Arihant NTA CUET UG 2022 Section 2 Domain (Commerce)

CUET (UG)
Common University Entrance Test 2022
Under Graduate Tests

for DU, JNU, Jamia Millia, BHU, AMU
and All other Central Universities (CUs)
Section II
Domain (Commerce)
Compiled and Edited by

Arihant 'Expert Team'
Arihant Publications (India) Limited

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Contents
Entrepreneurship 1-60
1. Entrepreneurial Opportunity 3-10
2. Entrepreneurial Planning 11-20
3. Enterprise Marketing 21-29
4. Enterprise Growth Strategies 30-36
5. Business Arithmetic 37-44
6. Resource Mobilisation 45-52
l Practice Sets (1-2) 55-60
Business Studies 1-80

1. Nature and Significance of Management 3-6
2. Principles of Management 7-11
3. Business Environment 12-16
4. Planning 17-21
5. Organising 22-27
6. Staffing 28-32
7. Directing 33-39
8. Controlling 40-43
9. Financial Management 44-48
10. Financial Market 49-54
11. Marketing 55-62
12. Consumer Protection 63-68
13. Entrepreneurship Development 69-72
Economics 1-100
Part A
1. Economics and Central Problems of Economy 3-5
2. Consumer’s Equilibrium 6-10
3. Demand 11-20
4. Producer’s Behaviour 21-30
5. Supply 31-40
6. Forms of Market and Price Determination 41-49
7. Simple Applications of Tools of Demand and Supply 50-53
Part B
1. National Income and Related Aggregates 57-66
2. Determination of Income and Employment 67-75
3. Money and Banking 76-81
4. Government Budget and the Economy 82-87
5. Foreign Exchange Rate and Balance of Payments 88-92
Accountancy 1-150
1. Accounting for Not-for-Profit Organisations 3-13
2. Accounting for Partnership: Fundamentals 14-23
3. Accounting for Partnership: Goodwill 24-28
4. Reconstitution of a Partnership: Change in Profit Sharing Ratio 29-39
5. Reconstitution of a Partnership: Admission of a Partner 40-50
6. Reconstitution of a Partnership: Retirement/Death of a Partner 51-60
7. Dissolution of a Partnership Firm 61-68
8. Accounting for Share Capital 69-79
9. Accounting for Debentures 80-89
10. Financial Statements of a Company 90-97
11. Financial Statement Analysis 98-107
12. Accounting Ratios 108-115
13. Cash Flow Statement 116-126
14. Overview of Computerised Accounting System 127-131
15. Using Computerised Accounting System 132-136
16. Accounting Using Database Management System 137-139
17. Accounting Applications of Electronic Spreadsheet 140-142
CUET (UG)
All About
Exam
Common University Entrance Test (CUET (UG) – 2022) will be conducted in 13 mediums across India
for admission into the Undergraduate Programmes in Computer Based Test (CBT) mode for all the
Central Universities (CUs) like DU, JNU, JMI, BHU, AMU, etc. in India for the academic year 2022-23.
EVENTS DETAILS
Online submission of Application Form 06 April to 06 May, 2022 (up to 5:00 pm)
Last date of successful transaction of 06 May, 2022 (up to 11:50 pm)

Examination Fee
Correction in the particulars of Application

To be announced later on the website
Form on Website only
Downloading of Admit Card from To be announced later on the website

NTA Website
Date(s) of Examination First and second week of July, 2022
Duration of Examination Slot 1: 195 minutes (3:15 hours)

Slot 2: 225 minutes (3:45 hours)
Timing of Examination Slot 1: 09.00 AM to 12.15 PM (IST)

Slot 2: 03.00 PM to 06.45 PM (IST)
TESTS DESIGN There are three Sections in the design of the test:
Section IA 13 Languages (As a medium and “Language”) Section IB 20 Languages
Section II 27 Domain Speci c Subjects Section III General Test
MERIT LIST
Merit list will be prepared by participating Universities/ organisations. Universities may conduct their individual
counselling on the basis of the score card of CUET (UG) 2022 provided by NTA.
Broad features of CUET (UG) - 2022 are as follows:

Questions to
Section Subjects/Tests Question Type Duration
be Attempted
Section IA- There are 13* different 40 questions to Language to be tested through 45 minutes
Languages languages. Any of these be attempted out Reading Comprehension (based on for each
languages may be chosen. of 50 in each different types of passages – Factual, language
language Literary and Narrative, [Literary Aptitude
Section IB- There are 19** languages. and Vocabulary]
Languages Any other language apart
from those offered in Section
IA may be chosen.
Section II- There are 20*** Domains 40 questions to Ÿ Input text can be used for MCQ 45 minutes
Domain specific subjects being be attempted out based questions for each
offered under this Section. A of 50 Domain
Ÿ MCQs based on NCERT Class XII Specific
candidate may choose a
maximum of Six (06) Domains syllabus only Subjects
as desired by the applicable
University/Universities.
Section III- For any such undergraduate 60 questions to Ÿ Input text can be used for MCQ 60 minutes
General programme/programmes be attempted out based questions
Test being offered by Universities of 75
Ÿ General Knowledge, Current
where a General Test is being
used for admission. Affairs, General Mental Ability,
Numerical Ability, Quantitative
Reasoning (Simple application of
basic mathematical concepts
arithmetic/algebra geometry/
mensuration/stat taught till Grade
8) Logical and Analytical Reasoning
* Languages (13): Tamil, Telugu, Kannada, Malayalam, Marathi, Gujarati, Odiya, Bengali, Assamese,
Punjabi, English, Hindi and Urdu
** Languages (20): French, Spanish, German, Nepali, Persian, Italian, Arabic, Sanskrit, Sindhi,
Kashmiri, Konkani, Bodo, Dogri, Maithili, Manipuri, Santhali, Tibetan, Japanese, Russian, Chinese.
*** Domain Specific Subjects (27): 1. Accountancy/ Book Keeping, 2. Biology/ Biological
Studies/Biotechnology /Biochemistry, 3. Business Studies, 4. Chemistry 5. Computer Science/
Informatics Practices 6. Economics/ Business Economics 7. Engineering Graphics 8.
Entrepreneurship 9. Geography/Geology 10. History 11. Home Science 12. Knowledge Tradition and
Practices of India 13. Legal Studies 14. Environmental Science 15. Mathematics 16. Physical
Education/ NCC /Yoga 17. Physics 18. Political Science 19. Psychology 20. Sociology 21. Teaching
Aptitude 22. Agriculture 23. Mass Media/ Mass Communication 24. Anthropology 25. Fine
Arts/Visual Arts (Sculpture/ Painting)/Commercial Arts, 26. Performing Arts – (i) Dance (Kathak/
Bharatnatyam/Oddisi/ Kathakali/Kuchipudi/ Manipuri (ii) Drama- Theatre (iii) Music General
(Hindustani/ Carnatic/ Rabindra Sangeet/ Percussion/ Non-Percussion).
27. Sanskrit/For all Shastri (Shastri 3 years/ 4 years Honours) Equivalent to B.A./B.A. Honours courses
i.e. Shastri in Veda, Paurohitva (Karmakand), Dharamshastra, Prachin Vyakarana, Navya Vyakarana,
Phalit Jyotish, Siddhant Jyotish, Vastushastra, Sahitya,Puranetihas, Prakrit Bhasha,Prachin Nyaya
Vaisheshik, Sankhya Yoga, Jain Darshan,Mimansa,Advaita Vedanta, Vishihstadvaita Vedanta, Sarva
Darshan, a candidate may choose Sanskrit as the Domain.]
Ÿ A candidate can choose a maximum of any 3 languages from Section IA and Section IB taken
together. However, the (one of the langueges chosen needs to be in lieu of 6th domain specific
Subjects).
Ÿ Section II offers 27 Subjects, out of which a candidate may choose a maximum of 6 Subjects.
Ÿ Section III comprises General Test.
Ÿ For choosing Languages (upto 3) from Section IA and IB and a maximum of 6 Subjects from
Section II and General Test under Section III, the candidate must refer to the requirements of
his/her intended University.
Broad features of CUET (UG) - 2022 are as follows:
Mode of the Test Computer Based Test-CBT
Test Pattern Objective type with Multiple Choice Questions
Medium 13 languages ( Tamil, Telugu, Kannada, Malayalam, Marathi, Gujarati,

Odiya, Bengali, Assamese, Punjabi, English, Hindi and Urdu)
Section IA & IB: Language to be tested through Reading Comprehension

(based on different types of passages– Factual, Literary and Narrative
[Literary Aptitude & Vocabulary]
Section II : As per NCERT model syllabus as applicable to Class XII only

Syllabus
Section III : General Knowledge, Current Affairs, General Mental Ability,
Numerical Ability, Quantitative Reasoning (Simple application of basic
mathematical concepts arithmetic/algebra geometry/mensuration/stat
taught till Grade 8), Logical and Analytical Reasoning
Registration Registration will be online at https://cuet.samarth.ac.in/. (available

from 06.04.2022)
Level of questions for CUET (UG) -2022:

All questions in various testing areas will be benchmarked at the level of Class XII only. Students
having studied Class XII Board syllabus would be able to do well in CUET (UG) – 2022.
Number of attempts : If any University permits students of previous years of class XII to take
admission in the current year also, such students would also be eligible to appear in CUET
(UG) – 2022.
Choice of Languages and Subjects : Generally the languages/subjects chosen should be the
ones that a student has opted in his latest Class XII Board examination. However, if any University
permits any flexibility in this regards, the same can be exercised under CUET (UG) -2022 also.
Candidates must carefully refer to the eligibility requirements of various Central Universities in this
regard. Moreover, if the subject to be studied in the Undergraduate course is not available in the list
of 27 Domain Specific Subject being offered, the candidate may choose the Subject closest to
his/her choice for e.g. For Biochemistry the candidate may choose Biology.
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Entrepreneurship 3
CHAPTER 01
Entrepreneurial Opportunity
Sensing Entrepreneurial Opportunities Exploring Opportunities in the Environment
Opportunities exist in the environment, they may exist in the
Introduction form of needs and problems of the society. An entrepreneur
An entrepreneur is a person who conceives the idea or should search for an opportunity suitable to him in terms of
discovers an opportunity in the environment and initiates profits expected and customers. Thus, an entrepreneur should
the process of converting the opportunity into business. spot the opportunity, evaluate the idea and through creativity
The process of identifying opportunities in the and innovation, build something valuable in the form of
environment and arranging the resources to exploit the enterprise/project.
identified opportunity in order to harness long-term gain is
called entrepreneurship. Stages of Enterprise Building Process
As depicted in the above diagram, the following stages take
An entrepreneur conceives the idea of setting up a business
place in enterprise building
and performs various activities to give shape to business.
● Spotting an opportunity by analysing the needs and
When business gets a proper shape, it is called an enterprise.
problems of the society.
Peter F Drucker defined entrepreneur as a person who ● Evaluating the ideas received from different sources to find a
always searches for opportunity and believes in increasing creative solution.

the value. The basic test of entrepreneur is to identify the ● Identifying a product or service through innovation.
business opportunity in the environment and initiate steps ● Setting up a project and nurturing it to success.
to provide and sell goods and services to make the best use
of that opportunity. Thus, sensing entrepreneurial opportunities is a process of
converting an idea into an opportunity and then into an
enterprise.
Business Opportunity
Business opportunity is an economic idea which can be Perceiving and Sensing Opportunities
implemented to create a business enterprise and earn The entrepreneurs perceive opportunities, synthesise the
profits. Two things should be kept in mind before selecting available information and analyse emerging pattern that
an opportunity escape the attention of other people.
● Ensure good market for the product, which is to be
An entrepreneur with a vision is able to persuade others such
produced or provided.
as customers, partners and employees to see the opportunity,
● Ensure attractive rate of return on the investment.
share and support it. He employs his skill, observation, vision,
All ideas cannot be converted into business. Sometimes knowledge and creativity to sense the opportunity.
entrepreneur conceives an idea and starts the business
Factors involved in Sensing Opportunities
without analysing the market criteria which results in
The most important factors involved in the process of sensing
failure of business.
opportunities are as follows
Before setting up a business, certain elements should be 1. Ability to Perceive and Preserve the Basic Ideas
considered which are as follows Perceiving an opportunity or an idea might come from
● Assured market scope.
different sources, such as
● An attractive and acceptable rate of return on investment.
(i) Problem Many times, a solution to a problem leads
● Practicability of the idea. to idea generation.
● Competency and ability of the entrepreneur to encash it. (ii) Change Any change in social, legal or technological
● Potential of future growth. aspects, leads to a new business opportunity.
4 CUET (UG) Section II : Domain
(iii) Invention New products or services lead to new 4. Better Performance It can be increased with the timely
business opportunities. action in dealing with threats and availing opportunities
(iv) Competition It is often a source of new and better for the purpose of improvement in the performance of the
ideas that results in new business opportunities. firm.
(v) Innovation Creating new things of value as well 5. Sensitisation of Entrepreneurs to Cope up
as new and creative processes that add value to with Rapid Changes A keen watch on trends in
the existing products or services. the environment would help sensitise the
2. Ability to Harness Different Sources of entrepreneur to become proactive towards the needs
Information There are various sources from which of customers, changing trends, government policy,
information can be gathered like magazines, books, technology, etc.
journals, seminars, friends, etc. Information from these 6. Image Building If a company is sensitive to the
sources should be analysed which helps in the external environment, it will come out with new
identification of the right opportunity to start a new products and services or bring out better goods and
business. services to meet customers requirements, which help in
3. Vision and Creativity The entrepreneurs should be image building or reputation of the company.
able to creatively identify an idea to generate valuable
solution to a problem. Creative vision helps the Environment Analysis
entrepreneurs to convert the solution into business It is the process of monitoring the economic and
opportunity. Through their vision and creativity, they non-economic environment, to determine the opportunities
constantly overcome adversity, exercise control over the and threats to an organisation.
business and make a significant difference. Such an anlysis involves data collection, information
processing and forecasting to provide a rational basis for
Environment Scanning developing goals and strategies for business survival and
Business environment is a set of all those forces and growth.
conditions, which are external to the business, but effect the It helps entrepreneurs to form their policies and strategies to
working of a business. These factors may be social, grab opportunities and overcome threats. Information for
economic, political, legal and other factors. environmental scanning can be collected from several
Environment scanning means careful monitoring of an sources. These include
organisation’s internal and external environment for ● Verbal information from customers, wholesalers, retailers,
detecting early signs of opportunities and threats that may distributors, consultants, etc.
influence its current and future plans. ● Records of companies.
● Government publications.
To scan the business environment, entrepreneurs receive and
● Publications by financial institutions.
harness ideas from different sources. Then they convert
● Formal studies conducted by strategic planners.
these ideas into viable projects.
The data collected is analysed using quantitative and
Importance of Environment qualitative techniques. The information received is tested for
Sensitivity to environmental factors is crucial for an its economic viability against important environmental
entrepreneur to succeed in the long-run. The following parameters to arrive at a sound business choice.
benefits arise by understanding the environment
1. Identification of Opportunities to Get First Mover SWOT Analysis Framework
Advantage By keeping in touch with the changes in the SWOT stands for Strengths, Weaknesses, Opportunities and
external environment, an enterprise can identify Threats. SWOT analysis helps to monitor the environment,
opportunities and find strategies to capitalise on the both internal and external, therefore, it is also referred to as
opportunities at the earliest. internal and external analysis.
2. Formulation of Strategies and Policies It helps in Environmental Scan
identifying threats and opportunities in the market.
These can serve as the basis of formulation of strategies
to counter threats and capitalise on opportunities in the Internal Analysis External Analysis
market.
3. Tapping Useful Resources If a company has a Strengths Weaknesses Opportunities Threats
thorough knowledge of environment, the enterprise can
tap resources like financial resources, human resources,
physical resources, etc., from the market at economical SWOT Matrix
prices at the right time. SWOT Analysis Framework
Entrepreneurship 5
SWOT analysis helps an entrepreneur to decide on a particular ● serendipity i.e. creation of something or discovery through
opportunity keeping in view his strengths and weaknesses accident.
(internal analysis) and the opportunities and threats (external ● exploring the ways of getting ideas.
analysis) in the market.
Idea Fields
Environmental Factors The process of generation of idea can be streamlined by
Entrepreneurship environment refers to the various forces developing an awareness for different ‘idea fields’. This will
within which various small, medium and large enterprises help the entrepreneur in enlarging the scope of thinking.
operate. These factors exert influence upon each other and Thus, idea fields can be defined as convenient frames of
do not operate in isolation. reference for streamlining the process of generation of ideas.
Business environment consists of two levels, i.e., micro Sources of Idea Fields
environment and macro environment. The various sources of idea are given below
Micro environment includes suppliers, customers, 1. Natural Resources Ideas can be generated based on
intermediaries, competitors and general public. natural resources. A product or service may be desired
Macro environment includes those factors which affect the from forest resources, agriculture, horticulture, mineral,
industry as a whole. These are Political, Economic, Social, marine or aqua mineral, animal husbandry, wind, the
Technological, Ecological and Legal factors, abbreviated as sun and human resources.
PESTEL.
Natural
Macro forces refer to all those forces that are part of the Existing Use Potential Use
Resources
larger society and are ‘uncontrollable’ in nature. Lumber Timber Furniture, craft ideas and
other wood based products.
Problem Identification Horticulture Plant
cultivation
Food preservation, canning,
freezing and pickling.
A problem is a road block in a situation which sets up a Citrus and other Juices Selling of preserved fruits for
conflict and forces you to find a solution. When one fruits supermarkets and bottled local
identifies this road block, it is called as problem juices for sale.
identification. Medicinal herbs Remedies Medicines and bio-fertilisers.
Clay Soil Ceramics, idols, gifts and
Objectives of Problem Identification show-pieces.
● It should clearly state the problem. Flowers Selling in Selling to floral decorators,
● To identify target group facing the problem. market florists.
Water resources Domestic and Paid tours for visitors and
● To find the market acceptability of the solution to the
(sulphur spring, recreational use tourists and opening of a
problem. waterfalls) water plant.
Uses of Problem Identification 2. Existing Products or Services Another field to
Identification of problem helps the entrepreneur in the generate new ideas can be improving the existing
following ways products or services. A great business idea combines
● To understand the needs and problems of the market. skills with imagination and market demand.
● To bring out new products in the market. Entrepreneurs who look at ways to make an existing
● To become creative. product or service better can be as successful as those
● To increase employment generation. who create and invent products.
● To increase national income of the country.
They use the latest technology in existing products or
Problems are generally identified by the entrepreneur make them cheaper by producing them with cost saving
themselves and sometimes, the problems are present for method. Quite often we come across a business which is
which the consumers want instant solutions. Here the improving on or changing its existing products. There
entrepreneur finds out the solution to their problems by are several reasons for doing so. Changes and
bringing out new products and services. improvements help a business to expand and grow.
The ideas of changing, improving or adding to existing
Idea Generation
product, have to be done skillfully or else other
Idea generation is a process of creating, developing and
problems can arise. It can benefit the business in the
communicating ideas which are abstract, concrete or visual.
following ways
It includes the process of developing the idea through
creativity and innovation and bringing the concept to reality. (i) Keep up with the Competition If the products
or services are of constantly changing nature, you
Business ideas are an outcome of have to stay aware of the changes and adopt such
● careful analysis of market trends.
changes.
● careful analysis of consumer needs.
(ii) Increase Sales The main reason for bringing (ii) Other Service/ Non-food Sector Opportunities
about change and improvement in existing Opportunities present in non-food sectors are as
products or services is to increase sales and follows
ultimately their revenue. So, the change should ● Speciality tourism
be such that, it helps in increasing the revenues ● Personal grooming salons
of the business. ● Career counselling centres
3. Market or Demand Driven Ideas One of the ● Chain of repair and maintenance services for
important methods of generating an idea is market electric and electronic goods

research. It is an organised effort to gather information 6. Creative Efforts Creativity is an important idea field. It is
about target markets or customers. not only used to spot and harness opportunities but, it can
It includes social and opinion research and is the also be applied to develop new products and services.
systematic gathering and interpretation of information There are five ways in which creative ideas can be
about individuals or organisations using statistical and generated
analytical methods and techniques of applied social ● Develop a new product or service.
sciences to gain insight or support decision-making. ● Improve an existing product or service.
Market research is a good source of generating ideas, ● Find a new process or resource for manufacturing a
as it gives information regarding market needs, market product.

size, level of competition, general environment and ● Find new markets for existing products or services.
state of technology. ● Find a new use of an existing product or service.
Often, market research and marketing research are Generally, creativity comes as a result of problem solving.
used synonymously. However, the distinction is that Whenever people face problems, to overcome those
marketing research is concerned specifically about problems new products and services are created.
marketing processes, while market research is e.g., when someone found it difficult and cumbersome to
concerned with markets. tighten the screw on fixture, the solution came with the
4. Trading Related Ideas Trading simply refers to invention of self adjusting screwdriver which prevented
buying goods and services and selling them to the over tightening.
consumers at a profit. Advantages of trading are that
it is easier to launch and is less risky. Product Identification
However, these days trading is not restricted to general After opportunity spotting and scanning of the environment,
stores and small outlets but its scope has enlarged to an entrepreneurial idea should lead to a definite product.
local trade, import, export, e-commerce, etc.
Transforming Idea into Opportunities
Umbrella markets, departmental stores, chain stores, Initial spotting of idea, i.e., identifying a basic idea is a
international companies like Walmart have entered random process but, developing idea after scanning
into market, making competition very fierce. environment is a strategic and deliberate process.
To survive in the market, new entrants will have to
All basic ideas undergo a vigorous process of examination,
acquire skills, competencies and knowledge required
evaluation, analysis and synthesis to identify viable
to launch, manage and expand business opportunities.
opportunities. The process of how a basic idea gets converted
5. Service Sector Related Ideas Service sector is the into an opportunity is depicted in the diagram given below
most growing field these days. The reason being the
emerging knowledge societies and advancements in Skills Knowledge
information and technology.
Many opportunities can be identified by understanding Processing Opportunity
Idea
the linkages to different business activities.
Some of the interesting opportunities in service sector Competencies Creative
are as follows Thinking
(i) Food Sector Opportunities Some of the Basic Idea Becoming an Opportunity
interesting opportunities in food sector are
● Indian fast food/finger food The above figure shows that a strategic positioning is required
● Family dinner
to convert an idea into an opportunity. It means that
● Sandwich and salad parlours
knowledge, creative thinking, competencies and skills of an
entrepreneur are backed by a thorough processing of the idea
● Ice-cream and juice/beverage parlours
through close examination, evaluation, analysis and synthesis
● Indian ‘desserts’ and ‘snack food’ chains
leading to an idea evolving as an opportunity.
Entrepreneurship 7
Idea and Opportunity Assessment 2. Supply and Nature of Competition The present
Generating ideas is relatively an easy exercise, especially if it is supply schedule of the competitors should be assessed.
done in groups. However, to ensure that idea should Not only this, future supplies by possible new entrants
necessarily become a sound business opportunity, we have to have to be gauzed too.
assess it in terms of the potentiality of the opportunity. 3. Cost and Price of Product The price of the product
The steps involved in this type of investigation are discussed should be competitively set with regard to existing
below competitors of the product. Cost reduction in variable
costs should be strived to be achieved.
Step 1 Product Identification The ideas should lead to a
definite product/service, which an entrepreneur can 4. Project Innovation and Change Market assessment
sell. The proposed product should be such that it can will require a study of prevailing innovations and
be marketed at a reasonable cost. changes being carried out by existing entrepreneurs.
Also, it should be analysed in the light of possible Technological advancements in the field have to be
product substitutes, preferences of customers, analysed because they may change the quality and
modifications suggested, etc. influence the cost and price ultimately.
If the product is already available in the market, Trend Spotting
identify the reason for introducing the same product
It means identification of new trends. It will help the
or service.
entrepreneur to understand the market and provide service
Step 2 Application and Use Ideas are to be examined for or produce goods according to the market trends.
their real life use and application. If it is an existing
There are several professional trend spotters, but they
product, modification should be proposed that
charge huge sums of money. So, entrepreneurs can spot
should lead to its better use.
these trends themselves by using the following ways
Step 3 Level of Operation The level of operation will
1. Read Trends Wide variety of information can be
depend upon the type of product, skill, use of labour
collected from various sources as given below
and expertise. The entrepreneur should decide
● Read the leading publications.
whether he/she will produce it in cottage industry,
● Websites related to their business.
small scale industry or large scale industry.
● Industry publications.
Step 4 Cost At different levels of operations, cost should
be assessed. Also, the price of the competiting ● Business magazines.
products should be known. This will help in ● Major newspapers.
determining the sale price. ● International trends through websites.
Step 5 Competition Competitive analysis of a product or ● Influential bloggers.

service should be done through its demand and
● Niche bloggers focused on specific aspects of their
supply position.
industry.
Step 6 Technical Complexity Whether the product
requires certain technology in terms of plant and The information available from the above sources is
machinery, training needs and application should be vast and every piece of information may not be
assessed. relevant for the entrepreneurs.
It is to be seen whether such requirements could be They have to make an intelligent choice as to which
met locally or will have to be sourced from outside. source is valuable for them and which is not.
Step 7 Annual Turnover and Profit Margin The annual For this, they use tech-tools like RSS feeds, e-mails,
turnover has to be estimated as profits are based on newsletters or websites and forums to get the
the amount of net sales. information that they want.
2. Talk Trends Talking to people is an equally important
Market Assessment trend-spotting tactic. For this, the entrepreneurs
Once the entrepreneur has assessed the opportunities, he has should participate in events organised by specific
to assess the market. Selection of product will depend upon industry’s trade association, whether it is online or
market assessment. offline. They should also take advantage of social
The following factors require careful evaluation while networking tools like social network sites and forums.
assessing the market They can also start or join groups on the networks to
1. Demand The demand of the product should be assessed know about the latest trends.
on the basis of the market being targeted, viz. local It is also important to talk to customers, both online
markets, or markets at state, national or international and offline. They should pay attention to what the
level. Also, a study should be conducted on target customers are saying not only on their product, but
consumers to assess their tastes and preferences. also on competitor’s product.
3. Watch Trends Observation in the market place is the cons, process of its implementation in his mind.
best way to get on the actual trends. Entrepreneurs can Here, the idea starts spreading its roots.
study the habits, preferences and likes and dislikes of the Step 4 Illumination The fourth stage or the illumination
consumers. stage occurs when the idea re-surfaces in a
If the target consumers of a product are the youth, then, realistic way.
they can visit a mall and observe trends of clothing, The entrepreneur comes with a viable plan to give
eating habits, how youth are engaging themselves in practical shape to his idea by collecting raw
different activities, etc. materials, arranging for finance, etc.
They can see which stores are attracting maximum Step 5 Verification This is also called the validation or
crowd and which are lying vacant. Trade shows are also testing stage. In this, the idea or plan is translated
a great place to get trend ideas. into useful application which has value.
4. Think Trends When an entrepreneur begins gathering This is the most difficult phase of creativity as
information regularly, he becomes a trend-spotter. After obstacles begin to appear. It is a stage when
reading, watching, talking and observing trends, they knowledge is developed into application.
will use their abilities of thinking, analysing and
synthesising to make connections with their business Innovation
and can come up with a great idea for a new product or a It is a process of entrepreneurship which involves the
new product line or a new business. translation of a useful idea into an application which has a
commercial value.
Creativity
Innovation is required to work out analytically the details of
It is the first stage in the process of innovation which leads
the enterprise, to develop marketing strategies, to organise,
to discovery of opportunity and new venture creation. One of
finance and strategies operations.
the important tasks demanded from entrepreneurs is to
manifest creative ability by conceiving a new product market Elements of Innovation Process
opportunity and unique value proposition.
Analytical
It is seen that the new entrants often start their beginning planning
(i) Analytical planning involves
by giving the reason of novelty, usefulness and (a) Identifying the product
appropriateness, which are nothing but an extension of orservice features
creativity. (b) Design
The entrepreneur must try to get first mover advantage by (c) Resources
trying new inventions and applying creativity in the Resource
organisation (ii) Resource organisation involves
organisation to survive and grow.
(a) Human resources
The Creative Process (b) Material resources
Creativity is important to entrepreneurs. The process of (c) Technology
creativity involves the following steps (d) Capital resources
Step 1 Idea Germination It is the seeding stage, where Implementation
(iii) Implementation involves
the new idea grows. The idea germinates from (a) Applying resources
the interest and curiosity of the entrepreneur.
(b) Delivering results
He then explore and exploits it to its best Commercial
application (iv) Commercial application involves
potential. The ideas can also germinate from the
need of a specific problem or area of study. (a) Provision of value to customers
Step 2 Preparation Now, with the germination of idea, it (b) Reward employees
needs to be implemented. (c) Satisfy stakeholders
For this, the entrepreneur takes up market
research to see whether the product will have any Selecting the Right Opportunity
future or not. The entrepreneur should look into various factors before
Step 3 Incubation This is the subconscious assimilation deciding on the opportunity. Even if the opportunity looks
of information. This is the transition period. The promising, an entrepreneur should look into the
entrepreneur think about his idea, its pros and environmental factors before choosing the best opportunity.
Entrepreneurship 9
Practice Questions
1 A prospective entrepreneur has to find an 8 Sushant planned to start a small fast-food joint in
opportunity which would be suitable for him/her in his area after finishing his degree in hospitality
terms of customers to be served and profits management. His plan was to combine and use
expected. An opportunity may be derived from healthy ingredients like whole wheat flour to make
spotting and analysing the …… and …… that exist the burger buns.
in the environment. He knew that he had to start collecting
(a) needs, market conditions information from different sources which will help
(b) market conditions, needs
him to identify the right opportunity to start his
(c) needs, problems
(d) market conditions, problems business. From where will Sushant get the
necessary information?
2 An economic idea which can be implemented to (a) Magazine (b) Shows
create a business enterprise and profit is called (c) Family members (d) All of these
(a) business environment (b) business opportunity
(c) business problem (d) product identification 9 Which of the following is not a natural source of
ideas?
3 The process of entrepreneurship which involves the (a) Horticulture (b) Existing products
translation of a useful idea into an application is (c) Agriculture (d) Forests
called
10 Which of the following is not a use of product
(a) incubation (b) innovation
(c) verification (d) illumination identification?
(a) It helps in increasing national income
4 Exploring opportunities in the environment is a (b) It increases employment generation
process involving various steps. Arrange the steps (c) It should clearly state the problem
in correct order. (d) It brings out new products in the market
(i) Evaluating the ideas received from different 11 LPG rationing led the manufacturers to come out
sources to find a creative solution. with induction cooker. Which importance of
(ii) Identifying a product or service through environment does the above example indicate?
innovation. (a) Identification of opportunities to get first mover
advantage
(iii) Opportunity spotting by analysing the needs (b) Tapping useful resources
and problems that exist in the environment. (c) Better performance
(iv) Setting up a project and nurturing it to (d) Image building
success. 12 Deepa after graduating from IIM wanted to
(a) (i) (ii) (iii) (iv) (b) (iii) (i) (ii) (iv) become an entrepreneur. She identified and
(c) (ii) (iii) (iv) (i) (d) (i) (iv) (iii) (ii) analysed the market need, market size and
5 Identify the micro-environmental factors from the competition and realised that there is an untapped
following. demand for ‘Almond milk’. She started supplying
(i) General public (ii) Competitors ‘Almond milk’ in different flavours.
(iii) Economic (iv) Intermediaries She used to get feedback from her customers. Over
(v) Legal a period of time ‘Almond milk’ became popular.
(a) (i), (ii) and (iii) (b) (ii), (iii) and (iv) Identify from the following the source of idea field
(c) (iii), (iv) and (v) (d) (i), (ii) and (iv) chosen by Deepa.
6 According to the ‘PESTEL Model’, which factor (a) Natural resources
emphasises the production of goods with minimum (b) Market driven or demand driven idea
(c) Creative efforts
environmental damage?
(d) Existing products or services
(a) Economic (b) Social
(c) Ecological (d) Technological 13 VM Ltd is looking into ideas to use eco-friendly
recyclable materials for the body of the phones that
7 Entrepreneur is ‘The Person’ who always searches may cause negligible damage to the environment.
for the opportunity and initiates steps to produce Identify the factor of the PESTEL model discussed
and sell goods and services which is ‘The Process’ here.
and ‘The Outcome’ is the enterprise. From the (a) Social and Policical
following identify ‘The Process’. (b) Ecological and Technological
(a) Opportunity (b) Entrepreneurship (c) Economic and Social
(c) Problem identification (d) Both (a) and (c) (d) Legal and Economical
14 Swami wants to start a new business. Before Which factor of PESTEL is highlighted here?
deciding the type of business, he started (a) Economic (b) Social
identifying the new trends in retail business. (c) Political (d) Ecological
He became a member of a trade association. 21 Which process is related to creating, developing
He attended its events both online and offline. and communicating ideas which are abstract,
He also took advantage of the social networking concrete or visual?
tools. Which of the following ways of trend spotting (a) Idea generation
did Swami adopt? (b) Product generation
(a) Watch trend (b) Think trend (c) Either (a) or (b)
(c) Talk trend (d) Read trend (d) None of the above
15 Entrepreneurs should take advantage of social 22 Name the element which is considered as
networking tools like social network sites i.e., convenient frame of reference for streamlining the
Facebook, Instagram, etc. to identify new trends. process of generation of ideas.
This is an example of (a) SWOT analysis (b) Idea fields
(a) read trends (b) talk trends (c) Trend spotting (d) None of these
(c) think trends (d) watch trends 23 What is the first stage in innovation?
16 Mr. Dinesh wanted to manufacture an energy (a) Implementation
efficient AC. He looked into various options and (b) Resource organisation
finally narrowed down to one option. He (c) Creativity
(d) Commercial application
understands that his idea would have to follow a
process. Identify the process. 24 ………… stage occurs when the idea re-surfaces in
(a) Process of idea germination a realistic way.
(b) Process of creativity (a) Preparation (b) Incubation
(c) Process of idea generation (c) Illumination (d) Verification
(d) Process of idea fields
25 There is a …… relationship between opportunities
17 Which of the following statements is/are correct? and problem solving.
Statement I E-commerce in India is growing at a (a) direct (b) inverse
rapid pace. (c) indirect (d) negative
Statement II India has a large number of young 26 Entrepreneurship leads to …… in GDP.
entrepreneurs with education from premier (a) increase (b) decrease
educational institutes. (c) both (a) and (b) (d) neither (a) nor (b)
Alternatives 27 Which of the following consists of micro level
(a) Both statements are correct business environment?
(b) Statement I is correct, but Statement II is incorrect (a) Political (b) Economic
(c) Statement I is incorrect, but Statement II is correct (c) Social (d) Customers
(d) Both statements are incorrect
28 Entrepreneur perceives opportunity from
18 A prospective entrepreneur has to find an (a) problems (b) needs
opportunity which would be suitable for him/her in (c) problems and needs (d) None of these
terms of ……… . 29 The various sources of idea fields are
(a) profitability (b) viability (a) Natural resources
(c) Both (a) and (b) (d) None of these (b) Service related
19 An entrepreneur with a ……… is able to pursuade (c) Trading related
(d) All of these
others to see the opportunity.
(a) mission (b) vission 30 Which of the following source ofidea fields provides
(c) process (d) None of these important information to identify and and analyse
20 Birla clothing started their business from India to the market need, market size andcompetition?
(a) Market or demand driven
various parts of the world in year 2018. Company
(b) Natural resources
had been successful in its business as people (c) Existing products or service
changed in fashion and lifestyle. (d) None of the above
ANSWERS
1. (a) 2. (b) 3. (b) 4. (b) 5. (d) 6. (c) 7. (d) 8. (d) 9. (b) 10. (c)
11. (a) 12. (b) 13. (b) 14. (c) 15. (b) 16. (b) 17. (a) 18. (c) 19. (b) 20. (b)
21. (a) 22. (b) 23. (c) 24. (c) 25. (a) 26. (a) 27. (d) 28. (c) 29. (d) 30. (a)
Entrepreneurship 11
CHAPTER 02
Entrepreneurial Planning
Introduction ● marketing ● finance
Planning can be defined as ‘‘thinking in advance, what is to ● operations ● human resources
be done, when it is to be done, how it is to be done and by ● legal compliance ● intellectual property rights
whom it should be done’’.
Importance of Business Plan
Before starting business venture, an entrepreneur needs to Business plan is required to start a venture because of the
gather information about internal and external environment following reasons
that may affect his business and form strategies and
● A business plan helps in determining the viability of the
objectives in harmony of the environment.
venture in the designated market.
It is an intellectual thinking process, with the organised
● It guides the entrepreneur in planning his activities such as
foresight, which is quite essential for an intelligent action.
(a) identifying the resources required.
Entrepreneur needs to workout in detail all the relevant (b) obtaining licenses, if required.
external and internal elements involved in starting a new
(c) meeting with the legal requirements as desired by
venture and then running it successfully which can be
the government.
achieved through the preparation of a business plan.
● A business plan helps in satisfying the concerns, issues and
Concept of Business Plan queries of each group of people interested in the venture.
● It provides room for self-assessment and self-evaluation by
A business plan is basically a written representation of an
entrepreneur’s vision for his business. It is a comprehensively requiring the entrepreneur to think through various
written document prepared by an entrepreneur describing scenarios and plan ways to avoid obstacles.
formally all the external and internal factors involved in ● At times, a business plan also helps to identify the
starting a new venture. obstacles which cannot be overcome, suggesting to

It is a comprehensive project report which not only includes terminate the venture while still on paper, thereby saving
the entire range of activities which are being planned in the time and money.
● Business plan is an important tool for procuring funds.
business, but also
● helps to understand the feasibility and viability of the
Any investor, before investing in a venture is interested in
proposed venture. knowing about 4 Cs to access the credit worthiness of the
entrepreneur and the business.
● facilitates in assessing and making provisions for the
bottlenecks in the progress and implementation of the idea. These 4 Cs are – Character, Cash flow, Collateral and
● discusses the potential for success of the project alongwith
Contribution towards equity.
the risk factors involved. And it is the business plan which reflects the
entrepreneur’s credit history, his ability to make payments
So, it can be concluded that business plan is a formal
against debt and interest and the amount of equity
statement of a set of business goals, the reason why they are
invested by him. So, it helps a business to raise funds by
thought to be attainable and a plan for reaching those goals,
providing the relevant information.
with complete understanding of internal and external
factors affecting those goals. ● A business plan gives a clear indication to the
entrepreneur, investors and the government regarding
Scope of Business Plan (a) What an entrepreneur is doing?
An effective business plan should represent all aspects of a (b) Why he/she is doing it?
business and sub-plans should be prepared to cover all (c) How he/she will do it?
aspects relating to
So, keeping the above points in view, it could be concluded One of the oldest, simplest and most commonly used forms
that although writing a good business plan can’t guarantee of business organisation, which is owned, financed,
success but it can go a long way towards reducing the odds controlled and managed by only one person is called as sole
of failure. proprietorship. It is also referred to as single
entrepreneurship or individual proprietorship.
Formats of a Business Plan According to ET Elbourne, ‘‘Sole proprietorship is a
The following formats can be used by an entrepreneur to business initiated and operated by one individual who carries
convey the same business plan to diverse stakeholders all financial and administrative responsibilities, employing
1. Elevator Pitch It is basically a 3 minute summary of such assistants as may be necessary’’.
the business plan’s executive summary.
This format is often used as a teaser to awaken the Characteristics of Sole Proprietorship
interest of the potential investors, customers or Main characteristics of sole proprietorship are as follows
strategic partners. 1. Individual Ownership The business is exclusively
2. A Pitch Deck With Oral Narrative This format owned by a single person.
presents the business plan in the form of an 2. Individual Management and Control All affairs of
entertaining slide show complemented with an oral the business like what is to be done, how it is to be
narrative. done and when it is to be done, etc., are managed and
It is meant to trigger discussion and awaken the controlled by the sole proprietor. However, competent
interest of the potential investors and induce them to people can also be employed for efficient management.
read the written presentation. It includes executive 3. Individual Financing Proprietor arranges all finance
summary, important graphs showing financial trends through personal sources, which can also be from
and key decision-making benchmarks. friends and other family members. He can also take
3. A Written Presentation for External Stakeholders loans and debts from financial institutions.
It includes a detailed, well written and pleasingly 4. Unlimited Liability The proprietor and the business
formatted plan targeted at external stakeholders. are considered to be the same and in case the assets of
4. An Internal Operational Plan It is a detailed plan the business are not sufficient to pay liabilities, his/her
describing planning details that are needed by personal property can also be used to pay off the
management, but may not be of interest to external business debts.
stakeholders. 5. Sole Beneficiary The sole proprietor is entitled to all
Format/Outline of a Business Plan the profits and losses of the business.
1. Introductory page 2. Executive summary 6. Easy Formation and Closure Starting and closing this
form of business is very easy as there are minimum
3. Industry analysis 4. Description of venture legal formalities subjected to this form.
5. Production plan 6. Operational plan 7. No Separate Legal Entity Owner and business are
7. Marketing plan 8. Organisational plan considered as one and the same. With the death of the
9. Assessment of risk 10. Financial plan owner, business also comes to an end.
11. Appendix (contains backup material) 8. Limited Area of Operation/Scope The scope of
operations is limited due to
Forms of Business Organisations ● limited finance availabilities.
The commonly opted forms of business organisations are ● limited managerial abilities.
● Sole Proprietorship
● Partnership Partnership
● Company
A partnership is an association of two or more persons as
co-owners, to carry on, a business and to share its profits and
Since, entrepreneurs are highly motivated by independence
losses. Thus, two or more persons may form a partnership by
and monetary gains, these three forms fufil the basic
making a written or oral agreement to carry a business
requirement of entrepreneurs well, which makes them the
jointly and share its proceeds. This is most accepted business
most desirable structure to commence a venture.
form for small-scale and medium-scale businesses.
Sole Proprietorship According to Indian Partnership Act, 1932, ‘‘Partnership
As the name suggests, sole means single and proprietor is a relationship between persons who have agreed to share
means an owner, thus, it is a form of business which is the profits of a business carried on by all, or any of them
managed and controlled by a single owner. acting for all’’.
Entrepreneurship 13
Characteristics of Partnership Joint Stock Company

The essential characteristics of partnership are as follows Joint stock companies are evolved because the resources and
1. Two or More Persons Partnership is formed by life span of both sole proprietorship and partnership form of
entering into a contract. So, organisations are limited, while their liability is unlimited.
● there must be at least two persons to enter into a So, keeping step with the changing time, organisations faced
contract to form partnership. growing needs for
● Capital ● Managerial talent and skills
● minors cannot be admitted to a partnership,
because they are incompetent to enter into contract, ● Limited liability
but they can be admitted to the benefits of a Thus, joint stock company as a modern form of business
running firm. organisation emerged to meet the requirements of large sized
● minimum number is 2 and maximum number of business. Joint stock company means a voluntary association of
partners is 50. persons, formed for some common objectives, with capital
2. Agreement When the partners enter into a divisible into units of equal value called shares and with limited
contract, that means they make an agreement which liability. Company is basically a creation of law, i.e. it is brought
can be oral or written. Written agreement is to life by law and can be put to death by law only.
advisable as it helps in resolving disputes, if any. A In terms of Companies Act, 2013, ‘‘A company means a
written agreement between partners is referred to as company incorporated under the Companies Act, 2013 or under
‘partnership deed’. any of the previous company law, [Section 2 (20)]’’. In common
3. Profit Sharing The profits of the partnership law, a company is a ‘legal person’ or legal entity’, separate from
business are shared amongst the partners in an and capable of surviving beyond the lives of its members.
agreed ratio. It should be kept in mind that sharing
of profits is the main feature of this form of Characteristics of a Company
organisation. Partnership is not formed for charity. A company is distinct from other forms of organisations
because of the following characteristics
4. Unlimited Liability The liability of partners is
individually and collectively unlimited. This means 1. Voluntary Association A company is a voluntary
that their personal properties can also be disposed association of two or more than two persons, joining
hands out of their free will, to form a company. A single
off to pay the firm’s debts. The creditors can claim
person cannot constitute a company except in the case of
their dues from anyone of them or all of them.
one person company.
5. Implied Authority Any partner can act on behalf
2. Artificial Person A company is created by law. Though,
of the firm and his acts bind the firm.
it has nobody and no conscience, it still exists as a person,
6. Mutual Agency The business of the firm can be having a distinct personality of its own and like a natural
carried on by all the partners or any one of them person, it can buy, sell and own property, sue others and
acting for all. Thus, every partner is a principal as be sued by others.
well as an agent.
3. Separate Legal Entity A company has an entity or
This means personality, which is absolutely independent and separate
● each partner is liable for the acts performed by
from the entity of its members.
other partners.
This implies that a company cannot be held liable for the
● each partner can bind other partners and the firm
actions of its members and vice-versa.
by his acts done in an ordinary course of business.
4. Common Seal Every company has a common seal with
7. Utmost Good Faith Mutual trust and confidence is
the name of the company engraved on it. Since, the
the main strength of partnership. Every partner should
company being an artificial person cannot sign, the
act honestly and give proper accounts to other
common seal of the company is affixed on all the
partners.
documents where the signature of the company is needed.
8. Restriction on Transfer of Shares No partner can Common seal is equivalent to the signature of the
sell or transfer his shares to anybody else without company.
the consent of the other partners. If a partner wants
5. Limited Liability It implies that the maximum liability
to discontinue, he can do so with the consent of
of a member is limited to the unpaid value of shares held
other partners.
by a member or guarantee given by him.
9. Continuity A partnership continues until all
e.g. if a member holds 20 shares of ` 100 each, on which
partners desire to continue it. Legally, a firm
he has paid ` 60 per share, then his maximum liability
dissolves on the retirement, death, bankruptcy,
will be limited to only ` 800, i.e. @ ` 40 per share on
lunacy or disability of a partner, if not otherwise
20 shares held by him.
provided in the partnership deed.
6. Transferability of Shares Shares of a company are The characteristics exhibited by a public company are as
freely transferable, i.e. if a member no longer desires follows
to hold shares of a company, he can transfer them to ● A public company has a minimum requirement of seven
somebody else. people to commence business, with no upper limit to

In a private company, there are certain restrictions to membership.
● It does not restrict any transfer of shares.
transfer shares, but the right to transfer shares is not
● It invites public to subscribe for its shares, debentures
denied by the company.
and public deposits.
7. Diffusion of Ownership and Management In this
● It uses the word ‘Limited’, at the end of its name.
form of organisation, there exists separation of
ownership from management. 3. One Person Company As per provision of Section
As the shareholders (i.e. the owners) are scattered 2(62) of the Companies Act, 2013, one person company
across the country, they give the right to manage the means a company which has only one person as
affairs of the company to the Board of Directors. member. It is a company incorporated as a private
Hence, through the Board of Directors, the company company which has only one member.
is managed in a democratic manner. Any natural person (should not be minor) who is an
Indian citizen whether a resident in India or not i.e.,
8. Number of Members
NRI, shall be eligible to incorporate a one person
Private Company
company and appoint nominee of an OPC.
Minimum required members = 2
Maximum members = 200 (excluding employees) Components of a Business Plan
Public Company Depending upon the entrepreneur’s experience, knowledge
Minimum required members = 7 and purpose, generally a business plan outlines sequentially
Maximum members = No limit following components or parts
9. Limitation of Action The scope of company is ● Organisational plan ● Production plan
determined by ● Operational plan ● Financial plan
● The Indian Companies Act, 2013 ● Marketing plan
● Memorandum of Association ● Human resource planning
● Articles of Association
I. Organisational Plan
If the company transgresses the limits as specified in
The organisational plan is that part of the business plan that
the above documents, then it can lead to winding up
describes the proposed ventures form of ownership, i.e. whether
of the company.
it is
10. Winding Up Since, a company is born out of law,
● sole proprietorship ● partnership
therefore, it can be terminated or winded up as per
● joint hindu family ● company
the provisions of law as stated in the Companies Act,
● corporation
only.
Their are four basic categories under which any business falls.
Forms of Company These are as follows
An entrepreneur under the company form of organisation 1. Manufacturing Business that makes a tangible product.
has option to incorporate an enterprise as a 2. Wholesale Business that buys products in bulk from the
1. Private Company Private company means a manufacturers to be sold in smaller lot to retailers.
company having a minimum paid-up share capital as 3. Retail Business that sells directly to the final consumers
may be prescribed and which by its articles for final satisfaction.
● Restricts the right to transfer its shares.
4. Service Business that sells intangible products such as
● Except in case of one person company, limits the
time or expertise.
number of its members to two hundred–(excluding
Each type of business differs significantly in terms of
present and past employees).
commencement procedures, legal constraints, financial
● Prohibits any invitation to the public to subscribe for
requirement, accounting methods, marketing and
any securities of the company. promotional strategies, risk and liability, etc.
2. Public Company Under Section 3 (i), (ii) of the So, before selecting the form of ownership, firstly, it is
Companies Act, ‘‘Public company means a company necessary to categorise the business. Also, each form of
which is not a private company and has a minimum
ownership has important, implications on taxes, liability,
paid-up share capital as may be prescribed”.
continuity, financing and ownership.
Entrepreneurship 15
As we already know, ‘no form is the best form’. So, an ● raw materials and suppliers names, addresses, terms
entrepreneur should select that form which best suits his and conditions.
business category and its needs and that would ensure ● cost of manufacturing.
long-term effectiveness of the enterprise and profitability. ● any future capital equipment required, etc.
Elements of Organisational Plan Objective of a Production Plan
The organisational plan is that part of the business plan The objective of a production plan in the words of Alford
which describes the proposed venture’s opted form of and Beathy is ‘‘Picturising ahead every step in a long series
ownership. An organisational plan throws light on of separate operations, each step to be taken in the right
● the terms and conditions associated with the selected form.
place of the right degree and at the right time and each
● lines of authority and responsibility of members of the new
operation to be done at maximum efficiency’’.
venture. So, a production plan helps to plan the work in such a
● the names, designation, addresses and resumes of the
manner that one can clearly form an idea about
members. ● production schedule and/or budget.
● stake of members in the organisation.

● machinery, equipment required.
● roles and responsibilities of each member.

● manufacturing method and process involved.
● procedure for solving conflicts/disputes amongst members. ● plant layout.
● forms of payment for the members of the organisation. ● time, motion and work study.
● voting rights, managerial and controlling rights of the ● manpower requirement.
● inventory requirement.
members.
The above information provides the potential investor with a
clear understanding of the organisational structure.
III. Operational Plan
Where the production plan aims at ‘plan your work’, the
II. Production Plan operational plan ensures ‘work your plan’. It is basically
related to how a business proposes to put its plan in action.
Production is the most important activity of an enterprise
because it is through this process that raw materials are So, operational plan is a blue print prepared in advance of
transformed into finished products. actual operations, to
● ensure orderly flow of materials in the manufacturing
Being highly complex and tedious, the manufacturing
process, right from the acquisition of raw materials to the
operation needs to be well planned.
completion of the product.
This venture mostly face the following situations ● facilitate continuous production, lesser work-in- progress
1. No Manufacturing Involved If the new venture does and minimisation of wastage.

not include any manufacturing function, i.e. it is a ● coordinate the work of engineering, purchasing,
trading business, then this section is eliminated from production, selling and inventory management.
the plan. ● describe the flow of goods or services from production
2. Partial Manufacturing If the entrepreneur plans to point to the consumers.

partially manufacture some of the parts and outsource ● introduce a proper system of quality control.
or subcontract for other processes, then the production ● undertake the best and most economic production policies
plan should describe and methods.

● name and location of subcontractors.
● reasons for their selection. Objectives of Operational Plan

● cost and time involved. An operational plan aims at getting desired manufacturing
● any contracts that have been completed by them. results in terms of
● any other relevant information.
● quantity ● quality ● time
● a clear mention of what entrepreneur intends to do

● place ● cost
himself and what he plans to get done from

outside. Thus, the objectives of an operational plan are as follows
● Planning for production in advance of operations.
3. Complete Manufacturing If the entrepreneur plans
● Establishing the exact route for each individual items in
to carry out the whole manufacturing process by
the part of the assembly line.
himself, then he/she needs to describe
● Setting starting or finishing dates for each important
● the physical plant layout.
assignment or work.
● the machinery and equipment required to perform the
● Regulating the orderly movement of goods throughout the
manufacturing operations.
entire manufacturing cycle.
Elements of Operational Plan Elements of Financial Plan

In order to achieve the above mentioned objectives, the An entrepreneur makes use of several financial projection
following elements of the operational plan need to be techniques and tools to draw up a financial plan. Generally,
specifically addressed a financial plan needs 3 years of projected financial data to
1. Routing It is a process concerned with determining satisfy any outside investors.
exact route or path a product/service has to follow right To simplify, the financial plan is so designed that the
from raw material till its transformation into finished entrepreneur and the investors could have a clear picture of
products. ● How much funds are required?
● Where will the funds come from?

2. Scheduling This means deciding the time frame within
which each operation would be completed. It simply ● How are they disbursed?
means fixation of time, day, date when each operation is ● The amount of cash available.
to be commenced and when it is to be completed. ● General financial well-being of the new venture, i.e.
3. Dispatching It means issuing necessary orders, probable revenue forecast for the first year atleast.
instructions and guidelines relating to the work to be
performed. It initiates the production process. Components of Financial Plan
Major financial items that should be included in the
4. Follow-up This element relates to evaluation and
financial plan are as follows
appraisal of work performed. It is helpful in early
detection of errors and helps all entrepreneur to 1. Proforma Investment Decisions This part of
● Develop ways to review the present situation with
financial plan highlights how the business proposes
to invest its assets, so as to be able to generate highest
regard to materials, work-in-progress and finished
possible returns. This part clearly specifies the amount
goods.
of investment required to be made in fixed as well
● Evolve ways to expedite the performance of those
as working capital.
departments which lag behind.
2. Proforma Financing Decisions This section gives
● Remove obstacles in the way of production by
a brief summary of all potential sources of finance
suggesting remedial measures.
available to the entrepreneur.
5. Inspection This means comparing materials, product Typically, sources of funds are owners, i.e. owner’s
or performance with established standards. Products funds and outsiders i.e. borrowed funds.
can be tested in specified laboratories or new methods
An entrepreneur should select the best overall mix
or strategies can be evolved to ensure pre-determined
of financing, so that
standard quality of the product. ● The cost of capital and the financial risk stands
6. Shipping This section goes beyond the manufacturing minimsed.

process and describes the flow of goods or services ● Return on investment and profitability stands
from production to the consumers. maximised.

All the above discussed elements help us to make a 3. Proforma Income Statement This section of the
successful operational plan. financial plan gives the projected net profit of the
business based on projected revenues and projected
IV. Financial Plan expenses. While estimating the projected revenues for
Finance is the life blood of any organisation and is the most the year, ‘sales by month’ must be estimated first by
important pre-requisite to establish any business. using forecasting techniques.
Availability of finance enables the entrepreneur to bring 4. Proforma Cash Flow This part reflects the projected
together the 5Ms of business, i.e. Men, Material, Machines cash available with the enterprise as a result of
and Methods, the fifth ‘Money’ is finance itself. subtracting projected cash payments from projected
An entrepreneur before drawing out the financial plan,must cash receipts.
keep in mind the following factors Cash flow results only when actual cash is received
● Financial requirements. ● Sources of raising funds. or paid. Credit sales or outstanding expenses are not
● Exact assessment of the revenue, cost, profits, cash flows,
considered in this section as they do not result in flow
dynamics, stock of inventory, loans, etc. of cash.
So, a financial plan is basically a projection of key financial 5. Proforma Balance Sheet This document helps the
data about enterprise to reflect the position of the business at the
● the potential investment commitment needed for the new
end of its first year. A summary of the projected assets,
venture. liabilities and net worth of the entrepreneur is depicted
● economic feasibility of the enterprise.
through proforma balance sheet.
Entrepreneurship 17
6. Break-even Point The break-even point is that level of Facts needed for Market Planning
volume of production at which firm neither makes a The facts that are needed for market planning are as follows
profit nor a loss. Here, the total revenue is equal to the ● Who are the users, where are they located, how much do
total cost of a firm at a given level of capacity. they buy, from whom do they buy, and why?
This section of the plan projects the number of units to ● How have promotion and advertising been employed and
be sold or sales volume to be achieved to break-even. which approach has been most effective?
7. Economic and Social Variables In view of the social ● What are the pricing changes in the market, who has
responsibility of business, the abatement costs, i.e. the initiated these changes, and why?
cost of controlling the environmental damage should ● What are the market’s attitudes concerning competitive
also be stated in the plan.
products?
It is always advisable to mention the following ● What channels of distribution supply consumers and how
socio-economic benefits expected from the proposed
do they function?
investments in the financial plan
● Who are the competitors, where are they located and what
● employment generation
advantages/disadvantages do they have?
● import substitution
● What marketing techniques are used by the most
● ancillarisation
successful competitors and by the least successful?
● export promotion
● What are the overall objectives of the company for the next
● local resource utilisation

year and 5 years hence?
● development of the area ● What are the company’s strengths and weaknesses?
If it is not possible to quantify the expected benefits, ● What are one’s production capabilities regarding product?
then each point should be carefully analysed and its

importance should be stated in this section. Steps in Preparing a Marketing Plan
Investors give a great weightage to this section of business
V. Marketing Plan plan to assess the chances of success of a business. So, an
This plan describes the market conditions and strategies entrepreneur should prepare a comprehensive and detailed
related to how marketing plan.
● products/services will be distributed, The steps involved in marking a marketing plan are as
● priced, follows
● promoted and 1. Business Situation Analysis This section starts with
● where to be distributed
addressing the question, ‘where we have been?’
In case of an existing enterprise, a review of past
The marketing plan is a significant element in the business
performance and achievements of the enterprise are
plan of a new venture, as it highlights how a business plan
stated in this part but in case the venture is new, then
makes a place for itself in a competitive market by providing
the following issues are addressed
answers to three basic questions, they are
● personal profile of the entrepreneur.
1. Where have We Been? This segment focuses on ● emphasis on products development.
● some history of the market place.

● what ‘needs’ it satisfies.
● marketing strengths and weaknesses of the new

● any other enterprise/experience of the entrepreneur.
venture. ● any marketing segmentation, if planned.
● market opportunities and threats.

2. Identify the Target Market This section identifies
2. Where do We want to Go? This primarily addresses the target consumers for a business, so that marketing
the marketing objectives and goals of the enterprise in strategies could be aimed towards them. Identification
the next 12 months. of target consumers involve
3. How do We get There? This question discusses ● deciding what the general market or industry wishes
● the specific marketing strategy that will be

to buy on the basis of market research or industry
implemented. analysis.
● when it will occur.
● dividing the market into smaller groups
● who will be responsible for the monitoring of

(segmentation), based on consumer’s characteristics
activities. and buying situation.
Normally, the entrepreneur should prepare an annual 3. Conduct SWOT Analysis A successful marketing plan
marketing plan each year so as to gel well with the changing needs to consider the strengths and weaknesses of the
business environment and its forces. new venture to ensure its success.
So, it is important for the entrepreneur to consider in Manpower planning thus helps to assess
the target market his/her enterprise’s 1. What Kind of People are Required?
● Strengths ● Weaknesses To carry on its operations effectively, each organisation
● Opportunities ● Threats needs manpower with the necessary qualifications,
All these together make the acronym ‘SWOT’. skills, knowledge, experience and aptitude for work.
4. Establish Goals ‘Where do we want to go?’ is So, in this section, an entrepreneur must clearly state
answered well by establishing ● What kind/type of person is required to be hired for
● Realistic, attainable and well defined goals and getting his work done?
objectives for the enterprise. ● As each person would have different position, duties
● Quantifying the goals, so that they could be measured and responsibilities, it becomes imperative for the
for control purposes. entrepreneur to clearly workout a wide range of
● Setting standards to measure those goals which are
personnel ranging from managers, supervisors,
qualitative in nature. administrators, engineers, technical, skilled and
unskilled class.
● Limiting, the goals to a specific number so that there
Nature of business activity helps entrepreneur to a
are no chaos, confusions or overlapping.
large extent in deciding the type of manpower
5. Define Marketing Strategy ‘How do we get there?’ required.
demands specific activities to be outlined to meet the
2. How Many People are Required?
enterprise’s established goals and objectives. The
This question deals with the number of personnel the
marketing strategy and action plan comprises of
enterprise needs. The important factors to be
decisions pertaining to the following 4P’s
considered before deciding the number of personnel
● Product ● Price
needed are
● Promotion ● Place
● The total work to be done.
6. Implementation and Monitoring of the Plan

● How much work can an average person do in a
Evolving a marketing plan is not a mere formality. It is
specified period of time?
meant to be a commitment by the entrepreneur to a
● Level of absenteeism expected.
specific strategy. It is important for the entrepreneur to
● Rate of labour turnover.
be flexible and be prepared to make adjustments if
necessary in the plan. ● The present number of employees.
● The future plans for expansion and diversification.
VI. Human Resource Plan/

3. How Will they be Selected?/
Manpower Planning How to Procure Personnel?
An organisation’s performance and resulting productivity Procurement of ‘right person, at right job, at the right
are directly proportional to the quantity and quality of its time’ is the objective of human resource plan.
manpower. So, human resources (men) are of paramount
So, in this section, an entrepreneur clearly mentions
importance for the success of an organisation.
the strategies, methods, policies, rules and regulations
So, in order to build up loyal, efficient and dedicated pertaining to manpower
personnel, entrepreneur needs to pay adequate and proper ● Recruitment ● Selection
attention to human resource planning. ● Training

Entrepreneurship 19
Practice Questions
1 A comprehensively written document prepared by They want to start a retail business. Can they form
the entrepreneur describing formal all the relevant a partnership?
internal and external elements in starting a new (a) They can form a partnership after taking permission for
venture is called the parents.
(a) marketing plan (b) They can form a partnership after taking permission
(b) business plan from their school principal.
(c) financial plan (c) They can form a partnership because they are more than
(d) operational plan two persons.
(d) No, they cannot form a partnership because all of them
2 The business plan
are minors.
(a) helps in determining the viability of the venture in a
designated market 9 The business of partnership firm can be carried
(b) helps in providing guidance to the entrepreneur in out by all the partners or any one of them acting
organising his/her planning activities for all. This highlights the following characteristic
(c) provides room for self-assessment and self-evaluation of partnership.
(d) All of the above (a) Agreement (b) Utmost good faith
3 Which of the following forms of business (c) Mutual agency (d) Implied authority
organisations require minimum two persons to 10 Which of the following is not a consequence for
start the same? non-registration of a partnership firm?
(i) Sole proprietorship (ii) Partnership (a) The creditors cannot claim their dues.
(iii) Private company (iv) Public company (b) A partner cannot file a suit aganist the firm in a court of
(a) (i) and (ii) law for enforcement of any right arising out of the
(b) (iii) and (iv) contract.
(c) (ii), (iii) and (iv) (c) A right arising from a contract cannot be enforced in any
(d) (ii) and (iii) court by or on behalf of the firm against any third party.
(d) The firm or any of the partners cannot claim a set-off
4 The scope of operation of sole proprietorship form against a third party.
of business is limited because of
(a) limited finance availabilities 11 The organisation structure in which there is
(b) limited managerial abilities separation of ownership and management is called
(c) Both (a) and (b) (a) sole proprietorship (b) partnership
(d) None of the above (c) company
(d) one person company
5 This form of business organisation has a limited
area of operation due to availability of limited 12 ‘It is an artificial person created by law’ is a
finance and limited managerial abilities characteristic of which of the follow forms of
(a) joint stock company business organisation?
(b) partnership (a) Company
(c) sole proprietorship (b) Partnership firm
(d) Both (a) and (c) (c) Sole proprietorship
(d) Both (a) and (b)
6 Which of the following is not a public sector
enterprise? 13 In which of the following forms of business
(a) Departmental undertaking organisation there exists separation of ownership
(b) Public corporation from management?
(c) Sole tradership (a) Sole proprietorship (b) Partnership
(d) Government company (c) Company (d) Both (b) and (c)
7 Which of the following is not a disadvantage of sole 14 Being an artificial person, a company cannot sign
proprietorship form of business organisation? the documents. Hence it uses a ……… on which its
(a) Limited capital name is engraved for the same.
(b) Quick decision-making (a) trademark (b) logo
(c) Limited managerial ability (c) patent (d) common seal
(d) Limited continuity
15 ……… plan is that part of the business plan which
8 Vani, Shiva, Bhanu and Kumar are good friends. describes the proposed venture’s opted form of
They are the students of Class IX and are studying ownership.
in the same school. They were admitted at the age (a) Operational (b) Production
of 5 years and did not fail in any class. (c) Organisational (d) Business venture
16 Ravi Mohan is in the process of developing the (a) production plan

business plan of a shoes manufacturing unit (b) marketing plan
(c) operational plan
which he wants to start in an industrial area of
(d) organisational plan
Kanpur. He is in the process of developing a
component of his business plan wherein he has to 23 Which of the following statements is/are correct?
detail the kinds of people required their number Statement I A sole proprietorship does not need
and the process of their selection. to be registered.
Which of the following components of his business Statement II Therefore, it is an expensive manner
plan he has to develop after this? of commencing business.
(a) Marketing plan Alternatives
(b) Financial plan (a) Statement I is correct, but Statement II is incorrect
(c) Operational plan (b) Statement I is incorrect, but Statement II is correct
(d) Organisational plan (c) Both statements are incorrect
17 Which of the following plans help to plan the work (d) Both statements are correct
in such a manner that one can clearly form an idea 24 ................. helps to understand the feasibility and
about plan layout? viability of the proposed venture.
(a) Operational plan (a) Business plan
(b) Production plan (b) Marketing plan
(c) Marketing plan (c) Production plan
(d) Financial plan (d) Financial plan
18 Routing is an element of which of the following 25 Which form of business in suitable when size of the
components of business plan? venture is small?
(a) Production plan (b) Operational plan (a) Company (b) Partnership
(c) Organisational plan (d) Financial plan (c) Sole proprietorship (d) None of these
19 Break-even point is useful for the entrepreneur as 26 The process of initiating production in accordance
it helps in assessing with pre-conceived production plan is said to be ... .
(a) the minimum level of output to be produced (a) routing (b) scheduling
(b) the selling price of the product (c) dispatching (d) inspection
(c) the effect of change in quantity of output upon the
profits 27 Production plan aims at ‘plan your work’, whereas
(d) All of the above ................. plan aims at ‘work your plan’.
(a) operational (b) marketing
20 Which of the following is not a component of (c) financial (d) organisational
financial plan?
(a) Economic and social variables 28 The maximum number of partners allowed in the
(b) Follow-up banking business are
(c) Break-even analysis (a) twenty (b) ten
(d) Proforma investment decisions (c) fifty (d) two
21 ‘How products/services will be distributed, priced 29 The board of directors of a joint stock company is
and marketed’ is described by which of the elected by
following components of a business plan? (a) general public
(a) Marketing plan (b) government bodies
(b) Production plan (c) shareholders
(c) Operational plan (d) employees
(d) Financial plan 30 Which of the following elements of plan relates to
22 The component of the business plan that goes evaluation and appraisal of work performed?
beyond the production process by describing the (a) Dispatching
market conditions and strategies related to (b) Routing
(c) Scheduling
products/services to be distrubuted is called
(d) Follow-up
ANSWERS
1. (b) 2. (d) 3. (d) 4. (c) 5. (c) 6. (c) 7. (b) 8. (a) 9. (c) 10. (a)
11. (c) 12. (a) 13. (c) 14. (d) 15. (c) 16. (d) 17. (b) 18. (b) 19. (d) 20. (b)
21. (a) 22. (b) 23. (a) 24. (a) 25. (c) 26. (c) 27. (a) 28. (c) 29. (c) 30. (d)
Entrepreneurship 21
CHAPTER 03
Enterprise Marketing
Meaning of Marketing Strategy Product mix involves planning and developing the right type
of product that will satisfy fully the needs of customers. A
A strategy is basically a comprehensive plan for achieving an
product has several dimensions like size and weight of the
organisations’ objectives. Marketing is the process of
product, volume of output, product quality, brand name,
exchange of goods and services for money or something
package, warranties, etc. These dimensions are collectively
valuable. So, on the basis of these two concepts, marketing
called product mix. The components of product mix are
strategy means a comprehensive plan to facilitate and
branding, labelling and packaging.
promote exchange of goods and services.
Marketing strategy includes all basic and long-term activities Branding
in the field of marketing that deal with the analysis of the It is the most important element of product mix. A producer
strategic initial situation of a company. has to decide whether the firm’s products will be marketed
It also includes the formulation, evaluation and selection of under a brand name or a generic name. Generic name refers
market-oriented strategies and contributes to the goal of the to the name of the class of the product, e.g. car, television,
company and its marketing objectives. It is composed of shoes, etc.
several strategies for growth as well as interrelated If products were sold by their generic names, then it would
components of the marketing mix. be very difficult for the marketers to distinguish their
products from that of competitors.
Meaning of Marketing Mix Therefore, most marketers give a ‘name’ (brand) to their
Marketing mix refers to the ingredients or the tools on the products, which helps in identifying their products from that
variables which the marketing mixes in order to interact of their competitors.
with a particular market.
Thus, ‘Branding’ can be defined as a process, a tool, a
Marketing mix consists of a list of the important elements or strategy, an orientation whereby a name, a sign, or a symbol,
ingredients that make the marketing system and a list of etc., is given to a product by the entrepreneur so as to
forces that shape the marketing operation of a firm. differentiate its product from the rival products.
According to Philip Kotler, ‘‘A marketing mix is the
mixture of controllable marketing variables that the firm use Brand
to pursue the sought level of sales in the target market’’. ‘Brand’ is a comprehensive term used to denote a name,
term, sign, symbol, design or combination of them, with a
The 4Ps that make up a typical marketing mix are Price,
view to identify the products of one’s firm and differentiate
Product, Promotion and Place.
them from those of their competitors.
However, now-a-days, the marketing mix increasingly
The three components of brand are as follows
includes several other Ps like Packaging, Positioning, People
and even Politics as vital mix elements. 1. Brand Name A part of a brand which can be spoken is
referred to as brand name. It is like naming a new born
Product Mix child. e.g. Mercedes, Coke, Lays, etc.
Product refers to the item actually been sold, i.e. goods or 2. Brand Mark It is that part of a brand which cannot be
services or ‘anything of value’, which is offered in the market spoken but can be recognised. It is non-utterable. It
for exchange. The product must deliver a minimum level of appears in the form of a symbol, design or distinct
performance, otherwise even the best work on the other colour scheme. e.g. ‘Girl’ of Amul, ‘Maharaja’ of Air
elements of the marketing mix won’t do any good. India, etc.
3. Trademark A brand or a part of a brand that is given Some logos are given below
legal protection against its use by other firms is called a
trademark. It is essentially a legal term. It confers upon
its owner, the exclusive right to use the brand name
and brand mark. e.g. is the trademark of Nike.
Qualities/Characteristics of a Good Brand

A good brand name should be distinct and be able to stand
out among competitors. In selecting a brand name,
entrepreneur should ask himself what he wants to achieve.
While selecting a brand name, an entrepreneur should
choose a name which is
● short, simple and easy to pronounce, e.g. Nano, LG, etc. Logo serves the following purposes
● noticeable, easy to recognise and remember, e.g. ‘girl’ of ● Logos are an important aspect of business marketing. As
Amul. the company’s graphical representation, a logo acts as an
● pleasing, impressive when uttered, e.g. Zodiac, Kodak, etc. anchor for the company’s brand.
● neither obscene, negative, offensive or vulgar, i.e. focus ● Corporate logos are intended to be the ‘identity’ of an
should be on positive attributes, e.g. Ujala, Swift, etc. enterprise by graphically displaying its uniqueness.
● adaptable to packaging, labelling requirements, to different
● Through a set colour combination, fonts, images,
advertising media and languages. impression and /or patterns, logos provide essential
● linked to product, symbolically eye catching, e.g. Hajmola,
information about a company and helps customers to
Hair and Care, etc. relate it to an enterprise’s core brand.
● contemporary, capable of being registered and protected
● Enterprises normally resort to logos as a shortcut to
legally, e.g., brand mark of Nike and Pepsi etc.
advertising.
Entrepreneur’s Perspective on Brand Name ● Logos act as the key visual component of an enterprise’s
Entrepreneur can follow different policies in choosing brand overall brand identity.
name keeping in mind the range of products offered by
Tagline
him/her. Various types of brands available are
Taglines are basically simple but powerful messages that
1. Individual Brand Name Under this strategy, an
help to communicate an enterprise’s goals, mission, distinct
entrepreneur chooses a distinct name for each of his
qualities, etc. Thus, a tagline is a short text which conveys a
offering, i.e. each product is promoted on the basis of a
thought effectively.
separate brand name.
‘Tagline’ and ‘tag’ are American terms. In UK, they are called
2. Family Brand Name Under this strategy, an
‘end lines’ or ‘straplines’, Germans call them as ‘claims’,
entrepreneur chooses a common or a successful family
French refer to them as ‘signatures’, while Belgians call
name for their several products. He can use his own
them as ‘baseline’.
name or the company’s name may be used for all the
products. It is also referred to as ‘Umbrella Branding’. They can come in the form of questions, statements or
exclamations. The basic purpose behind a tagline is to create
3. Corporate Names Entrepreneurs can choose to utilise
a memorable dramatic phrase that will sum up a product.
their corporate name or logo together with some brand
names of individuals products.
Packaging
4. Alpha-numeric Names Entrepreneurs have an option This is the second element of product mix after branding. It
to brand their product alpha-numerically. An alpha- refers to the act of designing and producing the container or
numeric name often signifies its physical wrapper of the product.
characteristics, thus creating a distinctive identity of
the product. According to Stanton, packaging refers to “All the activities
involved in designing and producing the container or
Logo wrapper for a product”.
Logo is the short for logotype and is an identifying symbol There are three levels of packaging, as discussed below
for a product/service or a business. ‘Logo’ is an important 1. Primary Package which encloses the actual commodity.
feature or part of branding. It is a graphic mark of emblem
2. Secondary Package which is the layer of cover added
used to aid and promote instant public recognition.
to the primary package for its protection.
Logos are either purely graphic (symbols/icons) or are
3. Transportation Package refers to further packaging
composed of the name of the organisation (a logotype or
components necessary for storage and transportation.
word mark).
Entrepreneurship 23
Labelling Selling a product at a high price, sacrificing high sales to

Labelling is that part of branding which enables product gain a high profit is therefore ‘skimming’ the market.
identification. It is the display of information about a This strategy is usually employed to reimburse the cost
product on its container, packaging, or the product itself. of investment on the original research and is commonly
Label may be in the form of simple tag attached to the used in the electronics market where a new range, such
product or complex graphics that are part of the package. as smartphones are initially dispatched into the market
at a high price. This strategy targets the early adopters
According to Philip Kotler and Ronald E. Turner,
of a product or a service.
“Labelling is part of packing and consists of printed
information that describes the product, appearing on or with But this strategy is employed only for a limited
the package”. duration to recover most of the investment made to
develop the product. To enhance its market share, the
Labelling is important because of the below mentioned
entrepreneur is required to follow other pricing
reasons
strategies in the long-run.
● It describes the product and specifies its contents.
4. Variable Pricing It is a marketing approach that
● It helps in the identification of the product or brands.
permits different rates to be extended to different
● It helps to grade the products.
customers for the same goods and services. This
● It helps in the promotion of the products. approach is generally followed for businesses where
● It helps in providing information as required by law. dickering or bargaining over the price of goods is
considered the norm.
Price Mix
Price refers to the value that is put on a product. It
Place and Place Mix
represents the sum of values that consumers are willing to In marketing, place refers to the point of sale. To catch the
exchange for the benefit of having or using the product. eye of the consumer and make it easy for him to buy, is the
Price of a product depends upon cost of production, segment main aim of a good distribution or ‘place’ strategy. In fact,
targeted, ability of the consumer to pay and market forces of the mantra for a successful retail business is ‘location,
demand and supply. location and location’.
Price is the only revenue generating element among the 4Ps, Place Mix (Distribution)
the rest being cost centres. Place mix is also referred to as ‘distribution mix’. The prime
Pricing Strategies/Methods concern of distribution mix is to make sure the timely
delivery of products to the customers at the right time and at
Pricing strategy refers to the method that the entrepreneur
the right place through various channels of distributions.
uses to price his/her products or services. All entrepreneurs,
large or small, determine the price of their products and A channel of distribution or trade channel is defined as the
services keeping in view production cost, labour charges, path or route along which goods move from producers or
advertising expenses, etc. and then add on a certain manufacturers to ultimate consumers.
percentage so as to earn some profit, based on their pricing This channel consists of producers, consumers or users and
strategies, each tied with an overall business plan. Some various middlemen like wholesalers, selling agents and
pricing strategies are discussed below retailers.
1. Cost-plus Pricing It is the most common technique of Therefore, this channel bridges the gap between the point of
pricing where the manufacturer charges a price to cover production and the point of consumption, thereby creating
the cost of producing a product plus a reasonable profit. time, place and possession utilities.
This method of pricing is typically based on A channel of distribution usually consists of three types of
manufacturing estimates. flows, which are
2. Penetration Pricing Under this pricing strategy, the ● Downward flow of goods from producers to consumers.
price of the product is initially set at a price lower than ● Upward flow of cash payments for goods from consumers
the prevailing market price to attract new customers to producers.

and increase its market share. Penetration pricing is ● Flow of marketing information in both downward and
most commonly associated with a marketing objective upward direction, i.e.

to increase market share or sales volume, rather than to (a) Information moves downward in the form of
make a profit in the short-run. The price is raised later information on new products, new uses of existing
when the market share is gained. products, etc., from producers to consumers.
3. Creaming or Skimming In this type of pricing (b) Information moves upward in the form of feedback
strategy, entrepreneurs set their prices higher, so that on wants of consumers, suggestions, complaints,
fewer sales are needed to break-even. etc., from consumers to producers.
Different Types of Channels of Distribution 2. Considerations Related to Market The following

An entrepreneur has a number of alternative channels considerations related to market need to be analysed by
available to him for distributing his products. These the entrepreneur before taking the final decision
channels are broadly divided into four types, which are as ● Number of buyers ● Types of buyers
follows ● Buying habits ● Buying quantity
1. Producer-Customer (Direct channel-zero level) This is ● Size of market
the simplest, shortest and the most economical channel 3. Considerations Related to Manufacturer/Company
of distribution, in which producers sell their products The following considerations related to a manufacturer/
directly to the consumers. company need to be closely analysed
● Goodwill
Producer Customer
● Desire to control the channel of distribution
2. Producer-Retailer-Customer (Indirect–one level) ● Financial strength
This channel of distribution involves only one 4. Considerations Related to Government This is also
middleman called ‘retailer’. Under it, the producers sell an important factor while deciding the channel of
their products to big retailers, who in turn sell to the distribution, e.g. only a license holder can sell
ultimate consumers. This channel relieves the medicines in the market according to the law of the
manufacturer from the burden of selling goods and government. So, the manufacturer of medicines should
also gives him control over the process of distribution. take care that the distribution of his product only takes
place through such middlemen who have the requisite
Producer Retailer Customer
license.
3. Producer-Wholesaler-Retailer-Customer (Two 5. Other Factors Certain other factors required to be
levels) This is the most common and traditional given due consideration are
channel of distribution, involving two middlemen, viz., ● Cost ● Availability
wholesalers and retailers. Here, the producer sells his ● Possibilities of sales
product to the wholesalers, who then sell it to retailers,

and retailers finally sell to consumers. Promotion
Promotion, in marketing, refers to raising customer
Producer Wholesaler Retailer Customer awareness about a product or brand, generating sales and
creating brand loyalty. It includes all the activities
4. Producer-Agent-Wholesaler-Retailer-Customer
undertaken to make the product or services known to the
(Three levels) This is the longest channel of
user and trade.
distribution in which three middlemen, viz., agent (or
distributor), wholesaler and retailer are involved. In the words of Prof. William J Stanton, “Promotion is
that element in an organisation’s marketing mix that serves
The producer handover his entire output to agents/
to inform, persuade and remind the market of a product
distibutors and the agents distribute the product
and/or the organisation selling it, in hope of influencing the
among wholesalers, who then distribute it among a
recipients’ feelings, beliefs or behaviour’’.
number of retailers, who finally sell it to the ultimate
consumers. Promotion Strategy
Producer Agent Wholesaler Promotion strategy is a comprehensive plan that aims at
finding an appropriate market for a product or service and
Customer Retailer utilising all aspects of promotion such as advertising and
discounts used to promote the product or a service in a
particular market.
Factors considered for Selection of Channel
Before selecting a channel of distribution, an entrepreneur A business may choose from among the following
should keep in mind the following factors approaches or strategies to promote its products/services
1. Considerations Related to Product While selecting 1. Above The Line (ATL) Approach This type of
a channel of distribution, entrepreneurs should take promotion focuses on advertising to a large audience. It
care of following factors related to the quality and uses mass media methods of promotion such as
● Advertisements in press.
nature of product, which are as follows
● Online banner advertisements.
● Unit value of the product ● Standardised products
● Place advertisements on billboards.

