ACCOUNTING SYSTEM AND COSTING: NOTES

(UNIT 1 (AS))
1. Basic Accounting Principles/Concepts
Accounting concepts are uniform accounting policies followed worldwide. They are the
common fundamental rules in accounting followed by businesses throughout the world.
The following points state the necessity for accounting concepts:
a. Help to compare the performance of one business with similar type of another
business.
b. Help to borrow money from different lending agencies.
c. Help in tax assessment.

1. Going Concern Concept

This concept means that the business will continue to operate for a foreseeable future. It
is with this expectation that the businessman invests large amounts on non- current
assets of the business. Annually the amount of depreciation is charged against profit
since the full cost is not to be written off in the year of purchase. The cost of the Non-
current assets has to spread over its useful life.

2. Historical Concept

Accounting is a historical record (past record). An asset is entered in the books at the
price agreed between the seller and buyer. It should be entered at the cost incurred. Eg.
If the premises which cost £10 000 has a market value of £15 000. But the market value
should not be entered in the books as the cost incurred for the asset is £15 000.

3. Business Entity Concept

This concept says that the business has a separate entity apart from the business man.
Business man is one person (natural person) and the business is another person (legal
person). Therefore, owner’s investment in to business is termed as capital and the
withdrawals by the owner for personal use is termed as drawings. Owner’s personal
expenses cannot be treated as business expenses

4. Money Measurement Concept

This concept says that only transactions or items which can be measured in terms of
money can be recorded in the books. The non-monetary transactions/items do not come
within the scope of accounting.

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E.g.1. The skill of staff. 2. Satisfaction of working force to the existing working conditions
in the factory. 3. Dispute between production manager and the sales manager, etc does
not come within the scope of accounting and therefore, cannot be recorded in the financial
statements

5. Accruals Concept (Matching Concept)

As per this concept, the total income or revenue of the year should be matched against
the total expense or cost of the same accounting year. Thus, the adjustment is required
for prepaid and accruals for the preparation of financial statements.
Depreciation of Non-current assets and the allowance of irrecoverable debts are also
come under this concept

7. Prudence Concept (Concept of Conservatism)

The Accountant should see that the assets, liabilities, expenses or income of the business
are neither under- valued or nor overvalued. He should always be on the safer side. It is
safer to understate an asset or profit rather than overstating it. If the profit is inflated, the
business will tend to draw more money and that overdrawing will be out of capital of the
business and the tax payable would be higher for higher profit. Thus, the Accountant
should be prudent or intelligent to value assets and liabilities, expenses or income
reasonably. He should create sufficient provisions for bad debts and depreciation.

8. Materiality Concept
The accountants should concern only with items which are material in relation to the size
of the business. For e.g., the purchase of a stapler- Though it can be used for longer
period, should not be treated as a non-current asset. Its value involves an insignificant
amount. So, its cost can be written off in the year of purchase in the statement of
comprehensive income and need not to be depreciated. The business may have the
policy to include an item as Non-current asset if its value is more than a specific level of
significance, say £500

9. Concept of Consistency

Every business should follow the policy or method which give the most reliable picture of
the business.

When there is a choice of option available for a policy or method, the accountant should
consistently follow the same policy or method chosen for year after year. Continuously
changing the policy or method may show misleading profit. It does not mean that the
business should follow the same policy lifelong. The method can be changed, but it should
be able to give the most reliable picture of the business. E.g., If the company follows

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straight line method of providing depreciation, the same method should be followed until
the life of the asset is over. The change is allowed only with a valid reason

10. Dual aspect concept

This concept is based on the fact that every business transaction has to consider two
aspects namely the debit and credit. This is double entry principle that for every debit
entry there should be a corresponding credit entry.

11. Realization Concept

As per this concept profit is regarded as being earned when goods are sold to customer
and the customer accepts the goods. Or an income can be regarded as only when it is
earned. Unrealized profit should never be entered in the books.
e.g. 1. Goods costing £10 000 was sent for £15 000 to a customer on a sale or returns
basis. £15 000 can be considered as revenue only after having been accepted by the
customer. Till then it should be the part of inventory.
e.g. 2. Inventory costing £4 000 has a market value of £4 800. Here the inventory should
be entered in the books at £4 000 and not at £4 800 as the inventory is unsold and the
profit is not yet realized/earned.

Evaluate the usefulness of accounting concepts

Advantages of accounting concepts
• Accounting concepts give a framework or a structure for the preparation of books of
accounts and financial statements for the accountants to follow
• These concepts enable the accountants to follow the generally accepted rules for the
treatment of various business transactions or items
• The performance of two or more businesses on similar lines can be compared if they
follow the same internationally accepted accounting concepts
• These concepts are very helpful to compute more accurate profit of the business that
they give true and fair view of the business
• Users of accounting information can trust the accounts prepared that it is accepted
worldwide and are accepted by the IAS that they are reliable
• They are helpful for taxation as they provide is more accurate profit for tax returns
Disadvantages of accounting concepts
• Some of the accounting concepts conflict each other. For e.g., Materiality and
matching
• There are many interpretations to concepts for e.g., materiality, which may vary from
firm to firm
• Accounting concepts may provide some arbitrary assumptions for the treatment of
items depending upon the size of the business and the value of items

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• It does not take into account the items which are not expressed in money value like
efficiency of the management, etc.
• They need the expertise of a trained professional to follow the accounting concepts
Conclusion
Despite a few shortcomings, accounting concepts are widely followed by business entities
throughout the world.
2. Irrecovarable debts and allowance for irrecoverable debts
1. State the difference between irrecoverable debts and allowance for
irrecoverable debts.
Irrecoverable debts are the amount of debt the customer is not going to pay and it is
identified as a loss for the business. They relate to the current period which is actual
bad debts
The estimated or expected amount of bad debts is called allowance or provision for bad
debts. This estimated bad debt will become ‘bad’ probably in the next accounting
period.
Bad debts Allowance for doubtful debts
Actual bad debts from the last period Estimate of possible debts in the next
period
Actual figure Estimate only
Expense of the period entered in the Application of prudence concept to
income statement value trade receivables accurately

These have occurred in the current This is for a debt which might occur in
period a future period

It is better to write off the bad debts when they actually occur.’ Evaluate the
statement.
Points in favour of allowance for doubtful debts
• Ensures that profits are more realistic, because an allowance will be
made of possible bad debts from the sales of the current period.
• Complies with the prudence concept in not overstating profits.

Points in favour of writing off bad debts as they occur

• Will not be based upon estimates, as the allowance will be.
• Based upon actual bad debts if they occur.
Conclusion: it is prudent to provide provision for doubtful debts than recording as bad
debts when occurred due to the application of accounting concepts

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2. State the reasons for providing provision for bad debts.
Bad debts and provision for bad debts should be provided on the following grounds.
➢ To know correct profit for the year
➢ To show correct value of trade receivables in the statement of financial position
➢ To comply with provisions of prudence and matching.

3. What are accounting concepts to be followed for provision for bad debts?
There are two accounting concepts which should be followed for provision for provision
for bad debts. They are prudence and matching concepts.
As per prudence concept, Accountant should be prudent enough to provide for provision
for bad debts. He should never underestimate provision for bad debts. Under estimated
provision for bad debts may inflate the profit.
As per matching concept, all the revenue income for a particular year should match with
the revenue expenses and provisions for that particular year. Only then we can arrive at
the true amount of profit for the year.
4. What do you mean by schedule of trade receivables? What is its usefulness?
Schedule of debtors is the list of trade receivables prepared in the order of their due
dates for payment. Before the due date they will be reminded of the payment on due
date. If this list is maintained we can know the debt outstanding for a greater number of
days. As a result, steps can be taken to recover the amount.
5. How can we ensure prompt payment by trader receivable?
Qualities of a good credit control policy
• Get trade reference and bank reference before providing credit
• Inform credit terms to customers before providing credit
• Fix credit limit for each customer depending upon their credit worthiness
• Maintain a schedule of trade receivables.
• Check the debts outstanding for more than one month
• Stop providing credit if the credit limit or credit period reached
• Before the due date remind them of payment
• For those who fail to pay on due date, send a warning letter stating that legal actions
will be taken.
• Legal action should be taken against those who ignore the warning given.

