Unit 4 carries the most numerical questions in the paper. The marks go to aspirants who know the formulas by heart and can apply them quickly. Practise each formula below with at least two examples.
1. Accounting Concepts and Standards
- Key concepts: going concern, accrual, consistency, prudence (conservatism), matching, materiality and the money measurement concept.
- Ind AS are Indian Accounting Standards converged with IFRS. They were phased in from 2016–17, starting with companies having a net worth of ₹500 crore or more.
- Ind AS 1 covers presentation of financial statements; Ind AS 7 covers the statement of cash flows.
2. Ratio Analysis
|
Group |
Ratio |
Formula / benchmark |
| Liquidity | Current ratio | Current assets ÷ Current liabilities (2:1) |
| Liquidity | Quick ratio | Quick assets ÷ Current liabilities (1:1) |
| Solvency | Debt–equity | Long-term debt ÷ Equity |
| Solvency | Interest coverage | EBIT ÷ Interest |
| Activity | Debtors turnover | Credit sales ÷ Average debtors |
| Activity | Collection period | 365 ÷ Debtors turnover |
| Profitability | Return on equity | Net profit ÷ Shareholders’ equity |
| Market | P/E ratio | Market price per share ÷ EPS |
DuPont analysis: ROE = Net profit margin × Asset turnover × Equity multiplier. The extended five-step version splits the margin into tax burden, interest burden and EBIT margin.
3. Cash Flow Statement
- Cash flows are classified as operating, investing and financing
- Operating cash flow can be prepared by the direct or indirect
- For a non-financial company, interest and dividends paid are usually shown under financing activities.
- Funds flow tracks changes in working capital; cash flow tracks actual cash.
4. Inventory and Depreciation
- Inventory valuation: FIFO and weighted average cost are permitted under Ind AS 2; LIFO is not permitted.
- In a period of rising prices, FIFO gives higher closing stock and higher profit than weighted average.
- Depreciation methods: the straight-line method charges equal amounts each year; the written-down value method charges more in early years.
5. Cost Sheet
- Prime cost = Direct material + Direct labour + Direct expenses
- Works (factory) cost = Prime cost + Factory overheads
- Cost of production = Works cost + Office and administration overheads
- Cost of sales = Cost of production + Selling and distribution overheads
- Sales = Cost of sales + Profit
6. Marginal Costing and CVP Analysis
- Contribution = Sales − Variable cost; Profit = Contribution − Fixed cost.
- P/V ratio = Contribution ÷ Sales × 100.
- Break-even sales (₹) = Fixed cost ÷ P/V ratio.
- Margin of safety = Actual sales − Break-even sales; it also equals Profit ÷ P/V ratio.
- Key (limiting) factor: when a resource is scarce, rank products by contribution per unit of that factor.
7. Standard Costing and Variances
- Material price variance = (Standard price − Actual price) × Actual quantity.
- Material usage variance = (Standard quantity − Actual quantity) × Standard price.
- Price variance + Usage variance = Material cost variance.
- Labour variances: rate, efficiency and idle time.
- A positive result is favourable; a negative result is adverse.
8. Budgeting
- Fixed budget: one activity level. Flexible budget: adjusts to actual activity.
- Zero-base budgeting: every item is justified from zero; developed by Peter Pyhrr at Texas Instruments around 1970.
- Performance budgeting links spending to outputs; the master budget combines all functional budgets.
9. Modern Cost Management
- Activity-based costing (Robin Cooper and Robert Kaplan): overheads are assigned through activities and cost drivers.
- Target costing: Target cost = Expected selling price − Desired profit; it starts from the market price.
- Responsibility accounting: costs are assigned to cost, profit and investment centres under specific managers.
10. Leverage and EBIT–EPS Analysis
- DOL = Contribution ÷ EBIT; DFL = EBIT ÷ EBT; DCL = DOL × DFL = Contribution ÷ EBT.
- Financial break-even point = Interest + Preference dividend ÷ (1 − tax rate).
- Indifference point: the EBIT at which two financing plans give the same EPS.
- High DOL means high business risk; high DFL means high financial risk.
11. Tools of Financial Statement Analysis
- Horizontal analysis (comparative statements) compares figures across years.
- Vertical analysis (common-size statements) shows each item as a percentage of a base, such as total sales or total assets.
- Trend analysis expresses figures for several years as percentages of a base year.
Common Exam Traps
- Break-even sales in units use contribution per unit; break-even sales in rupees use the P/V ratio.
- A material price variance is calculated on actual quantity; a usage variance uses standard
- DCL can be calculated directly as Contribution ÷ EBT, without finding DOL and DFL first.
Practice MCQs
- Sales ₹10,00,000; variable cost ₹6,00,000; fixed cost ₹2,00,000. The P/V ratio is: (a) 20% (b) 40% (c) 60% (d) 80%
- Using Question 1, break-even sales are: (a) ₹2,00,000 (b) ₹4,00,000 (c) ₹5,00,000 (d) ₹8,00,000
- If DOL is 2 and DFL is 3, DCL is: (a) 5 (b) 6 (c) 1.5 (d) 1
- Zero-base budgeting is associated with: (a) Peter Pyhrr (b) Peter Drucker (c) Ezra Solomon (d) J.R. Batliboi
- Debtors turnover is 8 times. The average collection period (365-day year) is about: (a) 30 days (b) 46 days (c) 60 days (d) 73 days
Answers: 1 (b), 4,00,000 ÷ 10,00,000; 2 (c), 2,00,000 ÷ 40%; 3 (b); 4 (a); 5 (b), 365 ÷ 8 ≈ 45.6.