Early Bird Volume 2 PDF

COSTING
INTER CA. – COSTING
COST SHEET
THEORY SECTION
(New & Applicable Format) Cost Sheet of...........

for the year ending.........
Particulars Total Cost (`)
Raw Materials Consumed
Opening Stock of Raw Materials xx
+ Purchase of Raw Materials xx
- Scrap of Raw Materials (xx)
+ Carriage Inwards (Any expenses on purchase) xx
Less : Closing Stock of Raw Materials (xx)
Less : Purchase Return (xx) xx
Direct employee (labour) cost xx
Direct expenses xx
Prime Cost xx
Works/ Factory Overheads xx
Gross Works Cost x
Add: Opening Work in Process xx
Less: Closing Work in Process (xx)
Works/ Factory Cost xx
Quality Control Cost xx
Research and Development Cost xx
Administrative Overheads (relating to production activity) xx
Less: Credit for Recoveries / Scrap / By- Products / miscellaneous (xx)
income
Add: Packing cost (primary) xx
Cost of Production xx
Add: Opening stock of finished goods xx
Less: Closing stock of finished goods (xx)
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Cost of Goods Sold xx

Add: Administrative Overheads (General) xx
Add: Marketing Overheads
-Selling Overheads xx
-Distribution Overheads xx
Cost of Sales xx
Profit xx
Sales xx
(Old Format) Cost Sheet of ........... for the year ending..............

Particulars Total Cost (`)
Raw Materials Consumed
Opening Stock of Raw Materials Xx
+ Purchase of Raw Materials Xx
- Scrap of Raw Materials (xx)
+ Carriage Inwards (Any expenses on purchase) xx
Less : Closing Stock of Raw Materials (xx)
Less : Purchase Return (xx) xx
Add : Direct Labour / Direct Wages / Manufacturing Wages / xx
Productive Wages / Factory Wages
Add : Direct Expenses xx
Prime Cost sx
Add : Factory / Manufacturing / Works / Production Overheads xx
xx
xx
xx
Less : Sale of Scrap xx xx
xx
Add : Opening Stock of WIP Xx
Less : Closing Stock of WIP xx
Factory / Works / Production / Manufacturing Cost xx
Add : Office & Administrative Overheads (related to production)
xx
xx
xx xx
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Cost of Production xx
+ Opening Stock of Finished Goods xx
- Closing Stock of Finished Goods (xx)
Cost of Goods sold xx

Add : Office & Administrative Overheads (General) xx
Add : Selling & Distribution Overheads xx
xx
xx
xx xx
Cost of Sales / Total Cost xx
Add : Profit xx
Sales xx
Notes:
1. Variable Cost: It is directly related to production. It is also known as product cost. For
e.g. Direct Material, Direct Labour, Direct Expenses.
Variable cost per unit normally remains same. Total variable cost keeps on changing.
If production is increased then total variable cost will increase & if production is
decreased then total variable cost will decreased.
2. Fixed Cost: It is related to period & not related to product. It is also known as period
cost. For e.g. Salary, Rent etc.
Total amount of Fixed Cost remains same. Fixed cost per unit keeps on changing.
If production is increased then Fixed cost per unit will decrease & if production is
decreased then Fixed cost per unit will increased.
3. Semi Variable Cost: It is also known as Semi Fixed Cost. It is neither variable nor Fixed.
It remains same upto certain level of Activity and then it will change.
Sometimes semi variable can be divided into two parts i.e. Variable & Fixed.
For e.g. Telephone Expenses.
4. Stock Valuation: In Cost Accounting stock is to be valued at Cost Price.
Cost Price means what?
(A) Closing stock of Raw Material → It is to be valued at purchase price of Raw
Material, purchase price of Raw Material also includes expenses related to
purchase.
(B) WIP → Valuation of WIP includes Direct Material + Direct Labour + Direct
Expenses + Factory Overheads.
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(C) Finished Goods → It is to be valued at cost of production. (Direct Material + Direct

Labour + Direct Expenses + Factory Overheads + Administrative Overheads.
5. Financial expenses & Financial incomes are to be ignored in cost accounting.
E.g. of Financial Expenses: Bad debts, Cash discount allowed, Loss on sale of Assets,
Interest, Provision for Income - tax etc.
E.g. of Financial incomes: Bad debts recovered, Interest received, Dividend received,
Rent received, Profit on Sale of Assets etc.
6. Disputed Expenses: E.g. Bad debts, Cash discount allowed, Interest, etc. {These
Expenses can be considered as Financial expenses or It can be recorded in Cost
Accounting}.
7. Notional Expenses are to be recorded in Cost Accounting only.
For e.g. Rent of Premises owned by the company i.e. notional rent.

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CLASSWORK SECTION
Question 1
The following extracts of costing information relate to commodity A for the year ended
31.3.2019.
Purchase of Raw Material ` 48,000
Direct Wages ` 40,000
Stock on 1-4-2018
of Raw Material ` 8,000
of Finished Goods 1,600 quintals ` 6,400
Stock on 31-3-2019
of Raw Material ` 6,800
of Finished Goods 3,200 quintals
Work on cost (factory overhead) ` 16,800
Work-in-Progress:
1st April 2018 ` 1,920
31st March 2019 ` 6,400
Office and Administrative Overheads (Related to Production) ` 3,200
Sales (Finished Product) ` 1,20,000
Advertising, discount allowed and selling cost is Re. 0.40 per quintal. During the year
25,600 quintals of commodity were produced. Prepare Cost sheet.
Question 2
X Ltd. Furnishes you the following details to enable you to prepare cost sheet.
Production Overheads ` 80,000
Material Purchased ` 5,00,000
Administrative Overheads (Related to Production) `1,00,000
Inventory Details Opening Closing

(`) (`)
Materials 1,50,000 1,20,000
Work-in-Progress 80,000 95,000
Finished Goods 2,04,000 ?
A firm had the stock of 12,000 units in opening inventory. It sold 64,000 units at ` 28.5
per unit. It has 8,000 units in its closing inventory. Labour cost incurred amounted to
` 3,85,000. The cost of sales amounted to ` 14,01,000.
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Question 3
(a) Electronics Ltd. furnished the following information for 10,000 CTV tubes
manufactured during the year 2019.
Materials ` 90,000 ; Direct wages ` 60,000; Power and Consumable Stores ` 12,000
; Factory indirect wages ` 15,000 ; Lighting of Factory ` 5,500 ; Sundry Factory
Overheads ` 3,000 ; Clerical Salaries and Management Expenses ` 33,500 ; Selling
Expenses ` 5,500 ; Sale proceeds of scrap ` 2,000 and plant repairs and maintenance
and depreciation ` 11,500.
The net selling price was ` 31.60 per unit sold and all units were sold.
You are required to prepare Cost sheet for the year 2019 showing various elements
of cost per unit.
(b) As from 1st January, 2020 the selling price is reduced to ` 31 per unit. It is estimated
that production could be increased in 2020 by 50% due to spare capacity. Rates for
materials and direct wages will increase by 10%.
You are required to prepare Estimated Cost Sheet for 2020 assuming that 15,000
units will be produced & sold during the year and factory overheads will be recovered
at 75% of direct wages and administrative overheads (General) and selling expenses
will be recovered at 20% of works cost.
Question 4
X and Y shoes Polish Company Ltd. manufactures black and brown polish in one standard
size of tin retailing at ` 1.08 & ` 1.20 respectively.
Following data are supplied to you.
`
Direct Materials : Polish 7,38,000
Tins 2,88,000
Direct wages 2,44,800
Production overheads 3,67,200
Administrative and Selling Overheads 1,22,400
Sales for the year were black 14,40,000 tins and brown 6,00,000 tins. The opening and
closing stock were:
Black Brown
Opening Stock 48,000 1,60,000
Closing Stock 1,08,000 60,000
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The opening stock of black and brown polish was valued at its production cost of paise
80.4 per tin and paise 86.4 per tin respectively. The cost of raw materials for Brown
Polish is 10% higher than that for black but there is no difference in the cost of tins. Direct
wages for brown are 8% higher than those for black polish and production overheads are
considered to vary with direct wages. Administrative and Selling overheads is absorbed
at a uniform rate per tin of polish sold.
Prepare a statement to show the cost and profit per tin of each polish.
Question 5
The books of Adarsh Manufacturing Company present the following data for the month
of April, 2020:
Direct labour cost ` 17,500 being 175% of works overheads. Cost of goods sold excluding
administrative expenses ` 56,000.
Inventory accounts showed the following opening and closing balances:
April 1 (`) April 30 (`)
Raw materials 8,000 10,600
Work-in-progress 10,500 14,500
Finished goods 17,600 19,000
Other data are:
(`)
Selling expenses 3,500
General and administration expenses 2,500
Sales for the month 75,000
You are required to:

(i) FIND out the value of materials purchased.
(ii) PREPARE a cost statement showing the various elements of cost and also the profit
earned.
Question 6
X Ltd. has the following expenditures for the year ended 31st March, 20X8:
Amount Amount (`)
(`)
Raw materials purchased 10,00,00,000
Freight inward 11,20,600
Wages paid to factory workers 29,20,000
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Contribution made towards employees’ PF & ESIS 3,60,000

Production bonus paid to factory workers 2,90,000
Royalty paid for production 1,72,600
Amount paid for power & fuel 4,62,000
Amount paid for purchase of moulds and patterns (life is 8,96,000
equivalent to two years production)
Job charges paid to job workers 8,12,000
Stores and spares consumed 1,12,000
Depreciation on:
- Factory building 84,000
- Office building 56,000
- Plant & Machinery 1,26,000
- Delivery vehicles 86,000 3,52,000
Salary paid to supervisors 1,26,000
Repairs & Maintenance paid for:
- Plant & Machinery 48,000
- Sales office building 18,000
- Vehicles used by directors 19,600 85,600
Insurance premium paid for:
- Plant & Machinery 31,200
- Factory building 18,100
- Stock of raw materials & WIP 36,000 85,300
Expenses paid for quality control check activities 19,600
Salary paid to quality control staffs 96,200
Research & development cost paid improvement in 18,200
production process
Expenses paid for pollution control and engineering & 26,600
maintenance
Expenses paid for administration of factory work 1,18,600
Salary paid to functional mangers:
- Production control 9,60,000
- Finance & Accounts 9,18,000
- Sales & Marketing 10,12,000 28,90,000
Salary paid to General Manager 12,56,000
Packing cost paid for:
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- Primary packing necessary to maintain quality 96,000

- For re-distribution of finished goods 1,12,000 2,08,000
Interest and finance charges paid 7,20,000
Fee paid to auditors 1,80,000
Fee paid to legal advisors 1,20,000
Fee paid to independent directors 2,20,000
Performance bonus paid to sales staffs 1,80,000
Value of stock as on 1st April, 20X7
- Raw materials 18,00,000
- Work-in-process 9,20,000
- Finished goods 11,00,000 38,20,000
Value of stock as on 31st March, 20X8
- Finished goods 18,20,000 36,50,000
Sale of scrap and waste generated 86,000
From the above data you are requested to PREPARE Statement of cost for X Ltd. for
the year ended 31st March, 20X8, showing (i) Prime cost, (ii) Factory cost, (iii) Cost of
Production, (iv) Cost of goods sold and (v) Cost of sales.
Question 7
Maximum production capacity of JK Ltd. is 5,20,000 units per annum. Details of estimated
cost of production are as follows:
- Direct material ` 15 per unit.
- Direct wages ` 9 per unit (subject to a minimum of ` 2,50,000 per month).
- Fixed overheads ` 9,60,000 per annum.
- Variable overheads ` 8 per unit.
- Semi-variable overheads are ` 5,60,000 per annum up to 50 per cent capacity and
additional ` 1,50,000 per annum for every 25 per cent increase in capacity or a part
of it.
JK Ltd. worked at 60 per cent capacity for the first three months during the year
2018-19, but it is expected to work at 90 per cent capacity for the remaining nine months.
The selling price per unit was ` 44 during the first three months.
You are required to find out, what selling price per unit should be fixed for the remaining
nine months to yield a total profit of ` 15,62,500 for the whole year.
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HOMEWORK SECTION
Question 1
A re-roller produced 400 metric tons of M.S. bars spending ` 36,00,000 towards
materials and ` 6,20,000 towards rolling charges. Ten percent of the output was found
to be defective, which had to be sold at 10% less than the price for good production. If the
sales realization should give the firm an Overall profit of 12.5% on cost, find the selling
price per metric ton of both the categories of bars. The scrap arising during the rolling
process fetched a realization of ` 60,000.
Question 2
A Ltd. Co. has capacity to produce 1,00,000 units of a product every month.
Its works cost at varying levels of production is as under:
Level Works cost per unit (`)
10% 400
20% 390
30% 380
40% 370
50% 360
60% 350
70% 340
80% 330
90% 320
100% 310
Its fixed administration expenses amount to `1,50,000 and fixed marketing expenses
amount to `2,50,000 per month respectively. The variable distribution cost amounts to
` 30 per unit.
It can sell 100% of its output at `500 per unit provided it incurs the following further
expenditure:
(a) it gives gift items costing ` 30 per unit of sale;
(b) it has lucky draws every month giving the first prize of ` 50,000;
2nd prize of ` 25,000, 3rd prize of ` 10,000 and three consolation prizes of ` 5,000
each to customers buying the product.
(c) it spends `1,00,000 on refreshments served every month to its customers;
(d) it sponsors a television programme every week at a cost of ` 20,00,000 per month.
It can market 30% of its output at `550 per unit without incurring any of the expenses
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referred to in (a) to (d) above.

PREPARE a cost sheet for the month showing total cost and profit at
30% and 100% capacity level.
Question 3
From the following particulars, you are required to PREPARE monthly cost sheet of Aditya
Industries:
Amount (`)
Opening Inventories:
- Finished goods (10,000 units) 9,60,000
Closing Inventories:
- Finished goods ?
Raw materials purchased 1,44,00,000
Wages paid to production workers 36,64,000
Expenses paid for utilities 1,45,600
Office and administration expenses paid 26,52,000
Travelling allowance paid to office staffs 1,21,000
Selling expenses 6,46,000
Factory overheads - ` 1,72,800
Units sold- 1,60,000
Units produced- 1,94,000
Desired profit- 15% on sales
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IMPORTANT THEORY QUESTIONS FOR EXAMINATION
Question 1
Define the terms ‘cost centre’ and ‘cost unit’.
Answer
Cost Centre: The term cost centre is defined as a location, person or an item of equipment
or a group of these for which costs may be ascertained and used for the purposes of cost
control. Cost centres can be personal cost centres, impersonal cost centres, operation
cost centres and process cost centres.
Cost Unit: The term cost unit is defined as a unit of quantity of product, service or time (or
a combination of these) in relation to which costs may be ascertained or expressed. It can
be for a job, batch, or product group.
Question 2
Given below is a list of ten industries. Give the method of costing and the unit of cost against
each industry.
(i) Nursing Home (vi) Bridge Construction
(ii) Road Transport (vii) Interior Decoration
(iii) Steel (viii) Advertising
(iv) Coal (ix) Furniture
(v) Bicycles (x) Sugar company having its own sugarcane fields.
Answer
Industry Method of costing Unit of cost
(i) Nursing Home Operating Per Bed per week or per day
(ii) Road transport Operating Per Tonne Kilometer or per mile
(iii) Steel Process Per Tonne
(iv) Coal Single Per unit
(v) Bicycles Multiple Each unit
(vi) Bridge construction Contract Each contract
(vii) Interior Decoration Job Each Job
(viii) Advertising Job Each Job
(ix) Furniture Multiple Each unit
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Question 3
Distinguish between:
(i) Cost Unit and Cost Centre
(ii) Cost Centre and Profit Centre
Answer
(i) Distinction between Cost Unit and Cost Centre
The term Cost Unit is defined as a unit of quantity of product, service or time (or a
combination of these) in relation to which costs may be ascertained or expressed. It
can be for a job, batch, or product group.
The term Cost Centre is defined as a location, person or an item of equipment or
a group of these for which costs may be ascertained and used for the purposes of
Cost Control. Cost Centres can be personal Cost Centres, impersonal Cost Centres,
operation cost and process Cost Centres.
Thus each sub-unit of an organisation is known as a Cost Centre, if cost can be
ascertained for it. In order to recover the cost incurred by a Cost Centre, it is necessary
to express it as the cost of output. The unit of output in relation to which cost
incurred by a Cost Centre is expressed is called a Cost Unit.
(ii) Cost Centre and Profit Centre
A Cost Centre is the smallest segment of activity or the area of responsibility for
which costs are accumulated. A Profit Centre is that segment of activity of a business
which is responsible for both revenue and expenses and discloses the profit of a
particular segment of activity.
Important points of distinction between Cost Centre and Profit Centre are as below:
(a) Cost Centres are created for accounting convenience of costs and their control.
Whereas a profit centre is created because of decentralisation of operations.
(b) A Cost Centre does not have target costs but efforts are made to minimise
costs, but each profit centre has a profit target and enjoys authority to adopt
such policies as are necessary to achieve its targets.
Question 4
List down any eight factors that you will consider before installing a costing system.
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Answer
The eight factors which must be considered before installing a Costing System are listed
below:
(i) Nature of business: The system of costing to be introduced should suit the general
nature of business.
(ii) Layout aspects: The size and layout of the organisation should be studied by the
system designers.
(iii) Methods and procedures in vogue: The system designers should also study various
methods and procedures for the purchase, receipts, storage and issue of material.
They should also study the methods of wage payment.
(iv) Management’s expectations and policies: The system of costing should be designed
after a careful analysis of the organisational operations, management’s expectation
and the policies of the concern.
(v) Technical aspects: The technical aspects of the business should be studied thoroughly
by the designers. They should also make an attempt to seek the assistance and
support of the supervisory staff and workers of the concern for the system.
(vi) Simplicity of the system: The system of costing to be installed should be easy to
understand and simple to operate. The procedures laid down for operating the
system should be easily understood by operating system.
(vii) Forms standardisation: Various forms to be used by the costing system for various
data / information collection and dissemination should be standardised as far as
possible.
(viii) Accuracy of data: The degree of accuracy of data to be supplied by the system should
be determined.
Question 5
Outline the steps involved in installing a costing system in a manufacturing unit. What
are the essentials of an effective costing system?
Answer
The main steps involved in installing a costing system in a manufacturing unit may be
outlined as below:
(i) The objectives of installing a costing system in a manufacturing concern and the
expectations of the management from such a system should be identified first. The
system will be a simple one in the case of a single objective but will be an elaborate
one in the case of multiple objectives.
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(ii) It is important to ascertain the significant variables of the manufacturing unit

which are amenable to control and affect the concern. For example, quite often
the production costs control may be more important than control of its marketing
cost. Under such a situation, the costing system should devote greater attention to
control production costs.
(iii) A thorough study to know about the nature of business, its technical aspects ;
products, methods and stages of production should also be made. Such a study will
facilitate in selecting a proper method of costing for manufacturing unit.
(iv) A study of the organisation structure, its size and layout etc., is also necessary.
This is useful to management to determine the scope of responsibilities of various
managers.
(v) The costing system should be evolved in consultation with the staff and should be
introduced only after meeting their objections and doubts, if any. The co-operation
of staff is essential for the successful operation of the system.
(vi) Details of records to be maintained by the costing system should be carefully worked
out. The degree of accuracy of the data to be supplied by the system should be
determined.
(vii) The forms to be used by foreman, workers, etc., should be standardised. These forms
be suitably designed and must ensure minimum clerical work at all stages.
(viii) Necessary arrangements should be made for the flow of information/data to all
concerned managers, at different levels, regularly and promptly.
(ix) Reconciliation of costs and financial accounts be carried out regularly, if they are
maintained separately.
(x) The costing system to be installed should be easy to understand and simple to
operate.
Essential of an effective costing system: The essential features that an effective costing
system should possess are as follows :
(a) Costing system should be tailor made, practical, simple and capable of meeting the
requirements of a business concern.
(b) The method of costing should be suitable to the industry.
(c) Necessary co-operation and participation of executives from various departments
of the concern is essential for developing good cost accounting system.
(d) The cost of installing and operating the system should justify the results.
(e) The system of costing should not sacrifice the utility by introducing meticulous and
unnecessary details.
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Question 6
Distinguish between the following?
Controllable costs and uncontrollable costs.
Answer
Controllable costs and uncontrollable costs:
Costs which can be influenced by the action of a specified person in an organisation are
known as controllable costs. Costs which remains unaffected by the action of such person
are termed as uncontrollable. In a business organisation heads of each responsibility
centre are responsible to control costs. Costs which they are able to control are known as
controllable and includes material, labour and direct expenses. Costs which they fail to
control includes fixed costs and all allocated costs.
It may be noted that controllable and uncontrollable cost concepts are related to the
authority of a person in the organisation. An expenditure which may be uncontrollable
by one person may be controllable by another. Moreover, in the long run all costs might
be controllable.
Question 7
(a) Describe briefly the role of the cost accountant in a manufacturing organisation.
(b) Distinguish between:
(i) Variable cost and direct cost
(ii) Estimated cost and standard cost.
Answer
(a) Cost accountant in a manufacturing organisation plays several important roles.
He establishes a Cost Accounting department in his concern. He ascertains the
equirement of cost information which may be useful to organisational mangers at
different levels of the hierarchy. He develops a manual, which specifies the functions
to be performed by the Cost Accounting department. The manual also contains the
format of various forms which would be utilised by the concern for procuring and
providing information to the concerned officers. It also specifies the frequency at
which the cost information would be supplied to a concerned executive.
Usually, the functions performed by a Cost Accounting department includes cost
ascertainment, cost comparison, cost reduction, cost control and cost reporting.
Cost ascertainment, requires the classification of costs into direct and indirect.
Further it requires classification of indirect costs (known as overheads) into three
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classes viz, factory overheads; administration overheads and selling and distribution
overhead. Cost accountant suggests the basis which may be used by his subordinates
for carrying out the necessary classifications as suggested above.
Cost comparison is the task carried out by Cost Accountant for controlling the
cost of the products manufactured by the concern. Cost Accountant of the concern
establishes standards for all the elements of cost and thus a standard cost of the
finished product. The standard cost so determined may be compared with the actual
cost to determine the variances. Cost Accountant ascertains the reasons for the
occurrence of these variances for taking suitable action.
Cost analysis may also be made by Cost Accountant for taking decisions like make
or by and for reviewing the current performance.
Cost Accountant also suggests suitable techniques for the purpose of cost reduction
/ cost control, after carrying out a cost benefit analysis.
Cost Accountant also plays a key role in the preparation of Cost reports. These
reports help the executives of a business concern in reviewing their own performance
and in identifying the weak areas, where enough control measure may be taken in
future.
In brief, one may say that there is hardly any activity in a manufacturing organisation
with which a Cost Accountant is not directly associated in some form or the other.
(b) (i) Variable and direct cost: A variable cost is a cost that changes in total in direct
proportion to changes in the related total activity or volume. Cost of material
is an example of variable cost.
Direct cost is a cost which can be identified either with a cost centre or with a
cost unit. An example of direct cost is the allocation of direct materials to a
department and then to the various jobs. All variable costs are direct-but each
direct cost may not be variable.
(ii) Estimated cost and standard cost: Kohler defines estimated costs as ‘the expected
cost of manufacture or acquisition, often in terms of a unit of product computed
on the basis of information available in advance of actual production or
purchase’ Estimated cost are prospective costs since they refer to prediction of
costs.
Standard Cost means a pre-determined cost. It attempts to show what the
cost should be for clearly defined conditions and circumstances. Standard costs
represent’ planned cost of a product. They are expected to be achieved under a
particular production process under normal conditions.
Although pre-determination is the essence of both standard costs and estimated
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costs, but they differ from each other in the following respects:
(i) Difference in computation (iv) Difference in records
(ii) Difference in emphasis (v) Applicability
(iii) Difference in use
Question 8
Enumerate the main objectives of introduction of a Cost Accounting System in a
manufacturing organisation. (Nov., 2002, 3 Marks)
Answer
The main objectives of introduction of a Cost Accounting System in a manufacturing
organization are as follows:
(i) Ascertainment of cost
(ii) Determination of selling price
(iii) Cost control and cost reduction
(iv) Ascertainment of profit of each activity
(v) Assisting in managerial decision making
Question 9
Write short notes on the following?
(i) Conversion cost
(ii) Sunk cost
(iii) Opportunity cost
Answer
(i) Conversion cost: It is the cost incurred to convert raw materials into finished goods. It
is the sum of direct wages, direct expenses and manufacturing overheads.
(ii) Sunk cost: Historical costs or the costs incurred in the past are known as sunk cost.
They play no role in the current decision making process and are termed as irrelevant
costs. For example, in the case of a decision relating to the replacement of a machine,
the written down value of the existing machine is a sunk cost, and therefore, not
considered.
(iii) Opportunity cost: It refers to the value of sacrifice made or benefit of opportunity
foregone in accepting an alternative course of action. For example, a firm financing
its expansion plan by withdrawing money from its bank deposits. In such a case
the loss of interest on the bank deposit is the opportunity cost for carrying out the
expansion plan.
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Question 10
How does a production account differ from a cost sheet? (May, 2000, 3 Marks)
Answer
The following are the points of difference between a production account and a cost sheet.
(i) Production Account is based on double entry system whereas cost sheet is not based
on double entry system.
(ii) Production Account consists of two parts. The first part shows cost of the component
and total production cost. The second part shows the cost of sales and profit for the
period. Cost Sheet presents the elements of costs in a classified manner and the cost
ascertained at different states such as prime cost; works cost; cost of production;
cost of goods sold; cost of sales and total cost.
(iii) Production Account shows the cost in aggregate and thus facilitates comparison
with other financial accounts. Cost sheet shows the cost in a detailed and analytical
manner which facilitates comparison of cost for the purpose of cost control.
(iv) Production Account is not useful for preparing tenders or quotations. Estimated cost
sheets can be prepared on the basis of actual cost sheets and these are useful for
preparing tenders or quotations.
Question 11
Discuss cost classification based on variability and controllability.
(Nov. 2004, 4 Marks)
Answer
Cost classification based on variability
Fixed cost – These are costs, which do not change in total despite changes of a cost driver.
A fixed cost is fixed only in relation to a given relevant range of the cost driver and a given
time span. Rent, insurance, depreciation of factory building and equipment are examples
of fixed costs where the final product produced is the cost object.
Variable costs – These are costs which change in total in proportion to changes of cost
driver. Direct material, direct labour are examples of variable costs, in cases where the
final product produced is the cost object.
Semi-variable costs – These are partly fixed and partly variable in relation to output e.g.
telephone and electricity bill.
Cost classification based on controllability
Controllable costs – Are incurred in a particular responsibility center and relate to a
defined time span. They can be influenced by the action of the executive heading the
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responsibility center e.g. direct costs.

Uncontrollable costs – Are costs are influenced by the action of the responsibility center
manager e.g. expenditure incurred by the tool room are controllable by the foreman in
charge of that section, but the share of tool room expenditure which are apportioned to
the machine shop are not controllable by machine shop foreman.
Question 12
Discuss the essential of a good cost accounting system? (May 2004, 2 Marks)
Answer
Essentials of a good cost accounting system:
• It should be tailor-made, practical, simple and capable of meeting the requirements
of a business concern.
• The data used by the system should be accurate, otherwise it may distort the output
of system.
• Cost of installing & operating the system should justify the results.
• Cost accounting system should have the support of top management of the concern.
• The system should have the necessary support from all the user’s departments.
Question 13
Explain:
(i) Sunk Costs
(ii) Pre-production Costs
(iii) Research and Development Costs
(iv) Training Costs (Nov., 2000, 2 x 4 = 8 Marks)
Answer
(i) Sunk Costs: These are historical costs which are incurred in the past. These costs were
incurred for a decision made in the past and cannot be changed by any decision that
will be made in future. In other words, these costs plays no role in decision making,
in the current period. While considering the replacement of a plant, the depreciated
book value of the old plant is irrelevant, as the amount is a sunk cost which is to be
written off at the time of replacement.
(ii) Pre-production Costs: These costs forms the part of development cost, incurred in
making a trial production run, preliminary to formal production. These costs are
incurred when a new factory is in the process of establishment or a new project is
20
undertaken or a new product line or product is taken up, but there is no established
or formal production to which such costs may be charged. These costs are normally
treated as deferred revenue expenditure (except the portion which has been
capitalised) and charged to the costs of future production.
(iii) Research and Development Costs: Research costs are the costs incurred for the discovery
of new ideas or processes by experiment or otherwise and for using the results
of such experimentation on a commercial basis. Research costs are defined as the
costs of searching for new or improved products, new applications of materials, or
improved methods, processes, systems or services.
Development costs, are the costs of the process which begins with the
implementation of the decision to produce a new or improved product or to employ
a new or improved method and ends with the commencement of formal production
of that product by that method.
(iv) Training Costs: These costs comprises of – wages and salaries of the trainees or
learners, pay and allowances of the training and teaching staff, payment of fees etc.,
for training or for attending courses of studies sponsored by outside agencies and
cost of materials, tools and equipments used for training. Costs incurred for running
the training department, the losses arising due to the initial lower production, extra
spoilage etc. occurring while providing training facilities to the new recruits.
All these costs are booked under separate standing order numbers for the various
functions. Usually there is a service cost centre, known as the Training Section,
to which all the training costs are allocated. The total cost of training section is
thereafter apportioned to production centers.
Question 14
Enumerate the factors which are to be considered before installing a system of cost
accounting in a manufacturing organization.
Answer
Factors which are to be considered before installing a system of cost accounting in a
manufacturing organization are:
(i) The objectives of installing a system of cost accounting should be defined, that is
whether the system is meant for control of cost or for price fixation.
(ii) The organization of the company should be studied to understand the authority and
responsibilities of the managers.
(iii) The technical aspects and flow process should be taken into consideration.
21
(iv) The products to be manufactured should be studied.

(v) The marketing set up to be looked into for devising suitable control reports.
(vi) The possibility of integrating cost accounting system with financial accounting
system should be examined.
(vii) The procedure for collection and verification of reliability of the information should
be studied.
(viii) The degree of details of information required at each level of management should
be examined.
(ix) The maximum amount of information that would be sufficient and how the same
should be secured without too much clerical labour, especially the possibility of
collection of data on a separate printed form designed for each process; also the
possibility of instruction as regards filling up of the forms in writing to ensure that
these would be faithfully carried out.
(x) How the accuracy of the data collected can be verified? Who should be made
responsible for making such verification with regard to each operation and the form
of certification that should be given indicate verification that he has carried out.
(xi) The manner in which the benefits of introducing Cost Accounting could be explained
to various persons in the concern, especially those incharge of production department
and an awareness created for the necessity of promptitude, frequency and regularity
in collection of costing data.
Question 15
You have been asked to install a costing system in a manufacturing company. What
practical difficulties will you expect and how will you propose to overcome the same?
(May 2004, 4 Marks)
Answer
The practical difficulties with which a Cost Accountant is usually confronted with while
installing a costing system in a manufacturing company are as follows:
(i) Lack of top management support: Installation of a costing system do not receive the
support of top management. They consider it as an interference in their work. They
believe that such, a system will involve additional paperwork. They also have a
mis-concept in their minds that the system is meant for keeping a check on their
activities.
(ii) Resistance from cost accounting departmental staff: The staff resists because of fear of
loosing their jobs and importance after the implementation of the new system.
22
(iii) Non - cooperation from user departments: The foremen, supervisor and other staff
members may not cooperate in providing requisite data, as this would not only add
to their responsibilities but will also increase paper work of the entire team as well.
(iv) Shortage of trained staff: Since cost accounting system’s installation involves
specialised work, there may be a shortage of trained staff.
To overcome these practical difficulties, necessary steps required are :
* To sell the idea to top management – To convince them of the utility of the
system.
* Resistance and non-cooperation can be overcome by behavioural approach. To
deal with the staff concerned effectively.
* Proper training should be given to the staff at each level.
* Regular meetings should be held with the cost accounting staff, user
departments, staff and top management to clarify their doubts / misgivings.
Question 16
Define Explicit costs. How is it different from implicit costs? (May, 2001, 2 Marks)
Answer
Explicit costs: These costs are also known as out of pocket costs. They refer to those
costs which involves immediate payment of cash. Salaries, wages, postage and telegram,
interest on loan etc. are some examples of explicit costs because they involve immediate
cash payment. These payments are recorded in the books of account and can be easily
measured.
Main points of difference: The following are the main points of difference between explicit
and implicit costs.
(i) Implicit costs do not involve any immediate cash payment. As such they are also
known as imputed costs or economic costs.
(ii) Implicit costs are not recorded in the books of account but yet, they are important for
certain types of managerial decisions such as equipment replacement and relative
profitability of two alternative courses of action.
Question 17
What are the main objectives of Cost Accounting? (May 2001, 2 Marks)
23
Answer
The main objectives of Cost Accounting are as follows:
(i) Ascertainment of cost.
(ii) Determination of selling price.
(iii) Cost control and cost reduction.
(iv) Ascertainment of profit of each activity.
(v) Assisting management in decision making.
Question 18
Explain controllable and non-controllable costs with illustrations. (May 2001, 2 Marks)
Answer
Controllable and non-Controllable costs
Controllable costs: These are the costs which can be influenced by the action of a specified
person in an organisation. In every organisation, there are a number of departments
which are called responsibility centres, each under the charge of a specified level of
management. Costs incurred in these responsibility centres are influenced by he action of
the incharge of the responsibility centre. Thus any cost that an organisational unit has
the authority to incur may be identified as controllable cost.
Non-controllable costs: These are the costs which cannot be influenced by the action of
a specified member of an undertaking. For example, expenditure incurred by the ‘Tool
Room’ is controllable by the Tool Room Manager but the share of Tool Room expenditure,
which is apportioned to the Machine Shop cannot be controlled by the manager of the
Machine Shop.
However, the distinction between controllable and non-controllable costs is not very
sharp and is sometimes left to individual judgment to specify a cost as controllable or
non-controllable in relation to a particular individual manager.
Question 19
Discuss the four different methods of costing alongwith their applicability to concerned
industry? (Nov. 1999, 4 Marks)
Answer
Four different methods of costing along with their applicability to concerned industry
have been discussed as below:
1. Job Costing: The objective under this method of costing is to ascertain the cost of
24
each job order. A job card is prepared for each job to accumulate costs. The cost of
the job is determined by adding all costs against the job it is incurred. This method
of costing is used in printing press, foundries and general engineering workshops,
advertising etc.
2. Batch Costing: This system of costing is used where small components / parts of the
same kind are required to be manufactured in large quantities. Here batch of similar
products is treated as a job and cost of such a job is ascertained as discussed under
1, above. If in a cycle manufacturing unit, rims are produced in batches of 2,500
units each, then the cost will be determined in relation to a batch of 2,500 units.
3. Contract Costing: If a job is very big and takes a long time for its completion, then
method used for costing is known as Contract Costing. Here the cost of each contract
is ascertained separately. It is suitable for firms engaged in the construction of
bridges, roads, buildings etc.
4. Operating Costing: The method of Costing used in service rendering undertakings is
known as operating costing. This method of costing is used in undertakings like
transport, supply of water, telephone services, hospitals, nursing homes etc.
Question 20
How would you deal the following items in the cost accounts of a manufacturing concern?
(a) Research and Development cost
(b) Packing Expenses
(c) Fringe Benefits
(d) Expenses on Removal and Re-erection of Machinery.
Answer
(a) Research and Development Cost: Research and Development Cost is the cost / expense
incurred for searching new or improved products, production method / techniques
or plants/ equipments. Research Cost may be incurred for carrying basic or applied
research. Both basic and applied research relates to original investigation to gain
from new scientific or technical knowledge and understanding, which is not directed
towards any specific practical aim (under basic research) and is directed towards a
specific practical aim or objective (under applied research).
Treatment in Cost Accounts
Cost of Basic Research (if it is a continuous activity) be charged to the revenues of
the concern. It may be spread over a number of years if research is not a continuous
activity and amount is large.
25
Cost of applied research, if it relates to all existing products and methods of

production then it should be treated as a manufacturing overhead of the period
during which it has been incurred and absorbed. Such costs are directly charged to
the product, if it is solely incurred for it.
If applied research is conducted for searching new products or methods of production
etc., then the research costs treatment depends upon the outcome of such research.
For example. If research findings are expected to produce future benefits or if it
appears that such findings are going to result in failure then the costs incurred may
be a mortised by charging to the Costing Profit and Loss Accounts of one or more
years depending upon the size of expenditure. If research proves successful, then
such costs should be charged to the concerned product.
Development Costs, begins with the implementation of the decision to produce a
new or improved product or to employ a new or improved method. The treatment of
development expenses is same as that of applied research.
(b) Packing Expenses: It includes the expenses incurred on wrapping, tying,
bottles, boxes, containers or bags etc. In Cost Accounts they are treated as
follows:
(i) It is treated as a direct material cost in the case of those products which cannot
be sold without the use of a packing. For example ink-pot; Bread; paste etc.
(ii) It may be treated as distribution overhead if packing expenses are incurred to
facilitate the transportation of finished products.
(iii) It may be treated as advertisement cost and included in selling overheads if it
is incurred for advertisement to make the product attractive.
(c) Fringe Benefits: Additional Benefits paid to the employees of a concern and are
not related to the direct efforts of the employees, are called fringe benefits. They
include holiday pay; leave pay; employer’s contribution to provident fund; gratuity
and pension schemes; state insurance; medical benefits; subsidised facility etc.
Expenditure incurred on fringe benefits in the case of factory workers should be
treated as factory overheads and are apportioned among all the production and
service departments on the basis of the number of workers in each department.
Fringe benefits to office and selling and distribution staff should be treated as
administration and selling and distribution overheads respectively and are recovered
accordingly.
(d) Expenses on Removal and Re- erection of Machinery: Expenses are sometime
incurred on removal and re-erection of machinery in factories. Such expenses may
be incurred due to factors like change in the method of production; an addition or
26
alteration in the factory building, change in the follow of production, etc. All such
expenses are treated as production overheads. When amount of such expenses is
large, it may be spread over a period of time.
If such expenses are incurred due to faulty planning or some other abnormal factor,
then they may be charged to Costing Profit and Loss Account.
Question 21
Define administration overheads and state briefly the treatment of such overheads in
Cost Accounts. (Nov. 1996, 4 Marks)
Answer
Definition of Administration Overhead: These are costs of formulating the policy, directing
the organisation and controlling the operation of an undertaking. These are not related
directly to production activity or function. In other words, all expenses, incurred on policy
formulation, direction, control, office administration and business management are
included in administration overheads.
Treatment of Administrative Overheads in Cost Accounting:
(i) Charge to Costing Profit and Loss Account: According to this method administrative
overheads should be treated as fixed cost as they are concerned with the formulation
of policy. Hence these overheads should be transferred to the Costing Profit and Loss
Account.
(ii) Apportionment between Production and Selling and Distribution: According to this method,
it is assumed that administrative overheads are incurred both for production and
for selling and distribution. Therefore these overheads should be divided on some
equitable basis between production and selling and distribution activity.
(iii) Treat as a separate element of total cost: Here administration overheads are considered
as a cost of a distinct and identifiable operation of the organisation necessary to
carry on its activity. Therefore these overheads are recovered separately on some
equitable basis which may be on cost or sales basis.
Question 22
Enumerate the arguments for the inclusion of interest on capital in cost accounts.
Answer
Arguments for the inclusion of interest on capital in cost accounts :
1. Interest is the cost of capital as wages are the reward for labour. Both are factors of
27
production and, therefore should not be treated differently in cost accounts. While
determining the total cost, interest like wages should also be included in the cost of
production.
2. The exclusion of interest from cost accounts, particularly in businesses where raw
material is used in different states of readiness would distort costs and render their
comparison a difficult one.
3. Profit on different jobs/ operations requiring different periods for completion may
not be comparable if interest on capital is not included in their total cost,
4. Sometime exclusion of interest cost may lead the management to take wrong
decisions.
5. The significance of time value of money is recognized only when interest is treated
as an element of cost.
Question 23
What is notional rent of a factory building? Give one reason why it may be included in
cost accounts. (November 1995, 2 Marks)
Answer
Notional Rent: It is a reasonable charge raised in the cost accounts for the use of owned
premises. One reason for the use of such a nominal charge is to enable comparison
between the cost of items made in factories which are owned and in rented factories.
However, it may be noted that in the case of owned factory, cost for the same is accounted
for by means of depreciation.
Question 24
How do you deal with the following in cost accounts?
Bad debts. (November 1999, 4 Marks)
Answer
Treatment of Cost Accounts
Bad debts: There is no unanimity among various authors about the treatment of bad
debts. Some authors believe that bad debts are financial losses and therefore should
not be included in the cost of a particular product or job. Another view is that, bad debts
are a part of selling and distribution overhead, especially where they arise in the normal
course of trading. Therefore they should be treated in cost accounts in the same way as
any other selling and distribution expense.
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Question 25
How would you treat the following in Cost Accounts?
(i) Employee welfare costs (2 Marks)
(ii) Research and development costs (2 Marks)
(iii) Depreciation (May, 1996) (2 Marks)
Answer
(i) Employee Welfare Costs: It includes those expenses, which are incurred by the
employers on the welfare activities of their employees. The welfare activities on
which these expenses are usually incurred may include canteen, hospital, play
grounds, etc. These expenses should be separately recorded as Welfare Department
Costs. These Costs may be apportioned to production cost centres on the basis of
total wages or the number of men employed by them.
(ii) Research and development costs: It is the cost/expense incurred for searching new
or improved products, production methods/techniques or plants/equipments. Re–
search cost may be incurred-for carrying basic or applied research. Both basic and
applied research relates to original investigations to gain from new scientific or
technical knowledge and understanding, which is not directed towards any specific
practical aim (under basic research) and is directed towards a specific practical aim
or objective (under applied research).
Treatment in Cost Accounts: Cost of Basic Research (if it is a continuous activity) be
charged to the revenues of the concern. It may be spread over a number of years if
research is not a continuous activity and amount is large.
Cost of applied research, if relates-to all existing products and methods of production
then it should be treated as a manufacturing overhead of the period during which it
has been incurred and absorbed. Such costs are directly charged to the product, it is
solely incurred for it.
If applied research is conducted for searching new products or methods of production
etc. then the research costs treatment depends upon the outcome of such research.
For example, if research findings are expected to produce future benefits or if it
appears that such findings are going to result in failure then the costs incurred may
be amortised by charging to the Costing Profit and Loss Account of one or more
years depending upon the size of expenditure. If research proves successful, then
such costs will be charged to the concerned product.
Development Costs begins with the implementation of the decision to produce a
new or improved product or to employ a new or improved method. The treatment of
29
development expenses is same as that of applied research.

(iii) Depreciation: It represents the fall in the asset value due to its use, wear and tear
and passage of time. Depreciation is an indirect cost of production and operations.
It is an important element of cost and without this true cost of production cannot
be obtained. In costing; depreciation on plant and machinery is normally treated as
part of the factory overheads.
Question 26
Discuss the treatment in cost accounts of the cost of small tools of short effective life.
(May 2002, 4 Marks)
Answer
Small tools are mechanical appliances used for various operations on a work place,
specially in engineering industries. Such tools include drill bits, chisels, screw cutter, files
etc.
Treatment of cost of small tools of short effective life:
(i) Small tools purchased may be capitalized and depreciated over life if their life is
ascertainable. Revaluation method of depreciation may be used in respect of very
small tools of short effective life. Depreciation of small tools may be charged to :
– Factory overheads
– Overheads of the department using the small tool.
(ii) Cost of small tools should be charged fully to the departments to which they have
been issued, if their life is not ascertainable.
Question 27
Define Product costs. Describe three different purposes for computing product costs.
Answer
Definition of product costs:
Product costs are inventoriable costs. These are the costs, which are assigned to the
product. Under marginal costing variable manufacturing costs and under absorption
costing, total manufacturing costs constitute product costs.
Purposes for computing product costs:
The three different purposes for computing product costs are as follows:
(i) Preparation of financial statements: Here focus is on inventoriable costs.
(ii) Product pricing: It is an important purpose for which product costs are used. For this
purpose, the cost of the areas along with the value chain should be included to
30
make the product available to the customer.

(iii) Contracting with government agencies: For this purpose government agencies may
not allow the contractors to recover research and development and marketing costs
under cost plus contracts.
rease tariff, increase in the prices of consumables etc.
31
CONTRACT COSTING
THEORY SECTION
Contract costing is mainly followed by those companies which are in the business of
construction. There are two parties:
1.
Contractor (Seller) 2. Contractee (Buyer)
Contractor is the person who undertakes construction activity.
Contractee is the person on whose behalf the construction activity is undertaken.
Contract price means selling price of contract.
Format of contract account
In the books of contractor
Contract account for the year ending
To Material xx By Material xx
To Direct labour xx [return / transfer to other
To Direct expenditure xx contract / sold (cost) /
Lost by fire,
To Depreciation on Plant & Machinery xx transferred to P & L A/c]
To Other Expenses xx By Work in progress
To P & L A/c (Notional profit) xx Work certified xx
Work uncertified xx
Material at site xx
By P & L A/c (Loss) xx xx
xx xx
NOTES:
1. Closing work in progress of 1st year will become opening work in progress in 2nd
year.
2. Material sold can be recorded either at cost price or at selling price. If it is recorded
at selling price then profit / loss on sale is to be transferred to P & L A/c.
32
3. Work Certified:
It represent that portion of contract work which is completed & for which certificate
of completion is received either from the Architect or from Surveyor. Work certified is
always valued at contract price.
4. Work Uncertified:
It represent that portion of contract work which is completed & for which certificate
of completion is not received. Work uncertified is always valued at cost price.
5. Progress Payment Received:
It represents advance received from the contractee against work certified.
Cash / Bank A/c Dr.
To Contractee's A/c
6. Retention Money:
It represent amount retained by the contractee till the completion of contract. From
retention money we can find out progress payment received.
E.g. : Retention money is 20% that means payment received will be 80% of work
certified.
* Calculation of Total Estimated Profit on Completion of Contract
Contract Price xx
Less: Total Estimated Cost
Cost already incurred xx
(+) Further estimated cost to be incurred xx xx
Estimated Profit xx
* If there is loss in contract in any year then entire loss is to be transferred to

P & L A/c.
* In the year of completion following entry is to be recorded.

Entry for Sale :
Contractee's A/c Dr.
To Contract A/c
33
classwork SECTION
Question 1
Pioneer Construction Company Ltd. obtained a contract for the erection of a multi-storey
building. Building operation started in July, 2018. The contract price was ` 9,00,000. On
30th June, 2019, the end of the year, the cash received on account was ` 3,60,000 being
80% of the amount on the surveyor’s certificate.
The following additional information is given:
`
Materials issued to contract 1,80,000
Materials on hand at site as on 30th June, 2019 7,500
Wages 2,46,600
Plant purchased specially for contract and to be depreciated at 10% per 30,000
annum
Direct Expenses 12,900
General overheads allocated to contract 7,600
Work finished but not yet certified (at cost) 15,000
You are required to prepare the contract account for the year ending 30th June, 2019.
Question 2
A Contractor prepares his accounts for the year ending 31st March each year. He
commenced a contract on 1st July, 2018.
The following information relates to the contract as on 31st March, 2019:
`
Materials issued 2,51,000
Labour charges 5,65,600
Salary to Foreman 81,300
A machine costing ` 2,60,000 has been on the site for 146 days, its working life is estimated
at 7 years and its final scrap value at ` 15,000.
A supervisor, who is paid ` 8,000 p.m. has devoted one-half of his time to this contract.
Materials in hand at site cost ` 35,400 on 31st March, 2019.
The Contract Price is ` 20 lakhs. On 31st March,2019 two thirds of the contract was
completed. The Architect issued certificates covering 50% of the contract price, and the
contractor had been paid ` 7,50,000 on account.
Prepare Contract A/c and show how much profit or loss should be included in financial
34
accounts to 31st March, 2019.
Question 3
Crystal Construction Ltd., engaged in contract works, has the following Trial Balance on
31st December 2019:
Debit (`) Credit (`)
Share capital (Shares of ` 10 each) 35,180
Profit & Loss A/c on 1st January 2019 2,500
Provision of depreciation on Plant & Tools 6,300
Contractee’s A/c (Contract 707) 1,28,000
Creditors 8,120
Land & Building (at cost) 7,400
Plant & tools at stores (at cost) 5,200
Bank Balance 4,500
Contract No.707
Materials issued 60,000
Direct labour 83,000
Expenses 4,000
Plant and tools at site (at cost) 16,000
1,80,100 1,80,100
Contract No.707 having a contract price of ` 2,40,000/- was begun on 1st January,2019,
and the contractee pays 80% of the work completed and certified. The cost of work
done since certification is estimated to be ` 1,600/-. After the above Trial Balance was
extracted on 31st December, 2019 plant costing ` 3,200/- was returned to the stores
and materials at site on that date were valued at ` 3,000/-. Provision is to be made for
depreciation on all plant and tools at 12.5% on cost.
Prepare contract no. 707 account showing the computation of profit, if any, for which the
credit may properly be taken in 2019 and prepare the Balance sheet for the construction
company as on 31st December 2019.
Question 4
Deluxe Ltd. undertook a contract for ` 5,00,000 on 1st July 2018. On 30th June 2019,
when the account were closed, the following details about the contract were gathered:
`
Materials purchased 1,00,000
Wages paid 45,000
35
General Expenses 10,000

Plant purchased 50,000
Materials on hand as on 30-6-2019 25,000
Wages Accrued as on 30-6-2019 5,000
Work certified 2,00,000
Cash received 1,50,000
Work uncertified 15,000
Depreciation of plant 5,000
The above contract contained an escalation clause which read as follows :

“In the event of prices of materials and rates of wages increasing by more than 5%, the
contract price would be increased accordingly by 25% of the rise in the cost of materials
and wages beyond 5% in each case”.
It was found that since the date of signing the agreement the prices of materials and
wage rates increased by 25% and 20% respectively. The value of work certified does not
take into account the effect of the above clause.
Prepare the contract account. Workings should form part of the answer.
Question 5
A contractor has entered into a long term contract at an agreed price of ` 1,75,000
subject to an escalation clause for materials and wages as spelt out in the contract and
corresponding actuals are as follows :
Materials Standard Actual
Qty (tonnes) Rate (`) Qty (tonnes) Rate (`)
A 5,000 5 5,050 4.80
B 3,500 8 3,450 7.90
C 2,500 6 2,600 6.60
Labour Hours Hourly Rate Hours Hourly Rate
(`) (`)
X 2,000 7.00 2,100 7.20
Y 2,500 7.50 2,450 7.50
Z 3,000 6.50 3,100 6.60
Reckoning the full actual consumption of material and wages the company has claimed
a final price of ` 1,77,360. Give your analysis of admissible escalation claim and indicate
the final price payable.
36
Question 6
A firm of contractors undertook a contract for ` 6,00,000 on 1st July, 2018. The following
expenses were incurred upto December 31, 2018:
Materials charged directly 7,500
Materials issued from stores 52,500
Wages 30,000
Direct charges 3,000
The amount of work certified was ` 1,20,000/- out of which the contractors received 75%
in cash.
The transactions for the year 2019 were as under:
Materials issued from stores 1,35,000
Direct charges 6,000
Wages 60,000
The cost of special plant issued on Jan. 1, 2019 for the contract was ` 1,20,000/-. Further
work certified during the year amounted to ` 3,30,000/-; 75% of which was received.
Work done and not certified as on 31-12-2019 was valued at ` 22,500/- Special plant
is to be depreciated at 25% p.a on the original cost. Materials on site were valued at `
15,000/-.
The contract was completed on 30-04-2020 upto which date the following further
expenses were incurred:
Materials charged directly 10,500
Materials issued from stores 60,000
Wages 22,500
Direct Expenses 2,025
The general overheads for each year is to be taken at 5% of the materials consumed and
wages paid during the year. On 30-04-2020 the plant was valued at ` 75,000/-. The
materials at site were sold for ` 10,500/- and those returned to stores amounted to `
19,500/-.
You are required to prepare Contract Account & Contractee's Account for the years 2018,
2019 & 2020.
Question 7
MNP Construction Ltd. commenced a contract on April 1, 2018. The total contract was for
` 17,50,000. It was decided to calculate Actual profit as well as estimated profit.
37
Actual expenditure in 2018-2019 and estimated expenditure in 2019-2020 are given

below.
2018-2019 2019-2020
(Actuals) (Estimated)
` `
Materials issued 3,00,000 5,50,000
Labour : Paid 2,00,000 2.50.000
Outstanding at end 20,000 30,000
Plant purchased 1,50,000 ----
Expenses : Paid 75,000 1,50,000
Prepaid at end 15,000 ----
Plant returned to store (historical cost) 50,000 1,00,000
(On 31.3.2019) (On 31.12.2019)
Material at site 20,000 50,000
Work certified 8,00,000 Full
Work uncertified 25,000 ----
Cash received 6,00,000 Full
The plant is subject to annual depreciation @ 25% of WDV. The contract is likely to be
completed on 31st December, 2019. Prepare the Contract A/c Determine the profit on the
contract for the year 2018-2019.Also compute Estimated Profit of the Contract.

38
Homework Section
Question 1
A construction company undertaking a number of contracts furnished the following data
relating to its incomplete contracts as on 31st March, 2019:
Contract No. (` in lakhs)
723 726 729 731
Expenses for the year ended 31.3.2019
Direct Materials 5.22 1.80 1.98 0.80
Direct Wages 2.32 4.32 3.90 2.16
Overheads (Excluding Depreciation) 1.06 2.60 2.62 1.05
Plant issued at cost 5.00 3.50 2.75 3.00
Materials at site on 1-4-2018 0.75 — — —
Materials at site as on 31-3-2019 0.45 0.20 0.08 0.05
Work certified till 31-3-2018 4.65 — — —
Work certified during the year 2018-2019 12.76 13.26 7.56 4.32
Work uncertified as on 31-3-2019 0.84 0.24 0.14 0.18
Progress payments received during the year 9.57 9.00 5.75 3.60
Depreciation at 20% per annum is to be charged on plant issued. While the contract no.
723 was carried over from last year, the remaining contracts were started in the 1st week
of April 2018.
Required:
Determine the profit/loss in respect of each contract for the year ended 31st March, 2019.
Question 2
A railway contractor makes up his accounts to 31st March. Contract No.SER/15 for
construction of a culvert between Bhilai and Raipur commenced on 1st July, 2018. The
costing records yield the following information at 31st March, 2019.
Materials charged out to site ` 31,540
Labour 75,300
Foreman’s Salary 11,700
A machine costing ` 25,000 has been on the site for 73 days. Its working life is estimated
at five years and its final scrap value at ` 1,000.
A Supervisor, who is paid ` 18,000 per annum, has spent approximately six months on
this contract. All other expenses and administration cost amounted to ` 17,000.
Materials at site at the end of the year cost ` 2,500.
39
The contract price is ` 3,00,000. At the end of the year two thirds of the contract was
completed for which amount the Architect’s certificate has been issued and ` 1,60,000
has so far been received on account.
Prepare a Contract account for the year ending 31st March, 2019.
40
Question 1
Write note on cost-plus-contracts. (Nov. 2000, 2 Marks)
Answer
These contracts provide for the payment by the contractee of the actual cost of manufacture
plus a stipulated profit, mutually decided between the two parties.
The main features of these contracts are as follows:
1. The practice of cost-plus contracts is adopted in the case of those contracts where the
probable cost of the contracts cannot be ascertained in advance with a reasonable
accuracy.
2. These contracts are preferred when the cost of material and labour is not steady
and the contract completion may take number of years.
3. The different costs to be included in the execution of the contract are mutually agreed,
so that no dispute may arise in future in this respect. Under such type of contracts,
contractee is allowed to check or scrutinize the concerned books, documents and
accounts.
4. Such a contract offers a fair price to the contractee and also a reasonable profit to
the contractor.
5. The contract price here is ascertained by adding a fixed and mutually pre-decided
component of profit to the total cost of the work.
Question 2
Write notes on Escalation Clause. (Nov. 2000, 2 Marks, May 1994, 4 Marks)
Answer
Escalation Clause: This clause is usually provided in the contracts as a safeguard against
any likely changes in the price or utilization of material and labour. If during the period
of execution of a contract, the prices of materials or labour rise beyond a certain limit,
the contract price will be increased by an agreed amount. Inclusion of such a term in a
contract deed is known as an 'escalation clause'
An escalation clause usually relates to change in price of inputs, it may also be extended
to increased consumption or utilization of quantities of materials, labour etc. In such a
situation the contractor has to satisfy the contractee that the increased utilization is not
due to his inefficiency.
41
Question 3
What are the main advantages of cost plus contract?
(2 Marks, May 2008; November 2009)
Answer
Costs plus contracts have the following advantages:
1. The contractor is assured of a fixed percentage of profit. There is no risk of incurring
any loss on the contract.
2. It is useful especially when the work to be done is not definitely fixed at the time of
making the estimate.
3. Contractee can ensure himself about “the cost of the contract”, as he is empowered
to examine the books and document of the contractor to ascertain the veracity of
the cost of the contract.
Question 4
Explain the terms Retention money in contract costing.
(4 Marks, November 2011)
Answer
Retention money in contract Costing:
A the default risk in contract contractor does not receive the full payment of work certified
by the surveyor of work certified by the surveyor. Contractee retains some amount to be
paid after some time, when it is ensured that there is no default in the work done by the
contractor. If any deficiency or defect is noticed it is to be rectified by the contractor before
the release of the retention money. Thus retention money provides a safe guard against

42
MATERIAL COST CONTROL,

STOCK VALUATION AND STOCK
CONTROL
THEORY SECTION
A. How To Purchase [Raw Materials]

Step Document Copies From To Copies With
1. Purchase Requisition 3 Stores Purchase Stores
Form Purchase
Account
2. Letters Purchase Suppliers
3. Quotations Suppliers Purchase
4. Purchase Order 5 Purchase Suppliers Purchase
Suppliers
Stores
Receiving
Accounts
5 Delivery Challan 2 Suppliers Receiving Suppliers
Dept. Receiving
6. Goods Received Note 5 Receiving Suppliers Receiving
OR Receiving Report Dept. Suppliers
OR Material Inward Purchase
Note Stores
Accounts
7. Material Outward 5 Stores Suppliers Stores
Note [For Purchase Suppliers [2]
Return] Accounts
Outward
register
8. Raw Materials 2 Production Stores Production
Requisition Form Stores
43
9 Raw Materials Issue 3 Stores Production Stores

Form Production
Accounts
10 R.M. Returns Forms 3 Production Stores Production
[Memo] Stores
Accounts
11 Raw Materials 2 Production Another Prod. Production
Transfer Form Dept Another
Prod.depts.
B. HOW MUCH TO BUY / MANUFACTURE AT A TIME:

(i) Total Ca or Acquisition cost or ordering cost :
The Acquisition cost is that cost which we specifically incur, every time the order
for buying the raw material is placed. The examples are paper & other stationery
cost that we incur for preparing the purchase requisition, purchase order etc., the
postage cost incurred for inviting the quotations, telephone expenses to be incurred,
fuel or carriage inward and so on.
The acquisition cost, as such, depends on the number of times that we buy but the
number of times that we buy itself would depend on how much we buy every time.
The more we buy at a time, the less the number of times we buy & therefore the less
would be our Ca. Thus, to minimise Ca, we should buy less no. of times.
It should be noted that expenses which are unaffected by the number of times
we buy are not acquisition costs at all (e.g. Salary of purchase department staff,
depreciation of vehicles etc.)
(ii) Total Ci or carrying cost:

This cost depends on the average stock that we carry in our inventory. The average
stock is half of how much we buy every time.
Interest cost, real or notional, that we incur on investments in our inventory or the
insurance premium that we pay to insure the stock against certain risk are examples
of carrying cost items.
The more we buy at a time, the more would be our investment and accordingly, the
more would be our carrying cost. To minimise Ci, we must buy less at a time so that
the investment & consequently, the carrying cost would get reduced.
It should be noted that expenses which are unaffected by quantity of stock that we
keep are not Ci items (e.g. salary of store keeper, depreciation or rent warehouse
44
etc.). Also unless instructed otherwise any change in purchase price or rate of interest
would change Ci.
(iii) Ca v/s Ci :
These two cost items are equally strong but conflicting cost items. If one tries to
minimise one of them the other would automatically increase. For example, to
minimise Ca, we should buy less number of times which means we should buy more
at a time. But if we buy more at a time, the Ci would increase.
The EOQ does one very important job of striking a good balance between the two by
making the two equal.
B. WHEN TO BUY:
(1) Re-order level (ROL):
This is the stock level which, when reached, signifies that the action should be
taken to procure fresh quantity of raw material. The ROL has to be such that
the stock out is eliminated completely.
If the stock-out is not to occur, then, we must find out the maximum-possible
requirements of raw material during the maximum possible lead time that
lapses before we get fresh quantity of Raw Material.
Therefore ROL= Maximum consumption in maximum lead time + safety stock /
buffer stock / base stock (if given).
(2) Maximum (possible) stock:

After ROL is reached & before we get the fresh quantity, at least some consumption
would take place out of ROL quantity. If we want maximum possible stock, the
consumption should be minimum possible. Just after that consumption is over,
we would get fresh quantity of Raw Material which would be Re-order quantity
(which could be EOQ or other than EOQ).
Therefore Maximum possible stock = ROL ¬– Minimum consumption in minimum
lead time + Re-order quantity.
(3) Minimum (desirable) stock:

The minimum desirable level is the usual stock. Once our stock level reaches
below minimum level, it signifies that the conditions are unusual & unless
some urgent steps are taken, the stock-out may occur. However as long as the
conditions are normal we have nothing to worry about.
45
The maximum lead time & the maximum consumption occur only rarely & so is
the case with minimum consumption & minimum lead time. These are extremes
& do not occur regularly. What happens usually is the average lead time &
average consumption. In other words as long as reduction from ROL is equal to
average consumption in average lead time, we have nothing to worry about as
that is something very normal and it happens in every inventory cycle. It is only
when, the stock goes below that level, that must make us worry.
Therefore, the minimum stock = ROL – Average consumption in average lead
time.
(4) Average stock =

(5) Danger Level:
1. Level at which emergency purchase action is made to replenish stock.
2. Level at which stocks are issued only on "most needed" basis.
Average consumption x Emergency lead time
46
CLASSWORK SECTION
Question 1
Calculate the Economic Order Quantity from the following information. Also state the
number of orders to be placed in a year.
Consumption of materials per annum : 10,000 kg.
Order placing cost per order : ` 50
Cost per kg. of raw materials : `2
Storage costs : 8% on average inventory
Question 2
(i) Compute E.O.Q. and the total material cost for the following:
Annual Demand = 5,000 units
Unit price = ` 20.00
Order cost = ` 16.00
Storage rate = 2% per annum
Interest rate = 12% per annum
Obsolescence rate = 6% per annum
(ii) Determine the total cost that would result for the items if an incorrect price of
` 12.80 is used.
Question 3
G. Ltd. produces a product which has a monthly demand of 4,000 units. The product
requires a component X which is purchased at ` 20. For every finished product, one unit
of component is required. The ordering cost is ` 120 per order and the holding cost is 10%
p.a.
You are required to calculate:

(i) Economic order quantity.
(ii) If the minimum lot size to be supplied is 4,000 units, what is the extra cost, the
company has to incur?
(iii) What is the minimum carrying cost, the company has to incur?
47
Question 4
ZED Company supplies plastic crockery to fast food restaurants in metropolitan city. One
of its products is a special bowl, disposable after initial use, for serving soups to its
customers.
Bowls are sold in pack 10 pieces at a price of ` 50 per pack.
The demand for plastic bowl has been forecasted at a fairly steady rate of 40,000 packs
every year. The company purchases the bowl directly from manufacturer at ` 40 per pack
within a three days lead time. The ordering and related cost is ` 8 per order. The storage
cost is 10% per annum of average inventory investment.
Required:
(i) Calculate Economic Order Quantity.
(ii) Calculate number of orders needed every year.
(iii) Calculate the total cost of ordering and storage bowls for the year.
(iv) Determine when should the next order to be placed. Assuming that the company
does maintain a safety stock and that the present inventory level is 333 packs with
a year of 360 working days.
Question 5
X. Ltd. for some time had been buying the inventory at random till recently when it
switched over to EOQ system of buying.
The firm’s annual requirement is 12,000 units. The cost of carrying inventory is ` 15 per
unit per annum. The ordering cost is ` 400 per order.
One supplier has approached the purchase manager with a proposal that if the company
buys all 12,000 units at a time, then he would give 10% discount in the purchase price
which is ` 100 per unit.
Decide whether the proposal should be accepted or not.
Question 6
JP Limited, manufacturer of a special product, follows the policy of EOQ (economic order
quantity) for one of its components. The components details are as follows:
`
Purchase price per components 200
Cost of an order 100
Annual cost of carrying one unit in inventory 10% of purchase price
Total cost of inventory carrying and ordering per annum 4,000
The company has been offered a discount of 2% on the price of the component, provided
48
the lot size is 2,000 components at a time.

You are required to :
(a) Compute the EOQ
(b) Advise whether the quantity discount offer can be accepted. (Assume that the
inventory carrying cost does not vary according to discount policy)
(c) Would your advise differ if the company is offered 5% discount on a single order.
Question 7
A company manufactures a product from a raw material, which is purchased at ` 60
per kg. The company incurs a handling cost of ` 360 plus freight of ` 390 per order.
The incremental carrying cost of inventory of raw material is ` 0.50 per kg. per month.
In addition, the cost of working capital finance on the investment in inventory of raw
material is ` 9 per kg. per annum. The annual production of the product is 1,00,000 units
and 2.5 units are obtained from one kg of raw material.
Required
(i) Calculate the economic order quantity of raw materials.
(ii) Advise, how frequently should orders for procurement be placed.
(iii) If the company proposes to rationalize placement of orders on quarterly basis, what
percentage of discount in the price of raw materials should be negotiated?
Question 8
(a) EXE Limited has received an offer of quantity discounts on its order of materials as
under:

Category Price per ton (`) Ton (Nos.)
1 1,200 Less than 500
2 1,180 500 and less than 1,000
3 1,160 1,000 and less than 2,000
4 1,140 2,000 and less than 3,000
5 1,120 3,000 and above.
The annual requirement for the material is 5,000 tons. The ordering cost per order is
` 1,200 and the stock holding cost is estimated at 20% of material cost per annum.
You are required to compute the most economical purchase level.
(b) What will be your answer to the above question if there are no discounts offered and
the price per ton is ` 1,500?
49
Question 9
Two components, A and B are used as follows:
Normal usage 50 per week each
Maximum usage 75 per week each
Minimum usage 25 per week each
Re-order quantity A: 300; B: 500
Re-order period A: 4 to 6 weeks
B: 2 to 4 weeks
Calculate for each component (a) Re-ordering level, (b) Minimum level, (c) Maximum
level, (d) Average stock level.
Question 10
From the details given below, calculate:
(i) Re-ordering level (ii) Maximum level
(iii) Minimum level (iv) Danger level.
Re-ordering quantity is to be calculated on the basis of following information:
Cost of placing a purchase order is ` 20
Number of units to be purchased during the year is 5,000
Purchase price per unit inclusive of transportation cost is ` 50
Annual cost of storage per units is ` 5.
Details of lead time: Average- 10 days, Maximum- 15 days, Minimum-5 days.
For emergency purchases - 4 days.
Rate of consumption: Average: 15 units per day, Maximum: 20 units per day
Question 11
A Company uses three raw materials A, B and C for a particular product for which the
following data apply:
Raw Usage Re-order Price Delivery period (In weeks) Re-order Minimum
Material per quantity per Kg Minimum Average Maximum level level (Kgs.)
unit of (Kgs.) (`) (Kgs)
Product
(Kgs.)
A 10 10,000 10 1 2 3 8,000 ?
B 4 5,000 30 3 4 5 4,750 ?
C 6 10,000 15 2 3 4 ? 2,000
Weekly production varies from 175 to 225 units, averaging 200 units of the said product.
50
What would be the following quantities:

(i) Minimum stock of A,
(ii) Maximum stock of B,
(iii) Re-order level of C,
(iv) Average stock level of A.
Question 12
Aditya Ltd. produces a product ‘Exe’ using a raw material Dee. To produce one unit of Exe,
2 kg of Dee is required. As per the sales forecast conducted by the company, it will able
to sale 10,000 units of Exe in the coming year. The following is the information regarding
the raw material Dee:
(i) The Re-order quantity is 200 kg. less than the Economic Order Quantity (EOQ).
(ii) Maximum consumption per day is 20 kg. more than the average consumption per
day.
(iii) There is an opening stock of 1,000 kg.
(iv) Time required to get the raw materials from the suppliers is 4 to 8 days.
(v) The purchase price is ` 125 per kg.
There is an opening stock of 900 units of the finished product Exe.
The rate of interest charged by bank on Cash Credit facility is 13.76%.
To place an order company has to incur ` 720 on paper and documentation work.
From the above information find out the followings in relation to raw material Dee:
(a) Re-order Quantity
(b) Maximum Stock level
(c) Minimum Stock level
(d) Calculate the impact on the profitability of the company by not ordering the EOQ.
[Take 364 days for a year].
Question 13
IPL Limited uses a small casting in one of its finished products. The castings are purchased
from a foundry. IPL Limited purchases 54,000 castings per year at a cost of ` 800 per
casting.
The castings are used evenly throughout the year in the production process on a 360-days-
per-year basis. The company estimates that it costs ` 9,000 to place a single purchase
order and about ` 300 to carry one casting in inventory for a year. The high carrying
costs result from the need to keep the castings in carefully controlled temperature and
humidity conditions, and from the high cost of insurance.
51
Delivery from the foundry generally takes 6 days, but it can take as much as 10 days.
The days of delivery time and percentage of their occurrence are shown in the following
tabulation:
Delivery time (days) 6 7 8 9 10
Percentage of occurrence 75 10 5 5 5
Required:
(i) Compute the economic order quantity (EOQ).
(ii) Assume the company is willing to assume a 15% risk of being out of stock. What
would be the safety stock? The re-order point?
(iii) Assume the company is willing to assume a 5% risk of being out of stock. What
would be the safety stock? The re-order point?
(iv) Assume 5% stock-out risk. What would be the total cost of ordering and carrying
inventory for one year?
(v) Refer to the original data. Assume that using process re-engineering the company
reduces its cost of placing a purchase order to only ` 600. In addition company
estimates that when the waste and inefficiency caused by inventories are considered,
the true cost of carrying a unit in stock is ` 720 per year.
(a) Compute the new EOQ.
(b) How frequently would the company be placing an order, as compared to the
old purchasing policy?
Question 14
M/s Tyrotubes trades in four wheeler tyres and tubes. It stocks sufficient quantity of tyres
of almost every vehicle. In year-end 20X1-X2, the report of sales manager revealed that
M/s Tyrotubes experienced stock-out of tyres.
The stock-out data is as follows:
Stock – out of Tyres No. of times
100 2
80 5
50 10
20 20
10 30
0 33
M/s Tyrotubes loses ` 150 per unit due to stock-out and spends ` 50 per unit on carrying
of inventory.
Determine optimum safest stock level.
52
Question 15
An invoice in respect of a consignment of chemicals A and B provides the following
Information:
(`)
Chemical A: 10,000 Kgs. at ` 10 per Kg. 1,00,000
Chemical B: 8,000 Kgs. at ` 13 per Kg. 1,04,000
Basic custom duty @ 10% (Credit is not allowed) 20,400
Railway freight 3,840
Total cost 2,28,240
A shortage of 500 kgs. in chemical A and 320 kgs. in chemical B is noticed due to normal
breakages. You are required to determine the rate per kg. of each chemical, assuming a
provision of 2% for further deterioration.
STOCK VALUATION AND STOCK CONTROL
Question 16
The following transactions in respect of material Y occurred during the six months ended
30th June, 20X1:
Month Purchase (units) Price per unit (`) Issued units
January 200 25 Nil
February 300 24 250
March 425 26 300
April 475 23 550
May 500 25 800
June 600 20 400
Required:
(a) The Chief Accountant argues that the value of closing stock remains the same no
matter which method of pricing of material issues is used. Do you agree? Why or
why not? Detailed stores ledgers are not required.
(b) When and why would you recommend the LIFO method of pricing material issues?
Question 17
The following information is extracted from the Stores Ledger:
53
Material X
Opening Stock Nil
Purchases:
Jan. 1 100 @ ` 1 per unit
Jan. 20 100 @ ` 2 per unit
Issues:
Jan.22 60 for Job W 16
Jan. 23 60 for Job W 17
Complete the receipts and issues valuation by adopting the First-In-First-Out, Last- In-
First-Out and the Weighted Average Method. Tabulate the values allocated to Job W 16,
Job W 17 and the closing stock under the methods aforesaid and discuss from different
points of view which method you would prefer.
Question 18
From the following details, draw a plan of ABC selective control:
Items Units Unit cost (`)
1 7,000 5.00
2 24,000 3.00
3 1,500 10.00
4 600 22.00
5 38,000 1.50
6 40,000 0.50
7 60,000 0.20
8 3,000 3.50
9 300 8.00
10 29,000 0.40
11 11,500 7.10
12 4,100 6.20
Question 19
Raw materials ‘AXE’ costing ` 150 per kg. and ‘BXE’ costing ` 90 per kg. are mixed in equal
proportions for making product ‘A’. The loss of material in processing works out to 25% of
the product. The production expenses are allocated at 40% of direct material cost. The
end product is priced with a margin of 20% over the total cost.
Material ‘BXE’ is not easily available and substitute raw material ‘CXE’ has been found for
‘BXE’ costing ` 75 per kg. It is required to keep the proportion of this substitute material
54
in the mixture as low as possible and at the same time maintain the selling price of the
end product at existing level and ensure the same quantum of profit as at present.
You are required to compute the ratio of the mix of the raw materials ‘AXE’ and ‘CXE’.
55
HOMEWORK SECTION
Question 1
Aditya Agro Ltd. produces edible oils of different varieties. The monthly demand pattern
for the finished products are as follows:
Mustard oil 45,000 Litre
Soybean oil 15,000 Litre
Olive oil 3,000 Litre
To produce one litre of Mustard oil, Soybean oil and Olive oil, 5 kg. of mustards, 6 kg. of
soybeans and 4.5 kg. of olives are required respectively. There is no opening and closing
stock of materials.
Aditya Agro Ltd. can purchase the materials either from the farmers directly or from
the wholesale market. The company can purchase any quantity of materials from the
wholesale market but in case of purchase from the farmers, it has to purchase the minimum
specified quantity of materials at a time. Following is the material-wise summary related
with the purchase of materials:
Wholesale Farmers
Market
Mustard:
Minimum Quantity to be purchased Any quantity 13,50,000 kg.
Purchase price per kg. (`) 15.00 12.50
Government Tax* 2% ---
Transportation cost per purchase 6,000 15,000
Sorting and piling cost per purchase --- 1,200
Loading cost per 50 kg. 10.00 5.00
Unloading cost per 50 kg. 2.00 2.00
Soybean:
Minimum Quantity to be purchased Any Quantity 2,70,000 kg.
Government Tax** --- ---
Transportation cost per purchase 9,000 12,000
Sorting and piling cost per purchase --- 800
Unloading cost per 50 kg. 2.00 2.00
Olive:
56
Minimum Quantity to be purchased Any Quantity 1,62,000 kg.