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3. Capital and Revenue expenditure
1. Explain with examples, the terms Capital expenditure and Revenue
expenditure.
Capital Expenditure
The term capital expenditure refers to money spent for:
Buying Non- current assets
Bringing Non- current assets
Installing Non- current assets and for
Improving Non-current assets (extension to Non-current assets)
e.g.
1. Purchase price of machinery
2. Carriage inward for machinery
3. Wages paid to workers for installing machinery
An expenditure which results in the acquisition of permanent asset which is intended to
be permanently used in the business for the purpose of earning revenue is known as
Capital Expenditure
These assets increase the profit earning capacity of the business and are
'non-recurring' by nature.
These are not expenditure for one accounting period, which has long life and its benefit
will be enjoyed over a long period of time. Therefore the cost should be spread over its
expected useful life

It should also be remembered that when an asset is purchased, all amounts spent up to
the point till the asset is ready for use should be treated as capital expenditure.

Revenue expenditure
All the expenditures which are incurred in the day-to-day conduct and administration of
a business are known as "revenue expenditures". The effect of which is completely
exhausted within the current accounting year
These expenditures are recurring (frequently repeating expenses.) by nature, i.e.,
which are incurred for meeting day today requirements of a business and the effect of
these expenditures is always short-lived i.e., the benefit thereof is enjoyed by the
business within the current accounting year.
They are current or short-term expenses of the business are incurred for every day,
maintaining the non-current assets (for e.g., repairs, fuel charges etc. for non-current
assets.)
e.g., Rent paid, Purchase of goods, repairs, bad debts, loan interest, Accountant’s fee
etc.

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Difference between Capital Expenditure and Revenue Expenditure:

Revenue Expenditure Capital Expenditure

1. Its effect is temporary, i.e., the 1. Its effect is long-term, i.e., it is not
benefit is received within the exhausted within the current accounting
accounting year. year-its benefit is received for a number
of years in future.
2. Neither an asset is acquired nor is 2. An asset is acquired or the value of an
the value of an asset increased. existing asset is increased.
3. It has no physical existence because 3. Generally, it has physical existence
it is incurred on items which are used except intangible assets.
by the business.
4. It is recurring and regular and it 4. It does not occur again and again. It is
occurs repeatedly. nonrecurring and irregular.
5. This expenditure helps to maintain 5. This expenditure improves the position of
the business. the business.
6. The whole amount of this 6. A portion of this expenditure (depreciation
expenditure is shown in Statement of on assets) is shown in statement of
comprehensive income. Comprehensive Income and the balance
is shown in the Statement of Financial
position on asset side.
7. It does not appear in the statement of 7. It appears in the Statement of financial
financial position. position until its benefit is fully exhausted.

2. What is the necessity for dividing expenditure between capital and revenue?
Expenditure must be divided between capital and revenue for the purpose of arriving at
correct profit and also for knowing true financial position of the business by applying
accrual and prudence concept
3. Which accounting concept governs capital expenditure?
Capital expenditure is governed by the provisions of going concern concepts. Going
concern concept states that the business will run for a foreseeable future and that the
owner invest in the long-term assets of the business.
4. Which accounting concept governs revenue expenditure?
Revenue expenditure is governed by matching concept. As per matching concept all the
revenue expenses for a year should be entered in the income statement. As per this
concept the part of the non-current assets used up during the trading year should be
treated as revenue expense.

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Capital and Revenue Receipts:

Capital Receipt:
Receipts which are non-recurring (not received again and again) by nature and whose
benefit is enjoyed over a long period are called "Capital Receipts", e.g., money brought
into the business by the owner (capital invested), loan from bank, sale proceeds of non-
current assets etc.
Revenue Receipt:
Receipts which are recurring (received again and again) by nature and which are
available for meeting all day-to-day expenses (revenue expenditure) of a business
concern are known as "Revenue receipts", e.g. sale proceeds of goods, interest
received, commission received, rent received, dividend received etc.
4. Depreciation of Non-current assets
1. What is depreciation? State the reasons for depreciation of non-current
assets.
Depreciation is the part of the original cost of non-current asset which is consumed
(used up) during its period of use by the business.
Depreciation occurs due to the following reasons.
➢ Everyday use. (wear and tear)
➢ Obsolescence (going out of dated)
➢ Passage of time ( for Patents)
➢ Depletion
➢ Amortization
2. What is the need for providing for depreciation?
➢ Non-current assets generally fall in value with age and usage, this should be
reflected in the financial statements
➢ Depreciation is an expense of a period of time and therefore should be charged
against income for that period as the profit should not be overstated
➢ To spread over the cost of non- current asset during the period of its useful working
life.
➢ To know more accurate profit for the year and to show more accurate value of asset
in the statement of financial position
➢ Charging depreciation complies with accounting concepts like accruals, going
concern
➢ To replace the asset after its useful working life
3. Accounting concepts complied with provision for depreciation
• Going concern
• Prudence
• Matching
• Consistency

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4. What is straight line method of providing depreciation? State its advantages
and disadvantages.
This is a method of providing depreciation whereby a fixed percentage of the original
cost of asset is charged as depreciation each year. The amount of depreciation each
year is the same. There is a formula for calculating depreciation under this method.
That is Depreciation =
Cost – Scrap value
Working life of asset
This method is most suited: to leases. (Lease hold premises/buildings), furniture,
fixtures and fittings

Advantages of Straight-line method of depreciation

• We can depreciate the non-current asset till its value reaches scrap value or Zero.
• The cost of asset is equally spread over its useful working life. Equal usage of non-
current assets from year to year should result in equal depreciation charged
• Applies accruals concept ensuring actual depreciation is matched to the period
• The application of the method does not distort profits
• Is the simplest and most widespread form of depreciation used by businesses
• It is suitable for assets that operate uniformly and consistently over the life of the
item. The fixed method is straightforward, uncomplicated, easy to understand and
simple to apply.

Disadvantages Straight line method of depreciation

• Many non-current assets market value depreciates heavily in the first year of
ownership. The asset may not lose the value at a constant rate.
• The market value of the non-current asset may be substantially different from the
book value.
• Total cost of ownership will increase when annual maintenance costs are added.
• The working life and scrap value are estimations as the functional life span of some
assets cannot clearly be estimated.
• Straight-line depreciation does not account for the loss of efficiency or the increase
in repair expenses over the years and is, therefore, not as suitable for costly assets
such as plant and equipment.
• Not suitable for assets which obsolete faster like computer equipment, machinery,
vehicles, etc
Conclusion
Despite these demerits, this method of providing depreciation is very popular and many
organizations follow this method, as it is known for its simplicity.

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5. What is diminishing balance method (written down value method)? State the
advantages and disadvantages.

This is a method of providing depreciation whereby a fixed percentage of the value of

non-current asset at the beginning of each year is charged as depreciation. As the value
of asset reduces each year the amount of depreciation also reduces each year.
As per this method the amount of depreciation charged in the early life of the asset is
higher and it will be less during the later life of the asset and it is suited to assets that
have a heavier fall in value in earlier years and repair/maintenance costs that increase
over life.
This method is most suited to assets involving more repairs like plant and
machinery.

Advantages of reducing balance method of depreciation

• This method is more realistic as the most part of the cost of asset is recovered in the
early years of the life of the asset for assets like machineries, motor vehicle,
computer equipment, etc.
• Total cost of operating the Non-current asset would be even over the life of the asset
because, high depreciation and low maintenance in early years. This will reverse in
later years.
• This method is more appropriate if the risk of obsolescence is very high as most part
of the cost is written off in the early life of the asset.
• May provide a more realistic net book value if asset loses more value in early years.

