may
be treated as basic concepts or assumptions :–
Entity concept states that business
enterprise is a separate identity apart from its owner. Accountants should
treat a business as distinct from its owner. Business transactions are
recorded in the business books of accounts and owner’s transactions in
his personal books of accounts. Business unit should have a completely
separate set of books and we have to record business transactions from
firm’s point of view and not from the point of view of the proprietor.
Kinds of Accounting Principles
Accounting
Conventions
Convention of Full Disclosure
Convention of Consistency
Convention of Conservatism
Convention of Materiality
Business Entity Concept
Money Measurement Concept
Going Concern Concept
Accounting Period Concept
Historical Cost Concept
Dual Aspect Concept
Revenue Recognition Concept
Matching Concept
Accrual Concept
Objectivity Concept
Accounting Concepts
or Assumptions
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(i) The proprietor is treated as a creditor of the business to the extent of
capital invested by him in the business. The capital is treated as a
liability of the firm because it is assumed that the firm has borrowed
funds from its own proprietors instead of borrowing from outside
parties. It is for the reason that we also allow interest on capital and
treat it as an expense of the business.
(ii) Similarly, the amount withdrawn by the proprietor from the business
for his personal use is treated as his drawings.
(iii) The proprietor’s house, his personal investment in securities, his
personal car and personal income and expenditure are kept separate
from the accounts of the business entity.
(iv) If the proprietor has some other business entity doing another
business, the records of that business should also be kept separate.
The concept of separate entity is applicable to all forms of business
organizations, i.e. sole proprietorship, partnership or a company.
As per this concept, only those
transactions, which can be measured in terms of money are recorded.
Transactions, even if, they affect the results of the business materially, are
not recorded if they are not convertible in monetary terms. Transactions
and events that cannot be expressed in terms of money are not recorded in
the business books. For example, accounting does not record a quarrel
between the production manager and sales manager; it does not report
that a strike is beginning and it does not reveal that a competitor has
placed a better product in the market. These facts or happenings cannot
be expressed in money terms and thus are not recorded in the books.
A business on a particular day has 5000 Kilograms of raw
materials, 5 Machines, 100 Chairs and 20 Fans. All these things cannot be
added up unless expressed in terms of money. In order to make a record of
these items, these will have to be expressed in monetary terms such as Raw
Materials Rs. 25000, Machines Rs. 200000, Chairs Rs. 5000 and Fans Rs.
8000. As such, to make accounting records relevant, simple, understandable
and homogeneous, they are expressed in a common unit of measurement i.e.,
money.
As per this concept it is assumed that the
business will continue to exist for a long period in the future. The
transactions are recorded in the books of the business on the assumption
that it is a continuing enterprise.
(i) It is on this concept that we record fixed assets at their original cost
and depreciation is charged on these assets without reference to their
market value.
(2) Money Measurement Concept :–
Example :–
(3) Going Concern Concept :–
Example :–
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(ii) It is also because of the going concern concept that outside parties
enter 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 in future.
According to this concept accounts
should be prepared after every period & not at the end of the life of the
entity. Usually this period is one calendar year i.e. 1 Jan to 31 December
or from 1 April to 31 March. According to Amended Income Tax Law, a
business has compulsorily to adopt financial year beginning on 1 April
and ending on 31 March. Apart from this, companies whose shares are
listed on the stock exchange are required to publish quarterly results to
depict the profitability and financial position at the end of three months
period.
According to this concept,
an asset is ordinarily recorded in the books of accounts at the price at
which it was purchased or acquired. This cost becomes the basis of all
subsequent accounting for the asset. Since the acquisition cost relates to
the past, it is referred to as historical cost. This cost is the basis of
valuation of the assets in the financial statements.
If a business purchases a building for Rs. 500000, it would be
recorded in the books at this figure. Subsequent increase or decrease in
the market value of the building would not be recorded in the books of
accounts.
(i) It is highly objective and free from bias.
(ii) Market values of assets are difficult to be determined.
(iii) Market values of the assets may change from time to time and it will
be extremely difficult to keep track of up and down of the market
price.
(i) Assets for which nothing is paid will not be recorded. Thus a
favourable location, brand name and reputation of the business,
knowledge and technological skill built inside the enterprise will
remain unrecorded though these are valuable assets.
(ii) Historical cost-based accounts may lose comparability.
(iii) Many assets do not have acquisition cost.
(iv) During periods of inflation, the figure of net profit disclosed by profit
and loss account will be seriously distorted because depreciation
(4) Accounting Period Concept :–
(5) Historical Cost Concept or Cost Concept :–
Example :–
Benefits :–
Limitations :–
st st
st st
st
st
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based on historical costs will be charged against revenues at current
prices.
(v) Information based upon historical cost may not be useful to
management, investors, creditors etc.
According to this concept, every business
transaction is recorded as having a dual aspect. In other words, every
transaction affects atleast two accounts. If one account is debited, any
other account must be credited. The system of recording transactions
based on this concept is called as ‘Double Entry System’. It is because of
this principle that two sides of the Balance Sheet are always are equal and
the following accounting equation will always hold good at any point of
time:-
X commences business with Rs. 5 Lacs in cash and takes a
loan of Rs. 1 Lac from the bank, and these 6 Lacs are used in buying some
assets, say, plant & machinery. The equation will be as follows:
Assets = Liabilities + Capital
Rs. 6 Lacs = Rs. 1 Lac + Rs. 5 Lacs
Revenue means the
amount which is added to the capital as a result of business operations.
Revenue is earned by sale of goods or by providing a service. Concept of
revenue recognition determines the time or the particular period in which
the revenue is realized. Revenue is deemed to be realized when the title or
ownership of the goods has been transferred to the purchaser and when
he has legally become liable to pay the amount. It should be remembered
that revenue recognition is not related with the receipt of cash.
For example, if a firm gets an order of goods on 1 January,
supplies the goods on 20 January and receives the cash on 1 April, the
revenue will be deemed to have been earned on 20 January, as the
ownership of goods was transferred on that day.
This concept is very important for correct
determination of net profit. According to this concept, all expense are
matched with the revenue of that period should only be taken into
consideration. This principle is based on accrual concept as it considers
the occurrence of expenses and income and do not concentrate on actual
inflow or outflow of cash. This principle helps us in finding Net profit or
Loss. Following points must be considered while matching costs with
revenue:
(6) Dual Aspect Concept :–
OR
Capital = Assets - Liabilities
Example :–
(7) Revenue Recognition (Realisation) Concept :–
Example :–
(8) Matching Concept :–
st
th st
th
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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 as
expenses in the profit and loss account.
(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 an
expense only next year and no this year.
(iii) Similarly, income receivable must be added in revenues and incomes
received in advance must be deducted from revenues.
In accounting, accrual basis is used for recording
transactions. It provides more appropriate information about the
performance of business enterprise as compared to cash basis. Accrual
concept applies equally to revenues and expenses. In accrual concept
revenue is recorded when sales are made whether cash is received or not.
Similarly, according to this concept, expenses are recorded in the
accounting period in which they assist in earning the revenues whether
the cash is paid for them or not.
This concept requires that accounting
transaction should be recorded in an objective manner, free from the
personal bias of either management or the accountant who prepares the
accounts.
An accounting convention may be defined as
a custom or generally accepted practice which is adopted either by general
agreement or common consent among accountants. Accounting
conventions differ from concept in respect to the following:
(i) Accounting concepts are established by law while accounting
conventions are guidelines based upon general agreement.
(ii) There is no role of personal judgment or individual bias in the
adoption of accounting concepts whereas they may play a crucial role
in following accounting conventions.
(iii) There is uniform adoption of accounting concepts in different
enterprise while it may not be so in case of accounting conventions.
