Unit IV , Accounting principles

Accounting Principles:
Generally accepted accounting principles (GAAP) refer to a common set of accounting principles,
standards, and procedures issued by the Financial Accounting Standards Board (FASB). Public
companies in the United States must follow GAAP when their accountants compile their financial
statements. GAAP is a combination of authoritative standards (set by policy boards) and the
commonly accepted ways of recording and reporting accounting information. GAAP aims to
improve the clarity, consistency, and comparability of the communication of financial information.
Elements of financial statements:
1) Assets
2) Liabilities
3) Capital: Money contributed by owners at the beginning and over the time period it requires.
It consists of equity share capital, preference share capital, retained earnings of company.
4) Expanses: all activities that results in outflow of cash or decrease in economic benefits.
Financial statements: (a) Format of trading account:
 (b)Profit and loss account

Financial Management

Financial Management means planning, organizing, directing and controlling the financial activities
such as procurement and utilization of funds of the enterprise. It means applying general
management principles to financial resources of the enterprise.
➢ Scope/Elements

1. Investment decisions includes investment in fixed assets (called as capital budgeting),

investment decisions called as working capital decisions.
2. Financial decisions - They relate to the raising of finance from various resources which will
depend upon decision on type of source, period of financing, cost of financing and the
returns thereby.
3. Dividend decision - The finance manager has to take decision with regards to the net profit
distribution. Net profits are generally divided into two:
a. Dividend for shareholders- Dividend and the rate of it has to be decided.
b. Retained profits- Amount of retained profits has to be finalized which will depend
upon expansion and diversification plans of the enterprise.

➢ Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern. The objectives can be-

1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders which will depend upon the earning capacity,
market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should be utilized in
maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that
adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition of capital so
that a balance is maintained between debt and equity capital.

➢ Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make estimation with

regards to capital requirements of the company. This will depend upon expected costs and
profits and future programmes and policies of a concern.
2. Determination of capital composition: This involves short- term and long- term debt
equity analysis. This will depend upon the proportion of equity capital a company is
possessing and additional funds which have to be raised from outside parties.
3. Choice of sources of funds: a company has many choices like-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.
4. Investment of funds: The finance manager has to decide to allocate funds into profitable
ventures so that there is safety on investment and regular returns is possible.
5. Disposal of surplus: The net profits decision have to be made by the finance manager. This
can be done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and other benefits
like bonus.
b. Retained profits - The volume has to be decided which will depend upon expansional,
innovational, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries,
payment of electricity and water bills, payment to creditors, meeting current liabilities,
maintainance of enough stock, purchase of raw materials, etc.
7. Financial controls: has to exercise control over finances, through many techniques like
ratio analysis, financial forecasting, cost and profit control, etc.

CAPITAL STRUCTURE

There are several competing capital structure theories, each of which explores the relationship
between debt financing, equity financing, and the market value of the firm slightly differently.
These theories explain theoretical relationship between capital structure, cost of capital (ko) ,
and value of firm (v).
1. Net income approach: Relevance of capital structure

It suggests that value of the firm can be increased by decreasing the overall cost of
capital (WACC) through higher debt proportion. Capital structure is the proportion of debt and
equity in which a corporate finances its business. The capital structure of a company/firm plays
a very important role in determining the value of a firm.

Net Income Approach was presented by Durand. The theory suggests increasing value of the
firm by decreasing the overall cost of capital which is measured in terms of Weighted Average
Cost of Capital. This can be done by having a higher proportion of debt, which is a cheaper
source of finance compared to equity finance.

(WACC) is the weighted average costs of equity and debts where the weights are the amount of
capital raised from each source.