Disadvantages of reducing balance method of depreciation

• Calculations may become complicated and the total cost of the asset may not be
depreciated over the life of the asset. It may not reach to scrap value or zero by
providing depreciation
• During the early years of the asset’s life there will be more depreciation and as a
result there will be lower profit for the year.
• Not suitable for assets like building, furniture, etc expected distribution of benefit
evenly
Conclusion
This is a very rational approach to depreciating non- current assets
6. What is revaluation method of providing depreciation?

Under this method, depreciation is provided by revaluing asset at the end of each year.
The difference between the value of asset at the beginning of the year and at the end of
the year is depreciation. This method is commonly used for assets like Loose Tools

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Depreciation under this method is:
Opening NBV of asset ******
Add purchase price of the new asset bought *****
Less NBV of the asset sold (****)
Less closing NBV (****)
Depreciation of the asset during the year *****

Why depreciation is an application of the going concern concept?

• The going concern concept assumes that, unless the opposite is known, the
business will operate for an indefinite period of time.
• The cost of purchasing a non-current asset will fall in a single year, but proportion of
the total cost is allocated to Comprehensive Income Statement, as depreciation,
each year will relate only to the amount estimated to have been used in that period.
• Non-current assets have a life of many years and require the estimated
diminution in value to be charged to each year. The assumption of going concern
therefore allows depreciation to be
charged over the life of the asset irrespective of length.
7. Availability of cash for replacing non-current asset, by providing depreciation
Supportive
• Depreciation accrues previous year’s capital expenditure over the life of the asset.
• Depreciation is provided as per accrual concept as the benefit is received for several
years. When we provide depreciation, it leads to lower profit. Lower profits mean
lower drawing and therefore, lower outflow of cash.
• Profit will be reduced by depreciation which should result in retention of profit. Profit
will increase cash flow
Against
• Although the accrual convention applies, this relates to the expenditure and cash
flow in previous year.
• The retention in profit may not be in cash. Depreciation is a non-cash expense and
thus there is no inflow or outflow of cash. It is merely an accounting entry to record
the reduction in the value of non-current asset.
• When we provide depreciation, it does not mean that the depreciation amount is
available as cash in the bank
Conclusion: depreciation is a non-cash expense, which doesn’t take cash from the
business for the created provision periods or brings money to the business. Thus, it can
be concluded that providing depreciation doesn’t retain cash in the business to replace
the asset

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 Schedule of Non-current Assets (Form 1)
Land and buildings Motor vehicles Loose tools
£ £ £
Cost at (opening date)
Additions for year (+)
Disposals for year (-)
Total non-current asset cost (Closing
date)
Less depreciation
Provision at (opening date)
Depreciation on non-current asset
disposals (-)
Depreciation for the year ended (+)
Total accumulated depreciation (--)
Carrying value at (closing date)

Schedule of Non-current Assets (Form 2) (revaluation method)

Carrying Additions for Disposals for Depreciation Carrying value
value year the year for the year (closing)
(opening) (carrying ended
value)
£ £ £ £ £
Non Current
Assets
Land and buildings
Motor vehicles
Loose tools

5. Trial Balance and Errors

1. What is trial balance? Evaluate the preparation of a trial balance.
Trial Balance is a list of closing balances of ledger accounts on a certain date and is the
first step towards the preparation of financial statements. It is usually prepared at the
end of an accounting period to assist in the drafting of financial statements.
Ledger balances are segregated into debit balances and credit balances. Asset and
expense accounts appear on the debit side of the trial balance whereas liabilities,
capital and income accounts appear on the credit side.

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 Advantages
▪ Balancing of the trial balance is ‘prima facie’ evidence that the double entry is correct
▪ Trial Balance acts as the first step in the preparation of financial statements. It is a
working paper that accountants use as a basis while preparing financial statements.
▪ Trial balance ensures that for every debit entry recorded, a corresponding credit
entry has been recorded in the books, which is in accordance with the double entry
principle of accounting.
If the totals of the trial balance do not agree, the differences may be investigated and
resolved before financial statements are prepared. So, trial balance is a statement
prepared to check the arithmetical accuracy of the ledger balances.
▪ Trail balance assists in the identification and rectification of errors that enter in
general ledgers as it is a checking device for ensuring the accuracy of ledger.
▪ It helps to check fraudulent practices, if any when it is not balanced
▪ It helps to ensure more accurate picture of financial performance of the business by
providing summary of all transactions for the period
▪ More accurate picture of financial position also can be known with the help of trial
balance and thereby helps to improve overall efficiency of the business.

Disadvantages
▪ Trial Balance only confirms that the total of all debit balances matches the total of all
credit balances. It doesn’t pinpoint the exact location of errors
▪ Trial balance totals may agree in spite of errors like- error of omission, commission,
principle, original entry, compensating, complete reversal, etc. as these are errors
that do not affect the agreement of trial balance.
Another example would be an incorrect debit entry being offset by an equal credit
entry.
Likewise, a trial balance gives no proof that certain transactions have not been
recorded at all because in such case, both debit and credit sides of a transaction
would be omitted causing the trial balance totals to still agree.
▪ Its preparation involves the investment of time and money as it is done by senior
accountants or internal auditors
▪ Trial balance is prepared by businesses following double entry principle and by
those who are skilled in accounting profession, so for small firms it might not be
affordable
Conclusion: despite some drawbacks, trial balance is acting as an excellent tool for
checking the accuracy of double entry and ledger accounts
6. Errors in Accounting
There are two major classifications of errors. They are:
(a) Errors not revealed by (not affecting) trial balance.
(b) Errors revealed by (affecting) trial balance.

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Errors not revealed by trial balance.
1. Errors of omission
This error happens when a transaction is being completely omitted from the books.
2. Errors of commission
This error happens when correct amount is posted to (entered in) wrong person’s
account or transaction is entered in the correct class but in wrong account
3. Errors of Principle
This error happens when a transaction is posted against the basic accounting principle.
The transaction is entered in the wrong class of accounts
4. Errors of Original entry
This error happens when we enter wrong amounts in correct accounts.
Remember........
➢ If second amount is less, same entry with the difference
➢ If second amount is more, reverse entry with the difference.
5. Errors of complete reversal of entries.
This error happens when the journal entry is completely reversed or the transaction is
recorded in the reverse side of the accounts. Here we should write the correct entry
with double amounts.
6. Compensating errors
This error happens when two or more errors compensated or counter balanced by each
other out.
Eg: revenue and purchases are undercast by £200.
Rent is overcast by £500 and drawings undercast by £500

Errors affecting (revealed by) trial balance.

Here the amounts on two columns of trial balance do not agree. The difference in
amount will be transferred to suspense account. After correcting the error, there will be
no balance left in the suspense account
What is a suspense account? State the usefulness of preparing a suspense
account?
A suspense account is an account where we record unclassified transactions. The
account temporarily holds entries while deciding how we will classify them.
Suspense account is a temporary account prepared in the general ledger when the
amounts on the two sides of trial balance do not agree due to some errors.
• Suspense account helps to balance the trial balance
• Helps for the preparation of draft financial statements
• Helps to identify that there are errors occurred in double entry

If the credits in the trial balance are larger than debits, record the difference as a debit.
If the debits are larger than credits, record the difference as a credit.