● Customised products ● Perishability
● Website development.
● Technical nature
● Television and cinema advertising.
Entrepreneurship 25
2. Below The Line (BTL) Approach Below the line 4. Competitors The actions of the competitors should also
methods of promotion are specific, memorable be analysed. What are the competitors doing?, Which
activities focused on targeted groups of consumers. media channel do they use? Are they successful? Can
These promotional techniques are under the control of you improve on their approach and beat them in
an organisation and include competition?
● Sponsorship ● Sales promotion These rules should be strictly adhered to, before finalising an
● Public relations ● Personal selling advertisement plan.
● Direct marketing Commonly Used Media for Advertising The commonly
3. Through The Line (TTL) Approach Through the used media are as follows
line approach refers to a promotional strategy 1. Stationery Stationery, which includes letterheads,
involving both above and below the line approaches envelopes and business cards, is a means by which the
used by a business to reach their customer base and business image or ‘name identification’ is projected.
generate conversions. In this approach, one form of Good quality stationery, used with care and attention and
advertising points the target to another form of with a high standard of presentation, portrays a positive
advertising, thereby crossing the ‘line’. image of the business.
Promotion Mix 2. Window Display or Office Front The external
presentation of the business office or shop is one of the
Promotion mix refers to the combination of promotional
principal ways of establishing and promoting the
tools used by an organisation to reach the targeted market.
business image.
According to Philip Kotler and Gray Armstrong, “The
An attractive, well-maintained exterior with clear, bold
promotion mix is the specific blend of advertising, public
sign, windows bright and attractively presented,
relations, personal selling, and direct-marketing tools that
scrupulously clean and well lit at night and neatly
the company uses to persuasively communicate customer
arranged displays, all project an attractive company
value and build customer relationships”.
image and give reasons to customers to buy its products
The various promotional tools are as follows or services.
● Advertising ● Personal selling
3. Press Advertising This is a commonly used form of
● Sales promotion ● Public relations
general advertising and includes advertising in print
media such as newspapers, magazines and journals.
1. Advertising
Advertising is a paid form of non-personal communication This form of advertising is suitable for image building,
designed to persuade potential customers to choose a information dissemination and sales campaigns.
product or a service over that of a competitor. 4. Radio It is considered to be an ideal medium due to its
ability to reach specific target groups such as teenagers,
The objective of advertising is to increase profit by
housewives, etc.
increasing sales. Advertising achieves this objective by
● making business and product name familiar to the public.
Radio advertising covers spot advertisements which
● creating goodwill and building a favourable image.
usually last for 15 to 30 seconds, promotions or
talkback/RJ discussions. Most radio stations offer
● offering specific products or services.
packages which include production and extension of the
● educating and informing the public.
radio campaign through their websites.
● attracting customers, so that they search for more
5. Television It is a powerful advertising medium because it
information about the products or services offered by the
creates impact through sight, sound and movement. But,
business.
high cost of advertising on this medium often makes it
Rules of Advertising Following four rules should be prohibitive for small businesses.
considered while planning any advertising
6. Direct Mail This is a very broad category, covering direct
1. Aim Before drafting out an advertisement, the communication with the consumer through e-mail, post
primary or basic purpose of advertisement should be or fax. It includes newsletters, catalogues and letters.
kept in mind.
7. Outdoor This form of advertising is done outdoors and
2. Target Target should be considered, i.e. from which includes static advertising such as billboards, backs of
sector of the public are we trying to achieve a street benches and bus shelters or mobile advertising
response? displayed on buses, trains, taxis or towed signage.
3. Media Keeping in mind, the aim and the target, the 8. Ambient It refers to any form of advertising that occurs
next decision relates to which of the available media in a non-standard medium outside the home and usually
will be the most suitable? where the consumer is most likely to be.
It includes advertising on the back of shopping receipts ● He should be pleasing, polite and courteous. Apart from
or toilet doors at the cinema, or placing branded having good oratory skills, he/she should also be a good
coasters at the local clubs, or projecting onto buildings, listener.
advertising inside lifts or distributing branded cups. ● He should not give false and misleading information about
9. Cinema Advertisers can opt to advertise their products the product.
through cinema advertising. The advertisements are ● He should be patient and confident.
run in the beginning of the movie or during ● He should be of pleasing personality. Being polite will
intermissions. always win customers.
10. Point of Sale This type of advertising is at the point, ● Salesperson should try to understand the needs of the
where the consumer makes purchase decision through customers and try to match them with the products
floor stickers, in-store digital advertising, shopping available.
trolley signage, shelf or counter posters or playing
3. Sales Promotion
interviews about the product in store. This method of
Sales promotion relates to short-term incentives that
advertising prompts purchases.
encourage or promote the purchase or sale of a product or a
11. Online Advertisers can post their advertisements on their service. Sales promotion initiatives are often referred to as
own site or on other sites, or they can create link to their ‘below the line activities’.
websites through other sites or advertise by publishing
blogs, offering online product games and through social Sales Promotion Activities The major sales promotion
networks and forums. activities are as follows
12. Directory Listings Many consumers use business 1. Consumer Promotions The promotion activities
directories to find a supplier or seller of a specific directed towards the final consumers are referred to as
product or service. So, entrepreneurs should get their consumer promotions activities.
business registered in various directories which include Important sales promotion activities of this segment are
the yellow or white pages, union directories, trade as follows
● Point of purchase display material which includes
directories or local business directories.
dangler, dump bin, lipstick board and necker.
2. Personal Selling ● In-store demonstrations, samplings and celebrity
Personal selling means selling products personally. It appearances.

involves oral presentation of message in the form of ● Competitions, coupons, lucky draw, sweepstakes and
conversation with one or more prospective customers for the games.

purpose of making sales. ● On-pack offers, discount, rebate, multipacks, product
Under personal selling, companies appoint sales persons, combination and bonuses.
who contact with prospective buyers to create product ● Loyalty reward programmes.
awareness and preferences with the aim of making sales.

2. Business Promotions The promotion activities
In the act of making a final sale, a salesperson plays three targeted towards the business customers are referred to
different roles as business promotions activities.
● Role of a persuader.
Important activities of this segment are as follows
● Role of a service provider. ● Seminars and workshops.
● Role of an informant. ● Conference presentations.
● Trade show displays.

From the above discussion, it can be inferred that personal
selling possesses the following features ● Telemarketing and direct mail campaigns.
● It is a personal form of selling. ● Newsletters.
● It leads to development of relations. ● Event sponsorship.
● It involves oral conversation. ● Capability documents which include the information
● It has a narrow coverage. necessary to support production, testing and

● It has the feature of flexibility. deployment of an affordable strategy.
Qualities of a Good Salesman A good salesman should 3. Trade Promotions These promotional activities are
possess the following qualities targeted towards retailers and wholesalers. Some
● A salesman should be good looking, healthy and smart in
typical activities of this segment are
● Reward incentives linked to purchase or sale.
appearance.
● Reseller staff incentives. ● Competitions.
● He should be fully conversant with technical knowledge of
● Corporate entertainment. ● Bonus stock.

the product.
Entrepreneurship 27
4. Sales Force Promotions The sales promotion Types of Sales Strategy

activities used to encourage members of the sales force There are basically two types of sales strategy to meet an
are referred to as sales force promotions. Some enterprise’s sales objectives, viz direct and indirect sales
important activities belonging to this segment are strategy. These are as follows
● Commissions.
1. Direct Sales Strategy Under this strategy, salesmen
● Sales competitions with prizes or awards.
attack the competitors directly. While talking to the
4. Public Relations customers, they talk about each feature of the
It is a deliberate, planned and sustained effort to establish competitor’s product and compare it to theirs. This
and maintain mutual understanding between an strategy is also termed as negative selling approach.
organisation and its stakeholders by obtaining favourable 2. Indirect Sales Strategy Under this strategy, salesmen
publicity, building a good corporate image and handling or apply more subtle techniques by demonstrating
heading off unfavourable rumours, stories and events. features and benefits of their products or services
without ever mentioning the name or features of
Tools of Public Relations Typical tools of public relations
competitor’s products.
include
● News creation and distribution in the form of media This is more sophisticated positive sales strategy which
releases. requires research and analysis of the competition.
● Special events such as news conferences, grand openings
and product launches. Components of Sales Strategy

● Speeches and presentations.
Components of sales strategy are classified into four types
● Educational programmes. 1. Product Placement It is basically an advertising
● Annual reports, brochures, newsletters, magazines and technique used by companies to place the product
audio-visual presentations. in market through various social media network.
● Community activities and sponsorships. Businesses can use the social network pages to
communicate with it’s customers.
Sales Strategy 2. Promotion It refers to all such activities which intend
A sales strategy is a plan that positions a company’s brand in to inform customers about the products of the
such a way, that it gains a competitive advantage in its company and persuade them to buy these products.
segment. Successful strategies help the sales force focus on 3. Testimonials Customers testimonials and feedback
target market customers and communicate with them in should regularly be posted on the company’s site and
relevant and meaningful ways. should be readily available for prospects to read or
A strategic sales plan not only involves a quick watch. This lends authenticity to the claim made by
understanding of market opportunities, threats and target a business with regards to its products or services.
markets, but also the strengths and weaknesses of the 4. Core Selling Strategies There are a number of
competitors. strategies available for the sales personnel to carry out
Successful sales strategies communicate to the sales force their responsibilities and duties effectively. But, the
how their products and services can solve the customers’ success of these strategies depends on the identification
problems, so that they can target the right customers at the and analysis of those factors that are treated as drivers
right time. of selling strategy formulation.
Functions of Sales Strategy

Significance of Sales Strategy
The two main functions of sales strategy are as follows
An effective sales strategy is important for a business
because of the below mentioned reasons 1. New Customer Acquisition A sales strategy lays out
● Planning an effective sales strategy requires looking at
steps and methods necessary for targeting customers in
different stages.
long-term sales goals and analysing the business sales
cycle. Potential customers need communication that
● It helps business owners and managers to gain a more
introduces the brand and product/service to them and
shows, how it can solve their problems.
precise knowledge of sales intervals, seasonal changes and
motivating factors about the sales team. Sales strategy facilitates this communication and helps
● After creating long-term sales strategy based on long-term
in expanding the customers base.
goals, sales managers create monthly and weekly sales 2. Customer Retention Retaining existing customers,
strategies. This allows for short-term performance so that they don’t deviate towards competitors is the
evaluation of sales team and allows to take remedial action second important function to be performed by sales
if targets are not achieved. strategy.
Current customers require more personal communication ● Market knowledge.

about new features or benefits to keep them engaged. ● Awareness of competitor’s activities.
Promotions and referral discounts work to motivate ● Awareness of current trends.
current customers to spend their money and spread the ● Detailed business analysis.
benefit of the product to others.
These considerations are crucial for a successful sales
Considerations while Formulating Sales Strategy strategy. Small business owners or those formulating a
The following considerations should be carefully analysed and sales strategy for a first time should hire a professional
reviewed by a business before formulating a sales strategy consultant for formulating an effective sales strategy.
Practice Questions
1 The ‘Marketing strategy’ and ‘Action plan’ comprise of 9 ................ pricing strategy is employed only for a
decisions pertaining to which of the following? short duration as it is not viable in the long-run.
(a) Potential hazards present in the competitive (a) Penetration (b) Cost-plus
environment (c) Skimming (d) Variable
(b) Product, place, price, promotion
(c) Customer’s characteristics
10 ................. channel of distribution completely
(d) Quantifying goals of the organisation relieves the manufacturer from the problem of
distribution and is suitable for marketing of
2 Which of the following is not a component of product industrial products.
mix? (a) Producer-customer
(a) Branding (b) Labelling (b) Producer-retailer-customer
(c) Packaging (d) Promotion (c) Producer-wholesaler-retailer-customer
3 Farhan Akhtar driving Royal Enfield bike in ‘Bhaag (d) Producer-agent-wholesaler-retailer-customer
Milkha Bhaag’ is an example of 11 XY Limited manufactures plastic buckets. The
(a) product placement (b) promotion CEO wants to select a distribution channel for
(c) testimonials (d) core selling strategies his buckets. The factor(s) related to the product
4 ‘Brand’ word has originated from the word ‘Brandr’ to be kept in mind is/are
which means ‘to burn’ in (a) unit value of product (b) perishability
(a) French (b) German (c) technical nature (d) All of these
(c) Norwegian (d) None of these 12 The associated cost of promotion is the highest
5 The ‘Maharaja’ of Air India is an example of in case of
(a) brand name (b) brand mark (a) advertising (b) personal selling
(c) trademark (d) None of these (c) sales promotion (d) publicity
6 ................. act as the key visual component of an 13 ................. promotional activities are targeted
enterprise’s overall brand identity. towards retailers and wholesalers.
(b) Brand name (b) Logo (a) Consumer promotions
(c) Tagline (d) Packaging (b) Business promotions
7 Vector Ltd., is in the Fast Moving Consumer Goods (c) Trade promotions
Industry. They introduced a new variety of biscuits in (d) None of the above
the market. It has high fibre content with different 14 ‘Balls red’ is a SSI producing cricket and tennis
new flavours incorporating various multigrains. balls. To promote its products, it wants to
State which promotion strategy should be used by advertise on TV but its Chartered Accountant
Vector Ltd.? advises the CEO of the firm against it. The
(a) Below the line (b) Through the line reason behind this could be
(c) Above the line (d) None of these (a) limited scope of TV
8 Various approaches may be used by a company to (b) high cost associated with it
(c) limited exposure
promote its products. One of them is the use of mass (d) All of the above
media methods by designing a promotion strategy
that aims at establishing brand identity. Identify 15 In the act of making a final sale, a sales person
promotion strategy. plays a role of
(a) Below the line (b) Through the line (a) a persuader (b) a service provider
(c) Above the line (d) None of these (c) an informant (d) All of these
Entrepreneurship 29
16 Sales strategy is important because 23 PapTap is a soft drink company. It sells 200 ml
(a) it creates awareness about business environment bottle for ` 8 and 2,000 ml bottle for ` 55. The
(b) it helps in measuring short-term performance of company follows which strategy?
sales team
(a) Cost-plus pricing (b) Pentration pricing
(c) Both (a) and (b) (c) Creaming (d) Variable pricing
(d) None of the above
24 What relates to short-term incentives that
17 Which of the following statements is/are correct? encourage or promote the purchase or sale
Statement I Labelling acts as a silent salesman. of a product or a service?
Statement II It helps in the promotion of products (a) Advertising (b) Pricing
by attracting the attention of customers and (c) Sales promotion (d) None of these
providing required information. 25 ................. is a plan that positions a company’s
Alternatives brand in such a way that it gains a competitive
(a) Both statements are correct advantage in its segment.
(b) Statement I is correct, but Statement II is incorrect (a) Promotion (b) Marketing
(c) Statement I is incorrect, but Statement II is correct (c) Sales strategy (d) None of these
26 Which sales strategy allows a business to cover
18 Which of the following statements is/are correct? a wide geographical market and to sell to a large
Statement I Advertising costs are passed on to customer base?
consumers in the form of higher prices. (a) Direct (b) Indirect
Statement II Advertising helps in increasing (c) Promotional (d) None of these
sales and thereby reducing costs. 27 Which of the following is not a quality of a good
Alternatives brand?
(a) Both statements are correct (a) It should be long.
(b) Statement I is correct, but Statement II is incorrect (b) Neither obscene, negative, offensive or vulgar.
(c) Statement I is incorrect, but Statement II is correct (c) Pleasing, impressive when uttered.
(d) Both statements are incorrect (d) Linked to product, symbolically eye catching.
19 ................. is defined as, ‘‘a process that can allow 28 Which of the following is an example of an example
an organisation to concentrate its resources on the of an umbrella branding?
optimal opportunities with the goals of increasing (a) Liril (b) Ponds (c) Lux (d) i10
sales and achieving a sustainable competitive
29 Which of the following pricing strategy of a product
advantage’’.
is initially set at a price lower than the eventual
(a) Marketing strategy (b) sales strategy
(c) Pricing mix (d) Promotion mix
market price to attact new customers?
(a) Cost-plus pricing (b) Penetration pricing
20 ................. is the mixture of controllable marketing (c) Skimming pricing (d) None of these
variables that the firm uses to pursue the sought
level of sales in the target market. 30 In which of the following channel of distribution no
(a) Product mix (b) Promotion mix middlemen is involved and producers directly sell
(c) Place mix (d) Marketing mix their products to the consumers?
(a) Direct channel-zero level (b) Indirect-one level
21 A ................. is either a tangible or an intangible
(c) Two levels (d) Three levels
offering that is required to satisfy the needs and
aspirations of a consumer. 31 Which of the following is the consumer sale
(a) service (b) goods promotion activity?
(c) product (d) None of these (a) Loyalty reward programmes
(b) Event sponsorship
22 Identify the term highlighted in the line “ These
(c) Competitions
are simple but powerful messages that help to (d) Corporate entertainment
communicate an enterprise’s goals, mission,
32 Which of the following is a powerful advertising
distinct qualities etc”.
medium?
(a) Logo (b) Brand name
(a) Radio (b) Television
(c) Taglines (d) None of these
(c) Direct mail (d) Cinema
ANSWERS
1. (b) 2. (d) 3. (a) 4. (c) 5. (b) 6. (b) 7. (c) 8. (c) 9. (c) 10. (d)
11. (d) 12. (b) 13. (c) 14. (b) 15. (d) 16. (c) 17. (a) 18. (b) 19. (a) 20. (d)
21. (c) 22. (c) 23. (d) 24. (c) 25. (c) 26. (b) 27. (a) 28. (b) 29. (b) 30. (a)
31. (a) 32. (b)
CHAPTER 04
Enterprise Growth Strategies
Growth and The net results of internal expansion are

Development of an Enterprise ● Increase in business activities.
● Broadening the present capital structure.
Growth is alwasys essential for the survival of the enterprise.
Once a business has started generating adequate profits, 2. External Expansion or Business Combination
growth is the next exciting challenge for an entrepreneur. External expansion occurs when two or more business
A successful entrepreneur is one who makes sure that there is enterprises come together with a common objective of
a constant flow of new ideas and is also committed to try out expanding their business. A firm may expand externally by
these ideas, so as to ensure the growth of the business. ● franchising
● mergers and acquisitions

The decision to expand one’s scale of operation must be the
result of thoughtful consideration of various factors affecting External expansion is financed through long-term sources
the business, such as financial viability, level of competition, of finance.
etc. The rule of thumb is that one should only expand when The net results of external expansion are
there are untapped opportunities that can benefit the business.
● Expansion of capital base as well as business activities.
On the road of growth, an entrepreneur has to play the dual ● Elimination of unnecessary competition.
role of a manager as well as a leader. Also, to ensure the
● Synergy effect is achieved.
efficiency, profitable functioning and growth of enterprise,
extra managerial ability is required.
Franchising
The expansion of an enterprise may be in the form of
Franchising can be defined as an arrangement whereby
diversification of activities or acquition of ownership and
the manufacturer or sole distributor of a trademarked
control of other business. Thus, expansion may be in the
product or service gives exclusive rights of local
following forms
distribution to independent retailers in return for their
1. Internal Expansion payment of royalties and conformance to standardised
It is a slow and time consuming process which is the result of a operating procedures.
gradual increase in the activities of the enterprise. A firm may According to Arnold S. Goldstein, “Franchising occurs
expand internally by when the franchisee markets a product or service
● expanding its present production capacity by increasing the developed by a franchiser under an agreement and license
number of machines. to do so.”
● replacing old machines with advanced technological
Today, franchising is helping thousands of individuals to
machines. be their own boss and operate their own business. It
● entering in the new areas of production or marketing or allows entrepreneurs to be in business for themselves, but
both. not by themselves.
● increasing the output of the enterprise.
There is usually a much higher likelihood of success of a
Internal expansion is generally financed through long-term franchise opened by an individual as compared to
sources of finance and also through undistributed profits and independent business, since a proven business formula is
reserves. in place.
Entrepreneurship 31
Following terms related to franchising are as follows 3. Business Franchise Opportunity Venture This
1. Franchisor model requires that a business owner purchases and
A franchisor sells the right to open stores and sell products or distributes the products for one specific company.
services using its brand, expertise and intellectual property. The company provides the business with customers
Thus, a person or company offering the franchise is known as and in return, the business owner pays a fee or any
the franchisor. other form of compensation to the company. e.g.
vending machine routes and distributorship.
2. Franchisee 4. Business Format Franchise Opportunity This is
The person or entity who purchases the franchise and is given the most popular form of franchising. In this model,
the opportunity to enter a new business with a better chance the franchisor provides the franchisee a proven
to success, is known as the franchisee. method of operating a business using its name and
3. Franchise Agreement trademark. The franchisor assists the franchisee in
It is a legal document defining the mutual terms and starting and managing the business.
conditions between a franchisor and a franchisee. The The franchisee pays a fee or royalty in return.
agreement is designed to assure that all the franchisees within Sometimes, the franchisee may even be required to
an organisation are treated equitably. purchase supplies from the franchisor. This model is
The main ingredients of a franchise agreement are as follows operative in the education sector.
(i) Contract Explanation It is the part of the agreement Advantages of Franchising
that defines the type of relationship, a franchisee is
The advantages enjoyed by both franchisee and franchisor
entering into with the franchisor.
are discussed below
(ii) Operations Manual This section of the agreement lays
forward the guidelines that the franchisee must legally Advantages to the Franchisee
follow while operating the business, as specified by the Following are the advantages enjoyed by a franchisee
franchisor. 1. Product Acceptance The franchisee usually enters
From time to time, amendments may be made and the into a business that has an accepted name, product
franchisee must be prepared to adjust operations or service. He does not have to spend resources to
accordingly. He should be aware that the contents of the establish the credibility of the business and create a
document are confidential. market for his product. The credibility already exists
(iii)Proprietary Statements These statements outline, how based on the years the franchise has existed.
the franchise name is to be used and also the marketing 2. Management Expertise The franchisor provides
and advertising procedures required to be followed by the managerial assistance related to all aspects of
franchisee. It also states the proportionate share of operating the franchise, to the franchisee.
franchisee towards national advertising campaigns. For this purpose, training programmes are conducted
(iv)Ongoing Site Maintenance This includes the types and which includes classes in accounting, personnel
time frames regarding various maintenance items and management, marketing and production.
upgrades that must be made to the franchisee’s location. 3. Capital Requirements Franchise offers an
opportunity to start a new venture with up-front
Types of Franchising support from franchisor, which saves considerable time
Following are the four different types of franchising and capital of the franchisee.
opportunities available In some cases, the franchisor also finances the initial
1. Product Franchise Business Opportunity Under this investment to start the franchise operation. Savings
model, the manufacturer grants a store owner the in start-ups are also reflected in the pooling of money
authority to distribute goods manufactured by the by individual franchisees for advertising and sales
manufacturer and allows the owner to use the name and promotion.
trademark owned by the manufacturer. The store owner This allows advertising on both local as well as
is either required to pay a fee or purchase a minimum national level to enhance the image and credibility of
inventory of stock in return for these rights. e.g. tyre the business, something that would be impossible for
stores. a single operation.
2. Manufacturing Franchise Opportunity Under this 4. Knowledge of the Market Franchisors are well
model, the franchisee is conferred with exclusive rights aware of the existing market conditions. With their
to manufacture a product and sell it to the public, using experience and knowledge, they can provide advice
the franchisor’s name and trademark. This type of and assistance to the franchisees for carving out a
franchise is common in food and beverage industry. market for themselves.
This is particularly important because of regional and 2. Continuing Cost Implication In addition to the
local differences in markets. Also, franchisors constantly original franchise fees and royalties, the franchisors
evaluate the market conditions and determine the most also demand a percentage of revenues.
effective strategies to communicate to the franchisees. They may also charge extra for providing advertising
5. Operating and Structural Controls Generally, a new and training facilities. So, entering into franchise
venture is faced with the problems of quality control agreements with well-known brands becomes a very
and managerial controls. The franchisor helps the expensive proposition.
franchisee to combat both the problems. 3. Risk of Franchisor getting Bought The franchisee
Standardisation in supplies and products/services offered faces serious problems and difficulties when the
helps to ensure that the entrepreneur will maintain franchisor either fails or gets bought out by another
quality standards. It also supports a consistent image on company.
which the franchise business depends for expansion. 4. Inability to provide Services When promises made
in the franchise agreement are not kept, the
Advantages to the Franchisor franchisees may be left without any support in
The advantages a franchisor gains through franchising are important areas such as advertising, training, quality
related to expansion risk, capital requirements and cost control, etc. This may be a cause for their failure.
advantages, which are discussed below
1. Quick Expansion The first and foremost advantage of Disadvantages to the Franchisor
franchising for franchisor is that, it allows a business to The disadvantages which exist for the franchisor are as
expand quickly, using little capital. follows
A franchisor can expand a business nationally and even 1. Difficulty in identifying Quality Franchisees The
internationally, by authorising and selling franchises in franchisor may find it difficult to identify quality
selected locations. Also, operating a franchised business franchisees.
requires fewer employees, thus cutting down an Even after extending all possible support towards
operational cost. training and providing capital, poor management skills
2. Cost Advantages The huge size of a franchised of the franchisee may lead to the failure of the
company offers many advantages to the franchisor. The franchise and adversely affect the goodwill of the
franchisor can purchase supplies in large quantities, franchisor.
thus achieving economies of scale. 2. Federal and State Regulation While not entirely a
Many franchise businesses produce parts, accessories, drawback, dealing with the federal regulations set
packaging and raw materials in large quantities and down by the Federal Trade Commission (FTC) for
then sell them to franchisees, earning a certain amount franchises can be a nuisance for franchisors.
of profit in between. These regulations ensure that franchises are operated
Also, one of the biggest cost advantage of franchising a fairly, but it requires time and effort from the
business is the ability to commit larger sums of money franchisors to meet all of these regulations.
towards advertising. 3. Loss of complete Brand Control When a franchisor
3. Reduced Risk One of the biggest benefits to the allows a franchisee to open a business under their
franchisor in a franchise agreement is the ability to brand, they are giving away some of the control over
expand without an increase in risk. Because the their small business branding.
franchisee takes on the debt and the liability of opening
a unit under the name of the franchise, the franchisor Growth through Mergers and
gets all the benefit of an additional location without Acquisitions (M&As)
taking on the risk themselves. Mergers and Acquisitions (M&As) is a strategy that ensures
the accelerated growth of a business and also helps a
Disadvantages of Franchising business to expand externally. Businesses of any size can
Along with the multiple advantages of growing a business flourish as a result of merging with another existing
through the franchise mode, certain disadvantages also exist. company or acquiring a business and absorbing it into its
current operations.
Disadvantages to the Franchisee
Some of the key disadvantages which exist for the franchisee The process of growth is accelerated by acquiring a target in
are as follows a line of business in which the bidding company wants to
enlarge when compared with internal expansion because
1. Right and the only Way of doing Things Entering into
the company already exists in place, with its own
the franchise agreement, limits the degree of freedom
production capacity.
for the franchisee. He looses his spirit of innovation.
Entrepreneurship 33
Growing through M&A, may usually turn out to be less This type of merger allows the merging companies to
expensive compared with internal expansion, particularly, when group together their products in order to increase their
replacement cost of assets is higher than the market value of profitability.
target assets.
5. Vertical Mergers
Mergers A merger between two companies producing different
goods or services for one specific finished product is
A merger is a combination of two companies into one larger
termed as a vertical merger. A vertical merger occurs
company. In merger, the acquiring company takes over the
when two or more firms, operating at different levels
assets and liabilities of the merged company. All the combining
within an industry’s supply chain, merge operations. The
companies are dissolved and only the new entity continues to
logic behind the merger is to increase synergies created
operate.
by merging firms that would be more efficient operating
Merger commonly takes place in the following two forms as one.
1. Amalgamation In amalgamation, two entities combine
together and form a new entity, extinguishing both the Acquisitions
existing entities. An acquisition is a corporate action in which a company
2. Absorption In absorption, one entity gets absorbed into purchases most or all of target company’s shares to gain
another but the latter does not lose its entity. control of that company. Acquisition is a general term
which includes
For instance, X + Y = Z, where Z is a new company ● Acquisition of control,
(amalgamation) and X + Y = X, where company Y is merged into ● Acquisition of tangible assets and intangible assets,
company X (absorption). ● Acquisition of rights and other kinds of obligations.
Types of Mergers Acquisitions are made as part of company’s growth

strategy when it is more economical to take over an
A brief discussion about the various types of mergers is as
existing business as compared to expanding internally.
follows
1. Conglomerate Mergers
Types of Acquisitions
In this type of merger, the firms which are involved in totally There are four types of acquisitions which are as follows
unrelated businesses come together. 1. Friendly Acquisition The companies involved
This form of merger can take the following two forms approve the acquisition under friendly terms. There is
no forceful acquisition and the process is cordial.
(i) Pure Conglomerate Merger This merger involves firms
with nothing in common. 2. Reverse Acquisition In this type of acquisition, a
private company takes over a public company.
(ii) Mixed Conglomerate Merger This merger involves firms
that are looking for product extensions or market 3. Backflip Acquisition In this form of acquisition,
extensions. the purchasing company becomes the subsidiary of
the purchased company. It is very rare.
2. Horizontal Mergers 4. Hostile Acquisition The whole transaction is
This merger occurs between companies in the same industry. It carried out through force. The target company is
is generally between competitors’ offering the same goods or driven to such extreme situations, that it has to agree
services. It is generally prevalent in oligopoly market form with the acquisition contrary to its own will. Or in
where few big firms operate in the industry. another way, the purchasing company can buy
Its goal is to create a new, larger organisation with more market majority of shares of the targeted company, thereby,
share. If the merging companies’ business operations are initiating acquisition.
similar, there may be opportunities to join centain operations Steps Involved in the
such as manufacturing and reduce costs. Process of Mergers and Acquisitions
Steps to be followed in the process of mergers and
3. Market Extension Mergers
acquisitions are as follows
This type of merger takes place between companies that deal in
the same products but in separate markets. The main purpose is Step 1 Analysis of Client’s Requirements Under
to make sure that merging companies can get access to a bigger this step, the client’s needs requiring mergers
market share. and acquisitions are analysed.
Step 2 Generating Ideas Keeping in view the client’s
4. Product Extension Mergers
requirements, ideas are generated to meet
This merger takes place between two business organisations
his/her objectives. These ideas are based on the
that deal in products which are related to each other and
study conducted on various companies
operate in the same market.
considered for this purpose.
Step 3 Valuing Companies This step puts a monetary (ii) Financial Synergy This is the direct result of financial
value to each company reviewed, so that the factors such as lower taxes, higher debt capacity or
purchase price could be negotiated. better use of idle resources.
Step 4 Identifying Potential Partners After the Also, the new firm stands to gain in the form of ‘tax
companies are valued, those within the budget are shield’, i.e. when a firm with accumulated losses merge
identified, so that future plan of action could be with a profitable firm and the combined firm can sets
carried on. off such losses against its profit, a financial synergy
occurs, known as ‘tax shield’.
Step 5 Drawing up Documentation The issues to
consider at this stage are drawing up of the letter 2. Acquiring New Technology
of intent, confidentiality agreements, etc. between To remain competitive, companies need to constantly
the buyer and the seller companies. upgrade their technology. So, by buying a company with
Step 6 Due Diligence Accounting and law firms are hired unique and modern technology, the buying company
to conduct due diligence. Lawyers review contracts, upgrades its existing technology and ensures a competitive
agreements, leases, pending litigation and all other edge in the market.
outstanding or potential liability and obligations, so
that the buyer can have a better understanding of 3. Improved Profitability
the target company’s binding agreements as well as Companies indulge in mergers and acquisitions if they feel
overall legal related exposure. that it would help to increase their profitability. A study
Step 7 Supporting Management If after the reports on conducted by International Business Owners Survey
due diligence, the company wants to continue with showed that 34% of businesses use M&A to maintain or
the process of merger and acquisition, then the improve their profitability.
next step is to ensure that managements of both
4. Acquiring a Competency
the companies are supportive of the process.
Companies, sometimes opt for mergers and acquisitions to
Step 8 Conducting Negotiations This is the last step in acquire a competency or capability that they do not have
the process of merger and acquisition wherein the and which the other firm does.
concerned parties negotiate with each other, so that
a favourable deal is struck between them. 5. Entry into New Markets
Mergers help companies to enter into new markets without
Reasons for Mergers and Acquisitions facing stiff competition from existing companies. It helps to
Some of the commonly identified reasons for mergers and ease the entry route for a company seeking to enter a new
acquisitions are given below market.
1. Synergy 6. Access to Funds
It implies a condition wherein 2 + 2 = 5, i.e. the combined If a company is faced with shortage of funds and it also does
value of the merging firm exceeds the sum of the individual not have proper access to raise funds from capital market,
values of the merged firms. then it may decide to merge with another company which
Synergy accrues in the form of revenue enhancement and has surplus funds.
cost savings. It is the most common reason, why businesses
7. Tax Benefits
opt for M&A. They aim to reap the benefits of synergy.
Mergers and acquisitions are also adopted to reduce tax
Synergy can take the following two forms liabilities. By merging with a loss-making entity, a company
(i) Operating Synergy This refers to the cost savings that with high tax liability can set-off accumulated losses of the
accrue through economies of scale or because of merging company from its profits, thereby reducing it’s tax
increased turnover leading to increased profits. liability.
Entrepreneurship 35
Practice Questions
1 Net result of internal expansion can be attributed 11 After completing his MBA from NIPS, Bangalore,
as Vivek decided to start his own business by taking
(a) increase in business activities the franchise of ‘Ferns N Petals’. Since, this is
(b) broadening the present capital structure Vivek’s first venture, advice him about the main
(c) Both (a) and (b) clause of a franchise agreement which defines the
(d) None of the above type of relationship.
2 ……… outline how the franchise name is to be (a) Contract explanation (b) Operations manual
used and also the marketing and advertising (c) Proprietary statements
procedures required to be followed by the (d) Ongoing site maintenance
franchisee. 12 The advantages of franchising for a franchiser
(a) Operations manual is/are
(b) Proprietary statements (a) quick expansion (b) cost advantage
(c) Ongoing site maintenance (c) Both (a) and (b) (d) None of these
13 The goal of a ……… merger is to create a new
3 Franchising include larger organisation with more market share.
(a) franchisor (b) franchisee (a) conglomerate (b) horizontal
(c) franchise agreement (d) All of these (c) market extension (d) Both (b) and (c)
4 In which type of acquistion, a private company 14 ………… synergy refers to the cost savings that
takes over a public company? accrue through economies of scale.
(a) Friendly acquisition (b) Reverse acquistion (a) Operating (b) Financial
(c) Hostile acquisition (d) Backflip acquisition (c) Overstated (d) None of these
5 Last step in the process of merger and acquisition is 15 Which of the following statements is/are correct?
(a) due diligence Statement I A firm may expand internally by
(b) generating ideas
(c) conducting negotiations
expanding its present production capacity by
(d) valuing companies increasing the number of machines.
6 In ………… form of acquisitions, the purchasing Statement II Internal expansion is a slow and
company becomes the subsidiary of the purchased time consuming process which is a result of a
company. gradual increase in the activities of the enterprise.
(a) friendly (b) reverse Alternatives
(c) backflip (d) hostile (a) Both statements are correct
(b) Statement I is correct, but Statement II is incorrect
7 Komal Company Ltd. was initially producing
(c) Statement I is incorrect, but Statement II is correct
crayons. Now, it has decided to produce oil paints and (d) Both statements are incorrect
water paints also. The company is attempting to
(a) expand internally (b) expand externally
16 Which of the following statements is/are correct?
(c) Both (a) and (b) (d) None of these Statement I Synergy is the primary reason for the
mergers to take place between the two companies.
8 Rahul, who is a diploma holder in computers,
Statement II The turnover and output produced
decides to take franchise of NIIT for his backward
by the individual firm would be more than the
town of Katni. Form of franchise decided to be
turnover produced by the firm after merger.
taken by him is
(a) product franchise business opportunity Alternatives
(b) manufacturing franchise opportunity (a) Both statements are correct
(c) business franchise opportunity venture (b) Statement I is correct, but Statement II is incorrect
(d) business format franchise opportunity (c) Statement I is incorrect, but Statement II is correct
9 A merger between Fiat and Tata motors would be
an example of 17 While ensuring the growth of his enterprise, an
(a) conglomerate merger entrepreneur has to play the dual role of a ……… .
(b) vertical merger (a) manager (b) leader
(c) horizontal merger (c) Both (a) and (b) (d) None of these
(d) market extension 18 Growth is essential for the business as it facilitates
10 “X + Y = Z, where Z is a new company”. It shows ……… .
(a) absorption (b) amalgamation (a) survival (b) stability
(c) acquisition (d) None of these (c) profit (d) None of these
19 ………… is generally financed through long-term 25 Which of the following types of franchises provide
loans as well as undistributed profits and reserves. an organisation with the right to manufacture a
(a) Internal expansion product and sell it to the public, using the
(b) External expansion franchisor’s name and trademark?
(c) Business combination (a) Product franchise business opportunity
(d) None of the above (b) Manufacturing franchise opportunity
20 Manufacturing franchise opportunity is common in (c) Business franchise opportunity ventures
(d) Business format franchise opportunity
which industry?
(a) Tyre 26 In which of the following from of merger, two
(b) Food and beverage entities combine together and form a new entity,
(c) Vending machine nutes extinguishing both the existing entities?
(d) None of the above (a) Absorption (b) Amalgamation
21 Mergers commonly take the form of ................ . (c) Both (a) and (b) (d) None of these
(a) amalgamation (b) absorption 27 In which of the following is the reason for mergers
(c) Both (a) and (b) (d) None of these and acquisitions?
22 The largest Hamburger manufacturer ‘Hamber’ in (a) Synergy
India merged with well-known cold drink (b) Acquiring new technology
(c) Acquiring a competency
manufacturer “Soda Pop” and renamed the brand (d) All of the above
“Ham Pop” to impart a different identity. The type
of merger discussed above is ………… . 28 In which type of franchising, the store owner is
(a) horizontal merger either required to pay a fee or purchase a
(b) market extension merger minimum inventory of stock in return for using the
(c) product extension merger name and trademark owned by the manufacturer?
(d) conglomerate merger (a) Business franchise opportunity venture
(b) Product franchise business opportunity
23 When a firm with accumulated losses merge with a (c) Manufacturing franchise opportunity
profitable firm and the combine firm can set-off (d) All of the above
such losses against its profit, a financial synergy
29 A …… merger occurs when two or more firms,
occurs, known as ................. .
operatng at different levels within an industry’s
(a) tax evasion
(b) tax reduction supply chain, merge operations.
(c) tax benefit (a) horizontal (b) conglomerate
(d) tax shield (c) vertical (d) product extension
24 The main ingredients of a franchise agreement 30 Identify the step which is not involved in the
(a) contract explanation process of mergers and acqusitions.
(b) operations manual (a) Generating ideas
(c) proprietary statements (b) Due diligence
(d) All of the above (c) Acquiring new technology
(d) Drawing up documentation
ANSWERS
1. (c) 2. (b) 3. (d) 4. (b) 5. (c) 6. (c) 7. (a) 8. (d) 9. (c) 10. (b)
11. (a) 12. (c) 13. (d) 14. (a) 15. (a) 16. (b) 17. (c) 18. (a) 19. (a) 20. (b)
21. (c) 22. (c) 23. (d) 24. (d) 25. (b) 26. (b) 27. (d) 28. (b) 29. (c) 30. (c)
Entrepreneurship 37
CHAPTER 05
Business Arithmetic
Every business person needs some quick and easy way of checking the progress of the business or to plan corrective action. He can do so by
calculating unit of sale, unit price and unit cost which will provide the gross profit as a result.
Unit of Sale e.g. if the 50 customers paid ` 1,75,000 for various items
This can be defined as the measure of unit in which the purchased by them from ‘Big-Bazaar’, then unit price will be
products are sold. Unit of sale is a management tool that is ` 3,500 (1,75,000 ÷ 50).
required to understand the economics of the business in an
easy and standardised way and for tracking progress over a Unit Cost
number of years and taking corrective actions, when This can be defined as the cost incurred by a company to
necessary. produce, store and sell one unit of sale of a particular product
or service. But, it should be remembered that unit cost refers
e.g. unit of sale for apples will be kilograms.
to the variable cost like raw material, packing material, sales
To understand this further, a list of businesses with their commission, freight, etc.
respective unit of sale is given below
Variable costs are directly proportional to the level of output.
Item being
For a business dealing in multiple products, unit cost is the
Business Unit of Sale average cost of the products.
Sold/Serviced
Grocer Rice Kilogram e.g. if during a day, Big-Bazaar sells various products to 100
customers being the total billed amount as ` 2,10,000 and
Dairy Milk Litre
the cost of the goods sold is ` 1,70,000, then the unit cost
Grocer Oil Litre will be ` 1,700 (` 1,70,000 ÷ 100). Unit cost is also referred
Garment Shop T-shirt Piece to as cost of goods sold.
Textile Shop Fabric Metre In some cases, unit cost can be calculated in another way.
Coaching Class Tution Time: Hour e.g. for every item, if the purchase price is 80% of selling
price and the selling price is ` 2,100 per customer, then in
The table hold goods if the business is dealing in one product such case, the unit cost would be ` 1,680 (80% of ` 2,100).
only. But, for a business dealing in multiple products, say for
Now, if in the first instance, the selling price is ` 2,100 and
example, ‘Big-Bazaar’ where one can buy rice, oil, milk,
unit cost comes out to be ` 1,700, then gross profit will
t-shirts, etc., and suppose a customer buys 2 kg of rice, 5
be ` 400/ per unit of sale (2,100 – 1,700) and the gross profit
litres of oil and 2 t-shirts, then in such an instance, the unit
in second instance will be ` 420/ per unit of sale
of sale for Big Bazaar will be number of customers and not
(2,100 – 1,680). This will depend on the industry specifics.
individual unit of sale. Similarly, for a restaurant, the unit of
sale will be ‘diner’ and for a beauty parlour, it will again be a Break-even Analysis
‘customer’. This analysis refers to a system of determination of that
level of activity where total cost equals total selling price. It
Unit Price
portrays the relationship between cost of production,
It is the price at which one unit of sale is sold. e.g. if 100 litre
volume of production and the sales value.
of milk is sold for ` 5,000, then unit price will be ` 50
(5 ,000 ÷ 100 ). In other words, break-even point is the level of sales that
equals all the expenses required for generating that revenue.
For a business dealing in multiple products, unit price is the
It is not more than the expenses (i.e. no profit) nor is it less
average amount billed per customer.
than the expenses (i.e. no loss).
So, at the break-even level, Need for Working Capital : Operating Cycle
Total Revenue = Total Expenses The duration between buying the raw material and receiving
i.e. (Quantity Sold × Unit Price) = (Quantity Sold × cash from the customer is known as operating cycle or Cash
Unit Cost) + Fixed Expenses Conversion Cycle (CCC).
or Quantity Sold × (Unit Price − Unit Cost) = Fixed During the time required to convert raw material into end
Expenses product, various expenses like wages, rent, salary, etc are to
or Quantity Sold × Gross Profit Per Unit = Fixed Expenses be paid. Once the end product is ready, it has to be sold and
The benefit of break-even analysis is same for single product money to be received from customers.
as well as multiple product business. The Cash Conversion Cycle is the length of time between a
firm’s purchase of inventory and the receipt of cash from
Working Capital accounts receivables. CCC represents the number of days a
Money needed to fund the normal day-to-day operations firm’s cash remains tied up in the operations of the business.
of the business is known as working capital. It refers to that Different products will have different operating cycles.
part of total capital, which is required for holding current “Longer the operating cycle, requirement of working capital
assets or it may also be defined as excess of current assets will be more, while shorter the cycle, less working capital is
over current liabilities. needed.”
Working capital indicates the liquidity levels of businesses For instance, the operating cycles of a trading concern and a
for managing day-to-day expenses and covers inventory, manufacturing concern are explained below
cash, accounts payable, accounts receivable and short-term 1. In a Trading Concern Since, there is no
debt. It is an indicator of the short-term financial position of manufacturing, the operating cycle will be shorter.
an organisation and is also a measure of its overall efficiency. Here, the operating cycle will include the length of time
It can be calculated as taken for procurement of goods, and realisation of sales
Working Capital = Current Assets – Current Liabilities revenue.
1. Current Assets These are the assets which are
2. In a Manufacturing Company It includes
expected to get converted into cash or cash equivalents
manufacturing, thus operating cycle will be longer.
within a period of one year.
Here, operating cycle is the length of time needed to
Examples of current assets in order of liquidity are complete the following
● Cash in hand/Cash at bank
● Conversion of cash into raw materials.
● Marketable securities ● Bills receivables

● Conversion of raw materials into work-in- progress.
● Debtors ● Finished goods inventory

● Conversion of work-in-progress into finished goods.
● Work-in-progress ● Raw materials

● Conversion of finished goods into accounts receivable.
● Prepaid expenses
● Conversion of accounts receivable into cash.
2. Current Liabilities These refer to those liabilities

which are payable within a period of one year. Factors affecting Working Capital
Examples of current liabilities are The finance manager must keep in mind following factors
● Bills payable
before estimating the amount of working capital
● Creditors
1. Nature of Business In case of trading concern or
retail shop the requirement of working capital is less
● Outstanding expenses
because length of operating cycle is small.
● Advances received from customers, etc.
The manufacturing company requires huge amount of

Types of Working Capital working capital because they have to convert raw material
There are two types of working capital which are as follows into finished goods before any sale become possible.
1. Gross Working Capital (GWC) It refers to investment 2. Scale of Operation The firms operating at large scale
in all the current assets taken together, i.e. need to maintain more inventory, debtors, etc. So they
generally require large working capital whereas firms
Gross Working Capital = Sum Total of all Current Assets
operating at small scale require less working capital.
2. Net Working Capital (NWC) It refers to excess of
3. Business Cycle Fluctuation During boom period, the
current assets over current liabilities, i.e.
sales as well as production are likely to be larger, thus
Net Working Capital = Current Assets (CA)
more amount of working capital is required.
− Current Liabilities (CL)
Whereas during depression period, less working capital
NWC can either be positive or negative.
will be required, since the sales as well as production
If CA > CL, then NWC is positive and if CA < CL, then will be less.
NWC is negative.
Entrepreneurship 39
4. Seasonal Factors The working capital requirement Inventory Control

is constant for the companies which are selling goods
Inventory means the stock of raw materials, semi-finished
throughout the season whereas the companies which
goods, consumables, spare parts and finished goods or we
are selling seasonal goods require huge amount during
can also say that inventory is required directly or indirectly to
peak season due to higher level of activity whereas
make a sale (of the finished goods) and may also represent
during lean season, demand is very low, so less
different stages in the process of getting the finished goods
working capital is needed.
(i.e. the stock of raw materials and work-in-progress).
5. Operating Cycle The amount of working capital
Inventory control refers to the process of deciding what and
directly depends upon the length of operating cycle.
how much of various items to be kept in stock. It is a system
If operating cycle is long then more working capital is
which is expected to help achieve desirable behaviour of the
required whereas for companies having short operating
inventory items.
cycle, the working capital requirement is less.
An effective inventory control system aims at
6. Credit Allowed Credit policy refers to average period ● Providing stock as and when the need arises.
for collection of sale proceeds. It depends on number ● Stock should be procured at minimum possible price.
of factors such as creditworthiness of clients, industry
norms etc. A company following liberal credit policy Inventory control has many facets as monetary, physical,
requires more working capital due to higher amount safety and many others. It is crucial to understand these
of debtors, whereas company following strict credit aspects in designing an inventory control system.
policy require less working capital.
Various Aspects to be
7. Credit Availed Just as firm allows credit to its Considered in the Process of Inventory Control
customers, it also may get credit from its suppliers. To The key terms related to inventory control system and
the extent, it avails the credit on purchases, the various aspects to be considered are as follows
working capital requirement is reduced and vice-versa.
1. Stock Keeping Unit (SKU) Code Each and every item
8. Operating Efficiency The firm which have high in the inventory is to be identified with a unique code
degree of operating efficiency will require less amount which signifies certain aspects of the item. This code is
of working capital as compared to firm which have low termed as SKU code.
degree of efficiency and require more working capital.
The aspects specified may be colour, weight, size, or any
9. Availability of Raw Materials If raw materials are other important characteristic. The SKU code can be a
easily and readily available, lower stock levels can be combination of alpha and/or numeric symbols.
maintained, thus require less working capital.
SKU is the very basic unit for data collection, helps in
Whereas, when the raw materials are scarce or not
deriving meaningful information and decision-making.
readily available, higher stock levels will have to be
Bar codes and Radio Frequency Identification (RFID)
maintained, thus requiring high working capital.
tags are used in tracking, using SKU code.
10. Level of Competition Higher level of competitiveness
2. Motley Crowd Inventory is basically a motley mix of
may necessitate company to maintain larger stock of
heterogeneous (different) assemblage of raw materials,
finished goods which will increase the working capital
packing materials, spare parts, semi-finished goods,
requirement. Whereas, a business having less
finished goods, etc. Collectively, it is termed as motley
competition will require less working capital.
crowd.
11. Inflation Price level changes also affect the working
3. Space Space requirements for all items of inventory
capital requirement. With rising prices, larger amount
will not be identical and neither will it have any
is required even to maintain a constant volume of
binding on the cost of the product.
production and sales.
There can be many bulky items with low cost e.g. straw,
Thus, working capital requirement becomes higher
as well as high value items with low volume, like
with the higher rate of inflation. But if company can
diamonds.
increase the price of its own goods also, then there will
be less problem of working capital. A good inventory control system should keep in mind
the space requirements for various inventories needed
12. Growth Prospects Companies which have a by the business.
possibility of growth potential or are planning to
expand, will require more amount of working capital 4. Value All the items of an inventory are differently
to meet higher production and sales target whenever priced. So, the value of the inventory should also be an
required. important consideration for an effective control system.
5. Lead Time It is the time taken by manufacturer to The main objective of fixing the minimum stock level
procure or manufacture an item and is dependent upon is to ensure that the required quantity of each item is
a number of factors, viz. processing time, scheduling of available at all times.
machines, distance between source and point of use, etc. The main factors to be considered while fixing the
Inventory control system has to consider the above minimum stock level are
factors before formulating an effective plan. ● Average rate of consumption of materials.
6. Standard vs Made to Order Some of the items of the ● Time needed to procure fresh supplies under top
inventory may be standard and could be sourced from priority conditions.

a number of suppliers. Other items may be specific and ● Reorder level.
can be sourced from certain suppliers only. An effective ● Production requirements in terms of materials.
control system considers this aspect also. ● Minimum quantity of materials that can be procured
7. Seasonality of Supply If the item is an agricultural advantageously.

product (grains, vegetables, fruits, etc.), then its supply 2. Maximum Level It is the quantity of materials beyond
would be seasonal. This can play a key role in designing which a firm should not exceed its stocks. If the
the inventory control system. quantity exceeds maximum level limit, then it will be
8. Demand not Uniform or not Predictable Demand termed as overstocking. A firm avoids overstocking
for an item could be seasonal, i.e. it may depend on because it will result in high material costs.
weather conditions, festival seasons, school opening Maximum stock level will depend upon the following
dates, etc. So, demand for umbrellas, crackers, sweets, factors
school uniforms, etc., are easy to predict. But for other ● Availability of capital for the purchase of materials.
items it may not be easy to predict demand, ● Maximum requirement of materials at any point of
e.g. requirement of a spare part. time.

So, an effective inventory control system has to ● Availability of space for storing the material.
formulate an effective plan for forecasting demand, ● Rate of consumption of materials.
so that it is able to meet the demand successfully. ● Cost of maintaining the stores.
● Possibility of fluctuations in prices of various material.

9. Shelf Life Items like vegetables, fruits, flowers, fish,
● Nature of material.
etc., are perishable in nature. This calls for special
● Availability of material.
storage conditions and equipments such as cold
● Restrictions imposed by the government.
storage, freezers, etc. These involve huge establishing
● Possibility of changes in fashions.
costs.
Similarly, some of the manufactured food or medicines 3. Danger Level It is the level below which stocks
have expiry dates, beyond which they are not fit for should not fall in any case. If danger level approaches,
consumption. The above factors impose certain then immediate steps should be taken to replenish the
constraints on inventory management. stocks even if more cost is incurred in arranging the
10. Safety Aspects Some of the items are hazardous in material.
nature and special precautions have to be taken in their 4. Reorder Level In management accounting, reorder
storage. e.g. gasoline and hazardous chemicals like level (or reorder point) is the inventory level at which
phosphorus and potassium chlorate. Inventory control a company should place a new order or start a new
system should ensure safety of men, material and manufacturing run. Reorder level depends on a
machines while deriving a plan for their storage. company’s work order lead time and its demand during
11. Obsolescence Due to advancement of technology, that time as well as the availablility of safety stock.
certain items may not be used and their value and
Pareto’s Principle
demand both falls. So, this aspect of inventory
This principle was propounded by Vilfredo Pareto, an Italian
management should also be kept in view by an
economist, who studied land ownership in Italy in the early
effective control system.
1900’s and found that roughly 20% of the population held
When to Order Inventory title to about 80% of the land. For this reason, Pareto’s
In a scientific system of inventory control, the following Principle is often referred to as the ‘80/20’ rule.
levels of quantities are fixed So, Pareto’s principle basically states that ‘A relatively
1. Minimum Stock Level A minimum stock level is a handful of things will generate the bulk of the results’ or
threshold value that indicates the level below which ‘vital few, trivial many’. The value of Pareto’s Principle in
the quantity actual material should not normally be inventory management is in reminding us to stay focused on
allowed to fall. the 20% that matters.
Entrepreneurship 41
ABC Analysis of Inventory Control ● Cost of deterioration or obsolescence,

ABC (Always Better Control) analysis can help in better ● Cost of store staff, and
inventory control. It is based on Pareto’s Principle. In ABC ● Interest on funds invested in purchasing the stock.
analysis, a company reviews its inventory and sorts all SKUs
in three categories, called ‘A’, ‘B’ and ‘C’ items. A typical Assumptions of EOQ
breakdown might look like this The computation of EOQ is based on the following
● ‘A’ Inventory 10-20% of the items in terms of quantity assumptions
account for 70-80% of the total value of items. ● Prior knowledge of annual usage of inventory
● ‘B’ Inventory 15-25% of the items in terms of quantity ● Constant rate of usage
account for 10-20% of the total value of inventory. ● Constant ordering costs
● ‘C’ Inventory 65-75% of the items in terms of quantity

● Constant carrying costs
account for 5-10% of the total value of inventory. ● Zero lead-time/delivery period
Based on the above information it can be concluded that,

inventory ‘A’ is outstandingly important, inventory ‘B’ is Determination of EOQ
average important and inventory ‘C’ is relatively EOQ can be determined with the help of the following
unimportant. So, more attention should be devoted to 2PD
inventory ‘A’ less to ‘B’ and still less to ‘C’. ABC analysis formula EOQ = , where
C
helps in an efficient and effective inventory control. P = Cost of placing one order or ordering cost per order
D = Annual demand for the inventory
Economic Order Quantity (EOQ) C = Inventory carrying cost per unit
Economic Order Quantity is the quantity which is most
At EOQ level, ordering costs are equal to carrying costs and
economical to order. It is the quantity for which order should
their sum is the least possible cost likely to be incurred on
be placed when the stock reaches re-order level.
placing an order.
Assuming that the future demand is known, one needs to
determine when to place an order (Reorder point) and how Re-Order Quantity (ROQ) or Re-order Level
much to order (order quantity). Also, to avoid zero stock After understanding how much units to order, one should
status before the supply arrives, the concept of safety stock also know when to place a order. Re-order level helps to
is used. determine the same. Re-order level is that level of stock at
Safety stock is a term used by logisticians to describe a level which fresh order should be placed for replenishment of
of extra stock that is maintained to mitigate risk of stock stock. It is computed with the help of following formula
outs (short fall in raw material or packaging) caused by Re-order Quantity = Average Daily Usage
uncertainties in supply and demand. × Average Lead Time
EOQ is determined after considering the following factors
1. Ordering Costs These costs refer to the cost incurred Profitability Ratios
for acquiring stock. These costs include Profitable business means earning more than what one
● Cost of placing an order spends. Profitability is an indication of the efficiency with
● Cost of transportation
which the operations of the business are carried on. Poor
● Cost of receiving goods
operational performance may indicate poor sales and hence,
poor profits. A lower profitability may also arise due to lack
● Cost of inspecting goods
of control over expenses.
There is an inverse relationship between order size and Entrepreneurs are interested in knowing about the
ordering cost. profitability of their ventures over different time periods and
Larger the order size Lower the ordering costs because of also as compared to competing firms. Profitability ratios help
fewer orders. to facilitate such comparisons.
Smaller the order size Higher the ordering costs because of Two important profitability ratios are as follows
more orders.
2. Carrying Costs The term carrying costs refer to the 1. Return on Investment (RoI)
costs incurred in maintaining a given level of inventory. It is a measure of overall profitability of the business. It
These costs include indicates the percentage of return on total capital employed
● Cost of storage space, in the business, irrespective of the fact whether it is
● Cost of handling materials,
self-owned or debt capital. It is also referred to as ‘Return on
Capital Employed’ (RoCE).
● Cost of insurance,
It is calculated with the help of the following formula

Net Profit Items A (`) B (`)

Return on Investment (RoI) = × 100
Total Capital Invested Total Fixed Expenses = (d) 2,60,000 3,20,000
Profit before tax = (g) = (c − d) 1,40,000 80,000
where, Total Capital Invested = Equity + Debt Tax @20% = (e) 28,000 16,000
e.g. if you spend ` 1,00,000 to open a grocery shop and make Profit after tax = f = (g − e) 1,12,000 64,000
a net profit of ` 20,000 in 1 year, your annual RoI equals Some Ratios
(20 ,000 / 1,00 ,000) × 100 = 20 %.
RoI = (f/x) 11.2% 6.4%
When calculating RoI, the investment will include not only RoE = (f/y) 11.2% 16%
what the investor spent out of his/her pocket, but also all EBITDA = (PBT + Int. + Dep. 1,50,000 1,50,000
borrowed funds. In the example, the owner might have and Amrt.)
invested ` 40,000 of his own money (equity) and secured a (EBITDA / Investment) × 100 15% 15%
loan for ` 60,000 but this ratio will consider the total (EBITDA / Equity) × 100 15% 37.5%
investment of ` 1,00,000. EBITDA stands for Earnings Before Interest, Tax,
Depreciation and Amortisation. This is arrived at by adding
2. Return on Equity (RoE) interest, depreciation and amortisation to PBT.
It is a measure of profitability, calculated as a percentage of In the given example, B makes less profit than A in terms of
equity only. RoE can be calculated by dividing the net income RoI. But, if we compare RoE, then B is ahead from A.
by the equity of the investor and multiplying the result by
100. So, for a true measure of how ‘own money’ or ‘equity’ is
being used, RoE is a good indicator.
The net income would be determined after deducting
interest from net profit. The following formula helps in the RoI, on the other hand, gives an indication of how the ‘total
computation of RoE money’ or ‘total investment’ is being used.
Net Income EBITDA
Return on Equity (RoE) = × 100
Equity The acronym EBITDA stands for Earnings Before Interest,
Taxes, Depreciation and Amortisation.
where, Net Income = Operating Profit − Interest Expenses
Its utility lies in normalising the extraneous factors to be
In the example taken above, where the grocery owner had
able to measure and compare true effectiveness of one
invested ` 40,000 and the interest payable by him on
operation and the managerial decisions with another
borrowed amount is ` 6,000, then
(20 ,000 − 6 ,000) operation.
RoE = × 100 = 35% It is one of the most widely used measures for evaluating a
40 ,000
business for acquisition.
The below example will help you to understand the above
two ratios The various components of EBITDA are discussed below
1. Interest Interest is a financial expense, paid to the
Let us take the case of two people, A and B starting identical
owner of the fund to compensate him for parting with
business and performing identically in terms of sales,
his funds. The interest paid is not an operational
variable cost, fixed cost, etc.
expense but it is a cost incurred due to ‘funding
The only difference is A did not borrow any money and B decision’. Adding back the interest to Profit before Tax
did. Interest rate is 10% per annum. Here are some figures (PbT), takes away the effect of this funding decision.
for both A and B.
2. Taxes Taxes are levied by the government. If you are
Items A (`) B (`) comparing profits of one period to another, the rates
Total Investment = x 10,00,000 10,00,000 might have changed. Two companies may have
Source of Funds different tax treatments due to difference in state taxes
Equity = y 10,00,000 4,00,000 or special duties.
Loan = z — 6,00,000 The business owner or manager has no control over
Total 10,00,000 10,00,000
these taxes. So, to avoid distortion in the profit, tax
Interest Rate per annum 10%
component is added back to the profit.
Income Statement for 1 Year
Sales Revenue (a) 7,00,000 7,00,000 3. Depreciation and Amortisation There are different
(−) Cost of Goods Sold (b) (3,00,000) (3,00,000) options available to depreciate (tangible assets) or
Gross Margin (c) = (a − b) 4,00,000 4,00,000 amortise (intangible assets).
Fixed Expenses One company may use a particular method and another
Salary, etc 2,00,000 2,00,000 one a totally different one.
Rent, Utility, etc 50,000 50,000
Interest — 60,000
Depreciation and Amortisation 10,000 10,000
Entrepreneurship 43
So, to avoid distortion due to differing practices being So, the EOQ is 200 jeans.
followed, depreciation and amortisation are added Annual Consumption
Number of Orders Placed =
back. EOQ
Price for a business is often quoted in terms of a Also find the number of orders placed, ordering cost and
multiple of its EBITDA—say (M) × (EBITDA), where carrying cost at the level of EOQ
M has a numeric value that varies from industry to =
1,200
= 6 orders
industry. 200
Basic philosophy in this thought process is when ∴ Ordering cost = 6 × 500 = ` 3,000
someone buys a business, he or she buys the ‘future 1
Average inventory = 200 × = 100 units
cash flows’ from that business. Hence, they are willing 2
to pay a multiple of EBITDA. ∴ Carrying cost = 100 × 30 = ` 3,000
So, it can be observed that at EOQ, ordering cost and
carrying cost are the same.
Solved Examples 2. The following information is taken from the cost
1. Annual quantity of jeans sold by a shop is 1,200 at records of Blue Chip Ltd.
the rate of ` 100 per piece. Cost of placing an order Monthly consumption of component ‘x’ = 100 − 120
and receiving goods is ` 500/- per order. Inventory units.
holding cost is ` 30 per annum. What is the Lead time or re-order period = 4 − 6 days. Find the
Economic Order Quantity (EOQ) for the re-order level.
shopkeeper?
Sol. Re-order Level = Maximum Consumption ×
Sol. Here, D = 1,200; P = ` 500 and C =` 30 Maximum Lead Time
So, 2 x P x D = 12,00,000 Accordingly = 120 × 6 = 720 units
This divided by 30 = 40,000 So, new order should be placed when stock reaches 720
Square root of which is = 200 units.
Practice Questions
1 Measure of unit in which the products are sold, is 8 Which amongst the following is/are example(s) of
called current liabilities?
(a) unit cost (b) unit of sale (a) Debtors (b) Creditors
(c) unit price (d) None of these (c) Bills receivables (d) Prepaid expenses
2 The price at which one unit of sale is sold, is called
9 According to ABC analysis, ‘B’ inventory accounts
(a) unit of sale (b) unit cost
(c) unit price (d) None of these
for ……… of the items in terms of quantity.
(a) 10-20% (b) 15-25% (c) 40-50% (d) 65-75%
3 At break-even level,
(a) Total Revenue > Total Expenses 10 XYZ Company uses 500 units of an item per day
(b) Total Revenue = Total Expenses and the order lead time is 7 days. Re-order level
(c) Total Revenue < Total Expanses will be
(d) None of the above (a) 1,000 units (b) 500 units
4 Investment in all the current assets taken together (c) 3,500 units (d) None of these
is called Hint RoL = Usage per Day × Lead Time
(a) net working capital (b) gross working capital 11 Annual consumption of units in
(c) Both (a) and (b) (d) None of these
Aahaar Limited = 2,000 units,
5 Which of the following is a factor affecting working Buying cost per order = ` 12,
capital? Price per unit = ` 1,000,
(a) Scale of operation (b) Seasonal factors Storage cost as percentage of price per unit = 12%,
(c) Credit allowed (d) All of these
EOQ = ?
6 Pareto’s principle is referred to as the (a) 400 units (b) 20 units
(a) ‘80/20’ rule (b) ‘70/20’ rule (c) 200 units (d) 100 units
(c) ‘60/10’ rule (d) ‘50/50’ rule
7 A business needs capital for 2AC
Hint EOQ =
(a) procuring fixed assets P
(b) meeting day-to-day expenses where A = Annual consumption (2,000 units)
(c) growth and diversification C = Buying cost (` 12)
(d) All of the above P = Storage Cost (` 120)
12 Sushant has opened a grocery shop with an (a) more (b) less
investment of ` 3 lakh. Out of this, ` 1 lakh was (c) Not required (d) Can’t say
his own and the rest he borrowed from friends and 18 ................. is the length of time between the firms
relatives. At the end of the year, he earned a net purchase of inventory and the receipt of cash from
profit of ` 40,000. Which ratio will be higher? account receivable.
(a) RoI (b) RoE (a) Operating cycle
(c) Both will be the same (d) None of these (b) Cash conversion
(c) Both (a) and (b)
13 A grocery store sold the following items at the (d) None of the above
price per unit mentioned against each 19 Ordering cost and carrying cost are .................
Item Price Per Unit (`) Quantity Sold related to each other.
Edible Oil 100 5 (a) directly (b) inversely
Bathing Soap 50 4 (c) Not (d) Can’t say
Cereals 75 10 20 ................. is an indication of the efficiency with
Broom 10 1 which the operations of the business are carried
on.
The above items were sold to 10 customers. The
(a) Expenditure (b) Profitability
‘Unit Price’ would be (c) Working capital (d) Inventory
(a) ` 1,460 (b) ` 146
(c) ` 100 (d) ` 75 21 ................. indicates the percentage of return on
total capital employed in the business.
14 During the last month, a total of 450 people took (a) Return on investment
meals in a restaurant and the total billed amount (b) Return on equity
was ` 90,000. The unit price per person will be (c) Re-order quantity
(a) ` 200 (b) ` 475 (d) None of the above
(c) ` 325 (d) ` 210
22 A company uses 300 units of an item per day and
15 Which of the following statements is/are correct? the order lead time is 5 days. What should be the
Statement I Higher the lead time, the lower is the level of inventory when a new order is to be placed?
amount of working capital required. (a) 1,500 units (b) 1,000 units
Statement II If the raw material is available (c) 500 units (d) 2,000 units
freely and continuously, then less working capital 23 Which of the following is an examples of carrying
is needed as less inventory has to be maintained. costs for inventories?
Alternatives (a) Money tied up in inventory
(a) Both statements are correct (b) Storage of inventories
(b) Statement I is correct, but Statement II is incorrect (c) Obsolescence cost
(c) Statement I is incorrect, but Statement II is correct (d) All of the above
(d) Both statements are incorrect 24 Annual quantity of shirts sold by a shop is 1,200
16 Which of the following statements is/are correct? at the rate of ` 100/- per month. Cost of placing an
Statement I A transport service provider needs order and receiving goods is ` 500/- per order.
less working capital. Inventory holding cost is ` 30/- per annum. What
is the economic order quantity for the shop keeper?
Statement II A service firm sells more on a cash (a) 500 shirts (b) 200 shirts
basis and does not have to maintain inventory. (c) 630 shirts (d) 800 shirts
Alternatives
25 Which of the following statement is false with
(a) Both statements are correct
(b) Statement I is correct, but Statement II is incorrect respect to ABC analysis?
(c) Statement I is incorrect, but Statement II is correct (a) ‘A’ includes the items whose annual consumption
(d) Both statements are incorrect value is the highest
(b) ‘B’ includes the items with a lower consumption
17 Amit is running an ‘Advertising agency’ and value
earning a lot by providing this service to big (c) ABC analysis can help you control you inventory
industries. The working capital requirement of the better
firm will be ………… . (d) All of the above
ANSWERS
1. (b) 2. (c) 3. (b) 4. (b) 5. (d) 6. (a) 7. (d) 8. (b) 9. (b) 10. (c)
11. (b) 12. (b) 13. (b) 14. (a) 15. (c) 16. (a) 17. (b) 18. (c) 19. (b) 20. (b)
21. (a) 22. (a) 23. (d) 24. (b) 25. (b)
Entrepreneurship 45
CHAPTER 06
Resource Mobilisation
Finance 2. External Sources It includes those sources of
financing, which are raised from outside the business.
Finance refers to funds or monetary resources needed by
The various external sources are
individuals, business houses and the government. It is one
● Debentures and bonds
of the most important pre-requisite to start an enterprise.
● Loan from financial institutions
Basically, it represents money management and the process
of acquiring needed funds. ● Loan from commercial banks
In other words, finance is defined as the management of ● Public deposits
money and includes activities such as investing, borrowing, ● Trade credit
lending, budgeting, saving and forecasting. ● Inter-corporate deposits
Need of Finance A business is always in need for additional funds. But, before
choosing from among the above sources, an entrepreneur
Right from the very beginning, i.e. conceiving an idea,
should be aware of the fact that not all of them are equally
finance is required to
appropriate for all enterprises at all times as these different
● Promote or establish the business
sources carry different
● Acquire fixed assets
● Obligations ● Responsibilities ● Opportunities
● Make market investigations
● Develop product Capital Market

● Keep men and machines at work It may be defined as an organised mechanism meant for
● Encourage management to make progress and create value effective and smooth transfer of money capital or financial
● Expand, diversify, improve and grow
resources from the investors to the entrepreneurs.
● Be enough to meet unexpected/unplanned expenses
The role of transferring financial resources from the surplus
units to the deficit units is known as financial
So, we can say that finance is the elixir that assists in the
intermediation.
formation of new businesses and also allows businesses
to take advantage of opportunities to grow and expand. Capital market plays a very vital role of financial
intermediatory. Here, productive capital is raised and made
Sources of Finance available for industrial purposes.
An enterprise can raise finance through various sources. In other words, capital market refers to the whole network of
These sources can be broadly classified as all organisations, institutions and instruments that provide
1. Internal Sources It includes all those sources which medium and long-term funds to the government as well as
are generated from within the business. The various industrial sector. Funds are raised in this market through
sources of this form of financing are both debt and equity.
● Equity shares
Importance of Capital Market
● Preference shares
Capital markets are the most important source of raising
● Retained earnings
finance for the entrepreneurs as this market can
● Global Depository Receipts (GDRs)
● mobilise the financial resources on a nationwide scale.
● American Depository Receipts (ADRs) ● secure the required foreign capital and know-how to
● Indian Depository Receipts (IDRs) promote economic growth at a faster rate.

● ensure the most effective allocation of mobilised financial (ii) Other Advantages Other advantages of raising
resources by investing in projects capable of generating finance through this source are
highest returns or by investing in underdeveloped priority ● Mergers and Acquisitions Public stock of a
areas so as to promote balanced industrialisation. company can be used for an enterprise to grow
through acquisitions.
Types of Capital Market ● Higher Valuations Public companies are valued
The capital market can be classified as more than private companies.

● Primary market (New issues market)
● Benchmark Trading Prices The trading prices of
● Secondary market a public company’s stock serves as a standard of the

Note As per syllabus, only primary market is discused. offer price of other securities.
● Capital Raising capital to meet additional
Primary Market requirements later on is typically easier because of

It is also known as the new issues market, as this market extra liquidity for the investors.
deals with the new securities being issued for the first time. ● Incentives Stock options and stock incentives can be
By issue of new securities, primary market facilitate the very helpful in attracting employees.
transfer of investible funds from savers to entrepreneurs ● Reduced Business Requirements While an
seeking funds for underwritten initial public offering requires significant

● setting new enterprises ● expanding ● diversifying earnings, this however does not prevent a private
The ‘new issues’ may be issued by company from going public.
● Liquidity A public company provides liquidity for
● new companies, also called initial issues.
● old companies, also called further issues. management, minority shareholders and investors.
● Prestige Raising capital through this source increases
Initial Issues the visibility of the company among customers,

When for the first time, entrepreneur for the purpose of investors and suppliers and add prestige to its name.
obtaining capital funds decides to issue securities to the Inspite of the above mentioned advantages, this source
public, then such issue of securities is termed as an ‘initial suffers from some disadvantages also which are
issue’ or ‘new money issues’. stated below
● Going public raises the obligations and reporting
Methods of Floatation of New Issues
requirements of a company, such as
An entrepreneur can raise the required capital through
‘initial issue’ by the following methods (a) Increasing accountability to public shareholders.
(b) Need to maintain dividend and profit growth
Methods of Floatation trends.
(c) Need to observe and adhere strictly to the rules
and regulations of governing bodies.
● A company becomes more vulnerable to an
Public Rights Private Offer to
Issue Issue Placement Employees unwelcome takeover.
● Increased costs in complying with higher level of
1. Public Issue reporting requirements.

Public issue involves raising of funds directly from the public ● Relinquishing some control of the company following
through the issue of prospectus. It is the most popular the public offering.
method of raising finance. ● Suffering a loss of privacy as a result of media interest.
This method requires compliance to various statutory laws Overall, going public is a complex decision that requires
relating to prospectus drafting, listing agreements, etc. careful consideration and planning.
The advantages of raising finance through public issue are 2. Rights Issue
(i) Access to Capital The first and foremost advantage Rights issue is a method of raising additional finance from
that an entrepreneur stands to gain by going public is existing shareholders by offering securities to them on
access to capital. In addition, the capital does not have pro-rata basis, i.e. giving them a right to purchase certain
to be repaid and does not involve an interest charge. number of shares in proportion to the shares they are
Entrepreneur can use the capital, thus raised, for holding.
● growth and expansion. In case the existing shareholders are not willing to purchase,
● retiring existing debt.
then they can renounce their right in favour of another
● corporate marketing and development.
person. This method is comparatively inexpensive as it does
not require any brokers, agents, underwriters, prospectus or
● as a source of acquisition capital.
enlistment, etc.
Entrepreneurship 47
3. Private Placement (iv) Appointment A company, which issues shares, has

Private placement means the direct sale by a company of its to appoint one or more merchant bankers, who act as
securities to a limited number of institutional investors like lead managers to the public issues. The company may
● Unit Trust of India
also appoint registrars, underwriters, brokers, etc.
● Life Insurance Corporation of India
(v) Drafting of Prospectus Apart from the notice of
● General Insurance Corporation of India
offer to issue shares to public, prospectus should also
disclose
● Army Group Insurance
● justification of premium, if called.
● State Level Finance Corporations, etc.

