MBA - Financial and Management Accounting

How to Use Self-Learning Material?
The pedagogy used to design this course is to enable the student to assimilate the concepts
with ease. The course is divided into modules. Each module is categorically divided into units or
chapters. Each unit has the following elements:
Table of Contents: Each unit has a well-defined table of contents. For example: “1.1.1.
(a)” should be read as “Module 1. Unit 1. Topic 1. (Sub-topic a)” and 1.2.3. (iii) should
be read as “Module 1. Unit 2. Topic 3. (Sub-topic iii).
Aim: It refers to the overall goal that can be achieved by going through the unit.
Instructional Objectives: These are behavioural objectives that describe intended

learning and define what the unit intends to deliver.
Learning Outcomes: These are demonstrations of the learner’s skills and experience
sequences in learning, and refer to what you will be able to accomplish after going
through the unit.
Self-Assessment Questions: These include a set of multiple-choice questions to be

answered at the end of each topic.
Did You Know?: You will learn some interesting facts about a topic that will help you
improve your knowledge. A unit can also contain Quiz, Case Study, Critical Learning
Exercises, etc., as metacognitive scaffold for learning.
Summary: This includes brief statements or restatements of the main points of unit and
summing up of the knowledge chunks in the unit.
Activity: It actively involves you through various assignments related to direct application
of the knowledge gained from the unit. Activities can be both online and offline.
Bibliography: This is a list of books and articles written by a particular author on a

particular subject referring to the unit’s content.
e-References: This is a list of online resources, including academic e-Books and journal
articles that provide reliable and accurate information on any topic.
Video Links: It has links to online videos that help you understand concepts from a
variety of online resources.
Financial and Management Accounting

LEADERSHIP KLEF
President Vice Chancellor

Er. Koneru Satyanarayana Dr. G. Pardha Saradhi Varma
Pro-Vice Chancellor Incharge Registrar

Dr. N. Venkatram Dr. K. Subbarao

CREDITS
Author
Dr. K. Hema Divya
Director CDOE
C. Shanath Kumar
Instructional Designer
Nabina Das
Content Editor
M. Mounika
Project Management
K. D. N. Lakshmi
Graphic Designer
B. V. Satyanarayana

First Edition, 2023.
KL Deemed to be University-CDOE has full copyright over this educational material. No

part of this document may be produced, stored in a retrieval system, or transmitted, in any
form or by any means.

Author’s Profile
Dr. K. Hema Divya, MBA, Mphil, PhD, is currently Deputy Head of the Department and Associate
Professor in Department of MBA, K L Business School, KL University. She has specialised in
the areas of Accounting, Finance and Analytics with 15 years of experience. She has published
11 Scopus-indexed papers and 10 papers in UGC Care-indexed journals. She has organised
various Faculty development programmes and workshops in the area of Finance and also
attended various national and international conferences. She also obtained a patent from Govt
of India Intellectual Property Rights in 2021.
She is a member of World Economic Association and International Society of Research and
Development. She is a reviewer for various international Journals. One PhD has also been
awarded under her guidance in the area of Finance in the year 2021. She has published one
textbook titled “Determinants of Equity share prices of companies listed in Sensex”.

Course Description
Financial and Management Accounting is a basic level course in accounting. It lays foundation to
other courses of accounting. This course begins with the basic concepts of accounting, process
of accounting, types of accounting and preparation of financial statements by a sole trading
concern and as well as a company form of organisation. This course explains the various tools
required to analyse the financial statements of a company and provides an analytical way of
analysing the performance of the company. It covers financial accounting and management
accounting required by management students which helps them to grasp and analyse the
financial statements of the company. Through this course, students will be able to explain the
books required to be maintained, procedure for recording and classifying of transactions into
various accounts, preparation of income statement and balance sheet and how to analyse the
financial statements for evaluating the performance of a company during a financial period.
The purpose of accounting is to accumulate and report financial information about the performance,
financial position, and cash flows of a business. This information is then used to reach decisions
about how to manage the business, or invest in it, or lend money to it. Financial statements, the
result of financial accounting, will help the investors in making decisions about whether to invest
or not to invest in a particular company. Break-even point and cost volume profit analysis can be
prepared which helps in management decision-making.
Put another way, accounting is the lifeblood of a business. All types of businesses have basic
information that is recorded to get that job done. Accounting is a way to communicate the
financial health of a business or an organisation to any interested parties, and is also a method
of assessing the assets, liabilities, and cash flow – or the future of an entity for all current and
future investors. So, even though accounting is not business, it is a vital part of the contemporary
business environment. The role of accounting in the current economy is an important one, as is
the role of management accounting in modern business.
By the end of this course, Students will be able to analyse the financial performance through
ratios and can advise the management on key areas where more focus is required in the near
future. This course lays down the foundation for any accounting course and provides a framework
for understanding the language of business.

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The Financial and Management Accounting Course contains 4 Modules.
Module 1: Introduction to Accounting
Accounting: Book-keeping – Users of Accounting information – Classification of Accounting –

Accounting concepts and conventions – Accounting standards and GAAP – Double entry sys-
tem – Journal – Ledger. Trial Balance – Subsidiary Books – Cash Book.
Module 2: Preparation of Financial Statements
Trading and Profit & Loss Account - Balance Sheet with Adjustments (problems) - Methods of
Depreciation. - Ratio Analysis (problems).
Module 3: Company Accounts
Issue of shares (entries) Companies Financial Accounts as per schedule 6 part I & Part II. For-
mats: Banking Accounts, Insurance Accounts and Electricity Accounts.
Module 4: Management Accounting
Marginal Costing (problems) – Break-even Analysis (problems).

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Table of Contents
MODULE 1
INTRODUCTION TO ACCOUNTING
Unit 1.1 Introduction to Accounting
Unit 1.2 Accounting Concepts and Conventions
Unit 1.3 Accounting Cycle
MODULE 2
PREPARARTION OF FINANCIAL STATEMENTS
Unit 2.1 Financial Statements
Unit 2.2 Ratio Analysis
MODULE 3
COMPANY ACCOUNTS
Unit 3.1 Adjustments in Financial Statements
Unit 3.2 Issue of Shares
Unit 3.3 Company Final Accounts
MODULE 4
MANAGEMENT ACCOUNTING
Unit 4.1 Marginal Costing
Unit 4.2 Break-Even Analysis

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FINANCIAL AND MANAGEMENT ACCOUNTING
MODULE 1
UNIT 1
INTRODUCTION TO
ACCOUNTING

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MODULE 1
INTRODUCTION TO ACCOUNTING
Module Description
Accounting is regarded as language of Business. It plays a key role in business to keep track of
incomes and expenses, ensure statutory compliance, and provide financial information about the
performance of business to external parties like prospective investors, management and to the
government. Business trends and projections are based on historical financial data to keep your
operations profitable. This financial data is most appropriate when provided by well-structured
accounting processes.
By the end of this module, the students will be able to summarise accounting concepts and
principles followed in reporting of financial statements and able to summarise the process of
accounting from recording of transactions, posting of entries to preparation of Trial balance.
Chapter 1.1 Introduction to Accounting

Chapter 1.2 Accounting Concepts and Conventions
Chapter 1.3 Accounting Cycle

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Unit Table of Contents
Unit 1.1
1.1 Introduction to Accounting
Aim -------------------------------------------------------------------------------------------------------------- 7
Instructional Objectives ------------------------------------------------------------------------------------ 7
Learning Outcomes ----------------------------------------------------------------------------------------- 7
1.1.1 Definition of Accounting ----------------------------------------------------------------------------- 8

Self-Assessment Questions ----------------------------------------------------------------------- 10
1.1.2 Book-Keeping ----------------------------------------------------------------------------------------- 14
1.1.3 Users of Accounting Information ----------------------------------------------------------------- 17
1.1.4 Classification of Accounting ----------------------------------------------------------------------- 18
Summary ------------------------------------------------------------------------------------------------------- 21
Terminal Questions ------------------------------------------------------------------------------------------ 21
Answer Keys -------------------------------------------------------------------------------------------------- 22
Bibliography --------------------------------------------------------------------------------------------------- 22
e-References ------------------------------------------------------------------------------------------------- 23
Video Links ---------------------------------------------------------------------------------------------------- 23
Keywords ------------------------------------------------------------------------------------------------------ 23

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Aim
The main aim of this unit is to provide the basics of accounting, classification of
accounting and users of accounting information.
Instructional Objectives
In this unit, students will be able to:
1. Define accounting
2. Differentiate Accounting from Book-keeping
3. Summarise Accounting Information
4. Identify distinct types of accounting
Learning Outcomes
At the end of the unit, students are expected to:
1. Illustrate the meaning of accounting
2. Compare and contrast the features of Accounting and Book-keeping
3. Analyse to whom accounting information is useful
4. Differentiate between Financial Cost and Management Accounting

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1.1 Introduction to Accounting
Accounting is the life blood of a business. All types of businesses have basic information that
is recorded to get that job done. Accounting is a way to communicate the financial health of a
business or an organisation to any interested parties, and is also a method of assessing the
assets, liabilities, and cash flow – or the future of an entity for all current and future investors.
So, even though accounting is not business, it is a vital part of the contemporary business
environment.
1.1.1 Definition of Accounting
“Accounting is the process of identifying, recording, classifying, and summarising in a significant

manner and in terms of money, transactions and events which are, in part at least, of financial
character, interpreting and communicating the results thereof.”
Attributes of Accounting:
The above definition of accounting brings out the following attributes of accounting:
1. Economic Events: It is the “happening of consequence” to a business entity and can be

divided into two parts
a) Internal Events: It is an economic event that occurs entirely within business.

Example: Supply of raw materials from stores department to manufacturing department.
b) External Events: It is a transaction which involves the transfer or exchange of
something for value between two or more people. Example: Sale of shoes by Bata and
company to its customers.
2. Identifying: Accounting records only those transactions and events which are of financial
character, therefore it is necessary to identify the recordable transactions. If an event cannot be
expressed in terms of money, then it is not considered for recording.
Example: manager’s honesty cannot be expressed in terms of money, hence not recorded in
books.
3. Recording: It is concerned with recording of identified events and transactions in the book of
original entry, i.e., in journal.
4. Classifying: It is concerned with classification of the recorded transactions based on their

nature at one place. Book containing several separate accounts is called ledger.
5. Summarising: This involves presenting the classified data in an understandable manner,

useful for internal as well as external users. This involves preparation of trial balance and final
accounts (trading account, profit and loss account and balance sheet).

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6. Analysing and interpreting: The recorded and classified data is analysed and interpreted in
a manner so that the end users such as creditors, bankers, managers, proprietors etc., can make
a meaningful judgment about the financial condition and profitability of the company.
7. Communicating: It involves presenting the analysed data in the form of financial reports or
statements, to the end users of the financial information, i.e., insiders and outsiders like officers,
staff members, shareholders, creditors, government, etc.

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Self-Assessment Questions
1. ________ is called as book of original entry.
(a) Ledger
(b) Journal
(c) Report
(d) Entry
2. Book of Final entry is called ___________.
(a) Ledger
(b) Journal
(c) Report
(d) Entry
3. ______________are called the eyes and ears of the business.
(a) Ledger
(b) Journal
(c) accounting records
(d) Entry
4. _____ statement is prepared to test the accuracy of accounts.
(a) Ledger
(b) Journal
(c) Report
(d) Trial Balance
5. Accounting deals with _____ data.
(a) Past
(b) Future
(c) Present
(d) None

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1.1.1.2 Functions of Accounting
The accounting process involves the following functions
1 To keep a systematic record of the financial activities: The first important function of
accounting is to keep a systematic record of the financial transactions of the business.
In accounting only those business transactions are recorded which can be expressed in
terms of money. Business transactions are properly recorded, classified into appropriate
accounts and summarised into financial statements.
2 To protect the properties of the business: Another important function of accounting is to

protect the properties of the business by maintaining proper records and providing up-to-
date information to the management. Thus, accounting records are called the eyes and
ears of the business.
3 To communicate the financial results: Accounting communicates the financial results and
other valuable financial information to the various interested groups such as officers,
creditors, employees, government, consumers.
4 To prevent and detect errors and frauds: The most important function of accounting is that
it helps in detecting errors and frauds, if any take place by maintaining proper records.
1.1.1.3 Advantages of Accounting

The main advantages of accounting are
Helpful in taking managerial decisions: Accounting provides operating and financial

performance of the business which is needed by management for taking planning and
controlling decisions.
Facilitates comparative study: A systematic record enables a businessperson to compare
one year’s results with those of other years and locate significant factors leading to the
change, if any.
Facilitates control: Accounting records enable a business concern to keep good control
over various activities and properties.
Information about debtors and creditors: Accounting records disclose the amounts due to
a business and the people from whom the amounts are due.
Helpful in assessment of tax liability: A systematic accounting record helps in assessing
the tax liability. The tax requirements can be satisfied, and tax liability can be calculated easily
with the help of accounting records.
Facilitates sale of business: if someone desires to sell his business, the accounts maintained
by him will enable the ascertainment of the proper purchase price.

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1.1.1.4 Limitations of Accounting
1. Based on accounting concepts and conventions: The results disclosed by financial state-
ments are not realistic as they are based on various accounting concepts and conventions. For
instance, fixed assets are shown at their historical cost and not at their market price.
2. Accounting can lead to window dressing: The management of the business can present
financial statements to meet their own needs by showing more profit or less profit than the
actual value. This is done by window dressing, i.e., showing the items at the convenience of the
management. For example, closing stock may be over or under valued than the true value.
3. Accounting ignores the effect of changes in price level: Accounting statements are
prepared at historical cost. Assets are shown in the books of account at the original cost. Thus,
assets do not disclose a true and fair view and the balance sheet does not reflect the true
financial position of the entity.
4. Accounting ignores the qualitative elements: Accounting is concerned with quantitative

elements only; qualitative elements like quality of management and labor force are ignored.
5. Based on Unrealistic information: Actual profit of the business can be known only when the
business is shut down and closing stock is valued at realisable value. For example, assets are
recorded at historical cost and accounts are prepared on a going concern basis, which provide
unrealistic financial information.

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5. The first important function of accounting is to keep a systematic record of the financial
transactions of the business.
(a) Yes
(b) No
6. Accounting may lead to window dressing.
(a) Yes
(b) No
7. Accounting statements are prepared at Actual cost.
(a) Yes
(b) No
8. Accounting ignores the quantitative elements.
(a) Yes
(b) No
9. Accounting statements reflect the true and fair value of financial information.
(a) Yes
(b) No

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Luca Pacioli is called the ‘father of accounting’ because he wrote the first book
DID that described double-entry accounting processes. The basic system of double
YOU entry bookkeeping was invented more than five hundred years ago by a Cistercian
KNOW
monk called Luca Pacioli. His system still endures today and is used throughout the
world, making bookkeeping a truly international profession.
1.1.2 Meaning of Book-keeping

R.N.Charter states that book-keeping is the art of recording the financial transactions of a
business, in terms of money, in a set of books accurately and systematically to obtain necessary
information.
Book-keeping is concerned with:

a. Identifying financial transactions and events. t
b. Measuring them in terms of money.
c. Recording the financial transactions and events in journal book.
d. Classifying recorded transactions and events i.e., posting them into ledger accounts.
1.1.2.1 Meaning of Accountancy

Accounting refers to a systematic knowledge of accounting concerned with principles and
techniques. It explains how to deal with various aspects of accounting. It educates as why and
how to maintain the books of accounts and how to summarise the accounting information and
communicate it to the various users.
According to Kohler, “Accountancy refers to the entire body of the theory and practice of
accounting.”
1.1.2.2 Difference between book-keeping and accounting
S.no Basis of Difference Book-Keeping Accounting
It is concerned with identi-
It is concerned with summaris-
fying financial transactions;
ing the recorded transactions,
1 Nature measuring them in mone-
interpreting them and commu-
tary terms; recording and
nicating the results.
classifying them.
It aims at ascertaining business
It is to maintain systematic income and financial position
2 Objective records of financial by maintaining records of busi-
transactions. ness transactions.
It is recording, classifying,
It is to record business summarising, interpreting
3 Function transactions. So, its scope business transactions and
is limited. communicating the results.
Thus, its scope is wide.

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Vouchers and other support-
ing documents are neces- Book-keeping work as the ba-
4 Basis
sary as evidence to record sis for accounting information.
the business transactions.
It is enough to have elemen- For accounting, advanced, and

Level of tary knowledge of account- in-depth knowledge and under-
5
knowledge ing to do book-keeping. standing is required.
Book-keeping is the first Accounting begins when book-

6 Relation
step of accounting. keeping ends.

15
11.____ is the art of recording the financial transactions of a business.
(a) Book-keeping
(b) Journal
(c) Accounting records
(d) Entry
12. Book-keeping records only those transactions which can be measured in money.
(a) Yes
(b) No
13. Summarising is not a part of Book-keeping.
(a) Yes
(b) No
14. Accounting follows Book-keeping.
(a) Yes
(b) No
15. Scope of Accounting is wide.
(a) Yes
(b) No

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‘Book-keeping’ is the only English word to contain three sets of double letters
DID
YOU back-to-back! The word ‘accounting’ comes from the French verb ‘computer’
KNOW meaning to count or score. The words ‘debits’ and ‘credits’ come from the Latin
words ‘debitum’ and ‘creditum’
1.1.3 Various Users of Accounting Information
Accounting is an information system which identifies records and communicates this information
to the interest users in the form of financial statements. These financial reports are transferred to
the users in two forms -- internal and external. Internal financial reports are used by an individual
who runs, manages, and operates the daily activities of an inside area of an organisation. Manager,
supervisor, financial director are the most featured examples of internal users. External financial
reports are used by individuals and organisations who want financial accounting information.
External users are not part of the management of the company.
1. Creditors: Creditors are focused on that information which are related to the borrower before
making a large loan such as the Bank will want information about the borrower to repay the loan,
the amount of assets and liabilities of the borrower, evidence of income, tax policies, and so on.
2. Investors: Investors provide money to individuals or organisations to start a business. Before
investing money investors want to know whether they should invest or not or if they would invest
to start a business now then how much return they will get from their investment.
3. Government regulatory agencies: Government regulatory agencies like State government
agencies and security and exchange commission want financial accounting information which
is related to the investors, business organisations or any individuals. These regulatory agencies
want information to know whether the business organisations are following the business rules
and regulations or not or whether the investors are able to invest or make decisions or not.
4. Taxing authority: Taxing authority wants financial accounting information relating to the tax
policies, tax laws, amount of payable tax, etc. from the individual or organisation. The taxing
authority wants financial accounting information to know whether the business organisations are
following tax rules or not and their ability to pay income tax because income tax is based on the
financial accounting reports.
5. Suppliers and customers: Customers also want to know about company issues like warranty,
product development, etc. Suppliers want to know about the company’s future goals so that they
can serve the best material in coming days.
6. Employers and labour unions: Employers use accounting information for their own benefit.
Accounting information helps the employee to ensure their future benefit from the company like
pension, health provision, retirement benefit, etc. The Labour union wants accounting information
to know their future salary.

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1.1.4 Differences between Financial, Cost and Management Accounting
1. Key responsibilities
Cost and management accounting is for finance professionals and business managers or owners
whose role it is to maintain records to identify where to cut costs for increased profitability.
Purpose: Ascertain business costs for day-to-day planning, cost control, and internal decision
making.
Financial accounting is for accountants whose role it is to record all transactions and accurately
report the entire financial picture and performance of a business.
Purpose: Secure overall business financial information and report on performance and position.
2. Recording systems
Cost management professionals book actual transactions and compare them to estimates. They
then base reports on the estimation of cost and on the recording of actual transactions.
Purpose: Cost of sale of product(s), addition of a profit margin and determination of selling price
of the product.
Financial accounting professionals evaluate actual transactions only and do not use estimation
in recording financial transactions.
Purpose: Journal entries, ledger accounts, trial balance, cash flow and financial statements.
3. Target audience
Cost accounting involves the preparation of a broad range of reports that management needs to
run a business.
Purpose: The readers are exclusively internal management.
Financial accounting involves the preparation of a standard set of reports for an outside audience.
Purpose: The readers may include investors, creditors, credit rating agencies, and regulatory
agencies.
4. Period of profit
Cost management accounting is used as per the requirement of management or on an
as-and-when-required basis.
Purpose: Profit is determined related to a particular product, job, or process.
Financial accounting is required during the report period at the end of the fiscal year.
Purpose: Profit is determined for the whole organisation made during a particular period only.
5. Regulatory framework
Cost accounting involves creating reports that can be in any format specified by management.
There are no regulatory framework governing cost accounting reports so they can be tailored to
suit a
certain costing need or managerial demand.
Purpose: Cost accounting reports are voluntary and created with the intention of including only
that information pertinent to a specific decision or situation.

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The reports prepared under financial accounting are highly specific in their format and content.
The structure of financial accounting reports is tightly governed by either accepted accounting
principles or international financial reporting standards.
Purpose: Financial reports are a statutory requirement and ensure a business’s accounting
standards are compliant.
6. Measurement
Cost accounting compiles the costs of raw materials, work-in-process, and finished goods
inventory.
Purpose: Record the details for each product, process, job, or contract.
Financial accounting incorporates this information into its financial reports, primarily into the
balance sheet.
Purpose: To show overall costs and profit gains or losses.
7. Reporting
Cost accounting usually results in reports at a much higher level of detail within the company.
Purpose: Record internal and external transactions for present and future, such as for individual
products, product lines, geographical areas, customers, or subsidiaries.
Financial accounting’s primary focus is on reporting the results and financial position of an entire
business entity.
Purpose: Record external transactions only, with a focus on historical data. One way of doing
this would be to translate an annual accounting cycle from a source document into financial
statements.

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16. Accounting provides information to external parties.
(a) Yes
(b) No
17. Is it the right of investors to know the performance of the company.
(a) Yes
(b) No
18.__________ accounting is widely used for internal purpose.
(a) Financial
(b) Management
(c) Cost
(d) Inflation
19. Determination of selling price of the product is Purpose of _______Accounting.
(a) Financial
(b) Management
(c) Cost
(d) Inflation
20. Financial accounting is required during the report period at the end of the fiscal year.
(a) Yes
(b) No
The development of joint-stock companies (especially from about 1600) built

wider audiences for accounting information, as investors without first-hand
DID knowledge of their operations relied on accounts to provide the requisite
YOU information. This development resulted in a split of accounting systems for
KNOW internal (i.e., management accounting) and external (i.e., financial accounting)
purposes, and subsequently also in accounting and disclosure regulations and
in a growing need for independent attestation of external accounts by auditors.

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Summary
1. Accounting is the process of identifying, recording, classifying, and summarising financial

transactions of an organisation during a particular fiscal year.
2. Accounting information is widely used by both internal and external parties to know the
performance of the company.
3. Accounting follows Book-keeping.
4. Cost and management accounting is for finance professionals and business managers or
owners whose role it is to maintain records to identify where to cut costs for increased prof
itability.
5. Financial accounting’s primary focus is on reporting the results and financial position of
an entire business entity.
Terminal Questions
1. Define Accounting and its Functions.
2. Explain Users of Accounting information.
3. Differentiating between Book-keeping and accounting.
4. Differentiate Financial and Management Accounting.
5. Discuss Accounting Process.

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Answer Keys
Question No. Answers
1 B
2 A
3 C
4 D
5 A
6 A
7 A
8 B
9 B
10 A
11 A
12 A
13 A
14 A
15 A
16 A
17 A
18 B
19 C
20 A

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Bibliography
Text Books
1. Libby, R., Libby, P., & Hodge, F. Financial Accounting (6th ed.). Tata McGraw-Hill.
2. Horngren, C. T., & Harrison, Jr. O. Financial & Management Accounting. PHI.
3. Drury, C. Cost & Management Accounting. Cengage Publishing.
4. Horngren, C. T., & Harrison Jr. O. Financial & Management Accounting. PHI.
e-References
1. https://www.accountingcoach.com/bookkeeping/explanation
2. https://www.toppr.com/guides/accounting-and-auditing/theoretical-framework-of-
accounting/merits-and-demerits-of-accounting/
3. https://web.ung.edu/media/university-press/Principles-of-Financial-Accounting.
pdf?t=1542408454385
Video Links
Topic Link
Fields of Accounting or Types of Ac- https://www.youtube.com/

counting watch?v=k8vRgk8-LSw
Book Keeping Vs Accounting - Impor- https://www.youtube.com/watch?v=W-

tance of Accounting GaKqd9cSP4
Keywords
• Journal
• Accounting records
• Inflation

23
MODULE 1
UNIT 2
ACCOUNTING CONCEPTS
AND CONVENTIONS

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Unit – 1.2 Accounting Concepts and Conventions
Aim --------------------------------------------------------------------------------------------------------------- 26
Instructional Objectives ------------------------------------------------------------------------------------- 26
Learning Outcomes ------------------------------------------------------------------------------------------ 26
1.2.1 Accounting Concepts ------------------------------------------------------------------------------ 27

Self-Assessment Questions ---------------------------------------------------------------------- 28
1.2.2 Accounting Conventions -------------------------------------------------------------------------- 31
Self-Assessment Questions ---------------------------------------------------------------------- 32
Summary -------------------------------------------------------------------------------------------------------- 35
Case lets -------------------------------------------------------------------------------------------------------- 36
Terminal Questions ------------------------------------------------------------------------------------------- 36
Answer Keys -------------------------------------------------------------------------------------------------- 37
Glossary --------------------------------------------------------------------------------------------------------- 38
Bibliography ---------------------------------------------------------------------------------------------------- 38
e-References -------------------------------------------------------------------------------------------------- 38
Video links ------------------------------------------------------------------------------------------------------ 38
Keywords ------------------------------------------------------------------------------------------------------- 39

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Aim
The primary goal of this unit is to improve comprehension of accounting concepts and
convections, upon which a theory is built, that companies incorporate, while reporting
financial statements.
This unit intends to:
• Elaborate concepts of accounting
• Examine accounting conventions
Learning Outcomes
After the completion of this unit, students will be able to:
• Apply the accounting concepts
• Analyse the range of accounting conventions

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Accounting Concepts and Conventions
Accounting concepts are the assumptions upon which financial statements of a business
organisation are prepared. These are the fundamental assumptions and terms that act as the
foundation for accounting. The same will help to maintain consistency and regularity in the
process of preparation of accounting reports. They help us to understand the business rules and
regulations that are required to be adopted by all types of business entities. Hence, they simplify
detailed and comparable financial information.
1.2.1 Accounting Concepts
The main concept of accounting refers to basic assumptions, rules, and principles that an
accountant needs to follow and serves as a basis for recording business transactions and
preparation of accounts. This concept of accounting brings to light those commercial enterprises
and their owners as two separate and independent accounting entities.
1. Separate business entity concept: This concept explains that the owner is different
from the business. An owner and a business are two different entities. A business is a
separate entity which has its own assets and liabilities. Business has its own signature in
the form of a common seal. Business can sue anyone, and anyone can sue business. It
is a separate legal entity. For example. When business is started by the owner, business
sees the owner as separate entity and taking this concept, capital contributed by owner
is shown as liability which indicates that business must repay back to its owner.
2. Double entry concept: This concept says that for every debit there will be corresponding
credit with an equal amount. In business, every transaction will have two aspects, one is
debit and another one is credit. Every transaction must be recorded twice in the books
of accounts, such recording of debit and credit is termed as double entry concept.
Accounting equation coins the above rule as Assets = Liabilities + Owners Equity. For
example, purchased goods Rs 5000. This transaction involves two aspects. one is
purchasing of goods and second one is cash. The balance in the purchase account
must be increased and the balance in the cash account needs to be decreased. For
this, purchase accounts must be debited and cash accounts to be credited.
3. The concept of ongoing concern: It states that the business activity will be carried
out for the indefinite future. It means that while maintaining books of accounts an
assumption is that business will be carried out for an extended period, that means
business entity is immortal.
4. Matching concept: It states that the incomes and expenses of a business entity which
is recorded in the books should belong to the same accounting period. It means that It
facilitates comparison of revenue with expenses related to the same accounting period.
Using this concept expenses and incomes are adjusted in the books of accounts.