WACC= Required Rate of Return x Equity + Cost of debt x Debt

Total Amount of Capital (Debt + Equity)

The Net Income Approach suggests that with the increase in leverage (proportion of debt), the
WACC decreases and the value of firm increases. On the other hand, if there is a decrease in the
leverage, the WACC increases and thereby the value of the firm decreases.
2. Net operating income approach (NOI): Irrelevance of capital structure

• The value of the firm and weighted average cost of capital are independent of firms capital
structure, therefore value of firm is same.
 • Hence value of firm for a given level of EBIT or operating profit remains same irrespective
of debt- equity mix
• Hence value of firm depends on EBIT and cost of capital (ko)
Value of the firm =EBIT/Ko
Value of equity= Value of firm- Value of debt
Cost of equity (ke) = ( EBIT- Interest)/value of equity
• In graph, Kd and Ko constant, with more use of debt in capital structure Ke starts raising
while Ko remains constant.
(C)Traditional Approach: Relevance of capital structure and midway between NI and NOI
approach:
• NI and NOI held extreme views on the capital structure, but traditional approach took a
compromising view and includes basic view of both approaches, it is midway between these
two
• It emphasis on judicious use of debt and equity in capital structure to find out optimum
capital structure ie at which cost of capital is minimum and value of firm is maximum.

• Debt use is beneficial for the firm upto certain limit beyond which use of debt gives negative
results and cost of capital starts to increase.
(D) Modigliani-Miller approach: MM Model ( Irrelevance of capital structure):
• MM approach is extension of NOI approach .
• It states that capital structure and its composition has no effect on value of the firm ie Ko and
Value of firm is independent of capital structure
Assumptions of MM model:
• Capital markets are perfect, complete information available free of cost
 • Securities infinitely divisible
• Investors are rational and well informed.
• No corporate income tax
• Personal leverage and corporate leverage are perfect substitutes.
→ Hence total value of firm is capitalised value of operating earnings of the firm
→ Value of firm independent of debt / equity mix
→ Ko depends upon risk class to which firm belongs
MM Model gives two propositions:
Proposition 1: composition of capital structure is irrelevant
• If two firms are same in all respects except different in their financing pattern and market
value.
• Arbitrage process comes into existence where investors sell shares of overvalued firms
and buy the shares of undervalued firm at the same time to earn riskless profit this process
will continue until value of two firms equal.
• Arbitrage process refers understanding two related actions by an individual
simultaneously to earn riskless profit.
• This process used by MM model to find relationship between Ko, leverage and market
value of firm.
• Even after different financing patterns , two firms achieve equal market value due to
arbitrage process.
• Hence composition of capital structure irrelevant for value of firm
Proposition 2: Cost of equity depends on three factors ie cost of capital (Ko), cost of debt (Kd)
and debt equity ratio.
• Ke=Ko+ ( Ko-Kd)* Debt/Equity
• Ke and leverage has positive relation as more use of leverage increases returns to
shareholders but at high cost of equity due to increase in financial risk perception .
• So benefits of cheaper debt is offset by increase in cost of equity, therefore value of firm
remains same.
 • Cost of capital:

• Ko is used for capital budgeting decisions as a discount rate to measure present value of
future cash flows, compare it with initial cost of project to find net present value.
• Ko can be compared with IRR ie internal rate of return of project to make decision.
• Ko used to decide composition of debt equity mix.
➢ Calculation of Ko:
• Different sources used by firm to raise funds and design capital structure
• Each source has its specific cost
(i) Cost of debt (Kd):
• Debt capital has cost attached with it in the form of interest amount paid to debt
holders at specific interest rate after adjustment of taxes:
Kd= I (1-t) , I—Interest rate, T---Tax rate
When debt is issued for first time it includes floatation cost and final cost of debt will be higher:
Kd (New issue)= I+ ((P-NP)/N)/ ((P+NP)/2)
P---Par value of debenture
NP---Net proceeds
N----no of maturity years
 (ii) Cost of preference shares (Kp): company also generates funds by issuing preference
shares from equity shares in two ways:
(a) Preference shareholder receive fixed amount of dividend , with priority over equity
shares.
(b) In case of liquidation preference shareholder have priority over equity shareholder for
payment of capital.
Preference dividend is paid only when sufficient profit is available. It is appropriation against
profit, and interest on debenture is charge against profit.
Cost of capital of redeemable preference shares: In these shares principal amount is paid
to shareholders at maturity.