This principle requires that all
significant information relating to the economic affairs of the enterprise
should be completely disclosed. The principle is so important that the
companies Act makes ample provisions for the disclosure of essential
information in the financial statements of a company. The proforma and
contents of Balance Sheet and Profit and Loss Account are prescribed by
Companies Act. Various items or facts which do not find place in
accounting statements are shown in the Balance Sheet by way of
footnotes. Such as :
(9) Accrual Concept :–
(10) Objectivity Concept :–
(B) Accounting Conventions :–
Following are the main accounting conventions :–
(1) Conventions of Full Disclosure :–
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(i) Contingent Liabilities.
(ii) If there is a change in the method of valuation of stock, or for
providing depreciation or in making provision for doubtful debts, it
should be disclosed in the Balance Sheet by way of a footnote.
(iii) Market value of investments should be given by way of a footnote.
According to this principle, accounting
principles and methods should remain consistent from one year to
another. These should not be changed from year to year. If a firm adopts
different accounting principles in two accounting periods, the profits of
current period will not be comparable with the profits of the preceding
period.
According to this principle, all
anticipated losses should be recorded in the books of accounts, but all
anticipated gains should be ignored. In other words, conservatism is the
policy of playing safe. When there are many alternative values of an asset,
an accountant should choose the method which leads to the lesser value.
(i) Valuation of closing stock – ‘cost or market price’ whichever is less.
(ii) Provision for Doubtful Debts on Debtors.
(iii) Joint Life Policies are recorded at Surrender Values.
Effects of Principle of Conservatism :–
(i) Profit & Loss account will disclose lower profits in comparison to the
actual profits.
(ii) Balance sheet will discloses understatement of assets and
overstatement of liabilities in comparison to the actual values.
This convention is an exception to the
convention of full disclosure. According to this convention, all the items
having significant economic effect should be disclosed in financial
statements and any insignificant item which will only increase the work of
the accountant should not be disclosed in the financial statements. It
should be noted that what is material for one concern may be immaterial
for another. Thus, the accountant should judge the important of each
transaction to determine its materiality.
Ans. Classification of Accounts are:
(2) Convention of Consistency :–
(3) Convention of Conservatism :–
Examples of the application of the principle of conservatism :–
(4) Convention of Materiality :–
Q. Give Classification Of Accounts. What are the Rules of Journalising?
:–
Classification of Accounts
Classification of Accounts
Personal Accounts Impersonal Accounts
Real Accounts Nominal Accounts
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1. Personal Accounts :–
Natural Personal Accounts :–
Artificial Personal Account :–
Representative Personal Accounts :–
Golden Rule of Personal Account :–
2. Impersonal Account :–
Real Account : –
Golden Rule of Real Account :–
Nominal Account :–
Golden Rule of Nominal Account :–
Q. Define Accounting Cycle OR Process of Accounting.
:–
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. are
the examples of Personal Accounts. This account is further classified into
three categories:-
(i) It relates to transactions of human
beings like Ram, Rita, etc.
(ii) These accounts do not have a
physical existence as human beings but they work as personal
accounts. For example: Government, Companies (private or limited),
Clubs, Co-operative Societies etc.
(iii) These are not in the name of
any person or organization but are represented as personal account.
For Example: Outstanding liability account or prepaid account,
capital account, drawings account.
Debit the Receiver
Credit the Giver
Accounts which are not personal such as
machinery account, cash account, rent account etc. These can be further
sub-divided as follows :–
(i) Accounts which relate to assets of the firm but not
debt. For example accounts regarding Land, Building, Investment,
Fixed Deposits etc., are real accounts Cash-in-hand and Cash at
Bank are also real.
Debit what comes in.
Credit what goes out.
(ii) Accounts which relates to expenses, losses,
gains, revenue etc. like salary account, interest paid account,
commission received account.
Debit all expense & Losses.
Credit all Incomes & Gains.
Ans. An accounting cycle is a complete sequence of
accounting procedures which are repeated in the same order during each
accounting period. The accounting cycle may be shown as below:-
Accounting Cycle
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(1) Identification of Transaction :–
(2) Journal :–
PROFORMA OF JOURNAL
Date :–
Particulars :–
Accounting deals with business
transactions which are monetary in nature. In other words, the
transactions which cannot be measured and expressed in terms of money
cannot be recorded in accounting.
Journal is one of the basic book of original entry in which
transactions are recorded in a chronological (day-to-day) order according
to the principles of double entry system. When the size of business is a
small one, it may be possible to record all transactions in the journal but
when the size of the business grows and the number of transactions is very
large journal is sub-divided into a number of books called subsidiary
Books.
There are five columns in journal which are:-
(i) In the first column, date of transaction is entered. The year
and month is written only once, till they change.
(ii) Each transactions affects two accounts out of which
one account is debited and other account is credited.
Books of Original Entry:
1. Cash Book
2. Purchase Book
3. Sales Book
4. Purchase Return Book
5. Bills Receivable Book
6. Bills Payable Book
7. Journal Proper
Journal
Ledger
Trial Balance
Trading, Profit &
Loss A/c and
Balance Sheet
Transactions
Diagram : Accounting Cycle
Date Particulars L.F. Amount Dr. Amount Cr.
(1) (2) (3) (4) (5)
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(iii) All entries from the journal are later posted
into the ledger accounts. The page number of the ledger account
where the posting has been made from the journal is recorded in the
L.F. column of the journal.
(iv) In the fourth column, the amount of the account being
debited is written.
(v) In the fifth column, the amount of the account being
credited is written.
Business transactions are first recorded in journal or
Subsidiary books. The next step is to transfer the entries to respective
accounts in ledger. This process is called ledger
Each ledger account is divided into two equal parts. The left-hand side is
known as the debit side and the right-hand side as the credit side.
As shown above, there are four columns on each side of an account:-
(i) The date of the transaction is recorded in this column.
(ii) Each transaction affects two accounts.
(iii) In this column page number of the journal or
subsidiary book from which the particular entry is transferred, is
entered.
(iv) The amount is entered in this column.
When posting of all the transactions into ledger is
completed and the accounts are balanced off, it becomes necessary to
check 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. The list
so prepared is called a trial balance.
(i) It is a list of balances of all ledger accounts and the cash book
Ledger Folio or L.F. :–
Amount Dr. :–
Amount Cr. :–
(3) Ledger :–
Date :–
Particulars :–
Journal Folio or J.F. :–
Amount :–
(4) Trial Balance :–
PROFORMA OF TRIAL BALANCE
Features of a Trial Balance :–
Date Particulars J.F. Amount Date Particulars J.F. Amount
Dr. Cr.
Name of the Accounts L.F. Dr. Balances Cr. Balances
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(ii) It is just a statement and not an account.
(iii) It is neither a part of double entry system, nor does it appear in the
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 every year.
(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 the ledger
accounts.
(vii) If the books are arithmetically accurate, the total of all debit balances
of a trial balance will be equal to the total of all credit balances.
(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 final accounts.
After having
checked the accuracy of the book of accounts through preparation of Trial
Balance, businessman wants to ascertain the profit earned or loss
suffered during the year and also the financial position of his business at
the end of the year. For this purpose he prepares ‘Final Accounts’ which
are also termed as” Financial Statements. These include the following:-
Trading Account.
Profit and Loss Account.
Balance Sheet.
Ans. According to Double Entry System, every
transaction has two fold-aspects- debit and credit and both the aspects are to
be recorded in the books of accounts. We may define the Double Entry System
as the system which records both the aspects of transactions. This principle
proves accounting equation i.e. both sides of Balance Sheet always equal.
This system affords the under
mentioned advantages :–
(1) Scientific System
(2) Complete Record of Every Transaction
(3) Preparation of Trial Balance
(4) Preparation of Trading & Profit & Loss A/c
(5) Knowledge of financial position of the Business
(6) Knowledge of Various Informations.
Objectives of Preparing Trial Balance :–
(5) :–
Q. Write a Short Note On Double Entry System.
:–
Advantages of Double Entry System :–
Trading, Profit & Loss Account And Balance Sheet
Double Entry System
Ø
Ø
Ø
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(7) Comparative Study
(8) Lesser possibility of Fraud.
(9) Help management in decision making.
(10) Legal Approval
(11) Suitable for All types of Businessmen.
Ans. In every business there are certain assets of a fixed
nature that are needed for the conduct of business operations. Some examples
of such assets are Building, Plant & Machinery, Motor Viechles, Furniture,
office Equipments etc. These assets have a definite span of life after the expiry
of which the assets will lose their usefulness for the business operations. Fall in
the value & utility of such assets due to their constant use and expiry of time is
termed as depreciation.
“Depreciation may be defined as the permanent and continuing
diminution in the quality, quantity or the vale of an asset”.
1. Depreciation is decline in the value of fixed assets (except Land)
2. Such fall is of a permanent nature.
3. Depreciation is a continuous process because value of assets will
decline by their constant use.
4. Depreciation decreases only the book value of the asset, not the
market value.
5. Depreciation is a non-cash expense. It does not involve any cash
outflow.
1. By Constant Use.
2. By Obsolescence
3. By expiry of time.
4. By Accident.
5. By expiry of legal rights.
6. By Depletion
7. By permanent fall in market price.
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.
Q. Define Depreciation. What are the Causes & Methods of
Depreciation?
:–
:–
According to William Pickles
:–
:–
:–
Depreciation
Definition of Depreciation
Features of Depreciation
Causes of Depreciation
Need, Importance or objects of providing depreciation
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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.
1. Total Cost of the Asset.
2. Estimated life of Asset.
3. Estimated Scrap Value.
1. Straight Line Method.
2. Written Down Value Method.
3. Annuity Method.
4. Depreciation Fund Method.
5. Insurance Policy Method.
6. Revaluation Method.
7. Depletion Method.
8. Machine hour rate Method.
Ans. This method is also termed as Original Cost
Method because under this method depreciation is charged at a fixed
percentage on the original cost of the asset. The amount of depreciation
remains equal from year to year and as such this method is also known as
‘Equal Installment Method’, or ‘Fixed Installment Method’. Under this method,
the amount of depreciation is calculated by deducting the scrap value from the
original cost of the asset and then by dividing the remaining balance by the
number of years of its estimated life.
Original Cost of the Asset – Estimated Scrap Value
————————————————————————
Estimated Life of the Asset.
1. Calculation of Depreciation under this method is very
simple and as such the method is widely popular.
2. Under this method, equal amount of
depreciation is debited to profit & loss account of each year. Hence, the
burden of depreciation on each year’s net profit is equal.
3. Under this method, the book
value of an asset can be reduced to net scrap value or zero value, which is
not possible under some other methods.
Factors determining the amount of Depreciation
Methods of providing or Allocating Depreciation
Straight Line Method
:–
:–
Q. Explain Straight Line Method of Depreciation with the help of an
Example.
:–
Yearly Depreciation =
Merits of Straight Line Method :–
Simplicity :–
Equality of Depreciation Burden :–
Assets can be completely written off :–
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4. under this
method, the original cost of the asset is shown in the Balance Sheet and
the upto-date depreciation is shown as a direct deduction from it.
1. When there are different machines having
different life-span, the computation of depreciation becomes complicated
because depreciation on each machine will have to be calculated
separately.
2. Repairs charges go on increasing year
by year as the asset becomes older but as the equal depreciation is
charged under this method each year.
3. This method does not take into
consideration the loss of interest on the amount invested in the asset.
4. Sometimes, even after
the value of an asset is reduced to zero in the books, it continues to be used
in the business in actual practice
5. It is quite difficult to
assess the true scrap value of the asset after a long period, say 15 or 20
years from the date of its installation.
This method is suitable for those assets whose useful life can be
renewals.
Birla Cotton Mills purchased a machinery on 1 May, 1991 for Rs. 90,000. On 1
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.
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. Accounts are
closed each year on 31 December. Show the Machinery Account for three years
Knowledge of original cost and upto date depreciation :–
:–
Difficulty in Computation :–
Unequal pressure in later years :–
Omission of Interest factor :–
Unrealistic to write off the vale of asset to zero :–
Difficulty in the determination of scrap value :–
:–
:–
Dr. Machinery Account Cr.
Demerits of Straight Line Method
Suitability
Example
st st
st
st
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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Q. Discuss the Merits And Demerits Of Providing Depreciation By
Diminishing Balance Method?
:–
Ans. Under this method, as the value of asset
goes on diminishing year after year, the amount of depreciation charged every
year also goes on declining.
Written Down Value Method
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
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For Example
:–
Easy Calculation :–
Equal Charge against income :–
No induce pressure in later years :–
Balance of asset is never written off to zero :–
Approved method by Income Tax Authorities :–
:–
Asset can not be completely written off. :–
Omission of Interest Factor :–
Difficulty in determining the rate of depreciation :–
Knowledge of original cost & up to date depreciation not possible :–
:–
if a machine is purchased for Rs. 10,000 and depreciation is to be
charged at 10% p.a. according to written down value method, the depreciation
will be charged as under:-
1 Year on Rs. 10,000 @ 10% =1,000
2 Year on Rs. 9,000 (10,000-1,000) @ 10% = 900
3 Year on Rs. 8,100 (9,000-900) @ 10% = 810
and so on.
It will be observed from the above calculations that each year’s depreciation is
calculated 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 the depreciation
charged on its goes on reducing year after year, this method is known as
‘Reducing Installment Method’.
1. It is easy to calculate the depreciation under this
method, even if some new assets are purchased year after year.
2. In this method, the total burden on
profit & Loss account in respect of depreciation and repairs put together
remains almost equal year after year.
3. The efficiency of machine is more in
the earlier years than in later years. Hence, the depreciation in first few
years should be more in comparison to the later years.
4. This method ensures that
the assets is never reduced to zero.
5. This method of
providing depreciation is permissible under Income Tax Regulations.
1. Under this method, the value
of an asset, even if it becomes obsolete and useless, cannot be reduced to
zero and some balance, however small, would continue on asset account.
2. This method does not take into
consideration the loss of interest on the amount invested in the asset.
3. Under this
method, the rate of providing depreciation cannot be easily decided.
4.
Under this method, the original cost of various assets is not shown in the
Balance Sheet.
A company had bought machinery for Rs. 100000 including there
st
nd
rd
Merits of Written Down Value Method
Demerits of Written Down Value Method
Example
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in a boiler worth Rs 10000 depreciation was charged on reducing balance
method at the rate of 10% p.a. for first five year and machinery account was
credited accordingly. During the fifth year, the boiler becomes useless on
account of damages. The damaged boiler is sold for Rs. 2000 prepares the
machinery account for five years.
MACHINERY ACCOUNT
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) 1000
By Bal. C/d
(i) 81000
(ii) 9000 9000
100000 100000
Year To Bal. B/d Year By Dep.
II (i) 81000 II (i) 8100
(ii) 9000 (ii) 900 9000
90000 By Bal. C/d
(i) 72900 81000
(ii) 8100
90000 90000
III (i) 72900 III (i) 7290
(ii) 8100 (ii) 810
81000 By Bal. C/d 8100
(i) 65,610
(ii) 7290
81000 81000
IV (i) 65610 72900 IV (i) 6561 7290
(ii) 7290 (ii) 729
By Bal. C/d
(i) 59049 65610
(ii) 6561
72900 72900
Year To Bal. B/d Year By Bank 2000
V (i) 59049 V By P & L A/c 4561
(ii) 6561 65610 (6561-2000)
By Dep. 5905
By Bal. C/d 53144
65610 65610
Year To bal B/d 53144
VI
Dr. Cr.
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Q. What do you mean by Final Accounts? What is their Necessity?
:–
:–
:–
Format of a Trading Account: Trading Account
(for the year ending————————————)
Dr. Cr.
Ans. Financial Statements refers to such statements which
report the profitability and the financial position of the business at the end of
accounting period. The term financial statements include the following:-
(1) Trading Account
(2) Profit and Loss Account.