27
1. Which concept explains that financial accounting purposes, the business enterprise,
and its owners are two separate independent entities:
(a) Money Measurement Concept

(b) Going Concern Concept
(c) Business Entity Concept
(d) Cost Concept
2. If all the business transactions are expressed in monetary terms, it will be easy to
understand the accounts prepared by the business enterprise.
(a) Business Entity Concept

(b) Revenue Recognition Concept
(c) Money Measurement Concept
(d) Going Concern Concept
3. This concept states that a business firm will continue to carry on its activities for an
indefinite period.
(a) Money Measurement Concept

(b) Historical Cost Concept
(c) Going Concern Concept
(d) Dual Aspect Concept
4. This concept requires assets to be shown at the price that has been acquired, which
can be verified from the supporting documents.
(a) Historical Cost Concept

(b) Accounting Period Concept
(c) Revenue Recognition Concept
(d) Matching Concept
5. It helps in knowing actual expenses and actual income during a particular time.
(a) Matching Concept

(b) Accrual Concept
(d) Cost Concept

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5. Money measurement concept: It states that a business entity can record only those
items that can be measured in money. Those transactions that can be quantifiable will
only be recorded. Non-monetary items cannot be recorded as accounting transactions
because they cannot be expressed in terms of money. A few examples are Skills of
employee, working conditions of staff, resale value of intangible asset etc., As the above-
stated transactions cannot be measured, in terms of money they are not recorded in
books of accounts.
6. Realisation concept: This concept is an income recognition principle which states

that the income or revenue is recognised or recorded only when it is earned. This
Concept defines that income or revenue must be entered in the records only when
they are recognised though not received. This principle gets recognised once goods
are delivered. For example, if you receive a deposit but the goods are not transferred,
you cannot recognise the income. It is to be recognised only when goods are delivered.
7. Accrual concept: An accrual is an important concept which states revenues and

expenses that have been earned or consumed must be recognised respectively, even
though for which the amounts have not yet been received or paid-out or due or yet to
be received or yet to be paid. For example, rent outstanding, prepaid insurance etc.,
Accrual concept defines that all expenses and revenues will be identified within the
current reporting period without considering the timing of cash flow. This Concept of
accounting helps in identifying the actual revenue, expense and profit and loss along
with the actual level of economic activity. It plays a key role in the closing process of
books of accounts for preparation of financial statements.
8. Accounting period concept: Accounting period concept states that every business
organisation has to main books of accounts for certain period to determine whether it
has derived profit /loss during that period. Maintaining accounting records for a specific
period helps the organisations to trace and analyse the overall performance of each
company during a specific time. When there are two different periods, various financial
parameters can be used to analyse and compare, and suggestions can be drawn up
for the growth or the downfall of the company. It serves as a reference to such a report
and is extremely useful for the stakeholders.
Accounting periods are two types
1. Calendar Year: Accounting books are opened on 1st January and closed on 31st
December of the same year.
2. Fiscal Year: Accounting books are opened on the first day of any month other than
January and are closed at the end of the same month of next year.

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6. ‘For every debit, there should be corresponding credit with equal amount’ is stated by
___ concept.
(a) Business Entity

(b) Money Measurement
(c) Dual Aspect
(d) Going Concept
7. ‘Business and its owner are different’ is explained by:
(a) Business Entity

(b) Money Measurement
(c) Dual Aspect
(d) Going Concept
8. ‘Organisation must record all probable losses than probable gains’ are stated by:
(a) Business Entity

(b) Principle of Conservatism
(c) Dual Aspect
(d) Principle of Disclosure
9. __________ concept states that ‘every business organisation has to maintain books
of accounts for certain period’
(a) Business Entity

(b) Accounting Period
(c) Dual Aspect
(d) Going Concept
10. ________ is a concept that states that the ‘income or revenue is recognised or
recorded only when it is earned’.
(a) Business Entity

(b) Accounting Period
(c) Dual Aspect
(d) Realisation Concept

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1.2.2 Accounting Conventions
Accounting, when an investor examines the financial accounts of a company, conventions are
formed to assure uniformity, consistency, and the same interpretation. Conventions are long-
standing customs, traditions, or practices that organisations do follow. The organisation will be
guided in the creation of financial statements by conventions. Principles are another name for
these conventional practices. Let us have a look at some of the most essential traditions that
businesses adhere to.

1. Convention of Disclosure
According to this convention, financial statements must be prepared in a fair and

transparent manner to ensure that all relevant information is reported. It specifies that
attention must be made while preparing financial statements to ensure that all required
information is reported. This principle assumes that shareholders and the Board of
Directors have a principal-agent relationship. As the Board of Directors oversees the
business’s activities, they must maintain fairness, honesty, integrity, and ethics, as well
as ensuring that vital information is not withheld from the public.
This convention underlines that the corporation must offer information to the
stakeholders for whom it will be responsible for all material and key facts of financial
performance and operational results.
There may be a time gap between the date of production of the balance sheet and
its publication, during that time, certain events such as bad debts, plant damage,
and debt recovery may occur, all of which must be disclosed to stakeholders. In
financial statements, the corporation is obligated to produce and disclose all relevant
information to all stakeholders. As a result, full disclosure becomes a healthy principle
and is regarded as crucial.
2. Convention of Consistency
The term “consistency” refers to the consistency of norms and practices. It does not
rule out the possibility of change. It states that any valuation strategies, methods, or
techniques used must be consistent over a period of time for the management to draw
conclusions about the company’s activities. It is necessary to guarantee that practices
and procedures do not change frequently, and that consistency is maintained. It will
be tough to compare if practices and approaches change frequently. Consistency aids
in the elimination of personal prejudice. Any changes in techniques and processes
must be clearly documented in the financial statements’ footnotes. This standard
improves the accuracy and comparability of accounting data for better forecasting and
decision-making. Changes are not prohibited by this convention. If a change occurs, its
implications must be understood and presented or indicated in the financial accounts.

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11. “Anticipate no profit and provide for all possible losses” is the essence of __________
convention.
(a) Convention of Materiality

(b) Convention of Conservatism
(c) Convention of Consistency
(d) Convention of Disclosure
12. ________implies that the economic significance of an item will affect its accounting
treatment.
(a) Principle of Materiality

(c) Principle of Consistency
(d) Convention of Disclosure
13. It states that any practices and methods or technique followed in valuation need
to be consistent for a certain number of years, which helps the management to draw
conclusions about the operations of the company.

(d) Principle of Disclosure
14. The purpose of this convention is to communicate all material and relevant facts
concerning financial position and results of operations to the users.

(b) Principle of Full Disclosure
(d) Principle of Conservatism
15. As per this concept, all accounting must be based on objective evidence. In other
words, the transactions recorded should be supported by verifiable documents.
(a) Matching Concept

(b) Dual Aspect Concept
(c) Verifiability and Objectivity Concept
(d) Realisation Concept

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3. Convention of Conservatism
This principle states that, if a business records transactions in its books, it should
always “anticipate no profit and provide for all conceivable losses.” Because the future
is unclear and unpredictable, changes and uncertainties are common. As a result,
this notion emphasises the ability to record potential losses rather than anticipated
earnings.
Closing shares, for example, should be valued at either the cost or market price,
depending on which is lower. This convention can be used as a precaution or a safe
bet while preparing financial statements.
The following are some instances of
(a) The asset’s value should not be exaggerated.

(b) The importance of the liability value cannot be overstated.
(c) Profits should not be exaggerated.
(d) The loss must not be overlooked.
If followed, this conservatism tends to produce true and fair value information in
financial accounts.
4. Convention of Materiality
An item is to be classified as material if there is valid cause to trust that knowledge

which will influence the decision of a prospective investor,” according to the American
Accounting Association. Materiality is also determined by the size and nature of the
transaction.
Purchasing tiny products such as a pen, stapler, printer and stationery, envelopes,
stamps, and other similar items, for example, can be classified as an asset based
on the asset’s durability and nature. Separating accounts is not essential; all can be
pooled and regarded as expenses for the accounting period.
As a result, minor and insignificant items can be overlooked or mixed with other items.
The quantity of their amount determines their materiality. When the numbers are in
the thousands, the omission of a paisa is inconsequential. In summary, all material
information that is required to make the financial statements clear and understandable
should be published.

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16. Accounting Conventions are developed to ensure that uniformity, Consistency, and
same interpretation is maintained when an investor look at the financial statements
of the company.
(a) yes
(b) No
17. It is helpful for the investors/shareholders to know the exact amount of profit or loss
of the business.
(a) Business Entity Concept

(b) Matching Concept
(d) Historical Cost Concept
18. It takes into consideration all prospective losses but leaves all prospective profits
(a) Convention of Conservatism

(b) Convention of consistency
(c) Convention of Full Disclosure
(d) Convention of Materiality
19. According to this convention the accounting practices should remain unchanged
from one period to another.
(a) Convention of Consistency

(b) Convention of Full disclosure
(c) Convention of Conservatism
(d) Convention of Materiality
20. It is because of this concept that fixed assets are recorded at their original cost and
depreciation in a systematic manner without reference to their current realisable
value.
(a) Going Concern Concept

(b) Realisation Concept
(c) Historical Concept
(d) Money Measurement Concept

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Summary
The concept of accounting refers to basic rules and standards called principles that
serve as a basis for recording business transactions and preparing accounts.
Separate Business entity accounting concept makes a clear distinction between the
business and the owner. The going concern assumes that business activities will
continue to operate for a longer period in future.
The concept of correspondence states that income and expenses must be recorded
at the same time as they are incurred.
Money measurement states that business transactions which are expressed in terms
of money will only be recorded in books of accounts.
Realisation Principle is an income recognition principle which provides that income

or revenue is recognised only when earned. Accruals are needed to confirm that all
revenues and expenses are recognised within the current reporting period, ignoring
the concept of timing of cashflows.
The Convention of Disclosure requires that accounting statements should be prepared

and ensure that all significant information should be disclosed therein.
The consistency principle states that consistency is to be followed in valuation of

items for a certain period.
Conservatism states that the business has to identify all possible losses rather than
anticipated profits.
The Principle of Materiality implies that the economic importance of an item will affect
its accounting treatment.

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Case lets
In the below cases, wherever possible apply concepts and analyse its recording.
1. At the conclusion of each month, a firm pays a 10% commission to sales leaders. If
the company makes Rs 50,000 in sales in March, it will pay a commission of Rs 5,000
the following June. Examine the numerous ideas that should be considered while
recording transactions in books of accounts.
2. A supplier invoice for Rs 20,000 will arrive a few days after the end of the month, but
the accountant prefers to close the accounts at the end of the fiscal year. As a result,
it makes a Rs 20,000 reverse entry to account for the charges this month. The entry
reverses the following month, resulting in a negative Rs 20,000 charge offset by the
arrival and recording of a supplier invoice.
Terminal Questions
1. Describe various accounting concepts.
2. Write a brief note on the Business Entity Concept.
3. Differentiate Matching concept and Realisation Concept.
4. Write a concise note on Dual Entity Concept.
5. Define Accounting Equation.
6. Explain Accounting Conventions.

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Answer Keys
Question No Answers
1 c
2 c
3 c
4 a
5 a
6 c
7 a
8 b
9 b
10 d
11 b
12 a
13 c
14 b
15 c
16 a
17 b
18 a
19 a
20 c

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Glossary
• Entity: Something that exists apart from other things, having its own independent
existence
• Cost concept: It refers to the amount of payment made to acquire any goods and
services.
Bibliography
Textbooks
1. Libby, R., Libby, P. A., & Hodge, F. (2020). Financial Accounting. McGraw-Hill
Education.
2. Horngren, C. T., Harrison, W., & Oliver, M. S. (2011). Financial & Managerial
Accounting. Pearson College Div.
3. Drury, C. (2018). Cost and Management Accounting. Cengage Learning.
4. Maheshwari, S. N. (2012). A Textbook of Accounting for Management. Vikas

Publishing House.
e-References
1. https://corporatefinanceinstitute.com/resources/knowledge/accounting/
2. https://www.tutor2u.net/business/reference/accounting-concepts-and-conventions
3. https://www.vedantu.com/commerce/accounting-concepts
Video Links
Topic Link
Accounting Concepts & Conventions https://www.youtube.com/watch?v=f-

NRXVAmkjDE
Accounting Principles & Concepts https://www.youtube.com/watch?v=Z-

71rEnjW-Z4

38
Keywords
• Dual Aspect Concept

• Accrual Concept
• Convention of Consistency

39
MODULE 1
UNIT 3
ACCOUNTING CYCLE

40
Table of Contents
Unit – 1.3 Accounting Cycle
Aim ------------------------------------------------------------------------------------------------------- 42
Instructional Objectives ------------------------------------------------------------------------------ 42
Learning Outcomes ---------------------------------------------------------------------------------- 42
1.3.1 Journal ----------------------------------------------------------------------------------------- 43

Self-Assessment Questions -------------------------------------------------------------- 45
1.3.2 Ledger ----------------------------------------------------------------------------------------- 46
1.3.3 Subsidiary books ---------------------------------------------------------------------------- 49
1.3.4 Trial Balance --------------------------------------------------------------------------------- 54
Solved Problems -------------------------------------------------------------------------------------- 55

Summary ------------------------------------------------------------------------------------------------ 60
Terminal Questions ----------------------------------------------------------------------------------- 60
Answer Keys ------------------------------------------------------------------------------------------- 61
Pratice Problems ------------------------------------------------------------------------------------- 62
Glossary ------------------------------------------------------------------------------------------------ 63
Bibliography -------------------------------------------------------------------------------------------- 63
e-References ------------------------------------------------------------------------------------------ 63
Image Credits ------------------------------------------------------------------------------------------ 64
Video links ---------------------------------------------------------------------------------------------- 64
Keywords ----------------------------------------------------------------------------------------------- 64

41
Aim
The main aim of this unit is to make students aware with the process of accounting. A
step-by-step process starting from recording to preparing a summary of accounts at the
end of the year.
• Examine the process of preparing accounts
• Identify various books to be maintained for accounting
Learning Outcomes
• Enumerate the accounting process/cycle
• Apply the accounting process
• Analyse various books of accounts at each process

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Accounting Cycle
The accounting cycle is the process of a company’s accounting events being identified, analysed,
and recorded. It’s an eight-step process that starts when a transaction occurs and finishes when
the transaction is recorded in the financial statements.
1 - Financial
Transaction
5 - Financial 2 - General
Statements Journal
4 - Trail 3 - General
Balance Ledger
Fig. 1: Accounting cycle
Financial transactions are the transactions that take place in the monetary aspect in the process of
running the business. All these transactions are initially recorded in bookkeeping in chronological
order and later they are recorded in various books. Accounting cycle speaks about various stages
of recording the transactions, classifying them, and summarising them to prepare the financial
statements of the firm.
1.3.1 Journal
It is the practice of recording transactions in the form of entries in a book called a Journal.
Journalising is the process of recording entries in a book journal. Book of Original Entry is
the name of the journal. A formal record that documents a transaction is an accounting entry.
There are two types of accounting entry systems. The income and expenses for transactions
are recorded in a cash register in single-entry bookkeeping, whereas the double-entry system
begins with a journal, then a ledger, a trial balance, and finally financial statements. The double-
entry system is the most often used accounting system due to its various advantages over the
single-entry system. In the double-entry system, every financial transaction is recorded in at least
two independent accounts, with equal and opposite impacts on the appropriate accounts. In a
double-entry system, the entries are made in the system to satisfy the equation:

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Assets = Liabilities + Equity
In this system, every credit is counterbalanced by debits, either in the general ledger or in a
T-account. To put it another way, every transaction has two separate accounts with credit and
debit entries.
Procedure for recording an entry into Journal
1. Determine which accounts will be impacted.

2. After you have identified the two or more accounts involved in a business transaction,
you must debit and credit at least one account by determining the account type.
3. Write an entry in your journal.
Let us look at an example to better grasp the method steps. The accounts that will be affected in
this example are your office supply account and your cash account.
1. Office supplies and cash are two accounts that have been recognised.
2. The cash account is a genuine account, but the office supplies account is an expense
account.
3. All expenses will be deducted from the account, and cash will be credited.
DATE No ACCOUNT DEBIT CREDIT

1-15-2020 1 Office Supplies 1500
DATE No ACCOUNT DEBIT CREDIT

1-15-2020 1 Cash 1500

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1. The practice of recording transactions in the form of entries in a book called a

________.
(a) Ledger
(b) Book
(c) Journal
(d) Bookkeeping
2. _______________ is the process of recording entries in a book journal.
(a) Journalising
(b) Ledge rising
(c) Entering
(d) Recording
3. The income and expenses for transactions are recorded in a cash register is
__________ system of Bookkeeping.
(a) Single
(b) Dual
(c) Double
(d) Empty
4. Every financial transaction is recorded in at least two independent accounts, with

equal and opposite impacts on the appropriate accounts.
(a) Single
(b) Dual
(c) Double
(d) Empty
5. In a double-entry system, the entries are made in the system to satisfy the equation:
(a) Assets = Liabilities + Equity

(b) Assets - Liabilities = Equity
(c) Equity= Assets -Liabilities
(d) None

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1.3.2 Ledger
It’s also known as the book of last entries. All transactions recorded in the journal will be placed into
distinct accounts in this book. For various transactions, various accounts are opened throughout
the year and after posting all the transactions, accounts will be closed at the end of the year and
balances will be finalised and carry forward for next year which will become opening balance of
the account. In accounting there are three types of accounts. An organisation may handle varies
transactions, but all these transactions are classified into these accounts and posting entries will
be as per the rules specified for various accounts.
Dr. Account Cr.

Date Particulars Rs Date Particulars Rs
An account will be in T shape having debit and credit. Debit refers to left side and credit refers to
right side of an account. What is posted on debit and credit side of an account depends on nature
or type of account and then rule of that account will be applied.
There are three types of Accounts:
1. Personal accounts
2. Real accounts
3. Nominal accounts
1. Personal accounts: Personal account represents accounts relating to individual

human beings. the artificial person or accounts of certain person or group of persons in
business dealing. Artificial persons mean accounts of organisations, associations, etc.
For example: Hema A/c, Sita A/c
Rules of personal account

Debit - The Receiver
Credit – The Giver
Example: Suresh is a personal account as a natural person in this transaction. In the
entry as the receiver, his account will be debited.
2. Real accounts: Real accounts deal with all forms of transactions involving an
organisation’s assets. It represents all asset accounts that involve transactions such
as asset purchases, asset sales, and so on. These are assets that can be touched and
have a tangible existence. Building a/c, cash a/c, stationery a/c, inventory a/c, and so
on.

46
Intangible real accounts: These are assets that do not exist in the real world and
cannot be touched. These, on the other hand, may be measured in terms of money and
have monetary value. For instance, goodwill, patents, copyright, and trademarks are all
examples of intellectual property.
Rules of real account
Debit: What Comes in

Credit: What goes out
Example: Purchased furniture in cash. Debit furniture A/c and credit cash A/c.
3. Nominal accounts: These account types are related to income or gains and expenses
or losses. For example: – Rent A/c, commission received A/c, salary A/c, wages A/c,
conveyance A/c, etc.,
Rules of nominal accounts
Debit all the expenses and losses of the business

Credit the incomes and gains of business
Example: The companies’ employees are paid salaries. When the expenses are
incurred, the salary account will be debited. Interest, discounts, and other benefits
obtained by an entity are credited to the entity as soon as they are received.
There are a few other accounts in accounting that you should be aware of:
• Cash account: Keep track of all cash payments, withdrawals, and deposits in this
account.
• Income account: This account is used to maintain track of the business’s revenue
sources.
• Expense account: This account keeps track of the company’s expenses.
• Liabilities: If there is any debt or loan, it is classified as a liability.
• Equities: If the account owner has made an investment in common stocks or retained
earnings, these are considered equities.
QUIZ
Write the accounts affected and applicable rules in the below-mentioned transactions.
1. Bought goods for cash.
2. Sold goods for cash
3. Paid expenses.
Answer
1. Debit purchase account and credit cash account.
2. Debit cash account and credit sales account.
3. Debit expenses account and credit cash/bank account.

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6. Hema Ltd is _________ account.
(a) Personal
(b) Real
(c) Nominal
(d) Other
7. Copyright is ___________asset.
(a) Tangible
(b) Intangible
(c) Traceable
(d) Perishable
8. Expenses and losses belong to _________ account.
(a) Nominal
(b) Personal
(c) Real
(d) Other
9. Entries are recorded in ___________.
(a) Journal
(b) Ledger
(c) Bookkeeping
(d) None of the above
10. Cash account is a Real account.
(a) Yes
(b) No
DID Amatino Manucci, a Florentine trader around the end of the 13th century, kept
YOU the first existing accounting records in Europe that used the contemporary
KNOW double-entry system. The Farolfi firm employed Manucci, and the firm’s
ledger from 1299 to 1300 shows full double-entry bookkeeping.

48
1.3.3 Subsidiary Books
Subsidiary Books are books that preserve a systematic record of similar transactions. Daybooks
and Special Journals are other names for them. It is difficult to record all transactions in one
journal and post them to numerous accounts in large corporations. As a result, the journal is
separated into multiple subsidiary books for quick and accurate recording of all transactions.
There is a separate book for each sort of transaction.
Types of subsidiary books
There are 8 types of subsidiary books that are used for recording several types of transactions.
The 8 Subsidiary books are as follows:
1. Cash Book
2. Purchase Book
3. Sales Book
4. Purchase Return Book
5. Sales Return Book
6. Bills Receivable Book
7. Bills Payable Books
8. Journal Proper
1. Cash Book
The cash book is the most essential and initial subsidiary book. It keeps track of all revenues
and payments made in cash and by bank. The cash books of a company are separated into
three sections. They are:
Single column cash book: A ledger account is similar to a cash book with only one column.
It has a debit and credit side to it. The debit side of the cash book records all cash receipts,
while the credit side records all cash payments.
The format of the single column cash book is as here:
Cash Book (Single Column)

Dr. Cr.
Date Particulars L.F. Cash Date Particulars L.F. Cash
Double column cash book: A discount column is added to both the debit and credit sides of
the cash book, which is the fundamental difference between a Double Column Cash Book
and a Single Column Cash Book. It keeps track of the discounts that have been given on
the debit side of the cash book as well as the discounts that have been acquired on the
credit side.

49
The format of the double-column cash book is given below:
Cash Book (Double Column)
Dr. Cr.
Date Particulars L.F. Discount Cash Date Particulars L.F. Discount Cash
Allowed Received
Triple column cash book: A triple column cash book contains all of the columns found in a
double column cash book, plus an additional bank column.
The format of the triple column cash book is given below:

Cash Book (Triple Column)
Dr. Cr.
Date Parti L.F Discount Cash Bank Date Parti L.F Discount Cash Bank
culars Allowed culars Received
2. Purchase Book
The Purchase Book is a sub-book in which all credit-related transactions are recorded. The
assets are never bought or registered in the buy book.
Below is the format of purchase book
Purchase Book
Date Particulars Inward Invoice No. L.F. Amount
3. Sales Book
All credit sales transactions are recorded in the Sales Book. Asset sales aren’t allowed to
be reported in the sales book. The sales book format is given below.
Sales Book
Date Particulars Outward Invoice No. L.F. Amount
4. Purchase Return Book
The purchase return book, also known as the return outward book, is used to track all
supplier returns. A debit note is issued for each return, which is recorded in the Purchase
Return Book.
Format of Purchase Return Book is as below:

Purchase Return Book
Date Particulars Debit Note No. L.F. Details Amount

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5. Sales Return Book
All incoming returns transactions are recorded in the sales return book. It’s also known as a
return inward book. A credit note is sent and recorded in the Sales Return Book every time
a consumer returns merchandise.
Sales Return Book format is as below:

Sales Return Book
Date Particulars Credit Note No. L.F. Details Amount
6. Bills Receivable Book
All transactions involving bills drawn in the company’s favour are recorded in the Bills
Receivable Book. The total of the bills receivable book is posted on the debit side of the
Bills Receivable account. The Format of Bills Receivable Book is as follows.
Bills Receivable Book
Date of Bill Bill No. Acceptor From Terms Due Date Amount
7. Bills Payable Book
The Bills Payable Book records all the transactions related to bills that are drawn on the
business and are payable by the business. The Bills Payable Books Format is as follows.
Bills Payable Book
Date of Bill Bill No. Drawee Payee Terms Date of Maturity Amount
8. Journal Proper
Certain transactions are referred to as miscellaneous transactions since they cannot be

recorded in any of the above-mentioned books. As a result, all miscellaneous transactions
are recorded in the Journal Proper. It includes things like asset credit purchases and sales,
depreciation, and so forth.
Solved Examples on Subsidiary Books
A few solved examples are given to make the content on subsidiary books clearer to the
students.
Mentioned below is a five-set of transactions of Moksha Ltd. Company to determine the

type of subsidiary books that will be used in recording each transaction.

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Transactions:
1. Purchase of goods from MA Ltd.

This is to be recorded in the Purchase Book.
2. Purchase of stationery in cash.

This is recorded in Cash Book.
3. Depreciation of buildings.
Journal Proper is the book.
4. Sale of goods in exchange for cash.

To be recorded in Cash Book
5. Bad Debts from Banyan Tree Ltd. Transaction.

This to be recorded in Journal Proper.