This value of Kp obtained by solving following equation by trial and error ,

Cost of irredeemable preference shares: its cost is very much easier than redeemable, no
adjustment for taxation is required in case of preference share because dividend paid to
shareholders after tax has been charged
Kp=PD/Po
Po---- par value of preference shares per share basis
PD------ expected dividend per share basis
Kp-------Cost of preference share.

(C) Cost of Equity Shares (Ke):

 • Payment of dividend to equity shareholders is not mandatory , depends upon wish
of company.
• Ke is the rate at which future dividend from shares are discounted to find out
market value of share.
• It represents minimum rate of return by investor on their funds provided to firm
Various methods to find Ke:
(i) Zero growth dividend: Here dividend assumed constant over entire life of firm and
dividend is perpetual:
Ke= D1/Po
D1----Dividend at the end of first year, Po------Current market price of share
(iii) Constant growth rate in dividend: Dividend assumed to grow at a constant rate, ie g
each year
Assumptions: Current market price of share is depends on future dividend, Dividend payout
ratio remains constant

Here required rate of return is Ke

From equation Ke=(D1/Po) + g
(c)Ke under CAPM or security market line: Friend and Blume estimate cost of equity share by
using beta as follows:

(d)Cost of retained earnings (Kr):

• It is that part of profit which is not distributed as dividend.
• It is addition to present capital by existing shareholders where firm will not pay any dividend
to shareholders
• Hence from firm’s point of view cost of retained earnings is equal to cost of equity capital
Ke because retained are fresh subscription to equity share capital.
• Hence no separate measurement of cost of retained earnings
Weighted average cost of capital (WACC or Ko):
 • The weighted average cost of capital is the rate that a company is expected to pay on
average to all its security holders to finance its assets. The WACC is commonly referred
to as the firm's cost of capital. Importantly, it is dictated by the external market and not by
management.
• After calculation of specific cost of each long term sources of finance ie debt, preference
shares capital , equity capital and retained earnings , Ko is calculated , which is used as
cut off rate or discount rate under capital budgeting decisions.

Similarly retained earnings can also be included:

Different approaches to decide weights:

• Historical or actual weights: based on actual proportion used in constructing capital structure.
• Marginal weights: weights or proportion in which firm wants to raise additional funds from
different sources.
• Target weights: Proprtions in which firm construct its desired capital structure.
• Book value weight : These proportions based on face value ie accounting value of different
sources of finance recorded in books of account.
• Market value weights: Based on current market value of different sources of finance.

LEVERAGE
 ➢ In financial management leverage depicts relationship between two financial variables ie
sales , operating profit (EBIT), earning per share (EPS) etc. which are interrelated and
interconnected to each other. It can be defined as:
Leverage= % Change in dependent variables / % change in independent variables

For ex Leverage= % change in sales (units)/ % change in advertising expenses

If this value comes 3 , it means that %change in sales will be 3 times of % changes in
advertising expenses.
➢ Sales revenue:

• Hence EBIT depends on sales volume and EPS depends on EBIT , this particular region
among EBIT, sales revenue and EPS serve as basis for study of operating , financial and
combined leverage.
(A)Operating leverage:
• It shows relation between sales revenue and EBIT (operating profit)
• It measures effect of change in sales revenue on the level of EBIT.
• Sales revenue is independent variable and EBIT is dependent variable because it depends on
sales revenue.
• Hence sales revenue works as a lever to move EBIT up.
 • Operating leverage (OL)= %change in EBIT or operating income / % change in sales
revenue
• OL= Contribution / EBIT
• Where contribution = Sales revenue- Variable cost,
• Or Contribution= EBIT+ Fixed cost

➢ Reason for existence of operating leverage:

