INDIAN INSTITUTE OF MODERN MANAGEMENT (IIMM)

Registration No. : IIMM/DH/1/2007/5516

Course : PM & HRD

ASSIGNMENT :-FUNDAMENTALS OF BOOK-KEEPING &ACCOUNTING

Answer 1. (a) Book Keeping

It can be defined as “Systematic Recording of business transactions in a set of books”. The

importance of recording business transactions need not be emphasized whether it is business or non
business activities. Hence book keeping is very important and essential for any person. Here the
person may be a Proprietary Concern, or Business Organizations such as Partnership Firms, Private
or Public Limited Companies, Charitable Institutions, Educations Institutions, State Government,
Central Government or any local bodies.

Transaction

To transact means to perform or carry out business. Thus ‘transaction’ is an event of

business between two or more persons or group of persons. The transaction involves exchange of
money, goods, property or services, viz. Sales, purchase, cash/cheque receipt or payment. A more
adjustment in the books can also be a transaction.

Single Entry Book Keeping:

First let us know what is meant by single entry booking keeping. Here it is not desired to go
into the details of single entry book keeping but only to make the student understand the term of
single entry book-keeping as one can always have in his mind what is this double entry?

Yes, there is single-entry system of accounting which is an old and unprofessional method
of accounting wherein only Personal Accounts and a Cash Accounts are maintained. Further, only
one aspect of each transaction as it affects the Personal Account is recorded. In certain cases though
there may be books viz, Sales purchases returns and bills etc. the postings from these books are
made only to the Personal Accounts concerned.

As explained above it sis not our intention to go into further details of single-entry system
as this system is not popular as it ahs many disadvantages like (i) the arithmetic accuracy of the
books cannot be tested as two fold aspect of transactions are not recorded (ii) Since nominal
accounts are not kept it will be difficult to obtain information regarding profit and loss of the
business periodically. (iii) One cannot ascertain the exact financial potion on a particular date (IV)
The information available on single entry system may not be reliable. (v) It can encourage fraud
and misappropriation as assets accounts are not generally maintained. (vi) If one wants to sell the
business it will be difficult to evaluate the assets and liabilities and also good will on a particular
date.

An example of a non-cash transaction is ordering a vehicle for £15,000. The vehicle might
take a month to arrive. During that month, a single entry system would not record the transaction
on the formal accounts. This would mean that the accounts showed you as having £15,000 more
than you do: a dangerous situation.

With the above serious draw backs in the Single Entry System, the same is not usually
practical now and hence the Double Entry Systems has been developed.

Double Entry System of Book – Keeping

In this system each transaction is given two effects once on the credit side. In other words
every debit will have a corresponding credit. This debit and credit are recorded simultaneously.

1
One or more accounts are debited and for equal amount one or more accounts are credited. Hence
the totals of debit and credit will be equal.

This system is called double-entry because each transaction is recorded in at least two
accounts. Each transaction results in at least one account being debited and at least one account
being credited, with the total debits of the transaction equal to the total credits. This requirement
has a benefit to the bookkeeper, but also introduces confusion to the layman. The benefit is that the
accuracy of the accounts can be checked quickly - for, when all the accounts that have debit
balance are summed, they should equal the sum of all the accounts which have a credit balance.
Without this requirement, there would be no quick means to check accuracy. The confusion arises
because a healthy business with money in the bank will have a debit balance in the account called
"Bank". This is contrary to the layman's experience that, when the layman's bank balance is
healthy, his bank statement shows a credit balance. An easy way to visualize this is to consider that
the bank writes the statement from its own point of view; hence if you are in credit, you are a
liability on their balance sheet - you can turn up and draw your money out.

Consider also these two examples, if Business A sells an item for cash to Business B, the
bookkeeper of the Business A would credit the account called "Sales" and debit the account called
"Bank". Conversely, the bookkeeper of Business B, would debit the account called "Purchases" and
credit the account called "Bank".

For instance, you might have an account called ‘Goods ordered’. Then, if the vehicle above
was ordered, the cash account would decrease by £15,000, and the ‘Goods ordered’ account would
increase by £15,000. This is just a transfer in the accounts: no real money would have moved.

But it would show you that you have put aside £15,000 for something. When the vehicle
arrives, and you have to pay the bill for it, then the double entry that you make would be to
decrease the ‘Goods ordered’ account by £15,000, and increase the ‘vehicles’ account by £15,000.

2
Answer 1. (b) Basic Features of Accounting Principles:

Following are the three basic features of allowing principles

− usefulness

− objectivity

− feasibility

Usefulness:

An accounting principle should be useful; an accounting rule which does not increase the
utility of the records is not accepted as an accounting principle.

Objectivity:

Accounting principle should be objective in nature. It should not be influenced by personal

bias.

Feasibility:

Accounting principle should be practicable and feasible.

Kinds of Accounting Principles:

There are two kinds of accounting principles, “Concepts” and conventions”.

The term concept is used to mean the accounting postulates necessary ideas and
assumptions which are fundamental to accounting practice. The term convention is used to mean
customs and or traditions as a guide to the preparation of accounting statements.