(3) Balance Sheet
(1) Trading account is prepared for calculating the gross
profit or gross loss arising or incurred as a result of the trading activities of
a business. In other words, it is prepared to show the result of
manufacturing, buying and selling of goods.
(i) It provides information about Gross Profit and Gross Loss.
(ii) It provides information about the direct expenses.
(iii) Comparison of closing stock with those of the previous years.
(iv) It provides safety against possible losses.
Final Accounts
Trading Account
Need and Importance of Trading Account
Particulars` Amount Particulars Amount
Rs. Rs.
To Opening Stock By Sales
To Purchases Loss Sales Return
Less : Purchase Reture OR
OR Returns In wards
By Closing Stock
To Carriage on Purchase
To Gas, Fuel and Power
To Freight, Octroi and Cartage
To Manufacturing Expenses
or Productive Expenses.
To Factory Expense, Such as
Factory Lighting, Factor Rent Etc.
To Dock Charges
To Import duty or Custom Duty
To Royalty
To Gross Profit
Transferred to P & L A/c
(Balancing Figure)
Return Outward
To Wages
To Wages & Salaries By Gross Loss (if any)
To Direct Expenses Transferred to P & L A/c
To Carriage or (Balancing Figure)
To Carriage Inwards or
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(2) Trading account only disclose the gross profit
earned as a result of buying and selling of goods. However, a businessman
has to incurr a number of expenses which are not taken into trading
account. Hence a businessman is more interested in knowing the net
profit earned or net loss incurred during the year.
A profit and loss account is an account into which all gains and losses are
collected, in order to ascertain the excess of gains over the losses or vice-
versa.
(i) To Ascertain the Net Profit & Net Loss
(ii) Comparison with previous year’s profit.
(iii) Control on Expenses
(iv) Helpful in preparation of the balance Sheet
Profit & Loss Account
Need and Importance of Profit & Loss Account
:–
:–
Format 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 Salaries By Rent form tenant
To Salaries & Wages By Discount Received
To Rent, Rate and Taxes By Commission Received
To Printing & Staionery By Any Other Income
To Lighting By Net Loss (if any)
To Telephone Charges Transferred to Capital A/c
To Audit Fees etc.
To Carriage outward or Carriage
on sales
To Advertisement
To Commission
To Bed-Debts
To Export Duty
To Parcking Exp etc.
To Discount/Discount Allowed
To Repairs
To Depreciation
To Interest
To Bank Charges etc.
To Net Profit
(Transferred to Capital A/c)
To Office Expenses :
To Selling & Distribution Expense:
To Miscellaneous Expenses :
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(3) After ascertaining the net profit or net loss of the
business enterprise, the businessman would also like to know the exact
financial position of his business. For this purpose a statement is
prepared which contains all the assets and liabilities of the business
enterprise. The statement so prepared is called a Balance Sheet.
Balance Sheet :–
Balance Sheet
(As on Or As At --------------)
Rs. Rs.
Bank Overdraft Cash-in-Hand
Bill Payable Cash at Bank
Sundry Creditors Bills Receivables
Outstanding Expenses Short Term Investments
Unearned Income Sundry Debtors
Closing Stock
Prepaid Expenses
Long Term Loans Accrued Income
Furniture
Loose Tools
Add: Net profit Motor Vehicle
Less: Drawings Long-term investments
Less: Income Tax Plant & machinery
Less: Life Insurance Premium Land & Building
Less: Net Loss Patents
Goodwill
Current Liabilities : Current Assets :
Fixed Liabilities :
Reserves: Fixed Assets:
Capital:
Need and Importance of Balance Sheet :–
Q. What is the necessity of doing adjustments? Give some adjustment
entries with their explanation.
:–
1. The main purpose of preparing balance sheet is to ascertain the true
financial position of the business at a particular point of time.
2. It gives exact information about the exact amount of capital at the end of
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 next year.
Ans. In order to ascertain the true profit or loss of the business
for a particular year, it is necessary that all expenses and incomes relating to
that year are taken into consideration. For example, if we want to ascertain the
net profit for the year ended on 31 December and rent for the month of
Adjustments
st
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December has not yet been paid, it would be proper to include such rent along
with the other expenses of the year. Similarly, it often happens that certain
incomes, like interest, dividend, etc. are earned but not received during the
year. Adjustment for such incomes must be made in the current year itself, so
that the profit and loss account may disclose the correct amount of net profit or
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 there
is a transaction
(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 ‘adjustment entries.’
(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 have not
been received.
(7) To provide for depreciation and other provisions.
(1) The amount of goods unsold at the end of the year is
called closing stock. It is valued at Cost Price or Realisable Value,
whichever is less. The basic principle underlying the valuation of closing
stock is that anticipated losses should be taken into account, but all
unrealized gains should be ignored.
(i) If the closing stock appears outside the Trial Balance, it will be shown
at two places, i.e., on the Credit side of the Trading A/c and on the
Assets side of the Balance Sheet.
(ii) If the closing stock appears inside the Trial Balance, it will be shown
only on the Assets side of the Balance Sheet.
(2) These are the
expenses which have been incurred during the year but have been unpaid
on the date of preparation of final accounts.
(i) If outstanding expenses have been mentioned inside the Trial
Need of Adjustments
Explanation of Important Adjustments
:–
:–
Closing Stock :–
Treatment in Final Accounts :–
Outstanding Expenses Or Expenses Due but not Paid :–
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Balance, they will be shown on the liabilities side only.
(ii) If outstanding expenses have been mentioned outside the Trial
Balance, then on the one hand, it will be added to the concerned
expenses on the debit side of Trading or Profit and Loss Account and
on the other hand, will also be shown on the liabilities side of the
Balance Sheet.
(3)
These are the expenses which have been paid in advance for the
next year during the current year itself.
(i) If Prepaid expenses have been mentioned inside the Trial Balance,
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 the concerned
expenses on the debit side of Trading or Profit and Loss Account and
on the other hand, will also be shown on the Assets side of the
Balance Sheet.
(4) Depreciation is the loss or fall in the value of fixed assets
due to their constant use and expiry of time.
Depreciation on the one hand, will be
shown 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 on the
Asset side of the Balance Sheet.
(5) It is quite common that certain
items of income such as interest, commission etc are earned during the
current year but have not been actually received by the end of the current
year. Such incomes are known as ‘Accrued Incomes’ or ‘Earned Incomes’
(i) If accrued incomes have been mentioned inside the Trial Balance,
they will be shown on the Assets side only.
(ii) If Accrued incomes have been mentioned outside the Trial Balance,
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 assets side
of the Balance Sheet.
(6) It may also
happen that a certain income is received in the current year but the whole
amount of it does not belong to the current year. Such portion of this
income which belongs to the next year is known as Unearned Income or
Income received but not earned.
Prepaid expenses Or Unexpired Expenses Or Expenses Paid in
Advance :–
Depreciation :–
Accrued Income or Income Receivable :–
Unearned Income Or Income Received in Advance :–
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(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 Trial Balance,
then on the one hand, It will be deducted from the concerned income
on the Credit side of the Profit & Loss Account and on the other hand,
will be shown on the Liabilities side of the Balance Sheet.
(7) Usually in order to ascertain the true efficiency of
the business, interest at a normal rate is charged on the capital invested
by the proprietor in the business.
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 to his
capital.
(8) Occasionally, the proprietor draws cash or goods
for his personal use. Such withdrawals are terms as Drawings. If the firm
pays interest on capital, it is fully justified that it should also charge
interest on drawings.
Interest on drawings is a gain to the
business and hence it is shown on the credit side of Profit & Loss Account.
At the same time, it is an expense from the proprietor’s view and hence will
be deducted from the capital.
(9)
(i) Generally, item of Loan appears on the credit side of the Trial
Balance. It means that the amount has been borrowed from some
person or the bank etc. Loan is a liability of the firm and the interest
on 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 calculated and
will be treated just like outstanding expenses.
