Second Part: Costing

Unit 6: Basic Accounting

6.1 Introduction
6.2 Role of engineering /technical manpower in an
organization
6.3 Types of engineering economics decision
6.4 Finance and Capital Management
6.4.1 Sources of finance for investment
6.4.2 Concept of assets and liabilities
6.4.3 Accounting - Basic Concept (definition, objectives and
importance of accounting, concept of debit and credit,
concept of journal and ledger, profit and loss account, balance
sheet)
6.4.4 Simple and compound interest rates, effective interest,
and continuous compound interest
6.4.5 Depreciation, its types and factors affect it
6.4.6 Depreciation Method: Straight line, Declining balance
method
6.4.7 Cash flow
6.4.8 Related numerical problems on interest and
depreciation
6.1 Introduction
Concept of Accounting
Accounting is the art of recording, classifying, and summarizing
financial transactions and events.
Accounting is the process of identifying, measuring, and communicating
economic information to make decisions.
In conclusion, Accounting is the recording of financial transactions
along with storing, sorting, retrieving, summarizing, and presenting the
results in various reports and analyses

6.2 Role of engineering /technical manpower of the

Organization (see in Next Pdf)
6.3 Types of engineering economics decision (see in Next pdf)
6.4 Finance and Capital Management

6.4.1 Sources of finance for Investment

A source or sources of finance, refer to where a business gets
money from to fund their business activities. A business can gain
finance from either internal or external sources.

Internal sources of finance

Internal sources of finance refer to money that comes from within a
business. There are several internal methods a business can use,
including owner's capital, retained profit and selling assets.
Owner's capital refers to money invested by the owner of a business.
This often comes from their personal savings. Personal savings is money
that has been saved up by an entrepreneur. This source of finance does
not cost the business, as there are no interest charges applied.
Retained profit is when a business makes a profit, it can leave some or
all of this money in the business and reinvest it in order to expand. This
source of finance does not incur interest charges or require the
payment of dividends, which can make it a desirable source of finance.
Selling assets involves selling products owned by the business. This may
be used when either a business no longer has a use for the product or
they need to raise money quickly. Business assets that can be sold
include for example, machinery, equipment, and excess stock.

External sources of finance

External sources of finance refer to money that comes from outside a
business. There are several external methods a business can use,
including family and friends, bank loans and overdrafts, venture
capitalists and business angels, new partners, share issue, trade credit,
leasing, hire purchase, and government grants.
Family and friends - businesses can obtain a loan or be given money
from family or friends that may not need to be paid back or are paid
back with little or no interest charges.
A bank loan is money borrowed from a bank by an individual or
business. A bank loan is paid off with interest over an agreed period of
time, often over several years.
Overdrafts - are where a business or person uses more money than
they have in a bank account. This means the balance is in minus figures,
so the bank is owed money. Overdrafts should be used carefully and
only in emergencies as they can become expensive due to the high
interest rates charged by banks.
Venture capital and business angels - refers to an individual or group
that is willing to invest money into a new or growing business in
exchange for an agreed share of the profits. The venture capitalist will
want a return on their investment as well as input into how the
business is run.
New partners - is when an additional person or people are brought into
the business as a new business partner. This means they would provide
money to then own part of the business.
Share issue - a business may sell more of their ordinary shares to raise
money. Buying shares gives the buyer part ownership of the business
and therefore certain rights, such as the right to vote on changes to the
business.
A trade credit must be agreed with a supplier and forms a credit
agreement with them. This source of finance allows a business to
obtain raw materials and stock but pay for them at a later date. The
payment is usually made once the business has had an opportunity to
convert the raw materials and stock into products, sell them to its own
customers, and receive payment.
Leasing - is a way of renting an asset that the business requires, such as
a coffee machine. Monthly payments are made and the leasing
company is responsible for the provision and upkeep of the leased
item.
Hire purchase - is used to purchase an asset, such as a delivery van or
piece of equipment. A deposit is paid and the remaining amount for the
asset is paid in monthly instalments over a set period of time. The
business does not own the item until all payments are made.
Government grants - are a fixed amount of money awarded by the
government. Grants are given to a business on the condition that they
meet certain criteria such as providing jobs in areas of high
unemployment. These do not usually need to be paid back.

6.4.2 Concept of Asset and Liability

Assets
Assets are everything that a business owns. They are found on the left
side of a balance sheet.

There are two types of assets: current and fixed assets. Current
assets are assets that can be quickly converted into cash. They include
cash, accounts receivable and inventory. The more current assets a
small business has the better, as this means they can survive longer
without borrowing money.

Fixed assets are physical items that last over a year and have financial
value to a company, such as computer equipment and tools.

Assets are also categorized as either tangible or intangible. Tangible

assets are physical objects that can be touched, like vehicles. Intangible
assets are resources that have no physical presence, though they still
have financial value. Examples include copyright and brand recognition.

Liabilities
Liabilities are everything a business owes, now and in the future. They
are found on the right side of a balance sheet. A common small
business liability is money owed to suppliers i.e., accounts payable.

All businesses have liabilities unless they exclusively accept and pay
with cash. Cash includes physical cash or payments made through a
business bank account.
There are two types of liabilities: current and long-term liabilities.
Current liabilities need to be paid back within a year and include credit
lines, loans, salaries, and accounts payable. Many company expenses
are current liabilities.

Long-term liabilities can be paid back after a year and include

mortgages and bonds.

6.4.3 Accounting - Basic Concept (definition, objectives and

importance of accounting, concept of debit and credit,
concept of journal and ledger, profit and loss account, balance
sheet)

Concept of Accounting
Accounting is the art of recording, classifying, and summarizing
financial transactions and events.
Accounting is the process of identifying, measuring, and communicating
economic information to make decisions.
In conclusion, Accounting is the recording of financial transactions
along with storing, sorting, retrieving, summarizing, and presenting the
results in various reports and analyses

Objectives of Accounting
To keep a systematic record of all business transactions

Accounting is used to maintain a systematic record of all the financial

transactions in the books of accounts of an entity and that is one of the
main accounting objectives. For this purpose, all transactions have
recorded the books of accounts in chronological order in Journal and
then posted to different ledger accounts.
To ascertain profit and loss & ascertainment of results

Every business starts with the motive to earn profits. We can say that
profits are the backbone of any business. Also, the users of financial
statements are very keen to know the net results of business
operations periodically. To check whether the business is earning
profits or making losses, we prepare a statement or account called
“Profit & Loss Account or Statement of Profits & Losses”.

To determine the financial position of an entity

By accounting for each and every asset owned by an entity and

liabilities incurred by the entity, we can get to know the exact financial
position of our business at a particular date. In this regard, we prepare
a “Balance Sheet” to check the value of assets and liabilities.

To provide information to various users of Financial Statement

Users of financial statements play a major role in the company. The

financial statements of an entity can affect the decision-making process
of the user of the financial statement. They also participate in future
business growth. Providing information to the various interested
parties or stakeholders is one of the most important objectives of
accounting, it helps them in making good financial decisions.
To assist the management

By analyzing the financial data of an entity and providing

interpretations in the form of reports, accounting can also assist
management in handling the daily business operations in an effective
manner.

Importance of Accounting in Business Organization

A business organization involves an individual or a group of people who
collaborate so as to achieve certain commercial goals.

Planning Budget
Budgeting is a core factor in every business. Planning budgets help
business to make strategies, save money and noticing any expenditure
exceeding the budgeted amount. To make a budget you need various
previous records. In order for these documents to be available, they
must be very well maintained through accounting since they are the
basis of planning and making budgets.

Banks and lenders

In order to get any loan from the financial institution, you must be able
to present your financial status in acceptable order. So in order to make
it, you need to have proper accounting system so as to present various
books of records such as profits recorded, assets and liabilities, taxes
paid among others. Financial institutions will scrutinize them carefully
before landing to a decision of awarding loan.

Keeping Records
Every business needs to keep records and act upon them in order to
run smoothly. In this case, accounting plays a big role in keeping
records. All records are collected, organized, and interpreted in order to
be communicated to the end users, therefore helping in making an
economically viable decision which will lead to the positive productivity
of the business organization.

Decision Making
Any economic or any decision regarding the business organization is
made depending on the financial statement of the organization. A
financial statement is as a result of accounting. Without proper
accounting in a business organization, the executives can’t make a
sounding decision since they will be operating in blindness hence
making it impossible to achieve organization objectives.

Information to Investors
Financial statements and accounts are used to represent the
organization to the stakeholders such as debtors, creditors,
government, and investors, customers and employees. Many investors
will run away from your organization if you lack financial records and
accounts to presents so as they can know the business progress.

Reporting Profits
The key objective of any business is to make profits. Every
business, being a small or large organization, must maintain accounting
system so as they can ascertain what they are making on their business
transactions. This also enables interested parties to make the decision
on the progress of the business productivity.

Managing and Monitoring Cash Flow

Proper accounting systems will take care of working capital and any
other cash requirements within the business organization.
Concept of Debit and Credit
Debits

A debit is an accounting entry that either increases an asset or

expense account, or decreases a liability or equity account. It is
positioned to the left in an accounting entry.

Credits

A credit is an accounting entry that either increases a liability or

equity account, or decreases an asset or expense account. It is
positioned to the right in an accounting entry.

Types of accounts

To understand the Golden Rules of Accounting we must first

understand the types of accounts. The account classification applies to
all the types of general ledger. In other words, every account will fall in
one of the broad classifications given below. There are three types of
accounts:

• Real Account
• Personal Account
• Nominal Account

A Real Account is a general ledger account relating to Assets and

Liabilities other than people accounts. These are accounts that don’t
close at year-end and are carried forward. An example of a Real
Account is a Bank Account.
A Personal account is a General ledger account connected to all
persons like individuals, firms and associations. An example of a
Personal Account is a Creditor Account.

A Nominal account is a General ledger account pertaining to all income,

expenses, losses and gains. An example of a Nominal Account is an
Interest Account.

Golden rules of accounting

Concept of Journal and Ledger

What is a Journal?
A journal is a subsidiary book of account that records monetary
transactions according to accounting standards. These transactions get
recorded in chronological order, and it gives details about the accounts
that are affected by each transaction. It is known as the first step of the
accounting process.
What are its features?
The features of a journal are as follows:

• Chronology: The journal entries get recorded in a date-wise order,

and it helps in checking the transactions much more quickly.
• Double Entry System: Journal entries follow a system where every
transaction is entered both on the debit and credit sides. It is an
example of a dual entry system. One account gets debited and the
other gets credited with the same value.
• Daybook: A journal records transactions on a day-to-day basis for
consistency and ease.
• Compound Entry: A single entry can have two or more accounts
on the same day, and a journal can also have more than one
related transaction.
• Explanation: Each transaction includes a short description known
as the narration (within brackets). It helps to explain the nature
and purpose of the transaction.

What is a Ledger?
A Ledger is a principal book of account, and its primary purpose is to
transfer transactions from a journal and then classify it into separate
accounts. Ledger is also known as the book of final entry as it helps
businesses prepare accounting statements like the Trial Balance.
The features of a ledger are as follows:

• Two Sides: Every Ledger has two sides – Debit and Credit. The
debit entries come on the left side of a ledger, while the credit
entries come on the right side.
• Transaction: Every transaction impacts two or more ledger
accounts, and it is because the transaction is related to a
particular person, asset, expense or income.
 • Balancing the ledger: The total debit and credit sides of a ledger
must always be the same. But that is not always the case since the
debit side could be more than the credit side and vice versa.

Concept of profit and loss account and Balance sheet

It is the statement of income which is popularly known as profit and
loss account, it is referred to in symbols of P&L, also known by revenue
statement, statement of financial performance, earnings statement,
statement of operations. It is one of the statements of the finances of a
company because it shows the revenues of the company and expenses
during a fixed interval of time.

It also shows how the revenue is changed into the net income or net
profit which is calculated after estimating the revenue and expenses.
The main aim of the profit and loss statement is to show businessmen
and investors whether the company made profit or loss during this
particular time period.

The term profit and loss (P&L) statement refers to a financial statement
that summarizes the revenues, costs, and expenses incurred during a
specified period, usually a quarter or fiscal year. A profit and
loss (P&L) statement is a financial report that provides a summary of a
company's revenue, expenses, and profit.
Importance

• Tracks the Net Profit or Net Loss – The Most important benefit of

preparing a profit and loss account is to track business

performance in terms of net profit or a net loss.

• Tracks Indirect Expenses – Indirect expenses of a particular period

can be easily tracked and monitored with the help of data

provided in a profit and loss account and thus can help in lowering

or minimising the excess expenses, thereby increasing

profitability.

• Helps in Ascertaining the Net Profit Ratios – This statement helps

in conducting financial statement analysis as with the help of net

profit, a company may easily determine the net profit linked

ratios.

• Helps in Decision Making – With the help of profit and loss

statements, comparison can be done between the current year’s

data with previous year data and then forecasting the future
 performance and thus helps in making future plans and decision-

making.

What Is a Balance Sheet?

The term balance sheet refers to a financial statement that reports a

company's assets, liabilities, and shareholder equity at a specific point
in time.

A balance sheet is a statement of the financial position of a business

that lists the assets, liabilities, and owners' equity at a particular point
in time. In other words, the balance sheet illustrates a business's net
worth.

In short, the balance sheet is a financial statement that provides a

snapshot of what a company owns and owes, as well as the amount
invested by shareholders.

Importance

It is important because it helps in understanding the performance of a

company. Following are the reasons why it is important:

• To understand the financial health of a company.

• Stakeholders can study the balance sheet to understand the
liquidity position and business performance of the company.
• Comparing balance sheets over the years helps in determining the
growth of the company.
• It is an essential document to obtain a business loan.
 • Analyzing the company’s balance sheet helps in understanding
the ability of the firm to undertake expansions projects and
unforeseen expenses.
• It helps in identifying the source of company funding, for example,
equity funding or debt funding.

6.4.4 Simple and compound interest rates, effective

interest and continuous compound interest
What is Simple Interest?

Simple interest calculates the total interest payment using a fixed

principal amount. The interest that is accrued over time is not
added to the principal amount. Consider the following example:

Example1: An investor invests Rs2,000 in a 4-year term deposit

paying simple interest of 12%.

Total Interest Earned = Principal * Interest Rate * Time

= Rs2,000 * 12% * 4 = Rs960

Total Amount Repaid = Principal + Total Interest

= Rs2,000 + Rs960 = Rs2,960

What is Compound Interest?

Compound interest is the interest calculated on the principal and
the interest accumulated over the previous period.

The interest that is accrued over time is added to the principal

amount. For example, the interest for the first year is calculated
as a proportion of the initial principal. The interest amount is then
 added to the initial principal, and the interest for the second year
is calculated as a proportion of the revised principal.

Compound Interest Formula

C.I. = Principal (1 + Rate)time– Principal

What is the compound interest (CI) on Rs.5000 for 2 years at 10% per
annum compounded annually?
Solution:
Principal (P) = Rs.5000, Time (T)= 2-year, Rate (R) = 10 %
We have, Amount,
CI= Rs 5000(1+0.1)2-Rs 5000
=Rs 6050- Rs 5000
= Rs 1050

What is the Effective Interest Rate?

The effective interest rate is that rate of interest actually earned on

an investment or loan over the course of a year, incorporating the
effects of compounding.

The effective interest rate is the usage rate that a borrower actually
pays on a loan.

r = (1 + i/n)^n-1
Where:

r = The effective interest rate

i = The stated interest rate
n = The number of compounding periods per year

Example of Calculating the Effective Interest Rate

For example, a loan document contains a stated interest rate of 10%

and mandates quarterly compounding. By entering this information
into the effective interest rate formula, we arrive at the following
effective interest rate:

(1 + 10%/4)^4-1 = 10.38% Effective interest rate

Continuously Compounded Interest Formula

Continuously compounded interest is the mathematical limit of the

general compound interest formula, with the interest compounded
an infinitely many times each year. Or in other words, you are paid
every possible time increment. Mathematicians have derived a way
to approximate the value such a sum would converge to, and it is
given by the following formula:

Continuously Compounded Interest – Formula

A = P (1 + r/n)nt

Here, n = the number of terms the initial amount (P) is compounding in

the time t and A is the final amount (or) future value.
Tina invested $3000 in a bank that pays an annual interest rate of 7%
compounded continuously. What is the amount she can get after 5
years from the bank? Round your answer to the nearest integer.
Solution:
To find: The amount after 5 years.
The initial amount is P = $3000.
The interest rate is, r = 7% = 7/100 = 0.07.
Time is, t = 5 years.
Substitute these values in the continuous compounding formula
A = Pert
A = 3000 × e0.07(5) ≈ 4257
The answer is calculated using the calculator and is rounded to the
nearest integer.
Answer: The amount after 5 years = $4,257.

6.4.5 Depreciation, its types and factors that affect it

Depreciation
In accounting terms, depreciation is defined as the reduction of the
recorded cost of a fixed asset in a systematic manner until the value of
the asset becomes zero or negligible.

An example of fixed assets is buildings, furniture, office equipment,

machinery etc. The land is the only exception that cannot be
depreciated as the value of land appreciates with time.
Depreciation is the deduction in the price of a tangible asset which
reduces the asset’s monetary value due to a variety of reasons like
wear and tear that is caused by a prolonged use of the asset.
Any tangible assets like vehicles, real estate, computers, business
equipment, office furniture and anything that you have bought for your
business to help your business to produce income can be depreciated.

Causes of Depreciation:
1. Wear and Tear:
Some assets physically deteriorate due to wear and tear in use. When
an asset is constantly used for production, the asset wears out. More
and more use of an asset, the greater would be the wear and tear.

2. Lapse of Time:
There are certain assets like leasehold property, patents, copy-right etc.
that are acquired for a particular period. After the expiry of the period,
they are rendered useless i.e. their value ceases to exist. Thus, their
cost is written off over their legal life.

3. Obsolescence:
Appearance of new and improved machines results in discarding of old
machines. Thus new inventions, change in fashions and taste, market
condition, Government policies etc. are the causes to discard the value
of an asset.

4. Exhaustion:
5. Non-Use:
6. Maintenance:
Factors affecting the amount of depreciation

1. Historical cost - Historical cost of a depreciable asset implies the cost

incurred on its acquisition, installation, commissioning and for additions to
or improvements thereof which are of capital nature.

2. Expected useful life - Expected useful life of a depreciable asset implies

either the period over which a depreciable asset is expected to be used by
the enterprise or the number of production or similar units expected to be
obtained from the use of the asset by the enterprise.

3. Estimated residual value - Estimated residual value of a depreciable asset

implies the value expected to be realized on its sale or exchange on the
expiry of its useful life.
4. Legal Provisions

The amount of depreciation also depends upon the statutory and legal
provisions prescribing the admissible rate of depreciation on fixed
assets.

6.4.6 Depreciation Methods: Straight line. Declining balance method

Straight Line Depreciation

Straight line depreciation is a common method of depreciation where
the value of a fixed asset is reduced over its useful life. It's used to
reduce the carrying amount of a fixed asset over its useful life. With
straight line depreciation, an asset's cost is depreciated the same
amount for each accounting period.
To calculate depreciation using a straight line basis, simply divide net
price (purchase price less the salvage price) by the number of useful
years of life the asset has.

Declining balance method

Declining balance is a method of computing depreciation rate for
the value of an asset. The declining balance method is also known as
reducing balance method or diminishing balance method. It is an
accelerated depreciation method that results in larger depreciation
amounts during the earlier years of an assets useful life and gradually
lower amounts in later years.
In diminishing balance method, depreciation is calculated on book
value of the asset at the start of the year instead of principle amount
with fixed percentage. In this, the percentage is same but depreciation
amount gradually decreases as it is done on book value.
Formula
Depreciation amount = (book value * rate of depreciation)/100

6.4.7 Cash Flow

Concept of Cash Flow

Cash Flow (CF) is the increase or decrease in the amount of money a
business, institution, or individual has. In finance, the term is used to
describe the amount of cash (currency) that is generated or consumed
in a given time period. There are many types of CF, with various
important uses for running a business and performing financial analysis.

Types of Cash Flow

There are several types of Cash Flow, so it’s important to have a solid
understanding of what each of them is. When someone refers to CF,
they could mean any of the types listed below, so be sure to clarify
which cash flow term is being used.

Types of cash flow include:

Cash from Operating Activities – Cash that is generated by a company’s

core business activities – does not include CF from investing. This is
found on the company’s Statement of Cash Flows (the first section).

Cash Flow from Investing (CFFI) – CFFI represents the cash that’s
available after reinvestment back into the business (capital
expenditures).

Cash Flow from (CFFF) – This is a measure that assumes a company has
no leverage (debt). It is used in financial modeling and valuation.

Net Change in Cash – The change in the amount of cash flow from one
accounting period to the next. This is found at the bottom of the Cash
Flow Statement.
6.4.8 Related Numerical problem on interest and depreciation
Straight Line Depreciation
Example of Straight-Line Depreciation

Pensive Corporation purchases the Procrastinator Deluxe machine

for $60,000. It has an estimated salvage value of $10,000 and a
useful life of five years. Pensive calculates the annual straight-line
depreciation for the machine as:

1. Purchase cost of $60,000 – estimated salvage value of $10,000

= Depreciable asset cost of $50,000
2. 1 / 5-year useful life = 20% depreciation rate per year
3. 20% depreciation rate x $50,000 depreciable asset cost =
$10,000 annual depreciation

Declining balance method

Example: On April 1, 2012, company X purchased a piece of equipment

for Rs. 100,000. This is expected to have 5 useful life years. The salvage
value is Rs. 14,000. Company X considers depreciation expenses for the
nearest whole month. Calculate the depreciation expenses for 2012,
2013, 2014 using a declining balance method.

Useful life = 5

Straight line depreciation percent = 1/5 = 0.2 or 20% per year

Depreciation rate = 20% * 2 = 40% per year

Depreciation for the year 2012 = Rs. 100,000 * 40% * 9/12 = Rs. 30,000
 Depreciation for the year 2013 = (Rs. 100,000-Rs. 30,000) * 40% *
12/12 = Rs. 28,000

Depreciation for the year 2014 = (Rs. 100,000 – Rs. 30,000 – Rs.
28,000) * 40% * 9/12 = Rs. 16,800

Book value at
Book value at Depreciation
Year Depreciation rate the end of the
the beginning Expense
year
2012 Rs. 100,000 40% Rs. 30,000 * (1) Rs. 70,000
2013 Rs. 70,000 40% Rs. 28,000 * (2) Rs. 42,000
2014 Rs. 42,000 40% Rs. 16,800 * (3) Rs. 25,200
2015 Rs. 25,200 40% Rs. 10,080 * (4) Rs. 15,120
2016 Rs. 15,120 40% Rs. 1,120 * (5) Rs. 14,000

The depreciation table is shown below:

Depreciation for 2016 is Rs. 1,120 to keep the book value same as
salvage value.
Rs. 15,120 – Rs. 14,000 = Rs. 1,120 (At this point the depreciation
should stop).