• Due to presence of Fixed cost in cost structure, OL came into existence
• OL always greater than 1 for firms having fixed cost element
• OL=1 for no fixed cost, ie % change in EBIT will be same as % change in sales revenue.
• Presence of fixed cost is necessary for OL to exist , higher the level of fixed cost higher will
be degree of OL, means larger will be magnifying effect on EBIT
• Positive OL means firm is operating at higher than break even level of EBIT
(B) Financial leverage:
• Depicts relationship between EBIT and EPS
• Measures effect of change in EBIT on level of EPS
• Defines firms ability enhance effect of change in EBIT on EPS, this magnifying effect rise
due to presence of fixed financial charges like interest on debentures etc.
• EBIT is independent variable and EPS is dependent variable.
• Funds raised from debt like debentures because debt is cheaper source of finance as
compared to equity financing hence fixed financing charges arises.
• So use of FL magnify returns available to owners of firm
FL= %change in EPS / % change in EBIT
FL= EBIT / EBT , EBT-----earnings before tax
• Without debt financing degree of FL=1, means % change in EPS will be same as % change
in EBIT
• Financial manager responsible to prospect where use of FL is beneficial to firm as leverage is
double edge weapon.
• Finance manager have to make comparison between cost od debt financing and returns
earned by investing these funds which results in three situations:
 • OL is called first order leverage and FL is called second order leverage.
(C)Combined leverage:
• It is combined effect of OL and FL
• OL deals with business risk & FL deals with financial risk
• CL helps in knowing overall risk of the firm which includes financial and business risk.

➢ Interpretation of CL:
• It shows % change in EPS from 1% change in sales
• Positive CL means EPS and sales level both move in same direction and EPS will be
positive.
• Negative CL means EPS will be negative.

EBIT – EPS Analysis:

• Capital structure can be constructed with different combinations of debt, equity and
preference capital
• Each combinations of these sources have different implications on EBIT and EPS
• Like debt financing results in fixed financialcharges of interest payment
• Preference capital involves fixed payment of dividend
• Both these reduces earnings available to owners of company , as as EPS
 • Hence different financing patterns with varying levels of EBIT can effect EPS on different
ways
• Finance managers are responsible to select the financing pattern for given level of EBIT that
will ensure highest level of EPS, Various cases arises:
• Case 1: constant EBIT with different finance pattern
• Case2: Varying EBIT with different finance pattern

Financial break even level of EBIT:

