MANAGEMENT ACCOUNTING

Unit-1:
HISTORY OF ACCOUNTING :
The Italian Renaissance brought the artistic accomplishments of man to new heights. At
this time, Venice was the business cradle of Europe, and it was here among merchants
that double entry accounting was invented and practised. During this period Fra Luca
Pacioli wrote his Book "Summa" dealing with record keeping and double-entry
accounting, one of the very first published books of the time that would become the
accounting "textbook" for the next 500 years. One section of this book was dedicated to
the description of double-entry accounting. The Summa was one of the first books
published on the Gutenberg press, became an instant success and was translated into
German, Russian, Dutch, and English. The Summa made Pacioli a celebrity and
insured him a place in history, as "The Father of Accounting."
INTRODUCTION :
The knowledge economy along with the ongoing information technology changes are
affecting the way we are doing business. We are becoming customers of each other,
and the economic value chain is integrating our businesses with our suppliers,
customers, and governments. As accounting is concerned, these peculiar changes are
being reflected in the present trends of shifting our attention from an obsolete
quantitative approach to a qualitative obsession where quality, customer satisfaction,
and innovation become the most important components. It suggests that accounting is
about providing information to others. Accounting
information is economic
information - it relates to the financial or economic activities of the business or
organisation.
Accounting information needs to be identified and measured. This is done by way of
a "set of accounts", based on a system of accounting known as double-entry
bookkeeping. The accounting system identifies and records "accounting
transactions".

- The "measurement" of accounting information is not a straight-forward process. it

involves making judgments about the value of assets owned by a business
or liabilities owed by a business. it is also about accurately measuring how much profit

or loss has been made by a business in a particular period. As we will see, the
measurement of accounting information often requires subjective judgement to come
to a conclusion
- The definition identifies the need for accounting information to be communicated. The
way in which this communication is achieved may vary. There are several forms of
accounting communication (e.g. annual report and accounts, management accounting
reports) each of which serve a slightly different purpose. The communication need is
about understanding who needs the accounting information, and what they need to
know!
DEFINITIONS OF ACCOUNTING
According to American Institute of Certified Public Accountants (AICPA) :The art of recording , classifying and summarizing in a significant manner and in terms
of money , transactions and event which are, in part at least of financial character and
interpreting the results there of

According to American Accounting Association (AAA) : Accounting is the process of identifying , measuring, and communicating economic
information to permit informed judgments and decisions by user of the information
According to Accounting principles Board of AICPA :The function of accounting is to provide quantitative information, primarily financial in
nature, and economic entities, that is intended to be useful in making economic
decisions
According to Smith and Ashburne :Accounting is a means of measuring and reporting the results of economic activities
According to Bierman & Derbin :Accounting may is means of collecting, summarizing, analyzing, and reporting in
monetary terms the information of the business

According to RN Anthony :-

Accounting system is
activities.
According to.AICPA

means of measuring and reporting the results of economic

The art of recording, classifying, and summarizing in a significant manner and in terms
of money, transactions and events which are, in part at least, of financial character, and
interpreting the results thereof.(AICPA)

PARTIES OR USERS INTERESTED IN ACCOUNTING INFORMATION

Accounting information of business house is useful not only to the owners but also to
many internal external parties. A classification of such interested groups in accounting
disclosures may be done as under :
Internal User

External User

Owners
Proprietors
Managers
Employees

Users of
Accounti
ng
Informat
ion

Creditors
Prospective
Investor
Government
Customers
Researchers
Foreigners
Others

Internal Users :
1) Owners / Proprietors : The business is done with a primary objective of making
profit. The accounting records reflects the profitability , financial position and the
financial soundness of the business
2) Managers : In case of large industrial organizations, where the owners and
managers are different, the managers are responsible for the day to day affair of
the business, The accounting records provide the vital information of the
performance of the business and analysis, which in turn helps management to
improve the performance by taking corrective action
3) Employee : The employees are interested I the job security and the future
growth. Both of these are related to the performance of the business.

External Users :
1) Creditors : Creditors are the persons who have extended credit to the
company. The creditors include the suppliers of goods and services, bankers
and other lenders. The financial statements helps them in ascertaining the
liquidity position of the business . i.e. the ability to meet the financial obligation,
as and when they fall due. For determining the credit worthiness of the
organization. Terms of credit are set according to the assessment of their
customers' financial health. Creditors include suppliers as well as lenders of
finance such as banks.
2) Prospective Investors : A Prospective investor is interested in knowing the
financial strengths of the business The expected rate of return on the
investment could be estimated based on the study of the financial statement. for
analyzing the feasibility of investing in the company. Investors want to make
sure they can earn a reasonable return on their investment before they commit
any financial resources to the company.
3) Government : The Government is interested in the financial statements form
the point of view of taxations compliance to corporate and labour laws.
4) Customers : The customers who have developed loyalty to a business are
interested in the continuance of the business. They are also interested I knowing
the future plans of the origination with which they can also link their growth. For
assessing the financial position of its supplier which is necessary for a stable
source of supply in the long term.
5) Researchers : Researchers need financial information for testing financial
hypothesis and development of theories and models.
6) Foreigners : The whole world has how became one big market due to modern
means of transport and communicating .
Many foreign agencies are
entrepreneurs are interested to have collaboration with Indian Enterprises of this
country. On the basis of accounting information, the foreigners make u their
mind for imports , experts also
7) Tax Authorities: For determining the credibility of the tax returns filed on behalf
of the company.
8) Regulatory Authorities: for ensuring that the company's disclosure of
accounting information is in accordance with the rules and regulations set in
order to protect the interests of the stakeholders who rely on such information in
forming their decisions.

9) Entrepreneurs : Entrepreneurs venture to enter a particular business only after

studying the profitability and finance position of business until ready working in
the world.
10)Trade Associates
: Trade associates consolidate and compared the
performance of the member unit and if needed demand certain concession,
exemptions and subsidies from the government. This is done only after
compiling the accounting information of the member units.
11) Stock Exchange : Stock exchanges require accounting information of
companies in connection with listing of securities and various dealings on the
exchange.
12)Media : News papers , magazines and electronics media as radio, television,
etc, collect accounting information of various units and undertakings and
bringing them to the notice of government and masses .
13)Political Parties : Political parties use accounting disclosures of public
undertaking s and various industries in placing their view in the parliament,
legislative as well as in public meetings I order to prove economic programme
and other wise.

BRANCHES OF ACCOUNTING
Accounting can be divided into several areas of activity. These can certainly overlap and
they are often closely intertwined. But it's still useful to distinguish them, not least
because accounting professionals tend to organize themselves around these various
specialties.
Financial Accounting : Financial accounting is the periodic reporting of a company's
financial position and the results of operations to external parties through financial
statements, which ordinarily include the balance sheet (statement of financial
condition), income statement (the profit and loss statement, or P&L), and statement of
cash flows. A statement of changes in owners' equity is also often prepared. Financial
statements are relied upon by suppliers of capital - e.g., shareholders, bondholders and
banks - as well as customers, suppliers, government agencies and policymakers.
There's little use in issuing financial statements if each company makes up its own rules
about what and how to report. When preparing statements,
Management Accounting : The part of Accounting that has to do with the provision of
information to interested parties inside the business, especially to managers, to help
them with decision making, planning, management and control, is called cost and
management accounting. Where financial accounting focuses on external
users, management accounting emphasizes the preparation and analysis of accounting
information within the organization. According to the Institute of Management

Accountants, it includes "designing and evaluating business processes, budgeting

and forecasting, implementing and monitoring internal controls, and analyzing,
synthesizing and aggregating informationto help drive economic value."
A primary concern of management accounting is the allocation of costs; indeed, much of
what now is considered management accounting used to be called cost accounting.
Although a seemingly mundane pursuit, how to measure cost is critical, difficult and
controversial. In recent years, management accountants have developed new
approaches like activity-based costing (ABC) and target costing, but they continue to
debate how best to provide and use cost information for management decision-making.

Cost Accounting : It is the process of accounting and controlling the cost of

production, operation or function, This purpose of this branch of accounting is to
ascertain the cost , to control the cost and to According to ICMA London Cost
accounting is the process of accounting for cost which begins with the recording of
income and expenditure and ends with the preparation of periodical statements and
reports for ascertaining and controlling cost
Auditing
Auditing is that part of Accounting that determines whether recorded information is a
true reflection of the business transactions that took place during an accounting period.
Auditing is done in two ways. It can be done internally, that is when the business itself
does it, or externally when the business contracts an outside company to do it. Most
companies make use of both methods.

THE MANAGEMENT ACCOUNTING

Meaning :
Management accounting can be viewed as Management-oriented Accounting. Basically
it is the study of managerial aspect of financial accounting, "accounting in relation to
management function". It shows how the accounting function can be re-oriented so as
to fit it within the framework of management activity. The primary task of management
accounting is, therefore, to redesign the entire accounting system so that it may serve
the operational needs of the firm. If furnishes definite accounting information, past,
present or future, which may be used as a basis for management action. The financial
data are so devised and systematically development that they become a unique tool for
management decision.
Management Accounting provides significant economic and financial data to the
management and the Management Accountant is the channel through which this

information efficiently and effectively flows to the management. The Management

Accountant has a very significant role to perform in the installation, development and
functioning of an efficient and effective management information system. He designs
the framework of the financial and cost control reports that provide each management
level with the most useful data at the most appropriate time. He educates executives in
the need for control information and ways of using it. This is because his position is
unique with respect to information about the organization. Apart from top management
no one in the organization perhaps knows more about the various functions of the
organization than him. He is, therefore, sometimes described as the Chief Intelligence
Officer of the top management. He gathers information, breaks it down, sifts it out and
organizes it into meaningful categories.
He separates relevant and irrelevant
information and then ranks relevant information in an intelligible form to the
management and sometimes also to those who are interested in the information in the
information outside the company. He also compares the actual performance with the
planned one and reports and interprets the results of operations to all levels of
management and to the owners of the business. Thus, in brief, management
accountant or controller is the person who designs the management information
system for the organization, operates it by means of interlocked budgets, computes
variances and exhorts others to institute 11corrective measures.
Definitions :
According to Mr. P.L. Tandon : "The management accountant is exactly like the
spokes in a wheel, connecting the rim of the wheel and the hub receiving the
information. He processes the information and then returns the processed information
back to where it came from"
According To Robert N. Antony : Management accounting is concerned with
accounting information that is useful to management.
According to TG Rose Management Accounting is the adaptation and analysis of
accounting information and its diagnosis and explanation in such a way as to assist
management.
According to Brown & Haward : The essential aim of management accounting should
be to assist management in decision making and control
According to Dr. Don barker : Management Accountants will be presented with many
opportunities for innovative actions in the global economic environment. In addition to
their role of providing accurate, timely and relevant information, management
accountants will be expected to participate as business consultants and partners with
management in the strategic planning process".

According to AACP (Anglo-American Council of Productivity (1950) "Management

accounting is the presentation of accounting information in such a way as to assist the
management in creation of policy and the day to day operation of an undertaking".
According to ICAI ( Institute of Chartered accountants of India) Such of its
techniques and procedures by which accounting mainly seeks to aid the management
collectively have come to be known as management accounting
According to N.K. Bose Management accounting is accounting for effective
Managements
The Report of the Anglo-American Council of Productivity (1950) has also given a
definition of management accounting, which has been widely accepted.
According to AACP "Management accounting is the presentation of accounting
information in such a way as to assist the management in creation of policy and the day
to day operation of an undertaking".
Thus, there are tremendous possibilities for management accountants to shine as a
professional group in the years to come. To fit in this role, it is necessary that the
management accountants develop effective communication abilities, adopt a structured
approach, a flexible accommodation and keep themselves aware with the latest
evolving technologies in the profession.
The term Management Accounting, observe, Broad and Carmichael, covers all those
services by which the accounting department can assist the top management and other
departments in the formation of policy, control of execution and appreciation of
effectiveness. This definition points out that management is entrusted with the primary
task of planning, execution and control of the operating activities of an enterprise. It
constantly needs accounting information on which to base its decision. A decision
based on data is usually correct and the risk of erring is minimized. The position of the
management in respect of its functions can be compared to that of an army general who
wants to wage a successful battle. A general can hardly fight successfully unless he
gets full information about the surrounding situation and the extent of effectiveness of
each of his battalions and, to the extend possible, even the enemy's intentions. Like a
general a successful management too strives to outstrip other competitors in the field by
streamlining its operating efficiency. It needs a thorough knowledge of the situation and
the circumstances in which the firm operates. Such knowledge can only be gained
through the processed financial data rendered by the accounting department on the
basis of which it can take policy decision regarding execution, control, etc. It is here
that the role of management accounting comes in. It supplies all sorts of accounting
information in the 3 form of such statements as may be needed by the management.
Therefore, management accounting is concerned with the accumulation, classification

and interpretation of information that assists individual executives to fulfill organizational

objectives.
The reasoning added to this statement was, "the technique of accounting is of extreme
importance because it works in the most nearly universal medium available for the
expression of facts, so that facts of great diversity can be represented in the same
picture. It is not the production of these pictures that is a function of management but
the use of them." An analysis of the above definition shows that management needs
information for better decision-making and effectiveness.
The collection and
presentation of such information come within the area of management accounting.
Thus, accounting information should be recorded and presented in the form of reports
at such frequent intervals, as the management may want.
These reports present a systematic review of past events as well as an analytical
survey of current economic trends. Such reports are mainly suggestive in approach
and the data contained in them are quite up to date. The accounting data so supplied
thus provide the informational basis of action. The quality of information so supplied
depends upon its usefulness to management in decision-making. The usual approach
is that, first of all, a thorough analysis of the whole 4 managerial process is made, then
the information required for each area is explored, and finally, all the information, after
analysis in terms of alternatives, is taken into consideration before arriving at a
management decision. It is to be understood here that the accounting information has
no end in itself; it is a means to an end. As its basic idea is to serve the management,
its form and frequency are all decided by managerial needs. Therefore, accounting aids
the management by providing quantitative information on the economic well being of
the enterprise. It would be appropriate if we called management accounting an
Enterprise Economics. Its scope extends to the use of certain modern sophisticated
managerial techniques in analyzing and interpreting operative data and to the
establishment of a communication network for financial reporting at all managerial levels
of an organization.
NATURE OF MANAGEMENT ACCOUNTING
The term management accounting is composed of 'management' and 'accounting'.
The word management' here does not signify only the top management but the entire
personnel charged with the authority and responsibility of operating an enterprise. The
task of management accounting involves furnishing accounting information to the
management, which may base its decisions on it. It is through management accounting
that the management gets the tools for an analysis of its administrative action and can
lay suitable stress on the possible alternatives in terms of costs, prices and profits, etc.
but it should be understood that the accounting information supplied to management
is not the sole basis for managerial decisions. Along with the accounting information,

management takes into consideration or weighs other factors concerning actual

execution. For reaching a final 5 decision, management has to apply its common
sense, foresight, knowledge and experience of operating an enterprise, in addition to
the information that is already has. The word 'accounting' used in this phrase should
not lead us to believe that it is restricted to a mere record of business transactions i.e.,
book keeping only.
It has indeed a 'macro-economic approach'. As it draws its raw material from several
other disciplines like costing, statistics, mathematics, financial accounting, etc., it can be
called an interdisciplinary subject, the scope of which is not clearly demarcated. Other
fields of study, which can be covered by management accounting, are political science,
sociology, psychology, management, economics, statistics, law, etc. A knowledge of
political science
helps to understand authority relationship and responsibility
identification in an organization. A study of sociology helps to understand the
behaviour of man in groups. Psychology enables us to know the mental make-up of
employers and employees. A knowledge of these subjects helps to increase
motivation, and to control the actions of the people who are ultimately responsible for
costs. This builds a better employer-employee relationship and a sound morale. The
subject of management reveals the processes involved in the art of managing, a
knowledge of economics assists in the determination of
optimum output in the
forecasting of sales and production, etc., and also makes it possible to analyze
management action in terms of cost revenues, profits, growth, etc. It is with the help of
statistics that this information is presented to the management in a form that can be
assimilated. The subject of management accounting also encompasses the subject of
law, knowledge 6 of which is necessary to find out if the management action is ultravires or not. It is, therefore, a wide and diverse subject. Management accounting has
no set principles such as the double entry system of bookkeeping. In place of generally
accepted accounting principles, the philosophy of cost benefit analysis is the core guide
of this discipline. It says that no accounting system is good or bad but is can be
considered desirable so long as it brings incremental benefits in excess of its
incremental costs. Applying management accounting principles to financial matters
can arrive at no single perfect solution. It is, therefore, an inexact science, which uses
its own conventions rather than standardized principles. The facts to be studied here
can be interpreted in different ways and the precision of the inferences depends upon
the skill, judgment and common sense of different management accountants. It
occupies a middle position between a fully matured and an infant subject.
Since management accounting is managerially oriented, its data is selective in nature.
It focuses on potential opportunities rather than opportunities lost. The data is operative
in nature catering to the operational needs of a firm. It details events, monetary and
non-monetary. The nature of data, the form of presentation and its duration are mainly

determined by managerial needs. It is quite frequently reported as it is meant for

internal uses and managerial control. An accountant should look at his enterprise from
the management's point of view. Whenever he fails to do that he ceases to be a
management accountant.
Management accounting is highly sensitive to management needs. However, it assists
the management and does not replace it. It represents a service 7 phase of
management rather than a service to management from management accountant. It is
rather highly personalized service. Finally, it can be said that the management
accounting serves as a management information system and so enables the
management to manage better.
FUNCTIONS OF MANAGEMENT ACCOUNTING
The basic function of management accounting is to assist the management in
performing its functions effectively. The functions of the management are planning,
organizing, directing and controlling. Management accounting helps in the performance
of each of these functions in the following ways:
(i) Provides data: Management accounting serves as a vital source of data for
management planning. The accounts and documents are a repository of a vast quantity
of data about the past progress of the enterprise, which are a must for making forecasts
for the future.
(ii) Modifies data: The accounting data required for managerial decisions is properly
compiled and classified. For example, purchase figures for different months may be
classified to know total purchases made during each period product-wise, supplier-wise
and territory-wise.
(iii) Analyses and interprets data: The accounting data is analyzed meaningfully for
effective planning and decision-making. For this purpose the data is presented in a
comparative form. Ratios are calculated and likely trends are projected.
(iv) Serves as a means of communicating: Management accounting provides a
means of communicating management plans upward, downward and outward through
the organization. Initially, it means identifying the feasibility and consistency of the
various segments of the plan. At later stages it keeps all parties informed about the
plans that have been agreed upon and their roles in these plans.
(v) Facilitates control: Management accounting helps in translating given objectives
and strategy into specified goals for attainment by a specified time and secures effective
accomplishment of these goals in an efficient manner. All this is made possible through

budgetary control and standard costing which is an integral part of management

accounting.
(vi) Uses also qualitative information: Management accounting does not restrict
itself to financial data for helping the management in decision making but also uses
such information which may not be capable of being measured in monetary terms.
Such information may be collected form special surveys, statistical compilations,
engineering records, etc.

SCOPE OF MANAGEMENT ACCOUNTING

Management accounting is concerned with
the most useful way for the management.
includes within its fold almost all aspects
following areas can rightly be identified as
accounting:

presentation of accounting information in

Its scope is, therefore, quite vast and
of business operations. However, the
falling within the ambit of management

(i) Financial Accounting: Management accounting is mainly concerned with the

rearrangement of the information provided by financial accounting.
Hence,
management cannot obtain full control and coordination of operations without a properly
designed financial accounting system.
(ii) Cost Accounting: Standard costing, marginal costing, opportunity cost analysis,
differential costing and other cost techniques play a useful role in operation and control
of the business undertaking.
(iii) Revaluation Accounting: This is concerned with ensuring that capital is
maintained intact in real terms and profit is calculated with this fact in mind.
(iv) Budgetary Control: This includes framing of budgets, comparison of actual
performance with the budgeted performance, computation of variances, finding of their
causes, etc.
(v) Inventory Control: It includes control over inventory from the time it is acquired till
its final disposal.
(vi) Statistical Methods: Graphs, charts, pictorial presentation, index numbers and
other statistical methods make the information more impressive and intelligible.
(vii) Interim Reporting: This includes preparation of monthly, quarterly, half-yearly
income statements and the related reports, cash flow and funds flow statements, scrap
reports, etc.

(viii) Taxation: This includes computation of income in accordance with the tax laws,
filing of returns and making tax payments.
(ix) Office Services: This includes maintenance of proper data processing and other
office management services, reporting on best use of mechanical and electronic
devices.
(x) Internal Audit: Development of a suitable internal audit system for internal control.

FUNCTIONS OF MANAGEMENT ACCOUNTANT

It is the duty of the management accountant to keep all levels of management informed
of their real position. He has, therefore, varied functions to perform. His important
functions can be summarized as follows:

(i) Planning: He has to establish, coordinate and administer as an integral part of

management, an adequate plan for the control of the operations. Such a plan would
include profit planning, programmes of capital investment and financing, sales
forecasts, expenses budgets and cost standards.
(ii) Controlling: He has to compare actual performance with operating plans and
standards and to eport and interpret the results of operations to all levels of
management and the owners of the business. This id done through the compilation of
appropriate accounting and statistical records and reports.
(iii) Coordinating: He consults all segments of management responsible for policy or
action. Such consultation might concern any phase of the operation of the business
having to do with attainment of objectives and the effectiveness of the organizational
structures and policies.
(iv) Other functions: He administers tax policies and procedures. He supervises and
coordinated the preparation of reports to governmental agencies. He ensures fiscal
protection for the assets of the business through adequate internal control and proper
insurance coverage. He carries out continuous appraisal economic and social forces
and the government influences, and interprets their effect on the business. It should be
noted that the functions of a Management Accountant are more of those of a 'staff
official'. He, in addition to processing historical 13 data, supplies a good deal of
information concerning the future operations in line with the management's needs.
Besides serving top management with information concerning the company as a whole,
he supplies detailed information to the line officers regarding alternative plans and their

profitability, which help them in decision-making. As a matter of fact the Management

Accountant should not bother himself regarding the decision taken by the line officials
after tendering advice unless he has reasonable grounds to believe that such a
decision is going to affect the interests of corporation adversely. In such an event also
he should report it to the concerned level of management with tact, firmness combined
with politeness.

MANAGEMENT ACCOUNTING AND FINANCIAL ACCOUNTING

Financial accounting and management accounting are closely interrelated since
management accounting is to a large extent rearrangement of the data provided by
financial accounting. Moreover, all accounting is financial in the sense that all
accounting systems are in monetary terms and management is responsible for the
contents of the financial accounting statements. In spite of such a close relationship
between the two, there are certain fundamental differences. These differences can be
laid down as follows:
(i) Objectives: Financial accounting is designed to supply information in the form of
profit and loss account and balance sheet to external parties like shareholders,
creditors, banks, investors and Government. Information is supplied periodically and is
usually of such type in which management is not much interested. Management
Accounting is designed principally for providing accounting information for internal 14
use of the management. Thus, financial accounting is primarily an external reporting
process while management accounting is primarily an internal reporting process.
(ii) Analyzing performance: Financial accounting portrays the position of business as
a whole. The financial statements like income statement and balance sheet report on
overall performance or statues of the business. On the other hand, management
accounting directs its attention to the various divisions, departments of the business and
reports about the profitability, performance, etc., of each of them. Financial accounting
deals with the aggregates and, therefore, cannot reveal what part of the management
action is going wrong and why. Management accounting provides detailed analytical
data for these purposes.
(iii) Data used: Financial accounting is concerned with the monetary record of past
events. It is a post-mortem analysis of past activity and, therefore, out the date for
management action. Management accounting is accounting for future and, therefore, it
supplies data both for present and future duly analyzed in detail in the 'management
language' so that it becomes a base for management action.

(iv) Monetary measurement: In financial accounting only such economic events find
place, which can be described in money. However, the management is equally
interested in non-monetary economic events, viz., technical innovations, personnel in
the organization, changes in the value of money, etc.
These events affect
management's decision and, therefore, management accounting cannot afford to ignore
them. 15 For example, change in the value of money may not find a place in financial
accounting on account of "going concern concept". But while affecting an insurance
policy on an asset or providing for replacement of an asset, the management will have
to take into account this factor.
(v) Periodicity of reporting: The period of reporting is much longer in financial
accounting as compared to management accounting. The Income Statement and the
Balance Sheet are usually prepared yearly or in some cases half-yearly. Management
requires information at frequent intervals and, therefore, financial accounting fails to
cater to the needs of the management. In management accounting there is more
emphasis on furnishing information quickly and at comparatively short intervals as per
the requirements of the management.
(vi) Precision: There is less emphasis on precision in case of management accounting
as compared to financial accounting since the information is meant for internal
consumption. (vii) Nature: Financial accounting is more objective while management
accounting is more subjective.
This is because management accounting is
fundamentally based on judgment rather than on measurement.
(viii) Legal compulsion: Financial accounting has more or less become compulsory
for every business on account of the legal provisions of one or the other Act. However,
a business is free to install or not to install system of management accounting. The
above points of difference between Financial Accounting and Management Accounting
prove that Management Accounting has flexible 16 approach as compared to rigid
approach in the case of Financial Accounting. In brief, financial accounting simply
shows how the business has moved in the past while management accounting shows
how the business has to move in the future. An attempt may now be made to compare
and study the two types of accounting on basis of the characteristics of the data used.

COST ACCOUNTING AND MANAGEMENT ACCOUNTING

Cost accounting is the process of accounting for costs. It embraces the accounting
procedures relating to recording of all income and expenditure and the preparation of
periodical statements and reports with the object of ascertaining and controlling costs.
It is, thus, the formal mechanism by means of which the costs of products or services
are ascertained and controlled. On the other hand, management accounting involves
collecting, analyzing, interpreting and presenting all accounting information, which is
useful to the management. It is closely associated with management control, which
comprises planning, executing, measuring and evaluating the performance of an
organization. Thus, management accounting draws heavily on cost data and other
information derived from cost accounting.
Today cost accounting is generally
indistinguishable from the so-called management accounting or internal accounting
because it serves multiple purposes. However, management accounting can be
distinguished from cost accounting in one important respect. Management accounting
has a wider scope as compared to cost accounting. Cost accounting deals primarily
with cost data while management accounting involves the considerations of both cost
and revenue. Management accounting is an all inclusive accounting information
system, which covers financial accounting, cost accounting, and all aspects of financial
management. But it is not a substitute for other accounting functions. It involves a
continuous process of reporting cost, financial and other relevant data in an analytical
and informative way to management. We should not be very much concerned with
boundaries of cost accounting and management accounting since they are
complementary in nature. In the absence of a suitable system of cost accounting,
management accountant will not be in a position to have detailed cost information and
his function is bound to lose significance. On the other hand, the management
accountant cannot effectively use the cost data unless it has been reported to him in a
meaningful and informative form.

LIMITATIONS OF MANAGEMENT ACCOUNTING

Management accounting, being comparatively a new discipline, suffers from certain
limitations, which limit its effectiveness. These limitations are as follows:
1. Limitations of basic records: Management accounting derives its information from
financial ccounting, cost accounting and other records. The strength and weakness of
the management accounting, therefore, depends upon the strength and weakness of
these basic records. In other words, their limitations are also the limitations of
management accounting.

2. Persistent efforts. The conclusions draws by the management accountant are not
executed automatically. He has to convince people at all levels. In other words, he
must be an efficient salesman in selling his ideas.
3. Management accounting is only a tool: Management accounting cannot replace the
management. Management accountant is only an adviser to the management. The
decision regarding implementing his advice is to be taken by the management. There is
always a temptation to take an easy course of arriving at decision by intuition rather
than going by the advice of the management accountant.
4. Wide scope: Management accounting has a very wide scope incorporating many
disciplines. It considers both monetary as well as non-monetary factors. This all brings
inexactness and subjectivity in the conclusions obtained through it.
5. Top-heavy structure: The installation of management accounting system requires
heavy costs on account of an elaborate organization and numerous rules and
regulations. It can, therefore, be adopted only by big concerns.
6. Opposition to change: Management accounting demands a break away from
traditional accounting practices. It calls for a rearrangement of the personnel and their
activities, which is generally not like by the people involved.
7. Evolutionary stage: Management accounting is still in its initial stage. It has,
therefore, the same impediments as a new discipline will have, e.g., fluidity of concepts,
raw techniques and imperfect analytical tools. This all creates doubt about the very
utility of management accounting.

Concepts & Conventions

1. Business Entity concept :
In accounting we treat a Business and owners as two separately identifiable parties.
This concept is called business entity concept. It means the personal transactions of the
owners are not mixed up with the business transactions. If we mixed transaction of
business and personal transaction of owners we will not get true picture of business.
For Example Mr.X Started business with 100,000/- Investment. He purchased
Machinery for 30,000/-, Furniture for 30,000/- and Computer (his personal) for
25,000/-.Remains in hand. Machinery and Furniture are the assets of the business and
not of the owner. Computer purchased for his personal usage, so it was treated as
personal drawings not business expenditure. According to the business entity concept
Rs100000 will be treated by business as capital i.e. a liability of business towards the
owner of the business.

This concept has now been extended to accounting separately for various divisions of a
firm in order to ascertain the results for each division separately. It has been of immense
value in determining results by each responsibility centre-Responsibility Accounting.
2. Money Measurement Concept.
Accounting records only those transactions which are expressed in monetary terms.
This concept assumes that all business transactions must be in terms of money that is
in the currency of a country. In our country such transactions are in terms of rupees.
Thus, as per the money measurement concept, transactions which can be expressed in
terms of money are recorded in the books of accounts.
For Example Investment 100,000/-Purchase of Machinery 30,000/- and Furniture
30,000/-etc.are expressed in terms of money, and so they are recorded in the books of
accounts. Lovality, honesty and Employees are not recorded in books of accounts
because these cannot be measured in terms of money although they do affect the
profits and losses of the business concern.
3. Cost Concept:
Cost concept states that all assets are recorded in the books of accounts at their
purchase price, which includes cost of acquisition, transportation and installation and
not at its market price. It means that fixed assets like building, plant and machinery,
furniture, etc are recorded in the books of accounts at a price paid for them. But some
times we have necessarily to be satisfied with an estimate only-the amount of
depreciation to be charged each year in respect of asset. It helps in calculating
depreciation on fixed assets.
For example we purchased one land for Rs.500, 000/-,and registration charges
20,000/- Out considers it as worth 700,000/-The total amount at which the land will be
recorded in the books of accounts 520,000/- (including expenses) not market price.
4. Going concern concept:
This concept assumed that the business will exist for a long time and transactions are
recorded from this point of view. It means that every business entity has continuity of
life. Thus, it will not be dissolved in the near future. This is an important assumption of
accounting, as it provides a basis for showing the value of assets in the balance
sheet; It is of great help to the investors, because, it assures them that they will continue
to get income on their investments
For example, a company purchases a plant and machinery of Rs.100, 000/ and its life
span is 10 years. According to this concept every year some amount will be shown as
expenses and the balance amount as an asset.

5. Dual-Aspect Concept.

Dual aspect concept basic principle of accounting. It provides the very basis of
recording business transactions in the books of accounts. This concept assumes that
every transaction has a dual effect, i.e. it affects two accounts in their respective
opposite sides. Therefore, the transaction should be recorded at two places. It means,
both the aspects of the transaction must be recorded in the books of accounts. The
interpretation of the Dual aspect concept is that every transaction has an equal effect on
assets and liabilities in such a way that total assets are always equal to total liabilities of
the business. This concept helps accountant in detecting error
For example if a business has purchased machinery for cash. There are two aspects 1)
Machinery received and 2) Cash paid. These two aspects are to be recorded. Thus, the
duality concept is commonly expressed in terms of fundamental accounting equation
Assets=Liabilities +Capital; or, rather,
Capital=Assets-Liabilities.
In other words, capital, the owners share of the assets of the firm is always what is left
out of assets after playing off outsiders. This is called the accounting Equation. It is self
evident but very useful.
6. Relisation concept:
Accounting is a historical record of transactions; it records what was happened. This
concept states that revenue from any business transaction should be included in the
accounting records only when it is realised. The term realisation means creation of legal
right to receive money. This is of great importance in stopping business firms from
inflating their profits by recording sales and incomes that are likely to accrue. Unless
money has been realized either cash has been received or a legal obligation to pay
has been assumed by the customer-no sales can be said to have taken place and no
profit or income can be said to have arisen. It helps in making the accounting
information more objective
For example Mr X Company received an order for supply Air conditioners worth
Rs.1,000,000/-.on 1st December.2011.They supplied worth Rs.500, 000/- up to
31stDecember.2011 and remaining supplied in Jan.2012.In this case X Company
recognized as a revenue up to 31st December.2011 only Rs. 500,000/- not
Rs.1,000,000/-.
7. Accrual Concept:
Accrual concept means that revenues are recognised when they become receivable.
Though cash is received or not received and the expenses are recognized when they
become payable though cash is paid or not paid. Both transactions will be recorded in
the accounting period to which they relate. Therefore, the accrual concept makes a
distinction between the accrual receipt of cash and the right to receive cash as regards
revenue and actual payment of cash and obligation to pay cash as regards expenses. It

helps in knowing actual expenses and actual income during a particular time period. It
helps in calculating the net profit of the business.
For Example Mr. X Company sold goods to Mr. Company worth of Rs.1, 000,000/- on
15thDecember.2011.cash received on 5 th Jan..2012. As per Accrual concept Mr. X
Company recognized revenue on 15 th December.2011 not 5th Jan.2012. Because
transaction happened on that day.
8. Accounting period Concept.
When accountants prepare financial statements like profit and loss account and balance
sheet, they assume that the life of the business can be divided into time periods. This is
called the accounting period concept. Normally periods divided like monthly, quarterly,
half-yearly and yearly basis.
It helps in future planning of the business. It helps in business liability of tax for specific
period. It helps in at the time divided declaration. It helps to creditors company financial
strength for particular period.
9. Matching Concept
The principle that requires a company to match expenses with related revenues.
Expenses are incurred for the purpose of producing revenue. In measuring net income
for a period, revenue should be offset by all the expenses incurred in producing that
revenue. This concept called Matching concept. The term matching means appropriate
association of related revenues and expenses. . On account of this concept,
adjustments are made for all outstanding expenses, accrued revenues, prepaid
expenses and unearned revenues, etc, while preparing the final accounts at the end of
the accounting period. It is very useful for find the exact revenues, expenses and profit
of the company for particular period.
For example if a company paid commission to sales man in January, 2012, for sale
made by him in December, 2011. According to this concept commission should be
adjust against sales of December 2000 because this expense is incurred for producing
revenue in December 2011.

Accounting Conventions:
Learning Objectives:
1. What are accounting conventions? Explain important accounting conventions.

The term "conventions" includes those customs or traditions which guide the
accountants while preparing the accounting statements. The following are the important
accounting conventions.
1. Convention of Disclosure
2. Convention of Materiality
3. Convention of Consistency
4. Convention of Conservatism

Convention of Disclosure:
The disclosure of all significant information is one of the important accounting
conventions. It implies that accounts should be prepared in such a way that all material
information is clearly disclosed to the reader. The term disclosure does not imply that all
information that any one could desire is to be included in accounting statements. The
term only implies that there is to a sufficient disclosure of information which is of
material in trust to proprietors, present and potential creditors and investors. The idea
behind this convention is that any body who want to study the financial statements
should not be mislead. He should be able to make a free judgment. The disclosures can
be in the way of foot notes. Within the body of financial statements, in the minutes of
meeting of directors etc.
Convention of Materiality:
It refers to the relative importance of an item or even. According to this convention only
those events or items should be recorded which have a significant bearing and
insignificant things should be ignored. This is because otherwise accounting will be
unnecessarily over burden with minute details. There is no formula in making a
distinction between material and immaterial events. It is a matter of judgment and it is
left to the accountant for taking a decision. It should be noted that an item material for
one concern may be immaterial for another. Similarly, an item material in one year may
not be material in the next year.
Convention of Consistency:
This convention means that accounting practices should remain uncharged from one
period to another. For example, if stock is valued at cost or market price whichever is
less; this principle should be followed year after year. Similarly, if depreciation is

charged on fixed assets according to diminishing balance method, it should be done

year after year. This is necessary for the purpose of comparison. However, consistency
does not mean inflexibility. It does not forbid introduction of improved accounting
techniques. If a change becomes necessary, the change and its effect should be stated
clearly.
Convention of Conservatism:
This convention means a caution approach or policy of "play safe". This convention
ensures that uncertainties and risks inherent in business transactions should be given a
proper consideration. If there is a possibility of loss, it should be taken into account at
the earliest. On the other hand, a prospect of profit should be ignored up to the time it
does not materialise. On account of this reason, the accountants follow the rule
'anticipate no profit but provide for all possible losses'. On account of this convention,
the inventory is valued 'at cost or market price whichever is less.' The effect of the
above is that in case market price has gone down then provide for the 'anticipated loss'
but if the market price has gone up then ignore the 'anticipated profits.' Similarly a
provision is made for possible bad and doubtful debt out of current year's profits.
Critics point out that conservatism to an excess degree will result in the creation of
secrets reserves. This will be quite contrary to the doctrine of disclosure.

TEST QUESTIONS
1. What do you mean by management accounting? Explain giving examples.
2. What are the functions of a management accountant? Elaborate each one of them.
3. Explain the benefits of management accounting in the business sector and service
sector.
4. Distinguish management accounting from financial accounting and cost accounting.
5. Explain the limitations of management accounting.
6. What are concepts and conventions of accounting.

Unit-2
Basic Accounting Terminology,

Non-accounting people can get puzzled by the accounting terms used. Every trade has
it's own jargon and accounting is no exception. Accountants need these terms to do
their job correctly. For the lay person it can however be quite daunting. The common
accounting terms are listed below, together with notes for Cashbook Complete users in
italics.
Accounting.Term.Definition
Accounts Payable Also called A/P or Creditors. Accounts payable are the bills your
business owes to suppliers. See the Bills to Pay screen in Cashbook Complete.
Accounts Receivable Also called A/R or Debtors, accounts receivable are the amounts
owed to you by your customers. See the Invoicing section in Cashbook Complete.
Accrual Based Accounting With the accrual method, you record income when the sale
occurs, not necessarily when you receive payment. You record an expense when you
receive goods or services, even though you may not pay for them until later. Cashbook
Complete uses Cash Based Accounting because it is easier to learn and understand.
Assets Things of value held by the business. Assets are balance sheet accounts.
Examples of assets are accounts receivable, furniture, fixtures and bank accounts. See
Balance
Sheet
Categories
in
the
Categories
Setup.
Balance Sheet Also called a statement of financial position, it is a financial "snapshot" of
your business at a given point in time. It lists your assets, your liabilities, and the
difference between the two, which is your equity, or net worth. Found under the
Cashbook
menu
in
Cashbook
Complete.
Capital Money invested in the business by the owners. Also called equity.
Cash Based Accounting If you use the cash method, you record income only when you
receive cash from your customers. You record an expense only when you write the
check to the vendor. Cashbook Complete uses this method,of accounting.
Chart of Accounts The list of account titles you use to keep your accounting records.
Cashbook Complete uses a simplified version of a chart of accounts and is called
Cashbook
Categories
(in
the
Setup
Wizard).
Cost of Goods Sold (COGS) Cost of items or services sold to your customers.
Creditor A company or individual whom you owe money to. See the Bills to Pay screen
in
Cashbook
Complete.
Credits At least one component of every accounting transaction (journal entry) is a
credit. Credits increase liabilities and equity and
decrease
assets.
Current Assets Assets that are in the form of cash or will generally be converted to cash

or used up within one year. Examples are accounts receivable and inventory.
Current Liabilities Liabilities payable within one year. Examples are accounts payable
and
payroll
taxes
payable.
Debits At least one component of every accounting transaction (journal entry) is a debit.
Debits
increase
assets
and
decrease
liabilities
and
equity.
Debtor A company or individual who owes you money. See Invoices Outstanding in
Cashbook
Complete.
Depreciation An annual write-off of a portion of the cost of fixed assets, such as vehicles
and equipment. Depreciation is listed among the expenses on the income statement.
With Cashbook Complete, this is normally done by your accountant at the end of the
year.
Double Entry Accounting In double-entry accounting, every transaction has two entries:
a debit and a credit (called a journal entry). Debits must always equal credits. All
General

Ledger

based

accounting

programs

use

double

entry

accounting.

End of Year Rollover With general ledger based accounting programs, the P & L
categories are zero'd and balance sheet categories are carried forward. This is a term
used in old accounting systems and not used much these days. Modern accounting
systems tend to use open ended accounting. See "End of Year" procedure in Cashbook
Complete
Help.
Equity The net worth of your company. Also called owner's equity or capital. Equity
comes from investment in the business by the owners, plus accumulated net profits of
the
business
that
have
not
been
paid
out
to
the
owners.
Fixed Assets Assets that are generally not converted to cash within one year. Examples
are
equipment
and
vehicles.
General Ledger A general ledger is the collection of all balance sheet, income, and
expense accounts used to keep the accounting records of a business. A general ledger
works with double entry accounting and journal entries for each transaction. Cashbook
Complete
uses
cash
based
accounting.
Income Accounts These are the accounts you use to keep track of your sources of
income. Examples are merchandise sales, consulting revenue, and interest income.
Income Statement Also called a profit and loss statement or a "P&L." It lists your
income, expenses, and net profit (or loss). The net profit (or loss) is equal to your
income minus your expenses. This is found under the Cashbook menu in Cashbook
Complete.

Inventory (Stock) Goods you hold for sale to customers. Inventory can be merchandise
you buy for resale, or it can be merchandise you manufacture or process, selling the
end product to the customer. See Products and Service in Cashbook Complete.
Journal The chronological, day-to-day transactions of a business are recorded in sales,
cash receipts, and cash payment journals. A general journal is used to enter period end
adjusting and closing entries and other special transactions not entered in the other
journals. In a traditional, manual accounting system, each of these journals is a
collection of multi-column spreadsheets. See "Journal Entries" in Cashbook Complete
Help.
Liabilities What your business owes creditors. Examples are accounts payable, payroll
taxes
payable,
and
loans
payable.
Long Term Liabilities Liabilities that are not due within one year. An example would be a
mortgage
payable.
Net Income Also called profit or net profit, it is equal to income minus expenses. Net
income is the bottom line of the income statement (also called the profit and loss
statement).
Profit & Loss Statement Also called an "Income Statement" or "P&L." It lists your
income, expenses, and net profit (or loss). The net profit (or loss) is equal to your
income minus your expenses. This is found under the Cashbook menu in Cashbook
Complete.
Retained Earnings Profits of the business that have not been paid to the owners; profits
that
have
been
"retained"
in
the
business.
Trial Balance A list of the categories (or general ledger accounts) and their totals. See
the Cash Trial Balance report in Cashbook Complete.
UNIT-3
Preparing Trial Balance / Accuracy of Ledger:
Learning Objectives:
1. Define and explain trial balance.
2. What are the advantages of preparing a trial balance?
3. What are the different methods of preparing trial balance?
Definition and Explanation:

Having posted all the transactions into the ledger, it is necessary to check the
correctness of the work done before proceeding further. In order to test the arithmetical
accuracy of our ledger we should prepare a statement called trial balance.
A trial balance is a statement prepared by taking out the debit and credit balances of all
accounts appearing in the ledger.
Objectives and Advantages of Preparing a Trial Balance:
The following are the main objectives of preparing a trial balance.
1. Trial balance helps in knowing the arithmetical accuracy of the accounting
entries. Trial balance represents a summary of all ledger balances and, therefore,
if the two sides of the trial balance tally, it is an indication of this fact that the
books
of
accounts
are
arithmetically
accurate.
2. Trial balance forms the basis for preparing financial statements such as income
statement / Trading and profit and loss account and balance sheet. In case, the
trial balance is not prepared, it will be almost impossible to prepare the financial
statements.
3. The entire ledger is summarised in the form of a trial balance. Thus the position
of a particular account can be judged simply by looking at the trial balance.

Proof of Accuracy:
If the debit and credit totals of the trial balance are equal and also correspond with the
total of journal, we may be satisfied that the posting have been properly made and are
arithmetically accurate.
How to Prepare a Trial Balance - An Example:
The trial balance is usually prepared on a loose sheet of paper. The ruling of trial
balance is similar to that of a journal. We may prepare a trial balance in one of the
following forms:
1. Total Trial Balance Method
2. Balance Trial Balance Method
Total Trial Balance Method:

According to total trial balance method two sides of each ledger account i.e., debit and
credit side are added up and debit and credit totals so obtained are placed in the debit
and credit columns of the trial balance respectively. Thus we may draw the following trial
balance by taking out the debit side total and credit side total of each account in
the ledger

Trial Balance

Ledger Account

J.F

Total Debits

Total Credits
Rs
12,453
43,675
23,654
430
26,670
-10,000
20,000
-3,400
600
1,000

Cash Account
Sundry Debtors Account
Sundry Creditors Account
Discount Account
Purchases Account
Sales Account
Machinery Account
Building Account
Capital Account
Rent Account
Wages Account
Salaries Account
1,141,882

Rs
8,436
34,453
31,298
550
-32,145
--35,000
---1,141,882

One clear defect of this method is that mistakes may be committed more often while
preparing the trial balance, because large number of figures would be required to be
enlisted. Thus, the process becomes unwieldy and cumbrous.
Balance Trial Balance Method:
The task of preparing a trial balance under balance - trial balance method is much
simplified. There is well known axiom that if equals are subtracted from equals the
remainders are equal. On this assumption, in place of writing against each account the
debit as well as the credit total the balance alone is written. The difference between the
two sides of an account is called the balance. If the debit side of an account is greater

than the credit side, the balance falls on the debit side and is known as "debit balance."
If the credit side of an account is greater than the debit, the the balance is on the credit
side and is called "credit balance."
Rules of Balancing Accounts:Rules of balancing each account is as follows:
1. Add up both sides of the account
2. Find out the difference in a separate slip.
3. Put the difference on the lighter side.
4. Add up both sides again.
5. Rule off.
The trial balance prepared above, if prepared with the balance of accounts will appear
as under (see example of ledger page):
Trial

Ledger Account

Balance

J.F

Dr. Balance

Cr. balance
Rs

Cash Account
Sundry Debtors Account
Sundry Creditors Account
Discount Account
Purchases Account
Sales Account
Machinery Account
Building Account
Capital Account
Rent Account
Wages Account
Salaries Account

4,017
9,222
--26,670
-10,000
20,000
-3,400
600
1,000
74,909

Rs--7,644
120
-32,145
--35,000
----

74,909

The second method has the added advantages and is the one that is generally used.
There are comparatively less chances of committing errors. As the magnitude of figures

is smaller the process is not cumbrous. It does not appear to be unwieldy. Moreover, in
a trial balance, the exact position of any account on the date of trial balance can be
determined at a glance.

Examples of Trading and Profit and Loss Account and Balance Sheet:
Learning Objectives:
1. Prepare trading and profit and loss account and balance sheet.

Example 1:
From the following balances extracted from the books of X & Co., prepare a trading
and profit and loss account and balance sheet as on 31st December, 1991.
Rs

Rs

Stock on 1st January

11,000

Returns outwards

500

Bills receivables

4,500

Trade expenses

200

Purchases

39,000

Office fixtures

1,000

Wages

2,800

Cash in hand

500

700

Cash at bank

4,750

Tent and taxes

1,100

Insurance
Sundry debtors

30,000

Carriage inwards

800

Carriage outwards

1,450

Commission (Dr.)

800

Sales

60,000

Interest on capital

700

Bills payable

3,000

Stationary

450

Creditors

19,650

Capital

17,900

Returns inwards

1,300

The stock on 21st December, 1991 was valued at Rs 25,000.

Solution:

X & Co.
Trading and Profit and Loss Account
For the year ended 31st December, 1991
To Opening stock
To Purchases
Less returns o/w

11,000
39,000
500
38,500

To Carriage
inwards

|By Sales

60,000

Less
|
returns i/w

1,300

58,700

By Closing
|
stock

25,000

800

To Wages

2,800

To Gross profit c/d

30,600

|
|

83,700

83,700

|
To Stationary

450

By Gross
|
profit b/d

To Rent and rates

1,100

To Carriage
outwards

1,450

To Insurance

700

To Trade expenses

200

To Commission

800

To Interest on
capital

700

To Net profit
transferred to
capital a/c

|
25,200

|
|

30,600

30,600

30,600

|
X & Co.
Balance Sheet
As at 31st December, 1991
Liabilities

Assets

Creditors

19,650

|Cash in hand

500

Bills payable

3,000

|Cash at bank

4,750

Capital

17,900

|Sundry debtors

30,000

Add Net profit

25,200

|Bill receivable

4,500

|Stock

25,000

|Office equipment

1,000

43,100

|
65,750

65,750

|
Example 2:
The following trial balance was taken from the books of Habib-ur-Rehman on December
31, 2011
Cash

13,000

Sundry debtors

10,000

Bill receivable

8,500

Opening stock

45,000

Building

50,000

Furniture and fittings

10,000

Investment (Temporary)

5,000

Plant and Machinery

15,500

Bills payable

9,000

Sundry creditors

20,000

Habib's capital

78,200

Habib's drawings

1,000

Sales

100,000

Sales discount

400

Purchases

30,000

Freight in

1,000

Purchase discount

500

Sales salary expenses

5,000

Advertising expenses

4,000

Miscellaneous sales expenses

500

Office salary expenses

8,000

Misc. general expenses

1,000

Interest income

1,000

Interest expenses

800

2,08,700

2,08,700

Closing stock on December 31, 2010 ... was $10,000

Required: Prepare income statement/trading and profit and loss account and balance
sheet from the above trial balance in report form.
Solution:
Habib-ur-Rehman
Income Statement/Profit and Loss Account
For the year ended December 31, 2011
Gross sales
Less: Sales discount

100,000
400

Net Sales

99,600

Cost of Goods Sold:

Opening stock

45,000

Purchases

30,000

Add: Freight in

1,000

31,000
Less purchase discount

500

Net purchases

30,500

Cost of goods available fort sale

75,500

Less closing stock

10,000

Cost of goods sold

65,500

Gross profit

34,100

Operating Expenses:
Selling Expenses:
Sales salary expenses

5,000

Advertising expenses

4,000

Misc. selling expenses

500
9,500

General Expense:
Office salaries expenses

8,000

Misc. general expenses

1,000
9,000

Total operating expenses

18,500

Net profit from operations

15,600

Other Expenses and Incomes:

Interest income
Interest expenses

1,000
800

Net increase

200

Net income

15,800

Habib-ur-Rehman
Balance Sheet
As at December 31, 2011.
ASSETS
Current Assets:
Cash

13,000

Sundry debtors

10,000

Bills receivable

8,500

Stock on Dec. 31, 19 ..

10,000

Investment

5,000

Total Current Assets

46,500

Fixed Assets:
Buildings

50,000

Plant and Machinery

15,500

Furniture and fittings

10,000

Total Fixed Assets

75,500

Total Assets

122,000

LIABILITIES:
Current Liabilities:
Sundry creditors

20,000

Bills payable

9,000

Total Current Liabilities

29,000

Fixed Liabilities:
Habib's capital

78,200

Net income for the year

15,800

94,000
Less: Drawings

1,000
93,000

Total Liabilities and Capital

122,000

Trial Balance of M/s Trinity Foods" as on 30th June 2005

Debit
Credit Amount
Particulars
L/F Amount
(in Rs)
(in Rs)
Cash a/c
Capital a/c
Bank a/c
Furniture a/c
Purchases a/c
Ram a/c
Sales a/c
Rahim a/c
Salaries and Wages a/c
Rent Paid a/c

Total

10,000
77,000
25,000
65,000
50,000
5,000
8,000
2,40,000

1,00,000

15,000
1,25,000

2,40,000

Consider the above Trial Balance. There are a total of 4 nominal accounts with either
debit or credit balances.
Purchases a/c [Debit Balance]

Sales a/c [Credit Balance]

Salaries and Wages a/c [Debit Balance]

Rent Paid a/c [Debit Balance]

To ascertain the profit or loss made by the organisation, the balance in these accounts
should be transferred to the "Trading and Profit & Loss a/c". The journal entries for
these transfers would be:
Journal Entries Hide/Show
Trading and Profit & Loss a/c
The "Trading and Profit & Loss a/c" would be
Dr
Trading and Profit & Loss a/c
Date
Particulars
J/F Amount
Date
Particulars

Cr
J/F Amount

(in Rs)
30/06/0
5
"
"

To Purchases a/c
To Salaries &
Wages a/c
To Rent Paid a/c

sub-total
30/06/0
5

To Bal (Profit)
Total

65,000 30/06/0
5,000 5
8,000
78,000

(in Rs)
By Sales a/c

sub-total

1,25,000

1,25,000

47,000
1,25,000

Total

1,25,000

Since the credit side total is greater, the account has a credit balance. Since a credit
balance in a nominal account indicates a gain, we can say that there is a profit.

What are Final Accounts?

Final Accounts consists of

Trading Account

Profit and Loss Account

Balance Sheet
Trading Account
It is a Nominal Account and is prepared for calculating the GROSS PROFIT or GROSS
LOSS arising as a result of trading activities of a business.
According to J.R.Batliboi:The Trading Account shows the results of buying and selling of goods. In
preparing, this account, the general establishment charges are ignored and only
the transactions in goods are included
Importance of Trading Account
Trading Account is prepared for the following reasons

To know the Gross Profit or Gross loss arising due to trading activities of the
business.

To find out the direct expenses incurred by the business for the goods sold during
the year.

Find out how much closing stock is left as compared to previous years and thus
find out the performance of the business.

Gives the trader an idea of the increase/decrease in Gross Profit /Gross Loss
and to assess the performance of the business and take corrective measures, if
needed.

Preparation of Trading Account

The following items usually appear in a Trading Account
Sales turnover
Both Cash and Credit sales are included. Net Sales is recorded after deducting Sales
returns (Return inwards).
Opening Stock
The closing stock of the previous accounting year is taken as the Opening stock for the
present year. If there is no Opening Stock then no entry is made. Opening stock is
derived by balancing the Stock Account and bringing down its balance to the next
period.
Purchases
Purchases include all the Cash and Credit purchases of goods made by the business
during the year.
Purchase returns (Return outwards) is deducted from the Purchases to arrive at Net
Purchases.
Direct Expenses
All expenses which are incurred in purchasing the goods and bringing them to the
trading place are recorded under this category.
These include:
Wages e.g. Warehouse worker wages.
Carriage Inwards i.e. the cost of transport of goods to the trading place. The
expense is usually borne by the buyer.
Duty on purchases, for example, Import duty or excise duty.
Closing Stock
All the goods which remain unsold at the end of the year are known as Closing stock.
The closing is stock is valued at Cost price or Market price, whichever is lower.
The reason for taking the lower value of the two is in accordance with the Prudence
Principle.
Normally, Closing stock is given outside the Trial Balance. This is so because its
valuation is made after the accounts have been closed.
Note: Sometimes, the Closing Stock may be given inside the Trail Balance. This
means that the entry to incorporate the closing stock in the books has already been
passed and it has already been deducted from the Purchases Account. In this case,
Closing Stock will not be shown in the Trading Account will only appear in the Asset
side of Balance Sheet.
Cost of goods sold
This means the finding the cost of only those goods which have been sold during the
year. It can be calculated as follows:
(Net Purchases+Opening Stock) - Closing Stock

Profit and Loss Account

According to Prof. Carter:
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.
Why Profit and loss account is made?

To find out the Net Profit or Net Loss

Compare the net profit of the business with previous years and to assess the
performance of the business.
Find out the amount of overheads of a business.

Items appearing on a Profit and Loss account

Any Incomes or gains
Any income or gains of the business from sources other than sales are recorded on the
Credit side of Profit and loss account.
Gross Profit or Loss
It is transferred to the P/L account from the Trading Account. Gross Profit is transferred
to the Debit side whereas Gross Loss is transferred to the Credit side.
Office and Administrative expenses
Example include salaries, office rent, lighting, stationery etc.
Selling and Distribution expenses
Include advertising expense, commission, carriage outwards, bad-debts etc.
Miscellaneous expenses
Such as, interest on loan, interest on capital, depreciation etc.

FOR CLOSING ENTRIES RELATED TO PROFIT AND LOSS ACCOUNT

Profit and Loss Account
According to Prof. Carter:
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.
Why Profit and loss account is made?

To find out the Net Profit or Net Loss

Compare the net profit of the business with previous years and to assess the
performance of the business.
Find out the amount of overheads of a business.
Balance Sheet
Balance Sheet is a statement which shows the financial position of the business on a
particular day.
According to A. Palmer
The Balance Sheet is a statement at a particular date showing on one side the
traders property and possessions and on the other hand the liabilities.

Thus we can say that

Balance sheet is a statement not an account.

It is prepared to show the financial position of the business.

It records all the assets and liabilities of the business.

It shows the financial position on a particular day not for a period of time.
Need and Importance of Preparing a Balance Sheet
A Balance Sheet serves the following purposes:

The true financial position of the business can be ascertained at a particular point
of time.

Reveals the amount of assets owned by the business for example machinery,
cash, debtors and so on.

Show the liabilities of the business such as total creditors, share capital etc.

To adjudge weather the firm is solvent or not.

Opening entries for the next financial year are based on the Balance Sheet of the
previous year.
Items appearing on a Balance Sheet

Assets
Assets of a business are what it owns. They can be classified as:
Fixed assets: All those assets which are owned by the business and last for more than
an accounting year. Examples include Land, building, machinery, vehicle, furniture and
fixtures and the like.
Current assets: It includes all those assets which either in the form of cash or can be
easily converted into cash within one accounting period. Current Assets include Cash,
Debtors and Stock.
Liabilities
Liabilities represents what the business owes to outside persons other than owners.
These liabilities are classified on basis of time period of repayment.
Long term liabilities: These are liabilities which the business owes for more than one
accounting period, e.g. long term bank loans, debentures etc.
Current liabilities: These are short term debts of the business that are to be repaid
within one accounting period, e.g. creditors and bank overdraft.
Owners Equity
Owners equity represents what the business owes its owner.
It is equal to total assets minus total liabilities.

Important points regarding Balance Sheet

The Balance Sheet is not an account but a statement.

It does not have debit or credit side but has two sections i.e. assets and liabilities.

The heading of Balance Sheet is as on a particular date. Thus a Balance Sheet

may have different figure on different dates.

The balances shown in the Balance Sheet act as Opening Balances for the next
accounting period.

Balance Sheet is based on the accounting equation

Assets= Owners Equity + Liabilities
Difference between Trial Balance and Balance Sheet
Objective
Trial Balance is prepared to verify the arithmetical accuracy of the books of account
whereas Balance Sheet shows the financial position of the business.
Headings
Trial Balance is two sides i.e. Debit and Credit whereas Balance Sheet has Assets and
Liabilities.Profit and LossTrial Balance does not show any information about the profit or
loss of a business, whereas Balance Sheet records the Profit or Loss of the business.

Closing stock
The valuation of closing stock is not necessary to prepare a Trial Balance whereas
Balance Sheet cannot be prepared unless the Closing stock for that particular
accounting year is not ascertained.
Types of Accounts
Balances of all types of accounts are recorded in a Trial Balance i.e. Personal, real and
nominal. Balance Sheet records balances of personal and real accounts only.
Adjustments
Adjustment for outstanding expenses, prepaid expenses and accrued incomes are not
required for the preparation of Trial Balance. A Balance sheet is only complete after all
the necessary adjustments are made.
Closing Stock
Closing stock refers to the goods remaining unsold during the year.
They are valued at Cost price or Market Price whichever is lower.
Closing entries
Closing Stock Account

Dr.

Trading Account
For closing Stock transferred to
tradingaccount
Treatment in Final Accounts
When closing stock is given outside the Trial Balance
It will appear on

The credit side of the Trading Account

Under Current Assets in the Balance Sheet.

When closing stock appears inside the Trail Balance
This means that the Closing stocks have already been deducted from the Purchases
and thus it will ONLY appear in the Balance Sheet under Current Assets.
Accrued expenses or outstanding expenses
Expenses which have been incurred but not been paid for till the end of the accounting
year are known as Accrued expenses or outstanding expenses.
For example,
Total salaries to be paid for the year were $10,000, but by the end of the year $1000
were not paid and will be treated as outstanding salary.
Adjusting Entry
Salaries Account
Outstanding Salaries Account
(Being salaries outstanding)

Dr.

Accounting treatment
Outstanding expense amount is added to that particular expense account in the Profit
and loss or Trading Account because it was the expense for that year. (Based on the
matching principle)
Outstanding expenses are liabilities for the business. Thus they will appear under the
Current Liabilities in the Balance Sheet.
Note: If the Outstanding expense appears in the Trial Balance then it will only be
recorded in the Liabilities side of the Balance Sheet.
Prepaid Expenses
All those expenses which are due next year but paid for in advance during the current
year are termed as Prepaid Expenses.
Adjustment Entries
Prepaid Expense Account

Dr.

Expense Account
(For expense paid in advance)
Accounting Treatment
The concerned expense will be deducted by the prepaid amount in the Trading Account
or Profit & Loss account.
Prepaid expenses are assets for the business thus it will appear under the Current
Assets in the Balance Sheet.
Note: If the Prepaid expense is given inside the Trial Balance, then the prepaid
expense will only appear in the Current Asset of the Balance Sheet.
Depreciation
Depreciation is the fall in the value of fixed assets over a period of time.
Adjustment Entries
Depreciation Account

Dr.

Assets Account
(Being depreciation charged)
Accounting Treatment
Depreciation amount is entered as expense on the Debit Side of Profit and Loss
account.
Depreciation is deducted from the value of the concerned asset in the Balance Sheet.
Accrued Income
Incomes which are earned during the year but not received till the end of the accounting
year are termed as Accrued Income / Earned Incomes/ Income Receivable.

Adjustment Entries
Accrued Income Account

Dr.

Income Account
(Being income received in advance)
Accounting treatment
Accrued income will be added to the concerned income account in the Profit and Loss
account because it the income for that particular year (matching principle)
Accrued incomes are asset for the business and appear under the Current Assets in the
Balance Sheet.
Note: If Accrued Incomes appear inside the Trial Balance then it will ONLY appear
under the Current Assets in the Balance Sheet.
Unearned Income/Revenue
All incomes or revenues which are received in advance but not earned during the year
are treated as unearned revenue. There may be times when a certain income is
received in the current year but the whole amount of it does not belong to the current
year.
Adjusting Entries
Revenue Account

Dr.

Revenue received in advance Account

(For revenue received in advance)
Accounting Treatment
Unearned incomes/revenues are not the actual income for that particular year and thus
deducted from that particular revenue account in the Profit and Loss Account.
Unearned incomes/revenues are treated as liability for the business and thus appear
under the Current Liabilities in the Balance Sheet.
Note: If unearned income/revenue appears inside the Trial balance then it will ONLY
appear under the Liabilities in the Balance Sheet.
Interest on Capital
Usually the owner gets an Interest on his investment the business. According to the
principle of separate entity, Capital is considered as Liability for the business and the
owner is paid a certain amount of interest on the capital employed.
Accounting Entries
Interest on Capital
Capital Account

Dr.

(Interest allowed on Capital)

Accounting Treatment in Final Accounts
Interest on Capital is an expense for the business and thus appears on the Debit side of
the Profit and Loss account.
It is a gain for the owner and thus it is added to the Capital in the Balance Sheet.
Interest on Drawings
Many times during the operation of business, the owner may take out some cash from
the business for his personal use. These withdrawals from the business are considered
as Drawings. Considering the fact that the business is a separate accounting entity, it
charges an interest on the drawings to the owner.
Adjusting Entries
Drawing Account

Dr.

Interest on drawings account

(Being interest charged on drawings)
Accounting Treatment
Interest on drawings is an income for the business and appears on the Credit side of the
Profit and Loss Account.
Interest on drawings is an expense for the proprietor and thus it is deducted from the
Capital Account in the Balance Sheet.
Interest on Loan
Interest paid on loans taken by the business is treated as expense and will appear on
the Debit side of the Profit and loss account.
Sometimes the interest on loan may not be fully paid and may be outstanding when the
final account is prepared. In this case, the Interest on loan account will be debited by
the outstanding interest amount.
Adjusting Entries
Interest on Loan account

Dr.

Outstanding Interest account

(Being outstanding interest on loan)
Accounting treatment
Interest on loan is an expense for the business and appears on the Debit side of the
Profit and Loss account.
Interest on loan is a liability for the business and is added to the Loan Account in the
Liabilities section of the Balance Sheet.

Writing off Bad Debts

There may be occasions when the business might not be able to collect its debts. This
may be due to the dishonesty of a debtor or may be due to the death or insolvency of a
debtor.
Bad Debts Account

Dr.

Debtors Account
(Bad debts written off)
This amount is then written off the books as Bad debts. It is a loss for the business and
thus it is written on the debit side of the Profit and Loss account.
Closing Entry
Profit and Loss Account

Dr.

Bad Debts Account

(Transfer of bad debts to Profit and
loss Account)
Accounting Treatment
Bad debts appear on the debit side of the Profit and Loss account because it is a loss.
Bad debts are deducted from the Debtors in the Current assets in the Balance Sheet.
Recovery of Bad Debts
Sometime a debts written off as Bad debts may be recovered later on. Cash is coming
in thus Cash account is debited whereas Recovery of bad debts is credited because it
a gain.
Accounting Entries
Cash Account

Dr.

Recovery of bad
debts
(Being bad debts
recovered)

Recovery of bad debts

Profit and Loss account
(Being transfer of recovery of bad debts to
Profit and Loss Account)

Dr.

Partial Settlement of Debtors

Sometimes, a business might only be able to recover a part of the debts. This means
the rest of the unrecovered debts will be written off as bad debts.
Accounting Entries
Cash Account

Dr.

Bad Debts Account

Dr.

Debtors Account
(Being partial recovery of debts)
Provision for Doubtful Debts
Even after deducting the amount of actual bad-debts from the Debtors, there may still
be some debts which may be regarded as bad or doubtful. Thus a business might make
an estimate of the amount of such doubtful debts, that is, debts that are likely to become
bad, and charge them as an expense against the current periods revenue.
When Provision for Doubtful Debts is set up for the first time
Accounting Entries
Doubtful Debts Account

Dr.

Provision for doubtful debts

(Being creation of provision for doubtful debts)
Closing Entries
Doubtful Debts Account is an expense for the business and thus it will be debited to the
Profit and Loss account
Profit and Loss Account

Dr.

Doubtful debts Account

(Being transfer of doubtful debts expense to the Profit and
Loss Account)
It will be deducted from the Sundry Debtors in the Balance Sheet.
Increasing the Existing Provision for Doubtful Debts
Adjusting Entry
Doubtful debts Account
Provision for doubtful debts Account

Dr.

(Being increase of provision for doubtful debts)

Closing Entry
Being a loss for the business the Doubtful Debts Account is transferred to the debit side
of Profit and Loss Account.
Profit and Loss Account

Dr.

Doubtful Debts
(Being transfer of doubtful debts expense to the Profit and
Loss Account)
Decreasing the Existing Provision for Doubtful Debts
Adjusting Entry
Provision for doubtful debts Account

Dr.

Doubtful debts Account

(Being decrease of provisions for doubtful debts)
Closing Entry
Being a gain for the business the Doubtful Debts Account is transferred to the Credit
side of Profit and Loss Account.
Doubtful Debts Account

Dr.

Profit and Loss Account

(Being transfer of doubtful debts expense to the Profit and
Loss Account)
In the Balance Sheet the debtors will appear net of the Provision for Doubtful debts.
Provision for Discount on Debtors
A provision for discounts to debtors who pay early is created in the current year itself.
Accounting Entries
Profit and Loss Account Dr.
Provision for Discount on Debtors Account
(For provision for discount created on Debtors)
It is shown on the Debit side of the Profit and Loss Account.
Provision for Discount on Debtors is deducted from the Debtors in the Balance Sheet.
Note: Provision for discount on debtors will be deducted after Further bad debts and
Provision for doubtful debts are deducted from the Debtors.

Provision for Discount on Creditors

When the business makes prompt payments of its debts, it is bound to receive
Discounts from its creditors.
Although the discounts will be earned in the next year, the discounts so earned are an
income of the current year. A Provision for such discount is made in the current year
itself so that that the discounts thus earned may be credited to the Profit and Loss
Account of the current year.
Provision for Discount on Creditors Account

Dr.

Profit and Loss Account

(For provision for discount on Creditors)
Accounting Treatment
Provision for Discount on Creditors will be shown on the Credit side of the Profit and
Loss Account.
It is deducted from Sundry Creditors on the Liabilities side of the Balance Sheet.
-------------------------------------------------------------------------------------------------------------------------------------------

MANAGEMENT ACCOUNTING- COSTING PART

Q. What is under absorption and over absorption? What are the reasons and
treatment for under absorption and over absorption.
Ans: Usually overheads are apportioned or allotted to cost units on an estimated basis.
But it is quite natural that the overhead so estimated may be different from the amount
of overhead actually incurred.
Hence the question of under or over absorption of overhead arises when there is a
difference between the amount of overhead absorbed and the amount of overhead
incurred.
Meaning of Under-absorption of overheads
Under-absorption of overheads means that the amount of overheads absorbed in the
production is less than the amount of actual overheads-Incurred. For example if the

overheads absorbed on a predetermined basis are Rs : 1, 00,000 and the actual

overheads incurred are Rs. 1, 20,000, there is under-absorption to the extent of Rs.20,
000.
It represents under stating the costs as the overheads incurred are not fully recovered in
the cost of jobs or processes, etc. Under-absorption is also termed as 'under recovery'
Meaning of over-absorption of overheads
Over-absorption of overheads means the excess of overheads absorbed over the actual
amount of overheads incurred. In other words when the amount absorbed is more than
the expenditure incurred due to expenses being less than the estimates it would mean
over-absorption of overheads. Usually over-absorption inflates the cost. Overabsorption is also formed as 'over recovery'.
For example the overheads recovered are Rs.3, 00,000 and the actual production
overheads are Rs.2, 75,000 then there will be over-absorption of Rs.25, 000. (Rs.3,
00,000 - Rs.2, 75,000).
Reasons of under / Over-absorption of overheads
The under or over-absorption of overheads may arise due to any one or more of the
following reasons:
(i) Wrong estimation of overhead expenses: The actual overhead expenses may be
substantially less or more than the estimated amount.
(ii) Wrong estimation of work done: The amount of work done may greatly exceed or
may be substantially less than the estimated work. For example if actual work is 8,000
working hours against estimated working hours of 10,000, then the expenses charged
to job will be 20% less.
(iii) Error in using method of absorption: Sometimes the method of absorption may not
be suitable. If the percentage of direct material method is used, fluctuation in prices of
material may lead to under or over-absorption of overheads.
(iv) Seasonal fluctuation in overhead: Due to seasonal nature of work, overhead may
fluctuate from one period to another period.
(v) Under or over utilization of capacity: There may be under or over-absorption of
overhead due to under or over utilization of productive capacity.
(vi) Wrong estimation of output: When the actual output substantially differs from the
anticipated output, it leads to under or over-absorption of overheads.

Treatment of under or over-absorption of overheads

The under or over-absorption of overheads may be disposed of by any one of the
following three methods:
1st method: Writing off to costing profit and loss account
If the difference between actual overheads and absorbed overheads is small, it is simply
transferred to costing profit and loss account.
If however this difference is large the reason should be investigated. When the cause is
abnormal the amount of under / over-absorption should be treated as abnormal loss and
transferred to costing profit and loss accent.
2nd method: Use of supplementary rate
Under this method, the difference of actual and estimated overheads is charged to three
parts, i.e. cost of work-in-progress, cost of finished stock and cost of sales
proportionately. This is usually done with the supplementary rate of overheads. The
supplementary rate is computed by dividing under/over-absorbed overheads with the
actual base.
Difference between actual and absorbed overheads
From the information given above show how do you adjust the difference among workin-progress, finished stock and cost of sales by way of supplementary rate?
3rd Method: Carry forward to the next year
Sometimes it is recommended that the difference should be carried forward to the next
year-with the expectation that in the next year the position will be corrected. But this
results in rendering the costing data of both the years misleading. However this method
is suitable only in case of new projects which will have more outputs in the next period
than in the initial period.
In this method, the amount of under-absorbed overheads? Transferred to the debit of
overhead reserve suspense account and the amount of over-absorbed overheads are
transferred to its credit side.

Q. What is budget? Explain with example how budgets are useful for the
manager.
Ans: An itemized forecast of an individual's or company's income and expenses
expected for some period in the future. With a budget, an individual is able to carefully
look at how much money they are taking in during a given period, and figure out the
best way to divide it among a variety of categories. When making a personal budget, an
individual will typically designate the appropriate amount of money to fixed
expenses such as rent, car payments, or utility bills, and then make an educated
estimation for how much money they will spend in other categories, such as groceries,
clothing, or entertainment. By keeping track of where one's money goes, one may be
less likely to overspend, and more likely to meet their financial goals.
Q.3 Write short notes on
1. Zero based budgeting:
Zero-based budgeting is an approach to planning and decision-making which reverses
the working process of traditional budgeting. In traditional incremental budgeting,
departmental managers justify only variances versus past years, based on the
assumption that the "baseline" is automatically approved. By contrast, in zero-based
budgeting, every line item of the budget must be approved, rather than only changes.
During the review process, no reference is made to the previous level of expenditure.
Zero-based budgeting requires the budget request be re-evaluated thoroughly, starting
from the zero-base. This process is independent of whether the total budget or specific
line items are increasing or decreasing.
The term "zero-based budgeting" is sometimes used in personal finance to describe
"zero-sum budgeting", the practice of budgeting every dollar of income received, and
then adjusting some part of the budget downward for every other part that needs to be
adjusted upward.
Zero based budgeting also refers to the identification of a task or tasks and then funding
resources to complete the task independent of current resourcing.

Advantages of ZBB:
1 Efficient allocation of resources, as it is based on needs and benefits rather than
history.

2 Drives managers to find cost effective ways to improve operations.

3 Detects inflated budgets.
4 Increases staff motivation by providing greater initiative and responsibility in
decision-making.
5 Increases communication and coordination within the organization.
6 Identifies and eliminates wasteful and obsolete operations.
7 Identifies opportunities for outsourcing.
8 Forces cost centers to identify their mission and their relationship to overall
goals.
9 Helps in identifying areas of wasteful expenditure, and if desired, can also be
used for suggesting alternative courses of

2. Classification of costs
The Meaning of Classification of Cost. (Cost Accounting)
Cost classification is the process of grouping costs according to their common
characteristics. A suitable classification of costs is of vital importance in order to identify
the cost with cost centres or cost units. Cost may be classified accounting to their
nature, i.e., material, labor and expenses and a number of other characteristics. The
same cost figures are classified according to different ways of costing depending upon
the purpose to be achieved and requirements of particular concern. The important ways
of classification are:
On the basis of Identity: According to this classification, the costs are divided into
there categories i.e., Materials, Labor and Expenses. There can be further subclassification of each element; for example, material into raw material components, and
spare parts, consumable stores, packing material etc. This classification is important as
it helps to find total cost, how such total cost is constituted and valuation of work-inprogress.

On the basis of Function: Production, Administration, Selling & Distribution are three
important functions of a business concern. Taking these functions into consideration,
costs have been classified by:
(a) Production or Manufacturing Cost: Manufacturing costs are those costs which are
incurred in the course of manufacture. It includes cost of raw material, cost of labour,
other direct cost and factory indirect cost. Example of production or manufacturing costs
may be power, lighting, heating, rent, depreciation etc.
(b) Office and Administration Cost: These costs are incurred for the general
administration of the enterprise. It includes office costs as well as administration cost.
For example, salary of office staff, rent of office building, electricity charges, audit fee,
printing and stationeries etc.
(c) Selling and Distribution Cost: It includes both selling cost as well as distribution cost.
Selling costs are those costs which are incurred in connection with the selling of goods
and services Distribution costs are those costs which are incurred on dispatch of
finished goods to the consumers. Example of selling and distribution costs are: sales
men salary, packing charges, carriage, out ward, advertisement, ware house charges
etc.
On the basis of Variability: The behavior of cost varies from one another as
production increases, some cost remains constant or varies in direct proportion to the
volume of out put, or others may vary partially. Thus on the basis of variability, costs can
be classified into the following three categories.
(a) Fixed Cost / Period Cost: Fixed costs are those costs which remain fixed irrespective
of the change in volume of output. As production increases cost per unit of the fixed cost
decreases and as production decreases fixed costs are, rent of the factory building
depreciation, salary of the office manager etc.
(b) Variable Cost / Product Cost: Variable costs are those costs which vary in direct
proportion to the volume of output. As production increases total cost increases but also
per unit remains constant. As production decreases total cost decreases and cost per
unit also decreases. Examples of variable costs are, cost of raw materials labor etc.
(c) Semi-Variable Cost / Semi-Fixed cost: These costs are partly fixed and partly
variable. Examples of variable costs are telephone rent. It includes partly fixed charge
up to a certain level and then varies according to the calls.
On the basis of controllability: From the point of view of controllability, the cost has
been classified in to two categories as controllable cost and uncontrollable cost.

(a) Controllable Cost: These costs are regulated or controlled by specified member of
an organization. Most of the variable costs are controllable. Generally direct material,
direct labor and direct expenses are controlled by the lower level of the management.
(b) Uncontrollable Cost: These costs can not be regulated or controlled by specified
member of an undertaking. Most of the fixed costs are uncontrollable. Example of
uncontrollable costs are, factory rent, managers salary etc.
On the basis of normality: On this basis the costs have been classified in to two
categories as.
(a) Normal cost: It is the cost which is normally incurred at a given level of out put.
These costs are part of cost production.
(b) Abnormal cost: It is the cost which is not normally incurred at a given level of out put.
These costs are not charged to the cost of production. It is transferred to the costing
profit and loss account.
On the basis of Time: On this basis the costs have been classified as
(a) Historical Cost: These costs are ascertained after they have been incurred such
costs are available only when the production of a particular thing has already been
done.
(b) Pre-determined Cost: Pre-determined costs are estimated costs which are set in
advance on a scientific way. It becomes standard cost and compared with the actual for
adopting controlling measures.
3. Cost center:
A department or other section of a company where managers are directly responsible
for costs. For example, consider a company that has a manufacturing department,
a research and development department, and a payroll department. Each department
could be a cost center, and the directors of each department would be responsible to
keep costs to as low a level as possible. The company thus accounts for each cost
center separately, which allows managers to take immediate responsibility for cost
growth and credit for cost cutting.
4. FIFO
FIFO, which stands for "first-in-first-out," is an inventory costing method which assumes
that the first items placed in inventory are the first sold. Thus, the inventory at the end of
a year consists of the goods most recently placed in inventory. FIFO is one method
used to determine Cost of Goods Sold for a business.

Q.4 What is marginal costing? Explain 1. P/V ratio, 2. Break Even Point, 3. Margin of
safety.
Marginal Costing: In economics and finance, marginal cost is the change in total
cost that arises when the quantity produced changes by one unit. That is, it is the cost
of producing one more unit of a good. If the good being produced is infinitely divisible,
so the size of a marginal cost will change with volume, as a non-linear and nonproportional cost function includes the following:

variable terms dependent to volume,

constant terms independent to volume and occurring with the respective lot size,

Jump fix cost increase or decrease dependent to steps of volume increase.

1 P/V ratio: The Profit Volume (PV) Ratio is the ratio of Contribution over Sales. It
measures the Profitability of the firm and is one of the important ratios for
computing profitability. The Contribution is the extra amount of sales over
variable cost. Contribution is also fixed cost plus profit.
Profit = Sales - Variable Cost - Fixed Cost.
Thus Contribution is:
Profit + Fixed Cost = Sales - Variable Cost.
Therefore PV Ratio = (Contribution/Sales) X100. (This as a percentage of sales)

2. Margin of safety: A principle of investing in which an investor only purchases

securities when the market price is significantly below its intrinsic value. In other
words, when market price is significantly below your estimation of the intrinsic value,
the difference is the margin of safety. This difference allows an investment to be
made with minimal downside risk.
The term was popularized by Benjamin Graham (known as "the father of value
investing") and his followers, most notably Warren Buffett. Margin of safety doesn't
guarantee a successful investment, but it does provide room for error in an analyst's
judgment. Determining a company's "true" worth (its intrinsic value) is highly
subjective. Each investor has a different way of calculating intrinsic value which may
or may not be correct. Plus, it's notoriously difficult to predict a company's earnings.

Margin of safety provides a cushion against errors in calculation.

3. Breakeven point:
Q.5 What is labour turnover? What are the causes of Labour turnover? How is it
measured?
Labour turnover refers to the movement of employees in and out of a business.
However, the term is commonly used to refer only to wastage or the number of
employees leaving.
High labour turnover causes problems for business. It is costly, lowers productivity and
morale and tends to get worse if not dealt with.
Causes of labour turnover
A high level of labour turnover could be caused by many factors:
Inadequate wage levels leading to employees moving to competitors
Poor morale and low levels of motivation within the workforce
Recruiting and selecting the wrong employees in the first place, meaning they leave to
seek more suitable employment
A buoyant local labour market offering more (and perhaps more attractive)
opportunities to employees
Measuring labour turnover
The simplest measure involves calculating the number of leavers in a period (usually a
year) as a percentage of the number employed during the same period. This is known
as the "separation rate" or "crude wastage rate" and is calculated as follows:
Number of leavers / average no employed x 100
For example, if a business has 150 leavers during the year and, on average, it
employed 2,000 people during the year, the labour turnover figure would be 7.5%

An alternative calculation of labour turnover is known as the "Stability Index. This

illustrates the extent to which the experienced workforce is being retained and is
calculated as follows:
Number of employees with one or more years service now / Number employed one
year ago x 100
Labour turnover will vary between different groups of employees and measurement is
more useful if broken down by department or section or according to such factors as
length of service, age or occupation.
Q.6 Define standard cost and standard costing. Write the advantages and
disadvantages of standard costing.
An estimated or predetermined cost of performing an operation or producing a good
or service, under normal conditions.
Standard costs are used as target costs (or basis for comparison with the actual costs),
and are developed from historical data analysis or from time and motion studies. They
almost always vary from actual costs, because every situation has its share of
unpredictable factors. Also called normal cost.
STANDARD COSTING is a control method involving the preparation of detailed cost
and sales budgets. Such budgets are then compared with the actual results for a
specific account period and any significant variances between the actual and the
budgeted results are investigated. Unexpected trends are corrected if they are not
acceptable or they cannot be accommodated.
Advantages / Benefits of Standard Costing System:
Standard costing System has the following main advantages or benefits:
1 The use of standard costs is a key element in a management by exception approach. If
costs remain within the standards, Managers can focus on other issues. When costs fall
significantly outside the standards, managers are alerted that there may be problems
requiring attention. This approach helps managers focus on important issues.
2 Standards that are viewed as reasonable by employees can promote economy
and efficiency. They provide benchmarks that individuals can use to judge their own
performance.
3 Standard costs can greatly simplify bookkeeping. Instead of recording actual co0sts for
each job, the standard costs for materials, labor, and overhead can be charged to jobs.

4 Standard costs fit naturally in an integrated system of responsibility accounting. The

standards establish what costs should be, who should be responsible for them, and
what actual costs are under control.

Disadvantages / Problems / Limitations of Standard Costing System:

The use of standard costs can present a number of potential problems or
disadvantages. Most of these problems result from improper use of standard
costs and the management by exception principle or from using standard costs
in situations in which they are not appropriate.
1 Standard cost variance reports are usually prepared on a monthly basis and often are
released days or even weeks after the end of the month. As a consequence, the
information in the reports may be so stale that it is almost useless. Timely,
frequent reports that are approximately correct are better than infrequent reports that
are very precise but out of date by the time they are released. Some companies are
now reporting variances and other key operating data daily or even more frequently.
2 If managers are insensitive and use variance reports as a club, morale may
suffer. Employees should receive positive reinforcement for work well done.
Management by exception, by its nature, tends to focus on the negative. If variances
are used as a club, subordinates may be tempted to cover up unfavorable variances or
take actions that are not in the best interest of the company to make sure the variances
are favorable. For example, workers may put on a crash effort to increase output at the
end of the month to avoid an unfavorable labor efficiency variance. In the rush to
produce output quality may suffer.
3 Labor quantity standards and efficiency variances make two important assumptions.
First, they assume that the production process is labor-paced; if labor works faster,
output will go up. However, output in many companies is no longer determined by how
fast labor works; rather, it is determined by the processing speed of machines. Second,
the computations assume that labor is a variable cost. However, direct labor may be
essentially fixed, and then an undue emphasis on labor efficiency variances creates
pressure to build excess work in process and finished goods inventories.
4 In some cases, a "favorable" variance can be as bad as or worse than an "unfavorable"
variance. For example, McDonald's has a standard for the amount of hamburger meat
that should be in a Big Mac. A "favorable" variance would mean that less meat was
used than standard specifies. The result is a substandard Big Mac and possibly a
dissatisfied customer.
5 There may be a tendency with standard cost reporting systems to emphasize meeting
the standards to the exclusion of other important objectives such as maintaining and
improving quality, on-time delivery, and customer satisfaction. This tendency can be
reduced by using supplemental performance measures that focus on these other
objectives.
6 Just meeting standards may not be sufficient; continual improvement may be necessary
to survive in the current competitive environment. For this reason, some companies
focus on the trends in the standard cost variances - aiming for continual improvement

rather than just meeting the standards. In other companies, engineered standards are
being replaced either by a rolling average of actual costs, which is expected to decline,
or by very challenging target costs.

Q.What is idle time? What are the factors causes it? How can it be controlled?
Meaning and Definition of Idle Time in Cost Accounting.
Generally idle time means that time for which the employer pays, but from which he
obtains no production. Otherwise it is the difference between the times for which
workers are paid but the workers do not work. So it is a loss to the organization. It can
be minimized but, cannot be controlled during idle time; the workers remain due and
contribute nothing towards production. It is the difference between actual hour and
actual hour worked. There are two types of idle times:
1 Normal idle time: The normal idle time is that idle time which cannot be fully
avoided but effective effort should be made to reduce it.
2 Abnormal idle time: Abnormal idle time arises due to various causes which can be
avoided. Abnormal idle time can be avoided if proper precautions are taken. Thus
the factors which are responsible for controlling and avoiding idle time must be
taken care of.
Normal idle time is permitted but abnormal idle time should be avoided.
Factor causes for it:
1. Normal causes
Some idle time is inherent in every situation. The time lost between factory gate and the
place of work, the interval between one job and another, the setting up time for the
machine, normal fatigue etc result in normal idle time.
2. Abnormal causes
Idle time may also arise due to abnormal factors like lack of co-ordination, power failure,
break-down of machines, non-availability of Raw Materials, strikes, lock-outs, poor
supervision, fire, flood etc. the causes for abnormal idle time should be further analyzed
into controllable and uncontrollable.
Controllable idle time refers to that idle time which could have been put to productive
use had the management not been more alert and efficient. All such time which could
have been avoided is controllable idle time. However time lost due to abnormal causes,
over which the management does not have any control Example: - breakdown of
machines, floods etc may be characterized as uncontrollable idle time.

Control:
Idle time can be prevented or reduced considerably by advanced production planning,
timely procurement of stores, proper maintenance of tools & machinery, assurance of
supply of power from own power plant, advance planning for machine utilization &
personnel etc. For causes which are not within the control of the organization, idle time,
in spite of best efforts shall arise to some extent.
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Q.8 From the following figures extracted from the books of ABC Ltd. For the year
ended on 31.03.2008. Prepare cost sheet showing:
1. Prime Cost 2. Works Cost 3. Cost of Production 4. Cost of Sales 5. Profit
(MBA Dec. 2010, New Syllabus)
Particulars
Direct Materials

Amount
70,000

Indirect Wages
Factory Rent & rates
Indirect Materials
Depreciation of Office Assets
General Factory Expenses
General Selling Expenses
Office Salaries
Advertisement
Direct Wages
Other Direct Expenses
Office Rent & Rates
Depreciation of Machines
Salary to Managing Directors
Travelling expenses
General Office Expenses
Carried Outward
Sales

10,000
50,000
500
100
5,700
1,000
4,500
2,000
75,000
15,000
500
1,500
12,000
1,100
1,000
1,000
2,50,000

Solution:
In the books of ABC Ltd.
Cost Sheet (For the year ended 31.03.2008)

Particulars

Rs.

Rs.

Direct Materials

70,000

Add Direct Wages

75,000

Add Other Direct Expenses

15,000

1 Prime cost

1,60,000

Add: Factory overheads:

1 Indirect wages

10,000

2 Factory rent & rates

50,000

3 Indirect materials

500

4 Depreciation of office assets

100

5 General factory exp.

5,700

6 Depreciation of machines

1,500

2 Work cost

67,800

Add: office & admin overheads:

1 Office salaries

4,500

2 Advertisement

2,000

3 Office rent &rates

500

2,27,800

2,47,800
4 Salary of M.D.

12,000

5 General office exp.

1,000

3 Cost of production
2,50,900
(900)
2,50,000

Add: Selling & distribution overheads:

1 General selling exp

1,000

2 Travelling exp

1,000

Q.9. Methods or Price of issue materials (MBA April 2010, New syllabus)
The following transactions occur in the purchase and issue of material
April 02

Purchased

40,000 units

@ Rs. 4 p.u.

April 20

Purchased

5,000 units

@ Rs. 5 p.u.

May 05

Issued

20,000 units

May 10

purchased

60,000 units

May 12

Issued

40,000 units

June 02

Issued

10,000 units

@ Rs. 6 p.u.

June 05

Issued

10,000 units

June 15

Purchased

45,000 units

June 20

Issued

30,000 units

@ Rs. 5.50 p.u.

Prepare stores ledger account.

1 By FIFO method

STORES LEDGER ACCOUNT (FIFO Method)

Solution:
Balance
Date

Apr. 2

Apr. 20

Particulars Receipt
Qty
Rate

Total

Issues
Qty

Rate Total

Qty

Rate

Total

Purchase
d

40,000

1,60,000

40,000

1,60,000

Purchase
d

5,000

25,000

40,000

1,60,000

5,000

25,000

Issued

20,000

80,000

20,000

80,000

5,000

25,000

20,000

80,000

5,000

25,000

60,000

3,60,000

45,000

2,70,000

May 5

Purchase
d

60,000

3,60,000

May 10

40,000
Issued
20,000
5,000

May 12

80,000

25,000

90,000

15,000

June 2 Issued

10,000

60,000

35,000

2,10,000

June 5 Issued

20,000

1,20,000

15,000

90,000

15,000

90,000

45,000

5.50

2,47,500

30,000

5.50

1,65,000

Purchase
June 15 d

ne 20

45,000

5.50

2,47,500

30,000
Issued
15,000
15,000

90,000

5.50

82,000

Q.10 Standard costing- Labour Variances (MBA Dec. 2008, New Syllabus)

The details regarding composition and the weekly wage rates of labour force engaged
on job scheduled to be completed in 30 weeks are as follows:
Actual
Standard
No. of
Workers

Type of Workers

Weekly Rate No. of

(Rs.)
Workers

Weekly
Rate (Rs.)

Skilled

75

60

70

70

Semi-skilled

45

40

30

50

Unskilled

60

30

80

20

The work is actually completed in 32 weeks. Calculate various labour variances.

Solution:

Standard
Type of workers

Skilled
Semi skilled
unskilled

Actual

Standard
proportion of
actual weeks

Weeks

Rate
(Rs.)

Total (Rs.)

Weeks

Rate
(Rs.)

Total
(Rs.)

75*30=
2250

60

1,35,000

70*32= 2240

70

1,56,800

2,400

40

54,000

30*32= 960

50

48,000

1,440

30

54,000

80*32= 2560

20

51,200

1,920

2,56,000

5,760

45*30=
1350
60*30=
1800
5,400

2,43,000

5,760

1 Labour Rate Variance (LRV)= (Standard Rate-Actual Rate)*Actual time

Skilled

(60-70)*2240

Semi-skilled

(40-50)*960

Unskilled =

(30-20)*2560

= 22,400(Adverse)
= 9,600 (Adverse)
= 25,600 (favorable)

6,400
(Adverse)

2 Labour efficiency variance (LEV)= (Standard Time- Actual Time)* standard rate
Skilled

(2250-2240)* 60

= 600 (F)

Semi-skilled =

(1350-960)* 40

= 15,600(F)

Unskilled

(1,800-25,600)* 30 = 22,800 (A)

= 6,600(A)
3 Labour cost variance (LCV)= Standard Cost- Actual Cost
Skilled= (1, 35,000-1, 56,000)

= 21,800 (A)

Semi-skilled = (54,000- 48,000)

= 6,000 (F)

Unskilled

= (54,000- 51,200)

= 2,800 (F)

= 13,000 (A)
4 Labour mix variance (LMV)= Standard Rate * Difference in mix
Skilled= 60*(2,400-2,240)
Semi-skilled = 40*(1,440-960)
Unskilled
= 9,600 (F)

= 30*(1,920-2,560)

= 9600 (F)
= 19,200 (F)
= 19,200 (A)

Q.11 Marginal costing

(MBA Apr 2009, New Syllabus)

Rahul and Sujata have a unit each, for manufacturing bats.

Details are as under:

Rahul Rs. Lakhs

Sujata Rs. Lakhs

Sales

300

120

Variable costs

220

90

Fixed overhead

40

20

Rahuls unit runs at 100% capacity and Sujatas at 60% capacity. They decided
to merge the two units from Kumar Brothers
1 Calculate for the individual pre-merge status 1. P/V ratio 2. BEP
2 Calculate the post-merge 1. P/V ratio 2. BEP
3 Find the profit of the merged firm at 75% capacity.
Solution:
1 Individual pre-merge status:
Rahul
P/V Ratio =

contribution /sales * 100

= 80/300 * 100
= 26.67%
BEP = Fixed Cost/ P/V ratio
= 40/26.67%
= 149.98 lakhs

Sujata
P/V Ratio = contribution /sales * 100
= 30/120*100
= 25%
BEP = Fixed Cost/ P/V ratio
= 20/25%
= 80 Lakhs
2 Computation of post merge P/V Ratio and BEP:

rticulars

Rahul

Sujata

Total

pacity utilization (%)

100%

60%

100%

les (Rs. In lakhs )

300

120

420

ss Variable costs

220

90

310

ntribution

80
40

30
20

110
60

40

10

50

xed cost

ofit

Composite P/V ratio: =Total Contribution/ Total Sales * 100

= 110/420*100
= 26.19047%
BEP:

= Total Fixed Cost/ Composite P/V ratio

= 60/ 26.190%
= 229.09 Lakhs
3 Profit of the merged firm at 75% capacity

Particulars

Rs. In lakhs

Sales

315.00

Less Variable cost

232.50

Contribution

82.50

Less fixed o.hs/ fixed cost

60.00

Profit

22.50