M. Com. Part-I Advanced Accountancy Paper-II (Management Accounting) PDF

H I SHIVAJI UNIVERSITY, KOLHAPUR CENTRE FOR DISTANCE AND ONLINE EDUCATION Advanced Accountancy Paper-II (Management Accounting) For M. Com. Part-I Sem...

H I SHIVAJI UNIVERSITY, KOLHAPUR CENTRE FOR DISTANCE AND ONLINE EDUCATION Advanced Accountancy Paper-II (Management Accounting) For M. Com. Part-I Semester - I (In accordance with National Education Policy 2020) (Implemented from the Academic Year 2023-24) K J Copyright © Registrar, Shivaji University, Kolhapur. (Maharashtra) First Edition 2023 Prescribed for M. Com. Part-I All rights reserved, No part of this work may be reproduced in any form by mimeography or any other means without permission in writing from the Shivaji University, Kolhapur (MS) Copies : 2,000 Published by: Dr. V. N. Shinde Registrar, Shivaji University, Kolhapur-416 004 Printed by : Shri. B. P. Patil Superintendent, Shivaji University Press, Kolhapur-416 004 ISBN- 978-93-89345-27-8  Further information about the Centre for Distance and Online Education & Shivaji University may be obtained from the University Office at Vidyanagar, Kolhapur-416 004, India. (ii)  Centre for Distance and Online Education Shivaji University, Kolhapur  ADVISORY COMMITTEE Prof. (Dr.) D. T. Shirke Prof. (Dr.) Smt. S. H. Thakar Hon'ble Vice Chancellor, I/c. Dean, Faculty of Science and Shivaji University, Kolhapur Technology, Shivaji University, Kolhapur Prof. (Dr.) P. S. Patil Prin. (Dr.) Smt. M. V. Gulavani Hon'ble Pro-Vice Chancellor, I/c. Dean, Faculty of Inter-disciplinary Shivaji University, Kolhapur Studies, Shivaji University, Kolhapur Prof. (Dr.) Prakash Pawar Dr. V. N. Shinde Department of Political Science Registrar, Shivaji University, Kolhapur Shivaji University, Kolhapur Prof. (Dr.) S. Vidyashankar Dr. A. N. Jadhav Hon'bleVice-Chancellor, KSOU, Director, Board of Examinations and Mukthagangotri, Mysuru, Karnataka Valuation, Shivaji University, Kolhapur Dr. Rajendra Kankariya Smt. Suhasini Sardar Patil G-2/121, Indira Park, Chinchwadgaon, Finance and Accounts Officer, Pune Shivaji University, Kolhapur Prof. (Dr.) Cima Yeole Dr. (Smt.) Kavita Oza Geet-Govind, Flat No. 2, Department of Computer Science, 1139 Sykes Extension, Kolhapur Shivaji University, Kolhapur Dr. Sanjay Ratnaparkhi Dr. Chetan Awati D-16, Teachers Colony, Vidhyanagari, Department of Technology, Mumbai University, Santacruz (E), Mumbai Shivaji University, Kolhapur Prof. (Dr.) S. S. Mahajan Prof. (Dr.) D. K. More Dean, Faculty of Commerce and (Member Secretary) Director, Management, Shivaji University, Kolhapur Centre for Distance Education, Shivaji University, Kolhapur. Prof. (Dr.) M. S. Deshmukh Dean, Faculty of Humanities, Shivaji University, Kolhapur (iii)  Centre for Distance and Online Education Shivaji University, Kolhapur MEMBERS OF B.O.S. IN ACCOUNTANCY Prof. (Dr.) Nandkumar Laxman Kadam Jaysingpur College, Jaysingpur, Jaysingpur, Dist. Kolhapur  Dr. Mrs. Sherya Vinay Patil  Dr. Ashok Ramchandra Shinde Balwant College, Vita, Dist. Sangli Yashwantrao Chavan Mahavidyalaya, Urun-Islampur, Tal. Walwa, Dist. Sangli  Dr. Anil S. Patil Arts, Commerce and Science College,  Prof. (Dr.) B. B. Shitole Palus, Dist. Sangli Karmaveer Bhaurao Patil Mahavidyalaya Pandharpur, Tal. Pandharpur, Dist. Solapur  Dr. Smt. Vandana S. Tandale Hon. Shri. Annasaheb Dange Arts,  Prof. (Dr.) V. K. Sawant Commerce and Science College, Dhananjayrao Gadgil College of Hatkanangale, Dist. Kolhapur Commerce, Satara  Dr. J. G. Mulani  Dr. M. N. Haladkar Shri. Sampatrao Mane Mahavidyalaya, Rajarshi Shahu Arts and Commerce Khanapur, Dist. Sangli College, Rukadi, Dist. Kolhapur  Dr. Sarjerao S. Chile  CA - A. A. Gawade Prof. (Dr.) N. D. Patil Mahavidyalaya Matoshri Plaze, Shop No. 210 2nd Floor Malkapur, Tal. Shahuwadi, Dist. Kolhapur Station Road, Venus Corner, Shahupuri, Kolhapur  Dr. Sagar R. Powar Karmaveer Hire Arts, Commerce, Science  CA - Mrs. C. K. Patil and Education College, Gargoti, Morya Residence, 4th Floor, Tal. Bhudargad, Dist. Kolhapur Rajarampuri 2nd lane, Nigade Hospital lane, Kolhapur  Dr. Ram Ningappa Naik Smt. Kusumtai Rajarambapu Patil Kanya Mahavidyalaya (Arts, Commerce & Science) Islampur, Tal. Walwa, Dist. Sangli (iv)  Preface Modern approach of the business propounds the concept of management with new horizon, according to which management is art and science of utilizing resources effectively and efficiently to achieve the organizational goal. Such effectiveness and efficiency can be attained by specific and scientific tools and techniques which can support managerial decision making. Management Accounting is such a branch of knowledge, which assists the management for planning, controlling and decision-making for each and every facets of management. It is expected that the students from M. Com. should be familiar with and skilled in various tools and techniques of management accounting. Hence, this self instructional material has been developed to the students on distance mode to learn this subject smoothly and it covers both theoretical and practical aspects. In the first part of this book there are four units. The first unit puts the light on introductary part of management accounting including meaning, need, importance and scope of management accounting, difference between management accounting and financial accounting, and tools and techniques of management accounting etc. The second and third units cover financial statement analysis. The fourth unit is about working capital which consists of meaning, types of working capital the estimation of working capital requirement. The students should read the theoretical part first and then they can solve the problems which are given wherever necessary. Practical approach to learning has been adopted in every unit especially to develop analytical skills and decision-making skills. We express our deep sense of gratitude to Hon. Vice-Chancellor and Director, the Centre for Distance Education for giving us opportunity to contribute this book. We would welcome suggestions for improvement in the book, from stakeholders of all corners.  Editors Prof. (Dr.) Shrikrishna S. Mahajan Prof. (Dr.) N. L. Kadam Dean, Faculty of Commerce & Chairman, Accountancy BOS, Management, Jaysingpur College, Jaysingpur, Shivaji University, Kolhapur Shirolwadi, Dist. Kolhapur Centre for Distance and Online Education Advanced Accountancy Paper-II Shivaji University, Kolhapur. (Management Accounting) M. Com. Part-I Writing Team Sem. I Writers Name Units Dr. V. K. Sawant 1 Dhananjayrao Gadgil College of Commerce, Satara Shivaji University, Kolhapur Dr. P. N. Devali 2, 3 M.B.A. Unit, Shivaji University, Kolhapur Dr. D. R. Bhutiyani L.B.S. College (Rtd.) Satara Dr. P. V. Mohite 4 Arts & Commerce College, Ashta Dr. N. S. Pandit S. G. M. College, Karad  Editors Prof. (Dr.) Shrikrishna S. Mahajan Prof. (Dr.) N. L. Kadam Dean, Faculty of Commerce & Chairman, Accountancy BOS, Management, Jaysingpur College, Jaysingpur, Shivaji University, Kolhapur Shirolwadi, Dist. Kolhapur (vi)  M. Com. Part-I SIM IN ADVANCED ACCOUNTANCY PAPER II (Management Accounting Paper-I) INDEX Unit No. Topic Page No. Semester-I 1. Introduction to Management Accounting 1 2. Analysis of Financial Statements Part-I 28 3. Analysis of Financial Statements Part-II 72 4. Working Capital 185 (vii) Each Unit begins with the section objectives - Objectives are directive and indicative of : 1. what has been presented in the unit and 2. what is expected from you 3. what you are expected to know pertaining to the specific unit, once you have completed working on the unit. The self check exercises with possible answers will help you understand the unit in the right perspective. Go through the possible answers only after you write your answers. These exercises are not to be submitted to us for evaluation. They have been provided to you as study tools to keep you in the right track as you study the unit. Dear Students The SIM is simply a supporting material for the study of this paper. It is also advised to see the new syllabus 2023-24 and study the reference books & other related material for the detailed study of the paper. (viii)  Unit-1 Introduction to Management Accounting Index 1.0 Objectives 1.1 Introduction 1.2 Presentation of Subject Matter 1.2.1 Meaning of Management Accounting 1.2.2 Scope of Management Accounting 1.2.3 Functions of Management Accounting 1.2.4 Role of Management Accountant in Decision Making 1.2.5 Management Accounting Versus Financial Accounting 1.2.6 Tools and Techniques of Management Accounting 1.2.7 Group Discussion Practical 1.3 Summary 1.4 Terms to Remember 1.5 Answers to Check Your Progress 1.6 Exercise 1.7 Reference for Further Study 1.0 Objectives: After studying this unit you will able to:  Understand the meaning of management accounting.  Explain the scope and functions of management accounting.  Understand the role of management accountant in decision making.  Find difference between management accounting and financial accounting.  Identify the tools and techniques of management accounting. 1 1.1 Introduction: Management plays crucial role in every organization. It may be business organization or non-business organization. Management of every business concern aims at ensuring maximum profitability with financial stability. That’s why management needs various kinds of information for use in operational needs of the business like costs, funds, profits etc. Management accounting provides accounting information to management with the internal reporting. Management accounting is essential to help the management in formulating policies and plans. Management accounting has emerged as a special branch of accounting which provides adequate information to the management in order to perform its various tasks Management accounting is purely voluntary and its use depends on its utility to the management. 