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11. Book in which records of only credit purchases are recorded:
(a) Sales book

(b) Purchases book
(c) Cash book
(d) Purchase returns book
12. Book in which all cash transactions are recorded:
(a) Cash book

(b) Bills receivable book
(c) Bills payable book
(d) Sales book
13. Book in which sales transactions are recorded:
(a) Sales book

(b) Purchases book
(c) Cash book
(d) Purchase returns book
14. Returns made to supplier is called _________.
(a) Supplier returns

(b) Debit note
(c) Purchases returns
(d) Sales returns
15. Returns made by customers are called _________.
(a) Supplier returns

(b) Debit note
(c) Purchases returns
(d) Sales returns
DID A cash book is a distinct ledger that records monetary transactions,

YOU whereas a cash account is a general ledger account. A cash book acts as
KNOW both a journal and a ledger, whereas a cash account is organised similarly
to a ledger.

53
1.3.4 Trial Balance
Accounts are settled once all of the accounts are opened and all transactions are posted to them
during the year, and only a few will be closed at the conclusion of the fiscal year by determining
the amounts remaining in each account. Accounts showing debit balances will be entered in the
debit column of trial balance and credit balances on credit column in trial balance.
The main objective of preparation of trial balance statement is to check the accuracy of accounts
at the end of the year. Accuracy can be ensured only when the sum of the debit column is equal
to the sum of the credit column. If there is any difference, transactions are to be checked where
there may be some error in recording and posting of transactions in accounts. Debit column and
credit column totals equal implies that there is accuracy, and it happens because of dual aspect
concept of accounting which states for every debit there will be a corresponding credit with equal
amount.
Statement of Trial Balance as on ----

Particulars Debit Rs Credit Rs
Total
Once trial balance is prepared, observe the following points to get clarity on nature of accounts
and balance they represent always in the account:
a. All debtors are shown on debit side of Trial balance

b. All creditors are shown on the credit side of Trial balance
c. All Expenses and losses on debit side of trial balance
d. All Incomes and Gains on Credit side of trial balance
e. All assets shown on debit side of Trial balance
f. All Liabilities on are shown on credit side of Trial balance

54
Solved Problems
From the balances of KP Ltd books, prepare Trial balance
Particulars Balances
Furniture 640
Buildings 7500
Machinery 6250
Capital 12500
Bad debts 125
Debtors 3800
Creditors 2500
Stock on 1-4-2011 3460
Purchases 5475
Sales 15450
Bank OD 2850
Sales returns 200
purchase returns 145
Advertisement 450
Interest 650
Cash 118
Commission 375
Tax and Insurance 1250
General Expenses 782
Salary 3300
Bills Payable 200
Total 34,000

55
Solution
Statement of Trial Balance as on 31.3.2012

Particulars Debit Rs Credit Rs
Furniture 640
Buildings 7500
Machinery 6250
Capital 12500
Bad debts 125
Debtors and Creditors 3800 2500
Stock on 1-4-2011 3460
Purchases and sales 5475 15450
Bank OD 2850
Sales returns and purchase 200 145
returns
Advertisement 450
Interest 650
Cash 118
Commission 375
Salary 3300
Bills Payable 200
Total 34,000 34,000
DID Trial Balance is thought to have originated and developed in Italy in the
YOU thirteenth and fourteenth centuries, while the precise date, style, and
KNOW
location are unknown.
Solved Problems
1. Journalise the following transactions

X invested in business 12,00,000
Sold goods worth 20,000
Purchased goods worth 75,000
Sold goods to jin 1,00,000
Building purchased 10,000
Paid to stationery 5,100
Cash deposited 50,000
Transport charges 7,300

56
Solution:
Journal entries for the transactions
S.No Description Transaction Amount

1. Cash a/c 12,00,000
To capital a/c 12,00,000
2. Cash a/c 20,000
To sales a/c 20,000
3. Purchases a/c 75,000
To cash a/c 75,000
4. Jk a/c 1,00,000
To sales a/c 1,00,000
5. Building a/c 1,00,000
To cash a/c 1,00,000
6. Stationery a/c 5,100
To cash a/c 5,100
7. Bank a/c 50,000
To cash a/c 50,000
8. Transport charges a/c 7,300
To cash a/c 7,300

57
Activity
Prepare Ledger for the above transactions.
Dr. Cash A/C Cr.

Particulars Amount Particulars Amount
To capital 1,200,000 By purchases 75,000
To sales 20,000 By buildings 100,000
By stationery 5,100
By bank 50,000
By transport 7,300
By balance c/d 982,600
1,220,000 1,220,000
Dr. Purchases A/C Cr.
To cash 75,000 By balance c/d 75,000
75,000 75,000
To balance b/d 75,000
Dr. sales A/C Cr.
To balance c/d 120,000 By cash 120,000
120,000 120,000
Dr. Buildings A/C Cr.
100,000 100,000
Dr. Bank A/C Cr.
50,000 50,000
Dr. Transport A/C Cr.
7,300 7,300

58
Dr. JK A/C Cr.
To sales 100,000 By balance c/d 100,000
100,000 100,000
Dr. Stationary A/C Cr.
5,100 5,100
Dr. Capital A/C Cr.
To balance c/d 1,200,000 By cash 1,200,000
1,200,000 1,200,000
To balance b/d 1,200,000

59
Summary
All transactions recorded in the journal will be posted to distinct accounts in the journal.
In Ledger, several accounts are opened throughout the year, and after posting all
transactions, accounts are closed at the end of the year, and balances are finalised
and carried forward for the following year, which becomes the account’s opening
balance.
Special journals or Daybooks are other names for subsidiary books. It is difficult to
record all transactions in one journal and post them to numerous accounts in large
corporations.
All cash receipts are recorded on the debit side of a single column cash book, while
all cash payments are entered on the credit side.
A Double Column Cash Book is similar to a Single Column Cash Book, except that it
has an additional discount column on both the debit and credit sides.
A triple column cash book features all of the columns of a double column cash book
plus an extra bank column.
At the end of the year, the trial balance statement is used to verify the accuracy of the
accounting.
Accounts with debit balances will be recorded in the debit column of the trial balance,
and accounts with credit balances will be entered in the credit column.
Terminal Questions
1. Explain the Journal and the process of recording transactions.
2. Differentiate between Journal and Ledger.
3. Explain the process of posting entries into accounts.
4. Explain the Golden rules of accounting.
5. State the various types of Subsidiary books.
6. Explain three types of cashbooks.
7. Describe the significance of Trial balance.

60
Answer Keys
Question No Answers
1 A
2 B
3 A
4 A
5 A
6 B
7 A
8 A
9 C
10 D
11 A
12 B
13 A
14 B
15 A

61
Practice Problems
1. From the following transactions prepare journal entries and ledger accounts of JK
traders
Started business with capital - 5 lakhs

Purchased goods from PK traders - 80,000
Purchased machinery - 1 lakh
Purchased furniture from furniture & co - 50,000
Sold goods to like traders - 7 lakhs
Deposited cash into bank - 20,000
Received Rs.30,000 from like traders
Paid to PK traders 20,000
Insurance paid - 3000
Commission received - 2000
2. Journalise the following transactions and prepare Ledger
Commenced business with cash - 5,00,000

Purchased furniture for cash - 20,000
Cash purchases - 50,000
Deposited with bank - 50,000
Sold to Niharika for cash - 2,00,000
Sold goods to Park & Co - 1,00,000
Purchases from Gucci & Co - 1,25,000
Wages paid - 75,300
Withdraw from bank - 12,500
Electricity expenditure paid - 3,575
3. Journalise the following transactions and post the entries in to Accounts
Started business with capital of Rs.10 lakhs

Purchased goods Rs.5 lakhs
Purchased building Rs.2,00,000
Purchased furniture Rs.50,000
Sold goods Rs.7 lakhs
Purchased goods from KP Ltd Rs.50,000
Paid Rs.20,00 towards insurance
Paid to KP Ltd Rs.20,000
Travelling expenses 10,000

62
4. Prepare journal entries and prepare Ledger
Invested capital of Rs.3,00,000

Purchased goods worth Rs.2,50,000
Paid wages 30,000
Received rent of 25,000
Sold goods for cash 4,75,000
Commission received 5,000
Discount allowed 2,500
Glossary
• Journal: A periodical dealing especially with matters of current interest.
• Liabilities: Any kind of financial obligation that a business has to pay at the end of
an accounting period to a person or a business.
Bibliography
Textbooks
Education.

Publishing House.
e-References
1. https://www.toppr.com/guides/principles-and-practice-of-accounting/subsidiary-books/in-
troduction-to-subsidiary-books/
2. https://www.yourarticlelibrary.com/accounting/subsidiary-books/subsidiary -books -types

-and-advantages/61368

63
Image Credits
• Figure 1
https://pakaccountants.com/courses/financialaccounting/cycle/simple/
Video Links
Topic Link
Subsidiary Books - Concept & Types https://www.youtube.com/watch?v=p-

7p1J8zC9SY
Cash Book - Concept & Problem https://www.youtube.com/

watch?v=G3q8DhBk2Mk
Keywords
• Ledger
• Expense Account
• Tangible
• Perishable

64
MODULE 2
UNIT 1
FINANCIAL STATEMENTS

65
PREPARATION OF FINANCIAL STATEMENTS
Module Description
Financial statements prepared at the end of the accounting period helps to identify and analyse
the performance of the company. Preparation of financial statements is one of the crucial steps
and is the main objective of financial accounting. Every firm at the end of the year would like
the know whether it has made profit or loss . These statements also help in understanding the
sustainability of the business.
It furnishes a snapshot of a company’s financial performance which gives an insight into its
performance, operations, and cash flow. These statements are necessary for every firm as since
they provide information about a company’s revenue, expenses, profitability, and debt.
At the end of this module, students will be able to understand various financial statements and
their preparation and various ratios to analyse the performance of company.
Unit 2.1 Financial Statements

Unit 2.2 Ratio Analysis

66
Unit – 2.1 Financial Statements
Aim --------------------------------------------------------------------------------------------------------- 68
Instructional Objectives ------------------------------------------------------------------------------- 68
Learning Outcomes ------------------------------------------------------------------------------- 68
2.1.1 Income Statement ---------------------------------------------------------------------------- 69

Self-Assessment Questions --------------------------------------------------------------- 71
2.1.2 Statement of Retained Earnings ---------------------------------------------------------- 72
2.1.3 Balance Sheet --------------------------------------------------------------------------------- 74
Self-Assessment Questions --------------------------------------------------------------- 77
Solved Problems --------------------------------------------------------------------------------------- 78

Summary ------------------------------------------------------------------------------------------------- 79
Terminal Questions ------------------------------------------------------------------------------------ 79
Answer Keys -------------------------------------------------------------------------------------------- 80
Practice Problems ------------------------------------------------------------------------------------- 81
Glossary -------------------------------------------------------------------------------------------------- 84
Bibliography --------------------------------------------------------------------------------------------- 84
e-References -------------------------------------------------------------------------------------------- 85
Image Credits ------------------------------------------------------------------------------------------- 85
Video links ----------------------------------------------------------------------------------------------- 85
Keywords ------------------------------------------------------------------------------------------------- 86

67
Aim
The main aim of this unit is to help students grasp the preparation of financial statements
and analyse these financial statements and final adjustments to be made after closing of
balance sheet.
This unit intends to encourage students to:
• Demonstrate and prepare financial statements
• Define the financial statements with adjustments
Learning Outcomes
• Apply accounting concepts and prepare financial statements
• Summarise the financial statements with adjustments

68
Financial Statements
For a given fiscal year, a standalone trading firm will produce and keep books of accounts.
All transactions for the fiscal year must be recorded in books that must be closed at the end
of the accounting period. The fundamental goal of financial accounting is to prepare financial
statements at the conclusion of the fiscal year. Three major financial statements make up these
financial statements:
1. Income statement
2. Statement of retained earnings
3. Balance sheet
2.1.1 Income Statement
Income statement, termed as Profit and Loss Account, is a financial statement that is prepared at
the conclusion of each fiscal year to show how much profit the company made during that period.
The Income Statement aids in determining a company’s performance over time. Revenue minus
expenses is referred to as income. If revenues exceed expenses, it is referred to as profit, and if
revenues fall short of expenses, it is referred to as a loss.
Income = Revenues – Expenses
Revenues are the goods received by the company throughout a given fiscal year.
The income gained from the selling of goods or services is referred to as revenues. It’s important
to note that revenues are earned when a sale is made. It’s possible that the payment was
received, but it’s also possible that it wasn’t. Sales for products and service fees for service firms
are examples of revenue. When a company receives goods and services, it incurs expenses.
Payment may or may not been earned, just like revenues. Salary expense, utility expense, and
interest expense are all examples of expenses.

69
Fig. 1: A simple format for an income statement
The cost of goods sold is the cost incurred by a company to purchase or manufacture a product
for resale. A bookstore, for example, buys a book for Rs 25 and then sells it for Rs 32. The
selling price of the goods is Rs 7/-. The expenses incurred in running a business are known as
operating expenses. Salary, utility, and depreciation expenses are examples of such accounts.
Revenue, expenses, gains, and losses that are not related to the company’s principal operations
are referred to as non-operating items. Interest expenses, as well as gains and losses from the
sale of equipment and assets, are recorded in these accounts.

70
1. A statement prepared to know the profit /loss of a firm.
(a) Income statement

(b) Balance sheet
(c) Retained earnings
(d) Trial balance
2. Gross profit less operating expenses+Operating incomes =
(a) Net income

(b) Operating expense
(c) Operating profit
(d) Non-operating profit
3. Gross profit – (Operating and Non-Operating expenses+Operating and non-operating

incomes) = .
(a) Net income

(d) Sales
4. Opening stock+purchases - closing stock =
(a) Net income

(d) Gross profit
5. Revenue and expenses, gains and losses which arise out of non-business activities
are called ______.
(a) Net Income activities

(b) Operating activities
(c) Operating profit activities
(d) Non-operating activities

71
Way back in 1494, the first ever financial statement was created by
DID Luca Pacioli, a monk, who lay the foundation for modern accounting by
YOU developing an independent record that provided a clearer view of an
KNOW entity’s financial activity. The formation of accounting experts was sparked
by the railroads and the emergence of corporations. We’ll see in this unit,
how we are indebted to Luca Pacioli in several more ways.
Solved Problem
1. KP Limited’s trial balance for the year ending 31.3.2020 is shown below. Prepare the
trading and profit and loss account, as well as the balance sheet, for the year ended
31.3.2020.
Particulars Debit Credit

Furniture 640
Buildings 7500
Machinery 6250
Capital 12500
Bad debts 125
Stock on 1-4-2011 3460
rent 5000
Insurance 1050
Bank OD 2850
Total 33,300 33,300
Dr. Trading &P&L Account for the year ended 31.3.2020 Cr.
Particulars Rs/- Particulars Rs/-
To opening stock 3460 By sales 15450
To Purchases 5475
To Gross Profit 6515
To Rent 5000 By Gross Profit 6515
To insurance 1050
T0 net Profit 465
2.1.2 Statement of Retained Earnings
The Statement of Retained Earnings shows how a company’s financial condition was affected by
net income and dividends during the period.

72
Fig. 2: The format of the statement
Note: The Income Statement comes first, followed by the Statement of Retained Earnings. This
is because calculating the ending balance of retained earnings requires knowing the amount of
net income.
Solved Problem
1. Extracted from the books of XYZ, prepare statement of retained earnings.
Particulars 2016 2015

Shareholders' Equity
Preferred stock 7,200 5,500
Common stock 350 350
Additional Paid-up capital 78,000 77,200
Treasury stock 3,200 2,900
Retained earnings 78,732 77,200
Accumulated other 3,200 2,800
comprehensive loss
Total XYZ shareholders' 1,64,282 1,60,350
Equity
Total Equity 1,64,282 1,60,350
Net incomes 5,900 4,700
Solution
Beginning Retained Earnings: Rs 77,200

Ending Retained Earnings: Rs 78,732
Net Income: 5,900
So 77,200-78,732+5,900 = Rs 4,368
Dividends paid = Rs 4,368

73
2.1.3 Balance Sheet
A balance sheet is a financial statement that shows a company’s assets and liabilities. A balance
sheet’s purpose is to report an accounting firm’s financial situation at a specific point in time.
Fig. 3: The format of Balance sheet
The balance sheet’s goal is to report an accounting entity’s financial situation at a specific point
in time.
The balance sheet has the following basic format:
Liabilities + Equity = Assets
Assets
Any resource or good utilised to produce cash flow, reduce expenses, or give future economic
benefits to an individual, government, or business is referred to as an asset. Assets have economic
value and can help a company’s operations, enhance a company’s value, or boost a person’s net
worth. The classification of assets can be done in a variety of ways. Assets are classed based on
how quickly they can be changed into cash, whether they are physically present or not, and their
usage and/or purpose. The following is a list of the various categories of assets.
Current assets: These are highly liquid assets that can be sold and turned into currency very
fast. Cash, bonds, mutual funds, stocks, and other marketable securities are regarded as the
most liquid current assets, which means they can be sold easily and rapidly without impacting
their value. Cash, accounts receivable, inventory, and prepaid expenses are examples of current
assets for firms.

74
Fixed assets: These are also known as hard assets or long-term assets, can take a long time
to produce cash value and are typically deemed low liquidity, which means they can’t be sold at
their full worth immediately. Buildings, land, furniture, and any other item that is not planned for
sale within the year are examples of fixed assets.
Intangible assets: Items or goods that exist in theory rather than in their physical form. Permits,
intellectual property, patents, brand reputation, and trademarks are examples of intangible assets
that increase in value as a result of successful use.
Liabilities
A liability is a phrase used in accounting to indicate any type of financial obligation that a company
has to pay to a person or a company at the conclusion of an accounting period. The distribution
of economic rewards such as money, products, or services is used to settle liabilities.
Liabilities, which include various types of loans, creditors, lenders, and suppliers, are recorded
on the right-hand side of the balance sheet.
Short-term and long-term liabilities are both possible. Short-term liabilities must be paid within
an accounting period (12 months), while long-term liabilities must be paid over a longer period
of time.
Liabilities can be divided into two categories:
1. Current Obligations
2. Fixed Liabilities/Long-term obligations
Current liabilities: Obligations that are due and must be paid within an accounting period are
referred to as current liabilities (which is usually a year or 12 months). Because of the quick
turnaround period, current liabilities are also known as short-term liabilities.
Current liabilities must be regularly controlled by a company’s management because it requires

sufficient liquidity in the form of current assets to pay off current liabilities.
Current liabilities have a direct impact on working capital as well as the business’s liquidity.
The following are some examples of current liabilities:
1. Interest to be paid
2. Accounts receivables
3. Short-term financing
4. Expenses that have accumulated
5. Overdraft at the bank

75
Fixed Liabilities/Long-term obligations: Fixed Liabilities, often known as long-term liabilities,
are financial obligations with a maturity date of more than a year. Long-term liabilities play a
significant role in the business’s long-term financing.
By supplying the necessary capital, these liabilities assist enterprises in acquiring capital assets.
Businesses can also use funds earned through long-term debts or liabilities to invest in new
capital projects.
Long-term liabilities are a key measure of a company’s ability to stay afloat. A corporation’s
inability to pay off long-term liabilities when they become due suggests a problem with the
company’s solvency or a crisis within the company.
Before investing, investors consider the company’s long-term liabilities.
The following are some examples of long-term liabilities:
1. Tax liabilities that have been deferred

2. Bonds to be paid
3. Long-term leases
4. Debentures

76
6. Retained earnings are earnings left after paying dividends.
(a) Yes
(b) No
7. Income Statement must be prepared before the Statement of Retained Earnings.
(a) Yes
(b) No
8. Assets= Capital +Liabilities:
(a) Asset equation

(b) Balance sheet equation
(c) Capital equation
(d) Liability
9. Balance sheet is a ___
(a) Account
(b) Report
(c) Statement
(d) Lesson
10. Balance sheet deals with:
(a) Incomes and Expenses

(b) Assets & Liabilities
(c) Sales
(d) None of these
Luca Pacioli, a Franciscan friar and Leonardo da Vinci’s math tutor, is

DID credited with creating a textbook in 1494 that listed an entity’s resources
YOU separately from any claim to those resources. In other words, he produced
KNOW
a balance sheet that divided the debits and credits. Modern accounting
began its journey since then.

77
Solved Problem
1. KP Limited’s trial balance for the year ending 31.3.2020 is shown below. Prepare the
31.3.2020.
Dr. Trading &P&L Account for the year ended 31.3.2020 Cr.
Particulars Rs/- Particulars Rs/-
To opening stock 3460 By sales 15450
To Purchases 5475
To Gross Profit 6515
To Rent 5000 By Gross Profit 6515
To insurance 1050
T0 net Profit 465
Balance sheet as on 31-03-2020

Liabilities Rs/- Assets Rs/-
Capital 12500 Furniture 640
creditors 2500 Buildings 7500
Net profit 465 Machinery 6250
Bank od's 2850 debtors 3675
(-) bad debts (3800-125)
18315 18065

78
Summary
The income statement (also known as the profit and loss account) is a financial
statement generated at the end of each fiscal year.
The income statement demonstrates how much profit the company made during that
time period.
A balance sheet is a financial statement that shows a company’s assets and liabilities.
A balance sheet’s aim is to report an accounting firm’s financial situation at a specific

point in time.
The statement of retained earnings shows how a company’s financial condition was
affected by net income and dividends during the period.
Terminal Questions
1. Explain income statement and its components.
2. Define balance sheet and its significance.
3. Describe the concept of retained earnings.
4. Explain financial statements and their significance in business.

79
Answer Keys
Question No Answers
1 A
2 C
3 A
4 D
5 D
6 A
7 A
8 B
9 C
10 B

80
Practice Problems
1. KP Limited’s trial balance for the year ending 31.3.2020 is shown below. Prepare
the trading and profit and loss account, as well as the balance sheet, for the year
ended 31.3.2020.
Furniture 640
Buildings 7500
Machinery 6250
Capital 12500
Bad debts 125
Stock on 1-4-2011 3460
rent 5000
Insurance 1050
Bank OD 2850
Total 33,300 33,300
2. Anitha Ltd trial balance for the year ending 31.3.2020 is shown below. Prepare the
31.3.2020.
Furniture 640
Buildings 7500
Machinery 6250
Capital 12500
Bad debts 125
Stock on 1-4-2011 3460
Bank OD 2850
Sales returns and 200 145
purchase returns
Advertisement 450
Interest 650
Cash 118
Commission 375
Salary 3300
Bills Payable 200
Total 34,000 34,000

81
3. Prepare the trading and profit and loss account for the year ended 31.3.2012 and
the balance sheet as on that date

Cash 500
Bank 9500
Stock on 1-4-2011 40,000
Wages 22525
Returns 2400 195
Repairs 1677
Debtors and creditors 30000 30305
Bad debts 2310
Bank Loan 20000
Discount 800 530
Capital 37500
Interest on Loan 600
Salaries 8000
Manufacturing 500
Expenses
Sales tax 800
Insurance 1000
Rent 2000
Charity 125
Machinery 16000
Total 269030 269030

82
4. Prepare the trading and profit and loss account for the year ended 31.3.2011

Capital 200000
Buildings 60000
Plant 100000
Salaries 14000
Printing and stationery 2000
Bad debts 600
Office rent 2600
Interest on loan to ram 1000
Opening stock 74000
Outstanding Wages 500
Furniture 4000
Discount 1500
Bills Payable 5700
Insurance 3000
Loose Tools 2000
Loan to ram 30200
Cash at bank 25000
Cash in hand 10500
Sales 107200
Total 354400 354400

83
5. From the following trial balance of Shukla & Company, prepare trading and profit
and loss account for the year ended 31.3.2020.

Buildings 20000
Capital 60000
Purchases& Sales 10000 30000
Opening stock 5000
Office salaries 8000
Postage and telegrams 1000
Receivables 8000 2000
Cash in hand 3500
Drawings Account 4000
Returns 2000 500
Freight 2500
Wages 1500
Machinery 15000
Advertisement 2000
Furniture 4000
Total 98500 98500
Glossary
• Balance Sheet: A financial statement that reports a company’s assets, liabilities, and
shareholder equity at a specific point in time.
• Net Income: Sales minus cost of goods sold, general expenses, taxes, and interest.
Bibliography
Textbooks
Education.

Publishing House.

84
e-References
1. https://www.investopedia.com/ask/answers/031815/how-are-three-major-finan-
cial-statements-related-eachother.asp#:~:text=Also%20referred%20to%20as%20the,in-
volved%20in%20its%20operating%20activities.
2.
https://www.schwab.com/resource-center/insights/content/3-financial-state-
ments-to-measure-companys-strength
3. https://online.hbs.edu/blog/post/how-managers-use-financial-statements
Image Credits
• Fig. 1
http://accountingcorner.org/multiple-step-income-statement-example-tem-
plate-and-single-step-income-statement-sample-format/
• Fig. 2
http://www.svtuition.org/2015/10/statement-of-retained-earnings.html
• Fig. 3
https://slideplayer.com/slide/8687215/
Video Links
Topic Link
The KEY to Understanding Financial
https://www.youtube.com/watch?v=_
Statements F6a0ddbjtI
How To Read & Analyze the Balance
https://www.youtube.com/watch?v=DM-
Sheet Like a CFO v9JC_K37Y
Understanding a P&L https://www.youtube.com/watch?v=02h-
kI7RcFeM
How to Read a Balance Sheet https://www.youtube.com/watch?v=NU-
w4d3Z7cc8
The INCOME STATEMENT for BEGIN- https://www.youtube.com/
NERS watch?v=0--AvwZabIQ

85
Keywords
• Income statement
• Retained earnings
• Trial balance

86
MODULE 2
UNIT 2
RATIO ANALYSIS

87
Unit – 2.2 Ratio Analysis
Aim -------------------------------------------------------------------------------------------------------- 89
Instructional Objectives ------------------------------------------------------------------------------ 89
Learning Outcomes ----------------------------------------------------------------------------------- 89
2.2.1 Meaning and Advantages of Ratio Analysis ------------------------------------------ 90

2.2.2 Classification of Ratios --------------------------------------------------------------------- 92
2.2.2.1 Liquidity ratios --------------------------------------------------------------------92
2.2.2.2 Leverage ratios ------------------------------------------------------------------ 93
2.2.3 Profitability Ratios and Investment Ratios -------------------------------------------- 96
2.2.4 Turnover Ratios ------------------------------------------------------------------------------ 101
Summary ------------------------------------------------------------------------------------------------ 104

Answer Keys ------------------------------------------------------------------------------------------- 105
Practice Problems ------------------------------------------------------------------------------------ 106
Glossary ------------------------------------------------------------------------------------------------- 108
Bibliography -------------------------------------------------------------------------------------------- 108
External Resources ----------------------------------------------------------------------------------- 109
e-References ------------------------------------------------------------------------------------------- 109
Video links -----------------------------------------------------------------------------------------------109
Keywords ------------------------------------------------------------------------------------------------ 109

88
Aim
The main aim of this unit is to help students to understand and able to analyse the financial
ratios through financial statements which helps to interpret the financial performance of
the company.
This unit intends to help students to:
• Describe several types of ratios
• Analyse the Interpretation of Ratios
Learning Outcomes
• Illustrate the ratios on financial data
• Demonstrate and interpret the ratio in meaningful way

89
2.2.1 Meaning and Advantages of Ratio Analysis
A ratio is a mathematical expression that describes the relationship between two variables. It can
be stated as a percentage, a ratio, or a rate. It is a useful financial analysis tool. Ratio analysis is
a quantitative method for analysing a company’s strengths and flaws. It aids investors in making
critical investment decisions by identifying the firm’s financial performance.
Ratio analysis attempts to explain the link between various components in the profit and loss
account and balance sheet by analysing their significance. This type of study aids investors in
drawing conclusions and forecasting the company’s future success.
A ratio analysis can be performed on a single company using data from the previous year or the
previous five years. It can also be done for certain years or for intra-firm analysis for organisations
in similar industries. This type of study gives information to both the company and potential
investors.
Advantages of ratio analysis
It aids in identifying key areas where the company is strong or weak.

