TABLE OF CONTENTS

UNIT-I: BUSINESS ENVIRONMENT AND INTERNATIONAL BUSINESS

UNIT-II: ACCOUNTING AND AUDITING

UNIT-III: BUSINESS ECONOMICS

UNIT-IV: BUSINESS FINANCE

UNIT-V: BUSINESS STATISTICS AND RESEARCH METHODS

UNIT-VI: BUSINESS MANAGEMENT AND HUMAN RESOURCE

MANAGEMENT

UNIT-VII: BANKING AND FINANCIAL INSTITUTIONS

UNIT-VIII: MARKETING MANAGEMENT

UNIT-IX: LEGAL ASPECTS OF BUSINESS

UNIT-X: INCOME-TAX AND CORPORATE TAX PLANNING

CONCEPT OF BUSINESS ENVIRONMENT
Business Environment refers to the sum total of all individuals, institutions and other forces that are
outside the control of a business enterprise but the business still depends upon them as they affect the
overall performance and sustainability of the business.

The forces which constitute the business environment are its

• Suppliers
• Competitors,
• Consumer groups
• Media, government
• Customers
• Economic conditions
• Market conditions
• Investors
• Technologies
• Trends and
• Multiple other institutions working externally of a business constitute its business environment.

FOR EXAMPLE: - changes in taxes by the government can make the customers buy less. Here the busi-
ness would have to re-establish its prices to survive the change. Even though the business had no in-
volvement in initiating the change it still had to adapt to it in order to survive or use the opportunity to
make profits

ELEMENTS OF BUSINESS ENVIRONMENT

The five elements in the business environment are
1. Demographic environment
2. Economic environment
3. Technological environment:
4. Cultural environment
5. Political enviroment

1. Demographic Environment
Demographic Environment relates to the human population with reference to its size, education,
sex ratio, age, occupation, income, status etc.
For example: If the population is large, then the demand for goods and services will be more. It
will have favorable
Effect on the business. In the same way educational level is also an important factor
affecting business.

2. Economic Environment
Economic environment includes all those forces which have an economic impact on business.
Accordingly, total economic environment consists of agriculture, industrial production, infra-
structure, and planning etc.
For example: - for a farmer, the weather and price of fertilizers are important factors. For a TV
channel on the other
Hand, the growth in Internet advertising matters a great deal, but not the weather

3. Technological Environment
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 Technology implies systematic application of scientific or other organized knowledge to practi-
cal tasks or activities. As technology is changing fast, businessmen should keep a close look on
those technological changes for its adaptation in their business activities.
For example: - In late 1990’s Pagers were very popular among the people, but then came the
mobile phone Revolution.

4. Cultural Environment:
Finally, the social and cultural environment also influences the business environment indirectly.
These includes people’s attitude to work and wealth, ethical issues, role of family, marriage, reli-
gion and education and also social responsiveness of business.
For example: - the chocolate boy ad of AXE effect was banned by Information and Broadcasting
Ministry on grounds Of being offensive and vulgar.

5. Political Environment
The political- legal environment includes the activities of three political institutions, namely, legis-
lature, executive and judiciary which usually play a useful role in shaping, directing, developing
and controlling business activities.
For example: - in 1977 when Janata Party came in power they made the policy of sending back
all the foreign Companies. As a result, the COCA COLA and IBM companies had to close their
businesses and leave the country. Planned economy: all decisions regarding production, distri-
bution, salaries, investment and

Economic environment
Economic environment includes all those forces which have an economic impact on business. Ac-
cordingly, total economic environment consists of agriculture, industrial production, infrastructure,
and planning etc. It includes: -
• ECONOMIC SYSTEM
• ECONOMIC POLICIES
• ECONOMIC PLANNING

1. ECONOMIC SYSTEM - An economic system is an organized way in which a country allocates

resources and
Distributes goods and services across the whole nation or a given geographic area. Every eco-
nomic system looks at three or four basic questions:
And or local government. Market forces determine what is produced, how much is produced,
How it is distributed, plus the prices of goods and services.
2. Mixed Economy:Having features of both 1 & 2. The developing countries like India have adopted
mixed economy to accelerate the pace of economic development. Even the developed countries
like UK, USA, etc. Have also adopted ‘Mixed Capitalist System.

ECONOMIC POLICIES- Economic Policies includes fiscal policy. Monetary policy, foreign trade pol-
icy, licensing policy, etc.
1. Fiscal Policy: - Fiscal Policy is the mechanism by means of which a government makes adjust-
ments to its planned spending and the imposed tax rates to monitor and thus in turn influence
the performance of a country’s economy.
2. Monetary Policy:- Monetary policy is how central banks manage liquidity to create economic
growth. Liquidity is how much there is in the money supply. That includes credit, cash, checks,
and money market mutual funds.
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3. Foreign trade Policy:-The Foreign Trade Policy (FTP) was introduced by the Government to grow
the Indian export of goods and services, generating employment and increasing value addition
in the country.
4. Licensing Policy:-In the pre-liberalization days, India has adopted licensing policy to regulate the
growth of industries in India. Since the days of Independence, India adopted licensing policy,
which in effect made the government control the growth of industries in accordance with the
national priorities.

ECONOMIC PLANNING – Under Economic Planning. We can select best alternative for increasing
the economic strength of the company. We have to make plan regarding optimum use of our re-
sources in producing goods. We also have to make plan to produce optimumsquantity of output. We
can use Economic Planning at small level and at large level like Investment decisions of Govt.

Political environment-Role of government in business

Political environment refers to the Government and political actions that impact the business oper-
ations. The political environment can be studies in terms of the central govt, the citizens of a country,
rules and regulations examples of political factors are levels of bureaucracy, corruption and govt
stability.
A highly unstable govt is unable to offer businessman the security they need to trade peacefully,
hence a highly volatile trading environment. So the Role of government in business is very important.

Legal Environment of Business in India

Legal environment of business means all factors relating to laws and legal orders which affect busi-
ness and its working.
Business must be operated under the rules and regulation of different laws of India. The following is
the list of main laws which affect business.
1. Indian contract act 1872
2. Indian sale of goods act 1930
3. Indian partnership act 1932
4. Industrial dispute Act 1947
5. Minimum wages act 1948
6. Indian companies act 1956
7. Foreign exchange regulation act (FERA) 1973
8. Foreign exchange management act 1999
9. Monopolies and restrictive trade practice act 1969
10. Consumer protection act 1986
11. Indian income tax act 1961
12. Central excise act 1944
13. Security exchange board of India act 1992
14. Banking regulation act 1949
15. Chartered accountant act 1949
16. Information technology act 2000
17. Competition act 2002
18. Right to information act 2005
19. Micro, Small and Medium Enterprises Development Act, 2006
20. Commissions for Protection of Child Rights Act, 2005

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As per syllabus, we have to cover: Consumer Protection Act, FEMA.

• Consumer Protection Act:- Consumer Protection Act, 1986 is an Act of the Parliament of India enacted
in 1986 to protect the interests of consumers in India. It makes provision for the establishment of
consumer councils and other authorities for the settlement of consumer’s disputes and for mat-
ters connected there with also. This act was passed in Assembly in October 1986.

Various Consumer Organizations:

To increase the awareness of consumer, there are many consumer organizations and NGO’s that
established, such as -
1. Consumer Education and Research Centre (Ahmedabad)
2. Bureau of Indian Standard
3. Federation of Consumer Organization in Tamil Nadu
4. Mumbai Grahak Panchayet
5. Consumer Voice( New Delhi)
6. Legal Aid Society(Kolkata)

Consumer Disputes Redressed Agencies:

Redressal Agencies under the Consumer Protection Act, 1986 and Their Jurisdiction
1. District Forum:
• District forum consists of a president and two other members.
• The president can be a retired or working judge of District Court. They are appointed by state
government
• The complaints for goods or services worth Rs 20 lakhs or less can be filed in this agency.
• The agency sends the goods for testing in laboratory if required and gives decisions on the
basis of facts and laboratory report.
• If the aggrieved party is not satisfied by the jurisdiction of the district forumthen they can file
an appeal against the judgment in State Commission within 30days by depositing Rs 25000
or 50% of the penalty amount whichever is less.

2. State Commission:
• It consists of a president and two other members. The president must be a retired or working
judge of high court. They all are appointed by state government.
• The complaints for the goods worth more than Rs 20 lakhs and less than Rs 1 crore can be
filed in State Commission on receiving complaint the State commission contacts the party
against whom the complaint is filed and sends the goods for testing in laboratory if required.
• In case the aggrieved party is not satisfied with the judgment then they can file an appeal in
National Commission within 30 days by depositing Rs 3500 or 50% of penalty amount which-
ever is less.

3. National Commission
• The national commission consists of a president and four members one of whom shall be a
woman They are appointed by Central Government.
• The complaint can be filed in National Commission if the value of goods exceeds Rs 1 crore.
• On receiving the complaint the National Commission informs the party against whom com-
plaint is file and sends the goods for testing if required and gives judgment?
• If aggrieved party is not satisfied with the judgment then they can file a complaint in Supreme
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 Court within 30 days.

Foreign Exchange Management Act, 1999(FEMA)

• The Foreign Exchange Management Act, 1999 (FEMA) has been in force from 2000, thus re-
placing the old Foreign Exchange Regulation Act (FERA) 1973.
• The object of FEMA is to consolidate and amend the law relating to foreign exchange with
the object of facilitating external trade and payments and for promoting the orderly develop-
ment and maintenance of foreign exchange markets in India.
• RBI is the overall controlling authority in respect of FEMA.

KEY FEATURES:
• RBI can authorize a person/ company to deal in foreign exchange.
• RBI can authorize the dealers to do transact the foreign currencies subject to review and RBI
was given to revoke the authorization in case of non-compliancy.
• RBI would authorize the persons as Money Changers who will convert the currency of one
nation to currency of their nation at rates “Determined by RBI”.
• NO person, other than authorized dealer would enter in any transaction of the foreign cur-
rency.
• No person except authorized by RBI shall send foreign currency out of India.
• For whatever purpose Foreign exchange was required, it was to be used only for that purpose.
If he feels that he cannot use the currency of that particular purpose, he would sell it to a
authorized dealer within 30 days.
• FEMA does not apply to Indian citizen’s resident outside India.

Comparison between FERA and FEMA:

The main differences between FERA and FEMA -
• FERA was compiled with 81 different and complex provisions however FEMA have only 48
simple sections to it.
• Current account was not defined under FERA however it was introduced in FEMA.
• FEMA have more widened definition of “Authorized Person” and have also included banks in
[Link] with IT was not at all dealt with under FERA however FEMA have provision for
IT.
• Under FERA, its violation was a criminal offence which was changed to civil offence in FEMA.
• Under FERA, the appeal used to be sent to High Court however FEMA had provision of Special
Director (Appeals) and Special Tribunal.
• Under FERA, no help was extended to the accused however as per section 32 of FEMA, the
accused have right to get help of a legal practitioner.
• FERA was set up with main objective of conservation of foreign exchange however FEMA was
set up with main objective of management of foreign exchange.
• FERA was formulated with an assumption that foreign exchange is a scarce resource and
hence must be protected and used with great care however FEMA was formulated with as-
sumption that foreign exchange is an asset and must be properly managed.
• Under FERA only authorized dealers and money changers were defined as Authorized Per-
sons however under FEMA even offshore banking units were included in this definition.

Conclusion
FEMA do not view outflow of foreign exchange as an evil act however it rather works to factor it out
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to manage the process of foreign exchange. It aims to manage foreign exchange more efficiently
rather than conserving it. It applies general asset management rules in foreign exchange manage-
ment and aims at optimizing it rather than maximizing it. It promotes more liberal form of economy.

Socio-cultural factors and their influence on business

Social and cultural factors affecting business include belief systems and practices, customs, tradi-
tions and behaviors of all people in given country, fashion trends and market activities influencing
actions and decisions.

Social factors affecting business

• Social classes and their influence on the society,
• Average disposable income level,
• Wealth of people,
• Economic inequalities,
• Level of education,
• Access to education (free, paid),
• Health consciousness in society (smoking, drinking, drug use, safe driving, etc.),

Cultural factors affecting business

• Fashion trends,
• Lifestyle,
• Social media influence (blogging, etc.) Vs. Traditional media (press, tv, radio),
• Dominant communication technology in social groups,
• Participation in cultural events,
• Willingness to pay for tickets,
• Popular actors, music styles, design forms, etc.
• Creativity of people,
• Relative population of local (folk) artists vs. Global imported culture,
• Various other determinants of culture.

Socio-cultural factors and demography

• Population growth rate,
• Birth control regulations and incentives,
• Age distribution (ageing of societies can change demand),
• Life expectancy rate,
• Sex distribution (differences between number of men and women in society),
• Average family size and family structure,
• Relative influence of minorities in society

Beliefs and value systems within society

• Majority and minority religions,
• Influence of religious leaders on social behaviors,
• Role of religion as a binding/dividing factor in society,
• Dominant beliefs in society,
• Eating habits connected with religion,
• Belief in superstitions (friday 13th, 13th floor in buildings, etc.) And myths,
• Role of science in relation to religion,
• Customs, traditions during holidays (worship days),

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Common attitudes in society
• Attitudes toward banking, saving money and investing,
• Attitudes toward ecological products, recycling, global warming, etc.,
• Attitudes toward renewable energy sources, green products,
• Attitudes toward imported products and services, foreign investments, etc.
• Attitudes toward work and career, possibility of development,
• Attitudes toward leisure and retirement

Corporate Social Responsibility (CSR)

A Company’s sense of responsibility towards the community and environment in which it operates.
Companies express this citizenship
1. Through their waste and pollution reduction processes
2. By contributing educational and social programs
3. By earning adequate returns on the employed resources

The potential benefits of CSR to companies include:

• Better brand recognition.
• Positive business reputation.
• Increased sales and
• Customer loyalty.
Hence, we can say, corporate social responsibility (CSR) is a broad term used to describe a compa-
ny's efforts to improve society in some way. These efforts can range from donating money to non-
profits to implementing environmentally friendly policies in the workplace

Scope and importance of international business; Globalization and its drivers; Modes of entry into
international business
International business consists of transactions that are devised and carried out across national bor-
ders to satisfy the objectives of individuals, companies, and organizations. International Business is
the process of focusing on the resources of the globe and objectives of the organizations on global
business opportunities and threats.
International business defined as global trade of goods/services.

Importance of international business:

• To achieve higher rate of profits
• Expanding the production capacity beyond the demand of the domestic country
• To increase market share
• Liberalization, Privatization and Globalization (LPG)
• Nearness to raw material
• Availability of technology and managerial competence
RECENT CHANGES IN INTERNATIONAL BUSINESS
• Total world trade declined dramatically after 2000, but is again on the rise.
• The rate of globalization is accelerating.
• Regionalization is taking place, resulting in trading blocs.
• The participation of countries in world trade is shifting

DIFFERENT MODES OF ENTRY IN INTERNATIONAL BUSINESS

1. Exports: -Export deals with physical movement of goods and services from one place to another
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 through a customs port followings the rules of both the country of origin and country of destina-
tion.
2. International licensing: -International licensing is an agreement between the licensor and the li-
censee over a period of time for the use of brand name, marketing, know-how, copyright, work
method and trade mark by paying a license fee.
3. Franchising: -Franchising is a form of licensing wherein the franchiser exercises more control
over franchisee. The franchiser supplies the main part of the product, and provides the following
services to the franchisee:
• TRADEMARKS
• OPERATING SYSTEMS
• PRODUCT
• BRAND NAME

1. Contract manufacturing: - Contract manufacturing is the strategy of identifying a manufacturing

unit to produce items at a competitive price in any part of the world. Nike is procuring its athletic
footwear in a number of factories in Southeast Asia
2. Contract marketing: -All the companies, which are strong in production, may not have equal mar-
keting strengths. However, they may be comfortable dealing with marketing outlets around the
world such as TESCO, Maeys, ‘K’ Mart, Wal-Mart and Spinneys.
3. Management contracts: -A management contract is an agreement between two companies
whereby one company provides managerial and technical assistance for which proper monetary
compensation is given, either as a flat lump sum fee or a percentage on the sales or a share in
the profits. Delta airlines, Air France and KLM offer such services in developing countries.
4. Joint venture: - A joint venture is a binding contract between two venture partners to set up a
project either in home country or host country or a third country. In this case both parties are
committed to joint risk taking and joint profit sharing
5. Collaboration: -Collaboration deals with only a part of the functions. For example Bajaj Auto has
technological collaboration with Kawasaki of Japan, who offers the technology for two wheelers.
Others well known technological collaborations are Ind-Suzuki, Kinetic-Honda and Hero-Honda.
6. Foreign direct investment: -The flow of funds from one destination to another is called invest-
ment. Companies, which are constantly involved in international business, invest their money in
manufacturing and marketing bases through ownership and control.
7. Mergers and acquisitions:- In this case the company in the host country selects a foreign com-
pany merges itself with it. The foreign company acquires the control of ownership. This mode of
entry gives an outstanding competitive edge over others. Such companies strengthen their inter-
national manufacturing facilities and marketing network. Proctor & Gamble entered Mexico and
became leaders in five years by acquiring Loreto.
8. Take-overs:-This is a strategy whereby a company identifies a healthy unit with strong brand
name and network and brings it under the management of another unit in order to become a
leader in the field and guarantee [Link] example, Unifier’s takeover of Brook Bond and Lip-
ton enhanced its position as a leader in the tea industry in India. Always takeovers cost more as
compared to acquisition but probability of success is high.
9. Turnkey projects:-A turnkey project is a contract under which a company is fully involved from
concept to completion. It covers right from supply of manpower, capital, and erection of plant,
installation and commissioning up to the trial operation of a project.
10. Counter trade:- Counter trade came in to existence in the absence of foreign exchange reserves
in a country. Sometimes the country is not willing to pay, though foreign exchange reserves are
with it. Such unwillingness will lead to non-repatriation of payment. Ultimate solution is to enter
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 in to counter trade practices. Counter trade can be classified in to three categories: 1. Pure Barter
2. Buy Back 3. Counter Purchase

GLOBALISATION
Globalization (or globalization) is the process of international integration arising from the inter-
change of world views, products, ideas and mutual sharing, and other aspects of culture.

• DRIVERS OF GLOBALIZATION
Two macro factors underlie the trend toward greater globalization.17 The first is the decline in bar-
riers to the free flow of goods, services, and capital that has occurred since the end of World War II.
The second factor is technological change, particularly the dramatic developments in recent dec-
ades in communication, information processing, and transportation technologies.
1. Declining trade and investment barriers:-During the 1920s and 30s many of the world's nation-
states erected formidable barriers to international trade and foreign direct investment. Interna-
tional trade occurs when a firm exports goods or services to consumers in another country. For-
eign direct investment (FDI) occurs when a firm invests resources in business activities outside
its home country
2. The role of technological change: -The lowering of trade barriers made globalization of markets
and production a theoretical possibility. Technological change has made it a tangible real-
[Link] the end of World War II, the world has seen major advances in communication, infor-
mation processing, and transportation technology, including the explosive emergence of the In-
ternet and World Wide Web. Telecommunications is creating a global audience.

Theories of international trade

1. Absolute Advantage Theory
• The Scottish economist Adam Smith developed the trade theory of absolute advantage
• Developed in 1776.
• A country has an absolute advantage in the production of a product when it is more efficient
than any other country in producing it
• If two countries specialize in production of different products (in which each has an absolute
advantage) and trade with each other, both countries will have more of both products available
to them for consumption
2. Theory of Mercantilism
• This theory was developed in the sixteenth century
• Considered to be the oldest theory of International Trade
• According to this theory, a country’s wealth could be determined by the amount of its gold
and silver holdings.
• During that point of time, gold and silver had the status of currency.
• The countries should focus on having a ‘trade surplus’ i.e. Value of exports should be greater
than the value of imports.
• ‘Trade deficit’ is to be avoided.
3. Theory of Comparative Advantage
• In 1817, famous Economist, David Ricardo introduced his theory of Comparative Advantage.
• As per this theory if a country had absolute advantage in two or more products or in no prod-
uct, specialization and trade could still occur between the countries.
• As per this theory, Comparative Advantage exists when a country is able to produce a com-
modity better and more efficiently than it does other commodities.
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 • Focuses on the relative productivity difference, whereas Absolute Advantage theory focused
only on absolute productivity.
4. Theory of Hecksher-Ohlin
• The Hecksher-Ohlin Model of International Trade was put forth by Eli Hecksherand Bertil Ohlin
• This theory is also called as Factor Proportions Theory
• Hecksher-Ohlin Model took into account production factors such as land, labor and capital
and not just labor cost alone.
• According to this model, the viability and cost effectiveness of goods is determined by the
input costs. Goods with cheap input costs will be cheaper to produce than the goods requir-
ing scarce inputs.
• A good example could be that of India that has abundant. It can cheaply produce labor inten-
sive goods like textile and clothes.
5. Product Life Cycle Theory
• Raymond Vernon, a Harvard Business School professor, developed the product life cycle the-
ory in the 1960s
• Stated that a product life cycle has three distinct stages:
(1) new product,
(2) maturing product, and
(3) standardized product
• The theory assumed that production of the new product will occur completely in the home
country of its innovation

Government Intervention in International Business

The government intervention is often stimulated by protectionism, which is referred to as specific
government actions and policies that either restrain or restrict free trade and protect domestic
firms from foreign competitorsthe most common tools that policymakers employ to impede
foreign trade are tariffs, nontariff barriers and arbitrary administrative rules. To limit operations of
foreign firms in the country, governments use yet another type of barriers called investment barriers.
• Government intervention has its pluses as well as minuses.
• On one hand, government a cti on s m a y cr e a te a n d s a v e h u n d r e d s o f j ob s i n th e
d om e s t i c m a r k e t .
• On th e downside, however, barriers may increase production costs for domestic firms that
use imported goods as inputs in their production process. As prices of materials goes
up, the ability of domestic firms to compete with foreign companies decreases.
• Finally, trade barriers may lead to smaller variety of products available to buyers.
• Rationale for Government Intervention
• In the broadest terms, there are four main motives for government intervention.
• Firstly, tariffs and other forms of intervention can generate considerable revenues.
• Secondly, intervention ensures the safety, security and welfare of citizens.
• Moreover, interventions a means for government to pursue economic, political, social goals
and objectives.
• Finally, intervention can help better serve the interests of nation’s firms and industries.

What are trade barriers?

Trade barriers unjustifiably prevent your business succeeding in exporting. You may have different
ways of describing them. They all mean the same thing. They’re often called:
• Red tape

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• Roadblocks to export
• Price controls
• Subsidies

Types of trade barriers: tariff and non-tariff

• Tariff barriers can include a customs levy or tariff on goods entering a country and are imposed
by a government. Free trade agreements seek to reduce tariff barriers.
• Non-tariff barriers can include excessive red tape, onerous regulations, unfair rules or decisions,
or anything else that is stopping you from competing effectively.
• Non-tariff barriers can affect all forms of goods and services exports – from food and manufac-
tured products, through to digital services.

India’s foreign trade policy

• In the Mid-Term Review of the Foreign Trade Policy (FTP) 2015-20 the Ministry of Commerce and
Industry has enhanced the scope of Merchandise Exports from India Scheme (MEIS) and Service
Exports from India Scheme (SEIS), increased MEIS incentive raised for ready-made garments and
made- ups by 2 per cent, raised SEIS incentive by 2 per cent and increased the validity of Duty
Credit Scrips from 18 months to 24 months.
• As of December 2018, Government of India is planning to set up trade promotion bodies in 15
countries to boost exports from Small and Medium Enterprises (SME) in India.
• In September 2018, Government of India increased the duty incentives for 28 milk items under the
Merchandise Export from India Scheme (MEIS).
• All export and import-related activities are governed by the Foreign Trade Policy (FTP), which is
aimed at enhancing the country's exports and use trade expansion as an effective instrument of
economic growth and employment generation.
• The Department of Commerce has announced increased support for export of various products
and included some additional items under the Merchandise Exports from India Scheme (MEIS) in
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 order to help exporters to overcome the challenges faced by them.
• The Central Board of Excise and Customs (CBEC) has developed an 'integrated declaration' pro-
cess leading to the creation of a single window which will provide the importers and exporters a
single point interface for customs clearance of import and export goods.
• As part of the FTP strategy of market expansion, India has signed a Comprehensive Economic
Partnership Agreement with South Korea which will provide enhanced market access to Indian
exports. These trade agreements are in line with India’s Look East Policy. To upgrade export sec-
tor infrastructure, ‘Towns of Export Excellence’ and units located therein will be granted additional
focused support and incentives.
• RBI has simplified the rules for credit to exporters, through which they can now get long-term
advance from banks for up to 10 years to service their contracts. This measure will help exporters
get into long- term contracts while aiding the overall export performance.
• The Government of India is expected to announce an interest subsidy scheme for exporters in
order to boost exports and explore new markets.

Foreign direct investment (FDI)

Foreign direct investment (FDI) is an investment made by a firm or individual in one country into
business interests located in another country.
Types of FDI
• Horizontal FDI: It is the investment done by a company or organization which practices all the
tasks and activities done at the investing company, back at its own country of operation. There-
fore, basically such investors are from the same industry where investments are done but operat-
ing in two different countries. For e.g., a car manufacture in Australia invests in a car manufactur-
ing company of India.
• Vertical FDI: The industry of the investor and the company where investments are done are related
to each other. This type of FDI is further classified as:
• Forward Vertical FDI: In such investments, foreign investments are done in organizations which
can take the products forward towards the customers. For e.g., a car manufacturing company in
Australia invests in a wholesale Car Dealer company in India.
• Backward Vertical FDI: IN such investments, foreign investments are done in an organization
which is involved in sourcing of products for the particular industry. For e.g., the car manufacturer
of Australia invests in a tyre manufacturing plant in India.
• Conglomerate FDI: Such investments are done to gain control in unrelated business segments
and industries in a foreign land. For e.g., the car manufacturer of Australia invests in a consumer
durable good manufacturer in India. Here the investing company ideally manages two challenges,
first being gaining operational control in a foreign land, and the second being starting operations
in a new industry segment.
• Greenfield Entry: In this special type of FDI, the investing company refers to an investing organi-
zation starting assembling from scratch just like Honda did in United Kingdom
• Foreign Takeover: This type of FDI takes the form of a foreign merger, acquisition or takeover of
an existing foreign company.

Costs and benefits of FDI to home and host countries

Benefits to Host Country
Foreign direct investment (FDI) has benefits for the host country as well as for the country that is
investing. First, we study the benefits accruing to host country due to FDI:
Resource-transfer effects

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Employment effects
Balance-of-payment effects

Costs to Host Country

There are three primary ways in which one can study potential costs to a host country of FDI:
Adverse effect on home manufacturers
Adverse effects on BOP
• National sovereignty is at stake

Trends of foreign direct investment in India

Foreign Direct Investment in India increased by 3675 USD Million in January of 2019. Foreign Direct
Investment in India averaged 1341.88 USD Million from 1995 until 2019, reaching an all-time high of
8579 USD Million in August of 2017 and a record low of -1336 USD Million in November of 2017.

1. Market size
According to Department for Promotion of Industry and Internal Trade (DPIIT), the total FDI in-
vestments in India April-December 2018 stood at US$ 33.49 billion, indicating that government's
effort to improve ease of doing business and relaxation in FDI norms is yielding results.

2. Investments/ developments
India emerged as the top recipient of Greenfield FDI Inflows from the Commonwealth, as per a
trade review released by The Commonwealth in 2018.
Some of the recent significant FDI announcements are as follows:
• In October 2018, vmware, a leading software innovating enterprise of US has announced invest-
ment of US$ 2 billion in India between by 2023.
• In August 2018, Bharti Airtel received approval of the Government of India for sale of 20 per cent
stake in its DTH arm to an America based private equity firm, Warburg Pincus, for around $350
million.
• In June 2018, Idea’s appeal for 100 per cent FDI was approved by Department of Telecommuni-
cation (dot) followed by its Indian merger with Vodafone making Vodafone Idea the largest tele-
com operator in India

13
• In May 2018, Walmart acquired a 77 per cent stake in Flipkart for a consideration of US$ 16 billion.
• In February 2018, Ikea announced its plans to invest up to Rs 4,000 crore (US$ 612 million) in the
state of Maharashtra to set up multi-format stores and experience centres.
• Kathmandu based conglomerate, CG Group is looking to invest Rs 1,000 crore (US$ 155.97 mil-
lion) in India by 2020 in its food and beverage business, stated Mr. Varun Choudhary, Executive
Director, CG Corp Global.
• International Finance Corporation (IFC), the investment arm of the World Bank Group, is planning
to invest about US$ 6 billion through 2022 in several sustainable and renewable energy Pro-
grammes in India.

3. Government Initiatives
As of February 2019, the Government of India is working on a road map to achieve its goal of US$
100 billion worth of FDI inflows.
• In February 2019, the Government of India released the Draft National e-Commerce Policy which
encourages FDI in the marketplace model of e-commerce. Further, it states that the FDI policy for
e- commerce sector has been developed to ensure a level playing field for all participants
• Government of India is planning to consider 100 per cent FDI in Insurance intermediaries in India
to give a boost to the sector and attracting more funds.
• In December 2018, the Government of India revised FDI rules related to e-commerce. As per the
rules 100 per cent FDI is allowed in the marketplace based model of e-commerce. Also, sales of
any vendor through an e-commerce marketplace entity or its group companies have been limited
to 25 per cent of the total sales of such vendor.
• In September 2018, the Government of India released the National Digital Communications Policy,
2018 which envisages increasing FDI inflows in the telecommunications sector to US$ 100 billion
by 2022.
• In January 2018, Government of India allowed foreign airlines to invest in Air India up to 49 per
cent with government approval. The investment cannot exceed 49 per cent directly or indirectly.
• No government approval will be required for FDI up to an extent of 100 per cent in Real Estate
Broking Services.
• In September 2017, the Government of India asked the states to focus on strengthening single
window clearance system for fast-tracking approval processes, in order to increase Japanese
investments in India.
• The Ministry of Commerce and Industry, Government of India has eased the approval mechanism
for foreign direct investment (FDI) proposals by doing away with the approval of Department of
Revenue and mandating clearance of all proposals requiring approval within 10 weeks after the
receipt of application.
• The Government of India is in talks with stakeholders to further ease foreign direct investment
(FDI) in defense under the automatic route to 51 per cent from the current 49 per cent, in order to
give a boost to the Make in India initiative and to generate employment.
• In January 2018, Government of India allowed 100 per cent FDI in single brand retail through au-
tomatic route

FDI Policy of Government of India

Government of India has taken various effective steps to simplify the Foreign Direct investment
policy. The Foreign Direct Investment Policy (FDI Policy) of the Government of India prescribes the
foreign investment cap in
Specified industrial sectors. But in the recent times many activities have been transferred to unre-
stricted sectors in which 100% Foreign Direct investment is permitted. Broadly, the industrial sectors
14
are categorized as:
1. Restricted
2. Prohibited
3. Unrestricted Sectors (Up to 100% foreign ownership)

Balance of payments (BOP)

The balance of payments, also known as balance of international payments and abbreviated B.O.P.
or BOP, of a country is the record of all economic transactions between the residents of the country
and the rest of world in a particular period of time (over a quarter of a year or more commonly over
a year).

Importance of Balance of Payments

• It analyses the business transactions of any economy into exports and imports of goods and
services for a particular financial year. Here, the government can identify the areas that have the
potential for export- oriented growth and can formulate policies supporting those domestic indus-
tries.
• The government can adopt some protective measures such as higher tariff and duties on imports
so as to discourage imports of non-essential items and encourage the domestic industries to be
self-sufficient.
• If the economy needs support in the form of imports, the government can formulate appropriate
policies to divert the funds and technology imported to the critical sectors of the economy that
can drive future growth.
• If the country has a flourishing export trade, the government can adopt measures such as deval-
uation of its currency to make its goods and services available in the international market at
cheaper rates and bolster exports.
• The government can also use the indications from Balance of Payments to discern the state of
the economy and formulate its policies of inflation control, monetary and fiscal policies based on
that.
•
Components of Balance of Payments
The balance of payment is listed in three components as per the proforma of Balance of payments
Shown here below-
1. Current Account:- Current account refers to an account which records all the transactions re-
lating to export and import of goods and services and unilateral transfers during a given period
of timeprivate: Merchandise (or trade) Balance Invisible: Travel (tourists) and transportation
(shipping and related services)
Income on Investment: investment, royalties, interest, dividends, foreign Bond earnings.
Other services government: Military supplies, grants etc.

Unit 1: Business Environment and International Business (NOTES)

2. Capital account: - Capital account of BOP records all those transactions, between the residents
of a country and the rest of the world, which cause a change in the assets or liabilities of the resi-
dents of the country or its government.
Long-term: private and government
Short term: private
Errors and Omissions: Net
3. Settlement Account
15
 Gold and SDR Movement (out and in)

Regional Economic Integration

Regional Economic Integration can best be defined as an agreement between groups of countries
in a geographic region, to reduce and ultimately remove tariff and non-tariff barriers to the free flow
of goods, services, and factors of production between each other.
Levels of Regional Economic Integration
1. Free trade. Tariffs (a tax imposed on imported goods) between members countries are signifi-
cantly reduced, some abolished altogether. Each member country keeps its own tariffs in regard
to third countries. The general goal of free trade agreements is to develop economies of scale
and comparative advantages, which promotes economic efficiency.
2. Custom union. Sets common external tariffs among member countries, implying that the same
tariffs are applied to third countries; a common trade regime is achieved. Custom unions are
particularly useful to level the competitive playing field and address the problem of re-exports
(using preferential tariffs in one country to enter another country).
3. Common market. Services and capital are free to move within member countries, expanding
scale economies and comparative advantages. However, each national market has its own reg-
ulations such as product standards.
4. Economic union (single market). All tariffs are removed for trade between member countries,
creating a uniform (single) market. There are also free movements of labor, enabling workers in
a member country is able to move and work in another member country. Monetary and fiscal
policies between member countries are harmonized, which implies a level of political integration.
A further step concerns a monetary union where a common currency is used, such as with the
European Union (Euro).
5. Political union. Represents the potentially most advanced form of integration with a common
government and were the sovereignty of member country is significantly reduced. Only found
within nation states, such as federations where there is a central government and regions having
a level of autonomy.

16
Trade creation and diversion effects
Trade creation takes place when domestic consumers in member countries import more goods from
other members as import prices fall due to a removal of tariff and quotas; production will shift to
lower cost producer.

• In the above diagram, when Thailand and Malaysia form a trading bloc, Thailand will remove tar-
iffs from Malaysian imports. Trade will go to more efficient Malaysian producers.
• The blue shaded regions shows that world efficiency will be regained as now more efficient pro-
ducer is producing the good and there are lower prices which lead to regaining of consumer sur-
plus.
• Increased income resulting from specialization & benefits of scale can further this by creating
increased demand for imports from non-member countries.
• Initial effects are the increase in consumer welfare resulting from more goods and lower prices,
while the long-run effects include enhance competitive advantage and increasing specialization.

Trade Diversion is when a customs union is created and tariffs differentials between members and
non-member result in trade flows being diverted toward higher cost producers.

17
• In the upper image, once the UK joined the EU, it had to place tariffs on the Palm Oil that it used
to import from Malaysia at lower prices.
• The trade now is diverted to EU nations inspire of the fact that they are inefficient in producing
palm oil.
• The blue shaded regions show a loss in efficiency due production by inefficiently European pro-
ducers. Moreover, the prices for consumers have increased from Pm to Peu which results in loss
of consumer surplus.
• In other words, lower cost imports from outside the union have been replaced by high cost imports
from within the union

Regional Trade Agreements

Regional trade agreements (rtas) are treaties among two or more governments that agree to offer
more favorable treatment to trade between them than they do to goods imported from outside the
region

Examples of regional trade agreements include

• The North American Free Trade Agreement (NAFTA),
• Central American-Dominican Republic Free Trade Agreement (CAFTA-DR),
• The European Union (EU) and
• Asia-Pacific Economic Cooperation (APEC).

1 . Association of Southeast Asian Nations (ASEAN)

• The Association of Southeast Asian Nations (ASEAN) was formed in 1967 by Indonesia, Malaysia,
the Philippines, Singapore, and Thailand to promote political and economic cooperation and re-
gional stability
• The member countries of the Association of Southeast Asian Nations (ASEAN) are Indonesia,
Malaysia, Philippines, Singapore, Thailand, Brunei Darussalam, Vietnam, Laos and Myanmar.

2. European Union (EU)

• The European Union was formally established when the Maastricht Treaty—whose main archi-
tects were Helmut Kohl and François Mitterrand—came into force on 1 November 1993.
• In 1995, Austria, Finland, and Sweden joined the EU.
• The European Union (EU) is an economic and political union of 28 member states that are located
primarily in Europe.

3. North American Free Trade Agreement (NAFTA)

• In January 1994, the United States, Mexico and Canada entered into the North American Free
Trade Agreement (NAFTA), creating the largest free trade area and richest market in the world.
• The NAFTA is the most comprehensive regional trade agreement ever negotiated by the United
States and is scheduled to be fully implemented by the year 2008
• In 1996, U.S. two-way trade in goods under the NAFTA with Canada and Mexico stood at $420
billion–a 44 % increase since the NAFTA was signed.

4. South Asian Free Trade Area (SAFTA)

• The South Asian Free Trade Area (SAFTA) is the free trade arrangement of the South Asian Asso-
ciation for Regional Cooperation (SAARC).
• The South Asian Free Trade Area (SAFTA) is an agreement reached on January 6, 2004, at the
18
 12th SAARC summit in Islamabad, Pakistan
• It created a free trade area of 1.6 billion people in Afghanistan, Bangladesh, Bhutan, India, Mal-
dives, Nepal, Pakistan and Sri Lanka
• The purpose of SAFTA is to encourage and elevate common contract among the countries such
as medium and long term contracts

International Economic institutions

1. World Trade Organization:
• WTO was formed in 1995 to replace the General Agreement on Tariffs and Trade (GATT), which
was started in 1948. GATT was replaced by WTO because GATT was biased in favor of developed
countries. WTO was formed as a global international organization dealing with the rules of inter-
national trade among countries.
• The main objective of WTO is to help the global organizations to conduct their businesses. WTO,
headquartered at Geneva, Switzerland, consists of 153 members and represents more than 97%
of world’s trade

The main objectives of WTO are as follows:

• Raising the standard of living of people, promoting full employment, expanding production and
trade, and utilizing the world’s resources optimally
• Ensuring that developing and less developed countries have better share of growth in the world
trade
• Introducing sustainable development in which balanced growth of trade and environment goes
together

The main functions of WTO are as follows:

• Setting the framework for trade policies
• Reviewing the trade policies of different countries
• Providing technical cooperation to less developed and developing countries
• Setting a forum for addressing trade-related disputes among different countries
• Reducing the barriers to international trade
• Facilitating the implementation, administration, and operation of agreements

2. International Monetary Fund:

IMF, established in 1945, consists of 187 member countries. It works to secure financial stability,
develop global monetary cooperation, facilitate international trade, and reduce poverty and maintain
sustainable economic growth around the world. Its headquarters are in Washington, D.C., United
States.

The objectives of IMF are as follows:

• Helping in increasing employment and real income of people
• Solving the international monetary problems that distort the economic development of different
nations
• Maintaining stability in the international exchange rates
• Strengthening the economic integrity of the nations
• Providing funds to the member nations as and when required
• Monitoring the financial and economic policies of member natio

3. United Nations Conference on Trade and Development:

19
UNCTAD, established in 1964, is the principal organ of United Nations General Assembly. It provides
a forum where the developing countries can discuss the problems related to economic development.
UNCTAD is headquartered in Geneva, Switzerland and has 193 member countries.
The conference of these member countries is held after every four years. UNCTAD was created be-
cause the existing institutions, such as GATT, IMF, and World Bank were not concerned with the
problem of developing countries. UNCTAD’s main objective is to formulate the policies related to
areas of development, such as trade, finance, transport, and technology.

The main objectives of UNCTAD are as follows:

• Eliminating trade barriers that act as constraints for developing countries
• Promoting international trade for speeding up the economic development
• Formulating principles and policies related to international trade
• Negotiating the multinational trade agreements
• Providing technical assistance to developing countries specially low developed countries

4. World Bank
• The World Bank is an international, intergovernmental institution for providing long-term loans on
easy terms for specific developmental projects.
• Recently it has been issuing loans for structural adjustment purposes to heavily indebted coun-
tries. Its capital stock is entirely owned by the 181-strong member Governments.

Objectives of the Bank:

• Helping the poorest people in poor countries by investing in health and education.
• Running projects on social development
• Helping the Governments to improve the quality of services.
• Protecting the environment.
• Encouraging private business enterpris
• Promoting macro-economic reforms to create a stable environment for investment and long-term
planning.

Agreement on Agriculture (AOA):

The Agreement on Agriculture is an international treaty of the World Trade Organization. The ap-
proach adopted Here is to encourage gradual reduction of trade distorting subsidies. The AOA spe-
cifically deals with: (i) providing Market access
(ii) containing of export subsidies, and
(iii) regulating domestic support.

General Agreement on Trade in Services (GATS):

The General Agreement on Trade in Services (GATS), which is the first multilateral, legally enforcea-
ble Agreement on trade in services. Negotiations are now underway to expand the scope of the GATS
to potentially Cover all services, including key public services, which could be opened to competition
with transnational Corporations and privatization.

Agreement on Trade-Related Intellectual Property Rights (trips):

Trade Related Intellectual Property Rights (TRIPS), which sets enforceable global rules on patents,
copyrights, And trademarks, which restrict access to life-saving medicines, and permits the patent-
ing of many plant and Animal forms, as well as seeds, opening the door to bio piracy and the
20
commodification of bio-diversity.

Agreement on Trade-related Investment Measures (trims):

The Agreement on Trade Related Investment Measures (trims) is rules that apply to the domestic
regulations a Country applies to foreign investors, often as part of an industrial policy. Beginning
1995, GATT’s inconsistent Agreement on trims were required to be notified and eliminated within a
transition period of two years (for Developed countries), five years (for developing countries) or
seven years (for least- developed countries).

21
 Match List-I with List-II and select the correct answer using the codes given below the lists :

List-I List-II
1. (Financing facilities of IMF)
(Their establishment years)
A. CCFF l 1979
B. SFF II. 1974
C. EFF III. 1963
A. A b c
III II I
B. A b c
II I III
C. A b c
I II III
D. A b c
III I II
Answer Report Discuss
Option: D
Explanation : Click on Discuss to view users comments.

2. Which of the following is the function of UNCTAD?

A. To promote international trade
B. To formulate principles and policies on international trade
C. To negotiate multinational trade agreements
D. All of the above.
Answer Report Discuss
Option: B
Explanation : Click on Discuss to view users comments.

3. In which aspect does the IMF act as the guardian of a code set up by its articles?
A. Regulatory
B. Consultative
C. Financial
D. Functional
Answer Report Discuss
Option: D
Explanation : Click on Discuss to view users comments.

4. Members of IMF are free to choose the form of exchange arrangements that they intend to apply
subject to
A. Their obligations to the Fund
B. The Fund's surveillance of their exchange rate policies.
C. Both (A) and (B)
D. Directive principles of the IMF.
Answer Option: C

5. The international monetory system introduced by Bretton Woods rested on

A. The maintenance of stable exchange rates
22
B. A multilateral credit mechanism institutionalised in the IMF
C. The principle of gold standard
D. Both (A) and (B)
Option: C

6. Under the "Par value system" each member country of IMF was required to define the
Value of its currency in terms of gold or the US dollar and to maintain the market value
Of its currency within
A. ± 10% of the par value
B. ± 7% of the par value
C. ± 1 % of the par value
D. ± 3% of the par value.
Answer Report Discuss
Option: C
Explanation : Click on Discuss to view users comments.

7. Which of the following is a function of WTO?

A. To facilitate the implementation of Multilateral Trade Agreement
B. To administer the Trade Review Mechanism
C. To administer the understanding on rules and procedures governing the settlementof disputes.
D. All of the above
Answer Report Discuss
Option: D
Explanation : Click on Discuss to view users comments.

8. F a country differs from the rest of the world n taste patterns but not in production capabilities,
trade will lead to some international specialisation in
A. Consumption
B. Production
C. Exports
D. Imports
Answer Report Discuss
Option: A
Explanation : Click on Discuss to view users comments.

9. The income terms of trade indicates a nation's capacity

A. To import
B. To export
C. To improve its trade
D. None of the above
Answer
Option: : C

10. The current account of balance of payments includes

A. Merchandise exports
B. Merchandise imports
C. Invisible exports and imports
D. All of the above
23
 24
Answer
Option: D

11. The payment of interest on loans and dividend payments are recorded in the
A. Unilateral transfer account
B. Official settlements account
C. Capital account
D. Current account
Answer
Option: C.

12. Consider the following 'Debit' entries in the Balance of Payments Account
1. Direct investments abroad
2. Tourist expenditure abroad
3. Income paid on loans and investments in the home country
4. Services purchased from abroad.
Which of the above are a part of the current account of balance of payment?
A. 1,2 and 3
B. 2,3 and 4
C. 1,2 and 4
D. 1,2,3 and 4
Answer
Option: B.

13. Consider the following

1. Incentives for foreign investment
2. Tourism development
3. Import substitution
4. Foreign loans
The above measures for correction of balance of payments disequilibrium, are collectivelyknown as
A. Monetary measures
B. Trade measures
C. Miscellaneous measures
D. None of the above
Answer
Option: C.

14. Where do the members allow full freedom of factor flows among themselves, in addition to hav-
ing a free-trade area?
A. Free economic zone
B. Customs-union
C. Common market
D. Economic-union
Answer
Option: C.

15. A case of international price discrimination in which an exporting firm sells at a lower price in a
foreign market than it charges in other markets, is known as
24
A. Dumping
B. Non-Dumping
C. Anti-Dumping
D. None of the above
Answer
Option: A.

16. Adjustment assistance is preferable to preventing import competition with trade barriers, if the
displacement costs of the free trade are
A. Equal to efficiency gains
B. Less than efficiency gains
C. More than efficiency gains
D. None of the above
Answer
Option: B.

17. Which method is the quickest method of transmitting funds from one centre to another?
A. Bank Drafts
B. Mail Transfer
C. Telegraphic Transfer
D. None of the above
Answer
Option: C

18. If the forward exchange rate quoted is exactly equivalent to the spot rate at the time of making
the contract, the forward exchange rate is said to be
A. At Par
B. At premium
C. At Discount
D. At reimbursement
Answer
Option.B

19. Which of these are not accounted for in the capital account of balance of payment?
A. Receipts of foreign private lending
B. Receipts of foreign public lending
C. Investments less repayment of principal and interest on former loans and investments
D. Import duties
Answer
Option: D

20. Total value of export earnings depends on

A. Volume of exports
B. Price paid for exports
C. Type of product
D. Both (A) and (B)
Answer
Option: D
25
21. Argument for a secular decline in the terms of trade of primary commodity exporters is based on
A. High income
B. Low income
C. Price elasticity of demand
D. Both (B) and (C)
Answer
Option: B.

22. If a country A can produce more of a commodity with the same amount of real resources than
Country B, country A is said to have over country B.
A. Comparative advantage
B. Positive advantage
C. Absolute advantage
D. Negative advantage
Answer
Option: C

23. The extent, in percentages, to which the domestic price of imported goods exceeds what their
price would be in the absence of protection is given by
A. Effective rate of protection
B. Value added tariff
C. Nominal rate of protection
D. None of the above
Answer
Option: C.

24. The gains in consumption come from two changes induced by the chance to trade
I. Chance to change consumption [Link]. Chance to change saving patterns
Ill. Chance to change investment portfolios
IV. Benefits of specialization in production Of these statements:
A. I and II are correct
B. II and III are correct
C. III and IV are correct
D. I and IV are correct.
Answer
Option: D

25. Ratio of a country's export prices to its import prices is called

A. Relative price ratio
B. Trade ratio
C. Terms of trade
D. Benefit ratio
Answer
Option: C

26. If a country differs from rest of the world in taste patterns but not in production capabilities, trade
will lead to some international specialization in
A. Production
26
B. Consumption
C. Productivity
D. Techniques of production
Answer
Option: B.

27. Factor-price equalisation theorem states that under certain assumptions.

A. Free trade equalises cost of production between nations
B. Cost of trade equals factor prices between countries
C. Free trade equalises not only commodity prices but also factor prices.
D. None of the above.
Answer
Option: C

28. GATT prescribes export subsidies as

A. Competition
B. Unfair competition
C. Monopolistic competition
D. Exploitation
Answer
Option: D.

29. Producer surplus is

A. Net gain in producer revenue minus cost
B. Net profit after payment of taxes
C. The reciprocal of consumer surplus
D. The surplus value of labour kept with the producer.
Answer
Option: A

30. Match List-I with List-II and select the correct answer using the codes given belowthe lists:
List-I List-II
A. Common market I. OPEC
B. Cartel II. EC
C. Free-trade area [Link]
D. Customs union [Link]
A. A b c d
I II III IV
B. A b c d
IV III II I
C. A b c d
II I III IV
D. A b c d
I II IV III
Answer
Option: C

31. The first United Nations Conference on Trade and Development (UNCTAD) was convened at
27
 Geneva in
A. 1967
B. 1964
C. 1961
D. 1963
Answer
Option: B

32. Which of the following statements is correct?

A. The United States is the main supplier of foreign direct investments to Latin America,Bangladesh,
Pakistan, the
Philippines and Saudi Arabia
B. Direct investments from the European Union flow mostly to Ghana and Morocco inAfrica, Brazil
in Latin America,India, Sri Lanka and Vietnam in Asia and to the former communist countries in
EasternEurope
C. Japan is the main supplier of foreign direct investments to South Korea, Singapore,Taiwan and
Thailand
D. All of the above
Answer
Option: D

33. Leftover net discrepancy in bop is recorded as net

A. Omissions
B. Miscellaneous
C. Suspense account
D. Errors and omissions
Answer
Option: B

34. A current account surplus represents

A. Net foreign investment
B. Net foreign drain
C. Disinvestment abroad
D. None of the above
Answer Report Discuss
Option: B

35. Exchange rates relate to demand and supply of

A. Foreigngoods
B. Foreignmoney
C. NationalMoney
D. Nationalgoods inrelation to foreign goods
Answer: C

36. When the nation draws down its reserves for a while, and keeps the reserve lossfrom affecting
national money supply, it is called
A. Deficit without tears
B. Temporary financing
28
C. Exchange control
D. Exchange rate compromise
Answer
Option: B

37. Marginal propensity to import is

A. The ratio of change in imports to the change in national income
B. The ratio of change in imports to change in exports
C. The ratio of change in imports to change in net income from abroad
D. The ratio of change in imports to change in the country share in world trade
Answer
Option: B

38. The nominal exchange rate weighed by the consumer price indeed in the twonations is
A. Real exchange rate
B. Relative exchange rate
C. Consumer exchange rate
D. Reciprocal exchange rate
Answer
Option: A

39. The extra return that investors require to purchase or hold on to foreign bonds to compensate
them for the additional currency and country risks involved in holding foreign bonds is called
A. Risk tariff
B. Risk premium
C. Foreign bonds effect
D. Investor's premium
Answer
Option: B

40. Pro trade production and consumption means

A. Increases in production and consumption that lead to less than proportionate increases in the
volume of trade.
B. Increases in production and consumption that lead to greater thanproportionate increases in the
volume of trade.
C. Increases in production and consumption that lead to proportionate increasesin the volume of
trade
D. Increases in production and consumption that lead to proportionate decreasesin the volume of
trade
Answer
Option: B

41. The entry of imports from the rest of the world into the low-tariff member of a free trade areato
avoid the higher tariffs of other members is called
A. Trade deflection
B. Trade diversion
C. Trade creation
D. Trade effect
29
 Answer
Option: A

42. Match List-I with List-II and select the correct answer using the codes given below the lists:
List-1 List -2
(a) (Measure towards Globalization) I.(Globalization)
(b) Off Sharing II. FEMA
(c) FEMA III. Liberalize the inflow of FDI
(d) Mr. Arthol Dunkal IV. Uruguay Round
A. A b c d
III I II IV
B. A b c d
II I III IV
C. A b c d
IV II I III
D. A b c d
I II IV III
Answer
Option: A

43. Match List-I with List-II and select the correct answer using the codes given below the lists:
List-I List-II
(a) Merchandise exports I. Purchase of foreign goods
(b) Merchandise imports II. Sales of goods Abroad
(c) Investment Income III. Largely caused by excess of imports in merchandise
(d) Balance of payment deficits IV. Dividends interest etc. Received from abroad
A. A b c d
I II III IV
B. A b c d
II III IV I
C. A b c d
II I IV III
D. A b c d
III IV II I
Answer
Option: C

44. Match List-I with List-II and select the correct answer using the codes given below the lists :
List-I List-II
(a) IBRD I. Uruguay Round
(b) WTO II. ECAFE
(c) ADB III. Bretton Wood
(d) IDA IV. Established by World Bank

A. A b cd
III I II IV
B. A b cd
III I IV II
30
C. A b cd
I III II IV
D. A b cd
I II III IV
Answer
Option: B.

45. A debit balance of payments occurs due to

(i) Low imports and high exports
(ii) High imports and Low exports
(a) Both (i) and (ii) are correct.
(b) Both (i) and (ii) are incorrect.
(c) Only (i) is correct
(d) Only (ii) is correc
Answer
Option: C

46. Assertion (A). Operating style of the international business can be spread to the entire globe.
Reason (R). The style is limited to the international economy only.
A. Both (A) and (R) are true.
B. (A) is true, about (R) is false.
C. (A) is false, but (R) is true.
D. Both (A) and (R) are false.
Answer
Option: A

47. Assertion (A). International Monetary find was set up in 1944.

Reason (R). To promote international monetary cooperation through a permanent institution which
provides Machinery for consultation and collaboration on internationalmonetary problem.
A. Both (A) and (R) are false.
B. Both (A) and (R) are true
C. (A) is true, but (R) is false
D. (R) is true but (A) is false.
Answer
Option: B

48. Purchase of goods from one country with the object of selling than to another country is called.
Trade
A. Import
B. Enterpot
C. Export
D. Indian
Answer
Option: B

49. In which year was the EXIM Bank established?

A. 1982
B. 1983
31
C. 1984
D. 1985
Answer
Option: A

50. Which of the below policy measures would lead to an expansion of exports?
1. Export duty
2. Export subsidy
3. Liberal import entitlement
4. Revaluation of currency
A. 1, 2, and 4
B. 1 and 3
C. 3 and 4
D. 2 and 4
Answer
Option: D 51….

51. According to the Uruguay Round Agreement on TRIPS, patentability may be

A. Diagnostic, therapeutic and surgical methods for the treatment of human
B. Plants and animals other than micro-organisms
C. Essentially biological process for the production of plants and animals
D. All of the above.
Ans-d

52. Consider the following:

1. The Generalised System of Preferences (GSP)
2. A maritime shipping code
3. Special international programmes to help the least developed countries
4. International aid targets.

53. Which association played a key role in the emergence of above mentioned aspects?
A. UNCTAD
B. UNIDO
C. IBRD
D. IDA
Ans—A

54. International Monetary Fund functions as an agency with resources available for shortter mem-
ber countries, which is its aspect.
A. Regulatory
B. Financial
C. Consultative
D. Functional
ANS-A

55. Which of the following is a major function of lmf?

A. Regulatory function
B. Consultative function
32
C. Financial function
D. All of the above
ANS A

56. Consider the following:

1. To conserve foreign exchange
2. To check capital flight
3. To curb consumption
4. To regulate foreign companies
Which of the are the objectives of exchange control?
A. 1 and 2
B. 1, 2 and 3
C. 2, 3 and 4
D. 1,2,3 and 4
ANS-D

57. The internationat monetary system that existed from 1947 to 1971 is generally known as the
A. Par value system
B. Pegged exchange rate system
C. Bretton Woods system
D. Both (A) and (B)
Option: C.

58. Following the Uruguay Round Agreement, GATT was converted from a provisional agreement
into WTO with effect from
A. January 1, 1994
B. April 1, 1994
C. January 1, 1995
D. March 1, 1995
Option: C.

59. What did the Multi fibre Arrangements (MFA) restrict?

A. Imports of textiles to developed economies
B. Exports of cotton to undeveloped economies
C. Imports of cotton to developed economies
D. Exports of jute to developed economies.
Answer
Option: A

60. In the trade between two countries, the gains are divided between nations in a way that depends
on whose
A. Exports are expensive
B. Imports are cheaper
C. Price ratio changes more
D. Both (A) and (B)
Answer
Option: D

33
61. The demand effect of economic development refers to the
A. Increase in demand for imports
B. Increase in demand for exports
C. Decrease in supply of imports
D. Decrease in supply of exports
Answer
Option: A

62. Which of the following is NOT a monetary measure for correction of balance of payments dise-
quilibrium?
A. Monetary expansion / contraction
B. Exchange control
C. Foreign loans
D. Devaluation
Answer
Option: C.

63. Trade measures for correction of balance of payments disequilibrium include

A. Export promotion
B. Import control
C. Both (A) and (B)
D. Import substitution
Answer
Option: C

64. The area where the members remove trade barriers among themselves but keep their separate
national barriers against trade with the outside world, is known as
A. Customs-Union
B. Common Market Area
C. Economic-Union
D. Free-trade Area
Answer
Option: D

65. An economic integration in which member countries unity all their economic policies, including
monetary, fiscal and welfare policies as well as policies toward trade and factoral
Migration, is known as
A. Economic-union
B. Common-market
C. Customs-union
D. Free-trade area
Answer
Option: A

66. If a nation has some monopoly power over world prices, it can reap net gains from
A. Export duty
B. Import duty
C. Both (A) and (B)
34
D. Transit duty
Answer
Option: C

67. [Link] which method, a sum can be transferred from a bank in one country to a bank in another
part of the world by cable?
A. Mail Transfer
B. Telegraphic Transfer
C. Bank Drafts
D. None of the above
Answer
Option: B.

68. Opening by the importer of a credit in favour of the exporter at a bank in the exporter's country,
is a distinctive feature of
A. Foreign bills of exchange
B. Reimbursement method
C. Cheque
D. Bank-Draft
ANS-A

PART 2
1. Bilateral arrangements instituted to restrain the rapid growth of exports of specific manufac-
tured goods, are called
A. Administered protection
B. Voluntary export restraints
C. Imposed export restraints
D. None of the above
Answer
Option:C.

2. Which of the following is NOT true about the International Finance Corporation (IFC)?
A. IFC does not make its investments in partnership with the private investors from the capital ex-
porting country.
B. The minimum investment that the IFC will make in an enterprise is fixed at $10,000
C. Rate of interest in each case would be a matter of negotiations depending on therisk.
D. None of the above.
Answer
Option: A

3. If a commodity X is subject to an import duty of 25% ad valorem, the nominal tariff is

A. 50%
B. 25%
C. 12.5%
D. 2.5%
Answer
Option: B.

35
4. An IMF member may purchase up to the full amount of its reserve tranche anytime
A. Without any condition
B. Subject only to the requirement of balance of payments need
C. Subject only to the requirements of development
D. None of the above
Answer
Option: B

5. Which of the following are included in the permanent facility for specific purpose of IMF?
A. The compensatory and contingency financing facility.
B. The buffer stock financing facility
C. The extended facility
D. All of the above
Answer
Option: D

6. India is not associated with

A. SAARC
B. NAFTA
C. BRICS
D. None of these
Answer
Option: B

7. Consider the following

1. Tariff binding
2. Tariffication
3. Tariff cuts
4. Reduction in subsidies and domestic support
Which of the above are aspects of the Uruguay Round Agreement on agriculture?
A. 1,2 and 3
B. 2,3 and 4
C. 1, 3 and 4
D. 1,2 ,3 and 4
Answer
Option: D

8. According to the credit tranche policy of the IMF, credit is made available in
A. Five tranches, each equivalent to 20% of country's qouta
B. Four tranches, each equivalent to 25% of country's quota
C. Ten tranches, each equivalent to 10% of country's sdrs
D. Four tranches, each equivalent to 25% of country's sdrs
Answer
Option: B.

9. The licence necessary to obtain foreign exchange to pay for the imports, is called
A. Foreign exchange licence
B. Import licence
36
C. Quota licence
D. None of the above
Answer
Option: B

10. Which one is not international Institution?

A. IMF
B. IDA
C. IBRD
D. TRAI
Answer
Option: D

11. The Uruguay Round Agreement deal with subsidies which are
A. Prohibited subsidies
B. Actionable subsidies
C. Non-Actionable subsidies
D. All of the above
Answer
Option: D

12. Under which system of valuation, sdrs were valued in terms of 16 currencies, which were as-
signed specific weights?
A. Standard basket valuation
B. Standard charted valuation
C. Various currencies valuation
D. None of the above
Answer
Option: A

13. Mr. James a citizen of US arrived in India for the first time of 1st July, 2010 and left for Nepal
on 15th Dec. 2010. He arrived to India again on 1st January, 2011 and stayed till the end of the
financial year 2010-11. His residental status for the assessment year 2011-12 is
A. Resident (Ordinarily resident)
B. Not ordinarily resident
C. Non-resident
D. None of the above
Answer
Option: B

14. A tariff fails to restrict imports when the demand for imports is
A. Perfectly price elastic
B. Price inelastic
C. Of unitary price elasticity
D. None of the above
Answer
Option: B

37
15. Which barrier can be used against recession induced exports into the country?
A. Quotas
B. Voluntary export restraints
C. Tariff
D. All of the above
Answer
Option: A

16. The Uruguay Round Agreement deal with subsidies which are
A. Prohibited subsidies
B. Actionable subsidies
C. Non-Actionable subsidies
D. All of the above
Answer
Option: D

17. Under which system of valuation, sdrs were valued in terms of 16 currencies, which were as-
signed specific weights?
A. Standard basket valuation
B. Standard charted valuation
C. Various currencies valuation
D. None of the above
Answer
Option: A

18. Mr. James a citizen of US arrived in India for the first time of 1st July, 2010 and left for Nepal
on 15th Dec. 2010. He arrived to India again on 1st January, 2011 and stayed till the end of the
financial year 2010-11. His residental status for the assessment year 2011-12 is
A. Resident (Ordinarily resident)
B. Not ordinarily resident
C. Non-resident
D. None of the above
Answer Report Discuss
Option:A:.

19. A tariff fails to restrict imports when the demand for imports is
A. Perfectly price elastic
B. Price inelastic
C. Of unitary price elasticity
D. None of the above
Answer
Option: B

20. Which barrier can be used against recession induced exports into the country?
A. Quotas
B. Voluntary export restraints
C. Tariff
D. All of the above
38
 Answer
Option: A.

21. The value of SDR tends to be more stable than that of any single currency in the "Standard bas-
ket valuation" because
A. It is internationally accepted measure
B. It is a weighted average of the exchange rates of the five majorcurrencies.
C. Both (A) and (B)
D. It is an imaginary currency.
Answer
Option: B.

22. Factor Endownment Theory of International Trade was propounded by

A. David Ricardo
B. Bertil-Ohlin
C. J. S. Mill
D. C.P. Kindleberges
Answer
Option: B.

23. Balance of Payment can be made favourable if

A. Exports are increased
B. Imports are increased
C. Devaluation of money
D. (A) and (C).
Answer
Option: D.

24. Which facility was established to provide assistance to members facing payments difficulties
that are large in relation to their economies and their fund quotas?
A. Supplementary Financing Facility (SFF)
B. Compensatory and Contingency Financing Facility (CCFF)
C. Extended Fund Facility (EFF)
D. Bufferstock Financing Facility (BFF)
Answer
Option: A

25. Quotas of all IMF members are reviewed at intervals of

A. Five years
B. Not more than five years
C. Three years
D. Two years
Answer
Option: B

26. What are the characteristics of the loans provided by the International Development Association
(IDA) to member countries?
A. They are on liberal terms with regard to the rate of interest
39
B. They are on liberal terms with regard to the period of repayment
C. They can be repaid in the currency of the member country
D. All of the above
Answer
Option: D

27. Which of the following is the best example of Agreement between Oligopolists
A. GATT
B. OPEC
C. WTO
D. UNIDO
Answer
Option: B

28. Which type of subsidies are provided to industrial research and pro competitive development
activity in disadvantaged regions?
A. Prohibited subsidies
B. Actionable subsidies
C. Non-actionable subsidies
D. None of the above
Answer C

29. Consider the following

1. Changes in quality
2. Changes in compositions
3. Tastes and preferences
4. Price differences
5.
Which of the above impose limitations in the use of price indices to measure theterms of trade?
A. 1 and 2
B. 2 and 3
C. 1,2 and 3
D. 1,2 and 4
Answer D

30. The comparative cost Advantage theory was given by

A. David Ricardo
B. Adam smith
C. Raymond Vernon
D. [Link] E. Parter
Answer
ANS- A

31. India suffered from deficit balance both in trade and balance and not invisibles, hence took up
a number of Steps to manage the problem. Which one is not appropriate for this?
A. Export control
B. Current Account Convertibility
C. Liberalised Export Policy
40
D. Unified Exchange Rate
Answer
Option: A
Explanation : Click on Discuss to view users comments.

32. Which of the following is true about the Board of Governors of IMF?
A. They meet once a year
B. They may vote by mail at other times except the annual meeting
C. Both (A) and (B)
D. They are elected annually
Answer
Option: C

33. Which one of the following is true statement

A. A balance of trade deals with export and import of invisible items only.
B. A balance of payment deals with both visible and invisible items.
C. The current account is not a component of balance of payment.
D. All of the above
Answer
Option: B.

34. In India --- has a predominant share in the debt market.

A. Government Securities
B. Corporate Deposits
C. Corporate Equity
D. Global Depository Receipts
Option: A.
Answer

35. Which of the following is the criteria for approving an IDA credit?
A. Poverty test
B. Performance test
C. Project test
D. All of the above
Option: D

36. Which of the following is NOT true about the borrowings of IMF?
A. The IMF may seek the amount it needs in any currency.
B. The IMF may seek the amount it needs from official entities.
C. The IMF may seek the amount it needs from private sources.
D. None of the above.
Answer C

37. A country making use of the resources of the IMF is generally required to carry out an economic
policy programme aimed at achieving a viable balance of payments positions over an appropri-
ate period of time, which is known as
A. Rationality
B. Conditionality
41
C. Relativity
D. Flexibility
Answer D

38. The companies globalise their operations through defficient means

A. Exporting directly
B. Licensing / Franchising
C. Joint venture
D. All of the above
Answer D

39. Match List-I with List-II and select the correct answer using the codes given below the lists:
List-I List -II
A. International Finance Corporation I. 1956
B. Asian Development Bank II. 1966
C. International DevelopmentAssociation III. 1960
A. A b c
III I II
B. A b c
I III II
C. A b c
I II III
D. A b c
II III I
Answer C

40. How many countries have been undertaken to lend to IMF if there is need to cope with an im-
pairment of the International monetary system?
A. 11
B. 50
C. 15
D. 20
Answer

42
Multiple Choice Questions.
1. A company is affected by two broad set of factors are
A. Local and Regional
B. Regional and National
C. Internal and External
D. Financial and Non-Financial
ANSWER: C

2. _________is a statement which derives the role that an organization plays in a society
A. Goals
B. Mission
C. Objective
D. Success
ANSWER: B

3. Economic Environment refers to all forces which have a____impact on business

A. Political
B. Natural
C. Economic
D. Social
ANSWER: C

4. The of the government covers all those principles ,policies,rules and procedures and control the
industrial enterprise of the economy.
A. Industrial
B. Fiscal
C. Monetary
D. Macro
ANSWER: A

5. _________ environment is beyond the control of the business

A. Internal
B. External
C. Micro
D. Macro
ANSWER: B

6. Micro environment is also called as

A. General environment
B. Operating environment
C. Economic environment
D. Political environment
ANSWER: B

7. _________ environment can be defined as that part of the environment that is concerned with the
entire social system.
A. General environment
B. Operating environment
43
C. Social environment
D. Political environment
ANSWER: C

8. _________ economy is not owned or managed by the government but owned by private individu-
als.
A. Social
B. Capitalist
C. Mixed
D. Macro

9. _________ environment sets the basis for developmental activity of the business system.
A. Financial Environment
B. Technology environment
C. Global environment
D. Macro environment
ANSWER: A

10. _________ audit implies a report on the social performance of business unit.
A. Global
B. Local
C. Natural
D. Social
ANSWER: D

11. External factors affecting a business environment also be referred to factors

A. Controllable
B. Uncontrollable factors
C. Relevant
D. Global
ANSWER: B

12. Study of human population is called as______ environment

A. Political
B. Social
C. Demographic
D. Economic
ANSWER: C

13. In which year the essential commodities act introduced -

A. 1954
B. 1955
C. 1956
D. 1957
ANSWER: B

14. Which is the one not included in national culture

A. Language
44
B. Internet
C. Belief
D. Attitude
ANSWER: B

15. Culture spreads from one place to another and such transmission is called as
A. Difference
B. Reputation
C. Adoption
D. Heritage
ANSWER: A

16. An attitude composed of effect

A. Flextime
B. Cognition
C. Relationship
D. Culture
ANSWER: B

17. What is the main occupation of kshatriyas

A. Engaged in cleanin
B. Engaged in trade
C. Engaged in army work
D. None of the above
ANSWER: C

18. A systematic application of scientific knowledge to practical task is known as_

A. Technology
B. Culture
C. Demographic
D. Legal
ANSWER: A

19. A complete stock taking of all the social activities of the corporation is undertaken in the
approach
A. Inventory
B. Cost outlay
C. Programme management
D. Social benefit
ANSWER: A

20. What are the elements of business ethics

A. Values rights and duties
B. Attitudes pressure and environment
C. Value environment and attitude
D. Responsibilities
ANSWER: A

45
21. Corporate values are the_______of the corporate sector
A. Shared values
B. Moral belie
C. Customer satisfaction
D. Goodwill
ANSWER: B

22. The economic system in which business units or factors of production are privately owned and
governed is called as
A. Capitalism
B. Socialism
C. Democratic
D. Republic
ANSWER: A

23. Under______economic system, all the economic activities of the country are controlled and reg-
ulated by the Government in the interest of the public
A. Capitalism
B. Socialism
C. Democratic
D. Republic
ANSWER: B

24. The economic system in which both public and private sectors co-exist is known as economy
A. Capitalism
B. Socialism
C. Democratic
D. Mixed
ANSWER: D

25. One Reserve Bank of India introduced certificates of deposit in

A. 196
B. 1989
C. 1986
D. 1990
ANSWER: B

26. Fiscal policy refers to the policy of government regarding taxation, public expenditure and
A. Public debt
B. Budgets
C. Policies
D. Deposits
ANSWER: B

27. ______is the process of analyzing the environment for the identification of the factors which have
implication for the business.
A. Scanning
B. Assessment
46
C. Evaluation
D. Information
Answer: a

28. Fiscal policy is called as policy

A. Monetary
B. Budgetary
C. Industrial
D. Economic
ANSWER: B

29. One concept of culture determines the of people

A. Experience
B. Etho
C. Education
D. Wealth
ANSWER: B

30. Self fulfillment and immediate gratification are cultural values

A. Decreases
B. Rises
C. Diminishes
D. Corporate
ANSWER: B

31. National stock exchange was set up as a joint stock company by all Indian financial institution
and banks on November 27
A. 1991
B. 1992
C. 1993
D. 1994
ANSWER: B

32. ______is a very important factor that provides competitive advantage

A. Innovation
B. Modulation
C. Dimension
D. Variation
ANSWER: A

33. Which can be a method of privatization

A. Denationalization
B. Purchasing shares
C. Takeove
D. Merger
ANSWER: A
34. In India liberalization and privatization began from
A. 1991
47
B. 1971
C. 1981
D. 1947
ANSWER: A

35. Industrial policy of 1948 aimed at

A. Industrialization
B. Growth of agriculture
C. Development of infrastructure
D. Development of service sector
ANSWER: A

36. The aim of the private sector is to maximize

A. Loss
B. Profit
C. Import
D. Export
ANSWER: B

37. Which can be possible restrictive trade practice

A. Takeover
B. Merger
C. Price discrimination
D. Monopol
ANSWER: C

38. _____means the proportion of a nation population living in urban areas.

A. Privatization
B. Globalization
C. Urbanization
D. Liberalization
ANSWER: C

39. _____change is a potent fame the reconfiguration of industrial boundaries

A. Technological
B. Economical
C. Organizational
D. Environmental
ANSWER: A

40. Obsolesce scene means______of products

A. Implementation
B. Outdated
C. Assessment
D. Quality
ANSWER: B
41. Corporate contribution to political parties are now been in our country
A. Legalized
48
B. Customized
C. Introduced
D. Authorized
ANSWER:

42. The authority coats to settle

A. Family disputes
B. Legal disputes
C. Personal disputes
D. Business disputes
ANSWER: B

43. The is an introduction to the constitution and contains its basic philosophy.
A. Preamble
B. Society
C. Process
D. Service
ANSWER: A

44. The term fraternity implies the spirit of

A. Brotherhood
B. Judiciary
C. Justice
D. Value
ANSWER: A

45. _____signifies the absence of any arbitrary restraint on the freedom of individual action and
creations for the development of personality of the individual
A. Fraternity
B. Liberty
C. Secularism
D. Socialism
ANSWER:

46. Secularism is understood to mean according equal encouragement to all

A. Country
B. Ethics
C. Values
D. Religion
ANSWER: D

47. _____state can have an elected or hereditary head

A. Democratic
B. Autocratic
C. Socialized
D. Republic
ANSWER: A

49
48. _____is a systematic application of scientific or other organized knowledge to practical task.
A. Technology
B. Society
C. Demography
D. Responsibility
ANSWER: A

49. The era of deregulation liberalization begin in _

A. 1950 - 51
B. 1980
C. 1991
D. 1960
ANSWER: A

50. Identification of companies technological assets that may provide in new businesse
A. Opportunities
B. Development
C. Failure
D. Authority
ANSWER: A

51. The activities involved in bringing raw materials to the factory and end products from there to
the market constitute business
A. Complex
B. Single
C. Multitudinous
D. Varied
ANSWER: A

52. _____occupies the central place in business

A. People
B. Raw material
C. Labor
D. Finished goods
ANSWER: B

53. Businesses represent the organized efforts of enterprises to supply with goods and services
A. Producers
B. Consumers
C. Intermediaries
D. Suppliers
ANSWER: A

54. India is good example for_____economy

A. Socialis
B. Mixed
C. Capitalist
D. Communist
50
ANSWER: B

55. _____are a primary mechanism for motivating business activities

A. Social relationship
B. Profit
C. Customers
D. Assets
ANSWER: A

56. According to whom, business environment is defined as total of all things external to firms and
industries effect
Their organization and operations
A. [Link]
B. John wick
C. [Link]
D. Mathew smith
ANSWER: A

57. Business includes

A. Non-economic activities
B. Economic activities
C. Social activities
D. Production activities
ANSWER: B

58. Is business a vast and fascinating subject

A. Technolog
B. Profit making
C. Change
D. People
ANSWER: A

59. What is the single word that can best describe todays business
A. Technology
B. Profit Making
C. Change
D. People
ANSWER: C

60. How many main characteristics the todays businesses have

A. Six
B. Four
C. Ten
D. Eight
ANSWER: D

61. Which of the following modern business is dynamic

A. Mass production
51
[Link] marketing
[Link] sales
[Link] purchase
ANSWER: A

62. Which of the following is not an economic activity

A. A doctor practicing
B. A lawyer practicing la
C. A professional cricketer playing cricket
D. A student playing cricket
ANSWER: D

63. A valid definition of a business purpose is to

A. Create a customer
B. Maximize profits
C. Serve the society
D. Increase the wealth in the firm
ANSWER: A

64. Is todays business is not characterized by diversification

A. Social relationship
B. Profit
C. Customers
D. Assets
ANSWER: B

65. Does internationalization of business is a mean of sustaining a strong domestic base in term of
technology,
Product, market and capital over a longer period
A. Six
B. Four
C. Ten
D. Eight
ANSWER: A

66. Environment is very significantly influenced by the world trade organization principles and
agreements.
A. Economi
B.
C. Global
D. Legal
E. Political
ANSWER: B

67. 1s ties interference of government in business was on the ascendancy

A. Mission objectives
B. Mission targets
C. Mission objectives target
52
D. Target
ANSWER: C

68. Refers to the system of moral principles and rules of conduct applied to business
A. Business culture
B. Business ethics
C. Business
D. Society
ANSWER: B

69. Competition is beneficial to the competing firms besides benefiting the

A. Producers
B. Intermediaries
C. Finances
D. Consumers
ANSWER: D

70. What are the main concepts concerning about business goals (or) objectives
A. Mission objectives
B. Mission target
C. Labor
D. Market
ANSWER: C

71. Mission is a statement which defines the role that plays in a society
A. People
B. Organization
C. Labour
D. Market
ANSWER: B

72. Does the targets will have much longer time span
A. People
B. Organization
C. Labor
D. Market
ANSWER: B

73. Goals realization continuously will lead to

A. Mission fulfillment
B. Maximize customers
C. High revenue
D. Maximize suppliers
ANSWER: A

74. Is the primary motive for a business enterprise

A. Profit
B. Maximize customers
53
C. Human objectiv
D. Maximize suppliers
ANSWER: A

75. The following statement with respect to culture is false

A. Culture is enduring
B. Culture is changing
C. Culture is evolved among the members of a society
D. Culture is determined by national boundaries
ANSWER: D

76. Is the business through which new ideas and innovations are given a sharp and are converted
into useful
Products and services
A. Market Leadership
B. Challenge
C. Joy of Creation
D. Growth
ANSWER: C

77. Pollution can be minimized by using low sulphur coal in industries.

A. Noise
B. Air
C. Water
D. Maco
ANSWER: B

78. Liberalization means

A. Reducing number of reserved industries from 17 to 8
B. Liberating the industry, trade and economy from unwanted restrictions
C. Opening up of economy to the world by attaining international competitiveness
D. Free determination of interest rate
ANSWER: B

79. What are the elements of business environment

A. Micro Environment
B. Macro Environment
C. Complex Environment
D. STEEPLE factor
ANSWER: D

80. Macro environment is also known as

A. Direct environment
B. Indirect environment
C. Competitive environment
D. Social environment
ANSWER: B

54
81. Is micro environment is also known as direct environment
A. Economic
B. Political & Legal
C. Competitors
D. Suppliers
ANSWER: A

82. Macro environment consist of

A. Public
B. Political & legal
C. Suppliers
D. Customers

83. The macro environment consists of

A. Economic Political &Legal
B. Consumer competitors
C. Public
D. Middlemen
ANSWER: A

84. What does micro environment consists of

A. Economic
B. Political &legal
C. Consumers competitors
D. Demographic
ANSWER: C

85. The micro environment consists _

A. Technological Environment
B. Political Environment
C. Economic Environment
D. Public middlemen consumers & competitors
ANSWER: D

86. Refers to all forces which have an economic impact

A. Technological Environment
B. Political Environment
C. Economic Environment
D. Social Environment
ANSWER: C

87. Political environments refers to the influence excreted by the political Institution
A. 2
B. 3
C. 4
D. 5
ANSWER: B

55
88. What are the bodies which political environment consists of
A. Middlemen
B. Suppliers
C. Customer
D. Legislature Executive & Judiciary
ANSWER: D

89. Decides on a particular course of action

A. Legislature
B. Executive
C. Judiciary
D. Public
ANSWER: A

90. Is also called government which implements whatever is decided by the parliament
A. Legislature
B. Executive
C. Judiciary
D. Public
ANSWER: B

91. Plays the watch dog in order to ensure that both function in public interest and within the bound-
aries of
Constitution
A. Legislatur
B. Executive
C. Judiciary
D. Public
ANSWER: C

92. Is a stable and dynamic political environment is indispensable for business growth
A. 2
B. 3
C. 4
D. 5
ANSWER: B

93. How many goals do the environment analysis has

A. 2
B. 3
C. 4
D. 5
ANSWER: B

94. Should facilitate & enhance strategies thinking in organization

A. Strategic management
B. Environmental analysis
C. Business environment
56
D. Business analysis
ANSWER: B

95. The environment analysis that provides inputs for strategies decision making is _
A. Strategic management
B. Environmental analysi
C. Business environment
D. Business analysis
ANSWER: A

96. The first MNC came to India in

A. A. 1920
B. B. 1921
C. C. 1919
D. D. 1923
ANSWER: B

97. An effective crisis management plan will

A. Minimize the seriousness of the problem
B. Exaggerate minor incident
C. Use the internet to convey the public affairs message
D. Immediately apologize to the public and accept any liability
ANSWER: A

98. Economic growth can be measured by

A. The CPI
B. The CBI
C. GDP
D. MPC
ANSWER: C

99. An increase in interest rates _

A. Is likely to reduce savings
B. Is likely to reduce the external value of the currency
C. Leads to a shift in the mec schedul
D. Leads to a movement along the MEC schedule
ANSWER: D

100. The accelerator assumes

A. The marginal propensity to consume is constant
B. The economy is at full employment
C. There is a constant relationship between net investment and the rate of change of output
D. The multiplier is constant
ANSWER: C

101. Refers to the density of competition among firms

A. Intensity of realty
B. Competitiveness
57
[Link] competition
[Link]
ANSWER: A

102. Identifies the early signals of possible environment changes

A. Scanning
B. Monitoring
C. Forecasting
D. Assessing
ANSWER: A

103. Involves tracking environment trend, sequence of events (or) streams of activities
A. Scanning
B. Monitoring
C. Forecasting
D. Assessin
ANSWER: B

104. Is concerned with developing projection of direction, scope, speed & intensity of environmen-
tal change
A. Scanning
B. Monitoring
C. Forecasting
D. Assessing
ANSWER: B

105. Does the assessment involves identifying &evaluating how & why current & projected environ-
ment change
Which effect strategic management of the organization
A. U.S.A
B. U.K
C. Russia
D. Africa
ANSWER: A

106. The scholar made research in the food canning market is

A. Informal research
B. Formal research
C. Indirect viewing
D. Conditioned Viewing
ANSWER: B

107. The relation between TRIPS and WIPO conventions is

A. WIPO conventions are more valid
B. TRIPS agreement excludes subjects covered by WIPO conventions
C. TRIPS agreement is subordinate to WIPO convention
D. TRIPS agreement incorporates substantive provisions of WIPO conventions
ANSWER: D
58
108. Involves a degree of purposefulness by manager as he receives information inputs
A. Informal research
B. Formal research
C. Indirect viewing
D. Conditioned viewing
ANSWER: D

109. Refers to the managers exposure & perception of information that has no specific purpose
A. Informal research
B. Formal research
C. Indirect viewing
D. Conditioned viewing
ANSWER: C

110. Porters model represents the relationship between

A. Organizational and environment
B. Society and environment
C. Organization and society
D. Society and industry
ANSWER: A

111. Environment refers to all economic factors which have a bearing on the functioning of a busi-
ness
A. Economic
B. Technological
C. Natural
D. Socia
ANSWER: A

112. Free trade is based on the principle of

A. Comparative advantage
B. Comparative scale
C. Economies of advantage
D. Production possibility advantage
ANSWER: A

113. The first five year plan was given in which year
A. 1952
B. 1950
C. 1951
D. 1953
ANSWER: C

114. The second five year plan was given during 1956 regarding _
A. Legal planning
B. Soviet planning
C. Government planning
59
D. Agricultural planning
ANSWER: A

115. Capitalism stresses the philosophy of individualism believing in private Ownership comes un-
der _
A. Legal planning
B. Soviet planning
C. Government planning
D. Agricultural planning
ANSWER: A

116. During which year Marxism was not followed in Russia and china
A. 1952
B. 1950
C. 1951
D. 1953
ANSWER: B

117. In which year socialism the tools production are not managed by government
A. 1952
B. 1950
C. 1951
D. 1953
ANSWER: B

118. In capitalism losses assumed by the customers

A. Economics
B. Technological
C. Natural
D. Social
ANSWER: B

119. In capitalism profits and wages are in relation to ones ability

A. Legal planning
B. Soviet planning
C. Government planning
D. Agricultural planning
ANSWER: D

120. Depreciation is permitted in communis

A. Legal planning
B. Soviet planning
C. Government planning
D. Agricultural planning
ANSWER: B
121. Marxism is otherwise called as
A. Socialism
B. Economics
60
C. Communism
D. Capitalism
ANSWER: A

122. In communism the state determines ones employer and employment

A. Socialism
B. Economics
C. Communism
D. Capitalism
ANSWER: A

123. The October revolution of 1917 saw for the first time emergence of a state based on prin-
ciples
A. Marxist
B. Communist
C. State
D. Public
ANSWER: A

124. Weakness of Marxism is the acceptances of individual freedom

A. Marxist
B. Communist
C. State
D. Communities
ANSWER: A

125. The socialism seems to fall between capitalism and communism

A. Increased
B. Decreased
C. Medium
D. Low level
ANSWER: A

126. One of the long term objectives of the five year plan is reducing inequalities of wealth and in-
come
A. Increased
B. Decreased
C. Medium
D. Low level
ANSWER: A

127. Has the per capita income increased or decreased from 1980 to 2009
A. Increased
B. Decreased
C. Medium
D. Narrow
ANSWER: A

61
128. Population is a component of the total environment
A. Economic
B. Socia
C. Natural
D. Technology
ANSWER: A

129. Which plan gives priority for family planning

A. State Policy
B. Judicial Policy
C. Industrial
D. Energy
ANSWER: A

130. Governments policy towards industries is called as

A. Economic policy
B. Industrial policy
C. Monetary policy
D. Work policy
ANSWER: B

131. Industrial policy was set up in the year

A. 1955
B. 1956
C. 1957
D. 1958
ANSWER: B

132. One of the objectives of industrial policy is to accelerate the rate of economic Growth and speed
up
Industrialization
A. 1955
B. 1956
C. 195
D. 1958
ANSWER: A

133. Announcement of a new industrial policy was done by [Link] RAO in the year
A. 1989
B. 1990
C. 1991
D. 1995
ANSWER: C

134. MRTP act was set up in the year

A. 1950
B. 1951
C. 1952
62
D. 1953
ANSWER: A

135. The liberalization of the rules relating to FDI permitting % equity in wide range of Industries
A. 50
B. 51
C. 53
D. 52
ANSWER: B

136. A license is a permission issued by the government to an industrial undertaking

A. Oral
B. Written
C. Verbal
D. Non verba
ANSWER: B

137. In some circles a multinational corporations is referred to

A. Multinational collaboration
B. Multinational entity
C. Multinational enterprises
D. Multinational development
ANSWER: C

138. The legislative frame work for industrial licensing is provided by the development and Regula-
tion act
A. Industries
B. Small scale
C. Labor
D. Owner
ANSWER: A

139. Multinational corporations is also referred to

A. Multinational collaboration
B. Multinational entity
C. Transnational corporation
D. Multinational development
ANSWER: C

140. FERA is foreign exchange regulation act for

A. Industries
B. Small scale
C. Labor
D. Owner
ANSWER:
141. ICPE is Indian center for public enterprises for
A. Industries
B. Small scale
63
C. Labor
D. Owner
ANSWER: B

142. GDP is _
A. Gross Domestic Product
B. Gross Domestic Percentage
C. Gross Domestic Personnel
D. Gross Domestic Public
ANSWER: A

143. PSU is
A. Private Sector Unit
B. Private Serious Unit
C. Private Steel Unit
D. Private Scale Unit
ANSWER: A

144. SAOIL is
A. Steel authority of India ltd
B. School authority of India ltd
C. State authority of India ltd
D. Span authority of India ltd
ANSWER: A

145. NDP is
A. Net Domestic Product
B. Net Domestic Percentage
C. Net Domestic Personnel
D. Net Domestic Public
ANSWER: A

146. Who gave a practical shape to privatization

A. Margrat thatcher
B. Louis peter
C. Williams
D. Fayol
ANSWER: A

147. In privatization SIP refers to

A. Share issue privatization
B. Shares in privatization
C. Share industry privatization
D. Share institution privatization
ANSWER: A

148. The techniques of privatization are contract and concession

A. Building
64
B. Free
C. Leases
D. Hire purchase
ANSWER: C

149. In 1993 committee was appointed by the government to recommend few measures for effective
privatization
A. Rangarajan
B. Soundarajan
C. Thangarajan
D. Ramarajan
ANSWER: A

65
Basic accounting principles

A number of basic accounting principles have been developed through common usage. They
form the basis upon which the complete suite of accounting standards have been built. The
best-known of these principles are as follows:

Accrual principle. This is the concept that accounting transactions should be recorded in the
accounting periods when they actually occur, rather than in the periods when there are cash
flows associated with them. This is the foundation of the accrual
basis of accounting. It is important for the construction of financial statements that show what
actually happened in an accounting period, rather than being artificially delayed or accelerated
by the associated cash flows. For example, if you ignored the accrual principle, you would
record an expense only when you paid for it, which might incorporate a lengthy delay caused by
the payment terms for the associated supplier invoice.

Conservatism principle. This is the concept that you should record expenses and liabilities as
soon as possible, but to record revenues and assets only when you are sure that they will
occur. This introduces a conservative slant to the financial statements that may yield lower
reported profits, since revenue and asset recognition may be delayed for some time.
Conversely, this
principle tends to encourage the recordation of losses earlier, rather than later. This concept
can be taken too far, where a business persistently misstates its results to be worse than is
realistically the case.

Consistency principle. This is the concept that, once you adopt an accounting principle or
method, you should continue to use it until a demonstrably better principle or method comes
along. Not following the consistency principle means that a business could continually jump
between different accounting treatments of its transactions that makes its long-term
financial results extremely
difficult to discern.

Cost principle. This is the concept that a business should only record its assets, liabilities, and
equity investments at their original purchase costs. This principle is becoming less valid, as a
host of accounting standards are heading in the direction of adjusting assets and liabilities
to their fair values.

Economic entity principle. This is the concept that the transactions of a business should be
kept separate from those of its owners and other businesses. This prevents intermingling of
assets and liabilities among multiple entities, which can cause consider able difficulties when
the financial statements of a fledgling business are first audited.

Full disclosure principle. This is the concept that you should include in or alongside the
financial statements of a business all of the information that may impact a reader’s
understanding of those statements. The accounting standards have greatly amplified upon
this concept in specifying an enormous number of informational disclosures.

Going concern principle This is the concept that a business will remain in operation for the
foreseeable future. This means that you would be justified in deferring the recognition of some
66
expenses, such as depreciation, until later periods. Otherwise, you would have to recognize all
expenses at once and not defer any of them.

Matching principle. This is the concept that, when you record revenue, you should record
all related expenses at the same time. Thus, you charge inventory to the cost of goods sold
at the same time that you record revenue from the sale of those inventory
items. This is a cornerstone of the accrual basis of accounting. The cash basis of accounting
does not use the matching the principle.

Materiality principle. This is the concept that you should record a transaction in the accounting
records if not doing so might have altered the decision-making process of someone reading the
company's financial statements. This is quite a vague concept that is difficult to quantify,
which has led some of the more picayune controllers to record even the smallest
transactions.

Monetary unit principle. This is the concept that a business should only record transactions
that can be stated in terms of a unit of currency. Thus, it is easy enough to record the purchase
of a fixed asset, since it was bought for a specific price, whereas the
value of the quality control system of a business is not recorded. This concept keeps a
business from engaging in an excessive level of estimation in deriving the value of its assets
and liabilities.

Reliability principle. This is the concept that only those transactions that can be proven should
be recorded. For example, a supplier invoice is solid evidence that an expense has been
recorded. This concept is of prime interest to auditors, who are constantly in search of the
evidence supporting transactions.

Revenue recognition principle. This is the concept that you should only recognize revenue
when the business has substantially completed the earnings process. So many people have
skirted around the fringes of this concept to commit reporting fraud that a variety of standard-
setting bodies have developed a massive amount of information about what constitutes
proper revenue recognition.

Time period concept. This is the concept that a business should report the results of its
operations over a standard period o f time. This may qualify as the most glaringly obvious of all
accounting principles, but is intended to create a standard set of comparable periods, which
is useful for trend analysis.

Definition and introduction

The worldview of accounting and accountants may certainly involve some unhelpful characters
poringover formidable figures stacked up in indecipherable columns.
However, a short and sweet description of accounting does exist:
Accounting is the language of business efficiently communicated by well-organised and honest
professionalscalled accountants.

A more academic definition of accounting is given by the American Accounting Association:

The process of identifying, measuring and communicating economic information to permit informed
judgments and decisions by users of the information. The American Institute of Certified Public
67
Accountants defines accounting as:
The art of recording, classifying, summarising in a significant manner and in terms of money,
transactions andevents which are, in part at least of financial character, and interpreting the results
thereof.

Accounting not only records financial transactions and conveys the financial position of a business
enterprise; it also analyses and reports the information in documents called “financial statements.”
Recording every financial transaction is important to a business organisation and its creditors and
investors. Accounting uses a formalised and regulated system that follows standardised principles
andprocedures.

The job of accounting is done by professionals who have educational degrees acquired after years
of study. While a small business may have an accountant or a bookkeeper to record money
transactions, alarge corporation has an accounts department, which supplies information to:
• Managers who guide the company.
• Investors who want to know how the business is doing.
• Analysts and brokerage firms dealing with the company’s stock.
• The government, which decides how much tax should be collected from the company.

Accounting Principles
Obviously, if each business organisation conveys its information in its own way, we will have a babel
of unusable financial data. Personal systems of accounting may have worked in the days when most
companies were owned by sole proprietors or partners, but they do not anymore, in this era of joint
stock companies.
These companies have thousands of stakeholders who have invested millions, and they need a
uniform, standardised system of accounting by which companies can be compared on the basis of
their performance and value.
Therefore, accounting principles based on certain concepts, convention, and tradition have been
evolved by accounting authorities and regulators and are followed internationally.
These principles, which serve as the rules for accounting for financial transactions and preparing
financial statements, are known as the “Generally Accepted Accounting Principles,” or GAAP.
The application of the principles by accountants ensures that financial statements are both
informative and reliable.

It ensures that common practices and conventions are followed, and that the common rules and
procedures are complied with. This observance of accounting principles has helped developed a
widelyunderstood grammar and vocabulary for recording financial statements.
However, it should be said that just as there may be variations in the usage of a language by two
people living in two continents, there may be minor differences in the application of accounting rules
and procedures depending on the accountant.
For example, two accountants may choose two equally correct methods for recording a particular
transaction based on their own professional judgement and knowledge.
Accounting principles are accepted as such if they are (1) objective; (2) usable in practical situations;
(3) reliable; (4) feasible (they can be applied without incurring high costs); and (5) comprehensible to
those with a basic knowledge of finance.
Accounting principles involve both accounting concepts and accounting conventions. Here are brief
explanations.

68
Accounting Concepts
1. Business entity concept: A business and its owner should be treated separately as far as their
financial transactions are concerned.
2. Money measurement concept: Only business transactions that can be expressed in terms of
money are recorded in accounting, though records of other types of transactions may be kept
separately.
3. Dual aspect concept: For every credit, a corresponding debit is made. The recording of a
transactionis complete only with this dual aspect.
4. Going concern concept: In accounting, a business is expected to continue for a fairly long time
and carry out its commitments and obligations. This assumes that the business will not be
forced to stopfunctioning and liquidate its assets at “fire-sale” prices.
5. Cost concept: The fixed assets of a business are recorded on the basis of their original cost in
the first year of accounting. Subsequently, these assets are recorded minus depreciation. No
rise or fall in market price is taken into account. The concept applies only to fixed assets.
6. Accounting year concept: Each business chooses a specific time period to complete a cycle of
the accounting process—for example, monthly, quarterly, or annually—as per a fiscal or a
calendar year.
7. Matching concept: This principle dictates that for every entry of revenue recorded in a given
accounting period, an equal expense entry has to be recorded for correctly calculating profit or
loss in a given period.
8. Realisation concept: According to this concept, profit is recognised only when it is earned. An
advance or fee paid is not considered a profit until the goods or services have been delivered to
thebuyer.

Accounting Conventions
There are four main conventions in practice in accounting: conservatism; consistency; full
disclosure; and materiality.

Conservatism is the convention by which, when two values of a transaction are available, the lower-
value transaction is recorded. By this convention, profit should never be overestimated, and there
should always be a provision for losses.

Consistency prescribes the use of the same accounting principles from one period of an accounting
cycle to the next, so that the same standards are applied to calculate profit and loss.

Materiality means that all material facts should be recorded in accounting. Accountants should
recordimportant data and leave out insignificant information.

Full disclosure entails the revelation of all information, both favourable and detrimental to a business
enterprise, and which are of material value to creditors and debtors. Basic AccountingTermsHere is
a quick look at some important accounting terms.

Accounting equation: The accounting equation, the basis for the double-entry system (see below),
is written as follows:
Assets = Liabilities + Stakeholders’ equity
This means that all the assets owned by a company have been financed from loans from creditors
and from equity from investors. “Assets” here stands for cash, account receivables, inventory, etc.,
that a company possesses.
69
Accounting methods: Companies choose between two methods—cash accounting or accrual
accounting. Under cash basis accounting, preferred by small businesses, all revenues and
expenditures at the time when payments are actually received or sent are recorded. Under accrual
basis accounting, income is recorded when earned and expenses are recorded when incurred.

Account receivable: The sum of money owed by your customers after goods or services have been
delivered and/or used.

Account payable: The amount of money you owe creditors, suppliers, etc., in return for goods and/or
services they have delivered.

Accrual accounting: See “accounting methods.”

Assets (fixed and current): Current assets are assets that will be used within one year.
For example, cash, inventory, and accounts receivable (see above). Fixed assets (non-current) may
provide benefits to a company for more than one year—for example, land and machinery.

Balance sheet: A financial report that provides a gist of a company’s assets and liabilities and
owner’s equity at a given time.

Capital: A financial asset and its value, such as cash and goods. Working capital is current assets
minus current liabilities.

Cash accounting: See “accounting methods.”

Cash flow statement: The cash flow statement of a business shows the balance between the
amount of cash earned and the cash expenditure incurred.

Credit and debit: A credit is an accounting entry that either increases a liability or equity account or
decreases an asset or expense account. It is entered on the right in an accounting entry. A debit is
an accounting entry that either increases an asset or expense account or decreases a liability or
equity account. It is entered on the left in an accounting entry.

Double-entry bookkeeping: Under double-entry bookkeeping, every transaction is recorded in at

least two accounts—as a credit in one account and as a debit in another.
For example, an automobile repair shop that collects Rs. 10,000 in cash from a customer enters this
amount in the revenue credit side and also in the cash debit side. If the customer had been given
credit,“account receivable” (see above) would have been used instead of “cash.” (Also see “single-
entry bookkeeping,” below.)

Financial statement: A financial statement is a document that reveals the financial transactions of
a business or a person. The three most important financial statements for businesses are the
balance sheet, cash flow statement, and profit and loss statement (all three listed here
alphabetically).

General ledger: A complete record of financial transactions over the life of a company.
Journal entry: An entry in the journal that records financial transactions in the chronological order.

70
Profit and loss statement (income statement): A financial statement that summarises a company’s
performance by reviewing revenues, costs and expenses during a specific period.

Single-entry bookkeeping: Under the single-entry bookkeeping, mainly used by small or businesses,
incomes and expenses are recorded through daily and monthly summaries of cash receipts and
disbursements. (Also see “double-entry bookkeeping,” above.)

Types of accounting: Financial accounting reports information about a company’s performance to

investors and credits. Management accounting provides financial data to managers for business
development.

Financial Accounting | Basic Concepts and Principles

Definition and introduction
Profit, it has been said often, is the sole objective of business. Therefore, for those running a
business, information about the financial performance of the enterprise is a most important
requirement.

This information is not available easily and can be obtained only by systematically recording,
classifying, and summarising all the business transactions. The branch of accounting that
accomplishes these tasks under internationally standardised procedures is called financial
accounting.

However, financial accounting is not limited to recording, classifying, and summarizing information
about business transactions. It also deals with reporting this information to stakeholders outside
the organisation, such as investors and creditors, who are the important, primary recipients of the
information.

There may be secondary recipients, too, such as competitors, customers, employees, and stock-
market analysts, but the information generated by financial accounting is mainly aimed at external
stakeholders who are not part of the business organisation per se.
Therefore, to put together a formal definition of financial accounting, it is a specialized branch of
accounting that records and reports information about the financial position and performance of a
company, mainly for use by the business entity’s external stakeholders.
How does financial accounting achieve its tasks? Financial accounting mainly generates three
financial statements to provide the information required—the balance sheet, income statement, and
cash flow statement.

These documents provide the stakeholders a clear idea about the performance of the business
during aparticular period and its financial position at a specific time. The objective of the financial
accountants is not to estimate the value of a company but to facilitate this valuation by others.
According to the International Financial Reporting Standards, financial accounting provides
information about a business organisation that is useful to existing and potential investors, lenders,
andother creditors in making decisions about providing resources to the organisation.
Objectives

The objectives of financial accounting can be put in four categories, as follows:

• Record financial transactions as and when they occur (bookkeeping), so that the data can be
analyzed for preparing financial statements
71
 • Calculate profit or loss, to enable management to take course-correction strategies if required
• Ascertain the financial strength of the company by determining its assets and liabilities
• Communicate the information to stakeholders through statements and reports, so that these
stakeholders can take appropriate decisions on their investments in the business
For meeting these objectives, financial accountants mainly prepare three types of documents, as
briefly mentioned in the introduction above—the balance sheet, which reflects the assets and
liabilities; incomestatement, which shows the profit and loss; and, cash flow statement, which charts
the cash inflow and outflow.
The external users of financial statements look at the balance sheet to find out how strong the
business is, financially (assets vs. liabilities), and at the income statement to find out how well the
business is doing (profit vs. loss).

Creditors and other lenders would be happy to see a positive balance sheet so that they know their
investments are safe, and investors would like to see an income sheet with profit so that they know
some money would be coming to them from the company in the form of dividend or interest.
Almost all stakeholders want to see the cash flow statement to know the cash availability with the
company and whether it will be able to clear its liabilities.
Among the internal users of financial statements are managers, who can take decisions on the basis
of the financial statements, and among the external users are government authorities, who can
initiate tax measures.
Here are some additional notes on the three financial statements mentioned above.

Balance sheet: The balance sheet of a company shows its assets, liabilities, and stockholders’ equity
as on the last day of the accounts-reporting period. Assets include cash, stocks, buildings, and
machinery, while liabilities include loans, interest, and wages. Stockholders’ equity is the difference
between the assets and the liabilities. Read more about balance sheets.

Income statement: The income statement (issued quarterly or annually) reports the company’s
profitability in a given period. It presents the revenues (sales and service revenues), expenses
(operating expenses, such as wages and rent, and non-operating expenses, such as loan interest),
gains, and losses. Read more on Profit and Loss.

Cash flow statement: The cash statement shows the inflow and outflow of cash and its use for
operating, financing, and investing activities. Here are some details on the cash flow statement.

Concepts of Financial Accounting

At the core of financial accounting is the double-entry accounting method, by which each financial
transaction is entered in at least two accounts (assets, liabilities, and expenses are examples of
accounts)—as a debit in one account and as a credit in another account.
“Debit” simply means to enter a transaction on the left side of an account, and credit means to enter
a transaction on the right side. A debit increases some accounts and decreases some others.
Similarly, a credit increases some accounts and decreases some others.
Imagine that a company takes a bank loan. Under the double-entry system, this transaction has to
be entered as a credit in one account and as a debit in another account. Bolstered by the loan, the
company’s cash/assets increase, and this transaction, where the assets have increased, is a debit
transaction. Therefore, it is entered as a debit transaction under the assets account.
However, with the loan, the company’s liabilities also increase, and this transaction, where the

72
liabilities have increased, is a credit transaction. So, it is entered as a credit transaction under the
liabilities account. This procedure is followed under the double-entry system of accounting.
Information about which accounts to credit or debit for each transaction is available from online
resources on accounting. For example, an increase in expense and a decrease in income are always
debit entries, and a decrease in assets and an increase in liabilities are always credit entries.
An important aspect to remember is that debiting an account does not always mean decreasing it,
nor does crediting an account always mean increasing it.

Each credit should be balanced by a debit, and vice versa (it is not a question of balancing each
increase in an account with a decrease in another account).
The advantage of double-entry accounting is that it helps keep the accounting equation (assets =
liabilities + stockholders’ equity) always balanced. If a company records its accounts accurately, the
left side of the equation will match the right side.

Another cornerstone of financial accounting is the accrual accounting system, by which revenues
and expenses are recorded in the financial statements when they are earned or incurred, not when
the cashcomes in or goes out, as is done under the cash accounting system.
The accrual system ensures that the statements reflect the financial position of the company
accurately, and that there is no overestimation of revenue or profits.

Principles of Financial Accounting

As discussed in the post “Accounting basics,” the rules of accounting, including financial accounting,
have been standardised to achieve the following goals:
1. Objectivity: Financial statements should be free from bias, and financial accountants should
scrupulously follow the principle of objectivity.
2. Usability: Users of financial documents should be able to depend on them—the documents
shouldfacilitate decision-making.
3. Materiality: Omission of data from financial statements will mislead financial decision-
makers; therefore, all important data should be recorded and misstatement of facts avoided.
4. Comparability: Financial statements should enable users to compare the performances of
companies, and the documents should follow the standards set internationally.
Financial Accounting Standards

Most or all of the general principles of accounting apply to financial accounting, too. These
principles are kept in mind in the preparation of financial statements under the “Generally Accepted
AccountingPrinciples,” or GAAP, followed internationally.
In India, financial accounting standards are notified by the Ministry of Corporate Affairs in tune with
the guidelines of the International Financial Reporting Standards.

A new set of standards known as “Indian Accounting Standards,” or “Ind AS,” is about to be
implemented in the country.

Comparison: Financial vs Management vs Cost Accounting

A final word on financial accounting: it differs from management accounting and cost accounting in
that it mainly caters to external stakeholders, such as investors.

Management accounting, however, is intended for a company’s internal use and provides managers
with the information necessary for taking steps to improve the performance of their company.
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The objective of cost accounting, which is also an internal tool, is to calculate the cost of production
andhelp managers come up with cost-reduction ideas.

Partnership Accounting
Except for the number of partners' equity accounts, accounting for a partnership is the same as
accounting for a sole proprietor. Each partner has a separate capital account for investments and
his/her share of net income or loss, and a separate withdrawal account. A withdrawal account is
used to track the amount taken from the business for personal use. The net income or loss is added
to the capital accounts in the closing process. The withdrawal account is also closed to the capital
account in the closing process.

Asset contributions to partnerships

When a partnership is formed or a partner is added and contributes assets other than cash, the
partnership establishes the net realizable or fair market value for the assets. For example, if the
Walking Partners company adds a partner who contributes accounts receivable and equipment
from an existing business, the partnership evaluates the collectability of the accounts receivable
andrecords them at their net realizable value. An existing valuation reserve account (usually
called allowance for doubtful accounts) would not be transferred to the partnership as the partner
would establish its own reserve account. Similarly, any existing accumulated depreciation
accounts are not assumed by the partnership. The partnership establishes and records the
equipment at itscurrent fair market value and then begins depreciating the equipment over its
useful life to the partnership.

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Income allocations
The partnership agreement should include how the net income or loss will be allocated to the
partners. If the agreement is silent, the net income or loss is allocated equally to all partners.
As partners are the owners of the business, they do not receive a salary but each has the right
to withdraw assets up to the level of his/her capital account balance. Some partnership
agreements refer to salaries or salary allowances for partners and interest on investments.
These are not expenses of the business, they are part of the formula for splitting net income.
Many partners use the components of the formula for splitting net income or loss to determine
how much they will withdraw in cash from the business during the year, in anticipation of their
share of net income. If the partnership uses the accrual basis of accounting, the partners pay
federal income taxes on theirshare of net income, regardless of how much cash they actually
withdraw from the partnership during the year.

Once net income is allocated to the partners, it is transferred to the individual partners' capital
accounts through closing entries. For example, assume Dee's Consultants, Inc., a partnership,
earned $60,000 and their agreement is that all profits are shared equally. Each of the three
partners would be allocated $20,000 ($60,000 ÷ 3). The journal entry to record this allocation of
netincome would be:

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Remember that allocating net income does not mean the partners receive cash. Cash is paid to
a partner only when it is withdrawn from the partnership.

In addition to sharing equally, net income may also be split according to agreed upon
percentages (for example, 50%, 40%, and 10%), ratios ([Link]), or fractions ( 1/ 3, 1/ 3, and 1/ 3) .
Using Dee's Consultants net income of $60,000 and a partnership agreement that says net
income is shared 50%, 40%, and 10% by its partners, the portion of net income allocated to each
partner is simply the $60,000 multiplied by the individual partner's ownership percentage. Using
this information, thesplit of net income would be:

Using the [Link] ratio, first add the numbers together to find the total shares (six in this case)
andthen multiply the net income by a fraction of the individual partner's share to the total parts
( 2/ 6, 3/ 6, and 1/ 6). Using the three ratios, the $60,000 of Dee's Consultants net income would
besplit as follows:

Using the fractions of 1/ 3, 1/ 3, and 1/ 3, the net income would be split equally to all three partners,
and each partner's capital account balance would increase by $20,000.
Assume the partnership agreement for Dee's Consultants requires net income to be allocated
based on three criteria, including: salary allowances of $15,000, $12,000, and $5,000 for Dee,
Sue,and Jeanette, respectively; 10% interest on each partner's beginning capital balance; and
any remainder to be split equally. Using this information, the $60,000 of net income would be
allocated

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$21,000 to Dee, $20,000 to Sue, and $19,000 to Jeanette. Information from the owners' capital
accounts shows the following activity:

The investments and withdrawal activity did not impact the calculation of net income because
they are not part of the agreed method to allocate net income. As can be seen, once the salary
and interest portions are determined, they are added together to determine the amount of the
remainderto be allocated. The remainder may be a positive or negative amount.

Assume the same facts as above except change net income to $39,000. After allocating the
salaryallowances of $32,000 and interest of $16,000, too much net income has been allocated.
The difference between the $48,000 allocated and the $39,000 net income, a decrease of $9,000,
is the remainder to be allocated equally to each partner. These assumptions would result in
allocations of netincome to Dee of $14,000, Sue of $13,000, and Jeanette of $12,000. The
calculations are as shown:

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Admission of a Partner: Goodwill, Revaluation and Other Calculations

Treatment of Goodwill:
Depending upon the share of profits to be given to the new partner, either a sum of money will be
directly paid by him to the old partners (through the firm or privately) or after recording new partner’s
capital, new partner’s capital account will be debited with his share of goodwill, the credit being given
to the old partners in the ratio of their sacrifice of future profits. The latter is an indirect method of
payment for goodwill by the new partner. The payment is justified became the new partner will take
a share of profits which comes out of the shares of other partners. The old partners must be
compensated for such a loss.

The various possibilities as regards goodwill are:

1. The new partner brings goodwill in cash which is left in the business.
2. The new partner brings goodwill in cash, but the cash is withdrawn by the old partners.
3. The amount of goodwill is paid by the new partner to the old partners privately.
4. The new partner does not bring in cash for goodwill as such; but an adjustment entry is
passed by which the new partner’s capital account is debited with his share of goodwill and
the amount is credited to old partners’ capital accounts in the ratio of sacrifice. This entry
reduces the capital of the new partner by the amount of his share of goodwill and results in
payment for goodwill by the new partner to the old partners.
5. Before considering the entries to be made in the above cases, one must decide regarding the
ratio in which goodwill is to be credited to the old partners. Traditionally, goodwill was
credited to the old partners in the old profit-sharing ratio and, if the amount was to be written
off as in case (v) above, it was written off to all the partners in the new profit-sharing ratio.
6. There would be no doubt that this should be the case when, on the admission of a new person
as partner, the ratio as among the old partners does not change. But what if on the admission
of a new partner, the profit-sharing ratio of old partners as among themselves is also
changed.
7. If one treats paying sums in respect of goodwill to old partners as compensation for their
surrendering to the new partner a part of their profits, then obviously the amount to be
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credited to
partners should be in then ratio of loss of profits. Suppose, A and B, sharing in the ratio of 3: 2, admit
C as partner and it is agreed that the new profit-sharing ratio is 2: 2: 1. It is obvious that B does not
suffer at all on Cs admission. He previously received 2/5ths of profits; he still receives 2/5ths of
profits. It is A alone who has suffered and, therefore, any amount brought in as goodwill by C should
be credited to only A. Thus, it is proper to credit goodwill brought in by a new partner to the old
partners in the ratio in which they suffer on the admission of the new partner.

The entries to be passed in the four cases given above are:

Illustration 1:
A and B share profits in the ratio: A, 5/8 and B 3/8. C is admitted as partner. He brings in Rs 70,000
as his capital and Rs 48,000 as goodwill. The new profit-sharing ratio among A, B andC respectively
is agreed to be 7: 5: 4 respectively. Pass Journal entries.

In the above illustration, the old partners have allowed the amounts of goodwill credited to their
capital accounts remain in the business. However, the arrangement may allow the old partners to
wholly or partly withdraw the amounts of goodwill credited to their capital accounts. Suppose, in the
above illustration, A and B withdraw their shares of goodwill A and Bwithdraw their shares of goodwill
brought in by C.
Then, the following additional journal entry will have to be passed:

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If the case is that the amount of goodwill is paid by the new partner to the old partners privately, no
entry is passed in the books of the firm. But the calculations have to be made in thesame manner as
shown above.

Illustration 2:

A and B are partners sharing profits and losses in the ratio 3:2 respectively. They admit C as partner
who is unable to bring goodwill in cash but pays Rs 96,000 as his capital. The goodwill of the firm is
to be valued at two years’ purchase of three years’ profits. The profits for the three
years were Rs 30,000, Rs 24,000 and Rs 27,000. An adjustment entry is to be passed for C’sshare of
goodwill. The new ratio will be 5: 2: 2. Pass journal entries.

Illustration 3:
X and Y were partners sharing profits in the ratio of 5:4 respectively. On 1st April, 2012 they admitted
Z as a new partner; all the partners agreeing to share future profits equally. On the date of admission
of the new partner, there was a goodwill account in the old firm’s ledger showing a balance of Rs
18,000. The current value of firm’s goodwill was placed at Rs 36,000. Zpaid Rs 50,000 by way of his
capital. He also paid an appropriate amount for his share of goodwill. X and Y wrote offthe goodwill
account before Z’s admission. Pass the necessary journal entries.

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Revaluation of Assets and Liabilities:
When a new partner is admitted, it is natural that he should not benefit from any appreciationin the
value of assets which has occurred (nor should he suffer because of any fall which has occurred up
to the date of admission) in the value of assets. Similarly, for liabilities.
Therefore, assets and liabilities are revalued, and the old partners are debited or credited with the
net loss or profit, as the case may be, in the ratio in which they have been sharing profits and losses
hitherto. Partners may agree that the change in the value of assets and liabilities is to
be adopted and figures changed accordingly or that the assets and liabilities should continue to
appear in the books of the firm at the old figures.
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 1. Values to be altered in books. In this case, a Profit and Loss Adjustment Account (or
Revaluation Account) is opened, and the following steps should be taken
2. If the values of assets increase, the particular assets should be debited and the Revaluation
Account credited with the increases only.
3. If the values of assets fall, the Revaluation Account should be debited and the particularassets
credited with the fall in values.
Note:
If the value of debtors, investments or stock falls, the entry should be to debit the RevaluationAccount
and credit a suitable provision account. Thus, suppose it is desired to record a fall in value of
investments to the extent of Rs 9,500.

The entry is:

If there is already a provision against a particular asset and the value of that asset increases, the
entry should be to debit the Provision and credit Revaluation Account rather than to follow (a) above.
(a) Increase in the amounts of liabilities is a loss.

Hence, the entry is:

If an increase is not definite but is expected, the credit should be to a suitable provisionaccount.
(a) Any reduction in the amounts of liabilities is a profit and hence the liabilities accounts should
be debited, and Revaluation Account credited with the difference between the old andpresent
figures.
(b) The Revaluation Account should then be closed by transfer to old partners’ capital (or current)
accounts in the old profit-sharing ratio. If debits exceed the credits, it is a loss and the entry is
to debit partners’ capital (or current) accounts and credit Revaluation Account. Reverse entry is
made when the credits exceed debits.

Illustration:
A and B share profits in the proportions of three-fourths and one-fourth respectively.
Their balance sheet on March 31, 2012, was as follows:

On April 1, 2012, C was admitted into partnership on the following terms:

1. That C pays Rs 40,000 as his capital for a fifth share.
2. That C pays Rs 20,000 for goodwill. Half of this sum is to be withdrawn by A and B.
3. That Stock and Fixtures be reduced by 10% and a Provision for Doubtful Debts amountingRs
950 be created on Sundry Debtors and Bills Receivable.
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 4. That the value of Land and Buildings be appreciated by 20%.
1. There being a claim against the firm of damage, a liability to the extent of Rs 1,000 should be
created.
2. An item of Rs 650 included in Sundry Creditors is not likely to be claimed and hence should
be written off.
Pass journal entries for the above-mentioned transactions excluding cash transactions; preparecash
book and important ledger accounts. Also prepare the balance sheet of the firm immediately afterCs
admission. Assume the profit-sharing ratio as between A and B has not changed.

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1. When values are not to be altered. In this case, the increases and decreases in the values of
assets and liabilities are entered in a Memorandum Revaluation Account without passing
corresponding entries in the assets and liability accounts. The balance is transferred to old
partners’ capital accounts in the old profit-sharing ratio. Then, entries passed in
Memorandum Revaluation Account for increases and decreases in the values of assets and
liabilities are
2. reversed, again without passing any entry in the assets and liability accounts. The balance of
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Memorandum Revaluation Account is, this time, transferred to all partners (including the new
one) in the new profit-sharing ratio.

In the illustration above, the Memorandum Revaluation Account and the capital accounts will
appear as follows if this method is to be followed: Journal entries regarding revaluation in the case
discussed above will be:

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New Profit-Sharing Ratio:

Finding out the new profit-sharing ratio might involve a little calculation. The language of the
agreement is the most important factor. In some cases, the new ratio is given. In others, only the
share to be given to the new partner is given; the assumption is that as amongst the old partners,
the ratio does not change. In such a case, one should deduct from 1 the share of the new partner
and then divide the remainder among the old partners in the old ratio. Suppose, Aand B are partners
sharing profits and losses in the ratio of 5: 3 respectively. They admit C andagree to give him 3/10
of the profits.

Then, the new ratio will be calculated as follows:

In certain cases, the incoming partner “purchases” his share from the other partners in different
proportions. Suppose, A and B sharing profits in the ratio of 5: 3 respectively admit Cgiving him a
3/10 share of profits of the firm. If C acquires 4/20 share from A and 2/20 share from B, the newratio
will be

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Example:
Doctors Glucose and Cibazol have a practice producing Rs 3,72,900 per annum, which they divide in
proportions of 17/33 and 16/33. They admit Dr. Zambuck to partnership on the basis of his buying,
at 2 years’ purchase, 5/17 of Dr. Glucose’s share and 4/16 of Dr. Cibazol’s share. After the lapse of
three years, they permit Dr. Zambuck to purchase a further 1/12 of their remaining shares. How
much did Dr. Zambuck pay to each of the others on each occasion, andwhat is the ultimate share of
each partner in the practice?
At first, Dr. Zambuck buys 5/17 of Dr. Glucose’s share. That comes to (5/17) x (17/33) or 5/33 Dr.
Glucose’s share, therefore, is (17/33)-(5/33) or 12/33. Dr. Zambuck acquires (4/16)x (16/33) or 4/33
from Dr. Cibazol whose share, therefore, is (16/33)-(4/33) = 12/33. Total shareof Dr. Zambuck is
[(5/33) + (4/33)] or 9/33. Goodwill is valued at Rs 3,72,900 x 2 or Rs 7,45,800. Therefore, Dr.
Zambuck has to pay Rs 7,45,800 x 9/33 or Rs 2,03,400 which is shared by Dr. Glucose andCibazol in
the ratio of 5 : 4 (the ratio in which they lose profits). Rs 1, 13,000 will go to Dr. Glucose and Rs 90,400
to Dr. Cibazol. The new ratio is 12/33,12/33 and 9/33.
Later, Dr. Zambuck acquires 1/12 of each partner’s share. Hence, he acquires 12/33 x 1/12 or 1/33
from both the other partners. The share of Dr. Glucose is reduced to 12/33-1/33 or 11/[Link] also
for Dr. Cibazol. The share of Dr. Zambuck comes to be 9/33 + 1/33 + 1/33 = 11/33.
Hence, all partners are now equal. Dr. Zambuck will have to pay 7,45,800 x 1/33 or ? 22,600 toeachof
the other two partners by way of goodwill.

Reserves, etc., Created Out of Profits:

Reserves existing at the time of the admission of a new partner should always be transferred tothe
capital or current accounts of the old partners in the profit-sharing ratio. Students should remember
to do this even if the question is silent on the point.

Capitals of Partners to be Proportionate to Profit-Sharing Ratio:

It is often agreed on admission of a partner that the capitals of all partners should be in proportion
to their respective shares in profits. The starting point may be the new partner’s capital or the new
partner himself may be required to bring in capital equal to his share in the firm. If the new partner’s
capital is given, one should find out the total capital of the firm on thebasis of his share.
Then the capital required of other partners should be ascertained. Suppose, C is admitted in afirm
with a 1/4 share of the profits of the firm. C contributes Rs 15,000 as his capital, A and B,the other
two partners, were sharing profits in the ratio of 3: 2.
Then, the required capital of A and B should calculate as follows:

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Treatment is similar if the basis is the existing partners’ capitals and the new partner is required to
bring in proportionate capital. Suppose, after making all adjustments as regards goodwill and
revaluation of assets, etc., the capitals of A and B are ?20,000 and Rs 16,000. Theprofits and losses

are shared by A and B in the ratio of 5: 3 respectively. C is admitted and is to be given 1/4th shareof
profits. He has to bring in capital representing his share. C gets 1/4, 3/4is left for A and B.
Therefore, the combined capital of A and B, viz., Rs 36,000 represents 3/4 share. Total capital should
be 36,000 x4/3 or Rs 48,000. C should bring Rs 12,000, i.e., 48,000 x 1/4. In other words, C’s share is
1/3 of the combined shares of A and B (1/4:3/4); his capital should be 1/3 ofthe combined capitals
of A and B.

If the actual capital of a partner is more than his proportionate share, the difference should be
credited to his current account. If the actual is less, he should being in the requisite amount of cash
or else his current account should be debited. If the Partnership Deed requires capitals to be
proportionate to the profit-sharing ratio, the capitals should be treated as fixed.

Illustration 1:
The following was the Balance Sheet of A, B and C sharing profits and losses in the proportion of
6/14, 5/14 and 3/14 respectively:
They agreed to take D into partnership and give 1/8th share of profits on thefollowing terms:
1. That D brings in Rs 48,000 as his capital.
2. That furniture be written down by Rs 2,760 and stock be depreciated by 10%.
3. That provision of Rs 3,960 be made for outstanding repair bills.
4. That the value of land and buildings be written up to Rs 1,95,300.

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5. That the value of goodwill be fixed at Rs 28,000 and an adjustment entry be passed for D’s
share of goodwill.
6. That the capitals of A, B and C be adjusted on the basis of D’s capital by opening current
accounts. Give the necessary journal entries, and the balance sheet of the firm as newly
constituted.

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Illustration 2:
The balance sheet of a partnership firm of X and Y, who were sharing profits inthe ratio of 5: 3
respectively, as on 31st March, 2012 was as follows:
On the above date, Z was admitted on the following terms:
i. Z would get 1/5th share in the profits.
ii. Z would pay Rs 1, 20,000 as capital and Rs 16,000 for his share of goodwill.
iii. Machinery would be depreciated by 10% and building would to be appreciated by 30%. A
provision for bad debts @ 5% on debtors would be created. An unrecorded liability amounting
to Rs 3,000 for repairs to building would be recorded in the books of account.
iv. Immediately after Z’s admission, goodwill account would be written off. Thereafter, the capital
accounts of the old partners would be adjusted through the necessary current accountsin such
a manner that the capital accounts of all the partners would be in their profit showing ratio.
Prepare revaluation account, capital accounts and the initial balance sheet of the newfirm.

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Partnership Accounts on Retirement orDeath (Accounting Procedure)
Accounting Procedure Regarding Partnership Accounts on Retirement or Death! The retirement of
a partner extinguishes his interest in the Partnership firm, and this leads to dissolution of the firm or
reconstitution of the Partnership. A partner, who goes out of a firm, is called retiring partner or
outgoing partner. Causes for the retirement may be that a retiring partner may be too old or he may
have better opportunity in a different line or he may dislike the co-partners’ attitude or any other
reasons.

The following are the ways in which a partner can retire:

1. With the consent of all the other partners,
2. In accordance with an express agreement among the partners,
3. By giving a written notice of intention to retire to all the other partners where partnership isat
will.

Various Adjustments on Retirement:

When a partner retires his share in the properties of the firm has to be ascertained and paid off.
Certain adjustments have to be made in order to ascertain the amount he is to get from the firm.
These adjustments are very similar to those which we saw in connection with admission of apartner.
When a partner retires from the business, it becomes necessary to prepare the accounts so as to
ascertain the amount payable to him.

When a partner retires, the following adjustments must be made:

1. Adjustment of accumulated reserves and undistributed profit and losses. Revaluation of assets
and liabilities.
2. Adjustment for goodwill of the firm.
3. Calculation of new profit and loss sharing ratio.
4. Calculation of the amount due to retiring partner and the mode of payment.
We shall discuss these points.

1. Adjustment of Accumulated Reserves and Undistributed Profits and Losses: Any reserves or
undistributed profits appearing on the liability side of the Balance Sheet, at the time of retirement,
are past profits, which are created to strengthen the financial position of thefirm the retiring partner
has a right over such profits. Therefore, it is necessary to divide the accumulated reserve or
undistributed profit among all the partners in their old profit or loss sharing ratio. When the
distribution is over, they do not appear in the Balance Sheet.

The journal entries are:

General Reserve Account [Link] and Loss Account Dr.
To All Partners Capital Account
(Being transfer of General Reserve and profit in the old profit-sharing ratio)
Alternatively, instead of transferring the entire reserve or profit, only the share of the Retiring Partner
may be transferred to the Retiring Partner’s Capital Account. The balance in the reserveor profit

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account continues to appear on the liability side, at reduced amount.

In case the firm has incurred any losses in the past and the losses were not adjusted so far to the
capital accounts, then such losses, which is found in the asset side of balance sheet, be transferred
to the Retiring Partner’s Capital Account, to the extent of his share. By doing so, the losses continue
to appear on asset side of the Balance Sheet, at a reduced amount.

2. Revaluation of Assets and Liabilities:

Revaluation of assets and liabilities is equally necessary at the time of retirement of a partner, as at
admission. The revaluation is done on the same principles as in case of admission. Even if he
Partnership Deed is silent, it is better to revalue assets and liabilities. If it is agreed to revalue the
assets and liabilities on the retirement of a partner, Profit and Loss Adjustment Account or
Revaluation Account is prepared.

The profit or loss arising out of this account is transferred to all partners including retiring partner in
OLD RATIO. Therefore, the assets and liabilities will then appear in the books at the revised values.
If the continuing partners decide to maintain the assets and liabilities at their original value, then a
MEMORANDUM REVALUATION ACCOUNT is prepared by passing reversal entry andthe profit or loss
of this account is transferred to continuing partner’s capital account in their NEW PROFIT-SHARING
RATIO.

Illustration 1:
A and B are partners in a business sharing profits and losses as A 3/5ths and B 2/5ths.

Their Balance Sheet as on 1st January 2005 is given below:

B decides to retire from the business owing to illness and A takes it over and the following
revaluation are made:
(a) Goodwill of the firm is valued at Rs 15,000.
(b) Depreciate Machinery by 7.5% and Stock by 15%.
(c) A Bad Debts provision is raised against Debtors at 5% and a Discount Reserve against Creditors
at 2.5%.Journalise the above transaction in the books of the firm; prepare ledger accounts and
theBalance Sheet of A.

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Illustration 2:

B retires on that date subject to the following adjustments:

1. The goodwill of the firm to be valued at Rs 18.000.
2. Plant to be depreciated by 10% and Motor vans by 15%.
3. Stock to be appreciated by 20% and Buildings by 10%.
4. Provision for doubtful Debts to be increased by Rs 1.950.
5. Liability for workmen’s compensation to the extent of Rs 450 is to be brought into account.
It was agreed that A and C will share profits in future in the ratio of A-3/5th and C-2/5th.
Pass journal entries: prepare Memorandum revaluation Account, capital account and balance Sheet
when the assets and liabilities are to continue to appear at their original figures.

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3. Adjustment of Goodwill:
The valuation of goodwill may be done according to the provisions of the Partnership Deed and in
the manner as in case of admission by any one of thefollowing methods:
A. When Goodwill does not appear in the books:

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Illustration 1:
A, B and C were partners in a firm with capitals of Rs 10,000, Rs 8,000 and Rs 6,000 respectively and
sharing profits and losses in the ratio of 3 : 2 : 1. On 31st December 2005, Bretires. For the purpose
of retirement, the goodwill of the firm was valued at Rs 18,000.

Pass necessary journal entries under the following circumstances and also find out the amount
payable to B:
(a) Total goodwill raised and maintained in the books.
(b) Total goodwill raised but written off later.
(c) Only B’s share of goodwill is raised and maintained in the Books.
(d) Only B’s share of goodwill is raised but later on written off.
(e) B is given his share of goodwill without raising Goodwill Account.

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Illustration 2:
1. A, B and C are equal partners. Goodwill appears in the books at Rs 10,000. C retires and
goodwill is revalued at Rs 15,000. Now A and B decide to share future profits and losses m
theratio of 3. 2
2. X, Y and Z are partners sharing profits in the ratio of 4: 3: 3. Goodwill does not appear in, the
books. Z retires from the firm and his share of goodwill is estimated to be Rs. 6,000, which
was purchased by X and Y in equal proportion. X and Y decide not to open Goodwill Account.
3. Ram, Mohan and Moni were partners sharing profits in the ratio of 2: 2: 1. On 1st January
2005, their goodwill was valued at Rs 30,000 and there is no Goodwill Account appearing m
the books. Mohan ordered No goodwill is to appear in the books.

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Pass journal entries:

4. Calculation of New Profit and Loss Sharing Ratio:

When a partner of a firm retires, it is for the continuing partners to agree amongst themselves as to
in what ratio, they shall share the profit and loss of the firm in future. The ratio so agreedupon is
called New Profit-Sharing Ratio.
In the absence of any agreement between the partners, the continuing partners will continue toshare
the profit or loss in between themselves in the same ratio in which they were sharing before
retirement.

For instance, A, B and C were partners sharing profits in the ratio of 3 : 2 : 1 and if Cretires,nothing is
given about the new profit sharing ratio, then the profit sharing ratio of the
continuing partners would be 3 : 2. Ratio of their gain will also be 3: 2 which was their old profit
sharing ratio.

Sometimes, the continuing partners may agree to have a new profit sharing ratio, by making changes
in the existing profit sharing ratio and sometimes, the remaining partners may agree topurchase the
share of the retired partner in a different ratio.
This is explained below:
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Illustration 1:
X, Y and Z were partners sharing profits in the ratio of 2: 2:1. Z retires and his share was takenup by
X and Y in the ratio of 3:2. Calculate new profit sharing ratio and gaining ratio of [Link]:

Illustration 2:
A, B and C are in partnership sharing profit or losses in the ratio of 5: 3:2.
Find the new ratio and gaining ratio in the following cases:
(a) A retires, B and C continue.
(b) B retires, A and C continue.
(c) C retires, A and B continue.
Solution:
In the absence of any agreement between the partners as regards the new profit sharing ratio, the
continuing partners will continue to share the profit or loss in between themselves, in the same ratio

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in which they were sharing profits before retirement of partner.
In other words, retiring partner’s share of profit is shared by remaining partners in their oldprofit-
sharing ratio. For example, take the case of (a) above.
(a) B’s share of profit = 3/10 + (5/10 x 3/5) = 3/10 + 3/10 = 6/10C’s share of profit = 2/10 + (5/10 x
2/5) 2/10 + 2/10 = 4/10
(Or) Ratio is 6: 4 or 3: 2 Gaining Ratio = 3:2 Similarly, it can be proved with case (b) and (c).

Illustration 3:
X, Y and Z are partners, sharing profit and losses in die ratio of [Link]. X retires and his share is
purchased by Y and Z in the ratio of 3: 2. What is new profit sharing ratio?
Solution:

Old profit faring ratio of X, Y and Z = 2: 3:1

Y and Z purchased X’s share i.e., 2/6 in the ratio of 3: 2.
New Profit-Sharing ratio of Y and Z is 7/10 and 3/10 or 7: 3Gaining Ratio of Y and Z = 3: 2 (given)
(That is the ratio at which they purchased X’s share.)

Illustration 4:
A, B and C are partners in a business, sharing profit and losses in the ratio of 2: 2:1. A retires byselling
his share in the business for a sum of Rs 6,000 which is paid by A and B as to Rs. 4,800 and Rs. 1,200
respectively. Find out the new profit-sharing ratio of B and C.

Solution:
B and C purchased A’s share in the ratio of 4800: 1200 (or) 4: 1
B’s future share in profits or losses = 2/5 + (2/5 x 4/5) = 2/5 + 8/25 = 18/25C’s future share in profit
or losses = 1/5 + (2/5 x 1/5) = 1/5 + 2/15 = 7/25 The new profit or loss sharing ratio of B and C =
18/25: 7/25 or 18: 7.

5. Calculation of Amount Due to Outgoing Partner:

To find out the amount payable to retiring partner, the following items are considered:
1. Balance to his Capital Account, as per last Balance Sheet.
2. Proportionate profit on revaluation.
3. Share of goodwill.
4. Interest on capital up to the date of retirement.
5. Salary, if any, payable to him.
6. Share of past profit or loss of the firm.
7. Share of profit till his date of retirement.
8. Share of proceeds of Joint Life Policy
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Any withdrawals and interest due thereon should be deducted from the amount payable to the
outgoing partner. The firm is obliged to make payment to the retiring partners of the firm due to him
at the time of retirement. The total amount so calculated will be transferred to retiring partner’s loan
account by debiting the retiring partner’s capital account.
If he is paid in full immediately after retirement, the account is settled. Sometimes, the agreement
may be to settle the share of the retiring partner by paying him a fixed annual sum(annuity).

Illustration 1:
The Balance Sheet of A, B and c who are sharing profits and losses in the proportion of one-half,
one-third and one-sixth, respectively, was as followson30th June 2002:
A retires from the business on 1st July 2002 and his share in the firm is to be ascertained on a
revaluation of the assets as follows:
Stock at Rs 20,000Furniture Rs 3,000
Plant and Machinery Rs 9,000Buildings at Rs 20,000
Rs 850 to be provided for Doubtful Debts
The goodwill of the firm is agreed to be valued at Rs 6,000
A is to be paid Rs 11,050 in cash on retirement and the balance in three equal yearlyinstallments
together with interest at 5% p.a.

Show the necessary accounts required giving effect to the above, the Balance Sheet of thecontinuing
partners and the Account of A till it is finally closed

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106

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Illustration 2:

On 31st March 2006, Hari desired to retire from the firm and the remaining partners decidedto carry
on the same business.

It was agreed to revalue the assets and liabilities on that date on the following basis: Land and
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 108
Buildings be appreciated by 30%.
1. Machinery be depreciated by 20%
2. Closing stock to be valued at Rs. 4,50,000
3. Provision for bad debts be made at 5%
4. Old credit balances of sundry creditors Rs. 50,000 be written back.
5. Joint Life Policy of the partners surrendered, and cash obtained Rs. 3,50,000
6. Goodwill of the entire firm be revalued at Rs. 6, 30,000 and Hari’s share of the goodwill be
adjusted in the accounts of Ram and Mohan who share the future profits and losses in the ratio
of 3: 2. No goodwill account be raised.

1. The total capital of the firm is to be the same as before retirement. Individual capital be intheir
profit-sharing ratio.
2. Amount due to Hari is to be settled on the following basis: 50% on retirement and the balance 50%
within one year.
3. Prepare revaluation account, capital accounts of partners, cash account and balance sheet as on
1-4-2006 of M/s Ram and Mohan

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109

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Illustration 3:

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A had been suffering from ill-health and gave notice that he wished to retire.

An agreement was, therefore, entered into as on 31st March 2006, the terms of which were as
follows:
1. The Profit and Loss Account for the year ended 31st March 2006, which showed a net profit
of Rs. 48 000 was to be reopened. B was to be credited with Rs. 4,000 as bonus, in
consideration of the extra work which had developed upon him during the year. The profit-
sharing ratio was to be revised as from 1st April 2005 to 3: 4: 4.

2. Goodwill was to be valued at two years’ purchase of the average profits of the preceding five
years. The Fixtures were to be valued by an independent value. A provision of 2% was to be
made for doubtful debts and the remaining assets were to be taken at their book values.

3. The valuations arising out of the above agreement were Goodwill Rs. 56,800 and Fixtures Rs.
10,980.

4. B and C agreed, as between themselves, to continue the business, sharing profits in the ratio
of3:2 and decided to eliminate goodwill from the Balance Sheet, to retain the Fixtures on the
books at the revised value and to increase the provision for doubtful debts to 6%.

5. You are required to submit the journal entries necessary to give effect to the above
arrangements and to draw up the capital account of the partners after carrying out all
adjustingentries as stated above

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Adjustment of Capitals to be Proportionate to the Profit-Sharing Ratio:

On the retirement of a partner, sometimes the continuing partners wish to keep the Capital Ac-counts
to be proportionate to new profit-sharing ratio. This implies determination of overall capital after
making all adjustments. Then find out the total amount of capital and the amount of each partner’s
share, on the basis of profit-sharing ratio.

Then continuing partners will meet their deficiency, if any, by introducing cash into the firm ofthe
surplus, if any, may be withdrawn or transferred to Current Accounts, if the Capital Accounts are
fixed.

Illustration 1:
The Balance Sheet of A. B and C who were sharing profits in the ratio of 3: 2: 1respectively stood
as follows on 31st December 2005:

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 114

B having given notice to retire from the firm, the following adjustments in the books of the firm
were agreed upon:
1. That investment be reduced to 90%.
2. That land and building be appreciated by 10%.
3. That the stock be appreciated by Rs 1,250.
4. That the goodwill of the firm be fixed at Rs 12,000 and B’s share of the same be adjustedthrough
the Capital Accounts of A and B.
5. That the entire capital of the newly constituted firm be fixed at Rs 60,000 and be readjusted
between A and B in their profit sharing ratio i.e. 3: 1, by bringing in or paying out cash.

From the above particulars, prepare Revaluation Account, Partners’ Capital Accounts and the
Balance Sheet of the new firm showing B’s balance as loan:

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 115

Admission and Retirement:

When a partner retires from a firm, there arise the needs for finance. The retiring partner is tobepaid
off. If cash is paid, then the working capital is affected. Therefore, when a partner
retires from the firm, the continuing partners feel the urgency of admitting an outsider as apartner
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to their firm.
The retiring partner can easily be paid off with the amount contributed by the incoming partner. But
the simultaneous retirement and admission do not introduce any new principles of accounting. The
principles studied under admission and retirement are combined-the combination of the two sets of
transactions.

Illustration 1: (Retirement-cum-Admission)
A and B were working in partnership sharing profits equally. On 31st December 2004, A decided to
retire, and, in his place, it was decided that C would be admitted as partner from 1stJanuary 2005 and
his share in the profits will be one-third.

Balance Sheet of the firm as on 31st December 2004 was as follows:

It was further decided as follows:

1. The goodwill should be raised to Rs 40,000.
2. The motor car would be taken over by A at its book value.
3. The value of land and buildings would be increased by Rs 16,560.
4. B and C would introduce sufficient capital to pay off A to leave thereafter a sum of Rs 14,700 as
working capital in a manner that the capitals of the new partners will be proportional to theirprofit-
sharing ratio.
5. The new partners decide to show the goodwill as an asset.
6. The partners introduced the capital on 10th January 2005. Show the accounts of the partners
and Bank Account with necessary Journal entries. Also prepare the Balance Sheet of the new
firm

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 118

Illustration 2:

On that date, C decides to retire. The value of goodwill to be Rs 15,000 and sundry assets are taken
to have increased in value by Rs 25,000. On C’s retirement, D is admitted as a partner. He pays no
premium for goodwill but brings in Rs 15,000 as capital. Profits and losses are to beshared in the
ratio of 4: 3: 3.

Show Capital Accounts and draw up two Balance Sheets, one after C’s retirement and the other after
D’s admission. The goodwill account is to be wiped off from the books and restore the sundry assets
at its original value after D’s admission

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119

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Illustration 3:

The following adjustments and arrangements have been agreed upon for the purposes of
retirement and admission of partners:
1. Goodwill to be written up to Rs 30,000 and Plant to Rs 50,000.
2. Sufficient money to be introduced so as to leave Rs 11,000 cash after payment of amount due to
Raman.
3. Deshpande and Pritam to provide such fund as would make their capitals proportionate totheir
share of profit.
4. Show the journal entries to record the above transactions assuming that Deshpande and Pritam
have paid in cash due on 2nd July 2005 and the amount due to Raman was paid on the same
day.

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121
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Illustration 4:

Y retired on 30th September 2005 and X and Y continued in partnership sharing profits and losses
in the ratio of 3: 2. It was agreed that Rs 16,000 of the balance remaining to him including his earlier
loan should remain as loan to the firm and balance amount will be paid tohim on 1st October 2005.

The following adjustments were agreed upon:

1. The lease was acquired on 1st October 2003 for 15 years. This was to be written off over the
period of lease. Depreciation not provided from the beginning.
2. The plant was to be revalued at Rs 11,600.
3. The provision for bad debts was to be increased by Rs 240.
4. Creditors for expenses amounting to Rs 1,000 had been omitted from the books.
5. Rs 800 were to be written off the stock in respect of obsolete items included therein.
6. Provision of Rs 240 was to be made for professional charges in connection with therevaluation.

The partnership agreement provided that on the retirement of a partner goodwill was to be valued
at an amount equal to the average profit of the three years expiring on the date of retirement and
that in arriving at the profit, a notional amount of Rs. 16,000 should be chargedfor partner’s salaries
and that for the purpose of valuing goodwill, revaluation of the plant and the professional charges
should not be regarded as affecting the profits.
The profits for the years ended on 30th Sept. 2003, 2004, and 2005 were Rs 28,800; Rs 33,600andRs
37,640, as shown by the draft accounts, respectively.

No Accounts for goodwill was to be maintained in the books, adjusting entries of transaction
between the partners being made in their Capital Accounts.

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125
Death of a Partner:
The problems arising on the death of a partner are similar to those arising on retirement. Retirement
can be anticipated and planned. Thus, the date of retirement coincides with the dateof closing of the
firm’s books of accounts.

The death may occur at any time during the course of trading period In the eventof death of a
partner, the Legal Representatives of the Deceased Partner will be entitled to receive from the firm
the amount due on account of the following:
1. Capital Account of the deceased partner as per the last Balance Sheet of the firm.
2. Interest on capital, if any, to the date of death of the partner.
3. Share in the goodwill of the firm.
4. Share in the revaluation of assets and liabilities.
5. Share in the accumulated reserves.
6. Share in the undistributed profits.
7. Share in the profit of the firm from the last Balance Sheet to the date of his death.
8. Share in the Joint Life Policy.
9. Salary, if any, due to him till the date of his death.

Further the amount due to the deceased partner as reduced by:

(a) Drawings,
(b) Interest on Drawings and
(c) Undistributed losses, if any, should be transferred to the loan account in the name of his
Executor’s Account.
Then the amount may be paid immediately or by installments. If payment is made by installments, it
will carry interest @ 6% p.a.

Illustration 1:
A and B were carrying on a business in partnership sharing profits and losses in the ratio of 3: 2
respectively. They closed their books of account on 31st December 2005.

Their balance Sheet was as follows:

B died on 1st May. 2006.

Partnership Deed provided that in the event of death of a partner his heirs would be entitled to be
paid out:
(a) Capital to his credit at the date of death.
(b) His share of reserve at the date of the last balance sheet.
(c) His share of profits at the date of his death based on the average profits of the last three
accounting years.
(d) By way of goodwill his share of total profits for the preceding three accounting years.
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The profits for the three preceding accounting years were:
2003 Rs. 41,800, 2004 Rs. 39,200, and 2005 Rs. 45,000
Prepare B’s capital account transferring the amount due to B’s heirs loan account. Clearly showyour
calculations.

Illustration 2:
Ram, Rahim and Robert carry on business sharing the profits in the ratio of 1/2: 1/3: 1/6respectively.

Capitals as on 31 -3-2006 are Ram Rs. 20,000, Rahim Rs. 15,000 and Robert Rs.10,000. On 30-6-
2006 Robert died, and his executors claim the following as per Partnership Deed:
1. The joint and several life policies against which premiums are charged to the Profit and Loss
Account are valued at 40% of the sum assured.
2. The policies of the partners are: Ram Rs. 10,000, Rahim Rs. 7,500 and Robert Rs. 17,000.
3. Allow interest on capital at 6% p.a.
4. Calculate Robert’s share of profits till the date of death on the basis of average profits of the
preceding 3 years.
5. Calculate the goodwill of the firm at 2 years’ purchase of the average profits of thepreceding 5
years.

The annual profit or loss figures of preceding five years were:

Prepare an account for presentation to the executors of Robert. Drawing till the date of death of
Robert was Rs. 5,000.

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 129

Illustration3:
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The following arrangements were agreed upon:
(a) Assets be valued at Rs. 29,000; Investments at Rs. 2,350; Stock Rs. 4,700
(b) Goodwill is valued at two years’ purchase of the average profits of the past five years.
(c) Sekhar’s profit to the date of death is calculated on the basis of the average profits of the past
three years.

(a) The profits of the last five years were:

Prepare continuing partners’ capital accounts and Sekhar’s accounts and show the new Balance
Sheet

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Illustration 4:

C died on 31st March 2005.

Under the terms of the Partnership Deed, the Executors of a deceased Partnerwere entitled to:
(a) Amount standing to the credit of the Partner’s Capital Account.
(b) Interest on Capital @ 5% p.a.
(c) Share of goodwill on the basis of twice the average of the past three years’ profits.
(d) Share of profits from the closing of the last financial year to the death on the basis of last year’s
profits.
Profits for 2002 Rs. 9,000; for 2003 Rs. 12,000 and for 2004 Rs. 10,500. Profits were shared inthe
ratio of capitals.
Pass the necessary journal entries and find out the amount payable to the heir of C.

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Goodwill = 9,000 + 12,000 + 10,500 x 2/3 = Rs. 21,000C’s Share = 21,000 x 1 /4 = Rs. 5,250
Profit = Rs. 10,500 x 1/4 x 3/12 = Rs. 656.25

Illustration 5:
It was provided under the Partnership Deed among A, B and C that in the event ofthe death of a
partner, the survivors would have to purchase his share in the firmon the following terms:

(a) Deceased’s share of goodwill to be taken at three years’ purchase of his share of profits on
average of previous four years.
(b) Total amount due to his representatives to be paid by survivors in four equal and half yearly
installments commencing at 6 months after the date of death with 5% interest on outstanding
dues.
(c) They shared profits and losses in the proportion of [Link] and accounts were drawn up each year
at30th June.

A died-on 31st December 2003 and their capital Accounts on that date were:
A Rs. 10,800
B Rs. 6,400
C Rs. 3,600
A’s Current Account on 31st December 2003 after crediting his share of profit to that date,however,
showed a debit of Rs 960.
Firm’s profit for the year ended 30th June 2000 Rs. 35,200; 30th June 2001 Rs. 28,160; 30thJune
2002 Rs. 24,080 and 30th June 2003 Rs. 8,704.

Show the relevant ledger accounts in the books of the firm recording half-yearlypayments to A’s
estate by surviving partners:

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Joint Life Policy:

When a partner dies, the continuing partners are to make payment to the Executors of the de-ceased
partner. They may desire to settle it without disturbing the working capital. The relationship among
the partners is based on mutual trust, faith and confidence and as such there is a mutual belief
among themselves. But the relationship with the Executor of deceasedpartner is entirely a new one
and there exists no relation.
Thus, the entire amount may be payable to the Executor in one lump sum. If so the working capital
of the firm will be depleted, and the business will be affected. In such a similar position,precautionary
measures are to be taken to safeguard the firm from the financial breakdowns.
The step to overcome this is to take a Joint Life Policy on the partners, by paying a small amount
known as premium and in the event of death of any one of the partners the amount of the policy is
payable.

The firm gets the full amount of the policy either on its maturity or on the death of a partner,
whichever is earlier. Thus the deceased partner’s account can be settled with the policy amount,
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without disturbing the business activities.
The Policy may be on individual life or may be on the lives of all the partners-Joint Life Policy.

The accounts relating to the Joint Life Policy can be maintained in any one of the following
methods:
Method I:
When premium is paid on the Joint Life Policy, it is treated as an expense and is debited to theProfit
and Loss Appropriation Account. On happening of death or maturity or surrender, the amount
received from the Insurance Company is treated as an income and is credited in the partners’ capital
accounts in their profit-sharing ratio. There is no Joint Life Policy Account [Link]

journal entries are:

Method II:
Here, the surrender value of the policy is taken into account. The premium paid is treated as anasset
and is debited to Policy Account. At the end of the year, the amount of premium in excess of the
surrender value is treated as a loss and is debited to the Profit and Loss Account.
The surrender value is shown on the asset side of the Balance Sheet every year at its computed
value. On the death or maturity, the excess amount received from the Insurance Company overthe
accumulated surrender value is credited to the partner’s capital accounts in profit sharing ratio.

The journal entries are:

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Method III:
Here, a Joint Life Policy and also a Joint Life Policy Reserve or Fund Account is maintained at
surrender value. The Policy Account will then appear at its surrender value on the asset side ofthe
Balance Sheet and Policy Reserve Account will appear on the liability side of the Balance Sheet.
The excess of the amount of policy received over the surrender value of the policy is treated as a
profit and credited to partners’ capital accounts in profit sharing ratio. This method is similar tothat
of Depreciation Fund method

The journal entries are:

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Illustration 1:
A and B sharing profits and losses in the ratio of 5 : 3 took out a Joint Life Policy for Rs. 40,000 in
January 2002 for 20 years paying an annual premium of Rs. 2,200. The surrender values were: 2002
Rs Nil; 2003 Rs. 500; 2004 Rs. 1.200 and 2005 Rs. 2,050; B died on April 20, 2005and the claim was
received on 25th May.
Show the necessary accounts in all the methods.
Solution: First Method

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Note: In the case of policies on the lives of individual partners, the deceased partner has also a right
to share the amount of surrender value, which the other partners’ policies acquired at thetime of
death.

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Partnership insolvency
A partnership is a relationship which exists between two or more persons carrying on business
together with a view to making profit. Unlike a company, a partnership has no separate legal
personality and so cannot be the subject ofany
legal proceedings on its own merits. Partners, who can be either individuals or companies, will
therefore be personally liable - usually without limit - for the debts of the partnership.
It should be noted, however, that a limited liability partnership (LLP) is a hybrid entity with
characteristics falling between those of a company and those of a partnership. Like a company, an
LLP is considered to be a body corporate and so a separate legal entity from the individuals or
companies making up the partnership. However, the partners' individual liability is limited. Like a
partnership, the relationship between the members of an LLP is governed by a partnership
agreement and it does not have shareholders or directors.
Partnership relationships do no neatly fall into the regimes for either personal or corporate
insolvency. Traditionally the law and practice of bankruptcy was applied to partnerships. Later, an
unsatisfactory approach of applying the relevant provisions of UK personal and corporate insolvency
law to insolvent partnerships - with some modifications - was taken. In 1994 the law surrounding
partnership insolvency was consolidated under the Insolvent Partnerships Order (the Order). It was
further modified by Amendment Orders in 2005, 2006 and twice in 2017 (The Deregulation Act 2015
and Small Business, Enterprise and Employment Act 2015 (Consequential Amendments) (Savings)
Regulations 2017, in force 6 April 2017 and Insolvency (Miscellaneous Amendments) Regulations
2017 in force 8 December 2017).

Under the Order, partnerships can be treated as legal entities in their own right for insolvency
purposes. Importantly, the Order has extended procedures relating to voluntary arrangements and
administrations to insolvent partnerships and the Amendment Orders apply the out-of-court
administration procedure and the new terms of creditor decisions and deemed consent procedures
to partnerships.
Due to the unique nature of a partnership, a creditor can pursue any one or more of the partners
individually – as well as the partnership itself – for any partnership debt.
On the basis that in most respects LLPs are treated as corporate entities in the same way as
companies, the insolvency regime applicable to them is governed by the legislation that applies to
companies.

Tests for insolvent partnerships

The tests for an insolvent partnership are similar to the two generally accepted tests for an insolvent
company. If a partnership is:
• unable to pay its debts as they fall due; or
• its assets, when realised in cash, would be insufficient to pay off its debts and other liabilities
then the partnership is insolvent for the purposes of UK law.
A partnership will not be insolvent solely on the basis of one of its members being individually
insolvent if it is itself able to pay its debts as they fall due or its assets are greater than its liabilities.

Partnership liquidation and partner bankruptcy

As explained above, partners are personally liable for the debts of a partnership. This means that the
partnership can itself be wound up and bankruptcy orders can be made against the individual
partners.

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1. A creditor of a partnership can petitions for either:
2. The winding up of the insolvent partnership as an unregistered company, with no action taken
against the individual partners; or
3. The winding up of the insolvent partnership as an unregistered company, with bankruptcy
petitions also presented against one or more of the partners.
4. Alternatively, a creditor may choose to only pursue the partners for the debt by petitioning for the
bankruptcy of one or more of the partners without petitioning for the partnership to be wound up.
The partnership debt will be treated as the debt of the partner against whom the bankruptcy
petition is presented.

A member of a partnership may also petition for the insolvent partnership to be wound up as an
unregistered company with no action against the insolvent partners, or with action taken against the
insolvent partners individually.
A creditor can only apply for a winding-up order against the partnership if that partnership has traded
in England and Wales at any time in the three years before the petition is presented.

Partnership Administration
The concept of putting a partnership into administration was introduced by the Order. Before 1994,
partnerships in financial difficulties were either liquidated or each partner individually was made
bankrupt. Now, a viable partnership business may be able to survive as a going concern or can obtain
the creditors' approval to enter into a voluntary arrangement for its debts.
Partnership administrations which began on or after 1 July 2005 now follow the corporate
administration procedure, allowing for an administrator to be appointed out of court.

A partnership may be put into administration in one of the following ways:

• by the court, on application of the members of the insolvent partnership.
• by the court, on application of a creditor of the insolvent partnership; and
• out of court, by the members of the insolvent partnership.

Under the court procedure an administrator will only be appointed if the court accepts that the
partnership is actually unable to pay its debts, unlike in the case of corporate insolvency where the
court only needs to be satisfied that the company is likely to become unable to pay its debts. Where
the administrator is appointed out of court, the members of the partnership have to sign a statutory
declaration that the partnership is unable to pay its debts.
The effect of administration generally, and the procedures for stopping partnership activity – or
moratorium - in relation to an insolvent partnership, closely resemble those that apply to corporate
administrations. However, the moratorium will not prevent a creditor from brin ging proceedings against
a partner in respect of a partnership debt for which that partner is liable.

Partnership voluntary arrangements

The Order has also introduced the concept of the partnership voluntary arrangement (PVA). A partnership
can enter into a binding debt-forgiveness arrangement or repayment schedule with its creditors
instead of liquidation. This will likely result in an improved outcome for the creditors and may allow
the company to survive.

The partnership alone may be the subject of a PVA, or both the insolvent partnership and one or
more of its partners can enter into a voluntary arrangement. This can be either an individual voluntary
arrangement (IVA) if the partner is a person, or a company voluntary arrangement (CVA) where the
141
partner is a company. If an IVA or a CVA is entered into alongside a PVA, the partners will be liable
for their own debt as well as that of the partnership. The Order does not provide for a combined
arrangement covering the partnership and its members, but this may be achieved by each of the
members proposing interlocking voluntary arrangements with that of the partnership.
There is no moratorium available where a PVA is entered into, so this has proved an unattractive option
for partnerships in f financial difficulties. Consequently, they have only really been useful when dealing
with large partnerships were entering into IVAs or CVAs with each partner would be too time-
consuming and costly.

Limited Liability Partnerships

In many ways the process of insolvency for an LLP reflects that of a limited company. LLPs can
enter into administration, go into receivership, be voluntarily or compulsorily wound up or propose a
voluntary arrangement. The Insolvency (England and Wales) Rules which came into force on 6 April
2017 in relation to corporations, have only applied to LLPs from 8 December 2017.
The process for appointing administrators to an LLP is very similar to that for a company. An
administrator may be appointed by the court on the application of the LLP itself, a creditor or both
and may be appointed out of court by the LLP itself or by a creditor who holds a qualifying floating
charge over the company. A qualifying floating charge holder must first give notice to any other
floating charge holders before appointing an administrator out of court.
The effect of administration generally, and the moratorium provisions in relation to LLPs, follow
those that apply to corporate administrations. However, as is the case for an ordinary partnership,
the moratorium will not prevent a creditor from bringing proceedings against a partner in respect of
a partnership debt for which the partner is liable.

Almost the same procedures apply to the winding-up of an LLP as do to the winding-up of a limited
company. The LLP can be placed into members' voluntary liquidation if the members of the LLP
declare solvency. If such a statement cannot be made, the creditors of the LLP can propose a
creditors' voluntary liquidation.
There are special provisions, which are only applicable to LLPs in liquidation, which may allow an
appointed liquidator to claim back any money withdrawn from the LLP by its members. This includes
distribution of profit shares, salary, loan repayments, interest payments or any withdrawal of
property belonging to the LLP. The liquidator's power to 'claw back' in this way applies when:

• within a two-year period before the LLP was liquidated, any person who is or was a member of
the LLP withdrew property of the LLP; and
• at the time of the withdrawal the member knew, or had reasonable grounds to believe, that the
LLP was unable to pay its debts or would become unable to pay its debts once the property was
removed, considered in conjunction with any property removed at the same time.
• When considering whether these claw-back provisions should apply, the courts will take into
account the level of knowledge, skill and experience that could be reasonably expected of a
member of an LLP at that level as well as the individual member's own knowledge, skill and
experience.
However, the member will not be liable unless that person knew or ought to have concluded that
after each withdrawal there was no reasonable prospect of the LLP avoiding going into insolvent
liquidation.

Liability of partners on insolvency

Partners and persons who have management control of partnerships or LLP businesses face the
142
same sanctions as directors of limited companies for specific misconduct, and may be disqualified
from office by virtue of the Order.
The court may disqualify a partner from office if that person is or was a partner in an insolvent
partnership and his conduct as a partner - either taken alone, or together with his conduct in any
other partnerships or as a director of a company - makes him unfit to be involved in the management
of another company or partnership. Similarly, a member of an LLP may be disqualified from being a
member of an LLP or a director of a company if that LLP has become insolvent and the court
considers that the conduct of that member was such as to make that member unfit to be involved
in the management of another LLP or company.

Partners and members of LLPs may also, in addition to their personal liabilities, be liable in the same
way as directors of limited companies if they are found guilty of wrongful or fraudulent trading and
liable top make a contribution to the assets of the partnership.
In the same way as there are restrictions on the reuse of company names, to prevent so-called
phoenix company practices, restrictions will also apply on the reuse of LLP names where the original
LLP has gone into insolvent liquidation.

When All Partners are Insolvent (Dissolutionof Partnership Firm)

If all the partners are insolvent, then the creditors cannot be paid in full. All the cash available,
together with whatever can be recovered from the private estates of the partners, willbe paid to the
creditors after the expenses of realisation are met.
The Realisation Account should be prepared in the usual course, but creditors should not be
transferred to this account nor will payment to creditors be debited to this account; the loss on
realization should be transferred to the capital accounts of partners in the profit-sharing ratio.
The available cash should then be paid to the creditors. The amount remaining unpaid shouldbe
transferred to Deficiency Account to which account, the balances of partners’ capital accounts
should also be transferred. Thus, the books will be closed.

Illustration 1:
Below is the balance sheet of M/s. A, B and C as on March 31, 2012:

Due to the inability to pay the creditors, the firm is dissolved. B and C cannot pay anything. A can
contribute only Rs 10,500 from his private estate. Stock realises Rs 1, 05,000. Debtors realise Rs 1,
12,000, and Furniture is sold for Rs 7,000. Expenses amount to Rs 21,000. Prepareaccounts to close
the books of the firm

143
DIWAKAR
144 EDUCATION HUB
Illustration 2:
Following is the balance sheet as on 31st March, 2012 of a firm having three equal P, Q and R:

The firm was dissolved due to insolvency of all the partners. Machinery was sold for Rs 15,000
while furniture fetched Rs 12,200. Stock realised Rs 30,800. Realisation expenses totalled Rs
1,660. Nothing could be recovered from Q and R, but Rs 3,800 could be collected from P’s private
estate. Close the books of account of the firm

145
Illustration 3:
X, Y and Z were partners in a business. Their balance sheet as on 31st March, 2012was as follows::
Due to bad financial position of the partners, the firm was dissolved, and all the partners were
declared bankrupt.

The assets realized are as follows:

Book Debts 45% less, Building Rs 1, 60,000, Stock Rs 1, 00,000, Machinery Rs 2, 00,000 andFurniture
& Fixtures Rs 40,000. Realisation expenses were Rs 10,000

146
147
Illustration 4:
Red, Zed and Ted shared profits and losses in the ratio of 5 31st March, 2012, theirbalance sheet
was as follows:
The bank had a charge on all the assets; these realised Rs 29,000 in all. Zed’s private estate realised
Rs 6,000; his private creditors were Rs 5,000. Ted was unable to contribute anything. Red paid 1/3
of what was finally due from him (taking the payment also into account) except onaccount of other
partners. Prepare ledger accounts, passing all matters relating to realisation of assets and payment
ofliabilities through the Realisation Account.

148
The amount brought in by Red has been calculated as follows:
Suppose the amount brought in by Red is x, i.e., 1/3 of amount due from Red. The amount then
payable to trade creditors will be Rs 20,000 + Rs 20,000 being available without the amount to be
brought in by Red. The loss on realisation will be: Rs (60,000 + 10,000 + 20,000 + x- 69,000) or Rs
21,000 + x.
Red’s share will be Rs 5/10 (21,000 + x) or Rs 10,500 + 1/2x, making the debit balance in hiscapital
account to be Rs 20,000 + 10,500 + x/2-30,000 or Rs 500 + x/2.
Then, 3x = 500 + x/2or6x = 1,000 + x
or 5x = 1,000 x = 200

Illustration 5:
The following is the balance sheet of A, B and C, who are equal partners, as atMarch 31, 2012:
149
A company named W Ltd., was registered with a capital of Rs 10,00,000 in Rs 10 shares. Thecompany
took over certain assets of the partnership.
The assets taken over were:

For the assets, the company allotted to the partners in due proportion fully paid shares of Rs 2,80,000;
the balance was to be left by the partners with the company as a temporary loan. The partners
collected the debts (which realised Rs 2, 90,000) and paid the liabilities in full. The cost of registering
the company and preparing the agreement with the company came to Rs 8,400. This was paid by
the partnership firm.
It was found that the liability in respect of excise duty was Rs 23,000 This was paid. Income-tax
amounting to Rs 30,000 was also paid, (A, Rs 15,000; B, Rs 10,000 and C, Rs 5,000). C is insolvent
and can pay only Rs 10,300. Write up the accounts to show how the books of M/s. A, B and C
areclosed.

150
151
Note:
Shares in W. Ltd., Cash and Temporary Loan in W. Ltd. have all been divided among A and B in the
152
ratio of A, Rs 1,77,800 and B, Rs 2,22,700, the balances due after transferring C’s deficiency to A and
B in the ratio of their fixed capitals, viz., 4 : 5 respectively.

Corporate Accounting
Corporate Accounting is a special branch of accounting which deals with the accounting for
companies, preparation of their final accounts and cash flow statements, analysis and interpretation
of companies’ financial results and accounting for specific events like amalgamation, absorption,
preparation of consolidated balance sheets. A public company usually refers to a company that is
permitted to offer its registered securities (stock, bonds, etc.) for sale to the general public, typically
through a stock exchange, but also may include companies whose stock is traded over the counter
(OTC) via market makers who use non-exchange quotation services suchas the OTCBB and the Pink
Sheets. The term "public company" may also refer to a government-owned corporation. This
meaning of a "public company" comes from the tradition of public ownership of assets and interests
by and for the people as a whole (public ownership), and is the less-common meaning in the United
States. Advantages It is able to raise funds and capital through the sale of its securities. This is the
reason why public corporations are so important: prior to their existence, it was very difficult to
obtain large amounts of capitalfor private enterprises. In addition to being able to easily raise capital,
public companies may issue their securitiesas compensation for those that provide services to the
company, such as their directors, officers, and employees.

PRIVATE COMPANY The term privately held company refers to the ownership of a business
company in two different ways: first, referring to ownership by non-governmental organizations; and
second, referring to ownership of the company's stock by a relatively small number of holders who
do not trade the stock publicly on the stock market. Because of these two different meanings, the
use of the term should normally be avoided unless the context makes clear which definition is
intended. Less ambiguous terms for a privately held company are unquoted company and unlisted
company. Though less visible than their publicly traded counterparts, private companies have a
major importance in the world's economy. In 2005, the 339 companies on Forbes' survey of closely
held U.S. businesses sold a trillion dollars' worth of goods and services and employed 4 million
people. In2004, the Forbes' count of privately held U.S. businesses with at least $1 billion in revenue
was only 305. KochIndustries, Bechtel, Cargill, Chrysler, PricewaterhouseCoopers, Flying J, Ernst &
Young, Publix, and Mars are among the largest privately held companies in the United States. IKEA,
Victorinox, and Bosch are examples of Europe's largest privately held companies. There has been a
general confusion among corporate managers about whether to have the status of their company
as private or public. Well, it basically depends on the requirement it needs to be. Notably, many
companies prefer it to be private considering the kind of privileges theyenjoy being private. Here’s a
brief list of concessions and privileges which favour formation of private limited companies:

Privileges: - Limited liability, - Simple and easy formation, - Immediate commencement of business
upon incorporation, - Liberal payment of remuneration and loans to directors without any
restrictions, - Easier inter-corporate loans - Lesser disclosure requirements - Tremendous ease in
operation - Two directors are enough - Two Shareholders are adequate - Need not declare dividend
- Listing of shares not mandatory - Directors need not hold qualification shares These continue to be
the dominating factors for carrying on trade and industry through the medium of private limited
companies. Limitations: Nevertheless, there are limitations too.
Under the Companies Act, a private limited company is: - prohibited to issue any invitation to the
public to subscribe to any shares or in debentures of the company - to limit the number of its
members to 50 - to restrictthe right of its members to transfer shares
153
Issue, Forfeiture & Reissue of Shares
Capital of the company is divided into a number of small indivisible units of a fixed amount and
each unit is called a share. The fixed value of a share is printed on the share certificate and is
called nominal / par / face value of a share.

Share Capital of a company is divided into following categories:

1. Authorized Capital: Nominal Capital –
2. Registered Capital It is the amount of capital registered in memorandum of [Link]
is a maximum amount of capital that can be raised.
3. Issued Capital: It is a part of authorized capital which is offered to the public for subscription.
4. Subscribed Capital: It is a response given by public to the companies offer. It indicates no.
of shares for which applications are received. If applications are received for the same no.
of shares that was offered by the company, It is called as fall subscription or exect
subscription. If applications are received for less no. of shares than offered it is under
subscription. [Minimum subscription 90%]
5. If applications are received for more no. of shares than offer, it is called as over subscription.
But the company cannot issue additional shares than offered [Issued]

Preference Shares
According to sec. 85 of the companies Act, 1956 Pref. Share is one , holder of which enjoys
preferential rights in the matter of:
• Payment of dividend
• Repayment of Capital Types of preference shares

A. Cumulative Pref. Shares: - It is one which carries right to accumulate a fixed rate of dividend
to next year if not paid. In India, Pref. Share is always cumulative unless otherwise stated. If
dividend is in arrears for not less than two years, holder of such shares are entitled to take
part & vote on every resolution, on every matter in general body meeting of shareholders.

B. Non-Cumulative Pref. Shares: - They carry right to a fixed rate of dividend, but it cannot be
carried forward if it is not given in a particular year. If dividend remains in arrears for a period
of not less than 2 years of an aggregate period of 3 years comprised in six years ending
financial year, holder of such shares is also entitled to take part and vote on all resolutions
at any meeting of shareholders.

C. Participating Pref. Shares: - Apart from fixed rate of dividend these shares confer on the
holder the right to participate in the surplus profit after equity holders have been paid
dividend at a stipulated rate. In the event of liquidation also after equity holder have been
paid they have a right to receive predetermined portion of surplus.

D. Non-participating Pref. Shares: - A share on which only fixed rate of dividend is paid every
year without any accompanying additional rights in profits or in surplus on liquidation or
winding up is called „Non participating Pref. Share‟ unless otherwise specified, Pref. Shares
154
 are generally non participating.

E. Redeemable Pref. Shares: - These shares may be issued by company on condition that
company may repay them after fixed period or even earlier at company‟ s discretion. The
repayment on their share is called redemption and is governed by section 80 of the
companies Act 1956. In India companies can now issue only this category of pref. Share.

F. Non-redeemable Pref. Shares: - According to sec. 80 (5A) no company limited by share shall
issue irredeemable Pref. Shares or preference shares redeemable after expiry of 20 years
from the date of issue.

G. Convertible Pref. Shares: - These shares give right to the holder to get them converted into
equity shares at their option according to the terms & conditions of their issue.

H. Non-convertible Pref. Shares: - They do not enjoy the right of conversion to equity shares.
Pref. Shares are non-convertible unless otherwise stated.

I. Unless otherwise stated, Preference shares are Redeemable, cumulative, Nonparticipating

& Non-convertible.

Issue of Shares for Cash:

Application money cannot be less than 5% of the face value of shares. A company cannot allot
shares unless minimum subscription is received by the company.

Minimum Subscription
A public limited company cannot make any allotment of share unless the amount of minimum
subscription stated in the prospectus has been subscribed & sum payable on application has
been actually received by company. As part the guidelines of Security Exchange Board of India,
company must receive minimum of 90% subscription against entire issue. If company neither
does nor receive minimum subscription of 90% of the issue, the entire subscription shall be
refunded to applicants within 78 days from the date of closure of issue as per new guidelines
of SEBI. Any delay will attract interest @ 15% p.a.
Minimum Application money: Not less than 5% of face value of share.
Journal Entries for Issue of Shares for Cash:

1. On receipt of the application money Bank A/c Dr. (actual amount received) To Share
Application A/c
2. On allotment of share Allotment, A/c Dr. (a m o u n t due on allotment) Share Application
A/c Dr. (application amount received)
3. To Share Capital A/c(amount due on allot. & application)
4. On receipt of allotment money Bank, A/c Dr. To Share Allotment A/c (amount received
on allotment)
5. On a call being made Share Call A/c Dr. (amount due on the call)To Share Capital A/c
6. On receipt of call money Bank, A/c
Dr. (amount actually received on callCalls in arrears A/c Dr.
7. To Share Call A/c

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Over – Subscription and Pro – Rata Allotment:
When the shares are oversubscribed, the company cannot issue shares to all the applicants. At
such a time the company may allot shares to the applicants on pro – rata basis. „Pro – rata
allotment‟ means allotment in proportion of shares applied In Pro – rata allotment the excess
application money received is adjusted against the amount due on allotment or calls. Surplus
money after making adjustment against future calls is returned to the applicants. When there
is a pro – rata allotment, the total application money paid by an applicant is more than the exact
amount due on application. The excess amount is treated as an advance against allotment.

Calls in Arrears: It is an amt. not received when demanded by the company. As per the table „A‟,
interest at 5% p.a. can be charged on arrears.
Calls in advance: It is an amt. received from the share holder before demanded or called by the
company [Received in Advance]. It carries interest of 6% p.a. which is a mandatory provision
.
Issue Price
Face Value Issue Price Issued at

1.

100

100

Par
2

100

120

20% Premium
3.

100

98

2% Discount
* Issue of shares at Par : At face value.
Liabilities

Assets

Share capital

100

156
Bank

100
Issue of shares at Premium: At a price higher than face value. Share premium is a capital profit,
which is recorded in the Balance Sheet under that Reserves and Surplus. Share premium A/c
can be utilized.
(a) For issuing fully paid bonus shares.
(b) For writing off capital losses like discount on issue.
(c) To w/off miscellaneous expenditure [Fictitious Assets] like Preliminary Expenses.
(d) To adjust premium on redemption [Repayment]

Premium is adjusted in the entry of transfer. If it is collected at the time of allotment thenentry
will be:-
1) Transfer:- Share Allotment A/c
To Share Capital A/c
To Securities Premium A/c

Dr.(a+b)
ab
2)Received: - Bank A/c
To Share Allotment A/c

DR

a+b
a+

Liabilities

Assets

Share capital
Reserves and Surplus Share Premium

100
20

Bank

120

120

120

157
Shares issued at discount: At a price less than face value.
Discount on issue of shares is a capital loss. Which is written off gradually. It is recorded in the
Balance Sheet on the assets side under the hade miscellaneous expenditure to the extent not
written off. Amount of discount is adjusted in the entry of transfer of allotment.
1)Transfer: - Share Allotment A/c Dr. a Discount of issue of shares A/c
Dr. b
To Share Capital A/c (a+b)
2)Received: - Bank A/c DR. a To Share Allotment A/c a

Liabilities

Assets

Share capital

100

Bank Misc. Expenses 98

2

110

100

Forfeiture of Shares: Failure to pay call money results in forfeiture of shares. Forfeiture of
shares is the action taken by a company to cancel the shares. Shares are forfeited, the title of
such shareholder is extinguished but the amount paid is not refunded to him. Shareholder has
no further claim on the company.
In case of forfeiture the Share Capital Account will be debited with the called – up value of
shares forfeited. Allotment or Calls Account will be credited with the amount due but not paid
by the shareholder(s). (Alternatively, Calls – in – Arrears Account can be credited for all amount
due, if it was transferred to Calls – in – Arrears Account). Forfeited Shares Account or Shares
Forfeiture Account will be credited with the amount already received in respect of those shares.

Entries: Forfeiture
Share Capital A/c

Dr

[Called up Amt.]
To Calls in Arrears A/c
To Share forfeiture A/c

[Unpaid Amt.
[Paid up Amt.]
*

158
Re issue of forfeited shares:Bank A/c

Dr[Amt. received]
Share forfeiture A/c
To Share Capital A/c

Dr.

[Discount on Re-issue][Total]
* After Re-issue of forfeited shares, Balance amount of share forfeiture a/c is transferred to
capital reserve A/c because it is a capital profit.
Share forfeiture A/c DrTo Capital Reserve A/c
* When shares are re-issued at premium, premium on re-issue is transferred to sharepremium
A/c

Calculation of Profit on Re–issue of Forfeited Shares:

Credit balance of forfeited shares cannot be considered a surplus until the shares forfeited have
been re – issued,
Dr. Share Forfeiture A/c Cr.
To Share Reissued
(No Amt not recd per share)

xx

By Shares Forfeited
([Link] recd per share)

xx
To Capital Reserve

xx

To Balance c/d
(bal. No. Amt recd)

xx
Total

xx
Total

xx

Illustration 1:
Rajan who was the holder of 100 shares of 100 each, on which 75 per share has been called up
could not pay his dues on Allotment and First call each at 25 per share. The Directors forfeited
the above shares and reissued 75 of such shares to Rakesh at 65 per share paid–up as 75 per
159
share. Find the amount to be transferred to capital reserve a/c.

Dr. Share Forfeiture A/c Cr.

ToShares Reissued (75 10 )To Capital Reserve To Balance c/d ( 25 25 )
Rs. 750
Rs.1,125Rs

625

By Shares forfeited ( 100

25 )

Rs.2,500
Total

Rs.2,500

Total

Rs.2,500

Illustration 2 :
tlas Co. Ltd issued 6,000 equity shares of 10 each payable as 3 per share on Application, 5
per share (including 2 as premium) on Allotment and 4 per share on Call. All the shares were
subscribed. Money due on all shares was fully received except Rajan, Shyam, holding 200
shares, failed to pay the Call money, 200 shares were forfeited, 150 shares were subsequently
re–issued to Jagan as fully paid up at a discount of 2 per share. Find transfer to capital reserve.
Dr.

Share Forfeiture A/c

Cr.

To Share Reissued ( 150 2 )To Capital Reserve

To Balance c/d ( 50

6)

300
600
300

By Shares Forfeited ( 200

6)
160
1,200
Total

1,200

Total

1,200
Forfeiture of shares, originally issued at discount. The amount of discount on forfeited share
should be cancelled on forfeiture.
Share Capital A/c

Dr.

[called up]
To Discount on Issue of share

[Discount]
To Calls in Arrears

[Unpaid]
To Share Forfeited A/c

[Paid up]
When such shares are re-issued the original discount is again recorded.
Bank A/c

Dr.

[Amt. Received]
Discount of issue of shares A/c

Dr.

[Original Discount]
Share forfeiture A/c

Dr.

[Discount on re-issue]
To Share Capital A/c

[Total]
161
* Forfeiture of shares, originally issued at premium. Share premium is a profit. Profits are
recorded only when realized. There for if the shares are originally issued at premium but the
amount of the premium is not paid by the shareholder whose share are forfeited, along with
capital the amt. of premium should be cancelled.
Share Capital A/c

Dr.

[Called up Amt.]
Share premium A/c

Dr.

[Not received]To Calls in arrears A/c

[Unpaid]To Shares forfeiture A/c

[Paid up]

Issue of Shares for Consideration other than cash:

Company may issue shares in a direct exchange for land, building or other assets. Shares may
also be issued in payment for services rendered by promoters & lawyers in the formation of the
company.

Accounting Entries:
(a) When assets are purchased in exchange of sharesAssets Account
Dr.
To Share Capital Account
(b) When shares are issued to Promoters Goodwill Account
Dr.
To Share Capital Account
Format of a company Balance Sheet as on
Particulars
Amt
Particulars
Amt
Authorised CapitalIssued Capital Subscribed Capital Called up Capital Paid up Capital
(- )Calls-in-Arrears

xx
xxxx
xx
xxxx Fixed Assets Investments Current Assets Misc. Expenditure Discount on issue of
Shares / Debenture

xxxx xxxxxxxx

162
Reserves & Surplus
Preliminary Expenses
xx

Secured Loans

Unsecured Loans
Current Liab. & Provisions

Total
Xx
Total
xx

Important Points for re - issue :

1. Loss on re – issue should not exceed the forfeited amount.
2. If the loss in re–issue is less than the amount forfeited, the surplus should betransferred to
Capital Reserve. The forfeited amount on shares not yet reissued should be shown in the
Balance
3. Sheet as an addition to the share capital.
4. When only a portion of the forfeited shares are re – issued, then the profit made onre–issue
of such shares must be transferred to Capital Reserve.
5. For private placement of share by listed company, maximum brokerage @ 0.5% ofissue price.
6. When dividend is declared by company, it is called „Proposed Dividend and appears on liability
side of Balance Sheet under “Provision”.
7. On approval from central govt. the rate of discount on issue of shares can be 20% of nominal
value of shares

Company Liquidation: Voluntary vs Compulsory

Liquidating a company refers to the procedure in which a limited company is brought to a close
byan appointed Insolvency Practitioner (Liquidator).
The company’s assets are then sold (liquidated) and any realisation of revenue is redistributed
inorder of priority.
The company is struck-off the registrar of companies and this is known as dissolution, which is
thefinal stage of the liquidation process.

TOPIC WE WILL DISCUSS

1. How Long Does a Creditors’ Voluntary Liquidation Take?
2. What are the Time-Frames for Compulsory liquidation?
3. The Role of a Liquidator
4. What are the Potential Consequences for Directors?
5. Difference between Winding up, Liquidation & Bankruptcy
6. Priority of Claims
7. Do Employees Get Paid?
8. Can I Liquidate My Own Limited Company?
163
9. What are the Different Types of Liquidation?
10. Voluntary Liquidation of an Insolvent Limited Company
11. Voluntary Liquidation of a Solvent Limited Company
12. Compulsory Liquidation of a Company
13. The Liquidation Process in 5 Steps
14. How Long Does it Take?
15. Alternative Options for Insolvent Companies

Can I Liquidate My Own Limited Company?

The short answer is no. All insolvency procedures require the services of a licensed insolvency
practitioner.

Many directors fear they will not be able to pay for liquidations. Fortunately, almost all liquidations
can be paid for via the realisation of company assets or directors redundancy payments. Do
contactone of our team for a confidential discussion on how your liquidation might be funded if
this is an area of concern.

What are the Different Types of Liquidation?

There are two voluntary liquidation procedures and one compulsory procedure.
The voluntary procedures, Creditors Voluntary Liquidation and Members Voluntary Liquidation
areinitiated by the shareholders and directors.

The compulsory procedure is usually initiated by creditors like HMRC via a court [Link] three are
explored in more detail below.

Voluntary Liquidation of an Insolvent Limited Company

A Creditors’ Voluntary Liquidation (CVL) used by insolvent companies and is initiated by a
shareholders’ resolution. It involves the dissolution of the insolvent company and the
redistributionof the company’s assets to the creditors. This procedure enables directors to write
164
off unsecured limited company debts that are not personally guaranteed.

Directors may see voluntary liquidation as a welcome and safe exit from a stressful situation;
whilstaddressing all of the creditors, appropriately.

If the limited company has liabilities that it cannot afford to pay and you would like to move on
without the stress of the company’s debts hanging over your head, this type of business
liquidationmay be an appropriate option.

Although it should be seen as a last resort, liquidating a company via this route can be considered
arational decision and it may not necessarily mean the end of business.

Voluntary Liquidation of a Solvent Limited Company

A Member’s Voluntary Liquidation (MVL) is the appropriate way to liquidate a solvent UK company
and can be used as part of an exit strategy.

An MVL may be considered if you have a solvent company that you want to close as part of your
business plan and reduce taxation. Your company may have outlived its purpose and be heading
towards a natural end of trading, or you may wish to extract the value of cash and assets from
thecompany in a tax efficient manner.

For an MVL, the directors must sign a declaration stating that there are no remaining creditors.
Oneexample of a creditor could be tax arrears with HMRC for VAT or PAYE, so this need to be
considered before going into liquidation.

Compulsory Liquidation of a Company

Compulsory liquidations are usually initiated by a creditor that is looking to force a company into
closure via a court order application. The process is usually instigated with a winding up petition
and once it is heard at court, it can become a winding up order.

This procedure is often used to wind up your business as a last resort by disgruntled creditors
after failed negotiations over missed payments. This insolvency procedure is usually handled by
the Official Receiver, or an appointed Insolvency Practitioner. Therefore, this is not a voluntary
processfor directors.

The conduct of the directors is reported back to the Secretary of State at the end of the liqu idation
proceedings and failure to cooperate with the Official Receiver can have serious repercussions.
If you cannot pay the creditor and do not act immediately the situation can escalate quickly. Do
notignore any threat in the form of a winding up petition, as the intention is to forcefully liquidate
your company.

The Liquidation Process in 5 Steps

The details of the process when voluntarily liquidating a limited company depend largely on the
typeof liquidation that is chosen. However, the five basic steps below are included within all of

165
the procedures:
1. An Insolvency Practitioner is appointed as Liquidator.
2. The company’s assets are then assessed and realised (liquidated).
3. If there are any creditors, they are then paid in order of priority.
4. Surplus cash is distributed to the shareholders.
5. The company is finally dissolved and struck-off the registrar of companies (Companies
House).

How Long Does it Take?

There is no set timeframe to liquidate a limited company and with several variables dependent
oneach case, it is challenging to give an accurate time-frame without sufficient information.

However, once engaged, the Insolvency Practitioners will act immediately and the company can
beplaced into liquidation within a two-to-three week period if sufficient information is provided,
promptly.

The liquidator will remain in office until all of their responsibilities have been addressed.

How Long Does a Creditors’ Voluntary Liquidation Take?

Once the decision is taken to liquidate, the timeframe can be fairly rapid, with the company in
liquidation within around 14 days. There is a minimum statutory notice period for creditors of 7
daysso, assuming 90% percent of shareholders agreed to the short notice, it could potentially
happen inas little as 7 days.
What are the Timeframes for Compulsory liquidation?

Prior to compulsory liquidation, the following stages follow these timeframes:

• Statutory Demand – If you’ve been sent one of these by a creditor, you have 21 days to pay it,
or 18 days to set it aside.
• Application for a Winding up Petition Hearing – After the 21 day statutory demand, the creditor
now has the right to apply for a Winding up Petition hearing. These can take up to 2 weeks,
depending on how busy the court is.
• Winding up Hearing – There is a legal requirement to give a company 14 days written notice
of a winding up hearing.

The Role of a Liquidator

An appointed licensed Insolvency Practitioner (Liquidator) is required for liquidation and they
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have several duties in their position. These professionals have the responsibility to act as an
impartial, third-party to oversee the process from beginning to end, after their appointment.

The role of a liquidator encompasses various responsibilities which include, but are not limited
to:
• Distributing the realised assets and surplus funds to the appropriate parties;
• Determine any outstanding claims against the company and satisfy those claims in order of
priority that is set by law.

What are the Potential Consequences for Directors?

The most important thing for directors to realise when liquidating a company is that their
responsibilities undergo a marked shift if the company becomes insolvent.

Once insolvent, the directors must prove they have acted in the best interests of the creditors. To
avoid the threat of personal liability, it is important that directors act responsibly and take
professional advice, immediately.

Directors should be aware that once an Insolvency Practitioner is appointed, they will have a
responsibility to investigate the actions of company directors during the period preceding the
liquidation.

Principally, the liquidator looks for clarification that, as soon as the director became aware of the
insolvency, he/she put the interests of creditors first. Where this is not the case, the director
becomes open to charges of wrongful or fraudulent trading.

If this can be proven, the director may become personally liable for some or all of the company
debts.

Difference between Winding up, Liquidation & Bankruptcy

Liquidation and ‘winding-up’ are often used in the same context. Both of these terms refer to
liquidating a limited company; either because the company has cash -flow problems, or because
there are cash and assets, such as property, that the directors and shareholders would like to
extract.

Sometimes people mistakenly refer to the phrase “company bankruptcy”. Bankruptcy is only
relevant to an individual, partner, or sole trader and not a limited company.

Priority of Claims
Part of the Liquidator’s duties involves addressing the priority of claims during the insolvency
process. You can read more about who gets paid and in what order, including how employees
areaddressed.

Do Employees Get Paid?

This is a commonly asked question which we cover in more detail here.

Wages, wage arrears, holiday pay and notice pay are all covered up to certain statutory limits by
the Redundancy Payments Office of the Department of Trade and Industry.
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Alternative Options for Insolvent Companies
When you are considering liquidating a company due to financial problems, take the time to compare
all of the available options. There are other courses of action that may be available tocompanies
in financial difficulty, so consider exploring these before you decide to close the company via
liquidation.

You may find that options such as a Company Voluntary Arrangement (CVA) or Administration
will provide a viable way for the company to carry on trading. Insolvency procedures such as CVAs
andAdministration can be useful ways of restructuring a private company and would also require a
licensed insolvency practitioner to supervise the process, professionally.

One example of a benefit could be after an Administrator has been engaged and appointed they
can apply for a moratorium to be implemented. This may give the business some breathing space
and protection from further legal action taken by creditors. The business can then address its
assets, liabilities and employees to help guide the company towards a state of recovery.

Acquisition of a Company
‘Acquisition’ is a corporate term to define buying all of another company and gain the ownership of
the company. Here, companies share a common target and work towards achieving the same. Once
the main company achieves 50% of the target company, the company takes over the ownership of
the company. This is called acquisition. Few aspects about acquiring a company are as follows:

• The acquiring company purchases the target company’s stock and other assets to claim
ownership of the company completely.
• The acquiring company becomes the decision maker and policy setter.
• The company doesn’t require approvals from the old company/shareholders after takeover.
• Acquisitions can be paid for either in cash or in the acquiring company’s stock, or a combination
of both.

Reasons for Acquisition

A company can acquire another company at multiple levels. This is subjective to the collaborative
agreement and necessities. Before acquiring a company, it is vital to note that the company to be
acquired should have its own labour and management, a brand name, and other intangible assets.
There are multiple reasons behind acquiring a company. They are:

• Achieve economies of scale

• Greater market share
• Increased synergy
• Cost reductions
• New niche offerings
• Expansion of operations to another country

Types of Acquisitions
An acquisition can be of two types as a company acquires the other company at different levels.

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These types are:
• Asset Acquisition
• Stock Acquisition

The level at which a company is being acquired by the other company decides the level of control
the company has got on the other. Taking over a company is usually a result of a collaborative
business venture or to expand the business into different segment, worldwide.

Asset Acquisition
By definition, the acquirer buys some or all of the target’s assets/liabilities directly from the seller. If
all assets are acquired, the target is liquidated. The company that purchases the assets is called-
‘Acquirer’ and the company that gets acquired is called ‘Seller’. The acquirer chooses the assets or
liabilities to be purchased from the seller. Focusing more on the office supply to goodwill, the
acquirer chooses wisely and avoids every unwanted asset. The whole process is costly and tedious
starting from transfer of name and payment of taxes. Few aspects of asset acquisition are as
follows:

• Some assets, such as government contracts, may be difficult to transfer without the consent of
business partners or regulators.
• If the assets to be acquired are not held in a separate legal entity, they must be purchased in an
asset sale, rather than a stock sale.
• If the target liquidates, then there are two levels of tax, at the corporate level and again at the
shareholder level when the liquidation proceeds are distributed.
• The major tax advantage is that acquirer receives fair value valuation in the target’s net assets
(assets minus liabilities).
• Payment of transfer of asset could lead to GST or stamp duty implication.

Stock Acquisition
A Stock purchase is where all of the assets and liabilities of the seller are sold upon transfer of the
seller’s stock to the acquirer. This is a much simpler and less tedious process where the acquirer
does not receive stepped-up tax basis in the acquired net assets. But, there is an ensured ‘Carryover’
(Buyer assumes the seller’s existing tax basis in the acquired net assets) basis. Any goodwill created
in a stock acquisition is not tax-deductible. Few factors of stock acquisition are:

• A single level of tax–at the shareholder level.

• The buyer’s basis in the acquired stock is stepped up to the purchase price (FV). The buyer
assumes a carryover basis in the acquired assets.
• The unwanted assets are sold back to the seller.

Mergers and Acquisitions:Definition

The key principle behind M&A is that two companies together are more valuable than two separate
companies—at least, that's the reasoning. This rationale is particularly alluring to companies when
times are tough. Strong companies will act to buy other companies to create a more competitive,
cost-efficient company and, theoretically, more shareholder value. Meanwhile,target companies will
often agree to be purchased when they know they cannot survive alone.

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Distinction between Mergers and Acquisition
The terms merger and acquisition mean slightly different things, though they are often used
interchangeably.

When one company takes over another and clearly establishes itself as the new owner, the purchase
is called an acquisition. From a legal point of view, the target company ceases to exist, the buyer
absorbs the business and the buyer's stock continues to be traded while the target company’s stock
does not.

In the pure sense of the term, a merger happens when two firms, often of about the same size, agree
to go forward as a single new company rather than remain separately owned and operated. This
kind of action is more precisely referred to as a "merger of equals." Both companies' stocks are
surrendered, and new company stock is issued in its place. For example, both Daimler-Benz and
Chrysler ceased to exist when the two firms merged, and a new company, Daimler Chrysler, was
created.

A purchase deal will also be called a merger when both CEOs agree that joining together is inthe
best interest of both of their companies. But when the deal is unfriendly—that is, when the target
company does not want to be purchased—it is always regarded as an acquisition.

Whether a purchase is considered a merger or an acquisition really depends on whether the

purchase is friendly or hostile and how it is announced. In other words, the real difference lies in how
the purchase is communicated to and received by theEDUCATION
DIWAKAR target company's
HUB board of directors,
employees and shareholders.

Synergy of M & A
Synergy is often cited as the force that allows for enhanced cost efficiencies of the new business
and a reason to justify the transaction. Synergy takes the form of revenue enhancement and cost
savings. By merging, the companies hope to benefit from the following:

• Staff reductions. As every employee knows, mergers tend to mean job losses. Consider all the
money saved from reducing the number of staff members from accounting, marketing and other
departments. Job cuts will also include the former CEO, who typically leaves with a
compensation package.
• Economies of scale. Yes, size matters. Whether it's purchasing stationery or a new corporate IT
system, a bigger company placing the orders can save more on costs. Mergers also translate
into improved purchasing power to buy equipment or office supplies. When placing larger
orders, companies have a greater ability to negotiateprices with their suppliers.
• Acquiring new technology. To stay competitive, companies need to stay on top oftechnological
developments and their business applications. By buying a smaller company with unique
technologies, a large company can maintain or develop a competitive edge.
• Improved market reach and visibility. Companies buy other companies to reach new markets
and grow revenues and earnings. A merger may expand two companies' marketing and
distribution, giving them new sales opportunities. A merger can also improve a company's
standing in the investment community: bigger firms often have aneasier time raising capital than
smaller ones.

Achieving synergy is easier said than done. Achieving synergy takes:

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 • Planning. How will the combined entity actually go about achieving the synergies toutedduring
the process?
• Preparation and analysis. Ideally planning is done during the M&A due diligence process to
ensure that these synergies are real and what it will take to achieve them after the culmination
of the transaction.
• Execution. Once the transaction is finalized, critical decisions have to be made. Which
operations will be kept or closed? How will you entice key employees to stay? Who will be
accountable to see that these synergies are actually realized?
Varieties of Mergers
From the perspective of business structures, there is a whole host of different types of [Link]
are a few types, distinguished by the relationship between the two companies that are merging:

1. Horizontal merger - Two companies that are in direct competition and share the same product
lines and markets.
2. Vertical merger - A customer and company or a supplier and company. Think of a cone
supplier merging with an ice cream maker.
3. Market-extension merger - Two companies that sell the same products in differentmarkets.
4. Product-extension merger - Two companies selling different but related products in thesame
market.
5. Conglomeration - Two companies that have no common business areas.

There are also two types of mergers that are distinguished by how the merger is financed. Eachhas
certain implications for the companies involved and for investors:

1. Purchase Mergers - As the name suggests, this kind of merger occurs when one company
purchases another. The purchase is made with cash or through the issue of some kind of
debt instrument; the sale is taxable. Acquiring companies often prefer this type of merger
because it can provide them with a tax benefit. Acquired assets can be written-up to the actual
purchase price, and the difference between the book value and the purchase price of the
assets can depreciate annually, reducing taxes payable by the acquiring company. We will
discuss this further in part four of this tutorial.
2. Consolidation Mergers - With this merger, a brand new company is formed and both
companies are bought and combined under the new entity. The tax terms are the same as
those of a purchase merger.

Acquisitions
An acquisition may be only slightly different from a merger. In fact, it may be different in name only.
Like mergers, acquisitions are actions through which companies seek economies of scale,
efficiencies and enhanced market visibility. Unlike mergers, all acquisitions involve one firm
purchasing another — there is no exchange of stock or consolidation as a new company.
Acquisitions are often congenial, and all parties feel satisfied with the deal. Other times,acquisitions
are more hostile.

In an acquisition, a company can buy another company with cash, stock or a combination of the two.
Another possibility, which is common in smaller deals, is for one company to acquire all theassets
of another company. Company X buys all of Company Y's assets for cash, which means that
Company Y will have only cash (and debt, if they had debt before). Of course, Company Y becomes
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merely a shell and will eventually liquidate or enter another area of business.

Another type of acquisition is a reverse merger, a deal that enables a private company to get publicly
listed in a relatively short time period. A reverse merger occurs when a private companythat has
strong prospects and is eager to raise financing buys a publicly-listed shell company, usually one
with no business and limited assets. The private company reverse merges into
the public company, and together they become an entirely new public corporation with tradable
shares.

Regardless of their category or structure, all mergers and acquisitions have one common goal: they
are all meant to create synergy that makes the value of the combined companies greater than the
sum of the two parts. The success of a merger or acquisition depends on whether this synergy is
achieved.

Mergers and Acquisitions:Valuation Matters

In a merger or acquisition transaction, valuation is essentially the price that one party will pay forthe
other, or the value that one side will give up to make the transaction work. Valuations can be
made via appraisals or the price of the firm’s stock if it is a public company, but at the end of theday
valuation is often a negotiated number.

Valuation is often a combination of cash flow and the time value of money. A business’s worth is in
part a function of the profits and cash flow it can generate. As with many financial transactions, the
time value of money is also a factor. How much is the buyer willing to pay and at what rate of interest
should they discount the other firm’s future cash flows?

Both sides in an M&A deal will have different ideas about the worth of a target company: its seller
will tend to value the company at as high of a price as possible, while the buyer will try to get the
lowest price that he can.

There are, however, many legitimate ways to value companies. The most common method is to look
at comparable companies in an industry, but deal makers employ a variety of other methods and
tools when assessing a target company. Here are just a few of them:

1. Discounted Cash Flow (DCF) - A key valuation tool in M&A, discounted cash flow analysis
determines a company's current value according to its estimated future cash flows. Forecasted
free cash flows (net income + depreciation/amortization - capital expenditures - change in
working capital) are discounted to a present value using the company's weighted average costs
of capital (WACC). Admittedly, DCF is tricky to get right, but few tools can rival this valuation
method.

2. Comparative Ratios - The following are two examples of the many comparative metrics on which
acquiring companies may base their offers:

1. Price-Earnings Ratio (P/E Ratio) - With the use of this ratio, an acquiring company makesan offer
that is a multiple of the earnings of the target company. Looking at the P/E for all the stocks
within the same industry group will give the acquiring company good guidance for what the
target's P/E multiple should be.
2. Enterprise-Value-to-Sales Ratio (EV/Sales) - With this ratio, the acquiring company makes an
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 offer as a multiple of the revenues, again, while being aware of the price-to-sales ratio of other
companies in the industry.

Replacement Cost - In a few cases, acquisitions are based on the cost of replacing the target
company. For simplicity's sake, suppose the value of a company is simply the sum of all its
equipment and staffing costs. The acquiring company can literally order the target to sell at that
price, or it will create a competitor for the same cost. Naturally, it takes a long time to assemble
good management, acquire property and get the right equipment. This method of establishing a price
certainly wouldn't make much sense in a service industry where the key assets - people and ideas -
are hard to value and develop.

Some factors to consider in any analysis include:

• Future prospects of the business. Does the target company have solid growth prospects or at
least generate solid profits and cash flow?
• The risk of the other company? Are they in an industry that will add too much risk to the
combined entity? Operationally is the business well-run, is there a solid employee base?
• The cost of capital in terms of this transaction providing the best return on the acquiring party’s
capital.

What to Look For

It's hard for investors to know when a deal is worthwhile. The burden of proof should fall on the
acquiring company. To find mergers that have a chance of success, investors should start by looking
for some of these simple criteria:

1. Price-Earnings Ratio (P/E Ratio) - With the use of this ratio, an acquiring company makes an
offer that is a multiple of the earnings of the target company. Looking at the P/E for all the
stocks within the same industry group will give the acquiring company good guidance for what
the target's P/E multiple should be.
2. Enterprise-Value-to-Sales Ratio (EV/Sales) - With this ratio, the acquiring company makes an
offer as a multiple of the revenues, again, while being aware of the price-to-sales ratio of other
companies in the industry.

Mergers are awfully hard to get right, so investors should look for acquiring companies with a healthy
grasp of reality.

Tender Offer
In this type of transaction, one company offers to buy the outstanding stock of the other firm. This
offer is widely communicated to shareholders via advertisements and direct mailings to
shareholders. This is a way for the acquiring company to bypass the management of the target
company and acquire a controlling interest via acquiring enough shares of the company.

Tender offers are often used to execute a hostile takeover. The result of a successful tender offer
can actually be a merger of the two firms.

Working with financial advisors and investment bankers, the acquiring company will arrive at an
overall price that it's willing to pay for its target in cash, shares or both. The tender offer is then
frequently advertised in the business press, stating the offer price and the deadline by which the

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shareholders in the target company must accept (or reject) it.

Once the tender offer has been made, the target company can do one of several things:

1. Accept the Terms of the Offer - If the target firm's top managers and shareholders are happy
with the terms of the transaction, they will go ahead with the deal.
2. Attempt to Negotiate - The tender offer price may not be high enough for the target company's
shareholders to accept, or the specific terms of the deal may not be [Link] a merger, there
may be much at stake for the management of the target If they're not satisfied with the terms
laid out in the tender offer, the target's management may try to work out more agreeable terms
that let them keep their jobs or, even better, send them off with a nice, big compensation
package.
3. Not surprisingly, highly sought-after target companies that are the object of several bidders will
have greater latitude for negotiation. Furthermore, managers have more negotiating power if
they can show that they are crucial to the merger's future success.
4. Execute a Poison Pill or Some Other Hostile Takeover Defense – A poison pill scheme can be
triggered by a target company when a hostile suitor acquires a predetermined percentage of
company stock. To execute its defense, the target company grants all shareholders—except the
acquiring company—options to buy additional stock at a dramatic discount. This dilutes the
acquiring company's share and intercepts its control of the company.
5. Find a White Knight - As an alternative, the target company's management may seek out a
friendlier potential acquiring company, or white knight. If a white knight is found, it will offer an
equal or higher price for the shares than the hostile bidder.

Mergers and acquisitions can face scrutiny from regulatory bodies. For example, if the two biggest
long-distance companies in the U.S., AT&T and Sprint, wanted to merge, the deal would require
approval from the Federal Communications Commission (FCC). The FCC would probably regard a
merger of the two giants as the creation of a monopoly or, at the very least, a threat to competition
in the industry.

If the target company agrees to the tender offer and regulatory requirements are met, the merger
deal will be executed by means of some transaction. In a merger in which one company buys
another, the acquiring company will pay for the target company's shares with cash, stock or both.

A cash-for-stock transaction is fairly straightforward: target company shareholders receive a cash

payment for each share purchased. This transaction is treated as a taxable sale of the shares of the
target company.

Other Types of Transactions

In a purchase of assets transaction, the assets of one firm are acquired by another for cash. This
can allow the buyer to purchase only specific assets or operating units of the company. This also
limits the liabilities acquired to those associated with these specific assets.

In a merger transaction, payment to the shareholders of the acquiring company will be made invia
shares of the acquirer’s stock, cash or a combination of the two.

In a management buyout the firm’s management are the leaders of or at least part of the deal. This
is usually done via a tender offer which can lead to the company ceasing to exist as a publiccompany
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and move forward as a private company. In a leveraged buyout the funds for the tenderoffer come
primarily from the issuance of debt.

Tax Considerations
Tax considerations are a critical piece of the equation regardless of the size of the transaction and
should be considered in structuring the deal.

If the transaction is made with stock instead of cash, then it's not taxable. There is simply an
exchange of share certificates. The desire to steer clear of the tax man explains why so many M&A
deals are carried out as stock-for-stock transactions.

When a company is purchased with stock, new shares from the acquiring company's stock are
issued directly to the target company's shareholders, or the new shares are sent to a broker who
manages them for target company shareholders. The shareholders of the target company are only
taxed when they sell their new shares.

When the deal is closed, investors usually receive a new stock in their portfolios—the acquiring
company's expanded stock. Sometimes investors will get new stock identifying a new corporate
entity that is created by the M&A deal.
As mergers capture the imagination of many investors and companies, the idea of getting smaller
might seem counterintuitive. But corporate break-ups, or de-mergers, can be very attractive options
for companies and their shareholders both in terms of the ongoing business and adding shareholder
value.

According to the Wall Street Journal, the value of corporate spin-offs, which occurs when a company
divests itself of a business unit to create a new standalone company, totaled over $250billion in
2015, almost double the level of 2014.

Some reasons cited by FINRA that can motivate spin-offs include:

• Better management. Senior management of the corporation may be adept at managing the
overall enterprise, but one particular business unit may be out of their scope of expertise.
Spinning this unit off as a separate company allows the management of that business unit to
drive strategy for the business unit as a separate, distinct company without worrying about the
impact on the larger corporation they are a subsidiary of.
• Differing growth paths and strategies. The business unit might be growing slower thanthe parent
corporation and could be a drag on the parent’s resources. Or the opposite could be the case. In
either situation allowing the unit to function as an independent business can allow it grow at its
own pace and potentially attract investors that are interested in direct ownership of the new
company.
• Better analyst coverage for the parent. Divesting and spinning off a business unit can actually
increase visibility among securities analysts resulting in better coverage of theparent company
post-spinoff. The parent company is less complex with one less business unit and easier for
analysts to understand and analyze.
• Unlocking shareholder value. Often spinning off a subsidiary can add value for shareholders.
The spinoff as an independent company may be more valuable than aspart of the parent.
• A spinoff can be a complex transaction for a whole range of reasons including how to handle
employment contracts with key employees, pensions and retirement plans, technology and
 back-office services among other things. These and and a host of other issues require careful
planning and execution to ensure a smooth transaction.

Beyond spinoffs there are some other methods companies rid themselves of business units:

Sell-Offs
A sell-off, also known as a divestiture, is the outright sale of a company subsidiary. Normally, sell-
offs are done because the subsidiary doesn't fit into the parent company's core strategy. Themarket
may be undervaluing the combined businesses due to a lack of synergy between the parent and
subsidiary. As a result, management and the board decide that the subsidiary is better off under
different ownership.

Besides getting rid of an unwanted subsidiary, sell-offs also raise cash, which can be used to payoff
debt. In the late 1980s and early 1990s, corporate raiders would use debt to finance acquisitions.
Then, after making a purchase they would sell-off its subsidiaries to raise cash to service the debt.
The raiders' method certainly makes sense if the value of the parts is greater than the whole. When
it isn't, deals are unsuccessful.

Equity Carve-Outs
More and more companies are using equity carve-outs to boost shareholder value. A parent firm
makes a subsidiary public through an initial public offering (IPO) of shares, amounting to a partial
sell-off. A new publicly listed company is created, but the parent keeps a controlling stake in the
newly traded subsidiary.

A carve-out is a strategic avenue a parent firm may take when one of its subsidiaries is growing
faster and carrying higher valuations than other businesses owned by the parent. A carve-out
generates cash because shares in the subsidiary are sold to the public, but the issue also unlocks
the value of the subsidiary unit and enhances the parent's shareholder value.

The new legal entity of a carve-out has a separate board, but in most carve-outs, the parent retains
some control. In these cases, some portion of the parent firm's board of directors may be shared.
Since the parent has a controlling stake, meaning both firms have common shareholders, the
connection between the two will likely be strong.

That said, sometimes companies carve-out a subsidiary not because it's doing well, but becauseit is
a burden. Such an intention won't lead to a successful result, especially if a carved-out subsidiary is
too loaded with debt, or had trouble even when it was a part of the parent and is lacking an
established track record for growing revenues and profits.

Carve-outs can also create unexpected friction between the parent and subsidiary. Problems can
arise as managers of the carved-out company must be accountable to their public shareholders as
well as the owners of the parent company. This can create divided loyalties.

Tracking Stock
Tracking stock is a special type of stock issued by a publicly held company to track the value ofone
segment of that company. The stock allows the different segments of the company to be valued
differently by investors.
Let's say a slow-growth company trading at a low price-earnings ratio (P/E ratio) happens to have a
fast-growing business unit. The company might issue a tracking stock so the market canvalue the
new business separately from the old one and at a significantly higher P/E rating.

Why would a firm issue a tracking stock rather than spinning-off or carving-out its fast growth
business for shareholders? The company retains control over the subsidiary; the two businessescan
continue to enjoy synergies and share marketing, administrative support functions, a headquarters
and so on. Finally, and most importantly, if the tracking stock climbs in value, the parent company
can use the tracking stock it owns to make acquisitions.

Still, shareholders need to remember that tracking stocks are class B, meaning they don't grant
shareholders the same voting rights as those of the main stock. Each share of tracking stock may
have only a half or a quarter of a vote. In rare cases, holders of tracking stock have no voteat all.

Concept And Types of Reconstruction

When a company is suffering loss for several past years and suffering from financial difficulties, it
may go for reconstruction. In other words,DIWAKAR when a EDUCATION
company's HUBbalance sheet shows huge
accumulated losses, heavy fictitious and intangible assets or is in
financial difficulties or is to over capitalized, and then the process of reconstruction is restored.
Reconstruction may be internal and external.

1. External reconstruction
When a company is suffering losses for the past several years and facing financial crisis, the
company can sell its business to another newly formed company. Actually, the new company is
formed to take over the assets and liabilities of the old company. This process is called external
reconstruction. In other words, external reconstruction refers to the sale of the business of existing
company to another company formed for the purposed. In external reconstruction, one company
is liquidated, and another new company is formed. The liquidated company is called "Vendor
Company" and the new company is called "Purchasing Company". Shareholders of vendor company
become the shareholders of purchasing company.

2. Internal Reconstruction
Internal reconstruction refers to the internal re-organization of the financial structure of a
company. It is also termed as re-organization which permits the existing company to be continued.
Generally, share capital is reduced to write off the past
accumulated losses of the company. The accounting procedure of internal reconstruction is
distinct from that of amalgamation, absorption and external reconstruction.

Difference Between Internal and ExternalReconstruction comparison Chart

BASIS FOR
INTERNAL RECONSTRUCTION EXTERNAL RECONSTRUCTION
COMPARISON

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 External reconstruction is one in
Internal reconstruction refers to the
which the company undergoing
method of corporate restructuring
Meaning reconstruction is liquidated to take
wherein existing company is not
over the business of existing
liquidated to form a new one.
company.

New company No new company is formed. New company is formed.

Use of specific terms in Balance Sheet of the company No specific terms are used in the
Balance Sheet contains "And Reduced". Balance sheet.

Capital is reduced and the external

Capital reduction No reduction in the capital
liability holders

BASIS FOR COMPARISON

INTERNAL RECONSTRUCTION

EXTERNAL RECONSTRUCTION

waive their claims.

Approval of court

Approval of court is must.

No approval of court is required.

Transfer of Assets and Liabilities

No such transfer takes place.

Assets and liabilities of existing company are transferred to the new company.

Difference Between Internal and ExternalReconstruction

June 7, 2017, By Surbhi S 1 Comment
Reconstruction is a process of the company’s reorganization, concerning legal, operational,
ownership and other structures, by revaluing assets and reassessing the liabilities. There are two
methods of reconstruction which are internal reconstruction and external reconstruction. The former
is the method in which the reconstruction is undertaken without winding up the company and
forming a new one, while the latter, is one whereby the existing company loses its existence, and a
new company is set up to take over the business of the existing company.

Reconstruction is required when the company is incurring losses for many years, and the
Content: Internal Reconstruction Vs External Reconstruction

1. Comparison Chart
2. Definition
3. Key Differences
4. Conclusion

Comparison Chart
BASIS FOR COMPARISON

INTERNAL RECONSTRUCTION

EXTERNAL RECONSTRUCTION

Meaning

Internal reconstruction refers to the method of corporate restructuring wherein existing company
is not liquidated to form a new one.

External reconstruction is one in which the company undergoing reconstruction is liquidated to

take over the business of existing company.
New company

No new company is formed.

New company is formed.
Use of specific terms in Balance Sheet

Balance Sheet of the company contains "And Reduced".

No specific terms are used in the Balance sheet.

Capital reduction

Capital is reduced, and the external liability holders waive their claims.

No reduction in the capital

Approval of court

Approval of court is must.

No approval of court is required.

Transfer of Assets and Liabilities

No such transfer takes place.

Assets and liabilities of existing company are transferred to the new company.

Definition of Internal Reconstruction

A recourse undertook by the enterprise, in which substantial changes are made in the company’s
capital structure, without resorting to the liquidation of the existing company, is
Internal Reconstruction focuses on relieving the company from debts and losses by negotiating with
the creditors and reducing the outstanding amount towards them, so as to reach a favorable
position. The methods given below are generally employed to affect the internal reconstruction
process:
 • Alteration of Share Capital
• Sub-division and Consolidation of Shares
• Conversion of shares into stock or stock into shares.
• Variation of Shareholder’s rights
• Reduction of Share Capital
• Compromise/Arrangement
• Surrender of Shares.

In this process, the assets are restated, to represent fair values, and liabilities are restated to show
the settable amount, and thus the balance sheet shows a true picture. In this scheme, trading losses
and fictitious assets are written off, against the claim sacrificed by the debenture holders, creditors,
etc.

Definition of External Reconstruction

External Reconstruction is a process in which the company’s financial affairs are wound up, and a
new company is formed to take over the assets and liabilities of the existing company, after the
reorganization of the financial position. It requires the approval of shareholders, creditors and
National Company Law Tribunal (NCLT).

In external reconstruction, the undertaking is being continued by the company but is in substance
transferred to a company which is not an external one, but another entity that comprises of almost
same shareholders, to be carried on by the transferee company. The accounting treatment of
external reconstruction is same as the amalgamation in the nature of the purchase

Key Differences Between Internal and External Reconstruction

The following points are relevant on account of the differences between internal and external
reconstruction:

1. Internal reconstruction can be defined as the reorganization of the company, without liquidating
the existing company and forming a new one. On the other hand, an external reconstruction is
a form of corporate restructuring wherein the existing company is liquidated to give birth to a
new company, for continuing the business of the existing one.
2. No new company is formed in internal reconstruction. Conversely, the new company is formed
in the external reconstruction, to take over the business of the existing company.
3. In internal reconstruction, the capital of the company is reduced, and external liabilities such
as debenture holders and creditors waive their claims by giving a discount. On the other hand,
in external reconstruction, there is no reduction in the capital of the company.
4. In internal reconstruction, court’s approval is mandatory, because the reduction in capital may
affect the rights of the shareholders, which requires confirmation from the court. As against,
in external reconstruction, there is no such approval required.
5. When the company undergoes internal reconstruction process, the Balance sheet prepared
after the process contains the terms, “And Reduced.” On the contrary, there are no specific
 terms used in the Balance Sheet in the case of external reconstruction.
6. In internal reconstruction, since there is no new company is formed, there is no transfer of
assets and liabilities. Unlike, external reconstruction, assets, and liabilities of the old company
are transferred to the new company.

Conclusion
The primary objective of reconstruction of an entity is the reorganization of its capital which can be
done by canceling unrepresentative value of the assets of the business, settling creditors claim by
taking the discount and achieving economies in operations.
Holding Company Accounts

Introduction:
A holding company is one which controls one or more companies either by meansof holding shares
in that company or companies or by having powers to appoint—directly or indirectly—the whole, or a
majority, of the Board of Directors of those companies.
A company controlled by a holding company is known as a subsidiary company. Practically, it is a
part and parcel of the combination movement in business and is operated for the purpose of
controlling companies engaged in a similar line of business.

A company, viz., X Ltd., may control another company, viz., Y Ltd., byany one of the three ways:
(a) by holding more than half the shares—having voting rights in Y Ltd.
(b) by controlling the composition of the Board of Directors of Y Ltd.; and by controlling a holding
company which actually controls Y Ltd. i.e., if Y [Link] the subsidiary of Z Ltd., and Z
Ltd. becomes the subsidiary of X Ltd., inthat case, Y Ltd. will also be the subsidiary of X Ltd.

Statutory Definition—Subsidiary Company:

There is no statutory definition of holding company in the Companies Act, [Link], Section 4 of the
Companies Act, 1956, defines a subsidiary company.
According to this section, a company is subsidiary company of another if, but onlyif,
1. that other company controls the composition of the Board of Directors, or,that other
2. where the first-mentioned company is an existing company in respect of which the holders of
preference shares issued before the commencement of this Act have the same voting rights in
all respects as the holders of equity shares, exercises or controls more than half of the total
voting power of such company.
3. where the first-mentioned company is any other company, which holds morethan half in nominal
value of its equity share capital; the first-mentioned company is a subsidiary of any company
which is thatother company’s subsidiary.
4. For the purpose of Subsection (a) stated above, the company is said to be in control or
composition of its Board of Directors if, but only if—’the other companyby the exercise of some
power exercisable by it at its discretion without the consent or concurrence of any other person,
can appoint or remove the holders of all or a majority of the directorships; but for the purpose of
this provision that other company shall be deemed to have power to appoint to a directorship
with respect to which any of the following conditions is satisfied, that is to say—that a person
cannot be appointed thereto without the exercise in his favourby that other company of such a
power as aforesaid

That a person’s appointment thereto follows necessarily from his appointment as Director, or
manager of, or to any other office of employment in, that other company; or that the directorship is
held by an individual nominated by that othercompany or a subsidiary there of.
A company shall be deemed to be the holding company of another if, but only if,that other is its
subsidiary.

Requirements of Sec. 212 (Legal Requirements for Presenting Infor-mation to the Members of the
Holding Company):

A holding company must attach to its Balance Sheet certain documents relating to its subsidiary.
According to the said section:
1. There shall be attached to the Balance Sheet of a holding company having a subsidiary or
subsidiaries at the end of the financial year as at which the holding company’s Balance Sheet is
made out, the following documents in respect of suchsubsidiary, or of each such subsidiary, as
the case may be—
(a) a copy of the Balance Sheet of the subsidiary.
(b) a copy of its Profit and Loss Account.
(c) a copy of the report of its Board of Directors.
(d) a copy of the report of its Auditors.
(e) a statement of the holding company’s interest in the subsidiary as specified inthe sub-section
(3);
(a) the statement referred to in sub-section (5), if any, and
(b) the report referred to in sub-section (6), if [Link] at the end of the financial year of the
subsidiary, where such financialyear coincides with the financial year of the holding company.

1. as at the end of the financial year of the subsidiary, where such financial year coincides with
the financial year of the subsidiary but does not coincide with thatof the holding company.
2. as at the end of the financial year of the subsidiary last before that of the holding company
where the financial year of the subsidiary does not coincidewith that of the holding company.
3. The Profit and Loss Account and the reports of the Board of Directors and of the auditors,
referred to in clauses (b), (c) and (d) of sub-section (1), shall be made out, in accordance with
the requirements of this Act, for the financial yearof the subsidiary referred to in clause (a).
4. Where the aforesaid financial year of the subsidiary shall not end on a day which precedes the
day on which the holding company’s financial year ends bymore than 6 months.
5. Where the financial year of the subsidiary is shorter in duration than that of its holding company,
references to the financial year of the subsidiary in clauses (a), (b) and (c) shall be construed
as references to two or more financial years of the subsidiary the duration of which, in the
aggregate, is not less than the duration of the holding company’s financial year.
6. The statement referred to in clause (e) of sub-section (I) shall specify—
7. the extent of the holding company’s interest in the subsidiary at the end of thefinancial year or
of the last of the financial years of the subsidiary referred to in sub-section (2);
8. the net aggregate amount, so far as it concerns member of the holding company and is not
dealt with in the company’s accounts of the subsidiary profitsafter deducting its losses, or vice
versa—for the financial year or years of the subsidiary company; and (ii) for the previous
financial years of the subsidiary since it became the holding company’ssubsidiary
the net aggregate amount of the profits of the subsidiary after deducting its losses, or vice
versa—
(i) for the financial year or years of subsidiary aforesaid; and (ii) for the previousfinancial years
of the subsidiary since it became the holding company’s subsidiary; so far as those profits are
 dealt with, or provision is made for those losses, in the company’s accounts.
1. Clause (b) and (c) of sub-section (3) shall apply only to profits and losses of the subsidiary
which may properly be treated in the holding company’s account as revenue profits or losses,
and the profits or losses attributable to any shares in a subsidiary for the time being held by the
holding company or any other of its subsidiaries shall not be treated as aforesaid so far as they
are profits or losses forthe period before the date on or as from which the shares were acquired
by the company or any of its subsidiaries, except they may in a proper case be so treated
where—
i. the company is itself the subsidiary of another body corporate; and
ii. the shares were acquired from that body corporate or a subsidiary of it.

Where the financial year or years of a subsidiary referred to in sub-section (2)do not coincide with
the financial year of the holding company, a statement containing information on the following
matters shall also be attached to the Balance Sheet of the holding company :

1. whether there has been any, and, if so, what change in the holding company’s interest in the
subsidiary between the end of the financial year or of the last of the financial years of the
subsidiary and the end of the holding company’s financial year;
2. details of any material change which has occurred between the end of the financial year or of
the last of the financial year of the subsidiary and the end ofthe holding company’s financial year
in respect of—
3. subsidiary’s fixed asset; (ii) its investments; (iii) the moneys lent by i t, and (iv) the moneys
borrowed by it for any purpose other than that of meeting current liabilities.
4. If the Board of Directors of the holding company is unable to obtain information on any one of
the matters required to be specified by sub-section (4),a report in writing to that effect shall be
attached to the Balance Sheet the holdingcompany.
5. The documents referred to in clause (e), (f) and (g) of sub-section (1) shall besigned by the
persons by whom the Balance Sheet of the holding company is required to be signed.
6. The Central Government may, on the application or with the consent of the Board of Directors
of the company, direct that in relation to any subsidiary the provision of this section shall not
apply or shall apply only to such extent as maybe specified in the direction.
7. If any such person, as is referred to in sub-section (6) of Section 209, fails to take all reasonable
steps to comply with the provisions of this section, he shall, in respect of each offence, be
punishable with imprisonment for a term which may extend to 6 months, or with fine which may
extend to Rs. 1,000, or with both.
8. If any person, not being a person referred to in sub-section (6) of Section 209, having been
charged by the managing director, manager or Board of Directors, as the case may be, with the
duty of seeing that the provisions of this section are complied with, makes default in doing so,
he shall, in respect of eachoffence, be punishable with imprisonment for a term which may
extend to 6 months, or with a fine which may extend to Rs. 1,000, or with both.

Advantages of Holding Companies:

1. Formation of a holding company offers many advantages some ofwhich are:
2. Since the subsidiary company can maintain its own separate entity, it can retain its own
individual existence, i.e., goodwill cannot be damaged as a result ofthe amalgamation
3. The subsidiary company can carry forward its losses for income-tax purposesas it possesses
its own separate entity.
 4. Economic and/or financial trend and rate of earning profit of subsidiary companies can be
known since they prepared their individual accounts.
5. If a particular process is found to be unprofitable, the same can be recognised and, if
necessary, may be dissolved. Necessary arrangement may be made for thesame.
6. Expenses and costs may be reduced as a result of the combination of different general
charges and overheads.
7. Since a large organisation can afford greater facilities for experiment and research, technical
knowledge and experience may be utilised properly.
8. Disadvantages:
9. Formation of a holding company is also not free from snags. Some ofthem are :
10. There is a greater possibility of the exploitation of ‘outside’ shareholders, i.e., interest of
minority shareholders are not properly protected.
11. It invites manipulation of accounts since the system of accounting is a complicated one,
particularly when the financial accounts of both the holding andsubsidiary companies are
prepared at different dates.
12. Valuation of share of a holding company is not so easy to calculate; as a result, the
shareholders find it very difficult to ascertain the value of their holdings.
13. Since the companies are connected with a number of companies, creditors are easily
misleaded.
14. The financial conditions of the subsidiary companies may not be expressed properly to the
shareholders of the holding company.
15. Inter-company transactions are not made and adjusted properly.
16. Where the holding company has worldwide interest, it is very difficult toprepare accounts in
different currencies.
17. Inter-company stock at a huge quantity creates a further trouble for their verification and
valuation.

Consolidation of Financial Statement:

1. Although, in India, it is not mandatory to prepare a consolidated financial statement other than
to fulfil the requirement of the Companies Act, 1956 (whichhas been discussed earlier), the Indian
holding companies prepare the consolidated final statement in order to take the benefit of
consolidation.
2. However, in developed countries (i.e., UK, USA, Japan, etc.) the financial statements are to be
consolidated with the subsidiary company since it ismandatory.
3. International Accounting Standard (IAS 27) supplies “Consolidated Financial Statements and
Accounting for Investment in Subsidiaries” which has been presented at the end of this chapter.

Consolidated Balance Sheet:

A Consolidated Balance Sheet is the Balance Sheet of both holding company and its subsidiary or
subsidiaries which is prepared in order to show the assets and liabilities in a consolidated form. Its
purpose is to show the financial position of a group consisting of a holding and one or more
subsidiary companies. In India, asper Companies Act, 1956, however, it is not required to make a
Consolidated Balance Sheet. The same is prepared only for the sake of convenience, i.e., in India, it
is not obligatory. But in U.K. the publication of the Consolidated Balance Sheet is obligatory.
Before discussing the principles of consolidation certain other adjustments relating to Consolidated
Balance Sheet are to be discussed. In short, all assets andliabilities should be classified in the same
manner, valuation is to be made on the same principles and the date of preparing accounts must
also be the same.
In the absence of the said information, adjustments must be [Link] of them are

1. to adjust any trading loss of subsidiary which is sustained between the end of financial year
and the date of consolidation.
2. if the liquid position of the group is affected by large transfer of cash between the two
companies or the capital expenditure sustained by the subsidiary betweenthe two Balance
Sheet dates: and for inter-company transactions.

Preparation of a Consolidated BalanceSheet: Miscellaneous Adjustments

Let us make an in-depth study of the miscellaneous adjustments inpreparation of a consolidated
balance sheet.

Unrealized Inter-Company Profits:

An unrealized inter-company profit exists only when there is a sale of goods by one company in the
group to another at a profit, and the same goods remain unsold and appear as an asset in the
Balance Sheet.
This unrealized profit made by the selling company is to be eliminated at the time of preparing a
Consolidated Balance Sheet since such profit is true from the individual point of view but not from
the view of a group.
The Consolidated Balance Sheet shows an overall picture of the group and that is why such
unrealized profit should be eliminated.

The following principles should be followed for the purpose:

(a) Ascertain the amount of profit on unsold stock supplied by the company in the group.
(b) Share of minority interest should be deducted from such unrealised profit so calculated, and
(c) The balance of unrealised profit (i.e., Molding Company’s share or after deducting minority
interest) is to be deducted from the profit of the company whois selling the goods and from
the books of the company receiving those goods as well. In short, holding company’s share
of unrealised profit should be deducte
from the Consolidated Stock in the assets side of the Consolidated Balance Sheetand the
same amount should also be deducted from the Profit and Loss Account in the Consolidated
Balance Sheet.
There are some authorities who prefer to eliminate the whole of such unrealised profit in all cases
since it represents the original cost of the asset in the group.
Similarly, unrealised profit on fixed assets (i.e., if one company transfers a fixed asset at a profit to
another company in the group) should also be adjusted.
However, as per AS 21, Clause 16, Consolidated Financial Statements, Unrealised Profit must be
deducted in full.

However, the elimination of inter-company profits is made only so long as suchasset is held. On the
disposal of the asset, the profit is treated for consolidation purposes as a realised profit.
Illustration 1:
H. Ltd. acquired 4,000 shares of S. Ltd. on 1.1.2000.
Their Balance Sheets as at 31.12.2000 stood as follows
171
 172

Issue of Bonus Shares:

When subsidiary company issues bonus shares, the same will increase only the number of shares
in the hands of the holding company. The treatment, of course,depends on the sources from which
such bonus shares are issued, i.e., whether the bonus shares are issued out of the Pre-acquisition
Profit/Capital Profit or outof the Post-acquisition Profit/Revenue Profit.

If Bonus Shares are Issued out of Capital Profit:

There will be no effect in Cost of Control or Goodwill Account and minority interest for this purpose
since pre-acquisition profit is reduced in one hand and paid-up value of share held will increase on
the other. As a result, there will be ultimately no effect for the purpose of issuing bonus shares out
of Capital Profit inGoodwill Account or Capital Reserve or Minority Interest.

If Bonus Shares are Issued out of Current Profit:

When bonus shares are issued out of current or revenue profit, holding company’s shares in current
profit should be calculated only after making the proper adjustment for bonus issue from the said
current profits, which will ultimately reduce the amount of holding company’s share in current
profits. Thus, Cost of Goodwill will be reduced by the amount of increased value of paid-up shares.
Out of Capital Profit:
Illustration 2:
Parent Ltd. acquired 6,000 equity shares of Rs.10 each in Subsidiary Ltd. onDec.31, 2000.
The summarized Balance Sheets of Parent Ltd. and Subsidiary Ltd. ason that date were
173
 174

(a) Out of Current Profit:

Illustration 3:
The Balance Sheets of H. Ltd. and S. Ltd. as at 19 ............................................. are:
 175

S. Ltd. has a credit balance of Rs. 40,000 in the General Reserve when H. Ltd. acquired share in S.
Ltd. S. Ltd. capitalized Rs. 20,000 out of profits earned afterthe acquisition of its shares by H. Ltd.
by making a bonus issue of one share for every five shares held. Prepare a consolidated Balance
Sheet as at19……………………

(b) Revaluation of Fixed Assets:

Sometimes fixed assets of the subsidiary company are revalued at the time of acquisition of shares.
If, as a result of revaluation, profit or loss on fixed assets takes place, such profit or loss should be
treated as capital profit or capital loss. Since the capital profit cannot be utilised for the purpose of
declaring dividend the same is shown in the Liability side of the Balance Sheet of the subsidiary
company under the head ‘Capital Reserve’ or may be written-off against Goodwill. Therefore, the
profit made on revaluation of fixed asset should be treated as Capital Profit and, hence, it will be
distributed between holding company and minority interest according to their ratio as usual.

ADVERTISEMENTS:
It should be remembered in this respect that depreciation should also be providedon the increased
or decreased value of fixed asset against the revenue profit as well. In other words, in case of profit
on revaluation or under-valuation of assets, additional provision for depreciation should be made,
i.e., it will be deducted from the current/revenue profit and, in the case of loss on revaluation or over-
valuation of assets, provision for depreciation should be written-back, i.e., it will be added with the
amount of current/revenue loss.

Illustration 4:
From the following Balance Sheets of H. Ltd. and its subsidiary S. Ltd. drawn up at 31.12.1999,
prepare a Consolidated Balance Sheet as at that date, having regard to the following:

1. Reserve and Profit and Loss Account (Cr.) of S. Ltd. stood at Rs. 25,000 and Rs. 15,000,
respectively, on the date of acquisition of its 80% shares held by [Link]. on 1.1.1999, and’

ADVERTISEMENTS:
1. Machinery (Book value Rs. 1,00,000) and Furniture (Book value Rs. 20,000)of S. Ltd. were revalued
at Rs. 1,50,000 and Rs. 15,000, respectively, for the purpose of fixing the price of its shares, there
was no purchase or sale of these assets since the date of acquisition
176
(c) Debentures of Subsidiary Company:
Sometimes Debentures of subsidiary company are held by holding company which are shown under
the head ‘Investments’ in the Balance Sheet of holding company. These are to be eliminated while
preparing Consolidated Balance [Link] if there is any difference between the cost price and paid-
up value of Debentures, the same will, however, be adjusted against Cost of Control or Goodwill
Account. Similarly, if there is any outstanding Debenture Interest, the same also will be adjusted.
Consider the following examples:

(d) Preference Shares of Subsidiary Company

(1) When Preference Shares are Held by Outsiders:
If preference shares are held by outsiders, the same will be included with minority interest by the
amount of paid-up value of shares held (including the arrear dividend, if any). But a proper provision
should be made against existing reserves which is to be added with minority interest if the profit of
the subsidiarycompany becomes insufficient to pay cumulative dividend on preference shares.

Illustration 5:
The following are the Balance Sheets of H. Ltd. and its subsidiary [Link]. as at 31.12.199
(2) When Preference Shares are Held by the Holding Company: When preference shares of
subsidiary company are held by the holding company,the treatment will be the same as in the case
of equity shares, i.e., the paid-up value will be deducted from the cost of shares. The difference
(between the cost price and paid-up value), if any, will represent cost of control which will be added
with cost of control that is derived from the equity shares. But if the subsidiary company issues
these shares either at a discount or at a premium, the same will not be adjusted against Cost of
Control/Goodwill but will be incorporated with the cost of preference shares.
The preference dividend accrued to the date of acquisition will be adjusted against Goodwill/Cost
of Control. But the dividend which has accrued from thedate of acquisition to the date of preparation
of accounts will, however, be considered as revenue profit and the same will be included with the
share of profit of holding company in the Liability side of the Balance Sheet.

Illustration 6:
H. Ltd. acquires 80% of both classes of shares of S. Ltd., on 1.1.2001, at a totalcost of Rs. 1,00,000.
The Balance Sheets of the two companies as on that date are
(e) Dividends:
(i) Ordinary:
It is quite natural that the holding company will receive dividend from the subsidiary company since
the former has acquired the major portion of shares. Itmay be stated that such dividend may be paid
by the subsidiary company out of
(i) Pre-acquisition Profit, or (ii) Post-acquisition Profit

(a) If dividends are paid out of Pre-acquisition Profit:

If the dividend has been distributed out of Capital Profit/Pre-acquisition Profit and has already been
credited by the Profit and Loss Account of holding company, in that case, Profit and Loss Account
should be debited and InvestmentAccount should be credited in order to make proper reconciliation
for the Consolidated Balance Sheet. In short, such dividend (only holding company’s share) will be
adjusted against Goodwill or Capital Reserve and the same also will be deducted from the
Consolidated Profit and Loss Account in the Consolidated Balance Sheet.
To Sum up:
1. Deduct the amount of dividend (holding company’s share) while computing Goodwill or
Capital Reserve; and
2. Deduct the same also from Consolidated Profit and Loss Account in theConsolidated Balance
Sheet, which appears in the Liability side.
3. Note: There will be no adjustment if the same has correctly been recorded in thebooks by the
holding company.

Consider this illustration:

Illustration 7:
Holders Ltd. acquired 4,000 shares of Rs. 10 each, on 30.6.2,000, for Rs. 52,000in Subs. Ltd. Holders
Ltd. received 10% dividend for 1999, but the dividends, as received, has been credited to Profit and
Loss Account of Holders Ltd.
The following are the Balance Sheets as at 31.12.2000
(b) If dividends are paid out of Post-acquisition Profit:
If dividend has been paid by the subsidiary company out of current profit and is received by the
holding company, the same will be treated as an income from investment and should be credited to
Profit and Loss Account of holding company.

What is cost and managementaccounting?

Cost accounting
Cost accounting deals with the calculation and assessment of costs and expenses to purchase or
produce something. It relates to calculation per unit cost using different costing techniques. Its
primary purpose is to facilitate managers in decision making.
The main activities of cost accounting are:

1. Budgeting: In cost accounting, various budgets are prepared, showing cost, revenue, profit,
production capacity and efficiency of plant and machinery, as well as the efficiency of workers.
The budget is planned in a scientific and systematic way that is often unique to the company, as
 reports are not bound to the principles of Generally Accepted Accounting Principles (GAAP).
2. Classify and break down costs for external reporting and internal profit measurement. Since
costs are calculated on a detailed level, identifying profitable and unprofitable items or activities
becomes easy.
3. Information on costs and activities may be used as a basis to estimate future costs in preparing
and reviewing budget estimates.
4. Determine the fees or prices for goods and services: in tough market conditions or in slump
periods, costing helps to determine the selling price of the product at the optimum level to be
competitive.

Management accounting
Management accounting relates to the provision of appropriate information for decision-making,
planning, cost control and performance evaluation. Management accounting turns data into
information, knowledge, and wisdom about a business entity’s operations. This is one step further
than cost accounting. Management accounting works to know the reasons of profit or loss and
studies the factors which influence efficiency to assist in decision making. Therefore, cause and
effect is an important feature of management accounting.
The main activities of management accounting are:
1. Reporting to management: It is the primary role of management accounting to inform and
advise th
2. departments on regular basis to the management which is helpful in taking timely decisions.
A management accountant also works in the capacity of an advisor to overcome any existing
financial or other problems of an organization.
3. Aid in decision-making: the success of any organization depends upon accurate effective
decision-making, which is in turn based on informational networks as provided by
management accounting. Applying techniq ues of differential costing, absorption costing,
marginal costing, and management accounting provides useful data to the management to
aid in their decision-making.
4. Planning and formulating policies: a management accountant provides necessary and
relevant information to achieve the targets of the company. Management accounting uses
regression analysis and time series analysis as forecasting techniques.
5. Controlling performance: in order to assure effective control, various techniques are used
by a management accountant such as budgetary control, standard costing, management
audit, et cetera. Management accounting provides a proper management control system to
the management. Reports are provided to the management regarding the effective and
efficient use of resources.
6. Interpreting financial statements: collecting and analyzing accounting data is a key role of
management accounting. This provides relevant information in a systematic way that can
be used by the management in planning and decision-making. Cash flow, fund flow, ratio
analysis, trend analysis, and comparative financial statements are the tools normally used in
management accounting to interpret and analyze accounting data.
7. Motivating employees: management accounting provides a selection of best alternative
methods of doing things. It motivates employees to improve their performance by setting
targets and starting incentive schemes.
8. Coordinating among departments: management accounting is helpful in coordinating the
departments of an organization by applying thorough functional budgeting and providing
reports for the same to the management on a regular basis.
9. Administrating tax: any organization must comply with the tax systems of the country they
 operate from. It is a
10. challenge due to the ever-increasing complexity of the tax structure. The organization needs
to file various kinds of returns with different tax authorities. They need to calculate the
correct amount of tax and assur
11. timely deposit of tax. Therefore, the management takes guidance from management
accountants to comply with the law of the country.

Conclusion
In short, cost accounting supports management accounting and in turn management accounting
pushes cost accounting further according to the needs of the management. Because of this strong
bondage between cost accounting and management accounting they are often seen as one and the
same nowadays.

Marginal Costing: Meaning andFeatures | Cost Accounting

Meaning of Marginal Costing:
Marginal costing is a principle whereby variable costs are charged to cost units and the fixed costs
attributable to the relevant period is written off in full againstthe contribution for that period.
Marginal costing is the ascertainment of marginal cost and the effect on profit ofchanges in volume
or type of output by differentiating between fixed costs and variable cost. In marginal costing, costs
are classified into fixed and variable costs.

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The concept of marginal costing is based on the behaviour of costs that vary with the volume of
output. Marginal costing is known as ‘variable costing’, in which only variable costs are accumulated
and cost per unit is ascertained only on the basis of variable costs. Sometimes, marginal costing
and direct costing are treatedas interchangeable terms.
The major difference between these two is that, marginal cost covers only thoseexpenses which are
of variable nature whereas direct cost may also include cost which besides being fixed in nature
identified with cost objective.

Contribution of Marginal Costing:

In marginal costing, costs are classified into fixed and variable costs. The concept marginal costing
isbased on the behaviour of costs with volume of output. From
this approach, it is not possible to identify an amount of net profit per product, but it is possible to
identify the amount of contribution per product towards fixedoverheads and profits. The contribution
is the difference between sales volume and the marginal cost of sales.
In marginal costing it is not possible to determine the profit per unit of product because fixed
overheads are charged in total to the profit and loss account rather than recovered in product
costing. Contribution is a pool of amount from which total fixed costs will be deducted to arrive at
the profit or loss.

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The distinction between contribution and profit is given below:Contribution:
1. It includes fixed cost and profit.
2. Marginal costing technique uses the concept of contribution.

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1. At break-even point, contribution equals to fixed cost.
2. Contribution concept is used in managerial decision making.
Profit:
1. It does not include fixed cost.
2. Profit is the accounting concept to determine profit or loss of a businessconcern.
3. Only the sales in excess of break-even point results in profit.
4. Profit is computed to determine the profitability of product and the concern.
Formulas used in Marginal Costing:
Sales — Variable cost + Fixed cost + ProfitSales – Variable cost = Contribution Sales – Variable cost
= Fixed cost + Profit
Contribution = Fixed cost + ProfitContribution – Fixed cost = Profit

Features of Marginal Costing:

The main features of marginal costing are as follows:
(a) All costs are categorized into fixed and variable costs. Variable cost per unit issame at any
level of activity. Fixed costs remain constant in total regardless of changes in volume.
(b) Fixed costs are considered period costs and are not included in product cost,only variable
costs are considered as product costs.
(c) Stock of work-in-progress and finished goods are valued at marginal cost of production.
(d) In marginal process costing, products are transferred from one process toanother are valued
at marginal costs only.
(e) Prices are determined with reference to marginal cost and contributionmargin.
(f) Profitability of departments, products etc. is determined with reference to their contribution
margin.
(g) In accounting, marginal cost, the overhead control account in the cost ledgerrepresents only
the variable overhead. Fixed costs are taken as expenses in the profit and loss account and
thus excluded from costs.
(h) Presentation of data is oriented to highlight the total contribution andcontribution from each
product.
(i) The difference in the magnitude of opening stock and closing stock does not affect the unit
cost of production since all the product costs are variable costs.

Arguments in Favour of Marginal Costing:

The supporters of marginal costing technique put forth the following points in support of their
argument:
(a) Fixed costs are period costs in nature, and it should be charged to the concerned period
irrespective of the quantum or level of production or sale.
(b) Inclusion of fixed costs in the product cost distorts the comparability of products at different
volumes and disturbs control actions. It highlights the significance of fixed costs on profits.
In a highly competitive situation, it may bewise to take an order which covers marginal costs
and makes some contributiontowards fixed costs, rather than loose the order.
(c) The difficulty in apportionment and absorption of fixed costs to product cost will not exist in
contribution approach and it is much easier for accounting and determination of product
costs.
(d) Marginal cost method is simple in application and is easy for exercise of costcontrol. It is more
informative and simpler to understand.
(e) It helps the management with more appropriate information in taking vital business decisions
like make or buy, subcontracting, export order pricing, pricing under recession, continue or
 discontinue a product/division, selection of suitableproduct mix etc.
(f) Profit-volume analysis is facilitated by the use of break-even charts and profit-volume graphs,
and so on.
(g) The analysis of contribution per key factor or limiting resource is a useful aidin budgeting and
production planning.
(h) Pricing decisions can be based on the contribution levels of individualproducts.
(i) The profit and loss statement is not distorted by changes in stock levels. Stock valuations are
not burdened with a share of fixed overhead, so profits reflect sales volume rather than
production volume.
(j) Responsibility accounting is more effective when based on marginal costing because
managers can identify their responsibilities more clearly when fixed overhead is not charged
arbitrarily to their departments or divisions.

Criticism against Marginal Costing:

The criticism levelled against marginal costing is summarized below:

(a) Difficulty may be experienced in trying to separate fixed and variableelements of overhead costs.
Unless this can be done with reasonable accuracy, marginal
(b) costing cannot be very accurate. ApplicationDIWAKAR of common sense andHUB
EDUCATION judgment will be necessary.
(c) The misuse of marginal costing approach may result in setting selling priceswhich do not allow
for the full recovery of overhead. This may be most likely in times of depression or increasing
competitors when prices set to undercut competitors may not allow for a reasonable contribution
margin.
(d) The main assumption of marginal costing is that variable cost per unit will be same at any level
of activity. This is only partly true within a limited range of activity. With a major change in activity
there may be considerable change in therates and prices of men, material due to shortage of
material, shortage of skilled labour, concessions of bulk purchase, increased transportation
costs, changes in productivity of men and materials etc.
(e) The assumption that fixed costs remain constant in total regardless of changes in volume will be
correct up to a certain level of output. Some fixed costs are liable to change from one period to
another. For example, salaries bill may go up because of annual increments or due to change in
the pay rates and due to pay structure. If there is a substantial drop in activity, management may
take immediate action to cut the fixed costs by retrenchment of staff, renting of office- premises,
warehouses taken on lease may be given-up etc.
(f) Increased automation and mechanization has resulted the reduction in labour costs and
increased fixed costs like installation, maintenance and operation costs, depreciation of
machinery. The use of marginal costing creates a tendency to disregard the need to recover cost
through product pricing. For long-run continuity of the business, it is not good. Assets have to be
replaced in the long- run.
(g) Exclusion of fixed overheads from costs may lead to erroneous conclusions. It may create
problems in inter-firm comparison, higher demand for salaries and other benefits by employees,
higher demand for tax by the Government authorities etc.
(h) The exclusion of fixed overhead from inventory cost does not constitute an accepted accounting
procedure and, therefore adherence to marginal costing will involve deviation from accepted
accounting practices.
(i) The income-tax authorities do not recognize the marginal cost for inventoryvaluation.
Absorption Costing and Marginal Costing: Impact on Profit:
In absorption costing, stock is valued at total cost while in marginal costing stock valuation is done
at variable cost only. This means that in absorption costing, stock valuation is higher than in
marginal costing. When production exceeds sales, profit under absorption costing is higher than
that of marginal costing. Butwhen sales exceed production, profit under absorption costing is lower
than that of marginal costing.

Absorption costing is a principle whereby fixed, as well as, variable costs are allotted to cost units
and total overheads are absorbed according to activity [Link] costing confirms with the
accrual concept by matching costs with revenue for a particular accounting period. Stock valuation
complies with the accounting standard and fixed production costs are absorbed into stocks.
Absorption costing method avoids separation of costs into fixed and variable elements, which is not
easily and accurately achieved. Cost plus pricing underabsorption costing ensures that all costs are
covered.

Pricing at the marginal cost may, in the long run, result in failing to cover the fixed costs. It is
important to note that in absorption costing sales must be equalto or exceed the budgeted level of
activity otherwise fixed costs will be under absorbed.
The absorption of production overheads under absorption costing hasthe following impacts:
(a) When production exceeds sales during the period, a higher profit is shown under absorption
costing, since the fixed overhead is absorbed over more numberof units produced, and carried
to next accounting period along with closing inventory.
(b) When sales are in excess of production, a lower profit is reported under absorption costing.
Since, less portion of fixed production overhead is recoveredin valuation of closing stock and
current period’s cost of production is higher.
(c) The following generalizations to be made on the impact on profit ofthese two different methods
ofcosting:
(d) Where sales and production levels are constant through time, profit is thesame under the two
methods.
(e) Where production remains constant but sales fluctuate, profit rises or fallswith the level of sales,
assuming that costs and prices remain constant, but thefluctuations in net profit figures are
greater with marginal costing than with absorption costing.
(f) Where sales are constant but production fluctuates, marginal costing provides for constant
profit, whereas under absorption costing, profit fluctuates.
(g) Where production exceeds sales, profit is higher under absorption costing than under marginal
costing for the reason that absorption of fixed overheads into closing stock increases their value
thereby reducing the cost of goods sold.
(h) Where sales exceed production, profit is higher under marginal costing. The fixed costs, which
previously were part of stock values, are now charged against revenue under absorption costing.
Therefore, under absorption costing the value of fixed costs charged against revenue is greater
than that incurred for the period.

The choice between using absorption costing and marginal costing will be determined by the
following factors:
(a) The system of financial control in use e.g., responsibility accounting is inconsistent with
absorption costing.
(b) The production methods in use e.g., marginal costing is favoured in simple processing
situations in which all products receive similar attention; but when different products receive
widely differing amounts of attention, the absorptioncosting may be more realistic.
(c) The significance of prevailing level of fixed overhead costs.

Break-Even Analysis – Definition, Formula& Examples

What is a Break-Even Analysis?

A break-even analysis is a financial tool which helps you to determine at what stage your company,
or a new service or a product, will be profitable. In other words, it’s a financial calculation for
determiningthe number of products or services a company should sell to cover its costs (particularly
fixed costs). Break-even is a situation where you are neither making money nor losing money, but all
your costs have been covered.

Break-even analysis is useful in studying the relation between the variable cost, fixed cost and
revenue. Generally, a company with low fixed costs will have a low break-even point of sale. For an
example, a company has a fixed cost of Rs.0 (zero) will automatically have broken even upon the
first sale of its product.

Components of Break-Even Analysis

Fixed costs
Fixed costs are also called as the overhead cost. These overhead costs occur after the decision to
start an economic activity is taken and these costs are directly related to the level of production, but
not the quantity of production. Fixed costs include (but are not limited to) interest, taxes, salaries,
rent, depreciation costs, labour costs, energy costs etc. These costs are fixed no matter how much
you sell.

Variable costs
Variable costs are costs that will increase or decrease in direct relation to the production volume.
These costs include cost of raw material, packaging cost, fuel and other costs that are directly
relatedto the production.

Calculation of Break-Even Analysis

The basic formula for break-even analysis is driven by dividing the total fixed costs of production by
the contribution per unit (price per unit less the variable costs)

For an example:
Variable costs per unit: Rs. 400 Sale price per unit: Rs. 600 Desired profits: Rs. 4,00,000 Total fixed
costs: Rs. 10,00,000 First we need to calculate the break-even point per unit, so we will divide the
Rs.10,00,000 of fixed costs by the Rs. 200 which is the contribution per unit (Rs. 600 – Rs. 200).
Break Even Point = Rs. 10,00,000/ Rs. 200 = 5000 units Next, this number of units can be shown in
rupees by multiplying the 5,000 units with the selling price of Rs. 600 per unit. We get Break Even
Sales at 5000 units x Rs. 600 = Rs. 30,00,000. (Break-even point in rupees)

Contribution Margin
Break-even analysis also deals with the contribution margin of a product. The excess between the
selling price and total variable costs is known as contribution margin. For an example, if the price of
aproduct is Rs.100, total variable costs are Rs. 60 per product and fixed cost is Rs. 25 per product,
thecontribution margin of the product is Rs. 40 (Rs. 100 – Rs. 60). This Rs. 40 represents the revenue
collected to cover the fixed costs. In the calculation of the contribution margin, fixed costs are not
considered.

When is Break even analysis used?

Starting a new business: If you wish to start a new business, a break-even analysis is a must. Not
only it helps you in deciding, whether the idea of starting a new is viable, but it will force you to be
realistic about the costs, as well as guide you about the pricing strategy.
Creating a new product: In the case of an existing business, you should still do a break-even analysis
before launching a new product—particularly if such a product is going to add a significant
expenditure.

Changing the business model: If you are about to the change your business model, like, switching
from wholesale business to retail business, you should do a break-even analysis. The costs could
change considerably, and this will help you to figure out the selling prices need to change too.
Breakeven analysis is useful for the followingreasons:
• It helps to determine remaining/unused capacity of the concern once the breakeven is reached.
This will help to show the maximum profit on a particular product/service that can begenerated.
• It helps to determine the impact on profit on changing to automation from manual (a fixed cost
replaces a variable cost).
• It helps to determine the change in profits if the price of a product is altered.
• It helps to determine the number of losses that could be sustained if there is a sales downturn.
Additionally, break-even analysis is very useful for knowing the overall ability of a business to
generate a profit. In the case of a company whose breakeven point is near to the maximum sales
level, this signifies that it is nearly impractical for the business to earn a profit even under the best of
circumstances.
Therefore, it’s the management responsibility to monitor the breakeven point constantly. This
monitoring certainly reduces the breakeven point whenever possible.
Ways to monitor Breakeven point
• Pricing analysis: Minimize or eliminate the use of coupons or other price reductions offers, since
such promotional strategies increase the breakeven point.
• Technology analysis: Implementing any technology that can enhance the business efficiency,
thus increasing capacity with no extra cost.
• Cost analysis: Reviewing all fixed costs constantly to verify if any can be eliminated can surely
help. Also, review the total variable costs to see if they can be eliminated. This analysis will
increase the margin and reduce the breakeven point.
• Margin analysis: Push sales of the highest-margin (high contribution earning) items and pay close
attention to product margins, thus reducing the breakeven point.
• Outsourcing: If an activity consists of a fixed cost, try to outsource such activity (whenever
possible), which reduces the breakeven point.

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 few expenses. Therefore, if you do a break-even analysis you have to review
all your financial commitments to figure out your break-even point. This analysis certainly
restricts the number of surprises down the road.
• 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, your 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.

Introduction to Standard Costing

Standard costing is an important subtopic of cost accounting. Standard costs are usually associated
with a manufacturing company's costs of direct material, direct labor, and manufacturing overhead.
Rather than assigning the actual costs of direct material, direct labor, and manufacturing overhead
to a product, many manufacturers assign the expected or standard cost. This means that a
manufacturer's inventories and cost of goods sold will begin with amounts reflecting the standard
costs, not the actual costs, of a product.
Manufacturers, of course, still have to pay the actual costs. As a result, there are almost always
differences between the actual costs and the standard costs, and those differences are known as
variances.

Standard costing and the related variances is a valuable management tool. If a variance arises,
management becomes aware that manufacturing costs have differed from the standard (planned,
expected) costs.
• If actual costs are greater than standard costs the variance is unfavorable. An unfavorable
variance tells management that if everything else stays constant the company's actual profit will
be less than planned.
• If actual costs are less than standard costs the variance is favorable. A favorable variance tells
management that if everything else stays constant the actual profit will likely exceed the planned
profit.
• The sooner that the accounting system reports a variance, the sooner that management can
direct its attention to the difference from the planned amounts.
• If we assume that a company uses the perpetual inventory system and that it carries all of its
inventory accounts at standard cost (including Direct Materials Inventory or Stores), then the
standard cost of a finished product is the sum of the standard costs of the inputs:
• Direct material
• Direct labor
• Manufacturing overhead
• Variable manufacturing overhead
• Fixed manufacturing overhead
Usually there will be two variances computed for each input:

Sample Standards Table

Let's assume that your Uncle Pete runs a retail outlet that sells denim aprons in two sizes. Pete
suggests that you get into the manufacturing side of the business, so on January 1, 2018 you start
up an apron production company called Denim Works. Using the best information at hand, the two
of you compile the following estimates to use as standards for 2018:
Standards Table for Denim Work
The aprons are easy to produce, and no apron is ever left unfinished at the end of any given day.
This means that your company never has work-in-process inventory.
When we make your journal entries for completed aprons (shown below), we'll use an account called
Inventory- FG which means Finished Goods Inventory. (Some companies will use WIP Inventory or
Work-in-Process Inventory). We'll also use the account Direct Materials Inventory. (Other account
titles often used for direct materials are Raw Materials Inventory or Stores.)

Direct Materials Purchased: Standard Costand Price Variance

Direct materials refers to just that—raw materials that are directly traceable into a product. In your
apron business the direct material is the denim. (In a food manufacturer's business the direct
materials are the ingredients such as flour and sugar; in an automobile assembly plant, the direct
materials are the cars' component parts).

Denim Works purchases its denim from a local supplier with terms of net 30 days, FOB destination.
This means that title to the denim passes from the supplier to DenimWorks when DenimWorks
receives the material. When the denim arrives, DenimWorks will record the denim received in its
Direct Materials Inventory at the standard cost of $3 per yard (see standards table above) and will
record the liability at the actual cost for the amount received. Any difference between the standard
cost of the material and the actual cost of the material received is recorded as a purchase price
variance.

Examples of Standard Cost of Materials and Price Variance

Let's assume that on January 2, 2018, Denim Works ordered 1,000 yards of denim at $2.90 per yard.
On January 8, 2018, Denim Works receives 1,000 yards of denim and an invoice for the actual cost
of $2,900. On January 8, 2018, Denim Works becomes the owner of the material and has a liability
to its supplier. On January 8 Denim Works' Direct Materials Inventory is increased by the standard
cost of $3,000 (1,000 yards of denim at the standard cost of $3 per yard), Accounts Payable is
credited for $2,900 (the actual amount owed to the supplier), and the difference of $100 is credited
to Direct Materials Price Variance. In general journal format the entry looks like this

The $100 credit to the price variance account communicates immediately (when the denim arrives)
that the company is experiencing actual costs that are more favorable than the planned, standard
cost.
In February, Denim Works orders 3,000 yards of denim at $3.05 per yard. On March 1, 2018 Denim
Works receives the 3,000 yards of denim and an invoice for $9,150 due in 30 days. On March 1, the
Direct Materials Inventory account is increased by the standard cost of $9,000 (3,000 yards at the
standard cost of $3 per yard), Accounts Payable is credited for $9,150 (the actual cost of the denim),
and the difference of $150 is debited to Direct Materials Price Variance as an unfavorable price

variance:
After the March 1 transaction is posted, the Direct Materials Price Variance account shows a debit
balance of $50 (the $100 credit on January 2 combined with the $150 debit on March 1). A debit
balance in a variance account is always unfavorable—it shows that the total of actual costs is higher
than the total of the expected standard costs. In other words, your company's profit will be $50 less
than planned unless you take some action.
On June 1 your company receives 3,000 yards of denim at an actual cost of $2.92 per yard for a total

of $8,760 due in 30 days. The entry is:

Direct Materials Inventory is debited for the standard cost of $9,000 (3,000 yards at $3 per yard),
Accounts Payable is credited for the actual amount owed, and the difference of $240 is credited to
Direct Materials Price Variance. A credit to the variance account indicates that the actual cost is less
than the standard cost.

After this transaction is recorded, the Direct Materials Price Variance account shows an overall credit
balance of
$190. A credit balance in a variance account is always favorable. In other words, your company's
profit will be

$190 greater than planned due to the favorable cost of direct materials.
Note that the entire price variance pertaining to all of the direct materials received was recorded
immediately. In other words, the price variance associated with the direct materials received was not
delayed until the materials were used.

Direct Materials Usage Variance

Under a standard costing system, production and inventories are reported at the standard cost—
including the standard quantity of direct materials that should have been used to make the products.
If the manufacturer
actually, uses more direct materials than the standard quantity of materials for the products actually
manufactured, the company will have an unfavorable direct materials usage variance. If the quantity
of direct materials actually used is less than the standard quantity for the products produced, the
company will have a favorable usage variance. The amount of a favorable and unfavorable variance
is recorded in a general ledger account Direct Materials Usage Variance. (Alternative account titles
include Direct Materials Quantity Variance or Direct Materials Efficiency Variance.) Let's demonstrate
this variance with the following information
.
Note:

We are not determining the quantity of aprons that DenimnWorks should have made. Rather, we are determining whether
the 100 large aprons and 60 small aprons that were actually manufactured were produced efficiently. In the case of
direct materials, we want to determine whether or not the company used the proper amount of denim to make the 160
aprons that were actually produced. (For the purposes of calculating the direct materials usage variance, it does not
concern us whether DenimWorks had a goal to produce 100 aprons, 200, aprons, or 250 aprons.)

Standard costs are sometimes referred to as the "should be costs." Denim Works should be using
278 yards of denim to make 100 large aprons and 60 small aprons as shown in the following table.

We determine the total standard cost of the denim that should have been used to make the 160
aprons by multiplying the standard quantity of denim (278 yards) by the standard cost of a yard of
denim ($3 per yard):
An inventory account (such as F.G. Inventory or Work-in-Process) is debited for $834; this is the
standard cost of the direct materials component in the aprons manufactured in January 2018.
The Direct Materials Inventory account is reduced by the standard cost of the denim actually
removed from the direct materials inventory. Let's assume that the actual quantity of denim removed
from the direct material s inventory and used to make the aprons in January was 290 yards. Because
Direct Materials Inventory reports the standard cost of the actual materials on hand, we reduce the
account balance by $870 (290 yards used $3 standard cost per yard). After removing 290 yards of
materials, the balance in the Direct Materials Inventory account is $2,130 (710 yards x $3 standard
cost per yard).

The Direct Materials Usage Variance is: [the standard quantity of material that should have been
used to make the good output minus the actual quantity of material used] X the standard cost per
yard.
In our example, Denim Works should have used 278 yards of material to make 100 large aprons and
60 small aprons. Because the company actually used 290 yards of denim, we say that DenimWorks
did not operate efficiently—an extra 12 yards of denim was used (278 vs. 290 = 12). When we
multiply the 12 yards by the standard cost of $3 per yard, the result is an unfavorable direct materials
usage variance of $36.

Let's put the above information into a format commonly used for computing variances:
Direct Materials Usage/Quantity/Efficiency Variance Analysi
DIWAKAR EDUCATION HUB

The journal entry for the direct materials portion of the January production is:
February 2018
Let's assume that in February 2018 Denim Works produces 200 large aprons and 100 small aprons
and that 520 yards of denim are actually used. From this information we can compute the following:
Let's put the above information into our format:
Direct Materials Usage (or Quantity) Variance Analysis

The journal entry for the direct materials portion of the February production is:
Direct Labor: Standard Cost, Rate Variance,

Efficiency Variance
"Direct labor" refers to the work done by those employees who actually make the product on the
production line. ("Indirect labor" is work done by employees who work in the production area, but do
not work on the production line. Examples include employees who set up or maintain the equipment.)
Unlike direct materials (which are obtained prior to being used) direct labor is obtained and used at
the same time. This means that for any given good output, we can compute the direct labor rate
variance, the direct labor efficiency variance, and the standard direct labor cost at the sametime.
Assuming that the actual direct labor in January adds up to 50 hours and the actual hourly rate of
pay (including payroll taxes) is $9 per hour, our analysis will look like this:
Direct Labor Variance Analysis for January 2018:

In January, the direct labor efficiency variance (#3 above) is unfavorable because the company
actually used 50 hours of direct labor—this is 8 hours more than the standard quantity of 42 hours
allowed for the good output.
The additional 8 hours is multiplied by the standard rate of $10 to give us an unfavorable direct labor
efficiency variance of $80. (The direct labor efficiency variance could be called the direct labor
quantity variance
or usage variance.)

Note that Denim Works paid $9 per hour for labor when the standard rate is $10 per hour. This $1
difference— multiplied by the 50 actual hours—results in a $50 favorable direct labor rate variance.
(The direct labor rate variance could be called the direct labor price variance.)
The journal entry for the direct labor portion of the January production is: February 2018
In February your company manufactures 200 large aprons and 100 small aprons. The standard cost
of direct labor for the good output produced in February 2018 is computed here

If we assume that the actual labor hours in February add up to 75 and the hourly rate of pay (including
payroll taxes) is $11 per hour, the total equals $825. The analysis for February 2018 looks like this:
Direct Labor Variance Analysis for February 2018:

Notice that for the good output in February, the total actual labor costs amounted to $825, and the
total standard cost of direct labor amounted to $800. This unfavorable difference of $25 agrees to
the sum of the two labor variances:
The journal entry for the direct labor portion of the February production is
What is BudgetaryControl?
Meaning and Definition of Budgetary Control:
Budgetary control is the process of preparation of budgets for various activities and comparing the
budgeted figures for arriving at deviations if any, which are tobe eliminated in future. Thus budget is
a means and budgetary control is the endresult. Budgetary control is a continuous process which
helps in planning and coordination. It also provides a method of control.
According to Brown and Howard “Budgetary control is a system of coordinating costs which
includes the preparation of budgets, coordinating the work of departments and establishing
responsibilities, comparing the actual performance with the budgeted and acting upon results to
achieve maximum profitability”.

ADVERTISEMENTS:
Wheldon characterizes budgetary control as planning in advance of the various functions of a
business so that the business as a whole is controlled.
I.C.M.A defines budgetary control as- “the establishment of budgets, relating theresponsibilities of
executives to the requirements of a policy, and the continuous comparison of actual with budgeted
results either to secure by individual action the objectives of that policy or to provide a basis for its
revision”.
Following are the features of budgetary control as per the abovedefinitions:
(a) The pre-requisite for budgetary control is to set different kinds of budgets and fix the
responsibility of personnel for the successful implementation of the policy.
(b) ADVERTISEMENTS:
(c) Actual performance is compared with budgets to reveal deviations for the purpose ofcost
control.
(d) Corrective action is initiated to set right the unfavorable deviations.
(e) Objectives of Budgetary Control:
(f) Budgetary control is inevitable for policy formulation, planning, control andcoordination. The
essence of budgeting is to plan and control.

ADVERTISEMENTS:
Following are the main objectives of budgetary control:
1. Planning:
2. Budgeting ensures effective planning by setting up of budgets.
3. Coordination:
 4. Budgets are helpful in coordination of business activities.
5. Efficiency and Economy:
6. Effective budgetary control results in cost control and cost reduction.
7. Increase in Profitability:
8. Costs are controlled with help of budgets and profits targeted are achieved.
9. Anticipation of Future Capital Expenditure:
10. Estimated increases in sales necessitating higher production capacity provides advance
warning for the possible capital expenditure in near future.
Control:
1. Controlling function is made to be effective as the control is centralised while budgets are
prepared and implemented.
2. Deviations:
3. Ascertainments of deviations are essential to fix responsibility and correct the deviations as
far as possible.

Essentials of Successful Budgetary Control:

A business budget is a detailed plan covering phases of operations for a definite future period. It is
laying down of policies, plans, objectives and goals set in advance by the top management for the
enterprise as a whole and for each segment.

The following are the essential requisites for implementing budgetarycontrol successfully:
1. Top Management Support:
2. The budgetary control system should have continuous support of topmanagement which can
ensure its all-round acceptance.
3. Clearly Defined Organisational Structure:
4. The authority and responsibilities are to be properly defined to pin-point the responsibility
ofspecific individuals in key [Link] Accounting System:
5. The accounting system should provide the required information in time.
6. Reporting of Deviations:
7. Efficient system has to be devised to reduce the differences between the budgets and actual
performance.
8. Motivation:
9. Staff are to be appraised of the budgets and benefits they are going to derive directly and
indirectly.
10. Realistic Targets:
11. The targets set should be realistic so that they are achievable, and budgets should not
frustrate the workers by fixing unrealistic targets.
12. Participation of All Departments Concerned:
13. Budgets are to be set for all the departments so that their participation inimplementation will
be effective.
14. Flexibility:
15. Budgets are prepared on the basis of certain conditions. If there is change in conditions
budgets also should be adjusted to accommodate the changes.

Advantages of Budgetary Control:

Budgetary control is helpful in setting targets for the whole concern and achievement of the targets.
It also makes the various operations of the enterprises economical.
 202
Following are some of the advantages of budgetary control:
• Maximisation of Profits:
• Budgetary control aims at increasing the over-all profits of the organisation. Thisis achieved
through planning, coordination and control of various activities in a programmed manner.
• Effective Coordination:
• Performance and working of various activities is effectively coordinated through budgetary
control. Budgets of the various functions are interlinked and dependent. Effective
implementation of budgets depends on cooperation of concerned personnel of various
departments. Emphasis on co-ordination and cooperation helps in achieving the predetermined
targets and goals.
• Evaluation of Executive Performance:
• Goals are set for each department. Actual performance is compared with standards and
deviations are reported to top management for action against unfavourable deviations. Thus,
the performance of the department heads andother executives is constantly [Link]-
Cut Goals andTargets:DIWAKAR EDUCATION HUB
• Through the process of budgeting the goals of different departments are set in advance in
consultation with those in charge of them. This makes the vision of theorganisation clear and
employee motivation and morale boosted by achievement of clearly set objectives.
• Economy in Operations:
• Expenses are properly planned and financial resources are put to optimum use. The benefits
are extended to the industry and then to national economy.
• Budgetary control is helpful in conservation, effective utilization and elimination of wastage in
scarce resources.
• Revelation of Ineffectiveness:
• Comparison of actual performance with budgeted performance reveals week spots so that
attention is focused on them to improve the performance.
• Correction of Performance Continuously:
• The deviations of actual performance compared with budgets are frequently reported and
corrections are made to rectify the unfavourable deviations immediately. In the absence of
budgetary control this may be done at the end of the accounting year by which time corrections
may not be fruitful or practicable.
• Introduction of Incentive Schemes of Remuneration:
• Incentive schemes can be easily introduced as the predetermined targets act as base to
compare actual performance and determine efficiency. Higher and lowerefficiency are suitably
rewarded or discouraged respectively.
• Shutting Down of Unprofitable Products and Activities:
• Budgetary control reveals inefficiencies in products, processes and [Link] is helpful
in closing down of loss making divisions to improve the overall profitability.
• Limitations of Budgetary Control:
• Budgetary control is an effective tool for management control. However, it hascertain

limitations while operating it as a technique.

1. Prediction of Uncertain Future:
2. Budgeting is a process of forecasting and estimation. Forecasting may not be accurate.
Therefore budgets based on inaccurate forecasts and estimates may not be accurate and
effective.
3. Changes of Conditions:
 203
4. Budgets are prepared on the basis of certain prevailing conditions. If the conditions change
budgets are also to be revised. Constant changes in budgetsmay frustrate the employees and
the charm in budgeting and implementationmay be lost. Complacence:
5. General tendency of employees is to achieve the targets as budgeting fixes the targets. Some
of the employees who are highly skillful may also be satisfied in performing up to the goals set
without showing full potential, which will be a lossto the enterprise as well as the employee in
terms of productivity.
6. Difficulty in Coordination:
7. Effective implementation of budgetary control depends upon proper coordination among
various departments as the performance of a department depends on the work of other
departments and vice versa. It requires budgetary officer to oversee the integration of various
activities to successfully implement the budgets.
8. Ineffective coordination leads to inefficient performance.
9. Conflict among Different Departments:
10. Budgetary control sets targets for different departments individually. This will make the
departmental heads to be selfish to get maximum funds and think in terms of achieving their
own set targets, thereby raising conflict among different departments. Inter-departmental
rivalries may endanger the performance of thewhole organisation.
11. Process Costing – Overview, Types &

Features
What is process costing?
A manufacturing unit that can differentiate its processes and produces a standard product will use
process costing method to determine cost of production. This is done by allocating all process cost
tothe total units produced.
In simple words, if an unit passes through different processes and the processes are easily
distinguishable then the cost of the unit will be cost of process that it goes through.
In process costing a separate account is opened for every process and on completion of the process
the cost is transferred to the next process.

Illustration
A paper manufacturing unit has the following processes
• Making pulp
• Beating
• Pulp to paper
• Finishing
Let us assume the costs incurred for producing 1000 units is
Making pulp

Rs. 10000
Beating

Rs. 20000
Pulp to paper

Rs. 15000
Finishing
Rs. 30000
Total Costs

Rs. 75000
Total units

1000
Cost per unit

Rs. 75
The above illustration is a simple presentation of process costing. However in an actual unit there
willbe Work in Progress at any given period end. So the steps for process costing will be
• To determine the total production that is: Opening stock at beginning of period + Production during
the period – Rejections if any + Equivalent units of Work in process
(To convert the number of WIP units to finished product equivalent lets understand this example :
Say 500 units are in WIP and they are 50% complete then the finished product equivalent will be
500*50%
=250)

• To determine the total costs, both direct and indirect costs incurred for the opening stock and
current production are to be considered.
• Allocation of the costs incurred for the entire inventory is done by dividing the total costs by
equivalent units of production.

As we know, there will be Work in progress during the opening and closing of a period and thus an
organization needs to decide on the cost flow assumptions. For computing costs under process
costing the organization can use either the FIFO or weighted average cost flow assumption.
Under the FIFO method it is assumed that the material that comes in first is transferred out first and
hence the two methods (FIFO and weighted average) vary while treating opening inventory. The
treatment of Work in progress in both the methods is as follows:
Steps

Weighted Average

First in first out

Total production

Units transferred out+ Ending inventory WIP

Beginning WIP+
Units transferred out+ endinginventory WIP
Total Costs Beginning WIP costs+ costs incurred

Total cost incurred during period

Cost allocation

Total costs /total units

Total costs /total units
The above is a simple chart differentiating the two methods. In case of WIP there will be percentage
of completion that will have to be looked into and equivalent units will have to be computed. Let us
understand the same with an example, the assumption is that the percentage of completion is the
same for both material and labour.
Opening inventory

5000, 40% complete

Units started during the period

12000
Closing inventory

4000,60% complete
Under the FIFO method, the computation of total production will be as follows: Opening inventory –
5000*60% ( since 40% has been completed) = Rs. 3000
Completed units 12000-4000= Rs. 8000
Closing WIP 4000*60%= Rs. 2400
Total production= Rs. 10400

Completed units (Units started – closing inventory) – 12000-4000= Rs. 8000Closing inventory –
4000*60%= Rs. 2400 Taking the same example let us calculate total production under the weighted
average method
Total production is 3000+8000+2400= Rs. 13400
Similarly, the costs will have to be determined and assigned to the Equivalent units of production.
In our day to day lives too there are many activities that can be segregated into defined processes.
And the time involved can be assigned to each process. The cumulative time for all the processes
willbe the time of the entire activity.

What does process costing include?

Process costing includes the following methods of costing:
Unit Costing
This method applies to businesses that produce a single product. In this method the total cost is
divided by number of units to derive per unit cost. This is mostly used in industries dealing in- Cement
manufacturing, paper manufacturing, textiles.
Operating costing

This applies to service industry wherein the services are defined and distinguished. This is mostly
used by Hospitals, Railways.

Operation Costing
This is similar to process costing. The only difference being that instead of process the cost for
various operations is considered.
This is mostly used in industries dealing in Toy manufacturing
Therefore, process costing is widely used method of costing. It can be easily applied to
manufacturing as well as service industries.
A process costing system accumulates costs when a large number of identical units are
being produced. In this situation, it is most efficient to accumulate costs at an aggregate
level for a large batch of products and
then allocate them to the individual units produced. The assumption is that the cost of each
unit is the same as that of any other unit, so there is no need to track information at an
individual unit level. The classic example of a process costing environment is a petroleum
refinery, where it is impossible to track the cost of a specific unit of oil as it moves through
the refinery.

A process costing system accumulates costs and assigns them at the end of an accounting
period. At a very simplified level, the process is:
1. Direct materials. Using either a periodic or perpetual inventory system, we determine the
amount of materials used during the period. We then calculate the number of units begun
and completed during the period, as well as the number of units begun but not completed
( work-in-process units). We generally assume that materials are
2. added at the beginning of the production process, which means that a work-in-process unit
is the same as a completed unit from the perspective of assigning material costs. We
then assign the amount of direct materials used based on the total of fully and partially
produced units.
3. Direct labor. Labor is accumulated by units throughout the production process, so it is
more difficult to account
4. for than direct materials. In this case, we estimate the average level of completion of all
work-in-process units, and assign a standard direct labor cost based on that percentage.
We also assign the full standard labor cost to all units that were begun and completed
in the period. If there is a difference between the actual direct labor cost and the
amount charged to production in the period, the difference can be charged to the cost of
goods sold or apportioned among the units produced.
5. Overhead. Overhead is assigned in a manner similar to what was just described for direct
labor, where we
6. estimate the average level of completion of all work-in-process units and assign a
standard amount of overhead based on that percentage. We then assign the full standard
amount of overhead to all units that were begun and completed in the period. As was the
case with direct labor, any difference between the actual overhead cost the amount
charged to production in the period is either charged to the cost of goods sold or
apportioned among the units produced.

Cost assigned to units produced or in process are recorded in the inventory asset account,
where it appears on the balance sheet. When the goods are eventually sold, the cost is shifted
to the cost of goods sold account, where it appears on the income statement.

Alternative Systems
If a process costing system does not mesh well with a company's cost accounting systems,
there are two other systems available that may be a better fit. The job costing system is
designed to accumulate costs for either individual units or for small production batches. The
other option is a hybrid costing system where process costing is used part of the time and job
costing is used the rest of the time; it works best in production environments where some of
the manufacturing is in large batches, and other work steps involve labor that is unique to
individual units.
Meaning of Activity Based Costing (ABC)
Activity Based Costing is an accounting methodology used for assigning accurately the extent of
resources consumed and overhead costs incurred to produce a product or service on the basis of
value adding activities.

Definition of Activity Based Costing

Definition by CIMA,
Cost attribution to cost units on the basis of benefit received from indirect activities e.g. ordering,
setting up, assuring quality.
Definition by CAM-1 Organization of Arlinton Texas,
The collection of financial and operation performance information tracing the significant activities
of the firm to product costs.
Kaplan and Cooper’s ABC

Kaplan and Cooper of Harvard Business School who have developed new accounting methodology
in costing to calculate product costs. They classify the costs into two types. They are
i. Short term variable costs and
ii. Long term variable costs.

The reason is that all the costs are variable in the long run. But only variable costs are variable in
the short term. Fixed costs i.e., long term variable costs are varying but not immediately.
For example, production scheduling costs can be changed in the long term by changing number of
runs rather than changing number of units produced.
Under ABC system, some activities are responsible for the determination of costof a product. They
are named cost drivers. A cost driver is an activity which generates cost.

Features or Characteristics of Activity Based Costing

The features or characteristics of Activity Based Costing are briefly explained below.
1. The total cost is divided into two types i.e., fixed cost and variable cost which is necessary to
provide quality information to design a suitable cost system in a manufacturing concern.
2. The proper distinction is made between the cost behavior patterns.
3. The cost behavior patterns are volume related, diversity related, events related and time related.
4. The appropriate cost driver has to be identified for tracing the overhead to a product.
5. The cost drivers dictate the cost behavior pattern.

Allocation of Overheads under Activity Based Costing

Under Activity Based Costing, the costs are classified as short-term variable costs and long term
variable costs.
The short-term variable costs are allocated to the products on the basis of volume related cost
drivers. Direct labour hour, Direct material cost and machine hours are some of the examples of
volume related cost drivers.
According to Kalpan and Cooper, volume related cost drivers cannot be used for allocating long term
variable costs to products. The reason is that the long-term variable costs are driven by the
complexity and variety of business activitiesrather than by volume.
Hence, the causes for the overhead costs should be understood in line with the types of activities
connected with the production department and service departments. The following figure discloses
the way of allocation of overhead under ABC.
 208

Allocation of Overheads under ABC

Objectives of Activity Based Costing
The objectives of Activity Based Costing are given below.
1. To rectify the inaccurate cost information.
2. To allocate the overheads on activity basis.
3. To help the management in taking quality and timely decision.

Development of Activity Based Costing

The development of Activity Based Costing involves the following steps.
1. The main functional areas of the organization have been identified. For example production, sales,
distribution etc.
2. Each functional area has separate activities. Out of many activities, the main activities of each
functional areas have been identified. For example: Purchase of raw materials, purchase of
packing materials etc.
3. The support activities of main activities have been identified. For example: repairs and
maintenance of machine, maintaining power supply, testing of qualityetc.
4. The factors which are influencing the main activities and support activities identified i.e. cost
drivers. The data relating to direct labour, material and overhead costs have been
5. collected accurately.
6. The cost driver rates have been fixed on the basis of the overheads incurred.
7. The cost of each activity is also find out in order to calculate the cost of each product
separately.
Thus, ABC is the process of tracing costs first from resources to activities andthen from
activities to specific products.
Implementation of Activity Based Costing

The following steps are involved in implementing Activity Based Costing toachieve the desired
results.
1. Identify the functional areas of organization.
2. Identify the main activities of each functional areas.
3. Allocate common indirect costs to each functional areas on suitable basis.
4. Identify the most suitable cost driver in each activity under functional areas.
5. Preparing the statement of expenditure on activity wise.
6. Compare this statement with the value addition activity wise.
7. Find the activities which are to be eliminated or improved for betterperformance of the
organization.

Relevant Costing and Costing forDecision Making

In management accounting, notion of relevant costing has great significance because these
costs are pertinent with respect to a particular decision. A relevant cost for a particular decision
is one that transforms if an alternative course of action is taken. Relevant costs are also termed
as differential costs. Studies have demonstrated that relevant costs will make a difference in a
decision. A relevant cost only relates to a particular management decision, andwhich will alter
in the future as a result of that decision. Other theorists described that relevant costs are future
costs that will differ among alternatives. The main intent of relevant costing is to determine the
objective cost of a business decision. An objective measure of the cost of a business decision
is the degree of cash outflows that shall result from its execution. Relevant costing focuses on
just that and overlooks other costs which do not influence the future cash flows. The
fundamental principles of relevant costing are quite simple and managers can perhaps relate
them to personal experiences involving financial decisions.

It is stated in theoretical literature that relevant costing is a management accounting toolkit that
assists management team to make decisions when they have to deal with some issues such
as whether to buy a component from an external vendor or manufacture it in house?, Whether
to accept a special order?, What price to charge on a special order?, Whether to discontinue a
product line?, How to utilize scarce resource optimally CIMA describes relevant costs as: "the
costs appropriate to a specific management decision". A study of relevant costs and benefits
assists to take wise decision. In order to meet the criteria for relevancy, a cost must have two
criteria that include they affect the future, and they differ among alternatives. Other group of
theorists asserted that the relevant costs are applicable to decision. Costs are relevant, if they
direct the executive towards the decision. It will be useful, if the costs are not only relevant but
also precise. Relevance and accuracy are not alike concepts. Costs may be correct and
irrelevant, costs may be incorrect, but it can be relevant (Varshney, 2008).

Relevant information is the predicted future costs and incomes that will differ among the
alternative’s relevant information (Horngren, et al, 2006). Relevant costs are the costs which
would change as a result of the decision under consideration, where as irrelevant costs are
those which would remain unchanged by the decision. Therefore only relevant cost would be
included in the investigative framework (Khan and Jain, 2008). A relevant cost is also defined
as a cost whose amount will be affected by a decision being made. Management should believe
only future costs and revenues that will differ under each alternative (Arora, 2008). Relevant
costs are accepted future costs and relevant profits are expected future revenues that differ
among the alternative course of action being considered (Hongren and Datar, 2008). In the arena
of Management accounting, one feature of relevant cost is that they are future costs which have
not been incurred. Hence the cost of material is relevant cost as long as the material not
purchased because of deciding whether or not to purchase the material, one is to decide to
sustain the cost or evade it. Therefore, all relevant costs are future costs. Whether particular
costs and profits are relevant for decision making depends on decision circumstance and the
options available. When selecting among different alternatives, manager must focus on the
costs and revenues that differ across the decisions alternatives; these are relevant
cost/revenues (Atkinson, et al, 2008). The relevance of cost to decision alternative is
determined by situation. The facts and policies explain situation. It is established that historical
cost is not relevant, only future cost is relevant. All sunk costs are irrelevant (Allied Publishers,
1997).

The following are relevant Costs:

Differential cost: A differential cost is the difference in cost items under two or more decision
alternatives distinctively two different projects or situations. Where same thing with the same
amount appears in all alternatives, it is irrelevant. Differential costs must be compared to
differential revenues.

Incremental or marginal cost: Relevant costing is an incremental investigation which indicates

that it considers only relevant costs that is costs that vary between alternatives and ignores
sunk costs that is costs which have been incurred, which cannot be changed and therefore are
inappropriate to the business situation. Incremental or marginal cost is a cost linked with
producing an additional unit.

Incremental cost must be compared with incremental revenues to take decision.

Opportunity cost: It is cost of opportunity foregone. Whenever an organization decides to go for
a particular project, it should not overlook opportunities for other projects. It should consider
what alternative opportunities are there and which the best of these alternative opportunities
is.

Irrelevant costs: The reverse of a relevant cost is a sunk cost. A sunk cost is an expense that
has already been made, and so will not change on a go-forward basis. Sunk costs are past
costs. These cannot be changed with any future decision. Similarly, a cost which is identical
in all decisions is immaterial.
Importance and usefulness: The notion of the relevant cost is very helpful to eliminate irrelevant
information from a particular decision-making process. Also, by eliminating irrelevant costs
from a decision, management is prevented from focusing on information that might
inaccurately affect its decision. The relevant cost is only applicable to management accounting
activities and this notion is not applicable in financial accounting, as no spending decisions are
involved in financial accounting. Whereas relevant costing is a functional tool in short-term
financial decisions, it would possibly not be sensible to form it as the foundation of all pricing
decisions because in order for a business to be sustainable in the long-term, it should charge a
price that provides enough profit margin above its total cost andnot just the pertinent cost.

There are numerous examples of use of relevant costing such as

• Competitive pricing decisions
• Make or buy decisions
• Further processing decisions

When company is willing to take long term financial decisions such as investment appraisal,
disinvestments and shutdown decisions, relevant costing is not suitable because most costs
which may seem non-relevant in the short term become preventable and incremental when
considered in the long term. Though, even long-term financial decisions such as investment
assessment may use the fundamental principles of relevant costing to make easy an objective
appraisal.
Limitation of relevant costing: There are many limitations of relevant costing:
If the correct and accurate results are to be obtained, then proper thought has to be given to the
matter. Each cost item apparent or hidden needs proper attention before assumption are built
in the solution. It is not proper to proceed on the assumption in the context of relevant costing.
The cost so indicated on the relevant cost statement is valid only at a given level of activity.
Experts stated that in relevant costing, period of comparison is often incomplete or
incomparable. Timing of cost and benefit is not important in the technique of relevant costing.
On the contrary, the financial analyst considers the cash flow along with the timing of it. The
consideration of time factors allows the discontinuation in the cash flow in financial management
theories. Relevant costing suffers the limitation on this count but serves the practical objective
of profit. Another issue in relevant costing is handling the opportunity cost. The difficulty of
estimating opportunity cost can be temporarily overcome by extendingrelevant costing solution
into the calculation of accounting rate of return. It is also termed as average rate of return. A
return as a percentage of investment is calculated (Allied Publishers, 1997).

To summarize, decision making is an integral part of any business of human life. But business
life presupposes the conscious level of decision making instead of rash decision. Before taking
the decision, managers must identify the variables that may have bearing on thedecision and try
to get information about those variables. Relevant cost, in managerial accounting, denotes to
the incremental and unnecessary cost of implementing a business decision. Relevant cost
analysis is a cost accounting-based evaluation technique. It is just an improved application of
basic principles to business decisions. The major factor in relevant costing is the capacity to
clean what is and is not pertinent to a business choice. This technique is applicable to all special
or non-routine situations.
Life Cycle Costing

Contents:
• Meaning of Life Cycle Costing
• Characteristics of Life Cycle Costing
• Stages of Product Life Cycle Costing
• Benefits of Product Life Cycle Costing
• Life Cycle Costing Process

Meaning of Life Cycle Costing:

Life cycle costing is a system that tracks and accumulates the actual costs and revenues
attributable to cost object from its invention to its abandonment. Lifecycle costing involves tracing
cost and revenues on a product-by-product base over several calendar periods

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The Life Cycle Cost (LCC) of an asset is defined as:
“The total cost throughout its life including planning, design, acquisition andsupport costs and any
other costs directly attributable to owning or using theasset”.
Life Cycle Cost (LCC) of an item represents the total cost of its ownership and includes all the cots
that will be incurred during the life of the item to acquire it,operate it, support it and finally dispose
it. Life Cycle Costing adds all the costs over their life period and enables an evaluation on a common
basis for the specified period (usually discounted costs are used).
This enables decisions on acquisition, maintenance, refurbishment or disposal tobe made in the light
 213
of full cost implications. In essence, Life Cycle Costing is a means of estimating all the costs
involved in procuring, operating, maintaining and ultimately disposing a product throughout its life.

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Life cycle costing is different from traditional cost accounting system which reports cost object
profitability on a calendar basis (i.e., monthly, quarterly and annually) whereas life cycle costing
involves tracing costs and revenues of a costobject (i.e. product, project etc.) over several calendar
periods (i.e. projected lifeof the cost object).

Thus, product life cycle costing is an approach used to provide a long-term picture of product line
profitability, feedback on the effectiveness of the life cycle planning and cost data to clarify the
economic impact on alternative chosen in thedesign, engineering phase etc.
It is also considered as a way to enhance the control of manufacturing costs. It isimportant to track
and measure costs during each stage of a product’s life cycle.

2. Characteristics of Life Cycle Costing:

(a) Product life cycle costing involves tracing of costs and revenues of a product over several
calendar periods throughout its life cycle

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(a) Product life cycle costing traces research and design and development costs and total
magnitude of these costs for each individual product and compared withproduct revenue.
(b) Each phase of the product life cycle poses different threats and opportunitiesthat may require
different strategic actions.
(c) Product life cycle may be extended by finding new uses or users or by increasing the
consumption of the present users.

3. Stages of Product Life Cycle Costing:

Following are the main stages of Product Life Cycle:
(a) Market Research:
(b) It will establish what product the customer wants, how much he is prepared to pay for it and how
much he will buy.
(c) Specification:
(d) It will give details such as required life, maximum permissible maintenance costs, manufacturing
costs, required delivery date, expected performance of the product.
(e) Design:
(f) Proper drawings and process schedules are to be defined.
(g) Prototype Manufacture:
(h) From the drawings a small quantity of the product will be manufactured. Theseprototypes will be
used to develop the product.
(i) Development:
(j) Testing and changing to meet requirements after the initial run. This period of testing and
changing is development. When a product is made for the first time, it rarely meets the
requirements of the specification and changes have to be made until it meets the requirements.
(k) Tooling:
(l) Tooling up for production can mean building a production line; building jigs, buying the necessary
tools and equipment’s requiring a very large initial investment.
Manufacture:
The manufacture of a product involves the purchase of raw materials and components, the use of
labour and manufacturing expenses to make the product.
(i) Selling
(ii) Distribution
(iii) Product support
(iv) Decommissioning:

When a manufacturing product comes to an end, the plant used to build theproduct must be sold or
scrapped.

4. Benefits of Product Life Cycle Costing:

Following are the main benefits of product life cycle costing:
(a) It results in earlier action to generate revenue or lower costs than otherwise might be
considered. There are a number of factors that need to be managed inorder to maximise return
in a product.
(b) Better decision should follow from a more accurate and realistic assessment of revenues and
costs within a particular life cycle stage.
(c) It can promote long-term rewarding in contrast to short term rewarding.
(d) It provides an overall framework for considering total incremental costs over the entire span of
a product.

5. Life Cycle Costing Process:

Life cycle costing is a three-staged process. The first stage is life cost planning stage which includes
planning LCC Analysis, Selecting and Developing LCC Model, applying LCC Model and finally
recording and reviewing the LCC [Link] Second Stage is Life Cost Analysis Preparation Stage
followed by third stage Implementation and Monitoring Life Cost Analysis.
The three stages are:

Life Cycle Costing Process:

LCC Analysis is a multi-disciplinary activity. An analyst, involved in life cycle costing, should be fully
familiar with unique cost elements involved in the life cycle of asset, sources of cost data to be
collected and financial principles to beapplied.
He should also have clear understanding of methods of assessing the uncertainties associated with
cost estimation. Number of iterations may be required to perform to finally achieve the result. All
these iterations should bedocumented in detail to facilitate the interpretations of final result.
Stage 1: LCC Analysis Planning:

The Life Cycle Costing process begins with development of a plan, which addresses the purpose,
and scope of the analysis.
The plan should:
(a) Define the analysis objectives in terms of outputs required to assist amanagement decision.
(b) Typical objectives are:
(c) Determination of the LCC for an asset in order to assist planning, contracting, budgeting or similar
needs.
(d) Evaluation of the impact of alternative courses of action on the LCC of an asset(such as design
approaches, asset acquisition, support policies or alternative technologies).
(e) Identification of cost elements which act as cost drives for the LCC of an assetin order to focus
design, development, acquisition or asset support efforts.
(f) Make the detailed schedule with regard to planning of time period for each phase, the operating,
technical and maintenance support required for the asset.
(g) Identify any underlying conditions, assumptions, limitations and constraints (such as minimum
asset performance, availability requirements or maximum capital cost limitations) that might
restrict the range of acceptable options to beevaluated. Identify alternative courses of action to
be evaluated.
(h) Identify alternative courses of action to be evaluated. The list of proposed alternatives may be
refined as new options are identified or as existing options are found to violate the problem
constraints.
(i) Provide an estimate of resources required and a reporting schedule for the analysis to ensure
that the LCC results will be available to support the decision-making process for which they are
required.

Next step in LCC Analysis planning is the selection or development of an LCC model that will satisfy
the objectives of the analysis. LCC Model is basically an accounting structure which enables the
estimation of an asset components cost.

Stage 2: Life Cost Analysis Preparation:

The Life Cost Analysis is essentially a tool, which can be used to control andmanage the ongoing
costs of an asset or part thereof. It is based on the LCCModel developed and applied during the Life
Cost Planning phase with one important difference: it uses data on real costs.
The preparation of the Life Cost Analysis involves review and development of the LCC Model as a
“real-time” or actual cost control mechanism. Estimates of capital costs will be replaced by the
actual prices paid. Changes may also be required to the cost breakdown structure and cost elements
to reflect the asset components to be monitored and the level of detail required.

Targets are set for the operating costs and their frequency of occurrence based initially on the
estimates used in the Life Cost Planning phase. However, these targets may change with time as
more accurate data is obtained, from the actualasset operating costs or from the operating cost of
similar another asset. Stage 3: Implementing and Monitoring:
Implementation of the Life Cost Analysis involves the continuous monitoring of the actual
performance of an asset during its operation and maintenance to identify areas in which cost
savings may be made and to provide feedback for future life cost planning activities.

For example, it may be better to replace an expensive building component with a more efficient
solution prior to the end of its useful life than to continue with a poor initial decision.
What is Target Costing?
Target costing is not just a method of costing, but rather a management technique wherein prices
are determined by market conditions brought about by several factors, such as homogeneous
products, level of competition, no/low switching costs for the endcustomer, etc. When these factors
come into the picture, management wants to control the costs, as they have little or no control over
the selling price.
CIMA defines target cost as “a product cost estimate derived from a competitive marketprice.”
Target Costing = Selling Price – Profit Margi

Why Target Costing?

In industries such as FMCG, construction, healthcare, and energy, competition is so intense that
prices are determined by supply and demand in the market, and hence producers can’t effectively
control selling prices. They can only control, to some extent,their costs, so management’s focus is
on influencing every component of product, service, or operational costs.

The key objective of target costing is to enable management to use proactive cost planning, cost
management, and cost reduction practices where costs are planned and calculated early in the
design and development cycle, rather than during the later stagesof product development and
production

Key Features of Target Costing:

(a) The price of the product is determined by market conditions. The company isa price taker rather
than a price maker.
(b) The minimum required profit margin is already included in the target selling price.
(c) It is part of management strategy to focus on cost reduction and effective costmanagement.
(d) Product design, specifications, and customer expectations are already built in while formulating
the total selling price.
(e) The difference between the current cost and the target cost is the “cost reduction,” which
management wants to achieve.
(f) A team is formed to integrate activities such as designing, purchasing,manufacturing, marketing,
etc. to find and achieve the target cost.
(g) Advantages of Target Costing:
(h) It shows management’s commitment to process improvements and productinnovation to gain
competitive advantages.
(i) The product is created from the expectation of the customer and hence cost isalso based on
similar lines. Thus, the customer feels more value is delivered.
(j) With the passage of time, the company’s operations improve drastically, creatingeconomies of
scale.
(k) The company’s approach to designing and manufacturing products becomesmarket-driven.
(l) New market opportunities can be converted into real savings to achieve the bestvalue formoney
rather than to simply realize the lowest cost.

Example:
ABC Inc. is a big FMCG player that operates in a very competitive market. It sells packaged food to
end customers. ABC can only charge $20 per unit. If the company’sintended profit margin is 10% on
the selling price, calculate the target cost per unit.

Solution:
Target Profit Margin = 10% of 20 = $2 per unit Target Cost = Selling Price – Profit Margin ($20 – $2)
Target Cost = $18 per unit
Kaizen Costing Method &Just-in-time Production!
Kaizen is a Japanese management concept launched by Masaaki Imai, which proved to be the key
to Japanese competitive success. The significance of this concept is: KAI = Change and ZEN = for
better, and the translation is “continuous improvement”, that means small improvements to the
ongoing efforts. Unlike the Western conception, implying total change, at large intervals of time,
using large amounts of resources and a high cost level, Kaizen Costing seeks daily, gradual, slow,
but continuous improvements, which take place at minimal cost.
Kaizen strategy is that a single day should not pass without an improvement to intervene in the
activity of each employee or each entity. The Japanese have shown that by applying this strategy,
improvement is achieved with minimal expenditure.

Specific characteristics that ensure successful approach of Kaizen activities are the following:
1. disregards all ideas implemented so far in the organization of production.
2. rejects the whole existent situation.
3. it does not look for perfection, seeking a 40-50% improvement of the existent situation, but at an
 acceptable cost.
1. allows any manager to use their knowledge and personal skills;
2. the ideas produced by many people are better than the ideas of a single person;
3. the improvements have no limits.

Cost is one of the basic synthetic indicators that characterize the effectiveness of an entity’s activity.
The importance of production cost is related to the functions it fulfills in the context of economic-
financial mechanism, schematically presenting itself as follows: ensures the resumption of
production, measures the means of production and labor, allows the calculation of some efficiency
indicators and the real knowledge of activity quality, sizes the profitability of economic entities, etc.
Kaizen Costing Method is focused on improving each process of a technological product sheet, the
main goal being eliminating losses and minimizing costs. Process improvement ensures production
efficiency, kaizen type activities ensuring maximization of product value corresponding to the
requirements of the beneficiary, a qualitative differentiation of this. There are eliminated all those
functions of the product which the customer has no interest in and which bring a cost increase
without a correspondent in value.

The KAIZEN principles presume a practical approach and low costs of improvement. The Kaizen
management system is based on the continuous loss reduction by means of methods that do not
rely on investments, but on the improvement of the processes and the employees performance.
According to the Kaizen principles, we must be sure that, when we take an action, our action will go
on in the best possible way and is not merely an intermediate action to generate a temporary result.
Innovation is achieved by sudden changes andDIWAKAR generatesEDUCATION
radical improvements,
HUB compared to the
initial situation, which is due to significant investments in technology, performance and equipment.
Kaizensignifies small improvements as a result of ongoing efforts.
In implementing Kaizen Costing strategy, managers rely on other techniques, methods and tools
such as: quality circles, suggestions system, kanban, total productive maintenance, action plans,
etc. The success of this strategy is subject to a number of changes in the entity’s culture and value
system on which it is based.

Suggesting small steps strategy, Kaizen Costing is a concept of “umbrella” which treats the basic
methods and concepts applied in quality management in Japan and whose value is recognized
[Link] superiority of the concept stems from the fact that, by applying small steps strategy,
the necessary resources are insignificant, while the strategies based on innovations involve huge
investments, although the results are relatively the same. In addition, Kaizen brings in the forefront
the employees of the entity, who are motivated to participate consciously and responsibly to achieve
the objectives of the entity. In this process the most important dimension is the organizational one,
the ability to communicate. Successful implementation of this approach is given by the technical
and managerial knowledge, put together, and by the across application of some management tools.
The implementation of Kaizen Costing management system in organizations would bring immediate
gains by eliminating waste and losses, increasing labour productivity by 20-30%, reducing operating
costs by 15-20%, reducing used areas, reducing the equipment needs and increasing the use of the
remaining, increasing staff motivation. Kaizen Costing focuses the entity interest and attention on
those places where you can reduce costs, this means on operating the production process and its
development in the most efficient way.

As a method of cost calculation and resizing, Kaizen Costing represents the expression of returning
to the source, through the causes of performance and the roots of productivity, what is possible in
a cross-viewing, and performing a process analysis. Cost reduction approach results by comparing
the target-cost to the estimated one, and is fulfilled in terms of value, through an iterative process
of continuous improvement.

Thus, Kaizen Costing is not interested in the product but in manufacturing process, which is more
than just a cost method, but a global management tool.

While implementing the concept of Kaizen, following few rules are tobe observed:
1. Identify your own problems.
2. Grade your problems like minor, difficult and major.
3. Select the smallest minor problem and start with it. After tackling this, move on to next graded
problem and so on.
1. Always ensure that improvement is a part of daily routine.
2. Never accept status quo.
3. Never reject any idea before trying it.
4. Share the experiments with colleagues.
5. Eliminate already tried but failed experiments, while sharing the problems with your colleagues.
6. Never hide problems, always highlight the
Just-in-time (JIT) purchasing is a cost accounting strategy where you purchase the minimum
amount of goods to meet customer demand. Say you decide to approach your supplier about moving
to a JIT purchasing arrangement. The supplier needs to deliver smaller shipments more frequently.
You request a pricequote based on new, different levels of purchasing activity. Compare the financial
impact of your current purchasing system with a JIT purchasing system.

JIT PURCHASING COSTS IN COST ACCOUNTING

Say you manage a large chain of sporting-goods stores. You’re considering the impact of JIT
purchasing for many products. At the moment, you’re evaluating baseball bats.
Here’s some information regarding baseball bat purchases:
1. Purchasing costs: The cost per baseball bat is $100 for both your currentpurchasing method
and JIT purchasing.
2. Ordering costs: The cost per order is $150 for both purchasing methods.
3. Opportunity costs: Company management has decided on an 8 percentrequired rate of return
on investment. That 8 percent rate applies to any use of capital, including inventory purchases.
This is the minimum return that the company expects from the money it has invested. If this
return is not achieved, there are likely better alternatives for the company’s cash.
4. Average inventory: Average inventory is defined as the average value ofinventory during a certain
time period. Average inventory is (beginning inventory + ending inventory) ÷ 2. Currently, your
average inventory is 10 percent of annual sales, or 2,000 bats. Under JIT, your average inventory
will decline to 200 units.
5. Carrying costs: You also incur costs for insurance and storage. Carryingcosts total $15 per unit.
This table compares your current purchasing costs with JIT purchasing costs.
Current Purchasing Costs versus JIT Purchasing Costs Total Costs Current Purchasing costs
Cost Units

$100/unit

20,000
$2,000,000

$2,000,000
Ordering costs

Cost

Orders

$150/order

20

$3,000

$150/order

200

$30,000
Opportunity costs

Cost

Inventory

8% rate

$100/unit

2,000

$16,000

8% rate

$100/unit

200

$1,600
Other carry costs

Cost
Inventory

$15/unit

2,000

$30,000

$15/unit

200

$3,000
Total costs

$2,049,000

$2,034,600
JIT purchasing saves you $14,400 in costs ($2,049,000 current costs less $2,034,600 JIT purchasing
costs).
Using JIT purchasing, the number of orders increases from 20 to 200. Purchase ordering costs
increase from $3,000 to $30,000.
The opportunity cost multiplies the 8 percent rate x $100 unit cost x the average inventory. Note that
the average inventory for your current process is 2,000 units;so, the opportunity cost for your current
purchasing system is much higher than with JIT ($16,000 versus $1,600).
Carrying costs are $15 per unit. When you cut the average inventory with JIT,you also reduce carrying
costs ($30,000 current versus $3,000 JIT).

JIT STOCKOUT COSTS IN COST ACCOUNTING

Before you decide on JIT purchasing, consider other costs. Stockout costsweren’t included in the
table. Those costs are more difficult to quantify.
The financial impact of a stockout is hard to pin down, but you can develop somedata. You can
probably identify individual stockout situations. Your store managers can track customers who ask
for out-of-stock items. The total stockoutcost would be the number of customers requesting an out-
of-stock product multiplied by the cost you incur to get them the product.
This table shows that the ordering cost is $150 per order. All suppliers give theirclients a cost quote
for placing small, last-minute orders. Now this is a different cost for a different service.
Say that the minimum cost for any order is $30. As stockouts occur, you place last-minute orders
for small amounts — sometimes two bats, sometimes ten. Youestimate a stockout cost per item of
$5 per bat.
 222

You can’t quantify the opportunity cost of future lost business due to stockouts.
Sure, you may be able to “save the order” by ordering the product when it’s out of
stock. The customer gets the product, but not as soon as he or she wanted it.
That experience may mean that he or she will do business somewhere else going
forward.

You forecast 50 customer orders placed when bats are out of stock. The totalstockout cost would
be $5 per unit x 50 orders = $250.
Financial statement analysis
Financial statement analysis involves gaining an understanding of an organization's financial
situation by reviewing its financial reports. The results can be used to make investment and
lending decisions. This review involves identifying the following items for a company's
financial statements over a series of reporting periods

1. Trends. Create trend lines for key items in the financial statements over multiple time
periods, to see how the company is performing. Typical trend lines are for revenue, the
gross margin, net profits, cash, accounts receivable, and debt.
2. Proportion analysis. An array of ratios are available for discerning the relationship
between the size of various accounts in the financial statements. For example, one can
calculate a company's quick ratio to estimate its ability to pay its immediate liabilities,
or its debt to equity ratio to see if it has taken on too much debt. These
3. analyses are frequently between the revenues and expenses listed on the income
statement and the assets, liabilities, and equity accounts listed on the balance sheet.
4. Financial statement analysis is an exceptionally powerful tool for a variety of users of
financial statements, each having different objectives in learning about the financial
circumstances of the entity.
5. Users of Financial Statement Analysis
6. There are a number of users of financial statement analysis. They are:
7. Creditors. Anyone who has lent funds to a company is interested in its ability to pay back
the debt, and so will focus on various cash flow measures.
8. Investors. Both current and prospective investors examine financial statements to learn
about a company's ability to continue issuing dividends, or to generate cash flow, or to
continue growing at its historical rate (depending upon their investment philosophies).
9. Management. The company controller prepares an ongoing analysis of the company's
financial results, particularly in relation to a number of operational metrics that are not
seen by outside entities (such as the cost per delivery, cost per distribution channel, profit
by product, and so forth).
10. Regulatory authorities. If a company is publicly held, its financial statements are examined
by the Securities and Exchange Commission (if the company files in the United States)
to see if its statements conform to the various accounting standards and the rules of the
SEC.
11. Methods of Financial Statement Analysis
12. There are two key methods for analyzing financial statements. The first method is the use
of horizontal and vertical analysis. Horizontal analysis is the comparison of financial
 223
information over a series of reporting periods, while vertical analysis is the proportional
analysis of a financial statement, where each line item on a financial statement is listed
as a percentage of another item. Typically, this means that every line item on an income
statement is stated as a percentage of gross sales, while every line item on a balance
sheet is stated as

percentage of total assets. Thus, horizontal analysis is the review of the results of multiple
time periods, while vertical analysis is the review of the proportion of accounts to each
other within a single period.
The second method for analyzing financial statements is the use of many kinds of ratios.
Ratios are used to calculate the relative size of one number in relation to another. After a
ratio is calculated, you can then compare it to the same ratio calculated for a prior period,
or that is based on an industry average, to see if the company is performing in accordance
with expectations. In a typical financial statement analysis, most ratios will be within
expectations, while a small number will flag potential problems that will attract the
attention of the reviewer.

There are several general categories of ratios, each designed to examine a different
aspect of a company's performance. The general groups of ratios are:
1. Liquidity ratios. This is the most fundamentally important set of ratios, because they
measure the ability of a company to remain in business. Click the following links for a
thorough review of each ratio.
2. Cash coverage ratio. Shows the amount of cash available to pay interest.
3. Current ratio. Measures the amount of liquidity available to pay for current liabilities.
4. Quick ratio. The same as the current ratio but does not include inventory.
5. Liquidity index. Measures the amount of time required to convert assets into cash.

1. Activity ratios. These ratios are a strong indicator of the quality of management, since
they reveal how well management is utilizing company resources. Click the following
links for a thorough review of each ratio.
2. Accounts payable turnover ratio. Measures the speed with which a company pays its
suppliers.
3. Accounts receivable turnover ratio. Measures a company's ability to collect accounts
receivable.
4. Fixed asset turnover ratio. Measures a company's ability to generate sales from a
certain base of fixed assets.
5. Inventory turnover ratio. Measures the amount of inventory needed to support a given
level of sales.
6. Sales to working capital ratio. Shows the amount of working capital required to
support a given number of sales.
7. Working capital turnover ratio. Measures a company's ability to generate sales from a
certain base of working capital.
8. Leverage ratios. These ratios reveal the extent to which a company is relying upon debt
to fund its operations, and its ability to pay back the debt. Click the following links for
a thorough review of each ratio.
Debt to equity ratio. Shows the extent to which management is willing to fund
operations with debt, rather than equity.
9. Debt service coverage ratio. Reveals the ability of a company to pay its debt
 obligations
1. Fixed charge coverage. Shows the ability of a company to pay for its fixed costs.
2. Profitability ratios. These ratios measure how well a company performs in generating a
profit. Click k the following links for a thorough review of each ratio.
3. Breakeven point. Reveals the sales level at which a company breaks even.
4. Contribution margin ratio. Shows the profits left after variable costs are subtracted
from sales.
5. Gross profit ratio. Shows revenues minus the cost of goods sold, as a proportion of
sales.
6. Margin of safety. Calculates the amount by which sales must drop before a company
reaches its breake ven point
7. Net profit ratio. Calculates the amount of profit after taxes and all expenses have
been deducted from net sales.
8. Return on equity. Shows company profit as a percentage of equity.
9. Return on net assets. Shows company profits as a percentage of fixed assets and
working capital.
10. Return on operating assets. Shows company profit as percentage of assets utilized.
11. Problems with Financial Statement Analysis
12. While financial statement analysis is an excellent tool, there are several issues to be
aware of that can interfere with the interpretation of the analysis results. These issues
are:
13. Comparability between periods. The company preparing the financial statements may
have changed the accounts in which it stores financial information, so that results may
differ from period to period. For example, an expense may appear in the cost of goods
sold in one period, and in administrative expenses in another period.
14. Comparability between companies. An analyst frequently compares the financial ratios
of different companies in order to see how they match up against each other. However,
each company may aggregate financial information differently, so that the results of
their ratios are not really comparable. This can lead an analyst to draw incorrect
conclusions about the results of a company in comparison to its competitors.
15. Operational information. Financial analysis only reviews a company's financial
information, not its operational information, so you cannot see a variety of key indicators
of future performance, such as the size of the order backlog, or changes in warranty
claims. Thus, financial analysis only presents part of the total [Link] Analysis
16. Ratio Analysis is a form of Financial Statement Analysis that is used to obtain a quick
indication of a firm's financial performance in several key areas. The ratiosare categorized as
Short-term Solvency Ratios, Debt Management Ratios, Asset Management Ratios,
Profitability Ratios, and Market Value Ratios.

Ratio Analysis as a tool possesses several important features. The data, which are provided by
financial statements, are readily available. The computation of ratios facilitates the comparison of
firms which differ in size. Ratios can be used to compare a firm's financial performance with industry
averages. In addition, ratios can be used in a form of trend analysis to identify areas where
performance has improved or deteriorated over time.

Because Ratio Analysis is based upon accounting information, its effectiveness is limited by the
distortions which arise in financial statements due to such things as Historical Cost Accounting and
inflation. Therefore, Ratio Analysis should only beused as a first step in financial analysis, to obtain
a quick indication of a firm's performance and to identify areas which need to be investigated further.
The pages below present the most widely used ratios in each of the categories given above. Please
keep in mind that there is not universal agreement as to how many of these ratios should be
calculated. You may find that different books use slightly different formulas for the computation of
many ratios. Therefore, if you are comparing a ratio that you calculated with a published ratio or an
industry average, make sure that you use the same formula as used in the calculation of thepublished
ratio.

Concepts
Short-term Solvency or LiquidityRatios
Short-term Solvency Ratios attempt to measure the ability of a firm to meet its short-term financial
obligations. In other words, these ratios seek to determine the ability of a firm to avoid financial
distress in the short run. The two most importantShort-term Solvency Ratios are the Current Ratio
and the Quick Ratio. (Note: The Quick Ratio is also known as the Acid-Test Ratio.)
Current Ratio

The Current Ratio is calculated by dividing Current Assets by Current [Link] Assets are
the assets that the firm expects to convert into cash in theEDUCATION HUB
DIWAKAR
coming year and Current Liabilities represent the liabilities which have to be paid in cash in the
coming year. The appropriate value for this ratio depends on the characteristics of the firm's industry
and the composition of its Current Assets.
However, at a minimum, the Current Ratio should be greater than one.

Quick Ratio
The Quick Ratio recognizes that, for many firms, Inventories can be rather [Link] these Inventories
had to be sold off in a hurry to meet an obligation the firm might have difficulty in finding a buyer
and the inventory items would likely have to be sold at a substantial discount from their fair market
value.

This ratio attempts to measure the ability of the firm to meet its obligations relyingsolely on its more
liquid Current Asset accounts such as Cash and Accounts Receivable. This ratio is calculated by
dividing Current Assets less Inventories by Current Liabilities.

Debt Management Ratios

Debt Management Ratios attempt to measure the firm's use of Financial Leverageand ability to avoid
financial distress in the long run. These ratios are also knownas Long-Term Solvency Ratios.
Debt is called Financial Leverage because the use of debt can improve returns to stockholders in
good years and increase their losses in bad years. Debt generallyrepresents a fixed cost of financing
to a firm. Thus, if the firm can earn more on assets which are financed with debt than the cost of
servicing the debt then theseadditional earnings will flow through to the stockholders. Moreover, our
tax lawfavors debt as a source of financing since interest expense is tax deductible.
With the use of debt also comes the possibility of financial distress and [Link] amount of
debt that a firm can utilize is dictated to a great extent by the characteristics of the firm's industry.
Firms which are in industries with volatile sales and cash flows cannot utilize debt to the same extent
as firms in industries with stable sales and cash flows. Thus, the optimal mix of debt for a firm
involves a tradeoff between the benefits of leverage and possibility of financialdistress.

Debt Ratio, Debt-Equity Ratio, and Equity Multiplier

The Debt Ratio, Debt-Equity Ratio, and Equity Multiplier are essentially three ways of looking at the
same thing: the firm's use of debt to finance its assets. The Debt Ratio is calculated by dividing Total
Debt by Total Assets. The Debt-EquityRatio is calculated by dividing Total Debt by Total Owners'
Equity. The Equity Multiplier is calculated by dividing Total Assets by Total Owners' Equity.

Asset Management Ratios

Asset Management Ratios attempt to measure the firm's success in managing its assets to generate
sales. For example, these ratios can provide insight into the success of the firm's credit policy and
inventory management. These ratios are alsoknown as Activity or Turnover Ratios.
Receivables Turnover and Days' Receivables
The Receivables Turnover and Days' Receivables Ratios assess the firm's management of its

Accounts Receivables and, thus, its credit policy. In general, thehigher the Receivables Turnover
Ratio the better since this implies that the firm is collecting on its accounts receivables sooner.
However, if the ratio is too high thenthe firm may be offering too large of a discount for early payment
or may have toorestrictive credit terms. The Receivables Turnover Ratio is calculated by dividing
Sales by Accounts Receivables. (Note: since Accounts Receivables arise from Credit Sales it is more
meaningful to use Credit Sales in the numerator if the data is available.)

The Days' Receivables Ratio is calculated by dividing the number of days in a year, 365, by the

Receivables Turnover Ratio. Therefore, the Days' Receivables indicates how long, on average, it takes
for the firm to collect on its sales to customers on credit. This ratio is also known as the Days' Sales
Outstanding (DSO)or Average Collection Period (ACP).

Profitability Ratios
Profitability Ratios attempt to measure the firm's success in generating income. These ratios reflect
the combined effects of the firm's asset and debt management.
Profit Margin
The Profit Margin indicates the dollars in income that the firm earns on each dollarof sales. This ratio

is calculated by dividing Net Income by Sales.

Return on Assets (ROA) and Return on Equity (ROE)

The Return on Assets Ratio indicates the dollars in income earned by the firm on its assets and the

Return on Equity Ratio indicates the dollars of income earned by the firm on its shareholders' equity.

It is important to remember that these ratios arebased on accounting book values and not on market
values. Thus, it is not appropriate to compare these ratios with market rates of return such as the
interest rate on Treasury bonds or the return earned on an investment in a stock. Funds Flow
Statement: Meaning, Objective and Importance

Meaning of Funds Flow Statement:

Funds flow statement is a statement which discloses the analytical information about the different
sources of a fund and the application of the same in an accounting cycle. It deals with the
transactions which change either the amount ofcurrent assets and current liabilities (in the form of
decrease or increase in working capital) or fixed assets, long-term loans including ownership fund.
It gives a clear picture about the movement of funds between the opening and closing dates of the
Balance Sheet. It is also called the Statement of Sources and Applications of Funds, Movement of
Funds Statement; Where Got—Where GoneStatement: Inflow and Outflow of Fund Statement, etc.
No doubt, Funds Flow Statement is an important indicator of financial analysis and control. It is
valuable and also helps to determine how the funds are financed. The financial analyst can evaluate
the future flows of a firm on the basis of past data.

This statement supplies an efficient method for the financial managerin order to assess the:
(a) Growth of the firm,
(b) Its resulting financial needs, and
(c) To determine the best way to finance those needs.

In particular, funds flow statements are very useful in planning intermediate and long-term
financing.
Objective of Preparing a Fund Flow Statement:
The main purpose of preparing a Funds Flow Statement is that it reveals clearly the important items
relating to sources and applications of funds of fixed assets, long-term loans including capital. It
also informs how far the assets derived fromnormal activities of business are being utilized properly
with adequate consideration.

Secondly, it also reveals how much out of the total funds is being collected by disposing of fixed
assets, how much from issuing shares or debentures, how much from long-term or short-term
loans, and how much from normal operationalactivities of the business.
Thirdly, it also provides the information about the specific utilization of such funds, i.e. how much
has been applied for acquiring fixed assets, how much for repayment of long-term or short-term
loans as well as for payment of tax and dividend etc.

Lastly, it helps the management to prepare budgets and formulate the policiesthat will be adopted
for future operational activities.
Significance and Importance of Funds Flow Statement: Since traditional reports (i.e. Income
Statement/Profit and Loss Account, andBalance Sheet) are not very informative, a financial analyst
has to depend on some other report—Funds Flow Statement. In other words, along with the
traditional sources of information, some other sources of information are
absolutely required in order to take the challenge offered by modern business.

Funds Flow Statement, no doubt, caters to the needs of management. This is because a Funds Flow
Statement not only presents the Balance Sheet values for consecutive two years, it also ascertains
the changes of working capital—which isa very important indicator.
It not only reveals the source from which additional working capital has been financed but also, at
the same time, the use of such funds. Moreover, from a projected funds flow statement the
management can easily ascertain the adequacy or inadequacy of working capital, i.e., it helps in
decision-making in anumber of ways.

The significance and importance of Funds Flow Statements may besummarized as:
(a) Analysis of Financial Statement:
The traditional financial statements, viz. Profit and Loss Account and Balance Sheet, exhibit the
result of the operation and financial position of a firm. Balance Sheet presents a static view about
the resources and how the said resources have been utilized at a particular date with recording
the changes in financial activities
But Funds Flow Statement can do so, i.e., it explains the causes of changes somade and effect
of such change in the firm accordingly.

(b) Highlighting Answers to Various Perplexing Questions:

Funds Flow Statement highlights answers of the following questions:
(a) Causes of changes in Working Capital.
(b) Whether the firm sells any Non-Current Asset; if sold, how were the proceedsutilized?
(c) Why smaller amount of dividend is paid in spite of sufficient profit?
(d) Where did the net profit go?
(e) Was it possible to pay more dividend than the present one?
(f) Did the firm pay-off its scheduled debts? If so, how, and from what sources?
(g) Sources of increased Working Capital, etc.
(a) Realistic Dividend Policy:
(b) Sometimes it may so happen that a firm, instead of having sufficient profit, cannot pay dividend
due to lack of liquid sources, viz. cash. In such a circumstance, Funds Flow Statement helps the
firm to take decision about asound dividend policy which is very helpful to the management.
(c) Proper Allocation of Resources:
(d) Resources are always limited. So, it is the duty of the management to make itsproper use. A
projected Funds Flow Statement helps the management to takeproper decision about the proper
allocation of business resources in a best possible manner since it highlights the future.
(e) As a Future Guide:
(f) A projected Funds Flow Statement acts as a business guide. It helps the management to make
provision for the future for the necessary funds to be required on the basis of the problem faced.
In other words, the future needs of thefund for various purposes can be known well in advance
which is a very helpful
(g) guide to the management. In short, a firm may arrange funds on the basis of thisstatement in
order to avoid the financial problem that may arise in future.
(h) Appraising of the Working Capital:
(i) A projected Funds Flow Statement, no doubt, helps the management to know about how the
 229
working capital has been efficiently used and, at the same time, also suggests how to improve
the working capital position for the future on thebasis of the present problem faced by it, if any.
Analyze Cash Flow the Easy Way
The statement of cash flow shows how a company spends its money (cash outflows) and from
where a company receives its money (cash inflows). The cash flow statement includes all cash
inflows a company receives from its ongoing operations and external investment sources, as well
as all cash outflows that pay for business activities and investments during a given quarter. In this
article, we'll explain the cash flow statement and how it can help youanalyze a company for investing.

Why the Cash Flow Statement is Important

There are two forms of accounting: cash and accrual.
Accrual accounting is used by most public companies and is the accounting method where revenue
is reported as income when it's earned rather than when the company receives payment. Expenses
are reported when incurred even though no cash paymentshave been made.
For example, if a company records a sale, the revenue is recognized on the income statement, but
the company may not receive cash until a later date. From an accountingstandpoint, the company
would be earning a profit on the income statement and be paying income taxes on it. However, no
cash would have been exchanged. Also, the
transaction would likely be an outflow of cash initially, since it costs money for the companyto buy
inventory and manufacture the product to be sold. It's common for businesses to extend terms of
thirty, sixty, or even ninety days for a customer to pay the invoice. The salewould be an accounts
receivable with no impact on cash until collected.

Analyze Cash Flow the Easy Way

Cash accounting is an accounting method in which payment receipts are recorded during theperiod
they are received, and expenses are recorded in the period in which they are actually paid. In other
words, revenues and expenses are recorded when cash is received and paid, respectively.
A company's profit is shown as net income on the income statement. Net income is the bottom line
for the company. However, because of accrual accounting, net incomedoesn't necessarilymean that
all receivables were collected from their customers.
From an accounting standpoint, the company might be profitable, but if the receivables become past
due or uncollected, the company could run into financial problems. Even profitable companies can
fail to adequately manage their cash flow, which is why the cashflow statement is a critical tool for
analysts and investors.

Cash Flow Statement

A cash flow statement has three distinct sections, each of which relates to a particular component
– operations, investing and financing – of a company's business activities. Below is the typical
format of a cash flow statement:

Cash Flow from Operations

This section reports the amount of cash from the income statement that was originallyreported on
an accrual basis. A few of the items included in this section are accounts receivables, accounts
payables, and income taxes payable.
If a client pays a receivable, it would be recorded as cash from operations. Changes in current assets
or current liabilities (items due in one year or less) are recorded as cash flowfrom operations.

Cash Flow from Investing

This section records the cash flow from sales and purchases of long-term investmentslike fixed
assets that include property, plant, and equipment. Items included in this section are purchases of
vehicles, furniture, buildings, or land.
Typically, investing transactions generate cash outflows, such as capital
expenditures for plant, property and equipment, business acquisitions and the purchase of
investment securities. Cash inflows come from the sale of assets, businesses, and
securities. Investors typically monitor capital expenditures used for the maintenance of, and
additions to, a company's physical assets to support the company's operation and competitiveness.
In short, investors can see how a company is investing in itself.

Cash Flow from Financing

Debt and equity transactions are reported in this section. Any cash flows that include payment of
dividends, the repurchase or sale of stocks, and bonds would be considered cash flow for financing
activities. Cash received from taking out a loan, or cash used to paydown long-term debt would be
recorded in this section.

For investors who prefer dividend-paying companies, this section is important since itshows cash
dividends paid since cash, not net income is used to pay dividends to shareholders.

Cash Flow Analysis

A company's cash flow can be defined as the number that appears in the cash flow statement as net
cash provided by operating activities, or "net operating cash flow." However, there is no universally
accepted definition. For instance, many financial professionals consider a company's cash flow to
be the sum of its net income and depreciation (a non-cash charge in the income statement). While
often coming close to net operating cash flow, the shortcut can be inaccurate, and investors should
stick with usingthe net operating cash flow figure.

While cash flow analysis can include several ratios, the following indicators provide a startingpoint
DIWAKAR
for an investor to measure the investment quality EDUCATION
of a company's cashHUB
flow:

Operating Cash Flow/Net Sales

This ratio, which is expressed as a percentage of a company's net operating cash flow to its net
sales, or revenue (from the income statement), tells us how many dollars of cash aregenerated for
every dollar of sales.
There is no exact percentage to look for, but the higher the percentage, the better. It shouldalso be
noted that industry and company ratios will vary widely. Investors should track this indicator's
performance historically to detect significant variances from the company's average cash
flow/sales relationship along with how the company's ratio compares to its peers. It is also essential
to monitor how cash flow increases as sales increase
since it's important that they move at a similar rate over time.

Free Cash Flow

Free cash flow (FCF) is often defined as net operating cash flow minus capital [Link]
cash flow is an important measurement since it shows how efficient a company is at generating
cash. Investors use free cash flow to measure whether a company might have enough cash, after
funding operations and capital expenditures, to pay investors
through dividends and share buybacks.
To calculate FCF from the cash flow statement, find the item cash flow from operations - also
referred to as "operating cash" or "net cash from operating activities" - and subtract capital
expenditures required for current operations from it.

You can go one step further by expanding what's included in the free cash flow number. For example,
in addition to capital expenditures, you could also include dividends for the amountto be subtracted
from net operating cash flow to arrive at a more comprehensive free cash flow figure. This figure
could then be compared to sales, as shown earlier.
As a practical matter, if a company has a history of dividend payments, it cannot easilysuspend or
eliminate them without causing shareholders some real pain. Even
dividend payout reductions, while less injurious, are problematic for many shareholders. For some
industries, investors consider dividend payments to be necessary cash outlays similar to capital
expenditures.

It's important to monitor free cash flow over multiple periods and compare the figures to companies
within the same industry. If free cash flow is positive, it should indicate the company is able to meet
its obligations including funding its operating activities and payingdividends.
Comprehensive Free Cash Flow Coverage
You can calculate a comprehensive free cash flow ratio by dividing the comprehensive freecash flow
by net operating cash flow to get a percentage ratio. Again, the higher the percentage, the better.

The Bottom Line

Free cash flow is an important evaluative indicator for investors. It captures all the positivequalities
of internally produced cash from a company's operations and monitors the use ofcash for capital
expenditures. If a company's cash generation is positive, it's a strong indicator that the company is
in a good position to avoid excessive borrowing, expand its business, pay dividends, and weather
hard times.
The term "cash cow," which is applied to companies with ample free cash flow, is not a veryelegant
term, but it is certainly one of the more appealing investment qualities you can applyto a company
with this characteristic.

Human Resource Accounting: Meaning, Definition, Objectives andLimitations

Meaning:
Human resources are considered as important assets and are different from the physical assets.
Physical assets do not have feelings and emotions, whereas human assets are subjected to various
types of feelings and emotions. In the sameway, unlike physical assets human assets never gets
depreciated.
Therefore, the valuations of human resources along with other assets are also required in order to
find out the total cost of an organization. In 1960s, Rensis Likert along with other social researchers
made an attempt to define the conceptof human resource accounting (HRA).

Definition:
1. The American Association of Accountants (AAA) defines HRA as follows: ‘HRA is a process of
identifying and measuring data about human resources and communicating this information to
interested parties.
2. Flamhoitz defines HRA as ‘accounting for people as an organizational resource. It involves
measuring the costs incurred by organizations to recruit, select, hire, train, and develop human
 assets. It also involves measuring the economic value ofpeople to the organization’.
3. According to Stephen Knauf, ‘HRA is the measurement and quantification of human
organizational inputs such as recruiting training, experience and commitment’.
Need for HRA:
The need for human asset valuation arose as a result of growing concern for human relations
management in the industry DIWAKAR EDUCATION HUB

Behavioral scientists concerned with management of organizations pointed out the following
reasons for HRA:
1. Under conventional accounting, no information is made available about the human resources
employed in an organization, and without people the financialand physical resources cannot be
operationally effective.
2. The expenses related to the human organization are charged to current revenueinstead of being
treated as investments, to be amortized over a period of time, with the result that magnitude of
net income is significantly distorted. This makes the assessment of firm and inter-firm
comparison difficult.
3. The productivity and profitability of a firm largely depends on the contribution of human assets.
Two firms having identical physical assets and operating in the same market may have different
returns due to differences in human assets. If thevalue of human assets is ignored, the total
valuation of the firm becomes difficult.
4. If the value of human resources is not duly reported in profit and loss account and balance sheet,
the important act of management on human assets cannot beperceived.
5. Expenses on recruitment, training, etc. are treated as expenses and written off against revenue
under conventional accounting. All expenses on human resources are to be treated as
investments, since the benefits are accrued over a period of time.

Objectives of HRA:
Rensis Likert described the following objectives of HRA:
1. Providing cost value information about acquiring, developing, allocating and maintaining human
resources.
2. Enabling management to monitor the use of human resources.
3. Finding depreciation or appreciation among human resources.
4. Assisting in developing effective management practices.
5. Increasing managerial awareness of the value of human resource
6. For better human resource planning.
7. For better decisions about people, based on improved information system.
8. Assisting in effective utilization of manpower.

Methods of Valuation of Human Resources:

There are certain methods advocated for valuation of human resources. These methods include
historical method, replacement cost method, present value method, opportunity cost method and
standard cost method. All methods havecertain benefits as well as limitations.

Benefits of HRA:
There are certain benefits for accounting of human resources, whichare explained as follows:
1. The system of HRA discloses the value of human resources, which helps inproper interpretation
of return on capital employed.
 233
2. Managerial decision-making can be improved with the help of HRA.
3. The implementation of human resource accounting clearly identifies human resources as
valuable assets, which helps in preventing misuse of human resources by the superiors as well
as the management.
4. It helps in efficient utilization of human resources and understanding the evileffects of labour
unrest on the quality of human resources.
5. This system can increase productivity because the human talent, devotion, and skills are
considered valuable assets, which can boost the morale of the employees.
6. It can assist the management for implementing best methods of wages and salary
administration.

Limitations of HRA:
HRA is yet to gain momentum in India due to certain difficulties
1. The valuation methods have certain disadvantages as well as advantages;therefore, there is
always a bone of contention among the firms that which method is an ideal one.
2. There are no standardized procedures developed so far. So, firms are providingonly as additional
information.

ADVERTISEMENTS:
1. Under conventional accounting, certain standards are accepted commonly, which is not possible
under this method.
2. All the methods of accounting for human assets are based on certain assumptions, which can
go wrong at any time. For example, it is assumed that allworkers continue to work with the same
organization till retirement, which is farfrom possible.
3. It is believed that human resources do not suffer depreciation, and in fact theyalways appreciate,
which can also prove otherwise in certain firms.
4. The lifespan of human resources cannot be estimated. So, the valuation seemsto be unrealistic.

Inflation Accounting
When there is a significant amount of price inflation or deflation, the impact on the financial
statements of a company operating in that environment can be so severe that the value of the
information in the statements declines to the point of being nearly useless. Consequently, it is
acceptable under GAAP to issue inflation- adjusted financial statements under the following
circumstances:
• The financial statements are denominated in a foreign currency; and
• The financial statements are for businesses operating in countries with highly inflationary
economies; and
• The financial statements are intended for readers in the United States
• For example, the measurement of income from continuing operations on a current cost
basis requires the following steps:
• Measure the cost of goods sold as of the date sold, using either its current cost or lower
recoverable amount, or when those resources are used on or at least committed to a
designated contract.
• Measure depreciation, amortization, and depletion based on either the average current
cost of the service potential of the underlying fixed assets or their lower recoverable
amount during the usage period.
• It is allowable to measure all other revenue and expense items, as well as income taxes,
 234
at the amounts stated in the company’s income statement.

In essence, the restatement steps required to convert historical cost information into
inflation-adjusted information are as follows:
1. Review the contents of inventory at the beginning and end of the year, as well as the cost
of goods sold, to determine when costs were incurred.
2. Restate both inventory and the cost of goods sold, so that they are presented at current
cost.
3. Review fixed assets to determine when they were acquired.
4. Restate fixed assets, depreciation, amortization, and depletion, so that they are presented
at current cost.
5. Determine the aggregate amount of net monetary items at the beginning and end of the
reporting period, as well as the net change in these items during the period.
6. Calculate the purchasing power gain or loss on the net monetary items.
7. Calculate the change in current cost for both inventory and fixed assets, as well as the effect
of changes in the general price level.

Inflation Accounting: Need, Meritsand Demerits | Accounting

Need for Inflation Accounting:
Accounting is based on the traditional concept of cost and revenue. Money is the yardstick for
measuring profits and losses and financial health of the business —operating results and financial
position. The basic objective of accounting is the preparation of financial statements in a way that
they give a true and fair view ofthe business. That is, the income statement should disclose the true
profit or lossmade by the business during a particular period while the balance sheet must show a
true and fair view of the financial position of the business on a particular
date. Financial statements are prepared in monetary units i.e., rupee. Themedium of expression is
the money value.
DIWAKAR EDUCATION HUB
The value of money is itself fluctuating; any measurement with an unsteady scale cannot be finite
and comparable. The recording of business transactions under the assumption that monetary unit
is stable is known as historical accounting.
However, it has been our experience that over a period of time, the prices havenot remained stable.
There have been inflationary as well as deflationary tendencies. Rise in general price level, termed
inflation erodes the intrinsic value of money, conversely, fall ingeneral prices called deflation, raises
its purchasing power. Inflation is a concept which every human being is not only aware of, but also
painfully experiencing.

The direct effect of inflation is the erosion in the purchasing power of money. Theroot cause of the
problem is the change in the value of money.

Monetary unit is never stable, and all types of countries have been experiencing high rates of
inflation. The prices change as a result of various economic and social forces and such changes
bring about a change in the purchasing power ofmoney.

Unless the necessary adjustments are made, price level changes produce distortions in the financial
statements and suffer serious limitations. Financial statements, prepared according to conventional
or historical accounting system,do not reflect current economic realities.
The assumption of stable money value subject to which the financial statements are prepared is
fallacious in the context of rising prices. Inflation by which we mean a rise in general price level and
a fall in the value of money. Because historical rupee is not comparable to the present-day rupee.
Unlike physical units,such as kilogram, meter etc. are stable units in measuring weight and distance,
monetary units i.e., rupee is an unstable unit of exchange value.

Thus, it is clear that the profit is over-stated, and the fixed assets are under-stated,when the effect
of inflation is ignored. In this example, when the asset has to be replaced larger, funds are required
on account of inflationary conditions. The asset purchased for Rs. 8, 00,000 and its life was expected
to be 10 years, a sum of Rs 80,000 (10%) would be charged as depreciation every year. If after 10
years,the asset can be purchased for Rs. 13, 00,000, the firm may have to face serious problems
because of insufficiency of funds. Hence, the need for inflation accounting. Merits of Inflation
Accounting: The following are the advantages:
1. Since assets are shown at current values, Balance Sheet exhibits a fair view of the financial
position of a firm.
2. Depreciation is calculated on the value of assets to the business and not ontheir historical cost—
a correct method. It facilitates easy replacement.
3. Profit and Loss Account will not overstate business income.
4. Inflation accounting shows current profit based on current prices.
5. Profit or loss is determined by matching the cost and the revenue at current values which are
comparable—a realistic assessment of performance.
6. Financial ratios based on figures, adjusted to current value, are moremeaningful.
7. Inflation accounting gives correct information, based on current price to the workers and
shareholders. In the absence of this, workers may claim for higherwages and shareholders too
claim for higher dividends.
8. Demerits of Inflation Accounting:
9. The system is not acceptable to Income tax authorities.
10. Too many calculations make complications.
11. Changes in prices are a never-ending process.
12. The amount of depreciation will be lower in times of deflation.
13. The profit calculated on the system of price level accounting may not be arealistic profit.
What is Environmental Accounting?

Environmental accounting principles and practices are mainly used by organizations to more
accurately trace environmental costs back toDIWAKAR
specific activities.
EDUCATION Government
HUB agencies, private
businesses, local communities and individuals all take responsibility for conserving natural
resources and operating sustainably in most developed nations. Governmental agencies and
businesses are accountable to the public for setting environmentally related efficiency goals
that lead to cost reductions and improved operational processes.

These organizations are more likely to implement methods from environmental accounting
which is a growing subset of traditional accounting. Here are some of the job duties of
environmental accountants, the typical education and training needed to become an
environmental accountant and the professional development certifications that position them
to be competitive in the job market.

Practices and Benefits of Environmental Accounting

While environmental accounting can focus on environmental management accounting or
financial accounting, the most prominent benefits come from the application of environmental
management accounting methods. This type of accounting focuses on gathering, estimating
and analyzing costs associated with the use of energy and physical materials like timber, metal
or coal. Standard accounting practices tended to place these costs in the catch all category of
overhead, but environmental management accounting allows accountants to apply activity-
based cost principles to more accurately associate these costs to various projects or events.
Decision makers who can see exactly where these natural resources are used across various
projects can locate areas of synergy that allow them to reduce the amount of wasted materials
at the program or enterprise level.

Job Duties of Environmental Accountants

Environmental accountants help decision makers to establish energy efficiency goals by doing
research on historical data and recent trends about the raw materials used to produce company
goods or services. These accountants also keep track of the availability of the raw materials
that are used in company goods and services. They conduct calculations to determine if
appropriate raw material substitutes can produce lower lifecycle costs as well as reduce
environmental impacts that are associated with their companies’ current practices.
Environmental accountants are also the business professionals who conduct break even and
cost benefit analyses for replacing traditional energy systems with alternative ones like wind
turbines and the new solar shingle roofs.

Education and Training Required for EnvironmentalAccountants

The niche field of environmental accounting has not yet matured, and there are only limited
university level academic programs that focus directly on this accounting category. For
example, Aquinas College in Michigan offers students a Bachelor of Science in Sustainable
Business and Dalhousie University in Canada has a Natural Resources MBA. However, most
environmental accountants earn traditional undergraduate degrees in accounting, and they
usually return to school to gain graduate certificates in environmental science. Many
environmental accountants earn specialized credentials like the Certified Environmental
Auditor (CEA) designation that is administered through
the National Registry of Environmental Professionals. Certifications like the CEA require
environmental accountants to have undergraduate degrees from accredited universities, a
minimum of four years of environmental auditing experience and successful completion of the
CEA exam.

Related Resource: Become an Auditor

Conclusion
Improved management of environmental costs is often good for industry and society, and
accountants are used to recognize opportunities for the reduction of environmental costs or to
support environmental initiatives that create revenue streams. Subsequently, tracking more
granular cost data often leads to better management of resources when it comes to
environmental accounting.

The Ministry of Corporate Affairs (MCA), in 2015, had notified the Companies (Indian Accounting
Standards
• Voluntary adoption
• SEBI Clarification

(IND AS)) Rules 2015, which stipulated the adoption and applicability of IND AS in a phased manner
beginning from the accounting period 2016-17. The MCA has since issued three Amendment Rules,
one each in year 2016, 2017, and 2018 to amend the 2015 rules.
The IND AS are basically standards that have been harmonised with the IFRS to make reporting by
Indian companies more globally accessible. Since Indian companies have a far wider global reach
now as compared to earlier, the need to converge reporting standards with international standards
was felt, which has led to the introduction of IND [Link] of IND AS – Indian Accounting
Standard
• Phases of adoption
• Net Worth Calculation

Phases of adoption
MCA has notified a phase-wise convergence to IND AS from current accounting standards. IND AS
shall be adopted by specific classes of companies based on their Net worth and listing status. Let’s
see the each of the phases in detail below:

Phase I
Mandatory applicability of IND AS to all companies from 1st April 2016, provided:
• It is a listed or unlisted company
• Its Net worth is greater than or equal to Rs. 500 crore*
*Net worth shall be checked for the previous three Financial Years (2013-14, 2014-15, and 2015-16).

Phase II
Mandatory applicability of IND AS to all companies from 1st April 2017, provided:
• It is a listed company or is in the process of being listed (as on 31.03.2016)
• Its Net worth is greater than or equal to Rs. 250 crore but less than Rs. 500 crore (for any of the
below mentioned periods).
Net worth shall be checked for the previous four Financial Years (2014-14, 2014-15, 2015-16, and
2016-17)

Phase III
Mandatory applicability of IND AS to all Banks, NBFCs, and Insurance companies from 1st April 2018,
whose:
• Net worth is more than or equal to INR 500 crore with effect from 1st April 2018.
IRDA (Insurance Regulatory and Development Authority) of India shall notify the separate set of IND
AS for Banks & Insurance Companies with effect from 1st April 2018. NBFCs include core investment
companies, stockbrokers, venture capitalists, etc. Net Worth shall be checked for the past 3 financial
years (2015-16, 2016- 17, and 2017-18)

Phase IV
All NBFCs whose Net worth is more than or equal to INR 250 crore but less than INR 500 crore shall
have IND AS mandatorily applicable to them with effect from 1st April 2019.

Please Note:
If IND AS become applicable to any company, then IND AS shall automatically be made applicable
to all the subsidiaries, holding companies, associated companies, and joint ventures of that
company, irrespective of individual qualification of such companies.
In case of foreign operations of an Indian Company, the preparation of stand-alone financial
statements may continue with its jurisdictional requirements and need not be prepared as per the
IND AS. However, these entities will still have to report their IND AS adjusted numbers for their Indian
parent company

Net Worth Calculation

Net worth will be determined based on the stand-alone accounts of the company as on 31st March
2014, or the first audited period ending after that date. Net Worth is the total of Paid-up share Capital
and all reserves out of profit & securities premium account, after deducting accumulated losses,
deferred expenditure, and miscellaneous expenditure not written off. Only capital Reserve arising
out of Promoters Contribution and Government Grants received can be included. Reserves created
out of revaluation of assets and written back depreciation cannot be included.
Voluntary adoption
Companies can voluntarily choose to incorporate IND AS in their reports for accounting periods
beginning on or after April 01, 2015. While reporting, such companies must include a comparative
report for the periods ending 31 March 2015 or thereafter, where IND AS have been incorporated to
present a comparative view.
However, once a company has started reporting as per the IND AS, it cannot change to reporting as
per previous laws.

SEBI Clarification
For all the issuer companies whose offer documents are filed with SEBI on or after 1st April 2016,
SEBI has issued a clarification on the applicability of the Indian Accounting Standards (IND AS) and
disclosures to be made in the offer documents. Typically, SEBI requires issuer companies to disclose
financial information for the previous 5 financial years immediately preceding the year of filing of the
offer document, while following uniform accounting policies for each of the financial years. For
those issuer companies filing an offer document these points can be noted:
1. Up to March 31, 2017, all of the financial statements filed by them can be under Indian GAAP.
2. Between April 1, 2017, and March 31, 2018, disclosures in the previous three financial years
immediately preceding the relevant financial year will have to be made under the IND AS
principles, while disclosures for the remaining two financial years may be done under Indian
GAAP.
3. Between April 1, 2018, and March 31, 2019, disclosures in the previous three financial years
immediately preceding the relevant financial year will have to be made under the IND AS
principles, while disclosures for the remaining two financial years may be done under Indian
GAAP.
4. Between April 1, 2019 and March 31, 2020, disclosures in the previous four financial years
immediately preceding the relevant financial year will have to be made under the IND AS
principles, while disclosures for the remaining one financial year may be done under Indian
GAAP.
5. On or after April 1, 2020, disclosures in all the previous five financial years will have to be made
as per the IND AS principles.

SEBI has also provided discretion to issuer companies to present financial statements for all five
financial years under IND AS on a voluntary basis. This clarification does not apply to issuer
companies making rights issue.

The major standards are listed here below:

Ind AS 101

First-time adoptions of Ind AS

Ind AS 102

Share Based payments

Ind AS 103

Business Combination

Ind AS 104

Insurance Contracts
Ind AS 105

Non-Current Assets Held for Sale and Discontinued Operations

Ind AS 106

Exploration for and Evaluation of Mineral Resources

Ind AS 107

Financial Instruments: Disclosures

Ind AS 108

Operating Segments
Ind AS 109

Financial Instruments
Ind AS 110

Consolidated Financial Statements

Ind AS 111

Joint Arrangements
Ind AS 112

Disclosure of Interests in Other Entities

Ind AS 113

Fair Value Measurement

Ind AS 114

Regulatory Deferral Accounts

Ind AS 115

Revenue from Contracts with Customers

Ind AS 1

Presentation of Financial Statements

Ind AS 2

Inventories Accounting
Ind AS 7
Statement of Cash Flows
Ind AS 8

Accounting Policies, Changes in Accounting Estimates and Errors

Ind AS 10

Events after Reporting Period

Ind AS 11

Construction Contracts
Ind AS 12

Income Taxes
Ind AS 16

Property, Plant and Equipment

Ind AS 17

Leases
Ind AS 18

Revenue
Ind AS 19

Employee Benefits
Ind AS 20

Accounting for Government Grants and Disclosure of Government Assistance

Ind AS 21

The Effects of Changes in Foreign Exchange Rates

Ind AS 23

Borrowing Costs
Ind AS 24

Related Party Disclosures

Ind AS 27

Separate Financial Statements

Ind AS 28

Investments in Associates and Joint Ventures

Ind AS 29

Financial Reporting in Hyperinflationary Economies

Ind AS 32
Financial Instruments: Presentation
Ind AS 33

Earnings per Share

Ind AS 34

Interim Financial Reporting

Ind AS 36

Impairment of Assets
Ind AS 37

Provisions, Contingent Liabilities and Contingent Assets

Ind AS 38

Intangible Assets

Ind AS 40

Investment Property
Ind AS 41

Agriculture

International Financial Reporting Standards

• What is IFRS?
• What is IASB?
• Components of Financial Statements under IFRS
• List of International Financial Reporting Standards (IFRS)

The field of financial reporting in India has seen major changes in the last 5 years. As the trade
increasingly moves beyond the national boundaries, the compliance and reporting requirements
move too. Presenting the financial statements of an entity in accordance with the reporting
requirements of every country it has a presence in, is becoming increasingly difficult.

What is IFRS?
The International Financial Reporting Standards (IFRS) are accounting standards that are issued by
the International Accounting Standards Board (IASB) with the objective of providing a common
accounting language to increase transparency in the presentation of financial information.

What is IASB?
The International Accounting Standards Board (IASB) is an independent body formed in 2001 with
the sole responsibility of establishing the International Financial Reporting Standards (IFRS). It
succeeded the International Accounting Standards Committee (IASC), which was earlier given the
responsibility of establishing the international accounting standards. IASB is based in London. It has
also provided the ‘Conceptual Framework for Financial Reporting’ issued in September 2010 which
provides a conceptual understanding and the basis of the accounting practices under IFRS.
Components of Financial Statements under IFRS
A complete set of financial statements prepared in compliance with the IFRS would ideally comprise
of the following:
• A statement of financial position as at the end of the period – more commonly known to us as
the ‘Balance sheet’.
• A statement of profit and loss for the year and the statement of other comprehensive income
• –Other comprehensive income would include those items of income/expense that are not
recognized in the profit and loss account to comply with the other relevant standards.
• Both these statements may either be combined or shown separately.
• A statement of changes in equity – This would include a reconciliation between amounts shown
at the beginning and the end of the year.
• A statement of cash flows for the period
• Notes to the financial statements – including a summary of significant accounting policies
followed and other explanatory information

The financial statements would sometimes also include a statement of the financial position of an
earlier period in the following scenarios:
• When an entity applies an accounting policy retrospectively.
• When an entity retrospectively restated an item in its financial statements; or
• When an entity reclassifies an item in its financial statements.

List of International Financial Reporting Standards(IFRS)

As already discussed, the Standards issued by the IASB are called IFRS. The predecessor body, IASC,
had however already issued certain International Standards which are called International
Accounting Standards (IAS). These IAS were issued by the IASC between 1973 and 2001. Both IAS
and the IFRS continue to be in force. The standards are listed below:
Standard No.

Standard Title
IFRS 1

First-time Adoption of International Financial Reporting Standards

IFRS 2

Share-based Payment
IFRS 3

Business Combinations
IFRS 4

insurance Contracts
IFRS 5

Non-current Assets Held for Sale and Discontinue Operations

IFRS 6

Exploration and Evaluation of Mineral Resources

IFRS 7

Financial Instruments: Disclosures

IFRS 8

Operating Segments
IFRS 9

Financial Instruments
IFRS 10

Consolidated Financial Statements

IFRS 11

Joint Arrangement
IFRS 12

Disclosure of Interests in Other Entities

IFRS 13

Fair Value Measurement

IFRS 14

Regulatory Deferral Accounts

IFRS 15

Revenue from Contracts with Customers

IFRS 16

Leases
IFRS 17
Insurance Contracts
IAS 1

Presentation of Financial Statements

IAS
Inventories
IAS 7

Statement of Cash Flows

IAS 8

Accounting Policies, Changes in Accounting Estimates and Errors

IAS 10

Events after the Reporting Period

IAS 11
Construction Contracts
IAS 12

Income Taxes
IAS 16

Property, Plant, and Equipment

IAS 17

Leases
IAS 18

Revenue
IAS 19

Employee Benefits
IAS 20

Accounting for Government Grants and Disclosure of Government

Assistance
IAS 21

The Effects of Changes in Foreign Exchange Rates

IAS 23

Borrowing Costs
IAS 24

Related Party Disclosures

IAS 26

Accounting and Reporting by Retirement Benefit Plans

IAS 27

Separate Financial Statements

IAS 28

Investments in Associates and Joint Ventures

IAS 29

Financial Reporting in Hyperinflationary Economies

IAS 32

Financial Instruments: Presentation

IAS 33

Earnings per Share

IAS 34
Interim Financial Reporting
IAS 36

Impairment of Assets
IAS 37

Provisions, Contingent Liabilities, and Contingent Assets

IAS 38

Intangible Assets
IAS 39

Financial Instruments: Recognition and Measurement IAS 40

Investment Property IAS 4

Agriculture
What is Auditing, Its Types, Purposes, andSome Current Issues
What is Auditing?
Auditing is the process of assessment and ascertaining of financial, operational, and strategic goals
and processes in organizations to determine whether they are in compliance with the stated principles
in addition to them being in conformity with organizational and more importantly, regulatory
requirements. Indeed, among the objectives of auditing as mentioned above, conformance with
regulatory norms and rules and regulations is indeed one of the drivers behind auditing and
historically and traditionally, has been the main reason why organizations get their financial
statements, operational process, and strategic imperatives audited.

Types of Audits
Among the various types of audits, financial audits are the most popular followed by operational and
strategic audits and in addition to the emerging practice of IT (Information Technology) audits.
Moreover, auditing as a process has now become so routine and compulsory worldwide that
organizations spend quite some time getting their books of accounts and processes audited by both
internal and external auditors.

1. Internal Audits
Internal audits refer to the audits done by employees and stakeholders within the organizations with a
view to evaluate and assess whether the organization is following the internal processes, norms, rules,
and regulations in addition to determining whether it is in compliance with the regulatory norms.
Indeed, internal audits are sometimes the first checkpoints for organizations to determine whether
their books of accounts, operational processes, and IT infrastructure and security protocols are in order
with both the internal objectives, strategic imperatives, and external regulatory requirements.
Having said that, it must be noted that the reason why internal audits are not accorded more
importance over external audits is that since they are being performed by employees and individuals
within the organizations, the apparent lack of objectivity and thoroughness apart from a tendency to
“cover things up” means that often, external audits are considered more trustworthy.

2. External Audits
External audits are done by independent and third-party agencies and companies that are especially
tasked with assessing and evaluating an organizations’ compliance with the regulatory norms.
Further, some organizations also hire external auditors to “hold a mirror to themselves” in the sense
that any deficiencies and irregularities can be found that are otherwise not “visible” to the senior
leadership and management during the course of conducting the everyday operational business.
Moreover, external audits are also mandatory due to regulatory and compliance reasons as well as
due to the shareholder requirements which mandate that external audits need to be done annually,
quarterly, and half yearly to be presented in the Annual General Meetings, and meetings of the Board
of Directors.
In addition, external audits might also be required in case of contingencies wherein the regulators who
suspect that “something is amiss” in the companies might mandate those companies to be audited
by independent and third-party auditors to ascertain the “true picture” of the finances and operational
details of those companies.

3. Financial Audits
As mentioned earlier, financial audits are the most common form of audits for various reasons including
the fact that businesses exist to make money and return profits and generate wealth for their
shareholders. This means that investors and other stakeholders must know whether the businesses
are being run properly so that their capital is safe and generating the stated returns.
Moreover, financial audits are also the most common forms of audits since any discrepancies in the
books of accounts reflects the mismanagement of the companies in addition to finance affecting
almost all operational and strategic areas of the companies’ and their businesses.
In addition, financial audits are also the first point of evaluation as to whether the companies are stating
the truth and whether they are hiding or covering up some aspect that can be uncovered and revealed
in a forensic audit. Strategic, Operational, and IT Audits Having said that, there are other types of
audits such as operational, strategic, and IT audits that have become popular in recent years mainly
due to the increasing complexity of organizational processes as well as the IT infrastructure and the
fast-paced external marketplace which needs an evaluation of whether the organizations are aligning
their internal processes and strategies with that of the external strategic drivers and imperatives.

In addition, IT audits are being sought to assess and evaluate the readiness of the organizations’ IT
infrastructure and systems and IT processes to meet the stated goals and objectives in addition to
being able to withstand IT risks and security breaches. Indeed, with the increase in the nature, type,
and variety of IT risks as well as the increasing complexity of the IT infrastructure, IT audits have
now become as commonplace as financial and operational audits because both internal and external
stakeholders need to know whether the organization’s IT infrastructure is up to the mark and
whether it can meet the stated goals and objectives.

Some Issues with Auditing and Auditors

In recent years, there have been concerns about audits being used to cover up and hide internal
deficiencies and weaknesses thereby defeating the very purpose for which such audits are needed.
Indeed, even external auditors have been found to be colluding with the organizations in this regard
and hence, regulators worldwide have turned their gaze and tightened the controls and the
requirements for such audits. This has been revealed in the way the United States passed several
landmark laws such as Sarbanes Oxley in the wake of the Enron scandal wherein the auditors, Arthur
Anderson, was found to be “in cahoots” with the management of Enron in cooking the books and
covering up the malpractices.
What is an independent audit?
The terms “audit" or "audited financial statements” in this Nonprofit Audit Guide© refer tothe work
product resulting from the independent examination of a nonprofit’s financial records by a licensed
certified public accountant (also referred to in this Guide as the “auditor,” or the "auditing firm").
An independent audit is an examination of the financial records, accounts, business transactions,
accounting practices, and internal controls of a charitable nonprofit by an "independent" auditor.
"Independent" refers to the fact that the auditor/CPA is not an employee of the nonprofits but instead
is retained through a contract for services, and hence is "independent." See YH Advisors' newsletter
on Financial Audit Basics for a helpful overview of financial audits.
During the independent audit, the auditor will review the organization’s financial statements to
determine whether they adhere to “generally accepted accounting principles” (commonly referred to
as “GAAP”). These accounting principles are created by the "Financial Accounting Standards Board,"
known as "FASB." While not law, thesestandards carry weight - when they are not followed, the
auditors are required to note that in their report.

What an audit is - and what it is not - and why would a nonprofit want one?
Some independent financial audits are required by state or federal regulations. However,even when
not required a nonprofit may choose to have an independent audit for a few important reasons:
1. Independent audits are important for inspiring and maintaining donor trust because they
demonstrate that the nonprofit is committed to financial transparency and accountability.
2. Audited financial statements help the board of director have more confidence in the
organization's finances because they are based on an analysis by an objective third-party.
3. Some private foundations require that potential grantees submit audited financial statements, or
similarly certified financial statements, in order to be eligible for funding.
4. "It is a common misconception that audits serve primarily to uncover fraudulent activities, like
embezzlement. Audits rarely detect fraud, but auditors can provide nonprofits with information,
tools, and strategies to better protect against such occurrences." Source: How independent
audits and audit committees protect nonprofits (Nonprofit Law Blog)

The Auditors' Report

FASB principles require the auditors to issue a report to the board of directors of the nonprofit
expressing a professional opinion about the organization’s financial practices;specifically, whether
the financial statements: “fairly present the financial position of the organization” without any
inaccuracies or material misrepresentations.

There are four types of reports that an auditor could issue: "Unqualified Opinion" (this is the type of
audit you hope for); "Qualified Opinion" which signals that the auditors found one or two situations
where the nonprofit is not following GAAP, or that the organizationis following GAAP in most cases
although perhaps not all, but overall there is not a material misstatement of any financial position(s);
"Adverse Opinion" (which signals that the auditors found a material misstatement or that overall the
organization is not conforming to GAAP); or a "Disclaimer of Opinion" report. Either one of the first
two reports is preferable to either the adverse opinion or a disclaimer report. The Disclaimerreport
essentially signals: "Something prevented us from forming an opinion, therefore we refuse to do so."
1. Receiving an Adverse Opinion or Disclaimer of Opinion can have a serious negativeimpact on
efforts to obtain funding for your organization.
2. Sample audited financial statements that express an unqualified opinion.
3. Share a primer with your board and staff: Understanding audited financial statements.
4. Cost
The cost of an independent audit varies depending on the geographic region where the nonprofit is
located and how large the organization is. Audit fees can exceed $20,000 forlarge nonprofits located
in major urban areas. It is not unusual for an independent audit to cost $10,000, even for a small
nonprofit. Because independent audits require a significant investment of resources, including staff
time and board member volunteer time, there is a growing trend among smaller nonprofits to have
a "remote audit" whichmeans that the auditors conduct the audit without a site visit.
As an alternative to an independent audit, auditors can provide either financial
statement “review,” or a “compilation.” Neither a review nor a compilation are substitutes for an
audit. If a third party has strict requirements that the nonprofit conduct an “audit,” a review or
compilation will not satisfy that requirement. Nevertheless, nonprofits trying to manage costs
should not be shy about asking whether the third party will accept a review in place of a full audit.
The third-party (usually a funder) may understand the goal of cost savings and accept a review
instead. Some nonprofits do not conduct an audit annually, but instead conduct one regularly every
few years (or whenever there is a significant change in the organization’s operations). In the years
DIWAKAR EDUCATION HUB
when the nonprofit does not have an independent audit the nonprofit could elect to have its financial
statements reviewed instead.

What is Vouching?
What is Vouching?
Definition: Vouching, widely recognized as “the backbone of auditing,” is a componentof an audit
seeking to authenticate the transactions recorded in a firm’s book of accounts. When an accounting
transaction is vouched, it is tested and verified by presenting relevant documentary evidence.

What Does Vouching Mean?

What is the definition of vouching? Seeking to establish the accuracy of recorded transactions,
vouching ensures that all the entries in the books of accounts come with the relevant evidence,
including invoices, receipts, and others. Vouching does not take into account the non-business
transactions, thus helping auditors to ensure that all transactions in a firm’s book of accounts are
business-related. Auditors confirm that the amounts mentioned in each transaction are truthful,
disclosing the nature of a transaction, and its authorization.
Let’s look at an example.

Example
A manufacturing company submits its financial statements and book of accounts to a leading
auditing firm for vouching. The auditor who undertakes the project seeks to verify that the company’s
transactions are valid, business-related and properly authorized.
In the company’s cash book, the auditor identifies entries of cash sales, receipts fromcreditors,
interest income, dividend income, mortgage payments, fixed asset sales
and accounts receivable. By using this technique, the auditor reviews all the entries andseeks for the
relevant documentary evidence that supports and verifies each transaction.
The auditor finds documentation of receipts, capital expenses, and others that pertain tothe recorded
transactions in the book of accounts. With the proof of being vouched, the auditor ensures that the
claims provided in the book of accounts are justified, and the company does not engage in any type
of fraud.

If the auditor didn’t vouch, he might have incurred control risk by neglecting some important
information and failing to display appropriate due diligence in reviewing the company’s books. Often,
auditors are guilty of fraud by presenting a company’s financialstatements as valid. With the use of
technique, the auditing process is accurate and transparent.
Verification ad valuation of assets
Valuation of Assets and Liabilities of a Business:
The processes of routine checking, and vouching would only substantiate transact tions as they
occur from day to day and confirm the acquisition of assets or assumption of liabilities at the first
instance, but the value thereof may change bythe end of a financial period when the balance sheet
is prepared.
Evidently, in the last analysis, variation in the inter-relation assets and liabilitiesis the most important
factor determining profit or loss through its influence on the difference between capitals at the
commencement and at the close of a particular financial period.

Such variation may be the result of genuine factors operating in course of normalbusiness activities
or it may be intentionally engineered by manipulation or fal- sification of accounts. Besides, any
inappropriate valuation of assets and liabilities, whether inadvertently or fraudulently done, would
vitiate the financialstate of affairs of a business by exhibiting a wrong picture in the balance sheet.

Basis of Valuation of Assets:

In view of the importance of valuation an auditor should always be careful to seewhether assets are
valued on some reasonable and appropriate basis.
The standard methods of valuation that are usually followed inrespect of different classes of assets
are enumerated below:

Nature and purpose of acquisition:

1. Fixed:
Stable in nature. Acquired for permanent or long-term retention and use in thebusiness for
earning income.
2. Intangible:
Semi-Stable in nature. Acquired as a non-monetary identifiable asset, for use in business to
augment earnings or as a class of fixed assets with no physical or tangible existence but
valuable all the same e.g., goodwill intellectual property, orlicense rights.
3. Fictitious:
Semi-stable or temporary assets without any tangible form, usually expenditure or losses of
unusual nature not realizable in cash e.g., preliminary expenses, losson issue of securities or
special advertisement cost. Floating:
4. Subject to constant movement or changes. Acquired for temporary retention andconversion
into cash as early as possible.

Basis of valuation:
1. Fixed:
Going concern value i.e., historical cost or original cost of acquisition (includingadjustments
for additions including all expenses of bringing an asset into a reasonable condition or
disposals) minus proper depreciation on a consistent basis irrespective of the market value.
2. Intangible:
Usually on the same basis as fixed assets i.e., written down value according to thepolicy on
amortization or fair value of benefits enjoyable on future. As per new norms from ICA,
intangible assets will have to be written-off in a maximum of 10years.
3. Fictitious:
Cost/expenditure incurred or balance thereof less amount written-off from year to year
 251
depending on financial policy.
4. Floating:
Realizable value, i.e., market value (net realizable value) or cost price whichever islower.

Revaluation of Assets:
There may be periodical revaluation of assets (i.e., revision of book values) by a systematic
assessment so as to show a more realistic value of assets based on the physical condition and
estimated future working life of assets, trend of market prices, etc. It may be noted that reserve
created on revaluation, if any, would notbe available for distribution.
Revaluation may be done on basis of:
(a) A number of factors like technical up gradation, replacement cost,productivity and efficiency of
the assets; or
(b) Historical cost, which does not reflect a true and fair view of the affairs,suitably revised to indicate
realistic value.
(c) Revaluation is made on the basis of- (a) replacement cost (net realisable value having regard to
market trends) as reduced by accumulated depreciation; or (b) indexation method based on
industrial indices;or (c) appraisal method i.e.
valuation by expert valuers or appraisers like architects, engineers, certifiedvaluers.
Accounting Standard AS 10 issued by the Institute of Chartered Accountants of India provides that
the revalued amount of a fixed asset should be shown in the financial statement by restating both
the gross book value and the accumulated depreciation to give the net revised book value, or by
restating the net book valueby adding the net increase thereof.
The selective revaluation processes as above are not available under instructions for making out
assets contained in Schedule VI to the Companies Act, 1956, which require that in case of any writing
up of the asset(s) it must be shown at itsincreased figure in the Balance Sheet subsequent to such
writing up.

Auditor’s Duty towards Valuation of Assets:

An auditor should inquire into the basis of valuation of all assets and liabilities used or adopted by
client with the greatest care before finally passing any item.
He should be thoroughly satisfied that they have been properly valued or revalued on scientific
principles so as to represent their true and fair worth to the business at the date of the balance sheet.
It is, however, no part of an auditor’s normal dutyto value assets or liabilities himself.

That work is usually done either by a responsible officer of the business or by some independent
and expert valuer and, in such circumstances, an auditor’s re- sponsibility is confined to the
acceptance of certificates of value from the management or the valuer, as the case may be, subject,
of course, to suitable personal inquiries made by himself to establish that the values appear to be
reasonable having regard to the nature of the business and of the assets or liabilities concerned.
In any case, an auditor is not responsible for valuation of assets and liabilities provided he exercises
reasonable skill and care in scrutinising the basis of valuation (London & General Bank case;
Kingston Cotton Mills case; WestminsterRoad Construction Co. case.

Verification of Assets and Liabilities of a Business:

Verification of assets means substantiation of the actual existence of assets under the legal
ownership and/or possession of the clients on the date of balance sheet. This is as important as
DIWAKAR
valuation of assets, ifnot more; because the balance sheetEDUCATION HUB
should include only such items as are genuinely owned by the clients and an auditor should never
 252
pass an asset unless he is fully satisfied about the bona fide ownership of the same by his clients.

Verification of Liabilities:
Generally liabilities are valued at face value. Verification of liabilities is as important as that of assets
because any under-statement or omission thereof would vitally affect the result of business and
also the financial state of [Link], liabilities are small in number and more or less fixed in
nature and, assuch, they offer less difficulties to an auditor than assets.
An auditor should see that all liabilities or obligations genuinely outstanding on the closing date even
those omitted accidentally or deliberately are duly accounted for, that all credit balances shown by
books are real liabilities and thatthere is no manipulation in regard thereto.
An auditor must be satisfied that liabilities recorded in books are real, omission, if any, of liabilities
are accounted for and duly disclosed. In fact, an auditor would be liable for negligence if he fails to
detect omission of liabilities [Westminster Road Construction Co. case. Auditor’s report should be
qualified for any omissionof liability.

Important points regarding verification of liabilities are enumerated below. It may, however, be noted
that a major portion of such verification would have already been done at the time of routine
checking and vouching of the books of account. As an additional safeguard the auditor may obtain
a certificate from some responsible officer stating that all liabilities have been fully taken into
account
253
Contingent Liabilities:
A contingent liability is an incidence which is conditional or contingent on the happening’ of certain
events. There is an element of uncertainty about this groupof liabilities, which may or may not occur.
Such a liability, if it eventually arises, involves payment of money in future.
The following are the main types of contingent liabilities:
(i) Liability in respect of bills discounted or accepted on behalf of other parties, but not matured.
(ii) Liability under guarantee or surety arrangements in favour of others.
(iii) Liability under incomplete contracts for which compensation may or may not have to bepaid
under forward contracts.
(i) Liability under pending lawsuits, claims or taxation appeals.
(ii) Liability in respect of unpaid calls on partly paid shares held.
(iii) Liability for accumulated arrear dividends on cumulative preference shares.
(iv) Liability for claims not acknowledged as debts.
(v) Liability of members of a company limited by guarantee.
(vi) Possible personal liabilities of partners in a firm.
 (vii) Liability under guarantee(s) for loans taken by others.
(viii) Other uncertain financial liability.

If any liability under the aforesaid heads does not actually accrue on the date ofthe balance sheet it
should be mentioned by way of a separate note on the liabilities side of the balance sheet,
compulsorily in case of a company and preferably in other cases also—but the figures should not be
extended to the money column.

The maturity of any contingent liability may arise from either acquisition of assetor incurring of loss.
If, however, any of these liabilities is expected to cause an actual loss, adequate reserve should be
provided for the same.

These items would usually be discovered in course of routine checking and vouching. It is also useful
to check contracts, notices, lawyers’ bills, minute books, bank letters, correspondence etc. and to
hold discussions with clients.

As additional measure an auditor may secure from the client’s solicitors, legal advisers or tax
consultants particulars of pending suits, claims, appeals etc. and obtain a schedule of contingent
liabilities certified by a responsible officer to the effect that all probable liabilities- under this head
have been taken into account, as it may not be possible for the auditor to gain in the normal course
of audit knowledge of all items of contingent liabilities. An auditor should see that proper notes re:
contingent liabilities are incorporated in the balance sheet.

The above exercise by an auditor would ensure disclosure of ‘true and fair view’ ofthe profit or loss
and of the state of affairs of an enterprise by the Profit and Loss Account and the Balance Sheet.

Auditor’s duties re: Contingent Liabilities:

1. Collect a schedule of contingent liabilities certified by a responsible officer.
2. Check the items in the list with notes taken in course of routine checking andvouching.
3. Gather copies of bills discounted, if any, from banks or other parties.
4. Check bills receivable book with entries in bank passbook.
5. Check payments against partly paid shares.
6. Mention in report insufficient provision, if any, for any contingent liability
7. Check computation of and reasons for unpaid dividend on cumulative pref-erence shares.
8. Ascertain all facts, justification and amount of contingent liabilities forpending lawsuits.
9. Check correspondence, certificates from solicitors’ lenders regardingcontingent liability under
guarantee(s) for loan(s).
10. In case of a company verify compliance with provisions of Schedule VI to the Companies Act,
1956.
11. Verify disclosure of contingent liabilities in the balance sheet.

Auditor’s Duties towards Events taking Place after the Balance SheetDate:
1. Analyse all relevant events to find out those relating to the balance sheet date in question.
2. Eliminate events not related to balance sheet date.
3. Correct the balance sheet by incorporating changes in value of assets and liabilities caused by
events occurred after the balance sheet date according to theconcept of “materiality”.
4. Suitably revise the profit and loss account by altering provisions and reserves due to
eventsoccurred after the balance sheet dates.
5. Prepare and authenticate a special statement of reconciliation covering the above points.
6. Valuation and Verification of Particular Assets:

Subject to the general principles of valuation and verification discussed above an auditor should
always take into full consideration special points in regard to the valuation and verification of
individual items of assets on the basis of their precisenature and utility.
Cash, book debts and stock-in- trade constitute three important assets requiring very careful
attention and, as such, their valuation and verification aspects are fully discussed below followed by
the enu- meration of main points in relation to other assets in a tabular form:

(i) Cash Balance:

There can be no separate basis of valuation in respect of cash balance except that the actual
balance in hand must be the same as indicated by the cash book; in other words, an auditor is
required to verify the existence of cash balance in handon the closing date.
For this purpose, the matter is to be handled separately in respect ofvarious types of cash balance
as under:

(a)Cash at bank:
As the balance remains with the bank no physical verification is possible; only a documentary
verification has to be conducted. For this purpose, the bank balance,as shown by the ‘bank column’
of the cash book, should be compared with the corresponding figure of the bank pass book.
The bank reconciliation statement should also be checked. If a discrepancy still persists, casting
and balancing of the passbook itself may be checked. It is desirable to obtain a certificate or
confirmation from the bank about the balanceheld by it. In case of fixed deposits, deposit receipts
from the bank should be seen; if such receipts are pledged, certificates from pledgees should be
obtained.

(b) Cash in hand including petty cash:

Physical verification is the only effective method of verification, i.e., if possible, cash in hand should
be actually counted by an auditor on the closing date. As, however, it is not practicable to attend
offices ofall clients on the closing date, forthis purpose, verification is usually done after that date.
In such cases, an auditor should attend as early as possible after the closing, carefully vouch cash
transactions from the date of closing up to the date of the visit and count the actual cash in hand on
the latter date. Sometimes a system of depositing the closing cash balance with the bank on the
closing date and withdrawing the same on the next day may be followed when the bank pass book
will provide the only reliable source of verification.

In case of organisations like banks etc. holding large cash balances at any time, complete physical
checking is not practicable and test checking has to be adopted,provided a good system of internal
control is in operation. Bundles of notes may be counted, checking some of them in detail. Bullion
or coins may be verified by taking the average weight of bags containing the coins, actually counting
some of the bags picked up at random.
An auditor should insist on the production of all cash balances at a time to prevent substitution with
a view to covering up defalcations. According to the decision of the London Oil Storage Co. case an
auditor will be liable for negligenceif he fails to verify cash balance.

(c) Cash held by officers:

An auditor should not ordinarily accept a certificate from an official about large cash balance held
by him. When such a practice is unavoidable the auditor shouldsee that it is properly authorized and
is absolutely necessary for the genuine purpose of business and that the balance is within the limit
fixed, if any, and is not allowed to remain with the officer concerned indefinitely.

(d) Cash with branches and agents or in transit:

It is not possible for an auditor to personally count cash balances at different branches or lying with
various agents or in transit; he has, therefore, to be satisfied with proper documentary evidence.
Where a system of depositing branch or agents’ balances on the last working day of a financial year
with banks is followed, an auditor should see the bank passbook and also obtain certificates from
the banks concerned about the balances held by them. In case of cash in transit, the respective
advices from branches or agents should be scrutinized.

(ii) Book Debts:

An auditor’s primary duty is to see that book value of sundry debtors has been correctly ascertained.
The basis of valuation should be net realisable value afterdeducting bad and doubtful debts.
The schedule of debtors’ accounts extracted from the debtors’ ledger and certified by the
management should be compared with the balance of the total debtors’, account in the general
ledger when the self-balancing system is in operation.
Checking of the items appearing in the said schedule of debtors with individual statements of
accounts and/or confirmation of balances received from customers is also a useful method of
verification.

A very important matter about verification of book debts is the checking of ad-equacy or otherwise
of the provision for bad and doubtful debts.
In this connection an auditor should obtain a certified schedule of badand doubtful debts from the
management, and he should thoroughly check the same paying special attention to the following
points:
1. Checking year-end balances and subsequent realizations.
2. Age of the debtor’s balances. See if there is any debt which is already time-barred or is nearing
the end of the period of limitation.
3. Whether regular payments are being made as per terms of credit allowed. Particularly look out
for overdue payments.
4. If cheques or bills of any customer have been dishonored.
5. If there is any history of bankruptcy or attachment of the funds and propertiesof any debtor.
6. If any suit had to be instituted against any debtor for recovery of dues.
7. Whether the balances of-individual debtors are stable, increasing ordiminishing.
8. Checking provisions for allowances, discounts, bad and doubtful debts, if any. Checking Debtors’
Ledger Trial Balance with Control A/cs.
9. Particularly enquire about suppression of sales leading to suppression ofdebtors.

On a careful consideration of the aforesaid information an auditor should make his own estimate of
probable bad or doubtful debts and compare the same with the provision made by the management.
If he is not satisfied with the provision he should, in the first instance, discuss the matter fully with
the management trying to persuade them to correct the position, failing which he should mention
the fact in his report.
Arthur E. Green & Co. case clearly established that an auditor will be liable for negligence if he
accepts a schedule of bad debts without being able to detect time-barred debts included therein.
(iii) Stock-in-Trade or Inventory:
This is one of the most important items in respect of which frauds are perpetratedand, as such, it
should receive the most careful attention of an auditor. It comprises stores and spares, loose tools,
raw materials and components, work-in-process and finished goods.

(a) Valuation of stock:

The fundamental basis of valuation in respect of stock is ‘cost or market value, whichever is lower’.
Cost includes cost of purchase/acquisition or conversion, other costs in bringing the items to
present location or condition.
The exact implication of the terms cost and market price which shouldbe clearly understood, are
outlined below:

(i) Chief Types of Cost:

1. First-in-first-out method:
It is assumed that the materials or stocks are used or dispatched in the chronological order of their
receipt so that the closing balance in hand would consist of the items acquired towards the end of
the year. The prices of such latterpurchases are, therefore, taken as the basis of ascertaining cost
of the closing stock.

2. Last-in-first-out method:
Just a reverse order is followed assuming that items received last are used or disposed of first so
that the balance in hand would represent earlier purchases; itscost is, therefore, assessed on the
basis of earlier purchase prices.

3. Average cost method:

Average is taken of the different rates at which particular items have been boughtat different times
during a year and that is taken as the basis of cost in respect of the stock in hand at the close of the
year. In view of the practical difficulties in calculating cost strictly according to the first two methods
the average cost method is the most popular and common due to its simplicity.

4. Standard cost method:

Stock is valued at a fixed cost per unit which may be regarded as a cost-budget foreach item.

(ii) Chief types of market value:

Description:
1. Realizable value
2. Replacement value

Nature:
Value that the stock is expected to realise if sold at the market price ruling on theclosing date minus
selling cost. Amount that would be necessary to replace an existing stock or to acquire similar stock
at the prevailing market price N.B. Although both realisable and replacement values are based on
market pricesthere is a fine technical distinction between the two. The chief idea behind the former
is the sale or disposal of stock, whereas that behind the latter is the purchase or acquisition of similar
stock in replacement of an existing one.

Usually, the prices at which a particular item can be bought or sold at any particular time differ and
this variation must be taken into account in assessingmarket values under the ‘realizable’ and the
‘replacement’ methods.
The precise applications of the aforesaid criteria for ascertaining costor market value of different
groups of stock items are indicated in theundernoted table
Verification of stock:
Physical existence of stock items represented by the stock figure in the balance sheet is usually
verified by actual annual or half-yearly stocktaking arranged by the management and necessary
reconciliation is made with book figures as per bin cards or store ledger accounts.
An inventory or schedule of all items is prepared at the time of stock-taking and each item is valued
on one of the accepted principles as discussed above and sucha schedule is usually certified by an
engineer or other expert, a director, manager or high official for authentication.
Sometimes a system of continuous stock-taking is adopted instead of periodical stock-taking to
cover substantial part, if not whole, of the inventory. This inventory forms the basic document for
inclusion of stock-in-trade in the balancesheet. Separate inventories for stocks on consignment, on
hire-purchase and on sale or return should also be similarly prepared.

(b) Auditor’s position re: stock-in- trade:

‘It is an accepted principle that an auditor is not a valuer of stock as he is not supposed to possess
expert knowledge regarding the nature and utility of various stock items nor is he in a position to
count or verify the physical existence of each and every item of the inventory, particularly in the case
of a big manufacturing ortrading concern holding a large variety of items in stock.

In practice, an auditor is obliged to depend on the system of internal control and to accept the
certified inventory as the basic documents for checking the valuationof and also verifying the stock.
The Kingston Cotton Mills Co.’s case established that an auditor is entitled to accept and rely on
stock-sheets certified by a responsible officer in the absence of suspicious circumstances and that
he is not to take stock himself. Evidently, acceptance of a certified inventory is conditional upon the
‘absence of suspicious circumstances’; an auditor should not blindly accept a certificate of stock
provided by the management.
To be sure that there is no ground for suspicion he should carry out proper independent checking of
the stock- sheets as far as circumstances permit; other-wise he may be held liable for negligence in
duty.

The Westminster Road Construction Co. Ltd. case established that an auditor would be negligent in
duty if he accepted from management a certificate re: work- in- progress without proper enquiries;
according to the decision in McKesson &Robins case of U.S.A. an auditor is expected to be present
at and see for himselfthe actual physical stocktaking.
(a) In actual practice an auditor should apply reasonable care and skill and normally take the
following steps in respect of stock-in-trade inorder to be able to prove, if necessary, that he
exercised reasonablecare and skill:
(b) Carefully examine the system of internal control in force and note any possibleloopholes therein.
Go through programmed of stock-taking adopted by management and instructions issued to
staff for this purpose.
(c) Obtain stock-sheets containing description, quantity, rate and value of stock including special
types of stock, if any, duly initialed by all persons connected with stock-taking and certified by
properly authorized person.
(d) Carefully check goods inward and outward books and also purchase and sales records for the
last week or so of the accounting year under audit with a view to finding out any purchase and
receipt of material that may not have been includedin the stock list, or any sale that may have
been included although correspondinggoods have not been actually delivered to the consumer.
(e) See by means of test checks that a proper basis of valuation is adopted, and that the same
principle is consistently followed from year to year unless there arevalid grounds for changing
 261
the basis.
(a) See that non-moving, slow-moving or obsolete stocks, if any, are duly written-off or adjusted and
that other assets like loose tools not meant for trading purposes are excluded from the stock-
sheets.
(b) Compare percentage of gross profit on turnover with previous year’s figure andenquire about any
abnormal fluctuation.
(c) Compare some of the items of the stock- sheets, particularly the bigger or material ones, with
previous year’s list and also with balances indicated by bin cards or stock ledger accounts and
ascertain the reasons for discrepancies, if any.
(d) Check casting of stock-sheets and a portion of the calculations.
(e) Verify some selected stock-items physically, if possible, or be present at leastfor some time uring
stock-taking. Compare inventories with stock records.
(f) Refer to the year-ending stock statement submitted to bankers under overdraft/ cash credit
arrangement, if any.

(iv) Loans and Advances:

(v) Security and Other Deposits:

(vi) Bills Receivable:

Unexpired Expenses and Accrued Incomes:

(vii) Fixed Assets:

The criteria and methods of valuation and verification in respect of important fixed assets are
tabulated hereunder:
Financial statement audit
A financial statement audit is the examination of an entity's financial statements and
accompanying disclosures by an independent auditor. The result of this examination is a report
by the auditor, attesting to the fairness of presentation of the financial statements and related
disclosures. The auditor's report must accompany the financial statements when they are
issued to the intended recipients.

The purpose of a financial statement audit is to add credibility to the reported financial
position and performance of a business. The Securities and Exchange Commission requires
that all entities that are publicly held must file annual reports with it that are audited.
Similarly, lenders typically require an audit of the financial statements of any entity to which
they lend funds. Suppliers may also require audited financial statements before they will be
willing to extend trade credit (though usually only when the amount of requested credit is
DIWAKAR EDUCATION HUB
substantial).
Audits have become increasingly common as the complexity of the two primary accounting
frameworks, Generally Accepted Accounting Principles and International Financial Reporting
Standards, have increased, and because there have been an ongoing series of disclosures of
fraudulent reporting by major companies.

The primary stages of an audit are:

1. Planning and risk assessment. Involves gaining an understanding of the business and the
business environment in which it operates, and using this information to assess whether
there may be risks that could impact the financial statements.
2. Internal controls testing. Involves the assessment of the effectiveness of an entity's suite of
controls, concentrating on such areas as proper authorization, the safeguarding of assets,
and the segregation of duties. This can involve an array of tests conducted on a sampling
of transactions to determine the degree of control effectiveness. A high level of
effectiveness allows the auditors to scale back some of their later audit procedures. If
the controls are ineffective (i.e., there is a high risk of material misstatement), then the
auditors must use other procedures to examine the financial statements. There are a variety
of risk assessment t questionnaires available that can assist with internal controls testing.

3. Substantive procedures. Involves a broad array of procedures, of which a small sampling

is:

1. Analysis. Conduct a ratio comparison with historical, forecasted, and industry results to
spot anomalies.
2. Cash. Review bank reconciliations, count on-hand cash, confirm restrictions on bank
balances, issue bank confirmations.
3. Marketable securities. Confirm securities, review subsequent transactions, verify market
value.
4. Accounts receivable. Confirm account balances, investigate subsequent collections, test year
-end sales and cutoff procedures.
5. Inventory. Observe the physical inventory count, obtain confirmation of inventories held
at other locations, test shipping and receiving cutoff procedures, examine paid supplier
invoices, test the computation of allocated overhead, review current production costs, trace
compiled inventory costs to the general ledger.
6. Fixed assets. Observe assets, review purchase and disposal authorizations, review lease
documents, examine
7. appraisal reports, recalculate depreciation and amortization.
8. Accounts payable. Confirm accounts, test year-end cutoff.
9. Accrued expenses. Examine subsequent payments, compare balances to prior years,
recompute accruals.
10. Debt. Confirm with lenders, review lease agreements, review references in board of direct
tors minutes.
11. Revenue. Examine documents supporting a selection of sales, review subsequent
transactions, recalculate percentage of completion computations, review the history of
sales returns and allowances.
12. Expenses. Examine documents supporting a selection of expenses, review subsequent
transactions, confirm unusual items with suppliers.
13. An audit is the most expensive of all the types of examination of financial statements. The
least expensive is a compilation, followed by a review. Due to its cost, many companies
attempt to downgrade to a review or compilation, though this is only an option if it is
acceptable to the report recipients. Publicly held entities must have their quarterly financial
statements reviewed, in addition to the annual audit.
14. Audits are more expensive for publicly-held firms, for auditors must adhere to the stricter
audit standards of the Public Company Accounting Oversight Board (PCAOB), and so will
pass their increased costs through to their clients.

Cost Audit: Meaning, Advantages andTypes

Meaning and Definitions:
Cost Audit is a critical review undertaken to verify the correctness of Cost Accounts and to check
that cost accounting principles and planning have been efficiently followed. It is noteworthy that
India is the only country which has introduced statutory cost audit to regulate about 45 vital
industries of the country. Cost Audit has been defined by the Chartered Institute of Management
Accountants (CIMA) of Landon as “the verification of cost accounts and a check on the adherence
to the cost accounting plan.”

This definition implies the following:

ADVERTISEMENTS:
1. The objects of cost accounting with reference to which the cost accounting planmust have been
drawn up have to be kept in mind to see whether or not the plan itself and the figures collected
will lead to the achievement of the goal or objectiveset. For instance, if the objective is to achieve
maximum efficiency, the plan and the analysis of data will be different from the case where the
only objective is to fix prices.
2. It has to be examined whether the methods laid down for ascertaining costs and other relevant
decisions are being implemented. Treatment and
3. determination of abnormal losses of gains or treatment of certain expenses asdirect or indirect
are cases in point.
4. The correctness of the figures has to be vouched.
5. ‘Statutory Cost Audit is a system of audit introduced by the Government of India for the review
examination and appraisal of the cost accounting record and addedinformation required to be
maintained by specified industries’ (ICWA of India).

ADVERTISEMENTS:
The concept of cost audit has been elaborated by ICWA as ‘an audit of efficiencyof minute details of
expenditure, while the work is in progress and not a postmortem examination. Financial audit is a
‘fait accompli’, cost audit is mainly a preventive measure, a guide for management policy and
decision in addition, tobeing a barometer of performance’.

Cost Audit can be called efficiency audit. It is evidenced by amendment in section209 which reads.
‘The object of the amendment of the section is to ensure specified company proper records relating
to utilization of material labour are available which would make efficiency audit (cost- audit)
possible’.

Management Auditing is the process of “auditing the quality of managers throughappraising them
as individual managers and appraising the quality of the total system of managing in an enterprise.”
Thus management audit aims at assessing how managers perform different functions of
management, e.g., planning, coordinating, motivating, etc.

Advantages of Cost Audit:

The chief advantage of a cost audit will be that management will be sure to getreliable data for its
objectives — price fixing, decision-making, control, etc.
Existence of such a system of audit will also be of great use for maintaining internal check and
control and will be of great help to even financial audit. But itmust be understood that the aims of
financial and cost audit are different.

The former aims at prevention of frauds and errors and with presentation of Profit and Loss Account
and Balance Sheet which exhibit a true and fair view of the state of affairs (of profit earned during
the year and of financial position at theend of the year).

It is concerned with totality of expenditure and revenue rather than its functionalanalysis. Cost Audit
will establish the accuracy of cost of each product, job, activity, etc., and is concerned with proper
analysis of information and its estimation so that management gets the necessary information
promptly. Apart from reliability of data, cost audit should afford certain incidental advantages.
Rather, it should be said that cost audit will help consolidate and realize advantages expected from
a system of costing. Following statement of the HR Gokhale Ex-minister of Law, Justice and
Company Affairs emphasizes the socialadvantage of cost audit.

‘The objective of this measure (cost audit) is to protect consumers from unwarranted increase in
prices. Reasonableness of the prices charged can only beensured by correct determination of costs
and the margin charged by producers and their retailers. Another object underlying this step is to
make the industries covered by such rules alert and efficient and also to make them know their
rational cost with a view to reducing it to the extent possible. Thus by resorting to this method, the
interest of consumer is safeguarded and it is definite step towards removal of social injustice’.

The advantages, briefly, are as follows:

1. A close check will be maintained on all wastages—materials in store, labour,etc.—and they
will be promptly located and reported.
2. Inefficiencies in production (or efficiencies) will be located and converted into monetary
terms.
3. Through fixation of individual responsibility, management by exception willbe possible.
4. The system of budgetary control and standard costing will be greatlyfacilitated with cost audit
at the hands of a qualified cost accountant.
5. Records will be up-to-date and information for various purposes will beavailable.
6. Cost audit may unearth a number of errors and frauds which may not be revealed otherwise.
This is because a cost auditor examines expenditure minutelyand compares it with standards
and ascertains exact reasons for discrepancy.
7. Cost audit offers many advantages to management, cost accountant,shareholders, statutory
auditor, consumers and the government.

8. These advantages are summarized below:

Advantages to Management:
1. Errors in following costing principles and techniques are detected. Inconsistencies and frauds
 can also be detected. This keeps everyone alert andpromotes efficiency.

2. Cost audit can serve to measure performance of managers and better performance can be
rewarded.
3. It helps to prepare accurate cost reports and this business planning can bemore accurate.
4. Inter-firm comparisons can be made with ease and this might be a very useful proposition if
industrial intelligence is good.
5. Cost audit can give an idea about the comparative operational efficiency ofeach department of
division; and may thus pin-point deficiencies and also encourage to operate in a competitive
spirit.

Advantages to Management/Cost Accountant:

Important advantages are:
1. His task is facilitated since errors, deficiencies, etc., are pointed out. Costing plans can be
prepared to take care of these things.
2. Cost audit may help in easier reconciliation of cost and financial accounts.
3. If the cost auditor is an outsider and is an expert, he can certainly give some practical and sound
advice to streamline costing systems and organisation.
4. Cost audit helps to focus attention of management on the problems faced by the cost
accountant. This helps him to realize his goals and objectives with ease.

5. Advantages to Statutory Auditor:

Important advantages are:
1. Audited cost data helps him to determine the value of stocks, remuneration of managerial
personnel, etc., with ease and accuracy.
2. Data and statements of cost audit help him to prepare his audit program and plan so that he
concentrates more on those aspects which have not been adequately covered by cost audit.

3. Advantages to Consumers:
4. The direct benefit accrues where a statutory cost audit has been done to fix a reasonable price
for the consumers.

5. Since cost audit aims at ensuring efficiency in the organisation, this may also get reflected in
reduced prices to the consumers.

6. Advantages to Labour:
7. If cost audit is done thoroughly labour also stands to gain through increased profitability in the
shape of bonus and other benefits.

8. Also, it brings into focus the role of labour in improving efficiency in term of increased
productivity.

Advantages to Shareholders:
1. There is correct valuation of all kinds of inventories. This may project a true picture of the
organisation before shareholders and other investors and help themto assess its performance.

2. External cost audit highlights efficiency or inefficiency, utilisation of manpower and other
 resources, adequacy of return, etc.

Advantages to Government and Economy:

1. It helps the government to settle accounts where cost-plus contracts have beenmade.
2. The government can intervene to protect the interests of the consumers, labour, shareholders
and investors from exploit-age or inefficient managements.
3. At the national level, cost audit promotes cost consciousness and overall efficiency. This means
that every rupee invested produces the maximum quantityof goods and services.

Types of Cost Audit:

The main types of Cost audit are the following:
(a) Cost Audit as an Aid to Management:
The aim is to see that all information placed before management is relevant, reliable and
prompt so that management can discharge its duties well. It must also be seen that no
relevant or pertinent information is suppressed.

(b) Cost Audit on Behalf of a Customer:

Often contracts are placed on “Cost Plus” basis. In other words, the customer will determine
the final price to be paid on the basis of exact cost plus an agreed margin of profit. The
customer, in such a case, usually gets cost accounts of the product concerned audited to
establish correct cost and, therefore, price.

(c) Cost Audit on Behalf of Government:

Sometimes the Government is approached with request for financial help or protection.
Before taking a decision on the request, the Government may chooseto get cost accounts of
the applicant audited to establish whether the need for help is genuine or is a result of mere
inefficiency.

(d) Cost Audit under Statute:

The Amendment Act of 1965 has inserted a new section, 233B, in the Companies Act, 1956
whereby the Central Government may order that certain classes of companies will get their
cost accounts audited by a member of the Institute of Cost and Works Accounts of India.
Only such companies as are required to maintain proper records regarding materials
consumed, labour and other expenses under Section 209 (as amended to date) and may be
required to gettheir cost accounts audited.

The powers and duties and manner of appointment of the cost auditor are the same as that of
external financial auditor and the same disqualifications will apply. The cost auditor will submit his
report to the Company Law Board with acopy to the company. The right to investigate all aspects of
cost accounts is presumably granted to the cost auditor.

The aim of cost audit under statute seems to be that the Government wishes to know, as an
instrument of control, the costs of various goods. Government has the power to prescribe the forms
in which cost audit reports are to be made out. These are designed not only to verify information,
but also to convey good deal ofinformation to Government.
 (e) Cost Audit on Behalf of the Trade Association:
Sometimes trade associations seek to maintain prices at a certain level. For this purpose, the
accuracy of costing information submitted by various concerns hasto be checked. The trade
associations may seek to have full information about production capacity and the relative
efficiency of productive processes

Types of Audits and Audit Reporting in India

For any foreign executive operating in India, it is beneficial to have a basic understanding of audit
procedures in the country. We have previously introduced audit in India for non-auditors. In this
article, we provide an overview of the different types of audits and audit reporting in India.

Audits are generally classified into two types:

• Statutory audits; and
• Internal audits.
Statutory audits are conducted in order to report the state of a company’s finances and accounts to
the Indian government. Such audits are performed by qualified auditors who are working as external
and independent parties. The audit report of a statutory audit is made in the form prescribed by the
government department.

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Internal audits are conducted at the bequest of internal management in order to check the health of
acompany’s finances and analyze the operational efficiency of the organization. Internal audits may
beperformed by an independent party or by the company’s own internal staff.
As per India’s Companies Act, 2013, the following companies must have an internal auditing system.
(a) Every company whose shares are registered on the stock exchange.
(b) Companies whose shares are not listed on the stock exchange and have:
(c) Paid up share capital of Rs 500 million (US$6.7 million) or more during the preceding financial
year;
(d) Turnover of Rs 2 billion (US$26.9 million) or more during the preceding financial year;
(e) Outstanding loans or borrowings from banks or public financial institutions exceeding Rs 1 billion
(US$13.4 million) or more at any point in time during the preceding financial year; or
(f) Outstanding deposits of Rs 250 million (US$3.3 million) or more at any point in time during the
preceding financial year.
(g) Every private company with:
(h) Turnover of Rs 2 billion (US$26.9 million) or more during the preceding financial year; or
(i) Outstanding loans or borrowings from banks or public financial institutions exceeding Rs 1billion
(US$13.4 million) or more at any point in time during the preceding financial year.
(j) The statutory auditor of the company must report on the internal auditing system of the company
inthe audit report.

Statutory audits in India

In India, statutory audits are conducted for each fiscal year (April 1 to March 31) and not the calendar
year. The two most common types of statutory audits in India are:
• Tax audits; and
• Company audits.

Tax audits
Tax audits are required under Section 44AB of India’s Income Tax Act 1961. This section mandates
that every person whose business turnover exceeds Rs 10 million (US$ 134,508) in any previous
year, and every person working in a profession with gross receipts exceeding Rs 5 million (US$
67,254) must have their accounts audited by an independent chartered accountant.
It should be noted that the provision of tax audits are applicable to everyone, be it an individual, a
partnership firm, a company or any other entity. The tax audit report is to be obtained by September
30 after the end of the previous fiscal year. Non-compliance with the tax audit provisions may attract
apenalty of 0.5 percent of turnover or Rs 100,000 (US$1,345), whichever is lower.
There are no specific rules regarding the appointment or removal of a tax auditor.

Company audits
The provisions for a company audit are contained in the Companies Act, 2013. Every company,
irrespective of its nature of business or turnover, must have its annual accounts audited each
financial year. For this purpose, the company and its directors have to first appoint an auditor at the
outset.

Thereafter, at each annual general meeting (AGM), an auditor is appointed by the shareholders of
thecompany who will hold the position from one AGM to the conclusion of the next AGM.

• MAT Audit in India: Tax Department Notifies Revised Reporting Form 29B
• The Companies (Amendment) Act, 2017provides that auditors can be appointed for a term of
five consecutive AGMs and their appointment need not be ratified in each of the AGMs.
Individuals and partnership firms, auditors cannot be appointed for more than one or two terms,
respectively. After the completion of the term, the auditor must be changed.
• Only an independent chartered accountant or a partnership firm of chartered accountants can
be appointed as the auditor of a company. The following persons are specifically disqualified
from becoming an auditor per the Companies Act:
• A body corporate.
• An officer or employee of the company.
• A person who is a partner with an employee of the company or employee of an employee of
the company.
• Any person who is indebted to a company for a sum exceeding Rs 1,000 (US$13) or whohave
guaranteed to the company on behalf of another person a sum exceeding Rs 1,000 (US$13);
or
• A person who has held any securities in the company after one year from the date of
• commencement of the Companies (Amendment) Act, 2000.
• The auditor is required to prepare the audit report in accordance with the Company Auditor’s
Report Order (CARO), 2016.
CARO requires an auditor to report on various aspects of the company, such as fixed assets,
inventories, internal audit standards, internal controls, statutory dues, among others.
The audit report must be obtained before holding the AGM, which itself should be held within six
months from the end of the financial year.

Audit reporting
Audits are conducted to express a true and fair view of a company’s financial statements. Therefore,
the auditor’s opinion expressed in the ultimate report is based on the information reviewed and
analyzed during the verification of financial statements. Upon completing the report, the auditor may
express one of the following four opinions:
• Unqualified opinion;
• Qualified opinion;
• Disclaimer of opinion; and
• Adverse opinion.

Unqualified opinion
When an independent auditor concludes that the financial records and statements of a company are
present fairly and appropriately, in accordance with the financial reporting framework, the judgment
is called an unqualified opinion.
An unqualified opinion generally indicates the following points:
• Generally accepted accounting principles (GAAP) are consistently applied in the preparation of
financial statements.
• Financial statements comply with the relevant statutory requirements and regulations;
• There is adequate disclosure of all material matters relevant to the proper presentation of
financial information (subject to statutory requirements); and
• If there are any changes in the accounting principles or in the application method, then it has been
properly checked and determined in the financial statement of the company.
• Qualified opinion

An auditor expresses a qualified opinion when according to him or her, the financial statements of
thecompany – as a whole – are not free from material misstatements, and the misstatements are
material but not pervasive in nature.
The effect of misstatement is material when information with such misstatement can affect the
decisions of the users of the financial statements
The effect of misstatement is pervasive when such misstatement is not confined to one element,
account or item of financial statement and reflects the widespread effect of misstatement.
Pervasive effects on the financial statements are those that, in the auditor’s judgment:
o Are not confined to specific elements, accounts or items of the financial statements;
o If so confined, represent or could represent a substantial proportion of the financial statements;
or
o In relation to disclosures, are fundamental to users’ understanding of the financial statements.

Disclaimer of opinion
A disclaimer of opinion is expressed when the possible effect of a limitation on scope is material
andpervasive to the extent that the auditor is unable to obtain sufficient appropriate audit evidence.
As a result, the auditor is unable to express an opinion on the financial statements.
Adverse opinion
An adverse opinion is issued when there are limitations on the scope of the auditor’s work.
It is also issued when there is disagreement with management regarding the acceptability of the
accounting policies selected, the method of their application, or the adequacy of the financial
statement disclosure.

What is Management Audit?

Management audit is audit of the management. It is similar to operational audit in several aspects.
However, management audit concentrates more on the inefficiencies and weaknesses of the
management.
Objectives of Management Audit
The following are the important objectives.
1. To identify the weaknesses and inefficiencies of management in differentfunctional areas, such
as production, sales, finance etc.
2. To analyses the different ways to overcome the inefficiencies, or weaknesses.
3. To critically review the organization structure.
4. To evaluate the ways for improving the management efficiency and to select the best are the
some of the objectives of management audit.

Scope of Management Audit

Management audit may cover a specific functional area or all the functional areas such as. Sales,
Inventory, Production, Purchase, Personnel, Finance, Administration, etc.
In management audit, experts from various fields –
a. Examine the organizational structure, Plans and Objectives, Policies,Systems and Procedures,
Methods of control, Standards fixed for performance and the method of evaluation of results.
b. Report on the defects, weaknesses and irregularities observed by them during their
examination.
c. Make suggestions to improve the efficiency and performance of themanagement.

Advantages of Management Audit

1. Management audit helps in decision making areas such as make or buy, closingdown of an unit,
acquisition of a business, etc.
2. It also helps in assessing the efficiency of the executives. It serves as a moralcheck on the
executives.
3. Management audit suggests ways to utilize the resources of the organizationeffectively.
4. Management audit helps in rehabilitation of sick units.
5. Management audit report is jointly reported by experts &om various fields.
6. The opinions and suggestions of a group of experts on the functioning of theorganization
are possible only through management audit.

Disadvantages of Management Audit

1. Management audit involves high cost and it is suitable only to big
organizations.
2. Management audit may create a fear in the minds of the executives and maycurb their
initiative and innovation.
3. The management auditor may lack independence and may simply takeinstructions from the
top management.
4. However, an organization can utilize management audit effectively to improve its various
functional areas

What is an energy audit?

An energy audit is a detailed inventory of the energy performances of your home carried out by
an auditor recognized by Bruxelles Environment/Leefmilieu Brussel, the government agency for
the environment and energy. Officially, this procedure is known as the Energy Advice Procedure
(EAP). N.B.: Do not confuse it with the EPB certificate or the heating audit!
Using a specialised software program, the auditor assesses the energy performance of your
home by examining the heating, hot water production, insulation, ventilation, etc. This makes it
possible to identify any weak points in your homeand give you personalised advice to help you
Rationalize your energy consumption.
A first step towards reducing consumption
The Energy Advice Procedure audit enables you, if you wish, to find out about the quality of your
energy installations and your daily habits. It provides you with personalised advice backed up
by figures on ways of using energy more rationally.
You can opt for a full audit or one that just covers certain elements.

The three stages of an energy audit

1. Preparation: before the auditor’s visit, gather information on your home: year of
construction, energy bills, type of heating, heating service certificate, plans of the building,
etc.

2. The audit: first of all, the information that you have gathered about your home is analysed.
After this, when conducting a full audit, the auditor checks:
3. the quality of the insulation of the outside walls
4. the proper functioning of the heating installation, the hot water system and the ventilation
system
5. the proper use of your various pieces of equipment (thermostats, thermostatic valves, etc.)
6. The report: All the data collected during the audit are encoded into a specialised software
program. This application is used to attribute a label from A to E to all the elements
analysed. The auditor then makes recommendations and draws up a projection of the way
your home would be if you were to follow these recommendations. In the last stage, the
auditor draws up a final report and adds any observations he may have.

Who are the energy auditors?

The energy auditors approved by Bruxelles Environnement/Leefmilieu Brussels (website in
French) have to follow a theory and practical training course in addition to their basic training
and their experience on the ground. They then have to take an examination on the various
elements of the energy audit and the use of the Energy Advice Procedure software program.
How much does it cost?
An energy audit usually costs between EUR 300 and EUR 700, depending on the auditor chosen
and the scope of the audit. The good news is: the Region gives you an energy grant via Bruxelles
Environnement/Leefmilieu. The amount of this grant is equal to 50 % of the amount of the audit,
whatever your income. However, the maximum amount of thegrant is EUR 400.

What is environmental auditing?

Environmental auditing is essentially an environmental management tool for measuring the effects of
certain activitieson the environment against set criteria or standards. Depending on the types of standards
and the focus of the audit, there are different types of environmental audit. Organisations of all kinds now
recognise the importance of environmental matters and accept that their environmental performance will
be scrutinised by a wide range of interested parties. Environmental auditing is used to
• investigate
• understand
• identify
These are used to help improve existing human activities, with the aim of reducing the adverse effects of
these activities on the environment. An environmental auditor will study an organisation's environmental
effects in a systematic and documented manner and will produce an environmental audit report. There are
many reasons for undertaking an environmental audit, which include issues such as environmental
legislation and pressure from customers.

Definitions
The term 'audit' has its origins in the financial sector. Auditing, in general, is a methodical examination -
involving analyses, tests, and confirmations - of procedures and practices whose goal is to verify whether
they comply with legal requirements, internal policies and accepted practices.
The International Chamber of Commerce (ICC) produced a definition in 1989 which is along the same lines
A management tool comprising systematic, documented, periodic and objective evaluation of how well
environmental organisation, management and equipment are performing with the aim of helping to
safeguard the environment by facilitating management control of practices and assessing compliance with
company policies, which would include regulatory requirements and standards applicable.
Source: after International Chamber of Commerce (1989)
There are other definitions available, although the above definition is still seen as the industry standard. The
key concepts, which occur in all the definitions, are as follows.
• Verification: audits evaluate compliance to regulations or other set criteria.
• Systematic: audits are carried out in a planned and methodical manner.
• Objective: information gained from the audit is reported free of opinions.
• Documented: notes are taken during the audit and the findings recorded.
• Management tool: audits can be integrated into the management system (such as a quality
management system or environmental management system).

Terminology
Environmental auditing should not be confused with environmental impact assessment (EIA). Both
environmental auditing and EIA are environmental management tools, and both share some terminology,
for example, 'impact', 'effect', and 'significant', but there are some important differences between the two.
Environmental impact assessment is an anticipatory tool, that is, it takes place before an action is carried
out (ex-ante). EIA therefore attempts to predict the impact on the environment of a future action, and to
provide this information to those who make the decision on whether the project should be authorised. EIA
is also a legally mandated tool for many projects in most countries.
Environmental auditing is carried out when a development is already in place, and is used to check on
existing practices, assessing the environmental effects of current activities (ex post). Environmental
auditing therefore provides a 'snap-shot' of looking at what is happening at that point in time in an
organisation.

The International Organization for Standardization (ISO) has produced a series of standards in the field of
environmental auditing. These standards are basically intended to guide organisations and auditors on the
general principles common to the execution of environmental audits. These are addressed elsewhere in this
module.
Environmental auditing means different things to different people. Environmental auditing is often used as
a generic term covering a variety of management practices used to evaluate a company's environmental
performance. Strictly, itrefers to checking systems and procedures against standards or regulations, but it
is often used to cover the gathering and evaluation of any data with environmental relevance - this should
actually be termed an environmental review. The distinction between an environmental audit and an
environmental review has become blurred, but the table in 2.1.1 should enable you to understand the
differences between the two.

Review

Audit
What is the objective?

Determine which performance standards should be met (eg Verify performance against these
standards (eg company check company decides to reduce total organic compound emissions
from 100 tons to 10 tones/ year) that it really has reduced emission to 10 tonnes/year)

Which environmental issues are covered?

All known environmental issues with or without explicit standards to measure performance Only
issues for which standards exist (EG regulatory requirements, internal company standards, or good
management practice)

How often are they required? Before developing environmental management systems or before
and after any significant changes in operations or practices

Regularly and on a pre-planned cyclical basis

Source: Dag (2005)

What are the geographic boundaries?

Wherever the business could have an environmental impact in the life of the product (ie raw
material selection, transportation, manufacturing, product use and disposal)

Usually well-defined geographic boundaries, (eg limited to site, distribution companies or local
planning authority)
Irrespective of the process that is actually being undertaken, some organisations prefer not to use the term
'audit'. In some cases, therefore, an organisation may call the procedure of measuring environmental
performance against set criteria an environmental review, an environmental assessment, or another term
used specifically for their own purposes (by now, you should be able to distinguish between these terms,
and be able to determine which is which).
In addition, the term 'audit', coming from the financial sector, may suggest that financial audits (whose result
typicallyis the Annual Report) and environmental audits are very similar. Some areas where they differ are
highlighted in thetable in 2.1.2.

Distinctions between financial audits and environmental audits financial audits Environmental
audits Legal basis of audit
Part of regulatory (legal) process, organizations have to perform it with few exceptions,
environmental audits are voluntary
affairs. Even the preparatory environmental review which is mandatory under ISO 14001 is voluntary
as the standard is voluntary

Frequency Annual affairs

Whenever the organization decides to perform one

Who does it?

Performed by external staff, certified to do so

Performed by external and/or internal staff. Professional indemnity considerations, there are no
legal requirements of auditors to be competent or trained, although professional bodies in many
countries try to stop this

Methodology

Financial audits are based on comparative standards which are publicly available - General
Principles of Accounting etc.

Varies very much between auditors and companies

Access to audit
The results are public documents in the form of annual reports

Very few audits are public, although some results are often published in the Environmental Reports
Liability

Auditors are partially liable for their reports. They have to provide a 'true and fair' view of the
organisation With few exceptions that are negotiated between auditor and auditee, there is no
external liability implication in environmental audits
 279

MCQ
PART -1
1. Which accounting concept satisfy the valuation criteria
(a) Going concern, Realisation, Cost
(b) Going concern, Cost, Dual aspect
(c) Cost, Dual aspect, Conservatism
(d) Realisation, Conservatism, Going concern.

2. A trader has made a sale of Rs.75,500 out of which cash sales amounted to Rs.25,500. He
showed trade receivables on 31-3-2014 at Rs.25,500. Which concept is followed by him?
(a) Going concern
(b) Cost
(c) Accrual
(d) Money measurement

3. In which of the following cases, accounting estimates are needed?

(a) Employs benefit schemes
(b) Impairment of losses
(c) Inventory obsolescence
(d) All of the above

4. Diwali advance given to an employee is

(a) Revenue Expenditure
(b) Capital Expenditure
(c) Deferred Revenue Expenditure
(d) Not an Expenditure

5. A firm has reported a profit of Rs.1,47,000 for the year ended 31-3-2014 after taking into
consideration the following items.
(a) The cost of an asset Rs.23,000 has been taken as an expense
(b) The firm anticipated a profit of Rs.12,000 on the sale of an old furniture
(c) Salary of Rs.7,000 outstanding for the year has not been taken into account.
(d) An asset of Rs.85,000 was purchased for Rs.75,000 and was recorded in the books at
Rs.85,000.

6. What is the correct amount of profit to be reported in the books?

(a) Rs.1,47,000
(b) Rs. 1,51,000
(c) Rs.1,63,000
(d) Rs.1,41,000

7. The process of recording financial data upto trial balance is

(a) Bookkeeping
(b) Classifying
(c) Summarising
 (d) Analyzing

8. Rohit carrying on real estate business sold a piece of land for Rs.4,00,00,000 (cost
Rs.3,50,00,000) then the type of receipt signature and profit on sale isa)
(a) Capital &transferred to capital reserve
(b) Revenue & transferred to P & L a/c c)
(c) Capital & transferred to P & L a/c d)
(d) Revenue & transferred to general reserve

9. In income measurement & recognition of assets & liabilities which of the following concepts goes
together?
(a) Periodicity, Accrual,

10. Interpretation means

(a) Explanation of meaning and significance of the data in Financial Statements.
(b) Concerned with preparation and presentation of classified data
(c) Systematic analysis of recorded data
(d) Methodical classification of data given in Financial Statements.

11. A trader purchases goods for Rs. 2500000 of these 70% of goods were sold during the year. At
the end of 31st December 2009, the market value of such goods were Rs. 500000. But the trader
recorded in his books for Rs. 750000. Which of the following concept is violated.
(a) Money measurement
(b) Conservatism
(c) Consistency
(d) None of these

12. Which of the following is wrong?

(a) All real and personal accounts are transferred to balance sheet
(b) Nominal accounts are transferred to P & L account
(c) Each account is opened separately in ledger
(d) Rent is a personal account, outstanding rent is nominal account

13. Is root cause for financial accounting Stewardship accountingSocialaccountingManagement

accounting Human resource accounting If nothing is given in the financial statements about the
three accounting assumptions, then it is to be treated as it
(a) Is assumed that it is not followed
(b) Is assumed to be followed
(c) Is assumed to be followed to some extent
(d) None of the above

14. The proprietor of the business is treated as creditor for the capital introduced by him due to
concept.
(a) Money measurement
(b) Cost
(c) Entity
(d) Dual aspect
15. Fixed assets are held by business for
(a) Converting into cash
(b) Generating revenue
(c) Resale
(d) None of the above

16. Which accounting concept specifies the practice of crediting closing stock to the trading
account?
(a) Cost
(b) Realization
(c) Going concern
(d) Matching

17. Amount spent to increasing the earning capacity is an expenditure

(a) Capital
(b) Revenue
(c) Deferred revenue
(d) Capital Loss

18. Change in the capital A/c of proprietor may occur due to

(a) Profit earned
(b) Loss incurred
(c) Capital Introduced
(d) All of the above

19. Consistency with reference to application of accounting procedures means

(a) All companies in the same Industry should use identical accounting procedures
(b) Income & assets have not been overstated
(c) Accounting methods & procedures shall be followed uniform basis year after year
(d) Any accounting method can be followed as per convenience

20. If one of the cars purchased by a car dealer is used for business purpose, instead of resale, then
it should be recorded by
(a) Dr Drawing A/c & Cr Purchases A/c
(b) Dr Office Expenses A/c & Cr Motor Car A/c
(c) Dr Motor Car A/c & Purchases A/c
(d) Dr Motor Car & Cr Sales A/c

21. If wages are paid for construction of business premises A/c is credited and A/c is debited.
(a) Wages, Cash
(b) Premises, Cash
(c) Cash, Wages
(d) Cash, Premises

22. Human resources will not appear in the balance sheet according to concept.
(a) Accrual
(b) Going concern
(c) Money measurement concept
 (d) None

23. Provision for discount on debtors is calculated on the number of debtors.

(a) Before deducting provision for doubtful debts.
(b) After deducting provision for doubtful debts.
(c) Before deducting actual debts and provision for doubtful debts.
(d) After adding actual bad and doubtful debts.

24. Which of the following is not a Real Account?

(a) Cash A/c b)
(b) Investments A/c
(c) Outstanding rent A/c
(d) Purchases A/c

25. Value of goods withdrawn by the proprietor for his personal use should be credited to
(a) Capital A/c
(b) Sales A/c
(c) Drawings A/c
(d) Purchases A/c

26. Which of the following is incorrect?

(a) Good will intangible asset
(b) Sundry debtors - current asset
(c) Loose tools tangible fixed asset
(d) Outstanding expenses -current asset.

27. M/s Stationery Mart will debit the purchase of stationery to

(a) Purchases A/c
(b) General Expenses A/c
(c) Stationery A/c
(d) None

28. Small items like, pencils, pens, files, etc. are written off within a year according to _ concept.
(a) Materiality
(b) consistency
(c) Conservatism
(d) Realisation

29. Business enterprise is separate from its owner according to concept.

(a) Money measurement concept
(b) Matching concept
(c) Entity concept
(d) Dual aspect concept

30. The policy of anticipate no profit and provide for all possible losses arise due to the concept of
(a) Consistency
(b) Disclosure
(c) Conservatism
 (d) Matching

31. According to which concept, the proprietor pays interest on drawings

(a) Accrual concept
(b) Conservatism concept
(c) Entity concept
(d) Dual Aspect concept

32. Cost concept basically recognizes

(a) Fair Market value
(b) Historical cost
(c) Realizable value
(d) Replacement cost

33. If the Market value of closing Inventory is less than its cost price, inventory will he shown at
(a) Marketable value
(b) Fair Market value
(c) Both
(d) None

34. The Market price of good declined than the cost price. Then the concept that plays a key role is
(a) Materiality
(b) Going concern concept
(c) Realization
(d) Consistency

35. Fixed assets are double the current assets and half the capital. The current assets are
Rs.3,00,000 and investments are Rs.4,00,000. Then the current liabilities recorded in balance
sheet will be
(a) 2,00,000
(b) 1,00,000
(c) 3,00,000
(d) 4,00,000

36. Which of the following provide framework and accounting policies so that the financial
statements of different enterprises become comparable.
(a) Business Standards
(b) Accounting Standards
(c) Market Standards None

37. Which of the following factor is not considered while selecting accounting policies?
(a) Prudence
(b) Substance over form
(c) Accountancy
(d) Materiality

38. Debit the receiver & credit the giver is account

(a) Personal
 (b) Real
(c) Nominal
(d) All the above

39. Cash a/c is a

(a) Real a/c
(b) Nominal
(c) Personal
(d) None

40. As per accrual concept, which of the followings is not true

(a) revenue – expenditure = profit
(b) revenue – profit = expenditure
(c) sales + gross profit = revenue
(d) revenue = profit + expenditure

41. Mr. X sold goods to Mr. Y ask Mr. X to keep the goods with him for some time
(a) symbolic delivery
(b) actual delivery
(c) constructive delivery
(d) none of these

42. If nothing is written about the accounting assumption to be followed it is presumed that
(a) They have been followed
(b) They have not been followed
(c) They are followed to some extent
(d) none of these

43. Capital A/c is a A/c.

(a) Personal
(b) Real
(c) Nominal
(d) None

44. Cash A/c is a/c.

(a) Personal
(b) Real
(c) Nominal
(d) None

45. The principle “Debit the receiver and credit the giver” is related to
(a) Personal a/c
(b) Real a/c
(c) Nominal a/c
(d) None

46. As per the Matching concept, Revenue –? = Profit

(a) Expenses
 (b) Liabilities
(c) Losses
(d) Assets

47. Sales – Gross Profit =

(a) Cost of goods sold
(b) Net sales
(c) Gross Sales
(d) Liabilities

48. Which of the following is a Real A/c?

(a) Building A/c
(b) Capital A/c
(c) Shyam A/c
(d) Rent A/c

49. Valuation of stock in accounting follows the principle of cost price or whichever is lower.
(a) Market Price
(b) Average Price
(c) Net realizable Value
(d) None of these.

50. Which of the following is not a nominal Account?

(a) Outstanding salaries Account
(b) Salaries account
(c) Interest paid
(d) Commission received

51. Mr. X is a dealer in electronic goods (refrigerator, washing machine, air conditioners,
televisions, etc.) He purchased two air conditioners and installed in his showroom. In the books
of X, the cost two air conditioners will be debited to
(a) Drawing account
(b) Capital Account
(c) Fixed assets
(d) Purchases account

52. A trader calculated his profit as Rs.150000 on 31/03/2014. It is an

(a) Transaction
(b) Event
(c) Transaction as well as event
(d) Neither transaction nor event

53. For every debit there will be an equal credit according to

(a) Matching concept
(b) cost concept
(c) Money measurement concept
(d) Dual aspect concept
54. Historical cost concept requires the valuation of an asset at
(a) Original cost
(b) Replacement value
(c) Net realizable value
(d) Market value

55. The comparison of financial statement of one year with that of another is possible only when
concept is followed
(a) Going concern
(b) Accrual
(c) Consistency
(d) Materiality

56. Profit and loss is calculated at the stage of

(a) Recording
(b) Posting
(c) Classifying
(d) Summarizing

57. Which of the following is not the main objective of accounting?

(a) Systematic recording of transactions
(b) Ascertaining profit or loss
(c) Ascertainment of financial position
(d) Solving tax disputes with tax authorities

58. An asset was purchased for Rs.1000000 with the down payment of Rs.200000 and bills
accepted for Rs.800000/-. What would be the effect on the total asset and total liabilities in the
balance sheet?
(a) Assets increased by Rs.800000 and liabilities decreased by Rs.800000
(b) Assets decreased by Rs.800000 and liabilities increased by Rs.800000
(c) Assets increased by Rs.1000000 and liabilities increased by Rs.800000
(d) Assets increased by Rs.800000 and liabilities increased by Rs.800000

59. The rule debit all expenses and losses and credit all income and gains relates to
(a) Personal account
(b) Real account
(c) Nominal accounts
(d) All

60. Matching concept means

(a) Assets = capital + liabilities
(b) Transactions recorded at accrual concept
(c) Anticipate no profit but recognize all losses
(d) Expenses should be matched with the revenue of the period.
1] a 2]c 3] d 4] d 5] b 6] a 7] b 8] a 9] a 10] b
11] d 12] a 13] b 14] c 15] b 16] d 17] a 18] d 19] c 20] c

21] d 22] c 23] b 24] c 25] d 26] d 27] a 28] a 29] c 30] c

31] c 32] b 33] a 34] c 35] b 36] b 37] c 38] a 39] a 40] c

41] a 42] b 43] a 44] b 45] a 46] a 47] a 48] a 49]c 50] a

51] c 52] b 53] d 54] a 55] c 56] d 57] d 58] d 59] c 60] d

PART-2
1. Reduction in the book value of an asset over a period of time is called-
(a) Appreciation
(b) Depreciation
(c) Proportion
(d) Depletion

2. Which among the following is not a reason for depreciation

(a) Use of asset
(b) Passage of time
(c) Obsolescence
(d) Repair of an asset

3. Depreciation is charged on
(a) Current asset
(b) Fixed asset
(c) Intangible asset
(d) Current liability

4. Depreciation helps in determining

(a) Accurate level of profit
(b) Increases the value of asset
(c) Revenue generation
(d) increase the burden of tax

5. The asset which is an exception from depreciation is

(a) Computer
(b) Furniture
(c) Land
(d) ATM Machine
6. Which of the following is true about the straight-line method?
(a) Complex method
(b) Cost of depreciation remains constant
(c) Cost of depreciation changes every year
(d) P&L account debited with different amount every year

7. Bank purchased a computer on 1.03.2015 at a cost Rs. 50000, estimated life is 8years, cost of
depreciation under straight-line method will be-
(a) 6250
(b) 7430
(c) 5000
(d) 4590

8. Annual depreciation of machine is 40000, cost of machine is 500000, rate of depreciation

according to straight-line method will be-
(a) 9%
(b) 18%
(c) 16%
(d) 8%

9. Value of an asset is 9 lakh, scrap value is 125000, estimated life is 10 years the cost of
depreciation under straight-line method will be-
(a) 65000
(b) 89000
(c) 77500
(d) 67880

10. Depreciation is a process of

(a) Valuation of asset
(b) Allocation of cost
(c) Both A& B
(d) Only A

11. Cost of the asset minus scrap value/ Life of the asset is the formula of
(a) Diminishing balance method
(b) Annuity method
(c) Straight line method
(d) Sum of digits method

12. The Diminishing balance method means a method by which-

(a) The rate of depreciation falls year by year
(b) The amount on which depreciation is calculated falls year by year
(c) The rate and amount which is applied falls year by year
(d) None of the above

13. Which among the following is false about Diminishing balance method-
(a) the amount of depreciation is high in the initial years
 289
(b) Depreciation is calculated on the original cost of the asset
(c) the value of the asset cannot be reduced to zero
(d) Cost of depreciation remains constant

14. Which of the following accounting concepts or principles require the calculation ofdepreciation
of the fixed assets?
(a) Prudence concept
(b) Accrual concept
(c) Consistency concept
(d) Matching concept

15. Depreciation is an
(a) Income
(b) Expense
(c) Asset
(d) Liability

16. The cost of the asset is 60000 and depreciated at 12% p.a. using the writtendown method. at the
end of three years, it will have a net book value of –
(a) 40888.32
(b) 43888.90
(c) 45322
(d) 40000

17. The vehicle costs Rs. 150000; it charges 20% depreciation according to written down value
method estimate the value of the vehicle after depreciation at the endof three years.
(a) 68000
(b) 56000
(c) 78000
(d) 76800

18. The loss on sale of an asset is debited to

(a) Reserves
(b) Depreciation fund
(c) Profit & Loss account
(d) Asset’s account

19. Under the diminishing balance method, depreciation is calculated on

(a) Scrap value
(b) Book value
(c) Original value
(d) All of these

20. A boiler was purchased from abroad for Rs. 10000. Shipping and forward charges Rs. 2000 and
expenses of installation amounts to Rs. 8000. Find the balance after three years @10% on
diminishing balance method.
(a) 12400
(b) 14580
 290
(c) 13800
(d) 11800

21. The amount of depreciation charged on machinery is debited to

(a) Depreciation account
(b) Machinery account
(c) Provision for depreciation account
(d) Expense account

PART- 3

1. Which of the following is not a Capital Expenditure?

(a) Money spent to purchase the Furniture
(b) Money spent to purchase the Building
(c) Money spent to pay the salary to the employees
(d) Money spent to purchase the Land

2. Which of the following is not a Revenue Expenditure?

(a) Money spent towards acquiring the Furniture
(b) Money spent to pay salary to the employees
(c) Money spent towards electricity bill
(d) Money spent towards interest on deposits

3. What is Accounting Equation?

(a) Assets = Capital + Liabilities
(b) Assets = Capital – Liabilities
(c) Liabilities = Capital + Assets
(d) Capital = Liabilities – Asset

4. How would you classify the Depreciation?

(a) Asset to the bank
(b) Expense to the bank
(c) Income to the bank
(d) Liability to the bank

5. How would you classify the ‘wages paid for construction of building’?
(a) Revenue Receipt
(b) Revenue Expenditure
(c) Capital Expenditure
(d) Revenue Expenditure

6. Which of the following best describes a trial balance?

(a) It shows the profit or loss of the organization
(b) It is a list of balances of ledger accounts
(c) Shows the financial position of a business
(d) It is a Ledger Account
7. Contingent liabilities are those and are shown under.
(a) Which are never payable and shown outside the balance sheet
(b) Which may or may not arise and shown liabilities side of the balance sheet
(c) Which crystallize at the time of liquidation of a company and shown in the asset side of the
balance sheet
(d) Which may or may not arise and shown outside of the balance sheet

8. Which of the following is a CapitalExpenditure?

(a) Purchase of raw material
(b) Purchase of machinery
(c) Interest on loan
(d) Depreciation on machinery

9. How would you journalise the depreciation charged on the asset?

(a) Debiting cash account and crediting depreciation account.
(b) Debiting depreciation account and crediting cash account.
(c) Debiting depreciation account and crediting asset account.
(d) Debiting cash account and crediting asset account

10. Which of the following convention says that “Once an entity follows a particular method of
accounting it should use the same method for all subsequent transactions and events of the same
nature”.
(a) Conservatism
(b) Full Disclosure
(c) Consistency
(d) Materiality

11. Interest earned in bank final statement is explained through ——-

(a) Schedule 13
(b) Schedule 1
(c) Schedule 15
(d) Schedule 2

12. How would you treat the purchase of a software that will be used for more than 12 months should
beregarded as:
(a) A revenue expenditure
(b) A capital expenditure
(c) A long term expense
(d) A capital receipt

13. Which of the following is a double entry for depreciation expenses?

(a) Accumulated depreciation debit and depreciation expenses Credit
(b) Depreciation expenses Debit and provision for depreciation Credit
(c) Cash Debit and depreciation expenses Credit
(d) Depreciation expenses Debit and cash Credit
 292

14. Which among the following represents the balance in the Capital account of the business?
(a) The amount of cash introduced by the owner at the commencement of business
(b) Total liabilities of the business
(c) The total of all assets of the business
(d) Total assets of the business minus its external liabilities

15. Which of the following statements states the meaning of Trial Balance?
(a) Lists the balances of the ledger accounts of asset accounts and liability accounts for a
particular period
(b) Lists the balances of all the ledger accounts for a particular period
(c) It reveals how profitable a business has been
(d) It balances even if the bookkeeper forgets to post a payment

16. How would you classify the summary statement of the tabulation of balances of all the
ledgeraccounts?
(a) Reconciliation Statement
(b) Trial Balance
(c) Balance Sheet
(d) Ledger

PART-4

1. Recording, classifying and summarizing in a significant manner of financial transactions is

known as –
(a) Accounting
(b) Analyzing
(c) Managing
(d) Dealing with finance
Answer is (A)

2. Which kind of transactions are recorded in accounting

(a) Transactions having financial and physical character
(b) Transactions having financial character
(c) Dealings having financial and social implications
(d) Transactions having social and money matters
(e) All the above
Answer is (B)

3. A firm obtains a loan of Rs. 37 lac from its bankers and purchases raw material stocks. The
transactions would be recorded as a part of …
(a) Accounting
(b) Analysis
(c) Management information system
(d) Cost accounting
292
 293
(e) A and B
Answer is (A)

4. Recording of a financial transaction can be done in which of the following books:

(a) Journal
(b) Cash book
(c) Purchase book
(d) Sale book
(e) Any of the above
Answer is (E)

5. The process of grouping of transactions or entries ofone nature is called ….

(a) Accounting
(b) Classifying
(c) Summarizing
(d) Recording
(e) All the above
Answer is (B)

6. For the purpose of classifying the financial transactions appropriately, which of the following
books are used
(a) Cash book
(b) Journal
(c) Purchase book
(d) Sales book
(e) Ledger
Answer is (E)

7. Presentation of classified data in a manner that is understandable and useful to management

and other parties is called
(a) Classifying
(b) Recording
(c) Summarizing
(d) Analyzing
(e) All the above
Answer is (C)

8. Summarizing is done through preparation of which of the following types of account

(a) Cash book and journal
(b) Trading and profit and loss account
(c) Balance sheet
(d) A to C all
(e) B and C
Answer is (E)

9. A financial happening that affects the finance of the business is called

(a) Transaction
(b) Entry
 (c) Book keeping
(d) Give and take
(e) None of the above
Answer is (A)

10. Which of the following is not a part of the accounting

(a) Process
(b) RecordingClassifying
(c) Smmarizing
(d) Analyzing and interpreting
(e) None of the above
Answer is (E)

PART-5

1. When a company makes a public issue of shares, the offer comes from:
(a) the applicants;
(b) the directors of the company;
(c) the company issuing the shares;
(d) the broker handing the share issue for the company;
(e) the shareholders.

2. Which of the following statements about share issue is incorrect?

(a) It is possible for a company to issue different types of preference shares if the rights of each
type are specified in it’s constitution.
(b) Prior to the allotment of shares, the balance in the application account represents a liability
of the company.
(c) A company is allowed under the Act to issue partly paid shares.
(d) A company offers shares as the directors see fit for the effective management of the
company.
(e) If a company has not reached a minimum subscription level after 3 months from the date of
the disclosure statement, the application money must be refunded by the company within 1
month.

3. According to the Corporation Act 2001, when a company listed on the Australian Stock
Exchange issues shares to the public, the issue price, terms and rights associated with the
shares are determinedby:
(a) the directors of the company;
(b) the Australian Stock Exchange and the company secretary of the company;
(c) the underwriters to the share issue and the directors of the company;
(d) the Australian Stock Exchange and the directors of the company;
(e) the Australian Stock Exchange and the financial controller of the company.

4. An appropriate journal entry to record the receipts of cash on application of shares will include
thefollowing line:
(a) Cr Cash trust;
(b) Dr Cash;
(c) Cr Application;
 295
(d) Dr Application.

5. Underwriting and other share issue costs are classified as:

(a) an increase in expense;
(b) a decrease in liability;
(c) an increase in asset;

6. A share option is a financial instrument that gives a shareholder the right to:
(a) receive a certain number of shares in a company at no cost;
(b) buy or sell a certain number of shares in the company by a specific date and at a stipulated
price;
(c) not pay the unpaid balance on shares they own when that balance is called in by the company;
(d) buy or sell a certain number of shares in the company at fair value by a specific date.

7. Without the prior approval of shareholders a company is restricted to private placements of

shares, in any one year, of no more than:
(a) 5% of existing capital;
(b) 10% of existing capital;
(c) 15% of existing capital;
(d) 20% of existing capital;
(e) 25% of existing capital.

8. Which of the following statements about redeemable preference shares is incorrect?

(a) Redeemable preference shares, depending on their terms of issue, may be classified as equity
or aliability, or a combination of both equity and a liability.
(b) Redeemable preferential shares may be redeemed out of profits or fresh issue of ordinary
shares.
(c) Any premium paid on the redemption of preference shares is regarded as an additional
dividend if the preference shares are treated as equity.
(d) A company’s capital cannot be reduced by the redemption of preference shares irrespective
of themethod of redemption.
(e) None of the above, ie all are correct.

9. Which of the following statements about debentures is incorrect?

(a) Unlike shares, debentures may be issued at a premium or discount.
(b) Under the Act, debentures exclude unsecured notes and convertible notes.
(c) Debentures usually represent secured, long-term liabilities on which interest must be paid.
(d) The issue of debentures must be preceded by the issue of a disclosure document.
(e) None of the above, ie all are correct.

10. According to the Corporation Act 2001, dividends may:

(a) Only be paid to shareholders once a year;
(b) Only be paid out of profits of a company;
(c) Be declared and paid to shareholders irrespective of whether a company has accumulated
losses;
(d) Only be paid if approved by the australian securities and investments commission.
(e) Only be paid from current year’s profit.
 296
11. An appropriate journal entry to record the payment of final dividends paid will include the
following line:
(a) Dr Retained earnings;
(b) Dr Final dividend payable;
(c) Cr Cash trust;
(d) Cr Final dividends payable;
(e) Dr Cash.

12. Which of the following items is not a reason given for issuing bonus shares?
(a) To provide a return to shareholders without any cash outlay, thus protecting the company’s
current liquidity.
(b) To capitalise the long-term reserve of a company by converting reserves such as asset
revaluationinto share capital.
(c) To capitalise the profits of the company under the Corporations Act.
(d) To signal to the capital market that the company expects good future profitability levels for
cashdividends.
(e) None of the above.

13. Which of the following statements about reserves is incorrect?

(a) There is no definition of a reserve in the accounting standard or in Corporations Act.
(b) Reserves may be established by normal practice.
(c) Movements in a revaluation reserve can be reclassified in a later period as part of profit or
loss.
(d) The reserves accounts of a company are regarded as equity.
(e) None of the above, ie all are correct.

14. For a company, retained earnings represent:

(a) contributed equity from shareholders;
(b) profits retained by the company before tax is paid to the government;
(c) net cash retained by the company before any payment for dividends to shareholders;
(d) profits retained by the company after payment and provision for dividends, and after any
transfer to and from reserves;
(e) profits retained by after payment and provision for dividends but before any transfer to
reserves.

15. In accordance with AASB 112 Income Taxes, which of the following statements about
accountingfor income taxes is incorrect?
(a) The tax-effect method focuses on the differences between an entity’s balance sheet prepared
under accounting standards and its tax-based balance sheet prepared in accordance with
income tax legislation.
(b) Accounting entries for current tax liabilities and assets are based on an assessment of an
entity’s current taxable income or tax loss.
(c) AASB 112 requires a company to account for both the current and the future tax
consequences of its economic events.
(d) Income tax expense recognized in the accounting records is a result of movements in current
tax liabilities (assets).
(e) The future tax consequences of accounting transactions result in the recognition of deferred
tax liabilities (assets).
 297

16. Which of the following items are classified as permanent difference? (Note: Permanent
difference arises where expense or revenue is included in the determination of taxable income
(or tax loss) which will never recognize in the profit or loss or vice versa.
I Impairment of goodwill II Insurance expense
III Rental revenue
IV Additional tax deduction for R & D V Government grant
(a) I and IV.
(b) II and III.
(c) I, II and III
(d) I, IV and V
(e) I, III and IV

17. The tax base for an asset equals:

(a) carrying amount – future taxable amount + future deductible amount;
(b) carrying amount + future taxable amount – future deductible amount;
(c) carrying amount – future taxable amount – future deductible amount;
(d) carrying amount + future taxable amount + future deductible amount;
(e) carrying amount – revenue received in advance which will not be taxable in the future periods.

18. The tax effect method of accounting for a company’s income tax is based on an assumption
that:
(a) income tax expense is equal to income tax payable;
(b) income tax expense is not equal merely to current tax liability (asset) but is also a function of
thecompany’s deferred tax liabilities and assets;
(c) an accounting balance sheet and a tax balance sheet are the same;
(d) a tax balance sheet is prepared according to the income tax legislation and accounting
standards.
(e) income tax expense is a function of the accounting profits adjusted for permanent
differences.

19. Which of the following items give rise to a taxable temporary difference? I Prepayments
II Rent received in advance
III Provision for employee benefits IV Research & development
V Goodwill
VI Provision for warranty
(a) I, II and II..
(b) I, II and VI.
(c) I, IV and V.
(d) II, III, and VI.
(e) I, and IV.

20. Current and deferred tax assets lead to the recognition of:
(a) reserves;
(b) income;
(c) expenses;
(d) losses;
(e) assets.
 298

21. Deductible temporary differences arise from tax losses can lead to the recognition of:
(a) current tax liability.
(b) deferred tax liability.
(c) current tax asset.
(d) income tax expense.
(e) deferred tax asset.

22. Where the impairment of goodwill is not tax deductible, AASB 112 Income Taxes:
(a) does not permit the application of deferred tax accounting to goodwill;
(b) allows the recognition of a deferred tax item in relation to goodwill;
(c) requires that any deferred tax items in relation to goodwill be recognized directly in equity;
(d) requires that any deferred tax items for goodwill be capitalized in the carrying amount of
goodwill;
(e) requires that the temporary difference be recognized as a deferred tax asset.

23. Which of the following items are excluded from the explanation of the relationship between
income tax expense and prima facie tax on profit (ie accounting profit multiplied by the
applicable rate)?
I Building depreciation II Bad debts expense III Exempt income
IV Loss from change in tax rate V Annual leave expense
VI Entertainment expense
(a) I and VI.
(b) II and VI.
(c) II and V.
(d) I, III, IV and VI.
(e) I, III, V and VI.

24. The revaluation under AASB 116 Property, Plant and Equipment apply to:
(a) all assets on an individual basis;
(b) individual current assets only;
(c) individual non-current assets only;
(d) assets on a class-by-class basis;
(e) none of the above.

25. A non-current property, plant and equipment asset is depreciated using the straight-line
method. The asset was revalued upwards after four years of use. There is no change in the
remaining useful life of six years or to the residual value. Which of the following relationships
reflect the effect of the revaluation on the prospective depreciation of the asset?
(a) Same depreciation rate – higher annual depreciation expense;
(b) Same depreciation rate – same annual depreciation expense;
(c) Higher depreciation rate – higher annual depreciation expense;
(d) Higher depreciation rate – same annual depreciation expense;
(e) Same depreciation rate – lower annual depreciation expense.

26. The accepted method of accounting for a business combination under AASB 3 Business
Combinations is:
(a) the purchase method;
 299
(b) the cost method;
(c) the acquisition method;
(d) the fair value method;
(e) the accrual method.

27. Which of the following statements about the requirements of AASB 3 Business Combinations
is incorrect?
(a) An acquirer to be identified.
(b) Goodwill acquired to be recognized.
(c) The assets, liabilities and contingent liabilities to be measured initially at cost at acquisition
date.
(d) Disclosure of information that enables users to evaluate changes in the carrying amount of
goodwill.
(e) The measurement of the cost of a business combination.

28. The appropriate account to debit in the records of the acquiring company for costs directly
attributable to a business combination is:
(a) cash;
(b) retained earnings;
(c) goodwill;
(d) net assets acquired;
(e) expense.

29. Consider the following quotation and answer the question below.
In accordance with AASB 3 Business Combinations, goodwill is an asset representing the future
economic benefits arising from other assets acquired in a business combination that are not
individually identified and separately recognized.
This statement is:
(a) incorrect because this is the definition of an internally generated goodwill.
(b) incorrect because it is the future economic benefits arising from other assets acquired that
are not
(c) capable of being individually identified and separately recognized.
(d) correct because this is the definition given by the accounting standard.
(e) correct because goodwill can be individually identified and separately recognized.
(f) correct because goodwill contains future economic benefits and is classified as an asset.

30. In a business combination, the acquiree is the part that:

(a) gives up control over the net assets acquired;
(b) pays the acquisition consideration;
(c) obtains control of the net assets of the other entity;
(d) finances the business combination;
(e) gives up control over all of its issued shares.
 300

Answers:

1 a 11 b 21 e
2 e 12 e 22 a
3 a 13 c 23 c
4 d 14 d 24 d
5 d 15 d 25 a
6 b 16 d 26 c
7 c 17 a 27 c
8 e 18 b 28 e
9 b 19 c 29 b
10 b 20 b 30 a

PART=6

1. An investment property is derecognized when

(a) It is disposed to a third party
(b) It is permanently withdrawn from use
(c) No future economic benefits are expected from its disposal,
(d) All of the above

2. An investment property should be measured initially at

(a) Cost
(b) Cost less accumulated impairment losses
(c) Depreciable cost less accumulated impairment losses,
(d) Fair value less accumulated impairment loss

3. A gain arising from a change in the fair value of an investment property for which an entity has
opted to use the fair value model is recognized in
(a) Net profit or loss for the year
(b) Generalreserve
(c) Revaluation surplus
(d) None of these

4. Capitalisation of borrowing cost is ceased when

(a) Physical construction of asset is completed
(b) Physical construction of asset is interrupted
(c) None of these

5. An entity can start to capitalize borrowing cost when

(a) Expenditure on the asset is being incurred
 301
(b) Borrowing cost are being incurred
(c) Activities undertaken that are necessary to prepare the asset for its intended use or sale
(d) All of the above

6. borrowing cost do not include

(a) interest incurred on bank draft
(b) incremental administrative fees for raising loans
(c) dividend declared to equity shareholders.

7. Borrowing cost are

(a) Interest and other cost that an entity incurs in connection with borrowing of funds.
(b) Interest expense calculated using effective interest method
(c) Financial charges in respect of finance lease
(d) None of the above

8. The cost of intangible asset at initial recognition is measured at its fair value when
(a) It is internally generated
(b) It is acquired by way of a government grant
(c) Either (a) or (b)
(d) None of these

9. An intangible (other than goodwill) is

(a) It is separable
(b) It arises from contractual or other legal rights, regardless whether those rights are
transferable or separable from the entity.
(c) Either (a) or (b)
(d) None of these

10. Which of the following asset is not coming under the scope of Ind AS 16?
(a) Office building
(b) Bus used for employee transport
(c) Right to mine coal from a government
(d) owned coal field-

11. 12. An entity must mea sure its property , plant and equipment after initial recognition at:
(a) Cost
(b) Cost less accumulated depreciation and impairment losses if any
(c) Cost less accumulated depreciation and impairment losses if any including cost of day to day
servicing
(d) None of these.

12. Property, plant and equipment are defined as:

(a) Tangible assets held for sale in the ordinary course of business
(b) Tangible asset held to earn rental or for capital appreciation or both
(c) Tangible assets used in the process of production or supply of goods or services or for rental
to others
(d) None of these.
13. A property developer must classify properties that it holds for sale in the ordinary course
ofbusiness as:
(a) Inventories
(b) Property, plant and equipment
(c) Financial assets
(d) Investment property

14. Cost of inventory does not include:

(a) Salary of factory staff
(b) Storage cost necessary in the production process
(c) Cost of abnormal wastage

15. Consumable stores are :

(a) Inventories
(b) Property, plant and equipment
(c) Investment property
(d) Intangible asset

16. Cost of inventory is a sum of :

(a) Cost of purchase and cost of conversion
(b) Direct cost, indirect cost and other cost
(c) Cost of purchase, cost of conversion and other cost to bring the material to the present
location.

17. Inventories must be measured at :

(a) Cost
(b) Lower of cost and estimated selling price less cost to complete and sell
(c) Lower of cost and fair value less cost to complete and sell.
(d) None of these

18. The entity assesses inventories for impairment :

(a) Only when there are external indicators that, an impairment has occurred School of Distance
Education
(b) At each reporting date
(c) Only when there are internal indicators that an impairment has occurred
(d) None

19. A percentage of completionmethod is applied to recognize revenue from

(a) The rendering of services and construction contracts
(b) The rendering of services only when the outcome of the revenue transaction can be estimated
reliably,
(c) The construction contracts only when the outcome of the contract can be estimated reliably
(d) Both C and B

20. As per Ind AS 115, a promise to transfer to the customer either good(s) or service(s) known as
(a) Agreement
(b) Contract
 (c) Performance obligation
(d) Liability

21. The price at which a good or service would be sold separately to a customer is :
(a) Variable price
(b) Stand alone price
(c) Specific price
(d) None of these

22. A provision is
(a) A liability of uncertain timing or amount
(b) A possible obligation as a result of past events that is of uncertain timing or amount,
(c) An adjustment to the carrying amount of assets
(d) None of these

23. An entity recognizes a provision only when:

(a) The entity has a present obligation as a result of a past event,
(b) It is probable that the entity will be required to transfer economic benefits in settlement
(c) The amount of the obligation can be estimated reliably
(d) All of the above apply

24. Which of the following is not an exception for application of IFRS 15?
(a) Lease contracts
(b) Insurance contract
(c) Pharmaceutical contracts,
(d) None of the above

25. A contract is wholly unperformed if :

(a) The entity has not yet transferred any promised goods or services to the customers
(b) The entity has not yet received any consideration in exchange for promised goods or services
(c) The entity is not yet entitled to receive any consideration in exchange for promised goods or
services
(d) All of the above.

26. According to IFRS 15, the asset is transferred to a customer:

(a) When the asset is physically delivered to the customer premises
(b) On the day specified by a contract with the customer ,
(c) When the customer obtain control over it,
(d) On the day when the entity satisfies all performance obligations, specified in the contract with
the customer

27. Which of the following is not specifically excluded from the purview of Ind AS 20?
(a) Government participation in ownership of the entity
(b) Government grants covered by Ind As 41
(c) Government assistance provided in the form of tax benefits
(d) Forgivable loan from the governmentIn the case of non monetary grant,
28. which of the following accountingtreatment is prescribed by Ind AS 20?
(a) Record the asset at replacement cost and the grant at a nominal value
(b) Record the grant at a value estimated by management
(c) Record both the grant and the asset at fair value of the non monetary asset
(d) Record only the asset at fair value, do not recognize the fair value of the grant.

29. The classification of a lease as either an operating or fiancé lease is based on

(a) The length of the lease
(b) The transfer of the risks and rewards of ownership
(c) The minimum lease payments being at least 50% of the fair value
(d) The economic life of the asset.

30. The accounting concept that is principally used to classify leases into operating and finance is
(a) Substance over form
(b) Prudence
(c) Neutrality
(d) Completeness

31. The classification of a lease is normally carried out

(a) At the end of the lease term
(b) After a cooling off period of one year
(c) At the inception of the lease
(d) When the entity deems it to be necessary

32. Which of the following transactions involving the issuance of shares does not come within the
definition of a share based payment under Ind AS 102?
(a) Employee share purchase plans
(b) Employee share option plan
(c) Share based payment relating to an acquisition of a subsidiary
(d) Share appreciation rights

33. Specific principles, bases, conventions, rules and practices applied in presenting
financialstatements, are called
(a) Accounting estimates
(b) Accounting policies
(c) Prospective application

34. Adjustment of the carrying amount of an asset or liability or the consumption of an asset is
defined as:
(a) A change in the accounting estimate
(b) Accounting policies
(c) Misstatements

35. Error includes:

(a) Mathematical mistakes
(b) Mistakes in applying accounting policies
(c) Oversights of misinterpretation of facts
(d) All of the above
36. Applying a new policy transaction as if that policy had always been applied. This is called
(a) Retrospective restatement
(b) Retrospective application
(c) Change in accounting estimates

37. In selecting an accounting policy, we should review

(a) The standard only
(b) The interpretation only
(c) Framework only
(d) All of the above

38. Where should extra ordinary items appear in an entity’s statement of comprehensive income?
(a) Other comprehensive income
(b) Income statement
(c) Notes
(d) Now here

39. Which of the following is not a minimum item on the face of the statement ofcomprehensive
income?
(a) Revenue
(b) Finance cost
(c) Deferred tax
(d) Profit or loss

40. Under Ind AS 1, which of the following must be disclosed on the statement of financial position?
(a) Property, plant and equipment
(b) Biological assets
(c) Provisions
(d) All of the above

41. Which of the following is a cash and cash equivalents?

(a) Cash in hand
(b) Foreign currency in hand
(c) Bank balance
(d) All of the above

42. Cash receipts from customers for the sale of goods are cash flows from :
(a) Operating activities
(b) Investing activities
(c) Operating or financing activities
(d) Financing activities

43. Cash payments to acquire the entity’s own share(ie, treasury shares) are:
(a) Outflows from operating activities
(b) Cash outflows from investing activities
 306
(c) Cash flows from financing activities.

44. The method of accounting for business combination is

(a) Equity method
(b) Acquisition method
(c) Pooling of interest method
(d) None of these School of Distance Education

45. Under Ind AS 103 assets and liabilities are recorded at

(a) Fair value
(b) Book value
(c) Intrinsic value
(d) None of these

46. When the amount paid for the purchase of controlling shares Is more than its proportionate
share of net assets acquired, the difference is accounted as
(a) Non controlling interest
(b) Goodwill
(c) Bargain purchase
(d) None of these

47. The acquire in a business combination is also called

(a) Holding company
(b) Parent company
(c) Subsidiary company
(d) None of these

48. Ind AS 28 deals with

(a) Investment in subsidiary
(b) Investment in parent company
(c) Separate financial statement
(d) Investment in associate and joint ventures.

49. The profit and loss account under double account system is termed as
(a) Revenue account
(b) Income and expenditure account
(c) Profit and loss account
(d) Receipts and payments account

50. Under double account system shares forfeited account is shown in

(a) Credit side of capital account
(b) Credit side of net revenue account\
(c) Credit side of revenue account
(d) Asset side of the general balance sheet

51. Capital redemption reserve is created

(a) Out of security premium account
(b) To meet legal requirements
 307
(c) Out of share forfeited account
(d) Voluntarily

52. Capital redemption reserve account can be utilized for

(a) Issuing fully paid bonus shares
(b) Writing of past losses
(c) Writing of capital losses
(d) Issuing partly paid bonusshares

53. when preference shares are redeemed it amounts to

(a) increasing share capital
(b) decreasing share capital
(c) both A and B
(d) none of these

54. amount due to untraceable share holder may be

(a) shown as current liability in the balance sheet
(b) transferred to profit and loss account
(c) kept as general reserve
(d) transferred to CRR

55. Profit not available for dividend includes

(a) Security premium
(b) Profit and loss account credit balance
(c) CRR
(d) Shared forfeited account

56. Redeemable preference shares can be redeemed by

(a) Selling investment
(b) Borrowing funds from bank
(c) Issue of debentures
(d) Issue of shares

57. Profit available for dividend excludes

(a) Profit and loss account
(b) General reserve
(c) Share forfeited account
(d) Dividend equalization reserve

58. Interest on debenture is

(a) Adjustment of profit
(b) Appropriation of profit
(c) Charge on profit
(d) None of these

59. After all the debentures are redeemed the balance in the sinking fund is transferred to
(a) General reserve
(b) Capital reserve
 308
(c) Profit and loss account
(d) Debentures account

60. When own debentures are cancelled any profit on cancellation is transferred to
(a) General reserve
(b) Capital reserve
(c) Profit or loss
(d) None of these

61. When debentures are bought as own for the purpose of investment, the own debenture account
isdebited with
(a) Face value
(b) Cum interest price
(c) Ex interest price
(d) Face value with premium

62. After realizing all investments the balance in the sinking fund account is transferred to
(a) Profit and loss account
(b) Debenture account
(c) Capital reserve
(d) Sinking fund account

63. Which of the following is not a source of redemption of debentures

(a) Redemption out of capital
(b) Redemption out of borrowing from financial institutions
(c) Redemption out of profit
(d) Redemption by conversion

PART-5

1. . Debenture includes debenture stock, bonds or any other securities of a company whether
constituting a charge on the asseets of the company or [Link]

2. Which of the following statements is true?

(a) A debenture holder is an owner of the company
(b) A debenture holder can get his money back only on the liquidation of the company
(c) A debenture issued at a discount can be redeemed at a premium
(d) A debenture holder receives interest only in the event of profits

3. Which of the following is False:

(a) Debenture is written instrument acknowledging a debt under the common seal of the
company.
(b) Debenture is a part of owned capital.
(c) The payment of interest on debentures is a charge on the profits of the compny.
(d) Redeemable debentures are those debentures, which are payable on the expiry of the
 309
specific period.

4. Which of the following statement is true:

(a) The debentures cannot be issued at a discount of more than 10% of the face value.
(b) Perpetual debentures are also known as irredeemable debentures. True
(c) Debentures cannot be converted into shares.
(d) Debentures cannot be issued at a premium.

5. Loss on issue of debentures account is a revenue loss.

False

6. Premium on redemption of debentures account is shown under the ‘Securities Premium’ in the
Balance Sheet.
False

7. Which of the following statements is false?

(a) A company can issue convertible debentures
(b) Debentures cannot be secured
(c) A company can issue redeemable debentures
(d) Debentures have no right to participate in profits over and above their fixed interest

8. Debenture premium cannot be used to .

(a) Write off the discount on issue of shares or debentures
(b) Write off the premium on redemption of shares or debentures
(c) Pay dividends
(d) Write off capital loss

9. Which of the following statements is false?

(a) At maturity, debenture holders get back their money as per the terms and conditions of
redemption
(b) Debentures can be forfeited for non payment of call money
(c) In company’s balance sheet, debentures are shown under secured loans
(d) Interest on debentures is charged against profits

10. Loss on issue of debentures is treated as .

(a) Intangible asset
(b) Current asset
(c) Current liability
(d) Miscellaneous expenditure

11. Which of the following is not true about debenture stock:

(a) It must be fully paid.
(b) Debenture Stock can be transferred in fraction.
(c) Debenture stock are identified by their distinct number

12. A debenture trust deed is an agreement between the company and the trustees to look
after the interest of debenture holders.
 310
13. True

14. Which of the following is false?

(a) A company can issue irredeemable debentures
(b) A company can issue debentures with voting rights
(c) A company can buy its own shares
(d) A company can buy its own debentures

15. Which of the following is not a characteristic of Bearer Debentures?

(a) They are treated as negotiable instruments
(b) Their transfer requires a deed of transfer
(c) They are transferable by mere delivery
(d) The interest on it is paid to the holder irrespective of identity

16. Which of the following is/are true with respect to debentures?

(a) They can be issued for cash
(b) They can be issued for consideration other than cash
(c) They cannot be issued as collateral security
(d) Both a and b above

17. When debentures are issued as collateral security, the final entry for recording the transaction
in the books is .
(a) Credit debentures a/c. and debit cash a/c.
(b) Debit debenture suspense a/c. and credit cash a/c.
(c) Debit debenture suspense a/c. and credit debentures a/c.
(d) Debit cash a/c. and credit the loan a/c. for which security is given

18. Which of the following is false with respect to debentures?

(a) They can be issued for cash
(b) They can be issued for consideration other than cash
(c) They can be issued as collateral security
(d) They can be issued in lieu of dividends

19. Debentures can be .

I. Mortgage Debentures or Simple Debentures.
II. Registered Debentures Or Bearer Debentures.
III. Redeemable Debentures or Irredeemable Debentures.
IV. Convertible Debentures or Non-convertible Debentures.
(a) Both (I) and (II) above
(b) Both (I) and (III) above
(c) Both (II) and (III) above
(d) All of (I), (II), (III) and (IV) above.

20. Which of the following statements is false?

(a) Debenture is a form of public borrowing
(b) It is customary to prefix debentures with the agreed rate of interest
(c) Debenture interest is a charge against profits
(d) The issue price and redemption value of debentures cannot differ.
 311

21. As per the Companies Act, “Interest accrued and due on debentures” should be shown
Under Debentures.
True

22. Which of the following is true with regard to 10% Debentures issued at a discount of 20%?
(a) The carrying amount of debentures gets reduced each year at a rate of 20%
(b) Issue price and the carrying amount of debentures are equal
(c) At the time of redemption, the debenture holder will be paid the issue price
(d) The face value and the carrying amount of debentures are equal.

23. Which of the following is false?

(a) Equity is owners’ stake and the debenture is a debt
(b) Rate of interest on debentures is fixed
(c) Debenture holders get preferential treatment over the equity holders at the time of liquidation
(d) Interest on debentures is an appropriation of profits.

24. Discount on issue of debentures is a .

(a) Revenue loss to be charged in the year of issue
(b) Capital loss to be written off from capital reserve
(c) Capital loss to be written off over the tenure of the debentures
(d) Capital loss to be shown as goodwill

25. Premium on redemption of debentures account is .

(a) A real account
(b) A nominal account - income
(c) A personal account
(d) A nominal account - expenditure

26. Which of the following is not true about Debenture redemption reserve(DRR):
(a) DDR created @ 50% of the amount of debentures issued before commencement of
redemption.
(b) Withdrawal fromm DRR can be made only after 10% of debenture liability has been redeemed.
(c) DRR is required in case of Fully convertible debenture.
(d) DRR is not required in case of debentures with a maturity period of 18 months or less.

27. When all the debentures are redeemed, balance in the debentures redemption fund account is
transferred to :
(a) Capital reserve,
(b) General reserve,
(c) Profits and loss
(d) appropriation account.

28. Debentures can be redeemed out of:

(a) Profits
(b) Capital
(c) Provisions made for redemption
(d) By converting them into shares or new debentures
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29. Which of the following statements are false if debentures redeemed out of capital:
(a) DRR is not created if debentures are redeemed out of capital
(b) Nominal value of debentures redeemed is not transferred to DRR or General Reserve.
(c) Debentures account is debited and bank account is credited

30. Own debentures are those debentures of the company which:

(a) The company allots to its own promoters,
(b) The company allots to its Director,
(c) The company purchases from the market and keeps them as investments.

31. Premium on redemption of debentures is transferred to sinking fund.

True

32. Profit on cancellation of own debentures is transferred to :

(a) Profit and loss appropriation a/c,
(b) Debenture redemption reserve,
(c) Capital reserve.

33. When debentures are redeemed out of profits, an equal amount is transferred to :
(a) General reserve,
(b) Debenture redemption reserve,
(c) Capital reserve.

34. Profit on sale of debenture redemption fund investments in the first instance is credited to :
(a) Debenture redemption fund account,
(b) Profit and loss appropriation account,
(c) General reserve account.

35. The balance of sinking fund investment account after the realisation of investments is
transferred to:
(a) Profit and loss account,
(b) Debentures account,
(c) Sinking fund account.

36. Excess value of net assets over purchase consideration at the time of purchase of business is
credited to :
(a) General reserve,
(b) Capital reserve,
(c) Vendors’ account
(d) Goodwill

37. Excess value of Purchase consideration over net assets at the time of purchase of business is
credited to :
(a) General reserve,
(b) Capital reserve,
(c) Vendors’ account
(d) Goodwill
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PART- 6

SOME ONE LINEAR QUESTION –

1. Special donations are carried to the… of the balance sheet.
Ans. liabilities side

2. Any profit on the sale of a cricket bat of a club will be taken to……….
Ans. income and expenditure account

3. Cash paid to creditors can be calculated from…………..

Ans. creditors accountUnder the net worth methodof single entry the net profit is calculated by
comparing

4. capital in the beginning and capital………….

Ans: at the end

5. Credit sales is computed from….......

Ans. total creditors account

6. Capital in the beginning is ascertained from ………….

Ans. opening balance sheet.

7. Bills receivable endorsed but dishonoured is debited to ……………

Ans. debtors account

8. Bills receivable received during the year is credited to ………….

Ans. debtors' account

9. Bills receivable as endorsed is debited to …………..

Ans. creditors' account

10. Bills payable honoured during the year will be debited to ……………
Ans. bills payable account

11. Bills payable dishonoured during the year will be credited to—
Ans. creditors account.

12. The amount of interest is credited by the buyer to……………...

Ans. vendor account

13. The depreciation in the books of buyer is charged on……………..

Ans. the cash price

14. Stock at the shop is debited to ………………

Ans. shop stock account

15. The goods with customers are transferred from stock in shop account……….
Ans. at hire-purchase price
16. If the rate of gross profit for department X is 25% of the cost and its sales amount to
Rs.1,00,000, then the amount of gross profit will be equal to…………
Ans. Rs. 20,000

17. Repairs to machines in different departments are to be allocated on the basis of…....
Ans: actual cost

18. Under debtors system, the branch account is……………..

Ans. nominal account.

19. Petty expenses paid by the branch out of petty cash maintained on imprested system will be
shown on the branch account.
Ans. debit side

20. Under the branch trading and profit and loss account system, the branch account is of the
nature of …………….
Ans. personal account

21. Under trading and profit and loss system, the remittances made to the branch are…to the
branch account
Ans. Credited

22. Under trading and profit and loss system, the profits of a branch are…branch account
Ans. debited to branch account

23. The difference of the two sides of the branch account, under branch trading and profit and loss
account system, shows from the branch.
Ans. amount due

24. Branch adjustment account is in the nature of………..

Ans. nominal account

25. If the branch has collected money from a customer of the head office, then (in the head office
books) branch account is………..
Ans. debited

26. In case of foreign branches, the remittances to and from head office should be
convertedat……………
Ans. actual rate at which the remittances were made.

27. Cash remitted by branch but not received by the head office is debited by the head office
to………………
Ans. cash-in-transit account.
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28. Goods sent by the head office to the branch not received by the branch are credited by H.O.
to………………
Ans. branch account

29. Goods sent by branch x to branch y, will be debited to………………

Ans. branch y

30. Closing stock + cost of goods sold—Purchases =…………………

Ans. opening stock

31. The main object of the average clause is to discourage……………..

Ans. under insurance

32. Under the average clause, the loss is suffered by both insurer and insured ………
Ans. in the ratio of risk covered

33. Royalty account is in the nature of………..

Ans. nminal account

34. If the right to recoup the shortcomings has expired, they are transferred by the lessee to…………
Ans. Profit and loss account

35. The receipts and payments account records receipts and payments of both apital and nature.
Ans. revenue

36. Income and Expenditure accunt is a …………………Ans. nominal accountThe income and
expenditureaccount begins with …………….
Ans. no balance

PART-7

1. The balance of royalty‟s receivable account is transferred to —

(i) Profit and loss account
(ii) Royalties suspense account
(iii) Production account.
Ans.(i) Profit and loss account

2. Under the double account system, the profit and loss account is called—
(i) Profit and loss account
(ii) Income and expenditure account
(iii) Revenue account.
Ans.(iii) Revenue account.
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3. Under the double account system, the profit and loss appropriation account is called —
(i) Net revenue account
(ii) Profit and loss appropriation account
(iii) Profit and loss account.
Ans. (i) Net revenue account

4. The depreciation on the fixed assets, under the double account system, is shown as—
(i) Depreciation reserve on the liabilities side of the general balance sheet
(ii) A deduction from the fixed assets
(iii) An expenditure on capital account in the first section of the balance sheet.
Ans. (i) Depreciation reserve on the liabilities side of the general balance sheet

5. Under the double account system, interest on debentures is shown in—

(i)Revenue account
(ii) Net revenue account
(iii) Profit and loss account.
Ans.(ii) Net revenue account

6. Share forfeited account is shownon—

(i) Liabilities side of the general balance sheet
(ii) Credit side of the net revenue account
(iii) Credit side of the receipts and expenditures on capital account
Ans.(iii) Credit side of the receipts and expenditures on capital account

7. A fixed asset originally acquired for Rs. 20,000 is to be replaced by new one. The estimated cost
of replacement of the original asset is Rs. 30,000. Hence, the revenue charge equals —
(i) Rs. 20,000
(ii) Rs. 10,000
(iii)Rs. 30,000.
Ans. (iii) Rs. 30,000.

8. A fixed asset originally acquired for Rs. 20,000 is replaced by a new asset costing Rs. 50,000.
But the estimated cost of replacement of the original asset is B Rs. 30,000. Hence, the capital
charge equals—
(i) Rs. 20,000
(ii) Rs. 50,000
(iii) Rs. 30,000.
Ans.(i) Rs. 20,000

9. A fixed asset originally acquired for Rs. 20,000 is replaced by a new asset. The estimated cost
of the replacement of the original asset is Rs. 30,000. The sale proceeds of old material
amounted to Rs. 2,[Link], the revenue charge equals
(i) Rs. 28,000
(ii) Rs. 18,000
(iii) Rs. 30,000.
Ans.(i) Rs. 28,000
10. Plant and machinery is shown on the—
(i) Assets side of the general balance sheet
(ii) Expenditure side of the receipts and expenditures on capital account
(iii) Receipts side of the receipts and expenditures on capital account.
Ans.(ii) Expenditure side of the receipts and expenditures on capital account

11. The value of goodwill, according to the simple profit method, is—
(i) The product of current year's profit and number of years
(ii) The product of last year's profit and number of years
(iii) The product of average profits of the given years and number of years.
Ans.(iii)The product of average profits of the given years and number of years.

12. The goodwill of a business is to be valued at 3 years' purchase of the average profits of the last
three years. The profits of the last three years are Rs. 5,000, Rs. 6,000 and Rs. 7,000
respectively. Hence, the goodwill be valued at—
(i) Rs. 18,000
(ii) Rs. 12,000
(iii) Rs. 15,000.
Ans. (i) Rs. 18,000

13. A business has a capital of Rs. 40,000 at the end. It had earned profits of Rs. 5,000 during the
year. Hence, the average capital of the business will be —
(i) Rs. 42,500
(ii) Rs. 37,500
(iii) Rs. 35,000.
Ans.(ii)Rs. 37,500

14. If the average capital of a business is Rs. 60,000 and the normal rate of profit is 15%, then the
normal profits will amount to—
(i) Rs. 10,000
(ii) Rs. 9,000
(iii) Rs. 15,000.
Ans.(ii) Rs. 9,000

15. If the super-profits of a business are Rs. 6,000 and the normal rate of profit is 10%, then the
amount of goodwill as per the capitalisation method will be—
(i) Rs. 60,000
(ii) Rs. 600
(iii) Neither of the two.
Ans.(i)Rs. 60,000

16. It is given that net assets available for equity and preference shares amount to Rs. 90,000. The
paid up capitals are 10,000 equity shares of Rs. 2 each and 5,000 preference shares of Rs. 10
each. Therefore, value of an equity share will be—
(i) Rs. 2 per share
(ii) Rs. 4 per share
(iii) Rs. 5 per share.
Ans.(ii) Rs. 4 per share

17. It is given that net assets available for equity and preference shares amount to Rs. 1,87,000.
The paid-up capitals are—10,000 equity shares of Rs. 4 each and 5,000 preference shares of Rs.
10 each. Therefore, value of a preference share will be—
(i) Rs. 10 per share
(ii) Rs. 8 per share
(iii) Rs. 20 per share.
Ans.(iii) Rs. 20 per share.

18. Under the yield method of valuation of equity share capital, if for an equity share of Rs. 50, the
normalrate of return is 10% and the expected rate of return is 5%, then the value of an
equity share will be—
(i) Rs. 25
(ii) Rs. 50
(iii) Rs. 100.
Ans.(i) Rs. 25

19. For calculating the value of an equity share by intrinsic value method, it is essential to know—
(i) Normal rate of return
(ii) Expected rate of return
(iii) Net equity.
Ans.(iii) Net equity.

20. For calculating the value of an equity share by yield method, it is essential to know—
(i) Expected rate of return
(ii) Called-up equity share capital
(iii) Capital employed.
Ans. (i) Expected rate of return

21. For calculating price-earnings ratio, it is essential to know—

(i) Market value per share
(ii) Nominal value per share
(iii) Paid-up value per share.
Ans.(i) Market value per share

22. For calculating the value of an equity share by earning capacity method, it is essential to know
—
(i)Nominal value per share
(ii) Rate of earning
(iii) Dividend per share.
Ans.(ii) Rate of earning

23. A Ltd. and B Ltd. go into liquidation and a new company X Ltd. is formed. It is a caseof—
(i) Absorption
(ii) External reconstruction
(iii) Amalgamation.
Ans.(iii) Amalgamation.
24. X Ltd. goes into liquidation and a new company Z Ltd. is formed to take over the business of X
Ltd. It is a case of—
(i) Absorption
(ii) External reconstruction
(iii) Amalgamation.
Ans.(ii) External reconstruction

25. X Ltd. goes into liquidation and an existing company Z Ltd. purchases the business of X Ltd. It
is a case of—
(i) Absorption
(ii) External reconstruction
(iii) Amalgamation.
Ans.(i) Absorption

26. Accumulated profits include—

(i) Provision for doubtful debts
(ii) Superannuation fund
(iii) Workmen's compensation fund.
Ans.(iii) Workmen's compensation fund

27. When the expenses of liquidation are to be borne by the vendor company, then the vendor
company debits—
(i) Realisation account
(ii) Bank account
(iii) Goodwill account.
Ans. (i) Realisation account

28. When the expenses of liquidation are to be borne by the purchasing company, then the
purchasing company debits—
(i) Vendor company's account
(ii) Bank account
(iii) Goodwill account.
Ans. (iii) Goodwill account.

29. When the purchasing company makes payment of the purchase consideration, it debits—
(i) Business purchase account
(ii) Assets account
(iii) Vendor company's account.
Ans. (iii) Vendor company's account.

30. The vendor company transfers preliminary expenses (at the time of absorption) to—
(i) Equity shareholders' account
(ii) Realisation account
(iii) Purchasing company's account.
Ans. (i) Equity shareholders' account
31. For paying liabilities not taken over by the purchasing company, the vendor company credits—
Realisation account
(i) Bank account
(ii) Liabilities account.
Ans.(ii) Bank account

32. In case of inter-company holdings, the purchasing company, at the time of payment of the
purchase consideration, surrenders the shares in the vendor company by crediting—
(i) Vendor company's account
(ii) Shares in the vendor company account
(iii) Share capital account.
Ans.(ii) Shares in the vendor company account

33. The share capital, to the extent already held by the purchasing company, is closed by the vendor
company by crediting it to—
(i) Share capital account
(ii) Purchasing company's account
(iii) Realisation account.
Ans.(iii) Realisation account.

34. In case of sub-division of share capital the total number of shares—

(i) Increases
(ii) Decreases
(iii) Does not change.
Ans.(i) Increases

35. If the shares of smaller denomination-are converted into the shares of higher denomination
without changing the total amount of share capital, then it is a case of—
(i) Consolidation of share capital
(ii) Sub-division of share capital
(iii) Decrease in unissued share capital.
Ans.(i) Consolidation of share capital

36. When a company converts its equity shares into the capital stock, then the account to be
creditedis—Equity share capital account
(i) Equity capital stock account
(ii) No entry is required.
Ans.(ii) Equity capital stock account

37. A Ltd. with a share capital of 10,000 equity shares of Rs. 10 each fully paid decides to repay Rs.
5 per share thus making each share of Rs. 5 fully paid. It is a case of—
(i) Reducing share capital by returning the excess capital
(ii) Reducing the liability on account of uncalled capital
(iii) Reducing the paid-up capital.
Ans.(i) Reducing share capital by returning the excess capital
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38. For writing off the accumulated Josses under the scheme of capital reduction, we debit—
(i) Share capital account
(ii) Accumulated losses account
(iii) Capital reduction account.
Ans.(iii) Capital reduction account.

39. If there is any balance in the capital reduction account after writing off all the accumulated
losses, then the same is transferred to —
(i) Share capital account
(ii) Capital reserve account
(iii) General reserve account.
Ans.(ii) Capital reserve account

40. A company has issued capital of 10,000 equity shares of Rs. 10 each fully paid. It decides to
convert its capital into 20,000 equity shares of Rs. 5 each. It is a case of
(i) Consolidation of share capital
(ii) Sub-division of share capital
(iii) Decrease in unissued share capital.
Ans.(ii) Sub-division of share capital

41. If the creditors are willing to reduce their claims against the company, (henthe amount of
reduction in their claim will be transferred to
(i) Share capital account
(ii) Creditors account
(iii) Capital reduction account.
Ans.(iii) Capital reduction account.

42. Any loss on revaluation of the assets at the time of internal reconstruction, will be charged
from—
(i) Revaluation account
(ii) Share capital account
(iii) Capital reduction account.
Ans.(iii) Capital reduction account.

43. A contingent liability, not provided for, materialised to the extent of Rs. 1,000. The insurance
company paid Rs. 600 in respect of this liability. Hence, the amount to be charged from the
capital reduction account will be —
(i) Rs. 600
(ii) Rs. 400
(iii) Rs. 1,000.
Ans.(ii) Rs. 400

44. A banking company can pay dividend on its shares without writing off —
(i) Preliminary expenses
(ii) Brokerage
(iii) The bad debts (provided adequate provision has been made).
 322
Ans.(iii) The bad debts (provided adequate provision has been made).

45. It is given that the paid-up capital, reserves and share premium account have balances
amounting to Rs. 10,00,000 Rs. 9,00,000 and Rs. 1,50,000 respectively. It is also given that the
profits of the company for the current year are Rs. 1,00,000. ft should make a transfer of—
Rs. 30,000 to statutoryreserve
(i) Rs. 25,000 to statutory reserve
(ii) May be exempted from making such transfer.
(iii) Ans.(iii) May be exempted from making such transfer.

46. Provision for bad debs and doubtful debts is —

(i) Not shown anywhere in the published accounts of a banking company
(ii) Shown on the debit side of the profit and loss account
(iii) Shown as a deduction from the interest and discount income on the credit side of profit and
loss account.
Ans.(i) Not shown anywhere in the published accounts of a banking company

47. Rebate on biffs discounted account is a—

(i) Real account
(ii) Personal account
(iii) Nominal account.
Ans.(ii) Personal account

48. If the balance of rebate on bills discounted is given in the trial balance, it will be taken to —
(i) Debit side of the profit and Joss account
(ii) Credit side of the profit and loss account as a deduction from interest and discount
(iii) Liabilities side of the balance-sheet.
Ans.(iii) Liabilities side of the balance-sheet.

49. Money at call and short notice is shown—

(i) On the liability side of the balance sheet
(ii) On the asset side of the balance sheet
(iii) It is a contra item.
Ans.(ii) On the asset side of the balance sheet

50. Provision for taxation is shown—On the debit side of the profit andloss account
(i) As a deduction from interest and discount on the credit side of the profit and loss account
(ii) On the asset side of the balance sheet.
Ans. (ii) As a deduction from interest and discount on the credit side of the profit and loss account

51. Loans, cash credits and overdrafts are shown—

(i) On the asset side of the balance sheet
(ii) On the liability side of the balance sheet
(iii) These are contra items.
Ans.(i) On the asset side of the balance sheet

52. Bills discounted and purchased are shown—

(i) On the asset side of the balance sheet
 (ii) On the liability side of the balance sheet
(iii) Neither of the two sides.
Ans.(i) On the asset side of the balance sheet

53. Deposits and other accounts are shown —

(i) On the asset side of the balance sheet
(ii) On the liability side of the balance sheet
(iii) These are contra items.
Ans.(ii) On the liability side of the balance sheet

54. A general insurance company carrying on two or more types of business prepares only—
(i) Revenue accounts in respect of different businesses
(ii) Profit and loss account (including appropriation account)
(iii) Separate revenue accounts for each type of business and combined profit and loss account.
Ans.(iii) Separate revenue accounts for each type of business and combined profit andloss account.

55. Reserve for unexpired risks appearing outside the trial balance under adjustments is—
(i) Shown on the debit side of the revenue account and liabilities side of the balance sheet
(ii) Shown on the credit side of the revenue account and asset side of the balance sheet
(iii) Shown as a contra item in the balance sheet.
Ans. (i) Shown on the debit side of the revenue account and liabilities side of the balance sheet

56. Reinsurance premium is shown—

(i) On the debit side of revenue account
(ii) On the liability side of the balance sheet
(iii) As deduction from the premiums on the credit side of the revenue account.
Ans.(iii) As deduction from the premiums on the credit side of the revenue account.

57. Expenses of management (not applicable to any particular business) are shown in—
(i) Revenue account
(ii) Profit and loss account
(iii) Profit and loss appropriation account.
Ans.(ii) Profit and loss account

58. Transfer fees are credited to—

(i) Revenue account
(ii) Profit and loss account
(iii) Profit and loss appropriation account.
Ans.(ii) Profit and loss account

59. Legal fees in respect of claims are shown in—

(i) Revenue account
(ii) Profit and loss account
(iii) Profit and loss appropriation account.
Ans.(i) Revenue accountIt is given that claims paid during the year amounted to Rs. 1,00,000. The
claimsoutstanding in

60. the beginning and at the end were Rs. 15,000 and Rs. 10,000 respectively. Hence, the amount to
 324
be debited to revenue account will be—
(i) Rs. 1,00,000
(ii) Rs. 1,15,000
(iii) Rs. 95,000.
Ans.(iii) Rs. 95,000.

61. It is given that additional reserve for unexpired risks was Rs. 50,000 in the beginning of the year.
The net premium for the current year were Rs. 4,00,000 and the additional reserve for unexpired
risks was to be increased by 5% of the net premiums. Hence, the amount of the additional
reserve will be—
(i) Rs. 20,000
(ii) Rs. 50,000
(iii) Rs. 70,000.
Ans.(iii) Rs. 70,000.

62. It is given that the balance being profit of the last year amounted to Rs. 80,000. During the
current year, the business suffered a loss of Rs. 20,000 and dividends amounting to Rs. 15,000
were paid in respect of the previous year. Hence, the profit and loss appropriation account will
be credited by—
(i) Rs. 65,000
(ii) Rs. 45,000
(iii) Rs. 80,000.
Ans.(i) Rs. 65,000

63. It is given that premiums, reinsurance premiums and commission on reinsurance ceded
amounted to Rs. 10,00,000, Rs. 50,000 and Rs. 30,000 respectively. Hence, premiums will be
shownin the revenue account at—
(i) Rs.10,00,000
(ii) Rs. 9,50,000
(iii) Rs. 9,20,000.
Ans.(ii) Rs. 9,50,000

100. Postulates of Accounting are:

(i) Exchange
(ii) Period
(iii) Unit of measure
(iv) All of these
Ans.(iv) All of these

101. Meaning of Net Assets is :

(i) Total Assets − Total Liabilities
(ii) Fixed Assets + Current Assets
(iii) Total Assets − Current Liabilities
(iv) Total Assets − Outside Liabilities
Ans.(iv) Total Assets − Outside Liabilities

102. Valuation of closing stock is to be made:

(i) on cost price
 325
(ii) on market price
(iii) cost price or market price, whichever is less
(iv) None of these
Ans.(iii) cost price or market price, whichever is less

103. According to the cost concept, the assets are always valued at :
(i) on cost price
(ii) on market price
(iii) on purchase priceNone of these
Ans.(iii) on purchase price

Under Hire Purchase System depreciation ischarged :On cash price

(i) Hire purchase price
(ii) Market price
(iii) None of these
Ans.(i) On cash price

104. Hirer charges depreciation on:

(i) Hire purchase price
(ii) Cash price.
(iii) Lower of the two
(iv) None of these
Ans.(ii) Cash price.

105. What is transferred to Hirer under hire purchase system :

(i) Ownership of assets
(ii) Possession of asset
(iii) Ownership and possession of asset
(iv) None of these
Ans.(ii) Possession of asset

106. Hire Purchase Act is :

(i) 1932
(ii) 1956
(iii) 1972
(iv) 1872
Ans.(iii) 1972

107. (92) The Sale of Goods Act is applicable in:

(i) Credit Purchases
(ii) Cash Purchases
(iii) Cash Sales
(iv) None of these
Ans.(i)Credit Purchases

108. What is transferred to Hirer under Instalment Paymentsystem :Ownership of Assets

(i) Possession of Assets
(ii) Ownership and Possession of assets
 (iii) None of these.
Ans.(iii) Ownership and Possession of assets

109. Branch Adjustment Account is prepared:

(i) By Dependent Branch
(ii) By H.O. of Dependent Branch
(iii) By H.O. of Independent Branch
(iv) None of these
Ans.(ii) By H.O. of Dependent Branch

110. Which account is prepared to find out the amount of closing stock:
(i) Head Office A/c
(ii) Branch A/c
(iii) Memorandum Stock A/c
(iv) None of these
Ans.(iii) Memorandum Stock A/c)

111. Branch account under debtor system is:

(i) Real account
(ii) Personal account
(iii) Nominal account
(iv) None of these
Ans.(iii) Nominal account

112. Branch Adjustment account is in the nature of :

(i) Real account
(ii) Nominal account
(iii) Personal account
(iv) None ofthese
Ans.(ii) Nominal account

113. In foreign branch fixed assets shall be converted at:

(i) Opening rate
(ii) Average rate
(iii) Rate of the date of purchase
(iv) None of these
Ans.(i) Opening rate

114. By what rate the balance of H.O. a/c is converted in foreign branch :
(i) Opening rate
(ii) Closing rate
(iii) Average rate
(iv) None of these
Ans.(iv) None of these

115. The Gross Profit of a business being Rs. 3 lakh and the amount of loss of Profit Policy being
Rs.1,50,000 then the claim for loss Rs. 20,000 will reduce to :
(i) Rs. 12,000
 (ii) (ii)Rs. 15,000
(iii) Rs. 20,000
(iv) None of these.
Ans.(ii) Rs. 15,000

116. Loss of Profit Policy indemnity :

(i) Capital Loss
(ii) Revenue Loss
(iii) Budgeted Loss
(iv) Gross Loss.
Ans.(iii) Budgeted Loss

117. The value of closing stock Rs. 72,000, the amount of the Policy was Rs. 63,000, theActual loss
of stock Rs. 54,000, there was an average clause in the Policy. Calculate the amount of claims:
(i) Rs. 47,250
(ii) (ii)Rs. 54,000
(iii) (iii)Rs.72,000
(iv) None of these
Ans.(i) Rs. 47,250

118. The rate of Gross Profit on sales is 20%. Sales up to date of fire amounted to Rs. 1,00,000. Find
Amount of Gross Profit:
(i) Rs. 20,000
(ii) Rs. 25,000
(iii) (iii)Rs. 50,000
(iv) None of these
Ans.(i) Rs. 20,000

119. The rate of Gross Profit on cost of sales is 25%. Sales up to date of fire amounted to Rs.
1,00,000. Find amount of Gross Profit:
(i) Rs. 20,000
(ii) Rs. 25,000
(iii) Rs. 50,000
(iv) None of these
Ans.(i) Rs. 20,000

120. Excess of assets over liabilities is called :

(i) Creditors
(ii) Profit
(iii) Capital
(iv) Goodwill
Ans.(iii) Capital

121. Amount of Drawings is added at the time of finding out profit in single entrysystem:
(i) In closing capital
(ii) In opening capital
(iii) Not in any capital.
Ans. (i) In closing capital
 328

122. The amount of additional capital is deducted at the time of finding out profit in Single Entry
System:
(i) from closing capital
(ii) from opening capital
(iii) not from any capital.
Ans.(i) from closing capital

123. Following records are made in single entry system, give correct answer:
(i) Only in cash book
(ii) In ledger, posting of personal accounts only
(iii) records in cash book and posting of only personal accounts in ledger.
Ans.(iii). records in cash book and posting of only personal accounts in ledger.

124. Meaning of single entry system of Book-keeping is:

(i) Only one entry for each transaction.
(ii) Incomplete double entry system
(iii) Both entries only in accounts
Ans.(ii). Incomplete double entry system

125. Single entry system of book-keeping system:

(i) is best system
(ii) is scientific system
(iii) is incomplete system
(iv) is most popular system.
Ans.(iii) is incomplete system

126. Liabilities and assets respectively are Rs. 87,000 and Rs. 92,000. Amount ofdifference will be:
(i) Creditors
(ii) Debentures
(iii) Profit
(iv) Capital
(v) None out of these.
Ans.(iv) Rs. 5,000 Capital.

127. To find out the opening and closing capitals, statement of affairs are prepared:
(i) One
(ii) Two
(iii) Four.
Ans.(ii) Two.

128. The expenses which are not departmental:

(i) are charged to departments in sales ratio.
(ii) are charged to departments in the ratio of assets employed thereto.
(iii) are charged to general profit and loss account.
Ans. (iii) are charged to general profit and loss account.
 329

129. Cum-dividend quotation of shares means that the quotation includes:

(i) dividend which may be declared in future.
(ii) dividend declared recently but not yet paid.
(iii) nothing else but the price of the share.
Ans. (ii) dividend declared recently but not yet paid.

130. Interest is calculated on:

(i) market price of securities
(ii) purchase price of securities
(iii) book value of securities
(iv) face value of securities.
Ans.(iv) face value of securities.

PART-8

1. Preparation of consolidated Balance Sheet of Holding Co. and its subsidiary company as per
(a) As 11
(b) AS – 22
(c) AS 21
(d) AS – 23

2. The share of outsiders in the Net Assets in subsidiary company is known as under :
(a) outsiders liability
(b) Assets
(c) subsidiary company's liability
(d) Minority Interest

3. Pre-acquisition profit in subsidiary company is considered as :

(a) Revenue profit
(b) Capital profit
(c) Goodwill
(d) Non of the above

4. Excess of cost of investment over paid up value of the shares is considered as:
(a) Goodwill
(b) Capital Reserve
(c) Minority Interest
(d) Non of above

5. Excess of paid up value of the shares over cost of investment is considered as:
(a) Goodwill
(b) Capital Reserve
(c) Minority Interest
(d) Non of above

6. Profit earned before acquisition of share is treated as

 330
(a) Capital profit
(b) Revenue profit
(c) General Reserve
(d) Revaluation Loss

7. Profit earned after acquisition of share is treated as

(a) Capital profit
(b) Revenue profit
(c) General Reserve
(d) Revaluation Loss

8. Preparation of consolidated statement as per AS 21 is

(a) Optional
(b) Mandatory for listed Companies
(c) Mandatory for Pvt. Ltd.
(d) Companies Ltd. partnership firm

9. Holding Co. share in capital profits of subsidiary company is adjusted in :

(a) Cost of control
(b) Shown on Assets side of Balance sheet
(c) Revenue profit
(d) None of above

10. Holding Co. share in revenue profits of subsidiary company is adjusted in :

(a) a. Cost of control
(b) Shown on Assets side of Balance sheet
(c) Profit and loss account
(d) None of above…

11. . Unrealised profit on goods sold and included in stock is deducted from :
(a) Capital Profit
(b) Revenue Profit
(c) Fixed Assets
(d) Minority interest

12. Face value debentures of subsidiary co. held by Holding Company is deducted from :
(a) Debentures
(b) Cost of control
(c) Minority interest
(d) Debentures in consolidated balance sheet

13. Which of the following statement is true:

(a) There is no change in the amount of capital reserve before and after issue of bonus share
of the issue is made from out of pre-acquisition profit.
(b) There is change in the amount of capital reserve before and after issue of bonus share of
the issue is made from out of post-acquisition profit.
(c) There is change in the amount of capital reserve before and after issue of bonus share of
the issue is made from out of pre-acquisition profit.
 331
(d) There is no connection between the issue of bonus shares and the calculation of capital
reserve.

14. Consolidated financial statements are prepared on the principle:

(a) In form the companies are one entity; in substance they are separate.
(b) In form the companies are separate; in substance they are one.
(c) In form and substance the companies are one entity.
(d) In form and substance the companies are separate.

15. Minority Interest includes

(a) Share in share capital
(b) Share in Capital profit
(c) Share in Revenue profit
(d) All of the above

16. The Time interval between the date of acquisition of shares in subsidiary company and date of
Balance Sheet of Holding Company is known as :
(a) Pre-acquisition period
(b) Post-acquisition period
(c) Pre-commencement period
(d) Pre-incorporation period.

17. Pre-acquisition dividend received by Holding company is credited to

(a) profit & loss A/c
(b) Capital profit
(c) Investment A/c
(d) non of the above

18. Post Acquisition dividend received by Holding Company is debited to :

(a) Bank A/c
(b) profit & loss A/c
(c) Dividend A/c
(d) Investment A/c

19. Which Exchange rate will be considered for conversion of share capital of subsidiary company.
(a) Opening Rate
(b) closing rate
(c) Average Rate
(d) Rate of which date share acquired (actual)

20. A subsidiary company shall be excluded from consolidation when:

(a) Control is intended to be temporary
(b) It operates under severe long-term restrictions which significantly impair its ability to
transfer funds to the parent
(c) Always included for consolidation
(d) Both a and b.
 332

PART-9

1. Costing is a technique of
(a) Inventory control
(b) Management control
(c) Ascertainment of cost
(d) Calculation of cost
(e) Reduction of cost

2. Cost accounting has been developed because of financial accounting.

(a) limitations
(b) expenditure
(c) statutory requirements
(d) both (a) and (b)
(e) None of these

3. Cost accountancy is the science, art and of cost accountant.

(a) Profession
(b) Management
(c) Administration
(d) Practice
(e) All of these

4. In automobile industry cost unit is

(a) Number
(b) Automobile quality
(c) Number of automobile industry
(d) Either (a) or (c)
(e) None of these

5. Cost unit in a college may be

(a) teacher
(b) Non teacher staff
(c) Student
(d) Number of departments
(e) None of these

6. costing is suitable for mines, quarries, cement works etc.

(a) Process
(b) Contract
(c) Batch
(d) Operation
(e) Job

7. is an extension of job costing.

(a) Process costing
(b) Batch costing
 333
(c) Contract costing
(d) Operation costing
(e) None of these

8. When job is very big and spread over long periods of time the method of costing adopted is
(a) Process
(b) Job
(c) Contract
(d) Operation
(e) Batch

9. Continuous costing is also called

(a) Operation costing
(b) Process costing
(c) Batch costing
(d) Contract costing
(e) None of these

10. The main types of costing for ascertaining costs do not include
(a) Uniform costing
(b) Standard costing
(c) Marginal costing
(d) Historical costing

11. Cost accounting is based on figures.

(a) Approximated
(b) Estimated
(c) Historical
(d) Either (a) or (c)
(e) None of these

12. costing is used in transport undertaking.

(a) Operating
(b) Standard
(c) marginal
(d) Absorption
(e) Service

13. In costing the cost of a group of products is ascertained.

(a) Process
(b) Job
(c) Batch
(d) Service
(e) Marginal

14. The total of all direct expenses Is known as

(a) Total cost
(b) Overhead
 334
(c) Prime cost
(d) Work cost
(e) None of these

15. Work cost is the total of

(a) Direct cost
(b) Indirect cost
(c) Variable cost
(d) Controllable cost
(e) Uncontrollable cost

16. Opportunity cost does not involve

(a) Cash inflow
(b) Cash outflow
(c) Cash outlay
(d) Either (a) or (b)
(e) None of these

17. Depreciation is expenditure.

(a) variable
(b) Fixed
(c) Direct
(d) Indirect
(e) Semi-variable

18. Out of pocket payment involves payment to

(a) Managers
(b) Promoters
(c) Directors
(d) Shareholders
(e) Outsiders

19. Value added is the change in

(a) Face value
(b) Market value
(c) Book value
(d) Realizable value
(e) None of these

20. The two aspects of material control are accounting aspect and aspect.
(a) Financial
(b) Economic
(c) C) social
(d) Operational
(e) None of these

21. Material control aims at achieving effective management.

(a) Marketing
 335
(b) Production
(c) Organization
(d) Material
(e) None of these

22. Stores ledger is maintained in the department.

(a) Cost accounting
(b) Stores
(c) Purchase
(d) Production
(e) None of these

23. Bin card is a record of only.

(a) Quality
(b) quanity
(c) Numbers
(d) Value
(e) None

24. Bin card is maintained by

(a) Purchase department
(b) Production department
(c) Marketing department
(d) Stores keeper
(e) None of these

25. With regard to break –even charts and break-even analysis, which of the following is true ?
(a) It is assumed that variable cost fluctuates in direct proportion to output
(b) The break the break-even point is at the intersection of the sales line and the variable cost line
(c) A break-even chart shown the maximum profit possible
(d) A break-even chart is capable of dealing with any change of product mix

26. The following data relate to two output levels of a department : Machine hours 17,000 18,500
Overheads (`) 2, 46,500 2,51,750
The variable overhead rate per hour is ` 3.50. The amount of fixed overheads is:
(a) 5,250
(b) 59,500
(c) 1,87,000
(d) 2, 46,500

27. The following data relate to two activity levels of an out-patients‘department in a hospital : No. of
consultations per patient 4,500 5,750
Overheads ` 2,69,750 ` 2,89,125
Fixed overheads are ` 2,00,000 per period. The variable cost per consultation is
(a) 15.50
(b) 44.44
(c) 59.94
(d) none of the above
 336

28. Break-even analysis assumes that over the relevant range:

(a) Total costs are unchanged
(b) Unit variable costs are unchanged
(c) Variable costs are non-linear
(d) Unit fixed costs are unchanged

29. ABC Ltd. Has fixed costs of ` 60,000 p.

(a) a.. It manufactures a single product, which it sells for ` 20 per unit. Its contribution to sales
ratio is 40%. ABC Ltd‘s break-even point in units is : sts of `
(b) 3,000
(c) 5,000
(d) 7,500

30. Sun Ltd. Makes a single product which it sells for ` 10 per unit. Fixed costs are ` 48,000 per month
and the product has a contribution to sales ratio of 40%. In a period when actual sales were
` 1, 40,000. Sun Ltd.‘s margin of safety in units was :
(a) 2,000
(b) 6,000
(c) 8,000
(d) 12,000

31. A company produced 500 units of a product and incurred the following costs: ` Direct materials
8,000 Direct wages 10,000 Overheads (20% fixed) 45,000 If the sales value of 500 units was `
1,02,000, what is contribution margin ?
(a) 44%
(b) 47%
(c) 53%
(d) 74%

32. -If fixed costs increased by ` 31,500 with no other cost or revenue factors changing, the break-
even sales in units would be :
(a) 34,500
(b) 80,500
(c) 69,000
(d) 94,500

33. If Happy Ltd. Is subject to an effective income tax rate of 40%, the number of units Happy Ltd.
Would have to sell to earn an after-tax profit of ` 90,000 is :
(a) 1,00,000 units
(b) 1,20,000 units
(c) 1,12,000 units
(d) 1,45,000 units

34. Selling a product at a price equivalent to or below marginal cost is recommended for a short
period in certain special circumstances, such as
(a) Introducing a new product
 337
(b) Exploring foreign market
(c) Driving out a weaker competitor
(d) All of the above

35. Which of the following is not a relevant cost information in a make or buy decision?
(a) Variable cost of making
(b) General fixed cost
(c) Purchase price
(d) Loss of contribution to make the product

36. Which of the following factors are not qualitative factors in a make or buy decision ?
(a) Doubt as to the ability of the subcontractor to meet delivery dates
(b) Doubt as to ability of the subcontractor to maintain quality
(c) The case with which improvements can be made to the product
(d) The effect of redundancy on labour relations

37. Raymond Corporation estimates factory overhead of ` 345,000 for next fiscal year. It is
estimated that 60,000 units will be produced at a material cost of `575,000. Conversion will require
34,500 direct labor hours at a cost of ` 10 per hour, with 25,875 machine hours.
FOH rate on the bases on Budgeted Production would be?
(a) per unit
(b) per unit
(c) per unit
(d) per unit

38. In a shutdown decision, one has to consider :

(a) Contribution
(b) Identifiable fixed cost, if any
(c) Impact of shutdown on other products, if any
(d) All of the above

39. When a firm doubles its inputs and finds that its output has more than doubled, this is known as:
(a) Economies of scale.
(b) Constant returns to scale.
(c) Diseconomies of scale.
(d) A violation of the law of diminishing returns.

40. The firms monthly cost of production is ` 1,46,000 at an output level of 8,000 units. If it achieves
an output level of 12,000 units it will incur production cost of ` 1,94,000 cost of production for 15,000
units is
(a) 1,80,000
(b) 2,00,000
(c) 50,000
(d) 2,30,000

41. The basic research cost should be treated as :

(a) Product cost
(b) Production cost
 338
(c) Production overhead
(d) Period cost

42. A firm requires 16,000 nos. of a certain component, which is buys at ` 60 each. The cost of placing
an order and following it up is ` 120 and the annual storage charges works out to 10% of The cost of
the item. To get maximum benefit the firm should place order for …………………….
Units at a time.
(a) 1,000
(b) 900
(c) 800
(d) 600

43. About 50 items are required every day for a machine. A fixed cost of ` 50 per order is incurred for
placing an order. The inventory carrying cost per item amounts to Re. 0.02 per day. The lead period
is 32 days. Compute reorder level.
(a) 1,200 items
(b) 1,400 items
(c) 1,600 items
(d) 1,800 items

44. The standard time required per unit of a product is 20 minutes. In a day of 8 working hours a
worker gave an output of 30 units. If he gets a time rate of ` 20/hr., his total earnings under Halsey
bonus scheme was :
(a) 200
(b) 192
(c) 180
(d) 16

45. The standard time required per unit of a product is 20 minutes. In a day of 8 working hours
a worker had given an output of 30 units. If he gets a time rate of ` 20/hr., his total earnings under
Halsey bonus scheme was:
(a) 200
(b) 192
(c) 180
(d) 160

46. A material loss during production or storage due to evaporation or shrinkage is called:
(a) Scrap
(b) Waste
(c) Spoilage
(d) Material loss

47. The process of distribution of overheads allotted to a particular department or cost center over
the units produced is called:
(a) Allocation
(b) Apportionment
(c) Absorption
(d) Departmentalization
 339

48. Angle of incidence defines:

(a) Systematic risk in CAPM model
(b) Post BEP relationship between total cost and total revenue
(c) Incidental factors in investments
(d) Marginal cost of production

49. A Ltd. Has sales of ` 2,200, total fixed cost of ` 570, variable cost of ` 1,540, raw material
consumed of ` 1,100, number of units sold 22,000. What shall be the BEP 9in units) if raw material
price is reduced by 2%?
(a) 18,387
(b) 18,560
(c) 18,750
(d) 19,000

50. If an item of overhead expenditure is charged specifically to a single department this would be an
example of:
(a) Apportionment
(b) Allocation
(c) Re-apportionment
(d) Absorption

51. Interest on own capital is a:

(a) Cash cost
(b) Notional cost
(c) Sunk cost
(d) Part of prime cost

52. Objectives of research and development costs include:

(a) Maintaining present competitive position
(b) Improving enterprise‘s competitive position
(c) Exploring now market/products
(d) All of the above

53. Normal stores losses are:

(a) Part of prime cost
(b) Part of production overheads
(c) Part of selling and distribution overheads
(d) Written-off to costing and profit and loss account

54. Secondary packing expenses are:

(a) Part of prime cost
(b) Part of production overheads
(c) Part of distribution overheads
(d) Written-off to costing profit and loss account

55. If you know that with 8 units of output, average fixed cost is `12.50 and average variable cost is `
81.25, then total cost at this output level is:
 340
(a) 93.75.
(b) 97.78.
(c) 750.
(d) 880.

56. The methods of treating cost of small tools in cost accounts include
(a) Charging to expense
(b) Charging to stores
(c) Capitalizing in a small tools account
(d) All of the above

57. under marginal costing:

(a) All costs are classified into two groups – variable and fixed
(b) Variable costs form part of the product cost and inventory valuation
(c) Fixed costs are treated as period costs
(d) All of the above

58. Which of the following definitions describe marginal cost?

(a) The variable cost of one unit of product or service
(b) A principle whereby variable costs are charged to cost units and the fixed costs attributable
to the relevant period are written-off in full against the contribution for that period
(c) Costs appropriate to aiding the making of specific management decisions
(d) The price at which material identical to that which is used up could be replaced on the date of
usage

59. According to Rowan premium plan, which of the following formula is used to calculate the bonus
rate?
(a) (Time saved/time allowed) x 100
(b) (Time allowed/time saved) x 100
(c) (Actual time taken/time allowed) x 100
(d) (Time allowed/actual time taken) x 100

60. Which of the following is not an assumption underlying the accountant‘s break-even chart?
(a) Fixed costs remain fixed throughout the range charted
(b) Selling prices do not change
(c) Variable costs fluctuate inversely with volume
(d) Unit variable costs remain constant throughout the range charted

61. Which of the following is/are the basic object/s of job analysis?
(a) Determination of wage rates
(b) Ascertain the relative worth of each job
(c) Breaking up job into its basic elements
(d) All of the given options

62. Analysis of selling and distribution overheads is done by:

(a) Nature of expenses and functions
(b) Areas, products and salesmen
(c) Types of customers and channels of distribution
 341
(d) All of the above

63. For exercising control over selling and distribution overheads, the following techniques may be
used:
(a) Comparison with past results
(b) Budgetary control
(c) Standard costing
(d) All of the above

64. Depreciation is a:
(a) Measure of consumption of assets
(b) Process of allocation and not of valuation
(c) Wear and tear due to use and/or lapse of time
(d) All of the above

65. Which of the following does not influence the useful life of an asset?
(a) Expected physical wear and tear
(b) Cost of the asset
(c) Obsolescence
(d) Legal or other limits on the use of the asset

66. For computing depreciation of an asset, the factors that are taken into consideration include the
following except:
(a) Historical cost
(b) Expected useful life
(c) Insurance premium
(d) Estimated residual value

67. Depreciation on plant and machinery is :

(a) Not a cash cost, so is ignored in the cost accounts
(b) Part of manufacturing overheads
(c) Part of prime cost
(d) Always calculated using the straight-line method

68. Which of the following methods of depreciation results in fixed per unit cost of depreciation?
(a) Straight line
(b) Reducing balance
(c) Sinking fund
(d) Production unit

69. Types of maintenance include the following except:

(a) Routine
(b) Overhaul
(c) Emergency
(d) Periodic

70. Which of the following is not included in the objectives of maintenance of plant and machinery?
 342
(a) Reducing idle time
(b) Reducing breakdown
(c) Maintaining efficiency
(d) Increasing life

71. Regular maintenance expenses are :

(a) Capitalized
(b) Part of manufacturing overheads
(c) Written-off to costing profit and loss account
(d) Part of prime cost

72. Obsolescence is the measure of the loss of value of an asset due to :

(a) Technological innovation
(b) Changes in market conditions
(c) Both (a) and (b) above
(d) None of the above

73. Which of the following is not a production cause of idle capacity?

(a) Set-up and change-over time
(b) Lack of supervision and instruction
(c) Lack of materials and tools
(d) Strike

74. Which of the following is not used as a base for apportionment of administration overheads?
a) Direct wages
b) Works cost
c) Conversion cost
d) Sales value

75. In account ting for labourcost:

a) A. direct labour cost and indirect labour cost are charged to prime cost
b) Direct labour cost and indirect labour cost are charged to overheads
c) Direct labour cost is charged to prime cost and indirect labour cost is charged to overheads
d) All of the above

76. Productive causes of idle time include the following except :

a) Power failure
b) Fall in demand
c) Machine breakdown
d) Waiting for materials, tools, instructions, etc.

77. The treatment of idle time in cost includes the following:

a) Cost of normal and controllable idle time is charged to factory overheads
b) Cost of normal but uncontrollable idle time is treated as prime cost
c) Cost of abnormal and uncontrollable idle time is charged to costing profit and loss account
d) All of the above
 343
78. Overtime premium may be treated, depending on the circumstances, as:
a) Part of direct wages
b) Part of production overheads
c) Part of capital order
d) All of the above

79. A manufacturing firm is very busy and is working overtime. The amount of overtime premium
contained in direct wages would normally be classed as:
a) Part of prime cost
b) Factory overheads
c) Direct labour cost
d) Administrative overheads

80. Fringe benefits are those for which efforts of the workers are not necessary and may include the
following except:
a) Holiday pay
b) Attendance bonus
c) Production bonus
d) Employer‘s contribution to P.F.

81. Avoidable causes of labour turnover include the following except:

a) Redundancy
b) Low wages
c) Bad working conditions
d) Marriage

82. The unavoidable causes of labour turnover include the following except:
a) Personal betterment
b) Dissatisfaction with the job
c) Illness
d) Retirement

83. Labour turnover can be measured by the following methods except:

a) Attrition method
b) Separation method
c) Replacement method
d) Flux method

84. At the start of the quarter there were 14,630 workers. 750 employees left during the quarter while
600 joined the organization during the same period. Using the flux method, the labour turnover was:
a) 5.13%
b) 9.23%
c) 9.32%
d) 9.28%

85. Which of the following is not a cost implication of labourturnover?

a) Training
b) Recruiting
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c) Ageing labour force
d) Damage of machine

86. Preventive costs of labour turnover include the following except:

a) Cost of recruitment and training
b) Medical services
c) Welfare
d) Gratuity and pension

87. Replacement costs of labour turnover include the following except :

a) Loss of output
b) Cost of personnel administration
c) Cost of tool and machine breakage
d) Cost of scrap and defective work

88. Cost of labour turnover may be treated as :

a) Direct wages
b) Prime cost
c) Overhead
d) None of the above

89. 1) labour cost control leads to minimization of cost of labour per unit of output. (2) When labour
cost is fixed nature, any reduction in total labour cost may not result in lower cost per unit. True or
false?
a. (1) True; (2) False
b. (1) False; (2) True
c. (1) and (2) False

90. Labour cost control embraces the following activities except:

a) Recruitment and promotion
b) Formulation of wage policy and payment and accounting for wages
c) Allocation of cost
d) Preparation of financial statement

91. (1) Payment of higher wages does not necessarily mean that labour cost per unit is high. (2)
Control over payment of wages aims at reducing or eliminating irregularities during actual
disbursements. True or False?
a) (1) and (2) True
b) (1) and (2) False
c) (1) False; (2) True
d) (1) True; (2) False

92. Which of the following techniques is not meant for labour cost control?
a) Budgetary control
b) Standard costing
c) ABC analysis
d) Ratio analysis
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93. Ratios which may be used for comparing labour cost over time include the following except :
a) Gross profit ratio
b) Efficiency ratio
c) Illness ratio
d) Absenteeism ratio
94. Cost of production is equal to
a) Prime costs+ other manufacturing costs.
b) Production costs + Administration expenses.
c) Prime costs + Manufacturing costs + Opening W.I.P – Closing W.I.P.
d) None of the above.

95. The cost of goods sold is equal to

a) Total Purchases - Total Sales.
b) Opening stock + Total Purchase.
c) Opening stock - Total Purchases +Closing Stock+ Direct Costs.
d) Opening stock + Total Purchases – Closing Stock + Direct Costs.

96. Which of the following is false regarding the LIFO method of inventory valuation?
a) The material issue will be priced at the price of the material that is purchased last.
b) The pattern of cash flow does not necessarily coincide with the actual flow pattern of materials.
c) It permits management to influence net income by timing the purchases.
d) LIFO determines closing inventory at recent costs.

97. Which of the following is NOT a reason for carrying inventory?

a) To maintain independence of operations
b) To take advantage of economic purchase-order size
c) To make the system less productive
d) To meet variation in product dem

98. Which of the following is TRUE regarding Departmental Rates.

a) A departmental absorption rate is a rate of absorption based upon the particular department's
overhead cost and activity level
b) A departmental absorption rate is a rate of absorption not based upon the particular
department's overhead cost and activity level
c) A single rate of absorption used throughout an organization‘s production facility and based upon
its total production costs and activity
d) None of the given options

99. Inventory of ` 96,000 was purchased during the year. The cost of goods sold was ` 90,000 and
the ending inventory was ` 18,000. What was the inventory turnover ratio for the year?
a) 5.0 times
b) 5.3 times
c) 6.0 times
d) 6.4 times

100. In a perpetual inventory system, an inventory flow assumption (i.e. LIFO or FIFO) is used
primarily for determining costs which are used in
a) Forecasts of future sale.
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b) Recording the cost of goods sold.
c) Recording Sales Revenue.
d) Forecasts of future operating results.

101. The factors to be taken into consideration in formulating incentive schemes include:
a) Quantity and quality of output
b) Incidence of overhead, and effect upon workers
c) Simplicity and legal provisions
d) All of the above

102. Contribution margin contributes to meet which one of the following options ?
a) Variable cost
b) Fixed cost
c) Operating cost
d) Net profit

103. Favorable conditions for the operation of piece rates include:

a) Homogeneous products
b) Long, uninterrupted run of production
c) Inspection
d) High proportion of indirect labour

104. If time allowed for a job is 10 hours, time taken for the job is 8 hours and rate of pay is ` 2 per
hour, the bonus to the worker is :
a. ` 1.20
b. ` 2.00
c. ` 3.20
d. None of the above

105. Group bonus schemes are generally suitable where:

a) Output depends on individual efforts
b) Output of individual workers can be measured easily
c) It is necessary to create a collective interest in the work
d) Normal loss rate is high

106. In a profit sharing scheme the available surplus is shared by the following except:
a) Government
b) Shareholders
c) Employees
d) Firm

107. Non-monetary incentives may include the following except:

a) Health and safety
b) Housing facilities
c) Education and training
d) Dearness allowance

108. The purposes served by preparation of payroll or wages sheet include:

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a) Spreading the volume of work to be done
b) Computation of labour rate for each department
c) Comparing actual wages with budgeted wages for control
d) All of the above

109. The authorized heads of deduction from wages payable include the following except :
a) Car allowance
b) Income tax
c) Provident fund
d) Employees‘state insurance

110. Wages analysis include :

a) Gross wages per product
b) Gross wages per operation or department
c) Gross wages per labour classification
d) Analysis of constituent of gross wages – direct/ lost time

111. The inventory method where the cost per unit is recomputed after every addition in the inventory
is known as.
a) Specific identification method.
b) Moving average method.
c) Last-in- First – Out method.
d) First-in-First-Out method.

112. Which of the following inventory valuation methods shows higher profits during the period of
rising prices?
a) FIFO method.
b) LIFO method.
c) Weighted average method.
d) Simple average method.

113. Which of the following systems of inventory valuation computes cost of goods sold as a
residual amount?
a) Weighted Average.
b) Last-in-First-out.
c) Periodic Inventory System.
d) Specific Identification.

114. Which of the following is calculated by a formula that uses net sales as denominator?
a) Inventory turnover ratio
b) Gross profit rate
c) Return on Investment
d) None of the given options

115. Overhead expenses can be classified according to:

a) Functions
b) Elements
c) Behavior
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d) All of the above

116. Which of the following is not included in functional classification of overheads?

a) Repairs and maintenance
b) Lubricating oil
c) Consumable stores
d) Chargeable expenses

117. Which of the following is not an example of marketing overheads?

a) Salary of the foreman
b) Publicity expenses
c) Salaries of sales staff
d) Secondary packing charges

118. Some overhead charges tend to vary almost directly, some tend to remain constant while some
again vary in part with the volume and in part remain constant. This statement describes sequentially
the following:
a) Variable, fixed and semi-variable overheads
b) Fixed, semi-variable and variable overheads
c) Semi-variable, variable and fixed overheads
d) Variable, semi-variable and fixed overheads

119. Suppose a firm sells its product at a price lower than the opportunity cost of the inputs used to
produce it. Which is true?
a) The firm will earn accounting and economic profits.
b) The firm will face accounting and economic losses.
c) The firm will face an accounting loss, but earn economic profits.
d) The firm may earn accounting profits, but will face economic losses.

120. Example of semi-variable items include the following except:

a) Telephone
b) Repairs and maintenance
c) Depreciation of plant and machinery
d) Insurance of plant and building

121. Direct Labor is an element of:

a) Prime cost
b) Conversion cost
c) Total production cost
d) All of the given options

122. Which of the following is not a production department?

a) Power department
b) Machining department
c) Refining department
d) Finishing department

123. Which of the following does not match? Item of cost Basis of cost allocation
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a) Power H.P. of machine
b) Supervision of building value of materials consumed
c) Insurance of building area occupied
d) Time-keeping number of employees

124. (1) Departmentalization of items of costs is known as primary distribution.

(2) Redistribution of service departments, costs is known as secondary distribution. True or false?
a) (1) and (2) true
b) (1) and (2) false
c) (1) False; (2) True
d) (1) True; (2) False

125. Which of the following costs is not a factory overhead expense?

a) Depreciation of equipment used in the research department
b) Salary of quality control inspector
c) Overtime premium paid to direct labour
d) Machine maintenance labour cost

126. Which of the following bases would be most appropriate to apportion the cost of electric power
to factory departments?
a) Number of outlet points
b) Amount metered out
c) Cubic capacity of premises
d) Kilowatt capacity of machines in department

127. A method of dealing with overheads involves spreading common costs over cost centres on the
basis of benefit received. This is known as
a) Overhead absorption
b) Overhead apportionment
c) Overhead identification
d) Overhead analysis

128. The process of cost apportionment is carried out so that :

a) Costs may be controlled
b) Cost units gather overheads as they pass through cost centres
c) Whole items of cost can be charged to cost centres
d) Common costs are shared among cost centres

129. An overhead absorption rate is used to :

a) Share out common costs over benefiting cost canters
b) Find the total overheads for a cost centre
c) Charge overheads to products
d) Control overheads

130. Which of the following is not a means whereby factory overheads can be charged out to
production?
a) Direct labour rate
b) Overtime rate
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c) Machine hour rate
d) Blanket rate

131. A management consultancy recovers overheads on chargeable consulting hours. Budgeted

overheads were ` 6,15,000 and actual consulting hours were 32,150. Overheads, were under
recovered by ` 35,000. If actual overheads, were ` 6,94,075, what was the budgeted overhead
absorption rate per hour ?
a. 19.13
b. 20.50
c. 21.59
d. 22.68

132. Idle capacity of a plant is defined as the difference between:

a) Practical capacity and normal capacity
b) Practical capacity and capacity based on sale expectancy
c) Maximum capacity and actual capacity
d) Maximum capacity and practical capacity

133. The capacity which is based on the long-term average of sales expectancy is known as :
a) Theoretical capacity
b) Operating capacity
c) Normal capacity
d) Derated capacity

134. Maximum capacity of a plant refers to its:

a) Theoretical capacity
b) Normal capacity
c) Practical capacity
d) Capacity based on sales expectancy

135. Annual requirement is 7800 units; consumption per week is 150 units. Unit price ` 5, order cost
` 10 per order. Carrying cost ` 1 per unit and lead time is 3 week, The Economic order quantity
would be.
a) 395 units
b) 300 units
c) 250 units
d) 150 units

136. What will be the impact of normal loss on the overall per unit cost?
a) Per unit cost will increase
b) Per unit cost will decrease
c) Per unit cost remain unchanged
d) Normal loss has no relation to unit cost

137. Alpha company purchased a machine worth Rs 200,000 in the last year. Now that machine can
be use in a new project which company has received this year. Now the cost of that machine is
to be called:
a) Project cost
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b) Sunk cost
c) Opportunity cost
d) Relevant cost

138. FOH absorption rate is calculated by the way of:

a) Estimated FOH Cost/Direct labor hours
b) Estimated FOH Cost/No of units produced
c) Estimated FOH Cost/Prime Cost
d) All of the given options

139. Which of the following is/are not associated with ordering costs?
a) Interest
b) Insurance
c) Opportunity costs
d) All of the given options

140. Under perpetual Inventory system at the end of the year:

a) No closing entry passed
b) Closing entry passed
c) Closing value find through closing entry only
d) None of the above.

141. The Hino Corporation has a breakeven point when sales are ` 160,000 and variable costs at that
level of sales are ` 100,000. How much would contribution margin increase or decrease, if
variable expenses dropped by ` 20,000?
a. 37.5%.
b. 60%.
c. 12.5%.
d. 26%

142. The short run is a time period in which:

a) All resources are fixed.
b) The level of output is fixed.
c) The size of the production plant is variable.
d) Some resources are fixed and others are variable

143. Opportunity cost is the best example of:

a) Sunk Cost
b) Standard Cost
c) Relevant Cost
d) Irrelevant Cost

144. The components of factory overhead are as follows:

a) Direct material + indirect material + direct expenses
b) Indirect material + Indirect labor + others indirect cost
c) Direct material + indirect expenses + indirect labor
d) Direct labor + indirect labor + indirect expenses
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145. The term Maximum level represents:
a) The maximum stock level indicates the maximum quantity of an item of material which can be
held in stock at any time.
b) The maximum stock level indicates the maximum quantity of an item of material which cannot
be held in stock at any time.
c) The average stock level indicates the maximum quantity of an item of material which can be held
in stock at any time.
d) The available stock level indicates the maximum quantity of an item of material which can be
held in stock at any time.

146. The FIFO inventory costing method (when using a perpetual inventory system) assumes that
the cost of the earliest units purchased is allocated in which of the following ways?
a) First to be allocated to the ending inventory
b) Last to be allocated to the cost of goods sold
c) Last to be allocated to the ending inventory
d) First to be allocated to the cost of goods sold

147. A firm Uses its own capital or Uses its owner's time and/or financial resources both are
examples of
a) Implicit Cost
b) Explicit Cost
c) Sunk Cost
d) Relevant Cost

148. If Direct Material = 12,000; Direct Labor = 8000 and other Direct Cost = 2000 then what will be
the Prime Cost?
a. 12000
b. 14000
c. 20000
d. 22000

125. Wage, Rent & Materials are examples of :

a) Implicit Cost
b) Explicit Cost
c) Direct Cost
d) Manufacturing Cost

126. An investor invests in stock exchange he foregoes the opportunity to invest further in his hotel.
The profit which the investor will be getting from the hotel is
.
a) Opportunity cost
b) Period Cost
c) Product Cost
d) Historical Cost

127. It is possible for an item of overhead expenditure to be shared amongst many departments. It
is also possible that this same item may relate to just one specific department.
If the item was not charged specifically to a single department this would be an example of:
 353
a) Apportionment
b) Allocation
c) Re-apportionment
d) Absorption

128. Generally, the danger level of stock is fixed the minimum level
a) Below
b) Above
c) Equal
d) Danger level has no relation to minimum level

129. Which of the following is / are time based incentive wage plan?
a) Hasley Premium Plan
b) Hasley Weir Premium Plan
c) Rowan Premium Plan
d) All of the given options

130. Which of the following is/are reported in production cost report?

a) The costs charged to the department
b) How the costs were assigned to the output?
c) The equivalent units of production by the department
d) All of the given options
131. Beginning goods in process were ` 15,000. The cost of goods manufactured is ` 245,000. What
is the cost assigned to the ending goods in process?
a. ` 45,000
b. ` 15,000
c. ` 30,000
d. There will be no ending Inventory

132. Sales are ` 450,000. Beginning finished goods were ` 23,000. Ending finished goods are ` 30,000.
The cost of goods sold is ` 300,000. What is the cost of goods manufactured?
a. ` 323,000
b. ` 330,000
c. ` 293,000
d. None of the given options

133. Under Periodic Inventory system Purchase of inventory is treated as:

a) Assets
b) Expense
c) Income
d) Liability

134. When prices are rising over time, which of the following inventory costing methods will result in
the lowest gross margin/profits?
a) FIFO
b) LIFO
c) Weighted Average
d) Cannot be determined
 354

135. The main difference between the profit center and investment center is:
a) Decision making
b) Revenue generation
c) Cost incurrence
d) Investment

136. The Inventory Turnover ratio is 5 times and numbers of days in a year is [Link] holding
period in days would be
a) 100 days
b) 73 days
c) 50 days
d) 10 days

137. Over applied FOH will always result when a predetermined FOH rate is applied and:
a) Production is greater than defined capacity
b) Actual overhead costs are less than budgeted overhead
c) Budgeted capacity is less than normal capacity
d) Actual overhead incurred is less than applied Overhead

138. The flux method of labor turnover denotes:

a) Workers appointed against the vacancy caused due to discharge or quitting of the organization
b) Workers appointed in replacement of existing employees
c) Workers employed under the expansion schemes of the company
d) The total change in the composition of labor force

139. Which of the following statement is TRUE about FOH applied rates?
a) They are used to control overhead costs
b) They are based on actual data for each period
c) They are predetermined in advance for each period
d) None of the given

140. Cost of Goods Manufactured can be calculated as follow

a) Total factory Cost Add Opening Work in process inventory Less Closing Work in process inventory
b) Total factory Cost Less Opening Work in process inventory Add Closing Work in process
inventory
c) Total factory Cost Less Opening Work in process inventory Less Closing Work in process
inventory
d) Total factory Cost Add Opening Work in process inventory Add Closing Work in process inventory

141. is the time worked over and above the employee's basic working week.
a) Flex time
b) Overtime
c) Shift allowance
d) Commission

142. In furniture manufacturing use of nail, pins, glue, and polish which use to increase its esteem
value that cost is treated as:
 355
a) Direct material cost
b) Indirect material cost
c) FOH cost
d) Prime cost

143. If labor is satisfied with high wages it may ultimately lead to:
a) Increased production and productivity
b) Increased efficiency
c) Reduced labor and overhead costs
d) All of the given options

144. Which of the following is a mechanical device to record the exact time of the workers?
a) Clock Card
b) Store Card
c) Token System
d) Attendance Register

145. Which of the following is a mechanical device to record the exact time of the workers?
a) Clock Card
b) Store Card
c) Token System
d) Attendance Register

146. Which of the following is / are element / s of production payroll?

a) Direct labor force wages
b) Administrative wages
c) Selling wages
d) All of the given options

147. If a predetermined FOH rate is not applied and the volume of production is reduced from the
planned capacity level, the cost per unit expected to:
a) Remain unchanged for fixed cost and increase for variable cost
b) Increase for fixed cost and remain unchanged for variable cost
c) Increase for fixed cost and decrease for variable cost
d) Decrease for both fixed and variable costs

148. Which of the following is NOT an assumption of the basic economic-order quantity model?
a) Annual demand is known
b) Ordering cost is known
c) Carrying cost is known
d) Quantity discounts are available

149. In order to ensure efficient functioning of the stores department and steady flow of materials to
the production departments, the restocking of stores is duty of:
a) Managers
b) Storekeeper
c) Production In charge
d) Sales supervisor
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150. In cost Accounting, abnormal loss is charged to:

a) Factory overhead control account
b) Work in process account
c) Income Statement
d) Entire production

151. A high inventory turnover may indicate:

a) An efficient use of the investment in inventory
b) A high risk of stock-outs
c) Stock position of store room
d) All of the given options

152. Which of the following cost is used in the calculation of cost per unit?
a) Total production cost
b) Cost of goods available for sales
c) Cost of goods manufactured
d) Cost of goods Sold

153. If, COGS = ` 50,000 GP Margin = 25% of sales what will be the value of Sales?
a. 200,000
b 66,667
c. 62,500
d. None of the given options

154. When a manufacturing Company has highly automated manufacturing plant producing many
different products, the most appropriate basis for applying FOH cost to work in process is:
a) Direct labor hours
b) Direct labor costs
c) Machine hours
d) Cost of material used

155. All of the following are cases of labor turnover EXCEPT:

a) Workers appointed against the vacancy caused due to discharge or quitting of the organization
b) Workers employed under the expansion schemes of the company
c) The total change in the composition of labor force
d) Workers retrenched

156. The Term Minimum Level Represents.

a) The quantity below which the stock of any item should not be allowed to fall
b) The quantity below which the stock of any item should be allowed to fall
c) The estimated time period in number of days or in weeks or in months.
d) The Lead time period in number of days or in weeks or in months.

157. Which of the following would be considered a major aim of a job order costing system?
a) To determine the costs of producing each job or lot
b) To compute the cost per unit
c) To include separate records for each job to track the costs
 357
d) All of the given option.

158. The Economic order quantity can be calculated by

a) Formula Method
b) Table Method
c) Graph Method
d) All of the given

159. A chemical process has normal wastage of 10% of input. In a period, 2,500 Kg of material were
input and there was abnormal loss of 75 Kg. What quantity of good production was achieved? a.
2,175 kg
b. 2,250 kg
c. 2,425 kg
d. 2,500 kg

160. Which of the following is likely to be classified as a direct material cost of a motor car wheel?
a) The metal used to manufacture it.
b) The metal used to manufacture one of the tools used in the car wheel factory.
c) The cost of operating the raw material stores in the factory.
d) The cost of the quality operation on the finished car wheels.
161. The first in, first out method of pricing raw material issues, exhibits which one of the following
features?
a) The issue price is recalculated each time new deliveries are made into stock.
b) The issue price is always at the latest price.
c) The goods are always issued strictly in the physical order in which they are received.
d) The issue price is always at the earliest price.

162. Which of the following is not a method of pricing raw material issues from stock?
a) Standard costing.
b) Unit cost.
c) Marginal cost.
d) Continuous weighted average.

163. While preparing the Cost of Goods Sold and Income Statement, the over applied FOH is;
a) Add back, subtracted
b) Subtracted, add back
c) Add back, add back
d) Subtracted, subtracted

164. Which of the following ratios expressed that how many times the inventory is turning over
towards the cost of goods sold?
a) Net profit ratio
b) Gross profit ratio
c) Inventory turnover ratio
d) Inventory holding period

165. What is the company's contribution margin ratio?

a. 30%
 358
b. 50%
c. 150%
d. None of given options

166. What is the company's break-even in units?

a) 48,000 units
b) 72,000 units
c) 80,000 units
d) None of the given options

167. How many units would the company have to sell to attain target profits of ` 600,000?
a) 48,000 units
b) 88,000 units
c) 106,668 units
d) None of given options

168. What is the company's margin of safety in `?

a 1,600,000
b 2,400,000
c 25,60,000
d. None of the given options

169. The margin of safety can be defined as:

a) The excess of budgeted or actual sales over budgeted or actual variable expenses
b) The excess of budgeted or actual sales over budgeted or actual fixed expenses
c) The excess of budgeted sales over the break-even volume of sales
d) The excess of budgeted net income over actual net income

170. The contribution margin ratio is calculated by using which one of the given formula?
a) (Sales - Fixed Expenses)/Sales
b) (Sales - Variable Expenses)/Sales
c) (Sales - Total Expenses)/Sales
d) None of the given options

171. Data of a company XYZ is given below Particulars `Sales 15,00,000 Variable cost 9,00,000
Fixed Cost 4,00,000 Break Even Sales in `
a. 1, 00,000
b. 2, 00,000
c. 13, 00,000
d. None of the given options

172. The break-even point is the point where:

a) Total sales revenue equals total expenses (variable and fixed)
b) Total contribution margin equals total fixed expenses
c) Total sales revenue equals to variable expenses only
d) Both a & b

173. The break-even point in units is calculated using

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a) Fixed expenses and the contribution margin ratio
b) Variable expenses and the contribution margin ratio
c) Fixed expenses and the unit contribution margin
d) Variable expenses and the unit contribution margin

174. Marginal costing is also known as:

a) Indirect costing
b) Direct costing
c) Variable costing
d) Both (b) and (c)

175. The difference between total revenues and total variable costs is known as:
a) Contribution margin
b) Gross margin
c) Operating income
d) Fixed costs

176. Percentage of Margin of Safety can be calculated in which one of the following ways?
a) Based on budgeted Sales
b) Using budget profit
c) Using profit & Contribution ratio
d) All of the given options

177. Which of the following represents a CVP equation?

a) Sales = Contribution margin (Rs.) + Fixed expenses + Profits
b) Sales = Contribution margin ratio + Fixed expenses + Profits
c) Sales = Variable expenses + Fixed expenses + profits
d) Sales = Variable expenses –Fixed expenses + profits

178. If 120 units produced, 100 units were sold @ ` 200 per unit. Variable cost related to production
& selling is ` 150 per unit and fixed cost is ` 5,000. If the management wants to decrease sales
price by 10%, what will be the effect of decreasing unit sales price on profitability of company?
a) Remains constant
b) Profits will increased
c) Company will have to face losses
d) None of the given options

179. A disadvantage of an hourly wage plan is that it:

a) Provides no incentive for employees to achieve and maintain a high level of production.
b) Is hardly ever used and is difficult to apply.
c) Establishes a definite rate per hour for each employee.
d) Encourages employees to sacrifice quality in order to maximize earnings.

180. The cost expended in the past that cannot be retrieved on product or service
a) Relevant Cost
b) Sunk Cost
c) Product Cost
d) Irrelevant Cost
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181. When a manufacturing process requires mostly human labor and there are widely varying wage
rates among workers, what is probably the most appropriate basis of applying factory costs to
work in process?
a) Machine hours
b) Cost of materials used
c) Direct labor hours
d) Direct labor dollars

182. The main purpose of cost accounting is to:

a) Maximize profits.
b) Help in inventory valuation
c) Provide information to management for decision making
d) Aid in the fixation of selling price

183. The combination of direct material and direct labor is :-

a) Total production Cost
b) Prime Cost
c) Conversion Cost
d) Total manufacturing Cost

184. method assumes that the goods received most recently in the stores or
produced recently are the first ones to be delivered to the requisitioning department.
a) FIFO
b) Weighted average method
c) Most recent price method
d) LIFO
185. Fixed cost per unit decreases when:
a) Production volume increases.
b) Production volume decreases.
c) Variable cost per unit decreases.
d) Variable cost per unit increases.

186. Prime cost + Factory overhead cost is:

a) Conversion cost.
b) Production cost.
c) Total cost.
d) None of given option.

187. Find the value of purchases if Raw material consumed ` 90,000; Opening and closing stock of
raw material is ` 50,000 and 30,000 respectively.
a. ` 10,000
b. ` 20,000
c. ` 70,000
d. ` 1,60,000

188. If Cost of goods sold = ` 40,000; GP Margin = 20% of sales Calculate the Gross profit margin.
a. ` 32,000
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b. ` 48,000
c. ` 8,000
d. `10,000

189. Annual requirement is 7800 units; consumption per week is 150 units. Unit price ` 5, order cost
` 10 per order. Carrying cost ` 1 per unit and lead time is 3 week, The Economic order quantity
would be:
a) 395 units
b) 300 units
c) 250 units
d) 150 units

190. Juniper Limited‘s budgeted overhead in the last period was ` 170,000. Its overhead absorbed
and incurred for the same period were `180,000 and `195,000 respectively. What is its amount of
over- or under-absorption of overhead?
a) Under-absorption of ` 15,000
b) Under-absorption of ` 25,000
c) Over-absorption of ` 15,000
d) Over-absorption of ` 25,000

191. Which of the following are the characteristics of management accounting?

(1) It must follow generally accepted accounting principles.
(2) It is concerned with information for the internal use of management.
(3) It emphasizes relevance and flexibility of data.
a. (1) and (2)
b. (1) and (3)
c. (2) and (3)
d. (1), (2) and (3)

ANSWER KEY -

1c 65c 27d
50c 12e
9b 73d 35d
58b 20b
17c 81a 43a
2a 66b 28a
25a 51b
10e 74b 36a
33a 59c
18e 82c 44d
41b 3d 67d
26d 52c
49c 11b 75d
34b 60c
57d 19e 83b
42d 4b 68d
 362
61d 39b
76b 54a 32c
5c 69d 47c
62d 40d
13c 77c 55b
6d 70b 48c
21b 63a
14c 78d 56b
29b 7b 71c
22d 64a
37b 15a 79d
30d 8c 72b
45a 23a
38b 16d 80a
53b 31a
46d 24b

84d 100a 115d 131a 147 c 163b 179b 195d 211c

85d 101d 116a 132b 148d 164b 180a 196a 212b
86b 102d 117a 133b 149c 165a 181c 197c 213d
87c 103d 118b 134d 150b 166b 182b 198c 214a
88d 104c 119a 135c 151a 167d 183b 199b 215b
89b 105a 120c 136b 152d 168d 184d 200d 216c
90a 106d 121d 137b 153a 169c 185a 201d 217d
91d 107b 122d 138b 154d 170a 186d 202c 218 b
92c 108d 123a 139c 155b 171b 187d 203d 219 a
93a 109b 124a 140a 156a 172b 188a 204a 220 c
94b 109b 125d 141a 157a 173d 189d 205d
95c 110b 126d 142a 158b 174a 190c 206c
96a 111c 127d 143d 159d 175d 191c 207c
97d 112c 128a 144 d 160d 176b 192b 208a
98a 113a 129b 145 d 161d 177d 193c 209b
99c 114d 130a 146 a 162d 178b 194b 210c

Part- 12 AUDITING CONCEPT OF AUDITING

1. The term “Audit” originated from the Latin word

a) Audire
b) Adhere
c) Adihere
d) None of the above
2. The basis for decision making by the management is
a) Accounting statements
b) Financial Statement
c) Bank statements
d) None of the above

3. The management takes so many decisions on the basis of

a) Accounting statement
b) Financial statements
c) Bank statements
d) None of the above

4. The authenticity of financial statements is very essential and such authenticity of accounts can
be assured with the help of an
a) Internal Audit
b) Performance Audit
c) Independant Audit
d) None of the above

5. Examination of books of accounts with supporting vouchers and documents in order to detect
and prevent error and fraud is the main function of
a) Accountant
b) Management
c) Company Director
d) Auditing

6. Express an opinion on the financial or non financial areas is the goal of-
a) Accounting
b) Managing
c) Auditing
d) None of the above

7. In the case of financial audit, a set of financial statements are said to be true and fair when they
are free of
a) Error
b) Fraud
c) Material Misstatements
d) None of the above

8. Audit deals with checking, verification and examination of

a) Accounts
b) Finance
c) Management
d) None of the above

9. Time, extent and nature of audit depend upon effectiveness of

a) Environmental Control System
b) Management Control System
c) Both(a) and (b)above
d) d) Internal Control System

10. is responsible for ‘Maintenence of accounts”

a) Auditing
b) Accountong
c) Both (a) and (b)above
d) Management

11. Auditor has to report that accounts have been prepared as per GAAP and presents
a) Correctview of business operantions
b) Authentic view of business operations
c) Both(a) and (b)above
d) true and fair view of business operation

12. Auditing can be defined as an independent examination of –

a) Financial records
b) Non financial records
c) Both(a) and (b)above
d) None of the above

13. The objective of an audit of financial statements is to enable an auditor to ... on

financial statements
a) Complition of an audit
b) Express on opinion
c) Check the transaction
d) Check frauds

14. Accounts maintenance is the function of .......

a) Auditor
b) Accountant
c) Auditor staff
d) Practicing Professionals

15. The main object of an audit is-

a) Expression of opinion
b) Detection and prevention of fraud and error
c) Both(a) and (b)above
d) Depends on the type of audit

16. Review of system and procedure is the primary function of-

a) Accounting
b) management
c) Auditing
d) None of the above

17. Review of internal contol system is very important for the auditor as the effectives of internal
control system will determine the extent of checking to be done by the -\
 365
a) Accountant
b) Management
c) Both accountant and management
d) Auditor

18. The compliance test and substantive procedures performed by the auditor will determine the
effectiveness of –
a) Management Accounting System
b) Cost Accounting system
c) Internal Audit system
d) Internal Control system

19. Auditor has to cpmpare the balance sheet and Profit and liss account or other statement with the
a) Bank statement
b) Cash Book
c) Both (a) and (b) above
d) Books of Accounts and supporting vouchers

20. The auditor has to give its opinion whether the financial statements depicts
a) Correct view of the accounts
b) Acceptable view of the accounts
c) True and fair view of the state of affairs of organization
d) None of the above

21. It is because of audit the the owner will be satisfied about the
a) Profits of the organisation
b) Employees, customers and suppliers of the organization
c) Business operations and working of its various departments
d) None of the above

22. No one will try to commit an error or fraud as the accounts are subject to
a) Scrutiny
b) Internal control
c) Audit
d) None of the above

23. Auditing is very useful in obtaining the independent opinion of the auditor about
a) Financial condition
b) business condition
c) Profits/losses
d) Business condition

24. Audit helps in protecting the interests of

a) Employees
b) Government
c) Management
d) Shareholders in case of joint stock company
 366
25. Money can be borrowed easily on the basis of audited balance sheet from
a) Private sources
b) Creditors
c) Financial institutions
d) Government

26. Generally auditing exercise on is based on test checking, Inferring a result on the basis of
testcheck always need not to be
a) Fair
b) Apparently correct
c) True
d) None of the above

27. Generally an auditor needs to release the report up to

a) A specified timeline
b) Unspecified timeline
c) Infinite timeline
d) End of the next accounting period

28. The evidences obtained by an auditor are persuasive rather than

a) Correct
b) Reliable
c) Conclusive
d) All of the above

29. An audit cannot add exactness and certainty to financial statements when these factors
a) Do not exist
b) Exists
c) Are not known
d) None of the above

30. The audit opinion is based on the information provided by the –

a) Employees
b) Government
c) Management
d) All of the above

31. The investigation is related to critical checking of

a) Internal records
b) Particular records
c) Accounting records
d) External records

32. Which of the following is not the objective of Internal audit

a) To keep proper control over business activities
b) To evaluate accounting system
c) To report to the owner and outsiders
d) To evaluate the internal check system
33. Primary responsibility for the adequacy of financial statement disclosures rest with the
a) Auditor
b) Management
c) Auditor’s Staff
d) Central Government

34 .One of the following not an advantage of audit

a) It provides satisfaction for owner
b) It helps in getting loans
c) It reduces cost burden
d) It detects errors andfrauds

35. The purpose of audit and investigation is

a) Same
b) Different
c) Sometimes same and sometimes different
d) None of the above

36. Investigation implies systematic, critical and special examination of the records of a business
for a
a) General purpose
b) Unspecified purpose
c) Specific purpose
d) None of the above

37. Investigation is conducted by

a) Cost Accountant
b) Company Secretary
c) Chartered Accountant
d) Any person

38. Audit is conducted by

a) Cost Accountant
b) Company Secretary
c) Chartered Accountant
d) Any person

39. Investigation seeks

a) Conclusive evidence
b) Corroborative evidence
c) Both (a) and (b) above
d) Persuasive evidence

40. Auditing seeks

a) Conclusive evidence
b) Corroborative evidence
c) Both (a) and (b) above
d) Persuasive evidence

Answers:

1 a 11 d 21 c 31 b
2 b 12 a 22 c 32 c
3 b 13 b 23 d 33 b
4 c 14 b 24 d 34 c
5 d 15 a 25 c 35 b
6 c 16 c 26 c 36 c
7 c 17 d 27 a 37 d
8 a 18 d 28 c 38 c
9 d 19 d 29 a 39 c
10 d 20 c 30 c 40 d
Typesof Auditing

1. Audit can be divided into two categories

a) Internal audit and external audit
b) Audit required under law and voluntary audit
c) Financial audit and cost audit
d) None of the above
2. Internal audit is an evaluation and analysis of the business operation conducted by the
a) Accounting staff
b) Managemene
c) Internal audit staff
d) External audit staff

3. In big organization an internal audit is carried out by the team of professionals

a) in the organization
b) outside the organization
c) As outsourcing function
d) as retailers

4. The purpose of internal Audit is to keep proper control

a) over accounting activities
b) over audit activities
c) over management activities
d) over business activities

5. The purpose of internal audit is to evaluate the

a) Accounting system
b) Internal audit system
c) Management accounting system
d) Statutory audit system

6. The purpose of internal audit is to review the

a) Accounting aspects
b) Auditing aspects
 369
c) working of employees
d) Working of business

7. The purpose of internal audit is to protect the

a) Accouning staff
b) Audit staff
c) Management
d) Assets

8. The purpose of internal audit is to evaluate the

a) Internal control system
b) Internal audit system
c) Internal check system
d) All of the above

9. The purpose of Internal audit is to detect the error in the

a) Bank records
b) Cash records
c) Accounting records
d) Employees records

10. The purpose of Internal audit is to detect frauds in the

a) bank accounts
b) Cash accounts
c) Cost accounts
d) Books of account

11. The internal audit can pin point the person responsible for
a) Errors
b) Frauds
c) Both errors and frauds
d) Carelessness

12. The purpose of internal audit is to help an

a) Internal audit
b) External audit
c) Management audit
d) Independent audit

13. The external auditor can rely on Internal auditor and there is no need of –
a) Stautory audit
b) Cost audit
c) Management audit
d) Cent percent checking

14. The purpose of internal audit is to,check the

a) Internal appraisal
b) Government appraisal
 370
c) External appraisal
d) Performance appraisal

15. The purpose of Internal audit is to provide suggestions for improvement of

a) Accounting activities
b) Audit activities
c) Employees activities
d) Business activities

[Link] purpose of internal audit is to determine liabilities of –

a) Accountant
b) Internal auditor
c) External auditor
d) Employees

17 .The internal auditor cannot compel the management to

a) Implement suggestions
b) Discontinue certain activities
c) Replace employees
d) None of the above

18. The internal audit staff can provide new ideas about
a) Accounting matters
b) Auditing matters
c) Legal matters
d) Various business matters

19. The purpose of internal audit is to determine the proper use of

a) Accouning staff
b) Audit staff
c) Leegal staff
d) Resources

20. The purpose of internal audit is to exmine tge

a) Auditing policies
b) Recruitment policies
c) Accounting policies
d) Production and sale policies

21. The benefit of internal audit is that proper accounting system is

a) Already being used
b) Not being used
c) Introduced
d) Not required

22. The benefit of internal audit is that there is better management of

a) Accounting concern
b) Auditing concern
 371
c) Legal concern
d) Business concern

23. Management could rely on internal audit for

a) Good results
b) Better results
c) Best results
d) All of the above

24. The management can review progress through

a) Internal check
b) Internal conrrol
c) Internal audit
d) External audit

25. The internal audit is helpful to have effective control over

a) Accounting activities
b) Auditing activities
c) Business activities
d) All of the above

26. The assets protection is possible through –

a) Internal control
b) Internal check
c) Internal audit
d) All of the above

27. The internal audit is helpful to apply

a) Division of labour
b) Integration of labour
c) Refinement of labour
d) Concentration of labour

28. The auditor can suggest the way and means to improve the
a) Accounting performance
b) Auditing performance
c) Management performance
d) Business performance

29. The internal audit is used to protect accounting records from

a) Errors
b) frauds
c) Both errors and frauds
d) None of the above

[Link] goals of business can be achieved if there isproper –

A ) Internal control b)Internal check
c) Internal audit d) All of the above
31 .The internal auditor can evaluate the result of
a) Accountant
b) Employees
c) Management
d) All persons

32. The auditor can go through the internal audit report at the time of
a) Starting audit work
b) Finishing audit work
c) Starting accounting work
d) Finishing accounting work

33. External auditor is responsible for

a) Internal audit
b) External audit
c) Both internal as well as external audit
d) Mangement audit

34. Internal auditor is helpful to improve the performance of the

a) Internal audit department
b) Statutory audit department
c) Accounting department
d) Organisation

35. Internal audit improves performance of

a) Accounts department
b) Audit department
c) Both account and audit department
d) Business and employees

36. Internal audit is used to check the proper use of

a) Accounts
b) Finanace
c) Employees
d) resources

37. Internal audit is a tool to use the resources in the best interest of the
a) Accounting staff
b) Audit staff
c) Bothe accounts and audit staff
d) Business

38. Internal audit is of help to investigate in to the

a) Accounting matters
b) Business matters
c) Financial matters
d) Employees matters

39. The limitation of internal audit is

a) Shortage of time
b) Shortage of finance
c) Shortage of time and finance
d) Shortage of staff

40. The shortage of staff is a hurdle to get benefit of

a) Internal audit
b) External audit
c) Performance audit
d) Efficiency audit

41. The limitation of internal audit is that it starts when

a) Errors are detected
b) Errors are suspected
c) Errors remains undetected
d) Accounting ends

42. If audit staff is competent there is less chance of errors being

a) Detected
b) Suspected
c) Located
d) Undetected

43. In case of poor audit staff there is no guarantee that audited accounts are
a) Full of errors
b) Free from errors
c) Free from frauds
d) Full of frauds

44. The limitation of internal audit is thatmanagement may not feel their responsibility in completing
the
a) Accounts formalities
b) Legal formalities
c) Audit formalities
d) Compliance formalities

45. The owners(shareholders)need assurance that the financialStatements prepares by the

management are
a) As per norms
b) Fair
c) Reliable
d) Reasonable

46. Other users of financial statements ,[Link] creditors,[Link] institutions. Tax

authorities,other government authorities,labour [Link],also place greater reliance
a) Computerised accounts
b) Internally audited accounts
c) Externally audited accounts
d) None of the above

47. Section 224 of the Companies Act 1956 contains provisions regarding the appointment of the –
a) Accountant
b) Internal auditor
c) External auditor
d) All of the above

48. Secretarial Audit is a ------------ and it is a part of total compliance management in an

Organization
a) Company audit
b) Management audit
c) Legal audit
d) Compliance audit

49. The secretarial audit is an effective tool for corporate compliance management. It helps to detect
non-compliance and to take
a) Appropriate action
b) Legal action
c) Corrective measures
d) All of the above

50. Secretarial audit is essentially a mechanism to monitor compliance with the requirements of
a) Company laws
b) Mercantile laws
c) Stated laws
d) Corporate laws

51.A compny secretary In Practice has been assigned the role of under section2(2)(c)(v) of
the Company Secretaries Act,1980-
a) Internal auditor
b) Company auditor
c) Statutory auditor
d) Secretarial auditor

52. It is recommended that the --------- be carried out periodically(quarterly/half yearly)and adverse
findings if any, be communicated to the Board for corrective action
a) Internal audit
b) Statutory audit
c) Financial audit
d) Secretarial audit

53. As of now ------- is not mandatory on the companies

a) Secretarial audit
b) Statutory audit
c) Cost and management audit
d) Internal audit

54. Ministary of Corporate Affairs has issed mandatory -on Companies engaged in Bulk
drugs,fertiliation,sugar ,telecommunications,industrial alcohol and electricity &petroleum
a) Secretarial audit records
b) Financial audit records
c) Statutory audit records
d) Cost audit records

55. Cost audit is mandatory if in immediate previous year aggregate value of exceeds the
specified limits
a) Total turnover
b) Paid up capital
c) Net worth
d) Total assets

56. The cost auditor has to judge, whether the planned expenditure is designed to give
a) Good results
b) Appropriate results
c) Targeted results
d) Optimum results
57. The cost auditor has to judge ,whether the size and channels of expenditure were designed to
produce the
a) Good results
b) Better results
c) Best results
d) optimum and targeted results

58. The cost auditor has to judge, whether the return from expenditure on capital as well as current
operations coluld be improved by
a) New methods and techniques
b) Scientific plans and a actions
c) Innovative skills
d) Some other alternative plan of action

59. Cost audit is useful for the purpose of ------ and proper utilization of scarce
Resources
a) Incresing profit
b) Reducing cost
c) Cost control and cost reduction
d) Optimum utilization

60. The objective of tax audit is to assist the---- in making the correct income tax assessment of
the assessee concerned
a) Government
b) Commissioner of income tax
c) CBDT
d) Income tax authorities

61. The tax auditor has to specifically report on certain transactions which have an effect on the -----
----of the assessee concerned and are,thus important to the tax authorities.
a) Income
b) Profits
c) Income tax liability
d) All of the above

62. Therre are certain features of co-operative which are similar to those of
a) Sole proprietorships
b) Partnership
c) Companies
d) All of the above

63. As in the case of companies , in co-operative socities also,there is a of ownership from

management
a) Integration
b) Seperation
c) Coordination
d) None of the above

64. Secretarial audit is optionally undertaken by the companiefor maintaining

a) Proper accounting
b) Proper records,documents& supervision
c) Good compliance management system
d) Good corporate Governance practice

65 of trusts assures the creators of trust and /or those for whose benefit the trust is
created.([Link])the financial statements of the trust are reliable.
a) Independent accounting
b) Independent financial audit
c) Independent appraisal
d) Independent internal audit

66. In many cases, it is specifically provided in the relevant law and/or in the trust deed that the ---
-----shall get the financial statements of the trust audited.
a) Owners
b) Management
c) Members
d) Trustees

67. In India the Income tax Act.1961,provides for non-Inclusion of certain incomes of
in their taxable income
a) Private trusts
b) charitable trusts
c) Public trusts
d) Educational and religious trusts

68. Many public trust ge their accounts audited pursuant to the requirement of the ---------
a) Companies Act
b) Indian Trusts Act
c) Cooperative socities Act
d) Income Tax Act,1961

69 is an examination of the operations,records and books of account of the insurance

company.
a) Internal audit
b) Extenal audit
c) Insurance audit
d) Tax audit

70. Auditor performs an audit to ensure that the customer has paid the appropriate premium for---
-------- provided to him.
a) Benifit
b) Assurance
c) Risk cover
d) All of the above

71. At present ,partnership firms in India are ------ to get their financial statements audited.
a) Legally required
b) Not legally required
c) Compulsorily
d) None of the above

72. Still, many firms get their financial statements audited as auditied accounts helps in proper
a) Maintainance of accounts
b) Maintainance of assets and properties
c) Valuation of goowill,distribution of share of the deceased Partner to their legal heirs etc.
d) All of the above.

73. Sole proprietary concerns are ------- to get their financial statements audited by independent
financial auditors.
a) Legally required
b) Not legally required
c) Ethically required
d) Not ethically required.

74. It is the duty of -----------to audit the receipts and expenditure of the union Government and State
Government
a) External (statutory auditor)
b) Secretarial auditor
c) Government
d) Comptroller and Auditor General of India (C&AG)
75. Audit of government companies can be conducted by
a) A Chartered Accountants in whole time practice
b) A Cost Auditor in whole time practice
c) A Company Secretary in whole time practice
d) Comptroller and Auditor General of India

76. Generally management audit /operational audit is –

a) Mandatory
b) Compulsory
c) Not mandatory
d) Not mandataory

77. A performance audit can be a review of a program to assure that it is

a) Complete
b) Satisfactory
c) Foolproof
d) Satisfying its objectives

78. but it recommendatory certainlyAfter the function audit, propersystems are put in place and gaps
as identified are filled by way of –
a) Legal actions
b) Corrective actions
c) Corroborative actions
d) Compensatory actions

79 may take into account the anticipated benefits of aprogram relative to the actual
Performance
a) Targeted performance
b) The performance audit
c) Planned performance
d) Achieveable and standard performance

80. The performance audit may be initiated by the organisation or by

a) Government
b) Employees and management
c) Shareholders
d) External interested parties

81. Balance sheet audit does not include

a) Vouching of income, expense, accounts related to assets and liabilities
b) Examination of adjusting and closing enthes
c) Verification of assets and liabilities d)Routine checks.

82. Cost audit is releted to

a) Cost accounting records
b) Compliance
c) Financial statements
d) Balance and Peofit &Loss account
83. Secretarial audit is also termed as
a) Financial audit
b) Compliance audit
c) operational audit
d) Tax audit

84. Cost audit i compulsory for

a) Specified entities
b) Specified industries
c) All companies
d) All manufacturing companies

85.A Company Secretary in Practice has been authirized under Section 2(2)(c)(v) of the Company
Secretaries Act 1980, to conduct:
a) VAT Audit
b) Secretarial Audit
c) Cost Audit
d) Bank Audit

86. Which types of audit is conducted by the internal audit staff:

a) Cost Audit
b) Secretarial Audit
c) Internal audit
d) Tax audit

87. Balance sheet audit is also known as:

a) Continues Audit
b) Annual audit
c) Internal audit
d) Financial audit

[Link] audit is conducted by:

a)Chartered Accountant in Practice b)Lawyer c)Internal auditor d)Company Secretary in practice

89. Which type of audit is conducted by the Internal audit staff:

a) Cost Audit
b) Secretarial Audit
c) Internal Audit
d) Tax Audit

90. In comparision to the independent auditors, an internal auditor is more likely to be concerned
with:
a) Cost accounting system
b) Internal control system
c) Legal compliance
d) Accounting system
Answers:

1 b 21 C 41 d 61 d 81 d
2 c 22 D 42 d 62 c 82 a
3 a 23 D 43 b 63 c 83 b
4 d 24 D 44 c 64 b 84 b
5 a 25 C 45 c 65 b 85 b
6 d 26 C 46 c 66 d 86 c7 d 27 c 47 c 67 c 87 d8 c 28 a 48 d 68 b 88 d9 c 29 d 49 c 69 c 89 c10 d 30 c
50 c70 c 90 b
11 d 31 d 51 d 71 b
12 d 32 a 52 d 72 c
13 d 33 b 53 a 73 b
14 d 34 d 54 d 74 d
15 d 35 d 55 d 75 d
16 d 36 d 56 c 76 d
17 a 37 d 57 d 77 b
18 d 38 b 58 c 78 d
19 d 39 d 59 d 79 b
20 c 40 a 60 C 80 d

Tools of Auditing

1 lays out the strategies to be followed to conduct an audit.

a) An action plan
b) An audit plan
c) An audit programme
d) All of the above

2. The objective of the auditor is to plan the audit so that it will be performed in
a) planned way and manner
b) timely manner
c) Both(a)and(b) above
d) an effective manner

3. While framing an audit plan auditor should ascertain his cast by various legislations on him.
a) Limitations
b) Duties and obligations
c) Rights and powers
d) Terms of appointment and responsibiliteies

4. Auditor should determine the ------ and the timing of the report.
a) Nature
b) Actual
c) Nature and actual
d) Form
5 followed by the enterprise affect the audit plan.
a) Accounting policies
b) Audit policies
c) Accountingand audit policies
d) Management policies

6. While preparing an audit plan due consideration may be given to the areas where there is any
change in
a) Legal policies
b) Audit policies
c) Accounting policies
d) Management policies

7. It is important for the auditor to identify the areas which involves , so that the audit can be
planned in such a way that overall audit risk will be less.
a) Lesser audit risk
b) Great audit risk
c) Inherent audit risk
d) Zero percent audit risk

8. While laying down an audit plan the auditor shall assess the effectiveness of
a) Accounting system
b) System of internal controls
c) Both (a)and (b) above
d) External controls on the operations of the entity

9. The nature and extend of audit evidence will vary

a) in different auditing situations
b) In different accounting situations
c) Indifferent managing situations
d) from one organisation to another organization

10. An audit programme is a set of--------- which are to be followed for proper execution of audit.
a) Orders
b) Directions
c) Instructions
d) Rules

11. The prepared audit program may be ------- if needed in accordance with the prevailing
circumstances.
a) Reviewed
b) Revised
c) Rechecked
d) Reconsidered

12. An audit program largely depends on the

a) Size of the business activities
b) Size of the documents and record
c) Size of the auditing staff
d) Size of the organization and other relevant factors.

13. Minimum essential work to be done is ------- and rest is according to circumstances.
a) Standard programme
b) General programme
c) Essential programme
d) Relevant programme

[Link] is no ----------- applicable for all situations.

a) Relevant audit programme
b) Actual audit programme
c) Writtenaudit programme
c) Standard audit programme

15. Audit programme is documented in the ------ ,which are the official rrecord that contains the
planning and execution of the audit agreement.
a) Audit plan
b) Action plan
c) Audit and action plan
d) Audit working papers

16. Audit programmes helps in ensuring that all important areas are appropriately covered during.
a) Accounting
b) Recording
c) Auditing
d) Accounting and auditing

17. Audit programme helps in distributing the work among the assistants in accordance with the
level of their.
a) Qalifications
b) Past knowledge
c) Expertise
d) Competence and experience

18. Audit programme provides instructions to the audit staff and reduces scope for
a) Understanding
b) Misunderstanding
c) Negligence
d) Liabilities

19. Audit programme helps in fixing the ------ for the work done among the audit staff as work
done may be traced back to the individual staff members.
a) Remuneration
b) Liabilities
c) Ngligencies
d) Responsibility
 383

20. Audit programme serves as evidence against charge of

a) Liabilities
b) Qalifications
c) Responsibilities
d) Negligence

21. On completion of an audit -------------- serves the purpose of audit record which may be useful
for future reference.
a) Audit programme
b) Audit working papers
c) Audit plan
d) Audit notes

22. Each business has separate problems. So a single/same audit programme can not be laid down
for
a) Each type of CA firms
b) Each type of work
c) Each type of method
d) Each type of business

23. The audit programme is-------- that it ignores many other aspects like internal contol.
a) Automational
b) Mechanical
c) Professional
d) Emotional

24. With the passage of time new problems arises during the audit may be in the audit Programme.
a) Looked
b) Over looked
c) Under looked
d) Ignored

25. Audit programme should be flexible must be always opens to changes and
a) Revisions
b) Insertions
c) Qualifications
d) Improvements

26. The audit staff should be encouraged to draw attention of the - to any defects in the
programme.
a) Company
b) Management
c) Accountant
d) Auditor

27. Audit programme kills the of capable persons. Assistantcan not suggest any improvement in the
 384
plan.
a) Qualities
b) Qualification
c) Efficiency
d) initiative

28 is an outline of how the audit is to be done,who is to do what work and within what
time.
a) Audit strategy
b) Audit plan
c) Audit programme
d) Audit methods

29 refers to the method and means adopted by the auditor for collection and evaluatin of
audit evidence in different audit situation:
a) Audit evidence
b) Audit tools
c) Audit planning
d) Audit technique

30. Audit programme is prepared bya)The auditor b) The client c)The audit assistant d)The auditor
and his [Link] maintainance is the function of;
a) Auditor
b) Accountant
c) Auditor staff
d) Practicing professionals.

31. Time, extent and ------------ of audit depends upon effectiveness of internal control:
a) Nature
b) Periodicity
c) Relevance
d) Format

32. What are analytical procedures:

a) Substantive tests designed to assess control risk
b) Substantive tests designed to evaluate the validity of management’s representation letter
c) Substantive tests designed to study relationships between financial and non-financial
information
d) all the above

33. The auditor has to obtain ------------- to substantiate his opinon on the financial statements.
a) Internal evidence
b) External evidence
c) Internal and external evidence
d) Sufficient and appropriate evidence

34. The audit evidence provides grounds for believing that a particular thing is by providing
support for a fact or a point in question.
a) Correct
b) Incorrect
c) True or not
c) Acceptable

35. The evidences collected by the auditor must support the contents of the
a) Audit work
b) Audit plan
c) Audit programme
d) Auditor’s report.

36. The audit evidence --------- ,the auditor to form an opinion on the financial
Information
a) Provides
b) Entitles
c) Enables
d) Supports

37. Sufficient evidence can be obtained by test checking instead of checking.

a) Routine
b) Exensive
c) Substantial
d)100%Evidence obtained by auditor are persuasive rather than in nature
38. The reliability of audit evidence is depend upon
a) Timing
b) Source
c) Nature
d) Surce and nature

39. Whether the evidence obtained within the organization,it is called

a) Internal
b) Reliable
c) Believable
d) External

40. When the evidence is obtained from outside the organization,it is called
a) Internal
b) External
c) Reliable
d) Corroboraative

41. The obtained audit evidence must be ------- to the matter being checked
a) correct
b) Reliable
c) Irrelevant
d) Relevant

42. Documentary evidence is usually better than -- evidence.

a) Circumstantial
b) visual
c) verbal
d) Testimonial

43. Audit evidence is more reliable when the auditor obtains ----- from difference sourcesor of
a different nature.
a) Internal evidence
b) External evidence
c) Circumstantial evidence
d) Consitent evidence

44. The quality of informantion generated by the audited organization is directly related to the
strength of the organization’s
a) Internal check
b) Internal control
c) Internal audit
d) All of the above

45. Evidence ------------- through the auditor’s direct observation,inspection and computation is
usually better than evidence obtained indirectly
a) Generated
b) Created
c) Fabricated
d) Manipulated.

46. Which of the following is not a technique of obtaining evidence.

a) Confirmation b)Computation
c)Analytical review procedures d)Guess work

47. Appropriateness of evidence depends on the following:

a)Information must be reliable b) Information must be affordable
c) Information must be relevant d) Information must be valid

48. The auditor has to obtain sufficient appropriate evidence toa)Form his opinion b)Mention his
opinion
c)Substantiate his opinion d)confirm his opinion

49. Which of the following is not corroborative evidteence? a)Minutes of meetings; b)Confirmations
from debtors; c)Information gathered by auditor through observation; d)Worksheet supporting
consolidated financial statements.

[Link] refore evidence cannot be 100% reliable.

a) Reliable
b) Circumstantial
c) conclusive
d) Attractive
[Link] of the following is not a technique of obtaining evidence.
a) Inspection
b) Observation
c) Enquiry
d) Investigation.

[Link] working papers are the property of th and the client cannot ask the auditor for their custody
a) Assistants who actually worked
b) Client
c) Auditor
d) Government

53 are the documents prepared or obtained by the auditors and tetained by him in
connection with the audit.
a) Audit notes
b) Audit working papers
c) Audit evidence
d) All of the above

54. Working papers are the connecting link between the

a) Auditor and his staff
b) Audit assistant and management
c) Auditor and audited accounts
d) Client’s records and the audited accounts

[Link] working papers provide --------historical record.

a) Permanant
b) temporary
c) Transitory
d) sometimes permanent and sometimes temporary as per the situation

56. Audit working papers are also serving as a great guide to the staff to whom the work of audit has
been assigned
a) Before the previous year audit
b) After the previous year audit
c) Before the next year audit
d) After the next year audit

57. It is the duty of the auditor to maintain --------- of the client information
a) Accuracy
b) Follow up
c) Secrecy
d) Confidentiality

58. Working papers helps in proper ------- of audit.

a) Planning
b) Performance
c) Planning and performance
d) Execution

59. Seniors can supervise the audit work performed by the juniors by examining their
a) Records and documents
b) Performance
c) Behaviour at work place
d) working papers

60. Working papers provide as evidence of the audit work performed to

a) support the auditor
b) support the audit assistant’s work
c) Save the auditor against adverse consequences
d) support the auditor’s opinion.

61. The Auditors Working Papers are divided into two parts;
a) Permanent audit file and current audit file
b) Permanent audit file and temporary audit file
c) temporary audit file and current audit file
d) current audit file and transitory audit file

Answers:

1 b 16 d 31 b 46 d 61 d2 d 17 d 32 a 47 a 62 a3 d 18 c 33 c 48 d4 d 19 d 34 d49 d5 a 20 d 35 d 50 c
6 c 21 a 36 a 51 a
7 b 22 d 37 c 52 d
8 c 23 d 38 d 53 b
9 a 24 b 39 c 54 d
10 c 25 b 40 d 55 a
11 b 26 d 41 a 56 b
12 d 27 d 42 b 57 c
13 a 28 c 43 d 58 d
14 d 29 d 44 c 59 c
15 c 30 a 45 b 60 d

13-AUDITOR AND RELATED PROVISIONS

1.A person who conducts an audit is an

a) Chartered Accountant
b) Cost Accountant
c) Company Secretary
d) Auditor

2. An auditor is a professional that accumulates and evaluates evidence to report whether the
company complies with the
a) Accounting policies
b) Accounting standards
c) Goverment policies
d) Established set of procedures or standards

3. An auditor may function as

a) An employee
b) Independent professional
c) An employee or an independent professional
d) An external professional

4. When the auditor works for the organization,he or she is usually referred to as an
a) Chief accountant
b) Employee
c) External auditor
d) Internal auditor

5. The internal auditor often conducts -- that may encompass several on a rotating basis
a) Internal audit
b) Periodic audits
c) Work beneficial to external auditor
d) Continuous audit

6. Often, the internal auditor will set up a schedule to ensure that audits are conducted o
of the company at least once per calendar:
a) each aspect
b) each area
c) each wing
d) each critical portion

7. So many Acts require organizations to get their accounts audited by

a) A qualified chartered Accountant
b) An internal auditor
c) An independent external agency
d) An independent internal agency

[Link] independent external agency is known as ----- of the organization.

a) Internal auditor
b) External auditor
c) Management auditor
d) All of the above

9. The external auditor has to check the accounts of the organization,and their compliances to
various
a) Rules and regulations
b) Needs and purposes
c) Requirements
d) Auditing standards

10. Section 224 of the Companies Act 1956 contains provisions regarding the
a) Remuneration of the external auditor
b) Remuneration of the internal auditor
c) Appointment of the auditor
d) Appointment of the internal auditor

11. As per section224 the auditor of any company can be appointed by the shareholders however in
some cases the auditor can be appointed by the
a) Government of the state in which the company is registerd
b) Directors
c) Central Government
d) Directors or the central government

12. Section 224(5)provides that the first auditor or auditors are to be appointed by the
a) Shareholders
b) Board of directors
c) Managing Directors
d) Central government

13. First directors are appointed with --------- of the date of the registration of the
Company.
a) One month
b) two months
c) Threemonths
d) Six months

14. The first auditor so appointed shall hold office till the conclusion of
a) First accounting year
b) Next accounting year
c) First Annual General Meeeting (AGM)
d) First statutory meeting

15. Company is not required to sent any intimation of appointment to first auditor to The
a) Auditors
b) Board of directors
c) Central government
d) Registrar of companies

16. In case the Board of Directors fails to appoint the first auditors within one month of its
incorporation the------------------- may appoint the first auditors.
a) Chairman of the company
b) Managing dorectors
c) Company in general meeting
d) central government

17. On appointment of subsequent auditors, the company must give intimation within 7 days of such
appointment to
a) The board of directors
b) The registrar of companies
c) The auditor so appointed
d) The central government

18. Sub-setion(6)of section 224 provides that the casual vacancy in the office of auditor may be filled
by the
a) Board of directors
b) shareholders
c) Central Government
d) C&AG

19. Where the vacancy is caused by resignation of auditor,such vacancy shall only be filled by the
a) C&AG
b) Cental Government
c) Company in general meeting
d) Board of directors

20. The auditor appointed in the casual vacancy holds office till the conclusion of the Next
a) Annual general meeting
b) Board meeting
c) Extraordinary general meeting
d) Financial year.
21. Casual vacancy means vacancy created by the ceasing to act after being validly appointed and
acceptance of appointement.
a) Chief accountant of the company
b) Board of directors
c) The auditor
d) The authority who appointed him

22. Examples of casual vacancy are vacancy arising due to

a) Resignaation of the auditor
b) Death ofthe auditor
c) Disqualification of the auditor
d) All of the above

23. If no auditors are appointed or re-appointed at the annual general meeting, The may appoint a
person to fill the vacancy [Section 224(3) ]
a) Board of directors
b) company in general meetong
c) Central Government
d) Comptroller and Auditor General of India (C&AG)

[Link] to give notice regarding filling of casual vacancy to the Central government is an offence
punishable with fine who of the following are the persons on whom such fine can be imposed –
a) Directors
b) company
c) Every officer of the company
d) Company or every officer of the company

25. Who may appoint an auditor in a casual vacancy arising due to resignation of auditor
a) Board of directors
b) Company in general meeting
c) Central government
d) Any of the above

26. In case the directors fail to appoint first auditor(s), the shareholders shall appoint Them at
bypassing a resolution
a) A general meeting
b) First annual general meeting
c) Statutory meeting
d) Annual general meeting

27. In a casual vacancy in the office of auditors arises by his resignation it should only Be filled by
the company in a -------------------------- --.
a) Boards’s meeting
b) Extraordinary general meeting
c) General meeting
d) Annual general meeting

28. The auditor of a Govermnent Company is appointe by the----------

a) Comptroller and Auditor General of India
b) The shareholder in a general meeting
c) The shareholder at an annual general meeting
d) The board of directors

29. Who appoints internal auditor

a) Management
b) Shareholders
c) Government
d) Stock exchange

30. Every auditor appointed under section224(1),must intimate to the registrar within----------- days of
the receipt of intimation of appointment from the company
a) 15
b) 21
c) 30
d) 18

31. The authority to remove the first auditor before the expiry of the term is witha)The shareholder in
a general meeting
b) The shareholders in the first annual general meeting
c) The board of directors
d) The central Government
32. Who out of the following cannot be appointed as a statutory auditor of the company
a) Erstwhile director
b) Inetrnal auditor
c) Relatove o! A director
d) only (2) and (3)

33. Section 226 contains provision as regards

a) First appointment of auditors
b) Subsequent appointment of auditors
c) Qualification s and disqualifications of auditors
d) All of the above

34. Provisions of section226 prescribed by section 26 regarding qualification and Disqualification of

auditor
a) Pvt,[Link]
b) Public [Link]
c) Section 25 companies (companies not for profit
d) Government companies e)All of the above

35. Who of the following can be appointed auditors of a limited company

a) A chartered accountant in practice
b) A cost accountant in practice
c) A company secretary in practice
d) All of the above
36. Where firm of chartered accountants is appointed as auditors,who of the following may act the
name of the said firm
a) Any partner of the firm
b) Any director of the firm
c) Any employee of the firm,who is also a chartered accountancy
d) Any of the above.

37. Disqualification of an auditor is defined under section 226(3)of the Companies Act,1956 ina
a) Positively
b) Negatively
c) Exhaustively
d) Inclusively

38. A statutory auditor ----------- also as internal auditor of the company.

a) can act
b) cannot act
c) though can act but ethically should not act
d) None of the above

39. A person acquires disqualification for appointment as a statutory auditor of the when he is
indebted to the company for more than
a) Rs.1000
b) Rs.5000
c) Above Rs.1000
d) Any sum

40. In the context of qualification or disqualification for appointment as statutory auditor,an

employee or officer of the company includes
a) Director
b) Manager
c) Secretary
d) All of the above

41. A person shall not be qualified to be appointed as an auditor of the company if he is in the
employment of
a) An officer of the company
b) An employee of the company
c) Both (a) and (b)
d) None of the above

42. If a partner of a firm of chartered accountants (who is appointed as statutory auditors) is

disqualified then the firm ----------- disqualified
a) will automatically be
b) will not be
c) may or may not be
d) will normally be.

43. In case of insolvency or unsound mind , a person will automatically be disqualified for
appointment as an auditor, because
a) He is not a person of repute
b) He cannot take decision properly
c) He is not wealthly
d) He ceases to be a member of ICAI

44. Who can be appointed as an auditor of the company;

a) Body corporate
b) A person who has indebted for more than Rs.1000
c) An officer of the company
d) A parter of a firm.

45 Of the Companies Act,1956 contains provisions regarding the appointment of

thecompany:a)Section223 b) Section221
c) Section 224 d) Section 226

46. The quality of auditor to be free from influence is being defined by which term
a) Self-control
b) objective
c) Independence
d) unbiased

47. The auditor of a compay shall have right of access , at all times, to the books, accounts and
vouchers of the company,whether kept at the
a) Regisered office of the company
b) Head office of the company
c) Corporate office of the company
d) Anywhere

48. The auditor shall be entitled to require from the officers of the company such-----
as he theinks necessary for the performance of his duties as auditor.
a) Documents and records
b) Informations
c) Explanations
d) Informantion and explanation

49. In case the information is not supplied tothe auditor, he can report the same to the
a) Board of directors
b) Managing director
c) Members
d) Chief executive officer(CEO) of the company

50. Only the person appointed as auditor of the compay or where a firm is so appointed, only a partner
in the firm practicing in India,may sign the
a) Certificate
b) Working papers
c) Documents
d) Auditor’s report
51. The auditors have the right to attend
a) Board meeting
b) Annual general meeting
c) Extraordinary general meeting
d) Any general meeting

52. Where the accounts of any branch office are audited by a person other than the company’s
auditor, the company’s auditor
a) Shall not be entitled to visit the branch office
b) Shall be entitled to visit the branch office
c) is not required to visit the branch office
d) is compulsorily required to visit the branch office

53. Where the accounts of any branch office are audited by a person other than the company’s
auditor, the company’s auditor
a) shall have a right of access
b) shall not have a right of access
c) shall berequired to access
d) shall not be required to access

54. The auditor shall have the right to receive ---- fro auditing the accounts of the company.
a) Remuneration
b) Comission
 396
c) Reward
d) Award

55. The duties of an auditor are

a) Many and general
b) Many and specific
c) General and specific
d) Many and varied

56. The auditor must examine the original books of account,kept by the company to discover any -
-----therein.
a) Inefficiencies
b) Irregularities
c) Inaccuracies or omissions
d) Errors and frauds.

57. The auditors’s duty is to examine the company’s balance sheet and profit and loss account,and
report on the original books of account and the annual accounts to the
a) Board of directors
b) Managing director
c) Members
d) Authority who has appointed him/her

[Link] 227(1A)requires an auditor to inquire;

Whether loans and advances made by the company have been shown as
a) Loans
b) Advances
c) Deposits
d) All the above

59. Section 227(1A) requires an auditor to inquire;

Whether personal expenses have been charged to
a) Capital accounts
b) Revenue accounts
c) Goodwill accounts
d) Assets accounts

60. Section 227(1A) requires an auditor to inquire; Whether -- hs actually been received in
respect of any shares shown in the books to have been allotted for cash
a) Payment
b) Cash
c) Asset
d) Consideration

61. Section 227(1A) requires an auditor to inquire;

Whether the position as stated in the books is correct,regular and is
a) Healthy
b) Sound
 397
c) Misleading
d) Not misleading

62. Auditor has to obtain --------- audit evidence;

a) Adquate
b) Correct
c) Relevant
d) Sufficient and appropriate

63. Who will be responsible for errors i report if external audit relies on the work of internal auditor:
a) External auditor
b) Internal auditor
c) Management
d) Shareholders

64. The retiring auditor does not have a right to;

a) To make written representation
b) Get his representation circulated
c) Be heard at the meeting
d) Speak as a member of the company

65. When an independent auditor relies on the work of an internal auditor ,he or she should;
a) Examine the scope of internal auditors work
b) Examine the system of supervising,review and documentation of internal auditor’s work
c) Adquacy of related audit programme.
d) All of the above

66. In comparison to the independent auditor,an internal auditor is more likely to be concerned with;
a) Cost accounting system
b) Internal control system
c) Legal compliance
d) Accounting system

67. Whether the management can restrict the scope of work of external auditor;
a) Yes
b) No
c) In some cases
d) If shareholders permit

68. It is the duty of the auditor to ------------ to the members of the company on theAccounts
examinedby him.
a) Give suggestions
b) Comment
c) Refer certain points
d) Make a report,

69. The reports besides other things necessary in any particular case,must expressly state; Whether
the balance sheet gives a true and fair view of the-------------------- as at the end of the financial year.
a) Assets and liabilities
b) Financial position
c) Company’s standing
d) company’s affairs

70. The report, besides other things necessary in any particular case, must expressly state; Whether
the profit and loss account gives a true and fair view of the ------------ for the financial year.
a) Financial position
b) company’s earning capacity
c) Profit and loss
d) All of the above

71. The report, besides other things necessary in any particular case, must expressly state; Whether
in his opinion , the profit and loss account and balance sheet comply with the -----------referred to i
Sub-section(3C) of section 211.
a) Auditing standards
b) Auditing guidelines
c) Accounting principles and policies
d) Accounting standards

72. The report, besides other things necessary in any particular case, must expressly state; --------
-the observation or comments of the auditors which have any adverse effect on the functioning of
the company.
a) In thick type
b) In italics
c) In thick type or in italics
d) In bold type

73. The report, besides other things necessary in any particular case, must expressly state;Whether
any director is ----------- from having appointed as director under clause (g) of 274(1)
a) Qualified
b) Disqualified
c) Qualified or disqualified
d) None of the above

74. Under Sub-section (4A) of section227 the ---------- is empowered to issue order requiring
the auditor to include in his report a statement on such matters as may be specified
a) Central Government
b) State Government
c) Comptroller and Auditor General of India (C&AG)
d) Registrar of Companies.

75. Cental Government had issued an order called

a) Manufacturing & other companies (report)order (MAOCARO)
b) General (Auditor Report) order2003 (GARO)
c) Company’s Report order.2003
d) Companies (Auditor Report) order2003 (CARO)
76. Auditor’s report is the expert’s opinion expressed by the auditor as to the fairness of-
a) Financial position
b) General position
c) Financial statements
d) Balance sheet and profit and loss account

[Link] will report on the matter and points as specified insection 227(1A) only if has a--------- to
make otherwise he will not make any comment.
a) General comment
b) Particular comment
c) Special comment
d) Legal comment

[Link] 227(4) states that where any of the abovematters is answered ,the Auditor’s report must
state the reason for the same
a) Positively
b) In the negative
c) With a qualification
d) INthe negative or with a qualification

79. is the medium through which an auditor expresses his opinion on the financial
Statements
a) Auditors observation
b) Auditors comments
c) Auditors views
d) Auditors report

80. Auditors report is an important part of ----- since it summarize the results of the examination
work conducted by the auditor
a) Accounting process
b) Audit process
c) Accounting and audit process
d) None of the above

81. The report shows the scope of the work done and the responsibility assumed by the auditor
regarding the ------------ of the financial statements.
a) Truthfulness
b) fairness
c) correctness ot otherwise
d) Fairness or otherwise

82. The auditor draws appropriate conclusions by ------ , which he conveys through theauditreport.
a) Examining books of account
b) Examining documents
c) Examining statements
d) Examining the various statements and accounts

83. Auditor report is addressed to the members of the company and is considered at the -----------
 400
of the company.
a) Board Meeting(BM)
b) Annual General Meeting (AGM)
c) Extraordinary Geneeral Meeting(EGM)
d) All of the above

84. Audit reports should be so drafted that they remain simple and intelligible to
a) Readers
b) Directors
c) employees
d) A comman man

85. The auditor report should be explicit so as to provide greater informantion and protection to the
interest of--------------- and others.
a) Board of Directors
b) Employees
c) Shareholders
d) Debtors and Creditors

86. An auditors report must have appropriate title, such as

a) Auditor’s opinions
b) Auditor’s observations
c) Auditor’s comments
d) Auditor’s Report

87. The management can issue any report about the

a) Accounts
b) Finance
c) Business performance
d) All of the above

88. The addressee in Auditor’s report may be

a) Managing Director
b) Board of director
c) Shareholders
d) Bothe (b) and (c)

89. The financial statement include

a) Trading profit and loss accounts,balance sheet
b) Statement of changes in financial position
c) Cash flow statements
d) All of the above

90. The audit report should indicate the ------- or practice followed in conducitong the audit.
a) Accounting standards
b) Auditing standard
c) Auditing guidelines
d) Accounting policies
 401

91. The audit report should be signed in the name of the –

a) Audit firm
b) Personal name
c) Either (a) or (b)
d) None of theabove

92. The auditor’s report shall be ----------the date on which the auditor has obtained sufficient
appropriatae audit evidence and date on which accounts are approved by the management.
a) dated
b) dated not earlier than
c) dated but not later than
d) None of the above

93. The auditor’s opinion may be of the following types

a) Unqualified opinion
b) Adverse opinion
c) Qualified opinion, and
d) Disclimer of opinion
e)Any of the above

94. Where auditor does not have any, reservation, objection, regarding the information under audit,
then he issues an
a) Adverse opinion
b) Qualified opinion
c) Unqualified opinion
d) Disclaimer of opinion.

95. Unqualified opinion as also known as

a) Adverse opinion
b) Disclaimer of opinion.
c) Clean report
d) None of the above

96. Where auditor expresses ---------- , he should also slate in his report the reason for the same, so
that the readers can assess their significance and effect.
a) An adverse opinion
b) Unqualified opinion
c) Disclaimer of opinion.
d) All of the above

97. In a situation where neither the unqualified, nor adverse opinion is appropriate the auditor gives
the
a) Clean report
b) Qualified opinion
c) Disclaimer of opinion
d) None of the above
98. Where auditor expresses a qualified opinion,he should also state in his report the
a) Matters on which he is satisfied
b) Matters on which he is not satisfied
c) Reasons for the qualified opinion
d) Consequencces of the dissatisfied areas/points

99. The words ----------- are written to show qualification.

a) Provided that
b) Qualifications
c) Notwithstanding
d) subject to

100. Due to lack of audit evidence , auditor issues a:

a) Qualified opinion
b) unqualified opinion
c) Averse opinion
d) Disclaimer of opinion

101. When auditor does not have any reservation,objection regarding the information under audit
then he issues an
a) Qualified opinion
b) Averse opinion
c) unqualified opinion
d) Negative opinion
102. Auditor has to give its opinion whether the financial statement depicts:
a) True and correct view
b) Fair and correct view
c) True and fair view
d) True and Exact view

103. Auditor has to report to:

a) Management
b) Owners
c) Government
d) Appointing authority

104. The date on auditor’s report should not be:

a) the date of AGM
b) later than the date on which the accounts are approved in boards’s meet.
c) earlier than the date on which the accounts are approved by the management
d) Both (a) and (b)

105. If the qualification are quantifiable (measurable)then the auditor has tit.
a) Quality
b) Calculate
c) Compute
d) Quantity
402
ANSWERS
1 d 21 c 41 c 61 d 81 d 101 a
2 d 22 d 42 d 62 c 82 d 102 c3 c 23 c 43 d 63 d 83 b 103 c4 d 24 d 44 d 64 a 84 d 104 d5 b 25 b 45
c 65d 85 c 105 d
6 d 26 a 46 c 66 d 86 d
7 c 27 c 47 d 67 b 87 c
8 b 28 a 48 d 68 b 88 d
9 a 29 a 49 c 69 d 89 d
10 c 30 c 50 d 70 d 90 b
11 d 31 a 51 d 71 c 91 c
12 b 32 b 52 b 72 d 92 b
13 a 33 c 53 a 73 c 93 e
14 c 34 e 54 a 74 b 94 c
15 d 35 a 55 d 75 d 95 c
16 c 36 a 56 c 76 a 96 a
17 c 37 b 57 c 77 d 97 b
18 a 38 b 58 c 78 c 98 c
19 c 39 c 59 b 79 d 99 d
20 a 40 d 60 b 80 b 100 da

403
 Business Economics
Business Economics covers most of the problems that a manager or an establishment faces.
Hence, the scope of business economics is wide. Since a firm can face internal/operational as well as
external and/or environmental issues, there are different economic theories applicable to them. Mi-
croeconomics helps with internal or operational issues whereas macroeconomics is applied to ex-
ternal or environmental issues. In this article, we will look at the scope of business economics un-
der both these heads.

The Scope of Business Economics

Microeconomics Applied to Operational Issues
As the name suggests, internal or operational issues are issues that arise within afirm and are within
the control of the management. It is within the scope of business economics to analyze this.

Further, few examples of such issues are choice of business, size of business, product designs, pric-
ing, promotion for sales, technology choice, etc. Most firms can deal with these using the following
microeconomics theories:

1. Analyzing Demand and Forecasting

Analyzing demand is all about understanding the buyer behavior. It studies the preferences of con-
sumers along with the effects of changes in the determinants of demand. Also, these determinants
include the price of the good, consumer’s income, tastes/ preferences, etc.
Forecasting demand is a technique used to predict the future demand for a goodand/or service. Fur-
ther, this prediction is based on the past behavior of factors which affect the demand. This is im-
portant for firms as accurate predictions help them produce the required quantities of goods at the
right time.
Further, it gives them enough time to arrange various factors of production inadvance like raw materi-
als, labor, equipment, etc. Business Economics offers scientific tools which assist in forecasting de-
mand.

2. Production and Cost Analysis

A business economist has the following responsibilities with regards to theproduction:
• Decide on the optimum size of output based on the objectives of the firm.
• Also, ensure that the firm does not incur any undue costs.
By production analysis, the firm can choose the appropriate technology offering a technically efficient
way of producing the output. Cost analysis, on the other hand,enables the firm to identify the behavior
of costs when factors like output, time period, and the size of plant change. Further, by using both
these analyses, a firmcan maximize profits by producing optimum output at the least possible cost.

3. Inventory Management
Firms can use certain rules to reduce costs associated with maintaining inventory in the form of raw
materials, work in progress, and finished goods. Further, it is important to understand that the inven-
tory policies affect the profitability of a firm. Hence, economists use methods like the ABC analysis
404
and mathematical models to help the firm in maintaining an optimum stock of inventories.

4. Market Structure and Pricing Policies

Any firm needs to know about the nature and extent of competition in the market.A thorough analysis
of the market structure provides this information. Further, with the help of this, firms command a
certain ability to determine prices in the market. Also, this information helps firms create strategies
for market management under the given competitive conditions.
Price theory, on the other hand, helps the firm in understanding how prices are determined under dif-
ferent kinds of market conditions. Also, it assists the firm increating pricing policies.

5. Resource Allocation
Business Economics uses advanced tools like linear programming to create thebest course of action
for an optimal utilization of available resources.

6. Theory of Capital and Investment Decisions

Among other decisions, a firm must carefully evaluate its investment decisions an allocate its capital
sensibly. Various theories pertaining to capital and investments offer scientific criteria for choosing
investment projects. Further, these theories also help the firm in assessing the efficiency of capital.
Business Economics assists the decision-making process when the firm needs to decide between
competing uses of funds.

7. Profit Analysis
Profits depend on many factors like changing prices, market conditions, etc. The profit theories help
firms in measuring and managing profits under such uncertain conditions. Further, they also help in
planning future profits.

8. Risk and Uncertainty Analysis

Most businesses operate under a certain amount of risk and uncertainty. Also, analyzing these risks
and uncertainties can help firms in making efficient decisions and formulating plans.

Macroeconomics applied to Environmental Issues

External or environmental factors have a measurable impact on the performance of a business. The
major macroeconomic factors are:
(a) Type of economic system
(b) Stage of the business cycle
(c) General trends in national income, employment, prices, saving, and investment.
(d) Government’s economic policies

405
(e) Performance of the financial sector and capital market
(f) Socio-economic organizations
(g) Social and political environment.
The management of a firm has no control over these factors. Therefore, it is important that the firm
fine-tunes its policies to minimize the adverse effects ofthese factors.

Solved Question for You

Q1. Demand Analysis is about understanding:
(a) buyer income
(b) buyer behavior
(c) the relationship between a buyer and seller
(d) number of buyers certainly buying from the competitors
Answer: Demand analysis is all about understanding the nature of the consumer’s preferences and
the effects of the changes in the determinants of demand on them. These determinants include the
price of the commodity, tastes, and preferences of consumers, consumer’s income, the price of re-
lated commodities, etc. In other words, demand analysis is about understanding buyer behavior.
Therefore, the correct answer is option b.

Economic objectives of firms

The main objectives of firms are:
(a) Profit maximisation
(b) Sales maximisation
(c) Increased market share/market dominance
(d) Social/environmental concerns
(e) Profit satisficing
(f) Co-operatives
Sometimes there is an overlap of objectives. For example, seeking to increase market share, may
lead to lower profits in the short-term, but enable profit maximisation in the long run.

Profit maximisation
Usually, in economics, we assume firms are concerned with maximising profit. Higher profit
means:
• Higher dividends for shareholders.

406
• More profit can be used to finance research and development.
• Higher profit makes the firm less vulnerable to takeover.
• Higher profit enables higher salaries for workers

See more on: Profit maximisation

Alternative aims of firms
However, in the real world, firms may pursue other objectives apart from profit maximisation.
1. Profit Satisficing

• In many firms, there is a separation of ownership and control. Those who own the company
(shareholders) often do not get involved in the day to day running of the company.
• This is a problem because although the owners may want to maximise profits, the manag-
ers have much less incentive to maximise profits because they do not get the same rewards,
(share dividends)
• Therefore managers may create a minimum level of profit to keep the shareholders happy,
but thenmaximise other objectives, such as enjoying work, getting on with other workers. (e.g. not
sacking them) This is the problem of separation between owners and managers.
• This ‘principal-agent‘ problem can be overcome, to some extent, by giving managers share
options and performance related pay although in some industries it is difficult to measure perfor-
mance.
• More on profit-satisficing.

2. Sales maximisation
• Firms often seek to increase their market share – even if it means less profit. This could occur
for various reasons:
• Increased market share increases monopoly power and may enable the firm to put up pric-
es andmake more profit in the long run.
• Managers prefer to work for bigger companies as it leads to greater prestige and higher sal-
aries.
• Increasing market share may force rivals out of business. E.g. the growth of supermarkets
have leadto the demise of many local shops. Some firms may actually engage in predatory pricing
which involves making a loss to force a rival out of business.

3. Growth maximisation
• This is similar to sales maximisation and may involve mergers and takeovers. With this objec-
407
tive, the firm may be willing to make lower levels of profit in order to increase in size and gain more
market share. More market share increases their monopoly power and ability to be a price setter.

4. Long run profit maximisation

In some cases, firms may sacrifice profits in the short term to increase profits in the long run. For
example, by investing heavily in new capacity, firms may make a loss in the short run but enable
higher profits in the future.

5. Social/environmental concerns
A firm may incur extra expense to choose products which don’t harm the environment or products
not tested on animals. Alternatively, firms may be concerned about local community / charitable
concerns.
• Some firms may adopt social/environmental concerns as part of its branding. This can ulti-
mately helpprofitability as the brand becomes more attractive to consumers.
• Some firms may adopt social/environmental concerns on principal alone – even if it does
little to improve sales/brand image.

• Co-operatives
• Co-operatives may have completely different objectives to a typical PLC. A co-operative is run to
maximize the welfare of all stakeholders – especially workers. Any profit the co-operative makes
willbe shared amongst all members.

Diagram showing different objectives of firms

• Q1 = Profit maximisation (MR=MC)

• Q2 = Revenue Maximisation (MR=0)
• Q3 = Marginal cost pricing (P=MC) – allocative efficiency
• Q4 = Sales maximisation – maximum sales while still making normal profit (AR=ATC)

Demand Analysis
Objectives of Demand Analysis:
According to Dean, demand analysis has four managerial purposes:

1. Forecasting sales,
2. Manipulating demand,
3. Appraising salesmen’s performance for setting their sales quotas, and
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4. Watching the trend of the company’s competitive position.

Of these the first two are most important and the last two are ancillary to the main economic prob-
lem of planning for profit.

1. Forecasting Demand:
Forecasting refers to predicting the future level of sales on the basis of current and past trends.
This is perhaps the most important use of demand studies. True, sales forecast is the foundation
for planning all phases of the company’s operations. Therefore, purchasing and capital budget
(expenditure) programmes are all based on the sales forecast.

2. Manipulating Demand:
Sales forecasting is most passive. Very few companies take full advantage of it as a technique for
formulating business plans and policies. However, “management must recognize the degree to
which sales are a result only of the external economic environment but also of the action of the
company itself.
Sales volumes do differ, “depending upon how much money is spent on advertising, what price
policy is adopted, what product improvements are made, how accurately salesmen and sales ef-
forts are matched withpotential sales in the various territories, and so forth”.
Often advertising is intended to change consumer tastes in a manner favourable to the advertis-
er’s product. The efforts of so-called ‘hidden persuaders’ are directed to manipulate people’s ‘true’
wants. Thus sales forecasts should be used for estimating the consequences of other plans for ad-
justing prices, promotionand/or products.

Importance of Demand Analysis:

A business manager must have a background knowledge of demand because all other business
decisions are largely based on it. For example, the amount of money to be spent on advertising
and sales promotion, the number of sales- persons to be hired (or employed), the optimum size of
the plant to be set up, and a host of other strategic business decisions largely depend on the level
of demand.
Why should a business firm invest time, effort and money to produce colour TV sets in a poor
country like Chad or Burma, unless there is sufficient demand for it? A firm must be able to de-
scribe the factors that cause households, governments or business firms to desire a particular
product like a typewriter. It is in this context that an understanding of the theory of demand is really
helpfulto the practicing manager.

Demand theory is undoubtedly one of the manager’s essential tools in business planning both short
run and long run. The objective of corporate planning is toidentify new areas of investment.

409
In a dynamic world characterised by changes in tastes and preferences of buyers, technological
change, migration of people from rural to urban areas, and so on, it is of paramount importance for
the business manager to take into account prospective growth of demand in various market areas
before taking any decisionon new plant location (i.e., the place of birth decision of a business firm).

If demand is expected to be stable, big sized plant may have to be set up. However, if demand is
expected to fluctuate, flexible plants (possibly with lower average costs at the most likely rate of
output) may be desirable.

A huge amount of capital may be required to carry inventories of finished [Link] demand is really
responsive to advertising, there may be a strong rationale for heavy outlay on market development
and sales promotion.

Demand considerations may directly and indirectly affect day-to-day financial, production and mar-
keting decisions of the firm. Demand (sales) forecasts do provide some basis for projecting cash
flows and net incomes periodically.
Moreover, expectations regarding the demand for a product do affect production scheduling and
inventory planning.

Again a business firm must take into account the probable reactions of rivals and buyers — actual
and potential — before introducing changes in prices, advertising or product design. Therefore, for
all these reasons, business managers can and should make good use of the various concepts and
techniques of demand theory.

Laws of Demand Analysis:

Perhaps one of the most fundamental concepts of economic theory is the Law ofDemand. The Law
simply describes the inverse relationship between price per unit (the dependent variable) and
quantity demanded of a product (the independent variable) per unit of time.

It simply states that all other variables remaining unchanged, as the price of a product (say tea)
falls, the quantity demanded (of it) increases. This may, however, lead to a fall in the quantity de-
manded of coffee. Thus the Law of Demand implies substitutability between products: an increase
in the quantitydemanded of one commodity is almost always at the expense of another.

We are focusing on some key concepts of demand analysis, even at the cost of repetition. To a
layman demand refers to the desire for a commodity.

For example, we often make such loose statements that the demand for Maruti cars in India is uni-
versal. However, such statements are of little significance to an economist whose primary purpose
is to give a quantitative expression to the above statement.

Therefore, to an economist the term ‘demand’ refers to the maximum number of Maruti cars that
may be purchased by all consumers at a particular price at a particular point of time.
In general, to an economist the term ‘demand’ refers to a specific relationship of various quantities
(of a particular product) per unit of time (say a day, a week, a month or a year) to such variable as
the price of the product under consideration, income of the buyer(s), prices of substitutes, prices of
complements, expected future conditions, seasonal factors, availability of consumer credit and
various other factors.
410
It is possible to estimate demand relationships for a particular firm or for the whole industry. The
basic concepts to be developed in this section are equally applicable to each type of demand, i.e.,
firm demand and industry demand.

The Law of Demand can be illustrated by a hypothetical table showing alternative combinations of
price and quantity demanded of say, Maruti cars. The table is known as the demand schedule. It
can also be explained graphically as a line or curve.

In fact, the demand curve is a graphical representation of the demand schedule. The modern ap-
proach, however, is to explain the law in terms of a function showing the relation between depend-
ent and independent variables.

Here we propose to explain the law of demand graphically. This is the general convention. This
curve simply describes the relationship between the price of a commodity (or service) and the
quantity demanded of the same per unit of time.

The convention is to express the demand curve for a product on a two- dimensional graph as in
Figure 10.1 It may be noted that the term demand refersto the whole demand curve for a commodi-
ty while the term ‘quantity demanded’indicates a particular point on the demand curve.

The demand curve also represents the average revenue function for the product. It is because av-
erage revenue is the same as the price of a product. The demand curve usually slopes downward
from left to the right. This is because the quantity de- the price of a commodity falls (other varia-
bles remaining unchanged), the quantity demanded of the commodity increases along the same
demand curvefrom left to right.

The converse is also true. This is shown in Figure 10.2. As a result the total sales revenue (which is
the product of price and the quantity demanded) may increase or fall depending on the elasticity of
demand for the product under consideration(a concept to be introduced later).
Thus if demand is a function of price: Qd = f (P), changes in quantity demanded are brought about
by changes in price of the commodity alone. If, on the other hand, there is a change in any other
variable affecting demand, the whole demandcurve may shift to a new position as in Figure 10.3.
If the income of the buyer increases, the consumer will buy more of the same commodity even at
the same price. This is indicated by point B which is not on the same demand curve. To show a
point like B we have to draw a new demandcurve D2. This is known as change in demand.

411
A change in the price of a related good or a change in the tastes and preferences of buyers is likely
to have the same effect. Thus factors other than price are conceived as demand curve shifters —
forces that move the price-quantity relationship, left or right. Changes in demand imply such shifts
of demand curves.

Functions of Demand Analysis:

(a) The Demand Function:
In economic theory the concept of demand is often expressed in an abstract way and economists
often make use of the term ‘demand function’ to give a quantitative expression of demand. This
function shows the functional relationship between the quantity demanded of a commodity and all
factors affecting the demand for the same.

It is usually stated as:

Qd = f (P1, Y, P2, P3, … Pn, A, C, etc)
Here Qd denotes the quantity, p1 its own price, Y is the income of the buyer, P2……… Pn are the
prices of all other goods which are either substitutes or com- plements, and so on. A is the level of
advertising and C denote all other factors affecting demand. For every commodity there is such a
demand function. This function has an important property.
It is homogenous of degree zero in prices and income which implies that if all prices and income
change in the same direction and in the same proportion, the quantity demanded of no commodity
will be altered in the process.
Thus Q in the above equation represents the quantity demanded of a particular product (say baby
food) in a particular market (say Calcutta or New Delhi) per unit of time (such as a week or a
month) and the other variables represent value of the specified influences (price, advertising,
availability of consumer credit anda host of other factors.)

412
For managerial decision-making it becomes necessary to arrive at quantitative estimates of de-
mand functions. In other words, for taking day-today decisionsregarding production, marketing and
stock holding managers need quantified estimates of the relationships of quantity to each of the
other variables.
A demand equation is a convenient way of giving a quantitative expression of demand. An example
of a demand equation is Q0 = α – β1P + β2A + e in which Q is quantity demanded of a commodity
and is obviously the dependent variable, P (price) and A (the level of advertising) are independent
variables, α, β1 and β2 are the parameters to be estimated. For example, β1 is the change in sales
for every rupee change in price. Finally e is the error term, which summarizes the effects of all ran-
dom variables (chance factors) on demand.

The above demand function specifies a linear relationship of Q to the independent variables. This
is at best an approximation and is not a reflection of reality. In the real commercial world the de-
mand function is usually assumed to be curvilinear.

A demand function of this type has the following form:

Q0 = αPβ ,Aβ2. e
in which the variables and parameters have their usual meaning. The assumption underlying the
second equation is that the marginal effects of each variable are not constant but rather are de-
pendent upon the numerical value of that variable and of all other influences represented in the
demand equation. This equation hasconstant elasticities.

In fact, the exponential of the variables are the elasticities. This non-linear equation can easily be
con- upon the numerical value of that variable and of all other influences represented in the de-
mand equation. This equation has constant elasticities. In fact, the exponential of the variables are
the elasticities. This non- linear equation can easily be converted into a linear equation by using
logarithms.

In terms of logarithms the transformed equation may be expressedas:

Demand schedues are also made use of to represent quantified demand relationships. The follow-
ing hypothetical demand schedule shows the associated values of quantity, and the variables af-
fecting quantity.

In our example, we show some assumed relationships of quantities to two demand determinants,
price and income. It may be noted that “demand schedules are specific for selected points on the
demand curve, and they become unwieldy if effects of three or more influences upon quantities
are to be handled.”
The information contained in the above table is represented in the form of graphs (Fig. 10.4). Here
we get three demand curves for three different levels of income. If price falls quantity demanded
increases and is shown by a movement from point A to B along the same demand curve.

413
In fact the demand curve shows the various quantities that would be demanded at alternative pric-
es, with other variables remaining unchanged. If income increases the quantity demanded of a
commodity will go up even at the same price (Compare points A and C). This is shown by a shift of
the original demand curve to a new position.
Demand curves are usually drawn on the assumption that price is the independent variable and
quantity the dependent variable. However, in certainreal life situations price is the function of quan-
tity.

For example, in the market for staple agricultural commodities like wheat or rice the quantity of-
fered for sale in the current year largely depends on the price that
prevailed last year and the current year’s output will be sold out at whatever priceit may fetch in the
market.

Moreover, in oligopolistic markets prices are administered or managed by the firms themselves.
Consider, for example, market for automobiles where prices are largely set by the producers them-
selves, leaving quantities to be determined by prices and other market forces.

In such situations quantity depends on price. In empirical demand analysis it is of utmost im-
portance to specify at the outset the dependent variables in the demandequation.

Determinants of Demand Functions:

Various factors cause changes in demand and thus shift of the demand curve to a new position.

For example, changes in demand for consumer goods are caused bythe following factors:
1. Changes in wages and compensation (bonus, overtime, etc.) of workers andsalaried people,
changes in rental income and/or interest income, if any;
2. Population growth and consequent changes in the size of the population and itsage composi-
tion;
3. Changes in government laws, regulations, policies (fiscal and monetary) andprocedures con-
cerning consumption of certain harmful or illegal products (likeliquors, or LSD)
4. Changes in the kinds and types of products having appeal to consumers. (Infact, the appeal to
new goods has always been a powerful factor of economic growth).

414
 Changes in corporate and/or unincorporated business profits also affect demand on the part of
business and government buyers.

Likewise the demand for durable goods depends on a host of factors like past purchase of such
goods, availability of after-sales service, expectation about future price, possibility of model
changes in near future and so on.

(b) The Demand for Durable Goods:

Very few empirical demand studies have so far been made on the durable goods and such goods
have not attracted the attention they deserve.

Yet durable goods seem to have attracted excise duties, import tariffs, quantitative trade controls,
license fees, and other policy measures far out of proportion to their weight in the national output
or expenditure. Housing for instance, is subject to a property (wealth) tax, and the return on busi-
ness capital,to a corporation income-tax as well.

Moreover, the demand for durable goods fluctuates so violently in comparison with the demand for
other sectors’ products, that most modern theories assign it a key role in causing and/or exacerbat-
ing business cycles.

Demand Determinants of Durable Goods:

Durable goods present complicated problems of demand analysis. As Joel Dean points out, “Sales
of non-durables are made largely to meet current de- mand which depends on current conditions.
Sales of durables, on the other hand, add an increment to a stock of existing goods that dole out
their services slowly over several years. It is thus a common practice to segregate current de-
mand for durables in terms of replacement of old products and expansion of the total stock”.
One peculiarity of demand for durables is its volatile relation to business conditions. Since current
output of a durable provides only a small fraction of the total current services demanded of that
kind of product, sales are highly sensitiveto small changes in the demand for the service.

In fact, both replacement demand and expansion demand have various determinants. For example,
in case of motor cars replacement demand depends on the value of existing cars as transportation
service relative to their value as scrap iron. Thus when expansion demand spurts up suddenly,
used – car valuesusually go higher than scrap values.

Consequently, the scrapping rate and thus replacement demand falls. Dean argues that, “If the
public want fewer cars (expansion rate negative), the scrap-page rate must be higher than the level
of new car production.
This excess scrap-page is possible if scrap prices are high enough, and the obsolescence price-
spread between new and old cars is wide enough
• To take the old cars off the road, and
• To cover the necessary costs of producing new cars”.

Perhaps the most important replacement determinant is the obsolescence rate, which sets prices
in the second-hand markets. On the contrary, the determinants of expansion demand are not differ-
ent from those for non-durables. In practice, however, a decision to buy a durable good is more
415
 complicated, because guesses about the future stand out more sharply in the buyer’s mind.

He worries about future maintenance and operating costs in relation to his future income and other
demands. He tries to guess the future sales values and wonders whether prices will rise or fall if he
postpones his purchase.

Thus for durable goods, not only present prices and incomes, but their current trends and the state
of optimism are proper variables to include in the demand function. So price expectations play a
dominant role for any purchase of a largestock of future services; but it is to be called ‘price protec-
tion’ and not ‘speculation’.

Again expectorations about improved product designs are also important. New models dry up de-
mand for existing ones and cause price concessions in current models. This is observable in case
of television, where the introduction of colour sets has depressed the prices of black and white
models.

(c) Durable Goods in Income Statement:

The consumer usually spends part of his disposable income on current consumption expenditures,
that is, the expenditures he marks for goods and services consumed during the current period. Alt-
hough most of the services he consumes are supplied by outside sources, some may be supplied
by durable goods such as a house, a car, or a washing machine that he himself owns.

The cost of such self-provided services equals all the current expenses he incurs in operating them,
plus whatever depreciation (i.e., loss in value) these goods undergo as a result of wear, tear, and
aging during the current period.
It follows that the current consumption entry in the consumers’ income statement should include
his expenditures for non-durables, his expenditures for services purchased from outside sources,
and the cost of the current-period services provided to him by his own durable goods. His current-
consumption entry should not, however, include his current-period expenditure on new durable
goods.

(d) Stock Demand Vs. Flow Demand:

Durable goods studies face another problem because of the existence of stock demand and flow
demand. At any point in time there is demand for the ownership of houses. There is also the de-
mand for newly constructed dwellings. These two demands are obviously interrelated. Demand
must always be considered in relation to supply because both are important in determining the
market price of a product (or factor).

(e) The Utility Function:

In the words of Joel Dean, “Demand analysis seeks to research and measure the forces that de-
termine sales”. Many factors influence thequantity of a product a business can sell. Some of these
are environmental factors, beyond the direct control of the business managers.
Others, however, can be manipulated by the business or managerial economist. What is of interest
to us is measurement of demand from a managerial point of view, i.e., in terms of executive deci-
sions that call for demand analysis and the kinds of estimates and forecasts that can be made
practically for all industrial products.

Among the environmental (external) factors affecting the level of demand are general economic
416
conditions, consumer tastes and the nature of competition. These are, at best, subject to only indi-
rect influence by a particular business.

Of the variables at the disposal of management in its attempts to influence sales, price is perhaps
the most important factor. Other elements in the overall marketing strategy of a business include:
expenditure for advertising and other methods of promotion; choice of channels of distribution;
and size and method ofcompensation of the sales force.

Imperfections of Data:
Perhaps the proximate cause of the paucity of durable goods demand studies is to be explained by
the difficulty of making them, rather than by any lack of interest in the quantitative relationships
they seek to the explore.
Prima facie, the data are far from being ideal because great differences in quality exist among the
major durables, and furthermore, there are much greater changes in quality over time in the dura-
bles sector than in, say, the basic foods. Price data, too, tend to be shaky in the durable field.

There is another problem on the quantity side. For instance, the market prices of dwelling units at
any one time cover an enormous range while the market prices of different bushels of wheat clus-
ter narrowly around their mean.
Moreover, for such items as automobiles and refrigerators, published prices tend to be manufac-
turers’ suggested list prices, actual transactions prices being clouded from our view by such de-
vices as trade- in allowances, cash discounts, and what not.

Normal Goods and Inferior Goods:

In traditional economics a distinction is often drawn between a normal good andan inferior good. A
normal goods is one the demand for which increases with an increase in disposable personal in-
come.
Over the course of a business (trade) cycle, the demand for a commodity produced by a company
may rise at increasing rates or fall very little. It is the task of the business (company) economist to
relate changes in income to changes in demand for all major products manufactured by the com-
pany.

This will enable him (her) to identify at an early stage before acquiring new capital goods and un-
dertaking costly expansion programme those products the demand for which increases with an in-
crease in the income of the buyers.

The demand for some products does fall in reality when income rises, these are called inferior
goods. With economic growth national and per capita income will rise and this, in its turn, may im-
ply a fall in the demand for inferior goods in the long-run. For example, when one’s income increas-
es one sells out a small apartment and acquires a big one.

Similarly poor people switch over to fruits and meat from bread and potato whenthey experience an
income increase. However, the same commodity may be a normal good at a particular level of in-
come and an inferior good at a different level of income.
What is of importance to the practicing manager is that aggregate demand and the long-run profit-
ability of an inferior good may well decline, and so production and investment decisions may be
taken accordingly.

417
 3 Methods For Measuring Elasticity OfDemand
The following three methods are usually used by the economists formeasuring it:
(i) Total Expenditure Method,
(ii) Proportional Method,
(iii) Geometrical Method.

Total Expenditure Method:

Under this method, we measure elasticity of demand by examining the change in the total expendi-
ture due to a change in price.

Look at the following demand schedule relating to handkerchiefs:

Unity Elasticity:
When the total amount of money spent remains the same (e.g., between Nos. 2 and 3 above), the
elasticity is said to be unity.

Greater Than Unity:

When the total amount of money spent increases with a fall in price (or decreases with a rise in
price), the elasticity is said to be greater than unity (as between the two prices Nos. 3 and 4).

Less than Unity:

When the total amount of money spent decreases with a fall in price (or increases with a rise in
price), the elasticity is said to be less than unity (e.g., between the two prices Nos. 1 and 2). We
can also represent this method diagrammatically (Fig. 10.5). Take total expenditure along the X-
axis and price along the Y-axis. We get a backward bending curve Olum. The portion O1 represents
less than unity elasticity, because an increase or decrease in price increases or decreases the total
expenditure.

The portion um represents unity elasticity because a change in price has got no effect on total ex-
penditure; it remains the same. Portion um represents more than unity elasticity because an in-
crease in price decreases the total expenditure and a decrease in price increases the total expendi-
ture.

418
Proportional Method:
Under this method, we measure elasticity by comparing the percentage in price with the percent-
age change in demand. The elasticity of demand is unity, greater than unity, or less than unity, ac-
cording as the change in demand is proportionate, more than proportionate, or less than propor-
tionate to the changein price respectively. The elasticity is the ratio of the percentage change in the
quantity demanded to the percentage change in the price charged.

The formula is:

Elasticity = Proportionate change in demand/ Proportionate change in price
= Change in Demand/ Amount demanded + Change in price/ Price

This formula will be better understood with the help of mathematical illustration.
Suppose mangoes are selling at the price 25 P. each and a consumer demands 10mangoes at this
price. If the price falls to 20 P. each and the consumer now demands 15 mangoes, find out his
elasticity of demand for mangoes.

According to the above formula:

15—10/10 ÷ 25—20/25
= 5/10 ÷ 5/25
= 5/10 × 25/5
= 25/10 = 2.5

In other words, the elasticity of demand of our hypothetical consumer for mangoes is high; it is
much greater than unity (2.5).

Let us now take an example of low elasticity.

Suppose that the demand for common salt is 5 kilogram per month at the price of 20 P. per kg.
Now suppose that its price is doubled, i.e., it rises to 40 P. per kg. and now only 4 kg. are demand-
ed.

According to our above formula:

Elasticity = 5-4/5 ÷ 40/-20/20
= 1/5 ÷ 20/20
= 1/5 × 1/1
= 1/5
419
In other words, elasticity of demand is very low and is less than unity. In regard to this proportional
method, we can broadly say that when the percentage change in price and the consequent per-
centage change in demand are equal, elasticity will be unity; when the percentage change in de-
mand is greater than that in price, elasticity will be greater than unity and, conversely, elasticity will
be less than unity when the percentage change in demand is less than that in price.
Geometrical Method: Point Elasticity:
This method is used to measure the elasticity of demand at any given point on the demand curve.
Look at Fig. 10.6

DD’ is the straight-line demand curve. Elasticity is represented by the fraction: distance from D’ to
the point on the curve divided by the distance from the otherend to that point.

Thus, elasticity of demand on the points P i, Pi, and P1 is respectively. D’P1 D’P2/DP1 DP2 and
D’P3/DP3
If P2, is the middle point of DD’, then elasticity at P2, will be D P2, = 1,(D’P2, being equal to DP,)
i.e., elasticity at P2, the middle point, is unity. At any point lower than P2, elasticity will be less than
unity and at any point above P2, it will be greater than unity.

Even if the demand curve is not a straight line, the above formula will apply. A tangent will, howev-
er, have to be drawn at the point on the curve where elasticity is to be measured. It is illustrated in
the diagram (Fig. 10.7) given on the previouspage.

DD’ is the demand curve, and two tangents PM and P’M’ are drawn respectively at the points T and
T’ At point T, elasticity will be equal to TM/PT. This will apply only so long as the tangent and the
curve coincides, which means for an
infinitesimally short distance. If there is any departure from point T, a new tangent will have to be
drawn and elasticity ascertained accordingly. At point T’elasticity = M/P’ T’/T. Clearly, elasticity at T
is greater than elasticity at T’.

Slope and Elasticity Distinguished:

This slope of the curve is not to be confused with elasticity. The steepness of thecurve is no indica-
tion of the extent of elasticity.
In the diagram 10.6, the demand curve DD’ has the same steepness but different elasticity’s at dif-
ferent points. If elasticity and slope were closely related, the elasticity would be constant through-
420
out. But it is not so. The demand is elastic near the price-axis (OY), say, near the point D, and uni-
tary half way, i.e., at point P2, and inelastic near the quantity-axis, i.e., near D’. Since elasticity de-
pends not an absolute change but no percentage changes, it really depends on the steepnessof the
curve relative to the price-quantity ratio.
In Fig. 10.8, the curves BP and AP have different slopes but they have the same elasticity at a given
price. Let OM be the price. Draw a straight line parallel to X- axis cutting BP at R and AP at S. Now
elasticity of the curve BP at the point R is
BR/RP
The elasticity of the curve at the point S is AS/SP.
Now in the right-angled triangle BQP,
BR/OM RP/MP
But in the right -tangled triangle AOP,
OM/AS = MP/SP
BR/AS = RP/SP

That is, elasticity at both R and S is the same even though the two curves have different slopes.
Such curves are called iso-elastic.

Thus elasticity of demand is not indicated by the slope of the curve as is generally supposed. Elas-
ticity of demand is always at a price. Different points on the- demand curve have different elastici-
ty’s of demand. By merely seeing the slope of the demand curve, therefore, we cannot say that the
demand is less elastic or more elastic. Again, it is possible to draw a curve which may throughout
its length represent unit (i.e., same) elasticity even though it may have different slopes. This curve is
known as a Rectangular Hyperbola.

Income Elasticity of Demand:

Elasticity of demand means the price elasticity of demand. As already pointed out, income elastici-
ty of demand must be clearly distinguished from the price elasticity of demand. Whereas the price
elasticity of demand refers to the change in quantity demanded as a result of change in price, the
421
income elasticity of demand means the change in demand which occurs as a result of change in
income.

Thus income elasticity of demand may be defined as:

Proportionate change in the quantity purchased/ Proportionate change in income while price re-
mains constant. Generally speaking, when our income increases, we desire to purchase- more of
the things than we were previously purchasing, unless the commodity happens to be an “inferior”
one.

Normally, then since the income effect is positive, income elasticity of demand is also positive. It is
zero when change in income makes no change to our purchases and it is negative when with an in-
crease in income, the consumer purchases less, e.g., in the case of inferior goods.

Cross Elasticity of Demand:

There is another concept of elasticity of demand which is called cross elasticity of demand. Cross
elasticity of demand refers to the change in demand for a good as a result of change in the price of
another goods. Proportionate change in quantity
demanded of X /Proportionate change in the price of Y Cross elasticity of demand arises in cases
of inter-related goods, such as substitutes and complementary goods.

Importance of the Concept of Elasticity of Demand:

The concept of elasticity of demand has great practical importance: For Businessmen and Mo-
nopolists:
It guides the businessman in fixing the prices of his goods. If the demand for a commodity is ine-
lastic, he knows that the people must buy it whatever be the price. In such cases, he will be able to
raise the price. If he is a monopolist he will certainly do so and earn a larger ne’ Profit. When the
demand is elastic, a small fall in price will increase the sales and bring more profit.

For the Finance Minister:

The Finance Minister also takes note of elasticity of demand when selecting commodities for taxa-
tion. In case he wants to be certain of the revenue, he taxes those commodities for which the de-
mand is inelastic. People must continue buying them even though the prices rise with the tax. If
the demand is elastic, people will buy less of them and the Government would get less revenue.

Joint Products:
In case of joint products, separate costs of production of the two commodities are not ascertaina-
ble. In such cases, price of each will depend on the elasticity of demand of each. The transport au-
thorities also fix the prices of the various services they sell, after considering their elasticity of de-
mand for the respective services.

In Industrial Production:
The volume of industrial output depends on the nature of demand. If the demand is elastic, by
slightly reducing the price, sales can be increased, and the output toowill increase.

Paradox of Poverty in Plenty:

The concept of elasticity can explain how the farmers may remain poor even when there is a
bumper crop. If the elasticity of demand for wheat is unity, the incomes of the growers would re-
main the same whatever the condition of the crop. In a year of bad harvest the rise in price would
422
compensate for reduced output and in a year of good crop, the price will fall and thus reduce the
income.
Determination of Wages:
Elasticity can also influence wages. If demand for a particular type of labour is inelastic, it can suc-
ceed in raising wages.

In International Trade:
The concept of elasticity of demand is of great significance in international trade also. That coun-
try will benefit the most from international trade the demand for whose imports is very elastic, but
that for exports is inelastic. The present position in respect of India’s exports and imports is the
reverse of it because her demand for imports of crude oil and machinery, etc., is more or less ine-
lastic, while the foreign countries’ demand for exports from India is quite elastic. India, therefore, is
unable to benefit from her international trade as much as many of her trading partners do from
their trade with India. Thus, the concept of elasticity has great practical importance in the various
fields of applied Economics.
Law of Demand Explained with Examples

The law of demand states that all other things being equal, the quantity bought of a good or ser-
vice is a function of price. As long as nothing else changes, people will buy less of something when
its price rises. They'll buy more when its price falls.

The demand schedule tells you the exact quantity that will be purchased at any given price. A real-
life example of how this works in the demand schedule for beef in 2014.

The demand curve plots those numbers on a chart. The quantity is on the horizontal or x-axis, and
the price is on the vertical or y-axis.

If the amount bought changes a lot when the price does, then it's called elastic demand. An exam-
ple of this is ice cream. You can easily get a different dessert if the price rises too high.

If the quantity doesn't change much when the price does, that's called inelastic demand. An exam-
ple of this is gasoline. You need to buy enough to get to work regardless of the price.

This relationship holds true as long as "all other things remain equal." That part is so
important that economists use a Latin term to describe it: . The "all other things" that need to be
equal under ceteris paribus are the other determinants of demand. These are prices of related
goods or services, income, tastes or preferences, and expectations. For aggregate demand, the
number of buyers in the market is also a determinant.

If the other determinants change, then consumers will buy more or less of the product even though
the price remains the same. That's called a shift in the demand curve.
Law of Demand Explained

For example, airlines want to lower costs when oil prices rise to remain profitable. They also don't
want to cut flights. Instead, they buy more fuel-efficient planes, fill all seats, and change operations
to improve efficiency. As a result, they've raised seat-miles per gallon from 55 in 2005 to 60 in
2011. The law of demand would describe this as the quantity of fuel required by the airlines
dropped as the price rose.
423
Of course, all other things were not equal during this period. In fact, demand for jet fuel was further
lessened because airlines' income also dropped at the same time. The 2008 global financial crisis
meant that travelers cut back on their demand for air travel. The airlines' expectations about the
price of jet fuel also changed. They realized it would probably continue to rise over the long term.
The other two determinants of airline's demand for jet fuel stayed the same. They couldn't switch
to another fuel, and their tastes or desire to use jet fuel didn't change.

Retailers use the law of demand every time they offer a sale. In the short-term, all other things are
equal. Sales are very successful in driving demand. Shoppers respond immediately to the adver-
tised price drop. It works especially well during massive holiday sales, such as Black Friday and
Cyber Monday.

The Law of Demand and the Business Cycle

Politicians and central bankers understand the law of demand very well. The Federal Reserve's
mandate is to prevent inflation while reducing unemployment. During the expansion
phase of the business cycle, the Fed tries to reduce demand for all goods and services by raising
the price of everything. It does this with contractionary monetary policy. It raised the fed funds
rate, which increases interest rates on loans and mortgages. That has the same effect as raising
prices, first on loans, then on everything bought with loans, and finally everything else.

Of course, when prices go up, so does inflation. That's not always a bad thing. The Fed has a 2
percent inflation target for the core inflation rate. The nation's central bank wants that level of mild
inflation. It sets an expectation that prices will increase 2 percent a year. Demand increases be-
cause people know that things will only cost more next year. They may as well buy it
now ceteris paribus.

During a recession or the contraction phase of the business cycle, policymakers have a worse prob-
lem. They've got to stimulate demand when workers are losing jobs and homes and have less in-
come and wealth. Expansionary monetary policy lowers interest rates, thereby reducing the price of
everything. If the recession is bad enough, it doesn't reduce the price enough to offset the lower
income.

In that case, fiscal policy is needed. The federal government starts spending to create public works
jobs. It extends unemployment benefits and cuts taxes. As a result, the deficit increases because
the government's tax revenue falls. Once confidence and demand are restored, the deficit should
shrink as tax receipts increase.

Relationship between AR and MRCurves

The relation between average revenue and marginal revenue can be discussed under pure competi-
tion, monopoly or monopolistic competition or imperfectcompetition.

424
1. Under Pure Competition:
The average revenue curve is a horizontal straight line parallel to the X-axis and the marginal reve-
nue curve coincides with it. This is because under pure (or perfect) competition the number of
firms selling an identical product is very large.

The price is determined by the market forces of supply and demand so that only one price tends to
prevail for the whole industry, as shown in Table 1. It is OP, as shown in Panel (A) of Figure 1. Each
firm can sell as much as it wishes at the market price OP.

Thus the demand for the firm’s product becomes infinitely elastic. Since the demand curve is the
firm’s average revenue curve, the shape of the AR curve is horizontal to the X-axis at price OP, as
shown in Panel (B) and the MR curve coincides with it. This is also shown in Table 1 where AR and
MR remain constant at Rs.20 at every level of output. Any change in the demand and supply condi-
tions will change the market price of the product, and consequently the horizontal AR curve of the
firm.

2. Under Monopoly or Imperfect Competition:

The average revenue curve is the downward sloping industry demand curve and its corresponding
marginal revenue curve lies below it. The relation between the average revenue and the marginal
revenue under monopoly can be understood with the help of Table 2.
The marginal revenue is lower than the average revenue. Given the demand for his product, the
monopolist can increase his sales by lowering the price, marginal revenue also falls but the rate of
fall in marginal revenue is greater than that in average revenue In Table 2 AR falls by Rs.2 at a time,
whereas MR falls by Rs.4.

425
This is shown in Figure 2 in which the MR curve is below the AR curve and lies halfway on the per-
pendicular drawn from AR to the Y-axis. This relation will always exist between straight line down-
ward slopping AR and MR curves.

In case the AR curve is convex to the origin as in Figure 3 (A), the MR curve will cut any perpendicu-
lar from a point on the AR curve at more than half-way to the Y-axis. MR passes to the left of the
mid-point В on the CA. On the other hand, if the AR curve is concave to the origin, MR will cut the
perpendicular at less than half-way towards the Y-axis. In Figure 3 (B), MR passes to the right of
the mid- point В on the CA.

AR, MR and Elasticity:

However, the true relationship between the AR curve and its corresponding MR curve under monop-
oly or imperfect competition depends upon the elasticity of the AR curve. We know that elasticity
at point С in Figure 4 is
E= CM/ PA =CM/CD (PA= CD being the sides of similar ∆s)

426
On the basis of this formula, the relationship between AR and MR is explained interms of the Figure
5 (A). At point B on the average revenue curve, PA, the elasticity of demand is equal to 1. Accord-
ing to the formula,
MR = AR 1-1/1 = AR 0/1 = 0

The MR curve is zero when it touches the X-axis at point F. Thus, where elasticity of AR curve is uni-
ty, MR is always zero
In case the elasticity of the AR curve is unity throughout its length like a rectangular hyperbola, the
MR curve will coincide with the X-axis, shown as adotted line in Figure 5 (B).2
If the elasticity of the AR curve at point D is greater than unity, say 3, MR = AR -3-1/3= 2/3. It shows
that when the elasticity of AR is greater than one, MR is always positive. It is EH in Figure 5

427
Where the elasticity of the AR curve is less than unity, say 1/2, MR
= AR= ½ -1/ ½ = -½/ ½ = -1. It shows MR to be negative. At point С on the AR curve, elasticity is less
than unity and MR is negative KG. If the elasticity of AR is infinity (E = ∞), MR coincides with it at
point P in Figure 5 (A). Lastly, when the elasticity of the AR curve is zero, the gap between AR and
MR curves becomes wider and MR lies much below the X-axis.

3. Monopolistic Competition:
Under monopolistic competition, the relationship between AR and MR is the same as under mo-
nopoly. But there is an exception that the AR curve is more elastic, as shown in Figure 6. This is be-
cause products are close substitutes under monopolistic competition. The firm can increase its
sales by a reduction in its price.

4. Under Oligopoly:
The average and marginal revenue curves do not have a smooth downward slope under oligopoly.
They possess kinks. Since the number of sellers under oligopolyis small, the effect of a price cut or
price increase on the part of one seller will be followed by some changes in the behaviour of other
firms. If a seller raises the price of his product, the other sellers will not follow him in order to earn
larger profits at the old price.

So the price-raising seller will experience a fall in the demand for his product. His average revenue
curve in Figure 7 (A) becomes elastic after К and its corresponding MR curve rises discontinuously
from a to b and then continues its course at the new higher level.

428
On the other hand, if the oligopolistic seller reduces the price of his product, his rivals also follow
him in reducing the prices of their products so that he is not ableto increase his sales. His AR curve
becomes less elastic from К onward, as in Figure7 (B). The corresponding MR curve falls vertically
from a to b and then slopes at a lower level.

Consumer Behaviour: Meaning/Definition and Nature ofConsumer Behaviour

Meaning and Definition:
Consumer behaviour is the study of how individual customers, groups or organizations select, buy,
use, and dispose ideas, goods, and services to satisfytheir needs and wants. It refers to the actions
of the consumers in the marketplace and the underlying motives for those actions.

Marketers expect that by understanding what causes the consumers to buy particular goods and
services, they will be able to determine—which products are needed in the marketplace, which are
obsolete, and how best to present the goodsto the consumers.
The study of consumer behaviour assumes that the consumers are actors in the marketplace. The
perspective of role theory assumes that consumers play various roles in the marketplace. Starting
from the information provider, from the user to the payer and to the disposer, consumers play these
roles in the decision process.

The roles also vary in different consumption situations; for example, a mother plays the role of an
influencer in a child’s purchase process, whereas she plays the role of a disposer for the products
consumed by the family.

Some selected definitions of consumer behaviour are as follows:

1. According to Engel, Blackwell, and Mansard, ‘consumer behaviour is the actions and decision
processes of people who purchase goods and services forpersonal consumption’.
2. According to Louden and Bitta, ‘consumer behaviour is the decision processand physical activity,
which individuals engage in when evaluating, acquiring, using or disposing of goods and services’.

Nature of Consumer Behaviour:

1. Influenced by various factors:
The various factors that influence the consumer behaviour are asfollows:
1. Marketing factors such as product design, price, promotion, packaging,positioning and dis-
tribution.
2. Personal factors such as age, gender, education and income level.
3. Psychological factors such as buying motives, perception of the product andattitudes to-
wards the product.
4. Situational factors such as physical surroundings at the time of purchase, socialsurround-
429
 ings and time factor.
5. Social factors such as social status, reference groups and family.
6. Cultural factors, such as religion, social class—caste and sub-castes.

2. Undergoes a constant change:

Consumer behaviour is not static. It undergoes a change over a period of time depending on the
nature of products. For example, kids prefer colourful and fancy footwear, but as they grow up as
teenagers and young adults, they prefer trendy footwear, and as middle-aged and senior citizens
they prefer more sober footwear. The change in buying behaviour may take place due to several
other factors such as increase in income level, education level and marketing factors.

3. Varies from consumer to consumer:

All consumers do not behave in the same manner. Different consumers behave differently. The dif-
ferences in consumer behaviour are due to individual factors such as the nature of the consumers,
lifestyle and culture. For example, some
consumers are technoholics. They go on a shopping and spend beyond theirmeans.

They borrow money from friends, relatives, banks, and at times even adopt unethical means to
spend on shopping of advance technologies. But there are other consumers who, despite having
surplus money, do not go even for the regular purchases and avoid use and purchase of advance
technologies.

4. Varies from region to region and country to county:

The consumer behaviour varies across states, regions and countries. For example, the behaviour of
the urban consumers is different from that of the rural consumers. A good number of rural con-
sumers are conservative in their buying behaviours.

The rich rural consumers may think twice to spend on luxuries despite having sufficient funds,
whereas the urban consumers may even take bank loans to buy luxury items such as cars and
household appliances. The consumer behaviour may also varies across the states, regions and
countries. It may differ dependingon the upbringing, lifestyles and level of development.

5. Information on consumer behaviour is important to the marketers:Marketers need to have a

good knowledge of the consumer behaviour. They need to study the various factors that influence
the consumer behaviour of their target customers.

The knowledge of consumer behaviour enables them to take appropriate marketing decisions in
respect of the following factors:
(a) Product design/model
(b) Pricing of the product
(c) Promotion of the product
(d) Packaging
(e) Positioning
(f) Place of distribution
6. Leads to purchase decision:
A positive consumer behaviour leads to a purchase decision. A consumer may take the decision of
buying a product on the basis of different buying motives. The purchase decision leads to higher
demand, and the sales of the marketers increase. Therefore, marketers need to influence consum-
430
er behaviour to increase their purchases.

7. Varies from product to product:

Consumer behaviour is different for different products. There are some consumers who may buy
more quantity of certain items and very low or no quantity of other items. For example, teenagers
may spend heavily on products such as cell phones and branded wears for snob appeal, but may
not spend on general and academic reading. A middle- aged person may spend less on clothing,
but may invest money in savings, insurance schemes, pension schemes, and so on.

8. Improves standard of living:

The buying behaviour of the consumers may lead to higher standard of living. The more a person
buys the goods and services, the higher is the standard of living.
But if a person spends less on goods and services, despite having a good income, they deprives
themselves of higher standard of living.

9. Reflects status:
The consumer behaviour is not only influenced by the status of a consumer, but it also reflects it.
The consumers who own luxury cars, watches and other items are considered belonging to a high-
er status. The luxury items also give a sense of pride to the owners.

UTILITY ANALYSIS:
A subset of consumer demand theory that analysis consumer behavior and market demand using
total utility and marginal utility. The key principle of utility analysis is the law of diminishing margin-
al utility, which offers an explanation for the law of demand and the negative slope of the demand
curve.

Utility analysis, a subset of consumer demand theory, provides insight into an understanding
of market demand and forms a cornerstone of modern microeconomics. In particular, this analysis
investigates consumer behavior, especially market purchases, is based on the satisfaction of
wantsand needs (that is, utility) generated from the consumption of a good.
Utility analysis is primarily taught in introductory courses. A more sophisticated version of con-
sumer demand theory relies on the analysis of indifference curves and is more commonly found at
the intermediate course level and above.

Utility and Satisfaction

The primary focus of utility analysis is on the satisfaction of wants and needs obtained by the con-
sumption of goods. This is technically termed utility. The utility generated from consumption af-
fectsthe decision to purchase and consume a good.
When used in the analysis of consumer behavior, utility assumes a very precise meaning, which
differs from the everyday use of the term. In common use, the term utility means "useful." For ex-
ample, a "utility" knife is one with many uses, something that is handy to have around. In baseball,
a "utility" player can perform quite well at several different positions and is thus useful to have on
the team. Moreover, a public "utility" is a company that supplies a useful product, such as electrici-
ty, natural gas, ortrash collection.
In contrast, the specific economic use of the term utility in the study of consumer behavior means
the satisfaction of wants and needs obtained from the consumption of a commodity. The good
consumed need not be "useful" in the everyday sense of the term. It only needs to provide satisfac-
tion.
431
In other words, a frivolous good that has little or no practical use, can provide as much utility as a
more useful good.
• An Omni Open Deluxe Can Opener is extremely useful, especially when a sealed can needs to
beopened.
• An autographed photo of Brace Brickhead, Medical Detective, is not very useful. It does nothing
but rest peacefully in a picture frame.

Both items, however, provide utility. Both items satisfy wants and needs. The OmniOpen Deluxe
Can Opener obviously makes it possible to open cans of food which satisfy the hunger need. The
autographed photo of Brace Brick head provides the owner with a warm, fuzzy feeling and a re-
minder ofthe time spent enjoying the thrilling exploits of Brace Brickhead, Medical Detective.

The Law of Demand

The primary focus of utility analysis is an understanding of market demand and the law of de-
mand. The law of demand, which gives rise to a negatively sloped demand curve, is an essential
principle underlying market analysis. Modern microeconomic theory, among other topics, is con-
cerned with understanding and explaining the law of demand.

The explanation of the law of demand using utility analysis is relatively simple. Consumers pur-
chase goods that satisfy wants and needs, that is, generate utility. Thosegoods that generate more
utility are more valuable to consumers and thus buyers are willing to pay a higher price. The key to
the law of demand is that the utility generated declines as the quantity consumed increases. As
such, the demand price that buyers are willing to pay decreases as the quantity demanded increas-
es.

Total Utility
Utility analysis begins with the total utility derived from the consumption of different

quantities of a good. Total utility is simply a measure of the total satisfaction of wants and needs
obtained from the consumption or use of a good or service. It is often convenient to present total
utility for a range of quantities in a table such as the one displayed to the right.

Utility analysis is based on the presumption that the amount of utility generated from the con-
sumption of a good can be explicitly measured. The standard hypothetical measurement unit is
"utils."

Suppose, for example, that Edgar Mill bottom spends a day riding the Monster Loop Death Plunge
roller coaster at the Shady Valley Amusement Park, then records the amount of total utility
achieved at the end of each
ride. The two columns presented in the table measure the number of rides and the total utility ac-
cumulated by Edgar at the end of each ride (in utils).

432
 • Before his first ride, Edgar receives no utility. No activity, no utility.
• Edgar's first ride generates 11 utils of utility.
• The total utility generated if Edgar takes 8 rides is 32 utils.
• Edgar's utility increases for the first 6 rides, reaching a high of 36 utils, before declining back
to32 utils for the 8th ride.
• Presumably Edgar's utility continues to decline after the 8th ride.
• Edgar obtains the highest total utility from 6 rides on the roller coaster.
The motivation that guides Edgar's roller coaster riding is to maximize utility, that is, to consume
the quantity of the good that generates the highest level of utility. In this example, utility is maxim-
ized at 6rides.
In many situations, however, the consumption of a good faces constraints. Edgar, for example,
might face a time constraint because he plans to attend a live concert of the rock-and-roll group,
Live Headless Squirrels, that prevents him from riding more than 4 times. Or he might face an in-
come constraint because the amusement park charges $1 per ride and he has only $5 in his pock-
et.
In these situations, Edgar, as well as other consumers, might pursue constrained utility maximiza-
tion. This means achieving the highest possible utility, given certain restrictions that prevent the
highest overall level of utility from being achieved.
Marginal Utility
Total utility is used as a starting point for utility analysis. However, a great
deal of additional insight is gained from marginal utility. Marginal utility is the
additional utility, or extra satisfaction of wants and needs, obtained from the
consumption or use of an additional unit of a good or service. Marginal utility
is, in other words, the extra satisfaction gained from an extra unit of good.
Marginal utility is specified as:
change in total utility
marginal utility =
change in quantity
If, for example, total utility increases from 20 to 27 utils, thenmarginal utility is 7 utils.

The far right column of this table presents marginal utility values derived from each ride Edgar un-
dertakes. Marginal utility from thefirst ride is 11 utils. The extra utility generated by the second ride
is 9 utils. The third ride provides another 7 utils. The remaining numbers in the right column are in-
terpreted in a similar manner.

Marginal utility provides a direct link between utility analysis and demand. The demand price a
buyer is willing to pay for a given good is based on the marginal utility derived from consuming the
good. In this example, Edgar is most likely willing is to pay more for the first ride than the fifth ride,
in that the first ride generates11 utils of satisfaction, but the fifth ride generates only 3 utils.

The Law of Diminishing Marginal Utility

A clear pattern is displayed by the marginal utility values in the far right column. Marginal utility
decreases as Edgar takes more rides. This decreasing marginal utility reflects the law of diminish-
ing marginal utility. The law of diminishing marginal utility states that marginal utility, or the extra
utility obtained from consuming a good, decreases as the quantity consumed increases. In es-
sence, each additional good consumed is less satisfying than the previous one. This law is particu-
larly important for insight into market demand and the law of demand.

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If each additional unit of a good is less satisfying, then a buyer is willing to pay less. As such, the
demand price declines. This inverse law of demand relation between demand price and quantity
demanded is a direct implication of the law of diminishing marginal utility.

Indifference Curve Analysis: Assumptions, Indifference Schedule and the Meaning of Marginal
Rate of Substitution
Indifference curve analysis is basically an attempt to improve cardinal utility analysis (principle of
marginal utility). The cardinal utility approach, though very useful in studying elementary consumer
behavior, is criticized for its unrealistic assumptions vehemently. In particular, economists such as
Edgeworth, Hicks, Allen and Slutsky opposed utility as a measurable entity. According to them, util-
ity is a subjective phenomenon and can never be measured on an absolute scale. The disbelief on
the measurement of utility forced them to explore an alternative approach to study consumer be-
havior. The exploration led them to come up with the ordinal utility approach or indifference curve
analysis. Because of this reason, aforementioned economists are known as ordinalists. As per in-
difference curve analysis, utility is not a measurable entity. However, consumers can rank their
preferences.

Indifference Curve Analysis Vs. Marginal Utility Approach

Let us look at a simple example. Suppose there are two commodities, namely apple and orange.
The consumer has $10. If he spends entire money on buying apple, it means that apple gives him
more satisfaction than orange. Thus, in indifference curve analysis, we conclude that the consumer
prefers apple to orange. In other words, he ranks apple first and orange second. However, in cardi-
nal or marginal utility approach, the utility derived from apple is measured (for example, 10 utils).
Similarly, the utility derived from orange is measured (for example, 5 utils). Now the consumer
compares both and prefers the commodity that gives higher amount of utility. Indifference curve
analysis strictly says that utility is not a measurable entity. What we do here is that we observe
what the consumer prefers and conclude that the preferred commodity (apple in our example)
gives him more satisfaction. We never try to answer ‘how much satisfaction (utility)’ in indifference
curve analysis.

Assumptions
Theories of economics cannot survive without assumptions and indifference curve analysis is no
different. The following are the assumptions of indifference curve analysis:

Rationality
The theory of indifference curve studies consumer behavior. In order to derive a plausible conclu-
sion, the consumer under consideration must be a rational human being. For example, there are
two commodities called ‘A’ and ‘B’. Now the consumer must be able to say which commodity he
prefers. The answer must be a definite. For instance – ‘I prefer A to B’ or ‘I prefer B to A’ or ‘I prefer
both equally’. Technically, this assumption is known as completeness or trichotomy assumption.

Consistency
Another important assumption is consistency. It means that the consumer must be consistent in
his preferences. For example, let us consider three different commodities called ‘A’, ‘B’ and ‘C’. If
the consumer prefers A to B and B to C, obviously, he must prefer A to C. In this case, he must not
be in a position to prefer C to A since this decision becomes self-contradictory.

Symbolically,
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If A > B, and B > c, then A > C.

More Goods to Less

The indifference curve analysis assumes that consumer always prefers more goods to less. Sup-
pose there are two bundles of commodities – ‘A’ and ‘B’. If bundle A has more goods than bundle
B, then the consumer prefers bundle A to B.

Substitutes and Complements

In indifference curve analysis, there exist substitutes and complements for the goods preferred by
the consumer. However, in marginal utility approach, we assume that goods under consideration
do not have substitutes and complements.

Income and Market Prices

Finally, the consumer’s income and prices of commodities are fixed. In other words, with given in-
come and market prices, the consumer tries to maximize utility.

Indifference Schedule
An indifference schedule is a list of various combinations of commodities that give equal satisfac-
tion or utility to consumers. For simplicity, we have considered only two commodities, ‘X’ and ‘Y’, in
our Table 1. Table 1 shows various combinations of X and Y; however, all these combinations give
equal satisfaction (k) to the consumer.

Table 1: Indifference Schedule

Combinations X (Oranges) Y (Apples) Satisfaction

A 2 15 k
B 5 9 k
C 7 6 k
D 17 2 k

You can construct an indifference curve from an indifference schedule in the same way you con-
struct a demand curve from a demand schedule.

On the graph, the locus of all combinations of commodities (X and Y in our example) forms an in-
difference curve (figure 1). Movement along the indifference curve gives various combinations of
commodities (X and Y); however, yields same level of satisfaction. An indifference curve is also
known as iso utility curve (“iso” means same). A set of indifference curves is known as an indiffer-
435
ence map.

Marginal Rate of Substitution

Marginal rate of substitution is an eminent concept in the indifference curve analysis. Marginal
rate of substitution tells you the amount of one commodity the consumer is willing to give up for an
additional unit of another commodity. In our
example (table 1), we have considered commodity X and Y. Hence, the marginal rate of substitu-
tion of X for Y (MRSxy) is the maximum amount of Y the consumer is willing to give up for an addi-
tional unit of X. However, the consumer remains on the same indifference curve.

In other words, the marginal rate of substitution explains the tradeoff between two goods.

Diminishing marginal rate of substitution

From table 1 and figure 1, we can easily explain the concept of diminishing marginal rate of substi-
tution. In our example, we substitute commodity X for commodity Y. Hence, the change in Y is
negative (i.e., -∆Y) since Y decreases.

Thus, the equation is MRSxy = -∆Y/∆X and MRSyx = -∆X/∆Y

However, convention is to ignore the minus sign; hence, MRSxy = ∆Y/∆X
In figure 1, X denotes oranges and Y denotes apples. Points A, B, C and D indicate various combina-
tions of oranges and apples.

In this example, we have the following marginal rate of substitution:

MRSx for y between A and B: AA1/A1B = 6/3 = 2.0 MRSx for y between B and C: BB1/B1C = 3/2 =
1.5 MRSx for y between C and D: CC1/C1D = 4/10 = 0.4
Thus, MRSx for y diminishes for every additional units of X. This is the principle of diminishing
marginal rate of substitution.

Law of Variable Proportions (WithDiagrams)

Law of Variable Proportions occupies an important place in economic theory. This law is also
known as Law of Proportionality.

Keeping other factors fixed, the law explains the production function with one factor variable. In the
short run when output of a commodity is sought to be increased, the law of variable proportions
comes into operation.
Therefore, when the number of one factor is increased or decreased, while other factors are con-
stant, the proportion between the factors is altered. For instance, there are two factors of produc-
tion viz., land and labour.
Land is a fixed factor whereas labour is a variable factor. Now, suppose we have a land measuring
5 hectares. We grow wheat on it with the help of variable factor i.e., labour. Accordingly, the pro-
portion between land and labour will be 1: 5. If the number of laborers is increased to 2, the new
proportion between labour and land will be 2: 5. Due to change in the proportion of factors there
will also emerge
a change in total output at different rates. This tendency in the theory of production called the Law
of Variable Proportion.

Definitions:
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“As the proportion of the factor in a combination of factors is increased after a point, first the mar-
ginal and then the average product of that factor will diminish.” Benham
“An increase in some inputs relative to other fixed inputs will in a given state of technology cause
output to increase, but after a point the extra output resulting from the same additions of extra in-
puts will become less and less.” Samuelson
“The law of variable proportion states that if the inputs of one resource is increased by equal in-
crement per unit of time while the inputs of other resources are held constant, total output will in-
crease, but beyond some point the resulting output increases will become smaller and smaller.”
Leftwich

Assumptions:
Law of variable proportions is based on following assumptions:
1. Constant Technology:
The state of technology is assumed to be given and constant. If there is an improvement in tech-
nology the production function will move upward.

2. Factor Proportions are Variable:

The law assumes that factor proportions are variable. If factors of production areto be combined in
a fixed proportion, the law has no validity.

3. Homogeneous Factor Units:

The units of variable factor are homogeneous. Each unit is identical in quality and amount with eve-
ry other unit.

4. Short-Run:
The law operates in the short run when it is not possible to vary all factor inputs.

Explanation of the Law:

In order to understand the law of variable proportions we take the example of agriculture. Suppose
land and labour are the only two factors of production.
By keeping land as a fixed factor, the production of variable factor i.e., labour can be shown with
the help of the following table:

From the table 1 it is clear that there are three stages of the law of variable proportion. In the first
stage average production increases as there are more and more doses of labour and capital em-

437
ployed with fixed factors (land). We see that total product, average product, and marginal product
increases but average product and marginal product increases up to 40 units. Later on, both start
decreasing because proportion of workers to land was sufficient and land is not properly used.
This is the end of the first stage.

The second stage starts from where the first stage ends or where AP=MP. In this stage, average
product and marginal product start falling. We should note that marginal product falls at a faster
rate than the average product. Here, total product increases at a diminishing rate. It is also maxi-
mum at 70 units of labour where marginal product becomes zero while average product is never
zero or negative.

The third stage begins where second stage ends. This starts from 8th unit. Here, marginal product
is negative and total product falls but average product is still positive. At this stage, any additional
dose leads to positive nuisance because additional dose leads to negative marginal product.

Graphic Presentation:
In fig. 1, on OX axis, we have measured number of labourers while quantity of product is shown on
OY axis. TP is total product curve. Up to point ‘E’, total product is increasing at increasing rate. Be-
tween points E and G it is increasing at the decreasing rate. Here marginal product has started fall-
ing. At point ‘G’ i.e., when 7 units of labourers are employed, total product is maximum while, mar-
ginal product is zero. Thereafter, it begins to diminish corresponding to negative marginal product.
In the lower part of the figure MP is marginal productcurve.

438
Up to point ‘H’ marginal product increases. At point ‘H’, i.e., when 3 units of labourers are em-
ployed, it is maximum. After that, marginal product begins to decrease. Before point ‘I’ marginal
product becomes zero at point C and it turns negative. AP curve represents average product. Be-
fore point ‘I’, average product is less than marginal product. At point ‘I’ average product is maxi-
mum. Up to point T, average product increases but after that it starts to diminish.
Three Stages of the Law:
1. First Stage:
First stage starts from point ‘O’ and ends up to point F. At point F average product is maximum and
is equal to marginal product. In this stage, total product increases initially at increasing rate up to
point E. between ‘E’ and ‘F’ it increases at diminishing rate. Similarly marginal product also in-
creases initially and reaches its maximum at point ‘H’. Later on, it begins to diminish and becomes
equal to average product at point T. In this stage, marginal product exceeds average product (MP >
AP).

2. Second Stage:
It begins from the point F. In this stage, total product increases at diminishing rate and is at its
maximum at point ‘G’ correspondingly marginal product diminishes rapidly and becomes ‘zero’ at
point ‘C’. Average product is maximum at point ‘I’ and thereafter it begins to decrease. In this stage,
marginal product isless than average product (MP < AP).

3. Third Stage:
This stage begins beyond point ‘G’. Here total product starts diminishing. Average product also de-
clines. Marginal product turns negative. Law of diminishing returns firmly manifests itself. In this
stage, no firm will produce anything. This happens because marginal product of the labour be-
comes negative. The employer will suffer losses by employing more units of labourers. However, of
the three stages, a firm will like to produce up to any given point in the second stage only.

ADVERTISEMENTS:
In Which Stage Rational Decision is Possible:

To make the things simple, let us suppose that, a is variable factor and b is the fixed factor. And a1,
a2 , a3….are units of a and b1 b2b3…… are unit of b.
Stage I is characterized by increasing AP, so that the total product must also be increasing. This
means that the efficiency of the variable factor of production is increasing i.e., output per unit of a
is increasing. The efficiency of b, the fixed factor, is also increasing, since the total product with b1
is increasing.
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The stage II is characterized by decreasing AP and a decreasing MP, but with MP not negative.
Thus, the efficiency of the variable factor is falling, while the efficiency of b, the fixed factor, is in-
creasing, since the TP with b1 continues to increase.

Finally, stage III is characterized by falling AP and MP, and further by negative MP. Thus, the effi-
ciency of both the fixed and variable factor is decreasing.

Rational Decision:
Stage II becomes the relevant and important stage of production. Production will not take place in
either of the other two stages. It means production will not take place in stage III and stage I. Thus,
a rational producer will operate in stage II.

Suppose b were a free resource; i.e., it commanded no price. An entrepreneur would want to
achieve the greatest efficiency possible from the factor for which he is paying, i.e., from factor a.
Thus, he would want to produce where AP is maximum or at the boundary between stage I and II.

If on the other hand, a were the free resource, then he would want to employ b to its most efficient
point; this is the boundary between stage II and III.

Obviously, if both resources commanded a price, he would produce somewhere in stage II. At what
place in this stage production takes place would depend upon the relative prices of a and b.

Condition or Causes of Applicability:

There are many causes which are responsible for the application of the law of variable proportions.

They are as follows:

1. Under Utilization of Fixed Factor:
In initial stage of production, fixed factors of production like land or machine, is under-utilized.
More units of variable factor, like labour, are needed for its proper utilization. As a result of em-
ployment of additional units of variable factors there is proper utilization of fixed factor. In short,
increasing returns to a factor begins to manifest itself in the first stage.

2. Fixed Factors of Production.

The foremost cause of the operation of this law is that some of the factors of production are fixed
during the short period. When the fixed factor is used with variable factor, then its ratio compared
to variable factor falls. Production is theresult of the co-operation of all factors. When an additional
unit of a variable factor has to produce with the help of relatively fixed factor, then the marginal re-
turn of variable factor begins to decline.

3. Optimum Production:
After making the optimum use of a fixed factor, then the marginal return of such variable factor
begins to diminish. The simple reason is that after the optimum use, the ratio of fixed and variable
factors become defective. Let us suppose a machine is a fixed factor of production. It is put to op-
timum use when 4 labourers are employed on it. If 5 labourers are put on it, then total production
increases very little and the marginal product diminishes.

4. Imperfect Substitutes:
Mrs. Joan Robinson has put the argument that imperfect substitution of factors is mainly responsi-
440
ble for the operation of the law of diminishing returns. One factor cannot be used in place of the
other factor. After optimum use of fixed factors, variable factors are increased and the amount of
fixed factor could be increased by its substitutes.
Such a substitution would increase the production in the same proportion as earlier. But in real
practice factors are imperfect substitutes. However, after the optimum use of a fixed factor, it can-
not be substituted by another factor.

Applicability of the Law of Variable Proportions:

The law of variable proportions is universal as it applies to all fields of production. This law applies
to any field of production where some factors are fixed and others are variable. That is why it is
called the law of universal application.
The main cause of application of this law is the fixity of any one factor. Land, mines, fisheries, and
house building etc. are not the only examples of fixed factors. Machines, raw materials may also
become fixed in the short period. Therefore, this law holds good in all activities of production etc.
agriculture, mining, manufacturing industries.

1. Application to Agriculture:
With a view of raising agricultural production, labour and capital can be increased to any extent but
not the land, being fixed factor. Thus when more and more units of variable factors like labour and
capital are applied to a fixed factor then their marginal product starts to diminish and this law be-
comes operative.

2. Application to Industries:
In order to increase production of manufactured goods, factors of production hasto be increased. It
can be increased as desired for a long period, being variable factors. Thus, law of increasing re-
turns operates in industries for a long period.
But, this situation arises when additional units of labour, capital and enterpriseare of inferior quality
or are available at higher cost.

As a result, after a point, marginal product increases less proportionately than increase in the units
of labour and capital. In this way, the law is equally valid inindustries.

Postponement of the Law:

The postponement of the law of variable proportions is possible underfollowing conditions:
1. Improvement in Technique of Production:
The operation of the law can be postponed in case variable factors techniques of production are
improved.

2. Perfect Substitute:
The law of variable proportion can also be postponed in case factors of production are made per-
fect substitutes i.e., when one factor can be substituted for the other.
Law of Returns to Scale : Definition,Explanation and Its Types
In the long run all factors of production are variable. No factor is fixed. Accordingly, the scale of
production can be changed by changing the quantity ofall factors of production.
Definition:
“The term returns to scale refers to the changes in output as all factors change bythe same propor-
tion.” Koutsoyiannis
“Returns to scale relates to the behaviour of total output as all inputs are varied and is a long run
441
concept”. Leibhafsky

Returns to scale are of the following three types:

1. Increasing Returns to scale.
2. Constant Returns to Scale
3. Diminishing Returns to Scale

Explanation:
In the long run, output can be increased by increasing all factors in the same proportion. Generally,
laws of returns to scale refer to an increase in output due to increase in all factors in the same
proportion. Such an increase is called returnsto scale.
Suppose, initially production function is as follows:
P = f (L, K):
Now, if both the factors of production i.e., labour and capital are increased insame proportion i.e., x,
product function will be rewritten as.

The above stated table explains the following three stages of returns toscale:
1. Increasing Returns to Scale:
Increasing returns to scale or diminishing cost refers to a situation when all factors of production
are increased, output increases at a higher rate. It means if all inputs are doubled, output will also
increase at the faster rate than double.
Hence, it is said to be increasing returns to scale. This increase is due to many reasons like divi-
sion external economies of scale. Increasing returns to scale can be illustrated with the help of a
diagram 8.

442
In figure 8, OX axis represents increase in labour and capital while OY axis shows increase in out-
put. When labour and capital increases from Q to Q1, output also increases from P to P1 which is
higher than the factors of production i.e. labour and capital.

2. Diminishing Returns to Scale:

Diminishing returns or increasing costs refer to that production situation, where if all the factors of
production are increased in a given proportion, output increases in a smaller proportion. It means,
if inputs are doubled, output will be less than doubled. If 20 percent increase in labour and capital
is followed by 10 percent increase in output, then it is an instance of diminishing returns to scale.
The main cause of the operation of diminishing returns to scale is that internal and external econ-
omies are less than internal and external diseconomies. It is clear from diagram 9.

In this diagram 9, diminishing returns to scale has been shown. On OX axis, labour and capital are
given while on OY axis, output. When factors of production increase from Q to Q1 (more quantity)
but as a result increase in output, i.e. P to P1 is less. We see that increase in factors of production
is more and increase in production is comparatively less, thus diminishing returns to scale apply.

3. Constant Returns to Scale:

ADVERTISEMENTS:
Constant returns to scale or constant cost refers to the production situation in which output in-
creases exactly in the same proportion in which factors of production are increased. In simple

443
terms, if factors of production are doubledoutput will also be doubled.

In this case internal and external economies are exactly equal to internal and external disecono-
mies. This situation arises when after reaching a certain level ofproduction, economies of scale are
balanced by diseconomies of scale. This is known as homogeneous production function. Cobb-
Douglas linear homogenous production function is a good example of this kind. This is shown in
diagram 10. In figure 10, we see that increase in factors of production i.e. labour and capital
are equal to the proportion of output increase. Therefore, the result is constantreturns to scale.

In traditional theory, costs are generalized in two parts on the basis of time period
i.e. costs in short run and costs in long run period.

Costs are mainly of the following types:

1. Total cost
2. Average cost

3. Marginal cost.

I. Total Cost:
According to Dooley, “Total cost of production is the sum of all expenditure incurred in producing a
given volume of output.” In other words, the amount of money spent on the production of different
levels of a good is called total cost. For instance, if a total sum of Rs. 2500 is spent on the produc-
tion of 100 bicycles, then the total cost of producing 100 bicycles will be Rs. 2500. Since, there are
twotypes of factors of production in the short run, so there are two types of costs.

444
Fixed Costs or Supplementary Costs:
The cost that remains fixed at any level of output is known as the fixed cost. These costs must be
paid whether there is production or not. These costs include, depreciation allowance, interest on
fixed capital, license fee, salaries to permanent staff etc.

In the words of Anatol Murad, “Fixed costs are costs which do not change with change in the quan-
tity of output.” These costs are also known as the overhead costs or indirect costs because a firm
has to incur these costs even if it shuts down
temporarily. Thus, fixed costs are unavoidable which occur even at the zero levelof output.
Fixed cost can be shown with the help of a table 1 and diagram 2:

In Figure 2 quantity has been measured on horizontal axis while costs on vertical axis. As is clear
from the fig. 2 that even at zero level of output a firm has to incur fixed costs equal to OP. In the
figure, output increases from OX1 to OX2 to OX3 but the fixed costs remain the same.

Variable Costs or Prime Costs:

Variable costs refer to those costs which change with the change in the volume of output. These
costs are unavoidable or contractual costs. Marshall called these costs as “Prime Costs”, “Direct
Costs” or “Special Costs”. Variable costs include expenditure on transport, wages of labour, elec-
tricity charges, price of raw material etc. Thus, according to Dooley, “Variable costs are one which
varies as the level of output varies.” It can be explained with the help of a table 2 and figure3.

445
In Figure 3 variable cost curve starts from zero. It means when output is zero, variable costs are
also zero. But as the output increases variable costs also increase. As is evident from the fig that
when output is 1 unit variable costs are Rs. 20. But, as the output increases to 3 units, variable
costs also increase to thetune of Rs. 2.

Relation between Total, Fixed and Variable Costs:

In order to determine the total costs of a firm, we aggregate fixed as well as variable costs at differ-
ent levels of output i.e.
TC = TFC + TVC

446
 TFC = TC – TVC
TVC= TC - TFC

In table 3, when output is zero, variable costs are also zero. But the fixed costs as well as total
costs are 40. As the output increases to 8 units, total costs go up to
86. It means as the output increases fixed costs remain the same, but variable costs increase at a
diminishing rate then at constant rate and ultimately at an increasing rate. The relationship has
been shown in diagram 4.
In Figure 4 quantity is measured on horizontal axis while costs on vertical axis. KK is fixed cost
curve which is parallel to horizontal axis which signifies the fact that at all levels of output, fixed
costs remain the same. VC is the variable cost curve.

It is of the shape of reverse S. It means as the output is zero variable costs are alsozero. But as the
output increases, variable costs also start increasing, initially at diminishing rate, constant rate and
then at an increasing rate.

Importance of Distinction between Fixed and Variable Costs:

This distinction is important in price theory. Every firm has the object to maximize profits or mini-
mize losses, if losses are unavoidable. At times the price of the product may not cover average to-
tal cost. Then the firm will have to decidewhether to shut down or produce some output.

1. Decision to Shut Down the Firm:

The producer may not cover the total costs, if the price of the product is less than the short-run av-
447
erage cost. Then the distinction between fixed cost and variable costs must be kept in mind. Fixed
costs are incurred even at zero output. They areunavoidable costs. Variable costs are incurred only
when some output is produced.

2. If the price does not cover average variable costs, the firm prefers to shut down. In other
words if the total revenue (total sale proceeds) does not cover total variable costs, the firm must
shut down. Otherwise, its total loss will be greater than the fixed costs. It will produce something
only when the price covers average variable cost and part of the average fixed costs. The output at
which marginal cost is equal to marginal revenue keeps losses minimum.

3. Break-Even Point:
At times the firm may not make any profit. It just pays to produce a given output. Total revenue is
just equal to total cost. The firm has crossed the losses zone and is about to enter the zero profit
zone. The output at which total revenue becomes equal to total cost represents break-even point.

Average Cost:
According to Dooley, “The average cost of production is the total cost per unit of output.” In other
words average cost of production is the total cost of production divided by the total number of
units produced.

Suppose, the total cost of producing 500 units is Rs. 1000, the averagecost will be:

Average Fixed Cost:

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Average fixed cost is the total fixed cost divided by the number of units of output produced.
Thus:

Since, total fixed cost is a constant quantity, average fixed cost will steadily fall asoutput incre
ases, thus, the average fixed cost curve slopes downward throughout the length. It can be shown
with the help of a figure 5.

In Figure 5 the average fixed cost curve slopes downward with a view to touch the horizontal axis.
But it will not be so because AFC can never be zero. Thus, it is clear that as output increases, aver-
age fixed costs go on diminishing.

Average Variable Costs:

Average variable cost is the total variable cost divided by the number of units ofoutput produced.
AVC = TVC / Q
AVC = Average variable costs.
TVC = Total variable costs Q = Output
Generally, the AVC falls as output increases from zero to the normal capacity output due to the law
of increasing returns. But beyond the normal capacity output, the AVC will rise steeply because of
the operation of the law of diminishing returns as has been shown in figure 6.

In Figure 6 the average variable cost curve assumes the U- shape. Initially, theAVC curve falls, after
having the minimum point the curve starts rising.

449
Relation between Average Cost, Average Fixed Cost and AverageVariable Cost:
Average cost is the lateral summation of average fixed and average variable cost.

The following table & fig. expresses their relationship:

Average cost can be calculated by dividing total cost with units of output (q). In the above table
AFC diminishes with the increase in production whereas AVC diminishes up to third unit. Total av-
erage cost is minimum at fourth unit after that it starts increasing because AVC is also increasing.
Fig. 7 shows that averagecost curve is of U-shape.
Why the short-run AC is curve U-shaped?
In the short-run average cost curves are of U-shape. It means, initially it falls and after reaching the
minimum point it starts rising upwards. It can be on account ofthe following reasons.

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1. Basis of Average Fixed Cost and Average Variable Cost:
It is well known, that average cost is the aggregate of average fixed cost and average variable cost
(AC = AFC + AVC). To begin with, as production increases, initially the average fixed cost and aver-
age variable cost falls. But after a minimum point, average variable cost stops falling but not the
average cost. It isdue to this reason that average variable cost reaches the minimum before AC.
The point, where AC is minimum is called the optimum point. After this point, AC begins to rise up-
ward. The net result is the increase in AC. Therefore, it is only due to the nature of AFC and AVC
that AC first falls, reaches minimum and afterwards starts rising upward and hence assume the U-
shape.

2. Basis of the Law of Variable Proportion:

The law of variable proportion also results in U-shape of short run average costcurve. If in the short
period variable factors are combined with a fixed factor, output increases in accordance with the
law of variable proportions. In other words, the law of ‘Increasing Returns’ applies.
Similarly, if we employ more and more variable factors with fixed factors the law of Diminishing Re-
turns is said to apply. Thus, it is due to the law of variable proportions that the average cost curve
assumes the shape of U.

3. Indivisibilities of the Factors:

Another reason due to which the average cost curve forms U-shape is the indivisibilities of factors.
When in the short-run a firm increases its production due to indivisibilities of fixed factors, it gets
various internal economies. It is these economies which cause the average cost curve to fall in the
initial stage. Generally, there are three types of internal economies which help to bring down the
cost viz., technical economies, marketing economies and managerial economies.

Marginal Cost:
The concept of marginal cost of production is recently developed by Austrian School of Econom-
ics. Marginal cost is an addition to the total cost caused by producing one more unit of output. For
instance, the total cost for the production of 100 units is Rs. 5000. Suppose the production of one
more unit costs Rs. [Link] will be called the marginal cost.

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Why is the MC Curve of U-shape?
Marginal cost means the addition made to total cost on account of producing one more unit of
output. In the beginning, when a firm increases its output, total costs as well as variable costs start
increasing at a diminishing rate.

It is only due to the reason that in the initial stage of production law of increasing returns applies.
Moreover, in the initial stage of production, the firm enjoys manyeconomies which cause the MC to
fall. As the output continues, marginal cost becomes minimum, thus, ultimately starts rising.
The reason being the operation of the Law of Diminishing Returns. In short, initially marginal cost
falls and after having the minimum point it begins to [Link], it is how the MC is also of U-shape.

Relation between Average and Marginal Cost:

The relation between average and marginal cost can be explained withthe help of following table:
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Main points of the relation are as under:
1. Average Cost and Marginal Cost can be calculated from Total Cost: Average cost and
marginal cost can be calculated from total cost. As is known, average cost is the ratio of total cost
to total output. In other words, AC is calculated by dividing the total cost by the quantity of output.
It means.
AC = TC / Q
In the same way, marginal cost can also be calculated from total cost. It refers to an addition made
to total output by producing one more unit of output. Thus,
MC = TCn – TC n-1
MC = ∆TC / ∆Q

2. When average cost falls, MC also falls:

In this situation, rate of fall in marginal cost is more than fall in average cost. In other words, when
AC curve is falling, MC curve will be below it. The reason behind this is that whereas average cost
is the aggregate of average fixed cost and average variable cost, marginal cost refers only to
change in average variable cost.

3. When AC rises, MC also rises:

When average cost curve rises, marginal cost too rises, but rate of increase inmarginal cost is more
than that of average cost.

4. MC cuts AC at its Lowest Point:

Marginal cost is equal to average cost when the latter is at its minimum. The minimum point of
marginal cost occurs earlier than the average cost.
5. When AC is constant MC becomes equal to AC:
When AC is constant, marginal cost first increases and then becomes equal to it. Figure 9 shows
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the picture more vividly.
6. Use of MC and AC in Price Determination:
The concept of marginal cost is of great significance in finding out equilibrium output and that of
average cost in finding out profit and loss. Equilibrium outputis one at which marginal cost is equal
to marginal revenue.
A firm earns normal profit when its average cost is equal to average revenue. It earns supernormal
profit when average revenue is more than average cost.
Moreover, a firm earns losses when average cost is more than average revenue.
7. Mutual Interaction between MC and AC:
In Fig. 10 when marginal cost is more than average cost, average cost has a tendency to rise. It
seems as if marginal cost curve is pulling the AC curve upward. On the other hand, when MC is
less than AC, it pulls the AC ‘curvedownward. When MC is equal to AC then the latter is constant.

Perfect Competition
Definition: The Perfect Competition is a market structure where a large number of buyers and
sellers are present, and all are engaged in the buying and selling of the homogeneous products at
a single price prevailing in the market.

In other words, perfect competition also referred to as a pure competition, exists when there is no
direct competition between the rivals, and all sell identically the same products at a single price.

Features of Perfect Competition

1. Large number of buyers and sellers: In perfect competition, the buyers and sellers are large
enough, that no individual can influence the price and the output of the industry. An individual cus-
tomer cannot influence the price of the product, as he is too small in relation to the whole market.
Similarly, a single seller cannot influence the levels of output, who is too small in relation to the
gamut of sellers operating in the market.
2. Homogeneous Product: Each competing firm offers the homogeneous product, such that
no individual has a preference for a particular seller over the others. Salt, wheat, coal, etc. are some
of the homogeneous products for which customers are indifferent and buy these from the one who
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charges a less price. Thus, an increase in the price would let the customer go to some other suppli-
er.
3. Free Entry and Exit: Under the perfect competition, the firms are free to enter or exit the in-
dustry. This implies, If a firm suffers from a huge loss due to the intense competition in theindustry,
then it is free to leave that industry and begin its business operations in any of the industry, it
wants. Thus, there is no restriction on the mobility of sellers.
4. Perfect knowledge of prices and technology: This implies, that both the buyers and sellers
have complete knowledge of the market conditions such as the prices of products and the latest
technology being used to produce it. Hence, they can buy or sell the products anywhere and any-
time they want.
5. No transportation cost: There is an absence of transportation cost, i.e. incurred in carrying
the goods from one market to another. This is an essential condition of the perfect competition
since the homogeneous product should have the same price across the market and if the transpor-
tation cost is added to it, then the prices may differ.
6. Absence of Government and Artificial Restrictions: Under the perfect competition, both the
buyers and sellers are free to buy and sell the goods and services. This means any customer can
buy from any seller, and any seller can sell to any [Link], no restriction is imposed on either
party. Also, the prices are liable to change freely as per the demand- supply conditions. In such a
situation, no big producer and the government can intervene and control the demand, supply or
price of the goods and services.

Thus, under the perfect competition, a seller is the price taker and cannot influence the market
price.
Monopolistic Competition – definition,diagram and examples
Definition: Monopolistic competition is a market structure which combines elements of monopoly
and competitive markets. Essentially a monopolistic competitive market is one with freedom of en-
try and exit, but firms can differentiate their products. Therefore, they have an inelastic demand
curve and so they can set prices. However, because there is freedom of entry, supernormal profits
will encourage more firms to enter the market leading to normal profits in the long term.
A monopolistic competitive industry has the following features:
• Many firms.
• Freedom of entry and exit.
• Firms produce differentiated products.
• Firms have price inelastic demand; they are price makers because the good is highly differ-
entiated
• Firms make normal profits in the long run but could make supernormal profits in the short
term
• Firms are allocatively and productively inefficient.
Diagram monopolistic competition short run the short run, the diagram for monopolistic competi-
tion is the same as for a monopoly.
The firm maximizes profit where MR=MC. This is at output Q1 and price P1, leading to supernormal
profit Monopolistic competition long run.

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In the long-run, supernormal profit encourages new firms to enter. This reduces demand for exist-
ingfirms and leads to normal profit.
Efficiency of firms in monopolistic competition
• Allocative inefficient. The above diagrams show a price set above marginal cost
• Productive inefficiency. The above diagram shows a firm not producing on the lowest point of
ACcurve
• Dynamic efficiency. This is possible as firms have profit to invest in research and development.

X-efficiency. This is possible as the firm does face competitive pressures to cut cost and provide

better products
Examples of monopolistic competition
• Restaurants – restaurants compete on quality of food as much as price. Product differentia-
456
 tion is a key element of the business. There are relatively low barriers to entry in setting up a
new restaurant.
• Hairdressers. A service which will give firms a reputation for the quality of their hair-cutting.
• Clothing. Designer label clothes are about the brand and product differentiation
• TV programs – globalisation has increased the diversity of tv programmes from networks
around the world. Consumers can choose between domestic channels but also imports
from other countries and new services, such as Netflix.
• Limitations of the model of monopolistic competition
• Some firms will be better at brand differentiation and therefore, in the real world, they will be
able to make supernormal profit.
• New firms will not be seen as a close substitute.
• There is considerable overlap with oligopoly – except the model of monopolistic competi-
tion assumes no barriers to entry. In the real world, there are likely to be at least some barri-
ers to entry
• If a firm has strong brand loyalty and product differentiation – this itself becomes a barrier
to entry. A new firm can’t easily capture the brand loyalty.
• Many industries, we may describe as monopolistically competitive are very profitable, so the
assumption of normal profits is too simplistic.

Key difference with monopoly

In monopolistic competition there are no barriers to entry. Therefore in long run, the market will be
competitive, with firms making normal profit.

Key difference with perfect competition

In Monopolistic competition, firms do produce differentiated products, therefore, they are not price
takers (perfectly elastic demand). They have inelastic demand.

New trade theory and monopolistic competition

New trade theory places importance on the model of monopolistic competition for explaining
trends in trade patterns. New trade theory suggests that a key element of product development is
the drive for product differentiation – creating strong brands and new features for products. There-
fore, specialization doesn’t need to be based on traditional theories of comparative advantage, but
we can have countries both importing and exporting the same good. For example, we import Italian
fashion labels and export British fashion labels. To consumers, the importance is the choice of
goods.

Oligopoly
The word Oligopoly is derived from two Greek words – ‘Oligi’ meaning ‘few’ and ‘Polein’ meaning ‘to
sell’. An Oligopoly market situation is also called ‘competition among the few’. In this article, we will
look at Oligopoly definitionand some important characteristics of this market structure.

Also, as there are few sellers in the market, every seller influences the behavior ofthe other firms and
other firms influence it.

Oligopoly is either perfect or imperfect/differentiated. In India, some examples ofan oligopolistic mar-
ket are automobiles, cement, steel, aluminum, etc.

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Oligopoly Definition
An oligopoly is an industry which is dominated by a few firms. In this market, there are a few firms
which sell homogeneous or differentiated products.

Characteristics of Oligopoly
Now that the Oligopoly definition is clear, it’s time to look at the characteristics ofOligopoly:

Few firms
Under Oligopoly, there are a few large firms although the exact number of firms is undefined. Also,
there is severe competition since each firm produces a significantportion of the total output.

Barriers to Entry
Under Oligopoly, a firm can earn super-normal profits in the long run as there are barriers to entry like
patents, licenses, control over crucial raw materials, etc.
These barriers prevent the entry of new firms into the industry.

Non-Price Competition
Firms try to avoid price competition due to the fear of price wars and hence depend on non-price
methods like advertising, after sales services, warranties, etc. This ensures that firms can influence
demand and build brand recognition.

Interdependence
Under Oligopoly, since a few firms hold a significant share in the total output of the industry, each
firm is affected by the price and output decisions of rival firms. Therefore, there is a lot of interde-
pendence among firms in an oligopoly. Hence, a firm takes into account the action and reaction of
458
its competing firms while determining its price and output levels.

Nature of the Product

Under oligopoly, the products of the firms are either homogeneous ordifferentiated.

Selling Costs
Since firms try to avoid price competition and there is a huge interdependence among firms, selling
costs are highly important for competing against rival firmsfor a larger market share.

No unique pattern of pricing behavior

Under Oligopoly, firms want to act independently and earn maximum profits on one hand and cooper-
ate with rivals to remove uncertainty on the other hand.
Depending on their motives, situations in real-life can vary making predicting thepattern of pricing be-
havior among firms impossible. The firms can compete or collude with other firms which can lead to
different pricing situations.

Indeterminateness of the Demand Curve

Unlike other market structures, under Oligopoly, it is not possible to determine thedemand curve of a
firm. This is because on one hand, there is a huge interdependence among rivals. And on the other
hand there is uncertainty regarding the reaction of the rivals. The rivals can react in different ways
when afirm changes its price and that makes the demand curve indeterminate.

Firms behavior under Oligopoly

Based on the objectives of the firms, the magnitude of barriers to entry and the nature of govern-
ment regulation, there are different possible outcomes in relationto a firm’s behavior under Oligopoly.
These are:
1. Stable prices
2. Price wars
3. Collusion for higher prices
Further, Oligopoly can either be collusive or non-collusive. Collusive oligopoly is a market situation
wherein the firms cooperate with each other in determining price or output or both. A non-collusive
oligopoly refers to a market situation where the firms compete with each other rather than cooperat-
ing.

Non-Collusive Oligopoly-Sweezy’s Kinked Demand Curve Model (Price-Rigidity)

Usually, in Oligopolistic markets, there are many price rigidities. In 1939, Paul Sweezy used an uncon-
ventional demand curve – the kinked demand curve to explain these rigidities.

Reason for the kink in the demand curve

It is assumed that firms behave in a two-fold manner in reaction to a price change by a rival firm. In
simple words, firms follow price cuts by a rival company but not price increases. So, if a seller in-
creases the price of his product, his rivals do not follow the price increase.

Therefore, the market share of the firm reduces significantly as a result of the price rise. On the oth-
er hand, if a seller reduces the price of his product, then the rivals also reduce their price to bring it at
459
par with the price reduction of the firm.

This ensures that they prevent their market share from falling. Once the rivals react, the firm lowering
the price first cannot gain from the price cut.
Why the price rigidity?
As can be seen above, a firm cannot gain or lose by changing its price from the prevailing price in
the market. In both cases, there is no increase in demand for thefirm which changes its price. Hence,
firms stick to the same price over time leading to price rigidity under oligopoly.

Explanation of the Kinked-Demand Curve Model

In the figure above, KPD is the is the kinked-demand curve and OP0 is the prevailing price in the oli-
gopoly market for the OR product of one seller. Starting from point P, corresponding to the point OP1,
any increase in price above it will considerably reduce his sales as his rivals will not follow his price
increase.

This is because the KP portion of the curve is elastic and the corresponding portion of the MR
curve (KA) is positive. Therefore, any price increase will not just reduce the total sales but also his
total revenue and profit. On the other hand,if the seller reduces the price of the product below OPQ (or
P), his rivals will alsoreduce their prices.

However, even if his sales increase, his profits would be less than before. This is because the PD por-
tion of the curve below P is less elastic and the corresponding part of the marginal revenue curve be-
low R is negative. Therefore, in both price- raising and price-reducing situations, the seller is the loser.
He will stick to the prevailing market price OP0 which remains rigid.

Working of the kinked-demand curve

Let’s analyze the effect of changes in cost and demand conditions on price stability in the oligopo-
listic market. Let’s suppose that the prevailing price in themarket is OP0.
Therefore, if one seller increases the price above OP0 and the rival sellers don’tand keep the prices of
their products at OP, then it will lead to the product becoming costlier than the others.

Subsequently, the demand for the costlier product will fall significantly. This is seen in the demand
curve of a firm for any price above OP0 or the KP section of the curve, is relatively elastic. The high
460
elasticity reduces the demand significantlyas a result of the price increase.

On the other hand, if the seller reduces the price below OP0, the rivals also followthe price cut to pre-
vent their demand from falling. This is seen in the demand curve of a firm for any price below OP0
or the PD segment of the curve is relatively inelastic. The low elasticity does not increase the de-
mand significantlyas a result of the price cut.

This asymmetrical behavioral pattern results in a kink in the demand curve and hence there is price
rigidity in oligopoly markets. The prices remain rigid at the kink (point P). In other words, the price
will remain sticky at OP0 and the output =OR at this price.

Due to the difference in the elasticities, the MR curve becomes discontinuous corresponding to the
point of change in elasticity of the demand curve. The kink represents this. At the output < OR, the
demand curve is KP and the corresponding MR curve is KA. For output > OR, the demand curve is PD
and thecorresponding MR curve is BMR.

Collusive Oligopoly
Sometimes, firms may try to remove uncertainty related to acting independently and enter into price
agreements with each other. This is collusion. Collusion is either formal or informal. It can take the
form of cartel or price leadership.

A cartel is an association of independent firms within the same industry which follow the common
policies relating to price, output, sale, profit maximization,and the distribution of products.

Price leadership is based on informed collusion. Under price leadership, one firmis a large or dominant
firm and acts as the price leader who fixes the price for theproducts while the other firms allow it.

Solved Question

Q1. What is Oligopoly?

Answer: An oligopoly is an industry which is dominated by a few firms. In this market, there are a
few firms which sell homogeneous or differentiated products. Also, as there are few sellers in the
market, every seller influences the behavior ofthe other firms and other firms influence it.

Price Leadership under Oligopoly(With Diagram)

In certain situations, organizations under oligopoly are not involved in collusion.
There are a number of oligopolistic organizations in the market, but one of them is dominant organ-
ization, which is called price leader.
Price leadership takes place when there is only one dominant organization in the industry, which
sets the price and others follow it.

Sometimes, an agreement may be developed among organizations to assign a leadership role to

one of them. The dominant organization is treated as price leader because of various reasons,
such as large size of the organization, large economies of scale, and advanced technology. Ac-
cording to the agreement, there is no formal restriction that other organizations should follow the
price set by theleading organization. However, sometimes agreement is formal in nature.

461
 Price leadership is assumed to stabilize the price and maintain price discipline.

This also helps in attaining effective price leadership, which worksunder the following conditions:
(a) When the number of organizations is small
(b) Entry to the industry is restricted
(c) Products are homogeneous
(d) Demand is inelastic or less elasticity
(e) Organizations have similar cost curves

Types of Price Leadership:

Price leadership helps in stabilizing prices and maintaining price discipline. There are three major
types of price leadership, which are present in industriesover a passage of time.

These three types of price leadership are explained as follows:

(i) Dominant Price Leadership:
Refers to a type of leadership in which only one organization dominates the entireindustry. Under
dominant price leadership, other organizations in the industry cannot influence prices. The domi-
nant organization uses its power of monopoly to maximize its profits and other organizations have
to adjust their output with the set price.

The interests of other organizations are ignored by the dominant organization. Therefore, domi-
nant price leadership is sometimes termed-as partial [Link] leadership by the leading or-
ganization is most commonly seen in the industry.

(ii) Barometric Price Leadership:

Refers to a leadership in which one organization declares the change in prices at first and as-
sumes that other organizations would accept it. The organization does not dominate others and
need not to be the leader in the industry. Such type of organization is known as barometer.

This barometric organization only initiates a reaction to changing market situation, which other
organizations may follow it if they find the decision in their interest. On the contrary, the leading or-
ganization has to be accurate while forecasting demand and cost conditions, so that the suggest-
ed price is accepted by other organizations.

Barometric price leadership takes place due to the following reasons:

(a) Lack of capacity and desire of organizations to estimate appropriate supply and demand
conditions. This influences organizations to follow price changes made by the barometric organi-
zation, which has a proven ability to make correct forecasts.
(b) Rivalry among the organizations may make a leader, which can be unacceptable by other
organizations. Thus, most of the organizations prefer barometric price leadership.

(iii) Aggressive Price Leadership:

Implies a leadership in which one organization establishes its supremacy by threatening the organ-
izations to follow its leadership. In other words, a dominant organization establishes leadership by
following aggressive price policies and forces other/organizations to follow the prices set by it.

Price-Output Determination under Price Leadership:

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Price leadership takes place when there is only one dominant organization in the industry, which
sets the price and others follow it. Different economists have developed different models for de-
termining price and output in price leadership.

Here, we would discuss a simple model for determining price and output in price leadership,
which is shown in Figure-4:
Suppose there are two organizations, A and B producing identical products where organization A
has a lower cost of the production than organization B. Therefore, consumers are indifferent be-
tween these two organizations due to identical products. This implies that both the organizations
would face same demand curve, which further represents equal market share.
In Figure-4, DD is the demand curve of both the organizations and MR is their marginal revenue.
MCa and MCb are the marginal cost curves of organization A and B respectively. As stated earlier,
the cost of production of organization A isless than B, thus, MCa is drawn below MCb.
Let us first start the discussion of price leadership with the case of organization A. The profits of
organization A would be maximized at a point where MR intersects MCa. At this point, the output of
organization A would be OQ with the price level OP. On the other hand, the profits of organization B
would be maximized at a point where MR intersects MCb with output OQ1 and price OP1.
In such a case, the price of organization B is more as compared to organization A. However, both
the organizations have to charge the same price as products are homogeneous. In this case, or-
ganization A is the price leader and organization B is the follower.
Thus, organization A will dictate the price to organization B. Both the organizations will follow the
same output, OQ and price OP. However, the profits earned by organization B are less than A, as it
has to produce at price OP which is less than its profit maximizing price, OP1. In addition, the organ-
ization B also has high costs of production that leads to lower profits at price OP1.

Drawbacks of Price Leadership:

The price leadership suffers from various drawbacks.

These are discussed as follows:

1. Makes it difficult for the price leader to assess the reactions of followers.
2. Leads to malpractices, such as charging lower prices by rival organizations in the form of
rebates, money back guarantees, after delivery free services, and easy installment facility.
The prices charged by rival organizations are comparatively less than the prices set by the
price leader.
3. Leads to non-price competition by rival organizations in the form of aggressive promotion
strategies.
4. Influences new organizations to enter into the industry because of price rise. These new or-
ganizations may not follow the leader of the industry.
5. Poses problems if there are differences in cost of price leaders and price followers. In case,
if cost of production of price leader is less, then he/she would fix lower prices. This will lead
to a loss for a price follower if his/her cost ofproduction is more than the price leader

What is a Monopoly
A monopoly refers to a sector or industry dominated by one corporation, firm or entity. Monopolies
can be considered an extreme result of free-market capitalism in that absent any restriction or re-

463
straints, a single company or group becomes large enough to own all or nearly all of the market
(goods, supplies, commodities, infrastructure and assets) for a particular type of product or ser-
vice. Antitrust laws and regulations are put in place to discourage monopolistic operations – pro-
tecting consumers, prohibiting practices that restrain trade and ensuring a marketplace remains
open and competitive. "Monopoly" can also be used to mean the entity that has total or near-total
control of a market.

BREAKING DOWN Monopoly

A monopoly is a kind of structure that exists when one company or supplier produces and sells a
product. If there is a monopoly in a single market with no other substitutes, it becomes a “pure
monopoly.” When there are multiple sellers in an industry and there are many similar substitutes
for the goods being produced, and companies keep some power in the market, then it is called mo-
nopolistic competition.
Characteristics of a Monopoly
• High or no barriers to entry: Other competitors are not able to enter the market
• Single seller: There is only one seller in the market. In this instance, the company becomes
the same as the industry it serves.
• Price maker: The company that operates the monopoly decides the price of the product that
it will sell.
• Price discrimination: The firm can change the price or quantity of the product at anytime.

Why Are Monopolies Illegal?

A monopoly is characterized by the absence of competition, which can lead to high costs for con-
sumers, inferior products and services, and corrupt behavior. A company that dominates a busi-
ness sector or industry can use that dominance to its advantage, and at the expense of others. It
can create artificial scarcities, fix prices and otherwise circumvent natural laws of supply and de-
mand. It can impede new entrants into the field, discriminate and inhibit experimentation or new
product development, while the public — robbed of the recourse of using a competitor — is at its
mercy. A monopolized market often becomes an unequal, and even inefficient, one.

Mergers and acquisitions among companies in the same business are highly regulated and re-
searched for this reason. Firms are typically forced to divest assets if federal authorities think a
proposed merger or takeover will violate anti-monopoly laws.

Natural Monopolies
Not all monopolies are illegal. There are such things as natural monopolies, which occur for several
reasons. Sometimes, a specialized industry may have certain barriers to entry that only one com-
pany or individual can meet. Or, a company may have patents on its products
that limit its competition in a specific field; the monopoly is considered just compensation for the
high start-up and research and development (R&D) costs the company has incurred.

There are also public monopolies set up by governments to provide essential services and goods,
such as the U.S. Postal Service (though of course, the USPS has less of a monopoly on mail deliv-
ery since the advent of private carriers like United Parcel Service and FedEx).

The utilities industry is an excellent example of a sector where natural monopolies flourish. Usual-
ly, there is only one major (private) company supplying energy or water in a region or municipality.
This is allowed because these suppliers incur large costs in producing power orwater and providing
464
these essentials to each local household and business, and it is considered more efficient for there
to be a sole provider of these services. (Imagine what your neighborhood would look like if there
were more than one electric company serving your area. The streets would be overrun with utility
poles and electrical wires as the different companies competed to sign up customers, and then
hook up their power lines to houses.) But the tradeoff is that the government heavily regulates and
monitors the utility company, controlling the rates it can charge its customers and the timing of
any rate increases.

Antitrust Laws
In 1890, the Sherman Antitrust Act became the first legislation passed by the U.S. Congress to lim-
it monopolies. The Sherman Antitrust Act had strong support by Congress, passing theSenate with
a vote of 51 to 1 and passing the House of Representatives unanimously 242 to0.

In 1914, two additional antitrust pieces of legislation were passed to help protect consumers and
prevent monopolies. The Clayton Antitrust Act created new rules for mergers and corporate direc-
tors, and also listed specific examples of practices that would violate the Sherman Act. The Feder-
al Trade Commission Act created the Federal Trade
Commission (FTC), which sets standards for business practices and enforces the two antitrust
acts, along with the Antitrust Division of the United States Department of Justice.

The laws are intended to preserve competition and allow smaller companies to enter a market, and
not to merely suppress strong companies.

Breaking Up Monopolies
The Sherman Antitrust Act has been used to break up large companies over the years, including
Standard Oil Company and American Tobacco Company.

In 1994, the U.S. government accused Microsoft of using its significant market share in the PC op-
erating systems business to prevent competition and maintain a monopoly. The complaint, filed on
July 15, 1994, stated that "The United States of America, acting under the direction of the Attorney
General of the United States, brings this civil action to prevent and restrain the defendant Microsoft
Corporation from using exclusionary and anticompetitive contracts to market its personal com-
puter operating system software. By these contracts, Microsoft has unlawfully maintained its mo-
nopoly of personal computer operating systems and has an unreasonably restrained trade." A fed-
eral district judge ruled in 1998 that Microsoft was to be broken into two technology companies,
but the decision was later reversed on appeal by a higher court. The controversial outcome was
that, despite a few changes, Microsoft was free to maintain its operating system, application de-
velopment and marketing methods.

The most prominent monopoly breakup in U.S. history was that of AT&T. After being allowed to
control the nation's telephone service for decades, as a government-supported monopoly, the giant
telecommunications company found itself challenged under antitrust laws. In 1982,
after an eight-year court battle, AT&T had to divest itself of 22 local exchange service companies,
and it has been forced to sell off assets or split units several times since.

What is Monopolistic Competition

Monopolistic competition characterizes an industry in which many firms offer products or services
that are similar, but not perfect substitutes. Barriers to entry and exit in a monopolistic competitive
465
industry are low, and the decisions of any one firm do not directlyaffect those of its competitors.

BREAKING DOWN Monopolistic Competition

Monopolistic competition is a middle ground between monopoly and perfect competition (a purely
theoretical state), and combines elements of each. All firms in monopolistic competition have the
same, relatively low degree of market power; they are all price makers. In the long run, demand is
highly elastic, meaning that it is sensitive to price changes. In the short run, economic profit is pos-
itive, but it approaches zero in the long run. Firms in monopolistic competition tend to advertise
heavily.

Monopolistic competition is a form of competition that characterizes a number of industries that

are familiar to consumers in their day-to-day lives. Examples include restaurants, hair salons, cloth-
ing, and consumer electronics. To illustrate the characteristics of monopolistic competition, we'll
use the example of household cleaning products.

Number of firms
Say you've just moved into a new house and want to stock up on cleaning supplies. Go to the ap-
propriate aisle in a grocery store, and you'll see that any given item—dish soap, hand soap, laundry
detergent, surface disinfectant, toilet bowl cleaner, etc.—is available in a number of varieties. For
each purchase you need to make, perhaps five or six firms will be competing for your business.

Product Differentiation
Because the products all serve the same purpose, there are relatively few options for sellers to dif-
ferentiate their offerings from other firms'. There might be "discount" varieties that are of lower
quality, but it is difficult to tell whether the higher-priced options are in fact any better. This uncer-
tainty results from imperfect information: the average consumer does not know the precise differ-
ences between the various products, or what the fair price for any of them is.

Monopolistic competition tends to lead to heavy marketing, because different firms need to distin-
guish broadly similar products. One company might opt to lower the price of their cleaning product,
sacrificing a higher profit margin in exchange—ideally—for higher sales. Another might take the
opposite route, raising the price and using packaging that suggests quality and sophistication. A
third might sell itself as more eco-friendly, using "green" imagery and displaying a stamp of ap-
proval from an environmental watchdog (which the other brands likely qualify for as well, but don't
display). In reality, every one of the brands might be equally effective.

Decision-Making
Monopolistic competition implies that there are enough firms in the industry that one firm's deci-
sion does not set off a chain reaction. In an oligopoly, a price cut by one firm can set off a price
war, but this is not the case for monopolistic competition.

Pricing Power
As in a monopoly, firms in monopolistic competition are price setters or makers, rather than price
takers.

Demand Elasticity
Due to the range of similar offerings, demand is highly elastic in monopolistic competition. In other
words, demand is very responsive to price changes. If your favorite multipurpose surface cleaner
466
suddenly costs 20% more, you probably won't hesitate to switch to an alternative, and your coun-
tertops probably won't know the difference.

Economic Profit
In the short run, firms can make excess economic profits. However, because barriers to entry are
low, other firms have an incentive to enter the market, increasing the competition, until overall eco-
nomic profit is zero. Note that economic profits are not the same
as accounting profits; a firm that posts a positive net income can have zero economic profit, since
the latter incorporates opportunity costs.
What is Price Discrimination?
Price discrimination refers to a pricing strategy that charges consumers different prices for the
identical good or service.

Different Types of Price Discrimination

1. First Degree Price Discrimination
Also known as perfect price discrimination, first-degree price discrimination involves charging
consumers the maximum price that they are willing to pay for a good or service. Here, consumer
surplus is entirely captured by the firm. In practice, a consumer’s maximum willingness to pay is
difficult to determine. Therefore, such pricing strategy is rarely employed.

2. Second Degree Price Discrimination

Second-degree price discrimination involves charging consumers a different price for theamount of
quantity consumed. Examples include:
• A phone plan that charges a higher rate after a determined amount of minutesare used
• Reward cards that provide frequent shoppers with a discount on future products
• Quantity discounts for consumers that purchase a determined number of more of a certain
good

3. Third Degree Price Discrimination

Also known as group price discrimination, third-degree price discrimination involves charging dif-
ferent prices depending on a particular market segment or consumer [Link] is commonly seen in
the entertainment industry.
For example, when an individual wants to see a movie, prices for the same screening are different
depending on if you are a minor, adult, or senior.

Primary Requirements for a Successful Price Discrimination

For a firm to employ the pricing strategy, there are certain conditions that must be met:

#1 Imperfect competition
The firm must be a price maker (i.e., operate in imperfect competition). Therefore, there must be a
degree of monopoly power to be able to employ price discrimination. If the company was in per-
fect competition, the pricing strategy would not be possible as therewould be no ability to influence
prices.

#2 Prevention of resale
The firm must be able to prevent resale. In other words, consumers who already purchased a good
or service at a lower price must not be able to re-sell it to other consumers who would’ve otherwise

467
paid a higher price for the same good or service.

#3 Elasticity of demand
Consumer groups must demonstrate varying elasticities of demand (i.e., low-income individuals
being more elastic to airplane tickets compared to business travelers). If consumers all show the
same elasticity of demand, the pricing strategy will not work.

Example of Price Discrimination: Cineplex

Canadian entertainment company Cineplex is a classic example of a firm using the pricing strate-
gy. Depending on the age demographic, tickets for the same movie are at different prices. In addi-
tion, Cineplex charges different prices on different days (Tuesday being the cheapest and week-
ends being the most expensive). The following is a diagram from Cineplex for a movie screening on
a Monday.

As indicated in the diagram above, different age demographics face a different price for the same
screening. It would be an example of third-degree price discrimination.

Price Discrimination in Increasing a Firm’s Profitability

Consider a firm that charges a single price for an apple: $9. In such a case, it would leadto one sale
and total revenue of $5:

468
Now, consider a firm that is able to charge a different price to each customer. Forexample:
• $5 for the first consumer
• $4 for the second consumer
• $3 for the third consumer, and so on.
In such a situation, the firm is able to increase its profit and sell to customers that were originally
not going to purchase by offering price = each customer’s willingness to pay. It would lead to five
sales and a total revenue of $5+$4+$3+$2+1 = $15.

As indicated above, price discrimination allows a firm to reap additional profits and convert con-
sumer surplus into producer surplus.

Advantages of Price Discrimination

Advantages of the pricing strategy can be viewed from the perspective of the firm and the consum-
er:

The Firm
• Profit maximization: The firm is able to turn consumer surplus into producer surplus. In a
first-degree price discrimination strategy, all consumer surplus is turned into producer surplus. It
also ties into survivability, as smaller firms are able to better survive if they are able to offer differ-
ent prices in times of greaterand lower demand.
• Economies of scale: By charging different prices, sales volume is likely to increase. As a re-
sult, firms can benefit from increasing their production towardscapacity and utilizing.

The Consumer
• Lower prices: Although not all consumers are winners, consumers that are highly elastic
may gain consumer surplus from the lower prices due to price discrimination. For example, at a
469
movie theatre, tickets for seniors and children are typically priced at a discount on adult tickets.

Disadvantages of Price Discrimination

• Higher prices: As indicated above, some consumers will face lower prices while others will
face higher prices. Consumers that face higher prices (i.e., consumers who purchase airline tickets
during peak season) are disadvantaged.
• Reduction in consumer surplus: The pricing strategy reduces consumer surplus and trans-
fers money from consumers to product, leading to inequality.

Monopoly - Price Discrimination

What is 1st degree (perfect) price discrimination?
Perfect Price Discrimination is charging whatever the market will bear
1. Sometimes known as optimal pricing, with perfect price discrimination, the firm separates the
market into each individual consumer and charges them the price they are willing and able to
pay
2. If successful, the firm can extract the entire consumer surplus that lies underneath the demand
curve and turn it into extra revenue or producer surplus.
3. This is hard to achieve unless a business has full information on every consumer's individual
preference and willingness to pay. The transactions costs involved in finding out through mar-
ket research what each buyer is prepared to pay is the main barrier to a business's engaging in
this form of price discrimination.
4. If the monopolist can perfectly segment the market, then the average revenue curve becomes
the marginal revenue curve.

A monopolist will continue to sell extra units as long as the extra revenue exceeds the marginal
cost of production.
In reality, most suppliers and consumers prefer to work with price lists and menus from which
trade can take place rather than having to negotiate a price for each unit bought and sold.

470
Pure price discrimination

2nd degree price discrimination

What is Second Degree Price Discrimination?
• This involves businesses selling off packages or blocks of a product deemed to be surplus ca-
pacity at lower prices than the previously published or advertised price.
• Price tends to fall as the quantity bought increases.
• Examples of this can be found in the hotel industry where spare rooms are sold on a last minute
standby basis. In these types of industry, the fixed costs of production are high. At the same time
the marginal or variable costs are low and predictable.
• If there are unsold rooms, it is in the hotel's best interest to offload spare capacity at
• a discount prices, providing that the extra evenue at least covers the marginal cost of each unit.
• There is nearly always some supplementary profit to be made. Firms may be quite happy to
• accept a smaller profit margin if it means that they manage to steal an advantage on their rival
firms.

Early-bird discounts – generating extra cash flow for a business

Customers booking early with airline carriers such as EasyJet or RyanAir will normally find lower
prices if they are prepared to book early. This gives the airline the advantage of knowing how full
471
their flights are likely to be and is a source of cash flow prior to the flight taking off.
Closer to the time of the scheduled service the price rises, on the justification that consumer's de-
mand for a flight becomes inelastic. People who book late often regard travel to their intended
destination as a necessity and they are likely to be willing and able to pay a much higher price.
• Peak and off-peak pricing and is common in the telecommunications industry, leisure retailing
and in the travel sector.
• For example, telephone and electricity companies separate markets by time:
• There are three rates for telephone calls: a daytime peak rate, and an off peak evening rate and a
cheaper weekend rate.
• Electricity suppliers also offer cheaper off-peak electricity during the night.
• Examples

At off-peak times, there is and marginal costs of production are low (the supply curve is elastic
Peak and Off-Peak Pricing

Peak and Off-Peak Pricing

• Peak and off-peak pricing and is common in the telecommunications industry, leisure retailing
and in the travel sector.
• For example, telephone and electricity companies separate markets by time:
• There are three rates for telephone calls: a daytime peak rate, and an off-peak evening rate and a
cheaper weekend rate.
• Electricity suppliers also offer cheaper off-peak electricity during the night.
• At off-peak times, there is plenty of spare capacity and marginal costs of production are
• low (the supply curve is elastic)
At off-peak times when demand is high, short run supply becomes relatively inelastic as the sup-
plier reaches capacity constraints. A combination of higher demand and rising costs forces up the
profit maximizing price.

How to price your product: 5 commonstrategies

Deciding how much to charge for your product requires more thought than simply calculating your
costs and adding a mark-up.

472
“How much the customer is willing to pay for the product has very little to do with cost and has
very much to do with how much they value the product or service they’re buying,” says Eric Dolan-
sky, Associate Professor of Marketing at Brock University in St. Catharines, Ont.

Figuring out how much the customer values your product or service and pricing it accordingly is
called value-based pricing. It’s a technique Dolansky believes more entrepreneurs should use.

5 common pricing strategies

Pricing a product is one of the most important aspects of your marketing strategy Generally, pric-
ingstrategies include the following five strategies.
1. Cost-plus pricing—simply calculating your costs and adding a mark-up
2. Competitive pricing—setting a price based on what the competition charges
3. Value-based pricing—setting a price based on how much the customer believes what you’re
selling is worth
4. Price skimming—setting a high price and lowering it as the market evolves
5. Penetration pricing—setting a low price to enter a competitive market and raising it later

How do you arrive at a value-based price?

Dolan sky provides the following advice for entrepreneurs who want to determine a value-based
price.
• Pick a product that is comparable to yours and find out what the customer pays for it.
• Find all of the ways that your product is different from the comparable product.
• Place a financial value on all of these differences, add everything that is positive about your
product and subtract any negatives to come up with a potential price.
• Make sure the value to the customer is higher than your costs.
• Demonstrate to customers why the price will be acceptable, which includes talking to them.
• If there is an established market, the current price range will help educate you about the custom-
ers’ price expectations.
You still have to make sure the value to the customer is higher than your costs. Otherwise you will
lose money with every product you sell.

Professor of Marketing, Brock University

Value-based pricing: Best for differentiated businesses

Dolansky says entrepreneurs often used cost-based pricing because it’s easier. They may also
copythe prices of their competitors, which, while not ideal, is a slightly better strategy.
In an ideal world, all entrepreneurs should use value-based pricing, Dolansky says. But entrepre-
neurs who sell a commodity-like service or product, for example warehousing or plain white t-shirts,
are more likely to compete on low costs and low prices.
For entrepreneurs offering products that stand out in the market—for example artisanal goods,
high- tech products or unique services—value-based pricing will help better convey the value they
offer.
1. The price is a better fit with the customer’s perspective.
2. Value-based pricing allows you to be more profitable, meaning you can acquire more re-
sources andgrow your business.
3. When a price doesn’t work, the answer isn’t just to lower it, but to determine how it can bet-
ter matchcustomer value. That may mean adapting the product to better suit the market.
4. Pricing needs to match your target market
473
 5. To sum up, pricing is one of the most important aspects of your market strategy, which also
includes promotion, placement (or distribution) and people.

“It’s important when you are considering your price that you realize it is not for yourself, but for
your target customers,” says Dolansky.
All pricing strategies are two-edge swords. What attracts some customers will turn off others. You
cannot be all things to all people. But, remember you want the customer to buy your product, which
iswhy you must use a strategy that’s appropriate to your target market

Price Skimming
What Is Price Skimming?
Price skimming is a product pricing strategy by which a firm charges the highest initial price that
customers will pay and then lowers it over time. As the demand of the first customers is satisfied
and competition enters the market, the firm lowers the price to attract another, moreprice-sensitive
segment of the population. The skimming strategy gets its name from 'skimming' successive lay-
ers of cream, or customer segments, as prices are lowered over time.

[Important: Skimming could encourage the entry of competitors - since other firms will notice the
(artificially) high margins available in the product, they will quickly enter.]

How Price Skimming Works

How Price Skimming Works
Price skimming is often used when a new type of product enters the market. The goal is to gather
as much revenue as possible while consumer demand is high and competition has not entered the
market. Once those goals are met, the original product creator can lower prices to attract more
cost-conscious buyers while remaining competitive toward any lower- cost copycat items entering
the market.

This approach contrasts with the penetration pricing model, which focuses on releasing a lower-
priced product to grab as much market share as possible. Generally, this technique is
better-suited for lower-cost items, such as basic household supplies, where price may be a driving
factor in most customers' production selections.

Firms often use skimming to recover the cost of development. Skimming is a useful strategywhen:
• There are enough prospective customers willing to buy the product at a high price.
• The high price does not attract competitors.
• Lowering the price would have only a minor effect on increasing sales volume and reducing
unit costs.
• The high price is interpreted as a sign of high quality.

When a new product enters the market, such as a new form of home technology, the price can af-
fect buyer perception. Often, items priced towards the higher end suggest quality and exclusivity.
This may help attract early adopters who are willing to spend more for a product and can also pro-
vide useful word-of-mouth marketing campaigns.

Key Takeaways
• Price skimming is a product pricing strategy by which a firm charges the highest initial price
that customers will pay and then lowers it over time
474
 • As the demand of the first customers is satisfied and competition enters the market,the firm
lowers the price to attract another, more price-sensitive segment of the population
• This approach contrasts with the penetration pricing model, which focuses on releasing a
lower-priced product to grab as much market share as possible

Price Skimming Limits

Generally, the price skimming model is best used for a short period of time – allowing the early
adopter market to become saturated, but not alienating price-conscious buyers over the long term.
Additionally, buyers may turn to cheaper competitors if a price reduction comes about too late,
leading to lost sales and most likely lost revenue.

Price skimming may also not be as effective for any competitor follow-up products. Since theinitial
market of early adopters has been tapped, other buyers may not purchase a competing product at
a higher price without significant product improvements over the original.

Penetration Pricing
What is Penetration Pricing?
Penetration pricing is a marketing strategy used by businesses to attract customers to a new prod-
uct or service. Penetration pricing includes presenting a low price for a new product or service dur-
ing its initial offering. The lower price helps to lure customers away from competitors. This market-
ing strategy relies on the idea of low prices making a customer aware of a new product. The price
entices the customer to try the new product.

Penetration Pricing
Breaking Down Penetration Pricing
Penetration pricing, similar to loss leader pricing, can be a successful marketing strategy when ap-
plied correctly. It can often increase both market share and sales volume.
Additionally, a higher number of sales can lead to lower production costs and quick inventory turn-
over.
The major disadvantage, however, is that an increase in sales volume may not lead to a profit if
prices must remain low. Also, if the low price is part of an introductory campaign, curiosity may
prompt customers to choose the brand initially, but once the price begins to rise or levels with a
competing brand, they may switch back to the competitor.

Penetration Pricing Versus Skimming

Skimming is the opposite pricing strategy to penetration pricing. With penetration pricing, compa-
nies advertise new products at low prices, with modest or nonexistent margins. Using skimming,
they market products at high prices with relatively high margins. This
strategy works well for innovative or luxury products where early adopters have low price sensitivity
and are willing to pay higher prices. Effectively, producers are skimming the market to maximize
profits. Over time, prices will reduce to levels comparable to market prices in order to capture the
rest of the market.

Small businesses or those in niche markets can benefit from price skimming when their products
or services are differentiated from competitors' and when synonymous with quality and a positive
brand image.

Example of Penetration Pricing

475
Costco and Kroger, two major grocery store chains, use penetration pricing for the organic foods
they sell. Traditionally, the margin on groceries is minimal. However, the margin on organic foods
tends to be higher. Also, the demand for organic, or natural, foods is growing significantly faster
than the market for non-organic groceries. As a result, many grocers offer more extensive selec-
tions of organic foods at premium prices to boost their profit margins.

However, Kroger and Costco use a penetration pricing strategy. They are selling the organic foods
at lower prices. Effectively, they are leveraging penetration pricing to increase
their wallet shares. While this strategy may be risky for small grocery stores, economies of scale
permit Kroger and Costco to employ this strategy.

476
 Multiple Choice Questions on Economics
1. Microeconomics theory deals with
(a) Economic behavior of individual economic decision making units.
(b) Economy asa whole.
(c) Trade relations;
(d) Economic growth of the society

2. Which of the following is a central problem of every economy

(a) Abundance of resources;
(b) Scarcity of economic resources;
(c) Poverty;
(d) Moral and ethical values

3. Equilibrium relates to which of these

(a) Market conditionwhich oscillate;
(b) Market state of falling price;
(c) Market condition of rising price ;
(d) Market conditions which once achieved tends to persist

4. General equilibrium analysis refers to

(a) Behaviour of individual economic decision making units and individual markets in isolation;
(b) Behaviour of all the individual decision making units and market viewed in totality;
(c) Both ;
(d) none

5. Normative economic theory deals with

(a) What is or how the economic problem facing the society are solved;
(b) How the problem should be solved ;
(c) What to Produce ;
(d) Howto produce

6. In a mixed economy which sector(s) is/ are found

(a) PrivateOnly ;
(b) Public sector only ;
(c) None ;
(d) Both a and b
7. In economic theory the term “means” refers to
(a) Resources ;
(b) Arithmetic mean ;
(c) A characteristic ;
(d)None

8. Market equilibrium of a commodity is determined by

(a) Balancing of demand and supply position ;
(b) Aggregate demand ;
(c) Aggregate supply;
(d) Government intervention

9. Cetris Paribus means

(a) Holding demand constant ;
(b) Holding supply constant ;
(c) Price being constant;
(d) Otherthings being constant

10. Economic resources are

(a) Unlimited ;
(b) Limited in supply and use ;
(c) Limited in supply but have alternativeuses;
(d) Unproductive

11. Which of the following is/ are not an economic resource

(a) Land ;
(b) Capital ;
(c) Labour ;
(d) Air

12. Which of the following is/ are an economic resource

(a) Land ;
(b) Capital ;
(c) Labour ;
(d) All the three

13. Which of the following is/ are a non-economic resource

(a) Air
(b) Water ;
(c) Sunlight ;
(d) All the three

14. Which of these resources would be called as land in economics

(a) Coal mines of Bihar ;
(b) Water resources of Uttaranchal ;
(c) Mineral deposits of Jharkhand;
(d) All thethree
15. Which of these is not land in economics
(a) Tehri Dam ;
(b)Forest reserves of Assam ;
(c) Fish reserves in the Bay of Bengal;
(d) Herbal plant of Uttaranchal
PAPER 1: FUNDAMENTALS OF ECONOMICS AND MANAGEMENT (SYL-
LABUS 2012)_MCQ INSTITUTE OF COST ACCOUNTANTS OF INDIA
16. Which of these would be classified as capital in economics
(a) Bhankra Dam ;
(b) Indira canal ;
(c) Golden triangle ;
(d) Allthe three

17. Capital in economics means

(a) Factor of production;
(b) Fund brought in by the entrepreneur;
(c) Investment in shares,bank deposits ;
(d) All the above

18. Scarcity of resources leads to

(a) Unsatisfaction of humanwants ;
(b) Evaluation of alternative uses of scarce resources;
(c) Both ;
(d) None
20. Economics cannot be considered a perfect science because
(a) Human behaviour is unpredictable
(b) It is difficult to makecorrect prediction of economic variables
(c) Economist do not have common opinion about a particular economic event
(d) All the three
21. In economic goods includes material things which
(a) Can be transferred ;
(b) Can be exchanged for one another ;
(c) Both ;
(d) None

22. In economic wealth is the stock of all those material and immaterial objects which……...
(a) Are transferable ;
(b) Haveutility ;
(c) Are scarce ;
(d) All the three

23. In addition to three Central problem of economy, the additional problem(s) raised by the Mod-
ern economists is /are
(a) Are the resources fully utilized or not ;
(b) How efficient is the production and distribution system;
(c) Whether the capacity to produce or grow is increasing or isstatic ;
(d) All the three

24. The basic assumption of an economic analysis is/ are

(a) Cetris paribus ;
(b) Rational behavior ;
(c) Both ;
(d) None
25. The terms Micro economic and Macro economics werecoined by
(a) Professor A Samulson ;
(b) Giffen ;
(c) Prof. Ragner Frisch ;
(d) Eagle

26. ----------is known as father of economics

(a) Adam Smith ;
(b) Professor A Samulson ;
(c) Alfred Marshall ;
(d) J R Hicks

27. Which of these are outside the domain of macro economics

(a) Consumer behavior ;
(b) National income ;
(c) Economic growth;
(d) Balance of payment and trade

28. Scarcity of resources means

(a) Limited resources ;
(b) Non – esxistence of resources ;
(c) Both ;
(d) None

29. Human wants are

(a) Unsatisfiable ;
(b) Unlimited ;
(c) Undefined ;
(d) Limited
30. Economics cannot be given the status of science because
(a) of non-uniformity of opinion and approach of economist;
(b) Economic behaviour of human being is unpredictable;
(c) Measuring rod of money is unstable ;
(d) All the three

31. Which of the following is not a central problem of a society

(a) What to produce ;
(b) How to produce ;
(c) Forwhom to produce ;
(d) Where to produce

32. The paradox of Diamond is more costly than water isexplained by

(a) Marginal utility concept ;
(b) Scarcity ;
(c)Relative cost of production ;
(d) All the three

33. Which of these is an economic activity

(a) A father teaching his son at home instead of sending to any coaching centre
(b) A hair dresser doing hair cut designing on payment
(c) A housewife mending her family cloths on her own
(d) Asinger giving a show on his son’s wedding anniversary
34. The term “ Micro” is derived from the …….word which means……..
(a) Latin, small ;
(b) Greek, small ;
(c) English, tiny ;
(d) Roman, small
35. Which of the following issue relates to micro-economics
(a) Impact of crude price hike on inflation
(b) Impact of changein bank rate on bank saving and investment
(c) Impact of Information technology on economic growth
(d) Impact of shortage of wheat production on wheat prices

36. Economics modes are

(a) Based on some realistic assumptions ;
(b) Based on hypothetical assumptions
(c)Scientifically tested ;
(d) Based on necessity

37. The famous book “An enquiry into the nature and causesof wealth of Nation” was written by –
(a) Adam Smith ;
(b) Samulson ;
(c) Robertson ;
(d) JB Say

38. The famous book “An enquiry into the nature and causes of wealth of Nation” was published in-
(a) 1776 ;
(b) 1750 ;
(c) 1850 ;
(d) 1886

39. The law of indifference is/are also know by-

(a) Law of substitution ;
(b) law of equimarginal utility ;
(c) Law of diminishing marginal utility
(d) All the three

40. Which of thefollowing is not a central problem of a society

(a) What to produce ;
(b) How to produce ;
(c) For whom to produce ;
(d)What to eat
41. The central problem of how to produce is resolved by
(a) Demand and supply of factor inputs ;
(b) Demand and supplyof goods;
(c) Relative prices and availability of factors of production ;
(d) Government intervention
42. In free economy the decision about investment, savingand consumption are decided by
(a) Price mechanism ;
(b)Central bank ;
(c) Planning Commission ;
(d) Finance budget

43. Which of these statement is true about production possibility curve (PPC/PPF)
(a) It shows various combinationsof two goods which yield same level of satisfaction
(b)It shows various combination of two goods which an economy can produce with a given
amount of resources
(c)It shows various combination of two goods which an economy can produce with a given budget
(d)It shows various combination of two goods which an economy can produce with a given time

44. If production possibility frontier is linear it implies

(a) Constant opportunity cost ;
(b) Economy is stagnant;
(c) Underemployment of factor of production ;
(d) With the increase in production, opportunity cost also increases
45. The opportunity cost of consumption is
(a) Lack of capitalformation for future ;
(b) Greater investment ;
(c) Full employment ;
(d) Deflation

46. The opportunity cost of capital investment is

(a) Sacrifice of current consumption ;
(b) More consumptionon luxury items;
(c) Lower capital growth in future ;
(d) Wastage of Resources
47. Any point beyond PPF is
(a) Attainable ;
(b) Unattainable ;
(c) Attainable with increase in production facilities ;
(d) None
48. If an economy is working at a point left to PPF curve it shows that………
(a) The economy is working at less than the full employment level ;
(b) The economy is at full employmentlevel ;
(c) The economy is country is faced with excess production ;
(d) There is glut of imports

49. Curvature of PPF is due to………

(a) Increase in opportunitycost ;
(b) Decrease in opportunity cost ;
(c) Fall in demand;
(d)Fall in supply

50. PPF is negative sloped due to

(a) Scarcity of productionresources ;
(b) Unlimited wants ;
(c) Improvement in technology;
(d) Increasing opportunity cost

51. Economic efficiency means

(a) Production of goods of mass consumption at lower cost;
(b) Production of goods and services for those who have purchasing power;
(c) Gettinggreatest satisfaction from available resources ;
(d) Full employment of working force

52. Higher PPC curve indicates

(a) More production of both the things with increase in technology or factor inputs supply;
(b) More production of one at the expense of other;
(c) More production of one items at the expense of other with increase in technology or factor in-
put supply ;
(d) Less thanfull employment situation

53. The following table shows the various combinations of two commodities, Gun and Bread that
an economy can produce with a given amount of resources. These combinations lies on the same
PPF Combinations Gun Bread in100 tons A 0 20 B 1 18 C 2 15 D 3 11 E 4 6 F 5 0 Based on the de-
tails given in the above table, the opportunity of producing 1 gun in combination No. B – is tons of
bread
(a) 200 ;
(b) 100 ;
(c) 300 ;
(d) 0

54. Opportunity cost of increasing production of Gun to 3 units in combination D is –tons of bread
(a) 200 ;
(b) 100 ;
(c)300 ;
(d) 400

55. Opportunity cost of increasing production of Gun to 4 units in combination E is –tons of bread
(a) 200 ;
(b) 500 ;
(c)300 ;
(d) 400

56. Opportunity cost of increasing production of Gun to 5 units in combination F is –tons of bread
(a) 200 ;
(b) 100 ;
(c)600 ;
(d) 500

57. In question No. 53 if the economy produces only 3 gunsand 900 tons of wheat instead of 1100
tons of wheat what does it indicates
(a) Under employment of resources ;
(b) Production in efficiency ;
(c) Sub-optimal production;
(d) Allthe three
58. If a firm is operating at any point inside the PPF, the firmis
(a) Efficient firm ;
(b) Inefficient firm ;
(c) Poised for abnormal growth ;
(d) None

59. Any point beyond PPF curve can be attained by

(a) Increasing supply of factor inputs ;
(b) Technological innovation ;
(c) Both ;
(d) None

60. Economic growth is best depicted by

(a) Outward shift inPPF ;
(b) Upward movement in PPF ;
(c) Inward movement inPPF
(d) Downward movement in PPF

61. Production possibility curves shows maximum combinations of -----products

(a) 1 ;
(b) 2 ;
(c) 3 ;
(d) 4

62. The relationship between aggregate consumption expenditure and aggregate income of house-
hold sector isknown as ………………………. function.
(a) Consumption ;
(b)Saving ;
(c) Expenditure ;
(d) Income

63. The …………………………….. measurement method of nationalincome aggregates all the money spent
by private citizens, firms and the government within the year.
(a) Expenditure;
(b) Income ;
(c) Input ;
(d) Saving

64. GDP at market price exceeds GDP at factor cost by the amount of revenue raised through
(a) Direct taxes;
(b) Indirect taxes ;
(c) Income tax ;
(d) Tax on rents

65. Macroeconomics is the study of

(a) Inflation ;
(b) Unemployment ;
(c) Growth ;
(d) All of (a) , (b) and (c) above.
66. In a closed economy savings are equal to at the equilibrium level of income.
(a) Investments ;
(b) Wages ;
(c) Income-Investments ;
(d) Wages – Consumption

67. Which of the following methods is/are used for measuringnational income?
(a) Output method ;
(b) Expenditure method ;
(c) Income method ;
(d) All of (a) , (b) and (c) above.

68. Net factor income from abroad is equal to

(a) NNP at market price – NDP at market price ;
(b) NDP at market prices – Indirect taxes + Subsidies ;
(c) NDP at factor cost + Depreciation ;
(d) NNP at market prices + Depreciation

69. Personal disposable income is equal to

(a) Wages and salaries + Dividends paid at home – Personal income tax
(b) Wages and salaries + Dividends paid at home +Factor income received from abroad – Personal
income tax
(c)Wages and salaries + Dividends paid at home + Factor income received from abroad + Trans-
fers from government – Personalincome tax.
(d) Wages and salaries + Dividends paid at home +Factor income received from abroad - Transfers
from government – Personal income tax.

70. Personal income equals personal disposable income (Yd) plus

(a) Personal savings ;
(b) Transfers from government ;
(c)Personal income taxes ;
(d) Dividend payments

71. GDP at market prices is the sum of Consumption, Investment, Government Spending and Net
Exports. „Net‟ exports is
(a) Gross exports minus depreciation ;
(b) Exportsminus imports ;
(c) Gross exports earnings minus capital inflow ;
(d) Export minus imports of merchandize

72. Macroeconomics is concerned with

(a) The level of outputof goods and services ;
(b) The general level of prices ;
(c) Thegrowth of real output ;
(d) All of the above

73. Personal income includes all of the following except

(a) Transfer payments ;
(b) Undistributed corporate profits;
(c)Personal income taxes ;
(d) Dividend payments

74. Nominal GDP is

(a) The total value of goods and services net of exports
(b) The total value of goods and services produced during periods of low unemployment
(c) The totalvalue of goods and services measured at current prices
(d) The total value of goods and services produced at fullemployment.

75. GDP at factor cost exceeds GDP at market price

(a) Whenthe factor income from abroad is negative ;
(b) When depreciation on fixed capital exceeds income in investment;
(c) When direct tax exceeds indirect tax ;
(d) When subsidiesexceeds indirect taxes.

76. The difference between Gross National Product (GNP) andGross Domestic Product GDP) is
(a) Excess of subsidies over indirect taxes ;
(b) Depreciation ;
(c) Net foreign income from abroad
(d) Excess of indirect taxes over subsidies

77. NDP does not include

(a) Payments made for income taxes;
(b) Depreciation allowances ;
(c) Undistributed profits;
(d)The value added from intermediate goods.

78. National income is

(a) NDP at market prices ;
(b) NDP at factor cost ;
(c) NNP at factor cost ;
(d) GNP at market prices.

79. The difference between personal disposable income andpersonal income is

(a) Indirect taxes ;
(b) Subsidies ;
(c) Transfer payments ;
(d) Personal taxes.

80. Which of the following is an example of a government transfer payment?

(a) Purchase of a new car for the Ministryof Finance ;
(b) Funding of a clinic to provide free vaccinations. ;
(c) Free food coupons issued to persons in an anti-poverty program. ;
(d) Funding of a new bridge in anurban area

81. The net factor income earned within the domestic territory of a country must be equal to
(a) Net Domestic Product at factor cost ;
(b) Net Domestic Product at market price;
(c) Net National Product at market price ;
(d) Personalincome.
82. By definition, the marginal propensity toconsume
(a) Equals ∆C/∆Yd ;
(b) Is the behavioral coefficient cin the equation C = a + cYd;
(c) Is the slope of the consumptionfunction ;
(d) All the above

83. Ceteris paribus, an income tax

(a) Increases the value of the expenditure multiplier and decreases the value of the nettax revenue
multiplier;
(b) Decreases the value of the expenditure and net tax revenue multiplier;
(c) Decreases thevalue of the expenditure multiplier and increases the value ofthe net tax revenue
multiplier ;
(d) None of the above.

84. On the basis of the Keynesian model of output determination, a multiplier of 3 implies that
(a) An increase inconsumption by `3 will result in an increase in investment by Re. 1
(b) An increase in investment by Re. 1 will result in an increase in consumption by `3
(c) An increase in investment byRe. 1 will result in an increase in consumption by `2
(d) An increase in investment by Re. 1 will result in an increase in consumption by Re. 1

85. Consumption demand does not depend upon the level of

(a) Income ;
(b) Propensity to consume ;
(c) Consumerspending ;
(d) Marginal efficiency of investment.

86. The slope of the consumption curve connotes

(a) Averagepropensity to save ;
(b) Marginal Propensity to consume ;
(c) Marginal propensity to save ;
(d) Level of consumption in the economy.

PAPER 1: FUNDAMENTALS OF ECONOMICS AND MANAGEMENT (SYLLABUS 2012)_MCQ

INSTITUTE OF COST ACCOUNTANTS OF INDIA

87. Financial interrelation ratio is equal to

(a) Total issues / National income ;
(b) Primary issues / Net capital formation;
(c) Total issues / Net capital formation ;
(d) Total stock offinancial assets/Stock of fiscal assets

88. If the available workers are unaware of the jobs being offered and the employers are not aware
of the available workers, such type on unemployment is called
(a) Frictionalunemployment ;
(b) Structural unemployment;
(c) Disguisedunemployment ;
(d) Demand pull unemployment.
89. Unemployment that arises when there is a general downturn in business activity is known as
(a) Frictional unemployment ;
(b) Structural unemployment;
(c) Cyclicalunemployment ;
(d) Disguised unemployment
90. Full employment is the level at which there is
(a) Zero unemployment ;
(b) Normal rate of unemployment;
(c) Leasesupply of labor ;
(d) Demand for goods is less than supply.

91. Natural rate of unemployment increases due to

(a) General downturn in business activity ;
(b) Changes in labormarket ;
(c) Structural changes in economy ;
(d) Frequent changes of jobs by labor

92. If the actual rate of unemployment exceeds to natural rateof unemployment then
(a) Actual output of the economy will fall below its potential ;
(b) Production will increase more than potential ;
(c) Consumption of goods decreases;
(d) Both (a) and (c) above.

93. Unemployment that arises due to regional occupational pattern of job vacancies, which does
not match the pattern ofworkers availability and suitability, is known as
(a) Frictional unemployment ;
(b) Structural unemployment ;
(c) Cyclical unemployment ;
(d) Demand pull unemployment.

94. Disguised unemployment means

(a) Unemployment inagriculture ;
(b) Unemployment due to recession ;
(c) Unemployment due to downturn in business activity ;
(d) Marginal Productivity of Labor (MPL) is zero.

95. In which sector of Indian economy will we find a high rateof disguised unemployment?
(a) Service sector. ;
(b) Agriculture sector. ;
(c) Manufacture sector. ;
(d) Mining sector.

96. Unemployment that is caused by a mismatch between thecomposition of the labor force (in
terms of skills, occupation, industries, or geographic location) and the make-up of the demand for
labor is called
(a) Real wage unemployment ;
(b) Deficient-demand unemployment ;
(c) Frictional unemployment ;
(d) Structural Unemployment
97. During the recessionary phase of a business cycle
(a) The natural rate of unemployment will increase dramatically
(b) Potential national income will exceed actual national income
(c) Actual national income will exceed potential national income
(d) The real rate of interest will exceed the nominalrate of interest.

98. The Philips curve shows that

(a) High unemployment ratesare associated with low increases in money wage rates
(b) Low unemployment rates are associated with low rates of inflation
(c) High unemployment rates are associated with low rates of inflation
(d) High inflation rates are associated with small increases in money wage rates.

99. Full employment exists when there is

(a) Zero unemployment ;
(b) Natural rate of unemployment ;
(c) Leastdemand for labor
(d) Least supply of labor

100. Balance of trade is

(a) The difference between balanceon current account and capital account
(b) Same as the balance of merchandize trade ;
(c) Same as the balance of current account
(d) Overall BoP balance.

101. All entries in the balance of payments should collectivelysum to

(a) GDP of that country ;
(b) GNP of that country ;
(c) Zero ;
(d) Exports of that country.

102. In the BoP statement, current account includes (i) Marchandize, invisible items (ii) Govern-
ment loans from abroad (iii) Foreign direct investment.
(a) (i) only ;
(b) Both (i)and (ii) above ;
(c) Both (i) and (iii) above ;
(d) Both (ii) and (iii)above

103. If the balance on current and capital accounts of Balanceof Payments (BoP) taken together
is negative, then
(a) It is a case of BoP surplus ;
(b) It is a case of BoP surplus where the official reserve account is in surplus;
(c) It is a case of BoP deficit ;
(d) It is case of BoP disequilibrium

104. “Transfer Payments‟ are

(a) Payments made to a factorof production ;
(b) Payments transferred from one sector to another;
(c) Payments made for no return service ;
(d) Payments made by government of one country to another

105. Which of the following transactions is included in thecurrent account balance of the Balance
of payments statement?
(a) Foreign direct investments. ;
(b) Portfolio investments.;
(c) External commercial borrowings. ;
(d) Dividends earned on portfolio investments

106. Personal taxes in India best illustrates a

(a) Proportional tax system ;
(b) Progressive tax system
(c) Indirect tax system;
(d) Value added tax system

107. In the Union Budget, profits from public sector undertakings are taken under
(a) Revenue receipts ;
(b)Capital receipts
(c) Monetized receipts ;
(d) Planned expenditure

108. Marginal product is………….

(a) Rate at which total production changes with change in variable input;
(b) Rate atwhich total production changes with change in total cost;
(c) Rate at which total production changes with change in fixed cost ;
(d) None

109. Total output is maximum when

(a) MP =0 ;
(b) MP isincreasing ;
(c) MP is decreasing ;
(d) MP is constant

110. Law of variable proportion applies…………….

(a) When allinputs are variable ;
(b) When all input are fixed ;
(c) Some inputs are fixed and some are variable ;
(d) All the three

111. Law of returns to scale applies when………

(a) All inputscost are variable ;
(b) All input cost are fixed;
(c) All cost arepartly fixed and partly variable ;
(d) None

112. Explicit cost refers to

(a) Actual expenses of the firm topurchase or hire input it needed
(b) Actual and notional expenses of the firm to purchase or hire input it needed
(c) Notional expenses of the firm to purchase or hire input it needed ;
(d) All the three

113. Implicit cost refers to ………………

(a) Value of inputs owned by the firm and used in its own manufacturing process
 (b) Value of input or services purchased from outside and used in its own manufacturing process
;
(c) Value of inputs owned by the firm and sold to others ;
(d) Value of inputs orservices for which no payments were made to outside

114. Which of these costs will increase or decrease with increase in production
(a) Marginal cost ;
(b) Financial costs ;
(c) Fixed costs ;
(d) All the three

115. If a firms cost of raw material increases then

(a) Marketprice of the final product will also increase
(b) Equilibrium level of quantity also increases ;
(c) Marginal cost curve willshift upward
(d) Marginal cost curve will shift downward
116. If a firms cost of raw material decreases then
(a) Marginal cost curve will shift downward ;
(b) Marginal costcurve will shift upward
(c) Market price will go down ;
(d) Market price will go up

117. ................................................................................................................... The law of diminish-

ing returns applies in
(a) Short run ;
(b) Long run ;
(c) Very short run ;
(d) All the timeperiod

118. If total production increases in the short run, the totalcost will also……..
(a) Increase due to increase in fixed cost ;
(b) Increase due to increase in variable cost
(c) Increase due toincrease in total cost ;
(d) Remain constant

119. Marginal cost is defined as…………………….

(a) Change in total cost due to addition of one unit ;
(b) Total cost divided byadditional unit;
(c) Total cost divided by total units produced ;
(d) Total sales / Total production

120. The positively sloped part of long run cost curve of a firmis due to
(a) Economies of scale ;
(b) Diseconomies of scale;
(c) Diminishing returns to scale ;
(d) Marginal utility theory

121. The negatively sloped part of long run cost curve of a firmis due to
(a) Increase in production due to specialization and division of labour;
(b) Diseconomies of scale ;
(c) Diminishingreturns to scale ;
(d) Marginal utility theory
122. Which of the following statement is true about average cost function
(a) ATC = AFC-AVC ;
(b) AVC = AFC + ATC ;
(c) AFC = ATC+AVC ;
(d) ATC = AFC + AVC

123. The output and cost pattern of a product are given belowOutput (q) 0 1 2 3 4 5 Total in `Cost
(Tc) 35 42 53 08 75 88 From the above details what is the fixed cost or sunk cost
(a) `25 ;
(b) `17.5 ;
(c) `22 ;
(d) `35

124. In question No. 123 the marginal cost of producing 2ndunit is

(a) `17.5 ;
(b) `11 ;
(c) `14 ;
(d) `11

125. In question No. 123 the average fixed cost of producing 3units is
(a) `17.5 ;
(b) `15 ;
(c) `10 ;
(d) `14

126. In question No. 123 the average total cost of producing 3units is
(a) `14.5 ;
(b) `15.5 ;
(c) `13 ;
(d) `21

127. The relationship between the labour hour worked and total output relationship in respect of
a product is given belowHours of labour worked Total output Marginal/ incremental output 0 0 0 1
50 50 2 60 3 175 4 65 5 300 6 355 55 7 350 -5 8 340 -10 From the above details what is the aver-
age output per hour when 2 hours of labour are deployed
(a) 55 ;
(b) 50 ;
(c) 60 ;
(d)65
128. In question No.127what is the total output when 2 hoursof labour are deployed
(a) 155 ;
(b) 110 ;
(c) 100 ;
(d) 165

129. In question No. 127 what is the marginal output for the3rd hours of labour
(a) 55 ;
(b) 50 ;
(c) 60 ;
(d) 65

130. In question No. 127 what is the marginal output for the5th hours of labour
(a) 55 ;
(b) 50 ;
(c) 60 ;
(d) 65

131. In question No. 127 what the average output for 5 hoursof labour
(a) 55 ;
(b) 50 ;
(c) 60 ;
(d) 65

132. In question No. 127 the firm remains in the stage of increasing returns to scale up to level of
labour hours
(a) 2 labour hours ;
(b) 3 labour hours ;
(c) 4 hrs ;
(d) 6 hrs

133. In question No. 127 the firm remains in the stage of constant returns to scale upto level of
labour hours
(a) 2 labour hours ;
(b) 3 labour hours ;
(c) 4 hrs ;
(d) 6 hrs

134. In question No. 127 the firm enter diminishing returns toscale from -----labour hours
(a) 2 labour hours ;
(b) 3 labour hours ;
(c) 5 hrs ;
(d) 6 hrs

135. In question No. 127 the firm should continue to deploy additional labour hours up to
(a) 2 labour hours ;
(b) 3 labourhours ;
(c) 5 hrs ;
(d) 6 hrs

136. In question No. 127 the optimum level of output of thefirm is

(a) 355 units ;
(b) 350 ;
(c) 340 hrs ;
(d) 300
137. In question No. 127 if the firm continue to operate beyond 6 labour hours as the labour cannot
be declared surplus –the firms should ------ to increase the output
(a) Increase fixed input ;
(b) Retrench the surplus labour ;
(c)Outsource the work;
(d) All the three

138. When a firm enters the law of diminishing returns to scale

(a) TVC curve begins to fall at an increasing rate
(b) TVCcurve begins to increase at an increasing rate
(c) TVC curve begins to fall at an decreasing rate
(d) TVC curve begins to increase at an decreasing rate
139. Which of these curve never touch X axis
(a) AVC ;
(b) AFC;
(c) TC ;
(d) MC

140. Total cost is the arithmetic sum of

(a) AFC and AVC ;
(b) FC and Variable cost ;
(c) Marginal cost and variable cost;
(d) Sunk cost and fixed cost

141. Variable cost is also known as

(a) Incremental cost ;
(b) Marginal cost ;
(c) Differential cost ;
(d) All the three

142. Which of these is not a factor of cost function of a product

(a) Market price of the product ;
(b) Size of the plant ;
(c) Output level ;
(d) Prices of inputs
143. In the short run which of the following is fixed
(a) Labour;
(b) Capital ;
(c) Raw material ;
(d) None

144. The slope of total variable cost curve equals

(a) AVC ;
(b) MC ;
(c) AC ;
(d) MPP

145. In the short run, diminishing marginal returns is impliedby

(a) Rising MC ;
(b) Falling MC ;
(c) Rising AVC ;
(d) ConstantTC

146. Total variable cost curve is explained by

(a) Law of thediminishing marginal returns ;
(b) The price of the variable inputs;
(c) Production function ;
(d) All the three

147. TVC curve begins to……….with the onset of diminishing returns

(a) Rise at an Increasing rate ;
(b) Rise at an decreasingrate;
(c) Fall at an Increasing rate ;
(d) Stabilize

148. TVC curve begins to………with the onset of increasing returns

(a) Rise at an increasing rate ;
(b) Rise at an decreasingrate;
(c) Fall at an Increasing rate ;
(d) Stabilize

149. Which of the following cannot be U shaped curve

(a) AFCcurve ;
(b) AC curve ;
(c) AVC curve ;
(d) AMC curve

150. Long run supply curve of a constant cost industry is

(a) Horizontal line at a price that is equal to the long run minimum average
cost of production;
(b) Horizontal line X axis ;
(c) Vertical line at mid of X axis ;
(d) Vertical line overlapping Y axis
151. Long run supply curve of a increasing cost industry is
(a) Horizontal line overlapping X axis ;
(b) Upward sloping line;
(c) Downward sloping line ;
(d) Vertical line

152. Long run supply curve of a decreasing cost industry is

(a) Downward sloping curve ;
(b) Upward sloping curve;
(c) Straight line parallel to X axis ;
(d) Straight line parallel to y axis
153. In economics, in the long run all the cost…
(a) Are fixed ;
(b) Are variable ;
(c) Except labour are variable ;
(d) Arenon controllable
154. In economic theory, in the short run all the cost are……………
(a) Fixed ;
(b) Variable ;
(c) Controllable ;
(d) Semivariable

155. Marginal cost curve is

(a) Positively sloped ;
(b) Negatively sloped ;
(c) Parallel to X axis ;
(d) Parallel to Y axis

156. Marginal cost can be equal to Average variable cost when

(a) Average variable cost is falling;
(b) Average variablecost is increasing;
(c) Average variable cost is constant ;
(d) Under any of the above situations

157. The measurement of sensitivity of quantity demand tochange in price is called

(a) Price elasticity;
(b) Income elasticity ;
(c) Expansion in demand ;
(d) None

158. Which of the following is not a type of elasticity ineconomics…………………

(a) Income elasticity ;
(b) Price elasticity ;
(c) Utility elasticity ;
(d) Cross elasticity

159. Which of the following is not a method of measurementof price elasticity of demand in eco-
nomics
(a) Total Outlay ;
(b) Total savings ;
(c) Point method ;
(d) Arcmethod

160. As per total outlay method, demand is said to be elastic ifas result of change in price total out-
lay
(a) Increases ;
(b) Decrease ;
(c) Remain same ;
(d) None

161. If price of sugar fills leading to fall in total outlay on sugar, the demand of sugar is
(a) Elastic ;
(b) Inelastic ;
(c)Unitary elastic ;
(d) Less than unit elastic
162. If price of X falls leading to increase in total outlay on X, the demand of X is
(a) Elastic ;
(b) Inelastic ;
(c) Unitary elastic;
(d) Less than unit elastic

163. If price of X falls leading to fall in total outlay on X, the demand of X is

(a) Elastic ;
(b) Inelastic ;
(c) Unitary elastic ;
(d)Less than unit elastic

164. If price of coffee falls leading to increase in total outlay on coffee, the demand of coffee is
(a) Elastic ;
(b) Inelastic ;
(c)Unitary elastic ;
(d) Less than unit elastic

165. If the price of burger rises from `12 per piece to `20 per piece as a result of which the daily
sales decreases from 300 to200 pieces per day. The price elasticity of demand can be estimated
as
(a) 0.5 ;
(b) 0.8 ;
(c) 0.25 ;
(d) 2.10

166. If the price of vegetable sandwich rises from `6 per piece to `12 per piece as a result of which
the daily sales decreases from 800 to 400 pieces per day. The price elasticity of demandcan be
estimated as
(a) 0.5 ;
(b) 1.5 ;
(c) 3.0 ;
(d) 2.5

167. A decrease in price will result in an increase in total revenue if

(a) Percentage change in quantity demanded in greater than the percentage
change in price
(b) Percentage change in quantity demanded is less than the percentage change
in price
(c) Percentage change in quantity demandedis equal to the percentage change
in price
(d) None

168. An increase in price will result in an increase in total revenue if

(a) Percentage change in quantity demanded in greater than the percentage
change in price
(b) Percentage change in quantity demanded is less than the percentage change
in price
(c) Percentage change in quantity demandedis equal to the percentage change
in price
(d) None

169. An increase in price will result in no change in total revenue if

(a) Percentage change in price equal the percentagechange in price
(b) Percentage change in demanded is more than the percentage change in price
(c) Percentage change in price is less than percentage change in demand
(d) Change in price is more than change in demand in absolute terms

170. Price elasticity of demand of a product will be more inelastic if

(a) It forms a major part of consumer house hold budget;
(b) It forms a very small part of consumers householdbudget;
(c) It is inferior ;
(d) It is for mass consumption

171. Price elasticity demand of product will be more elastic ifit

(a) Has no substitutes ;
(b) Has number of substitutes ;
(c) Isan item of necessity;
(d) Is life saving Product

172. If the consumption of a product can be postponed for thetime being

(a) The demand for the product will be inelastic
(b) The demand for the product will be relatively elastic
(c) The demand for the product will be perfectly elastic
(d) The demand for the product will be perfectly inelastic

173. Bread and butter have………..

(a) Negative cross price elasticity of demand ;
(b) Positive cross elasticity of demand
(c) Positive income elasticity of demand ;
(d) Negative incomeelasticity of demand
 Answer
1a 36 a 71 b 106 b 141 d
2b 37 a 72 d 107 a 142 a
3d 38 a 73 b 108 a 143 b
4b 39 d 74 c 109 a 144 b
5b 40 d 75 d 110 c 145 a
6d 41 c 76 c 111 a 146 d
7a 42 a 77 b 112 a 147 a
8a 43 b 78 c 113 d 148 b
9d 44 a 79 d 114 a 149 a
10 c 45 a 80 c 115 c 150 a
11 d 46 a 81 a 116 a 151 b
12 d 47 c 82 d 117 a 152 a
13 d 48 a 83 b 118 b 153 b
14 d 49 a 84 c 119 a 154 a
15 a 50 a 85 d 120 b 155 a
16 d 51 c 86 b 121 a 156 c
17 a 52 a 87 c 122 d 157 a
18 c 53 a 88 a 123 a 158 c
19 a 54 d 89 c 124 b 159 b
20 d 55 b 90 c 125 c 160 c
21 c 56 c 91 d 126 d 161 b
22 d 57 d 92 d 127 a 162 a
23 d 58 b 93 b 128 b 163 b
24 c 59 c 94 c 129 d 164 a
25 c 60 a 95 b 130 c 165 a
26 a 61 b 96 d 131 c 166 a
27 a 62 a 97 a 132 b 167 a
28 a 63 a 98 c 133 c 168 b
29 b 64 b 134 c 169 a
99 b
30 d 65 d 135 d 170 b
100 b
31 d 66 a 136 a 171 b
101 c
32 b 67 d 137 a 172 b
102 a
33 b 68 a 138 a 173 a
103 c
34 b 69 c 139 b
104 c
35 d 70 c 140 b
105 d

499
Finance Function: Definition, Scopeand Classification
Definition of the Finance Function:
There are three ways of defining the finance function. Firstly, the finance function can simply be
taken as the task of providing funds needed by an enterprise on favourable terms, keeping in view
the objectives of the firm.
This means that the finance function is solely concerned with the acquisition (or procurement) of
short- term and long-term funds.

However, in recent years, the coverage of the term ‘finance function’ has been widened to include
the instruments, institutions and practices through which funds are obtaine(d) So, the finance
function covers the legal and accounting relationship between a company and its source and uses
of funds.
For example, in financial management, we discuss debt-equity ratio (determined by the
government), as also various accounting and legal aspects of dividend policy.

No doubt, the basic function of the finance manager is one of determining how funds can best be
raised (i.e., at the minimum possible cost). In other words, the essence of finance function is
keeping the business supplied with enough funds tofulfil its objectives.
But such a definition is too narrow and is not of much practical use. No doubt, the finance function
is much broader than mere procurement of short-term and long- term funds so that a firm’s
working capital and fixed capital needs can be met.
Another extreme view is that finance is concerned with cash. This definition is much too broad and
thus is not really meaningful.

The third view — based on a compromise between the two — is more useful for practical purposes.
This definition treats the finance function as the procurement of funds and their effective utilisation
inbusiness. The finance manager takes all decisions that relate to funds which can be obtained as
also the best way of financing an investment such as the installation of a new machinery inside the
factory-or office building.
The cost of the machinery may be financed by making a public issue of 8% cumulative preference
shares. At the same time, he has to consider whether the additional return (cash flow) expected
from the new machinery is sufficient to cover the cost of capital in terms of interest to be paid over
a period of time.

In this case, the finance decision is based on an analysis of the alternative sources and uses of
funds. To start with the finance manager has to draw a plan outlining the company’s need for
funds. Such financial plan is based on forecasts of financial needs of the company. Such forecasts
are based on sales forecasts.
In the next step, the finance manager has to raise necessary funds to meet the company’s need for
fixed and working capital. Then, in the third step, he has to put the acquired funds into effective
uses.

The sequence of the three-step process is presented below:

1. Drawing a financial plan and forecasting financial needs
2. Raising necessary funds
3. Putting funds into proper use.
In a broad sense, the finance function covers the following six majoractivities:
1. Financial planning.
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2. Forecasting cash inflows and outflows.
3. Raising funds.
4. Allocation of funds; Effective use of funds; and Financial control (budgetary and nonbudgetary).
The last function is very important. Through financial control the finance man- ager tries to bring
performance closer to the targets.

Scope of Finance Function:

No doubt, the scope of finance function is wide because this function affects almost all the
aspects of a firm’s operations. The finance function includes judgments about whether a company
should make more investment in fixedassets or not.
It is largely concerned with the allocation of a firm’s capital expenditure over time as also related
decisions such as financing investment and dividend distribution. Most of these decisions taken
by the finance department affect the size and timingof future cash flow or flow of funds.
Classification of Finance Function:
Finance function can be classified into two broad categories, viz.,
(i) Executive finance function and
(ii) Incidental finance function.
While the former requires administration skill in planning and execution, the latter largely covers
works of a routine nature, which are necessary to implement financial decisions at the executive
level.

(i) Six Executive Functions:

Six basic executive finance functions are the following:
1. Determining asset-management policies:
All finance functions are concerned with the control of both cash flows and non- cash assets.
The reason is easy to find out. The finance managers must know howmuch cash will be ‘tied up’
in various kinds of non-cash (or non-liquid) assets.
Without the information, it is not possible to estimate and arrange for necessary cash
requirements. In fact, the formulation of sound and consistent asset management policies is
an indispensable pre-requisite to successful financial management

2. Determining the allocation of net profits:

This relates to retained earnings (corporate savings) and dividend policy. Most companies have
to achieve balance between two alternatives, i.e., payment of dividends and the retention of
earnings for acquiring additional assets.

3. Estimating cash flow requirements and control of such flows:

An important responsibility of the finance manager is to ensure an adequate flow of cash as
and when it is neede(d) Otherwise, the smooth operation of a company may not be possible.
Since cash flow originates from sales and cash requirements are closely related to sales
volume, adequate cash can be provided at the proper time only after forecasting cash needs.

4. Taking decision on needs and sources of new external finance:

On the basis of sales forecasts, the financial managers will have to draw a plan to borrow funds
from external sources. Such debt capital will add to the firm’s own cash resources and thus
improve its financial position. External capital may be obtained by borrowing funds from
commercial banks.
The finance manager must be competent enough to determine exactly when additional funds
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 from external sources will be neede(d) He (she) has also to judge how long they will be needed,
how economically they can be raised (i.e., at the lowest possible cost) and from which sources
will they be repai(d)

5. Carrying on negotiations with outside financiers:

The finance manager has also to carry on negotiations with outsiders to be able to arrange for
necessary external financing in required amount and on time. For obtaining working capital, a
line of credit has to be established with commercial banks. Again sufficient time has to be
devoted for completing arrangements for long-term financing. Long-term financing requires
more skillful negotiations than short-term financing.

6. Checking upon financial performance:

It is also necessary for the finance manager to evaluate the wisdom and efficiency of financial
planning. Such evaluation is to be based on past performance of the company. This will enable
thefinance manager to improve the standards, tech-
niques and procedures of financial planning and control which are important aspects of the
finance function.

Interrelationship:
It may be noted that all the six functions are interrelate(d) This means that a change in decision
with respect to any one of the functions will call for a change in decision relating to some or all
other functions.

(ii) Incidental Function:

The incidental finance functions include supervision of cash inflows and outflows and maintaining
cash balances and record keeping.

Lease Financing: Types, Advantagesand Disadvantages

Lease financing is one of the important sources of medium- and long-term financing where the
owner of an asset gives another person, the right to use that asset against periodical payments.
The owner of the asset is known as lessor andthe user is called lessee.
The periodical payment made by the lessee to the lessor is known as lease rental. Under lease
financing, lessee is given the right to use the asset but the ownership lies with the lessor and at the
end of the lease contract, the asset is returned to the lessor or an option is given to the lessee
either to purchase the asset or to renew the lease agreement.

Different Types of Leases:

Depending upon the transfer of risk and rewards to the lessee, the period of lease and the number
of parties to the transaction, lease financing can be classified into two categories. Finance lease
and operating lease.

1. Finance Lease:
It is the lease where the lessor transfers substantially all the risks and rewards of ownership of
assets to the lessee for lease rentals. In other words, it puts the lessee in the same condition as
he/she would have been if he/she had purchased the asset. Finance lease has two phases: The
first one is calledprimary perio(d)
This is non-cancellable period and in this period, the lessor recovers his total investment
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 through lease rental. The primary period may last for indefinite period of time. The lease rental
for the secondary period is much smaller thanthat of primary perio(d)

2. Features of Finance Lease:

From the above discussion, following features can be derived forfinance lease:
1. A finance lease is a device that gives the lessee a right to use an asset.
2. The lease rental charged by the lessor during the primary period of lease is sufficient to
recover his/her investment.
3. The lease rental for the secondary period is much smaller. This is often knownas peppercorn
rental.

ADVERTISEMENTS:
4. Lessee is responsible for the maintenance of asset.
5. No asset-based risk and rewards is taken by lessor.
6. Such type of lease is non-cancellable; the lessor’s investment is assure(d)

i. Operating Lease:
Lease other than finance lease is called operating lease. Here risks and rewards incidental to the
ownership of asset are not transferred by the lessor to the lessee. The term of such lease is much
less than the economic life of the asset and thus the total investment of the lessor is not recovered
through lease rental during the primary period of lease. In case of operating lease, the lessor
usually provides advice to the lessee for repair, maintenance and technical knowhow of the leased
asset and that is why this type of lease is also known as service lease.

ii. Features of Operating Lease:

Operating lease has following features:The lease term is much lower than the economic life of
the asset.
1. The lessee has the right to terminate the lease by giving a short notice and nopenalty is charged
for that.
2. The lessor provides the technical knowhow of the leased asset to the lessee.
3. Risks and rewards incidental to the ownership of asset are borne by the lessor.
4. Lessor has to depend on leasing of an asset to different lessee for recovery of his/her
investment.
Advantages and Disadvantages of Lease Financing:
At present leasing activity shows an increasing tren(d) Leasing appears to be a cost-effective
alternative for using an asset. However, it has certain advantages aswell as disadvantages.
i. Advantages:
Lease financing has following advantages
a. To Lessor:
The advantages of lease financing from the point of view of lessor are summarizedbelow

Assured Regular Income:

Lessor gets lease rental by leasing an asset during the period of lease which is an assured and
regular income.

Preservation of Ownership:
In case of finance lease, the lessor transfers all the risk and rewards incidental to ownership to the
lessee without the transfer of ownership of asset hence the ownership lies with the lessor.
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Benefit of Tax:
As ownership lies with the lessor, tax benefit is enjoyed by the lessor by way of depreciation in
respect of leased asset. High Profitability:
The business of leasing is highly profitable since the rate of return based on lease rental, is much
higher than the interest payable on financing the asset.

High Potentiality of Growth:

The demand for leasing is steadily increasing because it is one of the cost-efficient forms of
financing. Economic growth can be maintained even during the period of depression. Thus, the
growth potentiality of leasing is much higher as compared to other forms of business.

Recovery of Investment:
In case of finance lease, the lessor can recover the total investment through leaserentals.
b. To Lessee:
The advantages of lease financing from the point of view of lessee are discussedbelow:
Use of Capital Goods:
A business will not have to spend a lot of money for acquiring an asset but it can use an asset by
paying small monthly or yearly rentals.

Tax Benefits:
A company is able to enjoy the tax advantage on lease payments as lease payments can be
deducted as a business expense.
Cheaper:
Leasing is a source of financing which is cheaper than almost all other sources offinancing.
Technical Assistance:
Lessee gets some sort of technical support from the lessor in respect of leasedasset.
Inflation Friendly:
Leasing is inflation friendly; the lessee has to pay fixed amount of rentals each year even if the cost
of the asset goes up.
Ownership:
After the expiry of primary period, lessor offers the lessee to purchase the assets—by paying a very
small sum of money.
ii. Disadvantages:
Lease financing suffers from the following disadvantages
a. To Lessor:
Lessor suffers from certain limitations which are discussed below: Unprofitable in Case of
Inflation:
Lessor gets fixed amount of lease rental every year and they cannot increase thiseven if the cost of
asset goes up.
Double Taxation:
Sales tax may be charged twice:
First at the time of purchase of asset and second at the time of leasing the asset.
Greater Chance of Damage of Asset:
As ownership is not transferred, the lessee uses the asset carelessly and there is a great chance
that asset cannot be useable after the expiry of primary period of lease.
b. To Lessee:
The disadvantages of lease financing from lessee’s point of view aregiven below:
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Compulsion:
Finance lease is non-cancellable and even if a company does not want to use the asset, lessee is
required to pay the lease rentals.
Ownership:
The lessee will not become the owner of the asset at the end of lease agreementunless he decides
to purchase it.
Costly:
Lease financing is more costly than other sources of financing because lessee has to pay lease
rental as well as expenses incidental to the ownership of the asset.
Understatement of Asset:
As lessee is not the owner of the asset, such an asset cannot be shown in the balance sheet which
leads to understatement of lessee’s asset

Operating lease vs financing lease (capital lease)

The two most common types of leases are operating leases and financing leases (also called
capital leases). In order to differentiate the two, one must consider whether the risks and rewards
associated with ownership of the asset have been fully transferred tothe lessee from the lessor.
If these risks and rewards have been fully transferred, it is called a financing lease

under IFRS Standards. Under ASPE, financing leases are called capital leases. Otherwise, it is an
operating lease, which is basically the same as a landlord and renter contract.
Whether the risks and rewards have been fully transferred can be unclear sometimes, thus IFRS
outlines several other criteria to distinguish between the two leases.

The advantages of leasing

Leasing provides a number of benefits that can be used to attract customers:
• Payment schedules are more flexible than loan contracts.
• After-tax costs are lower because tax rates are different for the lessor and the
[Link] 100% financing of the price of the asset.
• For an operating lease, the company will create an expense instead of a liability, allowing the
company to obtain financial funding – often referred to as “off- balance sheet financing”.

Disadvantages of leasing
One major disadvantage to leasing is the agency cost problem. In a lease, the lessor will transfer
all rights to the lessee for a specific period of time, creating a moral hazard issue. Because the

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lessee who controls the asset is not the owner of the asset, the lessee may not exercise enough
care as if it were his/her own asset. This separation between the asset’s ownership (lessor) and
control of the asset (lessee) is referred to as the agency cost of leasing. This is an important
concept in lease accounting.

Criteria for operating lease vs capital lease accounting

In addition to the transfer of the risks and rewards associated with ownership, IFRS outlines a few
more criteria to meet the attributes of a financing lease or capital leaseunder ASPE.
At least one of the following criteria must be met in order to consider the lease afinancing lease:
• There is a bargain purchase option – an option given to the lessee to purchase the asset at a
price lower than its fair value at a future date. This option is usually determined at the beginning
of the lease.
• The life of the lease is for a significant portion of the economic life of the asset(generally, 75%).
• The net present value (NPV) of minimum lease payments is at least 90% of the asset’s fair
value.

Lease accounting example and steps

Let’s walk through a lease accounting example. On January 1, 2017, XYZ Company signed an 8-
year lease agreement for equipment. Annual payments are $28,500 at the beginning of each year.
At the end of the lease, the equipment will revert to the lessor. The equipment has a useful life of 8
years and has no residual value. At the time of the lease agreement, the equipment has a fair value
of $166,000. An interest rate of 10.5%and straight-line depreciation are use(d)

Step 1: Identify the type of lease

• There is no bargain purchase option because the equipment will revert back tothe lessor.
• The life of the lease is 8 years and the economic life of the asset is 8 years. This is100%.
• Using a financial calculator, calculate for the PV of the minimum lease payments:
• N=8
• I/YR = 10.5
• FV = 0
• PMT = 28,500
• PV = 164,995
• Therefore, 164,995/166,000 = 99%
Conclusion: This is a financing/capital lease because at least one of the above criteria is met and
during the lease, the risks and rewards of the asset have been fully transferre(d) We have satisfied
the criteria for proper lease accounting.

Step 2: Lease amortization schedule

Opening Interest Principal Closing

Year Balance Expense Payment Payment Balance

1 $136,495 $14,332 $28,500 $14,168 $122,327

2 122,327 12,844 28,500 15,656 106,671

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 3 106,671 11,201 28,500 17,299 89,372

4 89,372 9,384 28,500 19,116 70,256

5 70,256 7,377 28,500 21,123 49,133

6 49,132.90 5,158.95 28,500 23,341.05 25,791.86

7 $25,792 $2,708 $28,500 $25,792 $0

Step 3: Journal entries

January 1, 2017
DR Equipment 164,995
CR Cash 28,500

CR Lease Liability 136,495

The equipment account is debited by the present value of the minimum lease payments and the
lease liability account is the difference between the value of the equipment and cash paid at the
beginning of the year.
December 31, 2017
DR Depreciation Expense 20,624

CR Accumulated Depreciation 20,624

Depreciation expense must be recorded for the for the equipment that is lease(d)
DR Interest Expense 14,332
CR Interest Payable 14,332

January 1, 2018 14,332

DR Interest Payable

DR Lease Liability 14,168

CR Cash 28,500
What Is Cost of Capital
Cost of capital is a necessary economic and accounting tool that calculates investment opportunity
costs and maximizes potential investments in the process.
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The cost of capital is tied to the opportunity cost of pouring cash into a specific business project or
investment. Once those costs are evaluated, businesses can make better decisions to deploy their
capital to maximize profit potential.
Here's the skinny on the cost of capital, and why it's so important in business and in investing
circles.
What Is Cost of Capital?
Cost of capital is the amount of return an investment could have garnered if that investment was
execute(d) Loosely defined in general, cost of capital can involve debt, equity or any source of
capital.
Basically, cost of capital is the opportunity cost of investing the same amount of cash into
different investment opportunities, with the real cost of capital the amount of money that could
have been earned by choosing one investment over the other.
Like many accounting principles, the meaning of cost of capital can vary from one scenario to
another. For example, cost of capital can also be defined as the return of investment (ROI) that
could be gained if the right amount of money is steered into a specific investment, like a large
construction project or the purchase of a company's stock.
How Cost of Capital Works
In defining the cost of capital, it's also helpful to know the different cost of capital categories, as
follows:
• Cost of equity. This is the cost of leveraging the capital supplied by company shareholder,
repayable in (hopefully) stronger capital gains and a higher share price.
• Cost of debt. This type of capital represents the cost of a company or individual that borrows
money from a bank or financial institution to invest money in a project or other investment
opportunity. The financial institution earns its money back in the form of interest paid, along
with any appropriate fees and charges as noted in the loan contract.
• A company can raise funds in limited ways. It can sell bonds, borrow money and leverage equity
[Link] large, companies often apply their cost of capital in two definitions:
• Cost of capital is defined as the financing costs a company has to pay when borrowing money,
using equity financing, or selling bonds to fund a big project or investment. In each case, the
cost of capital is expressed as an annual interest rate,such as 7%.
• When weighing a big investment, like funding a new manufacturing plant, the cost of capital
represents the return rate the company could garner if it invested cash in an alternative
investment, with the same risk applie(d) That's why economists equate the cost of capital with
the opportunity cost of a company using financial capital for a significant project or investment.
Why Is Cost of Capital So Critical?
Cost of capital is a useful finance and accounting tool that companies and investors can use to
make better decisions on how they allocate their money.
How companies will finance a project or make an investment is an important decision, since
that choice will determine a firm's capital structure. Ideally, businesses seek a fair balance in
this scenario, with enough financing to get a project or investment done, while reducing or
limiting the cost of capital.
Cost of capital is especially important in the following ways:
• The cost of capital aids businesses and investors in evaluating all investment opportunities. It
does so by turning future cash flows into present value by keeping itdiscounte(d)
• The cost of capital can also aid in making key company budget calls that usecompany financial
sources as capital.
• In a cost of opportunity scenario, the cost of capital can be used to evaluate the progress of
ongoing projects and investments by matching up the progress of those investments against
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 the cost of capital.
How Cost of Capital Works
Cost of capital is very important to companies who need capital to expand their operations and
fund their business, while keeping debts as low as possible to satisfyshareholders.
In the cost of capital game, there are two main forms of capital - implicit cost of capital and
explicit cost of capital.
• Implicit cost. This represents the opportunity cost cited above, i.e., the cost of an investment
opportunity considered, but ultimately not taken. There is no bottom-linereduction in revenues -
it's implie(d) But under the cost of capital model, it can be factored into opportunity costs not
earne(d)
• Explicit cost. The explicit cost of capital is the cost that companies can actually use to make
capital investments, payable back to investors in the form of a stronger stock price or bigger
dividend payoutsto shareholders.
Company accountants use the cost of capital to estimate the cost of financing a project or
engaging in a large investment opportunity.
At minimum, any capital used by a company for such initiatives must have a minimum return that's
in line with what shareholders, stakeholders, and lenders expect for the use of their money. In short
form, the cost of capital represents a benchmark which any company investment or project must
meet or exceed in financial returns.
Cost of Capital Examples
In a real-life example, here's what cost of capital means in two common scenarios:
Cost of Capital for Investing
In investing, the cost of capital is the variation between an investment that you make and one that
you could have made - but didn't.
Consider a stock market trader or real estate investor that invests $10,000 into a particular
opportunity. The opportunity cost is the difference between any profit actuallyearned, and the profit
that could have been earne(d) Let's say the investor earned a 5% profit on the actual investment
(Opportunity "A") but could have earned 10% on the investment opportunity not chosen
(Opportunity "B".) The difference between the profit earned on Opportunity "A" and Opportunity "B"
(5%) is the actual cost of capital.
Cost of Capital for Business
In business, the goal with the cost of capital is to improve on the rate of return that might have
been generated by steering the amount of money into a separate investment, and with the same
amount of risk.
After all, companies count on the cost of capital to be the return rate it earns on business-related
investment projects, in order to maximize opportunities to attract investors, and to stay profitable
and competitive in its marketplace.
How to Calculate the Cost of Capital
Calculating the cost of capital means taking the total costs of debt, common stock and preferred
stock and using separate calculations for each of those three components. Ultimately, you'll need
to combine all threecalculations to figure out the total cost of capital on a weighted average
[Link] is the breakdown:
• To derive the cost of debt, multiply the interest expense associated with the debt by the inverse
of the tax rate percentage, and divide the result by the amount of debt outstanding.
• The amount of debt outstanding that is used in the denominator should include any
transactional fees associated with the acquisition of the debt, as well as any premiums or
discounts on the sale of the debt.
• These fees, premiums, or discounts should be gradually amortized over the life of the debt, so

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 that the amount included in the denominator will decrease over time.
The formula for the cost of debt is as follows:
(Interest Expense x (1 - Tax Rate) ÷
Amount of Debt - Debt Acquisition Fees + Premium on Debt - Discount on Debt
Key Things to Know About Cost of Capital
Lean on these takeaways to learn more about the cost of capital:
• Figuring out the cost of capital generally relies on two key criteria - a lender's required rate of
return and a borrower's weighted average cost of capital.
• Two key themes in calculating the cost of capital are recognizing the time value of money and
knowing how to discount cash flows and returns into present value.
• Investors looking for a better grip on the cost of capital should focus on the opportunity cost
of alternative investments, stemming from that investment's risk level and the investment's
estimated return.
• In formulating the total cost of equity and the cost of debt, companies need to calculate a
weighted average cost of capital (WACC), combing all company financing sources into the
calculation.
• In general, the definition of cost of capital is two-fold: For businesses, it's the cost of an
organization's debt and equity funds. For investors, the cost of capital is the required rate of
return on a particular investment.

Time Value of Money (TVM ) – Definition,Formula & Example

1. What is Time Value of Money – Definition
There is no reason for any rational person to delay taking an amount owed to him or her. More
than financial principles, this is basic instinct. The money you have in hand at the moment is
worth more than the same amount you ‘may’ get in future. One reason for this is inflation and
another is possible earning capacity. The fundamental code of finance maintains that, given
money can generate interest, the value of a certain sum is more if you receive it sooner. This is
why it is called as the presentvalue.
Basically, the time value of money validates that it is more beneficial to have cash now than
later. Say, if you invest a Rs. 100 today – the returns will be more compared to the same
investment made 2 months from now. Moreover, there is always a risk that the borrower might
delay even more or not pay at all in the future.

2. TVM with an example

The relevance of TVM depends on how much returns you can generate from the capital
available. Money has immense growth potential and the more you delay employing this
potential, the more you lose the chance to earn on it. For instance, if a friend or lender gives you
two options – to take Rs.
10,000 today or to take Rs, 10,500 next year.
Now, even if this promise is from someone or an entity you trust implicitly, chances are more
that the second option is a raw deal. With more and more schemes ranging from low-risk to
high-risk – tax- saving FDs, ELSS et. – there is a high chance that you can make at least 7% on
this sum, which is Rs. 10,700. But if the interest rate offered is less than 5%, then you may
consider taking the money next year. So, it depends on the possible returns as per the RBI
guidelines or the market.

3. Present Value and Future Value

Present Value is the same as Time Value as elaborated above. It is the money you have
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 currently that is equal to a future one-time disbursal or several part-payments – discounted by
a suitable rate of interest.
Future Value is the sum of money that any saving scheme with a compounded interest will
build to by a pre-decided future date. It applies to both lumpsum as well as recurring
investments like SIP.

4. Basic TVM Formula

Based on your financial circumstances at the time, the TVM formula can vary to some extent.
Example, in the case of annuity (income) or perpetuity (until death) pension payments, the
general formula can have more components. But as a whole, the basic TVM formula is as
shown in the image.

FV = PV x [ 1 + (I/ N) ] (N*T)
Where,
FV is Future value of money, PV is Present value of money, I is the interest rate,
N is the number of compounding periods annually and T is the number of years in the tenure.
For instance, if you invest Rs. 1 lakh for 5 years at 10% interest, the future value of this one
lakh will be Rs. 161,051 as per the formul(a) This formula can help you to analyze different
investments over different time periods, enabling you to make optimaland informed financial
decisions.
1. TVM and Compounding Periods
How often the invested amount compounds too has a huge impact on future value. See how
increasing the compounding frequency in the above example make a difference to the
earnings.
Monthly: Rs. 164530.89
Quarterly: Rs. 163,861.64
Semi-annually: Rs. 162889.46
Annually: Rs. 161,051
This is where the power of compounding works. It proves that TVM is dependent on interest
rate, tenure as well as the number of compounding periods per financial year

Capital Structure
What is the most basic and practical thing required to start a company? Yes, it is money. Capital
is the fund required to initiate the activities of any business. It is the foundation of business
finance. The capital structure is how a firm finances its overall operations and growth by using
different sources of funds.

Capital Structure
From a technical perspective, the capital structure is the careful balance between equity and debt

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 that a business uses to finance its assets, day-to-day
operations, and future growth. Capital Structure is the mix between owner’s funds and borrowed
funds.
• FUNDS = Owner’s funds + Borrowed funds.
• Owner’s funds = Equity share capital + Preference share capital + reserves and surpluses +
retained earnings = EQUITY
• Borrowed funds = Loans + Debentures + Public deposits = DEBT
In short, Capital Structure is the mixture of long-term sources of funds. Capital Structure is optimal
when the proportion of debt and equity maximizes the value of the equity share of the company.
However, a company heavily funded by debt has an aggressive capital structure and poses a greater
risk to investors. This risk,however, may be the primary source of thefirm’s growth.

Debt vs Equity
Cost of Debt is lower than the cost of equity but Debt is riskier than equity. Thereasons for this are
• Lender earns an assured interest and repayment of capital.
• Interest on debt is a tax-deductible expense so brings down the tax liability for a business
whereas dividends are paid out of profit after tax.
Debt is more dangerous for the business as it adds to the financial risk faced by a business. Any
failure with reference to the payment of interest or repayment of principal amount may lead to the
liquidation of the company.

Financial Leverage
The proportion of debt in the overall capital of a firm is called Financial Leverage or Capital Gearing.
When overall debt in the firm increases, cost of funds declinesas debt is a cheaper source of funds.
When the proportion of debt in the total capital is high then the firm is
called highly levered firm but when the proportion of debts in the total capital isless, then the firm will
be called low levered firm.

Factors Affecting Capital Structure

1. Cash Flow Position
A firm’s ability to pay expenses and loans determines debt capacity. Some firmsoperate involatile
financial environments affecting their ability to meet financial
obligations. The company may raise funds by issuing debts if it has a fluent cashflow position, as
they are to be paid back after some time.
It must cover fixed payment obligations with regards to,
• Normal business operations
• Investment in fixed assets
• Meeting debt services commitments as well as provide a sufficient buffer period
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2. Interest Coverage Ratio
Interest Coverage Ratio is the number of times earnings before interest and taxes of a company
covers the interest obligation. High-Interest coverage ratio indicatesthat company can have more
of borrowed funds.
Interest Coverage Ratio (ICR) = Earnings Before Interest and Tax (EBIT) /Interest.
3. Control
Public issues damage the reputation of the firm and make it vulnerable to takeovers. Debt
generally does not cost dilution of control. To have control, thefirm must issue debt. So there is a
constant struggle over whether to give up control or pay more for capital.
4. Return on Investment
It will be beneficial for a firm to raise finance through borrowed funds if the returnon investment is
higher than the rate of interest on the debt. But if the return is uncertain and the company is not
sure if it can cover the fixed cost of interest, theyshould opt for equity.
5. Floatation Cost
Flotation cost must be understood while selecting the sources of finance. Cost ofthe Public issue
is more than the floatation cost of taking a loan. The cost of issuing securities, brokers’
commission, underwriter’s fee, cost of prospectus etcis the flotation cost.
6. Flexibility
Issuing debenture and preference shares introduce flexibility. A good financial structure is
flexible and sound enough to have scope for expansion or contraction of capitalizationwhenever
the need arises.
7. Stock Market Conditions
Conditions of the stock market influence the determination of securities. During the depression,
people do not like to take a risk and do not take interest in the equity shares. During the boom,
investors are ready to take a risk and invest inequity shares.
8. Tax Rate
Interest on debt is allowed as a deduction; thus in case of the high tax rate, debts are preferred
over equity but in case of low tax rate more preference is given
to equity.

Solved Question for You

Question: Explain high levered firm and a low levered firm?
Answer: A high levered firm is when the proportion of debt in the total capital is high. A low levered
firm is when the proportion of debt in the total capital is low.
Capital Structure and its Theories
Capital Structure means a combination of all long-term sources of finance. It includes Equity Share
Capital, Reserves and Surplus, Preference Share capital, Loan, Debentures and other such
long-term sources of finance. A company has to decide the proportion in which it should have its
own finance and outsider’s finance particularly debt finance. Based on the proportion of finance,
WACC and Value of a firm are affecte(d) There are four approaches to this, viz. net income, net
operating income, traditional and M&M approach.
CAPITAL STRUCTURE
Capital structure is the proportion of all types of capital viz. equity, debt, preference et(c) It is
synonymously used as financial leverage or financing mix. Capital structure is also referred to as
thedegree of debts in the financing or capital of a business firm.
Financial leverage is the extent to which a business firm employs borrowed money or debts.
In financial management, it is a significant term and it is a very important decision in a business. In
the capital structure of a company, broadly, there are mainly two types of capital i.e. Equity and
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Debt. Out of the two, debt is a cheaper source of finance because the rate of interest will be less
than the cost of equity and the interest payments are a tax-deductible expense

Capital structure or financial leverage deals with a very important financial management question.
The question is – ‘what the ratio of debt and equity should be?’ Before scratching our minds to find
the answer to this question, we should know the objective of doing all this. In the financial
management context, the objective of any financial decision is to maximize the shareholder’s
wealth or increase the value of the firm. The other question which hits the mind in the first place is
whether a change in the financing mix would have any impact on the value of the firm or not. The
question is a valid question as there are some theories which believe that financial mix has an
impact on the value and others believe it has no connection.
HOW CAN FINANCIAL LEVERAGE AFFECT THE VALUE?
One thing is sure that wherever and whatever way one sources the finance from, it cannot change
the operating income levels. Financial leverage can, at the max, have an impact on the net income
or the EPS (Earning per Share). The reason we are discussing later. Changing the financing mix
means changing the level of debts. This change in levels of debt can impact the interest payable
by that firm. The decrease in interest would increase the net income and thereby the EPS and it is a
general belief that the increase in EPS leads to an increase in the value of the firm.
Apparently, under this view, financial leverage is a useful tool to increase value but, at the same
time, nothing comes without a cost. Financial leverage increases the risk of bankruptcy. It is
because higher the level of debt, higher would be the fixed obligation to honor the interest
payments to the debt’s providers.
Discussion of financial leverage has an obvious objective of finding an optimum capital structure
leading to maximization of the value of the firm. If the cost of capital is high
Important theories or approaches to financial leverage or capital structure or financing mix are as
follows:
Discussion of financial leverage has an obvious objective of finding an optimum capital structure
leading to maximization of the value of the firm. If the cost of capital is high
Important theories or approaches to financial leverage or capital structure or financing mix are as
follows:

NET INCOME APPROACH

This approach was suggested by Durand, and he was in favor of financial leverage decision.
According to him, a change in financial leverage would lead to a change in the cost of capital. In
short, if the ratio of debt in the capital structure increases, the weighted average cost of capital
decreases and hence the value of the firm increases.
NET OPERATING INCOME APPROACH
This approach is also provided by Duran(d) It is opposite of the Net Income Approach if there are
no taxes. This approach says that the weighted average cost of capital remains constant. It
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believes in the fact that the market analyses a firm as a whole and discounts at a particular rate
which has no relation to debt-equity ratio. If tax information is given, it recommends that with an
increase in debt financing WACC reduces, and value of the firm will start increasing.
TRADITIONAL APPROACH
This approach does not define hard and fast facts. It says that the cost of capital is a function of
the capital structure. The special thing about this approach is that it believes an optimal capital
structure. Optimal capital structure implies that at a particular ratio of debt and equity, the cost of
capital is minimum and value the of the firm is maximum.
MODIGLIANI AND MILLER APPROACH (MM APPROACH) It is a capital structure theory named
after Franco Modigliani and Merton Miller. MM theory proposed two propositions.
• Proposition I: It says that the capital structure is irrelevant to the value of a firm. The value of
two identical firms would remain the same and value would not affect by the choice of finance
adopted to finance the assets. The value of a firm is dependent on the expected future
earnings. It is when there are no taxes.
• Proposition II: It says that the financial leverage boosts the value of a firm and reduces WAC(C)
It is when tax information is available.
To summarize, it is essential for finance professionals to know about the capital structure.
Accurate analysis of capital structure can help a company by optimizing the cost of capital and
hence improveprofitability.

The following are the basic definitions:

The above assumptions and definitions described above are valid under any of the capital structure
theories. David Durand views, Traditional view and MM Hypothesis are tine important theories on
capital structure.
1. David Durand views:
The existence of an optimum capital structure is not accepted by all. There exist two extreme
views and a middle position. David Durand identified the two extreme views – the Net income
and net operating approaches.
(a) Net income Approach (Nl):
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 Under the net income (Nl) approach, the cost of debt and cost of equity are assumed to be
independent of the capital structure. The weighted average cost of capital declines and the total
valueof the firm rise with increased use of average.

(b) Net Operating income Approach (NOI):

Under the net operating income (NOI) approach, the cost of equity is assumed to increase
linearly with average. As a result, the weighted average cost of capital remains constant and the
total of the firm also remains constant as average change(d)
Thus, if the Nl approach is valid, average is a significant variable and financing decisions have
an important effect on the value of the firm, on the other hand, if the NOI approach is correct,
then the financing decision should not be of greater concern to the financial manager, as it does
not matter in the valuation of the firm.
2. Traditional view:
The traditional view is a compromise between the net income approach and the net operating
approach. According to this view, the value of the firm can be increased or the cost, of capital
can be reduced by the judicious mix of debt andequity capital.
This approach very clearly implies that the cost of capital decreases within the reasonable limit
of debt and then increases with average. Thus an optimum capital structure exists and occurs
when the cost of capital is minimum or the value of the firm is maximum.
The cost of capital declines with leverage because debt capital is chipper than equity capital
within reasonable, or acceptable, limit of debt. The weighted average cost of capital will
decrease with the use of debt. According to the traditional position, the manner in which the
overall cost of capital reacts to changes in capital structure can be divided into three stages and
this can be seenin the following figure

Criticism:
1. The traditional view is criticised because it implies that totality of risk incurred by all security-
holders of a firm can be altered by changing the way in which this totality of risk is distributed
among the various classes of securities.
2. Modigliani and Miller also do not agree with the traditional view. They criticise the assumption
that the cost of equity remains unaffected by leverage up to somereasonable limit.
3. MM Hypothesis:
The Modigliani – Miller Hypothesis is identical with the net operating income approach,
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 Modigliani and Miller (M.M) argue that, in the absence of taxes, a firm’s market value and the
cost of capital remain invariant to the capital structure changes.
Assumptions:
The M.M. hypothesis can be best explained in terms of two propositions.
It should however, be noticed that their propositions are based on thefollowing assumptions:
1. The securities are traded in the perfect market [Link] can be grouped
intohomogeneous risk classes.
2. The expected NOI is a random variable
3. Firm distribute all net earnings to the shareholders.
4. No corporate income taxes exist.

Proposition I:
Given the above stated assumptions, M-M argue that, for firms in the same risk class, the total
market value is independent of the debt equity combination and is given by capitalizing the
expected net operating income by the rate appropriate tothat risk class.

This is their proposition I and can be expressed as follows:

According to this proposition the average cost of capital is a constant and is not affected by
leverage.

Arbitrary process:
M-M opinion is that if two identical firms, except for the degree of leverage, have different market
values or the costs of capital, arbitrary will take place to enable investors to engage in ‘personal
leverage’ as against the ‘corporate leverage’ to restore equilibrium in the market.
Proposition II: It defines the cost of equity, follows from their proposition, and derived a formula as
follows:
Ke = Ko + (Ko-Kd) D/S
The above equation states that, for any firm in a given risk class, the cost of equity (Ke) is equal to
the constant average cost of capital (Ko) plus a premium for the financial, risk, which, is equal to
debt-equity ratio times the spread between the constant average of ‘capita’ and the cost of debt,
(Ko-Kd) D/S.
The crucial part of the M-M hypothesis is that Ke will not rise even if very excessive raise
ofleverage is made. This conclusion could be valid if the cost of
borrowings, Kd remains constant for any degree of leverage. But in practice Kd increases with
leverage beyond a certain acceptable, or reasonable, level of debt.
However, M-M maintain that even if the cost of debt, Kd, is increasing, the weighted average cost
of capital, Ko, will remain constant. They argue that when Kd increases, Ke will increase at a
decreasing rate and may even turn down eventually. This is illustrated in the following figure.

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Criticism:
The shortcoming of the M-M hypothesis lies in the assumption of perfect capital market in which
arbitrage is expected to work. Due to the existence of imperfections in the capital market/arbitrage
will fail to work and will give rise to discrepancy between the market values of levered and
unlevered firms.

Capital Budgeting
Capital budgeting is a company’s formal process used for evaluating potential expenditures or
investments that are significant in amount. It involves the decision to invest the current funds for
addition, disposition, modification, or replacement of fixed assets. The large expenditures include
the purchase of fixed assets like land and building, new equipment’s, rebuilding or replacing
existing equipment’s, research and development, et(c) The large amounts spent for these types of
projects are known as capital expenditures. Capital Budgeting is a tool for maximizing a
company’s future profits since most companies are able to manage only a limited number of large
projects at any one time.
Capital budgeting usually involves calculation of each project’s future accounting profit by period,
the cash flow by period, the present value of cash flows after considering time value of money, the
number of years it takes for a project’s cash flow to pay back the initial cash investment, an
assessment of risk, and various other factors.

Capital is the total investment of the company and budgeting is the art ofbuilding budgets.
FEATURES OF CAPITAL BUDGETING
1. It involves high risk
2. Large profits are estimated
3. Long period between the initial investments and estimated returns
CAPITAL BUDGETING PROCESS:
(a) Project identification and generation:
The first step towards capital budgeting is to generate a proposal for investments. There could
be various reasons for taking up investments in a business. It could be addition of a new
product line or expanding the existing one. It could be a proposal to either increase the
production or reduce the costs of outputs.
(b) Project Screening and Evaluation:
This step mainly involves selecting all correct criteria to judge the desirability of a proposal.
This has to match the objective of the firm to maximize its market value. The tool of time value
of money comes handy in this step.
Also, the estimation of the benefits and the costs needs to be done. The total cash inflow and
outflow along with the uncertainties and risks associated with the proposal has to be analyzed
thoroughly and appropriate provisioning hasto be done for the same.
(c) Project Selection:
There is no such defined method for the selection of a proposal for investments as different
businesses have different requirements. That is why, the approval of an investment proposal is
done based on the selection criteria and screening process which is defined for every firm
keeping in mind the objectives of the investment being undertaken.
Once the proposal has been finalized, the different alternatives for raising or acquiring funds
must be explored by the finance team. This is called preparing the capital budget. The average
cost of funds has to be reduce(d) A
detailed procedure for periodical reports and tracking the project for the lifetime needs to be
streamlined in the initial phase itself. The final approvals are based on profitability, Economic
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 constituents, viability, and market conditions.
(d) Implementation:
Money is spent and thus proposal is implemente(d) The different responsibilities like
implementing the proposals, completion of the project within the requisite time period and
reduction of cost are allotte(d) The management then takes up the task of monitoring and
containing the implementation of the proposals.
(e) Performance review:
The final stage of capital budgeting involves comparison of actual results with the standard
ones. The unfavorable results are identified and removing the various difficulties of the
projects helps for future selection and execution of the proposals.

FACTORS AFFECTING CAPITAL BUDGETING:

Availability of Funds Working Capital
Structure of Capital Capital Return
Management decisions Need of the project
Accounting methods Government policy
Taxation policy Earnings
Lending terms of financial Economic value of the
institutions project
CAPITAL BUDGETING DECISIONS:
The crux of capital budgeting is profit maximization. There are two ways to it; either increase the
revenues or reduce the costs. The increase in revenues can be achieved by expansion of
operations by adding a new product [Link] costs means representing obsolete return
onassets.

Accept / Reject decision – If a proposal is accepted, the firm invests in it and if rejected the firm
does not invest. Generally, proposals that yield a rate of return greater than a certain required rate
of return or cost of capital are accepted and the others are rejecte(d) All independent projects are
accepte(d) Independent projects are projects that do not compete with one another in such a way
that acceptance gives a fair possibility of acceptance of another.

Mutually exclusive project decision – Mutually exclusive projects compete with other projects in
such a way that the acceptance of one will exclude the acceptance of the other projects. Only one
may be chosen. Mutually exclusive investment decisions gain importance when more than one
proposal is acceptable under the accept / reject decision. The acceptance of the best alternative
eliminates the other alternatives.

Capital rationing decision – In a situation where the firm has unlimited funds, capital budgeting
becomes a very simple process. In that, independent investment proposals yielding a return greater
than some predetermined level are accepte(d) But actual business has a different picture. They
have fixed capital budget with large number of investment proposals competing for it.
Capital rationing refers to the situation where the firm has more acceptable investments requiring
a greater amount of finance than that is available with the firm. Ranking of the investment project
is employed on the basis of some predetermined criterion such as the rate of return. The project
with highest return is ranked first and the acceptable projects are ranked thereafter.

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Capital Budgeting: Techniques &Importance
CAPITAL BUDGETING TECHNIQUES / METHODS
There are different methods adopted for capital budgeting. The traditional methods or non
discount methods include: Payback period and Accounting rate of return metho(d) The discounted
cash flow method includes the NPV method, profitability index method and IRR.
• Payback period method:
As the name suggests, this method refers to the period in which the proposal will generate
cash to recover the initial investment made. It purely emphasizeson the cash inflows, economic
life of the project and the investment made in the project, with no consideration to time value of
money. Through this method selection of a proposal is based on the earning capacity of the
project. With simple calculations, selection or rejection of the project can be done, with results
that will help gauge the risks involve(d) However, as the method is
based on thumb rule, it does not consider the importance of time value of money and so the
relevant dimensions of profitability.

Payback period = Cash outlay (investment) / Annual cash inflow

Example

ProjectA ProjectB

Cost 1,00,000 1,00,000

Expected future cashflow

Year 1 50,000 1,00,000

Year 2 50,000 5,000
Year 3 1,10,000 5,000
Year 4 None None
TOTAL 2,10,000 1,10,000
Payback 2 years 1 year
Payback period of project B is shorter than A, but project A provideshigher returns. Hence, project A
is superior to (B)
• Accounting rate of return method (ARR):
This method helps to overcome the disadvantages of the payback period metho(d) The rate of
return is expressed as a percentage of the earnings of the investment in a particular project. It
works on the criteria that any project having ARR higher than the minimum rate established by
the management will be considered and those below the predetermined rate are rejecte(d)
This method takes into account the entire economic life of a project providinga better means of
comparison. It also ensures compensation of expected profitability of projects through the
concept of net earnings. However, this method also ignores time value of money and doesn’t
consider the length of life of the projects. Also it is not consistent with the firm’s objective of
maximizing the market value of shares. Discounted cash flow method:
The discounted cash flow technique calculates the cash inflow and outflow through the life of
ARR= Average income/Average Investment
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 an asset. These are then discounted through a discounting factor. The discounted cash inflows
and outflows are then compare(d) This technique takes into account the interest factor and the
return after the payback perio(d)
• Net present Value (NPV) Method:
This is one of the widely used methods for evaluating capital investment proposals. In this
technique the cash inflow that is expected at different periods of time is discounted at a
particular rate. The present values of the cash inflow are compared to the original investment.
If the difference between them is positive (+) then it is accepted or otherwise rejecte(d) This
method considers the time value of money and is consistent with the objective of maximizing
profits for the owners. However, understanding the concept of cost of capital is not an easy
task.
The equation for the net present value, assuming that all cash outflows are made in the initial
year (tg), will be:

Where A1, A2…. represent cash inflows, K is the firm’s cost of capital, C is the cost of the
investment proposal and n is the expected life of the proposal. It should be noted that the cost
of capital, K, is assumed to be known, otherwisethe net present, value cannot be known.
NPV = PVB – PVC
where,
PVB = Present value of benefitsPVC = Present value of Costs
• Internal Rate of Return (IRR):
This is defined as the rate at which the net present value of the investment is zero. The
discounted cash inflow is equal to the discounted cash outflow. This method also considers
time value of money. It tries to arrive to a rate of interest at which funds invested in the project
could be repaidout of the cash inflows. However, computation of IRR is a tedious task.
It is called internal rate because it depends solely on the outlay and proceeds associated with
the project and not any rate determined outside the investment.
It can be determined by solving the following equation:

If IRR > WACC then the project is [Link] IRR > k = accept
If IR < k = reject

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• Profitability Index (PI):
It is the ratio of the present value of future cash benefits, at the required rate of return to the
initial cash outflow of the investment. It may be gross or net, net being simply gross minus one.
The formula to calculate profitability index(PI) or benefit cost (BC) ratio is as follows.
PI = NPV (benefits) / NPV (Costs)
PI = PV cash inflows/Initial cash outlay A,

All projects with PI > 1.0 is accepte(d)

IMPORTANCE OF CAPITAL BUDGETING
1. Long term investments involve risks: Capital expenditures are long term investments which
involve more financial risks. That is why proper planning through capital budgeting is neede(d)
2. Huge investments and irreversible ones: As the investments are huge but the funds are limited,
proper planning through capital expenditure is a pre- requisite. Also, the capital investment
decisions are irreversible in nature, i.e. once a permanent asset is purchased its disposal shall
incur losses.
3. Long run in the business: Capital budgeting reduces the costs as well as bringschanges in the
profitability of the company. It helps avoid over or under
investments. Proper planning and analysis of the projects helps in the longrun.
SIGNIFICANCE OF CAPITAL BUDGETING
• Capital budgeting is an essential tool in financial management
• Capital budgeting provides a wide scope for financial managers to evaluate different projects in
terms of their viability to be taken up forinvestments
• It helps in exposing the risk and uncertainty of different projects
• It helps in keeping a check on over or under investments
• The management is provided with an effective control on cost of capitalexpenditure projects
• Ultimately the fate of a business is decided on how optimally theavailable resources are used
Example of Capital Budgeting:
Capital budgeting for a small scale expansion involves three steps: recordingthe investment’s cost,
projecting the investment’s cash flows and comparing the projected earnings with inflation rates
and the time value of the investment.
For example, equipment that costs $15,000 and generates a $5,000 annual return would appear to
"pay back" on the investment in 3 years. However, if economists expect inflation to rise 30 percent
annually, then the estimated return value at the end of the first year ($20,000) is actually worth
$15,385 when you account for inflation ($20,000 divided by 1.3 equals $15,385). The investment
generates only $385 in real value after the first year.

Techniques of Capital Budgeting

Capital budgeting is mathematical in nature which means that there are certain techniques related
to quantitative investment and are employed to determine the worth of an opportunity of
investment. Following are the important techniques of capital budgeting.
• Pay Back Period
• Return on Investment
• Net Present Value (NPV)
• Profitability Index (PI)
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• Internal Rate of Return (IRR)
Which employing the above techniques, discount rate or the interest rates or required rate of return
are given. Now each of these techniques is discussed below. Pay Back Period:
This is the technique through which the time duration is ascertained that is required to recover all
theinvested capital with the help of positive cash flows.

Example:
Mr. Ali wanted to start new project of café in certain college. Let suppose the initial investment is $
255,000 and there is expectation of $ 15,000 per month in the first year and $ 25,000 per month in
the second year.
Now it is easy to find the duration of time required to recover the initial investment of 255,000. It is
expected that in the first year total 180,000 is earned (in twelve months). Now only 75,000 are left
which is recovered in the next three months of the second year because the expected earning is
25,000 per month. In this way it is determined easily that it will take 15 months to recover all the
invested amount of the café project.
Pay Back Period technique is simple but still there are certain limitations like the time value of
moneyis not included and the timing of the occurring cash flows is not taken into account.

1. Return on Investment:
Return on investment can be analyzed by a number of ratios in general. But in capital budgeting
return on investment is defined as the generation of annual average cash flow by a business as
apercentage of investment. It is also defined as the average percentage of investment regained
incash each year.
Following is the formula for return on investmentROI = (∑CF/n)/Io
The return on investment can be calculated by the division of average investment cash flow
with theinitial investment.
Example:
Let’s take the above café example in which there is initial investment of $ 255,000, the
expected per month profit in the first year is 15,000 whereas the expected per month profit in
the second year is $25,000. The ROI can easily be calculated
ROI = (180,000+300,000/2)/255,000ROI = 0.94 = 94%
The concept of time value of money is not taken into account in return on investment. The
higher rate of return of 90% is healthy option for the business but other alternative
opportunities should also be considered before this one. The current rate of inflation in the
country should also be considered in order to adjust the returns accordingly.

2. Net Present Value (NPV):

It is one of the most important Techniques of Capital Budgeting in which discounting is made.
The current value of the future incremental after-tax net cash flows minus initial investment is
referred to as net present value.
Following is the formula of net present valueNPV = -Io+∑CFt / (1+i)t
Where – Io = Initial cash outflow
CFt = cash flow taking place in different time periodsi = Interest rate/discount
t = year in which cash flow occurs
The outflow is always negative so as expressed in initial cash outflow (- Io)
Although NPV is the famous criteria of capital budgeting but still it holds one disadvantage
which is that its calculations are based on too many estimates and therefore it is quite difficult
to calculate.
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 The sales & future cash flows need to be forecasted in calculation of NPV. There is also
another estimate which is discount factor. Whenever the value of NPV is higher than zero than
that projected is regarded as favorable. When two projectors are under consideration than the
project with the higher NPV should be pursue(d) The value of the company or the wealth of the
shareholders increases by following the project having positive NPV. Moreover, the economic
value added & market value added is also increase(d)
Example:
By considering the same café example in which there is initial investment of $ 255,000 and
expectedprofit of $ 15,000 in the first year while $ 25,000 in the second year. There should also
be discount rate which is assumed to be 10% which reflects the minimum return that is
expected from the business. The business should provide the return more than that 10%
otherwise it is not beneficial one.
Following is the data provided in the exampleInitial cash outflow = – Io = -255,000
CFt = cash flows taking place at various time periods which are figured as $ 180,000 in the first
yearand $ 300,000 in the second year.
i = Interest rate/discount = 10%t = 2 years
By putting values in the formula NPV = -Io+∑CFt / (1+i)tNPV = -
255,000+180,000/(1+0.10)+300,000/(1+0.10)2 NPV = 255,000+163,636+247,933NPV =+
156,569

3. Profitability Index (PI):

The concept & calculation of Profitability Index (PI) is similar to the NPV. The ratio of current
value offuture cash flows to the initial investment is referred to as PI.
Following is the formula of PIPI = [∑CFt / (1+i)t] / Io
The projects having PI greater than 1 are regarded as favorable ones. Moreover the projects
that areapproved through the NPV method are also favorable on criteria of PI.
Example:
By considering the same example of café, PI is calculated as follow PI =
[180,000/(1+1.0)]+[300,000/(1+0.10)2] / 255,000
PI = 163,636 + 247,933 / 255,000
PI = 411,569 / 255,000
PI = 1.61 > 1.0
As the value is more than 1 therefore the project is favorable.

4. Internal Rate of Return (IRR):

Internal Rate of Return (IRR) is more commonly used measure of capital budgeting techniques
than NPV. Unlike the NPV, IRR is expressed in terms of percentage and therefore it is quite
useful to compare it with other interest rate or other market interest rates.
The same equation is used in the calculation of Internal Rate of Return that is used in the
calculation of NPV. The main difference is that the value of NPV is kept as zero in the equation
and then the value of “i” is calculate(d) The IRR of return is that value of “i” where the NPV of
the project is equal to zero. Also it is important to remember that the value of IRR is constant in
every year throughout the life of the project. Moreover, the IRR is the break-even rate of return
which means that it is that rate at which the initial investment is will be recovered throughout
the life of the project.
Trial & error method or iteration method is used to calculate the IRR. The higher degree
polynomial equation is required to solve out for finding unknown variable. Therefore trial & error

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 method or iteration method is quite easy way to find out the solution. In trial & error method the
value of “i” is set out in order to makes the whole equation equal to zero. If the first value does
not bring the equation equal to zero than try another value and if that value also does not
equalize the equation to zero, then try the third value and so on. The higher value of IRR is
considered as good one, but it is quite difficult to measure that which value of IRR is more
acceptable.
Another important point that needs to be clarified is that the internal rate of return is quite
different from the discounting rate that is employed in the NPV calculation. In NPV, the
discount rate is used as required rate of return that is expected from the project to generate. On
the other hand, in IRR equation, the forecasted return is ascertained through existing cash
flows. SO in calculation of NPV & IRR the two different interpretations of “i” should be
remembere(d)
Example:
By taking the similar above example of café and by using the same formula of NPV, the IRR can
becalculated as follow
NPV = -Io + CF1 / (1+IRR) + CF2 / (1+IRR)2
= 0 = -255,000+180,000/(1+0.1)+300,000/(1+0.1)2
To solve the equation if IRR is assumed to be 10% than the NPV will be equal to 156,569 which
is much higher figure. The NPV should be bringing down to zero and therefore the rate of IRR
would consider being higher equal to 50%. So now
NPV = -Io + CF1 / (1+IRR) + CF2 / (1+IRR)2
= 0 = -255,000 + 180,000/(1+0.494) + 300,000/(1+0.494)2
= 0 = -255000 + 120,481 + 134,406
The answer of above equation is equal to -113 which is less than zero, so the rate of IRR need
to be kept slightly lower than 50%. By considering IRR equal to 49.4% the NPV is -113, which is
quite nearto zero and therefore IRR of the café project is 49.4% approximately

Working Capital Management –Applicability, Analysis & Ratios

Working capital management is the process of managing these short-term assets and liabilities to
ensure the company has adequate liquidity to operate smoothly.

Relevance of Working Capital

The working capital ratio is crucial to creditors as it shows the liquidity of the company. The
liabilities of current nature are paid with current assets like marketable securities, cash, and cash
equivalents. The faster an asset can be converted into liquid cash, more likely that the company
will be able to pay off its debts.
When the current liabilities are exceeded by the current assets, the business will have ample
capital for its daily operations. In other words, it will have enough capital to work with.
This ratio is a measure of a company’s short-term financial health and its efficiency.
Anything that is below 1 is indicative of a negative W/C (working capital). While anything that is
over 2 indicates that the company is not investing the excess assets. Most ideally this ratio should
be between 1.2 and 2.0. Another name for working capital is net working capital.

Working Capital = Current Assets – Current Liabilities

Measure the efficiency of working capital
Working capital efficiency can be measured by certain ratios. The working capital cycle and other
working capital ratios arecompared to other industry benchmarks or the company’s peers.

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Some of the measures used in estimating the efficiency of working capital management include
current ratio, days of payables outstanding, days of inventory outstanding, days of sales
outstanding, et(c) Due to the small scale of operations in small business, liquidity tends to be in
tight supply and investment in the area of working capital can be an issue.
Many small businesses are unable to fund their operating cycles with account payables and hence,
have to rely on the cash that is generated through the internal sources like the owner, et(c) if the
working capital is managed efficiently, the business will be able to free up cash to pay debts or for
reinvestments.

Working Capital can be divided into two main categories:

1. Based on capital
(a) Gross Working Capital
(b) Net Working Capital
2. Based on time period
(a) Fixed Working Capital
(b) Variable Working Capital

Importance of Gross Working Capital

Investments in current assets must not be either excessive or inadequate as it can threaten the
production capacity and the solvency of the company. It also undermines the profit of the
business.

Importance of Net Working Capital

Net working capital is crucial for maintaining a position of liquidity and to make sure that current
assets exceed current liabilities. This is also the number that gives the creditor a clear picture into
thefinancial soundness of your business.

Estimating the working capital of your business

1. Unless it is specified otherwise, the calculation of stocks of the finished products and debts
should be made at cost.
2. Profits are to be ignored when calculating the working capital as profits may or may not used
as working capital and even in the scenario of it being used the amount will be reduced due to
taxes, dividends, et(c)
3. Unless mentioned otherwise, take into consideration the 100 percent value of WIP.

Techniques to analysis working capital

There are several methods to conduct a working capital analysis, these include:
(a) Ratio Analysis
This is a simple arithmetic view of the relationship between numbers. It is used to measure the
short-term liquidity of the firm.

Liquidity Ratio
Ratio Formula Description
Also known as the Working
Current Assets/ Current Capital Ratio and measures the
Current ratio
Liabilities short-term financial health of a
company.

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 Measures if an asset can be
liquidated to cash in a short
Acid Test Ratio/ Quick Ratio Liquid Assets/Current Liabilities
period of time without the loss
of value.
Includes cash in hand and that
in the bank and the temporary
Cash Position Ratio/ Absolute [(cash & Bank) + short-term
investments including
Liquid Ratio securities]/Current Liabilities
marketable securities. This ratio
must ideally be 50 percent.

Inventory Turnover Ratio = Cost of Goods Sold/Average Inventory at Cost

When the cost of goods sold is not known one may look at the following numbers:
Ratio Formula Description
Cost of Goods Sold/Average
Inventory at Cost
When the cost of goods sold is
Net Sales/Average Inventory at
Inventory Turnover Ratio not known one may look at the
Cost
other formulas
Cost of Goods Sold / Average
Inventory at Selling Price

Dividend Decisions
What are Dividend Decisions?
Dividend decisions, as the very name suggests, refers to the decision-making mechanism of the
management to declare dividends. It is crucial for the top management to determine the portion of
earnings distributable as the dividend at the end of every reporting perio(d) A company’s ultimate
objective is the maximization of shareholders wealth. It must, therefore, be very vigilant about its
profit-sharing policies to retain the faith of the shareholders. Dividend payout policies derive
enormous importance by virtue of being a bridge between the company and shareholders for profit-
sharing.
Without an organized dividend policy, it would be difficult for the investors to judge the intentions
of the management.
Moreover, the dividend policies of an organization have a significant bearing on the market value
of stocks. Dividends must be distributed in line with the industry standards. The shareholders will
otherwise perceive this variability negatively. It casts a suspicion on the financial health and
motives of the management (signaling effect). In aggregate, an inefficient dividend decision
mechanism wouldadversely impact the valuation of the company.
Objects of Dividend Decisions
Cash Requirement
The financial manager must take into account the capital fund requirements while framing a
dividend policy. Generous distribution of dividends in capital-intensive periods may put the
company in financial distress.
Evaluation of Price Sensitivity
Companies chosen by investors for its regularity of dividend must have a more stringent dividend
policy than others. It becomes essential for such companies to take effective dividend decisions
for maintaining stock prices.

Stage of Growth
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Dividend decision must be in line with the stage of the company- infancy, growth, maturity &
decline. Each stage undergoes different conditions and therefore calls for different dividend
decisions.

Good Dividend Policy

What Constitutes a Good Dividend Policy?
There does not exist a single dividend decision process that works for every organization. A
decision suitable for one company may prove fatal for another company. For example, businesses
with a consistent order book such as telecom and banking are expected to pay regular dividends. It
may impact the stock prices if they do not pay dividends regularly. To the contrary, sectors of
pharmaceutical and technology are highly research oriente(d) Huge cash expenses are required to
further their operations. Therefore they cannot afford to pay a regular dividen(d) Investors of such
stocks earn income mainly through capital appreciation. In essense, there are a lot of factors
affectingdividend policy or decision.
We can refer to following renowned theories on Dividend Policy:
• Modigliani- Miller Theory on Dividend Policy
• Gordon’s Theory on Dividend Policy
• Walter’s Theory on Dividend Policy
A good financial manager must, therefore, answer the following questions before taking crucial
dividend decisions

Q. How much dividend should a company distribute to its shareholders?

The ideal dividend decision should be commensurate with the profitable investment opportunity
available with the company. If it can invest a dollar and reap two, it is insensible to lose out on that
dollar by paying dividends. Industry standards are another input to be factored in. A company
paying fewer dividends than its peers can face problems while raising capital. It also depends on
the kind of investors which the company wants to attract. For example, companies such as
American Express and Coke can be relied upon for their stable dividend policies. They attract
investors with a longer horizon and larger disposable funds since they are compensated by steady
cash flows.

Q. What will be the impact of dividend decision on the share prices of the company?
To answer this question, it is important to know the dividend history of the company. If the
company is known for regularly paying dividends, a pressure for maintaining the payout hovers over
it. A one-off year, where it may not want to pay dividends and divert the funds for capital
investment or retention may be hazardous. Conversely, an interesting phenomenon occurs incases
of company depicting no
stability in dividend policies. When it does declare a dividend, the share prices see a huge spike
before the ex-dividend date. More and more people seek to make a quick buck by buying its shares
on dividend declaration. These shares are then sold as soon as the dividends are declare(d) This is
followed by a fall in the share prices (dividend stripping). Thus the shares of a sparsely dividend
paying company undergo great volatility between the date of dividend declaration and payment.

Q. What is the consequential impact of inability to maintain dividend year after year?
Only a company with sustainable profitability and cash flows can expect to reasonably pay
dividend year after year. If any other company claims the same, it is a hoax. If the stock of the
company in question is a growth stock such as Qualcomm (NYSE), the shareholders may pardon a
stingy dividend policy. Such shareholders expect to be compensated via a fat capital appreciation
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and hardly through the dividen(d) On the hand, if the shareholders are sensitive to dividend
decisions of the company it is not a good idea to have an irregular policy. For example, Avista Corp
and CMS Energy Corporation (NYSE) have been consistently paying dividends for a while.
Investors which buy into these companies are conditioned to expect the same. Having established
the expectation of regular dividends, the companies must ensure regular payouts. The failure of
same could drive down the prices.
Types of Dividend Decision
There are various types of dividends and dividend decisions.
Stable Dividends
• Same amounts of dividends are paid out every year irrespective of the profitability.
• Shareholders remain immune to fluctuations and volatility faced by the company.
• Only long-standing and established companies with steady cash flows can afford to follow this
policy
• Investors that buy into these companies have a low risk appetite. They also do not get to
participate inthe profits of the company
Constant Dividends
• Dividends are paid at a fixed percentage of the profits.
• The brunt of recession is as much borne them as much they reap benefits of the boom.
• This policy is suitable for companies in their infancy stage as well as those prone to volatility.
• Investors of these companies are risk-taking. They prefer to swing with the company in its
earnings
Alternate Dividend Decisions
A company may not always issue the dividend in cash. A stock dividend is a significant option with
the management for recourse to non-cash options. It is a handy tool to which management may
resort to when it wants to balance both, shortage of cash and shareholder expectations. Such
decisions are only made in exceptional circumstances
Stock Dividend Calendar – What It Tells And Why ItsImportant?
A stock dividend calendar is basically a tool that offers all information an investor may require
related to a dividen(d) Using the calendar, you can get dividend-related information on a specific
company or a list of companies based on the selected criteri(a) Broker houses or websites related
to the stock market of such calendars as a free tool accessible to all.
Table of Contents [show]
STOCK DIVIDEND CALENDAR – WHAT IT TELLS?
The stock dividend calendar usually offers details like dividend amount, type of dividend, ex-
dividend date, payment date, payout ratio and yiel(d) Knowing about these terms in detail will give
us a clear understanding of the importance of the stockdividend calendar.
EX-DIVIDEND DATE
It the date on are after which the stock starts trading without the value of its next dividen(d) Such a
date is primarily used to distinguish between the investors who are entitled to a dividend and who
are not. Those who buy the stock on or after the ex-dividend date announced by that company are
not entitled to a dividen(d)
When the management decides to declare a dividend, they set record dat(a) This is the cut-off date
for investors to be on the company’s record to be eligible for the dividen(d) After the record date,
the ex- dividend date is set on the basis of rules set by the stock exchange where that particular
stock is trade(d)
Usually, ex-dividend date is one business day before the record date. For instance, if the record
date is Monday, February 4th, the ex-dividend date would fall on Friday, February 1st.
Knowing the ex-dividend date is very important for an income investor. An investor must buy a
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dividend-paying stock at least two days before the record date as it takes two days to settle a
trade. So, if you are aware of the ex-date, it will help you plan your trade and maximize the return.
You caneasily know about ex-date for any stock using the stock dividend calendar.
PAYMENT DATE
It is another important date available in the stock dividend calendar. This is the date when the
company sends dividend checks to the investors. Payment date has no impact on the share price
as this date is known in advance. Nevertheless, it still helps investors known when to expect some
income.
DECLARATION DATE
The date on which the company declares about the dividend is the declaration date. Some stock
calendars also include this date.
DIVIDEND YIELD
It is another important information provided in the stock dividend calendar. The dividend yield is
the ratio of a company’s annual dividend and the share price. It is represented in the form of a
percentage. Stocks with high dividend yield may be attractive as it means the company gives more
dividends.
But, this is not always the case. A company may see a high dividend yield even when its stock
prices are falling. Also, a high dividend yield mostly comes at the cost of growth. If a company is

paying a dividend, then it is not reinvesting that amount inthe business.

INTERIM AND FINAL DIVIDEND

Some calendars also tell if the dividend given is interim or final. The interim dividend is announced
and paid in the middle of the accounting year, while the final dividend is declared at the company’s
Annual General Meeting (AGM) and after the end of the financial year. The interim dividend is
usually paid from retained earnings, while the final or annual dividend is paid from the profits made
during the year.
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PAYOUT RATIO
It is the proportion of earnings that the company pays out as a dividen(d) The payout ratio is
expressed as a percentage, and one can calculate it by dividing total dividends paid by net income.
For instance, if a company has a payout ratio of 20%, it means the company pays 20% of its income
as a dividen(d) Overall, one can say that a stock dividend calendar is an important tool for an
investor and trader. It helps them make an informed decision along with giving all dividend-related
information on onescreen.

INTERIM DIVIDEND MEANING

Interim dividend is the dividend, which is announced and paid before the company has issued its
annual financial statements. It is declared by the board of directors. The company might have the
policy to pay dividend more than once in a year. So the dividends announced in between the two
annual general meetings are considered interim dividends.
Interim dividend, as suggested by the name, relates to the business activities of less than a year. It
is generally paid semi-annually or quarterly. Also, they are accompanied by the interim statements
issued by the company. Board of directors generally announces the interim dividend when the
company has enough retained earnings and it is observing higher than expected earnings.

FINAL DIVIDEND MEANING

Final dividend is the dividend, which is paid after the company has issued its annual financial
statements for a fiscal year.
Final dividend relates to business activities of a whole fiscal year. It is proposed by the board of
directors based on the earnings results available.
NTERIM DIVIDEND VS FINAL DIVIDEND
Differences:
Points Interim Dividend Final Dividend

It is the dividend which isIt is the dividend which is paid

declared and paid before theafter the annual financial
Meaning annual financial statements arestatements are issued for a
issued for a fiscal year. fiscal year.

It is paid semiannually or
quarterly in the middle of a fiscalIt is paid annually after the end
Timing
year. of fiscal year.

531
 It is declared by the board ofIt is proposed by the board of
directors. Some jurisdictionsdirectors. It compulsorily
also require shareholders’requires shareholders’ approval
Shareholder’s Approval
approval at the
while some don’t. AGM.
Generally, It can’t be canceled
once declare(d) While in someIt can’t be canceled once
Cancellation jurisdictions, it can be canceleddeclare(d) It becomes a liability
through shareholders’ vote. for the company.

It does not require any specific

It can only be declared if articlesmention in the articles of
Articles of Association
of association allow it. association for declaration.

It is lower than the final dividendIt is higher than the interim

DividendRate
rate. dividend rate.

How do Companies Calculate Dividends?

Dividend Yield Calculation

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DividendYield Vs. Payout

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Theories of Working Capital Management
Working capital is said to be the life blood of a business. Working capital signifies funds required
for day-to- day operation of the firm. In financial literature, there exist two concepts of working
capital namely: gross and net. Accordingly, gross concept working capital refers to current assets
viz: cash, marketable securities, inventories of raw materials, work-in process, finished goods and
receivables. According to net concept, working capital refers to the difference between current
assets and current liabilities. Ordinarily, working capital can be classified into fixed or permanent
and variable or fluctuating parts.
The minimum level of investment in current assets regularly employed in business is called fixed
or permanent working capital and the extra working capital needed to support the changing
business activities is called variable or fluctuating working capital.
The objectives of this Unit are:
(a) To provide an overview of the field of working capital management;
(b) To identify and explain the dimension of working capital management;
(c) To introduce and illustrate basic decision criteria, principles and approaches applicable in the
field of working capital management.

RISK RETURN TRADE-OFF IN WORKING

CAPITAL MANAGEMENT -WORKING
CAPITAL MANAGEMENT
All decisions of the financial manager are assumed to be geared to maximization of shareholders
wealth, and working capital decisions are no exception.
Accordingly, risk return trade-off characterizes each of the working capital decision; there are two
types of risks inherent in working capital management (WMC), namely: liquidity risk is the non-
availability of cash to pay a liability that fall due. It may happen only on certain days. Even so, it can
cause not only a lose of reputation but also make the work condition unfavourable for getting the
best terms on transaction with the trade creditors. The other risk involved in WCM is the risk of
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opportunity loss that is risk of having two little inventory to maintain production and sales or the
risk of not granting adequate credit for releasing the achievable level of sales. In other words, it is
the risk of not being able to produce more or sell more or both and therefore not being able to earn
the potential profit, because there were not enough funds to support higher inventory and book
debts.
Thus, it would not be out of place to mention that it is only theoretical that the current assets could
all take zero values. Indeed, it is neither practicable nor advisable in practice; all current assets
take positive values because firms seek to reduce working capital risk. However, the greater the
funds locked up or deployed in current assets, the higher is the cost of the funds employed and
therefore the lesser the profit.
The risk return trade-off involved in managing the firm’s liquidity via investing in marketable
securities is illustrated in the following example.
Firm A and B are identical in every aspect but one firm B has invested N5000 in marketable
securities which have been financed with equity. That is, the firm sold equity shares and raised
N5000. The balance sheets and net incomes of the two firms are in Table below. Note that firm A
has a current ratio of 2.5 and earns a 10 percent return on its total assets while firm B with its
larger investment in marketable securities has a current ratio of 3 and has net working capital of
N20,000 since the marketable securities earn a return of only 8% before taxes (4.5 percent after
taxes with a 50% tax rate). Firm B earns only 9.7 percent on the total investment. This investment
in current assets and in particular in marketable securities does have a favourable effect on the
firm’s rate of return earned on invested funds. The risk-return trade-off involved in holding more
cash and marketable securities therefore is one of added liquidity revenues and reduced
profitability. Table : The Effects of Investing in Current Assets on Liquidity and Profitability Balance
Sheet
During the year firm B held N5000 in marketable securities which earned a 9% return or N450 for
one year. After paying taxes at a rate of 50 percent, the firm netted a N225 return on its investment.
In the use of current versus long term debt for financing working capital needs also the firm faces
a risk-return trade- off. Other things remaining the same, the greater its reliance upon short term
debt or current liabilities in financing its current assets investment, the lower will be its liquidity. On
the other hand, the use of current liabilities offers some very real advantages to the user in that it
can be less costly than long term financing as they provide the firm with a flexible means of
financing of the fluctuation need for current assets. If for example a firm needs fund for a three
month period during each year to finance a seasonal expansion in inventories. Then a three month
loan can provide substantial cost saving over a long term (even if the interest rate on short term
financing should be higher). This results from the fact that the use of long term debt in this
situation involves borrowing for the entire year rather than for the three month period when the
funds are needed, this increase in the interest cost for the firm. There exist possibilities for further
saving because in general, interest rates on short-term debt are lower than on long-term debt for a
given borrower.
We may demonstrate the risk-return trade-off associated with the use of current versus long term
liabilities with the help of an example given below. Consider the risk return characteristics of firm X
and firm Y whose balance sheets and income statements are given in table below. Both firms had
the same seasonal needs for financing throughout the past year. In December, they each required
N20,000 to finance a seasonal expansion in accounts receivable. In addition, during the four-month
period beginning with August and extending throughout November, both firms needed N10,000 to
support a seasonal building in inventories. Firm X financed its seasonal financing requirement
using N20,000 in long term debt carrying an annual interest rate of 10 percent. Firm Y on the other
hand, satisfied its
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financing needs using short-term borrowing on which it paid 9 percent interest expense for which
X incurred N2000 in annual interest expense.
The end results of the two firms financing policies is evidenced in there current ratio, net working
capital and return on total assets which appear at the bottom of table below. Firm X using long
term rather than short term debt, has a current ratio of 3 times and N20,000 in net working capital.
Whereas firm Y’s current ratio is only one (1) which represents zero net working capital. However,
owing to its interest expense, firm Y was able to earn 10.8 percent on its invested funds whereas
firm X produced a 10 percent return. Thus, a firm can reduce its risk of liquidity through the use of
long-term debt at the expense of a reduction of its return on invested funds. Once again, we see
that the risk return trade off involves an increased risk of liquidity versus increased
[Link]:Effect of short versus long-term debt on firm liquidity and profitability Balance
Sheets Income Statements

1. Firm X paid interest during entire year on N20,000 on longterm debt as at rate of 10 percent, its
interest expense for the year was 10% x 20,000 = N2000).
2. Firm Y and interest on N20,000 for month and on N10,000 for four months at 9 percent
interest during the year. This fir Y’s interest expense for the year equals
N20,000 x 0.9 x 1/12) plus 10,000 x 0.9 x 4/12 or 150 + 300 = 450.

Risk-Return Analysis: Definition & Methods

Introduction
The process of trading is a complex one with a number of steps like stocks selection, the
formation of strategies, and creation of a portfolio and so on. Here, we will focus on one such step
which is computing the expected returns and variances for a portfolio having n number of stocks.

Expected return on a single stock

The expected return of a portfolio provides an estimate of how much return one can get from their
portfolio. And variance gives the estimate of the risk that an investor is taking while holding that
portfolio. The returns and the risk of the portfolio depending on the returns and risks of the
individual stocks and their corresponding shares in the portfolio.
The parameters of the risk and return of any stock explicitly belong to that particular stock,
however, the investor can adjust the return to risk ratio of his/ her portfolio to the desired level
using certain measures. One such measure is to adjust the weights of the stocks in the investors’
portfolio.
Here we will discuss how the weights of individual stocks impact these two parameters of the
portfolio. Consider a stock AB(C) Let ri be the expected return on the stock and rx be any return
having a probability of px. The expected return, ri, can be computed using the below equation.

536
Let us assume that ABC can generate the returns as per column A with corresponding probabilities
given in column (B) The expected return from ABC can be computed as shown in column C, which
is the product of columns A and (B)
Let us look at the code to compute the expected return of this stock. We start by importing the
pandas library.
The expected return on the stock is 8.10% as per the calculations shown above. The returns in
column A can be computed using Capital Asset Pricing Model (CAPM). Risk (or variance) on a
single stockThe variance of the return on stock ABC can be calculated usingthe below equation.

The
following table gives the computation of the variance using the same example above.
We can compute the variance of the single stock using python as:

Hence, the variance of return of the ABC is 6.39. The standard deviation of the returns can be
calculated as the square root of the variance.
Having computed the expected return and variance for the stock, we will now see how to calculate
the return and variance of the portfolio. We use the expected return and variance of the portfolio to
optimize it. We can adjust the weights of the stocks to maximize the return and minimize the
standard deviation.

Expected return on an n-stock portfolio

Let us take an n-stock portfolio. Assume that the expected return from i th stock is ri. The
537
expected return on the portfolio will then be:
The weight of any stock is the ratio of the amount invested in that stock to the total amount
investe(d) For the below portfolio, the weights are shown in the table.

Let us see how we can compute the weights using python for this portfolio. The sum of the weights
of all the stocks in the portfolio will always be 1. Next, we will see the expected return on this
portfolio.

The expected return of the portfolio can be computed as:

Covariances and correlation of returns

Before moving on to the variance of the portfolio, we will have a quick look at the definitions of
covariance and correlation. Covariance (or correlation) denotes the directional relationship of the
returns from any two stocks. The magnitude of the covariance denotes the strength of the
relationship. If covariance (or correlation) is zero, there is no relation and if the sign of covariance
(or correlation) is negative, it indicates that if one stock moves in one direction the other will move
in the other direction. The equations to compute the covariance and correlation are given below.
Box method for Variance of a portfolio

538
For variance of the portfolio, we will use box metho(d) For an n-stock portfolio, we will create an n
X n matrix with all the stocks on X and Y axes as illustrated below. Each cell contains the product
of the weights of the corresponding column and the covariance of the corresponding stocks.
Let us look at the stepwise procedure to use the box method for variance computation.

The variance of the portfolio will be the sum of all the cells of this table. Hence, the variance of a
two stock portfolio will be:
Special case of fully diversified portfolio

Now we will take a special case in which there are n stocks and the weights of all the stocks are
equal. Hence, the weight of each stock will be 1/n. Using the above box method, we can write
the sum of all the diagonal elements as:
After removing n diagonal elements, we are left with n2 – n elements. The sum of the remaining
elements can be written as:

Hence, the variance of such a portfolio will be:

For a fully diversified portfolio, we can assume that we have added every possible stock in our
portfolio. Therefore, n will tend to infinity and 1/n will tend to zero. So, the variance of a fully
diversified portfolio will be the average of the covariances. So, we can say that diversification
eliminates all risks except the covariances of the stocks, which is the market risk.

What is ‘Risk and Return’?

In investing, risk and return are highly correlate(d) Increased potential returns on investment
usually go hand-in-hand with increased risk. Different types of risks include project-specific risk,
industry-specific risk, competitive risk, international risk, and market risk. Return refers to either
gain and losses made from trading a security.
The return on an investment is expressed as a percentage and considered a random variable that

539
takes any value within a given range. Several factors influence the type ofreturns that investors can
expect from trading in the markets.
Diversification allows investors to reduce the overall risk associated with their portfolio but may
limit potential returns. Making investments in only one market sector may, if that sector
significantly outperforms the overall market, generate superior returns, but should the sector
decline then you may experience lower returns thancould have been achieved with a broadly
diversified portfolio.

How Diversification Reduces or Eliminates Firm-Specific Risk

First, each investment in a diversified portfolio represents only a small percentage of that portfolio.
Thus, any risk that increases or reduces the value of that particular investment or group of
investments will only have a small impact on the overall portfolio.
Second, the effects of firm-specific actions on the prices of individual assets in a portfolio can be
either positive or negative for each asset for any perio(d) Thus, in large portfolios, it can be
reasonably argued that positive and negative factors will average out so as not to affect the overall
risk level of the total portfolio.
The benefits of diversification can also be shown mathematically: σ^2portfolio= WA^2σA^2 +
WB^2σB^2 + 2WA WBр ABσ AσBWhere:
σ = standard deviation
W = weight of the investmentA = asset A
B = asset B
р = covariance
Other things remaining equal, the higher the correlation in returns between two assets, the smaller
are the potential benefits from diversification
Comparative Analysis of Risk and Return Models
• The Capital Asset Pricing Model (CAPM)
• APM
• Multifactor model
• Proxy models
• Accounting and debt-based models
For investments with equity risk, the risk is best measured by looking at the variance of actual
returns around the expected return. In the CAPM, exposure to market risk is measured by a market
bet(a) The APM and the multifactor model allow for examining multiple sources of market risk and
estimate betas for an investment relative to each source. Regression or proxy model for risk looks
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for firm characteristics, such as size, that have been correlated with high returns in the past and
uses them to measure market risk.
On investments with default risk, the risk is measured by the likelihood that the promised cash
flows might not be delivere(d) Investments with higher default risk usually charge higher interest
rates, and the premium that we demand over a riskless rate is called
the default premium. Even in the absence of ratings, interest rates will include a default premium
that reflects the lenders’ assessments of default risk. These default risk- adjusted interest rates
represent the cost of borrowing or debt for a business.
What is securitization?
Securitization is the process of taking an illiquid asset, or group of assets, and
through financial engineering, transforming it (or them) into a security. The derisive phrase
"securitization food chain," popularized by the film "Inside Job" about the 2007-2008 financialcrisis,
describes the process by which groups of such illiquid assets (usually debts) are packaged,
bought, securitized and sold to investors.
A typical example of securitization is a mortgage-backed security (MBS), a type of asset- backed
security that is secured by a collection of mortgages. First issued in 1968, this tactic led to
innovations like collateralized mortgage obligations (CMOs), which first emerged in 1983. MBS
became extremely common by the mid-1990s. The process works as follows.
Forging a Securitization Food Chain
The first step in the chain begins with the simple process of would-be home- or property- owners
applying for mortgages at commercial banks. The regulated and authorized financial institution
originates the loans, which are secured by claims against the various properties the mortgagor’s
purchase. Mortgage notes (claims on future dollars) are assets for the lenders, but these assets
come with clear counterparty risk. The borrower could fail to repaythe loan, and so banks often sell
notes for cash.
This leads to the second big link in the chain: Individual mortgages are bundled together into a
mortgage pool,which is held in trust as the collateral for an MBS. The MBS can be issued
by a third-party financial company, such as a large investment banking firm, or by the same bank
that originated the mortgages in the first place. Mortgage-backed securities are also issued by
aggregators such as Fannie Mae or Freddie Ma(c)

Securitization
Regardless, the result is the same: A new security is created, backed up by the claims against the
mortgagors' assets. Shares of this security can be sold to participants in the secondary mortgage
market. This market is extremely large, providing a significant
amount of liquidity to the group of mortgages, which otherwise would be quite illiquid on their own.
(For a one-stop shop on subprime mortgages, the secondary market and the subprime meltdown,
check out the Subprime Mortgages Feature.)
There are multiple kinds of MBS: pass-throughs, a simple variety in which mortgage payments are
gathered and passed through to investors, and CMOs. CMOs break the mortgage pool into a
number of different parts, referred to as tranches. This spreads the risk of default around, similar to
how standard portfolio diversification works. The tranches can be structured in virtually any way
that the issuer sees fit, allowing a single MBS to be tailoredfor a variety of risk tolerance profiles.
Pension funds will typically invest in high-credit rated mortgage-backed securities,
while hedge funds will seek higher returns by investing in those with low credit ratings. In any case,
the investors would receive a proportionate amount of the mortgage payments as their
– the return-on-investment final link in the chain.
What Is Illiquid?
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Illiquid refers to the state of a stock, bond, or other assets that cannot easily be sold or exchanged
for cash without a substantial loss in value. Illiquid assets may also be hard to sell quickly because
of a lack of ready and willing investors or speculators to purchase the asset. Additionally, a
company may be illiquid if it is unable to obtain the cash necessary to meet debt obligations.
Illiquidity is the opposite of liquidity.
What is Financial Engineering
Financial engineering is the use of mathematical techniques to solve financial problems. Financial
engineering uses tools and knowledge from the fields of computer science, statistics, economics,
and applied mathematics to address current financial issues as well as to devise new and
innovative financial products.
Financial engineering is sometimes referred to as quantitative analysis and is used by regular
commercial banks, investment banks, insurance agencies, and hedge funds
Mortgage-Backed Security (MBS)REVIEWED BYJULIA KAGANUpdated Jan 17, 2018
What is a Mortgage-Backed Security (MBS)
A mortgage-backed security (MBS) is a type of asset-backed security that is secured by a
mortgage or collection of mortgages. This security must also be grouped in one of the top two
ratings as determined by an accredited credit rating agency, and usually pays periodic payments
that are similar to coupon payments. Furthermore, the mortgage must have originated from a
regulated and authorized financial institution.
An MBS is also known as a "mortgage-related security" or a "mortgage pass through." An MBS can
be bought and sold through a broker and the minimum investment varies between issuers. It is
issued by either a federal government agency company, government-sponsored enterprise (GSE),
or private financial company.
BREAKING DOWN Mortgage-Backed Security (MBS)
An mortgage-backed security is a way for a smaller regional bank to lend mortgages to its
customers without having to worry about whether the customers have the assets to cover the loan.
Instead, the bank acts as a middleman between the home buyer and the investment market
participants. When an investor invests in a mortgage-backed security, he is essentially lending
money to a home buyer or business.
This type of security is also commonly used to redirect the interest and principal payments from
the pool of mortgages to shareholders. These payments can be further broken down into different
classes of securities, depending on the riskiness of different mortgages as they are classified
under the MBS.

International Monetary System

International monetary system refers to a system that forms rules and standards for facilitating
international trade among the nations.
It helps in reallocating the capital and investment from one nation to another.
It is the global network of the government and financial institutions that determine the exchange
rate of different currencies for international trade. It is a governing body that sets rules and
regulations by which different nations exchange currencies with each other.
With the growing complexity in the international trade and financial market, the international
monetary system is necessary to assign a standard value of the international currencies. The rules
and regulations set by the international monetary system to regulate and control the exchange
value of the currencies are agreed upon by the respective governments of the nations. Thus, the
government’sstand may affect the decision making of the international monetary
system. For example, change in the trade policy of a government may affect the international trade
of goods and services.
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International monetary system motivates and encourages the nations to participate in the
international trade to improve their BOP and minimize the trade deficit. It has grown over the years
as a single architectural body with a vision to integrate the global economy. Some of the important
achievements of the international monetary system over the years have been the establishment of
World Bank and International Monetary Fund in the year 1944.
The establishment of IMF and World Bank is the result of the agreement among nations to set a
body, which promotes and supports the international trade. Now, let’s discuss the evolution of
international monetary system. Earlier in 1870 to 1914, trade was carried with the help of gold and
silver without any institutional support. At that time, monetary system was decentralized and
market based and money played a minor role as compared to gold in international trade.
The use of gold declined after World War I as war increased expenditure and inflation. In such a
scenario, countries planned to revive the standard of gold but failed due to great depression. Thus,
in 1944, 730 representatives of 44 nations met at Bretton Woods, New Hampshire, United States to
create a new international monetary system.
This was called as the Bretton Woods system, which became a turning point in the history of
international trade. The aim of new international monetary system is to create a stabilized
international currency system and ensure a monetary stability for all the nations.
It was decided that since the United States held most of the world’s gold, thus all the nations would
determine the values of their currencies in terms of dollar. The central banks of nations were given
the task of maintaining fixed exchange rates with respect to dollar for each currency.
The Bretton Woods system ended in 1971 as the trade deficit and growing inflation undermined
the value of dollar in the whole worl(d) In 1973, the floating exchange rate system, also known as
flexible exchange rate system, was developedthat was market base(d)

Introduction
The 1944 Bretton Woods Conference, which created the International Monetary Fund (IMF) and the
International Bank for Reconstruction and Development (World Bank), and the San Francisco
Conference, which created the United Nations one year later, were major landmarks in international
cooperation—true‘acts of creation’, to use the title of one of the best-known books
on the founding of the United Nations (Schlesinger 2004). These success stories were particularly
remarkable in the light of the failures of international political and economic cooperation in the
1930s. There were, of course, disappointments, particularly the incapacity to launch an additional
leg of the system of economic cooperation, the International Trade Organization agreed to in
Havana in 1948, as the US Congress failed to ratify the agreement; only one of its components, the
General Agreement on Tariffs and Trade, approved one year earlier, was put in place. Almost half a
century later, the World Trade Organization was create(d) In any case, there has never been
another moment in the history of international cooperation that matches the end of the Second
World War and the early post-war years.
In the economic area, the success of cooperation was reflected, in particular, in the rapid
reconstruction of Western Europe and Japan, which led to the period of the fastest economic
growth and, particularly, the fastest growth of international trade in world history. There were also
disappointments, notably the inherent design problems, which in the case of the international
monetary system—the subject of this book—finally led in the early 1970s to the collapse of the
Bretton Woods arrangements, the failure to agree on an alternative system, and the de facto rise of
the ‘non-system’ that has survived until the present. To this we can add the incapacity to line up the
Communist countries as members of the Bretton Woods institutions, until 1980 in the
case (p.2) of China (when it took from Taiwan the membership in the IMF) and after the fall of the
Berlin Wall in the case of the Soviet blo(c)
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This chapter focuses on the international monetary system, as an introduction to the issues that
are analyzed in detail in the rest of the volume. The histories of the international monetary system
and of the IMF in particular have, of course, been the subj ect of significant attention. This includes
old and new histories of US–UK negotiations in the late war years and the agreement finally
reached at Bretton Woods (Conway 2015; Gardner 1969; Steil 2013), as well as more recent
analyses of the role of developing countries in those negotiations (Helleiner 2014). It also includes
academic histories of the international monetary system (Eichengreen 2008; Helleiner 1994; Yago,
Asai and Itoh 2015), the views of protagonists of that history (Solomon 1982), and the official and
semi-official histories of the IMF (de Vries 1976, 1985, 1987; Horsefield 1969; James 1996). The
chapter does not, therefore, aim to make a detailed reconstruction of the history of the system as
such, but rather to serve as a historical background to the contemporary issues that are analyzed
in the rest of this volume: the genesis of the problems faced by the system at different times, their
similarities and differences, and the role of emerging and developing countries in the system.
The chapter is divided into six sections, the first of which is this introduction. The second looks at
the background of the debates and the design of the Bretton Woods system. The third analyses the
tensions that the Bretton Woods monetary system faced from the 1960s until its collapse in the
early 1970s. The fourth looks at the management of the collapse, the failure to reach an
agreement on a new system, and the resulting non-system or ad hoc arrangements that followe(d)
The fifth considers the following quarter century or so, during which these arrangements mature(d)
The last section looks at current issues, which may be seen as the construction of a broader global
‘financial safety net’, to use a term that has become fashionable. This proce ss started before the
North Atlantic financial crisis1 but developed fully after the outbreak of that crisis.

The Bretton Woods Monetary System

The major objectives of international monetary cooperation as agreed at Bretton Woods are best
captured in Article [Link] of the IMF Articles of Agreement, which states that the purpose of the IMF is:
‘To facilitate the expansion (p.3) and balanced growth of international trade, and to contribute
thereby to the promotion and maintenance of high levels of employment and real income and to
the development of the productive resources of all members as primary objectives of economic
policy’. This objective reflects the central relation that, in the conception of the Bretton Woods
architects, the new international monetary system had with the reconstruction of world trade after
its collapse during the Great Depression and the Second World War. It also shows the centrality of
the new economic ideas that came from the Keynesian revolution, which placed employment as
the central objective of macroeconomic policy. In a more indirect way, the growth objectives of
developing countries were capture d in the reference to the ‘development of the productive
resources’ of its members.2
The rest of Article I can be read as instruments to achieve this major objective: (i) to create a
permanent institution ‘to promote international monetary cooperation’ (Article I.i); (ii) ‘to promote
exchange stability, to maintain orderly exchange arrangem ents among members, and to avoid
competitive exchange depreciation’ (Article [Link]), which was deemed as essential to reconstruct
international trade; (iii) to establish ‘a multilateral system of payments in respect of current
transactions’ that would eli minate the ‘foreign exchange restrictions which hamper the growth of
world trade’ (Article [Link]); and (iv) to provide IMF financing ‘to correct maladjustments in their
balance of payments without resorting to measures destructive of national or international
prosperity’ (Article I.v), meaning in this regard policies that could negatively affect employment in
the country adopting them or generate negative spillovers that would have that effect on other
countries.
Foreign Exchange Market
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The foreign exchange market is a global online network where traders buy and sell currencies. It
has no physical location and operates 24 hours a day from 5 p.m. EST on Sunday until 4
p.m. EST on Friday because currencies are in high deman(d) It sets the exchange rates for
currencies with floating rates.
This global market has two tiers. The first is the interbank market. It's where the biggest banks
exchange currencies with each other. Even though it only has a few members, the trades are
enormous. As a result, it dictates currency values.
The second tier is the over-the-counter market. That's where companies and individual’s trade. The
OTC has become very popular since there are now many companies that offer online trading
platforms. New traders, starting with limited capital, need to know more about forex trading. It’s
risky because the forex industry is not highly regulated and provides substantial leverage.
Foreign exchange trading is a contract between two parties. There are three types of trades. The
spot market is for the currency price at the time of the trade. The forward market is an agreement
to exchange currencies at an agreed-upon price on a future date.
A swap trade involves both. Dealers buy a currency at today's price on the spot market and sell the
same amount in the forward market. This way, they have just limited their risk in the future. No
matter how much the currency falls, they will not lose more than the forward price.
Meanwhile, they can invest the currency they bought on the spot market.
Interbank Market
The interbank market is a network of banks that trade currencies with each other. Each has a
currency trading desk called a dealing desk. They are in contact with each other continuously. That
process makes sure exchange rates are uniform around the worl(d)
The minimum trade is one million of the currency being trade(d) Most trades are much larger,
between 10 million and 100 million in value. As a result, exchange rates are dictated by the
interbank market.
The interbank market includes the three trades mentioned above. Banks also engage in
the SWIFT market. It allows them to transfer foreign exchange to each other. SWIFT stands for
Society for World-Wide Interbank Financial Telecommunications.
Banks trade to create profit for themselves and their clients. When they trade for themselves, it's
called proprietary trading. Their customers include governments, sovereign wealth funds, large
corporations, hedge funds, and wealthy individuals.
Here are the 10 biggest players in the foreign exchange market, according to Euromoney's 2018 FX
Survey:
Bank Market Share
JP Morgan Chase 12.13%
UBS 8.25%
XTX Markets 7.36%
Bank of America Merrill Lynch 6.20%
Citi 6.16%
HSBC 5.58%
Goldman Sachs 5.53%
Standard Chartered 4.49%
State Street 4.37%

Manipulation Scandal
In 2014, Citigroup, Barclays, JPMorgan Chase, and The Royal Bank of Scotland pled guilty to illegal
manipulation of currency prices. Here's how they did it.
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Traders at the banks would collaborate in online chat rooms. One trader would agree to build a
huge position in a currency, then unload it at 4 p.m. London Time each day. That's when the
WM/Reuters fix price is set. That price is based on all the trades taking place in one minute. By
selling a currency during that minute, the trader could lower the fix price. That's the price used to
calculate benchmarks in mutual funds. Traders at the other banks would also profit because they
knew what the fix price would be.
These traders also lied to their clients about currency prices. One Barclays trader explained it as the
“worst price I can put on this where the customer’s decision to trade with me or give me future
business doesn’t change.”
Retail Market
The Chicago Mercantile Exchange was the first to offer currency trading. It launched the
International Monetary Market in 1971. Other trading platforms include OANDA, Forex Capital
Markets LLC, and [Link].
The retail market has more traders than the Interbank Market. But the total dollar amount traded is
less. The retail market doesn't influence exchange rates as much.
Role of Central Banks
Central banks don't regularly trade currencies in foreign exchange markets. But they have a
significant influence. Central banks hold billions in foreign exchange reserves. Japan holds around
$1.2 trillion, mostly in U.S. dollars. Japanese companies receive dollars in payment for exports.
They exchange them for yen to pay their workers.
Japan, like other central banks, could trade yen for dollars in the forex market when it wants the
value to fall. That makes Japanese exports cheaper. Japan prefers to use methods that are more
indirect though, such as raising or lowering interest rates to affect the yen's value.
For example, in 2014, the Federal Reserve announced it would raise interest rates in 2015. That
sent the dollar's value up 15 percent, creating an asset bubble.
History
For the past 300 years, there has been some form of a foreign exchange market. For most of
U.S. history, the only currency traders were multinational corporations that did business in many
countries. They used forex markets to hedge their exposure to overseas currencies. They could do
so because the U.S. dollar was fixed to the price of gol(d) According to the gold price history, gold
was the only metal the United States used to back up the value ofthe nation’s paper currency.
The foreign exchange market didn't take off until 1973. That's when President Nixon completely
untied the value of the dollar to the price of an ounce of gol(d) The so-called gold standard kept the
dollar at a stable value of 1/35 of an ounce of gol(d) The history of the gold standard explains why
gold was chosen to back up the dollar.
Once Nixon abolished the gold standard, the dollar's value quickly plummete(d) The dollar index
was established to give companies the ability to hedge this risk. Someone created the U.S. Dollar
Index to give them a tradeable platform. Soon, banks, hedge funds, and some speculative traders
entered the market. They were more interested in chasing profit than in hedging risks.
How to Avoid Exchange Rate Risk
Exchange rate risk or foreign exchange (forex) risk is an unavoidable risk of foreign investing, but it
can be mitigated considerably through hedging techniques. To
eliminate forex risk, an investor would have to avoid investing in overseas assets altogether, but
this may not be the best alternative from the perspective of portfolio diversification since
numerous studies have shown that foreign investing improves portfolio return while reducingrisk.
For the U.S. investor, hedging exchange rate risk is particularly important when the U.S. dollar is
surging since the risk can erode returns from overseas investments. For overseas investors, the
reverse is true, particularly when U.S. investments are performing. This is because the depreciation
546
 of the local currency against the USD can provide an additional boost to returns. In such situations,
since exchange rate movement is working in the investor's favor, the appropriate course of action
is to go unhedge(d)
The rule-of-thumb is to leave exchange rate risk with regard to your foreign investments unhedged
when your local currency is depreciating against the foreign-
investment currency, but hedge this risk when your local currency is appreciating against the
foreign-investment currency.
How to Hedge Risk
Here are two ways to mitigate forex risk:
• Invest in hedged assets: The easiest solution is to invest in hedged overseas assets, such as
hedged exchange-traded funds (ETFs). ETFs are available for a wide range of underlying assets
traded in most major markets. Many ETF providers offer hedged and unhedged versions of
their funds that track popular investment benchmarks or indexes. Although the hedged fund
will generally have a slightly higher expense ratio than its unhedged counterpart due to the cost
of hedging, large ETFs can hedge currency risk at a fraction of the hedging cost incurred by an
individual investor. For example, for the MSCI EAFE index – the
primary benchmark for U.S. investors to measure international equity performance – the
expense ratio for the iShares MSCI EAFE ETF (EFA) is 0.32%. The expense ratio for the iShares
Currency Hedged MSCI EAFE ETF (HEFA) is 0.70% (although the Fund has waived 35 basis
points of the management fee, for a net fee of 0.35%).

• Hedge exchange rate risk yourself: You most likely have some forex exposure if your portfolio
contains foreign-currency stocks or bonds or American depositaryreceipts (ADRs – a common
misconception isthat their currency risk is hedged, butthat is not the case).
Instruments for Hedging Currency Risk
You can hedge currency risk using one or more of the following instruments:

1. Currency forwards: Currency forwards can be effectively used to hedge currency risk. For
example, assume a U.S. investor has a euro-denominated bond maturing in a year's time and is
concerned about the risk of the euro declining against the U.S. dollar in that time frame. The
investor can enter into a forward contract to sell euros (in an amount equal to the maturity
value of the bond) and buy U.S. dollars at the one-year forward rate. While the advantage of
forward contracts is that they can be customized to specific amounts and maturities, a major
drawback is that they are not readily accessible to individual investors. An alternative way to
hedge currency risk isto construct a synthetic forward contract using the money market hedge.
(For more information, read: "The Money Market Hedge: How It Works.")

2. Currency futures: Currency futures are used to hedge exchange rate risk because they trade on
an exchange and need only a small amount of upfront margin. The disadvantages are that they
cannot be customized and are only available for fixed dates. (For more information, read:
"Introduction to Currency Futures.")

1. Currency ETFs: The availability of ETFs that have a specific currency as

the underlying asset means that currency ETFs can be used to hedge exchange rate risk. This is
probably not the most effective way to hedge exchange risk for larger amounts. However, for
individual investors, their ability to be used for small amounts and the fact that they are margin-
eligible and can be traded on the long or short side leads them to provide major benefits. (For
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 more information, read: "Hedge Against Exchange Rate Risk With Currency ETFs.")

2. Currency Options: Currency options offer another feasible alternative to

hedging exchange rate risk. Currency options give an investor or trader the right to buy or sell a
specific currency in a specified amount on or before the expiration date at the strike price. (See
"Trading Forex Options: Process and Strategy.") For example, currency options traded on the
Nasdaq are available
in denominations of EUR 10,000, GBP 10,000, CAD 10,000 or JPY 1,000,000, making them well-
suited for the individual investor.
The Bottom Line
Exchange rate risk cannot be avoided altogether when investing overseas, but it can be mitigated
considerably through the use of hedging techniques. The easiest solution is to invest in hedged
investments such as hedged ETFs, because the fund manager can hedge forex risk at a relatively
lower cost. However, an investor who holds foreign-currency stocks or bonds, or even American
depository receipts should consider hedging exchange rate risk using one of the many avenues
available such as currency forwards, futures, ETFs or options.
Five Hedging Techniques
Hedging is a process by which risk is reduced; however, I'll emphasize that unless you liquidate a
position, all risk cannot be eliminate(d) Hedging can reduce most risk, but as you will see,
sometimes you wind up trading one risk for another.
Also, recognize that hedging is typically a short-term strategy to protect long-term positions. It may
also be utilized to complete an arbitrage transaction. However, you never want to apply a long-term
hedging strategyto a short-term position, as that wouldbe costly and add more risk in the long run.
Here are five essential hedging techniques that you'll learn about in this installment of"The Finance
Professor":
• Pairing
• Short against the box
• Exchange-traded funds (ETFs)
• Futures
• Options
1. Pairing
Pairing seeks to offset a position with a similar but not identical security. For example, let's say
you are seeking to hedge a stock position, XYZ Corp. The first step is to identify many
characteristics of XYZ Corp. that are relevant to its risk profile. These include (but are not
limited to):
• Industry/sector categorization ( "Industries vs. Sectors: What's the Difference?")
• Market capitalization
• Beta
• Dividend yield
• Historic volatility
"Understanding the Four Measures of Volatility")
• P/E Ratio
• Price/Book Ratio
The next step is to match up target stocks with similar characteristics. Once you ascertain which
stock (or group of stocks) best replicate XYZ Corp.'s risk metrics, you can then perform a
correlation of the historic prices of XYZ and the target hedges. If there is a highcorrelation between
XYZ and the potential hedge, we have found the right match.
The final step is to short sell the hedge and thereby pair up XYZ with the hedge. While the match
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between XYZ and the hedge is not identical, it might provide some short-term risk protection.
However, beware that you are adding additional risks, such as the inability to maintain a stock
borrow on the hedge or the possibility that the hedge gets acquire(d)
Here is a real-life example. In the early 1990s I was in charge of risk management
at County NatWest Securities (CNWS. CNWS was trying to build a proprietary tradingand derivative
business on its strong foundation of market-making. One day the market makers at CNWS were
stuck with a big position in Abbey National (a bank similar to a U.S. savings and loan) which they
could not trade out of in larger pieces. This was no secret. I told the market makers to accumulate
a short position in its nearest rival or rivals and then work out of the paired position in a piecemeal
fashion.

1. Short Against the Box

Selling "short against the box" (SATB) is a unique hedging technique whereby a stock is
hedged by short-selling the same exact stock (“What Do I Need to Know About Shorting
Stocks?"). This was once a very popular strategy employed by many high- net-worth individuals
and hedge funds to avoid capital gains taxes on low-cost- basis holdings.
However, after the abuse of the SATB transaction by the Lauder family when taking Estee
Lauder(EL public (see IPO) nearly a decade ago ( "Why a Blackstone IPO Makes Sense") ,
Congress placed many restrictions on the use of SATB by eliminating many of its long-term
tax benefits. In essence, SATB is now a short-term hedging strategy rather than a long-term
hedging and tax-avoidance tacti(c)

2. Futures
While futures are not available to most individual investors ( "Getting Started With Futures"), I
would like to draw your attention to its potential use as a hedging technique.
In my lesson discussing managing risk, I included an example of a portfolio of stocks. The
total beta adjusted risk relative to the S&P 500 ( SPX ( SPY - Get Report) for that portfolio was
$2,619,000. Each SPX futures contract is for 250 times that index.
Let's say the SPX is selling at $1,525. At that price, the market value of each SPX future would
be 250 x $1,525 = $381,250. Thus, each SPX future would provide $381,250 of equivalent SPX
exposure.
With $2,619,000 of portfolio risk, you would have to sell 6.8 contracts ($2,619,000 / $381,250)
to fully hedge the position. Since we have to sell whole contracts, our choices would be to sell
seven SPX contracts, which would slightly over-hedge the position, or less than seven
contracts and slightly under-hedge the portfolio.
Once again, I must admonish that while you may hedge out some risk, since this sample
portfolio is made up of only four stocks and the SPX is an index of 500 stocks, then you have
an imperfect hedge. The result may be failure of the portfolio to track the hedge, resulting in
risk expansion not risk reduction.

3. Exchange-Traded Funds
Exchange-traded funds ( ETFs) open up a whole range of hedging possibilities. Let's look at
three alternatives:

• The Spyders: Recalling that the sample portfolio had risk of $2,619,000 vs. the S&P 500 Index.
The S&P 500 ETF, commonly called the "Spyders" (SPY - Get Report), is a trust that replicates
the S&P 500. The Spyders are now selling for about $153 per share. Thus, you can short
17,117 shares of SPY ($2,619,000 / $153) to hedge yoursample portfolio.
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• Sector-specific ETFs: If you are trying to hedge an individual stock, you may want to utilize a
sector-specific ETF to achieve our risk management objectives. For example, I own CVS
Caremark (CVS - Get Report). CVS is a component stock in the Retail Holdrs ETF (RTH. I could
hedge out some of my CVSrisk by short-selling the RTH.

• Inverse and levered inverse ETFs: Whole new classes of negative correlating ETFs have been
recently liste(d) These ETFs allow you to buy downside protection in an index. Using the SPY
as an example, the Short S&P 500 ProShares (SH and
the Ultra Short S&P 500 ProShares (SDS - Get Report) will appreciate as the SPX declines and
will decline when the SPX increases. The SDS provides a double leverage impact on
movements in the SPX.
As with the use of futures, ETFs will provide imperfect hedges and could result in adding more risk
rather than reducing risk to your portfolio. (To learn more about ETFs,
visit [Link]'s ETF Center.)
1. Options
Options are the most complex tool available for hedging ( "Options: Getting Started"). Options
require an intimate knowledge of the non-linear aspects of options pricing in order to
effectively execute hedge and manage risk.
Options require a much more detailed explanation before one can integrate their use into risk
management. I will, however, state that you can consider one of three strategies:
• Selling covered calls: Selling a call against the position you desire to hedge.
• Buying puts: Buying put protection or insurance against your holding(s).
• Collaring: Simultaneously selling a covered call and buying a put to lock in a minimum and
maximum potential sales price.
International financial markets consist of mainly international banking services and international
money market. The banking services include the services such as trade financing, foreign
exchange, foreign investment, hedging instruments such as forwards and options, et(c) All these
banking services are provided by international banks. International money market includes the
Eurocurrency markets, Euro credits, Euro notes, Euro commercial Paper et(c)
International financial markets, as we saw, can broadly be classified into international banking and
international money market. International markets are accessed by multinational corporations
more than anybody else. Traders or businesses having import and export transaction also have
frequent access to these markets.
INTERNATIONAL BANKING
International banking is quite different from the domestic banking as there are several services
which are required only in an international environment and are provided by international banks.
Following are such services:
TRADE FINANCING Several trade financing services are required by importers and exporters. An
importer importing goods from outside may

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International Financial Markets
wish to open a letter of credit to be given to the exporter from another country. The importer is not
known to the exporter and therefore the deal is routed through the banks.
Documentary collection is another in which the exporter of goods provides the bank with all the
documents required for releasing the goods under shipment. They are handed over to the importer
only after the payment is made to the bank.
A trader who is not a place invest a lot of money into his debtors can avail factoring and forfeiting
services. Under this service, the trader hands over his accounts receivables into a bank or third
party’s hand for collection. The trader effectively sells his debtors at a discount and frees his
money.
FOREIGN EXCHANGE
International businesses have frequent transactions in foreign currencies and therefore have
payables or receivables in those currencies. To close such transactions the businesses need
foreign exchange which is provided by international banks and institutions. These institutions have
their bid and ask rates for such currency buying and deposits. They buy or accept currencies at a
bid price which is less than their ask price at which they sell. These banks have the privilege to
trade foreign exchange in international markets.
FOREIGN INVESTMENTS
We all know that the banks are no more doing traditional banking. They have a gamut of services
to be provided to their clients both domestic and international. Foreign investment is one of such
services being provided by multinational banks to their clients. Since these banks have the
presence in many countries; they are better positioned to provide consulting services totheir clients
for their investing requirements.

HEDGING EXCHANGE RATE RISK

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It is known fact that the dealing in foreign currency is risky. The risk is assumed because the prices
of currencies are very fluctuating. The price at which a deal is struck may not remain constant till
all the transactions are over. Here is where the hedging plays an important role. With the help of
hedging instruments such as forwards and options, such risk can be mitigated and planned profits
may be attaine(d) Such instruments are the contracts which lock the prices of currency on a
particular day in future.
INTERNATIONAL MONEY MARKET
International money market mainly deals in Eurocurrency deposits, Euro credits, Euro notes, Euro
commercial Papers et(c) All these involve foreign currencies. Eurocurrency deposits are deposits
of foreign currency in a bank situated in a country which is different from the country of that foreign
currency. An Indian depositing US dollar in Chinese bank situated in China is called Eurocurrency
deposit.
Euro credits are a kind of loan extended to corporations in a currency other than the home
currencies. These are normally short term to the medium-term loan and are extended by a
syndicate of banks because the quantum of loan is too big and the risk cannot be assumed just by
one bank.
Likewise, the other money market instruments include euro notes, euro commercial papers et(c)
In essence, the international financial market is even bigger a market available for multinational
and other domestic companies. A growing business when reaches international heights also has a
lot of services to be offered by international banks and financial institutions. These markets
provide a business with a platform to take their businesses to a different height.
What is Eurocurrency
Eurocurrency is currency deposited by national governments or corporations, outside of its home
market. For example, it can be currency held in banks located outside of the country which issues
the currency.
BREAKING DOWN Eurocurrency
It is important to note that the term eurocurrency applies to any currency and to banks in any
country. Having “euro" doesn't mean that the transaction has to involve European countries.
For example, South Korean won deposited at a bank in South Africa, is considered eurocurrency.
US dollars held in a UK bank, would also be considered eurocurrency. And Euros held in an Asian
bank would be considered eurocurrency, too. However, in practice, European countries are often
involve(d)
Eurocurrencies are traded in eurocurrency markets. Also known as "Euromoney." Eurocurrencies: A
Brief History
In an essay on international finance for Princeton University Press, economist Ronald I McKinnon
explained the rise of eurocurrency markets. In the late mid-70s, when he wrote the essay, it was
largely not understood why eurocurrency markets came to be. He wrote, "the Eurocurrency market
is unnecessary." This is because "to finance foreign trade for their customers, commercial banks
could "easily obtain spot or forward foreign exchange in the interbank market that operates
internationally or draw on the balances of foreign currency held within correspondent banks."
This changed with the eurocurrency market. In the eurocurrency market, "banks resident in country
A accept deposits and make loans in the currencies of countries B, C, D and so on, and depositors
and borrowers are often non-residents."
This market arose due to the "peculiarly stringent and detailed official regulations governing
residents operating with their own national currencies." According to McKinnon, "these regulations
contrast sharply with the relatively great freedom of nonresidents to make deposits or borrow
foreign currencies from these same constrained national banking systems."
Essentially, the market eases local regulations and gives access to foreign currencies to offshore
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business. It has made doing business in one currency, in a market that does not issue that
currency, much easier
What are the differences between global depositary receipts (GDRs) and American depositary
receipts (ADRs)?
A global depositary receipt (GDR) is a bank certificate issued in multiple countries for shares in a
foreign company. The shares of a GDR trade as domestic shares. They are offered for sale globally
through various banks. A GDR a financial tool that is used by private markets to raise capital that is
denominated in either American dollars or euros. They are
called European depository receipts when private markets are trying to get euros.
American Depositary Receipts
GDRs are similar to American depositary receipts (ADRs). The main difference is that ADRs are
issued only by U.S. banks for foreign stocks that are traded on a U.S. exchange. The underlying
security of the ADRs is held by an American financial
institution overseas rather than by a global institution. ADRs help reduce the administration and
duty costs that would otherwise be levied on each transaction. They are a great way to buy shares
in a foreign company while obtaining any dividends and capital gains in American dollars.
ADRss do not reduce or get rid of the currency and economic risks for the underlying shares in
another country, however. Dividend payments in euros are converted to American dollars, net of
conversion expenses and foreign taxes. This is done in accordance with the deposit agreement.
ADRs are listed on various stock exchanges, such as the New York Stock Exchange, the American
Stock Exchange and Nasdaq, as well as trading over the counter.
What is an American Depositary Receipt - ADR
An American depositary receipt (ADR) is a negotiable certificate issued by a U.S. bank representing
a specified number of shares (or one share) in a foreign stock traded on a [Link].
BREAKING DOWN American Depositary Receipt - ADR
ADRs are denominated in U.S. dollars, with the underlying security held by a U.S. financial
institution overseas. Holders of ADRs realize any dividends and capital gains in U.S. dollars, but
dividend payments in euros are converted to U.S. dollars, net of conversion expenses and foreign
taxes. ADRs are listed on either the NYSE, AMEX or Nasdaq, but they are also sold over the counter
(OTC).
American depositary receipts were introduced in 1927 as an easier way for U.S. investors to
purchase stock in foreign companies. Non-U.S. companies also benefit from ADRs, as they make it
easier to attract American investors. Before ADRs existed, if American investors wanted to
purchase shares of a non-U.S. listed company, they had to buy the shares on international
exchanges. Purchasing shares on international exchanges has potential drawbacks, particularly
currency-exchange issues and regulatory differences. Publicly traded companies have to answer to
regulatory bodies with jurisdiction over their country. In the United States, the regulatory body is
the Securities Exchange Commission (SEC), which works to protect investors. The regulatory
bodies implement and enforce rules on companies, including how companies should present
pertinent financial information. Before investing in an internationally traded company, U.S.
investors had to familiarize themselves with the different rules, or they could risk
misunderstanding important information, such as the company's financials.
Benefits
ADR holders do not have to transact in foreign currencies, because ADRs trade in U.S. dollars and
clear through U.S. settlement systems. The U.S. banks require that the foreign companies provide
them with detailed financial information, making it easier for investors to assess the company's
financial health compared to a foreign company that only transacts oninternational exchanges.
Trading ADRs
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To offer ADRs, U.S. banks simply purchase shares from the international company and reissue
them, typically on U.S. exchanges. An ADR may represent the underlying shares on a one-for-one
basis, or it may represent a fraction of a share or multiple shares. The depositary bank sets the
ratio of U.S. ADRs per home-country share at a value that appeals to investors. If an ADR’s value is
too high, it could deter some investors, but if it is too low, investors may think the underlying
securities resemble riskier penny stocks.
Numerous companies trade in the United States as ADRs. For example, Volkswagen trades OTC
under the tickerVLKAY. BP Pl(c) trades on the NYSE under the ticker BP.
What Does Global Depositary Receipt Mean?
A global depositary receipt (GDR) is a bank certificate issued in more than one countryfor shares in
a foreign company.
Understanding Global Depositary Receipt
A global depositary receipt (GDR) is very similar to an American depositary receipt (ADR). It is a
type of bank certificate that represents shares in a foreign company, such that a foreign branch of
an international bank then holds the shares. The shares themselves trade as domestic shares, but,
globally, various bank branches offer the shares for sale. Private markets use GDRs to raise capital
denominated in either U.S. dollars or euros. When private markets attempt to obtain euros instead
of U.S. dollars, GDRs are referred to as EDRs.
Investors trade GDRs in multiple markets, which they generally refer to as capital markets as they
are considered to be negotiable certificates. Investors use capital markets to facilitate the trade of
long-term debt instruments and for the purpose of generating capital. GDR transactions in the
international market tend to have lower associated costs than some other mechanisms that
investors use to trade in foreign securities.
Shares Per Global Depositary Receipt
Each GDR represents a particular number of shares in a specific company. A single GDR can
represent anywhere from a fraction of a share to multiple shares, depending on its design. In a
situation that involves multiple shares, the receipt value shows an amount higher than the price for
a single share. Depository banks manage and distribute various GDRs and function in an
international context.
Trading of Global Depositary Receipt Shares
Companies issue GDRs to attract interest by foreign investors. GDRs provide a lower-cost
mechanism in which these investors can participate. These shares trade as though they are
domestic shares, but investors can purchase the shares in an international marketplace.
A custodian bank often takes possession of the shares while the transaction processes, ensuring
both parties a level of protection while facilitating participation.
Brokers who represent the buyer manage the purchase and sale of GDRs. Generally, the brokers
are from the home country and are sellers within the foreign market. The actual purchase of the
assets is multi-staged, involving a broker in the investor's homeland, a broker located within the
market associated with the company that has issued the shares, abank representing the buyer, and
the custodian bank.
If an investor desires, brokers can also sell GDRs on their behalf. An investor can sell them as-is on
the proper exchanges, or the investor can convert them into regular stock for the company.
Additionally, they can be canceled and returned to the issuing company.
International Arbitrage Arbitrage can be loosely defi ned as capitalizing on a discrepancy in quoted
prices by making a riskless profit t. In many cases, the strategy does not require an investment of
funds to be tied up for a length of time and does not involve any risk. Two coinshops bu Chapter 7:
International Arbitrage and Interest Rate Parity 189 favorable rate. If the demand and supply
conditions for a particular currency vary among banks, the banks may price that currency at
554
different rates, and market forces will force realignment. When quoted exchange rates vary among
locations, participants in the foreign exchange market can capitalize on the discrepancy. Specifi
cally, they can use locational arbitrage, whichis the
process of buying a currency at the location where it is priced cheap and immediately selling it at
another location where it is priced higher. Akron Bank and Zyn Bank serve the foreign exchange
market by buying and selling currencies. Assume that there is no bid/ask sprea(d)
The exchange rate quoted at Akron Bank for a British pound is $1.60, while the exchange rate
quoted at Zyn Bank is $1.61. You could conduct locational arbitrage by purchasing pounds at
Akron Bank for $1.60 per pound and then selling them at Zyn Bank for $1.61 per poun(d) Under the
condition that there is no bid/ask spread and there are no other costs to conducting this arbitrage
strategy, your gain would be $.01 per poun(d) The gain is risk free in that you knew when you
purchased the pounds how much you could sell them for. Also, you did not have to tie your funds
up for any length of time.

• Locational arbitrage is normally conducted by banks or other foreign exchange dealers whose
computers can continuously monitor the quotes provided by other banks. If other banks
noticed a discrepancy between Akron Bank and Zyn Bank, they would quickly engage in
locational arbitrage to earn an immediate risk-free profi t. Since banks have a bid/ask spread
on currencies, this next example accounts for the sprea(d) The information on British pounds at
both banks is revised to include the bid/ask spread in Exhibit 7.1. Based on these quotes, you
can no longer profit from locational arbitrage. If you buy pounds from Akron Bank at $1.61 (the
bank’s ask price) and then sell the pounds at Zyn Bank at its bid price of $1.61, you just break
even. As this example demonstrates, even when the bid or ask prices of two banks are
different, locational arbitrage will not always be possible. To achieve profits from locational
arbitrage, the bid price of one bank must be higher than the ask price of another bank.

• Gains from Locational Arbitrage. Your gain from locational arbitrage is based on the amount of
money that you use to capitalize on the exchange rate discrepancy, along with the size of the
discrepancy. The quotations for the New Zealand dollar (NZ$) at two banks are shown in
Exhibit 7.2. You can obtain New Zealand dollars from North Bank at the ask price of $.640 and
then sell New Zealand dollars to South Bank at the bid price of $.645. This represents one
“roundtrip” transaction in locational arbitrage. If you start with $10,000 and conduct one round-
trip transaction, how many U.S. dollars will you end up with? The $10,000 is initially exchanged
for NZ$15,625 ($10,000/$.640 per New Zealand dollar) at North Bank. Then the NZ$15,625 are
sold for $.645 each, for a total of $10,078. Thus, your gain from locational arbitrage is
$78.

• Your gain may appear to be small relative to your investment of $10,000. However, consider
that you did not have to tie up your funds. Your round-trip transaction could EXAMPLE
EXAMPLE Exhibit 7.1 Currency Quotes for Locational Arbitrage Example Akron Bank Zyn Bank
Bid Ask Bid Ask British pound quote $1.60 $1.61 British pound quote $1.61 $1.62 EXAMPLE
190 Part 2: Exchange Rate Behavior take place over a telecommunications network within a
matter of seconds. Also, if you could use a larger sum of money for the transaction, your gains
would be larger. Finally, you could continue to repeat your round-trip transactions until North
Bank’s ask price is no longer less than South Bank’s bid price. This example is not intended to
suggest that you can pay for your education through part-time locational arbitrage. As
mentioned earlier, foreign exchange dealers compare quotes from banks on computer
terminals, which immediately signal any opportunity to employ locational arbitrage.
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 Realignment due to Locational Arbitrage. Quoted prices will react to the locational arbitrage
strategy used by you and other foreign exchange market participants. In the previous example,
the high demand for New Zealand dollars at North Bank (resulting from arbitrage activity) will
cause a shortage of New Zealand dollars there. As a result of this shortage, North Bank will
raise its ask price for New Zealand dollars. The excess supply of New Zealand dollars at South
Bank (resulting from sales of New Zealand dollars to South Bank in exchange for U.S. dollars)
will force South Bank to lower its bid price. As the currency prices are adjusted, gains from
locational arbitrage will be reduce(d) Once the ask price of NorthBank is not any lower than the
bid price of South Bank,
locational arbitrage will no longer occur. Prices may adjust in a matter of seconds or minutes
from the time when locational arbitrage occurs.

• The concept of locational arbitrage is relevant in that it explains why exchange rate quotations
among banks at different locations normally will not differ by a signifi cant amount. This
applies not only to banks on the same street or within the same city but to all banks across the
worl(d) Technology allows banks to be electronically connected to foreign exchange quotations
at any time. Thus, banks can ensure that their quotes are in line with those of other banks. They
can also immediately detect any discrepancies among quotations as soon as they occur, and
capitalize on Exhibit

• 7.2 Locational Arbitrage Step 2: Take the NZ$ purchased from North Bank and sell them to
South Bank in exchange for U.S. dollars. Foreign Exchange Market Participants North Bank Bid
Ask NZ$ quote $.635 $.640 South Bank Bid Ask NZ$ quote $.645 $.650 $ NZ$ NZ$ $ Step 1:
Use U.S.$ to buy NZ$ for $.640 at North Bank. Summary of Locational Arbitrage EXAMPLE
Chapter 7: International Arbitrage and Interest Rate Parity 191 those discrepancies. Thus,
technology enables more consistent prices among banks and reduces the likelihood of signifi
cant discrepancies in foreign exchange quotations among locations. Triangular Arbitrage Cross
exchange rates represent the relationship between two currencies that are different from one’s
base currency. In the United States, the term cross exchange rate refers to the relationship
between two nondollar currencies. If the British pound (£) is worth

• $1.60, while the Canadian dollar (C$) is worth $.80, the value of the British pound with respect
to the Canadian dollar is calculated as follows: Value of £ in units of C$ $1.60/$.80
The value of the Canadian dollar in units of pounds can also be determined from the cross-exchange
rate formula: Value of C$ in units of £ $.80/$1.60 .50 Notice that the value of a Canadian dollar
in units of pounds is simply the reciprocal of the value of a pound in units of Canadian dollars.

• If a quoted cross exchange rate differs from the appropriate cross exchange rate (as
determined by the preceding formula), you can attempt to capitalize on the discrepancy. Specifi
cally, you can use triangular arbitrage in which currency transactions are conducted in the spot
market to capitalize on a discrepancy in the cross-exchange rate between two currencies.
Assume that a bank has quoted the British pound (£) at $1.60, the Malaysian ringgit (MYR) at
$.20, and the cross-exchange rate at £1 MYR8.1. Your first task is to use the pound value in
U.S. dollars and Malaysian ringgit value in U.S. dollars to develop the cross-exchange rate that
should exist between the pound and the Malaysian ringgit. The cross-rate formula in the
previous example reveals that the pound should be worth MYR8.0. When quoting a cross
exchange rate of £1 MYR8.1, the bank is exchanging too many ringgits for a pound and is
556
 asking for too many ringgit in exchange for a poun(d) Based on this information, you can
engage in triangular arbitrage by purchasing pounds with dollars, converting the pounds to
ringgit, and then exchanging the ringgit for dollars. If you have $10,000, how many dollars will
you end up with if you implement this triangular arbitrage strategy? To answer the question,
consider the following steps illustrated in Exhibit 7.3: 1. Determine the number of pounds
received for your dollars: $10,000 £6,250, based on the bank’s quote of $1.60 per poun(d) 2.
Determine how many ringgits you will receive in exchange for pounds: £6,250 MYR50,625,
based on the bank’s quote of 8.1 ringgit per poun(d) 3. Determine how many U.S. dollars you
will receive in exchange for the ringgit: MYR50,625 $10,125 based on the bank’s quote of $.20
per ringgit (5 ringgit to the dollar). The triangular arbitrage strategy generates $10,125, which is
$125 more than you started with.

• Like locational arbitrage, triangular arbitrage does not tie up funds. Also, the strategy is risk free
since there is no uncertain 192 Part 2: Exchange Rate Behavior that can reduce or even
eliminate the gains from triangular arbitrage. The following example illustrates how bid and ask
prices can affect arbitrage profi ts. Using the quotations in Exhibit 7.4, you can determine
whether triangular arbitrage is possible by starting with some fictitious amount (say, $10,000)
of U.S. dollars and estimating the number of dollarsyou would generate by
implementing the strategy. Exhibit 7.4 differs from the previous example only in that bid/ask
spreads are now considere(d) Recall that the previous triangular arbitrage strategy involved
exchanging dollars for pounds, pounds for ringgit, and then ringgit for dollars. Apply this
strategy to the bid and ask quotations in Exhibit 7.4. The steps are summarized in Exhibit 7.5.
Step 1. Your initial $10,000 will be converted into approximately £6,211 (based on the bank’s
ask price of $1.61 per pound). Step 2. Then the £6,211 are converted into MYR50,310 (based on
the bank’s bid price for pounds of MYR8.1 per pound, £6,211 8.1 MYR50,310).
Step 3. The MYR50,310 are converted to $10,062 (based on the bank’s bid price of $.200). The
profit is $10,062 $10,000 $62. The profit is lower here than in the previous example because
bid and ask quotations are use(d)

• Exhibit 7.3 Example of Triangular Arbitrage Step 2: Exchange £ for MYR at MYR8.1 per £ (£6,250
MYR50,625) Step 1: Exchange $ for £ at
$1.60 per £ ($10,000 £6,250) Step 3: Exchange MYR for $ at $.20 per MYR (MYR50,625
$10,125) Malaysian Ringgit (MYR) British Pound (£) U.S. Dollar ($) Exhibit 7.4 Currency Quotes
for a Triangular Arbitrage Example Quoted Quoted Bid Price Ask Price Value of a British pound
in U.S. dollars $1.60 $1.61 Value of a Malaysian ringgit (MYR) in U.S. dollars
$.200 $.201 Value of a British pound in Malaysian ringgit (MYR) MYR8.10 MYR8.20 EXAMPLE
Chapter 7: International Arbitrage and Interest Rate Parity 193 Realignment Due to Triangular
Arbitrage. The realignment that results from the triangular arbitrage activity is summarized in
the second column of Exhibit 7.6. The realignment will likely occur quickly to prevent continued
benefi ts from triangular arbitrage. The discrepancies assumed here are unlikely to occur within
a single bank. More likely, triangular arbitrage would require three transactions at three
separate banks. If any two of these three exchange rates are known, the exchange rate of the
third pair can be determine(d) When the actual cross exchange rate differs from the appropriate
cross exchange rate, the exchange rates of the currencies are not in equilibrium. Triangular
arbitrage would force the exchange rates back into equilibrium. Like locational arbitrage,
triangular arbitrage is a strategy that few of us can ever take advantage of because the
computer technology available to foreign exchange dealers can easily detect misalignments in
cross exchange rates. The point of this discussion is that triangular arbitrage will ensure that
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 cross exchange rates are usually aligned correctly. If cross exchange rates are not properly
aligned, triangular arbitrage will take place until the rates are aligned correctly.
Exhibit 7.5 Example of Triangular Arbitrage Accounting for Bid/Ask Spreads Step 2: Exchange £
for MYR at MYR8.1 per £ (£6,211 MYR50,310) Step 1: Exchange $ for £ at
$1.61 per £ ($10,000 £6,211) Step 3: Exchange MYR for $ at $.20 per MYR (MYR50,310
$10,062) Malaysian Ringgit (MYR) British Pound ( £ ) U.S. Dollar ($) Exhibit 7.6 Impact of
Triangular Arbitrage Activity Impact 1. Participants use dollars to purchase Bank increases its
ask price of pounds with pounds. respect to the dollar. 2. Participants use pounds to purchase
Bank reduces its bid price of the British pound Malaysian ringgit. with respect to the ringgit; that
is, it reduces the number of ringgit to be exchanged per pound receive(d) 3.
Participants use Malaysian ringgit to Bank reduces its bid price of ringgit with purchase U.S.
dollars. respect to the dollar. 194 Part 2: Exchange Rate Behavior Covered Interest Arbitrage
The forward rate of a currency for a specifi ed future date is determined by the interaction of
demand for the contract (forward purchases) versus the supply (forward sales). Forward rates
are quoted for some widely traded currencies (just below the respective spot rate quotation) in
the Wall Street Journal. Financial institutions that offer foreign exchange services set the
forward rates, but these rates are driven by the market forces (demand and supply conditions).
In some cases, the forward rate may be priced at a level that allows investors to engage in
arbitrage. Their actions will affect the volume of orders for forward purchases or forward sales
of a particular currency, which in turn will affect the equilibrium forward rate. Arbitrage will
continue until the rate is aligned where it should be, and at that point arbitrage will no longer be
[Link] arbitrage process and its effects on the forward rate are described
next. Covered interest arbitrage is the process of capitalizing on the interest rate differential
between two countries while covering your exchange rate risk with a forward contract. The
logic of the term covered interest arbitrage becomes clear when it is broken into two parts:
“interest arbitrage” refers to the process of capitalizing on the difference between interest rates
between two countries; “covered” refers to hedging your position against exchange rate risk.
Covered interest arbitrage is sometimes interpreted to mean that the funds to be invested are
borrowed locally. In this case, the investors are not tying up any of their own funds. In another
interpretation, however, the investors use their own funds. In this case, the term arbitrage is
loosely defi ned since there is a positive dollar amount invested over a period of time. The
following discussion is based on this latter meaning of covered interest arbitrage; under either
interpretation, however, arbitrage should have a similar impact on currency values and interest
rates. You desire to capitalize on relatively high rates of interest in the United Kingdom and
have funds available for 90 days. The interest rate is certain; only the future exchange rate at
which you will exchange pounds back to U.S. dollars is uncertain.
You can use a forward sale of pounds to guarantee the rate at which you can exchange pounds
for dollars at a future point in time. This actual strategy is as follows: 1. On day 1, convert your
U.S. dollars to pounds and set up a 90-day deposit account in a British bank. 2. On day 1,
engage in a forward contract to sell pounds 90 days forwar(d) 3. In 90 days when the deposit
matures, convert the pounds to U.S. dollars at the rate that was agreed upon in the forward
contract.

• If the proceeds from engaging in covered interest arbitrage exceed the proceeds from investing
in a domestic bank deposit, and assuming neither deposit is subject to default risk, covered
interest arbitrage is feasible. The feasibility of covered interest arbitrage is based on the
interest rate differential and the forward rate premium. To illustrate, consider the following
numerical example. Assume the following information: • You have
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 $800,000 to invest. • The current spot rate of the pound is $1.60. • The 90-day forward rate of
the pound is $1.60. • The 90-day interest rate in the United States is 2 percent. • The 90-day
interest rate in the United Kingdom is 4 percent. EXAMPLE EXAMPL E EXAMPLE EXAMPL :
International Arbitrage and Interest Rate Parity 195 Based on this information, you should
proceed as follows: 1. On day 1, convert the $800,000 to £500,000 and deposit the £500,000 in
a British bank. 2. On day 1, sell £520,000 90 days forwar(d) By the time the deposit matures,
you will have £520,000 (including interest). 3. In 90 days when the deposit matures, you can
fulfill your forward contract obligation by converting your £520,000 into
$832,000 (based on the forward contract rate of $1.60 per pound).

• This act of covered interest arbitrage is illustrated in Exhibit 7.7. It results in a 4 percent return
over the 3-month period, which is 2 percent above the return on a U.S. deposit. In addition, the
return on this foreign deposit is known on day 1, since you know when you make the deposit
exactly how many dollars you will get back from your 90-day investment. Recall that locational
and triangular arbitrage do not tie up funds; thus, any profits are achieved instantaneously. In
the case of covered interest arbitrage, the funds are tied up for a period of time (90 days in our
example). This strategy would not be advantageous if it earned 2 percent or less, since you
could earn 2 percent on a domestic deposit. The term arbitrage here suggests that you can
guarantee a return on your funds that exceeds the returns you could achieve domestically.
Realignment Due to Covered Interest Arbitrage. As with the other forms of arbitrage, market
forces resulting from covered interest arbitrage will cause a market realignment. As many
investors capitalize on covered interest arbitrage, there is upward pressure on the spot rate and
downward pressure on the 90-day forward rate. Once the forward rate has a discount from the
spot rate that is about equal to the interest rate advantage, covered interest arbitrage will no
longer be feasible. Since the interest rate advantage of the British interest rate over the
U.S. Exhibit 7.7 Example of Covered Interest Arbitrage Day 1: Exchange $800,000 for£500,000
Day 1:Invest £500,000 in Deposit Earning 4% Day 1: Lock in Forward Sale of
£520,000 for 90 Days Ahead Day 90: Exchange £520,000 for $832,000 British Deposit Banks
That Provide Foreign Exchange Summary Initial Investment $800,000 Amount Received in 90
Days $832,000 Return over 90 Days 4% Investor 196 Part 2: Exchange Rate Behavior interest
rate is 2 percent, the arbitrage will no longer be feasible once the forward rate of the pound
exhibits a discount of about 2 percent. Assume that as a result of covered interest arbitrage,
the market forces caused the spot rate of the pound to rise to $1.62 and thatthe 90-day forward
rate of the pound declined to $1.5888. Consider the results from using
$800,000 (as in the previous example) to engage in covered interest arbitrage. 1. Convert
$800,000 to pounds: $800,000/$1.62 £493,827 2. Calculate accumulated pounds over 90 days
at 4 percent: £493,827 1.04 £513,580 3. Reconvert pounds to dollars (at the forward rate of
$1.5888) after 90 days: £513,580 $1.5888 $815,976 4. Determine the yield earned from covered
interest arbitrage: ($815,976 $800,000)/$800,000 .02, or 2% As this example shows, those
individuals who initially conduct covered interest arbitrage cause exchange rates and possibly
interest rates to move in such a way that future attempts at covered interest arbitrage provide a
return that is no better than what is possible domestically. Due to the market forces from
covered interest arbitrage, a relationship between the forward rate premium and interest rate
differentials should exist. This relationship is discussed shortly.

• Consideration of Spreads. One more example is provided to illustrate the effects of the spread
between the bid and ask quotes and the spread between deposit and loan rates. The following
exchange rates and one-year interest rates exist. Bid Quote Ask Quote Euro spot $1.12 $1.13
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 Euro one-year forward 1.12 1.13 Deposit Rate Loan Rate Interest rate on dollars 6.0% 9.0%
Interest rate on euros 6.5% 9.5% You have $100,000 to invest for one year. Would you benefit
from engaging in covered interest arbitrage? Notice that the quotes of the euro spot and
forward rates are exactly the same, while the deposit rate on euros is .5 percent higher than the
deposit rate on dollars. So it may seem that covered interest arbitrage is feasible.
However, U.S. investors would be subjected to the ask quote when buying euros (€) in the spot
market, versus the bid quote when selling the euros through a one-year forward contract.
Multinational Capital Budgeting
Complexities of Multinational CapitalBudgeting | Foreign Exchange
Multinational Corporation’s (MNCs) financial decisions are influenced by three types of economic
environments:
(a) Host country’s economic environment,
(b) Parent country’s economic environment, and International economic environment.
The influences of these three environments make the decisionmaking difficult and complex.
The main complexities are discussed below:
1. Complexities of Regulatory Environment:
The differences exist between the parent’s cash flow and the project’s cash flow because of
tax laws and other regulatory environment. For parent, the cash flows to the parent are
relevant because the shareholders expect higher rate of return. Therefore, it is necessary to
make a distinction between parent’s cash flow fromthat of the project.

2. Complexities Due to Type of Financing:

Parent’s cash flows depend on the form of financing that parent adopts to finance the project
(debt versus equity). Thus the parent’s cash flows cannot be separated from the financing
decisions.

3. Difficulty in Recognizing the Exact Remittances: Remittances to the parent must be explicitly
recognize(d) The differences in tax laws, and political systems, differences in financial markets
and institutions function, the cash flows to the parent tend to vary. These aspects are also
required to be considered while determining parent’s cash flows.

4. Difficultly in Anticipating Inflation Rates:

The rate of inflation in host country and parent country must also be anticipated to decide the
real return and exchange rate forecasts. Inflation also changes the competitive positron of the
product or service to be markete(d) If the cash flows arein different currencies,
the expected inflation rates are required to be forecasted forevaluating a project.

5. Difficulty in Anticipating Changes in Exchange Rate: The cash flow of the parent firm going to
be affected on account of change in the exchange rate between parent firm’s currency and
foreign subsidiary unit’s currency. Such changes in the exchange rate also affect the
competitive position of the parent firm, and in turn impact the long term cash flow of the
project.

6. Segmented Capital Markets:

Since the project is being implemented in a different country, therefore the capital markets are
segmented by space. Use of segmented capital markets may provide an opportunity or may
involve higher costs. The financing aspect has to be carefully examined, by considering the
regulating framework in respectivecountries.
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7. Subsidized Loans and Cost of Capital:
Uses of subsidized loans complicate both the capital structure and the ability to calculate
weighted average cost of capital for discounting purposes.

8. Evaluation of Political Risk:

For each project political risk must be evaluated, because the cash flows can be severely
affected by the changes in political environment. The changes in the government would
change the political philosophy thereby leading to new economic environment.
Extreme form of risk is the ‘risk of expropriation’ and repatriation. In the case ofexpropriation,
the projects and the parent’s cash flows
tend to change drastically because in this case the funds are blocked in the country of the
project.

9. Cash Flow Determination:

Like domestic capital budgeting decisions, foreign investment decisions require to be
evaluated on the basis of their cash flow requirements and their cash flow after taxation
(CFAT) generatingcapacity in the future years.
(a) At the Level of Subsidiary:
Assume that the subsidiary is an independent company and calculations are to be performed in
the local currency where the subsidiary is located, determination of cash outflows as well as
cash inflows related to the project is a simple exercise. In fact, it is similar to domestic
investment decisions.
Formats below (tables 13.1 and 13.2) elaborate the procedure to estimate thecash outflows and
cash inflowsrespectively:

(b) B: At the Level of Parent:

The parent firm makes investment in the form of FDI; hence the interested value would be
availability of prospective cash flow to be remitted to the parent firm. The cash flow after taxation
available tothe foreign subsidiary will not have importance.
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The difference between above two cash flows arises on account of tax regulations, exchange

controls, inflation and currency fluctuations. It is often customary to charge fees for technology
transfer, management or supervisory fees and royalties from the subsidiary unit. Though they are
treated as project expenses by the subsidiary, they in fact constitute returns (cash inflows) to the
parent MN(C)
Above all, a difference may also crop up if the project involves local production of products hitherto
exported by parent company to the host country. The difference may be favourable to parent MNC,
if the project can augment or promote sales of its other product(s), inhost country.
Table 13.3 enumerates a list of items pertaining to expected cash flows from the point of view of
parent MN(C)
The parent firm requires specific forecasts regarding the amounts and time period when such
remittances are expected to be received from the foreign subsidiary or affiliates. In addition, to the

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financial other benefits are available in the indirect formto the parent firm, like acquiring the better
knowledge about taste, fashion, and
attitude of market, habits and willingness to consume of foreigners,et(c)
Such knowledge and exposure supports the parent firm in future, to diversify in different product
groups, or to enter in to new market. It also supports them to strengthen their research and
developmental activities. For instance, some companies like to enter first into South-East Asia
before trying to establish a subsidiary in Japan or Chin(a)
Thus, evaluation of cash flows from the perspective of the parent firm should reckon factors such
as taxes, restrictions on repatriation of income, exchange rate risk, country risk (political and
economic risk) and so on.
Illustration 1:
FMC Lt(d) in India has plans to establish a project in a foreign location. Host country currency is
Dollar. Project details are givenbelow. Evaluate its acceptability.
1. Project:
Total cost is $ 24 Million. Life is three years. Scrap value is $ 6.8 Million. Operating cash flows
(PBDT) are $ 16.00 million per annum.
2. Funding:
(a) Local currency loan of $ 8 Million at 15%
(b) Domestic currency Loan of Rupees 6 Million at 9.5%Domestic funds byway of retained
earnings Rupees 2 Million
(c) Debt capacity of project fully utilised
1. Project Risk:
FMC has determined the asset beta for the project at 1.40
2. Market Information:
Risk free return in India presently is 6%, and the return on NSEmarker index is 16%.
3. Taxation:
Domestic Indian corporate tax rate presently is 35%. Tax is paid one year in arrears. Host
country taxation rate is 20% for operating activities and 40% for capital gain. This tax is paid
immediately, in the same year in which the tax dues arise.
4. Other Areas:
(a) Depreciation expenses straight line basis i.e., 100% of value depreciated ignoring scrap
value, over the life of the project and
(b) Interest expenses, are both tax deductible in host country

1. Repatriation:
Host country, restricts remittances to investor-parent only to the extent of 50% of accounting
profits computed as “after interest payment, but before tax”. Amounts withheld should be
placed in special deposit account carrying 5% interest, until it becomes eligible to be
repatriated after the project life tenor of three yearsover.
2. Current Spot Rate:Rupee is 0.50 = $ 1 (Indirect quote being $2 = Rs.1)
3. Expectations of Future Spot Rates:
The one-year forward rote is 0.4762.

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Solution:
Step 1. Basic Computations:
(a) Assuming that project is entirely equity financed, Base Case discount rate, applied in India
using CAPM would be = Rf + Beta(Rm-Rf) = 6 + 1.40 × {16-6} = 20%
(b) Using Interest rate parity theory, the comparable base Case discount rate in host country
would be:
1 + Rh/1 + Rf = F/S = 1.20/1 + Rf = 0.4762/0.5000
... 1.26 = 1 + 2f = ... Rf = 26%

(a) Cash inflow on sale of scrap:

(b) Assuming that project all equity financed, project evaluation datawould be:Step i: Investor-
Parent Cash Analysis – Relevant CashFlows:

(For evaluating returns in host country dollars, a discount rate of 26% is applie(d) Item f and item j
are the remittable funds)
Step ii: Present Value of Side-effects of Financing:
(a) Tax relief on host country loan of – $ 8.00 Million (@15%)Interest per annum: – $1.20 Million
(b) Annual tax savings at 20% – $ 0.24 Million
Tax savings cannot be remitted to India for three years. Hencewill beinvested at 5% annually
(c) Interest payment on host-country loan $ 8.00 million @ 15% will lead to reducing accounting

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 profit, and increasing the non- remittable fund to the extent of 50% of interest. Cash flow
impact ofthis aspect has to be evaluate(d)
(d) PV of increased terminal cash flow to investor-parent, attributable to investment of blocked
funds at 5% ($600,000)

Applying an effective multiplication factor of 3.1525 (FVIA5/3) –

$18,91,500
Present value discount factor at 15% for 3rd year – 0.6575 Present value of this cash flow –
$12,43,662
At 0.50 this equals – Rs.6,21,831
Present value of Tax relief on Rupee loa

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Step iii: Computing Adjusted Present Value:

Conclusion:
(a) Project evaluation in the normal course, adopting an adjusted discount rate of 26%, yields a
negative NPV.
(b)However, if all the side effects are taken into account, and the presentvalues adjusted suitably,
the project is seen to be worthwhile.
(c) Recommend that project be accepted subject to other non- financial factors, including political
risks, being equally acceptable.
Adjusted Present Value (APV) Criteria:

The adjusted present value of a foreign project is given by:

where:
APV = Adjusted Present Value.
So = Current exchange rate.
Co = Initial cash outlay in foreign currency [Link] = Activated funds.
St* = Expected exchange rate at time ‘t’.n = Life of the project.
Ct* = Excepted cash flow at time ‘t’, in foreign currency terms.
Et* = Expected effect on the cash flows of other divisions at time ‘t’, expressed in domestic
currency terms; can be either positive or negative.
T = Domestic or foreign tax rate, whichever is higher.
Dt = Depreciation in home currency terms at time ‘t’. (If the depreciation is not allowed to be set-off
566
by the parent company against its own profits, it needs to be define in foreign currency terms with
its present value being converted at So intodomesticcurrency terms).
Bo = Contribution of the project to borrowing capacity of the parentfirm,
r = Domestic interest rate.
CLo = Amount of concessional loan received in foreign currency. Rt = Repayment of concessional
loan at time ‘t’.
Pt = Expected savings at time ‘t’ from inter-subsidiary transferpricing.
It = Illegally repatriated cash flows at time ‘t’.
Ke = All-equity discount rate, reflecting all systematic risks, including country risk and exchange-
rate risk.
Kd = Discount rate for depreciation allowances.
Kb = Discount rate for tax savings from generation of borrowingcapacity.
Kc = Discount rate for savings due to concessionary loans, generally the interest rate in the
absence of concessionary loans.
Kp = Discount rate for savings through transfer [Link] = Discount rate for illegal transfers.
The last term in the equation requires some explanation. A project may be unviable despite the use
of all the possible ways of legally repatriating a subsidiary’s profits. Under such conditions, the
parent company may resort to use illegal ways of remitting these profits. In such a situation, these
illegal cash flows should also be taken into account while evaluating the project.

Discount Rate:
The ke is the all-equity discount rate, reflecting a premium for all systematic risks, including
country-risk and exchange-risk. The discount rate also reflects the riskimpact due to the portfolio
effect,
i.e., due to the imperfect correlation between returns from thevarious markets.
The presence of inflation makes the choice between the real and the nominal rate of discount, very
crucial. It is basic principle of financial management to match nominal cash flows with a nominal
discount rate, and real cash flows with a real discount rate.
To match cash flows with the appropriate discount rate, it becomes essential to analyse the nature
of the cash flow. If the future cash flow is predetermined, or contractual in nature (e.g.,
depreciation allowance, or pre-contracted sales at a pre- determined price), then the nominal
discount rate should be used as the cash flows would beexpressed in nominal terms.
If the future cash flows need to be estimated, then either real cash flow can be estimated and
discounted at the real discount rate, or the inflation estimates can be built into the cash flows
which wouldthen be discounted at nominal discount rates.

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1. Which of the Following Issue is NOT Covered By ‘Investment’ Area of Finance?
(a) Best Mixture of Financial Investment
(b) International Aspects of Corporate Finance
(c) Associated Risks and Rewards
(d) Pricing Financial Assets
2. Financial Policy is Evaluated by Which of the Following?
(a) Profit Margin
(b) Total Assets Turnover
(c) Debt-Equity Ratio
(d) None of the Above
3. Cash Flow From Assets Involves Which of the Following Component(s)?
(a) Operating Cash Flow
(b) Capital Spending
(c) Change in Net Working Capital
(d) All of the Above
4. Which of the Following Refers to the Cash Flows that Result From the Firm’s Day-Today
Activities of Producing and Selling?
(a) Operating Cash Flows
(b) Investing Cash Flows
(c) Financing Cash Flows
(d) All of the Above
5. Finance is Vital for Which of the Following Business Activity (Activities)?
(a) Marketing Research
(b) Product Pricing
(c) Design of Marketing and Distribution Channels
(d) All of the Above
6. Which of the Following Costs are Reported On the Income Statement as the Cost of Goods
Sold?
(a) Product Cost
(b) Period Cost
(c) Both Product Cost and Period Cost
(d) Neither Product Cost Nor Period Cost
7. Standard Company had Net Sales of Rs.750,000 Over the Past year. During that Time, Average
Receivables were Rs.150,000. Assuming a 365-Day year, What was the Average Collection
Period?
(a) 5 Days
(b) 36 Days
(c) 48 Days
(d) 73 Days
8. Which of the Following Terms Refers to the Use of Debt Financing?
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 (a) Operating Leverage
(b) Financial Leverage
(c) Manufacturing Leverage
(d) None of the Above
9. In Which Type of Market, New Securities are Traded?
(a) Primary Market
(b) Secondary Market
(c) Tertiary Market
(d) None of the Above
10. Which of the Following Ratios is Particularly Interesting to Short-Term Creditors?
(a) Liquidity Ratios
(b) Long-Term Solvency Ratios
(c) Profitability Ratios
(d) Market value Ratios
11. _____________Shows the Sources From Which Cash has Been Generated and How it has Been
Spent During Period of Time?
(a) Income Statement
(b) Balance Sheet
(c) Cash Flow Statement
(d) Owner’s Equity Statement
12. Quick Ratio is Also Known As:
(a) Current Ratio
(b) Acid-Test Ratio
(c) Cash Ratio
13. Of the Following Statement Measures Performance Over a Specific Period of Time?
(a) Income Statement
(b) Balance Sheet
(c) Cash Flow Statement Retained
(d) Earnings Statement
14. A Portion of Profits, Which a Company Retains Itself for Further Expansion, is Known As:
(a) Dividends
(b) Retained Earnings
(c) Capital Gain
(d) None of the Above
15. 19. Which of the Following Statement Shows Assets, Liabilities, and Net Worth as of a Specific
Date?
(a) Income Statement
(b) Balance Sheet
(c) Owner’s Equity Statement

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 (d) Cash Flow Statement
16. Which One of the Following is NOT a Liquidity Ratio?
(a) Current Ratio
(b) Quick Ratio
(c) Cash Coverage Ratio
(d) Cash Ratio
17. Which of the Following Ratio Gives an Idea as to How Efficient Management is At Using Its
Assets to Generate Earnings?
(a) Profit Margin
(b) Return On Assets
(c) Return On Equity
(d) Total Assets Turnover
18. Which of the Following is an Example of Capital Spending?
(a) Purchase of Fixed Assets
(b) Decrease in Net Working Capital
(c) Increase in Net Working Capital
(d) None of the Above
19. Which of the Following is Measured By Profit Margin?
(a) Operating Efficiency
(b) Asset Use Efficiency
(c) Financial Policy
(d) Dividend Policy
20. Which of the Following Make a Broader Use of Accounting Information?
(a) Accountants
(b) Financial Analysts
(c) Auditors Marketers
21. Which of the Following Set of Ratios is Used to Assess a Business's Ability to Generate
Earnings as Compared to Its Expenses and Other Relevant Costs Incurred During a Specific
Period of Time?
(a) Liquidity Ratios
(b) Leverage Ratios
(c) Profitability Ratios
(d) Market value Ratios
22. A Company Having a Current Ratio of 1 will have Net Working Capital.
(a) Positive
(b) Negative
(c) Zero
(d) None of the Above
23. Which of the Following is Not a Form of Business Organization?
(a) Sole Proprietorship
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 (b) Partnership
(c) Joint Stock Company
(d) Cooperative Society
24. Which of the Following Ratios are Intended to Address the Firm’s Financial Leverage?
(a) Liquidity Ratios
(b) Long-Term Solvency Ratios
(c) Asset Management Ratios
(d) Profitability Ratios
25. The Accounting Definition of Income Is:
(a) Income = Current Assets – Current Liabilities
(b) Income = Fixed Assets – Current Assets
(c) Income = Revenues – Current Liabilities
(d) Income = Revenues – Expenses
26. Which of the Following Item(s) Is (are) Not Included While Calculating Operating Cash Flows?
(a) Depreciation
(b) Interest
(c) Expenses Related to Firm’s Financing of Its Assets
(d) All of the Above
27. In Which Type of Market, Used Securities are Traded?
(a) Primary Market
(b) Secondary Market
(c) Tertiary Market
(d) None of the Above
28. Which of the Following is (Are) a Non-Cash Item(s)?
(a) Revenue
(b) Expenses
(c) Depreciation
(d) All of the Above
29. What will Be the Coupon value of a Rs.1,000 Face-Value Bond with a 10% Coupon Rate?
(a) Rs.100
(b) Rs.510
(c) Rs.1,000
(d) Rs.1,100
30. Which of the Following Comes Under the Head of Discounted Cash Flow Criteria for Capital
Budgeting Decisions?
(a) Payback Period
(b) Net Present Value
(c) Average Accounting Return
(d) None of the Above
31. Period Costs Include Which of the Following?
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 (a) Selling Expense
(b) Raw Material
(c) Direct Labor
(d) Manufacturing Overhead
32. The value of Net Working Capital will Be Greater Than Zero When:
(a) Current Assets > Current Liabilities
(b) Current Assets < Current Liabilities
(c) Current Assets = Current Liabilities
(d) None of the Above
33. According to Du Pont Identity, ROE is Affected By Which of the Following?
(a) Operating Efficiency
(b) Asset Use Efficiency
(c) Financial Leverage
(d) All of the Above
34. Balance Sheet for a Company Reports Current Assets of Rs.700,000 and Current Liabilities of
Rs.460,[Link] Would Be the Quick Ratio for the Company If There is an Inventory Level of
Rs.120,000?
(a) 1.01
(b) 1.26
(c) 1.39
(d) 1.52
35. Standard Corporation Sold Fully Depreciated Equipment for Rs.5,000. This Transaction will Be
Reported On the Cash Flow Statement as a(n):
(a) Operating Activity
(b) Investing Activity
(c) Financing Activity
(d) None of the Above
36. Balance Sheet for a Company Reports Current Assets of Rs.700,000 and Current Liabilities of
Rs.460,[Link] Would Be the Current Ratio for the Company If There is an Inventory Level of
Rs.120,000?
(a) 1.01
(b) 1.26
(c) 1.39
(d) 1.52
37. In Which Type of Business, All Owners Share in Gains and Losses and All have Unlimited Liability
for All Business Debts?
(a) Sole-Proprietorship
(b) General Partnership
(c) Limited Partnership
(d) Corporation
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38. A Firm Uses Cash to Purchase Inventory, Its Current Ratio Will:
(a) Increase
(b) Decrease
(c) Remain Unaffected
(d) Become Zero
39. Which of the Following is an Example of Positive Covenant?
(a) Maintaining Any Collateral Or Security in Good Condition
(b) Limiting the Amount of Dividend According to Some Formula
(c) Restricting Pledging Assets to Other Lenders
(d) Barring Merger with Another Firm
40. Which of the Following Refers to the Difference Between the Sale Price and Cost of Inventory?
(a) Net Loss
(b) Net Worth
(c) Markup
(d) Markdown
41. Which of the Following Allows a Company to Repurchase Part Or All of the Bond Issue At a
Stated Price?
(a) Repayment
(b) Seniority
(c) Call Provision
(d) Protective Covenants
42. Which of the Following is a Cash Flow From Financing Activity?
(a) Cash Outflow to the Government for Taxes
(b) Cash Outflow to Shareholders as Dividends
(c) Cash Outflow to Lenders as Interest
(d) Cash Outflow to Purchase Bonds Issued By Another Company
43. Which of the Following Form of Business Organization is Least Regulated?
(a) Sole-Proprietorship
(b) General Partnership
(c) Limited Partnership
(d) Corporation
44. The Principal Amount of a Bond At Issue is Called:
(a) Par Value
(b) Coupon Value
(c) Present value of an Annuity
(d) Present value of a Lump Sum
45. Which of the Following Item Provides the Important Function of Shielding Part of Income From
Taxes?
(a) Inventory
(b) Supplies
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 (c) Machinery
(d) Depreciation
46. A Firm Reports Total Liabilities of Rs.300,000 and Owner’s Equity of Rs.500,[Link] Would Be
the Total Worth of the Firm’s Assets?
(a) Rs.300,000
(b) Rs.500,000
(c) Rs.800,000
(d) Rs.1,100,000
47. Which of the Following Forms of Business Organizations is Created as a Distinct Legal Entity
Owned By One Or More Individuals Or Entities?
(a) Sole-Proprietorship
(b) General Partnership
(c) Limited Partnership
(d) Corporation
48. In Which Form of Business, Owners have Limited Liability.
(a) Sole Proprietorship
(b) Partnership
(c) Joint Stock Company
(d) None of the Above
49. Which of the Following Equation is Known as Cash Flow (CF) Identity?
(a) CF From Assets = CF to Creditors – CF to Stockholder
(b) CF From Assets = CF to Stockholders – CF to Creditors
(c) CF to Stockholders = CF to Creditors + CF From Assets
(d) CF From Assets = CF to Creditors + CF to Stockholder
50. The Difference Between Current Assets and Current Liabilities is Known As:
(a) Surplus Asset
(b) Short-Term Ratio
(c) Working Capital
(d) Current Ratio
51. Which of the Following Statement is Considered as the Accountant’s Snapshot of Firm’s
Accounting value as of a Particular Date?
(a) Income Statement
(b) Balance Sheet
(c) Cash Flow Statement
(d) Retained Earning Statement
52. Which of the Following Statement About Bond Ratings is TRUE?
(a) Bond Ratings are Typically Paid for By a Company’s Bondholders.
(b) Bond Ratings are Based Solely On Information Acquired From Sources Other Than the Bond
Issuer.
(c) Bond Ratings Represent an Independent Assessment of the Creditworthiness of Bonds.
(d) None of the Above
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53. Which of the Following is the Acronym for GAAP?
(a) Generally Applied Accountability Principles
(b) General Accounting Assessment Principles
(c) Generally Accepted Accounting Principles
(d) General Accepted Assessment Principles
54. A Firm has Paid Out Rs.150,000 as Dividends From Its Net Income of Rs.250,000. What is the
Retention Ratio for the Firm?
(a) 12 %
(b) 25 %
(c) 40 %
(d) 60 %
55. A Portion of Profits, Which a Company Distributes Among Its Shareholders, is Known As:
(a) Dividends
(b) Retained Earnings
(c) Capital Gain
(d) None of the Above
56. Which of the Following is (are) the Basic Area(s) of Finance?
(a) Financial Institutions
(b) International Finance
(c) Investments
(d) All of the Above
57. Which of the Following Ratios is NOT From the Set of Asset Management Ratios? Inventory
(a) Turnover Ratio
(b) Receivable Turnover
(c) Capital Intensity Ratio
(d) Return On Assets
58. You Just Won a Prize, You Can Either Receive Rs.1000 Today Or Rs.1,050 in One year. Which
Option Do You Prefer and Why If You Can Earn 5 % On Your Money?
(a) Rs.1,000 Because it has the Higher Future Value
(b) Rs.1,000 Because You Receive it Sooner
(c) Rs.1,050 Because it is More Money
(d) Either Because Both Options are of Equal Value
59. You Need Rs.10,000 to Buy a New Television. If You have Rs.6,000 to Invest At 5% Compounded
Annually, How Long will You have to Wait to Buy the Television?
(a) 8.42 years
(b) 10.51 years
(c) 15.75 years
(d) 18.78 years
60. Which of the Following is an Example of Positive Covenant?
(a) Maintaining Firm’s Working Capital At Or Above Some Specified Minimum Level

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 (b) Furnishing Audited Financial Statements Periodically to the Lender
(c) Maintaining Any Collateral Or Security in Good Condition
(d) Restricting Selling Or Leasing Assets
61. Which of the Following is Measured By Retention Ratio?
(a) Operating Efficiency
(b) Asset Use Efficiency
(c) Financial Policy
(d) Dividend Policy
62. Product Costs Include Which of the Following?
(a) Selling Expenses
(b) General Expenses
(c) Manufacturing Overhead
(d) Administrative Expenses
63. An Account was Opened with an Investment of Rs.3,000 Ten years Ago. The Ending Balance in
the Account is Rs.4,100. If Interest was Compounded, How Much Compounded Interest was
Earned?
(a) Rs.500
(b) Rs.752
(c) Rs.1,052
(d) Rs.1,100
64. What is the Effective Annual rate of 7 % Compounded Monthly?
(a) 7.00 %
(b) 7.12 %
(c) 7.19 %
(d) 7.23 %
65. Which of the Following Cash Flow Activities are Reported in the Cash Flow Statement and
Income Statement?
(a) Operating Activities
(b) Investing Activities
(c) Financing Activities
(d) All of the Above
66. Which of the Following Term Refers to Establishing a Standard to Follow for Comparison?
(a) Benchmarking
(b) Standardizing
(c) Comparison
(d) Evaluation
67. Rule of 72 for Finding the Number of Periods is Fairly Applicable to Which of the Following
Range of Discount Rates?
(a) 2% to 8%

576
 (b) 4% to 25%
(c) 5% to 20%
(d) 10% to 50%
68. Which of the Following Refers to a Conflict of Interest Between Principal and Agent?
(a) Management Conflict
(b) Interest Conflict
(c) Agency Problem
(d) None of the Above
69. Which of the Following is a Series of Constant Cash Flows that Occur At the End of Each Period
for Some Fixed Number of Periods?
(a) Ordinary Annuity
(b) Annuity Due
(c) Perpetuity
(d) None of the Above
70. Which of the Following is NOT an External Use of Financial Statements Information?
(a) Evaluation of Credit Standing of New Customer
(b) Evaluation of Financial Worth of Supplier
(c) Evaluation of Potential Strength of the Competitor
(d) Evaluation of Performance Through Profit Margin and Return On Equity
71. If a Firm has a ROA of 8 %, Sales of Rs.100,000, and Total Assets of Rs.75,000. What is the
Profit Margin?
(a) 4.30%
(b) 6.00%
(c) 10.70%
(d) 16.73%
72. Which of the Following is the Process of Planning and Managing a Firm’s Long Term
Investments?
(a) Capital Structuring
(b) Capital Rationing
(c) Capital Budgeting
(d) Working Capital Management
73. Mr. Y and Mr. Z are Planning to Share Their Capital to Run a Business. They are Going to
Employ Which of the Following Type of Business?
(a) Sole-Proprietorship
(b) Partnership
(c) Corporation
(d) None of the Above
74. If You have Rs.30 in Asset A and Rs.120 in Another Asset B, the Weights for Assets a and B will
Be and Respectively.
(a) 20%; 80%
(b) 37%; 63%
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 (c) 63%; 37%
(d) 80%; 20%
75. When Corporations Borrow, They Generally Promise To: I. Make Regular Scheduled Interest
Payments II. Give the Right of Voting to Bondholders III. Repay the Original Amount Borrowed
(Principal) IV. Give an Ownership Interest in the Firm
(a) I and II
(b) I and III
(c) II and IV
(d) I, III, and IV
76. Which of the Following is NOT Included in a Bond Indenture?
(a) The Basic Terms of Bond Issue
(b) The Total Amount of Bonds Issued
(c) A Personal Profile of the Issuer
(d) A Description of the Security
77. What Would Be the Present value of Rs.10,000 to Be Received After 6 years At a Discount rate
of 8 %?
(a) Rs.6,302
(b) Rs.9,981
(c) Rs.14,800
(d) Rs.15,869
78. Which of the Following Statement is TRUE Regarding Debt?
(a) Debt is an Ownership Interest in the Firm.
(b) Unpaid Debt Can Result in Bankruptcy Or Financial Failure.
(c) Debt Provides the Voting Rights to the Bondholders.
(d) Corporation’s Payment of Interest On Debt is Fully Taxable.
79. The Preferred Stock of a Company Currently Sells for Rs.25 Per Share. The Annual Dividend of
Rs.2.50 is Fixe(d) Assuming a Constant Dividend Forever, What is the rate of Return On this
Stock?
(a) 5.00 %
(b) 7.00 %
(c) 8.45 %
(d) 10.0 %
80. The Coupon rate of a Floating-Rate Bond is Capped and Upper and Lower Rates are Called:
(a) Float
(b) Collar
(c) Limit
(d) Surplus
81. Which of the Following Strategy Belongs to Restrictive Policy Regarding Size of Investments in
Current Assets?
(a) To Maintain a High Ratio of Current Assets to Sales

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 (b) To Maintain a Low Ratio of Current Assets to Sales
(c) To Less Short-Term Debt and More Long-Term Debt
(d) To More Short-Term Debt and Less Long-Term Debt
82. Which of the Following Terms Refers to the Costs to Store and Finance the Assets?
(a) Carrying Costs
(b) Shortage Costs
(c) Storing Costs
(d) Financing Costs
83. Which One of the Following Statement is INCORRECT Regarding MACRS Depreciation?
(a) Every Asset is Assigned to a Particular Class Which Establishes Asset’s Life for Tax
Purposes.
(b) Depreciation is Computed for Each year By Multiplying the Cost of the Asset By a Fixed
%Age.
(c) Annual Depreciation Remains Constant Every year Even By Using Different Rates.
(d) The Expected Salvage value and the Actual Expected Economic Life are Not Explicitly
Considered in Calculation of Depreciation.
84. Which of the Following Statement is CORRECT Regarding Compound Interest?
(a) It is the Most Basic Form of Calculating Interest.
(b) It Earns Profit Not Only On Principal But Also On Interest.
(c) It is Calculated By Multiplying Principal By rate Multiplied By Time.
(d) It Does Not Take into Account the Accumulated Interest for Calculation.
85. Mr. A has Just Recently Started a Business By Investing a Capital of Rs.500,000. He will Be the
Only Owner of the Business and Also Enjoy All the Profits of the Business. Which Type of
Business is Being Employed By Mr. A?
(a) Sole-Proprietorship
(b) Partnership
(c) Corporation
(d) None of the Above
86. Time value of Money is an Important Finance Concept Because:
(a) It Takes Risk into Account
(b) It Takes Time into Account
(c) It Takes Compound Interest into Account
(d) All of the Above
87. One Would Be Indifferent Between Taking and Not Taking the Investment When:
(a) NPV is Greater Than Zero
(b) NPV is Equal to Zero
(c) NPV is Less Than Zero
(d) All of the Above
88. Which of the Following is NOT a Shortcoming of Payback Rule?
(a) Time value of Money is Ignored

579
 (b) It Fails to Consider Risk Differences
(c) Simple and Easy to Calculate
(d) None of the Above
89. Business Risk Depends On Which of the Following Risk of the Firm’s Assets?
(a) Systematic Risk
(b) Diversifiable Risk
(c) Unsystematic Risk
(d) None of the Above
90. Which of the Following Type of Risk Can Be Eliminated ByDiversification?
(a) Systematic Risk
(b) Market Risk
(c) Unsystematic Risk
(d) None of the Above
91. Which of the Following Measure Reveals How Much Profit a Company Generates with the
Money Shareholders have Invested?
(a) Profit Margin
(b) Return On Assets
(c) Return On Equity
(d) Debt-Equity Ratio
92. Which of the Following is the Return that Firm’s Creditors Demand On New Borrowings?
(a) Cost of Debt
(b) Cost of Preferred Stock
(c) Cost of Common Equity
(d) Cost of Retained Earnings
93. Systematic Risk is Also Known As:
(a) Diversifiable Risk
(b) Market Risk
(c) Residual Risk
(d) Asset-Specific Risk
94. ABC Corporation has Two Shareholders; Mr. Aamir with 50 Shares and Mr. Imran with 70
Shares. Both Want to Be Elected as One of the Four Directors But Mr. Imran Doesn’t Want Mr.
Aamir to Be Director. How Much Votes Would Mr. Aamir Be Able to Cast as Per Cumulative
Voting Procedure?
(a) 70
(b) 120
(c) 200
(d) 280
95. The Difference Between the Return On a Risky Investment and that On a Risk-FreeInvestment.
(a) Risk Return
(b) Risk Premium

580
 (c) Risk Factor
(d) None of the Above
96. A Group of Assets Such as Stocks and Bonds Held By an Investor is Called:
(a) Portfolio
(b) Capital Structure
(c) Budget
(d) None of the Above
97. If the Variance Or Standard Deviation is Larger Than the Spread, Returns will Be:
(a) Less
(b) More
(c) Same
(d) None of the Above
98. The Following Risk is Entirely Wiped Out By Diversification.
(a) Systematic Risk
(b) Unsystematic Risk
(c) Portfolio Risk
(d) Total Risk
99. The Objective for Using the Concept of Diversification is To:
(a) Minimize the Risk
(b) Maximize the Return
(c) A & B
(d) None of the Above
100. While Studying the Relationship in Risk and Return, it is Commonly Known That:
(a) Higher the Risk, Lower the Return
(b) Lower the Risk, Higher the Return
(c) Higher the Risk, Higher the Return
(d) None of the Above
101. This Type of Risk Affects Almost All Types of Assets.
(a) Systematic Risk
(b) Unsystematic Risk
(c) Total Risk
(d) Portfolio Risk
Suppose You Bought 1,500 Shares of a Corporation At Rs.25 Each. After a year, You Received
Rs.3000 (Rs.2 Per Share) in Dividends. At the End of year the Stock Sells For Rs.30 Each. If You
Sell the Stock At the End of the year, Your Total Cash Inflow will Be Rs.48,000 (1500 Shares @
30 Each = Rs.45000 & Dividend = 3000).

102. According to the Given Data, the Capital Gain will Be:
(a) 10,500
(b) 7,500
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 (c) 10,000
(d) 7,000
103. According to the Given Data, the Dividend Yield will Be:
(a) 8.50 %
(b) 6.25%
(c) 8.00%
(d) 6.67%
104. According to the Given Data, Total %Age Returns will Be:
(a) 20%
(b) 28%
(c) 32%
(d) 35%
105. Which One of the Given Options Involves the Sale of New Securities From the Issuing Company
to General Public?
(a) Secondary Market
(b) Primary Market
(c) Capital Market
(d) Money Market
106. In Financial Statement Analysis, Shareholders Focus will Be On The:
(a) Liquidity of the Firm
(b) Long Term Cash Flow of the Firm
(c) Profitability and Long-Term Health of the Firm
(d) Return On Investment
107. The Statement of Cash Flows Helps Users to Assess and Identify All of the Following Except:
The
(a) Impact of Buying and Selling Fixed Assets.
(b) The Company's Ability to Pay Debts, Interest and Dividends.
(c) A Company's Need for External Financing.
(d) The Company's Reliance On Capital Leases.
108. Suppose Younas Corporation has Balance of Merchandise of 5000 Units. It Wants to Sell 2000
Units At 90% of Its Cost On Cash. What Would Be the Effect of this Transaction On the Current
Ratio?
(a) Fall
(b) Rise
(c) Remain Unchanged
(d) None of the Given Option
109. If the Interest rate is 18% Compounded Quarterly, What Would Be the 8-Year Discount Factor?
(a) 1.42215
(b) 2.75886
(c) 3.75886
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 (d) 4.08998
110. You have a Cash of Rs.150, 000. If a Bank Offers Four Different Compounding Methods for
Interest, Which Method Would You Choose to Maximize the value of Your Rs.150, 000?
(a) Compounded Daily
(b) Compounded Quarterly
(c) Compounded Semiannually
(d) Compounded Annually
111. Ali Corporation has a Cash Coverage Ratio of 6.5 Times. Whereas Its Earning Before Interest
and Tax is Rs.750 Million and Interest On Long Term Loan is Rs.160 Million. What Would Be the
Annual Depreciation for the Current year?
(a) Rs.200 Million
(b) Rs.240 Million
(c) Rs.275 Million
(d) Rs.290 Million
112. Suppose RZ Corporation Sales for the year are Rs.150 Million. Out of this 20% of the Sales are
On Cash Basis While Remaining Sales are On Credit Basis. The Past Experience Revealed that
the Average Collection Period is 45 Days. What Would Be the Receivable Turnover Ratio?
(a) Times
(b) 7.11 Times
(c) 8.11 Times
(d) Times
113. A Bank Offers 20% Compounded Monthly. What Would Be the Effective Annual Rates of Return?
(a) 20.00%
(b) 20.50%
(c) 21.00%
(d) 21.99%
114. Nz Corporation Reported Earnings Before Interest and Taxes of Rs.500, 000 for the Current
year. it has Taken a Long Term Loan of Rs.2 Million From a Local Bank @ 10% Interest. The Tax
is Charged At the rate of 32%.What will Be the Saving in Taxes Due to Presence of Debt
Financing in the Capital Structure of theFirm?
(a) Rs.60, 000
(b) Rs.64, 000
(c) Rs.72, 000
(d) Rs.74, 000
115. Ntp Corporation has Decided to Pay Rs.16 Per Share Dividend Every year. If this Policy is to
Continue Indefinitely, Then the value of a Share of Stock Would Be , If the Required rate of
Return is 25%?
(a) Rs.60
(b) Rs.64
(c) Rs.68

583
 (d) Rs.74
116. MT Corporation has a Previous year Dividend of Rs.14 Per Share Where as Investors Require a
17% Return On the Similar [Link] Company’s Dividend Grows By 7%.The Price Per Share in
this Case Would Be.
(a) Rs.149.8
(b) Rs.184.9
(c) Rs.198.4
(d) Rs.229.9
117. RTU Corporation Stock is Selling for Rs.150 Per Share. The Next Dividend is Rs.35 Per Share
and it is Expected to Grow 14% More Or Less Indefinitely. What Would Be the Return Does this
Stock Offer You If this is Correct?
(a) 17%
(b) 27%
(c) 37%
(d) 47%
118. Suppose a Corporation has 3 Shareholders; [Link] with 25 Shares, Mr. Kareem with 35
Shares, and [Link] with 40 Shares. Each Wants to Be Elected as One of the Six Directors.
According to Cumulative Voting Rule [Link] Would Cast
(a) 150 Votes
(b) 210 Votes
(c) 240 Votes
(d) 300 Votes
119. is the Market in Which Already Issued Securities are Traded Among Investors.
(a) Primary Market
(b) Secondary Market
(c) Financial Market
(d) Capital Market
120. Suppose Mehran Corporation is Dealing in the Automobile Industry. Based On Projected Costs
and Sales, it Expects that the Cash Flows Over the 3-Year Life of the Project will Be Rs.5,
000,000 in First year, Rs.7, 000,000 in the Next year and Rs.8,000,000 in the Last year. This
Project Would Cost About Rs.10,000,000. The Net Present value of the Project Would Be , If
Discount rate is Assumed to Be 25%.
(a) Rs.2, 060,800
(b) Rs.3, 060,800
(c) Rs.1, 576, 000
(d) Rs.4, 060,800
121. The Projects Costs are Rs.1 5,000,000. The Payback Period for this InvestmentWould Be .
(a) years
(b) years
(c) years
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 (d) years
122. Suppose Z Corporation, has the Present value of Its Future Cash Flows is Rs.450,000 and the
Project has a Cost of Rs.300, 000, Then the Profitability Index Would Be .
(a) 0.667
(b) 1.00
(c) 1.25
(d) 1.50
123. Fee Paid to the Consultant for Evaluating the Project is an Example of .
(a) Opportunity Cost
(b) Sunk Cost
(c) Decremented Cost
(d) None of the Given Option
124. If the Sales of the AB Corporation is Rs.20, 000,000 Where as Its Cost is Rs.12, 000,000 During
the Same Perio(d) Assume the Annual Tax rate is 37%. Its Annual Depreciation is Rs.5, 000,
[Link] Operating Cash Flow of the Organization Would Be .
(a) Rs.3,810,000
(b) Rs.4,810,000
(c) Rs.5,190,000
(d) Rs.6,890,000
125. Treasury Notes and Bonds Are:
(a) Default Free
(b) Taxable
(c) Highly Liquid
(d) All of the Above
126. The Difference Between an Investment’s Market value and Its Cost is Called the of the
Investment.
(a) Net Present Value
(b) Economic Value
(c) Book Value
(d) Future Value
127. When Real rate is High, All the Interest Rates Tendto Be .
(a) Higher
(b) Lower
(c) Constant
(d) None of the Above
128. is a Grant of Authority By a Shareholder to Someone Else to Vote the Shareholder’s Share.
(a) Cumulative Voting
(b) Straight Voting
(c) Proxy Voting

585
 (d) None of the Above
129. The Payment of the Dividend is At the Discretion of The:
(a) Chairman
(b) Board of Directors
(c) Shareholders
(d) Stakeholders
130. Based On the Investment is Accepted If the Exceeds the Required Return. it Should Be Rejected
Otherwise.
(a) Profitability Index
(b) Payback Period
(c) Internal rate of Return
(d) Net Present Value
131. If Two Investments are Mutually Exclusive, Then Taking One of Them Means That:
(a) We Cannot Take the Other One
(b) The Other is Pending for the Next Period
(c) The Projects are Independent
(d) None of the Above
132. Profitability Index (PI) Rule is to Take an Investment, If the Index Exceeds :
(a) -1
(b) 0
(c) 1
(d) All of the Above
133. Average Accounting Return is a Measure of Accounting Profit Relative To:
(a) Book Value
(b) Intrinsic Value
(c) Cost
(d) Market Value
134. it is Not Unusual for a Project to have Side Or Spillover Effects Both Good and Ba(d) This
Phenomenon is Called:
(a) Erosion
(b) Piracy
(c) Cannibalism
(d) All of the Above
135. The Average Time Between Purchasing Or Acquiring Inventory and Receiving Cash Proceeds
From Its Sale is Called--------------.
(a) Operating Cycle
(b) Cash Cycle
(c) Receivable Period
(d) Inventory Period
136. Which of the Following Does Not Affect Cash Cycle of a Company?

586
 (a) Inventory Period
(b) Accounts Receivable Period
(c) Accounts Payable Turnover
(d) None of the Given Option
137. [Link] Purchased Goods of Rs.100,000 On June01, 2006 From Zeeshan & Brothers On Credit
Terms of 3/10, Net 30. On June 09 Mr. Munir Decided to Make Payment to Zeeshan and
Brothers. How Much He Would Pay to Zeeshan & Brothers
(a) 100,000
(b) 97,000
(c) 103,000
(d) 50,000
138. A Firm has Cash Cycle of 100 Days. it has an Inventory Turnover of 5 and Receivable Turnover
of 2. What Would Be Its Accounts Payable Turn Over?
(a) 3.347 Approximately
(b) 5.347 Approximately
(c) 2.347 Approximately
(d) 6.253 Approximately
139. During the Financial year 2005-2006 Ended On June 30, the Cash Cycle of Climax Company was
150 Days, and Its Payable Turnover was 5. What was the Operating Cycle of the Company
During 2005-2006?
(a) 234 Days
(b) 223 Days
(c) 245 Days
(d) 230 Days
140. Which of the Following is the Cheapest Source of Financing Available to a Firm?
(a) Bank Loan
(b) Commercial Papers
(c) Trade Credit
(d) None of the Above.
141. Which of the Following Illustrates the Use of a Hedging (Or Matching) Approach to Financing?
(a) Short-Term Assets Financed with Long-Term Liabilities.
(b) Permanent Working Capital Financed with Long-Term Liabilities.
(c) Short-Term Assets Financed with Equity.
(d) All Assets Financed with a 50 % Equity, 50 % Long-Term Debt Mixture
142. 180 is an Incentive Offered By a Seller to Encourage a Buyer to Pay Within a Stipulated Time.
(a) Cash Discount
(b) Quantity Discount
(c) Float Discount
(d) All of the Above
143. If a Firm has a Net Float Less Than Zero, Then Which of the Following Statements is True About

587
 the Firm.
(a) The Firm’s Disbursement Float is Less Than Its Collection Float.
(b) The Firm’s Collection Float is Equal to Zero.
(c) The Firm’s Collection Float is Less Than Its Disbursement Float.
(d) None of the Above.
144. Financing a Long-Lived Asset with Short-Term Financing Would Be
(a) An Example of ‘Moderate Risk -- Moderate (Potential) Profitability’ Asset Financing.
(b) An Example of ‘Low Risk -- Low (Potential) Profitability’ Asset Financing.
(c) An Example of ‘High Risk -- High (Potential) Profitability’ Asset Financing.
(d) An Example of the ‘Hedging Approach’ to Financing
145. Suppose Flatiron Corporation has a Debt-To- Equity Ratio of 2/3. You are Analyzing the Capital
Structure of this Corporation. Base On Debt-To- Equity Ratio of the Corporation, How Much
Portion of the Capital Structure is Financed Through Equity.
(a) 66.67%
(b) 33.34%
(c) 0%
(d) 60%
146. Suppose the Common Stocks of Bonanza Corporation have Book value of 29 Per Share. The
Market Price of These Common Stocks is 69.50 Per Share. The Corporation Paid 5.396 Per
Share in Dividend Last year and Analysts Estimate that this Dividend will Grow At a rate of 6%
Through the Next Three years. Using the Dividend Growth Model, Estimated Cost of Equity of
Bonanza Corporation Would Be
(a) 11.15%
(b) 16.13%
(c) 15.80%
(d) 13.14%
147. Which Statement is True About the Relationship Between Weighted Average Cost of Capital
and value of a Firm in the Eyes of Investors?
(a) They have a Direct Relationship
(b) They have an Indirect Relationship
(c) They have Spontaneous Relationship
(d) None of the Above
148. Refers to the Extent to Which Fixed-Income Securities (Debt and Preferred Stock) are Used in a
Firm's Capital Structure.
(a) Financial Risk
(b) Portfolio Risk
(c) Operating Risk
(d) Market Risk
149. Let’s Imagine that Sony Corporation Currently Uses No-Debt Financing, it has Decided to Go for
Capital Restructuring incorporating One Billion of Debt at 6.6% P.A in Its Capital Structure. Sony
Corporation has 30 Million Shares Outstanding and the Price Per Share is 125. If the
588
 Restructuring is Expected to Increase EPS, What Would Be the Minimum Level of EBIT that
Sony Management Must Be Expecting?
(a) 202,200,000
(b) 247,500,000
(c) 283,500,000
(d) 321,250,000
150. A Corporation has WACC of 13.5 %( Excluding Taxes). The Current Borrowing rate in the Market
is 9.25%.If the Corporation has a Target Capital Structure of 65% Equity (There is No Preferred
Stock in the Capital Structure of the Corporation) And 35% Debt, What Would Be the Cost of
Equity of this Corporation?
(a) 13.5%
(b) 17.75%
(c) 15.79%
(d) 17.13%
151. Suppose Dux Corporation has Current Assets of 44 Million. Cash is 25% of the Total Current
Assets. After One year the Cash Item Increase By 12%.This Increase in Cash Item is A
(a) Source of Cash Use of Cash
(b) Neither of the Source of Cash
(c) Nor a Use of Cash
(d) None of the Given Option
152. During 2005 a Merchandize Sales Company had Cash Sales of 56.25 Million, Which were 15% of
the Total Sales. During this Period Accounts Receivables of the Company Were13% of Total
Sales. What was the Average Collection Period of the Company During 2005?
(a) 62 Days
(b) 18 Days
(c) 56 Days
(d) 19 Days
153. Suppose that Pearson Corporation has a Capital Structure Which Consists of Both Equity and
Debt. It had Issued Two Million Worth of Bonds At 6.5 % P.(A) The Tax rate is 40%. Its EBIT is
One Million. The Present value of Tax Shield for Pearson Corporation Would Be
(a) Rs.1,000,000
(b) Rs.1,200,000
(c) Rs800,000
(d) Rs.1,400,000
154. The Use of Personal Borrowing to Alter the Degree of Financial Leverage is Called .
(a) Homemade Leverage
(b) Financial Leverage
(c) Operating Leverage
(d) None of the Given Option
155. Refers to the Most Valuable Alternative that is Given Up If a Particular Investment is

589
 Undertaken.
(a) Sunk Cost
(b) Opportunity Cost
(c) Financing Cost
(d) All of the Above
156. SNT Company Paid a Dividend of Rs.5 Per Share Last year. The Stock’s Current Price is Rs.50
Per Share. Assuming that the Dividends are Estimated to Grow Steadily At 8% Per year, the Cost
of the Capital for SNT Company will Be?
(a) 13.07 %
(b) 15.67 %
(c) 16.00 %
(d) 18.80 %
157. is the Group of Assets Such as Stocks and Bonds Held By an Investor.
(a) Portfolio
(b) Diversification
(c) Stock Bundle
(d) None of the Above
158. Which of the Following Measures the Present value of an Investment Per Rupee Invested?
(a) Net Present value (NPV)
(b) Profitability Index (PI)
(c) Average Accounting Return (AAR)
(d) Internal rate of Return (IRR)
159. If We have Rs.150 in Asset A and Rs.250 in Asset B, Then the %Age of Asset B in the Portfolio
will Be:
(a) 37.5 %
(b) 47.5 %
(c) 62.5 %
(d) 72.5 %
160. A Risk that Influences a Large Number of Assets is Known As:
(a) Systematic Risk
(b) Market Risk
(c) Non-Diversifiable Risk
(d) All of the Above
161. Which of the Following Risk Can Be Eliminated By Diversification?
(a) Systematic Risk
(b) Unsystematic Risk
(c) A & B
(d) None of the Above
162. Suppose the Initial Investment for a Project is Rs.160,000 and the Cash Flows are Rs.40,000 in
the First year and Rs.90,000 in the Second and Rs.50,000 in the Thir(d) The Project will have a
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 Payback Period Of:
(a) 2.6 years
(b) 3.1 years
(c) 3.6 years
(d) 4.1 years
163. A Model Which Makes an Assumption About the Future Growth of Dividends is Known As:
(a) Dividend Price Model
(b) Dividend Growth Model
(c) Dividend Policy Model
(d) All of the Above
164. Which of the Following is Not a Quality of IRR?
(a) Most Widely Used
(b) Ideal to Rank the Mutually Exclusive Investments
(c) Easily Communicated and Understood
(d) Can Be Estimated Even Without Knowing the Discount Rate
165. is a Special Case of Annuity, Where the Stream of Cash Flows Continues Forever.
(a) Ordinary Annuity
(b) Perpetuity
(c) Dividend
(d) Interest
166. If a Bank Offers 15% Annual rate of Return Compounded Quarterly, What Would Be the Effective
Annual rate (EAR)?
(a) 15.00 %
(b) 15.34 %
(c) 15.87 %
(d) 16.42 %
167. A Bond Represents a Made By an Investor to the .
(a) Loan; Receiver
(b) Dividend; Issuer
(c) Dividend, Receiver
(d) Loan; Issuer
168. When the Interest Rates Fall, the Bond is Worth .
(a) More
(b) Less
(c) Same
(d) All of the Above.
169. If SNT Corporation Pays Out 30% of Net Income to Its Shareholders as Dividends. What Would
Be the Retention Ratio for SNT Corporation?
(a) 30 %
(b) 50 %

591
 (c) 70 %
(d) 90 %
170. If Sales are to Grow At a rate Higher Than the Sustainable Growth Rate, the Firm Must:
(a) Increase Profit Margin
(b) Increase Total Assets Turnover
(c) Sell New Shares
(d) All of the Above.
171. is the Current value of the Future Cash Flow Discounted At an Appropriate Discount Rate.
(a) Present Value
(b) Future Value
(c) Capital Gain
(d) Net Profit
172. SUMI In(c) has Outstanding Bonds Having a Face value of Rs.500. The Promised Annual
Coupon is Rs.50. The Bonds Mature in 30 years and the Market’s Required rate On Similar
Bonds is 12% P. (A) What Would Be the Present value of Each Bond?
(a) Rs.319.45
(b) Rs.390.75
(c) Rs.419.45
(d) Rs.463.75
173. The Sensitivity of Interest rate Risk of a Bond Directly Depends Upon:
(a) Time to Maturity Coupon Rate
(b) A and B
(c) None of the Above
174. An Insurance Company Offers to Pay You Rs.1000 Per year If You Pay Rs.6,710 Upfront. What
Would Be the rate Applicable in this 10-Year Annuity?
(a) 8 %
(b) 10 %
(c) 12 %
(d) 14 %
175. In the Formula Ke >= (D1/P0) + G, What Does (D1/P0) Represent?
(a) The Expected Capital Gains Yield From a Common Stock
(b) The Expected Dividend Yield from a Common Stock
(c) The Dividend Yield from a Preferred Stock
(d) The Interest Payment from a Bond
176. If You Owned 100 Shares of a Company and There are Three Directors to Be Electe(d) How
Much Votes You Would have as Per Cumulative Voting Procedure?
(a) 100 Votes
(b) 200 Votes
(c) 300 Votes
(d) 400 Votes
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177. SNT Corporation has Policy of Paying a Rs.6 Dividend Per Share Every year. If this Policy is to
Continue Indefinitely, What will Be the value of a Share of Stock At a 15% Required rate of
Return?
(a) Rs.30
(b) Rs.40
(c) Rs.50
(d) Rs.60
178. Which of the Following is NOT a Characteristic of Preferred Stock?
(a) Dividends On These Stocks Cannot Be Cumulative
(b) These Stocks have Dividend Priority Over Common Stocks
(c) These Stocks have Stated Liquidating Value
(d) These Bonds Hold Credit Ratings Much Like Bonds
179. A Project has an Initial Investment of Rs.400,000. What Would Be the NPV for the Project If it
has a Profitability Index of 1.5?
(a) Rs.30,000
(b) Rs.40,500
(c) Rs.50,000
(d) Rs.60,000
180. Following are the Two Cases:
Case I: Mr. A, as a Financial Consultant, has Prepared a Feasibility Report for a Project for ABC
Company that the Company is Planning to Undertake. He has Suggested that the Project is
Feasible.
Case II: Mr. A, as a Financial Consultant, has Prepared a Feasibility Report of a Project for XYZ
Company that the Company is Planning to Undertake. He has Suggested that the Project is Not
Feasible.
The Consultancy Fee Paid to Mr. A will Be Considered As:
(a) Sunk Cost in Case I and Opportunity Cost in Case II
(b) Opportunity Cost in Case I and Sunk Cost in Case II
(c) Sunk Cost in Both Cases I & II
(d) Opportunity Cost in Both Cases I & II
181. Suppose You Buy Some Stock for Rs.35 Per Share. At the End of the year, the Price is Rs.43 Per
Share. During the year, You Get a Rs.4 Dividend Per Share. What will Be the Total %Age Return?
(a) 22.85 %
(b) 25.16 %
(c) 30.52 %
(d) 34.29 %
182. If You have a Portfolio with Rs.10,000 in Asset A and Rs.15,000 in Asset B Then What will Be the
Weight of Asset B in Your Portfolio?
(a) 0.30
(b) 0.40
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 (c) 0.60
(d) 0.75
183. Which of the Following Set of Cash Flows Represents the Change in the Firm’s Total Cash Flow
that Occurs as Direct Result of Accepting the Project?
(a) Relevant Cash Flows
(b) Incremental Cash Flows
(c) Negative Cash Flows
(d) All of the Given Option
184. Time value of Money is an Important Finance Concept Because:
(a) it Takes Risk into Account
(b) it Takes Time into Account
(c) it Takes Compound Interest into Account
(d) All of the Above
185. The Present value of a Sum of Rs.100 to Be Received in the Future will Be:
(a) More Than Rs.100
(b) Equal to Rs.100
(c) Less Than Rs.100
(d) None of the Above
186. You Want to Buy an Ordinary Annuity that will Pay You Rs.3,000 a year for the Next 20 years.
You Expect Annual Interest Rates will Be 8 % Over that Time Perio(d) The Maximum Price You
Would Be Willing to Pay for the Annuity will Be Closest To:
(a) Rs.29,454
(b) Rs.34,325
(c) Rs.39,272
(d) Rs.49,023
187. You have Rs.1,000 that You Want to Save. If Four Different Banks Offer Four Different
Compounding Methods for Interest, Which Method Should You Choose to Maximize Your
Rs.1,000?
(a) Compounding Quarterly
(b) Compounding Monthly
(c) Compounding Semi-Annually
(d) Compounding Annually
188. If a Bond Sells At a High Premium, Then Which of the Following Relationships Hold True?
(a) Bond Price < Par value and YTM > Coupon Rate
(b) Bond Price > Par value and YTM > Coupon Rate
(c) Bond Price > Par value and YTM < Coupon Rate
(d) Bond Price < Par value and YTM < Coupon Rate
189. What will Be the value to You of a Rs.2,000 Face-Value Bond with an 8% Coupon rate When
Your Required rate of Return is 12% and Time Till Maturity is 5 years?
(a) Rs.1,556
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 (b) Rs.1,712
(c) Rs.2,082
(d) Rs.2,420
190. Which of the Following Carry the Provision that Within a Stipulated Time Period, the Bond May
Be Converted into a Certain Number of Shares of the Issuing Corporation's Common Stock At a
Pre-Stated Price?
(a) Convertible Bonds
(b) Income Bonds
(c) Put Bonds
(d) None of the Above
191. Interest Rates and Bond Prices:
(a) Move in the Same Direction
(b) Move in the Opposite Direction
(c) Sometimes Move in the Same and Sometimes in the Opposite Direction
(d) Have No Relation with Each Other
192. Long-Term Bonds have Risk of Loss Resulting From Changes in Interest Rates Than Do Short-
Term Bonds.
(a) Less
(b) Zero
(c) More
(d) None of the Above
193. What will Be Real rate If the Nominal rate is 17%, and the Inflation rate is 5%?
(a) 6.639%
(b) 8.251%
(c) 10.00%
(d) 11.43%
194. The Alternative Name Used for Interest Coverage Ratio is .
(a) Time Interest Earned
(b) Cash Coverage Ratio
(c) Profit Margin Ratio
(d) None of the Given Option
195. If You Want to Evaluate the Performance of an Organization, Which One of the Following Ratios
will Be Helpful to You in Evaluating the Performance of an Organization?
(a) Return On Short as Well as Long Term Investments
(b) Return On Equity and Return On Debt
(c) Return On Equity and Profit Margin
(d) All of the Above
196. Imran Corporation is a Firm Dealing in Hardware Industry. It Sold 5000 Units of Its Product to
Mr. Younas for a Sum of Rs.150, 000 Whose Cost was Rs.160, [Link] Would Be the Effect of
this Transaction On Current Ratio of the Company If the Current Ratio was 0.80 Before this

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 Transaction?
(a) Increase
(b) Decrease
(c) Remains Unchanged
(d) None of the Given Option
197. Mehran Corporation is Dealing in Furniture Industry. It has an Equity Multiplier of 1.78 Times.
The Debt to Equity Ratio Would Be ?
(a) 0.38 Times
(b) 0.58 Times
(c) 0.78 Times
(d) 0.98 Times
198. What Would Be the Level of EBIT If Imran Corporation Uses Both Debt as Well as Equity
Financing in Its Capital Structure, it has a Cash Coverage Ratio of 7.5 Times, Annual Interest
Expense is Rs.1 Million and Annual Depreciation is Rs.3 Million?
(a) Rs.2.5 Million
(b) Rs.3 Million
(c) Rs.3.5 Million
(d) Rs.4.5 Million
199. Suppose, Noman Corporation has a Debt to Equity Ratio of 0.45 Times. Its Return On Equity is
18%.The Return On Assets Would Be .
(a) 9.414 %
(b) 10.414 %
(c) 11.412 %
(d) 12.414 %
200. Suppose, Ilyas Corporation is One of the Dominant Firms in Electronics Equipment Industry. Its
Policy is Very Clear About Dealing with Stockholders. It Pays Out 30% of Its Income in the Form
of Dividen(d) If it Pays a Total Sum of Rs.150 Million as a Dividend, Then What Would Be the
Amount Transferred to the Retained Earning Balance From Current year Profit?
(a) Rs.150 Million
(b) Rs.250 Million
(c) Rs.350 Million
(d) Rs.500 Million
201. Sian Corporation is One of the Largest Firms in the Electronics Industry Covering 70% of the
Market Share. During the Current year Its Performance is Analysed By Judging the Various
[Link] has Return On Assets of 12.5% and Retention Ratio is 3/5. What Would Be the
Internal Growth rate of the Sian Corporation?
(a) 12.29%
(b) 14.29%
(c) 16.29%
(d) 18.92%
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202. What Would Be the Sustainable Growth rate If the Corporation has a Return On Equity (ROE) of
20% and a Retention Ratio of 4/5?
(a) 15 %
(b) 16 %
(c) 19%
(d) 18%
203. Rehan Corporation is Dealing in Agriculture Products. Its Annual Gross Sales are Rs.1975
Million. Out of Which 34% are On Cash Basis. Their Past Collection Experiences Show that it has
an Average Collection Period of 76 Days. What Would Be the Balance of Accounts Receivable At
the End of the year?
(a) Rs.251.415 Million
(b) Rs.261.415 Million
(c) Rs.271.415 Million
(d) Rs.281.415 Million
204. ROE in Dupont Identity is Affected By:
(a) Operating Efficiency
(b) Asset Usage Efficiency
(c) Financial Leverage
(d) All of the Above
205. A Decrease in the %Age of Net Income Paid Out as a Dividend will Increase The:
(a) Return On Assets Ratio
(b) Retention Ratio
(c) Leverage Ratio
(d) Profit Margin
206. Which of the Following Does Not Change Current Ratio of a Business?
(a) Efficient Usage of Current Assets
(b) Change in the Nature of the Firm
(c) Change in Accounting Method of the Firm
(d) Change in the Management of the Firm
207. Present value Factor Is:
(a) (1+R)^T
(b) (1-R) ^T
(c) 1/ (1+R) ^T
(d) 1/ (1+R) ^1/T
208. Depreciation Expense Is:
(a) Operating Expense
(b) Investing Expense
(c) Financing Expense
(d) All of the Above
209. Internal Growth rate Tell How Rapidly:
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 (a) The Firm Grows
(b) Sales of the Firm Grows
(c) Profit of the Firm Grows
(d) None of the Above
210. You Can Determine the Number of Periods (N) in a Present value Calculation, If You Know:
(a) Future Amount
(b) Present Value
(c) Interest Rate
(d) All of the Above
211. Which One of the Present value Factor is Larger?
(a) PV of 1 Factor for 10%
(b) PV of 1 Factor for 12%
(c) Both have the Same Effect
(d) It Cannot Be Determined
212. If We Deposit Rs.5,000 Today in an Account Paying 10%, How Long Does it Take to Grow to
Rs.10,000?
(a) 5.27 years
(b) 6.27 years
(c) 7.27 years
(d) 7.57 years
213. The Future value of First Rs.100 in 2 years At 8% Discount Is:
(a) Rs.116.64
(b) Rs.111.64
(c) Rs.164.64
(d) Rs.164.61
214. Investing Activities Include:
(a) Purchase of Property, Plant and Equipment
(b) Cash Received From the Issuance of Stock Or Equity in the Business.
(c) Purchases of Stock Or Other Securities (Other Than Cash Equivalents)
(d) Both A & C
215. Changes in Cash From Financing are ‘Cash In’ When:
(a) Capital is Raised
(b) Assets Increased
(c) Liabilities Decreased
(d) Cash Withdrawn
216. Generally, Changes Made in Cash, Accounts Receivable, Depreciation, Inventory and Accounts
Payable are Reflected In:
(a) Cash From Operations Activities
(b) Cash From Financing Activities
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 (c) Cash From Investing Activities
(d) None of the Above
217. Are Short-Term, Temporary Investments that Can Be Readily Converted into Cash.
(a) Marketable Securities
(b) Cash Equivalents
(c) Treasury Bills
(d) All of the Above
218. The Cash Flow Statement Records Your and Expenditure At the End of the 'Forecast'
Perio(d)
(a) Actual Cash Income
(b) Unearned Income
(c) Coming year Income
(d) Last year’s Income
219. Ratios Look At the Relationships Between Individual Values and Relate Them to How a
Company:
(a) Has Performed in the Past
(b) Might Perform in the Future
(c) Both a & B
(d) None of the Above
220. The Current Ratio is Also Known As:
(a) Working Capital Ratio
(b) Leverage Ratio
(c) Turnover Ratio
(d) None of the Above
221. Is Concerned with the Relationship Between the Long Terms Liabilities that a Business has
and Its Capital Employe(d)
(a) Gearing
(b) Acid Test Ratio
(c) Working Capital Management
(d) All of the Above
222. Give a Picture of a Company's Ability to Generate Cash Flow and Pay it Financial
Obligations:
(a) Management Ratios
(b) Working Capital Ratios
(c) Net Profit Margin Ratios
(d) Solvency Ratios
223. Balance Sheet Items Expressed as %Age Of:
(a) Net Sales
(b) Total Revenue
(c) Total Assets
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 (d) Total Liabilities
224. Ann is Interested in Purchasing Ted's Factory. Since Ann is a Poor Negotiator, She Hires Mary to
Negotiate a Purchase Price. Identify the Parties to this Transaction From the Given Options,
Keeping in View the Agency Theory:
(a) Ann is the Principal and Mary is the Agent.
(b) Mary is the Principal and Ann is the Agent.
(c) Ted is the Agent and Ann is the Principal.
(d) Mary is the Principal and Ted is the Agent.
225. Which of the Given Options Apply to Auction Markets?
(a) Trading in a Given Auction Exchange Takes Place At a Single Site On the Floor of the
Exchange.
(b) Transaction Prices of Shares are Communicated Almost Immediately to the Publi(c)
(c) Listing.
(d) All of the Above
226. Suppose a Corporation has a Taxable Income of 200,000 and the Tax Amount is as Given in the
Calculations:
50,000 X 15% = 7,500, ( 75,000 – 50,000) X 25% = 6,250 ( 100,000 – 75,000) X 34% = 8,500,
(200,000 – 100,000) X 39% = 39,000
Total Tax is 61,250.
Average Tax rate is 61,250 / 200,000 = 30.625%. Marginal Tax rate will Be:
(a) 39%
(b) 34%
(c) 15%
(d) 25%
227. According to the Accounting Profession, Which of the Given Options Would Be Considered a
Cash-Flow Item From an ‘Investing’ Activity in a Cash Flow Statement?
(a) Cash Outflow to the Government for Taxes.
(b) Cash Outflow to Shareholders as Dividends.
(c) Cash Outflow to Lenders as Interest.
(d) Cash Outflow to Purchase Bonds Issued By Another Company
228. Which One of the Given Options is Generally Considered the Most Liquid Asset?
(a) Accounts Receivable
(b) Inventory
(c) Net Fixed Assets
(d) Intangible Assets
229. Which of the Given Options is an Advantage of a Corporation that is Not an Advantage as a
Limited Partner in a Partnership?
(a) Limited Liability.
(b) Easy Transfer of Ownership Position.
(c) Double Taxation.
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 (d) All of the Options are Advantages that the Corporation has Over the Limited Partner.
230. In Finance We Refer to the Market for Relatively Long-Term Financial Instrumentsas the
Market.
(a) Money
(b) Capital
(c) Primary
(d) Secondary
231. is Concerned with the Branch of Economics Relating the Behavior of Principals and Their
Agents.
(a) Financial Management
(b) Profit Maximization
(c) Agency Theory
(d) Social Responsibility
232. Which of the Expenses in Given Options is Not a Cash Outflow for the Firm?
(a) Depreciation
(b) Dividends
(c) Interest Payments
(d) Taxes
233. A Standardized Financial Statement Presenting All Items of the Statement as a %Age of Total
Is:
(a) A Common-Size Statement
(b) An Income Statement
(c) A Cash Flow Statement
(d) A Balance Sheet
234. Ammar is Running a Company ‘Ammar & Co’. He has Asked You to Comment On Company’s
Ability to Pay Its Bills Over the Short Run Without Undue Stress. for this Purpose You will Study
Which Category of Ratios of the Company?
(a) Profitability Ratios
(b) Liquidity Ratios
(c) Debt Ratios
(d) Turnover Ratios
235. Which One of the Given Options Describes Desirable Current Ratio for a Business?
(a) 0
(b) 0.2
(c) 0.1
(d) At Least One
236. Interest Coverage Ratios are Also Known As:
(a) Times Interest Earned (TIE) Ratios
(b) Liquidity Ratios
(c) Debt Ratios

601
 (d) Asset Management Ratios
237. The Du Pont Identity Tells Us that Return On Equity is Affected By:
(a) Operating Efficiency (As Measured By Profit Margin)
(b) Asset Use Efficiency (As Measured By Total Assets Turnover)
(c) Financial Leverage (As Measured By Equity Multiplier)
(d) All of the Above (A, B and C)
238. Benchmarking is Used to Establish a Standard to Follow For:
(a) Comparison
(b) Identification
(c) Calculation
(d) Liability
239. Suppose the Total Cost of a College Education will Be 50,000 in 12 years for a Chil(d) The
Parents have 5,000 to Invest Today. What rate of Interest Must They Earn On Investment to
Cover the Cost of Child’s Education?
(a) 21.15%
(b) 12%
(c) 18%
(d) 30%
240. If the Bank Loans Out 10,000 for 90 Days At 8% Simple Interest, the PV Is:
(a) 9,806.56
(b) 9000
(c) 10000
(d) 9500
241. Suppose, You Deposited an Amount of Rs.1000 in Habib Bank At the Start of year 2016. How
Much Interest Amount will You have At the End of the year If the Bank Pays Simple Interest
@10% P.(A)?
(a) Rs.100
(b) Rs.10
(c) Rs.90
(d) Rs.1000
242. is Considered as Bottom Line in Income Statement?
(a) Total Assets
(b) Total Liabilities
(c) Net Profit
(d) Gross Profit
243. Can Be Considered as a Snapshot of a Company's Financial Position?
(a) Income Statement
(b) Balance Sheet
(c) Cash Flow Statement
(d) Owner's Equity Statement
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244. Involves the Sale of Used Securities from One Investor to Another?
(a) Primary Market
(b) Secondary Market
(c) Tertiary Market
(d) None of the Above
245. Ratios Shows a Firm's Ability to Pay Its Bills in Short Term?
(a) Liquidity
(b) Financial Leverage
(c) Profitability
(d) Market Value
246. The Process of Planning and Managing a Firm's Long-Term Investments is Called:
(a) Planning Process
(b) Capital Structure
(c) Capital Budgeting
(d) Managing Process
247. Income Statement for Sumi In(c) Shows the Net Income of Rs.363,000 Whereas the Total Sales
are Rs.2,311,000. The Profit Margin for the Sumi In(c) will Be:
(a) 6.37 %
(b) 8.37 %
(c) 15.7 %
(d) 12.5 %
248. S&T Company have 35 Thousands Shares Outstanding and the Stock Sold For Rs.99 Per Share
At the End of year. Income Statement Reported a Net Income of Rs.385,000. The Price Earning
Ratio for S&T Company will Be:
(a) Times
(b) Times
(c) Times
(d) Times
249. While Making Common-Size Statement, Balance Sheet Items are shown as a %Age of :
(a) Total Assets
(b) Total Liabilities
(c) Total Capital
(d) Net Profit
250. A Business, Created as a Distinct Legal Entity Owned By One Or More Individuals Or Entities, is
Known As:
Sole Proprietorship
(a) Partnership
(b) Corporation
(c) None of the Above

603
251. Which One of These is Considered as a Non-Cash Item?
(a) Inventory
(b) Accounts Payable
(c) Accounts Receivable
(d) Depreciation
252. Suppose Market value Exceeds Book value By Rs.250,000. What will Be the After-Tax Proceeds
If There is a Tax rate of 34 %?
(a) Rs.105,600
(b) Rs.148,500
(c) Rs.165,000
(d) Rs.225,000
253. Which of the Following Process Can Be Defined as the Process of Generating Earnings From
Previous Earnings?
(a) Discounting
(b) Compounding
(c) Factorization
(d) None of the Above
254. Which of the Following rate Makes the Net Present value (NPV) Equal to Zero?
(a) Average Accounting Return (AAR)
(b) Internal rate of Return (IRR)
(c) Required rate of Return (RRR)
(d) Weighted Average Cost of Capital (WACC)
255. Which of the Following Relationships Holds TRUE If a Bond Sells At a Discount?
(a) Bond Price < Par value and YTM > Coupon Rate
(b) Bond Price > Par value and YTM > Coupon Rate
(c) Bond Price > Par value and YTM < Coupon Rate
(d) Bond Price < Par value and YTM < Coupon Rate
256. Which of the Following is the Expected rate of Return On a Bond If Bought At Its Current Market
Price and Held to Maturity?
(a) Current Yield
(b) Yield to Maturity
(c) Coupon Yield
(d) Capital Gains Yield
257. Head of Treasury Department Reports to Whom?
(a) Financial and Cost Accountant
(b) Chief of Financial Officer
(c) Cash and Credit
(d) Manager Board of Directors
258. The Conflict of Interest Between Stockholders and Management is Known As:
(a) Agency Problem
(b) Interest Conflict
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 (c) Management Conflict
(d) Agency Cost
259. During the Accounting Period, Sales Revenue is Rs.25,000 and Accounts Receivable Increases
By Rs.8,000. What will Be the Amount of Cash Received From Customers for the Period?
(a) Rs.33,000
(b) Rs.25,000
(c) Rs.17,000
(d) Rs.8,000
260. Which of the Following Area of Finance Deals with Stocks and Bonds?
(a) Financial Institutions
(b) International Finance
(c) Investments
(d) All of the Above
261. Which of the Following is Subcategory (ies) of Finance Department?
(a) Accounting Department Only
(b) Treasury Department Only
(c) Accounting Department and Treasury Department
(d) None of the Above
262. A Borrower is Able to Pay Rs.40,000 in 5 years. Given a Discount rate of 12 %, What Amount of
Money the Lender Should Lend?
(a) Rs.14,186
(b) Rs.18,256
(c) Rs.22,697
(d) Rs.28,253
263. A Company Issues Bonds with a Rs.1,000 Face Value. What is the Coupon rate If the Coupon
Payments of Rs.60 are Paid Every 6 Months?
(a) 3 %
(b) 6 %
(c) 9 %
(d) 12 %
264. Which of the followings is Correct?
(a) Financial Asset is a Document Representing a Claim to Income
(b) Real Asset is a Document Representing a Claim to Income
(c) Financial Asset is an Object that Provides a Service
(d) All of the Above
265. The Price of a Rs.1,000-Face value Bond is Rs.910. What will Be the Yield to Maturity If There is
a Coupon Payment of Rs.90 for 6 years?
(a) Greater Than 9%
(b) Equal to 9%
(c) Lower Than 9%
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 (d) Cannot Be Determined Without More Information
266. Decisions About ‘How to Raise Money’ and ‘What to Do with It’ are Part of Which of the
Following?
(a) Business Finance
(b) Change Management
(c) Costing for Accounting
(d) All of the Above
267. Which of the Following is a Special Case of Annuity, Where the Stream of Cash Flows Continues
Forever?
(a) Ordinary Annuity
(b) Special Annuity
(c) Annuity Due
(d) Perpetuity
268. AST Company has a Current Ratio of 4:3. Current Liabilities Reported By the Company are
Rs.30,000. What Would Be the Net Working Capital for the Company?
(a) Rs.40,000
(b) (Rs.40,000)
(c) Rs.10,000
(d) (Rs.10,000)
269. Which of the Following Statements is (are) CORRECT Regarding a Bond?
(a) A Bond is an Evidence of Debt Issued By a Corporation Or a Governmental Body.
(b) A Bond Represents a Loan Made By Investors to the Issuer.
(c) When a Corporation Wishes to Borrow From Public On a Long Term Basis, it Does So By
Issuing Or Selling Bonds.
(d) All of the Above
270. How many years will it Take to Pay Off a Rs.11,000 Loan with a Rs.1,241.08 Annual Payment
and a 5% Interest Rate?
(a) 6 years
(b) years
(c) 24 years
(d) 48 years
271. Finance is the Art and Science of Handling .
(a) Money
(b) People
(c) Authority
(d) None of the Above
272. In Corporate Form of Business, What is the Objective of Shareholder?
(a) Maximize Current year Income
(b) Delay in Payment to Supplier
(c) Reduce the Expenditure On Inventory Maintenance
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 (d) Maximization of Shareholder Wealth
273. When a Corporation Wishes to Borrow From Public On a Long-Term Basis, it Does So By Issuing
Or Selling:
(a) Debt Securities Or Bonds
(b) Common Stocks
(c) Preferred Stock
(d) All of the Above
274. In 3 years You are to Receive Rs.5,000. If the Interest rate were to Suddenly Decrease, the
Present value of that Future Amount to You Would:
(a) Fall
(b) Rise
(c) Remain Same
(d) Cannot Be Determined with the Given Information
275. In How many years, an Amount will Be Doubled At a Discount rate of 8 %?
(a) 3 years
(b) 6 years
(c) 9 years
(d) Cannot Be Determined Without More Information
276. What will Be the value of a Rs.1,000 Face-Value Bond with an 8% Coupon rate At 8% Required
rate of Return?
(a) More Than Its Face Value
(b) Less Than Its Face Value
(c) Equal to Its Face Value
(d) Cannot Be Determined Without More Information
277. 337. Which of the Following Refers to the Difference Between the Sale Price and Cost of
Inventory?
(a) Net Loss
(b) Net Worth
(c) Markup
(d) Markdown
278. A Business Owned By a Single Person is Known As:
(a) Sole-Proprietorship
(b) General Partnership
(c) Limited Partnership
(d) Corporation
279. Net Income After Taxation Differs From Net Cash Flow From Operations Because:
(a) Depreciation Expense is shown in the Cash Flow Statement and Not in the Income
Statement
(b) Non-Cash Items are Included in the Income Statement, But Not in The Cash Flow
Statement
(c) Cash Sales are shown in the Cash Flow Statement But Not in the Income Statement
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 (d) Cash Expenses are shown in the Cash Flow Statement But Not in the Income Statement
280. The Most Common Application of Term ‘Finance’ Involves Raising Moneyto Acquire .
(a) Current Asset
(b) Fixed Asset
(c) Intangible Asset
(d) All of the Above
281. The Relationship Between Real and Nominal Returns is Described By The:
(a) M&M Proposition
(b) Capital Asset Pricing Model
(c) Fisher’s Effect
(d) BCG Matrix
282. an Investment Should Be Accepted If the Net Present value (NPV) is and Rejected If it is .
(a) Positive; Positive
(b) Positive; Negative
(c) Negative; Negative
(d) Negative; Positive
283. 350. In Which of the Following Procedure of Voting for a Company's Directors, Each
Shareholder is Entitled to One Vote Per Share?
(a) Straight Voting
(b) Proportional Voting
(c) Cumulative Voting
(d) None of the Above
284. Mr. Aslam Owns 100 Shares of a Company and There are Four Directors to Be Electe(d) How
Much Votes Mr. Aslam Would have as Per Cumulative Voting Procedure?
(a) 100 Votes
(b) 200 Votes
(c) 300 Votes
(d) 400 Votes
285. A Given rate is Quoted as 9 % APR, But the EAR is 9.38 %. What is the Compounding Period?
(a) Semiannually
(b) Quarterly
(c) Monthly
(d) Daily
286. Between the Two Identical Bonds Having Different Coupon, the Price of the Bond will Change
Less Than that of Bon(d)
(a) Higher-Coupon; Lower-Coupon
(b) Lower-Coupon; Higher-Coupon
(c) Long-Term; Short-Term
(d) None of the Above
287. Which of the Following Financial Statement Shows Both Rupees and %Ages in the Report?
608
 (a) Balance Sheet
(b) Common-Size Statement
(c) Income Statement
(d) Relative Statement of Equity
288. A is an Agent Who Arranges Security Transactions Among Investors.
(a) Broker
(b) Dealer
(c) Member
(d) Specialist
289. If a Firm Uses Cash to Purchase Inventory, Its Quick Ratio Will:
(a) Increase
(b) Decrease
(c) Remain Unaffected
(d) Become Zero
290. In Which Type of the Market, Securities are Originally Sold to the Investors?
(a) Primary Market
(b) Secondary Market
(c) Tertiary Market
(d) None of the Above
291. 361. Balance Sheet for a Company Reports Current Assets of Rs.700,000 and Current Liabilities
of Rs.460,000. What Would Be the Current Ratio for the Company If There is an Inventory Level
of Rs.120,000?
(a) 1.01
(b) 1.26
(c) 1.39
(d) 1.52
292. 362. How many Rs.190 Annual Payments Must Be Invested At 12% to Accumulate Rs.57,921?
(a) 14
(b) 28
(c) 32
(d) 56

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1. What are the aspects of working capital management?
a. Inventory management c. Cash management
b. Receivable management d. All of the above
2. function includes a firm’s attempts to balance cash inflows andoutflows.
a) Finance c) Investment
b) Liquidity d) Dividend
3. Firms which are capital intensive rely on .
a) Equity c) Debt
b) Short term debt d) Retained earnings

4. Hirer is entitled to claim .

a. Depreciation c. HP payments
b. Salvage value d. None of above
5. Which of the following is not an advantages of trade credit?
a. Easy availability c. Informality
b. Flexibility d. Buyout financing
6. Which of the following are theories for dividend relevance?
a. Walter’s Model c. Game theory
b. Mm Approach d. Market Value theory

7. What is not a form of dividend?

a. Cash Dividends c. Share Split
b. Bonus Shares(Stock Dividend) d. Split Reverse

8. The percentage of earnings paid as dividends is called .

a. Dividend policy c. Cash Dividends
b. Payout Ration d. Reverse Split

9. What are the various methods of estimating cash?

a. Receipts and payment method
b. Adjusted profit & loss method
c. Balance sheet method
d. All of the above

10. The art of managing, within the acceptable level of risk, the consolidated funds optimally and
profitably is called .
a. Integrated treasury c. Merchant banking
b. Treasury management d. None of the above
11. What are the different types of underlying assets?
a. Stocks d. Stock indices
b. Bonds e. All of the above
c. Currency

12. What are people who buy or sell in the market to make profits called?
a. Hedgers c. Arbitrageurs
b. Speculators d. None of the above
13. Which of the following is a technique that helps the exporter to sell the receivables to any
bank or financial institution without recourse?

610
a. Forfeiting
b. Leading & Lagging
c. Derivatives (d) Netting

14. Money market financial services not include:

a. Bill discounting c. Leasing
b. Merchant banking d. Securitisation
15. Factoring involves:
(a) Providing short term loan(b)
(b) Providing long term loan
(c) Financing of export receivables
(d) Management of receivables of borrower

16. The tools of treasury management does not include:

a. Foreign Exchange Management
b. Cash Management
c. Receivable Management
d. Risk Management

17. Under which type of bank borrowing can a borrower obtain credit from a bank against its
bills?
a. Letter of Credit
b. Cash
c. Purchase or discounting of bills
d. Working Capital Loan

18. The factors that affect dividend policy are:

a) Tax Consideration c) Foreign Investment
b) Privatisation d) Working cash flow

19. To financial analysts, "working capital" means the same thing as .

(a) total assets
(b) fixed assets
(c) current assets
(d) (d)current assets minus current liabilities.

20. Which of the following would be consistent with an aggressive approach to financing
working capital?
(a) Financing short-term needs with short-term funds.
(b) Financing permanent inventory buildup with long-term debt.
(c) Financing seasonal needs with short-term funds.
(d) Financing some long-term needs with short-term funds.

21. Which of the following would be consistent with a conservative approach to financing
working capital?
(a) Financing short-term needs with short-term funds.
(b) Financing short-term needs with long-term debt.
611
 (c) Financing seasonal needs with short-term funds.
(d) Financing some long-term needs with short-term funds.
22-Which of the following would be consistent with a hedging (maturitymatching) approach to
financing working capital?
(a)Financing short-term needs with short-term funds.
(b)Financing short-term needs with long-term debt.
(c) Financing seasonal needs with long-term funds.
(d)Financing some long-term needs with short-term funds.

23. Which of the following statements is most correct?

(a)For small companies, long-term debt is the principal source of externalfinancing.
(b)Current assets of the typical manufacturing firm account for over half of its totalassets.
(c)Strict adherence to the maturity matching approach to financing would call for all current
assets to be financed solely with current liabilities.
(d) Similar to the capital structure management, working capital management requires the
financial manager to make a decision and not address the issue againfor several months

24. The amount of current assets that varies with seasonal requirements is referred to as
working capital.
(a)permanent
(b)net
(c)temporary
(d)gross

25. Having defined working capital as current assets, it can be further classifiedaccording to .
(a)financing method and time
(b)rate of return and financing method
(c)time and rate of return
(d)components and time

26. Your firm has a philosophy that is analogous to the hedging (maturity matching) approach.
Which of the following is the most appropriate form forfinancing a new capital investment in
plant and equipment?
(a)Trade credit.
(b)6-month bank notes.
(c)Accounts payable.
(d)Common stock equity.
27. Your firm has a philosophy that is analogous to the hedging (maturity matching) approach.
Which of the following is the most appropriate non- spontaneous form for financing the
excess seasonal current asset needs?
(a) rade credit.

612
 (b) 6-month bank notes.
(c) Accounts payable.
(d) Common stock equity.
28- Under a conservative financing policy, a firm would use long-term financing tofinance some
of the temporary current assets. What should the firm do when a "dip" in temporary current
assets causes total assets to fall below the total long- term financing?
(a) se the excess funds to pay down long-term debt.
(b) Invest the excess long-term financing in marketable securities.
(c) Use the excess funds to repurchase common stock.
(d) Purchase additional plant and equipment.

29- Which of the following statements is correct for a conservative financing policyfor a firm
relative to a former aggressive policy?
(a)The firm uses long-term financing to finance all fixed and current assets. (b)The firm will see
an increase in its expected profits.
(c)The firm will see an increase in its risk profile.
(d)The firm will increase its dividends per share (DPS) this perio(d)

[Link] of the following statements is correct for an aggressive financing policy for a firm
relative to a former conservative policy?
(a)The firm will use long-term financing to finance all fixed and current assets.
(b)The firm will see an increase in its expected profits.
(c)The firm will see a decline in its risk profile.
(d)The firm will need to issue additional common stock this period to financetheassets.

31. How can a firm provide a margin of safety if it cannot borrow on short notice to meet its
needs?
(a)Maintain a low level of current assets (especially cash and marketable securities).
(b)Shorten the maturity schedule of financing.
(c)Increasing the level of fixed assets (especially plant and equipment).
(d)Lengthening the maturity schedule of financing.

32. Risk, as it relates to working capital, means that there is jeopardy to the firm for not
maintaining sufficient current assets to .
(a)meet its cash obligations as they occur and take advantage of prompt paymentdiscounts
(b)support the proper level of sales and take prompt payment discounts
(c)maintain current and acid-test ratios at or above industry norms
(d)meet its cash obligations as they occur and support the proper level of sales

33. If a company moves from a "conservative" working capital policy to an "aggressive" policy, it
should expect .
(a)liquidity to decrease, whereas expected profitability wouldincrease
613
 (b)expected profitability to increase, whereas risk would decrease
(c)liquidity would increase, whereas risk would also increase
(d)risk and profitability to decrease

34. To financial analysts, "net working capital" means the same thing as .
(a)total assets
(b)fixed assets
(c)current assets
(d)current assets minus current liabilities.
35. Working Capital Turnover measures the relationship of Working Capital with:
(a) Fixed Assets, (c)Purchases,
(b) (b)Sales, (d)Stock.

36. Dividend Payout Ratio is:(a)PAT Capital,

(b) DPS ÷ EPS,
(c) Pref. Dividend ÷ PAT,
(d) Pref. Dividend ÷ Equity Dividend

37. Inventory Turnover measures the relationship of inventory with:

(a) Average Sales, (c) Total Purchases,
(b) Cost of Goods Sold, (d) Total Assets.

38. The term 'EVA' is used for:

(a)Extra Value Analysis,
(b)Economic Value Added,
(c)Expected Value Analysis,
(d)Engineering Value Analysis.
39. In Current Ratio, Current Assets are compared with:
(a)Current Profit,
(b)Current Liabilities,
(c)Fixed Assets,
(d)Equity Share Capital.

40. There is deterioration in the management of working capital of XYZ Lt(d) What does it refer
to?
(a) That the Capital Employed has reduced,
(b) (b)That the Profitability has gone up,
(c)That debtors collection period has increased,
(d)That Sales has decreased

41. Which of the following statements is correct?

(a) A Higher Receivable Turnover is not desirable,
(b) Interest Coverage Ratio depends upon Tax Rate,
(c) (c)Increase in Net Profit Ratio means increase in Sales,
(d) Lower Debt-Equity Ratio means lower Financial Risk.

42. Debt to Total Assets of a firm is .2. The Debt to Equity boo would be:
(a) 0.80, (b)0.25,
614
(c) 1.00, (d)0.75

43. In Inventory Turnover calculation, what is taken in the numerator?

(a) Sales, (c) Opening Stock,
(b) Cost of Goods Sold, (d) Closing Stock.

44. Walter’s Model suggests that a firm can always increase i.e. of the share by
(a) Increasing Dividend , (c) Constant Dividend,
(b) Decreasing Dividend, (d) None of the above

45. ‘Bird in hand' argument is given by

(a) Walker's Model, (c) MM Mode,
(b) Gordon's Model, (d) Residuals Theory

46. Residuals Theory argues that dividend is a (c) Passive Decision,

(a) Relevant Decision , (d) Irrelevant Decision
(b) Active Decision,

47. Dividend irrelevance argument of MM Model is based on:

(a) Issue of Debentures,
(b) Issue of Bonus Share,
(c) Arbitrage ,
(d) Hedging

48. Which of the following is not true for MM Model?

(a) Share price goes up if dividend is paid
(b) Share price goes down if dividend is not paid,
(c) Market value is unaffected by Dividend policy,
(d) All of the above.

49. Which of the following stresses on investor's preference reorient dividend than higher future
capital gains ?
(a) Walter's Model, (c) Gordon's Model,
(b) Residuals Theory, (d) MM Model.
50. MM Model of Dividend irrelevance uses arbitrage between
(a)Dividend and Bonus,
(b)Dividend and Capital Issue,
(c)Profit and Investment,
(d)None of the above

51. If ke = r, then under Walter's Model, which of the following is irrelevant?

(a)Earnings per share,
(b)Dividend per share,
(c)DP Ratio
(d)None of the above

52. MM Model argues that dividend is irrelevant as

(a) the value of the firm depends upon earning power
(b) the investors buy shares for capital gain,
(c)dividend is payable after deciding the retained earnings,
615
 (d)dividend is a small amount

53. Which of the following represents passive dividend policy ?

(a) that dividend is paid as a % of EPS,
(b) that dividend is paid as a constant amount,
(c) that dividend is paid after retaining profits for reinvestment,
(d) all of the above

54. In case of Gordon's Model, the MP for zero payout is zero. It means that
(a)Shares are not traded,
(b) Shares available free of cost,
(c)Investors are not ready to offer any price,
(d) None of the above

55. Gordon's Model of dividend relevance is same as

(a) No-growth Model of equity valuation,
(b) Constant growth Model of equity valuation,
(c) Price-Earning Ratio
(d) Inverse of Price Earnings Ratio

56. If 'r' = 'ke', than MP by Walter's Model and Gordon's Model for different payoutratios would be
(a) Unequal,
(b) Zero,
(c)Equal,
(d)Negative

57. Dividend Payout Ratio is Pref. Dividend ÷ Equity Dividend

(a) PAT÷ Capital,
(b) DPS ÷ EPS,
(c) Pref. Dividend ÷ PAT,
58. Dividend declared by a company must be paid in
(a) 20 days, (c) 32 days,
(b) 30 days (d)42 days

59. Dividend Distribution Tax is payable by

(a)Shareholders to Government
(b)Shareholders to Company,
(c)Company to Government,
(d)Holding to Subsidiary Company

60. Shares of face value of 10 are 80% paid up. The dividend of 50%. company declares a
Amount of dividend per share is
(a) 5, (c) 80,
(b) 4 (d) 50

61. Which of the following generally not result in increase in total dividend liability?
(a) Share-split, (c)Bonus Issue
(b) (b)Right Issue, (d)All of the above

616
62. Dividends are paid out of
(a) Accumulated Profits
(b) Gross Profit,
(c) General Reserve
(d)Both (a) and (b)

63. In India, Dividend Distribution tax is paid o

(a)Equity Share
(b) Preference Share
(c)Profit after Tax,
(c) Debenture,
64. Every company should follow
(a)High Dividend Payment
(b)Low Dividend Payment,
(c)Stable Dividend Payment
(d)Fixed Dividend Payment

65. 'Constant Dividend Per Share' Policy is considered as:

(a) Increasing Dividend Policy
(b) Decreasing Dividend Policy,
(c) Stable Dividend Policy
(d) None of the above

66. Which of the following is not a type of dividend payment?

(a) Bonus Issue, (c) Share Split,
(b) Right Issue, (d) Both (b) and (c)

67. If the following is an element of dividend policy?

(a) Production capacity,
(b) Change in Management,
(c) Informational content,
(d) Debt service capacity

68. Stock split is a form of

(a) Dividend Payment,(b)Bonus Issue,
(c) Financial restructuring,
(d) Dividend in kind

69. In stock dividend:

(a) Authorized capital always increases,
(b) Paid up capital always increases,
(c) Face value per share decreases
(d) Market price for share decreases

70. Which of the following is not considered in Lintner's Model ?

(a) Dividend payout ratio,
(b) Current EPS,
(c)Speed of Adjustment,
617
(d)Preceding year EPS

71. Which of the following is not relevant for dividend payment for a year ?
(a) Cash flow position (c) Paid up capital,
(b) Profit position, (d) Retained Earnings
72. Cash Budget does not include
(a) Dividend Payable (c) Issue of Capital,
(b) Postal Expenditure, (d)Total Sales Figure

73. Which of the following is not a motive to hold cash?

(a) Transactionary Motive,
(b) Pre-scautionary Motive,
(c) Captal Investment,
(d) None of the above.

74. Cheques deposited in bank may not be available for immediate use due to
(a) Payment Float (c) Net Float,
(b) Recceipt Float (d)Playing the Float.

75. Difference between between the bank balance as per Cash Book and Pass Book may be due
to:
(a) Overdraft, (c) Factoring,
(b) Float, (d)None of the above.

76. Concentration Banking helps in

(a) Reducing Idle Bank Balance
(b) (b)Increasing Collection,
(c) Increasing Creditors,
(d) Reducing Bank Transactions.

77. The Transaction Motive for holding cash is for

(a) Safety Cushion
(b) Daily Operations,
(c) Purchase of Assets
(d) Payment of Dividends.

78. Miller-Orr Model deals with

(a)Optimum Cash Balance,
(b)Optimum Finished goods,
(c)Optimum Receivables,
(d)All of the above.

79. Float management is related to

(a)Cash Management,
(b)Inventory Management,
(c)Receivables Management,
(d)Raw Materials Management.

80. Which of the following is not an objective of cash management ?

(a)Maximization of cash balance
(b)Minimization of cash balance
618
 (c)Optimization of cash balance,
(d)Zero cash balance.

81. Which of the following is not true of cash budget ?

(a) Cash budget indicates timings of short-term borrowing,
(b) Cash budget is based on accrual concept
(c) Cash budget is based on cash flow concept
(d) Repayment of principal amount of law is shown in cash budget.

82. Baumol's Model of Cash Management attempts to:

(a) Minimise the holding cost,
(b) Minimization of transaction cost,
(c) Minimization of total cost,
(d) Minimization of cash balance

83. Which of the following is not considered by Miller-Orr Model?

(a)Variability in cash requirement
(b)Cost of transaction,
(c)Holding cost,
(d)Total annual requirement of cash.

84. Marketable securities are primarily

(a) Equity shares,'
(b) Preference shares,
(c) Fixed deposits with companies
(d) Short-term debt investments.

85. 5Cs of the credit does not include

(a) Collateral (c) Conditions,
(b) (b)Character, (d) None of the above.

86. Which of the following is not an element of credit policy?

(a) Credit Terms (c)Cash Discount Terms,
(b) Collection Policy (d)Sales Price.

87. Ageing schedule incorporates the relationship between

(a)Creditors and Days Outstanding,
(b)Debtors and Days Outstanding,
(c)Average Age of Directors,
(d)Average Age of All Employees.

88. Bad debt cost is not borne by factor in case of

(a) Pure Factoring,
(b) Without Recourse Factoring,
(c) With Recourse Factoring,
(d) None of the above.

89. Which of the following is not a technique of receivablesManagement?

(a)Funds Flow Analysis
(b)Ageing Schedule,
619
(c)Days sales outstanding
(d)Collection Matrix.
90. Which of the following is not a part of credit policy?
(a)Collection Effort,
(b) Cash Discount,
(c)Credit Standard,
(d) Paying Practices of debtors.

91. Which is not a service of a factor?

(a)Administrating Sales Ledger,
(b)Advancing against Credit Sales,
(c) Assuming bad debt losses,
(d) None of the above.

92. Credit Policy of a firm should involve a trade-off between increased

(a) Sales and Increased Profit
(b) Profit and Increased Costs of Receivables,
(c) Sales and Cost of goods sold,
(d) None of the above.

93. Out of the following, what is not true in respect of factoring?

(a)Continuous Arrangement between Factor and Seller,
(b)Sale of Receivables to the factor,
(c)Factor provides cost free finance to seller
(d)None of the above.

94. Payment to creditors is a manifestation of cash held for:

(a) Transactionery Motive, (c)Speculative Motive,
(b) Precautionary Motive, (d)All of the above.
95. If the closing balance of receivables is less than the opening balance foramonth then which
one is true out of
(a) Collections>Current Purchases,
(b) Collections>Current Sales,
(c) Collections<Current Purchases,
(d) Collections < Current Sales.

96. If the average balance of debtors has increased, which of the following might not show a
change in general?
(a) Total Sales,
(b) Average Payables
(c) Current Ratio
(d) Bad Debt loss.

97. Securitization is related to conversion of

(a)Receivables,
(b)Stock,
(c)Investments,
(d)Creditors.
98. 80% of sales of 10,00,000 of a firm are on credit. It has a Receivable Turnover of 8.
What is the Average collection period (360 days a year) and Average Debtors of the firm?
620
 (a) 45 days and 1,00,000,
(b) 360 days and 1,00,000,
(c) 45 days and 8,00,000
(d) 360 days and 1,25,000.

99. In response to market expectations, the credit pence r j been increased from 45 days to 60
days. This would result in
(a) Decrease in Sales,
(b) (b)Decrease in Debtors,
(c) (c)Increase in Bad Debts,
(d)Increase in Average Collection Perio

100. If a company sells its receivable to another party to raise funds, it is known as
(a)Securitization,
(b)Factoring,
(c)Pledging
(d)None of the above.

101. Cash Discount term 3/15, net 40 means

(a) 3% Discount if payment in 15 days, otherwise full payment in 40 days,
(b) 15% Discount if payment in 3 days, otherwise full payment 40 days,
(c) 3% Interest if payment made in 40 days and 15%,interest thereafter,
(d) None of the above.

102. If the sales of the firm are 60,00,000 and the average debtors are .
15,00,000 then the receivables turnover is
(a) 4 times, (c)400%,
(b) 25%, (d)0.25 times

103. If cash discount is offered to customers, then which of the following would
increase?
(a) Sales (c)Debt collection period
(b) Debtors, (d)All of the above
104. Receivables Management deals with
(a)Receipts of raw materials,
(b)Debtors collection,
(c)Creditors Management,
(d)Inventory Management

105. Which of the following is related to Receivables Management?

(a) Cash Budget,
(b) Economic Order Quantity,
(c) Ageing schedule,
(d) All of the above.

106. EOQ is the quantity that minimizes

(a)Total Ordering Cost,
(b)Total Inventory Cost,
(c)Total Interest Cost,

621
(d)Safety Stock Level.

107. ABC Analysis is used in

(a)Inventory Management
(b)Receivables Management
(c)Accounting Policies, (d)Corporate Governance.

108. If no information is available, the General Rule for valuation of stock forbalance sheet is
(a) Replacement Cost, (c)Historical Cost,
(b) Realizable Value, (d)Standard Cost.
109. In ABC inventory management system, class A items may require
(a)Higher Safety Stock
(b)Frequent Deliveries
(c)Periodic Inventory system
(d)Updating of inventory records.

110. Inventory holding cost may include

(a) Material Purchase Cost,
(b) Penalty charge for default,
(c) Interest on loan,
(d) None of the above.

111. Use of safety stock by a firm would

(a)Increase Inventory Cost
(b)Decrease Inventory Cost,
(c)No effect on cost
(d)None of the above.

112. Which of the following is true for a company which uses continuous review inventory
system
(a) Order Interval is fixed,
(b) (b)Order Interval varies,
(c) Order Quantity is fixed,
(d) Both (a) and (c).

113. EOQ determines the order size when

(a)Total Order cost is Minimum
(b)Total Number of order is least,
(c)Total inventory costs are minimum,
(d) None of the above.

114. ABC Analysis is useful for analyzing the inventories:

(a)Based on their Quality,
(b)Based on their Usage and value,
(c)Based on Physical Volume,
(d) All of the above.

115. If A = Annual Requirement, O = Order Cost and C = Carrying Cost per unit per annum, then
EOQ
(a) (2AO/C) 2 ,
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 (b) 2A÷OC,
(d)2AOC
(c)2AO/C

116. Inventory is generally valued as lower of

(a)Market Price and Replacement Cost
(b)Cost and Net Realizable Value
(c)Cost and Sales Value,
(d) Sales Value and Profit.

117. Which of the following is not included in cost of inventory?

(a) Purchase cost (c)Import Duty,
(b) (b)Transport in Cost, (d)Selling Costs.

118. Cost of not carrying sufficient inventory is known as

(a) Carrying Cost, (c) Total Cost
(b) Holding Cost, (d) Stock-out Cost

119. Which of the following is not a benefit of carrying inventories

(a) Reduction in ordering cost,
(b) voiding lost sales,
(c) Reducing carrying cost,
(d) Avoiding Production Shortages.

120. Which of the following is not a standard method of inventory valuation?

(a)First in First out (c)Average Pricing,
(b)Standard Cost, (d)Realizable Value.

121. System of procuring goods when required, is known as,

(a)Free on Board (FOB),

(b) always Butter Control (ABC),
(c) Jest in Time (JIT) (d)Economic Order Quantity.

122. A firm has inventory turnover of 6 and cost of goods sold is 7,50,000. With better inventory
management, the inventory turnover is increased to 10. This would result in:
(a) Increase in inventory by 50,000,
(b) Decrease in inventory by . 50,000,
(c) Decrease in cost of goods sold,
(d) Increase in cost of goods sol

123. What is Economic Order Quantity?

(c) Reorder level,
(a)Cost of an Order, (d) Optimum order size.
(b) Cost of Stock

124. The type of collateral (security) used for short-term loan is

(b) Real estate,
(b)Plant & Machinery, Stock of good,
125. Which of the following is a
(c) Equity share capital liability of a bank?
623
 (a)Treasury Bills, k
(b) Commercial papers,
(c) Certificate of Deposits,
(d) Junk Bonds.

126. Commercial paper is a type of (a)Fixed coupon Bond

(b)Unsecured short-term debt(c)Equity share capital,
(d) Government Bond
127. Which of the following is not a spontaneous source of short-term funds ?
(a)Trade credit,
(b)Accrued expenses,
(c)Provision for dividend,
(d)All of the above.

128. Concept of Maximum Permissible Bank finance was introduced by

(a)Kannan Committee
(b)Chore Committee,
(c)Nayak Committee,
(d)Tandon Committee.

129. In India, Commercial Papers are issued as per the guidelines issued by
(a) Securities and Exchange Board of India,
(b) Reserve Bank of India,
(c)Forward Market Commission,
(d)None of the above.

130. Commercial paper are generally issued at a price

(a)Equal to face value,
(b)More than face value,
(c)Less than face value,
(d)Equal to redemption value

131. Which of the following is not applicable to commercial paper

(a) Face Value (c)Coupon Rate
(b) Issue Price (d)None of the above
132. The basic objective of Tandon Committee recommendations is that the dependence of
industry on bank should gradually
(a) Increase, (c) Decrease
(b) Remain Stable (d) None of the above

133. Cash discount terms offered by trade creditors never be accepted because
(a)Benefit in very small
(b) Cost is very high
(c) No sense to pay earlier
(d) None of the above.

134. In lease system, interest is calculated on

(a)Cash down payment
(b)Cash price outstanding
(c)Hire purchase price
624
(d)None of the above

135. A short-term lease which is often cancellable is known as

(a) Finance Lease (c)Operating Lease,
(b) Net Lease, (d)Leverage Lease
136. Which of the following is not a usual type of lease arrangement?
(a) Sale & leaseback, (c)Leverage Lease,
(b) Goods on Approval, (d)Direct Lease

137. Under income-tax provisions, depreciation on lease asset is allowed to

(a) Lessor (c) Any of the two,
(b) Lessee (d)None of the two

138. Under the provisions of AS-19 'Leases', a leased asset is shown is the balancesheet of
(a) Manufacturer (c)Lessee,
(b) Lessor, (d Financing bank

139. A lease which is generally not cancellable and covers full economic life of the asset is
known as
(a) Sale and leaseback, (c)Finance Lease,
(b) Operating Lease (d)Economic Lease

140. Lease which includes a third party (a lender) is known as

(a) Sale and leaseback (c) Inverse Lease,
(b) Direct Lease, (d) Leveraged Lease

625
141. One difference between Operating and Financial leaseis:
(a)There is often an option to buy in operating lease
(b)There is often a call option in financial lease.
(c) An operating lease is generally cancelable by lease
(d)A financial lease in generally cancelable by lease.

142. From the point of view of the lessee, a lease is a:

(a)Working capital decision,
(b)Financing decision,
(c)Buy or make decision,
(d)Investment decision

143. For a lesser, a lease is a

(a)Investment decision,
(b)Financing decision,
(c)Dividend decision
(d)None of the above.

144. Which of the following is not true for a "Lease decision for the lessee?
(a) Helps in project selection
(b) (b)Helps in project financing
(c) Helps in project location
(d) All of the above.

145. Risk-Return trade off implies

(a) Minimization of Risk,
(b) Maximization of Risk,
(c) gnorance of Risk
(d) Optimization of Risk

146. Basic objective of diversification is

(a) Increasing Return,
(b) Maximising Return,
(c) Decreasing Risk,
(d) Maximizing Risk.

ANSWER KEY

1-d 16-d 31-d 46-c 61-a 76-b 91-d 106-a 121-c 136-b
2-b 17-c 32-d 47-c 62-c 77-b 92-b 107-a 122-b 137-a
3-c 18-a 33-a 48-c 63-d 78-a 93-c 108-c 123-d 138-c
4-a 19-c 34-d 49-c 64-c 79-a 94-a 109-a 124-c 139-c
5-d 20-d 35-a 50-b 65-c 80-c 95-b 110-d 125-c 140-d
6-a 21-b 36-b 51-c 66-c 81-b 96-b 111-a 126-b 141-c
7-d 22-a 37-b 52-a 67-c 82-c 97-a 112-b 127-c 142-b
626
8-b 23-b 38-b 53-c 68-c 83-d 98-a 113-c 128-d 143-a
9-d 24-c 39-b 54-c 69-d 84-d 99-d 114-b 129-b 144-b
10-b 25-d 40-c 55-b 70-d 85-d 100-b 115-b 130-c 145-d
11-d 26-d 41-d 56-c 71-d 86-d 101-a 116-b 131-d 146-c
12-b 27-b 42-b 57-b 72-d 87-b 102-a 117-d 132-c
13-a 28-b 43-b 58-b 73-c 88-c 103-a 118-d 133-d
14-b 29-a 44-d 59-c 74-b 89-a 104-b 119-c 134-b
15-d 30-b 45-b 60-b 75-b 90-d 105-c 120-c 135-c

627
MCQ of Corporate Finance
1. Which of the following is not one of the three fundamental methods of firm valuation?
a) Discounted Cash flow
b) Income or earnings - where the firm is valued on some multiple of accounting income or
earnings.
c) Balance sheet - where the firm is valued in terms of its assets.
d) Market Share

2. What is the value of the firm usually based on?

a) The value of debt and equity.
b) The value of equity.
c) The value of debt.
d) The value of assets plus liabilities.

3. Which of the following defines the market to book value?

a) The ratio of stock market valuation divided by the value of its NAV.
b) The ratio of NAV value divided by stock market valuation.
c) The market value of tangible assets divided by the book value of tangible assets.
d) The market value of intangible assets divided by the book value of intangible assets.

4. Shareholders wealth increases with the increase in

a) EPS
b) Market value of the firm
c) Dividend & market value of the firm
d) Market price of the equity share

5. Promotion of welfare of human by corporate is called as

a) Social service
b) Philosophy
c) NGO work
d) Corporate philanthropy

6. Leasing of machinery can be categorized as _

a) Fixed asset
b) Investment decision
c) Financing decision
d) Capital budgeting decision

7. A mutually exclusive decision means:

a) Accepting of an alternative, leads to rejecting of other
b) Accepting of both alternatives
c) Rejecting of both alternatives
d) Both c & d

8. Which of the following has Net profit as basis for calculation

a) Net present value
b) Average rate of return
c) Internal rate of return
628
d) Payback period

9. Internal rate of return is …

a) Rate at which discounted cash inflow is more than discounted cash outflow
b) Rate at which discounted cash inflow is less than discounted cash outflow
c) Rate at which discounted cash inflow is equal to the discounted cash outflow
d) Either a or b

10. Corporate wealth maximization is the value maximization for

a) Equity shareholders
b) Stakeholders
c) Employees
d) Debt capital owners

11. Book value of assets includes

a) Fixed assets, current asset
b) Fixed assets, current asset, intangible asset
c) Fixed assets, current asset, fictitious asset
d) Fixed assets, current asset, intangible asset, fictitious asset

12. Listed companies can be valued at

a) Book Value
b) Market value
c) Salvage value
d) Liquidation value

13. Unlisted company can be valued at

a) Net asset Method
b) Market value method
c) Both a & b
d) None of the above

14. Which of the following valuation methods is based on “Going concern concept”
a) Market value method
b) Book value method
c) Liquidation method
d) Salvage value method

15. A company has a profit attributable to ordinary shareholders of £100,000. The number of
ordinary shares of £1 in issue during the year was 300,000. The market value of the company’s
shares at the year end was £6.50. The price/earnings ratio for this company is:
a) 0.05 times
b) 0.33 times
c) 6.5 times
d) 19.5 times
16. What does the price/earnings (PE) ratio measure?
a) The multiple that the stock market places on a company’s earnings
b) The number of times that dividends paid are covered by profits
629
c) The return received by way of dividends as a percentage of current share price
d) The amount of profits available to ordinary shareholders
17. What does the price-to-earnings ratio (P/E) tell you?
(a). How much each of a company's products sells for on average.
(b) How much investors are willing to pay per unit of a company's earnings.
(c) How much tax per unit investors are willing to pay.
d) None of the above

18. How is the P/E ratio calculated?

a) Market value/quick ratio
b) Earnings per share/market capitalization
c) Market value per share/earnings per share
d) None of the above

19. What is the most important use of the P/E ratio for investors?
a) It helps investors decide how much profit a company is likely to make in future.
b) It helps investors decide whether a company's shares are overpriced or underprice(d)
c) It helps investors decide on the most appropriate risk to reward ratio.
d) None of the above

20. What does a high P/E ratio suggest?

a) A company shares are currently overpriced.
b) A company shares are currently underpriced.
c) No relation
d) None of the above

21. If a company has a share price of $100 and its earnings per share averaged $2, what is its P/E
ratio?
a) 20
b) 50
c) 80
d) 70

22. If a company's earnings per share is $20 and it has a share price of $600, what is the P/Eratio?
a) 30
b) 40
c) 50
d) 20

23. Making gifts of money, goods, or time to help non-profit organizations, groups orindividuals is:
a) Corporate social marketing
b) Cause marketing
c) Cause-related marketing
d) Corporate philanthropy

24. The term can be used in a broad sense to describe all the policies, procedures, relationships,
and systems in place to oversee the successful and legal operation of the enterprise.
a) corporate governance
630
b) corporate policy
c) corporate oversight
d) corporate strategy

25. A profitability index (PI) of .92 for a project means that .

a) the project's costs (cash outlay) are (is) less than the present value of the project's benefits
b) the project's NPV is greater than zero
c) the project's NPV is greater than 1
d) the project returns 92 cents in present value for each current dollar invested (cost)

26. The LMN Corporation is considering an investment that will cost $80,000 and have a useful life
of 4 years. During the first 2 years, the net incremental after-tax cash flows are $25,000 per year
and for the last two years they are $20,000 per year. What is thepayback period for this
investment?
a) 3.2 years.
b) 3.5 years.
c) 4.0 years.
d) Cannot be determined from this information.

27. Bulging Stomach Restaurants, Inc., has estimated that a proposed project's 8-year net cash
benefit will be $4,000 per year for years 1 through 8, with an additional terminal benefit of $8,000
at the end of the eighth year. Assuming that these cash inflows satisfy exactly Bulging's
required rate of return of 8 percent, the project's initial cash outflow is closest to which of the
following four possible answers?
a) $27,309
b) $25,149
c) $14,851
d) $40,000

28. Which of the following statements is incorrect regarding a normal project?

a) If the NPV of a project is greater than 0, then its PI will exceed 1.
b) If the IRR of a project is 8%, its NPV, using a discount rate, k, greater than 8%, will beless than
0.
c) If the PI of a project equals 0, then the project's initial cash outflow equals the PVof its cash
flows.
d) If the IRR of a project is greater than the discount rate, k, then its PI will be greaterthan 1.

29. Assume that a firm has accurately calculated the net cash flows relating to two mutually
exclusive investment proposals. If the net present value of both proposals exceed zero and the
firm is not under the constraint of capital rationing, then the firm should_______ .
a) calculate the IRRs of these investments to be certain that the IRRs are greater than the cost
of capital
b) compare the profitability index of these investments to those of other possible investments
c) calculate the payback periods to make certain that the initial cash outlays can be recovered
within a appropriate period of time
d) accept the proposal that has the largest NPV since the goal of the firm is to maximize
shareholder wealth and, since the projects are mutually exclusive, wecan only take one

631
30. A project whose acceptance does not prevent or require the acceptance of one or more
alternative projects is referred to as .
a) a mutually exclusive project
b) an independent project
c) a dependent project
d) a contingent project

31. When operating under a single-period capital-rationing constraint, you may first want to try
selecting projects by descending order of their in order to give yourself the best chance to
select the mix of projects that adds most to firm value.
a) profitability index (PI)
b) net present value (NPV)
c) internal rate of return (IRR)
d) payback period (PBP)

32. Which of the following statements is correct regarding the internal rate of return (IRR) method?
a) Each project has a unique internal rate of return.
b) As long as you are not dealing with mutually exclusive projects, capital rationing, or unusual
projects having multiple sign changes in the cash-flow stream, the internal rate of return
method can be used with reasonable confidence.
c) The internal rate of return does not consider the time value of money.
d) The internal rate of return is rarely used by firms today because of the ease at which net
present value is calculated
33. Which of the following is not a potential for a ranking problem between two mutuallyexclusive
projects?
a) The projects have unequal lives that differ by several years.
b) The costs of the two projects differ by nearly 30%.
c) The two projects have cash flow patterns that differ dramatically.
d) One of the mutually exclusive projects involves replacement while the otherinvolves
expansion.

34. A project whose acceptance precludes the acceptance of one or more alternative projects is
referred to as.
a) a mutually exclusive project.
b) an independent project.
c) a dependent project.
d) a contingent project.

35. Two mutually exclusive projects are being considered. Neither project will be repeated again in
the future after their current lives are complete. There exists a potential problem though -- the
expected life of the first project is one year and the expected life of the second project is three
years. This has caused the NPV and IRR methods to suggest different project preferences.
What technique can be used to help make a better decision in this scenario?
a) Rely on the NPV method and make your choice as it will tell you which one is best.
b) Use the common-life technique to replicate the one-year project three times and recalculate the
NPV and IRR for the one-year project.
c) Ignore the NPV technique and simply choose the highest IRR since managers are concerned
about maximizing returns.
632
d) In this situation, we need to rely on the profitability index (PI) method and choose the one with
the highest PI.

36. High P/E ratios tend to indicate that a company will

a) grow quickly
b) grow at the same speed as the average company
c) grow slowly
d) not grow

37. is equal to (common shareholders' equity/common shares outstanding).

a) Book value per share
b) Liquidation value per share
c) Market value per share
d) Tobin's Q

38. The is defined as the present value of all cash proceeds to the investor in thestock.
a) dividend payout ratio
b) intrinsic value
c) market capitalization rate
d) plowback ratio
39. Historically, P/E ratios have tended to be .
a) higher when inflation has been high
b) lower when inflation has been high
c) uncorrelated with inflation rates but correlated with other macroeconomicvariables
d) uncorrelated with any macroeconomic variables including inflation rates

40. All of the following influence capital budgeting cash flows EXCEPT:
a) Accelerated depreciation
b) Salvage value
c) Tax rate changes
d) Method of project financing used

41. A capital investment is one that

a) Has the prospect of long term benefit
b) Has the prospect of short term benefit
c) Is only undertaken by large corporations
d) Applies only to investment in fixed assets

43. Companies may adopt an aggressive or a conservative working capital policy. An aggressive
policy means that a company
a) holds high levels of cash and inventories
b) expects a lower level of profitability
c) has a low level of flexibility
d) faces a low level of risk

44. Which of the following would be consistent with a more aggressive approach to financing
working capital?
a. Financing short-term needs with short-term funds.
633
b. Financing permanent inventory buildup with long-term debt.
c. Financing seasonal needs with short-term funds.
d. Financing some long-term needs with short-term funds.

45. Which of the following illustrates the use of a hedging (or matching) approach tofinancing?
a) Short – term assets financed with long term liabilities
b) Permanent working capital financed with long-term liabilities.
c) Short – term assets financed with equity.
d) All assets financed with a 50 percent equity, 50 percent long-term debt mixture.

46. Permanent working capital

a. Varies with seasonal needs.
b. Includes fixed assets.
c. Is the amount of current assets required to meet a firm's long-term minimum needs.
d. Includes accounts payable.
47. Which of the following would not be financed from working capital?
a) Cash float
b) Accounts receivable
c) Credit sales
d) A new personal computer for the office

48. When economic value added is used as the performance measure, value is only created if the
after-tax operating income exceeds
a) cost of investing capital
b) investment
c) working capital
d) sales

49. Which of the performance evaluation methods takes into consideration tax effects?
a) Economic value added
b) Return on sales
c) Residual income
d) Return on investment

50. Which of the following best describes "Market Value Added"?

a) The value added to the product the firm produces above and beyond the costs ofthe inputs.
b) The difference between the book value of equity and debt versus the market valueof the firm.
c) The difference between the market value of the firm and the amount ofcontributed capital.
d) None of the above accurately describes Market Value Added.
51. Market price per share of a firm having equity capital of Rs. 100000 consisting of shares of Rs.
10 each, profit after tax of Rs. 82000, & P/E ratio of 8 is
a) Rs. 65.70
b) Rs.10.25
c) Rs.65.60
d) Rs.1.025

MCQ of Corporate Finance

1. Which of the following is not one of the three fundamental methods of firm valuation?

634
a) Discounted Cash flow
b) Income or earnings - where the firm is valued on some multiple of accounting income or
earnings.
c) Balance sheet - where the firm is valued in terms of its assets.
d) Market Share

2. What is the value of the firm usually based on?

a) The value of debt and equity.
b) The value of equity.
c) The value of debt.
d) The value of assets plus liabilities.

3. Which of the following defines the market to book value?

a) The ratio of stock market valuation divided by the value of its NAV.
b) The ratio of NAV value divided by stock market valuation.
c) The market value of tangible assets divided by the book value of tangible assets.
d) The market value of intangible assets divided by the book value of intangible assets.

4. Shareholders wealth increases with the increase in

a) EPS
b) Market value of the firm
c) Dividend & market value of the firm
d) Market price of the equity share

5. Promotion of welfare of human by corporate is called as

a) Social service
b) Philosophy
c) NGO work
d) Corporate philanthropy

6. Leasing of machinery can be categorized as _

a) Fixed asset
b) Investment decision
c) Financing decision
d) Capital budgeting decision

7. A mutually exclusive decision means:

a) Accepting of an alternative, leads to rejecting of other
b) Accepting of both alternatives
c) Rejecting of both alternatives
d) Both c & d

8. Which of the following has Net profit as basis for calculation

a) Net present value
b) Average rate of return
c) Internal rate of return
d) Payback period

635
9. Internal rate of return is …
a) Rate at which discounted cash inflow is more than discounted cash outflow
b) Rate at which discounted cash inflow is less than discounted cash outflow
c) Rate at which discounted cash inflow is equal to the discounted cash outflow
d) Either a or b

10. Corporate wealth maximization is the value maximization for

a) Equity shareholders
b) Stakeholders
c) Employees
d) Debt capital owners

11. Book value of assets includes

a) Fixed assets, current asset
b) Fixed assets, current asset, intangible asset
c) Fixed assets, current asset, fictitious asset
d) Fixed assets, current asset, intangible asset, fictitious asset

12. Listed companies can be valued at

a) Book Value
b) Market value
c) Salvage value
d) Liquidation value

13. Unlisted company can be valued at

a) Net asset Method
b) Market value method
c) Both a & b
d) None of the above

14. Which of the following valuation methods is based on “Going concern concept”
a) Market value method
b) Book value method
c) Liquidation method
d) Salvage value method

15. A company has a profit attributable to ordinary shareholders of £100,000. The number of
ordinary shares of £1 in issue during the year was 300,000. The market value of the company’s
shares at the year end was £6.50. The price/earnings ratio for this company is:
a) 0.05 times
b) 0.33 times
c) 6.5 times
d) 19.5 times

16. What does the price/earnings (PE) ratio measure?

a) The multiple that the stock market places on a company’s earnings
b) The number of times that dividends paid are covered by profits
c) The return received by way of dividends as a percentage of current share price
636
d) The amount of profits available to ordinary shareholders
17. What does the price-to-earnings ratio (P/E) tell you?
a) How much each of a company's products sells for on average.
b) How much investors are willing to pay per unit of a company's earnings.
c) How much tax per unit investors are willing to pay.
d) None of the above

18. How is the P/E ratio calculated?

a) Market value/quick ratio
b) Earnings per share/market capitalization
c) Market value per share/earnings per share
d) None of the above

19. What is the most important use of the P/E ratio for investors?
a) It helps investors decide how much profit a company is likely to make in future.
b) It helps investors decide whether a company's shares are overpriced or underpriced.
c) It helps investors decide on the most appropriate risk to reward ratio.
d) None of the above

20. What does a high P/E ratio suggest?

a) A company shares are currently overpriced.
b) A company shares are currently underpriced.
c) No relation
d) None of the above

21. If a company has a share price of $100 and its earnings per share averaged $2, what is its P/E
ratio?
a) 20
b) 50
c) 80
d) 70

22. If a company's earnings per share is $20 and it has a share price of $600, what is the P/E
ratio?
a) 30
b) 40
c) 50
d) 20

23. Making gifts of money, goods, or time to help non-profit organizations, groups orindividuals is:
a) Corporate social marketing
b) Cause marketing
c) Cause-related marketing
d) Corporate philanthropy

24. The term can be used in a broad sense to describe all the policies, procedures, relationships,
and systems in place to oversee the successful and legal operation of the enterprise.
a) corporate governance
637
b) corporate policy
c) corporate oversight
d) corporate strategy

25. A profitability index (PI) of .92 for a project means that .

a) the project's costs (cash outlay) are (is) less than the present value of the project's benefits
b) the project's NPV is greater than zero
c) the project's NPV is greater than 1
d) the project returns 92 cents in present value for each current dollar invested (cost)

26. The LMN Corporation is considering an investment that will cost $80,000 and have auseful life
of 4 years. During the first 2 years, the net incremental after-tax cash flows are $25,000 per
year and for the last two years they are $20,000 per year. What is thepayback period for
this investment?
a) 3.2 years.
b) 3.5 years.
c) 4.0 years.
d) Cannot be determined from this information.

27. Bulging Stomach Restaurants, Inc., has estimated that a proposed project's 8-year net
cash benefit will be $4,000 per year for years 1 through 8, with an additional terminal benefit of
$8,000 at the end of the eighth year. Assuming that these cash inflows satisfy exactly
Bulging's required rate of return of 8 percent, the project's initial cash outflow is closest to
which of the following four possible answers?
a) $27,309
b) $25,149
c) $14,851
d) $40,000

36. High P/E ratios tend to indicate that a company will

a) grow quickly
b) grow at the same speed as the average company
c) grow slowly
d) not grow

37. is equal to (common shareholders' equity/common shares outstanding).

a) Book value per share
b) Liquidation value per share
c) Market value per share
d) Tobin's Q

38. The is defined as the present value of all cash proceeds to the investor in thestock.
a) dividend payout ratio
b) intrinsic value
c) market capitalization rate
d) plowback ratio

39. Historically, P/E ratios have tended to be .

638
a) higher when inflation has been high
b) lower when inflation has been high
c) uncorrelated with inflation rates but correlated with other macroeconomicvariables
d) uncorrelated with any macroeconomic variables including inflation rates

40. All of the following influence capital budgeting cash flows EXCEPT:
a) Accelerated depreciation
b) Salvage value
c) Tax rate changes
d) Method of project financing used

41. A capital investment is one that

a) Has the prospect of long term benefit
b) Has the prospect of short term benefit
c) Is only undertaken by large corporations
d) Applies only to investment in fixed assets

42. Companies may adopt an aggressive or a conservative working capital policy. An aggressive
policy means that a company
a) holds high levels of cash and inventories
b) expects a lower level of profitability
c) has a low level of flexibility
d) faces a low level of risk

43. Which of the following would be consistent with a more aggressive approach to financing
working capital?
a. Financing short-term needs with short-term funds.
b. Financing permanent inventory buildup with long-term debt.
c. Financing seasonal needs with short-term funds.
d. Financing some long-term needs with short-term funds.

44. Which of the following illustrates the use of a hedging (or matching) approach tofinancing?
a) Short – term assets financed with long term liabilities
b) Permanent working capital financed with long-term liabilities.
c) Short – term assets financed with equity.
d) All assets financed with a 50 percent equity, 50 percent long-term debt mixture.

45. Permanent working capital

a. Varies with seasonal needs.
b. Includes fixed assets.
c. Is the amount of current assets required to meet a firm's long-term minimumneeds.
d. Includes accounts payable.

46. Which of the following would not be financed from working capital?
a) Cash float
b) Accounts receivable
c) Credit sales
d) A new personal computer for the office
639
47. When economic value added is used as the performance measure, value is only created if the
after-tax operating income exceeds
a) cost of investing capital
b) investment
c) working capital
d) sales

48. Which of the performance evaluation methods takes into consideration tax effects?

a) Economic value added

b) Return on sales
c) Residual income
d) Return on investment

49. Which of the following best describes "Market Value Added"?

a) The value added to the product the firm produces above and beyond the costs ofthe inputs.
b) The difference between the book value of equity and debt versus the market valueof the firm.
c) The difference between the market value of the firm and the amount ofcontributed capital.
d) None of the above accurately describes Market Value Adde(d)

50. Market price per share of a firm having equity capital of Rs. 100000 consisting of shares of Rs.
10 each, profit after tax of Rs. 82000, & P/E ratio of 8 is
a) Rs. 65.70
b) Rs.10.25
c) Rs.65.60
d) Rs.1.025

640
MEASURES OF CENTRAL TENDENCY

Introduction
A measure of central tendency is a single value that attempts to describe a set of data by
identifying the central position within that set of data. As such, measures of central tendency are
sometimes called measures of central location. They are also classed as summary statistics. The
mean (often called the average) is most likely the measure of central tendency that you are most
familiar with, but there are others, such as the median and the mode.

The mean, median and mode are all valid measures of central tendency, but under different
conditions, some measures of central tendency become more appropriate to use than others. In
the following sections, we will look at the mean, mode and median, and learn how to calculate
them and underwhat conditions they are most appropriate to be used.
Mean (Arithmetic)

The mean (or average) is the most popular and well known measure of central tendency. It can be
used with both discrete and continuous data, although its use is most often with continuous data .
The mean is equal to the sum of all the values in the data set divided by the number of values in
the data set. So, if we have n values in a data set and they have values x1, x2, ..., xn, the sample
mean, usually denoted by (pronounced x bar), is:

This formula is usually written in a slightly different manner using the Greek capitol letter, ,
pronounced "sigma", which means "sum of...":

You may have noticed that the above formula refers to the sample mean. So, why have we called it
a sample mean? This is because, in statistics, samples and populations have very different
meanings and these differences are very important, even if, in the case of the mean, they are
calculated in the same way. To acknowledge that we are calculating the population mean and not
the sample mean, we use the Greek lower caseletter "mu", denoted as µ:

An important property of the mean is that it includes every value in your data set as part of the
calculation. In addition, the mean is the only measure of central tendency where the sum of the
deviations of each value from the mean is always zero.

When not to use the mean

The mean has one main disadvantage: it is particularly susceptible to the influence of outliers.
These are values that are unusual compared to the rest of the data set by being especially small or
large in numerical value. For example, consider the wages of staff at a factory below:

Staff 1 2 3 4 5 6 7 8 9 10
Salary 15k 18k 16k 14k 15k 15k 12k 17k 90k 95k

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The mean salary for these ten staff is $30.7k. However, inspecting the raw data suggests that this
mean value might not be the best way to accurately reflect the typical salary of a worker, as most
workers have salaries in the $12k to 18k range. The mean is being skewed by the two large
[Link], in this situation, we would like to have a better measure of central tendency. As
we will find out later, taking the median would be a better measure of central tendency in this
situation.

Median
The median is the middle score for a set of data that has been arranged inorder of magnitude. The
median is less affected by outliers and skewed data. In order to calculate the median, suppose we
have the data below:

65 55 89 56 35 14 56 55 87 45 92

We first need to rearrange that data into order of magnitude (smallest first):

14 35 45 55 55 56 56 65 87 89 92

Our median mark is the middle mark - in this case, 56 (highlighted in bold). It is the middle mark
because there are 5 scores before it and 5 scores after it. This works fine when you have an odd
number of scores, but what happens when you have an even number of scores? What if you had
only 10 scores? Well, you simply have to take the middle two scores and average the result. So, if
we look at the example below:

65 55 89 56 35 14 56 55 87 45

We again rearrange that data into order of magnitude (smallest first):

14 35 45 55 55 56 56 65 87 89

Only now we have to take the 5th and 6th score in our data set and average them to get a median
of 55.5.

Mode

The mode is the most frequent score in our data set. On a histogram it represents the highest bar
in a bar chart or histogram. You can, therefore, sometimes consider the mode as being the most
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popular option. An example of a mode is presented below:

Normally, the mode is used for categorical data where we wish to know which is the most
common category, as illustrated below:

We can see above that the most common form of transport, in this particular data set, is the bus.
However, one of the problems with the mode is that it is not unique, so it leaves us with problems
when we have two or more values that share the highest frequency, such as below:

We are now stuck as to which mode best describes the central tendency of the data. This is
particularly problematic when we have continuous data because we are more likely not to have
any one value that is more frequent than the other. For example, consider measuring 30 peoples'
weight (to the nearest 0.1 kg). How likely is it that we will find two or more people with exactly the
same weight (e.g., 67.4 kg)? The answer, is probably very unlikely - many people might be close,
but with such a small sample (30 people) and a large range of possible weights, you are unlikely to
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find two people with exactly the same weight; that is, to the nearest 0.1 kg. This is why the mode
is very rarelyused with continuous data.

Another problem with the mode is that it will not provide us with a very good measure of central
tendency when the most common mark is far away from the rest of the data in the data set, as
depicted in the diagram below:

In the above diagram the mode has a value of 2. We can clearly see, however, that the mode is not
representative of the data, which is mostly concentrated around the 20 to 30 value range. To use
themode to describe the central tendency of this data set would be misleading.

Measures of Dispersion
Suppose you are given a data series. Someone asks you to tell some interesting facts about this data
series. How can you do so? You can say you can find the mean, the median or the mode of this data
series and tell about its distribution. But is it the only thing you can do? Are the central tendencies the
only way by which we can get to know about the concentration of the observation? In this section, we
will learn about another measure to know more about the data. Here, we are going to know about the
measure of dispersion. Let’s start.

Measures of Dispersion
As the name suggests, the measure of dispersion shows the scatterings of the data. It tells the
variation of the data from one another and gives a clear idea about the distribution of the data. The
measure of dispersion shows the homogeneity or the heterogeneity of the distribution of the
observations.

Suppose you have four datasets of the same size and the mean is also same, say, m. In all the cases
the sum of the observations will be the same. Here, the measure of central tendency is not giving a
clear and complete idea about the distribution for the four given sets.

Can we get an idea about the distribution if we get to know about the dispersion of the observations
from one another within and between the datasets? The main idea about the measure of dispersion
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is to get to know how the data are spread. It shows how much the data vary from their average
value.

Characteristics of Measures of Dispersion

• A measure of dispersion should be rigidly defined
• It must be easy to calculate and understand
• Not affected much by the fluctuations of observations
• Based on all observations

Classification of Measures of Dispersion

The measure of dispersion is categorized as:
(i) An absolute measure of dispersion:
• The measures which express the scattering of observation in terms of distances i.e., range,
quartile deviation.
• The measure which expresses the variations in terms of the average of deviations of
observations like mean deviation and standard deviation
(ii) A relative measure of dispersion:
• We use a relative measure of dispersion for comparing distributions of two or more data set
and for unit free comparison. They are the coefficient of range, the coefficient of mean
deviation, the coefficient of quartile deviation, the coefficient of variation, and the
coefficient of standard deviation.

Range
A range is the most common and easily understandable measure of dispersion. It is the difference
between two extreme observations of the data set. If X max and X min are the two extreme
observations then
Range = X max – X min

Merits of Range
• It is the simplest of the measure of dispersion
• Easy to calculate
• Easy to understand
• Independent of change of origin

Demerits of Range
• It is based on two extreme observations. Hence, get affected by fluctuations
• A range is not a reliable measure of dispersion
• Dependent on change of scale

Quartile Deviation
The quartiles divide a data set into quarters. The first quartile, (Q1) is the middlenumber between the
smallest number and the median of the data. The second quartile, (Q2) is the median of the data
set. The third quartile, (Q3) is the middle number between the median and the largest number.
Quartile deviation or semi-inter-quartile deviation is Q = ½ × (Q3 – Q1)

Merits of Quartile Deviation

• All the drawbacks of Range are overcome by quartile deviation

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• It uses half of the data
• Independent of change of origin
• The best measure of dispersion for open-end classification

Demerits of Quartile Deviation

• It ignores the 50% of the data
• Dependent on change of scale
• Not a reliable measure of dispersion

Mean Deviation
Mean deviation is the arithmetic mean of the absolute deviations of the observations from a
measure of central tendency. If x1, x2, … , xn are the set of observation, then the mean deviation of x
about the average A (mean, median, ormode) is

Mean deviation from average A = 1⁄n [∑i|xi – A|]

For a grouped frequency, it is calculated as:

Mean deviation from average A = 1⁄N [∑i fi |xi – A|], N = ∑fi

Here, xi and fi are respectively the mid value and the frequency of the ith classinterval.

Merits of Mean Deviation

• Based on all observations
• It provides a minimum value when the deviations are taken from the median
• Independent of change of origin

Demerits of Mean Deviation

• Not easily understandable
• Its calculation is not easy and time-consuming
• Dependent on the change of scale
• Ignorance of negative sign creates artificiality and becomes useless for further mathematical
treatment

Standard Deviation
A standard deviation is the positive square root of the arithmetic mean of the squares of the
deviations of the given values from their arithmetic mean. It isdenoted by a Greek letter sigma, σ. It is
also referred to as root mean square deviation. The standard deviation is given as

σ = [(Σi (yi – ȳ) ⁄ n] ½ = [(Σ i yi 2 ⁄ n) – ȳ 2] ½

For a grouped frequency distribution, it is

σ = [(Σi fi (yi – ȳ) ⁄ N] ½ = [(Σi fi yi 2 ⁄ n) – ȳ 2] ½

The square of the standard deviation is the variance. It is also a measure ofdispersion.

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 σ 2 = [(Σi (yi – ȳ) / n] ½ = [(Σi yi 2 ⁄ n) – ȳ 2]
For a grouped frequency distribution, it is

σ 2 = [(Σi fi (yi – ȳ) ⁄ N] ½ = [(Σ i fi xi 2 ⁄ n) – ȳ 2].

If instead of a mean, we choose any other arbitrary number, say A, the standard deviation becomes
the root mean deviation.

Variance of the Combined Series

If σ1, σ2 are two standard deviations of two series of sizes n1 and n2 with means ȳ1 and ȳ2. The
variance of the two series of sizes n1 + n2 is:

σ 2 = (1/ n1 + n2) ÷ [n1 (σ1 2 + d1 2) + n2 (σ2 2 + d2 2)]

where, d1 = ȳ 1 − ȳ, d2 = ȳ 2 − ȳ, and ȳ = (n1 ȳ 1 + n2 ȳ2) ÷ ( n1 + n2).

Merits of Standard Deviation

• Squaring the deviations overcomes the drawback of ignoring signs in meandeviations
• Suitable for further mathematical treatment
• Least affected by the fluctuation of the observations
• The standard deviation is zero if all the observations are constant
• Independent of change of origin

Demerits of Standard Deviation

• Not easy to calculate
• Difficult to understand for a layman
• Dependent on the change of scale

Coefficient of Dispersion
Whenever we want to compare the variability of the two series which differ widely in their averages.
Also, when the unit of measurement is different. We need to calculate the coefficients of
dispersion along with the measure of dispersion. The coefficients of dispersion (C.D.) based on
different measures ofdispersion are

• Based on Range = (X max – X min) ⁄ (X max + X min).

• C.D. based on quartile deviation = (Q3 – Q1) ⁄ (Q3 + Q1).
• Based on mean deviation = Mean deviation/average from which it is calculated.
• For Standard deviation = S.D. ⁄ Mean

Coefficient of Variation
100 times the coefficient of dispersion based on standard deviation is the coefficient of variation
(C.V.).

C.V. = 100 × (S.D. / Mean) = (σ/ȳ) × 100.

Solved Example for You

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Problem: Below is the table showing the values of the results for two companiesA, and B.

1. Which of the company has a larger wage bill?

2. Calculate the coefficients of variations for both of the companies.
3. Calculate the average daily wage and the variance of the distribution of wages of all the
employees in the firms A and B taken together.

Solution:

For Company A
No. of employees = n1 = 900, and average daily wages = ȳ 1 = Rs. 250
We know, average daily wage = Total wages ⁄ Total number of employees
or, Total wages = Total employees × average daily wage = 900 × 250 = Rs.225000 … (i)

For Company B
No. of employees = n2 = 1000, and average daily wages = ȳ2 = Rs. 220
So, Total wages = Total employees × average daily wage = 1000 × 220 = Rs.220000 … (ii)
Comparing (i), and (ii), we see that Company A has a larger wage bill.

For Company A
Variance of distribution of wages = σ 2 = 100
C.V. of distribution of wages = 100 x standard deviation of distribution of wages/ average daily
wages
Or, C.V. A = 100 × √100⁄250 = 100 × 10⁄250 = 4 … (i)

For Company B
Variance of distribution of wages = σ 2 = 144
C.V. B = 100 × √144⁄220 = 100 × 12⁄220 = 5.45 … (ii)
Comparing (i), and (ii), we see that Company B has greater variability.

For Company A and B, taken together

The average daily wages for both the companies taken together
ȳ = (n1 ȳ 1 + n2 ȳ2)⁄( n1 + n2) = (900 × 250 + 1000 × 220) ÷ (900 + 1000) = 445000⁄1900 = Rs.
234.21
The combined variance, σ2 = (1/ n1 + n2) ÷ [n1 (σ1 2 + d1 2) + n2 (σ2 2 + d2 2)]
Here, d1 = ȳ1 − ȳ = 250 – 234.21 = 15.79, d2 = ȳ2 − ȳ = 220 – 234.21 = – 14.21. Hence, σ2 = [900 ×
(100 + 15.792) + 1000 × (144 + – 14.212)] ⁄ (900 + 1000)
or, σ2 = (314391.69 + 345924.10) ⁄ 1900 = 347.53.

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Measure of Skewness
In statistics, we study about the management, observation and calculation generally over a large
numerical data. In the statistical analysis of a survey or research, a researcher is required to know
about the distribution, centraltendency, dispersion etc.

It is also needed to know that what would be the variability and location of the given data set. This
includes the measurement of skewness of the data, since all given data distributions are not
symmetric.

The skewness measures how asymmetric the distribution is. We can say that skewness is the
measure of asymmetry of the data. It also determines if the data is skewed to the left or to the
right.

The measure of skewness is being utilized in many areas. We know that a data which is normally
distributed, is said to be symmetric about its mean. It has skewness equal to zero. But usually, the
distributions are not symmetric.

Thus, the analysis of skewness becomes mandatory, as it defines the deviations from the mean
position. An asymmetric or skewed data is not a perfect mirror image about the mean. By the
measurement of skewness, one can determine how mean, median and mode are connected to
one another. Let us go ahead in this page and learn about skewness, its calculation and
applications in detail.

Definition
Measure of skewness determines the extent of asymmetry or lack of symmetry. A distribution is
said to be asymmetric if its graph does not appear similar to the right and to the left around the
central position. In more statistical language, the skewness measures how much is the asymmetry
of probability distribution of some given real-valued random variable about the mean. Skewness
can be observed in the given data when number of observations are less.

For Example: When the numbers 9, 10, 11 are given, we may easily inspect that the values are
equally distributed about the mean 10. But if we add a number 5, so as to get the data as 5, 9, 10,
11, then we can say that the distribution is not symmetric or it is skewed.

The skewness can be viewed by the having a look at the graph. The measure of skewness can be
of two types : positive skew and negative skew.

Positive Skew: When the given distribution concentrates on the left side in the graph, it is known
as the positive skew. In the following curve, we may easily observe that the right tail is bigger. This
may be called as right-tailed or right-skewed distribution.

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Negative Skew: If in the graph, the concentration of the curve is higher on the right side or the
left tail is bigger, then given distribution would known as left tailed or negatively skewed or left
skewed. It is shown in the following diagram:

FORMULAS
There are various measures of skewness of the statistical data. For univariate data, the expression
for measurement of skewness is given below:

SkSk = ∑ni=1(xi−x¯)3s3(n−1)∑i=1n(xi−x¯)3s3(n−1)

Where, xixi = given observations

x¯x¯ = mean
s = standard deviation
n = number of observations.

For normal distribution, the measure of skewness is zero. When skewness is negative, it means
that the data is left skewed. If it is positive, then the data is said to be right skewed.

Pearson’s Coefficient of Skewness

The method of finding skewness is also developed by Karl Pearson. This method is known as
"Pearson’s Coefficient of Skewness". According to this method, there are two formulas for the
measurement of skewness.

The formula is:

SkSk = x¯−Mosx¯−Mos

Where, $\bar{x} represents mean of the data, s is the standard deviation and Mo denotes the

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mode for the given sample. This formula uses mode, thats why it is called "Pearson Mode
Skewness".

There is another formula which utilizes median and eventually it is termed as " Pearson Median
Skewness".

This formula is given below:

SkSk = 3(x¯−Md)s3(x¯−Md)s

Where, Md stands for median and all other symbols are as above.
These formulas are used according to the given values, i.e. when mode is known, then Pearson
mode skewness is used and when median is given, Pearson median skewness is applied.

Moment Coefficient of Skewness

According to this technique, the formula for measure of skewness is given below:
Where,
SkSk = M3M322M3M232

M3M3 = Third moment of the given data and is calculated using the following formula:

M3M3 = ∑ni=1(xi−x¯)3n∑i=1n(xi−x¯)3n
and
M2M2 = Second moment or variance of the data which is measured by the use of following
formula :
M2M2 = ∑ni=1(xi−x¯)2n

Introduction to Correlation and RegressionAnalysis

In this section we will first discuss correlation analysis, which is used to quantify the association
between two continuous variables (e.g., between an independent and a dependent variable or
between two independent variables). Regression analysis is a related technique to assess the
relationship between an outcome variable and one or more risk factors or confounding variables.
The outcome variable is also called the response or dependent variable and the risk factors and
confounders are called the predictors, or explanatory or independent variables. In regression
analysis, thedependent variable is denoted "y" and the independent variables are denoted by "x".

[NOTE: The term "predictor" can be misleading if it is interpreted as the ability to predict even
beyond the limits of the data. Also, the term "explanatory variable" might give an impression of a
causal effect in a situation in which inferences should be limited to identifying associations. The
terms "independent" and "dependent" variable are less subject to these interpretations as they do
not strongly imply cause and effect.

Correlation Analysis
In correlation analysis, we estimate a sample correlation coefficient, more specifically the
Pearson Product Moment correlation coefficient. The sample correlation coefficient, denoted r,
ranges between -1 and +1 and quantifies the direction and strength of the linear association
between the two variables. The correlation between two variables can be positive (i.e., higher
levels of one variable are associated with higher levels of the other) ornegative (i.e., higher levels of
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one variable are associated with lower levels of the other).

The sign of the correlation coefficient indicates the direction of the association. The magnitude of
the correlation coefficient indicates the strength of the association.

For example, a correlation of r = 0.9 suggests a strong, positive association between two
variables, whereas a correlation of r = -0.2 suggest a weak, negative association. A correlation
close to zero suggests no linear association between two continuous variables.

LISA: [I find this description confusing. You say that the correlation coefficient is a measure of
the "strength of association", but if you think about it, isn't the slope a better measure of
association? We use risk ratios and odds ratios to quantify the strength of association, i.e., when
an exposure is present it has how many times more likely the outcome is. The analogous quantity
in correlation is the slope, i.e., for a given increment in the independent variable, how many times
is the dependent variable going to increase? And "r" (or perhaps better R-squared) is a measure
of how much of the variability in the dependent variable can be accounted for by differences in
the independent variable. The analogous measure for a dichotomous variable and a dichotomous
outcome would be the attributable proportion, i.e., the proportion of Y that can be attributed to
the presence of the exposure.]

It is important to note that there may be a non-linear association between two continuous
variables, but computation of a correlation coefficient does not detect this. Therefore, it is always
important to evaluate the data carefully before computing a correlation coefficient. Graphical
displays are particularly useful to explore associations between variables.

The figure below shows four hypothetical scenarios in which one continuous variable is plotted
along the X-axis and the other along the Y-axis.

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• Scenario 1 depicts a strong positive association (r=0.9), similar to what we might see for the
correlation between infant birth weight and birth length.
• Scenario 2 depicts a weaker association (r=0,2) that we might expect to see between age and
body mass index (which tends to increase with age).
• Scenario 3 might depict the lack of association (r approximately 0) between the extent of
media exposure in adolescence and age at which adolescents initiate sexual activity.
• Scenario 4 might depict the strong negative association (r= -0.9) generally observed between
the number of hours of aerobic exercise per week and percent body fat.

Example - Correlation of Gestational Age and Birth Weight

A small study is conducted involving 17 infants to investigate the association between gestational
age at birth, measured in weeks, and birth weight, measured in grams.

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We wish to estimate the association between gestational age and infant birth weight. In this
example, birth weight is the dependent variable and gestational age is the independent variable.
Thus y=birth weight and x=gestational age. The data are displayed in a scatter diagram in the
figure below.

Each point represents an (x,y) pair (in this case the gestational age, measured in weeks, and the
birth weight, measured in grams). Note that the independent variable is on the horizontal axis (or
X-axis), and the dependent variable is on the vertical axis (or Y-axis). The scatter plot shows a
positive or direct association between gestational age and birth weight. Infants with shorter
gestational ages are more likely to be born with lower weights and infants with longer gestational
ages are more likely to be born with higher weights.

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The formula for the sample correlation coefficient is

where Cov(x,y) is the covariance of x and y defined as

are the sample variances of x and y, defined as

The variances of x and y measure the variability of the x scores and y scores around their
respective sample means ( onsidered separately). The covariance measures the variability
of the (x,y) pairsaround the mean of x and mean of y, considered simultaneously.

To compute the sample correlation coefficient, we need to compute the variance of gestational
age, the variance of birth weight and also the covariance of gestational age andbirth weight.

We first summarize the gestational age data. The mean gestational age is:

The variance of birth weight is computed just as we did for gestational age as shown in the table
below.

To compute the variance of gestational age, we need to sum the squared deviations (or
differences) between each observed gestational age and the mean gestational age. The
computations are summarized below.

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The variance of gestational age is:

Next, we summarize the birth weight data. The mean birth weight is:

The variance of birth weight is computed just as we did for gestational age as shown in thetable
below.

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variance of birth weight is

Next we compute the covariance

To compute the covariance of gestational age and birth weight, we need to multiply the deviation
from the mean gestational age by the deviation from the mean birth weight for each participant
(i.e.,

The computations are summarized below. Notice that we simply copy the deviations from the
mean gestational age and birth weight from the two tables above into the table belowand multiply.

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The covariance of gestational age and birth weight is:

We now compute the sample correlation coefficient:

Not surprisingly, the sample correlation coefficient indicates a strong positive correlation. As we
noted, sample correlation coefficients range from -1 to +1. In practice, meaningful correlations
(i.e., correlations that are clinically or practically important) can be as small as (or -0.4) for positive
(or negative) associations. There are also statistical tests to determine whether an observed
correlation is statistically significant or not (i.e., statistically significantly different from zero).
Procedures to test whether an observed sample correlation is suggestive of a statistically
significant correlation are described in detail in Kleinbaum, Kupper and Muller.1

Difference Between Correlation and Regression

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Correlation and Regression are the two analysis based on multivariate distribution. A multivariate
distribution is described as a distribution of multiple variables. Correlation is described as the
analysis which lets us know the association or the absence of the relationship between two
variables ‘x’ and ‘y’. On the other end, Regression analysis, predicts the value of the dependent
variable based on the known value of the independent variable, assuming that average
mathematical relationship between two or more variables.

The difference between correlation and regression is one of the commonly asked questions in
interviews. Moreover, many people suffer ambiguity in understanding these two. So, take a full
read of this article to have a clear understanding on these two.

Content: Correlation Vs Regression

1. Comparison Chart
2. Definition
3. Key Differences
4. Conclusion

Comparison Chart

BASIS FOR
COMPARISON CORRELATION REGRESSION

Correlation is a statistical measure Regression describes how an

Meaning which determines co- relationship or independent variable is numerically
association of two variables. related to the dependent variable.

To fit a best line and estimate one

To represent linear relationship
Usage variable on the basis of another
between two variables.
variable.

BASIS FOR
COMPARISON CORRELATION REGRESSION

Dependent and
Independent No difference Both variables are different.
variables

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 Correlation coefficient indicates the Regression indicates the impact of a
Indicates extent to which two variables move unit change in the known variable (x)
together. on the estimated variable (y).

To estimate values of random

To find a numerical value expressing
Objective variable on the basis of the values of
the relationship between variables.
fixed variable.

Introduction to Conditional Probability and Bayes theorem for data science

professionals

Introduction
Understanding of probability is must for a data science professional. Solutions to many data
science problems are often probabilistic in nature. Hence, a better understanding of probability
will help you understand & implement these algorithms more efficiently.

In this article, I will focus on conditional probability. For beginners in probability, I would strongly
recommend that you go through this article before proceeding further.

A predictive model can easily be understood as a statement of conditional probability. For

example, the probability of a customer from segment A buying a product of category Z in next 10
days is 0.80. In other words, the probability of a customer buying product from Category Z, given
that the customer is from Segment A is 0.80.

In this article, I will walk you through conditional probability in detail. I’ll be using examples & real-
life scenarios to help you improve your understanding.

Table of Contents
1. Events – Union, Intersection & Disjoint events
2. Independent, Dependent and Exclusive events
3. Conditional Probability
4. Bayes Theorem
5. Probability trees
6. Frequentist vs Bayesian definitions of probability
7. Open Challenges

1. Events – Union, Intersection & Disjoint events

Before we explore conditional probability, let us define some basic common terminologies:

1.1 EVENTS
An event is simply the outcome of a random experiment. Getting a heads when we toss a coin is
an event. Getting a 6 when we roll a fair die is an event. We associate probabilities to these events
by defining the event and the sample space.

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The sample space is nothing but the collection of all possible outcomes of an experiment. This
means that if we perform a particular task again and again, all the possible results of the task are
listed in the sample space.

For example: A sample space for a single throw of a die will be {1,2,3,4,5,6}. One of these is bound
to occur if we throw a die. The sample space exhausts all the possibilities that can happen when
that experiment is performed.

An event can also be a combination of different events.

1.2 Union of Events

We can define an event (C) of getting a 4 or 6 when we roll a fair die. Here event C is a union of two
events:

Event A = Getting a 4
Event B = Getting a 6
P (C) = P (A ꓴ B)

In simple words we can say that we should consider the probability of (A ꓴ B) when we are
interested in combined probability of two (or more) events.

1.3. Intersection of Events

Let’s look at another example. Let C be the event of getting a multiple of 2 and 3 when you throw a
fair die.
Event A = Getting a multiple of 2 when you throw a fair die.
Event B = Getting a multiple of 3 when you throw a fair die
Event C = Getting a multiple of 2 and 3
Event C is an intersection of event A & B.
Probabilities are then defined as follows.
P (C) = P (A ꓵ B)

We can now say that the shaded region is the probability of both events A and B occurring together.

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1.4 Disjoint Events
What if, you come across a case when any two particular events cannot occur at the same time. For
example: Let’s say you have a fair die and you have only one throw.
Event A = Getting a multiple of 3
Event B = Getting a multiple of 5
You want both event A & B should occur together.
Let’s find the sub space for Event A & B.
Event A = {3,6}
Event B = {5}
Sample Space= {1,2,3,4,5,6}
As you can see, there is no case for which event A & B can occur together. Such events are called
disjoint event. To represent this using a Venn diagram:

Now that we are familiar with the terms Union, intersection and disjoint events, we can talk about
independence of events.

2. Independent, Dependent & Exclusive Events

Suppose we have two events – event A and event B.

If the occurrence of event A doesn’t affect the occurrence of event B, these events are called
independent events.

Let’s see some examples of independent events.

• Getting heads after tossing a coin AND getting a 5 on a throw of a fair die.
• Choosing a marble from a jar AND getting heads after tossing a coin.
• Choosing a 3 card from a deck of cards, replacing it, AND then choosing an ace as the second
card.
• Rolling a 4 on a fair die, AND then rolling a 1 on a second roll of the die.

In each of these cases the probability of outcome of the second event is not affected at all by the
outcome of the first event.

Probability of independent events

In this case the probability of P (A ꓵ B) = P (A) * P (B)

Let’s take an example here. Suppose we win the game if we pick a red marble from a jar
containing 4 red and 3 black marbles and we get heads on the toss of a coin. What is the
probability of winning?

Let’s define event A, as getting red marble from the jar

Event B is getting heads on the toss of a coin.
We need to find the probability of both getting a red marble and a heads in a coin toss.
P (A) = 4/7
P (B) = 1/2
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We know that there is no affect of the color of the marble on the outcome of the coin toss.
P (A ꓵ B) = P (A) * P (B)
P (A ꓵ B) = (4/7) * (1/2) = (2/7)

Probability of dependent events

Next, can you think of examples of dependent events?
In the above example, let’s define event A as getting a Red marble from the jar. We then keep the
marble out and then take another marble from the jar.

Will the probabilities in the second case still be the same as that in the first case?
Let’s see. So, for the first time there are 4/7 chances of getting a red marble. Let’s assume you got
a red marble on the first attempt. Now, for second chance, to get a red marble we have 3/6
chances.

If we didn’t get a red marble on the first attempt but a white marble instead. Then, there were 4/6
chances to get the red marble second time. Therefore the probability in the second case was
dependent on what happened the first time.

Quiz 1: If you have a Jack and your next card is dealt with a new deck of cards the probability
of you obtaining a jack again is? Are these events dependent or independent?

Mutually exclusive and Exhaustive events

Mutually exclusive events are those events where two events cannot happen together.
The easiest example to understand this is the toss of a coin. Getting a head and a tail are
mutually exclusive because we can either get heads or tails but never both at the same in a single
coin toss.

A set of events is collectively exhaustive when the set should contain all the possible
outcomes of the experiment. One of the events from the list must occur for sure when the
experiment is performed.

For example, in a throw of a die, {1,2,3,4,5,6} is an exhaustive collection because, it

encompasses the entire range of the possible outcomes.

Consider the outcomes “even” (2,4 or 6) and “not-6” (1,2,3,4, or 5) in a throw of a fair die.
They are collectively exhaustive but not mutually exclusive.

Quiz 2: Check whether the below events are mutually exclusive:

1. Drawing a red card or a jack from a given 52 cards deck.
2. Getting three heads or three tails when three coins are flipped.

3. Conditional Probability
Conditional probabilities arise naturally in the investigation of experiments where an outcome of a
trial may affect the outcomes of the subsequent trials.

We try to calculate the probability of the second event (event B) given that the first event (event A)
has already happened. If the probability of the event changes when we take the first event into
consideration, we can safely say that the probability of event B is dependent of the occurrence of
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event A.

Let’s think of cases where this happens:

• Drawing a second ace from a deck given we got the first ace
• Finding the probability of having a disease given you were tested positive
• Finding the probability of liking Harry Potter given we know the person likes fiction And so
on….Here we can define, 2 events:
• Event A is the probability of the event we’re trying to calculate.
• Event B is the condition that we know or the event that has happened.

A
We can write the conditional probability as P (B) , the probability of the occurrence of event A
given that B has already happened.

Let’s play a simple game of cards for you to understand this. Suppose you draw two cards from a
deck and you win if you get a jack followed by an ace (without replacement). What is the probability
of winning, given we know that you got a jack in the first turn?

Let event A be getting a jack in the first turn

Let event B be getting an ace in the second turn.

We need to find P(A) = 4/52

P(B) = 4/51 {no replacement}

P(A and B) = 4/52*4/51= 0.006

Here we are determining the probabilities when we know some conditions instead of calculating
random probabilities. Here we knew that he got a jack in the first turn.

Let’s take another example.

Suppose you have a jar containing 6 marbles – 3 black and 3 white. What is the probability of
getting a black given the first one was black too.

P (B) = getting a black marble in the second turn

P (A) = 3/6 P (B) = 2/5
P (A and B) = ½*2/5 = 1/5

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Reversing the condition
Example: Rahul’s favorite breakfast is bagels and his favorite lunch is pizza. The probability of
Rahul having bagels for breakfast is 0.6. The probability of him having pizza for lunch is 0.5. The
probability of him, having a bagel for breakfast given that he eats a pizza for lunch is 0.7.

Let’s define event A as Rahul having a bagel for breakfast, Event B as Rahul having a pizza for
lunch. P (A) = 0.6
P (B) = 0.5

If we look at the numbers, the probability of having a bagel is different than the probability of
having a bagel given he has a pizza for lunch. This means that the probability of having a bagel is
dependent on having a pizza for lunch.

Now what if we need to know the probability of having a pizza given you had a bagel for
breakfast. i.e. we

Need to know Bayes theorem now comes into the picture.

4. Bayes Theorem
The Bayes theorem describes the probability of an event based on the prior knowledge of the
conditions that might be related to the event. If we know the conditional probability

we can use the bayes rule to find out the reverse probabilities

How can we do that?

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The above statement is the general representation of the Bayes rule.

For the previous example – if we now wish to calculate the probability of having a pizza for lunch
provided you had a bagel for breakfast would be = 0.7 * 0.5/0.6.
We can generalize the formula further. If multiple events Ai form an exhaustive set with another
event B. We can write the equation as

5. Example of Bayes Theorem and Probability trees

Let’s take the example of the breast cancer patients. The patients were tested thrice before the
oncologist concluded that they had cancer. The general belief is that 1.48 out of a 1000 people
have breast cancer in the US at that particular time when this test was conducted. The patients
were tested over multiple tests. Three sets of test were done and the patient was only diagnosed
with cancer if she tested positive in all three of them.

Let’s examine the test in detail.

Sensitivity of the test (93%) – true positive Rate
Specificity of the test (99%) – true negative Rate
Let’s first compute the probability of having cancer given that the patient tested positive in the first
test.
P (has cancer | first test +)
P (cancer) = 0.00148
Sensitivity can be denoted as P (+ | cancer) = 0.93
Specificity can be denoted as P (- | no cancer)

Since we do not have any other information, we believe that the patient is a randomly sampled
individual. Hence our prior belief is that there is a 0.148% probability of the patient having cancer.

The complement is that there is a 100 – 0.148% chance that the patient does not have CANCER.
Similarly we can draw the below tree to denote the probabilities.

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Let’s now try to calculate the probability of having cancer given that he tested positive on the first
test i.e. P (cancer|+)

P (cancer and +) = P (cancer) * P (+) = 0.00148*0.93

P (no cancer and +) = P (no cancer) * P(+) = 0.99852*0.01

To calculate the probability of testing positive, the person can have cancer and test positive or he
may not have cancer and still test positive.

This means that there is a 12% chance that the patient has cancer given he tested positive in the
first test. This is known as the posterior probability.

Bayes Updating
Let’s now try to calculate the probability of having cancer given the patient tested positive in the
second test as well. Now remember we will only do the second test if she tested positive in the
first one. Therefore now the person is no longer a randomly sampled person but a specific case.
We know something about her. Hence, the prior probabilities should change. We update the prior
probability with the posterior from the previous test.

Nothing would change in the sensitivity and specificity of the test since we’re doing the same test
again. Look at the probability tree below.

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Let’s calculate again the probability of having cancer given she tested positive in the
second test.
P (cancer and +) = P(cancer) * P(+) = 0.12 * 0.93
P (no cancer and +) = P (no cancer) * P (+) = 0.88 * 0.01

To calculate the probability of testing positive, the person can have cancer and test positive or she
may not have cancer and still test positive.

Now we see, that a patient who tested positive in the test twice, has a 93% chance of having
cancer

6. Frequentist vs Bayesian Definitions of probability

A frequentist defines probability as an expected frequency of occurrence over large
number of experiments.

P(event) = n/N, where n is the number of times event A occurs in N opportunities. The Bayesian
view of probability is related to degree of belief. It is a measure of the plausibility of an event given
incomplete knowledge.

The frequentist believes that the population mean is real but unknowable and can only be
estimated from the data. He knows the distribution of the sample mean and constructs a
confidence interval centered at the sample mean. So the actual population mean is either in the
confidence interval or not in it.

This is because he believes that the true mean is a single fixed value and does not have a
distribution. So the frequentist says that 95% of similar intervals would contain the true mean, if
each interval were constructed from a different random sample.

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The Bayesian definition has a totally different view point. They use their beliefs to construct
probabilities. They believe that certain values are more believable than others based on the data
and our prior knowledge.

The Bayesian constructs a credible interval centered near the sample mean and totally affected by
the prior beliefs about the mean. The Bayesian can therefore make statements about the
population mean by using the probabilities.

7. Open Challenges

• In the cancer example taken above, try calculating the probability of a patient having cancer
provided the patient is tested positive in the third test as well.
• In an exam, there is a problem that 60% of students know the correct answer. However, there is
15% chance that a student picked the wrong answer even if he/she knows the right answer
And there is also a 25% chance that a student does not know the right answer but guessed it
correctly. If a student did get the problem right, what is the chance that this student really
knows the answer?

End Notes
The debate between Bayesian and frequentist approaches has been going on for a long while.
We have an amazing article which has gone deep into both these approaches. It has explained in
detail the two approaches and Bayesian Inference.

The aim of this article was to introduce you to conditional probability and Bayes theorem. Bayes
theorem forms the backbone of one of very frequently used classification algorithms in data
science – Naive Bayes.

Once the above concepts are clear you might be interested to open the doors the naive Bayes
algorithm and be stunned by the vast applications of Bayes theorem in it.

NORMAL DISTRIBUTION, BINOMIAL DISTRIBUTION & POISSON DISTRIBUTION

waiting time by the taxi driver of Uber taxi company. In the X axis, daily waiting time and Y-axis
probability per hour has been shown.

If one Uber taxi driver want to know the probability to wait more than 7 hours in a day? Then he will
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be interested in the yellow surface arear shown above. On basis of this graph you can estimate the
[Link] thing you can get form below cumulative probability curve.

Probability to wait more than 7 hours will be calculated using complementary rule 1- P.
Because corresponding to 7 in X axis we marked the probability is P and we are interested in
more than 7hours. So, P should be subtracted from 1 to get desired result.

Bell Shaped Distribution and Empirical Rule:

If distribution is bell shape then it is assumed that about 68% of the elements have a z-score
between -1 and 1; about 95% have a z-score between -2 and 2; and about 99% have a z-score
between -3 and 3.

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Assume the time you spend in week days by traveling has given by a normal distribution with
mean= 40 mins and SD= 10 mins.

What will be your range of travel time for 95 % of your weekdays?

As you know 95 % will come within 2 standard deviation of your mean. So, the range will be (40-
20) = 20 to (40+20) =60 mins.

Now another question you want to answer that what will be the probability to be travelling more
than 50 mins?

Actually you are interested in the yellow surface given in above diagram. You know that a
normal distribution is symmetric. So, half of the probability located one side of the mean and
another halflocated another side of the mean.

As SD =10. So, one standard deviation will be 30 to 50 [Link] already know for left side up 40
the probability is 0.5. Now if you calculate the probability from 40 to 50 range it will be half of 1

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Standard deviation i.e. 0.68/2 = 0.34

So the probability to travel less than 50 mins = 0.5 +. 0.34 = 0.84

But you are interested in more than 50 mins traveling time so it will be 1- 0.84 =0.16

Bernoulli trial & Binomial Distribution:

Every random variable has a corresponding probability distribution.

The probability distribution applies the theory of probability to describe the behavior of the random
variable. A discrete andom variable X has a finite number of possible integer values. The robability
distribution of X lists the values and their probabilities in a table

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• Every probability pi is a number between 0 and 1.
• The sum of the probabilities must be 1.

This properties we have already studied before. Now we will discuss about the most important
probability for discrete random variable is Binomial Distribution. Before that it is necessary to
know about Bernoulli trial.

Bernoulli trial or Binomial Trial:

Bernoulli trial (or binomial trial) is a random experiment with exactly two possible outcomes,
“success” and “failure”, in which the probability of success is the same every time the experiment
is conducted.

• The event (or trial) results in only one of two mutually exclusive outcomes – success/failure
• Probability of success is known, P(success) = π

Examples:
• A single coin toss (heads or tails), P(heads) = π = 0.5
• Survival of an individual after CABG surgery, P(survival) = π = 0.98
• Pick an individual from the Indian population, P(obese) = π = 0.31

Binomial Distribution:
A distribution is said to be binomial distribution if the following conditions are met.
1. Each trial has a binary outcome (One of the two outcomes is labeled a ‘success’)
2. The probability of success is known and constant over all trials
3. The number of trials is specified
4. The trials are independent. That is, the outcome from one trial doesn’t affect the outcome of
successive trials

If all the above conditions met then the binomial distribution describes the probability of X
successes in n trials.

A classic example of the binomial distribution is the number of heads (X) in n coin tosses.
The Notation for a binomial distribution is
X ~ B (n, π)
which is read as ‘X is distributed binomial with n trials and probability of success in one trial equal
to π ’.

Formula for Binomial Distribution:

Using this formula, the probability distribution of a binomial random variable X can be calculated if
nand π are known.

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n! is called ‘n factorial’ = n(n-1)(n-2) . . .(1)
P(X) = #of Scenario * Single Scenario

The first factorial terms gives the number of scenario and the second term describes the
probability of success to power of number of successes and probability of failure to the power of
number of failures.

Example:
What is the probability of 2 heads in 6 coin tosses?
• Success = ‘heads’
• n = 6 trials
• π = 0.5
• X = number of heads in 6 tosses which is 2 here.
• X has a binomial distribution with n = 6 and π = 0.5
• X ~ B (6, 0.5)

So, probability of getting 2 heads is 0.234.

Consider another example:

In a sample of 8 patients with a heart attack, what is the probability that 2 patients will die if the
probability of death from a heart attack = 0.03.
Assume that the probability of death is the same for all patients.
• Death from heart attack is a binary variable (Yes or No)
• ‘Success’ in this case is defined as death from heart attack
• n = number of ‘trials’ = 8 patients
• π = 0.03 = probability of success
• X = number of deaths. X =2 here. X ~ B (8, 0.03)
If you follow the same formula you will get P(x=2) = 0.021

Poisson Distribution:
Another probability distribution for discrete variables is the Poisson distribution. The Poisson
distribution is used to determine the probability of the number of events occurring over a specified
time or space. This was named for Simeon D. Poisson, 1781 – 1840, French mathematician.

Examples of events over space or time: -number of cells in a specified volume of fluid
• number of calls/hour to a help line
• number of emergency room beds filled/ 24 hours

Like the binomial distribution and the normal distribution, there are many Poisson distributions.
• Each Poisson distribution is specified by the average rate at which the event occurs.
• The rate is notated with λ
• λ = ‘lambda’, Greek letter ‘L’ – There is only one parameter for the Poisson distribution

The probability that there are exactly X occurrences in the specified space or time is equal to

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Research Definition
Research design is defined as a framework of methods and techniques chosen by a researcher to
combine various components of research in a reasonably logical manner so that the research
problem is efficiently handled. It provides insights about “how” to conduct research using a
particular methodology. Every researcher has a list of research questions which need to be
assessed – this can be done with research design.

The sketch of how research should be conducted can be prepared using research design. Hence,
the market research study will be carried out on the basis of researchdesign.

The design of a research topic is used to explain the type of research (experimental, survey,
correlational, semi-experimental, review) and also its sub-type (experimental design, research
problem, descriptive case-study). There are three main sections of research design: Data
collection, measurement, and analysis.

The type of research problem an organization is facing will determine the research design and not
vice-versa. Variables, designated tools to gather information, how will the tools be used to collect
and analyze data and other factors are decided in research design on the basis of a research
technique is decided.

An impactful research design usually creates minimum bias in data and increases trust on the
collected and analyzed research information. Research design which produces the least margin of
error in experimental research can be touted as the best. The essential elements of research
design are:

1. Accurate purpose statement of research design

2. Techniques to be implemented for collecting details for research
3. Method applied for analyzing collected details
4. Type of research methodology
5. Probable objections for research
6. Settings for research study
7. Timeline
8. Measurement of analysis

Research Design Characteristics

There are four key characteristics of research design:

Neutrality: The results projected in research design should be free from bias and neutral.
Understand opinions about the final evaluated scores and conclusion from multiple individuals and
consider those who agree with the derived results.

Reliability: If a research is conducted on a regular basis, the researcher involved expects similar
results to be calculated every time. Research design should indicate how the research questions
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can be formed to ensure the standard of obtained results and this can happen only when the
research design is reliable.

Validity: There are multiple measuring tools available for research design but valid measuring
tools are those which help a researcher in gauging results according to the objective of research
and nothing else. The questionnaire developed from this researchdesign will be then valid.

Generalization: The outcome of research design should be applicable to a population and not just
a restricted sample. Generalization is one of the key characteristics of research design.

Types of Research Design

A researcher must have a clear understanding of the various types of research design to select
which type of research design to implement for a study. Research design can be broadly classified
into quantitative and qualitative research design.

Qualitative Research Design: Qualitative research is implemented in cases where a relationship

between collected data and observation is established on the basis of mathematical calculations.
Theories related to a naturally existing phenomenon can be proved or disproved using
mathematical calculations. Researchers rely on qualitative research design where they are
expected to conclude “why” a particular theory exists along with “what” respondents have to say
about it.
Quantitative Research Design: Quantitative research is implemented in cases where it is important
for a researcher to have statistical conclusions to collect actionable insights. Numbers provide a
better perspective to make important business decisions.

Quantitative research design is important for the growth of any organization because any
conclusion drawn on the basis of numbers and analysis will only prove to be effective for the
business.

Further, research design can be divided into five types –

1. Descriptive Research Design: In a descriptive research design, a researcher is solely interested

in describing the situation or case under his/her research study. It is a theory-based research
design which is created by gather, analyze and presents collected data. By implementing an in-
depth research design such as this, a researcher can provide insights into the why and how of
research.

2. Experimental Research Design: Experimental research design is used to establish a relationship

between the cause and effect of a situation. It is a causal research design where the effect caused
by the independent variable on the dependent variable is observed. For example, the effect of an
independent variable such as price on a dependent variable such as customer satisfaction or
brand loyalty is monitored. It is a highly practical research design method as it contributes
towards solving a problem at hand. The independent variables are manipulated to monitor the
change it has on the dependent variable. It is often used in social sciences to observe human
behavior by analyzing two groups – affect of one group on the other.

3. Correlational Research Design: Correlational Reserach is a non-experimental research design

technique which helps researchers to establish a relationship between two closely connected
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variables. Two different groups are required to conduct this research design method. There is no
assumption while evaluating a relationship between two different variables and statistical analysis
techniques are used to calculatethe relationship between them.

Correlation between two variables is concluded using a correlation coefficient, whose value
ranges between -1 and +1. If the correlation coefficient is towards +1, it indicates a positive
relationship between the variables and -1 indicates a negative relationship between the two
variables.

4. Diagnostic Research Design: In the diagnostic research design, a researcher is inclined towards
evaluating the root cause of a specific topic. Elements that contribute towards a troublesome
situation are evaluated in this research design method.
There are three parts of diagnostic research design:
• Inception of the issue
• Diagnosis of the issue
• Solution for the issue

5. Explanatory Research Design: In exploratory research design, the researcher’s ideas and
thoughts are key as it is primarily dependent on their personal inclination about a particular topic.
Explanation about unexplored aspects of a subject is provided along with details about what, how
and why related to the research.

The horizontal axis is the index X. The function is defined only at integer values of X. The
connecting lines are only guides for the eye and do not indicate continuity. Notice that as λ
increases the distribution begins to resemble a normal distribution.

• If λ is 10 or greater, the normal distribution is a reasonable approximation to the Poisson

distribution
• The mean and variance for a Poisson distribution are the same and are both equal to λ
• The standard deviation of the Poisson distribution is the square root of λ

Example:
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A large urban hospital has, on average, 80 emergency department admits every Monday. What is
theprobability that there will be more than 100?

If we put λ =80 and x= 100 then we will get the probability value as 0.01316885. To get the same
result we can use normal approximation and then get the probability value. emergency room
admits on a Monday?

• λ is the rate of admits / day on Monday = 80

• we can use the normal approximation since λ > 10

The normal approximation has mean = 80 and SD = 8.94 (the square root of 80 = 8.94)

Now we can use the same way we calculate p-value for normal distribution. If you do that you will
get a value of 0.01263871 which is very near to 0.01316885 what we get directly form Poisson
formula. Here main intention is to show you how normal approximation works for Poisson
Distribution.

collection of data is a statistical requirement. Statistics are a set or series of numerical data that
acts as a facilitating factor of policy-making. In other words, numerical data establishes Statistics.
Numerical data undergoes processing and manipulations before it aids the process of decision
making. Hence, numerical data are the raw materials to statistics. These raw materials can
originate from various sources. Statisticians and analysts collect these data in different methods.

Read further to know all about:

• meaning of data,
• types of data,
• various sources for collecting data and
• different methods of collecting data.

INTRODUCING STATISTICAL DATA

Statistical data (or data) is a set of numbers or series of numerical data. Statistical data help in the
process of decision making. Since these statistical data are raw in nature. But it becomes helpful
in the process of decision making and policy making only after it has undergone certain
refinement. In addition, the person who collects these statistical data for further inspection is
addressed as the ‘investigator’. Whereas the person who provides raw data and facts to the
investigator is addressed as the ‘respondent’.

Before we go ahead with discussing the concept of the collection of data, understanding the

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preliminaries to data collection is crucial. Discussed below are the major preliminaries to data
collection:
a. The objectives of the statistical research
b. The available scope of the statistical research
c. The statistical units for the research – should be unambiguous and specific to the research.
They should also be stable and uniform in the usage fo statistical technique. Moreover,
statistical units should be appropriate to the research and should not digress from the main
objective. They can either be a collection of units or a collection of analysis and interpretation.
Various sources of data (in case of primary data) and information (in case of secondary data)
d. Methods of collecting data – are either census method or sample technique.
e. The degree of accuracy of the final results
f. Different types of enquiry (or research) – are official, confidential, regular, sample, census and
primary research. Secondary, ad-hoc, repetitive and direct are also examples of types of
enquiries.

TYPES OF DATA
There are 2 types of data. Discussed below are the types of data.

1. Primary Data – refers to the data that the investigator collects for the very first time. This type
of data has not been collected either by this or any other investigator before. A primary data
will provide the investigator with the most reliable first-hand information about the
respondents. The investigator would have a clear idea about the terminologies uses, the
statistical units employed, the research methodology and the size of the sample. Primary data
may either be internal or external to the organization.
2. Secondary Data – refers to the data that the investigator collects from another source. Past
investigators or agents collect data required for their study. The investigator is the first
researcher or statistician to collect this data. Moreover, the investigator does not have a clear
idea about the intricacies of the data. There may be ambiguity in terms of the sample size and
sample technique. There may also be unreliability with respect to the accuracy of the data.

PRIMARY DATA – METHODS OF COLLECTION OF DATA

Discussed below are 5 broad classifications of the methods of collecting primary data.

Direct Personal Investigation

Consists of the collection of data by the investigator in a direct manner. The investigator (or
researcher) is responsible for personally approaching a respondent and investigating the research
and gather appropriate information. In other words, the researcher himself enters the field and
solicits data that he requires to take the research forward. Thus, this method of data collection
ensures first-hand information. This data is all the more reliable for an intensive research. But in
an extensive research, this data is inadequate and proves to be unreliable. This method of
collection of data is time-consuming. Hence, it tends to get handicapped when there is lack of
time resource. However, the greatest demerit is that this method is very subjective in nature and is
not suitable for objective based extensive researches.

Indirect Oral Interview

Consists of the collection of data by the investigator in an indirect manner. The investigator (or
enumerator) approaches (either by telephonic interviews) an indirect respondent who possesses
the appropriate information for the research. Thus, this method of data collection ensures first-
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hand information because the interviewers can cross-question for the right and appropriate
information.

Mailed Questionnaire
Consists of mailing a set or series of questions related to the research. The respondent answers
the questionnaire and forwards it back to the investigator after marking his/her responses. This
method of collection of data has proven to be time-saving. It is also a very cost-efficient manner
of collecting the required data. An investigator who has the access to the internet and an email
account can undertake this method of data collection. The researcher can only investigate those
respondents who also have access to the internet and an email account. This remains the only
major restriction of this method.

Schedules
Scheduling involves a face to face situation with the respondents. In this method of collecting
data, the interviewer questions the respondent according to the questions mentioned in a form.
This form is known as a schedule. This is different than a questionnaire. A questionnaire is
personally filled by the respondents and the interviewer may or may not be physically present.
Whereas, the schedule is filled by the enumerator or interviewer after asking the respondent
his/her answer to a specific question. And in scheduling method of collecting data, the interviewer
or enumerator is physically present.

Local agencies
In this method, the information is not directly or indirectly collected by either the interviewer of the
enumerator. Instead, the interviewer hires or employs a local agency to work for him/her and help
in gathering appropriate information. These local agents are often known as correspondents as
well. Correspondents are only responsible for gathering accurate and reliable information.
They work according to their preference and adopt different methods to do so.

SECONDARY DATA – SOURCES OF DATA

Discussed below are 2 broad classifications of the sources of secondary data.

Published Sources
There are many national organizations, international agencies and official publications that collect
various statistical data. They collect data related to business, commerce, trade, prices, economy,
productions, services, industries, currency and foreign affairs. They also collect information
related to various (internal and external) socio-economic phenomena and publish them. These
publications contain statistical reports of various kinds. Central Government Official Publication,
Publications of Research Institutions, Committee Reports and International Publications are some
published sources of secondary data.

Unpublished Sources
Some statistical data are not always a part of publications. Such data are stored by institutions an
private firms. Researchers often make use of these unpublished data in order to make their
researches all the more original.

Sampling and Estimation

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Introduction
Each day, we observe the high, low, and close of stock market indexes from around the world.
Indexes such as the S&P 500 Index and the Nikkei-Dow Jones Average are samples of stocks.
Although the S&P 500 and the Nikkei do not represent the populations of US or Japanese stocks,
we view them as valid indicators of the whole population’s behavior. As analysts, we are
accustomed to using this sample information to assess how various markets from around the
world are performing. Any statistics that we compute with sample information, however, are only
estimates of the underlying population parameters. A sample, then, is a subset of the population—
a subset studied to infer conclusions about the population itself.

This reading explores how we sample and use sample information to estimate population
parameters. In the next section, we discuss sampling—the process of obtaining a sample. In
investments, we continually make use of the mean as a measure of central tendency of random
variables, such as return and earnings per share. Even when the probability distribution of the
random variable is unknown, we can make probability statements about the population mean
using the central limit theorem. In Section 3, we discuss and illustrate this key result. Following
that discussion, we turn to statistical estimation. Estimation seeks precise answers to the
question “What is this parameter’s value?”

The central limit theorem and estimation are the core of the body of methods presented in this
reading. In investments, we apply these and other statistical techniques to financial data; we often
interpret the results for the purpose of deciding what works and what does not work in
investments. We end this reading with a discussion of the interpretation of statistical results
based on financial data and the possible pitfalls in this process.

Learning Outcomes
The candidate should be able to:
a. define simple random sampling and a sampling distribution;
b. explain sampling error;
c. distinguish between simple random and stratified random sampling;
d. distinguish between time-series and cross-sectional data;
e. explain the central limit theorem and its importance;
f. calculate and interpret the standard error of the sample mean;
g. identify and describe desirable properties of an estimator;
h. distinguish between a point estimate and a confidence interval estimate of a population
parameter;
i. describe properties of Student’s t-distribution and calculate and interpret its degrees offreedom;
j. calculate and interpret a confidence interval for a population mean, given a normal distribution
with 1) a known population variance, 2) an unknown population variance, or 3) an unknown
population variance and a large sample size;
k. describe the issues regarding selection of the appropriate sample size, data-mining bias,sample
selection bias, survivorship bias, look-ahead bias, and time-period bias.

Summary
In this reading, we have presented basic concepts and results in sampling and estimation. Wehave
also emphasized the challenges faced by analysts in appropriately using and interpreting financial
data. As analysts, we should always use a critical eye when evaluating the results from any study.
The quality of the sample is of the utmost importance: If the sample is biased, the conclusions
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drawn from the sample will be in error.

• To draw valid inferences from a sample, the sample should be random.

• In simple random sampling, each observation has an equal chance of being selected. In
stratified random sampling, the population is divided into subpopulations, called strata or cells,
based on one or more classification criteria; simple random samples are then drawn from each
stratum.
• Stratified random sampling ensures that population subdivisions of interest are represented in
the sample. Stratified random sampling also produces moreprecise parameter estimates than
simple random sampling.
• Time series data are a collection of observations at equally spaced intervals of time. Cross-
sectional data are observations that represent individuals, groups, geographical regions, or
companies at a single point in time.
• The central limit theorem states that for large sample sizes, for any underlying distribution for a
random variable, the sampling distribution of the sample mean for that variable will be
• approximately normal, with mean equal to the population mean for that random variable and
variance equal to the population variance of the variable divided by sample size.
• Based on the central limit theorem, when the sample size is large, we can compute confidence
intervals for the population mean based on the normal distribution regardless of the
distribution of the underlying population. In general, a sample size of 30 or larger can be
considered large.
• An estimator is a formula for estimating a parameter. An estimate is a particular value that we
calculate from a sample by using an estimator.
• Because an estimator or statistic is a random variable, it is described by some probability
distribution. We refer to the distribution of an estimator as its sampling distribution. The
standard deviation of the sampling distribution of the sample mean is called the standard error
of the sample mean.
• The desirable properties of an estimator are unbiasedness (the expected value of the
estimator equals the population parameter), efficiency (the estimator has the smallest
variance), and consistency (the probability of accurate estimates increases as sample size
increases).
• The two types of estimates of a parameter are point estimates and interval estimates. A point
estimate is a single number that we use to estimate a parameter. An interval estimate isa range
of values that brackets the population parameter with some probability.
• A confidence interval is an interval for which we can assert with a given probability 1 − α, called
the degree of confidence, that it will contain the parameter it is intended to estimate. This
measure is often referred to as the 100(1 − α)% confidence interval for the parameter.
• A 100(1 − α)% confidence interval for a parameter has the following structure: Point estimate ±
Reliability factor × Standard error, where the reliability factor is a number based on the
assumed distribution of the point estimate and the degree of confidence (1 − α) for the
confidence interval and where standard error is the standard error of the sample statistic
providing the point estimate.
• A 100(1−α)% confidence interval for population mean μ when sampling from a normal
distribution with known variance σ2 is given by ¯¯¯X±zα/2σ√nX¯±zα/2σn, where za/2 is the
point of the standard normal distribution such that α/2 remains in the right tail.
• Student’s t-distribution is a family of symmetrical distributions defined by a single parameter,
degrees of freedom.
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• A random sample of size n is said to have n − 1 degrees of freedom for estimating the
population variance, in the sense that there are only n − 1 independent deviations from the
mean on which to base the estimate.
• The degrees of freedom number for use with the t-distribution is also n − 1.
• The t-distribution has fatter tails than the standard normal distribution but con-verges to the
standard normal distribution as degrees of freedom go to infinity.
• A 100(1−α)% confidence interval for the population mean μ when sampling from a normal
distribution with unknown variance (a t-distribution confidence interval) is given by
¯¯¯X±tα/2(s/√n)X¯±tα/2(s/n), where tα/2 is the point of the t-distribution such
• that α/2 remains in the right tail and s is the sample standard deviation. This confidence
interval can also be used, because of the central limit theorem, when dealing with a large
sample from a population with unknown variance that may not be normal.
• We may use the confidence interval ¯¯¯X±zα/2(s/√n)X¯±zα/2(s/n) as an alternative to the t-
distribution confidence interval for the population mean when using a large sample from a
population with unknown variance. The confidence interval based on the z-statistic is less
conservative (narrower) than the corresponding confidence interval based on a t-distribution.
• Three issues in the selection of sample size are the need for precision, the risk of sampling
from more than one population, and the expenses of different sample sizes.
• Sample data in investments can have a variety of problems. Survivorship bias occurs if
companies are excluded from the analysis because they have gone out of business or because
of reasons related to poor performance. Data mining bias comes from finding models by
repeatedly searching through databases for patterns. Look ahead bias exists if the model uses
data not available to market participants at the time the market participants act in the model.
Finally, time period bias is present if the time period used makes the results time period
specific or if the time period used includes a point of structural change.

The Central Limit Theorem (CLT) is a statistical theory states that given asufficiently large sample
size from a population with a finite level of variance, the mean of all samples from the same
population will be approximately equalto the mean of the population.

It tells us that,

The Central Limit Theorem is exactly what the shape of the distribution of means will be when we
draw repeated samples from a given population. Specifically, as the sample sizes get larger, the
distribution of means calculatedfrom repeated sampling will approach normality.

By the above definitions defined I’m sure that you would have the same reaction as of Mr. Trump
is having, so let’s dive in the understanding CLT withthe below stuff.

As the sample size increases, the sampling distribution of the mean, X-bar, can be approximated by
a normal distribution with mean µ and standard deviationσ/√n where:

µ is the population mean

σ is the population standard deviation
n is the sample size

In other words, if we repeatedly take independent random samples of size n from any population,
then when n is large, the distribution of the samplemeans will approach a normal distribution.
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Redefining it more ahead,

The central limit theorem states that when an infinite number of successive random samples are
taken from a population, the sampling distribution of the means of those samples will become
approximately normallydistributed with mean μ and standard deviation σ/√ N as the sample size
(N)becomes larger, irrespective of the shape of thepopulation distribution.

Let us understand CLT by following illustration:

Suppose we draw a random sample of size n (x1, x2, x3, … xn — 1, xn) from a population random
variable that is distributed with mean µ and standard deviation σ.

Do this repeatedly, drawing many samples from the population, and then calculate the x̄ of each
sample.

We will treat the x̄ values as another distribution, which we will call the sampling distribution of the
mean (x).

Given a distribution with a mean μ and variance σ2, the sampling distribution of the mean
approaches a normal distribution with a mean (μ) and a variance σ2/n as n, the sample size,
increases and the amazing and very interesting intuitive thing about the central limit theorem is
that no matter what the shape of the original (parent) distribution, the sampling distribution of the
mean approaches a normal distribution.

A normal distribution is approached very quickly as n increases, Note that nis the sample size for
each mean and not the number of samples.

Remember in a sampling distribution of the mean the number of samples isassumed to be infinite.

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Three different components of the central limit theorem
(1) Successive sampling from a population
(2) Increasing sample size
(3) Population distribution.

Central Limit Theorem (CLT) — Example

On the right are shown the resulting frequency distributions each based on 500 means. For n = 4, 4
scores were sampled from a uniform distribution 500 times and the mean computed each time.
The same method was followed with means of 7 scores for n = 7 and 10 scores for n = 10.

When n increases:
1. the distributions becomes more and more normal.
2. the spread of the distributions decreases.

Let’s take another Example of a Tumbling Dice:

Dice are ideal for illustrating the central limit theorem. If you roll a six-sided die, the probability of
rolling a one is 1/6, a two is 1/6, a three is also 1/6, etc. The probability of the die landing on any
one side is equal to the probability oflanding on any of the other five sides.

In a classroom situation, we can carry out this experiment using an actual die. To get an accurate
representation of the population distribution, let’s roll the die 500 times. When we use a histogram
to graph the data, we see that — as expected — the distribution looks fairly flat. It’s definitely not a
normal distribution (figure below).

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Let’s take more samples and see what happens to the histogram of the averages of those
samples.

This time we will roll the die twice, and repeat this process 500 [Link] can compute the average
of each pair (figure below).

We can then create a histogram of these averages to view the shape of their distribution (figure
below). Although the blue normal curve does not accurately represent the histogram, the profile of
the bars is looking more bell-shaped.

Now let’s roll the die five times and compute the average of the five rolls, again repeated 500 times.
Then, let’s repeat the process rolling the die 10 times, then30 times.

The histograms for each set of averages (figure below) show that as the sample size, or number of
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rolls, increases, the distribution of the averages comes closer to resembling a normal distribution.
In addition, the variation of the sample means decreases as the sample size increases.

The central limit theorem states that for a large enough n, X-bar can be approximated by a normal
distribution with mean µ and standard deviationσ/√n.

The population mean for a six-sided die is (1+2+3+4+5+6)/6 = 3.5 and the population standard
deviation is 1.708. Thus, if the theorem holds true, the mean of the thirty averages should be about
3.5 with standard deviation 1.708/ 30 = 0.31. Using the dice we “rolled” using Minitab, the average
of the thirty averages, depicted in Figure 4, is 3.49 and the standard deviation is 0.30, which are
very close to the calculated approximations.

Conclusion over here is that the central limit theorem enables us to approximate the sampling
distribution of X-bar with a normal distribution.

We can make it easier to understand through simple demonstrations using dice which we have
mentioned above.

I hope things mentioned above would have helped you to known little aboutthe topic. If yes then, do
bang the claps button because learning has no limits.

uld do that by adding up all the heights and then dividing by the total number of measurements (n
= 13). This would give you a sample mean of 72.

Next, calculate the difference between the sample mean and each measurement, square all these
values, and then add them all up. This is easier to do if you make a table like the one you are
looking at on your screen:

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Then, divide the sum you just calculated by n - 1 and take the square root to get the standard
deviation.

Finally, to calculate the standard error of your estimate, divide the standard deviation by the
square root of the number of measurements (remember n = 13). So the standard error equals:

Estimation in Statistics
In statistics, estimation refers to the process by which one makes inferences about a population,
based on information obtained from a sample.

Point Estimate vs. Interval Estimate

Statisticians use sample statistics to estimate population parameters. For example, sample
means are used to estimate population means; sample proportions, to estimate population
proportions.

An estimate of a population parameter may be expressed in two ways:

• Point estimate. A point estimate of a population parameter is a single value of a statistic. For
example, the sample mean x is a point estimate of the population mean μ. Similarly, the
sample proportion p is a point estimate of the population proportion P.
• Interval estimate. An interval estimate is defined by two numbers, between which a population
parameter is said to lie. For example, a < x < b is an interval estimate of the population mean μ.
It indicates that the population mean is greater than a but less than b.

Statisticians use a confidence interval to express the precision and uncertainty associated with a
particular sampling method. A confidence interval consists of three parts.
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• A confidence level.
• A statistic.
• A margin of error.

The confidence level describes the uncertainty of a sampling method. The statistic and the margin
of error define an interval estimate that describes the precision of the method. The interval
estimate of a confidence interval is defined by the sample statistic + margin of error.

For example, suppose we compute an interval estimate of a population parameter. We might

describe this interval estimate as a 95% confidence interval. This means that if we used the same
sampling method to select different samples and compute different interval estimates, the true
population parameter would fall within a range defined by the sample statistic + margin of error
95% of the time.

Confidence intervals are preferred to point estimates, because confidence intervals indicate (a)
theprecision of the estimate and (b) the uncertainty of the estimate.

Confidence Level
The probability part of a confidence interval is called a confidence level. The confidence level
describes the likelihood that a particular sampling method will produce a confidence interval that
includes the true population parameter.

Here is how to interpret a confidence level. Suppose we collected all possible samples from a
given population, and computed confidence intervals for each sample. Some confidence intervals
would include the true population parameter; others would not. A 95% confidence level means that
95% of the intervals contain the true population parameter; a 90% confidence level means that 90%
of the intervals contain the population parameter; and so on.

Margin of Error
In a confidence interval, the range of values above and below the sample statistic is called the
margin of error.

For example, suppose the local newspaper conducts an election survey and reports that the
independent candidate will receive 30% of the vote. The newspaper states that the survey had a
5% margin of error and a confidence level of 95%. These findings result in the following
confidence interval: We are 95% confident that the independent candidate will receive between
25% and 35% of the vote.

Note: Many public opinion surveys report interval estimates, but not confidence intervals. They
provide the margin of error, but not the confidence level. To clearly interpret survey results you
need to know both! We are much more likely to accept survey findings if the confidence level is
high (say, 95%) than if it is low (say, 50%).
Test Your Understanding

Problem 1
Which of the following statements is true.
I. When the margin of error is small, the confidence level is high.
II. When the margin of error is small, the confidence level is low.
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 III. A confidence interval is a type of point estimate.
IV. A population mean is an example of a point estimate.
(A) I only
(B) II only
(C) III only
(D) IV only.
(E) None of the above.

Solution
The correct answer is (E). The confidence level is not affected by the margin of error. When the
margin of error is small, the confidence level can low or high or anything in between. A confidence
interval is a type of interval estimate, not a type of point estimate. A population mean is not an
example of a point estimate; a sample mean is an example of point Hypothesis Testing.

When you conduct a piece of quantitative research, you are inevitably attempting to answer a
research question or hypothesis that you have set.
One method of evaluating this research question is via a process called hypothesis testing, which
is sometimes also referred to as significance testing. Since there are many facets to hypothesis
testing,we start with the example we refer to throughout this guide.

Hypothesis Testing
When you conduct a piece of quantitative research, you are inevitably attempting to answer a
research question or hypothesis that you have set.

One method of evaluating this research question is via a processcalled hypothesis testing, which is
sometimes also referred to as significance testing. Since there are many facets to hypothesis
testing,we start with the example we refer to throughout this guide.

An example of a lecturer's dilemma

Two statistics lecturers, Sarah and Mike, think that they use the best method to teach their
students. Each lecturer has 50 statistics students who are studying a graduate degree in
management. In Sarah's class, students have to attend one lecture and one seminar class every
week, whilst in Mike's class students only have to attend one lecture. Sarah thinksthat seminars, in
addition to lectures, are an important teaching method in statistics, whilst Mike believes that
lectures are sufficient by themselves and thinks that students are better off solving problems by
themselves in their own time. This is the first year that Sarah has given seminars, but since they
take up a lot of her time, she wants to make sure that she is not wasting her time and that
seminars improve her students' performance.

Hypothesis Testing
When you conduct a piece of quantitative research, you are inevitably attempting to answer a
research question or hypothesis that you have set.
One method of evaluating this research question is via a processcalled hypothesis testing, which is
sometimes also referred to as significance testing. Since there are many facets to hypothesis
testing,we start with the example we refer to throughout this guide.

An example of a lecturer's dilemma

690
Two statistics lecturers, Sarah and Mike, think that they use the best method to teach their
students. Each lecturer has 50 statistics students who are studying a graduate degree in
management. In Sarah's class, students have to attend one lecture and one seminar class every
week, whilst in Mike's class students only have to attend one lecture. Sarah thinks that seminars, in
addition to lectures, are an important teaching method in statistics, whilst Mike believes that
lectures are sufficient by themselves and thinks that students are better off solving problems by
themselves in their own time. This is the first year that Sarah has given seminars, but since they
take up a lot of her time, she wants to make sure that she is not wasting her time and that
seminars improve her students' performance.

The research hypothesis

The first step in hypothesis testing is to set a research hypothesis. In Sarah and Mike's study, the
aim is to examine the effect that two different teaching methods – providing both lectures and
seminar classes (Sarah), and providing lectures by themselves (Mike) – had on the performance
of Sarah's 50 students and Mike's 50 students. More specifically, they want to determine whether
performance is different between the two different teaching methods. Whilst Mike is skeptical
about the effectiveness of seminars, Sarah clearly believes that giving seminars in addition to
lectures helps her students do better than those in Mike's class. This leads to the following
research hypothesis:

When students attend seminar classes, in addition to lectures,

Research Hypothesis:
their performance increases.
Before moving onto the second step of the hypothesis testing process, we need to take you on a
brief detour to explain why you need to run hypothesis testing at all. This is explained next.

Sample to population
If you have measured individuals (or any other type of "object") in a study and want to understand
differences (or any other type of effect), you can simply summarize the data you have collected.
For example, if Sarah and Mike wanted to know which teaching method was the best, they could
simply compare the performance achieved by the two groups of students – the group of students
that took lectures and seminar classes, and the groupof students that took lectures by themselves
– and conclude that the best method was the teaching method which resulted in the highest
performance. However, this is generally of only limited appeal because the conclusions could only
apply to students in this study. However, if those students were representative of all statistics
students on a graduate management degree, the study would have wider appeal.

In statistics terminology, the students in the study are the sample and the larger group they
represent (i.e., all statistics students on a graduate management degree) is called the population.
Given that the sample of statistics students in the study are representative of a larger population
of statistics students, you can use hypothesis testing to understand whether any differences or
effects discovered in the study exist in the population. In layman's terms, hypothesis testing is
used to establish whether a research hypothesis extends beyond those individuals examined in a
single study.
Another example could be taking a sample of 200 breast cancer sufferers in order to test a new
drug that is designed to eradicate this type of cancer. As much as you are interested in helping
these specific 200 cancer sufferers, your real goal is to establish that the drug works in the
population(i.e., all breast cancer sufferers).

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As such, by taking a hypothesis testing approach, Sarah and Mike want to generalize their results
to a population rather than just the students in their sample. However, in order to use hypothesis
testing, you need to re- state your research hypothesis as a null and alternative hypothesis. Before
you can do this, it is best to consider the process/structure involved in hypothesis testing and
what you are measuring. This structure is presented Whilst all pieces of quantitative research
have some dilemma, issue or problem that they are trying to investigate, the focus in hypothesis
testing isto find ways to structure these in such a way that we can test them effectively. Typically,
it is important to:

1. Define the research hypothesis for the study.

Explain how you are going to operationalize (that

is, measure or operationally define) what you are studying and setout the variables to be
2.
studied.

Set out the null and alternative hypothesis (or more than onehypothesis; in other words, a
3.
number of hypotheses).

4. Set the significance level.

5. Make a one- or two-tailed prediction.

Determine whether the distribution that you are studying

is normal (this has implications for the types of statistical tests thatyou can run on your
6.
data).

Select an appropriate statistical test based on the variables youhave defined and whether the
7.
distribution is normal or not.

8. Run the statistical tests on your data and interpret the output.

9. Reject or fail to reject the null hypothesis.

Operationally defining (measuring) the study

So far, we have simply referred to the outcome of the teaching methods as the "performance" of
the students, but what do we mean by "performance". "Performance" could mean how students
score in a piece of coursework, how many times they can answer questions in class, what marks
they get in their exams, and so on. There are three major reasons why we should be clear about
how we operationalize(i.e., measure) what we are studying. First, we simply need to be clear so
that people reading our work are in no doubt about what we are studying. This makes it easier for
them to repeat the study in future to see if they also get the same (or similar) results; something
called internal validity. Second, one of the criteria by which quantitative research is assessed,
perhaps by an examiner if you are a student, is how you define what you are measuring (in this
case, "performance") and how you choose to measure it. Third, it will determine which statistical
test you need to use because the choice of statistical test is largely based on how your variables
were measured (e.g., whether the variable, "performance", was measured on a "continuous" scale
of 1-100 marks; an "ordinal" scale with groups of marks, such as 0-20, 21-40, 41-60, 61-80 and 81-
100; or some of other scale; see the statistical guide, Types of Variable, for more information).
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It is worth noting that these choices will sometimes be personal choices (i.e., they are subjective)
and at other times they will be guided by some other/external information. For example, if you
were to measure intelligence, there may be a number of characteristics that you could use, such
as IQ, emotional intelligence, and so forth. What you choose here will likely be a personal choice
because all these variables are proxies for intelligence; that is, they are variables used to infer an
individual's intelligence, but not everyone would agree that IQ alone is an accurate measure of
intelligence. In contrast, if you were measuring company performance, you would find a number of
established metrics in the academic and practitioner literature that would determine what you
should test, such as "Return on Assets", etc. Therefore, to know what you should measure, it is
always worth looking at the literature first to see what other studies have done, whether you use
the same measures or not. It is then a matter of making an educated decision whether the
variables you choose to examine are accurate proxies for what you are trying to study, as well as
discussing the potential limitations of these proxies.

In the case of measuring a statistics student's performance there are a number of proxies that
could be used, such as class participation, coursework marks and exam marks, since these are all
good measures of performance. However, in this case, we choose exam marks as our measure of
performance for two reasons: First, as a statistics tutor, we feel that Sarah's main job is to help her
students get the best grade possible since this will affect her students' overall grades in their
graduate management degree. Second, the assessment for the statistics course is a single two
hour exam.

Since there is no coursework and class participation is not assessed in this course, exam marks
seem to be the most appropriate proxy for performance. However, it is worth noting that if the
assessment for the statistics course was not only a two hour exam, but also a piece of
coursework, we would probably have chosen to measure both exam marks and coursework marks
as proxies of performance.

Variables
The next step is to define the variables that we are using in our study (see the statistical guide,
Types of Variable, for more information). Since the study aims to examine the effect that two
different teaching methods – providing lectures and seminar classes (Sarah) and providing
lectures by themselves (Mike) – had on the performance of Sarah's 50 students and Mike's 50
students, the variables being measured are:

Dependent variable: Exam marks

Independent variable: Teaching method ("seminar" vs "lecture only")

By using a very straightforward example, we have only one dependent variable and one
independent variable although studies can examine any number of dependent and independent
variables. Now that we know what our variables are, we can look at how to set out the null and
alternative hypothesis

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The null and alternative hypothesis
In order to undertake hypothesis testing you need to express your research hypothesis as a null
and alternative hypothesis. The null hypothesis and alternative hypothesis are statements
regarding the differences or effects that occur in the population. You will use your sample to test
which statement (i.e., the null hypothesis or alternative hypothesis) is most likely (although
technically, you test the evidence against the null hypothesis). So, with respect to our teaching
example, the null and alternative hypothesis will reflect statements about all statistics students on
graduate management courses.

The null hypothesis is essentially the "devil's advocate" position. That is, it assumes that whatever
you are trying to prove did not happen (hint: it usually states that something equals zero). For
example, the two different teaching methods did not result in different exam performances (i.e.,
zero difference). Another example might be that there is no relationship between anxiety and
athletic performance (i.e., the slope is zero). The alternative hypothesis states the opposite and is
usually the hypothesis you are trying to prove (e.g., the two different teaching methods did result
in different exam performances). Initially, you can state these hypotheses in more general terms
(e.g., using terms like "effect", "relationship", etc.), as shown below for the teaching methods
example:

Undertaking seminar classes has no effect on students'

Null Hypotheses (H0):
performance.

Alternative Hypothesis (HA): Undertaking seminar class has a positive effect on students'
performance.

Depending on how you want to "summarize" the exam performances will determine how you might
want to write a more specific null and alternative hypothesis. For example, you could compare
the mean exam performance of each group (i.e., the "seminar" group and the "lectures-only"
group).

This is what we will demonstrate here, but other options include comparing the distributions,
medians, amongst other things. As such, we can state:
Null Hypotheses (H0): The mean exam mark for the "seminar" and "lecture- only"
teaching methods is the same in the population.

Alternative Hypothesis (HA):

The mean exam mark for the "seminar" and "lecture- only"
teaching methods is not the same in the population.

Now that you have identified the null and alternative hypotheses, you need to find evidence and
develop a strategy for declaring your "support" for either the null or alternative hypothesis. We can
do this using some statistical theory and some arbitrary cut-off points. Both these issues are dealt
with next.

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Significance levels
The level of statistical significance is often expressed as the so-called p-value. Depending on the
statistical test you have chosen, you will calculate a probability (i.e., the p-value) of observing your
sample results (or more extreme) given that the null hypothesis is true. Another way of phrasing
this is to consider the probability that a difference in a mean score (or other statistic) could have
arisen based on the assumption that there really is no difference. Let us consider this statement
with respect to our example where we are interested in the difference in mean exam performance
between two different teaching methods. If there really is no difference between the two teaching
methods in the population (i.e., given that the null hypothesis is true), how likely would it be to see
a difference in the mean exam performance between the two teaching methods as large as (or
larger than) that which has been observed in your sample?

So, you might get a p-value such as 0.03 (i.e., p = .03). This means that there is a 3% chance of
finding a difference as large as (or larger than) the one in your study given that the null hypothesis
is true. However, you want to know whether this is "statistically significant". Typically, if there was
a 5% or less chance (5 times in 100 or less) that the difference in the mean exam performance
between the two teaching methods (or whatever statistic you are using) is as different as observed
given the null hypothesis is true, you would reject the null hypothesis and accept the alternative
hypothesis.

Alternately, if the chance was greater than 5% (5 times in 100 or more), you would fail to reject the
null hypothesis and would not accept the alternative hypothesis. As such, in this example where p
= .03, we would reject the null hypothesis and accept the alternative hypothesis. We reject it
because at a significance level of 0.03 (i.e., less than a 5% chance), the result we obtained could
happen too frequently for us to be confident that it was the two teaching methods that had an
effect on exam performance.

Whilst there is relatively little justification why a significance level of 0.05 is used rather than 0.01
or 0.10, for example, it is widely used in academic research. However, if you want to be particularly
confident in your results, you can set a more stringent level of 0.01 (a 1% chance or less; 1 in 100
chance or less).

Z Test: Definition & Two Proportion Z-Test

Hypothesis Testing > Z Test / Two-Proportion Z-Test

What is a Z Test?

A Z-test is a type of hypothesis test. Hypothesis testing is just a way for you to figure out if results
from a test are valid or repeatable. For example, if someone said they had found a new drug that

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cures cancer, you would want to be sure it was probably true. A hypothesis test will tell you if it’s
probably true, or probably not true. A Z test, is used when your data is approximately normally
distributed.

When you can run a Z Test.

Several different types of tests are used in statistics (i.e. f test, chi square test, t test). You would
use a Z test if:
• Your sample size is greater than 30. Otherwise, use a t test.
• Data points should be independent from each other. In other words, one data point isn’t related
or doesn’t affect another data point.
• Your data should be normally distributed. However, for large sample sizes (over 30) this doesn’t
always matter.
• Your data should be randomly selected from a population, where each item has an equal
chance of being selected.
• Sample sizes should be equal if at all possible.

How do I run a Z Test?

Running a Z test on your data requires five steps:

1. State the null hypothesis and alternate hypothesis.

2. Choose an alpha level.
3. Find the critical value of z in a z table.
4. Calculate the z test statistic (see below).
5. Compare the test statistic to the critical z value and decide if you should support or reject the
null hypothesis.

You could perform all these steps by hand. For example, you could find a critical value by hand,
or calculate a z value by hand. For a step by step example, see:

• One Sample Z Test.

• Two sample z test in Excel.
• Find a critical z value on the TI 83.
• Find a critical value on the TI 89 (left-tail).

Two Proportion Z-Test

This tests for a difference in proportions. A two proportion z-test allows you to compare two
proportions to see if they are the same.

• The null hypothesis (H0) for the test is that the proportions are the same.
• The alternate hypothesis (H1) is that the proportions are not the same.

Sample question: let’s say you’re testing two flu drugs A and B. Drug A works on 41 people out of
a sample of 195. Drug B works on 351 people in a sample of 605. Are the two drugs comparable?
Use a 5% alpha level.

Step 1: Find the two proportions:

P1 = 41/195 = 0.21 (that’s 21%) P2 = 351/605 = 0.58 (that’s 58%).
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Set these numbers aside for a moment.

Step 2: Find the overall sample proportion. The numerator will be the total number of “positive”
results for the two samples and the denominator is the total number of people in the two samples.
p = (41 + 351) / (195 + 605) = 0.49.
Set this number aside for a moment.

Step 3: Insert the numbers from Step 1 and Step 2 into the test statistic formula:

Solving the formula, we get:

Z = 8.99
We need to find out if the z-score falls into the “rejection region.”

Step 4: Find the z-score associated with α/2. I’ll use the following table of known values:

The z-score associated with a 5% alpha level / 2 is 1.96.

Step 5: Compare the calculated z-score from Step 3 with the table z-score from Step 4. If the
calculated z-score is larger, you can reject the null hypothesis.
8.99 > 1.96, so we can reject the null hypothesis.

T-test
The t test is one type of inferential statistics. It is used to determine whether there is a significant
difference between the means of two groups. With all inferential statistics, we assume the
dependent variable fits a normal distribution. When we assume a normal distribution exists, we
can identify the probability of a particular outcome. We specify the level of probability (alpha level,
level of significance, p) we are willing to accept before we collect data (p < .05 is a common value
that is used). After we collect data we calculate a test statistic with a formula.

We compare our test statistic with a critical value found on a table to see if our results fall within
the acceptable level of probability. Modern computer programs calculate the test statistic for us
and also provide the exact probability of obtaining that test statistic with the number of subjects
we have.

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STUDENT’S TEST (T TEST) NOTES
When the difference between two population averages is being investigated, a t test is used. In
other words, a t test is used when we wish to compare two means (the scores must be measured
on an interval or ratio measurement scale). We would use a t test if we wished to compare the
reading achievement of boys and girls. With a t test, we have one independent variable and one
dependent variable. The independent variable (gender in this case) can only have two levels (male
and female). The dependent variable would be reading achievement. If the independent had more
than two levels, then we would use a one-way analysis of variance (ANOVA).

The test statistic that a t test produces is a t-value. Conceptually, t-values are an extension of z-
scores. In a way, the t-value represents how many standard units the means of the two groups are
apart.

With a t test, the researcher wants to state with some degree of confidence that the obtained
difference between the means of the sample groups is too great to be a chance event and that
some difference also exists in the population from which the sample was drawn. In other words,
the difference that we might find between the boys’ and girls’ reading achievement in our sample
might have occurred by chance, or it might exist in the population. If our t test produces a t-value
that results in a probability of .01, we say that the likelihood of getting the difference we found by
chance would be 1 in a 100 times. We could say that it is unlikely that our results occurred by
chance and the difference we found in the sample probably exists in the populations from which it
was drawn.

FIVE FACTORS CONTRIBUTE TO WHETHER THE DIFFERENCE BETWEEN TWO GROUPS’ MEANS
CAN BE CONSIDERED SIGNIFICANT:

1. How large is the difference between the means of the two groups? Other factors being equal,
the greater the difference between the two means, the greater the likelihood that a statistically
significant mean difference exists. If the means of the two groups are far apart, we can be fairly
confident that there is a real difference between them.
2. How much overlap is there between the groups? This is a function of the variation within the
groups. Other factors being equal, the smaller the variances of the two groups under
consideration, the greater the likelihood that a statistically significant mean difference exists.
We can be more confident that two groups differ when the scores within each group are close
together.
3. How many subjects are in the two samples? The size of the sample is extremely important in
determining the significance of the difference between means. With increased sample size,
means tend to become more stable representations of group performance. If the difference we
find remains constant as we collect more and more data, we become more confident that we
can trust the difference we are finding.
4. What alpha level is being used to test the mean difference (how confident do you want to be
about your statement that there is a mean difference). A larger alpha level requires less
difference between the means. It is much harder to find differences between groups when you
are only willing to have your results occur by chance 1 out of a 100 times (p < .01) as compared
to 5 out of 100 times (p < .05).
5. Is a directional (one-tailed) or non-directional (two-tailed) hypothesis being tested? Other
factors being equal, smaller mean differences result in statistical significance with a directional
hypothesis. For our purposes we will use non-directional (two-tailed) hypotheses.
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ASSUMPTIONS UNDERLYING THE T TEST
1. The samples have been randomly drawn from their respective populations
2. The scores in the population are normally distributed
3. The scores in the populations have the same variance (s1=s2)

Note: We use a different calculation for the standard error if they are not.

THREE TYPES OF T TESTS

• Pair-difference t test (a.k.a. t-test for dependent groups, correlated t test) df= n (number of
pairs) -1 This is concerned with the difference between the average scores of a single sample of
individuals who are assessed at two different times (such as before treatment and after
treatment). It can also compare average scores of samples of individuals who are paired in some
way (such as siblings, mothers, daughters, persons who are matched in terms of a particular
characteristics).
• t test for Independent Samples (with two options)
This is concerned with the difference between the averages of two populations. Basically, the
procedure compares the averages of two samples that were selected independently of each other,
and asks whether those sample averages differ enough to believe that the populations from which
they were selected also have different averages. An example would be comparing math
achievement scores of an experimental group with a control group.

1. Equal Variance (Pooled-variance t-test) df=n (total of both groups) -2 Note: Used when both
samples have the same number of subject or when s1=s2 (Levene or F-max tests have p > .05).
2. Unequal Variance (Separate-variance t test) df dependents on a formula, but a rough estimate is
one less than the smallest group Note: Used when the samples have different numbers of
subjects and they have different variances — s1<>s2 (Levene or F-max tests have p < .05).

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ANOVA

Introduction
Buying a new product or testing a new technique but not sure how it stacks up against the
alternatives? It’s an all too familiar situation for most of us. Most of the options sound similar to
each other so picking the best out of the lot is a challenge.

Consider a scenario where we have three medical treatments to apply on patients with similar
diseases. Once we have the test results, one approach is to assume that the treatment which took
the least time to cure the patients is the best among them. What if some of these patients had
already been partially cured, or if any other medication was already working on them?

In order to make a confident and reliable decision, we will need evidence to support our approach.
This is where the concept of ANOVA comes into play.

In this article, I’ll introduce you to the different ANOVA techniques used for making the best
decisions. We’ll take a few cases and try to understand the techniques for getting the results. We
will also be leveraging the use of Excel to understand these concepts. You must know the basics
of statistics to understand this topic. Knowledge of t-tests and Hypothesis testing would be an
additional benefit.

And we believe the best way to learn statistics is by doing. That’s the way we follow in the
‘Introduction to Data Science‘ course where we provide a comprehensive introduction to statistics
– both descriptive and inferential.

So, let’s begin!

Table of Contents
1. Introduction to ANOVA
2. Terminologies related to ANOVA you need to know
o Grand Mean
o Hypothesis
o Between Group variability
o Within Group variability
o F-Statistic
3. One-way ANOVA
o Limitations of One-way ANOVA
o Steps to perform One-way ANOVA in Excel
4. Two-way ANOVA
o Steps to perform Two-way ANOVA in Excel

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5. MANOVA
o Steps to perform MANOVA in Excel

Introduction to ANOVA
A common approach to figure out a reliable treatment method would be to analyse the days it
took the patients to be cured. We can use a statistical technique which can compare these three
treatment samples and depict how different these samples are from one another. Such a
technique, which compares the samples on the basis of their means, is called ANOVA.

Analysis of variance (ANOVA) is a statistical technique that is used to check if the means of two
or more groups are significantly different from each other. ANOVA checks the impact of one or
more factors by comparing the means of different samples.

We can use ANOVA to prove/disprove if all the medication treatments were equally effective or
not.

Another measure to compare the samples is called a t-test. When we have only two samples, t-
test and ANOVA give the same results. However, using a t-test would not be reliable in cases
where there are more than 2 samples. If we conduct multiple t-tests for comparing more than two
samples, it will have a compounded effect on the error rate of the result.

Terminologies related to ANOVA you need to know

Before we get started with the applications of ANOVA, I would like to introduce some common
terminologies used in the technique.

Grand Mean
Mean is a simple or arithmetic average of a range of values. There are two kinds of means that we
use in ANOVA calculations, which are separate sample means and the grand mean .
The grand mean is the mean of sample means or the mean of all observations combined,
irrespective of the sample.

Hypothesis
Considering our above medication example, we can assume that there are 2 possible cases –
either the medication will have an effect on the patients or it won’t. These statements are called
Hypothesis. A hypothesis is an educated guess about something in the world around us. It should
be testable either by experiment or observation.

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Just like any other kind of hypothesis that you might have studied in statistics, ANOVA also uses a
Null hypothesis and an Alternate hypothesis. The Null hypothesis in ANOVA is valid when all the
sample means are equal, or they don’t have any significant difference. Thus, they can be
considered as a part of a larger set of the population. On the other hand, the alternate hypothesis
is valid when at least one of the sample means is different from the rest of the sample means. In
mathematical form, they can be represented as:

Where, belong to any two sample means out of all the samples considered for the test.
In other words, the null hypothesis states that all the sample means are equal or the factor did not
have any significant effect on the results. Whereas, the alternate hypothesis states that at least one
of the sample means is different from another. But we still can’t tell which one specifically. For
that, we will use other methods that we will discuss later in this article.

Between Group Variability

Consider the distributions of the below two samples. As these samples overlap, their individual
means won’t differ by a great margin. Hence the difference between their individual means and
grand mean won’t be significant enough.

Now consider these two sample distributions. As the samples differ from each other by a big
margin, their individual means would also differ. The difference between the individual means and
grand mean would Now consider these two sample distributions. As the samples differ from each
other by a big margin, their individual means would also differ. The difference between the
individual means and grand mean would therefore also be significant

means is different from the rest of the sample means. In mathematical form, they can be
represented as:

Now consider these two sample distributions. As the samples differ from each other by a big
margin, their individual means would also differ. The difference between the individual means and
grand mean would therefore also be significant.

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Such variability between the distributions called Between-group variability. It refers to variations
between the distributions of individual groups (or levels) as the values within each group are
different.

Each sample is looked at and the difference between its mean and grand mean is calculated to
calculate the variability. If the distributions overlap or are close, the grand mean will be similar to
the individual means whereas if the distributions are far apart, difference between means and
grand mean would be large.

We will calculate Between Group Variability just as we calculate the standard deviation. Given the
sample means and Grand mean, we can calculate it as:

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We also want to weigh each squared deviation by the size of the sample. In other words, a
deviation is given greater weight if it’s from a larger sample. Hence, we’ll multiply each squared
deviation by each sample size and add them up. This is called the sum-of-squares for between-
group

Variability

There’s one more thing we have to do to derive a good measure of between-group variability.
Again, recall how we calculate the sample standard deviation.

There’s one more thing we have to do to derive a good measure of between-group variability.
Again, recall how we calculate the sample standard deviation.

We find the sum of each squared deviation and divide it by the degrees of freedom. For our
between-group variability, we will find each squared deviation, weigh them by their sample size,
sum them up, and divide by the degrees of freedom ( ), which in the case of
between-group variability is the number of sample means (k) minus 1.

Within Group Variability

Consider the given distributions of three samples. As the spread (variability) of each sample is
increased, their distributions overlap and they become part of a big population.

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Such variations within a sample are denoted by Within-group variation. It refers to variations
caused by differences within individual groups (or levels) as not all the values within each group
are the same. Each sample is looked at on its own and variability between the individual points in
the sample is calculated. In other words, no interactions between samples are considered.

We can measure Within-group variability by looking at how much each value in each sample
differs from its respective sample mean. So first, we’ll take the squared deviation of each value
from its respective sample mean and add them up. This is the sum of squares for within-group
variability.

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Like between-group variability, we then divide the sum of squared deviations by the degrees of
freedom to find a less-biased estimator for the average squared deviation (essentially, the
average-sized square from the figure above). Again, this quotient is called the mean square, but for
within- group variability: . This time, the degrees of freedom is the sum of the sample
sizes (N) minus the number of samples (k). Another way to look at degrees of freedom is that we
have the total number of values (N), and subtract 1 for each sample:

F-Statistic
The statistic which measures if the means of different samples are significantly different or not is
called the F-Ratio. Lower the F-Ratio, more similar are the sample means. In that case, we cannot
reject the null hypothesis.

F = Between group variability / Within group variability

This above formula is pretty intuitive. The numerator term in the F-statistic calculation defines the
between- group variability. As we read earlier, as between group variability increases, sample
means grow further apart from each other. In other words, the samples are more probable to be
belonging to totally different populations.

This F-statistic calculated here is compared with the F-critical value for making a conclusion. In
terms of our medication example, if the value of the calculated F-statistic is more than the F-
critical value (for a specific α/significance level), then we reject the null hypothesis and can say
that the treatment had a significant effect.

Unlike the z and t-distributions, the F-distribution does not have any negative values because
between and within-group variability are always positive due to squaring each deviation.

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Therefore, there is only one critical region, in the right tail (shown as the blue shaded region
above). If the F-statistic lands in the critical region, we can conclude that the means are
significantly different and we reject the null hypothesis. Again, we have to find the critical value to
determine the cut-off for the critical region. We’ll use the F-table for this purpose.
unction of two things: and .

One Way ANOVA

As we now understand the basic terminologies behind ANOVA, let’s dive deep into its
implementation using a few examples.

A recent study claims that using music in a class enhances the concentration and consequently
helps students absorb more information. As a teacher, your first reaction would be skepticism. To
figure this out, we decided to implement it on a smaller group of randomly selected students from
three different classes. The idea is similar to conducting a survey. We take three different groups
of ten randomly selected students (all of the same age) from three different classrooms. Each
classroom was provided with a different environment for students to study. Classroom A had
constant music being played in the background, classroom B had variable music being played and
classroom C was a regular class with no music playing. After one month, we conducted a test for
all the three groups and collected their test scores. The test scores that we obtained were as

Now, we will calculate the means and the Grand mean.

So, in our case,

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Looking at the above table, we might assume that the mean score of students from Group A is
definitely greater than the other two groups, so the treatment must be helpful. Maybe it’s true, but
there is also a slight chance that we happened to select the best students from class A, which
resulted in better test scores (remember, the selection was done at random). This leads to a few
questions, like:

1. How do we decide that these three groups performed differently because of the different
situations and not merely by chance?
2. In a statistical sense, how different are these three samples from each other?
3. What is the probability of group A students performing so differently than the other two groups?

To answer all these questions, first we will calculate the F-statistic which can be expressed as the
ratio of Between Group variability and Within Group Variability

Let’s complete the ANOVA test for our example with = 0.05.
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Limitations of one-way ANOVA
A one-way ANOVA tells us that at least two groups are different from each other. But it won’t tell
us which groups are different. If our test returns a significant f-statistic, we may need to run a post-
hoc test to tell us exactly which groups have a difference in means. Below I have mentioned the
steps to perform one-way ANOVA in Excel along with a post-hoc test.

Steps to perform one-way ANOVA with post-hoc test in Excel 2013

Step 1: Input your data into columns or rows in Excel. For example, if three groups of students for
music treatment are being tested, spread the data into three columns.

Step 2: Click the “Data” tab and then click “Data Analysis.” If you don’t see Data Analysis, load the
‘Data Analysis Toolpak’ add-in.

Step 3: Click “ANOVA Single Factor” and then click “OK.”

Step 4: Type an input range into the Input Range box. For example, if the data is in cells A1 to C10,
type “A1:C10” into the box. Check the “Labels in first row” if we have column headers, and select
the Rows radio button if the data is in rows.

Step 5: Select an output range. For example, click the “New Worksheet” radio button.

Step 6: Choose an alpha level. For most hypothesis tests, 0.05 is standard.

Step 7: Click “OK.” The results from ANOVA will appear in the worksheet.

Results for our example look like this:

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Here, we can see that the F-value is greater than the F-critical value for the alpha level selected
(0.05). Therefore, we have evidence to reject the null hypothesis and say that at least one of the
three samples have significantly different means and thus belong to an entirely different
population.

Another measure for ANOVA is the p-value. If the p-value is less than the alpha level selected
(which it is, in our case), we reject the Null Hypothesis.

There are various methods for finding out which are the samples that represent two different
populations. I’ll list some for you:

1. Bonferroni approach
2. Least significant difference test
3. Tukey’s HSD

We won’t be covering all of these here in this article but I suggest you go through them.

Now to check which samples had different means we will take the Bonferroni approach and
perform the post hoc test in Excel.

Step 8: Again, click on “Data Analysis” in the “Data” tab and select “t-Test: Two-Sample Assuming
Equal Variances” and click “OK.”

Step 9: Input the range of Class A column in Variable 1 Range box, and range of Class B column in
Variable 2 Range box. Check the “Labels” if you have column headers in the first row.

Step 10: Select an output range. For example, click the “New Worksheet” radio button.

Step 11: Perform the same steps (Step 8 to step 10) for Columns of Class B – Class C and Class
A – Class C.

The results will look like this:

Here, we can see that the p-value of (A vs B) and (A vs C) is less than the alpha level selected
(alpha = 0.05). This means that groups A and B & groups A and C have less than 5% chance of
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belonging to the same population. Whereas for (B vs C) it is much greater than the significance
level. This means that B and C belong to the same population. So, it is clear that A (constant music
group) belongs to an entirely different population. Or we can say that the constant music had a
significant effect on the performance of students.

Voila! The music experiment actually helped in improving the results of the students.

Another effect size measure for one-way ANOVA is called Eta squared. It works in the same way
as R2 for t-tests. It is used to calculate how much proportion of the variability between the
samples is due to the between group difference. It is calculated as:

For the above example:

Hence 60% of the difference between the scores is because of the approach that was used. Rest
40% is unknown. Hence Eta square helps us conclude whether the independent variable is really
having an impact on the dependent variable or the difference is due to chance or any other factor.
There are commonly two types of ANOVA tests for univariate analysis – One-Way ANOVA and
Two-Way ANOVA. One-way ANOVA is used when we are interested in studying the effect of one
independent variable (IDV)/factor on a population, whereas Two-way ANOVA is used for studying
the effects of two factors on a population at the same time. For multivariate analysis, such a
technique is called MANOVA or Multi-variate ANOVA.

Two-Way ANOVA:
Using one-way ANOVA, we found out that the music treatment was helpful in improving the test
results of our students. But this treatment was conducted on students of the same age. What if the
treatment was to affect different age groups of students in different ways? Or maybe the
treatment had varying effects depending upon the teacher who taught the class.

Moreover, how can we be sure as to which factor(s) is affecting the results of the students more?
Maybe the age group is a more dominant factor responsible for a student’s performance than the
music treatment.

For such cases, when the outcome or dependent variable (in our case the test scores) is affected
by two independent variables/factors we use a slightly modified technique called two-way ANOVA.

In the one-way ANOVA test, we found out that the group subjected to ‘variable music’ and ‘no
music at all’ performed more or less equally. It means that the variable music treatment did not
have any significant effect on the students.
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So, while performing two-way ANOVA we will not consider the “variable music” treatment for
simplicity of calculation. Rather a new factor, age, will be introduced to find out how the treatment
performs when applied to students of different age groups. This time our dataset looks like this:

Here, there are two factors – class group and age group with two and three levels respectively. So
we now have six different groups of students based on different permutations of class groups
and age groups and each different group has a sample size of 5 students.

A few questions that two-way ANOVA can answer about this dataset are:

1. Is music treatment the main factor affecting performance? In other words, do groups
subjected to different music differ significantly in their test performance?
2. Is age the main factor affecting performance? In other words, do students of different age
differ significantly in their test performance?
3. Is there a significant interaction between the factors? In other words, how do age and music
interact with regard to a student’s test performance? For example, it might be that younger
students and elder students reacted differently to such a music treatment.
4. Can any differences in one factor be found within another factor? In other words, can any
differences in music and test performance be found in different age groups?

Two-way ANOVA tells us about the main effect and the interaction effect. The main effect is
similar to a one-way ANOVA where the effect of music and age would be measured separately.
Whereas, the interaction effect is the one where both music and age are considered at the same
time.

That’s why a two-way ANOVA can have up to three hypotheses, which are as follows:

Two null hypotheses will be tested if we have placed only one observation in each cell. For this
example, those hypotheses will be:

H1: All the music treatment groups have equal mean score.
H2: All the age groups have equal mean score.

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For multiple observations in cells, we would also be testing a third hypothesis:

H3: The factors are independent or the interaction effect does not exist. An F-statistic is computed
for each hypothesis we are testing.

Before we proceed with the calculation, have a look at the image below. It will help us better
understand the terms used in the formulas.

The table shown above is known as a contingency table. Here, represents the total of the
samples based only on factor 1, and represents the total of sample based only on
factor 2. We will see in some time that these two are responsible for the main effect produced.
Also, a term introduced which represents the subtotal of factor 1 and factor 2. This term will be
responsible for the interaction effect produced when both the factors are considered at the same
time. And we are already familiar with , which is the sum of all the observations (test
scores), irrespective of the factors

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We have calculated all the means – sound class mean, age group mean and mean of every group
combination in the above table.

Now, calculate the sum of squares (SS) and degrees of freedom (df) for sound class, age group
and interaction between factor and levels.

We already know how to calculate SS (within)/df (within) in our one-way ANOVA section, but in
two-way ANOVA the formula is different. Let’s look at the calculation of two-way ANOVA:

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In two-way ANOVA, we also calculate SSinteraction and dfinteraction which defines the
combined effect of the two factors.

Since we have more than one source of variation (main effects and interaction effects), it is
obvious that we will have more than one F-statistic also.

Now using these variances, we compute the value of F-statistic for the main and interaction effect.
So, the values of f-statistic are,

F1 = 12.16
F2 = 15.98
F12 = 0.36
We can see the critical values from the table
Fcrit1 = 4.25
Fcrit2 = 3.40
Fcrit12 = 3.40
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If, for a particular effect, its F value is greater than its respective F-critical value (calculated using
the F- Table), then we reject the null hypothesis for that particular effect.

Steps to perform two-way ANOVA in Excel 2013:

Step 1: Click the “Data” tab and then click “Data Analysis.” If you don’t see the Data analysis
option, install the Data Analysis Toolpak.

Step 2: Click “ANOVA two factor with replication” and then click “OK.” The two-way ANOVA
window will open.

Step 3: Type an Input Range into the Input Range box. For example, if your data is in cells A1 to
A25, type “A1:A25” into the Input Range box. Make sure you include all of your data, including
headers and group names.

Step 4: Type a number in the “Rows per sample” box. Rows per sample is actually a bit
misleading. What this is asking you is how many individuals are in each group. For example, if you
have 5 individuals in each age group, you would type “5” into the Rows per Sample box.

Step 5: Select an Output Range. For example, click the “new worksheet” radio button to display the
data in a new worksheet.

Step 6: Select an alpha level. In most cases, an alpha level of 0.05 (5 percent) works for mosttests.

Step 7: Click “OK” to run the two-way ANOVA. The data will be returned in your specified output
range.
Step 8: Read the results. To figure out if you are going to reject the null hypothesis or not, you’ll
basically be looking at two factors:
1. If the F-value (F)is larger than the f critical value (F crit)
2. If the p-value is smaller than your chosen alpha level.

And you are done!

Note: We don’t only have to have two variables to run a two-way ANOVA in Excel 2013. We can
also use the same function for three, four, five or more number of variables.

The results for two-way ANOVA test on our example look like this:

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As you can see in the highlighted cells in the image above, the F-value for sample and column, i.e.
factor 1 (music) and factor 2 (age) respectively, are higher than their F-critical values. This means
that the factors have a significant effect on the results of the students and thus we can reject the
null hypothesis for the factors.

Also, the F-value for interaction effect is quite less than its F-critical value, so we can conclude
that music and age did not have any combined effect on the population.

Multi-variate ANOVA (MANOVA):

Until now, we were making conclusions on the performance of students based on just one test.
Could there be a possibility that the music treatment helped improve the results of a subject like
mathematics but would affect the results adversely for a theoretical subject like history?

How can we be sure that the treatment won’t be biased in such a case? So again, we take two
groups of randomly selected students from a class and subject each group to one kind of music
environment, i.e., constant music and no music. But now we thought of conducting two tests
(maths and history), instead of just one. This way we can be sure about how the treatment would
work for different kind of subjects.

We can say that one IDV/factor (music) will be affecting two dependent variables (maths scores
and history scores) now. This kind of a problem comes under a multivariate case and the
technique we will use to solve it is known as MANOVA. Here, we will be working on a specific case
called one factor MANOVA. Let us now see how our data looks:

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Here we have one factor, music, with 2 levels. This factor is going to affect our two dependent
variables, i.e., the test scores of maths and history. Denoting this information in terms of variables,
we can say that we have L = 2 (2 different music treatment groups) and P = 2 (maths and history
scores).

A MANOVA test also takes into consideration a null hypothesis and an alternate hypothesis.:

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TYPE I AND II ERRORS

• Type I error —
reject a null hypothesis that is really true (with tests of difference this means that you say there
was a difference between the groups when there really was not a difference). The probability of
making a Type I error is the alpha level you choose. If you set your probability (alpha level) at p <
05, then there is a 5% chance that you will make a Type I error. You can reduce the chance of
making a Type I error by setting a smaller alpha level (p < .01). The problem with this is that as you
lower the chance of making a Type I error, you increase the chance of making a Type II error.
• Type II error —
fail to reject a null hypothesis that is false (with tests of differences this means that you say there
was no difference between the groups when there really was one)

HYPOTHESES (SOME IDEAS…)

1. Non directional (two-tailed)

Research Question: Is there a (statistically) significant difference between males and females
with respect to math achievement?
H0: There is no (statistically) significant difference between males and females with respect to
math achievement.
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HA: There is a (statistically) significant difference between males and females with respect to
math achievement.
2. Directional (one-tailed)
Research Question: Do males score significantly higher than females with respect to math
achievement?
H0: Males do not score significantly higher than females with respect to math achievement.
HA: Males score significantly higher than females with respect to math [Link] basic
idea for calculating a t-test is to find the difference between the means of the two groups and
divide it by the STANDARD ERROR (OF THE DIFFERENCE) — which is the standard deviation of the
distribution of [Link] for your information: A CONFIDENCE INTERVAL for a two-tailed t-
est is calculated by multiplying the CRITICAL VALUE times the STANDARD ERROR and adding and
subtracting that to and from the difference of the two [Link] SIZE is used to calculate
practical difference. If you have several thousand subjects, it is very easy to find a statistically
significant difference. Whether that difference is practical or meaningful is another questions.
This is where effect size becomes important. With studies involving group differences, effect size
is the difference of the two means divided by the standard deviation of the control group (or the
average standard deviation of both groups if you do not have a control group). Generally, effect
size is only important if you have statistical significance. An effect size of .2 is considered small,
.5 is considered medium, and .8 is considered large.

Using Chi-Square Statistic in Research

The Chi Square statistic is commonly used for testing relationships between categorical variables.
The null hypothesis of the Chi-Square test is that no relationship exists on the categorical variables
in the population; they are independent. An example research question that could be answered
using a Chi-Square analysis would be:

Is there a significant relationship between voter intent and political party membership?

How does the Chi-Square statistic work?

The Chi-Square statistic is most commonly used to evaluate Tests of Independence when using a
crosstabulation (also known as a bivariate table). Crosstabulation presents the distributions of two
categorical variables simultaneously, with the intersections of the categories of the variables
appearing in the cells of the table. The Test of Independence assesses whether an association
exists between the two variables by comparing the observed pattern of responses in the cells to
the pattern that would be expected if the variables were truly independent of each other.
Calculating the Chi-Square statistic and comparing it against a critical value from the Chi-Square
distribution allows the researcher to assess whether the observed cell counts are significantly
different from the expected cell counts.

The calculation of the Chi-Square statistic is quite straight-forward and intuitive: where fo = the
observed frequency (the observed counts in the cells)
and fe = the expected frequency if NO relationship existed between the variables As depicted in
the formula, the Chi-Square statistic is based on the difference between what is actually observed
in the data and what would be expected if there was truly no relationship between the variables.

How is the Chi-Square statistic run in SPSS and how is the output interpreted?
The Chi-Square statistic appears as an option when requesting a crosstabulation in SPSS. The
output is labeled Chi-Square Tests; the Chi-Square statistic used in the Test of Independence is
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labeled Pearson Chi-Square. This statistic can be evaluated by comparing the actual value against
a critical value found in a Chi-Square distribution (where degrees of freedom is calculated as # of
rows – 1 x # of columns – 1), but it is easier to simply examine the p-value provided by SPSS. To
make a conclusion about the hypothesis with 95% confidence, the value labeled Asymp. Sig.
(which is the p-value of the Chi-Square statistic) should be less than .05 (which is the alpha level
associated with a 95% confidence level).

Is the p-value (labeled Asymp. Sig.) less than .05? If so, we can conclude that the variables are not
independent of each other and that there is a statistical relationship between the categorical
variables.

In this example, there is an association between fundamentalism and views on teaching sex
education in public schools. While 17.2% of fundamentalists oppose teaching sex education, only
6.5% of liberals are opposed. The p-value indicates that these variables are not independent of
each other and that there is a statistically significant relationship between the categorical
variables.

What are special concerns with regard to the Chi-Square statistic?

There are a number of important considerations when using the Chi-Square statistic to evaluate a
crosstabulation. Because of how the Chi-Square value is calculated, it is extremely sensitive to
sample size – when the sample size is too large (~500), almost any small difference will appear
statistically significant. It is also sensitive to the distribution within the cells, and SPSS gives a
warning message if cells have fewer than 5 cases. This can be addressed by always using
categorical variables with a limited number of categories (e.g., by combining categories if
necessary to produce a smaller table).

Statistics Solutions can assist with your quantitative analysis by assisting you to develop your
methodology and results chapters. The services that we offer include:

Data Analysis Plan

• Edit your research questions and null/alternative hypotheses
• Write your data analysis plan; specify specific statistics to address the research questions, the
assumptions of the statistics, and justify why they are the appropriate statistics; provide
references
• Justify your sample size/power analysis, provide references
• Explain your data analysis plan to you so you are comfortable and confident
• Two hours of additional support with your statistician

Quantitative Results Section(Descriptive Statistics, Bivariate and Multivariate Analyses, Structural

Equation Modeling, Path analysis, HLM, Cluster Analysis)

Mann-Whitney U Test
Mann-Whitney U test is the non-parametric alternative test to the independent sample t-test. It is a
non-parametric test that is used to compare two sample means that come from the same
population, and used to test whether two sample means are equal or not. Usually, the Mann-
Whitney U test is used when the data is ordinal or when the assumptions of the t-test are not met.
Sometimes understanding the Mann-Whitney U is difficult interpret because the results are
presented in group rank differences rather than group mean differences
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Assumptions of the Mann-Whitney:
Mann-Whitney U test is a non-parametric test, so it does not assume any assumptions related to
the distribution of scores. There are, however, some assumptions that are assumed

1. The sample drawn from the population is random.

2. Independence within the samples and mutual independence is assumed. That means that an
observation is in one group or the other (it cannot be in both).
3. Ordinal measurement scale is assumed.

Calculation of the Mann-Whitney U:

Where:
U=Mann-Whitney U test
N1 = sample size one
N2= Sample size two
Ri = Rank of the sample size

Use of Mann-Whitney:
Mann-Whitney U test is used for every field, but is frequently used in psychology, healthcare,
nursing, business, and many other disciplines. For example, in psychology, it is used to compare
attitude or behavior, etc. In medicine, it is used to know the effect of two medicines and whether
they are equal or not. It is also used to know whether or not a particular medicine cures the
ailment or not. In business, it can be used to know the preferences of different people and it can be
used to see if that changes depending on location.

Types of question examined using the Mann-Whitney U

Good questions answered by the Mann-Whitney are examining rank differences. For example, Did
the horse racing finishes differ by horse sex (male vs. female)? Does the rank order of university
preferences differ by geographic region of student (urban vs. rural)?

Administration, Analysis, and Reporting

Statistics Solutions consists of a team of professional methodologists and statisticians that can
assist the student or professional researcher in administering the survey instrument, collecting the
data, conducting the analyses and explaining the results.

Kruskal-Wallis H Test using SPSS Statistics

Introduction
The Kruskal-Wallis H test (sometimes also called the "one-way ANOVA on ranks") is a rank-based
nonparametric test that can be used to determine if there are statistically significant differences
between two or more groups of an independent variable on a continuous or ordinal dependent
variable. It is considered the nonparametric alternative to the one-way ANOVA, and an extension
of the Mann-Whitney U test to allow the comparison of more than two independent groups.

Note: If you wish to take into account the ordinal nature of an independent variable and have an
ordered alternative hypothesis, you could run a Jonckheere-Terpstra test instead of the Kruskal-
Wallis H test.

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For example, you could use a Kruskal-Wallis H test to understand whether exam performance,
measured on a continuous scale from 0-100, differed based on test anxiety levels (i.e., your
dependent variable would be "exam performance" and your independent variable would be "test
anxiety level", which has three independent groups: students with "low", "medium" and "high" test
anxiety levels). Alternately, you could use the Kruskal-Wallis H test to understand whether
attitudes towards pay discrimination, where attitudes are measured on an ordinal scale, differed
based on job position (i.e., your dependent variable would be "attitudes towards pay
discrimination", measured on a 5-point scale from "strongly agree" to "strongly disagree", and your
independent variable would be "job description", which has three independent groups: "shop floor",
"middle management" and "boardroom").

It is important to realize that the Kruskal-Wallis H test is an omnibus test statistic and cannot tell
you which specific groups of your independent variable are statistically significantly different from
each other; it only tells you that at least two groups were different. Since you may have three, four,
five or more groups in your study design, determining which of these groups differ from each other
is important. You can do this using a post hoc test (N.B., we discuss post hoc tests later in this
guide).

This "quick start" guide shows you how to carry out a Kruskal-Wallis H test using SPSS Statistics,
as well as interpret and report the results from this test. However, before we introduce you to this
procedure, you need to understand the different assumptions that your data must meet in order
for a Kruskal-Wallis H test to give you a valid result. We discuss these assumptions next.

Assumptions
When you choose to analyse your data using a Kruskal-Wallis H test, part of the process involves
checking to make sure that the data you want to analyse can actually be analysed using a Kruskal-
Wallis H test. You need to do this because it is only appropriate to use a Kruskal-Wallis H test if
your data "passes" four assumptions that are required for a Kruskal-Wallis H test to give you a
valid result. In practice, checking for these four assumptions just adds a little bit more time to your
analysis, requiring you to click a few more buttons in SPSS Statistics when performing your
analysis, as well as think a little bit more about your data, but it is not a difficult task.

Before we introduce you to these four assumptions, do not be surprised if, when analysing your
own data using SPSS Statistics, one or more of these assumptions is violated (i.e., is not met).
This is not uncommon when working with real-world data rather than textbook examples, which
often only show you how to carry out a Kruskal-Wallis H test when everything goes well! However,
don’t worry. Even when your data fails certain assumptions, there is often a solution to overcome
this. First, let’s take a look at these four assumptions:

• Assumption #1: Your dependent variable should be measured at the ordinal or continuous
level (i.e., interval or ratio). Examples of ordinal variables include Likert scales (e.g., a 7-point
scale from "strongly agree" through to "strongly disagree"), amongst other ways of ranking
categories (e.g., a 3-pont scale explaining how much a customer liked a product, ranging from
"Not very much", to "It is OK", to "Yes, a lot"). Examples of continuous variables include revision
time (measured in hours), intelligence (measured using IQ score), exam performance (measured
from 0 to 100), weight (measured in kg), and so forth. You can learn more about ordinal and
continuous variables in our article: Types of Variable.

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• Assumption #2: Your independent variable should consist of two or more categorical,
independent groups. Typically, a Kruskal-Wallis H test is used when you have three or more
categorical, independent groups, but it can be used for just two groups (i.e., a Mann-Whitney U
testis more commonly used for two groups). Example independent variables that meet this
criterion include ethnicity (e.g., three groups: Caucasian, African American and Hispanic), physical
activity level (e.g., four groups: sedentary, low, moderate and high), profession (e.g., five groups:
surgeon, doctor, nurse, dentist, therapist), and so forth.

• Assumption #3: You should have independence of observations, which means that there is no
relationship between the observations in each group or between the groups themselves. For
example, there must be different participants in each group with no participant being in more than
one group. This is more of a study design issue than something you can test for, but it is an
important assumption of the Kruskal-Wallis H test. If your study fails thisassumption, you will need
to use another statistical test instead of the Kruskal-Wallis H test (e.g., a Friedman test). If you are
unsure whether your study meets this assumption, you can use our Statistical Test Selector which
is part of our enhanced content.

As the Kruskal-Wallis H test does not assume normality in the data and is much less sensitive to
outliers, it can be used when these assumptions have been violated and the use of a one-way
ANOVA is inappropriate. In addition, if your data is ordinal, a one-way ANOVA is inappropriate, but
the Kruskal-Wallis H test is not. However, the Kruskal-Wallis H test does come with an additional
data consideration, Assumption #4, which is discussed below:

• Assumption #4: In order to know how to interpret the results from a Kruskal-Wallis H test, you
have to determine whether the distributions in each group (i.e., the distribution of scores for each
group of the independent variable) have the same shape (which also means the same variability).
Tounderstand what this means, take a look at the diagram below:

In the diagram on the left above, the distribution of scores for the "Caucasian", "African American"
and "Hispanic" groups have the same shape. On the other hand, in the diagram on the right above,
the distribution of scores for each group are not identical (i.e., they have different shapes and
variabilities).

If your distributions have the same shape, you can use SPSS Statistics to carry out a Kruskal-
Wallis H test to compare the medians of your dependent variable (e.g., "engagement score") for
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the different groups of the independent variable you are interested in (e.g., the groups, Caucasian,
African American and Hispanic, for the independent variable, "ethnicity"). However, if your
distributions have a different shape, you can only use the Kruskal-Wallis H test to compare mean
ranks. Having similar distributions simply allows you to use medians to represent a shift in
location between the groups (as illustrated in the diagram on the left above). As such, it is very
important to check this assumption or you can end up interpreting yourresults incorrectly.

You can check assumption #4 using SPSS Statistics. You should also check that your data meets
assumptions #1, #2 and #3, which you can do without using SPSS Statistics. Just remember that if
you do not check assumption #4, you will not know whether you are able to compare medians or
just mean ranks, meaning that you might incorrectly interpret and report the result of the Kruskal-
Wallis H test. In the Test Procedure in SPSS Statistics section of this "quick start" guide, we
illustrate the SPSS Statistics procedure to perform a Kruskal-Wallis H test assuming that your
distributions are not the same shape and you have to interpret mean ranks rather than medians.
First, we set out the example we use to explain the Kruskal- Wallis H test procedure in SPSS
Statistics.

Example
A medical researcher has heard anecdotal evidence that certain anti-depressive drugs can have
the positive side- effect of lowering neurological pain in those individuals with chronic,
neurological back pain, when administered in doses lower than those prescribed for depression.
The medical researcher would like to investigate this anecdotal evidence with a study. The
researcher identifies 3 well-known, anti-depressive drugs which might have this positive side
effect, and labels them Drug A, Drug B and Drug C. The researcher then recruits a group of 60
individuals with a similar level of back pain and randomly assigns them to one of three groups –
Drug A, Drug B or Drug C treatment groups – and prescribes the relevant drug for a 4 week period.
At the end of the 4 week period, the researcher asks the participants to rate their back pain on a
scale of 1 to 10, with 10 indicating the greatest level of pain. The researcher wants to compare the
levels of pain experienced by the different groups at the end of the drug treatment period. The
researcher runs a Kruskal-Wallis H test to compare this ordinal, dependent measure ( Pain_Score )
between the three drug treatments (i.e., the independent variable, Drug_Treatment_Group , is the
type of drug with more than two groups).

Writing Reports
We start here – at the end - so that you can see where we are going and so that you can build up a
picture of the final product. This section is quite long as it also serves as a reference for the
writing-up of your dissertation. The main issues that you need to cover here are presented in Harris
(1986) and in many other textbooks. The basic rule is to be precise, concise and use the
conventions of reporting, referencing and data presentation that are set out in the guides. Harris
(1986) is the recommended course text for this unit. It can be found in the Arts and Social
Sciences Library and the full reference is:
Harris, P. (1986). Designing and Reporting Experiments. Buckingham: Open University Press.
BF200 HAR

Although the book is aimed at psychology students, a lot of the material is relevant to those who
study Deaf Studies as well. Another useful text (to which you may wish to refer) is: APA (1994).
Publication Manual of the American Psychological Association: 4th Edition. Washington, DC:

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American PsychologicalAssociation. PN147 PUB

This text is quite dense (and can be hard to follow) but provides exhaustive details of how to
prepare manuscripts for publication,including dissertations and theses.

Whilst Harris (1986) also covers relevant aspects of quantitative research, it does not include
qualitative research within its scope. The suggested text for qualitative research methods is:
Bowling, A. (1997). Research methods in health: Investigating health and health services.
Buckingham: OUP. RA440.85 BOW

Also included in these course notes are useful WWW links. These are well worth taking a look at,
and some of them will match your level of knowledge and interest.

So What is a Dissertation?
If we imagine the process of writing a project report, it can be thought of as like an hourglass
shape. So it is broad at the top, gradually narrows toa point and then starts to broaden again. This
is how your research report should look. The introduction should start from a very general point of
view – it sets the context of the research in other people’s work and then leads the reader through
a critical review (see last session) to the research question. At this point there should be a precise
and logical statement. The methodology of how to approach this question then begins to broaden
it out and the research study that is designed is a way to make operational, the ideas, takes this
further. The research results are then likely to lead outwards with implications and then into the
discussion that begins to draw out the implications for the field in general.

Preparing the Report

There are a number of variations on the structure but the papers shouldinclude:

• A Title page with course details and year of submission

• A Statement Page that the work is the whole an unaided work of the student – this to be
signed in each copy
• An Acknowledgement page (optional)
• A Summary – one page – which contains the background, study,results and implications
• A Table of Contents with page numbering for each chapter andsection
• An Introduction to the report. A review of relevant literature and previous
research/publications (up to 30%). The background and establishment of the research theme.
This should include a brief and concise version of the review of the literature. It is designed to
show that the candidate is capable of critical analysis of current research work and can deal
with the theories or models proposed in that field. This should lead to the Statement of a
Research Question.
• Next comes the Method section. A detailed account of the workcarried out by you (up to 50%).
This will have several sections. First, the Aims and Objectives will be presented. If theseare to
be expressed as hypotheses, they should appear here. Second, the methods to be used and
general procedure. This part should indicate which methods have been chosen and how these
are to be implemented. It should indicate the sampling and reasoning behind this. It should
indicate how participants were contacted and how the design was formulated. Thus you will
have a Participants section, followed by a Design section, and then a section detailing any
Apparatus/Materials used. Third, the Pilot Work. This should explain how you prepared for the

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 main study by trying out themethod and materials. Say what you learned and how your study
was altered as a result. Finally, the Procedure - the implementation of the method should be
described, showing what actually happened, what was measured and what analysis has been
carried out. The success of this section is measured by how well another person can
duplicate your study by just reading your report.
• Results: set out the results of your study, using tables, figures, statistics, and graphs, as
relevant. Make sure that the measurement is clear and that the tables are self-explanatory (so
they have to have labels and numbers e.g. Table 2.6: Deaf women who visit the doctor)
• Discussion: An analysis and discussion of the implications of what has been discovered in
terms of the previous review of the literature
• (20-30%). You should include the plans for future work, in the context of what you would do
next time to improve the study. Theseplans have to arise from and relate to the pilot work and
the work reported.
• A Reference List (a conventional list of all materials which have been referred to in the text
above)
• Appendices of relevant research materials
• The research should aim to provide some new insights and analysis. It should help us to
understand the research question better. There is always some learning from the conduct of
the research, so be positive and search for the real explanations of your findings, even if they
seem tobe limited at first.

Be systematic, be concise, be positive and be precise (in what you say, and how you apply the
format).

Writing – A Style Guide

[Dr. Sarah Stevenage from the University of Southampton wrote this section.] ‘Why is writing so
difficult?’ This is a question asked by students and lecturers alike. Very often, the problem is not
the writing but the whole host of emotions that a blank piece of paper seems to create. For
instance, there is the feeling that you have to get it right - first time - because you (YOU) are being
judged on what you write. The simple act of submitting a report opens up the field for criticism.
Sometimes you just don’t know what to write but armed with the impression that a thick report is
better than a paltry few pages you end up waffling about everything remotely linked to the title.
Sometimes you can feel that you are not qualified to criticise the work of people who have
numerous years of expertise in an area while you have merely read a couple of papers. The result
then is a paper that reads more like a reiteration of the work of others rather than a critical
evaluation of that work.

These are both common mistakes in students’ written work. In this section it is hoped you will gain
some insight into what the reader wants from a piece of writing. There are, of course, some rules
to follow and these are explained below. However, the main aim is to help you to gainconfidence in
your own writing abilities. Your style of writing is critical in persuading your reader of the validity
of your ideas. Confidence can help you achieve a writing style that makes you, and your work,
believable.
Helpful Hints - Things to Do

Generally:
1. Think about how to capture and maintain your reader’s interest: Too often, people view the

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writing stage of a piece of work as the boring bit. They have left their study too long before writing
it up and consequently they have ‘gone cold on it’. It no longer interests them and so they write as
thought they are bored to tears with the topic. This should not be the case. There are several
things you can do to safeguard against this. The first is obvious. Write a report up as soon as you
can. This will also help against the failures of the human memory! Secondly, before you start
writing, make sure you are in the right mood. How can you motivate others if you are not
motivated? Thirdly, view the report as a way of imparting knowledge to others. After all, you have
just completed a piece of research that, perhaps, no-one else has done and you should want to tell
people what you have found. Rather than being the boring bit of the process, this is actually the
exciting bit. You are in a position to help the scientific community pull together disparate pieces
of information and fill in another piece of an, as yet unsolved, puzzle. Your report should help the
reader appreciate the overall puzzle and how your research helps to answer certain questions
within that puzzle.

2. Think about your writing style: Style is a very important element of good writing. It is certainly
true that how you say something is as important as what you say. After all, the reader’s
comprehension of what you say is dependent solely on your way of saying it. It is also true that the
quality of presentation of your ideas can often be presumed to reflect the quality of those ideas. If
you write using sloppy English then the reader cannot be sure whether it is your English that is
sloppy or whether it is your ideas that are at fault. They will stumble over badly constructed
sentences and will have to read and re-read sentences to search for the information they need to
make it all fit together. What you must work towards is achieving clarity. If you can write clearly,
then the reader can go at a faster pace and will then be less likely to lose the thread of your
argument. Below, are somepoints that may help you to achieve this.

3. Keep in mind your aim: to inform your reader. Informing your reader means that you need to be
a reliable source of information. You must persuade, as well as inform him that your work is
credible. If you can demonstrate that you have researched an area accurately and have reported
the work of others clearly and honestly then you raise your own credibility. Doing this makes it
more likely that the reader will accept your own ideas too. This leads to two further points:

4. Provide explanations: It is not enough to provide your reader with fact after fact. You must also
endeavour to provide explanations. What you should be aiming to dois to provide the reader with a
logical path through what may otherwise be a maze of facts and theories. Do this by interrelating
theoretical ideas with the facts from previous research. Remember to use the facts to support (or
refute) what the theories are suggesting. Evaluate the work that you are reviewing. That is; how
do the results from one source fit with the results from another source? Is there any contradiction
in the published literature? Is there any clear conclusion that can be drawn so far? You may not
feel that you are in a position to critically evaluate someone else’s work as yet. However, a fresh
eye is no worse than an experienced eye. You all have good minds and are eminently capable of
evaluating the worth of a set of data, even if only tentatively: i.e., ‘On the basis of the present
literature it seems unlikely that...’

5. Maintain honesty in your reporting: Maintaining honesty means not being selective in the facts
that you use or the theories you review. We can all thread a few carefully chosen facts together to
make a story that fits with our intuitions and seems to have external validity. However, it doesn’t
take a trained mind to do that - you would be underselling yourself. It does, however, take some
skill to review all the information that is available - whether it supports your ideas or not - and use
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that information to guide the reader to a set of logical questions. This is what you should be
aiming to do. Anything else would be dishonest to the scientific community and it is from this
scientific community that your readers are drawn. By all means you should be selective in the
information that you review such that you include only relevant information. However, this does
not mean being blinkered to contradictory evidence.

6. Quality is better than quantity: It is not how much you write that is [Link] is what you
should be aiming for. A long report can reflect a lot of interesting ideas, however, it can also reflect
the work of a writer who takes several pages to say what could have been said in several lines.
Quality justifieslength, but length does not justify quality.

In Particular:
1. Use the passive voice. This puts the writer in the background and so it puts the ideas in the
foreground. The ideas are, after all, the important bits.
2. Be concise. Use a short title to grab the attention of the reader. Maintain conciseness to
maintain their interest.
3. Be precise. Use the words that most closely say what you want. Do not settle for words that
convey the approximate meaning. Keep a dictionary or thesaurus nearby if you need to. If two
words are as good as each other, use the simpler of the two. This is more reader-friendly.
4. Use examples. Examples are useful to help the reader understand particularly difficult ideas
or to illustrate ambiguous points. Examples also provide support forthe ideas that you present
and thus increase your credibility in the reader’s eyes. Remember to cite sources as well as
findings.
5. Use summary statements. These help the reader follow the structure of your writing and allow
them to recap on the important ideas before moving on.
6. Use transition statements. These direct the reader to a change of idea/topic and so help them
follow your argument. (e.g., I will now go on to discuss things that you should not do when
writing.)

Helpful Hints - Things Not to Do

Generally:
1. Avoid ‘slating’ the works of others: Open and unsubstantiated criticism of another’s work is
unprofessional. It is common for people to be very protective of their work and attack can often be
read as personal rather than as academic. If you are writing an article for publication it is certain
to be sent to the person whose work you are evaluating. Open, unqualified attack is therefore not a
good idea. Critical assessment is obviously to be encouraged but this must be done withcare and
within the limits of academic gain. Back up what you say with evidence - your own or from
published sources (but see below) - and be sure to cite the sources of this evidence so that the
reader can verify it/refer to it.
2. Avoid proof by indirect means: Just because one theory does not account for a finding it
doesn’t mean that your theory does and is therefore correct. Proof for alternative theoretical
explanations must come from a direct test of the predictions that result from this alternative
theory. No other support can be
considered valid or reliable. Ideally, support for an alternative theory should come from one
method which has been replicated, or from several methods which all converge to give the same
conclusion. A single source of support is not considered very strong.
3. Avoid being condescending: Write with confidence, but you should avoid developing a style that
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sounds too ‘cocky’. This has the effect of irritating the reader rather than reinforcing your ideas.
Avoid the use of ‘of course’, ‘clearly’ and ‘obviously’. Something may not be obvious to the reader
but if you suggest that ‘even an idiot can understand this’ then, odds are, your reader will stop
reading rather than struggle on feeling stupid.
4. Avoid blinkered selectivity: You should not use only the information that supports your case.
This is not honest scientific reporting. You may pull the wool over the eyes of people who are new
to the area but the people who matter will see that you have misrepresented the literature. This
does nothing but reduce your credibility as a researcher.

In Particular:
1. Avoid using long words. Use simple, everyday words rather than trying to soundhighbrow. If you
must use technical terms, be sure to define them the first time you use them.
2. Avoid redundancy. This means cutting out repetition. If you are having to repeat yourself for the
sake of emphasis then it is likely that you haven’t expressed yourself clearly enough first time
round. You should rewrite this first sentence rather than say things over and over again. Failure to
do this means that the reader can get confused and think they have missed something. This can
lead to them not reading the rest of the text properly, on the premise that you will say the important
things again anyway.
3. Avoid digressions. Do not go off at a tangent. If you must discuss a point that is slightly aside
from the main argument then use a footnote. Do not digress withinthe main body of the text.
4. Avoid over-explanations. Over-explanation for the sake of emphasis is equivalent to a pushy
salesman. The reader hates it. Again, you should look back to your initial explanation to make sure
that it is as clear as possible.
5. Avoid overstating your case. Selling your ideas is much more effective if you do it gently.
Stating that yours is the only theory that could possible account for such findings is rather strong
and somewhat shortsighted of you. Theories will always be superseded. Such strong claims can
reduce your credibility since it appears that you have not examined the theory/findings/ additional
literature for sources of weakness. Consequently, it is wise to express a certain amount of caution
in your writing.
6. Avoid sexist language. Do not use ‘he’ when you mean ‘he or she’. To overcome the
consequential wordiness of your writing you can use the plural pronoun e.g., ‘Once the subjects
had completed the task they were debriefed.’ Then there is noneed to nominate gender.

Commonly Misused Words

This section covers words that are commonly misused in lab reports and essays. Many of these
are listed below with an indication as to their correct meaning and usage. However, for a more
exhaustive list you areencouraged to refer to:

Strunk, W. and White, E.B. (1972). The elements of style (2nd Edition).New York: Macmillan.
Fowler, H.W. (1965). A dictionary of modern English usage (2nd Edition). Revised by E. Gowers.
New York: Oxford University Press.
Sternberg, R.J. (1988). The psychologist’s companion (2nd Edition). Cambridge, New York,
Melbourne: Cambridge University Press.

adapt/adopt
To adapt is to accommodate, to adjust, to bring into correspondence. To adopt is to embrace, to
take on, to make one’s own.

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affect, effect
Both can be used as nouns and verbs. An affect is an emotion or something that tends to arouse
an emotion. An effect is a result or outcome of some cause. To affect is to influence or to have an
effectupon something. To effect is to accomplish or to achieve.

(a) His display of affect seemed contrived.

(b) The effect of the variable was non-significant.
(c) The outcome was affected by several methodological flaws.
(d) With great skill and determination they were able to effect a changein their writing style.

among, between
If two things are related then there is said to be a relation between them. If there are more that
two things then the relation is among them. (The term between can be used if there are more than
two thingsbut only if the relationship is reciprocal - two way.)

amount of, number of

Use amount of to refer to quantities of things that can’t be counted -i.e., the amount of liquid in the
tall jar... Use number of to refer to quantities of things that can be counted - i.e., the number of
stimuli...(Note, monetary quantities is an exception - use ‘amount ofmoney’.)

average
This word has a precise statistical meaning - In statistical terms there are three ways to compute
an average resulting in a mean, a median and a modal value. The term ‘average’ is used as a
synonym for mean. More generally, the term average can be used as a generic term for all
measures of central tendency. To avoid confusion, the term average is best used in its more
specific meaning.

compare to, compare with

To compare to is to point out or emphasise similarities between different things. To compare with
is to point out or emphasise differences between similar things.
(a) When the two brothers were compared to each other they werefound to be very similar.
(b) The accountability of Theory A was found to be fundamentally lacking when compared with
that of Theory B.

continual, continuous
Continual means often repeated. Continuous means without stop.
(a) Continual interruptions forced the teacher to work at home.
(b) Continuous background music calmed the dentist’s patients.

data, datum
Data is the plural noun. Datum is the singular.
(a) The data were analysed...
(b) One datum was inconsistent with the others. (more usual to say‘one data point’ though)

fact
A fact should be directly verifiable either empirically or logically. Do not refer to judgments or
probable outcomes as facts.

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factor
This has two quite specific meanings in Psychology - one is statistical; the other refers to
determining reasons as in ‘several factors contributed to the current misunderstanding...’ Because
of this potential confusion it is best not to use the word in a non-technical sense.

fewer, less
Fewer refers to number. Less refers to degree.
(a) She experienced fewer sleepless nights after discovering Valium.
(b) It takes less time to mark a report in the morning than in theevening.

imply, infer
To imply something is to suggest it indirectly. To infer something is to conclude or deduce it from
the information available.

insignificant, non-significant
Insignificant means meaningless. Non-significant means that something does not reach
significance. Remember, a non-significant finding is NOTinsignificant.

relevant
This word should be used to express a clear connection ie., something is relevant to something
else.

reliability, validity
Reliability refers to how well or consistently a test measures whatever the test measures. Validity
refers to how well a test measures what it is supposed to measure. Thus, a perfectly reliable test
can be completely invalid if it measures something well but not what it is intended to measure. A
perfectly valid test, however, must be perfectly reliable too - as it measures what it is supposed to,
perfectly.

since
This word should only be used in a temporal sense. Do not use it as asubstitute for ‘because’.

Writing Scientific Reports

[Dr. Sarah Stevenage from the University of Southampton wrote this section.] In academic journals,
there is a certain conformity of style and convention of presentation that you should be aiming to
replicate. The best way to pick this up is, unfortunately, by reading through recognisedjournals.

Convention dictates that experimental articles are divided into certain sections. Your reader needs
to know exactly what you did and how you did it. They should also understand why you did it and
know what you found and what your results mean. These different bits of information are often
put into separate sections of an article and doing this helps thereader to use the article effectively
as they then know what aspect of a study they can find in any particular section.

There is no single correct way to set out a report or article. What follows is a general guide - you
should adapt the structure of your report to suit your material. Effective communication is the key
concern and is more important than whether or not you have correctly ‘parcelled’ your information.
Typically you should include a title, an abstract, an introduction, a method section, a results
section, a discussion section and finally the reference section. Each of these sections is quite
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specific in what it should contain. As well as referring to the guidelines given below, cross-
reference with the Marking Guide reported previously in these notes.

Title
This should be brief, concise, informative, and yet economical with words. The title is not just an
irrelevant phrase stuck at the beginning of an article. It is often the means by which someone will
decide whether or not to read the article. You should also bear in mind that many literature
searches are conducted, at least partially, on the basis of the keywords contained in the title.
These keywords are recognised words that all authors within an area use to designate their area of
interest.

Abstract (or Summary)

This should be 150-200 words long and should offer summary of the dissertation. Its job is to
provide a brief overview so that the reader can glance over this section and use it to decide
whether he or she needs to read the whole paper. This section always precedes the body of the
paper but it is sometimes useful to write it last.

You should include a sentence or two on the following points:

1. A brief introduction to the issue you are looking at and what has prompted you to look further
at it, i.e. is there any contradiction inthe literature that has prompted you to do this study?
2. A couple of sentences to say what YOU did, i.e. what sort of task did you use, what sort of
groups did you have, and what sort of measures did you record?
3. Briefly, what did you find? This might take the form of: The results suggest that age is a factor
in determining the performance on a perceptual learning task or, The ANOVA suggests that the
height of the stair rather than its horizontal depth is the important factor in determining the
ease ofclimbing
4. Briefly state how the results are to be interpreted. This doesn’t mean include half your
discussion section here, it means state how the results will be discussed in that section, i.e.
‘These results arediscussed in terms of the theoretical and practical issues involvedin ...’

Introduction
The Introduction section is designed to lay the foundation for the study you are about to present.
You should include a review of both theoretical and practical literature that is relevant to the issue
that youwill be examining. This should be presented in a critical fashion so that the reader can see
both the pluses and the minuses of the research to date and can see how it fits together.
Highlighting problems and controversies is especially useful as these often act as stimuli for
furtherresearch.

Your aim here is to provide the reader with enough background information so that they can see
how your study contributes to an area and can see the implications of your work in terms of what
has already been done. The overall direction or flow of the Introduction should lead from the
general background to the specific concerns and purposes of your study. Finally you should end
this section with a clear statement of the questions to be tackled and/or the hypotheses to be
tested.

The temptation in this section is often to include a summary of everything that you have read on a
subject - perhaps to show that you have read it. Try to avoid this - an Introduction is NOT
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supposed to be an essay and if you include too much you may well end up confusing the reader
rather than helping them. Your grasp of a topic is demonstrated as much by what you decide to
leave out as by what you include.

Note: There are several important points to note when referring to the work of other people. First,
it is important that you indicate clearly where you are making use of other people’s work. You
must not present the work of others as your own - this is called plagiarism and is an extremely
serious academic offence. Secondly, the best way to refer to previous authors is to cite the actual
publication that you have used. The reader is then able to go and look at the original for him or
herself if they want to get more information or check on details. Full information on where to find
such publications should be listed in a separate reference section at the end of your article but you
should give the surname(s) of the author(s) and the date of publication (in brackets) in the main
text.

Citing others’ work

1. Freud (1890) suggested that ... or, Boys’ development may be heavily influenced by their
relationshipwith their mother (Freud, 1890).
2. When there is more than one author use ‘and’ when writing in the main body of text e.g., ‘X, Y
and Z (1966) suggested that...’ but use ‘&’ when citing the authors within brackets e.g., ‘It has
been suggested that autistic children do show symbolic play (X, Y & Z, 1966).
3. The first time that you cite a reference source, list all of the authors (unless there are more than
6 of them, in which case use FirstAuthor et al). If there are more than two authors, all
subsequent citations should be of the form FirstAuthor et al. (Note: The reference section must
list all authors.)
4. When using a direct quote from a publication you must cite the relevant page number as well as
the year of publication. E.g., ‘Previous research notes that ‘the results are indicative of a general
trend in the developmental literature examining childhood disorders’ (Smith, 1994, p7).’
5. It is generally better to refer only to publications that you have actually read - these are called
primary sources. However, at times you may wish to refer to a publication that has been cited
by someone else. When doing so it is important toindicate that you are referring to a publication
via a secondary source. E.g., ‘Freud has argued that (Freud, 1890, cited in Kline, 1984).’
6. Finally, be sure to USE references rather than merely cite them. Give sufficient detail in the text
to show exactly how and why you are citing a reference source.

Method
This section is often the easiest to write - it breaks down into 4 sub- sections: Design, Participants,
Materials and Procedure. Each of these sections is basically a statement of (i) the experimental
design, (ii) who was used, (iii) what was used and (iv) what was said and done. These sections
MUST be written in the third person - avoid the use of I/We. It is also a good idea to write in the
past tense too (‘reaction times were recorded’ rather than ‘we will record the reaction times’). This
makes itsound more professional.

In the ‘Design’ section, you should describe the study in general terms. For experimental
dissertations, give details of (i) the number of independent variables - factors that you
manipulated. (How many levels did each of these have?), and (ii) the number of dependent
variables - things that you measured and that you expected to be influenced by the independent
variables. For more qualitative designs such information may be irrelevant. Discuss what to
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include with your supervisor. You should justify your design if others alternatives might have been
used in previous research. However, do not fall into the trap of repeating information that is better
placed in the Procedure section (below).

In the ‘Participants’ section include information about the number of participants and their
distribution across age and gender (NOT ‘sex’) if this is appropriate. Also, include information
such as socio-economic status, educational background, familiarity with the procedure, etc., if you
feel these are important. Were the participants volunteers or were they paid? If children were used
as participants be sure to state that consent was obtained from their parents/teachers. Ethical
problems surrounding participation of children is an important consideration and deserves
attention.

In the ‘Materials’ section include information on the materials and apparatus used. Do not simply
provide a list of items - you should use connected prose. If standard procedures or apparatus
were used of which there are already detailed descriptions available then simply name them, and if
possible, direct the reader to a publication where further information may be found. Include what
you, as the researcher used as well as what the participant used. This covers interview schedules,
questionnaires, and coding systems for observational research. Describe their general structure
and put copies in an Appendix. If there were no materials or apparatus then leave this section out.
You do not need to record things like ‘paper and pencil’!

In the ‘Procedure’ section include information on the precise order of tasks and any ‘instructions
to the participants’ that you feel are important to include. This section is important to get right - a
reader must be able to replicate exactly what you did if he/she wants. Do not forget to specify
things like the range and direction of rating scales (if used).

Results
This section is often the weakest section of a paper or report. It is the hardest section to get right
because you have to include so much information. People differ in how they like results to be
presented.

Basically, however, the following guidelines may prove helpful. Begin the Results section with a
statement of what was measured, i.e. a rating of the bizarreness of the images formed by the
participant together with their score on a memory task.

Then present a summary of the raw data. Rows and rows of figures are not what is required here
so present the mean, standard deviation and number of participants for each condition, either in
the form of a table or, if possible, in the form of a graph. (The pictorial presentation of data saves
the reader from having to plough through masses of text and it provides them with a source from
which they have to extract the information that they require - they are made active in the
interpretation of the results and this can force them to feel more involved and interested in these
results.) Remember to label any tables or graphs witha short but informative title.

Having presented the summary of the data (remember that ‘data’ is plural) then comment on any
trends apparent from the data, i.e. ‘From the table it appears that’ Then present the statistical
analyses of the data. Remember to includedetails of the statistical tests used and why, i.e. ‘A t-test
for independent samples was used to see whether the mean ratings for Group A differed from the
mean ratings for Group B.’. For qualitative dissertations this may not be necessary. Again, consult
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your supervisor.

Finally, summarise the results by relating the figures back to the predictions that you laid out in the
Introduction. Do the results supportor negate your predictions?

Discussion
This section should begin with a reiteration of the results - but take care to use plain English this
time rather than using figures and statistical- speak. If the results agree with your initial
predictions then you should say this and then go on to try to develop some theoretical argument
to account for these (and previous worker’s) results - i.e. put your results into some sort of
context. Thoughts for future research should also be discussed (if possible) in the light of your
findings and your emergentexplanations.

If your results don’t agree with your initial predictions then it may be that the predictions were
wrong and that your results have shown something new. However, you must not ignore the fact
that your contradictory results may reflect some methodological fault. It is wise, therefore, to
critically examine your method and see if you can suggest any ways in which your method may
have caused the unexpected results and to see if there are ways in which it can be improved to
overcome any flaws. Do not worry if you do find flaws in your methodology. That is part and parcel
of doing research.

You should aim to provide a clear and critical discussion of your findings with the context
discussed in the Introduction. Avoid unsupported personal opinions and over-generalisations.
However, do not be afraid toquestion previous research if you find something contrary to it. Where
speculations are presented make it clear to the reader. A good ending to this section is a
paragraph that recapitulates the main findings and their implications.

Finally, do not be tempted to sidestep embarrassing findings or paradoxical results. One way that
science advances is by having toexplain results that were not expected.

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Principles and functions of management

AIMS AND OBJECTIVES

This lesson is intended to introduce to the students about the different functions of management.
After studying this lesson you will be able to:
• Briefly describe the term-management
• Discuss various managerialfunction
• Explain different steps to befollowed by a manager whileperforming controlling operation
• Differentiate between co-ordination and communication
• Explore the nature of planning in an organization
• Describe - objectives, policies and decision makingconcept
• Understand the need ofglobalization for an International firm

INTRODUCTION
Management is an activity consisting of a distinct process which is primarily concerned with the
important task of goal achievement. No business enterprise can achieve its objectives until and
unless all the members of the enterprise make an integrated and planned effort under the
directions of a central coordinating agency. This central coordinating agency is technically known
as 'management' and the methodology of getting things done isknown as 'management process'.
The process of management involves the determination of objectives and putting them into
action. According to McFarland, "Management is the process by which managers create, direct,
maintain and operate purposive organizations through systematic, coordinated and cooperative
human effort".

According to G. R. Terry - "Management is a distinct process consisting of planning, organizing,

actuating and controlling, performed to determine and accomplish stated objectives by the use of
human beingsand other resources". Under management as a process, management is considered
as a continuing activity made up of basic management functions. The process is on going and
continuing. It assumes acyclical character.
• Planning: Denotes the determination of short-to- long-range plans to achievethe objectives of
organization.
• Organizing: Indicates the development of sound organization structure according to
predeterminedplans.
• Direction: Means stimulating and motivation of personnel of the organization according to
predetermined plans.
• Controlling: Offers assurance that directs action i.e., plan- in-action, is takingplace as per plan.

We have an ongoing cycle of planning - action - control – re- planning. Control function closes the
system loop by providing adequate and accurate feedback of significant deviations from planned
performance in time. Feedback can affect the inputs or any of the managerial functions or the
process so that deviations can be removed and goals can be accomplished.

MANAGERIAL FUNCTIONS
A manager is called upon to performthe following managerial functions:
• Planning
• Organizing
• Staffing
• Directing

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 • Motivating
• Controlling
• Co-coordinating and
• Communicating.

Planning: When management is reviewed as a process, planning is the first function performed by
a manager. The work of a manager begins with the setting of objectives of the organization and
goals in each area of the business. This is done through planning. A plan is a predetermined
course of action to accomplish the set objectives. It is today's projection for tomorrow's activity.
Planning includes objectives, strategies, policies, procedures, programmes e.t.c. As it involves
making choices, decision-making is the heart of planning.

Organizing: Organizing includes putting life into the plan by bringing together personnel, capital,
machinery, materials etc., to execute the plans. While, planning decides what management wants
to do, organizing provides an effective machine for achieving the plans.

Staffing: Staffing involves filling the positions needed in the organization structure by appointing
competent and qualified persons for the job. This needs manpower planning, scientific selection
and training of personnel, suitable methods of remuneration and performance appraisal.

Directing: Direction involves managing managers, managing workers and the work through the
means of motivation, proper leadership, effective communication as well as co-ordination. A
manager must develop the ability to commandand direct others.

Motivating: Motivation is a managerial function to inspire and encourage people to take required
action. Motivation is the key to successful management of any enterprise. Motivation can set into
motion a person to carry out certainactivity.

Controlling: Control is the process of measuring actual results with some standard of
performance, finding the reason for deviations of actual from desired result and taking corrective
action when necessary. Thus, controlling enables the realization of plans. A manager must adopt
the following steps in controlling:

• Identify potential problems.

• Select mode of control.
• Evaluate performance interms of planning.
• Spot significant deviations.
• Ascertain causes ofdeviations.
• Take remedial measures.

Co-ordination: Co-ordination is concerned with harmonious and unified action directed toward a
common objective. It ensures that all groups and persons work efficiently, economically and in
harmony. Co- ordination requires effective channels of communication. Person-to-person
communication is most effective for coordination.

Communication: It means transfer of information and under-standing from person to person.

Communication also leads to sharing of information, ideas and knowledge. It enables group to
think together and act together.
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PLANNING
Planning means looking ahead. It is deciding in advance what is to be done. Planning includes
forecasting. According to Henry Fayol - "purveyance, which is an essential element of planning,
covers not merely looking into the future but making provisions for it. A plan is then a projected
course of action". All planning involves anticipation of the future course of events and therefore
bears an element of uncertainty in respect of its success. Planning is concerned with the
determination of the objectives to be achieved and course of action to be followed to achieve
them. Before any operative action takes place it is necessary todecide what, where, when and who
shall do the things.

Decision-making is also an important element of planning. Planning determines both long-term

and short- term objectives and also of the individual departments as well as the entire
organization. According to Fayol - "The plan of action is, at one and the same time, the result
envisaged, the line of action to be followed, the stages to go through, and the methods to use. It is
a kind offuture picture wherein proximate events are outlined with some distinctness. " Planning
is a mental process requiring the use of intellectual faculties' imagination, foresight, sound
judgment etc.

Planning is deciding in advance what is to be done. It involves the selectionof objectives, policies,
procedures and programmes from among alternatives. A plan is a predetermined course of action
to achieve a specified goal. It is a statement of objectives to be achieved by certain means in the
future. In short, it is a blueprint for action.

According to Louis A Allen, "Management planning involves the development of forecasts,

objectives, policies, programmes, procedures, schedules and budgets". According to Theo
Haimann, "Planning is deciding in advance what is to be done. When a manager plans, he projects
a course of action, for the future, attempting to achieve a consistent, coordinated structure of
operations aimed at the desired results". According to Koontz O'Donnel - "Planning is an
intellectual process, the conscious determination of courses of action, the basing of decisions on
purpose, acts and considered estimates".

Nature of Planning:
• Planning is goal-oriented: Every plan must contribute insome positive way towards the
accomplishment of groupobjectives. Planning has no meaning without being related to goals.
• Primacy of Planning: Planning is the first of themanagerial functions. It precedes all other
management functions.
• Pervasiveness of Planning: Planning is found at all levelsof management. Top management
looks after strategic planning. Middle management is in charge of administrative planning.
Lower management has to concentrate on operational planning.
• Efficiency, Economy and Accuracy: Efficiency of planis measured by its contribution to the
objectivesas economically as possible. Planning also focuses on accurate forecasts.
• Co-ordination: Planning co- ordinates the what, who, how, where and why of planning.
Without co- ordination of all activities, wecannot have united efforts.
• Limiting Factors: A plannermust recognize the limiting factors (money, manpoweretc.) and
formulate plans inthe light of these critical factors.
• Flexibility: The process of planning should be adaptableto changing environmental
conditions.
• Planning is an intellectual process: The quality of planning will vary accordingto the quality of

740
 the mind of the manager.

Importance of Planning:
As a managerial function planning isimportant due to the following reasons:
• To manage by objectives: All the activities of an organization are designed toachieve certain
specified objectives. However, planning makes the objectives more concrete byfocusing
attention on them.
• To offset uncertainty and change: Future is always fullof uncertainties and changes.
Planning foresees the future and makes the necessary provisions for it.
• To secure economy in operation: Planning involves,the selection of most profitable course
of action that would lead to the best result at the minimum costs.
• To help in co-ordination: Co-ordination is, indeed, theessence of management, theplanning
is the base of it. Without planning it is not possible to co-ordinate thedifferent activities of an
organization.
• To make control effective: The controlling function of management relates to the
comparison of the planned performance with the actualperformance. In the absenceof plans,
a management willhave no standards for controlling other's performance.
• To increase organizational effectiveness: Mere efficiency in the organization is not
important; it should also lead to productivity and effectiveness. Planning enables the
manager to measure the organizational effectiveness in the context ofthe stated objectives
and take further actions in this direction.

Advantages of Planning
• All efforts are directed towards desired objectives orresults. Unproductive work and waste of
resources can beminimized.
• Planning enables a companyto remain competitive with other rivals in the industry.
• Through careful planning, crisis can be anticipated andmistakes or delays avoided.
• Planning can point out the need for future change and the enterprise can manage the change
effectively.
• Planning enables the systematic and thorough investigation of alternative methods or
alternative solutions to a problem. Thus we can select the best alternative to solve any
business problem.
• Planning maximizes the utilization of available resources and ensures optimum productivity
and profits. Planning provides theground work for laying downcontrol standards.
• Planning enables management to relate the whole enterprise to its complex environment
profitably.

Disadvantages of Planning
• Environmental factors are uncontrollable and unpredictable to a large extent. Therefore,
planning cannot give perfect insuranceagainst uncertainty.
• Planning is many times verycostly.
• Tendency towards inflexibility to change isanother limitation of planning.
• Planning delays action.
• Planning encourages a falsesense of security against riskor uncertainty.

PLANNING PROCESS
The planning process involves thefollowing steps:

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• Analysis of External Environment: The external
environment covers uncontrollable and unpredictable factors such astechnology, market,
socio- economic climate, political conditions etc., within whichour plans will have to operate.
• Analysis of Internal Environment: The internal environment covers relativelycontrollable factors
such as personnel resources, finance, facilities etc., at the disposal of the firm. Such an analysis
will give an exact idea about the strengths and weakness ofthe enterprise.
• Determination of Mission: The "mission" should describe the fundamental reason for the
existence of anorganization. It will give firmdirection and make out activities meaningful and
interesting.
• Determination of Objectives:The organizational objectivesmust be spelled out in key areas of
operations and should be divided according to various departments and sections. The
objectives mustbe clearly specified and measurable as far as [Link] member of the
organization should be familiar with its objectives.
• Forecasting: Forecasting is asystematic attempt to probe into the future by inference from
known facts relating to the past and the present. Intelligent forecasting is
essential for planning. The management should have no stone unturned in reducing the element
of guesswork in preparing forecasts by collecting relevant data usingthe scientific techniques of
analysis and inference.
• Determining Alternative course of Action: It is a common experience of all thinkers that an
action can be performed in several ways, but there is a particular way which is the most suitable
forthe organization. The management should try to find out these alternatives andexamine them
carefully in thelight of planning premises.
• Evaluating Alternative Courses: Having sought out alternative courses and examined their
strong and weak points, the next step is to evaluate them by weighingthe various factors.
• Selecting the Best: The nextstep - selecting the course ofaction is the point at which the plan is
adopted. It is the real point of decision- making.
• Establishing the sequence ofactivities: After the best programme is decided upon, the next task
is to work out its details and formulate the steps in full sequences.
• Formulation of Action Programmes: There are three important constituents of an action plan:
(A) The time- limit of performance. (B) The allocation of tasks to individual employees. (C) The
time-table or schedule ofwork so that the functional objectives are achieved within the
predetermined period.
• Reviewing the planning process: Through feedback mechanism, an attempt is made to secure
that which was originally planned. To dothis we have to compare the actual performance with
the plan and then we have to takenecessary corrective action toensure that actual performance
is as per the plan.

Features of Objectives
• The objectives must bepredetermined.
• A clearly defined objectiveprovides the clear directionfor managerial effort.
• Objectives must be realistic.
• Objectives must bemeasurable.
• Objectives must have socialsanction.
• All objectives are interconnected and mutuallysupportive
• Objectives may be short-range, medium-range andlong-range.
• Objectives may be constructed into a hierarchy.

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 Advantages of Objectives
• Clear definition of objectivesencourages unified planning.
• Objectives provide motivation to people in theorganization.
• When the work is goal- oriented, unproductive taskscan be avoided.
• Objectives provide standardswhich aid in the control of human efforts in an organization.
• Objectives serve to identify the organization and to link it to the groups upon which its
existence depends.
• Objectives act as a soundbasis for developing administrative controls.
• Objectives contribute to the management process: they influence the purpose of the
organization, policies, personnel, leadership as wellas managerial control.

Process of Setting Objectives

Objectives are the keystone of management planning. It is the most important task of
management. Objectives are required to be set in every area which directly and vitally effects the
survival and prosperity of the business. In the setting of objectives, the following points should be
borne in mind:
• Objectives are required to be set by management in every area which directly and vitally
affects the survival and prosperity of the business.
• The objectives to be set invarious areas have to be identified.
• While setting the objectives, the past performance must be reviewed, since past
performance indicates what the organization will be able to accomplish in future.
• The objectives should be set in realistic terms i.e., the objectives to be set should be
reasonable and capable of attainment.
• Objectives must be consistent with one and other.
• Objectives must be set inclear-cut terms.
• For the successful accomplishment of the objectives, there should be effective
communication.

STRATEGIES
The term 'Strategy' has been adapted from war and is being increasingly used in business to
reflect broad overall objectives and policies of an enterprise. Literally speaking, the term
'Strategy' stands for the war-art of the military general, compelling the enemy to fight as per out
chosen terms and conditions. A strategy is a special kind of plan formulated in order to meet the
challenge of the policies of competitors. This type of plan uses the competitors' plan as the
background. It may also be shaped by the general forces operating in an industry and the
economy.

Edmund P Learned has defined strategies as "the pattern of objectives, purposes or goals and
major policies and plans for achieving these goals, stated in such a way as to define what
business the company is in or is to be and the kind of company it is or is to be". Haynes and
Massier have defined strategy as “the planning for unpredictable contingencies about which
fragmentary information is
available”.

According to David I Cleland and William R King, "Strategy is the complex plans for bringing the
organization from a given posture to a desired position in a further period of time". In the words of
Haimann, "Strategy is a policy that has been formulated by the top management for the purpose
of interpreting and shaping the meaning of other policies". According to C. T. Hardwick and B. F.
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 Landuyt, "The word strategy is used to signify the general concept and salient aspect of
gamesmanship as an administrative course designed to bring success".

According to Koontz and O' Donnell. "Strategies must often denote a general programme of
action and deployment of emphasis and resources to attain comprehensive objectives".
Strategies are plans made in the light of the plans of the competitors because a modern business
institution operates in a competitive environment. They are a useful framework for guiding
enterprise thinking and action. A perfect strategy can be built only on perfect knowledge of the
plans of others in the industry. This may be done by the management of a firm putting itself in the
place of a rival firm and trying to estimate their plans.

Characteristics of Strategy
• It is the right combination ofdifferent factors.
• It relates the businessorganization to the environment.
• It is an action to meet a particular challenge, to solve particular problems or to attain desired
objectives.
• Strategy is a means to an endand not an end in itself.
• It is formulated at the topmanagement level.
• It involves assumption ofcertain calculated risks.

STRATEGY FORMULATION
There are three phases in strategyformation:
1) Determination of objectives.
2) Ascertaining the specific areas ofstrengths and weakness in the total environment.
3) Preparing the action plan to achieve the objectives in the light ofenvironmental forces.

Business Strategy
Seymour Tiles offers six criteria forevaluating an appropriate strategy.
1) Internal consistency: The strategy of an organization must be consistent with its other
strategies, goals, policies and plans.
2) Consistency with the environment: The strategy must be consistent with the external
environment. The strategy selected should enhance the confidence and capability of the
enterprise to manage and adapt withor give command over the environmental forces.
3) Realistic Assessment: Strategy needs a realistic assessment of the resources of the
enterprise—men, money and materials—both existingresources as also the resources, the
enterprise can command.
4) Acceptable degree of risk: Any major strategy carries with it certain elements of risk and
uncertainty. The amount of risk inherent in a strategy should be within the bearable
capacityof the enterprise.
5) Appropriate time: Time is the essence of any strategy. A good strategy not only provides
the objectives to be achieved but also indicates when those objectives couldbe achieved.
6) Workability: Strategy must befeasible and should produce the desired results.

POLICIES
A policy is a standing plan. Policies are directives providing continuous framework for executive
actions on recurrent managerial problems. A policy assists decision-making but deviations may
be needed, as exceptions and under some extraordinary circumstances. Policy- making is an

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 important part of the process of planning. Policies may be described as plans which are meant to
serve as broad guides to decision making in a firm. Policies exist at various levels of the
enterprise— Corporate level, divisional level and departmental level. Policies are valuable because
they allow lower levels of management to handle problems without going to top management for
a decision each time.

Essentials of Policy Formulation

The essentials of policy formationmay be listed as below:
• A policy should be definite, positive and clear. It should be understood by everyone in the
organization.
• A policy should be translatable into the practices.
• A policy should be flexibleand at the same time have ahigh degree of permanency.
• A policy should be formulated to cover all reasonable anticipatableconditions.
• A policy should be foundedupon facts and sound judgment.
• A policy should conform to economic principles, statutesand regulations.
• A policy should be a generalstatement of the established rule.

Importance of Policies
Policies are useful for the followingreasons:
• They provide guides tothinking and action andprovide support to the subordinates.
• They delimit the area withinwhich a decision is to be made.
• They save time and effort bypre-deciding problems and
• They permit delegation ofauthority to mangers at thelower levels.

DECISION MAKING
The word decision has been derived from the Latin word "decidere" which means "cutting off".
Thus, decision involves cutting off of alternatives between those that are desirable and those that
are not desirable. Decision is a kind of choice of a desirable alternative. A few definitions of
decision making are given below:

In the words of Ray A Killian, "A decision in its simplest form is a selection of alternatives". Dr. T.
G Glover defines decision "as a choice of calculated alternatives based on judgment". In the
words of George R. Terry, "Decision-making is the selection based on some criteria from two or
more possible alternatives".

Felix M. Lopez says that "A decision represents a judgment; a final resolution of a Functions of
Management conflict of needs, means or goals; and a commitment to action made in face of
uncertainty, complexity and even irrationally".

According to Rustom S. Davar, "Decision-making may be defined as the selection based on some
criteria ofone behaviour alternative from two ormore possible alternatives. To decide
means to cut off or in practical content to come to a conclusion".

Fremont A. Shull Andrew L Delbecq and Larry L Cummings define decision making as "a
conscious human process involving both individual and social phenomenon based upon factual
and value premises which concludes with a choice of one behavioural activity from among one or
more alternativeswith the intention of moving toward some desired state of affairs".

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 From the above definitions, we can conclude that, Decision Making involves the process of
establishinggoals, tasks and searching for alternatives for a decision problem.

Characteristics of Decision Making:

Decision making implies that there are various alternatives and the most desirable alternative is
chosen to solve the problem or to arrive at expected results.
1) The decision-maker has freedom tochoose an alternative.
2) Decision-making may not becompletely rational but may bejudgmental and emotional.
3) Decision-making is goal-oriented.
4) Decision-making is a mental or intellectual process because the finaldecision is made
by the decision- maker.
5) A decision may be expressed inwords or may be implied from behaviour.
6) Choosing from among the alternative courses of operation implies uncertainty about
the finalresult of each possible course of operation.
7) Decision making is rational. It is taken only after a thorough analysis and reasoning and
weighing the consequences of the various alternatives.

Types of Decisions
• Programmed and Non- Programmed Decisions: Herbert Simon has grouped organizational
decisions intotwo categories based on the procedure followed. They are:
• Programmed decisions: Programmed decisions are routine and repetitive and are made
within the framework of organizational policies and rules. These policies and rules are
established well in advance to solve recurring problems in the organization. Programmed
decisions have short-run impact. They are, generally, taken at the lower level of
management.
• Non-Programmed Decisions: Non-programmed decisions are decisions taken to meet non-
repetitive problems. Non-programmed decisions are relevant for solving unique/ unusual
problems in which various alternatives cannot be decided in advance. A common feature of
non-programmed decisions is that they are novel and non-recurring and therefore,
readymade solutions are not available. Since these decisions are of high importance and
have long-term consequences, theyare made by top level management.
• Strategic and Tactical Decisions: Organizational decisions may also be classified as
strategic or tactical.

Strategic Decisions: Basic decisions or strategic decisions are decisions which are of crucial
importance. Strategic decisions a major choice of actions concerning allocation of resources and
contribution to the achievement of organizational objectives. Decisions like plant location, product
diversification, entering into new markets, selection of channels of distribution, capital expenditure
e.t.c. are examples of basic or strategic decisions.

Tactical Decisions: Routine decisions or tactical decisions are decisions which are routine and
repetitive. They are derived out of strategic decisions. The various features of a tactical decision
are as follows:
1) Tactical decision relates to day-to- day operation of the organization and has to be taken
very frequently.
2) Tactical decision is mostly a programmed one. Therefore, the decision can be made
within thecontext of these variables.

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 3) The outcome of tactical decision is of short-term nature and affects a narrow part of the
organization.
4) The authority for making tactical decisions can be delegated to lower level managers
because: first, the impact of tactical decision is narrow and of short-term nature and
Second, by delegating authority for such decisions to lower-level managers, higher level
managers are free to devote more time on strategic decisions.

Decision Making Process

• Specific Objective: The need for decision making arises in order to achieve certain specific
objectives. The starting point in any analysis of decision making involves the determination of
whether a decision needs to be made.
• Problem Identification: A problem is a felt need, a question which needs a solution. In the
words of Joseph L Massie "A good decision is dependent upon the recognition of the right
problem". The objective of problem identification is that if the problem is precisely and
specifically identifies, it will provide a clue in finding a possible solution. A problem can be
identified clearly, if managers go through diagnosis and analysis of the problem:

Diagnosis: Diagnosis is the process of identifying a problem from its signs and symptoms. A
symptom is a condition or set of conditions that indicates the existence of a problem. Diagnosing
the real problem implies knowing the gap between what is and what ought to be, identifying the
reasons for the gap and understanding the problem in relation to higher objectives of the
organization.

Analysis: Diagnosis gives rise to analysis. Analysis of a problem requires: (i) Who would make
decision? (ii) What information would be needed? (iii) From where the information is available?
Analysis helps managers to gain an insight intothe problem.
• Search for Alternatives: A problem can be solved in several ways; however, all the ways
cannot be equally satisfying. Therefore, the decision maker must try to find out the various
alternatives available in orderto get the most satisfactory result Functions of Management of
a decision. A decision maker can use several sources for identifying alternatives: (i) His own
past experiences (ii)Practices followed by others and (iii) Using creative techniques.
• Evaluation of Alternatives: After the various alternativesare identified, the next step is
to evaluate them and select the one that will meet the choice criteria. The decision maker
must check proposed alternatives against limits, and if an alternative does not meet them, he
can discard it. Having narrowed down the alternatives which require serious consideration,
the decision maker will go for evaluating how each alternative may contribute towards the
objective supposed to be achieved by implementing the decision.
• Choice of Alternative: The evaluation of various alternatives presents a clear picture as to
how each one of them contribute to the objectives under question. A comparison is made
among the likely outcomes of various alternatives and the best one is chosen.
• Action: Once the alternative is selected, it is put into action. The actual process of decision
making ends with the choice of an alternative through which the objectivescan be achieved.
• Results: When the decision is put into action, it brings certain results. These results must
correspond with objectives, the starting point of decision process, if good decision has been
made and implemented properly. Thus, results provide indication whether decision making
andits implementation is proper.

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 Characteristics of Effective Decisions
An effective decision is one which should contain three aspects. Theseaspects are given below:
• Action Orientation: Decisions are action-oriented and are directed towards relevant and
controllable aspects of the environment. Decisions should ultimately find their utility in
implementation.
• Goal Direction: Decision making should be goal- directed to enable the organization to meet
its objectives.
• Effective in Implementation: Decision making should take into account all the possible
factors not only in terms of external context but also in internal context so that a decision
can be implementedproperly.

GLOBAL PLANNING
Globalization reflects a business orientation based on the belief that the world is becoming more
homogeneous and that distinctions between national markets are not only fading, but, for some
products will eventually disappear. As a result, companies need to globalize their international
strategy by formulating it across markets to take advantage of underlying market, cost,
environmental and competitive factors.

Why Plan Globally?

International firms have found it necessary to institute formal global strategic planning to provide
a means for top management to identify opportunities and threats from all over the world,
formulate strategies to handle them and stipulate how to finance the strategies implementation.
Global strategic plans not only provide for constancy of action among the firm's managers
worldwide but also require the participants to consider the ramifications of their actions on the
other geographical and functional areas of the firm.

Global Strategic Planning Process

Global strategic planning is the primary function of managers. The process of strategic planning
providesa formal structure in which managers:
• Analyze the company'sexternal environments
• Analyze the company'sinternal environments
• Define the company'sbusiness and mission
• Set corporate objectives
• Quantify goals
• Formulate strategies and
• Make tactical plans.
The steps mentioned above may not be in a sequential form. In practice, there is considerable
flexibility in theorder in which firms take up these items.

Nature of Planning Process

Planning shapes strategy and defines the means to achieve goals. It is the matching of markets
with products and other corporate resources so that the long term competitive advantage of the
firm gets strengthened. In other words, the process of planning seeks to answer question
regarding what thefirm expects to achieve and what method the firm is going to use to this end. It
decomposes problems and issues, applies rational tools on the basis of available information,
and finalizes action to achieve the goal. In small firm, planning may be ad hoc. But in large firms,
especially in multinational corporations that operate in varying environments, the process of
planning is more systematic and comprehensive.
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Formal and Informal Organization: Features, Advantages andDisadvantages
Formal Organisation:
When the managers are carrying on organising process then as a result of organising process an
organisational structure is created to achieve systematic working and efficient utilization of
resources. This type of structure is known as formal organisational structure.

Formal organisational structure clearly spells out the job to be performed by each individual, the
authority, responsibility assigned to every individual, the superior- subordinate relationship and
the designation of every individual in the organisation. This structure is created intentionally by
the managersfor achievement of organisational goal.
Features of Formalorganisation:
(1) The formal organisational structure is created intentionally bythe process of organising.
(2) The purpose of formal organisation structure is achievementof organisational goal.
(3) In formal organisational structure each individual is assigneda specific job.
(4) In formal organisation every individual is assigned a fixed authority or decision-making
power.
(5) Formal organisational structureresults in creation of superior- subordinate relations.
(6) Formal organisational structure creates a scalar chain of communication in the
organisation.

Advantages of FormalOrganisation:
1. Systematic Working:
Formal organisation structure results in systematic and smooth functioning of an
organisation.
2. Achievement of Organisational Objectives: Formal organisational structure is established
to achieve organisationalobjectives.
3. No Overlapping of Work:
In formal organisation structure work is systematically divided among various departments

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 and employees. So there is no chance of duplication or overlapping of work.
4. Co-ordination:
Formal organisational structure results in coordinating the activitiesof various departments.
5. Creation of Chain ofCommand:
Formal organisational structure clearly defines superior subordinate relationship, i.e., who
reports to whom.
6. More Emphasis on Work: Formal organisational structure lays more emphasis on work than
interpersonal relations.
Disadvantages of FormalOrganisation:
1. Delay in Action:
While following scalar chain andchain of command actions get delayed in formal structure.
2. Ignores Social Needs ofEmployees:
Formal organisational structure does not give importance to psychological and social need of
employees which may lead to demotivation of employees.

3. Emphasis on Work Only: Formal organisational structure gives importance to work only; it
ignores human relations, creativity, talents, etc.
Informal Organisation:
In the formal organisational structure individuals are assigned various job positions. While
working at those job positions, the individuals interact with each other and develop some social
and friendly groups in the organisation. This network of social and friendly groups forms another
structure in the organisationwhich is called informal organisational structure.

The informal organisational structure gets created automatically and the main purpose of such
structure is getting psychological satisfaction. The existence of informal structure depends upon
the formal structure because people working at different job positions interact with each other
to form informal structure and the job positions are created in formal structure. So, if there is no
formal structure, there will be no job position, there will be no people working at job positions and
therewill be no informal structure.
Features of informalorganisation:
(1) Informal organisational structure gets created automatically without any intended efforts
of managers.
(2) Informal organisational structure is formed by the employees to get psychological
satisfaction.
(3) Informal organisational structure does not follow any fixed path of flow of authority or
communication.
(4) Source of information cannot be known under informal structure as any person can
communicate with anyone in the organisation.
(5) The existence of informal organisational structure depends on the formal organisation
structure.
Advantages of InformalOrganisation:
1. Fast Communication:
Informal structure does not follow scalar chain so there can be faster spread of
communication.
2. Fulfills Social Needs: Informal communication gives due importance to psychological and
social need of employees which motivate the employees.
3. Correct Feedback:
Through informal structure the top level managers can know the real feedback of employees
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 on various policies and plans.

Strategic Use of Informal Organisation. Informal organisation can be used to get benefits in the
formal organisation in the followingway:

1. The knowledge of informal group can be used to gather support of employees and improve
their performance.
2. Through grapevine importantinformation can be transmitted quickly.
3. By cooperating with the informal groups the managers can skillfully take the advantage of
both formal and informal organisations.

Disadvantages of Informalorganisation:
1. Spread Rumours:
According to a survey 70% of information spread through informal organisational structure
are rumors which may mislead the employees.
2. No Systematic Working: Informal structure does not form a structure for smooth working of
anorganisation.
3. May Bring Negative Results: If informal organisation opposes the policies and changes of
management,then it becomes very difficult to implement them in organisation.
4. More Emphasis to IndividualInterest:
Informal structure gives more importance to satisfaction of individual interest as compared
toorganisational interest.
What is Span of Control AndOrganizational Structure?
It is very important to understand span of control and organizational structure when describing an
organization. Simply, span of control refers to the number of subordinates under the manager’s
direct control. As an example, a manager with five direct reports has a span of control of five. To
many or to few direct reports is a good way to view how efficent an organization is as long as it
looked at in the context of the companys organizational structure.

An Executive

team structure with a ‘narrow’ Span of Control

How many direct reports can a manager have?

Is there an optimal number? What needs to be considered is the nature of the work that
subordinates are performing and how much attention each requires. For example a Call Center,
the span of control can be numbers over 100, while executive functions – with high degrees of
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collaboration and interaction – could productively tolerate no more than three or four. So the
nature of the work being performed, and how much attention it requires should govern the
assignment of personnel to a manager, and not some industry ideal goal.

Call Center Organization showing a ‘wide’ Span of Control

Expanding On the Concept ofSpan of Control

While we are addressing span of control, let’s also broaden our understanding to see it in the
context of the organizational structure levels of hierarchy.
Width: Organization structures can be described as wide (with larger span of control) or narrow
(with smaller span of control.)

Height: As there are levels of management, or hierarchy, an organization may be tall (with many
levels) or flat (with fewer levels.)

Flat organizations have a ‘wide’ span of control and Tall organizations have a ‘narrow’ span of
control. While there are pros and cons with both tall and flat structures, a company’s structure
must be designed to suit the business (the customer and markets) and in a way that fits with the
workforce’s capability.

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 A Tall vs. Flat Organizational Structure

Characteristics of a Flat Organizational Structure (Wide Span of Control)

Pros
• Encourages delegation. Managers must better delegate to handle larger numbers of
subordinates, and grant opportunities for subordinates to take on responsibilities
• Agile. Improves communication speed and quality
• Reduces costs. More cost effective because of fewer levels, thus requiring fewer managers
• Helps prevent the workforce from disengaging by focusing on empowerment, autonomy and
self- direction

Cons
• High managerial workload comes with high Span of Control
• Role confusion more likely
• May cultivate distrust of management

Characteristics of a Tall Organizational Structure (Narrow Span of Control)

Pros
• More rapid communication between small teams
• Groups are smaller and easier to control/manage
• There’s a greater degree of specialization and division of labor
• More and better opportunities for employee promotion

Cons
• Communication can take too long, hampering decision-making
• Silos may develop and prevent cross- functional problem solving
• Employees may feel lost and powerless

Conclusion
As you can see the organization’s structure dictates the span of control you are going to assign to
managers. Whether you choose a ‘tall’ or ‘flat’ struture should depend on you business and serving
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 your customers and while each structure has it pros and cons the best way for you to model and
visualize the organization is with OrgChart Platinum. OrgChart gives you the ablity to model and
visualize the organization and automate the process.

The ideal Span ofControl

Everyone knows there is no such thing as the ideal span of control. It differs from organisation to
organisation, from position to position. For example:
• A highly technical role might have just 2 or 3 people reporting into one senior manager.
• A pool of support staff might be managed with 30 people reporting into one manager.
• If the manager of 4 people spends half of their time actually doing technical work, should we
count them as one manager, or actually only half a manager, giving a span of control of 0.5 :
4, or 1:4?

Span of control should not be used as a blunt instrument on an organisation There is a famous
example of a consulting firm marketing a blanket 8 x 8 approach: never more than 8 levels; never
fewer than 8 in the span of control. In another case we have heard of 6 x These numerical rules
can only be used as a first screen in the diagnosis, as they neglect the realities of different work
complexity in specific areas of the organisation; in call centres, typical spans will be 12-15
people while in executive teams, Neilson and Wulf (2012) report a median of 8 people in the CEO’s
span of control.

Span of Control and its consequences are not something that is easily understood through seeing
numbers on the page. How then can you bring spans of control to life? How do you make them
visual and easy for people to think about?

The questions people often want to answer are:

• How can I calculate the span of control?
• What is the average span of control for my whole organisation?
• What is the average span of control at each level?
• What is the average span of control for each of the top 10 roles?
• Where are the outliers in span of control for each of the top 10 roles?
• Where are our managers dangerously overstretched?
• What is the average number of layers in our organisation?

• If we set a minimum span of control, how many people would be affected? How much money
would we save?
The images below show how these questions can be answered, giving managers and HR teams
instant insight into their organisation. (All data is from a fictionalised company).

How can I calculate the span of control?

We calculate the span of control for managers by the number of heads managed, as this is the
human management challenge. So a manager of 12 part time staff has a span of control of 12,
even if they are managing only 6FTE.

What is the average span of control for mywhole organisation?

This is useful to understand as a starting point, but it is only a stepping stone to seeing useful
comparatives – either with other organisations or by making internal comparisons. So the next
question is often:
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What is the average span of control perdepartment?

Now this starts to get interesting – but what impact might these different spans of control have?
As a first experiment, we colour in the bar chart to show a distribution of performance by teams.
This gives an immediate visual sense of where there may be performance issues worth
addressing.

What is the average span of control ateach level?

This organisation appears to have a peak span of control at depth 5. Is there a reason for this? Is
the work relatively simple, and easily controlled at this level? Why do spans of control drop off
after the fifth level? To understand this, lets dive deeper – for example, role by role:

What is the average span of control foreach of the top 10 roles?

This begins to allow a diagnose of the true situation: working with the organisation, can we
understand what it is about the roles that requires a lower span per Warehouse Manager and
Programme Manager, for example, than for Sales Managers and Project Managers?

It is then worth a focus on a case by case basis. Who should we speak to?
Who are the outliers with low span ofcontrol? Where are our managers dangerously overstretched?

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The classic approach to de-layering looks not only at the spans of control, but also at the
maximum depth of the organisation. BCG argues, for example, that there are frequently too many
layers between the CEO and the front line. So let’s check – can we show quickly and intuitively
how manylayers there are in the organisation?

What is the maximum depth of eachdepartment?

The icicle chart represents the entire organisation on a page, and shows the layers visually.
Obviously a bar chart of departments’ depth would also be potentially useful. Another visualisation
shows example frontline employees and their depth in each department. In this case the
maximum depth is in IT programme delivery and project delivery:
Finally, it’s usually worth asking about benefits. Eliminating even only the most extreme examples
of low spans of control would be worth something. But how much?

If we were to set a minimum span of control, how many people would be affected? How much
money would wesave?
The notion of Span of Control is worth exploring and is a good healthcheck for all organisations
from time to time. There is no magic number on the ‘ideal’ span of control. However, investigating
and visualising span of control gives organisations an instant view of depths, spans, outliers,
opportunities and potential Delegation of Authority - Meaning,Importance and its Principles
A manager alone cannot perform all the tasks assigned to him. In order to meet the targets, the
manager should delegate authority. Delegation of Authority means division of authority and
powers downwards to the subordinate. Delegation is about entrusting someone else to do parts
of your job. Delegation of authority can be defined as subdivision and sub-allocation of powers to
the subordinates in order to achieve effective results.
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Elements of Delegation
1. Authority - in context of a business organization, authority can be defined as the power and
right of a person to use and allocate the resources efficiently, to take decisions and to give
orders so as to achieve the organizational objectives. Authority must be well- defined. All
people who have the authority should know what is the scope of their authority
is and they shouldn’t misutilize it. Authority is the right to give commands, orders and get the
things done. The top level management has greatest authority.

Authority always flows from top to bottom. It explains how a superior gets work done from
his subordinate by clearly explaining what is expected of him and how he should go about it.
Authority should be accompanied with an equal amount of responsibility. Delegating the
authority to someone else doesn’t imply escaping from accountability. Accountability still rest
with the person having the utmost authority.
2. Responsibility - is the duty of the person to complete the task assigned to him. A person who
is given the responsibility should ensure that he accomplishes the tasks assigned to him. If
the tasks for which he was held responsible are not completed, then he should not give
explanations or excuses. Responsibility without adequate authority leads to discontent and
dissatisfaction among the person. Responsibility flows from bottom to top. The middle level
and lower level management holds more responsibility. The person held responsible for a job
is answerable for it. If he performs the tasks assigned as expected, he is bound for praises.
While if he doesn’t accomplish tasks assigned as expected, then also he is answerable for
that.
3. Accountability - means giving explanations for any variance in the actual performance from
the expectations set. Accountability can not be delegated. For example, if ’A’ is given a task
with sufficient authority, and ’A’ delegates this task to B and asks him to ensure that task is
done well, responsibility rest with ’B’, but accountability still rest with ’A’. The top level
management is most accountable. Being accountable means being innovative as the person
will think beyond his scope of job. Accountability, in short, means being answerable for the
end result. Accountability can’t be escaped. It arises from responsibility.

For achieving delegation, a manager has to work in a system and has to perform following steps :
1. Assignment of tasks and duties
2. Granting of authority
3. Creating responsibility and accountability

Delegation of authority is the base of superior- subordinate relationship, it involves following

steps:-
1. Assignment of Duties - The delegator first tries to define the task and duties to the
subordinate. He also has to define the result expected from the subordinates. Clarity of duty
as well as result expected has to be the first step in delegation.
2. Granting of authority - Subdivision of authority takes place when a superior divides and
shares his authority with the subordinate. It is for this reason, every subordinate should be
given enough independence to carry the task given to him by his superiors. The managers at
all levels delegate authority and power which is attached to their job positions. The
subdivision of powers is very important to get effective results.
3. Creating Responsibility and Accountability - The delegation process does not end once
powers are granted to the subordinates. They at the same time have to be obligatory towards
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 the duties assigned to them. Responsibility is said to be the factor or obligation of an
individual to carry out his duties in best of his ability as per the directions of superior.
Responsibility is very important. Therefore, it is that which gives effectiveness to authority.
At the same time, responsibility is absolute and cannot be shifted. Accountability, on the
others hand, is the obligation of the individual to carry out his duties as per the standards of
performance. Therefore, it is said that authority is delegated, responsibility is created and
accountability is imposed. Accountability arises out of responsibility and responsibility arises
out of authority. Therefore, it becomes important that with every authority position an equal
and opposite responsibility should be attached.

Therefore every manager,i.e.,the delegator has to follow a system to finish up the delegation
process. Equally important is the delegatee’s role which means his responsibility and
accountability is attached with the authority over to here.

Relationship between Authority andResponsibilityAuthority is the legal right of person or superior

to command his subordinates while accountability is the obligation of individual to carry out his
duties as per standards of performance Authority flows from the superiors to subordinates,in
which orders and instructions are given to subordinates to complete the task. It is only through
authority, a manager exercises control. In a way through exercising the control the superior is
demanding accountability from subordinates. If the marketing manager directs the sales
supervisor for 50 units of sale to be undertaken in a month. If the above standards are not
accomplished, it is the marketing manager who will be accountable to the chief executive officer.
Therefore, we can say that authority flows from top to bottom and responsibility flows from
bottom to top. Accountability is a result of responsibility and responsibility is result of authority.
Therefore, for every authority an equal accountability is attached.

Differences between Authority andResponsibility

Authority Responsibility

It is the legal It is the

right of a obligation of
person or a subordinate to
superior to perform the work
command his assigned to him.
subordinates.

Authority is Responsibility
attached to arises out of
the position superior-
of a superior subordinate
in concern. relationship in
which
subordinate
agrees to carry
out duty given to
him.
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 Authority can Responsibility
be delegated cannot be shifted
by a superior and is absolute
to a
subordinate

It flows from It flows from

top to bottom to top.
bottom.

AUTHORITY ANDRESPONSIBILITY
Authority is the power to give orders and get it obeyed or in other words it is the power to take
decisions.
➢ Individuals can be held accountable.
➢ Systematized and effective achievement oforganizational objectives.

Consequences of violation of thisprinciple:

➢ Misuse of authority.
➢ Responsibility can’t be dischargedeffectively.
➢ No one can be held accountable.
➢ Conflicts between management andemployees.

Responsibility means state of being accountable or answerable for any obligation, trust, debt or
something or in other words it means obligation to complete a job assigned on time and in best
way. Authority and responsibility are closely related and this principle states that these two must
go hand in hand. It means that proper authority should be delegated to meet the responsibilities.

A match should be there between these two because of two main reasons:--

✓ Firstly, if a person is given some responsibility without sufficient authority he can’t perform better,
and also could not accomplish the desired goal.

✓ Secondly, if there is excess authority being delegated to an individual without matching

responsibility then thedelegated authority will be misused in oneway or the other.

This is an important and useful principle of management because if adequate authority is not
delegated to the employees they cannot discharge their duties with efficiency and this in turn will
hamper the achievement of the organizational goal. Sometimes the relation between
management andemployees is also badly effected by non delegation of proper authority.

Positive impacts of this principle:

➢ No misuse of authority.
➢ Helps to complete job effectively and efficiently.

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Leadership andMotivation
Motivation is a goal-oriented characteristic that helps a person achieve his objectives. It pushes
an individual to work hard at achieving his or her goals. An executive must have the right
leadership traits to influence motivation. However, there is no specific blueprint for motivation.
As a leader, one should keep an open perspective on human nature. Knowing different needs of
subordinates will certainly make the decision-making process easier. Both an employee as well as
manager must possess leadership and motivational traits. An effective leader must have a
thorough knowledge of motivational factors for others. He must understand the basic needs of
employees, peers and his superiors. Leadership is used as a means of motivating others.

Given below are important guidelines that outline the basic view of motivation:
▪ Harmonize and match the subordinate needs with the organizational needs. As a leader, the
executive must ensure that the business has the same morals and ethics that he seeks in his
employees. He should make sure that his subordinates are encouraged and trained in a
manner that meets the needs of the business.
▪ Appreciation and rewards are key motivators that influence a person to achieve a desired
goal. Rewarding good/ exceptional behavior with a small token of appreciation, certificate or
letter can be a great motivator. If a certificate is awarded to a person, it should mention the
particular act or the quality for which the individual is being rewarded.
▪ Being a role model is also a key motivator that influences people in reaching their goals. A
leader should set a good example to ensure his people to grow and achieve their goals
effectively.
▪ Encouraging individuals to get involved in planning and important issues resolution
procedure not only motivates them, but also teaches the intricacies of these key decision-
making factors. Moreover, it will help everyone to get better understanding of their role in the
organization. The communication will be unambiguous and will certainly attract
acknowledgement and appreciation from the leader.
▪ Developing moral and team spirit certainly has a key impact on the well-being of an
organization. The metal or emotional state of a person constitutes his or her moral fabric. A
leader’s actions and decisions affect the morale of his subordinates. Hence, he should
always be aware of his decisions and activities. Team spirit is the soul of the organization.
The leader should always make sure his subordinates enjoy performing their duties as a team
and make themselves a part of the organization’s plans.
▪ A leader should step into the shoes of the subordinates and view things from subordinate’s
angle. He should empathize with them during difficult times. Empathizing with their personal
problems makes them stronger-mentally and emotionally.
▪ A meaningful and challenging job accomplished inculcates a sense of achievement among
employees. The executive must make their employees feel they are performing an important
work that is necessary for the organization’s well-being and success. This motivational
aspect drives them to fulfill goals.

Remember, “To become an efficient leader, you must be self-motivated”. You must know your
identity, your needs and you must have a strong urge to do anything to achieve your goals. Once
you are self-motivated, only then you can motivate others to achieve their goals and to harmonize
their personal goals with the common goals of the organization.

Emotional Intelligence forLeaders

An organization is made up of people and when people are involved, emotions automatically
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come into play, and a workplace is no different. It would be unwise to assume that a workplace is
all objective, no-emotion only performance kind of a packed room where hormones have no scope
to creep in however the fact is that emotions alone are the biggest motivator or de-motivator of
an employee. The emotions alone, govern the performance and efficiency of a worker and had it
not been the case, we would have never talked about the importance of work- life balance and for
the present context, the need of emotionally intelligent leaders.

The current times are very dynamic not just economically but also socially where the social fabric
is rapidly evolving due to globalization and other influences. The average age of the workforce is
reducing and the leaders now look forward to managing people belonging to different cultures and
backgrounds. In such a situation, it is important for a leader to be highly sensitized to the
emotional aspects of his/her transactions with people. Emotional Intelligence is basically the
ability to recognize and understand one’s own feelings and emotions as well as those of others
and use that information to manage emotions and relationships. The 4 important aspects of EI as
proposed by Daniel Goleman are:
▪ Self Awareness
▪ Self Management
▪ Social Awareness
▪ Relationship Management or Social Skills

A leader tends to have a huge influence on the thoughts and motivation of people. He/she has the
capacity to enthuse optimism and confidence in the followers and lead them to constructive
endeavors which is called resonance and on the other hand they can negatively influence them to
destruct, e.g of such leaders being Hitler and d Osama Bin Laden which is opposite to resonance
called desonance.

Leaders are closely observed in terms of their body language, facial expressions etc. So, it is
important for a leader to consider the non-verbal form of expressions as well, which may
positively or negatively influence followers. Therefore, if a leader is talking about ethics in
business with a slightly unconvinced and bemused look on his face, the followers make a note of
it and the message is not received by them. A leader has to act as a role model too, supporting his
statements, ideologies and values with appropriate actions.

As a leader one also has to be aware of one’s own capabilities and weaknesses, it is difficult to
accept guidance from a leader who is not self aware. As managers, leaders have to empathize as
well with the situations, emotions, aspirations and motivations of the subordinates. A decreasing
performance of a team member might be because of a number of reasons, a disruptive worker
might be facing motivation issues and a subordinate who uses abusive language with others
might be lacking confidence in his own abilities. A leader needs to discern facts and try and reach
to deeper levels and understand things beyond obvious.

Apart from the above reasons, Emotional Intelligence is also important because the followers or
subordinate expect it from their leaders. A subordinate working closely with the manager would
expect the manager to understand his situation and priorities. And not surprisingly, whether
manger does so or not, affects his level of commitment and performance at work. A leader has to
suitably know and understand when he/she needs to be directive and when he needs to delegate.
He/she needs to be aware, when the team members are acting as one unit and when there are
differences.
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It is sometimes awkward to address emotional aspects of transactions between people but
leaders need to understand the importance and relevance of it as it has a huge impact on the
performance outcomes. While conducting reviews and development dialogues, the feedback has
to be delivered in a manner which is acceptable. The leader needs to be sensitive to the
insecurities and apprehensions of the subordinates which sometimes might be expressed and
sometimes kept undisclosed. At the senior level it is all the more important as the senior
executives find it hard to clearly outline their anxieties and differences and the leader has to
anticipate some of them.

So, to be able to attract and retain talented subordinates and keep them motivated, a leader
needs to brush up on his people skills and emotional intelligence, as all of them are not born with
the charisma to hold people. Fortunately, emotional intelligence with practice and carefully
directed efforts can be increased.

Organizations need strong leadership for optimum effectiveness. Leadership, as we know, is a

trait which is both inbuilt and can be acquired also. Organizational leadership deals with both
human psychology as well as expert tactics. Organizational leadership emphasizes on developing
leadership skills and abilities that are relevant across the organizations. It means the potential of
the individuals to face the hard times in the industry and still grow during those times. It clearly
identifies and distinguishes the leaders from the managers. The leader should have potential to
control the group of individuals.

An ideal organizational leader should not dominate over others. He should guide the individuals
under him, give them a sense of direction to achieve organizational goals successfully and should
act responsibly. He should be optimistic for sure. He should be empathetic and should
understand the need of the group members. An organizational leader should not only lead others
individually but also manage the actions of the group.

Individuals who are highly ambitious, have high energy level, an urge to lead, self-confidence,
intelligence, have thorough knowledge of job, are honest and flexible are more likely to succeed as
organizational leaders. Individuals who learn the organizational leadership develop abilities and
skills of teamwork, effective communication, conflict resolution, and group problem solving
techniques. Organizational leaders clearly communicate organizational mission, vision and
policies; build employees morale, ensure efficient business operations; help employees grow
professionally and contribute positively towards organizations mission.

Tips for Effective OrganizationalLeadership

1. A leader must lead himself, only then he can lead others. He must be committed on
personal and professional front, and must be responsible. He must be a role model for
others and set an example for them.
2. A leader must boost up the morale of the employees. He should motivate them well so that
they are committed to the organization. He should be well acquainted with them, have
concern for them and encourage them to take initiatives. This will result in more efficient
and effective employees and ensure organizational success.
3. A leader must work as a team. He should always support his team and respect them. He
should not hurt any employee. A true leader should not be too bossy and should not
consider him as the supreme authority. He should realize that he is part of the organization
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 as a whole.

Organizational leadership involves all the processes and possible results that lead to development
and achievement of organizational goals. It includes employees’ involvement, genuineness,
effective listening and strategic communication.

Leadership Ethics -Traits of an Ethical Leader

Ethics refer to the desirable and appropriate values and morals according to an individual or the
society at large. Ethics deal with the purity of individuals and their intentions. Ethics serve as
guidelines for analyzing “what is good or bad” in a specific scenario. Correlating ethics
with leadership, we find that ethics is all about the leader’s identity and the leader’s role.

Ethical theories on leadership talk about two main things:

(a) The actions and behaviour of leaders; and (b) the personality and character of leaders. It is
essential to note that “Ethics are an essential to leadership”. A leader drives and influences
the subordinates / followers to achieve a common goal, be it in case of team work,
organizational quest, or any project. It is an ethical job of the leader to treat his subordinates
with respect as each of them has unique personality. The ethical environment in an
organization is built and developed by a leader as they have an influential role in the
organization and due to the fact that leaders have an influence in developing the
organizational values.

An effective and ethical leader has the following traits / characteristics:

• Dignity and respectfulness: He respects others. An ethical leader should not use his
followers as a medium to achieve his personal goals. He should respect their feelings,
decision and values. Respecting the followers implies listening effectively to them,
being compassionate to them, as well as being liberal in hearing opposing viewpoints.
In short, it implies treating the followers in a manner that authenticate their values and
beliefs.

• Serving others: He serves others. An ethical leader should place his follower’s interests
ahead of his interests. He should be humane. He must act in a manner that is always
fruitful for his followers.

• Justice: He is fair and just. An ethical leader must treat all his followers equally. There
should be no personal bias. Wherever some followers are treated differently, the ground
for differential treatment should be fair, clear, and built on morality.

• Community building: He develops community. An ethical leader considers his own

purpose as well as his followers’ purpose, while making efforts to achieve the goals
suitable to both of them. He is considerate to the community interests. He does not
overlook the followers’ intentions. He works harder for the community goals.

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 • Honesty: He is loyal and honest. Honesty is essential to be an ethical and effective
leader. Honest leaders can be always relied upon and depended upon. They always
earn respect of their followers. An honest leader presents the fact and circumstances
truly and completely, no matter how critical and harmful the fact may be. He does not
misrepresent any fact.

It is essential to note that leadership is all about values, and it is impossible to be a leader if you
lack the awareness and concern for your own personal values. Leadership has a moral and ethical
aspect. These ethics define leadership. Leaders can use the above mentioned traits as yardsticks
for influencing their own behaviour.

Motivation Theory andLeadership

Anyone that's in a leadership role should understand how employees are motivated, and what
they can do as a leader to keep them motivated. The word is often defined as "getting someone
moving." Theory breaks down these forces into both internal or intrinsic motivation, as well as
external or extrinsic motivation.

Motivation Theory
When someone gets motivated, or tries to get someone else moving, they are developing the
incentives or conditions they believe will help move a person to a desired behavior. Whether it's
intrinsic or extrinsic, most individuals are moved by their beliefs, values, personal interests, and
even fear.

Additional Resources
• Effective Leadership
• Ethical Leadership
• Leadership in Sports
• Presentation Skills
One of the more difficult challenges for a leader is to learn how to effectively motivate those
working for them. This is difficult to master because what triggers this action can be so personal.
A misconception held by inexperienced leaders is the same factors that motivate one employee,
or the leader themselves, will have the same effect on others too. In fact, nothing could be further
from the truth.

Intrinsic or Self-Motivation
Fundamentally, all motivation comes from within. So the most common concepts involve self,
internal, or intrinsic motivation. All of these terms are used interchangeably to describe the same
forces that come from within a person. While it is certainly recognized that external factors can
influence behavior too, in this area, external factors play a secondary role. For external forces to
be effective in motivating someone, they must be in harmony with one of their intrinsic factors
too. In fact, several theorists such as Combs (1982), or Purkey & Stanley (1991), maintain there is
only a single kind of intrinsic motivation. This is described as engaging in activities that enhance

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or maintain a person's self-image or concept of oneself.

Other theorists such as Malone and Lepper (1987) define self motivation in broader and perhaps
more useful terms. Malone and Lepper believe this is simply what people will do without external
influence. Said another way, intrinsically-motivating activities are those in which people will
partake in for no reward other than the enjoyment these activities bring them. Malone and Lepper
have integrated a large amount of research into a summary of seven ways
the leadership of organizations can design environments that are self motivating.

Challenges
Individuals are motivated when they are working towards personally meaningful goals.
Attainment of those goals must require activity that is increasingly difficult, but attainable. In other
words, people like to be challenged, but they must feel their goals are achievable to stay
motivated. This can be accomplished by:
• Establishing goals that are personally meaningful
• Making those goals possible
• Providing feedback on performance
• Aligning goals with the individual's self esteem

Curiosity
This concept talks about providing something in the individual's environment that arouses their
curiosity. This can be accomplished by presenting the individual with something that connects
their present knowledge or skills with a more desirable level - if the person were to engage in a
certain activity. To motivate someone through curiosity, the environment must stimulate their
interest to learn more.

Control
Most people like to feel they are in control of their destiny. They want to feel in control of what
happens to them. To stay motivated, individuals must understand the cause and effect
relationship between an action they will take and the result.
Leaders can use this information in the following ways:
• Making the cause and effect relationship clear by establishing a goal and its reward.
• Allowing individuals to believe the work they do makes a difference.
• Allowing individuals to choose what they want to learn, and how to go about learning it.

Fantasy
Another intrinsically motivating factor is fantasy. That is, individuals can use mental images of
things and / or situations that are not actually present to motivate themselves. It's possible to
foster this in others by helping individuals imagine themselves in situations believed to be
motivating.
For example, if someone is highly inspired by the thought of being in control, then talk to them
about a future point in time when they might be in charge of a large and important business
operation.

Competition
Individuals can also be motivated by competition. That's because individuals gain a certain
amount of satisfaction by comparing their performance to that of others. This type of competition
can occur naturally as well as artificially. When using competition to foster motivation, keep in
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mind the following:

• Competition is more appealing to some than others.

• Losing in a competition de-motivates more than winning motivates.
• Competitive spirits can sometimes reduce the likelihood of a coworker being helpful to
competitors.

Cooperation
Cooperating with others can be very motivating. Most individuals feel quite satisfied when helping
others achieve their goals. As was the case with competition, this can occur naturally or
artificially. When using cooperation, keep in mind:
• Cooperation is more important to some individuals than others.
• Cooperation is a valuable skill that can be used in many different situations.
• Interpersonal skills are important for cooperation.

Recognition
Finally, individuals are oftentimes motivated through recognition. When their accomplishments are
recognized by others, they feel encouraged. It's important for a leader to make sure that
recognition is distinguished from competition. With recognition it's important to avoid comparing
one worker's achievements to those of others, as might occur with a competition.

Extrinsic or External Motivation

As previously mentioned, extrinsic or external motivation is the term used to describe outside
factors that stimulate someone's internal drive. The concept of externally motivating someone is
not at odds with the fact this drive comes from within. The point here is that it is possible to
provide others with situations, or an external environment, that fosters this feeling.

Employee Motivation
Some of the most effective ways for managers and leaders to motivate their staff includes
recognition, providing positive performance feedback, and by challenging employees to learn new
things. New managers often make the mistake of introducing de- motivating factors into the
workplace such as punishment for mistakes, or frequent criticisms.
When followers feel they are being supported, and they have the ability to remain in control of
their workplace, they stay motivated. Leaders can foster this feeling by allowing employees to take
on added responsibility and accountability for making decisions.
It's important to keep in mind that motivation is individual, and the degree of success achieved
through one single strategy will not be the most effective way to move all employees. The most
effective way to determine what triggers this feeling in others is through carefully planned trial and
error.

Figuring Out What Motivates Others

That being said, this article is going to finish up with some tips on how to determine what
motivates others:
Talk to employees about what they value. This will provide insights into which of the seven factors
mentioned above might be high on their list. Test a factor on an employee. For example, if it
seems that recognition might be effective, then try using that factor. Check in with employees
about their feelings. It's always a good idea to get feedback from employees. Make sure their
reaction to each factor is what's desired. Be on the lookout for signs of de- motivation. It's
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important to make sure something isn't being introduced into the work environment that is being
counter-productive to the goal.

Motivation Theories
Motivation theories, in its simplest from, are seeking to explain the driving force (s) that convert
our thoughts into behaviors. There are numerous theories of motivation, where each are either
explaining the same motivational concept with a different verbiage or they are offering a new
motivational theory. Regardless, attempting to understand them all would be a very cumbersome
task, if not impossible, as there are as many motivational theories as there are scholars that
studied and continue to study them. The reality is that understanding motivation is a very complex
undertaking because there are many inter-related factors that play within the equation, it isn't a
simple cause and effect relationship. If you are interested in reading a Reflection on Motivational
Theories. The categorization of the motivation theories, is an attestation to the complexity of the
phenomenon. Therefore, for the purpose of deepening our understanding of motivational concept,
we will categorize the Motivational Theories based on "Elsevier's Dictionary of Psychological
Theories", where they are divided into three broad categories:

1. Hedonic or Pleasure MotivationalTheories

2. Cognitive or Need-to-KnowMotivational Theories
3. Growth or Actualization MotivationalTheories
Categories of MotivationalTheories
Hedonic or Pleasure Motivation Theories

This is the largest category of motivational theories. They are based, like the name suggest, on
the role that pleasure plays with regards to organizing our lives. These theories will generally posit
that the best way to motivate an individual is from exposing him or her to naturally motivating
stimuli. Drive-Arousal or drive-reduction are important concept and both have the potential to lead
to optimal motivation.

Associated Theories
• Herzberg's Motivation Theory - TwoFactor Theory
• Attribution Theory
• Opponent-Process Theory
• Instinct Theory of Motivation

Cognitive or Need-to-Know MotivationTheories

This category emphasizes the cognitive processes involved within an individual. These theories
posit that motivation is the result of active information-processing where an individual,
subconsciously or consciously positively evaluates the acting out of a specific behavior, thus is
motivated.
Associated Theories
Cognitive Dissonance Theory
Victor Vroom's Expectancy Theory ofMotivation
Goal Setting Theory of Motivation
Reversal Theory of Motivation
Equity Theory of Motivation

Growth or Actualization MotivationTheories

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This category of motivational theories promotes the concept that motivation is the pursuit of
activities that lead to "Growth", "Self-fulfillment", and "Self-Actualization". Among the
psychologists, it is generally well accepted that the higher an organism, higher is his level of
motivation.

Associated Theories
Maslow's Hierarchy of Needs
Alderfer's ERG Theory - Existence,Relatedness, and Growth
Self-determination theory

leadership Theories
Great Man Theory (1840s)

The Great Man theory evolved around the mid 19th century. Even though no one was able to
identify with any scientific certainty, which human characteristic or combination of, were
responsible for identifying great leaders. Everyone recognized that just as thename suggests; only
a man could have the characteristic (s) of a great leader.

The Great Man theory assumes that the traits of leadership are intrinsic. That simply means that
great leaders are born...

they are not made. This theory sees great leaders as those who are destined by birth to become a
leader. Furthermore, the belief was that great leaders will rise when confronted with the
appropriate situation. The theory was popularized by Thomas Carlyle, a writer and teacher. Just
like him, the Great Man theory was inspired by the study of influential heroes. In his book "On
Heroes, Hero-Worship, and the Heroic in History", he compared a wide array of heroes.

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In 1860, Herbert Spencer, an English philosopher disputed the great man theory by affirming that
these heroes are simply the product of their times and their actions the results of social
conditions.

Trait Theory (1930's - 1940's)

The trait leadership theory believes that people are either born or are made with certain qualities
that will make them excel in leadership roles. That is, certain qualities such as intelligence, sense
of responsibility, creativity and other values puts anyone in the shoes of a good leader. In fact,
Gordon Allport, an American psychologist,"...identified almost 18,000 English personality-relevant
terms" (Matthews, Deary & Whiteman, 2003, p. 3).

The trait theory of leadership focused on analyzing mental, physical and social characteristic in
order to gain more understanding of what is the characteristic or the combination of
characteristics that are common among leaders.

There were many shortfalls with the trait leadership theory. However, from a psychology of
personalities approach, GordonAllport's studies are among the first ones and have brought, for the
study of leadership, the behavioural approach. In the 1930s the field of Psychometrics was in its
early years. Personality traits measurementweren't reliable across studies. Study samples were of
low levelmanagers Explanations weren't offered as tothe relation between each characteristic and
its impact on leadership. The context of the leader wasn'tconsidered.

Many studies have analyzed the traits among existing leaders in the hope of uncovering those
responsible for ones leadership abilities! In vain, the only characteristics that were identified
among these individuals werethose that were slightly taller and slightly more intelligent!

Behavioural Theories (1940's - 1950's)

In reaction to the trait leadership theory, the behavioural theories are offering a new perspective,
one that focuses on the behaviours of the leaders as opposed to their mental, physical or social
characteristics. Thus, with the evolutions in psychometrics, notably the factor analysis,
researchers were able to measure the cause an effects relationship of specific human behaviours
from leaders. From this point forward anyone with the right conditioning could have access to the
once before elite club of naturally gifted leaders. In other words, leaders are made not born.
The behavioural theories first divided leaders in two categories. Those that were concerned with
the tasks and those concerned with the people. Throughout the literature these are referred to as
different names, but the essence are identical.

Associated Theories
• The Managerial Grid Model /Leadership Grid
• Role Theory

Contingency Theories (1960's)

The Contingency Leadership theory argues that there is no single way of leading and that every
leadership style should be based on certain situations, which signifies that there are certain
people who perform at the maximum level in certain places; but at minimal performance when
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taken out of theirelement.

To a certain extent contingency leadership theories are an extension of the trait theory, in the
sense that human traits are related to the situation in which the leaders exercise their leadership.
It is generally accepted within the contingency theories that leader are more likely to express their
leadership when they feel that their followers will be responsive.

Associated Theories
• Fiedler's contingency theory
• Hersey-Blanchard SituationalLeadership Theory
• Path-goal theory
• Vroom-Yetton-Jago decision-makingmodel of leadership
• Cognitive Resource Theory
• Strategic Contingencies Theory

Transactional leadership Theories(1970's)

Transactional theories, also known as exchange theories of leadership, are characterized by a
transaction made between the leader and the followers. In fact, the theory values a positive and
mutually beneficial relationship.

For the transactional theories to be effective and as a result have motivational value, the leader
must find a means to align to adequately reward (or punish) his follower, for performing leader-
assigned task. In other words, transactional leaders are most efficient when they develop a
mutual reinforcing environment, for which the individual and the organizational goals are insync.

The transactional theorists state that humans in general are seeking to maximize pleasurable
experiences and to diminish un- pleasurable experiences. Thus, we are more likely to associate
ourselves with individuals that add to our strengths.

Associated Theories

Leader-member Exchange (LMX)

Transformational Leadership Theories(1970s)

The Transformational Leadership theory states that this process is by which a person interacts
with others and is able to create a solid relationship that results in a high percentage of trust, that
will later result in an increase of motivation, both intrinsic and extrinsic, in both leaders and
followers.

The essence of transformational theories is that leaders transform their followers through their
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inspirational nature and charismatic personalities. Rules and regulations are flexible, guided by
group norms. These attributes provide a sense of belonging f Corporate Governanceand Business
Ethics Introduction Corporate governance lies at the heart of the way businesses are run. Of ten
defined as the ‘way businesses are directed and controlled’, it concerns the work of the board as
the body which bears ultimate responsibility for the business. Governance relates to how the
board is constituted and how it performs its role.

It encompasses issues of board composition and structure, the board’s remit and how it carried
out and the framework of the board’s accountability to its stakeholders. It also concerns how the
board delegates authority to manage the business throughout the organization. The word
‘Corporate Governance’ (CG) has become a buzzword these days due to various corporate failures
world over in recent past. The Corporate Governance represents the value framework, the ethical
framework and the moral framework under which business decisions are taken. In other words,
when investment takes place across national borders, the investors want to be sure that not only
their capital handled effectively and adds to the creation of wealth, but the business decisions are
also taken in a manner which is not illegal or does not involve moral hazards (S.k verma & Suman
gupta, 2004). The Corporate Governance basically denoted the rule of law, 1086 Renu Nainawat &
Ravi Meena transparency, accountability and protection of public interest in the management of a
company’s affairs in the prevailing global and competitive market milieu. It called for an
enlightened investing community and strict regulatory regimes to protect the rights of the
investors and companies to improve productivity and profitability without recourse to any means
which would offend the moral, ethical and regulatory framework of business. 2.

Essentials of Good Corporate Governance Good Corporate Governance is a formal system of

Accountability and Control of ethical and socially responsible decisions and use of resources. The
following are the chief characteristics of Good Corporate Governance: it is 1. Participatory 2.
Consensus Oriented 3. Accountable 4. Transparent 5. Responsive 6. Effective and Efficient 7.
Equitable and Inclusive and 8. Follows the Rule of Law. 3. Business Ethics Business ethics is a
kind of applied ethics. It is the application of moral or ethical norms to business. The term ethics
has its origin from the Greek word “ethos”, which means character or custom- the distinguishing
character, sentiment, moral nature, or guiding beliefs of a person, group, or institution. Ethics is a
set of principles or standards of human conduct that govern the behaviour of individuals or
organization.

Ethics can be defined as the discipline dealing with moral duties and obligation, and explanation
what is good or not good for others and for us. Ethics is the study of moral decisions that are
made by us in the course of performance of our duties. Ethics is the study of characteristics of
morals and it also deals with the moral choices that are made in relationship with others.
Business ethics comprises the principles and standards that guide behaviour in the conduct of
business. Businesses must balance their desire to maximise profits against the needs of the
stakeholders. Maintaining this balance often requires tradeoffs. To address these unique aspects
of businesses, rules- articulated and implicit are developed to guide the businesses to earn profits
without harming individuals or society as a whole.

Corporate Governance and Business Ethics 1087 4. Advantages of Business Ethics More and
more companies recognize the link between business ethics and financial performance.
Companies displaying a clear commitment to ethical conduct consistently outperform companies
that do not display ethical conduct. 5. Attracting and Retaining Talent People aspire to join
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organizations that have high ethical values. Companies are able to attract the best talent and an
ethical company that is dedicated to talking care of its employees being equally dedicated in
taking care of the organization.

The ethical climate matters to the employees. Ethical organizations create an environment that is
trustworthy, making employees willing to rely, take decisions and act on the decisions and actions
of co- employees. 6. Investor Loyalty Investors are concerned about ethics, social responsibility
and reputation of the company in which they invest. Investors are becoming more and more
aware that an ethical climate provides a foundation for efficiency, productivity and profits. 7.
Customer Satisfaction Customer satisfaction is a vital factor in successful business strategy.
Repeat purchases or orders and enduring relationship of mutual respect are essential for the
success of the company.

The name of a company should evoke trust and respect among customers for enduring success.
This is achieved by a company that adopts ethical practices. When a company because of its
beliefs in high ethics is perceived as such, any crisis or mishaps along the way is tolerated by the
customers as a minor aberration. 8. Corporate Governance and Business ethics The national
codes all emphasize the ethical nature of good corporate governance. Special emphasis is placed
on the fact that good governance is based on a number of cardinal ethical values. Topping the list
of the values that should be adhered to in good governance are the values of Transparency,
accountability, responsibility and probability.

These values should permeate all aspects of governance and be displayed in all actions and
decisions of the board. The various aspects of governance, such as board complication and
functioning reporting, disclosure and risk management, are seen as instrumental in realizing
these cardinal values of good governance. Besides these underlying values of Corporate
Governance mention is also made of specific moral obligations that the board of directors and
the company abide by. Prominent among these ethical obligations are ensuring that the company
act on high 1088 Renu Nainawat & Ravi Meena ethical standards so that the reputation of the
company will be protected as well as respecting the rights of all shareholders (G. J. Rossouw,
2005) p.101.). A

well defined and enforced corporate governance provides a Structure that, at least in theory,
works for the benefit of everyone concerned by ensuring that the enterprises adheres to accepted
ethical standards and best practices as well as to formal laws. To that end, organizations have
been formed at the regional, national and global level. In recent years, Corporate Governance has
received increased attention because of high profile scandals involving abuse of corporate power
and, in some cases,alleged criminal activity by corporate officers. An Integral part of an effective
Corporate Governance regime Includes provisions for civil or criminal prosecution of individuals
who conduct unethical or illegal acts in the name of organizations. In all the national codes of
corporate governance and in India for the need for actively managing the ethical performance of
companies is emphasized.

The levels of detail with which these codes deal with the active management of ethics do,
however, differ drastically. All the codes recommend that the board of directors should ensure
that a code of ethics is developed and that it is endorsed by the board. Most Corporate
Governance codes also provide some guidance on the process of developing a code of ethics by
either making reference to issues or topics that typically should be addressed in a code or by
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outlining a process that could be followed in the process of code design or review. Few codes go
further to take the lead in venturing deeper into what the governing of ethical performances
entails beyond developing a code of ethics. The most comprehensive recommendations on the
ethics of governance are to be found in the Narayana Murthy Committee report on Corporate
Governance. 9. Conclusion Ethics is the first line of defence against corruption while law
enforcement id remedial and reactive. Good corporate governance goes beyond rules and
regulations that the government can put in place. It is also about ethics and the values which
drive companies in the conduct of their business. It is therefore all about the trust that is
established over time between companies and their different stakeholders. Good corporate
governance practice cannot guarantee any corporate failure.

But the absence of such governance standards will definitely lead to questionable practices and
corporate failures which surface suddenly and massively. In making ethics work in an
organization it is important that there is synergy between vision statements, mission statements,
core values, general business principles and code of conduct confers a variety of benefits. An
effective ethics programme requires continual reinforcement of strong values. Organizations are
challenged with how to make its employees live and imbibe the organization codes and values. To
ensure the right ethical climate a right combination of spirit and structure is required.

Human ResourceManagement: Meaning, Objectives, Scopeand Functions

Meaning:
Before we define HRM, it seems pertinent to first define the term ‘human resources’. In common
parlance, human resources means the people. However, different management experts have
definedhuman resources differently. For example, Michael J. Jucius hasdefined human resources
as “a whole consisting of inter-related, inter- dependent and interacting physiological,
psychological, sociological and ethical components”.

According to Leon C. Megginson “From the national point of view human resources are
knowledge, skills, creative abilities, talents, and attitudes obtained in the population;whereas from
the view-point of the individual enterprise, they represent the total of the inherent abilities,
acquired knowledge and skills as exemplified in the talents and aptitude of its employees”.

Sumantra Ghosal considers human resources as human capital. He classifies human capita into
three categories-intellectual capitals, socialcapital and emotional capital.
Intellectual capital consists of specialized knowledge, tacit knowledge and skills, cognitive
complexity, and learning capacity.

Social capital is made up of network of relationships, sociability, and trustworthiness Emotional

capital consists of self-confidence, ambition and courage, risk-bearing ability, and resilience. Now
it is clear from above definitions that human resources refer to the qualitative and quantitative
aspects of employeesworking in an organisation. Let us now define human resourcemanagement.
In simple words, HRM is a process ofmaking the efficient and effective useof human resources so
that the set goals are achieved. Let us also consider some important definitions of HRM.

According to Flippo “Personnel management, or say, human resource management is the

planning, organising, directing and controlling of the procurement development compensation
integration, 4intenance, and separation of human resources to the end that individual,
organisational and social objectives are accomplished”.
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The National Institute of Personnel Management (NIPM) of India has defined human
resource/personnel management as “that part of management which is concerned with people at
work and with their relationship within an enterprise. Its aim is to bring together and develop into
an effective organisation of the men and women who make up an enterprise and having regard
for the well-being of the individuals and of working groups, to enable them to make their best
contribution to its success”.

According to Decenzo and Robbins “HRM is concerned with the people dimension in
management. Since every organisation is made up of people, acquiring their services, developing
their skills, motivating them to higher levels of performance and ensuring that they continue to
maintain their commitment to the organisation are essential to achieving organisational
objectives. This is true, regardless of the type of organisation-government, business, education,
health, recreation, or social action”.

Thus, HRM can be defined as a process of procuring, developing and maintaining competent
human resources in the organisation so that the goals of an organisation are achieved in an
effective and efficient manner. In short, HRM is an art of managing people at work in such a
manner that they give their best to the organisation for achieving its set goals.
Objectives:
The primary objective of HRM is to ensure the availability of right people for right jobs so as the
organisationalgoals are achieved effectively.

This primary objective canfurther be divided into thefollowing sub-objectives:

To help the organisation to attain its goals effectively and efficiently byproviding competent
and motivated employees.

1. To utilize the available humanresources effectively.

2. To increase to the fullest the employee’s job satisfaction and self-actualisation.

3. To develop and maintain the quality of work life (QWL) which makes employment in the
organisation a desirable personal andsocial situation.

4. To help maintain ethical policies and behaviour inside and outside theorganisation.

5. To establish and maintain cordialrelations between employees and management.

6. To reconcile individual/groupgoals with organisational goals.

Werther and Davis have classified the objectives of HRM into four categories as shown in table
1.2.

Table 1.2: HRM Objectives andFunctions:

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Scope:
The scope of HRM is, indeed, very vast and wide. It includes all activities starting from manpower
planning till employee leaves the organisation. Accordingly, the scope of HRM consists of
acquisition, development, maintenance/retention, and control of human resources in the
organisation (see figure 1.1). The same forms the subject matter of HRM. As the subsequent
pages unfold, all these are discussed, indetail, in seriatim.

The National Institute of personnel Management, Calcutta has specified the scope of HRM as
follows:
1. The Labour or PersonnelAspect:
This is concerned with manpower planning, recruitment, selection, placement, transfer,
promotion, training and development, lay-off and retrenchment, remuneration, incentives,
productivity, etc.

2. Welfare Aspect:
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 and safety, recreation facilities, etc. It deals with working conditions, andamenities such as
canteen, creches, rest and lunch rooms, housing, transport, medical assistance, education,
health

3. Industrial Relations Aspects:

This covers union-management relations, joint consultation, collective bargaining,
grievance anddisciplinary actions, settlement of disputes, etc.
Functions:
We have already defined HRM. The definition of HRM is based on what managers do. The
functions performed by managers are common to all organizations. For the convenience of study,
the function performed by the resource management can broadly be classified into two
categories, viz.

ADVERTISEMENTS:
(1) Managerial functions, and
(2) Operative functions (see fig. 1.2).

These are discussed in turn.

(1) Managerial Functions:

Planning:
ADVERTISEMENTS:
Planning is a predetermined course of actions. It is a process of determining the organisational
goals and formulation of policies and programmes for achieving them. Thus planning is future
oriented concerned with clearly charting out the desired direction of business activities in future.
Forecasting is one of the important elements in the planning process. Other functions of
managers depend on planning function.

Organising:
Organising is a process by which the structure and allocation of jobs are determined. Thus
organising involves giving each subordinate a specific task establishing departments, delegating
authority to subordinates, establishing channels of authority and communication, coordinating
the work of subordinates, and so on.

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Staffing:
TOs is a process by which managers select, train, promote and retire their subordinates This
involves deciding what type of people should be hired, recruiting prospective employees,
selecting employees, setting performance standard, compensating employees, evaluating
performance, counseling employees, training and developing employees.

Directing/Leading:
Directing is the process of activating group efforts to achieve the desired goals. It includes
activities like getting subordinates to get the job done, maintaining morale motivating
subordinates etc. for achieving the goals of the organisation.

Controlling:
It is the process of setting standards for performance, checking to see how actual performance
compares with these set standards, and taking corrective actions as needed.
(2) Operative Functions: The operative, also called, service functions are those which are
relevant to specific department. These functions vary from department to department depending
on the nature of the department Viewed from this
standpoint, the operative functions of HRM relate to ensuring right people for right jobs at right
times. These functions include procurement,
development, compensation, andmaintenance functions of HRM.

A brief description of thesefollows:

Procurement:
It involves procuring the right kind of people in appropriate number to be placed in the
organisation. It consists of activities such as manpower planning, recruitment, selection
placement and induction or orientation of new employees.

Development:
This function involves activities meant to improve the knowledge, skills aptitudes and values of
employees so as to enable them to perform their jobs in a better mannerin future. These functions
may comprise training to employees, executive training to develop managers, organisation
developmentto strike a better fit between organisational climate/culture and employees.

Compensation:
Compensation function involves determination of wages and salaries matching with contribution
made byemployees to organisational goals. Inother words, this function ensures equitable and fair
remuneration for
employees in the organisation. It consists of activities such as job evaluation, wage and salary
administration, bonus, incentives,etc.

Maintenance:
It is concerned with protecting and promoting employees while at work. For this purpose virus
benefits such as housing, medical, educational, transport facilities, etc. are provided to the
employees. Several social security measures such as provident fund, pension, gratuity, group
insurance, etc. are also arranged.

It is important to note that the managerial and operative functions of HRM are performed in
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conjunction with each other in an organisation, be large or small organisations. Having discussed
thescope and functions of HRM, now itseems pertinent to delineate the HRM scenario in India.
What is Human Resource Planning ?
Human Resource Planning (HRP) is the process of forecasting the future human resource
requirements of the organization and determining as to how the existing human resource
capacity of the organization can be utilized to fulfill these requirements. It, thus, focuses on the
basic economic concept of demand and supply in context to the human resource capacity of the
organization.

It is the HRP process which helps the management of the organization in meeting the future
demand of human resource in the organization with the supply of the
appropriate people in appropriate numbers at the appropriate time and place. Further, it is only
after proper analysis of the HR requirements can the process of recruitment and selection be
initiated by the management. Also, HRP is essential in successfully achieving the strategies and
objectives of organization. In fact, with the element of strategies and long term objectives of the
organization being widely associated with human resource planning these days, HR Planning has
now became Strategic HR Planning.

Though, HR Planning may sound quite simple a process of managing the numbers in terms of
human resource requirement of the organization, yet, the actual activity may involve the HR
manager to face many roadblocks owing to the effect of the current workforce in the
organization, pressure to meet the business objectives and prevailing workforce market
condition. HR Planning, thus, help the organization in many ways as follows:

▪ HR managers are in a stage of anticipating the workforce requirements rather than getting
surprised by the change of events
▪ Prevent the business from falling into the trap of shifting workforce market, a common
concern among all industries and sectors
▪ Work proactively as the expansion in the workforce market is not always in conjunction with
the workforce requirement of the organization in terms of professional experience, talent
needs, skills, etc.
▪ Organizations in growth phase may face the challenge of meeting the need for critical set of
skills, competencies and talent to meet their strategic objectives so they can stand well-
prepared to meet the HR needs.
▪ Considering the organizational goals, HR Planning allows the identification, selection and
development of required talent or competency within the organization.

It is, therefore, suitable on the part of the organization to opt for HR Planning to prevent any
unnecessary hurdles in its workforce needs. An HR Consulting Firm can provide the organization
with a comprehensive HR assessment and planning to meet its future requirements in the most
cost-effective and timely manner.

An HR Planning process simply involves the following four broad steps:

▪ Current HR Supply: Assessment of the current human resource availability in the
organization is the foremost step in HR Planning. It includes a comprehensive study of the
human resource strength of the organization in terms of numbers, skills, talents,
competencies, qualifications, experience, age, tenures, performance ratings, designations,
grades, compensations, benefits, etc. At this stage, the consultants may conduct extensive
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 interviews with the managers to understand the critical HR issues they face and workforce
capabilities they consider basic or crucial for various business processes.
▪ Future HR Demand: Analysis of the future workforce requirements of the business is the
second step in HR Planning. All the known HR variables like attrition, lay-offs, foreseeable
vacancies, retirements, promotions, pre-set transfers, etc. are taken into consideration while
determining future HR demand. Further, certain unknown workforce variables like competitive
factors, resignations, abrupt transfers or dismissals are also included in the scope of
analysis.
▪ Demand Forecast: Next step is to match the current supply with the future demand of HR,
and create a demand forecast. Here, it is also essential to understand the business strategy
and objectives in the long run so that the workforce demand forecast is such that it is
aligned to the organizational goals.
▪ HR Sourcing Strategy and Implementation: After reviewing the gaps in the HR supply and
demand, the HR Consulting Firm develops plans to meet these gaps as per the demand
forecast created by them. This may include conducting communication programs with
employees, relocation, talent acquisition, recruitment and outsourcing, talent management,
training and coaching, and revision of policies. The plans are, then, implemented taking into
confidence the mangers so as to make the process of execution smooth and efficient. Here,
it is important to note that all the regulatory and legal compliances are being followed by the
consultants to prevent any untoward situation coming from the employees.

Hence, a properly conducted process of HR Planning by an HR Consulting Firm helps the

organization in meeting its goals and objectives in timely manner with the right HR strength in
action.

Introduction: The Typical Functionsof a HR Manager

Until now, we have discussed how the HRM function in organizations works and the role of the
function in organizational processes. We have also discussed the changing nature of the HRM
function in recent years and how with the introduction of enterprise software, an entirely new
dimension has been added to these functions.

This article discusses the typical functions of a HR manager and analyzes how he or she can
make a positive contribution to the organization and add value to the process. First, the HR
manager has to juggle between hiring, training, appraisals, and payroll among other things. This
means that a typical function of the HR manager would encompass the end to end management
of the employee people lifecycle which means that the HR manager would have to take care of
everything that is concerned with the people aspect right from the time the employee enters the
organization till the time the employee quits or retires from the organization. Hence, the lifecycle
of an employee’s time in an organization has to be managed and this means that the HR manager
is responsible for the hiring, training, appraisals, payroll, and exit interviews.

Entry to Exit: Managing the EmployeeLifecycle

If we take each of these activities in turn, we find that hiring is done in conjunction with the line
managers who put out their requirements periodically on the kind of recruits they want and the
number of recruits they want. Once the request reaches the HR manager, he or she has to scour
the market for potential recruits. Usually, the HR manager does not personally do this and
outsources this function to a placement consultancy. The next step is the interview stage after
the shortlists are done and this is an activity where the HR manager either delegates the task of
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assessing the potential recruits to the staffing team or does the job personally.

In large organizations like Fidelity and Microsoft, there are dedicated teams for each of these
activities and this is something we would be discussing in detail in subsequent articles. After the
interview stage is over, the important task of fixing the salary and benefits of the successful
candidates has to be done. This is usually the time when the HR manager plays a critical role as
he or she has to determine the fit between the role and the candidate and decide on the quantum
of salary and benefits that is appropriate to the role and after examining the budgets for the same.

The Appraisal Process and the ExitInterviews

After these activities, the HR manager is also involved in conducting the last stage of appraisals
or evaluating the appraisals. In recent years, the trend is more towards the latter where the HR
manager in charge of the business unit evaluates the appraisals instead of participating in the
process directly. This is done in a manner to determine the quantum of pay hike or bonuses
keeping in mind the same principles that were discussed in the hiring activity. What this means is
that the HR manager has to work closely with the line managers to get this done.

In many organizations, employees can take their grievances to the HR managers in case they are
not satisfied with their pay hikes or the quantum of benefits. They can also complain against their
managers in a confidential and private manner. The last activity that the HR manager is involved
in is conducting the exit interviews when employees leave the organizations. This is usually done
on the last day of the employee’s stay in the organization and this process consist of a free and
frank discussion on what the employee feels about the organization and why he or she is leaving
the organization. The exit interviews offer valuable sources of insights into organizational
behavior as the employees can vent their feelings on what works and what does not work in
organizations.

What is Selection?
Selection is the process of picking or choosing the right candidate, who is most suitable for a
vacant job position in an organization. In others words, selection can also be explained as the
process of interviewing the candidates and evaluating their qualities, which are required for a
specific job and then choosing the suitable candidate for the position. The selection of a right
applicant for a vacant position will be an asset to the organization, which will be helping the
organization in reaching its objectives.

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 Different authors define Selectionin different ways. Here is a list ofsome of the definitions −
• Employee selection is a process of putting a right applicant on a right job.
• Selection of an employee is a process of choosing the applicants, who have the
qualifications to fillthe vacant job in an organization.
• Selection is a process of identifying and hiring the applicants for filling the vacancies in an
organization.
• Employee selection is a process of matching organization’s requirements with the skills
and the qualifications of individuals.
A good selection process will ensure that the organization getsthe right set of employees with the
right attitude.

Difference betweenRecruitment and Selection

The major differences betweenRecruitment and Selection are asfollows −
is important to evaluate various attributes of each candidate such as their qualifications, skills,
experiences, overall attitude, etc. In this process, the most suitable candidate is picked after the
elimination of the candidates, le for the Both recruitment and selection work hand in hand
and both playa vital role in the overall growth of an organization.

Importance ofSelection

Selection is an important process because hiring good resources can help increase the overall
performance of the organization. In contrast, if there is bad hire with a bad selection process,
then the work will be affectedand the cost incurred forreplacing that bad resource will be high.
The purpose of selection is to choose the most suitable candidate, who can meet the
requirements of the jobs in an organization, who will be a successful applicant. For meeting the
goals of the organization, it to follow a process or e amount of iring a right sition. If a hen the
cost and training e will be a employer inort, and alsoion is very important and the process should
be perfect for the betterment of the organization.

Advantages of Selection
A good selection process offers the following advantages−
• It is cost-effective and reduces a lot of time and effort.
• It helps avoid any biasing while recruiting the right candidate.
• It helps eliminate the candidates who are lacking in knowledge, ability, and proficiency.
• It provides a guideline to evaluate the candidates further through strict verification and
reference-checking.
• It helps in comparing the different candidates in terms of their capabilities, knowledge, skills,
experience, work attitude, etc.
A good selection process helps in selecting the best candidate for the requirement of a vacant
position in an organization.

Selection Process and Steps

As we have discussed that Selection is very important for any organization for minimizing the
losses and maximizing the profits. Hence the selection procedure should be perfect. A good
selection process should comprise the following steps −

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• Employment Interview − Employment interview is a process in which one-on-one session in
conducted with the applicant to know a candidate better. It helps the interviewer to discover the
innerqualities of the applicant and helpsin taking a right decision.
• Checking References − Reference checking is a process of verifying the applicant’s qualifications
and experiences with the references provided by him. These reference checks help the interviewer
understand the conduct, the attitude, and the behavior of the candidate as an individual and also
as a professional.
• Medical Examination − Medical examination is a process, in which the physical and the mental
fitness of the applicants are checked to ensure that the candidates arecapable of performing a job
or not. This examination helps the organization in choosing the rightcandidates who are physically
and mentally fit.
• Final Selection − The final selection is the final process which proves that the applicant has
qualified in all the rounds of the selection process and will be issued an appointment letter.
A selection process with the above steps will help any organization in choosing and selecting the
right candidates for the right job.
Training and Development
Training and Development is one of the main functions of the human resource management
department. Training refers to a systematic setupwhere employees are instructed andtaught matters
of technical knowledge related to their jobs. It focuses on teaching employees howto use particular
machines or how to do specific tasks to increase efficiency. Whereas, Development refers to the
overall holistic and educational growth and maturity of people in managerial positions. The process
ofdevelopment is in relation to insights, attitudes, adaptability, leadership andhuman relations.

Training and DevelopmentProgrammes

Training and development programmes are designed according to the requirements of the
organisation, the type and skills of employees being trained, the end goals of the training and the
job profile of the employees. These programmes are generally classified into two types: (i) on the
job programmes, and (ii)off the job programmes.

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Different training is given to employees at different levels. The following training methods are used
For the training of skilled workers and operators- Specific job training
programmes, Technical training at a training with live demos, Internship training, Training via the
process of rotation of job. Training given to people in a supervisory or managerial capacity is –
Lectures, Group Discussions, Case studies, Role-playing, Conferences etc. People in managerial
programmes are given this type of training- Management Games to develop decision making,
Programmes to identify potential executives, Sensitivity training to understand and influence
employee behaviour, Simulation and role-playing, Programmes for improving communication,
human relations andmanagerial skills.

Other Training Programmes

Technical Training – Technical training is that type of training that is aimed at teaching employees
how aparticular technology or a machine.

Quality Training – Quality training is usually performed in companies who physically produce a
product. Quality training teaches employees to identify faulty products and only allow perfect
products to go out to themarkets.

Skills Training – Skills training refers to training given to employees so as to perform their particular
jobs. For e.g. A receptionist would be specifically taught to answer calls and handle the answering
machine.

Soft Skills – Soft skills training includes personality development, being welcoming and friendly to
clients, building rapport, training onsexual harassment etc.

Professional Training – Professional Training is done for jobs that have constantly changing and
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 evolving work like the field of medicine and research. People working in these sectors have to be
regularly updated on matters of the industry.

Team Training – Team training establishes a level of trust and synchronicity between team
membersfor increased efficiency.

([Link]) Benefits of Training

1. Training improves the quantity andquality of the workforce. It increases the skills and knowledge
base of the employees.
2. It improves upon the time and money required to reach the company’s goals. For e.g. Trained
salesmen achieve and exceed theirtargets faster than inexperienced and untrained salesmen.
3. Training helps to identify the highly skilled and talented employees and the company can give
them jobs ofhigher responsibilities.
4. Trained employees are highly efficient in comparison to untrainedones.
5. Reduces the need to constantlysupervise and overlook the employees.
6. Improves job satisfaction and thusboosts morale.

Benefits of Development
1. Exposes executives to the latesttechniques and trends in their professional fields.
2. Ensures that the company has an adequate number of managers withknowledge and skill at
any given point.
3. Helps in the long-term growth andsurvival of the company.
4. Creates an effective team of managers who can handle thecompany issues without fail.
5. Ensures that the employees utilise their managerial and leadership skills in particular to the
fullest.

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Solved Question for you
Q: List at least four benefits oftraining employees for any organisation.
Answer – Four benefits of trainingemployees for any organisation inbrief are
1. Training helps to identify the highly skilled and talented employees andso the company can give
them jobsof higher responsibilities.
2. Trained employees are highly efficient in comparison to untrainedones.
3. Ensures that the company has an adequate number of managers with knowledge and skill at
any given point and thus, adequately staffed.
4. Ensures that the employees utilisetheir managerial and leadership skills to the fullest.

Definition of'SuccessionPlanning'
Definition: Succession planning is a process by which individuals are scanned to pass on the
leadership role within a company. The process ensures that business continues to operate
efficiently without the presence of people who were holding key positions as they must have
retired, resigned, etc.

Description: Succession Planning, specifically

termed as Management Succession Planning, involves coaching and development of prospective
successors or people within a firm or from outside to take up key positions in an organisation
through an organized process of assessment and training.

It ensures a smooth transition of power in key leadership roles. If the successor is chosen within
the organisation, it will help motivate the employees, and also save on cost and extra time which
the management would have spent in scanning candidates from other firms. There are four main
stages in the succession planning process, which involve transition (movement of new role),
initiation, selection, and education. Let’s look at each phase. In the first phase of ‘initiations’,
potential candidates for the job learn about the business, more importantly about its value system,
guidelines, values, vision, etc. Here the CEO or any top leader of the organisation talks about these
key things to the candidates.

The second phase or ‘selection’ is a complex task, where a specific candidate is chosen to be a
successor among other candidates who were running for the same job. In the third phase of
‘training’ involves an exhaustive training scheduled for the successor so that he can meet the goals
of the organisation as well as returns for the shareholders. In the fourth and the last phase of
‘transition,’ the business owner or the CEO retires or moves out of the organisation, and the chosen
successor formally takes up the responsibility as his/her new leadership role.

Definition of 'TheoryX & Theory Y'

Definition: Theory X and theory Y are part of motivational theories. Both the theories, which are
very different from each other, are used by managers to motivate their employees. Theory X gives
importance to supervision, while theory Y stresses on rewards and recognition.

Description: Theory X and theory Y follow different methodologies of keeping people

motivated. Theory X follows an authoritarian approach to motivate people. One of the key
assumption in this approach is that the average employee doesn't like work and will do anything
to avoid it. The other assumption under theory X is that the employees need to be threatened or
forced to work towards the organizational goals. They will avoid responsibility and the managers
have to supervise them at every step.
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In an organisation where theory X is followed, the management too follows an authoritarian style.
There is little delegation of authority from the management. On the other hand, companies who
follow theory Y have a more decentralized approach, which means that the authority is distributed
among employees. This keeps them motivated.

There are some key assumptions under theory

Y One of them is that employees take responsibility of their actions and work towards achieving
the goals of the organization without much supervision. The workers are more participative and try
to solve problems on their own without relying on supervisors for guidance. This type of
management style is more common than theory X. In this type of management style, even a small
employee can participate in the decision-making process.

Theory X works on the idea of punishing people to keep the work going, while under theory Y,
promotions, rewards, and recognition play an important part. This keeps employees motivated to
work hard towards achieving goals of the organisation.
Compensation Management
Compensation: anoverview
Compensation management is one of the most challenging human resource areas because it
contains many elements and has a far- reaching effect on the organisation's goals.
The purpose of providing compensation is to attract, retain and motivate employees. There are two
main types of financial compensation.
1. Direct financial compensation - the pay that a worker receives as wages, salaries, commissions
and bonuses, and
2. Indirect financial compensation - all financial rewards that are not included in direct
compensation (i.e. benefits).

An example of direct
financial compensation is the money the worker receives as wages at the end of the week, or as a
salary paid at the end of the month. Many companies pay salaries straight into the employee's bank
account.

An example of indirect financial compensation is when the company contributes to an employee's

housing subsidy or a pension plan. Not all compensation is financial. A worker can get great
satisfaction from his work and enjoy the environment in which he works. This is called non-
financial compensation and cannot be counted in terms of money. For example, a veterinarian
might enjoy working outside, going to farms to treat animals and deliver calves. A publisher might
enjoy the challenge of producing books that will enrich people's lives. It is not always possible to
provide a perfect pay package (the agreement between the organisation and the employee about
how much money and other benefits the employee will receive). Because of this, some companies
allow their employees to work out their own compensation packages.

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 India: Central government employees draw more salary along with benefits than state government
employees, compared with private sector employees. There is a particular pay structure fixed for
every government employee in India which is not in private companies. The pay structure of
government employees in India is as follows Employee salary : Basic pay + Grade pay + Dearness
Allowance (DA) + House Rent Allowance (HRA) + City Compensatory Allowance (CCA)

The details of above said components of salary of government employees are as follows.

Basic pay: The primary component of employee salary which is bases for calculation of other
components in the employee salary.

• Grade pay: An amount which is fixed by the government on the range of employee in government
hierarchy. (for example; Group A officers have high grade pay than Group B officers.)

• Dearness Allowance: Certain percentage of the amount on basic pay. This percentage varies from
state government to Central government employees. An allowance paid to employees on the basis
of consumer Price index. Consumer price index denotes the cost of the products which influences
by the inflation. (in simple terms cost of living) At present, 41% is for state government employees
and 72 % is for Central government employees as dearness allowance ontheir basic pay.

• House Rent Allowance

(HRA): Certain percentage of the amount on basic pay. This percentage varies from state
government to Central government employees. This allowance is paid to employees are meeting
house rent expenditure.
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City Compensatory Allowance (CCA): An allowance paid according to the city or town where
employee do the job and the purpose of this allowance is to compensate high cost of living
especially in cities like Mumbai, Delhi, Calcutta and Hyderabad et cetera . Government decides the
amount of allowance to bepaid to employees on basis of city or town.

Objective of Compensation
The objective of the compensation function is to create a system of rewards that is equitable to
the employer and employee alike. The desired outcome is an employee who is attracted to the
work and motivated to do a good job for the employer. Patton suggests that in compensation
policy there are seven criteria for effectiveness. Compensation shouldbe:
1. Adequate Minimal governmental, union, and managerial levels should be met.
2. Equitable Each person should be paid fairly, in line with his or her effort, abilities, and training.
3. Balanced Pay, benefits, and other rewards should provide a reasonable total reward package.
4. Cost-effective Pay should not be excessive, considering what the organization can afford to pay.
5. Secure Pay should be enough to help an employee feel secure and aid him or her in satisfying
basic needs.
6. Incentive-providing Pay should motivate effective and productive work.
7. Acceptable to the employee The employee should understand the pay system and feel it is a
reasonable system for the enterprise and himself or herself.

India is one of the countries with very high population and stands second in place followed by
china. In the India, parliament has enforced four key laws on wages of workers that are Payment of
wages act 1936 and Minimum wages act 1948 for the purpose of ensuring minimum payment for
particular type of jobs in different sectors and industries according to stipulated working hours
prescribed by the law. Normally eight hours is stipulated working time in almost all countries, above
stipulated time if any worker is made to work, his employers has to compulsory pay overtime, if not
it shall be treated as unlawful by the court of law for which it may impose penalty. Other side of
coin it may create serious dissatisfaction among workers and make them feel that they are being
exploited which may lead to agitations eventually may lead strikes which is ultimate weapon in
hands of workers, ultimately organisations may chose for lockout which is the weapon in hands of
employers altogether may create industrial disputes.

On this law may support worker agitation for not complying payment of wages by their employer in
accordance with wage laws and in some cases law may support employer if workers agitation
causes serious damages to organisation. The third key law is workmen's compensation act 1923,
the primary objective of this law is to have any compensation by an employee from his employer if
any accident occurs, which make permanent are partial disablement. This law defines under
schedules various types of accidents certain to happen to worker and percentage of compensation
paid to him in accordance with his age. The fourth key law is Equal Remuneration Act, 1976,
according to the section 4 it is the DUTY OF EMPLOYER TO PAY EQUAL REMUNERATION TO
MEN AND WOMEN WORKERS FOR SAME WORK OR WORK OF A SIMILAR NATURE. According to
Section 3, a settlement arrived at between the management and the employees cannot be a valid
ground for effecting discrimination in payment of remuneration between male and female
employees performing the same work or work of a similar nature; Mackinnon Mackenzie and Co. v.
Audrey D’ Costa, (1987) 2 SCC 469.

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"The most important thing is to note that compensation plays a major role in attracting talent from
the market and compensation system of the organisation is Key factor for creating employer
brand, which is most important factor for attracting talent people. Having talent people for the
organisation is a major asset for the organisation development" Importance of employees
compensation or reward system.
• Compensation or reward system of the organisation is most influencing factor for employee
motivation, must remember.
• If we observe history of causes of industrial disputes, employee compensation a reward system
issueswere the main reason in most cases.
• good compensation system of rewards system in the organisation will minimise industrial
disputes and helps in maintaining peace and harmony within the organisation.
• Compensation system plays a key role in employee attrition.
• Compensation system mostly influences retention of employee in the organisation.
• Most of employee satisfaction depends upon compensation a reward system of organisation.
• Effective compensation system builds employer brand, which plays a key role in attracting talent.
• Effective compensation system makes employee to put his full efforts for achievement of
organisation's goals and objectives.
• Effective compensation system builds initiative towards work, which in turn enhances the
productivity of organisation.
• Effective compensation makes employees feel belongingness towards the organisation.
• Job Evaluation: Concept, Objectives andProcedure of Job Evaluation
Concept of job evaluation:
In simple words, job evaluation is the rating of jobs in an organisation. This is the process of
establishing the value or worth of jobs in a job hierarchy. It attempts to compare the relative
intrinsic value or worth of jobs within an organisation. Thus, job evaluation is a comparative
process.

Below are given some importantdefinitions of job evaluation: According to the International
Labour Office (ILO) “Job evaluation is an attempt to determine and compare the demands which
the normal performance of a particular job makes on normal workers, without taking into account
the individual abilities or performance of the workers concerned”. The British Institute of
Management defines job evaluation as “the process of analysis and assessment of jobs to
ascertain reliably their negative worth using the assessment as the basis for a balanced wage
structure”. In the words of Kimball and Kimball “Job evaluation is an effort to determine the
relative value of every job in a plant to determine what the fair basic wage for such a job should
be”.

Wendell French defines job evaluation as “a process of determining the relative worth of the
various jobs within the organisation, so that differential wages may be paid to jobs of different
worth. The relative worth of a job means relative value produced. The variables which are assumed
to be related to value produced are such factors as responsibility, skill, effort and working
conditions”. Now, we may define job evaluation as a process used to establish the relative worth of
jobs in a job hierarchy. This is important to note that job evaluation is ranking of job, not job holder.
Job holders are rated through performance appraisal. Job evaluation assumes normal
performance of the job by a worker. Thus, the process ignores individual abilities of the job holder.
Job evaluation provides basis for developing job hierarchy and fixing a pay structure. It must be
remembered that job evaluation is about relationships and not absolutes. That is why job
evaluationcannot be the sole determining factorfor deciding pay structures.
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External factors like labour market conditions, collective bargaining and individual differences do
also affect the levels of wages it, organisations. Nonetheless, job evaluation can certainly provide
an objective standard from which modifications can be made in fixing wage structure. The starting
point to job evaluation is job analysis. No job can be evaluated unless and until it is analysed. How
job evaluation is different from job analysis, job description and job specification is given in the
followingTable 14.1.

Objectives of job evaluation: The main objective of job evaluation is to determine relative worth of
different jobs in an organisation to serve as a basis for developing equitable salary structure.
States an ILO Report the aim of the majority of systems of job evaluation is to establish, on agreed
logical basis, the relative values of different jobs in a given plant or machinery i.e. it aims at
determining the relative worth of a job. The principle upon which all job evaluation schemes are
based is that of describing and assessing the value of all jobs in the firms in terms of a number of
factors, the relative importance of which varies from job to job.
The objectives of job evaluation,to put in a more orderly mannerare to:
1. Provide a standard procedure fordetermining the relative worth of each job in a plant.

2. Determine equitable wage differentials between different jobs inthe organisation.

3. Eliminate wage inequalities.

ADVERTISEMENTS:
1. Ensure that like wages are paid to all qualified employees for like work.
2. Form a basis for fixing incentivesand different bonus plans.
3. Serve as a useful reference forsetting individual grievances regarding wage rates.
4. Provide information for work organisation, employees’ selection, placement, training and
numerousother similar problems.
5. Provide a benchmark for making career planning for the employees inthe organisation.
Procedure of job evaluation: Though the common objective of jobevaluation is to establish the
relative worth of jobs in a job hierarchy, there is no common procedure of job evaluation
followed by all organisations. As such, the procedureof job evaluation varies from organisation
to organisation. For example, a job e valuation procedure may consist of the eight stages as
delineated in Figure 14.1.

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1. Preliminary Stage:
This is the stage setting for job evaluation programme. In this stage, the required information’s
obtained about present arrangements, decisions are made on the need for a new programme or
revision of an existing one and a clear cut choice is made of the type of programme is to be used

by the organisation.

2. Planning Stage:
In this stage, the evaluation programme is drawn up and the job holders to be affected are
informed. Due arrangements are made for setting up joint working parties and the sample of
jobs to be evaluated isselected.

3. Analysis Stage:
This is the stage when required information about the sample of jobs is collected. This
information serves as a basis for the internal and external evaluation of jobs.

4. Internal Evaluation Stage: Next to analysis stage is internal evaluation stage. In the internal
evaluation stage, the sample of bench-mark jobs are ranked by means of the chosen evaluation
scheme as drawn up at the planningstage. Jobs are then graded on the
basis of data pending the collection ofmarket rate data. Relative worth of jobs is ascertained by
comparing grades between the jobs.

5. External Evaluation Stage:

In this stage, information is collectedon market rates at that time.

6. Design Stage:

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 ADVERTISEMENTS:
Having ascertained grades for jobs,salary structure is designed in this stage.
7. Grading Stage:
This is the stage in which different jobs are slotted into the salary structure as designed in the
preceding stage 6.

8. Developing and MaintainingStage:

This is the final stage in a job evaluation programme. In this stage, procedures for maintaining
the salary structure are developed with a view to accommodate inflationary pressures in the
salary levels, grading new jobs into the structure and regarding the existing jobs in the light of
changes in their responsibilities and market rates.

In India, the Indian Institute of Personnel Management, Kolkata has suggested the following five
steps to be taken to develop a job evaluation programme:
1. Analyse and Prepare JobDescription

2. Select and Prepare a Job Evaluation Programme/Plan

3. Classify Jobs
4. Install the Programme

5. Maintain the Programme

These steps are self-explanatory. Hence are not discussed in detail.

Advantages of job evaluation: According to an ILO publication job evaluation offers the following
advantages:
1. Job evaluation being a logical process and objective technique helps in developing an equitable
and consistent wage and salary structure based on the relative worth of jobs in an organisation.
2. By eliminating wage differentials within the organisation, job evaluation helps in minimizing
conflict between labour unions and management and, in turn, helps in promoting harmonious
relations between them.
3. Job evaluation simplifies wageadministration by establishing uniformity in wage rates.
4. It provides a logical basis for wagenegotiations and collective bargaining.
5. In the case of new jobs, job evaluation facilitates spotting them into the existing wage and salary
structure.
6. In the modem times of mechanisation, performance depends much on the machines than on the
worker himself/herself. In such cases, job evaluation provides the realistic basis for
determination of wages.
7. The information generated by job evaluation may also be used for improvement of selection,
transfer and promotion procedures on the basis of comparative job requirements.
8. Job evaluation rates the job, not the workers. Organisations have large number of jobs with
specialisations. It is job evaluation here again which helps in rating all these jobs and
determining the wagesand salary and also removing ambiguity in them.

Drawbacks of job evaluation: In spite of many advantages, job evaluation suffers from the
following drawbacks/limitations:
1. Job evaluation is susceptible because of human error and subjective judgment. While there is no
standard list of factors to be considered for job evaluation, thereare some factors that cannot be
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 measured accurately.

2. There is a variation between wages fixed through job evaluation and market forces. Say Kerr and
Fisher, the jobs which tend to rate high as compared with the market are those of junior, nurse
and typist, while craft rates are relatively low. Weaker groups are better served by an evaluation
plan than by the market, the former places the emphasis not on force but on equity”.
3. When job evaluation is applied for the first time in an organisation, it creates doubts in the minds
of workers whose jobs are evaluated and trade unions that it may do away with collective
bargaining for fixing wage rates.
4. Job evaluation methods being lacking in scientific basis are often looked upon as suspicious
about the efficacy of methods of job evaluation.
5. Job evaluation is a time- consuming process requiring specialised technical personnel to
undertake it and, thus, is likely to becostly also.
6. Job evaluation is not found suitable for establishing the relative worth of the managerial jobs
whichare skill-oriented. But, these skills cannot be measured in quantitativeterms.
7. Given the changes in job contents and work conditions, frequent evaluation of jobs is essential.
This isnot always so easy and simple.
8. Job evaluation leads to frequent and substantial changes in wage and salary structures. This, in
turn, creates financial burden on organisation.

Incentives And Fringebenefits

Meaning:
Meaning Incentives are the rewards to an employee, over and above his base wage or salary, in
recognition of his performance and contribution. “ An incentive scheme is a plan or programmes to
motivate individual or group performance. An incentive programme is most frequently built on
monetary rewards but may also include a variety of non-monetary rewards or prizes.” By- Burack
and Smith.

Pre-requirements For Effective Incentive System:

Pre-requirements For Effective Incentive System Incentive plan should be simple so that it may be
easily understood by the workers. The plans should be acceptable to the workers, trade unions and
management. The incentives rates should be made attractive so as to encourage t he worker to
give his best results. All incentives should guarantee a minimum day’s wages.

PowerPoint Presentation:
The scheme should be explained and discussed with all employees and supervisors before it is
implemented. Standards once fixed should not be changes unless it is necessary.

Two Types Of Incentives:

Two Types Of Incentives Financial Incentives Non-Financial Incentives
PowerPoint Presentation:
Group Incentive/ Bonus Plan It is a plan in which a production standard is set for a specific work
group and its members are paid incentives if the group exceeds the production standard .
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Profit Sharing Scheme It is an incentive plan that engages many or all employees in a common
effort to achieve a company’s productivity and any resulting incremental cost- savings gains are
shared among employees and the company.
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Gainsharing Plan:
Gainsharing Plan It is an incentive plan that engages many or all employees in a common effort to
achieve a company’s productivity objectives and any resulting incremental cost saving are shared
among employees and the company.

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At-Risky Pay plan These are some times called variable pay plans but are essentially plans that put
some portion of the employee’s pay at risk, subject to the firm’s meeting its financial goals .

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Salary plan Salary plan varies from organization to organization. Some firms pay sales people fixed
salaries and no specific commission or bonus schemes are paid on achieving the sales targets.
The emphasis being on customer service rather on high pressure selling.

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Commission Plan Commission plans provide sales representatives with payment based on a
percentage of sales turnovers they generate.

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Combination Plan Most companies pay their salespeople a combination of salary and commission.
A portion of total earnings is paid in form of fixed salary.

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Bonus Scheme And Awards Bonus scheme provide pay in addition to basic salary which is related
to the achievement of
defined and preferably agreed targets. These may refer simply to sales volume or profit.

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Base Salary Decisions on the base salary of directors and senior executives are usually formed on
the basis of market worth of the individuals. Remuneration on joining the company is usually
settled by negotiation, often subject to the approval of a remuneration committee.

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The Annual Bonus Annual bonus plans are those which are aimed at motivating the short term
performance of their managers and executives and are given on the basis of the profitability of the
company.

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Stock Option A stock option is the right to purchase a specific number of shares of company stock
at a specific price during a period of time.

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Book Value Plan Managers are permitted to purchase stock at current book value. Executives can
earn dividend on the stock they own, as the company grows the book value of their shares may
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grow too.

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Stock Appreciation Rights The employee is given the appreciation in the value of shares from the
date the option was granted till the date it was relinquished. He earns without investing any money
in buying the options.

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Restricted Stock Plans Shares are usually awarded without cost to the executive but with certain
restrictions. One of the major restrictions is that the shares may be forfeited if they are not earned
out over a specified period of time.

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Phantom Stock Plan Executives receive not shares but “units” that are similar to shares of
company stock. Then at some future time they receive value equal to the appreciation of the
“phantom” stock they own.

Employee Stock Option Plan::

Employee Stock Option Plan: A company contributes shares of its own stock or cash to be used to
purchase such stock to a trust. The trust holds the stock in individual employee
accounts and distributes it to employees upon their retirement or at the time of separation from
service.

Employee Stock Purchase Plan:

Employee Stock Purchase Plan The employees are given the right to acquire shares of the
company, normally at a price lower than the prevailing market price.

Non-Financial Incentives:
Non-Financial Incentives Materialistic Incentives Canteens Housing Facilities Education Facilities
Pension Provident Fund Schemes Non-Materialistic Incentives Recognition and praise Good
working environment Cordial human relations Job satisfaction.

Fringe Benefits For Employees:

Fringe Benefits For Employees
PowerPoint Presentation:
“Imagine life as a game in which you are juggling some five balls in the air. You name them - work,
family, health, friends and spirit - and you're keeping all of these in the air. You will soon
understand that work is a rubber ball. If you drop it, it will bounce back. But the other four balls -
family, health, friends and spirit - are made of glass. If you drop one of these, they will be
irrevocably scuffed, marked, nicked, damaged or even shattered. They will never be the same. You
must understand that and strive for balance in your life.” -Brian G. Dyson President and CEO Coca-
Cola Enterprises.

Definition:
Definition Fringe benefits are those monetary and non monetary benefits given to the employee
during and post- employment period which are connected with employment but not to the
employees contribution to the organization.
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For Example You Could receive a benefit when you:
For Example You Could receive a benefit when you Use a work car for private purposes. Are
provided with a cheap loan. Are provided with free private health insurance. Are provided with
cleaning services for your private residence or enter in to a salary sacrifice arrangement.

Need & Importance of Fringe Benefits::

Need & Importance of Fringe Benefits: To retain the employees. To motivate performance. As a
social security. Trade Union demand. Skill shortage. Employee Demand.
Principles of Fringe Benefits:
Principles of Fringe Benefits Satisfaction of Real Needs. Flexibility. Proper Communication.
Educate the workers. Corporate Tools. Participation

Fringe Benefits Categories ::

Fringe Benefits Categories : Car Fringe benefits. Loan Fringe Benefits. Expenses Payment Fringe
Benefits. Housing Fringe Benefits. Airline Transport Fringe benefits. Living-Away-from- Home
allowance fringe benefits. Car Parking Fringe Benefits. Property Fringe Benefits.

Fringe Benefits In India ::

Fringe Benefits In India : Payment for Time not Worked. Voluntary Benefits. Payment For Special
Duties. Payment For Health and Security Benefits.

Conclusion::
Conclusion: Basically, a fringe benefit is a benefit provided to an employee or an associate (For
Example: Family, Spouse and children) because of his employment. Fringe Benefits provide output
in terms of employee loyalty and co-operation, employee welfare and create Organizational image
Performance Appraisal: Definition, Methods, 360 Degree Appraisal

PerformanceAppraisal
It is referred to as a systematic evaluation of performance of employees in an organization. This is
mainly done to have an understanding of the abilities of the resources for future growth and
development. The objectives of performance appraisal are as follows:
(i). Data maintenance to decide salary packages, increase in salary, pay structure etc.
(ii). To know the strengths and weaknesses of the resources in order to put them at the right job.
(iii). To understand the probable interests of the employees for future development.
(iv). Give feedback to the manpower about their performance at a given point of time.
(v). Analyze and keep hold of the training programs for the promotion of the employees.

Importance ofPerformance Appraisal

When we discuss in a deeper sense, we can say that Performance Appraisal is an asset to the
organization. This statement can be justified as follows:
1. Selection justification: Performance Appraisal helps the HR managers in validating the selection
made by them. It makes them clear as to the strengths and weaknesses of the employees
selected by them. This can be kept as sample study for future selection of employees.
2. Compensation: Appraisal system helps in merit rating from where a good compensation
program can be chalked out. A compensation system which has good pay, bonuses, variable
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 allowances and benefits is very much reliant on performance appraisal.
3. Promotion: It helps in deciding promotion programs for competent employees. By this,
inefficient workers can be either demoted or dismissed from the company.
4. Employee Development: A very good appraisal system helps the HR managers in developing
good training programs. This in turn helps the employees to discuss their interests in getting
trained in various programs with their managers.
5. Motivation: Appraisal can be called as a motivational tool for employees. By setting standards to
achieve the targets, the employees are motivated to perform as well as to develop their
performance in future.

Methods of PerformanceAppraisal
They are broadly classified into Traditional and Modern methods. Let us first discuss the
Traditional methods.
1. Rating Scale Method: It is the most common method of assessing the performance. Under this
method a scale is created from 1 to 10. The components of this method are traits like attitude,
regularity, performance and accountability, which will be rated on a scale of 10. In India, many
telecommunication industries are using this method to evaluate their employees. Here the
employees are assessed as per the nature of the job or company. The number of points scored
for all the traits are finally added; employee who scores more is regarded as good performer than
the employee who has a descending score.

2. Essay Appraisal Method: It is also called the “free form method” because the superior gives a
detailed description of its manpower’s performance. This will include supporting documents and
examples of his/her performance. The main hitch of this method is that it is highly biased. The
rater under this method may use Rating Scale method also to rate the weaknesses and strengths
of an employee to validate his essay appraisal. This method is very time consuming as the rater
should find enough time to collate all the documents. It is considered to be a non quantitative
evaluation method of appraisal.

3. Ranking Method: Under this, the manager compares the performance of employees with other
employees of the same rank or grade. A fixed percentage of employees are kept in different
performance categories like excellent, average, below average, poor etc. This method is used
when the managers have to make decision as to which person is the best worker for a given
period, who has to be promoted, which employee is being laid off etc. Under such circumstances
the Ranking Method comes handy to HR Managers in evaluating them correctly.

4. Critical Incident Method: As the name suggests these are based on events or incidents. Here
logs are maintained for each employee to record the events or decisive incidents of behavior of
employees. At the conclusion of the performance period these events are collated to find out the
rating of the employees. The main drawback of this method is that the negative incidents are
more obvious than the positive ones. Sometimes the employees will not like such close
supervision by managers.

5. Confidential Report System: This method is very well known in government organizations. Here
the superiors will write a confidential report on the subordinates with respect to his/her behavior
and duties in the organization. This report will not be exposed to anyone, and finally will be
referred the top management. In India this method is being used by most of the government
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 organizations like the Armed Forces, Police department, CBI etc. The main factors assessed here
are:
(a). Temperament of the employee.

(b). Promptness of employee.

(c). Unlawful absenteeism.
(d). Truthfulness and sincerity.
(e). His/her behavior with the public.

6. Check List Method: Under this method, the appraiser is given a set of metaphors to be used for
rating the employees. This comprises of a list of questions based on which the rater evaluates
the acts of the human resources. Let us see the below statements or descriptions used as
checklist:
(a). Is the employee actually interested in the job? Yes/No
(b). Do they give respect to their superiors? Yes/No
(c). Do they follow the directives? Yes/No
(d). Mistakes are made frequently? Yes/No

7. Graphic Rating Scale Method: It is a widely accepted conventional technique of performance

appraisal. Here the core traits of the employees are cautiously defined. These traits are assigned
numbers on a scale of 5 to evaluate for a given appraisal period. The values of each trait is added
to find out the best performer during the period of performance appraisal, the score will vary
from person to person giving the appraiser a clear picture as to who is the best performer. Look
at the example below for better understanding of the method.

Table Title: Graphic Rating Scale Method Now let’s see some new techniques of Performance
Appraisal. To overcome the drawbacks of the traditional performance appraisal methods a few
modern techniques were used by the organization.

1. The BARS Method: This is called Behaviorally Anchored Rating Scale which is

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comparatively a new one. It’s a combination of two methods like graphical rating scale and critical
incident method. This method consists of a set of behavioral statements that explains the
performance of the resources towards a particular job as good or bad. These statements are
1. derived from critical incidents or [Link] this method the definite behavior is compared with
the preferred behavior. The critical behavior thus obtained is given a numeric value based on which
performance is rated. The below example can make us understand better.

Table Title: BARS (Behaviorally Anchored Rating Scale)

2. Human Resource Accounting Method: This method measures the efficiency of personnel
management behavior and how the people are used in an organization. This is handing over,
budgeting and reporting of how much cost is involved in the acquisition of human resources,
which includes salaries and wages. There is a saying, ‘the human resources are the assets of an
organization.’ HRA method finds out net worth of these resources in monitory terms. Under this
method the cost incurred on employees right from recruitment to induction is calculated and the
contribution of employees which in this method is the total value added, is also calculated. The
difference between the cost and input is considered to be the performance of the manpower
hired; preferably the contribution from the employee’s side should be greater than the cost
incurred.

3. MBO (Management by Objectives): It is a process where in both the managers and

subordinates recognize common goals and characterize the individual’s
d to give important responsibility towards
suggestions
achieving those goals. It is a shared goal setting method, Can be laid off 7Employee can be exwith

setting these goals, the key constituent of MBO method is a constant performance review sessions
that happens between managers and subordinates. This helps in evaluating the growth on regular
basis.

360 Degree AppraisalSystem

It is a system in which employees will get feedback from all the people they work with. There are
about 7 to 12 people who will fill out a form which is usually a feedback form. The contents of the
form may vary from broad range competencies to work environment. The employee who receives
the feedback will also be required to fill out a self assessment which again might consist of the
same components. This system is used to get an improved understanding of every one’s strengths
and weaknesses.

There are three general reasons as to why an organization would go in for a360 degree appraisal.
▪ To get a better view of the performance and prospective of future leaders.
▪ To have a broad insight of developmental needs of manpower.
▪ To collect more feedback so as to ensure justice to the job performed by the employees.

In 360 degree appraisal system, the feedback is collected from managers, peers, subordinates,
customers, team members etc. A survey is conducted to get close understanding of-on the job
performance of the employees. A 360 degree appraisal has four stages in it:
▪ Self Appraisal
▪ Superior’s Appraisal
▪ Sub-ordinates Appraisal
▪ Peer Appraisal

799
Collective Bargaining:
Definition, Types,Features and Importance
Definition of CollectiveBargaining:
Industrial disputes between the employee and employer can also be settled by discussion and
negotiationbetween these two parties in order toarrive at a decision.
ADVERTISEMENTS:
This is also commonly known as collective bargaining as both the parties eventually agree to
follow a decision that they arrive at after a lot of negotiation and discussion. According to Beach,
“Collective Bargaining is concerned with the relations between unions reporting employees and
employers (or their representatives). It involves the process of union organization of employees,
negotiations administration and interpretation of collective agreements concerning wages, hours
of work and other conditions of employees arguing in concerted economic actions dispute
settlement procedures”. According to Flippo, “Collective Bargaining is a process in which the
representatives of a labor organization and the representatives of business organization meet and
attempt to negotiate a contract or agreement, which specifies the nature of employee-employer
union relationship”.

ADVERTISEMENTS:
“Collective Bargaining is a mode of fixing the terms of employment by means of bargaining
between organized body of employees and an employer or association of employees acting usually
through authorized agents. The essence of Collective Bargaining is bargaining between interested
parties and not from outside parties”.

According to an ILO Manual in1960, the Collective Bargainingis defined as:

“Negotiations about working conditions and terms of employmentbetween an employer, a group of
employees or one or more employers organization on the other, with a view to reaching an
agreement.” It is also asserted that “the terms of agreement serve as a code defining the rights and
obligations of each party in their employment relations with one another, if fixes large number of
detailed conditions of employees and during its validity none of the matters it deals with, internal
circumstances give groundsfor a dispute counseling and individual workers”.

ADVERTISEMENTS:
Collective Bargaining Involves:
(i) Negotiations
(ii) Drafting
(iii) Administration
(iv) Interpretation of documents written by employers, employees and the union
representatives
(v) Organizational Trade Unions withopen mind.

Forms of Collective Bargaining: The working of collective bargaining assumes various forms. In
the first place, bargaining may be between the single employer and the single union, this is known
as single plant bargaining. This form prevails in the United States as well as in India. Secondly, the
bargaining may be between a single firm having several plants and workers employed in all those
plants. This form is called multiple plants bargaining where workers bargain with the common
employer through different unions. Thirdly, instead of a separate union bargaining with separate
employer, all the unions belonging to the same industry bargain through their federation with the
800
employer’s federation of that industry. This is known as multiple employer bargaining which is
possible both atthe local and regional levels. Instances in India of this industry--wide bargaining are
found in the textile industry.

ADVERTISEMENTS:
The common malady of union rivalry, small firms and existence of several political parties has
given rise to a small unit of collective bargaining. It has produced higher labour cost, lack of
appreciation, absence of sympathy and economic inefficiency in the realm of industrial
relationships. An industry-wide bargaining can be favourable to the economic and social interests
of both the employers and employees.

Essential Pre-Requisites for Collective Bargaining: Effective collective bargaining requires the
following pre- requisites:
(i) Existence of a strong representative trade union in the industry that believes in
constitutional means for settling thedisputes.
(ii) Existence of a fact-finding approach and willingness to use new methods and tools for the
solution of industrial problems. The negotiation should be based on facts and figures and
both the parties should adopt constructive approach.
ADVERTISEMENTS:
(iii) Existence of strong and enlightened management which can integrate the different
parties, i.e., employees, owners, consumers and society or Government.

(iv) Agreement on basic objectives of the organisation between the employer and the
employees and on mutual rights and liabilities should be there.

(v) In order that collective bargaining functions properly, unfair labour practices must be
avoided by both theparties.

(vi) Proper records for the problemshould be maintained.

ADVERTISEMENTS:
(vii) Collective bargaining should be best conducted at plant level. It means if there are more
than one plant of the firm, the local management should be delegated proper authority to
negotiate with thelocal trade union.
(viii) There must be change in the attitude of employers and employees. They should realise
that differences can be resolved peacefully on negotiating table without the assistance of
third party.
(ix) No party should take rigid attitude. They should enter into negotiation with a view to
reachingan agreement.
(x) When agreement is reached afternegotiations, it must be in writing incorporating all term of
the contract.

ADVERTISEMENTS:
It may be emphasised here that the institution of collective bargaining represents a fair and
democratic attempt at resolving mutual disputes. Wherever it becomes the normal mode of setting
outstanding issues, industrial unrest with all its unpleasant consequences is minimised.

Main Features of CollectiveBargaining:

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Some of the salient features ofcollective bargaining are:
1. It is a Group Action: Collective bargaining is a groupaction as opposed to individual
action. Both the parties of settlement are represented by their groups. Employer is represented
by its delegates and, on the other side; employees are represented by theirtrade union.

2. It is a Continuous Process: Collective bargaining is a continuous process and does not end with
one agreement. It provides a mechanism for continuing and organised relationship between
management and trade union. It is a process that goes on for 365 days of the year.

3. It is a Bipartite Process: Collective bargaining is a two party process. Both the parties—
employers and employees— collectively take some action. There is no intervention of any third
party. It is mutual given- and-take rather than take-it-or-leave- it method of arriving at the
settlement of a dispute.

4. It is a Process:
Collective bargaining is a process in the sense that it consists of a number of steps. The starting
point is the presentation of charter of demands by the workers and the last step is the reaching
of an agreement, or a contract which would serve as the basic law governing labour-
management relations over a period of time in an enterprise.

5. It is Flexible and Mobile andnot Fixed or Static:

It has fluidity. There is no hard and fast rule for reaching an agreement. There is ample scope for
compromise. A spirit of give-and- take works unless final agreement acceptable to both the
parties is reached.

6. It is Industrial Democracy atWork:

Collective bargaining is based on the principle of industrial democracy where the labour union
represents the workers in negotiations with the employer or employers. Industrial democracy is
the government of labour with the consent of the governed—the workers. The principle of
arbitrary unilateralism has given way to that of self-government in industry. Actually, collective
bargaining is not a mere signing of an agreement granting seniority, vacations and wage
increase, by sitting around a table.

7. It is Dynamic:
It is relatively a new concept, and is growing, expanding and changing. In the past, it used to be
emotional, turbulent and sentimental, but now itis scientific, factual and systematic.

8. It is a Complementary and not a Competitive Process: Collective bargaining is not a competitive

process i.e., labour and management do not coopt while negotiating for the same object. It is
essentially a complementary process i.e., each party needs something which the other party has,
namely, labour can put greater productive effort and management has the capacity to pay for
that effort and toorganise and guide it for achieving the enterprise’s objectives.

The behavioural scientists have made a good distinction between “distributive bargaining” and
“integrative bargaining”. The former is the process of dividing up the cake which represents what
has been produced by the joint efforts of management and labour. In this process, if one party
wins something, the other party, to continue the metaphor of the cake, has a relatively smaller size
of the cake. So it is a win-lose’ relationship. The integrative bargaining, on the other hand, is the
802
process where both the parties can win—each party contributing something for the benefit of the
other party.

9. It is an Art:
Collective bargaining is an art, an advanced form of human relations.
Means of CollectiveBargaining:
Generally, there are four important methods of collective bargaining, namely, negotiation,
mediation, conciliation and arbitration for the settlement of trade disputes. In this context R.F.
Hoxie said that arbitration is often provided for in collective bargaining under certain contingencies
and for certain purposes, especially when the parties cannot reach agreement, and in the
interpretation of an agreement through negotiation. Conciliation is a term often applied to the art of
collective bargaining, a term often applied to the action of the public board which attempts to
induce collective bargaining. Mediation is the intervention usually uninvited, of some outside
person ofbody with a view of getting conciliation or to force a settlement, compulsory arbitration is
extreme mediation. All these things are aids or supplement to collective bargaining where it breaks
down. They represent the intervention ofoutside parties.

Constituents of CollectiveBargaining:
There are three distinct steps inthe process of collective bargaining:
(1) The creation of the tradeagreement,
(2) The interpretation of theagreement, and
(3) The enforcement of theagreement.
Each of these steps has its particular character and aim, and therefore, each requires a special kind
of intellectual and moral activity and machinery.
1. The Creation of the TradeAgreement:
In negotiating the contract, a union and management present their demands to each other,
compromise their differences, and agree on the conditions under which the workers are to be
employed for the duration of the contract. The coverage of collective bargaining is very uneven;
in some industries almost all the workers are under agreement, while in others only a small
portion of the employees of the firms are covered by the agreement. The negotiating process is
the part of collective bargaining more likely to make headline news and attract public attention;
wage increases are announced, ominous predictions about price increase are reduction in
employment are made.

2. The Interpretation of theAgreement:

The administrative process is the day-to-day application of the provisions of the contract to the
work situation. At the time of writing the contract, it is impossible to foresee all the special
problems which will arise in applying its provisions. Sometimes, it is a matter of differing
interpretations of specific clause in the contract, sometimes; it is a question of whether the
dispute is even covered by the contract. Nevertheless, each case must somehow be settled. The
spirit of thecontract should not be violated.

3. Enforcement of theAgreement:
Proper and timely enforcement of the contract is very essential for the success of collective
bargaining. If a contract is enforced in such way that it reduces or nullifies the benefits expected
by the parties, it will defeat basic purpose of collective bargaining. It may give rise to fresh
industrial disputes. Hence, in the enforcement of the contract the spirit of the contract should
not be violated. However, new contracts may be written to meet the problems involved in the
803
 previous contract. Furthermore, as day-to-day problems are solved, they set precedents for
handling similar problems in future. Such precedents are almost as important as the contract in
controlling the working conditions. In short, collective bargaining is not an on-and-off
relationship that is kept in cold storage except when newcontracts are drafted.

Theories of CollectiveBargaining:
There are three important concepts on collective bargaining which have been discussed as
follows:
1. he Marketing Concept and the Agreement as a Contract: The marketing concept views
collective bargaining as a contract for the sale of labour. It is a market or exchange relationship
and is justified on the ground that it gives assurance of voice on the part of the organised
workers in the matter of sale. The same objective rules which apply to the construction of all
commercial contracts are invoked since the union-management relationship is concerned as a
commercial one.

According to this theory, employees sell their individual labour only on terms collectively
determined on the basis of contract which has been made through the process of collective
bargaining. The uncertainty of trade cycles, the spirit of mass production and competition for jobs
make bargain a necessity. The trade union’s collective action provided strength to the individual
labourer. It enabled him to resist the pressure of circumstances in which he was placed and to
face an unbalanced and disadvantageous situation created by the employer. The object of trade
union policy through all the maze of conflicting and obscure regulations has been to give to each
individual worker something of the indispensability of labour as a whole. It cannot be said whether
the workers attained a bargaining equality with employers. But, collective bargaining had given a
new- relationship under which it is difficult for the employer to dispense without facing the
relatively bigger collective strength.

2. The Governmental Concept and the Agreement as Law: The Governmental Concept views
collective bargaining as a constitutional system in industry. It is a political relationship. The
union shares sovereignty with management over the workers and, as their representative, uses
that power in their interests. The application of the agreement is governed by a weighing of the
relation of the provisions of theagreement to the needs and ethics of the particular case.

The contract is viewed as a constitution, written by the point conference of union and
management representative in the form of a compromise or trade agreement. The agreement lays
down the machinery for making executing and interpreting the laws for the industry. The right of
initiative is
circumscribed within a framework oflegislation.

Whenever, management fails to conform to the agreement of constitutional requirements, judicial

machinery is provided by the grievance procedure and arbitration. This creates a joint Industrial
Government where the union sharesovereignty with management overthe workers and defend their
groupaffairs and joint autonomy from external interference.

3. The Industrial Relations (Managerial) Concept as JointlyDecided Directives:

The industrial relations concept views collective bargaining as a system of industrial
governance. It is a functional relationship. Group Government substitutes the State Government.
The union representative gets a hand in the managerial role. Discussions take place in good
804
 faith and agreements are arrived at. The union joins with company officials in reaching
decisions on matters in which both have vital interests. Thus, union representatives and the
managementmeet each other to arrive at a mutualagreement which they cannot do alone.

To some extent, these approaches represent stage of development of the bargaining process
itself. Early negotiations were a matter of simple contracting for the terms of sale of labour.
Developments of the latter period led to the emergence of the Government theory. The industrial
relations approach can be traced to the Industrial Disputes Act of 1947 in our country, which
established a legalbasis for union participation in the management.

Importance of CollectiveBargaining:
The collective bargaining advances the mutual understanding between the two parties i.e.,
employees and employers.
The role of collective bargainingmay be evaluated from the following point of view:
(1) From Management Point ofView:
The main object of the organisation is to get the work done by the employees at work at
minimum cost and thus earn a high rate of profits. Maximum utilization of workers is a must for
the effective management. For this purpose co-operation is required from the side of the
employees and collective bargaining is a device to get and promote co- operation. The labour
disputes are mostly attributable to certain direct or indirect causes and based on rumors, and
misconceptions. Collective bargaining is the best remedial measure for maintaining the cordial
relations.

(2) From Labour and TradeUnion Point of View:

Labour has poor bargaining power. Individually a worker has no existence because labour is
perishable and therefore, the employers succeed in exploiting thelabourers. The working class in
united form becomes a power to protect its interests against the exploitation of the employers
through the process of collective bargaining. The collective bargaining imposes certain
restrictions upon the employer. Unilateral action is prevented. All employees are treatedon equal
footings. The conditions of employment and rates of wages as specified in the agreement can
be changed only through negotiations with labour. Employer is not free to make and enforce
decisions at his will.

Collective bargaining can be made only through the trade unions. Trade unions are the
bargaining agents for the workers. The main function of the trade unions is to protect the
economic and non- economic interests of workers through constructive programmes and
collective bargaining is one of the devices to attain that objective through negotiations with the
employers, Trade unions may negotiate with the employer for better employment opportunities
andjob security through collective bargaining.

(3) From Government Point ofView:

Government is also concerned with the process of collective bargaining. Government passes
and implementsseveral labour legislations and desires it to be implemented in their true sense. If
any person violates the rules and laws, it enforces them by force. Collective bargaining prevents
the Government from using the force because an amicable agreement can be reached between
employer and employees for implementing the legislative provisions. Labour problems shall be
minimised through collective bargaining and industrial peace shall be promoted in the country
without any force.
805
Collective bargaining is a peaceful settlement of any dispute between worker and employers and
therefore it promotes industrial peace and higher productivity resulting an increase in the Gross
National Product or the national income of thecountry.

Main Hindrances for CollectiveBargaining:

The main objective of developing collective bargaining technique is to improve the workers-
management relations and thus maintain peace in industries. The technique has developed in India
only after India got independence and got momentum since then. The success of collective
bargaining lies in the attitude of both management and workers which is actually not consistent
with the spirit of collective bargaining in India. There are certain problems which hinder the growth
of collective bargaining in India.

The following factors or activities act as hindrances to effective collective bargaining:

(1) Competitive Process: Collective bargaining is generally becoming a competitive process, i.e.,
labour and management compete each other at negotiation table. A situation arises where
the attainment of one party’s goal appears to be in conflict with the basic objectives of the
other party.

(2) Not Well-Equipped:

Both the parties—management and workers—come to the negotiation table without doing
their homework. Both the parties start negotiations without being fully equipped with the
information, which can easily be collected from company’s records. To start with, there is
often a kind of ritual, that of charges and counter charges, generally initiated by the trade
union representatives. In the absence of requisite information, nothing concrete is achieved.

(3) Time to Protest:

The immediate objective of the workers’ representatives is always some kind of monetary
or other gains, accrue when the economy is buoyant and the employer has capacity to pay.
But in a period of recession, when demand of the product and the profits are falling, it is
very difficult for the employer to meet the demands of the workers, he might even resort to
retrenchment oreven closure collective bargaining is no answer to such a situation.

(4) Where Prices are Fixed bythe Government:

In industries, where the prices of products are fixed by the Government, it becomes very
difficult for the employer to meet the demands of workers which would inevitably lead to a
rise in cost of the products produced. Whereas the supply price to the consumers cannot be
increased. It will either reduce the profits of the firm or increase the loss. In other words, it
will lead to closure of the works, which again is not in the interest of the workers.

(5) Outside Leadership:

Most of the Indian trade unions are led by outsiders who are not the employees of the
concerned organisations. Leader’s interests are not necessarily to be identical with that of
the workers. Even when his bonafides are beyond doubt, between him and the workers he
leads, there cannot be the degree of understanding and communication as would enable
him to speak on behalf of the workers with full confidence. Briefly, in the present situation,
806
 without strong political backing, a workers’ organisation cannot often bargain successfully
with a strong employer.

(6) Multiplicity of TradeUnions:

One great weakness of collective bargaining is the multiplicity of trade unions. In a multiple
trade union situation, even a well recognised, union with long standing, stable and generally
positive relationship with the management, adopts a militant attitude as its deliberate
strategy. In Indian situation, inter-union rivalries are also present. Even if theunions combine,
as at times they do for the purpose of bargaining with the employer they make conflicting
demands, which actually confuse employer and the employees.

(7) Appointment of Low-StatusExecutive:

One of the weaknesses of collective bargaining in India is that the management deputes a
low-status executive for bargaining with the employees. Such executive has no authority to
commit anything on behalf of the management. It clearly indicates that the management is
notat all serious and the union leaders adopt other ways of settling disputes.

(8) Statutory Provisions:

The constraints are also imposed by the regulatory and participative provisions as
contained in the Payment of Wages Act, the MinimumWages Act, and Payment of Bonus Act
etc. Such provisions are statutoryand are not negotiable.

(9) Fresh Demands at the Timeof Fresh Agreement:

At the time when the old agreement is near expiry or well before that, workers
representatives come up with fresh demands. Such demands are pressed even when the
industry is running into loss or even during the period of depression. If management accepts
the demand of higher wages and other benefits, it would prefer to close down the works.

(10) Agreements in OtherIndustrial Units:

A prosperous industrial unit in the same region may agree with the trade
unions to a substantial increase in wages and other benefits whereas a losing industry
cannot do that. There is always pressure on the losing industries to grant wages and
benefits similar to those granted in other (relatively prosperous) units inthe same region.

Scope of Collective Bargaining: Collective bargaining broadly covers subjects and issues entering
into the conditions and terms of employment. It is also concerned with the development of
procedures for settlement of disputes arising between the workers and management.

A few important issues around which collective bargaining enters in this developing country are
as follows:
“Recognition of the union has been an important issue in the absence of any compulsory
recognition by law. In the under-developed countries in Asia, however, on account of the tradition
concept of management functions and the immaturity of the industrialist class there is much
resistance from the employers to recognise the status of the unions.” Bargaining upon wage
problems to fight inflation or rising cost of living and to resist wage cuts during depression has
resulted in several amicable agreements. But, no statistics are available for such amicable
settlements. Therefore, Daya, points out, “It has been customary to view collective bargaining in a
pattern of conflict; the competitively small number of strikes and lock-outs attract more attention
807
than the many cases of peaceful settlement of differences.”

Another issue on which bargaining takes place is seniority, but in India,it is of less importance than
in western countries. But, in India, lay- off, retrenchment, dismissal, rationalisation and participation
in the union activities have been important issues for collective bargaining. Regarding bargaining
on hours of work, it has recognized that “in one form or another subject of working time will
continue to play an important part in collective bargaining; although the crucial battles may be well
fought in the legislative halls.”

Overtime work, holidays, leave for absence and retirement continue to be issues for bargaining in
India, although they are not regarded as crucial. The union security has also been an issue for
collective bargaining, but it could not acquire much importance in the country, although stray
instances are found. The Tata Workers union bargained with M/s Tata Iron and Steel Co. Ltd.,
Jamshedpur, on certain issues, one of which was union security and in the resulting agreement
some of the union security clauses were also included.

The production norms, technical practices, details of working rules, standards of performance,
allowance of fatigue, hiring and firing, protection of life and limb, compensation for overtime, hours
of work, wage rates and methods of wage payments, recognition of unions, retrenchment, union
security, holidays and competence of workmen form the subjects of negotiations and agreements
through collective bargaining. Customary practices are evolving procedures to extend the area of
collective bargaining. Collective bargaining has been giving official sanction to trade experiences
and agreements.

Collective bargaining, thus, covers the negotiation, administration, interpretation, application and
enforcement of written agreement between employers and unions representing their employees
setting forth joint understanding, as to policies and procedures governing wages, rates of pay,
hours of work and other conditions of employment.

Collective Bargaining in the Post- Independence Period: Before Independence, the collective
bargaining as it was known and practised was virtually unknown in India. It was accepted, as a
matter of principle, for usage in union management relations by the state. Though it was
emphasised in the First Five Year Plan that the State would encourage mutual settlement,collective
bargaining and voluntary arbitration; to the utmost extent and thereby reduce number of
intervention of the state in union management relations. However, because of the imperatives of
political and economic factors, the State was not prepared to encourage voluntary arbitrations and
negotiations and the resulting show of strength by the parties. The State, therefore, armed itself
with the legal powers which enabled it to refer disputes to an arbitrator or an adjudicator if the two
parties fail to reach a mutually acceptable agreement.

This move of compulsory arbitration and adjudication was opposed by several labour leaders
because they believed that this would destroy the picture of industrial relations in India. Dr. V.V.
Giri expressed his views on this point at the Indian Labour Conference in 1952, “Compulsory
arbitration” he declared, “has cut at the very root of trade union organisation…If the workers find
that their interests are best promoted only by combining, no greater urge is needed to forge a band
of strength and unity among them. But compulsory arbitration sees to it that such a band is not
forged… It stands there is a policeman looking out for signs of discontent, and at the slightest
provocation, takes the parties to the court for a dose of costly and not wholly satisfactory justice.”
808
Despite this controversy, collective bargaining was introduced in India for the first time in 1952,
and it gradually gained importance in the following years. The information, however, on the growth
of collective bargaining process is very meager, and the progress made in this respecthas not been
very conspicuous, though not negligible. The data released by the Labour Bureau show that the
practice of determining the rates of wages and conditions of employment has spread to most of
the major segments of the national economy.

A sample, study covering the period from 1956 to 1960 conducted by the Employer’s Federation of
India has revealed that collective bargaining agreements have been arrived in respect of disputes
ranging from 32 to 49 percent. Most of the collective bargaining agreements have been entered
into at plant level. In this connection, the National Commission on Labour has thrown ample light
on the progress of collective agreement. In its own words, “Most of the collective bargaining
(agreements) has been at the plant level, though in important textile centres like Bombay and
Ahmedabad industry level agreements have been (fairly) common… Such agreements are also to
be found in the plantation industry in the South, and in Assam, and in the coal industry. Apart from
these, in new industries—chemicals, petroleum, oil refining and distribution, aluminium and
electrical equipment, automobile repairing—the arrangement for the settlement of disputes
through voluntary agreements have become common in recent years. In the ports and docks,
collective agreements have been the role at individual centres. On certain matters affecting all the
ports, all India agreements have been reached. In the banking industry, after the series of awards,
employers and unions have, in recent years, come closer to reach collective agreements. In the Life
Insurance Corporation (LIC) with the exception of the Employer’s decision to introduce automation
which has disturbed industrial harmony in some centres, there has been a fair measure of
discussion across the table by the parties for the settlementof disputes.”

The collective bargaining reached has been of three types:

(1) Agreement arrived at after voluntary direct negotiations between the parties concerned. Its
implementation is purely voluntary;

(2) Agreements between the two parties, though voluntary in nature, are compulsory when
registered as settlement before a conciliator; and

(3) Agreement which have legal status negotiated after successful discussion between the parties
whenthe matter of dispute is under reference to industrial tribunal/courts.

Many agreements are made voluntarily but compulsory agreements are not negligible. However,
collective bargaining and voluntary agreements are not as prominent as they are in other
industrially advanced countries. The practice of collective bargaining in India has shown much
improvement after the passing of some legislation like The Industrial Disputes Act 1947 as
amended from time to time. The Bombay Industrial Relations Act 1946 which provided for the
rights of workers for collective [Link] then, a number of collectivebargaining agreements
have beenentered into.

Issues Involved in CollectiveAgreements:

A study conducted by the Employer’s Federation of India revealed that out of 109 agreements,
‘wages’ was the most prominent issue in 96 cases (88percent) followed by dearness allowance (59
cases) retirement benefits (53 cases), bonus (50 cases) other issues involved were annual leave,
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paid holidays, casual leave, job classification, overtime, incentives, shift allowance, acting
allowance, tiffin allowance, canteen and medical benefits. A study of various collective agreements
entered into in India,certain trends in collective bargaining are noticeable.

These are:
(i) Most of the agreements are at plant level. However, some industry- level agreements are also
there;

(ii) The scope of agreements has been widening now and now includes matters relating to bonus,
productivity, modernisation, standing orders, voluntary arbitration, incentive schemes, and
job evaluation;
(iii) Long term agreements ranging between 2 to 5 years, are on increase;

(iv) Joint consultation in various forms has been provided for in a number of agreements; and
feasibleand effective.

Reasons for the Growth ofCollective Bargaining:

The growth of collective bargaining in India may beattributed to the following factors:
(1) Statutory Provisions:
Which have laid down certain principles of negotiations, procedure for collective agreements
and the character of representation of the negotiating parties?

(2) Voluntary Measures:

Such as tripartite conferences, joint consultative boards, and industrial committees at the
industry level haveprovided an ingenious mechanism for the promotion of collective bargaining
practices.

(3) Several GovernmentsMeasures:

Like schemes for workers’ education, labour participation in management, the evolution of the
code of Inter- union Harmony, the code of Efficiency and Welfare, the Code of Discipline, the
formation of Joint Management Councils, Workers Committees and Shop Councils, and the
formulations of grievances redressal procedure at the plant level— have encouraged the
collectivebargaining.

(4) Amendments to the Industrial Disputes Act:

The Amendments to the Industrial Disputes Act in 1964 provided for the termination of an
award or a settlement only when a proper notice is given by the majority of workers.
Agreements or settlements which are arrived at by a process of negotiation on conciliation
cannot be terminatedby a section of the workers.

(5) Industrial Truce Resolution: The Industrial Truce Resolution of 1962 has also influenced the
growth of collective bargaining. It provides that the management and the workers should
strive for constructive cooperation in all possible ways and throws responsibility on them to
resolve their differences through mutual discussion, conciliation and voluntary arbitration
peacefully.

Government Policy toEncourage Collective Bargaining:

Ever since independence, it has been the declared policy of the Central Government to encourage
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trade unions development and the settlement of differences in industry by mutual agreement.
Article 19 of the constitution guarantees for all citizens the right to form associations or unions,
only by reserving to the state powers in the interest of public order to impose reasonable
restrictions on the exercise of this right. The Industrial policy Resolution of 1956 declared that, “in
a socialist democracy labour is a partner in the common task of development”, thus following out
the resolution of the Lok Sabha of 1954 which set India on the path towards a “‘socialistic pattern
of society.”
The Second Five Year Plan in1956 was more specific and declared:
“For the development of an undertaking or an industry, industrial peace is indispensable; obviously,
this can best be achieved by the parties themselves. Labour legislation and the enforcement
machinery set up for its implementation can only provide a suitable framework in which employees
and workers can function.”

Has Government DiscouragedCollective Bargaining?

It is obvious, that the declared policy of the government laid emphasis on the voluntary settlement
of differences in industry. But industrial legislation since independence and government
intervention to establish various standards of working conditions and machinery for compulsory
arbitration of disputes have limited the scope of collective bargaining. The areas that are covered
by labour legislation are mainly physical working conditions and terms of employment, and to the
extent that these are prescribed by law the scopeof collective bargaining is limited.

The Industrial Employment (Standing Order) Act, 1948 makes compulsory the drawing up
conditions of employment relating to methods of paying wages, hours of work, over time, shifts,
holidays, termination of employment and disciplinary action, but not through joint negotiation.
There is no statutory requirement that employer should discuss the draft standing orders with the
union. The Minimum Wages Act, also passed in 1948, has given statutory power to appropriate
government to fix minimum wages in certain scheduled employments. The object of this
legislation was to secure a minimum in those occupations or industries where the worker were not
sufficiently organised to be able to negotiate reasonable wages for themselves. If the government
was committed to support the principle of collective bargaining, why no attempt was made to
encourage it by legislation? The Trade Union Amendment Act, passed in 1947, did not in fact
provide for the compulsory recognition by the employers of representative trade unions, but thisact
was never notified and so never came into force.

It is arguable that some legislative action to compel recognition of the more stable unions might
have helped to create a better climate for encouragement of voluntary settlement in industry. The
attitude of the management and unions was commonly “Let the issue go to the tribunal”, with the
result that little real effort was made towards mutual settlement and conciliation officers found
little response to their efforts at meditation. References to the adjudication piled up, the industrial
tribunals were overwhelmed with cases, and lengthy delays and general frustration resulted. From
the above facts, it looks that the Government has discouraged the Development of Collective
Bargaining in India. But the truth is that, the Government intention has never been to discourage it.
In fact, the labour in India is not very well organised and it is not expected that it would be able to
get its due share through collective bargaining.

Hence, the government has tried to protect in the interests of labour by passing the various acts
such as the Factory Act of 1948. Employees State Insurance Act, 1948 and Minimum Wages Act.
Hence, the cases involving industrial disputes should be to compulsory arbitration. Khandubhai
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Desai, the then Labour Minister, stated in July 1956 that voluntary agreement to refer questions to
arbitration was the best solution. But he added complete laissez-faire is out of date. Society
cannot allow workers or management to follow the law of jungle. Therefore, as a last resort, the
government has taken powers to refer disputes to adjudication. It has, further, been argued that in
a planned economy, the relations between the labour and management have also to be on planned
basis.

They cannot be allowed to upset the production target just because one of the parties would not
like to settle thedisputes in fair manner.

Therefore, the Government of India under Industrial Disputes Act 1947 has created the following
seven different
authorities for the preventionand settlement of disputes:
1. Workers Committees.
2. Conciliation Officer.
3. Board of Conciliation.
4. Court of Enquiry.
5. Labour Courts.
6. Industrial Tribunals.
7. National Tribunals.

The important characteristic of the above machinery for the prevention and settlement of disputes
is that, there is full scope for the settlement of dispute through collective bargaining and if it is not
settled by Works Committees, Conciliation Officer, Board of Conciliation, only then, it is referred to
Court of Enquiry and Labour Courts. The decision of the Labour Courts, Industrial Tribunal and
National Tribunal is binding on both the parties.

Advantages of CollectiveBargaining:
Perhaps the biggest advantage of this system is that, by reaching a formal agreement, both sides
come to know exactly what to expect from each other and are aware of the rights they have. This
can decrease the number of conflicts that happen later on. It also can make operations more
efficient. Employees who enter collective bargaining know they have some degree of protection
from employer retaliation or being let go from the job. If the employer were dealing with just a
handful of individuals, he might be able to afford to lose them. When he is dealing with the entire
workforce, however, operations are at risk and he no longer can easily turn a deaf ear to what his
employees are saying. Even though employers might need to back down a little, this strategy gives
them the benefit of being able to deal with just a small number of people at a time.

This is very practical in larger companies where the employer might have dozens, hundreds or
even thousands of workers on his payroll. Working with just a few representatives also can make
the issues at hand seem more personal. Agreements reached through these negotiations usually
cover a period of at least a few years. People therefore have some consistency in their work
environment and policies. This typically benefits the company’s finance department because it
knows that fewer items related to the budget might change. On a broad scale, using this method
well can result in more ethical way of doing business. It promotes ideas such as fairness and
equality, for example. These concepts can spill over into other areas of a person’s life, inspiring
better general behaviortowards others.

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Disadvantages of CollectiveBargaining:
A major drawback to using this type of negotiation system is that, even though everyone gets a say
in what happens, ultimately, the majority rules, with only a few people determining what happens
too many. This means that a large number of people, particularly in the general workforce, can be
overshadowed and feel like their opinion doesn’t really matter. In the worst case scenario, this can
cause severe division and hostility in the group. Secondly, it always requires at least two parties.
Even though the system is supposed to pull both parties together, during the process of trying to
reach an agreement, people can adopt us-versus-them mentality. When the negotiations are over,
this way of looking at each other can be hard to set aside, and unity in the company can suffer.
Collective bargaining can also be costly, both in terms of time and money. Representatives have to
discuss everything twice—once at the small representative meetings, and again when they relay
information tothe larger group. Paying outside arbitrators or other professionals quickly can run up
a fairly big bill, and when someone else is brought in, things often get slower and more complex
because even more people are involved. Some people point out that these techniques have a
tendency to restrict the power of employers. Employees often see this as a goodthing, but from the
company’s perspective, it can make even basic processes difficult. It can make it a challenge to
deal with individual workers, for example. The goal of the system is always to reach a collaborative
agreement, but sometimes tensions boil over. As a result, one or both parties might feel they have
no choice but to muscle theother side into giving up.

Workers might do this by going on strike, which hurts operations and cuts into profits. Businesses
might do this by staging lockouts, which prevents members’ of the workforce from doing their jobs
and getting paid, negatively effecting income and overall quality of living. Lastly, union dues are
sometimes an issue. They reduce the amount of take-home pay a person has, because they usually
are deducted right from his paycheck. When things are good in a company and people don’t feel
like they’re getting anything from paying the dues, they usually become unhappier about the rates.
The idea of collective bargaining emerged as a result of industrial conflict and growth of trade
union movement and was first given currency in the United States by Samuel Crompers. In India
the first collective bargaining agreement was conducted in 1920 at the instance of Mahatma
Gandhi to regulate labour management relation between a group of employers and their workers in
the textile industry in Ahmadabad Is minimum wage law justified? Minimum wage law creates
issues like unemployment. Yet most countries of the world have minimumwage law.

The minimum wage law isjustified on the following grounds:

(i) First, the problem of unemployment that might erupt is slight exaggeration. Practically labour
supply is heterogeneous consisting of unskilled, skilled, highly specialized and educated labour.
All other categories of labour – other than unskilled and unorganized labour – are paid wages
much higher than the minimum wage fixed by the law. Therefore, the negative unemployment
effective of the minimum wage law is confined to the category of unskilled labour. Therefore,
the minimum wage law of protecting the interest of the weaker section of labour is not as high
as projected above.
(ii) Second, the negative employment effect that minimum wage law may create is moderated by
the positive employment effect of higher wage earnings. Higher wage incomes lead to higher
consumption. Increase in demand for consumer goods, increases demand for labour and also
open up new opportunities for employment. There is, therefore justification of minimum wage
law.
(iii) Third, Inflation erodes the real income and real wage. The existence of minimum wage law
provides an opportunity and need for upward revision of the wage rate.
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(iv) Fourth, one major purpose of the minimum wage law is to promote social equity through a
more equitable distribution of income.

Workers Participation inManagement : Definition, Characteristics and Objectives

Definition:
Like other behavioural terms, WPM means different things to different people depending upon
their objectives and expectations. Thus, WPM is an elastic concept. For example, for management
it is a joint consultation prior to decision making, for workers it means co- determination, for trade
unions It is the harbinger of a new order of social relationship and a new set of power equation
within organisations, while for government it is an association of labour with management without
the final authority or responsibility in decision making. Let us also go through some important
definitions of WPM. According to Keith Davis, “Workers’ participation refers to the mental and
emotional involvement of a person in a group situation which encourages him to contribute to
group goals and share in responsibility of achieving them”.

In the words of Mehtras “Applied to industry, the concept of participation means sharing the
decision-making power by the rank and file of an industrial organisation through their
representatives, at all the appropriate levels of management in the entire range of managerial
action”. A clear and more comprehensive definition of WPM is given by the International Labour
Organisation(ILO).

According to the ILO:

“Workers’ participation may, broadly be taken to cover all terms of association of workers and their
representatives with the decision- making process, ranging from exchange of information, con-
sultations, decisions and negotiations to more institutionalized forms such as the presence of
workers’ members on management or supervisory boards or even management by workers
themselves as practised in Yugoslavia”. In Yugoslavia, WPM is governed by the Law on Workers’
Management ofState Economic Enterprises and Higher Economic Association. The Act consists of
a three-tier participation structure: collective bargaining, workers’ council, and hoard of
management. In fact, the basic reason for differences in perception of WPM is mainly due to the
differential pattern of practices adopted by various countries while implementing workers’
participation in man- agement. For example, in Great Britain and Sweden, WPM is in the form of
Joint Consultation through Joint Consultative Committees, Works Committees in France, Co-
determination Committees in West Germany, Joint Work Council in Belgium, Workers’ Council and
Management Board in Yugoslaviaand Union Management Co- operation in USA.

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In India, WPM is in the form of, what we call Labour Management Cooperation and Workers’
Participation in Management. It is implemented through the agencies like Works Committees,
Joint Management Councils (JMCs) Shop Councils, Unit Councils and Joint Councils.
Notwithstanding, these different forms of WPM differ only in degree, not in nature. Be the
perceptual differences as these may, WPM is a system of communication and consultation, either
formal or informal, by which the workers of an organisation are kept informed, as and when
required, about the affairs of the undertaking and through which they express their opinion and
contribute to decision- making process of management.

Characteristics:
The following are the maincharacteristics of WPM:
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1. Participation implies practices which increase the scope for employees’ share of influence in
decision-making process with theassumption of responsibility.

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2. Participation presupposes willingacceptance of responsibility by workers.
3. Workers participate in management not as individuals but as a group through their
representatives.

4. Worker’s participation in management differs from collective bargaining in the sense that while
theformer is based on mutual trust, information sharing and mutual problem solving; the latter is
essentially based on power play, pressure tactics, and negotiations.

5. The basic rationale tor worker’s participation in management is that workers invest their Iabour
and their fates to their place of work. Thus, they contribute to the outcomes of organization.
Hence, they have a legitimate right to share in decision-making activities of organisation.

Objectives:
The objectives of WPM are closely netted to the ration-able for WPM. Accordingly, the objectives
of WPM vary from country to country depending on their levels of socio- economic development
political philosophies, industrial relations scenes, and attitude of the working class. To quote, the
objective of WPM is to co-determine at the various levels of enterprises in Germany, assign the
final to workers over all matters relating to an undertaking in Yugoslavia, promote good
communication and understanding between labour and management on the issues of business
administration and production in Japan, and enable work-force to influence the working of
industries in China, for example. In India the objective of the government in advocating for workers’
participation in management, as stated in the Industrial Policy Resolution 1956, is a part of its
overall endeavour to create a socialist society, wherein thesharing of a part of the managerial
powers by workers is considerednecessary.

The objective of WPM, as envisaged in the Second Five Year Plan of India is to ensure:
1. Increase in productivity for the benefit of all concerned to an enterprise, i.e., the employer, the
employees and the community atlarge.

2. Satisfaction of worker’s urge forself-expression in the matters of enterprise management.

3 Making employees better understood of their roles in theorganisation.

In ultimate sense, the objective of WPM in India is to achieve organizational effectiveness and
thesatisfaction of the employees.

Accordingly, the objectives ofWPM in India are to:

1. Promote mutual understanding between management and workers,i.e., industrial harmony.
2. Establish and encourage good communication system at all levels.
3. Create and promote a sense ofbelongingness among workers.
4. Help handle resistance to change.
5. Induce a sense among workers to contribute their best for the cause oforganisation.

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6. Create a sense of commitment to decisions to which they were a party.
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 Levels of Participation: Having known the objectives of WPM, the question then is to whatextent
workers can participate in decision-making process. In other words, it is important to know the
extents/levels of co-determination inan organisation.

Viewed from this angle, Mehtras has suggested five levels of workers’ participation ranging from
the minimum to the maximum. Since these levels of workers’ influence the process and quality of
decision making in an organisation. We are therefore highlighting here these levels briefly ranking
them from the minimum to the maximum level of participation.

Informative Participation:
This refers to management’s information sharing with workers on such items those are concerned
with workers. Balance Sheet, production, economic conditions of the plant etc.,are the examples of
such items. It is important to note that here workers have no right of close scrutiny of the
information provided and management has its prerogative to make decisions on issues concerned
with workers.

Consultative Participation:
In this type of participation, workers are consulted in those matters which relate to them. Here, the
role of workers is restricted to give their views only. However the acceptance and non-acceptance
of these views depends on management. Nonetheless, it provides an opportunity to the workers to
expresstheir views on matters involving theirinterest.

Associative Participation: Here, the role of the workers’ council is not just advisory unlike
consultative participation. In a way, this is an advanced and improved form of consultative
participation. Now, the management is under a moral obligation to acknowledge, accept and
implement the unanimous decision of the council.

Administrative Participation: In the administrative participation, decisions already taken are

implemented by the workers. Compared to the former three levels of participation, the degree of
sharingauthority and responsibility by the workers is definitely more in this participation.

Decisive Participation:
Here, the decisions are taken jointly by the management and the workersof an organisation. In fact,
this is the ultimate level of workers’ participation in management. Attitudes, Perception and
Personality Since organisations involve working with people, an understanding of individual
behaviour is important. The goals of studying individual behaviour in the context of organisations
is being able to explain, predict and influence behaviour so that in turn, organisations can be
managed better Six Important Employee Behaviours In order to understand what influences
employees to engage in certain behaviours, an understanding of the most common (and
important) behaviours is needed. In essence, we want to know what influences employees to
engage or disengage from:

1. Being productive (includes both efficient and effective)

2. Being at work, or absenteeism, which is also related to
3. Turnover, or how often employees are changed in the organisation
4. Organisational citizenship behaviour (behaviour that is not a job requirement but promotes an
effective workplace, like supporting another employee's work
5. Workplace misbehaviour

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[Link] job satisfaction. (Even though this is more of an attitude than it is a behaviour its still a
very important as it influences behaviour) Research has shown that these behaviours are affected
by attitudes, personality, perception and learning. Further explanation of these factors follows.
Attitudes ]An attitude is a person's disposition or feeling about a person or object that is usually
expressed in a person's behaviour. It is made up of the following three components

1. Cognitive Component- the knowledge, belief or opinion a person has towards something
2. Affective Component- the emotion or feeling a person has towards something
3. Behavioural Component- the intention to behave in a certain way towards something

Note: when we refer to "attitudes" we usually refer to the affective component.'

In the organisational context, managers are usually only concerened with job related attitudes, the
most important of which are job satisfaction, jobinvolvement, organisational commitment and
employee engagement.

Job Satisfaction
Job satisfaction is an employee's general attitude towards their job. It is very closely related to the
worker's productivity, turnover, absenteeism as well as customer satisfaction. In general, high job
satisfaction translates into more effective and efficient workers, lower turnover, absenteeism and
workplace misbehaviour, and high customer satisfaction and citizenship behaviour.

Job Involvement and Organisational Commitment

Job involvement is the degree to which employees actively participate in the job while
organisational commitment refers to the degree to which employees identify with an
organisation's goals and want to maintain their membership with it. Organisational commitment is
split into three categories:

1. AffectiveCommitment- the emotional commitment to the organisation

2. Continuance Commitment- the commitment that stems from high costs in changing to another
organisation (financial or social)
3. Normative Commitment- the commitment that stems from persons feeling that they should stay
(for example staying because they "owe" it to their employer who has been responsible for their
wellbeing) Quite intuitively, high job satisfaction usually means high job involvement and
commitment.
Note: In order to increase productivity, managers can choose to increase any of these attitudes,
but research shows that increasing organisational commitment has the
most success.

Cognitive Dissonance Theory

Unfortunately, knowing an employees attitudes does not necessarily translate into being able to
predict their actions accurately. This can partly be explained by the cognitive dissonance theory.
The theory essentially says that individuals do not like internal conflicts between their attitudes
and behaviour or between two attitudes. The theory suggests that depending on the conflict,
stress levels increase and as a result individuals try to decrease these conflicts by changing the
attitudes or behaviours.
The pressure, or need to decrease this imbalance is based on:

817
 1. The importance of the factors creating the imbalance
2. The influence individuals have on these factors and
3. Th rewards they get from correcting the imbalance
The importance of the theory is that it helps predict how likely it is that employees will change their
attitudes or behaviours to suit a situation.

Personality
Personality is the unique combination of emotional, thought and behavioural patterns a person
holds. Describing a personality in terms of aggression, introvertness, ambition, loyalty etc is
categorising based on personality traits. These traits are classified in many personality theories,
most notably the Myers-Briggs Type Indicator and The Big Five Model.

Myers-Briggs Type Indicator (MBTI)

The Myers-Briggs Type Indicator is an approach to classifying personality traits which consists of
more than a hundred questions, the answers to which help classify individuals under four main
categories which are:
1. Social Interaction- Introvert or Extrovert: A measure of how much a person is outgoing.
2. Preference for Gathering Data- Sensing or Intuitive: A measure of how much a person like new
problems or prefer ones that have an established way of solving them
3. Preference for Decision Making- Feeling or Thinking: A measure of how much a person uses
their emotions or intellect in day to day life.
4. Style of Making Decisions- Perceptive or Judgemental: A measure of a person's curiosity,
spontaneity, flexibility, adaptability or tolerance.

Combining these four personality preferences together yields descriptions of sixteen different
possible personality types. Understanding these types enables clearer understanding of
individuals' preferences and by extension predicting their behaviour. Having said that though, the
MBTI lacks the ability to predict whether an employee will
be effective or not.

The Big Five Model

The Big Five Model explains that there are five basic personality dimensions that underlie all
others. These personality traits are:

1. Extroversion- The degree to which a person is sociable, talkative, assertive and comfortable in
relationships
2. Agreeableness- The degree to which a person is good-natured, cooperative and trusting
3. Conscientiousness- The degree to which a person is responsible, dependable, persistent and
achievement orientated
4. Emotional Stability- The degree to which a person is calm, enthusiastic and secure, nervous,
depressed and insecure
5. Openness to Experience- The degree to which a person has a wide range of interests, is
imaginative, fascinated with novelty and intellectual Research has shown that specific
combinations of these personality traits are highly linked to achievement in specific jobs.

Additional Personality Dimensions

Other important personality dimensions that are not
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included in the MBTI and Big Five Model are:
▪ Locus of Control- The degree to which a person believes that what happens to them
is out of their control
▪ Machiavelianism- The extent to which a person maintains emotional distance and is able to
manipulate power
▪ Self Esteem- The degree to which people like themselves
▪ Self Monitoring- The ability to adjust ones behaviour to suit external situations
▪ Risk Taking- The extent to which a person is willing to take chances Like the Big Five Model, these
personality dimensions often give a good indication of whether a person will achieve in a specific
job.

Perception
Perception is a process by which individuals interpret their sensory impressions in order to give
meaning to their environment. In other words, people might see the same thing but interpret it
differently. This interpretation is due to their individual perception. There are many reasons as to
why this happens, but in general perceptions differ due to the observer's individual personality and
context, the target being observed and the situation in which the perception takes place. On an
organisational level, managers are interested in why people perceive different people the way they
do. This has led to the emergence of attribution theory.

Attribution Theory
Attribution theory tries to explain why individuals perceive others the way they do. The theory
suggests that these perceptions are based on the meaning individuals give to others' actions. The
theory suggests that the meaning given is in turn based on the nature of the action. Actions can be
classified in terms of their:

1. Distinctiveness- is the behaviour unusual for that person?

2. Consistency- Does it happen often?
3. Consensus- Does the action deviate from other peoples' actions who are in the same position?

Shortcuts to Judgement
In general, judgements are not specifically made by those categories mentioned above. Instead
judgements are made through the following shortcuts:
Assumed similarity- the assumption that everyone is similar to oneself and wants the same
things
Stereotyping- the assumption that a person follows an attribute or behaviour because they are
part of a group Halo effect- an immediate impression of someone based on a single
characteristic Learning Learning is any relatively permanent change in behaviour that occurs as
a result of experience. There are two basic theories as to how people learn. They are:

1. Operant Conditioning- Argues that behaviour is a function of its consequences. That is people
learn to behave in certain ways to gain something they want or to avoid something they don't want.
2. Social Learning- Argues that people learn by observing (or listening) to what happens to others.
Implications to Managers By understanding personalities, managers can match the right people
with the right job and as a result increase job satisfaction and by extension increase effectiveness
and efficiency. In addition managers need to recognise that employees react to perceptions, not
reality. That is, employers need to understand that the perception of a good work environment and
high wages is more important that actually having it recognised as the best by some industry
819
 standard. Lastly, managers need to recognise that employees learn on the job. whether it is work
related learning or learning how to get promoted makes no difference- they still learn and
managers need to try get them to learn the right lessons.

GROUP DYNAMICS
A group can be defined as several individuals who come together to accomplish a particular task
or goal. Group dynamics refers to the attitudinal and behavioral characteristics of a group. Group
dynamics concern how groups form, their structure and process, and how they function. Group
dynamics are relevant in both formal and informal groups of all types. In an organizational setting,
groups are a very common organizational entity and the study of groups and group dynamics is an
important area of study in organizational behavior. The following sections provide information
related to group dynamics. Specifically, the formation and development of groups is first
considered. Then some major types or classifications of groups are discussed. Then the structure
of groups is examined.

GROUP DEVELOPMENT
As applied to group development, group dynamics is concerned with why and how groups develop.
There are several theories as to why groups develop. A classic theory, developed by George
Homans, suggests that groups develop based on activities, interactions, and sentiments. Basically,
the theory means that when individuals share common activities, they will have more interaction
and will develop attitudes (positive or negative) toward each other. The major element in this theory
is the interaction of the individuals involved. Social exchange theory offers an alternative
explanation for group development. According to this theory, individuals form relationships based
on the implicit expectation of mutually beneficial exchanges based on trust and felt obligation.
Thus, a perception that exchange relationships will be positive is essential if individuals are to be
attracted to and affiliate with a group. Social identity theory offers another explanation for group
formation. Simply put, this theory suggests that individuals get a sense of identity and self-esteem
based upon their membership in salient groups.

The nature of the group may be demographically based, culturally based, or organizationally based.
Individuals are motivated to belong to and contribute to identity groups because of the sense of
belongingness and self-worth membership in the group imparts. Group dynamics as related to
development concerns not only why groups form but also how. The most common framework for
examining the "how" of group formation was developed by Bruce Tuckman in the 1960s. In
essence, the steps in group formation imply that groups do not usually perform at maximum
effectiveness when they are first established. They encounter several stages of development as
they strive to become productive and effective. Most groups experience the same developmental
stages with similar conflicts and resolutions. According to Tuckman's theory, there are five stages
of group development: forming, storming, norming, performing, and adjourning. During these
stages group members must address several issues and the way in which these issues are
resolved determines whether the group will succeed in accomplishing its tasks.

1. Forming. This stage is usually characterized by some confusion and uncertainty. The major
goals of the group have not been established. The nature of the task or leadership of the group
has not been determined (Luthans, 2005). Thus, forming is an orientation period when members
get to know one another and share expectations about the group. Members learn the purpose of
the group as well as the rules to be followed. The forming stage should not be rushed because
trust and openness must be developed. These feelings strengthen in later stages of
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 development. Individuals are often confused during this stage because roles are not clear and
there may not be a strong leader.
2. Storming. In this stage, the group is likely to see the highest level of disagreement and conflict.
Members often challenge group goals and struggle for power. Individuals often vie for the
leadership position during this stage of development. This can be a positive experience for all
groups if members can achieve cohesiveness through resolution. Members often voice concern
and criticism in this phase. If members are not able to resolve the conflict, then the group will
often disband or continue in existence but will remain ineffective and never advance to the other
stages.
3. Norming. This stage is characterized by the recognition of individual differences and shared
expectations. Hopefully, at this stage the group members will begin to develop a feeling of group
cohesion and identity. Cooperative effort should begin to yield results. Responsibilities are
divided among members and the group decides how it will evaluate progress.
4. Performing. Performing, occurs when the group has matured and attains a feeling of
cohesiveness. During this stage of development, individuals accept one another and conflict is
resolved through group discussion. Members of the group make decisions through a rational
process that is focused on relevant goals rather than emotional issues.
5. Adjourning. Not all groups experience this stage of development because it is characterized by
the disbandment of the group. Some groups are relatively permanent (Luthans, 2005). Reasons
that groups disband vary, with common reasons being the accomplishment of the task or
individuals deciding to go their own ways. Members of the group often experience feelings of
closure andsadness as they prepare to leave.

GROUP TYPES
One common way to classify group is by whether they are formal or informal in nature. Formal
work groups are established by an organization to achieve organizational goals. Formal groups
may take the form of commandgroups, task groups, and functional groups.

COMMAND GROUPS.
Command groups are specified by the organizational chart and often consist of a supervisor and
the subordinates that report to that supervisor. An example of a command group is an academic
department chairman and the faculty members in that department.

TASK GROUPS.
Task groups consist of people who work together to achieve a common task. Members are brought
together to accomplish a narrow range of goals within a specified time period. Task groups are
also commonly referred to as task forces. The organization appoints members and assigns the
goals and tasks to be accomplished. Examples of assigned tasks are the development of a new
product, the improvement of a production process, or the proposal of a motivational contest. Other
common task groups are ad hoc committees, project groups, and standing committees. Ad hoc
committees are temporary groups created to resolve a specific complaint or develop a process.
Project groups are similar to ad hoc committees and normally disband after the group completes
the assigned task. Standing committees are more permanent than ad hoc committees and project
groups. They maintainlonger life spans by rotating members into the group.

FUNCTIONAL GROUPS.
A functional group is created by the organization to accomplish specific goals within an
unspecified time frame. Functional groups remain in existence after achievement of current goals
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and objectives. Examples of functional groups would be a marketing department, a customer
service department, or an accounting department. In contrast to formal groups, informal groups are
formed naturally and in response to the common interests and shared values of individuals. They
are created for purposes other than the accomplishment of organizational goals and do not have a
specified time frame. Informal groups are not appointed by the organization and members can
invite others to join from time to time. Informal groups can have a strong influence in organizations
that can either be positive or negative. For example, employees who form an informal group can
either discuss how to improve a production process or how to create shortcuts that jeopardize
quality. Informal groups can take the form of interest groups, friendship groups, or reference
groups.

INTEREST GROUPS.
Interest groups usually continue over time and may last longer than general informal groups.
Members of interest groups may not be part of the same organizational department but they are
bound together by some other common interest. The goals and objectives of group interests are
specific to each group and may not be related to organizational goals and objectives. An example
of an interest group would be students who come together to form a study group for a specific
class.

FRIENDSHIP GROUPS.
Friendship groups are formed by members who enjoy similar social activities, political beliefs,
religious values, or other common bonds. Members enjoy each other's company and often meet
after work to participate in these activities. For example, a group of employees who form a
friendship group may have an exercise group, a softball team, or a potluck lunch once a month.

REFERENCE GROUPS.
A reference group is a type of group that people use to evaluate themselves. According to
Cherrington, the main purposes of reference groups are social validation and social comparison.
Social validation allows individuals to justify their attitudes and values while social comparison
helps individuals evaluate their own actions by comparing themselves to others. Reference groups
have a strong influence on members' behavior. By comparing themselves with other members,
individuals are able to assess whether their behavior is acceptable and whether their attitudes and
values are right or wrong. Reference groups are different from the previously discussed groups
because they may not actually meet or form voluntarily. For example, the reference group for a new
employee of an organization may be a group of employees that work in a different department or
even a different organization. Family, friends, and religious affiliations are strong reference groups
for most individuals.

GROUP STRUCTURE
Group structure is a pattern of relationships among members that hold the group together and help
it achieve assigned goals. Structure can be described in a variety of ways. Among the more
common considerations are group size, group roles, group norms, and group cohesiveness.

GROUP SIZE.
Group size can vary from 2 people to a very large number of people. Small groups of two to ten are
thought to be more effective because each member has ample opportunity to participate and
become actively involved in the group. Large groups may waste time by deciding on processes and
trying to decide who should participate next. Group size will affect not only participation but
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satisfaction as well. Evidence supports the notion that as the size of the group increases,
satisfaction increases up to a certain point. In other words, a group of six members has twice as
many opportunities for interaction and participation as a group of three people. Beyond 10 or 12
members, increasing the size of the group results in decreased satisfaction. It is increasingly
difficult for members of large groups to identify with one another and experience cohesion.

GROUP ROLES
In formal groups, roles are usually predetermined and assigned to members. Each role will have
specific responsibilities and duties. There are, however, emergent roles that develop naturally to
meet the needs of the groups. These emergent roles will often replace the assigned roles as
individuals begin to express themselves and become more assertive. Group roles can then be
classified into work roles, maintenance roles, and blocking roles. Work roles are task-oriented
activities that involve accomplishing the group's goals. They involve a variety of specific roles such
as initiator, informer, clarifier, summarizer, and reality tester. The initiator defines problems,
proposes action, and suggests procedures. The informer role involves finding facts and giving
advice or opinions. Clarifiers will interpret ideas, define terms, and clarify issues for the group.
Summarizers restate suggestions, offer decisions, and come to conclusions for the group. Finally,
reality testers analyze ideas and test the ideas in real situations. Maintenance roles are social-
emotional activities that help members maintain their involvement in the group and raise their
personal commitment to the group. The maintenance roles are harmonizer, gatekeeper, consensus
tester, encourager, and compromiser.

The harmonizer will reduce tension in the group, reconcile differences, and explore opportunities.
Gatekeepers often keep communication channels open and make suggestions that encourage
participation. The consensus tester will ask if the group is nearing a decision and test possible
conclusions. Encouragers are friendly, warm, and responsive to other group members. The last
maintenance role is the compromiser. This role involves modifying decisions, offering
compromises, and admitting errors. Blocking roles are activities that disrupt the group. They make
take the form of dominating discussions, verbally attacking other group members, and distracting
the group with trivial information or unnecessary humor. Often times the blocking behavior may
not be intended as negative. Sometimes a member may share a joke in order to break the tension,
or may question a decision in order to force group members to rethink the issue. The blocking
roles are aggressor, blocker, dominator, comedian, and avoidance behavior. The aggressor
criticizes members' values and makes jokes in a sarcastic or semi-concealed manner. Blockers
will stubbornly resist the group's ideas, disagree with group members for personal reasons, and
will have hidden agendas. The dominator role attempts to control conversations by patronizing
others.

They often interrupt others and assert authority in order to manipulate members. Comedians often
abandon the group even though they may physically still be a part. They are attention-getters in
ways that are not relevant to the accomplishment of the group's objectives. The last blocking role,
avoidance behavior, involves pursuing goals not related to the group and changing the subject to
avoid commitment to the group. Role ambiguity concerns the discrepancy between the sent role
and the received role, as shown in Exhibit 1. Supervisors, directors, or other group leaders often
send (assign) roles to group members in formal groups. Group members receive roles by being
ready and willing to undertake the tasks associated with that role. Ambiguity results when
members are confused about the delegation of job responsibilities. This confusion may occur
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because the members do not have specific job descriptions or because the instructions regarding
the task were not clear. Group members who experience ambiguity often have feelings of
frustration and dissatisfaction, which ultimately lead to turnover. Role conflict occurs when there is
inconsistency between the perceived role and role behavior. There are several different forms of
role conflict. Interrole conflict occurs when there is conflict between the different roles that people
have. For example, work roles and family roles often compete with one another and cause conflict.
Intrarole conflict occurs when individuals must handle conflicting demands from different sources
while performing the tasks associated with thesame role.

GROUP NORMS.
Norms are acceptable standards of behavior within a group that are shared by the members of the
group. Norms define the boundaries of acceptable and unacceptable behavior. They are typically
created in order to facilitate group survival, make behavior more predictable, avoid embarrassing
situations, and express the values of the group. Each group will establish its own set of norms that
might determine anything from the appropriate dress to how many comments to make in a
meeting. Groups exert pressure on members to force them to conform to the group's standards.
The norms often reflect the level of commitment, motivation, and performance of the group.
Performance norms determine how quickly members should work and how much they should
produce. They are created in an effort to determine levels of individual effort. They can be very
frustrating to managers because they are not always in line with the organization's goals.
Members of a group may have the skill and ability to perform at higher levels but they don't
because of the group's performance norms. For example, workers may stop working a production
machine at 20 minutes before quitting time in order to wash up, even though they produced fewer
items that day than management intended.

Reward-allocation norms determine how rewards are bestowed upon group members. For
example, the norm of equality dictates equal treatment of all members. Every member shares
equally so rewards are distributed equally to everyone. Equity norms suggest that rewards are
distributed according to the member's contribution. In other words, members who contribute the
most receive the largest share of the rewards. Members may contribute through effort, skill, or
ability. Social responsibility norms reward on the basis of need. Members who have special needs
therefore receive the largest share of the reward. The majority of the group must agree that the
norms are appropriate in order for the behavior to be accepted. There must also be a shared
understanding

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Exhibit 1
Role Ambiguity and Role Conflict
that the group supports the norms. It should be noted, however, that members might violate group
norms from time to time. If the majority of members do not adhere to the norms, then they will
eventually change and will no longer serve as a standard for evaluating behavior. Group members
who do not conform to the norms will be punished by being excluded, ignored, or asked to leave the
group.

GROUP COHESIVENESS.
Cohesiveness refers to the bonding of group members and their desire to remain part of the group.
Many factors influence the amount of group cohesiveness. Generally speaking, the more difficult it
is to obtain group membership the more cohesive the group. Groups also tend to become
cohesive when they are in intense competition with other groups or face a serious external threat to
survival. Smaller groups and those who spend considerable time together also tend to be more
cohesive. Cohesiveness in work groups has many positive effects, including worker satisfaction,
low turnover and absenteeism, and higher productivity. However, highly cohesive groups may be
detrimental to organizational performance if their goals are misaligned with organizational goals.
Highly cohesive groups may also be more vulnerable to groupthink. Groupthink occurs when
members of a group exert pressure on each other to come to a consensus in decision making.
Groupthink results in careless judgments, unrealistic appraisals of alternative courses of action,
and a lack of reality testing. It can lead to a number of decision-making issues such as the
following:

1. Incomplete assessments of theproblem,

2. Incomplete information search,
3. Bias in processing information,
4. Inadequate development of alternatives, and
5. Failure to examine the risks of thepreferred choice.

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Evidence suggests that groups typically outperform individuals when the tasks involved require a
variety of skills, experience, and decision making. Groups are often more flexible and can quickly
assemble, achieve goals, and disband or move on to another set of objectives. Many organizations
have found that groups have many motivational aspects as well. Group members are more likely
to participate in decision-making and problem- solving activities leading to empowerment and
increased productivity. Groups complete most of the work in an organization; thus, the
effectiveness of the organization is limited by the effectiveness of its Power and Politics in
Organizational Life here are few business activitiesoups.
more prone to a credibility gap than the way in
which executives approach organizational life. A sense of disbelief occurs when managers purport
to make decisions in rationalistic terms while most observers and participants know that
personalities and politics play a significant if not an overriding role. Where does the error lie? In the
theory which insists that decisions should be rationalistic and nonpersonal? Or in the practice
which treats business organizations as political structures?

Whatever else organizations may be (problem- solving instruments, sociotechnical systems,

reward systems, and so on), they are political structures. This means that organizations operate by
distributing authority and setting a stage for the exercise of power. It is no wonder, therefore, that
individuals who are highly motivated to secure and use power find a familiar and hospitable
environment in business. At the same time, executives are reluctant to acknowledge the place of
power both in individual motivation and in organizational relationships. Somehow, power and
politics are dirty words. And in linking these words to the play of personalities in organizations,
some managers withdraw into the safety of organizational logics. As I shall suggest in this article,
frank recognition of the importance of personality factors and a sensitive use of the strengths and
limitations of people in decisions on power distributions can improve the quality of organizational
life.

Political Pyramid
Organizations provide a power base for individuals. From a purely economic standpoint,
organizations exist to create a surplus of income over costs by meeting needs in the marketplace.
But organizations also are political structures which provide opportunities for people to develop
careers and therefore provide platforms for the expression of individual interests and motives. The
development of careers, particularly at high managerial and professional levels, depends on
accumulation of power as the vehicle for transforming individual interests into activities which
influence other people.

Scarcity & competition

A political pyramid exists when people compete for power in an economy of scarcity. In other
words, people cannot get the power they want just for the asking. Instead, they have to enter into
the decisions on how to distribute authority in a particular formal organization structure. Scarcity
of power arises under two sets of conditions:
1. Where individuals gain power in absolute terms at someone else’s expense.
2. Where there is a gain comparatively—not literally at someone else’s expense—resulting in a
relative shift in the distribution of power.

In either case, the psychology of scarcity and comparison takes over. The human being tends to
make comparisons as a basis for his sense of self- esteem. He may compare himself with other
people and decide that his absolute loss or the shift in proportional shares of authority reflects an
826
attrition in his power base. He may also compare his position relative to others against a personal
standard and feel a sense of loss. This tendency to compare is deeply ingrained in people,
especially since they experience early in life the effects of comparisons in the family where—in an
absolute sense—time and attention, if not love and affection, go to the most dependent member.

Corporate acquisitions and mergers illustrate the effects of both types of comparisons. In the case
of one merger, the president of the acquired company resigned rather than accept the relative
displacement in rank which occurred when he no longer could act as a chief executive officer. Two
vice presidents vied for the position of executive vice president. Because of their conflicting
ambitions, the expedient of making them equals drove the competition underground, but not for
long. The vice president with the weaker power base soon resigned in the face of his inability to
consolidate a workable definition of his responsibilities. His departure resulted in increased power
for the remaining vice president and the gradual eliminnation of “rival camps” which had been
covertly identified with the main contenders for power.

The fact that organizations are pyramids produces a scarcity of positions the higher one moves in
the hierarchy. This scarcity, coupled with inequalities, certainly needs to be recognized. While it
may be humane and socially desirable to say that people are different rather than unequal in their
potential, nevertheless executive talent is in short supply. The end result should be to move the
more able people into the top positions and to accord them the pay, responsibility, and authority to
match their potential. On the other side, the strong desires of equally able people for the few top
positions available means that someone will either have to face the realization of unfulfilled
ambition or have to shift his interest to another organization.1

Constituents & clients

Besides the conditions of scarcity and competition, politics in organizations grows out of the
existence of constituencies. A superior may be content himself with shifts in the allocation of
resources and consequently power, but he represents subordinates who, for their own reasons,
may be unhappy with the changes. These subordinates affirm and support their boss. They can
also withdraw affirmation and support, and consequently isolate the superior with all the painful
consequences this entails. While appointments to positions come from above, affirmation of
position comes from below. The only difference between party and organizational politics is in the
subtlety of the voting procedure. Consider:

• In a large consumer products corporation, one division received almost no capital funds for
expansion while another division, which had developed a new marketing approach for products
common to both, expanded dramatically. The head of the static division found his power
diminished considerably, as reflected in how seriously his subordinates took his efforts at
influence (e.g., in programs to increase the profit return from existing volume).

He initiated one program after another with little support from subordinates because he could not
make a claim for capital funds. The flow of capital funds in this corporation provided a measure of
power gains and losses in both an absolute and a relative sense.

Power & action

Still another factor which heightens the competition for power that is characteristic of all political
827
structures is the incessant need to use whatever power one possesses. Corporations have an
implicit “banking” system in power transactions. The initial “capitalization” which makes up an
individual’s power base consists of three elements:

1. The quantity of formal authority vested in his position relative to other positions.
2. The authority vested in his expertise and reputation for competence (a factor weighted by how
important the expertise is for the growth areas of the corporation as against the historically
stable areas of its business).
3. The attractiveness of his personality to others (a combination of respect for him as well as liking,
although these two sources of attraction are often in conflict).

This capitalization of power reflects the total esteem with which others regard the individual. By a
process which is still not too clear, the individual internalizes all of the sources of power capital in a
manner parallel to the way he develops a sense of self-esteem. The individual knows he has
power, assesses it realistically, and is willing to risk his personal esteem to influence others. A
critical element here is the risk in the uses of power. The individual must perform and get results. If
he fails to do either, an attrition occurs in his power base in direct proportion to the doubts other
people entertained in their earlier appraisals of him.

What occurs here is an erosion of confidence which ultimately leads the individual to doubt himself
and undermines the psychological work which led him in the first place to internalize authority as a
prelude to action. (While, as I have suggested, the psychological work that an individual goes
through to consolidate his esteem capital is a crucial aspect of power relations, I shall have to
reserve careful examination of this problem until a later date. The objective now is to examine
from a political framework the problems of organizational life.)

What distinguishes alterations in the authority structure from other types of organizational change
is their direct confrontation with the political character of corporate life. Such confrontations are
real manipulations of power as compared with the indirect approaches which play on ideologies
and attitudes. In the first case, the potency and reality of shifts in authority have an instantaneous
effect on what people do, how they interact, and how they think about themselves. In the second
case, the shifts in attitude are often based on the willingness of people to respond the way
authority figures want them to; ordinarily, however, these shifts in attitude are but temporary
expressions of compliance.

One of the most common errors executives make is to confuse compliance with commitment.
Compliance is an attitude of acceptance when a directive from an authority figure asks for a
change in an individual’ position, activities, or ideas. The individual complies or “goes along” usually
because he is indifferent to the scope of the directive and the changes it proposes. If compliance
occurs out of indifference, then one can predict little difficulty in translating the intent of directives
into actual implementation. Commitment, on the other hand, represents a strong motivation on the
part of an individual to adopt or resist the intent of a directive. If the individual commits himself to
a change, then he will use his ingenuity to interpret and implement the change in such a way as to
assure its success. If he decides to fight or block the change, the individual may act as if he
complies but reserve other times and places to negate the effects of directives. For example:

• In one large company, the top management met regularly for purposes of organizational
planning. The executives responsible for implementing planning decisions could usually be
828
counted on to carry them out when they had fought hard and openly in the course of reaching such
decisions. When they seemed to accept a decision, giving all signs of compliance, the decision
usually ended up as a notation in the minutes. Surface compliance occurred most frequently when
problems involved loyalties to subordinates.

In one instance, a division head agreed to accept a highly regarded executive from another division
to meet a serious manpower shortage in his organization. When the time came to effect the
transfer, however, this division general manager refused, with some justification, on the grounds
that bringing someone in from outside would demoralize his staff. He used compliance initially to
respond to the problem of “family” loyalties to which he felt committed. Needless to say, the
existence of these loyalties was the major problem to be faced in carrying out organizational
planning.

Compliance as a tactic to avoid changes and commitment as an expression of strong motivation

in dealing with organizational problems are in turn related to how individuals define their interests.
In the power relations among executives, the so-called areas of common interest are usually
reserved for the banalities of human relationships. The more significant areas of attention usually
force conflicts of interest, especially competition for power, to the surface.

Interest Conflicts
Organizations demand, on the one hand, cooperative endeavor and commitment to common
purposes. The realities of experience in organizations, on the other hand, show that conflicts of
interest exist among people who ultimately share a common fate and are supposed to work
together. What makes business more political and less ideological and rationalistic is the
overriding importance of conflicts of interest. If an individual (or group) is told that his job scope is
reduced in either absolute or proportional terms for the good of the corporation, he faces a conflict.
Should he acquiesce for the idea of common good or fight in the service of his self-interest? Any
rational man will fight (how constructively depends on the absence of neurotic conflicts and on ego
strength). His willingness to fight increases as he comes to realize the intangible nature of what
people think is good for the organization. And, in point of fact, his willingness may serve the
interests of corporate purpose by highlighting issues and stimulating careful thinking before the
reaching of final decisions.

Secondary effects
Conflicts of interest in the competition for resources are easily recognized, as for example, in
capital budgeting or in allocating money for research and development. But these conflicts can be
subjected to bargaining procedures which all parties to the competition validate by their
participation. The secondary effects of bargaining do involve organizational and power issues.
However, the fact that these power issues follow debate on economic problems rather than lead it
creates a manifest content which can be objectified much more readily than in areas where the
primary considerations are the distributions of authority.

In such cases, which include developing a new formal organization structure, management
succession, promotions, corporate mergers, and entry of new executives, the conflicts of interest
are severe and direct simply because there are no objective measures of right or wrong courses of
action. The critical question which has to be answered in specific actions is: Who gets power and
829
position? This involves particular people with their strengths and weaknesses and a specific
historical context in which actions are understood in symbolic as well as rational terms. To
illustrate:

A large corporation, General Motors in fact, inadvertently confirmed what every seasoned
executive knows: that coalitions of power to overcome feelings of rivalry and the play of personal
ambitions are fragile solutions. The appointment of Edward Cole to the presidency followed by
Semon Knudsen’s resignation shattered the illusion that the rational processes in business stand
apart or even dominate the human emotions and ties that bind men to one another. If any
corporation prides itself on rationality, General Motors is it. To have to experience so publicly the
inference that major corporate life, particularly at the executive levels, is not so rational after all,
can be damaging to the sense of security people get from belief in an idea as it is embodied in a
corporate image.

The fact that Knudsen subsequently was discharged from the presidency of Ford (an event I shall
discuss later in this article) suggests that personalities and the politics of corporations are less
aberrations and more conditions of life in large organizations. But just as General Motors wants to
maintain an image, many executives prefer to ignore what this illustration suggests: that
organizations are political structures which feed on the psychology of comparison. To know
something about the psychology of comparison takes us into the theory of self-esteem in both its
conscious manifestations and its unconscious origins. Besides possibly enlightening us in general
and giving a more realistic picture of people and organizations, there are some practical benefits in
such knowledge.
These benefits include:
• Increased freedom to act more directly; instead of trying to “get around” a problem, one can meet
it.
• Greater objectivity about people’s strengths and limitations, and, therefore, the ability to use them
more honestly as well as effectively.
• More effective planning in organizational design and in distribution of authority;
instead of searching for the “one best solution” in organization structure, one accepts a range of
alternatives and then gives priority to the personal or emotional concerns that inhibit action.

Power Relations
Organizational life within a political frame is a series of contradictions. It is an exercise in
rationality, but its energy comes from the ideas in the minds of power figures the content of which,
as well as their origins, are only dimly perceived. It deals with sources of authority and their
distribution; yet it depends in the first place on the existence of a balance of power in the hands of
an individual who initiates actions and gets results. It has many rituals associated with it, such as
participation, democratization, and the sharing of power; yet the real outcome is the consolidation
of power around a central figure to whom other individuals make emotional attachments.

Faulty coalitions
The formal organization structure implements a coalition among key executives. The forms differ,
and the psychological significance of various coalitions also differs. But no organization can
function without a consolidation of power in the relationship of a central figure with his select
group. The coalition need not exist between the chief executive and his immediate subordinates or
staff. It may indeed bypass the second level as in the case of Presidents of the United States who
830
do not build confident relationships within their cabinets, but instead rely on members of the
executive staff or on selected individuals outside the formal apparatus.

The failure to establish a coalition within the executive structure of an organization can result in
severe problems, such as paralysis in the form of inability to make decisions and to evaluate
performance, and in-fighting and overt rivalry within the executive group.

When a coalition fails to develop, the first place to look for causes is the chief executive and his
problems in creating confident relationships. The causes are many and complex, but they usually
hinge around the nature of the chief executive’s defenses and what he needs to avoid as a means
of alleviating stress. For example:
The “palace revolt,” which led to Semon Knudsen’s departure from Ford Motor Company, is
an illustration of the failure in the formation of a coalition. While it is true that Henry Ford II named
Knudsen president of the company, Knudsen’s ultimate power as a newcomer to an established
power structure depended on forming an alliance. The particular individual with whom an alliance
seemed crucial was Lee Iacocca. For some reason, Knudsen and Iacocca competed for power and
influence instead of using cooperatively a power base to which both contributed as is the case
with most workable coalitions. In the absence of a coalition, the alternate postures of rivalry and
battle for control erupted. Ford ultimately responded by weighing his power with one side over the
other.

Stress Management:
How to Reduce,Prevent, and Cope with Stress
It may seem that there’s nothing you can do about your stress level. The bills aren’t going to stop
coming, there will never be more hours in the day for all your errands, and your career or family
responsibilities will always be demanding. But you have a lot more control than you might think.
In fact, the simple realization that you’re in control of your life is the foundation of stress
management.

Managing stress is all about taking charge: taking charge of your thoughts, your emotions, your
schedule, your environment, and the way you deal with problems. The ultimate goal is a balanced
life, with time for work, relationships, relaxation, and fun – plus the resilience to hold up under
pressure and meet challenges head on. Identify the sources of stress in your life Stress
management starts with identifying the sources of stress in your life. This isn’t as easy as it
sounds. Your true sources of stress aren’t always obvious, and it’s all too easy to overlook your
own stress-inducing thoughts, feelings, and behaviors. Sure, you may know that you’re constantly
worried about work deadlines. But maybe it’s your procrastination, rather than the actual job
demands, that leads todeadline stress.

To identify your true sources of stress, look closely at your habits,attitude, and excuses:
• Do you explain away stress as temporary (“I just have a million things going on right now”) even
though you can’t remember the last time you took a breather?
• Do you define stress as an integral part of your work or home life (“Things are always crazy
around here”) or as a part of yourpersonality (“I have a lot of nervous energy, that’s all”).
• Do you blame your stress on other people or outside events, or view it as entirely normal and
unexceptional?

Until you accept responsibility for the role you play in creating or maintaining it, your stress level
831
will remain outside your control.

Start a stress journal

A stress journal can help you identify the regular stressors in your life and the way you deal with
them. Each time you feel stressed, keep track of it in your journal. As you keep a daily log, you will
begin to see patterns andcommon themes. Write down:
• What caused your stress (make aguess if you’re unsure).
• How you felt, both physically andemotionally.
• How you acted in response.
• What you did to make yourselffeel better.
Look at how you currently cope with stress Think about the ways you currently manage and cope
with stress in your life. Your stress journal can help you identify them. Are your coping strategies
healthy or unhealthy, helpful or unproductive? Unfortunately, many people cope with stress in
ways that compound the problem.

Unhealthy ways of coping withstress

These coping strategies may temporarily reduce stress, but they cause more damage in the long
run:

• Smoking
• Drinking too much
• Overeating or undereating
• Zoning out for hours in front ofthe TV or computer
• Withdrawing from friends,family, and activities
• Using pills or drugs to relax
• Sleeping too much
• Procrastinating
• Filling up every minute of theday to avoid facing problems
• Taking out your stress on others(lashing out, angry outbursts, physical violence)

Learning healthier ways tomanage stress

If your methods of coping with stress aren’t contributing to your greater emotional and physical
health, it’s time to find healthier ones. There are many healthy ways to manage and cope with
stress, but they all require change. You can either change the situation or change your reaction.
When deciding which option to choose, it’s helpful to think of the four As: avoid, alter, adapt, or
accept. Since everyone has a unique response to stress, there is no “one size fits all” solution to
managing it. No single method works for everyone or in every situation, so experiment with
different techniques and strategies. Focus on what makesyou feel calm and in control.

Dealing with Stressful Situations: The Four A’s

Change the situation:
• Avoid the stressor.
• Alter the stressor

Change your reaction:

• Adapt to the stressor.
• Accept the stressor.
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Stress management strategy #1: Avoid unnecessary stress Not all stress can be avoided, and it’s
not healthy to avoid a situation that needs to be addressed. You may be surprised, however, by
the number of stressors in your lifethat you can eliminate.

• Learn how to say “no” – Know your limits and stick to them. Whether in your personal or
professional life, refuse to accept added responsibilities when you’re close to reaching them.
Taking on more than you can handle is a surefire recipe for stress.
• Avoid people who stress you out – If someone consistently causes stress in your life and you
can’t turn the relationship around, limit the amount of time you spend withthat person or end the
relationshipentirely.
• Take control of your environment – If the evening news makes you anxious, turn the TV off. If
traffic’s got you tense, take a longer but less-traveled route. If going to the market is an
unpleasant chore, doyour grocery shopping online.
• Avoid hot-button topics – If you get upset over religion or politics, cross them off your
conversation list. If you repeatedly argue about the same subject with the same people, stop
bringing it up or excuse yourself when it’s the topicof discussion.
• Pare down your to-do list – Analyze your schedule, responsibilities, and daily tasks. If you’ve got
too much on your plate, distinguish between the “shoulds” and the “musts.” Drop tasks that
aren’t truly necessary to the bottom of the list or eliminate thementirely.
Stress management strategy #2: Alter the situation If you can’t avoid a stressful situation, try to
alter it. Figure out what you can do to change things so the problem doesn’t present itself in the
future. Often, this involves changing the way you communicate and operate in yourdaily life.

• Express your feelings instead of bottling them up. If something or someone is bothering you,
communicate your concerns in an open and respectful way. If you don’t voice your feelings,
resentment will build and the situation will likely remain the same.
• Be willing to compromise. When you ask someone to change their behavior, be willing to do
the same. If you both are willing to bend at least a little, you’ll have a good chance of finding a
happy middle ground.
• Be more assertive. Don’t take a backseat in your own life. Deal with problems head on, doing
your best to anticipate and prevent them. If you’ve got an exam to study for and your chatty
roommate just got home, say up front that you only have five minutes to talk.
• Manage your time better. Poor time management can cause a lot of stress. When you’re
stretched too thin and running behind, it’s hard to stay calm and focused. But if you plan ahead
and make sure you don’t overextend yourself, you can alter the amount of stress you’re under.
Stress management strategy #3:Adapt to the stressor

If you can’t change the stressor, change yourself. You can adapt to stressful situations and
regain your sense of control by changingyour expectations and attitude.
• Reframe problems. Try to view stressful situations from a more positive perspective.
Rather than fuming about a traffic jam, look at it as an opportunity to pause and regroup,
listen to your favorite radio station, or enjoy some alonetime.
• Look at the big picture. Take perspective of the stressful situation. Ask yourself how
important it will be in the long [Link] it matter in a month? A year?Is it really worth getting
upset over? If the answer is no, focus your time and energy elsewhere.
• Adjust your standards. Perfectionism is a major source of avoidable stress. Stop setting
yourself up for failure by demanding perfection. Set reasonable standards for yourself and
others, and learn to be okay with “good enough.”
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• Focus on the positive. When stress is getting you down, take amoment to reflect on all the
things you appreciate in your life, including your own positive qualities and gifts. This
simple strategy can help you keep thingsin perspective.

Adjusting Your Attitude

How you think can have a profound effect on your emotional and physical well-being. Each time
you think a negative thought about yourself, your body reacts as if it were in the throes of a
tension-filled situation. If you see good things about yourself, you are more likely to feel good; the
reverse is also true. Eliminate words such as "always," "never," "should," and "must." These are
telltale marks of self-defeating thoughts. Stress management strategy #4: Accept the things you
can’t change Some sources of stress are unavoidable. You can’t prevent orchange stressors such
as the death of a loved one, a serious illness, or a national recession. Insuch cases, the best way
to cope with stress is to accept things as they are. Acceptance may be difficult, but in the long
run, it’s easier than railing against a situation you can’t change.

• Don’t try to control the uncontrollable. Many things in life are beyond our control—
particularly the behavior of other people. Rather than stressing out over them, focus on the
things youcan control such as the way you choose to react to problems.
• Look for the upside. As the saying goes, “What doesn’t kill us makes us stronger.” When
facing major challenges, try to look at them as opportunities for personal growth. If your
own poor choices contributed to a stressful situation, reflect on them and learn from your
mistakes.
• Share your feelings. Talk to a trusted friend or make an appointment with a therapist.
Expressing what you’re going through can be very cathartic, even if there’s nothing you
can doto alter the stressful situation.
• Learn to forgive. Accept the fact that we live in an imperfect world and that people make
mistakes. Let go of anger and resentments. Free yourself from negative energy by
forgiving and moving on.
Stress management strategy #5: Make time for fun and relaxation Beyond a take-charge
approach and a positive attitude, you can reduce stress in your life by nurturing yourself. If you
regularly make time for fun and relaxation, you’ll be in a better place to handle life’s stressors
when they inevitably come.

Healthy ways to relax andrecharge

• Go for a walk.
• Spend time in nature.
• Call a good friend.
• weat out tension with a good workout.
• Write in your journal.
• Take a long bath.
• Light scented candles
• Savor a warm cup of coffee or tea.
• Play with a pet.
• Work in your garden.
• Get a massage.
• Curl up with a good book.
• Listen to music.
• Watch a comedy
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Don’t get so caught up in the hustle and bustle of life that you forget to take care of your own
needs. Nurturing yourself is a necessity, not a luxury.
• Set aside relaxation time. Include rest and relaxation in your daily schedule. Don’t allow
other obligations to encroach. This is your time to take a break from all responsibilities and
recharge your batteries.
• Connect with others. Spend time with positive people who enhance your life. A strong
support system will buffer you from thenegative effects of stress.
• Do something you enjoy every day. Make time for leisure activities that bring you joy,
whether it be stargazing, playing the piano, or working on your bike.
• Keep your sense of humor. This includes the ability to laugh at yourself. The act of laughing
helps your body fight stress in a numberof ways.

Learn the relaxation response

You can control your stress levels with relaxation techniques that evoke the body’s relaxation
response, a state of restfulness that is the opposite of the stress response. Regularly practicing
these techniques will build your physical and emotional resilience, heal your body, and boost your
overall feelings of joy and equanimity.
Stress management strategy #6: Adopt a healthy lifestyle You can increase your resistance to
stress by strengthening your physical health.
• Exercise regularly. Physical activity plays a key role in reducing and preventing the effects
of stress. Make time for at least 30 minutes of exercise, three times per week. Nothing
beats aerobic exercise for releasing pent-up stress and tension.
• Eat a healthy diet. Well-nourished bodies are better prepared to cope with stress, so be
mindful of what you eat. Start your day right with breakfast, and keep your energy up and
your mind clear with balanced, nutritious meals throughout the day.
• Reduce caffeine and sugar. Thetemporary "highs" caffeine and sugar provide often end in
with acrash in mood and energy. By reducing the amount of coffee, soft drinks, chocolate,
and sugar snacks in your diet, you’ll feel more relaxed and you’ll sleep better.
• Avoid alcohol, cigarettes, and drugs. Self-medicating with alcohol or drugs may provide an
easy escape from stress, but the relief is only temporary. Don’t avoid or mask the issue at
hand;deal with problems head on and with a clear mind.
• Get enough sleep. Adequate sleep fuels your mind, as well as your body. Feeling tired will
increase your stress because it may cause you to think irrationally.

Organizational Cultureand Organizational Change

Organizational culture is defined as the shared norms, values, and beliefs of an academic library.
Values are the building blocks of organizational culture and are derived either from the
organization’s leaders or from organizational traditions with the latter making for stronger and
more enduring values. The culture of a library expresses itself through symbols, sagas, rites, and
rituals. By understanding the culture of a library, one gains an understanding of the underlying
values and assumptions of the organization and what motivates and drives the behavior of those
within the library. Change in an organization creates uncertainty in an organization. This uncertainty
creates fear among those in the organization making change management very difficult.

Building change on and around the core values of the library’s culture makes implementing the
change less uncertain and unpredictable thereby making the librarians and library staff less
stressed and fearful. Emphasizingan organization’s values, especially how the change will enhance
835
those values, strikes at the very heart of those within the organization and makes them more open
to and accepting of change. Organizational Culture When asked to describe the library, different
groups on campus will respond in different ways. Students may note the computers and quiet
study rooms; faculty might mention ILL and the online journals; and librarians may point to the
organization and collection of scholarship.

All of these descriptions are true, but they are only part of what the library is. Any organization is
more than simply their mission statement and services offered. Organizations are societies
complete with their own values that dictate behavior and norms that provide a frame for members
to interpret reality (Morgan 1997). In other words, all organizations, no matter their type, grow and
nurture their own culture, an organizational culture. Culture is an en vogue term in much leadership
literature of the day, but the phrase is usually given superficial treatment. When an organizational
leader speaks of the need to develop a “culture of sustainability” or a “culture of ethics,” this is not
the same as the deep, complex concept of organizational culture. Organizational members tacitly
understand their own culture but usually can not convey verbally what their culture is and what it
means; they just understand how things are done. Through shared values, heroes and heroines,
rituals and ceremonies, and a cultural network organizational culture creates a sense of identity,
community, and sense of belonging amongst its members (Deal and Kennedy 1983 and Jordan
2003). Culture provides meaning to the work of the organiJason Organizational Culture and
Organizational Change 461 April 10–13, 2013, Indianapolis, IN zation by allowing members to be
part of something larger than themselves, ensures members abide by organizational norms, and
frames the outside world so its members can more easily interpret reality (Smircich 1983). Culture
provides sustainability to an organization and maintains social cohesion and solidarity amongst
those in the organization (Cartwright and Baron 2002). An organization’s effectiveness is
influenced, either directly or indirectly, by its culture and the prevailing mindset and overall
happiness it engenders amongst the organization’s employees (Gregory et al. 2009).

Organizational culture emerges from the external environment, history, and day-to-day operations
of the organization. The interactions of the organization and its members shapes and molds the
cultureas does the longevity of the organization, the richness of its shared history, how well culture
is taught to new members, and the values and beliefs of its founders. An organization without a
long history, strong founding values, or steadfast personnel will have a weak culture (Schein 1990).
Values are the foundation of organizational culture and are the strongest when they have stood
firm over the course of an organization’s history. No matter how well meaning, values imposed
from the top of an organization are the weakest ones in an organization. The “old guard,” seasoned
members of the culture, teach the culture to new members. Teaching organizational culture begins
with the hiring process and is carried on in a plethora of ways, both formal and informal, including
training workshops, HR programs, employee stories, and ceremonies (Goffee and Jones 1998 and
Schein 1990).

How well new members learn the culture determines the future strength of the culture. The culture
becomes stronger when it is learned and accepted completely, and weakens over time when
newcomers are only partially taught the organization’s culture. Organizational culture is expressed
through cultural artifacts like symbols, rites and rituals, and sagas. Jordan (2003) defines a symbol
as any object that represents another object which holds a deep meaning for the culture’s
members. Librarians value books because they are symbolic of information, and access to
information is a deeply held value in librarianship. A symbol can take any number of forms other
than the physical including logos, slogans, and images. Jordan (2003) argues symbols are the
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most important part of any organizational culture as all cultures are composed of symbols. A rite
or ritual has a manifest purpose in the normal day-to-day operations of the organization, but they
also fulfill a latent or symbolic role by reinforcing the values of the organization through the active
participation of its members. Sagas are organizational histories that blend fact and fiction to
explain the current beliefs and norms of a culture.

Sagas often arise from an organization in chaos and tell how the members banded together to
save and advance the organization. Sagas are crucial to understanding an organizational culture
as they provide a glimpse into the past. Organizational Change Efforts to initiate change in
organizations are largely unsuccessful (Higgs and Rowland 2010). Change is complex and failure
can occur at many levels. Change agents can bring about their own downfall through a lack of
communication and the mismanagement of employee trust (Ford, Ford, and D’Amelio 2008) or by
trying to undertake too much change at once. Most change efforts, however, are unsuccessful
because of resistance, either active or passive, of those within the organization. People resist
change for a variety of reasons. Employees may actively work against a change initiative because
they feel they have no stake in the change process, do not want to take on the increased work
change creates, are concerned about their lack of needed skills to thrive in the organization after
the change, or are worried they might lose their jobs (Kanter 2012). Change means the elimination
of the status quo causing individuals and groups to lose their power in an organization. These
employees will work against change to ensure they keep their power. Mostly change creates
uncertainty, and people organize their lives in such a way so as to maximize their day-to-day
consistency. A large amount of congruity allows one to see life as “orderly, predictable, familiar,
and safe” (Bailey and Raelin 2010). Change makes life seem less safe and orderly, thereby causing
those undergoing change to feel threatened. The literature is filled with tips and advice on how to
manage change and overcome or diffuse resistance. Some of the most familiar methods include
implementing change slowly, understanding the reasons behind employee resistance, engaging
everyone in the organization, instituting a system of incentives and punishment, and personnel
turnover (Hansen

Organizational Culture and Organizational

Change When it comes to change, organizational culture can be a fickle mistress. Culture can both
help and hinder the change process; be both a blessing and a curse when it comes to successfully
undergoing change. As was earlier stated, organizational culture consists of the values, norms,
and beliefs of its members. Culture provides a sense of identity and the chance to belong to
something bigger than oneself. Organizational culture gives its members the certainty and
consistency they desire. Any attempt at change within the organization may be seen as a threat to
the culture and the employee’s identity. Challenges to an organization’s culture are met with strong
and immediate resistance. To be successful, therefore, a change agent needs to use organizational
culture to his/her advantage. Change should be tied to the organizational values; specifically, how
this change will make the values the organization holds

Organizational Culture and Organizational Change: An Example

At a large urban academic library, a new director’s task was daunting. She replaced a director who
held the position for over 20 years, during which time the library changed very little. As a result the
library was out- of-date, inefficient, and inexperienced with change. The new director needed to
bring the library up-to-date in its practices and procedures while also streamlining and combining
many job functions and processes. This meant fast and radical change in the library, an already
difficult feat made even more difficult by a lack of people and resources. The new director did
837
many of the standard change agent moves including engaging the librarians and staff and opening
up lines of communication, but her best move was to make the change about the values those
within the library held dear.

While the culture of the library was not deep and robust, several important values were widely held
across all departments and positions. Values An important and strongly held value in the library,
and probably in many academic libraries, was service. Librarians and staff in Public Services,
Technical Services, and IT all thought patron service was their main priority. When the new director
began changing work flows and procedures in Technical Services, she did not emphasize how
much faster the work would get done. Instead she talked about the increased service this would
bring to the students, faculty, and staff of the university. The quicker the new items moved from
Acquisitions to the shelf, meant the quicker a faculty member could read about the latest research
in his/ her field. The new director redesigned Public Services merging several point-of-service
desks into one, centrally located desk. Again, the emphasis was on the increased service this
arrangement would provide. No longer would a confused undergraduate wander around the
reference stacks looking for help and leaving the library in frustration.
Organisational Change: Meaning, Causesand Its Process
Meaning of OrganisationalChange:
Organisational change refers to any alteration that occurs in total work environment.
Organisational change is an important characteristic of most organisations. An organisation must
develop adaptability to change otherwise it will either be left behind or be swept away by the forces
of change. Organisational change is inevitable in a progressive culture. Modern organizations are
highly dynamic, versatile and adaptive to the multiplicity of changes. Organisational change refers
to the alteration of structural relationships and roles of people in the organization. It is largely
structural in nature.

An enterprise can be changed in several ways. Its technology can be changed, its structure, its
people and other elements can be changed. Organisational change calls for a change in the
individual behaviour of the employees. Organizations survive, grow or decay depending upon the
changing behaviour of the employees. Most changes disturb the equilibrium of situation and
environment in which the individuals or groups exist. If a change is detrimental to the interests of
individuals or groups, they will resist the change.

Causes of OrganisationalChange:
(A) External Pressures:
i. Change in Technology andEquipment:
Advancements in technology is the major cause (i.e., external pressure) of change. Each
technological alternative results in new forms of organization to meet and match theneeds.
ii. Market Situation:
Changes in market situation include rapidly changing goals, needs and desires of
consumers, suppliers, unions etc. If an organization has to survive, it has to cope with
changes inmarket situations.
iii. Social and Political Changes: Organisational units literally have no control over social and
political changes in the country. Relations between government and business or drive for
social equality are some factors which may compel for organisational change.

(B) Internal Pressures (Pressures for Change fromWithin the Organisation):

i. Changes in the ManagerialPersonnel:
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 One of the most frequent reasons for major changes in the organisation is the change of
executives at the top. No two managers have the same style, skills or managerial
philosophies.

ii. Deficiencies in the ExistingOrganization:

Many deficiencies are noticed in the organisations with the passage of time. A change is
necessary to remove such deficiencies as lack of uniformity in the policies, obstacles in
communication, any ambiguity etc.
iii. Other Factors:
ADVERTISEMENTS:

Certain other factors such as listedbelow also demand a change in theorganisation.

Employee’s desire to share in decision-making Employee’s desire for higher wage rate
Improvement in working conditions,etc.

Response to OrganisationalChange:
Every change is responded by the people working in the organisation. These responses may be
positive or negative depending upon the fact ashow they affect people.

Before introducing a change, the manager should study and understand employee’s attitudes so as
to create a positive response. Three sets of factors-psychological, personal and social- govern the
attitude of people.

Process of OrganisationalChange:
Unless the behavioural patterns ofthe employees change, the changewill have a little impact on the
effectiveness of the organisation.

A commonly accepted model for bringing change in people was suggested by Kurt Lewin in terms
of three phase process:-

839
(1) Unfreezing:
The essence of unfreezing phase is that the individual is made to realize that his beliefs, feelings
and behaviour are no longer appropriate or relevant to the current situation in the organisation.
Once convinced, people may change their behaviour. Reward for those willing to change and
punishment for others may help in this matter.

(2) Changing:
Once convinced and ready to change, an individual, under this phase, learns to behave in
new ways. He is first provided with the model in which he is to identify himself. Gradually he
will accept that model and behave in the manner suggested by the model. In another
process (known as internalisation), the individual is placed in a situation where new
behaviour is demanded ofhim if he is to operate successfully.

(3) Refreezing:
During this phase, a person has to practice and experiment with the new method of
behaviour and see that it effectively blends with his other behavioural attitudes.
Reinforcement, for creating a permanent set in the individual, is provided through either
continuousor intermittent schedules.

Resistance to OrganisationalChange:
Resistance to change is perhaps one of the baffling problems a manager encounters because it
can take many shapes. People may resign, they may show tardiness, loss of motivation to work,
increased absenteeism, request for transfer, wild-cat strikes, shoddy work, reduction in productivity
etc.

Classification of Resistance toChange:

Resistance to change may beclassified as:
1. Industrial Resistance
2. Organisational Resistance

1. Industrial Resistance: Individual resistance may be there because of the followingreasons:

A. Economic Reasons:
(a) Obsolescence of Skills: When a person feels that with the introduction of newer
processes, his skills will just become obsolete, he will resist the change. For example, a
twenty years experienced accountant is quite likely to resist the introduction of a
computer for preparing the wage bills because he feels that might affect his pay and
position.
840
 (b) Fear of Economic Loss: People resist change if it opens the possibility of lowering their
incomedirectly or indirectly.

B. Personal Reasons:
(a) Ego Defensiveness:
A sales manager may turn down the suggestions of a salesman simply because the
manager perceives that his ego may be deflated by acceptingthe suggestion.

(b) Status Quo:

Most of the people feel comfortable with status quo and strongly resist change as it may
involve uncertaintyand risk.

(c) Fear of Unknown:

Change presents unknown and unknown poses a constant threat and sores people. For
fear of unknown, a manager may refuse promotion that requires his relocating in another
state.
C. Social Reasons:
(a) Social Displacement: Introduction of change (e.g., relocating) may result in breaking up
of work groups and thus result in disturbance of the existing social relationships of
people.

(b) Peer Pressure:

Whenever change is unwilling to the peers, they force the individual subordinate
employees who are bentof accepting the change, to resist it.

2. Organizational Resistance: Resistance may also be present at organizational level. Some

organizations are so designed thatthey resist innovations.

Some of the reasons of organizational resistance are:

(a) Threats to Power andInfluence:
Some people (especially sitting at thetop levels) resist change because theyfeel that a change
might affect their position, power and influence in the organization.

(b) Organizational Structure: Some organization structures (e.g., bureaucratic structure) have
inbuilt mechanism for resistance to change.

(c) Resource Constraints:

Non-availability of financial, material and human resources may also act as a resistance to
change.

(d) Sunk Cost:

In some companies, heavy capital is blocked in the fixed or permanent assets. If such an
organization wishesto introduce change, then difficulty arises because of these sunk costs.

Overcoming Resistance to Organisational Change: Change creates tension and emotional turmoil
in the minds of employees. Change thus results in resistance quite frequently, negative reactions
doom the success of the change program especially when a manager is unable to handle it
841
properly.

Some of the techniques to handle the change properly andto deal with resistance to change are:
(a) Education andCommunication:
One of the easiest techniques to overcome resistance to change is to educate the people who
resist it. In many cases, people do not properly understand the change and hence become
afraid of its consequences and resist change.

(b) Participation andInvolvement:

If subordinates are allowed to participate and involve themselves in the change process
(decision-making regarding the implementation of the change), their misunderstandings
about the consequences of change are cleared, they generally feel satisfied and do not
oppose change.
(c) Support:
Support may be facilitative and emotional. Managers sometimes deal with potential
resistance by being supportive. This includes listening, providing emotional support, providing
training in new skills etc.

(d) Incentives:
Offering incentive is another fruitfulway to overcome resistance to change.

(e) Manipulation:
Managers generally indulge in manipulation when all other tactics have failed to overcome
resistance tochange.

(f) Coercion:
At times, there is no way except todeal with resistance coercively. People are forced to accept
change bythreatening them with loss of their jobs, promotion possibilities and so forth.

842
MCQ OF BUSINESSMANAGEMENT

843
1. Consider the followingstatements:
Planning involves
1. Forecasting
2. Choice among alternativecourses of action.
3. Wishful thinking
4. Decision only by productionmanager
Of these statements:
a. 1, 2, 3 and 4 are correct
b. 1, 3 and 4 are correct
c. 1 and 2 are correct
d. 2 and 3 are correct

2. Overall and strategic planning is done by the

a. 1, 2, 3 and 4 are correct
b. 1, 3 and 4 are correct
c. 1 and 2 are correct
d. 2 and 3 are correct

3. If a general manager asks the sales manager to recruit some salesman on his behalf, it is an
instance of
a. Division of authority
b. Decentralization of authority
c. Delegation of authority
d. Delegation of responsibility

4. Consider the following basicsteps involved in the process ofcontrol:

1. Identifying the strategiccontrol points
2. Establishment of thestandards
3. Measuring performanceagainst standards
4. Correcting deviations fromthe standards
a. 1, 2, 3 and 4 are correct
b. 1, 3 and 4 are correct
c. 1 and 2 are correct
d. 2 and 3 are correct

5. An organisation structure is effective if it enables individuals to contribute to the objectives of

the enterprise. This is known as
a. 1, 2, 3 and 4 are correct
b. 1, 3 and 4 are correct
c. 1 and 2 are correct
d. 2 and 3 are correct

6. While delegating, a superiordelegates

a. Only authority
b. Authority and responsibility
c. Authority, responsibility and accountability
d. Authority and responsibility but not accountability

844
7. Match the following
List I List II
(a) Fayol 1. Grapevine
(b) Simon 2. Cybernetics
(c) Shannon [Link]
(d) Weiner 4. Noise
A. a-3, b-4, c-2, d-1
B. a-3, b-2, c-4, d-1
C. a-3, b-1, c-4, d-2

8. Directing function ofmanagement implies

1. Planning
2. Staffing
3. Leadership
4. Motivation
Choose the correct answer usingthe codes given below:
a. 1 and 2
b. 3 and 4
c. 2 and 4
d. 2,3 and 4

9. Whlch of the following is truewith respect to planning function?

a. To make a blue print of ideas and work
b. To tell the work allocation to all
c. Monitoring whether the things allocated are done properly
d. None of the above

10. Which of the following pairsare correctly matched ?

1. 3D Theory V.J. Peddin
2. Life Cycle Theory Paul Hersey and Blandard
3. Continuum Approval Tannenbaum and Schmidt
4. Managerial Grid
Mountain & Black Select the correct answer usingthe codes given below?

A. 1, 2, 3 and 4
B. 3 and 4
C. 2 and 4

D.1 and 2

11. Each subordinate should have only one superior whose command he has to obey. This is
known as
a. Division of work
b. Exception principle
c. Unity of Command principle
d. Authority - responsibility principle

845
12. In line and staff organisation the staff performsthe function of
a. Management
b. Advising the management
c. Assigning responsibility
d. None of the above

13. Planning function is mainlyperformed at

a. Top management level
b. Middle management level
c. Lower management level
d. None of the above

14. Which one of the followingmay not necessarily be an advantage of coordination?

a. Effective supervision
b. Unity of direction
c. Creative force
d. None of the above

15. Leadership is a function ofall the following factors except

a. Work group
b. Product or service
c. Leader
d. Situation

16. Which of the following is not true in respect of planning?

a. Planning is an intellectual activity
b. Planning function is not performed by the top management
c. Planning is related to objectives
d. Planning is forward-looking

17. Which one of the followingorders indicates the correct logical order of managerial functions?
a. Organising, Planning, Directing, Staffing, Coordination and Control
b. Planning, Organising, Staffing,Directing, Control and Coordination
c. Planning, Directing, Organising, Staffing, Control and Coordination
d. Organising, Planning, Staffing,Directing, Control and Coordination

18. Which of the following skillsis equally important at all levelsof management?
A.
B.
C.
D.

19. Consider the followingstatements:

1. Decentralisation anddelegation are closely interrelated
2. Delegation and decentralisation both aredesirable
3. Decentralisation is not suitable for large organisation
4. Delegation is not possible inthe case of small organisationsOf these statements:

846
 a. 1 and 2 are correct
b. 2 and 3 are correct
c. 1 and 4 are correct
d. 1,3 and 4 are correct

20. Consider the following officeequipments used in various offices:

1. Fax
3. Dictaphone
2. Typewriter
4. Letter opener
The correct order in which theyare used is
a. 1 2 3 4
b. 4 3 2 1
c. 2 4 3 1
d. 3 2 4 1

21. Which one of the following formulae is used to calculate "Cross Relationship" under span of
control?
a. n(n-1)
b. n(2n/2-1)
c. n(2n/2+n-1)
d. None of the above

22. Which of the following isnot an advantage of MBO?

a. Success without planning
b. Employee commitment
c. Better appraisal
d. Self control

23. Motivational process and not the motivators as such isassociated with the
a. Need hierarchy theory
b. Two-factor theory
c. ERG Theory
d. Expectancy theory

24. Which one of the followingis the oldest form of organization?

a. Need hierarchy theory
b. Two-factor theory
c. ERG Theory
d. Expectancy theory

25. The potential disadvantageof MBO is

a. Its inability to control progress of work and achievement of results
b. Its over- emphasis on production and productivity
c. The additional commitment to the organization
d. The absence of short-teem and long-term planning

847
26. Delegation of authority islinked to
a. Managerial planning
b. Management coordination
c. Management control
d. Scientific management

27. Organisation Theory dealswith

a. Forms of business organisation
b. Structure of an organisation
c. Industrial relations
d. Incentives and wage policy

28. Consider the followingsteps:

1. Analysis of variances
2. Initiating corrective action
3. Measurement of Actualperformance
4. Establishment of standards What is the sequence of steps?
a. 1,2,3,4
b. 2,3,1,4
c. 3,1,2,4
d. 4,3,1,2

29. The following steps areinvolved in managing by objectives

1. Preliminary setting ofobjectives at the top
2. Setting subordinatesobjectives
3. Tying resources with the goals
4. Clarifying the organisationalroles
The correct sequence of thesesteps is
a. 1,2,3,4
b. 1,2,4,3
c. 1,3,2,4
d. 1,4,2,3

30. The main advantage offunctional organisation is

a. Specialisation
b. Simplicity
c. Expert advice
d. Experience

31. In a Functional organization

a. There are no advisers, the executive alone having the authority and competence
b. There are specialist advisers having no authority
c. The entire organization is divided into functions with specific role for specialists.
d. The organization is divided into functions with specialists having authority.

32. TQM's major emphasis is on

a. Company profitability
b. Product quality
848
 c. Customer delight
d. Employee training

33. Which of the followingfunctions is known as the essence of management?

a. Planning
b. Organising
c. Co-ordinating
d. Control

34. The following steps areinvolved in the process of organising

1. Forming supportive objectives
2. Delegating to the head of eachgroup the authority necessary toperform the activities
3. Establishing enterpriseobjectives
4. Identifying and classifyingactivities
The correct sequence of steps is:
a. 3,1,2,4
b. 3,1,4,2
c. 1,3,4,2
d. 1,3,2,4

35. In line and staff organisation, the authority liesin

a. Line
b. Staff
c. Both line and staff
d. None of the above

36. 'Matrix organisation' refersto a term of

a. Organisation where authority and responsibility coexist
b. Organisation in which two or more basic types of departmentation are combined.
c. Mathematical arrangement of events in columns and rows.
d. None of the above

37. Decentralisation of an organization is commanded on account of which of the following

advantages?
1. Reduced burden on topexecutives
2. Executive development
3. Improvement of morale
4. Solves problems ofcoordination
Select the correct answer from the codes given below and markyour answer accordingly.
a. 2 and 3
b. 1,2, and 4
c. 1,2 and 3
d. 3 and 4

849
38. In Taylor's functionalorganisation, gang boss

a. lnspects the quality of work done

b. Issues instructions to workers
c. Sets up tools and machines for work
d. Compiles cost of production

39. Repeated use plans orstanding plans include

a. Objectives and policies
b. Procedures and methods
c. Rules
d. All of the above

40. MBO is a technique whichrequires that the objectives ofthe enterprise

a. Be written and defined in broad terms
b. Lay down the time period for achieving the desired results
c. Include a plan of action for achieving the desired result
d. Be defined in terms of measurable results

41. When management pays attention to more important areas and when the day to day routine
problems are looked after by lower level management, it is known as
a. Management by objectives
b. Management by Exception
c. Participative Management
d. Critical path method

42. Staffing includes

1. Training
2. Appraisal
3. Placement
4. Directing
Choose the correct answer usingthe codes given below:
a. 1 and 3
b. 2 and 3
c. 1,2 and 3
d. 1,2,3,4

43. Span of controls means that

a. An organization consists of various departments
b. Each person's authority is clearly defined.
c. Every subordinate has one superior
d. A manager can supervise only a limited number of subordinates

44. If the span of control is narrow, a number of managers would be required in each unit of the
organization and there would be many managerial levels or layers, such an organizational
structure is referred to as
a. Flat structure
b. Tall structure
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 c. Matrix structure
d. Project structure

45. The famous book 'General and Industrial Management' waswritten by

a. Oliver Sheldon
b. Henri Fayol
c. Elton Mayo
d. Maslow

46. Consider the followingelements:

1. Indicators
2. Objectives
3. Controls
4. Key Result Areas
5. Roles and Missions
6. Action plans
Their correct sequence in management by objectives andresults is
a. 5 4 2 1 3 6
b. 4 5 2 1 3 6
c. 5 4 1 2 6 3
d. 4 5 1 2 6 3

47. Who wrote Management &Moral?

a. Taylor
b. Riggs
c. Dimock
d. Roethliberger

48. The following steps areinvolved in the process of organizing

1. Forming supportive objectives
2. Delegating to the head of eachgroup the authority
3. Necessary to perform theactivities
4. Establishing enterpriseobjectives
The correct sequence of thesesteps is
a. 3,1,2,4
b. 4,1,2,3
c. 1,3,4,2
d. 1,3,2,4

49. According to the principleof "Span of control" there is

a. A tendency of overload supervisors with too much of work
b. A limit to the number of subordinates a supervisor can effectively supervise.
c. No limit to the number of subordinates a supervisor can supervise.
d. A limit to delegation of authority to the subordinate.

50. Which one of the followingstatement is correct?

a. Planning and controlling are essentially one and the same.
b. Controlling is a part of the planning process.
851
 c. Controlling is a substitute for planning
d. A control process is meaningless without pre-set goals.

51. In the process of controlling office management certain stepsare normally taken.
These include
1. Analysing the actualperformance.
2. Finding out the reasons fordiscrepancies.
3. Evaluating the performance.
4. Establishing the standards ofwork performance.
The correct sequence in which these steps are usually taken is
a. 4,1,2,3
b. 1,4,2,3
c. 1,4,3,2
d. 4,1,3,2

52. What is the correct sequence of the following functions of a manager in an organisation?
1. Motivation
2. Controlling
3. Organising
4. Planning
Select the correct answer usingthe codes given below.
a. 4,3,2,1
b. 4,3,1,2
c. 3,4,2,1
d. 3,4,1,2

MULTIPLECHOICE ANSWERS

1.C 12.B 23.D 34.B 45.B

2.A 13.A 24.B 35.A 46.A

3.C 14.A 25.B 36.C 47.D

4.B 15.B 26.C 37.C 48.B

5.C 16. 27. 38. 49.

B B C B
6.A 17.B 28.D 39.D 50.D

7.C 18.B 29.C 40.A 51.B

852
Question # 1 Groups and Teams are Select correct option:
One and the same things
Different things

Question # 2
Which of the following is NOT a goal of HRM?Select correct option:
Integration of HRM with the corporate strategy of the organization
Producing the desired human behavior that helps to achieve the organizations goals Creation of a
flexible environment that can easily adopt change
To endure proper delivery of products

Question # 3
In order to promote unbiased management, organizations should develop:Select correct option:
Powerful union Legal compliance Strategic alliances
Stakeholder influence

Question # 4
Women can not do important or heavy jobs. This is an example of:Select correct option:
StereotypingHalo effect

Question # 5
Which of the following is a forecasting technique that involves experimenting a realworld situation
through a mathematical model?
Select correct option:
Simulation Modeling Mock-up Replication

Question # 6
Which one is not the component of training and development?Select correct option:
Orientation
Career development Organizational development

Question # 7
Which of the following component consists of a person’s beliefs, opinions, knowledge, and
information?
Select correct option:
Affective component Cognitive component Behavioral componentObjective component

Question # 8
Organization Behavior deals with:
Select correct option:
Budget of the Organization Structure of the OrganizationIndividual Behavior
None of the above

853
Question # 9
An organization operates in:
Select correct option:
An isolated systemA closed system
A clogged systemAn open system

Question # 10
According to which act, pay discrimination on the basis of gender for same position &performance
is prohibited?
Select correct option:
Civil rightsEqual pay
Worker compensationAge discrimination

Question # 11 Which of these functions is affected byexternal influences? Select correct option:
Staffing DevelopmentMaintenance
All of given options

Question # 12
Which of the following statement reflects the 'Age Discrimination Act' for workers? Select correct
option:
At the age of 40 to 70, workers can not be retired by force At the age below 18, workers can never
be hired
Having 10 years of experience, workers should be promoted Workers can never be rehired if retired
once

Question # 13
If a company is employing the fresh graduates as well as the professional experts, themanagement
is said to be enhancing.
Select correct option:
StereotypingVariety Diversity Uniformity

Question # 14 Organizations are adopting Total Quality Management in order to: Select correct
option:
Improve the qualityControl the costs
Restructure the organizationNone of the above

Question # 15
Which of the following involves holding beliefs about people that place them in categories for
recognizing and accepting differences?
Select correct option:
Backlash Mistrust CohesivenessStereotyping

Question # 16
1 Select correct option
of race, color, sex, religion, national origin, or age, has an equal chance for a job based on his/her
qualifications Equal Employment Opportunity

Question # 17 When Job analysis Is not performed?Select correct option:

854
When the organization is foundedWhen new jobs are created
When we have already completed job analysis for similar kinds of jobs When jobs are changed
significantly

Question # 18
Staffing is a process of hiring qualified employees at the right place and at the righttime,
to achieve .Select correct option:
Targeted sales goals Individual career goals Return on investment Organizational objectives

Question # 19
: 1 Controlling the Costs is an Challenge for HRMSelect correct option:
OrganizationalEnvironmental

Question # 20
A problem faced by the organization due to presence of people having differentnationalities is an
Select correct option:
Environmental ChallengeOrganizational ChallengeIndividual Challenge None of the above

PART- 2
Question # 1 : Organizational goals should be;
A. Achievable
B. Ambiguous
C. Random
D. Vague

Question # 2 Organization, where employees are provided with the opportunity to learn on
continuous basis is known as:
Select correct option:
Formal
Informal
Bureaucratic
Learning

Question # 3 Job evaluation is conducted to develop:

Select correct option:
Compensation packages
Training modules
Organizational grapevine
Rules & policies

Question # 4 The invisible barrier that blocks females & minorities from ascending into upper levels
of an organization, is termed as:
Select correct option:
Gender discrimination
Glass ceiling
Affirmative action
Stereotype
855
Question # 5 The process through which someone becomes aware of personal skills, interests,
knowledge, motivations; acquires information about opportunities; identifies career goals; and
establishes action plans to attain those goals is called .
Select correct option:
Organizational development
Career management
Career development
Career planning

Question # 6 The procedure of initiating a document that specifies job title, department, the date
the employee is needed for work, andother details, is known as:
Select correct option:
Employee request
Employee appropriation
Employee requisition
Employee demand

Question # 7 Who is the primary person responsible for doing the actual appraising of an
employee’s performance?
Select correct option:
The employee’s direct supervisor
The company appraiser
The human resource manager
The EEO contact person

Question # 8 Socialization process of newly hired employees is usuallyconducted by:

Select correct option:
Marketing department
HR department
Accounts department
All of the given options

Question # 9 Which of the following term is said to be a part of

Organizational Structure?
Select correct option:
Goal attainment
Hierarchy level
Performance standards
Supporting staff

Question # 10 HR responsibilities of staff managers include

Select correct option:
assistance in hiring
rewarding, counseling
assistance in promotion
all given option

856
Question # 11 Which of the following defines the process of'Recruitment'?
Select correct option:
Forecasting the demand of human resources
Forecasting the supply of human resources
Discovering potential job candidates for a particular position
Making a “hire” or “no hire” decisions

Question # 12 Charismatic leaders are those who have the ability to:
Select correct option:
Resolve every problem prevailing in the organization
Influence others in a desired manner
Command over larger number of employees
Strictly impose the set rules

Question # 13 Which of the following term is used for locating thequalified candidates?
Select correct option:
Recruitment sources
Recruitment leads
Recruitment pools
Recruitment personnels

Question # 14 Impact of individuals' behavior in an organization isstudied under:

Select correct option:
Organizational culture
Organizational norms
Organizational behavior
Organizational rules

Question # 15 The lifelong series of activities that contribute to a person’s career exploration,
establishment, success, and fulfillment iscalled:
Select correct option:
Organizational development
Career management
Career development
Career planning

Question # 16 Organization, where employees are provided with the opportunity to learn on
continuous basis is known as:
Select correct option:
Formal
Informal
Bureaucratic
Learning

Question # 17 Providing timely performance feedback, development assignments, and support are
all part of the ’s role in career development.
Select correct option:
Individual
857
Manager Company
Human resource
Specialist

Question # 18 Which of the following defines the process of'Recruitment'?

Select correct option:
Forecasting the demand of human resources
Forecasting the supply of human resources
Discovering potential job candidates for a particular position
Making a “hire” or “no hire” decisions

Question # 19 Which of the following practice involves the selling off portions of the company and
making severe staff reductions?
Select correct option:
Redesigning
Restructuring
Organizational designing
Reengineering

Question # 20 Authority is classified among levels of

categories.
Select correct option:
2
4
6
3

Question # 21 People within a group who initiate the work, give new ideas and also collect
information about the task, are actually performing:
Select correct option:
Information collector roles
Task oriented roles
Relationship oriented roles
Individual roles

Question #22 several factors radically changed attitudes towards human resource information
systems during
Select correct option:
During the 1960s and 1970s
During the 1970s and 1980s
During the 1990s and 2000s
During the 1950s and 1960s

Question # 23 System used to collect, record, store, analyze, & retrieve data related to an
organization, is termed as:
Select correct option:
IS (Information System)
MIS (Management Information System)
858
HRIS (Human Resource Information System)
DBMS (Data Base Management System)

Question # 24 For the selection of pilot, PIA’s management took the written test based on the
understanding & application of aeronautical
engineering; under which category this test will fall?Select correct option:
Reliable test
Content-valid test
Criterion-valid test
Face-valid test

Question # 25 Employees quit the organizations at their own choicethrough

Select correct option:
Outplacement, restructuring
Discharging, layoff
Transfer, demotion
Resigning, retirement

Question # 26 The inner drive that directs a person’s behaviortowards goal attainment is known as:
Select correct option:
Performance
Motivation
Need
Attitude

Question # 27 As being part of an organization, it is an employee’s

to align his/her actions according to the set rules &policies.
Select correct option:
Right
Responsibility
Task
Contractual right

Question # 28 Which of the following skill/s is/are required for aneffective team?
Select correct option:
Problem-solving skills
Technical skills
Interpersonal skills
All of the given options

Question # 29 The physical or psychological condition induced in workers by overwork or

overexposure to stress in the workplace, isknown as:
Select correct option:
Exhaustion
Burnout
Collapse
Fatigue

859
Question # 30 Which of the following role a manager performs as aResource allocator?
Select correct option:
Interpersonal role
Decisional role
Informational role
Supportive role

Question # 31 The emigration of trained and talented individuals to other nations due to lack of
opportunity or other reasons is known as
.
Select correct option:
Job Insecurity
Outsourcing
Workforce diversity
Brain Drain

Question # 32 Staffing is a process of hiring qualified employees at the right place and at the right
time, to achieve .
Select correct option:
Targeted sales goals
Individual career goals
Return on investment
Organizational objectives

Question # 33 Manufacturing was the main concern of personneldepartment during:

Select correct option:
Mechanistic period
Catalytic period
Organistic period
Strategic period

Question # 34 is achieved by combining capital, raw material

& human resource by an organization.
Select correct option:
Sales
Capital
Input
Output

Question # 35 Supervisors fall into the:

Select correct option:
Top-level
Middle-level
First-line level
Executive level

Question # 36 HRM is associated with the management of:

Select correct option:
860
General people
Labors only
Organizational people
Employers only

Question #37 A practice used by different companies to reduce costs by transferring portions of
work to outside provider rather than completing it internally is termed as:
Select correct option:
Planning
Decentralization
Restructuring
Outsourcing

Question #38 The cognitive component consists of a person’s:

Select correct option:
Emotions
Knowledge
Attitude
Feelings

Question 39 Reactive approach to overcome the influence of discriminatory practices occurred in

the past is referred as:
Select correct option:
Equal employment opportunity
Affirmative action
HR planning
Litigation process

Question 40 Which of the following terminology describes the legal legislation in which job
applicant should not be rejected on the basis ofdiscriminatory practices?
Select correct option:
Affirmative action
Legal compliance
Equal employment opportunity
Stereotype

Question 41 An organization operates in:

Select correct option:
An isolated system
A closed system
A clogged system
An open system

Question 42 _ refers to a set of expected behavior patterns attributed to

someone who occupies a given position in asocial unit.
Select correct option:
Norm
Perception
861
Role
Stereotyping

Question 43 People can be more productive while working in:

Select correct option:
Isolation
Groups
Crowd
None of the given options

Question 44 Which of the following component consists of aperson’s beliefs, opinions, knowledge,
and information?
Select correct option:
Affective component
Cognitive component
Behavioral component
Objective component

Question 45 Which of the following involves holding beliefs about people that place them in
categories for recognizing and acceptingdifferences?
Select correct option:
Backlash
Mistrust
Cohesiveness
Stereotyping

Question 46 Which of the following personality characteristics are associated with people who are
likely to exhibit violent behavior on thejob?
a. Neurotic
b. Optimistic
c. Extraverted
d. Type A

Question 47 Which of these suggestions is an effective way to dealwith stress?

a. Meditation
b. Exercise
c. Talking with others
d. All of the given options

Question 48 In most large facilities, who is responsible for reducing unsafe working conditions and
reducing unsafe acts by employees?
a. Chief executive officer
b. Chief safety officer
c. Occupational safety and health officer
d. Chief operations officer

862
Question 49 Who distinguished between intrinsic motivation andextrinsic motivation?
a. Frederick Taylor
b. Frederick Herzberg
c. David McClelland
d. Edward Deci

Question 50 Which of the following is categorized as an indirect payment portion of employee

compensation?
a. Wages
b. Salaries
c. Employer-paid insurance
d. Commissions

Question 51 Stress can affect not only your health, but also otheraspects of your life. What else can
be affected by stress?
a. Family relationships
b. Work performance
c. Your attention to safety
d. All of the given options

Question 52 Unemployment benefits are typically about percent of a person's earnings and
last for _ .
a. 50; 26 weeks
b. 75; 1 year
c. 100; 2 years
d. 25; 4 weeks

Question 53 Unsafe acts can be reduced through all of the followingmethods except:
a. Job rotation
b. Screening
c. Training
d. Incentive programs

Question 54 Which of these is the most common type of retirementplan?

a. Defined benefit
b. ERISA
c. Defined contribution
d. Money purchase plan

Question 55 Which one of the following statements is correct in relation to monetary rewards in
accordance with Herzberg’s Two-Factor theory?
a. Pay increases are a powerful long-term motivator
b. Inadequate monetary rewards are a powerful dissatisfier
c. Monetary rewards are more important than non-monetary rewards
d. Pay can never be used as a motivator

863
Question 56 Which pattern of communication is the quickest way tosend a message?
a. The circle
b. The chain
c. The Y
d. The wheel

Question 57 Chronic stress is the stress that wears at people day after day. Which of these is an
example of chronic stress?
a. An unhappy marriage
b. Ongoing money problems
c. Dissatisfaction with a job
d. All of the given options

Question 58 The relative position of an organization's pay incentives compared to other companies
in the same industry is known as:
a. Pay structure
b. Pay appraisal
c. Pay level
d. Pay feedback

Question 59 Poor quality lateral communication will result in which ofthe following?
a. Lack of direction
b. Lack of coordination
c. Lack of delegation
d. Lack of control

Question #60 Which of the following is a health hazard in the workplace?

a. Uncollected waste paper
b. Heavy object
[Link] crypt
d. All of the given options

Question #61 Managers can motivate people to avoid performingdysfunctional behaviors by using:
I. Extinction
II. Punishment
III. Negative reinforcement
a. I, II, III
b. I and III
c. II and III
d. I and II

Question #62 Workers' compensation benefits fall into all of thesemajor categories except:
a. Medical care
b. Retirement benefits
c. Disability income
d. Death benefits

864
Question # 63 Expectancy theory focuses on the relationshipsbetween which three factors?
a. Needs, effort and persistence
b. Needs, performance and inputs
[Link], performance and outcomes
d. Needs, performance and outcomes

Question #64 A horizontal extension of the object to increase taskvariety is called:

a. Job evaluation
b. Job enrichment
c. Job enlargement
d. Job rotation

Question # 65 Communication between two members of a project team from different function, but
the same level of authority is communication.
a. UP ward
b. Downward
c. Lateral
d. Diagonal

Question #66 HRM is associated with the management of;

a. General people
b. Financial resources
c. Organizational people
d. Community members

Q Question #67 To anticipate the human resource needs of the organization based on some
previous data or managerial judgment isknown as;
a. Demand forecasting
b. Supplies forecasting
c. Financial forecasting
d. Sales forecasting

Question # 68 Top level managers require skills the most;

a. Technical
b. Interpersonal
c. Conceptual
d. Mechanical

Question #69 Matching the job description with the individuals’ qualification is an important aspect
of;
a. IS
b. MIS
c. HRIS
d. DBMS

Question #70 HR managers are generally the managers;

a. Line
b. Middle
865
 c. Staff
d. Top

Question # 71 Cost of human resources refers to;

a. Company profits
b. Employee shares
c. Salary packages
d. Earned revenues

Question # 72 The process by which people acquire skills & abilities required to perform jobs at
hand, is known as:
Select correct option:
Learning
Training
Development
Need analysis

Question #73 SWOT Analysis is a tool for;

a. Determining organization’s mission
b. Developing organizational goals
c. Formulating strategies
d. Environmental scanning

Question #74 Jobs are identified & grouped while;

a. Planning
b. Organizing
c. Leading
d. Controlling

Question # 75 According to the Hawthorne studies, the productivityof employees;

a. Increased by increasing light
b. Decreased by decreasing light
c. Increased by observing them
d. No change in their productivity

Question # 76Manufacturing was the main concern of personneldepartment during;

a. Mechanistic period
b. Catalytic period
c. Organist period
d. Strategic period

Question # 78 Which one of the following is NOT the source ofworkforce diversity?
a. Age
b. Gender
c. Education
d. Resentment

866
Question # 79 The thorough & detailed study regarding jobs within an organization is represented
by;
a. Job analysis
b. Job description
c. Job specification
d. Job evaluation

Question #80 is the process of acquiring, training, appraising and

compensating employees, attending to their labor relations, health and safety and
fairness concerns.
a. Labor Relations
b. Organizational Behavior
c. Human Resource Management
d. Organizational Health and Safety Management

Question # 81 Which of these refers to the temporary, part-time andself-employed workers?

a. Internal labor force
b. Contingent work force
c. High-performance work systems
d. Downsized employees

Question # 82 Which basic function of management includes delegating authority to subordinates

and establishing channels ofcommunication?
a. Planning
b. Organizing
c. Leading
d. Staffing

Question # 83 Over the past 25 years, all of these areas of legal environment have influenced HRM
except:
a. Equal employment opportunity legislation
b. Employees pay and benefits
c. Employee competition legislation
d. Job security

Question # 84 One of the most popular methods of increasing employee responsibility and control
is .
a. Outsourcing
b. "Military model" of management
c. HRIS
d. Work teams

867
Question # 85 Which of these is a major dimension of HRM practices contributing to company
competitiveness?
a. Compensating human resources
b. Acquiring and preparing human resources
c. Managing the human resource environment
d. All of the given options

Question #86 How has technology changed HRM practices?

a. Recruiting using the web generates smaller, more focused applicantpools.
b. Employee training is offered through scheduled classes rather thanon demand.
c. Electronic resumes take less time to evaluate than paperresumes.
d. None of the given options.

Question # 87 How do companies facilitate workforce diversity?

a. Rely on external support systems for minority workers.
b. Encourage employees to challenge the beliefs and values of otheremployees.
c. Build in accountability through surveys and audits.
d. Reinforce traditional values.

Question # 89 Employee involvement requires extensive additional HRM activity in which of these
areas?
a. Training
b. Benefits
c. Labor negotiation
d. Marketing

Question # 90 Managers who meet designated goals are .

a. Assertive
b. Efficient
c. Effective
d. Entitled

Question #91 David conducts new employee orientation for a large organization. His work is within
which basic HRM function?
a. Management
b. Motivation
c. Career planning
d. Training and development

Question # 92 Employee relations specialists are involved in which ofthese activities?

a. Handling employee complaints
b. Working with position control specialists in compensation
c. Negotiating benefits packages
d. Coordinating interview schedules

Question # 93 The father of scientific management is

a. Deming
b. Burns
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 c. Taylor
d. Hawthorne

Question # 94 Organizational behavior depicts the;

a. Jargons used within the organization
b. Collective behavior of an organization
c. Effect of society’s common behavior on an organization
d. Culture prevails in an organization

Question # 95 Leaders perform;

a. Decisional roles
b. Informal roles
c. Informational roles
d. Interpersonal roles

Question # 96 Organizations take inputs from its;

a. Rules & Policies
b. Internal Environment
c. External Environment
d. Legislations

Question # 97 As organizational activities are interrelated, it is saidto be;

a. A closed system
b. An isolated system
c. An open system
d. A clogged system

Question # 98 Management sciences department is one of the _ of the VU;

a. System
b. Subsystem
c. Board
d. Structure

Question #99 Shifting from manual to computerized system isresulted due to;
a. Workforce diversity
b. Technological advancement
c. Stake holder’s involvement
d. Globalization

Question #100 A large organization is an EEO employer with an affirmative action plan. Which of
these activities is performed as partof the plan?
a. All job applicants must have a recommendation from current or pastemployee
b. Insurance premiums from former employers of all applicants areanalyzed
c. Job requirements are determined based on skills, knowledge andabilities
d. Job announcements are posted on the company bulletin board

869
Question # 101 Which of these items would be in the highest securitycategory of a typical HRIS?
a. Employee name
b. Former employers
c. Salary
d. Work location

Question #102 Which of these decreases in the labor supply is theeasiest to predict?
a. Transfers-in
b. Retirements
c. Voluntary quits
d. Prolonged illnesses

Question #103 Wal-Mart differentiates its business by offering the lowest prices. Offering the
lowest prices is Wal-Mart’s .
a. Functional strategy
b. Competitive advantage
c. Distinctive competence
d. Corporate strategy

Question #104 is the process of assessing progress toward strategic goals and taking
corrective action as needed.
a. Strategic management
b. Strategic planning
c. Strategic control
d. Diversification

Question #105 is the right to make decisions, to directthe work of others and to give orders.
a. Leadership
b. Authority
c. Delegation
d. Management

Question # 105 Which of the following is considered a qualitativeapproach to job analysis?

a. Position analysis questionnaire
b. Interviews
c. Department of Labor approach
d. Functional job analysis

Question #106 Willingness, capacity & opportunity to perform aresaid to be;

a. Performance outcomes
b. Determinants of performance
c. Performance appraisals
d. Types of performance standards

Question # 107 One of the major barriers to career advancementexperiencing by working ladies
is;
a. Difficulty in balancing work and family life
b. Top management is usually male oriented
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 c. Lack of educational opportunities
d. Common perception that woman can not be better boss

Question #108 Alternative work arrangements include all of thefollowing EXCEPT;

a. Part-time work
b. Flexible hours
c. On-site child care
d. Job sharing

Question # 109 Mr. Ahmed is a cashier and he feels dissatisfied at work. What best justifies this
situation?
a. His job may not be structured to suit his preferences
b. It involves physical toughness
c. It requires mental toughness
d. It involves too much customer interaction

Question #110 A practice used by companies to assign their costly activities to outside providers,
(for the purpose of cost saving), ratherthan completing it internally is called;
a. Planning
b. Decentralization
c. Restructuring
d. Outsourcing

Question #111 The _ problem occurs when supervisors tend to rate all their
subordinates consistently high.
a. Central tendency
b. Leniency
c. Strictness
d. Halo effect

Question #112 The relationship between critical incident method & BARS (behaviorally anchored
rating scale) is;
a. No relationship exists
b. Different methods to evaluate performance
c. Both are similar PA methods
d. Comparison method is used for PA, while BARS is related to trainingevaluation

Question #113 What is another term for 360-degree feedback?

a. Feedback loop
b. Multi-source assessment
c. Upward feedback
d. Circle feedback

Question #114 Standards are established to;

a. Achieve desired outcomes
b. Meet legal compliance
c. Achieve competitive advantage
d. Promote goodwill in market
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Question #115 The point method to evaluate job is an extension of;
a. Ranking method
b. Factor comparison method
c. Classification method
d. Point factor method

Question # 116 Job evaluation is based on the;

a. Physical skills required by the job
b. Relative job worth for an organization
c. Complexity of the job to perform
d. Conceptual skill required by the job

Question # 117 Who is in the best position to observe and evaluate an employee’s performance for
the purposes of a performance appraisal?
a. Peers
b. Customers
c. Top management
d. Immediate supervisor

Question # 118 Groups are called if jobs aresimilar.

a. Classes
b. Grades
c. Scales
d. Roles

Question # 119 Hawthorne studies depict the effects of workenvironment on:

a. Human Behavior
b. Human Performance
c. Human Satisfaction
d. All the given options

Question # 120 Train the raters prior to conduct the performance appraisal is an important
responsibility of;
a. Top management
b. HR department
c. Line managers
d. Production department

Question # 121 Currently Organizations are providing benefits totheir employees;

a. To attract new blood in the organization
b. To create stronger customer relationship
c. To enhance the market share
d. All of the above

Question # 122 Rewards offered to labors involved in production, arecategorized as;

a. Salary
b. Fringe benefits
c. Wage
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 d. Commission

Question # 123 The goal of pre-retirement educational programs is to;

A. Improve job satisfaction
B. Increase employee commitment
C. Minimize medical claims from retirees
D. Ease the transition from working life to retirement

Question # 124 Organizations put maximum effort in measuring performance of organizational

people because;
a. It makes procedures cost effective
b. It helps in detecting the problems
c. It leads to product innovation
d. It assists in implementing new technology

Question #125 Following are all examples of direct compensationEXCEPT;

a. Pension
b. Salary
c. Bonus
d. Income

Question # 126 One of the main flaws of Classification method toevaluate the jobs is;
a. It is an expensive method
b. Only beneficial for small organizations
[Link] probability of biasness
d. Not useful when jobs are different

Question #127 Appraisal of a worker’s performance can be describedas:

a. Planning Activity
b. Organizing Activity
c. Controlling Activity
d. Leading Activity

Question # 128 Which of the following measurement methods rates employee performance?
relative to other employees?
a. Graphic rating scale
b. Comparative method
c. Essay method
d. Critical incident method

Question # 129 Process of working with different resources to accomplish organizational goals is
known as:
a. Strategic management
b. Human Resource management
c. Management
d. Team work

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Question # 130 The concept of how a person behaves in a group can beattributed to:
a. Thermodynamics
b. Group Dynamics
c. MBO (Management by objectives)
d. Group Behavior

Question # 131The study of Organizational Behavior is closely relatedto:

a. Human Psychology
b. Human Behavior in general
c. Human Behavior at work
d. Human-Machine Interaction

Question #132 Essential component of an organization is:

a. Team
b. Structure
c. Individual
d. None of the given options

Question #133 The whole is greater than the sum of its parts isknown as:
a. Efficiency
b. Effectiveness
c. Productivity
d. Synergy

Question # 134 Virtual teams can contribute to better coordination among the team members
because:
a. Technology brings them together on a forum.
b. Team members meet physically with each other
c. Team members share views among themselves via communicationlinks.
d. Team members have the real time environment for interaction.

Question # 135 Setting standards should be left to the employee rather than organization leads to
self controlling because:
a. It follows the management by objective approach.
b. It increases the productivity of the worker
c. It increases the confidence of workers
d. Workers come up to the high standard since they have no pressure from his
superiors.

Question # 136 Organizational efficiency is expressed as:

a. Planning for long-run goals
b. Making the best use of scarce resources
c. Goal attainment
d. Meeting deadlines

Question # 137 Goal setting is:

a. Top down process
b. Bottom up process
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 c. A process of top down support and bottom up development
d. A function of senior management

Question # 138 When the firm changes the way it operates, theprocess is known as:
a. Downsizing
b. Brain drain
c. Restructuring
d. Outsourcing

Question # 139 Which one is not included in the hiring process?

a. Recruitment
b. Socialization
c. Selection
d. Job specification

Question # 140 Extents of individual freedom and discretionemployees have in performing

their jobs is Known as
a. Capitation
b. Flextime
c. Empowerment
d. Autonomy

Question #141 Which of the following measures are taken to assess the intensity of employees’
satisfaction and their attitude toward the training program?
Select correct option:
a. Continuous feedback
b. Profitability rate
c. Market share
d. Productivity levels

Question # 142 Organization, where employees are provided with theopportunity to

learn on continuous basis is known as
Select correct option:
a. Formal
b. Informal
c. Bureaucratic
d. Learning

Question #143 Under which of the following no screening of applicant pool is conducted before
making final selection?
Select correct option:
a. Walk-in applicants
b. Employee referrals
c. Employment agency
d. School placement

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Question # 144 Which of the following is NOT a concern of HumanResource Development (HRD)?
Select correct option:
a. Employee training
b. Employee orientation
c. Employee rights
d. Employee appraisals

Question #145 The process through which someone becomes aware of personal skills, interests,
knowledge, motivations; acquires information about opportunities; identifies
career goals; and establishes action plans to attain those goals is called _.
Select correct option:
a. Organizational development
b. Career management
c. Career development
d. Career planning

Question #146 Employee commitment has suffered in recent yearsbecause of:

Select correct option:
a. Downsizing
b. Training issues
c. Appraisals
d. Performance standards

Question #147 Following are the stages of socialization process,EXCEPT:

Select correct option:
a. Pre-arrival stage
b. Encounter stage
c. Metamorphosis stage
d. Completion stage

Question # 148 Which performance appraisal technique lists traitsand a range of performance?
Select correct option:
a. Alternation ranking
b. Graphic rating scale
c. Management By Objective
d. Paired comparison

Question # 149 Which of the following is part of an employee’s role in his or her own career
development?
Select correct option:
a. Providing timely performance feedback
b. Participating in career development discussions
c. Establishing goals and career plans
d. Offering a variety of career options

Question # 150 is achieved by combining capital, raw material & human resource by an
organization.
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 Select correct option:
a. Sales
b. Capital
c. Input
d. Output

Question #151 Decision regarding the delivery medium for training is made prior to which of the
following step?
Select correct option:
a. Evaluating the training program
b. Designing the contents of training to be delivered
c. Identifying whether the training is required or not
d. Conducting need assessment to identify issues

Question # 152 Unofficial part of an organization formed on the basis of common interests is
known as:
Select correct option:
a. Formal organization
b. Informal organization
c. Bureaucratic organization
d. Virtual organization

Question #153 The re-arrangement of organizational structure &change in organizational culture is

accomplished during:
Select correct option:
a. Task analysis
b. Organizational analysis
c. Person analysis
d. Management analysis

Question # 154 Which of the following statement reflects the 'Age Discrimination Act' for workers?
Select correct option:
a. At the age of 40 to 70, workers can not be retired by force
b. At the age below 18, workers can never be hired
c. Having 10 years of experience, workers should be promoted
d. Workers can never be rehired if retired once

Question # 155 Which of the following is a process of attracting individuals on timely basis, in
sufficient numbers and with appropriate qualifications, to apply for jobs with an
organization?
Select correct option:
a. Selection
b. Recruitment
c. Staffing
d. Enrollment

Question # 156 Which of the following method includes the exchange of information between
organizational member & the applicant througha goal-oriented conversation?
877
 Select correct option:
a. Counseling simulations
b. Vocational interest test
c. Role playing
d. Employment interview

Question # 157 If the workforce of an organization represents true proportion of the community
sectors in all its job classifications, it represents the of its affirmative action.
Select correct option:
a. Performance
b. Gaps
c. Effectiveness
d. Discrepancies

Question #158 Studying organizational behavior helps managers:

Select correct option:
a. To see the value of workforce diversity
b. To analyze the efficiency of organization
c. To analyze the efficiency of organization
d. To become more effective in society

Question # 159 If a company is employing the fresh graduates as well as the professional experts,
the management is said to be enhancing .
Select correct option:
a. Stereotyping
b. Variety
c. Diversity
d. Uniformity

Question # 160 The cognitive component consists of a person’s

Select correct option:
a. Emotions
b. Knowledge
c. Attitude
d. Feelings

Question # 161 Which of the given term is used to represent the segments of jobs held by an
individual throughout his/her life time?
Select correct option:
a. Responsibility
b. Career
c. Occupation
d. Position

Question # 162 Which of the following information is NOT collected through observation method
while conducting job analysis?
Select correct option:
a. Who is monitoring the task?
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 b. What task has done?
c. How task has done?
d. How long a task has taken to complete?

Question # 163 What is another term used for 360-degreefeedback?

Select correct option:
a. Feedback loop
b. Multi-source assessment
c. Upward reporting
d. Round communication

Question # 164 Which one of the following is an outcome of'organizing' function of management
Select correct option:
a. Organization’s strategy
b. Motivation & commitment
c. Organization’s structure
d. Performance measurement

Question # 165 Which of the following is a stated outcome of 'JobAnalysis'?

Select correct option:
a. Job description
b. Job specification
c. Job evaluation
d. All of the given options

Question # 166 Which of the following is MOST important to manageworkforce diversity?

Select correct option:
a. Lower cohesiveness
b. Support group
c. Top-level commitment
d. Resistance to change

Question # 167 Training to the raters of performance appraisal is animportant responsibility of:
Select correct option:
a. Top management
b. HR department
c. Line managers
d. Production department

Question # 168 Graphic rating scales are subjected to all of thefollowing problems, EXCEPT:
Select correct option:
a. Halo effects
b. Complexity
c. Central tendency
d. Leniency

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Question # 169 Which of the following is responsible for implementingthe developed strategies?
Select correct option:
a. Human resource
b. Physical resource
c. Rules & policies
d. Installed equipment

Question # 170 In which of the following area organizations are legally bound to maintain
consistency in HR policies?
Select correct option:
a. Compensation system
b. Training & development
c. Safety measures
d. None of the given options

Question # 171 How can companies provide career counseling, development advice, and therapy
for employees seeking to grow intheir careers?
Select correct option:
a. Provide career coaches
b. Encourage role reversal
c. Establish a corporate campus
d. Offer online career centers

Question # 172 Which ONE of the following is not a part of HumanResource Development?
Select correct option:
a. Training
b. Education
c. Development
d. Rewards

Question # 173 What type of screening mode is used to reduce absenteeism and establish a
baseline for future insurance claims?
Select correct option:
a. Physical examinations
b. Personality tests
c. Polygraph tests
d. Substance abuse screening

Question # 174 Which of the following is part of the organization’s role in an employee’s career
development?
Select correct option:
a. Communicating the mission, policies, and procedures
b. Providing timely performance feedback
c. Participating in career development discussions
d. Seeking out career information

880
Question # 175 Which of the following term is said to be a part ofOrganizational Structure?
Select correct option:
a. Goal attainment
b. Hierarchy level
c. Performance standards
d. Supporting staff

Question # 176 “On going process of evaluating & managing both the behavior & outcomes in the
workplace” is known as;
Select correct option:
a. Training & development
b. Performance appraisal
c. Compensation management
d. Job analysis

Question # 177 Which performance appraisal technique lists traitsand a range of performance?
Select correct option:
a. Alternation ranking
b. Graphic rating scale
c. Management By Objective
d. Paired comparison

Question # 178 HRIS helps managers to perform moreeffectively & systematically.

Select correct option:
a. Management functions
b. Controlling functions
c. Planning functions
d. HR functions

Question # 179 Job posting is:

a. Internal advertisement by an organization to attract candidates from the
existing employees, against a vacancy.
b. The system of transferring existing employees to comparable new jobs
available in the organization.
c. An arrangement of in house training of employees for careeradvancement.
d. Grouping together of a family of similar jobs, under a single title to establish
uniformity of standards in controls and compensations.

Question # 180 Realistic job preview is a:

a. Technique for listing elements of job before selecting someone toperform it.
b. Performance appraisal technique.
c. A selection device that enables the candidates to learn both the negative and
positive information about the job and organization.
d. None of the given options

881
Question # 181 Organizational efficiency is expressed as:
a. Planning for long-run goals
b. Making the best use of scarce resources
c. Goal attainment
d. Meeting deadlines

Question # 182 Goal setting is:

a. Top down process
b. Bottom up process
c. A process of top down support and bottom up development
d. A function of senior management

Question #183 When the firm changes the way it operates, theprocess is known as:
a. Downsizing
b. Brain drain
c. Restructuring
d. Outsourcing

Question # 184 Organization, where employees are provided with the opportunity to learn on
continuous basis is known as:
Select correct option:
a. Formal
b. Informal
c. Bureaucratic
d. Learning

Question # 185 Under which of the following no screening of applicant pool is conducted before
making final selection?
Select correct option:
a. Walk-in applicants
b. Employee referrals
c. Employment agency
d. School placement

Question # 186 Which of the following is NOT a concern of HumanResource Development (HRD)?
Select correct option:
a. Employee training
b. Employee orientation
c. Employee rights
d. Employee appraisals

Question #187 Employee commitment has suffered in recent years because of:
Select correct option:
a. Downsizing
b. Training issues
c. Appraisals
d. Performance standards

882
Question # 188 Following are the stages of socialization process,EXCEPT:
Select correct option:
a. Pre-arrival stage
b. Encounter stage
c. Metamorphosis stage
d. Completion stage

Question # 189 Which performance appraisal technique lists traitsand a range of performance?
Select correct option:
a. Alternation ranking
b. Graphic rating scale
c. Management By Objective
d. Paired comparison

Question # 190 Which of the following is part of an employee’s role in his or her own career
development?
Select correct option:
a. Providing timely performance feedback
b. Participating in career development discussions
c. Establishing goals and career plans
d. Offering a variety of career options

Question # 191 Decision regarding the delivery medium for training is made prior to which of the
following step?
Select correct option:
a. Evaluating the training program
b. Designing the contents of training to be delivered
c. Identifying whether the training is required or not
d. Conducting need assessment to identify issues

Question # 192 Unofficial part of an organization formed on the basis of common interests is
known as:
Select correct option:
a. Formal organization
b. Informal organization
c. Bureaucratic organization
d. Virtual organization

Question #193 The re-arrangement of organizational structure &change in organizational culture is

accomplished during:
Select correct option:
a. Task analysis
b. Organizational analysis
c. Person analysis
d. Management analysis

Question # 194 Which of the following statement reflects the 'AgeDiscrimination Act' for workers?
Select correct option:
883
 a. At the age of 40 to 70, workers can not be retired by force
b. At the age below 18, workers can never be hired
c. Having 10 years of experience, workers should be promoted
d. Workers can never be rehired if retired once

Question # 195 Which of the following is a process of attracting individuals on timely basis, in
sufficient numbers and with appropriate qualifications, to apply for jobs with an
organization?
Select correct option:
a. Selection
b. Recruitment
c. Staffing
d. Enrollment

Question # 196 If the workforce of an organization represents true proportion of the community
sectors in all its job classifications, it represents the of its affirmative action.
Select correct option:
a. Performance
b. Gaps
c. Effectiveness
d. Discrepancies

Question # 197 The cognitive component consists of a person’s:

Select correct option:
a. Emotions
b. Knowledge
c. Attitude
d. Feelings

Question # 198 Which of the given term is used to represent the segments of jobs held by an
individual throughout his/her life time?
Select correct option:
a. Responsibility
b. Career
c. Occupation
d. Position

Question # 199 Which of the following information is NOT collected through observation method
while conducting job analysis?
Select correct option:
a. Who is monitoring the task?
b. What task has done?
c. How task has done?
d. How long a task has taken to complete?

Question # 200 What is another term used for 360-degreefeedback?

Select correct option:
a. Feedback loop
884
 b. Multi-source assessment
c. Upward reporting
d. Round communication

Question # 201 Which one of the following is an outcome of'organizing' function of management?
a. Select correct option:
b. Organization’s strategy
c. Motivation & commitment
d. Organization’s structure
e. Performance measurement

Question # 202 Which of the following is a stated outcome of 'JobAnalysis'?

Select correct option:
a. Job description
b. Job specificationJ
c. ob evaluation
d. All of the given options

Question # 203 Which of the following is MOST important to manageworkforce diversity?

Select correct option:
a. Lower cohesiveness
b. Support group
c. Top-level commitment
d. Resistance to change

Question # 204 Training to the raters of performance appraisal is animportant responsibility of:
Select correct option:
a. Top management
b. HR department
c. Line managers
d. Production department

Question # 205 Graphic rating scales are subjected to all of thefollowing problems, EXCEPT:
Select correct option:
a. Halo effects
b. Complexity
c. Central tendency
d. Leniency

Question # 206 Which of the following is responsible forimplementing the developed strategies?
a. Select correct option:
b. Human resource
c. Physical resource
d. Rules & policies
e. Installed equipment

Question # 207 In which of the following area organizations are legally bound to maintain
consistency in HR policies?
885
 Select correct option:
a. Compensation system
b. Training & development
c. Safety measures
d. None of the given options

Question # 208 How can companies provide career counseling, development advice, and therapy
for employees seeking to grow intheir careers?
Select correct option:
a. Provide career coaches
b. Encourage role reversal
c. Establish a corporate campus
d. Offer online career centers

Question # 209 Which ONE of the following is not a part of HumanResource Development?
Select correct option:
a. Training
b. Education
c. Development
d. Rewards

Question # 210 What type of screening mode is used to reduce absenteeism and establish a
baseline for future insurance claims?
Select correct option:
a. Physical examinations
b. Personality tests
c. Polygraph tests
d. Substance abuse screening

Question # 211 Which of the following is part of the organization’s role in an employee’s career
development?
Select correct option:
a. Communicating the mission, policies, and procedures
b. Providing timely performance feedback
c. Participating in career development discussions
d. Seeking out career information

Question # 212 Which of the following term is said to be a part ofOrganizational Structure?
Select correct option:
a. Goal attainment
b. Hierarchy level
c. Performance standards
d. Supporting staff

Question # 213 Which performance appraisal technique lists traitsand a range of performance?
Select correct option:
a. Alternation ranking
b. Graphic rating scale
886
 c. Management By Objective
d. Paired comparison
Question # 214 A group comprises of employees who work together to complete a particular task
or project is known as:
Select correct option:
a. Interest groups
b. Command group
c. Task group
d. Friendship groups

Question # 215 People with which type of personality trait commonlymake poor decisions because
they make them too fast?
Select correct option:
a. Type As
b. Type Bs
c. Self-monitors
d. Extroverts

Question # 216 All of the following are Decision-making stylesEXCEPT:

Select correct option:
a. Analytical
b. Conceptual
c. Ethical
d. Behavioral

Question # 217 Which of the following is NOT a factor in theindividual perceiver?

Select correct option:
a. Attitude
b. Motive
c. Location
d. Perception

Question # 218 All are true for internal system approach except:
Select correct option:
a. Increase rate of product innovation
b. Cut decision making time
c. Reduce production costs
d. Reduce time to market

Question # 219 Factors other than satisfaction that impact one’s decision to leave a current job
include all of the following EXCEPT:
a. Select correct option:
b. Labor market conditions
c. Length of tenure with the organization
d. Expectations about alternative job opportunities
e. Organizational citizenship behavior

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Question #220 Organizational variable that affect the human behavior are Performance appraisal,
work design, communicationand _
Select correct option:
a. Organizational change
b. Cultural diversity
c. Rapid change
d. Organizational structure and design

Question # 221 Which of the following is not considered as acharacteristic of organizations?

Select correct option:
a. Social entities
b. Goal oriented
c. Closed system
d. Deliberately structured

Question # 222 Which of the following is NOT one of the six universal emotions, as agreed upon by
most contemporary researchers?
Select correct option:
a. Anger
b. Fear
c. Hate
d. Sadness

Question # 223 refers to manager's mental abilityto analyze and diagnose complex situations.
Select correct option:
a. Human Skill
b. Managerial Skill
c. Conceptual Skill
d. Technical Skill

Question # 224 Which of the following is ‘NOT’ one of the most common reasons people join
groups?
Select correct option:
a. Security
b. Status
c. Equity
d. Power

Question # 225 Job appraisal is the part of

Select correct option:
a. Sociology
b. Anthropology
c. Psychology
d. Political science

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Question # 226 Which of the following is NOT consistent with rational decision-making?
Select correct option:
a. Consistency
b. Value-maximizing
c. Restraints
d. Ranking of criteria

Question # 227 This of the following is NOT a factor influencingperception:

Select correct option:
a. Perceiver
b. Situation
c. Stimuli
d. Target

Question # 228 Which of the following statements about thedeterminants of personality is true?
Select correct option:
a. Personality appears to be a result of external factors
b. Personality appears to be a result of mainly hereditary factors
c. Personality appears to be a result of mainly environmental factors
d. Personality appears to be a result of both hereditary and environmental
factors

Question # 229 Which of the following is the most productive stage ingroup development?
Select correct option:
a. Producing
b. Increasing
c. Maturity
d. Performing

Question #230 Today’s managers understand that the success of any effort at improving quality
and productivity must include _ .
Select correct option:
a. Quality management programs
b. Customer service improvements
c. Employee’s participation
d. Manufacturing simplification

Question #231 Sana is an honest and straightforward person. She believes her employees are all
similarly honest and straightforward, ignoring signs that they may be manipulating
her. What perceptual shortcut is Sana most likely using?
Select correct option:
a. Contrast effect
b. Halo effect
c. Stereotyping
d. Projection

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Question # 232 Which of the following is not a core topic oforganizational behavior?
Select correct option:
a. Motivation
b. Attitude development
c. Conflict
d. Resource allocation

Question #233 What do we call the process by which individuals organize and interpret their
sensory impressions in order to givemeaning to their environment?
Select correct option:
a. Perception
b. Interpretation
c. Social verification
d. Environmental analysis

Question # 234 The organizations offer employee stock ownership programs to gain which of the
following benefit?
Select correct option:
a. Increasing employee satisfaction
b. Reducing salaries
c. Reducing stress
d. Increasing productivity

Question #235 Mr. Ehsan, Manager ABC Company found that skills of workers and machinery used
by them as compared to the competitors in the market are obsolete within a year,
which type of challenge ABC Company is facing?
Select correct option:
a. Globalization and Culture
b. High Quality and Low Quality
c. Rapid Pace of Change
d. Multiple Stakeholders

Question # 236 Asad, one of your newest employees, is an extravert. Which of the following
statements is LEAST likely to be true?
Select correct option:
a. Asad will probably attend the company picnic
b. Asad will be suited to a managerial or sales position
c. Asad will probably have a large number of relationships
d. Asad will perform well on specialized, detail-oriented tasks

Question # 237 Which of the following fields has most helped us understand differences in
fundamental values, attitudes, and behavioramong people in different countries?
Select correct option:
a. Anthropology
b. Psychology
c. Political science
d. Operations researches
890
Question # 238 Barriers to Social perception include all EXCEPT:
Select correct option:
a. Halo effect
b. Stereotyping
c. Projection
d. Selective Perception

Question # 239 People with which type of personality trait commonlymake poor decisions because
they make them too fast?
Select correct option:
a. Type As
b. Type Bs
c. Self-monitors
d. Extroverts

Question # 240 Workers in Pakistan are entitled to receive pension, medical facilities and gratuity
come under:
Select correct option:
a. Human Rights
b. Moral Rights
c. Legal Rights
d. Personal Rights

Question # 241 Which of the following are terminal values?

Select correct option:
a. Accuracy and Creativity
b. Equality and Friendliness
c. Profitability and Hard work
d. Excellence and Innovation

Question # 242 Ahmed is responsible to transmit information to outsiders on organization’s plans,

policies, actions and results. Whichmanagerial role is he playing in organization?
Select correct option:
a. Disseminator
b. Spokesperson
c. Representative
d. Figurehead

Question #243 Management roles (Interpersonal, Informational,Decisional ) were coined by

Select one:
a. Henry Mintzberg
b. Peter Drucker
c. Michael E. Porter
d. Bill Gates

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PART - 3

Question # 1
Which of the following term is used for locating the qualified candidates?
a. Select correct option:
b. Recruitment sources
c. Recruitment leads
d. Recruitment pools
e. Recruitment personnels

Question # 2 Organizational basic components are:

Select correct option:
a. Machinery, people, office building
b. People, purpose, structure
c. People, structure, finances
d. People, strategies, resources

Question 3 The manager’s responsible to specify the qualifications employees need to fill specific
positions is
Select correct option:
a. line manager
b. middle manager
c. top manager
d. none of given option

Question 4 Which of the following defines the process of 'Recruitment'?

Select correct option:
a. Forecasting the demand of human resources
b. Forecasting the supply of human resources
c. Discovering potential job candidates for a particular position
d. Making a “hire” or “no hire” decisions

Question 5 The process of discovering potential candidates for actual or anticipated

organizationalvacancies is known as:
Select correct option:
a. HR planning
b. Job analysis
c. Recruitment
d. Selection

Question 6 Background investigations and reference checks are considered to verify candidate’s
.
Select correct option:
a. Age
b. Marital status
c. Credentials
d. Gender

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Question 7 360% feedback involves appraisals by:
Select correct option:
a. Line managers
b. Subordinates'
c. Superiors'
d. Anyone who is directly in contact with the appraised person

Question 8 The best hiring occurs when

Select correct option:
a. The goals of the organization and the goals of the individual have consistency.
b. The goals of the supervisor and the goals of the individual have consistency.
c. The goals of the higher management and the goals of the individual have consistency.
d. The goals of HR department and the goals of the individual have consistency.

Question 9 Which one is not true about the Re-engineering?

Select correct option:
a. Stress level may be magnified
b. Conflict level may get severe
c. It may leave the employees confused and angry
d. People remain unaffected

Question 10 Who is said to be responsible for task allocation in order to fulfill the organizational
goals?
Select correct option:
a. Stockholders
b. Stakeholders
c. Managers
d. Investors

Question 11 is termed as the "right arm of the top executive.”

Select correct option:
a. staff manager
b. line manager
c. personnel manager
d. Secretary

Question 12 The ability to think about abstract & complex situations is refered as:
Select correct option:
a. Technical skill
b. Interpersonal skill
c. Conceptual skill
d. Mechanical skill

Question 13 Blind box Ads are used for

Select correct option:
a. Good reputation
b. Low profile jobs
c. Promotion
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 d. Publicity

Question 14 How do companies facilitate workforcediversity?

Select correct option:
a. By relying on external support systems for minority workers
b. By encouraging employees to challenge beliefs and values of other
employees
c. By organizing social activities
d. By reinforcing traditional values

Question 15 A manager's function is classified as line or staff based on the organization's

Select correct option:
a. Vision
b. Flow of authority
c. objectives
d. none of given option

Question 16 Methods of Collecting Job AnalysisInformation include

Select correct option:
a. Interview
b. Questionnaire
c. Logs
d. all of given option

Question 17 Followings are included in contingent workersEXCEPT:

Select correct option:
a. Part-timers
b. Contractors
c. Directors
d. Temporaries

Question 18 Entrepreneurs are said to perform the:

Select correct option:
a. Interpersonal roleIn
b. formational role
c. Supportive role
d. Decisional role

Question 19 HR department maintains records.

Select correct option:
a. Inventory
b. Sales
c. Production
d. Employee

Question 20 Which of the following is NOT a function ofHRM?

Select correct option:
a. To Attract People
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 b. To Develop People
c. To Motivate People
d. None of these

Question 21 If the workforce of an organization represents true proportion of the community

sectorsin all its job classifications, it represents the of its affirmativeaction.
Select correct option:
a. Performance
b. Gaps
c. Effectiveness
d. Discrepancies

Question 22 is termed as the "right arm of the top executive.”

Select correct option:
a. staff manager
b. line manager
c. personnel manager
d. Secretary

Question 23 Which of the following is the major objective of training function of HRM?
Select correct option:
a. To attract qualified applicant to fill the job vacancies
b. To give employees the skills and knowledge to perform their jobs effectively
c. To help a new employee adjust himself to the new job and the employer
d. To monitor employee performance to ensure that it is at acceptable levels

Question 24 KSA stands for

Select correct option:
a. Knowledge, talent, ability
b. Knowledge, skills, aptitude
c. Knowledge, skills, ability
d. Knowledge, talent, ability

Question 25 Manufacturing was the main concern of personneldepartment during:

Select correct option:
a. Mechanistic period
b. Catalytic period
c. Organistic period
d. Strategic period

Question 26 The process of pursuing an inclusive culture where newcomers feel welcomed by
existing employees and everyone sees the value of his or her job, is termed as:
a. Select correct option:
b. Management of uniformity
c. Variety management
d. Managing stereotypes
e. Diversity management
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Question 27 Which of the following recruitment method provides a platform to multiple employers
toattract large number of applicants?
Select correct option:
a. Job offer
b. Job fair
c. Job festival
d. Job listing

Question 28 A system that prohibits interaction with the world outside is termed as
Select correct option:
a. Closed System
b. Open System

Question 29 Unofficial part of an organization formed on the basis of common interests is known
as:
Select correct option:
a. Formal organization
b. Informal organization
c. Bureaucratic organization
d. Virtual organization

Part-4
1. Identify the managerial function out of the following functions of HR managers.
a. Procurement
b. Development
c. Organizing
d. performance appraisal

2. Which of the following is an example of operative function of HR managers?

a. Planning
b. Organising
c. Procurement
d. Controlling

3. The scope of human resource management includes

a. Procurement
b. Development
c. Compensation
d. all of the above

4. Human resource management is normally in nature

a. Proactive
b. Reactive
c. Combative
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 d. none of the above

5. The human resource management functions aim at

a. ensuring that the human resources possess adequate capital, tool, equipment and material to
perform the job successfully
b. helping the organisation deal with its employees in different stages. of employment
c. improving an organisation's creditworthiness among financial institutions
d. none of the above

6. Which of the 'following aptly describes the role of line managers and staff advisors, namely HR
professionals?
a. Staff advisors focus more on developing HR programmes while line managers are more
involved in the implementation of those programmes.
b. Line managers are concerned more about developing HR programmes whereas staff advisors
are more involved in implementing such programmes.
c. Staff advisors are solely responsible for developing, implementing and evaluating the HR
programmes while line managers are not all involved in any matters concerning HR.
d. Line managers alone are responsible for developinq, implementing and evaluating the HR
programmes while staff advisors are not all involved in any matters concerning HR.

7. Human resource management is the formal part of an organisation responsible for all of the
following aspects of the management of human resources except:
a. strategy development and analysis
b. systems, processes, and procedures
c. policy making, implementation, and enforcement
d. management of the organisation's finances

8. organisation relies on the following sources of capital

a. cultural, human and system capital
b. social, cultural and human capital
c. cultural, human and source capital
d. none of the above

9. To address the challenges and opportunities they face organisations engage in' a process of
strategic management. Strategic management is:
a. short-term focused and composed of organisational strategy, including strategy formulation
and implementation
b. long-term focused and composed of the organisation's mission, vision and value statements
c. long-term focused and composed of organisational strategy, including strategy formulation
and implementation
d. short-term focused and composed of the organisation's mission, vision and value statements

10. Strategic human resource management involves:

a. planning, foresight and analytical decision making
b. setting employment standards and policies
c. linking human resources with strategic objectives to improve performance
d. d. all of the above

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11. The balanced scorecard proposes that organisational success depends on:
a. focus on only the internal environment of the organization
b. constantly changing external environment
c. the belief that it is impossible to take a rationalist view of the organisation to make optimal
choices
d. an ability to develop a complete list of cause and effect relationships driving a firm's
success

[Link] and Barocci's (1985) model of HRM has three elements. These elements are:
a. the external environment, the internal environment and human resource management
b. HRM/lR system effectiveness, the external environment and the internal environment
c. human resource management, the internal environment and HRM/lR system effectiveness .
d. the external environment, human resource management and HRM/lR system effectiveness

13. The critical role of the SHRM Application Tool is to:

a. develop a better strategic management process to deal with the dynamic changing
environment today's organisations face
b. identify if the organisation has enough staff, if the staff need training, if the compensation
practices are appropriate, and if jobs are designed correctly
c. identify and assess a narrow group of actions and plan how the organisation can overcome
resistance to change
d. outline techniques, frameworks, and six steps that must be followed to effectively
implement change in an organization

[Link] which decade did HRM originate?

a. 1950s
b. 1970s
c. 1980s
d. 1990s

[Link] are the ideas underpinning 'soft', 'e commitment', or 'high-road' HRM practices?
a. Labour needs to be treated as an asset to be invested in
b. Employees are a cost which should be minimized
c. A lack of mutuality existing between employer and employee
d. A disregard for unlocking discretionary effort

[Link] consulting company is associated with the concept of talent management?

a. Price Waterhouse Coopers
b. Boston Consulting Group
c. Deloitte
d. McKinsey

[Link] are employers interested in employee engagement?

a. To encourage employees to trust their managers
b. To make a quick profit
c. Because engaged employees are more motivated and prepared to give of their best to make
the firm succeed
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 d. To make employees work harder for less

[Link] of the following is a key HR role as defined by Ulrich et al (2009)?

a. Personnel administrator
b. Business ally
c. Payroll adviser
d. Organisational geographer

19. The term 'emotional labour' is associated with which author?

a. Arlie Hochschild
b. Stephen Fineman
c. David Sims
d. Yiannis Gabriel

[Link] do some commentators claim that it is unlikely that the UK economy will become a
knowledge economy?
a. The lack of IT education in schools
b. Culturally low in intelligence.
c. Historically low levels of company investment into research and development
d. Unions try to prevent knowledge transfer from management level to the broader workforce.

[Link] measures are typically involved in the rationalising of businesses?

a. Downsizing and. Layering
b. Expanding and Layering
c. Downsizing and Delayering
d. Expanding and Delayering

[Link] kinds of practices outlined below are typically associated with non-standard working and
flexibility?
a. 9-5 working hours
b. The reduction in distinctions between standard and unsocial hours or standard and extra
hours
c. Premium rates for unsocial hours
d. The voluntary agreement of unsocial hours working

[Link] of the following is not a limitation of SWOT (Strengths, Weaknesses, Opportunity,

Threats) analysis?
a. Organisational strengths may not lead to competitive advantage
b. SWOT gives a one-shot view of a moving target
c. SWOT's focus on the external environment is too broad and integrative
d. SWOT overemphasises a single dimension of strategy

24.A marketing department that promises delivery quicker than the production department's ability
toproduce is an example of a lack of understanding of the:
a. synergy of the business units.
b. need to maintain the reputation of the company.
c. organisational culture and leadership
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 d. interrelationships among functional areas and firm strategies

[Link] Corp. is centering on the objective of low-cost, high quality, on-time production by curtailing
idle productive facilities and workers. The XYZ Corp. is taking advantage of a system
a. Just-In-Time (JIT)
b. Last In, First Out (UFO)
c. First In, First Out (FIFO)
d. Highly mechanized

[Link] of the following lists is comprised of support activities?

a. Human resource management, information systems, procurement, and firm infrastructure
b. Customer service, information systems, technology development, and procurement
c. Human resource management, technology development, customer service, and procurement
d. Human resource management, customer service, marketing and sales, and operations

27. Although firm infrastructure is quite frequently viewed only as overhead expense, it can become
asource of competitive advantage. Examples include all of the following except:
a. negotiating and maintaining ongoing relations with regulatory bodies
b. marketing expertise increasing a firm's revenues and enabling it to enter new markets.
c. effective information systems contributing significantly to a firm's overall cost leadership
strategy.
d. top management providing a key role in collaborating with important customers.

28. The competencies or skills that a firm employs to transform inputs into outputs are:
a. tangible resources
b. intangible resources
c. organisational capabilities
d. reputational resources

[Link] array of firm resources include interpersonal relations among managers in the firm, its
culture, and its reputation with its customers and suppliers. Such competitive advantages are
based upon:
a. physical uniqueness
b. path dependency
c. social complexity
d. tangible resources

30. A company's ability to meet its short-term financial obligations is measured by which of the
following categories?
a. Liquidity ratios
b. Profitability ratios
c. Activity ratios
d. Leverage ratios

31. The "balanced scorecard" supplies top managers with a view of the business.
a. longterm financial
b. detailed and complex
c. simple and routine
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 d. fast but comprehensive

[Link] strategic human resource management, HR strategies are generally aligned with:
a. business strategy
b. marketing strategies
c. finance strategy
d. economic strategy

[Link] of the following is closely associated with strategic human resource management?
a. Efficient utilisation of human resources
b. Attracting the best human resources
c. Providing the best possible training
d. All of the above

34. Treating employees as precious human resources is the basis of the approach.
a. hard HRM
b. soft HRM
c. medium HRM
d. none of the above

35. Strategic human resource management aims to achieve competitive advantage in the market
through
a. Price
b. Product
c. People
d. Process

[Link] and Snell made important contribution to the growth of:

a. Strategic fit model
b. Strategic labour allocation process model
c. Business-oriented model
d. none of the above

37. Strategic management process usually consists of __ steps

a. Four
b. Five
c. Six
d. Seven

[Link] of the components of corporate level strategy is:

[Link] strategy'
b. portfolio strategy
[Link] strategy
d. all of the above

39. Creating an environment that facilitates a continuous and two-way exchange of information
betweenthe superiors and the subordinates is the core of:
a. High involvement management model

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 b. High commitment management model
c. High performance management model
d. none of the above

[Link] crossing is an activity that

a. Creates internal organisational conflict between different departments as they compete to
generate new practices
b. Occurs when organisations advance into new areas of the market
c. Undermines the integration of an organisation through the breakdown of the departmental
boundaries.
d. Is focused upon achieving internal organisational integration between various
organisationalroles and units in order to generate creativity and synergy

41. Procedures provide for an important element of consistency in managerial?

[Link]
b. Strategy
[Link]
d. Decision-making

[Link] has the bureaucratic form of organisation been fundamentally questioned?

a. The pressures of globalisation have rendered it unsuitable.
b. Organisations are experiencing acute pressure to change and pursue innovation as a means
of securing business growth.
c. Organisations have grown so large that it is almost impossible to create an effective
bureaucracy to manage them.
d. Information Technology has made it redundant.

[Link] famously adopted Taylor's Scientific Management approach?

a. Ronald McDonald
b. Ralph Lauren
c. Henry Ford
d. James Dyson

44. The most pertinent criticism of the empowerment concept concerns

a. the balance between customers' wishes and efficiency.
b. the limited evidence for any shift towards a substantially .more empowered workforce.
c. the over-empowerment of employees
d. the limited theorising of the concept.

[Link] of the following attributes of potential employees is of heightened interest to employers

whenrecruiting. Which one is it?
a. The candidate's physical health
b. The candidate's ability to deal with customers
c. The candidate's ability to prepare for and cope with an uncertain future
d. The candidate's organisational abilities

46. Selection is concerned with:

a. The activity to select a suitable pool of candidates.

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 b. Always being stimulated by the departure of an employee.
c. Always ascertaining a candidate's personality to ensure a suitable fit.
d. Applying appropriate techniques and methods to select a candidate.

47. Which activities are not associated with workforce planning?

a. Forward planning reviewing internal and external labour supply
b. Assessing capability of workforce to develop any requisite skills
c. Time keeping
d. Identifying areas where recruitment will be needed

48. Why is job analysis soinfused with organisational politics?

a. Because it is a process which could lead to contraction of employees in a department and
therefore diminishing its power base
b. A result of interdepartmental rivalry d.
c. Because it is not an objective activity
d. Because it is a process through which companies try to shed labour

49. What do rational processes to recruitment and selection typically ignore?

a. Labour market demand
b. Wages
c. The time it takes to get to work
d. The use of power and micropolitics by managers

50. Which is the most popular method of recruiting applicants to jobs?

a. Radio and TV advertisement
b. Corporate website
c. Employee referral schemes
d. Commercial job boards

51. Which selection method remains the most used by organisations?

a. Interviews
b. Ability tests
c. References
d. A trial period

52. Which items below are' forms of perceptual errors made during the selection process?
a. Like-me judgements
b. A candidate's time-keeping
c. The interview setting
d. The time of day

53. Which of the below is a form of interview used in candidate selection?

a. The appraisal interview
b. The competency based interview
c. The disciplinary interview
d. The return to work interview

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54. The interview is used as a method for determining:
a. The personality of the candidate
b. The degree of fit between the applicant and the demands of the job.
c. His/her age.
d. Physical attributes

55. According to the Leitch Review of Skills (2006), the ability of firms to succeed in the face of
growing international competition depends increasingly on;
a. Work culture
b. Relaxed legal system
c. Good infrastructure
d. Skilled labour

56. What is the main reason employers give why employees are not fully proficient?
a. Lack of experience
b. Over qualified
c. Lack of numeracy skills
d. Lack of literacy skills

57. Which of the stages below are part of the Systematic Training Cycle?
a. Analyse operating conditions
b. Design training
c. Deliver on time
d. Evaluate customer feedback

58. What is the main disadvantage of off-the-job learning?

a. It isn't always directly related to real organisational issues and needs
b. The time needed to set up
c. Accessibility for those training
d. Long term costs

59. A cultural view of learning considers the values and norms of communities through:
a. Myths, legends and proverbs
b. Music, song and dance
c. Rituals, language and religion
d. Talk, practices and stories

60. What is a 'communities of practice' approach to organisational learning?

a. An approach that focuses on practising 'best practice'
b. An approach that focuses on the values, beliefs and norms of a social group
c. An approach that focuses on the skills embedded within the group
d. An approach that has a clear set of defined practices to use in all situations
61. Chase's study (1997) identified what issue as being the biggest obstacle to creating a
knowledgecreating company?
a. Limited resources for training and development
b. Organisational culture
c. Failure of management
d. Inability to access learning material

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62. What is the most common form of organisational intervention designed to improve employee
wellbeing?
a. Secondary and tertiary
b. Primary
c. Variable
d. Best-fit

63. What are the main aims of Employee Assistance Programmes?

a. To alter the organisational culture
b. To address team and individuaf performance and well-being in the workplace
c. To focus the attention Of employees to the power structures of an organization d.
d. To establish effective methods of care and support for 'everyone in an Organization

64. How does the selection of an international assignee usually take place?
a. Formal interview process with internal staff.
b. Informal discussion based on chance conversations with internal staff.
c. Informal discussion between each member of a specific team.
d. Formal recruitment process that includes internal and external candidates

65. Which multinational bank used business sponsors to monitor international assignees?
a. Oman International Bank
b. Falcon International
c. HSBC
d. Barclays

66. What is the major problem with the theorizing of strategic IHRM?
a. It becomes obsolete very quickly as change occurs so fast
b. It is biased towards western ideas
c. It tends to offer a highly idealised [Link] on strategy formulation
d. It fails to incorporate conflict

67. How can HRM help to build successful cross-border alliances?

a. By ensuring that organisations spend 25% of their budgets on cross-border alliances
b. By ensuring that a strategy is in place before embarking on a cross-border alliance
c. By ensuring that organisations export their ideas to other societies and cultures
d. By ensuring that international joint ventures are staffed by high-quality managers

68. Which of the following statements most accurately defines human resource management?
a. human resource management contributes to business strategy and plays and important role
inthe implementation of business strategy
b. human resource management is an approach to managing people
[Link] resource management seeks to achieve competitive advantage through the strategic
deployment of a highly committed and capable workforce, using an integrated array of
cultural, structural and personnel techniques
d. human resource management focuses on people as the source of competitive advantage

69. Which of the following techniques are not connected with human resource planning?

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 a. succession planning
b. management of change
c. simple linear regression
d. Markov matrix analysis

70. Which of the following is NOT true of the activity known as job analysis?
a. it aims to describe the purpose of a job and the conditions under which it is performed.
b. the job elements are rated in terms such as frequency of use or amount of time involved
c. the rate of pay for the job is fixed
d. jobs are broken into elements such as information or relations with other people

71. Which of the following is NOT a common criticism of using personality tests in selection?
a. Good performers in the same job may have different personalities
b. There are no reliable instruments with which to assess personality
c. An individual's personalitycan vary with circumstances
d. Candidates can fake the answers, so giving a misleading impression

72. Which of the following is not a recruitment technique?

a. Interviews
b. performance appraisal
c. psychometric testing
d. ability tests

73. Which statement best describes '360 degree feedback'? It is:

a. a method used to appraise employees
b. a system where managers give feedback to all their staff
c. a system where feedback on any individual is derived from peers, subordinates supervisors
and occasionally, customers
d. a development tool

74. Which of the following would not form part of a flexible reward package?
a. ability to 'buy and sell' leave days
b. non-pay items such as child care vouchers
c. cafeteria benefits
d. performance-related pay

75. Which one of the following becomes a creative factor in production?

a. Land
b. Capital
c. Consumers
d. Human Resources

76. People cast in the role of contributors to production are called

a. Capitalist
b. Land owners
c. Human Resources
d. Consumers

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77. Wide range of abilities and attributes possessed by people are called as
a. Management
b. Human Resources
c. Entrepreneur
d. Intreprenuer

78. Deployment of which resource is difficult to master

a. Human
b. Land
c. Capital
d. Natural

79. The focus of Human Resource Management revolves around"

a. Machined.
b. Motivation
c. Money
d. Men

80. Quality- oriented organisation primary concern centers around

a. Coordination
b. Communication
c. Human Resources
d. Discipline

81. Quality goals require alignment with:

a. Production
b. Human Resources
c. Finance
d. Purchase

82. Demand for human resources and management is created by

a. Expansion of industry
b. Shortage of labor
c. Abundance of capital
d. Consumer preferences

83. Management function arises as a result of:

a. Consumer preferences
b. Abundance of capital
c. Expansion of industry
d. Shortage of labour

84. Human Resource Management is primarily concerned with:

a. Sales
b. Dimensions of people
c. External environment
d. Cost discipline

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85. Human Resource Management aims to maximise employees as well as organisational
a. Effectiveness
b. Economy
c. Efficiency
d. Performativity

86. The difference between human resource management and personnel management is:
a. Insignificant
b. Marginal
c. Narrow
d. Wide

87. Human Resource Management function does not involve:

a. Recruitment
b. Selection
c. Cost control
d. Training

88. Which one is not the specific goal of human resource management?
a. Attracting applicants
b. Separating employees
c. Retaining employees
d. Motivating employees

89. Identify which one is an added specific goal of human resource management:
a. Retraining
b. Learning
c. Unlearning
d. Separating

90. Identify the top most goal of human resource management?

a. Legal compliance
b. Competitive edge
c. Work force adaptability
d. Productivity

91. To achieve goals organisations require employees:

a. Control
b. Direction
c. Commitment
d. Cooperation

92. Human resource management helps improve

a. Production
b. Productivity
c. Profits
d. Power

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93. The amount of quality output for amount of input means
a. Productivity
b. Production
c. Sales increase
d. Increase in profits

94. Responding to employees and involving them in decision making is referred to as:
a. Quality of work life
b. Autonomy
c. Empowerment
d. Preaction

95. The main challenge for modern organisations is:

a. To remain ahead of the talent developments in the market
b. To retain the talent they have to realise that talented people are the real wealth of the
organisation
c. To find ways to poach talent wherever they can find it
d. none of the above

96. Talent management is:

a. In essence about a contract between the organisation and the employee
b. Also taking into account other factors that unlock value in the business
c. A combination of hard and soft issues (including the psycho-social contract) and taking the
new economy into account (i.e. the knowledqe-based economy)
d. all of the above

97. Key factors in skills development and talent management are:

a. A broad definition of talent to ensure inclusivity and
b. Finding a balance between staff development and making staff more employable
c. Compliance with the EE Act
d. Both (a) and (b)

98. Most organisations for Talent Management

a. Will have the same skills requirements for jobs in the future as jobs do not change much
b. Experience a more disengaging workforce who are less loyal
c. Are effective in measuring performance and productivity
d. Have effective and pro-active talent management strategies

99. Trends in Talent Management include:

a. An increase in post-high school training and education in the future
b. Management and leadership skills are seen as most valuable to modern and competitive
organisations
c. Teaching jobs are very difficult to fill
d. all of the above

100. Benefits of Talent Management include:

a.A reduction in the recruitment cycle
b. Creating a competitive advantage

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[Link] client relations and retention
d. (b) and (c)

Answers
1. (e) 2. (e) 3. (d) 4. (a) 5. (b) 6. (a) 7. (d) 8. (b) 9. (e) 10. (d)
11. (d) 12. (d) 13. (a) 14. (e) 15. (a) 16. (d) 17. (e) 18. (b) 19. (a) 20. (e)
21. (e) 22. (b) 23. (e) 24. (d) 25. (a) 26. (a) 27. (b) 28. (e) 29. (e) 30. (a)
31. (d) 32, (a) 33. (d) 34. (b) 35. (e) 36. (e) 37. (b) 38. (d) 39. (a) 40. (d)
41. (d) 42. (b) 43. (e) 44. (b) 45. (e) 46. (d) 47. (e) 48. (a) 49. (d) 50. (b)
51. (a) 52. (a) 53. (b) 54. (b) 55. (d) 56. (a) 57. (b) 58. (a) 59. (d) 60. (b)
61. (b) 62. (a) 63. (b) 64. (b) 65. (e) 66. (e) 67. (d) 68. (e) 69. (b) 70. (e)
71. (b) 72. (b) 73. (e) 74. (d) 75. (d) 76. (e) 77. (b) 78. (a) 79. (d) 80. (e)
81. (b) 82. (a) 83. (d) 84. (b) 85. (a) 86. (d) 87. (e) 88. (b) 89. (a) 90. (d)
91. (e) 92. (b) 93. (a) 94. (a) 95. (b) 96. (e) 97. (d) 98. (b) 99. (d) 100. (d)

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