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CHAPTER 1
INTRODUCTION TO ACCOUNTING & BAISCS OF JOURNAL
Introduction The Double Entry System of Book-keeping provides a basic frame-work for analysis of business transactions. If the accounting process is to generate valuable information, the transactions which have taken place during the accounting period must be recorded in a systematic manner. The business transactions are recorded in financial books or books of accounts.
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Accounting Cycle and Books of Accounts The process of accounting cycle consists of the following steps:1. Analysis of transactions from sources documents.2. Journalizing the transactions. 3. Ledger posting. 4. Balancing of each ledger account.5. Preparation of a Trial Balance.6. Recording of adjustment entries.7. Posting of adjustment entries.8. Recording of closing entries.9. Preparation of financial statements.
Source of Documents Every business transaction is recorded in the books of accounts on the basis of some documentary evidence which is called as a source documents or supporting documents or business paper or voucher. It is the first record prepared for a business transaction. The source document shows the data, the amount, the nature of business transactions and the person involved in its preparation. Following are some of the source documents:1. Cash Memo: This documents results from a cash transactions. When goods are sold or assets are sold for cash, the business unit receives cash and gives cash memos which provide detailed information about the transaction. Cash transactions are recorded in the books of account on the basis of cash memos.2. Bills or Invoice This document is prepared when business transactions are regarding purchase or sale of goods on credit. The invoice gives details of the transactions. The original invoice is sent to the customers who record purchases on this basis.
3. Receipt: This document is an acknowledgement of money. It is prepared in duplicate or with counterfoil. The original copy is given to the person who pays money. The duplicate copy or the counterfoil is the basis of record. It is signed by a responsible person in the office of the business man who receives cash.
4. Cheque: It is an instruction in writing signed by the drawer directing the bank to pay a certain sum of money to or to the order of a third person or to the bearer. A separate page is provided in the cheque book on which the drawer enters the details.
5. Pay-in-slip: This slip is used for depositing money in a bank. Counterfoil of the slip gives the details of deposits made.
6. Debit Note and Credit Note: Debit note indicate that a debit has been given in our books of accounts to the personal account to whom it has been sent.
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Credit note is a document which indicates to the businessman, to whom it is given, that his account has been credited in our books of accounts.
Books of Original Entry Business transactions are recorded in the books of original entry on the basis of source documents. The following chart shows the books of original entry and the books of final entry:
Books of Accounts
Books of Original entry Books of Final Entry
Memorandum or Journal Special Ledger AccountsWaste Books journals
Purchase Sales Purchase sales Bills Bills Cash Journal Day Day Returns Returns Receivable Payable Book Proper Book Book Book Book Book Book
A business has to record the various business transactions in the proper books of accounts to be kept by a businessman.
Definition of Journal
‘Journal’ is derived from the French word, “Jour” which means a day. Journal therefore, means a ‘daily record’. According to a Dictionary for Accountant written by Eric L. Kohler “A ‘Journal’ is the book of original entry in which are recorded transactions not provided for in specialized journals”. A Journal is a book of “Original entry” or “primary entry”. It is a book of daily record. First of all the business transactions are recorded in the “Journal” and subsequently they are posted in the ledger. In modern times, a journal is divided into various books known as “subsidiary Books”. To study “Book-keeping” one must learn first how to journalize the transactions. To journalize the transactions means to record the two-fold effects of a transaction in terms of debit and credit. This has to be done by observing the rules of debit and credit.
Features of a Journal:1. It is a book of prime, original or first entry.2. It records transactions in a systematic manner.3. It analyses the transactions into their debits and credits.4. It is a gateway to the ledger.
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Utility of a Journal: A journal is needed for the following reasons:1. It contains records of various transactions that take place every day.2. It provides a complete records of transactions as both the aspects of transactions are
recorded at one place.3. Since narration of a transaction is written in the Journal, there is no need to give an
explanation in the ledger.
Forms of Journal
The form of a Journal is as given below:
Date Particulars Voucher No.
L.F.
Debit Rs. Ps.
Credit Rs. Ps.
YearMonth
Date Name of the A/c.Debited Dr.The Name of the A/cCredited Cr.(Narration/Explanation)
Example: Journalize the following transactions:1997 Rs.August 1 Shri Rajan invested in business. 20,000
2 Opened an account with the Bank of India by depositing cash. 10,0003 Purchased goods for cash. 5004 Purchase machinery for cash. 8005 Cash purchase of goods. 3006 Cash sales. 900
15 Withdraw cash for personal use. 200 16 Purchased goods from Preetam & sons on credit. 600 25 Received cash on account from Ramanand. 350 26 Paid cash to Minakshi Bros. 250 29 Paid rent. 125 30 Received commission. 175 30 M/s Ram & sons returned goods. 100
Solution:Journal of Shri Rajan
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Example:
Date Particular L.F
Debit Rs.
Credit Rs.
1997Aug 1 Cash A/c Dr.
To Capital A/c (Being cash invested in business)
20,00020,000
2 Bank of India’s A/c Dr. To Cash A/c(Being cash deposited in bank)
10,00010,000
3 Goods A/c Dr. To Cash A/c(Being goods purchased for cash)
500500
4 Machinery A/c Dr. To Cash A/c(Being machinery bought for cash)
800800
5 Goods A/c Dr To Cash A/c(Being goods bought on cash basis)
300300
6 Cash A/c Dr To Goods A/c (Being cash received on account of sale)
900900
15 Drawings A/c Dr. To Cash A/c(Being cash withdraw for personal use)
200200
16 Goods A/c Dr. To Pritam & sons A/c(Being goods purchased on credit basis )
600600
25 Cash A/c Dr To Ramanand’s A/c (Being cash received from Ramanand)
350350
26 Minakshi Bros. A/c Dr. To Cash A/c (Being cash paid to Minakshi Bros.)
250250
29 Rent A/c Dr. To Cash A/c(Being rent paid)
125125
30 Cash A/c Dr. To Commission A/c(Being commission received)
175175
30 Goods A/c Dr. To M/s. Ram & Sons A/c(Being goods returned by M/s. Ram & sons) Grand Total Rs
100
34,300
100
34,300
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Journalize the Following Transactions In The Books Of Sudhir Kumar:
1997 Rs.Jan 1 Sudhir commenced business with cash. 40,000
3 Purchased goods for cash. 5005 Sold goods for cash. 3006 Purchased one motor car for cash. 15,0009 Sold machinery for cash. 9,000
11 Purchased a building on credit from Narendra. 20,000 15 Sold furniture on credit to Randhir Kapoor. 9,500 17 Paid cartage. 110 22 Received commission. 50 27 Cash Sales. 1,200 29 Cash Purchases. 600 30 Received on account from Ahmed. 350 31 Paid cash to Sunitkumar on account. 190
Solution:Journal of Sudhirkumar
Date Particulars L.F.
DebitRs.
CreditRs.
1997Jan. 1 Cash A/c Dr.
To Capital A/c (Being capital bought in business)
40,00040,000
3 Goods A/c Dr. To Cash A/c(Being goods bought for cash)
500500
5 Cash A/c Dr. To Goods A/c (Being goods sold on a cash basis)
300300
6 Motor Car A/c Dr. To Cash A/c(Being purchased motor car for cash)
15,00015,000
9 Cash A/c Dr. To Machinery A/c(Being machinery sold for cash)
9,0009,000
11 Building A/c Dr. To Narendra’s A/c(Being building purchased on credit)
20,00020,000
15 Randhir Kapoor’s A/c Dr. To furniture A/c (Being furniture sold on credit)
9,5009,500
17 Cartage A/c Dr. To Cash A/c
110110
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(Being cartage paid) 22 Cash A/c Dr.
To commission A/c(Being cash recd. for commission)
5050
27 Cash A/c Dr. To Goods A/c(Being goods sold for cash)
1,2001,200
29 Goods A/c Dr. To Cash A/c(Being goods purchased for cash)
600600
30 Cash A/c Dr. To Ahmed’s A/c(Being cash recd. on account from Ahmed)
350350
31 Sunitkumar A/c Dr To Cash A/c (Being cash paid to sunitkumar on A/c) Grand Total Rs.
190
96,800
190
96,800Example: Pass journal entries of the following transactions in the books of Rajesh: 1996 Rs. July 1 Rajesh commenced business with cash. 16,000
3 He bought goods as his capital in the beginning 4,0007 Sold goods to Dinesh on credit. 6,5008 Purchased a horse for cash. 3,100
17 Ramesh’s A/c which is over due is closed as the amount is not recoverable 700
20 Goods burnt by fire. 390 21 Receivable cash on account from Dinesh. 3,300 25 Goods distribution as free samples. 325 Solution:
Journal of RajeshDate Particulars L.
F.DebitRs.
CreditRs.
1996July 1 Cash A/c Dr.
To Capital A/c(Being capital brought in the business)
16,00016,000
3 Goods A/c Dr. To Capital A/c(Being goods brought as capital in the business)
4,0004,000
7 Dinesh A/c Dr. To Goods A/c
6,5006,500
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(Being goods sold on credit) 8 Livestock A/c Dr.
To cash A/c(Being a horse purchase for cash)
3,1003,100
17 Bad Debt A/c Dr. To Ramesh A/c(Being the amount written off as bad debts )
700700
20 Loss by Fire A/c Dr. To Goods A/c(Being loss occurred due to fire)
390390
21 Cash A/c Dr. To Dinesh A/c (Being cash received on account)
3,3003,300
27 Advertisement A/c Dr. To Goods A/c(Being goods distributed as free samples) Total Rs.
325
34,315
325
34,315
Explanatory Notes:1) Horse will be recorded in Live Stock A/c is maintained to record the animals
purchase for business2) Amount not recoverable from Ramesh means it has become bad. Hence, it should be
debited to bad debt account.3) Distribution of goods as free samples is done mainly for advertisement purpose.
Hence Advertisement A/c should be debited.
CHAPTER 2
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BASICS OF LEDGER AND TRIAL BALANCE
Features of a Ledger1) it is a derived or secondary record2) it is a book of final entry 3) it is a king of books of accounts.
Nature of Ledger A Ledger is a bound book. It contains many pages which are called folios. These pages are consecutively numbered. For each account a separate page is kept. Every ledger has an index. It is generally an alphabetic index. One page is allotted for each alphabet. All the accounts commencing with the particular alphabet are indicated on that particular page only. The page number on which that particular account appears is shown against the account in the Index. This facilitates immediate reference.
Standard form of Ledger Account Each ledger account is divided into two sides, having column of varying sizes. The left hand side is known as “ Dr”. side and the right hand side is known as “Cr” side of a Ledger account. The columns “ Date” , “Particulars”, “J.F” , “ Amounts” appear on both the sides of a ledger account. A specimen ‘T’ form a ledger account is as follows:
Dr. Name of A/c Cr.Date Particulars J.
F.Amt.Rs.
Date Particulars J.F.
Amt.Rs.
Year Month
To Name of Account Credited
Year Month
By Name of Account Debited
Running Balance form of Ledger Account An alternative form of a ledger which is generally adopted by commercial banks and some other business houses, is the running balance form. The entire ledger is divided into six column viz; 1. Date; 4. Dr. Amount; 2. Particulars; 5. Cr. Amount; and 3. Folio; 6. Balance. The specimen form is as under:Dr. Name of A/c Cr.Date Particulars Folio Dr.
AmountRs.
Cr.Amount
Rs.
BalanceRs.
Process of Balancing Ledger Account
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Trial Balance After posting the transactions to respective ledger accounts they are balanced and then a Trial Balance is drawn. A Trial Balance is a statement which shows the list of accounts showing debit balances and list of accounts showing credit balances. If double entry principle are strictly followed the total of all the debit balances must agree with total of all the credit balance. The Trial Balance is prepared as under:
Trial Balance as onDebit Balances Amt.
Rs.Credit balances Amt.
Rs.All real accounts All accounts of
expenses & lossesAll personal accounts
showing debit balances
Total Rs.
xxxx
xx
xx
All accounts of incomes and gains
All personal accounts showing credit balances
Total Rs.
xx
xx
xx Example:
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The following are your transactions:1997 Rs. Jan 1 Received cash from Sudesh 2,400
2 Bought goods for cash 1,2003 Sold goods to Sudesh on credit 170 4 Paid carriage on behalf of Sudesh 30
5 Invoiced goods to Sudesh 4006 Goods return from Sudesh 250
7 Goods bought for cash from Amin 310 8 Received cash on account from Sudesh 370 9 Sold goods to Raju for cash 930
Journalize the above transactions, post them to Cash A/c, Goods A/c and sudesh’s A/c and balance them. The closing stock was valued at Rs. 400.
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Example:Journalize the following transactions in a journal & post them to the ledger accounts:1997 Rs.June 1 Shri Mathur invested in the business Rs. 6,000 cash, Goods worth Rs. 3000 and a building worth Rs. 12,000
2 Borrowed from Bank 8,0003 Purchased goods for cash 5,0004 Sold goods on credit to Rana Pratap 3,0005 cash received from Rana Pratap 1,0006 Purchased goods on credit basis from Jeevan 6,0009 Sold goods on credit to Jeevan 3,000
10 Paid Salaries 1,500 16 Paid Office Rent 350 17 Received Commission 175 19 Paid salary of salesmen 110 20 Paid Commission 50 25 Paid on account to Jeevan 2,200 26 Received from Rana Pratap 690 27 Repaid loan to Bank 3,400 28 Sold Building for cash 3,900 29 Received on account from Rana Pratap 1,400 30 Paid carriage for Jeevan 220
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Solution
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Example Rama, the businessman entered into the following transactions with Krishna on the following dates. Drafts the ledger account of Krishna and balance the same:1997 Rs.Jan Opening debt of Krishna to Rama 100
3 Sold goods to Krishna to 100% trade Discount 1,1008 Krishna returned goods 1009 Sold goods to Krishna 200
Solution
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Example Record the following transactions in the Personal Account of Mr. Nath and balance the account at the end of each month:
1997 Rs. Sept 1 sold goods to Nath 542.50
4 Received from Nath Cash 515.38 allowed him account 27.12 15 Nath bought goods 600.00 18 Received from Nath Cash on account 200.00Oct 1 balance from last month 400.00 13 Sold goods to Nath 1000.00 21 Received from Nath Cash 396.00
Allowed his Discount 4.00 31 Received cash in full settlement of account 980.00
Solution
Example Prepare the Personal Account of Sriniwas from the following transactions:1997 Rs.Jan 1 debit balance on Sriniwas account 1000
2 Sold goods on credit to shriniwas 54006 Received from Sriniwas 63006 Allowed him discount 100
10 Shriniwas bought goods on credit 150015 Received cash from Shriniwas 145015 allowed him Discount 5020 Purchased goods on credit from Shriniwas 1,04025 Paid cash to Shriniwas 50028 Returned goods to Shriniwas 14031 Paid to Shriniwas in full settlement of his 390
account
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Solution
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CHAPTER 3
A. Bank / Cash Book
Introduction / Meaning / Importance / Characteristic / Advantages The cash Book is a Book of original entry. All the cash transactions are recorded in the cash book. Even credit transactions result in cash. Cash is either received to paid. This indicates that there is a need to maintain a separate book to record all such cash transactions. Maintain of the cash book achieved three purposes:
1. Recording all transactions pertaining to cash.2. Ascertainment of the balance of cash on hand and bank balance.3. Verification of correctness of cash and bank balance.
When a cash book is maintain there is no need of opening a separate Cash account in the ledger as the purpose of opening a Cash Book. Thus, the Cash book plays a dual role as a journal as well as a ledger.
Utility of Maintaining a Cash Book A cash Book is one of the subsidiary books. All the cash transactions are recorded in the cash book. Even the banking transactions can be recorded in the cash book. When the cash transactions are recorded in the cash book, it serves both purpose of being a book of original entry as well as a ledger. Since the cash book enables the trader to find out the daily cash and bank balance, it serves the purpose of a cash account. Therefore, there is no need to open a separate Cash Account in the ledger. Similarly, writing in the cash book serve a lot of time and labour by enabling recording of cash and bank transactions without passing journal entries. In any business firm, cash and bank transactions constitute a major portion of the entries and therefore, the cash book is very useful and results in economy of time and labour.
Types of Cash Books.
The following are the different types of Cash Book: 1. The single column cash book.2. The Double column cash book having two amount columns on each side as under:
a) Cash and discount columns b) Cash and banks columns c) Bank and discount columns
3. The Triple column cash book having cash, bank and discount columns on both the sides of the Cash Book.
4. The Multi column cash book having multiple columns on both the sides of the cash book.
5. The petty cash book.
Features of Cash Book The Cash book is just like a Cash Account. A Cash Book has two sides i.e. a Receipts side and a payment side. On the receipt side of the Cash Book all transactions pertaining to cash receipts are recorded and on the payment side, all transactions pertaining to cash payments
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are recorded. On recording receipts and payments on the respective sides of the cash book it is balanced and cash on hand and/or cash in the bank is ascertained.
Sources of Writing the Cash Book1. Receipt: A businessman has to issue an official receipt for the amount received from different parties. The original copy is given to the person who pays cash and the carbon copy is retained for office use on the basis of which the cash receipt is recorded on the receipt side of, the Cash Book.
Cash Memo Cash Memo is issued on cash sale. Cash Memo Book is printed. It contains cash memos in duplicate. The original copy of the cash memo is given to the customer who pays cash on account of cash sales. The carbon copy is used as an office copy of Cash Memo.
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The above form shows that the ruling of the Cash book is not similar to the subsidiary books. It is similar to the ruling of an account. Like an account it has two sides—the left hand side and the right hand side. The left hand side is known as the debit side and the right hand side is known as the credit side. The Dr. and Cr. Pages of the cash book must always face each other. However, there are business houses which keep altogether separate books for receipts and payments. The debit side of the Cash Book is meant for recording all the receipts and therefore, it is known as “Receipts side”. The credit side of the Cash Book is meant for recording all the transactions pertaining to payment and, therefore, it is known as “Payment side”. Every entry appearing on receipt side of the Cash Book commence by the word “To” and that appearing on payment side of the Cash book by the word “By”. After recording all the transactions in the Cash Book it is balanced daily or weekly or fortnightly or monthly. Balancing is deducting total payments from the total receipts and carrying forward the balance to the next day. The balanced carried forward is known as the closing cash balance whereas when it is brought forward to the next day, it is regarded as the opening balance. When the total of debit side of the Cash Book exceed the total of credit side, the balancing figure appears on the payments side of the cash book, as “By Balance c/d” on the next day, it is brought forward as an opening balance as “To Balance b/d” on the receipt side of the Cash Book. The Cash Book always shows a debit balance, because unless a trader has got cash he cannot spend more than that.
Posting of the Cash Book: In order to complete the double entry of each and every transaction that has been recorded in the Cash Book, posting of such transactions is to be made to the respective ledger accounts.
Double column cash book The double column cash book has two columns on both the sides of the cash book. This cash book can have two columns on the both the sides as under:
a) Cash and Discount Columns.b) Cash and Bank Columns c) Banks and Discount Columns.
However, of the three types of Double Column cash book, the most common cash book used is with cash and discount columns. Therefore, the cash book with cash and discount columns has been elaborated in the following pages:
Cash book with Cash and Discount Columns: In order to record cash discount allowed or received one additional column for “discount” is provided on both the sides of the cash book. Cash Discount: It is a discount allowed to customers as an inducement to make the payment immediately. Cash discount is closely related to cash receipt and cash payment. When cash is received, discount is allowed and when it is paid discount is received. Cash discount allowed is a loss to a businessman while cash discount received is a gain to him.
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Trade Discount: It is an allowance made by a wholesaler to a retailer in order to enable the retailer to sell the articles at list prices and earn a reasonable margin of profit. The amount of trade discount is deducted from the invoice, therefore, it has no connection as to the receipt and payment of cash. Hence ,trade discount does not appear in the books of accounts.
Difference between cash discount and trade discount:1. A trade discount is offered by the trader to a buyer as a reduction in the catalogue or
invoice price of the goods sold. However, a Cash discount is a reduction in the amount due from a debtor.
2. While a trade discount is offered by the manufacturer or wholesaler to a retailer, a Cash discount is offered by a creditor to a debtor.
3. The purpose of offering the trade discount by the manufacturer or a wholesaler to a retailer is to enable him to sale the goods at the invoice price and to have a margin or profit. The purpose of offering a cash discount is to induce the debtor to make an early payment.
4. A trade discount is offered unconditionally where as a cash discount is offered only on payment of the amount.
5. A trade discount does not figure in the books of both the parties where as a cash discount is accounted for either as a gain or as a loss.
6. The rate at which a trade discount is offered where is from trade to trade and one commodity to another. However, a cash discount is offered almost at the same rate in all kinds of trade, but the cash discount rate may vary depending on the period of credit.
7. A trade discount is usually predetermined where as a cash discount is not predetermined.
Balancing While balancing the double column cash book with cash and discount column, it is only the cash column which is be balanced. For this purpose, totals of the debit and the credit cash columns are made first. Normally, the debit total of the cash column will be larger than the credit total of the cash column. The excess of debit total of the cash column shows there is a debit balance in the cash book. Such excess will be recorded on the credit side of the cash book in cash column as “By Balance c/d” with the amount of balance being entered in the cash column. Then, the total of the debit and cash columns will be equal. The cash book will normally show debit balance or nil balance of cash. It can not show any credit balance of all. This is because the payments can never exceed the availability of cash i.e. inclusive of opening cash balance and the receipt during the period. The discount columns appearing on both the side of the cash book or not to be balanced. Instead, discount column on both sides of the cash book or totaled separately. The total of the discount column on the debit side of the cash book shows the total cash discount allowed during the period. Thus the discount column appearing on the receipt side of the cash book is meant for recording the discount allowed to the business parties from whom the payments are received. Therefore, the total of the discount column on debit of the cash book is posted to the debit of the ‘Discount Allowed Account’, in the ledger. On the contrary, the discount column on the payment side of the cash book is meant for recording the discount received from the business parties to whom payment is made. Therefore, the total of the discount column on the payment side of the cash book is posted to the credit side of the ‘Discount Received Account’ in the ledger.
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Posting of Cash Book:1. Cash Column: Debit the accounts mentions on the credit side as ‘To Cash Account’
with amount written in the cash column and credit the accounts mentions on the debit side as ‘By Cash Account’ with the amount written in the cash column.
2. Discount Columns: Debit the Personal Account concerned mentioned on the credit side as “To Discount Received Account” with amount mentions in the Discount Received Column, and credit the personal account concerned mention on the debit side as “By Discount Allowed Account” with the amount mention in the discount column o the debit side.
Example Enter the following transaction in a Simple Cash Book 1997 Rs.Jan 1 Cash at hand 5,000.00
3 Received form Teji 500.006 Received from Nandu 370.008 Paid to Mahesh on account 750.00
10 Made cash purchases 1500.00 17 Sold goods to Sathe for cash 350.00 20 Paid in to Bank 1000.00 22 Purchase furniture for office use 300.00 25 Received of interest on debentures 75.00 27 Paid electricity charges 25.00 29 Paid Rent 150.00 31 Paid salaries to staff 570.00
Solution:
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Example:Enter the following transaction in a Simple Cash Book:1999 Jan 1 Opening cash balance b/f Rs. 25,000
2 the proprietor introduced Rs. 15,000 as further capital 4 sold goods for Rs. 23,0006 Received interest Rs. 1,200 from Mr. Avinash.9 Paid Rs. Rs. 2000 to Mr. Ashok on account
12 Purchase goods for Rs. 15000. 17 Deposited Rs. 3000 in to bank 18 Paid commission Rs. 1200 to Mr. Kamalesh 22 Received Rs. 2500 from Mr. Ramesh. Withdrew Rs. 4000 from the bank for office use.24 The proprietor withdrew Rs. 1700 for his purpose use.26 Borrowed Rs. 15000 from Desai27 Purchased goods for Rs. 41,000 and paid Rs. 400 as carriage there on.31 Deposited in to Bank all cash in excess of Rs. 15,000
Solution:
Working Notes: Excess cash deposited at the end of the month is worked out as under:i) Balance cash before depositing cash into the bank = Total amount on receipts side – Total of amount on payments side = 85,700 – 64,300 = 21,4000ii) Cash deposited in to the bank = Balance of cash before deposit – Balance of cash after
deposit = 21,400 – 15,000 = Rs. 6,400
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Example:Enter the following transaction in a simple Cash Book and post the transaction in to the ledger 1999 March 1 opening cash balance Rs. 15,000.
3 Deposited in to bank Rs. 6,000.7 Cash purchases Rs. 7,500
10 Cash sales Rs. 1400014 Sold office furniture costing Rs. 12000 for Rs. 800015 Purchased new furniture for Rs. 20000 for office use 18 Withdrawn from bank cash Rs. 6500 for office use 19 Withdrawn cash Rs. 1500 for personal use 24 Paid salaries Rs. 2000, Rent Rs. 500 and electricity charges Rs. 15028 Received interest Rs. 1500 on our investment
Solution:
Working note: cash balance at the end of month is worked out as under:Balance of cash at the end = Total of receipts side-Total of payments side = 45,000 – 37,650 = Rs. 7,350
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Ledger Accounts
27
Double Column Cash Book
Example Enter the following transactions in a cash book with cash and discount columns and post them to necessary ledger accounts:1998Aug 1 Opening cash balance Rs. 40,000
4 Received Rs. 11,950 from Ms. Smita in full settlement of Rs. 120005 Received Rs. 14,800 from Ms. Sarmila and allowed her cash discount of Rs.1007 Cash sales Rs. 10,0008 Sold goods of Rs. 6,000 to Mr. Kiran @ 10% T.D. and 5% C.D, half of the
amount received and balanced 10 days later9 Purchase goods of Rs. 15,000 at 10% T.D and 8% C.D., from Mr. Mehta. 60%
cash payment is made at the time of delivery.12 Paid Rs. 5,700 net to Mr. Sadanand after earning a cash discount of 5% 16 Cash Purchases Rs. 40,00019 Received Rs. 2,600 from Mr. Kiran in full settlement of his account.24 Paid Rs. 5,300 to Mr. Mehta in full settlement of his account.27 Purchase furniture for Rs. 15,000 for office use.29 Deposited all the cash into the bank in excess of Rs. 5,000.
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Solution:
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30
Purchase A/c
Date Particular J.F.
Amount Rs.
Date Particulars J.F
Amount Rs.
998Aug 16 To Cash A/c 40,000
Furniture A/cDate Particular J.
F.Amt Date Particular J.
F.Amt
1998Aug.27 To Cash A/c 15,000
Bank A/cDate Particular J.
F.Amount Rs.
Date Particulars J.F
Amount Rs.
1998Aug 29 To cash A/c 3,463
Working note:Calculation of trade discount and cash discount
i) Transaction dated 8th Aug 1998 Invoice Price: Rs. 6,000 Less 10% T.D. 600 Net Sales Rs. 5,400 Accounting entry for sale of goods. Mr. Kiran A/c Dr. 5,400 To Sales A/c 5,400 Out of amount Rs. 5,400 only half of the amount is received i.e. on Rs.2,700, 5% cash
discount is to be calculated. It is calculated as under: Amount receivable Rs. 2,700
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Less: 5% C.D 135 Net amount received Rs. 2,565 Accounting entry for receipt of cash and cash discount allowed: Cash A/c Dr. 2,565 Discount A/c Dr. 135 To Mr. Kiran’s A/c 2,700
ii) Transaction dated 9th Aug 1998Invoice Price Rs. 15,000Less: T.D. @ 10% 1,500
Net purchase price: Rs. 13,50060% of the amount due paid in cash, i.e. 60% of 13,500 = 8,100.Cash discount @ 8% on Rs.8,100 is calculated as under:
Amount payable Rs.8,100Less: C.D.@8% 648Amount paid Rs. 7,452
iii) Transaction dated 12th Aug.1998
Amount payable =
=
=
Cash Discount =Amount payable – Net amount paid = 6,000 – 5,700 = Rs. 300.
Example:
Enter the following transactions in a two columns Cash Book with discount and cash columns, balance of the cash and post the transactions to respective ledger accounts:1999April 1 Started business with cash Rs. 1,40,000 and Bank balance Rs. 60,000.
2 Deposited Rs. 18,000 into the bank8 Sold goods for Rs. 40,000 less 10% T.D and 5% C.D.
14 Purchased goods for Rs. 35,000 less 10% C.D. 18 Received Rs. 11,930 from Mr. Patel in full settlement of Rs.12,000 22 Paid Rs. 18,000 to Mr. Suresh and earned from him a discount of Rs. 200 24 Received commission of Rs. 2,000 from Mr. Mehta. 26 Paid salaries Rs. 2,600 to staff 28 Withdrawn from bank Rs. 10,000 for office use. 29 Withdrawn from office Rs. 4,000 for personal use.
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30 Withdrawn sufficient cash from the bank to keep Rs.1,50,000 in hand.
Solution:
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Working Notes:1) Amount withdrawn from the bank at the end to keep Rs. 1,50,000 in hand, is
calculated as under: Balance of cash at the end = Total of Receipts – Total of payments = 1,98,130 – 74,100 = 1,24,030
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Amount withdrawn from bank at the end = Desired balance – Actual balance in hand = 1,50,000 – 1,24,030 = Rs. 25,9702) Calculation of trade discount and cash discount transaction dated 8th April, 1999. Invoice Price Rs. 40,000 Less: T.D. @ 10% 4,000 Net sales Rs. 36,000 Less: C.D. @ 5% on Rs. 36,000 1,800 Amount received Rs.34,200
Example Enter the following transactions in a double column cash book having cash and discount columns and balance the cash book. Also post the transactions to the respective ledger accounts.1997Aug 1 Opening balance of Rs. 11,000.00
2 Sold goods to Sunita Rs. 3,000 and received half of the amount in cash after allowing 5% cash discount.
7 Purchase goods for cash Rs. 2,700.009 Paid for office rent Rs, 600.00
15 Received cash on account of 10 shares of Hindustan Lever at Rs. 10 each 17 Paid to Malini Rs. 180 and received a discount of Rs. 20.00 20 Received from Gokhale Rs. 190 after allowing him a discount of Rs.10.00 25 Received for commission Rs. 180.00
29 Received from Nimkar Rs. 195 and allowed him a discount of Rs. 5.00 31 Paid into the bank cash in excess of Rs. 500.00
Solution:
35
36
Triple-column cash book (with cash, Bank and Discount Column): In modern times, banks play a prominent role in providing finance to industry, trade and commerce. Banks grant credit to industry, trade and commerce. With the expansion of business opening of a Bank account becomes a necessity. By opening an account with a Bank, a businessman gets many benefits. He can make the payment by cheque at a very nominal to keep a very heavy balance at hand which is risky. The Bank collects money on cheque deposited for collection. Similarly, the Bank collects interest on investments and makes payment on behalf of the customers as per his standing instructions. He can get an overdraft facility. Banks act as a source of information. It is due to the above advantages every businessman opens an account with a Bank.
Types of Deposits Accounts:The following are the three main types of deposits accounts:1. Fixed Deposit Account 2. Saving Deposit Account 3. Current Account
1. Fixed Deposit Account: In this account, a certain amount is deposited for a fixed period. Usually, the amount deposited in this account is not withdrawable before the expiry of a certain period for which the amount is deposited. However, the amount can be withdrawn but
37
the depositor has to loose the interest. Generally, those persons intending to earn income by way of interest open this type of account.
2. Savings Account: This type of account is convenient for those whose incomes are limited. The amount deposited in this account can be withdrawn once or twice a week. Interest at the prescribed rate is allowed on this account. This is the best account to encourage savings. Amounts from the account may be withdrawn by cheque, but for getting cheque facility the depositor has to keep a minimum balance in this account.
3. Current Account: This account is convenient to businessman, since the amount can be withdrawn any number of times during office hours. Normally, no interest is slowed on this account. However, some banks pay 1% or 0.5% interest on Current Bank Account. Therefore, Current Bank Account is the most suitable type of bank account for carrying out bank transactions through this type of account. A businessman opens and operates Current Bank Account to enjoy banking credit and other services rendered by bank to the account-holders. As such, a businessman does not maintain Current Account to earn interest but to avail of Bank credit and other banking services. It should be noted that the bank columns in the cash book imply Current Bank Account. On opening an account with a Bank, the bank obtains the specimen signature of the depositor and issues the following to the depositor,
a) A cheque Bookb) A Pay-in-slip Book.c) A Pass Book.
a) A Cheque: “A cheque is a written unconditional order drawn by the depositor on the Bank, asking it to pay a certain amount to a person named therein.” A cheque has three parties i.e. a Drawer, a Drawee, and a Payee. A Drawer is a person who draws a cheque. A drawee is a person on whom a cheque is drawn and a payee is a person in whose favour a cheque is drawn. A cheque may be a Bearer cheque or an Order cheque and a Crossed cheque. A bearer cheque is a cheque the amount of which is paid by the Bank to the person who bears it and present it to the bank. An order cheque is payable to the person whose name appear on the cheque or to the person under the order of the payee. Drawing two parallel lines across the face of a cheque is known as crossing. Crossing is essential for ensuring the safety of a cheque.
Form of cheque
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b) Pay-in-slip-Book: This book contains Pay-in-slips used either for deposit of cheque or cash in a Bank. All the details about the cash deposited are recorded in the slip. The slip is divided in two parts. The main form of the slip is retained by the Bank and the counter-foil remains with the depositor. Separate Pay-in-slip are used for depositing cash and cheque. The form of a pay-in-slip is as under:
Specimen of a Pay-in-slip:
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c) Pass Book: A Pass Book is an extract of a depositor’s account in the books of a Bank. It shows the amount deposited, amount withdrawn and the balance. The Pass Book is to be sent to the Bank for verification from time to time and it is made up to data.
Date Particulars AmountWithdrawn
Rs.
AmountDeposited
Rs.
Balance at the credit of the depositor
Rs.
SignatureClerk/Actt
Accounting Treatment of Banking Transactions in a Cash Book:
1. A cheque is received but not deposited in the Bank: every cheque received, so long as it is not paid into the bank, should be treated as cash and should be recorded in the cash column.
2. A Cheque is received and deposited in the bank on the same day: In this case, the amount of such a cheque should be entered on the receipt side of the Cash Book in the Bank column as “To XYZ”.
3. A cheque received on the previous day deposited into a Bank: In this receipt, a contra entry should be passed on the day on which the cheque is deposited in the bank. It will appear in the Cash Book on the receipt side as “To Cash” Bank column, and on payment side as “By Bank” Cash column
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4. Received a Crossed Cheque: The amount of Crossed cheque received should be entered in the Cash Book on the receipt side as “To XYZ” Bank column.
5. Payment by issuing a Cheque: Whenever payments are made by cheque they should appear in the Cash Book on the payment side as Party’s Account, Expenditure Account – bank column.
6. Endorsement of Cheque: A businessman can endorse the cheque in favour of the creditor in settlement of his account. In this case, it will appear in the Cash Book on the payment side, as “By XYZ” (Creditor) - cash column or Bank column.
Whether it should be entered in the cash column or the Bank column depends upon the nature of the cheque. The simplest method is to see the original entry of that cheque. If it is originally entered in the cash column on the receipt side, then after endorsement it should be entered on the payment side of Cash Book in the cash column. If it is originally entered in the “Bank Column” on endorsement, it should be entered on the payment of the cash book in the Bank Column.
7. Dishonour of cheque: A cheque received from the customer or a cheque issued to the creditors may be dishonored owing to certain reasons. Dishonour means refusal of payment by the Bank. Cheque may be dishonored on the following grounds:a) If it is defaced.b) If the signature on the cheque does not agree with the specimen signature.c) If the amount in words does not agree with the amount in figures.d) If the funds to the credit of the Drawer are insufficient,e) If a period of six mounts has expired from the date of drawing the cheque.
I. A cheque received from XYZ is dishonoured: In this case, we have to reverse the entry originally passed and have to pass the reverse entry on the payment side of the Cash Book. Supposing the cheque received from Raman for Rs. 300 is dishonoured. If it is entered in the Bank column of the Cash Book on the receipt side, on being dishonoured it will be entered on the payment of the payment side of the Cash Book in the bank column as “By Raman” Rs. 300 (in the bank column).
If it is entered on the receipt side of the Cash Book in the Cash Column, then on being dishonoured, the entry will be passed on the payment side of the Cash Book as “By Raman”….Rs. 300 (in the Cash Column).
II A cheque to Smita for Rs. 200 I dishonoured : Issue of a cheque to Smita will be entered on the payment side of the Cash Book. (The amount being entered in the Bank Column). On being dishonoured, the entry will be passed on the receipt side of the Cash Book as “To Smita”…Rs. 200 (the amount will be entered in the Bank Column).
8 Direct Deposit by Customers: If the amount due from customer is directly deposited by him in our Bank amount, on receiving the advice, it will be entered in the Cash Book on the receipt side, as “To Customer’s Account…” (the amount will be entered will be entered in the Bank Column).
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9 Collection of Interest on Investment by the Bank: A Bank collects interest on our investment or allows interest on our deposit. The credit entry of such a collection is made in the pass book by the Bank. On receiving advice or the Pass Book as “To interest on investment”. (The amount will be entered in Bank Column.)
10 Payments made by the Bank under our Standing Instructions: As per our standing instruction, a Bank makes payment on our behalf, on account of insurance premium, interest on loan taken, call money on shares, etc. On making such payments, the Bank passes a debit entry in the Pass Book. After receiving the advice or Pass Book, it is entered on the payment side of the Cash Book as “By Insurance Premium or By Interest” or “By calls on shares” as the case may be (The amount will be entered in the bank column).
11 Bank charges and Bank commission: A Bank charges some amount for the services rendered to the customers. The Bank makes a debit entry in the Pass Book. On receiving the Pass Book or intimation, it is entered on the payment side of the Cash Book as “By Bank charges” or By Commission… (The amount will be entered in the Bank column).
12 Transfer: a) Transfer of an amount from a Saving Account in the Bank to a Current
Account: Bank columns appearing on both the sides of a Cash Book indicate a Bank Current Account. If the amount is transferred from a Saving Account to a Current Account it will be entered on the receipt side of the Cash Book as “To Saving Account….” (The amount will be entered in the bank column).b) Transfer of an amount from a Current Account to a Saving Account: In this case, the entry will appear on the payment side of the cash book as “By Saving Account” (the amount will be entered in the bank column).
13 Contra Entries: Contra entries means such entries that are made on both the sides of the cash book. When cash or a cheque is paid into the bank, the cash balance in the office will be reduced and the bank balance will be reduced and the bank balance will be increased. In such a case, the Bank account is to be debited and the cash account is to be credited. Since, in the amount will be written in a bank column on the receipt side and also in the cash column on the payment side of the Cash Book.
The transactions affecting the Cash Account and Bank Account (either Cash Account or Bank Account debited or Credited) are recorded on both the sides of the Cash Book. As the Triple Column Cash Book consist of Cash Account and Bank Account. Ledger posting of such transactions is completed by recording them on both the sides of the cash Book. Entries passed to record such transactions in the Triple Column Cash Book are regarded as contra entries. Letter “C” is written in the “L.F” column of the Cash Book in order to identify such entries
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Cash Book(With Cash, Bank and Discount column)
Date Receipts R.No.
L.F.
Disc. Cash Bank Date Payment
V.No
L.F.
Disc Cash Bank
Example Complete Mr. Shastri’s triple column cash book for the month of Feb 1994 from the following information, indicating the cash balances available for the next month.1994Feb 1 Balance b/f – Cash Rs. 5,000/- and Bank Rs. 15,000/-
2 Cash purchased of Rs. 1,000/- using office funds were recorded.5 Mr. B, settle his account of Rs. 10,000/- enjoying 5% C.D., paying partly by a
cheque of Rs. 3,000/- which was banked.7 The cash amount received from Mr. B and retained in the office was used to pay
rent of Rs. 2,000/- and a supplier Mr. C, to whom Mr. shastri owned money.10 Mr. Shastri secured a loan from Union Bank of India of Rs. 15,000/- which
amount he banked.15 Mr. P’s total amount of Rs. 7,000/- was cleared by a cheque payment, but after
accounting for a 2% C.D, allowed by Mr. P.18 Mr.B’s cheque was returned by the bank with request to represent the cheque.19 Accordingly, Mr. B’s cheque was redeposited by Shastri.25 Goods worth Rs. 15,000/- were sold for complete payment in cash, half of which
was banked immediately.
Solution
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Example Record in a two column Cash Book the following transactions which took place on 25.1.1979 Opening balances as on that day were Rs. 200/- as office cash and Rs. 10,000/- in the bank.
I. The bank charged Rs. 4/- for a new cheque book.II. Paid Rs. 48/- by cheque for the yearly water tax.
III. Banked Rs. 650/- being the proceeds from cash sales of the day.IV. Proprietor took Rs.50/- for his personal use from the cash box.V. Cashier received and banked a cheque for Rs. 10,000/- drawn on the proprietor’s
persona; bank account to meet additional capital requirements of the business.VI. Cashier gave the required cash to the petty cashier to restore the imprest amount to
Rs. 150/-, after checking the petty cash expenses of the week, totaling Rs. 110/-. Balance the Cash Book.
Solution:
Example: From the following particulars prepare a Cash Book with Cash, Bank and Discount Columns:1997 Rs.April 1 Cash on hand 200.00
2 Bank overdraft 3,000.003 Issued a cheque in favour of Ramchandra for Rs. 2,500/-
in full settlement of Rs. 2,600/-5 Received a cheque from Somesh for Rs. 3,250 in full
settlement of Rs. 3,300 and deposited the cheque into bank.7 Received an advice from the Bank starting that the Bank
Has paid Rs.250 on account of Insurance premium.9 Paid to petty cashier 100.0011 Made cash sales 3,500.00
and Cash purchases 900.0015 Purchased machinery for Rs.7,000 the amount
Being paid by cheque
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19 Direct deposit by Zaveri 4,800.0026 Received Crossed cheque from Pritam for Rs. 2,000/- in full settlement of Rs. 2,20028 Paid office expenses 300.0029 Paid office rent by cheque 350.00
Solution:
Example: Enter the following transactions in a Cash Book with Cash, Bank and Discount Columns and Balance the Cash Book:1997 Rs.Sept 1 Cash in hand 2,430.00
1 Balance at Bank 4,500.002 Received from Vinayak cash Rs.1,250 and a cheque
of Rs. 450 on account 3 Paid by cheque to Babul Rs. 350 in full settlement of
Rs. 3704 A cheque received on 2nd Sept. deposited in the Bank.5 Cash sales 890.006 Deposited in the Bank 500.007 Purchased goods from Mr.Unrellable for cash. 1300.008 A cheque received from Vinayak retuned dishonoured 450.009 Received from Sita a cheque for Rs. 2,100
In full settlement of her account of Rs. 2,200 and endorsedthe said cheque in favour of Rita in settlement of her account of Rs.2,150.
10 Transferred Rs. 7,000 from Saving Bank Account toCurrent Account in the bank.
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12 Bank commission debited by the Bank in the Pass Book Rs. 17 As advice received from the bank stated that:
a) Trustworthy has directly deposited Rs. 3,500 in our bank account. b) The Bank has collected interest on Investment Rs. 250. c) As per the standing instruction, the bank has paid on account of Insurance premium Rs. 300.
16 Purchased goods for cash Rs. 900 and received a Discount of Rs. 30.
17 Paid for salaries 5000.00 18 Paid for sundry expenses 30.00 19 Drew by cheque Rs. 450 for office use and Rs. 150 for personal use.
20 Deposited in the bank all cash in excess of Rs. 500.
Solution:
E
xample:
46
1997April 1 Balance of cash in hand Rs. 6,000, Bank overdraft Rs. 8,000.
4 Brought additional capital in cash Rs. 10,000.5 Deposited Rs. 7,500 into bank.6 Cash sale of goods Rs. 4,2007 Cash received from Deodas Rs. 10,800 and C.D. allowed Rs. 20010 Paid cash to Karamji Rs. 8,900 and C.D. received Rs. 100.11 Commission paid to agent Rs.85014 Purchased office furniture from Ram and Sons on credit Rs. 21,50015 Paid rent Rs.650 through cheque.16 Drew cheque for personal expenses Rs.84017 Cash sales Rs. 3,20020 Cash purchase Rs. 5,50021 Deposited Rs. 4,000 in bank.22 Drew Rs. 3,000 for office use from Bank.23 Received cheque for Rs. 1,000 from Vivek and deposited into the Bank.24 Received a crossed cheque of Rs.560 towards dividend.25 Received a cheque of Rs.1,350 from Laxman 26 Cheque received from Laxman deposited in the bank.26 Cheque of Rs.350 received from Ramdhan.27 Received a cheque of Rs. 1,300 received from Jaya and deposited in bank.29 Cheque received from Jaya dishonoured.29 Issued a cheque of Rs.1,150 from Aniket and received discount of Rs. 50.30 Deposited cash in the Bank Rs. 10,000.
Solution:
Example:
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Mr. Gajendra operates two bank accounts both of which are maintained in the columar Cash Book itself. You are required to drew up a Cash Book with necessary columns and show how the following transactions relating to 28th Feb 1997 will appear therein and does the Cash Book for the day:
1 Opening balance Rs.Cash 150Bank of Baroda 11,240 (Overdraft)Overseas Bank 35,460
2 Received a cheque for Rs.1,250 in respect of sales for realizing which the Bank of Baroda charged Rs. 2 and credited the balance.
3 Purchased goods for Rs.13,210 and cheque issued on the Overseas Bank. The Bank charged Rs. 3 for collection of the cheque to the concerned party.
4 Paid office expenses of Rs. 45 and Rs. 15 for stationery.5 Out of cash sales of Rs.13,625 a sum of Rs. 10,000 was deposited in the Bank of
Baroda.6 Credit purchases of Rs. 15,000 were made from Mr. Sandy who sent the documents
relating to the goods through the Overseas Bank for 90% of their value. The bank charged Rs. 115 for realizing the documents.
7 Withdraw Rs. 5,000 from the Overseas bank8 Deposited Rs. 5,000 in bank of Baroda.9 A bill receivable for Rs. 1,000 was discounted with the Overseas Bank which
charged 1% towards discounting.10 A demand draft was purchased for Rs. 3,000 from a bank after paying Rs.2 towards
their charges and paid to BSES deposit.11 Interest of Rs.122 and Rs. 50 was credited and debited respectively by the Overseas
Bank and Bank of Baroda.12 An amount of Rs. 1,500 was withdrawn from the Overseas Bank and salaries paid to
their extent.13 Manager’s salary of Rs.1,000 was paid by cheque drawn on the Bank of Baroda.14 Overseas Bank collected dividends of Rs.1,250 and sent a credit note.15 An amount of Rs.1,500 was transferred from the Overseas Bank to the Bank of
Baroda.Solution:
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Petty Cash Book: A businessman, who deposits all receipts (either by Cash or by cheque) into the Bank and makes all payments by means of issuing cheque, maintains a Petty cash Book. The term ‘Petty’ is derived from the French word, ‘Petit’ which means small. So this book is maintained for recording petty expenses as all payments (small payments) cannot be made by cheque. Payment of coolie charges, cartage, taxi fare and such other expenses cannot be made by issuing cheque. Therefore, petty cash book is maintained to record the payment of such expenses by cash.
Types of Petty Cash Books:Following are the two types of petty cash books:
a) Simple Petty Cash Bookb) Columnar Petty Cash Book.
a) Simple Petty Cash Book: A Simple Petty Cash Book is identical with a Cash Book. It has two sides viz. a receipt side and a payment side like a Cash Book. This type of Petty Cash Book is less useful. Therefore, many traders do not use this type of Petty Cash Book. A specimen form of a Simple Petty Cash Book is given below:
AmountReceived
Rs.
Cash BookFolio
Date Particulars VoucherNo.
LedgerFolio
AmountPaidRs.
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A simple Petty Cash Book is written on the lines of a Cash Book. There is only one amount column for recording all petty cash payments. There is no separate column for recording all classes of petty cash payments.
1. The “Amount Received” Column is used for recording the amount received form the cashier by the petty cashier.
2. The “Cash Book Folio” column is used for recording the page number of the cash where the payment of the petty cashier is made by the cashier.
3. The “Date” column which is common to both the “Receipt” and “Payment” side is used for writing the date of the receipt of an amount by the petty cashier on the “receipt” side and the date of payment on the “payment” side.
4. Similarly, the “Particulars” column which is common to both the sides is used for recording the particulars of Receipts and Payments.
5. The “Voucher Number” column is used for recording the Number of the voucher obtained by the petty cashier while making the payment.
6. The “Ledger folio” column is used for writing the page numbers of the ledger on which the particulars ledger account ism maintained.
7. The “Amount Paid” column is used for recording the amount paid for a particular class of expenditure.
The following illustration will make it clear how a simple petty cash book is written.
Example:Enter the following transactions in a simple petty cash book:1993Jan 1 Received cheque for Rs. 200 from the Head Cashier.
4 Paid Postage Rs.108 Paid taxi fare Rs.1510 Paid wages Rs. 2522 Paid for purchase of stationary Rs. 3525 Paid coolie charges Rs. 7031 Purchased revenue stamps Rs.30.
Solution:
b) The Columnar Petty Cash Book (Analytical Petty Cash Book): This type of Cash Book has two sides. The left hand side is used for recording receipts of Cash or cheque from
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the Chief Cashier. This part is very small as compared to the right hand side of the petty cash book. The right hand side is meant for recording payment. The payment side is ruled in suitable columns. A separate column is provided for recording a particular items of expenditure, i.e. Postage, Stationary, Traveling, Advertisement etc. In addition to it, a separate column for ledger is also provided for recording payment made on account of personal accounts or impersonal accounts. Payment made on a personal or impersonal account is entered in the Ledger column and posted item wise in the respective ledger account. A specimen from of the analytical or Columnar patty cash book is given below:
Receipt Date Particular V.No.
TotalRs.
PostageRs.
TravelingRs.
StationaryRs.
Misc.Exps.Rs.
L.F.
LedgerA/cRs.
When the amount is received from Chief Cashier, it is entered on the receipt side of the petty Cash Book and when payments are made, they are first entered in the total column of the petty cash book and then transferred in the respective column of expenditure. At the end of a certain period, the expenditure columns are totaled. The petty cashier prepares a statement stating the summary of expenses paid and submits it to the Chief Cashier for incorporation in the main Cash Book. The main cashier passes an entry in the journal as: Expenses A/c Dr. To Petty Cash A/c The totals of each head of expenditure are posted to the debit side of the respective accounts in the ledger so that the double entry is complete. Points to be remembered while preparing Analytical Petty Cash Book. 1. Ink pad, paper, pencil gum, pins, envelopes etc have to be entered in “Printing and
Stationary’ column. 2. Postage stamps, revenue stamps, telephone charges, telegram charges, cable charges,
post cards have to be entered in, “Postage and Telegram” column. 3. Cartage, carriage and fright should be entered under “Carriage” Column. 4. Taxi fare, train fare, bus fare, conveyance charges will be shown under, “Traveling and
conveyance expenses” column. 5. Refreshments and entertainment expenses should be entered under. ‘entertainment
Expenses’ column. 6. Tips office clearing packing charges, subscription to newspaper, may be put under,
“Sundry Expenses” column. 7. Small payment made to persons on account and small payments made for purchase of
some assets have to be entered under “Ledger A/c” Column.
Example:
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From the following particulars, prepare the petty cash book having analysis columns. Pass journal entry and prepare ledger accounts:1993 Rs.May 1 Received from chief cashier 200.00
3 Paid for postal stamps 20.005 Paid Telephone charges 8.006 Purchased pencil 5.007 Purchased revenue stamps 20.009 Paid for conveyance of the Manager 15.0010 Paid to Narendra 50.0014 Paid for advertisement 25.0015 Purchased files 15.00
Solution:
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Imprest System of Petty Cash Book: The most popular system of Petty Cash Book is the imprest system under this system, the cashier advance a certain amount to the Petty Cashier at the beginning of a fixed period e.g. a month or a fortnight or a week. This advance given to the Petty Cashier for meeting small expenses is called “Float”. The amount of float is fixed in such a way that the amount is enough to meet the petty expenses for a certain period. At the end of a certain period, the Petty Cashier submits the account to the Chief Cashier. On receiving the account from the petty cashier, the Chief Cashier scrutinizes it, and sends an amount equal amount spent for meeting petty expenses of the next period. As such the petty cashier beings the next period with the fixed amount of float. Advantages of the Imprest System: The imprest system has got many advantages over the other system. The advantages are given below:1. The record of petty cash is checked periodically. Therefore, mistakes, if any, in recording
the transactions can be rectified immediately.2. The Petty Cashier is not allowed to have idle cash in hand. If it found that the float is
more than adequate, it will be immediately reduced.3. Chances of cash being misused by the petty cashier are reduced.
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4. The regular check of the petty cash book creates a sense of responsibility in the petty cashier.
5. The main cash book is not unnecessarily clogged with large number of small items.6. The chief cashier is relieved from the botheration of petty disbursements.
Owing to the above advantages the Imprest System has become very popular in modern business houses.
Example:From the following particulars prepare the petty cash book having Analysis columns with suitable heads of expenditure. Adopt the imprest system 1997 Rs.April 1 Drew from Bank 100
2 Postal stamps 43 Telegrams 24 Paid for advertisement 256 Paid for cleaning 39 Purchased pencil, paper and ink bottles 1110 Paid to John on account 1513 Paid for telegram 314 Purchase postal stamps 215 conveyance 5
Solution:
Example: Enter the following transactions in an Analytical Petty Cash Book under the Imprest System and balance it.1997 Rs.March 1 Received a cheque towards petty cash 300
Paid cartage 20
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5 Paid taxi fare 3010 Purchased stationary 2015 Postage and Telegrams 2320 Wages paid 1825 Postage stamps 2628 Paid for repairs to chairs 2429 Sent subscription for news paper 4630 Refreshment to customers 4031 Paid Rajan in settlement of his account 15
Solution
(B)
CASH/BANK BOOK AND BANK RECONCILIATION STATEMENTS
1. Meaning and definition of Bank Reconciliation Statement: Just as a trader keeps a record of his transactions with the bank, so does the bank keep a record of its transaction with him, and periodically supplies him with a copy of this record i.e. record of trader’s A/C in the Bank’s ledger, in the form of either a Pass Book or a bank Statement. Normally, one would expect these two records i.e.. the Cash Book records and Pass book records to show the same balance. But in actual practice, it is seldom, if ever, that these two balances are the same. Hence, a trader frequently prepares a statement, called bank reconciliation statement to reconcile the two balances and explain the reasons for the difference between them. Thus, a statement which is prepared by the trader , usually at the end o0f every month to explain the causes of difference between balance shown by the Cash Book under Bank column and balance shown by the pass Book, is called Bank Reconciliation Statement. Note that, the Bank Reconciliation statement does not correct or alter either the Cash book or the Pass Book balance but merely explains why the two balances are different and also helps to detect errors and omissions, if any.
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2. Need and importance of Bank Reconciliation Statement : Need and importance of Bank Reconciliation statement are explained below ;
(i) By studying the bank reconciliation statement, an account holder or businessman understands the actual balance position with the bank.
(ii) It helps to detect errors and omissions if any, committed in the Cash Book as well as in the Pass book.
(iii) It explains the causes of difference between the balance shown by the cash Book under the bank column and the balance shown by the bank Pass Book, which increases faith and gains confidence of the account holders.
(iv) It helps to prevent mistakes and frauds in recording the banking transactions have become very common in the business.
3. Reasons of Disagreement : The usual reasons for the difference between the Cash Book balance and the corresponding Pass Book balance are explained below :
(1) Cheque deposited but not cleared: As soon as the trader deposits a cheques into his Bank A/C, he debits the bank column of his Cash Book, so that the bank balance shown by it is increased. But, his Pass Book balance will not be increased until the cheques is cleared, realised or collected. In the meanwhile, (after the cheques has been deposited but before it is cleared), the Cash Book balance will be more than the Pass book balance.
(2) Cheques deposited but dishonoured : Sometimes, a cheques deposited into the his Bank A/c by the trader may bounce or be dishonoured, in which case the bank makes a record on both side of the Trader’s A/c that is,on the credit side to show the deposit and again on the debit side to show the subsequent dishonour. Now, the trader will not naturally learn of the dishonour till a later date, when the dishonoured cheques is return to him. In the meanwhile, therefore,his Cash Book will show only the deposit but not the subsequent dishonour, with the result that the Cash Book balance will be more than the Pass Book balance.
(3) Cheques issued but not encashed : As soon as the trader issues a cheque, he credits the bank column of his cash book so that the bank balance shown by it is reduced, But his Pass book balance will not be reduced until the cheques is presented for payment and encashed . In the meanwhile, (after the cheques has been issued but before it is encashed), the Book balance will be less than the Pass Book balance.
(4) Cheques issued but dishonoured or lost: As seen in the above paragraph, as soon as cheques is issued, the bank balance shown by the Cash Book is reduced. Now, if the cheque issue by the trader is dishonoured by the bank or lost by the payee(and therefore not presented by him),the bank does not naturally make a payment on it, with the result that the Pass Book balance is not reduced. Thus, when a cheques issued is dishonoured and lost, the Cash Book balance is less than the Pass Book balance.
(5) Bank charges and commission: As and when the bank renders a service to the trader, or periodically, it debits the trader with the charges or commission for such service and reduces the balance on his account. The trader naturally will not record such charges or commission till he learn of them on a later date, when he receives a Bank Statement or gets his Pass Book filled in. In the meanwhile, (after the
56
commission or charges have been debited by the bank but before they are recorded by the trader), the cash Book balance will be more than the Pass book balance.
(6) Interest credited by bank: Once every six months, the bank generally credits the trader with the interest earned by him and increases the balance of his account. The trader naturally will not record such interest or bank balance till he learns of it at a later date, when its gets his Pass book filled in or receives a Bank Statement. In the meanwhile, (after the interest has been credited by the bank but before it is recorded by the trader), the Cash Book balance will be less than the Pass Book balance.
(7) Interest debited by bank : If instead of a bank balance or a balance in favour of the trader, there is a bank overdraft or a balance in favour of the bank , the bank will periodically debit the trader with the interest charged and increase his overdraft. The trader will not naturally record such interest on bank ovrerdraft till he learns of it. In the meanwhile, (after the interest has been debited y the bank but before it is recorded by the trader), the Cash Book overdraft will be less than the Pass Book overdraft.
(8) Direct deposits, collection and transfer from other accounts: Sometimes, a customer directly deposits money into the trader’s bank account and inform him of such deposit on a later date. Again, at times the bank may collect interest, dividends, pension or other amounts on behalf of the trader or may credit him for items like interest on fixed deposit or transfer of an amount to his current account from some other account. In each such case, the bank credits the trader and increases the balance on his account. The trader naturally will not record such deposits, collection, direct credits or transfer till he learns of them. In the meanwhile, (after the deposit, collection, transfer from some other account has been made but before it is recorded by the trader),the Cash Book balance will be less than the Pass Book balance.
(9) Direct payments, direct debits and transfers to other accounts: Sometimes, under standing instructions from the trader, the bank may make on his behalf certain periodic payments like municipal taxes, insurance premiums, electricity bills or telephone bills. Or again, the bank may debit him for items like dishonour of a bill, discounted or transfer of an account from his current account to some other account. In each such case, the bank debits the trader and reduces the balanceon his account. The trader will not naturally record such direct payments, direct debits or transfers till he learns of them. In the meanwhile, (after a direct payment, a direct debit or a transfer to some other account has been made but before it is recorded by the trader), the Cash Book balance will be more than the Pass Book balance.
(10) Mistakes : Overcasting (obtaining or showing a total larger than the correct one), undercasting (obtaining or showing a total smaller than the correct one) and/or other mistakes in the Cash Book, the Pass Book or both will obviously result in the Cash Book’s showing a larger or smaller balance than the Pass Book ( unless two or more mistakes compensate, offset or counterbalance one another).
4. Pro forma of a Bank Reconciliation Statement : A pre forma of a Bank Reconciliation Statement is given as under :
57
Bank Reconciliation Statement as on ……………..
Notes: (1) The Bank Reconciliation Statement is always as on a particular date. (2) It begins and also ends w3ith either a balance or an overdraft.
(3) If it begins with the Cash Book, it ends with the pass Book and conversely, if it begins with the Pass Book, It ends with the Cash Book.
5. Meaning of Bank balance and a bank overdraft :
(1) Bank balance : A Bank balance is represently by a debit balance in the Cash Book or a credit balance in the pass Book, and shows the amount due to the depositor by the bank.
(2) Bank Overdraft : A Bank overdraft, on the other hand, is represented by a credit balance in the Cash Book or a debit balance in the Pass Book and shows the amount due by the depositor to the bank.
6. Formulae to be used for preparation of the bank reconciliation statement : The following formula should be used when the debit balance (bank balance) as per Cash Book is given :
Add : (1) Cheque issued but not presented for payment.(2) Direct deposit made by a customer/debtor in the Bank account.(3) Interest and dividend collected by bank and credited pass Book only.(4) Interest on deposit credited by the bank in the Pass Book only.(5) An account of Bill of Exchange collected by the bank and credited in the Pass
Book only.
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Particulars Rs. Rs.
Balance/overdraft as per Cash/Pass BookAdd : 1. ………………………………………………. …… ….
2. …………………………………………….... ……3. ……………………………………………… ……4. ……………………………………………… ……5. ……………………………………………… …… …..
Less : 1. ……………………………………………… …… …..2. ……………………………………………… ……3. ……………………………………………… ……4. ……………………………………………… ……5. ……………………………………………… ……6. …………………………………………….... …… …..
_______ Balance/Overdraft as per Pass/Cash Book ….. _______________
Less : (1) Cheques deposited in the bank but not realised or cleared.(2) Dishonour of cheques or dishonour of Bills Receivable discounted debited in
the Pass Book only.(3) Bank Commission or charges debited by bank in the Pass Book only.(4) Insurance premium and/or electricity charges paid by the bank and debited
only in the Pass book.(5) Interest on overdraft charged and debited by the Bank in the Pass Book only.
Note : (1) The above formula should be applied when t6he overdraft or credit balance as per Pass Book is given. (2) The above formula should be reversed (i.e. item Nos. 1 to 5 given in the ‘Add’ list should be taken as ‘Less’ and items No. 1 to 5 given in the ‘Less’ list should be taken as ‘Add’) and applied when the credit balance (Bank balance) as per Pass Book is given, or when debit balance (Overdraft) as per Cash Book is given.
Prepare a Bank Reconciliation Statement as on 30th June,1999 from the following details :
1. Balance as per Cash Book: Rs. 15,000.2. Cheque deposited but not cleared: Rs. 2,000.3. Cheque issued but lost: Rs. 3,000.4. Interest credited by bank: Rs. 1,400.5. Direct Payment for electricity charges: Rs. 500.6. Cheque deposited but dishonoured: Rs. 6,000.7. Commission charged by Bank: Rs.170.8. Cheque issued in June but encashed in July: Rs. 8,000.9. Dividends collected by bank: Rs. 1,900.10. Transferred Rs. 4,000 from fixed deposit A/c to current account, not recorded in
the Cash Book.Solution:
Bank Reconciliation Statement as on 30 th June,1999Particulars Rs. Rs.
Bank balance as per Cash Book Add : (1) Interest credited only in the Pass Book 1,400 (2) Dividends collected by bank and credited only in the Pass Book 1,900
(3) Transferred an amount from fixed deposit acco- unt to current account only recorded in the Pass
Book 4,000 (4) Cheque issued and lost. It is recorded only in
Cash Book 3,000 (5) Cheque issued but not represented for payment till 30th June 1999 8,000 18,300
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33,300Less : (1) Electricity charges paid by the bank and record-
ded only in the Pass Book 5,000 (2) Cheque deposited and dishonoured by the bank but dishonoured cheque debited only in the Pass Book 6,000 (3) Commission charged and debited by the bank
only in the Pass Book 170 (4) Cheque deposited but not cleared 2,000 8,670 Bank balance as per Pass Book 24,630
Working Notes : (1) In order to find out items to be added to and items to be subtracted from statement following books of accounts are prepared :
Cash Book Pass BookDr (with bank column ) Cr. Dr. Cr.Item No. Rs. Item No Rs. Item No. Rs. Item No Rs.1.Bank balance
(4)(9)(10)(+)
15,0001,4001,9004,000
(5)(6)(7)(-)
5006,000170
(3)(8)
(+)
3,0008,000
(2)
(-)
2,000
(2) Item no. 4 is recorded on the credit side of the Pass Book on collection of interest by the bank, but it was not recorded in the Cash Book. Now we have recorded it on debit side of Cash Book. Item No. 5 recorded by the bank on the debit side of the Pass Book on payment of electricity charges. It’s corresponding credit was not given the Cash Book. Now, we have credited Cash Book. In this way, we have recorded all the items given in the problem.
(3) Since opening position appears on the debit side of the Cash Book all entries appearing on debit side of the Cash Book and debit side of Pass Book (i.e. item Nos. 4,9,10, 3 and 8) will be added to the reconciliation statement and all enteries appearing on opposite side (i.e. on credit side) of cash Book and Pass Book (i.e. item Nos.5,6,7 and 2) will be substracted from the reconciliation statement.
Note: Students are not expected to prepare working notes unless they asked to prepare working notes. However, working notes are prepared here for better understanding of students.
Prepare a Bank reconciliation Statement as on 30th September1998, From the following details :
1. Balance as per Pass Book: Rs. 17,000. 2. Direct payment of proprietor’s life insurance premium: Rs. 1,200 by the bank.
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3. Cheque issued but not encashed: Rs. 3,000.4. Cheque deposited but not cleared: Rs. 4,000.5. Interest credited by bank: Rs. 500.6. Cheque issued but dishonoured: Rs. 6,000, dishonour of cheque is not recorded in the
Cash book.7. Direct deposit by a customer: Rs. 7,000 into our bank account.8. Bank incidental charges: Rs. 800 debited in the Pass Book.9. Interest credited by bank in August but recorded in the Cash Book in September : Rs.
300.10. Cheques deposited but dishonoured : Rs. 9,000.11. Cheques issued in August but encashed in September : Rs. 1,000.12. The total of the debit side of the bank column in the Cash Book was short by Rs.600.
Bank Reconciliation Statement as on 30th September, 1998
Particulars Rs. Rs.
Bank balance as per Pass BookAdd : (1) Insurance premium paid and debited only in the
Pass Book (2) incidental charges debited by the bank only in the
Pass Book. (3) Cheques deposited and dishonoured, but dishonour of
cheques not recorded in the Cash Book. (4) Cheques deposited but not cleared
Less : (1) Interest credited by the bank in the Pass Book only (2) Cheque issued and dishonoured but dishonour of cheque
not recorded in the Cash Book. (3)Amount deposited by customer into bank but not
recorded in the Cash book (4) Debit side of the bank column in the Cash Book was cast
1,200
800
9,0004,000
500
6,000
7,000
17,000
15,000
32,000
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short now corrected (5) Cheque issued but not encashed
Bank Balance as per Cash Book
6003,000
17,000
14,900
Working Notes: (1) Since the Bank Reconciliation statement includes only those items which appear before the reconciliation date in only one of the two books, Cheques issued in August and encashed in September will not appear in the Bank Reconciliation Statement prepared on 30 th September 1998. (2) Similarly, interest credited by the bank in August ’98, but recorded in the Cash Book in September ’98 will not appear in the Bank Reconciliation Statement as on 30 th September ’98, as it appears before the reconciliation date in both the Cash Book and the Pass book. (3) Cash Book with bank column and Pass Book are prepared to find out items to be added to and items to be subtracted from the Statement
Cash Book Pass BookDr (with bank column) Cr. Dr. Cr.Item No. Rs. Item No Rs. Item No. Rs. Item No Rs.
(5)(6)(7)(12)(-)
5006,0007,000600
(2)(8)(10)
(+)
1,2008009,000
(3)
(-)
3,000 Bank Balance
(4)
(+)
17,000 4,000
Example:Preparation of Bank Reconciliation Statement from the extracts of Cash Book and Pass Book given for a single common and concurrent period ending with the reconciliation date.(i) From the following extracts of the Cash Book with bank column and Pass Book, prepare
a ban Reconciliation Statement:
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Solution:
Working Notes : (1) When Cash Book and Pass Book extracts both refer to a single common and concurrent Period, then ignore common entries and consider only uncommon entries and consider only uncommon entries for Bank Reconciliation Statement.(2) You can start with either Cash Book balance or Pass book balance. If you start with Cash
Book balance, then your answer must be tally with the balance shown by the Pass Book.(3) Cash Book with bank column and Pass Book are prepared to find out items to be added to
and items to be subtracted from the statement. Cash Book Pass BookDr (with bank column) Cr. Dr. Cr.Item No.
Rs. Item No Rs. Item No. Rs. Item No Rs.
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Balance
(23)(26) (+)
5,0001,200
(20)
(30)(10)(-)
170
850
(25)
(27)
(+)
6,500
8,000
(18)
(26)
(-)
5,000 10,000
Example:Where the Cash Book and the Pass Book extracts refer not to a single common and concurrent period but to two consecutive and successive periods with one extract ending with the and the other beginning with the reconciliation date.
(1) From the following extracts of the Cash Book and the Pass Book prepare a bank Reconciliation Statement:
Solution:
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15,800
Working notes : As the extracts of the Cash Book and the Pass Book are given for two consecutive and successive periods, (i.e. extracts of Cash Book for Dec.1998 and extracts of Pass Book to find out items to be added to and items to be deducted from the statement :
Example:
Miss Reshma’s Cash Book shows overdraft of Rs. 12,000 on 31st December, 1998, from the following details, find the balance shown by her Pass Book:
(1) Out of cheques for Rs. 17,000 deposited in December, cheques for Rs. 11,000 were cleared up to 31st December and a cheques for Rs.2,000 was dishonoured.
(2) Out of the cheques for Rs. 15,000 issued in December, a cheque for rs. 5,300 was lost, a cheques for Rs. 4,000 was encashed in January, and the rest were encashed in December.
(3) No entry is found in Cash Book for : (a) Interest of Rs. 1,400 debited by bank. (b) Direct deposit of Rs. 5,000 by a customer, Miss Anuradha. (c) A transfer of Rs. 6,600 from the Current A/c to be Recurring Deposit A/c. not recorded
in the Cash Book.
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(4) A Bill receivable of Rs. 5,000 which was discounted with the bank, was dishonoured on 25th December 1998. The intimation was not received till 31st December ’98.
(5) A cheques of Rs. 3,500 deposited into the bank, and it was cleared, but entered twice in the Cash Book.
(6) A cheques of Rs.5,245 was issued and it was presented for payment but wrongly recorded in the Pass Book as Rs. 5,425.
(7) A cheques of Rs. 2,000 issued to Miss Karishma and encashed by her was omitted to record in the Cash Book.
(8) The Total of the credit side of the bank column in the Cash Book was overcast by Rs. 1,600.
(9) A cheques for Rs. 20,000 deposited in the bank and it was cleared by the bank but wrongly recorded in the cash column of the Cash Book.
Solution:
66
Working Notes: (1) Cash Book with bank column and Pass Book are prepared to find out items to be added to and items to be subtracted from the statement.
(2) In item No. 1 cheques for Rs. 17,000 are deposited into the bank. Out of which cheques for Rs. 11,000 were cleared before 31 st Dec ’98 and cheques for Rs. 2,000 was dishonoured i.e. cheques for (17,000-11,000-2000 = 4,000) Rs. 4,000 were deposit but not cleared. Here, we have to consider two items for reconciliation statement viz.(i)
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cheques for Rs. 2,000 deposited and dishonoured and (ii) cheque for Rs. 4,000 deposited but not cleared.
(3) In item No. 2, we have to consider the following cheques for reconciliation statement: (i) Cheque for Rs. 1,200 issued and dishonoured(ii) Cheques for Rs. 5,000 issued and lost(iii) Cheque for Rs.4,000 issued but not encashed.
(4) Final answer of Bank Reconciliation Statement comes negative. Hence, our statement in answer is ‘Bank balance as per Pass Book’ and not ‘Overdraft as per Pass Book’.
Example:A debit balance in Mr. Deepak’s pass Book on 30 th June, 1998 was Rs. 12,600. Prepare his Bank Reconciliation Statement from the following details : (1) Cheques for Rs. 10,000 deposited but not cleared till 30 th June, 1996.(2) Cheque for Rs. 2,000 issued but lost by the receiving party.(3) Cheques for Rs. 15,000 issued in June ’98 but encashed in July ’98.(4) Learnt from the Bank that cheques for Rs. 6,000 deposited but were dishonoured.(5) There is no entry in the Cash Book for Rs. 10,000 transferred erom the Saving A/c to
Current A/c and for rs. 500 collected by bank as dividend.(6) A cheques for Rs. 2,000 issued to Mr. Bhaskar and encashed by him was omitted from
the Cash Book. (7) A cheques for Rs. 3,000 issued to Mr. Amit and encashed by him, but it was recorded in
the cash column of the Cash Book.(8) A cheques for Rs. 4,000 issued to Miss. Dimple and encashed by her was recorded twice
in the Cash Book.(9) A cheques for Rs. 6,000 deposited and cleared but wrongly recorded on the credit side of
the Cash Book.(10) A cheque for Rs. 8,000 received from Mr. Raja was recorded as deposited into the Bank
but was not in fact banked.(11) The credit side of the Pass Book was undercast by Rs. 2,000.
Solution:
68
Working Notes: (1) Cash Book with bank column and Pass Book are prepared to find out items to be added to and items to be subtracted from the statement.
(2) When cheque is deposited and dishonoured, we have to credit Cash Book to cancel the debit effect given to Cash Book on deposit of cheques into the bank. In item No. 4, we have given credit effect in Cash Book for dishonour of cheques for Rs. 6,000.
(3) When an amount is transferred to Current A/c, bank balance increases and Pass Book is given credit effect and corresponding debit is to given in Cash Book for transfer. In item No. 5, we have debited Cash Book for transfer of amount from Savings A/c to Current A/c.
(4) In item No.8, excess credit is given to Cash Book when cheques is recorded twice, to cancel that excess credit we have given debit effect to Cash Book.
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(5) In item No. 9, instead of giving debit effect to cash Book, unnecessary credit effect is given. In order to cancel credit effect and to give debit effect to Cash Book, we have given double debit of Rs. 12,000 i.e., 6,000 × 2.
Example:The Cash Book of Mr. Patel showed an overdraft of Rs. 11,000 in his Bank Current A/c on 31 st May, 1999. Prepare his Bank Reconciliation Statement based on the following :(1) A cheques for Rs. 7,560 issued to Mr. Shah and encashed by him was recorded in the Cas
Book as Rs. 5,670.(2) A cheques for Rs. 1,580 received from Mr. Sharma, deposited into the bank was credited
in the Pass book as Rs. 1,850. (3) A cheques for Rs. 12,700 issued to Mr. Rane and encashed by him was shown in the
deposit column of the Pass Book.(4) A direct payment by the bank of Rs. 900 for the proprietor’s life insurance premium was
debited in the Pass Book as Rs. 90 and wasn’t shown at all in the Cash Book.(5) A cheques for Rs. 3,000 issued to miss Sawant was cancelled before encashment and
Miss Sawant was given cash, but there was no entry for the cancellation.(6) Cheque issued in April but encashed in May amounted to Rs. 2,000. (7) A credit total of Rs.1,245 was brought forward on the debit side in the bank column of
the Cash Book.(8) The Pass book showed a direct debit of Rs. 5,000 for dishonour of a bill that had been
discounted by Mr. Patel earlier.
Solution:
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Working Notes : (1) In item 1, due to mistake, less credit is given by Rs. 1,890 (i.e. 7560-5,670 = 1,890), it is rectified by giving credit of Rs. 1,890 to Cash Book.(2) In item No. 2, due to mistake, excess credit of Rs. 270 (i.e. 1,850-1,580 = 270) is given to
Pass Book. It is now rectified by giving debit of Rs.270 to Pass Book.(3) In item No. 4, less debit of Rs. 810 is given to Pass book, it is now corrected by giving
debit of Rs. 810 to Pass Book. Similarly, no corresponding credit of Rs.900 given to Cash Book.
(4) Cash Book with bank column and Pass Book are prepared to find out items to be added to and items to be subtracted from statement.
Example:
From the following extracts of the Cash Book and the Pass Book, prepare a Bank Reconciliation Statement as on 31st January, 1999:
71
Solution:
72
Working Notes: Since the entracts of the Cash Book and the Pass Book are given for common period i.e. Jan ’99, only uncommon entries are posted in the following Cash Book and the Pass Book to find out items to be added to and subtracted from the statement.
Example:From the following extracts of the Cash Book and the Pass Book prepare a Bank Reconciliation statement.
73
Solution:
Working Notes : Since the extracts of the Cash Book and the Pass Book are given for two consecutive and successive periods (i.e. extracts of Cash Book for Dec. ’98 and extracts of Pass Book for Jan. ’99), only common entries from both the Cash Book and Pass Book are considered and posted to Pass Book to find out items to be added to and items to be deducted from the statement.
74
CHAPTER 4
INTRODUCTION TO COMPANY A/c AND FINAL A/c
FINAL ACCOUNTS
Syllabus : Preparation of Trading Account, Profit and loss Account, and Balance Sheet of a Sole Trader with the following adjustments : (i) Depreciation (ii) Bad Debts, Provision for Doubtful Debts and Provision for Discount allowed to Debtors and Discount to be received from the creditors. (iii) Outstanding Expenses and Prepaid Expenses (iv) Income received in advance and Accrued income (v) Closing Stock.
1. Final Accounts : Final Accounts may be defined as classified and tabulated summaries of all transaction for a period, usually for a year, presenting in an easily understandable form a summary of all that has been recorded in the various books of account.
During the year, a book-keeper has to perform the following three functions : (1) Record the transactions as and when they occur in the proper subsidiary books (2) Post these entries fro the subsidiary books into the leader and (3) Balance the ledger accounts.
Then, at the end of the accounting year, the accountant has to prepare a Trial Balance and update, adjust, classify and tabulate all the information contained in the trial Balance. And such an updated, adjusted, classified and tabulated information giving a summary of all the transactions during the accounting period may be collectively referred to as the final accounts, so called because they are prepared at the end of the period.
Now, these final accounts consist of three parts :(1) The Trading A/c showing the gross profit or loss for a given period on the buying and
selling of goods.
(2) The Profit & Loss A/c Showing the net profit or loss for a given period after taking into consideration all expenses and incomes of the business.
(3) The Balance Sheet, which is not an account but a statement, showing the financial position of the business in the form of assets and liabilities as on a given date (usually the last date of the accounting year). Final Accounts are prepared at the end of the financial year, on the basis of trial balance supplemented by additional information.
2. Object of Final Accounts : The objects or needs of final accounts are discussed as under: (1) To ascertain gross profit or gross loss made for a particular period i.e. year.
(2) To ascertain net profit or net loss made in the business for a specific period of time i.e. one year.
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(3) To find out the financial position of the business i.e. assets owned and possessed by the business and Liabilities owed to outsiders by the business.
(4) To determine tax payable to Government on net profit of the business, and on assets if taxable.
(5) To verify and check arithmetical accuracy of the accounts maintained by the business and thereby detect mistakes, frauds and misappropriation, which may have taken place.
3. Trading Account: Trading account is a part of income statement, prepared on the basis of direct expenses and direct incomes of the business concern. Trading account is prepared to ascertain the gross profit or gross loss for a given period on the buying and selling of goods. Debit side of trading account usually includes, opening stock, purchases less returns, and direct expenses like factory expense, carriage inwards, royalties on purchases, wages, freights paid on the goods purchased, etc. Credit side covers sales less returns, closing stock, goods lost by fire or theft, goods withdrawn by proprietor, goods distributed as free samples, etc. Debit balance of trading account indicates gross loss and credit balance of t4rading account shows gross profit. The balance of trading account is carried to Profit and Loss Account. In the case of a manufacturing concern, Trading A/c includes manufacturing expenses. The big manufacturing a concern prepares two separate account viz. Manufacturing A/c to in out cost of goods sold and Trading A/c to find out gross profit or gross loss. The specimen of Trading A/c is given as follow.
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In the books of …………, …………, & ……………Trading Account for the year ended………… …………
DR.Particulars Amount Particulars Amount
To Opening Stock
To Purchases Less Purchase returns/ Returns outwards
To Wages/productive wages/ Manufacturing wages/wages & Salaries
To Carriage /carriage inwardsTo Factory insuranceTo Factory RentTo Factory lightingTo Factory SalariesTo Trade ExpensesTo Import dutyTo FreightTo OctroiTo Customs, dock duesTo Fuel and Power/Motive PowerTo Royalty/Royalty on purchasesTo Work Manager’s salaryTo Landing and clearing chargesTo Gross Profit c/d
xxx
xxx
xxx
xxx
xxx
xxx
xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx
xxx
xxxxxx
xxx
By Sales
Less Sales Returns/ Returns inwards
By Goods Distributed as Free samplesBy Goods Destroyed by fireBy Goods withdrawn by ProprietorBy Closing StockBy Gross Loss c/d
xxx
xxx xxx
xxx
xxx
xxx
xxxxxx
xxx xxx
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4. Profit and Loss Account: Profit and loss account is a second part of income statement, prepared on the basis of indirect expenses and indirect incomes of the business concern. Profit and loss account is prepared to ascertain the net profit earned or net loss suffered by a business concern in the accounting year. All indirect expenses of a particular business like office or administrative expenses, distribution and selling expenses are shown on the debit side of the profit and loss account. All indirect incomes like commission earned or received, discount received, interest received, rent earned and all other sundry incomes of business are listed on credit side of profit and loss account, Debit balance of profit and loss account indicates net loss suffered or sustained whereas credit balance of profit and loss account shows net profit earned in a business activity. If business earns net profit, it is added to capital and it there is net loss, it is subtracted from capital. The specimen of Profit and Loss A/c is given as follows:
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PROFIT & LOSS A/C FOR THE YEAR ENDED ……………Particulars Amount
Rs.Particulars Amount
Rs.
To Gross Loss b/dTo Salaries/Salaries and WagesTo Office Rent & RatesTo Unproductive or Non-Productive WagesTo Office InsuranceTo Postage & TelegramTo Printing & StationeryTo Legal Expenses.To Trade ExpensesTo Repair & RenewalsToSundry/General/Miscellaneous Exps.To TaxesTo InsuranceTo Travelling ExpensesTo ConveyancesTo Commission & AllowancesTo forwarding chargesTo Carriage outwardsTo Storage/warehouses or Godown chargesTo Packing ExpensesTo Advertisement ExpensesTo Goods distributed as free samplesTo Export dutiesTo Bad debts written off/Prove. for bad debtsTo Bank ChargesTo Interest paidTo Discount allowed on debtorsTo Discount on billsTo Provision for discount on debtorsTo DepreciationTo Loss by fireTo Loss by theftTo Loss on sale fixed assetsTo Loss on sale of InvestmentTo Professional ChargesTo Net Profit c/d
xxxxxxxxxxxx
xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx
xxxxxxxxx
xxxxxx
xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx
By Gross Profit b/d By Commission
ReceivedBy Discount ReceivedBy Interest ReceivedBy Provision for Discount on CreditorsByDividends ReceivedBy Miscellaneous
IncomesBy Rent ReceivedBy Profit on sale of
assetsBy Profit on sale of investmentBy Net loss c/d
xxx
xxxxxxxxx
xxxxxx
xxxxxx
xxxxxx
xxx
xxx xxx
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6. Balance Sheet: The Balance Sheet is not an account but a positional statement showing the financial position of a firm, as on a given date in the form of assets and liabilities. N the left hand side of the balance sheet, closing balances of all types of liabilities are shown and on the right hand side, closing balances of all types of assets are shown, terms of assets shown on the assets side of balance sheet are classified into fixed assets, current sheets and fictitious assets, and items of liabilities shown on the liabilities side of balance sheet are categorized into fixed liabilities, current liabilities and contingent liabilities, Specimen of Balance Sheet is given as follows :
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6. Notes: (1) If trade expenses are given in the trial balance with other items like Sundry expenses or General expenses or office expenses, then only trade expenses should be shown be shown in trading A/c on debit side. If trade expenses are give in the trial balance and none of the items of Sundry expenses or General expenses or Office expenses are give, then trade expenses are to be debited to Profit & Loss Account.(2) The combined item of “Wages & Salaries” is to hew shown in trading account, while “Salaries & Wages” is to be shown in Profit & Loss Account.(3) Every item in the Trial Balance must be shown only once and in just one part of final accounts.(4) Every item of adjustment or item outside the Trial Balance must be shown twice in the final accounts, once on debit side of one account and once again on the credit side of the other account.(5) All items relating to the goods and direct expenses thereon to be shown in Trading Account and all indirect expenses and incomes of the business are to be shown in the Profit and Loss Account.(6) Closing stock being an adjustment item or an item outside the Trial Balance is to be shown twice, i.e. once on the credit side of the Trading Account and once again on the assets side of the Balance Sheet.(7) If the value of closing stock is given in the adjustment at cost price as well as at market price, then it is necessary to show closing stock at cost price or at market price whichever is lesser.
(8) Direct Expenses. : All expenses incurred for bringing the goods to the place at which and in the condition in which, they are to be sold are direct expenses. In manufacturing concerns, expenses which have direct relation with production and without which production process withheld, are called direct expenses, i.e. cost of raw material, power and fuel, wages, carriage, royalties, etc. are called direct expenses, All direct expenses are shown in the Trading A/c. Direct expenses on purchases include items like freight, customs, import duties, landing & clearing charges, dock dues, octroi and carriage inwards: while direct expenses on production include items like wages, fuel power, water, royalties on production and all factory expenses.
(9)Indirect Expenses : All expenses other than direct expenses are called indirect expenses. All indirect expenses are shown in the profit and loss account .Indirect expenses are classified as (i) Administrative or office expenses, (ii) Distribution expenses and (iii) Selling Expenses
(i) Administrative or office expenses are those expenses which are incurred for running the organization or the business and include items like rent, salaries, printing and stationery, postage, insurance, telephone, sundry expenses, etc.
(ii) Distribution expenses includes financial expenses like interest, bank charges, discount m bad debts, provision for bad debts, provision for discount,
81
depreciation, loss on sale of fixed assets, loss by fire, loss by theft, loss by misappropriation, etc.
(iii) Selling expenses are those expenses which are incurred for selling, sorting or distributing the goods and include items like commission, traveling expenses, carriage outwards, showroom, warehouse or godown expenses, advertising, free samples distributed and royalties on sales.
(10) Carriage inwards vs carriage Outwards : Carriage paid for bringing the goods in, that is, carriage on purchases is carriage inwards, whereas carriage paid for taking the goods out, that is, carriage on sales is Carriage Outwards. Both are debit balances as each represents an expense. Carriage Inwards is shown in the Trading A/c, while carriage outwards is shown in the Profit & Loss A/c as a selling expense. In the absence of information to the contrary, carriage is generally assumed to be carriage inwards.
(11) Freight & Insurance as one single item vs Freight and insurance as two separate items : If Freight & insurance is a single item, it is shown in the Trading A/c. If however, Freight and Insurance are given as tow separate items, Freight is shown in the Trading A/c. while Insurance is shown in the Profit & Loss A/c as an administrative expenses
(12) Fixed Assets vs Current Assets : Fixed Assets are assets purchased not for resale or ultimate conversion into cash but for permanent retention and use in the business with a view to earning an income, getting a service or reducing an expense. Current Assets, on the other hand, are produced or acquired in the course of business and held temporarily for resale or ultimate conversion into cash Buildings, Premises, Fixture & Fittings, Machinery and Office Equipment are a few examples or Fixed Assets, while Stock, Debtors, Bills Receivable, Bank and Cash are a few examples of Current Assets.
(13) Fixed or Long Term Liabilities vs Current Liabilities.:- Fixed or Long Term Liabilities are those which are to be repaid not in the near future but after a period exceeding one year from the date of the first Balance Sheet they appear in. Current Liabilities, on the other hand, are those which are repayable currently, i.e. in the near future, usually within a year.
(14) Wages vs Salaries, Salaries & Wages vs Wages & Salaries :- If Salaries and Wages are given in separate items, Wages are shown in the Trading A/c, while Salaries are shown in the Profit & Loss A/c. If wages are specified as non-productive, they are shown in the Profit & Loss A/c as an administrative expense, If wages and Salaries, is a single item, it is shown in the Trading A/c. If, however, Salaries and wages is also a single item, it is shown in the Profit * Loss A/c.
(15) Packing Expenses.: Packing Expenses are generally shown in the Profit & Loss A/c As a selling Expense, If, however, the packing is costly and forms an integral part of the goods sold (as for example, gas cylinders), the Packing Expenses should be shown in the
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Trading A/c. Generally, Primary Packing Expenses are shown in the Trading A/c and Secondary Packing Expenses in the Profit & Loss A/c as a selling Expense.
(16) Patents & Patters : A patent is an exclusive privilege of making or selling a new invention for a fixed number of year, whereas a pattern is a model or a design or a set of working instructions from which goods are to be manufactured, in the absence of adjustments, both patents and patters should be treated as fixed assets and shown in the Balance Sheet as such. If , however, a part of the patents and patterns is to be written off, the unwritten off part should be shown as a fixed asset in the Balance Sheet, while the written of part should be shown on the debit side of the Profit & Loss A/c.
(17) Royalties : Royalties are payments made to the holder of a patent, an inventor or author for use of his patent or sale of his work, if specifically indicated as payable or paid on sales, royalties are shown in the Profit & Loss A/c as a selling expense. In all other cases, they are assumed to be payable on purchases or production and shown in the Trading A/c.
(18) Depreciation : Depreciation is the permanent continuous and gradual fall in the value of a fixed asset brought about by factors like wear and tear. And it is generally recorded by debiting the Depreciation A/c and crediting the concerned Fixed Asset A/c Care must be exercised to see that such depreciation is calculated on the final balance on the fixed Asset A/c after all other adjustments have been made, and that both the rate and the period of time are considered for calculating the amount of depreciation. (If, however, no indication of the period is available. Depreciation may be provided for a full year and a note added to that effect.) Note that depreciation is always shown on the debit side of the Profit & Loss A/c and is again subtracted from the concerned fixed asset on the assets side of the Balance Sheet.
7. Adjustments : Adjustments refer to the additional information relating to some homes of accounts, given outside the trial balance for consideration, in preparation of final accounts. Every adjustment is to be shown twice, under two different account heads, one of which is to be debited to one account and other to be credited to the other account.
A brief synopsis of the usual adjustments to final accounts to final accounts in the form of a table is given below.
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Adjustments to Final Accounts.
Treatment inSr.No.
Adjustment for The trading account and Profit & Loss Account
The Balance Sheet
1. Closing Stock Show ‘Closing Stock’ on the credit side of the Trading A/c.
Show ‘Closing Stock’ on the assets side.
2. Outstanding Expenses
Add to the concerned expense on the debit side
Show ‘Outstanding Expenses’ on the liabilities side.
3. Prepaid Expenses Deduct form the concerned expense on the debit side
Show “Prepaid Expenses’ on the assets side.
4. Incomes Receivable
Add to concerned income on the credit side.
Show ‘Incomes Receivable’ on the assets side
5. Incomes Received in Advance
Deduct from the concerned income on the credit side.
Show “Income Received in Advance on the liabilities side.
6. Depreciation Show ‘Depreciation’ on the debit side of the P & L A/c
Deduct the Depreciation from the concerned asset on the assets side.
7. Further/Additional Bad debts
Add to ‘Bad Debts’ on the debit side of the P & L A/c.
Deduct the Further Bad Debts from the ‘Sundry Debtors on the assets side.
8. Provision for Bad debts
Show ‘Bad Debts’ + New Provision – Old Provision ‘ on the debit side, or if that gives a negative figure, ‘Old Provision –Bad Debts.- new Provision on the credit side of the P & L A/c
Deduct the New Provision for Bad Debts from the ‘Sundry Debtors’ on the assets Side.
9. Provision for Discount on Debtors
Show ‘Discount Allowed +New Provision Old Provision’ on the debit side, or if that gives a negative figure, ‘Old Provision Discount Allowed on the debit credit side of the P & L A/c
Deduct the New Provision for Discount from the ‘Sundry Debtors’ Less the provision for ‘Bad Debts’ on the assets Side.
10. Provision for Discount on Creditors
Show ‘Discount Received + New Provision, Old Provision’ on the Credit side, or if that gives a negative figure, ‘Old
Deduct the New Provision for Discount from the
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Provision Discount Received on the debit credit side of the P & L A/c
‘Sundry Creditors’ on the liabilities Side.
11. Insured goods Destroyed, Damaged or Stolen and Insurance Claim admitted
Show the uninsured loss as ‘Loss by Fire/ Damage/ Theft’ on the debit side of the P & L A/c and the full value of these goods as ‘Goods Lost by Fire/Damage/Theft’ on the credit side of the Trading A/c
Show the amount recoverable from the insurance company as ‘Insurance Claim Receivable’ on the assets side.
12. Uninsured Goods destroyed or damaged or stolen
Show full value of uninsured loss as ‘Loss by Fire/ Damage/ Theft’ on the debit side of the P & L A/c and the full value of the goods as ‘Goods Lost by Fire/Damage/Theft’ on the credit side of the Trading A/c
------
13. Goods distributed as Free Samples
Show the ‘Free Samples Distributed ‘ on the debit side of the P & L A/c and the ‘Goods Distributed as Free Samples’ on the credit side of the Trading A/c
------
14. Machinery erection charges included in Wages
Deduct from ‘Wages’ on the debit side of the Trading A/c
Add to ‘Machinery’ on the assets side.
15. Sale of machinery include in Sales
Deduct from ‘Sales’ on the Credit side of the Trading A/c
Deduct from ‘Machinery’ on the assets side.
16. Purchase of machinery included in Purchases
Deduct from ‘Purchases’ on the debit side of the Trading A/c
Add to ‘Machinery’ on the assets side.
17. Personal expenses of the proprietor included in a business expenses
Deduct from the concerned Expenses on the debit side.
Add to ‘Drawings’ and deduct the increased drawings fro the ‘Capital’ on the liabilities side.
18. Purchases of stationery included in Purchases
Deduct from ‘Purchases’ on the debit side of the Trading A/c and add to Stationery on the debit side of the P & L A/c.
---
19. Unrecorded purchase of goods
Add to ‘ Purchases’ on the debit side of the Trading A/c
Add to ‘Sundry Creditors’ on the liabilities side.
20 Unrecorded sale of goods
Add to ‘Sales’ on the credit side of the Trading A/c
Add to ‘Sundry Debtors’ on the assets side.
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21 Goods withdrawn by proprietor for personal use
Show ‘Goods withdrawn by proprietor’ on the credit side of the Trading A/c
Add to drawings of the proprietor.
22 Interest on capital Show on the debit side of the Profit & Loss A/c
Add to capital.
23 Interest on drawings
Show on the Credit side of the Profit & Loss A/c
Deduct from capital.
8. Important adjustments in detail : (i) Provision for bad and doubtful debts : Generally, we show the bad debts and the provision for bad debts by using the following pro forma on the debit side of Profit & Loss A/c. :
To Provision for Bad Debts Trial Balance Bad Debts + Adjustments Bad Debts + New Provision ( Calculated on the closing debtors)
- Old Provision (given in the Trial Balance)
xxxxxxxxx
xxxxxxxxx
If, however, the old provision for bad debts is larger than the total of the bad debts and the new provision, i.e. it the above pro forma gives a negative figure, we reverse the arrangement and use the following pro forma on the credit side of the Profit & Loss A/c
By Provision for Bad Debts Old Provision Less Trail Balance Bad Debts. Adjustment Bad Debts New Provision
xxxxxxxxx
xxx
xxx xxx
Notes : (1) The Provision for Bad Debts is the amount set aside from the current year’s profit to meet future bad debts on the current year’s debtors.(2) If there is no information to the contrary, the new provision for bad debts is generally assumed to be zero or nil(3) If there in no old provision for bad debts, the Profit & Loss A/c Will show the Bad Debts and the Provision for Bad Debts as two separate items.
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(4) The Balance Sheet always shows on the assets side, the Sundry Debtors less the further or adjustment Bad Debts that have been written off, less again the new Provisions for Bad Debts.
(ii) Reserve for discount of debtors : Usually we show the discount and the provision or discount on debtors by using the following pro forma on the debit side of Profit & Loss A/c :
To Reserve for Discount Trial Balance Discount Allowed + Adjustments Discount + New Provision ( Calculated on net Debtors after above adjustment)
-Old Provision (given in the Trial Balance)
xxxxxxxxx
xxx
xxx
xxx
If, however, the old provision for discount (allowed) is larger than the total of the discount and the new provision, i.e. if the above pro forma gives a negative result, we reverse the arrangement and use the following pro forma on the credit side of the Profit & Loss A/c
By Reserve for Discount on Debtors Old Provision (given Trial Balance) Less: Trail Balance Discount (allowed) Adjustment Discount (allowed) New Provision
xxxxxxxxx
xxx
xxx xxx
Note : If provision for Bad Debts and Reserve for discount on debtors both have given in the adjustments list for consideration, then first work out the adjustments of bad debts on debtors and then on balanced or net debtors work out reserve for discount on debtors.
(iii) Provision for discount on creditors : Working of adjustments of provision for discount on creditor is shown usually on credit side of Profit and Loss A/c :
By Provision for Discount on Creditors Trial Balance Discount (received) + Adjustments Discount + New Provision ( Calculated on net Creditors)
- Old Provision (given in the Trial Balance)
xxxxxxxxx
xxx
xxxxxx
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If, however, the old provision for discount (received is larger than the total of the discount and the new provision, i.e. if the above pro forma gives a negative result, we reverse the arrangement and use the following pro forma on the Debit side of the Profit & Loss A/c
To Provision for Discount on creditors Old Provision (given Trial Balance) Less: Trail Balance Discount (received) Adjustment Discount (received) New Provision
xxxxxxxxx
xxx
xxx xxx
(iv) Effect in Balance Sheet : Effects of Reserve for Doubtful Debts and Reserve for Discount on Debtors and creditors in the Balance Sheet are shown as under : Balance sheet as on 31st…………2000
Liabilities AmountRs
Assets AmountRs.
Sundry CreditorsLess : Adjustment Discount (received)
Less : New Provision for Discount on Creditors
xxx
xxx
Sundry DebtorsLess : Adjustment Bad
Debts
Less : New Provision for Bad Debts..
Less : Adjustment Discount
Less: New Provision for Discount on Debtors.
xxx
xxx
xxx
xxxxxxxxx
xxx
xxx
xxx
xxx
xxx
1.From the following information prepare Lal’s Trading A/c for 31st December 2000
(1) Purchases Returns Rs. 8,000 (8) Sales Returns Rs. 15,000.(2) Freight Rs. 30,000. (9) Closing Stock : Cost Rs. 20,000. and market Value Rs. 23,000.(3) Sales Rs. 2,80,000. (10)Wages Rs. 7,500.(4) Purchases Rs. 1,40,000. (11) Royalties Rs. 8,000.(5) Octroi Rs, 7,000. (12) Factory Rent Rs. 1,200.(6) Opening Power Rs. 12,000. (13) Goods worth Rs. 10,000. withdrawn by
proprietor for sell use(7) Motive Power Rs. 12,000. (14) Goods worth Rs. 15,000 destroyed by fire.
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Dr. Trading A/c for the year ended 31st December, 2000 Cr
Particulars Rs. Particulars Rs.To Opening StockTo Purchases Less : Purchases returnsTo WagesTo OctroiTo Motive PowerTo RoyaltiesTo Factory RentTo FreightTo Gross Profit c/d(Balancing figure)
1,40,000 8,000
10,000
1,32,000 7,500 7,000 12,000 8,000 1,200 30,0001,02,300
By Sales Less : Sales ReturnsBy Goods
withdrawn by ProprietorBy Goods destroyed
by fireBy Closing Stock
2,80,00015,000
2,65,000
10,000
15,000 20,000
3,10,000 3,10,000
Note : Closing Stock is shown at cost Rs. 20,000 which is lowered than market value Rs. 23,000, to show lower
2.Prepare Amit’s Profit & Loss A/c for the year ended 31st March , 2001 from the following balances.
(1) Gross Profit Rs. 40,000 (11) Interest Received Rs. 2,000(2) Salaries Rs. 18,000 (12) Sundry Expenses Rs. 8,000(3) Commission Received Rs. 1,000 (13) Net Loss By Fire Rs. 3,000(4) Carrage Outwards Rs. 5,000 (14) Rent Rs. 4,000(5) Printing & Stationery Rs.3,000 (15) Miscellaneous Incomes Rs. 1,500.(6) Bad Debts Rs.2,000 (16) Advertisement Rs. 5,000(7) Depreciation Rs. 7,000 (17) Discount Allowed Rs. 7,500(8) Postage Rs. 1,000 (18) Discount Receive Rs. 9,500(9) Rate & Taxes Rs. 1,000 (19) Bank Charges Rs. 1,200.(10) Godown Expenses Rs. 5,000 (20) Insurance Rs. 3000.
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Ans.Profit and Loss A/c for the year ended 31st March,2001.
Dr Cr.Particulars Rs. Rs. Particulars Rs. Rs.
To SalariesTo Printing & Stationery To PostageTo Rates & TaxesTo RentTo Carriage OutwardsTo Bad DebtsTo DepreciationTo Godown ExpensesTo Sundry ExpensesTo Net Loss By FireTo Advertisement ExpensesTo Discount (Allowed)To Bank Charges.To Insurance
18,0003,0001,0001,0004,0005,0002,0007,0005,0008,0003,0005,0007,5001,2003,000
By Gross Profit b/dBy Commission
(Received)By Interest (Received)By Miscellaneous
IncomesBy Discount (Received)By Net Loss c/d(Balancing figure)
40,0001,000
2,000
1,5009,500
19,700
73,700 73,700
3. From the following information prepare Raja’s Trading and Profit & Loss A/c for the year ended 30th June 2001 :
(1) Rent Rs. 6,000 (2) Discount Earned Rs. 1,000(3) Carriage Inwards Rs. 5,000 (4) Travelling Expenses RS. 5,000(5) Commission Rs. 3,000 (6) Wages Rs. 10,000(7) Salesmen’s Salaries Rs. 9,000 (8) Purchases Rs. 1,17,000(9) Opening Stock Rs. 24,000 (10) Bad Debts Rs. 1,000(11) Sundry Expenses Rs. 8,000 (12) Closing Stock Rs. 49,000(13) Interest Rs. 2,000 (14) Warehouse Expenses Rs. 4,000(15) Sales Rs. 2,60,000 (16) Salaries Rs. 12,000(17) Returns Inwards Rs. 4,500 (18) Returns Outwards Rs. 6,500(19) Royalties Rs. 7,500 (20) Goods lost by theft RS. 8,000(21) Net Loss by theft Rs. 1,500 (22) Goods distributed as free samples Rs.
5,000(23) Depreciation Rs. 6,000 (24) Trade Expenses Rs. 4,000(25) Rent (Received ) Rs. 8,000 (26) Sundry Income Rs. 7,000(27) Dividend (Received) Rs. 4,000 (28) Printing & Stationery Rs. 2,500.(29) Factory Rent Rs. 10,000
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Ans.
Dr. Trading A/c and Profit and Loss A/c for the year ended 30th June, 2001 Cr.
Particulars Rs. Rs. Particulars Rs. Rs.To Opening StockTo Wages To Purchases Less : Returns
OutwardsTo Carriage InwardsTo Factory RentTo RoyaltiesTo Trade ExpensesTo Gross Profit c/d (Balancing figure)
To SalariesTo Printing &
StationeryTo RentTo Travelling ExpensesTo CommissionTo Salesmen’s SalariesTo Bad DebtsTo Sundry ExpensesTo InterestTo Warehouse
ExpensesTo Net loss by theftTo goods distributed as
free SamplesTo DepreciationTo Net Profit c/d(Balancing figure)
1,17,0006,500
24,00010,000
1,10,500 5,000
10,0007,5004,000
1,46,500
By Sales Less : Returns InwardsBy Goods lost by theftBy Goods distributed as free SamplesBy Closing Stock
By Gross Profit b/dBy DiscountBy Rent(received)By Sundry IncomesBy Dividend
2,60,0004,500
2,55,500 8,000
5,000 49,000
3,17,5003,17,500
1,46,5001,0008,0007,0004,000
12,0002,500
6,0005,0003,0009,0001,0008,0002,000
4,0001,500
5,000 6,0001,01,500
1,66,500 1,66,500
Note : Trade expenses are shown in the Trading A/c on debit side because they are given in the trial balance along with Sundry Expenses.
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4. Using the following information, prepare Vinod’s Balance Sheet as on 31st March, 2001
(1) Bank Overdraft Rs. 10,000
(2) Sundry Creditors Rs. 28,000
(3) Machinery Rs. 50,000
(4) Cash at hand Rs. 5,000 (5) Sundry Debtors Rs. 25,000
(6) Capital Rs. 1,30,000
(7) (Closing ) Stock Rs. 15,000
(8) Net Profit Rs. 36,000 (9) Investment Rs. 18,000
(10) Furniture Rs. 7,000 (11) Drawings Rs. 24,000 (12) Loan from Rejesh Rs.15,000
(13) Motor Car Rs. 12,000 (14) Premises Rs. 60,000 (15) Loose Tools Rs. 3,000Ans.
Balance Sheet as on 31st March 2001.Liabilities Amount
Rs.Assets Amount
Rs.Capital Less Drawings
Add : Net Profit
Bank OverdraftSundry CreditorsLoan From Rajesh
1,30,00024,000
1,42,000
10,00028,00015,000
MachineryMotor CarLoose ToolsPremisesFurnitureInvestmentClosing StockCash At HandSundry Debtors
50,00012,000
3,00060,000
7,00018,00015,000
5,00025,000
1,06,00036,000
1,95,0001,95,000
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5. From the following Trial Balance prepare final accounts for the year ended 31 st
March 2002 taking the value of the closing stock to be Rs. 80,000.
Trial Balance as on 31st March 2002
Particulars Debit Rs.
Particulars Credit Rs.
DrawingsBills ReceivableMachinerySundry DebtorsWagesReturns InwardsPurchasesRentStockSalariesTravelling ExpensesInsuranceCashBankSundry ExpensesInterestFurniture
10,5509,500
28,80062,00040,9702,780
2,56,5905,620
89,68011,0004,8804,020
10,53015,9703,3705,870
18,970
LoanReturns OutwardsSalesCommission
ReceivedSundry CreditorsDividends ReceivedBills PayableCapital
20,0006,000
3,50,430
5,64069,6305,000
16,0001,08,400
5,81,1005,81,100
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Note: Advance against wages, erection of machinery included in wages, Purchases of stationery included in purchases, sale of investment included in sales, Drawings of proprietor, etc.
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6. Form the following Trial Balance and the under noted adjustments prepare final accounts for the year:
Trial Balance as on 30th June, 2003.Dr. Cr.Particulars Debit Rs. Particulars Credit Rs.WagesSalariesOpening StockMachineryInvestmentDrawingsPurchasesReturnsCustomersAdvertisingInterestCash
14,10013,00040,00049,00030,70023,000
1,30,0002,000
18,00013,4004,800
11,000
Dividend ReceivedBank OverdraftReturnsSuppliersSalesCapital
4,30041,0001,000
14,2002,58,500
30,000
3,49,000 3,49,000
Adjustments : (1) Closing Stock is valued at Rs. 53,000 (2) Wages include Rs. 350 being advance against wages. (3) Wages include Rs. 1,000 paid for erection of Machinery (4) A purchase of stationery for Rs. 430 has been inadvertently include in Purchases A/c (5) A sale of investment with a book value of Rs. 2,600 for Rs. 2,500 has been included in the sales a/c. (6) Salaries include Rs. 150 per month paid to the proprietor’s domestic servant. (7) Machinery is to be depreciated by 10 per cent.
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Ans:
Balance Sheet as at….
Liabilities AmountRs.
Assets AmountRs.
Capital Less : Drawings Less : Domestic servant’s Salaries
Add : Net Profit
Bank OverdraftSundry Creditors
30,00023,000
1,00680
41,00014,200
MachineryAdd : Erection charges
Less Depreciation @ 10%Investments Less : Investment soldSundry DebtorsCashClosing StockAdvance against wagesStock of stationery
49,0001,000
45,500
28,100 18,000
11,00053,000
350430
7,0001,800
50,0005,000
30,7002,600
5,20095,480
1,55,880 1,55,880
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Working Notes.(1) Advance against wages subtracted from wages as it is not wages and then shown on
the assets side of Balance Sheet.(2) Erection of machinery charges subtracted from wages and added to opening cost of
machinery because it is a capital expenditure.(3) Purchase of stationery subtracted from purchases and shown separately on assets side
of Balance Sheet because stock of stationery is an asset so long as it is not used.(4) Sale of investment is subtracted from sales at sales price and once again subtracted
from investment at cost. The loss incurred on sale of investment (i.e. 2600-2500 = Rs.100) debited to P/L A/c.
(5) Salaries payable to proprietor’s domestic servant is not a business expenses, and hence proprietor’s domestic servant’s salaries are subtracted from salaries and once again subtracted from capital as drawings.
Outstanding Expenses, Prepaid expenses, Bad Debts, R.D.D., Reserve for discount on debtors, insurance claim receivable, and distribution of goods as free samples.
8. From the following Trial Balance and the undernoted adjustments prepare final accounts for the year 2003.: Trial Balance as on 31st December ,2003
Particulars Debit Rs Particulars Credit Rs.SalariesDiscountRentOpening StockPurchasesWagesDrawingsReturnsDebtorsMachineryBankCash
15,5001,3002,200
77,0001,29,000
11,80015,0002,800
15,50080,00018,00010,700
SalesReturnsInterestCreditorsDividendsCommissionCapital
2,10,0004,000
12,00013,0009,400
10,4001,20,000
3,78,800 3,78,800
Adjustments : (1) Outstanding Salaries and Outstanding Rent were Rs. 2,500 and Rs. 4,200 respectively (2) Prepaid Wages were Rs. 3,200 (3) Interest earned but not received was Rs. 4,150 (4) Dividends earned but not received were Rs. 2,100 (5) Commission received but not earned was Rs. 450 (6) Closing Stock was valued at Rs. 98,000 (7) Bad Debts written off Rs. 6,000 and maintain R.D.D. @ 5% on debtors and Reserve for discount on debtors @ 2%. (8) Goods worth Rs. 12,000 destroyed by fire and insurance company admitted claim for Rs. 10,000 (9) Distributed goods worth Rs. 6,000 as free samples.
97
98
Working Notes : (1) Calculation of new reserve for bad and doubtful debts and reserve for discount on debtors.
Sundry Debtors 15,500
Less : Further Bad Debts 6000 -----------
9,500 Less : R.D.D. @ 5% 475 ----------- Less : Reserve for Discount 9,025 On debtors @ 2% 181 ----------- Net Debtors 8,844 =======
(2) Net loss by fire = Value of Goods lost – Insurance claim receivable = 12,000 – 10,000 = Rs. 2,000Full value of goods lost is credited to Trading A/c and Net loss by fire is debited to P/L A/c and Insurance claim receivable is shown at assets side of Balance Sheet.
(3) Good distributed as free sample is credited to trading A/c and debited to Profit & Loss A/c
Interest on Capital and interest on drawings, Reserve for discount on debtors and creditors, uninsured goods destroyed by fire, unrecorded purchases, etc.
9. From the following Trail Balance and adjustments, prepare a Trading and Profit & Loss A/c for the year ended 30th September, 2003 and a Balance Sheet as on that date:
Trail Balance as on 30th September, 2003
Particulars Rs. Particulars Rs.Opening StockDrawingsWagesPurchasesSundry ExpensesFurnitureDiscount ReceivedSalesCapitalCash
48,00011,00015,000
1,35,00011,00036,0005,000
2,80,00050,00023,000
BankReturn InwardMachinerySundry DebtorsReturn OutwardsSundry CreditorsBad DebtsProvision for Bad
DebtsBills Payable
12,0003,000
48,00034,0002,000
34,0003,0002,000
6,000
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Adjustments : (1) Machinery and furniture are both to be depreciated by 10 per cent p.a(2) Wages include Rs. 2,000 paid for erection of machinery(3) Write off further bad debts Rs. 1,000 and maintain a provision for bad debts at 5% on
sundry debtors(4) Interest on drawings and on capital is to be 10 per cent p.a(5) The closing stock is to be valued at Rs. 20,000(6) During the course of the year, the proprietor had obtained a T.V. set for his personal
us and given away goods costing Rs. 14,000 in exchange. No record, however, has been made for this transaction.
(7) Maintain Reserve for discount on debtors @ 2% and Reserve for discount on Cretiors @ 3% on creditors.
(8) Uninsured goods destroyed by fire Rs. 8,500.(9) Good worth Rs. 15,000 purchased 25th September, 1996 remained to be recorded in
the books of accounts.
100
101
Working Notes :(1) Calculation of interest on capital and drawings :
(i) Interest on Capital : 10% on Rs. 50,000 = Rs. 5,000(ii) Interest on drawings : Total drawings = 11,000 + 14,000 (withdrawal of
goods) = 25,000 As the date of drawings in not give, interest on drawings is to be calculated for average period of ½ year.: Interest on drawings = 10% on 25,000 for ½ year = P x N x R x 1/100 = 25,000/1 x ½ x 1/100 = Rs. 1,250.
( Where P= Principal, N= Period, R= Rate of Interest)(2) Unrecorded purchases added to purchases and once again added to creditors.
Unrecorded sales, provision for discount on debtors and creditors, depreciation on fixed assets, interest on loan, interest on investment etc.
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11. From that following trail balance and adjustments prepare final accounts for year ended 31st March, 2004:
Trial Balance As on 31st March, 2004.Particulars Debit
Rs.Particulars Credit
Rs.DrawingsPurchasesReturnsWages And SalariesMachineryPrepaid Rent18% InvestmentFurnitureSundry DebtorsBad DebtsDiscountOpening StockBankProvision for Discount on CreditorsCashStationary Premises
12,00087,0002,000
10,00067,000
6,0020,00045,00050,7004,000
80065,0006,0001,500
10,8007,000
80,000
Capital16% loan from Miss Ranjana (taken on 1st Oct 1998)SalesReturnsOutstanding SalariesInterest received on investmentSundry CreditorsDiscountProvision for Bad & Doubtful DebtsProvision for Discount on Debtors
2,04,200
50,0001,60,000
1,5007,5001,500
30,000700
9,000
5,000
4,69,400 4,69,400
Adjustments :
(1) The market price of the Closing Stock was RS. 60,000 which is 20% above cost(2) Depreciate Machinery @ 10%, Premises @ 20% and Furniture @ 15%(3) Further bad debts Rs. 1,000 are to be written off and maintain provision for bad debts
is to be maintained @ 5% and provision for discount on debtors and creditors @ 3% and 2% respectively.
(4) Goods worth Rs. 18,000 sold on credit on 28th March, 1999, were omitted from the account books.
(5) Stock of stationery at the end of the year was valued at Rs. 5,000.(6) Goods worth Rs. 3,000 withdrawn by proprietor for self use.
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Ans.:
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Working Notes.
(1) Valuation of Closing Stock : Market Price of Closing StockClosing stock at Cost =-------------------------------------- × 100 100+20 60000 = --------- × 100 120 = Rs. 50,000Closing Stock is taken at the cost, as cost is lower than market price.
(2) The Cost of Stationery used during the year= Value of Opening Stock of stationery – value of Closing Stock of stationery= 7000-5000= Rs. 2000.
(3) The value of goods withdrawn by the proprietor is credited to Trading A/c and then subtracted from Capital A/c.
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CHAPTER: 5
WORKING CAPITAL MANAGEMENT
Hoagland defines working capital as follows: “Working capital is descriptive of that capital which is not fixed. But, the more common use of working capital is to consider it as the difference between the book value of the current assets and the current liabilities.” This definition, as we have seen, is acceptable to the accountants. Gerestenberg defines working capital as follows: “Circulating Capital means current assets of a company that are changed in the ordinary course of business from one form to another, as for example, from cash to inventories, inventories to receivable to cash” The definition of working capital given by Shubin is more illustrative. He defines working capital as “the amount of funds necessary to cover the cost of operating the enterprise. Working Capital in a going concern is a revolving fund, it consists of cash receipts from sales which are used to cover the cost of current operations.” The Accounting Principles Board if the American Institute of Certificate Public Accountants defines working capital as under: “Working Capital is represented by the excess of current assets over current liabilities and identifies the relatively liquid portion of the total enterprise capital which constitutes a margin or buffer for maturing obligations within the ordinary operating cycle of the business.” Working Capital, thus refers to the investment made by a business organization in short term current assets like cash, debtors, etc. Current Assets and Current Liabilities are assets and liabilities which arise in the course of normal operations of an enterprise. These assets change form and are used to pay off current liabilities. This changing of assets due to and in course of operations is known as Working Cycle or Operating Cycle. The assets and liabilities thus, arising can be said to be Current Assets and Current Liabilities and the difference between the two as Working capital.
Balance sheet
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WORKING CAPITAL CYCLE Alternatively known as “Operating Cycle Concept”of working capital. This Concept is based on the continuity of flow of funds through business operations. This flow of value is caused by different operational activities during a given period of time. The operational activities of an organization may comprise:a) Purchase of raw materials.b) Conversion of raw materials into finished products.c) Sale of finished product and d) Realization of accounts receivable. Material cost is partly covered by trade credit from suppliers and successive operational activities also involve cash flow. If the flow continues without any interruption, operational activities of the company will also continue smoothly. A movement of cash through the above processes is called ‘circular flow of cash’. The period required to complete this flow is called’ the operating period’ or ‘the operating cycle.’
Operating cycle for a Manufacturer
Temporary or Variable Working Capital Temporary working capital is also as ‘Circulating working capital.’ It is influenced by (a) seasonal working capital or (b) special working capital. a) Seasonal Working Capital: This is the amount of working capital required at stated intervals to meet the changing seasonal requirements. When the season approaches, business needs more funds to meet the seasonal pressure of demand. For example, a textile dealer would require large amount of funds a few months before Diwali. b) Special Working Capital: this is the amount of working capital required to meet unforeseen eventualities that may arise during the course of operations. Any organization must have additional funds to meet such contingencies. Example: Sudden increase in demand, strikes, fire, floods, drastic rise in taxes, etc. The concept of permanent and variable working capital is illustrated through the following diagram:
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Permanent and Temporary Working Capital-Distinguished. Permanent Working Capital Temporary Working Capital 1. This is required as long as the business continues as a going concern.
2. Permanent working capital never leaves the business.
3. The size of permanent working capital increases with the growth of business.
1. This is required for a temporary period, as for example, during seasons.
2. Temporary working capital disappears from the business process once the purpose is served.
3. The size of temporary working capital need not necessarily increases with the growth of business.
Positive and Negative Working Capital: Working Capital is said to be positive when current assets exceed current liabilities. Working Capital becomes negative when current liabilities exceed current assets. Such a situation arises when a firm is nearing a crisis of some magnitude.
Cash and Net Liquid Assets Concept of Working Capital: Cash Working Capital is that part of gross working capital which is essentially in liquid form. It is available in cash or cash resources. It is calculated from the items appearing in the Balance sheet. It shows the real flow of money at a particular time. It is considered to be the most realistic approach in Working Capital Management. It indicates the adequacy of the cash flow. But, net working capital or net current assets concept of working capital emphasizes the signature of the amount obtained by deducting liquid liabilities from liquid assets.
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FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS The amount of working capital required by a business organization depends on many factors. They are as follows.
METHODS OF PROJECTING WORKING CAPITAL REQUIREMENTS a) Conventional Method, (b) Operating Cycle Method. a) Conventional Method: According to this method, cash inflows and outflows are matched with each other. Greater emphasis is laid on liquidity of a business. b) Operating cycle Method: this method is more dynamic. It reface to working capital in a realistic way. Working Capital is decided on the basis of length of the operating cycle. It is calculated by dividing operating expenditure by the number of operating cycles.Concept of Operating Cycle An important method of estimating working capital requirements is operating cycle. Operating cycle is also called as working capital cycle. It is the time period required for the whole operation starting with cash and ending up with cash plus. It is expressed in terms of months or weeks or days. The total period of operating cycle is broken into various stages viz. Raw Material waiting period, processing period, finished stock period, debtors period, and creditor period in the case of manufacturing cum marketing organization. In the case of marketing organization the operating cycle period will be short. It will include only the last three stages as shown in the following table: Estimation of working capital requirement becomes easy when the operating cycle is given. If it is not given, it has to be calculated with analysis of necessary data. The methodology is as follows:
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Factors Determining
Working Capital
Nature of Business
Production Policies
Production Process
Size of Business Unit
Terms of Purchase and sales
Turnover of Inventories
Seasons Variation
Divided Policies
Business Cycle
Inflation
Change Technology
Other Factors
Operating Cycle is (OC) = R + W + F + D + C Where, R = Period of waiting for raw material and stores. W= Processing period. F = Finished Goods waiting period. D = Debtors collection period C = Creditors payment period The carious components of operating cycle are calculated as follows:
R =
W=
F =
D =
C =
c) Percentage of Sales Method: It is traditional and very simple method of estimate of working capital requirements. As per this method working capital is determined on the basis of past experience. The relationship between sales and working capital is found. Then this relationship may be taken as a base for determination of working capital for the future.
Illustration Balance sheet of Shruti Ltd is as follows:
Total turnover of the company for the year 20002-03 was Rs. 120 lakhs. It anticipated turnover of Rs. 180 lakhs in 2002-04 Estimate the working capital requirement for the year 2003-04.
Solution:
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% of Current Assets & Current Liabilities on sales and Determination of WorkingCapital
Projection of working Capital Requirements: The problems generally faced by businessmen is the determination of working capital requirements of their respective business organizations for financing a particular level of activity. For this purpose, the finance manager, who generally is entrusted with this work, has to forecast the working capital.
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Illustration:
From the following information pertaining to Ambica Ltd., prepare a statement showing the working capital requirement: Budgeted sales Rs. 2,60,000 per annum Analysis of Sales (per unit) Rs. Raw material 3 Direct Labour 4 Overheads 2
Total cost 9 Profit 1
Sales Price 10 It is estimated that: a) Raw materials remain in stock for three weeks and finished goods for two weeks. b) Factory processing takes three weeks. c) Suppliers allows five weeks credit. d) Customer are allowed eight weeks credit. Assume that production and overheads accrue evenly throughout the year.
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Solution:
Working note:1. Budgeted sales = Rs. 2,60,000 Sales per unit = Rs. 10
Number of units to be sold = = 26,000
2. Requirement per week
3. work-in-Progress: It is stated that production and overhead accrue evenly. This wages and overheads to be included on average basis.
Thus, 1500 + = Rs. 3,000
4. Debtor are valued at selling price.
Illustration:
(Preparation of Forecast Profit and Loss Account and Balance Sheet) On the basis of the program formulated by Peerless Industries Ltd. to be implemented with effect from 1st Jan 2003, the management desires to know the quantum of working Capital required to finance the estimated production. The following cost percentage of sales have been extracted from the proforma cost sheet: Material: 50%; Labour: 20%; Overheads:10% Production in 2001 was 1,00,000 units and it is proposed to maintain the production level during 2003.
a. Raw material are excepted to remain in stores for an average period of one month before issuing for production.
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b. Finished goods are to stay in warehouse on an average for two months before being sold to customers.
c. Each unit of production will be in process for an average period of one month.d. Credit allowed by suppliers (From the date of delivery of materials) is one month.e. Debtors are allowed two months credit from the date of sales.f. Selling price is Rs. 9 per unit.g. Sales and production follow a consistent pattern throughout the year.h. Other information:
Paid up Share Capital Rs. 10,00,000; 6% Debentures Rs. 1,00,000; fixed Assets (1st Jan 2000) Rs.7,50,000.Estimate the working capital required and drew up a Forecast profit & Loss Account
and Balance Sheet of Peerless Industries Limited, assuming the activities are evenly spread out throughout the year.
Solution:
Working notes:1. Sales: 1,00,000 units @ Rs. 9 per unit = 9,00,000 for 12 months. For 1 months it will be Rs. 75,000. Material are 50% of sales and therefore, 50% of 75,000 = Rs. = 37,500 Labour cost for one month = 20% of 75,000 = Rs. 15,000. Overheads for one month = Rs. 7,5002. Work-In-Progress is valued at full Cost for Labour and overhead also.3. Debtors are valued at cost. But in balance sheet Debtors are shown at sales value.
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Illustration(Undrawn Profit given) X & Co. desires to purchase a business and seek your advice as to the average amount of working capital that will be required in the first year of its operations. You are given the following estimates and are instructed to add 10% to your computed figure for contingencies:
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Set up your calculation for the average amount of working capital required.
Notes:1. Undrawn profits have been ignored as the funds provided by profits may or may not be
used as working capital besides the profit figure is unadjusted in respect of tax, dividend, etc.
2. Processing Time is not given, thus Work-In-Progress is ignored.
Illustration (Valuation of W.I.P. Specific) From the following information pertaining to X Ltd., you are required to prepare a Forecast Profit and Loss Account for the year ended 30 th June, 2003 and Balance Sheet as on that date:
Rs.
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Paid up Share Capital 8% Debentures (Secured on Assets)Fixed Assets as on 1st July, 2002Bank Overdraft as on 1st July, 2002
10,00,0002,50,0006,25,0001,81,250
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CHAPTER 6
Cash Flow technique
INTRODUCTION Cash is the most liquid asset. It is most important for daily operations of the firm. Efficient management of cash is very crusial for solvency of the firm. Hence, it is considered as life blood of business organization.
MOTIVES FOR HOLDING CASH There are three important motives of holding cash: Transaction Motive Business organizations need cash for conducting business transactions. The collection of cash is not perfectly matched with payment of cash. Hence, some cash balance is required to be maintained.Precautionary Motive There may be uncertainties regarding receipt of cash and payment of cash. In order to protect against such uncertainties, it is necessary to maintain some cash balance.Speculative Motive Business organizations would like to tap business opportunities arising from fluctuations in commodity prices, shares prices, foreign exchange rates etc. A firm which has sufficient cash can exploit opportunities.
ASPECTS OF CASH MANAGEMENTCash BudgetingCash Budget This represents the cash receipts and cash payments and estimated cash balance for each month of the period for which budget is prepared. Cash budget serves the following purposes:
a) To ensure that sufficient cash is available whenever required,b) To point out any possible shortage of cash so that necessary steps can be taken to
meet the shortage by making arrangement with the bank for overdraft or loan.c) To point out any surplus cash so that management can invest it in interest fetching
securities.
Preparation of Cash Budget: Usually the responsibility of preparing the cash budget lies on the Treasurer or other Financial Executive. Cash Budget has to be prepared by estimating cash receipts and cash payments.
Estimating cash Receipts: Cash is received on the following accounts:
a) Cash sales,b) Collection from Debtors,c) Interest / Dividends on Investment,
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d) Sale of Assets etc.,e) Loans, Advances, Deposits etc.The person who is responsible for the budget has to estimate how much cash is likely to be received during the budget period on the above accounts.
Estimating Cash Payments : Cash payment is made on the following accounts :
1) Payment for purchases,2) Payment for overheads,3) Purchase of Assets,4) Payment to Creditors,5) Payment for Taxes,6) Payment for Dividends / Interests etc..7) Repayment of Loans / Advances / Deposits etc.
This budget is based on several factors such as : i) Several functional budgets, particularly sales, Purchases, etc,ii) Credit terms on sales, purchases and expenses.
Illustration 1 Prepare a Cash Budget of a company for April, May and June, 2003 in a columnar form using the following information:
You are further informed that:a) 10% of the purchases and 20% of sales are for cash.
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b) The average collection period of the company is ½ month and the credit purchases are paid off regularly after one month.
c) Wages are paid half monthly and the rent of Rs.500 included in expenses is paid monthly.
d) Cash and Bank balances as on April 1, was Rs. 15,000 and the company wants to keep it on the end of every month below this figure, the excess cash being put in fixed deposits.
Solution:
Working Notes :
Calculation of amount realized from Debtors: March April May JuneCredit Sales (80% of sales) 60,000 72,000 68,000 64,000 A Limited Company is to be formed to take over a running business. It has been decided to raise Rs. 55 lakhs by issuing equity shares, and the balance of capital required in the first six months is to be financed by a financial institution against an issue of Rs. 5 lakhs 8 per cent debentures (interest payable annually) in its favour.
Initial outlay consists of Rs. Freehold premises 25 lakhs Plant and Machinery 10 lakhs Stock 6 lakhs Vehicles and other items 5 lakhs(Payments, on above items are to be made in the month of incorporation)Sales during the first six months ending on June 30, are estimated as under :-
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January Rs. 14 lakhs April Rs. 25 lakhs February Rs. 15 lakhs May Rs. 26.50 lakhs March RS. 18.50 lakhs Lag in payment Debtor 2months Creditor 1monthsOther information:
(a) Preliminary Expenses: Rs. 50,000 (payable in February ). (b) General Expenses: Rs. 50,000 per month, at the end of each month. (c) Monthly wages & Salaries (payable on the first day of the next month ) : Rs. 95,000 thereafter.(d) Gross Profit rate is expected to be 20% on sales.(e) The Shares and debentures are to be issued on 1 st January.(f) The stock level throughout is to be the same as the outlay.
Prepare cash Budget, and a projected trading & profit & Loss Account for the 6 months ended June 30, and the projected Balance Sheet as at that date. (24 marks)
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Working Notes :
(1) Purchases: Since G.P. ratio is 20% , 80% of the sales in each month less wages etc. will represent the figure of purchase. For example, in June sale is Rs. 28 lakh and 80% thereof is Rs. 22.40 lakh. Hence purchase is calculated at Rs. 21.45 lakh, i.e. Rs. 11.20 lakh less wages, Rs. 0.80 lakh. The amount is shown as payment in February.
(2) In the absence of information, no depreciation has been calculated on the4 Fixed Assets.
Illustration 2 From the following information, prepare a monthly Cash Budget for the three months ending 31st December, 2003 :
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a) Credit terms are :i) Sales : 4 months to Debtors, 10% of sales are on cash. On an average, 50% of credit
sales are paid on the due dates while the other 50% are paid in the following months.
ii) Creditors of material : 2 months.b) Lag in payment : Wages : ¼ month Overheads : ½ month.c) Cash and Bank balances : On 1st October it is expected to be Rs. 1,500.d) Other information are :
i) Plant and Machinery to be installed in August at a cost of Rs. 24,000. It will be paid for by monthly installments of Rs. 500 each from 1st October.
ii) Preference share dividend @ 5% on Rs. 50,000 is to be paid on 1 st December.iii) Calls on 250 equity shares @ Rs. 2 per share expected on 1 st November.iv) Dividend from investments amounting to Rs. 250 are expected on 31st
December.v) Income tax (advance) to be paid in December: Rs. 500.
Solution:
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Working Note:Calculation of Receipts from sales:
Illustration 3 A company newly starting manufacturing operations on 1st January, 2003 has made adequate arrangement for funds required for fixed assets. It wants you to prepare on estimate of funds required as working capital. It is to be remembered that: a) In the First month, there will be no sale, in the subsequent month, sale will be 25 % cash and 75% credit. Customers will be allowed one month credit. b) Payment for purchase of raw materials will be made on one month credit basis. c) Wages will be paid fortnightly on the 22 nd and the 7 th of each month. d) Other expenses will be paid one month in arrear except that 50% of selling expenses are to be paid immediately on sale being effected. The estimated sales and expenses for the first six months, spread evenly over the period subject to (a) above are as under :
The articles produced is subject to excise duty equal to 10% of the selling price. The duty is payable on March 31, June 30, September 30 and December 31, for sales upto February 20, May 31 and November 30 respectively. Prepare Cash Budget for each of the six months indicating the reqirements of Working Capital.
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Solution:
Illustration 4 Draw out cash budget for October to December from the following assuming that cash and bank balances on 1 st October are Rs. 20,000.
Information : a) Credit period allowed : i) to customers : 1 month ii) by suppliers : 2 months.b) Time lag in payment of : i) wages : ¼ th month ii) other expenses : 1/8 month.
d) Cash sales are expected at 1/5 th of total sales of each month.
Solution:
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Illustration 5 A newly started company wishes to prepare cash budget fro a period of 4 months from January to April on the basis of the following information:
Sales commission at 5% on total sales is to be paid within the month following actual sales. Cash balance on 1 st January is expected to be Rs. 10,000/- A new machine is to be installed at Rs. 30,000/- to be paid in two equal installments during March and April. Rs. 10,000/-being the amount of second call may be received in march. Share premium of Rs. 2000/- is also expected to be received along with second call money.
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Period of credit allowed by suppliers : 2 months. Period of credit allowed to customers : 1 month. Delay in Payment of over
Illustration 6 Prepare Cash Budget for the three months ending 30 th June,2003 from the following information :
Sales: 10%sales are on cash. Of the remaining sales, 50% are collected in the next month and remaining balance in the next month. Creditors: Materials - 2 months. Wages- ¼ month. Overheads-1/2 month. Cash and Bank balance on 1st April, 1990 is expected to be Rs. 6,000/-Other information provided is as follows:
a) Plant and Machinery will be installed in February 2003 at a cost of Rs. 96,000/-. The monthly installments of Rs. 2,000/- is payable from April onwards.
b) Dividend at 5% on preference share capital of Rs. 2,00,000/- is to be paid on 1st June.c) Advance to be received for sale of vehicles Rs. 9,000/- in June.d) Dividend on investments amounting to Rs. 1,000/- is expected to be received in June.e) Income Tax (advance) to be paid in June is Rs.2,000/-.
Solution:
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Working notes :
Collection from Debtors: Rs. For April : Out of February 6,300 Out of March 6,750
13,050
(February Sales 14,000 Less 10% i.e. 1,400 = 12,600. Out of this, 50% in March and 50% in April, i.e.6,300 each month. March sales15,000 Less 10% i.e. 1,500 = 13,500. Out of this, 50% in April and 50% in May, i.e, 6,750 each month) For May = March 8,750 + April 7,200 = 13,950 For June = April 6,750 + May 7,650 = 14,400 Wages = For April = March 750 + April 2,400 = 3,150 For May = April 800 + May 2,700 = 3,500 For June = May 900 + June 3,000 = 3,900
Illustartion 7
Prepare Cash Budget of the Alpha Co. Ltd. Fro three months ended 30 th June , 2003 from the following information :
Additional information : 1. Sales are 20% cash and the balance are two months credit.2. Purchase are at one month’s credit subject to a cash discount of 5%.3. Wages are paid in ½ month and other expenditure on one month’s interval.4. During May, the Company pays a dividend of 15% on its equity capital of Rs.
2,00,000 and during June, deferred payment is instalment (quarterly) of Rs. 50,000 will fall due.
5. it is expected that at the end of march 2003, there will be cash balance of Rs.28,000.
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Solution :
Illustration 8 Prepare a cash Budget for the three months ended 30 th September, 2003 based on the following information : Rs.Cash at Bank on 1st July,2003 12,500Salaries and Wages estimated monthly 5,000Interest Payable- August 2003 2,500
Credit sales are collected 50% in the months sales are made and 50% in the month following. Collections from credit sales are subject to 5% discount if payment is received during the month and 2 ½ % (two and half per cent) if the payment is received in the following month. Creditors are paid either on ‘prompt’ or 30 days basis. It is estimated that 10% of the creditors are in the prompt category.
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Solution :
Illustration 9 Prepare a cash Budget of M/s. Warana Co. for the three months ending 30 th June, 2003 from the following information :
Additional Information:
1. 20% of purchases and 25% of sales are for cash .2. The average collection period of the company is ½ month.3. The credit purchases are paid regularly after one month.4. Wages are paid half- monthly and the rent of Rs. 500 included in expenses is paid
monthly. Other (remaining) expenses are paid after one month lag.5. Cash balance on 1st April, 2003 is expected to be Rs. 25,000.
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Solution:
Illustration 10 Lucky Ltd. Wishes to arrange overdraft facilities with its Bankers during the period April to June of a particular year, when it will be manufacturing mostly for stock. Prepare Cash Budget for the above from following data :a)
b) 50% of the credit sales are realized in the month following the sales and remaining sales in the second month.
c) Creditors are paid in the month following the purchases.d) Cash at Bank on 1st April (estimated) Rs. 25,000.
Solution :
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Illustration 11 Summarized below are the Income and Expenditure Forecasts for the month of March to August 2003 :
You are given in the following further information :a) Plant costing Rs. 16,000 is due for delivery 8in July payable 10% on delivery and the
balance after 3 months.b) Advance Tax of Rs. 8,000 is payable in March and June each.c) Period of credit allowed :
i) by suppliers : 2 months andii) by customers : 1 month.
d) Lag in payment of manufacturing expenses : ½ month.e) Lag in payment of all other expenses : 1 month.
Prepare a cash Budget for the months starting on 1 st May, 2003, when there was a cash of Rs. 8,000.Solution:
Notes :1. Collection from Debtors i.e. Credit Sales : As one months’ credit given, sales made
in the present month will be realised in cash in the next month, i.e. sales effected in April will be realised in May, those effected in May will be realised in June and so on.
2. Credit allowed by Suppliers : 2 months, Hence, payment will be made in the present month for the purchases made two months back, i.e., for purchases effected in march
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payment is made in May, for purchases made in April, payment is made in June and so on.
3. Manufacturing Expenses : Half the amount is to be paid in current month and the remaining half is paid in the next month.
Hence, the payment is made as under :
4. Other Expenses : As in the case of credit sales, 1 month’ lag is allowed, Hence, expenses of April are paid in May, expenses of May are paid in June and so on.
5. Plant of Rs. 16,000 is delivered in July and at the time of delivery, only 10% of the price is to be paid i.e. Rs. 1,600 are paid in July.
Illustration 12 Prepare a Cash Budget for the months ended 30 th September, 2003 based on the following information : Rs.Cash at Bank on 1 st July, 2003 25,000Salaries and Wages estimated monthly 10,000Interest payable: August 2003 5,000
Credit Sales are collection 50% in the month sales are made and 50% in the month following. Collections from credit sales are subject to 5% discount, if payment is received during the month of purchase and 2 ½ %, if payments is received in the following month. Creditors are paid either on a ‘prompt’ or 30 days basis. It is estimated that 10% of the creditors are in the ‘prompt’ category.Solution :
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Notes :
Long –term Cash Forecasting Long term cash is required for a period ranging from two to five years. Such forecast is helpful for planning capital investment outlays and long-term financing. Long term cash forecasting is done by adjusted Net Income method. This method shows long-term financial need for cash in future. It also indicates whether the need can be met out of internal, source or not. The format for adjusted net income is as follows :
Reports for Control Several types of cash reports may be prepared for the purpose of controlling cash. They are as follows :
Daily Cash Report This report shows cash balance at the beginning of the day, cash received, cash paid and the balance left out.
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Daily Treasury Report This report gives information about the changes in cash, marketable securities, debtors and Creditors. It gives a comprehensive picture of cash.
Monthly Cash Report This report shows actual cash receipts and payments on a monthly basis. The actuals are compared with the budgets and variances are calculated.
Cash Collection and Disbursement For understanding cash collection and disbursement it is necessary to known the concept of “float”.
Float The cash balance shown by the books is called the book, or ledger balance. The balance shown by bank account is called the available or collected balance. There are two types of float. Viz. disbursement float and collection float. Disbursement float is created by issue of cheques.Or example, on 31 st March, a company has a book balance of rs. 8,00,000. On 1 st April, it issued a cheques of Rs. 2,00,000 to its suppliers. On the same date the book balance will be reduced by Rs. 2,00,000. The book balance will not be reduced unless the cheques is presented for payment. Supposing it is presented on 5 th April. Between 1 st April to 5 th April, the available balance will be Rs. 8,00,000 where as the book balance will be Rs. 6,00,000. Hence, disbursement float will be Rs. 2,00,000. Collection float is created by receipt of cheques from customers. The book balance and available balance of a Ltd. Company on 31 st March is $RS. 8,00,000. On 1 st April, the company receives Rs. 3,00,000 from the customers. It is deposited into Bank but it is not available unless the cheques is realised. Supporting it is realised on 5 th April, Between 1 st April and 5 th April, the book balance will be Rs. 1,00,000 whereas the available balance will be Rs. 8,00,000. Hence, the collection float will be Rs. 3,00,000. Net float is the difference between the available balance and its book balance. As a finance manager you should try to maximise the net float. It meaqns you should try to speed up collections and delay disbursements.
SPEEDING UP COLLECTIONS Companies use the following methods for speeding up collections :
Lock Boxes Under the lock box system, customers are advised to mail their payments to soecial post boxes which are called lock boxes. These boxes are attended by the locak collecting banks instead of sending them to the company’s office. The local Bank collects the cheques from the lock box and deposits the same into the bank account of the customers and sends advice to the firm. Thus, through the lock Box System the processing time is saved.
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Concentration Banking In the system, the company asks its customers to deposit their cheques with their local branches rather than the corporate office. The cheques received by the local branch office are deposited for collection into a local bank account. Surplus funds from various local banks accounts are transferred to the principal bank regularly.
Delaying Payments Net float can be maximized by delaying payments. For this purpose, following techniques can be adopted :
a) Ensure that payments are made on due dates. b) Centralised disbursements. In this case payments are made by the head office of the company from its Central Bank Account.c) Arrange with the suppliers to set the due dates of their bills to match with the
company’s receipts.
Optimal Cash Balance One of the objectives of cash management is to maintain optimal cash balance which is not more than the requirements or less than t6he requirements. The company can take a decision regarding investment of excess cash.
OPTIONS FOR INVESTING SURPLUS CASH A company has the following options available for investment of surplus cash : 1. Term deposits with Scheduled Banks 2. Units of UTI 3. Mutual Fund Schemes 4. Read forwards 5.Treasury Bills 6. Certificates of Deposits 7. Commercial paper 8. Inter-corporate deposits 9. Bill Discounting.
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Strategies for Managing Surplus Cash Following are the seven strategies for handling the excess cash balance :
Do nothing The finance manager allows surplus funds to accumulate in the current account.
Make Adhok Investments In order to make some contribution, the finance manager makes adhok investments.
Ride the Yield Curve This is a strategy to increase the yield from the portfolio of marketable securities. If the finance manager expects fall in the rate of interest in the near future he would buy long –term securities. If the finance manager expects rise in interest rate, he would sell long-term securities.
Develop Guidelines A firm may develop a set of guidelines which reflect the view of the management regarding risk and return. For example do not speculate on interest rate changes, minimize transaction cost, hold marketable securities till maturity.
Utilize control Limits There are some models of cash management which set upper limit and lower limit for control of cash balance.
Manage with a portfolio perspective There are two steps in portfolio selection:
a) Define the efficient portfolio b) Select the optimal portfolio.
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Follow a Mechanical Procedure The finance manager may switch funds between Cash Account and Marketable securities using a mechanical procedure. There are some models which provide rules for such mechanical procedures.
CASH MANAGEMENT MODELS Baumol’s Model Baumol suggested that the cash should be managed in the same way as inventory and that the inventory model could reasonably reflect the cost volume relationship as well as cash flows. In this way EOQ could be applied to cash management. The model provides strong conceptual framework for cash management. The carrying cost of holding cash, i.e, the interest foregone on marketable securities is balanced against the fixed cost of transferring marketable securities to cash or vice versa.The model finds a perfect balance by combining holding cost and the transaction cost so as to minimize the total cost of holding cash he model assumes that the rate of cash usage is constant and known with certainty. It can be presented as follows :
2FI C = I
Where C = Optimal transaction size F = Fixed Cost per transaction T = Estimated cash Payment during the period.
I = Rate of Interest on marketable securities
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CHAPTER 7
Elements of cost and cost Accounting
IntroductionCost Accounting is one of the important disciplines of accountancy to give proper
information required to the management for effectively discharging its functions such as planning, organizing, controlling, directing, coordinating and decision making. In this regard Financial Accounting is concerned with record keeping directed towards the preparation of Profit and Loss Account and Balance Sheet. It provides information about the enterprise in a general way. Accordingly Financial Accounts are prepared as per the requirement of the Companies Act and Income Tax Act. The main purpose of financial accounting is to ascertain profit or loss of a concern as a whole for a particular period. Thus, financial accounting does not serve as the needs of management for effective control, determination of prices, making effective plan for future operations and formulating various policy decisions.
To overcome the limitations of the financial accounting, the cost accounting is a recent development born in response to the needs of management for detailed information about cost of a product or a unit pf services. Every business firm is expected to make profit in the long run and, keep costs within control. Recently the Companies. Act has made obligatory the keeping of cost records in some manufacturing companies. In essence, therefore Cost Accounting is now widely used by large manufacturing and non-manufacturing operations.
Definitions of Important ConceptsThe definitions of the following important concepts of Cost Accountancy are given
below: (a) Cost (b) Costing (c) Cost Accounting(d) Cost Accountancy (e) Cost Control (f) Cost Reduction(g) Cost Allocation (h) Cost Absorption (i) Cost Audit(j) Cost Unit (k) Cost Centre
(a) Cost : The word ‘Cost’ is used in a variety of ways. Cost may be defined as a total of all expenses incurred in a given thing. A I C P A defines cost as ‘the amount measured in money or cash expended or other property transferred, capital stock issued, services performed or a liability incurred in considerations of goods or services received or to received.’
‘Cost’ is defined by W.M. Harper in the following words “Cost is the value of economic resources used as a result of producing or doing the thing cost.”
(b) Costing : I C M A London has defined costing as “the technique and process of ascertaining costs.” As a technique, it refers to costing as the body of principles and rules concerned with appropriate allocation of expenditure for the determination of cost of products and services.
(c) Cost Accounting : Cost accounting is the method of accounting for cost. The I C W A defines Cost Accounting as the technique and process of ascertainment of costs. Cost
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accounting begins with the recording of all income and expenditure, and ends with the presentation of statistical data.
(d) Cost Accountancy : According to the Chartered Institute of Management Accountants London, cost accountancy means “the application of costing and cost accounting principles, methods and techniques to the science, art and practice of cost control and the ascertainment of profitability. It includes the presentation of information derived therefore for the purpose of managerial decision making. Thus, cost accountancy is the science, art and practice of a cost accountant.’(e) Cost Control : Cost control is the guidance and regulation by executive action of cost of operating an undertaking. It involves pre-determination of targeted costs, measuring the actual costs, investigating into the causes of variations and instituting the corrective action.
(f) Cost Reduction : The term ‘cost reduction’ refers to the achievement of real and permanent reduction in the unit of cost of goods manufactured or services rendered without impairing their suitability or diminution in the quality of product. Cost reduction involves saving in unit cost; such saving is of permanent nature and the utility and quality of the goods and services remain unaffected. (g) Cost Allocation : Cost Allocation is the allotment of whole item if cost to cost centers. The technique of charging the entire overhead expenses to a cost centre is known as Cost Allocation.
(h) Cost Absorption : The term ‘Cost Absorption’ refers to the process of absorption of all overhead costs allocated to or apportioned over particular cost centre or production department by the units produced.
(i) Cost Ascertainment : The term ‘Cost Ascertainment’ means to ascertain the cost of each product, process or operation and ensure that all the expenses have been absorbed in the cost of products. Cost Ascertainment is one of the important objectives of Cost Accounting.
(j) Cost Audit : I C M A defines ‘Cost Audit’ as a detailed examination or verification of cost accounts and check on the adherence to the cost accounting plan. The purpose of cost audit is to examine whether the methods laid down for ascertaining costs and other decisions are being properly implemented and whether the cost accounting plan is being adhered to or not. The purpose can be (i) Protective and (ii) Constructive. Protective purpose aims to examine that there is no undue wastage or losses and that the cost accounting system reflects the correct and realistic cost of production. Constructive purpose aims at providing the management with information useful in regulating production, choosing economic methods of operations, reducing the operational costs, etc. based on the findings during the course of cost audit.
(k) Cost Unit : The term ‘Cost Unit’ refers to a unit of product, service or time in relation to which costs may be ascertained. it is a unit of quality in terms of which costs can be measured. Cost Unit may be selected on the basis of (a) Single and (b) Composite (or) Commonly used.
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The following are some examples of Cost Units used in different industries :
Name of Industry Cost Units used Paper Per Tonne (or) Per kgSteel Per TonneSugar Per QuintalCement Per TonneTextile (cloth) Per MeterTransport Passenger KilometerElectricity Per Kilo Walt-hourBricks Per 1000 bricks
Cost CentreAccording to the Chartered Institute of management Accountants, London, Cost
Centre is defined as a location, person or items of equipment (or group of these) for which costs may b ascertained and used for purposes of cost control. In other words, cost centre is a part of an organization which includes location, processes, equipment, (or) machine centers, various department, person etc. in relation to which costs can be charged or ascertained.
Cost Centers can be classified into the following types:(1) Personal Cost Centre : It consists of a person or group of person, e.g.,
salesman, Marketing Manager, etc.(2) Impersonal Cost Centre : It is a Cost Centre which consists of a location or
items of equipment.(3) Operation Cost Centre : It consists of machines and/or persons carrying out
similar operations.(4) Process Cost Centre : It is a Cost Centre which consists of a specific process
or a continuous sequence of operations.
Objectives of Cost Accounting The following are the important objectives of Cost Accounting:
(1) Ascertainment of Cost.(2) Determination of selling price.(3) Cost control and cost reduction.(4) Ascertainment of profit of each activity.(5) Assisting Management in decision making.(6) Formulating Management in decision making.(7) Matching costs with revenue.
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Distinction between Financial Accounting and Cost AccountingThe following are the differences between Financial Accounting and Cost
Accounting:
Financial Accounting Cost Accounting(1) Purpose It is prepared for providing
information about the final results of the business activities as a whole for a particular period to its proprietors, outsiders etc.
The main purpose of Cost Accounting is to provide information to the management for the proper planning, control and decision making.
(2) Need Financial Accounts are maintained as per the requirements of Companies Act and Income Tax Act.
Cost accounts are maintained to meet the requirement of the Management.
(3) Recording Transactions are classified, recorded and analysed subjectively.
In cost accounting, transactions are classified, recorded and analysed objectively according to the purpose for which costs are incurred.
(4) Analysis of Profit
Financial accounting reveals the profit of a business as a whole.
Cost Accounting shows the profit made on each product, job or process.
(5) Accounting period
Financial accounts are prepared for a definite period.
Cost reports are prepared frequently and submitted to the management may be daily, weekly, etc.
(6) Stock valuation In financial accounts, stocks are valued at cost price or market price whichever is less.
Cost accounting stocks are valued at cost.
(7) Dealings Financial accounts deal with actual facts and figures.
In cost account lays emphasis on both actual facts and estimates or predetermined cost.
(8) Relative Efficiency
Financial accounts do not reveal the relative efficiency of each department or section.
Cost account provides information on the relative efficiencies of various plant and Machinery.
Management AccountingManagement Accounting helps the management in effectively performing its
functions or planning, organizing, controlling, co-ordinating and decision-making.The Institute of Cost and Management Accountants London has defined Management
Accounting as “the application of professional knowledge and skill in the preparation of accounting information in such a way as to assist management in the formation of policies, and in the planning and control of the operations of the undertaking.”
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Cost Accounting Vs Management AccountingThe following are the main distinctions between Cost Accounting and Management
Accounting:(1) Cost Accounting deals with cost ascertainment, cost allocation, cost
apportionment and cost control. Management Accounting provides all accounting information to the management for discharge of its functions effectively.
(2) Management Accounting has a wider scope as compared to cost accounting. Therefore Management Accounting uses more advanced techniques of Management reporting.
(3) Management Accounting deals with both Cost Accounting and Financial Accounting. But cost accounting deals with cost data.
(4) Standard Costing, Budgetary Control, Break-Even Analysis, Inventory Control etc. are the basic tools and techniques used in Cost Accounting. But in Management Accounting, fund flow analysis, cash flow analysis, ratio analysis etc. are the important tools used for analysis and interpretation of financial statements.
Advantages of Cost AccountingCost Accounting helps the Management to ascertain the true of every operation,
through setting objectives and standard of operation, comparison of actual performance with standard to reveal the discrepancies or variances. If the variances are adverse, the management takes up corrective measure to eliminate variations. The following are the advantages of cost accounting to the management, to the employees, to the creditors, to the government and to the public:Advantages to the Management
(1) Facilitates planning.(2) Helps in formulating policies.(3) Useful in setting up objectives and standards of performance.(4) Facilitates cost comparison.(5) Leads to effectives cost control.(6) Determines of selling price.(7) Ascertains profit of each activity.(8) Assists the Management in decision making.(9) Facilitates cost reduction.(10) Measures performance.
Advantages to the Employees(1) Ensures fair incentive wage schemes.(2) Facilitates job security, recognition and promotion.(3) Useful in measuring operating efficiency of the employees.
Advantages to the Creditors(1) Measures the financial strength and creditworthiness of the business.(2) Attract investors for extending their credit facilities.(3) Creates trustworthiness among the creditors, debenture holders, banks etc.
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Advantages to the Government (1) It helps to formulate business policies and national plans for industrial
development.(2) It facilitates assessment of taxation, and establishment of indexes.(3) It assists in effective utilization of resources, i.e. materials, labour and
machines etc.(4) It assists the government for cost reduction, price fixation, export and import
and granting subsidy etc.
Advantages to the public(1) It helps in elimination of wastages and inefficiencies.(2) It facilitates the consumers to pay fait price for products.(3) It leads to progress of national economic growth.(4) Creates employment opportunities.(5) Increases the living standards of the people.
Limitations of Cost Accounting The following are some of the limitations of cost accounting:
(1) There is lack of uniformity in regard to its procedure and practices.(2) Cost are classified and interpreted in such different manners that though given
the same title, they are computed on a different basis.(3) Lack of consistency becomes more acute when projections are made beyond
the recorded cost data.(4) Inherent limitations of cost accounting objections raised by different sections
of business societies against the introduction of cost accounting.(5) Cost accounting is unnecessary for recently established industries. And also
modern methods of costing systems are not suitable for all types of industries.(6) Cost accounting system involves considerable amount of expenditure at the
installation stage. Thus costing system is not economical for a small concern.(7) Cost accounting involves accounting procedures and record-keeping. These
are far more detailed and difficult than those required in financial accounting.
Installation of Cost Accounting SystemWhile installing a cost system, the cost accountant should consider the following
factors:(1) Objectives of Costing System: while installing a cost accounting system, it should be ensured that it will aid in ascertainment of cost, determination of selling price, cost control and cost reduction etc.(2) Nature of Business: Cost Accounting system should be suited to the nature of products and business. The nature of product and business is essential to determine proper method of costing on the basis of types of product, methods ad product life cycle, quantity, quality etc.(3) Nature of Organization: It is essential to examine existing organization structure of the company before introducing the costing system. Since the system is to be designed to suit the
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organization it is necessary to ascertain the layout, nature and size of the organization, scope o authority and responsibility.(4) Methods and Procedures: Before introducing the costing system, the Cost Accountant should carefully study the existing manufacturing procedures, process, methods, system of wage payments, receipts and issue of materials. This will help him to select the proper method of costing.(5) Communication: A good system of cost accounting will provide information which helps in decision making. Cost information should be made available promptly and regularly. It is necessary to examine the prompt reporting system.(6) Standardization: The system should be introduced after a detailed study of the standardization. Standard Forms should be used in order to reduce clerical work to the minimum.(7) Simplicity: The system to be adopted should be simple and easy to adopt to the changing requirement. The costing system should be capable of being understood by the operating personnel.(8) Co-Operation: There is need for co-operation and support of the various departments involved in the cost accounting process for being successfully implemented.(9) Reconciliation: Emphasis should be on whether separate set of cost and financial books are required or an integrated system has to be followed. This depends upon the nature and size of the industry. Where cost books are maintained independently of financial records there must be provision for reconciliation between the cost and financial records.
Practical Difficulties in Installing Costing System The following are the practical difficulties confronted in installing a costing system:(1) Lack of top management support.(2) Resistance from accounting department staff.(3) Non co-operation from user department.(4) Shortage of trained staff in costing department.(5) Heavy cost of installing the system.
Steps to Overcome Practical DifficultiesTo overcome these difficulties, the steps required are given below:(1) To sell the idea to top management to convince them of the utility of the system.(2) Resistance and non co-operation can be overcome by behavioral approach to
deal with the staff concerned effectively.(3) Proper training should be given to the staff at each level.(4) Regular meetings should be held with the cost accounting staff, user departments
staff and top management to clarify points.
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Cost – Methods, Techniques of Cost Accounting and Classification of Cost
1. METHODS OF COSTING
Meaning: The term ‘methods’ and ‘systems’ are used synonymously to indicate an integrated set of procedures based in a complex concept of ideas, principles and concepts. The term method of costing refers to cost ascertainment. Different methods of costing for different industries depend upon the production activities and the nature of business, For these, costing methods can be grouped into two broad categories: (1) Job costing and (2) Process costing.
(1) Job Costing Job costing is also termed as Specific Order Costing (or) Terminal Costing. In job
costing, costs are collected and accumulated according to jobs, contracts, products or work orders. Each job is treated as a separate entity for the purpose of costing. The material and labour costs are complied are complied through the respective abstracts and overheads are charged on predetermined basis to arrive at the total cost. Job costing is used in printing, furniture making, ship building, etc. Job costing is further classified into (a) Contract costing (b) Cost plus contract and (c) Batch costing
(a) Contract Costing: This method of costing is applicable where the job work is big like contract work of building. Under this method, costs are collected according to each contract work. Contract costing is also termed as Terminal Costing. The principles of job costing are applied in contract costing.
(b) Cost Plus Contract: These contracts provide for the payment by the contracted of the actual cost of manufacturer plus a stipulated profit. The profit to be added to the cost. It may be a fixed amount or it may be a stipulated percentage of cost. These contracts are generally entered into when at the time of undertaking of a work, it is not possible to estimate its cost with reasonable accuracy due to unstable condition of material, labour etc. or when the work is spread over a long period of time and prices of materials, rates of labour etc. are liable to fluctuate.
(c) Batch Costing: In Batch Costing, a lot of similar units which comprise the batch may be used as a cost unit for ascertainment of cost. Separate Cost Sheet is maintained for each batch by assigning a batch number. Cost per unit of product is determined by diving the total cost of a batch by the number of units of the batch. Batch Costing is used in drug industries, ready-made garments industries, electronic components manufacturing, T V Sets etc.
(2) Process CostingThis costing method refers to continuous operation or continuous process costing.
Process costing method is applicable where goods or services pass through different processes to be converted into finished goods. Process costing is used in Cement Industries, Sugar industries, Textiles, Chemical industries etc.
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The following are the important variants of process costing system:(a) Operation Costing: It is concerned with the determination of the cot of each operation rather then process. It offers scope for computation of unit operation cost at the end of each operation by dividing the total operation cost by total output if units.(b) Operating Costing: Operating costing is also termed as service costing. Operating costing is similar to process costing and is used in service industries. This method if costing is suitable for concerns rendering services. For example Hospitals, Transport, Canteen, Hotels, etc.(c) Output Costing: Output costing is also called Unit Costing (or) Single Costing. This method of costing is applicable where a concern undertakes mass and continuous production of single unit or two or three types of similar products or different grades of the same products. Under this method cost per unit is measured by dividing the total cost by number if units produce. Output Costing is used in industries like Cement, Cigarettes, Pencils and Quarries etc.(d) Multiple Costing: This method of costing means combination of two or more methods of costing like operation costing and output costing. Under this method of different sections of production are combined after finding out the cost of each and every part manufactured. This method of costing is suitable for the industries manufacturing motor cars, engines, aircraft, tractors, etc.
2. TECHNIQUES OF COSTINGCosting is the technique and process useful to allocation of expenditure, cost
ascertainment and cost control. In order to fulfill the needs of the management it supplies necessary information to the management. The following are the various techniques of costing:
(a) Uniform Costing(b) Marginal Costing(c) Standard Costing(d) Historical Costing(e) Absorption Costing
(a) Uniform Costing: Uniform Costing is not a distinct method of costing. In fact when several undertakings start using the same costing principles and/or practices, they are said to be following uniform costing. The basic idea uniform costing is that the different firms in an industry should adopt a common method of costing and apply uniformly the same principles and techniques for better cost comparison and common good.(b) Marginal Costing: The C.I.M.A. London defines Marginal costing as “a technique of costing which aims at ascertaining marginal costs, determining the effects of changes in costs, volume, price etc. on the Company’s profitability, stability etc. and furnishing the relevant data to the management for enabling it to take various management decisions by segregating total costs into variable and fixed costs.”(c) Standard Costing: Standard Costing is a technique of cost accounting which compares the standard cost of each product or service with actual cost to determine the efficiency of the operation, so that any remedial action may be taken immediately.
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(d) Historical Costing: Historical Costing is the ascertainment and recording actual costs when, or after, they have been incurred and was one of the first stages in the growth of the Cost Accountant’s work. Actual costs refer to material cost, labour cost and overhead cost.(e) Absorption Costing: Absorption Costing is also termed as Full Costing (or) Orthodox Costing. It is the technique that takes into account charging of all costs both variable and fixed costs to operation processed or products or services.
3. CLASSIFICATION OF COST
Classification is the process of grouping cists according to their common characteristics or features. There are various methods of classifying costs on the basis of requirements. The following are the important bases on which costs are classified:
(a) On the basis of Nature (or) Elements.(b) On the basis of Function.(c) On the basis of Variability.(d) On the basis of Normality.(e) On the basis of Controllability and Decision Making.
The following chart can explain further the classifications cost:
Classification of CostOn the basis of
Nature (or) Elements Function Variability Normality
(a) Material Cost (a) Production Cost (a) Fixed Cost (a) Normal Cost(b) Labour Cost (b) Administration Cost (b) Variable Cost (b) Abnormal Cost (c) Other Expenses (c) Selling Cost (c) Semi-Variable Cost
(d) Distribution Cost (or) Semi-Fixed Cost
Decision Making & Controlling
(a) Controllable Cost(b) Uncontrollable Cost(c) Sunk Cost(d) Opportunity Cost(e) Replacement Cost(f) Conversion Cost
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(1) On the basis of Nature (or) Elements : On of the important classification cost is on the basis of nature or elements. Based on elements, it is classified into Material Cost, Labour Cost and Other Expenses. They can be further subdivided into Direct and Indirect Material Cost, Direct and Indirect Labour Cost and Direct and Indirect Other Expenses.(2) On the basis of Function : The classification of costs on the basis of the various function of a concern is known as function-wise classification. Here there are four important functional divisions in the business organisation, viz.: (a) Production Cost (b) Administration Cost (c) Selling Cost and (d) Distribution Cost.(3) On the basis of Variability : On the basis of variability with the volume of production Cost is classified into Fixed Cost, Variable Cost and Semi Variable Cost; Fixed Costs are those incurred which remain constant with the volume of production. rent and rates of offices and factory buildings are examples of fixed cost.
Variable costs are those costs incurred directly with the volume of output. For example, cost of materials and wages to workers are the expenses chargeable with direct proportion to the volume of production.
Semi-Variable Costs are those costs incurred, partly fixed and partly variable, with the volume of production. Accordingly, it has both fixed and variable features. For example, depreciations and maintenance cost of plant and machinery.(4) On the basis of Normality : Costs are classified into normal features. Normal costs are those incurred normally within the target output or fixed plan.(5) On the basis of Controllability and Decision Making : Based on the managerial decision making and controllability the classifications are as follows: (a) Controllable Cost; (b) Uncontrollable Cost; (c) Sunk Cost; (d) Opportunity Cost, (e) Replacement Cost; and (f) Conversion Cost.(a) Controllable Cost: Controllable Costs are the costs which can be influenced by the action of a specified number of an undertaking. Controllable Costs incurred in a particular responsibility centre can be influenced by the action of the executive heading that responsibility centre. For example, direct materials and indirect materials. (b) Uncontrollable Cost: Uncontrollable Costs are those costs which cannot be influenced by the action of a specified number of an undertaking. In fact, no cost is controllable, it is only in relation to a particular individual that may specify a particular cost to either controllable or non-controllable. For example, rent and rates.(c) Sunk Cost: These are historical costs which were incurred in the past and are not relevant to the particular decision making problem being considered. While considering the replacement of a plant, the depreciated book-value of the old asset is irrelevant as the amount is a sunk cost which is to be written-off at the time of replacement. Unlike incremental or decremental costs, sunk costs are not affected by increase or decrease of volume. Example of sunk cost includes dedicated fixed assets, development cost already incurred.(d) Opportunity Cost: Opportunity costs mean the costs of forgoing or giving up an opportunity. It is the notional value of going without the next best use of time, effort and money. These indicate the income or potential benefits sacrificed because a certain course of action has been taken. An example of opportunity costs is the market value forgone or sacrificed when an old machine is being used.(e) Replacement Cost: Such expenses may be incurred due to factors like change in method of production, an addition or alteration in the factory building, change in flow of production
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etc. All such expenses are treated as production overheads, when amount of such expenses is large, it may be spread over a period of time.(f)Conversion Cost: Conversion cost are those costs incurred while converting materials into semi-finished or finished goods. It is the aggregate of direct wages ,direct expenses and overhead cost of converting raw materials into finished products.
COST SHEET (OR) STATEMENT OF COST
ELEMENTS OF COST
IntroductionElements of cost are necessary to have a proper classification and analysis of total
cost. Thus, elements of cost provide the management with necessary information for proper control and management decisions. For this purpose, the total cost is analysed by the elements or nature of cost, i.e., material, labour and overheads. The various elements of costs may be illustrated below
By grouping of the above elements of cost, the following divisions of cost are obtained:(1) Prime Cost = Direct Materials + Direct Labour + Direct Expenses(2) Work Cost (Factory) = Prime Cost + Factory Overhead(3) Cost of Production = Factory Cost + Office and Administrative Overhead(4) Cost of Sales (or) = Cost of Production + Selling and Distribution Overhead Total Cost
(1) Materials CostMaterials Costs refer to cost of materials which are the major substances used in
production and are converted into finished goods and semi-finished goods. Materials are grouped as direct materials and indirect materials.
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Direct Materials: Direct materials are those that form part of a product. Raw materials, Semi finished products, and finished products which can be identified with production of a product are known as direct materials. Sugar cane, cotton, oilseeds, woods etc. are examples of direct materials. The cost of materials involves conversion of raw materials into finished products.
Indirect Materials: Material costs, other than direct material cost are known as indirect material cost. Indirect materials cannot be identified with a particular unit of cost or product. Indirect materials are indirectly used for producing the products. Lubricating oil, consumable stores, fuel, design, layout etc. are examples of indirect material cost.
(2) Labour CostIn actual production of the product, labour is the prime factor which is physically and
mentally involved. The payment of remuneration of wages is made for their effort. The labour costs are grouped into (a) Direct Labour and (b) Indirect Labour.
(a) Direct Labour : Direct Labour cost or direct wages refer to those specifically incurred for or can be readily charged to or identified with a specific job, contract, work order or any other unit of cost are termed as direct labour cost. Wages for supervision, wages for labours who are actually engaged in operation or process are examples of direct labour cost.
(b) Indirect Labour : Indirect labour is for work in general. The importance of the distinction lies in the fact that whereas direct labour can be identified with and charged to the job, indirect labour cannot be so charged and has therefore to be treated as part of the factory overheads to be included in the cost of production. Examples are salaries and wages of supervisors, store keepers, maintenance labour etc. EXPENSES
All expenses are other than material and labour that are incurred for a particular product or process. They are defined by IMCA as “The cost of service provided to an undertaking and the notional cost of the use of owned assets.” Expenses are further grouped into (a) Direct Expenses and (b) Indirect Expenses.
(a) Direct Expenses : Direct Expenses which are incurred directly and identified with a unit of output or process are treated as direct expenses. Hire charges of special plant or tool, royalty on product, cost of special pattern etc. are the examples of direct expenses.
(b) Indirect Expenses : Indirect expenses are expenses other than indirect materials and indirect labour, which cannot be directly identified with a unit of output. Rent, power, lighting, repairs, telephone etc. are examples of indirect expenses.
Overheads All indirect material cost, indirect labour cost, and indirect expenses are termed as
Overheads. Overheads may also be classified into (a) Production or Factory Overhead (b) Office and Administrative Overheads (c) Selling Overhead and (d) Distribution Overhead.
(a) Production Overhead : Production Overhead is also termed as Factory Overhead. Factory overhead includes indirect material, indirect material, indirect labour and indirect wages which are incurred in the factory. For example, rent of factory building, repairs, depreciation, wages of indirect workers, etc.
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(b) Office and Administrative Overhead: Office and Administrative Overhead is the different expenditure incurred in formulating the policies, establishment of objectives, planning, organizing and controlling the operations of an undertaking. All office and administrative expenses like rent, staff salaries, postage, telegram, general expenses etc. are examples.
(c) Selling Overhead: Selling Overhead is the indirect expenses which are incurred for promoting sales, stimulating demand, securing orders and retaining customers. For example, advertisement, salesmen’s commission, salaries of salesman etc.
(d) Distribution Overhead: These costs are incurred from the time the product is packed until it reaches its distinction. Cost of warehousing, cost of packing, transportation cost etc. are some of the examples of distribution overhead.
COST SHEETMeaning: Cost Sheet or a Cost Statement is “a document which provides for the assembly of the estimated detailed elements of cost in respect of cost centre or a cost unit.” The analysis for the different element of cost pf the product is shown in the form of a statement called “Cost Sheet”. The statement summarizes the cost of manufacturing a particular list of product and discloses for a particular period:
(I) Prime Cost;(II) Works Cost (or) Factory Cost;(III) Cost of Production;(IV) Total Cost (or) Cost of Sales.
Importance of Cost Sheet(1) It provides for the presentation of the total cost on the basis of the logical
classification.(2) Cost Sheet helps in determination of cost per unit and total cost at different stages
of production.(3) Assists in fixing of selling price.(4) It facilitates effective cost control and cost comparison.(5) It discloses operational efficiency and inefficiency to the management for taking
corrective action.(6) Enables the management in the preparation of cost estimates to tenders and
quotations.
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CHAPTER 8
CAPITAL STRUTURE AND ROLE OF FINANCIAL INSTITUTION
Sources of long term and medium term finances Earlier the traditional sources of finance was share capital Including ordinary capital and preference capital. Over a period of time preference share capital lost its essence. Even the Ordinary share capital, which is known as equity share capital also gradually losing its significance and the corporate have gone for public deposits and debentures. We discuss below the sources available for long term financing.Equity/Ordinary share capital:Equity is that part of Capitalization which is not debt. It is the Ownership interest, which represented the first claim on assets and earning. Equity shares are purchased mainly with a eye on capital appreciation the reason being the return by way of dividend is very small. The equity shareholders are the real owners and also risk bearers of the company.
Features of equity shares: There is no fixed dividend on equity shares. The rate of dividend depends on the
amount of profits available for distribution and recommendation of the Board of Directors.
Equity shareholders have voting powers in the annual general meeting of the company.
Equity shareholders bears the risk of the business enterprises. Through they are the providers of long term finance their capital and returns are not safe.
The equity shares can be transferred to others according to a procedure laid down in the Articles of Association.
Dividend to the equity shareholders are paid only after paying interest to debenture holders and dividend to preference Shareholders. Hence there is no priority in payment of dividend.
In case of winding up of the company the equity shareholders are paid in the last only if any amount is left and hence there is no priority even in repayment of capital.
The equity share capital has a direct relationship with the progress of the company. If the company makes goods progress the market value of the shares goes up. Hence there is a fluctuation in value.
Preference shares: The alternative source of raising the long-term finances in a company is through issuance of preference shares. As the name indicates the preference shareholders gets priority over the other shareholders. Preference Share can be Ordinary preference shares.
Features of Preference Shares Preference shareholders get a fixed rate of dividend as dividend at the time of issue of
preference shares. Preference shareholders have no voting rights in the Annual general meetings. They
get the voting rights when their interest is affected.
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Cumulative preference shareholders are liable to accumulate their dividend even when the company makes losses.
Preference shareholders are given priority in repayment in case of winding up of the company.
Debentures The bulk of funds raised from capital in the recent times is through debentures. For the joint stock companies’ debentures are the major sources of long term financing. The main difference between share capital and debenture is that the share capital is “Owned Capital” of the company and debenture is “Borrowed Capital” of the company. A debenture is a document issued by a company in evidence of debt. The issue of the debentures is governed by the same rules as the issue of shares. Debenture is a smallest part of loan issued by a company and public can purchase as many parts of the loan as they like.
Features of Debentures A fixed rate of interest is paid at regular intervals to the Debenture holders. The debenture carries the company’s common seal which provides the repayment of
principle amount. The interest on debenture has to be paid whether the company makes profit or not. The repayment of capital is made first to the debenture holders. Dentures are generally secured by a fixed or floating charge on the assets of the
company A debenture holder is also known as creditor of the company. Hence debenture has
creditor-ship security.
Retained Earnings The profits, which are not distributed and kept in the business, are retained earnings. Retained earnings serve as a source of long-term finance. They are readily available in the company and have no floating costs.
Term Loans Term Loans also known as project finance loans are popular way of arranging finances and are usually given by commercial banks and financial institutions. Term loans can be
a) Long term loans b) Short term loans
The main purpose of term loan is a) New Projectsb) Expansion projects and c) Diversification Projects
Features of Term Loans Term loan has a maturity usually ranging from 6 to 10 years. The maturity can be
rescheduled due to exigencies and loan to be repaid in equal installments. Terms of the term loan are negotiated between borrowers and financial institutions. All term loans are secured by assets of the company.
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Term loans are associated with covenants. The covenants are restriction and conditions imposed by the Lender
Covenants are Asset related, liability related cash flow related and control related Asset related covenants are Maintenance of minimum assets base Minimum current ration No further charges of assets to be given by companies Restriction on sale of fixed assets. Liability related covenants are Restriction of additional debt without concurrence Reduction in debt equity ratio by issue of additional share capital Prohibition on disposal of promoter’s shareholdings. Cash flow related covenants are Restriction on new projects without permission. Limitation on higher dividend, controlled related covenants are Appointment of nominee directors Board of Directors and Management should be set up in consultation with Financial Institution.
COST OF CAPITAL Cost of capital is the rate of return required by those who supply capital. Cost of capital is very important concept in formulating capital structure of the company. As everything in life costs something, raising finances such as equity share capital, preference share capital, debentures and long term borrowings also incur cost In order to evaluate projects of average risk, we must know the overall cost of capital. Cost of capital which is calculated as the weighted average of each component of capitalThe components of cost of capital are
Cost of debtCost of Equity sharesCost of preference sharesCost of retained earnings
Each component is calculated as follows:Cost of Debt (Kd): Calculation of the after tax cost of debt based on the effective interests rate. The following formula is used to calculate the cost of debt:Kd = I/ NP (1-T) where I is Interest on debtNP is net proceeds of the debtT is the Tax Rate.
Example Century Corporation borrowed Rs. 100,000 at 8% interest. The amount of the loan proceeds was Rs.96,000 and the tax rate is 35%.Cost of Debt = 8000/ 96,000 ×(1- 0.35) = 8.3% × .65 = 5.4%
Cost of Equity shares: There are three different methods used to calculate the Cost of Common Stock.
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1. Dividend Price Ratio: Dividend paid to common shareholders is used to calculate a cost for the common stock. The formula for calculating the cost of common stock is as follows DP Ratio = Dividend on share/Market price of share ×100
2. Price Earning Ratio: Under this method instead of dividend per share earning per share is taken into consideration EP Ratio = Earning/ Market Price of share ×1003. Dividend Price + Growth Rate: This method is same as DP Ratio but anticipated growth rate will be added to DP ratioCost of capital = Dividend/Market price of the Share + Growth rate Example-Calculate the Cost of Common Stock based on Dividend Growth. Grant Corporation except to pay a Rs.6.00 as dividend this year to common shareholders. Historically, dividends have grown by 2% each year. Grant’s common stock is currently selling for Rs. 45.00 per share.Cost of Common Stock = (Rs.6.00/Rs 45.00) + 2% = 15.3%. Cost of Preference share (Kp): If capital structure of the company includes preference shares, the cost of preferred stock is calculated by the amount of dividend in relation to the market price of the preferred stock.The formula is Kp = Dividend on preference share/ Market Price of Stock.
Example-Calculate the cost of Preference shares Assume the company’s preference shares are sold for Rs. 80 per share and dividend per share is Rs. 10.The cost of preferred stock is:Kp = Rs. 10 / Rs. 80 = 12.5%.
Cost of Retained Earnings – The cost of retained earnings (intended funds) is similar to the cost of common stock. The cost of retained earnings is the opportunity cost of how we can use these funds. Generally, the cost of retained earnings is slightly less than the cost of common stock since no issuance costs is incurred.
Weighted Average Cost of Capital After the calculation of each component cost of capital, the effort should be made to calculate a weighted average cost of capital by giving proper weights to capital structure.
Example-Calculate Weighted Average Cost of CapitalA Company has the following capital structureCapital Component Book Value Cost of capital Long Term Debt Rs.5,000,000 5.4%Common stock Rs.2,500,000 13.9%
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Preferred Stock Rs. 500,000 12.5%Retained Earnings Rs. 750,000 12.0%The percentage of each component of capital in relation to total Capital structure is as follows:
Capital Component
Book Value % in total structure
Cost of Capital
% WCC
Long Term Debt 5,000,000 57.14 5.4% 3.08Common Stock 2,500,000 28.57 13.9% 3.97Preferred Stock 500,000 5.71 12.5% 0.71Retained Earnings 750,000 8.58 12.0% 1.02Total capital 8,750,000 100.00 8.79
Hence the weighted average cost of capital of the firm is 8.79%
What is capital structure? The word capital refers to the wealth, which is used in the production of additional wealth. The capital structure is made up of debt and equity, which comprises firm’s financing of its assets. The long-term investments a company makes today will determine the value of business tomorrow. In order to make long-term investments in new product line, new equipment and other assets, Finance managers must know the cost of obtaining funds to acquire these assets. The cost of obtaining funds to acquire these assets. The cost associated with different sources of funds is called the cost of capital. Cost of capital represents the rate a business must pay for each source of funds-debt, preference capital Equity share capital, and retained earnings. Since every company tries to maintain exiting market values, cost of capital is the minimum acceptable rate of return for long-term investments. If the business earns more than its cost of capital, the market value of the business will increase. Likewise, if returns on long-term investments are below the cost of capital, market values will decline. This leads us to a very important goal of financial management maximizing values for the owners of the business. Therefore, capital management is extremely important to fulfilling the basic objectives of increased shareholders value.
How to plan the capital structure? Capital structure refers to the mix of sources from which the long-term funds required in a business are raised. What should be the proportion of equity share capital, preference share capital, internal sources and debentures, long-term and other sources of long-term funds in the total amount of capital with an undertaking is the major task of a financial manager.
What are the basic considerations in managing capital? After understanding the importance of capital, one should focus on how to manage capital within an organization. The overall objective is to find an ‘optimal’ capital structure-the right mix of capital sources (debt and equity) that minimizes the overall cost of capital and maximize values to the shareholders (owners of the business). When a company raises capital, there are two choices
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Issue debtIssue stock Debt is represented by debentures, bonds, which are long term instruments sold to investors. Stock is the ownership interest of the business, stockholders will have certain rights. Therefore, one should understand the capital management by looking at the advantages and disadvantages of the two sources of capital.
Some advantages for using equity capital are: No fixed payment is required to investors; dividends are paid only as earnings are
available. No maturity data on the security, the invested capital does not have to be repaid. Improves the credit worthiness of the company.
Some disadvantages are: Dilutes the earnings per share to shareholders. Issuance costs are higher than debt. Issuing more stock can increase the overall cost of capital. Dividend payments to shareholders are not tax deductible.
Some advantages of using debt are: Interest payments are tax deductible. Does not dilute earnings per share or control within the company. Cost is fixed; interest and principle do not change. Expected returns to investors are usually lower than stock.
Some disadvantages of debt are: Fixed charges must be paid regardless of available earnings or cash flow. Adds more risk to the business. Has a maturity date and the capital invested must be repaid to investors.
Factors that determine capital structure There are certain factors and conditions, which determine the capital structureEconomic conditions: The demand and supply of capital in the marketplace can impact how capital is raised. For example, expectations of inflation will influence the cost that is paid for capital. Higher rates of inflation erode the value of investments and thus, investors will demand higher rates of return.
Market conditions: If a company raises capital with a security that is not highly marketable, investors will require higher rates of return for the increased risk.Operating conditions: The level of fixed costs used to operate the business needs to be considered. For example, higher fixed costs can result in wider variations to operating income from numerous factors-increased competition, slower economic growth, etc.
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Financial Conditions: The existing levels of outstanding debt and preference stock will have impact how capital will be raised. Higher levels of debt can result in wider variations to earnings due to higher fixed obligation that must be paid. Ex: interest to debt holders and fixed dividend to preferred stock holders. This is referred to as financial risk. Capital structure appears in the Balance Sheet as liabilities and equity; i.e. the long-term sources of funds to finance assets. Capital structure is the permanent financing of the business through the use debt and stock. The total of all liabilities and equity is referred to as Financial Structure. Therefore, Capital Structure = Financial Structure – Current Liabilities.Finding the right capital structure encompasses numerous considerations such as
Growth rates in sales, Risk attitudes of management, Liquidity of assets, Control position of the company, etc
Major consideration in capital structure planning are Risk, cost and control which help the finance manager in determining the proportion in which he can raise funds from various sources.
Risk Risk is of two kinds one is financial and the other is business risk. Here we are concerned primarily with the financial risk. Financial risk is of two typesa) Risk of cash insolvency: As a firm raises more debt, its risk of cash insolvency increased.
This is due to two reasons. Firstly higher proportion of debt that increases the commitments of the company with regards to fixed charges. This means that a company stands commitment to pay a higher amount of interest irrespective of the fact whether it has cash or not. Secondly, the possibility that the suppliers of funds may withdraw the funds at any given points of time also raises the risk of cash insolvency. Thus the long-term creditors may have to be paid back in installments, even if sufficient cash to do so does not exist. This risk is not there in the case of equity shares.
b) Risk of variation in the expected earnings available to equity share-holders: In case a firm has higher debt the risk of variation in expected earnings available to equity shareholders will be higher.
Theories of Capital Structure: Four theories have been identified to determine the optimum capital structure.I. Net Income Approach: This approach is given by Durand David. According to this approach the capital structure
decision is relevant to the valuation of the firm. There are three basic assumptions of Net Income approach.
o Corporate taxes do not exist.o Debt content does not change the risk perception of the investors.o Cost of debt is less than the cost of equity.
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This approach states that, with an increase in the leverage, the overall cost of capital declines and the value of the firm increases so that the optimum capital structure reaches maximum level of debt in the capitalization. In short cost of equity and cost of debt remain constant when debt equity ratio changes.
II. Net Operating Income Approach (NOI): This approach assumes that the value of the firm is independent to its capital structure. It believes that the leverage has no effect at all on the overall cost of capital and the value of the firm. According to this approach, the overall cost of capital and the cost of debt remain constant for all degrees of leverage. The following are the assumptions of Net operating income approach
o The investors capitalize the total earnings of the firm to find the total value of the firm as a whole
o The overall cost of capital of the firm is constant and depends upon the business risk, which is assumed to be unchanged. The cost of Debt of also constant.
o There is no tax.
III. Traditional Approach: This approach assumes that the overall cost of capital can be changed by increasing or decreasing the debt equity mix. This implies that every source of funds involves cost. The assumption of this approach is that when the debt equity ratio increases the overall weighted average cost of capital decreases.
IV. Modigliani-Miller Approach: This approach is invented by Modigliani and Miller. According to them the total cost of capital of a firm is independent of its methods and levels of financing and the average cost of capital of the firm is independent of its capital structure. The assumptions of this approach are: In the capital market individual and companies can borrow unlimited amounts at the
same rate of interest There are no taxes or transaction costs The firm’s investment schedule and cash flows are assumed constant and perpetual. The stock markets are perfectly competitive. Investors are rational and except other investors to be rational The firm exists with the same business or systematic risk at different levels of business
levels of business.
LEVEARGES A finance manager should estimate the requirement of funds for meeting the laid down objectives of the company. As the finance manager raises the estimated funds for the company before producing these funds he should determine the best mix of such funds or decides about the capital structure of the concern. The desired structure of funds influences the shareholders return and risk. Leverage analysis is the technique used by business firms to qualify risk-return relationship of different alternative capital structures.
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What is Leverage? The term leverage in general refers to a relationship between two interrelated variables. In financial analysis it represents the influence of one financial variable over some other related financial variable. These financial variables may be costs, output, sales revenue, Earnings before Interest & Tax (E.B.I.T.) Earnings per share(E.P.S) etc. Leverage is the ability of the firm to use fixed costs to magnify the returns to the shareholders There are three commonly used leverage in financial analysis. These are: i) Operating Leverageii) Financial Leverageiii) Combined Leverage
OPERATING LEVERAGE Operating leverage occurs when a firm has fixed cost which must be met regardless of volume of sales. When the firms has fixed costs, the % change in profit due to changed is sales level is greater than the % changes in sales. The operating leverage is calculated by the following formula:
Operating Leverage = Contribution / Earning Before Interest & Taxes (EBIT)
Where as contribution is sales value minus variable costs. Significance of operating leverage Analysis of operating leverage of a firm is very useful to the financial manager. It tells the impact of changes in sales on operating income. The operating leverage depends on fixed costs. If the fixed costs are higher, the higher would be form’s operating leverage and its operating risks. If operating leverage is high, it automatically means that the break-even points would also be reached at a high level of sales. Also, in the case of higher operating leverage, the margin of operate sufficiently above break-even point to avoid the danger of fluctuations in sales and profits.
WHAT IS FIANACILA LEVERAGE Financial leverage is defined as the ability of a firm to use fixed financial charges to magnify the effects of changes operating profits. The financial leverage occurs when a firm’s capital structure contains obligation of fixed financial charges e.g. Interest on debentures, dividend on preference share etc. along with the owner’s equity to enhance earnings of equity shareholders. The fixed financial charges to not vary with the operating profits or E. B. I. T. the ordinary shareholders of firm are entitled to residual income i.e. /earnings after financial charges. The financial leverage is CALCULATED by the following formula:Financial Leverage = EBIT / EBT
Combined Leverage Combined Leverage = Operating Leverage × Financial LeverageWhen the above formula is applied we getContribution / EBIT × EBIT / EBT Hence combined Leverage = Contribution / Earnings Before Taxes (EBT)
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Appraisal of Term Loans A financial institution has to carefully evaluate an application for a term loan before it is granted. This is because a term loan is a long term commitment of a substantial amount of funds. In a way, when it is grants a loan, the financial institution participates in the venture itself since it a quants a part of the risk by committing its own funds substantially. The repayment of the loans and the interest payments, no doubt, have priority over the money that it to be paid to the shareholders. Yet to committee substantial sums of money in a new business undertaking requires a very careful analysis of all aspects of the projects. The appraisal techniques of a term loan, therefore, are different than the conventional method by which bank apprise short term loans. Apart from the security, the technical institution look for managerial competence, basic viability of the project, demand of the project and technical excellence of the project. The financial institutions operating at he national level have device more or less common procedure of appraising long term loans and have a single proforma which may be submitted to any institution. Before a concern applies for loan, it must possess a Letter of Intent or other sanctions from the Government such as registration with DGTD or No Objection Certificate from the State Government. It must also have foreign exchange requirements sanctioned by the government as also a clearance for the technical and foreign collaboration agreement, if any. In case clearance is require under the MRTP Act, this must also be obtained. These, together with the filled application form and the detailed project report, constitute the basis on which the financial institutions appraise term loan. Normally, the financial institution for scrutinize the application at a preliminary level. If they are satisfied, they issue the detail application form. This application proforma for term loans is quite broad in its coverage and includes the general particulars of the company, its promoters and the management. In case it is an existing company, particulars of present production facilities; production, sales, raw material, inventories, executives, labour, research and development, existing capital structure and finance are also sought. In case it is a new project or in case an existing company seeks loans for a new project, details are sought regarding technical features, foreign technical collaboration and financial participation, estimated cost, installed capacity, particulars of land and building, plant and machinery, margin for working capital, the proposal for financing, production, sales, the future market profitability and cash flow, etc. Separate details are required regarding the security offered. The annexure to the application form contains details regarding existing and projected unit cost of production, past balance sheet, cost and profitability analysis, sources and uses of funds, estimated cost of the scheme and particulars about machinery, etc. The financial institutions generally conduct feasibility study on many aspects i.e., technical, commercial, economic, financial, social and managerial. These broad aspect of appraisal are briefly discuss below:-
1. Technical Feasibility: This has the following aspects: Review of infrastructure facilities, i.e., land, housing, transportation, raw material,
supplies, fuel, power and electricity etc. The location of the project, judged from the point of view of economy and
workability. The proposed size of the plant and capacity level.
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In case the technical know how has been imported from a foreign country its suitability and workability in the Indian conditions.
The project schedule in detail. The financial institution are extremely keen that the project schedule is drawn up in a manner that the project can be completed as stipulated. This is because delay increases costs substantially in view of the inflationary trends. Delay also increases the financial cash losses. All this result in acute shortage of working capital funds. As an example, a sugar plant of 1250 tonnes capacity which could be set up only at a cost of Rs.250 lacks in 1973, could in 1975 be set up only at a cost of Rs. 820 lacks. Thus a delay in the project schedule can upset all the calculations.
2. Economic Feasibility: This examines the market potential of the product proposed to be manufactured. It is important to analyse whether or not the out put of the new unit will be absorbed in the market. These projections are basically dependent upon the market forecasts for the product. For this purpose the overall demand forecasts of various important categories of product are regularly developed by various agencies. The planning commission while formulating the plans also has certain basic estimates of the demand and production of certain commodities. The financial institutions go into demand projection and examine whether or not the demand for the product will be there. Th projection of the demand, since it deals with future, is a highly complicated matter. It depends on a number of factors and statistical forecasting models are required to forecast demand for various products. Although such demand forecasts are basically approximations, they are important since they denote the broad trends regarding a project.
3. Commercial Feasibility: This refers to an examination of the commercial aspects of and arrangements for the project. The financial institution try to examine the arrangements made be the applicant for procurement of machinery and raw material and for sale of goods. They ensure that such arrangements are purely commercial in nature and do not tend to benefit the promoters of their relatives. In this regard, if all the machinery is supplied by a single supplier, the financial institutions go into the details. However, if the machinery and the raw materials are to be supplied on the basis of competitive bidding, it is preferred by the financial institutions. Similarly, arrangement for sale of finished goods are looked into.
4. Financial Feasibility: This refers to an appraisal of the financial structure and the expected financial results of the project. The following basic issues are examined: Estimates of the cost of the project are examined to ensure that the estimated costs
cover all items of expenditure and the assumptions made behind such costs are realistic in nature. Thus, where an applicant does not provide for the possible inflation and its impact on costs, the financial institution require him to change his cost estimates.
The sources of finances are examined in depth. The financial institution are very keen that the total financial requirements cover not only the cost of fixed assets but also contingencies, working capital and initial cash losses. As we have already emphasized, initial cash losses and pre-operative expenses tend to mount in the case
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of a delay in the project. This eats into the working capital available to the firm. If a financial institution finds itself in such a situation, it has to give more credit to the client to tide over these difficulties. Otherwise the institution is in the danger of losing even the initial sum of money. It is, therefore, important at the very beginning to ensure that adequate provision for contingencies working capital and initial cash losses has been made, taking into account the possible delays in the completion of the project.
The financial institutions also examine the pattern of financing the project. They prefer owners should commit their own funds substantially by way of subscription to share capital. Unsecured loans from promoters are allowed only in restricted circumstances and with the condition that the promoters unless interest has been paid to the financial institutions. Similarly, deferred payments in the case of large scale projects are not considered as supplementing working capital requirement as a stop gap arrangement. Financial institutions are keen that a proper debt equity ration is maintained. This is because this ratio, if sound, offers them a certain amount of security. The norms are that where the project is of less than Rs. 5 crores and is not in a backward area, at least 20 percent of the cost could be provided by the entrepreneurs. For technical, professional, qualified engineers, etc., at least 15 percent of the cost institutions normally wish to maintain a debt-equity ratio of 60:40. However, in extreme cases, specially in cases of over-runs, etc, they may allow a debt-equity ratio of 70:30.
In the case of an existing company, the impact of the new project on the level of production, net earnings, costs etc., is seen. The level at which the project is likely to break even is also examined.
The debt-services capacity and the repayment schedule are also looked into. The repayment schedule is drawn up as per the financial projections. Repayment, obviously, is to come from internal accruals and therefore, usually a stipulation is made in the loan agreement that the applicant will not declare a dividend higher than a certain rate without the consent of the financial institutions. The repayment schedule is also dependent upon the cash flow projections of the undertaking.
5. Managerial Assessment: An important part of assessment conducted by the financial institution is to examine the competence, skill and reliability of management. An assessment is made by the financial institutions regarding managerial skills keeping in view the professional qualifications, abilities, past record and integrity. Obviously, financial institution would put a premium on competent and honest management.
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CHAPTER 9
BUDGET CLASSIFICATION
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CHAPTER 10
ACCOUNTING RATIOS
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