Treatment in Final Accounts :– When Loan appears on the credit side
of the Trial Balance, interest on it will be an expense and hence will be
recorded on the debit side of Profit & Loss Account. Outstanding
amount of such interest will also be added to Loan Account on the
Liabilities side of the Balance Sheet.
(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. It will
be an asset in this case and interest on such loan will be an income
for the firm.
When Loan appears on the Debit
side of the Trial Balance, interest on it will be an income and hence
will be recorded on the credit side of Profit & Loss Account and will
also be added to Loan Account on the assets side of the Balance
Sheet.
Interest on Capital :–
Interest on Drawings :–
Interest on Loan :–
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(10) Persons to whom goods have been sold on credit are known
as Debtors. Sometimes due to the dishonesty, death or insolvency of a
debtor, full amount is not received from him. When it becomes certain
that a particular amount will not be recovered it is known a s ‘ B a d -
Debts’.
(i) If Bad-debts are given in the adjustments or outside the Trial
Balance, they will be shown on the debit side of the Profit & Loss
Account and will also be deducted from the Debtors on the assets side
of the Balance Sheet.
(ii) If Bad-Debts are given inside the trial balance, it will be shown on the
debit side of the Profit & Loss Account.
(11) Even after deducting the
amount of actual bad-debts from the debtors, the list of debtors at the end
of the year include some debts which are either bad or doubtful. A
provision is created to cover any possible loss on account of bad-debts
likely to occur in future. Such a provision is created at a fixed percentage
on debtors every year and is called ‘provisions for bad and doubtful debts’.
Treatment in Final Accounts :– The amount of provision for doubtful debts
on the one hand, is shown on the debit side of the Profit and Loss
Account and on the other hand, is deducted from Sundry debtors on the
assets side of the Balance Sheet.
(12) It is a normal practice in the
business to allow cash discount to those debtors from whom the payment
is received promptly or with a fixed period. Discount thus allowed will be
an expense of the business. It should be noted that discount will be
allowed only to those debtors who will make prompt payment.
Such provision is shown on the debit
side of the profit & loss account and is also deducted from Sundry
Debtors on the Assets side of the Balance Sheet.
(13) Such provision is shown on the
credit side of the Profit & Loss account and is also deducted from the
Sundry Creditors on the Liabilities side of the Balance Sheet.
(14) Sometimes losses occur due to some abnormal
circumstances such as accident, fire, flood, earthquakes etc. Such losses
are called abnormal losses. These may be divided into two categories:
(i) Loss of Goods :– It will be that on the one hand, the loss of goods will
deducted from the purchase on the Debit side of Trading Account and
it will also be shown on the debit side of Profit & Loss Account
(ii) Loss of Fixed Assets :– If some fixed assets of the firm is destroyed by
Bad Debts :–
Provisions for Bad and Doubtful Debts :–
Provisions for Discount on Debtors :–
Provisions for Discount on Creditors :–
Abnormal Loss :–
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some accident, then the loss will be shown on the debit side of P&L
A/c and also deducted from the value of Asset on the assets side of
the Balance Sheet.
(15) Occasionally, certain amount of goods is
given away as charity. On the one hand, the amount will be deducted from
purchase and on the other hand it will also be shown on the debit side of
P&L A/c.
(16) Sometimes the goods which the
business deals in are distributed as free samples for the purpose of
advertising these goods. On the one hand, the amount will be deducted
from purchase and on the other hand it will also be shown on the debit
side of P&L A/c.
(17) If the proprietor of the business has taken some
goods for his personal use from the business, it is known as Drawings in
Goods. It will be deducted from purchase in the Trading Account and will
also be deducted from the Capital on the liabilities side of the Balance
Sheet as Drawings.
(18) There are certain expenditures which
are revenue in nature but the benefit of which is likely to be derived over a
number of years. Such Expenditures are termed as ‘Deferred Revenue
Expenditure’. As such, the whole of such expenditure is not debited to the
Profit and Loss Account of the current year but spread over the years for
which the benefit is likely to last. Thus, only a part of such expenditure is
taken to Profit & Loss Account every year and the unwritten off portion is
allowed to stand on the assets side of the Balance Sheet.
(19) Sometimes, in addition to his
regular salary, the manager is entitled to a commission on net profit.
On the one hand, it will be recorded on
the debit side of P& L A/c and on the other hand, shown on the liabilities
side as an outstanding expense.
(i) On Profits before charging such commission: The formula is:
Rate
Manager’s Commission = Net Profit x ————
100
(ii) On Profits after charging such commission: The formula is:
Rate
Manager’s Commission = Net Profit x ————————
100 + Rate
Charity in the Form of Goods :–
Goods Distributed as Free Samples :–
Drawings in Goods :–
Deferred Revenue Expenditure :–
Manager’s Commission on Net Profit :–
Methods of Calculating the Commission :–
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Q. What is Ratio Analysis? Explain its Objectives and Limitations. Also
give its classification.
:–
:–
Helpful in Analysis of Financial Statements :–
Simplification of Accounting Data :–
Helpful in Comparative Study :–
Ans. Absolute figures expressed in monetary terms in financial
statements by themselves are meaningless. These figures often do not convey
much meaning unless expressed in relation to other figures. Thus, we can say
that the relationship between two figures, expressed in arithmetical terms is
called a ‘ratio.’
A ratio is simply one number expressed in terms of another. It found by dividing
one number into the other.
Ratio Analysis discloses the position of business, so it is a very important tool of
financial analysis. But ratio analysis suffers from a no. of limitations. These
limitations should be kept in mind while making use of the Ratio Analysis.
(1) Ratio analysis is an
extremely useful device for analyzing the financial statement. It helps the
bankers, creditors, investors, shareholder etc. in acquiring enough
knowledge about the profitability and financial health of the business.
(2) Accounting ratio simplifies and
summarizes a long array of accounting data and makes them
understandable. It discloses the relationship between two such figures
which have a cause and effect relationship with each other.
(3) With the help of ratio analysis
comparison of profitability and financial soundness can be made between
one firm and another in the same industry. Similarly, comparison of
current year figures can also be made with those of previous years with the
help of ratio analysis.
Ratio
According to R.N. Anthony
Objectives of Ratio Analysis
MBA 1st Semester (DDE)
UNIT – II
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(4) Current year’s
ratios are compared with those of the previous years and if some weak
spots are thus located, remedial measures are taken to correct them.
(5) Accounting ratios are very helpful in
forecasting and preparing the plans for the future.
(6) If accounting ratios are
prepared for a number of years, they will reveal the trend of costs, sales,
profits and other important facts.
(7) Ratio helps us in establishing ideal
standards of the different items of the business. By comparing the actual
ratios calculated at the end of the year with the ideal ratios, the efficiency
of the business can be easily measured.
(8) Ratio Analysis discloses the liquidity, solvency and
profitability of the business enterprise. Such information enables
management to assess the changes that have taken place over a period of
time in the financial activities of the business. It helps them in discharging
their managerial functions, e.g. planning, organizing, directing,
communicating and the controlling more effectively.
(9) Ratio analysis discloses the position of
business with different view-points. It discloses the position of business
with the liquidity point of view, solvency point of view, profitability point of
view etc. With the help of such a study we can draw conclusions regarding
the financial health of the business enterprise.
1. Accounting ratios are
calculated on the basis of data given in profit & Loss account and balance-
sheet. There are certain limitations of financial statements, and hence the
ratios calculated on the basis of such, financial statements will also have
the same limitation.
2.
There may be different accounting policies adopted by different
firms with regard to providing depreciation etc. For example, one firm may
Helpful in Locating the Weak Spots of the Business :–
Helpful in Forecasting :–
Estimate about the Trend of the Business :–
Fixation of Ideal Standards :–
Effective Control :–
Study of Financial Soundness :–
:–
False accounting date gives false ratios :–
Comparison not possible if different firms adopt different accounting
policies :–
Limitations of Ratio Analysis
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adopt the policy of charging dep. On Straight Line Method, while other
may charge on written-down-value method. Such difference makes the
accounting ratios incomparable.