• It represents that level of EBIT just sufficient to cover fixed financial charges ie interest on
debenturesand preference dividend.
• Ie where amount of operating profit (EBIT) is just covering or equal to the fixed finacial
charges of existing financial charges of firm
• Such level known as financial break even level of EBIT
• Also refers as that level of EBIT at which EPS would be zero, means no earnings available
for equity shareholders as the earnings are utilised for paying fixed financial charges.
• It can be calculated as:
➢ Indifference level of EBIT:
• That level of EBIT at which EPS under two financial patterns will be same, irrespective
of debt-equity mix.
• At this point firm is different between two financial plans to raise funds
• It can be calculated as:
FINANCIAL STATEMENT ANALYSIS
Ratio analysis is used to evaluate a number of issues with an entity, such as its liquidity, efficiency
of operations, and profitability. ... Trend lines can also be used to estimate the direction of
future ratio performance.
Classification of Ratio or types of ratios:
1. Liquidity ratio:
• It measures the liquidity of firm , indicate its ability to meet short term obligations . Under
this category are:
(a) Current ratio: it measures relationship between current assets and current liabilities. Also
known as working capital
Current ratio= current assets / current liabilities
• Ideal current ratio is 2:1
• Current assets are the assets of firm which can be converted into cash within one year , ex
cash in hand, cash at bank, debtors and bills receivables etc
• Current liabilities represents the amount payable to others within one year , consists of
creditors, bill payable, bank overdraft etc.
(b) Quick ratio or acid test ratio: it is ratio between quick assets and current liabilities.
 • It depicts short term liquidity position of a company.
• Quick ratio= Quick assets or liquid assets / Current liabilities
[ Quick assets= current assets – stock – prepaid expenses]
[ Quick assets are those assets which can be converted into cash immediately without decrease in
value]
• Ideal Quick ratio is 1:1
• Its significance is ,sometimes current assets have high portion of stock which creates
problem while converting into cash immediately , hence quick assets proves to be immediate
cash
• Hence it serve as more rigorous testing of liquidity position
2. Solvency ratio:
• It shows long term solvency position of firm. It indicate ability of a firm to meet long term
liabilities. Includes following ratios:
(a) Debt- Equity ratio:
• It measures relation between debt and equity as source of financing assets of firm
• Required amount of funds can be raised from equity capital (internal ) and debt (outsiders
fund) to finance assets of company
• Combination of debt and equity used to raise funds has implications on long term solvency
of firm.
• Also known as external- internal equity ratio.
Debt- equity ratio= Debt / equity = outsiders fund / shareholder’s funds= Total long term debt /
shareholder’s funds
• Ideal ratio is 2:1
• Long term debt= debentures and long term loans
• Shareholder’s fund = equity share capital+ preference share capital + reserves and surpluses
– accumulated losses – fictitious assets
(b) Total assets to debt ratio:
• It shows relationship between total assets and total long term debt.
• It is calculated as Total assets / long term debt
[ Total assets= fixed assets + current assets
Long term debt= debentures + long term loan]
• Used to measure safety margin available for suppliers of long term funds in form of total
assets.
• Expressed as pure ratio.
(c)Proprietary ratio:
• It measures relationship between proprietary’s funds or shareholders funds and total assets.
• Calculated as proprietary fund’s / total assets.
• It shows portion of total assets financed by shareholder’s funds or owner’s equity.
• Total assets= fixed assets + current assets – fictitious assets
• Shareholder’s funds = equity share capital + preference share capital + reserve and surpluses-
accumulated losses – fictitious assets
(d)Interest coverage ratio (ICR) :
• It gives relationship between EBIT and fixed financial charges ( interest paid on long term ).
• Also known as ‘ debt services ratio’
• It measures debt serving capacity of the firm .
• ICR = EBIT/ fixed interest charges
• It is calculated to make sure that availability of amount ( profit) sufficient to cover up the
interest charges.

3.Activity ratio or turnover ratio:

• These ratios measure operational efficiency of firm .
• Also known as turn over ratio or asset management ratio.
• It shows efficiency in assets management and utilisation.
• These ratios serve as link between assets management and sales or profit.
• Efficient utilisation of assets results in larger amount of sales as speed of conversion of assets
results in increase in sales.
• Higher this ratio, higher will be utilization of resources
• It is expressed in number of times
• Concerned with efficiency in assets management.

Ratios included in this are:

(a) Stock turnover or Inventory turnover ratio:
• Measures relation between COGS during concerned period and average inventory carried
during that period.
• Measures firms efficiency in inventory management.
• Higher inventory turnover ratio is better as it indicated quick conversion of inventory into
sales
• Low ratio indicate unsold inventory and excessive investment of sales.
• Stock turnover ratio= COGS / average inventory = net sales / average inventory
[ COGS = opening stock + purchase + direct expenses – closing stock]
Average inventory = (opening stock + closing stock ) /2
(b)Debtors turnover ratio:
• Also known as receivables turnover ratio
• Shows how quickly debtors are converted into sales.
• Measures liquidity of receivables
• Debtor turnover= credit sales / average debtors
[ credit sales= total sales – cash sales – sales return]
[Average debtor = [opening balance + closing balance ]/ 2
• Debtors includes book debts and bills receivables at end of year.
(c)Average collection period:
 • Approximate time period that a firm takes to collect debtors or accounts receivables.
• ACP= 365 days or 12 months / debtor’s turnover ratio
(d)Creditor’s turnover ratio:
• It depict credit period enjoyed by the firm
• Also indicates number of times account accounts payable rotate in a year.
• Creditor’s turnover ratio= net credit purchase / average payable
[Credit purchase = total purchase – cash purchase – purchase return]
[Average payable= [ opening balance + closing balance ]/2]
(e) Average payment period:
• Approximate time period that a firm takes to paid the account payables
• Average payment period = 365 days or 12 months / creditors turnover ratio
(f) Working capital turnover ratio:
• Measures efficiency of working capital
• Working capital turnover = cost of sales / net working capital
[ Net working capital = CA – CL]
• It shows conversion of working capital into sales and profit.
• Higher ratio indicates quick conversion of investment in working capital into sales and profit
(4) Profitability ratio:
• It shows firm ability to earn profit
• It shows economic progress , measure worth for owners,
• Measured in terms of percentage.
• Following ratios included in this ratio:
(a) Gross profit ratio:
• Also known as gross margin ratio