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▪ Move suspense account entries into their designated accounts to make the
suspense balance zero. Eventually, allocate entries in the suspense account to a
permanent account. On correcting the errors there will be no balance left out in the
suspense account.
▪ It is useful to have a suspense account rather than not recording a transaction at all
until there is sufficient information available to create an entry to correct account.
Moreover, when there is a suspense account, we can make a provisional (draft)
financial statements of the business and, later on, necessary correction can be
made to them.
7. INTERNATIONAL ACCOUNTING STANDARDS
Accounting standards provide a system of rules and principles that prescribe the format
and content of financial statements, which harmonizes the accounting standards
The main advantages of a single set of international accounting standards are
• Peer to Peer Comparison: An increased comparability between firms, which
reduces investor risk and facilitates cross-border financing and investment;
• A reduction in the cost of preparing consolidated financial statements for
multinational firms; and improved reliability and credibility of financial reports.
• Contribute to economic efficiency by helping investors to identify opportunities
and risks across the world, thus improving capital allocation
• The purpose of these standards is to ensure to develop a unified set of
accounting and reporting standards to build a single global financial reporting
language
• It provides as an accounting framework with global acceptance which is of high
quality, transparent, understandable, globally enforceable
• By having a uniform code of accounting standards, it evens the playing field
and allows business owners in different parts of the world to adhere to the
same guidelines. More cross border transactions facilitate access to international
capital and investments
• Enhance confidence of global stakeholders facilitate international acquisitions
and mergers
• One of the other benefits of accounting standards at the international level as it
relates to ethics is that they often include suggestions from accounting
professionals throughout the world. This helps to ensure that these standards aren’t
favorable to one country or culture over another.
• Financial reports become automatically acceptable in IFRS (International Financial
Reporting Standards) -compliant countries, and companies don't need to prepare
alternative sets of financial statements when pursuing business interests in these
countries. This reduces a business's costs of preparing financial statements destined
for international audiences.

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Demerits of following IAS:
• Business leaders need to take time to understand the rules and regulations and
develop practices that meet standards without huge costs. So, to follow IAS the
accounting staff should be trained
• Accounting Standards Integration Problems- One issue with changing or integrating
the domestic accounting system into IAS is the issue of complexity.
• Changing to an IAS accounting model would require the government to change tax
accounting systems.
• Integrating accounting standards will result in higher costs for small business due to
additional compliance mandates.
• All countries have specific securities laws, tax laws and banking and financial
regulations that dictate accounting principles. Adopting international accounting
standards would not only conflict with statute law, but also constitutional law
associated with "states' rights."
8. Control accounts
Control account will provide supporting evidence that the credit purchases are accurate
and fraud has not taken place, and are balanced with the payments, returns, discounts,
etc. It is a checking mechanism and is probably prepared by persons independent of
those who may be undertaking the fraud.
Explain advantages of operating a system of control accounts.

• It is easier to detect errors because control accounts provide an independent check

on the postings in the sales and purchases ledgers and errors in the ledger can be
located quickly.
• Segregation of duties helps in the prevention of fraud because members of staff who
complete the control accounts are not involved in completing the sales and
purchases ledgers. Control accounts are not handled by sales/purchases ledger
clerks.
• It Minimize fraud/makes fraud easier to find. Minimize time taken to find errors/make
errors easier to find.
• Totals of Receivables and Payables from control accounts can be determined
quickly and used in preparation of the trial balance and thereby financial statements
• When the ledger is subdivided, errors are difficult to find, therefore a control account
means that, only the ledger whose control account does not balance will need
checking, thus saving time.

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Against the system of control accounts:
• The control account may not balance for many reasons only one of which is fraud.
• Most commonly the control account will not balance because of errors in double
entry not because of fraud.
• If there are errors like omission, principle, etc. which could not be revealed through
the control accounts.
• Control accounts are prepared by businesses following double entry require
expertise, so it is expensive for smaller firms
Conclusion:
Control accounts are useful in detecting and rectifying fraud, but their use will not
guarantee that fraud will not take place.
9. Incomplete Records
Evaluate the system of not maintaining double entry records
Accounting records, which are not strictly kept according to double entry system, are
known as incomplete records. It is an unsystematic and unscientific method of recording
transactions.
This is a system of keeping the books followed by organizations with less capital
investments. If different organisations maintain records according to their convenience
and needs, and their accounts are not comparable due to lack of uniformity.
The profit or loss for the year cannot be ascertained under this system with high degree
of accuracy as only an estimate of the profit earned or loss incurred can be made. The
statement of financial position also may not reflect the complete and true position of
assets and liabilities.

Advantages of not following double entry

• This system is very simple to follow and suitable for small firms or firms with less
capital investment as they have less amount of accounting transactions
• Employing an independent accountant is not justified by the size of the business.
• The cost involved in this system is affordable for small businesses.

Disadvantages of not following double entry

• As double entry system is not followed, a trial balance cannot be prepared and
accuracy of accounts cannot be ensured.
• Correct ascertainment and evaluation of financial results of business operations
cannot be made.
• Analysis of profitability, liquidity and solvency of the business cannot be done. This
may cause a problem in raising funds from outsiders and planning future business
activities.

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• The owners face great difficulty in filing an insurance claim with an insurance
company in case of loss of inventory by fire or theft.
• It becomes difficult to convince the income tax authorities about the reliability of the
computed income.
• This system of keeping the books is unscientific and we cannot arrive at correct
profit of the business
• This system does not show the true financial position of the business.
• Large organizations like companies are not allowed to follow this system of keeping
the books.
Conclusion
Though there are some disadvantages to this system, it is very popular among small
businesses as it is less expensive.
Evaluate the system of double entry book keeping
This is a scientific and systematic way of keeping the books of accounts. This system is
generally followed by larger entities.
The following points illustrate the merits and demerits of double entry system.
Advantages of following double entry
• This is a systematic and scientific way of maintaining books of accounts and
therefore we can arrive at more accurate profit for the year that all the accounting
records are available for reference
• It is easy to prepare financial statements as the trial balance is prepared with the
proper double entry records with minimal errors
• The balances of trade receivable and trade payable are readily available for
reference and for trial balance preparation
• This system enables to show true picture of the affairs of the business so accepted
for various legal requirements like taxation, taking loans, insurance claim, etc.
• This system follows universally accepted accounting concepts so enable for
comparison
Disadvantages of following double entry
• This is an expensive system of maintaining the books, as skilled and trained
accountants are required for maintaining double entry system
• Preparation of accounts under double entry system involves investment of time and
money as skilled accountants are required to follow this
• There are more formalities to comply with, while preparing the accounts
• Double entry accounts produce information in a format which is difficult to
understand for non-accountants.
Conclusion
Double entry is system is widely followed by larger organizations as it shows true
financial performance and true financial position of the business.

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 10. Departmental Accounts-Notes
Departmental accounts refer to the maintenance of accounts of a business in a manner that
makes it possible to ascertain the operational results of each activity, section or department
by preparing separate statement of profit and other comprehensive income for each one of
them. In fact, departmental accounts are nothing more than as many trading and profit &
loss and other comprehensive income as there are the departments.

The main purpose of preparing departmental accounts is to ascertain the financial

performance of each section or department.
This is considered necessary
• To identify the departments which are inefficient and which need better attention;
• To control wastage or misuse of resources in different departments;
• To compare the performance of different departments, and also of their own with
those of the previous years;
• To evaluate the contribution of the departmental employees, compensate them
suitably by way of commission on departmental profit and motivate them for still
better results;
• To formulate suitable policies with regard to future business planning for expansion;
and to consolidate all operations on more profitable lines which may involve closing
down of unprofitable sections and improving the activities of departments which
generate' satisfactory profits.
Thus, in case of organizations that are engaged in various lines of business, the
preparation of departmental accounts is almost a financial necessity and a managerial
responsibility.
State the advantages of preparing departmental accounts.
• Preparing separate departmental accounts help us to know which department is
running more efficiently and which department needs more care.
• One can take necessary steps to improve the performance of the department which is
running at loss.
• It gives more authority and responsibility to each department head with regard to the
achievement of each department.
Comment on closing down a department. Very important
If a department is running at a loss, we should not reach a conclusion about closing
down the department. If the sales of the department can cover the variable cost of
sales, we should not close down a department. The closing down will have the following
negative implications.
1. Even if a department is closed down, the fixed cost cannot be saved.
2. Closing down a department will reduce the profit of other departments and thereby
the total profit.

