Unit I

Meaning and Scope of Accounting

Accounting is the language of business. The main objectives of Accounting is to safeguard the interests of the business, its
proprietors and others connected with the business transactions. This is done by providing suitable information to the
owners, creditors, shareholders, Government, financial institutions and other related agencies.

Definition of Accounting

The American Accounting Association defines accounting as "the process of identifying, measuring and communicating
economic information to permit informed judgments and decisions by the users of the information."

According to AICPA (American Institute of Certified Public Accountants) it is defined as "the art of recording, classifying
and summarizing in a significant manner and in terms of money, transactions and events which are in part at least of a
financial character and interpreting the result thereof."

Steps of Accounting

The following are the important steps to be adopted in the accounting process:
(1) Recording: Recording all the transactions in subsidiary books for purpose of future record or reference. It is referred to
as "Journal."
(2) Classifying: All recorded transactions in subsidiary books are classified and posted to the main book of accounts. It is
known as "Ledger."
(3) Summarizing: All recorded transactions in main books will be summarized for the preparation of Trail Balance, Profit
and Loss Account and Balance Sheet.
(4) Interpreting: Interpreting refers to the explanation of the meaning and significance of the result of finanal accounts and
balance sheet so that parties concerned with business can determine the future earnings, ability to pay interest, liquidity and
profitability of a sound dividend policy.

Functions of Accounting

From the definition and analysis of the above the main functions of accounting can be summarized as:
(1) Keeping systematic record of business transactions.
(2) Protecting properties of the business.
(3) Communicating the results to various parties interested in or connected with the business.
(4) Meeting legal requirements.

Objectives of Accounting

(1) Providing suitable information with an aim of safeguarding the interest of the business and its proprietors and others
connected with it.
(2) To emphasis on the ascertainment and exhibition of profits earned or losses incurred in the business.
(3) To ascertain the financial position of the business as a whole.
(4) To ensure accounts are prepared according to some accepted accounting concepts and conventions.
(5) To comply with the requirements of the Companies Act, Income Tax Act, etc.

Definition of Bookkeeping

Bookkeeping may be defined as "the art of recording the business transactions in the books of accounts in a systematic
manner." A person who is responsible for and who maintains and keeps a record of the business transactions is known as
Bookkeeper. His work is primarily clerical in nature.

On the other hand, Accounting is primarily concerned with the recording, classifying, summarizing, interpreting the
financial data and communicating the information disclosed by the accounting records to those persons interested in the
accounting information relating to the business.
Limitations of Accounting

(1) Accounting provides only limited information because it reveals the profitability of the concern as a whole.
(2) Accounting considers only those transactions which can be measured in terms of money or quantitatively expressed.
Qualitative information is not taken into account.
(3) Accounting provides limited information to the management.
(4) Accounting is only historical in nature. It provides only a post mortem record of business transactions.

Branches of Accounting
The main function of accounting is to provide the required informations for different parties who are interested in the welfare
of that enterprise concerned. In order to serve the needs of management and outsiders various new branches of accounting
have been developed. The following are the main branches of accounting:

(1) Financial Accounting.

(2) Cost Accounting.
(3) Management Accounting.

(1) Financial Accounting: Financial Accounting is prepared to determine profitability and financial position of a concern
for a specific period of time.

(2) Cost Accounting: Cost Accounting is the formal accounting system setup for recording costs. It is a systematic procedure
for determining the unit cost of output produced or service rendered.

(3) Management Accounting: Management Accounting is concerned with presentation of accounting information to the
management for effective decision making and control.

Accounting Principles

Various accounting systems and techniques are designed to meet the needs of the management. The information should be
recorded and presented in such a way that management is able to arrive at right conclusions. The ultimate aim of the
management is to increase profitability and losses. In order to achieve the objectives of the concern as a whole, it is essential
to prepare the accounting statements in accordance with the generally accepted principles and procedures.

The term principles refers to the rule of action or conduct to be applied in accounting. Accounting principles may be defined
as "those rules of conduct or procedure which are adopted by the accountants universally, while recording the
accounting transactions."

The accounting principles can be classified into two categories:

I. Accounting Concepts.
II. Accounting Conventions.

I. Accounting Concepts

Accounting concepts mean and include necessary assumptions or postulates or ideas which are used
to accounting practice and preparation of financial statements. The following are the important accounting
concepts:

(1) Entity Concept;

(2) Dual Aspect Concept;
(3) Accounting Period Concept;
(4) Going Concern Concept;
(5) Cost Concept;
(6) Money Measurement Concept;
(7) Matching Concept;
(8) Realization Concept;
(9) Accrual Concept;
(10) Rupee Value Concept.

II. Accounting Conventions

Accounting Convention implies that those customs, methods and practices to be followed as a guideline for preparation of
accounting statements. The accounting conventions can be classified as follows:

(1) Convention of Disclosure.

(2) Convention of Conservatism.
(3) Convention of Consistency.
(4) Convention of Materiality.

I. Accounting Concepts

(1) Entity Concept: Separate entity concept implies that business unit or a company is a body corporate and having a
separate legal entity distinct from its proprietors. The proprietors or members are not liable for the acts of the company. But
in the case of the partnership business or sole trader business no separate legal entity from its proprietors. Here proprietors
or members are liable for the acts of the firm. As per the separate entity concept of accounting it applies to all forms of
business to determine the scope of what is to be recorded or what is to be excluded from the business books. For example,
if the proprietor of the business invests Rs.50,000 in his business, it is deemed that the proprietor has given that much
amount to the business as loan which will be shown as a liability for the business. On withdrawal of any amount it will be
debited in cash account and credited in proprietor's capital account. In conclusion, this separate entity concept applies much
larger in body corporate sectors than sole traders and partnership firms.

(2) Dual Aspect Concept: According to this concept, every business transaction involves two aspects, namely, for every
receiving of benefit and. there is a corresponding giving of benefit. The dual aspect concept is the basis of the double entry
book keeping. Accordingly for every debit there is an equal and corresponding credit. The accounting equation of the dual
aspect concept is:
Capital + Liabilities = Assets
(or)
Assets = Equities (Capital)

The term Capital refers to funds provide by the proprietor of the business concern. On the other hand, the term liability
denotes the funds provided by the creditors and debenture holders against the assets of the business. The term assets
represents the resources owned by the business. For example, [Link] Starts business with cash of Rs.l ,00,000 and
building of Rs.5,00,000, then this fact is recorded at two places; Assets Accounts and Capital Account. In other words, the
business acquires assets of Rs.6,00,000 which is equal to the proprietor's capital in the form of cash of Rs.l,OO,OOO and
building worth of Rs.5,00,000. The above relationship can be shown in the form of accounting equation:

Capital + Liabilities
(Rs.l,OO,OOO + Rs.5,00,000_
= Assets
(Rs.6,OO,OOO)

(3) Accounting Period Concept: According to this concept, income or loss of a business can be analysed and determined
on the basis of suitable accounting period instead of wait for a long period, Le., until it is liquidated. Being a business in
continuous affairs for an indefinite period of time, the proprietors,the shareholders and outsiders want to know the financial
position of the concern, periodically. Thus, the accounting period is normally adopted for one year. At the end of the each
accounting period an income statement and balance sheet are prepared. This concept is simply intended for a periodical
ascertainment and reporting the true and fair financial position of the concern as a whole.

(4) Going Concern Concept: It is otherwise known as Continue of Activity Concept. This concept assumes that business
concern will continue for a long period to exit. In other [Link], under this assumption, the enterprise is normally viewed as
a going concern and it is not likely to be liquidated in the near future. This assumption implies that while valuing the assets
of the business on the basis of productivity and not on the basis of their realizable value or the present market value, at cost
less depreciation till date for the purpose of balance sheet. It is useful in valuation of assets and liabilities, depreciation of
fixed assets and treatment of prepaid expenses.

(5) Cost Concept: This concept is based on "Going Concern Concept." Cost Concept implies that assets acquired are
recorded in the accounting books at the cost or price paid to acquire it. And this cost is the basis for subsequent accounting
for the asset. For accounting purpose the market value of assets are not taken into account either for valuation or charging
depreciation of such assets. Cost Concept has the advantage of bringing objectivity in the preparation and presentation of
financial statements. In the absence of cost concept, figures shown in accounting records would be subjective and
questionable. But due to inflationary tendencies, the preparation of financial statements on the basis of cost concept has
become irrelevant for judging the true financial position of the business.

(6) Money Measurement Concept: According to this concept, accounting transactions are measured, expressed and
recorded in terms of money. This concept excludes those transactions or events which cannot be expressed in terms of
money. For example, factors such as the skill of the supervisor, product policies, planning, employer-employee relationship
cannot be recorded in accounts in spite of their importance to the business. This makes the financial statements incomplete.

(7) Matching Concept: Matching Concept is closely related to accounting period concept. The chief aim of the business
concern is to ascertain the profit periodically. To measure the profit for a particular period it is essential to match accurately
the costs associated with the revenue. Thus, matching of costs and revenues related to a particular period is called as
Matching Concept.

(8) Realization Concept: Realization Concept is otherwise known as Revenue Recognition Concept. According to this
concept, revenue is the gross inflow of cash, receivables or other considerations arising in the course of an enterprise from
the sale of goods or rendering of services from the holding of assets. If no sale takes place, no revenue is considered.
However, there are certain exceptions to this concept. Examples, Hire Purchase / Sale, Contract Accounts etc.

(9) Accrual Concept: Accrual Concept is closely related to Matching Concept. According to this concept, revenue
recognition depends on its realization and not accrual receipt. Likewise cost are recognized when they are incurred and not
when paid. The accrual concept ensures that the profit or loss shown is on the basis of full fact relating to all expenses and
incomes.

(10) Rupee Value Concept: This concept assumes that the value of rupee is constant. In fact, due to inflationary pressures,
the value of rupee will be declining. Under this situations financial statements are prepared on the basis of historical costs
not considering the declining value of rupee. Similarly depreciation is also charged on the basis of cost price. Thus, this
concept results in underestimation of depreciation and overestimation of assets in the balance sheet and hence will not reflect
the true position of the business.

II. Accounting Conventions

(1) Convention of Disclosure: The disclosure of all material information is one of the important accounting conventions.
According to this conventions all accounting statements should be honestly prepared and all facts and figures must be
disclosed therein. The disclosure of financial information’s are required for different parties who are interested in the welfare
of that enterprise. The Companies Act lays down the forms of Profit and Loss Account and Balance Sheet. Thus convention
of disclosure is required to be kept as per the requirement of the Companies Act and Income Tax Act.

(2) Convention of Conservatism: This convention is closely related to the policy of playing safe. This principle is" often
described as "anticipate no profit, and provide for all possible losses." Thus, this convention emphasize that uncertainties
and risks inherent in business transactions should be given proper consideration. For example, under this convention
inventory is valued at cost price or market price whichever is lower. Similarly, bad and doubtful debts is made in the books
before ascertaining the profit.

(3) Convention of Consistency: The Convention of Consistency implies that accounting policies, procedures and methods
should remain unchanged for preparation of financial statements from one period to another. Under this convention
alternative improved accounting policies are also equally acceptable. In order to measure the operational efficiency of a
concern, this convention allows a meaningful comparison in the performance of different period.
(4) Convention of Materiality: According to Kohler's Dictionary of Accountants Materiality may be defined as "the
characteristic attaching to a statement fact, or item whereby its disclosure or method of giving it expression would be likely
to influence the judgment of a reasonable person." According to this convention consideration is given to all material events,
insignificant details are ignored while preparing the profit and loss account and balance sheet. The evaluation and decision
of material or immaterial depends upon the circumstances and lies at the discretion of the Accountant.

Scope of Accounting:
Accounting has got a very wide scope and area of application. Its use is not confined to the business world alone, but
spread over in all the spheres of the society and in all professions. Now-a-days, in any social institution or professional
activity, whether that is profit earning or not, financial transactions must take place. So there arises the need for
recording and summarizing these transactions when they occur and the necessity of finding out the net result of the
same after the expiry of a certain fixed period. Besides, there is also the need for interpretation and communication of
those information to the appropriate persons. Only accounting use can help overcome these problems.

In the modern world, accounting system is practiced no only in all the business institutions but also in many non-trading
institutions like Schools, Colleges, Hospitals, Charitable Trust Clubs, Co-operative Society etc., and also Government and
Local Self-Government in the form of Municipality, Panchayat. The professional persons like Medical practitioners,
practicing Lawyers, Chartered Accountants etc., also adopt some suitable types of accounting methods. As a matter of
fact, accounting methods are used by all who are involved in a series of financial transactions.

The scope of accounting as it was in earlier days has undergone lots of changes in recent times. As accounting is a
dynamic subject, its scope and area of operation have been always increasing keeping pace with the changes in socio-
economic changes. As a result of continuous research in this field the new areas of application of accounting principles
and policies are emerged. National accounting, human resources accounting and social Accounting are examples of the
new areas of application of accounting systems.

Generally accepted accounting principles (GAAP)

 Generally accepted accounting principles (GAAP) refer to a common set of accounting principles, standards, and
procedures issued by the Financial Accounting Standards Board (FASB).
 Public companies in the U.S. must follow GAAP when their accountants compile their financial statements.
 GAAP is a combination of authoritative standards (set by policy boards) and the commonly accepted ways of
recording and reporting accounting information.
 GAAP aims to improve the clarity, consistency, and comparability of the communication of financial information.
 GAAP helps govern the world of accounting according to general rules and guidelines.
 It attempts to standardize and regulate the definitions, assumptions, and methods used in accounting across all
industries.
 The ultimate goal of GAAP is to ensure a company's financial statements are complete, consistent, and
comparable.
 This makes it easier for investors to analyze and extract useful information from the company's financial
statements, including trend data over a period of time.
 It also facilitates the comparison of financial information across different companies.

10 Key GAAP Principles

1. Principle of consistency: This principle ensures that consistent standards are followed in financial reporting from
period to period.
2. Principle of permanent methods: Closely related to the previous principle is that of consistent procedures and
practices being applied in accounting and financial reporting to allow comparison.
3. Principle of non-compensation: This principle states that all aspects of an organization’s performance, whether
positive or negative, are to be reported. In other words, it should not compensate (offset) a debt with an asset.
4. Principle of prudence: All reporting of financial data is to be factual, reasonable, and not speculative.
 5. Principle of regularity: This principle means that all accountants are to consistently abide by the GAAP.
6. Principle of sincerity: Accountants should perform and report with basic honesty and accuracy.
7. Principle of good faith: Similar to the previous principle, this principle asserts that anyone involved in financial
reporting is expected to be acting honestly and in good faith.
8. Principle of materiality: All financial reporting should clearly disclose the organization’s genuine financial
position.
9. Principle of continuity: This principle states that all asset valuations in financial reporting are based on the
assumption that the business or other entity will continue to operate going forward.
10. Principle of periodicity: This principle refers to entities abiding by commonly accepted financial reporting
periods, such as quarterly or annually.

Indian Accounting Standards

 Such standards have been developed in India over the period of time.
 These standards are also referred to as Ind As.
 Such standards have to be adopted by different form of companies and NBFCs in India, under the supervision and
the vigilance of the Accounting Standards Board (ASB).
 The accounting standards board was developed as a regulatory authority and body in 1977.
 The ASB is a professional and autonomous body which is governed under the Institute of Chartered Accountants
of India (ICAI).
 Along with this institute there are other bodies such as the Confederation of Indian Industry (CII), Federation of
Indian Chambers of Commerce and Industry (FICCI) and Associated Chambers of Commerce and Industry of India
(ASSOCHAM) which govern the requirements related to the ASB.

Objectives of Indian Accounting Standards (Ind As)

The following are the objectives of utilizing Indian Accounting Standards:

 Ensures that companies in India adopt such standards to carry out international recognized and best practices.
 Ensures that compliance is maintained across the globe.
 Have one framework related to unified accounting system.
 Such standards are developed on the principles of the IFRS. Hence this would be a guide to the applicability of
such standards.
 Accounting Systems which are utilized in India can be analyzed and understood by global companies.
 Through this financial statements and reports of companies would be transparent.
 Such standards are harmonized in order to ensure that the company is complying with global requirements.
 More coverage can be adopted through these Indian Accounting Standards, as Indian companies have increased
their global reach when compared to the past.

Applicability of Ind As
 The government of India and the Ministry of Corporate Affairs brought out a notification related to the adoption
and applicability of Indian Accounting Standards by all companies in India. This notification was brought through
a legislative enactment Companies (Indian Accounting Standards (IND AS)) Rules 2015.
 As per the above notification, all companies which receive this notification would be required to adopt the Ind As
in a phased manner in the financial year 2016-17. Ever since the above enactment, there have been three
amendments in the notification which occurred in 2016, 2017 and 2018.

Benefits of Adopting Indian Accounting Standards

There are different forms of benefits for adopting Indian Accounting Standards:
Harmonization
By adopting such standards harmonization of accounting rules can be carried out by the company. Through
harmonization, global principles related to accounting can be established by the company.
International Basis
Accounting standards have international acceptance, hence if a company wants to expand internationally, then such
principles would be accepted.
World Wide Acceptance
Having such standards ensure international acceptance amongst all institutions and governmental bodies.
Compliance
By adopting such standards, effective compliance can be maintained by the company.

Phases of Adoption of Indian Accounting Standards

 The Ministry of Corporate Affairs through such notification brought out the requirement for Indian Companies to
adopt Indian Accounting Standards in a phased manner in the accounting year 2016-17.
 The adoption of such standards would be carried out in a phased wise manner depending on the net worth and
the listing status of the company.
 The MCA divided the applicability and adopting of such accounting standards based on different principles.

The following are the phases of implementation:

Phase I
This phase is classified as the mandatory applicability of the Indian accounting standards as required by the companies.
Such phase was implemented from 01 April 2016. Phase I would be applicable to the following companies:
 Listed Companies (Companies that have their securities listed in a recognised stock Exchange).
 Companies that have the net worth value of more than Rs. 500 Crore.
Phase II
In this phase all companies would have to adopt Ind AS (Indian Accounting Standards) from 01 April 2017. Hence the
next financial year is considered for the applicability of Indian Accounting standards. Phase II would be applicable to the
following companies:
 Listed Companies (Companies that have their securities listed in a recognised stock Exchange- as on 31 March
2016.
 Companies that have the net worth value of more than Rs. 250 Crore but lesser than Rs. 500 Crore.
Phase III
This phase is classified as the mandatory applicability of Ind As by all forms of banks, NBFCs, SEBI regulated entities and
Insurance Companies. This phase would be applicable from 01 April 2018. Phase III would be applicable to the following
companies:
 Companies that have the net worth value of more than Rs. 500 Crore. Such net worth requirements would only
be applicable to such companies from 01 April 2018.
 The Insurance Regulatory and Development Authority of India (IRDAI) through a separate notification would
ensure that the insurance company meets the net worth requirement. NBFCs and other financial institutions net
worth requirement would be checked by looking into the past three financial years i.e. 2015-16, 2016-17 and
2017-18.
Phase IV
This phase would only be applicable for all NBFCs whose net worth is more than Rs. 250 crore but less than Rs. 500
crore. This Applicability would be considered from the period of 1 April 2019.

List of Applicable Indian Accounting Standards

The following table provides a list of the major applicable Ind As:
Ind AS 1 Presentation of Financial Statements
Ind AS 2 Inventories Accounting
Ind AS 7 Statement of Cash Flows
Accounting Policies, Changes in Accounting Estimates and
Ind AS 8
Errors
Ind AS 10 Events after Reporting Period
Ind AS 11 Construction Contracts
Ind AS 12 Income Taxes
Ind AS 16 Property, Plant and Equipment
Ind AS 17 Leases
Ind AS 18 Revenue
Ind AS 19 Employee Benefits
Accounting for Government Grants and Disclosure of
Ind AS 20
Government Assistance
Ind AS 21 The Effects of Changes in Foreign Exchange Rates
Ind AS 23 Borrowing Costs
Ind AS 24 Related Party Disclosures
Ind AS 27 Separate Financial Statements
Ind AS 28 Investments in Associates and Joint Ventures
Ind AS 29 Financial Reporting in Hyperinflationary Economies
Ind AS 32 Financial Instruments: Presentation
Ind AS 33 Earnings per Share
Ind AS 34 Interim Financial Reporting
Ind AS 36 Impairment of Assets
Ind AS 37 Provisions, Contingent Liabilities and Contingent Assets
Ind AS 38 Intangible Assets
Ind AS 40 Investment Property
Ind AS 41 Agriculture
Ind AS 101 First-time adoption of Ind AS
Ind AS 102 Share Based payments
Ind AS 103 Business Combination
Ind AS 104 Insurance Contracts
Non-Current Assets Held for Sale and Discontinued
Ind AS 105
Operations
Ind AS 106 Exploration for and Evaluation of Mineral Resources
Ind AS 107 Financial Instruments: Disclosures
Ind AS 108 Operating Segments
Ind AS 109 Financial Instruments
Ind AS 110 Consolidated Financial Statements
Ind AS 111 Joint Arrangements
Ind AS 112 Disclosure of Interests in Other Entities
Ind AS 113 Fair Value Measurement
Ind AS 114 Regulatory Deferral Accounts
Ind AS 115 Revenue from Contracts with Customers

IFRS
 IFRS standards are International Financial Reporting Standards (IFRS) that consist of a set of accounting rules that
determine how transactions and other accounting events are required to be reported in financial statements.
 They are designed to maintain credibility and transparency in the financial world, which enables investors and
business operators to make informed financial decisions.
 IFRS standards are issued and maintained by the International Accounting Standards Board and were created to
establish a common language so that financial statements can easily be interpreted from company to company
and country to country.
 IFRS are the standard in over 100 countries, including the EU and many parts of Asia and South America. The
United States, however, has not yet adopted them and the SEC is still deciding whether or not they should move
toward them as the official standard of accounting.
Standard IFRS Requirements

IFRS covers a wide range of accounting activities. There are certain aspects of business practice for which IFRS set
mandatory rules.
Statement of Financial Position: This is the balance sheet. IFRS influences the ways in which the components of a
balance sheet are reported.
Statement of Comprehensive Income: This can take the form of one statement or be separated into a profit and loss
statement and a statement of other income, including property and equipment.
Statement of Changes in Equity: Also known as a statement of retained earnings, this documents the company's change
in earnings or profit for the given financial period.
Statement of Cash Flows: This report summarizes the company's financial transactions in the given period, separating
cash flow into operations, investing, and financing.

Who Uses IFRS?

IFRS are required to be used by public companies based in more than 160 countries, including all of the nations in the
European Union as well as Canada, India, Russia, South Korea, South Africa, and Chile.8
The U.S. and China each have their own systems.

Why Is IFRS Important?

 IFRS fosters transparency and trust in the global financial markets and the companies that list their shares on
them. If such standards did not exist, investors would be more reluctant to believe the financial statements and
other information presented to them by companies. Without that trust, we might see fewer transactions and a
less robust economy.
 IFRS also helps investors analyze companies by making it easier to perform “apples to apples” comparisons
between one company and another and for fundamental analysis of a company's performance.