● Net Assets Value (NAV).
This is an effective source of raising capital if the company do ● high and low price of the shares of the company
not wish to disclose information in the open market. for the last two years.
● a clause that company shall refund the entire
4. Offer to Employees application money if minimum subscription is not

Stock options or offering shares to employees enables received.
employees to become shareholders of the company and ● a statement by the lead managers that in their
subsequently be able to share the profits of the company, opinion, the assets of the underwriters are
leading to adequate to meet their obligations.
● higher efficiency ● low employee turnover
(vi) Approval of Prospectus The draft prospectus along
● cordial relations ● low flotation cost with the application from the issue of shares should
● wider/higher generation of funds be approved by the solicitors/legal advisors/ stock
exchange (where application has been made seeking
So, a company can choose from either of the methods or a
permission for shares to be draft in) of the company
combination of them to raise finance through primary market.
to ensure that it contains all disclosures and
IPO (Initial Public Offer) information as required by various statues, rules,
A company proposing to raise resources by a public issue notification, etc.
should first select the type of securities, i.e. shares and/or
(vii) Approval of Board of Directors After the
debentures to be issued by it. The decision regarding the issue
concerned parties/agencies have approved the draft
of shares to be made at par or premium should be decided
prospectus and the application form, the Board of
keeping in view the SEBI guidelines.
Directors of the company should approve the final
The whole process of issue of shares can be divided into two draft, before filing it with Registrar of Companies.
parts
(viii) Registration of Prospectus with RoC Before the
● Pre-issue activities
prospectus is issued to the public, it must be filed
● Post-issue activities
with the Registrar of Companies, duly signed thereon
All activities beginning with the planning of capital issues, till by every director or proposed director of the
the opening of the subscription list are pre-issue activities, company. The prospectus must be registered with
while all activities subsequent to the opening of the RoC within 3 months of vetting of SEBI.
subscription list may be called post-issue activities. (ix) Application to Stock Exchange to List Shares
The various steps involved in public issue of shares are Before filing prospectus with the Registrar of
enumerated below Companies, the company should submit on
(i) Compliance with the SEBI Guidelines Before application to the stock exchange(s) for enlistment of
making any issue of capital, it is to be ensured that the securities offered to the public by the said issue.
proposed issue complies with the provision of the SEBI The fact that an application has/have been made to
guidelines for disclosure and investor protection with the stock exchange must be stated in the prospectus.
regards to pricing of issue, promoters contribution, lock (x) Printing and Distribution of Prospectus and
in period, reservation, etc. Application Forms After receipt of
(ii) Holding of General Meeting If it is required by the acknowledgement card from the SEBI and the
articles of association, that consent of shareholder is to intimation from Registrar of Companies regarding
be obtained, then meeting of the shareholders will be registration of prospectus, the company should take
called. steps to issue the prospectus within 90 days of its
(iii) Intimation to Stock Exchange A copy of the registration with RoC.
memorandum and articles of association of the For this compliance, requisite steps for printing and
company is to be sent to the stock exchanges where the distribution amongst banker, underwriter, public, etc
shares are to be listed, for approval. should be made.
(xi) Announcements and Advertisements If the money is not so refunded, the company is liable
Announcement regarding the proposed issue should to refund the money with interest as specified from
be made atleast ten (10) days before the subscription the expiry of the 8 days after 10 weeks of the closure of
list opens. No advertisement should include brand subscription list.
names for the issue except the normal commercial (xvii) Compliance Report As stipulated by SEBI guidelines
name of the company or commercial brand names of within 45 days of the closure of issue, a report in the
the company or commercial brand names of its prescribed form along with a compliance certificates
products already in use. from statutory auditor/ practicing chartered
(xii) Subscription List As stipulated by SEBI guidelines, accountant or by a company secretary in practice is to
the subscription list for public issue is to be kept open be forwarded to SEBI by the lead managers.
for atleast three working days and for a total period of
not exceeding ten working days, which is to be
disclosed in prospectus as well. Angel Investors
(xiii) Separate Bank Account A separate bank account is The term ‘angel’ originally comes from broadway, where it
opened for the purpose of collecting the proceeds of was used to describe wealthy individual who provide money
the issue. Further, the date of opening and closing of for theatrical productions.
the subscription list should be intimated to all the In 1978, William Wetzel, a professor at the University of
collecting and controlling branches of the bank with New Hampshire and founder of its center for venture
whom the company has entered into an agreement for research, completed a pioneering study on how
the collection of application forms. entrepreneurs raised seed capital in the USA and he began
(xiv) Minimum Subscription As per the SEBI guidelines, if using the term ‘angel’ to describe the investors who
the company does not receive 90% of the issue amount supported them.
from the public subscription including development from
An angel investor or angel, also known as a business angel or
underwriters within 120 days from the date of the issue,
informal investor or angel funder, is an affluent individual
the amount of subscription received is required to be
who provides capital for a business start-up, usually in
refunded to the applicants. In case of disputed
development also, subscription is required to be refunded exchange for convertible debt or ownership equity. Angel
if 90% of the issued amount plus accepted. investors, generally provide capital for a business start-up
and early stage companies having a high-risk, high-return
Development from underwriters, if any, is not received
matrix.
within 120 days of the issue of prospectus, all the
money received from the applicants for shares is
required to be repaid forthwith without interest and if
Features of Angel Investors
any such money is not so repaid in the next 10 days The service provided by angel investors is invaluable. They
(after the expiry of 120 days), the directors of the provide seed funding and formal venture capital. Humorously,
company are jointly and severally liable to repay that they were initially given the acronym FFF, i.e. Friends, Family
money, with interest from the expiry of the 130 days. and Fools.
The company should refund the amount within But, it is usually difficult to raise more than a few thousands
10 weeks of the closing of the subscription list and from friends and family, thus, angel investment is a common
pay interest, if refunds are delayed by more than second round of financing for high-growth start-ups or early
8 days after this period. stage companies. They are willing to take on the risk of a
(xv) Allotment of Shares A return of allotment in brand new firm and enjoy the benefits of its success
form no. 2 of the Companies (Central later on.
Government’s) General Rules and Form, 1956 The various features exhibited by angel investors are as
should be filed with Registrar of Companies within 30 follows
days of the date of allotment along with the fees ● Most angel investors are current or retired executives,
payable, as prescribed in Schedule X of the Act. business owners or high net worth individuals, who have
In case, the issue is oversubscribed, the basis of the knowledge, expertise and funds that help start-ups
allotment has to be decided in consultation with the match up to industry standards.
stock exchange authorities as per the guidelines laid ● As angel investors bear extremely high risk and their share
down by the stock exchange. is subjected to dilution after second round of funding,
(xvi) Oversubscription The oversubscribed amount after therefore they expect a high return on their investment.
the finalisation of allotment, should be refunded to ● Apart from investing funds, they also provide proactive
the applicants within 10 weeks of the closure of advice, guidance, industry connections and mentoring
subscription list. start-ups in its early stage.
Entrepreneurship 49
● Their objective is to create great companies by providing ● The venture capital institutions have a continuous
value creation, and simultaneously helping investors to involvement in the business after making the investment.
earn a high return on their investments. ● Venture capital institutions disinvest the holdings either to
● They have a keen desire to keep themselves acquainted the promoters or in the market.
with current developments and mentoring another
generation of entrepreneurs by making use of their vast Funding : Venture Capital vs Loans
experience. Obtaining venture capital is substantially different from
raising debt. With a loan, a lender gives a business money
Venture Capital and the business has a contractual obligation to pay back
Venture capital is a type of private equity capital provided as that amount plus interest over some period of time.
seed funding to early stage, high-potential, high-risk, Many a times, the loan is backed by assets. This backing
growth-up companies and entrepreneurs who lack the allows the lender to recoup some of its investment in case
necessary experience and funds to give shape to their ideas. the lendee defaults.
It is also known as risk-capital. With venture capital, the start-up business issues shares in
Development of entrepreneurship demands combination of exchange for money. The venture capitalist’s partnership
three vital factors fund actually becomes a partial owner of the start-up. Also,
● Innovative ideas venture capital is usually only used with high growth
● Competency in project preparation and implementation
industries, where risk is much higher. In these cases, there
are little or no assets to back the loan in the event of default,
● Project financing
therefore, the potential payouts must be drastically higher to
There may be many people with good project ideas. These result in a successful investment.
ideas however, do not get translated into commercially viable
practical projects in the absence of the other two factors. Investment Criteria for Venture Capitalists
Many young entrepreneurs with innovative ideas suffer Venture capitalists are very selective in deciding what to
because of this. invest in and as a rule of thumb
It is in this context that the venture capital can play a crucial ● They may invest in one in four hundred opportunities
role in entrepreneurship development by providing the two presented to them.

missing links. ● Looks for the extremely rare, yet sought after qualities,
Venture capital, thus is an equity-based investment in a such as

growth-oriented small to medium business enterprises, (a) Innovative technology
which in most cases would not qualify for bank loans, in (b) Potential for rapid growth
return for minority shareholding in the business or the (c) A well-developed business model
irrevocable right to acquire. It is a professionally managed
(d) An impressive management team
pool of equity capital.
● Looks for an ‘exit’ in the time frame of typically 3-7 years.
Features of Venture Capital ● Are inclined towards ventures with exceptionally high
Venture capital is characterised as a long-term investment growth potential.

discipline, usually occurring over a five-years period, that So, entrepreneurs are expected to carry out detailed due
helps in the creation of diligence prior to seeking venture capital as a source of
● early stage companies.
financing.
● expansion and revitalisation of existing businesses.
● financing of leveraged buyouts of existing divisions of

When to Seek Venture Capital Finance
major or privately owned enterprises. As venture capitalists investments are illiquid, requiring
extended time frame to harvest, an entrepreneur should
So, keeping in view the above usage of venture capital, the carefully evaluate and analyse the stage at which he/she
various features exhibited by it are would require venture capitalist to assist in. They can
● It is basically a equity finance in relatively new companies.
typically seek venture capital to assist in any of the following
● It is long-term investment in growth oriented small or stages in the company’s development
medium firms.
● Venture capitalist not only provides capital but also
I. Early Stage Financing
business skills to investee firms. This stage includes
● It involves high risk-return spectrum.
1. Seed Capital Finance It refers to the capital required
● It is a subset of private equity.
by an entrepreneur for conducting research at
pre-commercialisation stage.
During this stage, the entrepreneur has to convince the that investors can exit the venture with a profit matching
venture capitalist, why his idea/product is worthwhile. with the risk that they have taken.
The venture capitalist will then investigate into the At this stage, the venture achieves a certain amount of
technical and economical feasibility of the idea. market share and has opportunities to
Entrepreneur’s ability, technological skills and ● Merge with other companies
competencies are closely scrutinised by the venture ● keep competitors away from the market
capitalist. He may deny to assist if the findings and
● eliminate competition
investigations are not upto his satisfaction.
● develop and grow
2. Start-up Finance If the idea/product/process is
qualified for further investigation and/or investment, the Entrepreneur at this stage, should introduce a follow-up
process will go to the second stage, i.e. the start-up product/services to attract new client and markets, as only
stage. A business plan is presented by the entrepreneur through this, he can create interest as venture capitalist
to the venture capitalist firm. firms to get further financial assistance.
A management team is then formed to run the venture.
Venture Capital Institutions in India
If the company has a board of directors, then a person or
At present, many venture capital companies/funds have been
persons from the venture capitalist firm will take seats at
set-up in India, in both the public and the private sectors,
the board. The management team establishes a feasible
e.g.
production line to produce the product.
● Industrial Development Bank of India’s Venture Capital
The venture capitalist firm monitors the feasibility of the
Fund.
product and the capability of the management team
● Technology Development and Information Company of
from the board of directors.
India Limited (TDICIL).
3. Second-round Financing At this stage, the idea has
● Risk Capital and Technology Finance Corporation Limited.
been transformed into a product and is being produced
and sold. The entrepreneur at this stage, needs ● Gujarat Venture Finance Limited (GVFL).
assistance from the venture capitalist for expansion, ● Andhra Pradesh Industrial Development Corporation
modernisation and diversification, so that economies of (APIDC) Venture Capital Fund.

scale and stability could be attained. ● National Venture Fund for Software and IT Industry.
Venture capitalist firm will be interested in financing ● The Canbank Venture Capital Fund, the Credit Capital
this stage only if he is convinced about the capability of Venture Fund Limited, etc.
the management team to triumph against competition.
Entrepreneurs should be careful about sharing their
II. Last Stage Financing/Bridge/Pre-public Stage business plans with venture capital firms. They are advised
This is the last stage of the venture capital financing process. to protect their proprietary intellectual property by entering
The main goal of this stage is for the venture to go public, so into non-disclosure agreements with them.
Practice Questions
1 Internal sources of finance include They decided to raise the same through a limited
(a) trade credit (b) equity shares number of sophisticated investors. Identify this
(c) public deposit (d) All of these kind of issue.
2 In the capital market, funds are raised through (a) Right issue (b) Public issue
(a) debt (b) equity (c) Private placement (d) None of these
(c) Both (a) and (b) (d) None of these 5 ABC Ltd., decided to raise funds by issuing shares.
3 Full form of IPO is The finance department felt that the company
(a) Initial Public Offer should offer the shares to existing shareholders on
(b) Innovative Public Offer a pro-rata basis.
(c) Internal Public Offer Out of the following, identify the method of raising
(d) None of the above the funds beings suggested by the finance
4 Deepak Ltd. has been manufacturing cycles since department.
2015. Their market share in this field is 35%. They (a) public issue
decided to introduce new cycles with advanced (b) right issue
gear systems in 2022. For the same they estimated (c) private placement
their financial requirements to be ` 15 crore. (d) offer to employees
Entrepreneurship 51
6 Karma Limited needs finance to fund its 14 As per SEBI guidelines, if the company does not
expansion plans. However, it does not wants to receive 90% of the issue amount from public
issue its shares publicly, as it involves a number of subscription within ........... from the date of issue,
legal formalities. What other options(s) are the amount received is required to be refunded.
available for the company? (a) 60 days (b) 90 days
(a) Rights issue (b) Private placement (c) 120 days (d) 150 days
(c) Offer to employees (d) All of these 15 The word ‘angel’ was originally coined by ..............
7 Which amongst the following is/are the feature(s) in 1978 to describe the investors who supported
exhibited by angel investors? entrepreneurs to raise seed capital.
(a) They bear extremely high risk (a) William Wetzel
(b) They provide proactive advice and guidance (b) Louis Allen
(c) They are generally current or retired executives (c) Theo Haimann
(d) All of the above (d) Chester Barnard
8 Which amongst the following is/are venture capital 16 Angel investors provide ........... finance for product
institutions in India? development and initial marketing but with no
(a) Gujarat Venture Finance Limited commercial sales.
(b) Technology Development and Information Company of (a) long-term
India Limited (b) short-term
(c) Risk Capital and Technology Finance Corporation (c) start-up
Limited (d) growth stage
(d) All of the above 17 ………… is an equity based investment in a
9 At the ............ stage of financing, the venture growth-oriented, small to medium sized business,
achieves a certain amount of market share and has which in most cases would not qualify for receiving
opportunities to develop and grow. bank loans.
(a) seed capital (b) pre-start-up (a) Angle funding
(c) second (d) bridge (b) Venture capital
(c) Public issue
10 Karuna is studying in Kanpur University. She got (d) Financial intermediation
an idea to make a safety gadget for college going
girls which will give alert message to the 18 Divij is an innovative entrepreneur. He has
registered numbers as well as nearest policy decided to open an online portal which helps
stations, if the wearer is in any kind of danger. To people to order groceries 24 × 7. But before
execute her idea she requires finance. She launching his portal, he wants to investigate the
convinced one of her teacher who has the marketability of his idea. He approached Tech
knowledge of making such gadget to provide her Marts, a venture capital firm, to fund his
finance for feasibility studies. Identify the source investigation. Divij is looking for .......... finance.
of funding used by Karuna. (a) start-up (b) second round
(a) Right issue (b) Funding (c) last stage (d) seed capital
(c) Angel investors (d) None of these 19 Capital markets arethe most important source of
raising finance for the entrepreneurs as this
11 Finance raised by issue of ADRs and GDRs is said
market can
to be raised from ................. .
(a) secure the required foreign capital
(a) internal sources
(b) mobilise the financial resources on a nationwide
(b) external sources
scale
(c) either internal or external sources
(c) ensure the most effective allocation of mobilised
finanical resources
12 ................. refers to the whole network of all (d) All of the above
organisations, institutions and instruments that
20 The role of transferring financial resources from
provide medium and long-term funds to the
the surplus units to the deficit units is known as
government and industrial sector.
……
(a) Capital market
(b) Money market (a) right issue
(c) Financial intermediation (b) financial intermediation
(d) New issue market (c) new issue
(d) access to capital
13 ............ means the direct sale by a company of its
21 In primary market, ‘new issues’ may be issued by
securities to a limited number of institutional
(a) new companies only
investors. (b) old companies only
(a) Public issue (b) Right issue (c) Both (a) and (b)
(c) Private placement (d) Offer to employees (d) None of the above
22 Benefits of raising finance through public issue 26 Which of the following is not a step involved in
include public issue of shares?
(a) higher valuations (b) incentives (a) Appointment (b) Subscription list
(c) liquidity (d) All of these (c) Checks on brokers (d) Allotment of shares
23 …… is a method of raising additional financa from 27 An angle investor is also known as
existing shareholders by giving them a right to (a) Business angle (b) Informal investor
purchase certain number of shares in proportion to (c) Angel funder (d) All of these
the shares they are holding. 28 Identify the factors required in the development of
(a) Public issue entrepreneurship.
(b) Private placement (a) Innovative ideas
(c) Rights issue (b) Project financing
(d) Offer to employees (c) Competency in project preparation and
24 ……to employees enables them to become implementation
shareholders of the company and subsequently be (d) All of the above
able to share the profits of the company. 29 Under venture capital financing, early stage
(a) Private placement financing includes
(b) Rights issue (a) seed capital finance (b) start-up finance
(c) Stock options (c) bridge finance (d) Both (a) and (b)
30 Which of the following is/are the examples of
25 The whole process of issue of shares can be divided venture capital institutions in India?
into (a) Gujarat Venture Finance Limited (GVFL)
(a) pre-issue activiites (b) Technology Development and Information Company
(b) post-issue activities of India Limited (TDICIL)
(c) mid-issue activities (c) Andhra Pradesh Industrial Development Corporation
(d) Both (a) and (b) (d) All of the above
ANSWERS
1. (b) 2. (c) 3. (a) 4. (c) 5. (b) 6. (d) 7. (d) 8. (d) 9. (d) 10. (c)
11. (a) 12. (a) 13. (c) 14. (c) 15. (a) 16. (c) 17. (b) 18. (d) 19. (d) 20. (b)
21. (c) 22. (d) 23. (c) 24. (c) 25. (d) 26. (c) 27. (d) 28. (d) 29. (d) 30. (d)
PRACTICE SET 01 55
CUET (UG) Section II : Domain (Entrepreneurship)
Practice Set 01
Instructions 40 questions to be attempted out of 50. Time : 45 Min
1. The process of entrepreneurship 7. The various sources of idea fields 12. Which of the following is not a
which involves the translation of a are component of financial plan?
useful idea into an application is (a) Natural resources (a) Economic and social variables
called (b) Service related (b) Follow-up
(a) incubation (b) innovation (c) Trading related (d) All of these (c) Break-even analysis
(c) verification (d) illumination 8. LPG rationing led the (d) Proforma investment decisions
2. Which of the following is not a manufacturers to come out with 13. Vani, Shiva, Bhanu and Kumar are
natural source of ideas? induction cooker. Which good friends. They are the students
(a) Horticulture importance of environment does of Class IX and are studying in the
(b) Existing products the above example indicate? same school. They were admitted
(c) Agriculture (a) Identification of opportunities to at the age of 5 years and did not
(d) Forests get first mover advantage fail in any class. They want to start
(b) Tapping useful resources a retail business. Can they form a
3. According to the ‘PESTEL Model’, (c) Better performance partnership?
which factor emphasises the (d) Image building (a) They can form a partnership after
production of goods with minimum
9. Which of the following elements of taking permission for the parents.
environmental damage?
plan relates to evaluation and (b) They can form a partnership after
(a) Economic (b) Social taking permission from their
appraisal of work performed?
(c) Ecological (d) Technological school principal.
(a) Dispatching
(b) Routing (c) They can form a partnership
4. There is a …… relationship because they are more than two
between opportunities and problem (c) Scheduling
persons.
solving. (d) Follow-up
(d) No, they cannot form a
(a) direct (b) inverse 10. Which of the following forms of partnership because all of them
(c) indirect (d) negative business organisations require are minors.
5. A prospective entrepreneur has to minimum two persons to start the 14. ……… plan is that part of the
find an opportunity which would be same? business plan which describes the
suitable for him/her in terms of (i) Sole proprietorship proposed venture’s opted form of
……… . (ii) Partnership ownership.
(a) profitability (iii) Private company (a) Operational
(b) viability (iv) Public company (b) Production
(c) Both (a) and (b) (a) (i) and (ii) (c) Organisational
(d) None of these (b) (iii) and (iv) (d) Business venture
6. Entrepreneurs should take (c) (ii), (iii) and (iv) 15. The process of initiating production
advantage of social networking (d) (ii) and (iii)
in accordance with pre-conceived
tools like social network sites i.e., 11. ‘It is an artificial person created by production plan is said to be ... .
Facebook, Instagram, etc. to law’ is a characteristic of which of (a) routing (b) scheduling
identify new trends. This is an the follow forms of business (c) dispatching (d) inspection
example of organisation? 16. Which of the following statements
(a) read trends (a) Company is/are correct?
(b) talk trends (b) Partnership firm
(c) think trends Statement I A sole proprietorship
(c) Sole proprietorship
(d) watch trends does not need to be registered.
56 CUET (UG) Section II : Domain (Entrepreneurship)
Statement II Therefore, it is an achieving a sustainable competitive 29. Angel investors provide ...........
expensive manner of commencing advantage’’. finance for product development
business. (a) Marketing strategy and initial marketing but with no
Alternatives (b) sales strategy commercial sales.
(a) Statement I is correct, but (c) Pricing mix (a) long-term (b) short-term
Statement II is incorrect (d) Promotion mix (c) start-up (d) growth stage
(b) Statement I is incorrect, but 23. Cocu is a soft drink company. It 30. The role of transferring financial
Statement II is correct sells 200 ml bottle for ` 8 and 2,000 resources from the surplus units to
(c) Both statements are incorrect ml bottle for ` 55. The company the deficit units is known as ……
(d) Both statements are correct
follows which strategy? (a) right issue
17. Which of the following is not a (a) Cost-plus pricing (b) financial intermediation
quality of a good brand? (b) Pentration pricing (c) new issue
(a) It should be long. (c) Creaming (d) access to capital
(b) Neither obscene, negative, (d) Variable pricing
offensive or vulgar.
31. Benefits of raising finance through
(c) Pleasing, impressive when 24. Various approaches may be used by public issue include
uttered. a company to promote its products. (a) higher valuations
(d) Linked to product, symbolically One of them is the use of mass (b) incentives (c) liquidity
eye catching. media methods by designing a (d) All of these
promotion strategy that aims at
18. Which of the following is the 32. ……to employees enables them to
establishing brand identity.
consumer sale promotion activity? become shareholders of the
Identify promotion strategy.
(a) Loyalty reward programmes company and subsequently be able
(a) Below the line
(b) Event sponsorship to share the profits of the company.
(b) Through the line
(c) Competitions (a) Private placement
(c) Above the line
(d) Corporate entertainment (b) Rights issue
(d) None of these
(c) Stock options
19. XY Limited manufactures plastic 25. ‘Brand’ word has originated from (d) None of the above
buckets. The CEO wants to select a the word ‘Brandr’ which means ‘to
distribution channel for his 33. Identify the factors required in the
burn’ in
buckets. The factor(s) related to the development of entrepreneurship.
(a) French (b) German
product to be kept in mind is/are (a) Innovative ideas
(c) Norwegian (d) None of these
(a) unit value of product (b) Project financing
(b) perishability 26. In the capital market, funds are (c) Competency in project preparation
(c) technical nature raised through and implementation
(d) All of these (a) debt (d) All of the above
(b) equity
20. ................. act as the key visual 34. The whole process of issue of
component of an enterprise’s shares can be divided into
(d) None of these
overall brand identity. (a) pre-issue activiites
(a) Brand name (b) Logo 27. Which amongst the following is/are (b) post-issue activities
(c) Tagline (d) Packaging the feature(s) exhibited by angel (c) mid-issue activities
investors? (d) Both (a) and (b)
21. ‘Balls red’ is a SSI producing
(a) They bear extremely high risk
cricket and tennis balls. To 35. Which of the following statement
(b) They provide proactive advice and
promote its products, it wants to guidance is/are correct?
advertise on TV but its Chartered (c) They are generally current or Statement I Synergy is the
Accountant advises the CEO of the retired executives primary reason for the mergers to
firm against it. The reason behind (d) All of the above take place between the two
this could be companies.
(a) limited scope of TV
28. ................. refers to the whole
network of all organisations, Statement II The turnover and
(b) high cost associated with it
institutions and instruments that output produced by the individual
(c) limited exposure
provide medium and long-term firm would be more than the
(d) All of the above
funds to the government and turnover produced by the firm after
22. ................. is defined as, ‘‘a process industrial sector. merger.
that can allow an organisation to (a) Capital market Alternatives
concentrate its resources on the (b) Money market (a) Both statements are correct
optimal opportunities with the (c) Financial intermediation (b) Statement I is correct, but
goals of increasing sales and (d) New issue market Statement II is incorrect
PRACTICE SET 01 57
(c) Statement I is incorrect, but (a) horizontal merger (a) Debtors

Statement II is correct (b) market extension merger (b) Creditors
(d) Both statements are incorrect (c) product extension merger (c) Bills receivables
36. In ………… form of acquisitions, the (d) conglomerate merger (d) Prepaid expenses
purchasing company becomes the 41. In which of the following from of 46. Annual consumption of units in
subsidiary of the purchased merger, two entities combine Aahaar Limited = 2,000 units,
company. together and form a new entity, Buying cost per order = ` 12,
(a) friendly extinguishing both the existing Price per unit = ` 1,000,
(b) reverse entities? Storage cost as percentage of price
(c) backflip (a) Absorption per unit = 12%,
(d) hostile (b) Amalgamation EOQ = ?
37. The advantages of franchising for a (c) Both (a) and (b) (a) 400 units (b) 20 units
franchiser is/are (d) None of these (c) 200 units (d) 100 units
(a) quick expansion 42. A …… merger occurs when two 47. Ordering cost and carrying cost are
(b) cost advantage or more firms, operatng at ................. related to each other.
(c) Both (a) and (b) different levels within an (a) directly (b) inversely
(d) None of these industry’s supply chain, merge (c) Not (d) Can’t say
38. A merger between Fiat and Tata operations.
48. ................. indicates the percentage
motors would be an example of (a) horizontal
of return on total capital employed
(a) conglomerate merger (b) conglomerate
in the business.
(b) vertical merger (c) vertical
(a) Return on investment
(c) horizontal merger (d) product extension
(b) Return on equity
(d) market extension 43. Measure of unit in which the (c) Re-order quantity
39. In which type of acquistion, a private products are sold, is called (d) None of the above
company takes over a public (a) unit cost
49. Which of the following is an
company? (b) unit of sale
examples of carrying costs for
(a) Friendly acquisition (c) unit price inventories?
(b) Reverse acquistion (d) None of these
(a) Money tied up in inventory
(c) Hostile acquisition 44. Which of the following is a factor (b) Storage of inventories
(d) Backflip acquisition affecting working capital? (c) Obsolescence cost
40. The largest Hamburger (a) Scale of operation (d) All of the above
manufacturer ‘Hamber’ in India (b) Seasonal factors
50. XYZ Company uses 500 units of an
merged with well-known cold drink (c) Credit allowed item per day and the order lead
manufacturer “Soda Pop” and (d) All of the above time is 7 days. Re-order level will
renamed the brand “Ham Pop” to 45. Which amongst the following be
impart a different identity. The type is/are example(s) of current (a) 1,000 units (b) 500 units
of merger discussed above is ……… . liabilities? (c) 3,500 units (d) None of these
ANSWERS
1. (b) 2. (b) 3. (c) 4. (a) 5. (c) 6. (b) 7. (d) 8. (a) 9. (d) 10. (d)
11. (a) 12. (b) 13. (a) 14. (c) 15. (c) 16. (a) 17. (a) 18. (a) 19. (d) 20. (b)
21. (b) 22. (a) 23. (d) 24. (c) 25. (c) 26. (c) 27. (d) 28. (a) 29. (c) 30. (b)
31. (d) 32. (c) 33. (d) 34. (d) 35. (b) 36. (c) 37. (c) 38. (c) 39. (b) 40. (c)
41. (b) 42. (c) 43. (b) 44. (d) 45. (b) 46. (b) 47. (b) 48. (a) 49. (d) 50. (c)
CUET (UG) Section II : Domain (Entrepreneurship)
Practice Set 02
1. Which of the following statement is 6. At break-even level, analyse the market need, market
false with respect to ABC analysis? (a) Total Revenue > Total Expenses size andcompetition?
(a) ‘A’ includes the items whose (b) Total Revenue = Total Expenses (a) Market or demand driven
annual consumption value is the (c) Total Revenue < Total Expanses (b) Natural resources
highest (d) None of the above (c) Existing products or service
(b) ‘B’ includes the items with a lower (d) None of the above
7. Which of the following statements
consumption value
is/are correct? 11. Which process is related to
(c) ABC analysis can help you control
you inventory better
Statement I A transport service creating, developing and
(d) All of the above provider needs less working communicating ideas which are
capital. abstract, concrete or visual?
2. During the last month, a total of
Statement II A service firm sells (a) Idea generation
450 people took meals in a
more on a cash basis and does not (b) Product generation
restaurant and the total billed
have to maintain inventory. (c) Either (a) or (b)
amount was ` 90,000. The unit
Alternatives (d) None of the above
price per person will be
(a) Both statements I are correct
(a) ` 200 (b) ` 475 12. Identify the micro-environmental
(b) Statement I is correct, but
(c) ` 325 (d) ` 210 factors from the following.
Statement II is incorrect
3. A business needs capital for (c) Statement I is incorrect, but (i) General public
(a) procuring fixed assets Statement II is correct (ii) Competitors
(b) meeting day-to-day expenses (d) Both statements are incorrect (iii) Economic
(c) growth and diversification 8. A company uses 300 units of an (iv) Intermediaries
(d) All of the above item per day and the order lead (v) Legal
4. Amit is running an ‘Advertising time is 5 days. What should be the (a) (i), (ii) and (iii)
agency’ and earning a lot by level of inventory when a new order (b) (ii), (iii) and (iv)
providing this service to big is to be placed? (c) (iii), (iv) and (v)
industries. The working capital (a)1,500 units (d) (i), (ii) and (iv)
requirement of the firm will be (b) 1,000 units 13. Himanshu Ltd is looking into ideas
………… . (c) 500 units to use eco-friendly recyclable
(a) more (b) less (d) 2,000 units materials for the body of the
(c) Not required (d) Can’t say phones that may cause negligible
9. The ‘Marketing strategy’ and
5. Sushant has opened a grocery shop ‘Action plan’ comprise of decisions damage to the environment.
with an investment of ` 3 lakh. Out pertaining to which of the following? Identify the factor of the PESTEL
of this, ` 1 lakh was his own and (a) Potential hazards present in the model discussed here.
the rest he borrowed from friends competitive environment (a) Social and Policical
and relatives. At the end of the (b) Product, place, price, promotion (b) Ecological and Technological
year, he earned a net profit of ` (c) Customer’s characteristics (c) Economic and Social
40,000. Which ratio will be higher? (d) Quantifying goals of the (d) Legal and Economical
(a) RoI organisation 14. Mr. Dinesh wanted to manufacture
(b) RoE 10. Which of the following source of an energy efficient AC. He looked
(c) Both will be the same idea fields provides important into various options and finally
(d) None of these information to identify and and narrowed down to one option. He
understands that his idea would
PRACTICE SET 02 59
have to follow a process. Identify 22. Which of the following pricing (a) start-up (b) second round
the process. strategy of a product is initially set (c) last stage (d) seed capital
(a) Process of idea germination at a price lower than the eventual 30. …… is a method of raising
(b) Process of creativity market price to attact new additional financa from existing
(c) Process of idea generation customers? shareholders by giving them a
(d) Process of idea fields (a) Cost-plus pricing right to purchase certain number of
15. An entrepreneur with a ……… is (b) Penetration pricing shares in proportion to the shares
able to pursuade others to see the (c) Skimming pricing they are holding.
opportunity. (d) None of the above (a) Public issue
(a) mission (b) vission 23. Sales strategy is important because (b) Private placement
(c) process (d) None of these (a) it creates awareness about (c) Rights issue
business environment (d) Offer to employees
16. An economic idea which can be
(b) it helps in measuring short-term 31. Which of the following is not a step
implemented to create a business performance of sales team
enterprise and profit is called involved in public issue of shares?
(a) business environment (a) Appointment
(b) business opportunity (b) Subscription list
(c) business problem 24. Which sales strategy allows a (c) Checks on brokers
(d) product identification business to cover a wide (d) Allotment of shares
geographical market and to sell to 32. As per SEBI guidelines, if the
17. What is the first stage in a large customer base?
innovation? company does not receive 90% of
(a) Direct (b) Indirect the issue amount from public
(a) Implementation (b) Promotional (d) None of these
(b) Resource organisation subscription within ........... from the
(c) Creativity 25. ................ pricing strategy is date of issue, the amount received
(d) Commercial application employed only for a short duration is required to be refunded.
as it is not viable in the long-run. (a) 60 days
18. Vector Ltd., is in the Fast Moving
(a) Penetration (b) Cost-plus (b) 90 days
Consumer Goods Industry. They
(c) Skimming (d) Variable (c) 120 days
introduced a new variety of biscuits
(d) 150 days
in the market. It has high fibre 26. Internal sources of finance include
content with different new flavours (a) trade credit 33. ............ means the direct sale by a
incorporating various multigrains. (b) equity shares company of its securities to a
State which promotion strategy (c) public deposit limited number of institutional
should be used by Vector Ltd.? (d) All of these investors.
(a) Below the line (a) Public issue
27. At the ............ stage of financing, (b) Right issue
(b) Through the line
the venture achieves a certain
(c) Above the line (c) Private placement
amount of market share and has
(d) None of these (d) Offer to employees
opportunities to develop and grow.
19. The associated cost of promotion is (a) seed capital (b) pre-start-up 34. Which of the following is/are the
the highest in case of (c) second (d) bridge examples of venture capital
(a) advertising institutions in India?
28. Finance raised by issue of ADRs
(b) personal selling (a) Gujarat Venture Finance Limited
and GDRs is said to be raised from (GVFL)
(c) sales promotion
(d) publicity
................. . (b) Technology Development and
(a) internal sources Information Company of India
20. A ................. is either a tangible or (b) external sources Limited (TDICIL)
an intangible offering that is (c) either internal or external sources (c) Andhra Pradesh Industrial
required to satisfy the needs and (d) None of the above Development Corporation
aspirations of a consumer. (d) All of the above
29. Divij is an innovative
(a) service (b) goods
entrepreneur. He has decided to 35. A comprehensively written
(c) product (d) None of these
open an online portal which helps document prepared by the
21. What relates to short-term people to order groceries 24 × 7. entrepreneur describing formal all
incentives that encourage or But before launching his portal, he the relevant internal and external
promote the purchase or sale wants to investigate the elements in starting a new venture
of a product or a service? marketability of his idea. He is called
(a) Advertising (b) Pricing approached Tech Marts, a venture (a) marketing plan
(c) Sales promotion capital firm, to fund his (b) business plan
(d) None of these investigation. Divij is looking for (c) financial plan
.......... finance. (d) operational plan
36. This form of business (a) Marketing plan 46. While ensuring the growth of his
organisation has a limited area of (b) Production plan enterprise, an entrepreneur has to
operation due to availability of (c) Operational plan play the dual role of a ……… .
limited finance and limited (d) Financial plan (a) manager
managerial abilities 41. ................. helps to understand the (b) leader
(a) joint stock company feasibility and viability of the (c) Both (a) and (b)
(b) partnership proposed venture. (d) None of these
(c) sole proprietorship (a) Business plan 47. In which of the following is the
(d) Both (a) and (c) (b) Marketing plan reason for mergers and
37. The business of partnership firm (c) Production plan acquisitions?
can be carried out by all the (d) Financial plan (a) Synergy
partners or any one of them (b) Acquiring new technology
42. The maximum number of partners
acting for all. This highlights the (c) Acquiring a competency
allowed in the banking business are
following characteristic of (d) All of the above
(a) twenty
partnership. (b) ten 48. Manufacturing franchise
(a) Agreement (c) fifty opportunity is common in which
(b) Utmost good faith (d) two industry?
(c) Mutual agency (a) Tyre
(d) Implied authority 43. Komal Company Ltd. was initially (b) Food and beverage
producing crayons. Now, it has decided (c) Vending machine nutes
38. In which of the following forms of to produce oil paints and water paints
business organisation there exists (d) None of the above
also. The company is attempting to
separation of ownership from (a) expand internally 49. The main ingredients of a franchise
management? (b) expand externally agreement
(a) Sole proprietorship (c) Both (a) and (b) (a) contract explanation
(b) Partnership (d) None of the above (b) operations manual
(c) Company (c) proprietary statements
(d) Both (b) and (c) 44. “X + Y = Z, where Z is a new (d) All of the above
company”. It shows
39. Which of the following plans help 50. Which of the following types of
(a) absorption
to plan the work in such a franchises provide an organisation
(b) amalgamation
manner that one can clearly form with the right to manufacture a
(c) acquisition
an idea about plan layout? product and sell it to the public,
(a) Operational plan using the franchisor’s name and
(b) Production plan 45. The goal of a ……… merger is to trademark?
(c) Marketing plan create a new larger organisation with (a) Product franchise business
(d) Financial plan more market share. opportunity
(a) conglomerate (b) Manufacturing franchise
40. ‘How products/services will be (b) horizontal opportunity
distributed, priced and marketed’ (c) market extension (c) Business franchise opportunity
is described by which of the (d) Both (b) and (c) ventures
following components of a (d) Business format franchise
business plan? opportunity
ANSWERS
1. (b) 2. (a) 3. (d) 4. (b) 5. (b) 6. (b) 7. (a) 8. (a) 9. (b) 10. (a)
11. (a) 12. (d) 13. (b) 14. (b) 15. (b) 16. (b) 17. (c) 18. (c) 19. (b) 20. (c)
21. (c) 22. (c) 23. (c) 24. (b) 25. (c) 26. (b) 27. (d) 28. (a) 29. (d) 30. (c)
31. (c) 32. (c) 33. (c) 34. (d) 35. (b) 36. (c) 37. (c) 38. (c) 39. (b) 40. (a)
41. (a) 42. (c) 43. (a) 44. (b) 45. (d) 46. (c) 47. (d) 48. (b) 49. (d) 50. (b)
Business Studies 3
CHAPTER 01
Nature and Significance

of Management
5. Management is a Group Activity Management helps
Meaning of Management people to realise their individual as well as
Management is a process which consists of series of organisational goals through group efforts.
interrelated functions that are performed by all managers to
6. Management is a Dynamic Function Management
effectively achieve the goals of an organisation.
helps an organisation to adapt to the changes in the
In the words of Koontz, ‘‘Management is the art of getting environment.
things done through others and with formally organised
7. Management is an Intangible Force Management is an
groups.’’
invisible force that cannot be seen, but its presence can
Concept of Management be felt by orderliness, discipline, achievement of goals
and happy and satisfied employees.
There are two concepts of management, which are as follows
1. Traditional Concept The traditional concept of Objectives of Management
management is concerned with accomplishing Objectives are the desired result of any activity for the
organisational objectives by directing the efforts of benefit of organisation, employees and society. These are
others or it is an art of getting things done through 1. Organisational Objectives These are related with
others. survival, profit earning and growth of an organisation.
2. Modern Concept The modern concept insists on 2. Social Objectives These involve creation of benefits for
achieving goals effectively and efficiently. Thus, it is the society.
defined as a process of getting things done with the 3. Personal Objectives These are related to fulfilling the
aim of achieving goals effectively and efficiently. financial, social and higher level needs of employees.
Effectively It means completing the task/work on time. Importance of Management
Efficiently It means doing the task correctly and with Management is important due to following reasons
minimum cost. ● It helps in achieving group goals
● It increases efficiency
Features of Management ● It creates a dynamic organisation
1. Management is a Goal Oriented Process Management ● It helps in achieving personal objectives
aims to achieve the goals of the organisation by ● It helps in the development of society
integrating the efforts of all members.
2. Management is All Pervasive Management is essential Nature of Management
for all organisations, whether big or small, profit or The nature of management can be understood by
non-profit, social or political. considering it as an art, as a science and as a profession.
3. Management is Multi-dimensional Management is a 1. Management as an Art
complex activity with three main dimensions which are Like an art, management is a personalised process in
as follows which managers apply their personal experiences in real
● Management of work
life situations.
● Management of people
2. Management as Science
Like a science, management has a systematised body of
● Management of operations
knowledge, that explains general truths and factual
4. Management is a Continuous Process It is concerned situations. But it is not considered as a perfect science as
with constantly identifying the problems and solving it is concerned with human behaviour which is
them by taking appropriate actions. unpredictable.
Management is a Science as well as an Art Main role/functions of the lower level management are as
Management is a science as well as an art because it is follows
a combination of an organised body of knowledge ● To plan and execute day-to-day operations.
(science) and skillful application of this knowledge ● To supervise and control the workers.
(art).
● To arrange materials and tools to start the process and make
3. Management as Profession arrangements for training.

Like a profession, management has well defined body
● To represent workers’ grievances and suggestions before the
of knowledge but it is not considered as full fledged
management and ensure safe and proper working conditions
profession as it lacks certain distinct features of
in the factory.
profession such as code of conduct and professional
association.
Functions of Management
Levels of Management Following are the functions of management
There are three levels in the hierarchy ofan organisation. 1. Planning It is the process of deciding in advance what is
These are discussed below to be done, when, how and by whom it is to be done.
2. Organising It is the process of assigning duties, grouping
1. Top Level Management tasks, establishing authority and allocating resources
It consists of members at the highest level in the required to carry out a specific plan.
management hierarchy. This level includes Board of 3. Staffing It is the process of filling all positions in an
Directors, Chief Executives, Managing Directors, organisation with adequate and qualified personnel.
Chairman, President, Vice-President, CEO, COO, etc.
4. Directing This function is related with leading,
Main role/functions of the top level management are as influencing, guiding, supervising and motivating people
follows towards the attainment of planned targets.
● To analyse, evaluate and deal with the external
5. Controlling It is the process of ensuring that the
environment. organisation is able to attain the organisational goals. It
● To determine the objectives and policies of the business. ensures that activities conform to the standards set for
● To strive for welfare and survival of business. performance.
● To create an organisational framework consisting of
authority-responsibility relationship. Meaning of Coordination

Coordination is the force that binds all the functions
2. Middle Level Management of management. It is considered as the essence of
It consists of members or groups, who are concerned with management.
implementation of the policies laid down by the top
In the words of McFarland, ‘‘Coordination is the process
management.
whereby an executive develops an orderly pattern of group
This level includes Head of the Departments such as efforts among his subordinates and secures unity of action in
Finance Manager, Marketing Manager, Branch and the pursuit of common purpose.’’
Regional Managers, Departmental and Divisional Heads,
Plant Superintendent, etc. Characteristics/ Nature of Coordination
Main role/functions of the middle level management are Main characteristics of coordination are
as follows ● It integrates group efforts
● To interpret the policies framed by top management. ● It ensures unity of action
● To assign duties and responsibilities to lower level ● It is a continuous process
managers. ● It is required in all organisations and at every level
● To select and appoint employees for middle and ● It is a deliberate function
supervisory level and evaluate their performance. ● It is the responsibility of all managers
● To cooperate with other departments for smooth
functioning. Importance of Coordination

Following points highlight the importance of coordination
3. Operational or Supervisory level Management ● Coordination is necessary to manage large organisations.
It refers to the groups or members, who are concerned
● Due to functional differentiation in departments and
with execution of the work. They are also known as first
divisions, it is required to bring in a degree of homogeneity.
line managers. This level includes Foremen, Clerks,
● To create unity of action among specialists, it is required in
Inspectors, etc.
organisations.
Business Studies 5
Practice Questions
1 Which of the following is not a function of 10 ‘‘Management is considered as a continuous
management? process’’. Which of the following relates to this
(a) Planning (b) Staffing statement?
(c) Cooperating (d) Controlling (a) The process of management is a dynamic function
(b) The process of management is multi-dimensional
2 Management can be considered as
(c) The process of management is an ongoing process
(a) an art
(b) a science
(c) Both art and science 11 Identify the basic features of profession.
(d) None of the above (a) Systematic body of knowledge
3 The following is not an objective of management (b) Restricted entry
(a) earning profit (c) Service motive
(b) growth of the organisation (d) All of the above
(c) providing employment 12 Every manager applies his personal skills and
(d) policy making
knowledge in the day-to-day functioning of an
4 Policy formulation is the function of enterprise. It is proved because
(a) top level managers (a) management is an art
(b) middle level managers (b) management is a science
(c) operational management
(c) management is a profession
5 Coordination is
13 Identify the role of middle level management from
(a) function of management
(b) the essence of management the following.
(c) an objective of management (a) To implement the policies framed by top
(d) None of the above management.
(b) To maintain close contacts with operative level so as
6 ............... is concerned with the performance of to evaluate the performance.
various activities/tasks in an organisation. (c) To assign duties and responsibilities to lower level
(a) Management of people managers.
(b) Management of operations (d) All of the above
(c) Management of work 14 ............... is an important function of management
(d) Management of individuals as it ensures that right people with right
7 Identify the important characteristics of qualification are employed at a right place.
management. (a) Organising (b) Planning
(a) It is a goal oriented process (c) Staffing (d) Directing
(b) It is an intangible force
15 Superintendent works at which level of
(c) It is single dimensional
(d) Both (a) and (b) management?
(a) Operational level of management
8 Personal objectives are related with satisfying the (b) Middle level of management
personal needs of the employees. Management (c) Top level of management
must seek to satisfy the diverse needs of employees (d) Either (b) or (c)
like
(a) financial needs, by giving competitive salary and 16 Which of the following functions are required to be
perks carried out for successfully establishing
(b) social needs, by peer recognition coordination?
(c) higher level needs, by providing opportunities for (a) Planning and directing
personal growth and development (b) Organising
(d) All of the above (c) Staffing
9 Which of the following is not an importance of (d) All of the above
management? 17 ............... is a process through which harmony is
(a) Management increases efficiency established among different activities of an
(b) Management helps in achieving individual goals organisation.
only (a) Planning (b) Organising
(c) Management creates a dynamic organisation (c) Coordination (d) Either (a) or (b)
(d) Both (a) and (c)
18 The ............... coordinates the activities of the 26 …… concept of management is concerned with
whole organisation keeping in view the desired accomplising organisational objectives by directing
goals. the efforts of others.
(a) middle level management (a) Modern
(b) top level management (b) Traditional
(c) lower level management (c) Either modern or traditional
(d) All of the above (d) None of the above
19 Without coordination, directing is impossible and 27 What is concerned with completing activities or
of no worth if there is lack of coordination between achieving goals, within the prescribed time limit?
superiors and (a) Process
(a) managers (b) directors (b) Efficiently
(c) subordinates (d) All of these (c) Effectively
20 Which of the following highlights the importance of
coordination? 28 Which objectives of management deals with the
(a) Growth in size commitment of an organisation towards the
(b) Functional differentiation society?
(a) Personal objectives
(c) Specialisation
(b) Social objectives
(d) All of the above (c) Organisational objectives
21 ……… is the most important objective of every (d) Economic objectives
business. 29 ‘‘Coordination is the process whereby an executive
(a) Survival (b) Profit develops an orderly pattern of group efforts among
(c) Growth (d) Expansion his subordinates and secures unity of action in the
22 CEO is at which level of management in a pursuit of common purpose.” This is given by
company? (a) Henri Fayol
(a) All levels of management (b) Harold Koontz
(b) Supervisory level of management (c) McFarland
(c) Middle level of management (d) None of the above
(d) Top level of management 30 In Tysfo Ltd. the purchase department purchased
23 In order to achieve organisational goals, ........... 20 tonnes of raw material for the production
objectives should be integrated with organisational department. However, the production department
goals, as only satisfied employees will help in required only 15 tonnes. Due to this reason, goods
achieving organisational goals. were produced beyond required level and were not
(a) organisational accepted by sales department. As a result, many
(b) social goods remained unsold. Identify the aspect of
(c) personal management lacking in the given case.
(d) None of the above (a) Planning (b) Coordination
24 Which of the following is not an essential (c) Directing (d) None of these
organisational objective of management? 31 To conserve tigers, airtel started an earnest
(a) Survival awareness campaign ‘Save our Tigers’. Which
(b) Eco-friendly production objective of management is highlighted here?
(c) Growth (a) Organisational (b) Social
(d) Profit (c) Personal (d) Both (b) and (c)
25 Finance manager and marketing manager comes 32 Ajay is working as an operations manager in WH
at which level of management? Ltd. What is the managerial level at which he is
(a) Top level management
working?
(b) Lower level management
(a) Top level (b) Middle level
(c) Middle level management
(c) Lower level (d) Shop floor
(d) Either (a) or (c)
ANSWERS
1. (c) 2. (c) 3. (d) 4. (a) 5. (b) 6. (c) 7. (d) 8. (d) 9. (b) 10. (d)
11. (d) 12. (a) 13. (d) 14. (c) 15. (a) 16. (d) 17. (c) 18. (b) 19. (c) 20. (d)
21. (a) 22. (d) 23. (c) 24. (b) 25. (c) 26. (b) 27. (c) 28. (b) 29. (c) 30. (b)
31. (b) 32. (b)
Business Studies 7
CHAPTER 02
Principles of Management
Concept of Management Principles 7. Contingent The application of principles of

management is contingent or dependent upon the
Management principles are the statements of fundamental
prevailing situation. Therefore, principles have to be
truth, which serve as guidelines for decisions and actions of
applied as per the requirements of a given situation,
managers. These principles, lay down the general guidelines,
leading to professionalisation of management.
so that a manager can take valuable decisions or appropriate
steps to accomplish desired goals.
Significance of Management Principles
Nature of Management Principles Following points summarise the significance of principles of
management
Following points characterise the nature of management
principles 1. Providing Managers with Useful Insights into
Reality These principles enable managers to learn
1. Universal Applicability These principles are universal
from past mistakes and conserve time by solving
and can be applied in all types of organisations whether
recurring problems quickly.
it is profit making or non-profit making, small or large,
private or government and manufacturing or service 2. Optimum Utilisation of Resources and Effective
sector. Administration Optimum utilisation of resources
emphasise that resources should be utilised in such a
2. General Guidelines Management principles are general
manner that it should give maximum benefit with
guidelines, as they cannot be applied blindly in all the minimum cost.
situations. They do not provide solutions to all
3. Scientific Decisions Management principles help in
managerial problems, but only give the solution of a
thoughtful decision-making because they are based on
given problem.
logic rather than blind faith. Such decisions are free
3. Formed by Practice and Experimentation Proper from bias and prejudice.
observations and experiments are conducted under
4. Meeting changing Environment Requirements
different conditions by leaders and scholars of
Modern business environment is complex and ever-
management thoughts to develop them.
changing. In order to be successful, organisations have
4. Flexible The management principles are dynamic and to adapt to these changes. Principles are dynamic,
not static or rigid prescriptions, which are to be flexible and frequently adapt to changes, which are
followed absolutely. They are flexible in nature and can favourable and profitable for the business.
be modified by the manager as per the given situation.
5. Fulfilling Social Responsibilities Management
5. Mainly Behavioural Management principles aim at principles are evolved or developed to serve the
influencing human behaviour, for better utilisation of demands of society. These principles establish certain
resources in the organisation. ethics in response to social responsibility towards
6. Cause-and-effect Relationship These principles society.
establish cause-and-effect relationship between two 6. Management Training, Education and Research
variables. It indicates the consequences of Management principles act as a base of doing research
implementing a particular principle over a given and development in management studies. These
situation. Though the results may not be same, they principles provide basic groundwork for the
produce similar results everytime. development of managers.
Fayol’s Principles of Management Taylor’s Scientific Management

Henri Fayol is known as the ‘Father of General Management’. Scientific management means applying the scientific
He developed his own concept of administration. methods and tools to increase the output, its quality and
He has given fourteen principles of management which are as reduce costs and wastages.
follows It is a systematic and thoughtful approach, which was
1. Division of Work Work is divided into small tasks. This developed by FW Taylor. It stresses that there is always ‘one
helps in taking the advantage of specialisation. best way’ of doing work.
2. Authority and Responsibility According to Fayol, According to Taylor, ‘‘Scientific management means
‘‘There must be a balance or parity between authority and knowing exactly what you want from men to do and seeing
responsibility.’’ that they do it in the best and the cheapest way.’’
3. Discipline It signifies obedience to organisational rules
and regulations which are necessary for the smooth
Principles of Scientific Management
working of an organisation. Principles of scientific management are
4. Unity of Command According to this principle, an 1. Science, not Rule of Thumb Taylor is of the view that
employee should receive orders or instructions and there is one best method of doing a job and this method
should be accountable to only one superior. should be developed through scientific study and
analysis rather than wish of manager or hit and trial
5. Unity of Direction According to this principle, each
method and it should substitute the age old method of
group of activities having the same objective, must have
doing a job.
one head and one plan.
2. Harmony, not Discord There should be harmony
6. Subordination of Individual Interest to General
between the management and the workers.
Interest According to Fayol, ‘‘In all situations company’s
interest should supersede the interest of individual.’’ 3. Cooperation, not Individualism There should be
cooperation between workers and management. Every
7. Remuneration of Employees According to Fayol, ‘‘The
one should work for the betterment of the
quantum and methods of remuneration payable to the
organisation.
employees should be fair and reasonable.’’
4. Development of Each and Every Person to his/her
8. Centralisation and Decentralisation According to
Greater Efficiency and Prosperity Adequate
Fayol, ‘‘An organisation should strive to achieve a proper
opportunities must be made available for employees, so
balance between centralisation and decentralisation.’’
that they strive to improve their performance to achieve
9. Scalar Chain and Gang Plank According to Fayol, new heights in their careers.
scalar chain refers to the chain of authority and
communication that runs from top to bottom and should Techniques of Scientific Management
be followed by managers and their subordinates. Following are the techniques of scientific management
Gang plank refers to an arrangement in which two 1. Functional Foremanship Under this technique,
managers working at the same level can communicate planning and execution are separated from each other.
with each other directly for quick communication. Taylor advocated the appointment of eight foremen; out
10. Order According to Fayol, ‘‘People and materials must be of which, four of them will be responsible for planning
in suitable places at appropriate time for maximum viz. route clerk, instruction card clerk, time and cost
efficiency.’’ clerk and disciplinarian and the rest four viz. speed
11. Equity This principle advocates that everyone should be boss, gang boss, repair boss and inspector will be
equal in the eyes of the management. There should be no concerned with the execution of work.
discrimination against anyone on account of sex, religion, 2. Standardisation of Work It refers to the process of
language, caste, belief or nationality. setting standards for every business activity. It can be
12. Stability of Personnel According to Fayol, ‘‘Personnel standardisation of process, raw material, time, product,
should be selected and appointed after due and rigorous machinery, methods or working conditions.
procedure. But once selected they should be kept at their 3. Simplification of Work Simplification means
position for a minimum fixed tenure.’’ eliminating superfluous sizes, varieties and dimensions.
13. Initiative Fayol suggested that employees at all levels Its aim is to eliminate unnecessary diversity of products
should take initiative or actions without any force or and thereby reduce costs.
boundations. 4. Method Study This technique of scientific
14. Esprit de Corps According to Fayol, ‘‘Management management is conducted to find out the one best way
should promote team spirit of unity and harmony among of performing a particular task.
employees.’’
Business Studies 9
5. Motion Study It refers to the study of movements like 8. Differential Piece Wage System Under this system of
lifting, putting objects, sitting and changing positions, wage payment, wages are paid on the basis of work
etc. which are undertaken while doing typical jobs. done.
6. Time Study It determines the standard time taken to 9. Mental Revolution It involves change in the attitude
perform a well defined job. of workers and management. Both should realise the
7. Fatigue Study This study seeks to find out the amount importance of each other and cooperate with one
and frequency of rest intervals required in completing a another.
task.
Practice Questions
1 Principles of management are not 8 Which of the following statements best describes
(a) universal (b) flexible ‘Mental revolution’?
(c) absolute (d) behavioural (a) It implies change of attitude
(b) The management and workers should not play the
2 How are principles of management formed?
game of one upmanship
(a) In a laboratory
(c) Both management and workers require each other
(b) By experiences of managers
(d) Workers should be paid more wages
(c) By experiences of customers
(d) By propogation of social scientists 9 Which of the following statements is false about
3 The principles of management are significant Taylor and Fayol?
(a) Fayol was a mining engineer whereas Taylor was a
because of
mechanical engineer
(a) increase in efficiency
(b) Fayol’s principles are applicable in specialised
(b) initiative
situations whereas Taylor’s principles have
(c) optimum utilisation of resources
universal application
(d) adaptation to changing technology
(c) Fayol’s principles were formed through personal
4 Which of the following statement best describes experience whereas Taylor’s priniciples were formed
the principle of ‘Division of work’? through experimentation
(a) Work should be divided into small tasks (d) Fayol’s principles are applicable at the top level
(b) Labour should be divided management whereas Taylor’s principles are
(c) Resources should be divided among jobs applicable at the shop floor
(d) It leads to specialisation 10 Which of the following are the statement of
5 ‘She/he keeps machines, materials, tools etc., ready fundamental truth, which serve as guidelines for
for operations by concerned workers. decisions and actions of managers?
(a) Values of management
Whose work is described by this sentence under
(b) Principles of management
functional foremanship?
(c) Techniques of management
(a) Instruction card clerk (b) Repair boss
(c) Gang boss (d) Route clerk
11 Management principles help in thoughtful
6 Which of the following is not a principle of
management given by Taylor? decision-making because they are based on
(a) blind faith
(a) Science, not rule of the thumb
(b) Functional foremanship (b) intuition
(c) Maximum, not restricted output (c) logic
(d) Harmony, not discord (d) None of these
7 Management should find ‘One best way’ to perform 12 Management principles are ............... to serve the
a task. Which technique of scientific management demands of the society, with respect to
is defined in this statement? significance.
(a) Time study (a) irrelevant
(b) Motion study (b) developed
(c) Fatigue study (c) under developed
(d) Method study (d) None of these
13 Identify the reason from the following, why (a) Unity of command
principles of management do not provide (b) Centralisation and decentralisation
(c) Remuneration of employees
readymade solution to all managerial decisions? (d) Mental revolution
(a) Because they provide general guidelines to the
managers 21 Why is stability of tenure of personnel important
(b) Because they are evolved or developed by personal in an organisation?
experiences of the managers (a) It reduces employee turnover and reduces
(c) Because management principles are ethical in productivity
nature (b) It increases employee turnover and increases
(d) All of the above productivity
(c) It reduces employee turnover and increases
14 The main objective of ‘motion study’ is productivity
(a) to save cost of labour and machines (d) None of the above
(b) to determine and eliminate the unnecessary
movements 22 What does principle of initiative indicates?
(c) to represent a clear picture of management (a) It indicates that employee at all levels should be
(d) to plan and execute day-to-day work encouraged
(b) It indicates that employee at only lower level should
15 Which technique of scientific management be encouraged
suggests that, a disciplinarian should be appointed (c) It indicates that no employee should be encouraged
under the planning incharge, in order to maintain for the task
discipline among workers? (d) None of the above
(a) Harmony, not discord
(b) Cooperation not individualism 23 Which principle of management states that each
(c) Functional foremanship group having same objectives must have one head
(d) None of the above and one plan?
(a) Principle of equity
16 Under which system of wage payment, wages are (b) Principle of unity of command
paid on the basis of work done? (c) Principle of unity of direction
(a) Functional foremanship (d) Principle of authority and responsibility
(b) Motion study
(c) Time study 24 Identify the positive effects of principle of equity.
(d) Differential piece wage system (a) It ensures loyalty among the workers
(b) Cordial relation between workers and managers
17 Name the principle of scientific management (c) Congenial atmosphere within the organisation
which emphasised that there should be complete (d) All of the above
harmony between the management and workers.
(a) Harmony, not discord
25 Which principle means that an employee should
(b) Cooperation, not individualism
receive orders from one superior only?
(a) Coordination
(c) Science, not rule of thumb
(b) Unity of command
(d) Development of each and every person to his/her (c) Discipline
greatest efficiency (d) Unity of direction
18 Identify the technique of scientific management in 26 Which of the following techniques rely on operation
which a specialist supervises each worker. research and process charts to minimise the cost of
(a) Science, not rule of thumb
production and maximise the quality of product
(b) Mental revolution
(c) Functional foremanship
and satisfaction of customer?
(d) None of the above (a) Fatigue study
(b) Time study
19 The goals are achieved after integrating the efforts (c) Method study
of different individuals who are working in an (d) Motion study
organisation to satisfy their own personal needs. 27 How many principles were given by Henri Fayol?
Identify the principle of management. (a) 12 (b) 13
(a) Subordination of individual interest to general (c) 14 (d) 15
interest
(b) Remuneration of employees 28 Lin Dang, HR Manager of Xio Ltd. expects his
(c) Unity of direction subordinates to work for happiness and pleasure of
(d) None of the above being in organisation. Which principle of
20 An organisation should strive to achieve proper management is being overlooked?
balance between centralisation and (a) Equity
(b) Espirit de corps
decentralisation. Which principle of management (c) Remuneration of employees
is highlighted here? (d) Unity of direction
Business Studies 11
29 Which principle of scientific management discards (c) Universal application

the old approach of rule of thumb? (d) Contingent
(a) Harmony, not discord 33 ‘Shirt Up’ is a company engaged in the production
(b) Cooperation, not individualism of men’s shirt. The company follows Taylor’s
(c) Science, not rule of thumb differential wage rate payment method and has the
(d) Either (a) or (c)
following piece rate wages
30 Who gave the concept of scientific management? (i) `15 per shirt to every worker who is able to
(a) Henri Fayol (b) Seymour produce the standard output of 8 shirts or
(c) Philip Kotler (d) F W Taylor
more, per day.
31 Vijay purchased the raw material (required by (ii) `12 per shirt to every worker who is not able to
company in which he is purchase manager) at a produce the standard output.
higher price from a relative. Which principle is
violated here? Calculate the wages payable to Satish, who
(a) Discipline produced 11 shirts.
(b) Equity (a) ` 132 (b) ` 165
(c) Subordination of individual interest to general (c) ` 33 (d) None of these
interest Hint Satish shall fall in (i) category.
(d) Order 34 Wayne, the manager of RSA Ltd granted one
32 The effect of managerial principles vary from month medical leave to a supervisor with pay and
situation to situation. It is related to which the same to a accountant without pay. Which
characteristic of management principle? principle of management is violated here?
(a) Cause and effect relationship (a) Remuneration (b) Espirit de corps
(b) Flexible (c) Equity (d) Discipline
ANSWERS
1. (c) 2. (b) 3. (a) 4. (a) 5. (c) 6. (b) 7. (d) 8. (a) 9. (b) 10. (b)
11. (c) 12. (b) 13. (a) 14. (b) 15. (c) 16. (d) 17. (a) 18. (c) 19. (a) 20. (b)
21. (c) 22. (a) 23. (c) 24. (d) 25. (b) 26. (c) 27. (c) 28. (c) 29. (c) 30. (d)
31. (c) 32. (d) 33. (b) 34. (c)
CHAPTER 03
Business Environment
Concept of Business Environment 6. Complexity Business environment is complex, as it
consists of numerous, inter-related factors affecting
The term business environment means the sum total of all
business enterprises at the same time.
individuals, institutions and other forces that are outside
the control of a business enterprise but that may affect its 7. Relativity Business environment is a relative concept
performance. as it differs from country to country and region to
region.
It consists of social, political, economic, legal and
technological factors such as change in taxation, fashion,
Importance of Business Environment
taste of consumers, increased competition, etc, which affect
the working of a business significantly. The following points highlight the importance of business
environment
Features of Business Environment 1. It enables the Firm to identify Opportunities and
The main features of business environment are as follows get the First Mover Advantage A good knowledge of
business environment helps a manager to identify
1. Totality of External Forces Business environment is
opportunities earlier to take their benefit, rather than
aggregative in nature because it is the sum total of all
losing them to other competing enterprises.
things external to business enterprise, comprising of
social, political, economic, legal and technological 2. It helps the firm to identify Threats and Early
factors. Warning Signals Threats refer to the negative trends,
which will hinder the performance of the enterprise.
2. Specific and General Forces Business environment
The businessmen, who are able to scan and understand
includes both specific and general forces. General
the business environment on time get a warning signal
forces are economic, social, political, legal and
to deal with such negative changes.
technological conditions, which affect all the
enterprises indirectly. Specific forces are investors, 3. It helps in tapping Useful Resources Environment
customers, competitors and suppliers that affect is a source of various resources for business like
individual enterprises directly. finance, machinery, raw materials, etc. A good
understanding of environment helps the firm to convert
3. Inter-relatedness Different elements of business
such resources into output required by the environment
environment are closely inter-related e.g. an increase in
and society.
the income of consumer (economic environment) will
help in improving his living standard (social 4. It helps in coping with Rapid Changes Business
environment). environment is fast changing. In order to cope up with
changes and derive benefit from them, managers must
4. Dynamic Nature Business environment is dynamic in
examine their environment and develop suitable action.
nature as it keeps on changing whether in terms of
upgradation of technologies, shifts in consumer 5. It assists in Planning and helps in Policy
preference, change in government policy or changes in Formulation Since, business environment is a source
trends and traditions. of identifying both opportunities and threats, its proper
analysis and understanding provides the base for
5. Uncertainty Business environment is largely
planning and guides in framing policies.
uncertain because it is very difficult to predict future
events such as technological changes, change in 6. It helps in improving Performance An enterprise
government policies, etc, especially, when changes are that monitors its environment continuously, is in a
taking place at a fast pace. position to improve not only its present performance,
but also improve its future performance.
Business Studies 13
Dimensions of Business Environment Components of political environment include

● The Constitution of the Country
Business environment consists of factors that influences
many enterprises at the same time. These are called ● Political stability
dimensions of business environment. These factors are ● Political ideology
categorised as social, economic, political, legal and ● Political outlook on business sectors
technological environment which are considered relevant for

● Extent and nature of government intervention in business
decision-making and improving the performance of an
● Degree of politicisation of business and economic issues
enterprise.
1. Economic Environment 5. Legal Environment
The economic environment consists of the factors and forces The legal environment consists of laws and regulations of
concerning with means of production and distribution of the country. These laws have been implemented by the
wealth. It comprises of interest rate, rate of inflation, value government through Companies Act, Factories Act,
of GDP, per capita income, tax rates, disposable income, etc. Competitions Act, etc. It is necessary for business enterprises
to comply with these laws.
Components of economic environment include
● Rate of growth of GNP
Economic Environment in India
● Per capita income
Economic environment in India consists of a number of
● Rates of savings and investments
macro-level factors which have an impact on business and
● Balance of Payments industry. These are
● Value of exports and imports ● Stage of economic development of the country.
● Agricultural and industrial production ● Economic structure i.e. mixed economic form which allows
● Money supply in the economy both public and private participation in production process.
● Economic policies of the government such as monetary and
● Public debt
fiscal policies.
2. Social Environment ● Economic planning and Five Year Plans.
The social environment consists of all the social and cultural ● Economic aggregates like GNP (Gross National Product),
forces within which business firms operate. It comprises of GDP (Gross Domestic Product), per capital income,
customs and traditions, values, social trends, etc. savings, investments, etc.
Components of social environment include ● Infrastructural factors like banking, transport, fuels,
● Concern with quality of life communication, energy sources, etc.

● Life expectancy
Economic Policy Before and After 1991
● Expectations from workforce
Before 1991, in accordance with the objectives of planning,
● Birth and death rates the government emphasised an inward looking trade policy,
● Population shifts where public sector was given the responsibility of
● Educational system and literacy rates development. The government imposed several restrictions,
● Consumption habits regulations and controls on the private sector enterprises.
● Composition of family But in 1991, the economy faced a serious economic crisis in
● Attitudes towards product innovations, lifestyles, etc the form of the following problems
● High government deficit.
3. Technological Environment ● Soaring inflation.