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3. Employees of other departments may feel unsafe and they feel that their job is not
secured in the firm
4. Public will lose confidence on the business that the product range is not available as
before, so they may find rivals to get the goods and services where all together
available
5. The employees of closed down department should be given redundancy
(compensation), which involves heavy loss for the business.
6. If the workers of the closed department become redundant, leads to social issues
like unemployment and crimes.
However, if a department cannot be run except at a loss over many years, should be
closed down, so that loss of total profit earned by other departments can be reduced.
The floor space of closed down department can be used to sell some other products
which could be profitable. Or its floor space can be given on rent, which will earn some
revenue for the business.
Allocation of departmental expenditure
Expenditure Basis Applied for allocation
1. Selling Commission Sales revenue
2. Bad Debts Sales revenue
3. Carriage Outwards Sales revenue
4. Rent and Rates Floor area occupied
5. Building Insurance Floor area occupied
6. Building Repairs Floor area occupied
7. Lighting Number of lighting points or
Floor area occupied
8. Depreciation Value of assets
9. Power Horse Power/KW hour of Machinery
Installed
10. Insurance Average Stock, Value of Asset
11. Workmen's Compensation Wages
12. Labour Welfare Expenses Number of Employees
13. Advertising Sales revenue
14. Premises repairs/insurance/rent Floor area occupied
15. General expense Revenue basis

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11. Non- profit making organisations (clubs and societies):
Differences between a Receipts and Payments Account, and an Income and
Expenditure Account. Indicate when one would be used in preference to the other.

Receipts and Payments Account is a summary of the cash and bank transactions for a
period. The Receipts and Payments Account includes all transactions for a period and
does not distinguish between capital and revenue expenditure. It is similar to a cash
book in a commercial organisation. It shows the cash position at the end of a period. It
does not include any pre-payments/accruals.

The Income and Expenditure Account is accruals rather than cash based.
It is similar to a Profit and Loss Account in a commercial organisation. It shows the
surplus or deficit for a period. It includes prepayments and accruals. The Income and
Expenditure Account differentiates between capital and revenue expenditure and may
include depreciation. The Income and Expenditure Account is preferred in final
accounts as an indicator of annual performance.

Income and Expenditure Income and Expenditure

Receipts and Payments Receipts and Payments
- Equivalent to income statement - Equivalent to cash book
- Matches income to expenditure - Records actual cash transactions
- Non cash expenditure such as - Actual capital expenditure
estimate of depreciation, recorded. No non-cash items are
allowance for doubtful debts recorded
recorded
- Calculates surplus or deficit of income
over expenditure - Calculates cash and bank balance

Life membership:
where life memberships are paid, consideration must be given to the period over which
the service must be provided and therefore a payment must be apportioned over that
estimated period. This would therefore be an application for the accruals or matching
concept and also going concern concept. It will not have any special impact on the
overall income of the concern for a given period of time, but the working capital position
would change positively for the short run.

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Evaluate the effect of the life membership fund on the club’s liquidity.

In the short term:

- Lump sum received can be used for major expenditures so in the year of receipt,
liquidity is improved substantially.
- Improves cash flow in early years, so it can be utilized for the further improvement of
the club or to pay off long term debts like bank loan.
- The amount received need not to be repaid to the members, its more advantageous
than bank loan for improving liquidity
- Saves administration costs over the years unlike annual subscription.
- Life membership reduces bad debts as the full amount for the set life is received in
advance.
- This may attract more new members to the club as it is usually given at a discounted
rate.
In the long term
- No further direct cash injections from the life members.
- Annual transfer to income and expenditure account is just a book entry.
- However, the life members may be more likely to spend on ancillary activities at the
club, eg discos, whist drives, dinner dances etc.
- Less overall income and committing to providing the service to members for years
(mention Number)

12. Methods of Inventory valuation:

The general principle is that inventory should be valued at cost. However, it can
sometimes be difficult to determine which cost should be used.
Inventory valuation is important for:
To charge units of inventory at appropriate amount to cost of production or cost of sales,
the business will consistently use an appropriate basis:
• Financial reporting – for inclusion in the Financial statements of a business
• Costing – to calculate how much to charge for a product based on the amount of
inventory consumed.
There are two main methods of valuing unsold inventory:
FIFO (First in First Out)
This method assumes for valuation purposes that the items received earliest are those
which are issued first. Under this method issues are priced at the earliest prices of the
stock purchase while stock is valued at the price of the latest purchase.
Advantages/ characteristics of FIFO
• Provides a more realistic value as inventory is valued at latest price.
• Good representation of an actual cost system – unrealised profits on losses will not
occur.

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• This method is more logical and instep with actual inventory rotation.
• The inventory valuation is based upon recently acquired materials and will
approach the market value.
• It is accepted by the Inland Revenue Authorities and it is recommended by IAS2
Disadvantages of FIFO
• The product cost is based on the oldest market value and thus lags behind current
conditions. It is necessary to keep track of each batch which is not practically
possible
• In periods of inflation costs are understated and profits overstated.
• In periods of falling prices costs are overstated and profits understated.
• Difficult to compare costs from different jobs because the material issue price will
vary from batch to batch Issues may be at out-of-date prices.
• In times of rising prices , reported profits are high (‘high’ closing inventory
valuations), so against prudence concept

LIFO (Last in First Out):

Under this method issues are charged at the price of the latest batches. Inventory will
be valued at the price of earliest batches.
Advantages/ Characteristic of LIFO
• Product cost will be more realistic as the issues are based on current prices.
• Stocks are valued at the oldest prices since the Issues are at up-to-date prices
• In times of rising prices, reported profits are reduced where closing inventory is
valued at ‘lower’ cost that the tax payable is lower than FIFO
• It is an actual cost system and suitable at the time of deflation

Disadvantages of LIFO
• When prices are rising LIFO keeps inventory value down.
• Stocks are valued at the oldest prices which is not matched with current market price
• Not accepted by the Inland Revenue or recommended by IAS.
• Could result in batches of production being only partly charged when a new batch is
received. This method gives an outdated inventory valuation.

Important point: LIFO periodic and perpetual gives different value for closing
inventory, whereas FIFO perpetual and periodic gives same value for closing inventory.

Perpetual inventory:
• This will value issues and inventory balance on an ongoing (continuous) basis.
• This system keeps constant running check on stock levels.

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 • A firm which needs to keep detailed costing records of the types and quantities of
materials and components in stock at all times might use perpetual inventory
which reduces frauds and errors
• This takes place in FIFO and LIFO after each receipt or issue of stocks as taken
place.
Periodic inventory:
• In this method stock is valued once in a period, and not on a continuous basis.
• The receipts and issues are summarized (added together) to find closing stock
quantity.
• This method requires less time and cost as a regular record since it is not done on
regular basis.
• Sudden changes in price not reflected in periodic inventory.
Inventory rotation and inventory valuation
• Inventory rotation refers to the physical movement of inventory from stores to
production or to customers. It is the usual practice of good businesses that the
issues are in the order of receipt, which means firstly received materials are issued
first to avoid deterioration of goods’ quality.
• Inventory valuation is the pricing policy while issuing materials, whether FIFO or
LIFO.
• Inventory valuation refers to the theoretical value of the inventory that is sold or
issued to production. This may be influenced by the need to charge the customer
the most recent prices paid.

