Human Resources/MS 4 doubt in solving this
Q3. An Analysis of S Ltd. cost records give the following information.
Variable Cost Fixed Cost
(% of Sales) Rs.
Direct Material 32.8% -
Direct Labour 28.4 -
Factory Overhead 12.6 1,89,000
Distribution Overhead 4.1 58,400
Administration Overhead 1.1 66,700
Budgeted sales for the next year is Rs. 18, 50,000. You are required to determine:
(a) Break even sales value
(b) Profit at the budgeted sales volume
(c) Profit if actual sales: (i) drop by 10% (ii) increase by 5% from the sale.
Explain in detail the various accounting concepts and discuss the application of these concepts in the preparation of financial statements.
Solution: All financial statements should be created, preserved and presented according to the concepts and conventions that follow. Accounting concepts and conventions are the rules and guidelines by which the accountant lives.
The more important accounting concepts are briefly described as follows:
Separate Business Entity Concept- In accounting we make a distinction between business and the owner. All the books of accounts records day to day financial transactions from the view point of the business rather than from that of the owner. The proprietor is considered as a creditor to the extent of the capital brought in business by him. For instance, when a person invests Rs. 10 lakh into a business, it will be treated that the business has borrowed that much money from the owner and it will be shown as a ‘liability’ in the books of accounts of business. Similarly, if the owner of a shop were to take cash from the cash box for meeting certain personal expenditure, the accounts would show that cash had been reduced even though it does not make any difference to the owner himself. Thus, in recording a transaction the important question is how does it affects the business? For example, if the owner puts cash into the business, he has a claim against the business for capital brought in.
In so far as a limited company is concerned, this distinction can be easily maintained because a company has a legal entity of its own. Like a natural person it can engage itself in economic activities of buying, selling, producing, lending, borrowing and consuming of goods and services. However, it is difficult to show this distinction in the case of sole proprietorship and partnership. Nevertheless, accounting still maintains separation of business and owner. It may be noted that it is only for accounting purpose that partnerships and sole proprietorship are treated as separate from the owner (s), though law does not make such distinction. In fact, the business entity concept is applied to make it possible for the owners to assess the performance of their business and performance of those whose manage the enterprise the managers are responsible for the proper use of funds supplied by owners, banks and others.
Money Measurement Concept. In accounting, only those business transactions are recorded which can be expressed in terms of money. In other words, a fact or transaction or happening which cannot be expressed in terms of money is not recorded in the accounting books. As money is accepted not only as a medium of exchange but also as a store of value, it has a very important advantage since a number of assets and equities, which are otherwise different, can be measured and expressed in terms of a common denominator.
We must realize that this concept imposes two limitations.
Firstly, there are several facts which though very important to the business, cannot be recorded in the books of accounts because they cannot be expressed in money terms. For example, general health condition of the Managing Director of the company, working conditions in which a worker has to work, sales policy pursued by the enterprise, quality of product introduced by the enterprise, though exert a great influence on the productivity and profitability of the enterprise, are not recorded in the books. Similarly, the fact that a strike is about to begin because employees are dissatisfied with the poor working conditions in the factory will not be recorded even though this event is of great concern to the business. You will agree that all these have a bearing on the future profitability of the company.
Secondly, use of money implies that we assume stable or constant value of rupee. Taking this assumption means that the changes in the money value in future dates are conveniently ignored. For example, a piece of land purchased in 1990 for Rs. 2 lakh and another bought for the same amount in 1998 are recorded at the same price, although the first purchased in 1990 may be worth two times higher than the value recorded in the books because of rise in land values. In fact, most accountants know fully well that purchasing power of rupee does change but very few recognize this fact in accounting books and make allowance for changing price level.
Dual Aspect Concept- Financial accounting records all the transactions and events involving financial element. Each of such transactions requires two aspects to be recorded. The recognition of these two aspects of every transaction is known as a dual aspect analysis. According to this concept every business transactions has dual effect. For example, if a firm sells goods of Rs. 10,000 this transaction involves two aspects. One aspect is the delivery of goods and the other aspect is immediate receipt of cash (in the case of cash sales). In fact, the term ‘double entry’ book keeping has come into vogue because for every transaction two entries are made. According to this system the total amount debited always equals the total amount credited. It follows from ‘dual aspect concept’ that at any point in time owners’ equity and liabilities for any accounting entity will be equal to assets owned by that entity. This idea is fundamental to accounting and could be expressed as the following equalities:
Assets = Liabilities + Owners Equity............... (1)
Owners Equity = Assets - Liabilities............... (2)
The above relationship is known as the ‘Accounting Equation’. The term ‘Owners Equity’ denotes the resources supplied by the owners of the entity while the term ‘liabilities’ denotes the claim of outside parties such as creditors, debenture holders, bank against the assets of the business. Assets are the resources owned by a business. The total of assets will be equal to total of liabilities plus owners capital because all assets of the business are claimed by either owners or outsiders.
Going Concern Concept- Accounting assumes that the business entity will continue to operate for a long time in the future unless there is good evidence to the contrary. The enterprise is viewed as a going concern, that is, as continuing in operations, at least in the foreseeable future. In other words, there is neither the intention nor the necessity to liquidate the particular business venture in the predictable future. Because of this assumption, the accountant while valuing the assets do not take into account forced sale value of them. In fact, the assumption that the business is not expected to be liquidated in the foreseeable future establishes the basis for many of the valuations and allocations in accounting. For example, the accountant charges depreciation of fixed assets values. It is this assumption which underlies the decision of investors to commit capital to enterprise. Only on the basis of this assumption can the accounting process remain stable and achieve the objective of correctly reporting and recording on the capital invested, the efficiency of management, and the position of the enterprise as a going concern. However, if the accountant has good reasons to believe that the business, or some part of it is going to be liquidated or that it will cease to operate (say within six-month or a year), then the resources could be reported at their current values. If this concept is not followed, International Accounting Standard requires the disclosure of the fact in the financial statements together with reasons.
Accounting Period Concept. This concept requires that the life of the business should be divided into appropriate segments for studying the financial results shown by the enterprise after each segment. Although the results of operations of a specific enterprise can be known precisely only after the business has ceased to operate, its assets have been sold off and liabilities paid off, the knowledge of the results periodically is also necessary. Those who are interested in the operating results of business obviously cannot wait till the end. The requirements of these parties force the businessman ‘to stop’ and ‘see back’ how things are going on. Thus, the accountant must report for the changes in the wealth of a firm for short time periods. A year is the most common interval on account of prevailing practice, tradition and government requirements. Some firms adopt financial year of the government, some other calendar year. Although a twelve month period is adopted for external reporting, a shorter span of interval, say one month or three month is applied for internal reporting purposes.
This concept poses difficulty for the process of allocation of long term costs. All the revenues and all the cost relating to the year in operation have to be taken into account while matching the earnings and the cost of those earnings for the any accounting period. This holds good irrespective of whether or not they have been received in cash or paid in cash. Despite the difficulties which stem from this concept, short term reports are of vital importance to owners, management, creditors and other interested parties. Hence, the accountants have no option but to resolve such difficulties.
Cost Concept. The term ‘assets’ denotes the resources land building, machinery etc. owned by a business. The money values that are assigned to assets are derived from the cost concept. According to this concept an asset is ordinarily entered on the accounting records at the price paid to acquire it. For example, if a business buys a plant for Rs. 5 lakh the asset would be recorded in the books at Rs. 5 lakh, even if its market value at that time happens to be Rs. 6 lakh. Thus, assets are recorded at their original purchase price and this cost is the basis for all subsequent accounting for the business. The assets shown in the financial statements do not necessarily indicate their present market values. The term ‘book value’ is used for amount shown in the accounting records.
The cost concept does not mean that all assets remain on the accounting records at their original cost for all times to come. The asset may systematically be reduced in its value by charging ‘depreciation’, which will be discussed in detail in a subsequent lesson. Depreciation have the effect of reducing profit of each period. The prime purpose of depreciation is to allocate the cost of an asset over its useful life and not to adjust its cost. However, a balance sheet based on this concept can be very misleading as it shows assets at cost even when there are wide difference between their costs and market values. Despite this limitation you will find that the cost concept meets all the three basic norms of relevance, objectivity and feasibility.