1.2 Presentation of Subject Matter: 1.2.1 Meaning of Management Accounting: Management accounting deals with presenting and providing accounting information to the management in such a systematic way so that it can perform its managerial functions of planning, controlling and decision making in an effective and efficient manner. The term ‘management accounting’ is the modern concept of accounts as a tool of management. It is a broad term and is concerned with all such accounting information that is useful to the management. The term ‘management accounting’ refers to accounting for management, i.e., accounting which provides necessary information to the management for discharging its functions. Management accounting is a system of accounting concerned with the internal reporting. In the words of P F Drucker “the most exciting and innovative work in management today is found in accounting”. Some of the important definitions of management accounting are as under: 1. According to Robert N. Anthony, “Management accounting is concerned with accounting information which is useful to management”. 2. In the words of J. Batty, “Management accounting is the term used to describe the accounting methods, system and techniques which, coupled with special knowledge and ability, assist management in its task of maximizing profits or minimizing losses”. 2 3. The Institute of Chartered Accountants of England and Wales defines “any form of accounting, which enables a business to be conducted more efficiently, can be regarded management accounting”. 4. 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 formulation of policies and in the planning and control of the operation of the undertaking.” 5. The most acceptable definition of Management accounting has been furnished by the Management Accounting Team of the Anglo-American Council of Productivity, “Management accounting is the presentation of accounting information in such a way as to assist management in the creation of policy and in the day-to-day operations of an undertaking.” 6. In the words of R. H. Garrison “Management accounting is concerned with providing information to managers, that is, to those who are inside an organization and who are charged with directing and controlling its operations”. In views of these definitions, it is clear that management accounting refers to accounting for the management. Efficiency of the various phases of management is, as a manner of fact, the common thread which underlies all these definitions. It therefore, lies between the following two activities:  Completing the accounting results on the one hand, and  Controlling the business by the management on the other. Management accounting, therefore, covers all rearrangement, combination or adjustment of orthodox accounting figures which may require providing Chief Executive with the information from which he can control the business. 1.2.2 Scope of Management Accounting: Management accounting has a very wide scope. Management accounting includes not only financial accounting and cost accounting but also all types of internal financial controls, internal audit, tax accounting, office services, cost control and other methods and control procedures. Hence, the scope of management 3 accounting is beyond the boundaries of accounting and costing. Thus scope of management accounting includes the following: 1. Financial accounting: Financial accounting provides basic historical data which helps management to forecast and plan its financial activities for the future period. In short, for an effective and successful management accounting, there should be a proper and well designed financial accounting system. Management accounting applies the principles and practices of financial accounting. Thus, without efficient financial accounting system, management accounting cannot be operative. 2. Cost accounting: Cost accounting provides cost-related basic data to the management accounting, which analyses and interprets those costing data and provides necessary information to the management for the purpose of its controlling and decision making. Management accounting uses the principles and practices of cost accounting. The techniques of cost control, like standard costing, budgetary control, and the techniques of profit planning and decision making, like marginal costing, Cost-Volume-Profit (CVP) analysis and differential cost analysis, are used by the management accounting. Hence, cost accounting is considered as the backbone of management accounting. 3. Forecasting and budgeting: Management accounting exercises the tool of forecasting and budgeting in the process of planning, controlling and decision making. Budgeting lies at the heart of management accounting. Forecasting helps in the preparation of budgets and budgeting helps management accountant in exercising budgetary control. 4. Statistical tools: Various statistical tools like graphs, charts, diagrams, time series, sampling, index numbers and regression analysis are used in management accounting in the process of planning, controlling and decision making. 5. Operational research techniques: Various operational research techniques like Linear Programming, Transportation Theory, Games Theory and Simulation Method are used in management accounting to resolve various problems prevailing under the existing situation in the process of decision-making. 6. Financial analysis and interpretation: Various financial analysis techniques such as Ratio Analysis, Funds Flow Analysis, Cash Flow Analysis, Comparative Financial Statements, Common-Size Statements and Trend Analysis are widely 4  used in management accounting to analyze and interpret financial data to make them easily understandable and useable to the management. Successful application of management accounting depends a lot on these financial analysis and interpretation works. 7. Tax accounting and tax planning: Determination of taxable income and tax liability of the enterprise fall within the purview of the management accounting. In the process of decision-making, the analysis of implication of tax provisions on future projects also falls within the purview of management accounting. The management accountant must have a vast knowledge of tax laws and their accounting procedures, and also tax planning, to minimize the tax burden of the enterprise. 8. Reporting to management: For effective and timely decisions, there should be a system of prompt and intelligent reporting to management. Both routine and special reports are prepared for submission to top management, middle order management and operating level management depending on their requirements. Clear, informative, timely reports are essential management tools in reaching decisions that make the best use of a company’s resources. 9. Cost control procedures: Any system of management accounting is incomplete without effective cost control procedures, like inventory control, labour control, overhead control and budgetary control. 10. Internal control and internal audit: Management accounting highly depend upon internal control system existing in the organization, like internal check and internal audit, to appraise the targeted performance and to identify the weaker area of organization. 11. Legal Provisions: Management accounting system should also be well informed about relevant and necessary legal provisions like Companies Act, Foreign Exchange Act, Securities Act, and Direct and Indirect Tax Laws. In decision-making process, management accountants should restrict their plan and action within the periphery of such legal provisions. 12. Office Services: Management accountant is expected to maintain and control office routines and procedures, like filing, copying, communicating, electronic data processing, information network system, email, tax system and relevant allied services. 5 13. Other areas: Apart from the aforementioned areas, management accounting also includes various newly developed areas of accounting like Human Resource Accounting, Social Accounting, Environmental Accounting and Inflation Accounting within preview of its scope. 1.2.3 Functions of Management Accounting: Main functions or objectives of management accounting are described as below- 1. Planning: Planning is an essential aspect of every field of activity. Information and data provided by management accounting helps to management for forecasting and preparation of short-term and long-term plans for the future activities of the business and formulate corporate strategy. For this purpose management accounting techniques like budgeting, standard costing, marginal costing etc., are used. 2. Coordinating: Due to proper financial reporting, management accounting helps in achieving coordination in various business activities and accomplishing the set goals. While preparing budgets for various departments like production, sales, purchase etc, there should be full coordination so that there is no contradiction. 3. Controlling: Controlling is one of the important functions of management. It is a continuous process. Management accounting helps in controlling performance by control techniques such as standard costing, budgetary control, internal audit etc. 4. Communication: Management accounting system prepares report for presentation to various level of management which shows the performance of various sections of the business. Such communication in the form of reports to various level of management helps to exercise effective control on various business activities and successfully running the business. 