It aids in the development of strategies to address the company’s weaknesses.
It also aids in the identification of areas that need to be strengthened further.
It aids in determining the company’s current and previous performance.
For businesses, it aids intra and inter-comparison.

90
1. Which methods are used for company’s strengths and flaws?
(a) Qualitative methods

(b) Quantative methods
(c) Rational methods
(d) Income method
2. Which explain the strengths and weakness of a company?
(a) Ratio analysis

(b) Financial method
(c) Ratio accounting
(d) Internal accounting
3. Ratio analysis is _________analysis Ratio Qualitative.
(a) Quantitative
(b) Metric
(c) Measurement
(d) Qualitative
4. _________helps investors in making critical investment decisions by identifying the

firm’s financial performance.
(a) Ratio analysis

(b) Financial method
(c) Ratio accounting
(d) Internal accounting
5. Ratio Analysis can be used for comparing the performance between two firms.
(a) Yes
(b) No

91
2.2.2 Classification of Ratios
There are the four types of ratios that can be found as here:
1. Short term Solvency ratios

2. Longterm solvency ratios
3. Profit margin ratios
4. Fund management

2.2.2.1 Liquidity ratios
Liquidity ratios are used to measure short-term solvency of a business Liquidity ratios are a
measure of how liquid something is. These figures represent the company’s liquidity. It determines
whether or not the company will be able to repay its present creditors with current assets within
a year. If a company can pay off its debts, it is described as solvent; if it is unable to do so, it is
described as insolvent.
It is calculated by dividing current assets by current liabilities.
Current ratio = Current assets/Current liabilities
A ratio of 2:1 is preferable
Current assets Include:
Short-term loans deposits and advances

Stock
Loose tools
Cash in hand and bank
Prepaid expenses
Marketable investments and short-term securities
Incomes receivables
Bills receivables and debtors
Current liabilities include:
Sundry creditors/bills payable

Outstanding expenses
Unclaimed dividend
Advances received
Incomes received in advance
Provision for taxation
Proposed dividend
Instalments of loans payable within 12 months
Bank overdraft and cash credit

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Quick ratio or acid test ratio
The Quick ratio is the ratio of current assets which are of highly liquid to current liabilities.
Quick Ratio = Quick assets/Quick Liabilities
In most circumstances, a quick ratio of 1:1 is considered sufficient.
Quick assets are current assets that do not include prepaid expenses or inventories.
Quick liabilities are current liabilities minus bank overdrafts and money received in
advance.
2.2.2.2 Leverage ratios
Capital structure/ leverage ratios
These ratios demonstrate a business’s long-term solvency and ability to satisfy its long-term
obligations which implies Principal payments at maturity or in fixed instalments on predetermined
due date’s periodic interest payment during the loan’s term.
Debt equity ratio, proprietary ratio, debt to total capital ratio, interest coverage ratio, and debt
service coverage ratio are the various ratios of leverage ratios.
Debt equity ratio
The proportion of debt and equity used to fund a company’s assets is depicted in this graph. To
arrive at this ratio, long-term debt is split by shareholder money.
Long-term debts/Shareholders = Debt Equity Ratio
Financial organisations prefer a 2:1 ratio in general. However, this criterion should be applied in
light of the firm’s size, type, and character, as well as the level of risk involved.
Long-term Funds = Long-term loans from banks or financial Institutions +

Debentures+ Bonds
Shareholder’s Funds = Equity share capital + Preference share capital + Reserves and
surplus - (Preliminary expenses +Past accumulated losses+ Discount on
issue of shares).
Proprietary ratio
This ratio reflects both the company’s overall financial strength and its long-term solvency. The
proprietor’s funds are divided by total funds to arrive at this percentage. The proprietor’s funds
are equal to the proprietor’s ratio; total assets/funds.
As a rough guide, a proprietary ratio of 65 percent to 75 percent is recommended.

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Proprietor funds are the same as those described in the shareholder’s funds section.
Total Funds = Fixed assets + Current assets
Debt to total capital ratio
Outside liabilities are compared to the firm’s entire capitalisation in this ratio. It displays how
much of the firm’s permanent capital is made up of long-term debt.
Long-term debt to total capital ratio = Total capital = Long-term debt + Shareholder funds
Traditionally, a 2/3 ratio has been considered ideal.
Ratio of interest coverage
This ratio evaluates a company’s debt servicing capacity in terms of long-term loans with set
interest rates. It shows how many times EBIT will cover interest charges before they’re paid.
Interest coverage ratio (EBIT/Interest coverage ratio) = Interest Coverage Ratio (EBIT/
Interest Coverage Ratio)
A ratio of 6–7 times is deemed satisfactory. The better the company’s ability to pay interest out
of profits, the higher the ratio. A high ratio, on the other hand, may suggest a lower use of debt
and/or highly efficient operations.
Debt service coverage ratio
This approach of calculating a company’s debt payment capacity is more comprehensive. It shows
how much total operational funds after tax payments satisfy overall debt service obligations,
which comprise interest and principal repayment in instalments.
Debt service coverage ratio = (EAT+ Interest + Depreciation + Other non-cash exp) /
(Interest + Principal instalment)
EAT stands for earnings after taxes.

A 2:1 ratio is generally seen as acceptable by financial institutions.

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6. Ideal current ratio is ___________.
(a) 5:1
(b) 2:1
(c) 0.98:1
(d) 1:1
7. Ideal quick ratio is _____.
(a) 5:1
(b) 2:1
(c) 0.98:1
(d) 1:1
8. Acceptable debt equity ratio is ___________.
(a) 5:1
(b) 2:1
(c) 0.98:1
(d) 1:1
9. __________ratio shows how many times EBIT will cover interest charges before
they’re paid.
(a) Debt coverage ratio

(b) Interest coverage ratio
(c) Interest ratio
(d) Debt ratio
10. Shareholder funds are also called as ____________.
(a) Proprietor ratio

(b) Owner ratio
(c) Debt equity
(d) Capital ratio

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2.2.3 Profitability Ratios and Investment Ratios
Profitability ratios
These ratios assess a company’s operational efficiency and its capacity to provide
acceptable returns to its owners.
Profitability ratios can be used to assess a company’s profitability.
Profitability ratios can also be calculated I in terms of sales and (ii) in terms of investments.
Profitability ratios as a percentage of sales
Net profit margin (NPM), Gross profit margin (GPM) and Expenses-to-income ratio
Ratios of profitability in relation to investments
Earnings per share (EPS) Dividend per share (DPS) Dividend pay-out ratio (D/P) Price earnings
ratio (P/E) Return on assets (ROA) Return on capital employed (ROCE) Return on shareholder’s
equity (ROE) Earnings per share (EPS) Dividend pay-out ratio (D/P) Price earnings ratio (P/E).
Gross profit margin
Divide gross profit by sales to get the gross profit to sales ratio. It is expressed as a percentage.
Gross profit is determined by the relationship between prices, sales volume, and costs.
Gross profit margin = (Gross profit/ Net sales) * 100
A business should have a reasonable gross profit margin to cover its operating costs and provide
a reasonable return to its shareholders, or the company’s owners.
The ratio should be compared to the firm’s past ratios, as well as the ratios of similar companies
in the same industry or the industry average, to see if it is satisfactory.
Net profit margin

Divide net profit by total sales to get the net profit to sales ratio. It is expressed as a
percentage.
This ratio demonstrates the firm’s ability to provide a suitable compensation margin
for the owners for contributing capital after covering the cost of production, operating
expenses, and the cost of borrowed funds.
Net profit margin = Net profit less interest and taxes multiplied by 100.
Operating profit margin is a type of net profit margin that is computed as follows:
Net profit before interest and taxes multiplied by 100 equals operating profit margin.
The higher the ratio, the greater the firm’s ability to withstand difficult economic
conditions, and vice versa.

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Expenses ratio
These ratios are calculated by dividing the various expenses by sales. The variants of expenses
ratios are:
(a). Material consumed ratio = Material consumed to Net sales
(b). Manufacturing expenses ratio = Manufacturing expenses to Net sales
(c). Administration expenses ratio = Administration expenses to Net sales
(d). Selling expenses ratio = Selling expenses to Net sales.
(e). Operating ratio = Cost of goods sold plus operating expenses to Net sales
(f). Financial expense ratio = Financial expenses to Net sales
The expense ratios should be compared over time to the industry average as well as to the ratios
of similar businesses. A low expense ratio is advantageous.
A high ratio means that only a tiny percentage of sales is available to cover financial obligations
such as interest, tax, and dividends.
Return on assets (ROA)
This ratio determines the profitability of a company’s total funds. It’s a metric for determining
the relationship between net income and total assets. The purpose is to see how successfully
management has used the assets as a whole.
Return on Assets = (Net profit after taxes + Interest multiplied) / Total assets
Total assets do not include fictitious assets. The denominator could be average total assets
because total assets at the beginning and end of the year may not be the same.
Return on capital employed (ROCE)
This ratio measures the relationship between net profit and capital employed. It demonstrates
how well long-term funds held by owners and creditors are used.
ROCE = (Net profit after taxes + Interest)/Employed capital
Shareholder funds and long-term borrowings are referred to as CAPITAL EMPLOYED.

The denominator could be average capital employed to give a realistic depiction of capital
employed.
Return on shareholders’ equity
A gauge of the profit-to-ownership-funds relationship is the profit-to-ownership-funds ratio. The

two sorts of shareholders are preference shareholders and equity shareholders. As a result,

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there exist a wide range of shareholder equity returns.
ROE = (Earnings after tax / Total equity share capital) * 100
Total Shareholder Equity = Preference share capital+ Equity share capital + Reserves,
and surplus - Accumulated losses and fictitious assets
To get a fair depiction of total shareholders’ funds, the denominator might be average total
shareholders’ funds.
Earnings per share (EPS)
On a per share basis, this ratio quantifies the profit accessible to equity stockholders. The net
profit available to equity shareholders is divided by the number of equity shares to arrive at this
ratio.
Earnings per share = (Net profit after tax – Preference dividend) / Number of outstanding
equity shares
Dividend per share (DPS)
On a per-share basis, this ratio depicts the dividend paid to the shareholder. This is a stronger
measure than EPS since it displays the amount of dividend paid to regular shareholders, whereas
EPS only shows how much belongs to ordinary shareholders theoretically.
Dividend per share = Total Dividend / N of Outstanding equity shareholders
Dividend Pay-out ratio
The link between ordinary shareholders’ earnings and the dividend paid to them is measured by
this ratio.
Dividend pay-out ratio =DPS/EPS*100
DPS=Dividend per share
EPS=Earnings per share
Price earnings ratio (P/E)
The price-to-earnings ratio (P/E) is a measure of how much return per rupee is earned by no of
times of investment.

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Divide the market price of the shares by the earnings per share to get this ratio. It assesses
investor expectations as well as market perceptions of the firm’s performance.
Price earnings ratio = market price per share / Earnings per share
It is expressed in No of times.

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11. _______ ratio depicts the dividend paid to the shareholder.
(a) Dividend per share

(b) Earnings per share
(c) Price earnings per share
12._________Ratio measures the relationship between net profit and capital employed.

(b) Earnings per share
(d) Return on capital employed
13. Divide net profit by total sales to get the net profit to sales ratio.
(a) Net profit ratio

(b) Gross profit ratio
(c) Expenses ratio
(d) None
14. _______determined by the relationship between prices, sales volume, and costs.
(a) Net profit ratio

(b) Gross profit ratio
(c) Expenses ratio
(d) None
15. This ratio determines the profitability of a company’s total funds.

(b) Return on Assets
(d) Return on capital employed

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2.2.4 Turnover Ratios
Activity ratios
These ratios are referred to as efficiency ratios, asset utilisation ratios, and turnover ratios. The
relationship between a company’s sales and its various assets is depicted by these ratios. The
following are some of the many ratios that can be found in this category:
The inventory/stock turnover ratio, the debtor turnover ratio, and the average collection period,
asset turnover ratio, creditor turnover ratio, average credit period are all ratios to be considered.
Inventory /stock turnover ratio
The number of times inventory is replaced during the year is represented by this ratio. It calculates
the correlation between the cost of products sold and the amount of inventory on hand. This ratio
can be calculated using one of two methods:
Inventory turnover ratio = Cost of goods sold / Average stock

Average Stock = (Opening stock+ closing stock) / 2
Inventory turnover ratio = Sales / Closing inventory
The inventory turnover ratio of a business should be neither too high nor too low. A high ratio
could indicate a low inventory level, putting you at danger of running out of goods and incurring a
significant ‘stock out cost.’ A low ratio, on the other hand, shows that there is too much inventory,
resulting in a high carrying cost.
Debtors’ turnover ratio and average collection period
This ratio is used to assess a company’s debtors’ liquidity. It depicts the link between debtors and
credit sales.
Credit sales / Average debtor turnover ratio Debtors and accounts receivable are two types of
receivables.
Months/days in a year = Average collection period
The effectiveness of trade credit management is shown by these ratios. A high turnover rate and
short collection duration indicate that the debtor is making timely payments. A low turnover rate
and a long collection period, on the other hand, indicate that the debtor is delaying payments. In
general, a high debtor turnover percentage and a short collection period are favoured.

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Asset turnover ratio
Depending on the different concepts of assets employed, there are many variants of this ratio.
These ratios measure the efficiency of a firm in managing and utilising its assets.
Total asset turnover ratio = Sales / Average total assets.

Fixed asset turnover ratio = Sales / Average fixed assets.
Capital turnover ratio = Sales / Average capital employed.
Working capital turnover ratio = Sales/Net working capital.
Higher ratios indicate efficient resource management and use, while low ratios indicate
resource underutilisation and the availability of idle capacity.
Creditors turnover ratio and average credit period
This ratio represents the speed with which payments are made to suppliers for purchases
made from them. It shows how average creditors and credit purchases are linked.
Creditors turnover ratio= Credit Purchases / Average Creditors & Bills Payables.
Months or days in a year/ Creditor’s turnover ratio = average credit period.
The creditor turnover ratio is a measure of how often a creditor changes hands.
Higher creditor turnover ratios and shorter credit periods indicate that creditors are paid
on time, which improves the firm’s creditworthiness.

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16. The relationship between a company’s sales and its various assets is depicted by:
(a) Activity ratio

(b) Return on assets
(c) Gross Profit
(d) Creditors’ turnover ratio
17. _________calculates the correlation between the cost of products sold and the
amount of inventory on hand.
(a) Stock turnover ratio

(c) Debtors’ collection period
18. This ratio represents the speed with which payments are made to suppliers for
purchases made from them.

19. This ratio is used to assess a company’s debtors’ liquidity:

20. These ratios measure the efficiency of a firm in managing and utilising its assets.

(b) Asset turnover ratio

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Summary
Ratio analysis is a quantitative method for analysing a company’s strengths and flaws.
It aids investors in making critical investment decisions by identifying the firm’s

financial performance.
Ratio analysis attempts to explain the link between various components in the profit
and loss account and balance sheet by analysing their significance.
This type of study aids investors in drawing conclusions and forecasting the company’s
future success.
Terminal Questions
1. Write about significance of ratio analysis.
2. Describe advantages of the ratio analysis.
3. Define leverage ratio and significance in accounting.
4. Explain the capital structure of company.
5. Elaborate the Long-term funds.
6. What is the difference between Debt equity ratio and shareholders’ funds.
7. Explain in detail proprietary ratio.
8. Explain the need of EBIT to interest coverage for a company.
9. Write the meaning and formula of return on equity and its relevance.
10. Explain A. Return on capital employed B. Return on equity.
11. Analyse suggestions based on expenses ratio.
12. Bring out difference between creditors’ turnover ratio and average credit period.

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Answer Keys
Question No Answers
1 B
2 D
3 B
4 B
5 A
6 A
7 D
8 A
9 B
10 B
11 B
12 A
13 C
14 C
15 D
16 B
17 A
18 D
19 C
20 B

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Practice Problems
1. The following Trading and Profit and Loss Account of Fantasy Ltd. for the year
31-3-2000 is given below:
Particulars Rs. Particulars Rs.

To Opening Stock 76,250 By Sales 5,00,000
“Purchases 3,15,250 “Closing stock 98,500
“Carriage and Freight 2,000
“Wages 5,000
“Gross Profit b/d 2,00,000
Total 5,98,500 Total 5,98,500
To Administration expenses 1,01,000 By Gross Profit b/d 2,00,000

“Selling and Dist. expenses 12,000 “Non-operating incomes:
“Non-operating expenses 2,000 “Interest on Securities 1,500
“Financial Expenses 7,000 “Dividend on shares 3,750
Net Profit c/d 84,000 “Profit on sale of shares 750
Total 2,06,000 Total 2,06,000
Calculate:
(a). Gross Profit Ratio

(b). Expenses Ratio
(c). Non-Operating Ratio
(d). Net Profit Ratio
(e). Operating (Net) Profit Ratio
(f). Stock Turnover Ratio
2. The Balance Sheet of Punjab Auto Limited as on 31-12-2002 was as follows:

Equity Share Capital Capital 40,000
Plant and Machinery 24,000
Reserve 8,000
Land and Buildings 40,000
8% Loan on Mortgage 32,000
Furniture & Fixtures 16,000
Creditors 16,000
Stock 12,000
Bank overdraft 4,000
Debtors 12,000
Taxation: Investments 4,000
(Short-term)
Current 4,000 Cash in hand 12,000
Future 4,000
Profit and Loss A/c 12,000
Total 1,20,000 Total 1,20,000

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From the above, compute
(a). Current Ratio

(b). Quick Ratio
(c). Debt-Equity Ratio
(d). Proprietary Ratio
3. From the following particulars extracted from the books of Ashok & Co. Ltd., compute
the following ratios and comment:
(a) Current ratio, (b) Acid Test Ratio, (c) Stock-Turnover Ratio, (d) Debtors Turnover
Ratio, (e) Creditors’ Turnover Ratio, and Average Debt Collection period.
1-1-2002 31-12-2002
Particulars
Rs. Rs.
Bills Receivable 30,000 60,000
Bills Payable 60,000 30,000
Sundry Debtors 1,20,000 1,50,000
Sundry Creditors 75,000 1,05,000
Stock-in-trade 96,000 1,44,000
Additional information:
On 31-12-2002, there were assets: Building Rs. 2,00,000, Cash Rs. 1,20,000 and Cash
at Bank Rs. 96,000.
Cash purchases Rs. 1,38,000 and Purchases Returns were Rs. 18,000.
Cash sales Rs. 1,50,000 and Sales returns were Rs. 6,000. Rate of gross profit 25% on
sales and actual gross profit was Rs. 1,50,000.
4. Following is the summarised Balance Sheet of Mona Ltd. as on 31-3-04:

Equity Shares of Rs. 10 each 10,00,000 Fixed Assets 20,00,000
10%
Pref. Sh. of Rs.100 each 4,00,000Investments 2,00,000
Reserves and Surplus 7,00,000Closing Stock 2,00,000
15% Debentures 5,00,000Sundry Debtors 4,60,000
Sundry Creditors 2,40,000Bills Receivable 60,000
Bank Overdraft 1,60,000Cash at Bank 60,000
Preliminary Expenses 20,000
Total 30,00,000 Total 30,00,000

107
Summarised Profit and Loss Account is as under for the year ending on 31-3-04:
Particulars Rs.
Sales (25% Cash sales) 80,00,000
Less: Cost of goods sold 56,00,000
Gross Profit 24,00,000
Net profit (Before interest and tax 50%) 9,00,000
Calculate the following ratios:
Rate on Return on Capital Employed
Proprietary Ratio
Debt-Equity
Capital Gearing Ratio
Debtors Ratio (365 days of the year.)
Rate of Return on Shareholders’ Funds
Rate of Return on Equity shareholder’s fund
Glossary
• Liquidity Ratios: A measure of the ability of a company to pay off its short-term
liabilities.
• Leverage Ratios: Any one of several financial measurements that assesses the
ability of a company to meet its financial obligations.
Bibliography
Textbooks
Education.
2. Horngren, C. T., Harrison, W., & Oliver, M. S. (2011). Financial & Managerial Accounting.
Pearson College Div.

108
External Reference
1) Choate, G. M., & Tanaka, K. (1979). Using financial ratio analysis to compare hospitals’
performance. Hospital progress, 60(12), 43-58.
e-references
1. https://corporatefinanceinstitute.com/resources/knowledge/finance/ratio-analysis/
2. https://online.hbs.edu/blog/post/financial-performance-measures
3. https://www.investopedia.com/articles/stocks/06/ratios.asp
Video Links
Topic Link
https://www.youtube.com/watch?v=-
Learn Ratio Analysis
zl5YcY37MnY
https://www.youtube.com/
Profitability Ratios Explained
watch?v=ROqkmlVuXKU
Financial Ratio Analysis
watch?v=SHAaBeVKak4
Keywords
• Ratio analysis
• Rational methods
• Critical investment

109
MODULE 3
UNIT 1
ADJUSTMENTS IN
FINANCIAL STATEMENTS

110
Module 3
COMPANY ACCOUNTS
Module Description
When the final accounts of a firm are being finalised, necessary adjustment entries need to
be incorporated at the close of the year, in order to prepare correct accounts. Without passing
such adjustment entries, the correct value of the profit and loss for the year cannot be correctly
determined.To obtain a record of the transactions excluded from the record book. To correct the
errors made in the books of account. To record such incomes that have accrued but not have
been received. To provide for depreciation and other provision.
An accounting adjustment is a business transaction that has not yet been included in the
accounting records of a business as of a specific date. Most transactions are eventually recorded
through the recordation of (for example) a supplier invoice, a customer billing, or the receipt of
cash.
Unit 3.1 Adjustments in Financial Statements

Unit 3.2 Issue of Shares
Unit 3.3 Company Final Accounts

111
Unit – 3.1 Adjustments in Financial Statements
Aim ------------------------------------------------------------------------------------------------------- 113

Instructional Objectives ----------------------------------------------------------------------------- 113
3.1.1 Adjustments ---------------------------------------------------------------------------------- 114

3.1.2 Depreciation ---------------------------------------------------------------------------------- 117
3.1.3 Depreciation and Its Methods ------------------------------------------------------------ 120
Summary ------------------------------------------------------------------------------------------------ 127

Answer Keys ------------------------------------------------------------------------------------------- 128
Practice Problems ------------------------------------------------------------------------------------ 129
Glossary ------------------------------------------------------------------------------------------------- 132
Bibliography -------------------------------------------------------------------------------------------- 133
e-References ------------------------------------------------------------------------------------------ 133
Video links ---------------------------------------------------------------------------------------------- 133
Keywords ----------------------------------------------------------------------------------------------- 134

112
Aim
The main aim of this unit is to make students gain an insight into the preparation of
financial statements with adjustments to be made before the closure of the balance sheet.
• Apply adjustments in preparation of financial statements
• Identify depreciation and its various methods
Learning Outcomes
• Apply adjustments in financial statements using a Trial Balance
• Examine various methods of depreciation vis-a-vis Fixed Asset

113
Adjustments in Final Accounts
These financial statements are created using a given Trial balance. The expenses
listed in the Trial balance may not be the complete expenses for the accounting
year for which it was prepared. In the same way, part or all of the expenses listed in
the Trial balance may be for the following year (s).
Financial statements produced using such a Trial balance will not accurately reflect
the genuine state of the business. The amount of net profit or loss on the income
statement will be incorrect. Similarly, the balance sheet will not accurately reflect
the company’s genuine financial status.
As a result, before compiling the financial statement, it is necessary to identify

the unpaid current-year expenses. Expenses for a future year that were paid or
received during the current year must also be tracked down. As a result, some
‘adjustments’ to some expense and revenue categories become necessary, which
are called adjustments to Final Accounts.
Accounting Adjustments serve the following purposes:

1. To calculate the right net profit or loss for a specific accounting year.
2. To be informed of the genuine financial status of the company.
3. To keep track of accumulated outstanding invoices.
4. To keep track of expenses that have been paid in advance for the following year.
5. To account for depreciation of fixed assets.
3.1.1 Adjustments
1. Closing stock: Closing stock is the unsold stock of products at the end of the
accounting year. Normally, this item isn’t shown in the Trial balance. It shows
supplementary data outside of the trial balance.
Treatment:
a. Put it on the Credit side of the trading account;

b. Put it on the Assets side of the balance sheet as an asset.
2. Outstanding expenses: Outstanding expenses are expenses that relate to the

current year but have not been paid until the end of the accounting year. For
example, factory rent, wages, salaries, office rent, telephone charges, and so on
for the current year may not have been paid until the end of the accounting year.
Treatment:
a. Trading Account: Display on the debit side of the ledger (add to respective
direct expense).