It refers to the change, taking place in the method of
● Serious foreign exchange crisis.
production and use of equipment to improve the quality of
product. In other words, we can say technological This led to a change in the economic policy. Thus, New
environment includes forces relating to scientific Economic Policy, came into existence.
improvements and innovations, which provide new ways of
producing goods and services and methods and techniques New Economic Policy, 1991
of operating a business. The New Economic Policy, implemented in 1991, included a
number of reforms categorised as
4. Political Environment
● Liberalisation
The political environment consists of the forces concerning
● Privatisation
management of public affairs and their impact on business.
● Globalisation
It includes political conditions in the country and attitude of
the government towards businesses and business policy. The first letters of these terms make it known as LPG policy.
The broad features of this policy were The reforms introduced under globalisation were
● The government reduced the number of industries ● Abolition of licensing of imports.
under compulsory licensing to six. ● Removal of tariff restrictions and quantitative restrictions.
● Dereservation of a large number of industries under the ● The share of foreign equity participation was increased.
public sector. ● Foreign Investment Promotion Board (FIPB) was set up to
● Disinvestment of many public sector enterprises.

promote foreign investment in India.
● Increase in the share of foreign equity participation in
FDI upto 100 percent. Impact of LPG Policy

● Automatic permission granted for technology
Changes on Business and Industry
agreements with foreign companies. The LPG (Liberalisation, Privatisation and Globalisation) policy
● FIPB was set up to promote foreign investment in India.
of the government has made a significant impact on the
working of enterprises in business and industry.
Liberalisation Following are some of the challenges faced by the business and
Liberalisation means freedom of business and industry industries
from the unnecessary controls and restrictions of the 1. Increasing Competition Changes in the rules of
government, particularly licensing and quotas. The industrial licensing and entry of foreign firms, has
reforms introduced under liberalisation were increased the competition for Indian firms especially in
● Abolishing licensing in most of the industries. service industries such as banking, communication,
● Freedom in deciding the scale of business. health, etc.
● Freedom in deciding prices of goods and services. 2. More Demanding Customers Due to increase in
● Reduction in tax rates and unnecessary controls.
competition, wider choice of products are available in the
market. As a result, customers are becoming more choosy.
● Dereservation of public sector enterprises.
He is now regarded as the ‘King of the market’.
● Simplifying procedures for export and import.
3. Rapidly changing Technological Environment
● Automatic permission was granted for technology
Increased competition in market forces the firms to
agreements with foreign companies. develop new ways to survive and grow in market. Due to
● Removal of restrictions on the movement of goods and
this, smaller firms face tough challenges for
services. transformation in processes, technology, machines and
products.
Privatisation
4. Necessity for Change Rapid change in the market forces
Privatisation is the process of reducing the role of public
the enterprises to continuously modify their operations.
sector in the economic activities of a country. It involves
induction of private ownership, private management and 5. Need for Developing Human Resource The new
control in public sector through disinvestment. market conditions require people with higher competence
Disinvestment refers to the process of sale of public sector and greater commitment. Thus, the need to develop
enterprises to the private sector or dilution of government human resource is increasing.
ownership beyond 51% in public enterprises. 6. Market Orientation Earlier firms used to produce first
The government further decided to refer the loss-making and then sell goods in the market. But now, in the fast
and sick enterprises to the Board of Industrial and changing world, production-oriented technique has
Financial Reconstruction (BIFR). changed to market orientation, where firms study and
analyse the market first and produce goods accordingly.
Globalisation 7. Loss of Budgetary Support to the Public Sector The
Globalisation means integrating the economy of a central government’s budgetary support for financing the
country with the world’s economy. It is a process of public sector outlays has declined over the years.
increasing economic integration and growing economic Public sector undertakings have realised that in order to
interdependence between countries in the world survive, they will have to develop their own resources and
economy. be more efficient.
Practice Questions
1 Which of the following does not characterise the 10 Which of the following option correctly describes
business environment? the difference between specific and general forces
(a) Uncertainty (b) Employees of business environment?
(c) Relativity (d) Complexity (a) Specific forces affect the individual enterprise
directly, whereas general forces have indirect impact
2 Which of the following best indicates the
on all business enterprises
importance of business environment? (b) General forces have direct impact on individual
(a) Identification enterprise, whereas specific forces have indirect impact
(b) Improvement in performance on business enterprise.
(c) Coping with rapid changes (c) Specific forces does not affect an enterprise at all,
(d) All of the above whereas general forces affects directly on all
3 Which of the following is an example of social business enterprises
environment? (d) None of the above
(a) Money supply in the economy 11 Obstacles to privatisation are
(b) Consumer Protection Act (a) opposition by labourers
(c) The Constitution of the country (b) problem of financing
(d) Composition of family (c) political pressure
4 Liberalisation means (d) All of the above
(a) integration among economies 12 Demand for LED TVs are increasing day by day.
(b) reduced government controls and restrictions Thus, TV manufacturers have started making LED
(c) policy of planned disinvestments TVs instead of LCD. Identify the significance of
business environment being portrayed in the given
5 Which of the following does not explain the impact case.
of government policy changes on business and (a) Helpful in tapping useful resources
industry? (b) Helps the firm to identify threats and early warning
(a) More demanding customers signals
(b) Increasing competition (c) Helps in coping with rapid changes
(c) Change in agricultural prices (d) All of the above
(d) Market orientation 13 ‘‘Nothing can be said with certainty about the
6 As a foreign tourist visited India, he noticed that factors of business environment’’. Why?
Indian markets, tastes, trends and regulations (a) Because business environment is simple
were different from that of his country. Which (b) Because business environment is dynamic
feature of business environment is reflected here? (c) Because business environment is certain
(a) Business environment has uncertainty (d) Because business environment is inter-related
(b) Business environment is dynamic 14 Which of the following is not a challenge faced by
(c) Business environment is a relative concept business due to LPG policy changes?
(d) All of the above (a) Increasing competition
7 ........... assists in planning and helps in policy (b) Rapid changes in technological environment
formation. (c) Lesser need for developing human resources
(a) Group dynamics (b) Business environment (d) None of the above
(c) Turn around management 15 Which dimension of business environment requires
(d) None of the above putting a statutory warning on the packets of
8 Identify the examples of changes in business tobacco products?
environment that affect business enterprises. (a) Technological environment
(a) Increase in taxes by government can make products (b) Economic environment
expensive, causing reduced demand (c) Legal environment
(b) Change in taste and fashion may shift demand (d) All of the above
(c) Technological improvements may render existing
products obsolete 16 Which dimension of business environment is
(d) All of the above concerned with improvement and innovations,
which provides new ways of producing goods and
9 Business environment is ............., as it consists of
services?
inter-related factors affecting business enterprises (a) Technological environment
at the same time. (b) Economic environment
(a) simple (b) complex
(c) Legal environment
(c) dynamic (d) Either (a) or (c)
17 ‘‘Trends refer to changes and inclination towards 25 Fiscon Electricals Ltd was operating its business
new products and services’’. This statement in London. The company started exporting its
describes significant effect of which environment products to India when the Prime Minister
on business? announced relaxation in import duties on electrial
(a) Economic environment (b) Social environment products. The company also appointed retailers in
(c) Political environment (d) None of these India who had a direct on-line links with the
18 Which of the following statements regarding suppliers to replenish stocks when needed.
privatisation is correct? Identify the dimension(s) of business environment
(a) Privatisation is panacea for all economic problems highlighted in the given case.
(b) Privatisation always leads to attaining social and (a) Economic environment
economic efficiency (b) Political environment
(c) Privatisation may result in unbalanced development (c) Both (a) and (b)
of industries in the country (d) None of the above
(d) None of the above 26 Many multinational food joints such as Mc
19 Just after declaration of Lok Sabha elections 2019 Donalds, Domino’s etc have altered their menu
results, the Bombay Stock Exchange price index according to Indian taste and culture. Name the
rose by 2800 points in a day. This statement dimension of business environment which is
signifies the effect of which environment? responsible for this step.
(a) Technological environment (a) Social (b) Legal
(b) Political environment (c) Political (d) Economic
(c) Legal environment
27 The ……… means the sum total of all individuals,
(d) Economic environment
institutions and other forces that are outside the
20 Business enterprises cannot work in control of a business enterprise but that may affect
(a) isolated environment (b) complex management its performance.
(c) uncertain management (d) None of these (a) management principles
21 .......... refer to changes and inclination towards (b) business environment
new products. (c) economic environment
(a) Traditions (b) Values (d) social environment
(c) Trends (d) None of these 28 “Spirit of invention and innovation among people”
22 What is included in legal environment of business? is the component of which environment?
(a) Several acts passed by government (a) Legal environment
(b) Court judgements (b) Technological environment
(c) Statutory warning prescribed under law (c) Social environment
(d) All of the above (d) Economic environment
23 Liberalisation, globalisation and privatisation are 29 Seeing the need of connecting restaurants/food
the aims of outlets to people, Zomato established its app as a
(a) economic planning food delivery platform. Which importance of
(b) land reforms business environment is highlighted here?
(c) socialistic pattern of society (a) It enables the firm to identify opportunities and
(d) economic reforms getting the first mover advantage
(b) It helps in tapping useful resources
24 Managers needs to be dynamically competent for (c) It helps in coping with rapid changes
all the changes happening in the environment. In (d) It helps in improving performance
the music industry. CDs were major source of
entertainment in the past but gradually video 30 Hon’ble Prime Minister Shri Narendra Modi
cassettes replaced them. So, managers had to initiated and coined the slogan “Make in India.”
adopt in their organisation accordingly. Identify Which dimension of business environment does
the environment change highlighted here. this pertain to?
(a) Social environment change (a) Economic environment
(b) Technological environment change (b) Political environment
(c) Economic environment change (c) Legal environment
(d) Both (a) and (b) (d) Social environment
ANSWERS
1. (b) 2. (d) 3. (d) 4. (b) 5. (c) 6. (c) 7. (b) 8. (d) 9. (b) 10. (a)
11. (d) 12. (c) 13. (b) 14. (c) 15. (c) 16. (a) 17. (b) 18. (c) 19. (b) 20. (a)
21. (c) 22. (d) 23. (d) 24. (b) 25. (c) 26. (a) 27. (b) 28. (b) 29. (a) 30. (b)
CHAPTER 04
Planning
Concept of Planning 7. Planning is a Mental Exercise It is a mental
exercise as it requires creativity, imagination and
Planning is deciding in advance the objectives to be achieved
higher thinking skills with sound judgement.
during a given period, formulating alternative courses of
action to achieve them and selecting the best course of action.
Importance of Planning
Planning bridges the gap between where we are and where we Planning is certainly important as it tells us where to go.
want to go. It is a mental exercise that requires imagination, The major benefits of planning are
foresight, sound judgement, creativity and innovation. It
requires taking decisions, since it involves making choice 1. Planning provides Direction By stating in advance
from various alternative courses of action. It is concerned how work is to be done in future, planning provides
with both ends and means, i.e. what is to be done and how it direction for action.
is to be done. 2. Planning reduces the Risk of Uncertainties By
deciding in advance, planning shows the way to deal
According to ME Hurley, “Planning is deciding in advance
with changes and uncertain events.
what is to be done. It involves the selection of objectives,
policies, procedures and programmes among alternatives”. 3. Planning reduces Overlapping and Wasteful
Activities With planning, various activities of
Features of Planning different departments and divisions are carried on in
Following are the features of planning which throw light on an effective manner, which reduces the overlapping
its nature and scope and wasteful activities.
1. Planning focuses on achieving Objectives Planning 4. Planning promotes Innovative Ideas It is an
involves setting goals and determining the most intellectual process, which involves finding better
economical and viable course of action to achieve the ideas and methods to perform a particular job.
predetermined goals. 5. Planning facilitates Decision-making It helps the
2. Planning is a Primary Function of Management It manager to look into the future and choose amongst the
lays down the base for all other functions of various alternative courses of action, in order to find out
management. All other managerial functions are the most viable, economical and suitable plan.
performed within the framework of the plans drawn. 6. Planning establishes Standards for Controlling It
3. Planning is Pervasive It is required at all levels of provides the standards against which actual
management as well as in all the departments of the performance is measured.
organisation.
Limitations of Planning
4. Planning is Continuous Plans are made for a specific
Planning has both internal and external limitations.
time period. At the end of such time period, new plans
have to be drawn. Internal Limitations of Planning
5. Planning is Futuristic It is essentially looking ahead, Following are the internal limitations of planning
as it is based on forecasting and is prepared for the
1. Planning leads to Rigidity A specific plan made in
future.
an organisation clearly indicates the objective to be
6. Planning involves Decision-making Planning is achieved and the ways of doing work. Since, a
essentially the process of choosing among various manager may not be able to change these plans, it
alternatives. leads to rigidity.
2. Planning may not Work in a Dynamic 3. Identifying Alternative Courses of Action Once the
Environment Business environment consists of social, objectives and planning premises are established, it
economic, legal and other factors that keep on becomes necessary to discover the various courses of
changing. The organisation has to adapt itself to such action, which may be used to achieve the established
changes. objectives. These alternatives may be routine or
But, sometimes planning cannot assess future trends innovative.
exactly and thus fails in a dynamic environment. 4. Evaluating Alternative Courses The next step is to
3. Planning reduces Creativity It is an activity, which weigh the pros and cons of each alternative. It is
is done by the top management and the rest of the necessary to evaluate the positive and negative aspect of
members just implement these plans. each alternative in the light of the objectives to be
achieved.
Due to this, much of the initiative or creativity
inherent in managers or other members gets lost or 5. Selecting an Alternative In this step, the best plan
reduced, and there is nothing new or innovative in the has to be adopted and implemented. An ideal plan
organisation. would be the one which is most profitable, most
feasible and has the least negative consequences.
4. Planning involves Huge Cost It usually involves a lot
of time, effort and cost of the managers. 6. Implementing the Plan This step is concerned with
putting the plan into action and doing what is required.
5. Planning is a Time Consuming Process Sometimes,
plans to be drawn up take so much of time that there 7. Follow-up Action Planning is a continuous process, so
is not much time left for their implementation. This the managers keep on following up the plans to see that
leads to failure of planning. activities are performed as per the schedule or not.
6. Planning does not guarantee Success Success of
planning rests on its implementation. Lack of proper Plan
implementation may lead to failure of planning. A plan is a specific action proposed to help the organisation in
achieving its objective. In other words, it can be said that it is
External Limitations of Planning a document that outlines how goals are going to be achieved.
Following are the external limitations of planning are
Types of Plan
1. Unforeseen Events Natural calamities like floods,
Certain plans have a short-term horizon and help to achieve
earthquakes, etc are beyond the control of managers,
operational goals. These are
that cause failure of plans.
2. Political Outlook Political outlook towards industries 1. Single Use Plan
and their intervention also affects the company’s These plans are formulated to achieve a specific target or for
plans. a one-time event. After reaching that target, the plan
3. Environmental Changes Changes in social, becomes useless. Single use plan is one time plan specifically
economic, legal and technological environment may designed to achieve a particular goal. They are not applicable
affect forecasting and planning. to recurring situations. They may be in the form of budgets,
programmes and projects. They contain detailed analysis of
4. Competitors’ Strategy Sometimes, a change in the
work to be done, name of employees involved and time limits
strategy of competitor may lead to failure of planning.
for completion of work.
Process of Planning 2. Standing Plan
The process of planning involves a sequence of activities These plans are formulated by companies to deal with
performed by managers. situations that can occur again and again.
These activities are as follows They are usually made once but are modified from time to
1. Setting Objectives The first step in planning is to time, as per the needs of the business. It includes policies,
define and describe clearly the objectives of the procedures, methods and rules. These plans are applied to
organisation and each department or unit within the recurring situations for enhancing efficiency and effective
organisation. Once decided, these objectives should be decision-making. In an organisation, there are certain other
communicated to all the units and employees. plans also, which are as follows
2. Developing Premises Planning is concerned with 1. Objectives It refers to the desired future positions that
future, which is uncertain and every planner is using an organisation seeks to reach. They are the ‘ends’ of
conjecture about what might happen in future. managerial activity and the base for controlling.
Therefore, the manager is required to make certain They are framed by the top management and
assumptions about future. These assumptions are accordingly objectives are set for different departments
known as premises. and units.
Business Studies 19
Objectives should be set in specific, quantitative terms, 5. Method It provides the prescribed ways or manner, in
in the form of a written statement of desired results, to which a task has to be performed considering the
be achieved within a given time period. objectives. They are formalised and standardised ways
2. Strategy It is a comprehensive plan, which includes of accomplishing repetitive and routine jobs, thus, are
three dimensions for achieving organisational goals considered under the standing plan.
● Determining long-term objectives. It deals with a task which may be a step of a procedure
● Adopting a particular course of action.
and specifies how a step is to be performed.
● Allocating resources necessary to achieve objectives. 6. Rules They are specific statements that inform what is
to be done. There is no discretion allowed in rules. They
It helps to define the organisation’s scope and direction
must be followed strictly and one cannot make any
in the long-run. Therefore, it is formed on the basis of
changes in them. Rules are the simplest type of plans
changes occurring in business environment.
because there is no change or compromise in following
3. Policy It is a general statement that defines the them.
boundaries, within which decisions are made and they
7. Budget It is a statement of expected results expressed
direct decisions towards the accomplishment of
in numerical terms. It is a projection designed to
objectives.
define the anticipated costs and results in numerical
It comes under the standing plan, as they guide terms of a single project. Thus, it comes under the single
managerial decision-making and action on a regular use plan.
basis. They are of two kinds
Since, budgets are prepared in numerical terms, it
● Major policies, which are for all to know such as
becomes easier to compare them with the actual
customers, clients, etc. performance. Thus, it is considered as a control device,
● Minor policies, which are for insiders and provide vital
prepared during the planning process.
information to the employees.
8. Programme They are the detailed statements about a
4. Procedure It describes the exact manner, in which a project which outline the objectives, policies,
certain activity is to be performed. It is a chronological procedures and budgets which are to be implemented
sequence of steps to be taken. These also come under in the project.
the standing plan as it prescribes ways to handle
These are concrete action plans indicating how, when
routine problems and execute policies. They are usually
and by whom work is to be done.
meant for insiders to follow.
Practice Questions
1 Which of the following is an activity, which This statement describes which function of
requires a manager to look ahead and anticipate planning?
changes? (a) Planning focuses on achieving objectives
(a) Organising (b) Staffing (b) Planning is pervasive
(c) Planning (d) Controlling (c) Primacy of planning
(d) Planning is futuristic
2 Planning gives direction, reduces the impact of
change, minimises waste and redundancy and 5 ‘‘Planning is a thinking process, the organised
(a) establishes chaos among departments foresight, the vision based on facts and experience,
(b) sets the basis used for promotion of individuals i.e. required for intelligent action.’’ This definition
within the organisation of planning is given by
(c) planning guarantees safeguard from external (a) Henri Fayol (b) Alfred and Beatty
environment (c) Hurley (d) FW Taylor
(d) sets the standards used in controlling
6 ‘‘Planning provides the standards against which
3 Planning involves ............... . It is essentially the actual performance is measured.’’ In the light of
process of choosing among various alternatives. this statement, identify the benefit of planning
(a) mental exercise (b) decision-making from the following.
(c) wasteful activities (d) Both (a) and (c) (a) Planning establishes standard for controlling
4 ‘‘All other managerial functions are performed (b) Planning provides direction
within the framework of the plans drawn. Thus, it (c) Planning is a mental exercise
(d) Planning involves decision-making
can be said that planning preceeds other
functions.’’
7 Name the most critical step in the process of 17 Identify the key elements of planning from the
planning. following.
(a) Implementing the plan (a) Determining the objectives
(b) Developing the plan (b) Identifying alternative courses of action
(c) Selecting the best possible course of action (c) Selecting the best course of action
(d) None of the above (d) All of the above
8 What is meant by ‘follow-up action’ as the step 18 Name the type of plan in which the move of
involved in the process of planning? competitors is considered.
(a) Managing the plan (a) Budget
(b) Checking the plan (b) Rule
(c) Selecting the plan (c) Strategy
(d) None of the above (d) Method
9 Some plans are used repeatedly in similar 19 Manav Ltd. prepares budget in its Annual General
situations. Identify the type of plan. Meeting for the year 2021-2022. What kind of plan
(a) Standing plan (b) Single use plan is it?
(c) Policy plan (d) None of these (a) Single use plan (b) Standing plan
(c) Objective plan (d) None of these
10 Name the type of plan, which is in the form of
general statements and channelises energies 20 What is meant by ‘selecting an alternative’ as a
towards a particular direction. step in the planning process?
(a) Budget (b) Rule (a) Choosing the best course of action
(b) Implementing the best course of action
(c) Policy (d) Method
(c) Planning the best course of action
11 A company wants to introduce a new product. (d) Managing the best course of action
What type of plan should it prepare? 21 Which of these leads to failure of planning?
(a) Objective (b) Strategy (a) Change in government policy
(c) Policy (d) None of these (b) Pandemic
(c) Change in technology
12 Which plan is defined as the formalised or (d) All of the above
systematic way of doing routine and repetitive
jobs? 22 ‘Developing premises’ is a step in which function of
(a) Objective (b) Strategy management?
(c) Method (d) None of these (a) Planning (b) Organising
(c) Staffing (d) Controlling
13 Single use plans are 23 Which is the fourth step in planning?
(a) formulated to achieve a specific target (a) Identifying alternative courses of action
(b) responsible and can be easily fixed (b) Evaluating alternative courses
(c) comes under the standing plan (c) Selecting an alternative
(d) None of the above (d) Implementing the plan
14 “Planning is deciding in advance what is to be 24 How planning reduces overlapping and wasteful
done. It involves the selection of objectives, activities?
policies, procedures and programmes among (a) It helps the manager to look into the future and
alternatives.” This definition has been given by choose amongst the various alternatives.
(a) ME Hurley (b) It serves as the base for coordination by avoiding
(b) Peter Drucker confusion and misunderstanding.
(c) Henri Fayol (c) It enables a manager to look ahead and anticipate
(d) Chester Barnard changes.
15 Plans are made for a specific time period. At the (d) None of the above
end of such time period, new plans have to be 25 “Planning involves application of mind and
drawn. Identify the feature of planning. foresight”. What importance of planning is
(a) Planning is pervasive highlighted here?
(b) Planning is futuristic (a) Promotes innovative ideas
(c) Planning involves decision-making (b) Facilitates decision-making
(d) Planning is continuous (c) Establishes standard
16 Managers at the operational or supervisory level (d) Provides direction
make plans for 26 Which of these is not a feature of planning?
(a) strategic direction of organisation (a) Futuristic
(b) departmental working (b) Mental exercise
(c) day-to-day working (c) Reduces overlapping
(d) None of the above (d) Continuous process
Business Studies 21
27 If there is no planning, employees would work in 29 Natural disaster like flood in Kerala lead to failure
different directions and would not be able to of production sales strategies of many companies.
achieve its goals. In the light of this statement, Which limitation of planning is highlighted?
identify the importance of planning. (a) Planning leads to rigidity
(a) Planning reduces the risk of uncertainties (b) Planning may not work in dynamic environment
(b) Planning facilitates decision-making (c) Planning reduces creativity
(c) Planning provides direction (d) Planning does not guarantee success
30 Madhuban Oils Ltd. policy is to sell only for cash.
28 Having transformed 3,000 Kirana stores across In 2021, for the first time company’s number one
eight cities into virtual super markets, the position in the industry has been threatened
start-up quick flee further decided in advance, because other companies started selling oil on
to collaborate with 18,000-22,000 store owners credit also. But, the manager of Madhuban Oils
in top 40 cities of the country by the end of this Ltd. continued to rely on its previously tried and
year. tested successful plans, which didn’t work because
The company has set its eye on digitising over the environment is not static. This led to decline in
2,00,000 Kirana stores over next 24-30 months. sales of Madhuban Oils Ltd.
Identify the step in the process of planning The above said case highlights the limitation(s) of
discussed above. planning which led to decline in its sales. Identify
(a) Setting objectives such limitation(s).
(b) Developing premises (a) Planning does not guarantee success
(c) Evaluating alternative courses (b) Planning may not work in dynamic environment
(d) Selecting an alternative (c) Planning leads to rigidity
ANSWERS
1. (c) 2. (d) 3. (b) 4. (c) 5. (b) 6. (a) 7. (c) 8. (b) 9. (a) 10. (c)
11. (b) 12. (c) 13. (a) 14. (a) 15. (d) 16. (c) 17. (d) 18. (c) 19. (a) 20. (a)
21. (d) 22. (a) 23. (b) 24. (b) 25. (a) 26. (c) 27. (c) 28. (a) 29. (d) 30. (d)
CHAPTER 05
Organising
Concept of Organising Process of Organising
Organising is a process of identifying and grouping different The following steps are to be undertaken in the organising
activities in the organisation and bringing together the process
physical, financial and human resources to establish the most 1. Identification and Division of Work The first step
productive relations for the achievement of specific goals. in the process of organising involves identifying and
According to Theo Haimann, “Organising is the process of dividing the work that has to be done in accordance
defining and grouping the activities of the enterprise and with previously determined plans.
establishing authority relationships among them”. 2. Departmentalisation Once, work has been divided
into small and manageable activities, then those
Importance of Organising activities which are similar in nature, are grouped
The organising function helps in the growth and survival of an together. This process is called departmentalisation.
enterprise in a dynamic environment by providing the 3. Assignment of Duties Once the departments are
following benefits created, each department is placed under the charge
1. Benefits of Specialisation Systematic allocation of work of an individual, called departmental head. Then,
reduces the workload as well as enhances productivity. As each job is allocated to an individual, according to
each task is repetitively performed by a worker, it helps his knowledge and skill.
him to gain experience and attain specialisation. 4. Establishing Reporting Relationships In the
2. Clarity in Working Relationships The establishment of organisation, each employee has some authority as
working relationships clarifies the lines of communication well as responsibility. It is necessary that every
and specifies who is accountable to whom. individual must know whom he has to take orders
3. Optimum Utilisation of Resources It leads to proper from and to whom he is answerable. This creates
usage of all materials, financial and human resources by superior subordinate hierarchy and helps in
proper assignment of jobs. coordinating various activities in the organisation.
4. Adaptation to Change It facilitates modification in
Organisation Structure
organisational structure and revision of inter-relationships
among people in order to adapt to environmental changes. An organisation structure it can be defined as the
framework within which managerial and operating tasks
5. Effective Administration It gives a clear description of
are performed. It specifies relationships between people,
duties and responsibilities of each individual. This helps to
work and resources. This structure facilitates the flow of
avoid confusion regarding work and avoids duplication of
work and communication in the enterprise.
activities.
6. Development of Personnel It stimulates creativity Types of Organisation Structures
amongst the managers. Effective delegation allows the The organisation structure can be classified under two
managers to reduce their workload by assigning routine categories which are as follows
jobs to their subordinates.
1. Functional Structure
7. Expansion and Growth It helps in the growth and An organisation structure in which departments are
diversification of an enterprise by adding more job created on the basis of different functions performed in
positions, departments and new lines of product. the organisation is called a functional structure.
Business Studies 23
Suitability of Functional Structure Disadvantages of Divisional Structure

It is most suitable when ● Conflict may arise between different divisions on allocation
● The size of the organisation is large, generally with a of funds and other resources.
● There is a duplication of physical facilities and functions,
single product or a small number of similar products.
● Has diversified activities.
which leads to increase in cost.
● Greater autonomy to divisional heads may lead to misuse of
● Operations require a high degree of specialisation.
authority.
Advantages of Functional Structure ● Managers in each division focus on their own objectives,
● It leads to occupational specialisation, since emphasis is

without thinking of the organisational goals.
placed on specific functions and repeated performance
leading to efficient functioning. Formal Organisation
● It promotes control and coordination within a department An organisation is said to be formal when the structure is so
because of similarity in the tasks performed. designed and established to achieve systematic working and
● It leads to increased efficiency and profits.
efficient utilisation of resources. It is an official system of
clearly defined activities, job description, rules, procedures
● It leads to minimal duplication of efforts, which results in
and relationships, which are intended to divide and integrate
economies of scale, and lower costs.
the activities of the organisation.
● It makes training of employees easier as the focus is only
According to Louis Allen, ‘‘The formal organisation is a
on a limited range of skills. system of well-defined jobs, each bearing a definite measure
Disadvantages of Functional Structure of authority, responsibility and accountability’’.
● Work is assigned as per the specialisation. Due to this,
specialists working in different departments may not be Features of Formal Organisation

able to see the perspective of the organisation as a whole.
● It clarifies relationships and helps to know who has to
report to whom.
● It becomes difficult to hold a particular department
responsible for any problem.

● It is a means to achieve objectives specified in the plans.
● When organisation grows, structure of departments
● It facilitates interlinking of various departments, levels and
people in the organisation.
becomes complicated and creates problem in
coordination. ● It is deliberately designed by the top management.
● Conflict often arises when the interests of two or more
● It places more emphasis on work rather than interpersonal
departments are not compatible. relations.
2. Divisional Structure Advantages of Formal Organisation

An organisation structure in which various departments are ● There is no confusion regarding work to be done, by each
created on the basis of products, territory or region, is called individual.
a divisional structure. ● Unity of command is maintained, which avoids confusion
and conflicts.
Suitability of Divisional Structure ● It helps in achievement of goals, by emphasising systematic
It is most suitable when working.
● Organisation deals in large variety of products using ● It makes fixation of responsibility clear and easier.
different resources. ● It provides stability to the organisation.
● Growth prospects are high.
Disadvantages of Formal Organisation
● Organisation wants to diversify into different products
● It may lead to procedural delays and delayed
and even expand to different territories. decision-making, due to stringent rules and policies.
Advantages of Divisional Structure ● Creativity gets reduced, as it does not allow any deviations
● It helps the managers to develop varied skills related to a
from the rigidly laid down policies.
product and facilitates managerial development. ● It does not fulfil social needs of the employees, as the
● Fixation of responsibility and accountability is easy, as
emphasis is on work at all times.
divisional heads are responsible for the profits and losses Informal Organisation
of their divisions.
Interaction among people at work gives rise to a network of
● With more initiative and flexibility, decisions are taken
social relationships among employees. This is called informal
much faster in divisional structure. organisation. Through frequent interaction and
● It facilitates expansion and growth as new division can be
communication, people tend to form social friendly groups to
added without interrupting the existing operations. satisfy their social needs.
According to Chester Barnard, “An informal organisation is an Thus, it flows upward i.e. a subordinate is always
aggregate of interpersonal relationships without any conscious responsible to his superior. Granting authority is
purpose but which may contribute to joint results”. necessary to create responsibility and facilitates its
fulfilment.
Features of Informal Organisation 3. Accountability It implies being answerable for the
● It originates from within the formal organisation, due to final outcome. Once authority has been delegated
interaction among employees. and responsibility accepted, one cannot deny
● The standard of behaviour evolve from group norms. accountability. It is the obligation to carry out
● Communication is free and independent. responsibility and exercise authority. It flows
● It emerges spontaneously and not created deliberately. upwards as subordinate will be accountable to his
● It has no definite structure or form. superior, generally enforced through regular
feedback.
Advantages of Informal Organisation
● Prescribed lines of communication are not followed. Thus, it
facilitates quick feedback and spreads information faster.
Importance of Delegation
Delegation is important because of the following reasons
● It provides a sense of belongingness and gives due respect to
social and psychological needs. 1. Effective Management By empowering the
employees, the managers are able to function more
● It provides the necessary environment for individual creativity
efficiently as they get more time to concentrate on
and innovation.
important matters.
● It contributes to fulfilment of goals, promoting the feeling of
cooperation among employees. 2. Employee Development Delegation provides more
opportunities to the employees to utilise their talent
Disadvantages of Informal Organisation and develop latent abilities.
● Informal organisation structure spreads rumours. 3. Motivation of Employees Delegation provides a
● It opposes the policies and changes of management. feeling of status and recognition to subordinates, as
● It generally prefers status quo and existing work routine. it is not only a process of sharing workload, but also
involves trust of the superior on his subordinate.
● It gives importance to individual interest as compared to
organisational interest. 4. Facilitation of Growth Delegation helps in the
expansion of an organisation by providing a ready
● It pressurises members to conform to group expectations.
workforce to take up leading positions in new
ventures.
Delegation
Delegation refers to the downward transfer of authority from a 5. Basis of Management Hierarchy Delegation of
superior to subordinate. It is a pre-requisite to the efficient authority establishes superior subordinate
functioning of an organisation because it enables a manager to relationships, which helps employees to know ‘who
use his time on high priority activities. has to report to whom’.
6. Better Coordination The elements of delegation
According to Theo Haimann, ‘‘Delegation of authority means
helps to define the powers, duties and
merely the granting of authority to subordinates to operate
responsibilities related to various positions in an
within prescribed limits’’.
organisation. This helps to avoid overlapping and
Elements of Delegation duplication of work and facilitates coordination.
Following are the essential elements of delegation
Decentralisation
1. Authority The term authority implies the right of an Decentralisation of authority means systematic dispersal
individual to take decisions and to command his of authority among all departments and at all levels of
subordinates. management for taking decisions and actions appropriate
The concept of authority arises from the position in the at the respective levels. An organisation is said to be
scalar chain, which is highest at the top and declines as decentralised when managers at middle and lower levels
we move down the hierarchy.Thus, it flows from top to have been given the authority to take decisions for their
bottom. respective areas.
2. Responsibility It is the obligation of a subordinate to According to Louis Allen, ‘‘Decentralisation refers to
properly perform the assigned duty. It arises from a systematic efforts to delegate to the lowest level all
superior subordinate relationships because the subordinate authority except that which can be exercised at central
is bound to perform the duty assigned to him. points’’.
Business Studies 25
Importance of Decentralisation 5. Facilitates Growth It provides greater autonomy to

Decentralisation is important because of the following lower level managers and departmental heads. This
reasons encourages them to function more efficiently to prove
their supremacy, and facilitate expansion and growth of
1. Develops Initiative Among Subordinates It helps the organisation.
to promote self-reliance and confidence amongst the
subordinates. 6. Better Control It makes it possible to evaluate
performance at each level and making the departments
This is because, lower managerial levels have been accountable for their own results. Feedback is quick and
given freedom to take their own decisions and they leads to better control.
learn to depend on their own judgement.
2. Develops Managerial Talent for the Future Formal Differences between Delegation and Decentralisation
training along with experience of handling Basis Delegation Decentralisation
independent assignments helps to create a reservoir of
qualified and capable managers, who can take up more Purpose To lessen the burden To increase the role of the
of the manager. subordinates in the organisation
challenging positions in the upcoming ventures of the by giving them more autonomy.
organisation.
Scope It has narrow scope as It has wider scope as it implies
3. Quick Decision-making Under decentralisation, it is limited to superior extension of delegation to the
authority to make decisions is placed in the hands of and his immediate lowest level of management.
those, who are responsible for executing the decisions. subordinate.
Since, decisions are taken at levels nearest to the point
Status It is a process followed to It is the result of the policy
of execution, there is no delay or distortion of share tasks. decision of top management.
information.
Nature It is a compulsory It is an optional policy decision.
4. Relief to Top Management It helps to reduce the act because no It is done at the discretion of
amount of direct supervision over subordinates by individual can perform the top management only.
giving them freedom to take decision and act on their all the tasks on his
own. own.
Practice Questions
1 Which of the following is not an element of 6 For delegation to be effective, it is essential
delegation? that responsibility be accompanied with necessary
(a) Accountability (b) Authority (a) authority
(c) Responsibility (d) Informal organisation (b) manpower
2 A network of social relationship that arise (c) incentives
(d) promotions
spontaneously due to interaction at work is called
(a) Formal organisation (b) Informal organisation 7 Span of management refers to
(c) Decentralisation (d) Delegation (a) number of managers
(b) length of term for which a manager is appointed
3 Which of the following does not follow the scalar
(c) number of subordinates under a superior
chain? (d) number of members in top management
(a) Functional structure (b) Divisional structure
(c) Formal organisation (d) Informal organisation.
8 The form of organisation known for giving rise to
rumours is called
4 A tall structure has a
(a) Centralised organisation
(a) narrow span of management (b) Decentralised organisation
(b) wide span of management (c) Informal organisation
(c) no span of management
(d) Formal organisation
(d) less levels of management
9 Grouping of activities on the basis of product lines
5 Centralisation refers to
is a part of
(a) retention of decision making authority
(b) dispersal of decision making authority (a) delegated organisation
(c) creating divisions as profit centres (b) divisional organisation
(d) opening new centres or branches (c) functional organisation
(d) autonomous organisation
10 Grouping of activities on the basis of functions is a 19 If a firm wants to diversify its business into
part of different products and expand to different
(a) decentralised organisation territories, which organisation structure would be
(b) divisional organisation suited for this firm?
(c) functional organisation (a) Divisional structure (b) Functional structure
(d) centralised organisation (c) Informal structure (d) Network structure
11 The organisation process starts with 20 Mrs. Sharma has joined a new organisation named
(a) assignment of duties Realistic Ltd. On her first day to office,
(b) establishing reporting relationships she analysed that there were no different
(c) identification and division of work departments assigned for various product lines.
(d) departmentalisation She observed a separate team structure for each of
12 Which of the following is/are the importance of them and also that they functioned independently
organising? of one another. From her analysis, what can we
(a) Adaptation to change make out of the Realistic Ltd.?
(b) Effective administration (a) It is a functional form of organisation
(c) Expansion and growth (b) Divisional structure is the way of the organisation
(d) All of the above (c) The company follows the informal structure
13 In the context of process of organising, .......... (d) No observation can be made out of her analysis
creates superior subordinate hierarchy and helps 21 What explains informal organisation the best?
in coordination among various activities of the (a) All departments in an organisation reports to a
organisation. coordinating head
(a) assignment of duties (b) Network of personal and social relationships that
(b) departmentalisation arise as people associate with other people in a work
(c) identification and division of work environment
(d) establishing reporting relationships (c) This structure is created intentionally by the
managers for achievement of organisational goal
14 Organisation leads to optimal utilisation of (d) None of the above
resources which helps in
(a) prevention of confusion 22 Formal organisation leads to
(b) minimisation of wastage (a) freedom and independence
(c) increased project timeline (b) procedural delays and delayed decision-making
(d) Both (a) and (b) (c) more emphasis on the interpersonal relations
15 Once departments are created, each department is (d) faster spreading of information
placed under the charge of a ………… . 23 Informal organisation provides necessary
(a) branch manager environment for individual’s ……… .
(b) departmental head (a) authority
(c) HR manager (b) accountability and responsibility
(d) marketing head (c) creativity and innovation
16 Which of the following is/are true about functional (d) None of the above
structure? 24 Which of the following statements is not true?
(a) It is economical as there is minimal duplication of (a) Formal organisation originates as a result of
resources company’s rules and policies
(b) It is costlier as there is duplication of resources (b) Informal organisation arises out of personal
(c) It is easier to fix responsibility on each division qualities of individuals
(d) Both (b) and (c) (c) Under formal organisation, flow of communication
takes place in any direction
17 Functional structure of organisation is most (d) Formal organisation is rigid in nature
suitable
(a) in case of diversification of activities 25 One of the disadvantages of informal organisation
(b) in case of large organisation is that it generally prefers
(c) when high degree of specialisation is required (a) deviance
(b) status quo
(c) disruptiveness
18 Divisional structure can bring ............ that can (d) disorderliness
lead to incompatibilities. 26 ........... develops initiative among subordinates.
(a) specialisation (a) Delegation
(b) compartmentalisation (b) Authority
(c) departmentalisation (c) Obligation
(d) All of the above (d) Decentralisation
Business Studies 27
27 Minimum freedom for managers and maximum 32 On what, the degree of centralisation and
constraints are main features of decentralisation depend?
(a) total autonomy (b) total decentralisation (a) The amount of authority delegated to the middle
(c) total centralisation (d) total congruency level
(b) The amount of authority delegated to the lowest
28 Being answerable to the final outcome is a phrase level
which can be associated with (c) The amount of authority delegated to the highest
(a) authority (b) duty level
(c) responsibility (d) accountability (d) The amount of authority delegated to the topmost
29 A company is very flexible in its working. It wants level
the proper participation of all the employees in the 33 Organising can be defined as
organisation. Also, the company wants to expand (a) a structure
and hence it uses the feature ‘development of (b) a process
managerial talent for future.’ In which aspect is it (c) Both (a) and (b)
covered? (d) a function of planning
(a) Decentralisation (b) Formal organisation
(c) Authority (d) Continuity 34 I refer to a network of personal and social
relationships which spontaneously originates
30 Which of the following is not an importance of within the formal set up. Who am I?
delegation of authority? (a) Informal organisation
(a) Effective management (b) Party organisation
(b) Relief to top-managers (c) Social organisation
(c) Facilitation of growth (d) Formal organisation
(d) Basis of management hierarchy
35 ........... organisation emerges from ............
31 An organisation structure in which various organisation.
departments are created on the basis of products, (a) Divisional, functional
territory or region is called a (b) Formal, informal
(a) divisional structure (b) functional structure (c) Informal, formal
(c) matrix structure (d) staff structure (d) Functional, divisional
ANSWERS
1. (d) 2. (b) 3. (d) 4. (a) 5. (a) 6. (a) 7. (c) 8. (c) 9. (b) 10. (c)
11. (c) 12. (d) 13. (d) 14. (d) 15. (b) 16. (a) 17. (d) 18. (b) 19. (a) 20. (b)
21. (b) 22. (b) 23. (c) 24. (c) 25. (b) 26. (d) 27. (c) 28. (d) 29. (a) 30. (b)
31. (a) 32. (b) 33. (c) 34. (a) 35. (c)
CHAPTER 06
Staffing
It consists of specialists for all areas related to Human Resource
Concept of Staffing Management (HRM). It includes many specialised activities to
Staffing may be defined as the process of hiring and be performed by HR personnel, which are as follows
developing the required personnel to fill in various ● Recruitment, i.e. searching for eligible candidates.
positions in the organisation. ● Analysing jobs and preparing job description.
According to Koontz and O’Donnel, “The managerial ● Developing compensation and incentive plans.
function of staffing involves managing the organisational ● Training and development of employees.
structure through proper and effective selection, appraisal ● Maintaining labour relations and union management
and development or personnel to fill the roles designed relations.

into the structure”. ● Handling grievances and complaints
● Providing social security and welfare of employees.

Importance/Need of Staffing ● Defending the company in law suits and avoiding legal
Staffing is an important function of management. complications.
Following points highlight the same
Therefore, staffing is basically extended to Human Resource
1. Obtaining Competent Personnel It ensures the
Management (HRM), in order to attain specialisation in the
availability of the most suitable and capable person
area of human resource.
for various jobs.
Following are the steps in the staffing process
2. Higher Performance By placing the right person at
the right job, it ensures better performance. 1. Estimating the Manpower Requirements It involves
forecasting and determining the number and kind of
3. Continuous Survival and Growth It ensures the
manpower required by the organisation in future. It
continuous survival and growth of the enterprise,
involves workload analysis and workforce analysis.
through the successive planning for building
Workload analysis helps a manager to assess the number
managers.
and type of human resources necessary to perform various
4. Optimum Utilisation of Human Resource It helps jobs in the organisation, whereas, workforce analysis
in avoiding overmanning, under utilisation of helps him to know the number and type already available.
manpower and high labour cost. It also helps in 2. Recruitment It may be defined as the process of searching
preventing the disruption of work by indicating in for prospective employees and stimulating them to apply
advance about the likely shortage of employees. for jobs in the organisation.
5. Helps in achieving Organisational Goals It 3. Selection In this step, right candidate is chosen for the
improves job satisfaction by providing fair right job from the pool of candidates obtained through
remuneration and regular assessment which helps in recruitment. This process ensures that the organisation
achieving organisational goals. gets best among available and it enhances the self-esteem
and prestige of those who are selected.
Staffing as a Part of Human Resource Management
Staffing function deals with the human element of 4. Placement and Orientation Placement means occupying
management. It is important because the performance of the post or position for which the person has been selected.
an organisation depends upon its human resource, its Orientation/Induction implies introducing the selected
competence and motivation. But, as organisations grow employee to other employees and familiarising him with
and number of employees increase, a separate department rules and policies of the organisation, by giving him a brief
called Human Resource Department (HRD) is formed. presentation about the company, his superiors,
subordinates and colleagues.
Business Studies 29
5. Training and Development These involve improving Merits of Internal Sources

job knowledge, skills and attitudes of employees on a ● Employees are motivated to improve their performance.
regular basis so that they may perform their jobs ● It simplifies the process of selection and placement.
efficiently. Apart from this, training helps in career ● Transfer is a tool of training the employees to prepare them
building and increasing motivation of employees. for higher jobs.
6. Performance Appraisal It means evaluating an ● It is less costly source of recruitment.
employee’s current or past performance against the

● Selected employees do not need induction training.
pre-determined standards.
● It helps to fulfil the deficiency of one department with the
7. Promotion and Career Planning It becomes
surplus of another.
necessary for all organisations to address career related
issues and promotional avenues for their employees. Demerits of Internal Sources
This will prove to be beneficial for both an employee and ● Internal sources of recruitment are not suitable for new
the organisation, as it will result in increased employee enterprises.

satisfaction and productivity, which would serve ● Restricted choice and less scope for getting fresh talent in
long-term interests of the organisation. the organisation.

8. Compensation It means all forms of pay or rewards ● The spirit of competition among the employees may be
given to an employee. It may be in the form of direct hampered.

financial payments like wages, salaries, incentives,
● When employees are sure of time bound promotions, they
commissions, etc, or indirect payments such as
become lethargic.
insurance, free housing, vacations, etc.
External Sources
Meaning of Recruitment These refer to the recruitment of candidates from outside the
Recruitment may be defined as the process of searching for organisation. External source of recruitment has the
prospective employees and stimulating them to apply for following types
jobs in the organisation. 1. Direct Recruitment Under this method, a notice is
Recruitment is regarded as a positive process as it invites a placed on the notice board of the enterprise specifying
large number of candidates towards the organisation. the details of the jobs available.
The various activities involved in the process of recruitment Job seekers assemble outside the premises of the
are organisation on a specific date and selection is done on
● Identification of sources of labour supply. the spot.
● Assessing their validity. 2. Advertisement Advertising in newspapers and trade
● Choosing the most suitable source.
journals is a common method of encouraging people to
apply for jobs.
● Inviting applications from prospective candidates.
3. Employment Exchange These are run by government

Sources of Recruitment and help to match personnel demand and supply by
serving as a link between job seekers and employers.
There are two sources of recruitment– Internal and External.
4. Labour Contractors They maintain close contacts with
Internal Sources labourers and they can provide large number of workers
Internal sources refer to recruitment from within the at short notice.
organisation, from the existing staff and employees. 5. Web Publishing Internet is becoming a common source
The important internal sources of recruitment are as follows of recruitment these days. There are many websites like
naukri.com, monster.com, etc. which are designed to
1. Transfer It refers to shifting an employee to a similar
provide information to both job seekers and employers.
job with no change in salary, status and responsibility.
6. Casual Callers Many business organisations keep a
It is a horizontal movement of employees, which also
database of unsolicited applicants in their files. Such
helps in the training of employees and filling
files can be recalled to fill the current vacant positions in
deficiency of one department with the surplus of
the organisation.
another.
7. Recommendations of Employees Employees of an
2. Promotion It means shifting an employee to a higher
organisation recommend the names of their friends,
post carrying higher salary, status and responsibility. It
relatives and neighbours, which prove to be a good
is a vertical shifting of employees, which helps to
external source of recruitment.
increase the motivation and satisfaction of employees.
8. Placement Agencies and Management Consultants 5. Selection Decision Candidate who are considered
These provide a nationwide service in matching suitable are selected after taking the opinion of all the
personnel demand and supply. They compile the bio-data selectors, especially the manager of the concerned
of large number of candidates and provide them to department.
organisation on demand. 6. Medical or Physical Test Selected candidate may be
Such agencies charge a fee for the service they provide to asked to get themselves throughly examined by a
organisations. They help organisations to recruit prescribed doctor within or outside the organisation.
technical, professional and managerial personnel easily. 7. Job Offer If a candidate clears all the above formalities,
9. Campus Recruitment Many organisations maintain a then a job offer is given to him so that within a
close link with universities, vocational and management reasonable time he would be able to report.
institutes, in order to recruit fresh talent and qualified 8. Contract of Employment After the acceptance of job
personnel. On one hand, it gives good opportunities to offer, a contract of employment is given to the employees
freshers to be employed in reputed firms and on the that includes terms and conditions of employment such
other hand, provide qualified manpower in a cost as job title, job description, pay, working hours, etc.
effective way.
10. Advertising on Television Advertising through Meaning of Training
television allows enterprises to reach a large number of It is a process by which the aptitudes, skills and abilities of
people, providing detailed information regarding the job employees to perform specific jobs are increased.
as well as the company.
Meaning of Development
Merits of External Sources
● Qualified personnel ● Wider choice It refers to the learning opportunities designed to help the
● Fresh talent ● Competitive spirit employees to grow. It covers not only the activities which
improve performance but also those which help to develop
Demerits of External Sources the personality of the employee.
● Dissatisfaction among existing staff
● Lengthy process ● Costly process Importance of Training and Development
To the Organisation
Meaning of Selection ● It enhances employee productivity both in terms of
It is the process of carefully screening the candidates, so as quantity and quality and leading to higher profits.
to identify and choose the most suitable person for the job. ● It equips the future manager, who can takeover in case of
According to David and Robbins, ‘‘Selection is a emergency.
managerial decision process as to predict which job ● It increases employees morale and reduces absenteeism
applicants will be successful if hired’’. and employee turnover.
● It avoids wastages of efforts and money.
Selection Process
● It helps in obtaining effective response to fast changing
The important steps in the process of selection are as follows
environment.
1. Scrutiny of Applications Applications are received in
response to the advertisement or from other sources. To the Employee
They are scrutinised in the light of requirement and ● Increased performance by an individual helps him to earn
suitability and those found unsuitable are dropped or more.
rejected. ● Training makes the employee more efficient to handle
2. Selection/Employment Tests These tests are machines. Thus, less prone to accidents.
developed by psychologists and other experts to assess ● Training increases the satisfaction and morale of
candidate’s nature, abilities and characteristics. employees.
There are several tests such as aptitude test, intelligence ● Improved skills and knowledge leads to better career of the
test, interest test, personality test, trade test, etc. individual.
3. Employment Interview In this interview, the ability Methods of Training
and suitability of a candidate for a specific job is directly There are various methods of training. These are broadly
judged by experts or specialists in the board of selection. categorised into two groups, which are as follows
4. Reference and Background Checks Many employers
On-the-Job Training Method
request names, addresses and telephone numbers of
1. Apprenticeship Programmes Under this, a master
references for the purpose of verifying information and
worker as a trainer is appointed, who guides the workers
gaining additional information of an applicant.
regarding the skill of job.
Business Studies 31
2. Coaching The superior guides and instructs the trainee 2. Films They can provide information and skill can be
as a coach. He develops managerial qualities in the demonstrated explicitly, which are not easily presented
subordinates. by other techniques.
3. Internship Training A joint programme of training in 3. Case Study Cases represent an accurate figure of real
which educational institutes and business firms impart life problems that managers have faced in the post.
training to selected candidates to gain practical work 4. Computer Modelling It stimulates the work
experience. environment by programming a computer to imitate
4. Job Rotation The trainee is systematically transferred some of the realities of the job and allows to experience
from one job to another, so that he may get varied real life situation.
experience. 5. Vestibule Training In vestibule training, employees
5. Induction Training It is a type of training given to help learn their job on the equipment they will be using and
a new employee to settle down quickly into the job by actual work environments are created in a classroom,
becoming familiar with the people, surroundings, job, etc. which is away from the actual work floor.
6. Programmed Instructions Under this method,
Off-the-Job Training Method information is broken into meaningful units and these
1. Classroom Lectures Lectures, conferences and seminars units are arranged in a proper way to form a logical and
are conducted to convey specific information, rules, sequential learning package.
procedures or methods.
Practice Questions
1 Placing right person at right job is known as 9 Under which of the following external sources of
(a) selection (b) placement (c) training (d) staffing recruitment, a business organisation keeps a
2 Which is the first step of the process of staffing? database of unsolicited applications in their files
(a) Estimation of manpower requirement and such files are re-called to fill current vacant
(b) Recruitment positions.
(c) Selection (d) Performance appraisal (a) Advertisement (b) Casual callers
3 Give one word for all the forms of payments or (c) Campus recruitment (d) None of these
rewards given to an employee. 10 For the purpose of recruiting employees, M/s X
(a) Recruitment (b) Selection Ltd placed a T.V. commercial on a leading
(c) Compensation (d) Placement channel. This is an example of recruitment
4 Staffing function deals with which element of through
management? (a) advertisement on electronic media
(a) Human (b) Machine (c) Money (d) Material (b) advertisement on print media
(c) advertisement on web
5 Under which of the following method of recruitment, (d) None of the above
a notice is placed on the notice board of the
11 Recruitment of employees from external sources
enterprise specifying details of the jobs available?
increases dissatisfaction among the present
(a) Casual callers (b) Advertisement
(c) Direct recruitment (d) Web publishing
employees as their chances of ............... are
reduced .
6 Which of these involve shifting of an employee from (a) promotion (b) voluntary retirement
one job to another? (c) salary increment (d) None of these
(a) Apprenticeship programmes (b) Coaching
(c) Internship training (d) Job rotation
12 For the purpose of selecting employees for the
post of ‘sales executives’ for its retail outlets,
7 Which source of recruitment motivates the Reliance Fresh conducted a recruitment
employees for better performance and leads to programme at Rajasthan University. Considering
satisfaction among employees? the vast number of job seekers, group discussions
(a) Placement agencies (b) On site recruitment were conducted and the candidates who were
(c) College placement (d) Internal sources selected had to face interviews and then they
8 Columns appearing in newspapers and journals for were offered job if they passed such interviews.
motivating people to apply for jobs is an example of Such programmes are often known as
(a) advertisement on T.V. (b) advertisement (a) advertisement (b) campus recruitment
(c) casual callers (d) None of these (c) campus selection (d) direct recruitment
13 Training is a systematic learning, always better (a) trade test (b) interest test
than ............... which leads to wastage of efforts (c) intelligence test (d) aptitude test
and money. 22 Which of the following is not a factor which put
(a) coaching method limitations on the use of internal sources of
(b) programmed instructions method recruitment?
(c) internship training method (a) Low productivity (b) No induction training
(d) hit and try method (c) Lethargic employees (d) None of these
14 Which is a long-term process and takes place 23 In ……… , existing staff is used to fill up the
throughout the life of a person? vacant job in the organisation.
(a) Development (b) Education (a) promotion (b) transfer
(c) Training (d) Internship (c) Both (a) and (b) (d) None of these
15 Training is provided to employees on the actual 24 ................. refers to process by which skills and
machines, but away from actual work floor is abilities of employees to perform specific jobs are
known as vestibule training. It is provided where increased.
the employees are supposed to work on (a) Training (b) Selection
(a) sophisticated machinery (b) clients (c) Development (d) Both (a) and (c)
(c) outdated technology (d) None of these
25 TCS Ltd. does mass recruitment every year from
16 Under which of the following methods, training is different engineering colleges offering fresher level
not provided to employees at the place where he job to the final year students. Identify the source of
actually performs his work? recruitment adopted here.
(a) Coaching (b) Internship programmes (a) Placement agencies (b) Casual callers
(c) Job rotation (d) Conferences (c) Web publishing (d) Campus recruitment
17 Which of the following is not a benefit of training 26 The process of introducing the selected employee to
and development to employees? other employees and making him familiar with
(a) Improved skills and knowledge rules and policies of the organisation is known as
(b) Increased efficiency (a) orientation (b) compensation
(c) Increased satisfaction and morale (c) promotion (d) career planning
(d) Results in higher profits
27 Mr. NG talks to existing employees for information
18 Which of the following statements is not true? about candidates in their knowledge who can be
(a) Training improves performance of an employee and recruited in organisation. Which method of
helps him to earn more recruitment is highlighted here?
(b) Training is for present managers only (a) Recommendations from present employees
(c) Induction training is an on the job training method
(b) Campus recruitment
(d) Off the job training methods are based on the
principle of learning before doing (c) Casual callers (d) Labour contractors
19 In factory system where thousands of workers 28 Which of the following statements is not true?
(a) Staffing is a never ending process.
work under one roof, the responsibility of hiring
(b) Effective staffing ensures success of the
and maintaining staff is assigned to officers known organisation.
as (c) HRM is both a line and staff activity.
(a) personnel officers (b) labour welfare officers (d) Recruitment and staffing are one and the same
(c) Both (a) and (b) (d) None of these thing.
20 Human resource management includes many 29 The objective of ……… is to create a pool of
specialised activities to be performed by HR prospective candidates, from which the best
personnel except candidate can be selected.
(a) recruitment (a) selection (b) placement
(b) preparation of job description (c) training (d) recruitment
(c) handling employee grievances
(d) customer focus 30 Mr M introduced Mr J, a new employee to the old
employees and to their jobs. Identify the
21 A psychological test used to measure the level of IQ method/process being followed there.
of an individual and his ability to take decisions is (a) Orientation (b) Internship
known as (c) Vestibule (d) Apprenticeship
ANSWERS
1. (d) 2. (a) 3. (c) 4. (c) 5. (c) 6. (d) 7. (d) 8. (b) 9. (b) 10. (a)
11. (a) 12. (b) 13. (d) 14. (a) 15. (a) 16. (d) 17. (d) 18. (b) 19. (a) 20. (d)
21. (c) 22. (b) 23. (c) 24. (a) 25. (d) 26. (a) 27. (a) 28. (d) 29. (d) 30. (a)
Business Studies 33
CHAPTER 07
Directing
Meaning of Directing 5. Principle of Managerial Communication According
to this principle, it should be monitored by the
It means giving instructions and guiding people in doing
management that the subordinates get the same
work.
meaning for what has been said.
According to Theo Haimann, “Directing consists of the
6. Principle of Use of Informal Organisation According
processes and techniques utilised in issuing instructions and
to this principle, there must be a free flow of information
making decisions that operations are carried on as originally
between the seniors and the subordinates. The success of
planned.”
direction depends upon effective exchange of
Features of Directing information to a great extent.
● It initiates action 7. Principle of Leadership According to this principle,
● It takes place at every level of management while giving directions to the subordinates, a good
leadership must be provided by the managers. By this,
● It is a continuous process
subordinate get influenced by the managers.
● It flows from top to bottom
Elements of Directing
Importance of Directing
The process of directing involves guiding, coaching,
● It helps in achieving goals.
instructing, motivating and leading the people in an
● It integrates employees efforts. organisation to achieve organisational objectives.
● It improves efficiency.
So, in view of the above statement the elements of directing
● It facilitates change. are as follows
● It provides stability. ● Supervision
● Motivation
Principles of Directing
● Leadership
Following are the important principles of directing
● Communication
1. Principle of Maximum Individual Contribution
According to this principle, management should adopt Meaning of Supervision
that directing policy through which the employees get
It means monitoring and observing the employees when they
motivated and give their maximum individual
are performing their jobs in an organisation.
contribution for the achievement of organisational
objective. According to Viteless, ‘‘Supervision refers to the direct and
immediate guidance and control of subordinates, in the
2. Principle of Harmony of Objectives According to this
performance of their tasks.’’
principle, there must be full coordination between
organisational and individual objectives. Importance of a Supervision
3. Principle of Unity of Command According to this ● It provides guidance and leadership
principle, a subordinate should get directions from one ● It motivates the employees
officer at a time. If the subordinate gets directions from
● It preserves records
more than one officer, the subordinate will be unable to
prioritise his work. ● It controls output
4. Principle of Appropriateness of Direction ● It liaison between management and workers
Technique According to this principle, appropriate ● It helps in grievance handling
direction techniques should be used. ● It provides on-the-job training
Meaning of Motivation 4. Esteem Needs These needs include factors such as

It means to act in a desired manner to achieve certain self-respect, status and recognition. When these needs
organisational goals. are fulfilled through job title, it enhances
self-confidence and prestige of employees.
According to William Scott, ‘‘Motivation means a process
5. Self-actualisation Needs It is the highest level of
of stimulating people to action to accomplish desired goals.’’
need in the hierarchy. These needs include growth,
Process of Motivation self-fulfilment and achievement of goals.
● An unsatisfied need of an individual creates tension, which
Assumptions of Maslow’s Need Hierarchy Theory
stimulates his drives.
The main assumptions of Maslow’s need hierarchy theory
● These drives generate a search behaviour to satisfy such are
need. ● People’s behaviour is based on their needs. Satisfaction of
● When the need is satisfied, the individual is relieved of such needs influences their behaviour.
tension. ● People’s needs are hierarchical in order. They start from
Importance of Motivation basic physiological needs and reach to high level needs.
● A satisfied need can no longer motivate a person, only next
Motivation is considered important because of the following
benefits higher level need can motivate a person.
● A person moves to the next higher level need, only when
1. Improves Performance Motivation helps to improve
the performance level of employees. It bridges the gap the lower level need is satisfied.
between the ability to work and willingness to work,
resulting in higher level of performance. Financial Incentives
2. Builds Positive Attitude Motivation helps to change It refers to those incentives which are measurable in
negative attitude of employees to positive attitude, so monetary terms and serve to motivate people for better
as to achieve organisational goals, by using various performance.
incentives. The various financial incentives are as follows
● Pay and allowances
3. Reduces Employee Turnover Motivation helps to
● Bonus
reduce employee turnover and thereby saves the cost of
new recruitment and training. Thus, it helps to retain ● Profit sharing
talented people in the organisation. ● Co-partnership
4. Introduces Changes Motivation helps the managers ● Productivity linked wage incentives
to introduce changes and motivated employees show ● Retirement benefits

less resistance in accepting the changes, as they know
● Perquisites
it is necessary to adapt to changes in order to survive in
the competitive world.
Non-financial Incentives
5. Reduces Absenteeism Motivation helps to reduce
It refers to those incentives which are provided to satisfy
absenteeism by providing proper working conditions,
psychological, social and emotional needs.
adequate rewards and good relations with supervisor.
The various non-financial incentives are as follows
● Status
Maslow’s Need Hierarchy Theory of Motivation
Maslow has explained his theory as a hierarchy of five needs ● Job enrichment
which are depicted and explained below ● Job security
1. Basic Physiological Needs These are the basic needs, ● Employee participation
which a person is required to satisfy in order to survive. ● Organisational climate
Hunger, thirst, shelter, sleep are some of the examples ● Career advancement opportunity
of these needs. In an organisation, basic salary helps to
● Employee recognition programmes
satisfy these needs.
● Employee empowerment
2. Safety/Security Needs These needs are concerned
with physical, economic and social security, in the form
of job security, stability of income, etc. Meaning of Leadership
3. Affiliation/Belongingness/Social Needs These needs It may be defined as the process of influencing the behaviour
are concerned with affection, sense of belongingness, and performance of people in a group, so that their efforts
acceptance and friendship. It is fulfilled when are directed towards the achievement of goals.
employees have cordial relations with colleagues. According to George Terry, ‘‘Leadership is the activity of
influencing people to strive willingly for group objectives.’’
Business Studies 35
Importance of Leadership 8. Decisiveness A leader must be decisive in the sense that

Leadership is a key factor in making an organisation once he has taken a decision, he should be firm on it.
successful, because of the following benefits 9. Social Skills A leader should be sociable and friendly
1. Influences the Behaviour of People A good leader with his colleagues and followers, so that he can
influences the behaviour of people and contributes understand them and their needs.
their energies for the benefit of the organisation.
Leadership Styles
2. Provides Confidence A leader maintains personal
It refers to the behaviour pattern which the leader reflects in
relations and helps his followers in fulfilling their
his role as a leader.
needs. He provides confidence, support and
encouragement to his followers. Different types of leadership styles are as follows
3. Introduces Changes Leaders plays a key role in 1. Authoritative or Autocratic Leadership An autocratic
introducing required changes in the organisation. leader exercises complete control over the subordinates.
They help in solving the problem of resistance to He centralises power in himself and takes all decisions
change by inspiring and persuading employees to without consulting the subordinates.
accept the changes. 2. Democratic or Participative Leadership A democratic
4. Handles Conflicts A good leader helps in solving leader takes decisions after consultation and encourages
the conflicts, allows his followers to ventilate their the participation of subordinates. He decentralises
feelings and disagreements, and persuades them by authority and allows the subordinates to share his power.
giving suitable clarifications. 3. Free Rein or Laissez Faire Leadership It involves
5. Provides Training Leaders provide training to their complete delegation of authority, so that subordinates
subordinates, in order to make them efficient and to themselves take decisions. The free rein leader avoids
facilitate a smooth succession process. holding power and surrenders the authority to
subordinates.
Qualities of a Good Leader
Certain qualities or traits possessed by individuals help Meaning of Communication
them to become successful leaders. Communication can be defined as a process of exchange of
ideas, facts, feelings and views between two or more people to
These qualities are as follows
create common understanding.
1. Physical Qualities A good leader must possess a
According to Rogers, ‘‘Communication is a process by which
good height, weight, health and appearance. Health
people create and share information with one another in order
and endurance help a leader to work hard and
to reach common understanding.’’
inspire others also to do so.
2. Knowledge A good leader should have required Elements of Communication Process
knowledge and competence, so that he can influence Communication has been defined as a process.
others. This process has the following elements
3. Integrity A leader should possess high level of 1. Sender He is the person who conveys his thoughts,
integrity and honesty, so that he can be a role model messages or ideas to the receiver.
to others.
2. Message It is the subject matter of communication.
4. Initiative A leader should have courage and 3. Encoding It refers to converting message into
initiative to do things on his own, rather than communication symbols such as words, pictures, etc.
waiting for others to do it first.
4. Media It is the path, channel or medium through which
5. Communication Skills A leader should be a good encoded message is transmitted to the receiver.
communicator. He should be able to clearly explain
5. Decoding It is the process of translating the encoded
his views to others. He should not only be a good
message into effective language which could be
speaker, but a good listener, teacher and counsellor.
understood by the receiver.
6. Motivation Skills A leader should understand the
6. Receiver He is the person who receives the message of
needs of his employees and motivate them by
sender.
satisfying their needs.
7. Feedback It is the process through which receiver
7. Self Confidence A leader should have a high level
expresses his reaction to the sender.
of confidence. He should not lose confidence even in
the most difficult times. 8. Noise It is any obstruction or hindrance which hampers
the communication process.
Importance of Communication 4. Free Flow Network In this network, there is no

Effectiveness of a manager depends on his ability to restriction on the flow of communication.
communicate with his subordinates. 5. Inverted-V Network In this network, a subordinate is
Therefore, communication is important because of following allowed to communicate with his immediate superior,
reasons as well as his superior’s superior.
1. Acts as Basis of Coordination Communication acts
as basis of coordination. It helps in coordinating the Informal Communication
activities of various departments and persons in an It takes place in an organisation without following the
organisation. formal line of communication.
2. Helps in Smooth Working of an Enterprise The network of communication followed in the informal
Communication ensures smooth functioning of an communication is referred to as grapevine network. Some of
enterprise. Existence of an organisation depends fully the popular network used in informal communication are as
on communication i.e. transmitting information. When follows
communication stops, organised activity cease to exist. 1. Single Strand In this network, information passes
3. Acts as Basis of Decision-making Communication from one person to another in a sequential order.
provides needed information for decision-making. In its
2. Gossip In this network, one person passes information
absence, it may not be possible for managers to take
to everyone else on a non-selective basis.
decisions. Thus, it serves as basis of decision-making.
4. Increases Managerial Efficiency Various functions of 3. Probability Network In this network, information is
managers like providing information, instructions, passed randomly by one person to whomever he comes
allocating jobs and resources would not be possible in in contact with.
the absence of communication. Thus, communication is 4. Cluster In cluster network, the individual
essential for effective performance of managerial communicates with only those people whom he trusts.
functions.
5. Promotes Cooperation and Industrial Peace Barriers to Effective Communication
Effective operation is only possible when there is Managers usually face several problems due to certain
industrial peace in the factory and mutual cooperation barriers, causing failure of communication or
between workers and managers. Two-way miscommunication. These barriers are categorised as
communication promotes cooperation and mutual
understanding between them. 1. Semantic Barriers
6. Establishes Effective Leadership Communication is They are concerned with the meaning of words and symbols.
the basis of leadership. A good leader must possess Semantic barriers arise in the process of encoding and
efficient communication skills for influencing the decoding of message.
behaviour of subordinates. These barriers are as follows
7. Boosts Morale and Provides Motivation Good and (i) Badly Expressed Message Use of wrong words,
effective communication enables managers to motivate, omission of necessary words and inadequate vocabulary
influence and satisfy the employees. result in badly expressed messages.
It helps employees to adjust in the physical and social (ii) Symbols with different Meanings The same word or
aspect of work, which boosts their morale and motivate symbol may carry different meanings to different
them to perform better. people. The wrong meaning perceived by the receiver
leads to communication problem.
Formal Communication (iii) Faulty Translations When the translator is not
It refers to the communication taking place through official proficient in both the languages involved in translation,
channels in an organisation. It may be oral or written. the meaning of the message may get distorted.
Some of the popular networks used in formal (iv) Unclarified Assumptions A message may be
communications are as follows misunderstood, when the sender does not clarify the
assumptions behind it.
1. Single Chain Network Under this network,
(v) Technical Jargon Specialists often use technical
communication flows from every superior to his
language, which common man does not understand,
subordinate through single chain.
who are not specialists in the concerned field.
2. Wheel Network In wheel network, all communication (vi) Body Language and Gesture Decoding Sometimes,
passes through one superior who acts as a central the body language and gestures of the individual does
authority. not match with his communication. Thus, it leads to
3. Circular Network In circular network, each person miscommunication.
can communicate with his two adjoining colleagues.
Business Studies 37
2. Psychological Barriers (iii) Status Status of a superior may create a psychological

The state of mind of both sender and receiver affect the distance between him and his subordinates. A status
process of communication. Some of the psychological barriers conscious manager does not easily communicate with
are given below his subordinates.
(i) Premature Evaluation Communication is likely to fail, (iv) Complexity in Organisation Structure When there
if the receiver evaluates the meaning of message before are several managerial levels, communication gets
the sender completes the message. Such premature delayed and distorted.
evaluation may occur due to pre-conceived notions or There is loss of information as the message is
prejudices against the communicator. transmitted again and again before it reaches the
(ii) Lack of Attention When the receiver’s mind is receiver.
pre-occupied, he fails to understand what is being said. (v) Organisational Facilities Organisation facilitates
e.g. a worker explains some problems to his supervisor. like smooth and clear communication through
The supervisor is pre-occupied with a telephone call and facilities like meetings, suggestion box, complaint box,
does not grasp the message. social and cultural gatherings, etc. Lack of these
(iii) Loss by Transmission and Poor Retention When facilities create communication problems.
communication passes through various levels, it may 4. Personal Barriers
result in loss by transmission. Sometimes, poor
Personal characteristics of both sender and receiver may
retention of people due to lack of interest and attention
affect effective communication.
leads to miscommunication.
(iv) Distrust When the sender and the receiver do not Some of the personal barriers are given below
believe each other, the message may not be understood (i) Fear of Challenge to Authority A superior is likely
in its original sense. to withhold or suppress a message, if he perceives that
3. Organisational Barriers it will adversely affect his authority.
Sometimes, factors related to organisation structure, (ii) Lack of Confidence of Superior on his
authority, rules and regulations, etc act as barriers to Subordinates A superior, who does not have
communication. Some of these barriers are confidence in his subordinates is not likely to seek
their advice and suggestions.
(i) Organisational Policy Communication is hampered, if
the policy of an organisation does not support the free (iii) Unwillingness to Communicate A subordinate may
flow of communication. not communicate with his superiors, if he perceives
that it will affect his interests.
(ii) Rules and Regulations Rigid rules and cumbersome
procedures act as a barrier to effective communication. (iv) Lack of Proper Incentives Employees may not take
Communication through the prescribed channels may initiative to communicate in the absence of proper
result in delays. incentives.
Practice Questions
1 Which one of the following is not an element of 5 Status comes under the following type of barriers.
direction? (a) Semantic barrier (b) Organisational barrier
(a) Motivation (b) Communication (c) Non-semantic barrier (d) Psychological barrier
(c) Delegation (d) Supervision
6 The highest level need in the need Hierarchy of
2 The motivation theory which classifies needs in Abraham Maslow.
hierarchical order is developed by (a) Safety need (b) Belongingness need
(a) Fred Luthans (b) Scott (c) Self actualisation need (d) Prestige need
(c) Abraham Maslow (d) Peter F Drucker
7 The process of converting the message into
3 Which of the following is not an element of communication symbols is known as
communication process? (a) media (b) encoding
(a) Decoding (b) Communication (c) feedback (d) decoding
(c) Channel (d) Receiver
8 The communication network in which all
4 Grapevine is subordinates under a supervisor communicate
(a) formal communication through supervisor only is
(b) barrier to communication (a) single chain (b) inverted V
(c) lateral communication (c) wheel (d) free flow
(d) informal communication
9 The board of directors of a company has made 20 Which of the following qualities of a leader is
some guidelines and policies for the workers and concerned with ethics and values?
wants to communicate these to the workers. Who (a) Initiative (b) Integrity
would be the best communicator in this regard? (c) Decisiveness (d) None of these
(a) Board of directors (b) Manager 21 Leadership is a key factor in making an
(c) Supervisor (d) Clerk
organisation successful, because
10 Which of the following terms can be defined as (a) it influences the behaviour of people
overseeing subordinates at work? (b) it introduces changes
(a) Controlling (b) Leading (c) it handles conflicts
(c) Motivation (d) Supervision (d) All of the above
11 Which of the following is not an advantage of 22 In which of the following networks an individual,
directing? communicates with only those people whom he
(a) Initiates action trusts?
(b) Integrates employee efforts (a) Single strand network (b) Gossip network
(c) Provides leadership (c) Probability network (d) Cluster network
(d) Restricts changes
23 Name the barrier which is related to the
12 Which of the following is correct about function of personality of sender and receiver.
supervisor? (a) Semantic barrier (b) Psychological barrier
(a) Maintains group unity (c) Organisational barrier (d) Personal barrier
(b) Acts as a link between workers and management
24 If a production manager contacts marketing
(c) Maintains contact with workers
manager to discuss about production schedule, it
will be regarded as
13 Which of the following statements is not true? (a) upward communication
(a) Directing initiates action in the organisation (b) horizontal communication
(b) Directing helps a manager to integrate individual (c) downward communication
efforts (d) All of the above
(c) Directing does not help in developing commitment on
part of subordinates 25 In a factory, Mr. Suresh is at the position of
(d) None of the above supervisor and there are twenty subordinates
under him. He communicates with all the
14 Identify the need in which an employee desires
subordinates in a single line. They are following
self-respect, recognition and status. which type of communication network here?
(a) Security needs (b) Social needs
(a) Single chain (b) Inverted V
(c) Esteem needs (d) Self-actualisation needs
(c) Wheel (d) Free flow
15 In an organisational context, example of security/
26 Which of the following is an example of retirement
safety need is benefits?
(a) job security (b) stability of income
(a) Provident fund (b) Pension
(c) pension plans (d) All of these
(c) Gratuity (d) All of these
16 Out of the following, which is a financial incentive?
27 ABC company Ltd wants to motivate its employees
(a) Promotion (b) Stock option by providing them bonus on the occasion of Diwali.
(c) Job security
It can pay the bonus
(d) Employee participation
(a) in cash only (b) in kind
17 To satisfy esteem needs, which type of incentives (c) in cash or in kind (d) transferable coupons
are needed? 28 ………. is the process of converting encoded
(a) Financial incentives (b) Non-financial incentives
symbols of the sender.
(c) Additional incentives (d) None of these
(a) Encoding (b) Decoding
18 XYZ company offers its director certain benefits (c) Feedback (d) Media
such as car, housing, medical facilities, etc, apart 29 The need of affection, sense of belongingness,
from basic salary. Name the incentive provided acceptance and friendship is related with
here by the company to its director. (a) safety/security needs (b) social needs
(a) Stock option (b) Perquisites (c) esteem needs (d) self-actualisation needs
(c) Bonus (d) Job enrichment
30 Which of the following is a formal communication
19 A good leader should have network in which each person can communicate
(a) physical qualities
with two adjoining colleagues only?
(b) good communication skills
(c) motivation skills (a) Wheel network (b) Circular network
(d) All of the above (c) Free flow (d) Cluster network
Business Studies 39
31 Mr. Shriram, the manager of W Ltd. explains a 36 The process of influencing the behaviour of people
worker about operations to be carried out by him by making them strive voluntarily towards the
on a hi-tech machine. Which element of directing is achievement of goals is called as
highlighted? (a) leadership (b) controlling
(a) Motivation (b) Leadership (c) coordinating (d) None of these
(c) Communication (d) Supervision
37 The top management of Raheja Ltd. focuses on
32 MHD Ltd. offered its employees, shares having maintaining an effective two-way communication
market price of ` 150 at ` 110. What is this with their employees. They aim to keep everyone
monetary incentive known as? well informed and involve employees in company’s
(a) Bonus (b) Co-partnership activities and provide opportunities for them to
(c) Stock option (d) Both (b) and (c) give their feedback. What will the company achieve
33 Ishaan resigned from a company on the ground of by following such a network of communication?
‘lack of recognition’ in organisation towards his Give any two points.
work. Which need is not fulfilled here? (a) Smooth functioning of the enterprise
(a) Physiological need (b) Safety need (b) Managerial efficiency
(c) Affiliation need (d) Esteem need (c) Both (a) and (b)
34 Which of the following is/are considered as
38 If a manager wants to introduce new accounting
principle(s) of directing?
(a) Principle of leadership
system, then there may be initial resistance from
(b) Principle of managerial communication accounting staff. But, if manager explains the
(c) Principle of unity of command purpose, provides training and motivates them
(d) All of the above with incentive, the staff may cooperate with
manager. Which importance of directing is
35 Nitin works as a manager in ‘Manglam Ltd.’ He
highlighted here?
has been given the ‘Best Employee Award’. The
(a) Initiate action (b) Means of motivation
reasons behind this award is that he has been able (c) Facilitates change (d) Provides stability
to integrate group efforts and get maximum out of
his subordinates by attaining their willing 39 Which of these actually perform directing?
co-operation. For this, he stimulates and inspires (a) Top level management
(b) Middle level management
people at work and provides necessary incentives.
(c) Operational level management
He also listens to his employees and handles (d) All of the above
conflict. His qualities like initiative,
40 Ajay Thakur, chairperson of Thakur Enterprises
self-confidence, etc. has helped him to achieve the
misses no opportunity to praise his subordinates
objectives of the organisation. Which function of
for their good work. Which element of directing is
management is performed effectively by Nitin?
highlighted?
(a) Planning (b) Organising
(c) Directing (d) Controlling (a) Communication (b) Supervision
(c) Motivation (d) Leadership
ANSWERS
1. (c) 2. (c) 3. (b) 4. (d) 5. (b) 6. (c) 7. (b) 8. (c) 9. (c) 10. (d)
11. (d) 12. (d) 13. (c) 14. (c) 15. (d) 16. (b) 17. (b) 18. (b) 19. (d) 20. (b)
21. (d) 22. (d) 23. (d) 24. (b) 25. (a) 26. (d) 27. (c) 28. (b) 29. (b) 30. (b)
31. (d) 32. (d) 33. (d) 34. (d) 35. (c) 36. (a) 37. (c) 38. (c) 39. (d) 40. (c)
CHAPTER 08
Controlling
Concept of Controlling 2. Judging Accuracy of Standards Through an
effective control system, managers can easily judge the
Controlling refers to the process of measurement of
accuracy of standards.
performance according to standards, measuring deviations
and taking corrective action to achieve predetermined goals. 3. Making Efficient use of Resources By exercising
In order to seek results, manager must exercise effective control, a manager seeks to reduce wastage and
control over the workers. spoilage of resources. Each activity is performed in
According to Koontz and O’ Donnell, ‘‘Managerial control accordance with predetermined standards and norms,
implies the measurement of accomplishment against the which helps in effective and efficient utilisation of
standard and the correction of deviations to assure resources.
attainment of objectives according to plans’’. 4. Improving Employees Motivation It helps
employees in realising, what they are expected to do
Nature of Controlling and what are the standards of performance, on the
Following are the eminent features of controlling that basis of which they are appraised. This motivates them
describes its nature to perform better.
1. Goal-oriented Process Since, controlling ensures that 5. Ensuring Order and Discipline By keeping a check
an organisation’s resources are effectively and efficiently on the activities of the workers, controlling creates an
utilised for achievement of goals, it is regarded as a atmosphere of order and discipline among them. It
goal-oriented process. also helps to keep a check on the dishonest behaviour
2. Pervasive At the same time, controlling is performed by of employees.
all managers, i.e. top, middle and lower, to keep a check 6. Facilitating Coordination in Action It provides
on the activities of their subordinates. Therefore, it is direction to all activities and each department and
regarded as a pervasive function. employee is governed by predetermined standards,
3. Continuous Control should not be misunderstood as which helps in establishing coordination among them.
the last function of the management process. By
analysing deviations and taking corrective action, it Limitations of Controlling
helps in formulating better plans for the future. Thus, it The process of controlling suffers due to following reasons
is a function that brings the management cycle back to
1. Difficulty in Setting Quantitative Standards
planning and is regarded as a continuous function.
Control system is effective when standards are defined
4. Both a Backward Looking as well as a Forward in quantitative terms. But in some cases, like employee
Looking Function Controlling is backward looking morale, job satisfaction, etc, it is not possible to set
process because it is like a postmortem of past activities quantitative standards.
to find out deviations from standard plans and it is also
2. Little Control on External Factors There are certain
a forward looking process, as it seeks to improve future
external factors like change in government policies,
results by taking corrective action.
technological changes, competition, etc, which are
Importance of Controlling beyond the control of the organisation.
Controlling is an indispensable function of management due 3. Resistance from Employees Employees often resist
to the following reasons control as they consider it as restriction or boundation
1. Accomplishing Organisational Goals It measures on their freedom.
progress towards the organisational goals and find out 4. Costly Affair Control is a costly affair as it involves a
deviations. It guides the organisation and keeps it on lot of expenditure, time and effort. A small firm
the right track, so that it can attain its goals. cannot afford to install an expensive control system.
Business Studies 41
Relationship between Planning and Controlling 2. Measurement of Actual Performance

Planning and Controlling are interrelated and interdependent. Once the standards are fixed, the next step is to measure
Both of them are forward-looking as well as backward-looking the actual performance. Generally, it is conducted by the
functions. managers to analyse the overall efficiency level of the
employees. While measuring the performance, objective and
Planning and Controlling are reliable methods should be used, such as sample checking,
Interrelated and Interdependent preparing reports, personal observation, etc.
Planning and controlling are inseparable twins of
management. They are interrelated and interdependent 3. Comparing Actual Performance with Standards
functions of management. Planning is the base of controlling This step involves comparison of actual performance with
function, as controlling involves measurement of performance the standard. Such comparison helps in revealing the
against the standards to analyse deviations and take corrective deviations between actual and desired results. Comparison
action. Thus, controlling is impossible without planning. becomes easier when standards are set in quantitative
Planning without controlling is meaningless, because in the terms.
absence of controlling, it is impossible to monitor the progress 4. Analysing Deviations
and keep a check on the proper implementation of plans. Under this step, deviations in key areas of business need to
Thus, without controlling, planning will fail to achieve be attended on urgent basis as compared to deviations in
objectives. Planning is a thinking process while controlling is certain insignificant areas. There is a need to determine the
an executive function. While planning involves creative acceptable range of deviations in all operational areas.
thinking, imagination and sound judgement, controlling Following points should be kept in mind, while analysing
ensures that such decisions are converted into desired actions. deviations
Thus, planning is prescriptive, whereas, controlling is
(i) Critical Point Control According to this principle,
evaluative.
control system should first focus on Key Result Areas
Planning and Controlling are (KRAs) which are critical to the success of the
Forward-looking as well as Backward-looking Functions organisation. It is because, it is not possible to keep a
1. Planning is a Forward-looking Function Planning check on all the activities of the enterprise. Therefore,
involves setting objectives and deciding the future course if anything goes wrong at the critical points or key
of action to achieve them. Thus, it is regarded as a areas, immediate action should be taken.
forward-looking function. (ii) Management/Control by Exception It suggests
2. Controlling is a Backward-looking Function that, if manager tries to control everything, he may
Controlling involves a postmortem of the past activities end up in controlling nothing.
of an enterprise and finding out deviations from the Thus, in this context, it is stated that managers should first
targeted standard. Thus, it is regarded as a handle the deviations, which are beyond the specific range
backward-looking function. and he should not waste his time and energy in finding
3. Planning is a Backward-looking Function Planning solutions of minor deviations.
is guided by past experiences and corrective actions taken
5. Taking Corrective Action
in the controlling process. Thus, it is regarded as a
backward-looking function. This is the final step in which manager takes corrective
measures to bring back everything on track in the
4. Controlling is a forward-looking Function The organisation i.e. according to set plans, corrections are
process of control necessarily involves analysing required in KRAs, which are critical to the success of the
deviations and taking corrective action, which aims to organisation, or, in areas where deviations go beyond the
improve future performance and achievement of permissible limits.
predetermined goals. Thus, it is regarded as a
forward-looking function. Techniques of Controlling
There are various techniques of managerial control which
Process of Controlling can be classified as
The main steps in controlling process are
1. Traditional Techniques of Control
1. Setting Performance Standards These techniques are those which have been used by the
The first step of the control process is to establish standards, companies for a long-time now. These include
against which actual results are to be evaluated. Standards are ● Personal observation
set in quantitative as well as qualitative terms. Due to changes ● Statistical report
taking place in internal and external environment, standards ● Break-even analysis
need to be revised regularly. ● Budgetary control
2. Modern Techniques of Control These include

These techniques are those which are of recent origin and ● Return on investment
● Management audit
are comparatively new in management literature. These
● Ratio analysis
techinques provide a refreshingly new thinking on the ways
● PERT and CPM
in which various aspects of an organisation can be
● Responsibility accounting
controlled.
Practice Questions
1 An efficient control system helps to 10 Controlling is a pervasive function because it is
(a) accomplish organisational objectives performed
(b) boost employee morale (a) in all organisations whether profit making or non
(c) judge accuracy of standards profit making
(d) All of the above (b) at all levels of management to ensure that the work
at every stage is performed as planned
2 Controlling function of an organisation is
(c) goal oriented process
(a) forward-looking (d) Both (a) and (b)
(b) backward-looking
(c) forward as well as backward-looking 11 Which of the following is not an importance of
(d) None of the above controlling?
3 Management audit is a technique to keep a check (a) Judging accuracy of standards
(b) Effective use of resources
on the performance of (c) Ensures order and discipline
(a) company (d) Exploitation of resources
(b) management of the company
(c) shareholders (d) customers 12 Sales volume, sales expenses, advertising expenses
are the part of ………… standards.
4 Budgetary control requires the preparation of
(a) production (b) marketing (c) HR (d) finance
(a) training schedule (b) budgets
(c) network diagram (d) responsibility centres 13 In controlling process, the next stage after setting
performance standards is
5 Which of the following is not applicable to
(a) measurement of actual performance
responsibility accounting?
(b) comparing actual performance with standards
(a) Investment centre (b) Accounting centre
(c) analysing deviations
(c) Profit centre (d) Cost centre
(d) taking corrective action
6 “Managerial control implies the measurement of
accomplishment against the standard and the 14 Under controlling of HR area, corrective action
correction of deviations to assure attainment of must be taken for
objectives according to plans.” This definition has (a) high labour turnover rate
(b) low labour turnover rate
been given by
(c) zero labour turnover rate
(a) Koontz and O’ Donnell (b) Peter Drucker
(d) low labour absenteeism
(c) Henri Fayol (d) Chester Barnard
15 Is the final step of controlling process, the
7 Which of the following describes the nature of managers takes corrective measures to bring back
controlling? everything on track. Sometimes even after best
(a) Goal-oriented process (b) Pervasive function efforts, if deviations cannot be corrected then what
(c) Continuous process (d) All of these should be done?
8 Controlling provides direction to all activities and (a) Revise the standards (b) Fire the managers
each department and employee is governed by (c) Shut the company (d) None of these
predetermined standards, which helps in 16 Match the following causes of deviation with
establishing ……… among them. corrective options to be taken to correct them.
(a) organising (b) directing
(c) planning (d) co-ordination Column I Column II
A. Defective material (i) Modify existing process
9 Which of the following factor(s) is/are beyond the
B. Defective machinery (ii) Change the quality of
control of an organisation? materials
(a) Change in government policies C. Defective process (iii) Improve physical conditions
(b) Change in technology of work
(c) Competition level
D. Defective physical (iv) Repair/replace machine
(d) All of the above conditions
Business Studies 43
Codes Identify the management function to rectify the

A B C D A B C D above situation.
(a) (i) (iii) (ii) (iv) (b) (iv) (ii) (i) (iii) (a) Coordination (b) Controlling
(c) (ii) (iii) (i) (iv) (d) (ii) (iv) (i) (iii) (c) Directing (d) Planning
17 ‘Taking corrective action’ is …….. step in process of 25 The manager of 180 Ltd calculated total sales and
controlling. revenue earned by each sales executive to conduct
(a) first (b) second appraisals at the end of the year. Which step of
(c) third (d) last controlling is highlighted here?
18 “Planning is guided by past experience and (a) Setting performance standards
(b) Measurement of actual performance
corrective actions taken in the controlling process. (c) Comparing actual performance with standards
Thus, it is regarded as ……… .” (d) Analysing deviations
(a) backward-looking function
(b) forward-looking function 26 Mr. Nirbhay Kapur, the CEO of Patna Ltd.
(c) pervasive function
analysed the variances to find out the causes of
variances. Identify the step of controlling process
being performed.
19 In controlling process, while setting performance (a) Measurement of actual performance
standards, standards can be set (b) Comparing actual performance with standards
(a) in quantitative terms only (c) Analysing deviations
(b) in qualitative terms only (d) Taking corrective action
(d) in subjective terms 27 With which concept is the saying “If you try to
control everything you may end up controlling
20 Which standard(s) is/are used in production? nothing” associated?
(a) Quality Standards (b) Quantity Standards
(a) Critical point control
(c) Cost Standards (d) All of these
(b) Management by exception
21 Which of the following is the technique of (c) Control by exception
measurement of performance? (d) Both (b) and (c)
(a) Personal observation
(b) Sample checking
28 Himesh is a senior manager in a software
(c) Performance reports consultancy firm. He regularly prepares
(d) All of the above performance reports of his subordinates as part of
appraisal. The step of controlling process
22 ……………. is often referred to as control by
highlighted here is ……… .
exception. (a) measuring performance
(a) Deviation (b) compare performance against standard
(b) Management by exception (c) analysing deviation
(c) Feedback (d) taking corrective action
(d) Critical point
29 Bajaj, the operation manager set a limit of 5%
23 Which of the following is an advantage of critical
deviation in production and decided to take
point control and management by exception? corrective action only if deviations occurred beyond
(a) Saves time
(b) Better utilisation of managerial talent
5%. Name the concept applicable here.
(c) Facilitates delegation of authority (a) Coordination
(d) All of the above (b) Management principles
(c) Management by exception
24 Radihika Ltd is engaged in manufacturing (d) Critical point control
machine components. The target production is 350 30 An efficient control system helps to
units per day. The company had been successfully (a) judge accuracy of standards
attaining this target until four months ago. Over (b) boost employee morale
the last four months, it has been observed that (c) Both (a) and (b)
daily production varies between 250-270 units. (d) None of the above
ANSWERS
1. (d) 2. (c) 3. (b) 4. (b) 5. (b) 6. (a) 7. (d) 8. (d) 9. (d) 10. (d)
11. (d) 12. (b) 13. (a) 14. (a) 15. (a) 16. (d) 17. (d) 18. (a) 19. (c) 20. (d)
21. (d) 22. (b) 23. (d) 24. (b) 25. (b) 26. (c) 27. (d) 28. (a) 29. (c) 30. (c)
CHAPTER 09
Financial Management
Concept of Business Finance 2. Secondary Objectives
● It ensures availability of sufficient funds at a
Money required for carrying out business activities is called
Business Finance. To start the business, finance is required reasonable cost.
for investments in plant, machinery, land and building, etc. ● It ensures effective utilisation of funds and avoid idle
This investment is called fixed capital. Even acquiring finance.

intangible assets like trademarks, patents and copyrights ● It ensures safety of funds by creating reserves,
require finance. reinvesting profits, etc.

Further, finance is required for carrying out day-to-day ● It maintains adequate liquidity.
operations of the business. Salaries and wages have to be

paid, rent, various bills and premiums are to be paid, raw Meaning of Financial Planning
materials and other supplies have to be bought. This also Financial planning means preparation of financial blueprint
requires finance. So, we can say that finance is the life blood of an organisation’s future operations.
of any business, for its survival and growth. According to Walker and Baughn, ‘‘Financial planning
pertains functions of finance and includes the determination
Concept of Financial Management of firm’s financial objectives, policies and procedures.’’
Financial management is concerned with optimal
procurement as well as usage of finance. It aims at reducing Objectives of Financial Planning
the cost of funds procured, keeping the risk under control ● To ensure availability of funds whenever these are
and achieving effective deployment of such funds. required.
According to Weston and Brighan, “Financial ● To see that the firm does not raise resources unnecessarily.
management is an area of financial decision-making
harmonising individual motives and enterprise goals”. Time Frame for Financial Plans
Financial plans are made for both long-term as well as
Role of Financial Management short-term
● Determining the size and the composition of fixed assets of 1. Long-term Plans They focus on long-term growth
the business. and investment matters. They are made for 3-5 year
● Deciding the quantum of current assets and its break up time frames.
into cash, inventory and receivables.
2. Short-term Plans They are also known as budgets
● Deciding the amount of long-term and short-term funds to and are made for a period of one year or less.
be used.
● Determining break up of long-term financing into debt, Importance of Financial Planning
equity, etc. ● It helps in forecasting what may happen in future under
● Determining the quantum of the all items in the profit and different business situations.
loss account. e.g. Interest, expense, depreciation, etc. ● It helps in coordinating various business functions.
Objectives of Financial Management ● It tries to link the present with the future.
The two main objectives of financial management are ● It provides a link between investment and financing
decisions on a continuous basis.
1. Primary Objective The primary aim of financial
management is to maximise shareholders’ wealth. ● It helps in avoiding business shocks and surprises.
Business Studies 45
Concept of Capital Structure Fixed Capital

The term capital structure refers to the composition of the Fixed capital involves allocation of firm’s capital to
amount of long-term financing. In other words, we can say long-term assets or projects. Fixed assets are those which
that capital structure refers to the mix between owners’ fund remain in the business for more than one year, usually
and borrowed funds or it represents the proportion of debt longer, e.g. plant and machinery, furniture and fixtures, land
capital and equity capital to make up the total capital of the and buildings, etc. It provides the base for foundation of a
firm. Capital structure of the business affects its profitability business and absorbs the shocks of business.
and financial risk. The decision regarding investing in fixed assets is also
Components of capital structure include known as capital budgeting decision. It includes investments
in assets for acquisition, expansion, modernisation and
1. Owners Shareholders Funds/Equity They refer to
replacement.
the share capital, reserves and surplus and retained
earnings. Management of Fixed Capital
2. Borrowed Funds/Debt They refer to the finance Management of fixed capital involves allocation of firm’s
raised from debentures, public deposits, long-term capital to different projects or assets with long-term
loans, etc. implications for the business. The management of fixed
Capital structure can be calculated as debt equity ratio, capital or investment or capital budgeting decisions are
important for the following reasons
 Debt   Debt 
i.e.   or   as the debt out of total ● Long-term growth
 Equity   Debt + Equity 

● Large amount of funds involved
capital. Higher use of debt increases the financial risk. ● Risk involved
Financial risk is the chance that a firm would fail to
● Irreversible decisions
meet its payment obligations. It arises with higher use
of debt. Factors Affecting the Requirement of Fixed Capital
● Nature of business
Financial Leverage ● Scale of operations
The amount of total debt in the overall capital is called
● Choice of technique
Financial Leverage.
● Technology upgradation
D(Debt) D
Financial leverage = or ● Growth prospects
E(Equity) D + E ● Diversification
When financial leverage, (i.e. debt) increases, the cost of ● Financing alternatives
funds decline but risk increases. ● Level of collaboration
Trading on Equity Working Capital
The use of debt alongwith equity increases Earnings Per Working capital means the portion of capital which is
Share (EPS). This use of fixed financial charge, i.e. interest, invested in current assets. The term ‘working capital’ may
increases the profit earned by shareholders. This concept is mean gross working capital or net working capital.
known as trading on equity.
1. Gross working capital means current assets.
Factors Affecting the Choice of Capital Structure 2. Net working capital means current assets less
● Cash flow position current liabilities. Thus,
● Interest coverage ratio Net Working Capital = Current Assets − Current
● Debt service coverage ratio Liabilities
or
● Return on investment
NWC = CA − CL
● Cost of debt
Current Assets
● Tax rate
The term current assets refer to those assets held in a
● Cost of equity business which can be converted in the form of cash within
● Floatation costs a period of one year. These assets are more liquid but less
● Risk consideration profitable. Examples of current assets in order of
● Flexibility liquidity are: cash in hand/cash at bank, marketable
● Stock market condition securities, bills receivables, debtors, finished goods,
inventory, work-in-progress, raw material and prepaid
● Regulatory framework
expenses.
Current Liabilities Factors Affecting the Requirement of Working Capital

These refer to those liabilities which are to be paid off during ● Nature of business ● Scale of operations
the time span of one year. These are to be paid out of current ● Business cycle ● Seasonal factors
assets. Current liabilities consist of sundry creditors, bills ● Production cycle

payable, bank overdraft, outstanding expenses, etc. ● Credit allowed
Operating Cycle ● Level of competition
It is the time duration from procurement of raw materials to ● Inflation
sales realisation. It is a time gap between production of ● Credit availed
goods and realisation of sales. The operating cycle is ● Growth prospects
different for different firms depending upon their size and ● Availability of raw materials
nature of business. For example, manufacturing firm’s
operating cycle may be different from a trading concern.
● Time lag
Practice Questions
1 The cheapest source of finance is 8 Higher dividend per share is associated with
(a) debenture (b) equity share capital (a) high earnings, high cash flows, unstable earnings
(c) preference share (d) retained earnings and higher growth opportunities
2 Other things remaining the same, an increase in (b) high earnings, high cash flows, stable earnings and
the tax rate on corporate profits will higher growth opportunities
(a) make the debt relatively cheaper (c) high earnings, high cash flows, stable earnings and
(b) make the debt relatively the dearer lower growth opportunities
(c) have no impact on the cost of debt (d) high earnings, low cash flows, stable earnings and
(d) we can’t say lower growth opportunities
3 Financial leverage is called favourable if 9 A fixed asset should be financed through
(a) return on investment is lower than the cost of debt (a) a long-term liability
(b) RoI is higher than the cost of debt
(b) a short-term liability
(c) debt is easily available
(d) if the degree of existing financial leverage is low (c) a mix of long and short-term liabilities
4 Higher debt-equity ratio results in
(a) lower financial risk 10 Current assets of a business firm should be
(b) higher degree of operating risk financed through
(c) higher degree of financial risk (a) current liability only
(d) higher EPS (b) long-term liability only
(c) both types (i.e. long and short-term liabilities)
5 Higher working capital usually results in
(a) higher current ratio, higher risk and higher profits
(b) lower current ratio, higher risk and profits 11 Financial management helps in
(c) higher equity, lower risk and lower profits (a) reducing the cost of funds
(d) lower equity, lower risk and higher profits (b) keeping the risks under control
(c) achieving effective deployment of funds
6 Current assets are those assets which get
converted into cash
(a) within six months 12 In financial management, the procurement of
(b) within one year funds is done for
(c) between one and three years (a) long-term needs only
(d) between three and five years (b) short-term needs only
7 Financial planning arrives at
(d) maximising risks
(a) minimising the external borrowing by resorting to
equity issues 13 To maximise the wealth of owners (i.e.
(b) entering that the firm always have significantly shareholders) means
more fund than required so that there is no paucity (a) to minimise the risk of the shareholders
of funds (b) to maximise the shares of shareholders
(c) ensuring that the firm faces neither a shortage nor (c) to maximise the current price of equity shares of the
a glut of unusable funds company
(d) doing only what is possible with the funds that the (d) to minimise the tax in the hands of shareholders
firms has at its disposal
Business Studies 47
14 Dividend is that portion of profit, which is 23 Which of the following statement is incorrect?
distributed to the shareholders and undistributed (a) Current assets are usually more liquid than fixed
profit which remains in the business is known as assets
(a) earning (b) Current assets contribute less to the profits than
(b) equity fixed assets
(c) retained earnings (c) B/R, debtors, stock, etc are fixed assets
(d) interest (d) Fixed assets are financed through long-term
15 Debt is considered to be cheaper than equity liabilities
because for borrowers, interest on debentures is a 24 Company ‘A’ has profit after tax, ` 1,50,000 and its
.............. while dividend on equity is not. number of equity shares is 10,000. Company ‘B’
(a) exempt from tax
has profit after tax, ` 1,20,000 and its number of
(b) deductible expenditure
(c) non-deductible expenditure shares is 12,000. Which company has better EPS
(d) None of the above and how much?
(a) Company ‘A’, ` 10
16 The risk of default on payment of borrowed funds (b) Company ‘A’, ` 15
is known as (c) Company ‘B’, ` 10
(a) operating risk (b) financial risk (d) Company ‘B’, ` 12
(c) business risk (d) None of these Hint Earning Per share (EPS) = Profit after Tax/Number of
Equity Shares
17 In which case, a company should go to opt for
EPS of Company ‘A’ = 1,50,000/10,000 = ` 15
equity rather than debt?
EPS of Company ‘B’ = 1,20,000/12,000 = ` 10
(a) If the stock market is rising
(b) If the firm has higher operating cost 25 Calculate the net working capital from the
(c) If cash flow position is stronger following information
(d) Both (a) and (b) Sundry Debtors = ` 30,000, Cash = ` 25,000,
Prepaid expenses = ` 5,000.
18 Financial planning helps in
(a) running the business smoothly by forecasting Sundry Creditors = ` 17,000, Outstanding
(b) avoiding business shocks and surprises
expenses = ` 3,000, Bills Payable = ` 8,000.
(a) ` 32,000 (b) ` 30,000
(c) coordinating various business functions
(c) ` 88,000 (d) ` 60,000
Hint Net Working Capital = Current Assets – Current Liabilities
19 The objective of financial planning is 26 Use of debt alongwith equity increases EPS, this
(a) to ensure timely availability of funds
concept is also known as
(b) to avoid idle funds (a) trading of debt (b) trading on equity
(c) Both (a) and (b) (c) trading EPS (d) None of these
(d) to maximise financial costs
27 Which component of capital structure determines
20 Short-term plans are also known as ………… and the overall financial risk in an organisation?
are made for a period of…………. . (a) Equity (b) Debt
(a) capital budgeting programs, two years (c) Finance (d) None of these
(b) capital budgeting programs, one year or less
28 A finance manager identifies different available
(c) budgets, two years
(d) budgets, one year or less
sources and compares then in terms of costs and
associated risks for the optimal procurement of
21 Long-term financial planning is done for funds. Identify the concept highlighted here.
(a) zero to one year (a) Financial management
(b) more than one year (b) Financial decisions
(c) ten to twenty years (c) Financial planning
(d) twenty to thirty years (d) All of the above
22 The process of estimating the financial 29 Which of these is a factor affecting capital
requirements of an organisation specifying the structure decision?
sources of funds and ensuring that enough funds (a) Risk consideration
are available at the right time is called (b) Flexibility
(a) financial management (b) financial planning (c) Stock market conditions
(c) financial decision (d) business finance (d) All of the above
30 The impact of financial leverage on the (a) Marketable securities, cash, debtors, bills
profitability of a business can be seen through receivables
(b) Prepaid expenses, cash, marketable securities, bills
which analysis?
receivables
(a) EBT-EPS (b) EAT-EPS
(c) Bills receivables, cash, marketable securities,
(c) EBIT-EPS (d) EBIT-EBT
debtors
31 Which concept helps to increase the return on (d) Cash, marketable securities, bills receivables,
equity shares with a change in the capital debtors
structure of a company? 33 Seeta is a manufacturer who deals in stainless
(a) Trading on equity steel. Ram is also a manufacturer, dealing in
(b) Debt financing bakery products. Based on length of operating
(c) Equity financing
cycle
(d) Capital structure
(a) Seeta would require more working capital
32 Choose the correct option regarding the (b) Ram would require more working capital
arrangement of current assets in order of liquidity (c) Both would require equal working capital
from highest to lowest. (d) None of the above
ANSWERS
1. (d) 2. (a) 3. (b) 4. (c) 5. (a) 6. (b) 7. (c) 8. (c) 9. (a) 10. (c)
11. (d) 12. (c) 13. (c) 14. (c) 15. (b) 16. (b) 17. (d) 18. (d) 19. (c) 20. (d)
21. (b) 22. (b) 23. (c) 24. (b) 25. (a) 26. (b) 27. (b) 28. (a) 29. (d) 30. (c)
31. (a) 32. (d) 33. (a)
Business Studies 49
CHAPTER 10
Financial Market
Concept of Financial Market Money Market
A financial market is a market for creation and exchange of The money market is a market for short-term funds, which
financial assets. In an economy, there are two major sectors, viz, deals in monetary assets whose period of maturity is upto
households and producers. Households usually save a part of one year. It is a market where low risk, unsecured and
their income to earn returns on it through investment. On the short-term debt instruments that are highly liquid, are
other hand, producers and business firms are in need of finance issued and actively traded everyday, over the telephone and
at all times for conducting business activities. Financial through the internet.
markets and banks act as intermediaries in the allocative
function of matching the demand and supply of funds. The major participants in the money market are Reserve
Bank of India, commercial banks, non-banking finance
If the allocative function of directing funds available for companies, state governments, large corporate houses and
investment into most productive investment opportunity is mutual funds.
performed well, it leads to
● Higher rate of return to households. Money Market Instruments
● Allocation of scarce resources to those firms, which have the Various instruments available in the money market are
highest productivity. 1. Treasury Bill (T-Bill) It is a short-term borrowing
instrument issued by the Government of India. RBI
Features of Financial Market issues it on behalf of Government of India. It is also
● It transfer funds from potential saver to potential borrower. known as zero coupon bonds.
● It increases the interest income of saver (investor). 2. Commercial Paper It is issued by large
● It reduces the cost of financial transaction. creditworthy companies to raise short-term funds at
● It satisfies the need of fund of the borrower. lower rates of interest than the market rate. It is an
● It is a market where financial assets i.e., securities are dealt unsecured promissory note, having a maturity of 15
with. days to one year.
3. Call Money It is a method used by commercial
Functions of Financial Market banks to borrow funds from each other, in order to
Financial market plays an important role in the allocation of maintain the Cash Reserve Ratio (CRR). Cash
scarce resources in an economy by performing four important Reserve Ratio is the minimum balance of cash to be
functions maintained by banks, according to RBI guidelines.
● Mobilisation of savings and channelising them into the most Maturity of call money is 1 day to 15 days. The
productive uses interest paid on call money is called the call rate.
● Facilitating price discovery
4. Certificate of Deposit It is issued by commercial
● Providing liquidity to financial assets banks or developmental financial institutions to
● Reducing the cost of transactions individuals, institutions, corporations and
companies. It is an unsecured, negotiable instrument
Types of Financial Market in bearer form. It is issued in periods of tight
On the basis of maturity of financial instruments traded, liquidity, when the deposits by individuals and
financial markets can be classified into money market and households is less, but the demand for credit
capital market. is high.
5. Commercial Bill It is a bill of exchange used by Differences between Capital Market and Money
business firms to meet their working capital needs. It is Market
a short-term, self-liquidating, negotiable instrument, Basis Capital Market Money Market
used for financing credit sales of a firm.
Meaning It is a market dealing in It is a market dealing in
securities for long-term securities of short-term
Capital Market funds whose maturity funds, whose maturity
Capital market is a market for medium and long-term funds. period is more than one period is upto one year.
year.
This market facilitates the institutional arrangements
through which long-term funds, both debt and equity are Participants Individual investors as The participants are RBI,
well as institutional commercial banks financial
raised and invested. The capital market consists of investors like financial institutions, mutual funds
development banks, commercial banks and stock exchanges. institutions, banks, and corporate houses.
corporate houses and Individual investors do not
Types of Capital Market foreign investors participate in money market.
participate in the capital
There are two types of capital market market transactions.
1. Primary Market Instruments The instruments of Some of the main
Traded capital market include instruments used in money
It is also known as the new issues market, as this market equity shares, market are commercial
deals with the new securities issued for the first time. preference shares, paper, treasury bills, trade
In this market, companies issue securities directly to the bonds, debentures, etc. bills, certificate of deposit,
etc.
investors for the purpose of establishing new business or for
Investment It does not require huge In money market,
modernising and expanding the existing business. Outlay capital outlay, as the instruments require huge
Methods of Floatation of New Issues in Primary value of units of sums of money, because
Market securities is generally these are quite expensive.
low, i.e. ` 10 or ` 100.
There are various methods by which securities are issued in Even the trading lot is
the primary market. They are kept low at 5,50,100
or so.
1. Offer Through Prospectus/IPO Under this method, a
company invites public to subscribe for its shares Liquidity They are less liquid, e.g. They are highly liquid and
a person wanting to sell have an arrangement for
through issue of prospectus, which makes a direct shares may not get a providing liquidity, which
appeal to investors to invest in the company, through buyer instantly. is provided by Discount and
an advertisement in the newspapers and magazines. Finance House of India
2. Offer for Sale Under this method, securities are not (DFH).
issued directly to the public, but are offered for sale Duration of The capital market deals Money market deals in
Securities in medium and short-term securities
through intermediaries like issuing houses or stock Traded long-term securities having a maximum tenure
brokers. which are for more than of one year.
3. Private Placement It is the allotment of securities by one year.
a company to institutional investors and some selected Expected Higher returns on There is always a trade off
individuals. Return investment. between risk and return.
Low risk involved leads to
4. Rights Issue This is a privilege given to existing lesser returns.
shareholders to subscribe to a new issue of shares Safety Capital market is more The instruments of money
according to the terms and conditions of the company. risky. markets are safe, less risky
The shareholders are offered the ‘right’ to buy new due to short duration and
shares in proportion to the number of shares they soundness of issuers.
already possess. This right is called the ‘pre-emptive
right’ of the existing shareholders. Stock Exchange
5. e-IPOs When the public issue is made through an The stock exchange plays a pivotal role in the growth of the
online system of stock exchange, it is known as e-IPO, industry and commerce of the country that eventually
i.e. electronic Initial Public Offer. affects the economy to a great extent. It is a common
platform, where buyers and sellers of securities actively trade
2. Secondary Market/Stock Exchange already issued securities.
Secondary market is also known as the stock market or stock According to Securities Contracts Regulation Act, 1956,
exchange. In this market, securities are not directly issued by “Stock Exchange means any body of individuals, whether
the company to investors but it is sold by existing investor to incorporated or not, constituted for the purpose of assisting,
other investors. It provides liquidity and marketability to regulating or controlling the business of buying and selling
existing securities. of securities”.
Business Studies 51
Functions of Stock Exchange Working of the Demat System

A stock exchange performs the following functions ● The Depository Participant (DP) either a bank, broker or
financial services company may be identified.
1. Provides Liquidity and Marketability to
Existing Securities It provides a ready and ● An account opening form is filled giving details of PAN card,
continuous market where securities are bought and photograph and power of attorney.
sold. It gives investors the chance to disinvest or ● The physical certificate is to be given to the DP alongwith a
reinvest. Thus, regular dealing provides both liquidity dematerialisation request form.
and marketability to existing securities. ● If shares are applied in a public offer, simple details of DP and
2. Pricing of Securities It helps in determining the Demat Account are to be given and the shares on allotment
prices of various securities that reflect their real would automatically be credited to the Demat Account.
worth, through the interplay of demand and supply. ● If shares are to be sold through a broker, the DP is to be
3. Safety of Transactions It is well regulated and its unstructed to debit the account with the number of shares.
dealings are well-defined according to the existing ● The broker, then, gives instructions to his DP for delivery of
legal framework. This ensures that the investing shares to the stock exchange.
public gets a safe and fair deal in the market. ● The broker then receives payment and pay the person for the
4. Contributes to Economic Growth In stock shares sold.
exchange, the process of disinvestment and ● All these transactions are to be completed within 2 day that is
reinvestment channelise the savings into productive delivery of share and payment received from the buyer is on a
investment avenues. This leads to capital formation T+2 basis, settlement period.
and economic growth.
5. Spreading Equity Cult It is an organised market, National Stock Exchange of India (NSEI)
which takes various steps to guide and educate NSE is the largest, most modern, technology driven exchange,
investors, publish information about companies incorporated in 1992 and recognised as stock exchange in April
listed on the exchange and ensures better and safe 1993.
trading practices. It was set up by leading financial institutions, banks, insurance
6. Provides Scope for Speculation It is generally companies and other financial intermediaries. Its board
accepted that a certain degree of speculation is comprises of senior executives from promoter institutions and
necessary to ensure liquidity and price continuity in eminent professionals.
the stock market. Thus, it provides sufficient scope
for speculation in a restricted and controlled manner Objectives of NSE
within the provisions of law. The main objectives of NSE are
● Establishing a nationwide trading facility for all types of
Trading Procedure on a Stock Exchange securities.
Trading procedure on a stock exchange has the following ● Ensuring equal access to investors all over the country.
steps
● Providing a fair, efficient and transparent securities market.
● Selection of a broker
● Enabling shorter settlement cycles and book entry
● Opening demat account with depository
settlements.
● Placing the order
● Meeting international standards and benchmarks.
● Executing the order
● Settlement Market Segments of NSE

The two segments for trading in NSE are
Meaning of Depository Service
1. Wholesale Debt Market It provides a trading platform
Depository is an organisation which holds securities (like
for fixed income securities like T-bills, state development
shares, debentures, bonds, etc.) of investors in electronic
loans, public sector undertakings bonds, Central
form at the request of the investors through a registered
Government securities, floating rate bonds, zero coupon
depository participant.
bonds, corporate debentures, commercial paper, certificate
Meaning of Dematerialisation of deposit and mutual funds.
Dematerialisation is the process by which physical share 2. Capital Market Segment It provides an efficient and
certificates are converted to an equivalent number of transparent platform for trading in equity, preference,
securities in electronic form. Securities converted into debentures, exchange traded funds as well as retail
dematerialised form are held in a demat account. government securities.
Over the Counter Exchange of India This may be elaborated as follows

● To regulate stock exchanges and the securities industry to
(OTCEI)
promote their orderly functioning.
The OTCEI is a company incorporated under the Companies
● To protect the rights and interests of investors, particularly
Act, 1956 to provide access to small and medium companies
to capital market for raising funds. It provides an efficient individual investors, and to guide and educate them.
and transparent avenue for capital market investment. It ● To prevent fraudulent activities and malpractices.
provides a fully electronic, single window and transparent ● To regulate and develop a code of conduct for intermediaries
system for securities exchange. Basically, it is a place where with a view to make them competitive and professional.
buyers seek sellers and vice-versa in order to negotiate the
terms and conditions for sale/purchase of securities. Functions of SEBI
In the OTC exchange, a buyer/seller walks on its counter SEBI performs the following functions
taps on computer screen, finds quotes and attempt to
finalise a deal. Thus, there is no fixed geographical area for 1. Regulatory Functions
its operations, providing a simplified process of dealing in ● Registration of brokers, sub-brokers and other players in the
securities in an easy and economical way. However, the market.

OTCEI has now been withdrawn. ● Registration of collective investment schemes and mutual
Advantages of the OTCEI funds.
● It provides a trading platform to small and less liquid ● Regulation of stock brokers, portfolio exchanges,
company which are not competent to be listed on a underwriters and merchant bankers and the business in
regular exchange. stock exchanges.
● It is a cost effective method. ● Regulation of takeover bids by companies.
● It facilitates family concerns and closely held companies ● Levying fee or other charges for carrying out the purposes of
to go public.
the Act.
● It provides the option for primary as well as secondary
markets. ● SEBI conducts inspections, enquiries and audits of stock
● It provides investors the choice to choose stocks as per exchanges.
their requirements. ● Perform and exercise such power under Securities Contracts
● There is a transparent system of exchange, with no (Regulation) Act 1956, as may be delegated by the
problem of short or bad delivery. Government of India.
● Information can flow freely from market makers to 2. Development Functions
customers directly. ● Training of intermediaries of the securities market.
● Conducting research and publishing information useful to

Securities and Exchange Board of India all market participants.
(SEBI) ● Undertaking measures to develop the capital markets by
The Securities and Exchange Board of India (SEBI) was adopting a flexible approach.
established by the Government of India in 1988 as an
interin administrative body to promote orderly and healthy 3. Protective Functions
growth of securities market and for investor protection. ● Prohibition of fraudulent and unfair trade practices.
● Controlling insider trading and imposing penalties for such
Objectives of SEBI practices.

The overall objective of SEBI is to protect the interests of ● Undertaking steps for investor protection.
investors, promote the development of and regulate the ● Promotion of fair practices and code of conduct in securities
securities market. market.

Business Studies 53
Practice Questions
1 Primary and secondary markets 12 Mr B has purchased treasury bills of face value of
(a) compete with each other ` 1,00,000 at ` 96,000. At the time of maturity, he
(b) complement each other will get ` 1,00,000. How much interest is received
(c) function independently by him?
(d) control each other (a) ` 10,000 (b) ` 4,000
2 The settlement cycle in NSE is (c) Nil (d) None of these
(a) T+5 (b) T+3 13 Stock exchange helps in
(c) T+2 (d) T+1 (a) providing liquidity to existing securities
3 The National Stock Exchange of India was (b) contributing to economic growth
recognised as stock exchange in the year (c) pricing of securities
(a) 1992 (b) 1993 (d) All of the above
(c) 1994 (d) 1995 14 SEBI was established on …….. and its
4 NSE commenced future trading in the year headquarter is situated at ……… .
(a) 1999 (b) 2000 (a) 12th April, 1988, Mumbai
(c) 2001 (d) 2002 (b) 12th April 1990, Mumbai
(c) 12th May, 1988, Delhi
5 Clearing and settlement operations of NSE are (d) 12th May, 1990, Delhi
carried out by
15 Which of the following is a depository formed for
(a) NSDL (b) NSCCL
(c) SBI (d) CDSL the purpose of ensuring free transferability of
securities in India?
6 Treasury bill is basically (a) NSDL (b) RBI
(a) an instrument to borrow short-term funds (c) SEBI (d) None of these
(b) an instrument to borrow long-term funds
(c) an instrument of capital market 16 Which of following is/are depository participants?
(d) None of the above (a) ICICI bank (b) Angel broking
(c) SBI bank (d) All of these
7 Under which of the following methods, securities
are not issued directly to the public, but are offered 17 .………. is manipulating the market price of shares
through intermediaries like issuing houses or stock by increasing or decreasing their prices.
brokers? (a) Price rigging (b) Insider trading
(a) Offer through prospectus (c) Private placement (d) Fluctuation
(b) Offer for sale 18 Allotment of securities by a company to
(c) Private placement institutional investors and selected individuals is
(d) e-IPO known as
8 In which of the following aspects, money market is (a) public offer (b) private offer
different from capital market? (c) private placement (d) offer through prospectus
(a) Participants 19 What can be the method of floating new issues in
(b) Tenure of securities traded the primary market?
(c) Liquidity of securities traded
(a) Offer through prospectus
(b) Private placement
9 In case of an e-IPO, who co-ordinates with all the (c) Rights issue
intermediaries connected with the issue? (d) All of the above
(a) Issuing house (b) Managing director 20 ……….. is a market for the purchase and sale of
(c) Chief financial officer (d) Lead manager existing securities.
10 Funds raised through commercial paper are used (a) Primary market (b) Money market
to meet the floatation costs are known as (c) Secondary market (d) Retail market
(a) equity financing (b) bridge financing 21 Which market helps in channelising surplus funds
(c) debt financing (d) None of these into the most productive uses?
11 Mr A, an existing shareholder of a company is (a) Financial market (b) Wholesale market
offered the ‘right’ to buy new shares in proportion to (c) Retail market (d) None of these
the number of shares, he already possess. This kind 22 In case of public issue of shares, in order to save
of issue is known as company from undersubscription, the issue may be
(a) offer through sale (b) e-IPOs (a) insured (b) rigged
(c) private placement (d) rights issue (c) underwritten (d) All of these
23 ABC Ltd. a reputed industrial machines 27 WWW Ltd. is a large and creditworthy company.
manufacturer, need ` 20 crore as additional capital It recently raised capital through an instrument
to expand their business. Mr Kunal, the Chief which is alternative to bank borrowings. What
Executive Officer (CEO) of the company wants to could be the instrument?
raise funds through equity. The finance manager, (a) Call money
Mr Amit, suggested that the shares may be sold to (b) Treasury bills
investing public through intermediaries, as the (c) Commercial paper
same will be less expensive. The proposal was (d) Certificate of deposits
accepted. 28 According to ………, “stock exchange means any
Name the method through which the company body of individuals, whether incorporated or not,
decided to raise additional capital. constituted for the purpose of assisting, regulating
(a) Right issue (b) e-IPOs or controlling the business of buying and selling of
(c) Offer for sale (d) Private placement securities”.
(a) Securities Contracts Regulation Act, 1956
24 Which of these is not a money market participant?
(b) Securities and Exchange Board of India Act, 1992
(a) RBI
(c) Reserve Bank of India Act, 1934
(b) Commercial banks
(d) The Banking Regulation Act, 1949
(c) Large corporate houses
(d) Stock exchange 29 IM Ltd. issued prospectus for subscription of its
25 MD of Perk Ltd., Paul suggested that since the shares for ` 100 crores. The issue was
economy is buoyant, the company should invest in oversubscribed. Later, SEBI inspected the
……… market to take advantage of economy. prospectus and found some misleading statement
(a) primary market (b) secondary market about management of company. Identify the
(c) money market (d) capital market function performed by SEBI.
(a) Regulatory
26 Directors of FM Ltd. want to issue shares to (b) Protective
accumulate funds to modernise its plant and (c) Development
machines. Considering the huge expenditure (d) Both (a) and (b)
involved in floatation, the company decided to sell 30 “The securities in this financial market yield low
its shares to Yes Bank, an institutional investor. rate of return”. Which market is highlighted here?
Which method of floatation is considered by (a) Secondary market
Bharat Ltd.? (b) Primary market
(a) Offer for sale (c) Money market
(b) Offer through prospectus (c) Rights issue (d) Capital market
(d) Private placement
ANSWERS
1. (b) 2. (c) 3. (a) 4. (b) 5. (b) 6. (a) 7. (b) 8. (d) 9. (d) 10. (b)
11. (d) 12. (b) 13. (d) 14. (a) 15. (a) 16. (d) 17. (a) 18. (c) 19. (d) 20. (c)
21. (a) 22. (c) 23. (c) 24. (d) 25. (d) 26. (d) 27. (c) 28. (a) 29. (b) 30. (c)
Business Studies 55
CHAPTER 11
Marketing
Meaning of Marketing It helps to focus the activities of the organisation on
Marketing is a social process by which individuals and fulfilling the needs and wants of consumers, by
groups obtain what they need and want through creating, designing the product according to them. This helps to
offering and freely exchanging products and services of develop brand loyalty and bring prosperity for the firm.
value with others. 2. Role in the Economy Marketing acts as a catalyst in
According to Philip Kotler, ‘‘Marketing is a social process economic development of a country and helps in
by which individual groups obtain what they need and want raising living standard of the people. Marketing
through creating offerings and freely exchanging products inspires people to undertake various activities and to
and services of value, with others.’’ set-up enterprises for producing goods that are
demanded in the market, and ensure smooth flow of
Features of Marketing goods through efficient distribution system.
● Need and want
It helps to establish linkages between the business,
● Creating a market offering accelerating economic activity, leading to higher
● Customer value incomes, more consumption, increased savings and
● Exchange mechanism investment.
Functions of Marketing Differences between Marketing and Selling

● Gathering and analysing market information Basis Marketing Selling
● Market planning
Scope Marketing is a wider term Selling is only part of
● Product designing and development and includes selling also. It marketing process. It is
● Standardisation and grading covers all activities limited to exchange of
concerned with identifying goods or services for some
● Packaging and labelling and satisfying the wants of consideration.
● Branding the customers.
● Customer support services Focus It focuses on the needs of It focuses on transfer of
● Pricing of products customers. title of goods from sellers
to buyers.
● Promotions
● Physical distribution Objective It aims to earn profits It aims to maximise profit
through customer through increase in sales
● Transportation satisfaction. volume.
● Storage and warehousing
Start and It starts much before It starts after production
Role of Marketing End production and continues and ends with the sale of
even after sale. product.
All marketing organisations help the individual consumers
in raising the standard of living by making the products Strategy It involves strategies like It involves efforts like
available to them for satisfying their wants. It also plays an used product promotion, pricing promotion and persuasion
important role in a firm and in the economy, as explained and distribution. for selling the product.
below Emphasis It emphasises on It emphasises on bending
1. Role in a Firm Marketing emphasises customer development of product the customers according to
according to customers’ the product.
satisfaction as the key to survival and growth of an needs.
organisation.
Concept of Marketing Mix ● They are durable in nature and survive many uses, thus
Marketing mix represents the total marketing programme no regular demand.
● Purchase of these goods are pre-planned.
of an enterprise. The basic purpose of marketing mix is to
satisfy the needs and wants of customers in the most ● Competition is not so high as in case of convenience
effective manner. products.

According to Philip Kotler, ‘‘Marketing mix is the set of ● Salesmen and retailers help to promote their sales.
marketing tools that firm uses to pursue its marketing ● e.g. Jewellery, furniture, electronic goods, etc.
objectives in the target market.’’ (iii) Speciality Products The main features of speciality
products are
Elements of Marketing Mix
● These are purchased at a few locations involving a lot of
The elements of marketing mix are popularly referred to as
4ps which are product, price, place and promotion. time and effort of the consumer.
● Their unit price and profit margin is usually very high.
Product ● Demand for these products remains low.
A product is any good or service that a consumer wants. It ● Special efforts for buying. These are available for sale at a
is a bundle of utilities or a cluster of tangible and few places only.

intangible attributes which can be exchanged for a value. ● Almost no competition.
● Aggressive promotion is required to generate sales of

Classification of Products
these products and after sales services are an important
Products may be broadly classified as
part of the product promotion.
● Consumer products
● e.g. Rare collection of art, a hair cutting saloon or a dress
● Industrial products
designer.
1. Consumer Products On the basis of durability, we can classify consumer goods
Products which are purchased by the ultimate consumers, into three categories, viz
for the direct satisfaction of their needs and wants, are (i) Non-durable Products These goods are consumed in a
consumer products. They are classified on the basis of two single act of consumption.
important factors The main features of non-durable products are
● Shopping efforts involved ● They are available at convenient location.
● Durability of products ● Their unit price and profit margin is low.
● They need to be heavily advertised.

On the basis of shopping efforts involved, we can
classify consumer goods into three categories, viz e.g. Cosmetics, stationery, petrol, milk, etc.
(i) Convenience Products The main features of (ii) Durable Products These goods last for a long period of
convenience products are time and survive many uses.
● They are usually standardised goods, which are
The main features of durable products are
● They are usually available in central markets.
purchased at convenient locations, with least time
and efforts. ● Their unit price and profit margin is high.
● Their unit price and profit margin is low. ● They require greater personal selling efforts, guarantees
● They have a regular and continuous demand. and after sales service.
● e.g. Furniture, jewellery, electronics, etc.
● Impulse buying.
● Competition in these products is usually high. (iii) Services It means those activities, benefits or
● Sales promotion techniques help to promote the sale
satisfactions which are offered for sale.
of such products. The main features of services are
● e.g. Stationery, medicines, newspapers, books, etc. ● They are intangible in nature as they have no physical
(ii) Shopping Products The main features of shopping appearance, colour, shape or size.
● It is inseparable from its source. Therefore, it cannot be
products are
● These are purchased after a detailed comparison of
stored.
● They are highly variable and differ from one service
various products, which involves a lot of time and
effort of the consumer. provider to another.
● They provide social and psychological benefits to their
● Their unit price and profit margin is usually high.
users.
Business Studies 57
2. Industrial Products Product Mix

The products which are used as inputs for producing other A product is not just, a physical tangible object. It is rather a
goods, are called industrial goods. e.g. Raw materials, ‘bundle of services’ associated with the utilisation of that
engines, machines, tools, etc. These products are used as product. Apart from the physical product/service, product mix
inputs for producing other goods and are demanded by consists of branding, packaging and labelling.
manufacturers, transport agencies, banks, mining
companies and other producers. Branding
Branding is the process of assigning a distinctive name or
The important characteristics of industrial products are
symbol to a product, by which it can be remembered.
(i) Number of Buyers As compared to consumer
products, number of buyers of industrial products Important terms related to branding are as follows
are limited. 1. Brand A brand is the identification of a product. e.g.
(ii) Channel Levels Because of limited number of Nike, Reebok, LG, etc.
buyers, concentrated markets and bulky products, 2. Brand Name The part of brand, which can be spoken is
direct or shorter channels of distribution are used. called brand name. e.g. Maggi, Lux, Ambuja Cement, etc.
(iii) Geographic Concentration Usually, industries are 3. Brand Mark The part of brand, which cannot be spoken,
located in a particular region or location. Therefore, but can be recognised is known as brand mark. e.g. Red
market of industrial goods is highly concentrated. and blue ball of Pepsi.
(iv) Derived Demand The demand for industrial 4. Trademark A part of brand, which is given legal
products is dependent upon the demand of
protection is called trade mark. No other firm can use the
consumer goods that they help to produce. This is
name or sign, for which a company gets legal protection.
called derived demand.
e.g. Maruti Suzuki sign on Maruti cars.
(v) Technical Consideration While purchasing
industrial products, technical consideration assumes Characteristics of a Good Brand Name
great importance. The following points must be considered while deciding a
(vi) Reciprocal Buying It refers to exchange of brand name for a product
products by two industries with each other, which is 1. Short and Easy A brand name should be short, easy to
done many a times in case of industrial goods. pronounce, spell, recognise and remember. e.g. Vim,
(vii) Leasing Out Leasing refers to the use of an Ponds, Lux, etc.
industrial product, without purchasing it, by paying 2. Suggestive A brand should suggest the product’s quality
a nominal periodic rent, called lease rental. or benefit. e.g. Ujala, Fair and Lovely, etc.
Industrial goods can be classified into the following major 3. Distinct A brand name should be distinct from the other
categories brands present in the market. e.g. Liril, Sprite, Raymonds,
(i) Materials and Parts These goods become a part of etc.
the manufactured product completely. They are of
4. Adaptable to Packaging A brand name should be
two types
adaptable to packing and labelling requirements in
● Raw materials such as cotton, sugarcane, oilseeds,
different media and languages.
etc.
● Manufactured parts and materials such as tyres,
5. Versatile A brand name should be versatile enough to
electric bulb, battery, etc and glass, iron, plastic include other products under it.
respectively. 6. Capable of Registration A brand name should be
(ii) Capital Items These goods are used in the capable of being registered and legally protected.
production of finished goods. They are of two types 7. Staying Power A brand name should have long- lasting
● Installations such as elevators, plant, mainframe staying power and should not get out of date.
computers, etc.
Labelling
● Equipments such as hand tools, fax machines,
The term ‘labelling’ means designing a label to be put on the
personal computers, etc. package. A label may be a small slip attached or placed to the
(iii) Supplies and Business Services These goods last product to complex graphics that are part of package which
for a short duration and help in developing finished denote its nature, contents, ownership, destination, etc. A label
product. They are of two types describes the product, its usage and specifies its contents.
● Maintenance and repair items such as paint,
The various functions performed by a label are
nails, etc.
1. Describe the Product and Specify its Contents It
● Operating supplies such as lubricants, stationery,
specifies the contents and other features of the product.
writing papers, etc.
It enables the manufacturer to give clear instructions The package of a product performs various functions for the
to the consumer about the proper use of his product. product. These functions are
It helps to describe the product, its usage, cautions in 1. Product Identification The package of a product helps
use, contents, manufacturing and expiry dates, price, the customer to easily identify the product in the market.
quantity, etc. e.g. Red Label tea in a red colour packing, Taj Mahal tea
2. Identification of the Product or Brand It gives a in blue box pack, etc.
definite identity to the product or brand and therefore, 2. Product Protection The package of a product protects it
the identification of a product becomes easy. e.g. The from spoilage, breakage, pilferage, leakage, damage, etc.
name Pears printed on toilet soaps helps us to know e.g. Oil in plastic bottles.
which soap out of several soaps is Pears.
3. Facilitating Use of the Product The package of a
3. Grading of Products It enables the manufacturer to product helps the consumer to open, handle and use the
grade the products into different categories. e.g. product more conveniently, e.g. toothpaste tubes,
Hindustan lever sells different grades of tea under handwash soap dispenser, etc.
green, yellow and red labels.
4. Product Promotion An attractive package attracts the
4. Helps in Promotion of Products A good label can attention of people and at the same time, provides
attract attention, describe the product and stimulate detailed information about the product. e.g. Ferrero
the buyer to buy the product. It helps in the rocher chocolates.
promotion of the product.
Pricing
5. Providing Information Required by Law It
provides information required under law. e.g. Pricing refers to the process of determining the price of a
Statutory warning ‘Smoking is injurious to health’ product. Price of a product refers to the amount of money that
must be stated on the package of cigarettes. Such the customer has to pay to obtain a product from the market.
information is considered necessary on processed Pricing is considered as a regulator of demand of a product,
foods, poisonous materials, drugs, medicines, etc, because, when the price of the product is increased, demand
which provides safety warning to the consumers. falls, and vice-versa.
Factors Affecting Price Determination
Packaging The important factors that affect the price of a product are
Packaging refers to the act of designing and producing the
1. Product Cost The total cost of product includes
container or wrapper of a product. Various kinds of goods
production, selling and distribution costs. In the long
are placed or packed into appropriate containers for
run, the firm strives to cover all their costs. The cost sets
protection and convenient handling. the minimum level or floor price for a product. In
Thus, packaging implies placing products in suitable addition to that firm aims to earn profit margin over and
packages for delivery of the product to customer or for the above the costs.
purpose of storage and transport. Packaging is not limited 2. The Utility and Demand It is necessary to anticipate
to facilitating use and protection of the product, but also the utility and demand of a product, while fixing the
helps in product indentification and promotion of the price, as if a product is offering higher utility, one can
product. easily charge high price from the customer and vice-versa.
There can be three different levels of packaging viz 3. Extent of Competition in the Market The price of a
1. Primary Packaging It means the immediate product can be set upto the higher limit, if the extent of
container of a product. It may be kept till the competition is low in the market and vice-versa.
customer is ready to use the product, e.g. plastic 4. Government and Legal Regulations To protect the
package for socks, or throughout the life of a product, interest of general public, the government has all the
e.g. toothpaste tube or bottle of perfume. It provides rights to control the prices of various products and services
protection and facilitates the use of the product. by including the products in the category of essential
commodities such as drugs, some food items, LPG, etc.
2. Secondary Packaging It means additional layer of
protection. e.g. a toothpaste tube is packed in a 5. Pricing Objectives If the objective of the firm is to
cardboard box. When the consumer begins to use the maximise sales, price will be set at a lower level, whereas,
product, the box is disposed-off. if the firm’s objective is profit maximisation, price will be
set at a higher level.
3. Transportation Packaging It means packaging
done to protect the product and help in the process 6. Marketing Methods Used The price of the product also
of transportation and storage. e.g. toothpaste boxes gets affected by various techniques and methods of
are sent to retailers in corrugated boxes each marketing used to promote the products. If the company
containing 50 or 100 units. is using intensive advertising to promote the sale of
product, then it will charge high price, etc.
Business Studies 59
Physical Distribution The various indirect channels are

Physical Distribution is concerned with making the goods and (i) Manufacturer–Retailer–Consumer (One level
services available at the right place, so that people can channel) In this method, an intermediary is used.
purchase the same. There are two important decisions related Here, manufacturer sells the goods to the retailer and
to physical distribution. They are then retailer to consumer. This method is used for
expensive products. This method is also useful for
● Channels of distribution ● Physical movement of goods
selling Fast Moving Consumer Goods (FMCG).
Channels of Distribution (ii) Manufacturer–Wholesaler–Retailer– Consumer
Channels of distribution are set of individuals and firms that (Two level channel) In this method, manufacturer
sells the material to the wholesaler, wholesaler to the
take title or assist in transferring title, of particular goods and retailer and then retailer to the consumer. This
services as they move from producers to consumers. It refers medium is mainly used to sell consumer non-durable
to a team of merchants, agents and business institutions that goods like soap, tea, salt, sugar, ghee, etc.
combine physical movement and title movement of products. (iii) Manufacturer–Agent–Wholesaler–Retailer–
Consumer (Three level channel) In this case,
Functions/Role of Channels of Distribution manufacturers use their own agents or brokers who
Channels of distribution smoothen the flow of goods by connect them to wholesalers and then to the retailer.
creating possession, place and time utilities. Some important This is done when the line of product is limited and
functions performed by them are wide coverage is required.
1. Sorting It refers to the process of sorting the product Factors Determining Choice of Channels
into homogeneous groups on the basis of size, quality, The choice of channels depends on various factors which
features and price. are categorised as
2. Accumulation It refers to the process of accumulation 1. Product Related Factors These factors include
of goods into larger homogeneous stocks. This helps to nature of the product, perishability, unit value of the
maintain a continuous flow of supply. product and product complexity.
3. Allocation It involves breaking homogeneous stocks 2. Company Related Factors These factors include
into smaller, marketable lots. This helps in making sales financial strength of the firm and degree of control.
easily according to different requirements of different 3. Competitive Factors Sometimes, a firm may choose
buyers. such channel, which has been adopted by the
4. Assorting It refers to the process of combining various competitors. In some cases however, they may avoid
goods of the same line of product, for sale to customers the channel as adopted by the competing firm. Thus,
such as a cricket kit containing a bat, a ball, gloves, it will depend upon the policy of the firm, whether it
wickets, stumps, helmet and leg guards. wants to go with the competitors or be different from
5. Product Promotion Middlemen helps in the promotion them.
of product by organising demonstrations, displays, 4. Market Factors These factors include number of
contest, promotional events, etc. This helps in increasing buyers, size of the order and geographical
the sale of products. concentration of buyers.
8. Negotiation Intermediaries usually discuss and decide 5. Environmental Factors These factors such as
the terms and conditions of sale, by negotiating the economic condition and legal constraints also affect
price, quality, guarantee, terms and conditions of delivery the choice of channel.
and payment, etc.
7. Risk-taking Middlemen usually bear risks on account of Promotion
price and demand fluctuations, spoilage, destruction, etc, It refers to the use of communication with the twin
during the process of exchange. objectives of informing potential customers about a
product and persuading them to buy it.
Types of Channels of Distribution
The main role of promotion is to create awareness, get
The major types of channels of distribution are as follows:
people to try products, provide information, keep loyal
1. Direct Channel (Zero Level Channel) The most simple customers, increase use of product, identify potential
mode of distribution is direct distribution, where the customers and teach clients about potential services.
goods are directly made available to consumers from the
manufacturers, without use of any intermediary. Promotion Mix and its Elements
2. Indirect Channels When one or more intermediary is Promotion mix consists of all the activities aimed at
involved in the distribution network, then it is referred to persuading customers to buy the products.
as indirect channels.
The various elements of promotion mix are as under Objections against Advertising
● Advertising ● Personal selling (i) Economic Objections against Advertising
● Sales promotion ● Public relations ● Unproductive ● Creation of monopoly
● Increase in prices
Meaning of Advertising
Advertising involves dissemination of information about a (ii) Social Objections against Advertising
● Misleads consumers ● Creates confusion
product, service or enterprise to induce people to take actions
● Consumption of undesirable products
beneficial to the advertiser.
Features of Advertising Meaning of Personal Selling
● It is a paid form. Personal selling or salesmanship is the process of informing,
● It is a impersonal communication. assisting and persuading people to buy a product or service
● Identified sponsor. through direct personal contact.
Role of Advertising Qualities of a Good Salesman
● Generates employment If a salesman wants to become successful, he should possess
● Supports the press
the below mentioned qualities
● Stimulates research
● Physical qualities ● Mental qualities
● Improves standard of living

● Social qualities
Practice Questions
1 Which of the following functions of marketing 6 Which of the following refers to that process of
helps in making product more attractive and assigning a distinctive name or symbol to a
improving its performance? product, by which it can be known, remembered
(a) Marketing planning and identified?
(b) Product designing and development (a) Trademark (b) Product mix
(c) Branding (c) Branding (d) Packaging
(d) Promotion
7 Which of the following does not come under the
2 …………. is the process of planning, organising, category of non-controllable factors?
directing and controlling the activities relating to (a) Rate of inflation (b) Competition
exchange of goods and services. (c) Packaging decision (d) Credit policy of banks
(a) Marketing management
(b) Sales management
8 Packing helps the marketers in
(c) Personnel management (a) raising standards of health and sanitation
(d) Financial management (b) innovational opportunity
(c) product differentiation
3 Which of the following is the function of (d) All of the above
marketing?
9 Which of the following refers to the process of
(a) Gathering and analysing market information
(b) Marketing planning
designing a small slip or complex graphics that are
(c) Standardisation and grading a part of package, which denotes its nature,
(d) All of the above content and usage?
(a) Branding (b) Packing
4 Marketing plays a very important role in the (c) Labelling (d) None of these
economy by
(a) raising living standard of the people 10 Which function of channels of distribution refers to
(b) ensuring smooth flow of goods through efficient the process of creating desired combinations of
distribution system products to fulfil varied needs of customers such as
(c) accelerating economic activity cricket kit?
(d) All of the above (a) Sorting (b) Accumulation
(c) Allocation (d) Assorting
5 ……… refers to the important decisions related to
the product such as quality, design, branding, 11 If the management of a company, wants to exercise
product packaging, labelling, etc. highest level of control over the distribution of its
(a) Marketing mix products, which of the following channels of
(b) Product mix distribution would be preferred by it?
(c) Promotion mix (a) Zero level channel (b) One level channel
(d) Marketing (c) Two level channel (d) Three level channel
Business Studies 61
12 Which of the following should not be performed by 19 Utility and demand is an important factor for
the channels of distribution of goods? determing price of a commodity. If the demand is
(a) Sorting elastic, price should be set at a ……level and if the
(b) Assorting demand is less elastic or inelastic price can be set
(c) Quality improvement at a ……. level.
(d) Risk taking (a) higher, lower
13 Samsung is a leading manufacturer of electronic (b) lower, higher
goods across the globe. It is planning to introduce a (c) lower, minimum
(d) minimum, lower
high end smart TV in the asian markets and is
anticipating moderate demand for it. 20 Which of the following statements is not correct?
Based on these assumptions, it fixed the price of (a) Marketing is same thing as shopping for goods and
services
TV @ $ 1,500 per TV. Which of the following factors
(b) Marketing is equally relevant to non-profit
affected the price of the TV? organisations
(a) Utility and demand (c) Marketing management means management of the
(b) Product cost marketing functions
(c) Extent of competition in the market (d) Selling is only a part of the process of marketing
21 Transportation helps in creating ………. and
14 Which of the following statements is not correct?
warehousing helps in creating ……….. .
(a) In zero level channel, goods are directly made
(a) time utility, place utility
available to consumers from manufacturers
(b) place utility, time utility
(b) In one level channel, goods are made available from
(c) product utility, place utility
manufacturers to retailers and then to customers
(d) time utility, product utility
(c) In two level channel, goods are made available from
manufacturer to agent and then to retailers 22 As soon as CocaCola reduced its selling price on 2
(d) None of the above ltr to ` 75, soon Pepsi followed with a price
15 Mr Raj wants to buy a LCD for his family. When he reduction in its selling price and priced its 2 ltr per
visited Anand Electronics to make the purchase, bottle at ` 74.50. Which factor of pricing is being
he got confused. Which promotional tool brought discussed here?
him to the shop and which promotional tool is (a) The utility and demand
(b) Extent of competition in the market
required now to remove his confusion?
(c) Marketing methods used
(a) Advertising, personal selling
(d) Pricing objectives
(b) Personal selling, advertising
(c) Sales promotion, personal selling 23 Which of the following is not a brand name?
(d) Public relations, advertising (a) BMW (b) Star India
16 ‘‘Personal selling creates effective demand which (c) Vi (d) None of these
results in increase in income, with increase in 24 Which of the following is not a part of marketing
income, there will be more products and services, mix?
which in turn brings economic growth ’’. This (a) Price mix (b) Promotion mix
statement signifies the importance of personal (c) Place mix (d) Labelling and branding
selling to
25 Which of the concepts ensures profit through
(a) businessman (b) customers
(c) society (d) None of these product quality?
(a) Production (b) Product
17 When Sarita opened the door on hearing the (c) Selling (d) Marketing
doorbell, a person was standing who was selling
26 Which of these is not a generic name?
Britannica world ‘encyclopedia’. Here, Britannica
(a) Tubelight (b) Parker pen
is using which element of promotion mix?
(c) Shoes (d) Television
(a) Public relation
(b) Sales promotion 27 Computer education is an example of ……… being
(c) Advertising marketed.
(d) Personal selling (a) ideas (b) information
18 Abhinav Mehta, Marketing Manager of Roop (c) experience (d) services
Cosmetics, is facing the problem of poor sales. 28 ‘Visit Udaipur–The City of Lakes’ is an
What mode of communication he can adopt to advertisement of a travel agency. What is being
target the large population? marketed here?
(a) Newspaper (b) Television (a) Product (b) Experience
(c) Radio (d) All of these (c) Service (d) Place
29 ………function is concerned with the important (a) Primary packaging

decision of managing inventory. (b) Secondary packaging
(a) Product (b) Price (c) Transportation packaging
(c) Promotion (d) Physical distribution (d) All of the above
30 Ishita was suffering from hair loss problem. She 34 Fitgo Company is adopting a promotional tool,
wanted hair oil which would help her with this which plays a persuasive, service and
problem. She went to a departmental store and informational role thereby link a business firm to
picked up Sun’s hair grow oil with a tagline ‘Bhulo its customers. Identify this promotional tool.
balon ka Girna’. Then she read the price, read the (a) Sales promotion (b) Personal selling
instructions for use, its expiry date and other (c) Public relations (d) Advertising
details. Identify the elements of product mix 35 The function of marketing, concerned with
performed by oil selling company. informing the customers about the firm’s product is
(a) Branding (b) Labelling (a) market analysis
(c) Promotion (d) Packaging (b) standardisation
31 In which function of marketing, products are (c) promotion
(d) grading
divided into different groups?
(a) Market planning (b) Product development 36 In one of its labels, Dabur Amla Hair Oil had
(c) Standardisation (d) Grading printed “Baalon mei dum, life mei fun” as a
32 Philippines aero group PAL Holdings announced message. Which function of labelling is discussed
discounted fares, starting as low as ` 1,599 for here?
domestic destinations operated by its Indian joint (a) Describe the product and specify its contents
(b) Identification of product or brand
venture carrier and ` 2,599 for international (c) Helps in promotion of products
flights operated by other group airlines under a (d) All of the above
limited period offer.
37 Kalash Dairy Products Ltd. is a successful
Suggest the medium of communication, which can
business of making milk. They decided to put a
be used by the firm to inform a large number of
hologram seal on the packet to ensure that product
people about the new fares.
is not tampered with. Which decision is taken
(a) Personal selling
here?
(b) Sales promotion
(a) Labelling (b) Branding
(c) Advertising (c) Standardising (d) Packaging
(d) Public relations
38 Hindustan Unilever Ltd (HUL) differentiates its
33 Harish bought a pain relieving ointment after three types of tea with three different coloured
seeing it being displayed in the chemist’s shop. labels (Green, Red and Yellow). Which function of
The ointment tube has packet in a cardboard box. labelling is highlighted here?
The tubes were received by the chemist from the (a) Describe the Product
wholeseller in corrugated boxes containing 30 (b) Identification of Product
units. Identify the level of packaging involved in (c) Grading of Products
the above mentioned case. (d) Helps in Promotion of Products
ANSWERS
1. (b) 2. (a) 3. (d) 4. (d) 5. (b) 6. (c) 7. (c) 8. (d) 9. (c) 10. (d)
11. (a) 12. (c) 13. (a) 14. (c) 15. (a) 16. (c) 17. (d) 18. (d) 19. (b) 20. (a)
21. (b) 22. (b) 23. (d) 24. (d) 25. (b) 26. (b) 27. (d) 28. (d) 29. (d) 30. (b)
31. (d) 32. (c) 33. (d) 34. (b) 35. (c) 36. (c) 37. (d) 38. (c)
Business Studies 63
CHAPTER 12
Consumer Protection
Concept of Consumer Protection 2. Business uses Society’s Resources Business
Consumer protection is a very wide term. It aims at providing firms use resources that belong to the society such
information to the consumers about their rights and as manpower, mineral resources, capital, etc.
responsibilities, providing them protection against Therefore, it is the responsibility of businesses to
unscrupulous, unfair trade practices of traders and speedy convert these resources into useful goods and
redressal of their grievances. services for the welfare of society.
3. Social Responsibility Business organisation
Importance of Consumer Protection makes money by selling their products to
Consumer protection has assumed great importance for consumers. It is the social responsibility of
consumers as well as business in the following ways businessman to provide satisfaction to their
customers and take care of their interests.
Importance from Consumer’s Point of View 4. Moral Justification It is the moral duty of a
The importance of consumer protection from the consumer’s businessmen to serve their customers well and keep
point of view can be understood from the following points them away from exploitative and unfair trade
1. Consumer Ignorance Consumer Protection Act provides practices.
required information related to the rights and remedies Therefore, business must avoid unfair trade
available to consumers. practices such as adulteration, misleading
It spreads awareness, so that a consumer will be able to advertising, black marketing, etc.
know about the redressal agencies and can approach them
5. Government Intervention If a business
whenever needed.
organisation is engaged in any form of exploitative
2. Unorganised Consumers Consumers need to be trade practices, government would interfere and
organised in the form of consumer organisations which can tarnish the image of the company.
would take care of their interests. Due to lack of consumer Therefore, it is in the interest of business itself, to
organisation in India, consumer protection becomes take care of consumer protection.
necessary to promote and protect the interests of
consumers. The Consumer Protection Act, 2019
3. Widespread Exploitation of Consumers Consumer is the The Consumer Protection Act, 2019 seeks to protect and
kingpin of the market, still there is lot of exploitation of promote the consumers interest through speedy and
consumers as businessmen use various unfair trade practices inexpensive redressal of their grievances.
to cheat and exploit consumers. Consumer protection It is applicable to all types of businesses whether a
provides safety to consumers from such exploitations. manufacturer or a trader and whether supplying goods
or providing services including e-commerce firms. The
Importance from Businessmen’s Point of View act confers certain rights to consumers with a view to
The importance of consumer protection from businessmen’s empowering them and to protect their interests.
point of view can be understood from the following points
1. Long-term Interest of Business Customer is the Consumer Rights
foundation of business. Satisfied consumers not only bring The Consumer Protection Act, provides following six
repeated sales but also give positive feedback about the rights to consumers to safeguard their interests
product, which help to increase the customer-base of
1. Right to Safety It means a consumer has a right
business. This facilitates long-term profit maximisation of
to be protected against the marketing of such goods
the firm.
and services that are harmful to life and health.
Thus, consumers are educated to use standardised ● A consumer must ensure that he gets a fair deal.
goods, such as electrical goods with ISI mark, food ● A consumer should be honest in his dealings, choose legal
products with FPO mark, etc as such goods would be goods and discourage unscrupulous practices like black
an assurance of meeting quality specifications. marketing, hoarding, etc.
2. Right to be Informed A consumer has the right to get ● A consumer should always ask for a cash memo, as it is
true and complete information about the quality, the proof of purchase required at the time of taking any
quantity, price, contents, expiry date of the goods and action against a fraudulent seller/manufacturer.
services which he intends to buy. ● A consumer must file a complaint in case of any short-
Therefore, the legal framework in India has made it coming in goods or services availed.
compulsory to provide all such information on the ● A consumer should take initiative to form consumer
package of the product. societies that can take active part in educating consumers
3. Right to be Assured Consumers have the freedom to and safeguarding their interests. A consumer should
choose products of their choice. This implies that the respect the environment and avoid creating pollution.
marketers should offer a wide variety of products in
terms of quality, brand, size, etc, so that the consumer Meaning of Consumer
can make a wise choice by comparing different products Consumer is a person, who buys any good or avails any
available at competitive prices. service for a consideration which has been paid or promised,
4. Right to be Heard The consumer has a right to file a or partly paid and partly promised, or under any scheme of
complaint and to be heard in case of dissatisfaction with a deferred payment.
goods or a service. It is because of this reason, many
The term includes any other user of such goods when such
enlightened business firms have set up their own
use is made with the approval of the buyer. The term
consumer service and grievance cells and help consumers
‘consumer’, however, does not include a person, who obtains
in redressal of their grievances.
such goods for resale or for any commercial purpose.
5. Right to Seek Redressal This right assures justice to
consumers against exploitation and includes Who can File a Complaint?
compensation for any loss or injury suffered by the The following can file a complaint under the act
consumers, replacement of goods or repair of defects in ● A consumer.
the goods in order to provide satisfaction to consumers. ● Any voluntary consumer association registered under the
Thus, the consumer has a right to get relief in case the
Companies Act, 2013.
product falls short of his expectation.
● The Central Government or any State Government.
6. Right to Consumer Education Consumer should

● A legal heir or representative of a deceased consumer.
have knowledge about the various rights and reliefs
provided by the legislations to protect their interest. Against Whom a Complaint can be Filed?
Every consumer has the right to be well informed about ● A complaint can be filed against seller, manufacturer or
his rights, and to spread awareness and education by dealer of goods, whose goods are defective.
forming consumer organisations and associations.
● It can be filed against the provider of services, if they are
Consumer Responsibilities deficient in any manner.
A consumer should fulfil the following responsibilities, while
purchasing, using and consuming goods and services Redressal Agencies
● A consumer should be aware about the various goods and
For the redressal of consumer grievances, the Consumer
services available in the market, so that he can make a wise Protection Act, 2019 provides for setting up of a three-tier
choice by comparing their features and prices. machinery at the district, state and the national levels.
These agencies are
● A consumer must always buy standardised goods as they
provide quality assurance. Thus, look for ISI mark on 1. District Commission
electrical goods, FPO mark on food products, hallmark on ● The State Governments are required to establish District
jewellery, etc. Commission in each district.
● A consumer must learn about the various risks associated ● A District Commission can receive consumer complaints,
with the use and maintainence of goods. He must follow where the value of goods or services and the compensation
the manufacturer’s instructions carefully. claimed does not exceed ` 1crore.
● A consumer must read the labels carefully, so as to have ● On receiving the complaint, the District Commission shall
complete information about the price, quantity, refer the complaint to the opposite party concerned and
ingredients, usage, contents, expiry date, etc. send the sample of goods for testing in a laboratory.
Business Studies 65
2. State Commission Ways and Means of Consumer Protection

● State Commission is set up by the State Government
There are various ways, by which the objective of consumer
and its jurisdiction is restricted to the boundaries of protection can be achieved
the state concerned.
1. Self-regulation by Business Business firms realise that it
● Only those complaints can be filed, where the value of
is in their long-term interest to serve the customers well.
goods or services and compensation claimed is more Socially responsible firms follow ethical standards and
than ` 1 crore but not more than ` 10 crore. practices in dealing with their customers. Many firms have
● The appeals against the orders of any District
setup their customer service and grievance cells to redress
Commission can also be filed before the State the problems and grievances of their consumers.
Commission, within 45 days of passing of the order.
2. Business Associations The associations of trade,
3. National Commission commerce and business like Federation of Indian Chambers
● The National Commission is set up by the Central of Commerce of India (FICCI) and Confederation of Indian
Government. Industries (CII) have laid down certain code of conduct,
● All complaints pertaining to those goods or services which lay down for their members the guidelines in their
and compensation whose value is more than ` 10 crore dealings with the customers.
can be filed. 3. Consumer Organisations They play an important role in
● Appeals against the order of any State Commission can educating consumers about their rights and providing
also be filed before the National Commission, within 30 protection to them. They can also force business firms to
days of passing of the order. avoid malpractices and exploitation of consumers.
● An order passed by the National Commission is 4. Government The government can protect the interests of
appealable before the Supreme Court within a period the consumers by enacting various legislations. The legal
of 30 days of such order. framework in India encompasses various legislations, which
provide protection to consumers. The most important of
Reliefs Available these regulations is the Consumer Protection Act, 1986,
If the consumer court is satisfied about the genuineness which provides three-tier machinery for redressal of
of the complaint, it can issue one or more of the consumer grievances.
following directions to the opposite party
● To remove the defect in goods or deficiency in services.
Consumer Awareness
A consumer’s awareness about the rights and responsibilities can
● To replace the defective product with a new one, free
help to achieve the objective of consumer protecion. In addition,
from any defect. it also requires the consumers to get together and form consumer
● To refund the price paid for the product or the charges
organisations for promotion and protection of their interests.
paid for the service.
In India, several consumer organisations and Non-Governmental
● To pay a reasonable amount of compensation for any
Organisations (NGOs) have been set up for the protection and
loss of injury suffered by the consumer due to the promotion of consumers interest. They have their own
negligence of the opposite party. constitution and are free form government interference. Some of
● To pay punitive damages in appropriate circumstances.
them are
● To discontinue the unfair/restrictive trade practice and ● VOICE (New Delhi).
not to repeat it in the future. ● Common Cause (New Delhi).
● Not to offer hazardous goods for sale.

● Consumer Guidance Society of India (Mumbai).
● To withdraw the hazardous goods from sale.

● CERC (Consumer Education and Research Center) Ahmedabad.
● To cease manufacture of hazardous goods and to desist

● CUTS (Consumer Utility and Trust Society) Jaipur.
from offering hazardous services.

● To pay any amount (not less than 5% of the value of the Role of Consumer Organisations and NGOs
defective goods or deficient services provided), to be Consumer organisations and NGOs perform several functions for
credited to the consumer welfare fund or any other the protection and promotion of interest of consumers. These
organisation/person, to be utilised in the prescribed include
manner. ● Creating awareness about consumer rights by organising
● To issue corrective advertisement to neutralise the

training programmes, seminars and workshops.
effect of a misleading advertisement. ● Imparting knowledge about consumer problems, legal reporting
● To pay adequate costs to the appropriate party.

and reliefs available by publishing periodicals and publications.
● Carrying out comparative testing of consumer products in ● Providing consumers legal assistance by providing aid,
accredited laboratories and publishing the results for the advice, etc to seek legal remedy.
general benefit. ● Filing complaints in appropriate courts on behalf of
● Encourage consumers to take action against any unfair or consumers.
unscrupulous activity of the seller. ● Taking initiative for filing cases in the interest of general
public.
Practice Questions
1 To avail the benefit of Consumer Protection Act, 8 Which consumer right gives the freedom to
the consumer business firms to set up their own consumer
(a) must insist on cash memo grievance cell?
(b) no necessity for cash memo (a) Right to consumer education
(c) need a certificate of consumer (b) Right to choose
(d) None of the above (c) Right to be heard
(d) Right to be informed
2 Which of the following is an association of trade
and is engaged in the protection of consumers’ 9 To publish a magazine under the title ‘Upbhokta
interests? Jagran’ is an example of which right of consumer?
(a) SEBI (a) Right to be informed
(b) RBI (b) Right to safety
(c) CII (c) Right to be heard
(d) ICICI (d) Right to consumer education
3 Which of the following is a reason why a 10 Raman bought a room heater of a reputed brand of
businessman should lay emphasise on the ` 1,500, but it caused an electric shock while it was
protection of consumers and their interests? being used. Raman wants to exercise his ‘right’.
(a) For long-term profit maximisation Identify the ‘right’ under which he can be
(b) For fulfilling social responsibility protected?
(c) To avoid government intervention (a) Right to seek redressal
(d) All of the above (b) Right to be assured
(c) Right to be informed
4 As per …………., the consumer should have the (d) Right to consumer education
right to make wise choice by comparing different
products available at competitive prices. 11 A consumer should follow which responsibility
(a) right to safety while purchasing, using and consuming goods and
(b) right to be assured services?
(c) right to be informed (a) He must ensure that he gets a fair deal
(d) right to be heard (b) He should be aware about the various goods and
services available in the market
5 ………….. means right to know the MRP, expiry (c) He should always ask for a cash memo
date, weightage and quantity of the product. (d) All of the above
(a) Right to be heard
(b) Right to be informed 12 State commission entertains complaints of goods or
(c) Right to consumer education services whose value exceeds ……… but less than
(d) Right to be assured ……… .
(a) ` 40 lakh and ` 50 lakh
6 Saumya purchased a watch from a Titan Gallery. (b) ` 1 crore, ` 10 crore
As a proof of purchase, what she should ask for? (c) ` 10 crore, ` 100 crore
(a) Invoice (b) Cash memo (d) None of the above
(c) Warranty card (d) None of these
13 Which of the following major activities is/are
7 Sellers often adopt unfair trade practices to performed by the Bureau of Indian Standards?
increase the sales of their products. Give few (a) Formulation of quality standards for goods
examples of such practices adopted by seller. (b) Certification of goods through the BIS certification
(a) Misleading advertisements scheme
(b) Fake price stickers on products (c) Handling complaints about quality of goods carrying
(c) Supply of cheap quality product ISI mark
(d) All of the above (d) All of the above
Business Studies 67
14 For the following two statements, choose the (a) To remove the defect in goods or deficiency in
correct option. services
(b) To replace the defective good with a new one, free
Statement I Anshika wants to buy a packet of from any defect
juice. As an aware customer, she can be sure about (c) To refund the price paid for the product or the
the quality of juice she plans to buy by looking for charges paid for the service
FPO marks on the packet of juice. (d) All of the above
Statement II Consumer Protection Act provides 19 A complaint can be filed against a seller,
required information related to the rights and manufacturer or a dealer of goods whose goods are
remedies available to consumers. ............ in any manner.
(a) perfect (b) flawless
Alternatives
(c) defective (d) None of these
(a) Statement I is correct and Statement II is wrong
(b) Statement II is correct and Statement I is wrong 20 Who among the following can be President of the
(c) Both the statements are correct National Consumer Dispute Redressal
(d) Both the statements are incorrect Commission?
15 Coka Crackers Ltd., a fire cracker manufacturing (a) Judge of a High Court
company, launched some new products on the eve (b) Judge of a Supreme Court
(c) Lawyer of a High Court
of Diwali which attracted many customers.
(d) Lawyer of a Supreme Court
To meet the increased demand, the company
employed children from near by villages and in the 21 Mr. Surya has purchased a product and found it
urgency of work, they ignored to specify safety defective. The seller denied taking it back.
warnings on packets of crackers. Identify which Mr. Surya can file complaint under the Consumer
consumer right is being ignored. Protection Act, 2019.
(a) Right to be assured Within how much time, complaint can be filed
(b) Right to be heard from the date on which the cause of action has
(c) Right to be informed arisen?
(d) Right to seek redressal (a) Within three months
16 Sumit filed a case against Domestic Cooling Ltd. in (b) Within six months
(c) Within a year
the District Commission but he was not satisfied
(d) Within two years
with the order of the ‘District Commission’. Where
he can appeal further against the decision of 22 Shweta wants to buy a gold ring. As an aware
‘District Commission’? consumer, how can she be sure about the quality of
(a) State Commission gold ring she is going to buy?
(b) National Commission (a) She should check hallmark on the jewellery
(c) Consumer Committee
(b) She should check agro mark on the jewellery
(c) She should check FPO mark on the jewellery
17 Raghu purchased a truck worth ` 35 lakhs. The (d) She can ask from another jewellery
truck had some inbuilt problems and after some
days stopped starting. Since it was in the 23 Ms. Jeena wants to buy a mango drink. As a
guarantee period, it was shown to the company. responsible consumer, she should check which
The people in the company refused to attend his mark on the label of the mango drink?
complaints. (a) BSI mark
(b) ISI mark
It was heart breaking for him so he decided to file
(c) FPO mark
a complaint in the State Commission. The State
Commission on hearing the pleas from both the
parties gave decision in favour of the truck company. 24 A consumer court in Pune slapped a ` 55,000 fine
It was shockingly bad news for Raghu. on a reputed online food delivery company along
At what level of authority, should Raghu file a with a hotel for delivering non-vegetarian food to a
complaint now? lawyer who had ordered paneer butter masala but
(a) Supreme Court was delivered butter chicken instead.
(b) State Commission When he reportedly registered the complaint, the
(c) District Commission hotel promised to replace it and send another
(d) National Commission
parcel of food with the correct dish.
18 Which of the following is the relief available to a However, Deshmukh allegedly received butter
consumer under the Consumer Protection Act, chicken instead of paneer butter masala the second
2019? time as well.
Deshmukh sent notices to both the restaurant and 27 In what way the objective of consumer protection
the online food-delivery company for ‘hurting can be achieved?
religious sentiments’. (a) Self-regulation by business
(b) Business associations
Identify the right of consumer being violated in the
(c) Government
given case. (d) All of the above
(a) Right to be heard (b) Right to seek redressal
(c) Right to be assured (d) Right to safety 28 When the value of goods and services, alongwith
compensation claimed is more than ` 10 crore,
25 ‘Jago Grahak Jago’ is the publicity campaign
then the complaint can be filed in …… .
undertaken by government in eleventh five year
(a) State Commission
plan to (b) National Commission
(a) promote the demand (c) District Commission
(b) protect the seller (d) None of the above
(c) protect the interest of consumers
(d) promote the development of India 29 Where is consumer organisation CUTS situated?
(a) New Delhi (b) Ahmedabad
26 The Consumer Protection Act provides a number of (c) Jaipur (d) Bengaluru
reliefs to the consumers including replacement of
the product, removal of defect in the product, 30. Which of the following points highlight the
compensation paid for any loss or injury suffered by importance of consumer protection from
the consumer, etc. Identify the right of consumer. consumer’s point of view?
(a) Right to be informed (a) Consumer ignorance
(b) Right to be heard (b) Unorganised consumer
(c) Right to seek redressal (c) Widespreal exploitation of consumer
(d) Right to consumer education (d) All of the above
ANSWERS
1. (a) 2. (c) 3. (d) 4. (b) 5. (b) 6. (b) 7. (d) 8. (c) 9. (d) 10. (a)
11. (d) 12. (b) 13. (d) 14. (c) 15. (c) 16. (a) 17. (d) 18. (d) 19. (c) 20. (b)
21. (d) 22. (a) 23. (c) 24. (c) 25. (c) 26. (c) 27. (d) 28. (b) 29. (c) 30. (d)
Business Studies 69
CHAPTER 13
Entrepreneurship Development
Concept of Entrepreneurship ● Once an entrepreneur is aware that he has ventured on a
Entrepreneurship is the process of identifying opportunities new area and has taken certain calculated risks, he should
in the market place and arranging for resources to exploit also be aware that many problems are bound to come in
the identified opportunity in order to harness long-term the path of progress.
gains. This concept includes two important terms ● An entrepreneur should also be an effective leader who
entrepreneur and enterprise. An entrepreneur is a person should be able to guide and motivate his entire team.
who conceives the idea or discovers an opportunity in the ● In most cases, the entrepreneurial pursuits are new and
environment and initiates the process of converting the need very close attention.
opportunity into business. When business gets a proper ● Since entrepreneurs’ value outstanding performance, one
shape, it is called an enterprise. of the behavioural skills necessary is the sensitivity to and
concern for the ‘standards and quality of work’.
Characteristics of Entrepreneurship
● Every entrepreneur has limited resources in terms of time,
Following are the characteristics of entrepreneurship
finance and manpower.
1. Innovation It should be highly innovative to generate
new ideas, start a company and earn profits out of it. Functions of Entrepreneurship
2. Visionary and Leadership Quality To be successful, Following are the functions of entrepreneurship
the entrepreneur should have a clear vision of his new 1. Innovation and Creativity For businesses, innovation
venture. means implementing new ideas, creating dynamic
3. Ability to take a Risk Starting any new venture products or improving your existing services.
involves a considerable amount of failure risk. On the other hand, creativity is defined as the
4. Open Minded In a business, any circumstance can be tendency to generate or recognise ideas, alternatives, or
an opportunity and can be used for the benefit of a possibilities that may be useful in solving problems or
company. communicating with others. Entrepreneurs
think outside of the box and explore new areas for
5. Flexible An entrepreneur should be flexible and open
cost-effective business solutions.
to change according to the situation. To be on the top,
a businessperson should be equipped to embrace 2. Risk Taking and Achievement Entrepreneurship is a
change in a product and service, as and when needed. process in which the entrepreneur establishes new jobs
and organisation which are associated with risk, new
6. Know Your Product A company owner should know
opportunities and achievement. It results in
the product offerings and also be aware of the latest
introducing a new product or service to society. In
trend in the market.
general, entrepreneurs accept four types of risks namely
Competencies of an Entrepreneur financial risk, job risk, social and family risk as well as
These are certain basic competencies to be acquired by an mental and health risk.
entrepreneur 3. Organisation and Management The entrepreneurial
● One of the most fundamental competencies required for organisation is a simple organisational form that
the entrepreneurs is the ability to take initiative. includes one large operational unit, with one or a few
● Competency in creativity and innovation are sometimes
individuals in top management.
Entrepreneurial management means the skills
basic traits of certain individuals.
necessary to successfully develop and manage a
● An entrepreneur ventures into new ideas and new service.
business enterprise.
He treads into areas of uncertainty.
4. Research An entrepreneur finalises an idea only Process of Entrepreneurship Development

after considering a variety of options, analysing their It is a process meant to develop entrepreneurial abilities among
strengths and weaknesses by applying analytical entrepreneurs. Following steps will help to build an effective
techniques, testing their applicability, supplementing entrepreneurship development programme for an entrepreneur
them with empirical findings, and then choosing the to organise and launch the new ventures
best alternative.
1. Discover Any new process begins with fresh ideas and
5. Overcoming Resistance to Change New objectives, wherein the entrepreneur recognises and
innovations are generally opposed by people because analyses business possibilities.
it makes them change their existing behaviour
patterns. An entrepreneur always first tries new ideas 2. Evaluation The evaluation of an opportunity can be done
at his/her level. It is only after the successful by asking several questions to oneself.
implementation of these ideas that an entrepreneur 3. Developing a Plan After the identification of an
makes these ideas available to others for their benefit. opportunity, an entrepreneur has to build a complete
6. Catalyst of Economic Development An business plan.
entrepreneur plays an important role in accelerating 4. Resources Here, the entrepreneur recognises the source
the pace of economic development of a country by of finance and human resource from where they can be
discovering new uses of available resources and managed.
maximising their utilisation. In this step, the entrepreneur also tries to find investors
for his new business.
Concept of Entrepreneurship 5. Managing the Company After the hiring process and
Development funds are raised, it’s time for the entrepreneur to start the
Entrepreneurship development focuses on individual who operation to accomplish the desired goals.
wishes to start or expand a business. The whole point of 6. Harvesting The last step in this process is harvesting,
entrepreneurship development is to increase number of where an entrepreneur determines the future growth and
entrepreneurs and to create entrepreneurship culture development of the business.
within the society. In these days, it is treated as an
important tool of industrialisation and a solution of Entrepreneurial Values
unemployment problem of India. Milton Rokeach has defined values as “beliefs that guide
actions and judgement across a variety of situations.”
Need of Entrepreneurship Development Values determine what people consider to be good or bad for a
For a developing economy like India, need of civilised society. A civilised society considers qualities like
entrepreneurship development arises due to the following honesty, truthfulness, integrity, etc. as important for happy and
reasons healthy living.
1. Employment Opportunities It enables entre- These set of beliefs that provide standards which guide
preneurs to create more/additional employment behavior is known as values. In relation to business, social
opportunities for youth. values define the objectives of business as well as the manner
2. Economic Independence Entrepreneurs develop in which business affairs should be conducted.
and produce substituted products of imported goods The following are the prominent entrepreneurial values
and prevent the over-dependence on the other ● Innovativeness and creativity
countries. ● Independence or ownership
3. Capital Formation It encourage the establishment ● Quest for outstanding performance or achievement
of new industries in economy which increase the ● Respect for work
capital formation rate in country.

4. Development of Backward and Tribal Areas It Entrepreneurial Attitudes
leads to scattering of economic activities in all areas Attitudes constitute an important psychological attribute of
of the country. individuals which shape their behavior. It may be defined as
5. More Utilisation of Natural Resources It enables the way a person feels about something like a place, a
the economy to utilise and explore the abundant of commodity, a situation, an idea or a person.
natural resources. Entrepreneur should have a positive attitude for business
6. Economic Growth and Development It provides start-up and its growth because of the following reasons
● It inculcates in a person a high degree of motivation.
the base of industrialisation in economy which is
main cause of economic growth and economic ● The energy and capacity to take things forward.
development. ● The qualities of head and heart.

Business Studies 71
All of these help entrepreneurs in facing problems and Entrepreneurial Motivation

decision-making. They also help them to stay optimistic Entrepreneurial motivation may be defined as the process
under tough conditions. Therefore, by imbibing optimistic that activates the entrepreneurs to exert a high level of effort
behaviour in a person, the positive attitudes help them to for the achievement of their goals. In other words, the
exhibit the drive and energy to progress towards the entrepreneurial motivation refers to the drive or forces
realisation of their goal. Thus, positive attitude of an within an entrepreneur that affects his/her direction,
entrepreneur is essential for business and its growth. intensity and persistence of voluntary behavior.
Practice Questions
1 Entrepreneurship development programme is 10 Entrepreneurial development is the key to achieve
helpful for all round ………… through acceleration of
(a) Existing entrepreneurs industrial and entrepreneurial activities.
(b) First-generation entrepreneurs (a) economic development
(c) Future generation entrepreneurs (b) increase in profits
(d) All of the above (c) shareholders value
(d) business development
2 ............. makes a fortune out of ideas.
(a) Entrepreneurship (b) Trader 11 According to sociological approach,
(c) Engineer (d) None of these entrepreneurship is the ............... .
(a) process of sensitivity
3 Knowledge + skill + traits =
(b) process of role performance
(a) innovation (b) competency (c) process of economic change
(c) skill (d) creativity (d) All of the above
4 ................ is the means of enhancing the 12 Which of the following attitudes is not generally
knowledge and skill of entrepreneurs. associated with successful entrepreneurship?
(a) Entrepreneurship development (a) Competition and co-operation
(b) Intrapreneurship (b) Desire to influence others
(c) Both (a) and (b) (c) Innovation and product improvement
(d) None of the above (d) Status quo in business
5 Functions of entrepreneurship include which of the 13 The function of entrepreneur includes
following? (a) to imagine a business idea
(a) Innovation and creativity (b) to study project feasibility
(b) Risk taking and achievement (c) to setup enterprise
(c) Research (d) All of the above
14 Which of the following is not a characteristic of
6 The main point of the development process is to entrepreneurship?
(a) strengthen and increase the number of (a) Risk taking
entrepreneurs (b) Innovation
(b) stimulate sales of business (c) Creative activity
(c) increase demand for the product (d) Managerial training
15 An entrepreneur is
7 Characteristics of entrepreneurship include (a) born (b) made
(a) ability to take risk (b) open minded (c) Either born or made (d) All of these
(c) flexible (d) All of these
16 Which of the following is inconsistent in the
8 One of the competencies of entrepreneur is context of entrepreneur?
(a) taking initiative (b) close attention (a) He is the owner of the business
(c) influencing environment (d) All of these (b) He is the risk taker
(c) He only operates the production activities
9 Which of these statements best describes the (d) He searches out for the business opportunities
context for entrepreneurship?
(a) Entrepreneurship takes place in small businesses. 17 What is the main purpose of entrepreneurship
(b) Entrepreneurship takes place in large businesses. development?
(c) Entrepreneurship takes place in a wide variety of (a) To increase foreign trade
contexts. (b) To increase number of entrepreneurs
(d) Entrepreneurship does not take place in social (c) To increase GDP
enterprises. (d) To increase literacy
18 Which of the following is not involved in 25 Name the process by which individuals pursue
entrepreneurial development programme? opportunities without regard to resources they
(a) Identification of entrepreneurs for training currently control.
(b) Selection of entrepreneurs for training (a) Start-up management
(c) Developing entrepreneurial capabilities (b) Entrepreneurship
(d) Arranging infrastructural facilities (c) Financial analysis
(d) Feasibility planning
19 What is the hallmark of a successful entrepreneur?
(a) Risk bearing capacity (b) Persistence 26 Set of beliefs that provide standards which guide
(c) Flexibility (d) Self-confidence behavior is known as
20 Which of the following risks is borne by the (a) Attitude (b) Values
(c) Motivation (d) None of these
entrepreneur?
(a) Financial risk (b) Personal risk 27 An important psychological attribute of individuals
(c) psychological risk (d) All of these which shape their behavior is called
21 Which of the following cannot be considered as a (a) Attitude (b) Values
(c) Motivation (d) None of these
quality of a successful entrepreneur?
(a) He is endowed with unusual creativeness 28 The process that activates the entrepreneurs to
(b) He has a high degree of ambition exert a high level of effort for the achievement of
(c) He is enriched by a high propensity his/her goals is called
(d) He also has a strong need for achievement (a) Attitude (b) Values
22 Social attitude is one of the important problems of (c) Motivation (d) None of these
………… entrepreneur. 29 In India, the need of entrepreneurship
(a) drone (b) business development arises due to
(c) women (d) adoptive (a) employment requirements
23 Entrepreneurs are motivated by ………….. . (b) capital formation
(a) money (b) personal values (c) develop backward areas
(c) pull influences (d) All of these (d) All of the above
24 Which of the following behaviours is not associated 30 Sustainability of entrepreneurship development

with a successful entrepreneurship? depends on factors like ……………… .
(a) R & D (a) technical skills
(b) Running your business on a day-to-day basis (b) technology
(c) Continuous innovation and urgency (c) organisational sustainability
(d) Production as per customer’s requirement (d) All of the above
ANSWERS
1. (b) 2. (a) 3. (b) 4. (a) 5. (d) 6. (a) 7. (d) 8. (d) 9. (c) 10. (a)
11. (b) 12. (d) 13. (d) 14. (d) 15. (b) 16. (c) 17. (b) 18. (d) 19. (c) 20. (d)
21. (b) 22. (c) 23. (d) 24. (b) 25. (b) 26. (b) 27. (a) 28. (c) 29. (d) 30. (d)
PRACTICE SET 01 75
CUET (UG) Section II : Domain (Business Studies)
Practice Set 01
1. ............... is concerned with the quality of product and satisfaction (a) Legal environment
performance of various of customer? (b) Technological environment
activities/tasks in an organisation. (a) Fatigue study (b) Time study (c) Social environment
(a) Management of people (c) Method study (d) Motion study (d) Economic environment
(b) Management of operations 7. Which principle of scientific
(c) Management of work 12. Manav Ltd. prepares budget in its
management discards the old Annual General Meeting for the
(d) Management of individuals approach of rule of thumb? year 2021-2022. What kind of plan
2. Every manager applies his (a) Harmony, not discord is it?
personal skills and knowledge in (b) Cooperation, not individualism (a) Single use plan (b) Standing plan
the day-to-day functioning of an (c) Science, not rule of thumb (c) Objective plan (d) None of these
enterprise. It is proved because (d) Either (a) or (c)
(a) management is an art 13. What is meant by ‘follow-up action’
8. Which principle of management as the step involved in the process
(b) management is a science states that each group having same
(c) management is a profession of planning?
objectives must have one head and (a) Managing the plan
(d) None of the above one plan? (b) Checking the plan
3. Which of the following functions (a) Principle of equity (c) Selecting the plan
are required to be carried out for (b) Principle of unity of command (d) None of the above
successfully establishing (c) Principle of unity of direction
coordination? (d) Principle of authority and 14. Plans are made for a specific time
(a) Planning and directing responsibility period. At the end of such time
(b) Organising period, new plans have to be
9. Which of the following does not
(c) Staffing drawn. Identify the feature of
explain the impact of government
planning.
policy changes on business and
(a) Planning is pervasive
4. CEO is at which level of industry?
(b) Planning is futuristic
management in a company? (a) More demanding customers
(c) Planning involves decision-making
(a) All levels of management (b) Increasing competition
(d) Planning is continuous
(b) Supervisory level of management (c) Change in agricultural prices
(c) Middle level of management (d) Market orientation 15. Which of the following is/are the
(d) Top level of management
importance of organising?
10. ‘‘Nothing can be said with certainty
(a) Adaptation to change
5. Identify the technique of scientific about the factors of business
(b) Effective administration
management in which a specialist environment’’. Why?
(c) Expansion and growth
supervises each worker. (a) Because business environment is
simple (d) All of the above
(a) Science, not rule of thumb
(b) Because business environment is 16. What explains informal
(b) Mental revolution
dynamic organisation the best?
(c) Functional foremanship
(c) Because business environment is (a) All departments in an
(d) None of the above certain organisation reports to a
6. Which of the following techniques (d) Because business environment is coordinating head
rely on operation research and inter-related (b) Network of personal and social
process charts to minimise the cost relationships that arise as people
11. “Spirit of invention and innovation
of production and maximise the associate with other people in a
among people” is the component of work environment
which environment?
76 CUET (UG) Section II : Domain (Business Studies)
(c) This structure is created 23. Which of the following is not an (b) comparing actual performance
intentionally by the managers for advantage of directing? with standards
achievement of organisational (c) analysing deviations
(a) Initiates action
goal (d) taking corrective action
(b) Integrates employee efforts
(c) Provides leadership 31. Which of the following is the
17. Minimum freedom for managers (d) Restricts changes technique of measurement of
and maximum constraints are performance?
main features of 24. Out of the following, which is a
financial incentive? (a) Personal observation
(a) total autonomy
(a) Promotion (b) Sample checking
(b) total decentralisation
(b) Stock option (c) Performance reports
(c) total centralisation
(c) Job security (d) All of the above
(d) total congruency
(d) Employee participation 32. Debt is considered to be cheaper
18. I refer to a network of personal and than equity because for borrowers,
social relationships which 25. In which of the following networks
an individual, communicates with interest on debentures is a ..............
spontaneously originates within while dividend on equity is not.
the formal set up. Who am I? only those people whom he trusts?
(a) Single strand network (a) exempt from tax
(a) Informal organisation
(b) Gos sip network (b) deductible expenditure
(b) Party organisation
(c) Probability network (c) non-deductible expenditure
(c) Social organisation
(d) Cluster network (d) None of the above
(d) Formal organisation
19. Under which of the following 26. The need of affection, sense of 33. Financial planning helps in
external sources of recruitment, a belongingness, acceptance and (a) running the business smoothly by
business organisation keeps a friendship is related with forecasting
database of unsolicited applications (a) safety/security needs (b) avoiding business shocks and
surprises
in their files and such files are (b) social needs
(c) coordinating various business
re-called to fill current vacant (c) esteem needs
functions
positions. (d) self-actualisation needs
(a) Advertisement 27. Ishaan resigned from a company on
(b) Casual callers 34. The process of estimating the
the ground of ‘lack of recognition’ in financial requirements of an
(c) Campus recruitment organisation towards his work.
(d) None of these organisation specifying the sources
Which need is not fulfilled here? of funds and ensuring that enough
20. Training is provided to employees (a) Physiological need funds are available at the right
on the actual machines, but away (b) Safety need time is called
from actual work floor is known as (c) Affiliation need (a) financial management
vestibule training. It is provided (d) Esteem need (b) financial planning
where the employees are supposed (c) financial decision
28. Which of the following is not
to work on (d) business finance
applicable to responsibility
(a) sophisticated machinery accounting?
(b) clients 35. Which concept helps to increase the
(a) Investment centre return on equity shares with a
(c) outdated technology
(b) Accounting centre change in the capital structure of a
(d) None of these
(c) Profit centre company?
21. Human resource management (d) Cost centre (a) Trading on equity
includes many specialised activities (b) Debt financing
29. Controlling provides direction to all
to be performed by HR personnel (c) Equity financing
activities and each department and
except (d) Capital structure
employee is governed by
(a) recruitment predetermined standards, which
(b) preparation of job description 36. Clearing and settlement operations
helps in establishing ……… among of NSE are carried out by
(c) handling employee grievances them.
(d) customer focus (a) NSDL (b) NSCCL
(a) organising
(c) SBI (d) CDSL
22. ................. refers to process by (b) directing
which skills and abilities of (c) planning (d) co-ordination 37. In which of the following aspects,
employees to perform specific jobs money market is different from
30. In controlling process, the next capital market?
are increased.
stage after setting performance
(a) Training (a) Participants
standards is
(b) Selection (b) Tenure of securities traded
(a) measurement of actual
(c) Liquidity of securities traded
(c) Development (d) Both (a) and (c) performance
PRACTICE SET 01 77
38. Mr. A, an existing shareholder of a (a) The utility and demand (c) She should check FPO mark on
company is offered the ‘right’ to buy (b) Extent of competition in the the jewellery
new shares in proportion to the market (d) She can ask from another
number of shares, he already possess. (c) Marketing methods used jewellery
This kind of issue is known as (d) Pricing objectives 47. ‘Jago Grahak Jago’ is the publicity
(a) offer through sale 43. The function of marketing, campaign undertaken by
(b) e-IPOs concerned with informing the government in eleventh five year
(c) private placement customers about the firm’s plan to
(d) rights issue product is (a) promote the demand
(a) market analysis (b) protect the seller
39. What can be the method of floating
(b) standardisation (c) protect the interest of consumers
new issues in the primary market?
(c) promotion (d) promote the development of India
(a) Offer through prospectus
(b) Private placement (d) grading 48. Which of the following attitudes is
(c) Rights issue 44. To publish a magazine under the not generally associated with
(d) All of the above title ‘Upbhokta Jagran’ is an successful entrepreneurship?
example of which right of (a) Competition and co-operation
40. …………. is the process of planning,
consumer? (b) Desire to influence others
organising, directing and controlling
(a) Right to be informed (c) Innovation and product
the activities relating to exchange of improvement
goods and services. (b) Right to safety
(c) Right to be heard (d) Status quo in business
(a) Marketing management
(b) Sales management (d) Right to consumer education 49. What is the main purpose of
(c) Personnel management entrepreneurship development?
45. State commission entertains
(d) Financial management complaints of goods or services (a) To increase foreign trade
whose value exceeds ……… but (b) To increase number of
41. Which of the following should not be entrepreneurs
performed by the channels of less than ……… .
(c) To increase GDP
distribution of goods? (a) ` 40 lakh and ` 50 lakh
(d) To increase literacy
(a) Sorting (b) ` 1 crore, ` 10 crore
(c) ` 10 crore, ` 100 crore 50. Name the process by which
(b) Assorting
(d) None of the above individuals pursue opportunities
(c) Quality improvement
without regard to resources they
(d) Risk taking 46. Shweta wants to buy a gold ring. currently control.
42. As soon as CocaCola reduced its As an aware consumer, how can (a) Start-up management
selling price on 2 ltr to ` 75, soon she be sure about the quality of (b) Entrepreneurship
Pepsi followed with a price reduction gold ring she is going to buy?
(c) Financial analysis
in its selling price and priced its 2 ltr (a) She should check hallmark on
(d) Feasibility planning
per bottle at ` 74.50. Which factor of the jewellery
(b) She should check agro mark on
pricing is being discussed here?
the jewellery
ANSWERS
1. (c) 2. (a) 3. (d) 4. (d) 5. (c) 6. (c) 7. (c) 8. (c) 9. (c) 10. (b)
11. (b) 12. (a) 13. (b) 14. (d) 15. (d) 16. (b) 17. (c) 18. (a) 19. (b) 20. (a)
21. (c) 22. (a) 23. (d) 24. (b) 25. (d) 26. (b) 27. (d) 28. (b) 29. (d) 30. (a)
31. (d) 32. (b) 33. (d) 34. (b) 35. (a) 36. (b) 37. (d) 38. (d) 39. (d) 40. (a)
41. (c) 42. (b) 43. (c) 44. (d) 45. (b) 46. (a) 47. (c) 48. (d) 49. (b) 50. (b)
CUET (UG) Section II : Domain (Business Studies)
Practice Set 02
1. Functions of entrepreneurship 6. Without coordination, directing is 11. The highest level need in the need
include which of the following? impossible and of no worth if there Hierarchy of Abraham Maslow.
(a) Innovation and creativity is lack of coordination between (a) Safety need
(b) Risk taking and achievement superiors and (b)Belongingness need
(c) Research (a) managers (b) directors (c) Self-actualisation need
(d) All of the above (c) subordinates (d) All of these (d) Prestige need
2. The process that activates the 7. Which of the following is not an 12. Identify the need in which an
entrepreneurs to exert a high level essential organisational objective of employee desires self-respect,
of effort for the achievement of management? recognition and status.
his/her goals is called (a) Survival (a) Security needs
(a) Attitude (b) Eco-friendly production
(b) Social needs
(b) Values (c) Growth
(c) Esteem needs
(c) Motivation (d) Profit
(d) Self-actualisation needs
(d) None of these 8. Planning gives direction, reduces
13. ABC company Ltd wants to
3. Which of the following behaviours the impact of change, minimises
motivate its employees by
is not associated with a successful waste and redundancy and
providing them bonus on the
entrepreneurship? (a) establishes chaos among occasion of Diwali. It can pay the
(a) R & D departments
bonus
(b) Running your business on a (b) sets the basis used for promotion
(a) in cash only
day-to-day basis of individuals within the
organisation (b) in kind
(c) Continuous innovation and
(c) planning guarantees safeguard (c) in cash or in kind
urgency
from external environment (d) transferable coupons
(d) Production as per customer’s
requirement (d) sets the standards used in 14. The process of influencing the
controlling behaviour of people by making
4. The following is not an objective of
management 9. Name the type of plan, which is in them strive voluntarily towards the
(a) earning profit the form of general statements and achievement of goals is called as
(b) growth of the organisation channelises energies towards a (a) leadership
(c) providing employment
particular direction. (b) controlling
(d) policy making (a) Budget (c) coordinating
(b) Rule (d) None of these
5. Identify the role of middle level (c) Policy
management from the following. 15. Ajay Thakur, chairperson of
(d) Method
(a) To implement the policies framed Thakur Enterprises misses no
by top management. 10. “Planning involves application of opportunity to praise his
(b) To maintain close contacts with mind and foresight”. What subordinates for their good work.
operative level so as to evaluate importance of planning is Which element of directing is
the performance. highlighted here? highlighted?
(c) To assign duties and (a) Promotes innovative ideas (a) Communication
responsibilities to lower level (b) Facilitates decision-making (b) Supervision
managers. (c) Establishes standard (c) Motivation
(d) All of the above (d) Provides direction (d) Leadership
PRACTICE SET 02 79
16. The National Stock Exchange of 23. Which principle means that an (a) Saves time
India was recognised as stock employee should receive orders (b) Better utilisation of managerial
exchange in the year from one superior only? talent
(a) 1992 (b) 1993 (a) Coordination (c) Facilitates delegation of authority
(c) 1994 (d) 1995 (b) Unity of command
(c) Discipline 31. Bajaj, the operation manager set a
17. Under which of the following
(d) Unity of direction limit of 5% deviation in production
methods, securities are not issued
and decided to take corrective
directly to the public, but are 24. Grouping of activities on the basis
action only if deviations occurred
offered through intermediaries like of functions is a part of
beyond 5%. Name the concept
issuing houses or stock brokers? (a) decentralised organisation
applicable here.
(a) Offer through prospectus (b) divisional organisation
(a) Coordination
(b) Offer for sale (c) functional organisation (b) Management principles
(c) Private placement (d) centralised organisation (c) Management by exception
(d) e-IPO
25. If a firm wants to diversify its (d) Critical point control
18. Which of the following is a business into different products 32. Which of the following refers to
depository formed for the purpose and expand to different territories, that process of assigning a
of ensuring free transferability of which organisation structure would distinctive name or symbol to a
securities in India? be suited for this firm? product, by which it can be known,
(a) NSDL (b) RBI (a) Divisional structure remembered and identified?
(c) SEBI (d) None of these (b) Functional structure (a) Trademark (b) Product mix
19. Which market helps in (c) Informal structure (c) Branding (d) Packaging
channelising surplus funds into the (d) Network structure
33. Which of the following refers to the
most productive uses? 26. An organisation structure in which process of designing a small slip or
(a) Financial market various departments are created on complex graphics that are a part of
(b) Wholesale market the basis of products, territory or package, which denotes its nature,
(c) Retail market region is called a content and usage?
(d) None of these (a) divisional structure (a) Branding (b) Packing
20. Which of the following statement (b) functional structure (c) Labelling (d) None of these
best describes the principle of (c) matrix structure
(d) staff structure 34. When Sarita opened the door on
‘Division of work’?
hearing the doorbell, a person was
(a) Work should be divided into small 27. Being answerable to the final standing who was selling
tasks outcome is a phrase which can be Britannica world ‘encyclopedia’.
(b) Labour should be divided associated with Here, Britannica is using which
(c) Resources should be divided
(a) authority element of promotion mix?
among jobs
(b) duty (a) Public relation
(d) It leads to specialisation
(c) responsibility (b) Sales promotion
21. Which of the following are the (d) accountability (c) Advertising
statement of fundamental truth, (d) Personal selling
which serve as guidelines for 28. Which of the following is not an
decisions and actions of managers? importance of controlling? 35. Which of the concepts ensures
(a) Judging accuracy of standards profit through product quality?
(a) Values of management
(b) Principles of management (b) Effective use of resources (a) Production (b) Product
(c) Techniques of management (c) Ensures order and discipline (c) Selling (d) Marketing
(d) None of the above (d) Exploitation of resources
36. Kalash Dairy Products Ltd. is a
22. Which technique of scientific 29. In controlling process, while setting successful business of making milk.
management suggests that, a performance standards, standards They decided to put a hologram
disciplinarian should be appointed can be set seal on the packet to ensure that
under the planning incharge, in (a) in quantitative terms only product is not tampered with.
order to maintain discipline among (b) in qualitative terms only Which decision is taken here?
workers? (c) Both (a) and (b) (a) Labelling (b) Branding
(a) Harmony, not discord (d) in subjective terms (c) Standardising (d) Packaging
(b) Cooperation not individualism 30. Which of the following is an 37. Identify the examples of changes in
(c) Functional foremanship advantage of critical point control business environment that affect
(d) None of the above and management by exception? business enterprises.
(a) Increase in taxes by government can (a) promotion (c) business risk
make products expensive, causing (b) voluntary retirement (d) None of these
reduced demand (c) salary increment 47. Which of the following statement is
(b) Change in taste and fashion may (d) None of these
shift demand incorrect?
(c) Technological improvements may 42. Which of the following is not a (a) Current assets are usually more
render existing products obsolete benefit of training and liquid than fixed assets
(d) All of the above development to employees? (b) Current assets contribute less to
(a) Improved skills and knowledge the profits than fixed assets
38. Which dimension of business (c) B/R, debtors, stock, etc are fixed
(b) Increased efficiency
environment requires putting a assets
(c) Increased satisfaction and
statutory warning on the packets of morale (d) Fixed assets are financed through
tobacco products? (d) Results in higher profits long-term liabilities
(a) Technological environment 48. Which of the following is a reason
(b) Economic environment 43. The process of introducing the
selected employee to other why a businessman should lay
(c) Legal environment emphasise on the protection of
employees and making him
familiar with rules and policies of consumers and their interests?
39. What is included in legal the organisation is known as (a) For long-term profit maximisation
environment of business? (a) orientation (b) compensation (b) For fulfilling social responsibility
(a) Several acts passed by government (c) To avoid government intervention
(c) promotion
(b) Court judgements (d) All of the above
(d) career planning
(c) Statutory warning prescribed under 49. Who among the following can be
law 44. Current assets are those assets
President of the National
(d) All of the above which get converted into cash
Consumer Dispute Redressal
(a) within six months
40. The ……… means the sum total of all Commission?
(b) within one year
individuals, institutions and other (a) Judge of a High Court
(c) between one and three years
forces that are outside the control of (b) Judge of a Supreme Court
(d) between three and five years
a business enterprise but that may (c) Lawyer of a High Court
affect its performance. 45. Current assets of a business firm (d) Lawyer of a Supreme Court
(a) management principles should be financed through
50. Which of the following points
(b) business environment (a) current liability only
highlight the importance of
(c) economic environment (b) long-term liability only
consumer protection from
(d) social environment (c) both types (i.e. long and
consumer’s point of view?
short-term liabilities)
41. Recruitment of employees from (d) None of the above (a) Consumer ignorance
external sources increases (b) Unorganised consumer
dissatisfaction among the present 46. The risk of default on payment of (c) Widespreal exploitation of
employees as their chances of borrowed funds is known as consumer
............... are reduced. (a) operating risk (d) All of the above
(b) financial risk
ANSWERS
1. (d) 2. (c) 3. (b) 4. (d) 5. (d) 6. (c) 7. (b) 8. (d) 9. (c) 10. (a)
11. (c) 12. (d) 13. (c) 14. (a) 15. (c) 16. (a) 17. (b) 18. (a) 19. (a) 20. (a)
21. (b) 22. (c) 23. (b) 24. (c) 25. (a) 26. (a) 27. (d) 28. (d) 29. (c) 30. (d)
31. (c) 32. (c) 33. (c) 34. (d) 35. (b) 36. (d) 37. (d) 38. (c) 39. (d) 40. (b)
41. (a) 42. (d) 43. (a) 44. (b) 45. (c) 46. (b) 47. (c) 48. (d) 49. (b) 50. (d)
Economics 3
CHAPTER 01
Economics and Central

Problems of Economy
● Theory related to equilibrium level of output and
Concept of Economics employment.
Economics is concerned with the study of economic issues or ● Theory related to inflationary and deflationary gap in the
problems that arise because of the fact that resources are
economy.
scarce in relation to our wants and scarce resources have
alternative uses. Economics focuses on the rational Nature of Economics
management of scarce resources in such a manner that our
Economics is a science as well as art. As science, the nature
economic welfare is maximised. Thus, economics is about
of economics can be studied with respect to the following
making choices in the backdrop of scarcity.
1. Positive Economics It is concerned with the facts
Subject Matter of Economics about the economy, as they exist. e.g. positive economics
deals with questions like ‘what are the causes of
Subject matter of economics is broadly divided into two
unemployment’, ‘why prices are increasing’ and so on.
branches
It simply states ‘what is’ and not ‘what ought to be’. It
● Microeconomics ● Macroeconomics
is based on facts and doesn’t passes value judgement.
Microeconomics 2. Normative Economics Economics as a normative
Microeconomics is that branch of economics which deals science is concerned with ‘what ought to be’ or what
with economic issues at the level of an individual viz, an should be it examines real economic events from moral
individual person, an individual firm’s output, an individual and ethical angles and judges whether certain
industry, an individual market, a consumer’s demand, economic events are desirable or not.
market price of a commodity, etc. These are also termed as It passes value judgement as it is not based on facts
microeconomic variables. and prescribes methods to correct undesirable
Microeconomics studies how price of goods and services and happenings.
prices of factors of production are determined.
Vital theories or studies of microeconomics are Economy
● Theory of consumer behaviour. ● Theory of price. An economy is a system in which and by which people get a
● Theory of producer behaviour. living to satisfy their wants through the processes of
Microeconomics is concerned with determination of output production, consumption, exchange and investment.
and price for an individual firm or industry. Thus, it is also An economy can be capitalist, socialist or mixed, depending
known as the theory of price. on the level of government intervention in various economic
processess.
Macroeconomics
Macroeconomics is that branch of economics, which deals Economic Problem
with the behaviour of the economy as a whole. It is the study It is the problem of choice arising from the use of limited
of aggregates, covering the entire economy’s concepts such means which have alternative uses for the satisfaction of
as National Income, full employment, aggregate unlimited wants.
consumption, etc. These are also termed as macroeconomic
This problem arises due to the following reasons
variables.
● Human wants are unlimited and continuous.
Vital theories or studies of macroeconomics are ● Economic resources are limited.
● Theory of multiplier. ● Study of government budget.
● Resources have alternative uses.
● Study of exchange rate and Balance of Payments (BoP).
Central Problems of an Economy 2. How to Produce

Central problems of an economy are the problems of fuller It is the problem that is related to what technique is to be
and efficient utilisation of resources to satisfy maximum used for producing various goods and services. An economy
number of needs. These problems are common for all can choose from among the given two techniques
economies. ● Labour-intensive technique ● Capital-intensive technique
There are three central problems 3. For Whom to Produce

1. What to Produce It is a problem concerning the distribution of goods and
The first central problem encountered by an economy is to services among factors of production in an economy like
decide which goods and services are to be produced and in wages to the labour, rent to the land, interest to the capital
what quantities. and profit to the entrepreneur.
A country has to decide whether to produce luxury goods or This central problem has two dimensions
necessary goods, capital goods or consumer goods, as all the
● Personal distribution of income (among the factors).
● Functional distribution of income (within the factors).
goods cannot be produced in desired quantities.
This problem has two dimensions Opportunity Cost
● Kinds of goods to be produced. It is the cost of the value of next best alternative foregone
● Quantity of goods to be produced. for the best alternative.
Practice Questions
1 Which of the following is related to 8 Which of the following is not a macro variable?
microeconomics? (a) Wholesale price index (b) Output of firm
(a) Inflation in the economy (c) Aggregate demand (d) Aggregate supply
(b) Problem of unemployment
9 In free market economy, the allocation of resources
(c) National Income (d) Income from the railways
is determined by ...... .
2 The study of microeconomics and macroeconomics (a) votes by consumers
is ...... . (b) a central planning authority
(a) independent of each other (c) consumer preference
(b) interrelated to each other (d) the level of profits of firms
10 Central economic problems are the problems of a
3 Who is the father of economics? ………… .
(a) Karl Marx (b) J.M. Keynes (a) market economy (b) socialist economy
(c) Adam Smith (d) Alfred Marshall (c) mixed economy (d) All of these
4 In economics, scarcity refers to a situation when 11 ………… is a system in which people earn
(a) demand for goods exceeds its supply livelihood to fulfil their wants.
(b) supply of goods exceeds its demand (a) Abroad (b) Market (c) Economy (d) Village
(c) supply of goods is equal to its demand
(d) Both (a) and (b) 12 An economy is broadly classified as
(a) market economy
5 ...... economics states ‘what is’ and not ‘what should (b) centrally planned economy
be’. (c) mixed economy (d) All of these
(a) Positive (b) Normative
(c) Modern (d) None of these 13 The problem of what to produce is related with
(a) types of goods to be produced
6 ...... are the important tools of macroeconomic (b) types of production technique to be used
studies. (c) quantity of goods to be produced
(a) Demand and supply (d) Both (a) and (c)
(b) Aggregate demand and aggregate supply
14 ………… is the problem which is concerned with
(c) Exports and imports
(d) All of the above the distribution of national income among those
who have helped to produce it.
7 Which of the following questions is/are the part of (a) How to produce? (b) What to produce?
normative economics? (c) Why to produce? (d) For whom to produce?
(a) What are the causes of unemployment?
(b) Why prices are rising? 15 The causes of economic problem include
(c) Was demonetisation justified? (a) human wants are unlimited
(d) All of the above (b) economic resources are limited
Economics 5
(c) resources have alternative uses (c) Micro-Macro paradox means something which is true
(d) All of the above in Microeconomics does not hold true in
Macroeconomics.
16 Indian economy is a mixed economy because
(d) Opportunity cost is also referred to as accounting
(a) agriculture and industry have both simultaneously
cost.
developed in India
(b) agriculture and industry have both developed in the 23 Write the correct pair.
public sector
Column I Column II
(c) private ownership and public ownership over means
of production co-exist A. Market economy (i) Basis of demand and supply
(d) None of the above B. Centrally planned (ii) Both ‘central authority’ and
17 Which of the following statements is true? economy ‘market forces’ play role
(a) Economic problems arises only due to scarcity of C. Mixed economy (iii) Maximising social welfare
resources.
(b) If new technologies are constantly evolved. Central Codes
problems can be solved to the fullest. (a) A-(i) (b) B-(ii)
(c) Economic problem of How to Produce is the problem (c) C-(iii) (d) None of these
of choice between labour intensive technique or
capital intensive techniques.
24 Which one of the following is not the feature of
(d) Opportunity cost is the cost of second-best socialist economy?
alternative. (a) Social welfare (b) Freedom of enterprise
(c) Public ownership (d) Planning mechanism
18 Economics cost is equal to
(a) accounting cost (b) opportunity cost 25 Choose the correct statement from given below
(c) sum of accounting cost and opportunity cost (i) Positive economics is based on real facts which
(d) difference of accounting cost and opportunity cost can be varied using quantitative data.
19 Choose the correct statement from the given below (ii) Microeconomics is also known as theory of
(a) In a centrally planned economy, economics decisions income determination.
are governed by profit motive as per decision of
Central Bank of the country.
(iii) Central problems of an economy and problem of
(b) Normative statements are those which pass value choice goes hand in hand.
judgement at economic problems as they are. Choose from the options below
(c) There is limited degree of aggregation present in (a) (i) and (ii) (b) (ii) and (iii)
microeconomics whereas macroeconomics has greater (c) (i) and (iii) (d) (i), (ii) and (iii)
degree of aggregation.
26 Which of these is not a component of
(d) Central problems of an economy and problem of
choice are two different issues that only mixed microeconomics?
economies faces. (a) Theory of Consumer Behaviour
(b) Theory of Producer Behaviour
20 The following headline appeared in “Hindustan (c) Theory of Price
Times” dated 25th July, 2018, “Getting insurance (d) Theory of Money Supply
for rain damage cars an uphill task”. This
statement is 27 Identify the incorrect statement from the given
(a) Positive Economics (b) Normative Economics below
(c) General Economics (d) None of these (a) The central problem of “For whom to produce” is
concerned with selection of groups of the society to
21 Which of the following statements is true about the produce.
opportunity cost? (b) Mixed economics are governed by the objectives of
(a) Accounting cost minus the marginal benefit . profit maximisation as well as social welfare.
(b) Monetary costs and physical effort of an activity. (c) Economic problem of “What to produce” is concerned
(c) Highest valued alternative forgone. with the type of good to be produced and the quantity
(d) Accounting cost minus the marginal cost. of each good to be produced.
(d) Constant improvement in technology can solve the
22 Choose the correct statement from the given below central problems to the fullest.
(a) Positive statements pass value judgement as they are
based upon real facts. 28 Technique of production is focussed in which
(b) Microeconomics deals with problems related to an central problem of economy?
individual only, there is zero degree of aggregation in (a) What to produce? (b) How to produce?
Microeconomics. (c) For whom to produce? (d) Both (b) and (c)
ANSWERS
1. (d) 2. (b) 3. (c) 4. (a) 5. (a) 6. (b) 7. (c) 8. (b) 9. (c) 10. (d)
11. (c) 12. (d) 13. (d) 14. (d) 15. (d) 16. (c) 17. (c) 18. (c) 19. (c) 20. (a)
21. (c) 22. (c) 23. (a) 24. (b) 25. (c) 26. (d) 27. (d) 28. (b)
CHAPTER 02
Consumer’s Equilibrium
Concept of Utility successive units of a commodity. Mathematically, it is
calculated as
A consumer who seeks to maximise utility or satisfaction by
spending his given income is called a rational consumer.
TU = MU1 + MU 2 +… + MU n or ∑MU
Utility
For example, a consumer gets a satisfaction of 30, 20
It is the amount of satisfaction which a consumer derives
from the consumption of a commodity. In other words, want and 15 utils from consuming 3 ice-creams, respectively.
satisfying power of a commodity is called utility. Then, the Total Utility of the consumer is
Unit of measurement of utility is termed as utils. The 30 + 20 + 15 = 65 utils.
concept of utility is ethically neutral. 2. Marginal Utility (MU) The utility derived from the
A consumer is one who buys goods and services for consumption of an additional unit of a commodity is
satisfaction of his wants. termed as Marginal Utility. It may also be called as the
utility obtained from the consumption of an additional
Approaches of Utility
unit.
There are two approaches to measure utility
Mathematically, it is calculated as
1. Cardinal Utility Approach It was given by Professor
Alfred Marshall. It refers to the measurement of utility ∆TU
in terms of numbers such as 1, 2, 3, etc. The unit of MU nth = TU n − TU n − 1 or MU =
∆Q
measurement under this approach is ‘utils’. e.g. a
basket of oranges offers 10 utils of utility to a Here, MU = Marginal Utility
consumer and so on. TU n = Total Utility from n units
2. Ordinal Utility Approach It was given by Professor TU n−1 = Total Utility from (n −1) units
Allen and Hicks. It refers to the measurement of utility
∆ Q = Change in Quantity
in terms of psychological satisfaction on consuming
one good in comparison to other. e.g. a pizza offers ∆ TU = Change in Total Utility
greater satisfaction to a consumer than a chapatti. For example, a consumer gets a satisfaction of 30 utils
According to this approach, utility cannot be measured from consuming his first cup of ice-cream. After
in units, rather a consumer can just rank his preference consuming his second cup, his Total Utility rises from
from a set of most preferred to least preferred bundles. 30 utils to 50 utils. Then, the Marginal Utility of the
second cup is (50–30) = 20 utils.
Note As per syllabus, only cardinal utility approach is discussed.
Relationship between TU and MU
Total Utility and Marginal Utility The given diagram illustrates the relationship between TU
Cardinal utility has two concepts and MU.
1. Total Utility (TU) Total satisfaction obtained by a
From the given curve, we observe that by consuming
consumer by consuming given quantity of a particular
successive units of a particular commodity, the Total Utility
commodity is called Total Utility. It is the sum total of
increases (at a decreasing rate) and eventually falls.
the Marginal Utilities obtained from the consumption of
Economics 7
The shape of TU curve is inverse ‘S’ and shape of MU curve ● Standard and identical units of a good must be consumed.
is straight line sloping downward from left to right. ● Marginal Utility of money is assumed to be constant.
Y Maximum TU ● Consumption should be continuous.
TU ● Price of the commodity remains constant.
Utility
● Income of the consumer doesn’t change.

Now, let us try to understand this law with the help of the
O X following schedule
Quantity (units)
Y (+ve) Varun is enjoying his meal of burgers at McDonald’s.
MU on Following is his Total and Marginal Utility schedule
r a ti
a tu
Utility
o fs Burgers Total Utility Marginal Utility

int 0) (in units) (in utils) (in utils)
Po U =
(M 1 40 40
O X
(–ve) 2 72 32
MU
Quantity (units) 3 92 20
4 100 8
Relationship between Total Utility and Marginal Utility can 5 100 0
be understood from the following points
6 80 –20
● When MU is diminishing but remains positive (+ve), TU
tends to increase at a diminishing rate. As it is clear from the above schedule that as Varun increases
● When MU becomes zero, TU reaches at its maximum
his consumption of burgers, the Total Utility that he is getting
from his consumption is rising initially, reaches a maximum
point.
point of 100 utils and then starts to fall. On the other hand,
● When MU becomes negative ( − ve), TU starts to fall.
Marginal Utility is falling, reaches, zero and also becomes
The above relationship between TU and MU is due to the negative.
operation of Law of Diminishing Marginal Utility discussed
below. Exceptions to the Law of
Diminishing Marginal Utility
Laws of Utility Analysis The Law of DMU does not hold good for
● Money and expensive metals such as gold, silver, etc.
Utility analysis has two main laws, which are described
below ● Reading
● Listening to music
Law of Diminishing Marginal Utility (DMU) ● Acquiring knowledge

It is the fundamental law of utility. This law states that as
more and more standard units of a commodity are Law of equi-marginal Utility
continuously consumed, the Marginal Utility obtained from This law states that the consumers, in order to maximise their
each successive unit goes on diminishing. In other words, satisfaction, should spend their money income on two goods
Total Utility first increases at a diminishing rate, reaches its in such a manner that the ratio of Marginal Utility of a
maximum point and then eventually falls. commodity to its price becomes equal to the ratio of Marginal
The Law of Diminishing Marginal Utility is a psychological Utility of other commodity to its price.
law, therefore, it is called as a ‘fundamental law of MU X MU Y
satisfaction’ or ‘fundamental psychological law’. i.e. =
PX PY
Assumptions of DMU Where, MU X = Marginal Utility of good X
The following are the assumptions of Law of Diminishing MU Y = Marginal Utility of good Y
Marginal Utility
PX = Price of good X
● Utility is measurable in numerical units called ‘utils’.
PY = Price of good Y
● Consumer is a rational consumer.
Assumptions of Law of Equi-marginal Utility In the above table, it is assumed that MU of a rupee is 2
The following are the assumptions of the Law of Equi- utils. From the above table, it is clear that consumer is at
marginal Utility equilibrium when he is consuming 3 units, because
● Income of the consumer is given and fixed. MU X 6
= PX or = 3 or 3 = 3
● Prices of the commodities do not change. MU M 2
● Substitute goods are available in the market.
Y
Utility (utils) and price

● Law of Diminishing Marginal Utility operates. Point of equilibrium in case of one
6 commodity (MUx = PX )
Consumer’s Equilibrium 5
R
It refers to the situation in which a consumer gets maximum 4 PX = 4
satisfaction from the purchase of a commodity with given 3
income. Consumer will attain its equilibrium at the point 2
where Marginal Utility of a product divided by the Marginal MUX (measured in
1 terms of money)
Utility of a rupee is equal to the price of the commodity. 0 X
1 2 3 4 5 6
–1
Conditions of Consumer’s Equilibrium using Consumption of commodity X (units)
–2
Marginal Utility Analysis
The conditions of consumer’s equilibrium using Marginal Y
Consumer’s equilibrium : One commodity case
Utility approach is studied under two cases as discussed below
(curve is based on hypothetical data)
1. In Case of Single Commodity This diagram is drawn on the assumption that PX = ` 3 and
In case of a single commodity, consumer attains equilibrium, MU M = 2 utils. In a state of equilibrium, 3 units of
when commodity X are purchased.
MU X MU X
● = MU M or = PX
PX MU M 2. In Case of Two Commodities
In case of two commodities, consumer attains equilibrium,
It implies that in state of equilibrium, ratio of Marginal
when
Utility of X and Marginal Utility of money is equal to price of
MU X MU Y
commodity. ● = = MU M
PX PY
X = PX
● MU
It implies that in state of equilibrium, Marginal Utility derived It implies that in state of equilibrium, utility per rupee
from the consumption of a commodity is equal to its price. obtained by the consumer from good X or good Y should
when MU M = 1. be equal to Marginal Utility of money.
MU X MU Y
The following schedule will help in a better understanding of ● =
the above concept PX PY
MU X in It implies that in state of equilibrium, utility per rupee
Units MU X terms from good X must be equal to utility per rupee from good
Price Gain/Loss Y , when MU M = 1.
of ` 
Consumed (utils) MUx 

 2  MU X PX
The above condition can also be written as, =
1 10 5 3 2 MU Y PY
2 8 4 3 1 It implies that in state of equilibrium, ratio of Marginal
3 6 3 3 0 Utilities of two commodities is equal to the ratio of their
prices.
4 4 2 3 –1
5 2 1 3 –2
● MU X = MU Y , when MU M = 1 and PX = PY .
6 0 0 3 –3
(Assumption : PX = PY = ` 1 per unit)
Economics 9
MUX in Utility is maximum. Therefore, equilibrium is struck when he

terms MUX in consumes 2 units of X and 5 units of Y .
Units of of ` Units MU terms of
MU X PX PY Y Y
 MU X 
Y `
‘X’ of ‘Y’
  (MUY / PY )
 PX  100 100

90 90
1 100 10 10 1 24 2 12 80 80
70 70
2 80 10 8 2 22 2 11 60 Point of equilibrium 60
50 50
3 60 10 6 3 20 2 10
40 40
4 40 10 4 4 18 2 9 30 E 30
20 MUY MUX (Constant) MUM 20
5 20 10 2 5 16 2 8 10 10
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
MU X MU Y
In the above schedule, = , when consumer is Consumption of commodity X (units)
PX PY
Consumption of commodity Y (units)
consuming 1 unit of good X and 3 units of goods Y and also, 20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0
when he is consuming 2 units of good X and 5 units of good
Consumer’s equilibrium : Two commodities case
Y . Now, let us assume, that his money income is ` 30. So, for (curve is based on hypothetical data)
first combination, he pays1 × 10 + 3 × 2 = ` 16, which is less
than his money income, therefore he is not in equilibrium. Equilibrium equation for ‘n’ number of commodities
For the second combination, he pays 2 × 10 + 5 × 2 = ` 30,
MU 1 MU 2 MU 3 MU nth
which is equal to his money income. Also, at this level, Total = = = ... = = MU M
P1 P2 P3 Pnth
Practice Questions
1 The want satisfying power of a good is known as 7 If a consumer is in equilibrium consuming one
.................... . commodity, how will he respond to a fall in price of
(a) Utility (b) Usefulness the commodity?
(c) Both (a) and (b) (d) None of (a) and (b) (a) Decrease the consumption of the commodity
(b) Increase the consumption of the commodity
2 Cardinal utility approach was given by
(c) Consumption will remain constant
..................... . (d) None of the above
(a) Prof. Alfred Marshall (b) Prof. Hicks
(c) Prof. Samuelson (d) Prof. Gossen 8 The law of equi-marginal utility considers price of
money as
3 The unit of utility is known as ................. .
(a) zero (b) less than one
(a) marginal utility (b) MUM
(c) more than one (d) one
(c) utils (d) None of these
9 Law of Equi-Marginal utility is a law of
4 Which of the following is/are the feature(s) of
(a) Production of Wealth
utility? (b) Consumption of Wealth
(a) Subjective in nature (c) Distribution of Wealth
(b) Depending upon of urgency of wants (d) Exchange of Wealth
(d) None of (a) and (b) 10 “Utility is same as Usefulness”. Which of the below
options fits the given statement?
5 When MU is zero, TU will be ................. .
(a) Always true (b) Partially true
(a) maximum
(c) False (d) Incomplete
(b) maximum and constant
(c) constant 11 A consumer is in equilibrium, how will a consumer
(d) minimum behave if MUx/Px<MUx/Px?
6 When total utility increases at a diminishing rate, (a) Consumer will consume more of Good X and less of
marginal utility will be Good Y
(a) increasing (b) Consumer will consume more of Good Y and less of
(b) diminishing Good X
(c) constant (c) Consumer more of both Good
(d) diminishing but positive (d) Consumer less of both Good
12 According to cardinal measurement of 20 In accordance with the relationship between Total

utility Utility and Marginal Utility, when MU is negative,
(a) Utility is quantitative then
(b) Utility is qualitative (a) TU increases (b) TU decreases
(c) Utility is both quantitative and qualitative (c) TU remains constant (d) TU becomes zero
(d) Utility is constant
21 A consumer buys two commodities X and Y, he
13 Utility can be measured by would be in equilibrium when ...... .
(a) Money MUX MUY MUX
(b) Exchange of goods (a) = (b) = MUM
PX PY MUY
(c) Weight of the good
(d) None of the above MUX MUY PX
(c) = (d) = MU M
14 Law of equi-marginal utility is called PX PX PY
(a) Law of increasing utility
22 In case of single commodity, the consumer will be
(b) Law of diminishing utility
(c) Law of substitution in equilibrium when ....... .
(d) None of the above MUX MUX
(a) = MUM (b) = MUM
15 Consumer’s equilibrium takes at a point where MUY PX
(a) MU = Price (b) MU < Price PX
(c) MU > Price (d) None of these (c) = MUX (d) MUX = MUM
PY
16 Total Utility derived from consumption of
commodity will begin to fall ...... . 23 Which of the following is not correct about
(a) with every additional unit consumed consumer equilibrium through utility analysis?
(b) when Total Utility curve becomes flat (a) Law of Marginal Utility does not operate
(c) when Marginal Utility starts falling (b) MU M remains constant
(d) when Marginal Utility becomes negative MU x
(c) = MU M
17 ………… curve is a downward sloping curve cutting Px
the X-axis. (d) Consumer is rational
(a) Marginal Utility (b) Total Utility 24 Which of the following is an assumption of
(c) Average Utility (d) Both (a) and (c)
consumer equilibrium (through utility analysis)?
18 Utility approach is ...... . (a) Rationality
(a) cardinal (b) The cardinal measurability of utility
(b) ordinal (c) Constancy of the MU of money
(c) both cardinal and ordinal (d) All of the above
25 In case of single commodity, a consumer is at
19 Exceptions to law of diminishing marginal utility equilibrium point, marginal utility derived from
include consumption of commodities is 12, find the price of
(a) reading (b) money that commodity? (when MU M = 1)
(c) acquiring knowledge (d) All of these (a) ` 1 (b) ` 2 (c) ` 12 (d) ` 10
ANSWERS
1. (a) 2. (a) 3. (c) 4. (c) 5. (b) 6. (d) 7. (b) 8. (d) 9. (b) 10. (c)
11. (b) 12. (a) 13. (a) 14. (c) 15. (a) 16. (d) 17. (a) 18. (c) 19. (d) 20. (b)
21. (a) 22. (b) 23. (a) 24. (d) 25. (c)
Economics 11
CHAPTER 03
Demand
Pr = Price of related goods
Meaning of Demand Y = Consumers’ income
It is defined as the quantity of a commodity that a consumer
T = Consumers’ taste and preference
is willing and able to purchase in the market in a given
period of time and at different prices. E = Consumers’ expectations regarding
availability of goods
e.g. a consumer demands 5 kg of sugar in a month at a price
of ` 40 per kg. Market Demand Function
Demand is also referred to as ‘effective desire’. It shows how market demand for a commodity in the market
is related to its determinants.
Individual Demand
It is expressed as
Demand of an individual unit is termed as an individual
demand, e.g. demand of Sharma household for milk priced DX = f (PX , Pr , Y , T , E , N , D Y , PC)
at ` 44 per litre is 50 litres per month. Here, DX = Market demand for commodity X
f = Functional relation
Market Demand PX = Price of the commodity X
It means the total quantity of a commodity that all its buyers Pr = Price of related goods
are willing to purchase at different prices over a given period Y = Income of the consumers
of time, e.g. demand of all the households for milk priced at T = Taste and preference of consumers
` 44 per litre is 20,000 litres per month.
E = Expectations of consumers regarding
Is Demand and Quantity Demanded Synonymous? availability of goods
No, demand is defined as the quantity of a commodity that a N = Population size
consumer is willing to purchase at a given period of time at DY = Distribution of income
different possible prices, whereas, quantity demanded refers
PC = Composition of population
to a specific quantity which a consumer purchases against a
specific price of the commodity. Determinants of Demand
The factors which affect the demand of a commodity are
Demand Function
discussed below
The functional relationship between the demand for a
commodity and the factors affecting demand is termed as 1. Price of the Commodity ( PX ) Demand of a normal
demand function. commodity is inversely related to its price. When the
price of a commodity falls in the market, its quantity
Individual Demand Function demanded increases and vice-versa.
It shows how demand for a commodity by an individual 2. Income of the Consumers (Y ) Income provides
consumer in the market is related to its determinants. purchasing power for the purchase of commodities.
It is expressed as Demand of a normal commodity is directly related to
the income of the consumer. The demand will rise, if
DX = f (PX , Pr , Y ,T , E)
income of the consumer increases and vice-versa.
Here, DX = Demand for commodity X
f = Functional relation 3. Price of Related Goods ( Pr ) Demand for a
Px = Price of the commodity X commodity is also influenced by change in price of
related goods.
These are of two types, i.e. substitute goods and Individual Demand Schedule
complementary goods. It refers to the demand schedule of an individual buyer. It
● In case of substitute goods, market demand for a shows different quantities of a commodity which an
commodity falls with a fall in price of the substitute individual buyer can buy at different possible prices of that
commodities and vice-versa, e.g. tea and coffee. commodity at a point of time.
● In case of complementary goods, market demand for
a commodity rises with a fall in the price of the Price of Rice (`) Quantity Demanded of Rice (in kgs)
complementary commodities and vice-versa, 5 2
e.g. car and petrol. 4 3
4. Taste and Preferences of the Consumers (T) 3 5
These are influenced by advertisement, change in 2 8
fashion, climate, new inventions, etc. Other things The given table shows different quantities of rice to be
being equal, demand for those goods increases for brought by a consumer at different prices, at a given time.
which consumers develop favourable tastes and
preferences and vice-versa. Individual Demand Curve
It shows demand for a commodity by a person at different
5. Expectations of Consumers Regarding
prices at a point of time or we can say, it is a graphical
Availability of a Good (E) Future expectations
representation of an individual demand schedule.
regarding availability of a good affects a consumer’s
Y D
demand. So, if a consumer feels that a particular good
would be in short supply in future, then he might 5
increase his demand now, and vice-versa. 4
Price (`)
6. Distribution of Income (DY ) In case of equitable 3
distribution of income, market demand will tend to
rise as people from all sections of society will be able 2
D
to demand. However, in case of unequitable
distribution of income, demand will be made only 0 X
2 4 6 8 10
from certain section of the society, causing demand to Quantity demanded
(in kgs)
fall. It should also be remembered that in case of
equitable distribution, demand for necessities and Individual demand curve
necessaries of life will be high and in case of (The curve is based on abvove mentioned schedule)
unequitable distribution demand for high-end goods In this figure, demand curve slopes downward from left to
and inferior goods will be high. right. It shows inverse relationship between price and
7. Size of Population (N ) Higher population implies quantity demanded. Therefore, it is said that demand curve is
greater market demand for goods and services and negatively sloped. The above drawn demand curve is
vice-versa. non-linear, i.e. its slope is not constant.
8. Composition of Population (PC ) If the population of
Market Demand Schedule
a country has greater percentage of youth, then
It refers to the demand schedule for a commodity by all the
market demand for branded clothes, accessories, bikes,
consumers in the market. It shows different quantities of a
etc. would be more. On the other hand, if old age
commodity which the consumers intend to buy at different
people form a larger part of population, then market
possible prices of that commodity at a point of time.
demand for health facilities, walking sticks, etc, would
be high. Market demand schedule is obtained by horizontally
summation of individual demand schedules.
Demand Schedule and Demand Curve Market
The tabular presentation of price and quantity demanded is Price of A’s Demand B’s Demand Demand
Ice-cream (`) (1) (2) (1 + 2 = 3)
called the demand schedule and a demand curve is the
graphical representation of the demand schedule. 1 .4 5 4+5=9
Demand schedule and curve include 2 3 4 3+4=7
● Individual demand schedule and individual demand
3 2 3 2+3=5
curve. 4 1 2 1+2=3
● Market demand schedule and market demand curve. (For the sake of simplicity, it is assumed that market consists
of two consumers only).
Economics 13
The inverse relationship between own price of the The law of demand can be explained with the help of an
commodity and its quantity demanded holds good for both, imaginary schedule and the curve which is based on that data
individual demand schedule and market demand schedule.
Demand Schedule
Market Demand Curve Price (`) Quantity Demanded (units)
It shows demand for a commodity made by all the persons in 10 50
the market at different possible prices at a point of time or 8 60
we can say, it is a graphical representation of market demand 6 70
schedule. Market demand curve is obtained by horizontally 4 80
summing the individual demand curves.
2 90
Y DM
DY The above schedule and curve clearly depict that demand of
DX a commodity expands with fall in its price and contracts
Price (`)
with rise in its price.
Assumptions of the Law of Demand

DM The various assumptions of the Law of Demand are as
DX DY
X
follows
O
Quantity demanded (units) ● Tastes and preferences of the consumers remain constant.
Market demand curve ● There is no change in the income of the consumers.
Market demand curve has a negative slope. It is the ● Prices of the related goods do not change.
horizontal summation of individual demand curves. ● No expectation of further changes in the supply of a
D X D X is the individual demand curve of A. commodity.

D X DY is the individual demand curve of B. ● No change in the distribution of income.
D M D M is the market demand curve. ● No change in population.
The above drawn demand curve is linear, i.e. its slope is

Causes for Downward Sloping of Demand Curve
constant.
The causes for downward sloping of demand curve are as
Student should also remember that individual demand curve follows
is steeper and market demand curve is flatter.
1. Law of Diminishing Marginal Utility According to
Slope of Demand Curve this law, as the consumption of a commodity increases,
Demand curve normally slopes downward, indicating the utility from each successive unit goes on
negative relationship between price of a commodity and its diminishing. Accordingly, for every additional unit to be
quantity demanded. purchased, the consumer is willing to pay less price. i.e.
he will buy more only at reduced price.
Y D
2. Income Effect Change Change in own price of a
commodity causes a change in the real income of the
P1
Price (`)
consumer. With a fall in price, real income increases.

∆P { Accordingly, demand for the commodity increases and
P2
{
D vice-versa.
∆Q
X
O Q1 Q2 3. Substitution Effect It refers to substitution of one
Quantity (units)
commodity for the other when one becomes relatively
Slope of Demand Curve cheaper due to change in relative prices. e.g. petrol is
being substituted by CNG, because CNG is cheaper,
Change in Price ∆P
= (−) = (−) leading to an increase in its demand.
Change in Quantity Demanded ∆Q
4. Size of Consumer Group When price of a commodity
falls, it attracts new buyers who can afford to buy it,
Law of Demand hence quantity demanded rises.
The law of demand states that other factors remaining
5. Different Uses Many goods have alternative uses,
constant, the demand for a commodity expands with fall in its
e.g. milk is used for making curd, cheese and butter. If
price and contracts with rise in its price. In other words, law of
price of milk reduces, it will be put into different uses.
demand states that there is an inverse relationship between
Accordingly, demand for milk will expand.
the price of a commodity and its quantity demanded.
Exceptions to the Law of Demand An imaginary tabular presentation of extension and

Exceptions to the law of demand are those goods whose contraction in demand
demand do not increase with fall in price or do not decrease Price (`) Quantity Demanded (units) Description
with rise in price. The various exceptions are 1 500
1. Giffen Goods These are special type of highly inferior 2 400 ↓Contraction
goods in which as the price of the good increases, 3 300
demand for the good also increases and vice-versa, i.e.
4 200 ↑ Extension
they exhibit a positive price effect.
5 100
2. Conspicuous Consumption The law of demand will
not apply in case of costly items such as diamond.
Y
These commodities will be demanded, even if the prices D
B Contraction in demand
have gone up very high. These goods are also known as 5
veblen goods. 4
3. Conspicuous Necessities Certain things have become A
3
the necessity of modern life, so we have to purchase Extension in demand
2
those goods inspite of their price. The demand of C
television sets and automobiles has not gone down 1
D
inspite of the increase in their price. 0 X
100 200 300 400 500
4. Ignorance If the consumer is not aware of the Quantity demanded (units)
competitive price of the commodity, he may purchase Curve showing extension and contraction of demand
more of the commodity even at higher price. Such [The curve is based on above mentioned schedule]
ignorance of the buyers makes the law of demand
ineffective.
Shift in Demand Curve or Change in Demand
5. Future Expectations Regarding Change in Price A shift in the demand curve is caused due to the change in
If price of a particular good is falling, but it is expected factors other than price of the goods. It is also called change in
that it would fall further in future, then people will not demand. A shift of the demand curve can bring
increase their demand now. They will wait until prices
further fall, thereby defying the law of demand. 1. Increase in Demand
6. Necessities This law also does not hold true for It refers to more demand of a commodity at its existing price
necessities of life such as medicines, salt, flour, etc. or same demand at an increased price. It is indicated by a
Their demand is maintained at a constant level, shift from left to right on the different demand curves, as
irrespective of changes in price. from point A to B. It is also called forward shift or rightward
shift in demand curve.
Movement along the Demand Curve or The following scheduled and figure illustrates this situation
Change in Quantity Demanded
Price (`) Quantity (units)
Moving from one point to other on the same demand
curve is called movement along a demand curve. A 20 10
movement along the demand curve is caused by a change 20 15
in quantity demanded of a good in response to change in
the price of the good, other factors remaining constant. It As is clear from the above schedule that at the same price of
is also called change in quantity demanded of the ` 20, demand has increased from 10 to 15 units.
commodity. Y
D1
Movement along a demand curve can take the following forms
D
1. Extension in Demand
It refers to rise in quantity demanded due to fall in the price of A B
P
goods. It is indicated by downward or rightward movement
along the same demand curve as from point A to C. D1
2. Contraction in Demand D
It refers to fall in quantity demanded due to rise in the price X
O Q Q1
of goods. It is indicated by an upward or leftward movement
on the same demand curve as from point A to B. Quantity demanded (units)
Shift in demand curve : Increase in demand
Economics 15
The causes of increase in demand are as under Elasticity of Demand

● Increase in the income of the consumers in case of normal
It refers to the degree of responsiveness in demand due to
goods. change in price of a commodity or income of the consumers
● Decrease in the income of the consumer in case of inferior
or price of related goods.
goods. Elasticity of demand can be of three types
● Increase in the price of substitute goods.
1. Price Elasticity of Demand It measures the change
● Fall in the price of complementary goods.
in demand of a commodity due to change in its own
● Favourable shift in taste and preference. price.
● Future expectations regarding fall in the availability of 2. Income Elasticity of Demand It measures the
goods. change in demand of a commodity due to change in
consumers’ income.
2. Decrease in Demand 3. Cross Elasticity of Demand It measures the change
It refers to less demand of a commodity at its existing price in demand of a commodity due to change in the price
or same demand at a lesser price. It is indicated by a shift of related goods.
from right to left on the different demand curves, as from B
to A. Note Income and Cross Elasticity of Demand are beyond the scope of
the syllabus.
It is also called backward shift or leftward shift in demand
curve. Price Elasticity of Demand (Ed )
The following schedule and figure illustrates this situation Price elasticity of demand measures the degree of
responsiveness of quantity demanded of a commodity to a
Price (`) Quantity (units)
change in its price. Price elasticity of demand for a
20 15
commodity is defined as the percentage change in quantity
20 10 demanded for the commodity divided by the percentage
As is clear from the above schedule that at the same price of change in its price.
` 20, demand has decreased from 15 to 10 units. Price elasticity of demand is a pure number and does not
Y
D depend on the units in which price and quantity are
measured. Also, price elasticity of demand is a quantitative
D1
approach.
A B
P Degrees of Price Elasticity of Demand
The details of each degree of price elasticity of demand are as
D
follows
D1
X 1. Perfectly Elastic Demand (Ed = ∞) A perfectly elastic
O Q1 Q
demand is one in which the slight change in price will
Quantity demanded (units)
cause an infinite change in demand. In this case,
Shift in demand curve : Decrease in demand
demand curve is horizontal, i.e. parallel to X -axis.
The causes of decrease in demand are as under Y
Perfectly elastic
● Decrease in the income of the consumers in case of normal
Ed = ∞
Price (`)
goods. D
P D
● Increase in the income of the consumer in case of inferior
goods. P
● Decrease in the price of substitute goods.
● Rise in the price of complementary goods. 0 X

Q Q1 Q2
● Unfavourable shift in taste and preference. Quantity demanded
(units)
2. Unitary Elastic Demand ( Ed = 1 ) Unitary elastic percentage change in quantity demanded is more than
demand is one in which the percentage change in that of percentage change in its price.
quantity demanded is equal to the percentage change
in its price. Y More than
D unitary elastic
In this case, demand curve extends towards the X -axis
and Y -axis in a uniform manner without touching them. T Ed > 1
P
Price (`)
R
Y Unitary elastic P1
D
Ed = 1
D
T
P
Price (`)
R
P1
O X
Q Q1
Quantity demanded
D (units)
O X
Q Q1 Determinants of Price Elasticity of Demand
Quantity demanded
(units) Some of the important determinants of price elasticity of
demand are as follows
3. Less than Unitary Elastic Demand ( Ed < 1) Less ● Nature of the commodity
than unitary elastic demand is one in which the

● Availability of substitutes
percentage change in quantity demanded is less than
● Postponement of consumption
that of percentage change in its price.
● Different uses of the commodity
In this case, demand curve is steeper and originates
● Time period
from X-axis.
● Habits
Y Less than unitary ● Proportion of income spent on the goods

D
elastic
P T Ed < 1 Measurement of Price Elasticity of Demand
Price elasticity of demand can be measured using following
Price (`)
methods
P1 R
1. Percentage or Proportionate Method
In this method, elasticity of demand is measured by the ratio
D
O X of the proportionate change in quantity demanded to the
Q Q1
Quantity demanded (units)
proportionate change in price.
4. Perfectly Inelastic Demand ( Ed = 0 ) A perfectly E p or

inelastic demand is one in which the change in the Percentage Change in Quantity Demanded
price causes no change in the quantity demanded. Ed = (− )
Percentage Change in Price
In this case, demand curve is vertical, i.e. parallel to
Y -axis. ∆Q
Percentage Change in Quantity Demanded = × 100
Q
Y
∆P
D Percentage Change in its Price = × 100
P
P2 The formula can mathematically be presented as under
Perfectly ∆Q P
P1
inelastic E p or E d = (−) ×
∆P Q
Ed = 0
P Where, Q = Actual quantity, P = Actual price
0
D ∆Q = Change in quantity, ∆P = Change in price
Q X
Quantity demanded (units) Note E p or Ed is a negative number because price and quantity
demanded are inversely related. In numericals, the minus sign is
5. More than Unitary Elastic Demand ( Ed > 1) More dropped from the numbers for simplicity and all percentage
than unitary elastic demand is one in which the changes are treated as positive.
Economics 17
2. Total Expenditure Method 2. The price elasticity of demand for a good is ( −) 0.4.
Total expenditure method, also known as total outlay If its price increases by 5%, by what percentage
method of measuring price elasticity of demand was will its demand fall? Calculate.
developed by Professor Alfred Marshall. According to this Percentage Change in Quantity Demanded
Sol. Ed =
method, price elasticity of demand can be measured by Percentage Change in Price
comparing total expenditure on a commodity before and Percentage Change in Quantity Demanded
0.4 =
after the price change. This method includes three situations 5
as follows Percentage Change in Quantity Demanded = 0.4 × 5 = 2
(i) Elasticity of Demand will be Greater than Unity ∴ Demand falls by 2%.
(Ep > 1) When total expenditure increases with fall in 3. Price elasticity of demand of a good is ( −) 0.75.
price and decreases with rise in price, the value of price Calculate the percentage fall in its price that will
elasticity of demand will be greater than 1. Here, rise result in 15% rise in its demand. [All India 2013]
in price and total outlay or expenditure move in
opposite direction. Percentage Change in Quantity Demanded
Sol. Ed =
(ii) Elasticity of Demand will be Equal to Unity Percentage Change in price
(Ep = 1) When total expenditure on commodity 15
0.75 =
remains unchanged in response to change in price of Percentage Change in Price
the commodity, the value of PED will be equal to 1. 15
Percentage Change (fall) in Price = = 20%
(iii) Elasticity of Demand will be Less than Unity 0.75
(Ep < 1) When total expenditure decreases with fall in
price and increases with rise in price, the value of price 4. Price of a commodity is ` 10 per unit, quantity
elasticity of demand will be less than 1. Here, price of demanded at this price is 100 units. If price rises
commodity and total outlay move in same direction. by ` 2 per unit, quantity falls by 20 units. What
will be the price elasticity of deamand by total
3. Geometric Method expenditure method?
Geometric method was suggested by Prof. Marshall and is Sol. At price ` 10, quantity is 100 units
used to measure the elasticity at a point on the demand Thus, Total Expenditure = Price × Quantity
curve. When there are infinitely small changes in price and = 10 × 100 = ` 1,000
demand, then the ‘Geometric Method’ is used. This method When Price rises by ` 2, quantity falls by 20 units
is also known as ‘Graphic Method’ or ‘Point Method’ or ‘Arc ∴New total expenditure = New Price × New Quantity
Method’. Elasticity of demand (E d ) is different at different
= 12 × 80 = ` 960
points on the same straight line demand curve.
As price and total expenditure are changing in opposite
In order to measure E d at any particular point, lower portion direction, price elasticity of demand will be more than
of the curve from that point is divided by the upper portion unity i.e. elastic demand.
of the curve from the same point.
5. Observe the demand curve given below
Elasticity of Demand (E d ) = Lower Segment of Demand Y
Curve (LS) / Upper Segment of D
Demand Curve (US)
Solved Examples
1. Due to a 10% fall in the price of a commodity, its a
quantity demanded rises from 400 units to 450 D
units. Calculate its price elasticity of demand. O X
Quantity C
Sol. Percentage Change in Quantity Demanded
∆Q
= × 100 What will be the elasticity of demand at point a?
Q
Sol. Elasticity of demand by geometric method is calculated
(450 − 400)
= × 100 by the given formula
400 Lower Segment of Demand Curve
50 Ed =
= × 100 = 12.5% Upper Segment of Demand Curve
400
Percentage Change in Quantity Demanded ∴ at Point a,
Ed = ac
Percentage Change in Price Ed =
12.5 ae
= = 1.25
10 as ac < ae
∴ Price Elasticity of Demand (Ed ) = 1.25 (more than Thus, Ed < 1, i.e, less than unitary elastic demand.
unity)
Practice Questions
1 Demand of a commodity depends upon ....... . 11 Which of the following is/are determinants of
(a) price (b) income demand?
(c) price of related good (d) All of these (a) Price of the good
(b) Income of the consumer
2 Law of demand is a ....... .
(c) Price of related goods
(a) quantitative statement
(b) qualitative statement
(c) Both (a) and (b) 12 What will be the impact of fall in income of a
(d) hypothetical consumer on the demand for an inferior good?
3 The demand of which type of goods do not decrease (a) Rise in demand
(b) Fall in demand
with increase in their price?
(c) Demand remains constant
(a) Comforts (b) Conspicuous goods
(c) Necessities (d) Both (b) and (c)
13 Which of the following statements is true?
4 Expansion and contraction in demand are
(a) Market demand curve is the vertical summation of
caused by ...... . individual demand curves
(a) change in the income of buyer (b) Market demand curve is the horizontal summation
(b) change in the taste and preference of the buyer of individual demand curves
(c) change in the price of the commodity (c) Market demand curve is steeper than individual
(d) change in the prices of related goods demand curves
5 Giffen paradox is an exception of ...... .
(a) Law of Demand (b) Law of Supply 14 Movement along the demand curve is also known
(c) Law of Production (d) Law of Utility as
(a) change in demand
6 If the price of any complementary good rises, then
(b) change in quantity demanded
..... . (c) change in demand of related goods
(a) demand curve shifts to left (d) None of the above
(b) demand curve shifts to right
(c) demand curve moves downward 15 Movement along the demand curve is also known
(d) demand curve moves upward as
7 In case of inferior goods like bajra, a fall
in its price tends to ...... . (c) change in demand of related goods
(a) make the demand remain constant (d) None of the above
(b) reduce the demand
(c) increase the demand 16 Which of the following is/are components of change
(d) change the demand in an abnormal way in demand?
8 The demand function of a product X is given as (i) Increase in demand
Dx = 30 − 4 P, where P is the price of the product. (ii) Decrease in demand
The demand at price of ` 4 will be ...... . (iii) Contraction in demand
(a) 20 (b) 12 (iv) Expansion in demand
(c) 14 (d) 10 Choose from the options given below
Hint Demand Function (Dx) = 30 − 4 P (a) (i) and (iii) (b) (ii) and (iv)
P is given as ` 4 put value of P in demand function (c) (i) and (ii) (d) (iii) and (iv)
∴ 30 − 4(4) = 14 17 Which of the following is/are components of change
9 If price of sugar increases, the demand for tea will in quantity demanded?
...... . (i) Increase in demand
(a) decrease (b) increase (ii) Decrease in demand
(c) not affected (d) None of these (iii) Contraction in demand
10 Which of the following commodities will be (iv) Expansion in demand
demanded, even if the prices have gone up very Choose from the options given below
high? (a) (i) and (iii)
(a) Luxury (b) (ii) and (iv)
(b) Status symbol (c) (i) and (ii)
(c) Prestige (d) (iii) and (iv)
Economics 19
18 If demand is parallel to X-axis, what will be the It shows

nature of elasticity? (a) inelastic demand (b) elastic demand
(a) Perfectly elastic (b) Inelastic (c) unitary elastic demand (d) None of these
(c) Elastic (d) Highly elastic
26 See the diagram below
19 ...... measures the change in demand of a Y
commodity due to change in its own price.
(a) Elasticity of demand
(b) Price elasticity of demand D
Price P
(c) Income elasticity of demand
(d) Cross elasticity of demand
D
20 When Price Elasticity of Demand ( Ed ) is equal to
infinity ( ∞), this refers to
(a) perfectly elastic demand
(b) perfectly inelastic demand X
(c) unitary elastic demand Quantity Q
(d) more than unitary elastic demand
It shows
21 When percentage change in quantity demanded is (a) inelastic demand (b) elastic demand
more than the percentage change in price of the (c) unitary elastic demand (d) None of these
commodity, it is said to be
(a) less than unitary elastic demand 27 See the diagram below
(b) unitary elastic demand Y D
(c) more than unitary elastic demand
(d) perfectly elastic demand
22 Price elasticity of demand is ....... in number
Price P
because price and quantity demanded are inversely
related.
(a) positive (b) negative
(c) constant (d) prime
23 Price elasticity of demand of a good is ( −) 075,
. D
X
calculate the percentage fall in its price that will Quantity Q
result in 15% rise in its demand.
(a) 11.25% (b) 5% It shows
(c) 15% (d) 20% (a) inelastic demand
Hint Price Elasticity of Demand (b) elastic demand
Percentage Change in Quantity Demanded (c) unitary elastic demand
= (d) perfectly inelastic demand
Percentage Change in Price
15 28 If a 10% rise in price of Good X leads to 20% fall in
0.75 =
Percentage Change in Price its quantity demanded, its elasticity of demand is
15 (a) elastic (b) inelastic
Percentage Change in Price (fall) = = 20% (c) unitary elastic (d) perfectly inelastic
0.75
29 Which of the following statements is/are not true
24 Price elasticity of demand is calculated as
about elasticity of demand?
∆Q P ∆P Q
(a) ⋅ (b) ⋅ (i) Demand curve for a perfectly elastic demand is
∆P Q ∆Q P
horizontal line parallel to X-axis
(c) % ∆ QD / % ∆P (d) Both (a) and (c)
(ii) Demand curve for a perfectly inelastic demand
25 See the diagram below
is vertical line parallel to Y-axis
D
Y (iii) Demand for luxury goods is highly inelastic
Choose from the options given below
(a) (i) and (ii) (b) (ii) and (iii)
Price P
(c) (i) and (iii) (d) Only (iii)

30 Which of the below statements is true about
elasticity of demand?
D (a) The units are used to measure price but not used to
X measure quantity
Quantity Q
(b) The units are used are to measure price and quantity
(c) The units are used to measure quantity but not used 36 Which of the following are an example of derived
to measure price demand?
(d) Neither the units are used to measure price nor to
(a) Car and Petrol (b) Tea and Coffee
measure price
(c) Building and Brick (d) None of these
31 If the price elasticity of demand is 2, a 10 percent 37 What will be elasticity of demand on a linear
increase in the price will result in a ……… demand curve below the point using geometric
decrease in its quantity demanded. method?
(a) 5% (b) 10%
(a) Perfectly elastic (b) Perfectly inelastic
(c) 20% (d) 25%
(c) Inelastic (d) None of these
32 The price elasticity of demand ranges between Hint Below the mid-point of a linear demand curve, the lower
(a) –1 to 0 segment becomes less than upper segment thus elasticity
(b) 0 to 1 becomes inelastic.
(c) 0 to nfinity
(d) Negative infinity to infinity 38 What will be the elasticity of demand if price
changes and total expenditure remains constant
33 If the price elasticity of demand ranges between 0 using total outlay method?
and less than 1, demand is (a) Perfectly elastic (b) Perfectly inelastic
(a) inelastic (b) elastic (c) Unit elastic (d) None of these
(c) perfectly elastic (d) unit elastic
39 What will be the elasticity of demand if price and
34 Marginal utility curve of a consumer is also his total expenditure moves in the opposite direction
(a) indifference curve (b) total utility curve
using total outlay method?
(c) supply curve (d) demand curve
35 What will be elasticity of demand on a linear (c) Elastic (d) None of these
demand curve at the point using geometric 40 When demand for a good depends upon the
method? demand for the other, it is known as
(a) joint demand
(c) Unitary elastic (d) None of these
(b) composite demand
Hint At the point of a linear demand curve the lower segment (c) derived demand
becomes equal to upper segment thus elasticity becomes (d) None of the above
unity.
ANSWERS
1. (d) 2. (b) 3. (d) 4. (c) 5. (a) 6. (a) 7. (b) 8. (c) 9. (a) 10. (d)
11. (d) 12. (a) 13. (b) 14. (b) 15. (a) 16. (c) 17. (d) 18. (a) 19. (b) 20. (a)
21. (c) 22. (b) 23. (d) 24. (d) 25. (a) 26. (b) 27. (d) 28. (a) 29. (d) 30. (d)
31. (c) 32. (c) 33. (a) 34. (d) 35. (c) 36. (c) 37. (c) 38. (c) 39. (c) 40. (c)
Economics 21
CHAPTER 04
Producer’s Behaviour
Production L = Labour
K = Capital
A producer or a firm requires different inputs like labour,
machines, land, raw materials, etc. By combining these Here, it is assumed that only two factors of production are
inputs in different proportions, firms produce output. This is used for production, i.e. labour and capital.
called the process of production. Production is a process of
value adding. In other words, production is also defined as Concept of Time Period in Production
the transformation of input into output. Time period is categorised as under
1. Market Period or Very Short Period It is the period
Factors of Production of time during which factors of production cannot be
The inputs that a firm uses in the production process are changed at all. Subsequently, production is not affected
called factors of production. It includes in the market period.
1. Factor Inputs These factors include factors of 2. Short Period It is a time period in which the producer
production such as land, labour, capital and can change only the variable factors while the fixed
entrepreneurs. The prices of these factors are rent, wage, factors remain constant. So, production can be affected
interest and profit respectively. upto a certain extent only.
The above factor inputs are further classified as 3. Long Period It is a time period when the producer has
(i) Fixed Inputs These are the inputs which do not enough time to change both fixed and variable factors.
change with the change in output, e.g. land and In fact, all factors are variable in long-run. Production
machine. can be affected upto any extent in the long period.
(ii) Variable Inputs These are the inputs which
change with the change in the level of output,
Measure of Production
e.g. casual labour. There are mainly three measures of production viz, Total
Product (TP), Average Product (AP) and Marginal
2. Non-factor Inputs These factors include raw material Product (MP).
and fuels.
1. Total Product (TP) or Total Physical Product (TPP)
Production Function It is the sum total of output produced by all the units of
Production function of a firm is a functional relationship labour along with other factors of production. It is also
between inputs used and output produced by the firm. referred to as Total Physical Product of the variable input.
It expresses the maximum quantity of output that can be In other words, it is defined as total quantity of goods and
produced with any given quantities of inputs. Production services produced by a firm in a given period of time.
function considers only the efficient use of inputs that helps The shape of TP curve is steep from the origin, then begins to
in getting the maximum possible output. get flatten and eventually drops-off.
A production function is defined for a given technology. It is It is calculated as
the technology that determines the maximum levels of TP = Σ MP or = TP1 + TP2 + ... + TPn
output that can be produced using different combinations of
inputs. If the technology improves, the level of output 2. Average Product (AP) or Average Physical Product (APP)
obtainable for different input combinations also increases. It is per unit production of the variable factor. It is obtained
It is expressed in terms of the following equation by dividing the total product by the number of units of
Q X = f ( L, K ) variable inputs. The Average Product curve is hump shaped
Here, Q X = Production of commodity X or inverted ‘U’ shaped.
It is calculated as Explanation of the Law

AP = TP/L This law may be explained with the help of following
As Labour (L) is taken as variable factor. schedule and diagram (based on hypothetical data)
3. Marginal Product (MP) or Units of Units of Total Marginal

Stage
Marginal Physical Product (MPP) Land Labour Product Product
It is the change in total production as a result of a unit 1 1 2 2
change in the input of a variable factor. Marginal product is 1 2 5 3 I = Increasing
returns
an addition made to the total product by employing an 1 3 9 4
additional unit of variable input, keeping the other inputs
1 4 12 3
unchanged. The marginal product curve is generally inverted 1 5 14 2 II = Diminishing
‘U’ shape. returns
1 6 15 1
It is calculated as 1 7 15 0
∆TP −1 III = Negative
MP = TPn − TPn-1 or MP = 1 8 14
returns
∆L
Relationship between TP, AP and MP Curves Maximum point of

Y TP
The relationship between TP and MP can be described as T
follows
● When TP increases at an increasing rate, MP also increases. TP
Stage I Stage II Stage III
● When TP increases at a diminishing rate, MP declines.
infl nt of
n
exio
● When TP reaches its maximum, MP becomes zero. K
Poi
● When TP begins to decline, MP becomes negative.
The relationship between AP and MP can be described as X

O L S
follows Y Units of variable factor
● AP increases so long as MP > AP.
● AP decreases when MP < AP. Increasing Decreasing Negative

returns returns returns
● AP is at its maximum when AP = MP.
Marginal Product
nt
● MP may be zero or negative, but AP continues to be positive.

MP oi
of m p
● AP increases, even when MP falls but MP should lie above

u
xim
AP. K
Ma
Returns to a Factor : MP is zero

Law of Variable Proportion O L S
X
This law relates to short-run, in which to increase the Units of variable factor
MP becomes MP
production, only variable factor can be increased.
negative
It states that as more and more units of a variable factor are Law of variable proportion
employed with fixed factors, total product increases at an
increasing rate in the beginning, then increases at a Following observations can be made from the above table
diminishing rate and finally starts falling. and curve
● MP rises till 3rd unit of labour are employed. In this stage,
Assumptions of Law TP increases at an increasing rate. This condition is called

Assumptions followed in the law of variable proportion are condition of increasing returns to factors.
● With the use of 4th unit of labour, MP starts decreasing
● Technique of production does not change.
● All units of variable factor are equally efficient.

and TP increases only at decreasing rate. This stage is called
● Factors of production are not perfect substitute of each
stage of diminishing returns to factors.
● At 7th unit of variable factor, when decreasing MP reduces
other.
● There must be some inputs whose quantity is kept fixed.
to zero, TP is maximum.
● At 8th unit of variable factor, when MP is negative, TP
Because of this, the ratio between the fixed factor and
variable factor changes. Hence, the name ‘Variable starts declining.
Proportion’.
Economics 23
Stages of Law of Variable Proportion 2. Imperfect Factor Substitutability Factors of

Generally, there are three stages of law of variable production are imperfect substitutes of each other. e.g.
proportion more and more of labour cannot be continuously used in
place of additional capital.
Stage I Stage of Increasing Returns to Factor Accordingly, diminishing returns to the variable factor
It is between O to K on the TP curve. In this zone, MP is become inevitable.
increasing and because of this TP is increasing at an 3. Poor Coordination between the Factors Continuous
increasing rate. increasing application of the variable factor alongwith
In this stage, increasing returns to a variable factor is fixed factors beyond a point, crosses the limit of ideal
obtained because greater use of the variable factors makes factor ratio. This results in poor coordination between
it possible to utilise the fixed indivisible factors fully and to the fixed and variable factors.
introduce a greater degree of division of labour.
Stage III Stage of Negative Returns to Factor
Causes of Increasing Returns to a Factor
It is beyond point T on TP curve. In this zone, TP starts declining
1. Fuller Utilisation of the Fixed Factor In the initial because MP becomes negative. In this stage, the variable factors
stages, fixed factor remains underutilised. Its fuller become too much relative to fixed factors, disturbing the
utilisation is possible by adding additional units of production process due to which there is a fall in total product.
the variable factor to total output and the marginal
product of the variable factor tends to increase. Note Point of Inflexion It is a point from where slope of TP curve changes.
Upto this point, TP has been increasing at the increasing rate. From
2. Increased Efficiency of the Variable Factor this point onwards, TP increases but only at a diminishing rate.
Additional application of the variable factor causes
process based division of labour that raises efficiency Causes of Negative Returns to a Factor
of the factor. Accordingly, marginal productivity of the 1. Limitation of Fixed Factor The fixed factor can be
factor tends to rise. optimally used only upto a certain level.
3. Better Coordination between the Factors So long 2. Decrease in Efficiency of Variable Factor As the
as fixed factor remains underutilised, additional variable factor is increased, the efficiency of it, tends to
application of the variable factor tends to improve. fall.
As a result, total output increases at an increasing 3. Poor Coordination between the Fixed and the
rate. Variable Factors As the variable factor is increased, it
leads to a lack of coordination between the fixed and the
Stage II Stage of Diminishing Returns to Factor
variable factors leading to a fall in total product.
It is between K to T on TP curve. In this zone, MP is
decreasing and because of this TP is increasing at a Postponement of the Law
decreasing rate. Postponement of law of variable proportions is possible under
In this stage, total product increases at decreasing rate. the two conditions given below
It means marginal product starts decreasing but remains ● When there is improvement in technology used in the
positive. In this stage, diminishing returns to a factor is process of production, so that greater output is achieved with
obtained because in this stage, the proportion between the the same inputs.
variable factor such as labour has less fixed factors to work ● When some substitute of the fixed factor is discovered, so
upon. K is the point of inflexion where TP stops increasing that the constraint of fixity of the factor is removed.
at an increasing rate and instead, starts increasing at a
decreasing rate. Law of Diminishing Marginal Product
Causes of Diminishing Returns to a Factor (Law of Variable Proportion in Terms of Marginal Product)
1. Fixity of the Factor It is the principal cause behind This law states that with the increase in a variable factor,
the law of diminishing returns. As more and more keeping all other factors constant, the Marginal Product of the
units of the variable factor is combined with the fixed variable factor diminishes after a certain level of production
factor, the latter gets excessively utilised, leading to and eventually becomes negative. This law was given by
decrease in its productivity. classical economists and related to agriculture.
This law may be explained with the help of an imaginary A constant returns to scale means that the proportionate
schedule and diagram increase in input is exactly equal to the increase in output.
For example, the 10% increase in input resulting in a 10%
Total Marginal
Land Labour increase in output.
Product Product
(acre) (units) (quantity) (quantity) Y
Increasing Returns
5 1 50 50 Constant Returns
5 2 110 60 Decreasing Returns
5 3 180 70
Output Y
5 4 260 80
5 5 340 80
5 6 410 70
Law of Diminishing
5 7 470 60
Marginal Product
5 8 520 50 X
Input X
5 9 550 30
5 10 560 10
Concept of Cost
5 11 560 0
Cost refers to the monetary and non-monetary expenditure
5 12 550 –10 incurred by a producer on the factor as well as non-factor
5 13 530 –20 inputs for a given amount of output of a commodity.
Y
Cost Function
A cost function shows the functional relationship between
Maximum output and cost of production.
a point of MP Cost function is given as
C = f (Q)
Here, C = Cost, Q = Units of output
f = Functional relationship
Cost function of a firm depends on two factors
MP is zero ● Quantum of goods produced.
O X ● Prices of factors of production.
L
Units of variable
factors MP Short-run Costs
Marginal product curve Short-run cost is a cost which has short-term implications in
production process, i.e. these are used over a short range of
Law of diminishing marginal product operates in the second output.
stage of law of variable proportion. It includes following cost as follows
Returns to Scale 1. Production Cost This cost refers to the expenditure
incurred by the producer in the process of production on
Returns to scale is a term that refers to the proportionality
factor as well as non-factor inputs.
of changes in output after the amounts of all inputs in
production have been changed by the same factor. 2. Selling Cost The expenditure incurred by the producer
Technology exhibits increasing, decreasing, or constant in order to promote sales of the commodity is known as
returns to scale. selling cost. e.g. advertisement cost.
3. Implicit Cost Implicit costs are costs of self-owned and
An increasing returns to scale occurs when the output
increases by a larger proportion than the increase in inputs self-employed resources. e.g. interest on own capital,
during the production process. For example, if input is rent of own building etc.
increased by 3 times, but output increases by 4 times, then 4. Explicit Cost Explicit costs are those cash payments,
the firm or economy has experienced an increasing returns which firms make to outsiders for their services or goods
to scale. purchased from them. e.g. wages of labour, payment for
A decreasing returns to scale occurs when the raw material, etc.
proportion of output is less than the desired increased input 5. Total Fixed Cost (TFC) Fixed costs are costs, which do
during the production process. For example, if input is not change with the change in the quantity of output.
increased by 3 times, but output is increased by 2 times, the e.g. rent of factory, insurance premium, etc.
firm or economy has experienced decreasing returns to scale.
Economics 25
Total fixed cost curve is a straight line parallel to X-axis, TFC TFC
AFC = or
indicating that total fixed cost is constant at all levels of Number of Units Produced (Q) Q
output, including zero level of output.
AFC falls continuously with the rise in the level of
6. Total Variable Cost (TVC) Payment to the variable output however, it never becomes zero, as TFC
factors of production is called as variable cost. always remains positive.
e.g. wages of temporary labourers, cost of raw materials, The AFC curve derived from TFC curve is a
fuel, etc. rectangular hyperbola, as the area under the curve
Total variable cost curve slopes upward from left to the at each point is exactly the same.
right, i.e. with rise in output variable cost also rises. (ii) Average Variable Cost (AVC) It is defined as the
7. Total Cost (TC) Total cost is defined as the aggregate of variable cost of producing per unit of the
all costs of production at a given level of output. TC is commodity. It is obtained by dividing TVC by the
derived by the sum total of TFC and TVC, level of output.
i.e. TC = TFC + TVC. AVC =
TVC
or
TVC
Number of Units Produced ( Q) Q
Output Fixed Variable Total Cost
(units) Cost (`) Cost (`) (`) AVC curve is always ‘U’ shaped showing the
0 10 0 10
behaviour of declining cost in the initial stages
and rising finally in the later stages.
1 10 10 20
9. Marginal Cost (MC) It is defined as addition made to
2 10 18 28
total variable cost or total cost when one more unit of
3 10 24 34 output is produced.
4 10 28 38 MCnth = TCn − TCn−1
5 10 32 42 or TVCn − TVCn−1
Total cost curve is parallel to total variable cost curve. It Marginal cost curve is also ‘U’ shaped indicating that
shows the difference between TC and TVC, i.e. TFC, marginal cost falls in the beginning due to operation of
which is constant at all levels. Because of this, the law of increasing return and ultimately, it rises due to
difference between TC and VC curves is the same at all the operation of law of decreasing return.
levels. MC is addition to the variable cost as fixed remains
Y constant.
50
TC
Relationship between
40 Average Cost (AC) and Marginal Cost (MC)
Cost (`)
30 VC ● When AC falls, MC is less than AC.
● When AC rises, MC is greater than AC.

20
● When AC is constant and minimum, MC is equal to AC.
10 FC ● MC is always to the left of AC and cuts AC from its lowest
X point.
0 1 2 3 4 5 6
Output (units) Relationship between
Marginal Cost (MC) and Average Variable Cost (AVC)
8. Average Cost (AC) It is the cost per unit of output ● When AVC is falling, AVC > MC.
produced. It is also called unit cost of production.
● When AVC is constant and minimum, AVC = MC.
It is obtained by dividing the total cost by the total
● When AVC is rising, AVC < MC.
number of units produced.
● MC curve cuts AVC curve at its lowest point.
Total Cost (TC)
Average Cost (AC) = ● Both AVC and MC curves are ‘U’ shaped.
Number of Units Produced (Q)
● Both AVC and MC curves start from same point.
The AC curve derived from TC curve is ‘U’ shaped.
It shows that as output increases, the value of AC falls Relationship between
continuously till it reaches a minimum point and then Total Cost (TC) and Marginal Cost (MC)
starts to rise. ● MC is estimated as the difference between TC of two
It comprises of successive units of output.

(i) Average Fixed Cost (AFC) It is defined as the MC nth = TC n − TC n−1
fixed cost of producing per unit of the commodity. ● When MC is diminishing , TC increases at a diminishing rate.
It is obtained by dividing TFC by the level of
output.
● When MC is rising , TC increases at an increasing rate. Relationship between TR, AR and MR

● When MC reaches its lowest point, TC stop increasing From the curves, following relationship is derived between TR
at a decreasing rate, it represents the point of inflexion and MR (at falling price)
of TC curve. ● TR increases at diminishing rate, if MR is diminishing.
● TR is maximum and constant, when MR is constant and zero.
Concept of Revenue ● TR decreases, when MR becomes negative.
Revenue is the money payment received from the sale of

a commodity. In other words, the revenue of a firm is its Y
sale receipts or money receipts which is received from TR is um
im
max
Total Revenue
the sale of a product. Revenue is different from the
profit. TR
Revenue = Costs + Profit
Measures of Revenue
Concept of revenue has three variants, viz Total Revenue X
O Output
(TR), Average Revenue (AR) and Marginal Revenue Y (units)
(MR).
Marginal Revenue
Average and
1. Total Revenue
It is defined as the total or aggregate of proceeds to the
firm from the sale of different commodities. It can be
AR MR is e
calculated by multiplying the units of the sales with the ativ
neg
price. Also, it is sum of total marginal revenue. i.e.
X
TR = P × Q or ΣMR O Output
MR is zero
Where, TR = Total Revenue (units)
MR
P = Price
Q = Quantity From the above curves, following relationship is derived
MR = Marginal Revenue between AR and MR
● When AR is diminishing, AR > MR.
2. Average Revenue ● MR can be negative, but not AR.
It is revenue per unit of output sold. It can be obtained ● Slope of AR is twice of slope of MR.
by dividing total revenue by the quantity sold.

In other words, it is the per unit revenue received from Firm’s Revenue Curves in Different Markets
the sale of one unit of a commodity, i.e. Firm’s revenue curves in different market forms are given below
TR 1. Revenue Curves under Perfect Competition In perfect
AR =
Q competition, AR and MR are constant and equal to each other.
Where, AR = Average Revenue TR increases at a constant rate.
TR = Total Revenue Y TR
Q = Quantity D
6 D′
Revenue (`)
P = AR = MR
3. Marginal Revenue
4
It is the addition to total revenue by the sale of an
additional unit of the commodity. i.e. 2
∆TR
MR = TR n − TR n−1 or X
∆Q 0 1 2 3 4
Output (units)
Where, MR = Marginal Revenue
TR = Total Revenue Firm’s Revenue Curves under Perfect Competition
TR n−1 = Total Revenue from (n −1) units 2. Revenue Curves under Monopoly In monopoly, both AR
TR n =Total Revenue from n units and MR curves are downward sloping and inelastic. TR
∆TR = Change in Total Revenue curve initially rises but after reaching a maximum point,
∆Q = Change in Quantity tends to fall.
Economics 27
Y
Conditions of Producer’s Equilibrium in Terms of
TR Marginal Revenue (MR) and Marginal Cost (MC)
Approach
Revenue (`)
It is more useful to analyse the equilibrium of the firm

with the marginal curves, i.e. MR and MC curves.
AR The equilibrium conditions are as follows
O X ● MR = MC
MR
● Slope of MR < Slope of MC or MC should cut MR from
Quantity Sold (units)
Firm’s Revenue Curves Under Monopoly below.
In perfect competition, MR is a horizontal line. Therefore,
3. Revenue Curves under Monopolistic Competition In
its slope is equal to zero.
monopolistic competition, the curves behave in the same
manner as in monopoly, the only difference being that they are Hence, the second condition becomes, Slope of MC > 0
elastic. The second condition means that MC is greater than MR,
Y after the output level where MR = MC. In other words,
TR MC curve must be rising at the point of equilibrium or
Revenue (`)
MC curve must cut MR curve from below.

Under MR and MC approach, a producer is in
AR equilibrium, where
● MR = MC, also AR = MR, hence AR = MR = MC
MR
O X ● MC should be rising.
Output (units)
Firm’s Revenue Curves under Monopolistic Competition
Y Firm’s equilibrium point
(Perfect competition)
Producer
Cost and revenue (`)
MC
A producer is someone who produces output by combining
factor inputs which have exchange value. P Q
AR = MR
Producer’s Equilibrium
A producer is said to be in equilibrium when he produces that
level of output at which his profits are maximum or costs are
minimised, given his input and has no tendency to change from X
O L
that level of output. Output (units)
Producer’s equilibrium in terms of MR and
So, we can say that producer’s equilibrium refers to the
MC approach
situation of profit maximisation or cost minimisation.
A firm or a producer will have no inclination to either expand or In the above diagram, OL is the output level and OP is the
contract his production level beyond this point as both the price changed by the firm at the state of equilibrium.
conditions would result in earning lesser profits than before.
Note Producer’s equilibrium refers to a situation of ‘profit maximisation’.
π = TR − TC Solved Examples
(Here, π = Profit; TR = Total Revenue; TC = Total Cost) 1. Calculate TP and MP when AP and L is given.
Profit maximisation of a producer means maximising the difference
between Total Revenue (TR) and Total Cost (TC). Units of labour Average Product
(L) (AP)
Assumptions for Producer’s Equilibrium 1 50
Following are the assumptions for producer’s equilibrium
● Producer’s behaviour is rational.
2 60
● Producer’s behaviour is consistent, i.e. it does not change 3 70
frequently. 4 80
● There are two factors (machine and labour) taken into
consideration for determining producer’s equilibrium.

Sol. 3. In the given table, AR and output is given,

L AP TP = AP × L MPnth = TPn − TPn −1 calculate TR and MR.
1 50 50 50
AR Output
2 60 120 70
80 1
3 70 210 90
60 2
4 80 320 110
40 3
2. Complete the following table 20 4
Sol. AR Output TR = AR × Q MR n th = TR n − TR n −1
Average Average
Variable Marginal Total Average 80 1 80 80
Output Fixed
Cost Cost Cost
(units) Cost Cost 60 2 120 40
(MC) (`) (TC) (`) (AC) (`)
(AFC) (`) (AVC) (`) 40 3 120 0
1 ... ... 18 ... ...
4. In the following table, find out the level of output,
2 36 16 14 ... ... at which the producer will be in equilibrium. Give
3 24 ... ... 120 ... reason for your answer.
4 18 18 ... ... ... Output (units) 1 2 3 4 5

Marginal Revenue (`) 8 8 8 8 8
Sol.
Marginal Cost (`) 10 8 7 8 9
Output (Q) TFC AFC AVC MC TC AC TVC
(units) (`) (`) (`) (`) (`) (`) (`)
Output Marginal Marginal
1 72 72 18 18 90 90 18 (units) Revenue (`) Cost (`)
2 72 36 16 14 104 52 32 1 8 10
3 72 24 16 16 120 40 48 2 8 8
3 8 7
4 72 18 18 24 144 36 72
4 8 8
Formulae used 5 8 9
TC = TFC + TVC, TVC = AVC × Q
Producer is in equilibrium at 4th unit of output.
AVC = TVC/Q or AC – AFC
Reason At an output level, 2nd and 4th, the MR and MC
MC nth = TVC n – TVC n−1 are equal, i.e. profit maximisation. But the producer is in
TFC
AFC = , TFC = AFC ×Q equilibrium at 4th unit only where MR = MC, i.e. ` 8 and
Q MC is rising (MC > MR) afterwards.
Practice Questions
1 Function showing relationship between input and 5 In which time period, all factors of production
output is known as ...... . become variable and factors of production change
(a) consumption function (b) investment function with the change in level of production?
(c) production function (d) cost function (a) Long period
(b) Market period
2 What is ‘production’ in economics?
(c) Short period
(a) Creation/Addition to the value of output
(d) All of these
(b) Production of foodgrains
(c) Creation of services 6 Under the relationship between TP, MP and AP
(d) Manufacturing of goods curves, MP becomes negative when
3 When total product falls, then ...... . (a) TP increases (b) TP decreases
(a) average product is equal to zero (c) TP remain constant (d) TP becomes zero
(b) marginal product is equal to zero 7 If the Average Product (AP) of a labour is 30 units
(c) marginal product is negative of outputs, then find total product of 2 labours.
(d) average product continues to rise
(a) 10 units of output
4 Average Product (AP) is at its maximum when (b) 15 units of output
(a) MP > AP (b) MP < AP (c) 30 units of output
(c) MP = AP (d) MP becomes negative (d) 60 units of output
Economics 29
Hint Total Product (TP) is the sum total of output produced 19 Area under MC curve is ...... .
by all units of labour. (a) total cost (b) total fixed cost
TP = AP × L (c) total variable cost (d) None of these
where, AP = Average Product
20 Short-run supply curve of the firm is ..... .
L = Number of Labour, TP = 30 × 2 = 60 units
(a) rising portion of MC curve
8 If the total product of 5 labours is 50 units of (b) rising portion of MC curve which lies above AVC
output and total product of 6 labours is 66 units of curve
output, find Average Product (AP) of 6th unit of (c) rising portion of MC curve which lies above AFC
labour. curve
(d) entire MC curve
(a) 10 units of output
(b) 11 units of output 21 Cost function explain the relationship between
(c) 50 units of output (a) income and expenditure
(d) 16 units of output (b) input and output
Hint Average Product (AP) is total product per unit (c) fixed cost and variable cost
employment of a labour. (d) output and cost of production
TP 66
i.e. AP = = = 11 units of output 22 ...... are not zero at zero level of output.
L 6 (a) Fixed costs (b) Variable costs
9 ...... is the variable factor of production. (c) Marginal costs (d) Average variable costs
(a) Land (b) Labour 23 Average Revenue is equal to ..... .
(c) Capital (d) Factory Total Revenue Average Revenue
(a) (b)
10 In the first stage of law of variable proportions, Quantity Sold 2
Total Revenue Average Quantity
total product increases at an ...... . (c) (d) ×2
(a) decreasing rate (b) increasing rate 100 Quantity Sold
(c) constant rate (d) Both (a) and (b) 24 When the firm is producing 3 tonnes of sugar, it
11 Increasing returns is applicable because of ...... . receives total revenue of ` 24. Raising production
(a) increased efficiency of variable factor to 4 tonnes, increases total revenue to ` 28. Thus,
(b) fuller utilisation of fixed factor marginal revenue is ...... .
(c) indivisibility of factors (a) ` 4 (b) ` 8
(d) Both (a) and (b) (c) ` 28 (d) ` 52
12 Law of variable proportion is valid when ....... . 25 When marginal revenue is zero, ...... .
(a) atleast one input is fixed and all other inputs are (a) total revenue is also zero
kept variable (b) total revenue is the maximum
(b) all factors are kept constant (c) total revenue is the minimum
(c) all inputs are varied in the same proportion (d) total revenue starts increasing sharply
26 Total revenue generated from sale of output of a
13 At the point of inflexion, the marginal product is firm can be calculated as
...... . (a) TR = P × Q (b) TR = AR × Q
(a) increasing (b) decreasing (c) TR = ΣMR (d) All of these
(c) maximum (d) negative
27 If AR is ` 40 per unit from the sale of 3 goods and
14 Which of the stages is relevant for a firm which it is ` 30 per unit from the sale of 4 goods. Find the
aims at maximum economic efficiency in the law marginal revenue of 4th unit of goods.
of variable proportion? (a) ` 10
(a) Stage I (b) Stage II (b) ` 30
(c) Stage III (d) Stage IV (c) ` 40
15 Which of the following curve is not ‘U’ shaped? (d) 0
(a) AFC (b) AVC (c) MC (d) AC Hint Total revenue from 3 goods sold,
16 Payment made to outsiders for their goods and TR3 = AR × Q = 40 × 3 = `120
services are called ...... . Total revenue from 4 goods sold,
(a) opportunity cost (b) real cost TR4 = AR × Q = 30 × 4 = ` 120
(c) explicit cost (d) implicit cost Marginal Revenue (MR4 ) = TR4 − TR3
17 When average cost curve is rising, then marginal = 120 − 120 = 0
cost ...... . 28 Marginal Revenue (MR) curve is a straight
(a) must be decreasing (b) must be constant horizontal line in ....... .
(c) must be rising (d) Any of these
(a) perfectly competitive market
18 As output increases, average fixed cost ...... . (b) monopolistic competitive market
(a) remains constant (b) starts falling (c) oligopoly market
(c) starts rising (d) None of these (d) monopoly market
29 Average revenue of a monopolist firm is ....... . 37 In the process of production, fixed factors and
(a) always more than the marginal revenue variable factors are combined in a particular ratio,
(b) always less than the marginal revenue which gives equilibrium output. What is this ratio
(c) equal to marginal revenue called?
(d) None of the above (a) Factor output ratio (b) Capital output ratio
30 Which of the following statement is true? (c) Ideal factor ratio (d) None of these
(a) For a monopoly firm, average revenue can be zero. 38 ....... is a person who purchase factors of production
(b) For a monopoly firm, marginal revenue can be zero (inputs) to convert them into outputs.
or negative.
(a) Buyers (b) Consumer
(c) For a monopoly firm, marginal revenue and average
(c) Producer (d) Government
revenue are identical.
(d) For a monopoly firm, marginal revenue and average 39 A firm break-even point occurs when ...... . At this
revenue are positively sloped. point, firm is earning zero economic profit or
31 In perfect competition, normal profits. The market price passes through
(a) AR = MR the minimum point of AC curve.
(b) AR = P (a) AR = AC (b) TR = TC
(c) TR is positively sloped straight line from origin (c) AR = AVC (d) Both (a) and (b)
(d) All of the above 40 When MC is greater than MR after producer
32 Under imperfect competition, slope of AR is equilibrium, it means
generally ...... of slope of MR. (a) profit of firm
(a) half (b) twice (b) producing more will lead to decline in profit
(c) equal (d) one-third (c) no profit no loss
(d) firm enjoys economic efficiency
33 In monopoly and monopolistic competitions, AR
and MR curve are downward sloping because the 41 Which of the following is true about shape of
firms can sell more by marginal product and average product curves?
(a) increasing the price (a) Average product is ‘U’ shaped and marginal product
(b) lowering the price is inverted ‘U’ shaped
(c) keep in price constant (b) Marginal product is ‘U’ shaped and average product
(d) All of the above is inverted ‘U’ shaped
(c) Both average product and marginal product are ‘U’
34 In the long-run, a firm in a perfectly competitive shaped
market earns ...... . (d) Both average product and marginal product are
(a) normal profit inverted ‘U’ shaped
(b) abnormal profit
42 When total product is 100 units and units of
(c) atleast 15% profit on capital employed
(d) None of the above variable factor are 5, average product will be
(a) 20 (b) 95 (c) 105 (d) 500
35 A perfectly competitive firm attains equilibrium at TP 100
Hint AP = = = 20
a point where ...... . L 5
(a) MR is equal to MC and MC curve intersects MR
43 A seller can sell 5 smart phones at a price of
curve from below
(b) MC is equal to MR ` 12,000 each. If he sell 6th unit of mobile, his
(c) MC is falling but is equal to AC marginal revenue will be 10,500. The Price/AR of
(d) Both (a) and (b) the 6th unit will be
(a) ` 11,000 (b) ` 12,000
36 The firm in perfect competition maximises profit (c) ` 11,700 (d) ` 11,750
by producing at the rate of output where price Hint Total Revenue = P × Q = 12,000 × 5 = ` 60,000
equals to ...... . MR of 6th unit = ` 10,500
(a) revenue cost (b) marginal ∴New TR = 60,000 + 10,500 = ` 70,500
(c) revenue (d) marginal cost
TR 70,500
Now, Price /AR = = = ` 11,750
Q 6
ANSWERS
1. (c) 2. (a) 3. (c) 4. (c) 5. (a) 6. (b) 7. (d) 8. (b) 9. (b) 10. (b)
11. (d) 12. (a) 13. (c) 14. (b) 15. (a) 16. (c) 17. (c) 18. (b) 19. (c) 20. (b)
21. (d) 22. (a) 23. (a) 24. (a) 25. (b) 26. (d) 27. (d) 28. (a) 29. (a) 30. (b)
31. (d) 32. (b) 33. (b) 34. (a) 35. (a) 36. (d) 37. (c) 38. (c) 39. (d) 40. (b)
41. (d) 42. (a) 43. (d) .
Economics 31
CHAPTER 05
Supply
Meaning of Supply Determinants of Supply/

Supply refers to the quantity of a commodity that a seller is
Factors affecting Supply
willing to sell at different prices during a given period of
The various determinats of supply are
time.
1. Own Price of a Commodity (PX ) There is a direct
In other words, supply refers to whole quantity of goods that
relationship between own price of a commodity and its
can be offered for sale at different possible prices.
quantity supplied. Higher the price, higher the quantity
It should be kept in mind that supply is a desired quantity, supplied and vice-versa.
i.e. it is the quantity that the producers are willing to sell and
2. Price of Related Goods (PR ) The supply of a particular
not what they actually sell.
commodity is inversely related with the price of its
Quantity Supplied It refers to the amount of commodity substitute commodities, such as the supply of wheat
offered for sale against specific price at a point of time. will fall with rise in the price of rice, i.e. supply
decreases and vice-versa.
Individual Supply
In case of complementary goods, supply is directly
Supply of a particular commodity by an individual firm at
related with the price of complementary goods. With
different prices in the market is termed as individual supply.
rise in price of petrol, supply of cars will rise, i.e. supply
Market Supply increases and vice-versa.
Quantities of a particular commodity offered for sale by all 3. Goal of the Firm (G) If goal of the firm is to
the firms at different prices in the market is known as maximise profits, more quantity of the commodity will
market supply. be offered only at a higher price. On the other hand, if
goal of the firm is to maximise sales, more will be
Market supply is the sum total of supply of all the sellers (or
supplied even at the same price or same will be
firms) of a commodity in a market at different prices during
supplied even at a reduced price. Sales maximiser firm
a given period of time.
supplies greater quantity than a profit maximiser firm.
Supply Function 4. Price of Factors of Production (PF ) With the rise in
Supply function studies the functional relationship between the price of factors of production, the cost of
supply of a commodity and its various determinants. It is production rises, which results in decrease in supply
expressed in the following equation due to lesser profit margin and vice-versa.
S X = f (PX , PR ,G , PF ,T , N F , E X ,GP) 5. State of Technology (T ) New discoveries bring
Where, S X = Supply of commodity reduction in costs and increase in production. This will
increase the level of supply also. A cost saving
f = Functional relations
technology increases the supply.
PX = Own price of a commodity X
6. Number of Firms in the Industry (N F ) Increase in
PR = Price of related goods the number of firms in the market implies increase in
G = Goal of the firm market supply and decrease in the number of firms
PF =Price of factors of production implies decrease in market supply of a commodity.
T = State of technology 7. Business Confidence/Expectation (E X ) In the
NF = Number of firms in the industry situation of high business confidence, i.e. future
E X = Business confidence/Expectation expectations regarding as per in demand investments
GP = Government’s policy tend to rise and supply starts rising and vice-versa.
8. Government Policy (G P ) The production of the Supply curve has two aspects
commodity is discouraged, if heavy duty on its 1. Individual Supply Curve Graphical representation of
production is imposed. In this case, supply will the relationship between price and individual supply of
decrease. In the same way, tax concessions encourage a commodity by an individual unit is called individual
producers to increase supply. Also, subsidy offered by supply curve.
the government has a positive effect on supply. As Y
subsidy on a product increases, supply also increases,
and vice-versa. S
Price (`)
Supply Schedule
It is a tabular presentation of various quantities of a
commodity offered for sale, corresponding to different
possible prices of that commodity. It shows the positive S
relationship between price and quantity supplied of a O X
Quantity Supplied
commodity. (units)
Supply schedule has two aspects Individual supply curve
1. Individual Supply Schedule Tabular presentation of Upward slope individual supply curve shows that more
various quantities that a seller is willing to sell at of a commodity is supplied only at a higher price.
different prices is called individual supply schedule.
2. Market Supply Curve Graphical representation of the
Individual Supply Schedule relationship between price and market supply of a
commodity by all the firms is called market supply curve.
Price (`) Quantity Supplied (units)
1 100 Market supply curve is a horizontal summation of
individual supply curves. It is also an upward sloping
2 200
curve.
3 300
Y S(A)
4 400 S(B)
5 500
S(A + B)
Price (`)
From the above schedule, it is clear that as price rises,

supply increases. ply
up
2. Market Supply Schedule Tabular presentation of ts
rke
various quantities that all the sellers are willing to sell S Ma
S
at different prices is called market supply schedule. S
X
O Quantity Supplied (units)
Market Supply Schedule
Market supply curve
Quantity Quantity Market Supply
Price (`) Supplied of Supplied of
( A + B) (Units)
Firm A Firm B
Law of Supply
1 10 5 10 + 5 = 15
It states that keeping other determinants of supply constant,
2 20 10 20 + 10 = 30
the quantity supplied decreases with the fall in price and
3 30 15 30 + 15 = 45
increases with the rise in price.
4 40 20 40 + 20 = 60
Law of Supply derives the relationship between price and
5 50 25 50 + 25 = 75
quantity supplied. According to this law, quantity supplied of
(It has been assumed that market consists of only two a commodity is directly related to the price of a commodity.
firms). The quantity supplied decreases with the fall in price and
vice-versa.
Supply Curve Law of Supply is explained with the help of following
It is a graphical representation of supply schedule showing schedule and diagram
various quantities of a commodity offered for sale at
Price (`) Quantity Supplied (Units)
different possible prices of that commodity.
It shows the positive relationship between price of a 10 100
commodity and its quantity supplied. It is an upward sloping 15 200
curve. 20 300
Economics 33
Y 4. Future Expectations Regarding Prices If prices are

S rising, but sellers anticipate that they would rise
20 further in future, then they would not increase their
Price (`)
supply now.
15
5. Lack of Resources In underdeveloped or backward
10 economies, supply cannot be increased due to lack of
S
resources.
X 6. Labour Market In the labour market, it is observed
0 100 200 300
that as the wage rate rises, the workers tend to work
Quantity supplied (units)
for less hours, so as to enjoy more leisure.
Supply curve moves upward from left to right. It shows
This causes the supply of workers to decrease at
positive relationship between own price of the commodity
increased wage rate.
and its quantity supplied. As price rises, quantity supplied
also rises and vice-versa.
Movement Along the Supply Curve or
Assumptions of Law of Supply Change in Quantity Supplied
● There is no change in the price of the factors of production. A movement along the supply curve is caused by changes in
● There is no change in the techniques of production. the price of the goods, other factors remaining constant. It is
● There is no change in the goal of the firm. also called change in quantity supplied of the commodity.
Here, we move on the same supply curve either up or down.
● There is no change in the price of related goods.
Movements along a supply curve can take the form of
● Investors have full confidence over business.
1. Extension or Expansion of Supply
Causes for Application of ‘Law of Supply’ When the quantity supplied increases with the rise in price,
The following are the reasons for the operation of law of it is called expansion of supply. In this case, we move upward
supply or rightward on the same supply curve.
1. Profit Motive As price rises, supplier’s profit margin It is explained with the help of an imaginary schedule and
also rises. This increased profit motivates a supplier to diagram
supply more with increase in price. Price (`) Quantity Supplied (Units)
2. Change in the Number of Firms High prices 1 10
generally imply a higher profit margin, as discussed 2 20
above. High margin of profit makes the particular 3 30
business lucrative to new investors. As a result of this,
the number of firms increases in the market, causing
Y
supply to rise simultaneously. S
C
3. Reduction in Stock As price rises, the producers are 3
Price (`)
willing to supply more from their accumulated stocks,

B
causing stocks to deplete and supply to increase. 2
Exceptions to the Law of Supply 1

A
Certain goods which do not follow law of supply are
S
1. Agricultural Goods Law of Supply does not apply for 0
X
10 20 30
agricultural goods, as their supply depends on climatic Quantity supplied (units)
conditions and not on price. Extension of supply ( A → B→ C)
2. Perishable Goods Perishable goods like fruits,
vegetables, milk and milk products cannot be held for Extension of supply is shown by a movement from point A to
long. Therefore, suppliers are willing to supply these B to C on the same supply curve. More is supplied, in
products, even when prices are less, for fear that they response to increase in own price of the commodity. So,
would become totally useless. when price increases from ` 1 to ` 2, quantity supplied
3. Antique Goods, Rare Articles and Paintings These increases from 10 to 20.
goods are highly priced, but still their supply is limited,
as supply here is affected by factors other than price. 2. Contraction of Supply
So, the supply of Hussain’s paintings cannot be When the quantity supplied decreases with the fall in price,
increased even if buyers are willing to pay high price it is called contraction of supply. In this case, we move
for it. downward or leftward on the same supply curve.
It is explained with the help of an imaginary schedule and Y S

diagram S1
10 P A B
3 30
Price (`)
2 20
S
1 10
S1
Y 0 X
Q Q1
S 100
C 200
3 Quantity supplied (units)
Price (`)
Increase in supply ( A → B)
B
2
At the same price, supply increases from 100 to 200 units.
A
1 Accordingly, supply curve shifts rightward from SS to S1 S1 ,
the production shifts from point A to B (from old supply
S curve to new supply curve).
0 X
10 20 30
Quantity Supplied (units)
Causes for the Increase in Supply
Contraction of supply (C → B→ A) ● Fall in the price of substitute goods.
● Rise in the price of complementary goods.
Contraction of supply is shown by a movement from point ● Changes in the goals of producers to being sales
C to B to A on the same supply curve. Less is supplied in maximisation.

response to decrease in own price of the commodity. ● Fall in the price of factors of production.
So, when price decreases from ` 3 to ` 2, quantity supplied ● Improvements in technology.
falls to 20 units from 30 units. ● Increase in the number of firms in the market.
● Changes in government’s policy, either by decreasing

Shift in the Supply Curve or Change in Supply
taxes or increasing subsidies.
Shift in supply curve shows the situation of increase or decrease
in supply, even when, own price of the commodity remains 2. Decrease in Supply
constant. When supply of a commodity decreases due to
Shift is caused by other factors, which are unfavourable changes in factors other than price, it is
● Price of related commodities,
called decrease in supply. In this situation, supply curve
● State of technology,
shifts leftward. It is explained with the help of an
imaginary schedule and diagram
● Cost of production,
● Government policy,
● Number of firms in the industry,
10 200
● Business confidence/Expectation,
10 100
● Goal of firm.
Y S
It is also called change in supply. In shift, a new supply curve is S1
drawn.
10 P A B
Shift in supply curve can take the following two forms
Price (`)
1. Increase in Supply S
When supply of a commodity increases due to favourable S1
changes in factors other than price, it is called increase in X
0 Q Q1
supply. In this situation, supply curve shifts rightward.
100 200
It is explained with the help of an imaginary schedule and Quantity supplied (units)
diagram Increase in supply ( A → B)
Price (`) Quantity Supplied (Units) At the same price, supply decreases from 200 to 100 units.
Accordingly, supply curve shifts leftward from SS to S1 S1 ,
10 100
the production shifts from point A to B (from old supply
10 200 curve to new supply curve).
Economics 35
Causes for the Decrease in Supply 3. Unit Elastic Supply ( Es = 1) If percentage change
● Rise in the price of substitute goods. in supply is equal to percentage change in price, it
● Fall in the price of complementary goods.
is called unit elastic supply. In this case, the
coefficient of E s is equal to one.
● Changes in the goals of producers to being profit maximisation.
In this condition, supply curve is a straight line
● Rise in the price of factors of production.
passing through the origin, irrespective of the angle
● Outdated technology.
that it makes or how flat or steep it is.
● Decrease in the number of firms in the market.
Y
● Changes in government policy, either by increasing taxes or
decreasing subsidies.
S
Price Elasticity of Supply
Price (`)
P1
It can be defined as a measure of the responsiveness of quantity
supplied to change in the own price of the commodity. It is also P
defined as the percentage change in the quantity supplied of a S
commodity divided by the percentage change in its price. 0 X
Q1
Q
Price Elasticity of Supply
Percentage Change in Quantity Supplied
(Es ) = 4. Inelastic or Less than Unit Elastic Supply
Percentage Change in Price (Es < 1) When percentage change in quantity
supplied is less than percentage change in price, it is
Price Elasticity of Supply is a pure number, it has no unit. called inelastic supply. In this condition, the straight
line supply curve intersects the X-axis in its positive
Degrees of Elasticity of Supply range (or cuts the X-axis/quantity axis).
There are five degrees of elasticity of supply as explained below Y
S
1. Perfectly Inelastic Supply (Es = 0) When supply of a
P1
commodity does not change, irrespective of any change in its
price, it is called perfectly inelastic supply. In this condition,
Price (`)
supply curve will be a straight line parallel to Y −axis. P

Y
S
S S 0 X
Price (`)
P Q Q1
5. Elastic or More than Unit Elastic Supply
(Es > 1) When percentage change in supply is more
X
0 Q1 Q Q2 than the percentage change in price, it is called
Quantity supplied (units) more than unit elastic supply. In this condition,
2. Perfectly Elastic Supply (Es = ∞) Supply of a commodity the straight line supply curve intersects the X-axis
is said to be perfectly elastic when its supply expands or in its negative range (or cuts Y-axis/price axis).
contracts to any extent without any change in the price. In Y
this condition, supply curve will be a straight line parallel to
X-axis.
Y S
P1
Price (`)
P
S S
S
Price (`)
0 X
X Q Q1
0 Q1 Q Q2 Quantity supplied (units)
Factors affecting Elasticity of Supply e.g. in graph, the supply is highly elastic. Since LQ is
greater than OQ, the elasticity of supply at point A will
The factors which affect the elasticity of supply are
be greater than one (highly elastic).
1. Nature of Inputs Used The Elasticity of Supply
In general, we can say that a straight line supply curve
depends on the nature of inputs used for the production
passing through the Y-axis or having a negative
of a commodity. intercept on X-axis is highly elastic (Es > 1).
If commonly available inputs are used, supply will be
Y Highly Elastic Supply
elastic, but in case of scarcely available inputs, the
supply will be inelastic. SS
2. Risk Taking If entrepreneurs are willing to take risk,
Price (in `)
P1 B
the supply will be more elastic. On the other hand, if
entrepreneurs are reluctant to take risk, the supply will A
be inelastic. P C
3. Nature of Commodity Perishable goods are relatively

less elastic in supply than durable goods, because of
limited shelf-life of perishables.
X
4. Time Factor Longer the time period, greater will be the L O Q Q1
Elasticity of Supply. Because over a long period of time, Quantity supplied (In Units)
factors are easily adjustable and vice-versa. (ii) Unitary Elastic Supply (Es = 1) If the straight-line
5. Technique of Production In case of production of a supply curve passes through the origin (supply curve
commodity, supply will be less elastic if it involves the SS in graph.), then elasticity of supply will be equal to
use of a complex and expensive technology. On the other one. In the diagram,
hand, use of a simple technology facilitates quicker Elasticity of Supply (Es) = OQ/OQ = 1. Hence, the
changes in output and supply. supply is unitary elastic.
6. Cost of Production Elasticity of Supply is also influenced Y Unitary Elastic Supply
by cost of production. Supply will be less elastic in case,
increase in production causes a substantial increase in cost SS
of production and vice-versa.
Price (in `)
Measurement of Price Elasticity of Supply P1 B

Following are the methods of price elasticity of supply A
P C
1. Percentage Change Method
According to this method, elasticity of supply is the ratio X
O Q Q1
between ‘percentage change in quantity supplied’ and
Quantity supplied (in units)
‘percentage change in price’ of the commodity.
(iii) Less Elastic Supply (Es < 1) If a supply curve meets
Percentage Change in Quantity Supplied ∆Q P
Es = or × the X-axis at some point, say, L in graph, then supply is
Percentage Change in Price ∆P Q inelastic. As seen in the graph, Es = LQ/OQ and LQ <
Here, Q = Initial quantity OQ. So, Es < 1, i.e. supply is less elastic.
P = Initial price Y Less Elastic Supply
∆Q = Change in quantity supplied
∆P = Change in price SS
Price (in `)
2. Geometric Method
Geometric method is the technique of measuring price P1 B
elasticity of supply at any given point on the supply curve.
A
This method is also known as arc method or point method. P C
This method includes following three condistions
(i) Highly Elastic Supply (Es > 1) A supply curve, O L Q Q1
X
which passes through the Y-axis and meets the Quantity supplied (In units)
extended X-axis at some point.
Economics 37
Solved Examples 3. A firm supplies 10 units of a good at a price of

` 5 per unit. Price Elasticity of Supply is 1.25.
1. The Price Elasticity of Supply of commodities X What quantity will the firm supply at a price of
and Y are equal. The price of X falls from ` 10 to ` ` 7 per unit.
8 per unit and its quantity supplied falls by 16%. Sol. Given, Es = 1.25, P =`5
The price of Y rises by 10%. Calculate the P1 = ` 7,
Q = 10
percentage increase in its supply. Q1 =?,∆P = P1 − P = 7 − 5 = 2
Sol. Price Elasticity of Supply of Commodity X ∆Q P
Percentage Change in Quantity Supplied of X Price Elasticity of Supply (Es) = ×
(Es ) = ∆P Q
Percentage Change in Price of X ∆Q 5
1.25 = × , ∆Q = 1. 25 × 4 = 5
Percentage Change in Price of X 2 10
∆P 2 Q1 = Actual Quantity + Change in Quantity
= × 100 = × 100 = 20%
P 10 = Q + ∆Q = 10 + 5
16 Q1 = 15 units
∴ Es of X = = 0.8
20
According to the question, Es of X = Es of Y 4. Observe the diagram given below
Y
∴ Es of Y = 0.8
Now, Price Elasticity of Supply of Commodity Y
Percentage Change in Quantity Supplied of Y
(Es) = S
Price (`)
Percentage Change in Price of Y
Percentage Change in Quantity Supplied of Y a
0.8 =
10
0.8 × 10 = Percentage Change in Quantity Supplied of Y S
= 8% O X
Quantity
∴ Percentage change in quantity Supplied of Y = 8%
What will be the elasticity of supply at Point a?
2. A firm supplies 200 units of a good at a price of ` 5
per unit. When price changes, it supplies 100 units Sol. Y
less. Price Elasticity of Supply is 2.5. Calculate
price after change.
Price (in `)
S
Sol. Given, P =`5
∆ Q = 100 units, ∆P = ?, a
Q = 200 units, Es = 2.5
∆Q P
Price Elasticity of Supply (Es) = ×
∆P Q
X
100 5 L O Q
2.5 = × Quantity
∆P 200
5 5 Inter cept of X − axis LQ
∆P = = =1 Elasticity of Supply = =
2.5 × 2 5 Quantity at that Price OQ
∴New price (P1) = P − ∆P as ∠Q > OQ
= 5 − 1 = `4 ∴ e S > 1 (more elastic)
Practice Questions
1 The supply of a commodity implies (b) larger quantity of the commodity due to increased
(a) actual product of a good taxation on that commodity.
(b) stock available for sale (c) larger quantity of the commodity at the same price.
(c) total existing stock of the good (d) larger quantity of the commodity at the decreased
(d) the amount of goods offered for sale at a different price.
prices, per unit of time
12 Contraction of supply curve means
2 Supply of a commodity is …… concept. (a) upward movement along the supply curve
(a) stock (b) flow (b) downward movement along the supply curve
(c) Both (a) and (b) (d) wholesale (c) rightward shift in supply curve
(d) leftward shift in supply curve
3 The supply curve is usually
(a) upward rising 13 If a firm’s supply increases due to application of
(b) downward sloping improved technology, this is known as
(c) nothing definite can be said (a) expansion in supply
(d) None of the above (b) contraction in supply
4 The claim that other things being equal, the (c) increase in supply
quantity supplied of a good rises when the price of (d) increase in quantity supplied
good rises and vice-versa is known as 14 A supply curve will shift leftward due to
(a) Law of Economics (b) Law of Supply (a) increase in supply
(c) Law of Demand (d) All of these (b) increase in quantity supplied
5 The functional relationship between supply of a (c) decrease in supply
commodity and its various determinants is known (d) decrease in quantity supplied
as
15 Consider the following supply schedule.
(a) supply function
(b) change in supply Price (` per unit) Quantity Supplied (in units)
(c) change in quantity supplied 10 200
(d) None of the above 10 100
6 Supply schedule shows ...... relationship between
It is called
price and quantity supplied of a commodity. (a) decrease in supply
(a) positive (b) inverse (b) decrease in quantity supplied
(c) negative (d) opposite (c) decrease in demand
7 Which of the following shows relationship between (d) All of the above
the price of a commodity and quantity supplied 16 Which of the following is not a cause of decrease in
graphically? supply?
(a) Supply statement (b) Supply schedule (a) Rise in price of substitute goods
(c) Supply curve (d) All of these (b) Increase in price of complementary goods
8 A firm will supply more quantity of a commodity at (c) Increase in taxes
(d) Rise in price of labour (i.e. wages)
same price or even at a reduced price, if the firm
wants to 17 Consider the following supply schedule.
(a) maximise profit (b) maximise social welfare Price (` per unit) Quantity Supplied (in units)
(c) maximise sales (d) maximise wealth 25 50
9 When supply curve shifts to the right, there is ...... 35 70
in supply. This refers to
(a) an increase (b) expansion
(a) expansion in supply (b) contraction in supply
(c) contraction (d) decrease
(c) increase in supply (d) Both (b) and (c)
10 Increase or decrease in supply means
(a) change in supply due to change in its own price. 18 Supply of a good depends upon
(b) change in supply due to change in factors other than (i) Willingness to sell (ii) Ability to sell
its own price.
(iii) Price of the good (iv) Time period
(d) None of the above Choose from the options below
(a) (i) and (ii)
11 Expansion in supply refers to a situation when the (b) (iii) and (iv)
producers are willing to supply a (c) (i), (ii) and (iii)
(a) larger quantity of the commodity at an increased (d) (i), (ii), (iii) and (iv)
price.
Economics 39
19 As the cost of production increases, supply of a 28 Due to 10% fall in price of Good X, quantity
good demanded falls by 15%. Elasticity of supply is
(a) Increases (b) Decreases (a) Elastic
(c) Remains constant (d) None of these (b) Inelastic
(c) Unitary elastic
20 Relation between price of a good and its amount of (d) None of the above
good is known as
Hint Elasticity of Supply = Percentage change in QS/
(a) Supply (b) Quantity supplied
Percentage change in Price
(c) Stock (d) None of these
21 The supply of a good refers to 29 The following are causes of shift in supply
(a) Actual production of goods EXCEPT the one
(b) Total stock of goods (a) Change in government policy
(c) Stock available for sale (b) Change in cost of production
(d) Amount of goods offered for sale at a particular (c) Change in own price of the good
price per unit time (d) Change in expectation about future price
22 The variable which is measured over a point in 30 If the goal of the producer changes from profit
time is known as ………… . maximisation to sales maximisation, supply will
(a) stock (b) supply (a) increase
(c) quantity supplied (d) None of these (b) decrease
(c) remains constant
23 Indian government is focusing on Make in India (d) downward movement along supply curve
programme, which has led to significant
31 An increase in customers’ income will have
improvement in technology. What will be its impact
following impact on supply curve
on supply of goods concerned?
(a) Lead to movement along supply curve
(a) Increases (b) Decreases
(b) Lead to shift in supply curve
(c) No impact (d) Both (a) and (b)
(c) Lead to movement and shift along supply curve
24 Unitary elastic supply curve starts from the (d) No impact on the supply curve
(a) X-axis (b) Y-axis 32 Increase in price of the good leads to ……… in
(c) Origin (d) None of these
total revenue.
25 Elastic supply curve starts from the (a) increase
(a) X-axis (b) Y-axis (b) decrease
(c) Origin (d) None of these (c) no change
(d) either increase or decrease
26 When supply price increase in the short run, the
profit of the producer ……… . 33 Recently government of India increase excise duty
(a) increases (b) decreases on import of gold. It will lead to ……… in supply.
(c) remains constant (a) increase
(d) it may increase or decrease (b) decrease
(c) no change in supply
27 Look at the diagram below (d) either increase or decrease
Price ($) Supply (1)
34 As you are aware of recent outbreak of Covid-19,
which has a led to lockdown in many countries
around the globe. In extension of this, government
has stopped imports in India from various
countries. How it will impact supply of a good
5 Supply (2) concerned?
(a) Expansion in quantity supply
(b) Contraction in quantity supply
(c) Increase in supply
0 (d) Decrease in supply
Quantity
0 4 35 During year 2019-20, world recession led to fall in
Choose the most appropriate option income levels drastically. Automobile market in
(a) Supply (1) is more elastic and Supply (2) is less India faced a major setback due to fall in demand.
elastic To deal with these, Automobile companies offered
(b) Supply (2) is more elastic and Supply (1) is less huge discounts to attract buyers. This is an
elastic example of
(c) Supply (1) is perfectly elastic and Supply (2) is (a) Expansion in quantity supplied
perfectly inelastic (b) Contraction in quantity supplied
(d) Supply (2) is perfectly elastic and Supply (1) is (c) Increase in supply
perfectly inelastic (d) Decrease in supply
36 Elasticity of Supply is defined as a measure of the 39 When the price of a good rises from ` 20 per unit to
responsiveness of quantity supplied of a good to ` 30 per unit, the revenue of the firm producing
change in this good rises from ` 100 to ` 300. Calculate Price
(a) price of concerned good (b) price of substitute good Elasticity of Supply.
(c) demand (d) None of these (a) 0 (b) 1
37 When supply is perfectly inelastic, Elasticity of (c) 2 (d) −1
∆Q P 5 20
Supply is equal to Hint Price Elasticity of Supply (Es) = × = × =2
(a) – 1 (b) zero ∆P Q 10 5
(c) 1 (d) infinity where, P = 20
38 Total Revenue is ` 400 when the price of the Q = 100 ÷ 20 = 5
commodity is ` 2 per unit. When price rises to P1 = 30
` 3 per unit, the quantity supplied is 300 units. Q1 = 300 ÷ 30 = 10
Calculate the Price Elasticity of Supply? ∆P = P1 − P = 30 − 20 = 10
(a) 0 (b) – 1
(c) 1 (d) ∞
∆Q = Q1 − Q = 10 − 5 = 5
∆Q P 100 2 2 40 A firm supplies 500 units of a good at a price of ` 5
Hint (Es) = × = × = =1
∆P Q 1 200 2 per unit. The Price Elasticity of Supply of a good is
where, 2. At what price will the firm supply 700 units?
(a) ` 5 (b) ` 1
P =` 2 (c) ` 6 (d) ` 4
P1 = ` 3 ∆Q P
Hint Price Elasticity of Supply (Es) =
×
∆P = 3 − 2 = ` 1 ∆P Q
Q = 400 ÷ 2 = 200 200 5 200 × 5
⇒2= × or ∆P = =1
Q1 = 300 ∆P 500 500 × 2
∆Q = 300 − 200 =100 units ∴ New price (P1) = P + ∆P = 5 + 1 = ` 6
ANSWERS
1. (d) 2. (b) 3. (a) 4. (b) 5. (a) 6. (a) 7. (c) 8. (c) 9. (a) 10. (b)
11. (a) 12. (b) 13. (c) 14. (c) 15. (a) 16. (b) 17. (a) 18. (d) 19. (b) 20. (b)
21. (d) 22. (a) 23. (a) 24. (c) 25. (b) 26. (d) 27. (d) 28. (a) 29. (c) 30. (a)
31. (d) 32. (d) 33. (b) 34. (d) 35. (c) 36. (a) 37. (b) 38. (c) 39. (c) 40. (c)
Economics 41
CHAPTER 06
Forms of Market and

Price Determination
3. Free Entry and Exit of Firms In a perfectly com-
Concept of Market petitive market, there are no barriers to entry or exit of
It may be defined as an arrangement of establishing effective firms. Entry or exit may take time, but firms have
relationship between buyers and sellers of the commodities. freedom to move in and out of an industry, without
Market is considered as a complex set of activities by which any government intervention.
potential buyers and sellers are brought in close contact for
4. Perfect Knowledge Firms have all the knowledge
the purchase and sale of a commodity.
about the product market and the factor market.
It should be remembered that in economics, the term Buyers also have perfect knowledge about the product
‘market’ refers not necessarily to a place, but always to a market.
commodity. So, there exist a market for cars, a market for
5. Perfect Mobility of Factors of Production The
clothes, etc.
factors of production can move easily from one firm to
another. Workers can also move between jobs and
Forms of Market places.
Market may assume different forms depending on the
6. Absence of Transportation Cost It is assumed that
factors like number of buyers and sellers, nature of the
goods can be easily transported from one place to
product bought and sold and barriers to entry and exit of
another without any additional transportation cost or
firms.
that the transportation cost of all the firms are
On the basis of the given factors, there are two main forms identical.
of market
● Perfect competition Demand Curve under Perfect Competition
● Imperfect competition Under perfect competition, demand curve of the firm is
(a) Monopoly (b) Monopolistic competition perfectly elastic (E d = ∞). It means that the firm can sell any
amount of the commodity at the prevailing price.
(c) Oligopoly (not in syllabus)
Y
Perfect Competition
It is a form of market where there are very large number of Ed = ∞
Price (`)
P P
buyers and sellers of a commodity. Homogeneous products
are sold at a uniform price.
Features of Perfect Competition X

O A B
Perfect competitive market exhibits the features given below
Quantity (units)
1. Very Large Number of Buyers and Sellers There
are very large number of buyers and sellers in the Firm’s demand curve is indicated by a horizontal straight
market due to which no individual buyer or seller can line parallel to X-axis. This shows that the firm is to accept
influence the price of the commodity in the market. the price as determined by the forces of market supply and
2. Homogeneous Product Firms in this market sell market demand.
homogeneous product. Homogeneity of a product The above figure shows that at the given price OP, the firm
implies that one unit of the product is a perfect can sell any quantity of the commodity it produces. Price
substitute for another, i.e. there is no difference in the remains constant which is determined by the market
products in any form. whether quantity demanded is OA or OB or even zero.
Determination of Market Equilibrium under Perfect 4. Full Control Over Price Being a single seller of the
Competition product, a monopolist has full control over its price.
A monopolist thus, is a price maker. He can fix
Under perfect competition, market equilibrium is determined whatever price he wishes to fix for his product.
at the point where market demand and market supply for the Therefore, a monopolist is referred to as price maker.
industry as a whole are equal to each other, which gives the
price of individual firms as given, and hence AR and MR 5. Price Discrimination A monopolist may charge
curves of the firms coincide of each other and additional different prices from different buyers. It is called
revenue (MR) is the price charged for the previous unit. price discrimination.
e.g. electricity boards charge higher tariff for
Y Y commercial use than domestic use.
Price (`)
6. Price Maker Under monopoly, single seller dealt in

Price (`)
Ms
the market and he holds the power over the price
that he charges for a commodity.
E Ed = ∞
P
2. Monopolistic Competition
Md
X X It is a form of the market in which there are many sellers
O Q O Quantity (units) of the product, but the product of each seller is somehow
Quantity (units)
different from that of the others. e.g. firms producing
Demand curve and market equilibrium under perfect competition
different brands of toothpastes, viz colgate, closeup,
Where, pepsodent, etc.
M s = Market supply, E = Equilibrium point, Features of Monopolistic Competition
M d = Market demand, P = Equilibrium price, Monopoly market exhibits the features given below
Q = Equilibrium quantity 1. Large Number of Buyers and Sellers There are
large number of buyers and sellers of the commodity.
Imperfect Competition No individual seller is big enough to influence the
This market structure shows some, but not all features of market on his own and no single buyer can exercise
competitive market. It may be classified into following types any big influence on the price of the product on his
own.
1. Monopoly 2. Product Differentiation The products of the sellers
It is a market structure in which there is a single seller and are differentiated but are close substitutes of each
there are no close substitutes of the commodity sold by the other. Product differentiation can be real or artificial.
monopolist. e.g. government has the monopoly of cable Its effect is that sellers have some control over the
networks, water supply, Indian railways, etc. price of their product.
Features of Monopoly 3. Free Entry or Exit of Firms Firms can freely move
Monopoly market exhibit the features given below in and out of a ‘group’. In monopolistic competition,
the concept of industry is undefined as products are
1. One Seller and Large Number of Buyers Under
differentiated. Instead of industry, the word ‘group’
monopoly, there is a single producer of a commodity. He
should be used.
may be alone or there may be a group of partners or a
joint stock company or a state. However, there are a large 4. Imperfect Knowledge Buyers and sellers do not
number of buyers of the product. have perfect or complete knowledge of the market
condition. Buyer’s preferences are guided by
2. Restrictions on the Entry of New Firms Under
advertising and other selling activities undertaken by
monopoly, there are some restrictions on the entry of new
the sellers.
firms into the monopoly industry. Generally, there are
patent rights or exclusive control over a technique or raw 5. Selling Cost A firm under monopolistic competition
material which prevents other firms to enter into the incurs selling cost, which is the cost of promoting the
market. demand for its product, e.g. advertisement, window
displays, salesmen salaries, etc.
3. No Close Substitutes A monopoly firm produces a
commodity that has no close substitutes, e.g. there is no 6. High Transportation Cost Cost of transporting the
close substitute of operating systems made by Microsoft. commodity from one place to another is very high
They have monopoly in this segment. under monopolistic competition.
Economics 43
Market Equilibrium In the above schedule and diagram, demand and supply
It is a situation of the market in which demand for a become equal only at the price of ` 3.00, so it will be our
commodity is exactly equal to its supply corresponding to a equilibrium price.
particular price. At this price, 300 units are demanded and supplied. So,
Equilibrium Price The price at which the quantity equilibrium quantity is 300 units. Also, it is clear that
demanded and supplied are equal is known as equilibrium equilibrium price is determined at the point, where demand
price. and supply curves intersect each other.
Equilibrium Quantity The quantity demanded and Change in Demand and its Effect on
supplied at an equilibrium price is known as equilibrium Equilibrium Price
quantity.
1. Increase in Demand
Assumptions of Equilibrium Supply curve remaining unchanged, if there is increase in
The following are the assumptions of equilibrium demand, demand curve and equilibrium point will shift to
● Demand curve should always has a negative slope. the right. As a result, equilibrium quantity and equilibrium
● Supply curve should always has a positive slope.
price both will increase.
Y
D1
Determination of Equilibrium Price and Quantity
D S
In a market, market equilibrium is determined by the forces
of P1 E1
E
1. Market Demand It refers to the sum total of demand
Price (`)
P
of a commodity by all the buyers in the market. D1
2. Market Supply It refers to the sum total of supply of
a commodity by all the firms in the market. D Excess
S demand
In a market, the equilibrium price and quantity are
X
determined by the interaction of the demand and O Q Q1
supply curves in the market. Quantity (units)
Increase in demand
This has been explained with the help of an imaginary
schedule and diagram
In the given diagram, actual demand curve DD and actual
Price ( `) Demand (units) Supply (units) supply curve SS intersect at point E (i.e. equilibrium point).
1 500 100 Excess demand At this point, OP is equilibrium price and OQ is equilibrium
2 400 200 quantity. Now, with the increase in demand, new demand
[Equilibrium curve becomes D1 D1 .
3 300 300
(D = S)] So, equilibrium point shifts from E to E1 and OP1 is new
4 200 400 Excess supply equilibrium price and OQ1 is the new equilibrium quantity.
5 100 500
Y
D1
Excess supply means market
Y supply of a commodity is more D S
than the market demand for a
D Excess supply commodity at a given price.
5 P1 E1
S E
Price (`)
4
Price (`)
P
E Equilibrium
P point D1
3 Excess demand means
market demand exceeds
2 market supply of a D Excess
Equilibrium Excess
demand commodity at a given price. S demand
price 1
S R D
X X
0 100 200 300 400 500 O Q Q1
Quantity Equilibrium Quantity (units)
(units) quantity Increase in demand
Determination of equilibrium price
and quantity under perfect competition
2. Decrease in Demand As a result, equilibrium price will increase and equilibrium