5. Financial analysis and interpretation: Ratio analysis, cash flow statement, funds flow statement trend analysis etc; are some of the management accounting techniques which may be used for financial analysis and interpretation. 6. Qualitative information: Apart from monetary and quantitative data, management accounting provides qualitative information which helps in taking better decisions. Quality of goods, customers, employees, legal judgements, 6  opinion polls, logic, etc are some of the examples of qualitative information supplied and used by the management accounting system for better management. 7. Tax administration: In modern business organizations, the responsibilities of a management accountant also include the tax administration. This task involves submission of necessary documents and return to the tax authorities and supervision of all matter relating to tax administration. 8. Decision making: Management accounting provides necessary and relevant information to the management in the process of its decision making. Correct decision making is the crucial task. The success of the management highly depends on a perfect decision making. Techniques like marginal costing, differential costing, discounted cash flow etc. help in decisions such as pricing of products, make or buy, discontinuance of a product line, capital expenditure etc. 9. Special studies: Management is always interested to know the areas of business which can contribute to the stability and profitability of the concern. To meet this objective, management accountant undertakes various special studies such as sales analysis, economic forecasts, price spread analysis etc. 10. Advisory service: Management accounting renders valuable advice to the management for resolving any financial or other problems of the enterprise. To overcome any financial and other problems, various management accounting techniques are applied according to the nature of the problem. Management accounting also plays a very important role as an advisor to the management. 1.2.4 Role of Management Accountant in Decision Making: Decision making is an integral part of all managerial functions viz.: planning, organizing, directing and controlling. The decision making process includes the following steps: 1. Indentifying a problem requiring managerial action. 2. Specifying the objective or goal to be achieved. 3. Listing the possible alternative courses of action. 4. Gathering the information about the consequences of each alternative. 7  5. Making a decision, by selecting one of the alternatives. Management accounting plays a critical role for gathering the information about the consequences of each alternative in the decision making process. Management accountant does the formal structuring of decision making problems and places the information showing the outcome of each of the alternative courses of action making it easy for management to evaluate different alternatives and make rational decision. Marginal costing, particularly Differential Cost Analysis, Break-Even Analysis etc. helps the management accountant to take decisions about cost control, maximization of profit etc. Therefore, the management accountant is sometimes called the ‘Controller’. Management accountant plays a very important role in an organization He analyses and interprets accounting information and meets the informational needs of management at different levels. In an organization, a management accountant generally performs advisory role. Sometimes management accountant has to collect, analyze and present the information for some special decisions which are not regular such as:  Whether to establish a new plant.  Whether to develo1p own distribution system.  Whether to introduce a new market line or whether to enter a new market. The data for such decisions should be obtained from internal as well as external sources and presented in comparable form. This is a critical and skillful task. The management accountant in such a situation determines what information is necessary, obtains it from proper source and present it in an understandable form to the concerned managerial personnel who are to make such decision. Management accounting thus plays a crucial role in making managerial decision in every field of activity like production, marketing and in every function of management such as planning, organizing, directing and controlling. 8 1.2.5 Management Accounting Versus Financial Accounting: The following are main factors of distinction between management accounting and financial accounting. Factor Management Accounting Financial Accounting 1. Meaning Management accounting is a Financial accounting is system of accounting meant to serve parties concerned with the internal external to the operating reporting or information to responsibility of the the management for planning undertakings. and controlling operations, decision making on special matters and formulating long range plans. 2. Object The object of management The object of financial accounting is to provide accounting is to record financial, cost as well as various transactions with other information to the purpose of maintaining managerial personnel at all accounts and to know the levels in the hierarchy to financial position and to facilitate decision making. find out profit or loss at the end of financial year. 3. Entity Under management Financial accounting accounting system each considers the business as unit/department/ division/ one entity and accordingly cost centre of the business is financial accounting reports treated as a separate entity in have been confined to the order to ensure effective business operation as a planning and control. whole. Such statements Therefore, profitability and present the position and the performance reports are performance of the entire prepared for each unit or business. division of business separately. 9 4. Accounting Management accounting is Financial accounting is Method not based on double entry based on double entry system. system for recording business transactions. 5. Nature of Data Management accounting has Financial accounting has a Used a futuristic orientation. It historical orientation. It supplies projected or uses actual data. It is a post estimated data on basis of mortem analysis of past analysis. Thus, financial statements. management accounting has prospective character. 6. Description Management accounting Only those things which uses both monetary and non- can be measured in monetary events. The monetary terms are competition in the market, recorded in financial impact of political changes, a accounting. Anything situation of trade cycles and which cannot be recorded such other factors are in figures is outside the considered in management scope of financial accounting though these accounting. Hence, cannot be measured in financial accounting makes monetary terms. Hence, use of data which is management accounting historical in nature, makes use of data which is quantitative, monetary and descriptive, subjective and objective. relates to future. 7. Precision In Management accounting In financial accounting no emphasis is given to only actual figures are actual figures. The recorded and there is no approximate figures are room for using approximate considered more useful than figures. Hence, there is the exact figures. Hence, the great emphasis on precision information may be less and accuracy. precise only indicating the 10  trends to guide the management. 8. Methodology In management accounting In financial accounting information is collected and transactions relating to analyzed according to Nominal Accounts, Real responsibility centre or cost Accounts and Personal centre. Accounts are to be recorded. 9. Importance Management accounting Financial accounting gives gives more importance on more importance on qualities such as flexibility, obligation such as consistency, comparability objectivity, precision, etc. correctness etc. 10. Accounting No Generally Accepted Financial accounts are Principles Accounting Principles strictly prepared on the (GAAP) and standard rules basis of Generally are followed in management Accepted Accounting accounting. While preparing Principles (GAAP) and reports, there is a lot of standard rules. The flexibility in method and principles and standard style of presentation of rules are rigidly followed in information. financial accounting. 11. Reporting Management accounting Financial accounts are reports are meant for internal prepared to find out the use only. These are prepared profitability and financial for the benefit of different position of the concern. levels of management. Financial accounting reports are useful for outsiders like bankers, investors, creditors, Government agencies, etc. 12. Quickness Reporting of management Reporting of financial 11  accounting is very quick. accounting is slow and time Management is fed with consuming. Profit and Loss reports at regular intervals. Account and Balance Sheet are prepared at the end of financial year. The management is able to know profitability and financial position only after the preparation of the final accounts. 13. Compulsion The management is free to The preparation of financial use or not to use accounts is management accounting. mandatory/compulsory in certain undertakings while these are a necessity of others. 14. Use of Other Management accounting Financial accounting does Subjects uses certain aspect of other not use any other subjects subjects such as Economics, to record and prepare its Statistics, Law, statements. Management, Finance, Costing, Taxation, Marketing and Computers etc. to prepare its reports. 15. Period The management accountant Financial statements are supplies information from prepared for a particular time to time during the period. Financial whole year by considering statements like Profit and the need of management. Loss Account, Balance There are no specific periods Sheet are prepared at a for furnishing accounting longer time interval such as information to management. half yearly or yearly. 16. Publication Publication of records and Financial statements like reports prepared by Profit and Loss Account 12  management accountant is and Balance Sheet are not compulsory under any published in the form of law. Management annual report for the accounting statements are benefit of the public. Under prepared for the benefit of the Companies Act, every the management only and registered company is hence, these are not supposed to supply a copy published. of Profit and Loss Account and Balance Sheet to the Registrar of Companies at the end of the financial year. 17. Audit Management accounting Financial accounting statements cannot be audited. records can get audited. They are not based on the Under the Company Act, actual figures and projected auditing of financial data are also used in accounts is compulsory. management accounting. So it is not possible to get management accounting statements audited. 1.2.6 Tools and Techniques of Management Accounting: Management accounting uses various tools and techniques for providing necessary and effective information to the management for performing its managerial functions. Some of the important tools and techniques are as follows: 1. Financial Statement Analysis 2. Historical Cost Accounting 3. Marginal Costing 4. Standard Costing 5. Budgetary Control 13  6. Funds Flow Analysis 7. Cash Flow Statement 8. Statistical Analysis 9. Inflation Accounting 10. Reporting / Communicating These tools and techniques have been elaborated as under: 1. Financial Statement Analysis: Financial planning helps to determine in advance the financial activities which are necessary in order to achieve primary objectives of a business enterprise. Financial statements are the indicators of profitability and financial position of business. Financial statement analysis is the process of identifying the financial strength or weakness by properly establishing relationships between the items of the financial statements. Tools of financial statement analysis are: a) Comparative Financial Statements: A business concern does not exist in isolation. It coexists with other competing concerns in the same industry. It has to constantly compare its performance with such competing concerns. Such comparison is called inter-firm comparison. It also needs to compare its own past performance with its current performance to ascertain it progress or decline over the years. This is known as inter-period comparison. Comparative financial statement is a tool of arranging the Balance Sheets and Profit and Loss Accounts of business enterprises in comparable form so as to enable enterprises to facilitate inter-firm comparison and inter-period comparison. b) Common-Size Financial Statements: Common-size financial statement is a tool of rearranging the financial statements (i.e. Profit and Loss Account and Balance Sheet) by converting the figures therein into percentages to some common base so as to facilitate inter-firm comparison or inter-period comparison of the same business. In common-size Profit and Loss Account the sale figure is assumed as common base and treated to be 100 and all other figures therein are expressed as a percentage of sale. Similarly, in common-size Balance Sheet the total of assets or liabilities is taken as 100 and rests of the figures are expressed as a percentage of this figure. 14  c) Trend Analysis: The comparative statements and common-size statements compare the figures of year 2 with those of year 1, the figures of year 3 with those of year 2, and the figures of year 4 with those of year 3 and so on. But, a trend analysis is a technique which treats year 1 as the base year and compares the figures of all the years (year 2, year 3, year 4 and so on) with those to the base year to ascertain trend in the figures. For example, trend analysis of sales will reveal whether compared to base year i.e. year 1, the sales show a trend of increase or decrease in the subsequent years i.e. year 2, year 3, and year 4 and so on. Thus, trend of sales, debtors and inventory may studied together to arrive at meaningful conclusion. d) Ratio Analysis: A ratio shows the relationship between two numbers. Accounting ratios show relationship between the two accounting figures. Ratio analysis is a tool of studying the financial status and performance of a concern on the basis of accounting ratios. It helps to evaluate the performance of business concern over a period of time as well as in comparison with other competing concerns. We know ratios are the best tool for measuring liquidity, solvency, profitability and activity of a concern and it is also equally useful to the internal management, prospective investors, creditors and outsiders etc. The role of accounting ratios is very significant to increase the efficiency of the management. As such, it is a very important tool of management accounting also. 2. Historical Cost Accounting: Historical cost accounting provides financial past data relating to cost of each job, process and department etc, so that proper comparison may be made with the standard cost which ultimately helps to control cost and makes future planning properly. 3. Marginal Costing: Marginal cost is an economic concept. Marginal costing, particularly Differential Cost Analysis, Break-Even Analysis etc. helps the management accountant to take decisions about cost control, maximization of profit etc. Hence, marginal costing is a technique of guiding the management in decision making, in assessment of pricing and profitability. 4. Standard Costing: Standard costs are pre-determined or forecast estimates of cost to manufacture a single unit or a number of units of a product, during a specific immediate future period and are used as a measure with which the 15  actual cost, as ascertained, may be compared. As such, this technique, i.e. the analysis of variance is considered while controlling costs and helps to take correct decision for future. Standard costing is a specialized technique of costing. It is also treated as a powerful tool in the hands of management accountant which enables him to guide the managerial person in their task of cost control and improve the economy, efficiency and productivity of the manufacturing operations. 5. Budgetary Control: Budgetary control system is a system of controlling and planning costs. So this technique is widely used in management accounting for planning and controlling different activities of a business unit. In other words, it helps the management to achieve a desired return on investment. Hence, budgetary control has become an essential technique of management for controlling costs and maximizing profits. 6. Funds Flow Statement: This statement discloses the analytical information about the different sources of a fund and the application of the same in an accounting cycle. It deals with the transactions which changes either the amount of current assets and current liabilities (with their respective reasons) or fixed assets, long-term loans including ownership fund between two different dates. It also explains how the funds are coming and from which sources and application of the same. Funds Flow Statement helps in making better estimate about company’s financial position and policies. It has become an important tool in the hands of management accountant. 7. Cash Flow Statement: It indicates the inflows and outflows of cash during a period. It shows the receipts of cash from various sources and the payment of cash for various purposes during a particular period. It is a tool in the hands of financial analyst, and this is also useful in management accounting. Cash Flow Statement overcomes the limitation of Balance Sheet that it shows only the cash balance as on a particular day and fails to depict the movements of cash over a period. 8. Statistical Analysis: At present statistical data are widely used in financial and management accounting for the purpose of financial data to be made more meaningful for future guidance, comparative studies etc. Some of the statistical techniques are Correlation and Regression, Time Series Data, Index Number, 16  Measures of Dispersion, Graphical Presentation etc. which are really very useful to management accountant. 9. Inflation Accounting: This technique is very useful and widely accepted for ensuring the maintenance of original capital under conditions of changing prices i.e., inflation. It also incorporates its effect on the financial statements as well. 10. Reporting and Communicating: It helps to communicate desired financial information through reports to the users of financial statements by which the management can take right decision at right time and determine the future courses of action which proves useful to the business enterprise as well. Check Your Progress (A) State whether the following statements are True or False: 1. Management accounting provides decisions to management. 2. In management accounting only those figures which can be measured in monetary terms are used. 3. Management accounting is a traditional concept. 4. Specific rules are followed in management accounting. 5. Management accounting presents reports covering shorter or longer periods. 6. Reporting of management accounting is slow and time consuming. 7. Management accounting deals only with the information which is useful to the management. 8. Management accounting deals with both quantitative and qualitative information. 9. Management accounting reports are based on current year’s figures as in financial accounting. 10. Publication of management accounting statements is not compulsory. 11. Management accounting is a branch of financial accounting. 12. Management accounting is a backward looking tool to the management. 13. Management accountant is sometimes called the ‘Controller’. 17  14. Management accountant must be a qualified MBA or CA. 15. Small organizations find it difficult to afford a system of management accounting. (B) Fill in the blanks: 1. ------------------------- accounting is more subjective 2. Management accounting is an ------------------- reporting. 3. Accounting designed to serve parties external to the operating responsibility of the business is termed as -----------------------. 4. Accounting designed for use in the operational needs of the business is termed as --------------------. 5. Management accounting is helpful in increasing------------------- of an organization. 6. Management accounting is helpful in ------------------------ of data. 7. No generally accepted accounting principles and standard rules are followed in --------------------------- accounting. 8. Success of the management accounting highly depends on ---------------. (C) Select the most appropriate answer: 1. The basic function of management accounting is to: a) record all business transactions b) interpret the financial data c) record some transactions d) assist the management in performing its functions effectively 2. Management accounting rearranges for management control, data provided by: a) financial accounting b) cost accounting c) revaluation accounting d) taxation 18 3. Management accounting involves: a) preparation of financial statements b) analysis and interpretation of data c) recording of transactions d) following standard rules 4. Management accounting relates to: a) recording of accounting data b) recording of costing data c) recording of general data d) presentation of accounting data 5. The use of management accounting is: a) compulsory b) optional c) common d) none of these 1.2.7 Group Discussion Practical: 1) Introduction: Group discussion is a group activity. It involves exchange of ideas on a specific topic/ issue. Participation in a discussion is the role of every group member. It is the tool of screening. It is the means of thought exposure. The basic aim of a group discussion is to evaluate the effectiveness of a student/ candidate/participant in a group activity by means of team spirit and communication skills displayed by him/her during the discussion. Initiating, agreeing, disagreeing, interrupting, adding and summarizing are the elements of group discussion. 2) Some Do’s and Don’ts for Group Discussion (GD): Do’s Don’ts It is advisable to take a stand – in Sit with arms and legs crossed. favour (agree) or against (disagree) topic. Express opinion based on facts, Maintain a sardonic smile on your figures and statistics. face throughout the GD. Ability to read between the lines. Never agree to anyone else’s point of 19  view. Be creative and innovative, thought Disagreement with everyone will provoking. guarantee you more enemies. Candidate should be audible. Stare at your GD members and point fingers at others. Voice Modulation. Interrupt if someone is making a good point. Sit attentively in GD. Use abbreviations and acronyms without explaining them. Use Slang – words like ‘yar’ etc. Analyze somebody’s viewpoints and Maintain a blank look on your face. reason own viewpoint. Contribute to the GD through content Only listen and never speak. and ideas. Try to put GD into proper Aggression, shouting in GD. perspective to have focuses discussion towards topic. Encourage other candidates to speak. Enforce views on others and questioning. 3) How to carry out Group Discussion?  Forming Groups- Group size may range from 6 to 10 students for classroom discussion.  Topics from syllabi or related happenings.  Groups should be mixed- Heterogeneous (involvement of male and female students.)  Sitting Arrangement- Considerable distance.  Choosing a leader  Time to think and jot down points before discussion.  Consensus at the end of discussion is desired.  Mentor’s / Teacher’s Role. 20 4) Evaluation/ Assessment Criteria: Suppose, if Group Discussion is held for 10 Marks. Evaluation/ Assessment criteria for that shall be as under- Evaluation Criteria Marks Communication skills 3 Subject knowledge 3 Analytical ability 2 Consistency of Participation 1 Leadership and Group Behaviour 1 Total 10 5) Example: Group Discussion on ‘Functions of Management Accounting’. BACKGROUND INFORMATION It is a group of eight students/participants/ candidates who are sitting in a closed circle. The teacher/ mentor extend them a welcome, announce the topic of group discussion and wish them success. A time limit of 30 minutes is fixed. After this silence breaks and students start whispering. Gradually the noise in the group increases and a chaotic scene takes shape. At this stage student No.2 raises his voice and addresses the group. Student No. 2: Friends, I appeal to all of you to take assignment seriously. As the teacher has given us only 30 minutes time, we have to plan accordingly. Keeping in view that all students get equal chance to express their view on topic, we are free to exchange our arguments but we have to be decent and differential to one another’s ideas. Let us begin with No.1 and move on to the last speaker. Student No. 6: Hey, what is all this about? Why does Mr.2 think of himself? Is he self styled commander? Group discussion is a free-for-all fair, doesn’t he know this? Everybody is at his liberty to make his/ her point. This is the way of the world. Student No. 5: Please go ahead. Be quiet everyone. Student No. 3: Thank you, may I draw kind attention of all of you towards topic of our group discussion that is functions of management. 21  Student No. 8: Friends. I think management is the need of every organization. Without management, an organization cannot run properly, therefore, role of management is very significant to the organization. Student No. 1: As per my knowledge, I would like to highlight here the term ‘Management’ and ‘Accounting’ separately for further discussion. Management is a task of planning, controlling and co-ordinating efforts of others towards a specific objective. It mainly involves planning and controlling functions. Management is a continuous process. Whereas, accounting is the process of identifying, measuring and communicating economic information to users of information. Hence, accounting is mainly concerned with monetary information. Student No. 4: Our friend (i.e. No.1) has given meaning of ‘Management’ and ‘Accounting’ separately, but I am focusing here, ‘Management Accounting’ only. Management accounting is a separate branch of accounting which provides accounting information to the management for decision making. The term ‘management accounting’ refers to accounting for management. Management accounting is fundamentally based on judgement rather than on measurement. It is a modern concept. Student No. 7: Well, friends, the topic for our discussion is quite interesting. Our friends especially No. 1 and No.4 have given information pertaining to management, accounting and management accounting. I would like to express the functions of management accounting viz.: planning, co-ordinating, communicating and controlling. Planning helps to do things as per pre-determined way. Management accounting provides data to the management for short and long term planning. Co-ordination is essential in every activity for smooth functioning. Due to proper financial reporting, management accounting helps in achieving coordination in various business activities and accomplishing the set goals. Communication is the need of hours for success in every line of activity. Management accounting does communication by preparing reports of performance of various sections of the enterprise. Management accounting applies various useful techniques such as Standard Costing, Budgetary Control and Responsibility Accounting, to ensure an effective managerial control over the use of resources of the enterprise. Hence, planning cannot success without suitable controlling. 22  Student No. 6: Our friend No.7 has clearly pointed out the functions of management accounting in right way. I would also like to add certain functions of management accounting namely decision making, financial analysis and interpretation, qualitative information, and tax policies. Student No. 3: Right, I would like to elaborate some functions of management accounting as mentioned by No.6 such as decision making and financial analysis. Decision making is a complex task. It requires accurate information, knowledge and experience. Management accounting has certain special techniques such as marginal costing. differential costing, discounted cash flow etc which help management in short and long term decisions. There are certain techniques of management accounting like ratio analysis, cash flow statement and funds flow statement which may used for financial analysis and interpretation. Student No. 1: Well friends, the topic of our discussion is quite interesting. I wanted to say that, to provide qualitative information is one of the important functions of management accounting.. Quality of employees, opinion polls, legal judgements, logic etc; are some examples of qualitative information supplied and used by the management accounting system for better management. Student No.7: Friends, I have listened about functions of management accounting. I find that more speakers have pointed out the functions of management accounting properly. But, no one speaks about limitations of management accounting in regards to performing its functions. Management accounting uses data that are available from financial and costing statements. Thus, the validity of the decisions largely depends on the reliability of the historical data as obtained from financial statements. Any drawback in such statements is bound to affect the effectiveness of the decisions. The principle of objectivity is not followed in its real spirit in management accounting. The interpretation of information as provided by management accounting in the form of reports may be influenced by a personal bias of the interpreter, which may reduce the utility of management accounting. Student No. 2: I feel that tax administration and performance evaluation are two important functions of management accounting. In modern business organizations, the responsibilities of a management accountant also include the tax administration. This task involves submission of necessary documents and return to the tax authorities and supervision of all matter relating to the tax administration. 23 Management accounting evaluates the performance of activities of different departments/ divisions as well as the business as a whole of an enterprise by using various tools and techniques. Student No. 4: Friends, thank you all for making my task easier. As the topic of discussion has been properly covered by all of you. I do not believe in criticizing or contradicting others. I agree with everyone. Student No. 8: Dear Friends, I am summarizing our discussion by saying that, the role of management accounting is to assist the management to perform its functions of planning, organizing, directing, controlling and decision-making. Student No. 5: Friends, I am glad that I am the last speaker. Since all of you have covered functions of management accounting thoroughly and ably. I do not disagree with anyone. Thank you. 1.3 Summary: The aim of management accounting is to assist management in decision making and control. Management accounting is a segment of accounting that deals specifically with the accounting and reporting of information to management regarding the detailed operations of the enterprise in order for decisions to be taken in various areas of business. It is oriented primarily towards managerial control and other decision-making groups inside the organization. Management accounting has emerged as a special branch of accounting which provides adequate information to the management in order to perform its various tasks. It is a system of accounting concerned with the internal reporting. It refers to accounting for the management. It is more subjective. Management accounting is fundamentally based on judgement rather than on measurement. It is a modern concept. The management accounting serves the management by providing information which is necessary to run the business smoothly and efficiently. It is helpful in increasing efficiency of an organization. It involves analysis and interpretation of data. Management accounting has a very wide spread scope. It includes not only financial accounting and cost accounting but also all types of internal financial controls, internal audit, tax accounting, office services, cost control and other methods and control procedures. Monetary and non-monetary events like technical changes, competition etc., are to be recorded in management 24 accounting. The use of management accounting is optional. No specific rules are followed in management accounting as in the case of financial accounting. In management accounting there are no prescribed formats for presentation of information to the management. Management accounting plays a crucial role in making managerial decision in every field of activity like production, marketing and in every function of management such as planning, organizing, directing and controlling. Management accounting makes use of data which is descriptive, subjective and relates to future. On the other hand, financial accounting makes use of data which is historical in nature, quantitative, monetary and objective. Management accounting statements cannot be audited. They are not based on the actual figures and projected data are also used in management accounting. So it is not possible to get management accounting statements audited. On the contrary, financial accounting records can get audited. Under the Company Act, auditing of financial accounts is compulsory. In management accounting various tools and techniques are being used such as ratio analysis, funds flow analysis, marginal costing, standard costing, budgetary control, statistical analysis, reporting/communicating etc. It is the duty of management accountant to supply necessary information to management by using different tools and techniques. 1.4 Terms to Remember:  Accounting: The process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of information.  Financial Accounting: The art of recording, classifying and summarizing in a significant manner and in terms of money transactions and events which are at least in part of a financial character and interpreting the results thereof.  Financial Management: The efficient raising and optimum utilization of funds.  Cost Accounting: The accounting mechanism through which the costs of the products and services ascertained and controlled.  Management Accounting: The presentation of accounting information in order to formulate the policies to be adopted by the management and assist its day-to- day activities. 25  Management Accountant: The official who uses the accounting information for management planning and control.  Management Accounting Tools: The techniques used by the management accountant in performance of his job. 1.5 Answers to Check Your Progress: (A) 1. False 2. False 3. False 4. False 5. True 6. False 7. True 8. True 9. True 10. True 11. False 12. False 13. True 14. False 15. True. (B) 1. Management 2. internal 3. financial accounting 4. management accounting 5. efficiency 6. interpretation 7. management 8. decision-making. (C) 1. d 2. a 3. b 4. d 5. b. 1.6 Exercise: 1. Describe the scope of management accounting. 2. What are the functions of management accounting? 3. Explain the role of management accountant in decision making. 4. Define management accounting. How does it different from financial accounting. 5. Explain in brief tools and techniques of management accounting. 6. Conduct Group discussion (Practical) on: a) Scope of management accounting b) Tools and techniques used in management accounting c) Importance of management accounting in relation to management 26 1.7 Reference for Further Study: 1. Arora, M.N. (2018). Cost and Management Accounting. (10th Edition). Noida: Vikas Publishing House Pvt Ltd. 2. Bhattacharyya, Debarshi. (2011). Management Accounting. New Delhi: Dorling Kindersley (India) Pvt Ltd., licensees of Pearson Education in South Asia. 3. Gordon, E., Jeyaram, N., Sundram, N. & Jayachandran, R. (2010). Management Accounting. Mumbai: Himalaya Publishing House. 4. Jain, S.P. & Narang, K.L. (2000). Advanced Accountancy. New Delhi: Kalyani Publishers. 5. Jefferson, Richard. (2005). Learn the Art of Group Discussions. Chandigarh: Abhishek Publications. 6. Maheshwari, S.N. & Maheshwari, S.K. (2008). An Introduction to Accountancy. New Delhi: Vikas® Publishing House Pvt Ltd. 7. Paul, S. Kr., (1994). Management Accounting. Calcutta (Kolkata): New Central Book Agency (P) Ltd. 8. Patnaik, Priyadarshi. (2014). Group Discussion and Interview Skills. New Delhi: CAMBRIDGE HOUSE. 9. Prasad, Hari Mohan. & Mohan, Rajnish. (2005). New Delhi: Tata McGraw-Hill Publishing Company Limited. 10. Sahaf, M.A. (2000). Management Accounting Principles and Practice. New Delhi: Vikas Publishing House Pvt Ltd.  27  Unit-2 Analysis of Financial Statements Part - I Structure 2.0 Objectives 2.1 Introduction 2.2 Presentation of Subject Matter 2.2.1 Meaning and Types of Financial Statements 2.2.2 Analysis of Financial Statements 2.2.3 Comparative Statement Analysis 2.2.4 Common-size Statement Analysis 2.2.5 Trend Analysis 2.2.6 Practical Problems 2.3 Summary 2.4 Terms to Remember 2.5 Answers to Check Your Progress 2.6 Exercise 2.7 Reference for Further Study 2.0 Objectives: After studying this unit you will be able to; ◆ Understand the concept of financial statements. ◆ Explain the types of financial statements. ◆ Understand the different tools of financial statement analysis. ◆ Study the analysis and interpretation of financial statements. 2.1 Introduction Financial statement analysis evaluates a company's performance or value through a company's balance sheet, income statement, or statement of cash flows. By 28 using a number of techniques, such as horizontal, vertical, or ratio analysis, investors may develop a more nuanced picture of a company's financial profile. Business is mainly concerned with the financial activities. In order to ascertain the financial status of the business every enterprise prepares certain statements, known as financial statements. Financial statements are mainly prepared for decision making purposes. But the information as is provided in the financial statements is not adequately helpful in drawing a meaningful conclusion. Thus, an effective analysis and interpretation of financial statements is required. 2.2 Presentation of Subject Matters: Financial statement analysis is the process of analyzing a company's financial statements for decision-making purposes. External stakeholders use it to understand the overall health of an organization and to evaluate financial performance and business value. 2.2.1 Meaning and Types of Financial Statements The term financial statements refer to two basic statements which an accountant prepares at the end of an accounting period for a business enterprise. These are: 1. Balance Sheet (or Statement of Financial Position) which reflects the assets, liabilities and capital as on a certain date, and 2. Profit and Loss Account (or Income Statement) which shows the results of operations i.e. profit or loss during a certain period. 3. Other Statements - Apart from the Balance Sheet and Profit-and Loss Account, the following financial statements are also prepared. 4. Profit and Loss Appropriation Account - This shows how profit of a business is utilised for declaring dividends, transfer to general reserve or other reserves etc. 5. Funds Flow Statement' - This shows increase or decrease in working capital during the accounting period. 6. Cash Flow Statement - This shows changes in cash position between the beginning and end of the accounting period. All these statements taken together are called package of financial statements. 2.2.2 Financial Statement Analysis: Analysis of financial statements means to critically examine the composition of 29 an item or amount appearing in the financial statements. In other words, analysis means breaking up of an amount into its elements so that a particular element may be correlated to another and significant relationship may be established between them and conclusions may be drawn on the data presented in financial statements. Such an analysis makes use of various analytical tools and techniques to data of financial statements so as to derive from them certain relationships that are significant and useful for decision making. In the words of John N. Myers, "Financial statement analysis is largely a study of the relationships among the various financial factors in a business as disclosed by a single set of statements and a study of the trends of these factors as shown in a series of statements." Interpretation is determining the meaning and drawing inferences or conclusions with regard to the results of significant relationship between the items correlated. Thus, financial statement analysis converts the mass of data into useful information which is always in scarce supply. It pinpoints the strengths and weaknesses of a business undertaking by use of various techniques such as ratio analysis, comparative statements etc. Such analysed information is used by management, bankers, creditors, investors and others to form judgement about the operating performance and financial position of the business. Thus financial statement analysis helps in evaluating a business performance according to some Analysis means establishing a meaningful relationship between various items of the two financial statements with each other in such a way that a conclusion is drawn. By financial statements we mean two statements: (i) Profit and loss Account or Income Statement (ii) Balance Sheet or Position Statement These are prepared at the end of a given period of time. They are the indicators of profitability and financial soundness of the business concern. The term financial analysis is also known as analysis and interpretation of financial statements. It refers to the establishing meaningful relationship between various items of the two financial statements i.e. Income statement and position statement. It determines financial strength and weaknesses of the firm. Analysis of financial statements is an attempt to assess the efficiency and performance of an enterprise. Thus, the analysis and interpretation of financial 30 statements is very essential to measure the efficiency, profitability, financial soundness and future prospects of the business units. The following are the principal tools of analysis of financial statements. i) Comparative Financial & Operating Statements. ii) Common-size Financial Statements. iii) Trend Percentages/Trend Ratios. iv) Ratio Analysis. 2.2.3 Comparative Statement Analysis: i) Comparative Balance Sheet Comparison of financial statements is one of the very important tools of analysis of financial statements. It has been seen that balance sheet and profit and loss account are the two most important financial statements. Information contained in these financial statements for a particular year is extremely important and useful. However such information becomes still more useful if it is compared with the data shown in the financial statements of the previous few years. Such comparison of financial statements is accomplished by setting up balance sheet and profit and loss account of two or more years side by side and studying the changes that have occurred in the individual figures therein from year to year and over the years. Thus comparison of financial statements means financial statements of a company for any year are compared with financial statements of the same company for earlier years. Comparative financial statements take the form of comparative balance sheets and comparative profit and loss accounts. Illustration: 1 From the following information prepare a Comparative Balance Sheet. 31st March 2003 31st March 2004 Rs. Rs. Equity Share Capital 4,00,000 6,00,000 Debentures 2,00,000 3,25,000 Sundry Creditors 2,55,000 1,17,000 Bank Overdraft 7,000 10,000 Total Liabilities and Capital 8,62,000 10,52,000 Plant and Machinery 1,00,000 2,00,000 31  Land and Building 3,60,000 5,40,000 Investments 2,70,000 1,70,000 Sundry Debtors 1,00,000 88,000 Cash in hand 32,000 54,000 Total Assets 8,62,000 10,52,000 Solution: Comparative Balance Sheet 31st March Increase or Decrease Item 2003 2004 Absolute Percentage s Rs. Rs. Rs. % Equity share Capital 4,00,000 6,00,000 2,00,000 50 Debentures 2,00,000 3,25,000 1,25,000 62.25 Sundry Creditors 2,55,000 1,17,000 (-)1,38,000 (-)54.12 Bank Overdraft 7,000 10,000 3,000 42.86 Total Liabilities and Capital 8,62,000 10,52,000 1,90,000 22.04 Plant and Machinery 1,00,000 2,00,000 1,00,000 100 Land and Building 3,60,000 5,40,000 1,80,000 50 Investments 2,70,000 1,70,000 (-)1,00,000 (-)37.04 Sundry Debtors 1,00,000 88,000 (-)12000 (-)12 Cash in hand 32,000 54,000 22,000 40.74 Total Assets 8,62,000 10,52,000 1,90,000 22.04 ii) Comparative Income Statement (or Profit and Loss Account): An income statement shows the net profit or net loss resulting from the operation of a business for a definite period of time. A comparative income statement is prepared to show the net profit or loss for a number of years in comparative form. By comparing income statement for two or more years, it is possible to observe the progress of a business. A comparative income statement contains the same columns as the comparative balance sheet and provides the same type of information. The first two columns are provided to show the balances of various accounts for two years for which comparison is to be made. Third column is provided to show the change i.e. increase or decrease in various items in absolute amounts in rupees, the fourth column shows the increase or decrease for each item in percentage. 32 Illustration: 2 From the following information, prepare a comparative Income Statement. 31st March 2003 31st March 2004 Rs. Rs. Sales 10,00,000 8,00,000 Cost of Goods Sold 6,00,000 4,00,000 Adm. Selling and Distribution Expenses 2,00,000 1,40,000 Other Incomes 40,000 20,000 Income Tax 1,20,000 1,40,000 Solution : Comparative Income Statement For two years 2003 and 2004 Year Change Particulars 2003 2004 Absolute % Rs. Rs. Rs. Sale 10,00,000 8,00,000 (-)2,00,000 (-)20.00 Less: Cost of Goods Sold 6,00,000 4,00,000 (-)2,00,000 (-)33.33 Gross Profit 4,00,000 4,00,000 Nil Nil Less: Operating Expenses: 2,00,000 1,40,000 (-)60,000 (-)30.00 Year Change Particulars 2003 2004 Absolute % Rs. Rs. Rs. Adm., Selling and Dist. Exp. Net Operating Profit 2,00,000 2,60,000 60,000 30.00 Other Incomes 40,000 20,000 (-) 20,000 50.00 Net Profit before tax 2,40,000 2,80,000 40,000 16.67 Less: Income Tax (50% of Net 1,20,000 1,40,000 20,000 16.67 Profit) Net Profit after Income Tax 1,20,000 1,40,000 20,000 16.67 33 2.2.4 Common Size Statements Analysis: Common size statement is a type of comparative financial statement in which each item of the financial statement is expressed as percentage of the appropriate total. The appropriate total is taken as 100 per cent and each item is shown as a proportion of this 100 per cent. Such a statement is also known as 100 per cent Statement or 'Vertical analysis'. It should be noted that when a comparative statement is prepared for a number of years to show the trend, it is known as 'Horizontal analysis', a common size statement may be prepared for balance sheet as well as income statement. Common Size Balance Sheet In common size balance sheet, each item of asset is shown as a percentage of total assets and each, item of liability and capital is shown as a percentage of total liabilities and capital (which is the same as total assets). In other words, the total of the assets and also that of liabilities and capital is taken as 100 per cent and each item appearing on the assets side as well as liabilities side is shown as a proportion of the total of 100. Illustration: 3 Please refer Illustration No: 1. A common Size Balance Sheet should be prepared as follows; Common Size Balance Sheet 31st March 2003 31st March 2004 Particulars % of Rs. % of Total Rs. Total Liabilities and Capital Equity share Capital 4,00,000 46.40 6,00,000 57.03 Debentures 2,00,000 23.20 3,25,000 30.89 Sundry Creditors 2,55,000 29.58 1,17,000 11.13 Bank Overdraft 7,000 0.82 10,000 0.95 Total Liabilities and Capital 8,62,000 100 10,52,000 100 Assets: Plant and Machinery 1,00,000 11.60 2,00,000 19.01 Land and Building 3,60,000 41.76 5,40,000 51.33 Investments 2,70,000 31.32 1,70,000 16.16 34  Sundry Debtors 1,00,000 11.60 88,000 8.37 Cash in hand 32,000 3.72 54,000 5.13 Total Assets 8,62,000 100 10,52,000 100 Procedure of preparing common size balance sheet Assume total of the balance sheet as 100 %. Then express each item in the balance sheet ·as a percentage of total of 100. For example, in the above Illustration, equity capital on 31st March 2003 is Rs. 4,00,000. Total of the balance sheet on this date is Rs. 8,62,000. We can now calculate percentage of equity capital in the total of 100% as follows: , , Equity Capital = , ,  100 = 46.40% Similarly calculation of other items in the balance sheet is made. For example: , , Debentures = , ,  100 = 23.20% , , Plant and Machinery = , ,  100 = 11.60% As on 31st March 2004, each item is calculated as a percentage of Rs. 10,52,000. For example : , , Equity Capital = , ,  100 = 57.03% , , Land and Building = , , 100 = 51.33% In this way each and every items is calculated. Common Size Income Statement This statement is similar to common size balance sheet. In the common size income statement, total sales figure is taken as 100 per cent and each item is then calculated as a percentage of sales. Illustration: 4 Please refer Illustration No: 2. A common Size Income Statement should be prepared as follows. 35 Solution: Common Size Income Statement 2003 2004 Particulars % of % of Rs. Rs. Sales Sales Sale 10,00,000 100.00 8,00,000 100.00 Less: Cost of Goods Sold 6,00,000 60.00 4,00,000 50.00 Gross Profit 4,00,000 40.00 4,00,000 50.00 Less: Operating Expenses 2,00,000 20.00 1,40,000 17.50 Net Operating Profit 2,00,000 20.00 2,60,000 32.50 Other Incomes 40,000 4.00 20,000 2.50 Net Profit before tax 2,40,000 24.00 2,80,000 35.00 Less: Income Tax (50% of Net Profit) 1,20,000 12.00 1,40,000 17.50 Net Profit after Income Tax 1,20,000 12.00 1,40,000 17.50 Procedure of preparing common size income statement Total net sales figure is taken as 100% and then each item appearing in the income statement is taken as a percentage of sales. For example, in the above illustration, sales of Rs. 10,00,000 in the year 2003 are taken as 100 per cent. Then cost of sales is calculated as a percentage of sales as follows: , ,  100 = , ,  100 = 60% , , Gross Profit as a % of sales = , ,  100 = 40% 2.2.5 Trend Analysis A trend percentage is a technique of studying financial statements of a company over a number of years. Under this method, a representative year is selected as the base year and the values of items in the base year are assumed to be 100. Then the relationship of each item in the subsequent years is expressed as a percentage of the same item in the base year. This means, when an item is expressed as 100, all other values expressed in term of the base year will reflect in trend, upward or downward, in relation to 100. Any year may be taken as the base but generally the starting or initial year is taken as the base year. Trend percentages may be used for both Balance Sheet and Profit and Loss 36 Account. Advantages 1) Trend percentages analysis is of immense use in making a comparative analysis over a series of years. 2) It is easy to identify changes and interpret the same because percentage figures disclose more than the absolute figures. Illustration: 5 Calculate the trend percentages from the following figures taking 1995 as the base and interpret them: Rs. in lakhs Sales Stocks PBT Year 1995 1,881 709 321 Year 1996 2,340 781 435 Year 1997 2,655 816 458 Year 1998 3,021 944 527 Year 1999 3,768 1,154 672 Solution The formula for calculating the trend percentages =  100 1995 has been taken as the base year Year 1995 1996 1997 1998 1999 Sales 100 124.40 141.15 160.61 200.32 Stock 100 110.16 115.10 133.15 162.76 PBT 100 135.51 142.68 164.18 209.35 PBT = Profit Before Tax Interpretation: Sales and profit are showing a rising trend thereby indicating a smooth rate of growth of company over the years. It is important to note that while both sales and profit are rising, rate of increase of PBT is more than the rate of growth in sales. This means that quite a good part of the total cost is fixed in nature because total cost is not increasing in proportion to sales. The stock is also showing a rising trend. The company should review its production policy in coordination with sales department so that unnecessary stocks are not built up. 37 Illustration: 6 From the following information, interpret the results of operations of a manufacturing concern using Trend Ratios. Use 1995 as the base. (Amount in Rs. lakhs for the year ended.) Year 1995 1996 1997 1998 Net sales 100.00 95.00 120.00 130.00 Cost of goods sold 60.00 58.00 69.60 72.80 Gross profit 40.00 36.10 50.40 57.20 Operating expenses 10.00 9.70 11.00 12.00 Net Operating profit 30.00 -26.40 39.40 45.20 Solution Year 1995 1996 1997 1998 Net sales 100.00 95.00 120.00 130.00 Cost of goods sold 100.00 96.67 116.00 121.33 Gross profit 100.00 90.25 126.40 143.20 Operating expenses 100.00 97.00 110.00 120.00 Net Operating profit 100.00 88.00 131.33 150.67 Interpretation: The performance in the year 1996 was quite poor as compared to the base year 1995 because of lower sales and profit. Sales have declined by 5% but the net operating profit has come down by 12% i.e. from 100% to 88%. Significant recovery was made in the year 1997 in respect of sales and profit. This trend of recovery was continued in 1998. One important point to be noted is that rate of change in net operating profit is more than rate of change in sales. For example when sales decline by 5% in 1996, profit declines by 12%. Similarly when sales increase in 1997 and 1998 by 20% and 30% respectively, net profit increase by 31% and 50% respectively. This means that a substantial portion of the cost of goods sold and operating expenses are of fixed nature which do not change when there is a change in sales. Illustration: 7 From the following Profit & Account of Philips Co. Ltd. for the year ending 31st Dec. 2003 and 2004 you are required to prepare a comparative Profit & Loss Account and given your comments: 38  Profit & Loss Account Particulars 2003 2004 Particulars 2003 2004 Rs. Rs. Rs. Rs. To Cost of goods sold 420 560 By Sales 600 720 To Administration 50 66 By Dividend received 30 90 Expenses To Selling and distribution 25 23 Expenses To Interest on debentures 12 12 To Loss on Sale of Plant 6 4 To Provision for income 40 48 Tax To Net Profit 77 97 630 810 630 810 Solution: (Figures in Rs. Lakhs) Increase or 2003 2004 Particulars Decrease Rs. Rs. Rs. % Sales 600 720 120 20.00 Less: Cost of goods Sold 420 560 140 33.33 Gross Profit (A) 180 160 (-)20 (-)11.11 Less: Operating expenses: Administration expenses 50 66 16 32.00 Selling & distribution expenses 25 23 (-)2 (-)8.00 Total operating expenses (B) 75 89 +14 +18.67 Operating Profit (A- B) 105 71 (-)34 (-)32.38 Add: Dividend received 30 90 +60 200.00 Total income (C) 135 161 +26 19.26 Less: Other expenses: 39  Interest on debentures 12 12 - - Loss on sale of plant 6 4 (-)2 (-)33.33 Total other expenses (D) 18 16 (-)2 (-)11.11 Income before tax (C-D) 117 145 28 23.93 Less: Provision for tax 40 48 8 12.00 Income after Tax 77 97 20 25.97 Comments 1. Increase in sales is 20% in 2004 while the cost of goods sold has increased by 33.33% resulting in a fall in gross profit by 11.11 %. As the increase in cost is more than the increase in sales, it is a matter of concern for the management of the company 2. Administration expenses have gone up by 32%-which is not justified because of falling profitability. The management should look into this matter. 3. There is a 32.38% fall in operating profit whereas the fall in net profit before tax is lower at 23.93%. This is because non-operating income (dividend) has increased substantially by 200% Illustration: 8 Prepare comparative balance sheets from the Balance sheet given. 2002 2003 2002 2003 Liabilities Assets Rs. Rs. Rs. Rs. Equity Share Capital 3,00,000 4,00,000 Goodwill 1,15,000 90,000 Redeemable Pref. Capital 1,50,000 1,00,000 Land and Building 2,00,000 1,70,000 General Reserve 40,000 70,000 Plant 80,000 2,00,000 Profit and Loss Account 30,000 48,000 Debtors 1,60,000 2,00,000 Proposed Dividend 42,000 50,000 Stock 77,000 1,09,000 Creditors 55,000 83,000 Bills Receivable 20,000 30,000 Bills Payable 20,000 16,000 Cash in Hand 15,000 10,000 Provision for Taxation 40,000 50,000 Cash at Bank 10,000 8,000 6,77,000 8,17,000 6,77,000 8,17,000 40  Comparative Balance Sheets Increase Increase or or 2002 Rs. 2003 Rs. Decrease Decrease Rs. % Assets Goodwill 1,15,000 90,000 (-)25,000 (-)21.74 Land and building 2,00,000 1,70,000 (-)30,000 (-)15.00 Plant 80,000 2,00,000 1,20,000 150.00 Debtors 1,60,000 2,00,000 40,000 25.00 Stock 77,000 9,000 32,000 41.56 Bills Receivable 20,000 30,000 10,000 50.00 Cash in hand 15,000 10,000 (-)5,000 (-)33.33 Cash at bank 10,000 8,000 (-)2,000 (-)20.00 Total 6,77,000 8,17,000 1,40,000 20,68 Liabilities Equity share capital 3,00,000 4,00,000 1,00,000 33.33 Re