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b. Profit & Loss Account: Display the debit side of the ledger (add to respective
indirect expense).
c. Balance Sheet: On the liability side of the balance sheet, show current
liabilities.
3. Prepaid expenses or Unexpired expenses: These are also known as pre-paid
expenses. Prepaid expenses are those that are paid ahead of time for a benefit that
has not yet been obtained. It’s critical to report profits near the end of an accounting
year to avoid understating them. Prepaid rent, prepaid interest, prepaid insurance,
and so forth are examples.
Treatment:
a. Trading Account: Display on the Debit side of the ledger (subtract from the
respective direct expense.)
b. Profit & Loss Account: Display the Debit side of the ledger (subtract from
the respective indirect expense).
c. Assets side of the balance sheet (usually under the head current assets).
4. Outstanding income vs. Accrued income: Expenses like this are also known as
income generated but not yet received. Accrued income refers to revenue that has
already been earned but has not yet been received by the company. Rent that has
not been paid, commission that has not been received, and so on.
Treatment:
a. Profit & Loss Account: Display on the Credit side of the ledger (Add to
respective income).
b. Balance Sheet: Display the Assets side of the balance sheet (usually under
the head current assets).
5. Unearned income: This is also known as income received in advance. Income

received in advance is money that the company has already received but has yet
to be earned. Rent is paid in advance, commission is paid in advance, and so on.
Treatment:
a. Profit & Loss Account: Display on the Credit side of the ledger (Subtract
from the respective income)
b. Show on the Liability side of the balance sheet (usually under the head current
liabilities)

115
1. Every adjusting entry affects?
(a) Income statement account only

(b) Balance sheet account only
(c) Both A & B
(d) None
2. If a business pays only 11 months’ rent during a financial year, what accounting term
is given to the outstanding one month’s rent?
(a) Repayment
(b) Prepayment
(c) Underpayment
(d) Payable
3. A balance of unearned rent at the end of period represents:
(a) An asset
(b) Expenses
(c) A liability
(d) Revenue
4. Which one of the following is an example of unearned income:
(a) Cash paid to supplier

(b) Advanced received from bank
(c) Advanced received from a customer for a purchase order place by him
(d) Cash discount received from customer
5. A liability account that reports amounts received in advance of providing goods and
services:
(a) Unearned revenue

(b) Earned liabilities
(c) Earned revenue
(d) Revenue

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3.1.2 Depreciation
It’s a non-cash expense, which means it’s not paid in cash or currency equivalents. The cost of a
fixed asset is allocated over its anticipated useful life through depreciation. Because fixed assets
are used to generate revenue, a reduction in their value is considered an expense incurred in
order to generate that revenue.
Treatment:
Profit & Loss Account: Display on the debit side of the ledger (calculate as per
percent & method given).
Asset side of the balance sheet: (subtract depreciation from the fixed asset).
Bad debts
Not all of a company’s creditors will be able to pay 100 percent of their bills all of the time. This
can result in a loss for the receiving company, which is referred to as bad debt.
Treatment:
Situation 1: When bad debts are included in the trial balance, they are only reported
in the P&L.
Situation 2: When bad debts are presented as an adjustment outside the trial balance,
they are referred to as further bad debts, and final accounts adjustments are recorded.
Profit & Loss Account: Display on the debit side of the ledger (add to bad debts
already written off)
Asset side of the balance sheet: (subtract from sundry debtors)
Contingency fund for doubtful debts
Prudence and conservatism, an accounting principle, warns that each company should be
prepared to bear all expected losses. As a result, all firms set aside money in the form of provision
for dubious debts to cover the possibility of bad debts originating from non-payment by debtors.
Provision for debtor discount
Debtors are given a monetary discount as an incentive for making timely payments. Because the
payment may be received in the following accounting year in some situations, such discounts
should be treated as a cost in the current year under the accrual approach of accounting. A
provision for discount on debtors is generated when such a provision is made.
Treatment:
Profit & Loss Account: Show on the debit side (compute on good debtors, i.e.,
after adjusting bad debts & provision for doubtful debts).
Balance Sheet: Show on the asset side (calculate on good debtors, i.e., after
adjusting bad debts & provision for doubtful debts) (subtract from sundry debtors).

117
Capital interest
Capital refers to the amount of money invested in a business by the owner. It is usual for a
company to pay some type of (pre-determined) interest on its capital. Interest paid is recognised
as an expense and is deducted before calculating a company’s net profit or loss.
Treatment:
Show the Debit side of the profit and loss account.
Show on the Liabilities side of the balance sheet (add to the owner’s capital).
Drawings of personal use goods
A business owner may opt to withdraw cash or items from their own company; this is a regular
practice. It’s known as drawings, and it lowers a company’s total purchases.
Treatment:
Debit Side Trading Account (Subtract from purchases).
Balance Sheet: Show on the Liabilities side (subtract from owner’s capital).
Profit & Loss Account: No effect.

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6. Closing stock is _______ in balance sheet.
(a) Liabilities
(b) Assets
(c) Income
(d) Expense
7. Interest on drawings is _________.
(a) Liabilities
(b) Assets
(c) Income
(d) Expense
8. All provisions are _______.
(a) Liabilities
(b) Assets
(c) Income
(d) Expense
9. Interest on capital is ____.
(a) Liabilities
(b) Assets
(c) Income
(d) Expense
10. Outstanding expense is a____.
(a) Liabilities
(b) Assets
(c) Income
(d) Expense

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3.1.3 Depreciation and its Methods
Depreciation is defined as the systematic reduction of the recorded cost of a fixed

asset until the asset’s value reaches zero or inconsequential.
Buildings, furniture, office equipment, machinery, and other fixed assets are
examples. Because the value of land increases with time, it is the sole exception
that cannot be depreciated. Depreciation permits a portion of the cost of a fixed
asset to be applied to the revenue provided by the fixed asset. Revenues are
recorded with their corresponding expenses in the accounting period when the
asset is in use, hence this is required by the matching principle. This makes it
easier to acquire a full view of the revenue generation transaction.
Depreciation Example: If a firm buys a delivery truck for Rs.100,000 and expects
to use it for 5 years, the company may depreciate the asset at a rate of Rs.
20,000 per year for 5 years.
Depreciation causes
1. Wear and tear: As a result of normal use, some assets deteriorate physically.
When an asset is used for production on a regular basis, it wears out. The more
an asset is used, the more wear and tear it will suffer. Movement, pressure,
friction, erosion, and other factors contribute to the physical deterioration of an
asset. Buildings, machinery, furniture, automobiles, and plants, for example.
Wear and tear are a common yet important cause of depreciation.
2. Time lapse: Certain assets, such as leasehold property, patents, and copyright,
are purchased for a specific period of time. They are rendered useless after the
period has expired, i.e., their value has vanished. As a result, their expenses are
written off over the course of their legal careers.
3. Obsolescence: When new and improved machines are introduced, old machines
are phased out. As a result, new inventions, changes in fashion and taste, market
conditions, government legislation, and other factors might cause an asset’s value
to be discarded. However, this is neither the cause nor the effect of depreciation
in the true sense.
A new machine performs the same work faster and is more affordable than the
old one. As a result, existing machines may become obsolete or out of date.
4. Exhaustion: Some assets are inherently wasteful. For example, quarries, mines,
and oil wells. It’s the diminishing worth of natural deposits as resources are
removed year after year. As a result, these assets are referred to as “wasting
assets.” The removal of its contents physically exhausts the coalmine or oil well.

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5. Non-use: Machines that are left idle grow less and less useful as time passes.
Certain sorts of machinery that are exposed to the elements may depreciate
more from not being used than from being used.
6. Maintenance: Keeping a machine in good working order will automatically

extend its life. There is greater depreciated value when there is no maintenance.
Machines have a longer life span when they are well maintained. Good and
competent maintenance is essential for a machine’s extended life.
7. Market trend: In the case of some assets, such as gilt-edged securities, the
market price may change. When prices fall, the value of the asset in question
may decrease. Accidents can depreciate the value of assets in some instances.
Depreciation providers’ objectives
1. Replacement of fixed assets: The primary goal of depreciation is to amass

sufficient funds to replace an old asset with a new one at the end of its useful life.
2. To expose the true financial situation: Fixed assets are charged depreciation,
which helps to indicate the asset’s current value. As a result, it aids in displaying
the genuine financial situation (assets and liabilities) of the company.
3. To lower tax obligation: Depreciation is deducted from the business’s operational

profit, lowering the company’s taxed liability.
4. Calculating true profit: Depreciation (the decrease in the book value of fixed
assets) is charged to revenue in the same way that other operating expenses
are. As a result, it aids in determining the firm’s genuine profit.
5. Calculate the cost of production: In order to ascertain the true or actual cost
of production, depreciation should be applied to fixed assets such as machinery
and plants.

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11. What is the definition of depreciation?
(a) A rise in the value of an asset over a period of time

(b) Over time, resource usage depletes the resource
(c) Assets that can be converted into cash fast
(d) Having more assets than liabilities
12. What is the most important goal of depreciation?
(a) Display the profit from the previous year

(b) Present records to the internal revenue service
(c) To receive a tax refund
(d) To figure out how much money you’ve made
13. What is the purpose of a depreciation provision in the accounts?
(a) To display the current asset value

(b) To demonstrate current liabilities
(c) To deduct the cost of assets from profits
(d) To acquire new assets
14. What is the definition of depreciable value?
(a) An asset’s whole cost of purchase and installation can be discounted less its
salvage value.
(b) The value of the components of a physical asset when the item itself is no
longer usable
(c) Indicates how much a firm is worth on the stock market
(d) An asset’s expected resale value at the end of its useful life
15. What is the salvage value of a vehicle?
(a) An asset’s whole cost of purchase and installation can be discounted less its
salvage value
(b) The value of the components of a physical asset when the item itself is no
longer usable
(c) Indicates how much a firm is worth on the stock market
(d) An asset’s expected resale value at the end of its useful life

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Methods for Providing Depreciation
1. Uniform Charge Methods

a. Fixed installment method
b. Depletion method
c. Machine hour rate method
2. Declining Methods
a. Diminishing balance method
b. Sum of years digits method
c. Double declining method
3. Other Methods
a. Group depreciation method
b. Inventory system of depreciation
c. Annuity method
d. Depreciation fund method
1. Uniform charge methods
Depreciation is charged on a uniform basis year after year.
a. Fixed installment method:
Straight Line method

Depreciation is charged evenly every year throughout the life of the asset.
Depreciation = C-S /L where c= cost of asset, S=scrap and L= life of Asset
The same amount of depreciation is charged from year to year.
b. Depletion method: It’s a productive output method based on the following

factors:
Total amount paid.

Total estimated qty of output available.
Actual qty taken out during the accounting year.
For Example,
Mine = Rs 20,000/-, mineral in mine = 40,000 tonnes
Rate of depreciation per tonne = 20,000/40,000 =0.50 Per tonne
If output in a year =1,000 tonnes = 1,000*0.50 =5,000 as Depreciation
c. Machine hour rate method
Also called service hours method

The running time of the asset
Depreciation = C-S/Life of asset in hours

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For Example,
Machine = Rs 10000/-, Life 10 Years of 1000 hours each Scrap value = 1000
Depreciation per hour = (10000-1000)/10000 = 0.90
If machine works for 600 hours
Depreciation = 600*0.90 = 540
2. Declining charge methods
The amount of depreciation declines over the assets expected life.
a. Diminishing balance method
Depreciation is charged on the book value of the asset each year.

Amount of Depreciation goes on decreasing every year.
For Example,
The rate of Depreciation = 10%, Machinery =200000/-
Depreciation for I year = 20000/-, II year = 180000*10/100=18000/-
III yr =162000*10/100 =16200 and so on.
b. Sum of years digits Method
The amount of depreciation to be charged under this goes on decreasing

every year.
Depreciation = (Remaining life of asset /Sum of all digits of life of the assets)
* original cost
For Example,
Cost of Machine -10000/-, Life=5 years
Dep I yr = (5/1+2+3+4+5) *10000 = 3333/-
II yr = (4/1+2+3+4+5) *10000=2,666/-
III yr = (3/1+2+3+4+5) *10000 = 1,333/-
c. Double declining balance method
Similar to declining balance method where the rate of depreciation is charged

is twice the straight-line rate.
3. Other methods
a. Group depreciation method
All Homogenous assets are grouped into a single asset category.

One summary account will be established for each group.
Cost of all assets in the group is charged to this account.

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Depreciation is charged for the group total not item by item.
Depreciation is charged for the group at a rate based on the expected average
service life and scrap values of the assets of the group.
b. Inventory system of depreciation
Those assets which are of small values such as loose tools or where the life
of the asset cannot be ascertained.
Cost of asset at Beginning ****
+ Cost of Asset purchased ***
Cost of asset at the end ***
Dep= ***
c. Annuity method
It takes into account Depreciation +Interest

Interest is calculated on the book value of the asset in the beginning of the
year.
Depreciation is uniform
d. Sinking fund method
To provide replacement of asset at the end of its useful life.

Amount of Depreciation gets invested in particular securities at a particular
rate of interest.
Interest +Depreciation = Invested
At the end of the period when asset is to be replaced, securities are sold away,
and asset is replaced.

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16. The systematic reduction of the recorded cost of a fixed asset until the asset’s value
reaches zero or inconsequential.
(a) Depreciation
(b) Amortisation
(c) Intangible
(d) Tangible
17. Depreciation is charged on a uniform basis year after year.
(a) Uniform method

(b) Declining method
(c) Machine hour method
(d) Depletion
18. Depreciation is charged for the group total not item by item.
(a) Uniform method

(b) Declining method
(c) Group depreciation method
(d) Depletion
19. ______ method takes into account depreciation and interest.
(a) Uniform method

(b) Group depreciation method
(c) Depletion
(d) Annuity method
20. _______is used provide for replacement of asset at the end of its useful life.
(a) Uniform method

(b) Sinking fund method
(c) Depletion
(d) Annuity method

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Summary
These financial statements are created by using a given Trial balance. The expenses
listed in the Trial balance may not be the complete expenses for the accounting year
for which it was prepared.
In the same way, part or all the expenses listed in the Trial balance may be for the
following year. Financial statements produced using such a Trial balance will not
accurately reflect the genuine state of the business.
The amount of net profit or loss on the income statement will be incorrect. Similarly,
the balance sheet will not accurately reflect the company’s genuine financial status.
Depreciation is defined as the systematic reduction of the recorded cost of a fixed

asset. There are different methods like uniform charge, declining charge and other
methods of depreciation.
Terminal Questions
1. Explain adjustment treatment for provision for bad and doubtful debts.
2. Write about objectives of Depreciation.
3. Explain various depreciation methods.
4. Explain adjustment treatment for
a. Closing stock
b. Prepaid expense
c. Income received in advance
d. Outstanding expense
5. Explain the adjustment treatment for bad debts.

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Answer Keys
Question No Answers
1 C
2 C
3 A
4 C
5 A
6 B
7 C
8 A
9 D
10 A
11 B
12 D
13 D
14 D
15 D
16 A
17 A
18 C
19 D
20 B

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Practice Problems
1. The following Trial Balance is extracted from the books of Murthy on 31-12-2014.
Prepare the balance sheet as on that date after considering all the adjustments.
Particulars Debit Credit Particulars Debit Credit

Furniture 640 Bad debts 125
Motor Vehicles 6,250 Provision for Bad debts 200
Buildings 7,500 Debtors and Creditors 3,800 2,500
Capital 12,500 Opening Stock 3,460
Purchases & Sales 5,475 15,450 Bank OD 2,850
Returns 200 125 Advertising 450
Interest 118 Commission 375
Cash 650 Tax and Insurance 1,250
General Expenses 782 Salaries 3,300
Total 33,800 33,800 Total 33,800 33,800
Adjustments:
i. Closing Stock Rs 3,250/-
ii. Depreciate Buildings by 5%, Furniture 10%, Motor by 20%
iii. 85/- is due for interest on Bank OD
iv. Salaries Rs 300/- and taxes Rs 120/- are Outstanding
v. Prepaid Insurance Rs 100/-
vi. Write off further Bad debts Rs 100/-
vii. Provision for Bad and doubtful debts is to be made equal to 5% on debtors
viii. 1/3rd of the commission is received in advance.
2. From the following Trial balance and additional information, Prepare a trading and
profit and Loss account and balance sheet.
Capital 20,000
Sundry Debtors 5,400
Drawings 1,800
Machinery 7,000
Sundry Creditors 2,800
Wages 10,000
Purchases 19,000
Opening stock 4,000
Bank 3,000
Carriage inwards 300
Salaries 400
Sales 29,000
Rent and taxes 900
Total 51,800 51,800

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Adjustments:
i. Closing stock Rs 1,200/-
ii. Outstanding rent and taxes Rs 100/-
iii. Depreciation on Machinery at 10%.
iv. Wages prepaid Rs 400/-.
3. From the following details, prepare trading and profit and loss account for the year
ended 31.3.2014 and balance sheet as on that date.
Drawings 14,000
Capital 85,000
Machinery 19,200
Stock 29,200
Purchases & Sales 2,07,240 2,38,120
Returns 4,200 5,820
Sundry Expenses 15,200
Apprentice Premium 2,400
Bank OD 4,000
Bad debts 3,440
Debtors & Creditors 64,000 20,000
Bills Receivable 4,800
Bills Payable 3,600
Provision for Bad and doubtful debts 3,300
Cash 960
Total 3,62,240 3,62,240
Adjustments:
i. Closing stock Rs 40,000/-
ii. Maintain provision for doubtful debts at 2% on debtors.
iii. Depreciate Machinery at 20%.

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4. Prepare trading and profit and loss account and balance sheet from the following
closing balances extracted from the books of Mr. Sudeep as on 31.3.2013
Particulars Rs
Capital 10,000
Drawings 2,000
Purchases 20,800
Opening stock 6,900
Sales 27,500
Creditors 8,100
Rent 1,000
Discount received 270
Furniture 900
Machinery 5,000
Travelling Expenses 650
Bad debts 120
Debtors 7,500
Returns inwards 300
Returns Outwards 580
Carriage inwards 400
Wages 325
Salaries 900
Interest 480
Carriage Outwards 705
Insurance 900
Bank loan 3,000
Cash in hand 700
Outstanding Expenses 130
Adjustments:
i. Closing stock was valued at Rs 8,900/-
ii. Insurance Prepaid Rs 250/-
iii. Outstanding Salaries Rs 100/-
iv. Outstanding Rent Rs 200/-
v. Interest on Bank loan Rs 150/-
vi. Depreciation Machinery and Furniture at 10%
vii. Provide for doubtful debts at 5% on debtors.

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5. From the following Trial balance of M/S Sundry Traders as on 31.3.13, Prepare
Profit and Loss account and Balance sheet as on 31.3.13.

Capital 1,00,000
Drawings 18,000
Buildings 15,000
Furniture 7,500
Motor Van 25,000
Loan to Sri 15,000
Interest and sales 450 1,00,000
Purchases 75,000
Stock 1.4.12 25,000
Establishment 15,000
Expenses
Freight inward 2,000
Freight Outward 1,050
Bank OD 25,000
Commission received 7,500
Debtors 28,000
Bank 20,500
Sundry Creditors 15,000
Adjustments:
i. Closing Stock was valued at Rs 25,000/-
ii. Depreciate Buildings by 10% and furniture by 5%
iii. Provide a reserve for Bad debts @5%
iv. Outstanding bank OD Rs 2,000/-
Glossary
• Repayment: The period from the starting point of credit to the final maturity of a
transaction.
• Trial Balance: A financial report showing the closing balances of all accounts in the
general ledger at a point in time.

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Bibliography
Textbooks
Education.
e-References
1. https://nios.ac.in/media/documents/Seccour224New/ch_15.pdf
2. https://www.accountingcapital.com/india/adjustments-in-final-accounts/
3. https://www.accaglobal.com/in/en/student/exam-support-resources/fundamentals-ex-
ams-study-resources/f3/technical-articles/adjustments-financial-statements.html
Video Links
Topic Link
Final Accounts
watch?v=z1dNEz0zO4U
Final accounts adjustments https://www.youtube.com/watch?v=T-

Explanation Dv8F-GphpM
Depreciation Methods
watch?v=isqop9h22XY

133
Keywords
• Outstanding expenses
• Prepayment
• Underpayment
• Payable

134
MODULE 3
UNIT 2
ISSUE OF SHARES

135
Table of Contents
Unit – 3.2 Issue of Shares
Aim ------------------------------------------------------------------------------------------------------- 137

3.2.1 Issue of Shares: Meaning and Procedure -------------------------------------------- 138

3.2.2 Entries in Issue of Shares ---------------------------------------------------------------- 143
3.2.2.1 Accounting entries regarding issue of shares at par ------------------- 143
3.2.2.2 Issue of shares at premium -------------------------------------------------- 146
3.2.2.3 Issue of shares at discount --------------------------------------------------- 149
3.2.3 Posting of Entries --------------------------------------------------------------------------- 151
Summary ------------------------------------------------------------------------------------------------ 154

Answer Keys ------------------------------------------------------------------------------------------- 155
Practice Problems on Entries ---------------------------------------------------------------------- 156
Glossary ------------------------------------------------------------------------------------------------- 156
Bibliography -------------------------------------------------------------------------------------------- 156
e-References ------------------------------------------------------------------------------------------- 156
Image Credits ------------------------------------------------------------------------------------------ 157
Video links ---------------------------------------------------------------------------------------------- 157
Keywords ----------------------------------------------------------------------------------------------- 157

136
Aim
The main aim of this unit is to enhance the understanding of company accounts and
procedure for the issue of shares by the companies.
• Elaborate upon the concept of share and its types
• Describe the procedure for the issue of shares
• Explain entries and posting of accounts for issue of shares
Learning Outcomes
• Conceptualise shares and its types
• Examine the procedure for the issue of shares in a business
• Summarise the entries and posting of accounts for issue of shares

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3.2.1 Issue of Shares: Meaning and Procedure
It is evident from the first unit that an individual can run a business in a variety of ways, such as
a sole trader, a partnership, or a joint stock company. There is a distinction between ownership
and management in the company form of business that does not exist in the sole trading concern
or partnership form of business. Owners in a company type of business are shareholders who
supply capital to the company by subscribing to the company’s shares. Because all of these
shareholders are spread out across the country, they must appoint a Board of Directors to oversee
the company’s activities. To be clear, the company capital is provided by shareholders and
managed by the Board of Directors, which is referred to as the Principle and Agent relationship.
A share is a unit of ownership in the company’s capital. Any individual or institution who purchases
stock in the company becomes a shareholder. He has the right to receive notices and agendas,
as well as voting rights at annual general meetings. A vote is equal to one share. Both public
and private companies can issue shares. Public firms can issue shares to the general public, but
private corporations can only obtain funds from their own friends, relatives, or directors.
Types of shares:
1. Equity shares
2. Preference Shares
1. Equity shareholders: Anyone who invests in equity shares is referred to as an

equity shareholder. They are referred to be the company’s true owners. In the event
of the company’s winding up, they were given last priority in dividend payments and
capital return. There is no set dividend rate. They have the right to vote, with one
vote equivalent to one share. They have a right to participate in decision-making
by attending yearly general meetings and voting on resolutions approved at these
sessions. Equity shareholders have a right to obtain additional equity shares provided
by the company before they are offered to the public for subscription, which is known
as a preemptive right.
2. Preference shares: Preference shareholders are investors who purchase Preference

shares. When a corporation is being wound up, preference shareholders are given
first priority in dividend pay-out and capital payback. They are paid a predetermined
dividend rate. They do not have the right to attend, get notice, or vote in general
meetings unless their rights are affected by the decisions made in those meetings.
Issue of Shares
The term “issue of shares” refers to the distribution of an enterprise’s or any financial asset’s
shares among shareholders who choose to purchase them. Individuals or corporations can be
shareholders if they participate in the purchase of shares at a set price. Let’s look at an example
to better understand the notion of share allocation. XYZ is a firm with a total capital of Rs. 6
lakhs. The capital has been divided into 6000 units of shares, each worth Rs. 100. As a result,

138
each unit or share of the corporation is valued at Rs. 100. At this price, individuals or businesses
can purchase the stock. As a result, owning a share in a company is frequently seen as partial
ownership. Anyone who owns a share is referred to as a shareholder for the same reason.
Procedure for Issuing Shares
The process of issuing shares is separated into three major parts, which are as follows:
each unit or share of the corporation is valued at Rs. 100. At this price, individuals or businesses
can purchase the stock. As a result, owning a share in a company is frequently seen as partial
ownership. Anyone who owns a share is referred to as a shareholder for the same reason.
Procedure for Issuing Shares
The process of issuing shares is separated into three major parts, which are as follows:
Issue of Prospectus
Application of shares
Allotment of shares PROCEDURE

FOR ISSUE OF
SHARES
calls on shares
INVESTOR
TO NIGHT
calls in arrears
calls in advance
Fig. 1: Process of issuing shares
1. The prospectus: This is the first phase in the Issue of Shares process, in which an
organisation distributes a prospectus to the general public. It informs the public that
a new business has been established and that it will require public funding to run, for
which the public can purchase shares in the business.
The prospectus contains all of the relevant information about the share issuing
authority, as well as information about how they will collect money from investors.

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2. Receipt of application: The receipt of an application when an investor seeks to
purchase a share of that asset or firm is the second step in share issuing. They must,
however, adhere to the necessary norms and regulations outlined in the prospectus.
They must also put the money down against the shares they want to buy. Along with
the application, the money must be deposited at any designated bank.
3. Allocation of resources: This is the final phase in the issue of shares, in which the
firm issues the shares to the investors after the investor’s formalities are completed.
Because there is a minimum subscription limit, one must wait till it is met.
The shares will be allotted to those investors who have subscribed for the capital
shares after that limit has been reached. Those who have been assigned shares
receive a letter of allotment as well.
As a result, this procedure provides a genuine means of exchanging shares between

investors and businesses.
The primary motive for the corporation issuing new shares is to raise funds to finance
the business. The following are some scenarios in which a share allotment might be
considered:
When a corporation is formed, a number of shares are normally issued. The company
will be able to trade with the help of a share offering, as well as any money it may
borrow.
When a corporation requires additional cash to grow organically, it considers allotment

of shares. Several factors determine the number of shares to be issued.
Shares might be issued in order to repay all or part of the company’s debt.
Shares can be issued to fund the acquisition of another firm, which entails obtaining
money through a share offering and then using that money to buy the new company.
Shares can also be issued to keep a company trading after a particularly tough period,
to restore a damaged balance sheet, or in the event of widespread issues in an industry
or as part of a larger economic slump.
A capitalisation issue of shares to existing shareholders is an option for the corporation.

Rather of the shareholders paying for the shares directly, the firm funds the allotment
with its own funds. This has the effect of lowering the value of the shares in circulation,
potentially making them more marketable to investors.

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If shareholders prefer not to receive a cash dividend, the corporation may instead
offer them a ‘scrip’ dividend, which consists of the same number of shares as the cash
dividend. Because releasing shares as a dividend does not have the same impact on
cash flow as a cash dividend, this is a popular option among businesses.
The company may acquire shares if a director or employee of the company exercises
a share option after being granted permission by the company.
If a new director or senior employee joins the company, or an existing employee

becomes a director, the firm may consider allocating the shares. This might reflect an
employee’s or a new director’s dedication to the company, and they will have a vested
stake in its success. The shares would be transferred from existing shareholders to the
employee or new director, or a new Allotment of Shares would be issued.

141
1. Shares are issued to public by _________companies.
(a) Private
(b) Public
(c) Government
(d) None
2. Preference shareholders receive _________dividend.
(a) Fixed
(b) Variable
(c) Profit
(d) None
3. Any Public issue will remain open for __days.
(a) 3
(b) 2
(c) 1
(d) None
4. Identify Steps in issue of shares:
(a) Prospectus, share application, Share allotment

(b) Share application, Share allotment, Prospectus
(c) Share allotment, Share application, Prospectus
5. Dividends paid in form of scrips are called ___________.
(a) Cash dividend

(b) Scrip dividend
(c) Bond debenture

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3.2.2 Entries for Issue of Shares

ISSUE OF SHARES
FOR CASH
AT A PAR AT A PREMIUM AT A DISCOUNT
FOR CONSIDERATION
OTHER THAN CASH
ISSUE OF SHARES ISSUE OF SHARES

TO VENDORS TO PROMOTERS
Fig. 2: Entries for Issue of shares
3.2.2.1 Accounting entries regarding issue of shares at par
A corporation can issue shares at face value or at a price that is different from the face value.
Shares issued at par are those that are issued at the same price as their face value. Shares
issued at a premium are those whose issue price is higher than their face value. Shares issued
at a discount are those whose issue price is less than their face value. A share’s issue price is
usually collected in stages: with the application, on allotment, and afterwards by making one or
two calls. Only when all of the money payable on the shares is received does it become fully paid
up.
1. On receipt of applications money:
Bank A/C Dr. ****

To share application A/C ****
(Being Application money received)
2. On allotment of shares:
a) Share application a/c Dr. ****

To share capital a/c ****
(Being appropriation of application money towards share capital)
b) Share Allotment a/c Dr. *********

To share capital a/c *********
(Being allotment money due on shares @ Rs. per share)
3. When allotment money is received, the following entry is passed:
Bank a/c Dr. ***********

To share allotment a/c ********
(Being allotment money received)

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4. If any call is made on the shares, the following entries are passed:
Share call a/c Dr. **********

To share capital a/c ********
(Being call made on share)
5. On receipt of call money:
Bank a/c Dr. *******

To share call a/c *******
(Being call money received)

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6. According to SEBI, minimum subscription needed for allotment of share:
(a) 80%
(b) 10%
(c) 90%
(d) None of these
7. Which of the following groups not included a company could issues shares for
consideration other than cash?
(a) Issue of shares to promoters

(b) Issue of shares to underwriter
(c) Issue of shares to vendors
(d) Issue of shares to general public for cash
8. Equity shareholders are ____ of the company.
(a) Owners
(b) Creditors
(c) Suppliers
(d) Customers
9. Minimum Share application money is _____% of the nominal value of shares.
(a) 15%
(b) 10%
(c) 25%
(d) 30%
10. The net gain made by the company on the reissue of shares will be credited to:
(a) Reserve capital account

(b) Capital reserve account
(c) Securities premium reserve account
(d) Statement of P/L

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3.2.2.2 Issue of shares at premium
The sale of shares at a price higher than the share’s face value is referred to as a “premium issue.”
The premium, in other words, is the amount paid for a share over and beyond its face value.
Companies that are financially sound, well-managed, and have a positive market reputation
typically issue stock at a premium. For example, if a firm issues a ten-dollar share at eleven
dollars, it is releasing it at a 10% premium. Applicants or shareholders may be required to pay the
premium at any time, including during the application process, allotment, and calls. A company,
on the other hand, normally calls the amount of Premium at the time of allotment.
Premium is due at the time of application
On receipt of Application money
Bank A/c (application and premium amount) Dr.

To Share Application A/c Cr.
(Being application money received on shares)
Transfer of application money to Share Capital A/c and Securities Premium A/c
Share Application A/c Dr.
To Securities Premium A/c Cr.
To Share Capital A/c Cr.
(Being share application money transferred to share capital)
On Share Allotment due
Share Allotment A/c (amount due on allotment) Dr.

(Being share allotment due)
Share Allotment money received
Bank A/c (actual amount received) Dr.
To Share Allotment A/c Cr.
(Being share allotment money received)
On Share call due
Share Call A/c Dr.

(Being money on share call due)
Share call amount received
Bank A/c Dr.
To Share Call A/c Cr.
(Being share call amount received)

146
Premium is due at the time of allotment
On receipt of Application money
Bank A/c (actual amount received) Dr.

To Share Application A/c Cr.
(Being application money received on shares)
Transfer of application money to Share Capital A/c
Share Application A/c Dr.

(Being share application money transferred to share capital)
On Share Allotment and Premium due
Share Allotment A/c (amount due on allotment including premium) Dr.

To Securities Premium A/c Cr.
(Being share allotment money and premium due)
Share Allotment money received
Bank A/c (allotment and premium amount received) Dr.

To Share Allotment A/c Cr.
On Share call due
Share Call A/c Dr.

(Being money on share call due)
Share call amount received
Bank A/c Dr.

To Share Call A/c Cr.

147
11. When a corporation issue shares at a premium, the company may get the following
amount of premium:
(a) With application money

(b) In addition to application money
(c) In addition to calls
(d) In addition to any of the above
12. The securities premium is not applicable:
(a) To pay dividends to members

(b) To issue bonus shares to members
(c) To write off the company’s preparatory expenses
(d) To write off the discount on the issuance of debentures
13. Where does the securities premium appear on the Balance Sheet?
(a) Reserve and surplus

(b) Current liabilities
(c) Current liabilities
(d) Capitalisation of shares
14. The premium on the initial public offering of shares is:
(a) Capital gain

(b) Capital loss
(c) General loss
(d) General profit
15. Which side of the balance sheet does the premium on share issuance appear on?
(a) Assets
(b) Liabilities
(c) Both (a) Assets (b) Liabilities
(d) None of these are true

148
3.2.2.3 Issue of shares at discount
Shares issued at a discount are priced less than the face value. It is lawful for a company to issue
shares at a discount if several conditions are met.
On receipt of applications:
Bank A/C Dr.

To Share application A/C Cr.
(Being share applications received)
On allotment of shares:
Share application A/C Dr.

Discount on shares A/C Dr.
To Share capital A/C Cr.
(Being shares are allotted)
If shares are issued at a discount to the promoters in consideration of their services, the
entries should look like the following:
Preliminary expenses A/CDr.

Discount on shares A/CDr
To Share capital A/C Cr.
(Being shares are issued at a discount to the promoters in consideration of their services)

149
16. When full amount is due on any call, but it is not received, then the short fall is
debited to:
(a) Calls-in-advance
(b) Calls-in-arrear
(c) Share Capital
(d) Suspense Account
17. The difference between subscribed capital and called up capital is called _______.
(a) Calls-in-arear
(b) Calls-in-advance
(c) Uncalled capital
(d) None of these
18. Which statement is issued before the issue of shares:
(a) Prospectus
(b) Articles of association
(c) Memorandum of association
(d) All of these

150
3.2.3 Posting of Entries
Solved example on issue of shares at premium
1. Sahni Ltd. issues a total of 10,000 equity shares worth $100 each at a 25% premium. At
the time of allotment, the premium is due. The following is the sum due:
Jan 1, 2018: Rs 20 on application Feb 1, 2018: Rs 75 on allotment
On the 1st and 3rd of March 2018, Rs 30 will be charged on the first and last call.
Journal Entries in the books of Sahni Ltd.
Date Amount
Description
2018 Dr. Cr.
1 Jan Bank A/c 2,00,000
To Share Application A/c 2,00,000
(Being application money received on 10000
shares @20 per share)
1 Feb Share Application A/c 2,00,000
To Share Capital A/c 2,00,000
(Being share application money transferred to
share capital)
1 Feb Share Allotment A/c 7,50,000
To Securities Premium A/c 2,50,000
(Being share allotment due on 10000 shares
@50 per share)
1 Feb Bank A/c 7,50,000
To Share Allotment A/c 7,50,000
1 Mar Share First and Final Call A/c 3,00,000
(Being money on share call due on 10000
shares @30 per share)
1 Mar Bank A/c 3,00,000
To Share First and Final Call A/c 3,00,000

151
2. Harry Limited has a capital of Rs 2,00,000, which is divided into 4,000 shares at Rs 50
each. The corporation has taken the processes necessary to issue 3,000 shares at a
10% discount. On March 25, 2018, 500 shares were distributed to directors, while 2,500
shares were distributed to the general public. On April 1, 2018, applications for 2,000
shares were received. These shares were allotted by the board of directors on April 10,
2018.
Date Amount
Description
2018 Dr. Cr.
25 March Bank A/c 22,500
Discount on shares 2,500
Share capital 25,000
(Issued 500 shares to directors at a discount)
01 April Bank 90,000
Share application 90,000
(Received applications for 2,000 shares)
10 April Shares application 90,000
Discount on shares 10,000
Share capital 1,00,000
(Allotted 2,000 shares to public)

152
19. Capital included in the liabilities of a company is called _______.
(a) Authorised capital

(b) Issued capital
(c) Subscribed capital
(d) Paid-up capital
20. Total amount of liabilities side includes:
(a) Authorised capital

(b) Issued capital
(c) Subscribed capital
(d) Paid-up capital

153
Summary
A share is a share in the share capital of the company. These shares are of two types.
Equity share is one who is the real owner of the company received no fixed rate of
dividend but participates in the decision-making process through vote and determines
the future of the company.
Preference shareholders receive fixed rate of dividend and were paid fixed rate of
dividend, but don does not have a right to participate in AGM and vote.
Shares are issued to public-by-public companies who in turn subscribe to the shares.
It is a three-step process of issuing prospectus, share application and share allotment.
Shares can be issued at face value or at discount or at premium.
Terminal Questions
1. Explain various types of shares.
2. Explain the procedure in the issue of shares.
3. Explain entries for issue of shares at discount.
4. Explain entries for issue of shares at premium.

154
Answer Keys
Question No Answers
1 B
2 A
3 A
4 A
5 B
6 C
7 A
8 A
9 C
10 B
11 A
12 A
13 B
14 A
15 B
16 B
17 C
18 A
19 D
20 D

155
Practice Problems
1. A Limited Company issued 25,000 Ordinary Shares of Rs. 25 each, payable Rs. 5
on application, Rs. 10 on allotment, and Rs. 5 each on successive calls, with 20,000
shares completely subscribed and funds paid in full. You are expected to keep a
journal.
2. On March 1st, X Ltd. issues 20,000 equity shares of Rs.10 each at a price of Rs.11,
payable as follows: Rs. 2 for the application, Rs. 3 for the allotment, and Rs. 6 for the
First and Last Call. All of the shares have been purchased. transfer the necessary
journal entries.
Glossary
• Prospectus: An essential disclosure document that a company has to issue at the

time of issuing investment securities to the public.
• Vendor: An individual or company that sells goods or services to someone else in

the economic production chain.
Bibliography
Textbooks
Education.
e-references
1. https://www.edudel.nic.in//upload_2015_16/accunts_12_eng_2015.pdf
2. https://blog.ipleaders.in/allotment-shares-appropriation-share-inappropriate-share-com-
pany/
3. https://www.toppr.com/guides/principles-and-practices-of-accounting/issue-forfeiture-re-
issue-of-shares/issue-of-shares-at-premium/

156
Image Credits
• Fig. 1
https://investortonight.com/blog/issue-of-shares/
• Fig. 2
https://www.toppr.com/guides/accounting-and-auditing/introduction-to-company-ac-
counts/basic-concepts-of-company-accounts/
Video Links
Topic Link
Issue and allotment of shares https://youtu.be/5V4M_uEJSw8
Issue of Shares
watch?v=GtUKPCMA0xY
Accounting Treatment- Issue of https://www.youtube.com/

Shares watch?v=C7PrA4v4-f0
Keywords
• Posting of entries
• Equity shares
• Preference shares

157
MODULE 3
UNIT 3
COMPANY FINAL
ACCOUNTS

158
Unit – 3.3 Company Final Accounts
Aim ------------------------------------------------------------------------------------------------------- 160

3.3.1 Format and Components of P&L and Balance Sheet ----------------------------- 161
3.3.2 Format and Components of Banking Accounts ------------------------------------- 169
3.3.3 Format and Components of Insurance Accounts ----------------------------------- 172
3.3.4 Final Accounts of Electricity Companies ---------------------------------------------- 178
Self-Assessment Questions ------------------------------------------------------------- 182
Summary ------------------------------------------------------------------------------------------------ 183

Answer Keys ------------------------------------------------------------------------------------------- 184
Activity --------------------------------------------------------------------------------------------------- 185
Glossary ------------------------------------------------------------------------------------------------ 185
Bibliography -------------------------------------------------------------------------------------------- 185
e-References ------------------------------------------------------------------------------------------- 185
Image Credits ------------------------------------------------------------------------------------------ 186
Video links ---------------------------------------------------------------------------------------------- 187
Keywords ----------------------------------------------------------------------------------------------- 187

159
Aim
The main aim of this unit is to analyse the components of financial statements of banking,
insurance, and electricity companies.
This unit will help students to:
• Elaborate the financial statements of companies
• Describe the components of banking, insurance, and electricity company’s
financial statements
• Differentiate between the components of banking, insurance, and electricity
company’s financial statements
Learning Outcomes
• Examine the components of financial statements for various types of companies
• Analyse the components using ratios for various types of companies

160
3.3 Company Financial Statements
The primary goal of any business activity is to make a profit. In the course of normal business
operations, there will be a greater number of transactions. All these operations are recorded in
books of accounts on a daily basis so that the company may disclose the amount of profit loss
derived at the end of the fiscal year.
There is no conventional format for preserving final accounts in the event of a sole trading
business, except reflecting the profit or loss at the conclusion of the financial year. Organisations
registered as companies under Schedule III of the Companies Act of 2013 must follow the format
and guidelines set forth in the act in maintaining their accounts and preparing their profit and loss
statements and balance sheets.
The Companies Act of 2013 establishes prescribed guidelines for the preparation of financial
statements in Section 129. Balance sheet, profit and loss account/income statement, cash flow
statement, statement of changes in equity, and any accompanying explanatory note are all
included in Section 2(40).
The following is a profit and loss statement prepared in accordance with the Companies Act of
2013.
Annual Financial Statements
Statement
Balance Cash Flow
of Profit and
Sheet Statement
Loss
Statement Notes to
of Changes Financial
in Equity Statement
Fig. 1: Annual financial statements
3.3.1 Format and Components of P&L and Balance Sheet
PART II – STATEMENT OF PROFIT AND LOSS
Name of the Company…………………….

Profit and loss statement for the year ended ………………………
(Rupees in…………)

161
Schedule III of the Companies Act, 2013
PART II - STATEMENT OF PROFIT AND LOSS
Name of the Company ...........................................
Porfit and loss statement for the year ended ...........................
(Rupees in ...........................)
Particulars Note Figures Figures

No. for the for the
current previous
reporting reporting
period period
1 2 3 4
I Revenue from operations xxx xxx
II Other income xxx xxx
III Total Revenue (I+II) xxx xxx
IV Expenses:
Cost of materials consumed xxx xxx
Purchase of Stock-in-Trade xxx xxx
Changes in inventories of finished goods xxx xxx
Work-in-progress and xxx xxx
Stock-in-trade xxx xxx
Employee benefits expenses xxx xxx
Finance costs xxx xxx
Depreciation and amortisation expenses xxx xxx
Other expenses xxx xxx
Total expenses xxx xxx
V Profit before exceptional and extraordinary xxx xxx
items and
tax (III-IV
VI Exceptional items xxx xxx
VII Profit before extraordinary items and tax (V-VI) xxx xxx
VIII Extraordinary items xxx xxx
IX Profit before tax (VII-VIII) xxx xxx
X Tax expense: xxx xxx
(1) Current tax
(2) Deferred tax
XI Profit (Loss) for the period from continuing xxx xxx
operations (VII-VIII)
XII Profit (Loss) from discontinuing operations xxx xxx
XIII Tax expense of discontinuing operations xxx xxx
XIV Profit (Loss) from discontinuing operations (after xxx xxx
tax) (XII-XIII)

162
XV Profit (Loss) for the period (XI+XIV) xxx xxx
XVI Earnings per equity share: xxx xxx
(1) Basic
(2) Diluted
Fig. 2: Format of Part II – Statement of Profit And Loss
The figures in the Financial Statements may be rounded off depending on the company’s turnover,
as seen below:
The balance sheet is a statement which reports the financial position or situation at the end of a
financial period, such as March 31 at midnight.
The balance sheet of a company shows:
1. Possessions (Assets held by firm)

2. Responsibilities (obligations held by firm)
3. The value of a company’s stockholders’ equity (Net worth)
4. The assets and claims against those assets are reported on the balance sheet.
Balance sheet as on --------------
Company Name Here
Balance Sheet
For the period Ended ______________
Assets Liabilities
Current Assets Current Liabilities
Cash xxx Accounts payable xxx
Short-Term Investments xxx Salaries Payable xxx
Accounts Receivables xxx Accrued Interest xxx
Inventories xxx Taxes Payable xxx
Prepaid Insurance xxx Current Portion of Notes xxx xxx
Others xxx xxx
Long-Term Investments Long-Term Liabilities

Stock Investments xxx Note Payable xxx
Cash Value of xxx xxx Mortgage Liability xxx
Investments
Fixed Assets Total Liabilities xxx

Land xxx

163
Building and Equipment xxx Stock Holder’s Equity
Less Accumulated xxx xxx xxx Capital Stock xxx
Depreciation
Retained Earnings xxx
Intangible Assets
Good will xxx Total Stock Holder’s xxx
Equity
Other Assets
Receivables from xxx
Employees
Total Assets xxx Total Liabilities xxx
Fig. 3: Balance sheet
Points to remember while preparing balance sheet
1. Calls in arrears: This refers to the amount that shareholders have not paid on the
company’s calls. In most cases, this item is included in the trial balance. To calculate
paid up capital, subtract call in arrears from the called-up capital in balance sheet. If the
trial balance reflects only the paid-up capital and the adjustment only shows the calls
in arrears, the amount is to be first added to the paid-up capital to reflect the called-up
capital, then deducted to show the paid-up capital in the outer column.
2. Unclaimed dividend: This is the amount of dividend that has not been collected by the
company’s shareholders. This item is always shown on the trial balance’s credit side. It’s
listed under the heading - current liabilities in the balance sheet.
3. Forfeited shares account: This item is shown on the credit side in the trial balance and
is added to the paid-up capital on the liabilities side of the balance sheet.
4. Securities premium account: This is displayed under Reserves and surplus on the
liabilities side of the balance sheet.
The profit and loss account details an organisation’s income and costs that result in a net profit
or loss. It assists in evaluating an organisation’s performance and providing a foundation for
anticipating future success. It also gives important information that the banker while approving
a loan. The profit and loss account are used to describe various business activities such as
revenues and expenses and is especially useful in determining the risk of not meeting a certain
level of income in the future.

164
Assets
Accounts are listed from top to bottom in the assets segment in order of liquidity. They are divided
into two types: current assets, which can be converted to cash in less than a year, and non-
current or long-term assets, which are held for a longer period of time.
Assets Classification
Assets
Non Current Assets Current Assets
Fixed Assets Tangible Assets Current

Investments
Non - Current
Investments Intangible Assets Inventories
Diferred Tax
Assets (Net) Trade Recievables
Capital WIP
LT Loans and Cash and Cash
Advances Equivalents
Intangible Assets
Other Non Under Development ST Loans and
Current Assets Advances
Other Current
Assets
Fig. 4: Assets classification
The following are examples of long-term assets:
Securities that will not or cannot be liquidated in the following year are classified as long-term
investments.
Land, machinery, equipment, buildings, and other long-term, capital-intensive assets are
examples of fixed assets.
Non-physical (but nonetheless valuable) assets such as intellectual property and goodwill are
examples of intangible assets. Intangible assets are often only recorded on the balance sheet if they
are purchased rather than produced in-house. Their worth could thus be grossly underestimated
– for example, by omitting a globally recognisable brand – or grossly exaggerated.

165
Fig. 5: Balance sheet formula
Liabilities
Taxes that have accrued but will not be paid for another year are referred to as deferred tax
liabilities.
(In addition to time, this figure reconciles discrepancies in financial reporting standards and tax
assessment methods, such as depreciation computations.)
Equity and
Liablities
Shareholders’ Share Application Non-Current Current

Fund Money Pending Liabilities Liabilities
Allotment
Share Capital Long-Term Short-Term
Borrowings Borrowings
Reserve and Diferred Tax Trade Payables
Surplus Liabilities (Net)
Money received Other LT Other Current
against Share Liabilities Liabilities
Warrants
Long-Term Short-Term
Provisions Provisions
Fig. 6: Liability classification
Some liabilities are deemed off-balance sheet, which means they won’t show up on the balance
sheet.

166
Equity of shareholders
The money attributable to a company’s owners, or Shareholders, is referred to as Shareholders’

equity. It’s also called “net assets” since it’s equal to a company’s total assets less its liabilities,
or the debt it owes to non-shareholders.
The net earnings that a firm either reinvests in the business or uses to pay off debt are known as
retained earnings, and the rest is given to shareholders in the form of dividends.
Shareholder’s Equity Formula = Total Assets - Total Liabilities
Fig. 7: Equity of shares
Treasury stock is a stock that has been repurchased or never issued in the first place by a firm.
It can be sold later to raise cash or kept in reserve to fend off a hostile takeover. Preferred stock
is issued by some firms and is listed separately from common stock under shareholders’ equity.
Preferred stock, like common stock in some situations, is given an arbitrary par value that has no
influence on the market value of the shares. The par value is multiplied by the number of shares
issued to determine the “common stock” and “preferred stock” accounts.
The amount invested in excess of the “common stock” or “preferred stock” accounts, which
are based on par value rather than market price, is referred to as additional paid-in capital or
capital surplus. Shareholders’ equity is unrelated to a company’s market capitalisation, which is
based on the stock’s current price, whereas paid-in capital represents the total amount of equity
purchased at any price.

167
1. The business is said to be profitable if:
(a) Income exceeds Expenditure

(b) Expenditure surpasses Income
(c) Income exceeds liability
(d) Assets exceed expenditure
2. Balance sheet is in the ______.
(a) Vertical form

(b) Horizontal form
(c) Horizontal and vertical form
3. Identify the odd man out:
(a) Car
(b) Debtors
(c) Stock
(d) Prepaid expenses
4. Income statement is also known as ______.
(a) Statement of operations

(b) Statement of income
(c) Statement of earnings
(d) All of the above
5. The premium paid on the issuance of shares cannot be used for ______.
(a) The issuance of bonus shares.

(b) For the preparation of preliminary costs
(c) To provide a premium that will be paid out at the time of redemption
(d) For dividend distribution

168
3.3.2 Format and Components of Banking Company Accounts
Final accounts of banks
A banking company incorporated in India is obliged by Section 29 to compile a balance sheet

and profit and loss statement as of the last working day of the year at the end of each accounting
year.
a. Profit and loss account
A banking firm must create its profit and loss account in accordance with Form B under
the Banking Regulation Act of 1949’s Third Schedule. The following is Form B:
Form ‘B’
Form of Profit & Loss Account
for the year ended 31st March
Schedule Year ended (‘000 omitted)

As on 31.3..... Year ended
(Current year) As on 31.3....
(Previous year)
I. Income
Interest earned 13
Other income 14
Total
II. Expenditure
Interest expended 15
Operating expenses 16
Provisions and
contingencies
Total
III. Profit/Loss
Net profit/loss (-) for the
year
Profit/Loss (-) brought
forward
Total
IV. Appropriations
Transfer to Government/
Proposed dividends
Balance carried over to
balance sheet
Total
Fig. 8: Form B; Form of profit & loss account for the year ended 31st March

169
b. Balance sheet
Following is the balance sheet of a Banking company given under section 29 of the
Banking regulation Act.
The formats are given below as specified in Banking Regulation Act in Form A of
Balance Sheet, Form B of Profit and Loss Account and eighteen other schedules of
which the last two relates to Notes and Accounting Policies.
New Revised Formats

The Third Schedule
(See Section 29)
Form ‘A’
Form of Balance Sheet
Balance Sheet of ______________ (here enter name of the Banking company)
Balance Sheet as on 31st March (Year)

Schedule Year ended (‘000 omitted)
As on 31.3..... Year ended
(Current year) As on 31.3....
(Previous year)
Capital & Liabilities
Capital 1
Reserve & Surplus 2
Deposits 3
Borrowings 4
Other liabilities and 5
provisions
Total
Assets
Cash and balances with 6
Reserve Bank of India
Balance with banks and 7
Money at call and short
notice
Investments 8
Advances 9
Fixed Assets 10
Other Assets 11
Total
Contingent liabilities 12
Bills for collection
Fig. 9: Balance sheet

170
6. Banking companies in India are governed by:
(a) As per act 1932

(b) Income Tax act
(c) AS-23
(d) Banking Regulation Act 1949
7. Banks are to recognise their income on _____ basis in respect of income on

performing assets.
(a) Accrual
(b) Cash
(c) Credit
(d) None
8. Substandard assets are certain loan assets of a bank which are classified as______
assets for a period not exceeding two years.
(a) Non-performing
(b) Performing
(c) Current
(d) Fluctuating
9. The main function of _______ company is to accept deposits.
(a) Private
(b) Public
(c) Banking
(d) Capital marketing
10. Every banking company should prepare a balance sheet and profit and loss accounts
as on______ each year.
(a) 31st March

(b) 31st July
(c) 31st December
(d) None

171
3.3.3 Format and Components of Insurance Companies
The provisions of the Insurance Act of 1938, as well as its required forms, must be followed while
preparing final accounts. Although Life Insurance is administered by the LIC (Life Insurance
Corporation) Act of 1956, the Insurance Act of 1938 applies to both General and Life Insurance.
The accounts are prepared for the calendar year, which means that an insurance company’s
accounts must be made up to the 31st of December each year.
These are the forms of final accounts required by the Insurance Act of 1938:
(i) FORM A: For both life and general insurance, this is the form of the balance sheet.
(ii) FORM B: Profit and Loss Account (for both Life and General Insurance).
A life insurance company’s final accounts include (a) Revenue Account, (b) P&L Account,
and (c) Balance Sheet.
(iii) FORM C: Profit and Loss Appropriation Form—for both Life and General Insurance.
(iv) FORM D: Revenue Account Form—only for Life Insurance.
(v) FORM F: Revenue Account Form—only for General Insurance.
(vi) FORM I: Balance Sheet of Valuation.
a. Revenue account
Form ‘D’ of the First Schedule to the Insurance Act of 1938 must be used to produce this
account. It just shows the balance of the Life Insurance Fund at the end of the year, not the
profit or loss for the year. The opening balance of Life Insurance Fund (Cr.) is combined
with all revenue incomes/receipts on the credit side, while all revenue expenditures show
on the debit side. The balance is carried forward as Life Insurance Fund.

172
Name of the insurer: FORM A - RA
Registration No. and Date of Registration with the IRDA
REVENUE ACCOUNT FOR THE YEAR ENDED 31ST MARCH, 20___
Policyholders’ Account (Technical Account)
Particulars Schedule Current Previous

Year Year
(Rs.000) (Rs.000)
Premiums earned-net
(a) Premium
(b) Reinsurance ceded
(c) Reinsurance accepted-
Income from Investments

(a) Interest, Dividends & Rent - Gross
(b) Profit on sale/redemption of investments
(c) (Loss on sale/redemption of investments)
(d) Transfer/Gain on revaluation/change in fair value
Other Income (to be specified)

TOTAL (A)
Commission
Operating Expenses related to insurance Business
Other Expenses (to be specified)
Provisions (other than taxation)
(a) For diminution in the value of investments (Net)
(b) Others (to be specified)
TOTAL (B)
Benefits Paid (Net)
Interim Bonuses Paid
Change in valuation of liability against life policies in
force
(a) Gross”
(b) (Amount coded in Reinsurance)
(c) Amount accepted in Reinsurance
TOTAL (C)
SURPLUS (DEFICIT) (D) WAHBHC)
APPROPRIATIONS
Transfer to Shareholders Account
Transfer to Other Reserves (to be specified)
Transfer to Funds for Future Appropriations
TOTAL (D)
Fig. 10: Revenue account form of insurance company

173
b. Profit and Loss account of Insurance company for the year ended ________

BALANCE SHEET AS AT 31 MARCH, 20_
Year Year
(Rs.000) (Rs.000)
SOURCES OF FUNDS
SHAREHOLDERS FUNDS
SHARE CAPITAL 5
RESERVES AND SURPLUS 6
CREDIT/[DEBIT] FAIR VALUE CHANGE ACCOUNT
Sub-Total
BORROWINGS 7
POLICYHOLDERS' FUNDS
CREDIT/DEBIT] FAIR VALUE CHANGE ACCOUNT
POLICY LIABILITIES
INSURANCE RESERVES
PROVISION FOR LINKED LIABILITIES
Sub-Total
FUNDS FOR FUTURE APPROPRIATIONS
TOTAL
APPLICATION OF FUNDS
INVESTMENTS
SHAREHOLDERS 8
POLICYHOLDERS 8A
ASSETS HELD TO COVER LINKED LIABILITIES
LOANS 9
FIXED ASSETS 10
CURRENT ASSETS
CASH AND BANK BALANCES 11
ADVANCES AND OTHER ASSETS 12
SUB-TOTAL (A)
CURRENT LIABILITIES 13
PROVISIONS 14
Sub-Total (B)
NET CURRENT ASSETS (C) = (A =B)
MISCELLANEOUS EXPENDITURE (to the extent not 15
written off or adjusted)
Fig. 11: Profit and loss account of insurance company

174
Balance sheet of an insurance company as on ________________-
c. Balance sheet

PROFIT & LOSS ACCOUNT FOR THE YEAR ENDED 31ST MARCH, 20____
Shareholders’ Account (Non-technical Account)

Year Year
(Rs.000) (Rs.000)
Balance brought forward from /transferred to the
Policyholders Account
(Technical Account)
Income from Investments

(a) Interest, Dividends & Rent-Gross
(b) Profit on sale/redemption of investments
(c) (Loss on sale redemption of investments)
Other Income (to be specified)

TOTAL (A)
Expense other than those directly related to the
insurance business
Provisions (Other than taxation)
(a) For diminution in the value of investments (Net)
(b) Others (to be specified)
TOTAL (B)
Profit (Loss) before taxx
Provision for Taxation
Profit/ (Loss) after tax
TOTAL (C)
APPROPRIATIONS
(a) Brought forward Reserve Surplus from the Balance
Sheet
(b) Interim dividends paid during the year
(c) Proposed final dividend
(d) Dividend distribution on tax
(e) Transfer to reserves/ other accounts (to be specified)
Profit carried forward to the Balance Sheet

175
Year Year
DEBIT BALANCE IN PROFIT & LOSS ACCOUNT
(Shareholders Account)
TOTAL
Fig. 12: Balance sheet of insurance company

176
11. Annuities which are due and unpaid are reflected on _____ of Balance Sheet.
(a) Liabilities
(b) Assets
(c) None
(d) Both
12. Premium which has become due but not yet received by the insurance company.
(a) Liabilities
(b) Assets
(c) None
(d) Both
13. What is the income to the insurance company
(a) Claims
(b) Premiums
(c) Surrender
(d) Matured policies
14. Revenue account in insurance deals with
(a) Life Insurance Fund

(b) Assets
(c) Liabilities
(d) Income and expenses
15. Insurance companies prepare financial reports for
(a) Calendar year

(b) Academic year
(c) Financial year
(d) None

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3.3.4 Final Accounts of Electricity Companies
The Electricity (Supply) Act of 1948, which was amended by the Electricity Supply Amendment
Act of 1956, went into effect on September 10, 1948. All Electricity Supply Companies in India
are subject to the financial provisions of the 6th and 7th schedules to the aforesaid Act. According
to Rule 26 of the Indian Electricity Rules 1956, every Electricity Supply Company is required to
report to the State Government (or its nominee, which is the State Electricity Board created as
per Sec. 3) statistics statements in the appropriate form. As a result, every electricity company
is required to file their annual accounts in the prescribed format within 6 months after the end of
the fiscal year.
Revenue account
Revenue account will be:

(A) Generation By Sale of energy for lighting
To Fuel
To Oil wastage, water By Sale of energy for power
To Salary of engineers
To Wages and gratuities By Sale of energy under special
contracts
To Repairs and maintenance
(B) Distribution By Public lighting
To Salary of engineer
To Wages and gratuities By Rental of meters
To Repairs
(C) Public Lamps By Rent receivables
To Attendance and repairs
To Renewals By Transfer fees
(D) Rent, Rates and Taxes
To Rents payable By Other Items
To Rates and taxes
(E) Management Expenses By Miscellaneous receipts
To Director's remuneration
To Management By Sale of ashes
To General establishment
To Auditor of the company By Reconnection and
disconnection fees
(F) Law Charges
To Law charges
(G) Depreciation
To Lease
To Buildings

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To Plant
To Mains
To Meters, etc.
(H) Special Charges
To Bad Debts
Fig. 13: Revenue account of an electricity company
Net revenue account
It’s the same as a trade company’s profit and loss appropriation account. In the balance
sheet, the balance of the net revenue account is indicated. Below is the statutory form
of a net revenue account.

To Balance from last year’s By Balance from last years
Account Account
To Interest on loans By Balance brought from
Revenue Account
To Contingency reserve By Interest on Bank Account
To Interest on debentures By Balance carried to General
Balance Sheet
To Dividends
To Balance carried to General
Balance Sheet
Fig. 14: Net revenue account of an electricity company
Receipts and expenditure on capital account
The goal of this account is to track the total amount of cash raised and how it was used
to buy fixed assets for the company. Each side has three columns, as required by the
Indian Electricity Act of 1910:
1. A balance sheet from the previous year’s conclusion.

2. Making public the amount of money collected or spent throughout the year
3. At the conclusion of the year, there should be a positive balance.
Receipts and expenditure on capital account format is given below:

179
Expenditure Expendi- Expen- Total Receipts Receipts Receipts Total
ture up diture Expen- up to the during Rece-
to end of during diture end of the year ipts
previous the previous
year year year
(Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
To Preliminary By
Expenses Ordinary
shares
To Land By Prefe-
rence
shares
ToBuilding By Debe-
ntures
To Plant By Loans
To Mains By
Calls-in-
advance
To By Other
Transformers, receipts
motos, etc.
To Meters Total
Receipts
To General By
stoms Balance
of
Capital
Account
To Special cared to
items General
Balance
sheet
Total
Expenditure
To Balance of
Capital
Account
carredto
General
Balance
Shoot
Fig. 15: Receipts and expenditure on capital account of an electricity company

180
Balance sheet
In balance sheet all receipts are shown on liabilities side and total expenditure on
Assets side of balance sheet.

To Capital Account By Sundry Debtors
To Sundry Creditors for By Preliminary expenses
Capital Expenditure
To Sundry Creditors on By Securities
Open Account
To Net Revenue Account By Special
To Reserve Fund By Cash at bank
To Depreciation Fund By Cash in hand
To Special Items By Capital Account
By Stores in hand
Fig. 16: Balance sheet of an electricity company

181
16. ______is to identify the total amount of capital raised and its application for acquisition
of fixed assets.
(a) Fixed assets

(b) Receipts and expenditure account
(c) Revenue account
(d) P&L account
17. Electricity accounts are prepared for:
(a) Financial year

(b) Base year
(c) Calendar year
(d) None
18. Interest on loans is shown in____.
(a) Fixed assets

(b) Net revenue account
(c) Revenue account
(d) P&L account
19. Identify the source of income for the electricity company:
(a) Sale of energy

(b) Production
(c) Distribution
(d) All the above
20. Electricity companies prepare financial statements under:
(a) Electricity (Supply) Act, 1948

(b) RBI Act
(c) Banking Regulation Act
(d) None

182
Summary
Every firm registered as a company needs to prepare profit and loss account and
balance sheet as prescribed in schedule III of Companies Act of 2013.
Banking companies are required to prepare profit and loss account and balance sheet
for every bank.
Insurance companies have to report revenue accounts, net revenue account, receipt
and expenditures account and balance sheet at the end of fiscal year.
Electricity companies prepare financial statements under the Electricity (Supply) Act,
1948.
Terminal Questions
1. Explain the financial statements to be prepared under Companies act 2013.
2. Describe various components of banking company accounts.
3. Explain briefly the financial statements for Insurance companies.
4. Describe financial statements prepared by electricity companies.

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Answer Keys
Question No Answers
1 A
2 C
3 A
4 D
5 D
6 D
7 A
8 A
9 C
10 A
11 A
12 A
13 B
14 A
15 A
16 B
17 A
18 B
19 D
20 A

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Activity Or Practical Exercises
Activity type: Online/Offline -- 40-60 mins
1. Collect the financial statements of any bank from annual reports of banking company
and analyse its components with the help of ratio analysis.
2. Obtain an insurance company financial statement and its components with the help of
ratio analysis.
3. Take a financial statement of Last 2 years of electricity company and analyse its com
ponents with the help of ratio analysis.
Glossary
• Balance sheet: A financial statement that contains details of a company’s assets or

liabilities at a specific point in time.
• Assets: A resource with economic value that an individual, corporation, or country

owns or controls with the expectation that it will provide a future.
Bibliography
Textbooks
Education.
e-References
1. https://www.irdai.gov.in
2. https://rbidocs.rbi.org.in/rdocs/content/pdfs/83MD01092021_A1.pdf
3. http://kb.icai.org/pdfs/PDFFile5b277ee88fc1b0.09627304.pdf

185
Image Credits
• Fig. 1: https://twitter.com/dheerajvaidya/status/1319859671306588160/photo/1
• Fig. 2: https://www.brainkart.com/article/Financial-statements-of-companies_38853/
• Fig. 3: https://www.edelweiss.in/investology/fundamental-analysis-218cf3/balance-
sheet-of-a-company---meaning-format-importance--how-to-prepare-5d9238
• Fig. 4: http://kb.icai.org/pdfs/PDFFile5b277ee88fc1b0.09627304.pdf
• Fig. 5: https://www.investopedia.com/
• Fig. 6: http://kb.icai.org/pdfs/PDFFile5b277ee88fc1b0.09627304.pdf
• Fig. 7: https://www.wallstreetmojo.com/shareholders-equity-formula/
• Fig. 8: RBI (Reserve Bank of India)
• Fig. 9: https://commercelecturer.wordpress.com/2020/07/23/form-a-of-balance-
sheet-of-banking-companies/
• Fig. 10: https://irdai.gov.in/

• Fig. 13: https://indiafreenotes.com/final-accounts-of-electricity-companies/

186
Video Links
Topic Link
Final Accounts https://www.youtube.com/watch?v=-

j76Tdl2D-p4
Introduction to Financial Statements https://www.youtube.com/

watch?v=4sGEtZcLdx8
Trick to learn banking schedules https://www.youtube.com/

watch?v=zxdVFXeeU7E
Balance Sheet And Profit & Loss https://www.youtube.com/

Statement of Banking Company watch?v=34BEOoKKTHQ
Keywords
• Forfeited shares account

• Calls in arrears
• Equity of Shareholders

187
MODULE 4
UNIT 1
MARGINAL COSTING

188
Module 4
MANAGEMENT ACCOUNTING
Module Description
Management accounting cultivates students’ skills in financial planning, control, decision-making,

and problem-solving. Students train to become strategic partners by using business sense,
accounting principles, and financial data to help executives make sound decisions.
Marginal cost is concept from economics which has a significant role in business management
which helps businesses to optimise their production levels. Marginal costing is a valuable
decision-making technique. It helps management to set prices, compare alternative production
methods, set production activity levels, close production lines, and choose which of a range of
potential products to manufacture.
The break-even point is essential for business owners because it represents the minimum level
of sales that must be achieved to generate a profit. If a business owner knows the break-even
point, they can make informed decisions about pricing, production levels, and other factors that
impact the bottom line.
Unit 4.1 Marginal Costing

Unit 4.2 Break-Even Analysis

189
Unit – 4.1 Marginal Costing
Aim ------------------------------------------------------------------------------------------------------- 191

4.1.1 Marginal Costing ---------------------------------------------------------------------------- 192

4.1.2 Marginal Costing Vs. Absorption Costing --------------------------------------------- 195
4.1.3 Applications of Marginal Costing -------------------------------------------------------- 197
4.1.4 Formula in Marginal Costing ------------------------------------------------------------- 202
Summary ------------------------------------------------------------------------------------------------ 205

Answer Keys ------------------------------------------------------------------------------------------- 206
Glossary ------------------------------------------------------------------------------------------------- 207
Bibliography -------------------------------------------------------------------------------------------- 207
e-References ------------------------------------------------------------------------------------------ 207
Video links ---------------------------------------------------------------------------------------------- 207
Keywords ----------------------------------------------------------------------------------------------- 208

190
Aim
The main aim of this unit is to enhance the learner’s comprehension of marginal costing
and various areas of its application in business decision-making.
This unit will help students to:
• Elaborate upon the concept of marginal costing
• Differentiate marginal costing from absorption costing
• Examine the application of marginal costing in business.
Learning Outcomes
• Examine marginal costing and its significance
• Analyse how marginal costing plays a key role in business decisions

191
4.1.1 Marginal Costing
Marginal cost, also called variable cost, is calculated as per unit cost whereas fixed cost is taken
as lump sum and deducted from the contribution. The change in total cost with a change in
quantity produced is increased by one unit which is known as marginal cost. Marginal cost is the
difference in total cost when the amount produced is raised by one. It is the cost of producing one
more unit of a product. The variable cost per unit remains the same; any change in production
affects the total cost of output. Given a particular level of production, total fixed cost remains
constant and does not fluctuate as production increases or decreases. In terms of total cost, this
means that the fixed cost remains constant.
For example,
Rs 25 per unit of variable cost

10,00,000 rupees is the fixed cost.
10,000 units at a cost of Rs 2,50,000 = 25 x 10,000 = Rs 2,50,000
10,000 units = 1,00,000 + 2,50,000 = Rs 3,50,000 Total Cost = Fixed Cost + Variable Cost =
1,00,000 + 2,50,000 = Rs 3,50,000
The total cost of 10,001 units is Rs 3,50,025 (1,00,000 + 2,50,025 = Rs 3,50,025 total).
3,50,025 – 3,50,000 – 3,50,000 – 3,50,000 – 3,50,000 – 3,50,000 – 3,50,000 – 3,50,000 = Rs 25
Features of marginal costing
The following are the characteristics of marginal costing:
1. Marginal costing is used to determine the impact of variable costs on production or

output volume.
2. Marginal costing includes a break-even analysis, which is a crucial element of the

process.
3. The contribution of each product or department acts as a foundation for determining the
product’s or department’s profitability.
4. Selling price = Variable cost – Profit.
5. Marginal costing is the basis for valuing finished goods and work-in-progress inventories.
6. Contribution is used to recoup fixed costs, whereas variable costs are charged to
production.
7. Fixed and variable costs are the only costs that are classified. Semi-fixed prices can be
turned into either fixed or variable costs.

192
Advantages of marginal costing
1. It is simple to use and understand.
2. Marginal costing is helpful in profit planning because it allows you to determine

profitability at various levels of production and selling.
3. It helps in determining the selling price, deciding whether to export, and deciding
whether to create or buy.
4. Marginal costing techniques such as break-even analysis and P/V ratio are useful.
5. Marginal costing can be used to evaluate different departments.
6. It gives you control over variable costs by avoiding arbitrary fixed cost allocation.
7. Maintaining a constant overhead recovery rate is simple.
8. Inventory is valued at marginal cost under marginal costing. As a result, irrational fixed
overheads cannot be carried forward from one accounting period to another.
9. Because fixed costs are difficult to control in the short term, it is easier to focus on
variable costs.
Ascertainment of profit under marginal cost
Contribution Selling Price – Marginal Cost

Contribution Fixed Expenses + Profit
Contribution – Fixed Expenses Profit

193
1. If the total cost of 1,000 units is Rs. 60,000 and the total cost of 1,001 units is
Rs. 60,400, the increase in total cost of Rs. 400 is __________.
(a) Prime cost

(b) All variable cost
(c) Marginal cost
2. Which of the following claims concerning marginal costs are correct?
(a) Fixed costs are handled as product costs

(b) Marginal costing is not an independent costing system
(c) Cost elements in marginal costing are separated into fixed and variable
components
(d) None of these
3. In marginal costing:
(a) The fixed cost is added to the contribution

(b) The total marginal cost is deducted from total sales income
(c) The whole marginal cost is added to total sales revenue
(d) None of the above is true
4. In marginal costing, the contribution margin is called __________.
(a) Net profit

(b) Gross profit
(c) Marginal profit
5. Which of the following costing approaches distinguishes fixed and variable costs?
(a) Marginal
(b) Standard
(c) Absorption

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4.1.2 Marginal Costing vs. Absorption Costing
Marginal costing, termed as variable costing, is a costing approach for determining total cost
or determining fixed and variable costs in order to choose the optimal process and product for
manufacturing, among other things. It determines the Marginal Cost of Production and shows
how it affects profit as output units change. The shift in total cost owing to the manufacturing of
an additional unit of output is referred to as marginal cost.
Absorption Costing is a strategy for valuing inventory that involves allocating all manufacturing
expenses to cost centres in order to recognise the whole cost of production. All fixed and variable
costs are included in these manufacturing charges. It is also known as the classic approach of
cost estimation.
DIFFERENCES MARGINAL COSTING ABSORPTION COSTING

Meaning Marginal costing is a Absorption costing is the
decision-making technique process of allocating total
for fixing the total cost of expenses to cost centres in
production. order to calculate the overall
cost of production.
Identification of Cost Variable costs are referred Product cost includes both
to as product costs, whereas fixed and variable costs.
fixed costs are referred to as
period costs.
Categorisation of Overheads Fixed and Variable Production, Administration
and Selling & Distribution.
Profitability The Profit Volume Ratio Profitability suffers as a result
is a metric for determining of the addition of fixed costs.
profitability.
Per unit cost The cost per unit of output is The cost per unit is affected
unaffected by variations in the by variations in the opening
opening and closing stock. and closing stock.
Focuses on Contribution per unit Net Profit per unit
Objective The goal of this presentation The information is presented
is to show the overall in a traditional manner.
contribution of each product.

195
6. How much does absorption cost?
(a) Method in which variable costs are considered product costs and fixed costs
are considered period costs
(b) Method in which both fixed and variable costs are considered product costs
(c) The distinction between selling price and variable costs
(d) The distinction between selling price and fixed costs
7. Sales –Variable cost =?
(a) Direct costing

(b) Contribution
(c) Profit
8. How is the profit of a company affected?
(a) Through sales volume

(b) Variable cost per unit
(c) Selling prices
9. What establishes the relationship between contribution & sales?
(a) Marginal costing

(b) Absorption costing
(c) Profit volume ratio
(d) Fixed cost ratio
10. What are semi–variable expenses?
(a) This does not vary in response to variations in output levels.

(b) Costs that fluctuate with time.
(c) A fixed-cost component and a variable-cost component are both included in
an expense.
(d) Expenses that arise at separate times of the year.

196
4.1.3 Applications of Marginal Costing
Areas where marginal costing is applied
Marginal costing is a strategy for determining cost that may be used to any costing approach.
Variable expenses are charged to cost units, and the fixed cost corresponding to the relevant
period is written off in full against the contribution for that period, according to this technique. The
gap between sales value and variable cost is known as contribution.
The following are some examples of Marginal Costing applications:
1. Setting the selling price:
One of the most important factors that affects the market for a product as well
as the amount of profit made by an organisation is the price. Under typical
conditions, a product’s price must cover the product’s total costs plus a profit
margin. However, in some instances, the price must be set even lower than the
entire cost. While there is a general trade depression (or) when identifying new
markets (or) taking further orders, for example, the producer is forced to decrease
the price even lower than the total costs of the product in question. The concept
of marginal cost is usefully employed to suit the prices in these unique conditions.
2. Taking large orders (or) Orders placed on the international market
Some bulk orders may be received from local (or foreign) merchants who are
requesting a lower price than the market pricing. This raises the decision of
whether to accept or not to accept the offer. The order from a local dealer should
not be accepted at a price below the market price because it will have an adverse
effect on the company’s normal market and goodwill. On the other hand, the
order from a foreign dealer should be accepted because it will provide additional
contribution after the fixed costs have been met.
3. Buy or Make a decision
When management is faced with the decision of whether it is more cost-effective

to purchase a component or a product from outside sources or to make it internally,
marginal cost analysis might help. In these situations, a conclusion based on the
total cost analysis would be inaccurate. If the idea is to buy from outside, the
proposal should be based on what is already being created, and the outsider’s
price should be less than the marginal cost.
If the decision is to manufacture something that will be acquired elsewhere, the

cost of acquisition should include all additional costs such as depreciation on new
equipment and interest on capital, and this cost will be compared to the purchase
price.

197
4. Choosing the right product mix
When a factory produces multiple products, management faces the challenge

of determining which product will provide the most profit. The idea is to keep the
products that contribute the most and grow their output.
PAUSE AND THINK
Assume a company can create four products: M, N, P, and Q, each of which

earns 20, 40, 50, and 60 in contribution per unit for each product. M, N, P, and
Q require 1, 4, 4, and 5 hours of machine time, respectively, from a machine
with a capacity of 100,000 machine hours. M, N, P, and Q contribute 20, 10,
12.50, and 12 each machine hour, respectively.
5. Important factor
It’s also referred to as a limiting factor, controlling factor, or scarce factor. A crucial
element is one that limits a company’s production and profit. It may occur as a
result of a scarcity of materials, labour, capital, plant capacity, or sales. In most
cases, when there is no limiting factor, the product with the highest profit volume
ratio will be chosen. When there are limiting constraints, the product will be
chosen based on the main factor’s largest contribution per unit.
6. Maintaining a desired profit level
Competition, government laws, and other compelling factors force a corporation

to lower its product pricing from time to time. The contribution per unit due to
such a reduction is lowered, notwithstanding the industry’s desire to maintain
a minimal level of profit. If the demand for a company’s product is elastic, the
maximum profit level can be maintained by increasing sales. Marginal costing
techniques can be used to determine the volume of such sales.
7. Alternative production methods
Marginal costs are useful for evaluating different production processes, such as
machine work (or) hand work. The strategy that provides the most contribution
should be used while keeping the limiting factor in mind.
8. Determination of the optimal activity level
The marginal costing technique aids management in determining the optimal

amount of work. Contribution at various levels of activity can be identified to help
make such a decision. The optimum level of activity is the one that makes the
most contribution. The output level can be increased as long as the marginal cost
does not exceed the selling price.

198
9. Performance evaluation
Marginal costing can be used to evaluate the effectiveness of different departments

or product lines. Management must stop producing non-profitable commodities or
departments in order to maximise profits. In such cases, the lowest contribution,
or P/V Ratio, will be utilised to decide whether or not to proceed.
10. Keep costs under control
Variable and fixed expenses are controllable and non-controllable costs,

respectively. The production department is in charge of variable costs, whereas
management oversees fixed costs.
11. A product’s discontinuation or a department’s closure
The marginal costing technique is used to explain how each product contributes
to fixed expenses and profit. If an organisation, department, or a product
contributes the least, it may be closed (or) the manufacturing of the product may
be suspended. It means that the product that makes the most contribution should
be chosen, while the others are phased out.
12. Profit forecasting profitability
May be improved in four ways: (a) by increasing volume; (b) by increasing selling
price; (c) by lowering variable costs; and (d) by lowering fixed costs.
The process of determining potential activities in order to maximise profit or

maintain a desired level of profit is known as profit planning. When the selling
price, variable costs, or product mix vary, the contribution ratio shows the relative
profitability of the different sectors of the company. Because fixed and variable
expenses are combined, absorption costs do not accurately reflect the impact of
any change on the company’s profitability.
13. The launch of a new product
A manufacturing organisation can introduce additional things with the available

facility. In order to sell on significant quantities, the new product is sold at a
reasonable price in the market. It has the potential to gain a lot of traction. If the
market is favourable, sales can be increased. As a result, total costs fall, with
some of the savings going to fixed costs and earnings.
14. Technique selection
Every executive wants to produce items in the most cost-effective manner possible.
For this, marginal costs is a helpful guide as to the goods at various phases of

199
production, i.e., whether management should use a hand-operated system, a semi-
automatic system, or a fully automated system. Fixed costs are lower than fixed
costs incurred by machines while processes are performed manually, and fixed
costs are higher than variable costs in a fully automated system.
15. Making a decision
Under typical circumstances, the price cannot be less than the overall cost.
Marginal costing functions as a price fixer, and a large margin contributes to the
fixed cost and profit. However, this idea cannot always be followed. The price
should be equal to marginal cost plus an acceptable amount, which is determined
by demand and supply, competition, pricing policy, and other factors.
There is a loss equal to fixed costs if the price is equal to marginal cost. When a
businessman suffers a loss, it can be difficult to recover.
There is a high-stakes competition.

There is apprehension about future market conditions.
That the commodities are perishable, and that the staff are unable to be withdrawn.
There is a new product on the market.
Competitors cannot be pushed out, for example.
16. Providing quotes
Offering low-cost quotations is one of the most effective techniques to promote

sales. A corporation makes a profit of $240,000 by producing 80,000 units (80%
of capacity).
Let’s assume the Punjab government has issued a tender for 20,000 units.
The units taken by the government are not expected to have an impact on
the company’s current sales of 80,000 units, and the company also wants
to submit the lowest feasible quotation. Because it will provide an additional
marginal contribution and thus profit, the corporation may quote any amount
above marginal cost.

200
11. The fixed costs are Rs 2,00,000 for a production of 100,000 units. The selling price
per unit is Rs 10 and the variable cost is Rs 6. Marginal costing is a technique for
calculating profit.
(a) Rs 2, 00,000
(b) Rs 8, 00,000
(c) Rs 6, 00,000
12. In make or buy decision, marginal costs as well as additional fixed costs are the
factors to be considered.
(a) True
(b) False
13. A machine is being used to create a component. At a cost of Rs 10 per unit, 10,000
units are produced (of which Rs 9 are variable). The market price for the same
component is Rs 9.50 per unit. The owner, on the other hand, plans to rent the
machine for Rs 6,000 and then purchase components from the market. What will
the consequences be if he does so?
(a) Savings of Rs 1,000

(b) Loss of Rs 1,000
(c) No change
Who came up with the concept of marginal cost?

DID
YOU Revolution on the fringes. Three economists, William Jevons in England,
KNOW Carl Menger in Austria, and Léon Walras in Switzerland are credited with
developing marginalism as a formal theory. In essays published in 1863
and 1871, William Stanley Jevons initially proposed the theory.

201
4.1.4 Formulas in Marginal Costing
Profit volume ratio (P/V)
The Profit Volume (P/V) Ratio is one which takes the rate of change in profit as a function of sales
volume. It shows the contribution made in relation to sales. The PV ratio, often known as the P/V
ratio, is calculated using the formula below.
Contribution x100/sales = P/V ratio

Selling Price - Variable Cost = Contribution
The percentage is calculated by multiplying the contribution by 100.
If a cup’s sale price is Rs.80 and its variable cost is Rs.60, then the PV ratio is (80-60)
100/80=2010080=25 percent.
Profit calculation when sales are given
Fixed Cost + Profit = Sales - Variable Cost

Profit is calculated using the following formula:
Sales - Variable Cost-Fixed Cost = Profit

Required sales to achieve the desired profit of Rs ****
(Fixed cost + Desired Profit) / Contribution Per Unit = Sales (in Units)
(Fixed cost + Desired Profit) / PV Ratio = Sales (in Rs/-)
Solved Problems
1. The following data is given:
Fixed cost =Rs 12,000 Selling price =Rs 12 per unit Variable cost= Rs 9 per unit
1). What will be the profit when sales are a) Rs 60,000 b) Rs 1,00,000?
2). What will be the amount of sales desired to earn a profit of c) 6,000;
d) 15,000?
Solution
PV ratio = contribution / sales = 3/ 12 *100= 25%
a. When sales = Rs 60,000 contribution = sales × PV ratio = Rs 60,000×25%=

Rs 15,000
profit = contribution − Fixed cost = 15,000 − 12,000 = 3,000

202
b. When sales = Rs 1,00,000 contribution = 1,00,000 × 25% = 25,000
profit = 25,000 − 12,000 = 13,000
c. Sales for desired Profit of Rs 6,000 = Fixed Cost+ Desired Profit /

ProftVolumeratio
When Sales for desired Profit = (12,000 + 6,000)/25% = Rs 72,000
d. Sales for desired Profit of Rs 15,000 = (12,000+15,000) / 25% = 1,08,000
2. The Bansi firm produces a single item with a marginal cost of Rs. 1.50 per unit.
The annual fixed cost is Rs. 30,000. Up to 40,000 units can be sold at Rs. 3.00
per unit in the current market, but any extra sales must be done at Rs. 2.00 per
unit. The company expects to make a profit of Rs. 50,000. What is the minimum
number of units that must be manufactured and sold?
Solution
a. Targeted contribution = Fixed Cost + Targeted Profit = 30,000 + 50,000 =

80,000
b. Contribution calculation based on the production of 40,000 units. Selling
price – marginal cost = 3.00 – 1.50 = 1.50 Contribution per unit
c. Contribution for 40,000 units produced = 1.50 x 40,000 units = Rs.60,000
d. After 40,000 units, more units would be created and sold at Rs. 2.00 per unit.
e.g., =Rs.80,000 –Rs.60,000 =Rs.20,000
After a price revision, units will be created for a donation of Rs. 20,000.
e. Additional units to be created with a donation of Rs. 20,000 = (20,000 x
100)/50 = 40,000 units
f. Contribution per unit = Rs. 2.00 – Rs. 1.50= Rs. 0.50 Total units must be
manufactured in order to make the targeted profit = 40,000 + 40,000 =
80,000 units

203
14. If management decides to produce an in-house product, the focus should be on:
(a) Cost factors

(b) All Non-cost variables
(c) Both a and b
15. If the raw material is a crucial consideration in making a selection, then a product
that provides the following benefits should be preferred:
(a) Highest contribution per hour

(b) Highest contribution per unit
(c) Highest contribution per unit of material
(d) Lowest contribution per unit of material

204
Summary
The marginal cost, i.e., variable cost, is charged to units of cost, whereas the fixed
cost for the time is totally written off against the contribution.
Absorption costing is an inventory valuation method in which all manufacturing costs

are allocated to cost centres in order to recognise the overall cost of production.
Making or buying decisions, accepting bulk orders (or) foreign market orders, selecting
a good product mix, identifying critical factors, and maintaining a desired level of profit
can all be done with marginal costing.
The Profit Volume (P/V) ratio measures the rate of change in profit as a result of
changes in sales volume.
Profit = Sales - Fixed Cost-Variable Cost
Terminal Questions
1. Define marginal costing and its advantages.

2. Differentiate marginal costing and absorption costing.
3. Explain various applications of marginal costing.
4. Explain the significance of PV ratio.
5. Describe the features of marginal costing.

205
Answer Keys
Question No Answers
1 C
2 D
3 A
4 C
5 A
6 B
7 B
8 D
9 C
10 C
11 A
12 A
13 A
14 A
15 C

206
Glossary
• Variable cost: A corporate expense that changes in proportion to how much a

company produces or sells.
• Prime cost: The total direct costs of production, including raw materials and labor.
Bibliography
Textbooks
Education.
e-References
1. http://www.bhagininiveditacollege.in/pdf/2020/Dr-Rachna-Mahalwala-%20B.com-III-yr-
Management-accounting-problems-solutions-of-Unit-IV-Management-Accounting.pdf
2. http://tumkuruniversity.ac.in/oc_ug/comm/notes/cost%20accounting%20II_2.pdf
3. https://www.economicsdiscussion.net/cost-accounting/applications-of-marginal-cost-
ing/31695
4. https://commerceiets.com/applications-of-marginal-costing/#gsc.tab=0
Video Links
Topic Link
https://www.youtube.com/watch?v=aE4Jn-
Marginal Costing (Introduction)
jAx2Qc
https://www.youtube.com/watch?v=wVe-
Marginal Costing
HtQ3k2X0
https://www.youtube.com/watch?v=T-
Marginal Costing Technique
0Gdvq7th64
Marginal costing
watch?v=i_7dxah6h3w

207
Keywords
• Marginal costing
• Net profit
• Gross profit
• Marginal profit

208
MODULE 4
UNIT 2
BREAK-EVEN ANALYSIS

209
Unit – 4.2 Break-Even Analysis
Aim ------------------------------------------------------------------------------------------------------- 211

4.2.1 Break-even Analysis Meaning ----------------------------------------------------------- 212

4.2.2 Break-even Analysis Chart --------------------------------------------------------------- 215
4.2.3 Calculation of Break-even Point --------------------------------------------------------- 218
4.2.4 Uses of Break-even Analysis ------------------------------------------------------------ 221
Summary ------------------------------------------------------------------------------------------------ 224

Caselet -------------------------------------------------------------------------------------------------- 224
Answer Keys ------------------------------------------------------------------------------------------- 225
Practice Problems in Break-even Point --------------------------------------------------------- 226
Glossary ------------------------------------------------------------------------------------------------- 226
Bibliography -------------------------------------------------------------------------------------------- 226
e-References ------------------------------------------------------------------------------------------ 227
Image Credits ------------------------------------------------------------------------------------------ 227
Video links ---------------------------------------------------------------------------------------------- 227
Keywords ----------------------------------------------------------------------------------------------- 227

210
Aim
The main aim of this unit is to enhance the understanding of company accounts and
procedure for the issue of shares by the companies.
• Elaborate upon the concept of Break-even point
• Apply the Break-even point concept and its role in decision-making
Learning Outcomes
• Analyse the Break-even point and sales
• Apply Break-even point in business decisions

211
4.2.1 Break-even Analysis Meaning
Break-even analysis determines how many units of a product must be sold in order to pay fixed
and variable production expenses. The break-even point is a metric for determining the margin of
safety. Break-even analysis plays a significant role from product planning to receiving profitability
on the product, covering a wide range of decisions.
In economics and business, break-even analysis is described as the point where total cost and
total revenue are equal. A break-even point analysis is used to assess the number of units or
rupees of revenue required to be earned to cover all costs (fixed and variable costs) incurred on
a product or service.
It’s a no-profit, no-loss situation.

It’s also known as the moment at which Fixed Cost equals Contribution.
Variable Costs
or +
# of Units Revenue
Fixed Costs
Fig. 1: Fixed cost and variable cost
Significance of break-even analysis
a. Specifies the sales to be made to cover the variable cost and fixed cost and determine
the selling price of each individual product, as well as the total cost.
b. Breakeven Analysis helps to determine the amount of sales to be a goal and helps
in creating a budget for the business.
c. The break-even analysis assists the company in determining the minimum number
of sales required to break even. The management can make a high-level business
judgment based on the margin of safety reports.
d. Fixed and variable costs can have an impact on a company’s profit margin. As a
result, management can use break-even analysis to analyse the impact of changing
costs.
e. Any change in a product’s pricing can impact on the break-even point. If the selling
price is increased, the amount of the product that must be sold to break even is
reduced. Similarly, if a company’s selling price is cut, it must sell more to break even.
It helps in determining the price of a product.

212
Components of break-even analysis
1. Overhead costs
These are also known as fixed costs. Once a business’ financial activity begins,
these costs become apparent. Taxes, salaries, rentals, depreciation costs, labour
costs, interest costs, energy costs, and so on are all included in the fixed prices.
2. Variable costs
These expenses change with the volume of production and will drop or grow. These
expenses include packaging, raw material costs, fuel, and other production-related
components.

213
1. At break-even point one where there is:
(a) A Profit
(b) A Loss
(c) No profit or loss
(d) None of these
2. Break Even Point is represented as:
(a) Total expenses are equal to total revenue

(b) Total expenses are greater than total revenue
(c) Total expenses are less than total revenue
3. In any organisation, profit is determined by:
(a) Cost of production

(b) Production output
(c) Revenue
4. Break-even point does not follow one assumption among the given.
(a) All fixed costs are fixed

(b) All variable costs are fixed
(c) The prices of input factors are constant
(d) Volume of production and volumes of sales are equal
5. The break-even point is derived between:
(a) Total revenue line and total cost line

(b) Total cost line and variable cost line
(c) Variable cost line and fixed cost line
(d) Fixed cost line and total cost line

214
4.2.2 Break-even Analysis Chart
A break-even chart depicts the amount of sales volume where total costs equal sales. Below this
amount, losses will be incurred, while gains will be earned above this point. Revenue, fixed costs,
and variable costs are plotted on the vertical axis, while volume is plotted on the horizontal axis.
Break-even analysis plays a significant role from product planning to receiving profitability on the
product, covering a wide range of decisions. A break-even point analysis is used to assess the
number of units or rupees of revenue required to be earned to cover all costs (fixed and variable
costs) incurred on a product or service.
Any change in a product’s pricing can impact on the break-even point. If the selling price is
increased, the amount of the product that must be sold to break even is reduced. Similarly, if a
company’s selling price is cut, it must sell more to break even.
Graphic representation of costs at various levels of activity displayed alongside the change in
income in terms of sales or revenue with the same variation in activity.
nue
ve
200000 Break-even Point Re
180000
ed)
160000 Variab le + Fix
Total Costs (
140000
120000
Fixed Costs
100000
80000
60000
40000
20000
0
2000 4000 6000 8000 10000 12000 14000 16000 18000
Number of Units
Fig. 2: Break-even analysis chart

215
Analysis of chart
1. The X-axis represents the number of units, while the Y-axis represents the amount.
2. The red line shows total fixed costs. Rs 100,000.
3. The revenue per unit sold is represented by the blue line. Sales of 10,000 units, for
example, would result in an income of 10,000 x Rs 12 = Rs 120,000.
4. Total costs are represented by the yellow line which covers fixed cost and variable
cost.
For example, if the company sells 0 units, it will incur Rs 0 in variable costs and Rs
100,000 in fixed costs, totalling Rs 100,000 in total costs. If the company sells 10,000
units, the variable expenses will be 10,000 x Rs 2 = Rs 20,000, and the fixed costs will
be Rs 100,000, for a total cost of Rs 120,000.
5. In the above chart, it clearly depicts that at 10,000 units, the break-even point is reached.
Revenue would be 10,000 x Rs 12 = Rs 120,000 at this point, with expenditure being
10,000 x 2 = Rs 20,000 in variable costs and Rs 100,000 in fixed costs.
6. The company will make a profit on the units sold whenever the total number of units
sold hits 10,000. After 10,000 items are manufactured, the blue revenue line exceeds
the yellow total costs line. Similarly, if the number of units sold is less than 10,000, the
corporation will lose money. The total costs line lies above the revenue line from 0 to
9,999 units. The term “margin of safety” refers to when actual sales exceed BEP sales.

216
6. Margin of safety =
(a) Actual sales – BEP sales

(b) Actual sales + BEP sales
(c) Actual sales x BEP sales
(d) Actual sales / BEP sales
7. Angle of incidence is the angle which represents:
(a) Total revenue line intersects the total cost line

(b) Total cost line intersects the variable cost line
(c) Variable cost line intersects fixed cost line
(d) Fixed cost line intersects total revenue line
8. Redline in the above chart represents:
(a) Selling cost

(b) Fixed cost
(c) Total sales
(d) Variable cost
9. The yellow line represents ______________in the above chart.
(a) Selling cost

(b) Fixed cost
(c) Total sales
(d) Variable cost
10. __________is a graphic representation of costs at various levels of activity shown

on the same chart as the variation of income.
(a) Break-even chart

(b) Analytical chart
(c) Sales chart
(d) Volume chart

217
4.2.3 Calculation of Break-even Point
1. Contribution = Sales – Variable Cost
2. P/V ratio = Contribution / Sales *100
3. If P/V ratio is 40%, it implies 60% is variable cost on sales.
4. BEP (in Units) = Fixed Cost / Contribution Per Unit
5. BEP (in Rs) = Fixed Cost / P/V ratio
(or)
BEP (in Rs) = BEP (in Units) * Selling Price per Unit
6. Margin of Safety = Actual sales – BEP Sales
Examples
1. Raja is a watch salesman. The following items are included in the price of each watch:
The selling price is Rs 1,000, with Rs 400 in variable cost. Raja’s total fixed costs are
Rs 90,000.
a). Calculate the contribution margin per watch?
Revenues – variable Cost = CM

Rs 1,000 - Rs 400 = Rs 600
b). Calculate the total profit when 200 watches are sold?
Sales- Variable cost = Fixed cost +Profit

To find out Profit
Sales – Variable cost – Fixed cost = Total Profit
200 (Rs 1,000) – 200(Rs 400) - Rs 90,000 = Rs 30,000
c). Specify how many watches the company needs to sell in order to break even
X = Fixed Costs/Contribution Margin

X = Rs 90,000/Rs 600
X = 150 dresses
d). In order to get a profit of Rs 60,000 specify how many watches are to be sold by
the company.
Sales = (Fixed cost +Desired Profit)/ Contribution per unit

= (90000+60000) /600
= 1,50,000/600
= 25 watches.

218
2. Shaik offers phones for sale for Rs 100. The unit variable cost per phone is Rs 50,
plus a 10% selling commission. Monthly fixed production costs are Rs 1,250, whereas
monthly fixed sales and administrative expenditures are Rs 2,500.
a). Determine the contribution margin per phone?
CM per phone = Rs 100 - Rs 50 - 0.1(Rs 100) = Rs 40
b). Determine the break-even point in phones?
N = Break-even in phones
Rs 100N - Rs 50N - Rs 10N - Rs 1,250 - Rs 2,500 = 0
Rs 40N - Rs 3,750 = 0
N = Rs 3,750 / Rs 40 = 93.75 phones
Break-even Point = 94 phones
c). To earn a targeted profit of Rs 7,500, determine how many phones need to be
sold.
N = Phones to be sold
Rs 100N - Rs 50N - Rs 10N - Rs 1,250 - Rs 2,500 = Rs 7,500
Rs 40N = Rs 11,250
N = Rs 11,250 / Rs 40 = 281.25 phones
To achieve target profit: Must sell 282 phones

219
11. If the selling price is Rs 10 per unit, the variable cost is Rs 6 per unit, and the fixed
cost is Rs 5,000, the total cost is Rs 10,000 then break-even point is:
(a) 500 units

(b) 1,000 units
(c) 1,250 units
12. If the selling price is Rs 20 per unit and the variable cost is Rs 16, the contribution is:
(a) Rs 1.25 per unit

(b) Rs 4 per unit
(c) Rs 0.8 per unit
13. Selling price of a product is Rs 10/-. Fixed cost of Rs. 40,000 and a variable cost of
Rs. 6 per unit. How many units are to be sold in order to break even?
(a) Rs. 12,000

(b) Rs. 14,000
(c) Rs. 8,000
(d) Rs. 10,000
14. Fixed costs = Rs. 20,000, Price per unit sold = Rs. 8 Variable cost = 60,000,
Contribution = Rs. 12,000. The sales volume is:
(a) Rs. 6,000

(b) Rs. 10,000
(c) Rs. 12,000
(d) Rs. 14,000
15. Determine the BEP in units and rupees if the number of units produced is 10,000,
the fixed cost is 40,000, the selling price is 50 per unit, and the variable cost is 30
per unit.
(a) Rs 40 per unit, Rs 2,00,000

(b) Rs 50 per unit, Rs 10,00,000
(c) Rs 20 per unit, Rs 1,00,000

220
4.2.4 Uses of Break-even Analysis
Applications and limitations of break-even point
1. It aids in determining the point of profitability.
A business that isn’t profitable could go out of existence at any time. Therefore, every
business should concentrate on its profit centre. Consider the following questions:
a). How much income do I need to cover all my expenses?

b). What items or services are profitable?
c). What are the items or services that are being sold at a loss?
2. Calculating a break-even point will help you price your products more effectively. It
helps to set margins for the product to generate the right amount of revenue to break
even.
3. Break-even analysis helps the firm to devise future strategy. A business’ profitability is
driven by the break-even point for each product, which provides a timeline that helps
in building an overall financial plan that meets the projected earnings and can cover
the costs.
4. Cost-benefit analysis examines all fixed costs on a regular basis to determine if any
can be cut. Examine variable costs to see whether they can be reduced or eliminated,
as this enhances margins and lowers the break-even point.
5. Examine the margins. Keep an eye on product margins and push sales of the highest-
margin items to lower the break-even point.
6. Outsourcing: If a fixed cost is involved, consider outsourcing it to convert it to a per-

unit variable cost, which lowers the break-even point.
7. Technology: Implement any technologies that can help the company become more
efficient, allowing it to expand capacity without increasing costs.
Limitations of break-even analysis
1. Break-even analysis assumes that all expenses and expenditures can be clearly
split into fixed and variable components. In practice, however, it may be difficult to
distinguish between fixed and variable expenses.
2. At all levels of activity, fixed costs are believed to be constant. It should be noted that
fixed costs tend to fluctuate after a certain level of activity.
3. Variable costs are considered to fluctuate according to output volume. In actuality, they
move in lockstep with production volume, but not always in direct proportions.

221
4. Assuming that the selling price remains constant, a straight revenue line is produced,
which may or may not be realistic. A product’s selling price is influenced by a number
of factors, including market demand and supply, competition, and so on, and it rarely
remains constant.
5. It’s uncommon to see the assumption that just one product will be produced or that the
product mix will remain steady in practice.
6. It’s difficult to distribute fixed costs over a variety of products.
7. It assumes that business conditions will remain unchanged, which is incorrect.
8. It assumes that production and sales quantities are identical, and that the opening and
closing stock of finished goods are unchanged; nevertheless, both assumptions are
incorrect.
9. In the break-even analysis, the amount of capital used in the business is not taken
into account. In truth, a company’s profitability is mostly determined by the amount of
capital it employs.

222
16. Break-even analysis helps to determine the profitability at a given level of sales.
(a) True
(b) False
17. Pricing of a product cannot be done through breakeven analysis.
(a) True
(b) False
18. Cost analysis helps to reduce the variable cost.
(a) True
(b) False
19. Break-even analysis assumes that fixed costs do not remain constant at all levels
of activity.
(a) True
(b) False
20. Break-even analysis assumes that variable costs vary with the volume of output.
(a) True
(b) False

223
Summary
The break-even point is a metric for determining the margin of safety.
Break-even analysis plays a significant role from product planning to receiving

profitability on the product, covering a wide range of decisions.
A break-even point analysis is used to assess the number of units or rupees of

revenue required to be earned to cover all costs (fixed and variable costs) incurred on
a product or service.
Any change in a product’s pricing can impact on the break-even point.
If the selling price is increased, the amount of the product that must be sold to break
even is reduced. Similarly, if a company’s selling price is cut, it must sell more to break
even.
Caselet
The entire fixed cost of OGE Professional Services Ltd is $300,000, and the average variable
cost (variable cost per unit of production) is $2.00. Furthermore, the corporation sells the
product for #5.00 per unit. The corporation is trying to figure out where it will break even.
In this context you are required to analyse and advise the management.
Terminal Questions
1. Explain the significance of Break-even point.
2. Explain Break-even analysis using chart.
3. Describe limitations of Break-even analysis.
4. Explain various applications of Break-even analysis.

224
Answer Keys
Question No Answers
1 C
2 A
3 D
4 B
5 A
6 A
7 A
8 B
9 C
10 A
11 C
12 B
13 D
14 A
15 B
16 A
17 B
18 A
19 B
20 A

225
Practice Problems
1. A business plans to manufacture 150,000 units. The variable unit cost is Rs. 14 and
the fixed unit cost is Rs. 2. The corporation sets its selling price to make a 15 percent
profit on cost.
a). Where does the break-even point occur?

b). How is the profit-to-volume ratio calculated?
c). How would the reduced selling price affect the break-even point and profit-
volume ratio if it lowers its selling price by 5%?
d). What should be the sales at the reduced pricing if a profit gain of 10% is required
more than the budget?
2. Retail selling Price - Rs. 20 per unit

The cost of variable production is Rs. 11 per unit. Rs. 3 per unit is a variable selling
cost.
Factory overheads are fixed at Rs. 5,40,000 per year.
Selling costs are fixed at Rs. 2,52,000 per unit.
a). BEP Volume and Value
b). Required sales to make a Rs. 60,000 profits.
c). Required sales to earn a 10% profit margin.
Glossary
• Break-even Analysis: A financial calculation that weighs the costs of a new busi-
ness, service or product against the unit sell price to determine the point at which
you will break even.
• Cost analysis: The act of breaking down a cost summary into its constituents and
studying and reporting on each factor.
Bibliography
Textbooks
Education.

226
e-References
1. https://hrcak.srce.hr/file/239680
2. https://doi.org/10.2307/1349300
Image Credits
• Fig. 1
https://corporatefinanceinstitute.com/resources/accounting/break-even-analysis/
• Fig. 2
https://corporatefinanceinstitute.com/resources/accounting/break-even-analysis/
Video Links
Topic Link
https://www.youtube.com/watch?v=r-
Break-even analysis
8BIz5I-aDc
Break-even Analysis: Contribution & https://www.youtube.com/

Contribution per Unit watch?v=mN8dGY57IBk
Break-Even Analysis Explained
watch?v=vUT8lZLZpKg
Keywords
• Break-even point
• Cost of production
• Production output

227
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Instructional Objectives: These are behavioural objectives that describe intended

Self-Assessment Questions: These include a set of multiple-choice questions to be

Bibliography: This is a list of books and articles written by a particular author on a

Financial and Management Accounting

President Vice Chancellor

Pro-Vice Chancellor Incharge Registrar

Financial and Management Accounting

Financial and Management Accounting

KL Deemed to be University-CDOE has full copyright over this educational material. No

Financial and Management Accounting

Financial and Management Accounting

Financial and Management Accounting

Module 1: Introduction to Accounting

Accounting: Book-keeping – Users of Accounting information – Classification of Accounting –

Module 2: Preparation of Financial Statements

Module 3: Company Accounts

Module 4: Management Accounting

Marginal Costing (problems) – Break-even Analysis (problems).

Financial and Management Accounting

Financial and Management Accounting

Financial and Management Accounting

Chapter 1.1 Introduction to Accounting

Financial and Management Accounting

1.1 Introduction to Accounting

1.1.1 Definition of Accounting ----------------------------------------------------------------------------- 8

Financial and Management Accounting

Financial and Management Accounting

1.1.1 Definition of Accounting

“Accounting is the process of identifying, recording, classifying, and summarising in a significant

1. Economic Events: It is the “happening of consequence” to a business entity and can be

a) Internal Events: It is an economic event that occurs entirely within business.

4. Classifying: It is concerned with classification of the recorded transactions based on their

5. Summarising: This involves presenting the classified data in an understandable manner,

Financial and Management Accounting

Financial and Management Accounting

2. Book of Final entry is called ___________.

3. ______________are called the eyes and ears of the business.

4. _____ statement is prepared to test the accuracy of accounts.

5. Accounting deals with _____ data.

Financial and Management Accounting

2 To protect the properties of the business: Another important function of accounting is to

1.1.1.3 Advantages of Accounting

Helpful in taking managerial decisions: Accounting provides operating and financial

Financial and Management Accounting

4. Accounting ignores the qualitative elements: Accounting is concerned with quantitative

Financial and Management Accounting

6. Accounting may lead to window dressing.

7. Accounting statements are prepared at Actual cost.

8. Accounting ignores the quantitative elements.

Financial and Management Accounting

1.1.2 Meaning of Book-keeping

Book-keeping is concerned with:

1.1.2.1 Meaning of Accountancy

Financial and Management Accounting

It is enough to have elemen- For accounting, advanced, and

Book-keeping is the first Accounting begins when book-

Financial and Management Accounting

13. Summarising is not a part of Book-keeping.

14. Accounting follows Book-keeping.