The following diagram gives the classification of generally accepted accounting principle
into “concepts” and conventions.

Conservatism
Concepts Disclosure
Entity
Going Concern
Duality
Accounting Period
Historic cost
Money Measurement
Revenue Recognition
Maching
Accural
Objectivity Materiality

Consistency

3
 The following chart also explain the accounting principles

ACCOUNTING PRINCIPLES

While Recording Transactions While Preparing Financial Statement

Concepts Conventions Concepts Convention

Entity Revenue Cost Verifiable Continuity Accounting Matching of Cost &

(Income) Recognition Objective Period Revenue

Evidence

Conservatism Consistency Materiality disclosure

Let us now briefly understand what the above concepts and conventions indicate.

Concepts

Entity:

Which means a business institution in its own rights is difference from the parties who
owns it. In other words a business institution is a legal person having its own entity and is different
from those who have generated the funds to form it.

Continuity or Going Concern:

Which means a business institution when set up is not expected to be liquidated or

dissolved in the near future; it is perpetual. It is assumed that the concern will continue indefinitely.

Duality Concept:

The recognition of two aspects to every transaction is known as duality concept or dual
aspect analysis. Modern financial accounting is based on such recognition. One entry consists of
debit to one or more accounts and another entry consists of credit to one or more accounts. The
total amount debited equals to the total amount credited. This balancing of the debit and credit is
the fundamental and basic concept of modern accounting.

Accounting Period:

Twelve months period is normally adopted as accounting period under the Companies Act
and Banking Regulations Act. Accounts are to be prepared for a 12 months period.

4
Historic Cost:

This concept indicates that the value of transaction is recorded at the price paid to acquire
it, that is at its cost and the cost is the basis for all subsequent accounting. The value may change in
future but the recorded cost does not change.

Money Measurement:

In this concept all the event, happening or transaction is recorded in terms of money. In
other words a fact or a happening which cannot be expressed in terms of money is not recorded in
the accounting books.

Revenue Recognition / Realization Concept:

The revenue is derived from selling the products, rendering services, disposing of resources
other than products. The revenue is generally recognized when the earning process is complete or
reasonably complete and an exchange is taken place. Thus when a sale has been affected there is
evidence of revenue realized and the inventory exchanged for costs or account receivable.

Maching:

This concept consists of two different concepts, concepts of accounting period and concept
of matching. Once the revenue is recognized to have been earned then it is essential to determine
the related expenses and costs incurred for earning the same. For determining the net profit, both
costs viz. product cost and period costs are matched against revenue. This process is known as
matching of cost against revenue.

Accrual:

This concept indicates that the revenue recognition depends on its realization and not actual
receipt. Provision to be made for income accrued relating to a particular period. Similarly provision
to be made for expense incurred or proposed to incur against particular revenue already accounted.
This concept is known as accrual basis.

Objectivity:

According to this concept all accounting must be based on objective evidence. In other
words the transaction recorded should be supported by verifiable documents.

5
Answer 2. (a) Need and Importance of Final Account:

Generally the Trading, Profit and Loss Accounts are prepared every financial year (12
months period) to find out status of business, profit or loss and also to know the Asset & Liabilities
(net worth) of the business, such accounts can be made of regular intervals depending on need for
decision making.

It is important to know the following terms during finalization.

Trial Balance (T/B):

The trial balance is prepared by listing out the balances (Debit or Credit) of each ledger
account (summary of account). If the balances are rightly recorded the credit and debit balance if
totalled will tally. This ensures arithmetical accuracy of the account.

Balance Sheet (B/S):

This is a statement which shows the capital assets and liabilities of a business.

Incomes:

This amount will show the various receipt of amount by sale of goods or services rendered.

Expenses:

This is the amount spent for running the business; it covers all expenses.

Closing Entries

Again through journal proper we have to make certain entries to transfer all nominal
accounts to trading, profit and loss account. After passing the entries the relevant ledger accounts
are posted two more accounts, trading accounts and profit and loss account are prepared. After
preparation of Trading, Profit & Loss Account, only Real and Personal Account (Assets &
Liabilities) will have balances which will be later on opening balances for the next accounting
period.

Depreciation

The process of writing off of a part of the cost of the various assets like land, building,
vehicles, plant, machinery etc. used in business is known as depreciation. Many of the assets will
have a life span and hence the cost written off every year be used to replace such assets. The
expenditure incurred for acquiring the assets are known as capital expenditure.

Process of Finalization of Accounts

Briefly following is the finalization process of accounts. The balance in all ledger accounts,
balance in cash books, petty cash books, bank book are summarized and tabulated in the form of
trial balance as per the following format.

Trial Balance for the period 01-04-06 to 31-03-07

Sr. No. Name of Ledger Folio Debit (Rs.) Credit (Rs.)

Account
The total of Debit Column and Credit Column will be equal which ensures arithmetical accuracy.