Import duty*** --- 10%
Transportation Cost per purchase (`) 3,000 11,000
Sorting and piling cost per purchase 1,800 ---
Unloading cost per 50 kg 2.00 2.00
The company is paying 12.5% p.a. as interest to its bank for cash credit facility and
` 100 per 100 kg. as rent to the warehouse.
* Government tax for Mustard will be added to the purchased price of mustards.
** There was no Government tax for Soybean.
*** Import duty will be added to purchase price.
You are required to

(i) Calculate the purchase cost of each material
(a) from Wholesale market
(b) from the Farmers
(ii) Calculate Economic Order Quantity of each material under the both options.
(iii) Recommend the best purchase option for the material ‘olive’.
Question 2
From the following data for the year ended 31st December, 20X1, calculate the inventory
Turnover ratio of the two items and put forward your comments on them.
Material A (`) Material B (`)
Opening stock 1.1.20X1 10,000 9,000
Purchase during the year 52,000 27,000
Closing stock 31.12.20X1 6,000 11,000
Question 3
A Company manufactures a special product which requires a component ‘Alpha’. The
following particulars are collected for the year 20X1:
(i) Annual demand of Alpha 8,000 units
(ii) Cost of placing an order ` 200 per order
(iii) Cost per unit of Alpha ` 400
(iv) Carrying cost p.a. 20%
57
The company has been offered a quantity discount of 4 % on the purchase of ‘Alpha’
provided the order size is 4,000 components at a time.
Required:
(i) Compute the economic order quantity
(ii) Advise whether the quantity discount offer can be accepted.
Question 4
‘AT’ Ltd. furnishes the following store transactions for September, 20X1:
1-9-X1 Opening balance 25 units value ` 162.50
4-9-X1 Issues Req. No. 85 8 units
6-9-X1 Receipts from B & Co. GRN No. 26 50 units @ ` 5.75 per unit
10-9-X1 Return to B & Co. 10 units
15-9-X1 Receipts from M & Co. GRN. No. 33 25 units @ ` 6.10 per unit
19-9-X1 Received replacement from B & Co. GRN No. 38 10 units
20-9-X1 Returned from department, material of
M & Co. MRR No. 4 5 units
22-9-X1 Transfer from Job 182 to Job 187 in the dept. 5 units
MTR 6
29-9-X1 Transfer from Dept. “A” to Dept. “B” MTR 10 5 units
30-9-X1 Shortage in stock taking 2 units
Write up the priced stores ledger on FIFO method and discuss how would you treat the
shortage in stock taking.
58
Question 1
List five types of inefficiency in the use of materials that may be discovered as the result
of investigating material quantity variances. What measures may be taken in each such
situation to prevent their recurrence?
Answer
The five types of inefficiency in the use of materials that may be discovered as a result of
investigating materials quantity variances are as follows :
1. Purchase of inferior quality of materials.
2. Inefficient labour force leading to excessive utilisation of materials.
3. Defective machines, tools and equipments and bad or improper maintenance leading
to breakdowns resulting in excessive usage of materials.
4. Inaccurate technical specifications and slackness in inspection may cause more
rejections, resulting in greater requirement of materials for rectification of defects.
5. Faulty material processing.
The measures which may be taken in each of the above situations to prevent their
recurrence in future are as below :
1. To ensure the purchase of proper quality of material, each lot of material
purchased should be inspected in accordance with the terms and conditions
of purchase before they are accepted and issued for production. The extent
of inspection may depend on the circumstances. For instance, when materials
are of small value or where the quality of raw materials does not appreciably
affect the final product, the inspection may not be very rigid. In such a case,
inspection may be carried out by taking random samples. However, for
materials of vital importance like raw materials for explosive factories or for
pharmaceutical concerns where material cost is high, a rigid or strict inspection
will be necessary.
2. Labour inefficiency can be reduced by adopting following measures :
(a) Imparting on-the-job training to workers.
(b) Supervising the workers while performing the jobs.
(c) Evaluating workers performance.
(d) Incorporating incentive schemes for workers.
(e) Reducing labour turnover ratio.
3. The wastage of material can also be reduced by properly maintaining machines,
59
tools and other equipment. The concern should adopt a policy of preventive
maintenance. The use of such a policy will reduce machine down time and
over-consumption of materials. Besides this, workers must be educated to
realise fully the importance of tools and equipment in their day-to-day work.
4. A reduction in the number of defective units, in this case may automatically
bring down the excessive consumption of material required for rectification
of defects. Reduction in the number of defectives can be achieved by laying
down accurate technical specifications, standards for materials and tactfully
handling the problem of slackness.
5. Faulty material processing also results in excess consumption of material.
The supervisors at the shop floor level should educate and guide the workers
properly so that they make use of the correct procedure laid down for processing
raw materials.
Question 2
Discuss briefly how the following items are to be treated in costs :
(i) Carriage inwards raw materials
(ii) Storage losses
(iii) Cash discount received
(iv) Insurance costs on stocks of raw materials.
Answer
(i) Carriage inwards on raw materials: It represents the expenditure incurred in bringing
raw materials to factory from outside. This expense is directly allocated to materials
and thus forms a part of the .cost of such materials. When this is not practicable
and allocation to specific items of materials is difficult, the expense is treated as
manufacturing overhead and is charged to cost of production at a re-determined
rate. In some of the undertakings the practice is to charge these expenses as a
percentage of cost, weight or some other physical unit of material.
(ii) Storage losses: The losses arising out of storage of material can be classified into
two categories. The treatment of losses under each category in Cost Accounts is as
under:
(a) Losses due to reasons like evaporation, shrinkage, absorption and moisture, etc.
are considered as normal losses. Such losses are absorbed by good production
units by inflating the cost of material issued for production.
(b) Losses due to fire, flood, storm, theft etc. are treated as abnormal losses. If
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these losses are heavy and are not recoverable from the insurance authorities,
it is preferred to charge them to Costing Profit and Loss Account.
(iii) Cash discount received: It is an allowance given by the vendor for prompt payment
of material price. The opinion among accountants about its treatment differs. Two
prevalent approaches for treating the cash discount received are as follows:
(a) The cash discount received in the course of materials buying should be deducted
from the invoice price of the materials. This way the discount received will
reduce the purchase price of the materials.
(b) It may be treated as an item of financial nature and therefore be kept outside
the purview of cost accounting. However, it can be dealt in the following manner.
The full invoice price should be charged to the material account crediting the
suppliers with the net invoice price, and the discount earned account with
the amount of cash discount received. If the prompt payment could not be
made, the discount lost is debited to the discount lost account. Any difference
between the discount earned and discount lost may be treated as an item of
administrative overhead.
(iv) Insurance costs on stocks of raw materials : The amount paid as insurance costs
(insurance premium) on stocks of raw materials is meant for covering the risk which
may arise due to fire, theft, riot etc. The insurance cost is apportioned over different
materials on the basis of their value. This cost may be charged directly to the cost
of material.
Question 3
Distinguish between spoilage and defectives in a manufacturing company. Discuss their
treatment in cost accounts and suggest a procedure for their control.
Answer
Spoilage can be defined as the materials which are badly damaged in the course of
manufacturing operations to the extent that they cannot be rectified economically and
hence taken out of process, to be disposed of in some manner without further processing.
Spoilage may be either normal or abnormal.
Defective products are such semi-finished or finished products produced by a
manufacturing unit, which are not in conformity with laid-down standard or dimensional
specifications. Defectives produced can be re-worked or reconditioned by the application
of additional materials, labour and / or processing and brought to the point of either
standard or sub-standard product. The costs incurred for reconditioning are known as
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the "Costs of re-operations of the defectives". Defective production may be the result
of various causes such as sub-standard materials, bad-workmanship, carelessness in
planning, laxity in inspection etc.
The difference between spoilage and defectives is that while spoilage cannot be repaired
or reconditioned, defectives can be rectified and transformed, either back to standard
production or to seconds.
Treatment of spoilage and defectives in Cost Accounting : Under Cost Accounts normal spoilage
costs (i.e., which is inherent in the operation) are included in cost either by charging the
loss due to spoilage to the production order or charging it to production overhead so that
it is spread over all products. Any value realised from the sale of spoilage is credited
to production order or production overhead account, as the case may be. The cost of
abnormal spoilage (i.e. arising out of causes not inherent in manufacturing process) are
charged to the Costing Profit and Loss Account. When spoiled work is the result of rigid
specifications the cost of spoiled work is absorbed by good production while the cost of
disposal is charged to production overheads.
The problem of accounting for defective work is the problem of accounting of the costs of
rectification or rework.
The possible ways of treatment are as below :
(i) Defectives that are considered inherent in the process and are identified as normal
can be recovered by using the following methods:
(a) Charged to good products: The loss is absorbed by good units. This method is
used when 'seconds' have a normal value and defectives rectified into 'seconds'
or 'first' are normal.
(b) Charged to general overheads: When the defectives caused in one department are
reflected only on further processing, the rework costs are charged to general
overheads.
(c) Charged to the departments overheads: If the department responsible for
defectives can be identified then the rectification costs should be charged to
that department.
(d) Charged to Costing Profit and Loss Account: If defectives are abnormal and are
due to causes beyond the control of organisation; the rework cost should be
charged to Costing Profit and Loss Accounts.
(ii) Where defectives are easily identifiable with specific jobs the re-work costs are
debited to the job.
Procedure for the control of Spoilage and Defectives : To control spoilage, allowance for
a normal spoilage should be fixed up and actual spoilage should be compared with
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standard set. A systematic procedure of reporting would help control over spoilage.
A spoilage report (as below) would highlight the normal and abnormal spoilage,
the department responsible, the causes of spoilage and the corrective action taken
if any.
Control of defectives may cover the following two areas :
(a) Control over defectives produced
(b) Control over reworking costs.
For exercising effective control over defectives produced and the cost of reworking,
standards for normal percentage of defectives and reworking costs should be
established.
Question 4
Define (i) Replacement Price and (ii) Standard Price. Discuss the objectives of these methods
of pricing of materials and state the circumstances in which they are used.
Answer
(i) Replacement Price is defined as the price at which it is possible to purchase an item,
identical to that which is being replaced or revalued.
(ii) A Standard Price may be defined as a predetermined price fixed for a specified period
on the basis of all factors which may affect future price.
Under Replacement Price method, materials issued are valued at the replacement
costs of the items. This method pre-supposes the determination of the replacement
cost of the materials at the time of each issue, viz., the cost at which identical
materials could be currently purchased. The product cost under this method is at
current market price which is the main objective of the replacement price method.
Replacement Price method is used to value material issues in periods of rising prices
because the cost of material considered in cost of production would be able to
replace the materials at the increased price. This method is used to find the true cost
of production.
The fixation of Standard Price takes into account the quantity of materials to be
purchased, possibility of price fluctuations, etc. The Standard Price is used for
comparison with actual prices from period to period and to measure the efficiency of
the purchase of materials. This is used in conjunction with Standard Costing System
for control purposes and is a tool to the management if fluctuations in prices are not
violent.
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Question 5
Explain the distinction between waste and scrap in the manufacturing process. Discuss
their treatment in cost accounts and suggest a procedure for control.
Answer
Waste: It represents that portion of basic raw materials, which is either lost or which
evaporates or shrinks during a manufacturing process. It may be visible or invisible. But
it has no recovery value.
Scrap: The incidental residue arising from the manufacturing operations, small in quantity
and low in value, recoverable without further processing.
From the definitions of waste and scrap stated above it is quite apparent that waste
cannot be realised whereas scrap can be. Scrap is always visible whereas waste may or
may not be.
Waste can be differentiated as normal and abnormal. Normal waste is absorbed in the
cost of net output, whereas abnormal waste is transferred to the Costing Profit and Loss
Account.
For effective control of waste, normal allowances for yield and waste should be made
from past experience, technical factors and special features of the material process
and product. Actual yield and waste should be compared with anticipated figures and
appropriate actions should be taken where necessary. Responsibility should be fixed on
purchasing, storage, maintenance, production and inspection staff to maintain quality of
the materials and other standards. A systematic procedure for feedback of Achievements
against standards laid should be established.
Scrap may be treated in Cost Accounts in the following ways:
(i) Where the value of scrap is negotiable, it may be excluded from costs. In other
words, the cost of scrap is borne by good units and income from scrap is treated as
other income.
(ii) If the scrap value is considerable, the net sale proceeds of scrap (Gross sales proceeds
of scrap—the cost of selling scrap) is deducted from the material cost or factory
overhead. Under this method the material cost or factory overhead recovery rate
are reduced on account of sale proceeds of scrap. However, no distinction is made
between various processes or jobs.
(iii) Where the various jobs or processes give rise in varying amount of scrap, the scrap
from each job or process is recorded separately and the sale proceeds from the
same credited to the particular job or process. This method is useful where scrap is
of considerable value and does not arise uniformly. However, this would necessitate
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the scrap being identified with various jobs or processes. For this purpose detailed
records for scrap will be required.
Control of scrap really arises at the maximum effective utilization of the raw
material. Scrap control does not, therefore, start in the production department; it
starts from the stage of product designing. Thus the most suitable type of materials,
the appropriate size, the right type of equipment and personnel would help getting
maximum quantity of finished product from a given raw material.
The procedure for control of scrap should start with establishing a standard of
scrap with each department, job or process, taking into consideration the nature of
material, the nature of the manufacturing operation, the use of proper equipment,
the size of the material, the employment of proper personnel and defining areas
of responsibility. It is also necessary to establish a scheme of scrap reporting. The
actual scrap should be compared with the predetermined standard, and the reasons
for the difference, if any, should be investigated, corrective action taken, whenever
the actual scrap is found to be more than what is normally allowed. Also, it is to be
ensured that proper supervision is exercised at the scrap generation stage.
Question 6
What is ABC analysis? Discuss its role in a sound system of material control.
Answer
ABC analysis is a technique through which selective control can be exercised over the
various items of inventory. These days the manufacturing units have such a large number
of items in their stores that it is often not possible for the management to pay minute
attention to each and every item. A system is therefore divided by which these items are
classified according to their importance and then selective control exercised. ABC analysis
or Selective Inventory Control is a technique whereby the measure of control over an item
of inventory varies directly with its usage value. In other words, the high value items are
controlled more closely than the items of low value.
To classify the various items according to their usage value, the following procedure is
adopted:
(a) The quantity or the number of parts expected to be used for production in the given
period is estimated.
(b) The quantity as estimated above is multiplied by the unit value of the item.
(c) All the items are then re-arranged according to their usage value in a descending
order.
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(d) It would normally be found that a small number of items add upto a very high value.
Thus 5 to 10 percent of total items may constitute 70 to 85 percent of material cost.
Such items are classified as A items. Another 10 to 20 percent of total items may
represent 10 to 20 percent of the total material cost. These items may be categorised
as B items. The rest, i.e. 70 to 85-percent of items, though numerous, will thus form
only 5 to 10 percent of total material cost. These may be called C items.
This classification thus highlights the more significant items. Management can then
exercise a very close control over A items. It may apply occasional control over B
items. As regards C items, it may exercise control only in a general manner. For
example, it may order the quantities of C items annually or once in six months or so.
It is obvious that since C items do not have a high value, the total investment in such
items will not be large.
Regarding A items, the management will have to define the stock levels, i.e.,
maximum, minimum, reordering and danger very carefully. Also a close check on
the consumption of these items will have to be kept. The economic order quantity for
each of the items in this category should be worked out. Similarly other technique
of inventory control should also be applied to A items. It would be appreciated that
since A items constitute the bulk of the investment in the total inventory, it would
be worthwhile to bring them under close control and to apply modern management
inventory control techniques.
ABC analysis helps the management in the following ways:
(1) The investment in inventories is optimised through a close and direct control
over A items. This would naturally release funds which can then be channelised
into more profitable areas. This would raise the overall return on investment
earned by the unit.
(2) The ordering and carrying costs are reduced since the management would
attempt to optimise such costs so far as they relate to the bulk of the items.
(3) If the management seeks to exercise direct control over all the items of
inventory, the inventory control system would become very expensive. ABC
analysis therefore cuts down the cost of the system and relates its cost to the
attendant benefits.
(4) The main objectives of inventory control are fulfilled under this system at the
minimum cost. With scientific control of inventories, the stock turnover rate can
be maintained at comparatively high levels.
The concept of ABC analysis can be used in areas other than inventory also.
This technique basically emphasises that where the items to be controlled are
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numerous, one should categorise them according to their importance. Close

control should then be exercised on the most significant category. On the less
important categories, the degree of control maybe related to the benefit from
control.
Thus finally it may be concluded that ABC analysis plays an important role for
a sound system of material control.
Question 7
Distinguish between: Perpetual Inventory System and continuous stock taking.
Answer
(a) Distinction between Perpetual Inventory System and Continuous Stock taking
Perpetual Inventory System: It is a system of stock control followed by the stores
department. Under this system, a continuous record of receipt and issue of material
is maintained by the stores department. In other words, in this system, stock control
cards or bin cards and the stores ledger show clearly the receipts, issues and balance
of all items in stock at all times. This system facilitates planning of production and
ensures that production is not interrupted for want of materials and stores.
Continuous Stock taking: It means physical verification of stores items on a continuous
basis to reveal the position of actual balances. Such a verification is conducted
round the year, thus covering each item of store twice or thrice. Any discrepancies,
irregularities or shortages brought to the notice, as a result of continuous stock
verification are reported to the appropriate authorities for initiating necessary
rectification measures. This system works as a moral check as stores staff and acts
as a deterrent to dishonesty.
A perpetual inventory system is usually supported by a programme of continuous
stock taking. That is continuous stock taking is complementary to the perpetual
inventory system. Sometimes the two terms are considered synonymous but it is not
so. The success of the perpetual inventory system depends upon the maintenance
and upto date writing up of (i) the stores ledger and (ii) bincards/stock control cards,
Continuous stock taking, ensures the veracity of figures shown by the above records.
Question 8
Distinguish amongst :
1. Spoilage
2. Salvage
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3. Rectification
How are they treated in Cost Accounts.
Answer
1. Spoilage: It is the term used for materials which are badly damaged in manufacturing
operations, and they cannot be rectified economically and hence taken out of process
to be disposed of in some manner without further processing. Spoilage maybe either
normal or abnormal.
Normal spoilage (i.e., which is inherent in the operation) costs are included in costs
either by charging the loss due to spoilage to the production order or charging it to
production overhead so that it is spread over all products. Any value realised from
spoilage is credited to production order or production overhead account, as the case
may be.
The cost of abnormal spoilage (i.e., arising out of causes not inherent in manufacturing
process) are charged to the Costing Profit and Loss Account. When spoiled work is the
result of rigid specification, the cost of spoiled work is absorbed by good production
while the cost of disposal is charged to production overhead.
To control spoilage, allowance for normal spoilage should be fixed and actual
spoilage should be compared with standard set. A systematic procedure of reporting
would help control over spoilage. A spoilage report should highlight the normal and
abnormal spoilage, the department responsible, the causes of spoilage and the
corrective action taken, if any.
Salvage: Salvaged material refers to the material retrieved from the spoiled work.
Salvage is the process by which salvaged material is retrieved. The salvaged units of
material are usable in the production.
The value of salvaged material may be credited to the account to which spoilage is
charged.
Rectification: It means bringing back the defective units either to standard units of
production or as seconds, by reworking. The work of rectification in small concern's
is usually entrusted to the production shop, whereas in big concerns, a separate
department carries out the task. Before the start of rectification work an estimate
of the cost of rectification is prepared and compared with the excess value to be
obtained after rectification. The concern only goes ahead with the task of rectification
if the aforesaid comparison is found favourable.
The task of rectification is usually carried out under a 'Rectification Work Order', and
all costs of re-work are collected against this work order for material, labour and
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overhead.
If the defective production is inherent in the process of manufacture, and arises as a
normal consequence of productive activities and if it can be identified with specific
jobs, the rectification cost is charged to the jobs as the cost of manufacturing good
units of the product. This will have the effect of adding to the cost of the jobs. If
the expenditure on rectification is considered abnormal, it is excluded from product
costs and charged to Costing Profit and Loss Account.
Question 9
How are normal and abnormal loss of material arising during storage treated in Cost
Accounts? (May 2001, 5 Marks)
Answer
Cost Accounts treatment of normal and abnormal loss of material arising during storage.
The difference between the book balance and actual physical stock, which may either be
gain or loss, should be transferred to Inventory Adjustment Account pending scrutiny to
ascertain the reason for the difference.
If on scrutiny, the difference arrived at is considered as normal, then such a difference
should be transferred to overhead control account and if abnormal, it should be debited
to costing profit and loss account.
In the case of normal losses, an alternative method may be used. Under this method the
price of the material issued to production may be inflated so as to cover the normal loss.
Question 10
Distinguish clearly Bincards and Stores Ledger. (May 1999, 4 Marks)
Answer
Both bin cards and stores ledger are perpetual inventory records. None of them is a
substitute for the other. These two records may be distinguished from the following points
of view:
(i) Bin card is maintained by the store keeper, while the stores ledger is maintained by
the cost accounting department.
(ii) Bin card is the stores recording document whereas the stores ledger is an accounting
record.
(iii) Bin card contains information with regard to quantities i.e. their receipt, issue and
balance while the stores ledger contains both quantitative and value information in
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respect of their receipts, issue and balance.

(iv) In the bin card entries are made at the time when transaction takes place. But in the
stores ledger entries are made only after the transaction has taken place.
(v) Inter departmental transfer of materials appear only in stores ledger.
(vi) Bin cards record each transaction but stores ledger records the same information in
a summarized form.
Question 11
What is Just in Time (JIT) purchases? What are the advantages of such purchases?
(May 1999, 3 Marks)
Answer
Just in time (JIT) purchases means the purchase of goods or materials such that delivery
immediately precedes their use.
Advantages of JIT purchases:
Main advantages of JIT purchases are as follows :
1. The suppliers of goods or materials cooperates with the company and supply
requisite quantity of goods or materials for which order is placed before the start of
production.
2. JIT purchases results in cost savings for example, the costs of stock out, inventory
carrying, materials handling and breakage are reduced.
3. Due to frequent purchases of raw materials, its issue price is likely to be very close
to the replacement price. Consequently the method of pricing to be followed for
valuing material issues becomes less important for companies using JIT purchasing.
4. JIT purchasing are now attempting to extend daily deliveries to as many areas as
possible so that the goods spend less time in warehouses or on store shelves before
they are exhausted.
Question 12
"To be able to calculate a basic EOQ certain assumptions are necessary. "List down these
assumptions. (November 1995, 2 Marks)
Answer
The computation of economic order quantity is subject to the following assumptions:
(i) Ordering cost (per order) and carrying cost (per unit/annum) are known and constant.
(ii) Anticipated usage (in units) of material for a period is uniform and known.
(iii) Cost per unit of the material (to be purchased) is known and it is constant.
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Purchase Officer
Question 13
How is slow moving and non-moving item of stores detected and what steps are necessary
to reduce such stocks? (November 2001, 4 Marks)
Answer
Detection of slow moving and non-moving item of stores:
The existence of slow moving and non-moving item of stores can be detected in the
following ways.
(i) By preparing and scanning periodic reports showing the status of different items or
stores.
(ii) By calculating the stock holding of various items in terms of number of days/ months
of consumption.
(iii) By computing ratios periodically, relating to the issues as a percentage of average
stock held.
(iv) By implementing the use of a well - designed information system.
Necessary steps to reduce stock of slow moving and non-moving item of stores :
(i) Proper procedure and guidelines should be laid down for the disposal of non-moving
items, before they further deteriorates in value.
(ii) Diversify production to use up such materials.
(iii) Use these materials as substitute, in place of other materials.

71
STRATEGIC
MANAGEMENT
INTER C.A. – STRATEGIC MANAGEMENT
Introduction to Strategic
Management
Concept 1: Business Policy:
Introduction;
The origin of business policy can be traced back to 1911. When Harvard Business School introduced
an integrative course in management aimed at the creation of general management
capability among business executives. This course was based on interactive case studies
which had been in use at the school for instructional purposes since 1908.
However, the introduction of business policy in the curriculum of business schools or

management institutes came much later. In 1969, the American Assembly of Collegiate
Schools of Business, a regulatory body for business schools, made the course of business
policy, a mandatory requirement for the purpose of recognition of business schools or
management institutes.
During the next few decades, business policy as a course spread to different management
institutes across different nations and became an integral part of management curriculum.
Definition;
Business Policy is “the study of the functions and responsibilities of senior management,
the crucial problems that affect success in the total enterprise and the decisions that
determine the direction of the organization and shape its future.
Utility of Business Policy;
i. Business Policy are the guidelines developed by an organization to govern the actions
of those who are a part of it.
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ii. Business Policy defines the scope within which decisions may be taken by the
subordinates in an organization.
Evolution;
According to William F Glueck, evolution of business policy emerged from the development
in the use of planning techniques by managers.
• Starting from day-to-day planning in earlier times, managers tried to anticipate

the future through preparation of budgets and using control systems like capital
budgeting and management by objectives.
• With the inability of these techniques to adequately emphasize the role of future,
long-range planning came to be used.
• Soon, long-range planning was replaced by strategic planning, and later by strategic
management, a term that is currently used to describe the process of strategy
formulation, implementation and control.
The problems of policy in business, like those of policy in public affairs, have to do with the
choice of purposes, the moulding of organizational identity and character, the continuous
definition of what needs to be done, and the mobilization of resources for the attainment
of goals in the face of competition or adverse circumstance”.
Conclusion; (Importance)
Business Policy tends to emphasize on the rational-analytical aspect of strategic

management. It presents a framework for understanding strategic decision making in
organisations. Such a framework enables a manager to make preparations for handling
general management responsibilities effectively.
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Concept 2: Concept of Management:
To understand the concept of strategic management, we need to have a basic understanding

of the term management. The term ‘management’ is used in two senses, such as:
1. People view;
It is used with reference to a key group in an organisation in-charge of its affairs. In relation
to an organisation, management is the chief organ entrusted with the task of making
it a purposeful and productive entity, by undertaking the task of bringing together and
integrating the disorganised resources of manpower, money, materials, and technology into a
functioning whole.
An organisation becomes a unified functioning system when management systematically

mobilises and utilises the diverse resources efficiently and effectively.
The survival and success of an organisation depends to a large extent on the competence and
character of its management. Management has to also facilitate organisational change and
adaptation for effective interaction with the environment.
2. Functional view;
The term ‘Management’ is also used with reference to a set of interrelated functions
and processes carried out by the management of an organisation to attain its objectives.
These functions include Planning, Organising, Directing, Staffing and Control. The functions
or sub-processes of management are wide-ranging but closely interrelated. They range all
the way from determination of the goals, design of the organisation, mobilisation and
acquisition of resources, allocation of tasks and resources among the personnel and
activity units and installation of control system to ensure that what is planned is achieved.
Management is an influence process to make things happen, to gain command over

phenomena, to induce and direct events and people in a particular manner. Influence
is backed by power, competence, knowledge and resources. Managers formulate
organisational goals, values and strategies, to cope with, to adapt and to adjust
themselves with the behaviour and changes in the environment.
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Concept 3: Strategy:
Introduction;
The term strategy has been derived from the Greek word ‘strategos’ which means
generalship.
Business today is like fighting a war and businessmen have to respond to the dynamic and
hostile (i.e., unfriendly) environment. Every businessman makes use of strategies to face
the tricks of his enemy (i.e., rivals).
Strategy may be defined as a long-range blueprint of an organisation, what it wants to be?

(i.e., desired image), what it wants to do? (i.e., direction) and where it wants to go? (i.e.,
destination).
Policy and Strategy are quite interrelated, but the interesting thing to study is how they
differ. Where a policy is a thought process, it talks about what should be done in a particular
situation, or what should be the reaction to a given circumstance. The strategy part of it
explains the real actions, strategy talks about how the policy would be followed.
For example, the policy of an organisation could be to not drop their prices to fight
competition. The strategy could be to give more quantity for the same price, or give some
other product as a freebie to attract customers without dropping their price.
Strategy is consciously considered and flexibly designed scheme of corporate intent and
action to mobilise resources, to direct human effort and behaviour, to handle events and
problems, to perceive and utilise opportunities, and to meet challenges and threats for
corporate survival and success.
Strategy is the game plan that the management of a business uses to take market position,
conduct its operations, attract and satisfy customers, compete successfully, and achieve
organizational objectives.
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Definition of Strategy;
Strategy is defined by William F. Glueck as, “A unified, comprehensive and integrated plan
designed to assure that the basic objectives of the enterprise are achieved”.
3.1 Classification of Strategy based on approach;
1. Proactive approach (i.e., Proactive strategy), and
2. Reactive approach (i.e., Reactive strategy).
Q. “Strategy is partly proactive and partly reactive.” do you agree?
Answer: Yes,
In Proactive Strategy, organizations will analyse possible environmental scenarios and

create strategic framework after proper planning and set procedures and work on these
strategies in a predetermined manner.
However, in reality no company can forecast both internal and external environment
exactly. Everything cannot be planned in advance. It is not possible to anticipate moves
of rival firms, consumer behaviour, evolving technologies and so on.
There can be significant deviations between what was visualized and what actually
happens. Strategies need to be modified in the light of possible environmental changes.
There can be significant or major strategic changes when the environment demands.
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It is based on unanticipated events such as Competitor’s strategies, Market changes require

changes in planned strategy is known as Reactive Strategy. Reactive strategy is triggered by
the changes in the environment and provides ways and means to cope with the negative
factors or take advantage of emerging opportunities.
Hence, strategy is partly proactive and partly reactive.
3.2 Characteristics of Strategy;
• Ways to win over enemy:
A typical dictionary defines the word ‘strategy’ as something that has to do with war
and ways to win over enemy.
• Forward looking:
Strategy is forward looking it defines in broad terms the action which an organisation
proposes to take in future.
• Designed to move to the desired future position:
Strategy is designed to move an organisation from its current position to the desired
future position.
• Pragmatic and flexible:
Strategy needs to pragmatic (i.e., practical) and flexible as per the situation.
• Strategy is partly proactive and partly reactive:
Proactive refers to actions on the part of managers to improve the company’s market position,
competitive advantage and financial performance by deciding and planning in advance.
However, if a company’s strategy is developed as a response to unanticipated

developments, it is known as reactive strategy. For E.g., Airtel changing its tariff rates
on introduction of JIO.
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• Strategy is not a substitute:
Strategy is not a substitute for sound, alert and responsible management. It provides
a directions and support to the management. Strategy formulation should be
complemented (i.e., supported) with strategy implementation to achieve objectives.
• Strategy can never be perfect, flawless and optimal:
Means strategies may fail if there are loopholes in formulation or implementation of

strategy. Similarly, it may also fail due to changes in environment. In a sound strategy,
allowances are made for possible miscalculations and unanticipated events.
• Strategy is not a bundle of tricks and magics:
Strategic management is not a bundle of tricks and magic. It is a deliberate managerial

process as it involves critical thinking and commitment of resources to action.
• Application of strategy:
Every organisation whether it is large or small requires strategies. These organisations

irrespective of their sizes face similar business environment and face competition. In
large organisations, strategies are formulated at the corporate, business (divisional)
and operational (functional) levels. Corporate strategies are formulated by the top
managers.
Q. “Strategic management is a bundle of tricks and magic. Do you agree?
Answer: No, the term ‘strategic management’ refers to the managerial process of;
• Developing a strategic vision,
• Setting objectives,
• Crafting a strategy,
• Implementing the strategy,
• Evaluating the strategy and
• Initiating corrective adjustments where deemed appropriate.
Hence, strategic management is not a bundle of tricks and magic.
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Concept 4: Strategic Management:
Introduction;
In a hyper competitive marketplace, companies can operate successfully by creating

and delivering superior value to target customers and also learning how to adapt to a
continuously changing business environment. So, to meet changing conditions in their
industries, companies need to be farsighted and visionary, and must develop long-
term strategies. Strategic planning, an important component of strategic management,
involves developing a strategy to meet competition and ensure long-term survival and
growth of the company.
Definition of Strategic Management;
“The art and science of formulating, implementing and evaluating cross-functional decisions
that enable an organization to achieve its objectives.”
4.1 The overall objectives of strategic management are twofold;
i. To create competitive advantage;
So that the company can outperform the competitors in order to have dominance
over the market.
ii. To guide the company successfully through all changes in the environment.
To put the concept in a few words, the term ‘strategic management’ refers to the
managerial process of developing a strategic vision, setting objectives, crafting a
strategy, implementing and evaluating the strategy, and finally initiating corrective
adjustments where deemed appropriate. The process does not end, it keeps going on
in a cyclic manner.
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4.2 Importance (Benefits) of Strategic Management;
Introduction;
Formulation of strategies and their implementation have become essential for all
organizations for their survival and growth in the present turbulent business environment.
‘Survival of fittest ‘as promoted by Charles Darwin is the only principle of survival for
organization, where ‘fittest’ are not the ‘largest’ or ‘strongest’ organizations but those who
can change and adapt successfully to the changes in business environment.
Many business giants have followed the path of extinction failing to manage drastic changes in
the business environment. For E.g., Bajaj Scooters, LML Scooters, Murphy Radio, BPL Television,
Nokia, kodak and so on. Thus, it becomes essential to study Business Strategy.
The major benefits of strategic management are:

• Direction to the company:
The strategic management gives a direction to the company to move ahead. It defines
the goals and mission. It helps management to define realistic objectives and goals which
are in line with the vision of the company.
• Proactive instead of Reactive:
Strategic management helps organisations to be proactive instead of reactive in

shaping its future. Organisations are able to analyse and take actions instead of
being mere spectators. Thereby they are able to control their own destiny in a better
manner. It helps them in working within unpredictable environment and shaping it,
instead of getting carried away by its turbulence or uncertainties.
• Framework for all major decisions:
Strategic management provides framework for all major decisions of an enterprise such
as decisions on businesses, products, markets, manufacturing facilities, investments
and organisational structure. In other words, it provides better guidance to entire
organisation on the crucial point - what it is trying to do.
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• Futuristic:
Strategic management seeks (i.e., attempt) to prepare the organisation to face the
future and act as pathfinder to various business opportunities. Organisations are able
to identify the available opportunities and identify ways and means to reach them.
• Corporate Defence Mechanism:
Strategic management serves as a corporate defence mechanism against mistakes and

pitfalls. It helps organisations to avoid costly mistakes in product market choices or
investments.
• Enhance Longevity:
Strategic management helps to enhance the longevity (i.e., durability) of the business.
With the state of competition and dynamic environment it may not be possible for
organisations to survive in long run. It helps the organization to take a clear stand
in the related industry and makes sure that it is not just surviving on luck.
• Developing Core Competence and Competitive Advantage:
Strategic management helps the organisation to develop certain core competencies

and competitive advantages that would facilitate assist in its fight for survival and
growth.
4.3 Limitations (Drawbacks) of Strategic Management;
Introduction;
The presence of strategic management cannot counter all hindrances and always achieve
success. There are limitations attached to strategic management. These can be explained
in the following lines.
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• Strategic management is a costly process;
Strategic management adds a lot of expenses to an organization. Expert strategic

planners need to be engaged, efforts are made for analysis of external and internal
environments devise strategies and properly implement.
These can be really costly for organisations with limited resources particularly when
small and medium organisation create strategies to compete. Strategic Management
requires experts and these experts are costly resources. Thus, the process as a whole
required good amount of funds to be spent
• Strategic management is a time-consuming process;
Organisations spend a lot of time in preparing, communicating the strategies that may
impede daily operations and negatively impact the routine business.
• Environment is highly complex and turbulent (i.e., unstable);
It is difficult to understand the complex environment and exactly pinpoint how it will
shape-up in future. The organisational estimate about its future shape may awfully
(i.e., inadequately go wrong) and jeopardise (i.e., causing harm to) all strategic plans.
The environment affects as the organisation has to deal with suppliers, customers,
governments and other external factors. Thus, relying on a business strategy blindly
could go absolutely wrong if the environment is turbulent.
• In a competitive scenario;
In a competitive scenario, where all organisations are trying to move strategically, it

is difficult to clearly estimate the competitive responses to a firm’s strategies.
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Concept 5: Strategic levels in Organisations:
Introduction;
A typical large organization is a multi-divisional organisation that competes in several

different businesses. It has separate self-contained divisions to manage each of these.
For example, Patanjali has healthcare, FMCG, Organic Foods, Medicinal Oils and Herbs,
and various different businesses. It has separate divisions which work within themselves
to sustain each of these businesses.
General managers are found at the first two of these levels, but their strategic roles differ
depending on their sphere of responsibility.
5.1 Corporate level of management consists of;
1. The Chief Executive Officer (CEO),

2. Other Senior Executives,
3. The Board of Directors (BOD) and
4. Corporate Staff.
Those individuals are mainly strategic decision-making authority of the organisation.
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Q. What tasks are performed by a strategic Manager? Or, The role of corporate level
management includes.
Answer: The primary task of the strategic manager is conceptualising, designing and
executing company strategy. For this purpose, his tasks include;
• To oversee the development of strategies for the whole organization.
• To set corporate vision, mission and goals,
• Determining what business, it should be in,
• Allocation of resources,
• Formulating strategies and implementing strategies that span (i.e., to cover or to

reach) individual businesses,
• Providing leadership for the organization as a whole, etc...
5.2 Distinction between strategic levels of the organisation;
i. Corporate Level;
Consist of?
Chief executive officer and other top-level executives. These individuals participate
in strategic decision making within the organization.
Role’s;
The role of corporate-level managers is to oversee the development of strategies for

the whole organization.
This role includes defining the mission and goals of the organization, determining
what businesses it should be in, allocating resources among the different businesses,
formulating and implementing strategies that span (i.e., cover or to reach) individual
businesses, and providing leadership for the organization as a whole.
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ii. Business Level;

Consist of?
General Manager or Divisional Manager and Staff.
Role’s;
To translate the general statements (i.e., general strategies) into concrete strategies
of their individual businesses.
The strategic role of business-level manager, head of the division, is to translate

the general statements of direction and intent that come from the corporate level
into concrete strategies for individual businesses. Such divisions are called Strategic
Business Units (SBUs).
In other words, The development of strategies for individual business areas. To

support corporate strategy.
iii. Functional Level;

Consist of?
Functional Manager’s like, Finance Manager’s, HR Manager’s, etc...
Role’s;
Responsible for the specific business functions or operations such as human resources,
purchasing, product development, customer service, and so on.
To develop functional strategies in their area that help fulfil the strategic objectives
set by business and corporate level general managers. Functional managers provide
most of the information to formulate realistic and attainable strategies.
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Concept 6: Strategic Management in Government and Non-Profit Organisations:
Introduction;
Organizations can be classified as commercial and non-commercial on the basis of the

interest (i.e., object) they have. A commercial organization has profit as its main aim. We
can find many organizations around us, which do not have any commercial objective of
making profits. Their formation may be for social, charitable, or educational purposes.
For E.g., ICAI, NGO’s such as Help-Age, Child Relief and You.

Their main aim is to provide services to members, beneficiaries or public at large. A
non-commercial organization comes to existence to meet the needs not met by business
enterprises. These organizations may not have owners in true sense.
The strategic management process is being used effectively by countless non-profit

governmental organizations. Many non-profit and governmental organizations
outperform (meaning it perform better than) private firms and corporations on innovation,
motivation, productivity, and human relations.
Compared to for-profit firms, non-profit and governmental organizations often function

as a monopoly, produce a product or service that offers little or no measurability of
performance, and are totally dependent on outside financing. They thus face a challenge
in getting the right amount of funds to keep functioning because the profits are not the
motive. Especially for these organizations, strategic management provides an excellent
vehicle for developing and justifying requests for financial support.
6.1 Educational Institutions;
Education is considered to be a noble profession. An educational institution often functions

as a not-for-profit organization managed by trusts and societies. They include schools,
colleges and universities.
Being inherently non-commercial in nature, educational organisations do not have cut-

throat competition as in case of their commercial counterparts.
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However, as the number of institutions belonging to both public and private sector are
increasing, the competition is gradually rising. Educational institutions are using strategic
management techniques and concepts more frequently.
The educational delivery system has also undergone considerable changes with the
introduction of computers and internet technologies. The first all-Internet law school,
Concord University School of Law, boasts nearly two hundred students who can access
lectures anytime and chat at fixed times with professors. Online college degrees are
becoming common and represent a threat to traditional Colleges and universities. For E.g.,
Distance learning.
Through the use of strategic management techniques such institutions are expected to
concentrate attention towards:
• Getting better name and recognition.
• Attracting talented students.
• Designing the curriculum in such a way to provide better citizen and ensure
employability.
• Appointing and retaining quality faculty for teaching.
• Preparing students for the future challenges by capacity building. etc...
6.2 Medical Institutions;
Modern hospitals are creating new strategies today as advances in the diagnosis and treatment
of chronic diseases are undercutting that earlier mission. Hospitals are beginning to bring
services to the patient as much as bringing the patient to the hospital. Pathological
laboratories have started collecting door-to-door samples.
Chronic care will require day–treatment facilities, electronic monitoring at home, user-
friendly ambulatory services, decentralized service networks, and laboratory testing.
A successful hospital strategy for the future will require renewed and deepened
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collaboration with physicians. who are central to hospitals’ well-being and a reallocation
of resources from acute to chronic care in home and community settings.
Backward integration strategies that some hospitals are pursuing include acquiring ambulance
services, waste disposal services, and diagnostic services.
The whole strategic landscape (i.e., environment) of healthcare is changing because of

the Internet. Millions of persons research medical ailments (i.e., disease) online, which is
causing a dramatic shift in the balance of power between doctor, patient, and hospitals.
Intel recently began offering a new secure medical service whereby doctors and patients can
conduct sensitive business on the Internet such as sharing results of medical tests and
prescribing medicine.
 The most successful hospital strategies today are:
• Providing free-standing outpatient surgery centres,

• Outpatient surgery and diagnostic centres,
• Physical rehabilitation centres,
• Home health services,
• Cardiac rehabilitation centres,
• Industrial medicine services,
• Women's medicine services,
• Skilled nursing units,
• Psychiatric services, etc...
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6.3 Governmental agencies and departments;
Central, State, Municipal Agencies, Public Sector Units, departments are responsible for
formulating, implementing, and evaluating strategies that use taxpayers’ money in the
most cost-effective way to provide services and programs.
Strategic-management concepts increasingly are being used to enable some organizations

to be more effective and efficient.
Strategists in governmental organizations operate with less strategic autonomy (mean less
flexibility) than their counterparts in private firms. Public enterprises generally cannot
diversify into unrelated businesses or merge with other firms.
Governmental strategists usually enjoy little freedom in altering the organizations’ missions
or redirecting objectives. Legislators and politicians often have direct or indirect control
over major decisions and resources. Issues become politicized, resulting in fewer (i.e., less)
strategic choice alternatives.
But in government agencies and departments are finding that their employees get excited
about the opportunity to participate in the strategic-management process and thereby
have an effect on the organization’s mission, objectives, strategies, and policies.
In addition, government agencies are using a strategic management approach to develop

and substantiate formal requests for additional funding. For E.g., PM Care Fund.
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Question Bank
Q. 1 Enumerate business policy.

Ans. Refer page Concept

Q. 2 “Strategy is partly proactive and partly reactive.” Discuss.


Q. 3 What is strategy? and explain its features (characteristics).


Q. 4 Strategic management is a bundle of tricks and magic? Comment.


Q. 5 Define Strategic management and objectives of strategic management?


Q. 6 What is Strategic Management? What benefits accrue by following a strategic
approach to managing?


Q. 7 Are there any limitations attached to strategic management in organizations?
Discuss.
or
Define Strategic Management. Also discuss the limitations of Strategic Management.
or
“Strategic Management is not a panacea for all the corporate ills, it has its own
pitfalls which can’t counter all hindrances and always achieve success.
Do you agree with this statement?
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Q. 8 What tasks are performed by a strategic Manager?


Q. 9 Explain the difference between three levels of strategy formulation.


Q.10 “Strategic Management concepts are useful for educational institution.” Explain with
reasons.


Q.11 How concept of strategic management is useful in medical organizations? List
successful hospital strategies for today.


Q.12 How concept of strategic management is useful in governmental agencies and
department?


Q.13 How concept of strategic management is useful in Government and medical
organizations? Discuss.


Q.14 Non-Profit organisation do not require strategic management?


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Q.15 Acquiring of ambulance services by a hospital is an example of forward integration

strategy? Do you agree?

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Dynamics of Competitive
Strategy
Concept 1: Competitive Strategy:
Strategy is formed and developed by organisational managers for achieving basic objectives
of management i.e., survival, stability, efficiency, growth, profitability and prosperity. But
along with above mentioned business objectives one of the most important objectives of
framing strategies is to fight competition.
In simple words, strategies formed for fighting and sustaining external competition is known
as Competitive strategies.
Competitive strategy of a firm evolves out of consideration of several factors that are external
to it. The external environment affects the internal environment of the firm.
A continuous change in this environment provides new opportunities and creates new
challenges in terms of threats for the organisation.
The objectives of a competitive strategy are;

• Generate competitive advantage,
• Increase market share, and
• Beat competition.
A competitive strategy consists of moves (steps) to…

 Attract customers.
 Withstand competitive pressures.
 Strengthen market position.
Having a competitive advantage is necessary for a firm to compete in the market. Competitive
advantage comes from a firm’s ability to perform activities more effectively than its rivals. But
what is more important is whether the competitive advantage is sustainable? By knowing if it
is a leader, challenger, or follower, it can adopt appropriate competitive strategy.
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Concept 2: Competitive Landscape:
Introduction;
Competitive landscape is a business analysis which identifies competitors, either direct or indirect.
Competitive landscape is about identifying and understanding the competitors and at the same
time, it permits the comprehension (i.e., knowledge) of their vision, mission, core values,
niche market, strengths and weaknesses.
Understanding of competitive landscape requires an application of “competitive intelligence”.
An in-depth investigation and analysis of a firm’s competition allows it to assess the

competitor’s strengths and weaknesses in the marketplace and helps it to choose and
implement effective strategies that will improve its competitive advantage. Competitive
advantage comes from a firm’s ability to perform activities more effectively than its rivals.
Thus, understanding the competitive landscape is important to build upon a competitive

advantage.

Steps to understand the Competitive Landscape;
1. Identify the competitor,

2. Understand the competitors,
3. Determine the strengths of the competitors,
4. Determine the weaknesses of the competitors,
5. Put all of the information together.
1. Identify the competitor:
The first step to understand the competitive landscape is to identify the competitors
in the firm’s industry and have actual data about their respective market share.

This answers the question:
• Who are the competitors?
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2. Understand the competitors:
Once the competitors have been identified, the strategist can use market research
report, internet, newspapers, social media, industry reports, and various other
sources to understand the products and services offered by them in different markets.
• What are their product and services?
3. Determine the strengths of the competitors:
What is the strength of the competitors? What do they do well? Do they offer great
products? Do they utilize marketing in a way that comparatively reaches out to more
consumers? Why do customers give them their business?
This answers the questions:
• What are their financial positions?

• What gives them cost and price advantage?
• What are they likely to do next?
• How strong is their distribution network?
• What are their human resource strengths?
4. Determine the weaknesses of the competitors:
Weaknesses can be identified by going through consumer reports and reviews

appearing in various media. After all, consumers are often willing to give their
opinions, especially when the products or services are either great or very poor.
• Where are they lacking?
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5. Put all of the information together:
At this stage, the strategist should put together all information about competitors
and draw inference (i.e., conclusion) about what they are not offering and what the
firm can do to fill in the gaps. The strategist can also know the areas which need to
be strengthen by the firm.
This answers the questions:
• What will the business do with this information?

• What improvements does the firm need to make?
• How can the firm exploit the weaknesses of competitors?
Concept 3: Strategic Analysis:
Introduction;
Understanding the business environment before starting the business is known as

strategic analysis. Strategic analysis is conscious efforts made by the business managers in
understanding the internal factors (S & W) and external forces (O & T) which are related to the
business organization.
All business managers should perform situational analysis before they start planning for
the organization.
Strategy formulation is not a task in which managers can get by with intuition, opinions,
instincts, and creative thinking. But it is a judgment about what strategies to pursue need
to flow directly from analysis of;
• A firm’s external environment,

• Its internal resources, and
• Capabilities.
The two most important situational considerations (factors) are:
i. Industry and Competitive Conditions, and
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ii. An organisation’s own competitive capabilities, resources, internal strengths,

weaknesses, and market position.
For developing sound and meaningful long-term strategy strategist must perform
strategic appraisal of the external and internal situation, to evaluation of alternatives,
to the choice of strategy.
Efforts made in formulation of strategies without perceptive analysis of businesses factors

and forces will increase the chance of developing faulty strategy which will decrease the
chance of improving the performance of the organization, will lead to little prospect of
developing competitive advantage and unachieved vision, mission and objectives and
goals.
Issues (limitations) to consider for Strategic Analysis:
a. Strategy evolves over a period of time;
Development of strategy requires detailed analysis of all the aspects of internal and
external factors and forces. This is time consuming process.
An important aspect of strategic analyses is to consider the possible implications of

routine decisions.
Strategy of a firm, at a particular point of time, is result of a series of small decisions

taken over an extended period of time.
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b. Balance of external and internal factors;
The process of strategy formulation is often described as one of the matching the
internal potential of the organization with the environmental opportunities.
In reality, as perfect match between the two may not be feasible. There are constraints
that limit the choice such as existence of a big competitor.
c. Risk;
Competitive markets, liberalization, globalization, booms, recessions, technological

advancements, inter-country relationships all affect businesses and pose risk at
varying degree.
In strategic analysis, the principle of maintaining balance is important. However, the

complexity and intermingling (i.e., inter mix) of variables in the environment reduces
the strategic balance in the organisation.
An important aspect of strategic analysis is to identify potential imbalances or risks

and assess their consequences.
External risk is on account of inconsistencies between strategies and the forces in the
environment.
Internal risk occurs on account of forces that are either within the organization or are
directly interacting with the organization on a routine basis.
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3.1 Types of Risk;

Time
Short Term Long Term
An error in Changes in the
External
interpreting the environment lead to
Strategic Risks
environment, causes obsolescence of strategy.

strategic failure.
Organizational Inconsistencies with the

Internal
capacity is unable to strategy are developed

cope up with strategic on account of changes
demands. in internal capacities &
preferences.
3.2 Framework of Strategic Analysis;
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Concept 4: Methods of Industry and Competitive Analysis:
What is Industry?
Industry is “a group of firms whose products have same and similar attributes such that
they compete for the same buyers.”
For E.g., Telecom Industry.
Introduction;
Industry and competitive analysis can be done using a set of concepts and techniques to
get a clear picture on;
• Key Industry Traits,
• The intensity of competition,
• The drivers of industry change,
• The market positions and strategies of rival companies,
• Competitive success, and
• Profit (i.e., Financial) prospects.
It provides a way of thinking strategically about any industry’s overall situation and
drawing conclusions about whether the industry represents an attractive investment for
organisational funds.
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The analysis involves examining business in the context of a wider environment. Industry
and competitive analysis aim at developing understanding to several issues.
Analysing these issues build understanding of a firm’s surrounding environment and,

collectively, form the basis for matching its strategy to changing industry conditions and
competitive realities.
4.1 Dominant Economic Features of the Industry; (Key Industry Traits)
Introduction;
Industries differ significantly in their basic character and structure. Industry and competitive
analysis begin with an overview of the industry’s dominant economic features.
Industry is “a group of firms whose products have same and similar attributes such that
they compete for the same buyers.”
The factors to be considered in summarising an industry’s economic features are fairly

standard and are given as follows:
• Size and nature of market.
• The number of buyers and their relative sizes.
• Number of rivals and their relative market share.
• Market growth rate and position in the business life. (Such as, early development,
rapid growth and take-off, early maturity, saturation and stagnation, decline).
• Scope of competitive rivalry. (i.e., local, regional, national, international, or global).
• The types of distribution channels used to access consumers.
• The pace of technological change in both production process innovation and new
product introductions.
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• Whether the products and services of rival firms are highly differentiated, weakly
differentiated, or essentially identical?
• Whether organisation can realize economies of scale in purchasing, manufacturing,

transportation, marketing, or advertising?
• Whether key industry participants are assembled in a particular location?
For E.g., Lock industry in Aligarh, Saris and diamonds in Surat, information technology
in Bangalore, etc...
• Whether certain industry activities are characterized by strong learning and experience
effects (“learning by doing”) such that unit costs decline as cumulative output grows?
• Whether high rates of capacity utilization are crucial to achieving low-cost production efficiency?
• Capital requirements and the ease of entry and exit.
• Whether industry profitability is above or below par?
Conclusion;
All of these considerations from economic perspective, help the management to decide on
various factors of strategy like viability of their product, location of production, consumer
preferences, cost of production, beneficial government support, etc...
4.2 Nature and Strength of Competition;
Introduction;
An important component of industry and competitive analysis involves study of the

industry’s competitive process to discover what the main sources of competitive pressure are
and how strong each competitive force is?
This analytical step is essential because managers cannot frame a successful strategy
without in-depth understanding of the industry’s competitive character.
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Even though competitive pressures in various industries are never precisely the same, the
competitive process works similarly enough to use a common analytical framework in
gauging the nature and intensity of competitive forces.
Porter’s five (5) forces model is useful in understanding the competition. It is a powerful tool
for systematically diagnosing the main competitive pressures in a market and assessing how
strong and important each one is. Not only is it the widely used technique of competition
analysis, but it is also relatively easy to understand and apply.
4.3 Triggers of Change; (Driving Forces)
Introduction;
Triggers of change;
All industries are characterized by trends and new developments that gradually produce
changes important enough to require a strategic response from participating firms. Like
desktop computers slowly got beaten by portable laptops
These changes force strategist to change their business plan to adjust to the changes in the
business environment. This change either individual or group is understood as triggers of
change.
The life-cycle stages are strongly linked to changes in the overall industry growth rate.
For E.g., Introduction of Smart TV or Android TV.
All triggers sometimes are not powerful enough but those which powerful are known as
Drivers to change.
Driving Forces;
Industry and competitive conditions change because forces are in motion that creates
incentives or pressures for changes. The most dominant forces are called driving forces
because they have the biggest influence what kinds of changes will take place in the industry’s
structure and competitive environment.
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Most common driving forces;
Many events can affect an industry powerfully enough to qualify as driving forces. Some
are unique and specific to a particular industry situation, but many drivers of change fall into
general category affecting different industries simultaneously. Some of the examples of
general drivers are follows:
• Increasing globalization, more FDI and global competition.
• Product innovation.
• Changes in cost and efficiency, due to technology and consumer behaviour.
• Changes in the long-term industry growth rate, slowing GDP.
• Marketing innovation, Digital marketing.
• Entry or exit of major firms, should be watched closely.
• The internet and e-commerce opportunities and threats it reproduces in the industry.
Analysing driving forces has two steps:
i. Identifying what the driving forces are? and
ii. Assessing the impact, they will have on the industry.

(Can creates an opportunity or introduce threats).
4.4 Identifying the Strongest–Weakest Companies; (Strategic Group Mapping)
Introduction;
The next step in examining the industry’s competitive structure is to study the market
positions of rival companies. Identifying the strongest and weakest companies help
understand what techniques can be implemented and which ones are to be avoided.
One technique for revealing the competitive positions of industry participants is strategic
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group mapping, which is useful analytical tool for comparing the market positions of each
firm separately or for grouping them into like positions when an industry has so many
competitors that it is not practical to examine each one in-depth.
For example, Smart Phone industry has numerous options to select from. Thus, grouping
them into categories based on various parameters can be really insightful and time saving
A strategic group consists of those rival firms which have similar competitive approaches
and positions in the market.
Companies in the same strategic group can resemble one another in any of the several ways:
• They may have comparable product-line breadth,

• Sell in the same price or quality range,
• Emphasize the same distribution channels,
• Depend on identical technological approaches,
• Use essentially the same product attributes to appeal to similar types of buyers, or
• Offer buyers similar services and technical assistance.
An industry may contain only one strategic group when all sellers pursue essentially
identical strategies and have comparable market positions. At the other extreme, there are
as many strategic groups as there are competitors when each rival pursues a distinctively
different competitive approach and occupies a substantially different competitive position
in the marketplace.
The procedure for constructing a Strategic Group Mapping;
1. Identify the competitive characteristics that differentiate firms in the industry.
Typical variables are (mean competitive characteristics can be based on)

• price or/and quality range (high, medium, low),
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• geographic coverage (local, regional, national, global),

• degree of vertical integration (none, partial, full),
• product-line breadth (wide, narrow),
• use of distribution channels (one, some, all), and
• degree of service offered (no-frills, limited, full).
2. Plot the firms on a two-variable map using pairs of these differentiating

characteristics.
3. Assign firms that fall in about the same strategy space to the same strategic group.
4. Draw circles around each strategic group, making the circles proportional to the size
of the group’s respective share of total industry sales revenues.
4.5 Likely Strategic Moves of Rivals;
Introduction;
Unless a business organisation pays attention to what competitors are doing, it ends up flying
blind into competitive battle. A company can’t expect to bypass its rivals without monitoring
their actions, understanding their strategies, and anticipating what moves they are likely
to make next.
Competitive intelligence about the strategies rivals are deploying, their latest moves, their
resource strengths and weaknesses, and the plans they have announced is essential to
anticipating the actions they are likely to take next and what bearing i.e., impact their moves
might have on a company’s own best strategic moves.
Competitive intelligence can help a company determine whether it needs to defend against
specific moves taken by rivals or whether those moves provide an opening for a new
offensive force.
This analysis should be on regular basis as competitors react to changes way quicker than
a business can imagine. Dedicated review of competitors actions gives unmatched
advantage to any business.
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4.6 Key Success Factors; (KSF’s)
Introduction;
These are the key elements that affect the ability of a firm or industry to prosper in the
market. KSFs are those things that most affect industry members’ ability to prosper in the
marketplace between competitive success or failure.
For E.g., JIO Cost efficient i.e., Economical for customers is a KSF’s in telecom industry at
present.
Some of the successful key factors are;
• Core competitions,
• Business outcome (Result),
• Competitive capabilities,
• Internal & External recourses,
• Strategy in production, marketing, etc...
KSFs by their very nature are so important that all firms in the industry must pay close
attention to them. They are the prerequisites for industry success and they form (i.e., create)
the rule that figure whether a company will be financially or competitively successful.
Misdiagnosing the industry factors critical to long-term competitive success greatly raises
the risk of a misdirected strategy. In contrast, an organisation with perceptive understanding
of industry KSFs can gain sustainable competitive advantage by training its strategy on
industry KSFs and devoting its energies to being distinctively better than rivals on one or
more of these factors. Indeed, business organisations that stand out on a particular KSF
enjoy a stronger market position for their, efforts-being distinctively better than rivals on one
or more key success factors presents a golden opportunity for gaining competitive advantage.
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How to find out or identify the KSF’s of an industry?
1. On what basis do customer select between the competing brands of sellers? What
product attributes are crucial? Such as quality, durability, etc...
2. What competitive capabilities does a seller need to have to be competitively successful,

better human capital, quality of product or quantity of product, cost of service,
etc...?
3. What does it take for seller to achieve a sustainable competitive advantage, something
that can be sustained for long term?
For E.g., in apparel i.e., outfit manufacturing, the KSFs are;
• Appealing designs and colour combinations (to create buyer interest)

and
• Low-cost manufacturing efficiency (to permit attractive retail pricing and ample profit
margins).

Conclusion;
Key success factors vary from industry to industry and even from time to time within the
same industry as driving forces and competitive conditions change.
The purpose of identifying KSFs is to make judgments about what things are more important
to competitive success and what things are less important.
4.7 Prospects and Financial Attractiveness of Industry;
Introduction;
The final step of industry and competitive analysis is to use the results of analysis of previous
six issues to draw conclusions about the relative attractiveness or unattractiveness of the
industry, both near-term and long-term.
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Company strategists are obligated to assess the industry outlook carefully, deciding whether
industry and competitive conditions present an attractive business opportunity for the
organisation or not.
The important factors on which to base such conclusions include:
• The industry’s growth potential, is it futuristically viable?
• Whether competition currently permits adequate profitability and whether competitive

forces will become stronger or weaker?
• Whether industry profitability will be favourably or unfavourably affected by the

prevailing driving forces?
• The competitive position of an organisation in the industry and whether its position is
likely to grow stronger or weaker.
• Whether the company is able to defend against or counteract the factors that make the
industry unattractive?
• The degrees of risk and uncertainty in the industry’s future.
• Whether continued participation in this industry adds importantly to the firm’s ability
to be successful in other industries in which it may have business interests?
As a general proposition, if an industry’s overall profit prospects are above average,

the industry can be considered attractive; if its profit prospects are below average, it is
unattractive.
However, it is a mistake to think of industries as being attractive or unattractive to all

firms in the industry and all potential entrants.
Attractiveness is relative, not absolute. Industry environments unattractive to weak

competitors may be attractive to strong competitors.
If the industry and competitive situation is judged relatively unattractive, more successful
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industry participants may choose to invest cautiously, look for ways to protect their long-
term competitiveness and profitability, and perhaps acquire smaller firms if the price is right;
over the longer term, strong companies may consider diversification into more attractive
businesses.
Weak companies in unattractive industries may consider merging with a rival to increase
market share and profitability or, alternatively, begin looking outside the industry for
attractive diversification opportunities.
Concept 5: Core Competence:

Introduction;
Core competencies are capabilities that serve as a source of competitive advantage for a
firm over its rivals.
An organization’s combination of technological and managerial know-how, wisdom and

experience are a complex set of capabilities and resources that can lead to a competitive
advantage compared to a competitor.
C.K. Prahalad and Gary Hamel have advocated a concept of core competency, which is a
widely-used concept in management theories.
Competency is defined as a;
“Combination of skills and techniques rather than individual skill or separate technique.”
Core Competency is defined as a;
“The collective learning in the organization, especially coordinating diverse production

skills and integrating multiple streams of technologies.”
For core competencies, it is characteristic to have a combination of skills and techniques,

which makes the whole organization utilize these several separate individual capabilities.
The optimal way to define core competence is to consider it as sum of 5 – 15 areas of

developed expertise.
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Therefore, core competencies cannot be built on one capability or single technological knowhow,
instead, it has to be the integration of many resources.
5.1 According to C.K. Prahalad and Gary Hamel, Major core competencies are identified in
three (3) areas;
i. Competitor differentiation,
ii. Customer value, and
iii. Application to other markets (i.e., Application of competencies within the

organisation).
i. Competitor Differentiation,
The company can consider having a core competence if the competence is unique and it
is difficult for competitors to imitate (i.e., Copy or Follow). This can provide a company
an edge (i.e., advantage) compared to competitors. It allows the company to provide
better products or services to market with no fear that competitors can copy it.
The company has to keep on improving these skills in order to sustain its competitive
position. Companies operating in the same market would have the equal skills and
resources, if one company can perform this significantly better; the company has
obtained a core competence.

ii. Customer Value,
When purchasing a product or service it has to deliver a fundamental benefit for the end
customer in order to be a core competence. It will include all the skills needed to
provide fundamental benefits. The service or the product must have real impact on the
customer as the reason to choose to purchase them.
iii. Application to other markets (i.e., Application of competencies within the organisation).
Core competence must be applicable to the whole organization; it cannot be only one
particular skill or specified area of expertise.
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Therefore, although some special capability would be essential or crucial for the
success of business activity, it will not be considered as core competence, if it is not
fundamental from the whole organization’s point of view.
Thus, a core competence is a unique set of skills and expertise, which will be used
throughout the organisation to open up potential markets to be exploited.
Examples
Hindustan Unilever Limited (HUL)
Marketing and Sales is a core competence.

Wal-Mart
Focused on lowering its operating costs.

Conclusion;
If the three above-mentioned conditions are achieved, then the company can regard it
competence as core competency.
Core competencies are the knowledge, skills, and facilities necessary to design and produce
core products. Core competencies are created by superior integration of technological, physical
and human resources. They represent distinctive skills as well as intangible, invisible,
intellectual assets and cultural capabilities.
Core Competence-based diversification reduces risk and investment and increases the
opportunities for transferring learning and best practice across business units.
5.2 Why to identify and develop a core competency? (Core competency fulfils three criteria);
Introduction;
Core competencies distinguish a company competitively and reflect its personality. These
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competencies emerge over time through an organizational process of accumulating and

learning how to deploy different resources and capabilities.
It is important to identify core competencies because it is difficult to retain those competencies

in a price war and cost-cutting environment.
Failing to identify core competencies is a kind of opportunity loss for a company. That
failure is due to the inability of management to conceive of a company as other than a mere
collection of discrete businesses. A Core competency fulfils three criteria:
i. It should provide potential access to a wide variety of markets.
ii. It should make a significant contribution to the perceived (i.e., to see) customer benefits
of the end product.
iii. It should be difficult to imitate for competitors i.e., rivals.
For E.g., *Note; Only for understanding purpose.

Small retail shops Big retail stores Supermarkets
Core Competencies
Extended working Securing supplies at lower Locational advantage,

hours, Easy credit, cost, In-house activity Quality assurance,
as to;
Free home deliveries, management, Computerized Customer ease in

Amicable style of the stock ordering, Computerized shopping, Etc...
owner, Etc... billing systems, Own brand
labels, Etc...
5.3 How to build Core Competencies?
Introduction;
Four specific criteria of sustainable competitive advantage that firms can use to determine
those capabilities that are core competencies. Capabilities that are;
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i. Valuable,
ii. Rare,
iii. Costly to Imitate (i.e., copy or follow), and
iv. Non – Substitutable
i. Valuable,
Valuable capabilities are the ones that allow the firm to exploit opportunities or
avert i.e., prevent the threats in its external environment. A firm created value for
customers by effectively using capabilities to exploit opportunities.
For E.g., Finance companies build a valuable competence in financial services. In

addition, to make such competencies as financial services highly successful require
placing the right people in the right jobs. Human capital is important in creating
value for customers.
ii. Rare,
Core competencies are very rare capabilities and very few of the competitors possess
this.
Capabilities possessed by many rivals are unlikely to be sources of competitive advantage

for any one of them. Competitive advantage results only when firms develop and exploit
valuable capabilities that differ from those shared with competitors.
iii. Costly to imitate (copy or follow),
Costly to imitate means such capabilities that competing firms are unable to develop
easily.
For E.g., intel has enjoyed a first mover advantage more than once because of its rare
fast R&D cycle time capability that brought SRAM (Static Random-Access Memory)
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and DRAM (Dynamic Random-Access Memory) integrated circuit technology, and

brought microprocessors to market well ahead of the competitor. The product could
be imitated in due course of time, but it was much more difficult to imitate the R&D
cycle time capability.
iv. Non – Substitutable,
Capabilities that do not have strategic equivalents are called non-substitutable

capabilities.

This final criterion for a capability to be a source of competitive advantage is that
there must be no strategically equivalent valuable resources that are themselves
either not rare or imitable.
For E.g., Tata and Apple,
Firms tried to imitate Tata’s low-cost strategy but most have been unable to
duplicate Tata’s success. The culture and excellent human capital worked
together in implementing Tata’s strategy and are the basis for its competitive
advantage.
Competitors are deeply aware about Apple’s operating system’s (iOS) successful
model. However, to date, no competitor has been able to imitate Apple’s
capabilities. These are also protected through copyrights.
Conclusion;
To sum up, we can say that only when a capability is valuable, rare, costly to imitate,
and non-substitutable, it is a core competence and a source of competitive advantage.
Over a time, core competencies must be supported. Core competencies are a source
of competitive advantage only when they allow the firm to create value by exploiting
opportunities in its external environment.
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5.4 A core competence is identified by the following tests;
i. Leverage Test: Does it provide potential access to a wide variety of markets?
ii. Value Enhancement Test: Does it make a significant contribution to the perceived (i.e.,
to see) customer benefits of the end product?
iii. Imitability Test: can it be imitated? Does it reduce the threat of imitation by competitors?
5.5 Advantages of identifying core competencies;
• Provide competitive advantage,

• Ensure profits,
• Helps firm stretches into new opportunities,
• Help in maintaining progress, etc...
Conclusion;
Thus, a core competence is a unique set of skills and expertise, which will be used
throughout the organisation to open up potential markets to be exploited.
If the three above-mentioned conditions are met, then the company can regard it
competence as core competency.
It is important to identify core competencies because it is difficult to retain those

competencies in a price war and cost-cutting environment.
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Concept 6: Value Chain Analysis:
Introduction;
A value chain is a set of activities that a firm operating in a specific industry performs in
order to deliver a valuable product or service for the market.
Value chain analysis has been widely used as a means of describing the activities within and
around an organization, and relating them to an assessment of the competitive strength
of an organization. In other words, its ability to provide value-for-money products or
services.
Value chain analysis was originally introduced as an accounting analysis to shed light (i.e.,
to reveal information) on the ‘value added’ of separate steps in complex manufacturing
processes, in order to determine where cost improvements could be made, value creation
improved.
The two basic steps of identifying separate activities and assessing the value added from each
were linked to an analysis of an organization’s competitive advantage by Michael Porter.
One of the key aspects of value chain analysis is the recognition that organizations are
much more than a random collection of Man (people), Machines, Material, and Money.
These resources are of no value unless deployed into activities and organised into systems
and routines which ensure that products or services are produced which are valued by the
final consumer i.e., user.
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In other words, it is these competences to perform particular activities and the ability to
manage linkages between activities which are the source of competitive advantage for
organizations. Porter argued that an understanding of strategic capability must start with
an identification of these separate value activities.
The primary activities of the organization are grouped into five main areas:
• Inbound logistics; These are the activities concerned with receiving, storing and
distributing the inputs to the product/service. This includes materials handling,
warehousing, inventory control, transport etc...
• Operations; It comprise the transformation of the inputs into the final product form.
This includes production, machining, assembly, packaging, testing, etc...
• Outbound logistics; It involve the collecting, storing, and distributing the product to
the buyers.
For tangible products this would be processing of orders, warehousing of finished

goods, materials handling, transport, etc...
In the case of services, it may be more concerned with arrangements for bringing
customers to the service, if it is a fixed location, for example sports events.
• Marketing and sales; It deals with how buyers can be convinced to purchase the
product. Provides the means whereby users are made aware of the product or service
and are able to purchase it. This would include sales administration, advertising,
promotion, distribution, etc...
• Service; It involves how to maintain the value of the product or service after it is
purchased. Through installation, repair, maintenance, training, etc..
Each of these groups of primary activities are linked to support activities. These can be divided
into four areas:
• Procurement; It concerned with the tasks of purchasing inputs such as raw materials,
equipment, and even labour.
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• Technology Development; These activities are intended to improve the product (through
R&D in product design) and the process (through process development), or with a
particular resource (e.g., raw materials improvements).
• Human Resource Management; This is a particularly important area which to reach

all primary activities. It is concerned with those activities involved in recruiting,
managing, training, developing and rewarding people within the organization.
• Firm Infrastructure; The activities which are not specific to any activity area. The
systems of planning, finance, quality control, information management, etc…. are
crucially important to an organization’s performance in its primary activities.
Infrastructure also consists of the structures and routines of the organization which
sustain its culture.
6.1 Use of Value Chain Analysis for Identifying Core Competences:
Introduction;
Value chain analysis is useful in describing the separate activities which are necessary to support
an organization’s strategies and how they link together both inside and outside the organization.
Although a threshold competence in all of these activities is necessary to the organization’s

successful operation, it is important to identify those competences which critically support the
organization’s competitive advantage. These are known as the core competences and will
differ from one organization to another depending on how the company is positioned and
the strategies it is pursuing.
For E.g., Japanese manufacturers were developing competences in defect-free manufacture.

Which became critical success factors in allowing them to achieve global sales.
Value chain analysis is a reminder that the long-term competitive position of an organization
is concerned with its ability to sustain value for-money products or services, and it can be
helpful in identifying those activities which the organization must undertake at a threshold
level of competence and those which represent the core competences of the organization.
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Core competences may also be the basis on which the organization stretches into new
opportunities. So, in deciding which competences are core, this is another criterion which
should be used - the ability to exploit the competence in more than one market or arena.
However, in order to do this, it is necessary to identify the basis on which an organization

has gained competitive advantage and hence which are the core competences in sustaining
this advantage.
6.2 Managing linkages:
Introduction;
Core competences in separate activities may provide competitive advantage for an

organization, but nevertheless over time it may be imitated by competitors.
Core competences are likely to be stronger and more difficult to imitate if they relate to the
management of linkages within the organization’s value chain (i.e., internal linkages) and
linkages into the supply and distribution chains (i.e., external linkages).
It is the management of these linkages which provides ‘leverage’ and levels of performance
which are difficult to match by the competitors.
The ability to co-ordinate the activities of specialist teams or departments may create
competitive advantage through improving value for money in the product or service.
Specialization of roles and responsibilities is common in most organizations and is one
way in which high levels of competence in separate activities is achieved. However, it often
results in a set of activities which are incompatible - different departments pulling in
different directions - adding overall cost, diminishing value in the product or service.
This management of internal linkages in the value chain could create competitive advantage in
a number of ways:
• There may be important linkages between the primary activities.
For E.g., a decision to hold high levels of finished stock might ease production
scheduling problems and provide for a faster response time to the customer.
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• Linkages between different support activities may also be the basis of core competences.
For E.g., the extent to which human resource development is in tune with new
technologies has been a key feature in the implementation of new production and
office technologies.
• The management of the linkages between a primary activity and a support activity
may be the basis of a core competence.
For E.g., Computer-based systems provides better infrastructure to facilitate quick

sales and service especially in transport (Ola, Uber, etc...) & hotel (Oyo, Make My
Trip, etc...) business.
External Linkages;
In addition to the management of internal linkage, competitive advantage may also

be gained by the ability to co-ordinate the organization’s own activities with those of
suppliers, channels or customers i.e., external linkage.
Again, this could occur in a number of different ways:
• Vertical integration;
Firm attempts to improve performance through ownership of more parts of the value
system, making more linkages internal to the organization. However, the practical
difficulties and costs of coordinating a wider range of internal activities can outweigh
the theoretical benefits.
• Closely monitoring the suppliers;
Within manufacturing industry, the competence in closely specifying requirements

and controlling the performance of suppliers (sometimes linked to quality checking
and/or penalties for poor performance) can be critical to both quality enhancement
and cost reduction.
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• By applying concept of TQM;
A more recent philosophy has been total quality management, which seeks to
improve performance through closer working relationships between the specialists
within the value system. For example, many manufacturers will now involve their
suppliers and distributors at the design stage of a product or project.
Concept 7: Competitive Advantage:
Introduction;
Competitive advantage allows a firm to gain an edge over rivals when competing. ‘It is a set
of unique features of a company and its products that are perceived by the target market as
significant and superior to the competition.’
Companies, achieving superior performance relative to rivals is the ultimate challenge. If a

company’s strategies result in superior performance, it is said to have a competitive advantage.
“If you don’t have a competitive advantage, don’t compete”

- Jack Welch
Competitive advantages and the differences they create in the firm’s performance are
often strongly related to the resource’s firms hold and how they are managed.
Resources are the foundation for strategy and unique bundles of resources generate
competitive advantages leading to wealth creation.
Resources and capabilities are not inherently valuable, but they create value when the firm
can use them to perform certain activities that result in a competitive advantage.
7.1 Benefits of competitive advantage;
• Competitive advantage is the position of a firm to maintain and sustain a favourable

market position when compared to the competitors.
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• Competitive advantage is ability to offer buyers something different and thereby

providing more value for the money.
• It is achieved advantage over rivals when a company’s profitability is greater than

average profitability of firms in its industry. It is the result of a successful strategy.
• This position gets translated into higher market share, higher profits when compared to
those that are obtained by competitors operating in the same industry.
• Competitive advantage may also be in the form of low-cost relationship in the

industry or being unique in the industry along dimensions that are widely valued by
the customers in particular and the society at large.
All competitive advantages have a limited life. The question of duplication is not if it
will happen, but when the sustainability of competitive advantage and a firm’s ability
to earn profits from its competitive advantage depends upon four major characteristics
of resources and capabilities:
7.2 Competitive Advantage depends upon four (4) major characteristics of resources and
capabilities:
i. Durability: The period over which a competitive advantage is sustained depends in

part on the rate at which a firm’s resources and capabilities deteriorate (i.e., decline). For
example, in industries where the rate of product innovation is fast, product patents
are quite likely to become obsolete.
ii. Transferability: Even if the resources and capabilities on which a competitive advantage
is based are durable, it is likely to be eroded by competition from rivals.
The ability of rivals to attack position of competitive advantage relies on their gaining
access to the necessary resources and capabilities. The easier it is to transfer resources
and capabilities between companies, the less sustainable will be the competitive
advantage which is based on them.
iii. Imitability: If resources and capabilities cannot be purchased by a would-be imitator,

then they must be built from scratch. How easily and quickly can the competitors
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build the resources and capabilities on which a firm’s competitive advantage is

based? This is the true test of imitability.
For Example, in financial services, innovations lack legal protection and are easily
copied.
iv. Appropriability: It refers to the ability of the firm’s owners to appropriate the returns
on its resource base. Even where resources and capabilities are capable of offering
sustainable advantage, there is an issue as to who receives the returns on these
resources. This means, that rewards are directed to from where the funds were
invested, rather than creating an advantage with no actual reward to people to
invested capital.
Concept 8: What is Value Creation?
Introduction;
The concept of value creation was introduced primarily for providing products and services
to the customers with more worth.
Value is measured by a product’s, features, quality, availability, durability, performance, by

its services for which customers are willing to pay. Further, the concept took more space in the
business and organizations started discussing about the value creation for stakeholders.
Many businesses now focus on value creation both in the context of creating better value for
customers purchasing its products and services, as well as for stakeholders in the business
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who want to see their investment in business appreciate in value.
Ultimately, this concept gives business a competitive advantage in the industry and helps
them earn above average profits/returns.
Competitive advantage leads to superior profitability. At the most basic level, how
profitable a company becomes depends on three factors:
i. The value customers place on the company’s products;
ii. The price that a company charges for its products; and
iii. The costs of creating those products.
The value customers place on a product reflects the utility they get from a product the
happiness or satisfaction gained from consuming or owning the product.
Utility must be distinguished from price. Utility is something that customers get from a
product. It is a function of the attributes of the product, such as its performance, design,
quality, and point-of-sale and after-sale service.
Thus, we can say that the value creation is an activity or performance by the firm to
create value that increases the worth of goods, services, business processes or even the
whole business system.
Ultimately, this concept gives business a competitive advantage in the industry and helps
them earn above average profits or returns.
For E.g.,
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Concept 9: Portfolio Analysis:
Introduction;
In business terms, a portfolio is a group of businesses, brands, products, services offered

by an organisation.
In order to analyse the current business portfolio, the company must conduct portfolio
analysis (a tool by which management identifies and evaluates the various businesses
that make up the company).
In portfolio analysis top management views its product lines and business units as a series of
investments from which it expects returns. A business portfolio is a collection of businesses and
products that make up the company. The best business portfolio is the one that best fits the
company’s strengths and weaknesses to opportunities in the environment.
Portfolio analysis can be defined as a set of techniques that help strategists in taking strategic
decisions with regard to individual products or businesses in a firm’s portfolio.
It is primarily used for competitive analysis and corporate strategic planning in multi-product
and multi business firms. They may also be used in less-diversified firms, if these consist
of a main business and other minor complementary interests.
The main advantage in adopting a portfolio approach in a multi-product, multi-business

firm is that resources could be channelised at the corporate level to those businesses that
possess the greatest potential. For instance, a diversified company may decide to divert
resources from its cash-rich businesses to more prospective ones that hold promise of a
faster growth so that the company achieves its corporate level objectives efficiently.
In order to design the business portfolio, the management must;
• Analyse: It’s current business portfolio and decide which businesses should receive
more or less investment, and
• Develop Growth Strategies: For adding new products or businesses to the portfolio, whilst
at the same time deciding when products and businesses should no longer be retained.
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There are three (3) important concepts and the knowledge of which is a prerequisite to understand
different models of portfolio analysis:
• Strategic Business Unit,

• Experience Curve, and
• Product Life Cycle.
9.1 Strategic Business Unit (SBU):
Introduction;
Analysing portfolio may begin with identifying key businesses also termed as strategic
business unit (SBU). SBU is a unit of the company that has a separate mission and objectives
and which can be run independently from other company businesses.
The SBU can be;
• A company division,
• A product line within a division,
• Even a single product, or
• Brand.
SBUs are common in organisations that are located in multiple countries with independent
manufacturing and marketing setups.
Characteristics of SBU’s;
• SBU is a single business or collection of related businesses that can be planned for
separately,
• SBU has its own set of competitors. E.g., Realme, Vivo and Oppo.
• SBU has a manager who is responsible for strategic planning & profit.
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• SBU helps in comparisons between divisions.
• Improving the allocation of resources.
After identifying SBU’s, the management will assess their respective attractiveness and
decide how much support each SBU’s deserves. For example, Reliance Industries has
different SBUs for petroleum, Internet services, clothing, retail, etc. headed by different
individuals responsible for that line of business.
9.2 Experience Curve:
Introduction;

Experience curve is an important concept used for applying a
portfolio approach.
The concept is akin (similar) to a learning curve which explains

the efficiency increase gained by workers through repetitive
productive work.
Experience curve is based on the commonly observed phenomenon (i.e., situation) that
unit costs decline as a firm accumulates experience in terms of a cumulative volume of
production. It is based on the concept, “we learn as we grow”.
The implication (i.e., assumption) is that larger firms in an industry would tend to have lower
unit costs as compared to those for smaller companies, thereby gaining a competitive
cost advantage.
Experience curve results from a variety of factors such as learning effects, economies
of scale, product redesign and technological improvements in production. For example,
in the contemporary (i.e., present) Indian automobile industry, the experience curve
phenomenon (i.e., situation) seems to be working in Maruti Suzuki.
The concept of experience curve is relevant for a number of areas in strategic management.
• Considered a barrier for new firms,
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• Used to build market share,

• Discourage competition.
Experience Curve has following features:
• As business organisation grow, they gain experience.

• Experience may provide an advantage over the competition.
• Experience is a key barrier to entry.
• Large and successful organisation possess stronger “experience effect”.
9.3 Product Life Cycle: (PLC)
Introduction;
PLC indicate S-shaped curve. PLC, which exhibits (i.e., indicate) the relationship of sales with
respect to time for a product that passes through the four successive stages of product
life cycle.
The different stages in a product life cycle are:
 Introduction (Slow sales growth),

 Growth (Rapid market acceptance),
 Maturity (Slowdown in growth), and

 Decline (Sharp downward fall).
Product life cycle (PLC) has to do with the life of a product in the market with respect to
business/commercial costs and sales measures. PLC is a useful concept for guiding strategic
choice.
i. Introduction Stage;
At the introduction stage in which competition is almost negligible, prices are relatively
high and markets are limited. The growth in sales is at a lower rate because of lack of
knowledge on the part of customers.
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ii. Growth Stage;
The demand expands rapidly, prices fall, competition increases and market expands.
The customer has knowledge about the product and shows interest in purchasing it.
iii. Maturity Stage;
In this stage, the competition gets tough and market gets stabilised. Profit comes down
because of stiff competition. At this stage, organisations have to work for maintaining
stability.
iv. Decline Stage;
The sales and profits fall down sharply due to some new product replaces the existing
product. So, a combination of strategies can be implemented to stay in the market
either by diversification or retrenchment.
The main advantage of PLC:
• It can be used to diagnose a portfolio of products (or businesses).
• Particular attention is to be paid on the businesses that are in the declining stage.
• A combination of strategies can be implemented on various SBU’s.
Conclusion;
In this way, a balanced portfolio of businesses may be built up by exercising a strategic

choice based on the PLC concept.
9.4 Igor Ansoff’s Product Market Growth Matrix:
Introduction;
The Ansoff’s product market growth matrix (proposed by Igor Ansoff) is a useful tool that
helps businesses decide their product and market growth strategy. With the use of this
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matrix a business can get a fair idea about how its growth depends upon it markets (i.e.,
offers) in new or existing products in both new and existing markets.
Companies should always be looking to the future. One useful device for identifying growth
opportunities for the future is the product/market expansion grid. The product/market
growth matrix is a portfolio-planning tool for identifying growth opportunities for the company.

Market Penetration:
 Market penetration refers to a growth strategy where the business focuses on selling
existing products into existing markets.
 It is achieved by making more sales to present customers without changing products in

any major way.

 Penetration might require greater spending on advertising or personal selling.
 Risk involved in this strategy is less as compared to other strategies.
 For E.g. A leading producer of tooth paste, advises its customers to brush teeth twice
a day to keep breath fresh.
Market Development:
 Market development refers to a growth strategy where the business seeks (i.e.,
attempts) to sell its existing products into new markets.
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 It is a strategy for company growth by identifying and developing new markets for
current company products.
 This strategy may be achieved through new geographical markets, new product
dimensions or packaging, new distribution channels or different pricing policies to
attract different customers or create new market segments.
 Risk involved in this strategy is moderate as compared to other strategies.
 For E.g. One of India’s premier utility vehicles manufacturing company ventures to
foray (i.e., attempt to enter) into foreign markets.
Product Development:
 Product development refers to a growth strategy where business aims to introduce new
products into existing markets.
 It is a strategy for company growth by offering modified or new products to current

markets.
 This strategy may require the development of new competencies and requires the
business to develop modified products which can appeal to existing markets.
 Risk involved in this strategy is moderate as compared to other strategies.
 For E.g. A renowned geared scooters manufacturing company launches ungeared

scooters in the market.
Diversification:
 Diversification refers to a growth strategy where a business markets new product in

new markets.
 It is a strategy by starting up or acquiring businesses outside the company’s current

products and markets.
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 Typically, the business is moving into markets in which it has little or no experience.
 Risk involved in this strategy is high as compared to other strategies.
 For E.g. A business giant in hotel industry decides to enter into dairy business.
9.5 ADL Matrix:
Introduction;
The ADL matrix (derived its name from Arthur D. Little) is a portfolio analysis technique
that is based on product life cycle.
The approach forms a two-dimensional matrix;
• Where on ‘X’ Axis it represents life cycle of the industry. (Environmental assessment)
Stage of industry maturity is an environmental measure that represents a position in

industry’s life cycle.
• Where on ‘Y’ Axis it represents competitive position of the firm. (Business strength
assessment)
Competitive position is a measure of business strengths that helps in categorization of

products or SBU’s into one of five competitive positions.
The competitive position of a firm is based on an assessment of the following criteria:
1. Dominant:
This is a comparatively rare position and in many cases is attributable either to a

monopoly or a strong and protected technological leadership.
2. Strong:
By virtue of this position, the firm has a considerable degree of freedom over its choice
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of strategies and is often able to act without its market position being unduly
threatened by its competitions.
3. Favourable:
This position, which generally comes about when the industry is fragmented (break
into pieces) and no one competitor stand out clearly, results in the market leaders a
reasonable degree of freedom.
4. Tenable:
Although the firms within this category are able to perform satisfactorily and can
justify staying in the industry, they are generally helpless (vulnerable) in the face of
increased competition from stronger and more proactive companies in the market.
5. Weak:
The performance of firms in this category is generally unsatisfactory although the

opportunities for improvement do exist.
 Limitations of ADL Matrix;
• There is no standard life cycle length.
• Determining the current industry life cycle phase is difficult.
• Competitors may influence the length of the life cycle.
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It is four by five matrix as follows;
9.6 SWOT Analysis;
Introduction;
The identification and analysis of strengths, weaknesses, opportunities, and threats is

normally referred to as SWOT analysis. SWOT Analysis is quite helpful in formulating a
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company’s strategy” Concept of SWOT identify by Kurt Levin in 1950’s.
For the generation of a series of strategic alternatives or choices, it is necessary to analyse

the firm’s internal strengths and weaknesses and its external opportunities and threats.
The major purpose of SWOT analysis is to enable the management to create a firm–
specific business model that will best align, fit, or match an organisational resources and
capabilities to the demands of the environment in which it operates.
 Strength: Strength is an inherent capability of the organization which it can use to gain
strategic advantage over its competitors.
 Weakness: A weakness is an inherent limitation or constraint of the organization which

creates strategic disadvantage to it.
 Opportunity: An opportunity is a favourable condition in the organisation’s environment

which enables it to strengthen its position.
 Threat: A threat is an unfavourable condition in the organisation’s environment which

causes a risk for, or damage to, the organisation’s position.

The organization’s performance in the marketplace is significantly influenced by the three factors:
i. The organization’s correct market position.
ii. The nature of environmental opportunities and threat.
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iii. The organization’s resource capability to capitalize the opportunities and to protect
against the threats.
The significance of SWOT analysis lies in the following points:
 It provides a logical framework of analysis.
 It guides the strategist in strategy identification.
 It presents a comparative account.
Conclusion;
SWOT analysis helps managers to craft a business model that will allow a company to
gain a competitive advantage in its industry.
Competitive advantage leads to increased profitability, and this maximizes a company’s

chances of surviving in the fast-changing, global competitive environment that
characterizes most industries today.
9.7 TOWS Matrix;
Introduction;
Through SWOT analysis organisations identify their strengths, weaknesses, opportunities

and threats. While conducting the SWOT Analysis managers are often not able to come to
terms with the strategic choices that the outcomes demand.
Heinz Weihrich developed a matrix called TOWS matrix by matching strengths and weaknesses
of an organization with the external opportunities and threats.
The incremental benefit of the TOWS matrix lies in systematically identifying relationships
between these factors and selecting strategies on their basis. Thus, TOWS matrix has a
wider scope when compared to SWOT analysis. TOWS analysis is an action tool whereas
SWOT analysis is a planning tool.
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The TOWS Matrix is tool for generating strategic options. Through TOWS matrix four distinct
alternative kinds of strategic choices can be identified.
• SO (Maxi-Maxi): Aggressive Strategy
SO is a position that any firm would like to achieve. The strengths can be used to
capitalize or build upon existing or emerging opportunities. Such firms can take lead
from their strengths and utilize the resources to build up the competitive advantage.
• ST (Maxi - Mini): Conservative Strategy
ST is a position in which a firm strives to minimize existing or emerging threats

through its strengths.
• WO (Mini - Maxi): Competitive Strategy
The firm needs to overcome internal weaknesses and make attempts to exploit
opportunities to maximum.
• WT (Mini-Mini): Defensive Strategy
WT is a position that any firm will try to avoid. A firm facing external threats and
internal weaknesses may have to struggle for its survival. WT strategy is a strategy
which is pursued to minimize or overcome weaknesses and as far as possible, cope
with existing or emerging threats.
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Conclusion;
By using TOWS Matrix, a strategist can look intelligently at how he can best take advantage
of the opportunities open to him, at the same time that he can minimize the impact of
weaknesses and protect himself against threats.
TOWS used after detailed analysis of threats, opportunities, strength and weaknesses,
it helps the strategist to consider how to use the external environment to his strategic
advantage, and so he can identify some of the strategic options available to him.
9.8 BCG Growth-Share Matrix:
Introduction;
The BCG Growth-Share Matrix is a portfolio planning model developed by Bruce Henderson
of the Boston Consulting Group in the early 1970's.
Using the BCG approach, a company classifies its different businesses on a two-dimensional
growth - share matrix;
• The Vertical Axis (‘y’ Axis) represents market growth rate and provides a measure of
market attractiveness.
• The Horizontal Axis (‘x’ Axis) represents relative market share and serves as a measure
of company strength in the market.
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Growth share matrix also known for its cow and dog metaphors is popularly used for resource
allocation in a diversified company.
Using the matrix, organisations can identify four different types of products or SBU as follows:
Stars; (high growth, high market share businesses or products)
• They are products or SBUs that are growing rapidly.
• They also need heavy investment to maintain their position and need finance their
rapid growth potential.
• They represent best opportunities for expansion.
Cash Cows; (low growth, high market share businesses or products)
• Cash Cows are products which give high returns at low investment. Excess revenue
generated by such products, will be milked (i.e., invested) into another product or
business.
• They generate cash and have low costs.
• They are established, successful, and need less investment to maintain their market
share.
• In long run when the growth rate slows down, stars become cash cows.
Question Marks; (high growth potential, low market share businesses or products)
• Question marks are products which may give high returns but at the same time
may also flop and may have to be taken out of the market. This uncertainty gives the
quadrant the name “Question Mark”.
• Sometimes called problem children or wildcats.
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• They require a lot of cash to hold their share. They need heavy investments with low
potential to generate cash.
• Question marks if left unattended are capable of becoming cash traps.
• Since growth rate is high, increasing it should be relatively easier.
• It is for business organisations to turn them stars and then to cash cows when the
growth rate reduces.
Dogs; (low growth, low market share businesses or products)
• They may generate enough cash to maintain themselves, but do not have much
future.
• Sometimes they may need cash to survive. Dogs should be minimised by means of
divestment or liquidation.
9.8.1 After a firm, has classified its products or SBUs, it must determine what role each
will play in the future. The four strategies that can be pursued are:
1. Build: (Suitable for turning a "question mark" into a star)
Here the objective is to increase market share, even by forgoing short-term earnings
in favour of building a strong future with large market share.
2. Hold: (Suitable for Star)
Here the objective is to preserve market share. In other words, here the company
invests just enough to keep the SBU in its present position.
3. Harvest: (Suitable for Cash Cow)
Here the objective is to increase short-term cash flow regardless of long-term effect.
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4. Divest: (Suitable for Dog’s)
Here the objective is to sell or liquidate the business because resources can be better
used elsewhere.
9.8.2 Limitations of BCG Matrix;
The growth-share matrix has done much to help strategic planning; however, there are
some problems and limitations with the technique.
• BCG matrix can be difficult, time-consuming, and costly to implement.
• Management may find it difficult to define SBUs and measure market share and
growth.
• BCG matrix focuses on classifying current businesses but provide little advice for
future planning.
• BCG matrix led the company to placing too much emphasis on market-share growth or
growth through entry into attractive new markets. This can cause unwise (i.e., faulty)
expansion into hot, new, risky ventures or divesting established units too quickly.
9.9 General Electric Matrix [“Stop – Light” Strategy Model];
Introduction;
This model has been used by General Electric Company (developed by GE with the assistance
of the consulting firm McKinsey & Company). This model is also known as Business Planning
Matrix. GE Nine-Cell Matrix and GE Model.
The strategic planning approach in this model has been inspired from traffic control lights.
The lights that are used at crossings to manage traffic are:

Green Go
Yellow Caution
Red Stop
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This model is similar to the BCG growth-share matrix. However, there are differences.
Firstly, market attractiveness replaces market growth as the dimension of industry
attractiveness, and includes a broader range of factors other than just the market growth
rate. Secondly, competitive strength replaces market share as the dimension by which the
competitive position of each SBU is assessed.
This model uses two factors while taking strategic decisions:
Axis’s Factors

‘x’ axis Business Strength
‘y’ axis Market Attractiveness
The Market attractiveness is measured by a number of factors like:

 Size of the market,  Competitive intensity,
 Market growth rate,  Availability of Technology,
 Industry profitability,  Pricing trends,
 Overall risk of returns in the industry,  Distribution structure,
Etc...
The Business strength is measured by a number of factors like:

 Market share,  Distribution efficiency,
 Market share growth rate,  Brand image,
 Profit margin,  Customer loyalty,
 Production capacity,  Technological capability,
Etc...

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Strategy to be opt;
 If a product falls in the green section, the business is at advantageous position. To

reap (i.e., acquire) the benefits, the strategic decision can be to expand, to invest and
grow.
 If a product is in the amber or yellow zone, it needs caution and managerial discretion
(i.e., preference) is called (meaning required) for making the strategic choices.
In other words, Firm will look forward to protect existing business or product. Here,
no fresh investment is willing to have, rather firm is willing to have the security of
the given investment. So that does not result in losses.
 If a product is in the red zone, it will eventually lead to losses that would make
things difficult for organisations. In such cases, the appropriate strategy should be
retrenchment, divestment or liquidation.
Concept 10: Globalization:
Meaning;
The process by which businesses or other organizations develop international influence or

start operating on an international scale.
It means integration with the world economy. In simple economic terms, globalization
refers to the process of integration of the world into one huge market.
The global company views the world as one market, minimises the importance of national
boundaries.
For E.g., Intel, HUL, IBM, Tata, Vodafone, Mc’D, etc...
At the company level, globalization means two things:
a) The company commits itself heavily with several manufacturing locations around
the world and offers products in several diversified industries, and
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b) The company’s ability to compete in domestic markets with foreign competitors.
A company which has gone global is called a multinational (MNC) or a transnational

(TNC). An MNC is, therefore, one that, by operating in more than one country gains R&D,
production, marketing and financial advantages in its costs and reputation that are not
available to purely domestic competitors.
10.1 Distinguished between MNC vs. TNC vs. SNC;
A Multinational Company (MNC): MNC is a corporation enterprise that manages production

or delivers services in more than one country. It can also be referred to as an international
corporation. It owns a home company and its subsidiaries. It has a centralized management
system. It will face a barrier in decision making due to its centralized management system.
For Instance; PEPSICO, NOKIA, etc...
A Transnational Company (TNC): TNC is a corporation enterprise that manages production

or delivers services in more than one country. It can also be referred to as an international
corporation. Transnational companies do not have subsidiaries but just many companies.
It has a decentralized management system. Transnational companies are able to gain
more interest in the local market since they maintain their own systems.
For Instance; TATA Communication, ONGC, etc...
Super – National Enterprise (i.e., SNC): It is a worldwide enterprise chartered (i.e., established)
by a substantially non-political international body such as WTO, IMF or World Bank.
It operates as a private business without direct obligations. Its function is international

business service, and it remains viable only by performing that service adequately for
nations which permit its entry.
With its integrative view, it should be able to draw the economic world closer together. It
could serve all nations without being especially attached to anyone of them.
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10.2 To be specific, a global company has three characteristics:
1. It is a conglomerate of multiple units (i.e., located in different parts of the globe) but
all linked by common ownership.
2. Multiple units draw (i.e., utilised) on a common pool of resources, such as money, credit,
information, patents, trade names and control systems.
3. The units respond to some common strategy. Besides, its managers and shareholders
are also based in different nations.
10.3 Why do companies go global?
There are several reasons why companies go global. These are discussed as follows:
• The first and foremost reason is need to grow. It is basic need of organisations. Often
finding opportunities in the other parts of the globe organisation extend their businesses
and globalise.
• There is rapid shrinking of time and distance across the globe thanks to faster
communication, speedier transportation, growing financial flows and rapid
technological changes.
• It is being realised that the domestic markets are no longer adequate and rich.

For instance, Japanese have flooded the U.S. market with automobiles and electronics
because the home market was not large enough to absorb whatever was produced.
• Companies often set up overseas plants to reduce high transportation costs.
For instance, making a car in Korea and exporting it in Europe and America is expensive
and time consuming therefore India as a manufacturing hub for Hyundai proved to
be better place.
• There can be varied other reasons such as need for reliable or cheaper source of raw-
materials, cheap labour, etc...
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For instance, Hyundai got competent engineers at lower cost, industry friendly
Maharashtra Govt. which allowed them to setup a unit in India which supplies spare
parts for all Hyundai Cars across the world.
• The rise of services to constitute the largest single sector in the world economy:
and regional economic integration, which has involved both the world’s largest
economies as well as certain developing economies.
For instance, Manufacturing of Hyundai cars in India will help to improve Indian
economy by generating more and more employment.
• The trend is towards increased privatization of manufacturing and services sectors,

less government interference in business decisions and more dependence on the
value-added sector to gain market place competitiveness.
• The trade tariffs and custom barriers are getting lowered, resulting in increased flow of
business.
• Globalization has made companies in different countries to form strategic alliances

to ward off economic and technological threats (i.e., to avoid being hit by economic
and technological threats) and leverage their respective comparative and competitive
advantages.
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Question Bank
Q. 1 Explain competitive strategy.


Q. 2 What do you understand by ‘Competitive Landscape’? What are the steps to
understand the competitive landscape?


Q. 3 Explain strategic analysis and issues to consider for strategic analysis.


Q. 4 “Industry and competitive analysis begin with an overview of the industry’s dominant
economic features.” Explain and also narrate the factors to be considered in profiling
in industry’s economic features.


Q. 5 Explain nature and strength of competition.


Q. 6 Explain triggers of change or driving forces.


Q. 7 Explain Strategic Group Mapping and procedure to construct.
or
Identifying the Strongest – Weakest Companies.


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Q. 8 Explain likely strategic moves of rivals.


Q. 9 Explain the significance of KSF’s for competitive success.


Q.10 Explain prospects and financial attractiveness of industry.


Q.11 Explain core competencies and major areas in which core competencies are identified?


Q.12 Explain core competencies and criteria of core competencies?


Q.13 Explain core competencies and how to build core competencies?


Q.14 Explain core competencies and test of core competencies?


Q.15 Explain core competencies and advantages of identifying core competencies.


Q.16 Explain Value chain analysis.

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Q.17 “Management of internal linkages in the value chain could create competitive
advantage in a number of ways”. Briefly explain.


Q.18 Explain competitive advantage and its major characteristics.


Q.19 What is Value Creation.


Q.20 Explain strategic business unit and its features.


Q.21 Explain the concept of Experience Curve and highlight its relevance in strategic
management.


Q.22 Write a short note on Product Life Cycle (PLC) and its significance in portfolio diagnosis.


Q.23 Write a short note on Ansoff’s Growth Matrix.


Q.24 Write a short note on ADL Matrix.


Q.25 What is the purpose of SWOT analysis? Why is it necessary to do a SWOT analysis
before selecting a particular strategy for a business organization?
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Q.26 How is TOWS Matrix an improvement over the SWOT Analysis? Describe the
construction of TOWS Matrix.


Q.27 Describe the construction of BCG matrix and discuss its utility in strategic management.


Q.28 Write short note on GE Matrix.


Q.29 Explain difference between MNC and TNC and SNC.


Q.30 Explain globalization and its characteristics.


Q.31 Explain globalization and why companies go global?


Q.32 Aurobindo, the pharmaceutical company wants to grow its business. Draw Ansoff’s
Product Market Growth Matrix to advise them of the available options.
or
In the context of Ansoff’s Product-Market Growth Matrix, identify with reasons, the
type of growth strategies followed in the following cases:
i. A leading producer of tooth paste, advises its customers to brush teeth twice a
day to keep breath fresh.
ii. A business giant in hotel industry decides to enter into dairy business.
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iii. One of India’s premier utility vehicles manufacturing company ventures to foray
into foreign markets.
iv. A renowned auto manufacturing company launches ungeared scooters in the

market.
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Strategic Management Process
Concept 1: Strategic Planning:
Planning means deciding what needs to done in the future (today, next week, next month,
next year, over the next couple of years, etc...) and generating blueprints for action. Good
planning is an important constituent of good management. Planning involves determination
of the course of action to attain the predetermined objectives. It bridges the gap between
where we are to where we want to go. Thus, planning is future oriented in nature.
1.1 Types of Planning’s;
1. Strategic Planning,
2. Operational Planning.
1. Strategic Planning;
Strategic plans are made by the senior management for the entire organization after taking
into account the organization’s strength and weaknesses in the light of opportunities and
threats in the external environment.
Strategic planning is the game plan that actually steers (i.e., drive) the firm towards
success. The degree of aptness (i.e., correctness) of this game plan decides the extent of
the firm’s success. That is why formulation of corporate strategy forms the crux of the
strategic planning process.
Strategic planning determines where an organization is going over the next year or more
and the ways for going there.
It is the process of determining the objectives of the firm, resources required to attain
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these objectives and formulation of policies to govern the acquisition, use of resources.
In other words, they involve acquisition and allocation of resources for the attainment of
organisational objectives.
2. Operational Planning;
Operational plans on the other hand are made at the middle and lower-level management.
They specify details on how the resources are to be utilized efficiently for the attainment
of objectives.

Conversion of virtual goals in to actual are the prime responsibility of the operational
level managers.
Operational level managers should be efficient enough to understand the overall vision
of the organisation and work accordingly to fulfil it within the allocated time.
1.2 A major functions (task) of planning’s;
1. Dealing with uncertainty;

• Through scenario analysis.
2. Impact of uncertainty;
• Positive → represent opportunity,
• Negative → represent threat.
1. Dealing with uncertainty;
Uncertainty in business is been developed because of continuous changes in the business

environment. These changes force business organisation to change their strategies and
to create a fit between newly happened change and its new plan to achieve the same
objective.
As discussed above these changes in the business environment develops uncertainty and
connected risk associated with it.
Strategic uncertainty, which has far reaching implications, is a key construct in strategy formulation.
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A typical external analysis will emerge with dozens of strategic uncertainties. To be

manageable, they need to be grouped into logical clusters or themes. It is then useful to
assess the importance of each cluster in order to set priorities with respect to Information
gathering and analysis.
Sometimes, Strategic uncertainty is represented by a future trend or event that has inherent
unpredictability. Information gathering and additional analysis will not be able to reduce
the uncertainty.
In that case, scenario analysis can be employed. Scenario analysis basically accepts the
uncertainty as given and uses it to drive a description of two or more future scenarios.
Strategies are then developed for each. One outcome could be a decision to create
organisational and strategic flexibility so that as the business context changes the
strategy will adapt.
2. Impact with uncertainty;
Each element of strategic uncertainty involves potential trends or events that could have an
impact on present, proposed, and even potential businesses.
For E.g., a trend toward Aayurvedic Products may present opportunities for a firm producing
or manufacturing herbal product on the basis of a strategic uncertainty.
Similarly, a trend toward natural foods may present opportunities for a firm producing or
manufacturing juices on the basis of a strategic uncertainty.
The impact of a strategic uncertainty will depend on the importance of the impacted SBU
to a firm. Some SBUs are more important than others. The importance of established
SBUs may be indicated by their associated sales, profits, or costs. However, such measures
might need to be supplemented for potential growth as present sales, profits, or costs
may not reflect the true value.
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Concept 2: Strategic Decision Making:
Introduction;
Decision making is a managerial process of selecting the best course of action out of
several alternative courses for the purpose of accomplishment of the organizational
goals.
 They may also be strategic in nature.

 Decisions may be operational, i.e., which relate to general day-to-day operations.
According to Jauch and Glueck,
“Strategic decisions encompass the definition of the business, products to be handled, markets
to be served, functions to be performed and major policies needed for the organisation to
execute these decisions to achieve the strategic objectives.”
The major dimensions (characteristics) of strategic decisions are as follows;
• Strategic decisions require top-management involvement:
Strategic decisions involve thinking in totality of the organisation. Hence, problems

calling for strategic decisions require to be considered by the top management.
• Strategic decisions involve commitment of organisational resources:
Strategic decisions to launch a new project by a firm requires allocation of huge

funds and assignment of a large number of employees.
• Strategic decisions necessitate consideration of factors in the firm’s external environment:
Strategic focus in organisation involves building its internal environment to the

changes of external environment.
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• Strategic decisions are likely to have a significant impact on the long-term prosperity of the firm:
Generally, the results of strategic implementation are seen on a long-term basis

and not immediately.
• Strategic decisions are future oriented:
Strategic thinking involves predicting the future environmental conditions and how
to build for the changed conditions.
• Strategic decisions usually have major multifunctional or multi–business consequences:
As they involve organisation in totality, they affect different sections of the

organisation at various levels.
Concept 3: Strategic Intent;
Definition;
Strategic Management is defined as a dynamic process of; formulation, implementation,

evaluation, and control of strategies to realise the organization’s strategic intent.
Introduction;
The intentions with which organisational manager’s plans the future course of action, that
intention is known as strategic intent. Strategic intent is the base of all the activities every
manager at all levels is doing to achieve organisational goals.
It is the fire within the organisational officers which keeps them moving more closer to the
objectives and goals instead they face the hardest challenge and unfriendly business
environment.
As a name suggesting that “intent” related to future. Clarity in strategic intent is extremely
important for the future success and growth of the enterprise, irrespective of its nature and size.
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Senior managers must define “what they want to do” and “why they want to do”. This “why
they want to do” underlies the end result that is likely to be achieved through “what they
want to do”. This end result is referred to as “strategic intent”
Strategic intent can be understood as the philosophical base of strategic management.
Strategic intent provides the framework within which the firm would adopt a predetermined
direction and would operate to achieve strategic objectives. Strategic intent could be in the
form of vision and mission statements for the organisation at the corporate level. It could
be expressed as the business definition and business model at the business level of the
organisation.
3.1 Element of Strategic Intent;

 Vision:
Vision implies the blueprint of the company’s future position. It describes where the
organisation wants to land. It represents the organisation’s aspirations and provides a
glance of what the organization would like to become in future.
Every sub system (meaning every unit, division, etc...) of the organization is required to
follow its vision.
For E.g., Google – “to provide access to the world’s information in one click.”
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 Mission:
Mission describes the firm’s business, its goals and ways to reach the goals. It explains the
reason for the existence of the firm in the society. It is designed to help potential shareholders
and investors understand the purpose of the company.
A mission statement helps to identify, ‘what business the company undertakes.’ It defines
the present capabilities, activities, customer focus and role in society.
For E.g., Google – “to organize the world’s information and make it universally accessible
and useful.”
 Business Definition:
It tries to explain the business undertaken by the firm, with respect to the customer needs,
target markets, and alternative technologies. With the help of business definition, one
can ascertain the strategic business choices.
Organisational restructuring also depends upon the business definition.
For E.g., Companies should shift from Functional structure to Divisional structure in order
to manage different products and services in different markets.
Note: The concept of organizational structure will be covered in chapter no. 7.
 Business Model:
Business model, as the name implies is a strategy for the effective operation of the
business, ascertaining sources of income, desired customer base, and financial details.
Rival firms, operating in the same industry rely on the different business model due to their
strategic choice.
For E.g., i-Ball opt for low-cost strategy for tablet, whereas Apple opt for differentiation
strategy for iPad.
Note: Business level strategies will be covered in chapter no. 5.
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 Goals and Objectives:

These are the base of measurement. Goals are the end results, that the organization
attempts to achieve. On the other hand, objectives are time-based measurable targets,
which help in the accomplishment of goals.
These are the end results which are to be attained with the help of an overall plan, over
the particular period. However, in practice, no distinction is made between goals and
objectives and both the terms are used interchangeably.
Conclusion;
The vision, mission, business definition, and business model explain the philosophy of the
organisation but the goals and objectives represent the results to be achieved in multiple
areas of business.
Concept 4: Vision:
Introduction;
The most important issue organisational managers need to work on is clarity of destination
i.e., where they want the organisation to be in specified time period. Where to go is the
most important question and should be always asked before planning how to go.
Strategic vision thus points out a particular direction, charts a strategic path to be followed
in future, and moulding organizational identity.
Definition;
A Strategic vision is a road map of a company’s future – providing specifics about technology
and customer focus, the geographic and product markets to be pursued, the capabilities
it plans to develop, and the kind of company that management is trying to create.
 Vision implies the blueprint of the company’s future position.
 A strategic vision shows management’s aspirations for the business, providing a

view of “where we are going”.
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 It describes where the organisation wants to land.
 Every sub system of the organization is required to follow its vision.
Some examples of Vision are

ICAI;
“To be World’s leading accounting body, A regulator and developer of

trusted and independent professionals, with world class competencies
in accounting, assurance, taxation, finance and business advisory
services.”
Tesla;
“to create the most compelling car company of the 21st century by
driving the world's transition to electric vehicles.”
Walt Disney
“to make people happy.”
Amazon;
“to be earth's most customer-centric company; to build a place where people

can come to find and discover anything they might want to buy online.”
4.1 The three elements of a strategic vision are;
1. Coming up with a mission statement that defines what business the company is
presently in and conveys the essence of “Who we are and where we are now?”
2. Using the mission statement as basis for deciding on a long-term course making
choices about “Where we are going?”
3. Communicating the strategic vision in clear, exciting terms that inspire organization
wide commitment.
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4.2 Essentials of a strategic vision;
• The entrepreneurial challenge in developing a strategic vision is to think creatively

about how to prepare a company for the future.
• Forming a strategic vision is an exercise in intelligent entrepreneurship.
• A well-articulated strategic vision creates enthusiasm among the members of the

organisation.
• The best-worded vision statement clearly enhances the direction in which organization
is headed.
Concept 5: Mission:
Introduction;
A company’s mission statement is typically focused on its present business and answer to the
basic question scope – i.e., “who we are? And what we do?”
Mission statements broadly describe organizations;
• Present capabilities, • Customer focus,

• Activities, and • Business makeup.
It has been observed that many firms fail to conceptualise and articulate the mission and
business definition with the required clarity. Such firms are seen to fumble in the identification
of opportunities and fail in formulating strategies to make use of opportunities.
Firms working to manage their organisation strategically cannot be lax (meaning cannot
be careless i.e., लापरवाह or बेपरवाह) in the matter of mission and business definition, as the
two ideas are absolutely central to strategic planning.
 Mission statement should reflect the philosophy of the organizations that is perceived
by the senior managers.
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 A good mission statement should be precise, clear, feasible, distinctive and motivating.
 The mission is a statement which defines the role that an organization plays in the
society.
Some examples of Mission are

ICAI will leverage technology and infrastructure and partner with its
stakeholders to:
• Impart world class education, training and professional development

opportunities to create global professionals.
• Develop an independent and transparent regulatory mechanism that

keeps pace with the changing times.
• Ensure adherence to highest ethical standards.
• Conduct cutting edge research and development in the areas of

accounting, assurance, taxation, finance and business advisory
services.
• Establish ICAI members and firms as Indian multi-national service

providers.
Tesla;
“to accelerate the world’s transition to sustainable energy.”
Walt Disney
“to entertain, inform and inspire people.”

Amazon;
“We strive to offer our customers the lowest possible prices, the best
available selection, and the utmost convenience.”
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5.1 Why an organization should have a mission?
• To ensure unanimity of purpose within the organization.
• To develop a basis, or standard, for allocating organizational resources.
• To provide a basis for motivating the use of the organization’s resources.
• To establish a general tone or organizational climate.
• To serve as a focal point for those who can identify with the organisation’s purpose
and direction.
• To facilitate the translation of objective and goals into a work structure involving the
assignment of tasks to responsible elements within the organisation.
• To specify organizational purposes and the translation of these purposes into goals
in such a way that cost, time, and performance parameters can be assessed and
controlled.
5.2 Points (tips) to be considered (or useful) while writing mission statement;
 One of the roles of a mission statement is to give the organisation its own special
identity, business emphasis and path for development – one that typically sets it
apart from other similarly positioned companies.
 A company’s business is defined by what needs it is trying to satisfy, which customer

groups it is targeting and the technologies and competencies it uses and the activities
it performs.
 Good mission statements should be unique to the organisation for which they are
developed.
 The mission of a company should not be to make profit. Surpluses may be required for
survival and growth, but cannot be mission of a company.
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5.3 What is our mission? And what business are we in?
The well-known management experts, Peter Drucker and Theodore Levitt were among the
first to agitate (i.e., concern) these issues through their writings. They emphasised that
as the first step in the business planning endeavour (i.e., effort), every business firm must
clarify the corporate mission and define accurately the business the firm is engaged in.
They also explained that towards facilitating this task, the firm should raise and answer
certain basic questions concerning its business, such as:
• What is our mission?

• What is our ultimate purpose?
• What do we want to become?
• What kind of growth do we seek?
• What business are we in?
• Do we understand our business correctly and define it accurately in its broadest
connotation?
• Whom do we intend to serve?
• What human need do we intend to serve through our offer?
• What brings us to this particular business?
• What would be the nature of this business in the future?
• In what business would we like to be in, in the future?
At the time these two experts raised this issue, the business managers of the world did
not fully appreciate the importance of these questions; those were the days when business
management was still a relatively simple process even in industrially advanced countries
like the US. It was only in subsequent years that captains of industry all over the world
understood the significance of the seemingly simple questions raised by Drucker and
Levitt.
Corporate mission;
The corporate mission is an expression of the growth ambition of the firm. It is, in fact,
the firm’s future visualised. It provides a dramatic picture of what the company wants to
become. It is the corporation’s dream crystallised. It is a colourful sketch of how the firm
wants its future to look, irrespective of the current position. In other words, the mission is a
grand design of the firm’s future.
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Mission amplifies what brings the firm to this business or why it is there, what existence
it seeks and what purpose it seeks to achieve as a business firm. In other words, the
mission serves as a justification for the firm’s very presence and existence; it legitimises the
firm’s presence.
Mission is also an expression of the vision of the corporation, its founder/ leader. To make the
vision come alive and become relevant, it needs to be spelt out. It is through the mission
that the firm spells out its vision.
It represents the common purpose, which the entire firm shares and pursues. A mission is not
a confidential affair to be confined at the top; it has to be open to the entire company. All
people are supposed to draw meaning and direction from it. It adds zeal to the firm and its
people. A mission is not a fad-it is a tool to build and sustain commitment of the people
to the corporation’s policies. A mission is not rhetoric - it is the corporation’s guiding
principle.
Every organisation function through a network of goals and objectives. Mission statement is the
foundation from which the network of goals is built. The mission serves as a proclamation
to insiders and outsiders on what the corporation stands for. A mission, however, is not a
PR document; while it legitimises the corporation’s existence and role in society, its main
purpose is to give internal direction for the future of the corporation.
According to Peter Drucker, every organisation must ask an important question “What
business are we in?” and get the correct and meaningful answer. The answer should have
marketing or external perspective and should not be restated to the production or generic
activities of business. The table given below will clarify and highlight the importance of
external perspective.
Company Production-oriented answer Marketing-oriented answer

Indian Oil We produce oil and gasoline We provide various types of safe
products. and cost-effective energy.
Indian Railways We run a railroad. We offer a transportation and
material-handling system.
Revlon In the factory, we make cosmetics In the retail outlet, we sell hope.
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Concept 6: Goals and Objectives:
Introduction;
Business organisation translates their vision and mission into goals and objectives.
Goals and Objectives are the base of measurement. As such the term objectives are
synonymous with goals, however, some authors make an attempt to distinguish the two.
• Goals are the end results, that the organization attempts to achieve. Goals are open-
ended attributes that denote the future states or outcomes.
• Objectives are time-based measurable targets, which help in the accomplishment of

goals. Objectives are close-ended attributes which are precise and expressed in specific
terms.
Thus, the Objectives are more specific and translate the goals to both long term and
short-term perspective.
However, in practice, no distinction is made between goals and objectives and both the terms
are used interchangeably.
Objectives are organization’s performance targets. The results and outcomes it wants to
achieve. Objective function as yardsticks for tracking an organization’s performance and
progress.
6.1 Characteristics of Objectives;
All organisations have objectives. The pursuit of objectives is a never-ending process such
that organisation sustain themselves. Objectives provide meaning and sense of direction to
organisational endeavour.
Organisational structure and activities are designed and resources are allocated around
the objectives to facilitate their achievement. They also act as benchmarks for guiding
organisational activity and for evaluating how the organisation is performing.
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Objectives with strategic focus relate to outcomes that strengthen an organisation’s overall
business position and competitive vitality.
Objectives, to be meaningful to serve the intended role, must possess the following
characteristics.
• Objectives should define the organization’s relationship with its environment.
• Objectives should be facilitative towards achievement of mission and purpose.
• Objectives should be measurable and controllable.
• Objectives should provide the basis for strategic decision-making.
• Objectives should provide standards for performance appraisal.
• Objectives should be concrete and specific.
• Objectives should be related to a time frame.
• Objectives should be challenging.
• Different objectives should correlate with each other.
• Objectives should be set within the constraints (i.e., scope) of organisational resources
and external environment.
6.2 Long-term Objectives;
Introduction;
As a rule, a company’s set of financial and strategic objectives ought to include both
short-term and long-term performance targets.
Long-term objectives represent the results expected from pursuing certain strategies,
Strategies represent the actions to be taken to accomplish long-term objectives. The time
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frame for objectives and strategies should be consistent, usually from two to five years.
To achieve long-term prosperity, strategic planners commonly establish long-term
objectives in seven areas.
1.
Profitability. 2. Productivity.
3. Competitive Position. 4. Employee Development.
5. Employee Relations. 6. Technological Leadership.
7. Public Responsibility.
Objectives should be quantitative, measurable, realistic, understandable, challenging,

hierarchical, and obtainable among organizational units. Each objective should also be
associated with a time line.
Objectives are commonly stated in terms such as growth in assets, growth in sales,
profitability, market share, degree and nature of diversification, degree and nature of
vertical integration, earnings per share, and social responsibility.
6.3 Short-range objectives then serve as steps toward achieving long term objective?
Short-range objectives can be identical to long-range objectives if an organisation is

already performing at the targeted long-term level. For instance, if a company has an
ongoing objective of 15 percent profit growth every year and is currently achieving this
objective, then the company’s long range and short-range objectives for increasing profits
coincide.
The most important situation in which short-range objectives differ from long-range
objectives occurs when managers are trying to elevate organisational performance and
cannot reach the long-range target in just one year.
Hence, short-range objectives then serve as steps toward achieving long term objective.
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Concept 7: Strategic Management Model:
Introduction;
Identifying an organization’s vision, mission, goals and objectives, is the starting point for
strategic management process.
The strategic management process is dynamic and continuous. A change in any one of the
major components in the model can necessitate a change in any or all of the other components.
Therefore, strategy formulation, implementation, and evaluation activities should be

performed on a continual basis, not just at the end of the year or semi-annually. The
strategic management process never really ends.
The strategic management process can best be studied and applied using a model. Every
model represents some kind of process. Strategic Management Model (Fred R David) is a
widely accepted, comprehensive.
This model like any other model of management does not guarantee sure-shot success, but it does
represent a clear and practical approach for formulating, implementing, and evaluating
strategies. Relationships among major components of the strategic management process
are shown in the model.
Strategists do not go through the process in lockstep fashion. Generally, there is give-and-take
among hierarchical levels of an organization.
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Many organizations conduct formal meetings semi-annually to discuss and update the
firm’s vision & mission, opportunities & threats, strengths & weaknesses, strategies, objectives,
policies, and performance.
Creativity (i.e., response) from participants is encouraged in meeting. Good communication

and feedback are needed throughout the strategic management process.
7.1 Stages in Strategic Management;
Crafting and executing strategy are the heart and soul of managing a business enterprise.
1. Developing a strategic vision and formulation of statement of mission, goals and objectives,
First a company must determine what directional path the company should take
and what changes in the company’s product – market – customer – technology –
focus would improve its current market position and its future prospect.
2. Environmental and organizational analysis,

This stage is the diagnostic phase of strategic analysis. It entails two types of
analysis:
i. Environmental scanning;
External environment of a firm consists of economic, social, technological,
market and other forces which affect its functioning. The firm’s external
environment is dynamic and uncertain.
ii. Organisational analysis;

Organisational analysis involved a review of financial resources, technological
resources, productive capacity, marketing and distribution effectiveness,
research and development, human resource skills and so on.
3. Formulation of strategy,
The strategic alternatives may be designated as stability strategy, growth/ expansion
strategy and retrenchment strategy. A company may also follow a combination
these alternatives called combination strategy.
Note: The above all are corporate level strategies will be covered in chapter no. 4.
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4. Implementation of strategy,
Implementation and execution are an operations-oriented, activity aimed at shaping
the performance of core business activities in a strategy-supportive manner. It is the
most demanding and time-consuming part of the strategy-management process.
5. Strategic evaluation and control.

The final stage of strategic management process – evaluating the company’s
progress, assessing the impact of new external developments, and making corrective
adjustments – is the trigger point for deciding whether to continue or change the
company’s vision, objectives, strategy, and/or strategy-execution methods.
7.2 Principal aspects of strategy-execution process;
Introduction;
Good strategy execution involves creating strong “fits” between strategy and organizational
capabilities, between strategy and the reward structure, between strategy and internal
operating systems, and between strategy and the organization’s work climate and culture.
In most situations, strategy–execution process includes the following principal aspects;
 Developing budgets that steer (i.e., direct) ample (i.e., adequate) resources into those
activities critical (i.e., important) to strategic success.
 Staffing the organization with the needed skills and expertise, carefully building and
strengthening strategy-supportive competencies and competitive capabilities, and
organizing the work effort.
 Ensuring that policies and operating procedures facilitate rather than restrain or
slowdown effective execution.
 Using the best-known practices to perform core business activities and pushing for
continuous improvement.
 Installing information and operating systems that enable company personnel to better
carry out their strategic roles day in and day out.
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 Motivating people to pursue the target objectives energetically.
 Creating a company culture and work climate helpful to successful strategy

implementation and execution.
 Exerting (i.e., look for) the internal leadership needed to drive implementation forward
and keep improving strategy execution.
 When the organization encounters barrier or weaknesses, management has to see

that they are addressed and rectified quickly.
 Distinction between Vision and Mission;
Vision Mission
Meaning;
A short statement that depicts the company's A statement that describes the company's
aspiration for the future position of the objectives and its approach to reach those
company. objectives.
Talks about;
A vision statement talks about organisation’s A mission statement talks about the present
future. leading to its future.
Shows;
Where we want to be? Where we are at present?
Answer;
It answers the question, “Where do we aim to It answers the question, “What do we do?
be?” and What makes us different?”
Term;
Long term Short term
Purpose;
To inspire To inform
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Question Bank
Q. 1 Explain planning or strategic planning and its types.


Q. 2 Explain planning major functions of planning.


Q. 3 What is strategic decision making? What tasks are performed by a strategic Manager?
or
Briefly explain the major dimensions of strategic decisions.


Q. 4 Briefly explain elements of strategic intent.


Q. 5 Explain vision and elements of a strategic vision.


Q. 6 Explain vision and essentials of a strategic vision.


Q. 7 Explain mission statement and why an organization should have a mission?


Q. 8 What is a mission statement? State the points that may be considered while writing
a mission statement of a company.

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Q. 9 What are the characteristics which must be possess by objectives, to be meaningful
to serve the intended role?
or
Explain goals and objectives and its characteristics?


Q.10 Explain Long-term objectives?


Q.11 Explain strategic management model and Briefly explain stages in strategic
management model.


Q.12 Explain the principal aspects of strategy-execution process.


Q.13 Briefly discuss the difference between vision and mission.


Q.14 Why an organisation should have a mission? What considerations are to be kept in
mind while writing a good mission statement of a company?


Q.15 Present a diagrammatic representation of a Strategic Management Model.

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INDIRECT TAX
INTER – INDIRECT TAX
Introduction to GST &

Supply Under GST
1. Multiplicity of taxes
• Prior to 1.7.2017, there were multiple taxes on goods or services such as Value Added
Tax (VAT), Central Sales Tax (CST), Service Tax, Excise Duty, Entry Tax, Entertainment
tax, etc.
• With effect from 1.7.2017, the above taxes were replaced by Goods and Services Tax
(GST). India follows dual GST which means GST is levied by both Central Government
and State Government.
• Even after introduction of GST, local bodies have the power to levy certain taxes as
the power of local bodies has not been subsumed under GST. Basic Custom Duty is
also not subsumed under GST.
• Goods and Service Tax (“GST”) is charged by the Central Government as well as the
respective State Government/ Union Territory on Goods and Services. GST is a value
added tax levied on manufacture, sale and consumption of goods and services.
• GST offers comprehensive and continuous chain of tax credits from the producer's point/
service provider's point upto the retailer's level/consumer’s level thereby taxing only
the value added at each stage of supply chain.
• Power to levy and collect tax is obtained from the Constitution of India. There are 3
list specifying the various subjects of regulations and taxation viz Union List, State List
and Concurrent List under article 246 read with seventh schedule of constitution.
• Article 246A was added to the constitution to provide for concurrent powers to Central
Government and State Government to levy GST on intra state supplies of goods and
services.
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• Article 269A provides that Central Government has exclusive powers to make a law for
Inter State supplies and it will be apportioned as provided by Parliament.
• Article 279A provides for GST Council which is empowered to make recommendations
to the Central Government and State Government with regard to GST. It is headed by the
Union Finance Minister.
• Legislations under GST Regime
2. Relevant Definitions
• Person includes an individual, HUF, Company, Firm, LLP, AOP or BOI, whether
incorporated or not, in India or outside India; a co-operative society, local authority,
CG, SG, society, trust, artificial juridical person and any corporation established by
or under any Central Act, State Act or Provincial Act or a Government company as
defined in clause (45) of section 2 of the Companies Act, 2013.
• India means-
(a) Territory of India as referred to in article 1 of the Constitution
(b) Its territorial waters, seabed and sub soil under lying such waters, continental
shelf, exclusive economic zone or any other maritime zone as referred to in
the Territorial Waters, Continental Shelf, Exclusive Economic Zone and other
Maritime Zones Act,1976
(c) The air space above its territory and territorial waters [Section 2(56)]
• Works contract means a contract for building, construction, fabrication, completion,

erection, installation, fitting out, improvement, modification, repair, maintenance,
renovation, alteration or commissioning of any immovable property wherein transfer
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of property in goods (whether as goods or in some other form) is involved in the

execution of such contract.
• Exempt supply means supply of any goods or services or both which attracts nil rate
of tax or which may be wholly exempt from tax under section 11, or under section 6
of the Integrated Goods and Services Tax Act, and includes non-taxable supply [Section
2(47)].
• Non-taxable supply means a supply of goods or services or both which is not leviable
to tax under CGST Act or under IGST Act. [Section 2(78)]
• Taxable supply means supply of goods &/or services which is chargeable to tax under
CGST Act.
• Recipient: of supply of goods and/or services means-

(a) Where a consideration is payable for the supply of goods or services or both, the
person who is liable to pay that consideration,
(b) Where no consideration is payable for the supply of goods, the person to whom
the goods are delivered or made available, or to whom possession or use of the
goods is given or made available, and
(c) Where no consideration is payable for the supply of a service, the person to
whom the service is rendered.
It shall also include an agent acting as such on behalf of the recipient in relation
to the goods or services or both supplied. [Section 2(93)]
• Supplier: in relation to any goods or services or both, shall mean the person supplying
the said goods or services or both and shall include an agent acting as such on
behalf of such supplier in relation to the goods or services or both supplied. [Section
2(105)]
• Taxable person means a person who is registered or liable to be registered u/s 22 or

section 24.
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3. Levy of GST – Section 9 of CGST/ Section 5 of IGST
• Section 9(1) - Main Provision: There shall be levied a tax called the central goods and
services tax on all intra-State supplies of goods1 or services2 or both, except on the
supply of alcoholic liquor for human consumption, on the value determined under
section 15 and at such rates, not exceeding twenty per cent, as may be notified by the
Government on the recommendations of the Council and collected in such manner as
may be prescribed and shall be paid by the taxable person.
1
Goods means every kind of movable property other than money and securities but includes actionable claim, growing
crops, grass and things attached to or forming part of the land which are agreed to be severed before supply or under
a contract of supply. [Section 2(52)]
2
Services means anything other than goods, money and securities but includes activities relating to the use of money or
its conversion by cash or by any other mode, from one form, currency or denomination, to another form, currency or
denomination for which a separate consideration is charged. [Section 2(102)].
Explanation: For the removal of doubts, it is hereby clarified that the expression “services” includes facilitating or
arranging transactions in securities.
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• Sec 9(2) - Petroleum products from the date to be notified: The central tax on the supply
of petroleum crude, high speed diesel, motor spirit (commonly known as petrol), natural
gas and aviation turbine fuel shall be levied with effect from such date as may be
notified by the Government on the recommendations of the Council.
• Sec 9(3) - Reverse Charge Mechanism for notified Goods or services: The Government
may, on the recommendations of the Council, by notification, specify categories of
supply of goods or services or both, the tax on which shall be paid on reverse charge basis
by the recipient of such goods or services or both and all the provisions of this Act
shall apply to such recipient as if he is the person liable for paying the tax in relation
to the supply of such goods or services or both.
• Sec 9(4) - Purchases from unregistered person: The Government may, on recommendations
of the Council, by notification, specify a class of registered persons who shall, in
respect of supply of specified categories of goods or services or both received from
an unregistered supplier, pay the tax on reverse charge basis as the recipient of such
supply of goods or services or both, and all the provisions of this Act shall apply to
such recipient as if he is the person liable for paying the tax in relation to such supply
of goods or services or both.
• Sec 9(5) - Tax on notified services to be paid by E Commerce Operator3: The Government
may, on the recommendations of the Council, by notification, specify categories
of services the tax on intra-State supplies of which shall be paid by the electronic
commerce operator if such services are supplied through it, and all the provisions of this
Act shall apply to such electronic commerce operator as if he is the supplier liable
for paying the tax in relation to the supply:
- Provided that where an electronic commerce operator does not have a physical
presence in the taxable territory, any person representing such electronic commerce
operator for any purpose in the taxable territory shall be liable to pay tax:
- Provided further that where an electronic commerce operator does not have a
physical presence in the taxable territory and also he does not have a representative
in the said territory, such electronic commerce operator shall appoint a person
in the taxable territory for the purpose of paying tax and such person shall be
liable to pay tax.
3
E-Commerce operator means any person who owns, operates or manages digital or electronic facility or platform for
electronic commerce. [Section 2(45)]
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• Examples for section 9
4. Type of Tax – Section 7 and 8 of IGST Act
• Where the location of the supplier and the place of supply of goods or services are in
the same State/Union territory, it is treated as intra-State supply of goods or services
respectively.
• Where the location of the supplier and the place of supply of goods or services are
in (i) two different States or (ii) two different Union Territories or (iii) a State and a
Union territory, it is treated as inter-State supply of goods or services respectively.
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5. Scope of the term supply & taxability of various transactions – Section 7 of CGST Act
5.1. Supply for consideration and in the course or furtherance of business
• “All forms of supply of goods or services or both such as sale, transfer, barter, exchange,
licence, rental, lease or disposal made or agreed to be made for a consideration by a
person in the course or furtherance of business”4
Example
• Business includes –
(a) Any trade, commerce, manufacture, profession, vocation, adventure, wager or

any other similar activity, whether or not it is for a pecuniary benefit;
(b) Any activity or transaction in connection with or incidental or ancillary to (a)

above;
(c) Any activity or transaction in the nature of (a) above, whether or not there is
volume, frequency, continuity or regularity of such transaction;
(d) Supply or acquisition of goods including capital assets and services in connection
with commencement or closure of business;
4
Activities or transactions by a person, other than an individual, to its members or constituents or vice versa for cash,
deferred payment or other valuable consideration shall be a supply. Notwithstanding anything contained in any other
law or judgement, the person and its members or constituents shall be deemed to be two separate persons and supply
of activities or transactions between them shall be deemed to take place from one to another.
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(e) Provision by a club, association, society, or any such body (for a subscription or
any other consideration) of the facilities or benefits to its members, as the case
may be;
(f) Admission, for a consideration, of persons to any premises; and
(g) Services supplied by a person as the holder of an office which has been accepted
by him in the course or furtherance of his trade, profession or vocation;
(h) Activities of a race club including by way of totalisator or a license to book

maker or activities of a licensed book maker in such club and
(i) Any activity or transaction undertaken by the Central Government, a State

Government or any local authority in which they are engaged as public authorities
[Section 2(17)].
• Consideration: in relation to the supply of goods or services or both includes:
(a) Any payment made or to be made, whether in money or otherwise, in respect of,
in response to, or for the inducement of, the supply of goods or services or both,
whether by the recipient or by any other person but shall not include any subsidy
given by the Central Government or a State Government.
(b) The monetary value of any act or forbearance, in respect of, in response to, or
for the inducement of, the supply of goods or services or both, whether by the
recipient or by any other person but shall not include any subsidy given by the
Central Government or a State Government.
Note: However, a deposit given in respect of the supply of goods or services or both
shall not be considered as payment made for such supply unless the supplier applies
such deposit as consideration for the said supply. [Section 2(31)].
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5.2. Importation of service
• Import of services for a consideration whether or not in the course or furtherance of

business.
5.3. Supply without Consideration – Schedule I
• This includes all supplies by a taxable person to a taxable or non-taxable person,

even if the same is without consideration. These are specifically mentioned in Schedule
I appended to the CGST Act. The same has been discussed in the subsequent paras
i. Permanent Transfer/Disposal of Business Assets where ITC was taken
• Any kind of disposal or transfer of business assets made by an entity on permanent

basis even though without consideration.
• This clause is wide enough to cover transfer of business assets from holding to
subsidiary company for nil consideration. However, it is important to note that this
provision would apply if input tax credit has been availed on such assets.
Example: Dealer of laptops or dealers of cloth gives laptops or clothes free of cost to
their friend.
ii. Supply between related person or distinct persons
• Related person is defined under Section 15 of CGST Act which means the following:
a. Such persons are officers or directors of one another’s businesses;
b. Such persons are legally recognised partners in business;
c. Such persons are employer and employee;
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d. Any person directly or indirectly owns, controls or holds twenty-five per cent or
more of the outstanding voting stock or shares of both of them;
e. One of them directly or indirectly controls the other;
f. Both of them are directly or indirectly controlled by a third person;
g. Person who are associated as sole agent or sole distributor or sole concessionaire.
h. Together they directly or indirectly control a third person; or they are members
of the same family; FAMILY MEANS
Explanation: Persons who are associated in the business of one another in that one
is the sole agent or sole distributor or sole concessionaire, howsoever described, of
the other, shall be deemed to be related.
Examples:
(i) Mr. A and Mr. B are partners in the partnership firm A&B Co. Mr. A & Mr. B are
related persons. Thus, a transaction of supply between Mr. A & Mr. B in the
course or furtherance of business is treated as supply even if made without
consideration.
(ii) Ms. Priya holds 30% shares of ABC Ltd. and 35% shares of XYZ Ltd. ABC Ltd.
and XYZ Ltd. are related.
(iii) Q Ltd. has a deciding role in corporate policy, operations management and
quality control of R Ltd. It can be said that Q Ltd. controls R Ltd. Thus, Q Ltd.
and R Ltd. are related.
(iv) Alpha Ltd. controls the composition of Board of directors of Beta Ltd. and Gama
Ltd. It is said to control both Beta Ltd. and Gama Ltd. Beta Ltd. and Gama Ltd.
are related persons.
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(v) Brita Ltd. and Grita Ltd. together control Margarita Ltd. Brita Ltd. and Grita Ltd.
are related.
• Supply of goods or services or both between an employer and employee: By virtue of

aforesaid definition of related person, employer and employee are related persons.
However, services provided by an employee to the employer in the course of or in
relation to his employment shall not be treated as supply of services [Schedule III
(Negative List)].
Further, Schedule I provides that gifts not exceeding ` 50,000 in value in a financial
year by an employer to an employee shall not be treated as supply of goods or services
or both.
Examples
• Distinct persons: As per section 25 of CGST Act, A person who has obtained/is required
to obtain more than one registration, whether in one State/Union territory or more
than one State/Union territory shall, in respect of each such registration, be treated
as distinct persons.
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Stock transfers or branch transfers: In view of the aforesaid discussion, transactions

between different locations (with separate GST registrations) of same legal entity
(eg., stock transfers or branch transfers) will qualify as ‘supply’ under GST.
iii. Importation of Service
Import of services by a person from a related person or from his establishments

located outside India, in the course or furtherance of business shall be treated as
“supply”.
iv. Principal - Agent
• Supply of goods by a principal to his agent, without consideration, where the agent
undertakes to supply such goods on behalf of the principal is considered as supply.
Similarly, supply of goods by an agent to his principal, without consideration, where
the agent undertakes to receive such goods on behalf of the principal is considered
as supply.
Scope of Principal Agent relationship - Circular 57/31/2018 dated 4th September 2018
The key ingredient for determining relationship under GST would be whether the invoice
for the further supply of goods on behalf of the principal is being issued by the agent or
not. Where the invoice for further supply is being issued by the agent in his name then, any
provision of goods from the principal to the agent would fall within the fold of the said
entry. However, it may be noted that in cases where the invoice is issued by the agent
to the customer in the name of the principal, such agent shall not fall within the ambit of
Schedule I of the CGST Act.
Scenario 1
Mr. A appoints Mr. B to procure certain goods from the market. Mr. B identifies various
suppliers who can provide the goods as desired by Mr. A, and asks the supplier (Mr. C) to
send the goods and issue the invoice directly to Mr. A. In this scenario, Mr. B is only acting
as the procurement agent, and has in no way involved himself in the supply or receipt of the
goods. Hence, Mr.B is not an agent of Mr. A for supply of goods in terms of Schedule I.
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Scenario 2
M/s XYZ, a banking company, appoints Mr. B (auctioneer) to auction certain goods.
The auctioneer arranges for auction and identifies potential bidders. The highest bid is
accepted and the goods are sold by M/s XYZ and invoice for supply of goods is issued by
M/s XYZ to successful bidder. In this scenario, auctioneer is merely providing auctioneering
services with no role in supply of goods. Even in this scenario, Mr.B is not an agent of M/s
XYZ for supply of goods in terms of Schedule I.
Scenario 3
Mr. A, an artist, appoints M/s B (auctioneer) to auction his painting. M/s B arranges for the
auction and identifies the potential bidders. The highest bid is accepted and the painting
is sold to the highest bidder. The invoice for the supply of the painting is issued by M/s B
on the behalf of Mr. A but in his own name and the painting is delivered to the successful
bidder. In this scenario, M/s B is not merely providing auctioneering services, but is also
supplying the painting on behalf of Mr. A to the bidder, and has the authority to transfer
the title of the painting on behalf of Mr. A. This scenario is covered under Schedule I.
A similar situation can exist in case of supply of goods as well where the C&F or commission
agent takes possession of the goods from the principal and issues the invoice in his own
name. In such cases, the C&F/commission agent is an agent of the principal for the supply
of goods in terms of Schedule I. The disclosure or non-disclosure of name of principal is
immaterial in such situations.
Scenario 4
Mr. A sells agricultural produce by utilizing the services of Mr. B, a commission agent
as per Agricultural Produce Marketing Committee Act (APMC Act). Mr. B identifies the
buyers and sells the agricultural produce on behalf of Mr. A for which he charges a
commission from Mr. A. As per the APMC Act, commission agent is a person who buys
or sells the agricultural produce on behalf of his principal, or facilitates buying and
selling of agricultural produce on behalf of his principal and receives commission in such
transaction.
In cases where invoice is issued by Mr. B to the buyer, the former is an agent covered under
Schedule I. However, in cases where invoice is issued directly by Mr. A to the buyer, the
commission agent (Mr. B) doesn’t fall under the category of agent covered under Schedule I.
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5.4. Activities to be treated as supply of goods or supply of services – Schedule II
Sl No. Transaction Type Nature of

Supply
1 Title of goods
Right in goods/ undivided share in goods
without transfer of goods
Transfer
Title in goods under an agreement which
stipulates that property shall pass at a
future date
2 Lease, tenancy, easement, licence to
occupy land
Land & Building
Lease or letting out of building wholly or
partly
3 Treatment or Applied to other person’s goods
process
4 Renting of immovable property
5 Transfer of right to use any goods for any purpose
6 Construction of complex, building, civil structure, etc. except
where the entire consideration has been received after
issuance of completion certificate, where required, by the
competent authority or after its first occupation, whichever
is earlier
7 Temporary transfer or permitting use or enjoyment of any
intellectual property right
8 Development, design, programming, customisation,
adaptation, upgradation, enhancement, implementation of
IT software
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9 Goods forming part of business assets

are transferred or disposed off by/under
directions of person carrying on the business
Goods held/used for business are put to
private use or are made available to any
person for use for any purpose other than
business, by/under directions of person
Transfer of carrying on the business
business assets Goods forming part of assets of any
business carried on by a person who
ceases to be a taxable person, shall be
deemed to be supplied by him, in the
course or furtherance of his business,
immediately before he ceases to be a
taxable person
10 Agreeing to obligation to refrain from an act, or to tolerate an
act or situation, or to do an act
11 Works contract services
12 Supply by way of or as part of any other service or in any
other manner whatsoever, of goods, being food or any other
article for human consumption or any drink
5.5. Negative list under GST – Schedule III

No. Activities or transactions neither as a supply of goods nor a supply of services
1 Services by an employee to the employer in the course of or in relation to his
employment
2 Services by any court or Tribunal established under any law for the time being
in force
Explanation - The term "Court" includes District Court, High Court and
Supreme Court
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3 (a) Functions performed by the Members of Parliament, Members of State

Legislature, Members of Panchayats, Members of Municipalities and
Members of other local authorities;
(b) Duties performed by any person who holds any post in pursuance of the
provisions of the Constitution in that capacity; or
(c) Duties performed by any person as a Chairperson or a Member or a Director

in a body established by the Central Government or a State Government
or local authority and who is not deemed as an employee before the
commencement of this clause
4 Services of funeral, burial, crematorium or mortuary including transportation
of the deceased.
5 Sale of land and, subject to paragraph 5(b) of Schedule II (Construction service),
sale of building
6 Actionable claims, other than lottery, betting and gambling.
7 Services by way of any activity in relation to a function entrusted to a Panchayat
under article 243G of the Constitution by CG, SG or local authority
8 Alcoholic Liquor License fee charged by State Government
IMMOVABLE PROPERTY
Money
ACTIONABLE CLAIM
Goods
Employee
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6. Questions on Section 7

Case Taxability and classification
Sale of goods for a consideration in the
course of business.
Purchase of mobile phone paying ` 15,000
after exchange of old phone worth ` 4,000.
Mr A (photographer) clicks a photograph
of Mr B and gets his bicycle for 2 days.
Renting of immovable property.
Sale of land by Mr A.
Sale of lottery ticket.
Demand draft of ` 5,000 without a fee.
Demand draft of ` 5,000 with a fee of ` 40.
Exchange of foreign currency with a fee.
Commission earned from sale of goods.
Employer providing transportation service
to employees for ` 200 per month as part
of employment contract.
Employer providing canteen facility for a
charge.
Finance minister receiving teaching fee
from JKSC.
Investment in Mutual Fund.
Commission earned by mutual fund agents.
Insurance claim receipts.
Insurance Premium charged by insurance
company.
Commission earned by insurance agent.
Sale of old car which was used for personal
purpose.
Inter-state movement of various modes of
conveyance such as trucks, buses between
distinct persons.
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7. Composite and Mixed Supplies [Section 8 of CGST Act]
• The tax liability on composite or a mixed supply shall be determined in the following
manner, namely:-
- A composite supply5 comprising two or more supplies, one of which is a principal

supply, shall be treated as a supply of such principal supply6.
- A mixed supply7 comprising of two or more supplies shall be treated as supply

of that particular supply that attracts highest rate of tax.
5
Composite supply means a supply made by a taxable person to a recipient and comprises two or more taxable supplies
of goods or services or both, or any combination thereof are naturally bundled and supplied in conjunction with each
other, in the ordinary course of business.
6
Principal supply means the supply of goods or services which constitutes the predominant element of a composite supply
and to which any other supply forming part of that composite supply is ancillary.
7
Mixed supply means two or more individual supplies of goods or services, or any combination thereof, made in
conjunction with each other by a taxable person for a single price where such supply does not constitute a composite
supply.
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DIRECT TAX
INTER CA. – DIRECT TAXES
INTRODUCTION
What is a Tax?
Let us begin by understanding the meaning of tax. Tax is a fee charged by a government
on a product, income or activity. There are two types of taxes – direct taxes and indirect
taxes (See Chart below this paragraph). If tax is levied directly on the income or wealth
of a person, then it is a direct tax e.g. income-tax. If tax is levied on the price of a good
or service, then it is called an indirect tax. In the case of indirect taxes, the person paying
the tax passes on the incidence to another person.
Why are Taxes Levied?

The reason for levy of taxes is that they constitute the basic source of revenue to the
government. Revenue so raised is utilized for meeting the expenses of government like
defence, provision of education, health-care, infrastructure facilities like roads, dams etc.
Overview of Income-Tax Law in India

Income-tax is the most significant direct tax. In this material, we would be introducing
the students to the Income-tax law in India. The income-tax law in India consists of the
following components–
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The various instruments of law containing the law relating to income-tax are explained
below:
Income-tax Act, 1961: The levy of income-tax in India is governed by the Income-tax Act,
1961. In this book we shall briefly refer to this as the Act. This Act came into force on
1st April, 1962. The Act contains 298 sections and XIV schedules. These undergo change
every year with additions and deletions brought about by the annual Finance Act passed
by Parliament. In pursuance of the power given by the Income-tax Act, 1961 rules have
been framed to facilitate proper administration of the Income-tax Act, 1961.
The Finance Act: Every year, the Finance Minister of the Government of India introduces the
Finance Bill in the Parliament’s Budget Session. When the Finance Bill is passed by both
the houses of the Parliament and gets the assent of the President, it becomes the Finance
Act. Amendments are made every year to the Income-tax Act, 1961 and other tax laws
by the Finance Act.
The First Schedule to the Finance Act contains four parts which specify the rates of tax -
→ Part I of the First Schedule to the Finance Act specifies the rates of tax applicable for
the current Assessment Year.
→ Part II specifies the rates at which tax is deductible at source for the current Financial
Year.
→ Part III gives the rates for calculating income-tax for deducting tax from income
chargeable under the head “Salaries” and computation of advance tax.
→ Part IV gives the rules for computing net agricultural income.
Income-tax Rules: The administration of direct taxes is looked after by the Central Board
of Direct Taxes (CBDT). The CBDT is empowered to make rules for carrying out the
purposes of the Act. For the proper administration of the Income-tax Act, 1961, the CBDT
frames rules from time to time. These rules are collectively called Income-tax Rules,
1962. It is important to keep in mind that along with the Income-tax Act, 1961, these
rules should also be studied.
Circulars and Notifications: Circulars are issued by the CBDT from time to time to deal with
certain specific problems and to clarify doubts regarding the scope and meaning of the
provisions. These circulars are issued for the guidance of the officers and/or assessees.
The department is bound by the circulars. While such circulars are not binding on the
assessees, they can take advantage of beneficial circulars. Notifications are issued by
the Central Government to give effect to the provisions of the Act.
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For example, under section 10(15)(iv)(h), interest payable by any public sector company
in respect of such bonds or debentures and subject to such conditions as the Central
Government may, by notification in the Official Gazette, specify in this behalf would
be exempt. Therefore, the bonds and debentures, interest on which would qualify for
exemption under this section are specified by the Central Government through Notifications.
The CBDT is also empowered to make and amend rules for the purposes of the Act by
issue of notifications. For example, under section 35CCD, the CBDT is empowered to
prescribe guidelines for notification of skill development project. Accordingly, the CBDT
has, vide Notification No.54/2013 dated 15.7.2013, prescribed Rule 6AAF laying down
the guidelines and conditions for approval of skill development project under section
35CCD. .
Case Laws: The study of case laws is an important and unavoidable part of the study of
income-tax law. It is not possible for Parliament to conceive and provide for all possible
issues that may arise in the implementation of any Act. Hence the judiciary will hear
the disputes between the assessees and the department and give decisions on various
issues. The Supreme Court is the Apex Court of the country and the law laid down by
the Supreme Court is the law of the land. The decisions given by various High Courts will
apply in the respective states in which such High Courts have jurisdiction.
Income tax Act 1961

Introduction
In India, Constitution is the parent law. All other laws should be enacted without
exceeding the framework of the constitution and subject to the norms laid down therein.
The Constitution of India empowers Central Government to levy tax on income. By virtue
of this power and to achieve this objective the Income Tax Act 1961 was enacted in the
place of the Income tax Act 1922.
According to Section 1 of the Income tax Act. The Act is to be called as “The Income Tax
Act 1961” and it extends to whole of India. It came into force on the 1st day of April 1962
i.e from AY 1962-63 onwards.
Preliminary
(a) Section 2 of the Income Tax Act gives definition of the various terms and expressions
used in the Act. Unless the context otherwise requires, these definitions should be
applied. The words “means”, “Includes” and “means and includes” are used in these
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definitions and the significance of these terms needs to be understood.

(b) When definition uses the word “means”, the definition is self - explanatory, restrictive
and in a sense exhaustive. It implies that term or expression so defined means only
as to what it is defined as and nothing else. For example, the terms Agricultural
Income, Assessment Year, Capital Asset are exhaustively defined.
(c) When the legislature wants to widen the scope of a term or expression and where
an exhaustive definition cannot be given, it uses the word includes in the definition.
Hence, the inclusive definition provides an illustrative meaning and not an
exhaustive meaning. In practical application the definition could include what is not
specifically stated or mentioned in the definition so long as the stipulated criteria
are satisfied. To illustrate reference is drawn to the definition of the terms Income,
Person, Transfer.
(d) When the legislature intends to define a term or expression to mean something
and also intends to specify certain items to be included both the words means and
includes are used. Such definition is not only exhaustive but also illustrative in
specifying what is intended to be included. Sometimes specific items are included
in an exhaustive definition in order to avoid ambiguity and with a view to provide
clarity. One can find that these words are used in the definition of the terms Assessee,
Firm etc.
(e) Apart from the definition under section 2 the Act defines various other terms under
the respective sections where they are used. For Example Section 17(2) defines
perquisite, Section 3 defines Previous year.
Section 4: Charging Section

As per Section 4 of the Income tax Act, 1961 Income-tax is payable by every Person on
his total Income earned in the Previous Year at the Rates applicable for the relevant
Assessment Year.
DEFINITIONS
Some of the words used in the above statement require elaboration
1. PERSON: [Section 2 (31)]
Section 4 provides for charging tax on every person and person is defined under
section 2(31) as including :
1. An individual.
2. A Hindu Undivided Family (H.U.F.).
3. A Company.
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4. A Firm; [Partnership Firm Assessed as Such (PFAS)].

5. An Association of Persons (A.O.P.) or Body Of Individuals (B.O.I.) whether
incorporated or not.
6. Local Authority.
7. Every artificial juridical person, not falling under any one of the preceding
categories.
Thus, this section enumerates seven types of assessees who are covered under
the Act. The seventh category is residuary and includes all sorts of artificial juridical
bodies not covered under any of the first six categories.
(2) INCOME [Section 2(24)]

Income is defined under section 2(24) of the Act. The definition contained in that
section is inclusive and not exhaustive, which means that income includes not only
those items which are enumerated in the section but besides it may include various
other items to which the natural meaning of the word may apply.
Section 2(24) defines as "Income" includes the following;
1. Profits and gains which are covered by section 28 or section 41.
2. Dividend
3. In case of charitable or religious trust or institution or educational institution
or university or hospital, or an electoral trust, voluntary contribution received.
4. The value of any perquisite taxable u/s 17(2), or profit in lieu of salary taxable
u/s 17(3), under the head salaries.
5. Any special allowance granted by the employer to meet expenses wholly,
necessarily and exclusively for the performance of the duties of employment &
dearness allowance & city compensatory allowance.
6. The value of any benefit or perquisite received by :
→ director of a company,
→ person who has a substantial interest in the company,
→  relative of director or person who has substantial interest in the
company, from a company, which otherwise was the obligation payable
by such persons.
7. The value of any benefit or perquisite obtained / paid by
→ by the representative assessee on behalf of the beneficiary -
→ which otherwise was the obligation payable by such beneficiary.
8. Any capital gains chargeable under section 45.
9. The profit and gain of any business or insurance carried on by a mutual insurance
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company or by a co-operative society, computed in accordance with section 44.

10. The profit and gains of any business of banking (including providing credit
facilities) carried on by a cooperative society with its members.
11. Any winnings from lotteries, crossword, puzzles, races including horse races,
card games and other games of any sort or from gambling or betting of any
form or nature whatsoever.
12. Any sum received by the assessee from his employees as contributions to any
provident fund or super annuation fund or any fund set up under the provisions
of the Employee's State Insurance Act, 1948, or any other fund for the welfare
of such employees.
13. Any sum received under a keyman insurance policy including the sum allocated
by way of bonus on such policy.
14. Any sum of money or any property (movable or immovable) received for no
consideration or inadequate consideration shall be considered as income,
subject to the provisions of section 56.
15. Any consideration received by a closely held company for issue of shares as
exceeds the fair market value of the shares referred to in section 56.
16. Any assistance in the form of subsidy, grant, cash incentive, duty drawback,
concession or reimbursement provided by Central Government or State
Government or any authority or any agency, except for-
(a) Subsidy provided for acquiring fixed assets for business purposes; and
(b) Subsidy provided by Central Government for the corpus of a trust or
institution set up by Central/State Government.
Following are the broad principles to understand the concept of "Income".

1. Different forms of income - Income may be received in cash or in kind. When it is
received in kind, its valuation is to be made according to the rules prescribed in
the Income-tax Rules. If however there is no prescribed rule, valuation thereof
is made on the basis of market value.
2. Receipt Vs. Accrual - Income arises either on receipt basis or on accrual basis.
Income may accrue to a tax payer without its actual receipt.
→ Salaries: Due or receipt whichever is earlier
→ House - property: Due basis
→ Business & Profession : As per method of accounting regularly followed
→ Capital Gains: Due basis
→ Income from other sources: As per method of accounting regularly
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followed.
3. Relief or reimbursement of expenses is not treated as income - Mere relief or
reimbursement of expenses is not treated as income; for instance, reimbursement
of conveyance expenses to an employee is not an income.
4. Illegal income - The income - tax law does not make any distinction between
income accrued or arisen from a legal source and income tainted with illegality.
5. Disputed title - Income-tax assessment cannot be held up or postponed
merely because of existence of a dispute regarding the title of income.
6. Source of income need not exist in the assessment year: It is not necessary that a
source of income should exist in the assessment year.
Question.
Write short notes on Diversion of income
Answer
. Where by an obligation, income is diverted before it reaches the assessee, it
is "diversion of income" and not taxable. Conversely, after earning the income, if it
is required to be applied to discharge an obligation, it is merely an "application of
income" and income is chargeable to tax.
'Diversion of income', means handing over the income or part of it under a legal
obligation, i.e. the income infact relates to some other person and because of the
legal right of some other person, it is handed over to him Thus it cannot be considered
as income of the person who has initially received it and subsequently handed it
over to the other person. It will be considered as income of the other person who has
subsequently received it. Some examples of Diversion of Income are :
→ Right of maintenance of dependants or of co-parceners on partition of HUF.
→ Right under a statutory provision.
→ A charge created by a decree of a court of law.
Example: A and B are the joint authors of a book and are to share the remuneration
equally. The book is published in December, 2022 and in January 2023, as per the
Contract, A, the first author receives the entire remuneration of 2,50,000 and 50% of
the same is paid by A to B subsequently. This payment by A to B is "diversion of income
by overriding title", and his taxable income is only `1,25,000 and B's income will also
be `1,25,000. Now whatever A & B spend / invest out of their income of `1,25,000
each is an "application of income".
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GROSS TOTAL INCOME (G.T.I.) [Section 80B(5)]

G.T.I. means the 'total income' computed under the five heads.
TOTAL INCOME [Section 2(45)]
It means the total amount of income referred to in section 5, computed in the
manner laid down in this Act.
*As per section 14, income of a person is computed under the following five heads
1. Income from salaries
2. Income from house property
3. Profits or gains of business or profession
4. Capital gains
5. Income from other sources
The aggregate of above is G.T.I. from which deductions under sections 80C to 80U are
deducted, and thus we arrive at the total income.
(3) PREVIOUS YEAR [Section 2(34)]

It means the previous year as defined in section 3. Section 3 has defined the previous
year as the financial year immediately preceding the assessment year. Income tax
is payable on the income earned during the previous year. It is brought to tax in
the immediately succeeding financial year, which is called as an Assessment year.
Therefore, the income earned during the previous year 2022-23.
i.e. 1st of April 2022 to 31st March, 2023, will be charged to tax in the assessment
year 2023-24.
Provided that, in the case of a business or profession newly set up, or a source of
income newly coming into existence, in the financial year, the previous year shall be
the period beginning with the date of setting up of the business or profession or, as
the case may be, the date on which the source of income newly comes into existence
and ending with the said financial year i.e. 31st March.
For e.g. Mr. "S" sets up a new business on 10th July, 2022 then the period from
10.7.2022 to 31.3.2023 will be his first previous year for the assessment year 2023-
2024. Thereafter every year a period of 12 months of April-March will be his previous
year. Thus only in the first year previous year will be for a broken period.
(4) ASSESSMENT YEAR [Section 2(9)]

Assessment year means the period of twelve months commencing on the 1st day of
April every year.
This means that every financial year beginning on the first of April and ending on
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the 31st of March, is the assessment year. For example, the period from the 1st
April, 2023 to 31st March 2024 is called assessment year 2023 - 2024 in respect of
previous year 2022 - 2023.
Thus Income-Tax is an annual tax, charged on the total income earned by a person.
For computation of Income, the law applicable for the relevant assessment year
should be referred. Income-tax law changes frequently. Income taxable in a year
may be exempt or taxable differently in another assessment year.
The rates of tax may change from one assessment year to another. Thus the amount
of tax may differ from one assessment year to another, although the income earned
is the same in both the years.

(5) TAX RATES FOR ASSESSMENT YEAR 2023-2024
Particulars Individual/H.U.F./ Firm & Local Indian Foreign
A.O.P./B.O.I/A.J.P. Authority Company Company
Basic tax Slab rates Flat rate of Flat rate of Flat rate of
30% 30% 40%
Add: If Total Income If Total If Total If Total
Surcharge > `50 lakhs, 10% of Income Income > ` 1 Income > ` 1
Basic tax >`1 Crore but < = Crore but <
Crore, 12% of ` 10 = ` 10
Basic tax crores, 7% of crores, 2% of
Basic tax Basic tax
If Total Income If Total If Total
> ` 1 Crore, 15% of Income Income
Basic tax > >
If total income > 2 `10 crores, ` 10 crores,
crores, 25% of Basic tax 12% of Basic 5% of Basic
If total income > 5 tax tax.
crore,
37% of Basic tax
Add: Health 4% of (Basic tax – 4% of 4% of 4% of
& Education Rebate + Surcharge) (Basic tax + (Basic tax + (Basic tax +
Cess Surcharge) Surcharge) Surcharge)
TAX PAYABLE XXXX XXXX XXXX XXXX
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(I) SLAB RATES

Resident Senior Citizens Resident Very Senior / Super Others (Individuals aged <
(Age > = 60 years but < 80 Senior Citizens (Age > = 80 60 years at any time during
years at any time during years at any time during the the P.Y., H.U.F, A.J.P.) and
the P.Y.) P.Y.) all not resident individuals
Upto 3,00,000 NIL Upto 5,00,000 NIL Upto 2,50,000 NIL
3,00,001-5,00,000 5% 5,00,001-10,00,000 20% 2,50,001-5,00,000 5%
5,00,001-0,00,000 20% > 10,00,000 30% 5,00,001- 20%
10,00,000
> 10,00,000 30% > 10,00,000 30%
` 3,00,000, ` 5,00,000 and ` 2,50,000 are called as " BASIC EXEMPTION LIMIT"since
income tax is payable by the person on the income exceeding this limit.
Note 1:
If turnover or gross receipts for previous year 20 - 21 is upto 400 crores = basic tax
is 25% (applicable only to companies).
Note 2:
If an individual is born on 1/4/1963, then he / she turn 60 years of age on 31/3/2023.
Therefore he/ she will be considered as senior citizen for the P.Y. 2022-23 and will
be entitled to higher basic exemption limit of ` 3,00,000
(II) REBATE UNDER SECTION 87A

An individual who is resident in India, and whose total income does not exceed ` 5,00,000,
shall be entitled to a deduction, of the amount of "Basic tax" (calculated as per slab
rates) or a maximum of ` 12,500, whichever is less. This rebate shall be reduced
from the basic tax. Please note that this rebate is available to "individuals" only &
not to the other six persons as per section 2(31).
Note: No Rebate available from tax payable on LTCG u/s 112A.
(III) MARGINAL RELIEF

(ia) For persons other than companies
The total amount payable as income-tax and surcharge on total income
exceeding 50 lakhs rupees shall not exceed the total amount payable as
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income-tax on a total income of 50 lakhs rupees by more than the amount of

income that exceeds one crore rupees.
If
[Basic tax + S.C. on Total Income] – [Basic tax on Total Income of ` 50 lakhs] >
Income in excess of ` 50 lakhs,
Then
Marginal Relief = [Basic tax + S.C. on Total Income] – [Basic tax on Total Income of `
50 lakhs] - Income in excess of ` 50 lakhs
(ib) For persons other than companies
exceeding one crore rupees shall not exceed the total amount payable as
income-tax on a total income of one crore rupees by more than the amount of
income that exceeds one crore rupees.
If
[Basic tax + S.C. on Total Income] – [Basic tax on Total Income of ` 1 crore] >
Income in excess of ` 1 crore, Then
1 crore] - Income in excess of ` 1 crore.
(ii) For companies having income
(a)
exceeding ` 1 crores but not exceeding ` 10 crores and
(b)
exceeding ` 10 crores.
exceeding one crore rupees but not exceeding ten crore rupees, shall not exceed
the total amount payable as income-tax on a total income of one crore rupees,
by more than the amount of income that exceeds one crore rupees.
exceeding ten crore rupees, shall not exceed the total amount payable as
income-tax and surcharge on a total income of ten crore rupees, by more than
the amount of income that exceeds ten crore rupees.
If
[Basic tax + S.C. on Total Income] – [Basic tax + S.C. on Total Income of ` 10
crore] > Income in excess of ` 10 crore,
Then
10 crore] - Income in excess of ` 10 crore.
204
(IV) Section 115BAC: New tax regime for individual/ HUF- Optional
Government has introduced a new scheme for individuals and HUFs with lower rates
for those foregoing certain exemptions/deductions:

Total income Tax Rate (Under the new regime)
Up to Rs. 2,50,000 Nil
Rs.2,50,000 to Rs. 5,00,000 5%
Rs.5,00,000 to Rs. 7,50,000 10%
Rs. 7,50,000 to Rs. 10,00,000 15%
Rs.10,00,001 to Rs. 12,50,000 20%
Rs. 12,50,001 to Rs. 15,00,000 25%
Above Rs.15,00,000 30%
1. Optional Scheme
2. Individual or HUF does not have business income, the option is to be exercised
for every year along with the filing of the return of income under section 139(1)
for the year.
3. Where such individual or HUF has business/profession, the option is to be
exercised on or before the due date of filling the return of income and such
option once exercised shall apply for that previous year and to all subsequent
years. One – time change is possible. After such change is done once, then
change is never possible unless business stops.
4. Which deduction/exemptions not to be allowed u/s 115 BAC?
1. Leave Travel Concession – section 10(5)
2. House Rent Allowance – section 10(13A)
3. Exemption for allowance u/s 10(14) except – transport allowance, Conveyance,
daily allowance, tour-travel-transfer allowance
4. Allowance to MPs /MLAs – section 10(17)
5. Clubbed income of minor upto Rs.1,500 –section 10(32)
6. Exemption for unit in SEZ – section 10AA
7. Standard and other deductions (including profession tax) from salary – section16
8. Interest in respect of Self Occupied Property – section 24(b)
9. Set off of loss under the head income from house property against other heads
– Section 71 or any loss of earlier years belonging to any deductions mentioned
in this list
10. Additional depreciation – section 32(1)(iia)
11. Deduction under sections 32AD, 33AB and 33ABA
205
12. Specified deduction for donations or for expenditure on scientific research-

section 35(1)(ii)/(iia)/(iii) or section 35(2AA)
13. Weighted deduction for expenditure on specified business/agricultural extension
project-section 35AD and 35CCC
14. Standard deduction for family pension – section 57 (iia)
15. Deduction under Chapter VI-A (such as section 80C, 80D, 80TTA, 80TTB, 80G
etc.) Other than following:-
a) 80CCD(2) – employer’s contribution in notified pension scheme
b) 80JJAA – employment of new employees
c) 80LA – IFSC centre
Comparison with New tax regime with old.

[In new regime No – Standard deduction u/s 16(ia) of 50,000, No deduction of 80C of 1,50,000
& S.O. P Int. of 2,00,000 which normally people claim.]
ANNUAL INCOME TAX LIABILITY EXCLUDING SURCHARGE & EDUCATION CESS

1A 2A 3A 4A 5A 2B 3B 4B 5B 6B
Income Difference Rate Basic Cum. Difference Rate Basic Cum. Diff of
up to of tax of tax TAX
tax [5A – 5B]
2,50,000 - - Nil Nil - - Nil Nil -
5,00,000 2,50,000 5% 12,500 12,500 2,50,000 5% 12,500 12,500 -
7,50,000 2,50,000 10% 25,000 37,500 2,50,000 20% 50,000 62,500 25,000
8,00,000 50,000 15% 7,500 45,000 50,000 20% 10,000 72,500 27,500
10,00,000 2,00,000 15% 30,000 75,000 2,00,000 20% 40,000 1,12,500 37,500
12,50,000 2,50,000 20% 50,000 1,25,000 2,50,000 30% 75,000 1,87,500 62,500
15,00,000 2,50,000 25% 62,500 1,87,500 2,50,000 30% 75,000 2,62,500 75,000
50,00,000 35,00,000 30% 10,50,000 12,37,500 35,00,000 30% 10,50,000 13,12,500 75,000
75,00,000 25,00,000 30% 7,50,000 19,87,500 25,00,000 30% 7,50,000 20,62,500 75,000
Thus now the difference remains same.

But in the new tax regime the assesse will not get the deductions mentioned in point
4(sub points 1 to 15) mentioned in earlier page.
(v) Rounding - off of Income / Tax [Section 288A / 288B]

The taxable income / tax shall be rounded off to the nearest multiple of ten rupees
and for this purpose any part of a rupee consisting of paise shall be ignored and
206
thereafter if such amount is not a multiple of ten, then, if the last figure in that
amount is five or more, the amount shall be increased to the next higher amount
which is multiple of ten and if the last figure is less than five, the amount shall be
reduced to the next lower amount which is a multiple of ten.
Example:
Income / tax before rounding off Income/Tax after rounding off as per sec. 288A / 288 B
1, 23, 454.90 1, 23, 450
1, 23, 455.00 1, 23, 460
1, 23, 458.90 1, 23, 460
1, 23, 464.80 1, 23, 460
207
RESIDENCE OF AN
ASSESSEE
WHAT IS RELEVANCE OF RESIDENTIAL STATUS

Tax incidence on a assessee depends on his residential status. For instance, whether
an income, accrued to an individual outside India, is taxable in India depends upon the
residential status of the individual in India. Similarly, whether an income earned by a
foreign national in India (or outside India) is taxable in India, depends on the residential
status of the individual, rather than on his citizenship. Therefore, the determination of the
residential status of a person is very significant in order to find out his tax liability.
WHAT ONE MUST KNOW FOR DECIDING RESIDENTIAL STATUS

→ Residential status is a term coined under Income Tax Act and has nothing to do
with nationality or domicile of a person. An Indian, who is a citizen of India can be
non-resident for Income-tax purposes, whereas an American who is a citizen of
America can be resident of India for Income-tax purposes. Residential status of a
person depends upon the territorial connections of the person with this country, i.e.,
for how many days he has physically stayed in India.
→ The residential status of different types of persons is determined differently.
Similarly, the residential status of the assessee is to be determined each year with
reference to the “previous year”. The residential status of the assessee may change
from year to year. What is essential is the status during the previous year and not in
the assessment year.
→ Duty of Assessee- It is assessee’s duty to place relevant facts, evidence and material
before the Income Tax Authorities supporting the determination of Residential
status.
→ Dual Residential Status is possible - A person may be resident of one or more countries
in a relevant previous year e.g., Mr. X may be resident of India during previous year
2022 - 23 and he may also be resident/non-resident in England in the same previous
year. The emergence of such a situation depends upon the following
(a) the existence of the Residential status in countries under considerations
(b) the different set of rules having laid down for determination of residential
208
status.
→ Different residential status – An assessee is either (a) Resident in India, or (b) non
– resident in India. However, a resident Individual or a Hindu undivided family has
to be (a) resident and ordinarily resident, or (b) resident but not ordinarily resident.
Therefore, an individual and a Hindu undivided family can either be:
(a) Resident and ordinarily resident
(b) resident but not ordinarily resident
(c) Non resident in India.
All other assessees (viz, a firm, an association of person, a joint stock company and
every other person) can either be:
(a) Resident in India or
(b) Non-resident in India
The following chart highlights the same –

The following chart highlights the same –
HOW TO DETERMINE RESIDENTIAL STATUS OF AN INDIVIDUAL – SECTION 6(1)
209
1. Basic Conditions:
(a) If the Individual stayed in India for a period of 182 DAYS OR MORE during the
Relevant Previous Year (RPY), he is Resident of India;
(OR)
(b) (i) If he stayed in India for a period of 60 DAYS OR MORE during
Relevant Previous Year (RPY)
AND
(ii) 365 DAYS OR MORE during the four preceding Previous Years, he is Resident
of India.
If the assessee fails to satisfy either of the above basic conditions, as applicable,
then the assessee is a Non-Resident for that Relevant Previous Year.
2. Additional Conditions: Sec. 6(6) (a)

(1) Resident in India for at least 2 years out of the preceding 10 Previous Years.
(Preceding to relevant PY)
AND
(2) Stay in India for at least 730 days during the 7 preceding Previous Years
(Preceding to relevant PY).
If the assessee satisfies above additional conditions, then assessee is Resident
and ordinarily otherwise Resident but not ordinarily resident.
Special exceptional situations:

For the following persons, condition mentioned in 1(a) above shall only apply to determine
their Residential Status i.e. i.e. only (a) basic condition will be applicable and not (b) basic
condition.
210
Note:
1. The day on which he enters India as well as the day on which he leaves India
shall be taken into account as the stay of the Individual in India.
2. The stay in India need not be at the same place
3. It is also not essential that the stay should be continuous.
4. The place of stay and purpose of stay in India, is not material
How to determine period of stay in India for an Indian citizen, being a crew member?
In case of foreign bound ships where the destination of the voyage is outside India,
there is uncertainty regarding the manner and the basis of determining the period of stay
in India for an Indian citizen, being a crew member.
To remove this uncertainty, Explanation 2 to section 6(1) provides that in the case of an
211
Individual, being a citizen of India and a member of the crew of a foreign bound ship
leaving India, the period or periods of stay in India shall, in respect of such voyage, be
determined in the prescribed manner and subject to the prescribed conditions.
Accordingly, the CBDT has, vide Notification No.70/2015 dated 17.8.2015, inserted Rule
126 in the Income-tax Rules, 1962 to compute the period of stay in such cases.
According to Rule 126, for the purposes of section 6(1), in case of an individual, being a
citizen of India and a member of the crew of a ship, the period or periods of stay in India
shall, in respect of an eligible voyage, not include the following period:
Period to be excluded
Period commencing from Period ending on
the date entered and the date entered into the Continuous
into the Continuous Discharge Discharge Certificate in respect of
Certificate in respect of joining signing off by that individual from the
the ship by the said individual ship in respect of such voyage
for the eligible voyage
Meaning of certain terms:

Terms Meaning
(a) Continuous Discharge This term has the meaning assigned to it in the
Certificate Merchant Shipping (Continuous Discharge Certifi-
cate-cum Seafarer’s Identity Document) Rules, 2001
made under the Merchant
Shipping Act, 1958.
(b) Eligible voyage A voyage undertaken by a ship engaged in the
carriage of passengers or freight in international
traffic where –
(i) for the voyage having originated from any port
in India, has as its destination any port outside
India; and
(ii) for the voyage having originated from any port
outside India, has as its destination any port in
India.
212
HOW TO DETERMINE RESIDENTIAL STATUS OF AN HINDU UNDIVIDED FAMILY– SECTION

6(2)
A Hindu Undivided Family is said to be R&OR/RNOR in India if control and management of
its affairs is, wholly or partly, situated in India. A Hindu Undivided Family is non-resident
in India if control and management of its affairs is wholly situated outside India.
1. Control and management means de- facto control and management and not merely
the right to control or manage. Control and management is situated at a place
where the head, the seat and the directing power are situated.
2. And ordinarily/ not ordinarily depends upon the individual residential status of the
karta, i.e. satisfaction of additional conditions by the Karta.
HOW TO DETERMINE RESIDENTIAL STATUS OF FIRM AND ASSOCIATION OF PERSON –

SECTION 6(2)
A partnership firm and an association of person are said to be resident in India if control
and management of their affairs are wholly or partly situated within India during the
relevant previous year.
HOW TO DETERMINE RESIDENTIAL STATUS OF COMPANY [SECTION 6(3)]

An Indian company is always resident in India. A foreign company is resident in India only
if its "Place of effective management", in that year, is in India.
→ The term "Place of effective management" means a place where Key management
and commercial decisions that are necessary for the conduct of the business of an
entity as a whole are, in substance, made.
→ Usually control and management of a company's affairs is situated at the place
where meetings of board of directors are held. Moreover, control and management
referred to in section 6 is central control and management and not the carrying on
of day to day business by servants, employees or agents.
→ The term "control" does not mean shareholding control.
HOW TO DETERMINE RESIDENTIAL STATUS OF "EVERY OTHER PERSON" [SECTION 6(4)]

Every other person is resident in India if control and management of his affairs is wholly
or partly situated within India during the relevant previous year. On the other hand, every
other person is non-resident in India if control and management of its affairs is wholly
situated outside India.
213
SCOPE OF INCOME (SECTION 5)

Sr. Situations Whether taxable in the case of
No. R & OR R N OR NR
1. Income accruing or arising in India Yes Yes Yes
whether received in India or outside
India
2. Income received in India for the 1st Yes Yes Yes
Indian Income
time whether accrued in India or
outside India.
3. Income deemed to be received in India Yes Yes Yes
whether accrued in India or outside
India (Sec. 7)
4. Income deemed to accrue or arise Yes Yes Yes
in India whether received in India or
outside India (Sec. 9)
5. Income received and accrued outside Yes Yes No
India from a business controlled in or
profession set up in India
Foreign Income
6. Income received and accrued outside Yes No No
India from a business controlled from
outside India or a profession setup
outside India
7. Income accrued and received outside Yes No No
India (other than business and
profession)
8. Income earned and received outside No No No
India for an earlier year, but remitted
to India in the current year (whether
tax incidence arises at the time of
remittance?- No, as earlier is taxed on
accrual or due basis.)
214
Incomes deemed to accrue or arise in India [Section 9]

Certain Incomes are deemed to accrue or arise in India u/s 9 even though they may
actually arise outside India. The following is a list of such incomes in simple words.
1. Any business connection in India is taxable in India
2. Income through or from any property, any asset or source of income in India.
3. Income through the transfer of Capital Asset situated in India.
4. Income which falls under the head "Salaries" shall be regarded as income
earned in India if the income is payable for -
→ service rendered in India, and
→ the rest period or leave period, which is preceded and succeeded by services,
rendered in India and forms part of the service contract of employment.
5. Salary paid by the Government to a citizen of India for rendering service
outside India. However the allowances and perquisites paid outside India by
the Government to the citizen of India, is exempt u/s 10(7).
6. Dividend paid by an Indian company outside India.
7. Interest payable by:
(a) Government ; or
(b) any resident person, unless the interest is payable on any debt incurred or
money borrowed and used for a business or profession carried on by him outside
India or for earning any income from any source outside India ; or
(c) any non-resident person, when the interest is payable on any debt incurred or
money's borrowed and used for the purpose of a business or profession carried on
by him in India.
8. Royalty payable by:
(a) Government ; or
(b) any resident person, unless the royalty is payable in respect of any right,
property or information used or services utilised for the purposes of a business
or profession carried on by him outside India or for earning any income from
any source outside India ; or
(c) any non-resident person, when the royalty is payable in respect of any right,
property or information used or services utilised for the purposes of a business
or profession carried on by him in India or for earning any income from any
source in India.
9. Income by way of fees for technical services payable by :
(a) Government ; or
(b) any resident person, unless the technical fees is payable for a business or
215
profession carried on by him outside India or for earning any income from any
source outside India ; or
(c) any non-resident person, when the technical fees is payable for a business
or profession carried on by him in India or for earning any income from any
source in India.
The income of the non-resident shall be deemed to accrue or arise in India,
whether or not -
(i) the non-resident has a residence or place of business or business connection
in India
OR
(ii) the non-resident has rendered services in India.
OR
(iii) The possession or control of such right, property or information is with the
payer or used directly by the payer or the location is in India.
10. Income arising outside India, being any sum of money referred to in
sub clause (xviia) of clause (24) of section 2, paid on or after the 5th day of July,
2019 by a person resident in India to a non - resident, not being a company, or to a
foreign company.
Note: For Royalty & Fees for Technical services, Sec9 shall be applicable if
1. The payer is non-resident;
2. The patent, formula etc. (for Royalty) or services (or fees) are used for earning ANY
INCOME IN INDIA.
216
CLASSWORK PROBLEMS
Question 1
Mr. J is a citizen of Japan. He visited India for the first time of 1st April, 2017 and stayed
in India upto 10th April 2020. He again came back to India on 12th January, 2023 and
stayed here thereafter. Determine his residential status for Assessment Year 2023-24.
Question 2
Brett Lee, an Australian cricket player visits India for 100 days in very financial year. This
has been his practice for the past 10 financial years.
(a) Determine his residential status for A.Y. 2023-24.
(b) Would your answer be different if the above facts relate to Srinath, an Indian citizen
who resides in Australia and represents the Australian cricket team?
(c) What would be your answer if Srinath had visited India for 120 days instead of 100
days every year, including P.Y. 22-23?
Question 3
Mr. X is Professor at IIM, Ahmedabad. On 10th August, 2022, he left India to take Up the
professors Job at London School of Economics. He had never been out of India in the past.
Determine his residential status for A.Y. 2023-24.
(a) Would your answer be different if he had gone on a leisure trip?
Question 4
'F' was born in FRANCE in 1969 and his father was born in Australia in 1939, but F's
Grandfather was born in Dhaka in 1915. Will 'F' be a resident in India if he visits India for
181 days during the previous year 2022-23.
Determine Residential status for assessment year 2023 – 24, assuming his Indian income
is < 15 Lakhs.
Question 5
X, a citizen of India, left India for the 1st time on 6.6.2019 for employment abroad.
During 2020–21 and 2021-22 he visited India for 145 days and 165 days respectively. In
the previous year 2022-23 he came to India on 7.4.22 and left on 30.11.22.
Determine the residential status for the assessment year 2023-24, assuming his Indian
income is < 15 Lakhs.
217
Question 6
Mr. Ramchandra HUF is partly controlled from India. Mr. Ramchandra, Karta of HUF, is
visiting India for 50 days every year since 2018-19. Prior to that he visited India for 200
days every year.
Determine residential status of Mr. Ramchandra HUF for A.Y. 2023-24.
Question 7
Following are the particulars of taxable income of Mr R for the previous year ended
31.03.2023.
1. Royalty received from Government of India ` 24,000
2. Income from business earned in Afghanistan ` 25,000 of which 15,000 were received
in India (Controlled from Afghanistan).
3. Interest received from G a non- resident against a loan provided to him to run a
business in India 5000.
4. Royalty Received in India from S a resident for technical services provided to run a
business outside India 20,000.
5. Income from business in Jaipur 40,000. This business is controlled from France
20,000 were remitted to France.
6. Profit on sale of shares in Indian Company received in Germany ` 15,000
7. Dividend
- From Japanese Company received in Japan – 10,000
- From RP Ltd an Indian Company – 5,000
8. Income from property in London deposited in a bank in London, later on remitted to
India 1,00,000.
9. Income from Business in Canada Controlled from Mumbai 50,000 of which 27,000 is
received in India.
Find out Total Income of Mr R, if he is –
(a) Resident and Ordinarily Resident
(b) Resident but not Ordinarily Resident
(c) Non Resident.
218
HOMEWORK PROBLEMS
Question 1
Mr. Kohli, a citizen of India, is an export manager of Arjun Overseas Limited, an Indian
Company, since 1.5.2018. He has been regularly going to USA for export promotion. He
spent the following days in U.S.A. for the last five years:
Previous year ended No. of days spent in USA
31.3.2019 317 days
31.3.2020 150 days
31.3.2021 271 days
31.3.2022 311 days
31.3.2023 294 days
Determine his residential status for assessment year 2023-24 assuming that prior to
1.5.2018 he had never travelled abroad.
Question 2
Mr. A is an Indian citizen and a member of the crew of a Singapore bound Indian ship
engaged in carriage of passengers in international traffic departing from Chennai port on
6th June, 2022. From the following details for the P.Y.2022-23, determine the residential
status of Mr. A for A.Y.2023-24, assuming that his stay in India in the last 4 previous years
(preceding P.Y.2022-23) is 400 days and last seven previous years (preceding P.Y.2022-
23) is 750 days:
Particulars Date
Date entered into the Continuous Discharge Certificate in respect 6th June, 2022
of joining the ship by Mr. A
Date entered into the Continuous Discharge Certificate in respect 9th December 2022
of signing off the ship by Mr. A
Question 3
Determine the residential status in the following cases for the assessment year
2023-24:
(i) The control and management of a HUF is situated in India. The manager of the H.U.F.
visited England with his wife from 14.8.2022 to 30.6.2023. Earlier to that he was
always in India.
219
(ii) A company, whose registered office is in America, has a place of its effective
management in the previous year in India.
(iii) In a partnership firm, there are three partners namely A, B and C. A and B reside in
India while C lives in Germany. The firm is fully controlled by C. During the previous
year, Mr. C stayed for 6 months in India.
(iv) A V.I.P. Club is in India, whose director Mr. X belongs to China. The Club is controlled
fully by Mr. X. In the previous year. Mr. X did not come for a single day to India.
Question 4
‘A’ earns the following income during the financial year 2022-23:
Particulars Amount (`)
(a) Interest paid by an Indian company but received in London 2,00,000
(b) Pension from former employer in India, received in USA (after Std. 8,000
Deduction)
(c) Profits earned from business in Paris which is controlled in India, 40,000
half of the profits being received in India
(d) Income from agriculture in Bhutan and remitted to India 10,000
(e) Income from property (computed) in England and received there 8,000
(f) Past foreign untaxed income brought to India 20,000
Determine the total income of ‘A’ for the assessment year 2023-24 if he is
(i) Resident and ordinarily resident, (ii) Not ordinarily resident, and (iii) Non-
resident in India.
Question 5
Following are the incomes of R, a citizen of India, for the previous year 2022-23:
1. Interest on Saving Bank Deposit in Corporation Bank, Delhi 12,000
2. Income from agriculture in Africa invested in Russia 5,000
3. Dividends received in USA from an English Company, out of which ` 12,000
2,000 were remitted to India
4. Salary drawn for two months for working in Indian Embassy’s Office in 48,000
Australia and salary received there (After Standard Deduction)
5. Income from house property (computed). (The building is situated in Iraq, out 25,000
of which ` 20,000 deposited in a bank in Iraq and the balance remitted to India)
6. Pension received in Belgium for services rendered in India with a 10,000
limited company (After standard deduction)
220
You are required to compute his gross total income for the assessment year 2023-24
if he is (a) a resident and ordinarily resident, (b) not ordinarily resident, and (c) a non-
resident.
Question 6
Mr. Kapoor earns the following incomes:
Sr. Particulars `
1 Income (computed) from a HP in London, received in India 60,000
2 Profits from a Business in Japan, managed & received in Japan 900,000
3 Dividend from a Foreign Company, received in India 30,000
4 Dividend from an Indian Company, received in England 50,000
5 Profits from a Business in Kenya, controlled from India but received 300,000
in England
6 Profits from a Business in Delhi, managed in France 700,000
7 Capital Gains on transfer of shares of Indian Companies, sold in 200,000
USA, gains received in USA
8 Pension from a former employer in India, received in Vatican City 50,000
9 Profits from a business in Melbourne, deposited in a Bank in 20,000
Melbourne
10 Profit on sale of an asset in India, but received in Canada 8,000
11 Past untaxed profits of a UK Business for P.Y. 2014-15, brought 90,000
into India
12 Interest on Government Securities accrued in India, but received 80,000
in Chile
13 Interest on USA Government Securities, received in India 20,000
14 Interest on USA Government Securities, received in Malaysia 100,000
15 Salary earned in Mumbai, but received in Ottawa 60,000
16 Income from a property (computed) in Hong Kong, received there 100,000
On the presumption that all the above incomes are computed incomes, determine the
Gross Total Income of Mr. Kapoor, assuming that he is a ROR or RNOR or NR.
221
Question 7
Mr. Suhaan furnished the following particulars of his income
Sr. Particulars `
(a) Income earned from business in France which is controlled from 90,000
Mumbai (` 65,000 is received in India)
(b) Computed Pension for services rendered in India but received in 14,000
France
(c) Dividend received in France from Titanium Inc., a French company 25,000
(d) Rent from property in France deposited in a bank in France and 85,000
later on, remitted to India through approved banking channels
(e) Dividend from Sunset Ltd., an Indian company received in France 98,000
Compute the Gross Total Income of Mr. Suhaan, if he is ROR, RNOR, NR.
Question 8
Mr. Shantaram, a foreign national, furnishes the following particulars
Profit on sale of plant at London - [1/2 is received in India] 46,000
Profit on sale of plant at Delhi - [1/2 is received in London] 52,000
Interest on U.K. Power Bonds - [entire amount received in London] 40,000
Interest on Bank Accounts in India 5,000
Dividend from British Company received in India 2,000
Interest received in London from a Company registered in India but mainly 18,000
operating in U.K.
Profit from a business in Delhi managed from India 30,000
Income from a business in China controlled from India 10,000
Rent from a property in Nepal deposited by a tenant in a foreign branch 1,00,000
of an Bank of India operating there
Computed salary earned and received in Hong Kong 20,000
Determine the Gross Total Income of Mr. Shantaram, if he is ROR, RNOR, NR.
222
Question 9
Mr. Sehwag settled in Australia in the year 1991. He has earned following incomes.
Compute his Gross Total Income.
Particulars `
Fees for technical services rendered in India, but received in Australia 75,000
Interest on Savings Bank Deposit in Bank of India 12,000
Interest on Australia Development Bonds(only 50% of interest received 55,000
in India)
Dividend from Indian company received in Australia 28,000
Profit from a business in Nagpur, but managed directly from Australia 95,000
Short-term capital gain on sale of shares of an Indian company received 90,000
in India
Agricultural income from a land situated in Punjab 55,000
Rent received in respect of house property at Bhopal 1,25,000
Question 10
Mr. Trilok, an Indian Citizen furnishes the following particulars of his income
Particulars `
1. Interest on Nepal Development Bond - [1/3rd received in India] 21,000
2. Income from Agriculture in Bangladesh 40,000
3. Rent from Property in Japan received outside India 10,000
4. Income earned from Business in London which is controlled from
Delhi [` 15,000 received in India] 35,000
5. Interest paid by an Indian Company but received outside India 9,000
6. Past untaxed profit brought to India 33,000
7. Profit from a Business in Pune & managed from outside India 50,000
8. Profit on Sale Building in Mumbai but received in Sri Lanka 40,000
9. Computed pension from an Indian employer in India received in 30,000
London
Find out Gross Total Income for Mr. Trilok if he is a [i] ROR; [ii] RNOR; or [iii] NR in India.
223
Question 11
Mr. Harshal, an Indian citizen had following incomes:
Sr. Particulars `
1. Professional Fees received in India for three months 75,000
2. Payment received in the United Kingdom for the services rendered 55,000
in India
3. Income from business, in Sri Lanka being controlled from India 50,000
4. Income from agriculture in Japan 80,000
5. Interest received Paris in respect of securities in a German company 25,000
6. Amount brought into India out of the past untaxed profits earned 30,000
in Germany
7. Dividend on shares of foreign companies:
- received abroad 22,000
- received in India 23,000
8. Interest on bank accounts in UAE 15,000
9. Profits from business in Spain which is controlled from India [50% 1,00,000
received in India]
10. Profits from Business in Mumbai, controlled and managed from 3,00,000
USA
11. Profit on sale of Building in India but received in Japan 2,40,000
12. Interest on Fixed Deposit with the ICICI Bank Ltd. 60,000
13. Computed salary earned and received in Bangladesh 40,000
Question 12
State with reasons whether the following transactions attract income tax in India in the
hands of recipients:
(1) Interest on Post Office Savings A/c amounting to ` 15,000 received by a resident
assessee, Mr. Robin.
(2) Legal Charges amounting to ` 5,00,000 paid in Mumbai to a lawyer of Canada who
visited India to represent a case at the Bombay High Court.
(3) Royalty paid by Mr. Satbir, a resident, to Mr. Ronald, a non-resident, in respect of a
business carried on in France.
(4) Salary paid by the Central Government to Ms. Monika, a citizen of India ` 11,00,000
(computed) for the services rendered in USA.
224
Question 13
Mr. Shaun, a Government employee serving in the Ministry of External Affairs, left India
for the first time on 31-03-2020 due to his transfer to High Commission of Canada.
He did not visit India any time during the P.Y. 2022-23. He has received the following
income for the F.Y. 2022-23:
Particulars `
Salary 5,00,000
Foreign Allowance 4,00,000
Interest on fixed deposit from a bank in India 1,00,000
Income from agriculture in Pakistan 2,00,000
Income from house property (computed) in Pakistan 2,50,000
Compute his Gross Total Income.
Question 14
Mr. Rachit, an Indian citizen, left India on 08-08-2022 for the first time to work as an
officer of a company in Germany. Determine the residential status of Rachit for the A.Y.
2023-24 and explain the conditions to be fulfilled for the same under the Income Tax
Act, 1961.
Question 15
Mr. Bhandari, a Canadian citizen, comes to India for the first time during the P.Y.
2018-19. During the F.Y.s 2018-19, 2019-20, 2020-21, 2021-22 and 2022-23,
he was in India for 55 days, 60 days, 90 days, 150 days and 70 days, respectively.
Determine his residential status for the A.Y. 2023-24.
Question 16
Mr. Deepak, an Indian citizen, leaves India on 22-9-22 for the first time, to work as an
officer of a company in France. Determine his residential status for the A.Y. 2023-24.
Question 17
The business of a HUF is transacted from USA and all the policy decisions are taken
there. Mr. Sharad, the Karta of the HUF, who was born in Kolkata, visits India during the
P.Y. 2022-23 after 15 years. He comes to India on 01-04-2022 and leaves for Australia
on 01-12-2022. Determine the residential status of Mr. Sharad and the HUF for the A.Y.
2023-24.
225
Question 18
Mr. Kevin is a foreign citizen (not being a person of Indian origin). Since 1981, he visits
India every year in the month of April for 100 days. Find out the residential status of Mr.
Kevin for the A.Y. 2023-24.
Question 19
Mr. Kamless, an Indian citizen, left India for the first time as a member of the crew of an
Indian ship on 15th November 2021. Thereafter he settles down abroad because of his
employment and comes back on a visit to India on 10th December, 2022 and
stays in India for 190 days. Determine his residential status for A.Y. 2023-24.
Question 20
Mr. Chandu, an individual, is Resident but Not Ordinarily Resident in India for the P.Y.
2022-23). During the P.Y. 2022-23, the affairs of Chandu (HUF), a HUF, whose karta is
Mr. Chandu since 1987, are partly managed from Nagpur and partly from Kathmandu
(Nepal). Determine the residential status of Chandu (HUF).
226
HOMEWORK PROBLEMS SOLUTIONS
Answer 1
Total stay in India
2018 – 19 48 days
2019 – 20 216 days
2020 – 21 94 days
2021 – 2022 54 days
2022 – 2023 71 days
During previous year 2022-23 his stay in India is 71 days and in the four preceding years
48 + 216 + 94 + 54 = 412 days.
Resident in India [exception one of (b) basic condition is NOT applicable as he has not
gone for employment abroad but has gone out of India during the course of his Indian
employment]
2021 - 22 54 days (Non-Resident)
2020 -21 94 days but more than 365 days in the 4 preceding previous
year. Hence, resident
2019 -20 216 days — resident
2018-19 48 days non-resident
Prior to 2018-19 resident
He satisfies the first condition of being resident in at least 2 out of 10 previous year prior
to relevant previous year and the 2nd condition of being in India for 730 days or more in
the 7 preceding previous years. He is “resident and ordinarily resident in India”.
Answer 2
In this case, the voyage is undertaken by an Indian ship engaged in the carriage of
passengers in international traffic, originating from a port in India (i.e., the Chennai
port) and having its destination at a port outside India (i.e., the Singapore port). Hence,
the voyage is an eligible voyage for the purposes of section 6(1). Therefore, the period
beginning from 6th June, 2022 and ending on 9th December, 2022, being the dates
entered into the Continuous Discharge Certificate in respect of joining the ship and signing
off from the ship by Mr. A, an Indian citizen who is a member of the crew of the ship, has
to be excluded for computing the period of his stay in India. Accordingly, 187 days [25
+ 31 + 31 + 30 + 31 + 30 + 9] have to be excluded from the period of his stay in India.
Consequently, Mr. A’s period of stay in India during the P.Y.2022-23 would be 178 days
227
[i.e., 365 days – 187 days]. Since his period of stay in India during the P.Y.2022-23 is less
than 182 days, he is a non-resident for A.Y.2022-23.
Note - Since the residential status of Mr. A is “non-resident” for A.Y.2023-24 consequent
to his number of days of stay in P.Y.2022-23 being less than 182 days, his period of stay
in the earlier previous years become irrelevant.
Answer 3
Residential Status for the assessment year 2023-24.
1. HUF is a resident in India, as it is partly controlled from India. Further, the karta of
the HUF satisfies both the conditions of category B. He was resident in at least 2 out
of 10 previous year prior to relevant previous year and was in India for 730 days or
more in the 7 preceding previous years. Hence, the HUF is “resident and ordinarily
resident in India”.
2. Company is resident in India as its place of effective management in the previous
year is in India.
3. A partnership firm is said to be resident in India if control and management of its
affairs is partly situated in India.
4. VIP Club is non-resident - no part of the control and management was in India.
Answer 4
Particulars ROR RNOR NR
(`) (`) (`)
(a) Interest paid by an Indian company but received
in London 2,00,000 2,00,000 2,00,000
(b) Pension from former employer in India, received
in USA (after Std. Deduction) 8,000 8,000 8,000
(c) Profits earned from business in Paris which is
controlled in India, half of the profits being 40,000 40,000 20,000
received in India
(d) Income from agriculture in Bhutanand remitted
to India 10,000 — —
(e) Income from property (computed) in England and
received there 8,000 Nil Nil
(f) Past foreign untaxed income brought to India Nil Nil Nil
Note : Since such income does not relate to
current year, thus not taxable in all 3 cases.
2,66,000 2,48,000 2,28,000
228
Answer 5
Computation of Gross Total Income of RR
Particulars Resident Not Non-
and ordinarily resident
ordinarily resident resident
(`) (`) (`)
1. Interest on Savings Bank Deposit 12,000 12,000 12,000
2. Income from Agriculture in Africa 5,000 — —
3. Dividends received in USA 12,000 — —
4. Salary drawn for working in Indian Embassy
in Australia 48,000 48,000 48,000
5. Income from house property in Iraq 25,000 — —
6. Pension received in Belgium for services
rendered in India 10,000 10,000 10,000
Gross Total Income 1,12,000 70,000 70,000
Answer 6
Name of the Assessee: Mr. Kapoor
Legal Status: Individual PAN: _____________________
P.Y.:______________________ A.Y.: _____________________
Determination of Gross Total Income:
Sr. Particulars Note ROR RNOR NR
1 Income from a HP in London, received 60,000 60,000 60,000
in India
2 Profits from a Business in Japan, 9,00,000 - -
managed & received in Japan
3 Dividend from a Foreign Company, 30,000 30,000 30,000
received in India
4 Dividend from an Indian Company, 50,000 50,000 50,000
received in England
5 Profits from a Business in Kenya, 3,00,000 3,00,000 -
controlled from India but received in
England
6 Profits from a Business in Delhi, 7,00,000 7,00,000 7,00,000
managed in France
229
7 Capital Gains on transfer of shares of 2,00,000 2,00,000 2,00,000

Indian Companies, sold in USA, gains
received in USA
8 Pension from a former employer in 50,000 50,000 50,000
India, received in Vatican City
9 Profits from a business in Melbourne, 20,000 - -
deposited in a Bank in Melbourne
10 Profit on sale of an asset in India, 8,000 8,000 8,000
but received in Canada
11 Past untaxed profits of a UK Business (1) - - -
for 2014-15, brought into India
12 Interest on Government Securities 80,000 80,000 80,000
accrued in India, but received in Chile
13 Interest on USA Government 20,000 20,000 20,000
Securities, received in India
14 Interest on USA Government 1,00,000 - -
Securities, received in Malaysia
15 Salary earned in Mumbai, but 60,000 60,000 60,000
received in Ottawa
16 Income from a property in Hong 1,00,000 - -
Kong, received there
26,78,000 15,58,000 12,58,000
Note:
(1) As per Section 5, any past untaxed profits/income shall not be considered to be the
income of the current year. Therefore, the amount of past untaxed profits of the UK
Business for the P.Y. 2014-15, brought to tax in India has been ignored.
230
Answer 7
Name of the Assessee: Mr. Suhaan
Legal Status: Individual PAN: _______________________
P.Y.: ________________________ A.Y.: _______________________

Sr. Particulars ROR RNOR NR
(a) Income earned from business in France 90,000 90,000 65,000
which is controlled from Mumbai, out of
which ` 65,000 is received in India
(b) Pension for services rendered in India but 14,000 14,000 14,000
received in France
(c) Dividend received in France from Titanium 25,000 - -
Inc., a French company
(d) Rent from property in France deposited in a 59,500 - -
bank in France
(e) Dividend from Sunset Ltd., an Indian 98,000 98,000 98,000
Company
Gross Total Income 2,86,500 2,02,000 1,77,000
Note:
(1) As per section 5(1), global income is taxable in case of an ordinary resident.
However, as per section 5(2), in case of a non-resident, only the following incomes
are chargeable to tax in India:
(i) Income received or deemed to be received in India; and
(ii) Income accruing or arising or deemed to accrue or arise in India.
Further, the income which accrues or arise outside India would be chargeable to tax
in case of resident but not ordinarily resident in India, only if such income is derived
from a business controlled in India. Accordingly, the entire income earned from
business in France which is controlled from Mumbai would be chargeable to tax in
the hands of Mr. Suhaan if he is a resident in India or resident but not ordinarily
resident. However, if he is non- resident then only that part of income which is
received in India would be taxable in his hands.
(2) Pension for services rendered in India but received in France would be taxable in all
cases, since it has accrued or arisen in India.
(3) Dividend received in France from a French company would be taxable in the hands
231
of Mr. Suhaan, only if he is resident and ordinarily resident in India. If he is a resident

but not ordinarily resident or a non-resident, the same would not be taxable in his
hands in India since it has neither accrued nor arisen in India nor is it received in
India.
(4) Likewise, rental income from property in France would also be taxable only if he is
resident in India. It has been assumed that the rental income is the gross annual
value of the property. Therefore, deduction @ 30% u/s 24(a), has been provided and
the net income so computed is taken into account for determining the gross total
income of a resident and ordinarily resident.
Rent received (assumed as gross annual value) ` 85,000
Less: Deduction u/s 24(a) (30% of ` 85,000) (` 25,500)
Income from House Property ` 59,500
Answer 8
Name of the Assessee: Mr. Shantaram
Legal Status: Individual PAN: ___________________________
P.Y.: ___________________________ A.Y.: ___________________________

Particulars ROR RNOR NR
Profit on sale of plant at London
[i] one-half is taxable on receipt basis
[ii] one-half is taxable in the case of ROR 23,000 23,000 23,000
23,000 - -
Profit on sale of plant at Delhi
[Income accrued in India then where it is received
is immaterial] 52,000 52,000 52,000
Interest on U.K. Power Bonds 40,000 - -
[Income accruing / arising outside India]
Interest on Bank Accounts in India 5,000 5,000 5,000
[Income accrued and received In India]
Dividend from British Co. received in India 2,000 2,000 2,000
[Income received in India]
Interest received in London from Indian Co. 18,000 18,000 18,000
[Income accrued in India]
232
Profit from a business in Delhi managed from 30,000 30,000 30,000

India [Income accrued in India ]
Income from business in China controlled from 10,000 10,000 -
India
[Income accrued & received outside India but from
a business controlled from India]
Rental income from a property in Nepal received 70,000 - -
outside India [Income accrued & received outside
India] - (Note)
Salary earned & received in Hong Kong 20,000 - -
[Income accrued & received outside India]
Note: Income from house property in Nepal:

Rent received (assumed to be gross annual value) 1,00,000
Less: Deduction u/s 24(a) - (30% of Rs. 1,00,000) (30,000)
Income from House Property 70,000
The net income from house property in Nepal would be taxable in the hands of Mr.
Shantaram only when he is ROR. Further, the tenant has deposited the rent outside India
in the bank account of Mr. Shantaram therefore, the income from this house property is
considered to be received by Mr. Shantaram outside India.
Answer 9
Mr. Sehwag, is a non-resident as he is settled in Australia since 1991.
Accordingly, his total income would be computed as follows:
Name of the Assessee: Mr. Sehwag
Legal Status: Individual - Non Resident PAN: _______________________
P.Y.: ___________________________ A.Y.: _______________________
233

Particulars `
Fees for technical services rendered in India, but received in Australia 75,000
(Note 1)
Interest on Savings Bank Deposit in Bank of India (Note 1) 12,000
Interest on Australia Development Bonds (Note 1) 27,500
Dividend from Indian Company received in Australia 28,000
Profit from business in Nagpur but managed directly from Australia 95,000
(Note 1)
Short-term capital gain on sale of shares of an Indian company received 90,000
in India (Note 1)
Agricultural income from a land in Punjab (Note 2) -
Income from house property at Bhopal (Note 3) 87,500
Gross Total Income 4,15,000
Note:
(1) In case of a resident, his global income is taxable as per section 5(1). However, as per
section 5(2), in case of a non-resident, only the following incomes are chargeable to
tax:
(ii) Income which accrues or arises or is deemed to accrue or arise in India.
Therefore, fees for technical services rendered in India would be taxable in hands of
Mr. Sehwag, even though he is a non-resident. The income referred to in Sr. No. 2,
5 and 6 are also taxable in his hands, since these incomes accrue or arise or deemed
to accrue or arise in India. Interest on Australia Development Bonds to the extent of
50% would be taxable in India, since this portion is received in India.
(2) Agricultural income from a land situated in India is exempt u/s 10(1).
(3) Income from house property

Rent received (assumed to be gross annual value) 1,25,000
Less: Deduction u/s 24(a) - (30% of Rs. 85,000) (37,500)
The net income from house property in India would be taxable in his hands since the
accrual and receipt of the same are in India
234
Answer 10
Name of the Assessee: Mr. Trilok
Legal Status: Individual PAN: ________________________
P.Y.: ______________________ A.Y.: ________________________

Sr. Particulars ROR NOR NR
1. Interest on Nepal Development Bonds
1/3rd is taxable on receipt basis
2/3rd is taxable in the case of ROR on accrual 7,000 7,000 7,000
basis 14,000 - -
2. Income from Agriculture in Bangladesh 40,000 - -
3. Income from property in Japan received outside 7,000 - -
India
[Income accruing & arising outside India] - (Note)
4. Income earned from business in London,
controlled from Delhi
[i] ` 15,000 is taxable on receipt basis 15,000 15,000 15,000
[ii] Balance is not taxable in the case of NR 20,000 20,000 -
5. Interest paid by an India Company received 9,000 9,000 9,000
outside India
[Income deemed to accrue or arise in India]
6. Past untaxed profit brought to India - - -
[Does not represent current year’s income, hence
not taxable]
7. Profit from a business in Pune & managed from 50,000 50,000 50,000
outside India
[Income Accrued in India]
8. Profit on sale of building in Mumbai but received 40,000 40,000 40,000
in Sri Lanka
9. Pension from an Indian former employer received 30,000 30,000 30,000
in London
235
Note:
Income from house property in Japan:
Rent received (assumed to be gross annual value) 10,000
Less: Deduction u/s 24(a) - (30% of ` 10,000) (3,000)
The net income from house property in Japan would be taxable in the hands of Mr. Trilok
only when he is Ordinarily Resident (ROR).

Answer 11
Name of the Assessee: Mr. Harshal
Legal Status: Individual PAN: _________________________
P.Y.: __________________________ A.Y.: __________________________

Sr. Particulars ROR RNOR NR
1. Professional Fees received in India for three 75,000 75,000 75,000
months
[Income received in India]
2. Payment received in the United Kingdom for the 55,000 55,000 55,000
services rendered in India
3. Income from business, in Sri Lanka being 50,000 50,000 -
controlled from India
[Income accrued & received outside India from a
business outside India but controlled from India]
4. Income from agriculture in Japan 80,000 - -
5. Interest received Paris in respect of securities in 25,000 - -
a German company [Income accrued & received
outside India]
6. Amount brought into India out of the past untaxed - - -
profits earned in Germany [To be ignored]
236
7. Dividend on shares of foreign companies:

received abroad 22,000 - -
received in India 23,000 23,000 23,000
[Income accrued outside India but received in
India]
8. Interest on bank accounts in UAE 15,000 - -
9. Profits from business in Spain which is controlled
from India 50,000 50,000 50,000
50% received in India 50,000 50,000 -
Balance 50% received outside India
10 Profits from Business in Mumbai, controlled and 3,00,000 3,00,000 3,00,000
managed from USA [Income accrued in India]
11 Profit on sale of Building in India but received in 2,40,000 2,40,000 2,40,000
Japan
12 Interest on Fixed Deposit with the ICICI Bank Ltd. 60,000 60,000 60,000
13 Salary earned and received in Bangladesh 40,000 - -
Answer 12
Sr Taxable or Taxable Reason
not? Amount
(1) Partly 1,500 The interest on Post Office Savings Deposit Account,
Taxable would be exempt u/s 10(15) only to the extent of
` 3,500 in case of an individual account. Hence, `
11,500 shall be taxable under the head ‘Other
Sources’ and will form part of Gross Total Income.
Note: ` 10,000, however, would be allowed as
deduction u/s 80TTA from the Gross Total Income.
237
(2) Taxable 5,00,000 In case of a non-resident, any income which accrues

or arises in India or which is deemed to accrue or arise
in India or which is received in India or is deemed to
be received in India is taxable in India.
Therefore, legal charges paid in India to a non-
resident lawyer of Canada, who visited India to
represent a case at the Bombay High Court would
be taxable in India.
(3) Not Taxable NIL Royalty paid by a resident to a non-resident in
respect of a business carried on in France would not
be taxable in the hands of the non-resident provided
the same is not received in India.
This has been provided as an exception to deemed
accrual mentioned in section 9(1)(vi)(b).
(4) Taxable 11,00,000 As per section 9(1)(iii), Salary payable by the
Government to a citizen of India for service rendered
outside India shall be deemed to accrue or arise in
India.
Therefore, salary paid by the Central Government
to Ms. Monika for services rendered in USA shall be
deemed to accrue or arise in India, since she is a
citizen of India.
Answer 13
As per the provisions of section 6(1), Mr. Shaun is a non-resident for the A.Y.
2023-24, since he was not present in India at any time.
As per section 5(2), a non-resident is chargeable to tax in India only in respect of following
incomes:
(ii) Income accruing or arising or deemed to accrue or arise in India.
In view of the above provisions, income from agriculture in Pakistan and income from
house property in Pakistan would not be chargeable to tax in the hands of Mr. Shaun,
assuming that the same were received in Pakistan.
Income from ‘Salary’ payable by the Government to a citizen of India for services
rendered outside India is deemed to accrue or arise in India as per section 9(1)(iii). Hence,
such income is taxable in the hands of Mr. Shaun, even though he is a non-resident. It has
238
been assumed that Mr. Shaun is a citizen of India. However, allowances or perquisites paid
or allowed as such outside India by the Government to a citizen of India for rendering
service outside India is exempt u/s 10(7). Hence, foreign allowance of ` 4,00,000 is exempt
u/s 10(7).
Hence, Gross Total Income of Mr. Shaun for the A.Y. 2023-24:
Particulars `
Salary [5,00,000(-) Ded. u/s 16(ia) of 50,000 S.D.] 4,50,000
Interest on fixed deposit from a bank in India (Income from ‘Other Sources’) 1,00,000
Gross Total Income 5,50,000
Answer 14
As per the provisions of 6(1), an individual is said to be a resident in India in any
P.Y. if he satisfies any one of the following conditions:
(A) He has been in India during the P.Y. for a total period of 182 days or more;
or
(B) He has been in India for at least 60 days in the P.Y. and has been in India for a total
period of 365 days or more during the 4 years immediately preceding to current P.Y.
In the case of Indian citizens leaving India for employment, the period of stay during the
P.Y. must be 182 days instead of 60 days given in condition ‘B’ above. During the P.Y. 2022-
23, Mr. Rachit, an Indian citizen, was in India for 130 days only (i.e. 30+31+30+31+8).
Thereafter, he left India for employment purposes.
Since he does not satisfy the minimum criteria of 182 days, he is a Non- Resident.
Answer 15
During the P.Y. 2022 - 23, Mr. Bhandari was in India for 70 days and during the 4 years
preceding the P.Y. 2022 -23, he was in India for 355 days (i.e. 55+ 60+90+150 days).
He does not satisfy the basic conditions as prescribed u/s 6(1). Therefore, he is a Non-
Resident.
Answer 16
During the P.Y. 2022 -23, Mr. D, an Indian citizen, was in India for 175 days (i.e.
30+31+30+31+31+22 days). He does not satisfy the minimum criteria of 182 days. Also,
since he is an Indian citizen leaving India for the purposes of employment, the second
condition u/s 6(1) is not applicable to him.
Therefore, Mr. Deepak is a non-resident.
239
Answer 17
(a) During the P.Y. 2022 - 23, Mr. Sharad has stayed in India for 245 days (i.e. 30 + 31
+ 30 + 31 + 31 + 30 + 31 + 30 +1 days). Therefore, he is a resident. However, since he
has come to India after 15 years, he does not satisfy any of the conditions for being
ordinarily resident.
Therefore, the residential status of Mr. Sharad for the P.Y. 2022-23 is resident but not
ordinarily resident.
(b) Since the business of the HUF is transacted from Australia and nothing is mentioned
regarding its control and management, it is assumed that the control and
management is also wholly outside India. Therefore, the HUF is a non-resident for
the P.Y. 2022-23.
Answer 18
Mr. Kevin is a Resident but Not Ordinarily Resident (RNOR).
Hint: Stay in India for the P.Y. 2022-23: 100 days
Stay during Past 4 P.Y.s: 400 days (100days x 4 years) Resident in all the 10 P.Y.s out of
last 10 P.Y.s
Stay during Past 7 P.Y.s: 700 days (100days x 7 years)
Answer 19
Mr. Kamless is a Non - Resident (NR).
Hint: Stay in India for the P.Y. 2022-23: 112 days (Out of 190 days; 78 days stay in India
is not in the current P.Y., it is during the next P.Y., hence; not considered)
Mr. Kamless is an Indian Citizen who comes to India during the current P.Y. for the purpose
of visit; hence he is covered by the exceptions to the basic conditions u/s 6(1) and basic
condition (b) is not applicable in his case and he is not able to satisfy the one & only (a)
basic condition, since stay is <182 days in P.Y. 22-23.
Answer 20
Chandu (HUF) is a Resident but Not Ordinarily Resident (RNOR).
Hint: Since, Control & Management of the affairs of Chandu (HUF) is partly situated in
India & partly outside India during the P.Y. 2022-23; hence Chandu (HUF) is a Resident.
Further, Mr. Chandu, the karta of Chandu (HUF) himself is a RNOR during the P.Y. 2022-
23 which means he does not satisfy both the additional conditions.
240
INCOME FROM HOUSE

PROPERTY
Introduction:
This chapter deals with income which falls under the head “Income from house property”.
While the scope of the income charged under this head is defined by section 22, the
computation of income falling under this head is governed by sections 23 to 27. All
the provisions having a bearing on tax treatment of income from house property are
explained in this chapter.
What is the basis of Charge (Sec. 22)

Section 22 specifies three conditions. All these 3 conditions must be satisfied by a property to be
treated as House property. These conditions are:
(1) The property must consist of buildings or lands appurtenant thereto
(2) The assessee must be the owner of such house property (owner includes deemed
owner)
(3) The property must not be utilised by the owner for his own business or profession
whose income is chargeable to income tax
Analysis of Section 22
(a) Building includes not only Residential Building but also Factory Building, Offices,
Shops, Godowns and other Commercial Premises where these are let out on floor
area basis
(b) Land Appurtenant means land connected to building, like garden, garage, etc.
The appurtenant land in respect of a residential building may be in the form of
approach roads to and from public streets, compounds, courtyards, gardens, cattle-
shed etc. The owner cannot apportion rent received from tenant. He should consider
entire rent as belonging to house property.
(c) Vacant Plot: Vacant plot without any building cannot be treated as building and
thus, income from such vacant plot is not taxable u/s 22, but u/s 56 as Income from
Other Sources.
(d) Buildings/ staff quarters let out to employees / allotted to employees as rent free
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accommodation are treated as business premises. Hence they cannot be considered

as house properties u/s 22. Income from such property, if any, is incidental income
from business, as the intention is to enhance or maintain the existing business.
(e) Income from subletting is not income from house property because of absence of
ownership unless tenant is deemed owner u/s 27.
(f) Dispute in title of property: In case there is dispute in relation to ownership of the
property, the income therefrom shall be assessed according to decision taken by
Income tax department considering factors like receipt of such income & occupier of
the property.
(g) Foreign property: If the property is situated outside India & income is also received
outside India, it is brought to tax in India provided the assessee is R & OR (Resident in
India in case of assessees other than Individual & HUF). Income should be calculated
as per provisions of Income Tax Act by converting the relevant foreign currency into
INR at the rate prevailing on the last day of the previous year (i.e. closing TT
buying rate) if income is earned in foreign currency.

Section 23 Computation of Net annual Value Certain Concepts
For Calculating net annual value, house property 1. Municipal Value/MV is
must be classified as Let Out Property (LOP) or That value that the Municipal
Self Occupied Property (SOP) or Deemed to be Authorities deem as the
Let Out Property (DLOP) estimated annual rent of
 Section 23 (1) deals with Net Annual property for the purpose of
Value of LOP assessment of Property Taxes.
 Section 23(2) deals with Net Annual Mun Tax = % X
Value Of SOP & Municipal Value
 it also says that NAV of SOP must be Nil
 Section 23 (3) rules that if a property 2. Fair Rent/FR of the property is
is let out for part of the year & self - the rent fetched by a similar
occupied for part of the year it should property, in same or similar
be classified as LOP & its NAV must be locality, with same facilities.
calculated according to provisions of Generally it is estimated by
Section 23(1). approved valuer.
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 Section 23 (4) rules that if owner occupies 3. Standard Rent/SR SR is the

more than two properties owned by him maximum rent which a person
as SOP, any two properties at his choice can recover from the Tenant,
should be considered as SOP & its NAV under the Rent Control Act.
should be according to section 23 (2) (i.e
Zero NAV) & remaining SOPs should be
deemed to be let out (D.L.O.P.) & their
NAV should be according to Section 23
(1)
GROSS ANNUAL VALUE (G.A.V.) (Section 23)

(a) Annual letting value (A.L.V.) / Reasonable
letting value (R.L.V.) of the property
for the whole year, i.e. higher of fair
rent and municipal value, subject to
standard rent under the Rent Control
Act (if applicable).
(b) Actual rent received / receivable for the
period and portion actually let out, less
any unrealised rent, if any.
(c) Amount at (b) above, plus any rent for
the period the property was vacant.
If (c) < (a), (a) is G.A.V.
If (c) > = (a), (b) is G.A.V.
Section 23 as per Act Unrealised Rent

For the purposes of section 22, the annual value As per Rule 4, the unrealised
of any property shall be deemed to be - rent is the amount of rent
(a) the sum for which the property might payable but not paid by a tenant
reasonably be expected to let from year to of the assessee and so proved
year; or to be lost and irrecoverable.
(b) where the property or any part of the It shall be deducted from AR
property is let and the actual rent received only if following conditions are
or receivable by the owner in respect thereof satisfied —
is in excess of the sum referred to in clause (a) The tenancy is bonafide;
(a), the amount so received or receivable; or
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(c) where the property or any part of the (b) The defaulting tenant has
property is let and was vacant during the vacated or steps have been
whole or any part of the previous year taken to compel him to
and owing to such vacancy, the actual vacate the property;
rent received or receivable by the owner in (c) The defaulting tenant is not
respect thereof is less than the sum referred in occupation of any other
to in clause (a), the amount so received or property of the assessee;
receivable. and
Provided that the taxes levied by any local (d) The assessee has taken
authority in respect of the property shall be all reasonable steps to
deducted (irrespective of the previous year institute legal proceedings
in which the liability to pay such taxes was for the recovery of the
incurred by the owner according to the method unpaid rent or satisfies
of accounting regularly employed by him) in the Asses sing Officer that
determining the annual value of the property legal proceedings would
of that previous year in which such taxes are be useless.
actually paid by him.

Explanation - For the purposes of clause (b) or
clause (c) of this sub-section, the amount of
actual rent received or receivable by the owner
shall not include, subject to such rules as may
be made in this behalf, the amount of rent which
the owner cannot realise.
Self-Occupied Property (SOP) or Property Reserved for Self Occupancy –
A SOP can be
(a) Self Occupied House Property (now even 2 house properties in different building
structures), its NAV will be exempt u/s 23(2) (a).
OR
(b) Self Occupied Property kept vacant / reserved by the Assessee due to employment
or carrying on Business or Profession in any other place, and cannot use such a
property at the native place, its NAV will be exempt u/s 23(2)(b).
The SOP must satisfy following conditions :

(a) The property was not let out for any part of the previous year.
(b) No other benefit is derived from the property.
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NAV of two SOP is always NIL. Thus regarding SOP, the following are irrelevant:
- Municipal value
- Fair Rent
- Standard rent
- Municipal taxes
Deemed to be let out property-Section 23 (4)

If an owner owns & occupies more than two house properties for self-residence, the
benefit of section 23(2) can be granted in case of two house properties only & remaining
such properties are deemed to be let out (DLOP) .
Annual value of such DLOP should be calculated u/s 23(1)(a) i.e. ALV only.
GAV of DLOP: Municipal Value p.a & Fair rent p.a. whichever is more is designated as
Expected rent.
Expected rent or Standard Rent whichever is less is GAV for DLOP.
Sec.23 (5): Where the property consisting of any building or land appurtenant thereto is held
as stock-in-trade (constructed / purchased for selling the property) and the property or
any part of the property is not let during the whole or any part of the previous year,
the annual value of such property or part of the property, for the period up to TWO years
from the end of the financial year in which the certificate of completion of construction of
the property is obtained from the competent authority, shall be taken to be nil.”.
Note : If it is the business of the assessee to buy property and give it on rent, then income
from such property will be taxable under “Income from business and profession”, as
per judgement of Supreme Court in case of “Rayala Corporation Pvt. Ltd. v/s Assistant
Commissioner of Income tax”.
DEDUCTIONS AVAILABLE FROM NET ANNUAL VALUE (N.A.V.) [Sec. 24]:

After determining Net Annual Value of the house property, deductions U/s 24 must be
given. These are as below:
(1) Standard Deduction.

It is 30% of Net annual value. It is standard amount in respect of expenses connected
with house property excluding interest on borrowed capital.
Thus assessee cannot get separate deduction for expenses like insurance premium,
lease rent, annual charge, repairs, land revenue etc. If such actual expenses are
245
given these should be ignored altogether.
(2) Interest On Borrowed Capital.

(i) Interest on borrowed capital is allowable as deduction on accrual basis if
capital is borrowed for the purpose of construction, repair, renewal,
reconstruction or acquisition of the house property. (CRRRA)
(ii) As the deduction is available on “accrual basis” it should be claimed as deduction
on yearly basis, even if the interest is not actually paid during the year.
(iii) Interest on unpaid interest / Interest on Interest is not deductible.
(iv) Interest on a fresh loan taken to repay the original loan raised for the aforesaid
purposes, is allowable as deduction.
(v) Pre-construction period interest is allowed at 1/5 of the interest over 5 years.
(vi)
NO DEDUCTION for Interest on loan remitted abroad / sent abroad
without deducting tax at source in India -Section 25.
(vii)
NO DEDUCTION if the loan is taken for purposes other than construction,
repair, renewal, reconstruction or acquisition of the house property.(CRRRA).
Thus if the loan is taken for personal purposes like for children’s marriage,
education etc. or business purposes, no deduction should be made.
(viii) Brokerage / Commission for arranging a loan, is not deductible.
Interest on loan for L.O.P. / D.L.O.P. / L.O.P. with S.O.P

The actual interest due is fully allowed as a deduction under section 24(b) without any
maximum limit.
Interest on loan for S.O.P.

The maximum deduction can be either ` 30,000 or ` 2,00,000. Deduction in no case i.e.
House 1 and House 2 aggregate interest due cannot exceed either 30,000 or 2,00,000
whichever maximum permissible limit is applicable.
When SOP interest maximum is ` 2,00,000?

If following 4 conditions are simultaneously satisfied, the deduction for interest can be
maximum ` 2,00,000.
1. The loan should be taken on or after 1-4-1999.
2. Loan must be for Construction or Acquisition of SOP.
(Loan should not be for Reconstruction, Repair or Renovation)
3. The date of completion of construction or the date of acquisition should be within 5
246
years from the end of the Financial Year in which the loan is taken.
E.g.: Loan taken on 20 Aug 2017
FY end 31 Mar 2018
Add 5 years 31 Mar 2023
If the construction or acquisition is completed within 31 March 2023, the maximum
deduction is ` 2,00,000. Otherwise it is ` 30,000 only.
4. Certificate of Interest from lender is obtained.
If anyone the conditions is not satisfied, the maximum interest in case of SOP is only
` 30,000.
Pre-construction Interest / Prior Period Interest :

The deduction for Interest on borrowed capital will also include Pre-construction Period
Interest. Pre-Construction Period Interest means the interest for the period prior to
completion of construction or acquisition of the house property. It is calculated as follows:
Pre-Construction Period Interest = outstanding x rate of x Pre-Construction

loan amount Interest p.a Period
Pre-construction Period
From: Date of taking loan
To: A day prior to the P.Y. in which the construction / acquisition is completed.
The pre-construction period interest shall be allowed in five equal annual installments
(i.e. 1/5 each year) starting from the P.Y. in which construction or acquisition is completed.
Thus within first five years:

Actual Interest = Interest for Previous Year +1/5 x PCPI
After first five years:
Actual Interest = Interest for Previous Year
Tax Treatment Of Recovery of Arrears of Rent and Recovery of Unrealised rent U/s 25A
Meaning: Arrears of Rent means the disputed rent belonging to earlier financial years, or
receipt of past period rent when retrospective increase is accepted by tenant.
If the tenant had not paid rent for any past period, it is termed as unrealised rent.
Subsequently, if the tenant pays the unrealised rent, either fully or partly, it will be the
owner's income in the year of recovery.
Chargeability: Receipt of Arrears of Rent and recovery of unrealised rent will be chargeable
247
to tax under the head Income from House Property only.

Year of Taxability: It is taxable as income of the financial year in which the arrears or
unrealised rent are received.
Ownership not a condition: It will be taxable in the hands of the assessee, even if he does
not own the property in the year of recovery.
Deduction: A standard deduction of 30% of the amount of arrears received or unrealised
rent received will be allowed as deduction. Any other expenses cannot be deducted.
CO-OWNERSHIP Section 26:

Where a property is owned by two or more persons jointly and their respective shares are
definite and ascertainable, income from such property shall not be assessed on such persons
as association of persons (A.O.P), but the shares of each such person from the property
shall be included in his respective total income.
If any portion of the house belonging to a co-owner is occupied by him for his own
residence, that portion will be treated as self - occupied house and its annual value will
be NIL i.e. it will be exempt from tax and each co-owner is entitled to interest deduction
within a maximum limit of 30,000 / 2,00,000 as the case may be for his unit /units u/s
24(b).
If any property or part of such a property belonging to the co-owners is let out, then the
income will be calculated as per L.O.P. provisions as if such a property or part interest
is owned by one owner only and the final computed income or loss will be distributed
amongst each co-owner as per their co-ownership ratio.
The S.O.P. NIL / Loss along with the L.O.P. share, is the income from house property of
each co-owner.
DEEMED OWNERS [Section 27]

As per Section 27 following persons will be deemed to be the owner of the property and
hence responsible for payment of tax under this head:
(1) An individual who transfers house property without adequate consideration to his or
her spouse (not being a transfer in connection with an agreement to live apart) or
to his minor child (not being a married daughter).
(2) A member of a co-operative society, company or other association of persons, to
whom a building is given under a house building scheme of the organisation.
(3) Any person who is allowed to retain possession of any building as per section 53A
248
of the TRANSFER OF PROPERTY ACT, 1882.

Sec. 53A comes into operation only if the following conditions are satisfied :
(a) There should be a contract for consideration, in the writing, duly signed, in
relation to transfer of immovable property.
(b) The transferee should have taken the possession of the property.
(c) The transferee has performed or is willing to perform his part of the contract.
The transferee shall be considered to be the owner, even if the instrument of
transfer is not registered.
(4) The holder of an impartible estate is deemed to be the owner of all the properties
comprised in the estate.
E.g.: Mr. A has a property consisting of 6 flats and a terrace. He divided his 6 flats
amongst his 6 sons. Ownership of terrace has not been transferred but given to
eldest son.
However, remaining 5 sons are having the right to enjoy the benefit. In such a case
the eldest son shall be treated as holder of an impartible asset i.e. terrace.
(5) A person who acquires any right (excluding any rights by way of a lease from month
to month for a period not exceeding one year) in or with respect to any building or
part thereof by virtue of a transfer by way of lease for a term of not less than 12
years. (Whether fixed originally or there a provision for extension of term and the
aggregate period is not less than 12 years).

249
CLASSWORK PROBLEMS
“Unless specifically mentioned, the provisions of section 115BAC is not to be considered."
Question 1
Compute GAV
PARTICULARS ` ` ` ` `
M.V. 30,000 30,500 30,000 40,000 70,000
F.R. 32,500 33,000 32,250 39,000 75,000
SRRCA 29,750 29,500 31,500 42,500 60,000
Actual rent received 33,000 24,938 21,000 27,000 8,000
Property Vacant in 1 1 1/2 5 3 10
months
Vacancy rent 3,000 3,562 15,000 9,000 40,000
Question 2
You are required to calculate interest on pre-construction period in respect of following assesses:
Assesses A B C
Date of Taking loan 1 Jun 2016 11 April 2022 15 Oct 2018
Date of Starting Construction 1 Nov 2016 31 March 2022 1st Dec 2018
Date of Complete of Construction 10 Aug 2022 20 Jan 2023 20 July 2022
Amount of Loan 12,00,000 5,00,000 23,00,000
Rte of interest p.a. 12% 15% 13.5%
Pre- Construction Period:
From
To
Pre-Construction Period (in month)
Interest (in `)
Question 3
Ganesh has a property whose municipal valuation is 2,50,000 p.a. The fair rent is 2,00,000
p.a. and the standard rent fixed by the Rent Control Act is 2,10,000 p.a. The property was
let out for a rent of 20,000 p.m. However, the tenant vacated the property on 31.1.2023.
Unrealised rent was 20,000 and all conditions prescribed by Rule 4 are satisfied. He paid
municipal taxes @ 8% of municipal valuation. Interest on borrowed capital was 65,000
for the year. Compute the income from house property of Ganesh for A.Y.2023-24.
250
Question 4
Poorna has one house property at Indira Nagar in Bangalore. She stays with her family in
the house. The rent of similar property in the neighbourhood is 25,000 p.m.
The municipal valuation is 23,000 p.m. Municipal taxes paid is 8,000. The house
construction began in February 2015 with a loan of 20,00,000 taken from SBI Housing
Finance Ltd. The construction was completed on 30.11.2018. The accumulated interest
up to 31.3.2018 is 1,50,000. During the previous year 2022- 23, Poorna paid 2,40,000
which included 1,80,000 as interest. Compute Poorna’s income from house property for
A.Y. 2023-24.
Question 5
Mr. Suraj has one house property consisting of identical units. Unit 1 is SOP throughout
the year and Unit 2 is LOP for 5 and a half month at 30000 p.m. and SOP for 6 months
and vacant for half month. One month rent could not be realized as per rules. Fair
rent and municipal value of entire house is Rs. 27000 p.m. and 26000 p.m. respectively.
Standard rent under the Rent Control Act is 30000 p.m. Municipal taxes for the entire
house payable is rs. 22000 whereas paid is only rs. 20000/-. Interest on loan due (loan
taken on 5.5.98) is Rs 65000 for financial year 2022-23. Compute income from house
property.
Question 6
Mrs. Rohini Ravi, a citizen of the U.S.A., is a resident and ordinarily resident in India during
the financial year 2022-23. She owns a house property at Los Angeles, U.S.A., which is
used as her residence. The annual value of the house is $20,000. The value of one USD
($) may be taken as 60.
She took ownership and possession of a flat in Chennai on 1.7.2022, which is used for
self-occupation, while she is in India. The flat was used by her for 7 months only during
the year ended 31.3.2023. The municipal valuation is 32,000 p.m. and the fair rent is
4,20,000 p.a. She paid the following to Corporation of Chennai:
Property Tax 16,200

Sewerage Tax 1,800
251
She had taken a loan from Standard Chartered Bank for purchasing this flat. Interest on
loan was as under:
`
Period prior to 1.4.2022 49,200
1.4.2022 to 30.6.2022 50,800
1.7.2022 to 31.3.2023 131300
She had a house property in Bangalore, which was sold in March, 2015. In respect of this
house, she received arrears of rent of 60,000 in March, 2023. This amount has not been
charged to tax earlier.
Compute the income chargeable from house property of Mrs. Rohini Ravi for the assessment
year 2023-24, exercising the most beneficial option available.
Question 7
Two brothers Arun and Bimal are co-owners of a house property with equal share. The
property was constructed during the financial year 1998-1999. The property consists of
eight identical units and is situated at Cochin.
During the financial year 2022-23, each co-owner occupied one unit for residence and
the balance of six units were let out at a rent of 12,000 per month per unit. The municipal
value of the house property is 9,00,000 and the municipal taxes are 20% of municipal
value, which were paid during the year. The other expenses were as follows:
`
(i) Repairs 40,000
(ii) Insurance premium (paid) 15,000
(iii) Interest payable on loan taken for construction of house 3,00,000
One of the let out units remained vacant for four months during the year.
Arun could not occupy his unit for six months as he was transferred to Chennai. He does
not own any other house.
The other income of Mr. Arun and Mr. Bimal are 2,90,000 and 1,80,000, respectively, for
the financial year 2022-23.
Compute the income under the head ‘Income from House Property’ and the total income
of two brothers for the assessment year 2023-24.
252
Question 8
Smt. Rajalakshmi owns a house property at Adyar in Chennai. The municipal value of
the property is ` 5.00,000, fair rent is ` 4,20,000 and standard rent is ` 4,80,000. The
property was let-out for ` 50,000 p.m. up to December 2022. Thereafter, the tenant
vacated the property and Smt. Rajlakshmi used the house for self- occupation. Rent for
the months of November and December 2022 could not be realized in spite of the owner’s
efforts. All the conditions prescribed under Rule 4 are satisfied. She paid municipal taxes
@ 12% during the year. She had paid interest of ` 25,000 during the year for amount
borrowed for repairs for the house property. Compute her income from house property
for the A.Y. 2023-24.
Question 9
Prem owns a house in Madras. During the previous year 2022-23, 2/3rd portion of the
house was self-occupied and 1/3rd portion was let out for residential purposes of a
rent of ` 8,000 p.m. Municipal value of the property is ` 3,00,000 p.a. He paid municipal
taxes @ 10% of municipal value during the year. A loan of ` 25,00,000 was taken by him
during the year 2018 for acquiring the property. Interest on loan paid during the previous
year 2022-23 was ` 1,20,000. Compute Prem’s income from house property for the A.Y.
2023-24.
Question 10
Mr Rajesh owns a residential house, let out for a monthly rent of ` 15,000. The fair rental
value of the property for the let out period is ` 1,50,000. The house was self-occupied
by him from 1st January, 2023 to 31st March, 2023. He has taken a loan from bank of `
20 lacs for the construction of the property, and has repaid ` 1,05,000 (including interest
` 40,000) during the year.
Compute Rajesh’s income from house property for the Assessment Year 2023-24.

253
HOME WORK PROBLEMS
Question 1
Mr. Vikas owns a house property whose Municipal Value, Fair Rent and Standard Rent are
` 96.,000, ` 1,26,000 and Rs. 1,08,000 (per annum), respectively.
During the Financial Year 2022-23, one-third of the portion of the house was let out for
residential purpose at a monthly rent of ` 5,000. The remaining two-third portion was
self-occupied by him. Municipal tax @ 11% of municipal value was paid during the year.
The construction of the house began in June, 2015 and was completed on 31-5-2018.
Vikas took a loan of ` 1,00,000 on 1-7-2015 for the construction of building.
He paid interest on loan @ 12% per annum and every month such interest was paid.
Compute income from house property of Mr. Vikas for the Assessment Year 2023-24.
Answer
Computation of income form house property of Mr. Vikas for the A.Y. 2023-24.
Particulars ` `
Income from house property
I. Self-occupied portion (Two third)
Net Annual value Nil
Less: Deduction under section 24(b)
Interest on loan (See Note below) (` 18,600 x 2/3) 12,400
Loss from self-occupied property (12,400)
II. Let-out portion (One third)
Gross Annual Value
(a) Actual rent received (` 5,000 x 12) ` 60,000
(b) Expected rent ` 36,000
[higher of municipal valuation (i.e., ` 96,000) and fair rent
(i.e., ` 1,26,000) but restricted to standard rent
(i.e., ` 1,08,000)] = ` 1,08,000 x 1/3 60, 000
Higher of (a) or (b)
Less: Municipal taxes ` 96,000 x 11% x 1/3) 3,520
Net Annual Value 56,480
Less: Deductions under section 24
(a) 30% of NAV 16,944
(b) Interest on loan (See Note below) (` 18,600 x 1/3) 6,200 13,336
Income from house property 20,936
254
Note: Interest on loan taken for construction of building

Interest for the year (1.4.2022 to 31.3.2023) = 12% of ` 1,00,000 = ` 12,000
Pre-construction period interest = 12% of ` 1,00,000 for 33 months (from 1.7.2015
to 31.3.2018) = ` 33,000
Pre-construction period interest to be allowed in 5 equal annual installments of ` 6,600
from the year of completion of construction i.e. from F.Y. 2018-19 till F.Y. 2022-23.
Therefore, total interest deduction under section 24 = ` 12,000 + ` 6,600 = ` 18,600.
Question 2
Mr. N is the owner of three house properties in Delhi, particulars in respect of which for
the year ended 31.3.2023 are as below:
Particulars I House II House III House
(i) Construction started on 1.4.1994 1.8.1994 1.7.1989
(ii) Construction completed on 31.12.1995 31.1.1995 31.12.1990
Amount (`) Amount (`) Amount (`)
Actual Rent received 3,50,000 1,90,000 self- occupied
Standard Rent 4,50,000 4,00,000 N.A.
Municipal Value 6,00,000 1,90,000 2,78,000
Amount (`) Amount (`) Amount (`)
Municipal Taxes (paid by owner) 60,000 19,000 1,20,000
Cost of repairs (borne by tenant) 10,000 70,000
Collection charges 15,000 13,000
Insurance premium 10,000 12,000 26,000
(Paid) (Not paid)
Interest on loan taken for renovation 24,000 30,000 60,000
of house
Unrealised rent allowed in the past, 20,000
recovered during the year
Mr. N, resided in Bombay for three months during the previous year in connection with
his business and for all these months the house remained vacant. During the period of
his stay in Delhi he did not occupy any other house of his own. Compute Mr. N’s “Income
from house property” for the assessment year 2023-24.
255
Answer
Particulars I II III
(`) (`) (`)
G ross annual value 4,50,000 1,90,000
Less: Municipal taxes (60,000) (19,000) —
Net annual value 3,90,000 1,71,000
Less: Deductions u/s 24 — —
(a) Standard deduction @ 1,17,000 51,300
30%
(b) Interest 24,000 (1,41,000) 30,000 (81,300) (30,000)
2,49,000 89,700 (-) 30,000

House I 2,49,000
House II 89,700
House III (-) 30,000
3,08,700
Add: Unrealised rent
Recovered 20,000
Less: Standard deduction (6,000) 14,000
Income from House Property 3,22,700
Question 3
Mr. X is the owner of a residential house, whose construction was completed on 31.8.1996.
It has been let out from 1.12.1996 for residential purposes. Its particulars for the financial
year 2022-23 are given below:
256
S. No. Particulars Amount (`)

(i) Municipal valuation 55,000
(ii) Expected fair rent per annum 60,000
(iii) Standard rent under the Rent Control Act 6,000 p.m.
(iv) Actual monthly rent 6,000 p.m.
(v) Municipal taxes (including ` 5,000 paid by tenant) paid 1,5000
(vi) Water/sewage benefit tax levied by State Government but 6,000
disputed in Court
(vii) Fire Insurance payable 800
(viii) Interest on loan taken for the construction of the house.
The interest has been paid outside India to a non-resident
without deduction of tax at source, as the non-resident agreed
to pay income tax on such interest directly to the Government 10,000
(ix) Legal charges for the recovery of rent 4,000
(x) Stamp duty and registration charges incurred in respect of the
lease agreement of the house 2,000
Compute his income from house property for the assessment year 2023-24.
Answer
Particulars Amount (`) Amount (`)
Gross Annual Value, higher of the following two 72,000
(a) Municipal value (` 55,000), Fair rent (` 60,000) 60,000
whichever is more but restricted to standard rent
(b) Actual rent received or receivable (6,000 x 12) 72,000
Less: Municipal taxes (10,000)
Net annual value 62,000
Less: Standard deduction @ 30% u/s 24(a) (18,600)
Question 4
Ganesh has three houses, all of which are self-occupied. The particulars of the houses for
the P.Y. 2022-23 are as under:
257
Particulars House I House II House III

Municipal valuation p.a. ` 3,00,000 ` 3,60,000 ` 3,30,000
Fair rent p.a. ` 3,75,000 ` 2,75,000 ` 3,80,000
Standard rent p.a. ` 3,50,000 ` 3,70,000 ` 3,75,000
Date of completion/purchase 31.3.1999 31.3.2001 01.4.2015
Municipal taxes paid during the year 12% 8% 6%
Interest on money borrowed for repair 55,000
of property during the current year
Interest for current year on money 1,75,000
borrowed in July 2019 for purchase of
property
Compute Ganesh’s income from house property for A.Y.2023-24 and suggest which houses
should be opted by Ganesh to be assessed as self-occupied so that his tax liability is
minimum.
Answer
Let us first calculate the income from each house property assuming that they are deemed
to be let out.
Computation of income from house property of Ganesh for the A.Y. 2023-24.
Particulars Amount in `
House I House II House III
Gross Annual Value (GAV)
ER is the GAV of house property
ER = Higher of MV and FR, but 3,50,000 3,60,000 3,75,000
restrict-ed to SR
Less: Municipal taxes (paid by the (36,000) (28,800) (19,800)
owner during the previous year)
Net Annual Value (NAV) 3,14,000 3,31,200 3,55,200
Less: Deductions under section 24
(a) 30% of NAV (94,200) (99,360) (1,06,560)
(b) Interest on borrowed capital (55,000) (1,75,000)
Income from house property 2,19,800 1,76,840 73,640
258
Ganesh can opt to treat any two of the above house properties as self-occupied. OPTION
1 (House I and II– self-occupied and House III – deemed to be let out) If House I and II are
opted to be self-occupied, the income from house property shall be –
House I (Self-occupied) Nil
House II (Self-occupied) (interest deduction restricted to ` 30,000) (30,000)
House III (Deemed to be let-out) 73,640
OPTION 2 (House I and III – self-occupied and House II – deemed to be let out) If House I and
III are opted to be self-occupied, the income from house property shall be –
House I (Self-occupied) Nil
House II (Deemed to be let-out) 1,76,840
House III (Self-occupied) (1,75,000)
OPTION 3 (House II and III – self-occupied and House I – deemed to be let out) If House II and
III are opted to be self-occupied, the income from house property shall be –
House I (Deemed to be let-out) 2,19,800
House I (Deemed to be let-out)
House II (Self-occupied) (interest deduction restricted to ` 30,000)
(30,000)
House III (Self-occupied) (1,75,000)
(Total interest deduction of 2,05,000 restricted to ` 2,00,000 (2,00,000)
maximum allowed)
Since Option 2 is most beneficial, Ganesh should opt to treat House I and III as self-
occupied and House II as deemed to be let out. His income from house property would
be ` 1,840 for the A.Y. 2023-24.
259
ACCOUNTING
STANDARDS
INTER C.A. – ACCOUNTING
CASH FLOW STATEMENT
PART A : THEORY SECTION
1. Cash Flow Statement shows relationship between Profitability and Cash generating
ability and hence the "quality of profits" of the reporting entity.
2. It is mandatory for listed companies and entities with a turnover exceeding ` 50

crores.
3. Cash comprises cash on hand & demand deposits with bank.

Cash equivalents are short term highly liquid investments that are readily convertible
into known amounts of cash & which are subject to an insignificant risk.
4. Classification of Activities : According to the revised Accounting Standard 3, the cash

flow statement should show cash flows during the period classified by operating,
investing & financing activities.
(a)
Operating Activities : These are principle revenue producing activities of an
enterprise other activities which are not investing or financing activities. Cash
flows from operating activities generally result from the transactions & other
events that determine the net profit or loss of the business. e.g. of cash flows
from Opening activities are :
(i) Cash receipts from sale of goods & rendering of services.
(ii) Cash Receipts from commission, fees, royalties etc.
(iii) Cash payments suppliers of goods & services.
(iv) Cash payments of operating expenses such as salaries & wages, rent,
electricity etc.
(v) Cash payments or refund of income tax.
(b)
Investing Activities : These are acquisition & disposal of Long-term assets
such as land, building, plant, furniture, goodwill, trademarks, copyrights and
investments not included in cash equivalents e.g.
260
(i) Cash payments to acquire fixed assets.

(ii) Cash payments relating to capatalisation research & development cost.
(iii) Cash received on disposal of fixed assets.
(iv) Loans made to third parties.
(v) Cash received from repayments of loans made to third parties.
(vi) Interest received on investments / Income from investment.
(c) Financing Activities: These are activities that result in changes in the size and
composition of owners capital including preference share capital & borrowings
of a business e.g.
(i) Cash receipts from issue of shares, debts, bonds, loans & other borrowings.
(ii) Cash repayment of loans taken.
(iii) Cash payment to redeem preference shares.
(iv) Interest and dividend paid.
5. Net basis reporting is allowed in following situations.

(a) Cash Flows reflecting activities of customers rather than those of the reporting
entity (e.g. deposits and withdrawals by a bank's customers).
(b) Cash Flows in respect of items in which the taken over is quick and amounts are
large and maturities are short (e.g. principal amounts relating to credit card
customers).
261
The AS-3 (Revised) "Cash Flow Statement" has prescribed two formats for the presentation
of Cash Flow Statement. These formats are given in Tables.
CASH FLOW STATEMENT [PARAGRAPH 18 (A)] (DIRECT METHOD)
Cash flows from Operating Activities
Cash receipts from Customers *****
Cash paid to suppliers and employees (*****)
Cash generated from operations *****
Income Tax paid (*****)
Cash flow before extraordinary item *****
± Extraordinary Items *****
Net cash from Operating Activities *****
Cash flows from Investing Activities
Purchase of fixed assets (*****)
Proceed from sale of equipment *****
Interest received *****
Dividend received *****
Net cash from investing activities *****
Cash flows from Financing Activities
Proceeds from issuance of share capital *****
Proceeds from long-term borrowings/short - term borrowings *****
Repayments of long - term borrowings (*****)
Interest paid (*****)
Dividend paid (*****)
Net cash from financing activities *****
Net increase in cash and cash equivalents *****
Cash and cash equivalents at beginnings of period *****
Cash and cash equivalents at end of period *****
262
CASH FLOW STATEMENT [PARAGRAPH 18 (B)] (INDIRECT METHOD)
Cash flows from Operating Activities

Net profits before taxation and extraordinary item *****
Adjustment for :
Depreciation *****
Interest Income *****
Dividend Income *****
Interest expense *****
Operating profit before working capital changes *****
Increase in sundry debtors (*****)
Decrease in inventories *****
Decrease in sundry creditors *****
Cash generated from operations *****
Income tax paid (*****)
Cash flow before extraordinary items *****
± Extraordinary items *****
Net cash from operating activities *****
Cash flow from Investing Activities
Purchase of fixed assets (*****)
Proceeds from sale of equipment *****
lnterest received *****
Dividend received *****
Net cash from operating activities *****
Cash flow from Financing Activities
Proceeds from issuance of share capital *****
Proceeds from long – term borrowings / short – term *****
borrowings
Repayment of long - term borrowings (*****)
Interest paid (*****)
Dividend paid (*****)
Net cash from financing activities *****
Net increase in cash and cash equivalents *****
Cash and cash equivalents at beginning of period *****
Cash and cash equivalents at end of period *****
263
PART B : CLASSWORK SECTION
Question 1
From the following information, calculate cash flow from operating activities:
Summary of Cash Account
for the year ended March 31, 20X1
Particulars ` Particulars `
To Balance b/d 1,00,000 By Cash Purchases 1,20,000
To Cash sales 1,40,000 By Trade payables 1,57,000
To Trade receivables 1,75,000 By Office & Selling Expenses 75,000
By Income Tax 30,000
To Trade Commission 50,000 By Investment 25,000
To Sale of Investment 30,000 By Repayment of Loan 75,000
To Loan from Bank 1,00,000 By Interest on loan 10,000
To Interest & Dividend 1,000 By Balance c/d 1,04,000
5,96,000 5,96,000
Question 2
Prepare cash flow statement of M/s MNT Ltd. for the year ended 31 st March, 20X1 with
the help of the following information:
(1) Company sold goods for cash only.
(2) Gross Profit Ratio was 30% for the year, gross profit amounts to ` 3,82,500.
(3) Opening inventory was lesser than closing inventory by ` 35,000.
(4) Wages paid during the year ` 4,92,500.
(5) Office and selling expenses paid during the year ` 75,000.
(6) Dividend paid during the year ` 30,000.
(7) Bank loan repaid during the year ` 2,15,000 (included interest ` 15,000).
(8) Trade payables on 31st March, 20X0 exceed the balance on 31st March, 20X1 by `
25,000.
(9) Amount paid to trade payables during the year ` 4,60,000.
(10) Tax paid during the year amounts to ` 65,000 (Provision for taxation as on 31.03.20X1`
45,000).
(11) Investments of ` 7,00,000 sold during the year at a profit of ` 20,000.
(12) Depreciation on fixed assets amounts to ` 85,000.
(13) Plant and machinery purchased on 15th November, 20X0 for ` 2,50,000.
264
(14) Cash and Cash Equivalents on 31st March, 20X0` 2,00,000.

(15) Cash and Cash Equivalents on 31st March, 20X1` 6,07,500.
Question 3
Prepare Cash flow for Gamma Ltd., for the year ending 31.3.20X1 from the following
information:
(1) Sales for the year amounted to ` 135 crores out of which 60% was cash sales.
(2) Purchases for the year amounted to ` 55 crores out of which credit purchase was
80%.
(3) Administrative and selling expenses amounted to ` 18 crores and salary paid
amounted to ` 22 crores.
(4) The Company redeemed debentures of ` 20 crores at a premium of 10%. Debenture
holders were issued equity shares of ` 15 crores towards redemption and the balance
was paid in cash. Debenture interest paid during the year was` 1.5 crores.
(5) Dividend paid during the year amounted to ` 11.7 crores.
(6) Investment costing ` 12 crores were sold at a profit of ` 2.4 crores.
(7) ` 8 crores was paid towards income tax during the year.
(8) A new plant costing ` 21 crores was purchased in part exchange of an old plant.
The book value of the old plant was ` 12 crores but the vendor took over the old
plant at a value of ` 10 crores only. The balance was paid in cash to the vendor.
(9) The following balances are also provided:
` in crores 1.4.20X0 ` in crores 31.3.20X1

Debtors 45 50
Creditors 21 23
Bank 6 18.2
Question 4
Prepare cash flow from investing activities as per AS 3 of M/s Subham Creative Limited
for year ended 31.3.2019.
Machinery acquired by issue of shares at face value 2,00,000
Claim received for loss of machinery in earthquake 55,000
Unsecured loans given to associates 5,00,000
Interest on loan received from associate company 70,000
Pre-acquisition dividend received on investment made 52,600
265
Debenture interest paid 1,45,200

Term loan repaid 4,50,000
Interest received on investment (TDS of ` 8,200 was deducted on the 73,800
above interest)
Purchased debentures of X Ltd., on. 1st December, 2018 which are 3,00,000
redeemable within 3 months
Book value of plant & machinery sold (loss incurred ` 90,000
9,600)
Question 5
The following data were provided by the accounting records of Ryan Ltd. at year-end,
March 31, 2013:
Income Statement
`
Sales 6,98,000
Cost of Goods Sold 5,20,000
Gross Margin 1,78,000
Operating Expenses (including Depreciation Exp. of ` 37,000) (1,47,000)
31,000
Other Income (Expenses)
Interest Expense paid (23,000)
Interest Income received 6,000
Gain on Sale of Investments 12,000
Loss on Sale of Plant (3,000) (8,000)
23,000
Income tax (7,000)
16,000
Comparative Balance Sheets

` `
31st March 31st March
2013 2012
Assets
Plant Assets 7,15,000 5,05,000
Less: Accumulated Depreciation (1,03,000) (68,000)
6,12,000 4,37,000
Investments (Long - term) 1,15,000 1,27,000
Current Assets
266
Inventory 1,44,000 1,10,000

Accounts Receivable 47,000 55,000
Cash 46,000 15,000
Prepaid Expenses 1,000 5,000
9,65,000 7,49,000
Liabilities
Share Capital 4,65,000 3,15,000
Reserves & Surplus 1,40,000 1,32,000
Bonds 2,95,000 2,45,000
Current Liabilities:
Accounts Payable 50,000 43,000
Accrued Liabilities 12,000 9,000
Income Taxes Payable 3,000 5,000
9,65,000 7,49,000
Analysis of selected accounts and transactions during 2012-2013 :

1. Purchased investments for ` 78,000.
2. Sold investments costing ` 90,000.
3. Purchased plant assets for ` 1,20,000
4. Sold plant assets that cost ` 10,000 with accumulated depreciation of ` 2,000 for
` 5,000.
5. Issued ` 1,00,000 of bonds at face value in a exchange for plant assets on 31st
March, 2013.
6. Repaid ` 50,000 of bonds at face value at maturity.
7. Issued 15,000 shares of `10 each.
Prepare Cash Flow Statement as per AS-3 (Revised), using indirect and direct method.
Question 6
The following are the summarised balance sheets of Sound Ltd. as on March 31, for the
two consecutive years 1 and 2 (` in thousand)
Year 2 Year 1
Assets :
Plant and machinery 1,980 1,010
Land and buildings 1,000 1,000
Long - term investments 550 550
Short - term investments 470 85
Sundry debtors 2,195 2,500
Inventories 1,400 1,300
Interest receivable 100 65
Cash in hand 300 500
Cash in bank 405 300
267
8,400 7,310
Liabilities:
Share Capital 2,600 2,150
Reserve and surplus 1,460 900
15% Debentures 2,000 1,800
Sundry creditors 440 650
Wages outstanding 40 20
Income - tax payable 400 450
Accumulated depreciation:
Plant and machinery 910 840
Land and buildings 550 500
8,400 7,310
Income statement for the period ending March 31, year 2 (` in thousand)
Sales revenue 45,300

Less : cost of sales 39,000
Gross profit 6,300
Less : depreciation (540)
Selling and administration expenses (2,960)
Interest paid (300)
Add : interest income 65
Dividend income (gross) 95
Net profit before extraordinary items 2,660
Add : insurance settlement received 10
2,670
Less : provision for income - taxes 550
Net profit after taxes 2,120
Additional information (` in thousand):

(1) 15% Debentures of ` 300 was redeemed during year 2.
(2) Tax deducted at source on dividends received (included in provision for taxes) amounts
to ` 15.
(3) A plant costing ` 500, having accumulated depreciation of ` 420 was sold for
` 80.
(4) During year 2, interim dividend of ` 760 was paid; final dividend paid was ` 800.
268
(5) All sales and purchases are made on credit basis.

You are required to prepare Cash Flow statement as per ICAI's Accounting Standard 3 (revised).
Question 7
Ms. Jyothi of Star Oils Limited has collected the following information for the preparation
of cash flow statement for the year ended 31st March, 2013:
(` in lakhs)
Net profit 25,000
Dividend and corporate dividend tax thereon paid 8,535
Provision for income-tax 5,000
Income-tax paid during the year 4,248
Loss on sale of fixed assets (net) 40
Book value of the fixed assets sold 185
Depreciation charged to Profit & Loss Account 20,000
Amortisation of capital grant 6
Profit on sale of investments 100
Carrying amount of investments sold 27,765
Interest income on investments 2,506
Interest expenses 10,000
Interest paid during the year 10,520
Increase in working capital (excluding cash and bank balances) 56,075
Purchase of fixed assets 14,560
Investment in joint venture 3,850
Expenditure on construction, work-in-progress 34,740
Proceeds from calls in arrear 2
Receipt of grant for capital projects 12
Proceeds from long-term borrowings 25,980
Proceeds from short-term borrowings 20,575
Opening cash and Bank balances 5,003
Closing cash and bank balances 6,988
Required:
Prepare the cash flow statement in accordance with AS-3, Cash Flow Statements issued
by the Institute of Chartered Accountants of India. Make necessary assumptions.
269
Question 8
From the following, calculate the Net Profit before tax.
Particulars 31st March 31st March
2012 2013
Equity Share Capital 2,50,000 5,00,000
Securities premium ---- 25,000
General Reserve 75,000 1,00,000
Profit and Loss A/c 1,00,000 3,00,000
10% Debentures 2,00,000 2,00,000
Sundry Creditors 10,000 35,000
Provision for Tax 25,000 45,000
During the year, Dividend paid for the year end 31st March, 2012 was ` 25,000
Question 9
From the following Balance sheet of Grow More Ltd., prepare Cash Flow Statement for
the year ended 31st March, 20X1 :
Particulars Notes 31st March, 31st March,

20X1 20X0
Equity and Liabilities
1 Shareholders’ funds
A Share capital 10,00,000 8,00,000
B Reserves and Surplus 1 3,00,000 2,10,000
2 Non-current liabilities
Long term borrowings 2 2,00,000 -
3 Current liabilities
A Trade Payables 7,00,000 8,20,000
B Other current liabilities 3 - 1,00,000
C Short term provision 1,00,000 70,000
(provision for tax)
Total 23,00,000 20,00,000
Assets
1 Non-current assets
A Property, plant and. 4 13,00,000 9,00,000
Equipment
B Non-Current Investments 1,00,000 -
2 Current assets
270
A Inventories 4,00,000 2,00,000

B Trade receivables 5,00,000 7,00,000
Cash and Cash equivalents - 2,00,000
C Total 23,00,000 20,00,000
Notes to accounts
No. Particulars 31st March, 31st March,
20X1 20X0
1 Reserves and Surplus
Revenue reserve 2,00,000 1,50,000
Profit and Loss account 1,00,000 60,000
Total 3,00,000 2,10,000
2 Long term borrowings
Debentures 2,00,000 --
3. Other current liabilities
Dividend payable - 1,00,000
4 Property, plant and equipment
Plant and machinery 7,00,000 5,00,000
Land and building 6,00,000 4,00,000
Net carrying value 13,00,000 9,00,000
(i) Depreciation @ 25% was charged on the opening value of Plant and Machinery.
(ii) At the year end, one old machine costing ` 50,000 (WDV ` 20,000) was sold for `
35,000. Purchase was also made at the year end.
(iii) ` 50,000 was paid towards Income tax during the year.
(iv) Construction of the building got completed on 31.03.20X1 and hence no depreciation
may be charged on the same.
Prepare Cash flow Statement.
Question 10
From the following Balance Sheets and information, prepare Cash Flow Statement of
Ryan Ltd. by Indirect method for the year ended 31st March, 20X1:
Particulars Notes 31st March 31st March
20X1 ` 20X0 `
A Share capital 1 6,00,000 7,00,000
271

Long term borrowings 3 2,00,000 -
A Trade Payables 1,15,000 1,10,000
B Other current liabilities 4 30,000 80,000
C Short term provision (provision
for tax) 95,000 60,000
Total 14,60,000 12,50,000
Assets
A Property, plant and Equipment 5 9,15,000 7,00,000
B Non-Current Investments 50,000 80,000
2 Current assets
A Inventories 95,000 90,000
C Cash and Cash equivalents 50,000 90,000
D Other Current assets 1,00,000 65,000
Total 14,60,000 12,50,000
Notes to accounts
No. 31st March, 31st March,
20X1 20X0
1. Share capital
Equity share capital 6,00,000 5,00,000
10% Redeemable Preference share capital -- 2,00,000
Total 6,00,000 7,00,000
Capital redemption reserve 1,00,000 -
Capital reserve 70,000 -
General reserve 1,50,000 2,50,000
Profit and Loss account 1,00,000 50,000
Total 4,20,000 3,00,000
9% Debentures 2,00,000 --
Dividend payable - 60,000
Liabilities for expenses 30,000 20,000
272
Total 30,000 80,000

Land and building 1,50,000 2,00,000
Additional Information:
(i) A piece of land has been sold out for `1,50,000 (Cost – `1,20,000) and the balance
land was revalued. Capital Reserve consisted of profit on revaluation of land.
(ii) On 1st April, 20X0 a plant was sold for `90,000 (Original Cost – `70,000 and W.D.V.
– ` 50,000) and Debentures worth `1 lakh were issued at par as part consideration
for plant of `4.5 lakhs acquired.
(iii) Part of the investments (Cost – `50,000) was sold for `70,000.
(iv) Pre-acquisition dividend received `5,000 was adjusted against cost of investment.
(v) Interim dividend was declared and paid @ 15% during the current year.
(vi) Income-tax liability for the current year was estimated at `1,35,000.
(vii) Depreciation @ 15% has been charged on Plant and Machinery but no depreciation
has been charged on Building.
Question 11
The Balance Sheet of New Light Ltd. as at 31st March, 20X1 and 20X0 (for the years
ended) are as follows:
Notes ` `
20X0 20X1
A Share capital 1 16,00,000 18,80,000
Long term borrowings 3 4,00,000 2,80,000
A Other current liabilities 4 6,00,000 5,20,000
B Short term provision (provision for 3,60,000 3,40,000
tax)
Total 38,00,000 41,20,000
Assets
273
B Non-Current Investments 4,00,000 3,20,000
2 Current assets
A Cash and Cash equivalents 10,000 10,000
B Other Current assets 11,10,000 11,50,000
Total 38,00,000 41,20,000
Notes to accounts
No. 31st March, 31st March,
20X0 20X1
1. Share capital
Equity share capital 12,00,000 16,00,000
10% Preference share capital 4,00,000 2,80,000
Total 16,00,000 18,80,000
General reserve 6,00,000 7,60,000
Profit and Loss account 2,40,000 3,40,000
Total 8,40,000 11,00,000
9% Debentures 4,00,000 2,80,000
Total 4,00,000 2,80,000
Dividend payable 1,20,000 -
Current Liabilities 4,80,000 5,20,000
Total 6,00,000 5,20,000
Property, plant and equipment 32,00,000 38,00,000
Less: Depreciation (9,20,000) (11,60,000)
Additional information:
(i) The company sold one property, plant and equipment for ` 1,00,000, the cost of
which was ` 2,00,000 and the depreciation provided on it was `80,000.
(ii) The company also decided to write off another item of property, plant and equipment
costing ` 56,000 on which depreciation amounting to ` 40,000 has been provided.
(iii) Depreciation on property, plant and equipment provided ` 3,60,000.
274
(iv) Company sold some investment at a profit of ` 40,000.

(v) Debentures and preference share capital redeemed at 5% premium.
(vi) Company decided to value inventory at cost, whereas previously the practice was
to value inventory at cost less 10%. The inventory according to books on 31.3.20X0
was ` 2,16,000. The inventory on 31.3.20X1 was correctly valued at ` 3,00,000.
Prepare Cash Flow Statement as per revised Accounting Standard 3 by indirect method.
Question 12
Given below are the relevant extracts of the Balance Sheet and the Statement of Profit
and Loss of ABC Ltd. along with additional information:
Extract of Balance sheet
Particulars Notes 31.3.20X1 31.3.20X0
(` in lakhs) (` in lakhs)
(a) Trade Payables 250 230
(b) Short term Provisions 1 200 180
(c) Other current liabilities 2 70 50
Assets
1 Current assets
(a) Inventories 200 180
(b) Trade Receivables 400 250
(c) Other current assets 3 195 180
Statement of Profit and Loss of ABC Ltd. for the year ended 31st March, 20X1
Particulars Notes ` in lakhs
I Revenue from operations 4,150
II Other income 4 100
III Total Revenue (I + II) 4,250
Expenses:
Purchases of Stock-in-Trade 2,400
Change in inventories of finished goods (20)
Employee benefits expense 800
Depreciation expense 100
Finance cost 5 60
Other expenses 200
IV Total expenses 3,540
275
V Profit before tax (III – IV) 710

VI Tax expense: Current tax 200
VII Profit for the year from continuing operations 510
Appropriations
Balance of Profit and Loss account brought forward 50
Transfer to general reserve 200
Dividend paid 330
Notes to accounts:
20X1 20X0
1 Short term Provisions:
Provision for Tax 200 180
2 Other current liabilities:
Outstanding wages 50 40
Outstanding expenses 20 10
Total 70 50
3 Other current assets:
Advance tax 195 180
4 Other income:
Interest and dividend 100
5 Finance cost:
Interest 60
Compute cash flow from operating activities using both direct and indirect method.
Question 13
Following information was extracted from the books of S Ltd. for the year ended 31st
March,2020 :
(1) Net profit before talking into account income tax and after talking into account the
following items was `30 lakhs;
(i) Depreciation on Property, Plant & Equipment `7,00,000
(ii) Discount on issue of debentures written off `45,000.
(iii) Interest on debentures paid `4,35,000
(iv) Investment of Book value `3,50,000 sold for `3,75,000.
276
(v) Interest received on Investments `70,000

(2) Income tax paid during the year ` 12,80,000
(3) Company issued 60,000 Equity Shares of `10 each at a premium of 20% on 10th
April,2019.
(4) 20,000,9% Preference Shares of `100 each were redeemed on 31st March, 2020 at
a premium of 5%
(5) Dividend paid during the year amounted to `11 Lakhs (including dividend distribution
tax)
(6) A new Plant costing `7 Lakhs was purchased in part exchange of an old plant on
1st January,2020. The book value of the old plant was `8 Lakhs but the vendor took
over the old plant at a value of `6 Lakhs only. The balance amount was paid to
vendor through cheque on 30th March,2020.
(7) Company decided to value inventory at cost, whereas previously the practice was to
value inventory at cost less 10%. The inventory according to books on 31.03.2020
was ` 14,76,000.
The inventory on 31.03.2019 was correctly valued at ` 13,50,000.
(8) Current Assets and Current Liabilities in the beginning and at the end of year 2019-
2020 were as:
As on 1st As on 31st
April,2019 (`) March,2020 (`)
Inventory 13,50,000 14,76,000
Trade Receivables 3,27,000 3,13,200
Cash &Bank Balances 2,40,700 3,70,500
Trade Payables 2,84,700 2,87,300
Outstanding Expenses 97,000 1,01,400
You are required to prepare a Cash Flow Statement for the year ended 31st March, 2020
as per AS 3 (revised).
277
PART C : HOMEWORK & PAST PAPER SECTION

Question 14
Classify the following activities as (a) Operating activities, (b) Investing activities (c)
Financing activities (d) Cash equivalents with reference to AS 3 (Revised).
(a) Brokerage paid on purchase of investments
(b) Underwriting commission paid
(c) Trading commission received
(d) Proceeds from sale of investment
(e) Purchase of goodwill
(f) Redemption of preference shares
(g) Rent received from property held as investment
(h) Interest paid on long-term borrowings
(i) Marketable securities
(j) Refund of income tax received (5 Marks – May 2019 – IPCC)
Question 15
Prepare cash flow for ABC Ltd., using Direct Method for the year 10 ending 31-03-2019
from the following information:
(1) Sales for the year amounted to ` 270 Lakh out of which 50% was cash sales.
(2) Purchases for the year amounted to ` 60 lakh out of which credit purchases were
80%.
(3) Administrative expenses amounted to ` 18 lakh. Salary of ` 16 lakh was charged to
profit and loss account for the year. Salary of ` 4 lakh was outstanding as on 31-
03-2019. (Salary does not form part of Administrative expenses)
(4) The company has 15% debentures of ` 10 lakh, which it redeemed during the year
at a premium of 10% by issue of equity shares of ` 9 lakh towards redemption and
the balance was paid in cash. Debenture Interest was also paid during the year.
(5) Dividend paid during the year amounted to ` 12 lakh (including dividend distribution
tax).
(6) Investment costing ` 10 lakh were sold at a profit of ` 2.50 lakh.
(7) Income tax payable for the year was ` 80,000.
(8) Depreciation of 25% is charged by the company on opening balance of Plant and
Machinery. At the year end one old plant costing ` 5,00,000 (WDV ` 2,00,000) was
sold for ` 3,50,000. The purchases were also made at year end.
(9) The following balances are also provided:
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` in Lakh ` in Lakh
31-03-2018 31-03-2019
Debtors 40 45
Creditors 20 23
Bank 5 -
Plant & Machinery 50 70
Provision for tax 1 0.7
(10 Marks – Nov 2019 – IPCC)
Question 16
The following figures have been extracted from the books of Manan limited for the year
ended on 31.3.2020. You are required to prepare the cash flow statement as per AS 3
using indirect method.
(i) Net profit before taking into account tax and income from law suits but after taking
into account the following items was `30 lakhs:
(a) Depreciation on Property, Plant & Equipment `7.50 lakhs.
(b) Discount on issue of Debentures written off `45,000.
(c) Interest on Debentures paid `5,25,000.
(d) Book value of investment `4.50 lakhs (Sale of investments for `4,80,000).
(e) Interest received on investments `90,000.
(ii) Compensation received `1,35,000 by the company in a suit filed.
(iii) Income tax paid during the year `15,75,000
(iv) 22,500, 10% preference shares of ` 100 each were redeemed on 02-04-2019 at
a premium of 5%.
(v) Further the company issued 75,000 equity shares of `10 each at a premium of 20%
on 30.3.2020 (Out of 75,000 equity shares, 25,000 equity shares were issued to a
supplier of machinery)
(vi) Dividend for FY 2018-19 on preference shares were paid at the time of redemption.
(vii) Dividend on Equity shares paid on 31.01.2020 for the year 2018-2019 `7.50 lakhs
(including dividend distribution tax ) and interim dividend paid `2.50 lakhs for the
year 2019-2020.
(viii) Land was purchased on 02.4.2019 for `3,00,000 for which the company issued
22,000 equity shares of ` 10 each at a premium of 20% to the land owner and
balance in cash as consideration.
(ix) Current assets and current liabilities in the beginning and at the end of the years
were as detailed below:
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As on As on
01.04.2019 31.3.2020
(`) (`)
Inventory 18,00,000 19,77,000
Trade receivables 3,87,000 3,79,650
Cash in hand 3,94,450 16,950
Trade payable 3,16,500 3,16,950
Outstanding expenses 1,12,500 1,22,700
(10 Marks – Nov 2020 – Inter)
Question 17
From the following summary cash account of K Ltd., prepare cash flow statement for the
year ended 31st March, 2020, in accordance with AS 3 (Revised) using the direct method.
The company does not have any cash equivalents.
Summary Cash Account for the year ended 31-03-2020
Particulars Amount in Particulars Amount in (`)
(`) ‘000 ‘000
Balance as on 01.04.2019 100 Payment to suppliers 4,000
Issue of Equity Share 600 Purchase of Fixed Assets 400
Receipts from Customers 5,600 Overhead Expenses 400
Sale of Fixed Assets 200 Wages and Salaries 200
Taxation 500
Dividend 100
Repayment of bank loan 600
Balance as on 31.03.2020 300
6,500 6,500
(8 Marks – Nov 2020 – IPCC)
Question 18
Following are extracts of the Balance Sheets of Ajay Ltd.:
Particulars Notes 31.3.20X1 31.3.20X2
` `
Shareholder’s funds
(a) Share capital 1 5,00,000 5,00,000
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(b) Reserve & surplus 2 50,000 90,000

Non-current liabilities
(a) Long-term borrowings 3 5,00,000 7,50,000
Current liabilities
(a) Other current liabilities 4 --- 5,000
Assets
Non-current assets
(a) Intangible assets 5 2,05,000 1,80,000
Notes to accounts
31.3.20X1 31.3.20X2
` `
1 Share Capital
50,000 Equity Shares of `10 each 5,00,000 5,00,000
2 Reserve & surplus
Profit & Loss A/c 50,000 90,000
3 Long-term borrowings
10% Debentures 5,00,000 7,50,000
4 Other current liabilities
Unpaid interest --- 5,000
5 Intangible assets
Goodwill 2,05,000 1,80,000
You are required to show related items in cash flow statement
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Question 19
ABC Ltd. gives you the Balance sheets as at 31st March 20X0 and 31st March 20X1. You
are required to prepare Cash Flow Statement by using indirect method as per AS 3 for the
year ended 31st March 20X1:
Particulars Notes ` `
20X0 20X1
1 Equity and Liabilities Shareholders’
funds
A Share capital 50,00,000 50,00,000
2 B Reserves and Surplus 26,50,000 36,90,000
Non-current liabilities
3 Long term borrowings 1 - 9,00,000
Current liabilities
A Short-term borrowings 1,50,000 3,00,000
(Bank loan)
B Trade payables 8,80,000 8,20,000
C Other current liabilities 2 4,80,000 2,70,000
Total 91,60,000 1,09,80,000
Assets
2 Current assets
A Current Investments Inventory 11,80,000 15,00,000
C Cash and Cash equivalents 4 22,40,000 26,40,000
D Other Current assets (Prepaid expenses) 15,20,000 15,20,000
E 90,000 1,20,000
Total 91,60,000 1,09,80,000
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Notes to accounts
No. `20X0 20X1

9% Debentures - 9,00,000
Total - 9,00,000

Dividend payable 1,50,000 -
Liabilities for expenses 3,30,000 2,70,000
Total 4,80,000 2,70,000

Less: Depreciation (6,10,000) (7,90,000)
4 Trade receivables
Gross amount 23,90,000 28,30,000
Less: Provision for doubtful debts (1,50,000) (1,90,000)
Total 22,40,000 26,40,000
(i) Net profit for the year ended 31st March, 20X1, after charging depreciation
` 1,80,000 is ` 10,40,000.
(ii) Trade receivables of ` 2,30,000 were determined to be worthless and were written
off against the provisions for doubtful debts account during the year.
Question 20
The following information was provided by PQR Ltd. for the year ended 31st March, 2019 :
(1) Gross Profit Ratio was 25% for the year, which amounts to ` 3,75,000.
(2) Company sold goods for cash only.
(3) Opening inventory was lesser than closing inventory by ` 25,000.
(4) Wages paid during the year ` 5,55,000.
(5) Office expenses paid during the year ` 35,000.
(6) Selling expenses paid during the year ` 15,000.
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(7) Dividend paid during the year ` 40,000 (including dividend distribution tax).
(8) Bank Loan repaid during the year ` 2,05,000 (included interest ` 5,000)
(9) Trade Payables on 31st March, 2018 were ` 50,000 and on 31st March, 2019 were `
35,000.
(10) Amount paid to Trade payables during the year ` 6,10,000
(11) Income Tax paid during the year amounts to ` 55,000 (Provision for taxation as on
31st March, 2019 ` 30,000)·
(12) Investments of ` 8,20,000 sold during the year at a profit of ` 20,000.
(13) Depreciation on furniture amounts to ` 40,000.
(14) Depreciation on other tangible assets amounts to ` 20,000.
(15) Plant and Machinery purchased on 15th November, 2018 for ` 3,50,000.
(16) On 31st March, 2019 ` 2,00,000, 7% Debentures were issued at face value in an
exchange for a plant.
(17) Cash and Cash equivalents on 31st March, 2018 ` 2,25,000.
A) Prepare cash flow statement using direct method

B) Calculate cash flow from operating activities, using indirect method.
Question 21
Following information was extracted from the books of S Ltd. for the year ended 31st
March,2020 :
(1) Net profit before talking into account income tax and after talking into account the
following items was ` 30 lakhs;
(i) Depreciation on Property, Plant & Equipment ` 7,00,000
(ii) Discount on issue of debentures written off ` 45,000.
(iii) Interest on debentures paid ` 4,35,000
(iv) Investment of Book value ` 3,50,000 sold for ` 3,75,000.
(v) Interest received on Investments ` 70,000
(2) Income tax paid during the year ` 12,80,000
(3) Company issued 60,000 Equity Shares of ` 10 each at a premium of 20% on 10th
April,2019.
(4) 20,000,9% Preference Shares of ` 100 each were redeemed on 31st March, 2020 at
a premium of 5%.
(5) Dividend paid during the year amounted to ` 11 Lakhs (including dividend distribution
tax)
(6) A new Plant costing ` 7 Lakhs was purchased in part exchange of an old plant on
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1st January,2020. The book value of the old plant was ` 8 Lakhs but the vendor
took over the old plant at a value of ` 6 Lakhs only. The balance amount was paid
to vendor through cheque on 30th March,2020.
(7) Company decided to value inventory at cost, whereas previously the practice was to
value inventory at cost less 10%. The inventory according to books on 31.03.2020
was ` 14,76,000.
The inventory on 31.03.2019 was correctly valued at ` 13,50,000.
(8) Current Assets and Current Liabilities in the beginning and at the end of year 2019-
2020 were as:
As on 1st As on 31st
April,2019 March,2020
(`) (`)
Inventory 13,50,000 14,76,000
Trade Receivables 3,27,000 3,13,200
Cash &Bank Balances 2,40,700 3,70,500
Trade Payables 2,84,700 2,87,300
Outstanding Expenses 97,000 1,01,400
You are required to prepare a Cash Flow Statement for the year ended 31st March,
2020 as per AS 3 (revised) using the indirect method. (Jan' 21)
Question 22
The following information is provided by Alpha Limited, for the year ended 31st March,
2022.
(i) Net profit before taking into account income tax and income from law suits but after
taking into account the following items was ` 40 lakhs.
(ii) Depreciation on Fixed Assets ` 10 lakhs.
(iii) Discount on issue of Debentures written off ` 60,000.
(iv) Interest on Debentures paid ` 7,00,000.
(v) Book value of investments ` 6 lakhs (Sale of Investments for ` 6,40,000).
(vi) Interest received on investments ` 1,20,000.
(vii) Compensation received ` 1,80,000 by the company in a suit filed.
(viii) Income tax paid ` 21,00,000
(ix) Current assets and current liabilities in the beginning and at the end of the year
were as detailed below:
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As As on
31.3.2021 31.3.2022
` `
Stock 24,00,000 26,36,000
Sundry Debtors 4,16,000 4,26,200
Cash in hand 3,92,600 70,600
Bills Receivable 1,00,000 80,000
Bills Payable 90,000 80,000
Sundry Creditors 3,32,000 3,42,600
Outstanding Expenses 1,50,000 1,63,600
You are required to prepare Cash Flow Statement from operative Activities in
accordance with AS-3 (revised) using the indirect method for the year ended 31st
March, 2022 (May' 22)
Question 23
Prepare cash flow statement of Gama Limited for the year ended 31st March, 2021 in
accordance with AS-3(Revised) from the following cash account summary :
Cash summary Account
Inflows ` ('000) Outflows ` ('000)
Opening Balance 945 Payment to suppliers 54,918
Receipts from Customers 74,682 Purchase of Investments 351
Sale of Investments 459 Property, plant and 6,210
(Cost ` 4,05,000) equipment acquired
Issue of Shares 8,100 Wages and salaries 1,863
Sale of Property, Plant and 3,456 Payment of overheads 3,105
equipment Taxation 6,561
Dividends 2,160
Repayment of Bank Overdraft 6,750
Interest paid on Bank Overdraft 1,350
Closing Balance 4,374
87,642 87,642
(July' 21)
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Question 24
Following are the extracts from the Balance Sheet of ABC Ltd.
Liabilities 31.3.2020 31.3.2021
(`) (`)
Equity Share Capital 25,00,0000 35,60,000
10% Preference Share Capital 7,00,000 6,00,000
Securities Premium Account 5,00,000 5,50,000
Profit & Loss A/c 20,00,000 28,00,000
Equity Share Capital for the year ended 31st March, 2021 includes ` 60,000 of equity
shares issued to Grey Ltd. at par for supply of Machinery of ` 60,000.
Profit & Loss account on 31st March, 2021 includes ` 50,000 of dividend received on
Equity shares invested in X Ltd.
Show how the related items will appear in the Cash Flow Statement of ABC Ltd. as per
AS-3 (Revised) (Dec' 21)
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ACCOUNTING
STANDARDS
INTRODUCTION TO ACCOUNTING STANDARDS
1. What are Accounting Standards?

Accounting Standards are written policy documents, covering guidelines relating to
Issues in Financial Reporting.
2. Which Issues are Covered by AS?

AS deals with the following issues:-
a. Recognition; (when to recognise a transaction in Books of Accounts)
b. Measurement; (At what Value to recognise transactions in Books of Accounts)
c. Presentation; (How to present the transactions in the Financial Statements)
d. Disclosure;
3. WHY AS?
AS are introduced so that there can be:-
a. Uniformity;
b. Comparability;
c. Better Decision Making;
4. How Many AS?

At Intermediate Level there are 22 AS to be studied, Off which:-
• AS 1,2,3,10,11,12,13,16 are covered in Paper 1 Accounting;
• AS 4,5,7,9,14,17,18,19,20,21,22,24,26,29 are covered in Paper 5 Advanced
Accounting.
5. To Whom AS are Applicable?

AS are applicable to ALL Business entities. AS are not applicable to entities engaged
in solely Charitable Activities. (e.g. an organisation collecting donations and giving
them to flood affected people)
Business Entities are classified as:-
• Corporate entities; (Companies)
• Non-Corporate Entities; (Other than Companies)
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HOMEWORK SECTION
Question 1
What are the issues, with which Accounting Standards deal?
Covered with Classwork Section
Question 2
List the criteria to be applied for rating a non-corporate entity as Level-I entity for the
purpose of compliance of Accounting Standards in India.
Question 3
List the criteria to be applied for rating a non-corporate entity as Level-II entity for the
purpose of compliance of Accounting Standards in India.
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PAST PAPER SECTION
Question 1
Please explain briefly two benefits and two limitations of Accounting Standards for an
accountant. (May’19)
Answer
Accounting standards seek to describe the accounting principles, the valuation
techniques and the methods of applying the accounting principles in the preparation
and presentation of financial statements so that they may give a true and fair view. By
setting the accounting standards the accountant has the following benefits:
(i) Standardisation of alternative accounting treatments: Standards reduce to a reasonable
extent or eliminate altogether confusing variations in the accounting treatments
used to prepare financial statements.
(ii) Comparability of financial statements: The application of accounting standards would,

to a limited extent, facilitate comparison of financial statements of companies
situated in different parts of the world and also of different companies situated in
the same country. However, it should be noted in this respect that differences in the
institutions, traditional and legal systems from one country to another give rise to
differences in accounting standards adopted in different countries.
However, there are some limitations of setting of accounting standards:

(i) Difficulties in making choice between different treatments: Alternate solutions to certain
accounting problems may each have arguments to recommend them. Therefore, the
choice between different alternative accounting treatments may become difficult.
(ii) Lack of flexibilities and Restricted Scope: There may be a trend towards rigidity and
away from flexibility in applying the accounting standards. Accounting standards
cannot override the statute. The standards are required to be framed within the
ambit of prevailing statutes.
Question 2
List the Criteria for classification of non-corporate entities as level I Entities for the purpose
of application of Accounting Standards as per the Institute of Chartered Accountants of
India.
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Answer
Criteria for classification of non-corporate entities as level 1 entities for purpose of
application of Accounting Standards decided by the Institute of Chartered Accountants of
India is given below:
Non-corporate entities which fall in any one or more of the following categories, at the
end of the relevant accounting period, are classified as Level I entities:
(i) Entities whose equity or debt securities are listed or are in the process of listing on
any stock exchange, whether in India or outside India.
(ii) Banks (including co-operative banks), financial institutions or entities carrying on
insurance business.
(iii) All commercial, industrial and business reporting entities, whose turnover (excluding
other income) exceeds rupees two fifty crore in the immediately preceding accounting
year.
(iv) All commercial, industrial and business reporting entities having borrowings
(including public deposits) in excess of rupees fifty crore at any time during the
immediately preceding accounting year.
(v) Holding and subsidiary entities of any one of the above
Question 3
Explain how financial capital is maintained at historical cost?
Kishore started a business on 1st April, 2019 with ` 15,00,000 represented by 75,000
units of `20 each. During the financial year ending on 31st March, 2020, he sold the
entire stock for ` 30 each. In order to maintain the capital intact, calculate the maximum
amount, which can be withdrawn by Kishore in the year 2019-20 if Financial Capital is
maintained at historical cost. (Jan' 21)
Question 4
List the Criteria for classification of non-corporate entities as level I Entities for the purpose
of application of Accounting Standards as per the Institute of Chartered Accountants of
India. (Jan' 21)
Question 5
A trader commenced business on April 1, 2020 with ` 1,20,000 represented by 6,000 units
of a certain product at ` 20 per unit. During the year 2020-21 he sold these units at ` 30/-
per unit and had withdrawn ` 60,000. The price of the product at the end of financial year
was ` 25/- per unit. Compute retained profit of the trader under the concept of physical
291
capital maintenance at current cost. Also state, whether answer would be different if the
trader had not withdrawn any amount. (July' 2021)
Question 5
Mrs. A is showing the consolidated aggregate opening balance of equity, liabilities and
assets of ` 6 lakh, 4 lakh and 10 lakh respectively. During the current year Mrs. A has the
following transactions:
1. Received 20% dividend on 10,000 equity shares of ` 10 each held as investment.
2. The amount of ` 70,000 is paid to creditors for settlement of ` 90,000.
3. Salary is pending by ` 20,000.
4. Mrs. A’s drawing ` 20,000 for her personal use.
You are required to prepare the statement of the effect of aforesaid each transaction on
closing balance sheet in the form of Assets – Liabilities = Equity after each transaction.
(Dec' 21)
Question 6
What is meant by ‘Measurement’? What are the bases of measurement of Elements of
Financial Statements? Explain the brief. (Dec' 21)
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AS 1 - DISCLOSURE OF ACCOUNTING
POLICIES
1. WHAT ARE ACCOUNTING POLICIES?

Accounting policies are rules or principles and methods to adopt such principles in
financial accounts for true and fair recording and presentation of financial statements.
2. EXAMPLES OF DIFFERENT ACCOUNTING POLICIES :

• Methods of Amortization (AS26)
• Valuation of Inventories (AS 2)
• Valuation of Investments (AS 13)
• Valuation of Fixed Assets (AS10)
• Treatment of Government Grants (AS 12)
• Treatment of Contingent liabilities (AS29)
• Conversion of Foreign currency items (AS 11), etc.
3. WHY AS 1?
There is no single list of accounting policies which are applicable in all circumstances.
The differing circumstances in which enterprises operate in a situation of diverse and
complex economic activity make alternative accounting principles and methods of
applying those principles acceptable.
If every entity follows separate method to comply with principle then even if they
follow the correct accounting policy but still books are not comparable, so there is
need for disclosure.
4. DISCLOSURE REQUIREMENT :
• SIGNIFICANT ACCOUNTING POLICIES:
All significant accounting policies adopted in preparation and presentation of
financial statements should be disclosed.
Significant accounting policies means those accounting policies which deals with
material items of assets, liabilities, incomes and expenses.
Such disclosure should form part of financial statements.
These significant accounting policies should be disclosed at one place.
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• INSIGNIFICANT ACCOUNTING POLICIES:

All accounting policies relating to immaterial items of assets, liabilities, incomes
and expenses need not be disclosed.
• FUNDAMENTAL ACCOUNTING ASSUMPTIONS:

Fundamental accounting assumptions form the basis for preparations and
presentation of financial statements.
They are usually not specifically stated because their acceptance and use are
assumed. Disclosure is necessary if they are not followed.
The following are generally accepted fundamental accounting assumptions:

• Going concern
The enterprise is normally viewed as going concern, that is, as continuing in operations
for foreseeable future.
It is assumed that enterprise neither has any need nor any will to shut down
business in near future. (As per SA 570 going concern issued by the ICAI suggests
that foreseeable future means 12 months from the date of financial statements)
• Consistency:
It is assumed that accounting policies are consistent from one period to another.
However, Consistency is not an excuse to adopt/ continue to adopt inappropriate
accounting policies.
• Accrual:
It is assumed that revenues and costs are: Recognized as they are earned/incurred
rather than as and when money is received /paid.
Recorded in financial statements of the period to which they relate.
5. FACTORS TO BE CONSIDERED WHILE CHOOSING AN ACCOUNTING POLICIES:

The primary consideration in selection of accounting policies by an enterprise is
that financial statements prepared and presented on the basis of such accounting
policies should represent a true and fair view of state of affairs of enterprise as at
balance sheet date and profit/loss for the period ended on that date.
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Secondary consideration governing selection and application of accounting policies are:

• Prudence:
Anticipated profits should not be recorded, anticipated losses are to be recorded.
• Substance over form:

The accounting treatment and presentation in financial statements of transaction
and events should be governed by their substance and not merely by legal form.
Substance refers to economic reality.
• Materiality:
Financial statements should disclose all material items i.e. items the knowledge of
which might influence the decisions of the user of financial statements. Determination
of materiality is a matter of professional judgement.
6. CHANGES IN ACCOUNTING POLICIES:

Accounting policies can be changed if such change is required by
• Law
• AS
• Management, if they can justify better presentation and preparation of financial
statements. Any change that has material effect should be disclosed.
The amount by which any item in GPFS is affected by such change should be
disclosed. Where such amount is not ascertainable, wholly/ in part, the fact
should be indicated.
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CLASSWORK QUESTIONS
Question 1
In the books of M/s Prashant Ltd., closing inventory as on 31.03.2015 amounts to
` 1,63,000 (on the basis of FIFO method).
The company decides to change from FIFO method to weighted average method for
ascertaining the cost of inventory from the year 2014-15. On the basis of weighted average
method, closing inventory as on 31.03.2015 amounts to ` 1,47,000. Realisable value of
the inventory as on 31.03.2015 amounts to ` 1,95,000. Discuss disclosure requirement of
change in accounting policy as per AS1.
Question 2
X Ltd. sold its building to mini Ltd. For ` 60 Lakhs on 30.09.2010 and gave possession of
the property to mini Ltd. However, documentation and legal formalities are pending. Due
to this, the company has not recorded the sale and has shown the amount received as an
advance. The book value of the building is ` 25 lakhs as on 31st March, 2011.
Do you agree with this treatment? If you do not agree, explain the reasons with reference
to the accounting standard.
Question 3
State whether the following statements are 'True' or 'False'. Also give reason for your
answer.
(i) Certain fundamental accounting assumptions underline the preparation and
presentation of financial statements. They are usually specifically stated because
their acceptance and use are not assumed.
(ii) If fundamental accounting assumptions are not followed in presentation and
preparation of financial statements, a specific disclosure is not required.
(iii) All significant accounting policies adopted in the preparation and presentation of
financial statements should form part of the financial statements.
(iv) Any change in an accounting policy, which has a material effect should be disclosed.
Where the amount by which any item in the financial statements is affected by such
change is not ascertainable, wholly or in part, the fact need not to be indicated.
(v) There is no single list of accounting policies which are applicable to all circumstances.
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Question 4
Summarised Balance Sheet of Cloth Trader as on 31.03.2017 is given below:
Liabilities Amount (`) Assets Amount (`)
Proprietor's Capital 3,00,000 Fixed Assets 3,60,000
Profit & Loss Account 1,25,000 Closing Stock 1,50,000
10% Loan Account 2,10,000 Sundry Debtors 1,00,000
Sundry Creditors 50,000 Deferred Expenses 50,000
Cash & Bank 25,000
6,85,000 6,85,000
Additional Information is as follows :
(1) The remaining life of fixed assets is 8 years. The pattern of use of the asset is even.
The net realisable value of fixed assets on 31.03.2018 was ` 3,25,000.
(2) Purchases and Sales in 2017-18 amounted to ` 22,50,000 and ` 27,50,000
respectively.
(3) The cost and net realizable value of stock on 31.03.2018 were ` 2,00,000 and `
2,50,000 respectively.
(4) Expenses for the year amounted to ` 78,000.
(5) Deferred Expenses are amortized equally over 5 years.
(6) Sundry Debtors on 31.03.2018 are ` 1,50,000 of which ` 5,000 is doubtful. Collection
of another ` 25,000 depends on successful re-installation of certain product supplied
to the customer;
(7) Closing Sundry Creditors are ` 75,000, likely to be settled at 10% discount.
(8) Cash balance as on 31.03.2018 is ` 4,22,000.
(9) There is an early repayment penalty for the loan of ` 25,000.
You are required to prepare: (Not assuming going concern)
(1) Profit & Loss Account for the year 2017-18.
(2) Balance Sheet as on 31st March, 2018.
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CLASSWORK SOLUTIONS
Answer 1
As per para 22 of AS 1 “Disclosure of Accounting Policies”, any change in an accounting
policy which has a material effect should be disclosed in the financial statements. The
amount by which any item in the financial statements is affected by such change should
also be disclosed to the extent ascertainable. Where such amount is not ascertainable,
wholly or in part, the fact should be indicated. Thus Prashant Ltd. should disclose the
change in valuation method of inventory and its effect on financial statements. The
company may disclose the change in accounting policy in the following manner:
The company values its inventory at lower of cost and net realisable value. Since net
realisable value of all items of inventory in the current year was greater than respective
costs, the company valued its inventory at cost. In the present year i.e. 2014 -15, the
company has changed to weighted average method, which better reflects the consumption
pattern of inventory, for ascertaining inventory costs from the earlier practice of using
FIFO for the purpose. The change in policy has reduced current profit and value of inventory
by ` 16,000.
Answer 2
As per AS 1, “Disclosure of accounting policies”, the main consideration in selection of
accounting policy is the presentation of a true and fair picture of the state of affairs
& performance of the enterprise. To ensure true and fair view, principles of prudence,
substance over form and materiality should be considered.
In this case, the economic reality and substance of the transaction is that the rights and
beneficial interest in the property has been transferred although legal title has not been
transferred.
Hence, X Ltd. In its financial statements for the year ended 31.3.2011, should record
the sale and recognize the profit of ` 35 lakhs (60 Lakhs - 25 Lakhs) in its Profit & Loss
Account statement and building should be derecognized from the balance sheet of X Ltd.
Therefore, the treatment given by the company is not correct.
Answer 3
(i) False; As per AS 1 “Disclosure of Accounting Policies”, certain fundamental accounting
assumptions underlie the preparation and presentation of financial statements. They
are usually not specifically stated because their acceptance and use are assumed.
Disclosure is necessary if they are not followed.
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(ii) False; As per AS 1, if the fundamental accounting assumptions, viz. Going Concern,
Consistency and Accrual are followed in financial statements, specific disclosure
is not required. If a fundamental accounting assumption is not followed, the fact
should be disclosed.
(iii) True; To ensure proper understanding of financial statements, it is necessary that
all significant accounting policies adopted in the preparation and presentation of
financial statements should be disclosed. The disclosure of the significant accounting
policies as such should form part of the financial statements and they should be
disclosed at one place.
(iv) False; Any change in the accounting policies which has a material effect in the
current period or which is reasonably expected to have a material effect in later
periods should be disclosed. Where such amount is not ascertainable, wholly or in
part, the fact should be indicated.
(v) True; As per AS 1, there is no single list of accounting policies which are applicable
to all circumstances. The differing circumstances in which enterprises operate in a
situation of diverse and complex economic activity make alternative accounting
principles and methods of applying those principles acceptable.
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HOMEWORK SECTION
Question 1
What are the three fundamental accounting assumptions recognized by Accounting
Standard (AS) 1? Briefly describe each one of them.
Answer
Accounting Standard (AS) 1 recognizes three fundamental accounting assumptions. These
are as follows:
(i) Going Concern: The financial statements are normally prepared on the assumption
that an enterprise will continue its operations in the foreseeable future and neither
there is intention, nor there is need to materially curtail the scale of operations.
(ii) Consistency: The principle of consistency refers to the practice of using same
accounting policies for similar transactions in all accounting periods unless the
change is required (i) by a statute, (ii) by an accounting standard or (iii) for more
appropriate presentation of financial statements.
(iii) Accrual basis of accounting: Under this basis of accounting, transactions are
recognised as soon as they occur, whether or not cash or cash equivalent is actually
received or paid.
Question 2
Mention few areas in which different accounting policies are followed by companies.
Answer
Following are the examples of the areas in which different accounting policies may be
adopted by different enterprises:
1. Valuation of Inventories.
2. Valuation of Investments.
3. Valuation of Goodwill.
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PAST PAPER SECTION
Question 1
Please explain briefly two limitations of Accounting Standards for an accountant.
Answer
There are some limitations of setting of accounting standards:
(i) Difficulties in making choice between different treatments: Alternate solutions
to certain accounting problems may each have arguments to recommend them.
Therefore, the choice between different alternative accounting treatments may
become difficult.
(ii) Lack of flexibilities and Restricted Scope: There may be a trend towards rigidity and
away from flexibility in applying the accounting standards. Accounting standards
cannot override the statute. The standards are required to be framed within the
ambit of prevailing statutes.
Question 2
Explain in brief, the alternative measurement bases, for determining the value at which
an element can be recognized in the Balance Sheet or Statement of Profit and Loss.
Answer
The Framework for Recognition and Presentation of Financial statements recognises four
alternative measurement bases for the purpose of determining the value at which an
element can be recognized in the balance sheet or statement of profit and loss. These
bases are: (i) Historical Cost; (ii)Current cost (iii) Realisable (Settlement) Value and (iv)
Present Value.
A brief explanation of each measurement basis is as follows:
1. Historical Cost:
Historical cost means acquisition price. According to this, assets are recorded at an
amount of cash or cash equivalent paid or the fair value of the asset at the time of
acquisition. Liabilities are recorded at the amount of proceeds received in exchange
for the obligation.
2. Current Cost:
Current cost gives an alternative measurement basis. Assets are carried out at the
amount of cash or cash equivalent that would have to be paid if the same or an
equivalent asset was acquired currently. Liabilities are carried at the undiscounted
amount of cash or cash equivalents that would be required to settle the obligation
currently.
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3. Realisable (Settlement) Value:

As per realisable value, assets are carried at the amount of cash or cash equivalents
that could currently be obtained by selling the assets in an orderly disposal. Liabilities
are carried at their settlement values; i.e. the undiscounted amount of cash or cash
equivalents paid to satisfy the liabilities in the normal course of business.
4. Present Value:
Under present value convention, assets are carried at present value of future net cash
flows generated by the concerned assets in the normal course of business. Liabilities
under this convention are carried at present value of future net cash flows that are
expected to be required to settle the liability in the normal course of business.
Question 3
Shankar started a business on 1st April, 2017 with ` 12,00,000 represented by 60,000
units of ` 20 each. During the financial year ending on 31st March, 2018, he sold the
entire stock for ` 30 each. In order to maintain the capital intact, calculate the maximum
amount, which can be withdrawn by Shankar in the year 2017-18 if Financial Capital is
maintained at Historical cost.
Answer
Particulars Financial Capital Maintenance at

Historical Cost (`)
Closing equity (`30 x 60,000 units) 18,00,000 represented by cash
Opening equity 60,000 units x `20 = 12,00,000
Permissible drawings to keep 6,00,000
Capital intact (18,00,000 – 12,00,000)
Therefore, ` 6,00,000 is the maximum amount which can be withdrawn by Shankar in the
year 2017-18 if the Financial Capital Maintenance is maintained at Historical Cost.
Question 4
What are the bases of measurement of Elements of Financial Statements? Explain in brief.
Answer
Measurement is the process of determining money value at which an element can be
recognized in the balance sheet or statement of profit and loss. The framework recognizes
four alternative measurement bases for the purpose. These bases can be explained as:
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Historical Acquisition price. According to this, assets are recorded at an

cost amount of cash and cash equivalent paid or the fair value of the
assets at time of acquisition.
Assets are carried out at the amount of cash or cash equivalent
that would have to be paid if the same or an equivalent asset
Current was acquired currently. Liabilities are carried at the undiscounted
Cost amount of cash or cash equivalents that would be required to
settle the obligation currently.
Realisable For assets, amount currently realizable on sale of the asset in an
(Settlement) Value orderly disposal. For liabilities, this is the undiscounted amount
expected to be paid on settlement of liability in the normal
course of business.
Assets are carried at present value of future net cash flows
Present generated by the concerned assets in the normal course of
Value business. Liabilities are carried at present value of future net
cash flows that are expected to be required to settle the liability
in the normal course of business.
In preparation of financial statements, all or any of the measurement basis can be used
in varying combinations to assign money values to financial items
Question 5
"One of the characteristic of the financial statement is neutrality. "Do you agree with this
statement? Explain in brief.
Answer
Yes, one of the characteristics of financial statements is neutrality. To be reliable, the
information contained in financial statement must be neutral, that is free from bias.
Financial Statements are not neutral if by the selection or presentation of information,
the focus of analysis could shift from one area of business to another thereby arriving
at a totally different conclusion based on the business results. Information contained in
the financial statements must be free from bias. It should reflect a balanced view of the
financial position of the company without attempting to present them in biased manner.
Financial statements cannot be prepared with the purpose to influence certain division,
i.e. they must be neutral.
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Question 6
Following is the Balance Sheet of M/s. S Traders as on 31st March, 2019:
Liabilities (`) Assets (`)
Capital 1,50,000 Fixed Assets 1,05,000
11% Bank loan 80,000 Closing stock 76,000
Trade payables 52,000 Debtors 68,000
Profit & loss A/c 56,000 Deferred Expenditure 24,000
Cash & bank 65,000
3,38,000 3,38,000
(i) Remaining life Fixed Assets is 6 years with even use. The net realizable value of fixed
Assets as on 31st March, 2020 is ` 90,000.
(ii) Firm’s Sales & Purchases for the year ending 31st March, 2020 amounted to `7,80,000
and ` 6,25,000 respectively.
(iii) The cost & net realizable value of the stock as on 31st March, 2020 was ` 60,000
and ` 66,000.
(iv) General expenses (including interest on loan) for the year 2019-20 were ` 53,800.
(v) Deferred expenditure is normally amortised equally over 5 years starting from the
financial year 2018-19 i.e. `6,000 per year.
(vi) Debtors on 31st March, 2020 is `65,000 of which `5,000 is doubtful. Collection of
another `10,000 debtors depends on successful re-installation of certain products
supplied to the customer.
(vii) Closing trade payable `48,000, which is likely to be settled at 5% discount.
(viii) There is a prepayment penalty of `4,000 for bank loan outstanding.
(ix) Cash & bank balances as on 31st March, 2020 is `1,65,200.
Prepare profit & loss Account and Balance sheet for the year ended 31st March,
2020 assuming the firm is not a going concern.
(Nov’ 20)
Question 7
In the books of Rani Ltd., closing inventory as on 31.03.2020 amounts to ` 1,75,000
(valued on the basis of FIFO method).
The Company decides to change from FIFO method to weighted average method for
ascertaining the costs of inventory from the year 2019-20. On the basis of weighted
average method, closing inventory as on 31.03.2020 amounts to ` 1,59,000. Realizable
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value of the inventory as on 31.03.2020 amounts to ` 2,07,000.

Discuss disclosure requirements of changes in accounting policy as per AS 1.
(Nov’ 20)
Question 8
What do you mean by 'Accrual' in reference to AS-1? Also, specify any three reasons for
'Accrual Basis of Accounting'. (May’ 19)
Answer
The term “Accrual” has been explained in the AS 1 on Disclosure of Accounting Policies,
as “Revenues and costs are accrued, that is, recognised as they are earned or incurred
(and not as money is received or paid) and recorded in the financial statements of the
periods to which they relate”
Reasons for Accrual Basis of Accounting
1. Accrual basis of accounting, attempts to record the financial effects of the
transactions, events, and circumstances of an enterprises in the period in which they
occur rather than recording them in the period(s) in which cash is received or paid by
the enterprise.
2. Receipts and payments of the period will not coincide with the buying producing or
selling events and other economic events that affect entity performance.
3. The goal of Accrual basis of accounting is to follow the matching concept of income
and expenditure so that reported net income measures an enterprise’s performance
during a period instead of merely listing its cash receipts and payments.
4. Accrual basis of accounting recognizes assets, liabilities or components of revenues
and expenses for amounts received or paid in cash in past, and amounts expected
to be received or paid in cash in the future.
5. Important point of difference between accrual and accounting based on cash receipts
and outlay is in timing of recognition of revenues, expenses, gains and losses.
Question 9
State whether the following statements are ‘True’ or ‘False’. Also give reason for your
answer.
(i) Certain fundamental accounting assumptions underline the preparation and
presentation of financial statements. They are usually specifically stated because
their acceptance and use are not assumed.
(ii) If fundamental accounting assumptions are not followed in presentation and
preparation of financial statements, a specific disclosure is not required.
(iii) All significant accounting policies adopted in the preparation and presentation of
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financial statements should form part of the financial statements. .

(iv) Any change in an accounting policy, which has a material effect should be disclosed.
Where the amount by which any item in the financial statements is affected by such
change is not ascertainable, wholly or in part, the facts need not to be indicated.
(May' 22)
Question 10
(i) ABC Ltd. was previously making provision for non-moving stocks based on stocks
not issued for the last 12 months up to 31.03.2020. Now, the company wants to
make provisions based on technical evaluation during the year ending 31.03.2021.
Total value of stock ` 133.75 lakhs
Provision required based on technical evaluation ` 4.00 lakhs Provision required
based on 12 months not issued ` 5.00 lakhs.
(ii) In the Books of Kay Ltd., Closing stock as on 31st March, 2021 amounts to ` 1,24,000
(on the basis of FIFO method)
The company decides to change from FIFO method to weighted average method
for ascertaining the cost of inventory from the year 2020-2021. On the basis of
weighted average method, closing stock as on 31st March, 2021 amounts to `
1,15,000. Realisable value of the inventory as on 31st March, 2021 amounts to `
1,54,000.
Discuss Disclosure Requirements of change in accounting policy in above cases as per AS 1.
(Dec' 21)
306
AS 2 - VALUATION OF INVENTORY
1. WHY VALUATION OF INVENTORY IS REQUIRED ?

To know correct Financial Performance (net profit or loss)
And
To know True & fair Financial Position
Since, Appropriate / In-appropriate valuation of inventory affects both the profit /
loss from operations & financial position as reflected in the Balance Sheet.
2. MEANING / DEFINITION OF INVENTORY As Per AS-2 :

According to AS 2, Inventories are assets
a. held for sale in the ordinary course of business or
b. in the process of production for such sale or
c. in the form of materials or supplies to be consumed in the production process
or in the rendering of services
3. INVENTORIES INCLUDES :
Thus, Inventory consists of :
a. Goods purchased & held for re-sale
b. Finished goods produced for sale
c. Work in progress
d. Stores, spares, loose tools etc. awaiting use in production process (of goods
meant for sale)

4. AS 2 DOES NOT COVER :
a. Financial instruments such as shares, debentures etc. held as stock
b. Work in progress under construction contracts
c. Work in progress arising in the ordinary course of business of service providers
d. Live stock, agricultural & forest products, mineral oils (for whose valuation
certain established practices may exist)
5. VALUATION :
Inventories are valued at COST or NRV, whichever is less.
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6. COST INCLUDES :
• Cost = Purchase cost + conversion cost + other costs incurred to bring the
inventory to its present location & condition
• Purchase cost = purchase price + duties & taxes + freight inward + other directly
attributable expenses (like in-transit insurance) – (duties & taxes recoverable +
trade discount & rebates etc.).
• Conversion cost = Direct labour + variable production overheads (calculated
on actual production) + fixed production overheads (calculated on normal
capacity)
• In case of joint products, the conversion cost is allocated on rational & consistent
basis (e.g. : sales).
• In case of by products, the NRV of by product is deducted from the conversion
cost
• Inventory Cost does not include : Administration cost, Selling & distribution
cost, abnormal wastage, storage costs etc.
• Normal capacity means the production expected to be achieved on an average
over a number of periods under normal conditions. Fixed production overheads
per unit will be revised if actual production exceeds normal capacity so that
inventories are not measured above their cost.
• Interest & other borrowing costs are usually not included in inventory valuation.
However, they can be included if time plays a major factor in bringing about a
change in the condition of inventories.
7. METHODS OF INVENTORY VALUATION :

a. Inventory not ordinarily interchangeable: specific identification method : Specific
identification method tracks the actual physical flow of goods. It is also called
the actual cost method because specific job bears the actual cost of materials
bought for the job. This method is suited for antique shops, expensive jewellery,
custom-made merchandise etc.
b. Inventory ordinarily interchangeable: FIFO or weighted avg. method
• Other methods allowed are standard cost method or retail price method if it
were to result in estimation of value of inventory that approximates the actual
cost. Standard cost is a pre-determined cost based on attainable efficiency
standard for a given volume of output. Retail price method is generally adopted
by retail stores having numerous low unit cost items. Cost is measured by
deducting gross margin from retail prices of year end inventory.
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8. NRV :
NRV = estimated selling price in the ordinary course of business – estimated cost of
completion – estimated costs necessary to make the sale. Considerations governing
estimation of NRV are :
a. Most reliable evidence available at the time estimates are made as to amounts
that inventories are expected to realize &
b. Fluctuations of prices or costs directly relating to events occurring after the
Balance Sheet date, to the extent that such events confirm the conditions
existing at the Balance Sheet date.
9. VALUATION OF MATERIAL :
Materials & other supplies held for use in production are not written down below the
cost if finished goods in which they will be used are expected to be sold at or above
cost. When finished goods are not expected to fetch the cost & there is a decline in
process of material & other supplies then the materials & other supplies are written
down to their NRV. In such a case, the replacement cost is the NRV.
10. DISCLOSURES REQUIRED :

a. Accounting policy applied in measuring inventories including cost formula
b. Carrying amount of inventory classified appropriately e.g. : finished goods,
work in progress, raw material, spare parts, loose tools etc.
c. Any changes in accounting policy with respect to valuation of inventory & its
effect on the financial statements.
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CLASSWORK QUESTIONS
Question 1
The following are Cost and NRV value of five inventory items
Cost (`) NRV (`)

A 15,000 5,000
B 27,000 52,000
C 54,000 74,000
D 1,10,000 85,000
E 68,000 62,000
2,74,000 2,78,000
Find out the value of inventories of

a. Individual items are distinct items,
b. Individual items are not distinct items and should be taken as a group.
Question 2
Anil Pharma Ltd. ordered 16,000 kg. of certain material `160 per unit. The purchase
price includes excise duty ` 10 per kg. in respect of which full CENVAT credit is admissible.
Freight incurred amounted to ` 1,40,160. Normal transit loss is 2%. The company actually
received 15,500 kg. and consumed 13,600 kg. of material. Compute cost of inventory
under AS 2 and amount of abnormal loss.
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Question 3
Calculate the value of raw materials and closing stock based on the following information:
Raw material X
Closing balance 500 units
` per unit
Cost price including excise duty 200
Excise duty (Cenvat credit is receivable on the excise duty paid) 10
Freight inward 20
Unloading charges 10
Replacement cost 150
Finished goods Y
Closing Balance 1200 units
` per unit
Material consumed 220
Direct labour 60
Direct overhead 40
Total Fixed overhead for the year was ` 2,00,000 on normal capacity of 20,000 units.
Calculate the value of the closing stock, when
(i) Net realizable value of the finished goods Y is ` 400
(ii) Net Realizable value of the finished goods Y is ` 300
Question 4
Materials costing ` 12,000 bought for processing and assembly for a profitable special
order. Since buying these items, the cost price has fallen to ` 10,000. How will you deal in
the valuation of raw material if the finished product is sold above the cost? Suppose the
finished product is likely to be sold less than the cost, what value will it be reasonable to
be assigned for the raw material?
Question 5
Cost of a partly finished unit at the end of 2004-05 is ` 150. The unit can be finished next
year by a further expenditure of ` 100. The finished unit can be sold at ` 250, subject to
payment of 4% brokerage on selling price. Determine the value of inventory.
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Question 6
The Company X Ltd., has to pay for delay in cotton clearing charges. The company up to
31.3.2014 has included such charges in the valuation of closing stock. This being in the
nature of interest, X Ltd. decided to exclude such charges from closing stock for the year
2014-15. This would result in decrease in profit by ` 5 lakhs. Comment.
Question 7
You are required to value the inventory per kg of finished goods consisting of :
a. Material Cost ` 200 per Kg.
b. Direct Labour ` 40 Per Kg.
c. Direct Variable Overhead ` 20 Per Kg.
Fixed production charges for the year on normal working capacity of 2 lakh kg. is
` 20 lakhs. 4,000 Kgs. of finished goods are in stock at the year end.
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CLASSWORK SOLUTIONS
Answer 6
According to AS - 2 “valuation of inventories” Cost of inventories generally doesn’t include
interest & other borrowing cost. Interest and other borrowing costs are usually considered
as not relating to bringing the inventories to their present location and condition.
Interests and other borrowing costs however are taken as part of inventory costs where
the inventory necessarily takes substantial period of time for getting ready for intended
sale. Example of such inventory is wine.
Here, X Ltd. has decided to exclude delay in clearing charges from closing stock for the
year 2014-15 this would result in decrease in profit by ` 5 lakhs.
So the contention of X Ltd. for not to include such delay in clearing charges is correct.
313
HOMEWORK SECTION
Question 1
The Company deals in three products, A, B and C, which are neither similar nor
interchangeable. At the time of closing of its account for the year 2014-15, the Historical
Cost and Net Realizable Value of the items of closing stock are determined as follows:
Items Historical Cost (` in lakhs) Net Realizable Value (` in lakhs)
A 40 28
B 32 32
C 16 24
Answer
As per para 5 of AS 2 on „Valuation of Inventories", inventories should be valued at the
lower of cost and net realizable value. Inventories should be written down to net realizable
value on an item-by-item basis in the given case.
Items Historical Cost (` in Net Realisable Value Valuation of
lakhs) (` in lakhs) closing stock (` in lakhs)
A 40 28 28
B 32 32 32
C 16 24 16
88 84 76
Hence, closing stock will be valued at ` 76 lakhs.
Question 2
Capital Cables Ltd., has a normal wastage of 4% in the production process. During the
year 2013-14 the Company used 12,000 MT of raw material costing ` 150 per MT. At
the end of the year 630 MT of wastage was in stock. The accountant wants to know how
this wastage is to be treated in the books. Explain in the context of AS 2 the treatment
of normal loss and abnormal loss and also find out the amount of abnormal loss if any.
Answer
As per para 13 of AS 2 (Revised) „Valuation of Inventories", abnormal amounts of wasted
materials, labour and other production costs are excluded from cost of inventories and
such costs are recognized as expenses in the period in which they are incurred. The normal
loss will be included in determining the cost of inventories (finished goods) at the year
end.
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Amount of Abnormal Loss:

Material used (12,000 MT @ `150) `18,00,000
Normal Loss (4% of 12,000 MT) 480
MT Net quantity of material 11,520
MT Abnormal Loss in quantity 150
MT Abnormal Loss ` 23,437.50
[150 units @ ` 156.25 (` 18,00,000/11,520)]
Amount ` 23,437.50 will be charged to the Profit and Loss statement.
Question 3
Mr. Mehul gives the following information relating to items forming part of inventory as
on 31-3-2015. His factory produces Product X using Raw material A.
(i) 600 units of raw material A (purchased @ ` 120). Replacement cost of raw material
A as on 31-3-2015 is ` 90 per unit.
(i) 500 units of partly finished goods in the process of producing X and cost incurred till
date ` 260 per unit. These units can be finished next year by incurring additional cost
of ` 60 per unit.
(ii) 1500 units of finished Product X and total cost incurred ` 320 per unit. Expected
selling price of Product X is ` 300 perunit.
Determine how each item of inventory will be valued as on 31-3-2015. Also calculate
the value of total inventory as on 31-3-2015.
Answer
As per AS 2 “Valuation of Inventories”, materials and other supplies held for use in the
production of inventories are not written down below cost if the finished products in
which they will be incorporated are expected to be sold at cost or above cost. However,
when there has been a decline in the price of materials and it is estimated that the cost
of the finished products will exceed net realizable value, the materials are written down
to net realizable value. In such circumstances, the replacement cost of the materials may
be the best available measure of their net realizable value. In the given case, selling price
of product X is ` 300 and total cost per unit for production is ` 320.
Hence the valuation will be done as under:
(i) 600 units of raw material will be written down to replacement cost as market value
of finished product is less than its cost, hence valued at ` 90 per unit.
(ii) 500 units of partly finished goods will be valued at 240 per unit i.e. lower of cost
` 320 (` 260 + additional cost ` 60) or Net estimated selling price ` 240 (Estimated
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selling price ` 300 per unit less additional cost of ` 60).

(iii) 1,500 units of finished product X will be valued at NRV of ` 300 per unit since it is
lower than cost ` 320 of product X.
Valuation of Total Inventory as on 31.03.2015:

NRV/Replacement Value = units x cost or NRV
cost whichever is less (`)
Raw material A 90 54,000
Partly finished goods 240 1,20,000
Finished goods X 300 4,50,000
Value of Inventory 6,24,000
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PAST PAPER SECTION
Question 1
Raw materials inventory of a company includes certain material purchased at ` 100 per
kg. The price of the material is on decline and replacement cost of the inventory at the
year-end is ` 75 per kg. It is possible to convert the material into finished product at
conversion cost of ` 125.
Decide whether to make the product or not to make the product, if selling price is (i)
` 175 and (ii) ` 225. Also find out the value of inventory each case. (May’10)
Answer
As per para 24 of AS 2 ‘Valuation of Inventories’, materials and other supplies held for use
in the production of inventories are not written down below cost if the finished products in
which they will be incorporated are expected to be sold at or above cost. However, when
there has been a decline in the price of materials and it is estimated that the cost of the
finished products will exceed net realizable value, the materials are written down to net
realisable value. In such circumstances, the replacement cost of the materials may be the
best available measure of their net realisable value.
(i) When selling price is ` 175
Incremental Profit = ` 175 – ` 125 = ` 50 Current price of the material = ` 75
Therefore, it is better not to make the product. Raw material inventory would be
valued at net realisable value i.e. ` 75 because the selling price of the finished
product is less than `225 (100+125) per kg.
(ii) When selling price is `225
Incremental Profit = ` 225 – ` 125 = ` 100 Current price of the raw material =
` 75.
Therefore, it is better to make the product.
Raw material inventory would be valued at `100 per kg because the selling price of
the finished product is not less than ` 225.
Question 2
In determining the cost of inventories, it is appropriate to exclude certain costs and
recognize them as expenses in the period in which they are incurred. Provide example
of such costs as per AS-2 Valuation of Inventories. (May’ 12)
Answer
As per AS-2 ‘Valuation of Inventories’, certain costs are excluded from the cost of the
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inventories and are recognised as expenses in the period in which incurred. Examples
of such costs are:
(a) abnormal amounts of wasted materials, labour, or other production costs;
(b) storage costs, unless those costs are necessary in the production process prior to a
further production stage; administrative overheads that do not contribute to bringing
the inventories to their present location and condition; and
(c) selling and distribution costs.
Question 3
Z Limited ordered 13,000 kg. of chemicals at ` 90 per kg. The purchase price includes GST
of ` 5 per kg, in respect of which full credit is admissible. Freight incurred amounted to `
30,000. Normal transit loss is 4%. The company actually received 12,400 kg and consumed
10,000 kg. The company has received trade discount in the form of cash amounting to `
1 per kg. The chemicals were delivered in containers. The containers were not reusable,
hence sold for ` 500. The administrative expenses incurred to bring the chemicals were `
10,000.
Compute the value of inventory and allocate the material cost as per AS – 2.
(May’16)
Answer
Cost of inventory and allocation of material cost `
Purchase price (13,000 Kg. x ` 89) 11,57,000
Less: Credit Available (13,000 Kg. x ` 5) (65,000)
10,92,000
Add: Freight Allocated 30,000
Add: Administrative expenses 10,000
A. Total material cost 11,32,000
B. Number of units to be normally received = 96% of 13,000 Kg. Kg. 12,480
C. Normal cost per Kg. (A/B)
Allocation of material cost Kg. `/Kg. ` 90.705
Materials consumed 10,000 kgs. @ 90.705 (approx.) 9,07,050
Cost of inventory (12,400- 10,000) 2,400 kgs. 2,17,692
Abnormal loss (80 kgs.) 7,258*
Total material cost (for 12,480 kgs) 1,32,000
*The difference due to rounding off of normal cost per Kg has been adjusted. Thus the
inventory will be valued at ` 2,17,692.
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Note:
1. The Company has received trade discount in the form of cash. This discount has
been treated as trade discount in the given answer.
2. Abnormal losses are recognized as separate expenses.
3. Containers are used for delivery of the chemicals and are not reusable. Cost of these
containers is treated as selling and distribution expense. The sale value of these
containers will be credited to Profit and Loss Account and shall not be considered
for the purpose of valuation of inventory.
Alternatively, the sales value of container amount of ` 500 may be deducted, while
computing material cost. In that case the material cost will be computed as `
11,31,500 (11,32,000-500) instead of ` 11,32,000. Accordingly the allocation of
material cost will get changed.
4. State VAT has not been included in the cost of materials in the above answer as VAT
is generally credited in the later course of time.
Question 4
A Limited is engaged in manufacturing of Chemical Y for which Raw Material X is required.
The company provides you following information for the year ended 31st March, 2017.
Raw Material X ` per unit
Cost price 380
Unloading Charges 20
Freight Inward 40
Replacement cost 300
Chemical Y ` per unit
Material consumed 440
Direct Labour 120
Variable Overheads 80
(i) Total fixed overhead for the year was ` 4,00,000 on normal capacity of 20,000 units.
(ii) Closing balance of Raw Material X was 1,000 units and Chemical Y was ` 2,400
units.
Qty. Rate (`) Amount (`)
Raw Material X 1,000 440 4,40,000
Finished Goods Y 2,400 660 15,84,000
Total Value of Closing Stock 20,24,000
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You are required to calculate the total value of closing stock of Raw Material X and
Chemical Y according to AS 2, when
(a) Net realizable value of Chemical Y is ` 800 per unit
(b) Net realizable value of Chemical Y is ` 600 per unit (Nov’17)
Answer
(a) When Net Realizable Value of the Chemical Y is ` 800 per unit
NRV is greater than the cost of Finished Goods Y i.e. ` 660 (Refer W.N.) Hence, Raw
Material and Finished Goods are to be valued at cost.
Value of Closing Stock:
(b) When Net Realizable Value of the Chemical Y is ` 600 per unit
NRV is less than the cost of Finished Goods Y i.e. ` 660. Hence, Raw Material is to be
valued at replacement cost and Finished Goods are to be valued at NRV since NRV is
less than the cost.
Value of Closing Stock:
Qty. Rate (`) Amount (`)

Raw Material X 1,000 300 3,00,000
Finished Goods Y 2,400 600 14,40,000
Total Value of Closing Stock 17,40,000
Working Note:
Statement showing cost calculation of Raw material X and Chemical Y
Raw Material X `
Cost Price 380
Add: Freight Inward 40
Unloading charges 20
Cost 440
Chemical Y `
Materials consumed 440
Direct Labour 120
Variable overheads 80
Fixed overheads (`4,00,000/20,000 units) 20
Cost 660
Question 5
Wooden Plywood Limited has a normal wastage of 5% in the production process. During
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the year 2017-18, the Company used 16,000 MT of Raw material costing ` 190 per MT.
At the end of the year, 950 MT of wastage was in stock. The accountant wants to know
how this wastage is to be treated in the books.
(1) Calculate the amount of abnormal loss.
(2) Explain the treatment of normal loss and abnormal loss. [In the context of AS-2
(Revised)] (May’ 19)
Answer
(i) As per AS 2 (Revised) ‘Valuation of Inventories’, abnormal amounts of wasted
materials, labour and other production costs are excluded from cost of inventories
and such costs are recognised as expenses in the period in which they are incurred.
The normal loss will be included in determining the cost of inventories (finished
goods) at the year end.
Amount of Abnormal Loss:
(ii) Material used 16,000 MT @ ` 190 = ` 30,40,000
Normal Loss (5% of 16,000 MT) 800 MT (included in calculation of cost of inventories)
Net quantity of material 15,200 MT
(iii) Abnormal Loss in quantity (950 - 800) 150 MT
Abnormal Loss ` 30,000
[150 units @ ` 200 (` 30,40,000/15,200)]
Amount of ` 30,000 (Abnormal loss) will be charged to the Profit and Loss statement.
Question 6
The closing stock of finished goods at cost of a company amounted to ` 4,50,000. The
following items were included at cost in the total:
(a) 100 coats, which had cost ` 2,200 each and normally sold for ` 4,000 each.
Owing to a defect in manufacture, they were all sold after the balance sheet date
at 50% of their normal selling price.
(b) 200 skirts, which had cost ` 50 each. These too were found to be defective. Remedial
work in April cost ` 2 per skirt, and selling expenses for the batch totaled ` 200.
They were sold for ` 55 each.
(c) Shirts which had cost ` 50,000, their net realizable value at Balance sheet date was
` 55,000. Commission @ 10% on sales is payable to agents.
What should the inventory value be according to AS 2 after considering the above
items? (May’ 19)
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Answer
Valuation of closing stock
`
Closing stock at cost 4,50,000
Less: Adjustment for 100 coats (Working Note 1) (20,000)
Value of inventory 4,30,000
Working Notes:
1. Adjustment for Coats `
Cost included in Closing Stock 2,20,000
NRV of Coats 2,00,000
Adjustment to be made as NRV is less than Cost 20,000
2. No adjustment required for skirts and shirts as their NRV is more than their cost
which was included in value of inventory.
Question 7
Mr. Rakshit gives the following information relating to items forming part of inventory as
on 31st March, 2019. His factory produces product X using raw material A.
(i) 800 units of raw material A (purchased @ ` 140 per unit). Replacement cost of raw
material A as on 31st March, 2019 is ` 190 per unit.
(ii) 650 units of partly finished goods in the process of producing X and cost incurred
till date ` 310 per unit. These units can be finished next year by incurring additional
cost of ` 50 per unit.
(iii) 1,800 units of finished product X and total cost incurred ` 360 per unit. Expected
selling price of product X is ` 350 per unit.
In the context of AS-2, determine how each item of inventory will be valued as
on 31st March, 2019. Also, calculate the value of total inventory as on 31st March,
2019. (Nov’19)
Answer
As per AS 2 (Revised) “Valuation of Inventories”, materials and other supplies held for use
in the production of inventories are not written down below cost if the finished products
in which they will be incorporated are expected to be sold at cost or above cost. However,
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of product X is ` 350 and total cost per unit for production is ` 360.
(i) 800 units of raw material will be valued at cost 140.
(ii) 650 units of partly finished goods will be valued at 300 per unit* i.e. lower of
cost (` 310) or Net realizable value ` 300 (Estimated selling price ` 350 per unit less
additional cost of ` 50).
(iii) 1,800 units of finished product X will be valued at NRV of ` 350 per unit since it is
lower than cost ` 360 of product X.

Units Cost NRV / Value = units x cost `
(`) Replacement or NRV whichever is
Cost ` less (`)
Raw material A 800 140 190 1,12,000 (800 x
140)
Partly finished goods 650 310 300 1,95,000 (650 x
300)
Finished goods X 1,800 60 350 6,30,000 (1,800 x
350)
*It has been assumed that the partly finished unit cannot be sold in semi-finished form
and its NRV is zero without processing it further.
Question 8
Mr. Jatin gives the following information relating to the items forming part of the inventory
as on 31.03.2019. His enterprise produces product P using Raw Material X.
(i) 900 units of Raw Material X (purchases @ ` 100 per unit). Replacement cost of Raw
Material X as on 3103.2019 is ` 80 per unit
(ii) 400 units of partly finished goods in the process of producing P. Cost incurred till
date is ` 245 per unit. These units can be finished next year by incurring additional
cost of ` 50 per unit.
(iii) 800 units of Finished goods P and total cost incurred is ` 295 per unit.
Expected selling price of product P is `280 per unit, subject to a payment of 5%
brokerage on selling price.
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Determine how each item of inventory will be valued as on 31.03.2019. Also calculate
the value of total Inventory as on 31.03.2019. (Jan' 21)
Answer
As per AS 2 (Revised) “Valuation of Inventories”, materials and other supplies held for use
in the production of inventories are not written down below cost if the finished products
in which they will be incorporated are expected to be sold at cost or above cost. However,
of product P is ` 266 and total cost per unit for production is ` 295.
(i) 900 units of raw material X will be written down to replacement cost as market
value of finished product is less than its cost, hence valued at ` 80 per unit.
(ii) 400 units of partly finished goods will be valued at 216 per unit i.e., lower of cost
(` 245) or Net realizable value ` 216 (Estimated selling price ` 266 per unit less
additional cost of ` 50).
(iii) 800 units of finished product P will be valued at NRV of ` 266 per unit since it is
lower than cost ` 295.
Units Cost (`) NRV / Value = units
Replacement x cost or NRV
cost whichever is
less (`)
Raw material X 900 100 80 72,000
Partly finished goods 400 245 216 86,400
Finished goods P 800 295 266 2,12,800

Question 9
Joy Ltd. purchased 20,000 kilograms of Raw Material @ ` 20 per kilogram during the
year 2020-21. They have furnished you with the following further information for the
year ended 31st March, 2021:
Particulars Units Amount (`)
Opening Inventory:
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Finished Goods 2,000 1,00,000

Raw Materials 2,200 44,000
Direct Labour 3,06,000
Fixed Overheads 3,00,000
Sales 20,000 11,20,000
Closing Inventory:
Finished Goods 2,400
Raw Materials 1,800
The plant has a capacity to produce 30,000 units of finished product per annum. However,
the actual production of finished products during the year 2020-21 was 20,400 units.
Due to a fall in the market demand, the price of the finished goods in which the raw
material has been utilized is expected to be sold @ ` 40 per unit. The replacement cost
of the raw material was ` 19 per kilogram.
You are required to ascertain the value of closing inventory as at 31st March, 2021 as per
AS 2. (July' 21)
Question 10
SM Enterprises is a leading distributor of petrol. A detail inventory of petrol in hand is
taken when the books are closed at the end of each month. For the end month of June
2021 following information is available :
(i) Sales for the month of June 2021 was ` 30,40,000.
(ii) General overheads cost ` 4,00,000.
(iii) Inventory at beginning 10,000 litres @ ` 92 per litre.
(iv) Purchases - June 1 2021, 20,000 litres @ ` 90 per litre, June 30 2021, 10,000 litres
@ ` 95 per litre.
(v) Closing inventory 13,000 litres.
You are required to compute the following by FIFO method as per AS 2:
(i) Value of Inventory on 30th June, 2021.
(ii) Amount of cost of goods sold for June, 2021.
(iii) Profit/Loss for the month of June, 2021. (May ' 22)
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REVISION QUESTIONS
Question 1
Mr. Mehul gives the following information relating to items forming part of inventory as
on 31-3-2019. His factory produces Product X using Raw material A.
(i) 600 units of Raw material A (purchased @ Rs. 120). Replacement cost of raw material
A as on 31-3-2019 is Rs. 90 per unit.
(ii) 500 units of partly finished goods in the process of producing X and cost incurred till
date Rs. 260 per unit. These units can be finished next year by incurring additional
cost of Rs. 60 per unit.
(iii) 1500 units of finished Product X and total cost incurred Rs. 320 per unit. Expected
selling price of Product X is Rs. 300 per unit.
Determine how each item of inventory will be valued as on 31-3-2019. Also calculate
the value of total inventory as on 31-3-2019.
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AS 13 - ACCOUNTING FOR
INVESTMENT
1. WHAT ARE INVESTMENTS?

Investments are:-
• Assets
• Held by an enterprise for earning incomes by way of dividends, interest, a n d ,
rentals, for capital appreciation, or for other benefits to the investing
enterprise.
Assets held as stock in trade are not 'investments'.
Some investments have no physical existence and are represented merely by
certificates or similar documents while others exist in physical form.
2. DETERMINATION OF COST:
• If investments are purchased:
The cost of an investment includes acquisition charges such as brokerage, fees
and duties. Interest, dividends and rentals receivables in connection with an
investment are generally regarded as income, being the return on investment.
However, in some circumstances, such inflows represent a recovery of cost and
do not form part of income. In such case, it should be deducted from the cost.
• If investments are acquired for consideration other than cash:
Sr. no. Consideration in the form of Valued at

1. Shares or securities Fair value of securities issued
2. Other assets Fair value of asset given up or Fair value
of asset acquired whichever is known more
appropriately.
• Cost of right shares:

- When right shares offered are subscribed for, the cost of right shares is added
to the carrying amount of the original holding.
- If the right shares are not subscribed for but are sold in the market, the sale
proceeds are taken to the profit and loss statement.
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• However, where the investments are acquired on cum cum-right basis and the
market value of investments immediately after their becoming ex- right is lower
than the cost for which they were acquired, it may be appropriate to apply the
sale proceeds of right to reduce the carrying amount of such investments to the
market value.
3. DETERMINATION OF FAIR VALUE:

Fair value is the amount for which an asset could be exchanged between a
knowledgeable, willing buyer and a knowledgeable, willing seller in an arms'
length transaction.
4. DETERMINATION OF CARRYING AMOUNT OF INVESTMENTS (VALUATION):

• Current investments
Current Investments should be carried in the financial statement at lower of
cost or fair value. The lower of cost or fair value should not be determined on
overall basis. It should be determined-
a. On an individual investment basis (More prudent) or
b. By category of investment.
Any reduction to fair value of current investments or any reversal of such
reduction should be included in profit or loss account.
• Long term Investments:
Long term investments are usually carried at cost.
However, when there is a decline, other than temporary, in the value of a long term
investment, the carrying amount is reduced to recognize the decline.
Such reduction should be determined and made for each long term investments
individually.
4. Disposal:
On disposal of an investment, the difference between the carrying amount and
disposal proceeds, net of expenses, is recognized in profit or loss account. When
disposing of a part of the holding of an individual investment, the carrying amount
to be allocated to that part is to be determined on the basis of the average carrying
amount of the total holding of the investment (i.e. weighted average cost)
5. RECLASSIFICATION OF INVESTMENTS:
From long term investment to current investment.
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Transfers are made at the lower of cost and carrying amount on the date of transfer
From current investment to long term investment.
Transfers are made at the lower of cost and fair value on date of transfer.
6. DISCLOSURE:
• The accounting policies for determination of carrying amount of investments.
• An Enterprise should disclose current Investments and long term investments
separately.
• As per Schedule III of Companies Act, 2013 further classification should disclose
investments in:
a. Government securities
b. Shares, Debentures or bonds
c. Investment properties
d. Others-Specifying nature.
• The amounts included in profit or loss statement for:
a. Interest, dividends and rentals on investments showing separately such in-
come from long term and current investments. Gross income should be stated,
the amount of income tax deducted at source being included under Advance
Taxes paid.
b. Profit or loss on disposal of current investments and changes in the carrying
amount of such investments.
c. Profit or loss on disposal of Long term investments and changes in the carrying
amount of such investments.
• Significant restrictions on the rights of ownership, realisability of investments or the
remittance of income and proceeds of the disposal.
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CLASSWORK QUESTIONS
Question 1
Albert Ltd. has made the following investments:
(i) Purchased the following equity shares from stock exchange on 1st June, 2010:
Cost `
Scrip X 1,80,000
Scrip Y 50,000
Scrip Z 1,70,000
4,00,000
(ii) Purchased gold of ` 3,00,000 on 1st April, 2007.
(iii) Invested in mutual funds at a cost of ` 6,00,000 on 31st March, 2010.
(iv) Purchased government securities at a cost of ` 5,00,000 on 1st April, 2010.
How will you treat these investments as per applicable AS in the books of the company
for the year ended on 31st March, 2011, if the values of these investments are as follows:
Shares ` `
Scrip X 1,90,000
Scrip Y 70,000
Scrip Z 40,000 3,00,000
Gold 5,00,000
Mutual funds 4,50,000
Government securities 7,00,000
Also explain is it possible to set of diminution in investment in mutual funds against
appreciation of the value of investment in government securities?
Question 2
An unquoted long-term investment is carried in the books at a cost of ` 2 lakhs. The
published accounts of the unlisted company received in May, 2012 showed that the
company was incurring cash losses with declining market share and the long term
investment may not fetch more than ` 20,000. Financial statement of 31st March, 2012
of investor are yet to be completed and approved by the Board of Directors.
Question 3
Bharat Ltd. wants to re-classify its investments in accordance with AS 13. Decide on the
amount of transfer, based on the following information:
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1) A portion of current investments purchased for ` 20 lakhs, to be re - classified as

Long - term investments, as the company has decided to retain them. The market
value as on the date of balance sheet was ` 25 lakhs.
2) Another portion of current investments purchased for ` 15 lakhs, to be re- classified
as long-term investments. The market value of these investments as on the date of
balance sheet was ` 6.5 lakhs.
3) Certain Long-term investments no longer considered for holding purposes, to be
re-classified as current investments. The original Cost of these were ` 18 lakhs but
had been written down to ` 12 lakhs to recognize permanent decline as per AS 13.
Question 4
Sabka Bank has classified its total investment on 31-3-2017 into three categories (a)
held to maturity (b) available for sale (c) held for trading. ‘Held to maturity’ investments
are carried at acquisition cost less amortised amount. ‘Available for sale’ investments
are carried at marked to market. ‘Held for trading’ investments are valued at weekly
intervals at market rates or as per the prices declared by FIMMDA. Net depreciation, if
any, is charged to revenue and net appreciation, if any, is ignored. Comment whether the
policy of the bank is in accordance with AS 13?
Question 5
Following is the Investment made by Ranka Ltd. as on 31.03.2005.
Type of Share Quantity Cost Market
Value
(i) Equity Shares:
X Ltd. 250 124 175
Y Ltd. 400 106 156
Z Ltd. 200 97 95
(ii) Preference Shares:
F Ltd. 400 102 88
M Ltd. 10 115 149
R Ltd. 55 116 121
Value the investments as per Global/Category/Individual method.
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CLASSWORK SOLUTIONS
Answer 2
As it is stated in the question that financial statement for the year ended 31st March,
2012 are under preparation, the views have been given on the basis that the financial
statements are yet to be completed and approved by the Board of Directors.
As per AS 13, Accounting for investment, long term investment should be valued at cost
unless reduction is other than temporary. Here, cost of unquoted long term investment
was ` 2,00,000, however, fair value of this investment is ` 20,000 only and this reduction
is due to cash losses suffered by company with declining market share, which is other
than temporary in nature.
On this basis, the facts of the given case clearly suggest that the provision for diminution
of ` 1,80,000 (` 2,00,000 - ` 20,000) should be made to reduce the carrying amount of
long term investment to ` 20,000 in the financial statements as on 31st March, 2012.
Answer 4
As per para 2(d) of AS 13 ‘Accounting for Investments’, the accounting standard is not
applicable to Bank, Insurance Company, Mutual Funds. In this case Sabka Bank is a
bank, therefore, AS 13 does not apply to it. For banks, the RBI has issued guidelines for
classification and valuation of its investment and Sabka Bank should comply with those
RBI Guidelines/Norms. Therefore, though Sabka Bank has not followed the provisions of
AS 13, yet it would not be said as non-compliance since, it is complying with the norms
stipulated by the RBI.
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HOMEWORK SECTION
Question 1
Blue-chip Equity Investments Ltd., wants to re-classify its investments in accordance
with AS 13. State the values, at which the investments have to be reclassified in the
following cases:
(i) Long term investments in Company A, costing ` 8.5 lakhs are to be re-classified as
current. The company had reduced the value of these investments to ` 6.5 lakhs to
recognize a permanent decline in value. The fair value on date of transfer is ` 6.8
lakhs.
(ii) Long term investments in Company B, costing ` 7 lakhs are to be re-classified as
current. The fair value on date of transfer is ` 8 lakhs and book value is ` 7 lakhs.
(iii) Current investment in Company C, costing ` 10 lakhs are to be re-classified as long
term as the company wants to retain them. The market value on date of transfer is
` 12 lakhs.
(iv) Current investment in Company D, costing ` 15 lakhs are to be re-classified as long
term. The market value on date of transfer is ` 14 Lakhs.
Answer
As per AS 13 „Accounting for Investments", where long-term investments are reclassified
as current investments, transfers are made at the lower of cost and carrying amount at
the date of transfer.
And where investments are reclassified from current to long term, transfers are made at
lower of cost and fair value on the date of transfer. Accordingly, the re-classification will
be done on the following basis:
(i) In this case, carrying amount of investment on the date of transfer is less than the
cost; hence this re-classified current investment should be carried at ` 6.5 lakhs in
the books.
(ii) The carrying / book value of the long term investment is same as cost i.e. ` 7 lakhs.
Hence this long term investment will be reclassified as current investment at book
value of ` 7 lakhs only.
(iii) In this case, reclassification of current investment into long-term investments will
be made at ` 10 lakhs as cost is less than its market value of ` 12 lakhs.
(iv) In this case, market value is ` 14 lakhs which is lower than the cost of ` 15 lakhs.
The reclassification of current investment as long-term investments will be made at
` 14 lakhs.
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Question 2
M/s Innovative Garments Manufacturing Company Limited invested in the shares of
another company on 1st October, 2014 at a cost of ` 2, 50,000. It also earlier purchased
Gold of ` 4, 00,000 and silver of ` 2, 00,000 on 1st March, 2012. Market value as on 31st
March, 2015 of above investments are as follows:
`
Shares 2,25,000
Gold 6,00,000
Silver 3,50,000
How above investments will be shown in the books of accounts of M/s Innovative
Garments Manufacturing Company Limited for the year ending 31st March, 2015 as per
the provisions of Accounting Standard 13 "Accounting for Investments"?
Answer
As per AS 13 „Accounting for Investments", for investment in shares - if the investment is
purchased with an intention to hold for short-term period then it will be shown at the
realizable value of ` 2,25,000 as on 31st March, 2015.
If equity shares are acquired with an intention to hold for long term period then it will
continue to be shown at cost in the Balance Sheet of the company. However, provision for
diminution shall be made to recognize a decline, if other than temporary, in the value of
the investments.
As per the standard, investment acquired for long term period shall be shown at cost.
Gold and silver are generally purchased with an intention to hold it for long term period
until and unless given otherwise. Hence, the investment in Gold and Silver (purchased
on 1st March, 2009) shall continue to be shown at cost as on 31st March, 2015 i.e., `
4,00,000 and ` 2,00,000 respectively, though their realizable values have been increased.
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PAST PAPER SECTION
Question 1
M/s. Active Builders Ltd. invested in the shares of another company on 31st October,
2015 at a cost of ` 4,50,000. It also earlier purchased Gold of ` 5,00,000 and Silver of
` 2,25,000 on 31st March, 2013. Market values as on 31st March, 2016 of the above
investment are as follows:
Shares ` 3,75,000; Gold ` 7,50,000 and Silver ` 4,35,000
How will the above investments be shown in the books of accounts of M/s. Active Builders
Ltd. for the year ending 31st March, 2016 as per the provision of AS – 13?
(May’16)
Answer
As per AS 13 „Accounting for Investments", if the shares are purchased with an intention
to hold for short-term period then investment will be shown at the realizable value.
If equity shares are acquired with an intention to hold for long term period then it will
continue to be shown at cost in the Balance Sheet of the company. However, provision
for diminution shall be made to recognize a decline, if other than temporary, in the value
of the investments. In the given case, shares purchased on 31st October, 2015, will be
valued at ` 3,75,000 as on 31st March, 2016.
Gold and silver are generally purchased with an intention to hold it for long term period
until and unless given otherwise. Hence, the investment in gold and silver (purchased
on 31st March, 2013) shall continue to be shown at cost as on 31st March, 2016 i.e.,
` 5,00,000 and ` 2,25,000 respectively, though their realizable values have been increased.
Thus the shares, gold and silver will be shown at
` 3,75,000, ` 5,00,000 and ` 2,25,000 respectively and hence, total investment will be
valued at ` 11,00,000 in the books of account of M/s Active Builders for the year ending
31st March, 2016 as per provisions of AS 13
Question 2
How you will deal with following in the financial statement of the Paridhi Electronics Ltd.
as on 31.3.16 with reference to AS – 13?
(i) Paridhi Electronics Ltd. invested in the shares of another unlisted company on 1st
May 2012 at a cost of ` 3,00,000 with the intention of holding more than a year.
The published accounts of unlisted company received in Jan 2016 reveals that the
company has incurred cash losses with decline market share and investment of
Paridhi Electronics Ltd. may not fetch more than ` 45,000.
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(ii) Also Paridhi Electronics Ltd. has current investment (X Ltd.'s shares) purchased for `
5 lakhs, which the company wants to reclassify as long term investment. The market
value of these investments as on date of Balance Sheet was ` 2.5 lakhs.
(Nov’16)
Answer
(i) As per AS 13, “Accounting for investments” Investments classified as long term
investments should be carried in the financial statements at cost. However, provision
for diminution shall be made to recognise a decline, other than temporary, in the
value of the investments, such reduction being determined and made for each
investment individually. The standard also states that indicators of the value of an
investment are obtained by reference to its market value, the investee's assets and
results and the expected cash flows from the investment. On this basis, the facts of
the given case clearly suggest that the provision for diminution should be made to
reduce the carrying amount of shares to ` 45,000 in the financial statements for the
year ended 31st March, 2016 and charge the difference of loss of ` 2,55,000 to Profit
and Loss account.
(ii) As per AS 13 ‘Accounting for Investments’, where investments are reclassified from
current to long-term, transfers are made at the lower of cost or fair value at the
date of transfer. In the given case, the market value of the investment (X Ltd. shares)
is ` 2.50 lakhs, which is lower than its cost i.e. `5 lakhs. Therefore, the transfer to
long term investments should be made at cost i.e. `2.50 lakhs. The loss of ` 2.50
lakhs should be charged to profit and loss account
Question 3
Sun Ltd. wants to re-classify its investments in accordance with AS-13.
State the values at which the investments have to be re-classified as per AS-13 in the
following cases:
(1) Current investments in Company Fine Ltd., costing ` 39,000 are to be re- classified
as long term investments. The fair value on the date of transfer is ` 37,000.
(2) Long term investments in Company Bold Ltd., costing ` 16 lakhs are to be re-classified
as current investments. The fair value on the date of transfer is ` 15 lakhs and book
value is ` 16 lakhs. (May’18)
Answer
Re-classification will be done on the following basis:
(i) As per AS 13, where investments are reclassified from current to long term, transfers
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are made at lower of cost and fair value on the date of transfer. In this case, fair
value is ` 37,000 which is lower than the cost of ` 39,000. The reclassification of
current investment as long-term investments will be made at
` 37,000.
(ii) As per AS 13 ‘Accounting for Investments’, where long-term investments are
reclassified as current investments, transfers are made at the lower of cost and
carrying amount at the date of transfer. The carrying / book value of the long term
investment is same as cost i.e. ` 16 lakhs. Hence this long term investment will be
reclassified as current investment at book value of ` 16 lakhs only.
Question 4
The Investment portfolio of XYZ Ltd. as on 31.03.2018 consisted of the following:
(` in lakhs)
Current Investments Cost Fair Value as on 31.03.2018
1 1000 Equity Shares of A Ltd. 500 5 7
2 Equity Shares of B Ltd. 10 15
3
1000 Equity Shares of C Ltd. 15 12
Total 30 34
Give your comments on below:

(i) The company wants to value the above portfolio at ` 30 lakhs being lower of cost
or fair market value.
(ii) Company wants to transfer 1000 Equity Shares of C Ltd. from current investments to
long term investments on 31.03.2018 at cost of ` 15 lakhs.
(Hint: i) Value at 30 Lakhs; ii) Reclassified at 12 Lakhs.
Question 5
On 15th June, 2018, Y limited wants to re-classify its investments in accordance
with AS 13 (revised). Decide and state the amount of transfer, based on the following
information:
(1) A portion of long term investments purchased on 1st March, 2017 are to be re-
classified as current investments. The original cost of these investments was ` 14
lakhs but had been written down by ` 2 lakhs (to recognise 'other than temporary'
decline in value). The market value of these investments on 15th June, 2018 was
` 11 lakhs.
(2) Another portion of long term investments purchased on 15th January, 2017 are to
be re-classified as current investments. The original cost of these investments was `
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7 lakhs but had been written down to ` 5 lakhs (to recognise 'other than temporary'
decline in value). The fair value of these investments on 15th June, 2018 was ` 4.5
lakhs.
(3) A portion of current investments purchased on 15th March, 2018 for ` 7 lakhs are
to be re-classified as long term investments, as the company has decided to retain
them. The market value of these investments on 31st March, 2018 was ` 6 lakhs and
fair value on 15th June 2018 was ` 8.5 lakhs,
(4) Another portion of current investments purchased on 7th December, 2017 for ` 4
lakhs are to be re-classified as long term investments. The market value of these
investments was:
on 31st March, 2018 ` 3.5 lakhs
on 15th June, 2018` 3.8 lakhs (May’ 19)
Answer
As per AS 13 (Revised) ‘Accounting for Investments’, where long-term investments are
reclassified as current investments, transfers are made at the lower of cost and carrying
amount at the date of transfer; and where investments are reclassified from current to
long term, transfers are made at lower of cost and fair value on the date of transfer.
Accordingly, the re-classification will be done on the following basis:
cost; hence this re-classified current investment should be carried at ` 12 lakhs in
the books.
(ii) In this case also, carrying amount of investment on the date of transfer is less
than the cost; hence this re-classified current investment should be carried at ` 5
lakhs in the books.
be made at ` 7 lakhs as cost is less than its fair value of ` 8.5 lakhs on the date of
transfer.
(iv) In this case, market value (considered as fair value) is ` 3.8 lakhs on the date of
transfer which is lower than the cost of ` 4 lakhs. The reclassification of current
investment into long-term investments will be made at ` 3.8 lakhs.
Question 6
State whether the following statements are 'True' or 'False'. Also give reason for your
answer.
(1) As per the provisions of AS-5, extraordinary items should not be disclosed in the
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statement of profit and loss as a part of net profit or loss for the period.
(2) As per the provisions of AS-12, government grants in the nature of promoters'
contribution which become refundable should be reduced from the capital reserve.
(3) As per the provisions of AS-2, inventories should be valued at the lower of cost and
selling price.
(4) As per the provisions of AS-13, a current investment is an investment, that by its
nature, is readily realisable and is intended to be held for not more than six months
from the date on which such investment is made.
(5) As per the provisions of AS-4, a contingency is a condition or situation, the ultimate
outcome of which (gain or loss) will be known or
Determined only on the occurrence of one or more uncertain future events. (May’19)
Answer
(1) False: The nature and the amount of each extraordinary item should be separately
disclosed in the statement of profit and loss in a manner that its impact on current
profit or loss can be perceived.
(2) True: When grants in the nature of promoters’ contribution becomes refundable, in
part or in full to the government on non-fulfillment of some specified conditions, the
relevant amount refundable to the government is reduced from the capital reserve.
(3) False: Inventories should be valued at the lower of cost and net realizable value (not
selling price) as per AS 2.
(4) False: A current investment is an investment that is by its nature readily realizable
and is intended to be held for not more than one year from the date on which such
investment is made.
(5) False: A contingency is a condition or situation, the ultimate outcome of which, gain
or loss, will be known or determined only on the occurrence, or non-occurrence, of
one or more uncertain future events.
Question 7
Mother Mart Ltd., wants to re-classify its investment in accordance with AS 13. Decide
the treatment to be given in each of the following cases assuming that the market value
has been determined in an arm's length transaction between knowledgeable and willing
buyer and seller:
(i) A portion of current investments purchased for ` 25 lakhs to be reclassified as long-
term investments, as the company has decided to retain them. The market value
as on the date of balance sheet was ` 30 lakhs.
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(ii) Another portion of current investments purchased for ` 20 lakhs has to be re-
classified as long-term investments. The market value of these investments as on
the date of the balance sheet was ` 12.5 lakhs.
(iii) One portion of long-term investments, no longer considered for holding purposes,
to be reclassified as current investments. The original cost of these was ` 15 lakhs,
but had been written down to ` 11 lakhs to recognize permanent decline as
per AS 13. (May’19)
Ans.
As per AS 13 ‘Accounting for Investments’, where investments are reclassified from
current to long-term, transfers are made at the lower of cost and fair value at the date
of transfer.
When long-term investments are re-classified as current investments, transfers are
made at the lower of cost and carrying amount at the date of transfer.
(i) In the first case, the market value of the investments is ` 30 lakhs , which is higher
than its cost i.e. ` 25 lakhs. Therefore, the transfer to long term investments should
be made at cost i.e. ` 25 lakhs
(ii) In the second case, the market value of the investment is ` 12.5 lakhs*, which is
lower than its cost i.e. ` 20 lakhs. Therefore, the transfer to long term investments
should be made in the books at the market value i.e. ` 12.5 lakhs. The loss of ` 7.50
lakhs (20-12.5) should be charged to Profit and Loss account.
(iii) In the third case, the book value of the investments is ` 11 lakhs, which is lower
than its cost, i.e. ` 15 lakhs. As the transfer should be at carrying amount, hence this
re- classified current investment should be carried at ` 11 lakhs.
Question 8
PQR Investments Ltd., wants to re-classify its investments in accordance with AS 13.
State the values, at which the investments have to be reclassified in the following cases:
(i) Long term investments in Company A, costing ` 10 lakhs are to be re-classified as
current. The company had reduced the value of these investments to ` 8 lakhs to
recognize a permanent decline in value. The fair value on date of transfer is ` 8.50
lakhs.
(ii) Long term investments in Company B, costing ` 5 lakhs are to be re-classified as
current. The fair value on date of transfer is ` 6 lakhs and book value is ` 5 lakhs.
(iii) Current investment in Company C costing ` 8 lakhs are to be re-classified as long
term as the company wants to retain them. The market value on date of transfer is
` 9 lakhs.
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(iv) Current investment in Company D, costing ` 12 lakhs are to be re-classified as long

term. The market value on date of transfer is ` 11 Lakhs.
You are required to advise PQR Investments Ltd., the correct treatment in light of
relevant accounting standard.
Answer
As per AS 13 ‘Accounting for Investments’, where long-term investments are reclassified
as current investments, transfers are made at the lower of cost and carrying amount at
the date of transfer. And where investments are reclassified from current to long term,
transfers are made at lower of cost and fair value on the date of transfer.
cost; hence this re-classified current investment should be carried at ` 8 lakhs in the
books.
(ii) The carrying / book value of the long term investment is same as cost i.e. ` 5 lakhs.
Hence this long term investment will be reclassified as current investment at book
value of ` 5 lakhs only.
be made at ` 8 lakhs as cost is less than its market value (considered as fair value)
of ` 9 lakhs.
(iv) In this case, market value is ` 11 lakhs which is lower than the cost of ` 12 lakhs.
The reclassification of current investment as long-term investments will be made at
` 11 lakhs.
Question 9
A Limited invested in the shares of XYZ Ltd. on 1st December, 2019 at a cost of ` 50,000.
Out of these shares ` 25,000'shares were purchased with an intention to hold for 6 months
and ` 25,000 shares were purchased with an intention to hold as long-term Investment.
A Limited also earlier purchased Gold of ` 1,00,000 and Silver of ` 30,00,000 on 1st April,
2019. Market value as on 31st March, 2020 of above investments are as follows:
Shares ` 47,500 (Decline in the value of shires is temporary.)
Gold ` 1,80,000
Silver ` 30,55,000
How above investments will be shown in the books of accounts of M/s A Limited for the
year ending 31st March, 2020 as per the provisions of AS 13 (Revised)?
(Nov’20)
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Answer
As per AS 13 (Revised) ‘Accounting for Investments, for investment in shares - if the
investment is purchased with an intention to hold for short-term period (less than one
year), then it will be classified as current investment and to be carried at lower of cost
and fair value.
In the given case ` 25,000 shares held as current investment will be carried in the books
at ` 23,750 (` 47,500/2).
If equity shares are acquired with an intention to hold for long term period (more than
one year), then should be considered as long-term investment to be shown at cost in
the Balance Sheet of the company. However, provision for diminution should be made
to recognize a decline, if other than temporary, in the value of the investments. Hence,
` 25,000 shares held as long-term investment will be carried in the books at ` 25,000.
Gold and silver are generally purchased with an intention to hold them for long term
period (more than one year) until and unless given otherwise.
Hence, the investment in Gold and Silver (purchased on 1st March, 2019) should continue
to be shown at cost (since there is no ‘other than temporary’ diminution) as on 31st March,
2020. Thus Gold at ` 1,00,000 and Silver at ` 30,00,000 respectively will be shown in the
books.
Question 10
M/s. Gowtham Limited invested in shares of another company (with the intention to hold
the shares for short-term period) on 30th November, 2019 at a cost of ` 4,25,000. It also
earlier purchased Gold of ` 8,00,000 and Silver of ` 3 50,000 on 31st March, 2017.
Market values as on 31st March, 2020, of the above investments are as follows :
Shares ` 3,50,000
Gold ` 10,25,000
Silver ` 5,10,000
You are required to explain how will the above investments be shown (individually and in
total) in the books of account of M/s. Gowtham Limited for the year ending 31st March,
2020 as per the provisions of As 13. (Nov’ 20)
Question 11
Kunal Securities Ltd. wants to reclassify its investments in accordance with AS-13 (Revised).
State the values, at which the investments have to be reclassified in the following cases:
(i) Long term investment in Company A, costing ` 10.5 lakhs is to be re-classified as
current investment. The company had reduced the value of these investments to
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` 9 lakhs to recognize a permanent decline in value. The fair value on the date of
reclassification is ` 9.3 lakhs.
(ii) Long term investment in Company B, costing ` 14 lakhs is to be re-classified as
current investment The fair value on the date of reclassification is ` 16 lakhs and
book value is ` 14 lakhs.
(iii) Current investment in Company C, costing `12 lakhs is to be re-classified as long
term investment as the company wants to retain them. The market value on the
date of reclassification is ` 13.5 lakhs.
(iv) Current investment in Company D, costing ` 18 lakhs is to be re-classified as long
term investment. The market value on the date of reclassification is ` 16.5 lakhs.
Answer
As per AS 13 (Revised) ‘Accounting for Investments’, where long-term investments are
reclassified as current investments, transfers are made at the lower of cost and carrying
amount at the date of transfer. And where investments are reclassified from current to
long term, transfers are made at lower of cost and fair value on the date of transfer.
cost; hence this re-classified current investment should be carried at ` 9 lakhs in the
books.
(ii) The carrying / book value of the long-term investment is same as cost i.e., ` 14
lakhs. Hence this long-term investment will be reclassified as current investment at
book value of ` 14 lakhs only.
be made at ` 12 lakhs as cost are less than its market value of ` 13.5 lakhs.
(iv) Market value of the investment is ` 16.5 lakhs, which is lower than its cost i.e., ` 18
lakhs. Therefore, the transfer to long term investments should be done in the books
at the market value i.e., ` 16.5 lakhs.
Question 12
Mr. Mohan has invested some money in various Mutual funds. Following information in
this regard is given:
Mutual Date of pur- Purchase cost Brokerage Stamp duty (`) Market val-
Funds chase (`) Cost (`) ue as on
31.03.2021 (`)
A 01.05.2017 50,000 200 20 48,225
B 05.08.2020 25,000 150 25 24,220
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C 01.01.2021 75,000 300 75 78,190

D 07.05.2020 70,000 275 50 65,880
1. Classify his investment in accordance with AS-13 (revised).
2. Value of Investment in mutual fund as on 31.03.2021 (Dec' 21)
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REVISION QUESTIONS
Question 1
A manufacturing company purchased shares of another company from stock exchange
on 1st May, 2007 at a cost of ` 5,00,000. It also purchased Gold of ` 2,00,000 and
Silver of ` 1,50,000 on 1st April, 2005. How will you treat these investments as per the
applicable AS in the books of the company for the year ended on 31st March, 2008, if the
values of these investments are as follows:
`
Shares 2,00,000
Gold 4,00,000
Silver 2,50,000
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AS 5 - NET PROFIT OR LOSS FOR THE PERIOD,

PRIOR PERIOD ITEMS AND CHANGES IN
ACCOUNTING POLICY
1. NET PROFIT OR LOSS FOR THE PERIOD INCLUDES :

All items of income and expense including extra ordinary items and effects of changes in
accounting estimates which are recognized in a period.
The net profit or loss for the period comprises the following component, each of which
should be disclosed on the face of the statement of profit and loss:
• Profit or loss from ordinary activities and
• Profit or loss from extra ordinary activities.
Any activities which are undertaken by an enterprise as a part of its business and Such
related activities in which the enterprise engages in furtherance of, incidental to, or arising
from, these activities.
When the items of income and expense from ordinary activities are of such size, nature or
incidence that their disclosure is relevant to explain the performance of the enterprise for
the period, the nature and amount of such items should be disclosed separately.
Following are items of income/expense which require separate disclosure:
a. The write down of inventories to NRV
b. Disposal of fixed assets
c. Disposal of long term investments
d. Litigation settlements, etc.
Profit or loss from extra ordinary activities:

Extra ordinary items are incomes or expenses that arise from events or transactions
that are clearly distinct from ordinary activities of the enterprise and, therefore, are not
expected to occur frequently. The nature and amount of each extraordinary items should
be separately disclosed in the statement of profit or loss in a manner that its impact on
profit or loss can be perceived.
Examples of extraordinary items:
a. Loss due to earthquake
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b. Attachment of property
c. Government Grants becoming refundable
d. Loss due to fire
e. Loss due to enemy attack, etc.
2. CHANGES IN ACCOUNTING ESTIMATES :

As a result of the uncertainties inherent in business activities, many financial statements
items cannot be measured with precision but can only be estimated based on the latest
information available. Estimates may be required, for example, of bad debts, inventory
obsolescence or lives of assets.
The estimates can be revised if-
Changes occur regarding the circumstances on which the estimates are based As a result
of new information, more experience or subsequent developments.
NOTE: Revision of accounting estimates is not an extra-ordinary item or a prior period
item. Classification of change in accounting estimates:
The effect of a change in an accounting estimate should be classified under the same
classification in the statement of profit or loss as was used previously for the estimate.
The effect of a change in an accounting estimate which was previously included in profit
or loss from ordinary activities is included in that component of net profit or loss.
The effect of a change in an accounting estimate which was previously included in profit
or loss as extra-ordinary item is reported as extra-ordinary item.
3. CHANGES IN ACCOUNTING POLICIES:

Accounting policies can be changed if such change is required by
• Law
• AS
• Management, if they can justify better presentation and preparation of financial
statements. Any change that has material effect should be disclosed.
The amount by which any item in GPFS is affected by such change should be disclosed.
Where such amount is not ascertainable, wholly/ in part, the fact should be indicated.
The following are not changes in accounting policies:
• The adoption of a new accounting policy for events or transactions that differ in
substance from previously occurring events or transactions.
• The adoption of a new accounting policy for events or transactions which did not
occur previously or that were material.
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4. Prior period items:

Prior period items are incomes or expenses which arises in current period as a result of
error or omissions in the preparation of financial statements of one or more prior periods.
Errors may be occur as a result of:
• Mathematical mistakes,
• Mistakes in applying accountingpolicies,
• Misinterpretation of facts, or
• Oversight.
The nature and amount of prior period items should be separately disclosed in the
statement of profit and loss in a manner that their impact on the current profit or loss
can be perceived.
Examples of prior period item:
a. Error in calculation ofdepreciation
b. Use of incorrect rates ofdepreciation
c. Omission to provide depreciation Non provision for bad/doubtful debts, etc
348
CLASSWORK QUESTIONS
Question 1
Advise B Co. Ltd. about the treatment of the following in the financial statement of
accounts for the year ended 31st March 2012:
The company finds that the stock sheets as on 31st March 2011 had included twice an
item the cost of which was ` 55,000
Question 2
A limited company created a provision for bad and doubtful debts at 2.5% on debtors in
preparing the financial statements for the year 2010-2011.
Subsequently on a review of the credit period allowed and financial capacity of the
customers, the company decided to increase the provision to 8% on debtors as on
31.3.2011. The accounts were not approved by the Board of Directors till the date of
decision. While applying the relevant accounting standard can this revision be considered
as an extraordinary item or prior period item?
Question 3
X Co. Ltd. signed an agreement with its employees union for revision of wages in June, 2012.
The wage revision is with retrospective effect from 1.4.2008. The arrear wages upto
31.3.2012 amounts to ` 80 lakhs. Arrear wages for the period from 1.4.2012 to 30.06.2012
(being the date of agreement) amounts to ` 7 lakhs.
Decide whether a separate disclosure of arrear wages is required.
Question 4
S.T.B. Ltd. makes provision for expenses worth ` 7,00,000 for the year ending March 31,
2011, but the actual expenses during the year ending March 31, 2012 comes to ` 9,00,000
against provision made during the last year. State with reasons whether difference of
` 2,00,000 is to be treated as prior period item as per AS-5.
Question 5
Closing Stock for the year ending on 31st March, 2013 is `1,50,000 which includes stock
damaged in a fire in 2011-12. On 31st March, 2012, the estimated net realizable value
of the damaged stock was ` 12,000. The revised estimate of net realizable value of
damaged stock included in closing stock at 2012-13 is ` 4,000. Find the value of closing
stock to be shown in Profit and Loss Account for the year 2012-13, using provisions of
Accounting Standard 5.
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Question 6
ABC Ltd. was making provision for non-moving stocks based on no issues for the last 12
months up to 31.3.2015.
The company wants to provide during the year ending 31.3.2015 based on technical
evaluation:
Total value of stock ` 100 lakhs
Provision required based on 12 months issue ` 3.5 lakhs
Provision required based on technical evaluation ` 2.5 lakhs
Does this amount to change in Accounting Policy? Can the company change the method
of provision?
CLASSWORK SOLUTIONS
Answer 1
As per AS – 5 Prior period items are incomes or expenses, which arise in the current period
as a result of errors or omissions in the preparation of financial statement of one or more
prior periods.
Hence Rectification of Error in opening stock valuation is a prior period item.
The amount of ` 55,000 shall be deducted from the opening stock in the profit & loss
account for the current year and should also be charged as prior period adjustment in the
Profit & Loss account, below the line.
As 5 requires separate disclosure of prior period item with their nature and amount.
Answer 6
The decision of making provision for non-moving stocks on the basis of technical evaluation
does not amount to change in accounting policy. Requirement to provide for non-moving
stocks may be said as accounting policy but the basis for making provision will not constitute
accounting policy. It will be considered as an accounting estimate. Further, the method of
estimating the amount of provision may be changed in case a more prudent estimate can
be made.
In the given case, considering the total value of stock, the change in the amount of required
provision of non-moving stock from ` 3.5 lakhs to ` 2.5 lakhs is also not material. The
disclosure can be made for such change in the following lines by way of notes to the
accounts in the annual accounts of ABC Ltd. for the year 2014-15: “The company has
provided for non-moving stocks on the basis of technical evaluation unlike preceding years.
Had the same method been followed as in the previous year, the profit for the year and the
corresponding effect on the year end net assets would have been higher by ` 1 lakh.”
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HOMEWORK SECTION
Question 1
(i) During the year 2016-2017, a medium size manufacturing company wrote down its
inventories to net realisable value by ` 5,00,000. Is a separate disclosure necessary?
(ii) A company signed an agreement with the Employees Union on 1.9.2016 for revision
of wages with retrospective effect from 30.9.2015. This would cost the company
an additional liability of ` 5,00,000 per annum. Is a disclosure necessary for the
amount paid in 2016-17?
Answer
(i) Although the case under consideration does not relate to extraordinary item, but the
nature and amount of such item may be relevant to users of financial statements
in understanding the financial position and performance of an enterprise and in
making projections about financial position and performance.
AS 5 on ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting
Policies’ states that:
“When items of income and expense within profit or loss from ordinary activities
are of such size, nature or incidence that their disclosure is relevant to explain the
performance of the enterprise for the period, the nature and amount of such items
should be disclosed separately.”
Circumstances which may give to separate disclosure of items of income and expense
in accordance with AS 5 include the write-down of inventories to net realisable
value as well as the reversal of such write-downs.
(ii) It is given that revision of wages took place on 1st September, 2016 with retrospective
effect from 30.9.2015. Therefore wages payable for the half year from 1.10.2016 to
31.3.2017 cannot be taken as an error or omission in the preparation of financial
statements and hence this expenditure cannot be taken as a prior period item.
Additional wages liability of ` 7,50,000 (for 1½ years @ ` 5,00,000 per annum)
should be included in current year’s wages. It may be mentioned that additional
wages is an expense arising from the ordinary activities of the company. Such an
expense does not qualify as an extraordinary item. However, as per AS 5, when
items of income and expense within profit or loss from ordinary activities are of such
size, nature or incidence that their disclosure is relevant to explain the performance
of the enterprise for the period, the nature and amount of such items should be
disclosed separately.
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Question 2
Explain whether the following will constitute a change in accounting policy or not as per
AS 5.
(i) Introduction of a formal retirement gratuity scheme by an employer in place of ad
hoc ex-gratia payments to employees on retirement.
(ii) Management decided to pay pension to those employees who have retired after
completing 5 years of service in the organisation. Such employees will get pension of
` 20,000 per month. Earlier there was no such scheme of pension in the organisation.
Answer
As per AS 5 ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting
Policies’, the adoption of an accounting policy for events or transactions that differ in
substance from previously occurring events or transactions, will not be considered as a
change in accounting policy.
(i) Accordingly, introduction of a formal retirement gratuity scheme by an employer in
place of ad hoc ex-gratia payments to employees on retirement is not a change in
an accounting policy.
(ii) Similarly, the adoption of a new accounting policy for events or transactions which
did not occur previously or that were immaterial will not be treated as a change in
an accounting policy.
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PAST PAPER QUESTION
Question 1
M/s PQR Ltd. is in the process of finalising its accounts for the year ended 31st March,
2018. The company seeks your advice on the following:
(i) Goods worth ` 5,00,000 were destroyed due to flood in September, 2015. A claim
was lodged with insurance company. But no entry was passed in the books for
insurance claim in the financial year 2015-16. In March, 2018, the claim was passed
and the company received a payment of ` 3,50,000 against the claim. Explain the
treatment of such receipt in final account for the year ended 31st March, 2018.
(ii) Company created a provision for bad and doubtful debts at 2.5% on debtors in
preparing the financial statements for the year 2017-18. Subsequently, on a review
of the credit period allowed and financial capacity of the customers, the company
decides to increase the provision to 8% on debtors as on 31.03.2018. The accounts
were not approved by the Board of Directors till the date of decision. While applying
the relevant accounting standard, can this revision be considered as an extra ordinary
item or prior period item? (May’18)
Answer
(i) As per the provisions of AS 5 “Net Profit or Loss for the Period, Prior Period Items and
Changes in Accounting Policies”, prior period items are income or expenses, which
arise, in the current period as a result of error or omissions in the preparation of
financial statements of one or more prior periods. Further, the nature and amount
of prior period items should be separately disclosed in the statement of profit and
loss in a manner that their impact on current profit or loss can be perceived.
In the given instance, it is clearly a case of error/omission in preparation of financial
statements for the year 2015-16. Hence, claim received in the financial year 2017-
18 is a prior period item and should be separately disclosed in the statement of
Profit and Loss.
(ii) In the given case, a limited company created 2.5% provision for doubtful debts for
the year 2017-2018. Subsequently, the company revised the estimates based on the
changed circumstances and wants to create 8% provision.
As per AS 5, the revision in rate of provision for doubtful debts will be considered as
change in estimate and is neither a prior period item nor an extraordinary item.
The effect of such change should be shown in the profit and loss account for the year
ending 31st March, 2018.
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Question 2
HIL Ltd. was making provision for non-moving stocks based on no issues having occurred
for the last 12 months up to 31.03.2017. The company now wants to make provision
based on technical evaluation during the year ending 31.03.2018.
Total value of stock `120 lakhs
Provision required based on technical evaluation ` 3.00 lakhs Provision required based on
12 months no issues `4.00 lakhs
You are requested to discuss the following points in the light of Accounting Standard
– 1:
(i) Does this amount to change in accounting policy?
(ii) Can the company change the method of accounting? (Nov’18)
Answer
The decision of making provision for non-moving inventories on the basis of technical
evaluation does not amount to change in accounting policy. Accounting policy of a
company may require that provision for non-moving inventories should be made but the
basis for making provision will not constitute accounting policy. The method of estimating
the amount of provision may be changed in case a more prudent estimate can be made.
In the given case, considering the total value of inventory, the change in the amount
of required provision of non-moving inventory from ` 4 lakhs to ` 3 lakhs is also not
material. The disclosure can be made for such change in the following lines by way of
notes to the accounts in the annual accounts of HIL Ltd. for the year 2017-18 in the
following manner:
“The company has provided for non-moving inventories on the basis of technical evaluation
unlike preceding years. Had the same method been followed as in the previous year, the
profit for the year and the value of net assets at the end of the year would have been
lower by ` 1 lakh.”
Question3
Tiger Motor Car Limited signed an agreement with its employees union for revision of
wages on 01.07.2011. The revision of wages is with retrospective effect from 01.04.2008.
The arrear wages up to 31.3.2011 amounts to ` 40,00,000 and that for the period
from 01.04.2011 to 01.07.2011 amount to ` 3,50,000. In view of the provisions of AS 5
“Net Profit or Loss for the period, Prior Period Items and Changes in Accounting Policies”,
decide whether a separate disclosure of arrear wages is required while preparing financial
statements for the year ending 31.3.2012.
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Answer
It is given that revision of wages took place in July, 2011 with retrospective effect from
1.4.2008. The arrear wages payable for the period from 1.4.2008 to 31.3.2011 cannot
be taken as an error or omission in the preparation of financial statements and hence
this expenditure cannot be taken as a prior period item. Additional wages liability of
` 40,00,000 (from 1.4.2008 to 31.3.2011) should be included in current year’s wages. It
may be mentioned that additional wages is an expense arising from the ordinary activities
of the company. Although abnormal in amount, such an expense does not qualify as an
extraordinary item. However, as per para no. 12 of AS 5, when items of income and
expense within profit or loss from ordinary activities are of such size, nature or incidence
that their disclosure is relevant to explain the performance of the enterprise for the
period, the nature and amount of such items should be disclosed separately. However,
wages payable for the current year (from 1.4.2011 to 1.7.2011) amounting ` 3,50,000 is
not a prior period item hence need not be disclosed separately. This may be shown as
current year wages.
Question 4
Give two examples on each of the following items:
(i) Change in Accounting Estimate
(ii) Extra Ordinary items
(iii) Prior Period Items (Nov’12)
Answer
Changes in Accounting Estimates examples:
• Estimation of provision for doubtful debts on sundry debtors.
• Estimation of useful life of fixed assets.
Extraordinary items examples:
• Loss due to earthquakes / fire / strike
• Attachment of property of the enterprise
Prior period items examples:
• Applying incorrect rate of depreciation in one or more prior periods.
• Omission to account for income or expenditure in one or more prior periods.
Question 5
The Accountant of Mobile Limited has sought your opinion with relevant reasons, whether
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the following transactions will be treated as change in Accounting Policy or not for the
year ended 31st March, 2017. Please advise him in the following situations in accordance
with the provisions of relevant Accounting Standard;
(i) Provision for doubtful debts was created @ 2% till 31st March, 2016. From the
Financial year 2016- 2017, the rate of provision has been changed to 3%.
(ii) During the year ended 31st March, 2017, the management has introduced a formal
gratuity scheme in place of ad-hoc ex-gratia payments to employees on retirement.
(iii) Till the previous year the furniture was depreciated on straight line basis over a
period of 5 years. From current year, the useful life of furniture has been changed to
3 years.
(iv) Management decided to pay pension to those employees who have retired after
completing 5 years of service in the organization. Such employees will get pension of
` 20,000 per month. Earlier there was no such scheme of pension in the organization.
(v) During the year ended 31st March, 2017, there was change in cost formula in
measuring the cost of inventories. (Nov 17)
Answer
(i) In the given case, Mobile limited created 2% provision for doubtful debts till 31st
March, 2016. Subsequently in 2016-17, the company revised the estimates based
on the changed circumstances and wants to create 3% provision. Thus change in rate
of provision of doubtful debt is change in estimate and is not change in accounting
policy. This change will affect only current year.
(ii) As per AS 5, the adoption of an accounting policy for events or transactions
that differ in substance from previously occurring events or transactions, will not
be considered as a change in accounting policy. Introduction of a formal retirement
gratuity scheme by an employer in place of ad hoc ex-gratia payments to employees
on retirement is a transaction which is substantially different from the previous
policy, will not be treated as change in an accounting policy.
(iii) Change in useful life of furniture from 5 years to 3 years is a change in estimate and
is not a change in accounting policy.
(iv) Adoption of a new accounting policy for events or transactions which did not occur
previously should not be treated as a change in an accounting policy. Hence the
introduction of new pension scheme is not a change in accounting policy.
(v) Change in cost formula used in measurement of cost of inventories is a change in
accounting policy.
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Question 6
Shama was working with ABC Ltd. drawing monthly salary of ` 25,000 per month. She
went on maternity leave with pay for 7 months i.e. from 01-01-2017 to 31-7-17. Her
salary for 3 months was not provided for in financial statements for F.Y. 2016-17 due to
omission. When she joined after leave period, the whole salary for 7 months was paid to
her. You are required to
(i) Pass the necessary journal entries in F.Y. 2017-18 to record the above transaction as
per accounting standard – 5 and state reason for thesame.
(ii) Would the treatment have been different, if Shama was terminated on 01- 01- 2017
and was reinstated in service by the court w.e.f. 01-08-2017 with instruction to pay
Shama salary for the intervening period i.e. 01-01-2017 to 31-07-2017.
(Nov’17)
Answer
As per AS 5 “Net Profit or Loss for the Period”, Prior Period Items and Changes in
Accounting Policies, the term ‘prior period items’, refers to income or expenses which arise
in the current period as a result of errors or omissions in the preparation of the financial
statements of one or more prior periods. The nature and amount of prior period items
should be separately disclosed in the statement of profit and loss so that their impact on
the current profit or loss can be perceived. Hence, in this case salary paid to Shama for
3 months i.e 1.1.2017 to 31.3.2017 ` 75,000 will be classified as prior period item in FY
2017-18 and following journal entry shall be passed:
(i)
Journal entry in FY 2017-18
Salary A/c (Rs 25,000 x 4) Dr. 1,00,000
Prior period item (Rs 25,000 x 3) Dr. 75,000
To Bank A/c 1,75,000
(Salary related to 7 months paid out of which 3’months’ salary is prior period item)
Alternative Entry
Salary A/c (prior period item) Dr. 75,000
To Bank A/c 75,000
(Salary related to 3 months i.e. January, 2017 to March 2017 paid in 2017-2018)
Salary A/c Dr. 1,00,000
(Salary related to 4 months paid on 1.8.2017 for April to July, 2017)
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(ii) AS 5 inter alia states that the term ‘prior period items’ does not include other
adjustments necessitated by circumstances, which though related to prior periods,
are determined in the current period. Accordingly, in the second case though
Shama was terminated on 1.1.2017 i.e. in 2016-2017, yet she was reinstated due to
court’s order in 2017-2018, with the instruction by the court to pay the salary for the
intervening period i.e. with retrospective effect from January, 2017. The adjustment
of salary of ` 75,000 (for January 2017 to March, 2017) would not be considered as
prior period item and will be accounted for in the books as current year expense.
Thus the entire amount of Salary of ` 1,75,000 for January, 2017 to July, 2017 is a
current year expense only.
Salary A/c (Rs 25,000 x 7)Dr. 1,75,000
(Salary related to 7 months paid i.e. for the period 1.1.2017 to 31.7.2017).
Question 7
State whether the following items are examples of change in Accounting Policy / Change
in Accounting Estimates / Extraordinary items / Prior period items / Ordinary Activity :
(i) Actual bad debts turning out to be more than provisions.
(ii) Change from Cost model to Revaluation model for measurement of carrying amount
of PPE.
(iii) Government grant receivable as compensation for expenses incurred in previous
accounting period.
(iv) Treating operating lease as finance lease.
(v) Capitalisation of borrowing cost on working capital.
(vi) Legislative changes having long term retrospective application.
(vii) Change in the method of depreciation from straight line to WDV.
(viii) Government grant becoming refundable.
(ix) Applying 10% depreciation instead of 15% on furniture.
(x) Change in useful life of fixed assets (Jan 2021)
Question 8
TQ Cycles Ltd. is in the manufacturing of bicycles, a labour intensive manufacturing
sector. In April 2022, the Government enhanced the minimum wages payable to workers
with retrospective effect from the 1st January, 2022. Due to this legislative change, the
additional wages for the period from January 2022 to March 2022 amounted to ` 30
lakhs. The management asked the Finance manager to charge ` 30 lakhs as prior period
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item while finalizing financial statements for the year 2022-23. Further, the Finance
manager is of the view that this amount being abnormal should be disclosed as extra-
ordinary item in the Profit and loss account for the financial year 2021-22.
Discuss with reference to applicable Accounting Standards. (May 22)
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REVISION QUESTIONS
Question 1
A company created a provision of ` 75,000 for staff welfare while preparing the financial
statements for the year 2010 - 11. On 31st March, in a meeting with staff welfare
association, it was decided to increase the amount of provision for staff welfare to
` 1,00,000. The accounts were approved by Board of Directors on 15th April, 2011.
Explain the treatment of such revision in financial statements for the year ended 31st
March,2011.
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AS 7 - CONSTRUCTION CONTRACT
1. APPLICABLITY :
AS 7 addresses the issue of allocation of revenue & costs attributable to contract
activity to the accounting period in which construction work is performed.
2. DEFINITION :
A construction contract is defined as a contract specifically negotiated for the
construction of an asset or combination of assets that are closely inter-related or
inter-dependent in terms of their design, technology & function or their ultimate
purpose or use e.g. :- contract for construction of a bridge, building, dam, pipeline,
road etc. Construction contracts also include contract for rendering services relating
to construction of assets (e.g. :- service of architect) & contracts for destruction or
restoration of asset & restoration of environment following demolition of asset.
3. TYPES OF CONSTRUCTION CONTRACTS :

Construction contracts are of the following 2 types:
a. Fixed price construction contracts : are those in which parties agree to a fixed
price or fixed rate per unit & in some cases subject to escalation clause
b. Cost plus construction contracts : are those which involves reimbursement of
defined costs plus a percentage of such cost or a fixed fee.
Cost plus contracts involving a maximum ceiling would bear the characteristics
of both the above types.
4. ADDITIONAL ASSET :
Construction contracts may provide for construction of additional asset at the option
of the customer. The construction of additional asset should be treated as a
separate contract if the asset differs significantly from the asset covered by
the original contract & the price of the additional asset is independent of the
original contract price.
5. PROFIT OR LOSS ON CONTRACT :

Profit / Loss is to be calculated for each contract separately but when a group of
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contracts have been negotiated as a single package with an overall profit margin
then all such contracts put together would be treated as a singlecontract.
To calculate the contract profit/loss, contract revenue & costs must be calculated.
 Contract revenue consists of :
a. Agreed price
b. Claims arising due to escalation clause
c. Claims for re-imbursement of costs not included in the contract price
d. Increase or decrease in revenue due to change or variation in scope of
work to be performed
e. Incentives (additional amounts paid if performance exceeds agreed
targets)
 Contract costs consists of the following :

a. Direct or specific costs : Direct materials, direct labour & direct expenses
b. Allocable costs : Insurance, design & technical assistance expenditure
etc. specifically chargeable under the contract
 Following costs are excluded from contract costs :

a. General administration cost
b. Selling costs
c. R & D costs
d. Depreciation on idle plant & equipment
 Costs incurred in securing contracts & pre-contract costs are included in the
contract costs if it is probable that contract will be obtained. Otherwise they
should be charged to the General P & L A/c.
 Interest cost can be included in contract costs if the asset is a qualifying asset
as per AS – 16.
6. RECOGNITION OF CONTRACT COST & REVENUE :

When the outcome of the contract can be estimated reliably then contract revenue
& related costs are recognized as revenue & costs by reference to the stage of
completion of the contract activity at the Balance Sheet date. This is also called
Percentage Completion Method (PCM). The stage of completion can be determined in
a variety of ways:
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a. Cost to cost method: Compare the total cost incurred to date with the total
estimated cost of the contract. Therefore,
cost incurred till date
% of completion = x 100
(cost incurred till date + cost likely to be
incurred for completion)
b. Survey of work performed
c. Completion of a physical proportion of the contract work.
 Contract revenue recognition = Contract price * % of completion – Revenue
recognized earlier.
7. PROVISION FOR EXPECTED LOSS :

When it is probable that total contract costs will exceed total contract revenue, expected
loss should be recognized as an expense immediately irrespective of
a. Whether or not work has commenced
b. The stage of completion
c. The amount of profit on other contracts which are not treated as a single contract
8. When the outcome of a contract cannot be reliably estimated then revenue should
be recognized only to the extent of costs incurred & of which recovery is possible.
Recognition of revenue & expenditure in construction contracts is based on estimates.
Changes in estimates in year- to-year are accounted as a change in accounting
estimate as per AS 5. This change will neither be a PPI nor an extra-ordinary item.
9. DISCLOSURE :
An enterprise should disclose the method used to determine the stage of completion
& method used to determine contract revenue. In addition to the policy disclosure,
the following disclosures are also required :
a. Amount of contract revenue recognized during the period
b. Contract cost incurred & recognition of profit
c. Advance received
d. Gross amount due to / from customers (Costs Incurred = + Recognised Profit -
Recognised Losses - Progressive Billing)
e. Gross amount due to customers (Progressive Billing + Recognised Losses -
Recognised Profit - Costs Incurred)
f. Retentions
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CLASSWORK QUESTIONS
Question 1
M/s Highway .Constructions undertook the construction of a highway on 01.04.2013. The
contract was to be completed in 2 years. The contract price was estimated at ` 150
crores. Up to 31.03.2014 the company incurred ` 120 crores on the construction. The
engineers involved in the project estimated that a further ` 45 crores would be incurred
for completing the work.
What amount should be charged to revenue for the year 2013-14 as per the provisions
of Accounting Standard 7 "Construction Contracts"? Show the extract of the Profit & Loss
A/c in the books of M/s. Highway Constructions.
Question 2
Akar Ltd. Signed on 01/04/16, a construction contract for ` 1,50,00,000. Following
particulars are extracted in respect of contract, for the period ending 31/03/17.
- Materials issued ` 75,00,000
- Labour charges paid ` 36,00,000
- Hire charges of plant ` 10,00,000
- Other contract cost incurred ` 15,00,000
- Out of material issued, material lying unused at the end of period is ` 4,00,000
- Labour charges of ` 2,00,000 are still outstanding on 31.3.17.
- It is estimated that by spending further ` 33,50,000 the work can be completed in
all respect.
You are required to compute profit/loss to be taken to Profit & Loss Account and
additional provision for foreseeable loss as per AS-7.
Question 3
A construction contractor has a fixed price contract for ` 9,000 lacs to build a bridge in 3
years’ time frame. A summary of some of the financial data is as under:
(Amount ` in lacs)
Year 1 Year 2 Year 3
Initial Amount for revenue agreed in contract 9,000 9,000 9,000
Variation in Revenue (+) - 200 200
Contracts costs incurred up to the reporting 2,093 6,168* 8,100**
date 950 1,000 1,000
Estimated profit for whole contract
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* Includes ` 100 lacs for standard materials stored at the site to be used in year 3 to
complete the work.
** Excludes ` 100 lacs for standard material brought forward from year 2.
The variation in cost and revenue in year 2 has been approved by customer.
Compute year wise amount of revenue, expenses, contract cost to complete and profit or
loss to be recognized in the Statement of Profit and Loss as per AS-7 (revised).
Question 4
Mr. Shyam, a construction contractor undertakes the construction of an industrial complex.
He has separate proposals raised for each unit to be constructed in the industrial complex.
Since each unit is subject to separate negotiation, he is able to identify the costs and
revenues attributable to each unit. Should Mr. Shyam treat construction of each unit as a
separate construction contract according to AS 7?
CLASSWORK SOLUTIONS
Answer 4
As per AS 7 ‘Construction Contracts’, when a contract covers a number of assets, the
construction of each asset should be treated as a separate construction contract when:
(a) Separate proposals have been submitted for each asset;
(b) Each asset has been subject to separate negotiation and the contractor and customer
have been able to accept or reject that part of the contract relating to each asset;
and
(c) The costs and revenues of each asset can be identified.
Therefore, Mr. Shyam is required to treat construction of each unit as a separate
construction contract.
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HOMEWORK SECTION
Question 1
M/s Excellent Construction Company Limited undertook a contract to construct a building
for ` 3 crore on 1st September, 2014. On 31st March, 2015 the company found that it
had already spent ` 1 crore 80 lakhs on the construction. Prudent estimate of additional
cost for completion was ` 1 crore 40 lakhs. What amount should be charged, to revenue
in the final accounts for the year ended on 31st March, 2015, as per the provisions of
Accounting Standard 7 "Construction Contracts (Revised)"?
Answer
` in crores
Cost of construction incurred till date 1.80
Add: Estimated future cost 1.40
Total estimated cost of construction 3.20
Percentage of completion till date to total estimated cost of construction

= (1.80/3.20) `100 = 56.25%
Proportion of total contract value recognised as revenue as per AS 7 (Revised)
= Contract price x percentage of completion
= ` 3 crores x 56.25% = ` 1.6875 crores
Amount of foreseeable loss (` in crores)

Total cost of construction 3.20
Less: Total contract price (3.00)
Total foreseeable loss to be recognized as expense 0.20
According to of AS 7 (Revised 2002), when it is probable that total contract costs will
exceed total contract revenue, the expected loss should be recognized as an expense
immediately.
Question 2
B Ltd. undertook a construction contract for ` 50 crores in April, 2014. The cost of
construction was initially estimated at ` 35 crores. The contract is to be completed in
3 years. While executing the contract, the company estimated the cost of completion of
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the contract at ` 53 crores. Can the company provide for the expected loss in the book of
account for the year ended 31st March, 2015?
Answer
As per para 35 of AS 7 “Construction Contracts”, when it is probable that total contract
costs will exceed total contract revenue, the expected loss should be recognised as an
expense immediately. Therefore, The foreseeable loss of ` 3 crores (` 53 crores less ` 50
crores) should be recognised as an expense immediately in the year ended 31st March,
2015. The amount of loss is determined irrespective of
(i) Whether or not work has commenced on the contract;
(ii) Stage of completion of contract activity; or
The amount of profits expected to arise on other contracts which are not treated as a
single construction contract in accordance with para 8 of AS 7.
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PAST PAPER SECTION
Question 1
An amount of ` 9,90,000 was incurred on a contract work up to 31-3-2010. Certificates
have been received to date to the value of ` 12,00,000 against which ` 10,80,000 has
been received in cash. The cost of work done but not certified amounted to ` 22,500. It
is estimated that by spending an additional amount of ` 60,000 (including provision for
contingencies) the work can be completed in all respects in another two months. The
agreed contract price of work is ` 12,50,000. Compute a conservative estimate of the
profit to be taken to the Profit and Loss Account as per AS-7.
(Nov’10)
Answer
`
Expenditure incurred upto 31.3.2010 9,90,000
Estimated additional expenses (including provision for contingency) 60,000
Estimated cost (A) 10,50,000
Contract price (B) 12,50,000
Total estimated profit [(B-A)] 2,00,000
Percentage of completion (9,90,000 / 10,50,000) x 100 94.29%
Computation of estimate of the profit to be taken to Profit and Loss Account:
Expenses incurred till 31.3.2010

Total estimated profit X
Total estimated cost

9,90,000
2,00,000 X = `1,88,571
10,50,000

According to para 21 of AS 7 ‘Construction Contracts’, when the outcome of a construction

contract can be estimated reliably, contract revenue and contract costs associated with
the construction contract should be recognised as revenue and expenses respectively
by reference to stage of completion of the contract activity at the reporting date. Thus
estimated profit amounting ` 1,88,571 should be recognised as revenue in the statement
of profit and loss.
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Question 2
From the following data, show Profit and Loss A/c (Extract) as would appear in the books
of a contractor following Accounting Standard-7:
(` in lakhs)
Contract Price (fixed) 480.00
Cost incurred to date 300.00
Estimated cost to complete 200.00 (Nov’11)
Answer
(a) Calculation of Estimated Total Cost
(` in lakhs)
Cost incurred to date 300
Estimate of cost to completion 200
Estimated total cost in completing the contract 500
Percentage of completion (300/500) x 100 = 60% Revenue recognised as a percentage

to contract price
= 60% of ` 480 lakhs = ` 288 lakhs
As per para 35 of AS 7 ‘Construction Contracts’, when it is probable that total contract
costs will exceed total contract revenue, the expected loss should be recognised as
an expense immediately. Accordingly, expenses to be recognized in the Profit and
Loss Account will be
(` in lakhs)
Total foreseeable loss (500-480) 20
Less: Loss for the current year (300-288) (12)
Expected loss to be recognized immediately as per para 35 of AS 7 8
Profit and Loss A/c (An Extract)

To Construction cost 300 By Contract price 288
To Estimated loss on completion of
Contract 8
Question 3
M/s Excellent Construction Company Limited undertook a contract to construct a building
for ` 3 Crore on 1st September, 2011. On 31st March, 2012 the company found that it
had already spent ` 1 Crore 80 Lakhs on the construction. Prudent estimate of additional
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cost for completion was ` 1 Crore 40 Lakhs. What amount should be charged, to revenue
in the final accounts for the year ended on 31st March, 2012, as per the provisions of
Accounting Standard 7 “Construction Contracts (Revised)”?
(May’12)
Answer
(a) Calculation of Estimated Cost of Construction
` in crores
Percentage of completion of contract till date to total estimated cost of construction

= ` (1.80/3.20)100 = 56.25%
Proportion of total contract value recognised as revenue as per AS 7 (Revised)
= ` 3 crores x 56.25% = `1.6875 crores
Question 4
Uday Constructions undertake to construct a bridge for the Government of Uttar Pradesh.
The construction commenced during the financial year ending 31.03.2016 and is likely to
be completed by the next financial year. The contract is for a fixed price of ` 12 crores with
an escalation clause. The costs to complete the whole contract are estimated at ` 9.50
crores of rupees. You are given the following information for the year ended 31.03.2016:
Cost incurred up to 31.03.2016 `4 crores
Cost estimated to complete the contract `6 crores
Escalation in cost by 5% and accordingly the contract price is increased by 5%. You are
required to ascertain the state of completion and state the revenue and profit to
be recognized for the year as per AS-7. (May’16)
Answer
Cost of construction of bridge incurred 31.3.16 4.00
Contract Price (12 crore x 1.05) 12.60 crore
Stage of completion Percentage of completion till date to total estimated cost of
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construction = (4/10)×100 = 40% Revenue and Profit to be recognized for the year ended
31st March, 2016 as per AS 7 Proportion of total contract value recognized as revenue =
Contract price x percentage of completion =` 12.60 crore x 40% =` 5.04 crore
Profit for the year ended 31st March, 2016 = ` 5.04 crore less ` 4 crore = 1.04 crore
Question 5
Akar Ltd. signed on 01/04/16, a construction contract for ` 1,50,00,000. Following
particulars are extracted in respect of contract, for the period ending 31/03/17.
 Materials issued `75,00,000
 Labour charges paid `36,00,000
 Hire charges of plant `10,00,000
 Other contract cost incurred `15,00,000
 Out of material issued, material lying unused at the end of period is `4,00,000
 Labour charges of `2,00,000 are still outstanding on 31.3.17.
 It is estimated that by spending further ` 33,50,000 the work can be completed in
all respect.
You are required to compute profit/loss to be taken to Profit & Loss Account and additional
provision for foreseeable loss as per AS – 7. (May’17)
Answer
Statement showing the amount of profit/loss to be taken to Profit and Loss Account
and additional provision for the foreseeable loss as per AS 7
Cost of Construction `
Material Issued 75,00,000
Less: Unused Material at the end of period 4,00,000 71,00,000
Labour Charges paid 36,00,000
Add: Outstanding on 31.03.2017 2,00,000 38,00,000
Hire Charges of Plant 10,00,000
Other Contract cost incurred 15,00,000
Cost incurred upto 31.03.2017 1,34,00,000
Add: Estimated future cost* 33,50,000
Total Estimated cost of construction 1,67,50,000
Degree of completion (1,34,00,000/1,67,50,000 x 100) 80%
Revenue recognized (80% of 1,50,00,000) 1,20,00,000
Total foreseeable loss (1,67,50,000 - 1,50,00,000) 17,50,000
Less: Loss for the current year (1,34,00,000 - 1,20,00,000) 14,00,000
Loss to be provided for 3,50,000
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Question 6
M/s Action Construction Company Ltd. undertook a fixed price construction contract to
construct a building within 3 year’s time for `10,000 lakhs.
A summary of the financial data during the construction period is as follows:
(` in lakhs)
Initial amount for revenue agreed in contract 10,000 10,000 10,000
Variation in Revenue (+) - 500 1,000
Contract costs incurred up to the reporting date 2,415 6,375 8,500
Estimated profit for whole contract 1,950 2,000 2,500
The variation in cost and revenue in year 2 and 3 has been approved by customer.
Determine the stage of completion of contract and amount of revenue, expenses and
profit or loss to be recognised in the statement of Profit and Loss for three years as per
AS-7 (Revised). (Nov’18)
Answer
The amounts of revenue, expenses and profit recognized in the statement of profit
and loss in three years are computed below:
Up to the Recognized in Recognized in
reporting previous current year
date years
Year 1
Revenue (10,000 x30%) 3,000 - 3,000
Expenses (8,050 x 30%) 2,415 - 2,415
Profit 585 - 585
Year 2
Revenue (10,500 x75%) 7,875 3,000 4,875
Expenses (8,500 x 75%) 6,375 2,415 3,960
Profit 1,500 585 915
Year 3
Revenue (11,000 x 100%) 11,000 7,875 3,125
Expenses (8,500 x 100%) 8,500 6,375 2,125
Profit 2,500 1,500 1,000
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Working Note - Calculation of stage of completion of contract

Revenue after considering variations 10,000 10,500 11,000
Less: Estimated profit for whole contract 1,950 2,000 2,500
Estimated total cost of the contract (A) 8,050 8,500 8,500
Actual cost incurred upto the reporting date (B) 2,415 6,375 8,500
Degree of completion (B/A) 30% 75% 100%
Question 7
Sarita Construction Co obtained a contract for construction of a dam. The following
details are available in records of company for the year ended 31st March, 2018:
` in lakhs
Total Contract Price 12,000
Work Certified 6,250
Work not certified 1,250
Estimated further cost to completion 8,750
Progress payment received 5,500
Progress payment to be received 1,500
Applying the provisions of Accounting Standard 7 "Accounting for Construction

Contracts" you are required to compute:
(i) Profit/Loss for the year ended 31st March, 2018.
(ii) Contract work in progress as at end of financial year 2017-18.
(iii) Revenue to be recognized out of the total contract value.
(iv) Amount due from/to customers as at the year end.
(May’18)
Answer
(i) Loss for the year ended, 31st March, 2018 (` in lakhs)
Amount of foreseeable loss
Total cost of construction (6,250 + 1,250 + 8,750) 16,250
Less: Total contract price (12,000)
Total foreseeable loss to be recognised as expense 4,250
According to AS 7, when it is probable that total contract costs will exceed total
contract revenue, the expected loss should be recognised as an expense immediately.
Loss for the year ended, 31st March, 2018 amounting ` 4,250 will be recognized.
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(ii) Contract work-in-progress as on 31.3.18 (` in lakhs)

Contract work-in-progress i.e. cost incurred to date are `
7,500 lakhs:
Work certified 6,250
Work not certified 1,250
7,500
(iii) Proportion of total contract value recognised as revenue

Cost incurred till 31.3.18 is 46.15% (7,500/16,250 x 100) of total costs of construction.
Proportion of total contract value recognised as revenue: 46.15% of ` 12,000 lakhs
= ` 5,538 lakhs
(iv) Amount due from/to customers at year end
(Contract costs + Recognised profits – Recognised Losses) – (Progress payments
received + Progress payments to be received)
= (7,500 + Nil – 4,250) – (5,500 + 1,500) ` in lakhs
= [3,250 – 7,000] ` in lakhs
Amount due to customers = ` 3,750 lakhs
Question 8
Shyan Limited commenced a construction contract on 01-04-2018. The company
expended ` 500 crores in 2018-19 for 40% work. The total estimated cost of the
project is ` 1,250 crores. Compute (i) Revenue, (ii) Expense, (iii) Provision for loss and
(iv) Profit or loss to be recognized in the statement of Profit and Loss A/c
as per AS-7 for the year ending 31-03-2019 if:
(1) It is fixed price contract of ` 1,200 crores.
(2) It is cost plus contract of 20%. (Nov’ 19)
Answer
1. If it is a fixed price contract of ` 1,200 crores
Percentage of completion till date to total estimated cost of construction = 40%
(` in crores)
i Revenue (` 1,200 crores x 40%) 480
ii Expenses 500
iii Provision for loss (Refer Working note) 30
iv Loss 50
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2. If it is a cost-plus contract of 20%

(` in crores)
i Revenue (500 crores x120%) 600
ii Expenses 500
iii Provision for loss Nil
iv Profit 100
Working Note:
Calculation of provision for loss in case of fixed price contract
Amount of foreseeable loss (` in crores)
Total cost of construction 1,250
Less: Total contract price (1,200)
Amount of foreseeable loss 50
Loss for current year [500 – 480 (` 1,200 crores x 40%)] (20)
Expected loss to be recognized immediately 30
According to AS 7, when it is probable that total contract costs will exceed total contract
revenue, the expected loss should be recognized as an expense immediately.
Question 9
On 1st December, 2019, Mahindra Construction Co. Ltd. undertook a contract to construct
a building for ` 170 lakhs. On 31st March, 2020, the company found that it had already
spent ` 1,29,98,000..on the construction. Prudent estimate of additional cost for
completion was ` 64,02,000. Calculate total estimated loss on contract and what should
be charged to statement of profit and loss account as contract revenue and contract cost
in the final accounts for the year ended 31st March, 2020, as per provision of Accounting
Standard 7 (Revised). (Nov’ 20)
Question 10
(i) AP Ltd., a construction contractor, undertakes the construction of commercial
complex for Kay Ltd. AP Ltd. submitted separate proposals for each of 3 units of
commercial complex. A single agreement is entered into between the two parties.
The agreement lays down the value of each of the 3 units, i.e. ` 50 Lakh ` 60 Lakh
and ` 75 Lakh respectively. Agreement also lays down the completion time for each
unit.
omment, with reference to AS- 7, whether AP Ltd., should treat it as a single contract
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or three separate contracts.