The Matching concept- This concept is based on the accounting period concept. In reality we match revenues and expenses during the accounting periods. Matching is the entire process of periodic earnings measurement, often described as a process of matching expenses with revenues. In other words, income made by the enterprise during a period can be measured only when the revenue earned during a period is compared with the expenditure incurred for earning that revenue. Broadly speaking revenue is the total amount realized from the sale of goods or provision of services together with earnings from interest, dividend, and other items of income.
Expenses are cost incurred in connection with the earnings of revenues. Costs incurred do not become expenses until the goods or services in question are exchanged. Cost is not synonymous with expense since expense is sacrifice made, resource consumed in relation to revenues earned during an accounting period. Only costs that have expired during an accounting period are considered as expenses. For example, if a commission is paid in January, 2002, for services enjoyed in November, 2001, that commission should be taken as the cost for services rendered in November 2001. On account of this concept, adjustments are made for all prepaid expenses, outstanding expenses, accrued income, etc, while preparing periodic reports.
Accrual Concept- It is generally accepted in accounting that the basis of reporting income is accrual. Accrual concept makes a distinction between the receipt of cash and the right to receive it, and the payment of cash and the legal obligation to pay it. This concept provides a guideline to the accountant as to how he should treat the cash receipts and the right related thereto. Accrual principle tries to evaluate every transaction in terms of its impact on the owner’s equity. The essence of the accrual concept is that net income arises from events that change the owner’s equity in a specified period and that these are not necessarily the same as change in the cash position of the business. Thus it helps in proper measurement of income.
Realization Concept- Realization is technically understood as the process of converting non-cash resources and rights into money. As accounting principle, it is used to identify precisely the amount of revenue to be recognized and the amount of expense to be matched to such revenue for the purpose of income measurement. According to realization concept revenue is recognized when sale is made. Sale is considered to be made at the point when the property in goods passes to the buyer and he becomes legally liable to pay. This implies that revenue is generally realized when goods are delivered or services are rendered. The rationale is that delivery validates a claim against the customer. However, in case of long run construction contracts revenue is often recognized on the basis of a proportionate or partial completion method. Similarly, in case of long run installment sales contracts, revenue is regarded as realized only in proportion to the actual cash collection. In fact, both these cases are the exceptions to the notion that an exchange is needed to justify the realization of revenue.
Fairdeals Ltd. presents the balance sheets as at 31.12.2009 and 31.12.2010 as follows:
Assets Rs. Rs.
Fixed Assets at cost 31,30,000 36,05,000
Less: Depreciation 6,80.000 8,20,000
Investments 12,50,000 13,50,000
Marketable Securities 60,000 30,000
Inventories 4,10,000 5,20,000
Book Debts 5,30,000 5,05,000
Cash and Bank 1,20,000 1,40,000
Preliminary Expenses 1,00,000 50,000
Share Capital 20,00,000 25,00,000
Reserve and Surplus 4,20,000 4,70,000
Profit and Loss Account 3,80,000 4,00,000
13.5% Debentures (Convertible) 10,00,000 8,00,000
Mortgage Loan 3,00,000 2,50,000
Current Liabilities 8,20,000 9,60,000
You are informed that during 2010
Rs. 2,00,000 of debentures were converted into shares at par;
Rs. 1,00,000 shares were issued to a vendor of fixed assets;
A machine costing Rs. 50,000 book value Rs. 30,000 as at 31st December, 2009 was disposed off for Rs. 20,000;
Rs. 30,000 of marketable securities (cost) was disposed off for Rs. 36,000.
You are required to prepare a schedule of working capital changes and funds flow statement of the company for 2010.
Solution: (i) Schedule of changes in Working Capital for the year 2010
Rs. Net effect on working capital
Cash & Bank
Working Capital (A-B)
Decrease in Working Capital
3,00000 3,00,000 1,95,000 1,95,000
Preparation of Non-Current Account
Calculation of Purchased of Fixed Asset for cash:
Fixed Asset Account
To Balance b/d
To share Capital Purchase
To Bank (Purchase) (Balancing Fig.) Rs.
By Accumulated Depreciation A/C
By Bank (Sale)
By Adjusted profit & loss A/C (loss on sale)
By Balance c/d Rs.
Calculation of depreciation on Fixed Asset:
Accumulated Depreciation A/C
To Fixed Assets a/c (Depreciation on machine sold)
To Balance c/d Rs.
By balance b/d
By adjusted profit & Loss a/c (Current year’s depreciation) (Balancing Figure) Rs.
Calculations of Funds from Operation
Adjusted profit and Loss A/C
To Proposed Dividend
To Preliminary expenses
To loss on sale of machine
To bonus share
To Balance c/d Rs.
By balance b/d
By premium on issues of shares
By funds from operations (Balancing Fig.) Rs.
Funds Flow Statement for the Year 2010
Funds from operations
Sale of Machine
Decrease in Working Capital Rs.
Payment of Dividend
Purchase of fixed asset (for cash)
Purchase of trade investments
Repayment of Mortgage Loan
An Analysis of S Ltd. cost records give the following information.
Variable Cost Fixed Cost
(% of Sales) Rs.
Direct Material 32.8% -
Direct Labor 28.4 -
Factory Overhead 12.6 1,89,000
Distribution Overhead 4.1 58,400
Administration Overhead 1.1 66,700
Budgeted sales for the next year are Rs. 18, 50,000. You are required to determine:
Break even sales value
Profit at the budgeted sales volume
Profit if actual sales: (i) drop by 10% (ii) increase by 5% from the sale.
Briefly explain the following
Solution: A rolling budget is a budget that is continually updated to add a new budget period as the most recent budget period is completed. A rolling budget calls for considerably more management attention than is the case when a company produces a one-year static budget, since some budgeting activities must now be repeated every month. In addition, if a company uses participative budgeting to create its budgets on a rolling basis, then the total employee time used over the course of a year is substantial. Consequently, it is best to adopt a leaner approach to a rolling budget, with fewer people involved in the process.
Advantages and Disadvantages of the Rolling Budget
This approach has the advantage of having someone constantly attend to the budget model and revise budget assumptions for the last incremental period of the budget. The downside of this approach is that it may not yield a budget that is more achievable than the traditional static budget, since the budget periods prior to the incremental month just added are not revised.
Example of a Rolling Budget
ABC Company has adopted a 12-month planning horizon, and its initial budget is from January to December. After a month passes, the January period is complete, so it now added a budget for the following January, so that it still has a 12-month planning horizon that now extends from February of the current year to January of the next year.
Solution: Among the methods which relate costs to outputs or results, performance budgeting stands out the most prominent. It has emerged as a whole new way of considering fiscal responsibility. Also sometimes called as performance, or programme budgeting and planning, programming and budgeting system (PPBS), it focuses attention on the physical aspects of achievement. It is a refined approach to budgeting with an emphasis on work done or services rendered rather than being based simply on spending limits. It establishes cost/output relationship. It is a process of integrating inputs with outputs of a development programme.
Performance budgeting involves three levels of management.
Policy management – identification of needs, analysis of options, selection of programmes and allocation of resources.
Resource management – establishment of basic support systems consisting of budgeting structures and financial management practices.
Programme budgeting – implementation of policies and related operations, accounting, reporting and evaluation.
Thus, a performance budget is one that presents the purposes and objectives of which funds are required, the cost of achieving them, and the quantitative data measuring the accomplishment and work performed under each programme.
Performance budgeting involves the following steps:
Activity classification in terms of functions, programmes and activities.
Financial and physical measurement of the activities.
Progress reporting of performance at periodic intervals.
Needed restructuring of the accounting system.
The main objectives of performance budgeting are:
to coordinate the physical and financial aspects;
to improve the budget formulation, review and decision-making at all levels of management;
To facilitate better appreciation and review by controlling authorities (legislatures, Board of Trustees or Governors, etc.);
to make more effective performance audit possible; and
To measure progress towards long-term objectives which are envisaged in a development plan.
Since the financial and physical results are interwoven, it facilitates management control. It is of particular importance to government and non-profit organizations. With them, budgets have been essentially appropriation budgets with the focus largely on spending resources rather than on obtaining results. At the year-end, managers in these establishments are tempted to spend the appropriated amounts even if they are not needed. Performance budgeting changes the emphasis as budgets get related to outputs since it integrates financial outlays with physical content of programmes.
Zero base budgeting
Solution: The ZBB takes into account consequences that may flow if the project or responsibility centre is scratched. In other words, the objects of the ZBB are to formulate the budget so as to estimate the amount of expenditure likely to be incurred if the existing project resumes operation after being scratched. This method is called Zero-Base Budgeting since the existing system is discontinued and a fresh is made or the existing system is reviewed on the assumption of 'Zero-Base'.
Generally, the following points are to be considered before introducing ZBB:
Is it absolutely necessary?
What should be the qualitative features of current activities?
Will production be continued according to the existing system?
What is the cost of production under current conditions?
In this way, cost reduction is possible in the enterprises after careful analysis. However it takes a long time to implement this method although, through a minute review of the present system, overheads can be controlled.
Application of ZBB
It is very useful where 'cost analysis' is taken into consideration. Normally, the ZBB is applicable to those budgets which are not involved with direct costs only, because, direct costs (e.g. Direct Material and Direct Labor) may be controlled by the normal prediction operation since it assumes that each component of direct cost has been monitored and adjusted with production. That is why, ZBB is applicable to those budgets which involve overheads (e.g. Administration, Selling and Distribution Overhead) i.e., it is more applicable to discretionary cost areas. It is implied that ZBB is relevant where a budgeting system which has already been introduced, requires managers at the same time to develop qualitative measures.
The significant advantages of ZBB are:
It supplies the firm a systematic way in order to evaluate different programmes which are undertaken by the management allocating resources according to priority of the programmes and operations of the undertaking.
It helps the management to know different departmental budgets on the basis of cost-benefit analysis, as such, no arbitrary increase or cuts in budget estimates are done.
It is most appropriate both for the staff and supported areas of an organization since the output are not related directly to the finished products of the unit.
It also helps to locate the areas of wasteful expenditure, if any, and as such, it can also suggest alternative courses of action, if so desired by the management.
Limitations of ZBB
ZBB suffers from the following:
Introduction of ZBB system is no doubt expensive and time consuming process.
ZBB also invites ranking process problems. It includes
Who will do the ranking?
What method should be adopted for this purpose? and
To what extent it will be ranked and how?
Since ZBB requires significant support from the top management level which is practically not possible from different sources, its successful implementation practically is very difficult.
ZBB involves a lot of training for managers, i.e., if the managers do not understand properly the idea of ZBB, it cannot be successfully implemented.
Moreover, the determination of performance measures is difficult.
Features of ZBB
Before its implementation justify 'why' is it so needed and not 'how' much.
All levels of management should participate in the discussion making process.
Corporate objectives and individual unit objectives should be linked.
Measures of financial leverage
Solution: Different measures of financial leverage are the total debt to assets, debt to equity, and interest coverage ratios. These ratios are used to determine if the company will be able to meet its long-term financing obligations.
Financial leverage ratios provide an indication of the long-term solvency of the firm. Unlike liquidity ratios that are concerned with short-term assets and liabilities, financial leverage ratios measure the extent to which the firm is using long term debt.
Debt Ratio- The debt ratio is defined as total debt divided by total assets:
Debt Ratio=(Total Debt)/(Total Assets)
Debt-to-equity Ratio- The debt-to-equity ratio is total debt divided by total equity:
Debt-to-Equity Ratio=(Total Debt)/(Total Equity)
Debt ratios depend on the classification of long-term leases and on the classification of some items as long-term debt or equity.
Interest Coverage Ratio- The times interest earned ratio indicates how well the firm’s earnings can cover the interest payments on its debt. This ratio also is known as the interest coverage and is calculated as follows:
Interest coverage=EBIT/(Interest charges)
Where EBIT = Earnings before Interest and Taxes
Measures of financial leverage should be used with benchmarks in order to be the most useful. This can be done by comparing the ratio with the company’s historical results, competitors or industry averages. The use of different accounting methods can result in inaccurate comparisons when a company compares its ratio with those of its competitors or industry.
What is capital structure? Explain the features and determinants of an appropriate capital structure.
Solution: Capital Structure
Any company requires funds to run and maintain its business. The required funds may be raised from short-term sources or long term sources. Capital structure is that part of financial structure, which represents long-term sources. The term capital structure is generally taken as the mix of long – term sources of funds, such as equity shares, reserves and surpluses, preference share capital, debenture and long-term loan. In simple words, capital structure is used to represent the proportionate relationship between debt and equity. Capital structure decision is a significant managerial decision. The financial stability of a company and risk insolvency to which it is exposed is primarily dependent on the source of its funds as well as the type of assets it holds and relative magnitude of such asset categories.
Importance of Capital Structure Decision
The objective of any company is to mix the permanent sources of funds used by it in a manner that will maximize the company’s market price. It is a significant managerial decision which influences the risk and return of the investors. The company will have to plan its capital structure at the time of promotion itself and also subsequently whenever it has to raise additional funds for various new investments decisions. Wherever, the company needs to raise finance, it involves a capital structure decision because it has to decide the amount of finance to be raised as well as the source from which it is to be raised. This decision will involve an analysis of the existing capital structure and the factors which will govern the decision at present.
Features of an appropriate Capital Structure
Financial Manager should develop an appropriate capital structure, which is helpful to maximize shareholders wealth. This can be possible when all factors which are relevant to the company’s capital structure are properly analyzed, balanced and considered.
An appropriate capital structure should have the following features:
Profitability- The Company should make maximum use of leverage at a minimum cost. In other words, it should generate maximum returns to owners without adding additional cost.
Flexibility- Flexible capital structure means it should allow the existing capital structure to change according to the changing conditions without increasing cost. It should be possible for the company to provide funds whenever needed to finance its possible activities. The company should be able to raise funds whenever the need arises and also retire debts whenever it becomes too costly to continue with that particular source.
Solvency- The use of excessive debt threatens the solvency of the company. Debt should be used till the point where debt does not add significant risk, otherwise use of debt should be avoided.
Control- The capital structure should involve minimum dilution of the control of the company. A company that issues more and more equity dilutes the power of existing shareholders as number of shareholders increases. Also raising of additional funds through public issue may lead to dilution of control.
Cost of capital- If cost of any component of capital structure of the company like interest payment on debt is very high then it can increase the overall cost of capital of the company. In such case the company should minimize the use of that component of capital structure in its total capital structure.
Flotation costs- It is the cost involved in issuing a security or a debt. If such cost is too high for new issue of any component of capital structure, then the use of such a source of fund should be minimized.
Determinants of Capital structure
Determining the optimal capital structure at the time of starting the company is very important. Management of any company should set a target capital structure and the subsequent financing decisions should be made with a view to achieve the target capital structure. The following are the major determinants of capital structure:
Tax benefit of Debt- Debt is the cheapest source of long-term finance, when compared with other source equity, because the interest on debt finance is a tax-deductible expense. Hence, debt can be accepted as tax sheltered source of finance, which helps in shareholders’ wealth maximization.
Control- Equity shareholders have voting right to elect the directors of the company. Raising funds by way of issue of new equity shares to the public may lead to loss of control. If the main objective of management is to maintain control, they will have to prefer debt and preference shares in additional capital requirements. However the company earnings should be such that it is able to repay the debt in time.
Flexibility- The capital structure should be determined within the debt capacity of the company, and this capacity should not be exceeded. The debt capacity of a company depends on its ability to generate future cash flows. It should have enough cash to pay the debt obligations. The capital structure should be able to adapt its capital structure with a minimum cost and delay if warranted by a changed situation.
Industry Standards- a Company needs to examine industry standards of debt-equity mix while planning its capital structure. For example Electrical Industry tries to maintain debt-equity ratio of less than 2:1; Chemical Industry has a conservative debt policy; and in Automobile Industry government permits a debt – equity ratio of 2:1.
Company Size: Companies that are very small must rely to a considerable degree on the owner’s fund for their financing; they find it difficult to obtain long–term debts. Large companies can make use of different sources of funds.