Adjustments entries are passed, closing entries are passed

Depreciation is calculated on assets as per rules

6
Following illustration will explain the process clearly

TRIAL BALANCE AS ON 31-03-2007

PARTICULARS DEBIT (DR) Rs. CREDIT (CR) Rs.

Purchase Account 41,000
Sales Returns 3,000
Sales Account 46,300
Purchase Returns 20,000
Staff Welfare Account 200
Conveyance Account 50
Salaries Account 300
Postage & Telegram Account 25
Interest Account 2,000
Depreciation Account 1,670
Books & Periodicals Account 40
Discount Allowed Account 50
Rent Account 100
Professional Charges Account 250
Electricity Account 150
Bad Debts Account 50
Discount Received Account 160
Capital Account 44,000
Avinash Loan Account 10,000
Balu Account 5,000
Shyam Account 1,000
Chavan Account 1,500
Goods withdrawn for Personal use A/c. 500
Goods withdrawn for Free Sample A/c. 200
Goods Donated A/c 300
Goods lost by theft Account 50
Drawings Account 1,100
Plant & Machinery Account 4,080
Furniture & Fixture Account 2,000
Office Equipment Account 1,350
Investments Account 3,000
Telephone Deposit Account 1,500
Dinesh Account 2,000
Rajesh Account 5,000
Raj Account 3,850
Cash on hand 13,795
Bank Balance 22,530
Advertisement Account 200
Donation and charity Account 300
Loss by Theft Account 50
Advance Salary Account 100
Advance to Saurabh Account 2500
Divident Account 300
Profit on Sale of Furniture Account 1,000
Hemali Account 100
Bank Charges Account 20
Bank Interest Account 50
Jay Account 5,000
Bombay Furniture Mart Account 5,000
TOTAL 1,17,360 1,17,360
7
 Following additional information is given

i. Stock as on 31st march 2007 was Rs. 2,800/- at cost. The market value of which was Rs.
3,500/-

ii. Interest of Rs. 800/- was paid in advance

iii. Salaries of Rs. 60/- were outstanding at end of the year.

For illustration, the following adjusting and closing entries are passed (also taking into additional
information provided above.

Decide whether transaction is Completed or not

No Yes

No entry Decide which subsidiary

Book to enter

Credit Credit Purchase Sale Cash Bank

Others
Purchase Sale Return Return Transaction Transaction

Enter in Enter in Enter in Enter in Enter in Enter in Enter in

Purchase Sales Purchase Sales Cash Bank Book journal
Registers Registers Return Return Book Proper
Registers Registers

Post in Ledger

Balance Ledger Accounts

Prepare Trial Balance

Prepare Final Accounts

8
 Answer 2. (b) Financial forecasting is a continuous process of directing
and allocating financial resources to meet strategic goals and objectives. The output
from financial planning takes the form of budgets. The most widely used form of
budgets is Pro Forma or Budgeted Financial Statements. The foundation for
Budgeted Financial Statements is Detail Budgets. Detail Budgets include sales
forecasts, production forecasts, and other estimates in support of the Financial Plan.
Collectively, all of these budgets are referred to as the Master Budget.

We can also break financial forecasting down into planning for operations and
planning for financing. Revenue people focus on sales and production while
financial planners are interested in how to finance the operations. Therefore, we can
have an Revenue Plan and a Financial Plan. However, to keep things simple and to
make sure we integrate the process fully, we will consider financial forecasting as
one single process that encompasses both operations and financing.

Financial forecasting aims at predetermining the demand for funds and the avenues
where in the funds are to be utilized. Thus, a systematic projection of the financial
data is made in the form of financial statements. Fund Flow Statement, Financial
ratios etc. These projections are based on past record of an enterprise with a view to
predict the future financial performance. Financial forecasting generates certain
information which is utilized by the management of an enterprise for taking
decisions particularly for judging the financial efficiency of the funds and
projecting a scale of standards to be followed in the future course. Another
important basic objective of financial forecasting is its use as a control device.
Standard of financial performance of an enterprise could e laid down through
financial forecasting for evaluating the results and assuring its growth. It aids the
corporate unit in planning its growth on anticipation of the financial needs.
Optimum utilization of fund, by a company can be planned through financial
forecasting. A pre-testing of financial feasibility of implementation of its production
prospects or programmes can also be arranged through financial forecasting.

Financial forecasting is done by using the following techniques:

1) Fund Flow Analysis

2) Proforma Financial Statements
3) Cash Budget

(1) Fund Flow Analysis

Fund flow analysis is accomplished by preparing a fund flow statement for evaluating the
uses of funds and determining the sources of funds to finance those uses. Fund flow analysis is
done by studying past fund flows and projecting future fund flows. Fund flow statement provides
the management of a corporate enterprise complete first hand knowledge of the financial growth of
the enterprise and its resulting financial needs. As a matter of fact funds flow statement is known as
the best way of determine as to how to finance those needs. It is a useful foot in planning needs.

(2) Proforma Financial Statement

Preparation of Proforma financial statement is another technique for financial forecasting.

In Proforma financial statement, the Proforma Balance Sheet and Profit and Loss Account (or
Income Statement) is prepared to enable the management to evaluate the performance of the
enterprise in future financial conditions.

(3) Cash Budget

Cash Budget is another technique of financial forecasting. It is used to determine short term
cash needs. The liquidity position of an enterprise and degree of business risk involved for
planning a realistic margin of safety. It given clues of the enterprise for adjusting the liquidity
cushion, rearranging maturity structure of the debts and making arrangement for availing cash
credit facilities from the banks.
9
PROBLEMS IN FINANCIAL FORECASTING

(1) Business environment is frequently changing. Every change reflects upon the
uncertainty of future and enhances the degree of incompatibility of present decision in
future. Therefore, the likely margin of error inherent in forecasting the future should be
considered in advance to avoid disappointment caused by false results and the loss to
be incurred due to inaccuracy attached to the forecast.

(2) Pretesting under controlled conditions of forecast should be done by designing

alternative forecasts for making a better choice and flexibility in decision making by
allowing to pick up one out of several alternative forecasts.

(3) Continuous modifications should be made in forecasting to adjust the same against
changes in business environment. Many experts hold that forecasting is a changeable
phenomenon and forecasts should be continuously reviewed and modified and adjusted
to changes in sales volumes, inventory levels, balances of debtors affected by seasonal
parameters.

(4) To make the forecast reliable and also as a precautionary measure to unpredictability of
forecasting results, the corporate enterprise is advised by experts to maintain sufficient
cash balances to minimize the risk involved in higher degree of unpredictability
associated with forecasting liquidity.

(5) Use of mathematical techniques can make the forecast more reliable and dependable.
These techniques may include (a) simple linear regression method; (b) simple
curvilinear regression method or (c) multiple regression models.

10
Answer 4. (a) Process of Determination of Cost

The Process of determination of cost involves the following steps:

1. Collection and classification of costs.

2. Analysis of costs.
3. Allocation and appointment of costs to the cost centres or cost units.
4. Absorption of overheads
5. Determination of costs.

(1) Collection and classification of costs: After costs are collected from some basic or subsidiary
documents, they have to be classified and analyzed according to the needs of the organization.
Costs may be classified according to their nature and a number of other characteristics. Such
as, function variability, controllability, normality etc. This has been discussed in detail
subsequently.

(2) Analysis of Costs: If management is to be provided with the data required for cost control it is
necessary to analyse costs. The total cost of production or service can be ascertained without
such analysis and in most cases an average unit cost can also be obtained, but none of the by
what is known as “Element of Cost”.

(3) Allocation and apportionment of costs to the Cost Centres or Cost Units: Allocation
implies identification of the overhead costs with particular cost centre or production or service
department to which they relate. It is the process of charging the full amount of overhead costs
to a particular cost centre. This is possible when the nature of expense is such that it can be
easily identified with a particular cost centre. As for example, the salary paid to a foreman of a
particular production department can be directly identified with that department and therefore it
should be directly charged to that production department.

Appointment refers to the distribution of overheads among department of cost centres

on an equitable basis. In short, appointment involves charging a share of the aggregate
overhead expenses, to a number of departments or cost centres. This is done in case of those
overhead items which cannot be wholly allocated to a particular department. As for example,
the salary paid to the works manager of the factory, factory rent, general manager’s salary etc.
cannot be charged wholly to a particular department or cost centre, but will have to be charged
to all departments or cost centres on an equitable basis.

A greater degree of precision is required in allocation while there is an effort to obtain a

reasonable standard of precision in apportionment.

(4) Absorption of overheads: Absorption of overheads is charging of overheads from cost

centres to products or services by means of absorption rates for each cost centre which is
calculated as follows :

Overhead absorption Rate = Total overheads of the cost centre

Total quantum of base

The base (denominator) is selected on the basis of type of the cost centre and its contribution to the
products or services, for example, machine hours, labour hours, quantity produced etc.

Overhead absorbed = Overhead absorption rate x units of base in product or service

(5) Determination of Cost: After the costs are analysed into different elements the next step is to
proceed towards determining the total cost. In arriving at the total cost of the product from the
different elements of cost, the build up is done in four stages successfully known as (I) Prime

11
 Cost, (II) Works Cost of Factory Cost (III) Cost of Production and (IV) Total Cost or Cost of
Sales. This can be expressed in the form of chart as follows:

Components of Total Cost

1st Stage 2nd Stage 3rd Stage 4th Stage
1. Direct 4. Prime 6. Works Cost or 8.Cost of 10. Total cost of
Materials Cost Add (+) Factory Cost Add Production Add Cost of Sales
(+) (+)
2. Direct 5. Factory 7. Office and 9. Selling and
Labour Overhead or Administration Distribution
Works Overhead Overhead
Overhead
3. Direct
Expenses

(I) Prime Cost:

Direct materials plus direct labour plus direct expenses together make up the prime cost.
This is also known as direct cost first cost, flat cost etc.

(II) Works Cost:

Prime cost plus works overhead together make up the Works Cost. This is also known as
Factory cost, production cost, manufacturing cost etc.

(III) Cost of Production:

Works cost plus office and administration overhead together makeup the cost of production.
This is also known as office cost, administrative cost etc.

(IV) Total Cost:

Cost of production plus selling and distribution plus selling and distribution overhead
together make up the total cost. This is also known as cost of sales, selling cost etc.

12
Answer 4. (b) Working capital management is a significant fact of financial management. Its importance arises
from two reasons

− Investment in current assets represents a substantial portion of total investment.

− Investment in current asset and the level of current liabilities have to be geared quickly to
changes in sales. Hence any business in operations need long term investment in fixed
assets like Land, Building, and Plant & Machinery etc. and also for daily operation, cash,
raw material, finished goods, receivables etc.

Constituents of current assets & current liabilities

Part A - Current Assets

Inventories

− Raw Materials and components

− Work in progress
− Finished goods
− Others

Trade Debtors

Loans & advances

Investment

Cash and Bank balances

Part B - Current Liabilities

− Sundry Creditors
− Trade Advances
− Borrowings
− Commercial Banks
− Provisions
− Others

Factors influencing the requirement of working capital

The requirement of working capital is generally decided by the Revenue cycle of the business
which we discussed above.

− Daily requirement of cash

− Minimum requirement of raw material for smooth production activities
− The number of day’s requirement to convert raw material into finished product.
− Minimum quantity of finished goods to be kept on stock to meet market demand.
− The number of day’s credit given to customers.

13
 Current Assets Cycle

Finished Goods

Accounts Work in Process

Receivable

Wages, Salaries Raw Materials

Factory Overheads

Cash Supplies

CREDIT POLICY

The credit policy of a company is very important for the business prospects and hence a
decision on this should be taken after considering various factors.

a. Government guidelines
b. Nature of product
c. Competition
d. Customer background
e. Financial position of the company

We will see how the decision of credit policy affects the working of the company and the
profitability.

Following three credit policies were under consideration of ‘X’ Ltd we have to find out which
of the policies would be beneficial to the company considering the net profit for the year
concerned.

Particulars Credit Policy (A) Credit Policy (B) Credit Policy (C) 60
30 days 45 days days
Sales in Units 25,000 30,000 40,000
Sales price per unit (RS.) 100 100 100
Profit/Volume Ratio 50% 51% 51%
Fixed Cost (Rs) 1,00,000 1,00,000 1,00,000
Cost of Credit Interest 15% 15% 15%
Collection expenses 1% 2% 3%
Bad Debts 1% 2% 3%

Answer

Particulars Credit Policy (A) Credit Policy (B) Credit Policy (C)

Sales 25,00,000 30,00,000 40,00,000

Less: Variable cost 12,50,000 14,70,000 19,60,000
Contribution 12,50,000 15,30,000 20,40,000

14
Less: Fixed Cost 1,00,000 1,00,000 1,00,000
Gross Profit (a) 11,50,000 14,30,000 19,40,000
Less: Cost of credit Interest 30,822, 55,479 98,630
Collection Expenses 25,000 60,000 1,20,000
Bad Debts 25,000 60,000 1,20,000
Total cost of credit (b) 80,822 1,75,479 3,38,630
Net Profit (a) - (b) 10,69,178 12,54,521 16,01,370

From the above working, we can come to a conclusion that credit policy ‘C’ would give
more profit hence to be ranked as I, credit policy ‘B’ as II and credit policy ‘A’ as III.

Note: collection expenses and bad debts are calculated as percentage of sales. Interest is calculated
on average receivables. Credit policy ‘A’ Rs.25,00,000 x 30 = Rs. 2,05,479/-
365
Interest on Rs. 2,05,479 x 15% = Rs. 30,822/-

Policy ‘B’ Rs. 30,00,000 x 45 = Rs. 3,69,863/-

365
Interest on Rs. 3,69,863 x 15% = Rs. 55,479/-

Policy ‘C’ Rs. 40,00,000 x 60 = Rs. 6,57,534/-

Interest on 6,57,534 x 15% = Rs. 98,630/-

15
Answer 5. (a) Budgetary Capital Expenditure

The capital budgeting refers to the process of planning the investment of funds is long term
assets of an enterprise. The purpose is to help the management control capital expenditure. With the
help of capital budgeting, the management is able to reject poor investment decisions and select
profitable ones. The same principles apply to additions, replacements modification etc. where funds
are required.

A wide range of techniques are used for evolving investment proposals. The most
commonly used technique are as follows:

− The pay back period method (PBP)

− The average rate of return method (ARR)
− Discounted cash flow method (DCF)

The pay back method (PBP)

This technique estimate the time required by the project to recover through cash inflows,
the first initial outlay while estimating net cash inflows the following points are to be considered.

− The cash inflows should be estimated on incremental basis, so that only the difference
between the cash inflows of the firm with an without the proposed investment is
considered.
− Cash inflow should be estimated on after tax basis.
− Since non cash expense like depreciation do not involve any cash out flows estimated cash
inflows form a project should be adjusted for such item.

Pay back period = Initial investment = Rs.25,000 = 5 Years

Annual cash inflows 5,000

The annual cash inflow is calculated taking into account the net income of the asset before
depreciation and after taxation advantages of pay back period method.

1. It is easy to calculate and investment proposals can be ranked quickly.

2. It considers early recovery of investment
3. The pay back method permits the firm to determine the length of time required to recover
the investment.
4. It is suitable for industries which are subject to early obsolescence.
5. Due to lesser PBP the operational tension is less for the managers.

DISADVANTAGES

1. It ignores the time value of money

2. It does not consider long term profits given by a firm
3. It does not take into account salvage value (Residual value) of the asset.
4. It ignores the cost of capital

Suitability of the Method

− Where the firm suffers from liquidity problem and is interested in quick recovery of fund
the profitability.
− High external financing cost of the project.
− Those projects involving uncertain return
− Political and economic pressures.

Average Accounting of rate of return method (ARR)

16
 This method considers the relative profitability of different capital investment proposals for
ranking the projects. Rate of return is calculated by dividing earnings by capital invested. We may
find number of variations to the average rate of return method. The following are the common
variations.
a) Average rate of return on original investment
= Net earnings after depreciation of taxes ÷ Average investment
No. of years project will last
b) Average rate of return on average investment
= Net earnings after depreciation of taxes ÷ Average investment
No. of years project will last

Average investment is arrived at by dividing the total original investment and investment in
the project at the end of its economic life by 2.

The following example will help us to learn how the ARR is calculated and how it can be
compared with pay back period method.

There are two investments proposals ‘A’ and ‘B’ each with capital investment of Rs.
20,000/- and depreciable like of 4 years. Assume that following are the estimated profits and cash
inflows when annual straight line depreciation charges is Rs. 5,000/-

Period Project ‘A’ Project ‘B’

Book Profits Net Cash inflows Book Profits Net cash inflows
Rs. Rs. Rs. Rs.
1 4,000 9,000 1,000 5,000
2 3,000 8,000 2,000 6,000
3 2,000 7,000 3,000 7,000
4 1,000 6,000 4,000 8,000
Total 10,000 30,000 10,000 30,000

Average rate of return = Average Annual Profit x 100

Investments x 2500 x 100
ARR = *2,500 x 100 2,000
2,000
= 12.5% = 12.5%
* Average profit of 4 years
Hence both the projects are equally profitable as per ARR method. But if we apply PBP method
project ‘A’ is more favourable as it gives better cash flows in the initial years

Advantages of this method

1. Earnings for the entire life of profits are considered.

2. Easy to understand and single to follows

3. Accounting comparison possible

Disadvantages

1. It does not consider early recovery of investments

2. Not suitable for fast changing industries

3. Does not consider time value of money.

17
Answer 5. (b) Budget as Tools of Control

As discussed before the budget is a statement of estimated performance for a specific

period. The means of performance evaluation is the comparison between the ideals and actual.
Hence the ideals are the budgeted or standard specifications which are not before preparation of the
budget. Hence the actual performance is confirmed with the standard / budgeted performance. This
comparison gives the fact of success or failure of the actual performance.

Budgetary control refers to the principles, procedure and practices of achieving given
objective through budgets. A budgetary control system secures control over Performa and costs in
the different parts of a business. If a budgeting is the Art of planning, budgetary control is the act of
adhering to the plan.

Advantages of budgetary control

The principle advantages of a budgetary control system are as follows:

1. Budgetary control aims at maximization of profits through effective planning and control of
income and expenditure.

2. There is a planned approach to expenditure and financing of the business so that economy
is affected in the utilization of funds to the optimum benefit of the concern.

3. It provides a clear definition of the objective and policies of the concern and subjecting
these policies to provide reviews.

4. The task of managerial coordination is facilitated through budgeting control.

5. Since each level of management is aware of its task to be performed maximum utilization
of men, material and resources can be attained.

6. Reports are furnished under the principles of management or control by exception; only
deviations from budgets which point out the week spots and inefficiencies are properly
looked into

7. It enables the management to think ahead, making possible to identify the problems in
advances before taking decisions.

8. Budgetary control system assists delegation of authority and is a powerful tool of

responsibility accounting.

9. Budgets help setting up the conditions for standard tooling.

10. Provides a basis for performance appraisal (variance analysis). A budget is basically a
yardstick against which actual performance is measured and assessed. Control is provided
by comparisons of actual results against budget plan. Departures from budget can then be
investigated and the reasons for the differences can be divided into controllable and non-
controllable factors.

11. It helps in establishing reward and punishment system for better / work performance.

12. It ensures better working capital.

13. Prerequisites for an effective budgeting control system.

14. The objectives, plans and policies of the business should be defined in clear terms.

15. A budget committed should be set up for formation and execution of plans.
18
 16. The budges should primarily be prepared by those who are responsible to perform.

17. For the success of a budgetary control system there should be a sound organization for
budget preparations, headed by budget controller or budget director.

Phases in budgetary control

Following are the stages to be considered and followed while budget as a technique of
control and performance evaluation.

1. Preparing a budget statement

2. Recording the actual performance

3. Periodical comparison between the budgeted and actual performance and finding out the
variances (favourable and unfavourable).

4. Foundry out the causes for such variances

5. Grouping the variances as ‘controllable’ and uncontrollable based on the causes found.

6. Deciding the quantum of reward of penalty for the individual or group of individuals for
their favourable or unfavourable variances.

7. If required revising the standards or budgeted specification in order to suit the cyclical
environment changes.

It is clear from above that the process of budgetary control has to be continuous, flexible and
unbiased. The technique of budgetary control requires the knowledge and practical application of
following concepts:

1. Cost benefit analysis including social,

2. Contingency approach

3. Responsibility accounting based on the application of the technique of variance analysis.

4. Value analysis for revenues, system, cost incurrence etc.

5. Application of certain mathematical models such as PERT, CPM, Transportation and

assignment models, L.P. and simplex models, sensitivity analysis, etc.

19
Answer 6. (b) Indian Financial Market

Financial market means an organized or unorganized system though which funds are raised
by the industries to meet their financial needs. The savings of both individual and corporate sector
are harnessed to meet the above need. Let us now find out the structure of Indian Financial Market.

INDIAN FINANCIAL MARKET

Indian Financial System

Unorganized Organized

Money Indigenous Securities Loans from Banking Non

Lenders Bankers Market Banking Financial
Institutions

New Issue Market Stock Market IFCI

ICICI
LIC
IDBI
Government Corporate Government Corporate UTI
Bond Securities Bond Securities SIDBI
State Finance
Corporations

Bonds/ Shares
Debentures

From the above chart we can observe that the Indian Capital Market is mainly divided into
two organized and unorganized. Under unorganized we have money lenders and Indigenous
Bankers. In the organized sector we have a host of Agencies and Systems, Security Market under
which there are news issues and further Government bonds and Corporate Securities. Then there is
stock market under which again Government Bonds and Corporate Securities and under Corporate
Securities here are again Bonds and Shares. In addition to these under organized sector there are
Banks and Non Banking Financial Institutions exclusively engaged in capital financing. The
organized sector is under the direct control of Reserve Bank of India and those under the
unorganized sector they work under certain guidelines of government or Reserve Bank of India.
Let us now have a look into the role of major financial institutions that provides long and medium
term capital market.

20
Answer 6. (c) Securities and Exchange Board of India (SEBI)

Securities and Exchange Board of India (SEBI) is a board (autonomous body) created by
the Government of India in 1988 and given statutory form in 1992 with the SEBI Act 1992. Its
head office is in Mumbai, and other offices in Chennai, Kolkatta and Delhi. SEBI is the regulator
of Securities markets in India.

SEBI has three functions rolled into one body: quasi-legislative, quasi-judicial and quasi-
executive. It drafts rules in its legislative capacity, it conducts enquiries and enforcement action in
its executive function and it passes rulings and orders in its judicial capacity. Though this makes it
very powerful, there is an appeals process to create accountibility. There is a Securities Appeallate
Tribunal which is a three member tribunal and is presently headed by a former Chief Justice of a
High court - Mr. Justice NK Sodhi. A second appeal lies directly to the Supreme Court(where
important questions of law arise.

In 1998 Government of India established the Board with the following objectives.

− To guide & control companies while issuing shares / debentures etc.

− To regulate stock market operation
− To audit and inspect the brokers, lenders etc.
− To control amalgamation and mergers
− To design rules for investor protection
− To control intermediates like, mutual funds, Merchant Bankers, portfolio managers etc.

21
Answer 6. (d) Capital and Revenue

There are no single fixed criteria for deciding the distinction between capital and Revenue
Expenditure and Receipt.

Capital Expenditure:

An expenditure incurred to get an asset or advantage or benefit of an enduring nature for

the business such expenditure is considered as capital and not revenue. Expenditure on Land &
Building, Plant and Machinery, development of patent trade mark etc.

Capital expenditures (CAPEX or capex) are expenditures creating future benefits. A capital
expenditure is incurred when a business spends money either to buy fixed assets or to add to the
value of an existing fixed asset with a useful life that extends beyond the taxable year. Capex are
used by a company to acquire or upgrade physical assets such as equipment, property, or industrial
buildings. In accounting, a capital expenditure is added to an asset account ("capitalized"), thus
increasing the asset's basis (the cost or value of an asset as adjusted for tax purposes). Capex is
commonly found on the Cash Flow Statement as "Investment in Plant Property and Equipment" or
something similar in the Investing subsection.

Revenue Expenditure:

In business, a Revenue expense is a day-to-day expense such as sales and administration, or

research & development, as opposed to Production, costs, and pricing. In short, this is the money
the business spends in order to turn inventory into throughput. Revenue expenses also include
depreciation of plants and machinery which are used in the production process.

On an income statement, "Revenue expenses" is the sum of a business's Revenue expenses

for a period of time, such as a month or year.

In throughput accounting, the cost accounting aspect of Theory of Constraints (TOC),

Revenue expense is the money spent turning inventory into throughput. In TOC, Revenue expense
is limited to costs that vary strictly with the quantity produced, like raw materials and purchased
components. Everything else is a fixed cost, including labour unless there is a regular and
significant chance that workers will not work a full-time week when they report on its first day.

In a real estate context, Revenue expenses are costs associated with the operation and maintenance
of an income producing property. Revenue expenses include

− accounting expenses
− license fees
− maintenance and repairs, such as snow removal, trash removal, janitorial service, pest
control, and lawn care
− advertising
− office expenses
− supplies
− attorney fees and legal fees
− utilities, such as telephone
− insurance
− property management, including a resident manager
− property taxes
− travel and vehicle expenses
− leasing commissions
− salary and wages

22
Answer 6. (f) Source and Uses of Funds

Sale of fixed Sale of Long term Funds from Cash expenses Tax,
Sources
assets Stock loan operations Interest

Working Capital Pool (All Current Accounts)

Marketable Securities

Cash
Accounts Accounts
Receivables Payable

Inventory

Purchase of Payment of Repayment of Make up Buy Back

Uses
Fixed Assets Dividend Long term loans losses Stocks

Though the traditional fund flow analysis is useful in assessing Net Working Capital needs
of the enterprise and in enlightening on the sources and application of funds, yet it assimilates
certain weaknesses as listed below:

1. All flows of funds through business operations are not depicted in the statement. For
example, intra-period flows like repayment of loans at several times during the year are not
shown in the statement. Thus management is deprived of the useful information required as
basic input in making various financial strategic decisions which require information above
intra- period movement of funds.

2. Historical accounting information in fund flow statement is analyzed as supplementary to

final accounts profit and loss account and balance sheet and nothing fundamentally new
information is added to make the analysis more pragmatic and problem solving.

23
Answer 6. (g) Classification of Costs

Classification of costs is the process of grouping costs according to their common

characteristics. In order to identify costs with cost centres or cost units a suitable classification of
costs is of much significance, costs may be classified from difference view points which are as
follows

a. Costs may be classified from the view point of their nature : According to the nature of items, costs
may be of two types, namely

I). Direct Costs :

Direct costs refer to those costs which can be easily identified with a product, process or
department, materials used and labour employed in manufacturing in article or in a particular
process of production are common examples of direct costs.

II). Indirect Costs :

Indirect costs, on the other hand, refer to those costs which are not traceable to any particular
product, process or department, but are common to a number of products, processes or
departments; Factory rent, factory manager’s salary etc. are typical examples of indirect costs.

b. Costs may be classified from the view point of their variability. According to variability, cost may
be classified into three types, namely

I). Fixed Costs :

Fixed costs refer to those costs which tend to remain unaffected by variations in the volume
of output of sales. In other words, fixed costs remain the same when the volume of output or
sale changes.

II). Variable Costs :

Variable costs refer to those costs which vary directly in proportion to changes in the volume
of output or sales. These costs increase or decrease with the rise of fall in production or sales.

III). Semi Variable Costs :

Some costs have tendency to vary with changes in the volume of output or sales, but not in
direct proportion to the change. These costs are partly fixed and partly variable and as such
these costs are known as semi variable costs.

c. Costs may be classified from the view point of their controllability. According to controllability
costs may be classified into two types namely

I). Controllable Costs :

Controllable costs refer to those costs which can be influenced by the action of a specified
member of an undertaking. Any undertaking is usually divided into departments or costs
centres which are placed under the direct control and supervision of specified persons.

II). Uncontrollable Costs :

Uncontrollable costs, on the other hand, refer to those costs which cannot be influenced by
the action of a specified member of an undertaking.

d. Costs may be classified from the view point of their normality

I). Normal or unavoidable costs :

Normal or unavoidable costs refer to those costs which are normally incurred at a given level
of output in the conditions in which that level of output is normally attained. Such costs
cannot be avoided at all.

II). Abnormal or Avoidable costs :

24
 Abnormal or avoidable costs refer to those costs which are not normally incurred at a given
level of output in the conditions in which the level of output is attained. Such costs can be
avoided if proper action is taken.
e. Costs may be classified from the view point of relevance to decision making and control.
According to relevance to decision making and control, costs may be classified into

I). Sunk Costs :

Sunk costs refer to those costs which have already been incurred and cannot be altered by any
decision in the future.

II). Out of pocket costs :

Out of pocket costs refer to those costs which signify the present or future cash expenditure
regarding a certain decision that will vary depending upon the nature of decision made.

III). Opportunity costs :

Opportunity costs refer to those costs which are related to benefits sacrificed or foregone.

IV). Imputed Costs :

Imputed costs refer to those costs which are not included in costs but are considered for
making management decisions.

V). Differential costs :

Differential costs refer to the difference in total costs between two alternatives. In case, the
choice of alternative results in an increase in total costs such increased costs are knows as
incremental costs.

25