Introduction to management accounting and Financial Statement Analysis

Ms .Lakshmi V, AssistantProfessor
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MANGAEMENT ACCOUNTING
CHAPTER 1: MANAGEMENT ACCOUNTING AND FINANCIAL STATEMENTS
Introduction
Accounting is considered as a process of recording the financial activities of a
businessman. The concept of accounting existed in the very olden days itself when the activities
of trading started in the history of human beings. It is believed that the accounting system
existed during 4500 B.C. itself in the ancient civilization of Babylonia and Assyria. The
businessmen need to know the profit or loss in his business and hence, he recorded the financial
transactions. The accounting system adopted in the early periods got a good shape due to the
introduction of double entry system in the place Genova of Italy during 1340. This system was
properly developed by Fra Luco Pacioli an Italian in the year 1494. In the initial period, the
accounting system is meant for recording the historical financial data for the calculation of profit.
Later on, due to the economic and social developments brought by industrial revolution, the
scope of the accounting increased to a very great extent. This is due to enormous growth of
business units leading to high competition. Hence, companies are compelled to reduce the cost
to face competition. In this respect, there is a need for analysis of the financial information so
that more information can be generated for planning, decision making and cost control. The new
branches of accounting are called Cost Accounting and Management Accounting.
Meaning and Definition of Accounting
Accounting is recording of business transactions with the purpose of managing the
concern in a better way and also reporting the true financial position of operations. According to
the Committee on Terminology of American Institute of Certified Public Accountants,
Accounting is “the art of recording, classifying and summarising in a significant manner and in
terms of money, transactions and events, which are in part at least, of a financial character and
interpreting the results thereof”.
Smith and Ashburne describe it as, “Accounting is the science of recording and
classifying business transactions and events, primarily of a financial character, and the art of
making significant summaries, analysis and interpretation of those transactions and events and
communicating the results to persons who must make decisions or form judgements”. This
definition emphasizes financial reporting and decision-making aspect of accounting.
Functions of Accounting:
1. Historical Function
2. Managerial Function
The word ‘Accounting’ can be classified into three categories:
(a) Financial Accounting
(b) Cost Accounting
(c) Management Accounting

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Meaning of Financial Accounting
Financial Accounting may be defined as the science and art of recording and classifying
business transactions and preparing summaries of the same for determining yearend profit or loss
and the financial position of the concern. It is that part of accounting which is employed to
communicate the financial information of a business unit.
The object of financial accounting is to find out the profitability and to provide
information about the financial position of the concern. Two principal statements of financial
accounting are Income Statement and Balance Sheet. The Income Statement is prepared for a
particular year. All revenue transactions relating to that period are included in this statement
with a view to determine the profitability of the concern. The balance sheet is prepared on a
particular date and it determines the financial position of the concern on that date.
Limitations of Financial Accounting:
The financial accounting is mainly concerned with the preparation of final accounts i.e.,
Profit and Loss Account and Balance Sheet. The business has become so complex that mere
final accounts information is not sufficient in meeting informational needs. The management
needs information for planning, controlling and co-ordinating business activities. It is because of
the limitations of financial accounting that cost accounting and management accounting have
developed. Some of the limitations of financial accounting are discussed as follows:
1. Provides only historical data: It provides only past data in the form of Profit & Loss
Account and Balance Sheet. There is no analysis carried on in Financial Accounting for
planning and cost control for future. (Dr. M Wilson)
Financial Accounting is historical in nature in the sense that it is a record of all those
transactions which have taken place in the business during a particular period of time.
The impact of future uncertainties has no place in financial accounting. As management
needs information for future planning, financial accounting can only give information
about what has happened and not about what will happen. It does not suggest what
should be done to increase the efficiency of the concern. (Shashi K Gupta)
2. Provides information about the concern as a whole: In financial accounting,
information is recorded for the whole concern. One can find information about total
expenses and total receipts only. The information is not recorded product-wise, process-
wise, department-wise or any other line of activity. It is essential to record information
activity-wise so as to be helpful for cost determination and cost control purposes (SG).
Financial accounting provides information about profit, loss, cost etc., of the collective
activities of the business as a whole. (M.N.Arora). The data related to cost at different
stages of production or the rate of growth in various activities are not provided by
Financial Accounting.

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3. Not helpful in Price Fixation: Financial accounting is not helpful in fixing prices of
products. The cost of a product can be obtained only when all expenses have incurred. It
is not possible to determine the price in advance. The concern may be required to quote a
price for the supply of goods in the near future (for submitting tenders, etc). Financial
accounting cannot supply all the information, so it is not helpful in price determination.
Price fixation requires information about variable and fixed cost, direct and indirect costs.
Indirect expenses are estimated on the basis of past records for price determination
purposes.
4. Cost Control is not possible: Cost Control is not possible in financial accounting. The
cost figures are known only at the end of financial period. When the cost has already
been incurred then nothing can be done to control it. There is no technique in financial
accounting which can help to ascertain whether the cost is more or less while the
expenses are being incurred. There is no procedure to assign responsibility for higher
costs, if any. The costing process requires a constant review of actual costs from time to
time and this thing is not possible in financial accounting.
5. No Material and Labour cost control system: Generally, there is no proper system of
control of materials losses which may arise in the form of obsolescence, deterioration,
excessive scrap and misappropriation etc. There is no system of recording loss of labour
time, i.e., idle time. Labour cost is not recorded by jobs, processes or departments and as
such no system of incentives may be easily used to compensate workers for their above-
standard performance.
6. Appraisal of Policies is not possible: it is not possible to evaluate various policies and
programmes in financial accounting. There is no technique for comparing actual
performance with budgeted targets. Whether the work is going on as per schedule or not,
cannot be determined. The only criterion for determining efficiency is to see the profits
at the end of financial period. The profitability is the only yardstick for evaluating
managerial performance. Profits of an enterprise are influenced by a number of outside
factors also, so it is not a reliable test for ascertaining efficiency of the management.
7. Not helpful in taking strategic decisions: Management is to take strategic decisions like
replacement of labour by machinery, introduction of a new product, discontinuation of an
existing line of production, expansion of capacity, etc. The impact of these decisions and
cost involved will have to be ascertained in anticipation. Various alternative suggestions
are to be studied before taking a final decision. Final accounts cannot provide necessary
information for taking important decisions because information is recorded for the whole
concern and it is available only when the event has taken place.
8. Chances of Manipulation: There are chances of using financial accounts to suit the
whims of management. The over-valuation or under-valuation of inventory may change
the figures of profits. More profits may be shown to get more remuneration, issue more
dividends or to raise the prices of company’s shares.

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9. No cost comparison: Comparison is the foundation of modern management control. But
financial accounting does not provide data for comparison of costs of different periods,
different jobs or departments, or sales territories, etc.
Costing:
The ICMA, London, defines costing as “the techniques and process of ascertaining cost.”
Meaning of Cost Accounting
The costing terminology of ICMA, London defines cost accounting as “the process of
accounting for cost from the point at which expenditure is incurred or committed to the
establishment of its ultimate relationship with cost centres and cost units. In its widest usage, it
embraces the preparation of statistical data, the application of cost control methods and the
ascertainment of the profitability of activities carried out or planned.
Cost Accountancy:
The application of costing and cost accounting principles, methods and techniques to the science,
art and practice of cost control and the ascertainment of profitability. It includes the presentation
of information derived there from for the purpose of managerial decision-making.
Limitations of Cost Accounting:
Some of the important deficiencies and limitations of cost accounting are given as
follows:
1. It is not an independent system of accounts.
2. It is based largely on estimates like absorption of indirect expenses or apportionment of
expenses on estimate basis.
3. There is a scope for subjectivity on items like depreciation, valuation of closing stock etc.
4. It does not take into consideration all items of expenses and incomes, e.g., items of purely
financial nature such as interest, finance charges, discount and loss on issue of shares and
debentures, etc.
MANAGEMENT ACCOUNTING
Cost accounting, no doubt, serves the internal management by directing their attention on
inefficient operations and assisting in a day-to-day control of activities of the enterprise. But
even costing information fails to meet informational needs for managerial functions. The costing
data needs to be arranged, re-analysed and processed further for playing more effective role in
the managerial process. In addition to costing and accounting data, managerial functions need
the use of socio-economic and statistical data (e.g., population break-ups, income structures,
etc.). This information is beyond the scope of cost accounting and financial accounting which
pave the way for emergence of management accounting. Management accounting provides all
possible information required for managerial purposes.

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MEANING AND EMERGENCE OF MANAGEMENT ACCOUNTING
Management Accounting is comprised of two words ‘Management’ and ‘Accounting’. It
is the study of managerial aspect of accounting. The emphasis of management accounting is to
redesign accounting in such a way that it is helpful to the management in formation of policy,
control of execution and appreciation of effectiveness. It is that system of accounting which
helps management in carrying out its functions more efficiently.
The term ‘Management Accounting’ is of a recent origin. This term was first used in
1950 by a team of accountants visiting U.S.A. under the auspices of Anglo-American Council on
Productivity. The terminology of cost accountancy had no reference to the word management
accountancy before the report of this study group. The complexities of business environment
have necessitated the use of management accounting for planning, co-ordinating and controlling
functions of management.
The introduction of professionalism in management has brought in the division of
organisation into functional areas and delegation of authority and decentralisation of decision-
making. The decision-making no ore remains a matter of intuition. It requires the evolution of
information system for helping management in planning and assessing the results. The
accounting information is required as a guide for future. The management is to be fed with
precise and relevant information so as to enable it in performing managerial functions efficiently
and effectively.
Definition of Management Accounting
According to Anglo-American Council on Productivity “Management Accounting is the
presentation of accounting information in such a ways as to assist management in the creation of
policy and the day-to-day operation of an undertaking”.
According to National Association of Accountants (USA), Management Accounting is
“the process of identification, measurement, accumulation, analysis, preparation and
communication of financial information used by management to plan, evaluate and control
within the organisation and to assure appropriate use and accountability for its resources”.
Characteristics or Nature of Management Accounting
It is clear from the above definitions that management accounting is concerned with
accounting data that is useful in decision making. The main characteristics of management
accounting are as follows:
1. Provides accounting information: Management accounting is based on accounting
information. The collection and classification of data is the primary function of
accounting department. The information so collected is used by the management for
taking policy decisions. Management accounting involves the presentation of
information in a way it suits managerial needs. The accounting data is used for reviewing
various policy decisions. Management accounting is a service function and it provides
necessary information to different levels.

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Basic accounting information useful for management accounting is derived from
financial and cost accounting records.
2. Useful in decision making: The essential aim of management accounting is to assist
management in decision making and control. It is concerned with all such information
which can prove useful to management in decision making.
3. Cause and Effect Analysis: Financial accounting is limited to the preparation of profit
and loss account and finding out the ultimate result, i.e., profit or loss. Management
accounting goes a step further. The cause and effect relationship is discussed in
management accounting. If there is a loss, the reasons for loss are probed. If there is
profit, the factors directly influencing the profitability are also studied. The figures of
profits are compared to sales, different expenditures, current assets, interest payables,
share capital, etc. So the study of cause and effect relationship is possible in management
accounting.
4. Use of special techniques and concepts: Management accounting uses special techniques
and concepts to make accounting data more useful. The techniques usually used include
financial planning analysis, standard costing, budgetary control, marginal costing, project
appraisal, control accounting etc. The type of technique to be used will be determined
according to the situation and necessity.
5. Internal use: Information provided by management accounting is exclusively for use by
management for internal use. Such information is not to be given to parties external to
the business like shareholders, creditors, banks etc.
6. Purely optional: Management accounting is a purely voluntary technique and there is no
statutory obligation. Its adoption by any firm depends upon its utility and desirability.
7. Concerned with future: As management accounting is concerned with providing
information for decision making, it is related with future because decisions are taken for
future course of action and not for the past. It helps the management in planning and
forecasting.
8. Flexibility in presentation of information: Unlike financial accounting, in management
accounting there are no prescribed formats for presentation of information to
management. The form of presentation of information is left to the wisdom of the
management accountant who decides which is the most useful format of providing the
relevant information, depending upon the utility of each type of form and information.
9. Supplies information and not decision: The management accountant supplies
information to the management. The decisions are to be taken by the top management.
The information is classified in the manner in which it is required by the management.
Management accountant is only to guide and not to supply decisions. The data is to be
used by management for taking various decisions. ‘How is the data to be utilised’ will
depend upon the calibre and efficiency of the management.

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Scope of Management Accounting
Management accounting has a very wide scope. It includes not only financial accounting
and cost accounting but also all types of internal financial controls, internal audit, tax accounting,
office services, cost control and other methods and control procedures. Thus scope of
management accounting, inter alia includes the following:
1. Financial accounting: Financial accounting provides basic historical data which helps
management to forecast and plan its financial activities for the future period. Though
planning is always for the future but still it has to be based on past and present data. Thus
for an effective and successful management accounting, there should be a proper and well
designed financial accounting system. So management accounting is closely related to
financial accounting.
2. Cost Accounting: Many of the techniques of cost control like standard costing and
budgetary control and techniques of profit planning and decision-making like marginal
costing, CVP analysis and differential cost analysis are used by the management
accounting.
3. Budgeting and forecasting: In order to plan business activities for the future, forecasting
and budgeting play a very significant role. Forecasting helps in the preparation of
budgets and budgeting helps management accountant in exercising budgetary control.
4. Tax planning: In order to take advantage of various provisions of tax laws, management
accountant has to depend upon tax accounting and planning to minimise its tax liabilities
and save more funds for the business. Tax accounting comes under the purview of
management accountants duties.
5. Reporting to Management: For effective and timely decisions, there should be a system
of prompt and intelligent reporting to management. Both routine and special reports are
prepared for submission to top management, middle order management and operating
level management depending on their requirements. The reports may cover profit and
loss statement, cash and fund flow statements, stock reports, absentee reports and reports
on orders in hand etc. These reports are helpful in giving a constant review of the
working of the business.
6. Cost control procedures: Any system of management accounting is incomplete without
effective cost control procedures like inventory control, labour control, overhead control,
budgetary control etc.
7. Statistical tools: Various tools of analysing and presenting statistical data like graphs,
tables, charts, etc., are used in preparing reports for use by the management.
8. Internal Control and internal audit: Management accountant heavily depends on
internal financial controls like internal audit and internal check to plug loop holes in the
financial system of the concern. Internal audit helps management in fixing responsibility
of different individuals.

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9. Financial analysis and interpretation: Management accountant employs various
techniques to analyse and interpret financial data to make it understandable and useable
to the management. Such analysis helps management to achieve objectives of
management in a more efficient manner.
10. Other office services: Management accountant is expected to maintain and control office
routines and procedures like filing, copying and communicating, electronic data
processing and other allied services.
Functions or Objectives of Management Accounting
The basic function of management accounting is to assist the management in performing
its functions effectively. The functions of the management are planning, organising, directing
and controlling. Management accounting helps in the performance of each of these functions in
the following ways:
1. Provides data for Planning: Information and data provided by management accounting
helps management to forecast and prepare short-term and long-term plans for the future
activities of the business and formulate corporate strategy. For this purpose management
accounting techniques like budgeting, standard costing, marginal costing, probability,
correlation and regression, etc., are used.
2. Coordinating: Management accounting techniques of planning also help in coordinating
various business activities. For example, while preparing budgets for various
departments like production, sales, purchases, etc., there should be full coordination so
that there is no contradiction. By proper financial reporting, management accounting
helps in achieving coordination in various business activities and accomplishing the set
goals.
3. Facilitates Control: Management accounting helps in translating given objectives and
strategy into specified goals for attainment by a specified time and secures effective
accomplishment of these goals in an efficient manner. All this is made possible through
budgetary control and standard costing which are integral parts of management
accounting.
4. Serves as a means of Communication: Management accounting system prepares reports
for presentation to various levels of management which show the performance of various
sections in the business and helps to exercise effective control on various business
activities and successfully running the business.
Management accounting provides a means of communicating management plans
upward, downward and outward through the organisation. Initially, it means identifying
the feasibility and consistency of the various segments of the plan. At later stages it
keeps all parties informed about the plans that have been agreed upon and their roles in
these plans.

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5. Financial analysis and interpretation: In order to make accounting data easily
understandable, the management accounting offers various techniques of analysing,
interpreting and presenting this data in non-accounting language and meaningfully for
effective planning and decision-making. Ratio analysis, cash flow and fund flow
statements, trend analysis, etc., are some of the management accounting techniques
which may be used for financial analysis and interpretation.
6. Qualitative information: Apart from monetary and quantitative data, management
accounting provides qualitative information which helps in taking better decisions.
Quality of goods, customers and employees, legal judgments, opinion polls, logic etc., are
some of the examples of qualitative information supplied and used by the management
accounting system for better management.
7. Tax policies: Management accounting system is responsible for tax policies and
procedures and supervises and coordinates the reports prepared by various authorities.
8. Decision-making: Correct decision-making is crucial to the success of a business.
Management accounting has certain special techniques which help management in short-
term and long-term decisions. For example, techniques like marginal costing, differential
costing, discounted cash flow, etc., help in decisions such as pricing, make or buy,
discontinuance of a product line, capital expenditure etc.
Tools and Techniques used in Management Accounting
Management accounting uses a number of tools and techniques to help management in
achieving business goals. Some of the important tools and techniques are as follows:
1. Budgeting
2. Standard costing and variance analysis
3. Marginal costing and cost volume profit analysis
4. Ratio analysis
5. Comparative financial statements
6. Differential cost analysis
7. Fund flow statements.
8. Cash flow statements.
9. Responsibility accounting
10. Accounting for price level changes
11. Statistical and graphical techniques
12. Discounted cash flow
13. Risk analysis
14. Learning curve
15. Value analysis
16. Work Study etc.

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Financial Accounting and Management Accounting – Comparison
Financial accounting and management accounting are two major sub-systems of
accounting information system. Both are concerned with revenues and expenses, assets and
liabilities and cash flows. Both therefore involve financial statements. But the major differences
between the two arise because they serve different audiences. The main points of difference
between the two are as follows:
Basis Financial Accounting Management Accounting
1. External and internal
users
Financial accounting
information is mainly
intended for external users
like investors, shareholders,
creditors, government
authorities, etc.
Management accounting
information is mainly meant
for internal users, i.e.,
management.
2. Accounting Method It is based on double entry
system for recording business
transactions.
It is not based on double
entry system.
3. Statutory requirements Under company law and tax
laws, financial accounting is
obligatory to satisfy various
statutory provisions.
Management accounting is
optional though its utility
makes it highly desirable to
adopt it.
4. Analysis of cost and
profit
Financial accounting shows
the profit/loss of the business
as a whole. It does not show
the cost and profit for
individual products,
processes or departments etc.
provides detailed information
about individual products,
plants, departments or any
other responsibility centre.
5. Past and future data It is concerned with
recording transactions which
have already taken place, i.e.,
it represents past or historical
records.
It is future oriented and
concentrates on what is likely
to happen in future though it
may use past data for future
projections.
6. Periodic and continuous
reporting
Financial reports, i.e., Profit
& Loss account and Balance
Sheet are prepared usually on
a year to year basis.
reports are prepared
frequently i.e., these may be
monthly, weekly or even
daily depending on
managerial requirements.
7. Accounting Standards Companies are required to
prepare financial accounts
according to Accounting
Standards issued by the
Institute of Chartered
Accountants of India.
not bound by accounting
standards. It may use any
practice which generates
useful information to
management.
8. Types of statements
prepared
Financial accounting
prepares general purpose
In management accounting
special purpose reports are

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statements Profit & Loss
Account and Balance Sheet
which are used by external
users.
prepared, e.g., performance
report of sales manager or
any other department
manager which are used by
top level management.
9. Publication and Audit Financial statements, i.e.,
P&L A/c and Balance Sheet
are published for general
public use and also sent to
shareholders. These are
required to be audited by the
Chartered Accountants.
statements are for internal
use and thus neither
published for general public
use nor are these required to
be audited by Chartered
Accountants.
10. Monetary and non-
monetary measurements
Financial Accounting
provides information in terms
of money only.
Management accounting may
apply monetary or non-
monetary units of
measurement. For example,
information may be
expressed in terms of Rs. Or
units of quantity, machine
hours, labour hours etc.
Cost Accounting and Management Accounting – Comparison
An examination of the meaning and definitions of cost accounting and management
accounting indicates that the distinction between the two is quite vague. Some writers even
consider these two areas as synonymous while others distinguish between the two. Horngren, a
renowned author on the subject, has gone to the extent of saying, “Modern cost accounting is
often called management accounting, why? Because cost accountants look at their organisation
through manager’s eyes”. Thus managerial aspects of cost accounting are inseparable from
management accounting. One point on which all agree is that these two types of accounting do
not have clear cut territorial boundaries. However, distinction between cost accounting and
management accounting may be made on the following points.
Basis Cost Accounting Management Accounting
1. Scope Scope of cost accounting is
limited to providing cost
information for managerial
uses.
Scope of management
accounting is broader than that
of cost accounting as it
provides all types of
information, i.e., cost
accounting as well as financial
accounting information for
managerial uses.
2. Emphasis Main emphasis is on cost
ascertainment and cost
control to ensure maximum
Main emphasis is on planning,
controlling and decision-
making to maximise profit.

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profit.
3. Techniques employed Various techniques used by
cost accounting include
standard costing and variance
analysis, marginal costing
and cost volume profit
analysis, budgetary control,
uniform costing and inter-
firm comparison etc.
Management accounting also
uses all these techniques used
in cost accounting but in
addition it also uses techniques
like ratio analysis, funds flow
statement, statistical analysis,
operations research and certain
techniques from various
branches of knowledge like
mathematics, economics, etc.,
which so ever can help
management in its task.
4. Evolution Evolution of cost accounting
is mainly due to the
information of financial
accounting.
Evolution of management
accounting is due to the
limitations of cost accounting.
In fact, management accounting
is an extension of the
managerial aspects of cost
accounting.
5. Statutory requirements Maintenance of cost records
has been made compulsory in
selected industries as notified
by the government from time
to time.
purely voluntary and its use
depends upon its utility to
management.
6. Data base It is based on data derived
from financial accounts.
It is based on data derived from
cost accounting, financial
accounting and other sources.
7. Status in organisation In the organisational set up,
cost accountant is placed at a
lower level in hierarchy than
the management accountant.
Management accountant is
generally place at a higher level
of hierarchy than the cost
accountant.
8. Installation Cost accounting system can
be installed without
management accounting.
Management accounting cannot
be installed without a proper
system of cost accounting.
MANAGEMENT ACCOUNTANT
Any person responsible for the supply of accounting information to management is
known as management accountant. He feeds informational needs of different managerial levels.
He is known by different names I different organisations, i.e., Controller, Comptroller, Chief
Accountant, Financial Adviser, Financial Controller, etc. It is essential to determine the status
of management accountant in the organisation. It is also necessary to determine his scope of
work and responsibility.

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If management accountant provides the facts as accurately as are needed and are
presented in a manner which allows proper analysis and interpretation then he cannot be held
responsible for any wrong judgment by the management. On the other hand, if the information is
biased, inaccurate or it is not presented properly then responsibility will lie on the management
accountant.
Another important factor is to determine whether management accounting is a line
function or a staff function. Whether he is a manager like other functional manager? These
questions can be answered after considering his place in the organisation. If he participates in
planning and execution of policies, he is equal to other functional managers. In most of the
industries, management accountant performs only of staff function. He supplies information
and gives his views about the data and leaves the final decision making to functional
departmental heads. In America, controller has been given a top position in managerial
hierarchy. He is associated with controlling finances and costs and providing data for decision
making. This is no doubt a combination of staff and line function. As the management
accounting is of recent origin the role of controller or management accountant has not been
finally settled. He is associated according to the needs and requirements of the organisation. But
one thing is certain that he is given an important role in the organisation.
Functions of Management Accountant
The functions of management accountant depend upon his status the organisation needs
of the enterprise and personal capabilities of the persons. But still some functions are commonly
performed by management accountants.
The Financial Executives Institute, America has specialised the functions of the
controller as follows:
1. Planning for Control: Management accountant establishes co-ordinates and maintains an
integrated plan for the control of operations. Such a plan would provide cost standards,
expense budgets, sales forecasts, capital investment programmes, profit planning and the
system to effectuate the plans.
2. Reporting: Management accountant measures performance against given plans and
standards. The results of operations are interpreted to all levels of management. This
function will include installation of accounting and costing systems and recording of
actual performance so as to find out deviations, if any.
3. Evaluating: He should evaluate various policies and programmes. The effectiveness of
planning and procedures to attain the objectives of the organisation will depend upon the
calibre of the management accountant.
4. Administration of Tax: Management accountant is expected to report to Government
agencies as required under different laws and to supervise all matters relating to taxes.
5. Appraisal of External Effects: He is to assess the effect of various economic and fiscal
policies of the Government and also to evaluate the impact of other external factors on
the attainment of organisational objects.

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6. Protection of Assets: The protection of business assets is another function assigned to the
management accountant. This function is performed through the maintenance of internal
controls, auditing and assuring proper insurance coverage of assets.
Controller and Treasurer
Controller and Treasurer are the terms associated with Management Accounting. There
are in charge of all the financial transactions. They provide crucial information to management.
Due to the role played by these personnel, controller (or comptroller) is a term used in USA for
the top Management Accountant Executive in a firm. Hence, these terms are more associated
with USA. Controller is more concerned with the establishment, delegation and execution of the
activities of an organisation. His duty is also to report to the management about the result of the
activities I order to help the management for planning, controlling and decision making. Is
duties are defined by Controllers Institute of America. These duties are the duties which are to
be executed as Management Accountant.
The Treasurer is responsible for the management of the funds of a concern. He has to
ascertain the financial needs of a company, the ways in which the needs are to be met, utilisation
of the funds and ascertainment of the fair return on the investment. He has to see that funds are
effectively utilised to give a fair return.
FINANCIAL STATEMENT ANALYSIS
Introduction
Accounting is the process of identifying, measuring and communicating economic
information to permit judgments and decisions by users of the information. It involves
recording, classifying and summarizing various business transactions. The end products of
business transactions are the financial statements comprising primarily the position statement or
the balance sheet and the income statement or the profit and loss account. These statements are
the outcome of summarizing process of accounting and are; therefore the sources of information
on the basis of which conclusions are drawn about the profitability and the financial position of a
concern.
Financial Statements are the basis for decision making by the management as well as all
other outsiders who are interested in the affairs of the firm such as investors, creditors,
customers, suppliers, financial institutions, and employees, potential investors, Government and
the general public. The analysis and interpretation of financial statement depend upon the nature
and type of information available in these statements.
Meaning of Financial Statements
A financial statement is collecting of data organized according to logical and consistent
accounting procedures. Its purpose is to convey an understanding of some financial aspects of a

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business firm. It may show a position at a moment in time, as in the case of a balance sheet, or
may reveal a series of activities over a given period of time, as in the case of income statement.
Definition of Financial Statement
Financial statements are the outcome of summarizing process of accounting.
In the words of John N. Myer, “The financial statements provide a summary of the
accounts of a business enterprise, the balance sheet reflecting the assets, liabilities and capital as
on a certain date and the income statement showing the results of operations during a certain
period.”
Financial statements are also called financial reports.
Nature of Financial statements
The financial statements are composed of data which are the results of combinations of
1. Recorded facts concerning the business transactions,
2. Conventions adopted to facilitate the accounting technique
3. Postulates, or assumptions made to and
4. Personal judgements used in the application of the conventions and postulates. (John. N.
Myer)
1. Recorded Facts: The term ‘recorded facts’ refers to the data taken out from the
accounting records. The records are maintained on the basis of actual cost data. The
original cost or historical cost is the basis of recording various transactions. The figures
of various accounts such as cash in hand, cash in bank, bills receivables, sundry debtors,
fixed assets etc, are taken as per the figures recorded in the accounting books. The assets
purchased at different times and at different prices are put together and shown at cost
prices. As recorded facts are not based on replacement costs, the financial statements do
not show current financial condition of the concern.
2. Accounting Conventions: Certain accounting conventions are followed while preparing
financial statements. The convention of valuing inventory at cost or market price,
whichever is lower, is followed. The valuing of assets at cost less depreciation principle
for balance sheet purposes is followed. The convention of materiality is followed in
dealing with small items like pencils, pens, postage stamps, etc. These items are treated
as expenditure in the year in which they are purchased even though they are assets in
nature. The stationary is valued at cost and not on the principle of cost or market price
whichever is less. The use of accounting conventions makes financial statements
comparable, simple and realistic.
3. Postulates: The accountant makes certain assumptions while making accounting records.
One of these assumptions is that the enterprise is treated as a going concern. The other
alternative to this postulate is that the concern is to be liquidated; this is untenable if
management shows an intention to liquidate the concern. So the assets are shown on a

16
going concern basis. Another important assumption is to presume that the value of
money will remain the same I different periods. Though there is a drastic change in
purchasing power of money the assets purchased at different times will be shown at the
amount paid for them. While preparing profit and loss account, the revenue is treated in
the year in which the sales were undertaken even though the sale price may be received in
a number of years. The assumption is known as realisation postulate.
4. Personal Judgements: Even though certain standard accounting conventions are
followed in preparing financial statements but still personal judgements of the accountant
plays an important part. For example, in applying the cost or market value whichever is
less to inventory valuation the accountant will have to use his judgement in computing
the cost in a particular case. There are a number of methods for valuing stock, viz.,
LIFO, FIFO, average cost method, standard cost method, base stock method etc. The
accountant will use one of these methods for valuing materials. The selection of
depreciation method, to use of the several methods for estimating uncollectable debts, to
determine the period for writing off intangible assets are some of the examples where
judgement of the accountant will play an important role in choosing the most appropriate
course of action.
Meaning and Concept of Financial Analysis
The term ‘financial analysis’, also known as analysis and interpretation of financial
statements’, refers to the process of determining financial strengths and weaknesses of the firm
by establishing strategic relationship between the items of the balance sheet, profit and loss
account and other operative date.
Definition of Financial Statement Analysis [Jawaharlal]
In the words of John N. Myers, “Financial Statement Analysis is largely a study of the
relationship among the various financial factors in a business as disclosed by a single set-of
statement, and a study of the trend of these factors as shown in a series of statements.
The purpose of financial analysis is to diagnose the information contained in financial
statements so as to judge the profitability and financial soundness of a firm. The analysis and
interpretation of financial statements is essential to bring out the mystery behind the figures in
financial statements. Financial statements analysis is an attempt to determine the significance
and meaning of the financial statement data so that forecast may be made of the future earnings,
ability to pay interest and debt maturities (both current and long-term) and profitability of a
sound dividend policy.
The term ‘financial statement analysis’ includes both ‘analysis’ and ‘interpretation’.
Analysis is used to mean the simplification of financial data by methodical classification of the
data given in the financial statements and Interpretation means explaining the meaning and

17
significance of the data so simplified. However both analysis and interpretation are interlinked
and complimentary to each other. Analysis is useless without interpretation and interpretation
without analysis is difficult or even impossible.
Objectives of Financial Statement Analysis
(i) To assess the earning capacity or profitability of the firm
(ii) To assess the operational efficiency and managerial effectiveness.
(iii) To assess the short term as well as long term solvency position of the firm.
(iv) To identify the reasons for change in profitability and financial position of the firm.
(v) To make inter-firm comparison.
(vi) To make forecasts about future prospects of the firm.
(vii) To assess the progress of the firm over a period of time.
(viii) To help in decision making and control.
(ix) To guide or determine the dividend action.
(x) To provide important information for granting credit.
Types of Financial Statement Analysis
The types of financial statements analysis are classified on basis of
(i) The material used
(ii) The method of operation followed in the analysis or the modus operandi of analysis.
i) On the basis of material used: According to material used, financial analysis can be of
two types:
(a) External Analysis: This analysis is done by outsiders who do not have access to the
detailed internal accounting records of the business firm. These outsiders include
investors, potential investors, creditors, potential creditors, government agencies,
credit agencies, and the general public. For financial analysis, these external parties
to the firm depend almost entirely on the published statements. External analysis,
thus serves only a limited purpose. However, the recent changes in the government
regulations requiring business firms to make available more detailed information to
Types of
Financial Analysis
On the basis of
material used
External Analysis
InternalAnalysis
On the basis of
modus operandi
Horizontal Analysis
Vertical Analsis

18
the public through audited published accounts have considerably improved the
position of the external analysis.
(b) Internal Analysis: The analysis conducted by persons who have access to the internal
accounting records of a business firm is known as internal analysis. Such an analysis
can, therefore, be performed by executives and employees of the organisation as well
as government agencies which have statutory powers vested in them. Financial
analysis for managerial purposes is the internal type of analysis that can be affected
depending upon the purpose to be achieved.
ii) On the basis of Modus Operandi: According to the method of operation followed in the
analysis, financial analysis can be of two types:
(a) Horizontal Analysis: Horizontal analysis refers to the comparison of financial data of
a company for several years. The figures for this type of analysis are presented
horizontally over a number of columns. The figures of the various years are
compared with standard or base year. A base year is a year chosen as beginning
point. This type of analysis is also called ‘Dynamic Analysis’ as it is based on the
data from year to year rather than on data of any one year. The horizontal analysis
makes it possible to focus attention on items that have changed significantly during
the period under review. Comparison of an item over several periods with a base year
may show a trend developing. Comparative statements and trend percentages are two
tools employed in horizontal analysis.
(b) Vertical Analysis: Vertical analysis refers to the study of relationship of the various
items in the financial statements of one accounting period. In these types of analysis
the figures from financial statement of a year are compared with a base selected from
the same year’s statement. It is also known as ‘Static Analysis’. Common-size
financial statements and financial ratios are the two tools employed in vertical
analysis. Since vertical analysis considers data for one time period only, it is not very
conducive to a proper analysis of financial statements. However, it may be used
along with horizontal analysis to make it more effective and meaningful.
In addition to the above primary classification of financial analysis, the following other
types of financial analysis are also discussed:
iii) On the basis of entities involved: on the basis of entities involved in the analysis,
financial analysis can also be of two types:
(a) Cross sectional or inter-firm analysis: Cross sectional analysis involves comparison
of financial data of a firm with other firms (competitors) or industry averages for the
same time period.

19
(b) Time Series or Intra-firm Analysis: Time series analysis involves the study of
performance of same firm over a period of time.
iv) On the basis of time horizon or objective of analysis: On the basis of time horizon,
financial analysis can be classified under two categories:
(a) Short-term Analysis: Short-term analysis measures the liquidity position of a firm,
i.e., the short-term paying capacity of a firm or the firm’s ability to meet its current
obligations.
(b) Long-term Analysis: Long-term analysis involves the study of firm’s ability to meet
the interest costs and repayment schedules of its long-term obligations. The solvency,
stability and profitability are measured under this type of analysis.
Procedure of Financial Statement Analysis
Broadly speaking there are three steps involved in the analysis of financial statement.
These are:
(i) Selection
(ii) Classification and
(iii) Interpretation
The first step involves selection of information (data) relevant to the purpose of
analysis of financial statements. The second step involved is the methodical
classification of the data and the third step includes drawing of inferences and
conclusions.
The following procedure is adopted for the analysis and interpretation of financial statement:
(1) The analyst should acquaint himself with the principles and postulates of accounting. He
should know the plans and policies of the management so that he may be able to find out
whether these plans are properly executed or not.
(2) The extent of analysis should be determined so that the sphere of work may be decided.
If the aim is to find out the earning capacity of the enterprise then analysis of income
statement will be undertaken. On the other hand, if financial position is to be studied
then balance sheet analysis will be necessary.
(3) The financial data given in the statements should be re-organised and re-arranged. It will
involve the grouping of similar data under same heads, breaking down of individual
components of statements according to nature. The data is reduced to a standard form.
(4) A relationship is established among financial statements with the help of tools and
techniques of analysis such as ratios, trends, common size, funds flow etc.
(5) The information is interpreted in a simple and understandable way. The significance and
utility of financial data is explained for helping decision-taking.

20
(6) The conclusions drawn from interpretation are presented to the management in the form
of reports.
Methods or Devices of Financial Analysis
The analysis and interpretation of financial statements is used to determine the financial
position and results of operations as well. The following are some of the methods of analysis:
1. Comparative Statements
2. Common Size Statements
3. Trend Analysis
4. Funds Flow Analysis
5. Cash Flow Analysis
6. Ratio Analysis
7. Cost-Volume-Profit Analysis.
1. COMPARATIVE STATEMENTS
Comparison of financial statements is one of the very important tools of analysis of
financial statements. The comparative financial statements are statements of the financial
position at different periods of time. The elements of financial statements are shown in a
comparative form so as to give an idea of financial position at two or more periods. Any
statement prepared in a comparative form will be covered in comparative statements. From
the practical point of view, generally tow financial statements (Balance sheet and income
statement) are prepared in comparative form for financial analysis purposes. Not only the
comparison of the figures of two periods but also be relationship between balance sheet and
income statement enables an in-depth study of financial position and operative results.
In the process of comparison, the good or poor performance of each item for a period
can be known in order to take corrective action for the future.
(a) Comparative Balance Sheet
The comparative balance sheet analysis is the study of the trend of the same
items, group of items and computed items in two or more balance sheets of the same
business enterprise on different dates. The changes in periodic balance sheet items reflect
the conduct of a business. The changes can be observed by comparison of the balance
sheet at the beginning and at the end of a period and these changes can help in forming an
opinion about the progress of an enterprise.
The comparative balance sheet has two columns for the data of original balance
sheets. A third column is used to show increases or decreases in figures and fourth
column may be added to for giving percentages of increases or decreases.
Guidelines for Interpretation of Comparative Balance Sheet

21
While interpreting Comparative Balance Sheet the interpreter is expected to study the
following aspects:
(1) Current financial position and liquidity position.
(2) Long-term financial position.
(3) Profitability of the Concern.
(1) For studying current financial position or short term financial position of a concern, one
should see the working capital in both the years. The excess of current assets over
current liabilities will give the figures of working capital. The increase in working
capital will mean improvement in the current financial position of the business. An
increase in current assets accompanied by the increase in current liabilities of the same
amount will not show any improvement in the short-term financial position.
The second aspect which should be studied in current financial position is the liquidity
position of the concern. If liquid assets like cash in hand, cash at bank, bills receivables,
debtors, etc., show an increase in the second year over the first year, this will improve the
liquidity position of the concern. The increase in inventory can be on account of
accumulation of stocks for want of customers, decrease in demand or inadequate sales
promotion efforts. An increase in inventory may increase working capital of the business
but it will not be good for the business liquidity.
(2) The long-term financial position of the concern can be analysed by studying the changes
in fixed assets, long-term liabilities and capital. The proper financial policy of the
concern will be to finance fixed assets by the issue of either long-term securities such as
debentures, bonds, loans from financial institutions or issue or fresh share capital. An
increase in fixed assets should be compared to the increase in the long-term loans and
capital. If the increase in fixed assets is more than the increase in long term securities
then part of fixed assets has been financed form working capital. On the other hand, if
the increase in long-term securities is more than the increase in fixed assets then fixed
assets have not only been financed from long-term sources but part of working capital has
also been financed from long-term sources. A wise policy will be to finance fixed assets
by raising long-term funds.
The nature of assets which have increased or decreased should also be studied to form an
opinion about the future production possibilities. The increase in plant and machinery
will increase production capacity of the concern. On the liabilities side, the increase in
loaned funds will mean an increase in interest liability whereas an increase in share
capital will not increase any liability for paying interest. An opinion about the long-term
financial position should be formed after taking into consideration above mentioned
aspects.

22
(3) The next aspect to be studied in a comparative balance sheet is the profitability of the
concern. The study of increase or decrease in retained earnings, various resources and
surpluses, etc. will enable the interpreter to see whether the profitability has improved or
not. An increase in the balance of profit & loss account and other resources created from
profits will mean an increase in profitability to the concern. The decrease in such
accounts may mean issue of dividend, issue of bonus shares or deterioration in
profitability of the concern.
(4) After studying various assets and liabilities an opinion should be formed about the
financial position of the concern. One cannot say if short-term financial position is good
then long-term financial position will also be good and vice-versa. A concluding word
about the overall financial position must be given at the end.
(b) Comparative Income Statement
The Income Statement gives the results of the operations of a business. The comparative
income statement gives an idea of the progress of a business over a period of time. The
changes in absolute data in money values and percentages can be determined to analyse
the profitability of the business. Like comparative balance sheet, income statement also
has four columns. First two columns give figures of various items for two years. Third
and fourth columns are used to show increase or decrease in figures in absolute amounts
and percentages respectively.
Guidelines for Interpretation of Income Statement
The analysis and interpretation of income statement will involve the following steps:
(1) The increase or decrease in sales should be compared with the increase or decrease in
cost of goods sold. An increase in sales will not always mean an increase in profit. The
profitability will improve if increase in sales is more than the increase in cost of goods
sold. The amount of gross profit should be studied in the first step.
(2) The second step of analysis should be the study of operational profits. The operating
expenses such as office and administrative expenses, selling and distribution expenses
should be deducted from gross profit to find out operating profits. An increase in
operating profit will result from the increase in sales position and control of operating
expenses. A decrease in operating profit may be due to an increase in operating
expenses or decrease in sales. The change in individual expenses should also be studied.
Some expenses may increase due to the expansion of business activities while others
may go up due to managerial inefficiency.

23
(3) The increase or decrease in net profit will give an idea about the overall profitability of
the concern. Non-operating expenses such as interest paid, losses from sale of assets,
writing off of deferred expenses, payment of tax etc. decrease the figure of operating
profit. When all non-operating expenses are deducted from operational profit, we get a
figure of net profit. Some non-operating incomes may also be there which will increase
net profit. An increase in net profit will give us an idea about the progress of the
concern.
(4) An opinion should be formed about profitability of the concern and it should be given at
the end. It should be mentioned whether the overall profitability is good or not.
2. COMMON SIZE STATEMENTS
Common size statement is concerned with the analysis of the financial statements on
percentage basis. It explains each item of the financial statements in terms of the percentage
to the total. Hence, the share of each item of expenses or incomes, assets or liabilities to total
can be known through this analysis. The importance of each item in a statement can also be
known through this analysis.
The common-size statements are shown in analytical percentages. The figures are shown as
percentages of total assets, total liabilities and total sales. The total assets are taken as 100
and different assets are expressed as a percentage to the total. Similarly, various liabilities
are taken as a part of total liabilities. These statements are also known as Component
Percentage or 100 Percent Statements because every individual item is stated as a percentage
of the total 100. The short comings in comparative statements and trend percentage where
changes in items could not be compared with the totals have been covered up. The analyst is
able to assess the figures in relation to the total assets.
(a) Common-size Balance Sheet
A statement in which balance sheet items are expressed as the ratio of each asset to total
assets and the ratio of each liability is expresses as a ratio of total liabilities is called
common-size balance sheet.
The common-size balance sheet can be used to compare companies of differing size.
(b) Common-size Income Statement
The items in income statement can be shown as percentages of sales to show the relation
of each item to sales. A significant relationship can be established between items of
income statement and volume of sales. The increase in sales will certainly increase
selling expenses and not administrative or financial expenses. In case the volume of sales
increases to a considerable extent, administrative and financial expenses may go up. In
case the sales are declining, the selling expenses should be reduced at once. So, a
relationship is established between sales and other items in income statement and this
relationship is helpful in evaluating operational activities of the enterprise.

24
3. TREND ANALYSIS
The financial statements may be analysed by computing trends of series of information.
This method determines the direction upwards or downwards and involves the computation
of the percentage relationship that each statement item bears to the same item in base year.
The information for a number of years is taken up and one year, generally the first year is
taken as a base year. The figures of the base year are taken as 100 and trend ratios for other
subsequent years are calculated on the basis of base year. The analyst is able to see the trend
of figures, whether upward or downward.
Procedure for Calculating Trends:
(1) One year is taken as a base year. Generally, the first or the last is taken as base year.
(2) The figures of base year are taken as 100.
(3) Trend percentages are calculated in relation to base year.
The interpretation of trend analysis involves a cautious study. The mere increase or
decrease in trend percentage may give misleading results if studied in isolation. An increase
of 20% in current assets may be treated favourable. If this increase in current assets is
accompanied by an equivalent increase in liabilities, then this increase will be unsatisfactory.
The increase in sales may not increase profits if the cost of production has also gone up. The
accounting procedures and conventions used for collecting data and preparation of financial
statements should be similar; otherwise the figures will not be comparable.

Introduction to management accounting and Financial Statement Analysis

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