List of IFRS Standards

1 First-time Adoption of International Financial Reporting Standards

2 Share-based Payment

3 Business Combinations

4 Insurance Contracts

5 Non-current Assets Held for Sale and Discontinued Operations

6 Exploration for and Evaluation of Mineral Resources

7 Financial Instruments: Disclosures

8 Operating Segments

9 Financial Instruments

10 Consolidated Financial Statements

11 Joint Arrangements
 12 Disclosure of Interests in Other Entities

13 Fair Value Measurement

14 Regulatory Deferral Accounts

15 Revenue from Contracts with Customers

16 Leases

17 Insurance Contracts

Harmonisation of Accounting Standards

Accounting is the science of communicating the financial information of the business organization in an organized manner.
Before communicating the business information it is necessary to record the actual business results in a scientific manner
so as to ensure the true and fair view of the transactions. Financial information disclosed with true and fair state will get
absolute confidence from various stakeholders. To do this there is a necessity of having some policies, principles, standards
and framework which lay the guidelines in identifying, reporting and communicating the financial information of the
business; these are popularly known as GAAPs (Generally Accepted Accounting Principles).

These are not common in all the countries of the world because each country of the world is having their own GAAP which
is popularly called as Accounting Standards. Different countries are having different accounting standards set by their own
accounting professional bodies. If this is the reality then it is very difficult to ensure the uniformity in reporting pattern
across the globe and also it is tedious compare the reported information across the boarders this because of diversity in
accounting standards. So it is need of the hour to bring uniformity in reporting pattern across the globe by having single
set of accounting standards at the international level. By realizing this IASB (International Accounting Standards Board)
have developed the single set of accounting standards at the global level that is IFRS (International Financial Reporting
Standards). These standards can be used for harmonizing of accounting standards across the globe.

Harmonization of accounting standards means the process of eliminating the diversity in accounting standards across
the globe by bringing uniformity in accounting standards through single set of international accounting standards.

Harmonization of accounting standards can be done in two ways. One is adoption of IFRS as countries own accounting
standards and another way is developing countries own accounting standards in confirmation with the principles of IFRS
i.e., convergence of IFRS.

In India convergence of IFRS is used for harmonizing Indian accounting standards. By this method MCA with the ICAIs
support designed its own new set of accounting standards that is popularly known as Ind-As which can be elaborated as
Indian converged accounting standards with IFRS. The new set of accounting standards were converged as per the special
provision of section 133 of the Companies Act, 2013.

Need for harmonization of accounting standards

India is one of the fastest developing countries in the world and having liberalized economic policy to promote
globalization through having favourable environment which welcomes the foreign investors to invest their surplus funds
on Indian market. Apart from this government of India is continuously trying to make the companies for more accountable
to its investors and other group of stakeholders. For investors companies are accountable through its operational and
financial information disclosure so today MCA made Indian companies to disclose their operational and financial
information which is acceptable at the international market by harmonizing its accounting standards through convergence
with IFRS (International Financial Reporting Standards). The need for harmonization of accounting standard is important
because:
 It helps to enhance the international transactions. The economic environment today majorly depends on cross-border
transactions and the free flow of international capital. There is a growth in the cross border financial transactions and it is
projected to increase even more in near future.

 It provides wider opportunity to investors. The major expectations of investors are diversification and investment
opportunities. On the other hand companies give more importance on rising of capital, international operations with
multiple countries with help of subsidiaries.

It eliminates the complexity in accounting standards.

Earlier cross-border activities were very complicated by different countries maintaining their own sets of domestic
accounting standards. If a company wants to operate at the multinational level then they were needed to maintain
multiple books of accounts under different GAAPs. This was resulted in diversity, complexity and more cost of financial
reporting. This was also more complex for investors because for analysing the financial statements.

 It eliminates the diversity in accounting standards. By the adoption of single set of international accounting standards
it is easy to eliminate the diversity in accounting standards across the globe and in turn it brings uniformity which enables
the stakeholders for easy comparison of results of multinational companies which are situated across the different
countries. This also helps to recognise the country itself at the global market.

Harmonization of accounting standards in India

 In India MCA (Ministry of Corporate Affairs) in consultation with ICAI(Institute of Chartered Accountants of India)
accounting standards were converged with IFRS and they are named as IND AS(Indian converged accounting
standards with IFRS).
 It realizes that India also one of the country which recognized at the global level by initiating IFRS based accounting
standards from the year 2016 onwards by government of India with the help of MCA and ICAI and started to
mandate this standards for Indian companies in phased manner.
 It shows how India is in dynamic in nature of giving responses to the changes occurred in both national and
international environment.
 This initiative enables the firm to report their financial information in transparent and consistent manner and
which helps for various categories of stakeholders for easy comparison of the performance of one company with
another.
 The implementation of IFRS based Indian Accounting standards i.e. IND AS had created a great opportunity to
academicians, regulatory authorities and business houses to carry the research for the advancement of the
financial reporting system in India..
 Corporate Balance Sheet

 Equity and Liabilities: It indicates what the firm ‘owes’ to others.

 Shareholder’s Funds: It shows the shareholder’s contribution to the firm in any form.
 Share Capital: The portion of the firm’s capital, raised from the issue of shares. It encompasses equity share
capital and preference share capital.
 Reserves and Surplus: It covers retained earnings and shares premium. It encompasses capital reserves,
debenture redemption reserves, general reserve, revaluation reserve and surplus.
 Non-Current Liabilities: The liabilities which can be settled after one year from the date of reporting, is called
non-current liabilities.
 Long-term Borrowings: Term loans from banks and financial institutions which have a tenor of more than a
year are called long-term borrowings.
  Deferred tax liabilities: A deferred tax liability arises when the amount allowed for tax purposes exceeds the
charge in the financial statements.
 Long-term provisions: Provisions for employee benefits comes under long-term provisions. It
includes provident fund, leaves encashment, gratuity, superannuation fund, etc.
 Current Liabilities: These are short-term liabilities which need to be settled within a period of one year or less.
 Short-term Borrowings: The borrowings that are to be repaid within one year is called short-term borrowings
and includes commercial paper, working capital loans, corporate deposits, etc.
 Trade Payables: The amount due to suppliers from whom goods are bought on credit are called trade payables.
It includes sundry creditors and bills payables.
 Short-term provisions: It refers to the provisions made by the firm for dividend and taxes.
 Assets: These are the resources owned by the firm that provide future economic benefits.
 Non-current Assets: The assets which remain with the entity for more than a year are non-current assets.
 Fixed Assets: Assets bought by the company for long-term use, and are not converted into cash quickly are
called fixed assets.
 Tangible Assets: The assets that are used in their physical form are called tangible assets. It includes land,
building, vehicles, furniture, plant, etc.
 Intangible Assets: Assets with no physical shape and structure are called intangible assets, such as copyright,
patent, trademark, design, software, etc.
 Non-current Investments: It consists of financial securities of other companies such as shares,
debentures, bonds and so forth.
 Long-term loans and advances: Loans and advances made to subsidiary companies, associate companies,
comes under this category.
 Current Assets: The assets that can be converted into cash within a period of one year or less are current assets.
 Current Investments: The holdings in shares of mutual funds, usually for a short term are called current
investments.
 Inventories: It refers to the stock of goods in various forms such as raw material, work-in-process and finished
items.
 Trade Receivables: The amount owed by the customers to the firm, to whom goods are sold, but not yet paid.
 Cash and cash equivalents: It includes cash owned by the company and the credit balance with the bank and
financial institutions.
 Short-term loans and advances: Loans and advances provided to parties such as suppliers and employees
are covered in this category.

UNIT II
DEPRECIATION
The term depreciation refers to the reduction in or loss of quality or value of a fixed asset through wear and tear,
effusion of time, obsolescence through technology and market changes or from any other cause. Depreciation takes
place in case of all fixed assets with certain possible exceptions e.g. land and antiques etc, although the process may
be invisible or gradual. Depreciation does take place irrespective of regular repairs and proper maintenance of
assets. The word depreciation is closely related to the concept of business income. Unless it is charged against
revenues, we cannot say that the business income has been ascertained properly. This is because of the fact that the
use of long-term assets tends to consume their economic value and at some point of time these assets become
useless. The economic value so consumed must be recovered from the revenue of the firm to have a proper measure
of its income. Hence, the process of charging depreciation is the technique used by accountants for recovering the
cost of fixed assets over a period.

Depreciation is the allocation of the depreciable amount of an asset over its estimated useful life. According to AS-
6, depreciation is a measure of wearing out, consumption or other of value of a depreciable asset arising
from use, effusion of time or obsolescence through technology and market changes. Depreciation is
allocated so as to charge a fair proportion of the depreciable amount in each accounting period during the expected
useful life of the assets. Depreciation includes amortization of assets whose useful life is predetermined.
The American Institute of Certified Public Accountants (AICPA) employed the definition as given below:
“Depreciation Accounting is a system of accounting which aims to distribute the cost or other basic value of
tangible capital assets, less salvage value (if any) over the estimated useful life of unit (which may be a group of
assets) in a systematic and rational manner. It a process of allocation, not that of valuation. Depreciation for the
year is the portion of the total charge under such a system that is allocated to the year.

From the above definitions it is clear that each accounting period must be charged with a fair proportion of the
depreciable amount of the asset, during the expected useful life of the asset. Depreciable amount of an asset is its
historical cost less the estimated residual value. Finally, it could be concluded that depreciation is a gradual
reduction in the economic value of an asset from any cause.

Depreciation, Depletion, Obsolescence and Amortization:

The terms depreciation, depletion, obsolescence and amortization are used often interchangeably. However, these different
terms have been developed in accounting usage for describing this process for different types of assets. These terms have been
described as follows:

Depreciation: Depreciation is concerned with charging the cost of man-made fixed assets to operation (and not
with determination of asset value for the balance sheet). In other words, the term depreciation is used when expired
utility of physical asset (building, machinery, or equipment) is to be recorded.

Depletion: This term is applied to the process of removing an available but irreplaceable resource such as extracting
coal from a coal miner or oil out of an oil well. Depletion differs from depreciation in that the former implies removal
of a natural resource, while the latter implies a reduction in the service capacity of an asset.

Amortization: The process of writing off intangible assets is termed as amortization. The intangible assets like
patents, copyrights, leaseholds and goodwill are recorded at cost in the books of account. Many of these assets have
a limited useful life and are, therefore, written off.

Obsolescence: It refers to the decline in the useful life of an asset because of factors like (i) technological
advancements, (ii) changes in the market demand of the product, (iii) legal or other restrictions, or (iv) improvement
in production process.

CAUSES OF DEPRECIATION

The depreciation occurs because of the following:

1. Constant use: The constant use of assets results into their wear and tear, which in turn reduces their working
capacity. Hence, a decrease in the value of assets may be seen due to reduced capacity. The value of assets like,
machinery, furniture, etc., declines with the constant use of them.

2. Passage of Time: Many fixed assets lose their value with the passage of time. This holds true in case of intangible
fixed assets such as patents, copyrights, lease hold properties etc. The term amortization is generally used to indicate
the reduction in the value of such assets.
3. Depletion: Depletion also causes decline in the value of certain assets. This is true in case of wasting assets such
as mines, oil wells and forest-stands. On account of continuous extraction of minerals or oils, these assets go on
declining in their value and finally they gets completely exhausted.

4. Obsolescence: There may not be any physical deterioration in the asset itself. Despite of this there may be
reduction in the utility of an asset that results from the development of a better method, machine or process. For
example, an old machine which is still in good working condition may have to be replaced by a new machine because
of the later being more economical as well as efficient. In fact, new inventions, developments in production processes,
changes in demand for product or services, etc. make the asset out of date.

5. Accidents: An asset may get reduction in its value if it meets an accident.

6. Permanent fall in the Market Value: Certain assets may get permanent fall in their value and this decline in
their value is treated as depreciation. For example, a permanent decline in the market value of securities and
investment may be assumed as depreciation

NEED FOR PROVIDING DEPRECIATION

The need for providing depreciation arises on account of the following points:
1. To Ascertain the Profits or Losses: The true profits or losses could be ascertained when all costs of earning
revenues have been properly charged against them. Fixed assets like building, plant and machinery, furniture, motor
vehicles etc. are important tool in earning business income. But the cost of the fixed asset is not charged to profit and
loss of the accounting period in which the asset is purchased. Therefore, the cost of the fixed asset less its salvage
value must be allocated rationally to the periods that receive benefit from the use of the asset. Thus, depreciation is
an item of business expense and must be
provided for a proper matching of costs with the revenue.

2. To show the Asset at its Reasonable Value: The assets decrease in their value over a period of time on account
of various reasons such as passage of time, constant use, accidents, etc. Therefore, if the depreciation is not charged
then the asset will appear in the balance sheet at the over stated value. This
practice is unfair as the balance sheet would fail to present the true financial position.

3. Replacement of assets: Business assets become useless at the expiry of their life and, therefore, need
replacement. The cash resources of the concern are saved from being distributed by way of dividend by providing
for depreciation. The resources so saved, if set aside in each year, may be adequate to replace it at the end of life of
the asset.

4. To Reduce Income Tax: If tax is paid on the business income without providing for depreciation then it will be
in excess to the actual income tax. This is a loss to the business. Thus, for calculating tax, depreciation should be
deducted from income similar to the other expenses as depreciation is a chargeable expense and results in tax
benefit.

FACTORS AFFECTING DEPRECIATION

In order to assess depreciation amount to be charged in respect of an asset in an accounting period the following
three important factors should be considered:

1. Cost of the asset: The knowledge about the cost of the asset is very essential for determining the amount of
depreciation to be charged to the profit and loss account. The cost of the asset includes the invoice price of the asset
less any trade discount plus all costs essential to make the asset usable.
Cost of transportation and transit insurance are included in acquisition cost. However, the financial charges such as
interest on money borrowed for the purchase for the purchase of the asset should not be included in the cost of the
asset.

2. Estimated life of the asset: Estimated life generally means that for how many years an asset could be used in
business with ordinary repairs for generating revenues. For estimating useful life of an asset one must begin with
the consideration of its physical life and the modifications, if any, made, factors
of obsolescence and experience with similar assets. In fact, the economic life of an asset is shorter than its physical
life. The physical life is based mostly on internal policies such as intensity of use, repairs, maintenance and
replacements. The economic life, on the other hand, is based mostly on external factors such as obsolescence from
technological changes.

3. Scrap Value of the Asset: The salvage value of the asset is that value which is estimated to be realized on
account of the sale of the asset at the end of its useful life. This value should be calculated after deducting the disposal
costs from the sale value of the asset. If the scrap value is considered as insignificant, it is normally regarded as nil.

METHODS OF CALCULATING DEPRECIATION

There are different concepts about the nature of depreciation. Moreover, the nature of all fixed assets cannot be the
same. As a result, different methods are found to exist for charging depreciation. A broad classification of the
methods may be summarized as follows:

Straight Line Method

This is also known as fixed installment method. Under this method the depreciation is charged on the uniform basis
year after year. When the amount of depreciation charged yearly under this method is plotted on a graph paper,we
shall get a straight line. Thus, the straight-line method assumes that depreciation is a function, of time rather than
use in the sense that each accounting period received the same benefit from using the asset as every other period.
The formula for calculating depreciation charge for each accounting period is:

This method has many shortcomings. First, it does not take into consideration the seasonal fluctuations, booms and
depression. The amount of depreciation is the same in that year in which the machine is used day and night and in
the another year in which it is used for some months. Second, it ignores the interest on the money spent on the
acquisition of that asset. Third, the total charge for use of asset (i.e., depreciation and repairs) goes on increasing
from year to year though the assets might have been in use uniformly from year to year. For example, repairs cost
together with depreciation charged in the beginning years is much less than what it is in the later years. Thus, each
subsequent year is burdened with greater charge for the use of asset on account of increasing cost on repairs.

Diminishing Balance Method

This is also known as Written down value method [WDV]. Under the diminishing balance method depreciation is
charged at fixed rate on the reducing balance (i.e., cost less depreciation) every year. Thus, the amount of
depreciation goes on decreasing every year. Under this method also the amount of depreciation is transferred to
profit and loss account in each of the year and in the balance sheet the asset is shown at book value after reducing
depreciation from it. For example, if an asset is purchased for Rs. 10,000 and depreciation is to be charged at 20%
p.a. on reducing balance system then the depreciation for the first year will be Rs. 2000. In the second year, it will
Rs. 1600 (i.e. 20% of 8000), in the third year Rs. 1280 (i.e. 20% of 6400) and so on.

Merits of Diminishing Balance Method:

(i) It is very easy to understand and calculate the amount of depreciation despite the early variation in the book value
after depreciation.
(ii) This method puts an equal burden for use of the asset on each subsequent year since the amount of depreciation
goes on decreasing for each subsequent year while the charge for repairs goes on increasing for each subsequent
year.
(iii) This method has also been approved by the income tax act applicable in India.

Inventory Valuation
 Inventory valuation is the cost associated with an entity's inventory at the end of a reporting period.
 It forms a key part of the cost of goods sold calculation, and can also be used as collateral for loans.
 This valuation appears as a current asset on the entity's balance sheet.
 The inventory valuation is based on the costs incurred by the entity to acquire the inventory, convert it into a
condition that makes it ready for sale, and have it transported into the proper place for sale.
 Do not add any administrative or selling costs to the cost of inventory.
 The costs that can be included in an inventory valuation are direct labor, direct materials, factory overhead, freight
in, handling fees, and import duties.

Importance of Inventory Valuation

Impact on the Cost of Goods Sold
When a higher valuation is recorded for ending inventory, this leaves less expense to be charged to the cost of goods sold,
and vice versa. Thus, inventory valuation has a major impact on reported profit levels.
Impact on Multiple Periods
An incorrect inventory valuation will cause the reported profits in two consecutive periods to be incorrect, because the
incorrect ending balance in the first period will be wrong, and it then carries over into the beginning inventory balance in
the next reporting period.
Impact on Loan Ratios
If an entity has been issued a loan by a lender, the agreement may include a restriction on the allowable proportions of
current assets to current liabilities. If the entity cannot meet the target ratio, the lender can call the loan. Since inventory
is frequently the largest component of this current ratio, the inventory valuation can be critical.
Impact on Income Taxes
The choice of cost-flow method used can alter the amount of income taxes paid. The LIFO method is commonly used in
periods of rising prices to reduce income taxes paid.

Inventory Valuation Methods

Specific Identification Method

The specific identification method is used when you want to track the specific cost of individual items of inventory. It is
most commonly used when each inventory item is unique, such as in an art gallery.
First In, First Out Method
The first in, first out method is used when the first items to enter the inventory are the first ones to be used. This means
that the costs of the oldest items in the inventory records are charged to the cost of goods sold first. In a period of price
inflation, this means that the cost of goods sold tends to be somewhat low, resulting in higher reporting profits and
more income taxes.
Last In, First Out Method
The last in, first out method is used when the last items to enter the inventory are the first ones to be used. This implies
that the oldest items are kept in stock, which is not likely. However, it is frequently used because it charges the most
recent costs to the cost of goods sold; in a period of price inflation, this tends to reduce profits and therefore the
amount of income taxes to be paid.
Weighted Average Method
The weighted average method applies an average of the costs in inventory to the cost of goods sold. This means that the
cost of goods sold will be neither excessively high nor low in a period of price inflation, making this method
representative of the actual cost of the items stored in inventory

Unit III
Financial Statements of a Company

Financial statements are the basic and formal annual reports through which the corporate management communicates
financial information to its owners and various other external parties which include investors, tax authorities, government,
employees, etc.
These refer to:
 The balance sheet (position statement) as at the end of accounting period,
 The statement of profit and loss of a company and
 The cash flow statement.

Nature of Financial Statements

Recorded Facts: Financial statements are prepared on the basis of facts in the form of cost data recorded in accounting
books. The original cost or historical cost is the basis of recording transactions. The figures of various accounts such as
cash in hand, cash at bank, trade receivables, fixed assets, etc., are taken as per the figures recorded in the accounting
books. The assets purchased at different times and at different prices are put together and shown at costs. As these are
not based on market prices, the financial statements do not show current financial condition of the concern.
Accounting Conventions: Certain accounting conventions are followed while preparing financial statements. The
convention of valuing inventory at cost or market price, whichever is lower, is followed. The valuing of assets at cost less
depreciation principle for balance sheet purposes is followed. The convention of materiality is followed in dealing with
small items like pencils, pens, postage stamps, etc. These items are treated as expenditure in the year in which they are
purchased even though they are assets in nature. The stationery is valued at cost and not on the principle of cost or
market price, whichever is less. The use of accounting conventions makes financial statements comparable, simple and
realistic.

Postulates: Financial statements are prepared on certain basic assumptions (pre-requisites) known as postulates such
as going concern postulate, money measurement postulate, realisation postulate, etc. Going concern postulate assumes
that the enterprise is treated as a going concern and exists for a longer period of time. So the assets are shown on
historical cost basis. Money measurement postulate assumes that the value of money will remain the same in different
periods. Though there is drastic change in purchasing power of money, the assets purchased at different times will be
shown at the amount paid for them. While, preparing statement of profit and loss the revenue is included in the sales of
the year in which the sale was undertaken even though the sale price may be received over a number of years. The
assumption is known as realisation postulate.

Personal Judgments: Under more than one circumstance, facts and figures presented through financial statements are
based on personal opinion, estimates and judgments. The depreciation is provided taking into consideration the useful
economic life of fixed assets. Provisions for doubtful debts are made on estimates and personal judgments. In valuing
inventory, cost or market value, whichever is less is being followed. While deciding either cost of inventory or market
value of inventory, many personal judgments are to be made based on certain considerations. Personal opinion,
judgments and estimates are made while preparing the financial statements to avoid any possibility of over statement of
assets and liabilities, income and expenditure, keeping in mind the convention of conservatism.

Objectives of Financial Statements

1. To provide information about economic resources and obligations of a business: They are prepared to provide
adequate, reliable and periodical information about economic resources and obligations of a business firm to investors
and other external parties who have limited authority, ability or resources to obtain information.
2. To provide information about the earning capacity of the business: They are to provide useful financial information
which can gainfully be utilised to predict, compare and evaluate the business firm’s earning capacity.
3. To provide information about cash flows: They are to provide information useful to investors and creditors for
predicting, comparing and evaluating, potential cash flows in terms of amount, timing and related uncertainties.
4. To judge effectiveness of management: They supply information useful for judging management’s ability to utilise the
resources of a business effectively.
5. Information about activities of business affecting the society: They have to report the activities of the business
organisation affecting the society, which can be determined and described or measured and which are important in its
social environment.
6. Disclosing accounting policies: These reports have to provide the significant policies, concepts followed in the process
of accounting and changes taken up in them during the year to understand these statements in a better way.

Types of Financial Statements

 The financial statements generally include two statements:

 Balance sheet and statement of profit and loss which are required for external reporting and also for internal
needs of the management like planning, decision-making and control.
 Apart from these, there is also a need to know about movements of funds and changes in the financial position of
the company. For this purpose, a cash flow statement is prepared.
 Financial Statements Analysis

We know business is mainly concerned with the financial activities. In order to ascertain the financial status of the business
every enterprise prepares certain statements, known as financial statements. Financial statements are mainly prepared
for decision making purposes. But the information as is provided in the financial statements is not adequately helpful in
drawing a meaningful conclusion. Thus, an effective analysis and interpretation of
Financial statements is required.

Analysis means establishing a meaningful relationship between various items of the two financial statements with each
other in such a way that a conclusion is drawn. By financial statements we mean two statements:
(i) Profit and loss Account or Income Statement
(ii) Balance Sheet or Position Statement

These are prepared at the end of a given period of time. They are the indicators of profitability and financial soundness of
the business concern.

The term financial analysis is also known as analysis and interpretation of financial statements. It refers to the establishing
meaningful relationship between various items of the two financial statements i.e. Income statement and position
statement. It determines financial strength and weaknesses of the firm.

The term ‘financial analysis’ includes both ‘analysis and interpretation’.

The term analysis means simplification of financial data by methodical classification given in the financial statements.
Interpretation means explaining the meaning and significance of the data. These two are complimentary to each other.
Analysis is useless without interpretation, and interpretation without analysis is difficult or even impossible.
Analysis of financial statements is an attempt to assess the efficiency and performance of an enterprise. Thus, the analysis
and interpretation of financial statements is very essential to measure the efficiency, profitability, financial soundness and
future prospects of the business units.

Objectives of Financial Statement Analysis

Financial analysis serves the following purposes:

Measuring the profitability

The main objective of a business is to earn a satisfactory return on the funds invested in it. Financial analysis helps in
ascertaining whether adequate profits are being earned on the capital invested in the business or not. It also helps in
knowing the capacity to pay the interest and dividend.

Indicating the trend of Achievements

Financial statements of the previous years can be compared and the trend regarding various expenses, purchases, sales,
gross profits and net profit etc. can be ascertained. Value of assets and liabilities can be compared and the future
prospects of the business can be envisaged.

Assessing the growth potential of the business

The trend and other analysis of the business provides sufficient information indicating the growth potential of the
business.

Comparative position in relation to other firms

The purpose of financial statements analysis is to help the management to make a comparative study of the profitability
of various firms engaged in similar businesses. Such comparison also helps the management to study the position of
their firm in respect of sales, expenses, profitability and utilizing capital, etc.

Assess overall financial strength

The purpose of financial analysis is to assess the financial strength of the business. Analysis also helps in taking decisions,
whether funds required for the purchase of new machines and equipment’s are provided from internal sources of the
business or not if yes, how much? And also to assess how much funds have been received from external sources.

Assess solvency of the firm

The different tools of an analysis tell us whether the firm has sufficient funds to meet its short term and long term
liabilities or not.

PARTIES INTERESTED
Analysis of financial statements has become very significant due to widespread interest of various parties in the
financial results of a business unit. The various parties interested in the analysis of financial statements are:

(i) Investors: Shareholders or proprietors of the business are interested in the well being of the business. They
like to know the earning capacity of the business and its prospects of future growth.

(ii) Management: The management is interested in the financial position and performance of the enterprise as a
whole and of its various divisions. It helps them in preparing budgets and assessing the performance of various
departmental heads.

(iii) Trade unions: They are interested in financial statements for negotiating the wages or salaries or bonus
agreement with the management.

(iv) Lenders: Lenders to the business like debenture holders, suppliers of loans and lease are interested to know
short term as well as long term solvency position of the entity.
(v) Suppliers and trade creditors: The suppliers and other creditors are interested to know about the solvency
of the business i.e. the ability of the company to meet the debts as and when they fall due.

(vi) Tax authorities: Tax authorities are interested in financial statements for determining the tax liability.

(vii) Researchers: They are interested in financial statements in undertaking research work in business affairs
and practices.

(viii) Employees: They are interested to know the growth of profit. As a result of which they can demand better
remuneration and congenial working environment.

(ix) Government and their agencies: Government and their agencies need financial information to regulate the
activities of the enterprises/ industries and determine taxation policy. They suggest measures to formulate
policies and and regulations.

(x) Stock exchange: The stock exchange members take interest in financial statements for the purpose of
analysis because they provide useful financial information about companies.

TECHNIQUES AND TOOLS OF FINANCIAL STATEMENT ANALYSIS

Financial statements give complete information about assets, liabilities, equity, reserves, expenses and profit and loss of
an enterprise. They are not readily understandable to interested parties like creditors, shareholders, investors etc. Thus,
various techniques are employed for analyzing and interpreting the financial statements. Techniques of analysis of
financial statements are mainly classified into three categories:
(i) Cross-sectional analysis
It is also known as inter firm comparison. This analysis helps in analyzing financial characteristics of an enterprise with
financial characteristics of another similar enterprise in that accounting period. For example, if company A has earned
15% profit on capital invested. This does not say whether it is adequate or not. If we analyze further and find that a
similar company has earned 16% during the same period, then only we can make a conclusion that company B is better.
Thus, it turns into a meaningful analysis.

(ii) Time series analysis

It is also called as intra-firm comparison. According to this method, the relationship between different items of
financial statement is established, comparisons are made and results obtained. The basis of comparison may be :
– Comparison of the financial statements of different years of the same business unit.
– Comparison of financial statement of a particular year of different business units.

(iii) Cross-sectional cum time series analysis

This analysis is intended to compare the financial characteristics of two or more enterprises for a defined
accounting period. It is possible to extend such a comparison over the year. This approach is most effective in
analyzing of financial statements. The analysis and interpretation of financial statements is used to determine
the financial positon.

A number of tools or methods or devices are used to study the relationship between financial statements.
However, the following are the important tools which are commonly used for analysing and interpreting
financial statements:
_ Comparative financial statements
_ Common size statements
_ Trend analysis
_ Ratio analysis
_ Funds flow analysis
_ Cash flow analysis
_ Comparative financial statements
In brief, comparative study of financial statements is the comparison of the financial statements of the business
with the previous year’s financial statements. It enables identification of weak points and applying corrective
measures. Practically, two financial statements (balance sheet and income statement) are prepared in
comparative form for analysis purposes.

1. Comparative Balance Sheet

The comparative balance sheet shows the different assets and liabilities of the firm on different dates to make
comparison of balances from one date to another. The comparative balance sheet has two columns for the data
of original balance sheets. A third column is used to show change (increase/decrease) in figures. The fourth
column may be added for giving percentages of increase or decrease. While interpreting comparative Balance
sheet the interpreter is expected to study the following aspects:

(i) Current financial position and Liquidity position: For studying current financial position or liquidity
position of a concern one should examine the working capital in both the years. Working capital is the excess of
current assets over current liabilities.

(ii) Long-term financial position: For studying the long-term financial position of the concern, one should
examine the changes in fixed assets, long-term liabilities and capital.

(iii) Profitability of the concern: The next aspect to be studied in a comparative balance sheet is the
profitability of the concern. The study of increase or decrease in profit will help the interpreter to observe
whether the profitability has improved or not.
.
After studying various assets and liabilities, an opinion should be formed about the financial position of the
concern.

Example:
The following is the Balance Sheets of MS Gupta for the years 2006 and 2007. Prepare the comparative Balance Sheet
and study the financial position of the concern.
Interpretation

(i) The comparative balance sheet of the company reveals that during 2007 there has been an increase in fixed assets of
110,000 i.e. 13.49%. Long term liabilities to outsiders have relatively increased by Rs 150,000 and equity share capital
has increased by Rs 200000. This fact indicates that the policy of the company is to purchase fixed assets from the long
term sources of finance.
(ii) The current assets have increased by Rs 152000 i.e. 26.67% and cash has increased by Rs 20,000. The current
liabilities have increased only by Rs 20000 i.e. 12.9%. This further confirms that the company has used long-term
finances even for the current assets resulting into an improvement in the liquidity position of the company.
(iii) Reserves and surplus have decreased from Rs 330,000 to Rs 222,000 i.e. 32.73% which shows that the company has
utilized reserves and surplus for the payment of dividends to shareholders either in cash or by way of bonus.
(iv) The overall financial position of the company is satisfactory.

Comparative Income statement

The income statement provides the results of the operations of a business. This statement traditionally is known as trading
and profit and loss A/c.
Important components of income statement are net sales, cost of goods sold, selling expenses, office expenses etc. The
figures of the above components are matched with their corresponding figures of previous years individually and changes
are noted. The comparative income statement gives an idea of the progress of a business over a period of time. The
changes in money value and percentage can be determined to analyse the profitability of the business. Like comparative
balance sheet, income statement also has four columns. The first two columns are shown figures of various items for two
years. Third and fourth columns are used to show increase or decrease in figures in absolute amount and percentages
respectively.
The analysis and interpretation of income statement will involve the following:

– The increase or decrease in sales should be compared with the increase or decrease in cost of goods sold.
– To study the operating profits
– The increase or decrease in net profit is calculated that will give an idea about the overall profitability of the concern.

Example:-
Interpretation
The comparative income statement given above shows that there has been an increase in net sales of 14.65%. The cost of
goods sold has increased by 11%. This has resulted in increase of gross profit by 19.4%.

Operating expenses have increased by 8%. The increase in gross profit is sufficient to cover the operating expenses. There
is also an increase in net profit after tax of Rs 38000 i.e. 42.22%.

It is concluded from the above analysis that there is sufficient progress in the performance of the company and the overall
profitability of the company is good.

_Common Size Statements

The common size statements (Balance Sheet and Income Statement) are shown in analytical percentages. The figures of
these statements are shown as percentages of total assets, total liabilities and total sales respectively.

Common size balance sheet

A statement where balance sheet items are expressed in the ratio of each asset to total assets and the ratio of
each liability is expressed in the ratio of total liabilities is called common size balance sheet.
Thus the common size statement may be prepared in the following way.
– The total assets or liabilities are taken as 100
– The individual assets are expressed as a percentage of total assets i.e. 100 and different liabilities are
calculated in relation to total liabilities.

For example, if total assets are Rs10 lakhs and value of inventory is
Rs 100,000, then inventory will be 10% of total assets i.e. (1000000/100000*100 = 10%)

Example:
The balance sheet of Mr Anoop Private (Pvt) Limited (Ltd) and Bansal Private Limited are given below:
Compare the financial position of two companies with the help of common size balance sheet.

Interpretation
(i) An analysis of pattern of financing of both the companies shows that Bansal Ltd is more traditionally financed as
compared to Anoop Ltd. The former company has depended more on its own funds as is shown by balance sheet. Out of
total investment, 74.01% of the funds are proprietory funds and outsiders funds account only for 25.9%. In Anoop Ltd
proprietors’ fund are 64.83% while the share of outsiders funds is 34.17% which shows that this company has depended
more upon outsiders funds.
(ii) Both the companies are suffering from shortage of working capital. The percentage of current liabilities is more than
the percentage of current assets in both the companies.
(iii) A close look at the balance sheet shows that investments in fixed assets have been from working capital in both the
companies. In Anoop Ltd. fixed assets account for 94.52% of total assets while in Bansal Ltd fixed assets account for
89.48%.
(iv) Thus, both the companies face working capital problem and immediate steps should be taken to issue more capital
or raise long term loans to improve working capital position.

Common size income statement

The items in income statement can be shown as percentages of sales to show the relations of each item to sales.

Following are the income statements of a company for the year ending 31st December 2006 and 2007

Interpretation
– The sale and gross profit have increased in absolute figures in 2007 as compared to 2006. But the percentage of gross
profit to sales has gone down in 2007.
– The increase in cost of sales as a percentage of sales has brought the profitability from 34% to 27.14%.
– Operating expenses have remained the same in both the years.
– Net profit have decreased both in absolute figures and as a percentage in 2007 as compared to 2006.

Trend percentage analysis (TPA)

The trend analysis is a technique of studying several financial statements over a series of years. In this analysis the trend
percentages are calculated for each item by taking the figure of that item for the base year taken as 100. Generally the
first year is taken as a base year. The analyst is able to see the trend of figures, whether moving upward or downward.

In brief, the procedure for calculating trends is as:

– One year is taken as a base year which is generally is the first year or last year.
– Trend percentages are calculated in relation to base year

Example:

Interpretation
On the whole, 2005 was a bad year but the recovery was made during 2006. In this year there is increase in sales as well
as profit.
The figure of 2005 when compared with 2004 reveal that the sales have come down by 5%. However, the cost of goods
sold and the expenses have decreased only by 1.8% and 3% respectively. This has resulted in decrease in Net profit by
12%.
The position was recovered in 2006 and not only is the decline but also there positive growth in both 2006 and 2007.
Moreover, the increase in profit by 31.3% (2006) and 50.6% (2007) is much more than the increased in sales by 20% and
30% respectively. This shows major portion of cost of goods sold and expenses is of fixed nature.
 Ratio Analysis
 Ratio analysis is a quantitative method of gaining insight into a company's liquidity, operational efficiency, and
profitability by studying its financial statements such as the balance sheet and income statement.
 Ratio analysis can mark how a company is performing over time, while comparing a company to another within
the same industry or sector.
 Investors and analysts employ ratio analysis to evaluate the financial health of companies by scrutinizing past and
current financial statements.
 Comparative data can demonstrate how a company is performing over time and can be used to estimate likely
future performance.
 This data can also compare a company's financial standing with industry averages while measuring how a company
stacks up against others within the same sector.

Liquidity Ratio
 Liquidity is the ability to convert assets into cash quickly and cheaply.
 Liquidity ratios are an important class of financial metrics used to determine a debtor's ability to pay off current
debt obligations without raising external capital.
 Liquidity ratios determine a company's ability to cover short-term obligations and cash flows, while solvency ratios
are concerned with a longer-term ability to pay ongoing debts.

Types of Liquidity Ratios

The Current Ratio

The current ratio measures a company's ability to pay off its current liabilities (payable within one year) with its
total current assets such as cash, accounts receivable, and inventories. The higher the ratio, the better the company's
liquidity position.
Current Ratio= Current Asset
Current Liability
The Quick Ratio
The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assets and therefore
excludes inventories from its current assets. It is also known as the acid-test ratio.
 Quick Ratio = C+MS+AR
CL
Where:
C = cash & cash equivalents
MS = marketable securities
AR = accounts receivable
CL = current liabilities
OR

Quick ratio = (Current assets - inventory - prepaid expenses)

Current liabilities

Solvency Ratio
 A solvency ratio examines a firm's ability to meet its long-term debts and obligations.
 The main solvency ratios include the debt-to-assets ratio, the interest coverage ratio, the equity ratio, and the
debt-to-equity (D/E) ratio.
 Solvency ratios are often used by prospective lenders when evaluating a company's creditworthiness as well as by
potential bond investors.
 Solvency ratios and liquidity ratios both measure a company's financial health but solvency ratios have a longer-
term outlook than liquidity ratios.

Types of solvency ratio

Debt-to-Assets Ratio
 The debt-to-assets ratio measures a company's total debt to its total assets.
 It measures a company's leverage and indicates how much of the company is funded by debt versus assets, and
therefore, its ability to pay off its debt with its available assets.
 A higher ratio, especially above 1.0, indicates that a company is significantly funded by debt and may have
difficulty meetings its obligations.

Debt-to-asset ratio = Debt

Asset
Debt Equity Ratio
 The debt-equity ratio is a measure of the relative contribution of the creditors and shareholders or owners in the
capital employed in business.
 Simply stated, ratio of the total long term debt and equity capital in the business is called the debt-equity ratio.
Debt/Equity= Total Liabilities
Total shareholder’s equity

Profitability Ratios
 Profitability ratios assess a company's ability to earn profits from its sales or operations, balance sheet assets, or
shareholders' equity.
 Profitability ratios indicate how efficiently a company generates profit and value for shareholders.
 Higher ratio results are often more favorable, but these ratios provide much more information when compared
to results of similar companies, the company's own historical performance, or the industry average.

Gross Profit Ratio

Gross Profit Ratio/Margin= Net Sales − COGS
Net Sales

Operating profit Ratio

 Operating profit Ratio = Operating Profit / Net Sales × 100
  Operating profit = Net sales – (Cost of goods sold + Administrative and office expenses + Selling and distribution
exp.)

Net Profit Ratio

Return on Capital Employed

ROCE = EBIT
Capital Employed
where:
EBIT=Earnings before interest and tax
Capital Employed=Total assets − Current liabilities

UNIT IV
CASH FLOW STATEMENTS

 A Cash-Flow statement may be defined as a summary of receipts and disbursements of cash for a particular period
of time. It also explains reasons for the changes in cash position of the firm
 Cash flows are cash inflows and outflows. Transactions which increase the cash position of the entity are called as
inflows of cash and those which decrease the cash position as outflows of cash.
 The statement shows the incoming and outgoing of cash.
 The statement assesses the capability of the enterprise to generate cash and utilize it.
 A cash flow statement provides information about the historical changes in cash and cash equivalents of an
enterprise by classifying cash flows into operating, investing and financing activities.
  AS-3 has made it mandatory for all listed companies to prepare and present a cash flow statement along with
other financial statements on annual basis. It requires that an enterprise should prepare a cash flow statement
and should present it for each accounting period for which financial statements are presented.

Objectives of Cash Flow statement

The statement of cash flow serves a number of objectives which are as follows :
 Cash flow statement aims at highlighting the cash generated from operating activities.
 Cash flow statement helps in planning the repayment of loan schedule and replacement of fixed assets, etc.
 Cash is the centre of all financial decisions. It is used as the basis for the projection of future investing and financing
plans of the enterprise.
 Cash flow statement helps to ascertain the liquid position of the firm in a better manner. Banks and financial
institutions mostly prefer cash flow statement to analyse liquidity of the borrowing firm.
 Cash flow Statement helps in efficient and effective management of cash.
 The management generally looks into cash flow statements to understand the internally generated cash which is
best utilised for payment of dividends.
 Cash Flow Statement based on AS-3 (revised) presents separately cash generated and used in operating, investing
and financing activities.
 It is very useful in the evaluation of cash position of a firm.

Benefits of Cash Flow Statement

Cash flow statement provides the following benefits:
 A cash flow statement when used along with other financial statements provides information that enables users
to evaluate changes in net assets of an enterprise, its financial structure (including its liquidity and solvency) and
its ability to affect the amounts and timings of cash flows in order to adapt to changing circumstances and
opportunities.
 Cash flow information is useful in assessing the ability of the enterprise to generate cash and cash equivalents and
enables users to develop models to assess and compare the present value of the future cash flows of different
enterprises.
 It also enhances the comparability of the reporting of operating performance by different enterprises because it
eliminates the effects of using different accounting treatments for the same transactions and events.
 It also helps in balancing its cash inflow and cash outflow, keeping in response to changing condition. It is also
helpful in checking the accuracy of past assessments of future cash flows and in examining the relationship
between profitability and net cash flow and impact of changing prices.

Cash and relevant terms as per AS-3 (revised) issued by Accounting Standard Board

1. (A) Cash fund: Cash Fund includes

(i) Cash in hand
(ii) Demand deposits with banks, and
(iii) cash equivalents.
(B) Cash equivalents are short-term, highly liquid investments, readily convertible into cash and which are subject to
insignificant risk of changes in values.

2. Cash Flows are inflows and outflows of cash and cash equivalents.
3. Classification of Activities for the Preparation of Cash Flow Statement
The statement of cash flow shows three main categories of cash inflows and cash outflows, namely: operating,
investing and financing activities.
(a) Operating activities are the principal revenue generating activities of the enterprise.
(b) Investing activities include the acquisition and disposal of long term assets and other investments not included in
cash equivalents.
(c) Financing activities are activities that result in change in the size and composition of the owner’s capital (including
Preference share capital in the case of a company) and borrowings of the enterprise.
Cash from Operating Activities
Operating activities are the activities that constitute the primary or main activities of an enterprise. For example, for a
company manufacturing garments, operating activities are procurement of raw material, incurrence of manufacturing
expenses, sale of garments, etc.

Cash flow from Investing Activities

Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash
equivalents. Investing activities relate to purchase and sale of long-term assets or fixed assets such as machinery,
furniture, land and building, etc. Transactions related to long term investment are also investing activities.

Cash flow from Financing Activities

 As per AS-3, financing activities are activities that result in changes in the size and composition of the owners’
capital (including preference share capital in case of a company) and borrowings of the enterprise.
 Financing activities relate to long-term funds or capital of an enterprise, e.g., cash proceeds from issue of equity
shares, debentures, raising long-term bank loans, repayment of bank loan, etc.

Treatment of Some Peculiar Items

1. Extraordinary items - e.g. theft, accident etc. are recorded either leading to increase or decrease in cash under all
the heads (operating, financing and investing activities) of cash flow statement.
2. Interest and Dividend
 In case of a financial enterprise (whose main business is lending and borrowing)
Operating activities: Interest paid, interest received and dividend received
Financing activity: dividend paid
 In case of a non-financial enterprise
Financing Activity: Interest and Dividend paid
Investing Activity: Interest and Dividend received

3. Taxes on Income and Gains

  Tax on operating profit should be classified as operating cash flows.
 Dividend tax, i.e., tax paid on dividend should be classified as financing activity along with dividend paid.
 Capital gains tax paid on sale of fixed assets should be classified under investing activities.

4. Payment of Interim Dividends

The following procedure is followed
(i) The amount of interim dividend paid during the year is shown as outflow of cash in cash flow statement.
(ii) It will be added back to the profits for the purpose of calculating cash provided from operating activities.
(iii) No adjustment is necessary if the cash provided from operating activities is calculated on the basis of revised
figure of net profit.

5. While preparing cash flow statement, previous year's proposed dividend will be added to Profit under operating
activities and will be shown under financial activity.

METHOD OF PREPARING CASH FLOW STATEMENT

There are two methods of preparing the Cash Flow Statement. Both methods give the same results in respect of the final
total as well as sub-totals of the three sections – operating, investing and the financing. They differ only in the manner the
information regarding cash flow from operating activities is presented.

Indirect Method

Format of Cash Flow Statement for the year ended................ As per Accounting Standard 3
Particulars Rs
(i) Cash flows from operating Activities

Net Profit as per Profit and Loss A/c or

difference between closing balance and opening balance xxx
of Profit and Loss A/c

Add: Transfer to reserve xxx

Proposed dividend for current year xxx
Interim dividend paid during the year xxx
Provision for tax made during the current year xxx
Extraordinary items, if any, debited to Profit and Loss A/c xxx

Less: Extraordinary Items, if any, credited to Profit and Loss A/c xxx
Refund of Tax credited to Profit and Loss A/c xxx xxx

A. Net profit before taxation and Extra ordinary items

Adjustment for Non-Cash and Non-Operating Items. xxx

B. Add: – Depreciation xxx

Preliminary expenses xxx
 Discount on issue of shares and debentures written off xxx
Interest on borrowings and debentures xxx
Loss on sale of fixed assets xxx

C. Less: – Interest income/received xxx

Dividend income received xxx
Rental income received xxx
Profit on sale of fixed asset xxx

D. Operating profits before working capital changes (A + B – C) xxx

Add: Decrease in current assets xxx

Increase in current liabilities xxx
Less: Increase in current assets xxx
Decrease in current liabilities xxx

Cash generated from Operating activities xxx

Less: Income tax paid (Net tax refund received) xxx
+/- Extraordinary Items xxx
Net cash from operating activities xxx

(ii) Cash flow from investing accounting

Add: – Proceeds from sale of fixed assets xxx

Proceeds from sale of investments xxx
Proceeds from sale of intangible assets xxx
Interest and dividend received xxx

Less: – Rent income xxx

Purchase of fixed assets xxx
Purchase of investment xxx
Purchase of intangible assets like goodwill xxx

+/- Extraordinary Items xxx

Net cash from (or used in) investing activities xxx

(iii) Cash flow from financing activities

Add: Proceeds from issue of shares and debentures xxx

Proceeds from other long term borrowings xxx

Less: Final dividend fund xxx

Interim dividend fund xxx
Interest on debentures and loans paid xxx
Repayment of loans xxx
Redemption of debenture preference shares xxx

Adjust extraordinary items (+/–) xxx

Net cash from (or used in) financing activities xxx

(iv) Net increase/Decrease in cash and cash equivalent (i + ii + iii)

(v) Add: cash and cash equivalents in the beginning of the year
 – cash in hand xxx
– cash at bank overdraft xxx
– short term deposit xxx
– marketable securities xxx

Cash and cash equivalents in the end of the year xxx

Unit V
Responsibility Accounting
 Responsibility accounting is a system of management accounting under which accountability is established
according to the responsibility delegated to various levels of management and a management information and
reporting system instituted to give adequate feedback in terms of the delegated responsibility.
 Under this system, divisions or units of an organisation under a specific authority in a person are developed as
responsibility centres & evaluated individually for their performance.
 It is used to measure performance of divisions of an organisation rather than organisation as a whole.

Essential Features of Responsibility Accounting

1. Inputs and Outputs or Costs and Revenues:

• The implementation and maintenance of responsibility accounting system is based upon information relating to inputs
and outputs.
• The physical resources utilized in an organisation such as quantity of raw material used and labour hours consumed, are
termed as inputs. These inputs expressed in the monetary terms are known as costs.
• Similarly, outputs expressed in monetary terms are called revenues.
• Thus, responsibility accounting is based on cost and revenue information.

2. Planned and Actual Information or Use of Budgeting:

• Effective responsibility accounting requires both planned and actual financial information.
• It is not only the historical cost and revenue data but also the planned future data which is essential for the
implementation of responsibility accounting system.
• It is through budgets that responsibility for implementing the plans is communicated to each level of management.
• The use of fixed budgets, flexible budgets and profit planning are all incorporated into one overall system of
responsibility accounting.

3. Identification of Responsibility Centres:

• The whole concept of responsibility accounting is focused around identification of responsibility centres.
• The responsibility centres represent the sphere of authority or decision points in an organisation. In a small firm, one
individual or a small group of individuals, who are usually the owners may possibly manage or control the entire
organisation.
• However, for effective control, a large firm is, usually, divided into meaningful segments, departments or divisions. These
sub- units or divisions of organisation are called responsibility centres.
• A responsibility centre is under the control of an individual who is responsible for the control of activities of that sub-
unit of the organisation.
• This responsibility centre may be a very small sub-unit of the organisation, as an individual could be made responsible
for one machine used in manufacturing operations, or it may be very big division of the organisation, such as a divisional
manager could be responsible for achieving a certain level of profit from the division and investment under his control.
• However, the general guideline is that “the unit of the organisation should be separable and identifiable for operating
purposes and its performance measurement possible”.

4. Relationship between Organisation Structure and Responsibility Accounting System:

• A sound organisation structures with clear-cut lines of authority—responsibility relationships are a prerequisite for
establishing a successful responsibility accounting system.
• Responsibility accounting system must be so designed as to suit the organisation structure of the organisation.
• It must be founded upon the existing authority- responsibility relationships in the organisation.
• In fact, responsibility accounting system should parallel the organisation structure and provide financial information to
evaluate actual results of each individual responsible for a function.

5. Assigning Costs to Individuals and Limiting their Efforts to Controllable Costs:

• After identifying responsibility centres and establishing authority-responsibility relationships, responsibility accounting
system involves assigning of costs and revenues to individuals.
• Only those costs and revenues over which an individual has a definite control can be assigned to him for evaluating his
performance
• The following guidelines should be followed while assigning of costs
 If the person has authority over both the acquisition and use of the services, he should be charged with the cost of
these services.
 If the person can significantly influence the amount of cost through his own action, he may be charged with such costs.
 Even if the person cannot significantly influence the amount of cost through his own direct action, he may be charged
with those elements with which the management desires him to be concerned, so that he will help to influence those
who are responsible.

6. Performance Reporting:
• A control system to be effective should be such that deviations from the plans must be reported at the earliest so as to
take corrective action for the future. The deviations can be known only when performance is reported.
• Responsibility accounting system is focused on performance reports also known as ‘responsibility reports’, prepared for
each responsibility unit.
• Unlike authority which flows from top to bottom, reporting flows from bottom to top. These reports should be addressed
to appropriate persons in respective responsibility centres.
• The reports should contain information in comparative form as to show plans (budgets) and the actual performance and
should give details of variances which are related to that centre.
• The variances which are not controllable at a particular responsibility centre should also be mentioned separately in the
report.
• To be effective, the reports should be clear and simple. Use of diagrams, charts, illustrations, graphs and tables may be
made to make them attractive and easily understandable.

Pre-requisites of Responsibility Accounting

• It should be a big company with divisionalised organisation structure

• The organisation should have clearly set goals and targets
• Managers should actively participate in establishing budgets against which their performance is measured
• Managers are held responsible only for those activities over which they exercise significant degree of control
• Performance reporting should be timely and contain significant information relating to the responsibility centres

Responsibility center

• The main focus of responsibility accounting lies on the responsibility centers.

• A responsibility center is a sub unit of an organization under the control of a manager who is held responsible for the
activities of that center.
• It is like a small business to achieve the objectives of a large organisation
1. Cost Centre
 A cost or expense centre is a segment of an organisation in which the managers are held responsible for
the cost incurred in that segment but not for revenues.
 According to CIMA, London a cost centre is “a location person or equipment , for which costs maybe
ascertained and used for purposes of cost control”
 Responsibility in a cost centre is restricted to cost.
 For planning purposes, the budget estimates are cost estimates; for control purposes, performance
evaluation is guided by a cost variance equal to the difference between the actual and budgeted costs for
a given period.
 Cost centre managers have control over some or all of the costs in their segment of business, but not over
revenues.
 In manufacturing organisations, the production and service departments are classified as cost centre.
Also, a marketing department, a sales region or a single sales representative can be defined as a cost
centre.
 Cost centre may vary in size from a small department with a few employees to an entire manufacturing
plant. In addition, cost centres may exist within other cost centres.
 E.g. accounting department, repairs & maintenance department.

2. Revenue Centre
 It is a segment of the organisation which is primarily responsible for generating sales revenue.
 A revenue centre manager does not possess control over cost, investment in assets, but usually has
control over some of the expense of the marketing department.
 The revenue centre manager will control the selling price, promotion mix and product mix
 The performance of a revenue centre is evaluated by comparing the actual revenue with budgeted
revenue, and actual marketing expenses with budgeted marketing expenses.
 E.g. sales department

3. Profit Centre
 Also called business centre
 It is a segment of an organisation whose manager is responsible for both revenues and costs.
 In a profit centre, the manager has the responsibility and the authority to make decisions that affect both costs
and revenues (and thus profits) for the department or division.
 The managers are encouraged to act as if they were running their own separate business.
 The main purpose of a profit centre is to maximise profit by making decisions relating to production volume,
product mix, selling price, marketing strategy.
 Profit centre managers aim at both the production and marketing of a product.

4. Investment Centre
 It is responsible for both profits and investments.
 The investment centre manager has control over revenues, expenses and the amounts invested in the centre’s
assets.
 He also formulates the credit policy which has a direct influence on debt collection, and the inventory policy which
determines the investment in inventory.
 The manager of an investment centre has more authority and responsibility than the manager of either a cost
centre or a profit centre.
 Besides controlling costs and revenues, he has investment responsibility too. ‘Investment on asset’ responsibility
means the authority to buy, sell and use divisional assets.
 E.g. a new hotel being developed

Steps for Achieving Goals of Responsibility Accounting:

 1. The organisation is divided into various responsibility centres each responsibility centre is put under the charge of
a responsibility manager. The managers are responsible for the performance of their departments.
2. The targets of each responsibility centre are set in. The targets or goals are set in consultation with the manager
of the responsibility centre so that he may be able to give full information about his department. The goals of the
responsibility centres are properly communicated to them.
3. The actual performance of each responsibility centre is recorded and communicated to the executive concerned
and the actual performance is compared with goals set and it helps in assessing the work of these centres.
4. If the actual performance of a department is less than the standard set, then the variances are conveyed to the
top management. The names of those persons who were responsible for that performance are also conveyed so
that responsibility may be fixed.
5. Timely action is taken to take necessary corrective measures so that the work does not suffer in future. The
directions of the top level management are communicated to the concerned responsibility centre so that
corrective measures are initiated at the earliest.

The purpose of all these steps is to assign responsibility to different individuals so that the performance is improved. In
case the performance is not up to their targets set, then responsibility may be fixed for it. Responsibility accounting will
certainly act as control device and it will help in improving the overall performance of the business.

Advantages of Responsibility Accounting

 Some responsibility is given to each individual and he is held accountable for his performance. No person can
assign his responsibility to others. In this system, responsibility is fixed individually
 Facilitates stricter control on costs & revenue along with helping in planning and decision making
 When responsibility is fixed for each department, managers consider themselves important part of the
organisation. It helps in developing spirit of initiative among employees and increases their motivation
 A mechanism for presenting information is provided. A framework for managerial performance appraisal systems
can be established on that basis, besides motivating managers to act in the best interest of the enterprise
 Relevant and up to the minute information is made available which can be used to estimate future costs &/or
revenue and fix up standards for departmental budgets.

Problems in Responsibility Accounting

 For responsibility accounting to be effective, a proper classification between controllable and non-controllable
costs is a prime requisite. But practical difficulties arise while doing so on account of the complex nature & variety
of costs.
 Separate departmental pursuits may lead to inter-departmental rivalry and it may be prejudicial to the interest of
the enterprise as a whole. Managers may act in the best interest of their own, but not in the best interest of the
enterprise
 Can’t be relied upon completely as a tool for management control. It is a system just to direct the attention of
management to those areas of performance which require further investigation
 Preparation of an organisation chart which clearly delineates lines of responsibility and authority is a difficult task
 Responsibility accounting reports may be overloaded with all available information.
Divisional Performance- Concept
 The whole organisation is divided into separate divisions and each divisional manager has great deal of
independence.
 The manager of each division is accountable for performance of its operations as also the nature of operations
undertaken.
 It leads to creation of a decentralised organisation structure and each division is treated as a separate
responsibility centre. The performance of each responsibility centre will be separately measured and compared
with other responsibility centres for managerial decisions.
 However, authority can’t be exclusive one, implying that full autonomy can’t be fully granted to the divisional
head as no unit can be independent of other units within one organisation.
  The performance of each division hasto be separately and independently evaluated only to place responsibility
for effective management so that those who are doing the jobs don’t shrink from their duties and the operations
which they are bound to perform.

Merits of Divisional Performance

 Promotes quick decision making and avoids red tape and delays
 Motivates divisional managers to perform better. It also helps to improve their job satisfaction and self-fulfillment
 Makes top management free from detailed involvement in the day to day operations and enables them to devote
themselves to important policy matters.

Demerits of Divisional Performance

 Various divisions may compete with each other and in that divisional mangers may try to increase their own profits
at the expenses of other divisions
 There may be lack of coordination and cooperation between divisions. This results in lack of harmony in achieving
overall goals of the business.

Measurement of Divisional Performance

1. Variance Analysis
 Actual performance is compared with standard or budgeted performance and any variance between the two is
analyzed to know the causes so that responsibility can be established and corrective actions taken.
 Should be undertaken at each cost center & revenue center.
2. Profit
The absolute amount of profit earned by a profit center

3. Return on Investment
 ROI addressed divisional profit as a percentage of the assets employed in the division. Assets employed can be
defined as total divisional assets, assets controllable by the divisional manager, or net assets.
ROI= (Divisional Profit/ Divisional investment) * 100
= (EBIT/ capital employed) * 100
= (Profit/ sales) * (Sales/ capital invested) * 100

 An organisation can improve the ROI either by improving the net profit margin or by increasing the turnover with
the same amount of investment. It implies that the performance of a firm/ segment can be improved either by
increasing the profit margin per rupee of sales or by generating more sales volume per rupee of investment.

 Advantages
1) Is easy to understand & interpret
2) It Is a measure of relative performance and therefore can be used to compare the firms od different sizes.
3) Helps in ensuring good congruence between the different divisions and the firm.
4) Is widely accepted measure of performance because it relates net income to investments made in the division.
5) Motivate divisional managers to improve their performance by optimum utilisation of the capital invested in the
divisions.

 Limitations
 Satisfactory definition of profit & investment on which ROI is based are difficult to find
 There are different methods of valuation of assets such as book value, original cost, current replacement cost etc
which of these valuations is to be taken for calculating ROI remains a difficult question to answer
 There may be some practical difficulties in calculating the divisional profit which in turn will make calculations of ROI
difficult.

4. Residual Income
  Also known as Economic value added (EVA) method
 Was developed by consulting firm Stern Stewart & co.
 Residual income is excess income generated more than the minimum rate of return

Residual Income = Divisional Profit- Cost of capital

=Divisional Profit- (Divisional Investment* rate of interest)

• Advantages
a) It leads to better decisions than ROI
b) It has the advantage of showing division’s ability to earn more than the cost of capital
c) Divisional managers are made to realise that there is an opportunity cost of funds used by the divisions in the
form of cost of capital.

• Disadvantages
a) Cannot be used to compare the performance of divisions of different size
b) This method is difficult to understand and apply
c) It may be difficult to determine the rate of calculating cost of capital

Transfer Pricing
 Large businesses are organized into different divisions for effective management control.
 When the business is organized into divisions and if one division supplies its finished output as input to another
division, there arise the question of transfer pricing.
 Transfer price is the price at which the supplying division prices its transfer of output to the user division.
 The price assigned to the interdivisional transfer of output represents a revenue of the selling division and a cost of
the buying division.
 It should be noted that there is only an internal transfer and not a ‘sale’.
 Transfer prices are set at the time of the transfer rather than waiting until the manufacturing process is completed
and the goods are sold to someone outside the company.
 Selection of transfer price to some extent depends upon the nature of the product, type of the product and policy of
the organization.
 Transferor would like to obtain the highest possible price while the transferee would require the lowest possible price.
 Goal congruence should be taken into account while fixing the transfer price because the actions of one division should
not have a detrimental effect on the group as a whole.

Objectives of Transfer Pricing

1. Goal congruence: The prices should be set so that the divisional management desire to maximize divisional earnings
is consistent with the objectives of the company as a whole. The transfer prices should not encourage sub-optimal
decision-making. The system should be so designed that decisions that improve business unit profits will also improve
company profits.
2. Performance appraisal: The prices should enable reliable assessments to be made of divisional performance. The
prices form part of information, which should:
1) Guide decision making
2) Appraise managerial performance
3) Evaluate the contribution made by the division to overall company profits.
4) Assess the worth of the division as an economic unit.

The transfer prices should be designed such that they help in measuring the economic performance

3. Divisional autonomy: The prices should seek to maintain the maximum divisional autonomy so that the benefits
of decentralization (motivation, better decision-making, initiatives, etc.) are maintained. The profits of one division
should not be dependent on the actions of other divisions.
4. Simple and easy: The system should be simple to understand and easy to administer.

5. The transfer price should provide each segment with the relevant information required to determine the optimum
trade-off between company costs and revenues.

METHODS OF TRANSFER PRICING

 There are different methods for pricing the output of one division to another. The selection of an appropriate
transfer price will have significant impact on decision making, product costing and performance evaluation of
different divisions in the organization.
 Generally transfer pricing methods can be classified into two broad categories. They are:
(1) Market Price Based
(2) Cost - based.
There are a number of alternative methods within each of the above two methods and these are discussed below.

Market Price Based

This method consist of the following methods:
a) Market Price
b) Adjusted Market Price, and
c) Negotiated Price

a) Market Price: When a market price is available or when there is a comparable product on the market and its price is
available, this price can be used as a transfer price. Both the selling and buying divisions can sell and buy as much as they
can at this market price. Managers of both the selling and buying divisions are indifferent trading with each other or with
outsiders. From the company’s perspective this is fine as long as the supplying unit is operating at capacity. The market
price is useful for fixing transfer price when there is a competitive external market for the transferred product. An
advantage of this method is that it can be regarded as the opportunity cost to a division in so far as there is choice whether
or not to purchase from external market. Additionally managers have control over their transfer price so performance
measurement is facilitated. Another advantage of this method is that it helps to assure profit independence of the
divisions. Any gain of the selling division do not get passed on to the buying division.

b) Adjusted Market Price: This price is based on the above market price, but it is adjusted to allow for the fact that such
cost as sales commission and bad debts should not be incurred within the divisions.

c) Negotiated Price: This price can occur when there is some basis on which to negotiate between the divisional
managers. The negotiated price, normally, may be a market price or a cost price. For example, one basis may be the
contribution margin on the product being transferred divided between the transferor and the transferee or it may be
the total cost which the transferor could suggest or the market price which the transferee could suggest. Both the
divisions could negotiate between these two figures. Sometimes the negotiated price may be based on manufacturing
cost plus an extra percentage added to approximate market price.
Whatever the basis chosen, the company should be careful in avoiding arbitrary price between the divisions. The
arbitrary price may be rewarding to one division and prevailing to another division. Sometimes negotiated prices are
imposed by company top level, but this could not hamper the autonomy of divisional managers and distorting the
financial performance of any division.

Cost Price Based

Another method to be followed for charging transfer price for the transfer of output from one division to another
division is Cost Price. When external markets do not exist or when the information about external market prices is not
readily available, companies may elect to use some of cost based transfer pricing methods as stated below:
a) Absorption Cost
b) Cost plus Profit Margin
c) Marginal Cost
d) Standard Cost
e) Opportunity Cost

a) Absorption Cost: Absorption or full cost is based on the total cost incurred in manufacturing a product. When cost
alone is used for transfer pricing, the selling division cannot realize any profit on the goods transferred. This method has
a disadvantage that any excess cost on account of inefficiency may be passed on to the other divisions.

b) Cost Plus Profit Margin: Under absorption costing when cost alone is used for transfer pricing, the selling division
cannot make any profit on the goods transferred. This is disincentive to selling division. To overcome this problem, some
companies set transfer price on cost plus profit margin. This includes the cost of the item plus a mark up or other profit
allowance. Under this method, the selling division obtains a profit contribution on the units transferred. It also benefits
the transferring division if performance is measured on the basis of divisional operating profits. At the same time,
it has also similar drawback of absorption costing that the inefficiencies if any, may also creep into the other divisions.

c) Marginal Cost: Another method to be followed for transfer pricing is the marginal cost. All costs that change in
response to the change in the level of activity should be taken into account for the transfer price while transferring
output from one division to another division. But this method fails to motivate divisional managers because it makes no
contribution towards fixed overheads and profit.

d) Standard Cost: If actual costs are used as the basis for the transfer, any variances or inefficiencies in the selling
division are passed along to the buying division. To promote responsibility in the selling division and to isolate variances
within divisions, standard costs are usually used as a basis for transfer pricing in cost based systems. Use of standard
costs reduces risk to the buyer. The buyer knows that the standard costs will be transferred and avoids being charged
with the seller’s cost overruns.

e) Opportunity Cost: It represents the opportunity which has been foregone by following one course of action rather
than another. Thus, if goods are transferred internally the organization could lose a contribution to profit which could
have been obtained from an external sale. Generally, an opportunity cost approach will be used to establish a range of
transfer prices in situations where the market is imperfect.

If the selling division has sufficient sales in the intermediate market such that it would have had to forgo those sales to
transfer internally, the transfer price should be equal to differential cost to the selling division plus implicit opportunity
cost to company if goods are transferred internally. The formulae is:

Transfer Price = Differential cost to the selling division + Implicit opportunity cost to company if goods are transferred
internally.

Differential costs are those costs that change in response to alternative course of action. In estimating differential cost,
the manager concerned unit has to determine which costs will be effected by an action and how much they will change.
As long as the transfer price is greater than the opportunity cost of the selling division and less than the opportunity cost
of the buying division, a transfer will be encouraged. A transfer is in the best interest of the company if the opportunity
cost for the selling division is less than the opportunity cost for the buying division.

Recent developments in the field of Accounting.

Financial Accounting:
Financial accounting is a specific branch of accounting involving a process of recording, summarizing, and reporting the
myriad (very large number) of transactions resulting from business operations over a period of time.

Cost Accounting:
 Cost accounting is a form of managerial accounting that aims to capture a company's total cost of production by
assessing its variable and fixed costs.
  It is a systematic set of procedures for recording and reporting measurements of the cost of manufacturing goods
and performing services in the aggregate and in detail.

Management Accounting:
 Management accounting is the process of preparing reports about business operations that help managers make
short-term and long-term decisions.
 It helps a business pursue its goals by identifying, measuring, analyzing, interpreting and communicating
information to managers.

Government Accounting:
Government accounting refers to the process of recording and the management of all financial transactions incurred by
the government which includes its income and expenditures.

H.R. Accounting:
 Human Resource Accounting (HRA) is a new branch of accounting.
 HRA means accounting for people as the organisational resources.
 It is the measurement of the cost and value of people to organisations.
 It involves measuring costs incurred by private firm and public sectors to recruit, select, hire and train and develop
employees and judge their economic value of the organisation.
 Human Resources Accounting is the process of identifying and measuring data about human resources and
communicating this information to interested parties.

Social Accounting:
 Social accounting is the accounting of costs and benefits to the society on account of business activities of the
organisation; for the purpose of communicating it to the interested parties. Social accounting is also known as
Social Responsibility accounting or social and environment accounting, corporate social reporting, Non- financial
accounting.
 Social accounting is the normal accounting of social responsibilities met by the organisation. It is concerned with
measuring and disclosing the cost and benefits to the society as a result of operating activities of a business
enterprise.

Environment Accounting:
 Environment Accounting or Green Accounting is the subset of accounting purpose is to incorporate both economic
and environmental information.
 It can be conducted at the corporate level or at the level of a national economy.
 It is a field that identifies resource use, measures and communicates costs of a company’s or national economic
impact on the environment.
 It is defined as important tool for understanding the role played by the environment in the economy as a mutual
relationship is identified between the two.

Taxation Accounting:
 Tax accounting is the subsector of accounting that deals with the preparations of tax returns and tax payments.
 It applies to everyone—individuals, businesses, corporations, and other entities. Even those who are exempt from
paying taxes must participate in tax accounting.
 The purpose of tax accounting is to be able to track funds (funds coming in as well as funds going out) associated
with individuals and entities.

Inflation Accounting:
 Inflation accounting comprises a range of accounting models designed to correct problems arising from historical
cost accounting in the presence of high inflation and hyperinflation.
 Inflation accounting is the practice of adjusting financial statements according to price indexes.
Responsibility Accounting:
 It is a kind of management accounting that is accountable for all the management, budgeting, and internal
accounting of a company.
 The primary objective of this accounting is to support all the Planning, costing, and responsibility centres of a
company.