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1. “If a financial statement is not prepared using GAAP principle, the statement is very well”!

in light of the statement , explain GAAP principle in detail

What Is GAAP?
Full form of is Generally Accepted Accounting Principles. its refers to a specific set of guidelines that have
been established to help publicly-traded companies create their financial statements. Publicly-traded
companies are companies that have made stock in their organization available for sale to the public. Unlike
some superheroes that are made up of plutonium and kryptonite, its made up of 10 basic accounting
principles. They are:

1. Economic Entity Assumption

2. Monetary Unit Assumption
3. Time Period Assumption
4. Cost Principle
5. Full Disclosure Principle
6. Going Concern Principle
7. Matching Principle
8. Revenue Recognition Principle
9. Materiality
10. Conservatism

Let's take a minute to look at what each of my parts mean:

The economic entity assumption means that any activities of a business must be kept separate from the
activities of the business owner.
The monetary unit assumption means that only activities that can be expressed in dollar amounts can be
included in accounting records.
The time period assumption means that business activities can be reported in distinct time intervals. These
intervals may be in weeks, months, quarters, or in a fiscal year. Whatever the time period is, it must be
identified in the financial statement dates.
The cost principle refers to the historical cost of an item that is reported on the financial statements. Historical
cost is the amount of money that was paid for an item when purchased and is not changed to account for
The full disclosure principle means that all information that is relative to the business be reported either in
the content of the financial statements or in the notes to the financial statements.
The going concern principle refers to the intent of a business to continue operations into the foreseeable
future and not to liquidate the business.
The matching principle refers to the manner in which a business reports income and expenses. This principle
requires that businesses use the accrual form of accounting and match business income to business expenses
in a given time period. For example, a sales expense should be recorded in the same accounting period that
sales income was made.
The revenue recognition principle addresses the manner in which revenue, or income, is recognized. This
standard requires that revenue be reported on the income statement in the period in which it is earned.
The materiality principle refers to the measure of importance of a misstatement in accounting records. For
example, if the price of an asset is understated by $10.00, will that misstatement have enough effect on the
financial statements to matter? This is a gray area in accounting standards that requires professional judgment
to be used.
The last principle that makes me up is conservatism. Conservatism is the principle that calls for potential
expenses and liabilities to be recognized immediately if you are unsure whether they will actually occur or not,
but potential revenue not to be recognized until it is actually received.
History of GAAP
Now that you know what I am made of, let's talk about why I was created. Way back in 1929, a significant event
in American history occurred. It was called the Stock Market Crash of 1929, and it affected not only those
people who had placed their hard-earned money into corporate stocks and bonds but also every single person
in America. The 1929 stock market crash was a precursor to one of the hardest economic times that has ever
been known, the Great Depression.
During this time, many people lost faith in the stock market and in the American economy. The government
decided that there needed to be some way to rebuild that lost faith, and so, in the early 1930s, the Securities
and Exchange Commission (SEC) was created.
The purpose of the SEC was to regulate financial practices among publicly-traded companies. In 1934, the
SEC asked for assistance from the American Institute of Accountants, or the AIA, in examining the
formation of financial statements. Two years later, in a report on financial statement formation, the concept of
GAAP was mentioned for the very first time.
In the late 1930s, the AIA created a subcommittee to specifically create the GAAP principles. It was called
the Committee on Accounting Procedure, or CAP, and comprised 18 accountants and three accounting
professors. Shortly after CAP was formed, the first set of GAAP standards was created. In 1973, the SEC
decided to replace CAP with the Financial Accounting Standards Board (FASB), which is still in place today.

2. What are objective of financial accounting? also discuss the demerits of financial
accounting (600 words 15 Mks/10 MKS)

Financial accounting (or financial accountancy) is the field of accounting concerned with the
summary, analysis and reporting of financial transactions pertaining to a business. [1]This
involves the preparation of financial statements available for public
consumption. Stockholders, suppliers, banks, employees, government agencies, business owners,
and other stakeholders are examples of people interested in receiving such information for
decision making purposes.
Financial accountancy is governed by both local and international accounting
standards. Generally Accepted Accounting Principles (GAAP) is the standard framework of
guidelines for financial accounting used in any given jurisdiction. It includes the standards,
conventions and rules that accountants follow in recording and summarizing and in the
preparation of financial statements.

Financial accounting and financial reporting are often used as synonyms.
1. According to International Financial Reporting Standards, the objective of financial reporting
To provide financial information about the reporting entity that is useful to existing and potential
investors, lenders and other creditors in making decisions about providing resources to the entity.
2. According to the European Accounting Association:
Capital maintenance is a competing objective of financial reporting.
Benefits or Advantages of Financial Accounting
 Financial information about business: Accounting makes available financial information ie. the profit
earned or loss suffered and also what are the assets and liabilities of the enterprise.To provide
information useful for the making economic decision.
 To serve primarily those users who have limited authority ability or resource to obtain information and
who rely on the financial statement as their principal source of information about the economic activities
of an enterprise.
 Facilitates comparative study: To provide information useful to investors and creditors for predicting
comparing and evaluating cash flow in terms of amount timing and related uncertainty.
 To provide users with information for predicting comparing and evaluating the earning power of the
 Assistance to Manager: The management responsible for the function of the business and has to,
therefore, plan to make decisions and exercise effective control over the affairs of the business.The
management performs these function on the basis of accounting information. To supply useful
information in judgment the management ‘s ability to utilize enterprise resources effectively for
achieving the primary enterprise goals.
 To provide factual and interpretive information about the transaction that is useful for predicting
comparing and evaluating the earning power of an enterprise.
 Replace memory: No business man can remember everything about his business since human
memory has limitation.It is necessary to record the transaction in the book of accounts promptly.There
is no necessity of remembering various transaction since on need the records will furnish the necessary
 Facilitates loan: Loan is granted by the bank and financial institution on the basis of growth potential
which is supported by the performance.Accounting makes available the information with respect to
Some important activities financial accounting includes :
1. It helps to prepare in bank reconciliation statement.
2. Financial reporting for movement and banks and shareholders.
3. It helps in debtor and creditor reconciliation
4. It helps in bookkeeping of the organization.
5. it helps in tax management.
6. It helps in payroll processing.
Disadvantages of Financial Accounting
Accounting is not fully exact: Accounting is influenced by the personal judgment in respect of various
terms.People are bound to have different ideas and the estimates will naturally differ from person to
person.Thus this will lead to the different amount of profit shown by a different person.Thus the profit
cannot be treated as exact.
Accounting does not indicate the releasable value: The balance sheet does not show the amount of cash
which the firm may realize by the sale of all assets.
Accounting ignores qualitative elements: Since accounting is confined to monetary matters only
qualitative elements like a quality of management and labor force industrial relations and public relations
are ignored.
Accounting ignores the effect of price level change: Accounting statement is prepared at historical
cost.Money as measurement unit change in value. It does not remain stable.The financial statement does
not show the effect of the change in price level.The assets remain to undervalue in many case particular
land and building So while preparing financial statement accounting information will not show the true
Accounting may lead to window dressing: The term window dressing means manipulation of accounts
in a way so as to conceal vital facts and present the financial statement in a way to show better position
than what it is actually.In this solution, income statement fails to provide a true and fair view of the result
of the operation and the balance sheet fails to provide a true and fair view of the financial position of the

3. What is a variance? Explain material cost variance with suitable example.

The difference between an expected and actual result, such as between a budget and actual

Variance Analysis refers to the investigation as to the reasons for deviations in the financial
performance from the standards set by an organization in its budget. It helps the management to
keep a control on its operational performance.

The difference between the standard cost of direct materials and the actual cost of direct
materials that an organization uses for production is known as Material Variance.

“It is the difference between the standard cost of direct materials specified for the output
achieved and the actual cost of direct materials used”.

The direct material cost variances including material price variance, material usage variance,
material mix variance and material yield variance. The following chart depicts the divisions of
Direct Material Cost Variances very clearly.


Formula to calculate Direct Material Cost Variance

The following formula is used to calculate Direct Material Cost Variance.

Standard Cost – Actual Cost

In other words, (Standard Quantity x Standard Price) – (Actual Quantity x Actual Price)

MCV = (SQx SP) -(AQxAP)


 MCV = Material Cost Variance

 SQ = Standard Quantity for Actual Output
 SP = Standard Price
 AQ = Actual Quantity
 AP = Actual Price
 The following formula is used for calculating SQ for actual output.
 Standard Quantity for Actual Output = (Std. Input / Std. Output) x Actual Output
 Standard Cost = SQ x SP
 Actual Cost = AQ x AP
 If the standard cost is more than the actual cost, the variance will be favorable and on the
other hand if the standard cost is less than the actual cost the variance will be unfavorable
or adverse.


1. Standard cost has to be calculated with reference to standard quantity for actual output. In such
case, the information regarding standard output to be ignored.

2. If the problem is silent in respect of standard output and actual output, it will be assumed that
standard output for which the standard was fixed has actually been achieved i.e. SO = AO

Causes for Direct Material Cost Variance

Direct material cost variance is caused due to the following reasons.

1. Change (increase / decrease) in the price of materials

2. Change (increase / decrease) in the quantity of materials used. This is happened due to

a. Change in the mix of more than one type of materials in the process of manufacture.
b. Change (increase / decrease) in the output.

4. What do you understand by budget and budgetary control? Explain Fixed, Flexible,
Master and zero budget.
A budget is an estimation of revenue and expenses over a specified future period of time; it is
compiled and re-evaluated on a periodic basis. Budgets can be made for a person, a family, a
group of people, a business, a government, a country, a multinational organization or just about
anything else that makes and spends money. At companies and organizations, a budget is an
internal tool used by management and is often not required for reporting by external parties.

Budgetary control Meaning: Budgetary control is the process of determining various actual
results with budgeted figures for the enterprise for the future period and standards set then
comparing the budgeted figures with the actual performance for calculating variances, if any.
First of all, budgets are prepared and then actual results are recorded.

The comparison of budgeted and actual figures will enable the management to find out
discrepancies and take remedial measures at a proper time. The budgetary control is a continuous
process which helps in planning and co-ordination. It provides a method of control too. A budget
is a means and budgetary control is the end-result.
“According to Brown and Howard, “Budgetary control is a system of controlling costs which
includes the preparation of budgets, coordinating the departments and establishing
responsibilities, comparing actual performance with the budgeted and acting upon results to
achieve maximum profitability.” Weldon characterizes budgetary control as planning in advance
of the various functions of a business so that the business as a whole is controlled.
From the above given definitions it is clear that budgetary control involves the follows:
(a) The objects are set by preparing budgets.
(b) The business is divided into various responsibility centres for preparing various budgets.
(c) The actual figures are recorded.
(d) The budgeted and actual figures are compared for studying the performance of different cost
(e) If actual performance is less than the budgeted norms, a remedial action is taken immediately.
The main objectives of budgetary control are the follows:
1. To ensure planning for future by setting up various budgets, the requirements and expected
performance of the enterprise are anticipated.
3. To operate various cost centers and departments with efficiency and economy.
4. Elimination of wastes and increase in profitability.
5. To anticipate capital expenditure for future.
6. To centralise the control system.
7. Correction of deviations from the established standards.
8. Fixation of responsibility of various individuals in the organization.

Fixed Budgeting
In a fixed, or static, budget, the budget shows results for only one level of activity, such as
production. Even if that activity level changes, the budget does not. For example, if you
budgeted $5,000, the budget would remain the same, regardless of whether you produced 300,
400 or 500 units. The basic process for a fixed budget thus is very simple: First, identify a base
activity level. Then figure out what cost components you have, identifying which are flexible and
which are static. Next, multiply the flexible costs by the activity level and add the static costs.
Leave the budget alone for the entire budget period regardless of the actual activity level.

Flexible Budgeting
Flexible budgeting is basically the opposite of fixed budgeting. With this method, your company
looks at multiple activity levels and creates a series of static budgets so the budget you use
accommodates what really happened. For example, you could create budgets that allot $1,000 for
300 units, $1,500 for 400 units and $2,000 for 500 units. Once you've done this using the basic
fixed budget process, compare the actual expenses incurred to the budgeted amount for actual
activity. For example, if you produced 300 units and spend $750 to do it, you'd look at the
budget for the 300-unit production level. Because you'd allowed $1,000 in that budget, you
would come out $250 under budget.

Zero-Based Budgeting
Fixed budgets are often incremental. This means that companies use the budget from the
previous budget period as a foundation, justifying only the difference, or increments, between the
old and new budget item costs. For example, if the old budget allowed $500 and the new one
allowed $600, you would justify the $100 increase. This also applies to fixed budgets, as fixed
budgets are just a series of static budgets. Zero-based budgeting, however, is a budgeting method
in which you start from scratch every time. To create this type of budget, you figure out your
income, as well as your fixed and flexible expenses. You then allocate a percentage of your
income to each expense, focusing on the fixed expenses first. When you subtract the expenses
from your income, the total should be zero. If it is not, it means you have to adjust your
allocation. Every dollar has to be accounted for in this budget method, so if you have more
income than expenses, you include savings or similar allocations as regular expenses or give a
higher percent to the expenses already listed.
Each budgeting method and its related process has advantages and disadvantages. For example, a
fixed budget requires much less work, but is not as accurate as a flexible budget. Similarly, a
zero-based budget helps prevent budget padding, as you must justify everything, but it requires a
lot of data and thus usually has to roll over through more than one budget period. Thus,
companies have to pick the budget method and processes that work best for their given

100-150 words 3 MKS

i. Difference between financial and management Accounting

The following points explain the major differences between financial accounting and
managerial accounting:

1. Financial accounting is the branch of accounting which keeps track of all the financial
information of the entity. Management accounting is that branch of accounting which
records and reports both the financial and nonfinancial information of an entity.
2. Users of financial accounting are both the internal management of the company and the
external parties while the users of the management accounting are only the internal
3. Financial accounting is to be publicly reported whereas the management accounting is for
the use of the organization and hence it is very confidential.
4. Only monetary information is contained in financial accounting. As against this,
management accounting contains both monetary and non-monetary information such as
the number of workers, the quantity of raw material used and sold, etc.
5. Financial accounting is done in the prescribed format, whereas there is no prescribed
format for the management accounting.
6. Financial accounting focuses on providing information about the functioning of the
entity’s business to its users, whereas management accounting focuses on providing
information to help them in evaluating the performance and devising plans for the future.
7. The financial accounting is mainly done for a specific period, which is usually one year.
On the other hand, the management accounting is done as per the needs of the
management say quarterly, half yearly, etc.
8. Financial accounting is a must for any company for auditing purposes. On the contrary,
management accounting is voluntary, as no editing is done.
9. Financial accounting information is required to be published and audited by statutory
auditors. Unlike, management accounting, which does not require information to be
published and audited, as they are for internal use only.

ii. Briefly explain the classification of the cost

Classification of cost means, the grouping of costs according to their common characteristics.
The important ways of classification of costs are:

1. By Nature or Traceability: Direct Costs and Indirect costs. Direct Costs are Directly
attributable/traceable to Cost object. Direct costs are assigned to Cost Object. Indirect
Costs are not directly attributable/traceable to Cost Object. Indirect costs are allocated or
apportioned to cost objects.
2. By Functions: production, administration, selling and distribution, R&D.
3. By Behavior: fixed, variable, semi-variable. Costs are classified according to their
behavior in relation to change in relation to production volume within given period of
time. Fixed Costs remain fixed irrespective of changes in the production volume in given
period of time. Variable costs change according to volume of production. Semi-variable
costs are partly fixed and partly variable.
4. By control ability: controllable, uncontrollable costs. Controllable costs are those which
can be controlled or influenced by a conscious management action. Uncontrollable costs
cannot be controlled or influenced by a conscious management action.
5. By normality: normal costs and abnormal costs. Normal costs arise during routine day-to-
day business operations. Abnormal costs arise because of any abnormal activity or event
not part of routine business operations. E.g. costs arising of floods, riots, accidents etc.
6. By Time: Historical costs and predetermined costs. Historical costs are costs incurred in
the past. Predetermined costs are computed in advance on basis of factors affecting cost
elements. Example: Standard Costs.
7. By Decision making Costs: These costs are used for managerial decision making.And
these are :-

 Marginal costs: Marginal cost is the change in the aggregate costs due to change in the
volume of output by one unit.
 Differential costs: This cost is the difference in total cost that will arise from the selection of
one alternative to the other.
 Opportunity costs: It is the value of benefit sacrificed in favor of an alternative course of
 Relevant cost: The relevant cost is a cost which is relevant in various decisions of
 Replacement cost: This cost is the cost at which existing items of material or fixed assets can
be replaced. Thus this is the cost of replacing existing assets at present or at a future date.
 Shutdown cost:These costs are the costs which are incurred if the operations are shut down
and they will disappear if the operations are continued.
 Capacity cost: These costs are normally fixed costs. The cost incurred by a company for
providing production, administration and selling and distribution capabilities in order to
perform various functions.
 Sunken cost: cost already incurred
 Other costs

iii. Explain the components of cost sheet

The four main components of costs are: (a) Prime Cost, (b) Works Cost, (c) Office Cost and
(d) Total Cost.

Prime Cost
It consists of costs of direct material, direct labour and direct expense specifically attributable
to the job. This is also known as flat, direct or basic cost.

Works Cost
It comprises of prime cost and factory overheads, (cost of indirect material, indirect labour
and indirect expenses related to factory works). This cost is also known as factory cost,
production or manufacturing cost.

Cost of Production (Office Cost)

It is the sum total of works cost and office and administrative overheads <Cost of indirect
material, indirect labour and indirect expenses related to office works). This cost is known as
office cost.

Cost of Production = Works Cost + Office and Administrative Overheads

Total Cost
It comprises of cost of production and selling and distribution overheads (Cost of indirect
material, indirect labour and indirect expenses for selling and distribution activities).

Total Cost = Cost of Production + Selling and Distribution Overheads

iv. Explain the application of marginal costing

The following points highlight the top four applications of marginal costing. The applications
are: 1. Cost Control 2. Profit Planning 3. Evaluation of Performance 4. Decision Making.
Marginal Costing: Application # 1. Cost Control:
Marginal costing divides the total cost into fixed and variable cost. Fixed cost can be controlled
by the top management and that to a limited extent. Variable costs can be controlled by the lower
level of management. Marginal costing by concentrating all efforts on the variable costs can
control and thus provides a tool to the management for control of total cost.

There may be situations where the profits of the concern are decreasing in-spite of increase in
sales. If the data is presented on the basis of absorption costing basis, the management may not
be able to comprehend the results. Marginal costing analysis will correctly bring out the reasons
as to why the profits are decreasing in-spite of increase in sales.

Moreover, it should be noted that in marginal costing fixed costs are not eliminated at all. These
are shown separately as a deduction from the contribution instead of merging with cost of sales
and inventories. This helps the management to have control on fixed costs also in the long period
as these costs are programmed in advance.

Marginal Costing: Application # 2. Profit Planning:

Marginal costing helps the profit planning i.e., planning for future operations in such a way as to
maximise the profits or to maintain a specified level of profit. Absorption costing fails to bring
out the correct effect of change in sale price; variable cost or product mix on the profits of the
concern but that is possible with the help of marginal costing.
Profits are increased or decreased as a consequence of fluctuations in selling prices, variable
costs and sales quantities in case there is fixed capacity to produce and sell.

Marginal Costing: Application # 3. Evaluation of Performance:

The different products, departments, markets and sales divisions have different profit earning
potentialities. Marginal cost analysis is very useful for evaluating the performance of each sector
of a concern.

Performance evaluation is better done if distinction is made between fixed and variable expenses.
A product, department, market or sales division giving higher contribution should be preferred if
fixed expenses remain same.

Marginal Costing: Application # 4. Decision Making:

The information provided by the total cost method is not sufficient in solving the management
problems. Marginal costing technique is used for providing assistance to the management in vital
decision-making, especially in dealing with the problems requiring short-term decisions where
fixed costs are excluded.

v. Break Even Point & Margin of Safety

Errors of rectification

In financial accounting, every single event occurring in

monetary terms is recorded. Sometimes, it just so
happens that some events are either not recorded or it is recorded in
the wrong head of account or wrong figure is recorded in the correct head of account.

Whatever the reason may be, there is always a chance of error in the books
of accounts. These errors in accounting require rectification. The procedure adopted
to rectify errors in financial accounting is called "Rectification of error".


One way of rectification is that we can simply erase or overwrite the
incorrect entry and replace it with the correct one. But this practice is not allowed
in accounting. We have to Rectify / correct the mistake by recording another entry

vi. Classification of errors

vii. Difference between Budget & standers

viii. Asset & Liabilities

ix. Difference between gross profit & net Profit

A. Numerical
a. Two or Three cash book column
b. Trading & PL, B/s with adjustment entry
c. Cost Sheet