•
[Net sales= cash sales + credit sales – sales return]
[ COGS = opening stock + purchase + direct expenses – closing stock]
• Gross profit represents difference between revenue from operations and direct expenses.
• Low ratio shows low profitability
(b) Net profit ratio:
•
 • Net profit= gross profit- indirect expenses
• Net sales= cash sales + credit sales – sales return
(c)Operating ratio:

• Net sales= cash sales + credit sales – sales return

• COGS= opening stock + purchase + direct expenses – closing stock
• Operating expenses = administrative expenses + selling and distributive expenses + interest
on short term loan +discount allowed and bad debt.
• Lower ratio is better for firm as lower operating ratio is corresponding to higher productivity.
(d)operating profit ratio:

• Operating profit = net profit + non operating income – non operating expenses
• Net sales= cash sales + credit sales – sales return
(e)Expenses ratio:
• Relation between operating expenses and sales volume.
• Following ratios included in it:
i) Material consume ratio= material consumes / net sales * 100
ii) Conversion cost ratio = [ labour expenses + manufacturing expanses] /net sales * 100
iii) Administrative expenses ratio = administrative expenses / net sales *100
iv) Selling expenses ratio= selling expense ratio/ net sales * 100
(f) Earning ratio:
• Calculated for companies listed on stock exchanges. Main ratios are:
(i) Earning per share ratio ie EPS= net PAT and preference dividend / no of equity shares
(ii) Price earnings ratio, P/E ratio= market price per equity share/ earning per share
 (iii) Dividend payout ratio (DPS) = dividend per equity share/ earning per share
(iv) Earning yield ratio= [ earnings per share / market price per share ] * 100

Fund flow statements ,,cash flow statements , all formats,, yourself.

BUDGETING AND BUDGETARY CONTROL
A budget is a formal statement of estimated income and expenses based on future plans and
objectives. In other words, a budget is a document that management makes to estimate the
revenues and expenses for an upcoming period based on their goals for the business.
Budgetary control:
Steps involved in preparation of budget:
1) Appointment of budget controller
2) Formulation of budget committee
3) Budget period
4) Identifying key factor or limiting factor
5) Budget center
6) Preparation of budget manaual
Types of budget:
1) On the basis of capacity:

2) On the basis of coverage of function called functional budgets:

These are associated with different functions of management for every major function like
production budget, marketing budget, sales budget, purchase budget etc.
i) Sales budget:
ii) Production budget:

iii) Production cost budget:

• Prepared for estimating planned production cost for specific period.
• Serve the budgeted figure of production cost ie aggregate of direct material cost, direct
labour, direct expenses, overhead expenses separately for budgeted period and facilitate
comparison with actual results.
iv) Purchase budget:
A purchases budget contains the amount of inventory that a company
must purchase during each budget period. The amount stated in the budget is the amount
needed to ensure that there is sufficient inventory on hand to meet customer orders for
products.
The budget is created using a simple formula: the desired ending inventory, plus the cost
of goods sold, minus the value of the beginning inventory. This equation gives you the
total purchases budget.
v) Raw material budget:
The materials budget (or materials purchases budget) is used to plan how much raw
materials we need to have available to meet budgeted production. This budget is prepare
similarly to the production budget as the company must decide how much raw
materials inventory they want to have on hand at the end of each quarter.
 vi) Factory / production/ Manufacturing overhead budget:
A manufacturing budget is a set of three budgets that estimate the cost of direct materials, direct
labor, and overhead for the number of units predicted to be produced in the production budget.
vii) Administrative cost budget:is usually prepared on an annual or quarterly basis and
identifies the costs of running an operation that is not tied to producing a product or
service. This budget includes expenses from non-manufacturing departments, such as
sales, marketing, and human resource departments.
viii) Selling and distribution cost budget: forecasts the cost of selling and distributing the
products. ... These expenses will very with the expected sales figures during the period.
These expenses may be estimates per unit of sales or some percentage on sales, etc.
The selling and administrative expense budget lists the operating expenses involved
in selling the products and in managing the business
ix) Cash budget: details a company's cash inflow and outflow during a
specified budget period, such as a month, quarter or year. Its primary purpose is to
provide the status of the company's cash position at any point of time. ... It also helps in
analyzing budget-versus-actual variances in cash inflow and outflow
x) Master budget: is the aggregation of all lower-level budgets produced by a company's
various functional areas, and also includes budgeted financial statements, a cash forecast,
and a financing plan.

Zero based budgeting: (ZBB) is a method of budgeting in which all expenses must be justified
for each new period. The process of zero-based budgeting starts from a "zero base," and every
function within an organization is analyzed for its needs and costs. It was introduced in by “ Peter
Phyrr”.
Marginal costing:

Marginal cost= direct material + direct labour cost+ direct expenses + variable overheads
➢ Merits of marginal costing:
• Facilitate managerial decision making.
• Feature of segregation of cost into fixed and variable component as it ensure better cost
control emphasis.
• Simple in application due to constant nature of per unit variable cost.
• Facilitate determination of price of productson the basis of marginal cost
• Helps in profit planning
COST VOLUME PROFIT ANALYSIS
Cost-volume-profit (CVP) analysis is used to determine how changes in costs and volume affect
a company's operating income and net income. In performing this analysis, there are several
assumptions made, including: Sales price per unit is constant. Variable costs per unit are
constant. Total fixed costs are constant. It is a form of cost accounting. It is a simplified model,
useful for elementary instruction and for short-run decisions.
Concepts used under CVP analysis:
(a) Break even analysis:
A break-even analysis is a financial tool which helps you to determine at what stage your
company, or a new service or a product, will be profitable. In other words, it's a financial
calculation for determining the number of products or services a company should sell to cover its
costs (particularly fixed costs)

Assumptions under Break even analysis and CVP analysis:

i) All cost is separated into fixed and variable cost
ii) Total fixed cost remains constant
iii) Selling price per unit remains same
iv) Variable cost per unit remains constant
v) Total variable cost is directly proportional to volume of output
vi) Only one product is there in case of multiple products sales mix doesn’t change.

Profit volume ratio: indicates the relationship between contribution and sales and is usually
expressed in percentage. The ratio shows the amount of contribution per rupee of sales. It is
influenced by sales and variable or marginal cost.Influenced by following factors:
• Change in sales level
• Change in variable cost
• Change in contribution or profit
P/V ratio (%) = contribution / sales * 100 = change in profit / change in sales * 100
Contribution = [ sales – variable cost] = [FC + profit or loss]
Significance of P/V ratio:
• It facilitate calculation of sales, contribution, variable cost, break even point, profit, volume
of sales required to earn given profit
• It represents profitability of products, higher will be better
• Facilitate managerial decision making
• It represents rate of profitability
Calculation of break even point (BEP):the break-even point can be defined as a point where total
costs (expenses) and total sales (revenue) are equal. Break-even point can be described as
a point where there is no net profit or loss. Its calculation necessary for effective management of
production activities and ensure profit generating output.
Formulas for break even point:

Margin of safety (MoS):

• It refers to excess of actual sales over breakeven sales or it is difference between actual sales
and break even sales. Expressed in money terms.
• It represent profit earning range for firm
• Business continue to make profit till MoS is positive , it means actual sales level is higher
than break even level
• It is directly related to profit
Formulas:

Limiting factor / key factor:

Some of the limiting factors which effects profit:
1) Sales
 2) Availability of raw material
3) Skilled labour
4) Production capacity
5) Financial resources availability
Cost indifference point:
• It denotes that level of output at which total cost between two alternate courses of action is
same ie management is indifferent between two alternative.
• Cost indifference point = differential fixed cost / differential variable cost per unit
Interpretation of cost indifference point:

STANDARD COSTING
• Technique of cost control where standards are set against each element of cost and compared
with actual data received for further analysis of variance.
• is the practice of substituting an expected cost for an actual cost in the accounting records.
• Subsequently, variances are recorded to show the difference between the expected and actual
costs
• Standard is the cost under the given set of operating conditions.
• It is pre determined cost based on technical estimates for material, labour and overhead for a
selected period of time , for prescribed set of working conditions.
Features of standard cost:
• Cost calculated in advance
• For a specific period
• Serve as benchmark for comparison
• Based on scientific methods
• It states “what cost should be ?”
Prerequisite for standard costing system:
1) Establishment of cost center
2) Classification and codification of accounts on particular basis
Types of standard:
a) Basic standard:These are long-term standards which remain unchanged over a period of
years. Their sole use is to show trends over time for such items as material prices, labour
rates and efficiency and the effect of changing methods. They cannot be used to highlight
current efficiency
b) Current standard: Current standards are standards which are established for use over a
short period of time, and are related to current conditions. They represent current costs to be
expected from efficient operations.These are of three types:
1) Ideal standard: Ideal standards (costs) are the standards which can be attained under the
most favourable conditions possible. means that there is no wastage or scrap, no
breakdowns, no stoppages or idle time; in short, no inefficiencies . but in reality not
possible to achieve as these based on perfect conditions.
2) Practical or expected standard: based on expected performance to be achieved in future
after considering normal wastages etc.
3) Normal standard: based on average performance in past , realistic and attainable under
normal conditions.
Significance / importance of standard costing:
• It facilitate planning by setting up standards
• Standard is set for each element of cost
• Assist in comparison of actual data with standard data.
• Ensure analysis of variance and their causes
• Facilitate coordination among different functions
• Ensure correcting measures for reducing wastage
• Locate areas needed for further improvement.
ANALYSIS OF VARIANCE
Cost variance refers to difference between standard cost and comparable actual cost incurred during
a period.
Main group of variance:
1) Variance of efficiency: arise due to inefficiency in use of material or labour
2) Variance of price rates: arises due to difference between actual rates and standard rates of
material, labour hours, overhead rates.
3) Variance of volume: difference between actual activity and standard activity.
Favourable / credit variance = actual cost < standard cost
Unfavourable / adverse variance = actual cost > standard cost
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Dupont analysis/ dupont model/ dupont identity
• Is a technique to measure ROE
• Provides deeper insight of financial performance of company
• allows an investor to determine what financial activities are contributing the most to the
changes in ROE.
 • this model developed by “DUPONT corporation” in 1920 as broader analysis of ROE
Interpretation of Dupont analysis:
• ROE depends on profit margin, asset turnover ratio, and uses of financial leverage.
• Profit margin indicates operational efficiency of business
• Assets turnover ratio express efficiency with which managers using assets of company
• Finally financial leverage or debt financing beneficial for augmentation of ROE as debt
financing is cheaper source.
Importance of Dupont analysis:
• It shows specific areas of strength and weakness of firm, areas require for improvement
• In depth analysis of financial performance.
• Valuable information tool for management and shareholders.
• Facilitate comparison of financial performance of two similar company’s

SOURCES OF FINANCE: