Question No. 5 - MMPC 004 - Accounting for Managers - MBA and MBA (Banking & Finance)

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                            MBA and MBA (Banking & Finance)

MMPC 004 - Accounting for Managers

MMPC-004/TMA/JULY/2022

Question No. 5 From the following calculate cash from operations:

Solution:

Question No. 4 - MMPC 004 - Accounting for Managers - MBA and MBA (Banking & Finance)

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                            MBA and MBA (Banking & Finance)

MMPC 004 - Accounting for Managers

MMPC-004/TMA/JULY/2022

Question No. 4. Explain in detail the various contents of an Annual Report.
Solution:

Let‘s look at the contents of an annual report. Figure 1 displays the four broad contents of an annual report, namely, 1) Non-audited information, 2) Financial statement, 3) Notes to the accounts and 4) Accounting policies.

Let‘s understand each of the four broad contents one by one. 

1) Non-audited information 

 The non-audited information is further classified into: 

 a) Narrative items and 

 b) Non-narrative items. 

a) Narrative items Within narrative items in the annual report, following are some of the important statements: Chairman‘s statement, Directors‘ report, Operating and financial review, Statement of corporate governance, Auditors report, Statement of directors‘ responsibilities, Sustainability report and Management Discussion and Analysis. 

i) Chairman‘s statement Chairman‘s statement highlights corporate activities, strategies, researches, labour relations, main achievements, focuses on future goals, growth. In corporate annual report, the chairman‘s statement may or may not always be found but may be provided to shareholders as a separate document. Chairman‘s statement may concentrate on economic condition of the industry to which the corporate unit belongs and the economy of the country. It also provides an overview of the trading year, a personalized overview of the company‘s performance over the past year and usually covers strategy, financial performance and future prospects.

ii) Directors‘ Report Its principal objective is to supplement the financial information with other information consider necessary for a full appreciation of the company‘s activities. It includes:

A description of the principal activities of the company 

 A fair review of the current and future prospects of the business 

 Information on the sale, purchase or valuation of assets Recommended dividends 

 Employee statistics  

 Names of directors and their interests 

 Details of political or charitable donations

iii) Operating and financial review 

 This is a statement in the annual report which provides a formalized, structured explanation of financial performance 

 The operating review covers items such as operating results, profit and dividend 

 The financial review discusses items such as capital structure and treasury policy 

iv) Statement of corporate governance Statement of corporate governance includes a statement of corporate governance procedures and compliance, information on board composition, statements on the company's performance, and information about compliance and conformance with best practices for good corporate governance. Corporate Governance focuses on a company‘s structure and processes to ensure transparent and responsible corporate behaviour. Corporate governance is a dynamic process. Effective corporate governance not only reduces the agency costs incurred due to division of ownership but it helps in saving of time and resources of investors. On one hand, poor corporate governance practices enhance the agency costs and reduce firm valuation whereas on the other, good corporate governance facilitates independent supervision of company‘s management and encourages effective decision making which enhances firm value, reputation, credit rating, improves overall performance, lowers cost of capital, improves access to capital markets and increases competitive edge.

v) Auditor‘s report The independent and external audit report is typically published with the company's annual report. The auditor's report is important because banks and creditors require an audit of a company's financial statements before lending to them. The auditors shall make a report to the members of the company. It is the obligatory duty of the directors to get the accounts of company audited every year by qualified auditors. An auditor is appointed by the shareholders of a company to audit accounts and as such, auditor addresses the report to the shareholders of the company on the accounts audited by him. It is the duty of the board of directors to attach the auditor‘s report to the balance sheet so as to provide a copy of auditor‘s report to every member of company.

vi) Statement of directors‘ responsibilities It is an important statement in the annual report and is prepared in accordance with section 135 (5) of the Companies Act, 2013.

vii) Sustainability report A sustainability report is a report published by a company about the economic, environmental and social impacts caused by its everyday activities. A sustainability report is the key platform for communicating sustainability performance and impacts – whether positive or negative.

Apart from the broader overview of sustainability, the Sebi (Securities and Exchange Board of India) has developed new norms, voluntary this year (2019-20) and mandatory thereafter, which would apply to the top 1,000 listed entities. The Sebi reporting norms on business responsibility follow the National Guidelines on Responsible Business Conduct, put forth by the ministry of corporate affairs last year. The norms require that businesses conduct themselves with integrity and transparency, provide goods and services in a safe, sustainable manner, and respect the interests of all their stakeholders, which is unexceptionable. The new requirements include disclosure on redressal procedures for complaints/grievances, including on those pending resolution, R&D spends on better environmental and social outcomes, employee skill levels, including of those differently abled, and provision for insurance, maternity, paternity and day-care facilities. But also required now are routine disclosures upfront of energy consumed to turnover, ditto for water, and, more generally, the percentage of recycled or reused input materials to total raw material usage (by value) is also to be revealed. Gender diversity should get more attention in the reporting, and a board committee, rather than just a board member, should be accountable for ESG reporting. Businesses are, of course, accountable to their shareholders. But, increasingly, consumers, employees and investors also seek sustainability, social responsibility and good governance in corporate performance. ESG — short for environment, social and governance — is quite the rage among large investors. That means that companies must disclose their governance processes, social practices and environmental impacts. That is what Sebi wants.

viii) Management Discussion and Analysis This section is perhaps one of the most important sections in the whole of Annual Report. The most standard way for any company to start this section is by talking about the macro trends in the economy. They discuss the overall economic activity of the country and the business sentiment across the corporate world. If the company has high exposure to exports, they even talk about global economic and business sentiment. Following this, the companies usually talk about industry trends and what they expect for the year ahead. This is an important section as we can understand what the company perceives as threats and opportunities in the industry. Remember, until this point, the discussion in the Management Discussion and Analysis is broad-based and generic (global economy, domestic economy, and industry trends). However, in the future, the company would discuss various aspects related to its business. It talks about how the business had performed across various divisions, how it fares compared to the previous year, etc.

b) Non-narrative items Within non-narrative items in the annual report are: Financial highlights, highlights of the year and shareholder information. 

i) Financial highlights Financial highlights include year on year comparison of revenue from operations, EBITDA (Earnings before Interest, Tax, Depreciation and Amortization), ROE (Return on Equity) and PAT (Profit after Tax) for the financial years 2018-19 and 2019-20.

ii) Highlights of the year It includes other than financial highlights, for instance, launching new products, brands, opening new showrooms and the like.

2) Financial Statements There are three financial statements discussed in the annual report, namely, 

a) Balance Sheet, 

b) Profit and Loss account and 

c) Cash flow statement 

a) Balance Sheet A balance sheet is a statement of the resources owned and controlled by a business at a single point in time. It gives a snapshot of assets, liabilities and capital at a point in time. It provides information about the company‘s funds and how they are used in the business. Balance sheet which is also known as position statement provides a bird‘s eye view on company‘s financial position as well as condition. This statement indicates whatever company has and whatever company owes. The excess of assets over liabilities is known as owners equity/shareholders funds. 

b) Profit and loss account The Profit and Loss Account is a statement which shows total business revenue less expenses. The P&L account quantifies and explains the gains or losses of the company over the period of time bounded by two balance sheets. It provides a summary of the year‘s trading activities: revenue from sales (turnover), business cost, and profit or (loss). The profit and loss account which is also known as Income Statement indicates net profits earned by company during current financial year. Income statement also indicates profits available for distribution and appropriation after meeting tax liabilities. Profit and Loss Appropriation Account or Retained Earnings Account is also submitted with profit and loss account which indicates appropriations made during the period. 

c) Cash flow statement 

 This is a statement which shows the flow of cash into and out of the business

 It is not the same as a profit and loss account 

 The cash flow statement only records movements of cash and, for example, does not include credit sales or purchases until such time as cash actually flows  

 This statement became mandatory because of some high profile business failures of the 1980s/90s - these were companies that, in terms of the P&L, were profitable but were short of cash to pay their debts  The cash flow statement should not be confused with a cash flow forecast. The former is historical whereas the latter is a forecast about the future

3) Notes to the accounts Provides a more detailed analysis of some of the entries in the accounts including: 

 Disclosure of accounting policies used (e.g. depreciation) and any changes to these policies 

 Inventories 

 Sources of turnover from different product segments 

 Details of fixed assets and share capital 

 Directors‘ emoluments (how much the Directors earned) 

 Earnings per share In this part, we will look at some of the important notes to the accounts sourcing the same from Titan Company‘s Annual Report 2019-20. 

i) Depreciation Depreciable amount for assets is the cost of an asset, or other substituted for cost, less its estimated residual value. Depreciation is calculated on the basis of the estimated useful lives using the straight line method and is generally recognized in the statement of consolidated profit and loss. Depreciation for assets purchased / sold during the year is proportionately charged from/up to the date of disposal. Free hold land is not depreciated. 

ii) Inventories Inventories [other than quantities of gold for which the price is yet to be determined with the suppliers (Unfixed gold)] are stated at the lower of cost and net realizable value determined on an item-by-item basis. Cost is determined as follows: 

a) Gold is valued on first-in-first-out basis. 

b) Stores and spares, loose tools and raw materials are valued on a moving weighted average rate. 

c) Work-in-progress and finished goods (other than gold) are valued on full absorption cost method based on the moving average cost of production. 

d) Traded goods are valued on a moving weighted average rate/ cost of purchases.

iii) Revenue from operations In this note, sources of revenue from different product segments like watches, jewellery, eyes wear and others are stated.

iv) Details of fixed assets and share capital Fixed assets: Land and buildings held for use in the production or supply of goods or services, or for administrative purposes, are stated at cost less accumulated depreciation and accumulated impairment losses. Freehold land is not depreciated. Property, plant and equipment are carried at cost less accumulated depreciation and impairment losses, if any. The cost of property, plant and equipment comprises its purchase price/ acquisition cost, net of any trade discounts and rebates, any import duties and other taxes (other than those subsequently recoverable from the tax authorities), any directly attributable expenditure on making the asset ready for its intended use, other incidental expenses and interest on borrowings attributable to acquisition of qualifying property, plant and equipment up to the date the asset is ready for its intended use. Machine spare parts are recognized in accordance with this Ind AS (Indian Accounting Standard) when they meet the definition of property, plant and equipment; otherwise, such items are classified as inventory. Subsequent expenditure on property, plant and equipment after its purchase / completion is capitalized only if such expenditure results in an increase in the future benefits from such asset beyond its previously assessed standard of performance. The estimated useful life of the tangible assets and the useful life are reviewed at the end of the each financial year and the depreciation period is revised to reflect the changed pattern, if any. An item of property, plant and equipment is derecognized upon disposal or when no future economic benefits are expected to arise from continued use of the asset. Any gain or loss arising on the disposal or retirement of an item of property, plant and equipment is determined as the difference between the sales proceeds and the carrying amount of the asset and is recognized in the statement of consolidated profit and loss.

v) Directors’ emoluments The information required under Section 197 of the Act read with Rule 5(1) of the Companies (Appointment and Remuneration of Managerial Personnel) Rules, 2014 are given below:

The above snapshot shows the ratio of the remuneration of each director to the median remuneration of the employees of the company and the percentage increase in remuneration of each Director, Managing Director, Chief Financial Officer and Company Secretary in the financial year. 

vi) Earnings per share Basic Earnings Per Share (‗EPS‘) is computed by dividing the net profit attributable to the equity shareholders by the weighted average number of equity shares outstanding during the year. Diluted earnings per share is computed by dividing the net profit by the weighted average number of equity shares considered for deriving basic earnings per share and also the weighted average number of equity shares that could have been issued upon conversion of all dilutive potential equity shares. Dilutive potential equity shares are deemed converted as of the beginning of the year, unless issued at a later date. In computing diluted earnings per share, only potential equity shares that are dilutive and that either reduces earnings per share or increases loss per share are included.

4) Accounting policies 

 Companies must describe the accounting policies they use in preparing financial statements 

 Companies have a choice of accounting policies in many areas such as foreign currencies, goodwill, pensions, sales and stocks 

 As different accounting policies will result in different figures it is necessary to state the policy that was used so that readers of the accounts can make an informed judgment about performance 

 It is also important to state the effect of any changes in accounting policies – restating prior year numbers where this is materially significant. 

Question No. 3 - MMPC 004 - Accounting for Managers - MBA and MBA (Banking & Finance)

Solutions to Assignments

                            MBA and MBA (Banking & Finance)

MMPC 004 - Accounting for Managers

MMPC-004/TMA/JULY/2022

Question No. 3. What is CVP analysis? Does it differ from break even analysis? How is break-even point calculated?

Solution:

The Cost-Volume-Profit (CVP) analysis is an attempt to measure the effect of changes in volume, cost, price and products-mix on profits. You will appreciate that while these variables are interrelated, each one of them, in turn, is affected by a number of internal and external factors. For instance, costs vary due to choice of plant, scale of operations, technology, the efficiency of workforce and management efficiency etc. 

Also, the cost of inputs bought externally is affected by market forces. While many wide-ranging factors influence costs and profits, the largest single variable affecting them in the short run is the volume of output. Hence, the CVP relationship acquires a vital significance for the manager facing a wide spectrum of short-run decisions like: what are the most profitable and what are the least profitable products? How does a reduction in selling prices affect profits? How does volume or product mix affect product costs and profits? What will be the break-even point if volume and costs change? How will an increase in wages and/or other operating expenses affect profit? What will be the effect of plant expansion on costs, profit and volume of sales? Answers to all such questions will have to be formulated in a cost-benefit framework, and CVP analysis will offer the technique for doing it.

You may now be getting ready to comprehend the CVP concept. You will observe that profits are a function of the interplay of costs, prices, and each one of them is relevant to profit planning. The variance between actual and budgeted profit arises due to one or more of the following factors: selling price, volume of sales, variable costs, and fixed costs. 

You will also appreciate that these four factors, which cause deviations in planned profits, differ from each other in terms of controllability by management. It is evident that selling prices largely depend upon external forces. Costs, of course, are more controllable. But they pose a problem of measurement. This is more so when a firm manufactures two or more products. Nevertheless, knowledge of fixed and variable costs is essential if costs are to be controlled. Consider a tenuous cost - volume-profit transit.

A break-even analysis is a financial calculation that weighs the costs of a new business, service or product against the unit sell price to determine the point at which you will break even. In other words, it reveals the point at which you will have sold enough units to cover all of your costs. At that point, you will have neither lost money nor made a profit.

How Break-Even Analysis Works
A break-even analysis is a financial calculation used to determine a company’s break-even point (BEP). It is an internal management tool, not a computation, that is normally shared with outsiders such as investors or regulators. However, financial institutions may ask for it as part of your financial projections on a bank loan application.
The formula takes into account both fixed and variable costs relative to unit price and profit. Fixed costs are those that remain the same no matter how much product or service is sold. Examples of fixed costs include facility rent or mortgage, equipment costs, salaries, interest paid on capital, property taxes and insurance premiums.
Variable costs rise and fall according to changes in sales. Examples of variable costs include direct hourly labor payroll costs, sales commissions and costs for raw material, utilities and shipping. Variable costs are the sum of the labor and material costs it takes to produce one unit of your product.
Total variable cost is calculated by multiplying the cost to produce one unit by the number of units you produced. For example, if it costs $10 to produce one unit and you made 30 of them, then the total variable cost would be 10 x 30 = $300.
The contribution margin is the difference (more than zero) between the product’s selling price and its total variable cost. For example, if a suitcase sells at $125 and its variable cost is $15, then the contribution margin is $110. This margin contributes to offsetting fixed costs.
The average variable cost is calculated as your total variable cost divided by the number of units produced.
In general, lower fixed costs lead to a lower break-even point—but only if variable costs are not higher than sales revenue.
Why Does Your Business Need to Perform Break-Even Analysis?
A break-even analysis has broad uses on its own merit. But it’s also a critical element of financial projections for startups and new or expanded product lines. Use it to determine how much seed money or startup capital you’ll need, and whether you’ll need a bank loan.
More mature businesses use break-even analyses to evaluate their risks in a variety of activities such as moving innovative ideas to production, adding or deleting products from the product mix and other scenarios. One example is in budgeting the addition of a new employee. A break-even analysis will reveal how many additional sales it will take to break even on expenses associated with the new hire.
What Is a Standard Break-Even Time Period?
An acceptable break-even window is six to 18 months. If your calculation determines a break-even point will take longer to reach, you likely need to change your plan to reduce costs, increase pricing or both. A break-even point more than 18 months in the future is a strong risk signal.
When to Use a Break-Even Analysis
Basically, a business will want to use a break-even analysis anytime it considers adding costs. These additional costs could come from starting a business, a merger or acquisition, adding or deleting products from the product mix, or adding locations or employees.
In other words, you should use a break-even analysis to determine the risk and value of any business investment, especially when one of these three events occurs:
1. Expanding a business
Break-even points (BEP) will help business owners/CFOs get a reality check on how long it will take an investment to become profitable. For example, calculating or modeling the minimum sales required to cover the costs of a new location or entering a new market.
2. Lowering pricing
Sometime businesses need to lower their pricing strategy to beat competitors in a specific market segment or product. So, when lowering pricing, businesses need to figure out how many more units they need to sell to offset or makeup a price decrease.
3. Narrowing down business scenarios
When making changes to the business, there are various scenarios and what-ifs on the table that complicate decisions about which scenario to go with. BEP will help business leaders reduce decision-making to a series of yes or no questions.

Importance of Break-Even Analysis

• Manages the size of units to be sold: With the help of break-even analysis, the company or the owner comes to know how many units need to be sold to cover the cost. The variable cost and the selling price of an individual product and the total cost are required to evaluate the break-even analysis.
• Budgeting and setting targets: Since the company or the owner knows at which point a company can break-even, it is easy for them to fix a goal and set a budget for the firm accordingly. This analysis can also be practised in establishing a realistic target for a company.
• Manage the margin of safety: In a financial breakdown, the sales of a company tend to decrease. The break-even analysis helps the company to decide the least number of sales required to make profits. With the margin of safety reports, the management can execute a high business decision.
• Monitors and controls cost: Companies’ profit margin can be affected by the fixed and variable cost. Therefore, with break-even analysis, the management can detect if any effects are changing the cost.
• Helps to design pricing strategy: The break-even point can be affected if there is any change in the pricing of a product. For example, if the selling price is raised, then the quantity of the product to be sold to break-even will be reduced. Similarly, if the selling price is reduced, then a company needs to sell extra to break-even.

Components of Break-Even Analysis

• Fixed costs: These costs are also known as overhead costs. These costs materialise once the financial activity of a business starts. The fixed prices include taxes, salaries, rents, depreciation cost, labour cost, interests, energy cost, etc.
• Variable costs: These costs fluctuate and will decrease or increase according to the volume of the production. These costs include packaging cost, cost of raw material, fuel, and other materials related to production.

Uses of Break-Even Analysis

• New business: For a new venture, a break-even analysis is essential. It guides the management with pricing strategy and is practical about the cost. This analysis also gives an idea if the new business is productive.
• Manufacture new products: If an existing company is going to launch a new product, then they still have to focus on a break-even analysis before starting and see if the product adds necessary expenditure to the company.
• Change in business model: The break-even analysis works even if there is a change in any business model like shifting from retail business to wholesale business. This analysis will help the company to determine if the selling price of a product needs to change.

Benefits of Break-even analysis

• Catch missing expenses: When you’re thinking about a new business, it’s very much possible that you may forget about a few expenses. Therefore, a break-even analysis can help you to review all financial commitments to figure out your break-even point. This analysis certainly restricts the number of surprises down the road or at-least prepares a company for them.
• Set revenue targets: Once the break-even analysis is complete, you will get to know how much you need to sell to be profitable. This will help you and your sales team to set more concrete sales goals.
• Make smarter decisions: Entrepreneurs often take decisions in relation to their business based on emotion. Emotion is important i.e. how you feel, though it’s not enough. In order to be a successful entrepreneur, decisions should be based on facts.
• Fund your business: This analysis is a key component in any business plan. It’s generally a requirement if you want outsiders to fund your business. In order to fund your business, you have to prove that your plan is viable. Furthermore, if the analysis looks good, you will be comfortable enough to take the burden of various ways of financing.
• Better pricing: Finding the break-even point will help in pricing the products better. This tool is highly used for providing the best price of a product that can fetch maximum profit without increasing the existing price.
• Cover fixed costs: Doing a break-even analysis helps in covering all fixed cost.

CVP analysis is important because it is used to understand the effects of differing levels of activity on the financial results of a business, reports the global body for accounting professionals, the ACCA. Specifically, it helps to determine a company's break-even point. This is the level of sales where the company will not incur a loss, yet not make a profit.

To calculate the break-even point, you must first calculate the contribution margin. The contribution margin is a company's sales less its variable expenses. Then, divide the company's fixed costs by the contribution margin. This will give you the company's break-even point in total dollars of sales. the formula looks like this:

FIXED COSTS ÷ (SALES PRICE PER UNIT – VARIABLE COSTS PER UNIT)

If you want to calculate the break-even point in units sold, replace the contribution margin in the denominator with the contribution margin per unit. The contribution margin per unit is calculated as the sales price less the variable cost per unit.

Break Even Example

Suppose Acme Cereal Inc is considering introducing a new breakfast bar, called Cerealicious. The company wants to know whether this new product will be worth the investment, so the product development team sets about finding the break even point.

Fixed Costs = $3,000 (for the month)
Variable Costs = $0.50 (per bar produced)
Sales Price = $1.00 (per bar)

As a reminder, the formula is: Fixed Costs ÷ (Sales price per unit – Variable costs per unit)

$3,000/($1.00 – $0.50)
$3,000/0.50
=6,000 units

This means Acme needs to sell 6,000 bars of Cerealicious in a month to reach the break-even point.

Question No. 2 - MMPC 004 - Accounting for Managers - MBA and MBA (Banking & Finance)

Solutions to Assignments

                            MBA and MBA (Banking & Finance)

MMPC 004 - Accounting for Managers

MMPC-004/TMA/JULY/2022

Question No. 2. Explain the following 
(a) Marginal Costing 
(b) Activity Based Costing

Solution: 

a)  Marginal Costing

Marginal costing in economics and managerial accounting refers to an increase or decrease in the total cost of production due to a change in the quantity of the desired output. It is variable, depending on the inclusion of resources required to produce or deliver additional unit(s) of a product or service.

Calculating marginal cost enables managers to make decisions on resource allocation, optimize the production and operation, control manufacturing costs, plan budget and profits, etc. It considers expenses incurred at each production stage, except for overhead pricing. The practice is common in manufacturing industries, allowing companies to achieve economies of scale.

Definition: Marginal Costing is a costing technique wherein the marginal cost, i.e. variable cost is charged to units of cost, while the fixed cost for the period is completely written off against the contribution. 

Marginal cost is the change in the total cost when the quantity produced is incremented by one. That is, it is the cost of producing one more unit of a good. 

For example, let us suppose: 

Variable cost per unit = Rs 25 

Fixed cost = Rs 1,00,000 

Cost of 10,000 units = 25 × 10,000 = Rs 2,50,000 

Total Cost of 10,000 units = Fixed Cost + Variable Cost = 1,00,000 + 2,50,000 = Rs 3,50,000 

Total cost of 10,001 units = 1,00,000 + 2,50,025 = Rs 3,50,025 

Marginal Cost = 3,50,025 – 3,50,000 = Rs 25 

The term marginal cost implies the additional cost involved in producing an extra unit of output, which can be reckoned by total variable cost assigned to one unit. It can be calculated as: 

Marginal Cost = Direct Material + Direct Labor + Direct Expenses + Variable Overheads

Characteristics of Marginal Costing 

•  Classification into Fixed and Variable Cost: Costs are bifurcated, on the basis of variability into fixed cost and variable costs. In the same way, semi variable cost is separated. 
• Valuation of Stock: While valuing the finished goods and work in progress, only variable cost are taken into account. However, the variable selling and distribution overheads are not included in the valuation of inventory.
• Determination of Price - the prices are determined on the basis of the marginal cost and marginal contribution.
• Profitability - the ascertainment of departmental and product's profitability is based on the contribution margin.

Features of Marginal Costing Features of marginal costing are as follows: 

 Marginal costing is used to know the impact of variable cost on the volume of production or output.  Break-even analysis is an integral and important part of marginal costing. 

 Contribution of each product or department is a foundation to know the profitability of the product or department. 

 Addition of variable cost and profit to contribution is equal to selling price. 

 Marginal costing is the base of valuation of stock of finished product and work in progress. 

 Fixed cost is recovered from contribution and variable cost is charged to production. 

 Costs are classified on the basis of fixed and variable costs only. Semi-fixed prices are also converted either as fixed cost or as variable cost.

Ascertainment of Profit under Marginal Cost 

‘Contribution’ is a fund that is equal to the selling price of a product less marginal cost. 

Contribution may be described as follows: 

Contribution = Selling Price – Marginal Cost 

Contribution = Fixed Expenses + Profit 

Contribution – Fixed Expenses = Profit

Marginal Costing Approach

The difference between product costs and period costs forms a basis for marginal costing technique, wherein only variable cost is considered as the product cost while the fixed cost is deemed as a period cost, which incurs during the period, irrespective of the level of activity. Facts Concerning Marginal Costing 

 Cost Ascertainment: The basis for ascertaining cost in marginal costing is the nature of cost, which gives an idea of the cost behavior, that has a great impact on the profitability of the firm. 

 Special technique: It is not a unique method of costing, like contract costing, process costing, batch costing. But, marginal costing is a different type of technique, used by the managers for the purpose of decision making. It provides a basis for understanding cost data so as to gauge the profitability of various products, processes and cost centers. 

 Decision Making: It has a great role to play, in the field of decision making, as the changes in the level of activity pose a serious problem to the management of the undertaking. 

Marginal Costing assists the managers in taking end number of business decisions, such as replacement of machines, discontinuing a product or service, etc. It also helps the management in ascertaining the appropriate level of activity, through break even analysis, that reflect the impact of increasing or decreasing production level, on the company’s overall profit.

Advantages of Marginal Costing 

The advantages of marginal costing are as follows: 

 Easy to operate and simple to understand. 

 Marginal costing is useful in profit planning; it is helpful to determine profitability at different level of production and sale. 

 It is useful in decision making about fixation of selling price, export decision and make or buy decision. 

 Break even analysis and P/V ratio are useful techniques of marginal costing. 

 Evaluation of different departments is possible through marginal costing. 

 By avoiding arbitrary allocation of fixed cost, it provides control over variable cost. 

 Fixed overhead recovery rate is easy. 

 Under marginal costing, valuation of inventory done at marginal cost. Therefore, it is not possible to carry forward illogical fixed overheads from one accounting period to the next period. 

 Since fixed cost is not controllable in short period, it helps to concentrate in control over variable cost.

b) Activity Based Costing

Activity-Based Costing (ABC) is a system of costing, where costs are first traced to activities and then to products. This costing system works with an assumption that activities are responsible for the costs that are incurred. As stated earlier, costs are charged to products based on the individual product's use for each activity. 

The Chartered Institute of Management Accountants, UK (CIMA) defines1 ABC as “an approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities, and activities to cost objects based on consumption estimates. The latter utilise cost drivers to attach activity costs to outputs”.

The important issues of the definition are as follows:

 

 ABC is a tactic to the costing and does monitoring of activities in a process. 

 It traces the consumption of resources and then the costing of resultant outputs. 

 In this, resources are assigned to activities and then activities to cost objects based on consumption estimates. 

 It utilises identified cost drivers to assign activity costs to depicted outputs. 

Another description of Activity-based costing is that it is a two-stage based costing method that allocates indirect costs and overheads to products and services. Some costs are tough to assign to a product or a service. It identifies the connection between overheads and manufactured products and gives indirect costs to the products. The method is less arbitrarily than the traditional costing system.

Features of Activity Based Costing (ABC) 

Features of Activity Based Costing are as follows: 

 ABC is a modern approach to the allocation of indirect costs. Costs allocated to each activity symbolise the resources consumed by the activity.
 As done in conventional costing, ABC is not restricted to the allocation of indirect costs to departments. It moves further to identify the individual activity for indirect cost allocation as the lowest unit. 

 Based on consumption, resources are allotted to each activity and then to cost objects. 

 ABC identifies the activities using the activity cost drivers and results in a more accurate cost calculation. 

 This approach facilitates easy identification of cost according to activities cost driver. 

 This costing method is suitable if there is more than one product in the manufacturing line and overheads have a high share in total cost. 

 This approach creates a straight cause and effect association with various resources. 

Development of Activity Based Costing 

Limits of the traditional costing system gave way for the development of ABC. The traditional arrangement segregates costs into fixed and variable. As the business grows, the costs become more complex, and then the traditional approach may not be appropriate for making complex decisions related to production and developing product strategies. The traditional methods facilitate financial reporting and primarily put prominence on calculating overhead rates for the valuation of stocks. It was seen that the traditional absorption costing approach could not go well with multi-product scenarios, so a change was in line. In fact, multiple-products scenario or product diversification requires accurate product cost ascertainment due to increasing market competition within the country and internationally. In the 1980s, ABC was first defined by Kaplan and Bruns2 . It was taken as the modern alternative to absorption costing, which could define product and profitability in a better way. It provides better information to make more effective decisions.

OBJECTIVES OF ACTIVITY BASED COSTING (ABC) 

Some objectives of ABC are listed as under: 

 To recognise several activities in the process of production, including the activities that add value. 

 To eliminate the non value-adding activities. 

 To put emphasis on the high-cost activities

 To incorporate activities based on distribution overheads. 

 To help in decision-making process in the identification of a suitable price of product and services. 

 To ensure accurate and precise cost determination of products and services. 

 To find options to improve the process and reduction of costs. 

MERITS AND DEMERITS OF ACTIVITY BASED COSTING (ABC) 

Merits 

 Removes Cross Subsidization Issues 

The traditional system gives rise to the issues of over and under-costing. Products may be subject to over-costing, which may result in under costing of other products. ABC may take care of this issue. ABC put the role of activities between costs and products and makes the relationship more explicit. 

 Deals with Complicated Processes 

There have been growth and development in all walks of life, including production of product and services. Due to this, complications in various processes have risen in the industries too. Now, there are cross-linkages in the production process and costing of products. The number of processes and activities involved in production has increased. ABC deals with these complications in costing that emerged due to processes. 

 Product Customisations 

Nowadays, production is being done with many variations, in terms of sizes, design etc. If the production takes place on one premise, the costing process will need refinement to price the products suitably. ABC helps here. 

 Identification of Cost Saving Chances 

In ABC, it is easier to identify cost saving opportunities. It considers costs to all areas, including various processes, products, managerial responsibility, customers, departments etc. It removes the issues related to the error of estimation.

In this system, costs are managed in the long run by controlling the activities that drive them. In other words, the aim is to manage the activities rather than costs. By managing the forces that cause the activities (cost drivers), costs will be managed long-term. Collecting and reporting on the significant activities a business engages in makes it possible to understand and manage costs more effectively.

Demerits 

 A Complex System 

ABC works with various cost pools and drivers. It is assumed to be more complex than the traditional system of product costing. This is one of the demerits. In fact, selection of drivers, common costs, driver rates etc., put forward a complex system. 

 Product and Process should be Fully Known 

One of the significant demerits is that the people who are employing ABC usually require significant experience in the products and processes of the industry. ABC is preferred if the firm uses cost-plus pricing, whereas marketbased prices may not favour it. 

 Rely on a sophisticated system 

ABC requires a minimum level of information technology in the organisation. Much data is needed and processed for implementing a particular decision. Small and new organisations may not take full advantage of ABC, due to poor information technology systems. 

 Consumes a lot of Time and efforts 

ABC is a time-consuming process. It comprises a number of steps and a lot of groundwork to start and complete the process. Organisations may put time and effort if they get utility out of the process. As mentioned earlier also, large manufacturing firms can utilise it better than small firms. 

 Increase in Indirect Costs 

Due to the high involvement of technology in ABC, indirect costs rise significantly.

PROCESS OF ACTIVITY BASED COSTING (ABC)

Stages in ABC 

Stages of ABC costing are mentioned as follows: 

• Identification of the organisational activities and manufacturing process For ABC, it is indispensable to study the organisational activities and manufacturing process to determine the number of stages involved. By this, all the activities involved in producing the product or service can be identified. ABC believes that activities cause cost.
• Classify the factors which determine the costs of an activity, known as cost drivers. According to CIMA, ‘cost driver is any factor which causes a change in the cost of an activity, e.g. the quality of parts received by an activity is a determining factor in the work required by that activity and therefore affects the resources required. An activity may have multiple cost drivers associated with it.’’4 As per this definition, in the traditional system of product costing, the number of cost drivers can be identified as direct labour hours, units produced, etc. In ABC, cost drivers are related more closely to the consumption of resources and activities. As mentioned earlier, ABC considers that activities bring about costs, so they are linked, and the identified cost drivers are the linkages amid them.
• Identify the costs of each activity, known as cost pools The cost pool concept is similar to the concept of the cost centre. CIMA defines cost pool as ‘the point of focus for the costs relating to a particular activity in an activity-based costing system. ‘It is the sum total of the cost elements allotted to an activity. The cost pool is taken as the point of focus to assign the total cost to an activity.
• Charge costs to the products It is known that ABC is the method of tracing and assigning costs:  from resources to activities and then  from activities to specific products  

Question No 1 - MMPC 004 - Accounting for Managers - MBA and MBA (Banking & Finance)

 

Solutions to Assignments

                            MBA and MBA (Banking & Finance)

MMPC 004 - Accounting for Managers

MMPC-004/TMA/JULY/2022

Question No. 1. Explain the following accounting concepts 
(a) Business Entity concept 
(b) Money measurement concept 
(c) Continuity concept 
(d) Accrual concept 

Solution:

a) Business Entity concept

The business entity concept states that the transactions associated with a business must be separately recorded from those of its owners or other businesses. Doing so requires the use of separate accounting records for the organization that completely exclude the assets and liabilities of any other entity or the owner. Without this concept, the records of multiple entities would be intermingled, making it quite difficult to discern the financial or taxable results of a single business. Here are several examples of the business entity concept:

• A business issues a $1,000 distribution to its sole shareholder. This is a reduction in equity in the records of the business, and $1,000 of taxable income to the shareholder.

• The owner of a company personally acquires an office building, and rents space in it to his company at $5,000 per month. This rent expenditure is a valid expense to the company, and is taxable income to the owner.

• The owner of a business loans $100,000 to his company. This is recorded by the company as a liability, and by the owner as a loan receivable.

There are many types of business entities, such as sole proprietorships, partnerships, corporations, and government entities.
Reasons for the Business Entity Concept
There are a number of reasons for the business entity concept, including the need to separately track taxes, financial performance, and financial position for each entity. It is also useful for when an organization is liquidated, to determine the amounts of payouts to the various owners. Further, the business entity concept is needed from a liability perspective, to ascertain the assets available in the event of a legal judgment against a business entity. And finally, it is not possible to audit the records of a business if the records have been combined with those of other entities and/or individuals.

Importance of Business Entity Concept in Accounting

Business entity concept is important in accounting for the following reasons:
1. The business entity concept is very important as it helps to measure the performance of a business separate from its owner and on different parameters such as cash flows, profitability, etc.
2. If the business organisation record mixes with the records of the business owners, it creates an inaccurate representation of the financial position of business. The business entity concept helps in preventing such an issue.
3. It helps the business in comparison of financial performance with other business organisations.
4. It helps in calculation of separate taxes for the business and its owners.
5. It helps in ascertaining the value of the assets and liabilities of a business in the event of any legal action taken against the business.

b) Money Measurement Concept

The money measurement concept states that a business should only record an accounting transaction if it can be expressed in terms of money. This means that the focus of accounting transactions is on quantitative information, rather than on qualitative information. Thus, a large number of items are never reflected in a company's accounting records, which means that they never appear in its financial statements. Examples of items that cannot be recorded as accounting transactions because they cannot be expressed in terms of money include:

• Employee skill level
• Employee working conditions
• Expected resale value of a patent
• Value of an in-house brand
• Product durability
• The quality of customer support or field service
• The efficiency of administrative processes

All of the preceding factors are indirectly reflected in the financial results of a business, because they have an impact on either revenues, expenses, assets, or liabilities. For example, a high level of customer support will likely lead to increased customer retention and a higher propensity to buy from the company again, which therefore impacts revenues. Or, if employee working conditions are poor, this leads to greater employee turnover, which increases labor-related expenses.

Problems with the Money Measurement Concept
The key flaw in the money measurement concept is that many factors can lead to long-term changes in the financial results or financial position of a business (as just noted), but the concept does not allow them to be stated in the financial statements. The only exception would be a discussion of pertinent items that management includes in the disclosures that accompany the financial statements. Thus, it is entirely possible that the key underlying advantages of a business are not disclosed, which tends to under-represent the long-term ability of a business to generate profits. The reverse is typically not the case, since management is encouraged by the accounting standards to disclose all current or potential liabilities in the notes accompanying the financial statements. In short, the money measurement concept can lead to the issuance of financial statements that may not adequately represent the future upside of a business. However, if this concept were not in place, managers could flagrantly add intangible assets to the financial statements that have little supportable basis.

Importance of Money Measurement Concept
As money is regarded as a common unit of recording transactions related to the income, profit, loss, capital, assets and liabilities of a business, it becomes easier to record and present business transactions into the financial statements such as Profit and Loss statement and Balance Sheet.

Advantages of Money Measurement Concept
Following are some of the advantages of the money measurement concept
1. It helps in maintaining business records by recording all transactions that are having monetary value.
2. It is helpful in preparation of financial statements (such as Profit and Loss Statement, Income Statement)
3. As the financial transactions are recorded in a proper manner, it becomes easy when two separate accounting periods are compared.
4. It provides a clear picture of the financial transactions and state of the business which help in assessing the investors in knowing the status of their investment.

c) Continuity Concept

• This concept facilitates preparation of financial statements. 

• On the basis of this concept, depreciation is charged on the fixed asset. 

• It is of great help to the investors, because, it assures them that they will continue to get income on their investments. 

• In the absence of this concept, the cost of a fixed asset will be treated as an expense in the year of its purchase. 

• A business is judged for its capacity to earn profits in future.

Importance of Going Concern Concept in Accounting

This concept states that a business firm will continue to carry on its activities for an indefinite period of time. Simply stated, it means that every business entity has continuity of life. Thus, it will not be dissolved in the near future. This is an important assumption of accounting, as it provides a basis for showing the value of assets in the balance sheet; For example, a company purchases a plant and machinery of Rs.100000 and its life span is 10 years. According to this concept every year some amount will be shown as expenses and the balance amount as an asset. Thus, if an amount is spent on an item which will be used in business for many years, it will not be proper to charge the amount from the revenues of the year in which the item is acquired. Only a part of the value is shown as expense in the year of purchase and the remaining balance is shown as an asset. 

Significance 

The following points highlight the significance of going concern concept; 

Going concern concept is very important for the generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). The concept of going concern plays a significant role in the way assets are treated.

The concept of depreciation and amortization are based on the assumption that a business will continue to perform its operations in the near future (this period is the next 12 months after an accounting period).

Advantages of Going Concern Concept

Following are some of the advantages of the going concern concept

1.Companies during the formation years will be purchasing fixed assets that will be requiring expenditure upfront, but such assets will be providing the benefits spread over a long term, that is well beyond one accounting period. Therefore, the going concern concept provides a way to record the value of such assets.

2. It is the basis on which the profits and losses of the business are recorded for the year to which it belongs.

Disadvantages of Going Concern Concept

Listed below are some of the disadvantages of the going concern concept:

1. Financial statements are prepared at cost and not on the basis of current market value. In such a case, if the company in an event of liquidation, will have assets valued at the market value, and as such these values will be different from the value determined at cost.

2. In the event of business being liquidated, the financial statements will be calculated on the on going concern basis, which can be misleading for the stakeholders.

d) Accrual Concept

The meaning of accrual is something that becomes due especially an amount of money that is yet to be paid or received at the end of the accounting period. It means that revenues are recognised when they become receivable. Though cash is received or not received and the expenses are recognised when they become payable though cash is paid or not paid. Both transactions will be recorded in the accounting period to which they relate. Therefore, the accrual concept makes a distinction between the accrual receipt of cash and the right to receive cash as regards revenue and actual payment of cash and obligation to pay cash as regards expenses. 

The accrual concept under accounting assumes that revenue is realised at the time of sale of goods or services irrespective of the fact when the cash is received. For example, a firm sells goods for Rs 55000 on 25th March 2005 and the payment is not received until 10th April 2005, the amount is due and payable to the firm on the date of sale i.e. 25th March 2005. It must be included in the revenue for the year ending 31st March 2005. Similarly, expenses are recognised at the time services provided, irrespective of the fact when actual payment for these services are made. For example, if the firm received goods costing Rs.20000 on 29th March 2005 but the payment is made on 2nd April 2005 the accrual concept requires that expenses must be recorded for the year ending 31st March 2005 although no payment has been made until 31st March 2005 though the service has been received and the person to whom the payment should have been made is shown as creditor. In brief, accrual concept requires that revenue is recognised when realised and expenses are recognised when they become due and payable without regard to the time of cash receipt or cash payment.

Advantages of Accrual Basis of Accounting

The following are some of the advantages of accrual basis of accounting.

1. It helps the businesses in realising the true profit by providing a more realistic representation of the business.

2. Businesses that use an accrual basis of accounting are seen as more reliable than those using a cash basis method.

3. Auditing of financial statements is possible only when accrual basis is chosen as the method of accounting.

4. It allows for easy planning as the business accounts for all the revenues and expenses that will occur during the accounting period and prepare a budget accordingly.

Disadvantages of Accrual basis of Accounting

Following are some of the disadvantages of accrual basis of accounting:

1. Accrual basis of accounting can be complicated requiring more skill, time and resources.

2. It can give a skewed view of the short term financial position of the company.

MMPC 004 - Accounting for Managers - MBA and MBA (Banking & Finance)

Solutions to Assignments

                            MBA and MBA (Banking & Finance)

MMPC 004 - Accounting for Managers

MMPC-004/TMA/JULY/2022

Note: Attempt all the questions and submit this assignment to the coordinator of your study centre. (Last date of submission for July 2022 session is 31st October, 2022 and for January 2023 session is 30th April, 2023). 

Question No. 1. Explain the following accounting concepts 

(a) Business Entity concept 

(b) Money measurement concept 

(c) Continuity concept 

(d) Accrual concept                                                             CLICK HERE

Question No. 2. Explain the following 

(a) Marginal Costing 

(b) Activity Based Costing       CLICK HERE

Question No. 3. What is CVP analysis? Does it differ from break even analysis? How is break-even point calculated?       CLICK HERE

Question No. 4. Explain in detail the various contents of an Annual Report.       CLICK HERE

Question No. 5 From the following calculate cash from operations:

                                                                                                                                      CLICK HERE

Question No. 3 - MMPC 013 - Business Law - MBA and MBA (Banking & Finance)

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                            MMPC- 013 - Business Law

Question No. 3. 
What is a ‘Contract’? Discuss the essentials of a Valid Contract. 

Solution: 

A contract is an agreement enforceable in a court of law. An agreement is a set of reciprocal promises between the parties to the contract. These set of promises arises from an offer and acceptance from the parties to the contract. The contract may be express or implied i.e., it may be oral words or in writing and even inferred from the conduct of the parties.2 It may be bilateral or unilateral contract. The former one refers to the involvement of two parties and the latter refers one party alone can perform without the other.

Generally, the contract completes when the acceptance of the offeree is posted or put in to transmission. It was made at the place where the acceptance is received by the offeror. It was easy to determine the completion of contract when the parties negotiate in person. But it will be difficult to determine in case of negotiation by post, telegram, telephone and mail, etc. The contract in case of instantaneous contracts completes only when the communication of the acceptance is received by the offeror. In other words, the contract is said to be made at the place where the acceptance received but not at the place where it is transmitted.

The United Nations Commission on International Trade Law (UNCITRAL) adopted the Model Law on Electronic Commerce in 1996. As a result the Information Technology Act, 2000, governs the rules relating to the e-commerce contracts. The offeror and acceptor are substituted by expression soriginato15 and addressee. The electronic record sent by the originator may be received intact or it may vary. The addressee has to acknowledge the receipt of electronic record by communication automated or any mode or by conduct.16 The contract completes where the principal place of business of the originator, in case of more than one place of business of originator or addressee the principal place of business of the originator or addressee and in case of no place of business his usual place of residence will be considered as the completion of the contract for the purpose of jurisdiction.

Essentials of a valid Contract

Consideration, capacity to contract, free consent, and legality of consideration and object are some of the essentials of a valid contract. These are explained in detail below: 

1) Consideration: Consideration is one of the essential conditions for the validity of contract.18 The essential condition for the enforceability of simple contacts is consideration, and the rule is expressed by the Latin maxim: ex-nudopacto non orituractio which means out of nude pact no cause of action arises. It can be understood in the sense quid pro quo. “ A valuable consideration in the sense of the law may consist either some right, interest, profit or benefit accruing to one party, or some forbearance, detriment, loss or responsibility, given suffered undertaken by the other.”19 “An act or forbearance of one party or the promise thereof, is the price for which the promise of the other is brought and the promise thus given for value is enforceable.” “When at the desire of the promisor, the promisee or any other person has done or abstained from doing, or does or abstains from doing, or promise to do or abstain from doing something, such act or abstinence or promise is called a consideration for the promise.”

The analysis of the above definitions says that the consideration may be executed or executory. In a contract to deliver a watch by A to B for Rs.100, A and B gained money and watch and in another stand point A and B lost watch and Rs.100, respectively. The law insists more upon the presence of the element of detriment to the promisee B and then the presence of benefit to the promisor A.

A promise from one party to the other and a promise from the other to the former support the consideration. In other words, the reciprocity of promises between the parties establishes the consideration. The absence of consideration makes the contract void. This principle has certain exceptions recognized under the provisions of law. They are: 

i) Where the contract reduced in to writing and registered and made out of natural love and affection between the parties standing in near relationship to each other. 

ii) Where the contract is to compensate the person who voluntarily rendered services in past. In other words, past services rendered at the desire of the promisor constitute a valid consideration in India. But under English law past consideration is not valid. 

iii) Where a promise is made to pay a time-barred debt does not require a fresh consideration. 

iv) Where a gift between the donor and donee is not affected for want of consideration if it is registered and attested by two witnesses. 

Though consideration is necessary it need not be adequate. The adequacy and sufficiency of consideration is immaterial. It is said that pepper corn is sufficient for purchase of an elephant. The consideration is to move from whom is the question to be determined for the enforceability of the contract. It must proceed or move from the promisee. Under English law a stranger to a consideration cannot sue. In other words, the promisee cannot sue the promisor if the consideration doesn’t move from him. But under Indian law, a stranger to consideration can sue.

The doctrine of consideration is not extended to the discharge of contract. The reciprocal promises between the parties constitute consideration. Subsequently if both the parties agree not to enforce the contract also constitute consideration in India. But it is not so in English law. Till 1947 the law of England applied the doctrine of consideration not only to the formation of a contract, but also to its discharge. It was pointed out that a creditor ‘might accept anything in satisfaction of his debt except a less amount of money’ A canary or pepper corn may be accepted in full discharge of a debt, but a part payment of the debt cannot be accepted so as to operate as full discharge of the debt. The following are the exceptions to the rule in Pinnel’s case. 

a) Under the scheme of composition if the debtor agrees to pay a portion of the debt discharges liability without application of the doctrine of consideration under English law. 

b) In case a third party pays a part of the amount less than the amount due from the debtor discharges the debtor without application of the doctrine of consideration under English law. 

c) The doctrine of estoppel or quasi-estoppel neutralized the rule in Pinnel’s case. 

Under Indian law, a contract may be discharged by what is called “an accord and satisfaction” i.e., mutually agreed settlement. The English law allows the delivery of horse against the payment of debt but not accept the delivery in future to discharge the debt. The part payment of debt is also not accepted as accord and satisfaction.

2) Capacity to Contract: There are certain persons in law who are incapable wholly or in part, of binding themselves by a promise or of enforcing a promise made to them. In mercantile contracts lexloci contractus i.e., the law of the place will prevail whereas in case of land lexsitus i.e., the law of the place where the land situate will be applicable. The incapacity of a party to enter into a contract will arise in two ways namely, on account of status, or on account of mental deficiency. The former would occur on the grounds of political consideration and expediency, the latter is imposed to protect the interest of the disabled person. 

The incapacity of a party is broadly divided into two; one which arises out of status of an individual for the following reasons: 

a) Political or Civil status e.g., where the contracting party is a ruler of a foreign state, Ambassador or envoy or alien enemy, or a convict or a bankrupt. 

b) Profession of the contracting person e.g., barrister 

c) Incorporation d) Marriage 

The other which arises from mental deficiency (soundness of mind) of the person contracting in case of: a) Minors 

b) Insane persons 

c) Idiots 

d) Drunken persons

The person below the age of 21 is called as an infant as per the Infant Relief Act, 1874 under the Common Law and the person below the age of 18 is a minor as per the Family Reforms Act, 1969, under English law and Indian law respectively. He is a person who is not a major. The Infant Relief Act, 1874 which modified the Common Law of England allows an infant to enter into a contract for the following: 

a) For necessaries 

b) Beneficial contracts of service 

c) Contracts involving recurring rights and duties e.g., an interest in property binding on him unless he rescind them either during infancy or within reasonable time of becoming a major 

d) An isolated act or a contract to pay for goods supplied other than necessaries, were voidable and not binding on him unless he ratified them within reasonable time after attaining majority.

Mutuality of mind: The parties to the contract must have consensus-ad-idem35 which means mutuality of mind as to the subject matter of the contract. The lack of mutuality of mind makes the contract void. ‘A’ had two houses namely ‘X’ and ‘Y’. ‘A’ enters into contract with ‘B’ to sell keeping ‘X’ house in his mind and ‘B’ entered into contract with ‘A’ by keeping ‘Y’ house in his mind. This results the contract void due to lack of consensus-ad-idem on the subject matter of the contract.

3) Free Consent: “The consent of the party to the contract is said to be free if it is not caused by; coercion, undue influence, fraud, misrepresentation and mistake. These are explained hereunder: 

i) Coercion: “The committing, or threatening to commit, any act forbidden by the Indian Penal code, or the unlawful detaining, or threatening to detain, any property to the prejudice, of any person whatever, with the intention of causing any person to enter in to an agreement.” The term duress in English law defined as causing, threatening to cause, bodily violence or imprisonment, with a view to obtain the consent of the other party to the contract. Coercion in Indian law has a much wider connotation than duress in English law. The main distinction between coercion and duress as the first denotes the offense forbidden by Indian Penal Code whereas the latter confined only to bodily violence and imprisonment. The presence of coercion or duressin both Indian and English law was an invalidating element for the enforceability of contract. 

ii) Undue Influence: This was also called as constructive fraud. It covers all the contracts where one party will be in a position to dominate the will of the other because of relationship while entering the contract. This influence can be presumed in existence among the following relationships: 

a. Parent and child 

b. Guardian and ward 

c. Trustee and beneficiary 

d. Spiritual master and Disciple 

e. Lawyer and client 

f. Doctor and patient 

The contract between the parties with above relationship turns it voidable by presuming the existence of undue influence of the former against the other. It is the burden on the former party to prove that he was not in dominating position and that his position was not used to obtain the consent of the other.

iii) Fraud: The following acts of a party to a contract establish fraud while entering into a contract with the other: 

a) the suggestion of a fact, of that which is not true by one who does not believe it to be true 

b) the active concealment of a fact by one having knowledge or belief of the fact 

c) a promise made without intention of performing it; 

d) any other act fitted to deceive 

e) any such act or omission as the law specially declares as fraudulent.  

The mere silence on the part of party does not amount to fraud. But silence amount to fraud where there is a duty on the party to speak. 

iv) Misrepresentation: A party may give his consent to enter into a contract because of misrepresentation of the other. These false statements or misrepresentations may be either inducing cause of contract. These statements may be called as innocent misrepresentation and willful or actionable misrepresentation which amounts to fraud. A misrepresentation consists of the following ingredients: 

a) Failure to disclosure of a fact 

b) Such non-disclosure must relate to a fact not to an opinion 

c) Such representation must be untrue 

d) It must be material to influence the other to enter into a contract.

Any representation made by a party with full knowledge of the fact that it is not true, or without belief in its truth or recklessly, not caring whether it is true or false, it is said to be fraudulent. Whenever the consent of the party is obtained in the absence of free consent the contract is voidable at the option of the party whose consent is not free because of the presence of coercion, or fraud, or misrepresentation. The aggrieved party of such voidable contract had an option to continue the contract or rescind the contract and entitled for damages. Further, the contract induced by undue influence can be set side or it is voidable at the option of the party whose consent was obtained by dominating the will of the aggrieved party. 

v) Mistake: While entering into a contract the parties to the contract may be under a mistake. This mistake may be as to a fact or law. Mistake of fact may be as to subject matter of the contract e.g., regarding the existence, quality or quantity etc.; nature of contract; person entering into contract. Mistake of law may be regarding foreign law, or ordinary law, law of our country, or private rights of the contracting parties. Another classification of these mistakes is bilateral and unilateral. A mistake of fact in the minds of both the parties negatives the consensus ad idem and the contract in such cases is void. Where both parties to an agreement are at mistake as to a matter of fact essential to the agreement, the agreement is void. This will come under the classification of bilateral mistake. In case of unilateral mistake, i.e., where only one party to a contract is under a mistake, the contract, generally speaking, is not valid. A contract is not merely voidable because it was caused by one of the parties to it being under mistake as to a matter of fact. A contract is not voidable because it was caused by mistake as to any law in force in India but a mistake as to a law not in force in India has the same effect as a mistake of fact.

4) Legality of Consideration and Object: Apart from the above essentials for the formation of a valid contract the legality of consideration and object48 is must. The unlawful agreements may be classified as follows: 

1) Illegal-where the agreement is contrary to the statute law 

2) Immoral- where it is opposed to public morals e.g., agreement for illicit cohabitation, or separation between husband and wife 

3) Opposed to public policy- where the agreement is forbidden as conflicting with the well-being of the state e.g., agreements tending to the abuse of legal process, agreements in restraint of trade, agreements in restraint of marriage, agreements in restraint of parental rights, etc.

Where a part of consideration or object of an agreement is unlawful the agreement is void. In case of non-separation of the unlawful part from the agreement the total transaction will be void. The rule applicable to separate the unlawful and lawful part is known as blue pencil rule. In such cases the lawful part which separated by drawing blue pencil lining from the unlawful part can be enforceable. A contract without consideration is said to be void with certain exceptions;

a) Every agreement in restraint of marriage of any person, other than a minor is void. 

b) An agreement in restraint of trade is void with an exception where goodwill is sold or as per the provisions of the Partnership Act, 1932. 

c) Any agreement in restraint of legal proceeding is void with an exception of arbitration agreement. 

d) Where the meaning of an agreement is not certain, or capable of being certain are void,

e) Agreement by way of wager is void.

f) The performance of the contract is depending on the happening or non-happening of an event at a future date is called as contingent contract. If the happening of the event is impossible the contract becomes void.

g) The enforcement of a contingent contract is possible before the impossibility of its occurrence. The promise of A to pay B a sum of money if B marries C. C marries D. Marriage between B and C is impossible during the life time of A makes the agreement void.

h) The contingent contract to do or not to do within a specified becomes void after the expiry of the time.

i) Any agreement contingent on impossible events is void.