13. Labour Remuneration/ Labour Costing:

Labour costing can be of two types:
1. Direct labour cost: such costs can be identified directly and easily to the product
manufactured. E.g.: the wages paid to carpenter for the manufacturer of a table.
2. Indirect labour: these are cost which cannot be directly identified with a product or
service. E.g.: wages paid to a sweeper.
Methods of labour remuneration
1. Time based payments/day work: under this method, workers are paid based on the
time worked by them. The rate can be day based, hour based or minute based.
Day work remuneration= time rate X actual time worked
(minutes/hours/days/weeks)
2. Piece work remuneration: in this method payment is made to the worker according to
the number of units he has produced.
Piece work remuneration = rate per unit X no: of units produced.

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Advantages of piece work:
• The output produced increases leading to higher productivity.
• Increase in productivity decreases the unit labour cost per item, the firm can
enjoy the benefit of economies of scale, thus making the product competitively
priced.
• Efficient workers are better motivated and thus they produce more to earn more,
which would in turn increase the profitability of the business
• Less supervision required for piecework method of remuneration, if the product
is of uniform standard quality.

Disadvantages (Against) of piece work

• The workers in their haste to finish the work may not regard safety regulations
and this leads to accidents.
• Quality of work may be compromised as the worker is more interested in
producing more units within a set time to earn more
• Wastage of material could increase due to the haste (hurry) of the workers in
producing more units increases costs
• More chance of breakdown of machinery and equipment and thereby
maintenance of machinery could increase due to mishandling in the workers
haste to finish the work.
• The workers consider that the time is their own. This leads to irregular
attendance, and higher level of absentees.
• Piecework is not suitable and difficult to set for all jobs as all jobs will be
different.
• Some workers will be de-motivated, if they are unable to earn more due to their
lack of speed and inefficiency which may increase labour turnover.
• Potential impact on quality of work may lead to loss of reputation of business.
Advantages of time-based payments:
• Easier to understand and administer the time rate system.
• This system guarantees the quality of the output as the workers are focusing
more on quality not quantity
• Workers are guaranteed an equal pay for equal work as a fixed wage is paid for
the agreed hours. So lower labour turn over compared to piecework.
• This method is more suitable to the work where quality is of higher priority.
Disadvantages of time based payments:
• Efficiency of workers is not rewarded, so the efficient workers might be
demotivated as there is no additional incentives for the worker to put in extra
effort
• Workers may go slow during normal hours in order to work for over time.

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 • Will have to install a rigid (tough) control system to ensure adequate productivity
and reduce idle time.
Guaranteed minimum wages:
• When a piece work remuneration is applied, if the employee fails to achieve
piece work earning as basic earning,( due to some external reasons) he is
assured a minimum payment.
Bonus schemes:
• The main aim of a bonus scheme is to give an incentive to the direct labour
employees based on time saved. The time saved is converted into money value
as per the bonus scheme.
• The bonus scheme is an effective method for reducing the wage bill, if it is
achievable. There is a chance that the quality of the product may be
compromised.
• Importance of bonus scheme is improvising labour productivity when quality is
essential.
• Bonus schemes are designed to finish work in a shorter period. This leads to
time saving and leads to decrease in unit labour cost. Decrease in unit labour
cost will increase labour productivity.

• To save time and to finish the work within a shorter period, quality may be
compromised. Thus, quality and bonus schemes are not compatible.

• To make bonus scheme and quality compatible, the business should adopt strict
supervision, strict quality control measures and going for capital intensive
production (machine)
Labour productivity:
• This is a relationship between inputs of labour and output of labour. This is
normally measured as output which is achieved from each hour or pound of
labour input.
• Labour productivity is used to measure efficiency and effectiveness of the labour
force. When labour productivity is high the cost of production per unit is low.
Increase in labour productivity helps a business to become competitive.

Methods of improving labour productivity:

• Produce the same output with smaller labour input.
• Achieve smaller output with proportionally lower input of labour
• Increase efficiency through capital intensive method
• Improve working practices
• Provide training to skill of workers.

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14. Partnership accounts
The partnership Act (1980) defines a partnership as a business carried out between two
or more people with a view to make profit.
Need for a partnership agreement:
Partnership agreement is a written agreement which ensures an amicable (harmonious)
dissolution of the business.
• To enable matters to be resolved amicably when there is an admission or
retirement of a partner.
• Partnership agreement formalizes duties and responsibilities of partners.
• It enables the profit sharing, state the rate of interest paid on capital and interest
charged on drawings.
Against the partnership agreement
• Preparation of a partnership agreement involves investment of time and cost and it
is a registered document which needs to be more formal.
• It is not flexible to take account of changing circumstances.

In the absence of the agreement, Section 24 of the partnership Act applies, and the
following will be applicable: -
• Profits and losses will be shared equally
• No interest will be charged on drawings
• No interest to be paid on capital balances
• Partners will not be entitled to get salaries
• Any loan given by a partner to the business will carry an interest at 5% per annum.

Partner’s salary: this is paid to reward the efforts and skill put in by the partners
towards the business. It is to encourage partners to spend more time in the conduct of
the business.
Interest on capital: This is paid to encourage those partners who have contributed
more capital. It is paid to discourage partners from withdrawing capital
Interest on drawings: This is charged to discourage partners from making huge
drawings. When interest is allowed on capital it is only logical that we charged interest
on drawings.
Profit share of partners: This is the reward paid to the partners for their entrepreneurship
skills.
Fixed and floating capital method:
Fixed capital method:
• In this method the capital account balance remains more or less fixed. This
method helps to keep the capital intact irrespective of the performance of the
partnership for each year. It changes only when there is an introduction of
capital, or withdrawal of capital and for goodwill adjustment.

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 • In this method a a separate current account is also prepared and all adjustments
like interest on drawing, interest on capital and share of profit are shown in the
current account.
Floating capital method (fluctuating capital method): in this method capital account
only maintained and no separate current account is prepared. All adjustments like
interest on drawings, interest on capital, salaries etc. are shown in the capital account

Goodwill: Goodwill is the value of a business over and above the book value of the
tangible assets. It is the excess of purchase price over net assets of the business when
a business is bought or sold.
It is brought about by such factors as location, reputation or existing customer base.
Goodwill is an intangible non- current asset on the financial position.

• Goodwill is not normally shown in the accounts because it is uncertain and cannot
be accurately measured in monetary terms until it is realised.
• Its value can also be severely affected by matters beyond the control of the
business, such as new competition.
Goodwill is the excess of the purchase price over the value of net assets, when a
business is bought.
Goodwill = purchase price – Net assets
Net assets = total assets – total liabilities

Goodwill is of two types:

1) Purchased goodwill: this goodwill arises when a business is purchased. This can
be shown in the books of accounts, or written off immediately or written off over a
period of twenty years.
2) Non purchased goodwill: this goodwill arises when there is an admission or
retirement of a partner or a change in the profit and loss sharing ratio. This goodwill
cannot be shown in the books of accounts.
Reasons for showing goodwill in the books of accounts:
a) Either a partner has retired or has been admitted or there has been a change in the
profit and loss sharing ratio.
b) If the partners are planning to sell the business and is thus showing goodwill to get a
fair price.
Reasons for not showing goodwill in the books of accounts:
• It is difficult to place an exact value on goodwill
• The purchaser of a business might not be prepared to pay more than what is shown
in the books.
• The value of goodwill keeps changing from time to time
• Its recording is against money measurement and prudence concept

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Why goodwill is valued at the time of retirement of a partner?
When a partner retires, the assets and liabilities are revalued and goodwill is created as
this retiring partner has also contributed to the growth of the business,
Admission of partners:
Advantages:
a) More capital comes in and thus liquidity improves. More capital enhances
expansion prospects, thus, better potential profitability of the business
b) More ideas and specialist skills available as the new partner might be having
previous experience in the field
c) The skills and contacts of the partner could improve the profitability of the
business
d) The work is shared between more people and this ensures better efficiency.
e) When there is a loss in any accounting period, the share of loss each partner
would be lower
Disadvantages:
a) Less profit is available to the partners since profits shared between more
partners
b) Decision making could be delayed as more people have to be consulted before
implementing any decision
c) Greater chance of disagreements/disputes among partners
d) Dilution in management influence, as the controlling power of each partner
might be lower than before

Many partnerships maintain separate capital and current accounts. Evaluate the
extent to which a partnership is likely to benefit from this practice.
Advantages of following fixed capital method for partnership
• Separate capital accounts distinguish clearly between capital that has been
introduced or derived from capital adjustments.
• It facilitates to have permanent capital and the capital that is internally generated
and withdrawn, shown in the current accounts.
• It allows users of the accounts to see when partners withdraw more profits from the
business than they are earning.
• It allows a calculation of interest on capital to be made, thus rewarding the partners
for the amount of invested in the business. Very difficult if only capital accounts are
kept to decide for interest on capital
• If interest on capital is not an issue, then there is probably not a great deal of benefit
in keeping the accounts separate

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An explanation of the advantages and disadvantages of changing from a sole
trader business to a partnership in terms of ownership and finance
Advantages
• Increase in capital – providing money for expansion
• Shared responsibilities, risks and losses – ‘two heads better than one’
• Greater expertise available – to deal with any problems arising/able to take
advantage of opportunities

Disadvantages
• Loss of overall control – partner needs to be consulted on decisions
• Requirement to share business losses incurred by partner as well as own – may
be greater risk for individual, means profits are to be shared
• Possibilities of disagreement between partners in future

15. Accounting Ratio Analysis:

Accounting ratios show the relationship between financial statements. Accounting
ratios can be expressed as a percentage, turn or time, rate, proportion. Ratios are used
by the business as well as various other stack holders for the following:
For (advantages):
1. To compare results between years
2. To compare results with businesses of similar nature
3. Compare actual figures with budgeted figures in order to take corrective action
4. To evaluate and determine the trend of the business
5. To evaluate and determine the trend of the business
6. Accounting ratios help non-accountants to understand and evaluate the
information provided in financial statement.
Limitations of the ratio analysis (against):
• Ratios do not measure non-financial factors like reputation of the firm, reliable
suppliers, etc.
• Ratios are based on past results and thus there is very little that can be done on
whatever has taken place.
• Ratios do not take into account seasonal demands of product.
• External factors that affect the business (government policies) are not taken into
account.

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Profitability ratios:
1. Gross profit margin (as %) = Gross profit X 100
Sales
Indicators of the ratio
A high gross profit margin or mark-up indicates that the cost of purchases is well within
control or the business was able to sell goods at a higher price might be due to less
competition
A low gross profit mark up or margin is an indication that cost of purchases and other
costs connected to purchases are too high. Or to increase sales bulk discounts may
have been given which leads to a low gross profit margin or mark up.
2. Net profit margin / net profit ration (as %)
Net profitX100
Sales
Indicators of the ratio
• A high net profit margin shows that administration, selling and distribution expenses
are within control and vice versa. Good gross profit amount also lead to more profit
and profit margin
• A high net profit margin also shows that the resources available are being put to
good use.
3. Return on capital employed [ROCE] (as %)
Profit for the year before interest X100
Capital Employed
Capital employed= owners capital + long term liabilities
Owners capital = opening capital + net profit – drawings
Or Capital employed = Fixed asset + working capital
Capital employed = Total assets – Current liabilities
Indicators of the ratio
• It shows how well the available resources have been utilized
• It measures the performance of the business. The higher the ratio the better the
performance.
• Prospective inspectors use this ratio to assess alternative forms of investment
• The % of ROCE helps in the deciding whether capital can be raised from external
sources.
Liquidity Ratios:
1. Current ratio/working capital ratio = Current assets
Current liabilities
Indicators of the ratio
• The ideal ratio would be 2:1
• A low ratio indicates inability of the business to pay debts on time
• A high ratio than the expected norm is not good as it shows idle resources

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• A low ratio could also mean that the business is facing financial difficulties.
2. Acid test ratio/quick ratio/liquid ratio =
Current assets excluding closing stock
Current liabilities
Indicators of the ratio
• An ideal ratio would be 1:1 to1.5:1
• A low ratio could indicate large funds tied up in stock.
• An acceptable ratio indicates good inventory management and credit management.
Efficiency ratio
1. Fixed asset to sales ratio
Fixed assets X 100
Sales
Indicators of the ratio
• It shows how best the resources available are being utilized
• It shows the efficiency of the management in putting its resources to the maximum
possible use
• This ratio helps to decide whether to reduce investment while maintaining the
present level of activity.
2. Inventory turnover ratio (in times)
Cost of goods sold
Average stock
Indicators of the ratio
• It shows the number of times the stock is being purchased
• The higher the stock turnover ratio the higher would be the sales due to speed of
sales. This ratio highlights efficiency of inventory management.
• A too high ratio could be an indication that the business is over trading
3. Trade receivables collection period
Debtors X 365
Credit Sales
Indicators of the ratio:
• It measures the duration of time taken to collect debts
• The shorter the period, the better is the credit management

4. Trade payables payment period

Creditors X 365
Credit purchases
Indicators of the ratio:
• It measures the time taken to pay the suppliers of good
• Too longer time could mean that the collection from debtors is poor and thus the
business lacks sufficient cash to pay its creditors.

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• There is always a risk that if creditors are not paid on time they might stop supplies.

16. Overheads: Overhead costs:

Overheads are either fixed cost or semi-fixed cost. All overheads do not vary with the
change in the level of activity.
Overhead costs are all indirect cost namely indirect material (e.g.: clearing cloth in
manufacturing industries), indirect labour (e.g.: salaries of supervisor) and indirect
expenses (rent and rates). Overhead can be classified as the following:
1. Fixed overhead: such overheads remain constant irrespective of the changes in the
activity or output (e.g.: production, sales). Fixed cost remains fixed only up to a
certain period of time and may vary in the long run
2. Semi-fixed cost: it is fixed cost which remains constant to a certain range of
production or activity. It will increase a step when the output or activity reaches to
another level and remains constant. It fixed for a range or output or activity ( eg:
when production increases a second warehouse will have to be rented and thus rent
will increase)
3. Variable overhead: these are costs which change in accordance with the change in
activity or output. E.g.: indirect labour cost
4. Semi variable: these are costs which have both fixed and variable element in it. The
fixed element remains fixed while the variable element changes in accordance with
the changes in activity. E.g.: telephone charges, the deposit amount remains fixed
while the call charges vary in accordance to the number of calls made.
Stages in overhead accounting:
1. Allocation: there are some overhead costs that can be exclusively identified to
particular cost centres. Those overheads are to be allocated directly to that particular
cost centres or cost units directly.
2. Apportionment: there are some costs which cannot be identified to a cost centre.
Such costs have to be apportioned or divided among the various departments on
some suitable basis, e.g.: rent and rates apportioned on the basis of floor area.
3. Reapportionment: This refers to the cost of the service department being re-
apportioned to the production departments based on the services provided to
production centres
Methods of re-apportionment:
1. Direct distribution: in this method service department overheads are apportioned
to the production departments only.
2. Elimination method: in this method, the service department with the largest total
is apportioned first and then to the other service departments are apportioned.
The apportionment of the second service department overhead to the first
service department is ignored.

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 3. Continuous apportionment method: this method apportions overhead costs
continuously between service departments until the amount becomes small
enough to be ignored.
Absorption of overheads
After the overheads are finally reapportioned to the production departments, a unit rate
is found for production cost centre. The overheads are absorbed or recovered by using
the overhead absorption rate from customers.
Predetermined overhead absorption rate/overhead recovery rate (OAR/ORR)
Overhead Recovery rates are the rates calculated on the budgeted overhead with the
expected number of chargeable machine hours or labour hours. It is determined to
charge on actual hours for ascertaining actual overhead cost.
The under or over overhead recovery depends on the comparison of budgeted
overhead and actual overhead.
Methods of calculation:
Machine hour rate: total overheads/ total budgeted machine hours
Labour hour rate: total budged overheads/ total budged labour hours
Under or over absorption of overheads/under or over recovery of overheads:
• If the recovered/planned overheads are less than the actual overhead (overhead
incurred) it is called under recovery of overheads
• If the recovered/planned overheads are more than the actual overheads (overhead
incurred) it is called over recovery.
Explain the problems associated with using predetermined overhead absorption rates,
indicating how an unsatisfactory method of overhead absorption can adversely affect
the profits of a business.
- Problems with use of estimated data over a period could be inaccurate.
- Actual figures could differ from estimated data leading to under/over absorption of
overhead.
- Over absorption of overhead will lead to too much overhead charged to product
and therefore a higher price to the customer. This will cause a fall in demand since
the rate is higher than competitors for the product and subsequent loss of revenue.
- Under absorption of overhead could lead to insufficient overhead charged to
product and therefore a lower price to customer, which does not cover costs and will
therefore reduce profits
Costing for Job
Job costing is followed by organizations doing job work, according to specific order
given by customer. e.g. Job work done by electricians, plumbers, caterers etc.
What are the features of job costing/quotation?
1. Each job order is unique
2. Job work is done to customer’s specific order
3. The job work is finished in a short time period.

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 4. The job cost includes the cost of completing the job plus profit

Evaluate job costing.

Advantages
1. It is very helpful to fix the price of a product(quotation)
2. It is helpful to control cost and earn more profit
3. It is a rational approach to job work
Disadvantages
1. Extreme care should be taken while preparing job cost sheet
2. Underestimated cost will lead to loss of revenue
3. Overestimated cost will lead to loss of job work.
Conclusion
In spite of a few demerits, job cost sheet is prepared by many individual job workers to
submit quotation to the customer.

17. Social responsibility accounting

Social issues
In the interests of social responsibility, firms should be willing to adjust some of their activities
and incur greater costs. The major issues which should cause firms to take the wider view
are as follows:
a) The closure of an unprofitable branch in a deprived area:
The firm has to consider many external factors before taking a decision for the closure
of an unprofitable branch of it. This may be due to external pressure which arises
with the consideration of future increase of unemployment, a fall in the standard of living
of the area and all the associated social problems of family break-up, crime, social deprivation, etc.
b) The replacement of labour by advanced technology:
This is similar to the closure of an unprofitable branch like social cost in unemployment
and its associated problems.
c) The effects of using non-renewable, rare or scarce materials:
There can be conflict between a firm which wants to use large quantities of a material which is
in very short supply and those who want to protect the supply source.
d) The effects on the environment of the use of dangerous materials:
The firms which handle dangerous substances or poisons have a real and obvious responsibility
to both their employees and the community as a whole to deal with and dispose of this safety.
e) Trading which has political or ethical implications:
A good example is the tobacco industry, arms and alcohol industries. Society may wish to place
some restrictions on their freedom to sell wherever and however they wish.
f) Keeping to a code of ethics in advertising:
ASA in UK is a self- regulating body which tries to ensure that all advertisements are legal,
decent, honest and truthful.

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g) The effects of redundancy and early retirement on the labour:
the stress and anxiety associated with unemployment can cause both physical and mental
illness and perhaps the company who dismissed the employees should make some
contribution towards helping the people involved.
Importance of social accounting
The complex and growing field of study which relates to the social responsibility of
firms is termed as social responsibility accounting.
Decisions taken by firms to balance the conflicting interest of owners and other
stakeholders may not lead to maximum profits.
A business decision affects not only profits accruing to owners but also has
consequences on employees, consumers and in some cases the environment
Evaluate the role of social accounting in decision making for a business
Benefits
• Improved reputation/ increased profits in future
• Considers matters such as the environment and impact on the community not just
financial matters.
• May restrict more extreme decision making which would seriously impact on the
environment and the community.
Disadvantages
• May reduce profits in the short term
• In the final analysis the business must be profitable.
• Businesses are not obliged to consider social accounting in their decision making.
Accounting Standards
What are accounting standards?
These are rules according to which accounts should be prepared and financial
statements presented to the users of accounting information. These rules are enforced
by accounting bodies and governments.
Why do we need accounting standards?
• If there are no accounting standards for accounts to follow in preparing accounts,
each business will prepare its accounts in different ways. The users will find it
difficult to understand the accounts.
• If there are no standards; there will not be uniformity in presentation of final
statements. It will be difficult to compare the performance of the businesses.
• Some businesses may not always be honest. They may try to deceive the public by
presenting accounting information by hiding some facts or figures. They may show
that the business is making profits when in reality it is making losses. Standards
make accounts more reliable.
• Accounting standards help to narrow the differences in presentation of financial
statements between various counties. There would be more uniformity.

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Professional Ethics in Accounting
What is the importance of professional ethics in accounting?
• Ethics begin where the law ends. Actions may be legal but not necessarily ethical.
e.g applying only minimum safety standards.
• Profitability should not be only consideration in business policies, social and moral
aspects should also be considered.
• Policy should consider honesty and trustworthiness and therefore fraud and
corruption should be prevented.
• Accounting organisations should actively encourage businesses to apply a minimum
code of conduct to give a true and fair view of the business.
• Ethics is a branch of philosophy and is about the way people judge the rights and
wrongs of their actions.
Therefore, the nature of work done by accountants needs high level of ethics
• Many people rely on the financial statements prepared by the accountants in
evaluating the performance of the business
• If accountants provide wrong information, or keep the material information from
reaching the public, the users of accounts will make wrong decisions – accounting
information will be unreliable
• Ethics in accounting includes honesty, trustworthiness, prevention of fraud and
corruption
• Accounting organizations encourage accountants to apply minimum code of conduct
to ensure that accountants provide a reliable service to their clients/employers.
• Accountants know the trade secrets or commercial information about the
businesses. Leaking this information could harm the business.
What happens if an accountant breaches the code of conduct/ acts unethically in
the profession?
• loss of reputation or good name – people will not trust the accountant anymore
• the accountant could go to jail could face fines and penalties
What are the benefits of an accountant following professional code of ethics?
• Clients would consider the accountant trustworthy and not sharing commercial
information
• Clients would be satisfied that the accountant is competent and produce reliable
accounting information
• Clients would accept the advice given by the accountant
• Clients would have confidence in the accountant and decision he or she makes.

Why are International Accounting Standards (IASs) used?

IASs provide commonly understood range of rules for accountants as a guidance to
follow
• it offers less opportunity for confusion

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• Comparison is easier as similar rules are followed
• there is less opportunity for manipulation of results
• I ASs means there is some regulation of accounts improving reliability

Sate the benefits of ICT (Information and Communications technology) in

bookkeeping and accounting. (What are the advantages of a computerized
accounting system?)
• Accuracy: Computers are extremely accurate and can perform calculations free from
errors. However, the information should be keyed in accurately.

• Ability to process high volumes of information: computers can process large

quantities of information much faster by using updated software

• Speed of processing information: in addition to processing information very quickly,

computers systems can also produce reports and analyze the information much
quicker than is possible manually.

• Performing reconciliations (corrections) is easier: computer programs can be

designed to automatically perform corrections and provide the management with that
information.

• Greater and easier storage of information: the use of computers enables vast
amounts of data to be stored easily using little space.

• Exception reports: The reports generated by computers help the management to act
promptly and take necessary actions.
What are the disadvantages of using computerized accounting systems?
• It is highly expensive for installing and starting computerized accounting system
• Developing the information system and appropriate software could be costly
• The staff should be trained to follow and prepare financial reports using ICT and
their knowledge should be updated to use the new software

• Increased dependence on computers: if the system crashes or breaks down, there

can be serious problems

• Security of the information: people can obtain unauthorized access to accounting

information and there is the possibility of virus attacks and hacking.

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