3.
Price level over the years goes on changing, therefore, the ratios of various
years cannot be compared.
4. For e.g. X
Co. produces 10 Lakh meters of cloth in 1992 and 15 Lakh meters in 1993,
the progress is 50%. Y Co. raises production from 10 thousand meters in
1992 to 20 thousand meters in 1993, the progress is 100%. Comparison of
these two firms made on the basis of ratio will disclose that the second firm
is more active that the first firm. Such conclusion is quite misleading
because of the difference in size of the two firms, it is therefore essential to
study the ratios along-with the absolute data on which they are base.
5. The analyst should not merely rely on a
single ratio. He should study several connected ratios before reaching a
conclusion.
6. Circumstances differ from firm to firm hence
no single standard ratio can be fixed for all the firms against which the
actual ratio may be compared.
7. Ratios derived
from analysis of statements are not sure indicators of good or bad
financial position and profitability of a firm. They merely indicate the
probability of favorable or unfavorable position. The analyst has to carry
out further investigations and exercise his judgment in arriving at a
correct diagnosis.
8. Another important
point to keep in mind is that different persons draw different meaning of
different terms. One analyst persons draw different meaning of different
terms. One analyst may calculate ratios on the basis of profit after interest
and tax, while other may consider profit after interest but before tax
Ratios may be classified into the four categories.
Classification of ratios can be explained with the help of following diagram:
Ratio Analysis becomes Less Effective Due to Price Level Changes :–
Ratios may be misleading in the absence of absolute data :–
Limited Use of a Single Ratio :–
Lack of Proper Standard :–
Ratios alone are not adequate for Proper Conclusions :–
Effect of Personal ability and bias of the Analyst :–
:–
Classification of Ratios
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Q. Explain the Important Ratios calculated for Evaluating the Short-
Term Solvency Position of a Company.
OR
Q. Explain the Liquidity Ratios in detail.
:–
Ans. “Liquidity” refers to the ability of the firm to meet its
current liabilities. The liquidity ratios, therefore, are also called ‘Short-term
Solvency Ratios.’ These ratios are used to assess the short-term financial
position of the concern.
Liquidity Ratios
Classification of Ratios
Liquidity Ratios Leverage Or Activity Or Profitability
Or Short-term Capital Structure Turnover Ratios
Solvency Ratios Ratios Ratios
Current Ratio Stock Turnover Ratio
Liquid Ratio Debtors Turnover Ratio
Average Collection Period
Debt Equity Ratio Creditors Turnover Ratio
Debt to Total Funds Average Payment Period
Ratio Fixed Assets Turnover
Proprietary Ratio Ratio
Fixed Assets to Working Capital
Proprietor’s fund Ratio Turnover Ratio
Capital Gearing Ratio
Interest Coverage Ratio
Profitability Ratios Profitability Ratios based
based on Sales on Investment
Gross Profit Ratio Return on Capital Employed
Net Profit Ratio Return on Shareholder’s Fund
Operating Ratio (i) Return on Total
Expenses Ratios Shareholder’s Funds
(ii) Return on Equity’s
Shareholder’s funds
(iii) Earning Per Share
(iv) Dividend per Share
(v) Price Earning Ratio
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Liquidity ratios include two ratios :–
Current Ratio:–
Current Assets
Current Ratio = ——————————————
Current Liabilities
Current Assets :–
CONSTITUENTS OF CURRENT ASSETS
CONSTITUENTS OF CURRENT LIABILITIES
1. This ratio explains the relationship between current assets
and current liabilities of a business. The formula for calculating the ratio is:
Current assets include those assets which can be converted
into cash within a year’s time.
1. Cash-in-hand and Bank balances
2. Bills Receivables
3. Sundry Debtors (less provision for bad debts)
4. Short-term Loans and Advances
5. Inventories of Stock, as :
(a) Raw materials,
(b) Work-in process
(c) Stores and spares
(d) Finished goods
7. Prepaid Expenses
8. Accrued Incomes
Current Liabilities :– All liabilities which are payable within one year are
known as current liabilities.
1. Bills Payables
2. Sundry Creditors or Accounts Payable
3. Accrued or Outstanding Expenses
4. Short-term Loans, Advances and Deposits.
5. Dividends Payables.
6 . Bank Overdraft
7. Provision for Taxation, if it does not amount to
appropriation of profits
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Ideal Ratio :–
Significance :–
Liquid Ratio :–
Liquid Assets
Liquid Ratio = ————————————-
Current Liabilities
Liquid Assets :–
CONSTITUENTS OF LIQUID ASSETS
OR Liquid Assets= Current Assets- Stock – Prepaid Expenses
Ideal Ratio :–
According to accounting principle, a current ratio of 2:1 is
supposed to be an ideal ratio. It means that current assets of a business
should, atleast, be twice of its current liabilities. The reason of assuming 2: 1 as
the ideal ratio is that the current assets include such assets as stock, debtors
etc., from which full amount cannot be realized in case of need. Hence, even
half the amount is realized from the current assets on time, the firm can still
meet its current liabilities in full.
This ratio is used to assess the firm’s ability to meet its short-
term liabilities on time. According to accounting principle, a current ratio of 2:1
is assumed to be an ideal ratio. If the current ratio is less than 2:1, it indicates
lack of liquidity and shortage of working capital. But a much higher ratio, even
though it is beneficial to the short-term creditors, is not necessarily good for the
company. A much higher ratio than 2:1 may indicate the poor investment
policies of the management. A much higher ratio may be considered to be
adverse from the view point of management on account of the following
reasons:
2. Liquid ratio explains the relationship between liquid
assets and current liabilities of a business. The formula for calculating the
ratio is :–
Liquid assets include those assets which will yield cash very
shortly. All current assets except stock and prepaid expenses are included in
liquid assets.
1. Cash-in-hand and Bank balances
2. Bills Receivables
3. Sundry Debtors (less provision for bad debts)
4. Short-term Loans and Advances
5. Temporary Investment of Surplus Funds
6. Accrued Incomes
According to accounting principle, a liquid ratio of 1:1 is
supposed 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 it is,
because the firm will able to pay its current liabilities more easily.
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Significance :–
Q. Explain the Important Ratios Calculated for Evaluating the Long -
Term Solvency Position of a Company.
OR
Q. Explain the Capital Structure Ratios in detail
:–
Debt Equity Ratio :–
Debt Long term Loans
Debt Equity Ratio= ————— OR —————————————
Equity Shareholder’s funds
Debt :–
Shareholder’s Funds :–
Significance :–
An ideal Liquid ratio is said to be 1:1. If it is more, it is
considered 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, as it
considers only those assets which can be easily and readily converted into
cash. Liquid ratio thus is a more rigorous test of liquidity than the current ratio
and, when used together with current ratio, it gives a better picture of the short-
term financial position of the business.
Ans. These ratios are calculated to assess the
ability of the firm to meet its long term liabilities when they become due. Long
term creditors including debenture holder and primarily interested to know
whether the co. has ability to pay regular interest due to them and to repay the
principal amount when it become due. These ratios includes the following
ratios:-
These ratios include the following:
1.
These refer to long-term liabilities which mature after one year. These
include Mortgage Loan, Debenture, Bank Loan, Loan from financial
institutions, Public Deposits etc.
Equity Share Capital, Preference Share capital,
Securities premium, General Reserve, Capital Reserve, other reserves and
credit balance of profit & loss a/c.
However, accumulated losses and fictitious assets remaining to the written off
like preliminary expenses, underwriting commission, share issue expense etc,
should be deducted.
This ratio is calculated to assess the liability of the firm to meet
its 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 position
from the long term point of view, as it indicates that more and more funds
invested business are provided by long-term lenders. A high debt equity ratio is
a danger-signal for long-term lenders.
Capital Structure Ratios
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2.
Generally, debt to total fund ratio is (.67:1) is considered
satisfactory. In other words, the proportion of long term loans should not more
than 67% of total funds. A high ratio than this is generally treated an indicator
of risky financial position from the long-term point of view, because it means
that the firm depends too much upon outside loans for its existence.
3.
Equity
Proprietary Ratio = ——————————
Equity + Debt
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 position
from long-term point of view.
4.
Fixed Assets
Fixed Assets to Proprietor’s Ratio= ———————————————
Proprietor’s funds (net worth)
The ratio indicates the extent to which proprietor’s funds are
sunk into fixed assets. Normally, the purchase of fixed assets should be
financed by proprietor’s funds. If this ratio is less than 100%, it would mean
that proprietor’s funds are more than fixed assets and a part of working capital
is provided by the proprietors.
5.
Significance :– A high gearing will be beneficial to equity shareholders when the
rate of interest/dividend payable on fixed cost bearing capital is lower than the
rate of return on investment in business.
Debt to Total Funds Ratio :–
Significance :–
Proprietary Ratios :–
Significance :–
Fixed Assets to Proprietor’s Ratio :–
Significance :–
Capital Gearing Ratio :–
Fixed Cost bearing capital = Preference share capital+ Debenture+ Long
term loans
Debt Long term loans
Debt to total funds ratio= ————— OR ————————————————————
Debt+ Equity long term loans+ shareholder’s Funds
Equity Share Capital+ Reserves + P&L (Cr.) Balance
Capital Gearing Ratio=———————————————————————————
Fixed Cost bearing capital
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6.
Net Profit before interest & tax
Interest Coverage Ratio = ——————————————————
Fixed Interest Charges
This ratio indicates how many times the interest charges are
covered by the profits available to pay interest charges. A long term lenders in
finding out whether the business will earn sufficient profits to pay the interest
charges regularly. The higher ratio more secure the lender is in respect of
payment of interest regularly. An interest coverage ratio of 6 to 7 times is
considered appropriate.
Ans. These ratios are calculated on the basis of ‘cost of sales’
or ‘sales’, therefore, these ratios are also called as ‘Turnover Ratios’. Turnover
indicates the speed or number of items the capital employed has been rotated
in the process of doing business. In other words, these ratios indicated how
efficiently the capital is being used to obtain sales; how efficiently the fixed
assets are being used to obtain sales; and how efficiently the working capital
and stock is being used to obtain sales. Higher turnover ratios indicate the
better use of capital or resources and in turn lead to higher profitability.
Turnover ratios include the following:
1) This ratio indicates whether inventory has
been efficiently used or not. This ratio indicates the relationship between
the cost of goods sold during the year and average stock kept during that
year. The formula for calculating the ratio is :
Cost of goods sold can be calculated by two ways :–
Cost of Goods Sold = Sales – Gross Profit
OR
Cost of Goods Sold = Opening Stock + Purchases + Carriage + Wages
+ Other Direct Expenses – Closing Stock
This ratio shows the speed with which the stock is rotated into
sales or the number of times the stock is turned into sales during the year. The
higher the ratio, the better it is, since it indicates that stock is selling quickly. In
Interest Coverage Ratio :–
Significance :–
Q. Explain the Activity Ratios Or Turnover Ratios in detail.
:–
Inventory Turnover Ratio :–
Cost of Goods Sold
Inventory Turnover Ratio = —————————————
Average Stock
Opening Stock + Closing Stock
Average Stock = ——————————————————
2
Significance :–
Activity Ratios
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a business where stock turnover ratio is high, goods can be sold at a low margin
of profit and even then the profitability may be quite high.
(2) This ratio indicates the time within which the
stock is converted into sales. This ratio is computed by the following
formula:
Inventory holding period can be calculated in days or months or weeks.
(3) This ratio indicates the relationship between
credit sales and average debtors during the year. The formula for
calculating the ratio is:
Net Credit Sales = Total Sales – Cash Sales
Bills receivable are added in debtors for the purpose of calculation of this ratio.
While calculating this ratio, provision for bad and doubtful debts is not
deducted from total debtors, so that it may not give a false impression that
debtors are collected quickly. Debtors turnover ratio can be calculated on the
basis of total sales instead of credit sales.
This ratio indicates the speed with which the amount is
collected from debtors. The higher the ratio, the better it is, since it indicates
that amount from debtor is being collected more quickly. The more quickly the
debtors pay, the less the risk from bad debts, and so the lower the expenses of
collection and increase in the liquidity of the firm.
(4) This ratio indicates the time within which
the amount is collected from debtors and bills receivable. This ratio can be
computed by the following three formulas:
Inventory Holding Period :–
12months/ 52 weeks/ 365 days
Inventory Holding Period = ——————————————————
Stock Turnover Ratio
Net Credit Sales
Debtors Turnover Ratio = ————————————————————
Average Debtors + Average B/R
Opening Debtors + Closing Debtors
Average Debtors = ————————————————————————
2
Opening B/R + Closing B/R
Average B/R = —————————————————
2
Significance :–
Average Collection Period :–
Debtors Turnover Ratio :–
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First Formula :–
Average Debtors + Average B/R
Average Collection Period = ——————————————————
Credit Sales per day
Net Credit Sales of the Year
Credit Sales per Day = ————————————————
365
:–
Average Debtors x 365
Average Collection Period = ————————————————
Net Credit Sales
Third Formula :–
12 months/ 365 days/ 52 weeks
Average Collection Period = —————————————————
Debtor Turnover Ratio
Significance :–
Creditors Turnover Ratio :–
Net Credit Purchases
Creditors Turnover Ratio = ——————————————————
Average Creditors + Average B/P
Net Credit Purchase = Total Purchases – Cash Purchase
Opening Creditors + Closing Creditors
Average Creditors = ———————————————————————
2
Opening B/P + Closing B/P
Average B/P = ————————————————
2
This ratio shows the time in which the customers are paying for
credit sales. For example, in a business average collection period is 30 days. It
means that, on an average, if sale is made today, the cash will be collected
actually after 30 days, i.e., 30 days credit sales are locked up in debtors.
(5) This ratio indicates the relationship between
credit purchases and average creditors during the year. The formula for
calculating the ratio:
Second Formula
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This ratio can be calculated on the basis of total purchases instead of credit
purchases.
This ratio indicates the speed with which the amount is being
paid to creditors. The higher the ratio, the better it is, since it will indicate that
the creditors are being paid more quickly which increases the credit worthiness
of the firm.
(6) This ratio indicates the time which is
normally taken by the firm to make payment to its creditors. This ratio can
be calculated by the following three formulas:
This ratio shows the time in which the creditors are paid for
credit purchases. The lower the ratio, the better it is, because a shorter
payment period implies that the creditors are being paid rapidly.
(7) This ratio indicates the relationship
between cost of goods sold and working capital. The formula for
calculating the ratio is:
This ratio indicates how efficiently working capital has been
utilised in making sales. This ratio is of particular importance in non-
manufacturing concerns where current assets play a major role in generating
sales. This ratio shows the number of times on which working capital has been
Significance :–
Average Payment Period :–
First Formula :–
Average Creditors + Average B/P
Average Payment Period = ——————————————————
Credit Purchase per day
Second Formula :–
Average Creditors x 365
Average Payment Period = ———————————————
Net Credit Purchases
Third Formula :–
12months/ 52 weeks/ 365 days
Average Payment Period = ——————————————————
Creditors Turnover Ratio
Significance :–
Working Capital Turnover Ratio :–
Cost of Goods Sold
Working Capital Turnover Ratio = ————————————
Working Capital
Working Capital = Current Assets – Current Liabilities
Significance :–
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rotated in producing sales. A high working capital turnover ratio shows
efficient use of working capital and quick turnover of current assets like stock
and debtors.
Ans. The main object of every business is to earn profits.
A business must be able to earn adequate profits in relation to the risk and
capital invested in it. The efficiency and the success of a business can be
measured with the help of profitability ratios. Profitability Ratios can be
determined on the basis of either sales or investment into business.
(A) These ratios include the following
(1) This ratio shows the relationship between gross
profit and sales. The formula for computing this ratio is:
Gross Profit = Sales – Cost of Goods Sold
Net Sales = Sales – Sales Return.
Significance :– This ratio measures the margin of profit available on sales. The
higher the gross profit ratio, the better it is. No ideal standard is fixed for this
ratio, but the gross profit ratio should be adequate enough not only to cover the
operating expenses but also to provide for depreciation, interest on loans,
dividends and creation of reserves.
(2) This ratio shows the relationship between net profit
and sales. It may be calculated by two methods:
(i)
Net Profit= Gross Profit- All Indirect Expenses + All indirect Incomes
(ii)
Q. Explain the Important Ratios Calculated for evaluating the
Profitability of a Company.
OR
Q. Explain the Profitability Ratios in detail
:–
:–
Gross Profit Ratio :–
Gross Profit
Gross profit Ratio= —————————x 100
Net Sales
Net Profit Ratio :–
Net Profit Ratio :–
Net Profit
Net Profit Ratio= ———————— x100
Net Sales
Operating Net Profit Ratio :–
Operating Net Profit
Operating Net Profit Ratio = ————————————— x100
Net Sales
Profitability Ratios
Profitability Ratios Based on Sales
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Operating Net Profit= Gross Profit- Operating Expenses
Operating Expenses= Office and Administration Expenses, Selling and
distribution expenses, Bad debts, Discount, Interest on short-term debts.
This ratio measures the rate of net profit earned on sales. It
helps in determining the overall efficiency of the business operations. An
increase in the ratio over the previous year shows improvement in the overall
efficiency and profitability of the business.
(3) This ratio measures the proportion of an enterprise’s
cost of sales and operating expenses in comparison to its sales:
Cost of Goods Sold + Operating Expenses
Operating Ratio : ————————————————————— X 100
Net Sales
Cost of Goods Sold = Sales – Gross Profit
OR
Cost of Goods Sold = Opening Stock + Purchases + Carriage + Wages +
Other Direct Expenses – Closing Stock
= Office and Administration Expenses, Selling and
distribution Expenses, Bad debts, Discount, Interest on short-term debts
Operating ratio is a measurement of the efficiency and
profitability of the business enterprise. The ratio indicates the extent of sales
that is absorbed by the cost of goods sold and operating expenses. Lower the
operating ratio, the better it is, because it will leave higher margin of profit on
sales.
(4) These ratios indicate the relationship between
expenses and sales. The ratio may be calculated as:
(i)
(ii)
(iii)
Significance :–
Operating Ratio :–
Cost of goods sold can be calculated by two ways :–
Operating Expenses
Significance :–
Expenses Ratios :–
Material Consumed
Material Consumed Ratio = ————————————— X 100
Net Sales
Direct Labour Cost
Direct Labour Cost Ratio = —————————————X 100
Net Sales
Factory Expenses
Factory Expenses Ratio = ———————————— X 100
Net Sales
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(B) These
ratios reflect the true earning capacity of the resources employed in the
enterprise Sometimes the profitability ratios based on sales are high
whereas profitability ratios based on investment are low. These may be
classified into two categories:
(1) Return on Capital Employed
(2) Return on Shareholder’s Funds
(1) This ratio reflects the overall profitability
of the business. This ratio is also known as ‘Rate of Return’ or ‘Yield on
Capital’. The ratio is computed as under:
This can be computed by any of the following two
methods:
Capital Employed = Debt + Equity – Non Operating Assets
OR
Capital Employed = Fixed Assets + Current Assets – Current Liabilities
(2) Return on shareholders funds
measures only the profitability of the funds invested by shareholders.
There are several measures to calculate the return on shareholder’s
funds:
(i) The ratio is computed as under:
This ratio reveals how profitably the proprietor’s funds have
been utilized by the firm. A comparison of this ratio with that of similar firms
will throw light on the relative profitability and strength of the firm.
(ii) This ratio is computed as
under:
Profitability Ratios Based on Investment in the Business :–
Return on Capital Employed :–
Capital Employed :–
Return on Shareholder’s Funds :–
Return on Total Shareholder’s Funds :–
Total Shareholder’s Funds = Equity Share Capital + Preference Share
Capital + All Reserves + P&L A/c Balance – Fictitious assets
Significance :–
Return on Equity Shareholder’s Funds :–
Profit before Interest, tax and dividends
Return on Capital Employed = —————————————————— X 100
Capital Employed
Net profit After Interest and Tax
Return on Total Shareholder’s Funds = ———————————————— X 100
Total Shareholder’s Funds
Net profit After Interest, Tax and Preference Dividend
Return on Equity Shareholder’s Funds = —————————————————— X 100
Equity Shareholder’s Funds
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Equity Shareholder’s Funds = Equity Share Capital + All Reserves + P&L
A/c Balance – Fictitious Assets
This ratio measures how efficiently the equity shareholder’s
funds are being used in the business.
(iii) This ratio measures the profit available to
the equity shareholders on a per share basis. This ratio is computed as under:
This ratio is helpful in the determination of the market price of
the equity share of the company.
(iv) Profit remaining after payment of tax and
preference dividend are available to equity shareholders. But all of these
are not distributed among them as dividend. Out of these profits, a portion
is retained in the business and remaining is distributed among equity
shareholders as dividend.
(v) This ratio is computed as under:
(vi)
(vii) Price Earnings(P.E) Ratio :–
Significance :–
Earning Per Share (E.P.S.) :–
Net Profit – Dividend on Preference Shares
Earning Per Share = ———————————————————————
Number of Equity Shares
Significance :–
Dividend Per Share :–
Dividend Paid to Equity Shareholders
Dividend Per Share = —————————————————————
Number of Equity Shares
Dividend Payout Ratio Or D.P. :–
D.P.S
D. P. = —————— X 100
E.P.S
Earning and Dividend Yield :–
EPS
Earnings Yield = ——————————————— X 100
Market Value Per Share
DPS
Dividend Yield = ———————————————— X 100
Market Value Per Share
Market price of the share
P.E. Ratio = —————————————————
EPS
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Q. What is Fund Flow Statement? How is it prepared?
:–
Meaning of Funds :–
Meaning of Flow :–
:–
Schedule of Changes in Working Capital :–
SCHEDULE OF CHANGES IN WORKING CAPITAL
Ans. The balance sheet of a firm discloses
the position of assets, liabilities and capital at the end of a particular year. But
it does not disclose the causes of changes in these items between the end of
previous year and the end of current year. Therefore, an additional statement
called ‘Fund Flow Statement’ is prepared to show the changes in assets,
liabilities and capital between the dates of two balance sheets.
In a limited sense, the term ‘fund’ means ‘cash’. But this
is not the correct meaning of the term ‘fund’ because there are many
transactions in the business which do not result in inflow or outflow of cash but
certainly result in the inflow or outflow of funds. As such, the term ‘fund’ stands
for ‘Net Working Capital”.
The term ‘flow’ means change or movement. Therefore, the
term ‘Flow of Funds’ means increase or decrease in working capital. If a
transaction results in the increase of working capital, it is said to be a source of
funds and if the transaction results in the decrease of working capital, it is said
to be an application of funds. If the transaction does not result in any change in
the working capital, it is said that it does not result in the flow of fund.
For preparing Fund Flow Statement
we have to prepare the following three statements:
(1) This schedule considers only
current assets and current liabilities, at the beginning and at the end of
the year. This schedule shows either increase or decrease in working
capital.
Meaning of Fund Flow Statement
Preparation of Fund Flow Statement
Particulars Amount Amount Increase in Decrease in
As on As on Working Working
Capital Capital
Cash-in-hand
Cash at Bank
Debtors
Closing Stock
Short Term
investments
Bills Receivables
Prepaid Expenses
Other current assets ________
……….. ………..
________
Current Assets:
Ø
Ø
Ø
Ø
Ø
Ø
Ø
Ø
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