(ii) On 1st December, 2017, GR Construction Co. Ltd. undertook a contract to construct
a building for ` 45 lakhs. On 31st March, 2018, the company found that it had
already spent ` 32.50 lakhs on the construction. Additional cost of completion is
estimated at ` 15.10 lakhs. What amount should be charged to revenue in the final
accounts for the year ended 31st March, 2018 as per provisions of AS-7?
Answer
(i) As per AS 7 ‘Construction Contracts’, when a contract covers a number of assets, the
construction of each asset should be treated as a separate construction contract
when:
(a) separate proposals have been submitted for each asset;
(b) each asset has been subject to separate negotiation and the contractor and
customer have been able to accept or reject that part of the contract relating
to each asset; and
(c) the costs and revenues of each asset can be identified.
Therefore, Mr. AP Ltd. is required to treat construction of each unit as a separate
construction contract as the above-mentioned conditions of AS 7 are fulfilled in the
given case.
` in lakhs
Percentage of completion till date to total estimated cost of construction

= (32.50/47.60) x 100 = 68.28%
Proportion of total contract value recognised as revenue for the year ended 3 1 s t
March, 2018 per AS 7 (Revised)
= ` 45 lakh x 68.28% = ` 30.73 lakhs.
` in lakhs
Total cost of construction 47.60
Less: Total contract price (45.00)
Total foreseeable loss to be recognized as expense 2.60
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According to of AS 7, when it is probable that total contract costs will exceed total
contract revenue, the expected loss should be recognized as an expense immediately.
Question 11
Rajendra undertook a contract for ` 20,00,000 on an arrangement that 80% of the value
of work done as certified by the architect of the contractee, should be paid immediately
and that the remaining 20% be retained until the Contract was completed.
In Year 1, the amounts expended were ` 8,60,000, the work was certified for` 8,00,000
and 80% of this was paid as agreed. It was estimated that future expenditure to complete
the Contract would be ` 10,00,000.
In Year 2, the amounts expended were ` 4,75,000. Three-fourths of the Contract was
certified as done by December 31st and 80% of this was received accordingly. It was
estimated that future expenditure to complete the Contract would be ` 4,00,000.
In Year 3, the amounts expended were ` 3,10,000 and on June 30th, the whole Contract
was completed.
Show how Contract revenue would be recognized in the P & L A/c of Mr. Rajendra each
year. (Nov’ 20)
Answer
(a) Year 1
Actual expenditure 8,60,000
Future estimated expenditure 10,00,000
Total Expenditure 18,60,000
18,60,000
% of work completed = x 100 = 46.24% (rounded off)
18,60,000
Revenue to be recognized = 20,00,000 x 46.24%

= ` 9,24,800
Year 2
Actual expenditure 4,75,000
Future Expenditure 4,00,000
Expenditure incurred in Year 1 6,60,000
17,35,000
% of work completed
4,75,00+8,60,000
= =76.95% (rounded off)
17,35,000
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Revenue to be recognized (cumulative) = 20,00,000 x 76.95%

= 15,39,000
Less : revenue recognized in Year 1 = (9,24,800)
Revenue to be recognised in Year 2 ` 6,14,200

Year 3
Whole contract got completed therefore total contract value less revenue recognized up
to year 2 will be amount of revenue to be recognized in year 3 i.e. 20,00,000 – 15,39,000
(9,24,800 + 6,14,200) = ` 4,61,000.
Note: Calendar year has been considered as accounting year.
Question 12
The following data is provided for M/s. Raj Construction Co.
(i) Contract Price - ` 85 lakhs
(ii) Materials issued - ` 21 Lakhs out of which Materials costing ` 4 Lakhs is still lying
unused at the end of the period.
(iii) Labour Expenses for workers engaged at site - ` 16 Lakhs (out of which ` 1 Lakh is
still unpaid)
(iv) Specific Contract Costs - ` 5 Lakhs
(v) Sub-Contract Costs for work executed - ` 7 Lakhs, Advances paid to sub-contractors
- ` 4 Lakhs
(vi) Further Cost estimated to be incurred to complete the contract - ` 35 Lakhs
You are required to compute the Percentage of Completion, the Contract Revenue and
Cost to be recognized as per AS-7. (July 21)
Question 13
Grace Ltd., a firm of contractors provided the following information in respect of a contract
for the year ended on 31st March, 2022:
Particulars (` in ‘ 000)
Fixed Contract Price with an escalation clause 35,000
Work Certified 17,500
Work not Certified (includes ` 26,25,000 for materials issues, out of 3,815
which material lying unused at the end of the period is ` 1,40,000)
Estimated further cost to completion 17,325
Progress Payment Received 14,000
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Payment to be Received 4,900

Escalation in cost is by 8% and accordingly the contract price is increased
by 8%
From the above information, you are required to:
(i) Compute the contract revenue to be recognised,
(ii) Calculate Profit/Loss for the year ended 31st March, 2022 and additional
provision for loss to be made, if any, for the year ended 31st March, 2022.
(May 22)
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REVISION QUESTIONS
Question 1
On 1st December, 2016, Vishwakarma Construction Co. Ltd. undertook a contract to
construct a building for ` 85 lakhs. On 31st March, 2017, the company found that it had
already spent ` 64,99,000 on the construction. Prudent estimate of additional cost for
completion was ` 32,01,000. What amount should be charged to revenue in the final
accounts for the year ended 31st March, 2017 as per provisions of Accounting Standard
7 (Revised)?
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AS 9 - REVENUE RECOGNITION
1. WHY AS 9?
It is basically concerned with the "timing of recognition" in the statement of Profit
and Loss. It lays down criteria for recognition of revenue most suited to preparers of
FS of enterprises engaged in varied activities.
2. WHAT IS REVENUE?
Revenue means the gross inflow of cash, receivable or other consideration arising
in the course of ordinary activities of an enterprise from sale of goods, from the
rendering of services and from the use by others of the resources of the enterprise
yielding interest, royalties and dividend.
3. COMMON ELEMENTS FOR RECOGNITION OF REVENUE:

To all these three groups aforesaid, there are two common elements. It is imperative
to seek answers to two questions.
• No significant uncertainty exists regarding the amount of the consideration
that will be derived (MEASURABILITY)
• Are we certain that the amount will be received? (COLLECTABILITY)
NOTE:
a. If Consideration is not measurable
Consideration receivable for sale of goods or for rendering of services should be
determinable. When such consideration is not determinable within reasonable
lim- its, revenue recognition will be postponed.
b. If collectability isuncertain
When there is uncertainty about the collection of revenue even at the time
when claim is raised recognition must be postponed to the extent of uncertainty
involved. In such cases, it may be appropriate to recognize revenue only when
it is reasonably certain that the ultimate collection will be made.
Where there is no uncertainty as to ultimate collection, revenue is recognized
at the time of sale or rendering of service even though payments are made by
installments.
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c. Effect of postponement
When recognition of revenue is postponed due to the effect of uncertainties', the
amount is considered as revenue of the period in which it is properly recognized.
d. Uncertainty arises later - make a provision(Do not adjust revenue)
When a transaction was concluded initially, the collectability was certain.
Revenue, therefore, stood recognized. Subsequent to sale or rendering of the
service, and at a much later date, the collectability of consideration is rendered
uncertain. In such a situation, it is more appropriate to make a separate
provision to reflect the uncertainty rather than to adjust the amount of revenue
originally recorded.
4. SALE OF GOODS:
Revenue is to be recognized when the following conditions are satisfied:
a. The seller has transferred to the buyer the property in goods for a consideration,
OR
b. Significant risks and rewards of ownership have been transferred to the buyer
AND
c. No significant uncertainty exists regarding the amount of consideration that
will be derived from the sale of goods.
5. RENDERING OF SERVICES :
The Standard prescribes two methods:
a. COMPLETED SERVICE CONTRACT METHOD:
Performance in a service contract may consist of
(i) one single act
(ii) or more than one act, where services not performed are significant enough
in relation to all transaction taken as whole. Under such conditions,
performance is not deemed complete and service is not chargeable unless
all the transactions are completed.
Revenue is recognized only when the SOLE or FINAL act takes place and
the service becomes chargeable.
b. PROPORTIONATE COMPLETION METHOD:

This method evolved out of accrual concept - is to be applied when performance
consists of execution of more than one act. Revenue is to be recognized proportionately
by reference to the performance of each act.
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Revenue is recognized when EACH independent act takes place and the proportionate
service becomes chargeable.
6. OTHER INCOME:
a. INTEREST:
Revenue must be recognized on time proportion basis.
b. ROYALTIES:
Revenue is recognized on accrual basis in accordance with the terms of relevant
agreement.
c. DIVIDENDS:
Revenue is to be recognized only when the owner's right to receive payment is
established (When dividends are DECLARED)
EXCEPTION: When interest, royalties and dividends are receivable from other
countries which requires forex permission, revenue recognition has to be on CASH
BASIS.
383
CLASSWORK QUESTIONS
Question 1
M/s Prima Co ltd sold goods worth ` 50,000 to M/s Y and Company. Y and Co asked for
discount of ` 8,000 which was agreed by M/s Prima Co. Ltd the sale was effected and
goods were dispatched. After receiving the consignment, goods worth ` 7,000 are found
defective, which were returned immediately. They made a payment of ` 35,000 to M/s
Prima Co. Ltd Accountant booked the sales for ` 35,000. Please Discuss
Question 2
Y Co. Ltd., used certain resources of X Co. Ltd. In return X Co. Ltd. Received ` 10 lakhs and
` 15 lakhs as interest and royalties respectively from Y Co. Ltd. during the year 2005-06.
You are required to state whether and on what basis these revenues can be recognised
by X Co. Ltd, as per AS-9.
Question 3
X Limited has recognized ` 10 lakhs on accrual basis income from dividend on units of
mutual funds of the face value of ` 50 lakhs held by it as at the end of the financial year
31st March, 2003. The dividends on mutual funds were declared at the rate of 20% on
15th April, 2003. The dividend was proposed on 10th March, 2003 by the mutual funds.
Whether the treatment is as per the relevant Accounting Standard? You are asked to
answer with reference to provisions of Accounting Standard.
Question 4
The Board of Directors of X Ltd. decided on 31.3.2007 to increase sale price of certain
items of goods sold retrospectively from 1st January, 2007. As a result of this decision
the company has to receive ` 5 lakhs from its customers in respect of sales made from
1.1.2007 to 31.3.2007. But the Company’s Accountant was reluctant to make-up his
mind. You are asked to offer your suggestion.
Question 5
A Ltd. entered into a contract with B Ltd. to dispatch goods valuing
`25,000 every month for 4 months upon receipt of entire payment. B Ltd. accordingly
made the payment of ` 1,00,000 and A Ltd. started dispatching goods. In third month,
due to a natural calamity, B Ltd. requested A Ltd. not to dispatch goods until further
notice though A Ltd. is holding the remaining goods worth ` 50,000 ready for dispatch. A
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Ltd. accounted ` 50,000 as sales and transferred the balance to advance received against
sales. Comment upon the treatment of balance amount with reference to the provisions
of accounting standard 9.
Question 6
Arjun Ltd. sold farm equipment’s through its dealers. One of the conditions at the time of
sale is payment of consideration in 14 days and in the event of delay interest is chargeable
@ 15% per annum. The Company has not realized interest from the dealers in the past.
However, for the year ended 31.3.2015, it wants to recognise interest due on the balances
due from dealers. The amount is ascertained at ` 9 lakhs. Decide, whether the income by
way of interest from dealers is eligible for recognition as per AS 9?
385
CLASSWORK SOLUTIONS
Answer 1
As per Para 4.1 of AS 9 “Revenue Recognition”, revenue is the gross inflow of cash,
receivables or other consideration arising in the course of the ordinary activities of an
enterprise from the sale of goods, from the rendering of services, and from the use by
others of enterprise resources yielding interest, royalties and dividends. In the given case,
M/s Prima Co. Ltd. Should record the sales at gross value of ` 50,000. Discount of ` 8,000
in price and goods returned worth ` 7,000 are to be adjusted by suitable provisions. M/s
Prime Co. Ltd. might have sent the credit note of ` 15,000 to M/s Y & Co. to account for
these adjustments. The contention of the accountant to book the sales for ` 35,000 is not
correct.
Answer 2
As per para 13 of AS 9 on Revenue Recognition, revenue arising from the use by others
of enterprise resources yielding interest & royalties should only be recognised when no
significant uncertainty as to measurability or collectability exists.
These revenues are recognised on the following bases:
1) Interest: on a time proportion basis taking into account the amount outstanding and
the rate applicable.
2) Royalties: on an accrual basis in accordance with the terms of the relevant agreement.
Answer 3
Paragraph 8.4 and 13 of Accounting Standard 9 on Revenue Recognition states that
dividends from investments in shares are not recognised in the statement of profit and
loss until a right to receive payment is established.
In the given case, the dividend is proposed on 10th March, 2003, while it is declared
on 15th April, 2003. Hence, the right to receive payment is established on 15th April,
2003. As per the above mentioned paragraphs, income from dividend on units of mutual
funds should be recognised by X Ltd. in the financial year ended 31st March, 2004. The
recognition of ` 10 lakhs on accrual basis in the financial year 2002-2003 is not as per
AS 9 'Revenue Recognition'.
Answer 4
As per para 10 of AS 9 ‘Revenue Recognition’, the additional revenue on account of increase
in sales price with retrospective effect, as decided by Board of Directors of X Ltd., of ` 5
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lakhs to be recognised as income for financial year 2006-07, only if the company is able
to assess the ultimate collection with reasonable certainty. If at the time of raising of
any claim it is unreasonable to expect ultimate collection, revenue recognition should be
postponed.
Answer 5
According to AS- 9, In case of sale of goods, the physical delivery of goods is not important
for revenue recognition. What is relevant is transfer of significant risk & reward. Where
delivery is delayed at buyer’s request and buyer takes title and accepts billing. Revenue
should be recognized notwithstanding that physical delivery has not been completed so
long as there is every expectation that delivery will be made. However, the item must be
on hand, identified and ready for delivery to the buyer at the time the sale is recognized
rather than there being simply an intention to acquire or manufacture the goods in time
for delivery.
Here in this case on the request of B Ltd., goods worth `50,000 ready for dispatch but are
held with A Ltd. until further notice is received from B Ltd. for its delivery.
Therefore A Ltd. will recognize ` 50,000 as its revenue for that period.
Answer 6 :
As per AS 9 “Revenue Recognition”, where the ability to assess the ultimate collection with
reasonable certainty is lacking at the time of raising any claim, the revenue recognition is
postponed to the extent of uncertainty inverted. In such cases, the revenue is recognized
only when it is reasonably certain that the ultimate collection will be made. In this case,
the company never realized interest for the delayed payments make by the dealers.
Hence, it has to recognize the interest only if the ultimate collection is certain. The interest
income hence is not to be recognized
387
HOMEWORK SECTION
Question 1
M/s. Moon Ltd. sold goods worth ` 6, 50,000 to Mr. Star. Mr. Star asked for a trade
discount amounting to ` 53,000 and same was agreed to by M/s. Moon Ltd. The sale
was effected and goods were dispatched. On receipt of goods, Mr. Star has found that
goods worth ` 67,000 are defective. Mr. Star returned defective goods to M/s. Moon Ltd.
and made payment due amounting to ` 5, 30,000. The accountant of M/s. Moon Ltd.
booked the sale for ` 5, 30,000. Discuss the contention of the accountant with reference
to Accounting Standard (AS) 9.
Answer
As per AS 9 „Revenue Recognition", revenue is the gross inflow of cash, receivable or other
consideration arising in the course of the ordinary activities of an enterprise from the
sale of goods. However, trade discounts and volume rebates given in the ordinary course
of business should be deducted in determining revenue. Revenue from sales should be
recognized at the time of transfer of significant risks and rewards. If the delivery of the
sales is not subject to approval from customers, then the transfer of significant risks and
rewards would take place when the sale is affected and goods are dispatched.
In the given case, if trade discounts allowed by M/s. Moon Ltd. are given in the ordinary
course of business, M/s. Moon Ltd. should record the sales at ` 5,97,000 (i.e. ` 6,50,000
– ` 53,000) and goods returned worth ` 67,000 are to be recorded in the form of sales
return. However, when trade discount allowed by M/s. Moon Ltd. is not in the ordinary
course of business, M/s. Moon Ltd. should record the sales at gross value of ` 6,50,000.
Discount of ` 53,000 in price and return of goods worth ` 67,000 are to be adjusted by
suitable provisions. M/s Moon Ltd. might have sent the credit note of ` 1,20,000 to Mr.
Star to account for these adjustments. In both the cases, the contention of the accountant
to book the sales for ` 5,30,000 is not correct
Question 2
Sarita Publications publishes a monthly magazine on the 15th of every month. It sells
advertising space in the magazine to advertisers on the terms of 80% sale value payable
in advance and the balance within 30 days of the release of the publication. The sale of
space for the March 2014 issue was made in February 2014. The magazine was published
on its scheduled date. It received ` 2, 40,000 on 10.3.2014 and ` 60,000 on 10.4.2014 for
the March 2014 issue. Discuss in the context of AS 9
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the amount of revenue to be recognized and the treatment of the amount received from
advertisers for the year ending 31.3.2014. What will be the treatment if the publication
is delayed till 2.4.2014?
Answer
As per para 12 of AS 9 „Revenue Recognition", „In a transaction involving the rendering of
services, performance should be measured either under the completed service contract
method or under the proportionate completion method, whichever relates the revenue
to the work accomplished".
In the given case, income accrues when the related advertisement appears before
public. The advertisement service would be considered as performed on the day the
advertisement is seen by public and hence revenue is recognized on that date. In this
case, it is 15.03.2014, the date of publication of the magazine.
Hence, ` 3,00,000 (` 2,40,000 + ` 60,000) is recognized as income in March, 2014. The
terms of payment are not relevant for considering the date on which revenue is to be
recognized. ` 60,000 is treated as amount due from advertisers as on 31.03.2014 and `
2,40,000 will be treated as payment received against the sale.
However, if the publication is delayed till 02.04.2014 revenue recognition will also be
delayed till the advertisements get published in the magazine. In that case revenue of `
3,00,000 will be recognized for the year ended 31.03.2015 after the magazine is published
on 02.04.2014. The amount received from sale of advertising space on 10.03.2014 of `
2,40,000 will be considered as an advance from advertisers for the year ended 31st
March, 2014.
Question 3
Given the following information of M/s. Paper Products Ltd.
(i) Goods of ` 60,000 were sold on 20-3-2015 but at the request of the buyer these
were delivered on 10-4-2015.
(ii) On 15-1-2015 goods of ` 1, 50,000 were sent on consignment basis of which 20%
of the goods unsold are lying with the consignee as on 31-3-2015.
(iii) ` 1, 20,000 worth of goods were sold on approval basis on 1-12-2014. The period of
approval was 3 months after which they were considered sold. Buyer sent approval
for 75% goods up to 31-1-2015 and no approval or disapproval received for the
remaining goods till 31-3-2015.
(iv) Apart from the above, the company has made cash sales of ` 7, 80,000 (gross).
Trade discount of 5% was allowed on the cash sales.
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You are required to advise the accountant of M/s. Paper Products Ltd., with valid reasons,
the amount to be recognized as revenue in above cases in the context of AS-9 and also
determine the total revenue to be recognized for the year ending 31- 3-2015.
Answer
As per AS 9 “Revenue Recognition”, in a transaction involving the sale of goods, performance
should be regarded as being achieved when the following conditions are fulfilled:
(i) the seller of goods has transferred to the buyer the property in the goods for a
price or all significant risks and rewards of ownership have been transferred to the
buyer and the seller retains no effective control of the goods transferred to a degree
usually associated with ownership; and
(ii) no significant uncertainty exists regarding the amount of the consideration that will
be derived from the sale of the goods.
Case (i)
The sale is complete but delivery has been postponed at buyer‟s request. M/s Paper
Products Ltd. should recognize the entire sale of ` 60,000 for the year ended 31st March,
2015.
Case (ii)
20% goods lying unsold with consignee should be treated as closing inventory and sales
should be recognized for ` 1,20,000 (80% of ` 1,50,000). In case of consignment sale
revenue should not be recognized until the goods are sold to a third party.
Case (iii)
In case of goods sold on approval basis, revenue should not be recognized until the goods
have been formally accepted by the buyer or the buyer has done an act adopting the
transaction or the time period for rejection has elapsed or where no time has been fixed,
a reasonable time has elapsed. Therefore, revenue should be recognized for the total
sales amounting ` 1,20,000 as the time period for rejecting the goods had expired.
Case (iv)
Trade discounts given should be deducted in determining revenue. Thus ` 39,000 should
be deducted from the amount of turnover of ` 7,80,000 for the purpose of recognition of
revenue. Thus, revenue should be ` 7,41,000. Thus total revenue amounting ` 10,41,000
(60,000 + 1,20,000+ 1,20,000+7,41,000) will be recognized for the year ended 31st March,
2015 in the books of M/s Paper Products Ltd.
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PAST PAPER SECTION
Question 1
According to Accounting Standard – 9, when revenue from sales should be recognised?
(May’10)
Answer
As per para 11 of AS 9 ‘Revenue Recognition’, revenue from sales should be recognised
only when requirements as to performance are satisfied provided that at the time of
performance it is not unreasonable to expect ultimate collection. These requirements can
be given as follows:
(i) the seller of goods has transferred to the buyer the property in the goods for a price
or all significant risks and rewards of ownership have been transferred to the buyer
and the seller retains no effective control of the goods transferred to a degree usually
associated with ownership; and no significant uncertainty exists regarding the amount of
the consideration that will be derived from the sale of the goods.
Question 2
M/s. SEA Ltd. recognized ` 5.00 lakhs on accrual basis income from dividend during the
year 2010-11, on shares of the face value of ` 25.00 lakhs held by it in Rock Ltd. as at 31st
March, 2011. Rock Ltd. proposed dividend @ 20% on 10th April, 2011. However, dividend
was declared on 30th June, 2011. Please state with reference to relevant Accounting
Standard, whether the treatment accorded by SEA Ltd. is in order.
(Nov’11)
Answer
Para 8.4 of AS 9 “Revenue Recognition” states that dividend from investments in shares
are not recognized in the statement of Profit and Loss until the right to receive dividend
is established.
In the given case, the dividend is proposed on 10th April, 2011, while it was declared on
30th June, 2011. Hence, the right to receive dividend is established on 30th June, 2011
only. Therefore, on applying the provisions stated in the standard, income from dividend
on shares should be recognized by Sea Ltd. in the financial year 2011-2012 only.
Therefore, the recognition of income from dividend of ` 5 lakhs, on accrual basis, in the
financial year 2010-11 is not in accordance with AS 9.
Question 3
M/s. Umang Ltd. sold goods through its agent. As per terms of sales, consideration is
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payable within one month. In the event of delay in payment, interest is chargeable @
12% p.a. from the agent. The company has not realized interest from the agent in the
past. For the year ended 31st March, 2015 interest due from agent (because of delay in
payment) amounts to ` 1,72,000. The accountant of M/s Umang Ltd. booked
` 1,72,000 as interest income in the year ended 31st March, 2015. Discuss the contention
of the accountant with reference to Accounting Standard – 9. (Nov’15)
Answer
As per para 9.2 of AS 9 “Revenue Recognition”, “where the ability to assess the ultimate
collection with reasonable certainty is lacking at the time of raising any claim, the revenue
recognition is postponed to the extent of uncertainty involved. In such cases, the revenue
is recognized only when it is reasonably certain that the ultimate collection will be made”.
In this case, the company never realized interest for the delayed payments made by the
agent. Hence, based on the past experience, the realization of interest for the delayed
payments by the agent is very much uncertain. The interest should be recognized only if
the ultimate collection is certain. Therefore, the interest income of ` 1,72,000 should not
be recognized in the books for the year ended 31st March, 2015. Thus the contention of
accountant is incorrect.
However, if the agents have agreed to pay the amount of interest and there is an element
of certainty associated with these receipts, the accountant is correct regarding booking of
` 1,72,000 as interest amount.
Question 4
A manufacturing company has the following stages of production and sale in manufacturing
Fine paper rolls:
Date Activity Costs to Date Net Realizable
(`) Value
(`)
15.1.16 Raw material 1,00,000 80,000
20.1.16 Pulp (WIP 1) 1,20,000 1,20,000
27.1.16 Rough & thick paper (WIP 2) 1,50,000 1,80,000
15.2.16 Fine Paper Rolls 1,80,000 3,50,000
20.2.16 Ready for sale 1,80,000 3,50,000
15.3.16 Sale agreed and invoice raised 2,00,000 3,50,000
02.4.16 Delivered and paid for 2,00,000 3,50,000
Explain the stage on which you think revenue will be generated and state how much
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would be net profit for year ending 31-3-16 on this product according to AS – 9.
(Nov’16)
Answer
According to AS 9 “Revenue Recognition”, in a transaction involving the sale of goods,
performance should be regarded as being achieved when the following conditions have
been fulfilled:
Thus, sales will be recognized only when following two conditions are satisfied:
(i) The sale value is fixed and determinable.
(ii) Property of the goods is transferred to the customer. Both these conditions are
satisfied only on 15.3.2016 when sales are agreed upon at a price and goods are
allocated for delivery purpose through invoice. The amount of net profit ` 150,000
(3,50,000 – 2,00,000) would be recognized in the books for the year ending 31st
March, 2016.
Question 5
Raj Ltd. entered into an agreement with Heena Ltd. to dispatch goods valuing ` 5,00,000
every month for next 6 months on receipt of entire payment. Heena Ltd. accordingly
made the entire payment of ` 30,00,000 and Raj Ltd. started dispatching the goods.
In fourth month, due to fire in premise of Heena Ltd., Heena Ltd. requested to Raj Ltd.
not to dispatch goods until further notice. Due to this, Raj Ltd. is holding the remaining
goods worth ` 15,00,000 ready for dispatch. Raj Ltd. accounted ` 15,00,000 as sales and
transferred the balance to Advance received against Sales account.
Comment upon the above treatment by Raj Ltd. with reference to the provision of AS–9.
(May’17)
Answer
(i) the seller of goods has transferred to the buyer the property in the goods for
a price or all significant risks and rewards of ownership have been transferred to
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the buyer and the seller retains no effective control of the goods transferred to a
degree usually associated with ownership; and
In the given case, transfer of property in goods results in or coincides with the transfer
of significant risks and rewards of ownership to the buyer. Also, the sale price has
been recovered by the seller. Hence, the sale is complete but delivery has been
postponed at buyer’s request. Raj Ltd. should recognize the entire sale of `
30,00,000 (` 5,00,000 x 6) and no part of the same is to be treated as Advance
Received against Sales.
Question 6
Fashion Limited is engaged in manufacturing of readymade garments. They provide you
the following information oh 31st March, 2017:
(i) On 15th January, 2017 garments worth ` 4,00,000 were sent to Anand on consignment
basis of which 25% garments unsold were lying with Anand as on 31st March, 2017.
(ii) Garments worth ` 1,95,000 were sold to Shine boutique on 25th March, 2017 but at
the request of Shine Boutique, these were delivered on 15th April, 2017.
(iii) On 1st November, 2016 garments worth ` 2,50,000 were sold on approval basis. The
period of approval was 4 months after which they were considered sold. Buyer sent
approval for 75% goods up to 31st December, 2016 and no approval or disapproval
received for the remaining goods till 31st March, 2017.
You are required to advise the accountant of Fashion Limited, the amount to be recognised
as revenue in above cases in the context of AS 9.
Question 7
Goods worth ` 6,62,500 were sold on 31.10.2017 by X Ltd. to Y Ltd. Y Ltd. requested for a
trade discount of 8 % which was agreed by X Ltd. The sale was effected and goods were
dispatched. However, on receipt of the goods, Y Ltd. found that goods worth ` 77,500
were damaged. Consequently, Y Ltd. returned the damaged goods to X Ltd. and made
the due payment amounting to ` 5,32,000, The accountant of X Ltd. booked the sale for
`5,32,000.
Discuss the above treatment by the accountant with reference to applicable Accounting
Standard. (Nov’18)
Answer
As per AS 9 ‘Revenue Recognition’, revenue is the gross inflow of cash, receivable or other
394
consideration arising in the course of the ordinary activities of an enterprise from the
sale of goods. However, trade discounts and volume rebates given in the ordinary course
of business should be deducted in determining revenue. Revenue from sales should be
recognized at the time of transfer of significant risks and rewards. If the delivery of the
sales is not subject to approval from customers, then the transfer of significant risks and
rewards would take place when the sale is affected and goods are dispatched.
In the given case, if trade discount allowed by X Ltd. is given in the ordinary course of
business, X Ltd. should record the sales at ` 6,09,500 (after deducting 8% trade discount
from 6,62,500) and goods returned worth ` 77,500 are to be recorded in the form of sales
return.
However, when trade discount allowed by X Ltd. is not in the ordinary course of business,
X Ltd. should record the sales at gross value of ` 6,62,500. Discount of
` 53,000 in price and return of goods worth ` 77,500 are to be adjusted by suitable
provisions. X Ltd. might have sent the credit note of ` 1,30,500 to Y Ltd. to account for
these adjustments.
In both the cases, the contention of the accountant to book the sales for ` 5,32,000 is not
correct.
Question 8
Given the following information of ABC Ltd.
(ii) On 25-01-2019 goods of ` 2,00,000 were sent on consignment basis of which 20%
(iii) ` 2,40,000 worth of goods were sold on approval basis on 1-12-2018. The period of
(iv) Apart from the above, the company has made cash sales of ` 9,60,000 (gross).
Trade discount of 5% was allowed on the cash sales.
You are required to advise the accountant of ABC Ltd., with valid reasons, the amount
to be recognized as revenue in above cases in the context of AS-9 for the year ending
31-03-2019.
Answer
395
(i) the seller of goods has transferred to the buyer the property in the goods for a price
or all significant risks and rewards of ownership have been transferred to the buyer
and the seller retains no effective control of the goods transferred to a degree
Case (i)
The sale is complete (assuming risks and rewards transferred on 10.3.19) but delivery
has been postponed at buyer’s request. M/s ABC Ltd. should recognize the entire sale of
` 80,000 for the year ended 31st March, 2019.
Case (ii)
20% goods lying unsold with consignee should be treated as closing inventory and sales
should be recognized for ` 1,60,000 (80% of ` 2,00,000). In case of consignment sales
revenue should not be recognized until the goods are sold to a third party.
Case (iii)
In case of goods sold on approval basis, revenue should not be recognized until the
goods have been formally accepted by the buyer or the buyer has done an act adopting
the transaction or the time period for rejection has elapsed or where no time has been
fixed, a reasonable time has elapsed. Therefore, revenue should be recognized for the
total sales amounting ` 2,40,000 as the time period for rejecting the goods had expired.
Case (iv)
Trade discounts given should be deducted in determining revenue. Thus ` 48,000 should
be deducted from the amount of turnover of ` 9,60,000 for the purpose of recognition of
revenue. Thus, revenue should be recognized for ` 9,12,000.
Question 9
Given below are the following informations of B.S. Ltd.
(ii) On 13-01-2018 goods of ` 1,25,000 are sent on consignment basis of which 20%
396
(iii) ` 1,00,000 worth of goods were sold on approval basis on 01-12-2017. The period of
You are required to advise the accountant of B.S. Ltd., with valid reasons, the
amount to be recognized as revenue for the year ended 31st March, 2018 in above
cases in the context of AS-9. (May’ 19)
Answer
Case (i)
The sale is complete but delivery has been postponed at buyer’s request. B.S. Ltd. Should
recognize the entire sale of ` 50,000 for the year ended 31st March, 2018.
Case (ii)
In case of consignment sale revenue should not be recognized until the goods are sold
to a third party.20% goods lying unsold with consignee should be treated as closing
inventory and sales should be recognized for ` 1,00,000 (80% of ` 1,25,000).
Case (iii)
In case of goods sold on approval basis, revenue should not be recognized until the goods
have been formally accepted by the buyer or the buyer has done an act adopting the
transaction or the time period for rejection has elapsed or where no time has been fixed,
a reasonable time has elapsed. Therefore, revenue should be recognized for the total
sales amounting ` 1,00,000 as the time period for rejecting the goods had expired.
Thus total revenue amounting ` 2,50,000 (50,000 + 1,00,000+ 1,00,000) will be recognized
for the year ended 31st March, 2018 in the books of B.S. Ltd.
397
Question 10
Indicate in each case whether revenue can be recognized and when it will be recognized
as per AS-9.
(1) Trade discount and volume rebate received.
(2) Where goods are sold to distributors or others for resale.
(3) Where seller concurrently agrees to repurchase the same goods at a later date.
(4) Insurance agency commission for rendering services.
(5) On 11-03-2019 cloths worth ` 50,000 were sold to X mart, but due to refurbishing
of their showroom being underway, on their request, clothes were delivered on 12-
04-2019.
Answer
(1) Trade discounts and volume rebates received are not encompassed within the
definition of revenue, since they represent a reduction of cost. Trade discounts and
volume rebates given should be deducted in determining revenue.
(2) When goods are sold to distributor or others, revenue from such sales can generally be
recognized if significant risks of ownership have passed; however, in some situations
the buyer may in substance be an agent and in such cases the sale should be treated
as a consignment sale.
(3) For transactions, where seller concurrently agrees to repurchase the same goods at
a later date that are in substance a financing agreement, the resulting cash inflow
is not revenue as defined and should not be recognized as revenue.
(4) Insurance agency commissions should be recognized on the effective commencement
or renewal dates of the related policies.
(5) On 11.03.2019, if X mart takes title and accepts billing for the goods then it is
implied that the sale is complete and all risk and reward on ownership has been
transferred to the buyers.
Revenue should be recognized for year ended 31st March, 2019 notwithstanding
that physical delivery has not been completed so long as there is every expectation
that delivery will be made and items were ready for delivery to the buyer at the
time.
Question 11
Given the following information of Rainbow Ltd.
(i) On 15th November, goods worth ` 5,00,000 were sold on approval basis. The period
of approval was 4 months after which they were considered sold. Buyer sent approval
398
for 75% goods sold upto 31st January and no approval or disapproval received for
the remaining goods till 31st March.
(ii) On 31st March, goods worth ` 2,40,000 were sold to Bright Ltd. but due to refurnishing
of their show-room being underway, on their request, goods were delivered on 10th
April.
(iii) Rainbow Ltd. supplied goods worth ` 6,00,000 to Shyam Ltd. and concurrently
agrees to re-purchase the same goods on 14th April.
(iv) Dew Ltd, used certain assets of Rainbow Ltd. Rainbow Ltd. received ` 7.5 lakhs and
` 12 as interest and royalties respectively from Dew Ltd. during the year 2020 -21.
(v) On 25th December, goods of ` 4,00,000 were sent on consignment basis of which
40% of the goods unsold are lying with the consignee at the year-end on 31st
March.
In each of the above cases, you are required to advise, with valid reasons, the amount to
be recognized as revenue under the provisions of AS-9. (Dec 21)
399
FINANCIAL
MANAGEMENT
INTER C.A. – FINANCIAL MANAGEMENT
ESTIMATION OF
WORKING CAPITAL
THEORY SECTION
Meaning and Objective

Capital is nothing but money required to start or run the business. How much to raise
money depends on, how much we are planning to invest. Invest where? Invest in Fixed
Assets and Working Capital. Fixed Assets cannot work on its own until and unless
adequate level of working capital is maintained. This extra capital that we need for
smooth working of our fixed assets is known as working capital.
Objective
This chapter will give us the answer to the following question,
“How much money should we raise to meet our working capital requirement”?
The level of working capital depends on the level of Current Assets and the level of
Current Liabilities. The level of Current assets in turn depends upon the level of Stock
(Stock of Raw Material, WIP, Finished Goods), Debtors and Cash Bank, whereas the level
of Current liabilities is dependent on the level of Creditors and Outstanding expenses. So
if we can fairly estimate the level of these individual components of current assets and
the current liabilities we can very well estimate our Working Capital Requirement.
Scope
In this chapter we will learn
(a) How to estimate our working capital requirement
(b) Working Capital Operating Cycle
(c) How to finance the Working Capital requirement
* How to estimate our working Capital requirement
There are two approaches for estimating our working capital requirement
(1) Total Basis: Under this approach all the expenses and profit margins are considered
for estimating our working capital needs.
(2) Cash Cost Basis: Under this approach only cash expenses are considered for
estimating our working capital needs
400
Rates of Valuation of various items –
Component Total Approach Cash Cost Approach

Raw Materials Purchase Price net of discounts Purchase Price net of discounts
W o r k - i n - Raw Materials+50% of [Direct Raw Materials + 50% of [Direct
Progress Labour +Direct Expenses +All Labour + Direct Expenses
Production OH] + Production OH excluding
Depreciation]
Finished Goods Cost of Production Cost of Production Less
Depreciation
Sundry Debtors Selling Price Selling Price Less Profit Margin
Less Depreciation
Sundry Creditors Purchase Price net of discounts Purchase Price net of discounts
Note: For WIP valuation, it is assumed that materials are fully issued and conversion (i.e.
Labour and Production OH) is half - complete.
* Working Capital Operating Cycle

The process of conversion of cash back into cash is known as Working Capital Operating
Cycle i.e. the process of cash which is used for purchasing Raw materials to again get
converted back into cash as realisation from Debtors is known as Working Capital
Operating Cycle and the time taken for this conversion of cash back into cash is known as
duration of Operating Cycle.
CASH CYCLE OF MANUFACTURING FIRM CASH CYCLE OF TRADING FIRM
Cash
Cash
Debtors
Raw Materials
Debtors
Finished Goods Finished Goods

Work-in-Progress
401
Duration of the Working Capital Operating Cycle is calculated in the following manner
Raw material holding period xx
WIP conversion period xx
Finished Goods Holding period xx
Debtors Collection Period xx
Gross Duration xx
Less: Creditors Payment period xx
Net Duration xx
Average Stock of Raw Material

Raw Material Holding Period = x 365/52/12
Raw Material Consumed
RWIP Conversion Period = Average Stock of WIP x 365/52/12

COP
Average Stock of Finished Goods

Finished Goods Holding Period = x 365/52/12
COGS
Average Debtors
Debtors Collection Period = x 365/52/12
Credit Sales
Average Creditors
Creditors Payment Period = x 365/52/12
Credit Purchases
* Financing of Working Capital

Working Capital can be classified based on (a) Concept or (b) Time Factor, as under -
402
There are two views as to the amount of Permanent Working Capital –
PERMANENT WORKING CAPITAL
403
Approaches to Finance the working Capital
Hedging Approach
Hedging approach is also known as matching approach. It is based upon concept of
bifurcation of total working capital needs into permanent and temporary working capital.
Under this approach, the permanent working capital needs are financed by long term
sources and the temporary working capital requirement from short term sources.
Conservative Approach
As the name suggests, under this approach finance manager doesn’t undertake risk. As
a result, all the working capital needs are financed by long term source and the use of
short term sources may be restricted to unexpected and emergency situations only.
Aggressive Approach
A working capital policy is also called as aggressive policy if the firm decides to finance a
part of the permanent working capital by short term sources. So, the short term financing
under aggressive policy is more than hedging approach.
404
CLASSWORK SECTION
Question 1
Cost sheet of the company provides the following data:
Particulars Cost p.u.

Raw Material 50
Direct Labour 20
Overheads (including Depreciation ` 10) 40
Total Cost 110
Profit 20
Selling Price 130
- Raw materials remain in stores for one month
- Credit allowed by suppliers is one month
- Credit allowed to Debtors is 2 months
- Time lag in payment of wages is 10 days
- Time lag in payment of expenses is 30 days
- 25% of the sales are on cash basis
- Cash balance is expected to be ` 1,00,000.
- Finished goods remain in warehouse for 2 month.
- WIP 1 month (50% completion).
You are required to estimate the working capital required to finance a level of activity
of 50000 units p.a. Assume that all the business activities are carried out evenly
throughout the year. Assume 360 days for calculation purpose.
Question 2
The following annual figures relate to XYZ Co.
`
Sales (at two months' credit) 36,00,000
Materials consumed (Suppliers extend two months' credit) 9,00,000
Wages (paid monthly in arrears) 7,20,000
Manufacturing expenses outstanding at the end of the year
(Cash expenses are paid one month in arrears) 80,000
Total administrative expenses, paid as above 2,40,000
Total Sales promotion expenses, paid quarterly in advance 1,20,000
405
The company sells its products on gross profit of 25% counting depreciation as part of
the cost of production. It keeps one month's stock each of raw materials and finished
goods, and a cash balance of ` 1,00,000.
Assuming a 20% safety margin, work out the working capital requirements of the
company on cash cost basis. Ignore work-in-process.
Question 3
Samreen Enterprises has been operating its manufacturing facilities till 31.3.2017 on a
single shift working with the following cost structure:
Per unit (`)

Cost of Materials 6.00
Wages (out of which 40% fixed) 5.00
Overheads (out of which 80% fixed) 5.00
Profit 2.00
Selling Price 18.00
Sales during 2016 – 2017 - ` 4, 32,000.
As at 31.3.2017 the company held:

(`)
Stock of raw materials (at cost) 36,000
Work-in-progress (valued at prime cost) 22,000
Finished goods (valued at total cost) 72,000
Sundry debtors 1, 08,000
In view of increased market demand, it is proposed to double production by working an

extra shift. It is expected that a 10% discount will be available from suppliers of raw
materials in view of increased volume of business. Selling price will remain the same.
The credit period allowed to customers will remain unaltered. Credit availed of from
suppliers will continue to remain at the present level i.e., 2 months. Lag in payment of
wages and expenses will continue to remain half a month.
You are required to assess the additional working capital requirements, if the policy to
increase output is implemented.
406
Question 4
Following information is forecasted by R Limited for the year ending 31st March, 2021:
Balance as at Balance as at
31st March, 31st March,
2021 2020
(` in lakh) (` in lakh)
Raw Material 65 45
Work-in-progress 51 35
Finished goods 70 60
Receivables 135 112
Payables 71 68
Annual purchases of raw material (all credit) 400
Annual cost of production 450
Annual cost of goods sold 525
Annual operating cost 325
Annual sales (all credit) 585
You may take one year as equal to 365 days. You are required to CALCULATE:
(i) Net operating cycle period.
(ii) Number of operating cycles in the year.
(iii) Amount of working capital requirement.
Question 5
From the following information of XYZ Ltd., you are required to calculate:
(a) Net operating cycle period.
(b) Number of operating cycles in a year.
(`)
(i) Raw material inventory consumed during the year 6,00,000
(ii) Average stock of raw material 50,000
(iii) Work-in-progress inventory 5,00,000
(iv) Average work-in-progress inventory 30,000
(v) Finished goods inventory 8,00,000
(vi) Average finished goods stock held 40,000
(vii) Average collection period from debtors 45 days
(viii) Average credit period availed 30 days
(ix) No. of days in a year 360 days
407
Question 6
The following information is provided by the DPS Limited for the year ending 31st March,
2020.
Raw material storage period 55 days
Work-in-progress conversion period 18 days
Finished Goods storage period 22 days
Debt collection period 45 days
Creditors’ payment period 60 days
Annual Operating cost ` 21, 00,000
(Including depreciation of ` 2, 10,000)
[1 year = 360 days]

(i) Operating Cycle period.
(ii) Number of Operating Cycle in a year.
(iii) Amount of working capital required for the company on a cash cost basis.
(iv) The company is a market leader in its product, there is virtually no competitor in the
market. Based on a market research it is planning to discontinue sales on credit and
deliver products based on pre-payments. Thereby, it can reduce its working capital
requirement substantially.
What would be the reduction in working capital requirement due to such decision?
Question 7
An engineering company is considering its working capital investment for the year 2019-
20. The estimated fixed assets and current liabilities for the next year are ` 6.63 crore
and ` 5.967 crores respectively. The sales and earnings before interest and taxes (EBIT)
depend on investment in its current assets - particularly inventory and receivables. The
company is examining the following alternative working capital policies:
Working Capital Policy Investment in Current Estimated Sales EBIT

Assets (` Crores) (` Crores) (` Crores)
Conservative 11.475 31.365 3.1365
Moderate 9.945 29.325 2.9325
Aggressive 6.63 25.50 2.55
408
You are required to calculate the following for each policy:

(i) Rate of return on total assets.
(ii) Net working capital position.
(iii) Current assets to fixed assets ratio.
(iv) Discuss the risk-return trade off of each working capital policy.
Question 8
On 1st January, the Board of Directors of Dowell Co. Ltd wishes to know the amount of
Working Capital that will be required to meet the activity programme they have planned
for the year. The following data is given -
1. Issued and Paid-up Capital of the Company is Rs. 2,00,000.
2. 5% Debentures (Secured on Assets) Rs. 50,000.
3. Fixed Assets were valued at Rs. 1,25,000 on 31st December at the end of the year.
4. Production during the previous year was 60,000 units. It is planned that the same
level of activity should be maintained during the current year also.
5. The ratios of Costs to Selling Price are Materials - 60%, Wages -10% and Overheads
- 20%
6. Raw Materials are expected to remain in stores for an average of two months before
they are issued for production. Each unit of production is expected to be in process
for one month.
7. Finished Goods will stay in the warehouse for approximately three months. Trade
Creditors allow 2 months credit from the date of delivery of raw materials. The
Company allows 3 months credit to Debtors from the date of despatch.
8. Selling Price per unit is Rs. 5. There is a regular production and sales cycle.
9. The Company normally keeps cash in hand to the extent of Rs. 20,000.
10. Wages and Overheads are paid on the 1st of each month for the previous month.
Prepare - (1) Working Capital Requirement Forecast, (2) Projected P&L A/c for the year &
Balance Sheet at the end of the year.
Question 9
The management of MNP Company Ltd. is planning to expand its business and consults
you to prepare an estimated working capital statement. The records of the company
reveal the following annual information:
Rs.
Sales –Domestic at one month’s credit 24,00,000
409
Export at three month’s credit (sales price 10% below domestic 10,80,000
price)
Materials used (suppliers extend two months credit) 9,00,000
Lag in payment of wages – ½ month 7,20,000
Lag in payment of manufacturing expenses (cash) – 1 month 10,80,000
Lag in payment of Adm. Expenses – 1 month 2,40,000
Sales promotion expenses payable quarterly in advance 1,50,000
Income tax payable in four installments of which one falls in 2,25,000
the next financial year
Rate of gross profit is 20%.

Ignore work-in-progress and depreciation.
The company keeps one month’s stock of raw materials and finished goods (each) and
believes in keeping ` 2,50,000 available to it including the overdraft limit of ` 75,000
not yet utilized by the company.
The management is also of the opinion to make 12% margin for contingencies on
computed figure.
You are required to prepare the estimated working capital statement for the next year.
Question 10
MN Ltd. is commencing a new project for manufacture of electric toys. The following cost
information has been ascertained for annual production of 60,000 units at full capacity:
Amount per unit Rs.

Raw materials 20
Direct labour 15
Manufacturing overheads: Rs.
Variable 15
Fixed 10 25
Selling and Distribution overheads: Rs.
Variable 3
Fixed 1 4
Total cost 64
Profit 16
Selling price 80
In the first year of operations expected production and sales are 40,000 units and
410
35,000 units respectively. To assess the need of working capital, the following additional
information is available:
(i) Stock of Raw materials............................................3 months consumption.
(ii) Credit allowable for debtors.....................................1½ months.
(iii) Credit allowable by creditors....................................4 months.
(iv) Lag in payment of wages.........................................1 month.
(v) Lag in payment of overheads...................................½ month.
(vi) Cash in hand and Bank is expected to be Rs. 60,000.
(vii) Provision for contingencies is required @ 10% of working capital requirement
including that provision.
You are required to prepare a projected statement of working capital requirement for the
first year of operations. Debtors are taken at cost.
Question 11
Aneja Limited, a newly formed company, has applied to the commercial bank for the
first time for financing its working capital requirements. The following information is
available about the projections for the current year:
Estimated level of activity: 1,04,000 completed units of production plus 4,000 units of
work-in-progress. Based on the above activity, estimated cost per unit is:
Raw Material Rs.80 per unit

Direct Wages Rs.30 per unit
Overheads Rs.60 per unit
Total Cost Rs.170 per unit
Selling Price Rs.200 per unit
Raw materials in stock: Average 4 weeks consumption, work-in-progress (assume

50%completion stage in respect of conversion cost) (materials issued at the start of the
processing).
Finished goods in stock 8,000 units
Credit allowed by suppliers Average 4 weeks
Credit allowed to debtors / receivables Average 8 weeks
Lag in payment of wages Average 1½ weeks
Cash at banks (for smooth operation) is expected to be Rs.25,000.
411
Assume that production is carried on evenly throughout the year (52 weeks) and wages
and overheads accrue similarly. All sales are on credit basis only.
You are required to calculate the net working capital required.
412
HOMEWORK SECTION
Question 12
On 1st January, the Managing Director of Naureen Ltd. wishes to know the amount of
working capital that will be required during the year. From the following information
prepare the working capital requirements forecast.
Production during the previous year was 60,000 units. It is planned that this level of
activity would be maintained during the present year.
The expected ratios of the cost to selling prices are Raw materials 60%, Direct wages
10% and Overheads 20%.
Raw materials are expected to remain in store for an average of 2 months before issue
to production.
Each unit is expected to be in process for one month, the raw materials being fed into
the pipeline immediately and the labour and overhead costs accruing evenly during the
month.
Finished goods will stay in the warehouse awaiting dispatch to customers for approximately
3 months.
Credit allowed by creditors is 2 months from the date of delivery of raw material.
Credit allowed to debtors is 3 months from the date of dispatch. Selling price is Rs. 5 per
unit.
There is a regular production and sales cycle.
Wages and overheads are paid on the 1st of each month for the previous month.
The company normally keeps cash in hand to the extent of Rs. 20,000.
Answer:
Working Notes:
1. Raw material inventory: The cost of materials for the whole year is 60% of the Sales
value.
60
Hence it is 60,000 units x Rs. 5 x = Rs. 1,80,000. The monthly consumption of
100
raw material would be Rs. 15,000. Raw material requirements would be for two
months; hence raw materials in stock would be Rs. 30,000.
2. Work-in-process: (Students may give special attention to this point). It is stated that
each unit of production is expected to be in process for one month).
413
Rs.
(a) Raw materials in work-in-process (being one
month’s raw material requirements)
15,000
(b) Labour costs in work-in-process 1,250
(It is stated that it accrues evenly during the month. Thus, on the
first day of each month it would be zero and on the last day of
month the work-in-process would include one month’s labour costs.
On an average therefore, it would be equivalent to ½ of the month’s labour
costs)
(c) Overheads
(For ½ month as explained above) Total work-in process 2,500
18,750
3. Finished goods inventory:
(3 month’s cost of production) 45,000
Raw materials 7,500
Labour 15,000
Overheads 67,500
4. Creditors: Suppliers allow a two months’ credit period. Hence, the average amount
of creditors would be Rs. 30,000 being two months’ purchase of raw materials.
5. Direct Wages payable: The direct wages for the whole year is 60,000 units × Rs. 5 x
10% = Rs.30,000. The monthly direct wages would be Rs. 2,500 (Rs. 30,000 ÷12).
Hence, wages payable would be Rs.2,500.
6. Overheads Payable: The overheads for the whole year is 60,000 units × Rs. 5 x 20%
= Rs. 60,000. The monthly overheads will be Rs. 5,000 (Rs. 60,000 ÷ 12). Hence
overheads payable would be Rs. 5,000 p.m.
7. Debtors: The total cost of sales = 2,70,000.
3
Therefore, debtors = 2,70,000 x = 67,500.
12
Total Cost of Sales = RM + Wages + Overheads + Opening Finished goods inventory

– Closing finished goods inventory.
414
= 1,80,000 + 30,000 + 60,000 + 67,500 – 67,500 = 2,70,000.

Here it has been assumed that inventory level is uniform throughout the year,
therefore opening inventory equals closing inventory.
Statement of Working Capital Required:
Rs. Rs.
Current Assets
Raw materials inventory (Refer to working note 1) 30,000
Debtors (Refer to working note 2) 67,500
Working–in-process (Refer to working note 3) 18,750
Finished goods inventory (Refer to working note 4) 67,500
Cash 20,000 2,03,750
Current Liabilities
Creditors (Refer to working note 5) 30,000
Direct wages payable (Refer to working note 6) 2,500
Overheads payable (Refer to working note 7) 5,000 37,500
Estimated working capital requirements 1,66,250
Question 13
The following annual figures relate to XYZ Co.,
(Rs.)
Sales (at two months’ credit) 36,00,000
Materials consumed (suppliers extend two months’ credit) 9,00,000
Wages paid (1 month lag in payment) 7,20,000
Cash manufacturing expenses 9,60,000
Administrative expenses (1 month lag in payment) 2,40,000
Sales promotion expenses (paid quarterly in advance) 1,20,000
The company sells its products on gross profit of 25%. Depreciation is considered as a
part of the cost of production. It keeps one month’s stock each of raw materials and
finished goods, and a cash balance of Rs. 1,00,000.
Assuming a 20% safety margin, work out the working capital requirements of the
company on cash cost basis. Ignore work-in-process.
415
Answer:
Statement of Working Capital requirements (cash cost basis)
(Rs.) (Rs.)
A. Current Asset
Inventory:
Raw materials Rs.9,00,000 75,000
x 1 month
12 months
Finished Goods Rs.25,80,000 2,15,000

x 1 month
12 months
Receivables (Debtors) Rs.29,40,000 x 2 months 4,90,000

12 months
Sales Promotion expenses paid in advance 30,000

Rs.1,20,000
x 3 months
12 months
Cash balance 1,00,000 9,10,000

Gross Working Capital 9,10,000
B. Current Liabilities:
Payables:
Creditors for materials 1,50,000
Wages outstanding 60,000
Manufacturing expenses outstanding 80,000
Administrative expenses outstanding 20,000 3,10,000
Net working capital (A - B) 6,00,000
Add: Safety margin @ 20% 1,20,000
Total Working Capital requirements 7,20,000
Working Notes:
(i) Computation of Annual Cash Cost of Production (Rs.)

Material consumed 9,00,000
Wages 7,20,000
Manufacturing expenses 9,60,000
Total cash cost of production 25,80,000
416
(ii) Computation of Annual Cash Cost of Sales: (Rs.)

Cash cost of production as in (i) above 25,80,000
Administrative Expenses 2,40,000
Sales promotion expenses 1,20,000
Total cash cost of sales 29,40,000
Since, the cash manufacturing expenses is already given in the question hence, the
amount of depreciation need not to be computed. However, if it were required to be then
it could be computed as follows:
( Rs.)
Sales 36,00,000
Less: Gross profit (25% of Rs.36,00,000) (9,00,000)
Cost of Production (including depreciation) 27,00,000
Less: Cash Cost of Production (as calculated above) (25,80,000)
Depreciation (Balancing figure) 1,20,000
Question 14
The Trading and Profit and Loss Account of Beta Ltd. for the year ended 31st March, 2011
is given below:
Particulars Amount Rs. Amount Particulars Amount Rs. Amount

Rs. Rs.
To Opening Stock: By Sales (Credit) 20,00,000
Raw Materials 1,80,000 By Closing Stock:
Work- in- progress 60,000 Raw Materials 2,00,000
Finished Goods 2,60,000 5,00,000 Work-in-progress 1,00,000
To Purchases (credit) 11,00,000 Finished Goods 3,00,000 6,00,000
To Wages 3,00,000
To Production Expenses 2,00,000
To Gross Profit c/d 5,00,000
26,00,000 26,00,000
To Administration 1,75,000 By Gross Profit b/s 5,00,000
Expenses
To Selling Expenses 75,000
To Net Profit 2,50,000
5,00,000 5,00,000
417
The opening and closing balances of debtors were Rs. 1,50,000 and Rs. 2,00,000
respectively whereas opening and closing creditors were Rs. 2,00,000 and Rs. 2,40,000
respectively.
You are required to ascertain the working capital requirement by operating cycle method.
Answer:
Computation of Operating Cycle
(1) Raw Material Storage Period (R)
Average Stock of Raw Material

Raw Material Storage Period (R) =
Daily Average Consumption of Raw Material
(1,80,000+2,00,000)/2
= =63.33 Days
10,80,000/360
Raw Material Consumed = Opening Stock + Purchases – Closing Stock

= 1,80,000 + 11,00,000 – 2,00,000 = Rs.10,80,000
(2) Conversion/Work-in-Process Period (W)
Average Stock of WIP

Conversion/Processing Period =
Daily Average Production Cost
= (60,000+1,00,000)/2
=18.7 days
15,40,000/360
Production Cost: Rs.

Opening Stock of WIP = 60,000
Add: Raw Material Consumed = 10,80,000
Add: Wages = 3,00,000
Add: Production Expenses = 2,00,000
16,40,000
Less: Closing Stock of WIP = 1,00,000
Production Cost 15,40,000
(3) Finished Goods Storage Period (F)
Average Stock of Finished Goods

Finished Goods Storage Period =
Daily Average Cost of Goods Sold
418
(2,60,000+3,00,000)/2
= =67.19 Days
15,00,000/360
Cost of Goods Sold Rs.

Opening Stock of Finished Goods 2,60,000
Add: Production Cost 15,40,000
18,00,000
Less: Closing Stock of Finished Goods 3,00,000
15,00,000
(4) Debtors Collection Period (D)

Debtors Collection Period =
Average Debtors (1,50,000+2,00,000)/2

= =31.5 Days
Daily Average Sales 20,00,000/360
(5) Creditors Payment Period (C)
Average Creditors
Creditors Payment Period =
Daily Average Purchase
(2,00,000+2,40,000)/2
= = 72 Days
11,00,000/360
(6) Duration of Operating Cycle (O)

O = R+W+F+D–C
= 63.33 + 18.7 + 67.19 + 31.5 – 72
= 108.72 days
Computation of Working Capital

(i) Number of Operating Cycles per Year
= 360/Duration Operating Cycle = 360/108.72 = 3.311
(ii) Total Operating Expenses Rs.

Total Cost of Production 15,00,000
Add: Administration Expenses 1,75,000
Selling Expenses 75,000
17,50,000
419
(iii) Working Capital Required
Total Operating Expenses

Working Capital Required =
Number of Operating Cycles per year

17,50,000
= = Rs.5,28,541
3.311
[Note: The solution can also be solved by taking of 365 days a year.]
Question 15
STN Ltd. is a readymade garment manufacturing company. Its production cycle indicates
that materials are introduced in the beginning of the production phase; wages and
overhead accrue evenly throughout the period of cycle. The following figures for the 12
months ending 31st December 2011 are given.
Production of shirts 54,000 units
Selling price per unit Rs. 200
Duration of the production cycle 1 month
Raw material inventory held 2 month’s con
Finished goods stock held for 1 month
Credit allowed to debtors is 1.5 months and credit allowed by creditors is 1 month.
Wages are paid in the next month following the month of accrual.
In the work-in-progress 50% of wages and overheads are supposed to be conversion
costs.
The ratios of cost to sales price are-raw materials 60% direct wages 10% and overheads
20%. Cash is to be held to the extent of 40% of current liabilities and safety margin of
15% will be maintained.
Calculate amount of working capital required for the company on a cash cost basis.
Answer:
Working Notes:
1. Raw material inventory: The cost of materials for the whole year is 60% of the
Sales value.
= 54,000 units x (60% of Rs.200)

x 2 months = Rs.10,80,000
12 months
420
2. Work-in-process: (Each unit of production is expected to be in process for one

month):
( Rs.)
(a) Raw materials in work-in-process (being one month’s raw 5,40,000
material requirements)
(b) Labour costs in work-in-process
54,000 units x 10% of Rs.200 45,000
x 0.5
12months
54,000 units x (20% of Rs.200)

(c) Overheads x 0.5 90,000
12months
3. Finished goods inventory:

54,000 units x (90% of Rs.200)
x 1 month = Rs.8,10,000
12months
4. Receivables : 54,000 units x (90% of Rs.200)

x 1.5 months = Rs.12,15,000
12 months
5. Payable to suppliers: 54,000 units x (60% of Rs.200) x 1 month = Rs.5,40,000

12 months
6. Direct Wages payable: 54,000 units x (10% of Rs.200) x 1 month = Rs.90,000

12 months
Calculation of Working Capital Requirement
( Rs.) ( Rs.)
A. Current Assets
(i) Inventories:
- Raw Materials 10,80,000
- Finished goods 8,10,000 25,65,000
421
(ii) Receivables 12,15,000

(iii) Cash in hand (40% of Rs.6,30,000) 2,52,000
Total Current Assets 40,32,000
(i) Payables for raw materials 5,40,000
(ii) Direct wages payables 90,000
6,30,000
Net Working Capital (A – B) 34,02,000
Add: Safety margin (15% of Net Working Capital) 5,10,300
Working capital requirement 39,12,300
Question 16
Black Limited has furnished the following cost sheet:
Rs.
Per Unit
Raw Material 98.00
Direct Labour 53.00
Factory Overhead (Includes depreciation ofRs.15 per unit at budgeted 88.00
level of activity)
Total Cost 239.00
Profit 43.00
Selling Price 282.00
(i) Average raw material in stock 3 weeks
(ii) Average work-in-progress (% of completion with respect to Material- 75% Labour
& Overhead - 70%) 2 weeks
(iii)
Finished goods in stock 4 weeks
(iv) Credit allowed to receivables 2 ½ weeks
(v) Credit allowed by suppliers 3 ½ weeks
(vi) Time lag in payments of labour 2 weeks
(vii) Time lag in payments of factory overheads 1 ½ weeks
(viii) Company sells, 25% of the output against cash
(ix) Cash in hand and bank is desired to be maintained Rs.2,25,000
(x) Provision for. contingencies is required @ 4% of working capital requirement including
that provision.
422
You may assume that production is carried on evenly throughout the year and labour
and factory overheads accrue similarly.
You are required to prepare a statement showing estimate of working capital needed
to finance a budgeted activity level of 1,04,000 units of production. Finished stock,
receivables and overhead are taken at cash cost.
Answer:
Statement of Estimation of Working Capital Needs
Rs. Rs.
A. Current Assets
(i) Inventories :
1,04,000 units x Rs.98
- Raw Materials x 3 weeks
52 weeks 5,88,000
- Work-in-process
Materials 1,04,000 units x Rs.98

x 2 weeks
52 weeks 2,94,000
Labour & Overheads 3,52,800

1,04,000 units x Rs.126
x 2 weeks x 0.75
52 weeks
- Finished goods 17,92,000 30,26,800
1,04,000 units x Rs.224
x 4 weeks
52 weeks
(ii) Receivables 8,40,000
1,04,000 units x Rs.224
x 2.5 weeks x 0.75
52 weeks
(iii) Cash in hand 2,25,000
B. Current Liabilities :
(i) Payable to suppliers 6,86,000
1,04,000 units x Rs.98
x 3.5 weeks
52 weeks
(ii) Direct wages payables 2,12,000
1,04,000 units x Rs.53
x 2 weeks
52 weeks
423
(iii) Overheads payables 2,19,000

1,04,000 units x Rs.73
x 1.5 weeks
52 weeks
11,17,000
Net Working Capital (A-B) 29,74,800
Add : Provision for contingencies (4% of total Working 1,23,950
Capital requirement)
Working Capital requirement 30,98,750
Question 17
The following data relating to an auto component manufacturing company is available
for the year 20X4:
Raw material held in storage 20 days
Receivables collection period 30 days
Conversion process period (raw material - 100%, other costs - 50% complete)
10 days Finished goods storage period 45 days
Credit period from suppliers 60 days
Advance payment to suppliers 5 days
Total cash operating expenses per annum Rs.800 lakhs
75% of the total cash operating expenses are for raw material. 360 days are assumed
in a year.
(i) Each item of current assets and current liabilities,
(ii) The working capital requirement, if the company wants to maintain a cash
balance of Rs. 10 lakhs at all times.
Answer:
Particulars For Raw Material For Other Costs Total

Cash Operating expenses 75 25 800.00
x800=600 x800=200
100 100
Raw Material Stock Holding 20 - 33.33
x600=33.33
360
424
WIP Conversion 10 5 19.45

x600=16.67 x200=2.78
360 360
Finished Goods Stock Holding 45 45 100.00
x600=75 x200=25
360 360
Receivable Collection Period 30 30 66.67
x600=75 x200=16.67
360 360
Advance to suppliers 5 - 8.33
x600=8.33
360
Credit Period from suppliers 60 - 100.00
x600=100
360
Computation of working capital
Rs. in lakhs
Raw Material Stock 33.33
WIP 19.45
Finished Goods stock 100.00
Receivables 66.67
Advance to Suppliers 8.33
Cash 10.00
237.78
Less: Payables (Creditors) 100.00
Working capital 133.78
Question 18
The following information is available for Excel Ltd.
Amount (Rs.)
Average stock of raw materials and stores 2,00,000

Average work-in-progress inventory 3,00,000
Average finished goods inventory 1,80,000
Average accounts receivable 3,00,000
Average accounts payable 1,80,000
Average raw materials and stores purchased on credit and consumed 10,000
per day
Average work-in-progress value of raw materials committed per day 12,500
425
Average cost of goods sold per day 18,000
Average sales per day 20,000
Calculate the duration of operating cycle.
Answer:
Calculation of operating cycle
Period of raw material stage 2,00,000 = 20 days

10,000
Period of work-in-progress stage 3,00,000 = 24 days

12,500
Period of finished goods stage 1,80,000 = 10 days

18,000
Period of Accounts receivable stage 3,00,000 = 15 days

20,000
Period of Accounts payable stage 1,80,000 = 18 days

10,000
Duration of operating cycle = (20 + 24 + 10 + 15) - 18 =51 days
Question 19
A company is considering its working capital investment and financial policies for the
next year. Estimated fixed assets and current liabilities for the next year are Rs.2.60
crores and Rs. 2.34 crores respectively. Estimated Sales and EBIT depend on current
assets investment, particularly inventories and book-debts. The financial controller of
the company is examining the following alternative Working Capital Policies:
(Rs. Crores)
Working Capital Policy Investment in Current Assets Estimated Sales EBIT

Conservative 4.50 12.30 1.23
Moderate 3.90 11.50 1.15
Aggressive 2.60 10.00 1.00
426
After evaluating the working capital policy, the Financial Controller has advised the
adoption of the moderate working capital policy. The company is now examining the
use of long- term and short-term borrowings for financing its assets. The company will
use Rs. 2.50 crores of the equity funds. The corporate tax rate is 35%. The company is
considering the following debt alternatives.
(Rs. Crores)
Financing Policy Short-term Debt Long-term Debt

Conservative 0.54 1.12
Moderate 1.00 0.66
Aggressive 1.50 0.16
Interest rate-Average 12% 16%
Working Capital Policy

Conservative Moderate Aggressive
Current Assets: (i) 4.50 3.90 2.60
Fixed Assets: (ii) 2.60 2.60 2.60
Total Assets: (iii) 7.10 6.50 5.20
Current liabilities: (iv) 2.34 2.34 2.34
Net Worth: (v)=(iii)-(iv) 4.76 4.16 2.86
Total liabilities: (iv)+(v) 7.10 6.50 5.20
Estimated Sales: (vi) 12.30 11.50 10.00
EBIT: (vii) 1.23 1.15 1.00
(a)Net working capital position: (i)-(iv) 2.16 1.56 0.26
(b) Rate of return: (vii)/(iii) 17.3% 17.7% 19.2%
(c) Current ratio: (i)/(iv) 1.92 1.67 1.11
Answer:
(i) Statement Showing Effect of Alternative Financing Policy
(Rs.in crores)
Financing Policy Conservative Moderate Aggressive

Current Assets: (i) 3.90 3.90 3.90
Fixed Assets: (ii) 2.60 2.60 2.60
Total Assets: (iii) 6.50 6.50 6.50
427
Current Liabilities: (iv) 2.34 2.34 2.34

Short term Debt: (v) 0.54 1.00 1.50
Long term Debt: (vi) 1.12 0.66 0.16
Equity Capital (vii) 2.50 2.50 2.50
Total liabilities 6.50 6.50 6.50
Forecasted Sales 11.50 11.50 11.50
EBIT: (viii) 1.15 1.15 1.15
Less: Interest short-term debt: (ix) 0.06 0.12 0.18
(12% of (12% of (12% of
Rs.0.54) Rs.1.00) Rs.1.50)
Long term debt: (x) 0.18 0.11 0.03
(16% of (16% of (16% of
Rs.1.12) Rs.0.66) Rs.0.16)
Earning before tax: 0.91 0.92 0.94
(xi) - (ix + x)
Tax @ 35% (0.32) (0.32) (0.33)
Earning after tax: (xii) 0.59 0.60 0.61
(a) Net Working Capital Position: (i) 1.02 0.56 0.06
-[(iv)+(v)]
(b) Rate of return on Equity 23.6% 24% 24.4%

shareholders’ capital : (xii)/(vii)
(c) Current Ratio: [(i)/(iv)+(v)] 1.35 1.17 1.02
Question 20
The Management of Fibroplast Limited is trying to establish a Current Assets policy.
Fixed Assets are Rs. 6,00,000, and the Company plans to maintain a 50% Debt-to-
Assets ratio. It has no operating Current Liabilities. The Interest Rate is 10% on all
Debts. The Company is considering three alternative Current Asset Policies - 40%, 50%
and 60% of Projected Sales. The Company expects to earn 15% before Interest and
Taxes on Sales of 30,00,000. The effective tax rate is 40%. You are required to calculate
the expected Return on Equity under each alternative.
428
Answer:
Computation of ROE under alternative financing policies
(Amounts in Rs.)
Particulars Restricted Moderate Relaxed (60%)

(40%) (50%)
1. Current Assets (% of sales) 12,00,000 15,00,000 18,00,000
2. Fixed Assets 6,00,000 6,00,000 6,00,000
3. Total Assets (1 + 2) 18,00,000 21,00,000 24,00,000
4. Debt (50% of Total Assets) 9,00,000 10,50,000 12,00,000
5. Equity (50% of Total Assets) 9,00,000 10,50,000 12,00,000
6. Total Liabilities and Equity (4+5) 18,00,000 21,00,000 24,00,000
7. Sales 30,00,000 30,00,000 30,00,000
8. EBIT at 15% on Sales 4,50,000 4,50,000 4,50,000
9. Interest (10% on Debt) 90,000 1,05,000 1,20,000
10. EBT (8 - 9) 3,60,000 3,45,000 3,30,000
11. Tax at 40% on EBT 1,44,000 1,38,000 1,32,000
12. EAT = Net Income (10 - 11) 2,16,000 2,07,000 1,98,000
13. Return on Equity = EAT + Equity 24.00% 19.70% 16.50%
Question 21
M.A. Limited is commencing a new project for manufacture of a plastic component. The
following cost information has been ascertained for annual production of 12,000 units
which is the full capacity:
Costs per unit (`)

Materials 40.00
Direct labour and variable expenses 20.00
Fixed manufacturing expenses 6.00
Depreciation 10.00
Fixed administration expenses 4.00
80.00
The selling price per unit is expected to be ` 96 and the selling expenses ` 5 per unit,
80% of which is variable.
In the first two years of operations, production and sales are expected to be as follows:
429
Year Production (No. of units) Sales (No. of units)

1 6,000 5,000
2 9,000 8,500
To assess the working capital requirements, the following additional information is

available:
(a) Stock of materials 2.25 months’ average consumption
(b)
Work-in-process Nil
(c) Debtors 1 month’s average sales.
(d)
Cash balance ` 10,000
(e) Creditors for supply of materials 1 month’s average purchase during the year.
(f) Creditors for expenses 1 month’s average of all expenses during the
year.
PREPARE, for the two years:
(i) A projected statement of Profit/Loss (Ignoring taxation); and
(ii) A projected statement of working capital requirements.
Answer:
M.A. Limited
Projected Statement of Profit / Loss (Ignoring Taxation)
Year 1 Year 2
Production (Units) 6,000 9,000
Sales (Units) 5,000 8,500
(`) (`)
Sales revenue (A) (Sales unit × ` 96) 4,80,000 8,16,000
Cost of production:
Materials cost 2,40,000 3,60,000
(Units produced × ` 40)
Direct labour and variable expenses (Units produced × 1,20,000 1,80,000
` 20)
Fixed manufacturing expenses 72,000 72,000
(Production Capacity: 12,000 units × ` 6)
Depreciation 1,20,000 1,20,000
(Production Capacity : 12,000 units × ` 10)
430
Fixed administration expenses (Production Capacity : 48,000 48,000

12,000 units × ` 4)
Total Costs of Production 6,00,000 7,80,000
Add: Opening stock of finished goods (Year 1 : Nil; Year --- 1,00,000
2 : 1,000 units)
Cost of Goods available for sale 6,00,000 8,80,000
(Year 1: 6,000 units; Year 2: 10,000 units)
Less: Closing stock of finished goods at average cost (1,00,000) (1,32,000)
(year 1: 1000 units, year 2 : 1500 units)
(Cost of Production × Closing stock / units produced)
Cost of Goods Sold 5,00,000 7,48,000
Add: Selling expenses – Variable (Sales unit × ` 4) 20,000 34,000
Add: Selling expenses -Fixed (12,000 units × `1) 12,000 12,000
Cost of Sales : (B) 5,32,000 7,94,000
Profit (+) / Loss (-): (A - B) (-) 52,000 (+) 22,000
Working Notes:
1. Calculation of creditors for supply of materials :
Year 1 (`) Year 2 (`)

Materials consumed during the year 2,40,000 3,60,000
Add: Closing stock (2.25 month’s average consumption) 45,000 67,500
2,85,000 4,27,500
Less: Opening Stock --- 45,000
Purchases during the year 2,85,000 3,82,500
Average purchases per month (Creditors) 23,750 31,875
2. Creditors for expenses:
Year 1 (`) Year 2 (`)

Direct labour and variable expenses 1,20,000 1,80,000
Fixed manufacturing expenses 72,000 72,000
Fixed administration expenses 48,000 48,000
Selling expenses (variable + fixed) 32,000 46,000
Total (including 2,72,000 3,46,000
Average per month 22,667 28,833
431
(ii) Projected Statement of Working Capital Requirement

(Cash Cost Basis)
Year 1 Year 2
(`) (`)
(A) Current Assets
Inventories:
- Stock of Raw Material 45,000 67,500
(6,000 units x ` 40 x 2.25/12); (9,000 units x ` 40 x
2.25 /12)
- Finished Goods (Refer working note 3) 80,000 1,11,000
Receivables (Debtors) (Refer working note 4) 36,000 56,250
Minimum Cash balance 10,000 10,000
Total Current Assets/ Gross working capital (A) 1,71,000 2,44,750
(B) Current Liabilities
Creditors for raw material (Refer working note 1) 23,750 31,875
Creditors for Expenses (Refer working note 2) 22,667 28,833
Total Current Liabilities 46,417 60,708
Net Working Capital (A – B) 1,24,583 1,84,042
Working Note:
3. Cash Cost of Production:
Year 1 (`) Year 2 (`)

Cost of Production as per projected Statement of P&L 6,00,000 7,80,000
Less: Depreciation 1,20,000 1,20,000
Cash Cost of Production 4,80,000 6,60,000
Add: Opening Stock at Average Cost: -- 80,000
Cash Cost of Goods Available for sale 4,80,000 7,40,000
Less : Closing Stock at Avg. Cost
` 4,80,000×1,000 ` 7,40,000×1,500 (80,000) (1,11,000)
;
6,000 10,00
Cash Cost of Goods Sold 4,00,000 6,29,000
432
4. Receivables (Debtors)
Year 1 Year 2
(`) (`)
Cash Cost of Goods Sold 4,00,000 6,29,000
Add : Variable Expenses @ ` 4 20,000 34,000
Add : Total Fixed Selling expenses (12,000 units × `1) 12,000 12,000
Cash Cost of Debtors 4,32,000 6,75,000
Average Debtors 36,000 56,250
Question 22
PQ Ltd., a company newly commencing business in 2020 has the following projected
Profit and Loss Account:
(`) (`)
Sales 2,10,000
Cost of goods sold 1,53,000
Gross Profit 57,000
Administrative Expenses 14,000
Selling Expenses 13,000 27,000
Profit before tax 30,000
Provision for taxation 10,000
Profit after tax 20,000
The cost of goods sold has been arrived at as under:
Materials used 84,000
Wages and manufacturing Expenses 62,500
Depreciation 23,500
1,70,000
Less: Stock of Finished goods
(10% of goods produced not yet sold) 17,000
1,53,000
The figure given above relate only to finished goods and not to work-in- progress. Goods
equal to 15% of the year’s production (in terms of physical units) will be in process on
the average requiring full materials but only 40% of the other expenses. The company
believes in keeping materials equal to two months’ consumption in stock.
All expenses will be paid one month in advance. Suppliers of materials will extend 1-1/2
433
months credit. Sales will be 20% for cash and the rest at two months’ credit. 70% of
the Income tax will be paid in advance in quarterly instalments. The company wishes
to keep ` 8,000 in cash. 10% has to be added to the estimated figure for unforeseen
contingencies.
PREPARE an estimate of working capital.
Note: All workings should form part of the answer.
Answer:
Statement showing the requirements of Working Capital
Particulars (`) (`)

A. Current Assets:
Inventory:
Stock of Raw material (` 96,600 × 2/12) 16,100
Stock of Work-in-progress (As per Working Note) 16,350
Stock of Finished goods (` 1,46,500 × 10/100) 14,650
Receivables (Debtors) (`1,27,080 × 2/12) 21,180
Cash in Hand 8,000
Prepaid Expenses:
Wages & Mfg. Expenses (` 66,250 × 1/12) 5,521
Administrative expenses (` 14,000 × 1/12) 1,167
Selling & Distribution Expenses (`13,000 × 1/12) 1,083
Gross Working Capital 84,051 84,051
Payables for Raw materials (`1,12,700 × 1.5/12) 14,088
Provision for Taxation (Net of Advance Tax) (`10,000 × 30/100) 3,000
Total Current Liabilities 17,088 17,088
C. Excess of CA over CL 66,963
Add: 10% for unforeseen contingencies 6,696
Net Working Capital requirements 73,659
434
Working Notes:
(i) Calculation of Stock of Work-in-progress
Particulars (`)
Raw Material (` 84,000 × 15%) 12,600
Wages & Mfg. Expenses (` 62,500 × 15% × 40%) 3,750
Total 16,350
(ii) Calculation of Stock of Finished Goods and Cost of Sale
Particulars (`)
Direct material Cost [` 84,000 + ` 12,600] 96,600
Wages & Mfg. Expenses [`62,500 + ` 3,750] 66,250
Depreciation 0
Gross Factory Cost 1,62,850
Less: Closing W.I.P (16,350)
Cost of goods produced 1,46,500
Add: Administrative Expenses 14,000
1,60,500
Less: Closing stock (14,650)
Cost of Goods Sold 1,45,850
Add: Selling and Distribution Expenses 13,000
Total Cash Cost of Sales 1,58,850
Debtors (80% of cash cost of sales) 1,27,080
(iii) Calculation of Credit Purchase
Particulars (`)
Raw material consumed 96,600
Add: Closing Stock 16,100
Less: Opening Stock -
Purchases 1,12,700
Question 23
While applying for financing of working capital requirements to a commercial bank, TN
Industries Ltd. projected the following information for the next year:
Cost Element Per unit (`) Per unit (`)

Raw materials
435
X 30
Y 7
Z 6 43
Direct Labour 25
Manufacturing and administration 20
overheads (excluding depreciation)
Depreciation 10
Selling overheads 15
113
(a) Raw Materials are purchased from different suppliers leading to different credit
period allowed as follows:
X – 2 months; Y– 1 months; Z – ½ month
(b) Production cycle is of ½ month. Production process requires full unit of X and Y
in the beginning of the production. Z is required only to the extent of half unit in
the beginning and the remaining half unit is needed at a uniform rate during the
production process.
(c) X is required to be stored for 2 months and other materials for 1 month.
(d) Finished goods are held for 1 month.
(e) 25% of the total sales is on cash basis and remaining on credit basis. The credit
allowed by debtors is 2 months.
(f) Average time lag in payment of all overheads is 1 months and ½ months for direct
labour.
(g) Minimum cash balance of ` 8,00,000 is to be maintained.
CALCULATE the estimated working capital required by the company on cash cost basis if
the budgeted level of activity is 1,50,000 units for the next year. The company also intends
to increase the estimated working capital requirement by 10% to meet the contingencies.
(You may assume that production is carried on evenly throughout the year and direct
labour and other overheads accrue similarly.)
Answer:
Statement showing Working Capital Requirements of TN Industries Ltd. (on cash cost basis)
(`) (`)
A. Current Assets
436
(i) Inventories:
Raw Material
`1,50,000 units x `30 7,50,000
X x 2 months
12 months
`1,50,000unitsx`7
Y x 1 month
12 months 87,500
`1,50,000 units x `6
Z x 1 month
12months 75,000
`1,50,000 units x `64

WIP x 0.5 month
12months 4,00,000
Finished Goods
`1,50,000 units x `88
x 1 month
12months 11,00,000 24,12,500
(ii) Receivables (Debtors)
`1,50,000 units x `103
x 2 months
12 months 19,31,250
(iii) Cash and Bank balance 8,00,000

(i) Payables (Creditors) for Raw materials
7,50,000
`1,50,000 units x `30
X x 2 months
12 months
`1,50,000 units x `7
Y x 1 month
12months 87,500
`1,50,000 units x `6
Z x 0.5 month
12months 37,500 8,75,000
(ii) Outstanding Direct Labour 1,56,250

`1,50,000 units x `25
Z x 0.5 month
12months 1,56,250
437
(iii) Outstanding Manufacturing and administration

overheads
`1,50,000 units x `20 2,50,000
x 1 month
12months
(iv) Outstanding Selling Overheads

`1,50,000 units x `15
x 1 month
12months 1,87,500
Total Current Liabilities 14,68,750
Net Working Capital (A – B) 36,75,000
Add: Provision for contingencies @ 10% 3,67,500
Working Capital requirement 40,42,500
Workings:
1.
(i) Computation of Cash Cost of Production Per unit (`)

Raw Material consumed 43
Direct Labour 25
Manufacturing and administration overheads 20
Cash cost of production 88
(ii) Computation of Cash Cost of Sales Per unit (`)
Cash cost of production as in (i) above 88
Selling overheads 15
Cash cost of sales 103
2. Calculation of cost of WIP
Particulars Per unit (`)

Raw material (added at the beginning):
X 30
Y 7
Z (` 6 x 50%) 3
Cost during the year:
Z {(` 6 x 50%) x 50%} 1.5
Direct Labour (` 25 x 50%) 12.5
Manufacturing and administration overheads (` 20 x 50%) 10
64
438
Question 24
From the following data, calculate the maximum permissible bank finance under the
three methods suggested by the Tandon Committee:
Liabilities ` in lakhs
Creditors 120
Other current liabilities 40
Bank borrowing 250
Total 410
Current Assets ` in lakhs
Raw material 180
Work-in-progress 60
Finished goods 100
Receivables 150
Other current assets 20
Total current assets 510
The total Core Current Assets (CCA) are ` 200 lakhs
Answer
The maximum permissible bank finance for the firm, under three methods may be
ascertained as follows:
Method I: = 0.75 (CA – CL)
= 0.75 (510 – 160)
= ` 262.50 lakhs
Method II: = 0.75 CA – CL
= 0.75 × 510 – 160
= ` 222.50 lakhs
Method III: = 0.75 (CA – CCA) – CL
= 0.75 (510 – 200) – 160
= ` 72.50 lakhs
So, it may be noted that the MPBF decreases gradually from the first method to second
method and then to third method. As the firm, has already availed the bank loan of
250 lakhs, it can still avail a loan of ` 12.50 lakhs as per the first method. However, as
per the second and third method, it is not eligible for additional financing as maximum
financing allowed is for ` 222.50 lakhs and ` 72.50 lakhs only whereas its present bank
borrowings are already ` 250 lakhs.
439
Question 25
The following annual figures relate to manufacturing entity:
A. Sales at one month credit 84,00,000

B. Material consumption 60% of sales value
C. Wages (paid in a lag of 15 days) 12,00,000
D. Cash Manufacturing Expenses 3,00,000
E. Administrative Expenses 2,40,000
F. Creditors extend 3 months credit for payment.
G. Cash manufacturing and administrative expenses are paid 1 months in arrear.
The company maintains stock of raw material equal to economic order quantity. The
company incurs ` 100 as per ordering cost per order and opportunity cost of capital
is 15% p.a. The optimum cash balance is determined using Baumol’s model. The bank
charges ` 10 for each cash withdrawal. Finished goods are held in stock for 1 month.
The company maintains a bank balance of `12,00,000 on an average. Creditors are paid
through net banking and all other expenses are incurred in cash which is withdrawn from
bank.
Assuming a 20% safety margin, you are required to ESTIMATE the amount of working
capital that needs to be invested by the Company.
Answer
Statement of working capital Requirement
Particular (`) (`)

A. Current Assets
Stock of Raw Material (W.N. 2) 81,975
1
Stock of finished Goods 65,40,000 x 5,45,000
12
1
Average Receivables (at Cost) 67,80,000 x
12 5,65,000
Bank Balance 12,00,000

Cash Balance (W.N. 3) 15,232
Gross Working Capital 24,07,207
B. Current Liabilities
440
3
Average Creditor for materials 50,40,000 x 12,60,000
12
0.5
Outstanding Wages 12,00,000 x 50,000
12
Outstanding Cash Manufacturing Expenses 25,000

1
3,00,000 x
12
1
Outstanding administrative Expenses 2,40,000 x 20,000
12
13,55,000
Net Working Capital (A-B) 10,52,207
Add: Safety Margin @ 20% 2,10,441
Total Working Capital Requirement 12,62,648
Working Notes:
1. Computation of annual cash Cost of Production & Sales
Material Consumed (84,00,000 × 60%) 50,40,000

Wages 12,00,000
Manufacturing expenses 3,00,000
Cash Cost of production 65,40,000
(+) Administrative Expenses 2,40,000
Cash Cost of Sales 67,80,000
2. Computation of stock of Raw Material

A = 50,40,000
B = 100
C = 0.15
2AB 2x50,40,000x100
∴ EOQ = = = ` 81,975
C 0.15
3. Calculation of Cash Balance

A = 12,00,000+3,00,000+2,40,000
A = 17,40,000
441
B = 10
C = 0.15
2AB 2x17,40,000x10
Optimal Cash Balance = = = ` 15,232
C 0.15
442
MANAGEMENT OF RECEIVABLES
AND MANAGEMENT OF PAYABLES
PART A: MANAGEMENT OF RECEIVABLES

THEORY SECTION
Meaning
Sales department would like to grant more & more credit in an effort to increase the
sales. It is the finance manager who has to decide whether the credit period should be
extended. A credit policy decision is a "trade - off" between profit on additional sales &
cost of carrying debtors. Cost of carrying debtors (COCD) means minimum return required
on investment in debtors. A credit policy decision may be general or customer specific.
Scope
The three basic aspects of management of Sundry Debtors will be studied in this Chapter.
1. Credit Policy : decisions on credit period to be allowed, early payment discount
rates, etc.
2. Credit Analysis : decisions on whether credit can be extended to a particular customer.
3. Factoring : decision on whether services of factor should be taken or not.
Statement showing evaluation of Credit Policy

Existing Proposed Options
Credit Policy I II
Sales x x x
(-) Variable Cost x x x
Contribution x x x
(-) Fixed Cost x x x
(-) Administrative Cost x x x
(-) Bad Debts x x x
(-) Collection Expenditure x x x
(-) Discount Allowed x x x
(-) COCD x x x
Net Benefit
443
CLASSWORK SECTION
Question 1
A company currently has an annual turnover of ` 10 lakhs and an average collection
period of 45 days. The company wants to experiment with a more liberal credit policy
on the ground that increase in collection period will generate additional sales. From the
following information, kindly indicate which of the policies you would like the company
to adopt:
Credit Policy Increase in collection Increase in Sales (`) Percentage of
period default
1 15 days 50,000 2%
2 30 days 80,000 3%
3 40 days 1,00,000 4%
4 60 days 1,25,000 6%
The selling price of the product is ` 5, average costs per unit at current level is ` 4 and
the variable costs per unit is ` 3.
The current bad debt loss is 1% and the required rate of return on investment is 20%. A
year can be taken to comprise of 360 days.
Question 2
PTX Limited is considering a change in its present credit policy. Currently it is evaluating
two policies. The company is required to give a return of 20% on the investment in
new accounts receivables. The company's variable costs are 70% of the selling price.
Information regarding present and proposed policies is as follows:
Present Policy Policy Option 1 Policy Option 2
Annual Credit Sales (`) 30,00,000 42,00,000 45,00,000
Debtors turnover ratio 4 times 3 times 2.4 times
Loss due to bad debts 3% of sales 5% of sales 6% of sales
Note: Return on investment in new accounts receivable is based on cost of investment in debtors.
(A) Which option would you recommend?
(B) Give change in working based on incremental approach.
Question 3
A Company has sales of ` 25, 00,000. Average collection period is 50 days, bad debt
losses are 5% of sales and collection expenses are ` 25,000. The cost of funds is 15%.
The Company has two alternative Collection Programmes:
444
Programme I Programme II
Average Collection Period reduced to 40 days 30 days
Bad debt losses reduced to 4% of sales 3% of sales
Collection Expenses ` 50,000 ` 80,000
Evaluate which Programme is viable.
Question 4
A firm has a current sale of ` 50,00,000. The firm has unutilised capacity. In order to
boost its sales, it is considering the relaxation in its credit policy. The proposed terms of
credit will be 60 days credit against the present policy of 45 days. As a result, the bad
debts will increase from 1.5% to 2% of sales. The firm’s sales are expected to increase
by 10%. The variable operating costs are 72% of the sales. The Firm’s corporate tax rate
is 35%, and it requires an after-tax return of 15% on its investment. Should the firm
change its credit period?
Question 5
A new customer with 10% risk of non-payment desires to establish business connections
with you. He would require 1.5 month of credit and is likely to increase your sales by `
1, 20,000 p.a. Cost of sales amounted to 85% of sales. The tax rate is 30%. Should you
accept the offer if the required rate of return is 40% (after tax)?
Question 6
A group of customers want to enter into a contract with you to buy goods worth ` 20
lakhs during 2019-2020 the deliveries to be made in four equal instalments quarterly.
The price of the commodity is ` 20 per unit on which you expect a profit of ` 10. The
acceptance of this proposal would mean an additional recurring expenditure of ` 10,000
p.a. on your part.
The ageing schedule of accounts receivables in respect of this group of customers in the
past was as follows:
Period Percentage of bills for which payment is received
At the end of 30 days 15%
Assuming an opportunity cost of 20% of the funds locked up in accounts receivables, will
be desirable to accept this proposal?
445
Question 7
A company is presently having credit sales of ` 12 lakh. The existing credit terms are
1/10, net 45 days and average collection period is 30 days. The current bad debts loss is
1.5%. In order to accelerate the collection process further as also to increase sales, the
company is contemplating liberalization of its existing credit terms to 2/10, net 45 days.
It is expected that sales are likely to increase by 1/3 of existing sales, bad debts increase
to 2% of sales and average collection period to decline to 20 days. The contribution to
sales ratio of the company is 22% and opportunity cost of investment in receivables is
15 percent (pre-tax). 50 per cent and 80 percent of customers in terms of sales revenue
are expected to avail cash discount under existing and liberalization scheme respectively.
The tax rate is 30%.
Should the company change its credit terms? (Assume 360 days in a year).
Question 8
A Factoring firm has credit sales of ` 360 lakhs and its average collection period is 30
days. The financial controller estimates, bad debt losses are around 2% of credit sales.
The firm spends ` 1, 40,000 annually on debtors administration. This cost comprises of
telephonic and fax bills along with salaries of staff members. These are the avoidable
costs. A Factoring firm has offered to buy the firm’s receivables. The factor will charge
1% commission and will pay an advance against receivables on an interest @15% p.a.
after withholding 10% as reserve. What should the firm do?
Assume 360 days in a year.
Question 9
A Ltd. has total sales of ` 3.2 crores and its average collection period is 90 days. The past
experience indicates that bad-debt losses are 1.5% on sales. The expenditure incurred
by the firm in administering its receivable collection efforts are ` 5, 00,000. A factor is
prepared to buy the firm’s receivables by charging 2% commission. The factor will pay
advance on receivables to the firm at an interest rate of 18% p.a. after withholding 10%
as reserve. Calculate the effective cost of factoring to the Firm.
Question 10
Primer Steel Limited has a present annual Sales turnover of Rs. 40,00,000. The unit sale price
is Rs. 20. The variable costs are Rs. 12 per unit and fixed costs amount to Rs. 5,00,000 per
annum. The present credit period of one month is proposed to be extended to either 2 or 3
months whichever will be more profitable. The following additional information is available:
446
ON THE BASIS OF CREDIT PERIOD OF

1 month 2 months 3 months
Increase in sales by — 10% 30%
% of Bad debts to sales 1 2 5
Fixed cost will increase by Rs. 75,000 when sales will increase by 30%. The company
requires a pre-tax return on investment at 20%.
Evaluate the profitability of the proposals and recommend best credit period for the
company.
Question 11
Easy Limited specializes in the manufacture of a computer component. The component is
currently sold for Rs. 1,000 and its variable cost is Rs. 800. For the year ended 31.3.2014
the company sold on an average 400 components per month.
At present the company grants one month credit to its customers. The company is thinking
of extending the same to two months on account of which the following is expected:
Increase in Sales 25%
Increase in Stock Rs.2,00,000
Increase in Creditors Rs.50,000
You advise the company on whether or not to extend the credit terms if:
(a) All customers avail the extended credit period of two months and
(b) Existing customers do not avail the credit terms but only the new customers avail
the same.
Assume in this case the entire increase in sales is attributable to the new customers. The
company expects a minimum return of 40% on the investment.
Question 12:
A factoring firm has offered a company to buy its accounts receivables. The relevant
information is given below:
(i) The current average collection period for the company's debt is 80 days and ½% of
debtors default. The factor has agreed to pay over money due to the company after
60 days and it will suffer all the losses of bad debts also.
(ii) Factor will charge commission @2%.
(iii) The company spends ` 1,00,000 p.a. on administration of debtor. These are avoidable cost.
(iv) Annual credit sales are ` 90 lakhs. Total variable costs is 80% of sales. The company's
cost of borrowing is 15% per annum. Assume 365 days in a year.
Should the company enter into agreement with factoring firm?
447
HOMEWORK SECTION
Question 13
Mosaic Limited has current sales of Rs. 15 lakhs per year. Cost of sales is 75per cent
of sales and bad debts are one per cent of sales. Cost of sales comprises 80 per cent
variable costs and 20 per cent fixed costs, while the company’s required rate of return is
12 percent. Mosaic Limited currently allows customers 30 days’ credit, but is considering
increasing this to 60 days’ credit in order to increase sales. It has been estimated that
this change in policy will increase sales by 15 percent, while bad debts will increase from
one per cent to four per cent. It is not expected that the policy change will result in an
increase in fixed costs and creditors and stock will be unchanged. Should Mosaic Limited
introduce the proposed policy? (Assume a 360 days year)
Answer:
Evaluation of Credit Policies:
Particulars Existing Policy (30 days) Proposed Policy (60 days)
Sales 15,00,000 17,25,000
Less: Variable Costs (9,00,000) (10,35,000)
Contribution 6,00,000 6,90,000
Less: Fixed Costs (2,25,000) (2,25,000)
Profits 3,75,000 4,65,000
Additional Costs:
Less: Bad Debts (15,000) (69,000)
Less: Collection Charges -- --
Less: Cost of Investment in (11,250) (25,200)
Debtors (WN 1)
Net Benefits 3,48,750 3,70,800
Conclusion : We should accept the proposal because Net Benefit is higher.

Increase in Profits is Rs. 22,050
Working Note : 1
Calculation of Cost of Investment in Debtors:
Particulars Existing Policy (30 days) Proposed Policy (60 days)
Debtors at Total Cost 11,25,000 X 30/360 X 12% 12,60,000 X 60/360 X 12%
(Variable Cost + Fixed Cost )
= Rs. 11,250 = Rs. 25,200
448
Question 14
A company has prepared the following projections for a year:
Sales 21,000units
Selling Price per unit Rs. 40
Variable Costs per unit Rs. 25
Total Costs per unit Rs. 35
Credit period allowed One month
The Company proposes to increase the credit period allowed to its customers from one
month to two months. It is envisaged that the change in the policy as above will increase
the sales by8%. The company desires a return of 25% on its investment.
You are required to examine and advise whether the proposed Credit Policy should be
implemented or not.
Answer:
Statement showing the Evaluation of Debtors Policy
Particulars Present Policy Proposed Policy
1 month 2 months
A. Expected Profit:
(a) Net Credit Sales (Sales units x Rs. 40) 8,40,000 9,07,200
(b) Less: Total Cost:
Variable (Sales units x Rs. 25) 5,25,000 5,67,000
Fixed Cost 2,10,000 2,10,000
7,35,000 7,77,000
(c)Expected Profit [(a)-(b)] 1,05,000 1,30,200
B. Opportunity Cost of Investment in Receivables 15,313 32,375
C. Net Benefits [A-B] 89,687 97,825
Recommendation: Proposed Policy should be implemented since the net benefit under this
policy are higher than those under present policy.
Working Note: Calculation of Opportunity Cost
Collection Period
Opportunity Cost =Total Cost x x Rate of Return
12
1 25
Present Policy = Rs.7,35,000 x x =Rs.15,313
2 100
1 25
Present Policy = Rs.7,77,000 x x =Rs.32,375
2 100
449
Question 15
A firm has a total sales of Rs. 12,00,000 and its average collection period is 90 days.
The past experience indicates that bad debt losses are 1.5% on sales. The expenditure
incurred by the firm in administering receivable collection efforts are Rs. 50,000. A factor
is prepared to buy the firm’s receivables by charging 2% commission. The factor will pay
advance on receivables to the firm at an interest rate of 16% p.a. after withholding 10%
as reserve. Calculate effective cost of factoring to the firm. Assume 360 days in a year.
Answer:
Computation of Effective Cost of Factoring
Average level of Receivables= 12,00,000 × 90/360 3,00,000
Factoring Commission = 3,00,000 × 2/100 6,000
Factoring Reserve = 3,00,000 × 10/100 30,000
Amount Available for Advance =Rs. 3,00,000-(6,000+30,000) 2,64,000
Factor will deduct his interest @ 16% :-
Rs.2,64,000 x 16 x 90
Interest = = Rs.10,560
360 x 100
Advance to be paid =Rs.2,64,000–Rs. 10,560 =Rs. 2,53,440

Annual Cost of Factoring to the Firm: Rs.
Factoring Commission ( Rs. 6,000 × 360/90) 24,000
Interest Charges ( Rs. 10,560 × 360/90) 42,240
Total 66,240
Firm’s Savings on taking Factoring Service: Rs.
Cost of Administration Saved 50,000
Cost of Bad Debts ( Rs. 12,00,000 x 1.5/100) avoided 18,000
Total 68,000
Net Benefit to the Firm ( Rs. 68,000 –Rs. 66,240) 1,760
Rs.66,240 x 100
Effective Cost of Factoring = 26.136%
2,53,440
Effective Cost of Factoring = 26.136%
Question 16
A company currently has an annual turnover of Rs. 50 lakhs and an average collection
period of 30 days. The company wants to experiment with a more liberal credit policy on
450
the ground that increase in collection period will generate additional sales.
From the following information, kindly indicate which policy the company should adopt:
Credit policy Average collection period Annual sales ( Rs. lakhs)
A 45days 56
B 60days 60
C 75days 62
D 90days 63
Costs: Variable cost: 80% of sales

Fixed cost: Rs. 6 lakhs per annum
Required (pre-tax) return on investment: 20%
A year may be taken to comprise of 360 days.
Answer:
Evaluation of Credit Policies
Credit Policy Present A B C D
Average collection period(days) 30 45 60 75 90
A. Sales Revenue 50 56 60 62 63
Less: Variable Costs (VC) 40 44.80 48 49.60 50.40
Contribution 10 11.20 12 12.40 12.60
Less: Fixed Costs (FC) 6 6 6 6 6
Profit 4 5.20 6 6.40 6.60
Increase in profit due to increase in - 1.20 2 2.40 2.60
contribution (20% of sales) compared to
present profit (A)
B. Investment in Debtors:
Total Cost (VC + FC) 46 50.80 54 55.60 56.40
Debtors Turnover Ratio (DT) (360/Average 12 8 6 4.80 4
Collection Period)
Average Investment in Debtors (Total 3.83 6.35 9 11.58 14.10
Cost/DT)
Additional Investment compared to - 2.52 5.17 7.75 10.27
Present Level
Cost of Additional Investment @ 20% (B) - 0.50 1.03 1.55 2.05
C. Incremental Profit (A-B) - 0.70 0.97 0.85 0.55
Recommendation: Credit Policy (B) is recommended since it yield maximum profit of 0.97
lakhs.
451
Question 17
A trader whose current sales are in the region of Rs. 6 lakhs per annum and an average
collection period of 30 days wants to pursue a more liberal policy to improve sales. A
study made by a management consultant reveals the following information:-
Credit Policy Increase in Increase in sales Present default
collection period anticipated
A 10 days Rs. 30,000 1.5%
B 20days Rs. 48,000 2%
C 30days Rs. 75,000 3%
D 45days Rs. 90,000 4%
The selling price per unit is Rs. 3. Average cost per unit is Rs. 2.25 and variable costs per
unit are Rs. 2. The current bad debt loss is 1%.Required return on additional investment
is 20%.Assumea 360 days year.
(A) Which option would you recommend?
(B) Give change in working based on incremental approach.
Answer:
A. Statement showing the Evaluation of Debtors Policies (Total Approach)
Particulars Present Proposed Proposed Proposed Proposed
Policy30 Policy A Policy B Policy C Policy D
days 40 days 50 days 60 days 75 days
A. Expected Profit:
(a) Credit Sales 6,00,000 6,30,000 6,48,000 6,75,000 6,90,000
(b) Total Cost other
than Bad Debts
(i) Variable Costs 4,00,000 4,20,000 4,32,000 4,50,000 4,60,000
[Sales x Rs. 2/ Rs. 3]
(ii) Fixed Costs 50,000 50,000 50,000 50,000 50,000
4,50,000 4,70,000 4,82,000 5,00,000 5,10,000
(c) Bad Debts 6,000 9,450 12,960 20,250 27,600
(d) Expected Profit [(a) 1,44,000 1,50,550 1,53,040 1,54,750 1,52,400
– (b) – (c)]
B. Opportunity Cost 7,500 10,444 13,389 16,667 21,250
of Investments in
Receivables
C. Net Benefits (A – B) 1,36,500 1,40,106 1,39,651 1,38,083 1,31,150
452
Recommendation: The Proposed Policy A (i.e. increase in collection period by 10 days

or total40 days) should be adopted since the net benefits under this policy are
higher as compared to other policies.
Working Notes:
(i) Calculation of Fixed Cost
= [Average Cost per unit – Variable Cost per unit] x No. of Units sold
= [ Rs. 2.25 - Rs. 2.00] x ( Rs. 6,00,000/3)
= Rs. 0.25 x 2,00,000 =Rs. 50,000
(ii) Calculation of Opportunity Cost of Average Investments

Collection period Rate of Return
Opportunity Cost = Total Cost x x
360 100

30 20
Present Policy = 4,50,000 x x = 7,500
360 100

40 20
Policy A = 4,70,000 x x = 10,400
360 100

50 20
Policy B = 4,82,000 x x = 13,389
360 100

60 20
Policy C = 5,00,000 x x = 16,667
360 100

75 20
Policy D = 5,10,000 x x = 21,250
360 100
B. Another method of solving the problem is Incremental Approach. Here we assume that
sales are all credit sales.
Particulars Present Proposed Proposed Proposed Proposed
Policy30 Policy A Policy B Policy C Policy D
days 40 days 50 days 60 days 75 days
A. Incremental Expected
Profit:
(a) Incremental Credit 30,000 48,000 75,000 90,000
Sales
(b) Incremental Costs
(i) Variable Costs 4,00,000 20,000 32,000 50,000 60,000
(ii) Fixed Costs 50,000 - - - -
453
(c) Incremental Bad 6,000 3,450 6,960 14,250 21,600

Debt Losses
(d) Incremental 6,550 9,040 10,750 8,400
Expected Profit(a
– b –c)]
B. Required Return
on Incremental
Investments:
(a) Cost of Credit Sales 4,50,000 4,70,000 4,82,000 5,00,000 5,10,000
(b) Collection period 30 40 50 60 75
(c) Investment in 37,500 52,222 66,944 83,333 1,06,250
Receivable (a x
b/360)
(d) Incremental - 14,722 29,444 45,833 68,750
Investment in
Receivables
(e) Required Rate of 20 20 20 20
Return (in %)
(f) Required Return - 2,944 5,889 9,167 13,750
on Incremental
Investments (d x
e)
C. Net Benefits (A – B) - 3,606 3,151 1,583 (5,350)
Recommendation: The Proposed Policy A should be adopted since the net benefits
under this policy are higher than those under other policies.
Question 18
The current credit sales of a firm is Rs. 15 lakhs and the firm still has an unutilized
capacity. In order to boost its sales, the firm is willing to relax its credit policy.
The firm proposes a new credit policy of 2/10 net 60 days as against the present policy
of 1/10 net 45 days.. The firm expects an increase in the sales by 12%. However, it is also
expected that bad debts will go upto 2% of sales from 1.5%.
The contribution to sales ratio of the firm is 28%. The firm’s tax rate is 30% and firm
requires an after tax return of 15% on its investment.
Should the firm change the credit policy?
Note: No customers will take cash discount and one year= 360 days.
454
Answer:
Evaluation of Credit policies
Credit policy Average collection period Annual sales ( Rs. lakhs)
Credit Sales 15,00,000 15,80,000
(112% of 15,00,000)
Variable Cost (72%) (10,80,000) (12,09,600)
Contribution 4,20,000 4,70,400
Bad debt (22,500) (33,600)
(15,00,000 x 15%) (16,80,000 x 2%)
Profit Before Tax (PBT) 3,97,500 4,36,800
Tax @ 30% (1,19,250) (1,31,040)
Profit After Tax (PAT) 2,78,250 3,05,760
Opportunity Cost (Refer working (20,250) (30,240)
note)
Net Profit 2,58,000 2,75,520
In proposed scheme the net profit is more by Rs. 17,520 i.e. (Rs. 2,75,520 - Rs. 2,58,000),
hence, company should change the credit policy.
Working Note:
Opportunity Cost on Credit sales:
15 45 days
Present policy = Rs.10,80,000 x x =Rs.20,250
100 360 days
15 60 days
Proposed policy =Rs.12,09,600 x x =Rs.30,240
100 360 days
Assumption:
(i) Cash discount is not availed by the debtors.
(ii) Debtors are utilizing full credit period for payment.
(iii) No. of days in a year is 360 days.
Question 19
A firm has a total sales of Rs. 200 lakhs of which 80% is on credit. It is offering credit
terms of 2/40, net 120. Of the total, 50% of customers avail of discount and the balance
pay in 120days. Past experience indicates that bad debt losses are around 1 % of credit
sales. The firm spends about Rs. 2,40,000 per annum to administer its credit sales. These
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are avoidable as a factor is prepared to buy the firm’s receivables. He will charge 2%
commission. He will pay advance against receivables to the firm at an interest rate of
18% after withholding 10% as reserve.
(i) What is the effective cost of factoring? Consider year as 360 days.
(ii) If bank finance for working capital is available at 14% interest, should the firm avail
of factoring service
Answer:
Particulars Rs.
Total Sales Rs. 200 lakhs
Credit Sales (80%) Rs. 160 lakhs
Receivables for 40 days Rs. 80 lakhs
Receivables for 120 days Rs. 80 lakhs
Average collection period [(40 x 0.5) + (120 x 0.5)] 80 days
Average level of Receivables (Rs. 1,60,00,000 x 80/360) Rs.35,55,556
Factoring Commission (Rs. 35,55,556 x 2/100) Rs.71,111
Factoring Reserve (Rs. 35,55,556 x 10/100) Rs. 3,55,556
Amount available for advance {Rs. 35,55,556 - (3,55,556 + 71,111)} Rs.31,28,889
Factor will deduct his interest 18% : Rs. 1,25,156
Rs.31,28,889 x 18 x 80
Interest =
100 x 360
Advance to be paid (Rs. 31,28,889 - Rs. 1,25,156) Rs.30,03,733
(i) Statement Showing Evaluation of Factoring Proposal

Rs.
A. Annual Cost of Factoring to the Firm:
Factoring commission (Rs. 71,111 x 360/80) 3,20,000
Interest charges (Rs. 1,25,156 x 360/80) 5,63,200
Total 8,83,200
B. Firm’s Savings on taking Factoring Service: Rs.
Cost of credit administration saved 2,40,000
Bad Debts (Rs. 160,00,000 x 1/100) avoided 1,60,000
Total 4,00,000
C. Net Cost to the firm (A - B) (Rs. 8,83,200 - Rs. 4,00,000) 4,83,200
Rs.4,83,200
Effective cost of factoring = x100 = 16.09* %
Rs.30,03,733
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* If cost of factoring is calculated on the basis of total amount available for advance,
then, it will be

Rs.4,83,200
= x 100 = 15.44%
Rs.31,28,889
(ii) If Bank finance for working capital is available at 14%, firm will not avail factoring
service as 14 % is less than 16.08% (or 15.44%)
Question 20
Sug Ltd. is a regular eash customer of Quest Ltd. The former has offered to buy goods of
Rs.20,00,000 in one year and is expected to make payments as per following schedule :
By the end of 20 days 15% of the Bill
Non Recovery (Discount) 2% of the Bill
Purchases of Rs. 20,00,000 would be scattered over the year and to be made in equal
quantities on the first day of each quarter. The selling price and the profit per unit are Rs.
200 and Rs. 30 per unit. Quest Ltd. expects that if the offer is accepted, additional cost
of Rs. 35,000 p.a. would be required. The opportunity cost of funds for Quest Ltd. may be
taken as 25%; Should the offer be accepted or not ?
Answer:
Expected Profit for Sale (20,00,000 ÷200) X 30 Rs. 3,00,000
Less : Incremental cost 35,000
Incremental Profit 2,65,000
Quarterly Sales (Rs. 20,00,000 ÷ 4) Rs. 5,00,000
Cost of quarterly sales is (5,00,000 ÷ 200) X 170 4,25,000
Cost of Credit availed by Sug Ltd : Product per Quarter

15% of Rs. 4,25,000 Rs. 63,750 X 20 days Rs. 12,75,000
30% of Rs. 4,25,000 1,27,500 X 45 days 57,37,500
25% of Rs. 4,25,000 1,06,250 X 90 days 5,62,500
28% of Rs. 4,25,000 1,19,000 X 100 days Rs. 1,19,00,000
2% of Rs. 4,25,000 (Non-recovery) _________-
Total Funds blocked for 1 day 2,84,75,000
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Interest @ 25% for 1 day for 1 Quarter Rs. 19,503

Interest for 4 quarters 78,012
Cost of Bad Debts (5,00,000 X 2% X 4) 40,000
Total cost (Interest + Bad Debt) 1,18,012
Incremental Profit 2,65,000
Net Profit (2,65,000 - 1,18,012) 1,46,988
The firm should accept the offer.
Question 21
Tony Limited, manufacturer of Colour TV sets is considering the liberalization of existing
credit terms to three of their large customers A, B and C. The credit period and likely
quantity of TV sets that will be sold to the customers in addition to other sales are as
follows:
Quantity sold (No. of TV Sets)
Credit Period (Days) A B C
0 1,000 1,000 -
30 1,000 1,500 -
60 1,000 2,000 1,000
90 1,000 2,500 1,500
The selling price per TV set is Rs. 9,000. The expected contribution is 20% of the selling
price. The cost of carrying receivable averages 20%per annum.
You are required:
(a) COMPUTE the credit period to be allowed to each customer.
(Assume360daysinayearforcalculationpurposes).
(b) DEMONSTRATE the other problems the company might face in allowing the credit
period as determined in (a)above?
Answer:
(a) In case of customer A, there is no increase in sales even if the credit is given. Hence
comparative statement for B & C is given below:
Particulars Customer B Customer C
1. Credit period 0 30 60 90 0 30 60 90
(days)
2. Sales Units 1,000 1,500 2,000 2,500 - - 1,000 1,500
Rs. in lakhs Rs.in lakhs
3. Sales Value 90 135 180 225 - - 90 135
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4. Contribution at 18 27 36 45 - - 18 27
20% (A)
5. Receivables:
Credit Period× - 11.25 30 56.25 - - 15 33.75
Sales 360
6. Debtors at cost i.e. - 9 24 45 - - 12 27
80% of 11.25
7. Cost of carrying - 1.8 4.8 9 - - 2.4 5.4
debtors at 20%
(B)
8. Excess of 18 25.2 31.2 36 - - 15.6 21.6
contributions
over cost
of carrying
debtors (A – B)
The excess of contribution over cost of carrying Debtors is highest in case of credit
period of 90 days in respect of both the customers B and C. Hence, credit period of
90 days should be allowed to B and C
(b) Problem:
a. Customer A is taking 1000 TV sets whether credit isgiven or not. Customer C is
taking 1000 TV sets at credit for 60 days. Hence A also may demand credit for
60 days compulsorily.
b. B will take 2500 TV sets at credit for 90 days whereas C would lift 1500 sets
only. In such case B will demand further relaxation in credit period i.e. B may
ask for 120 days credit.
Question 22
Hari Ltd has just acquired a large order. As a result, it needs an additional Rs. 75,000
in Working Capital immediately. It has been determined that there are three feasible
sources of funds. Determine the best course of action for the Company.
• Trade Credit: The Company buys about Rs. 50,000 of Materials per month on term
of 3/30, net 90. Discounts are taken.
• Bank Loan: The Firm’s Bank will lend Rs. 1,00,000 at 13%. A 10% Compensating
Balance will be required, which otherwise would not be maintained by the company.
• Factoring: A Factor will buy the Company’s Receivables ( Rs. 1,00,000 per month),
459
which have a collection period of 60 days. The Factor will advance up to 75% of
the Face Value of the Receivables at 12% on an annual basis. The Factor will also
charge a 2% Fee on all Receivables purchased. It has been estimated that the
Factor’s Services will save the Company, Credit Department Expenses and Bad-Debt
Expenses of Rs. 1,500 per month.
Answer:
Computation of Effective Cost of Alternative Sources of Funds
Particulars Explanation Computation & Result
Trade Credit Effective Cost of Trade Credit (without 3 365
x =18.81%
considering Compounding Effect) = 97 90-30
d 365
x , where d = Discount Rate, t
100-d t
= Reduction in Payment Period necessary to
obtain the early payment discount.
Bank Loan For getting a loan of Rs. 100, a compensating 13
=14.44%
balance of Rs. 10 has to be maintained 100-10
without earning any interest thereon. Hence,
Effective Cost =
Factoring Cost of Factoring = Interest (12% onRs. Rs. 15,000

=20.00%
75,000) + Fees (2% onRs.12,00,000), whereas Rs. 75,000
the Benefits are Cost Savings Rs. l,500x 12
=Rs. 18,000.So, Net Cost of Factoring =Rs.
9,000 +Rs. 24,000 -Rs. 18,000 =Rs. 15,000
Conclusion: Based on Effective Cost, Bank Borrowing is the most cost-effective source of
funds.
Question 23:
As a part of the strategy to increase sales and profits, the sales manager of a company
proposes to sell goods to a group of new customers with 10% risk of non-payment. This
group would require one and a half months credit and is likely to increase sales by `
1,00,000 p.a. Production and Selling expenses amount to 80% of sales and the income-
tax rate is 50%. The company’s minimum required rate of return (after tax) is 25%.
Should the sales manager’s proposal be accepted? ANALYSE
Also COMPUTE the degree of risk of non-payment that the company should be willing to
assume if the required rate of return (after tax) were (i) 30%, (ii) 40% and (iii) 60%.
460
Answer:
Statement showing the Evaluation of Proposal
Particulars `
A. Expected Profit:
Net Sales 1,00,000
Less: Production and Selling Expenses @ 80% (80,000)
Profit before providing for Bad Debts 20,000
Less: Bad Debts @10% (10,000)
Profit before Tax 10,000
Less: Tax @ 50% (5,000)
Profit after Tax 5,000
B. Opportunity Cost of Investment in Receivables (2,500)
C. Net Benefits (A – B) 2,500
Advise: The sales manager’s proposal should be accepted.
Working Note: Calculation of Opportunity Cost of Funds
Opportunity Cost = Total Cost of Credit Sales x
Statement showing the Acceptable Degree of Risk of Non-payment
Particulars Required Rate of Return

30% 40% 60%
Sales 1,00,000 1,00,000 1,00,000
Less: Production and Sales 80,000 80,000 80,000
Expenses
Profit before providing for 20,000 20,000 20,000
Bad Debts
Less: Bad Debts (assume X) X X X
Profit before tax 20,000 – X 20,000 – X 20,000 – X
Less: Tax @ 50% (20,000 – X) 0.5 (20,000 – X) 0.5 (20,000 – X) 0.5
Profit after Tax 10,000 –0.5X 10,000 –0.5X 10,000 –0.5X
Required Return (given) 30% of 10,000* 40% of 10,000* 60% of 10,000*
= ` 3,000 = ` 4,000 = ` 6,000
*Average Debtors = Total Cost of Credit Sales ×
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Computation of the value and percentage of X in each case is as follows:

Case I 10,000 – 0.5x = 3,000
0.5x = 7,000
X = 7,000/0.5 = ` 14,000
Bad Debts as % of sales = ` 14,000/`1,00,000 × 100 = 14%
Case II 10,000 – 0.5x = 4,000

0.5x = 6,000
X = 6,000/0.5 = ` 12,000
Case III 10,000 – 0.5x = 6,000
0.5x = 4,000
X = 4,000/0.5 = ` 8,000
Thus, it is found that the Acceptable Degree of risk of non-payment is 14%, 12% and 8%
if required rate of return (after tax) is 30%, 40% and 60% respectively.
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PART B: MANAGEMENT OF PAYABLES
Question 24
A Ltd. is in the manufacturing business and it acquires raw material from X Ltd. on a
regular basis. As per the terms of agreement the payment must be made within 40 days
of purchase. However, A Ltd. has a choice of paying Rs. 98.50 per Rs. 100 it owes to X
Ltd. on or before 10th day of purchase.
Required:
EXAMINE whether A Ltd. should accept the offer of discount assuming average billing of
A Ltd. with X Ltd. is Rs. 10,00,000 and an alternative investment yield a return of 15%
and company pays the invoice.
Answer:
Annual Benefit of accepting the Discount
Rs.1.5 365 days
x =18.53%
Rs.100-Rs.1.50 40-10 days
Annual Cost = Opportunity Cost of foregoing interest on investment = 15%.
OR
If average invoice amount is Rs.10,00,000
If discount is
Accepted Rs. Not Accepted Rs.
Payment to Supplier (Rs.) 9,85,000 10,00,000
Return on investment of Rs.9,85,000 for 30 (12,144)
days (Rs.9,85,000 x (30/365) x 15%)
9,85,000 9,87,856
Question 25
Lalita Ltd purchases Raw Materials on terms of 2/10, net 30. A review of the Company’s
records by the Owner, Mr. Easwar, revealed that payments are usually made 15 days
after purchases are received. When asked why the Firm did not take advantage of its
discounts, the Accountant, Mr. Ram, replied that it cost only 2% for these funds, whereas
a Bank Loan would cost the Company 12%.
(a) What mistake is Ram making?
(b) What is the Real Cost of not taking advantage of the Discount?
(c) If the Firm could not borrow from the Bank and was forced to resort to the use of
Trade Credit funds, what suggestion might be made to Ram that would reduce the
Annual Interest Cost?
463
Answer
(a) Discount Rate of 2% should not be compared directly with the Interest Rate on Bank
Borrowings. In this case, Ram is confusing the percentage cost of using funds for 5
days (i.e. paying on 15th day instead of 10th day) with the cost of using funds for a
year (i.e. Bank Interest Rate). These cost are clearly not comparable because of the
difference in time period. One must be converted to the time scale of the other.
(b) Effective Cost of Lost Cash Discount= Effective Cost of Trade Credit (without
d 365
considering Compounding Effect) = x
100-d t
where d = Discount Rate, t = Reduction in Payment Period necessary to obtain the
discount.
2 365
Hence, in this case, Effective Cost of Discount = x = 148.98%
98 15-10
(c) If the firm has decided to use Trade Credit and not to take the Cash Discount, it is
not advisable to pay 15th day, i.e. before the due date of 30 days. In such case,
payment on 30th day rather than 15th day would reduce the Annual

2 365
Interest Cost = x = 37.24%
98 30-10
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CASH BUDGET
THEORY SECTION
Meaning
Cash Budgets are a tool for forecasting short - term cash requirements of an enterprise.
They provide a blueprint of the cash inflows and outflows that are expected to occur in
the immediate future period. They assist the management in determining the surplus or
shortage of funds and to take suitable action. The Cash Budget can be prepared for short
period or for long period.
Monthly Cash Budget
Particulars April May June
Opening Balance
Add : Receipts
Cash sales
Collection from debtors
Raising of loans
Issue of share capital or debentures
Sale of FA / Investments
Income from Investments, etc.
(A)
Less : Payments
Payment to suppliers
Payment of operating expenses
Purchase of FA / Investments
Redemption of shares / debentures
Repayment of loans
Interest Payment, etc.
(B)
Balance (A - B)
Borrowings
Repayment of borrowings
Investment of surplus cash
Balance c/f to Next month
465
CLASSWORK SECTION
Question 1
From the following information relating to a departmental store for the three months
period ending 31st March, 2020, you are required to prepare the following :
Monthly cash budget on receipts and payments basis
It is anticipated that the working capital items on 31st December, 2019 will be as follows:
` 000's
Cash in hand and at bank 545
Short-term investments 300
Debtors 2,570
Stock 1,300
Trade Creditors 2,110
Other Creditors 200
Dividends Due 485
Tax Due 320
BUDGETED PROFIT STATEMENT

Particulars ` 000's
Jan. Feb. March
Sales 2,100 1,800 1,700
Cost of Sales 1,635 1,405 1,330
Gross Profit 465 395 370
Administrative, selling and distribution expenses 315 270 255
and interest
Net Profit prior to tax 150 125 115
BUDGETED BALANCES AT THE END OF EACH MONTH

` 000's
31st Jan. 28th Feb. 31st March
Short-term investments 700 ---- 200
Debtors 2,600 2,500 2,350
Stock 1,200 1,100 1,000
Trade Creditors 2,000 1,950 1,900
Other Creditors 200 200 200
Dividends Due 485 ---- ----
Tax Due 320 320 320
466
Depreciation amounting to ` 60,000 is included in the budgeted expenditure for each

month.
Capital expenditure amounting to ` 8,00,000 is expected to be incurred during February
2020 and proceeds from the sale of plant and equipment of ` 50,000 is expected in
March, 2020.
Question 2
Ram, Arun & Kalish, Chartered Accountants are partners of the Firm Ranka Associates
specialising in the areas of internal and corporate audit, taxation and project consultancy.
The revenue of the firm is steadily increasing over the years. For the year they decided
to operate a budgetary control system to monitor the profitability as well as cash
movements. To start with the following forecast of profits was prepared for the first six
months :
RANKA ASSOCIATES (` IN
'000)
PROJECTED PROFIT FORECASTS FOR THE SIX MONTHS ENDING 30.9.2020
Particulars April May June July Aug. Sept.
Incomes
Internal / Corporate
Audit 60 60 60 60 60 60
Taxation 30 45 40 50 40 60
Project Consultancy 30 50 30 40 60 40
Total A 120 155 130 150 160 160
Expenses
Depreciation 10 10 10 10 10 10
Rent 5 5 5 5 5 5
Stipend 15 15 15 15 15 15
Telephone 5 7 8 9 13 15
Office Expenses & Salaries 35 45 50 35 40 42
Training 5 6 4 10 12 13
Travel & Conveyance 10 12 13 14 15 15
Partners & Assistants' Salaries 20 30 35 35 40 40
Toal B 105 130 140 133 150 155
Profit (A – B) 15 25 (10) 17 10 5
The following additional information is significant :

(a) Rent is payable in advance on the last day of the previous quarter.
(b) Stipend will be paid in the same month.
467
(c) Telephone will be paid every two months in arrears. (i.e. April and May will be paid in June)
(d) Office expenses and Salaries will be paid in the following month.
(e) Travel & Training will be paid in the same month.
(f) Partners and assistants salaries will be paid in the following month.
(g) The firm is planning to invest a sum of ` 50,000 in July for acquiring a computer.
(h) The firm expects to pay a self-assessment tax of ` 5,000 and advance tax of `15,000
in August.
(i) The firm is planning to open a branch and spend a sum of ` 20,000 in September in
this regard.
(j) Collection of Fees : Internal / Corporate Audit fees will be collected in the following
month. Taxation : 50% in the same month and 50% in the following month.
Consultancy charge is normally received after 2 months.
(k) The firm's Cash Balance as on July 1st was ` 25,000.
You are required to :
(i) Prepare a Cash Budget for each of the three months - July, August and September.
(ii) Suggest two improvements that could smoothen the cash position as on 30th
September.
Question 3
A firm maintains a separate account for cash disbursement. Total disbursements are
` 1,05,000 per month or ` 12, 60,000 per year. Administrative and transaction cost of
transferring cash to disbursement account is ` 20 per transfer. Marketable securities yield
is 8% per annum.
Determine the optimum cash balance according to William J. Baumol model.
Question 4
The following details are forecasted by a Company for the purpose of effective utilization
and management of Cash –
1. Estimated Sales and Manufacturing Costs:
Year 2010 Month Sales Materials Wages Overheads
April Rs. 4,20,000 Rs. 2,00,000 Rs. 1,60,000 Rs. 45,000
May Rs. 4,50,000 Rs. 2,10,000 Rs. 1,60,000 Rs. 40,000
June Rs. 5,00,000 Rs. 2,60,000 Rs. 1,65,000 Rs. 38,000
July Rs. 4,90,000 Rs. 2,82,000 Rs. 1,65,000 Rs. 37,500
August Rs. 5,40,000 Rs. 2,80,000 Rs. 1,65,000 Rs. 60,800
September Rs. 6,10,000 Rs. 3,10,000 Rs. 1,70,000 Rs. 52,000
468
2. Credit-Terms:
(a) 20% Sales are on Cash. 50% of the Credit Sales are collected next month and
the balance in the following month.
(b) Credit allowed by Suppliers is 2 months.
(c) Delay in payment of Wages is 1/2 (one-half) month and of Overheads is 1
(one) month.
3. Interest on 12% Debentures of Rs. 5,00,000 is to be paid half-yearly in June and
December.
4. Dividends on Investments amounting to Rs. 25,000 are expected to be received in
June.
5. A New Machinery will be installed in June at a cost of Rs. 4,00,000 payable in 20
monthly instalments from July onwards.
6. Advance Income-Tax to be paid in August is Rs. 15,000.
7. Cash balance on 1st June is expected to be Rs. 45,000 and the Company wants to
keep it at the end of every month around this figure, the excess cash (in multiple of
thousands rupees) being put in Fixed Deposit.
You are required to prepare monthly Cash Budget on the basis of above information
for four months beginning from June.
Question 5
Prepare monthly cash budget for six months beginning from April 2017 on the basis of
the following information:-
(i) Estimated monthly sales are as follows:-
( Rs. ) ( Rs. )
January 1,00,000 June 80,000
February 1,20,000 July 1,00,000
March 1,40,000 August 80,000
April 80,000 September 60,000
May 60,000 October 1,00,000
(ii) Wages and salaries are estimated to be payable as follows:-

Rs. Rs.
April 9,000 July 10,000
May 8,000 August 9,000
June 10,000 September 9,000
469
(iii) Of the sales, 80% is on credit and 20% for cash. 75% of the credit sales are collected
within one mo nth and the balance in two months. There are no bad debt losses.
(iv) Purchases amount to 80% of sales and are made on credit and paid for in the
month preceding the sales.
(v) The firm has 10% debentures of Rs. 1,20,000. Interest on these has to be paid
quarterly in January, April and so on.
(vi) The firm is to make an advance payment of tax of Rs. 5,000 in July, 2017.
(vii) The firm had a cash balance of Rs. 20,000 on April 1, 2017, which is the minimum
desired level of cash balance. Any cash surplus/deficit above/below this level
is made up by temporary investments/ liquidation of temporary investments or
temporary borrowings at the end of each month (interest on these to be ignored).
470
HOMEWORK SECTION
Question 6
VK Co. Ltd. has total cash disbursement amounting Rs. 22,50,000 in the year 2017 and
maintains a separate account for cash disbursements. Company has an administrative
and transaction cost on transferring cash to disbursement account Rs. 15 per transfer.
The yield rate on marketable securities is 12% per annum.
You are required to determine optimum cash balance according to William J Baumol
Model.
Answer:
Determination of Optimum Cash Balance according to William J. Baumol’s Model
2UP
C=
S
Where,
C = Optimum cash balance
U = Annual cash disbursement
P = Fixed cost per transaction
S = Opportunity cost of one-rupee p.a.
Therefore, Optimum Cash Balance
2 x Rs.22,50,000 x Rs.15
= 56,25,00,000
0.12
= Rs.23,717.08 or Rs.23,717
Question 7
Prepare cash budget for the period of July-December 2010 from the following information:
(i) The estimated sales and expenses are as follows:
(Figures in Rs. lacs)
June July Aug. Sept. Oct. Nov. Dec.
Sales 35 40 40 50 50 60 65
Purchases 14 16 17 20 20 25 28
Wages and Salaries 12 14 14 18 18 20 22
Expenses 5, 6 6 6 7 7 7
Interest received 2 - - 2 - - 2
Sale of Fixed assets - - 20 - - - -
471
(ii) 20% of the sales are made on cash and balance on credit. 50% of the debtors are
collected in the month of sales and the remaining in the next month.
(iii) The time lag in payment of purchases and expenses is 1 month, however, wages
and salaries are paid fortnightly with a time lag of 15 days.
(iv) The company keeps a minimum cash balance of Rs. 5 lacs. The cash balance in
excess of Rs. 7 lacs is invested in Government Securities in multiple of Rs. 1 lac.
Shortfalls in cash balance are made good by borrowing from banks The interest
received as well as paid is to be ignored.
Answer:
CASH BUDGET FOR THE PERIOD JULY-DECEMBER 2010
(Figures in Rs. lacs)
July Aug. Sept. Oct. Nov. Dec.
Cash in the beginning 5 7 7 7. 7. 7
Cash Inflows : Cash Sales 8 8 10 10 12 13
Debtors Collection 30 32 36 40 44 50
Interest Received - - 2 - - 2
Sale of fixed assets - 20 - - - -
Total cash (A) 43 67 55 57 63 72
Cash Outflows :
Purchases 14 16 17 20 20 25
Expenses 5 6 6 6 7 7
Wages and Salaries 13 14 16 18 19 21
Total Outflows (B) 32 36 39 44 46 53
Balance at the end (A-B) 11 31 16 13 17 19 I
Investment in Government Securities 4 24 9 6 10 12
Closing Balance 7 7 7 7 7 7
Working Notes:
1. Cash collected from debtors has been calculated follows :
(Figures in Rs.)
June July Aug. Sept. Oct. Nov.
Credit sales Cash collected 28 32 32 40 40 48
(Previous Month) Cash collected - 14 16 16 20 20
(Current Month) - 1,6 16 20 20 24
Total cash collected - 30 32 36 40 44
472
2. Cash balance in excess of Rs. 7,00,000 has been invested in Government Securities.
No borrowing is required in any of these month as the cash balance is more than the
minimum cash requirement.
3. Since wages and salaries are payable with a time lag of 15days, therefore, in a
particular month the amount of wages and salaries payable would be the sum of
wages and salaries of the 2nd half of the previous month and the 1st half of the
current month.
Question 8
Prepare monthly cash forecast for the company XYZ Ltd. for the quarter ending 31st
March, from the following details :
(i) Opening balance as on 1st January is Rs. 22,000.
(ii) Its estimated sale for the month of January and February Rs. 1,00,000 each and
for the month of March is Rs. 1,20,000. The sale for November and December of the
previous year have been Rs. 1,00,000 each.
(iii) Cash and credit sales are estimated 20% and 80% respectively.
(iv) The receivables from credit sales are expected to be collected as follows: 50% of the
receivable on an average of one month from the date of sales; and balance 50%
after two months from the date of sale. No bad debts on the realization of sales.
(v) Other anticipated receipt is Rs. 5,000 from the sale of machine in March.
The forecast of payment is as follows :
(a) The purchase of materials worth Rs. 40,000 in January and February and materials
worth Rs. 48,000 in March.
(b) The payments for these purchases are made approximately a month after the
purchase. The purchases for December of the previous year have been Rs. 40,000
for which the payment will be made in January.
(c) Miscellaneous cash purchase of Rs. 2,000 per month.
(d) The wages payments are expected to be Rs. 15,000 per month.
(e) Manufacturing expenses are expected to be Rs. 20,000 per month.
(f) General selling expenses are expected to be Rs. 10,000 per month.
(g) A machine worth Rs. 50,000 is proposed to be purchased on cash in March.
473
Answer:
CASH BUDGET FOR THE PERIOD JANUARY-MARCH
January February March
Opening Cash Rs. 22,000 Rs. 35,000 Rs. 48,000
Cash Inflows :
Cash sales 20,000 20,000 24,000
Debtors collected 80,000 80,000 80,000
Sale of machine — — 5,000
Total Cash (A) 1,22,000 1,35,000 1,57,000
Cash Outflows:
Cash Purchases 2,000 2,000 2,000
Payment to creditors 40,000 40,000 40,000
Wages 15,000 15,000 15,000
Manufacturing expenses 20,000 20,000 20,000
General selling expenses 10,000 10,000 10,000
Purchase of machine — — 50,000
Total Outflows (B) 87,000 87,000 1,37,000
Cash balance (A-B) 35,000 48,000 20,000
Question 9
A new manufacturing company is to be incorporated from January 1, 2015. Its authorised
capital will be Rs. 2 crores divided into 20 lakh equity shares of Rs. 10 each. It intends to
raise capital by issuing equity shares of Rs. 1 crore (fully paid) on 1stJanuary. Besides, a
loan of Rs. 13 lakhs @ 12%per annum will be obtained from a financial institution on
1stJanuary and further borrowings will be made at same rate of interest on the first day
of the month in which borrowing is required. All borrowings will be repaid along with
interest on the expiry of one year. The company will make payment for the following
assets in January.
Rs. (in lakhs)
Plant and Machinery 20
Land and Building 40
Furniture 10
Motor Vehicles 10
Stock of Raw Materials 10
The following further details are available:
(1) Projected Sales (January-June):
474
( Rs. in lakhs) ( Rs. in lakhs)

January 30 April 40
February 35 May 40
March 35 June 45
(2) Gross profit margin will be 25% on sales.
(3) The company will make credit sales only and these will be collected in the second
month following sales.
(4) Creditors will be paid in the first month following credit purchases. There will be
credit purchases only.
(5) The company will keep minimum stock of raw materials of Rs. 10 lakhs.
(6) Depreciation will be charged @ 10% per annum on cost on all fixed assets.
(7) Payment of preliminary expenses of Rs. 1 lakh will be made in January.
(8) Wages and salaries will be Rs. 2 lakhs each month and will be paid on the first day
of the next month.
(9) Administrative expenses ofRs.1 lakh per month will be paid in the month of the
incurrence.
Assume no minimum required cash balance.
You are required to prepare the monthly cash budget (January-June), the projected Income
Statement for the 6 months period and the projected Balance Sheet as on 30thJune,
2015.
Answer:
Monthly Cash Budget (January-June)
( Rs. in lakhs)
Jan. Feb. March April May June Total
Opening cash balance - 21.00 - 2.75 10.50 14.50 -
A. Cash inflows
Equity shares 100.00 - - - - - 100.00
Loans 13 2.50 - - - - 15.50
(Refer to working note 1)
Receipt from debtors - - 30.00 35.00 35.00 40.00 140.00
Total (A) 113.00 23.50 30.00 37.75 45.50 54.50 255.50
B. Cash Outflows
Plant and Machinery 20.00 - - - - - 20.00
Land and Building 40.00 - - - - - 40.00
Furniture 10.00 - - - - - 10.00
475
Motor Vehicles 10.00 - - - - - 10.00

Stock of raw materials 10.00 - - - - - 10.00
(minimum stock)
Preliminary expenses 1.00 - - - - - 1.00
Payment to creditors for - 20.50 24.25 24.25 28.00 28.00 125.00
credit purchases(Refer to
working note 2)
Wages and salaries - 2.00 2.00 2.00 2.00 2.00 10.00
Admn. expenses 1.00 1.00 1.00 1.00 1.00 1.00 6.00
Total :(B) 92.00 23.50 27.25 27.25 31.00 31.00 232.00
Closing balance (A)-(B) 21.00 - 2.75 10.50 14.50 23.50 23.50
Budgeted Income Statement for the

six-month period ending 30thJune
(Rs. In lakhs)
Particulars Rs. Particulars Rs.
To Purchases 166.75 By Sales 225.00
To Wages and Salaries 12.00 By Closing stock 10.00
To Gross profit c/d 56.25
235.00 235.00
To Admn. expenses 6.00 By Gross profit b/d 56.25
To Depreciation (10% on Rs. 80 4.00
lakhs for six months)
To Accrued interest on loan 0.905
(Refer to working note 3)
To Net profit c/d 45.345
56.25 56.25
Projected Balance Sheet as on 30th June, 2015

(Rs. in lakhs)
Liabilities Amount Assets Amount
Rs. Rs.
Share Capital : Fixed Assets :
Authorised capital Land and Building
20,00,000 equity - 200.00 40.00
shares of Rs.10 each
476
Less : Depreciation 38.00

Issued, subscribed
and paid up capital 2.00
10,00,000 equity 100.00 Plant and 20.00
shares of Rs.10 each Machinery
Reserve and Surplus Less : Depreciation 19.00
Profit and Loss 45.345 1.00
Long term loans 15.50 Furniture 10.00
Current liabilities Less : Depreciation 0.50 9.50
and provisions :
Sundry Creditors 31.75 Motor Vehicles 10.00
Accrued interest 0.905 Less :Depreciation 0.50 9.50 76.00
Outstanding 2.00 34.655 Current Assets :
expenses
Stock 10.00
Sundry Debtors 85.00
Cash 23.50 118.50
Miscellaneous
expenditure to the
extent not written
off :
Preliminary 1.00
expenses
195.50 195.50
Working Notes:
1. Subsequent Borrowings Needed ( Rs. in lakhs)
A. Cash inflow
Equity shares 100.00
Loans 13.00
Receipt from debtors - - 30.00 35.00 35.00 40.00
Total (A) 113.00 - 30.00 35.00 35.00 40.00
B. Cash Outflow
Purchase of fixed assets 80.00
Stock 10.00
Preliminary expenses 1.00
477
Payment to creditors - 20.50 24.25 24.25 28.00 28.00

Wages and salaries - 2.00 2.00 2.00 2.00 2.00
Administrative expenses 1.00 1.00 1.00 1.00 1.00 1.00
Total 92.00 23.50 27.25 27.25 31.00 31.00
Surplus / (Deficit) 21.00 (23.50) 2.75 7.75 4.00 9.00
Cumulative balance 21.00 (2.50) 0.25 8.00 12.00 21.00
1. There is shortage of cash in February of Rs. 25 lakhs which will be met by borrowings
on February
2. Payment to Creditors
Purchases = Cost of goods sold-Wages and salaries
Purchases for January= (75% of 30 lakhs) - Rs. 2 = Rs. 20.50 lakhs.
(Note: Since gross margin is 25% of sales, cost of manufacture i.e. materials plus
wages and salaries should be 75% of sales)
Hence, Purchases = Cost of manufacture minus wages and salaries of Rs. 2 lakhs)
The creditors are paid in the first month following purchases.
Therefore, payment in February is Rs. 20.50 lakhs
The same procedure will be followed for other months.
Total purchases = Rs. 125 lakhs (for Jan-May) + Rs. 31.75 lakhs (for June) + Rs. 10
lakhs (stock)= Rs. 166.75 lakhs
3. Accrued Interest on Loan
12% interest on Rs. 13 lakhs for 6 months 0.78 lakhs
Add: 12% interest on Rs. 2.5 lakhs for 5 months 0.125 lakhs
0.905 lakhs
Question 10
The following information relates to Zeta Limited, a publishing company:
The selling price of a book is Rs. 15, and sales are made on credit through a book club
and invoiced on the last day of the month.
Variable costs of production per book are materials (Rs. 5), labour (Rs. 4), and overhead
(Rs. 2)
The sales manager has forecasted the following volumes:
Month No. of Books
Nov 1,000
Dec 1,000
Jan 1,000
Feb 1,250
Mar 1,500
478
Apr 2,000
May 1,900
Jun 2,200
July 2,200
Aug 2,300
Customers are expected to pay as follows:

One month after the sale 40%
Two months after the sale 60%
The company produces the books two months before they are sold and the creditors
for materials are paid two months after production. Variable overheads are paid in the
month following production and are expected to increase by 25% in April; 75% of wages
are paid in the month of production and 25% in the following month. A wage increase of
12.5% will take place on 1stMarch.
The company is going through a restructuring and will sell one of its free hold properties
in May for Rs. 25,000, but it is also planning to buy a new printing press in May for Rs.
10,000.Depreciation is currently Rs. 1,000 per month, and will rise toRs.1,500 after the
purchase of the new machine.
The company’s corporation tax (of Rs. 10,000) is due for payment in March.
The company presently has a cash balance at bank on 31 December 2013, of Rs.1,500.
You are required to prepare a cash budget for the six months from January to June.
Answer:
Workings:
1. Sale receipts
Month Nov Dec Jan Feb Mar Apr May Jun
Forecast 1,000 1,000 1,000 1,250 1,500 2,000 1,900 2,200
sales (S)
Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs.
S×15 15,000 15,000 15,000 18,750 22,500 30,000 28,500 33,000
Debtors
pay:
1 month 6,000 6,000 6,000 7,500 9,000 12,000 11,400
40%
2 month - 9,000 9,000 9,000 11,250 13,500 18,000
60%
- - 15,000 15,000 16,500 20,250 25,500 29,400
479
2. Payment for materials – books produced two months before sale

Qty produced 1,000 1,250 1,500 2,000 1,900 2,200 2,200 2,300
(Q)
Materials 5,000 6,250 7,500 10,000 9,500 11,000 11,000 11,500
(Q×5)
Paid (2 - - 5,000 6,250 7,500 10,000 9,500 11,000
months
after)
3. Variable overheads
Qty produced 1,000 1,250 1,500 2,000 1,900 2,200 2,200 2,300
(Q)
Var. 2,000 2,500 3,000 4,000 3,800
overhead
(Q×2)
Var. 5,500 5,500 5,750
overhead
(Q×2.50)
Paid one 2,000 2,500 3,000 4,000 3,800 5,500 5,500
month later
4. Wages payments
Month Dec Jan Feb Mar Apr May Jun
Qty produced (Q) 1,250 1,500 2,000 1,900 2,200 2,200 2,300
Rs. Rs. Rs. Rs. Rs. Rs. Rs.
Wages (Q × 4) 5,000 6,000 8,000
Wages (Q × 4.50) 8,550 9,900 9,900 10,350
75% this month 3,750 4,500 6,000 6,412 7,425 7,425 7,762
25% this month 1,250 1,500 2,000 2,137 2,475 2,475
5,750 7,500 8,412 9,562 9,900 10,237
480
Cash budget – six months ended June

Jan Feb Mar Apr May Jun
Rs. Rs. Rs. Rs. Rs. Rs.
Receipts:
Credit sales 15,000 15,000 16,500 20,250 25,500 29,400
Premises disposal - - - - 25,000 -
15,000 15,000 16,500 20,250 50,500 29,400
Payments:
Materials 5,000 6,250 7,500 10,000 9,500 11,000
Var. overheads 2,500 3,000 4,000 3,800 5,500 5,500
Wages 5,750 7,500 8,412 9,562 9,900 10,237
Fixed assets - - - - 10,000 -
Corporation tax - - 10,000 - - -
13,250 16,750 29,912 23,362 34,900 26,737
Net cash flow 1,750 (1,750) (13,412) (3,112) 15,600 2,663
Balance b/f 1,500 3,250 1,500 (11,912) (15,024) 576
Cumulative cash flow 3,250 1,500 (11,912) (15,024) 576 3,239
Question 11
Consider the balance sheet of Maya Limited at December 31 (in thousands).The company
has received a large order and anticipates the need to go to its bank to increase its
borrowings. As a result, it has to forecast its cash requirements for January, February
and March. Typically, the company collects 20 percent of its sales in the month of sale,
70 per cent in the subsequent month, and 10 per centin the second month after the sale.
All sales are credit sales.
Rs. Rs.
Cash 50 Accounts payable 360
Accounts receivable 530 Bank loan 400
Inventories 545 Accruals 212
Current assets 1,125 Current liabilities 972
Net fixed assets 1,836 Long-term debt 450
Common stock 100
Retained earnings 1,439
Total assets 2,961 Total liabilities and equity 2,961
Purchases of raw materials are made in the month prior to the sale and amount to 60 per
cent of sales in the subsequent month. Payments for these purchases occur in the month
after the purchase. Labour costs, including overtime, are expected tobeRs.1,50,000 in
481
January, Rs. 2,00,000 in February, and Rs. 1,60,000 in March. Selling, administrative,
taxes, and other cash expenses are expected to be Rs. 1,00,000 per month for January
through March. Actual sales in November and December and projected sales for January
through April are as follows (in thousands):
Rs. Rs. Rs.
November 500 January 600 March 650
December 600 February 1,000 April 750
On the basis of this information:

(a) Prepare a cash budget for the months of January, February and March.
(b) Determine the amount of additional bank borrowings necessary to maintain a cash
balance of Rs. 50,000 at all times.
(c) Prepare a pro forma balance sheet for March 31.
Answer:
(a) Cash Budget(in thousands)
Nov. Dec. Jan. Feb. Mar. Apr.
Rs. Rs. Rs. Rs. Rs. Rs.
Sales 500 600 600 1,000 650 750
Collections, current 120 200 130
month’s sales
Collections, previous 420 420 700
month’s sales
Collections, previous 2 50 60 60
month’s sales
Total cash receipts 590 680 890
Purchases 360 600 390 450
Payment for purchases 360 600 390
Labour costs 150 200 160
Other expenses 100 100 100
Total cash 610 900 650
disbursements
Receipts less (20) (220) 240
disbursements
482
(b)
Jan. Rs. Feb. Rs. Mar. Rs.
Additional borrowings 20 220 (240)
Cumulative borrowings 420 640 400
The amount of financing peaks in February owing to the need to pay for purchases
made the previous month and higher labour costs. In March, substantial collections
are made on the prior month’s billings, causing large net cash inflow sufficient to
pay off the additional borrowings.
(c) Pro forma Balance Sheet, March 31 (in thousands)

Rs. Rs.
Cash 50 Accounts payable 450
Accounts receivable 620 Bank loan 400
Inventories 635 Accruals 212
Current assets 1,305 Current liabilities 1,062
Net fixed assets 1,836 Long-term debt 450
Common stock 100
Retained earnings 1,529
Total assets 3,141 Total liabilities and equity 3,141
Accounts receivable = Sales in March x 0.8 + Sales in February x 0.1

Inventories = Rs. 545+Total purchases January through March- Total
Sales January through March x 0.6
Accounts payable = Purchases in March
Retained earnings = Rs. 1,439 + Sales – Payment for purchases – Labour costs
And –Other expenses, all for January through March
Question 12
You are given below the Profit & Loss Accounts for two years for a company:
Profit and Loss Account
Year 1 Year 2 Year 1 Year 2

` ` ` `
To Opening stock 80,00,000 1,00,00,000 By Sales 8,00,00,000 10,00,00,000
To Raw materials 3,00,00,000 4,00,00,000 By Closing stock 1,00,00,000 1,50,00,000
To Stores 1,00,00,000 1,20,00,000 By Misc. Income 10,00,000 10,00,000
To Manufacturing 1,00,00,000 1,60,00,000
Expenses
483
To Other Expenses 1,00,00,000 1,00,00,000

To Depreciation 1,00,00,000 1,00,00,000
To Net Profit 1,30,00,000 1,80,00,000 - -
9,10,00,000 11,60,00,000 9,10,00,000 11,60,00,000
Sales are expected to be ` 12,00,00,000 in year 3.

As a result, other expenses will increase by ` 50,00,000 besides other charges. Only raw
materials are in stock. Assume sales and purchases are in cash terms and the closing
stock is expected to go up by the same amount as between year 1 and 2. You may
assume that no dividend is being paid. The Company can use 75% of the cash generated
to service a loan. COMPUTE how much cash from operations will be available in year 3
for the purpose? Ignore income tax.
Answer:
Projected Profit and Loss Account for the year 3
Year 2 Year 3 Year 2 Year 3

Actual Projected (` Actual Projected
(` in lakhs) in lakhs) (` in lakhs) (` in lakhs)
To Materials 350 420 By Sales 1,000 1,200
consumed
To Stores 120 144 By Misc. Income 10 10
To Mfg. Expenses 160 192
To Other expenses 100 150
To Depreciation 100 100
To Net profit 180 204
1,010 1,210 1,010 1,210
Cash Flow:
(` in lakhs)
Profit 204
Add: Depreciation 100
304
Less: Cash required for increase in stock 50
Net cash inflow 254
Available for servicing the loan: 75% of ` 2,54,00,000 or ` 1,90,50,000
484
Working Notes:
(i) Material consumed in year 2: 35% of sales.
Likely consumption in year 3:
(ii) Stores are 12% of sales, as in year 2.

(iii) Manufacturing expenses are 16% of sales.
Note: The above also shows how a projected profit and loss account is prepared.
Question 13
Prachi Ltd is a manufacturing company producing and selling a range of cleaning products
to wholesale customers. It has three suppliers and two customers. Prachi Ltd relies on its
cleared funds forecast to manage its cash.
You are an accounting technician for the company and have been asked to prepare a
cleared funds forecast for the period Saturday 7 August to Wednesday 11 August 2021
inclusive. You have been provided with the following information:
(1) Receipts from customers
Credit terms Payment 7 Aug 7 Jul 2021

method 2021 sales sales
W Ltd 1 calendar month BACS ` 150,000 ` 130,000
X Ltd None Cheque ` 180,000 ` 160,000
(a) Receipt of money by BACS (Bankers' Automated Clearing Services) is

instantaneous.
(b) X Ltd’s cheque will be paid into Prachi Ltd’s bank account on the same day as
the sale is made and will clear on the third day following this (excluding day
of payment).
(2) Payments to suppliers
Supplier name Credit terms Payment 7 Aug 7 Jul 7 Jun

method 2021 2021 2021
purchases purchases purchases
A Ltd 1 calendar month Standing ` 65,000 ` 55,000 ` 45,000
order
B Ltd 2 calendar months Cheque ` 85,000 ` 80,000 ` 75,000
C Ltd None Cheque ` 95,000 ` 90,000 ` 85,000
485
(a) Prachi Ltd has set up a standing order for ` 45,000 a month to pay for supplies
from A Ltd. This will leave Prachi’s bank account on 7 August. Every few months,
an adjustment is made to reflect the actual cost of supplies purchased (you do
NOT need to make this adjustment).
(b) Prachi Ltd will send out, by post, cheques to B Ltd and C Ltd on 7 August.
The amounts will leave its bank account on the second day following this
(excluding the day of posting).
(3) Wages and salaries

July 2021 August 2021
Weekly wages ` 12,000 ` 13,000
Monthly salaries ` 56,000 ` 59,000
(a) Factory workers are paid cash wages (weekly). They will be paid one week’s
wages, on 11 August, for the last week’s work done in July (i.e. they work a
week in hand).
(b) All the office workers are paid salaries (monthly) by BACS. Salaries for July will
be paid on 7 August.
(4) Other miscellaneous payments

(a) Every Saturday morning, the petty cashier withdraws ` 200 from the company
bank account for the petty cash. The money leaves Prachi’s bank account
straight away.
(b) The room cleaner is paid ` 30 from petty cash every Monday morning.
(c) Office stationery will be ordered by telephone on Sunday 8 August to the value
of ` 300. This is paid for by company debit card. Such payments are generally
seen to leave the company account on the next working day.
(d) Five new softwares will be ordered over the Internet on 10 August at a total cost of
` 6,500. A cheque will be sent out on the same day. The amount will leave Prachi
Ltd’s bank account on the second day following this (excluding the day of posting).
(5) Other information

The balance on Prachi’s bank account will be ` 200,000 on 7 August 2021. This
represents both the book balance and the cleared funds.
PREPARE a cleared funds forecast for the period Saturday 7th August to Wednesday
11th August 2021 inclusive using the information provided. Show clearly the
uncleared funds float each day.
486
Answer:
Cleared Funds Forecast
Receipts 7 Aug 21 8 Aug 21 9 Aug 21 10 Aug 21 11 Aug 21

(Saturday) (Sunday) (Monday) (Tuesday) (Wednesday)
` ` ` ` `
W Ltd 1,30,000 0 0 0 0
X Ltd 0 0 0 1,80,000 0
(a) 1,30,000 0 0 1,80,000 0
Payments
A Ltd 45,000 0 0 0 0
B Ltd 0 0 75,000 0 0
C Ltd 0 0 95,000 0 0
Wages 0 0 0 0 12,000
Salaries 56,000 0 0 0 0
Petty Cash 200 0 0 0 0
Stationery 0 0 300 0 0
(b) 1,01,200 0 1,70,300 0 12,000
Cleared excess
Receipts
over payments 28,800 0 (1,70,300) 1,80,000 (12,000)
(a) – (b)
Cleared balance 2,00,000 2,28,800 2,28,800 58,500 2,38,500
b/f
Cleared balance 2,28,800 2,28,800 58,500 2,38,500 2,26,500
c/f (c)
Uncleared funds
float
Receipts 1,80,000 1,80,000 1,80,000 0 0
Payments (1,70,000) (1,70,300) 0 (6,500) (6,500)
(d) 10,000 9,700 180,000 (6,500) (6,500)
Total book 2,38,800 2,38,500 2,38,500 2,32,000 2,20,000
balance c/f
(c)+ (d)
487
Question 14
A garment trader is preparing cash forecast for first three months of calendar year 2021.
His estimated sales for the forecasted periods are as below:
January (` '000) February (` '000) March (` '000)

Total sales 600 600 800
(i) The trader sells directly to public against cash payments and to other entities on
credit. Credit sales are expected to be four times the value of direct sales to public.
He expects 15% customers to pay in the month in which credit sales are made, 25%
to pay in the next month and 58% to pay in the next to next month. The outstanding
balance is expected to be written off.
(ii) Purchases of goods are made in the month prior to sales and it amounts to 90%
of sales and are made on credit. Payments of these occur in the month after the
purchase. No inventories of goods are held.
(iii) Cash balance as on 1st January, 2021 is ` 50,000.
(iv) Actual sales for the last two months of calendar year 2020 are as below:
November (` '000) December (` '000)

Total sales 640 880
You are required to prepare a monthly cash, budget for the three months from January
to March, 2021.
Answer:
Working Notes:
(1) Calculation of cash and credit sales (` in thousands)
Nov. Dec. Jan. Feb. Mar.

Total Sales 640 880 600 600 800
Cash Sales (1/5th of total sales) 128 176 120 120 160
Credit Sales (4/5th of total sales) 512 704 480 480 640
(2) Calculation of Credit Sales Receipts (` in thousands)
Month Nov. Dec. Jan. Feb. Mar.

Forecast Credit sales (Working note 1) 512.00 704.00 480.00 480.00 640.00
Receipts:
488
15% in the month of sales 72.00 72.00 96.00

25% in next month 176.00 120.00 120.00
58% in next to next month 296.96 408.32 278.40
Total 544.96 600.32 494.40
Cash Budget (`in thousands)
Nov. Dec. Jan. Feb. Mar.

Opening Balance (A) 50.00 174.96 355.28
Sales 640.00 880.00 600.00 600.00 800.00
Receipts:
Cash Collection (Working note 1) 120.00 120.00 160.00
Credit Collections (Working note 2) 544.96 600.32 494.40
Total (B) 664.96 720.32 654.40
Purchases (90% of sales in the month 540 540 720
prior to sales)
Payments:
Payment for purchases (next month) 540 540 720
Total (C) 540 540 720
Closing balance 174.96 355.28 289.68
(D) = (A + B – C)
489

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COSTING

INTER CA. – COSTING

(New & Applicable Format) Cost Sheet of...........

Cost of Goods Sold xx

(Old Format) Cost Sheet of ........... for the year ending..............

Cost of Goods sold xx

(C) Finished Goods → It is to be valued at cost of production. (Direct Material + Direct

Inventory Details Opening Closing

You are required to:

Contribution made towards employees’ PF & ESIS 3,60,000

- Primary packing necessary to maintain quality 96,000

referred to in (a) to (d) above.

IMPORTANT THEORY QUESTIONS FOR EXAMINATION

(ii) It is important to ascertain the significant variables of the manufacturing unit

responsibility center e.g. direct costs.

(iv) The products to be manufactured should be studied.

Cost of applied research, if it relates to all existing products and methods of

development expenses is same as that of applied research.

make the product available to the customer.

* If there is loss in contract in any year then entire loss is to be transferred to

* In the year of completion following entry is to be recorded.

accounts to 31st March, 2019.

General Expenses 10,000

The above contract contained an escalation clause which read as follows :

Actual expenditure in 2018-2019 and estimated expenditure in 2019-2020 are given

IMPORTANT THEORY QUESTIONS FOR EXAMINATION

MATERIAL COST CONTROL,

A. How To Purchase [Raw Materials]

9 Raw Materials Issue 3 Stores Production Stores

B. HOW MUCH TO BUY / MANUFACTURE AT A TIME:

(ii) Total Ci or carrying cost:

(2) Maximum (possible) stock:

(3) Minimum (desirable) stock:

(4) Average stock =

You are required to calculate:

the lot size is 2,000 components at a time.

What would be the following quantities:

STOCK VALUATION AND STOCK CONTROL

Minimum Quantity to be purchased Any Quantity 1,62,000 kg.

You are required to

IMPORTANT THEORY QUESTIONS FOR EXAMINATION

numerous, one should categorise them according to their importance. Close

respect of their receipts, issue and balance.

Concept 1: Business Policy:

However, the introduction of business policy in the curriculum of business schools or

Utility of Business Policy;

• Starting from day-to-day planning in earlier times, managers tried to anticipate

Business Policy tends to emphasize on the rational-analytical aspect of strategic

Concept 2: Concept of Management:

To understand the concept of strategic management, we need to have a basic understanding

An organisation becomes a unified functioning system when management systematically

Management is an influence process to make things happen, to gain command over

Strategy may be defined as a long-range blueprint of an organisation, what it wants to be?

3.1 Classification of Strategy based on approach;

1. Proactive approach (i.e., Proactive strategy), and

2. Reactive approach (i.e., Reactive strategy).

Q. “Strategy is partly proactive and partly reactive.” do you agree?

In Proactive Strategy, organizations will analyse possible environmental scenarios and

It is based on unanticipated events such as Competitor’s strategies, Market changes require

Hence, strategy is partly proactive and partly reactive.

3.2 Characteristics of Strategy;

• Ways to win over enemy:

• Designed to move to the desired future position: