DR. S.

Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

Hindusthan College of Engineering and Technology, Coimbatore – 641 032 information than supplied by these financial statements. Cost accounting
I Year Master of Business Administration provides detailed cost information to various levels of management for efficient
STUDY NOTES performance of their functions. The information supplied by cost accounting
ACCOUNTING FOR MANAGEMERS acts as a tool of management for making optimum use of scarce resources and
Name of The Faculty : Dr.S.Kamalasaravanan ultimately add to the profitability of business. Cost accounting mainly consists
--------------------------------------------------------------------------------------------------------- of principles and rules which are used for determining:
Unit I : FINANCIAL ACCOUNTING (a) the cost of manufacturing a product, e.g., motor car, furniture, chemical,
Financial Accounting – Meaning and Definition. Accounting Concepts and steel, paper, etc., and
conventions. Double entry principles of book keeping. Journal entry-Posting in (b) the cost of providing a services, e.g., electricity, transport, education, etc.
to Ledger-Preparation of Trial Balance- Preparation of Final Accounts. Cost accounting information is mainly for internal use i.e., for management. It
------------------------------------------------------------------------------------------------ is not to be provided to external parties such as shareholders, creditors, potential
1.1. Introduction to Accounting investors, etc. Neither do outsiders have any claim on this information, except
Accounting is often called the ‘language of business’ because government agencies, to whom cost information may have to be submitted.
accounting terms and concepts are used to describe the events that make up the Management Accounting: The term ‘management accounting’ is the modern
existence of business. As you gain knowledge of accounting, you also increase concept of accounts as a tool of management. It is a broad term and is
your understanding of the ways businesses are conducted. Like other languages, concerned with all such accounting information that is useful to management.
accounting is also a man made art. Changes and improvements are continually In simple words, the term management accounting is applied to the provision of
being made in it. accounting information for management activities such as planning, controlling
Broadly speaking, on the basis of type of accounting information and and decision-making, etc.
the purpose for which such information is used, accounting may be divided into It encompasses techniques and processes that are intended to provide financial
three categories: and nonfinancial information to people within an organisation to make better
1. Financial Accounting (or General Accounting), decisions to achieve business objectives. The management accountant needs to
2. Cost Accounting, and be dynamic and forward looking and his role is determined by the requirements
3. Management Accounting. of business. Clearly, the management accounting information is only for
Financial Accounting: Financial accounting is mainly concerned with internal users i.e., management at all levels. It is not published for general
recording business transactions in the books of account for the purpose of public.
computing profit or loss for a specified period (generally one year) and also to
show the financial position of the business at the end of the period. Thus at the 1.1.2. Users of Accounting Information
end of the financial year, the following two financial statements are prepared It was stated above that financial accounting information is mainly for use by
for a business enterprise: outsiders whereas cost accounting and management accounting is for use by
(a) Profit and Loss Account showing the net profit or loss during the period. internal management. In other words, users of accounting information may be
(b) Balance Sheet showing the financial position of the firm. divided into two broad categories — internal users and external users.
Financial accounting covers preparation and interpretation of the above 1. Internal Users: Internal users of accounting information are insiders of the
financial statements. It is historical in nature as it records only past transactions. enterprise who need information to effectively manage the activities of the
Financial accounting is mainly for use by the outside parties such as business. These include owners and partners in the case of sole tradership and
shareholders, creditors, bankers, public, government agencies and others. partnerships and in the case of corporate business, these include managers and
Cost Accounting: Cost accounting is a branch of accounting which specialises directors, etc.
in providing information about the detailed cost of products or services being 2. External Users: External users are individuals and organisations who have
supplied by the undertaking. present and future economic interest in the business but are not part of the
Compared with financial accounting, cost accounting is relatively a recent management team. These include:
development. It has primarily developed to meet the needs of management. (i) Shareholders and present investors: to judge whether the financial
Profit and Loss Account and Balance Sheet are presented to management by the position of the business is sound and whether the firm is engaged in profitable
financial accountant. But modern management needs much more detailed operations.
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

(ii) Potential Investors: to judge whether or not to invest in the business on the 5. Interpreting the results of accounts: Accounting information may be
basis of its financial position, profitability, etc. interpreted with the help of certain techniques like ratio analysis, comparative
(iii) Creditors/Bankers: to appraise the financial soundness of the business and statements, etc. discussed
to judge the risks involved before making loans and granting credit. later in this book.
(iv) Employees: to judge the capacity of the company to pay bonus and their 1.1.4. Book-Keeping Vs. Accounting
claims for higher salary/wage structure. Often the terms ‘book keeping’ and ‘accounting’ are used inter-changeably, but
(v) Government Agencies: such as Income-tax Department, Registrar of there are differences between the two. Book keeping is defined as the art of
Companies, Ministry of Commerce and Industry, Company Law Board, Central recording business transaction in a systematic way. It is the mechanical and
Statistical Organisation, etc. for regulating general business activity and also repetitive process of recording financial transactions and keeping financial
particular types of business. records. It is a small part of accounting and is more clerical in nature. In other
1.1.3. Meaning of Financial Accounting words, book-keeping records and keeps track of the business transactions that
Accounting is generally taken in the sense of financial accounting. It represents are later used to prepare financial statements (Profit and Loss Account and
a field of accounting that focuses primarily on reporting a company’s financial Balance Sheet).
information to meet the needs of the company’s external users. Financial Accounting is a wider term and book-keeping is a very important part
accounting is concerned with recording and reporting the results of financial of accounting process. It means, accounting sets up the book keeping system,
transactions of an enterprise (business or non-business) to interested users of monitors the system that it is working as it should and then interprets the data
such information. It is described as a process of collecting, summarising and produced by the system.
reporting financial information of an entity according to established standards 1.1.5. Objectives and Functions of Financial Accounting
and principles. Accounting performs the following functions:
Definition: Of the various definitions of financial accounting one of the most 1. Recording: This is the basic function of accounting. Accounting keeps a
accepted definitions is that given by American Institute of Certified Public systematic record of financial transactions in the sequence of their dates. In this
Accountants (AICPA) as follows. “Accounting is the art of recording, process, it passes through journal, ledger, work sheets and ultimately to final
classifying and summarising in a significant manner and in terms of money, statements.
transactions and events, which are in part at least, of a financial character and 2. Ascertaining Profit/Loss and Financial Position of Business: The
interpreting the results thereof.” information supplied by financial accounting is summarised in the following
This definition reveals the following characteristics of accounting: two statements at the end of the period,
1. Accounting is an art which helps in attaining the objective of ascertaining the generally one year:
financial results i.e. profit or loss. (a) Profit and Loss Account showing the net profit or loss during the period;
2. Recording, classifying and summarising: In accounting, business transactions and
are recorded as and when they take place. These transactions are then classified (b) Balance Sheet showing the financial position of the firm at a point of time.
by opening accounts in the form of a ledger. Lastly, all recorded and classified Thus, the objective of financial accounting is to present a true and fair view of
information is summarised in the form of Trading and Profit and Loss Account company’s income and financial position at regular intervals of one year.
and Balance Sheet. 3. Communicating: Recording function loses much of its importance if
3. Accounting records the transactions in terms of money: If 5 tonnes of coal is recorded facts are not communicated to those who have to make use of them,
purchased for ` 2,000, it is ` 2,000 which will be recorded in accounts and not 5 i.e., business managers, owners, creditors, etc.
tonnes. 4. Meeting legal requirements: Accounting performs the function of fulfilling
4. Only transactions and events of financial nature are recorded : If a the requirements of law as a business has to file income tax return, sales tax
ransaction or an event has no financial character, it cannot be expressed in return, etc.
terms of money and therefore it will not be recorded. For example, when 5. Interpreting: Interpreting of accounting records is an attempt to determine
general manager is not on speaking terms with a sales manager, it is not the meaning of the data in financial statements. The interpretation pinpoints the
recorded in the accounts even though this is an important event in the business. strengths and weaknesses of a business undertaking. The various devices used
This is a serious limitation of accounting because it is not able to project the full for this purpose are ratio analysis, trend, percentage, etc.
picture of business conditions. 1.2. Accounting Concepts and Conventions
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

The important accounting concepts are discussed hereunder: The properties owned by a business enterprise are referred to as assets and the
12.1. Accounting Concepts rights or claims to the various parties against the assets are referred to as
a)Business Entity Concept equities. The relationship between the two may be expressed in the form of an
It is generally accepted that the moment a business enterprise is started it attains equation as follows:
a separate entity as distinct from the persons who own it. Equities = Assets
In recording the transactions of a business, the important question is: How do Equities may be subdivided into two principal types: the rights of creditors and
these transactions affect the business enterprise? The question as to how these the rights of owners. The rights of creditors represent debts of the business and
transactions affect the proprietors is quite irrelevant. This concept is extremely are called liabilities. The rights of the owners are called capital.
useful in keeping business affairs strictly free from the effect of private affairs Expansion of the equation to give recognition to the two types of equities
of the proprietors. In the absence of this concept the private affairs and business results in the following which is known as the accounting equation:
affairs are mingled together in such a way that the true profit or loss of the Liabilities + Capital = Assets
business enterprise cannot be ascertained nor its financial position. f)Accounting Period Concept
b)Going Concern Concept According to this concept accounting measures activities for a specified interval
This concept assumes that the business enterprise will continue to operate for a of time called the accounting period. For the purpose of reporting to various
fairly long period in the future. The significance of this concept is that the interested parties one year is the usual accounting period. Though pacioli wrote
accountant while valuing the assets of the enterprise does not take into account that books should be closed each year especially in a partnership, it applies to
their current resale values as there is no immediate expectation of selling it. all types of business organizations.
Moreover, depreciation on fixed assets is charged on the basis of their expected g)Periodic Matching Of Costs And Revenues
life rather than on their market values. When there is conclusive evidence that This concept is based on the accounting period concept. It is widely accepted
the business enterprise has a limited life, the accounting procedures should be that desire of making profit is the most important motivation to keep the
appropriate to the expected terminal date of the enterprise. In such cases, the proprietors engaged in business activities. Hence a major share of attention of
financial statements could clearly disclose the limited life of the enterprise and the accountant is being devoted towards evolving appropriate techniques of
should be prepared from the ‘quitting concern’ point of view rather than from a measuring profits. One such technique is periodic matching of costs and
‘going concern’ point of view. revenues.
c)Money Measurement Concept h) Realization Concept
Accounting records only those transactions which can be expressed in monetary Realization refers to inflows of cash or claims to cash like bills receivables,
terms. This feature is well emphasized in the two definitions on accounting as debtors etc. Arising from the sale of assets or rendering of services. According
given by the american institute of certified public accountants and the american to realization concept, revenues are usually recognized in the period in which
accounting principles board. The importance of this concept is that money goods were sold to customers or in which services were rendered. Sale is
provides a common denomination by means of which heterogeneous facts about considered to be made at the point when the property in goods passes to the
a business enterprise can be expressed and measured in a much better way. buyer and he becomes legally liable to pay.
d)Cost Concept 1.2.2. Accounting Conventions
This concept is yet another fundamental concept of accounting which is closely i) Convention of Conservatism
related to the going-concern concept. As per this concept: (i) an asset is It is a world of uncertainty. So it is always better to pursue the policy of playing
ordinarily entered in the accounting records at the price paid to acquire it i.e., at safe. This is the principle behind the convention of conservatism. According to
its cost and (ii) this cost is the basis for all subsequent accounting for the asset. this convention the accountant must be very careful while recognizing increases
The implication of this concept is that the purchase of an asset is recorded in the in an enterprise’s profits rather than recognizing decreases in profits. For this
books at the price actually paid for it irrespective of its market value. the accountants have to follow the rule, anticipate no profit, provide for all
e)Dual Aspect Concept (Double Entry System) possible losses, while recording business transactions. It is on account of this
This concept is the core of accounting. According to this concept every convention that the inventory is valued at cost or market price whichever is less,
business transaction has a dual aspect. This concept is explained in detail i.e. When the market price of the inventories has fallen below its cost price it is
below: shown at market price i.e. The possible loss is provided and when it is above
the cost price it is shown at cost price i.e. The anticipated profit is not recorded.
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

It is for the same reason that provision for bad and doubtful debts, provision for accounts etc. but not in double entry form. Such an incomplete double entry
fluctuation in investments, etc., are created. This concept affects principally the system is called single entry system. In the words of Kohler, single entry
current assets. system ‘ is a system of book keeping in which as a rule, only records of cash
ii) Convention of Full Disclosure and personal accounts are maintained, it is always incomplete double entry,
the emergence of joint stock company form of business organization resulted in varying with circumstances.’ In such a system, only records of cash and
the divorce between ownership and management. This necessitated the full personal accounts of debtors and creditors are maintained. This type of system
disclosure of accounting information about the enterprise to the owners and does not have a definite form and varies with circumstances such as size of
various other interested parties. Thus the convention of full disclosure became business, requirements of the businessman, etc.
important. 1.3.2. Double Entry System
iii) Convention of Consistency In accounting, double entry system is the standard system used for recording
According to this concept it is essential that accounting procedures, practices financial transactions. This system is called double entry system because each
and method should remain unchanged from one accounting period to another. transaction has two aspects, one is in the form of receiving some benefit and the
This enables comparison of performance in one accounting period with that in other is giving or sacrificing some benefit at the same time. Both of these
the past. For e.g. If material issues are priced on the basis of fifo method the aspects are properly recorded, one is debited and other is credited. That is why
same basis should be followed year after year. Similarly, if depreciation is it is called double entry system. In this system, two aspects of a transaction are
charged on fixed assets according to diminishing balance method it should be recorded in two or more accounts with equal debits and credits. In other words,
done in subsequent year also. But consistency never implies inflexibility as not each transaction results in at least one account being debited and at least one
to permit the introduction of improved techniques of accounting. However if account being credited, with total debits of the transaction equal to the total
introduction of a new technique results in inflating or deflating the figures of credits. Two sided effect of a transaction is recorded in appropriate accounts.
profit as compared to the previous methods, the fact should be well disclosed in Double entry system enables a full record to be kept of every
the financial statement. transaction. It also helps in providing an automatic check on the arithmetical
iv) Convention of Materiality accuracy of accounting entries because total of debits must be equal to total of
The implication of this convention is that accountant should attach importance credits.
to material details and ignore insignificant ones. In the absence of this 1.3.3. Accounting Equation
distinction, accounting will unnecessarily be overburdened with minute details. Double entry system is governed by fundamental accounting equation, i.e.,
The question as to what is a material detail and what is not is left to the Assets = EquityOr Assets = Liabilities + Owners’ Equity
discretion of the individual accountant. Further, an item should be regarded as It may also be stated as:
material if there is reason to believe that knowledge of it would influence the Owners’ Equity = Assets – Liabilities.
decision of informed investor. Some examples of material financial information 1.3. Capital and Revenue Expenditure
are: fall in the value of stock, loss of markets due to competition, change in the Income of a business enterprise can be ascertained by matching business
demand pattern due to change in government regulations, etc. Examples of receipts (such as sales, interest income, commission received, etc.,) against the
insignificant financial information are: rounding of income to nearest ten for tax expenses incurred in the same period. In order to ascertain correct profit or loss
purposes etc. Sometimes if it is felt that an immaterial item must be disclosed, of a business during a period, it is essential to distinguish between capital and
the same may be shown as footnote or in parenthesis according to its relative revenue expenditures and receipts. For example, if a machine is purchased for `
importance. 1,00,000 during a year, it is wrong to treat this cost as an expense (revenue
1.3.Systems of Accounting item) of that period because machine is expected to provide useful service for a
There are two systems of accounting – single entry system and double entry number of years. It would, therefore, be wise to charge only a proportionate
system. share of the cost of machine (in the form of depreciation) as an expense of the
1.3.1.Single Entry System period.
For a small business like grocery shop, market stall, etc. it may not be feasible 1.3.1. Capital Expenditure (Capex)
to keep books using a full double entry system. Owner of such a business may Capital expenditure is the expenditure in the acquisition of an asset (tangible or
not even know how to write double entry records, even if he wanted to. intangible) which results in an increase in the earning capacity of business. The
However, small firms keep only necessary accounts like cash book, personal benefits of capital expenditure are likely to accrue for a long period. Common
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

examples of capital expenditure are purchase of land and building, plant and Sometimes an expenditure is of a revenue nature but the benefit of the
machinery, furniture and fixtures, goodwill, major repairs in building, patent expenditure will be available for three to four years. In such a case it is fair that
rights, copyrights, trade marks, etc. Certain expenses are recognised as being of the total expenditure should not be charged to the Profit and Loss Account only
a capital nature, although no tangible property may have been acquired as a in one year. It should be distributed over the years over which the benefit will
result of expenditure. Examples of such items are: be available. Suppose, a heavy advertisement campaign is carried out on a new
(i) Preliminary expenses of a company product introduced in the market. The benefit of this campaign will be available
(ii) Cost of research and development for the next three or four years. In such a case, the advertisement expenditure
(iii) Cost of issue of shares and debentures should be distributed to the Profit and Loss Accounts of these three or four
(iv) Repairs on purchase of a dilapidated asset to put it back into working years. If this is so, the expenditure will be known as deferred revenue
condition, etc. expenditure. Sometimes extraordinarily heavy accidental losses are also treated
(v) Fees paid to lawyer for drawing up the purchase deed of land. as deferred revenue expenditure and charged to the Profit and Loss Accounts of
It should be kept in mind that an expenditure cannot be said to be a capital three or four years. (Example: Loss of a building by fire) That portion of
expenditure only because the amount is large or it is paid in lumpsum. A capital deferred revenue expenditure which is not charged to the Profit and Loss
expenditure may also be paid in instalments. An expenditure is treated as Account is shown in the Balance Sheet as a sort of asset.
capital expenditure in the following circumstances: 1.4.Capital and Revenue Receipts
1. Capital expenditure results in the acquisition of a permanent asset. For The distinction between capital and revenue receipts is also important because
example, land and building, plant and machinery, etc. revenue receipts are shown in the Profit and Loss Account whereas capital
2. Capital expenditure results in a benefit which will last for a long time receipts are shown in the Balance Sheet.
3. Capital expenditure results in extra capacity 1.4.1.Capital Receipts. When a business issues shares or debentures or sells a
4. Capital expenditure may be incurred in putting an asset in working condition. fixed asset or sells investment, etc., the money received there from is classified
Examples are overhauling an old machinery or cost of installation of plant and as capital receipt. Capital receipts may thus be said to consist solely of
machinery additional payments into the business made either by shareholders of a
5. Capital expenditure may result in reduction in the cost of production. company or by proprietor of a business and receipts from the sale of any fixed
Suppose, goods are produced at a cost of `20 per unit but with various assets of a business (not being in the nature of normal sale).
alterations made in plant and machinery, the goods can be produced at a cost of 1.4.2.Revenue Receipts. Revenue receipts are incomes received in the normal
`17 per unit. Cost of such alterations is capital expenditure. course of business. For example sales (of goods), interest and dividend received
1.3.3.Revenue Expenditure on investment, commission and discount received, etc.
It is an expenditure which is incurred on consumable items or goods and It is not always possible by mere name of item to distinguish between capital
services acquired for resale. Revenue expenditure helps in maintaining the and revenue items. For example, certain expenses are in the nature of the capital
earning capacity of a business. The benefit of revenue expenditure is exhausted for some business and the same expenses are of revenue nature for other
in the accounting period itself or within one year. Examples of revenue business. Purchase of land and building for an engineering firm is a capital
expenditure are: expenditure. But when land and building is purchased by real estate firm for
1. Cost of goods purchased for resale. resale, it is a revenue expenditure.
2. Expenses incurred in connection with production of goods or services. For
example, 1.5. Advantages of Accounting
payment of wages to labour, rent, etc. The main advantages of accounting are stated below:
3. Administrative and selling and distribution expenses. 1. Maintains systematic records. Basic advantage of accounting is that it
4. Interest on business loans, depreciation on fixed assets, etc. maintains proper and systematic records of all financial transactions and events
5. Any expenditure to maintain fixed assets in working order. that take place in a business. As it is not possible for a businessman to
6. Loss of all types of stock-in-trade or of current assets. remember all business transactions, accounting furnishes all information as and
All revenue expenditure is deducted from income for calculating profit or loss when required.
during the period. 2. Meets legal requirements. Accounting helps to comply with legal
1.3.4. Deferred Revenue Expenditure requirements. For example, in the case of joint stock companies it is mandatory
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

to prepare and maintain proper books of accounts as per the provisions the 5. Danger of window dressing. There is always a danger of companies
Companies Act, 1956. practicing window dressing in accounts i.e. manipulating accounting
3. Ascertains profit / loss. Accounting ascertains net profit or loss in the information to make it more attractive to its users.
business at the end of each year by preparing Profit and Loss Account.
4. Ascertains financial position. In accounting a Balance Sheet is prepared at 1.7. Basic Terms used in Accounting
the end of each year which explains the financial position of the business. In order to understand the language of accounting, it is essential to understand
5. Acts as legal evidence. Properly maintained books of accounts may prove as the basic terms used therein. Important accounting terms are briefly described
good evidence in court of law to settle certain disputes. below:
6. Facilitates rational decision making. Accounting provides necessary data 1. Accounting: It is an ‘art of recording, classifying and summarising in a
to management in planning and controlling business operations and also making significant manner and in terms of money, all those transactions and events,
business decisions. An effective pricing policy, satisfied wage structure, which are in part at least of a financial character and interpreting the results
advertisement and sales promotion policy etc. all owe it to proper accounting thereof.’
information. 2. Accounting Equation: It is a fundamental equation on which double entry
7. Facilitates comparative study. Accounting provides necessary data to make system is based. The equation is: Assets = Liabilities + Capital
a comparative study of business performance in terms of sales, profit etc with 3. Accounting Principles: The concepts and conventions of accounting are
its own past performance to know the progress. Comparison of figures with often referred to as principles of accounting.
other firms i.e. inter firm 4. Accounting Concepts: These are the basic assumptions on which accounting
comparison also makes an interesting study. functions. Examples are going concern concept, cost concept, business entity
concept, etc.
1.6. Limitations of Accounting 5. Accounting Conventions: These are the customs or traditions that serve as a
The main limitations of accounting are as follows: guide to the preparation of financial statements i.e. Profit and Loss Account and
1. Records only monetary matters. One of the major limitations of financial Balance Sheet.
accounting is that it records only transactions and events which can be 6. Accounting Process (or cycle): The accounting process is a complete
expressed in money terms. It does not take into account the non-monetary facts sequence of accounting procedures which are repeated in the same order during
of the business, such as relations with customers, competitive position of each accounting period.
business, quality of products, quality of labour force, etc. 7. Account: An account is a summarised record of business transactions
2. Element of subjectivity. Accounting is also affected by personal judgments pertaining to a particular item like a person, an asset, an income, an expense,
and bias of the accountant. For example, in inventory valuation, an accountant etc. For example, an account of a person shows the business transactions that
has to choose a method (out of FIFO, LIFO, etc). Similarly, in providing take place with that person and the net position in respect of money owed to
depreciation, a method has to be chosen out of various methods available. Thus him or by him.
different accountants choose different methods and profit/loss will vary 8. Entry. It is recording of a transaction in any book of account.
according to the methods used. Due to lack of objectivity, the financial 9. Personal Accounts: These are the accounts of other persons and other
statements may not reflect true picture. business entities with which business deals and records transactions. For
3. Ignores price level changes. Fixed assets such as land and building, plant, example, Ram’s A/c , Bank A/c, X & Co. A/c, etc.
etc are shown in the books at their actual cost less depreciation. But over the 10. Impersonal Accounts: These are the accounts of business transactions
years these values keep on changing and there may be a great difference which are not personal accounts. Impersonal accounts are divided into two
between the original costs and the present replacement values of these assets. types i.e. real accounts and nominal accounts.
Thus balance sheet does not reflect the true financial position of the business. 11. Real Accounts: These are the accounts of assets and properties. For
4. Provides only historical information. Financial accounting is historical in example, plant and machinery account, cash account, goodwill account, etc.
nature in the sense that it records only past transactions. It has no provision for 12. Nominal Accounts: The accounts of incomes and gains, expenses and
future estimates which is very important for managerial control and decision losses are known as nominal accounts. For examples, wages account, interest
making. income account, commission account, etc. These are unreal accounts because
these cannot be seen.
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

13. Balance Sheet. It is a financial statement showing the financial position of 31. Equity. It is the the claim on the assets of the business. Creditors claim on
a business entity in terms of assets, liabilities and capital at a specified date. assets in creditor’s equity and the owner’s claim on assets is called owner’s
14. Profit and Loss Account: It is an account which is prepared at the end of equity.
an accounting period to show the net results of operations of a business in the 32. Capital. It is the same thing as owner’s equity. It is also referred to as
form of profit or loss. It shows all revenue and expense items. It is also known shareholders equity. It represents the amount invested in the business by the
as Income Statement. owners.
15. Trial Balance: It is a schedule of debit and credit balances of all the 33. Asset. It is a property owned by a business firm.
accounts appearing in the ledger. Total debits must be equal to total credits. It is 34. Fixed assets. It is a long term piece of property that a firm owns and uses in
prepared to test the arithmetic accuracy of the accounts. Trial balance is not an the production of its income and which is not normally expected to be
account. consumed or converted into cash any sooner than at least one year’s time. Some
16. Book Value: It is the value at which assets are stated in the books of typical fixed assets include machinery and plant, office furniture, land and
account or balance sheet. buildings, vehicles, etc.
17. Book Keeping: It is a part of accounting which is concerned with simply 35. Current Assets. It means cash and such other assets like stocks, accounts
recording the business transactions. receivable, etc. which are reasonably expected to be realised in cash or sold or
18. Cash Discount: Price reduction offered by supplier for quick payment. consumed during a period of one year or the normal operating cycle of the
19. Trade Discount: This is an allowance made by the supplier to a purchaser business.
who has to resell the goods. 36. Tangible and Intangible assets. Tangible assets are those which have
20. Quantity Discount: This is an allowance made by a supplier to a purchaser physical identity like plant and machinery, furniture, etc. Intangible assets are
who places large orders. those which do not have physical existence, like patent rights, goodwill, trade
21. Reserve: It is a portion of the profit or surplus which is set aside by marks, etc.
management for a general or specific purpose. 37. Fictitious assets. These assets are those which are actually not assets in the
22. Capital Reserve: That type of reserve which is not available for real sense of the term because no benefit is derived from these. Examples are
distribution as dividend. discount on the issue of shares and debentures, deferred revenue expenditure,
23. Revenue Reserve: Any reserve which is not a capital reserve. etc.
24. General Reserve: A revenue reserve which is not earmarked for any 38. Liquid assets. These are the assets which are immediately convertible into
specific purpose. It is a free reserve. cash without much loss. Examples are cash in hand and cash at bank, short term
25. Goodwill: It is an intangible asset representing in monetary terms the value investments, etc. It includes all current assets except stocks and prepaid
of reputation of a business. expenses.
26. Inventory: It includes stocks of raw materials, work-in-progress and 39. Wasting assets. An asset that is depleted or used up over time, such as oil
finished goods. It is a tangible asset held for sale in the ordinary course of and gas reserves, mines, or timberland, etc.
business or in the process of production for such sale or for consumption in the 40. Liability. It is an obligation of a business entity to pay. A liability includes
production of goods or services for sale. any type of borrowing from persons or banks that is payable during short or
27. Expired cost: It is a portion of the expenditure which has been consumed long time.
and from which no further benefit is expected. It is the same thing as expense. 41. Fixed liabilities. These liabilities are those which do not become due for a
28. Unexpired cost: This is that part of the expenditure whose benefit has not long time (say, more than one year). Examples are debentures, long term loan
been consumed or exhausted. from banks or other financial institutions.
29. Provision: This is an amount which is written off or retained for providing 42. Current Liabilities. The term current liabilities includes all such
for any known liability, the amount of which cannot be ascertained with obligations which are likely to mature within one year in the normal course of
reasonable degree of accuracy. business operations. These are paid out of current assets or by creating current
30. Financial year: It is a period of reporting of profit/loss generally covering a liabilities.
period of 12 months and ending on 31st March or 31st Dec., etc. 43. Contingent liabilities. These are those liabilities which may or may not
arise depending on certain factors. Example are liabilities for a guarantee given,
liability in respect of a pending law suit in a court case, etc.
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

44. Working capital. It represent funds required for day to day operations of a 60. RTGS (Real Time Gross Settlement). It is also an electronic system of
business. It is defined as the difference between current assets and current ‘Inter Bank Transfer’ of funds where the processing of funds transfer
liabilities. It is also known as net current assets. instructions takes place at the time they are received (real time). Also the
45. Net worth. In business, net worth (sometimes known as net assets) means settlement of funds transfer instructions occurs individually on an instruction by
total assets minus outside liabilities. In other words, net worth is the amount by instruction basis (gross settlement). RTGS is the fastest possible interbank
which assets exceed liabilities. It is shareholders’ equity. A consistent increase money transfer facility available through secure banking channels in India.
in net worth indicates good financial health. Both NEFT and RTGS systems are maintained by Reserve Bank of India..
46. Revenue. It is an income of a recurring nature from any source, such as sale
of goods, dividend income, etc. 1.8. The Accounting Process
47. Capital expenditure. It is the expenditure in the acquisition of an asset During the accounting period the accountant records transactions as and when
(tangible or intangible) which results in an increase in the earning capacity of they occur. At the end of each accounting period the accountant summarizes the
business. The benefits of capital expenditure are likely to accrue for a long information recorded and prepares the trial balance to ensure that the double
period. Common examples of capital expenditure are purchase of land and entry system has been maintained. This is often followed by certain adjusting
building, plant and machinery, etc. entries which are to be made to account the changes that have taken place since
48. Revenue Expenditure. It is an expenditure which is incurred on the transactions were recorded. When the recording aspect has been made as
consumable items or goods and services acquired for resale. complete and upto-date as possible the accountant prepares financial statements
49. Deferred Revenue Expenditure. It is an expenditure of a revenue nature reflecting the financial position and the results of business operations. Thus the
but the benefit of the expenditure will be available for three to four years. In accounting process consists of three major parts:
such a case, the total of such expenditure should not be charged to the Profit i.The recording of business transactions during that period;
and Loss Account only in one year but it should be distributed over the years ii.The summarizing of information at the end of the period and
over which the benefit will be available. iii.The reporting and interpreting of the summary information.
50. Drawings. It is the withdrawal of cash or goods from the business by the The success of the accounting process can be judged from the responsiveness of
owner for personal use. financial reports to the needs of the users of accounting information. This
51. Debtor. A person who owes money to the business is called a debtor. Total lesson takes the readers into the accounting process.
of all debtors is known as sundry debtors. 1.8.1.The Account
52. Creditor. A person who has a claim for money against the business is a The transactions that take place in a business enterprise during a specific period
creditor. Total of all creditors is known as sundry creditors . may effect increases and decreases in assets, liabilities, capital, revenue and
53. Bill of exchange. It is a document directing a certain person to pay a expense items. To make up to-date information available when needed and to
specific sum of money to the bearer of the document or to the order of a certain be able to prepare timely periodic financial statements, it is necessary to
person. maintain a separate record for each item. For e.g. It is necessary to have a
54. Bills receivable. It is a bill of exchange for the person entitled to receive the separate record devoted exclusively to record increases and decreases in cash,
amount. another one to record increases and decreases in supplies, a third one on
55. Bills payable. It is a bill of exchange for the person liable to pay the machinery, etc. The type of record that is traditionally used for this purpose is
amount. called an account. Thus an account is a statement wherein information relating
56. Accounts receivable. It includes both bills receivable and debtors. to an item or a group of similar items are accumulated.
57. Accounts payable. It includes both bills payable and creditors. 1.8.2.Debit And Credit
58. Goods. These are properties purchased for resale i.e. those materials in The left-hand side of any account is called the debit side and the right-hand side
which business trades. In other words, goods are those materials which are is called the credit side. Amounts entered on the left hand side of an account,
purchased and sold regularly for profit motive. regardless of the tile of the account are called debits and the amounts entered on
59. NEFT (National Electronic Fund Transfer). It is a system of electronic the right hand side of an account are called credits. To debit (dr) an account
‘Inter Bank Transfer’ of fund from the account of the remitter in one Bank to means to make an entry on the left-hand side of an account and to credit (cr) an
the account of beneficiary maintained with any other Bank branch. account means to make an entry on the right-hand side. The words debit and

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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

credit have no other meaning in accounting, though in common parlance; debit Periodically, usually at the end of the accounting period, all revenue and
has a negative connotation, while credit has a positive connotation. expense account balances are transferred to an account called income summary
Double entry system of recording business transactions is universally followed. or profit and loss account and are then said to be closed. (a detailed discussion
In this system for each transaction the debit amount must equal the credit on profit and loss account can be had in a subsequent lesson). The balance in
amount. If not, the recording of transactions is incorrect. The equality of debits the profit and loss account, which is the net income or net loss for the period, is
and credits is maintained in accounting simply by specifying that the left side of then transferred to the capital account and thus the profit and loss account is
asset accounts is to be used for recording increases and the right side to be used also closed. In the case of corporation the net income or net loss is transferred
for recording decreases; the right side of a liability and capital accounts is to be to retained earnings account which is a part of owners’ equity. The entries
used to record increases and the left side to be used for recording decreases. which are passed for transferring these accounts are called as closing entries.
The account balances when they are totaled, will then conform to the two Because of this periodic closing of revenue and expense accounts, they are
equations: called as temporary or nominal accounts. On the other hand, the assets,
1. Assets = liabilities + owners’ equity liabilities and owners’ equity accounts, the balances of which are shown on the
2. Debits = credits balance sheet and are carried forward from year to year are called as permanent
1.8.3.Journal or real accounts.
When a business transaction takes place, the first record of it is done in a book The principle of framing a closing entry is very simple. If an account is having
called journal. The journal records all the transactions of a business in the order a debit balance, then it is credited and the profit and loss account is debited.
in which they occur. The journal may therefore be defined as a chronological Similarly if a particular account is having a credit balance, it is closed by
record of accounting transactions. It shows names of accounts that are to be debiting it and crediting the profit and loss account. In our example sales
debited or credited, the amounts of the debits and credits and any other account and interest account are revenues, and purchases account and salaries
additional but useful information about the transaction. A journal does not account are expenses. Purchases account is an expense because the entire goods
replace but precedes the ledger. have been sold out in the accounting period itself and hence they become cost
1.8.4.The Ledger of goods sold out. This aspect would become more clear when the reader
A ledger is a set of accounts. It contains all the accounts of a specific business proceeds to the lessons on profit and loss account.
enterprise. It may be kept in any of the following two forms:
(i) bound ledger and 1.9. Preparation of Final Accounts
(ii) loose leaf ledger The primary objective of any business concern is to earn income.
A bound ledger is kept in the form of book which contains all the accounts. Ascertainment of the periodic income of a business enterprise is perhaps the
These days it is common to keep the ledger in the form of loose-leaf cards. This important objective of the accounting process. This objective is achieved by the
helps in posting transactions particularly when mechanized system of preparation of profit and loss account or the income statement. Profit and loss
accounting is used. account is generally considered to be of greatest interest and importance to end
1.8.5.The Trial Balance users of accounting information. The profit and loss account enables all
The trial balance is simply a list of the account names and their balance as of a concerned to find out whether the business operations have been profitable or
given moment of time with debit balances in one column and credit balances in not during a particular period. Usually the profit and loss account is
another column. It is prepared to ensure that the mechanics of the recording and accompanied by the balance sheet as on the last date of the accounting period
posting of the transaction have been carried out accurately. If the recording and for which the profit and loss account is prepared. A balance sheet shows the
posting have been accurate then the debit total and credit total in the trial financial position of a business enterprise as of a specified moment of time. It
balance must tally thereby evidencing that an equality of debits and credits has contains a list of the assets, the liabilities and the capital of a business entity as
been maintained. In this connection it is but proper to caution that mere of a specified date, usually at the close of the last day of a month or a year.
agreement of the debt and credit total in the trial balance is not conclusive proof While the profit and loss account is categorized as a flow report (for a particular
of correct recording and posting. There are many errors which may not affect period), the balance sheet is categorized as a status report (as on a particular
the agreement of trial balance like total omission of a transaction, posting the date).
right amount on the right side but of a wrong account etc.
1.8.6. Closing Entries
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

1.9.1. Form And Presentation Of Profit And Loss Account / Income i.e. Expenses were incurred during the period but no record of them as yet has
Statement been made: e.g. Rs.500 wages earned by an employee during the period
In practice there is considerable variety in the format and degree of detail used remaining to be paid.
in income statements. The profit and loss account is usually prepared in “t” (ii) Prepaid Expenses:
shape. i.e., expenses relating to the subsequent period paid in advance in the current
In the “t” shaped profit and loss account, expenses are shown on the left hand accounting period. An example which is frequently cited for this is insurance
side i.e., the debit side and revenues are shown on the right hand side i.e., the paid in advance.
credit side. Net profit or loss is the balancing figure. In the above four cases unrecorded revenues and prepaid expenses are assets
The profit and loss account can also be presented in the form of a statement and hence debited (as debit may signify increase in assets) and revenues
when it is called as income statement. There are two widely used forms of received in advance and unrecorded expenses are liabilities and hence credited
income statement: single step form and multiple-step form. The single-step (as credit may signify increase in liabilities).
form of income statement derives its name from the fact that the total of all Besides the above mentioned four adjustments, some more are to be done
expenses is deducted from the total of all revenues. before preparing the financial statements. They are:
1.9.2. Balance Sheet 1. Inventory at the end
The balance sheet is basically a historical report showing the cumulative effect 2. Provision of depreciation
of past transactions. It is often described as a detailed expression of the 3. Provision for bad debts
following fundamental accounting equation: 4. Provision for discount on receivables and payables
Assets = Liabilities + Owners’ Equity (Capital) 5. Interest on capital and drawings.
Assets are costs which represent expected future economic benefits to the ------------------------------------------------------------------------------------------------
business enterprise. However, the rights to assets have been acquired by the
Enterprise as a result of past transactions.
Liabilities also result from past transactions. They represent obligations which
require settlement in the future either by conveying assets or by performing
services. Implicit in these concepts of the nature of assets and liabilities is the
meaning of owners’ equity as the residual interest in the assets of the enterprise.

1.9.3. Adjustment Entries

Because of the adopting of accrual accounting, after the preparation of trial
balance, adjustments relating to the accounting period have to be made in order
to make the financial statements complete. These adjustments are needed for
transactions which have not been recorded but which affect the financial
position and operating results of the business. They may be divided into four
kinds: two in relation to revenues and the other two in relation to expenses. The
two in relation to revenues are:
(i) Unrecorded Revenues:
Income earned for the period but not received in cash. For e.g. Interest for the
last quarter of the accounting period is yet to be received though fallen due.
(ii) Revenues Received In Advance:
i.e. Income relating to the next period received in the current accounting period:
e.g. Rent received in advance.
(i) Unrecorded Expenses:

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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

figures of the various years are compared with standard or base year. This type
of analysis is also called Dynamic analysis as it is based on the data from year
Unit II :FINANCIAL STATEMENT ANALYSIS to year rather than on data of any one year.
Analysis of financial statements. Nature and importance of financial analysis. 2. Vertical analysis
Techniques of Interpretation of financial statements-Comparative statement- It refers to the study of relationship of the various items in the financial
Common size statement-Trend analysis. Ratio Analysis-meaning-usage-types statements of one accounting period. In this type of analysis the figures from
of ratios. Funds Flow Analysis-sources and applications. Cash Flow Analysis – the financial statement of a year are compared with a base selected from the
inflow and outflow of cash. same year’s statement. It is also known as Static Analysis.
---------------------------------------------------------------------------------------- 2.1.2. Tools of Financial Analysis:
2.1. Financial Analysis Various tools and techniques are used for financial analysis. The most widely
The term financial analysis also known as analysis and interpretation of used tool is the ratio analysis. Given are the important tools of financial
financial statements refers to the process of determining financial strengths and analysis:
weaknesses of the firm by establishing strategic relationship between the items  Comparative Financial Statement analysis or Horizontal Analysis
of the balance sheet and profit and loss account and other operative date. It  Common Size Statement analysis or Vertical Analysis and
involves compilation and study of financial and operating data and the  Trend Analysis
preparation and interpretation of measuring devices such as ratios, trends and  Funds flow analysis
percentages.  Cash flow Analysis
The analysis and interpretation of financial statements being the last step in  Ratio Analysis
accounting which involves the presentation of information that will aid business  Cost Volume Profit Analysis
executives , investors and creditors. Interpretation and analysis of financial 1. Comparative Financial Statement Analysis
statements involves identifying the users of the accounts, examining the Comparative Financial Statement analysis provides information to assess the
information, analyzing and reporting in a format which will give information direction of change in the business. Financial statements are presented as on a
for economic decision making. particular date for a particular period. The financial statement Balance Sheet
It is a process of evaluating the relationship between component parts of a indicates the financial position as at the end of an accounting period and the
financial between component parts of a financial statement to obtain a better financial statement Income Statement shows the operating and non operating
understanding statement to obtain a better under standing of a firm s position results for a period. But financial managers and top management are also
and performance. interested in knowing whether the business is moving in a favorable or an
2.1.1. Types of Financial Analysis unfavorable direction. For this purpose, figures of current year have to be
On the basis of the materials used and The modus operandi of analysis The compared with those of the previous years.
modus operandi of analysis In analyzing this way, comparative financial statements are prepared.
On the basis of materials used: Comparative Financial Statement Analysis is also called as Horizontal analysis.
1. External analysis. The Comparative Financial Statement provides information about two or more
This analysis is done by outsiders who do not have access to the detailed years' figures as well as any increase or decrease from the previous year's figure
internal accounting records of the business firm. (Investors, creditors, and it's percentage of increase or decrease.
government agencies, credit agencies and general public.) The two comparative statements are
2. Internal analysis. 1. Comparative Balance Sheet
This analysis is conducted by persons who have access to the internal 2. Comparative Income Statement
accounting records of a business firm. (Executives and employees of the 1. Comparative Balance Sheet
government agencies which have statutory powers vested in them.) A comparative balance sheet presents side-by-side information about an entity's
On the basis of modus operandi: assets, liabilities, and shareholders' equity as of multiple points in time. For
1. Horizontal analysis. illustration, a comparative balance sheet could present the balance sheet as of
Comparison of financial data of a company for several years. The figures for the end of each year for the past three years. The changes in periodic balance
this type of analysis are presented horizontally over a number of columns. The sheet items reflect the conduct of a business.
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

2. Comparative Income Statement accounting data. In the analysis of financial information, trend analysis is the
A comparative income statement will consist of two or three columns of presentation of amounts as a percentage of a base year.
amounts appearing to the right of the account titles or descriptions. For
illustration, the income statement for the year 2012 will report the amounts for 2.2. Ratio Analysis
each of the years 2012, 2011, and 2010. Comparative income statement is the The ratio analysis is one of the powerful tools of financial analysis. It is
part of financial statement analysis. This statement is made for analysis of the process of establishing and interpreting various ratios. It is with the help of
company's revenue position. For making this statement, we take two years ratios that the financial statements can be analyzed more clearly ad decisions
income statement. We compare it’s all figures. By comparing its all figures, we made from such analysis.
find increase or decrease in its all items. After this, we calculate % of increase Meaning of Ratio
or decrease by taking previous year as base year. It means, we divide increase A ratio is a simple arithmetical expression of the relationship of one number to
or decrease figure by previous year figure. another. It may be defined as the indicated quotient of two mathematical
2. Common Size Statements expressions. According to Accountant’s Handbook by Wixon , Kell and
Common size statements examine the proportion of a single line item to the Bedford, a ratio is an expression of the quantitative relationship between two
total statement. For balance sheets, all assets are expressed as a percentage of numbers. In simple language ratio is one number expressed in terms of another
total assets, while liabilities and equity are expressed as a percentage of total and can be worked out by dividing one number into the other. A ratio can be
liabilities and shareholders’ equity. Income statement items are expressed as a expressed in the form of a fraction, number of times, percentage or in
percentage of revenues, i.e, sales. proportion.
Common size statements are of two types: Nature of Ratio analysis
1. Common size Balance sheet Ratio analysis is a technique of analysis and interpretation of financial
2. Common size Income statement statements. It is the process of establishing and interpreting various ratios for
1. Common Size Balance sheet: helping in making certain decisions. It is not an end in itself and is only a means
A statement in which balance sheet items are expressed as the ratio of each of better understanding of financial strengths and weakness of a firm. A ratio
asset to total assets and the ratio of each liability is expressed as a ratio of total will be meaningful only when it is analysed and interpreted. The following are
liabilities is called common-size balance sheet. The common size balance sheet the four steps involved in ratio analysis.
can be used to compare companies of differing size. 1. Selection of relevant data from the financial statements depending upon the
2. Common size Income statement objective of the analysis.
The items in Income statement can be shown as percentages of sales to show 2. Solution of appropriate ratios from the above data
the relation of each item to sales. A significant relationship can be established 3. Comparison of the calculated ratios with the ratios of the same firm in the
between items of income statement and volume of sales. The increase in sales past, or the ratios developed from projected financial statements or the ratios of
will certainly increase selling expenses and not administrative financial some other firms or the comparison with ratios of the industry to which the firm
expenses. In case the volume of sales increases to a considerable extent, belongs.
administrative and financial expenses may go up. In case the sales are 4. Interpretation of the ratios.
declining, the selling expenses should be reduced at once. So a relationship is 2.2.1.Use and Significance of Ratio analysis
established between sales and other items in income statement and this Mainly the persons interested in the analysis of the financial statements can be
relationship is helpful in evaluating the operational activities of the enterprise. grouped under three heads (i) Owners or investors, (ii) Creditors and (iii)
Common-size income statement is the type of income statements in which each Financial executives. The importance of analysis varies materially with the
item is reported as a reference to the revenue of the company. This method is purpose for which it is calculated. The primary information which seeks to be
executed by converting all the items of the income statements as a reference to obtained from these statements differs considerable reflecting the purpose that
percentage of the revenue. This is a method used for the analysis purpose. the statement is to serve.
3. Trend analysis The significance of these ratios varies for these three groups as their purpose
Trend means a tendency. It discloses the changes in financial and operating data differs widely. These investors are mainly concerned with the earning capacity
between specific periods and makes it possible for the analysis to form opinion of the company whereas the creditors including bankers and financial
as to whether favorable or unfavorable tendencies are reflected by the institutions are interesting in knowing the ability of enterprise to meet its
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

financial obligations timely. The financial executives are concerned with 3. Inherent limitations of accounting. Like financial statements, ratios also
evolving analytical tools that will measure and compare costs, efficiency, suffer from the inherent weakness of accounting records such as their historical
liquidity and profitability with a view to making intelligent decisions. nature. Ratios of the past are not necessarily true indicators of the future.
{a} Managerial uses of Ratio analysis 4. Change of accounting procedure. Change in accounting procedure by a firm
1. Helps in decision making often makes ratio analysis misleading. E.g., a change in the valuation methods
2. Helps in financial forecasting and planning of inventories, from FIFO to LIFO increases the cost of sales and reduces
3. Helps in communicating considerably the value of closing stocks which makes stock turnover ratio to be
4. Helps in co-ordination lucrative and an unfavorable gross profit ratio.
5. Helps in control 5. Window dressing. Financial statements can easily be window dressed to
{b}Utility to Share holders/ Investors present a better picture of its financial and profitability position to outsiders.
An investor is particularly interested to know about the Long term financial Hence, one has to be very careful in making a decision from ratios calculated
position and profitability position. Ratio analysis will be useful to the investor from such financial statements. But it may be very difficult for an outsider to
in making up his mind whether present financial position of the concern know about the window dressing made by the firm.
warrants further investment or not. 6. Personal bias Ratio are only means of financial analysis and not an end in
{c}Utility to Creditors itself. Ratios have to be interpreted and different people may interpret the same
The creditors or suppliers extend short term credit to the concern. They are ratio in different ways.
interested to know whether financial position of the concern warrants their 7. Incomparable. Not only industries differ in their nature but also the firms of
payments at a specified time or not. the similar business widely differ in their size and accounting procedures etc. It
{d}utility to the Employees makes comparison of ratios difficult and misleading. Moreover, comparisons
The employees are also interested in the financial position of the concern are made difficult due to differences in definitions of various financial terms
especially profitability because their wage increases and amount of fringe used in ratio analysis.
benefits are related to the volume of profits earned by the concern. 8. Absolute Figures Distortive. Ratios devoid of absolute figures may prove
{e}Utility to government distortive as ratio analysis is primarily a quantitative analysis and not a
Government is interested to know the overall strength of the industry. Various qualitative analysis
financial statements published by industrial units are used to calculate ratios for 9. Price level changes. While making ratio analysis, no consideration is made to
determining short term, long term and overall financial position of the concerns. the changes in price levels and this makes the interpretation of ratios invalid.
Ratio analysis also serves this purpose. 10. Ratios no substitutes. Ratio analysis is merely a tool of financial statements.
{f}Tax audit requirements Hence, ratios become useless if separated from the statements from which they
Clause 32 of the Income tax Act requires that the business should calculate are computed.
Gross Profit/turnover, Net Profit/turnover , stock in trade/ turnover and Material 2.2.4. Classification of Ratios
consumed/finished goods produced ratios. The use of ratio analysis is not confined to financial manger only. There are
2.2.2.Limitations of Ratio Analysis different parties interested in the ratio analysis for knowing the financial
The ratio analysis is one of the most powerful tools of financial management. position of the firm for different purposes. In view of various users of ratios,
Though ratios are simple to calculate and easy to understand, they suffer from there are many types of ratios which be calculated from the information given
some serious limitations. in the financial statements. The particular purpose of the use determines the
1. Limited use of a single ratio. A single ratio usually does not convey much of particular ratios that might be used for financial analyses Ratios can be
a sense. To make a better interpretation a number of ratios have to be calculated classified on the basis of function, significant and statement of ratios or
which is likely to confuse the analyst than help him in making any meaningful traditional classification of ratios.
conclusion. On the basis of the functions performed ratios can be classified in to the
2. Lack of adequate standards. There are no well accepted standards or rules of following types :-
thumb for all ratios which can be accepted as norms. It renders interpretation of I. Analysis of Short-Term Financial Position or Test Of Liquidity
the ratios difficult. The short term creditors of a company like suppliers of goods of credit and
commercial banks providing short-term loans are primarily interested in
13
DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

knowing the company’s ability to meet its current or short term obligations as been deterioration in the liquidity position of the firm. As a convention a
and when these become due. The short term obligations of a firm can be met minimum of 2: 1 is considered as the standard current ratio of a firm.
only when there are sufficient liquid assets. Therefore, a firm must ensure that it 2. Quick Ratio: Quick ratio, also known as Acid Test Ratio or Liquid Ratio, is
does not suffer from lack of liquidity or the capacity to pay its current a more rigorous test of liquidity than the current ratio. The term liquidity refers
obligations. Even a very high degree of liquidity is not good for the firm to the ability of a firm to pay its short term obligations as and when they
because such a situation represents unnecessarily excessive funds of the firm become due. Quick ratio may be defined as the relationship between
being tied up in current assets. Two types of ratios can be calculated for quick/liquid assets and current or liquid liabilities.
measuring short term financial position or short term solvency of the firm. An asset is said to be liquid if it can be converted into cash within a
A. Liquidity Ratios B. Current assets movement or Efficiency Ratios short period without loss of value. In that sense cash in hand and cash at bank
A. Liquidity Ratios are the most liquid assets. The other liquid assets include bills receivable,
Liquidity refers to the ability of a concern to meet its current obligations as and sundry debtors, marketable securities and short term or temporary investments.
when these become due. The short term obligations are met by realizing Prepaid expenses and Inventories cannot be termed as liquid asset because they
amounts from current, floating or circulating assets. The current assets should cannot be converted into cash without loss of value. A ratio of 1:1 is considered
either be liquid or near liquidity. These should be convertible into cash for as satisfactory quick ratio.
paying obligations of short term nature. The sufficiency or insufficiency of Quick Ratio = Quick(Or) Liquid Assets/Current Liabilites
current assets should be assessed by comparing them with short term (current) 3. Absolute Liquid Ratio or Cash Ratio: Absolute Liquid Ratio is calculated
Liabilities. If current assets can pay off the current liabilities, then liquidity by dividing Absolute Liquid assets by current Liabilities .Absolute Liquid
position will be satisfactory. The important liquidity ratios include Assets include cash in hand and at bank and marketable securities or temporary
1. Current ratio: Current ratio may be defined as the relationship between investments. The acceptable norm for this ratio is 50% or 0.5 :1 or 1 :2.
current assets and current liabilities. This ratio, also known as working capital Absolute Liquid Ratio = Absolute Liquid Assets/Current Liabilites
ratio, is a measure of general liquidity and is most widely used to make the Absolute Liquid assets = Mark. Securities+ Cash in hand and at Bank
analysis of a short term financial position or liquidity of the firm. It is II. Analysis of Solvency – Solvency Ratios
calculated by dividing the total of current assets by total of the current The term solvency refers to the ability of a firm to meet all liabilities in full in
liabilities. the event of liquidation. It is the long- term liquidity of the firm. The Balance
Current ratio= Current Assets/ Current Liabilites sheet discloses the long term financial position in the form of sources and
Current assets include cash and those assets which can be converted applications of long term funds in the business. The important measures of
into cash within a short period of time, generally, one year, such as marketable solvency and analysis of capital structure are
securities, bills receivables, sundry debtors, inventories, work-in-progress etc. 1. Debt-Equity Ratio: A firm uses both equity and debt for financing its assets.
Prepaid expenses should also be included in current assts because they The ratio of these two sources of funds is turned as Debt Equity Ratio.
represent payments made in advance which will not have to be paid in ear Debt Equity Ratio = Total borrow ed funds/Ow ned funds
future. Total Borrowed funds include both long term and short term borrowings or
Current liabilities are those obligations which are payable within a short current liabilities. It is the aggregate of bonds, debentures, bank loans and all
period of generally one year and include outstanding expenses, bills payable, the current liabilities. Owned funds include equity capital, preference capital
sundry creditors, accrued expenses, short term advances, income tax payable, and all items of reserve and surplus.
dividend payable, etc. Bank overdraft should also generally be included in The standard norm of Debt-Equity ratio is 2:1. It indicates that total borrowed
current liabilities because it represents short term arrangement with the bank fund can be two times of equity or owned funds. The intention is to maximize
and is payable within a short period. But where bank overdraft is a permanent the return of equity share holders by taking, advantage of cheap borrowed
or long term arrangement with the bank, it should be excluded. funds.
A relatively high current ratio is an indication that the firm is liquid and 2. Capital Gearing Ratio: This ratio indicates the relationship between fixed
has the ability to pay its current obligations in time as and when they become interest bearing securities and equity shareholders funds.
due. An increase in current ratio represents the improvement in the liquidity Capital Gearing Ratio =
position of the firm while a decrease in the current ratio indicates that there has Fixed Income bearing securites/Equity Shareholders funds

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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

Fixed income bearing securities are Debentures, Bonds and Preference shares. means efficient use of funds by management in generating more sales. The
Equity shareholders funds include Equity share capital and Reserves and important turnover ratios are :
Surpluses. 1. Inventory turnover ratio: This ratio measures the number of times a
A firm is said to be highly geared when it uses more of fixed income bearing company's investment in inventory is turned over during a given year. The
securities like bonds, debentures and preference share capital.. It indicates the higher the turnover ratio, the better, since a company with a high turnover
risk perception of investors is high. If the ratio is less than one, the firm is said requires a smaller investment in inventory than one producing the same level of
to be low geared. The position of creditors is more safe when the firm is low sales with a low turnover rate. Company management has to be sure, however,
geared. to keep inventory at a level that is just right in order not to miss sales.
3. Propreitory ratio/ Equity Ratio: It is the ratio of shareholders funds to This ratio indicates the efficiency in turning over inventory and can be
Total Assets of the firm. It indicates the relative contribution of owners or compared with the experience of other companies in the same industry. It also
shareholders in financing total assets. This ratio is also called net worth to Total provides some indication as to the adequacy of a company's inventory for the
Assets Ratio. This ratio establishes the relationship between shareholder’s funds volume of business being handled. If a company has an inventory turnover rate
to total assets of the firm. that is above the industry average, it means that a better balance is being
Proprietary ratio or Equity Ratio= Shareholders funds/Total Assets maintained between inventory and cost of goods sold. As a result, there will be
Where shareholders funds = Equity share capital+ preference share capital+ less risk for the business of being caught with top-heavy inventory in the event
undistributed profits+ reserves and surpluses of a decline in the price of raw materials or finished products.
Total assets = Total resources of the concern Inventory turnover ratio =Cost of goods sold/Inventory
4. Solvency Ratio: It is the ratio of total borrowed funds to total assets (also Some companies calculate the inventory turnover by using sales instead of cost
equal to total liabilities). It indicates the relative contribution of outsiders in of goods sold as the numerator. This may be less appropriate because sales
financing the assets of the firm. It is calculated as :- include a profit markup which is absent from inventory. Inventory includes all
Solvency ratio = Total Borrow ed funds/Total Assets types of stocks like raw materials, work in progress, finished goods,
Or Solvency Ratio = 100- Equity Ratio consumable stores, spares etc. Inventory turnover ratio is the relationship of
A high ratio indicates that the firm is depending more on outsiders’ funds in cost of goods sold to average inventory.
financing assets. The position of creditors is not safe in the event of winding up. Inventory turnover ratio = cost of goods sold/ average inventory
5. Ratio of Fixed assets to Net worth: The ratio shows the relationship Cost of goods sold = net sales – gross profit
between net fixed assets and Net worth. Cost of goods sold = opening stock +net purchases + direct expenses – closing
Ratio of Fixed assets to Net worth = Net Fixed Assets/Net Worth stock
6. Funded Debt to capitalization: This ratio indicates the contribution of Average inventory = opening inventory +closing inventory/2
owners in financing fixed assets. If the ratio is less than one, it is considered as 2.Debtors Turnover Ratio indicates the velocity of debt collection of a firm.
ideal. It means that the whole of fixed assets and a part of working capital are In simple words it indicates the number of times average debtors (receivable)
financed from shareholders funds. If the ratio is more than one, it means that a are turned over during a year.
part of the fixed assets is financed using borrowed funds. Debtors Turnover Ratio = Net Credit Sales / Average Trade Debtors
Funded Debt to capitalization = Long term deb/Total Assets or Total Liabilites The two basic components of accounts receivable turnover ratio are net credit
III Activity Ratios annual sales and average trade debtors. The trade debtors for the purpose of this
Activity ratios, sometimes referred to as operating ratios or management ratios, ratio include the amount of Trade Debtors & Bills Receivables. The average
measure the efficiency with which a business uses its assets, such as receivables are found by adding the opening receivables and closing balance of
inventories, accounts receivable, and fixed (or capital) assets. The more receivables and dividing the total by two. It should be noted that provision for
commonly used operating ratios are the average collection period, the inventory bad and doubtful debts should not be deducted since this may give an
turnover, the fixed assets turnover, and the total assets turnover. These ratios impression that some amount of receivables has been collected. But when the
indicate the efficiency of management in the use of resources, both short term information about opening and closing balances of trade debtors and credit
and long term. The overall performance of a company is evaluated on the basis sales is not available, then the debtors turnover ratio can be calculated by
of its ability to make sales using minimum resources. Turnover ratios reflect the dividing the total sales by the balance of debtors (inclusive of bills receivables)
speed at which assets are utilized in effecting sales. A higher turnover ratio given. And formula can be written as follows.
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

Debtors Turnover Ratio = Total Sales / Debtors

Accounts receivable turnover ratio or debtors turnover ratio indicates the IV. Profitability Ratios
number of times the debtors are turned over a year. The higher the value of Profitability ratios may be classified in to two types :
debtors turnover the more efficient is the management of debtors or more liquid [a] operating profitability ratios
the debtors are. Similarly, low debtors turnover ratio implies inefficient [b]overall profitability ratios
management of debtors or less liquid debtors. It is the reliable measure of the
time of cash flow from credit sales. There is no rule of thumb which may be [A] Operating Profitability Ratios
used as a norm to interpret the ratio as it may be different from firm to firm. In this type of analysis profit is related to the volume of operation or sales. The
Average Collection Period Ratio: important measures of operating profitability are :
Average Collection Period. This ratio measures how long a firm's average sales 1. Gross profit ratio
remains in the hands of its customers. A longer collection period automatically 2. Operating profit ratio
creates a larger investment in assets. The average collection period is calculated 3. Operating ratio
in two steps. The first step is calculating the average daily sales, which is done 4. Net profit ratio
by dividing the total annual net sales by 365 days. The second step is dividing 1. Gross Profit Ratio (GP Ratio): Gross profit ratio (GP ratio) is the ratio of
the average daily sales into accounts receivable. gross profit to net sales expressed as a percentage. It expresses the relationship
Average Collection Period = Trade Debtors / Average Daily Credit Sales between gross profit and sales. The basic components for the solution of gross
Average Daily Credit Sales= Credit Sales / No. of working days in a year profit ratio are gross profit and net sales. Net sales mean those sales minus
3. Creditors / Accounts Payable Turnover Ratio: sales returns. Gross profit would be the difference between net sales and cost of
This ratio is similar to the debtor’s turnover ratio. It compares creditors with the goods sold. Cost of goods sold in the case of a trading concern would be equal
total credit purchases. It signifies the credit period enjoyed by the firm in to opening stock plus purchases, minus closing stock plus all direct expenses
paying creditors. Accounts payable include both sundry creditors and bills relating to purchases. In the case of manufacturing concern, it would be equal to
payable. Same as the sum of the cost of raw materials, wages, direct expenses and all
debtor’s turnover ratio, creditors turnover ratio can be calculated in two manufacturing expenses. In other words, generally the expenses charged to
forms, creditors turnover ratio and average payment period. Following formula profit and loss account or operating expenses are excluded from the solution of
is used to calculate creditors turnover ratio: cost of goods sold. Following formula is used to calculate gross profit ratios:
Creditors Turnover Ratio = Credit Purchase / Average Trade Creditors [Gross Profit Ratio = (Gross profit / Net sales) × 100]
Average payment period ratio gives the average credit period enjoyed from 2. Net profit ratio is the ratio of net profit (after taxes) to net sales. It is
the creditors. It can be calculated using the following formula: expressed as percentage. The two basic components of the net profit ratio are
Average Payment Period = Trade Creditors / Average Daily Credit Purchase the net profit and sales. The net profits are obtained after deducting income-tax
Average Daily Credit Purchase= Credit Purchase / No. of working days in a and, generally, non operating expenses and incomes are excluded from the net
year profits for calculating this ratio. Thus, incomes such as interest on investments
4. Fixed Assets Turnover: The fixed (or capital) assets turnover ratio measures outside the business, profit on sales of fixed assets and losses on sales of fixed
how intensively a firm's fixed assets such as land, buildings, and equipment are assets, etc are excluded.
used to generate sales. A low fixed assets turnover implies that a firm has too Net Profit Ratio = (Net profit / Net sales) × 100
much investment in fixed assets relative to sales; it is basically a measure of 3. Operating ratio is the ratio of cost of goods sold plus operating expenses to
productivity net sales. It is generally expressed in percentage. Operating ratio measures the
Fixed Assets Turnover Ratio = Cost of Sales / Net Fixed Asset cost of operations per Rs. of sales. This is closely related to the ratio of
5. Working Capital Turnover Ratio: Working capital turnover ratio indicates operating profit to net sales.
the velocity of the utilization of net working capital. This ratio represents the The two basic components for the solution of operating ratio are operating cost
number of times the working capital is turned over in the course of year and is (cost of goods sold plus operating expenses) and net sales. Operating expenses
calculated as follows: Following formula is used to calculate working capital normally include (a) administrative and office expenses and (b) selling and
turnover ratio distribution expenses. Financial charges such as interest, provision for taxation
Working Capital Turnover Ratio = Cost of Sales / Net Working Capital etc. are generally excluded from operating expenses.
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

Operating profit Ratio or Operating Margin Ratio The operating profit of a shareholders are more interested in the profitability of a company and the
business is the profit after meeting all operating expenses incurred in the regular performance of a company should be judged on the basis of return on equity
course of operations. It is a measure of operating efficiency of a business. The capital of the company. Return on equity capital which is the relationship
ratio is calculated by dividing operating profit or earnings before interest and between profits of a company and its equity, can be calculated as follows:
taxes [EBIT] by Net Sales Formula of return on equity capital ratio is:
Operating profit Ratio = Operating profit or EBIT/Net SalesX100 Return on Equity Capital = [(Net profit after tax − Preference dividend) /
Operating Ratio = [(Cost of goods sold + Operating expenses) / Net sales] × 100 Equity share capital] × 100
4. Expense ratios indicate the relationship of various expenses to net sales. The
operating ratio reveals the average total variations in expenses. But some of the Return on Capital Employed Ratio (ROCE Ratio)
expenses may be increasing while some may be falling. Hence, expense ratios The prime objective of making investments in any business is to obtain
are calculated by dividing each item of expenses or group of expense with the satisfactory return on capital invested. Hence, the return on capital employed is
net sales to analyze the cause of variation of the operating ratio. used as a measure of success of a business in realizing this objective. Return on
Particular Expense = (Particular expense / Net sales) × 100 capital employed establishes the relationship between the profit and the capital
employed. It indicates the percentage of return on capital employed in the
[B] Overall Profitability Ratios business and it can be used to show the overall profitability and efficiency of
It is the analysis of profitability in relation to the volume of capital employed or the business.
investment in the business. Management and shareholders are interested in Capital employed and operating profits are the main items. Capital employed
ascertaining the return on capital employed, return on shareholders’ funds etc. may be defined in a number of ways. However, two widely accepted definitions
the important tests applied to measure overall profitability are : are "gross capital employed" and "net capital employed".
1. Return on total assets Gross capital employed usually means the total assets, fixed as well as current,
2. Return on capital employed used in business, while net capital employed refers to total assets minus
3. Return on shareholder’s equity liabilities. On the other hand, it refers to total of capital, capital reserves,
4. Return on equity capital revenue reserves (including profit and loss account balance), debentures and
Return on Shareholders’ Investment or Net Worth Ratio long term loans
It is the ratio of net profit to share holder's investment. It is the relationship Gross capital employed = Fixed assets + Investments + Current assets
between net profit (after interest and tax) and share holder's/proprietor's fund. Net capital employed = Fixed assets + Investments + Working capital .
This ratio establishes the profitability from the share holders' point of view. The Working capital = current assets − current liabilities.
ratio is generally calculated in percentage. The two basic components of this Return on capital employed ratio is considered to be the best measure of
ratio are net profits and shareholder's funds. profitability in order to assess the overall performance of the business. It
Shareholder's funds include equity share capital, (preference share capital) and indicates how well the management has used the investment made by owners
all reserves and surplus belonging to shareholders. Net profit means net income and creditors into the business. It is commonly used as a basis for various
after payment of interest and income tax because those will be the only profits managerial decisions. As the primary objective of business is to earn profit,
available for share holders. higher the return on capital employed, the more efficient the firm is in using its
[Return on share holder's investment = {Net profit (after interest and tax) / funds. The ratio can be found for a number of years so as to find a trend as to
Share holder's fund} × 100] whether the profitability of the company is improving or otherwise.
Return on Capital Employed=
Return on Equity Capital (ROEC) Ratio (Adjusted net profits /Capital employed)×100
In real sense, ordinary shareholders are the real owners of the company. They Net profit before interest and tax minus income from investments .
assume the highest risk in the company. (Preference share holders have a Return on Total Assets
preference over ordinary shareholders in the payment of dividend as well as Return on total Assets is also called Return on Investment or ROI. It is
capital. Preference share holders get a fixed rate of dividend irrespective of the calculated by dividing operating profit by total tangible assets.
quantum of profits of the company). The rate of dividends varies with the Return on total Assets = Operating Profit/ Total Tangible Assets x100
availability of profits in case of ordinary shares only. Thus ordinary
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

A high ratio implies better overall performance of the business or efficient use 7. It helps in knowing the overall credit worthiness of the firm
of total assets. 8. It states how much funds has been generated from operations during the year
9. It helps the management in framing financial policies like dividend policies,
2.3. Funds Flow Statement issue of shares etc.
Balance sheet discloses the financial position at the end of the year and it is a 10. Creditors and financial institutions who have lend money to the firm can
static statement. The management is interested to know what changes occurs in assess the financial strengths and repayment capacity based on funds flow
the balance sheet figures between two balance sheet dates. The statement analysis
prepared to show changes in assets, liabilities and owners equity of a business Limitations of Funds Flow Statement
are called statement of changes in financial position. These include Funds flow 1. The funds flow statement cannot substitute the income statement or balance
statement and cash flow statement. Statement of changes in financial position sheet.
prepared on working capital basis is called funds flow statement and on cash 2. The interpretation of fund as working capital distorts the real change in
basis is called cash flow statement. financial position of a business
3. Preparation of funds flow statement requires a lot of workings and
Meaning of the term ‘Fund’ preparation of non current accounts.
In a narrow sense it means cash and in a broader sense it is capital or all 4. Certain items like provision for tax and proposed dividend can be treated
financial resources of a business. But the fund is commonly used in its popular differently as current liability or non current liability which gives misleading
sense as working capital or net current assets. Thus for accounting purpose and results regarding funds from operations
for preparing funds flow statements , the term fund means working capital of 5. A statement of changes in financial position on cash basis [ cash flow
the excess of current assets over current liabilities. statement ] is more informative and useful than the funds flow statement which
Meaning and definition of flow of funds is prepared on working capital basis.
Fund flow statement is a method by which we study changes in financial 2.3.2. Procedure for Preparing a Funds Flow Statement
position of an enterprise between beginning and ending financial statements. Funds Flow Statement is a method by which we study changes in the financial
Funds flow statement may be defined as “ a statement of sources and position of a business enterprise between beginning and ending financial
applications of funds is a technical devise designed to analyze the changes in statement dates. Hence the funds flow statement is prepared by comparing two
financial conditions of business enterprise between two dates. balance sheets and with the help of such other information derived from the
2.3.1. Uses, Significance and Importance of Fund Flow Statement accounts as may be needed. Broadly speaking the preparation of FFS consists
A funds flow statement is an essential tool for the financial analysis and is of of two parts
primary importance to the financial management. The basis purpose of funds 1. Statement or schedule of changes in working capital
flow statement is to reveal the changes in the working capital on two balance 2. Statement of sources and application of funds
sheet dates. It also describes the source from which additional working capital Statement or schedule of changes in working capital
has been financed and the uses to which working capital has been applied. By Working capital means the excess of current assets over current liabilities.
making use of projected funds flow statement the management can come to Statement of changes in working capital is prepared to show the changes in the
know the adequacy or inadequacy of working capital even in advance. One can working capital between the two balance sheet dates. This statement is prepared
plan the intermediate and long term financing of the firm, repayment of long with the help of current assets and current liabilities derived from the two
term debts, expansion of the business, allocation of resources etc. balance sheets as
The significance of funds flow statement are explained as follows:- Working capital = Current assets - Current liabilities
1. It helps in the analysis of financial operations So
2. It gives answers to many questions like happening of net profit, proceeds of  An increase in current assets increases the working capital
sale of shares etc.  The decrease in current assets decreases the working capital
3. It helps in the formation of a realistic dividend policy  An increase in current liabilities decreases the working capital
4. It helps in the proper allocation of resources  A decrease in current liabilities increases working capital
5. It acts as a guide for future to the management. The total increase and the total decrease are compared and the difference shows
6. It helps in appraising the use of working capital the net increase or net decrease in working capital. It is worth nothing that
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

schedule of changes in working capital is prepared only from current assets and 1. Cash comprises of cash in hand and demand deposits with banks
current liabilities. The Net increase in working capital represents the application 2. Cash equivalents are short term, highly liquid investments that are readily
of funds and the Net decrease in working capital represents the source of fund. convertible into known amounts of cash and which are subject to an
For the preparation of FFS, we have to prepare non current accounts to find out insignificant risk of changes in value. Cash equivalents are held for the purpose
whether there is any source or application of funds. The fund from operation of meeting cash commitments rather than for investment or other purposes. For
should also be find out in order to prepare the Funds flow statement. an investment to qualify as cash equivalent, it must be readily convertible into
Preparing Non Current Accounts known amount of cash subject to an insignificant risk of changes in value.
This is to ascertain the inflows or outflows of funds from non current accounts. Therefore , an investment normally qualifies as a cash equivalent only when it
In the preparation of non current accounts the general principle is that a has a short maturity, i.e,three months or less from the date of acquisition.
decrease in non current assets or increase in non current liabilities results in an 3. Cash flows are inflows and outflows of cash and cash equivalents. Flow of
inflow of funds. Similarly, an increase in non current assets or decrease in non cash is said to have taken place when any transaction makes changes in the
current liabilities results in an out flow of fund. This principle is subject to amount of cash and cash equivalents available before happening of the
exceptions when additional information is given in the problem. It may relate to transaction. If the effect of the transaction results in increase of cash and its
depreciation written off on assets, old assets discarded, intangible or fictitious equivalents, it is called an inflow of cash and if it results in decrease of cash, it
assets written off , transfer to general reserve, bonus share issued etc. is known as outflow of cash.
Funds from operations Cash Flow Statement Funds Flow Statement
It means regular source of funds received from operations of the business. It is 1.Cash flow statement is a 1.Fund flow statement is a statement
the cash operating profit of the business or the income from operations net of statement which discloses the which discloses the sources and uses
cash operating expense. It is an important item coming under the head ‘source inflows and outflows of cash of funds or working capital during a
of funds ‘ during a period. period
2.4. Cash Flow Statement 2.It is prepared on cash basis, that 2. It is prepared on working capital
Cash plays an important role in the entire economic life of a business. A firm is , actual cash inflows and basis and follows accrual concept of
needs cash to make payments to suppliers, to incur day-to-day expenses and to outflows are shown accounting.
pay salaries, wages, interest and dividend etc .Management of liquidity or cash 3.It is mainly used for cash 3.It is mainly used for long term
flow is an important aspect for the successful functioning of every business. planning and managing liquidity financial planning
Cash is the most liquid form of current asset and maintenance of sufficient cash 4.It explains reasons for shortage 4.It explains reasons for a net
is a pre requisite for the smooth functioning of the business. Therefore , it is or surplus of liquid cash at the end increase or decrease in working
necessary to make a cash flow analysis by preparing a Cash flow statement. of an accounting year. capital at the end of an accounting
Meaning of the term cash year
The term ‘cash’ includes cash and cash equivalents. These include cash in hand, 5.It is presented in prescribed 5.It is not presented in prescribed
cash at bank and short term investments or marketable securities. Short term format as per AS-3 format.
investments are highly liquid and can be converted into cash on demand or on 6.A schedule of changes in 6. A schedule of changes in working
short notice. These are not held for a real return but to meet the liquidity working capital is not required. capital is prepared to ascertain the
requirements of the business. net
Meaning of cash flow statement increase or decrease in working
Cash flow statement is a statement which describes the inflows and outflows of capital
cash and cash equivalents in an enterprise during a specified period of time. It Classification of Cash Flows
explains the reasons for changes in a firm’s cash position during an accounting The revised Accounting Standard [ AS-3] has made the following
year. The Institute of Cost and Works Accountant of India defines cash flow classification in respect of cash flows.
statement as “ a statement setting out the flow of cash under distinct heads of 1. Cash flows from operating activities
sources of funds and their utilization to determine the requirements of cash 2. Cash flows from investing activities
during the given period and to prepare for its adequate provision.” 3. Cash flows from financing activities
The term cash, cash equivalents and cash flow are explained as follows:-
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

1. Cash flow from operating activities 5. A cash flow statement can explain how much cash is generated within the
These are cash flows from regular course of operations. The operations of a business from operations for meeting various demands for cash such as
firm include manufacturing, trading, rendering of services etc. Examples of payment of dividend, tax, financing expansion and investment son new projects
cash flows from operating activities are;- etc.
a. Cash sales 6. It also explains reasons for paying very low dividend in spite of earning
b. Cash received from debtors on account of credit sales sufficient net profit by the business.
c. Cash purchase of goods Limitations of cash flow statement
d. Cash paid to suppliers on account of credit purchases 1. A cash flow statement discloses changes in financial position on cash basis
e. Wages paid to employees and staff only. Therefore, non cash transactions affecting changes in financial position
f. Cash operating expenses are ignored
g. Income from investing activities 2. It is not a substitute to financial statements like Profit and Loss Account and
2. Cash from investing activities Balance sheet. It can only substantiate these statements.
The investing activities of a business include purchase and sale of fixed assets 3. It is easy to manipulate cash position by delaying payment or quick
like land buildings, equipments, machinery etc. Acquisition or disposal of collection of cash by management decisions. Therefore, the real cash position
companies also comes under investing activities. These are separately discloses may not be disclosed.
in cash flow statement 4. The real liquidity position can be evaluated only by analyzing other current
Eg. assets also. But in cash flow analysis only cash is evaluated.
a. Cash payments to acquire fixed assets 2.4.2. Preparation of Cash Flow Statement
b. Cash receipts from disposal of fixed assets It requires comparative balance sheet at the beginning of the year and at the end
c. Cash payments to acquire shares, debt instruments or warrants f the year. In addition income statement for current year and/ or additional
d. Cash receipts from disposal of shares information regarding sale of asset, depreciation provided, tax paid etc. are also
e. Cash advances and loans made to third parties given. Thus the information given is the same as that is required for the
3. Cash flows from financing activities preparation of funds flow statement.
The financing activities of a firm include issuing or redemption of share capital, The following steps are involved in the preparation of cash flow statement.
issue and redemption of debentures , raising and repayment of long term loans 1. Prepare all non current accounts and ascertain inflow or outflow of cash
etc. these are items changing the owners equity and debt capital during an 2. Calculate cash from operations for current year
accounting year. Dividends paid to shareholders also come under financing 3. Prepare cash flow statement in the prescribed format as per AS-3
activities Cash from operations
Eg. Cash from operations is an important source of inflow of cash into the business.
a. Cash proceeds from issuing shares or other similar instruments It can be calculated by the following methods;-
b. Cash proceeds from issuing debentures, loans, notes , bonds and other a. Direct method
short or long term borrowings and b. The indirect method
c. Cash repayments of amounts borrowed such as redemption of debentures, Direct method
bonds, preference shares. Under this method, all cash receipts on accounts of normal course of operations
2.4.1.Uses of Cash Flow Statement of business are added and from these total all cash payments on account of
1. A Cash flow statement discloses changes in financial position on cash basis. operations are deducted.
t facilitates management of cash flows of a business. Indirect method
2. It facilitates management in the evaluation of cash position and appropriate Under this method cash from operations are calculated by adjusting net profit
measures may be taken to arrange loans or make investments of surplus cash for
3. It helps management in formulating financial policies such as dividend 1. Non operating and non cash items like depreciation, provision for tax, loss on
policy, credit policy etc. sale of asset, goodwill written off, preliminary expenses written off and
4. A projected cash flow statement can guide the management regarding the
need for arranging cash on long term basis by issuing shares, raising loans etc.
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

2. Changes in current assets and current liabilities except cash and bank,
changes in current assets and liabilities result in notional inflow or notional
outflow of cash.
The indirect method is followed when details of cash receipts and cash
payments are not given. Unit III Cost and Management Accounting
------------------------------------------------------------------------------------------------ Definitions, Objectives, Merits and Demerits of Cost Accounting and
Management Accounting –Distinction between Financial Accounting with Cost
Accounting and Management Accounting. Cost Terminology – functional
classification of cost. Cost Centre- Cost Unit. Elements of Cost – Prime cost-
factory cost-administration cost-selling and distribution cost. Preparation of
Cost Sheet.
------------------------------------------------------------------------------------------------
3.1. Meaning of Cost Accounting
Cost accounting developed as an advanced phase of accounting science and is
trying to make up the deficiencies of financial accounts. It is essentially a
creation of the twentieth century. Cost accounting accounts for the costs of a
product, a service or an operation. It is concerned with actual costs incurred and
the estimation of future costs. Cost accounting is a conscious and rational
procedure used by accountants for accumulating costs and relating such costs to
specific products or departments for effective management action. Cost
accounting through its marginal costing technique helps the management in
profit planning and through its another technique i.e. Standard costing
facilitates cost control. In short, cost accounting is a management information
system which analyses past, present and future data to provide the basis for
managerial decision making.
3.1.1. Distinction Between Financial Accounting And Cost Accounting
Though there is much common ground between financial accounting and cost
accounting and though in fact cost accounting is an outgrowth of financial
accounting yet the emphasis differs. Firstly financial accounting is more
attached with reporting the results of business to persons other than internal
management – government, creditors, investors, researchers, etc. Cost
accounting is an internal reporting system for an organisation’s own
management for decision making. Secondly financial accounting data is
historical in nature and its periodicity of reporting is much wider. Cost
accounting is more concerned with short-term planning and its reporting period
much lesser than financial accounting. It not only deals with historic data but
also is futuristic in approach. Thirdly, in financial accounting the major
emphasis in cost classification is based on the type of transaction e.g. Salaries,
repairs, insurance, stores, etc. But in cost accounting the major emphasis is on
functions, activities, products, processes and on internal planning and control
and information needs of the organisation.
3.1.2.Utility Of Cost Accounting

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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

A properly installed cost accounting system will help the management in the (iii) Analyses and interprets data: The accounting data is analyzed
following ways: meaningfully for effective planning and decision-making. For this purpose the
- The analysis of profitability of individual products, services or jobs. data is presented in a comparative form. Ratios are calculated and likely trends
- The analysis of profitability of different departments or operations. are projected.
- It locates differences between actual results and expected results. (iv) Serves as a means of communicating: Management accounting provides a
- It will assist in setting the prices so as to cover costs and generate an means of communicating management plans upward, downward and outward
acceptable level of profit. through the organization. Initially, it means identifying the feasibility and
- Cost accounting data generally serves as a base to which the tools and consistency of the various segments of the plan. At later stages it keeps all
techniques of management accounting can be applied to make it more parties informed about the plans that have been agreed upon and their roles in
purposeful and management oriented. these plans.
- The effect on profits of increase or decrease in output or shutdown of a (v) Facilitates control: Management accounting helps in translating given
product line or department can be analysed by adoption of efficient cost objectives and strategy into specified goals for attainment by a specified time
accounting system. and secures effective accomplishment of these goals in an efficient manner. All
3.1.3. Meaning of Management Accounting this is made possible through budgetary control and standard costing which is
Management accounting can be viewed as Management-oriented Accounting. an integral part of management accounting.
Basically it is the study of managerial aspect of financial accounting,” (vi) Uses also qualitative information: Management accounting does not
accounting in relation to management function". It is developed mainly to help restrict itself to financial data for helping the management in decision making
the management in the discharge of its functions and for taking various but also uses such information which may not be capable of being measured in
decisions. monetary terms. Such information may be collected form special surveys,
The Report of the Anglo-American Council of Productivity (1950) has also statistical compilations, engineering records, etc.
given a definition of management accounting, which has been widely accepted.
According to it, "Management accounting is the presentation of accounting 3.1.5.Scope of Management Accounting
information in such a way as to assist the management in creation of policy and Management accounting is concerned with presentation of accounting
the day to day operation of an undertaking". information in the most useful way for the management. Its scope is, therefore,
According to the Institute of Chartered Accountants of England and Wales “any quite vast and includes within its fold almost all aspects of business operations.
form of accounting which enables a business to be conducted more efficiently However, the following areas can rightly be identified as falling within the
can be regarded as Management Accounting “ ambit of management accounting:
The term management accounting is composed of 'management' and (i) Financial Accounting: Management accounting is mainly concerned with
'accounting ‘It is the use of Accounting Information for discharging the rearrangement of the information provided by financial accounting. Hence,
Management functions, especially planning and decision making. management cannot obtain full control and coordination of operations without a
3.1.4.Functions of Management Accounting properly designed financial accounting system.
The basic function of management accounting is to assist the management in (ii) Cost Accounting: Standard costing, marginal costing, opportunity cost
performing its functions effectively. The functions of the management are analysis, differential costing and other cost techniques play a useful role in
planning, organizing, directing and controlling. Management accounting helps operation and control of the business undertaking.
in the performance of each of these functions in the following ways: (iii) Revaluation Accounting: This is concerned with ensuring that capital is
(i) Provides data: Management accounting serves as a vital source of data for maintained intact in real terms and profit is calculated with this fact in mind.
management planning. The accounts and documents are a repository of a vast (iv) Budgetary Control: This includes framing of budgets, comparison of
quantity of data about the past progress of the enterprise, which are a must for actual performance with the budgeted performance, computation of variances,
making forecasts for the future. finding of their causes, etc.
(ii) Modifies data: The accounting data required for managerial decisions is (v) Inventory Control: It includes control over inventory from the time it is
properly compiled and classified. For example, purchase figures for different acquired till its final disposal.
months may be classified to know total purchases made during each period
product-wise, supplier-wise and territory-wise.
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

(vi) Statistical Methods: Graphs, charts, pictorial presentation, index numbers detail in the 'management language' so that it becomes a base for management
and other statistical methods make the information more impressive and action.
intelligible. (iv) Monetary measurement: In financial accounting only such economic
(vii) Interim Reporting: This includes preparation of monthly, quarterly, events find place, which can be described in money. However, the management
halfyearly income statements and the related reports, cash flow and funds flow is equally interested in non-monetary economic events, viz., technical
statements, scrap reports, etc. innovations, personnel in the organization, changes in the value of money, etc.
(viii) Taxation: This includes computation of income in accordance with the These events affect management's decision and, therefore, management
tax laws, filing of returns and making tax payments. accounting cannot afford to ignore them.
(ix) Office Services: This includes maintenance of proper data processing and (v) Periodicity of reporting: The period of reporting is much longer in
other office management services, reporting on best use of mechanical and financial accounting as compared to management accounting. The Income
electronic devices. Statement and the Balance Sheet are usually prepared yearly or in some cases
(x) Internal Audit: Development of a suitable internal audit system for internal half-yearly. Management requires information at frequent intervals and,
control. therefore, financial accounting fails to cater to the needs of the management. In
(xi)Management Information System [MIS]: Management Accounting serves management accounting there is more emphasis on furnishing information
as a centre for collection and dissemination of information. .MIS is an essential quickly and at comparatively short intervals as per the requirements of the
part of Management Accounting. management.
(vi) Precision: There is less emphasis on precision in case of management
3.1.6.Management Accounting and Financial Accounting accounting as compared to financial accounting since the information is meant
Financial accounting and management accounting are closely interrelated since for internal consumption.
management accounting is to a large extent rearrangement of the data provided (vii) Nature: Financial accounting is more objective while management
by financial accounting. Moreover, all accounting is financial in the sense that accounting is more subjective. This is because management accounting is
all accounting systems are in monetary terms and management is responsible fundamentally based on judgment rather than on measurement.
for the contents of the financial accounting statements. In spite of such a close (viii) Legal compulsion: Financial accounting has more or less become
relationship between the two, there are certain fundamental differences. These compulsory for every business on account of the legal provisions of one or the
differences can be laid down as follows: other Act. However, a business is free to install or not to install system of
(i) Objectives: Financial accounting is designed to supply information in the management accounting.
form of profit and loss account and balance sheet to external parties like 3.1.7.Cost Accounting and Management Accounting
shareholders, creditors, banks, investors and Government. Information is Cost accounting is the process of accounting for costs. It embraces the
supplied periodically and is usually of such type in which management is not accounting procedures relating to recording of all income and expenditure and
much interested. Management Accounting is designed principally for providing the preparation of periodical statements and reports with the object of
accounting information for internal use of the management. Thus, financial ascertaining and controlling costs. It is, thus, the formal mechanism by means
accounting is primarily an external reporting process while management of which the costs of products or services are ascertained and controlled. On the
accounting is primarily an internal reporting process. other hand, management accounting involves collecting, analyzing, interpreting
(ii) Analyzing performance: Financial accounting portrays the position of and presenting all accounting information, which is useful to the management.
business as a whole. The financial statements like income statement and It is closely associated with management control, which comprises planning,
balance sheet report on overall performance or statues of the business. On the executing, measuring and evaluating the performance of an organization. Thus,
other hand, management accounting directs its attention to the various management accounting draws heavily on cost data and other information
divisions, departments of the business and reports about the profitability, derived from cost accounting.
performance, etc., of each of them. Today cost accounting is generally indistinguishable from the so-called
(iii) Data used: Financial accounting is concerned with the monetary record of management accounting or internal accounting because it serves multiple
past events. It is a post-mortem analysis of past activity and, therefore, out the purposes. However, management accounting can be distinguished from cost
date for management action. Management accounting is accounting for future accounting in one important respect.
and, therefore, it supplies data both for present and future duly analyzed in
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

Management accounting has a wider scope as compared to cost accounting. Management accounting, being comparatively a new discipline, suffers from
Cost accounting deals primarily with cost data while management accounting certain limitations, which limit its effectiveness. These limitations are as
involves the considerations of both cost and revenue. follows:
Management accounting is an all inclusive accounting information system, 1. Limitations of basic records: Management accounting derives its
which covers financial accounting, cost accounting, and all aspects of financial information from financial accounting, cost accounting and other records. The
management. But it is not a substitute for other accounting functions. It strength and weakness of the management accounting, therefore, depends upon
involves a continuous process of reporting cost, financial and other relevant the strength and weakness of these basic records. In other words, their
data in an analytical and informative way to management. limitations are also the limitations of management accounting.
We should not be very much concerned with boundaries of cost accounting and 2. Persistent efforts. The conclusions draws by the management accountant are
management accounting since they are complementary in nature. In the absence not executed automatically. He has to convince people at all levels. In other
of a suitable system of cost accounting, management accountant will not be in a words, he must be an efficient salesman in selling his ideas.
position to have detailed cost information and his function is bound to lose 3. Management accounting is only a tool: Management accounting cannot
significance. On the other hand, the management accountant cannot effectively replace the management. Management accountant is only an adviser to the
use the cost data unless it has been reported to him in a meaningful and management. The decision regarding implementing his advice is to be taken by
informative form. the management. There is always a temptation to take an easy course of arriving
3.1.8. Objectives of Management Accounting at decision by intuition rather than going by the advice of the management
The primary objective is to enable the management to maximize profits or accountant.
minimize losses. The fundamental objective of management accounting is to 4. Wide scope: Management accounting has a very wide scope incorporating
assist management in their functions. The other main objectives are: many disciplines. It considers both monetary as well as non-monetary factors
1. Planning and policy formulation: planning is one of the primary functions of This all brings inexactness and subjectivity in the conclusions obtained through
management. It involves forecasting on the basis of available information. it.
2. Help in the interpretation process: The main object is to present financial 5. Top-heavy structure: The installation of management accounting system
information. The financial information must be presented in easily requires heavy costs on account of an elaborate organization and numerous
understandable manner. rules and regulations. It can, therefore, be adopted only by big concerns.
3. Helps in decision making: Management accounting makes decision making 6. Opposition to change: Management accounting demands a break away from
process more modern and scientific by providing significant information traditional accounting practices. It calls for a rearrangement of the personnel
relating to various alternatives. and their activities, which is generally not like by the people involved.
4. Controlling: The actual results are compared with pre determined objectives. 7. Evolutionary stage: Management accounting is still in its initial stage. It
The management is able to control performance of each and every individual has, therefore, the same impediments as a new discipline will have, e.g., fluidity
with the help of management accounting devices. of concepts, raw techniques and imperfect analytical tools. This all creates
5. Reporting: This facilitates management to take proper and timely decisions. doubt about the very utility of management accounting.
It presents the different alternative plans before the management in a 3.2.1. Classification Of Cost
comparative manner. In the process of cost accounting, costs are arranged and rearranged in various
6. Motivating: Delegation increases the job satisfaction of employees and classifications. The term `classification’ refers to the process of Grouping costs
encourages them to look forward. so it serves as a motivational devise. according to their common characteristics. The different bases of cost
7. Helps in organizing: “return on capital employed” is one of the tools if classification are:
management accounting. All these aspects are helpful in setting up effective 1. By nature or elements (materials, labour and overheads)
and efficient organization. 2. By time (historical, pre-determined)
8. Coordinating operations: It provides tools which are helpful in coordinating 3. By traceability to the product (direct, indirect)
the activities of different sections. 4. By association with the product (product, period)
3.1.9.Limitations of Management Accounting 5. By changes in activity or volume (fixed, variable, semi-variable)
6. By function (manufacturing, administrative, selling, research and
development, pre-production)
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

7. By relationship with the accounting period (capital, revenue) These are expenses which can be directly, conveniently and wholly identifiable
8. By controllability (controllable, non-controllable) with a job, process or operation. Direct expenses are also known as chargeable
9. By analytical/decision-making purpose (opportunity, sunk, differential, joint, expenses or productive expenses. Examples of such expenses are: cost of
common, imputed, out-of-pocket, marginal, uniform, replacement) special layout, design or drawings, hire of special machinery required for a
10. By other reasons (conversion, traceable, normal, avoidable, unavoidable, particular contract, maintenance cost of special tools needed for a contract job,
total) etc.
1. Elements Of Cost Ii) Indirect Expenses:
The elements of costs are the essential part of the cost. There are broadly three Expenses which cannot be charged to production directly and which are neither
elements of cost, as explained below: indirect materials nor indirect wages are known as indirect expenses. Examples
(A) Material are rent, rates and taxes, insurance, depreciation, repairs and maintenance,
The substance from which the produce is made is called material. It can be power, lighting and heating etc.
direct as well as indirect. 1. Overheads
I) Direct Material: it refers to those materials which become an integral part of The term overheads includes, indirect material, indirect labour and indirect
the final product and can be easily traceable to specific physical units. Direct expenses, explained in the preceding paragraphs. Overheads may be incurred in
materials, thus, include: the factory, office or selling and distribution departments/divisions in an
1. All materials specifically purchased for a particular job or process. undertaking. Thus overheads may be of three types: factory over heads, office
2. Components purchased or produced. and administrative overheads and selling and distribution overheads.
3. Primary packing materials (e.g., carton, wrapping, card-board boxes etc.). 2. Cost Classification By Time
4. Material passing from one process to another. On the basis of the time of computing costs, they can be classified Into
Ii) Indirect Material: all materials which are used for purpose ancillary to the historical and pre-determined costs.
business and which cannot conveniently be assigned to specific physical units I) Historical Costs:
are known as `indirect materials’. Oil, grease, consumable stores, printing and These costs are computed after they are incurred. Such costs are available only
stationery material etc. Are a few examples of indirect materials. after the production of a particular thing is over.
(b) Labour Ii) Pre-Determined Costs:
In order to convert materials into finished products, human effort is required. These costs are computed in advance of production on the basis of a
Such human effort is known as labour. Labour can be direct as well as indirect. specification of all factors influencing cost. Such costs may be:
I) Direct Labour: 1. Estimated costs: estimated costs are based on a lot of guess work. They try to
It is defined as the wages paid to workers who are engaged in the production ascertain what the costs will be based on certain factors. They are less accurate
process and whose time can be conveniently and economically traceable to as only past experience is taken into account primarily, while computing them.
specific physical units. When a concern does not produce but instead renders a 2. Standard costs: standard costs is a pre-determined cost based on a technical
service, the term direct labour or wages refers to the cost of wages paid to those estimate for material, labour and other expenses for a selected period of time
who directly carry out the service, e.g., wages paid to driver, conductor etc. Of and for a prescribed set of working conditions. It is more scientific in nature
a bus in transport service. and the object is to find out what the costs should be.
ii) Indirect Labour: 3.Cost Classification By Traceability
Labour employed for the purpose of carrying out tasks Incidental to goods As explained previously, costs which can be easily traceable to a product are
produced or services provided is called indirect labour or indirect wages. In called direct costs. Indirect costs cannot be traced to a product or activity. They
short, wages which cannot be directly identified with a job, process or are common to several products (e.g., salary of a factory manager, supervisor
operation, are generally treated as indirect wages. Examples of indirect labour etc.) And they have to be apportioned to different products on some suitable
are: wages of store-keepers, foremen, supervisors, inspectors, internal transport basis. Indirect costs are also called `overheads’.
men etc. 4. Cost Classification By Association With Product
(C) Expenses Costs can also be classified (on the basis of their association with products) as
Expenses may be direct or indirect. product costs and period costs. .Product Costs: product costs are traceable to the
I) Direct Expenses:
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

product and include direct material, direct labour and manufacturing overheads. 3.Selling Cost: selling cost is the cost of seeking to create and stimulate demand
In other words, product cost is equivalent to factory cost. e.g., advertisements, show room expenses, salespromotion expenses, discounts
2.Period Costs: period costs are charged to the period in which they are incurred to distributors, free repair and servicing expenses, etc.
and are treated as expenses. They are incurred on the basis of time, e.g., rent, 4.Distribution Cost: it is the cost of the sequence of operations which begins
salaries, insurance etc. They cannot be directly assigned to a product, as they with making the packed product, available for despatch and ends with making
are incurred for several products at a time (generally). the reconditioned returned empty package, if any, available for re-use. Thus,
5. Cost Classification By Activity/Volume distribution cost includes all those expenses concerned with despatching and
Costs are also classified into fixed, variable and semi-variable on the basis of delivering finished products to customers, e.g., warehouse rent, depreciation of
variability of cost in the volume of production. delivery vehicles, special packing, loading expenses, carriage outward, salaries
1.Fixed Cost: Fixed cost is a cost which tends to be unaffected by variations in of despatch clerks, repairing of empties for re-use, etc.
volume of output. Fixed cost mainly depends on the passage of time and does 5. Research And Development Cost: it is the cost of discovering new ideas,
not vary directly with the volume of output. It is also called period cost, e.g., processes, products by experiment and implementing such results on a
rent, insurance, depreciation of buildings etc. It must be noted here that fixed commercial basis.
costs remain fixed upto a certain level only. These costs may also vary after a 6.Pre-Production Cost: expenses incurred before a factory is started and
certain production level. expenses involved in introducing a new product are preproduction costs. They
2.Semi-Variable Cost: These costs are partly fixed and partly variable. Because are treated as deferred revenue expenditure and charged to the cost of future
of the variable element, they fluctuate with volume and because of the fixed production on some suitable basis.
element, they do not change in direct proportion to output. Semi-variable or 7. Cost Classification By Relationship With Accounting Period
semi-fixed costs change in the same direction as that of the output but not in the On the basis of controllability, costs can be classified as controllable or
same proportion. For example, the expenditure on maintenance is to a great uncontrollable.
extent fixed if the output does not change significantly. Where, however, the 1.Controllable Cost: a cost which can be influenced by the action of a specified
production rises beyond a certain limit, further expenditure on maintenance will member of an undertaking is a controllable cost, e.g., direct materials, direct
be necessary although the increase in the expenditure will not be in proportion labour etc.
to the rise in output. Other examples in this regard are: depreciation, telephone 2.Uncontrollable Cost: a cost which cannot be influenced by the action of a
rent, repairs etc. specified member of an undertaking is an uncontrollable cost, e.g., rent, rates,
3.Variable Cost: Cost which tends to vary directly with volume of outputs is taxes, salary, insurance etc.
called `variable cost’. It is a direct cost. It includes direct material, direct labour, The term controllable cost is often used in relation to variable cost and the term
direct expenses etc. It should be noted here that the variable cost per unit is uncontrollable cost in relation to fixed cost. It should be noted here that a
constant but the total cost changes corresponding to the levels of output. It is controllable cost can be controlled by a person at a given organisation level
always expressed in terms of units, not in terms of time. only. Sometimes two or more individuals may be involved in controlling such a
6. Cost Classification By Function cost.
On the basis of the functions carried out in a manufacturing concern, 8. Cost Classification By Decision-Making Purpose
Costs can be classified into four categories: Costs may be classified on the basis of decision-making purposes for which
1.Manufacturing/Production Cost: it is the cost of operating the manufacturing they are put to use, in the following ways:
division of an enterprise. It is defined as the cost of the sequence of operations 1.Opportunity Cost: it is the value of the benefit sacrificed in favour of
which begin with supplying materials, services and ends with the primary choosing a particular alternative or action. It is the cost of the best alternative
packing of the product. foregone. If an owned building, for example, is proposed to be used for a new
2Administrative/Office Cost: it is the cost of formulating the policy, directing project, the likely revenue which the building could fetch, when rented out, is
the organisation and controlling the operations of an undertaking, which is not the opportunity cost which should be considered while evaluating the
directly related to production, selling, distribution, research or development. profitability of the project.
Administration cost, thus, includes all office expenses: remuneration paid to 2.Sunk Cost: a cost which was incurred or sunk in the past and is not relevant
managers, directors, legal expenses, depreciation of office premises etc. for decision-making is a sunk cost. It is only historical in nature and is

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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

irrelevant for decision-making. It may also be defined as the difference between changes expected in the prices of materials, labour, etc., and submit the tender
the purchase price of an asset and its salvage value. or quotation accordingly.
3.Differential Cost: the difference in total costs between two alternatives is ------------------------------------------------------------------------------------------------
called as differential cost. In case the choice of an alternative results in increase
in total cost, such increase in costs is called `incremental cost’. If the choice
results in decrease in total costs, the resulting decrease is known as decremental
cost.
4.Joint Cost: whenever two or more products are produced out of one and the
same raw material or process, the cost of material purchased and the processing
are called joint costs. Technically speaking, joint cost is that cost which is
common to the processing of joint products or by-products upto the point of
split-off or separation.
5.Common Cost: common cost is a cost which is incurred for more than one
product, job territory or any other specific costing object. It cannot be treated to
individual products and, hence, apportioned on some suitable basis.
6.Imputed Cost: this type of cost is neither spent nor recorded in the books of
account. These costs are not actually incurred (hence known as hypothetical or
notional costs) but are considered while making a decision. For example, in
accounting, interest and rent are recognized only as expenditure when they are
actually paid. But in costing, they are charged on a notional basis while
ascertaining the cost of a product. 7.Out-Of-Pocket Cost: it is the cost which
involves current or future expenditure outlay, based on managerial decisions.
For example a company has its own trucks for transporting goods from one
place to another. It seeks to replace these by employing public carriers of
goods. While making this decision, management can ignore depreciation, but Unit IV MARGINAL COSTING
not the out-of-pocket costs in the present situation, i.e., fuel, salary to drivers Marginal costing-Meaning and Characters. Assumptions-Merits and Demerits
and maintenance paid in cash. of Marginal Costing. Equation-Contribution. Break Even Analysis-Break even
8.Marginal Cost: it is the aggregate of variable costs, i.e., prime cost plus point- Decision involving alternative choices-managerial applications of
variable overheads. marginal costing.
9.Replacement Cost: it is the cost of replacing a material or asset in the current ------------------------------------------------------------------------------------------------
market. 4.1. Marginal Costing
3.2.3. Cost Sheet The basic objectives of Cost Accounting are cost ascertainment and cost
Cost sheet is a statement presenting the items entering into cost of products or control. In order to help management in cost control and decision making, cost
services. It shows the total cost components by stages and cost per unit of accounting has developed certain tools and techniques. Marginal costing and
output during a period. It is usually prepared to meet three objectives: to Break even analysis are important techniques used for cost control and decision
provide the classification of costs in a summarised form, to prepare estimates of making.
costs for future use and to facilitate a comparative study of costs with previous Marginal Cost
cost sheets to know the cost trends The term Marginal cost means the additional cost incurred for producing an
3.2.4.Tenders And Quotations: additional unit of output. It is the addition made to total cost when the output is
While preparing tenders or quotations, manufacturers or contractors have to increased by one unit.
look into the figures pertaining to the previous year as shown in the cost sheet Marginal cost of nth unit = Total cost of nth unit- total cost of n-1 unit.
for that period. These figures have to be suitably modified in the light of Marginal cost is also equal to the total variable cost of production or it
is the aggregate of prime cost and variable overheads. The chartered Institute of
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

Management Accountants [CIMA] England defines Marginal as “the amount at Contribution = Fixed costs + Profit
any given volume of output by which aggregate costs are changed if the volume Therefore, Fixed cost = Contribution – Profit’
of output is increased or decreased by one unit Profit Volume Ratio [P/V Ratio].
Marginal Costing Contribution is an absolute measure of profitability but it cannot be used for
It is the technique of costing in which only marginal costs or variable are comparison of two products or departments. Therefore, the contribution is
charged to output or production. The cost of the output includes only variable related to volume of sales. It is called Contribution / Sales Ratio or
costs .Fixed costs are not charged to output. These are regarded as ‘Period Profit/Volume Ratio [P/V Ratio]
Costs’. P/V Ratio = Contribution/ Sales x100
These are incurred for a period. Therefore, these fixed costs are directly When the P/V Ratio is higher, profitability of the product will also be higher. It
transferred to Costing Profit and Loss Account. According to CIMA, marginal is an index of relative profitability of products or departments.
costing is “the ascertainment, by differentiating between fixed and variable Sales = Contribution
costs, of marginal costs and of the effect on profit of changes in volume or type ----------------
of output. P/V Ratio
Under marginal costing, it is assumed that all costs can be classified into fixed Contribution = Sales x P/V Ratio
and variable costs. Fixed costs remain constant irrespective of the volume of P/V Ratio can also be find out by the following formula :-
output. Variable costs change in direct proportion with the volume of output. P/V Ratio = Change in Profit/ Change in Sales x100
The variable or marginal cost per unit remains constant at all levels of output. Or P/V Ratio = Fixed Cost x 100/Break even sales
4.1.2.Features of Marginal Costing [Assumptions in Marginal Costing]
1. All costs can be classified into fixed and variable elements. Semi variable 4.1.4.Advantages of Marginal Costing
costs are also segregated into fixed and variable elements. Following are the advantages of Marginal costing
2. The total variable costs change in direct proportion with units of output. It 1. It is simple to understand and easy to apply to any firm
follows a linear relation with volume of output and sales. 2. There is no arbitrary apportionment of fixed cost in this system. Fixed costs
3. The total fixed costs remain constant at all levels of output. These are are transferred to costing profit and Loss account.
incurred for a period and have no relation with output. 3. It also prevents the illegal carry forward in stock valuation of some
4. Only variable costs are treated as product costs and are charged to output, proportion of current years fixed cost.
product, process or operation 4. The effect of different sales mix on profit can be ascertained and
5. Fixed costs are treated as ‘Period costs’ and are directly transferred to management can adopt the optimum sales mix
Costing Profit and Loss Account. 5. It is used in control of cost by concentrating on variable cost of production.
6. The closing stock is also valued at marginal cost and not at total cost. 6. It helps in profit planning by break even and cost volume profit analysis
7. The relative profitability of product or department is based on the 7. It helps management to take a number of short term decisions like pricing,
contribution it gives and not based on the profit output, closing down of department, sales mix, make or buy etc..
8. It is also assumed that the selling price per unit remains the same i.e, any Disadvantages
number of units can be sold at the current market price. Important disadvantages of marginal costing are ;
9. The product or sales mix remains constant over a period of time 1. All Assumptions of marginal costing are not appropriate. The assumption
Concept of Contribution fixed cost remains constant for all levels may not hold good in the long run.
Contribution is the excess of sales over marginal cost. It is not purely profit. It 2. The assumption that changes in direct proportion with the volume of also do
is the profit before recovery of fixed assets. Fixed costs are first met out of not hold good under all circumstances.
contribution and only the remaining amount is regarded as profit. Contribution 3. It is difficult to segregate all costs into fixed and variable elements.
is an index of profitability. It has a fixed relationship with sales. Larger the 4. The exclusion of fixed costs in ascertaining cost of production may give
sales more will be the contribution and vice versa. misleading results and lead to non recovery of total costs.
Contribution = Sales – Marginal cost 5. The exclusion of fixed costs from inventories affect profit and financial
4.1.3.Marginal cost equation statements may not reflect true and fair view of financial affairs.
Sales-Marginal cost = Contribution 4.15.Marginal costing and Absorption costing
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

Marginal costing is the practice of charging only variable costs to cost of It is the graphical presentation of breakeven point. It shows the relationship
production, leaving fixed costs to be charged to the costing profit and loss between sales volume, variable and fixed costs. It also shows the profit or loss
account. at different levels of output or volume of sales.
In Absorption costing or Total costing all types of costs are charged to output or Angle Of Incidence
process. While variable costs are wholly allocated to output or production, fixed It is the angle caused by the intersection of the total sales line and total cost line
costs are apportioned and a portion is charged to output or production. The at the Break even point. The width of the angle represents the rate of
profits disclosed under the two methods will be the same, provided there is no profitability i.e, the larger the angle the greater will be the profit the business is
closing stock. But in the event of closing stock, the profits disclosed will be making on additional sales
different under the two methods. This is due to the practice followed in stock Margin Of Safety
4.1.6. Cost-Volume Profit Analysis [ CVP Analysis] Margin of safety represents the strength of the business to face an adverse
It is the study of the impact of a change in cost , price and volume on profit. market condition. It is the excess of actual sales over break even sales. Higher
Break even analysis is a narrow interpretation of cost volume profit analysis. the Margin of safety, better the position of the firm.
But it is mainly confined to finding out the Break even point. In CVP analysis Margin of safety = Actual sales- Break even sales
the relationship between cost, volume and profit is studied in detail. It helps Margin of safety = Profit / P/V Ratio
management in profit planning, decision making and cost control. Or Profit = margin of safety x P/V Ratio
Break Even Analysis Managerial uses of Marginal Costing and Break Even Analysis
Every business is interested in ascertaining the breakeven point. It is the level of Marginal costing and Beak even analysis are very useful to management. The
operation where total revenue or sales are equal to total cost. It is the point of important uses of marginal costing and Break Even analysis are the following
no profit or no loss. The contribution received at Breakeven point is just 1. Profit Planning; The first step in profit planning is the ascertainment of
sufficient to meet the fixed costs, leaving nothing as profit. The firm ceases to Break even point. It is the level of operation when there is no profit no loss.
incur losses at this point or it starts to earn a profit from this point. Breakeven Once BEP is found out the management can decide upon the required level of
point can be expressed in algebraic method or graphical method. sales to earn a particular amount of profit.
Algebraic Method 2. Cost control: Cost control is an important function of management. In
Breakeven point may be expressed in terms of number of units to be produced, marginal costing all costs are classified into fixed and variable elements. Fixed
or in terms of volume of sales or in terms of the capacity of operation. It can be costs are generally non controllable in nature. But variable costs can be
calculated by the following formula. controlled by managerial actions. Therefore, managerial attention is drawn
1.Break even point in units = Total Fixed costs/Contribution per unit towards the control of variable costs in marginal costing.
2.Break even point in value = Total Fixed costs / P/V Ratio 3. Decision making
or Total Fixed cost/ Contribution x sales Marginal costing helps to take important managerial decisions like ;-
3.Break even point (in % of capacity utilization) = 1. Fixation of selling price under different market conditions
Total Fixed Costs/ Contribution x 100 2. Whether to accept a special order or not
Target Profit 3. Whether to accept an export order or not
The Break even analysis can guide an organization to determine the volume of 4. Selection of suitable product or sales mix
sales required to earn a desired level of profit. The firm can decide upon the 5. Make or buy decisions
target return or profit in advance. To achieve this profit, efforts would be taken 6. Whether to discontinue a product or not
to increase the volume of sales. The volume of sales required to achieve the 7. Closing down of a department
desired level of profit may be computed as follows :- 8. Merger of plant capacities
Number of units to be sold = Fixed costs + desired Profit/ Contribution per unit 9. Key factor or limiting factor
10. Shut down or continue
Sales volume required = Fixed costs+ Desired Profits/P/V Ratio
Break Even Chart [Graphic Method] 1. Fixation of selling price
Selling price is actually the profit plus cost. But under severe competition or in
a depressed market, it may not be possible to earn a uniform profit on sales.
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

Some times the price may be fixed even below the cost. In marginal costing any
product which gives the positive contribution is profitable and recommended in
the long run.
2. Selection of a Product/ sales mix
The marginal costing technique is useful for deciding the optimum
product/sales mix. The product which shows higher P/V ratio is more
profitable. Therefore, the company should produce maximum units of that
product which shows the highest P/V ratio so as to maximize profits.
3. Make or buy decision
Marginal costing helps the management in deciding whether to make a
component part within the factory or to buy it from an outside supplier. Here,
the decision is taken by comparing the marginal cost of producing the
component part with the price quoted by the supplier. If the marginal cost is
below the supplier’s price, it is profitable to produce the component within the Unit V Budgetary Control
factory. Whereas if the supplier’s price is less than the marginal cost of Introduction –meaning of Budget. Meaning and need of budgetary control.
producing the component, then it is profitable to buy the component from Merits and demerits-objectives. Different types of budgets- Preparation of
outside. budget -Cash budget- flexible budget and other budgets.
4. Closing down of a department or discontinuing a product --------------------------------------------------------------------------------------------
The firm that has several departments or products may be faced with this 5.2. 1. Meaning and Definition of Budget
situation, where one department or product shows a net loss. Should this We are all well-familiar with the term budget. Budgeting is a powerful tool that
product or department be eliminated? In marginal costing, so far as a helps the management in performing its functions such as planning,
department or product is giving a positive contribution then that department or coordinating, and controlling the operations efficiently. The definition of
product shall not be discontinued. If that department or product is discontinued budget is,
the overall profit is decreased. A plan quantified in monetary terms prepared and approved prior to a define
5. Limiting factor or key factor period of time usually showing planned income to be generated and/or
A limiting factor or key factor is defined as the factor which restricts the expenditure to be incurred during the period and the capital to be employed to
volume of operation of the firm. Sometimes a firm may be confronted with attain a given objective.
scarce supply of materials , labour hours or production capacities . when there ---CIMA, England
is a limiting factor in operation, the product that gives a higher contribution per 5.2.2.Budget, Budgeting, and Budgetary Control
unit of the limiting factor is more profitable than other products . therefore Budget
contribution is related to unit of the limiting factor and choose the product mix Budget represents the objectives of any organization that is based on the
based on higher contribution per unit of the limiting factor. implication of forecast and related to planned activities.
------------------------------------------------------------------------------------------------ Budget is neither an estimate nor a forecast because an estimation is a
predetermination of future events, may be based on simple guess or any
scientific principles.
Similarly, a forecast may be an anticipation of events during a specified period
of time. A forecast may be for a specific activity of the company. We normally
forecast likely events such as sales, production, or any other activity of the
organization.
On the other hand, budget relates to planned policy and program of the
organization under planed conditions. It represents the action according to a
situation which may or may not take place.
Budgeting
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

Budgeting represents the formation of the budget with the help and organization chart explaining clearly the position of each executive's authority
coordination of all or the various departments of the firm. and responsibility of the firm. All the functional heads are entrusted with the
Budgetary Control responsibility of ensuring proper implementation of their respective
Budgetary control is a tool for the management to allocate responsibility and departmental budgets.
authority in planning for future and to develop a basis of measurement to (2) Budget Center: A Budget Center is defined by the terminology as "a
evaluate the efficiency of operations. section of the organization of an undertaking defined for the purpose of
A budget is a plan of the policy to be pursued during a defined time period. All budgetary control." For effective budgetary control budget centre or
the actions are based on planning of budget because budget is prepared after departments should be established for each of which budget will be set with the
studying all the related activities of the company. Budget gives a help of the head of the department concerned.
communication ground to the top management with the staff of the firm who (3) Budget Officer: Budget Officer is usually some senior member of the
are implementing the policies of the top management. accounting staff who controls the budgetary process. He does not prepare the
Budgetary control helps in coordinating the economic trends, financial position, budget himself, but facilitates and co-ordinates the budgeting activity. He
policies, plans, and actions of an organization. assists the individual departmental heads and the budget committee, and
Budgetary control also helps the management to ensure and control the plan and ensures that their decisions are communicated to the appropriate people.
activities of the organization. Budgetary control makes it possible by (4) Budget Committee: Budget Committee comprising of the Managing
continuous comparison of actual performance with that of the budgets. Director, the Production Manager, Sales Manager and Accountant. The main
Budgets are the individual objectives of a department whereas budgeting may objectives of this committee is to agree on all departmental budgets, normal
be said to be the act of building budgets. Budgetary Control embraces all this standard hours and allocations. In small concerns, the Budget Officer may co-
and in addition, includes the science of planning the budgets themselves and ordinate the work for preparation and implementation of budgets. In large-scale
utilization of such budget to effect an overall management tool f or the business concern a budget committee is setup for preparation of budgets and execution
planning and control. of budgetary control.
5.2.3.Objectives of Budgetary Control (5) Budget Manual: A Budget Manual has been defined as "a document which
Budgetary Control is planned to assist the management for policy formulation, set out the responsibilities of persons engaged in the routine of and the forms
planning, controlling and co-ordinating the general objectives of budgetary and records required for budgetary control." It contains all details regarding the
control and can be stated in the following ways: plan and procedures for its execution. It also specifies the time table for budget
(1) Planning: A budget is a plan of action. Budgeting ensures a detailed plan of preparation to approval, details about responsibility, cost centers, constitution
action for a business over a period of time. and organization of budget committee, duties and responsibilities of budget
(2) Co-ordination: Budgetary control co-ordinates the various activities of the officer.
entity or organization and secure co-operation of all concerned towards the (6) Budget Period: A budget is always related to specified time period. The
common goal. budget period is the length of time for which a budget is prepared and
(3) Control: Control is necessary to ensure that plans and objectives are being employed. The period may depend upon the type of budget. There is no specific
achieved. Control follows planning and co-ordination. No control performance period as such. However, for the sake of convenience, the budget period may be
is possible without predetermined standards. Thus, budgetary control makes fixed depending upon the following factors:
control possible by continuous measures against predetermined targets. If there (a) Types of Business
is any variation between the budgeted performance and the actual performance, (b) Types of Budget
the same is subject to analysis and corrective action. (c) Nature of the demand of the product
5.2.4.Organization for Budgetary Control (d) Length of trade cycle
In order to introduce budgetary control system, the following are essential to be (e) Economic factors
considered for a sound and efficient organization. The important aspects to be (f) Ava!lability of accounting period
considered are : (g) Availability of finance
(1) Organisation Chart: For the purpose of effective budgetary control, it is (h) Control operation
imperative on the part of each entity to have definite "plan of organization." (7) Key Factor: Key Factor is also called as "Limiting Factor" or Governing
This plan of organization is embodied in the organization chart. The Factor. While preparing the budget, it is necessary to consider key factor for
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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

successful budgetary control. The influence of the Key Factor which dominates (4) The system does not substitute for management. It is mere like a
the business operations in order to ensure that the functional budgets are management tool.
reasonably capable of fulfilment. The Key Factors include. (5) Budgeting may be cumbersome and time consuming process.
(1) Raw materials may be in. short supply. 4.2.7. Types of Budgets
(2) Non-availability of skilled labours. As budgets serve different purposes, different types of budgets have been
(3) Government restrictions. developed. The following are the different classification of budgets developed
(4) Limited sales due to insufficient sales promotion. on the basis of time, functions, and flexibility or capacity.
(5) Shortage of power. (A) Classification on the Basis of Time
(6) Underutilization of plant capacity. 1. Long-Term Budgets: Long-term budgets are prepared for a longer period
(7) Shortage of efficient executives. varies between five to ten years. It is usually developed by the top level
(8) Management policies regarding lack of capital. management. These budgets summarise the general plan of operations and its
(9) Insufficient research into new product development. expected consequences. Long-Term Budgets are prepared for important
(10) , Insufficiency due to shortage of space. activities like composition of its capital expenditure, new product development
5.2.5.Advantages of Budgetary Control and research, long-term finance etc.
The advantages of budgetary control may be summarized as follows : 2. Short-Term Budgets: These budgets are usually prepared for a period of
(1) It facilitates reduction of cost. one year. Sometimes they may be prepared for shorter period as for quarterly or
(2) Budgetary control guides the management in planning and formulation of half yearly. The scope of budgeting activity may vary considerably among
policies. different organization.
(3) Budgetary control facilitates effective co-ordination of activities of the 3. Current Budgets: Current budgets are prepared for the current operations of
various departments and functions by setting their limits and goals. the business. The planning period of a budget generally in months or weeks. As
(4) It ensures maximization of profits through cost control and optimum per ICMA London, "Current budget is a budget which is established for use
utilization of resources. over a short period of time and related to current conditions."
(5) It evaluates for the continuous review of performance of different budget (B) Classification on the Basis of Function
centers. 1. Functional Budget: The functional budget is one which relates to any of the
(6) It helps to the management efficient and economic production control. functions of an organization. The number of functional budgets depend upon
(7) It facilitates corrective actions, whenever there is inefficiencies and the size and nature of business. The following are the commonly used:
weaknesses comparing actual performance with budget. (1) Sales Budget
(8) It guides management in research and development. (2) Purchase Budget
(9) It ensures economy in working. (3) Production Budget
(10) It helps to adopt the principles of standard costing. (4) Selling and Distribution Cost Budget
5.2.6.Limitations of Budgetary Control (5) Labour Cost Budget
Budgetary Control is an effective tool for management control. However, it has (6) Cash Budget
certain important limitations which are identified below: (7) Capital Expenditure Budget
(1) The budget plan is based on estimates and forecasting. Forecasting cannot 2. Master Budget: The Master Budget is a summary budget. This budget
be considered to be an exact science. If the budget plans are made on the basis encompasses all the functional activities into one harmonious unit. The ICMA
of inaccurate forecasts then the budget progamme may not be accurate and England defines a Master Budget as the summary budget incorporating its
ineffective. functional budgets, which is finally approved, adopted and employed.
(2) For reasons of uncertainty about future, and changing circumstances which (C) Classification on the Basis of Capacity
may develop later on, budget may prove short or excess of actual requirements. 1. Fixed Budget: A fixed budget is designed to remain unchanged irrespective
(3) Effective implementation of budgetary control depends upon willingness, of the level of activity actually attained.
co-operation and understanding among people reasonable for execution. Lack 2. Flexible Budget: A flexible budget is a budget which is designed to change
of co-operation leads to inefficient performance. in accordance with the various level of activity actually attained. The flexible

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DR. S. Kamalasaravanan,, Associate Professor of Management Sciences, Hindusthan College of Engineering and Technology, Coimbatore-32

budget also called as Variable Budget or Sliding Scale Budget, takes both fixed,
variable and semi fixed manufacturing costs into account.
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