Supply curve remaining unchanged, if there is a decrease in quantity will decrease. In the given diagram, actual demand
demand, demand curve and equilibrium point will shift to curve DD and actual supply curve SS intersect at point E (i.e.
the left. As a result, equilibrium quantity and equilibrium equilibrium point).
price both will decrease. Y
S1
Y D
D S
S
D1
Price (`)
Excess P1 E1
P E supply
P E
Price (`)
P1 Excess
S1 demand
E1 D D
S
D1 X
S O Q1 Q
Quantity (units)
O X
Q1 Q Decrease in demand
Quantity (units)
Decrease in demand At this point, OP is the equilibrium price and OQ is the
equilibrium quantity. Due to decrease in supply, new supply
In the given diagram, actual demand curve DD and actual
curve S1 S1 is formed. It cuts demand curve at new
supply curve SS intersect at point E (i.e. equilibrium point).
equilibrium point E1 . At this point, new equilibrium price
At this point, the equilibrium price is OP and equilibrium
increases to OP1 and the equilibrium quantity reduces to OQ 1 .
quantity is OQ. Due to decrease in demand, new demand
curve is formed at D1 D1 . It shows that price declines from OP Simultaneous Change in both Demand and
to OP1 because the demand has decreased from OQ to OQ1 .
Supply
There may be the cases when demand and supply change
Change in Supply and its Effect on
simultaneously. There may be simultaneous increase in
Equilibrium Price demand and supply or there may be simultaneous decrease
1. Increase in Supply in demand and supply.
Demand curve remaining unchanged, if there is increase in Different situations are discussed as under
supply, supply curve and equilibrium point will shift
rightwards. As a result, equilibrium price will decrease but 1. When Both Demand and Supply Increase
equilibrium quantity will increase. in the Same Proportion
Y When increase in demand is equal to increase in supply, the
S
D price will remain the same and the equilibrium output will
S1 increase.
E Y
Price (`)
P Excess
D1 S
P1 E1 supply
D S1
D E
S
Price (`)
P E1
S1
X S
O Q Q1 D1
Quantity (units) S1
D
Increase in supply
O X
Q Q1
In the given diagram, actual demand curve DD and actual Quantity (units)
supply curve SS intersect at point E (i.e. equilibrium point). In the given diagram, actual demand curve DD and actual
At this point, the equilibrium price is OP and equilibrium supply curve SS intersect at point E, (i.e. equilibrium point).
quantity is OQ. Due to increase in supply, new supply curve is
At this point, OP is the equilibrium price and OQ is
formed at S1 S1 . It shows that price declines from OP and OP1
equilibrium output. Demand increases to D1 D1 and supply
and quantity increases from OQ to OQ1 .
increases to S1 S1 , such that both increases are equal. The new
2. Decrease in Supply curves intersect each other at point E1 . It shows that
Demand curve remaining unchanged, if there is decrease in equilibrium price remains the same because increase in
supply, supply curve and equilibrium point will shift demand and supply are in the same proportion. However,
leftwards. equilibrium quantity increases from OQ to OQ1 .
Economics 45
2. When Increase in Supply is Less than Increase in Demand 4. When Both Demand and Supply Decrease in the
If the increase in demand is more than the increase in Same Proportion
supply, both equilibrium price and quantity will increase. When decrease in supply is equal to decrease in demand,
Y equilibrium price will remain the same, but equilibrium
D1 output will decrease.
S
D S1 Y
S1
P1 D
E1 S
Price (`)
D1
P E
E1
Price (`)
D1 P E
S D S1
S1
D
X S
O Q Q1 D1
Quantity (units)
X
Increase in supply is less than O Q1 Q
increase in demand Quantity (units)
Demand and supply decrease in
In the given diagram, actual demand curve DD and actual the same
supply curve SS intersect at point E (i.e. equilibrium point). In the above diagram, actual demand curve DD and actual
At this point, OP is the equilibrium price and OQ is supply curve SS intersect at point E (i.e. equilibrium point).
equilibrium output. Demand increases to D1 D1 and supply
At this point, OP is equilibrium price and OQ is equilibrium
increases to S1 S1 . The increase in demand is greater than the
quantity. Demand decreases to D1 D1 and supply decreases to
increase in supply. The new curves intersect each other at
S1 S1 . The new curves intersect each other at point E1 . It shows
point E1 . It shows that price has increased to OP1 , because
that equilibrium price remains constant because both demand
increase in demand is more than the increase in supply and
and supply have decreased in the same proportion. However,
quantity demanded and supplied increase to OQ1 .
equilibrium quantity decreases to OQ1.
3. When Increase in Supply is More than Increase in
Demand 5. When Decrease in Demand is More than the
Decrease in Supply
If the increase in supply is more than the increase in
If decrease in demand is more than the decrease in supply, the
demand, equilibrium price falls and equilibrium quantity
equilibrium price and output both will fall.
goes up.
In the above diagram, actual demand curve DD and actual
Y
D1 S supply curve SS intersect at point E (i.e. equilibrium point).
D S1
Y
E
Price (`)
S1
P S
P1 E1 D
D1
Price (`)
S D
1
D P E
S1 E1
P1
O Q Q1 X S1
Quantity (units) S D
Increase in supply is more than increase in demand D1
X
O Q1 Q
In the above diagram, actual demand curve DD and actual Quantity (units)
supply curve SS intersect at point E (i.e. equilibrium point). Decrease in demand is more than
the decrease in
At this point OP is the equilibrium price and OQ is
equilibrium quantity. Demand increases to D1 D1 and supply At this point, OP is equilibrium price and OQ is equilibrium
increases to S1 S1 . The increase in supply is greater than the quantity. Demand decreases to D1 D1 and supply decreases to
increase in demand. The new curves intersect each other at S1 S1 . The new curves intersect each other at point E1 which is
point E1 . the new equilibrium point.
It shows that price has decreased to OP1 because increase Thus, the equilibrium price reduces to OP1 because decrease in
in supply is more than increase in demand. The quantity demand is more than that of supply. Equilibrium quantity
demanded and supplied has increased to OQ1 . demanded and supplied will decrease to OQ1 .
6. When Decrease in Demand is Less than the The equilibrium price has risen from OP to OP1 and
Decrease in Supply equilibrium quantity remains the same at OQ units. Thus,
If decrease in demand is less than the decrease in supply, equilibrium price increases sharply when increase in demand
equilibrium price will rise and equilibrium quantity will is equal to decrease in supply.
fall.
8. When the Decrease in Demand is Equal to Increase
Y in Supply
S1 If the demand for a commodity decreases and its supply
D
D1 S increases in the same proportion, its equilibrium price will fall
P1
sharply and equilibrium quantity will remain the same.
E1
P E
Price (`)
Y
D S
S1
D1 S1
S D
D1 E
P
Price (`)
X
O Q1 Q
P1 E1
Quantity (units)
Decrease in demand is less than the S D
decrease in supply
S1 D1
In the given diagram, actual demand curve DD and actual O
X
Q
supply curve SS intersect at point E (i.e. equilibrium point). Quantity (units)
At this point, OP is equilibrium price and OQ is equilibrium Decrease in demand is equal to
quantity. Demand decreases to D1 D1 and supply decreases to increase in supply
S1 S1 . The new curves intersect each other at point E1 which In the given diagram, actual demand curve DD and actual supply
is the new equilibrium point. curve SS intersect at point E (i.e. equilibrium point).
Thus, the equilibrium price increases from OP to OP1 At this point, OP is equilibrium price and OQ is equilibrium
because decrease in demand is less than that of supply. quantity. Demand decreases to D1 D1 and supply increases to
Equilibrium quantity demanded and supplied will decrease S1 S1 . New demand and supply curves intersect each other at
from OQ to OQ 1 . point E1 .
7. When Increase in Demand is Equal to Decrease in Supply It is the new point of equilibrium. The equilibrium price falls
If the increase in demand is equal to decrease in supply, its from OP to OP1 and equilibrium quantity remains the same at
equilibrium price will increase sharply and equilibrium OQ units. Thus, equilibrium price declines sharply when
quantity will remain the same. decrease in demand is equal to increase in supply.
Y Special Cases which Affect Equilibrium Price
D1
S1 There are some special cases also, which affects the
D
E1 S equilibrium price and quantity
P1
Price (`)
1. Change in Supply when Demand is Perfectly Elastic

P E
In this case, price will remain constant, only quantity will
S1 D1
increase with rise in supply and vice-versa.
S Y
D
X S2
O Q S
S1
Price (`)
Quantity (units) SS Initial supply

E2 E E1
P D S1S1 Increased supply
In the given diagram, actual demand curve DD and actual D
S2 S2S2 Decreased supply
supply curve SS intersect at point E (i.e. equilibrium point). S
S1
At this point, OP is equilibrium price and OQ is equilibrium O
X
Q2 Q Q1
quantity. Demand increases to D1 D1 and supply decreases Quantity (units)
to S1 S1 . New demand and supply curves intersect each other Change in supply when demand is perfectly elastic
at point E1 .
Economics 47
2. Change in Supply when Demand is Perfectly Inelastic Y
Price (`)
In this case, quantity will remain unchanged, only price will D1
increase with fall in supply and vice-versa. D2 D DD Initial demand
E2 E E1 D1D1 Increased demand
Y S
PS D2D2 Decreased demand
D S2
D1
S D2 D
X
P2 S1 O Q2 Q Q1
Price (`)
E2
Quantity (units)
P E Change in demand when supply is perfectly elastic
S2
P1
S E
S1 D1 4. Change in Demand when Supply is Perfectly Inelastic
X
O Q In this case, quantity will remain unchanged, only price will
Quantity (units) rise with rise in demand and vice-versa.
SS Initial supply Y D1 S
D DD Initial demand
S1S1 Increased supply E1
P1 D1D1 Increased demand
S2S2
Decreased supply D2
Price (`)
E D2D2 Decreased demand
P D1
Change in supply when demand is perfectly inelastic E2
P2 D
3. Change in Demand when Supply is Perfectly Elastic S D2
X
O Q
In this case, price will remain constant, quantity will Quantity (units)
increase with the increase in demand and vice-versa. Change in demand when supply is perfectly inelastic
Practice Questions
1 In perfect competition, as the firm is a price taker, 7 In monopolistic competition, which relationship is
the ...... curve is a horizontal straight line. true from the following between AR and MR?
(a) marginal cost (a) AR = MR (b) AR < MR
(b) total cost (c) AR > MR (d) None of these
(c) total revenue 8 Which is the best example of monopoly market?
(d) marginal revenue
(a) Communication market
2 Monopolist can determine ...... . (b) Indian railway
(a) price (b) output (c) Stock exchange
(c) Both (a) and (b) (d) None of these (d) OPEC (Oil Producing Export Countries)
3 Which of the following is not an essential condition 9 Imperfect competition is a type of market structure
of pure competition? showing some but not all features of competitive
(a) Large number of buyers and sellers market. Which of the following is/are imperfect
(b) Homogeneous product competition?
(c) Freedom of entry and exit (a) Perfect competition (b) Monopolistic competition
(d) Absence of transport cost (c) Oligopoly (d) Both (a) and (b)
4 Firm in a monopolistic market has ...... control over 10 An increase in supply with demand remaining the
price. same bring about ...... .
(a) no (b) full (a) an increase in equilibrium quantity and decrease in
(c) partial (d) None of these equilibrium price
5 The product sold by monopolist has (b) an increase in equilibrium price and decrease in
equilibrium quantity
(a) many substitutes (c) decrease in both equilibrium price and quantity
(b) close substitutes (d) None of the above
(c) no close substitutes
(d) perfect substitutes 11 An increase in demand with unchanged supply
leads to ...... .
6 Under monopoly, monopolist tries to increase his
(a) rise in equilibrium price and fall in equilibrium
profits by restricting supply of his product and quantity
fixing (b) fall in both equilibrium price and quantity
(a) low price (b) high price (c) rise in both equilibrium price and quantity
(c) market price (d) All of these (d) fall in equilibrium price and rise in equilibrium
quantity
12 If price is forced to stay below equilibrium price, (c) No price control by buyers or sellers
then ...... . (d) All of the above
(a) excess supply exists 20 Which forms of market sells homogenous goods?
(b) excess demand exists (a) Perfect competition
(c) Either (a) or (b) (b) Monopolistic competition
(d) Neither (a) nor (b) (c) Both (a) and (b)
13 Equilibrium price may be determined through ..... . (d) None of the above
(a) only demand 21 ………… is/are the consequences of freedom of
(b) only supply entry and exit of firms under perfect competition.
(c) both demand and supply (a) Firms are price takers
(d) None of the above (b) Normal profit in long run
14 ...... is a situation of the market in which demand (c) Both (a) and (b)
for a commodity is exactly equal to its supply (d) Neither (a) nor (b)
corresponding to a particular price. 22 ………… form of market demand curve is perfectly
(a) Consumer equilibrium elastic in nature.
(b) Producer equilibrium (a) Perfect competition
(c) Market equilibrium (b) Monopoly market
(d) Balance of trade (c) Monopolistic market
15 If the market supply is less than the market (d) Oligopoly market
demand of a commodity at a given price, it is called 23 Which of the following is/are causes of emergence
(a) excess supply of monopoly?
(b) excess demand (a) Government licensing
(c) deficit demand (b) Patents and Copyright
(d) market supply (c) Natural monopoly
16 Under what condition, equilibrium price will (d) All of the above
increase and equilibrium quantity will decrease? 24 Mobile phone industry in India belongs to which
(a) Increase in supply form of market?
(b) Decrease in supply (a) Perfect competition
(c) Increase in demand (b) Monopoly market
(d) Decrease in demand (c) Monopolistic competition
17 What is the impact of change in supply on market (d) Oligopoly market
equilibrium when demand is perfectly inelastic? 25 Xerox was the first company which invented
(a) Both equilibrium price and equilibrium quantity will photocopier machine; it enjoyed Monopoly for about
change 15 years. This is an example of
(b) Both equilibrium price and equilibrium quantity will (a) Licensed monopoly
not change (b) Patented monopoly
(c) Equilibrium price remains same and equilibrium (c) Natural monopoly
quantity will change (d) None of the above
(d) Equilibrium price will change and equilibrium
quantity remains same 26 Indian Railways in India is an example of ……… .
(a) Licensed monopoly
18 Which of the following is/are broad market forms (b) Patented monopoly
based on the level of competition? (c) Natural monopoly
(i) Perfect competition (d) None of the above
(ii) Imperfect competition 27 Monopolistic competition combines the features of
(iii) Monopolistic competition following market
(iv) Oligopoly competition (a) Perfect competition and Monopoly
(b) Monopoly and Oligopoly
Choose the most appropriate option (c) Perfect competition and Oligopoly
(a) (i) and (ii) (d) Perfect competition, Monopoly and Oligopoly
(b) (ii) and (iii) market
(c) (iii) and (iv)
(d) (i), (ii) and (iii) 28 Selling cost is a unique feature of monopolistic
competition, wherein firms incur huge sums on
19 Which of the following are true about perfect
promotional activities. Choose the most
competition? appropriate reason for the same.
(a) Infinitely large number of buyers and sellers
(a) Large number of buyers and seller
(b) Perfect substitute goods
(b) Differentiated goods
Economics 49
(c) Freedom of entry and exit of firms (d) Demand curve under monopoly market is steeper
(d) All of the above than monopolistic competition as goods under
monopoly market has no substitutes available
29 Practise of price discrimination is observed under
which of the following market forms? 32 Which of the following is/are the features of
(a) Monopoly (b) Monopolistic competition monopoly form of market?
(c) Both (a) and (b) (d) None of these (a) Restrictions on entry of new firms
(b) No close substitutes
30 Which of the following forms of price discrimination (c) Full control over price
is usually followed by social utility service providers? (d) All of the above
(a) Individual price discrimination
(b) Block/Unit price discrimination 33 Which of the following is/are the features of
(c) Geographical price discrimination monopolistic competition?
(d) None of the above (a) Product differentiation
(b) Selling cost
31 Identify the correct statement of the given below (c) Both (a) and (b)
(a) Demand curve under monopoly is flatter than (d) None of the above
monopolistic competition due to freedom of entry
and exit of firms 34 Which of the following is/are the assumptions of
(b) Demand curve under monopolistic competition is equilibrium?
flatter than monopoly market due to homogenous (a) Demand curve should always has a negative slope.
goods under monopolistic competition (b) Supply curve should alwayus has a positive slope.
(c) Demand curve under monopoly is flatter than (c) Both (a) and (b)
monopolistic competition due to heterogeneous goods (d) None of the above
under monopolistic competition
ANSWERS
1. (d) 2. (c) 3. (d) 4. (c) 5. (c) 6. (b) 7. (c) 8. (b) 9. (d) 10. (a)
11. (c) 12. (b) 13. (c) 14. (c) 15. (b) 16. (b) 17. (d) 18. (a) 19. (d) 20. (a)
21. (b) 22. (a) 23. (d) 24. (c) 25. (b) 26. (c) 27. (a) 28. (b) 29. (a) 30. (b)
31. (d) 32. (d) 33. (c) 34. (c)
CHAPTER 07
Simple Applications of Tools

of Demand and Supply
Examples of price ceiling can be described as follows
Introduction
1. Minimum Support Price Government considers as
Price determination is an important component of
remunerative for farmers and hence deserving of
microeconomics theories, where interaction of demand and
‘support’. It is also the price that government agencies
supply determines price of various goods and services.
pay whenever they procure the particular crop.
However, sometimes market mechanism fails to attain the
desired outcome. In such situations government The Centre currently fixes MSPs for 23 farm
intervention becomes inevitable. commodities — 7 cereals (paddy, wheat, maize, bajra,
Government can intervene in the market to bring in a jowar, ragi and barley), 5 pulses (chana, arhar/tur, urad,
socially desirable outcome in two ways moong and masur), 7 oilseeds (rapeseed-mustard,
groundnut, soyabean, sunflower, sesamum, safflower
1. Direct Action This action comprises of tools like price
and nigerseed) and 4 commercial crops (cotton,
ceiling, price floor, etc.
sugarcane, copra and raw jute).
2. Indirect Action This action comprises of tools like
2. Minimum Wage Legislation These laws specify the
taxes and subsidies.
minimum amount that employers may pay to their
employees for doing a specified type of work. The first
Price Ceiling minimum-wage laws in the United States were passed
Ceiling means maximum limit. Price ceiling means maximum by state legislatures in the mid-nineteenth century and
price of a commodity that the sellers can charge from the applied only to women and children. India introduced
buyers. Often the government fixes this price much below the the Minimum Wages Act in 1948, giving both the
equilibrium market price of a commodity, so that it becomes Central government and State government, the
within the reach of the poorer sections of the society. It is
jurisdiction in fixing wages. The act is legally
resorted to protect the interest of the consumer.
non-binding, but statutory.
Equilibrium price = OP
Equilibrium quantity = OL Price Floor
Ceiling price = OP * Floor means the lowest limit. Y
D S
Excess demand = ab = L1 L 2 Price floor means the
minimum price fixed by the a b
Excess demand may be fulfilled by P*
government for a commodity Floor price
Price (`)
● Rationing ● First-cum-first serve basis Q

in the market to protect the P
It leads to black marketing.
interest of the producers. It
Y
D S
seems paradoxical, but is true
that the government in most S D
Q
countries fixes floor price for
Price (`)
P X
O L 1 L L 2
a b Ceiling most agricultural products, Quantity (units)
P*
S D price food grains in particular. In
fact, floor price invariably implies support price as well.
X
O L1 L L 2 Equilibrium price = OP Equilibrium quantity = OL
Quantity (units) Floor price = OP * Excess supply = ab = L1 L 2
Price ceiling
Generally, government buys the excess supply at this price.
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Economics 51
Examples of price floor can be described as follows Since that is not enough to survive, Cubans must purchase
1. Insurance Reimbursement Medical insurance additional supplies on the open market, where the price of
companies often set maximums on the amount they will rice is around 20 times higher. Additionally, there are limits
reimburse doctors or the amount they will reimburse on the number of higher-quality items Cubans can purchase
patients for office visits. You could therefore consider on the open market, such as chicken.
medical insurance an industry in which price ceilings
play a role. Food Availability Decline (FAD) Theory
2. Rent Control In some cities, such as New York City, The Food Availability Decline (FAD) approach assumes that
there are certain buildings or rental units that are famines are caused by a sudden reduction of per capita food
subject to rent control : a law that limits rental rates. supply. It is usually triggered by natural disasters (drought,
This determines the maximum price or the maximum floods, pest infestation, etc.), wars and epidemics that lead
percentage upto which a landlord can legally raise the to a contraction of the food supply. As a consequence, food
rent each year for the apartment. Rent control is a prices go up and people, who are not able to bear such an
government intervention to keep rental housing costs increase, consume less calories and nutrients.
down in an effort to create more affordable housing This model points out the insufficient production and
units. availability of food as the main causes of famines and
starvation. This approach implicitly assumes an equal
Rationing division of the available food, but unfortunately, such an
If there is shortage of certain goods, the government assumption fails to reflect reality.
introduces rationing for distribution of commodity to
consumers especially weaker sections of the society. Application of Some Other
Rationing ensures the availability of the commodity to the Tools of Demand and Supply
poor consumers, who would not have received the
These tools are as follows
commodity in free marketing of the commodity.
Rationing implies restriction on quantity which can be 1. Viable Industry
bought and consumed by the consumer. An industry is said to be inviable condition, if corresponding to
the minimum price, there is some demand in the market. In
However, if goods are rationed for a long time,
such industries demand and supply curves coincide in the
invariably black markets emerge to supply consumers with
positive quadrant.
the controlled products or services. The black marketeers
Y
either get their goods from local citizens who sell them their D S
rations, or from abroad.
Price (`)
In the 1973 energy crisis, there was rationing of gasoline

(UK: petrol) in many countries. The authorities as well as S D
filling stations took the measure to try to prevent gasoline
prices from going through the roof and attempted to make
sure that the scarce resource was as evenly distributed as X
O Supply/Demand
possible.
Other examples for rationing are as follows
● An individual might be allotted a certain amount of food
2. Non-viable Industry
per week. A non-viable industry is one which will not produce the
product in an economy. It may be because cost of the product
● Households might be allowed to water their lawns only on
is too high and the consumers are not willing to pay a price
certain days.
that will cover the cost, e.g. commercial aircraft is a
Rationing to Combat Shortages non-viable industry in India. In this case, demand and supply
Many capitalist economies have temporarily resorted to curve will not intersect in the positive quadrant.
rationing in order to cope with wartime or disasterrelated Y
S
shortages: the US and Britain issued ration books during
World War II, for example, limiting the quantities of tires,
Price (`)
gasoline, sugar, meat, butter, and other goods that could be S

purchased.
D
In communist countries, by contrast, rationing was in many
cases a permanent or semi-permanent feature of daily life. In D
Cuba in 2019, a ration book entitled an individual to small O X
Supply/Demand
amounts of rice, beans, eggs, sugar, coffee, and cooking oil
for the equivalent of a few cents in the United States.
3. Black Marketing Normal price is the price i.e. is expected to exist when
It is a situation in which the controlled commodity is sold at the forces of supply and demand have fully adjusted
a price higher than the price fixed by the government themselves.
illegally under the desk. Market price always tends to move around the normal
The reason arising for this situation are price.
● Presence of such consumers who are willing to pay more
Y
than the ceiling price.
● Presence of excessive influential and wealthy consumers
Market
price
in large numbers.
Price (`)
Black marketing will continue so far where consumers are P Normal
willing to pay more than the ceiling price. price
4. Market Price and Normal Price
Market price is the price that exists in the market at a
particular point of time, no matter, forces of supply and O
X
Quantity (units)
demand have adjusted themselves or not.
Practice Questions
1 If there is shortage of certain goods, the What does the line at P1 indicates?
government introduces ...... for distribution of (a) Price Ceiling (b) Price Floor
commodity to consumers. (c) Both (a) and (b) (d) None of these
(a) planning (b) marketing (c) rationing (d) financing 6 The surplus caused by a binding price floor will be
2 If in an industry, demand and supply will not greatest if ?
intersect in positive quadrant, then it is called (a) demand is inelastic and supply in elastic
(a) illegal industry (b) viable industry (b) supply is inelastic, and demand is elastic
(c) non-viable industry (d) sick industry (c) both supply and demand are elastic
(d) both supply and demand are inelastic
3 For a price ceiling to be binding constraint on the
market, the government must set it 7 Which of the following would cause a change in
(a) above the equilibrium price supply?
(b) at any price because all price ceilings are binding (a) A change in the number of sellers
constraints (b) A change in technology available
(c) precisely at the equilibrium price (c) A change in market price
(d) below the equilibrium price (d) All of the above
4 Suppose the equilibrium price for home rent is 8 ________ protects the interest of the buyer in the
` 500 per month and the government imposes rent market when market mechanism fails to attain
controls of `250. Which of the following is unlikely desired result.
to occur as a result of the rent controls? (a) Price Ceiling (b) Price Floor
(c) Price regulation (d) Both (a) and (b)
(a) There may be long lines of buyers waiting for
apartments 9 Which of the following is an example of price
(b) The quality of home will improve flooring?
(c) Landlords may discriminate among apartment (a) Minimum wage legislation
renters (b) Minimum support price
(d) There will be a storage of housing (c) Rent control
5 Observe the figure given below (d) None of the above
Price 10 Price ceiling leads to
(a) excess demand (b) excess supply
Supply (c) black Marketing (d) Both (b) and (c)
P1 11 Price ceiling and price floor are part of
Qs>Qd
(a) direct action (b) indirect action
P2 (c) associated action (d) Both (a) and (b)
12 Which of following is/are not a consequence(s) of
P3 Demand
price floor?
Q1 Q2 Q3 Quantity
(a) Rationing (b) Black Marketing
(c) Excess supply (d) All of these
Economics 53
13 Price ceiling means …… price of a commodity that 17 What is the relation between support price and
the sellers can charge from the buyers. equilibrium price?
(a) Minimum (a) Support price is higher than the equilibrium price
(b) Maximum (b) Support price is lower than the equilibrium price
(c) Any (c) Support price is equal to the equilibrium price
(d) None of the above (d) No relation exists
14 ……means the minimum price fixed by the 18 Black marketing is a situation in which the
government for a commodity in the market. controlled commodity is sold at a price …… than
(a) Price ceiling (b) Price floor the price fixed by the government.
(c) Rationing (d) Black marketing (a) higher (b) lower
(c) Either (a) or (b) (d) None of these
15 Price floor isa tool of government to protect the
interest of …… 19 Which price exists in the market at a particular
(a) consumers (b) producers point of time, irrespective of the fact that demand
(c) Both (a) and (b) (d) None of these and supply forces have adjusted themselves or not?
16 Often the government fixes price ceiling much (a) Normal price (b) Market price
(c) Floor price (d) Price ceiling
below the equilibrium market price of a commodity,
so that it becomes within the reach of which 20 Which price is expected to exist when the forces of
section of society? supply and demand have fully adjusted
(a) Richer (b) Middle class themselves?
(c) Poorer (d) All of these (a) Market price (b) Price ceiling
(c) Floor price (d) Normal price
ANSWERS
1. (c) 2. (c) 3. (d) 4. (b) 5. (b) 6. (c) 7. (d) 8. (a) 9. (c) 10. (d)
11. (a) 12. (b) 13. (b) 14. (b) 15. (b) 16. (c) 17. (a) 18. (a) 19. (b) 20. (d)
CHAPTER 01
National Income and

Related Aggregates
Macroeconomics (ii) Intermediate Goods Those goods which will be
used for the production of other goods or which
Macroeconomics is that branch of economics which deals
will be resold are known as intermediate goods.
with aggregates or issues related to the economy as a whole. e.g. cloth, electronic parts, etc.
It is concerned with the determination of aggregate output
(iii) Consumer/Consumption Goods These are the
and general price level in the economy as a whole. It studies
goods which are used by end-users to satisfy their
the problems at the level of an economy such as, problems of
needs and desires.
inflation, unemployment, etc, which are not the problems of
Such goods are not used in the production of
only one individual.
other goods. e.g., ice-cream and milk used by the
households.
Subject Matter of Macroeconomics
The study of macroeconomics includes (iv) Capital Goods These are the goods which are
used to produce other goods and services for a
1. Theory of Employment It studies determination of number of years.
employment in the economy, which further includes
These goods are fixed assets of the producers. e.g.,
study of full employment, underemployment, voluntary building, plant and machinery, etc.
and involuntary unemployment, etc.
2. Theory of National Income Determination It 2. Investment It is the process of capital formation for a
studies determination of domestic income and national firm or increase in the stock of capital.
income by different methods. I = ∆K
3. Theory of General Pricing Issues related to inflation, Here, I = Investment,
deflation, excess demand, deficient demand, etc are ∆K = Change in capital stock during the year
studied under this theory. 3. Components of Investment There are mainly two
4. Theory of Money It explains the important role of components of investment
money and banking in the functioning of the economy. (i) Fixed Investment It refers to increase or addition
5. Theory of International Trade It studies all in the stock of fixed assets of the producers during
international transactions between home country and a financial year.
rest of the world. Determination of foreign exchange (ii) Inventory Investment It refers to the stock of
rate also comes under the subject matter of finished goods, semi-finished goods and
macroeconomics. raw material. This stock keeps varying overtime.
4. Types of Investment There are mainly two types of
Basic Concept of Macroeconomics investment
Following are the basic concepts of macroeconomics (i) Gross Investment Increase in value of capital
1. Types of Goods Produced in an Economy In an stock during a specific period is called gross
economy, following goods are produced investment, i.e. expenditure on fixed assets or on
inventory stock.
(i) Final Goods Those goods, which have crossed the
boundary line of production and are ready for use Gross Investment
by their final users are known as final goods. e.g. = Expenditure on the Purchase of Fixed Assets in
shirt, pen, TV, washing machine, etc. an Accounting Year + Expenditure on the
Inventory Stock in an Year
(ii) Net Investment It is the actual increase in stock Types of Circular Flow of Income
of capital during an accounting year. It is also
Circular flow of income can be broadly classified as
termed as net capital formation.
1. Real Flow Real flow explains the exchange of factor
Net Investment = Gross Investment − Depreciation
services by the households for the goods and services
5. Depreciation It refers to loss in the value of fixed produced by the firms. It is also termed as physical
assets in use on account of flow.
(i) Normal wear and tear
(ii) Normal rate of accidental changes 2. Money Flow In money flow, factor services by the
(iii) Expected or foreseen obsolescence households are exchanged for monetary compensations
Depreciation reserve fund is created by the by the firms.
producers to meet the upcoming depreciation losses in Leakage It means withdrawal from the circular flow. When
the process of production. households and firms save part of their incomes, it
6. Stock A stock is a quantity of any economic variable constitutes leakages. They may be in form of tax payments
which is measured at a particular point of time. and imports also. Leakages reduce the flow of income.
e.g. amount in the bank account at a specific date. Injection It means introduction of income into the circular
7. Flow Flow variables are defined as any quantity which flow. When households and firms borrow, they constitute
is measured over a period of time. injections. Injections increase the flow of income. Injections
e.g. income or expenditure over a time period of one can take the forms of
month or one year. ● Investment ● Government spending ● Exports
Circular Flow of Income Circular Flow in Two-sector Economy

The circular flow means the unending flows of production of In a two-sector economy, there are only two sectors of
goods and services, income and expenditure in an economy economic activity, namely households and firms. Households
from one sector of an economy to another. It helps to know supply factor services to firms and firms hire factor services
the functioning of an economy. from households. Households spend their entire income on
consumption of goods and services. Firms sell what is
Phases of Circular Flow
produced by the households.
There are three phases in any circular flow of income, which
There are two types of markets
includes
1. Product Market Market for goods and services.
1. Production Phase In this phase, firms produce goods
and services with the help of factor services. 2. Factor Market Market for factors of production.
In this type of economy, circular flow can be explained with
2. Income Phase This phase involves the flow of factor
the help of the following diagram
income (rent, wages, interest and profits) from firms to
the households.
3. Expenditure Phase In this phase, the income
received by factors of production, is spent on the goods and services (R
ods eal
and services produced by firms. Go flo
w)
Income is first generated in production units, then
distributed to households and finally spent on goods and
services produced by these units to make the circular Producers/ Households
Firms sector sector
flow complete its course.
w)
Sectors Involved in Circular Flow

Fa
flo
ct
ey
or
Different sectors, which are involved in circular flow within pa n

ym
en ( Mo
an economy are ts
ts :
Rent, rofi
wages, intere st, p
1. Household Sector It is engaged in the consumption
of goods and services and is also the provider of factor Product market
services. According to the diagram
2. Producing Sector It is engaged in the production of ● Total production of goods and services by producers sector
goods and services. It is also referred to as ‘firms’. is equal to total consumption of goods and services by
3. Government sector It is engaged in such activities households sector.
which are related to taxation and subsidies as well as ● Factor payments by firms is equal to factor incomes of
consumption and production. households sector.

4. Rest of the World It is engaged in exports and imports.
Economics 59
● Consumption expenditure of household sector is equal to 3. Gross National Product at Market Price (GNPMP )
income of household sector. It is the market value of final goods and services
● Thus, real flows of production and consumption of firms produced in the economy, during a year inclusive of Net
and households is equal to money flows of income and Factor Income from Abroad (NFIA).
expenditure of firms and households. GNPMP = GDPMP + NFIA
Concept of National Income 4. Net National Product at Market Price (NNPMP ) It is

It is defined as the sum total of factor incomes accruing to the market value of the final goods and services
normal residents of a country, within the domestic territory produced in the economy, during an accounting year,
of a country and from rest of the world, during a period of an exclusive of depreciation and adjusted for Net Factor
accounting year. Income from Abroad.
Residents A resident or normal resident is said to be a NNPMP = GDPMP − Depreciation + NFIA
person or an institution, who ordinarily resides in a country
for a period of one year or more and whose centre of 5. Gross Domestic Product at Factor Cost (GDPFC ) It
economic interest lies in that country. is the sum total of factor incomes generated within the
domestic territory of a country along with consumption
Non-residents Those citizens, who visit home country for
of fixed capital during a year.
travelling, recreation, holidays, medical treatment, studies or
sports are known as non-residents of a country. GDPFC = GDPMP − NIT
National Income at Current Prices 6. Net Domestic Product at Factor Cost (NDPFC ) It is
It is the money value of all final goods and services measured the sum total of factor incomes generated within the
at current prices. domestic territory of a country during a year, exclusive
of depreciation.
Y = Q× P
NDPFC = GDPMP − NIT − Depreciation
Where, Y = National income at current prices
Q = Quantity of goods and services produced during 7. Gross National Product at Factor Cost (GNPFC ) It is
an accounting year the sum total of factor incomes earned by normal
P = Price of goods and services prevailing residents of a country, inclusive of depreciation during
during the accounting year an accounting year and Net Factor Income from Abroad
(NFIA).
National Income at Constant Prices
It is the money value of all final goods and services measured GNPFC = GDPFC + NFIA
at constant prices.
8. Net National Product at Factor Cost (NNPFC ) It is
Y ′ = Q × P′ the sum total of factor incomes earned by normal
residents of a country during the period of an
Where, Y ′ = National Income at constant prices accounting year, exclusive of depreciation.
Q = Quantity of goods and services produced during
an accounting year NNPFC = GNPFC – Depreciation
P′ = Price of goods and services prevailing during
the base year Some Terms related to National Income
To understand above aggregates of national income, the
Aggregates related to National Income following three terms should be understood
There are eight aggregates of national income, which are as 1. Depreciation It refers to the loss in the value of fixed
follows assets due to their normal wear and tear.
1. Gross Domestic Product at Market Price (GDPMP ) It 2. Net Indirect Tax (NIT) It is equal to the difference
is the market value of the final goods and services between Indirect Tax (IT) and Subsidies (S).
produced during a year within the domestic territory Where, indirect taxes add to the factor cost of the
of a country. It includes the value of depreciation. product and subsidies reduce the factor cost of the
2. Net Domestic Product at Market Price (NDPMP ) It product to reach the market price.
is the market value of final goods and services 3. Net Factor Income from Abroad (NFIA) It is
produced within the domestic territory of a country defined as the difference between factor income
during a year, exclusive of depreciation. received from abroad and the factor income paid to
NDPMP = GDPMP − Depreciation abroad.
Components of Net Factor Income from Abroad are ● Value of self-consumed services should not be included in
● Net compensation to employees. the estimation of national income.
● Net income from property and entrepreneurship ● Commission earned on account of sale and purchase of
received by residents of the country. second hand goods is included.
● Net retained earnings. ● Imputed rent on the owner occupied house is also taken
into the account.
Nominal GDP
It refers to market value of the final goods and services ● The value added in the government sector is equal to
produced within the domestic territory of a country during a compensation of employees only. Also, in case of general
financial year, as estimated using the current year prices. It is government sector, no data of capital consumption is
also called GDP at current price or monetary GDP. available. That is why, value added is supposed to be equal
to net value added.
Real GDP ● Double counting should be avoided. For this, we can
It refers to market value of the final goods and services adopt either of the following methods
produced within the domestic territory of a country during a
1. Final Output Method This method takes into
financial year, as estimated using the base year prices. It is
account the value of only final goods and services in the
also called GDP at constant price.
estimation of GDP. Intermediate goods are not to be
Nominal GDP considered.
Real GDP = × 100
Current Price Index 2. Value Added Method This method takes into account
the sum total of value added by all the producing units
Methods of Estimating National Income within the domestic territory, while computing national
There are three methods of estimating national income. They income.
are
Income Method
● Value Added Method ● Income Method
In this method, we take sum total of factor incomes earned
● Expenditure Method
by the normal residents of a country during a year. It is also
called factor payment method.
Value Added Method /Production Method
In value added method, national income is estimated by National Income (NNPFC)
adding contribution of each producing enterprise in = NDPFC + Net Factor Income from Abroad
production of final goods and services produced in an
accounting year. Where, NDPFC = Compensation of Employees
+ Operating Surplus + Mixed
GDPMP / GVA MP = Value of Output − Intermediate Income of Self Employed
Consumption Operating Surplus = Rent + Interest + Profit
Where,
Value of Output = Sales + Change-in-stocks Precautions of Income Method
Intermediate Consumption = Purchases + Opening Stock of While using income method, items included or excluded in
Raw Material − Closing Stock of Raw Material calculation of national income are
● Income from illegal activities like smuggling, theft,
National Income (NNPFC )
gambling, etc should not be included.
= Gross Value Added by all the
Production units within the
● Commission paid on the sale and purchase of second
Domestic Territory of the Country hand goods are to be included.
− Depreciation − Net Indirect Taxes ● Transfer earnings like old age pensions, unemployment
+Net Factor Income from Abroad allowances, scholarships, pocket expenses, etc should not
be included.
Net Indirect Taxes = Indirect Tax − Subsidies
● Income in terms of windfall gains should not be included.
Precautions of Value Added Method ● Imputed rent of owner occupied houses is to be treated
While using value added method, items to be included or along with rent as a component of factor incomes.
excluded in calculation of national income are ● Income tax is paid out of compensation of employees. It
● The value of intermediate goods should not be included. should not be separately added in the estimation of
● Purchase and sale of second hand goods should be national income.
excluded. ● Brokerage on the sale/purchase of shares and bonds is to
● Imputed value of self-consumed goods should be included. be included.
● Own account production should be included.
Economics 61
Expenditure Method Other Related Concepts of

In this method, national income is measured in terms of National Income
expenditure on the purchase of final goods and services Following are the other related concepts of national income
produced in the economy during an accounting year.
1. National Disposable Income
National Income (NNPFC) It may be derived from national income by adding all
= GDPMP − Net Indirect Taxes − Depreciation current transfers in cash receivable by resident institutional
+ Net Factor Income from Abroad units from non-resident units and subtracting all current
transfers in cash payable by resident institutional units to
Where, non-resident units.
GDPMP = Private Final Consumption Expenditure + National disposable income can be categorised into
Government Final Consumption Expenditure
(i) Gross National Disposable Income It can be
+ Investment Expenditure + Net Exports
calculated as
Precautions of Expenditure Method Gross National Disposable Income
While using expenditure method, items included or excluded
= Gross National Income (at market prices)
in calculation of national income are
− Current Transfers (current taxes on income,
● Only final expenditure is to be taken into account to avoid
wealth etc., social contributions, social benefits
error of double counting. and other current transfers) payable to non-
● Expenditure on second hand goods is not to be included,
resident units, + Current Transfers Receivable by
because value of second hand goods has already been Resident units from the Rest of the World.
accounted for during the year of their production. (ii) Net Disposable Income It is the gross earnings less
● Expenditure on shares and bonds is not to be included in
only one mandatory deduction i.e., State and Federal
total expenditure, as these are mere paper claims and are taxes
not related to the production of final goods and services.
● Expenditure on transfer payments by the government is not
2. Private Income
Private income consists of factor incomes earned within the
to be included.
domestic territory and abroad by private enterprises and
● Imputed value/estimated value of expenditure on goods
workers (factor owners in the private sector) as well
produced for self-consumption should be taken into account, as current transfer from government and the rest of the
as these goods are reflected in the estimation of GDP. world.
Terms related to National Income Methods Private Income = Income from Domestic Product accruing
1. Primary Sector It includes production of goods by to Private Sector
exploiting natural resources, i.e., agriculture, forestry, + Net Factor Income from Abroad
logging, etc. + National-debt Interest
+ Current Transfers from Government
2. Secondary Sector It includes all those units which
+ Other Current Transfers from the rest
produce commodities by transforming one type of
of the world (net).
commodity into other type of commodity, i.e.,
manufacturing, electricity, etc. 3. Personal Income
3. Tertiary Sector It is that sector in which entrepreneurs Personal income includes all income which are actually
provide services. It includes units like educational, received by all individuals in a year. It includes income
medical, transport, etc. which is not directly earned but is received by individuals.
4. Factor Payments These are the payments made to Personal Income = National income
scarce resources or the factors of production in return for + Transfer Payments
productive services. – Corporate retained earnings, income
5. Factor Incomes These are the incomes received by the taxes, social security taxes
owners of factors of production for rendering their factor 4. Personal Disposable Income
services to the producers. Personal disposable income is the amount which is actually
6. Transfer Incomes Incomes received by households, at the disposal of households to spend as they like. It is the
production units and non-profit making institutions amount which is left with the households after paying
from government and other sources without rendering personal taxes such as income tax, property tax, national
any services are known as transfer incomes. insurance contributions, etc.
7. Transfer Payments It is a redistribution of income in Personal Disposable Income = Personal Income − Personal
the market system. Transfer payments do not add to the Taxes
current flow of goods and services.
S.No. Contents ` (in crore)

Solved Examples (v) Corporation Tax 30
S.No. Contents ` (in crore) (vi) Retained Earnings of Private
1. Corporations 10
(i) GNPMP 15,000
(vii) Interest 300
(ii) Depreciation or Consumption of Fixed
Capital 1,000 Sol. By income method
(iii) Indirect Taxes 500 Net Domestic Product at Factor Cost (NDPFC)
(iv) Subsidies 150 = Wages and Salaries + Social Security Contribution
(v) Net Factor Income from Abroad 650 by Employers + Corporation Tax
+ Retained Earnings of Private Corporations
On the basis of the above information, calculate + Dividend + Rent + Interest
(i) NNPMP (ii) NNPFC = 2,000 + 100 + 30 + 10 + 60 + 300 + 300
(iii) NDPFC (iv) GDPMP = ` 2,800 crore
Sol. (i) NNPMP = GNPMP – Depreciation
4. Calculate national income by the expenditure
= 15 ,000 − 1,000 method.
= ` 14 ,000 crore
(ii) NNPFC = GNPMP – Depreciation – Net Indirect Taxes
= 15 ,000 − 1,000 − (500 − 150) (i) Government Final Consumption
Expenditure 150
= 14 ,000 − 350
(ii) Private Final Consumption Expenditure 750
= ` 13 ,650 crore
(iii) Consumption of Fixed Capital 150
(QNIT = Indirect Taxes – Subsidies)
(iv) Net Indirect Taxes 120
(iii) NDPFC = GNPMP – Depreciation – Net Factor
Income from Abroad – Net Indirect Taxes (v) Net Factor Income from Abroad 20
= 15 ,000 − 1,000 − 650 − (500 − 150) (vi) Net Domestic Fixed Capital Formation 220
= ` 13 ,000 crore (vii) Change-in-stocks (–) 20
(iv) GDPMP = GNPMP – Net Factor Income from Abroad (viii) Net Imports 50
= 15 ,000 − 650 = ` 14 ,350 crore
Sol. By expenditure method
2. Calculate national income from the following data. National Income (NNPFC)
= Private Final Consumption Expenditure + Government
S.No. Contents ` (in lakh)
Final Consumption Expenditure + Net Domestic Fixed
(i) Sales 800 Capital Formation + Change-in-stocks − Net Imports
(ii) Purchase of Raw Materials from Domestic − Net Indirect Taxes + Net Factor Income from Abroad
Market 400 = 750 + 150 + 220 + (− 20) − 50 − 120 + 20 = 1140 − 190
(iii) Import of Raw Material 100 = ` 950 crore
(iv) Subsidies 30
(v) Consumption of Fixed Capital 40 5. From the data given below, calculate private
(vi) Change-in-stock 50
income
(vii) Rent 70 S.No. Contents ` (in crore)
(viii) Net Factor Income from Abroad 10 (i) NDP at FC 2,000
Sol. National Income (ii) Income from property and

entrepreneurship accruing to
= Sales + Change-in-stock − (Purchase of Raw Material government 100
from Domestic Market + Import of Raw Material)
− Consumption of Fixed Capital + Subsidies + NFIA (iii) Saving of non-departmental enterprises 20
= 800 + 50 − (400 + 100) − 40 + 30 +10 (iv) National debt interest 5
= (880 − 540 + 10) = ` 350 lakh
(v) Net factor income from abroad (–)10
3. Calculate net domestic product at factor cost by (vi) Net current transfers from government 15
income method (vii) Net current transfers from ROW 25
Sol. Income from Domestic Product Accruing to Private Sector
(i) Dividend 60
= NDP at FC – Income from property and
(ii) Wages and Salaries 2,000 entrepreneurship accruing to government – Saving of
(iii) Social Security Contribution by non-departmental enterprises
Employers 100 = 2,000 – 100 – 20 = ` 1,880 crore
(iv) Rent 300
Economics 63
Private Income = Income from Domestic Product (ii) Personal Disposable Income
accruing to Private Sector + National = Personal Income – Direct taxes paid by
debt interest + Net Factor Income from Households – Other Miscellaneous Receipts of
Abroad + Net Current transfers from Government Administrate Departments
Government + Net Current Transfers = 1,875 – 25 – 5 = ` 1,845 crore
from Rest of the World.
= 1,880 + 5 + (−)10 + 15 + 25 7. Calculate (i) Gross National Disposable Income
= ` 1,915 crore and (ii) Net National Disposable Income from the
following data
6 Calculate (i) personal income and (ii) Personal
disposable income from the following data
(i) NNP at FC 3,000
(ii) Net Current Fransfers from Government 20
(i) Private income 1,915
(iii) Net Current Transfers from ROW 25
(ii) Income from domestic product accruing
(iv) Net Indirect Taxes 50
sector to private 1,880
(v) Depreciation 40
(iii) Net factor income from abroad (−) 10
(iv) Corporation tax 25 Sol. (i) Gross National Disposable Income
(v) Savings of private corporate sector 15 = GNP at MP + Net current transfers from Row
(vi) Direct taxes paid by households 25 = NNP at FC + Depreciation + Net Indirect Taxes
(vii) Other miscellaneous receipts of + Net Current transfers from ROW
government administrate departments 5 = 3,000 + 40 + 50 + 25 = ` 3,115 crore
(ii) Net National Disposable Income
Sol. (i) Personal Income = Private Income – Corporation
Tax – Savings of Private = NNP at MP + Net Current Transfers from ROW
Corporate Sector = NNP at FC + Net Indirect Taxes + Net Current
= 1,915 – 25 – 15 Transfers from ROW
= 1,875 crore = 3,000 + 50 + 25 = ` 3,075 crore
Practice Questions
1 Which concept is known as the study of 6 Building, plant and machinery are capital goods.
aggregates? In the light of this statement, following are the
(a) Microeconomics characteristics of capital goods excluding
(b) Macroeconomics (a) they are of high value
(c) Market demand (b) they are the assets of the company
(d) Aggregate demand (c) they are used for less than one year
(d) they are used in production process
2 The individuals or institutions which take
decisions regarding consumption, production, 7 The process of adding to physical stock of capital is
budget, taxation, policy, etc are known as known as
(a) producers (b) consumers (a) investment (b) savings
(c) government (d) All of these (c) capital formation (d) Both (a) and (c)
3 The goods which are ready to be used by the 8 Transfer payments are …… .
producers, are called .......... . (a) payments transferred from Central Government
(a) final goods (b) consumer goods account to State Government account
(c) producer goods (d) Both (a) and (c) (b) payments made to factors of production by an
organiser
4 .......... of the goods is the principle basis of (c) payments made for no return service
classifying the goods into intermediate and final (d) None of the above
goods.
(a) Production (b) Consumption 9 Real national income means the national income
(c) End-use (d) Expenditure measured in terms of …… .
(a) constant prices
5 The goods used by manufacturer like tools,
(b) current prices
equipment and plant, etc are known as (c) wholesale prices
(a) manufactured goods (b) intermediate goods (d) retail prices
(c) final producer goods (d) All of these
10 In GNP calculation, which of the following should 20 Scholarship is an example of

be excluded? (a) grant (b) transfer payment
(a) Rental incomes (c) subsidies (d) capital formation
(b) Interest payments
21 Match the following.
(c) Dividends
(d) Government transfer payment Types of Producing
Examples
Units
11 Which of the following represents national income? A. Primary sector (i) Medical and Transportation
(a) GNPFC (b) NDPFC (c) NNPMP (d) NNPFC B. Secondary sector (ii) Mining and Quarrying
12 National income is the sum of factor incomes C. Tertiary sector (iii) Construction and
accuring to manufacturing
(a) nationals (b) economic territory Codes
(c) residents A B C A B C
(d) both residents and non-residents (a) (iii) (ii) (i) (b) (ii) (iii) (i)
13 Which of the following affects national income? (c) (i) (ii) (iii) (d) (iii) (i) (ii)
(a) Goods and Service Tax (b) Corporation Tax
22. Under income method, profit of a company is the
(c) Subsidies (d) None of these
sum total of
14 Domestic territory of country includes (a) retained earnings and dividends
(a) political frontiers (b) territorial water (b) dividends and corporation taxes
(c) embassies of a country located abroad (c) corporation taxes and retained earnings
(d) All of these (d) retained earnings, dividends and corporation taxes
15 When gross domestic product of a country is 23 Which of the following items are excluded in
calculated at current prices, it is called calculation of national income under income
(a) current GDP (b) real GDP method?
(c) nominal GDP (d) constant GDP (a) Income from illegal activities like smuggling, theft,
gambling, etc.
16 Match the following. (b) Income from windfall gains.
Column I Column II (c) Transfer earnings like unemployment allowance,
scholarship, etc.
A. NDPMP (i) NDPFC + NFIA
B. NDPFC (ii) GDPMP – Depreciation
C. NNPFC (iii) GDPMP − NIT – Depreciation 24 Gross Investment = Net Investment + …… .
(a) Factor Income from Abroad
(Where, NDP = Net Domestic Product, GDP = (b) Net Indirect Taxes
Gross Domestic Product, NNP = Net National (c) Depreciation
Product, NIT = Net Indirect Taxes, MP = Market (d) None of the above
Price, FC = Factor Cost, NFIA = Net Factor Income 25 If GNP at MP is ` 5,200 and NNP at MP is ` 5,000,
From Abroad) what will be the value of consumption of fixed
Codes capital?
A B C A B C (a) ` 5,000 (b) ` 5,200
(a) (iii) (i) (ii) (b) (i) (ii) (iii) (c) ` 200 (d) Can’t be determined
(c) (ii) (iii) (i) (d) (ii) (i) (iii) Hint Consumption of Fixed Capital
17 The most common problem in estimating = GNP at MP – NNP at MP
GNP is …… . 26 Which of the following is correct?
(a) double counting (b) smuggling (a) Disposable Income = Personal Income – Direct Taxes
(c) black marketing (d) unorganised market (b) Disposable Income = Private Income – Direct Taxes
(c) Disposable Income = Personal Income – Indirect
18 As per the value added method of measuring
Taxes
national income, identify which of the following (d) Disposable Income = Private Income – Indirect Taxes
item will be excluded.
(a) Production for self-consumption 27 If gross value added at market price is ` 350 crore,
(b) Imputed rent of owner occupied houses change in stock is − ` 50 crore and intermediate
(c) Brokerage earned by selling second hand goods consumption is ` 200 crore, find the total amount
(d) Sale proceeds of second hand goods of sales.
19 The difference between value of output and value (a) ` 200 crore (b) ` 250 crore
(c) ` 600 crore (d) ` 500 crore
added is …… .
(a) depreciation Hint GVA MP = Sales + Change-in-stock − Intermediate
(b) intermediate consumption Consumption
(c) Net Indirect Taxes 350 crore = Sales − 50 − 200
(d) NFIA Sales = 350 + 50 + 200 = ` 600 crore
Economics 65
28 Factor income received from abroad is ` 100 crores 38 Why are the intermediate goods not included in
while factor income paid to abroad is `120 crores. the national income while measuring national
The value of NFIA will be ............ . income?
(a) ` 20 crores (b) ` – 20 crores (a) To avoid double accounting
(c) ` 100 crores (d) Can’t be determined (b) It decreases income
Hint NFIA = Factor Income received from Abroad – Factor (c) Intermediate goods are not good
Income paid to Abroad (d) All of the above
29 If the value of NIT is ` 150 and subsidies is ` 30. 39 Calculation of national income at market prices is
What will be the value of indirect taxes? known as .................... .
(a) ` 120 (b) ` 150 (a) Money income (b) Real income
(c) ` 180 (d) Can’t be determined (c) Non-monetary income (d) None of these
Hint NIT = Indirect Taxes – Subsidies 40 Accounting of national income at constant prices is
150 = Indirect Taxes – 30 known as ............... .
Indirect Taxes = 150 + 30 = 180 (a) Money income (b) Real income
(c) Current income (d) Domestic income
30 National income for a given economy is ` 10,000
crores while the domestic income of the same 41 Increase in stock of capital is known as
country is ` 12,000 crores. What will be the value (a) Capital Loss (b) Capital Profit
(c) Investment (d) None of these
of NFIA?
(a) ` 2,000 crores (b) ` – 2,000 crores 42 Which one of the following is included in circular
(c) ` 10,000 crores (d) None of these flow?
Hint National income is equal to NNP at FC while domestic (a) Real Flow (b) Money Flow
income is NDP at FC. (c) Both (a) and (b) (d) None of these
So, NFIA = NNP at FC – NDP at FC = 10,000 – 12,000 43 Which of the following is not a flow concept?
31 Increase in stock of capital is known as (a) Capital (b) Income
(a) Capital Loss (b) Capital Profit (c) Investment (d) Depreciation
(c) Capital Formation (d) None of these 44 Which one of the following is not true?
32 Which one of the following is included in circular (a) GNP = GDP + Depreciation
flow? (b) NNP = GNP + Depreciation
(a) Real Flow (b) Money Flow (c) NDP = GNP – Depreciation – NFIA
(c) Both (a) and (b) (d) None of these (d) GNP = NDP + Depreciation + NFIA
33 Which one is included in the two-sector model? 45 Consumption of fixed capital expenses are included
(a) Family, Firm, Industry in
(b) Family, Firm, Government (a) GNPMP (b) NNPMP
(c) Family, Firm, Government, Foreign Sector (c) NNPFC (d) None of these
(d) None of the above 46 If the Nominal GDP is ` 1,200 and Price Index
34 Which of the following items are excluded from (with base = 100) is 120, calculate Real GDP.
GNP measurement? (a) ` 1,200 (b) ` 1,000
(a) Purely financial transactions (c) ` 120 (d) Can’t be determined
(b) Transfer of used goods and non-market goods and Nominal GDP
Hint Price Index = × 100
services Real GDP
(c) Illegal activities and the value of leisure 1,200
(d) All of the above 120 = × 100
Real GDP
35 Which of the following is not included in the
47 Find Net Value Added at Factor Cost.
calculation of gross national product?
(a) Purchase and sale of old commodities S.No. Contents ` (in lakhs)
(b) Intermediate commodities
(c) (a) and (b) both (i) Durable use Producer Goods with a
(d) None of the above Life Span of 10 Years 10
36 GNP at MP = ................. . (ii) Single use Producer Goods 5
(a) GDPMP – Depreciation (iii) Sales 20
(b) GDPMP + Depreciation
(iv) Unsold Output Produced During the
(c) GDPMP / Depreciation
Year 2
(d) GDPMP + Net Factor Income from Abroad
(v) Taxes on Production 1
37. Which of the following is/are the method(s) of
measuring national income? (a) ` 10 lakh (b) ` 15 lakh
(a) Income method (b) Product method (c) ` 29 lakh (d) ` 17 lakh
(c) Expenditure method (d) All of these
Hint Net Value Added at Factor Cost (NVA FC ) S.No. Contents ` (in lakh)
= Sales + Unsold Output Produced During the Year (i) Value of Output 200
− Single use Producer Goods − Depreciation on (ii) Net Value Added at Factor Cost 80
Durable use Producer Goods − Taxes on Production (iii) Sales Tax 15
= 20 + 2 − 5 − 1 − 1 (iv) Subsidy 5
Value of Durable Goods (v) Depreciation 20
Where, Depreciation =
Life Span (a) ` 200 lakh (b) ` 140 lakh
10
= = `1 lakh (c) ` 150 lakh (d) ` 220 lakh
10
Hint Intermediate Consumption
48 Calculate national income from the following data = Value of Output − NVA FC + Depreciation + (Sales Tax
− Subsidy)
= 200 − 80 + 20 + (15 − 5)
(i) Net Current Transfers to the Rest of
the World 50 Calculate gross national product at market price from the
(–) 5
following data
(ii) Private Final Consumption
Expenditure 500 S.No. Contents ` (in crore)
(iii) Consumption of Fixed Capital 20 (i) Compensation of Employees 4,000
(iv) Net Factor Income to Abroad (–)10 (ii) Rent 800
(v) Government Final Consumption (iii) Profits 1,500
Expenditure 200 (iv) Undistributed Profits 400
(vi) Net Indirect Tax 100 (v) Mixed Income of Self-employed 1,800
(vii) Net Domestic Fixed Capital Formation 120 (vi) Net Exports (–) 30
(vii) Net Domestic Capital Formation 900
(viii) Net Imports 30
(viii) Gross Domestic Fixed Capital Formation 1,000
(ix) Change-in-stock (–)20
(ix) Change-in-stock (–) 80
(a) ` 680 crore (x) Interest 50
(b) ` 500 crore
(xi) NIT 900
(c) ` 820 crore
(d) ` 670 crore (xii) Net Current Transfer from Rest of the
World 500
Hint National Income (NNPFC)
= Private Final Consumption Expenditure (xiii) Net Factor Income from Abroad 60
+ Government Final Consumption Expenditure (a) ` 5,800 crore (b) ` 2,600 crore
+ Net Domestic Fixed Capital Formation (b) ` 9,130 crore (d) ` 8,100 crore
+ Change-in-stock − Net Imports − Net Indirect Tax Hint GNPMP = Compensation of Employees + Rent
− Net Factor Income to Abroad + Profits + Interest + Mixed Income of
= 500 + 200 + 120 + (−20) − 30 − 100 − (−10) Self-employed + Net Indirect Taxes + Net
Factor Income from Abroad + Depreciation
49 Calculate intermediate consumption from the
= (4,000 + 800 + 1,500 + 50 + 1,800 + 900 + 60 + 20)
following data
Note where, depreciation = [(viii) + (ix) − (vii)]
ANSWERS
1. (b) 2. (d) 3. (d) 4. (c) 5. (c) 6. (c) 7. (d) 8. (c) 9. (a) 10. (d)
11. (d) 12. (d) 13. (b) 14. (d) 15. (c) 16. (c) 17. (a) 18. (d) 19. (b) 20. (b)
21. (b) 22. (d) 23. (d) 24. (c) 25. (c) 26. (a) 27. (c) 28. (b) 29. (c) 30. (b)
31. (c) 32. (c) 33. (d) 34. (d) 35. (c) 36. (d) 37. (d) 38. (a) 39. (a) 40. (b)
41. (c) 42. (c) 43. (a) 44. (a) 45. (a) 46. (b) 47. (b) 48. (a) 49. (c) 50. (c)
CHAPTER 02
Determination of
Income and Employment
It is determined by the market rate of interest. Higher
Aggregate Demand (AD) the market rate of interest, lower the investment
Aggregate demand is the value of total expenditure on all expenditure as rate of interest is considered as cost of
goods and services in an economy during a fiscal year. borrowings.
Aggregate demand of the economy depends upon the level 3. Government Expenditure or Demand for Goods
of employment. There is direct or positive relationship and Services (G) It refers to government planned
between the level of employment or output in the economy expenditure on purchase of consumer and capital goods
and the aggregate demand. It signifies that aggregate to fulfil common needs of the society. These include
expenditure will increase with rise in the level of provision for schools, transport, hospitals, roads, parks,
employment and fall with the decline in the level of etc.
employment. Aggregate demand is the summation of
4. Net Export (X − M ) It is defined as the aggregate of all
consumption and investment.
demand for our goods and services by foreign countries
Aggregate Demand (AD) = C + I over our country’s demand for foreign countries’ goods
and services. It depends upon foreign exchange rate,
Where, C = Consumption expenditure
terms of trade, trade policy, etc.
I = Investment
Thus, Aggregate Demand can also be written as
Components of Aggregate Demand AD = C + I + G + (X − M)
Following are the components of aggregate demand (AD)
in a four sector economy Aggregate Supply (AS)
1. Household Consumption Demand or The quantity of goods and services produced by the entire
Expenditure (C) It refers to total expenditure to be economy constitutes the total supply. Aggregate supply is the
incurred by all households on purchase of goods and minimum sale proceeds which the producers must get in
services, e.g. households demand for food, clothing, order to continue production at given level of employment.
housing, etc. It is also called private consumption
In other words, aggregate supply is the money value of the
expenditure. It is determined by the level of personal
final goods and services or national product produced in an
disposable income in the economy. Higher the level of
economy during one year. It is equal to income generated.
personal disposable income, higher the private
consumption expenditure. So, AS = Y = C + S
2. Investment Expenditure by Firms (I) It refers to Aggregate supply is the summation of consumption
planned expenditure by private entrepreneurs on expenditure and saving.
creation of new capital assets like machines, buildings AS = C + S
and raw materials. An economy grows through
investment. Increase in capital assets through
Components of Aggregate Supply
investment is called capital formation. It is also called
The two main components of AS are
private investment expenditure. Private investment
● Consumption expenditure (C)
expenditure comprises of investment in fixed assets
● Saving (S)
and inventory stock.
A major portion of income is spent on consumption of goods Consumption Function

and services and the balance is saved. The relationship between the consumption expenditure and
Aggregate Supply/National Income = Consumption + Savings income is known as consumption function.
or Y = AS = C + S C = F (Y)
Where, C = Consumption expenditure,
Propensity to Consume Y = Income
It refers to the ratio between consumption (C) and income ( The algebraic expression of consumption function is:
Y ). It shows level of consumption (C) with respect to a given
C = C + bY
level of income (Y). It has two aspects
1. Average Propensity to Consume (APC) The ratio Where, C = Consumption
between the total consumption expenditure and total C = Autonomous consumption,
income at a given level of income, is called Average i.e. consumption at zero level of income
Propensity to Consume (APC). In other words, average b = Marginal Propensity to Consume
propensity to consume is the ratio of aggregate Y = Disposable income, i.e. income after tax
Consumption Expenditure (C) to aggregate Income (Y).
C Saving Function
APC = The relationship between savings and income is known as
Y
saving function.
It represents the fraction of total income which is
S = F (Y)
consumed.
Where, S = Saving, Y = Income
2. Marginal Propensity to Consume (MPC) The ratio Saving is the excess income which is left with the consumer
between the change in consumption expenditure (∆C) after doing all the consumption expenditure.
and the change in income (∆Y ) is called marginal
S=Y− C
propensity to consume.
The algebraic expression of saving function is
∆C S = − S + sY
MPC =
∆Y Where, S = Saving
It refers to the fraction of changed income which is S = Autonomous saving, i.e. level of saving when
consumed. income is zero
Ex-ante consumptions are the consumptions that an s = Marginal Propensity to Save
entrepreneur expects during a year.
Y = Disposable income
Propensity to Save Influence of Income over Induced
It refers to the ratio between Saving (S) and Income (Y) with and Autonomous Investment
respect to given level of income. It has two aspects Influence of income over induced and autonomous
1. Average Propensity to Save (APS) The ratio between investment can be understood as
aggregate saving (S) and aggregate income (Y) is called 1. Induced Investment Induced investment is positively
Average Propensity to Save (APS). related to the level of income in an economy. At higher
S levels of income, consumption expenditure tends to
APS = increase.
Y
Increased consumption expenditure or the increased
It refers to the fraction of total income which is
level of demand raises expected profitability of the
saved.
producers who accordingly are induced to make greater
2. Marginal Propensity to Save (MPS) The ratio investment, leading to rise in the level of investment.
between change in Saving (∆S) and change in Income
(∆Y) is called Marginal Propensity to Save (MPS). Y I
∆S
MPS = K2
∆Y
Investment
K1
It refers to the fraction of changed income which is
saved.
I
Ex-ante saving refers to the planned saving at different X
O L1 L 2
levels of income in the economy.
Income
Induced investment
Economics 69
2. Autonomous Investment An investment which is 1. AS = AD Approach According to modern theory of

not influenced by expected profitability or level of income and employment determination, in any
income is called autonomous investment. In fact, it is economy at any given time, income and employment
an investment expenditure incurred by the producers are determined at that level where aggregate demand is
with a view to continue production at its present level. equal to aggregate supply.
Y 2. S = I Approach Equilibrium level of income/output is
determined at a point where planned saving is equal to
Investment
planned investment.
I I
Investment Multiplier
Investment multiplier or output multiplier refers to the
O X number by which change in investment (∆ I) multiplies to
Income
become change in output/income (∆ Y ). It is measured as the
Autonomous investment
ratio between change in output/income and change in
investment.
Determination of Income and
∆Y
Employment in Two Sector Model K=
∆I
Determination of income and employment in two sector
model can be understood with the help of short-run Where, K = Multiplier
equilibrium output. ∆ Y = Change in output/income
∆ I = Change in investment
Concept of Short-run Y S
Short-run in an economy can be defined as the period of
time during which, level of output is determined only by the
Saving/Investment
E1
level of employment. Higher the level of employment, higher I1 I1
would be the level of output and vice-versa. ∆I
E
I I
Equilibrium Output ∆Y R
Equilibrium output refers to a situation, where, O X
Y Y1
Aggregate Demand = Aggregate Supply S Income/Output
AD = AS Y′
Diagrammatic presentation of multiplier
It signifies that whatever the producers intend to produce
during the year, is exactly equal to what the buyers intend to Relationship between Investment Multiplier and Marginal
buy during the year. Propensity to Consume (MPC)
Since, Aggregate Demand = Consumption There is a direct relationship between investment multiplier
+ Investment and MPC. Higher the value of MPC, higher the multiplier
or AD = C + I and vice-versa. In fact, multiplier is estimated using the
following equation
and Aggregate Supply = Consumption + Saving
1
or AS = C + S K=
1 − MPC
We can write the equation of equilibrium output as under: This equation establishes a direct relationship between MPC
Equilibrium Output = AS = AD and K.
⇒ C + S=C + I Relationship between Investment Multiplier and Marginal
or S=I Propensity to Save (MPS)
There is an inverse relationship between investment
Thus, equilibrium output is also achieved when,
multiplier and MPS. Higher the value of MPS, lower the
Saving = Investment ⇒ S = I multiplier and vice-versa. In fact, multiplier is estimated using
Determination of Equilibrium Output the following equation
The determination of income and employment depends on 1
K=
the level of aggregate demand and aggregate supply. We have MPS
two approaches to study the determination of equilibrium
This equation establishes an inverse relationship between
output/income
MPS and K.
Paradox of Thrift It implies that if all the individuals Inflationary Gap

increase the proportion of income that they save, then the Inflationary gap is equal to the difference between the
total volume of savings in that economy will not increase. actual level of aggregate demand and the level of the
Total savings will either decrease or remain same. aggregate demand required to establish full employment
equilibrium. It measures the size of excess demand.
Full Employment, Voluntary and Involuntary
Y
Unemployment AS = Y = C + S
Full Employment It refers to a situation where all those Inflationary
who are able to work and are willing to work, are getting
Aggregate Demand/
gap AD1 (above full employment)
Aggregate Supply
work. = C1 + I1
E′
Voluntary Unemployment It refers to the situation when F AD (at full employment)
=C+I
some people are not willing to work at the existing wage rate.
{E Excess demand
Involuntary Unemployment It refers to the situation
where some people are not getting work, even when they are
willing to work at the existing wage rate. 45°
X
Full employment never implies a situation of ‘zero O S R
involuntary unemployment’. There always exists some degree Income and employment
of unemployment, called ‘natural unemployment’. In other Curve showing inflationary gap
words, full employment is a situation in which everyone who
Inflationary gap causes a rise in price level or inflation
wants to work is working except for those, who are
because full employment has already been attained, hence
frictionally and voluntarily unemployed.
output and income level cannot be increased.
Full Employment Equilibrium and
Under Employment Equilibrium Causes of Excess Demand and Inflationary Gap
Equilibrium is struck when aggregate demand and aggregate The main causes for excess demand is increase in money
supply are equal or saving is equal to investment. But this supply in the economy which is due to
equilibrium may not correspond to full employment in the ● Increase in investment demand
economy. ● Increase in consumption demand
In this case, three situations arise, that are ● Increase in export demand
1. Full Employment Equilibrium Full employment ● Increase in disposable income
refers to the situation, when all those who are able to ● Increase in money supply due to deficit financing
work at the existing wage rates are getting jobs.
● Increase in the government demand for goods and
It refers to that situation in the economy where AS = AD
services
or S = I , along with fuller utilisation of labour force.
● Increase in private demand
2. Under Employment Equilibrium Under employment
refers to a situation ,when all those who are able to Consequences of Excess Demand and Inflationary Gap
work at existing wage rates, are not getting jobs. The following are the consequences of excess demand and
It refers to that situation in the economy where AS = AD inflationary gap:
or S = I , but without fuller utilisation of labour force. ● When AD increases beyond its full employment level,
3. Over Full Employment Equilibrium It refers to the output remains constant, simply because output cannot
situation in which actual Aggregate Demand (AD), i.e. exceed is beyond full employment level.
ex-post tends to be higher than what is required to ● Flow of goods and services remaining constant, excess
maintain full employment. demand implies excess pressure of demand on the

As the economy has already achieved full employment, existing output.
hence this AD cannot be attainable, as a result, it will ● Excess pressure of demand on the existing output causes a
end up creating excess demand. rise in prices. This implies a situation of inflation.
● Inflation causes increase in cost of production.
Excess Demand
It refers to the situation when Aggregate Demand (AD) is in Deficient Demand
excess of Aggregate Supply (AS) corresponding to full It refers to the situation when Aggregate Demand (AD) is
employment in the economy. short of Aggregate Supply (AS) corresponding to full
AD > AS employment in the economy.
Excess demand gives rise to inflation. AD < AS
Economics 71
Deflationary Gap Measures to Correct Excess Demand and

The extent to which current aggregate demand falls Deficient Demand
short of the actual aggregate demand required for full There are two policy measures to solve the problem of excess
employment level, is termed as deflationary gap. demand and deficient demand which are as follows
Deflationary gap is equal to the difference between the I. Monetary Measures
actual level of aggregate demand and the level of
In a situation of excess and deficient demand, the RBI uses
aggregate demand to establish full employment
various instruments of monetary policy. It refers to the economic
equilibrium.
policy of the government relating to currency and credit money.
It measures the size of deficient demand. The instruments of monetary policy are
Y
AS = Y =C+S 1. Quantitative Instruments
Aggregate Demand/
(i) Bank Rate Policy It is the rate at which commercial

Aggregate Supply
AD (at full employment)

banks borrow from Central Bank for a period of more than
=C+I
E
AD1 (at under employment)
90 days. In a situation of deficient demand, the RBI
} = C1 + I1
reduces the bank rate or market interest rate. It is also
E′ called cheap money policy.
F
Deflationary
In case of excess demand, the RBI increases the bank rate
gap or interest rate. It is also called dear money policy.
45° (ii) Open Market Operations It refers to buying and selling
X of government approved securities in the open market by
O S R
Income and employment the RBI to general public and commercial banks. In the
Curve showing deflationary gap situation of deficient demand, the RBI buys securities
from the open market and releases funds for the banks
Deflationary gap causes the economy’s income, output,
and the individuals. In a situation of excess demand, RBI
employment and prices to decline, hence pushing the
sells the eligible securities in its possession to commercial
economy into under employment equilibrium.
banks. So that, commercial bank’s cash is blocked with
Causes of Deficient Demand and Deflationary Gap them and their capacity to offer loan will be reduced.
The main causes of deficient demand is decrease in (iii) Cash Reserve Ratio (CRR) It is the fraction of total
money supply in the economy which is due to deposits that each commercial bank must keep with RBI, as
● Decrease in investment demand
a part of fractional reserve system. During deficient
● Decrease in public expenditure
demand, RBI reduces the CRR which increases cash
reserves with the banks. Thus, bank credit creation power
● Decrease in export demand
increases. In a situation of excess demand, RBI raises the
● Decrease in consumption demand
CRR. This will reduce the cash deposits left with commercial
● Decrease in disposable income banks to be loaned out.
● Decrease in supply of money (iv) Statutory Liquidity Ratio (SLR) It refers to the fraction
● Decrease in credit creation of total deposits which each commercial bank must keep
with itself in liquid assets like gold, government securities,
Consequences of Deficient Demand and etc. RBI reduces SLR in situations of deficient demand
Deflationary Gap while in a situation of excess demand, RBI raises the SLR.
The following are the consequences of deficient demand
2. Qualitative Instruments
and deflationary gap
(i) Marginal Requirement It is the difference between the
● When AD fails to cope with fuller employment of the
market value of securities provided by the borrower and
factors, producers tend to build up unwanted inventory the amount of loan granted to him. There will be reduction
stock. in marginal requirement in a situation of deficient
Actual Stocks > Desired Stocks demand and vice-versa.
● Idle inventory stocks would force the producers to plan
(ii) Moral Suasion In this, RBI issues directives to bank to
lesser production, implying a cut in planned AS. follow rules and regulations. During deficient demand, the
● A cut in planned AS implies a situation of reduction in
RBI issues instructions to member banks to increase the
the level of planned output. availability of credit to borrowers for non-essential
● Reduction in the level of planned output causes a purposes also. But, in case of excess demand, RBI imposes
situation of reduction in employment. restrictions on commercial banks on granting loans.
(iii) Selective Credit Controls It refers to a method in Again, when income and consumption expenditure rise,
which the Central Bank gives directions to other Y = ` 100 crore; C = ` 78 crore
banks to give or not to give credit for certain purposes So, Average Propensity to Consume,
to particular sectors. It imposes rationing of credit to C 78
A= =
prevent excessive flow of credit. Y 100
Here, ∆Y = 100 − 80 = ` 20 crore
II. Fiscal Measures and ∆C = 78 − 64 = ` 14 crore
Fiscal policy is the government’s revenue and expenditure So, Marginal Propensity to Consume,
policy. In a situation of excess demand, government uses ∆ C 14
MPC = = = 0.70
various instruments of fiscal policy to reduce budgetary ∆Y 20
deficit. Budgetary deficit is excess of government
expenditure over government revenue. 2. If national income is ` 90 crore and consumption
expenditure is ` 81 crore, find out average
The instruments of fiscal policy used to control deficient propensity to save. When income rises to ` 100 crore
and excess demand are and consumption expenditure to ` 88 crore, what
1. Revenue Policy In a situation of deficient demand, will be the marginal propensity to consume and
the government should reduce taxes. It will increase marginal propensity to save?
disposable income of the buyers and hence, the Sol. Here, in first condition, Y = ` 90 crore, C = ` 81 crore
purchasing power of the people and they will spend Average Propensity to Save
more on consumption of goods and services. Thus, S Y − C 90 − 81
APS = = = = 0.10
Aggregate Demand will rise. Y Y 90
In a situation of excess demand, government raises Again, when the income and consumption expenditure rise,
the rates of all taxes. This reduces the purchasing Y = `100 crore; C = ` 88 crore
power of the people and reduces both consumption ∆C = 88 − 81 = ` 7 crore; ∆Y =100− 90 = ` 10 crore
∆C 7
and investment expenditures. Marginal Propensity to Consume (MPC) = = = 0.70
∆Y 10
2. Expenditure Policy In a situation of deficient
demand, the government should raise its expenditure. Again, Marginal Propensity to Save (MPS)
This will raise the level of employment. It will in turn, =1− MPC =1− 0.7 = 0.30
increase the wages and the purchasing power. Thus, 3. The saving curve of an economy makes an intercept
aggregate demand will rise. on negative axis at ` 50 crore and 20% of additional
In a situation of excess demand, government reduces income is saved. Find out the consumption function.
its public expenditure. It will result in fall in demand Sol. MPS = 20% or 0.20; MPC = 1– MPS = 1 − 0. 20 = 0. 80
for goods and services. The fall in government Consumption = Income – Savings
expenditures should be equal to the inflationary gap. = Y − (− S + sY ) = Y − (−50 + 0. 20 Y )
3. Deficit Financing To correct deficient demand, = Y + 50 − 0. 20 Y
government should take resort to deficit financing or ∴ C = 50 + 0. 80Y
printing of notes to increase purchasing power of the Where, autonomous consumption = ` 50 crore and
economy. MPC = 0.80
In order to correct excess demand, government should 4. With the help of consumption function C = 20 + 0.8 Y ,
reduce the deficit financing or printing of notes to calculate savings at an income level of ` 500 crore.
bring the excess demand down. Sol. C = 20 + 0.8Y
Savings = Income − Consumption
= Y − (20 + 0.80Y ) = Y − 20 − 0.80 Y
Solved Examples S = −20 + 0. 20Y
1. Given that national income is ` 80 crore and As, Y = 500
consumption expenditure is ` 64 crore, find out S = −20 + 0.20(500)
average propensity to save. When income rises to = −20 + 100 = 80 crore
` 100 crore and consumption expenditure to ` 78
crore, what will be the average propensity to 5. It is given that MPC is 1/3rd of MPS, while
consume and marginal propensity to consume? consumption at zero level of income is given as ` 100
Sol. Here, in first condition, Y = ` 80 crore; C = ` 64 crore crore. Derive the consumption and saving functions.
Hence, S = Y − C = 80 − 64 = ` 16 crore
What does you suggest about this economy?
Now, Average Propensity to Save, Sol. We know that, MPC + MPS = 1, C = ` 100
1
APS =
S 16
= = 0. 20 According to question, MPC = MPS
Y 80 3
Economics 73
1 Sol. Given, C = ` 100 + 0.4Y , I = ` 1100

,
∴ MPS + MPS = 1
3 (i) Y =C + I
3
MPS = or S or MPS = 0.75 Y = 100 + 0. 4Y+ 1100
, ⇒ Y − 0. 4Y = 100 + 1100
,
4 1,200
0.6Y = 1,200 ⇒ Y = = ` 2,000
and b or MPC = 1 − 0.75 = 0. 25 0.6
Consumption function (C) = C + bY = 100 + 0. 25Y (ii) C = 100 + 0.4Y ⇒ C = 100 + 0.4 × 2,000
We also know that, −S is the negative expression of C . ∴ C = 100 + 800 = 900
Saving function (S) = − S + sY = −100 + 0.75Y
The economy suggests that people consume less and save 7. As a result of increase in investment by ` 60 crore,
more out of their additional income. National Income rises ` 240 crore. Calculate MPC.
Sol. Here, ∆ I = ` 60 crore, ∆ Y = ` 240 crore,
6. C = 100 + 0.4Y is the consumption function of an ∆ Y 240
economy, where C is consumption expenditure Hence, K = = =4
∆I 60
and Y is national income. Investment expenditure 1 1
is ` 1,100. Calculate Now, K = ⇒ 4=
1 − MPC 1 − MPC
(i) Equilibrium level of national income. 4 − 4 MPC = 1 ⇒ 4 MPC = 4 − 1
(ii) Consumption expenditure at equilibrium level ∴
3
MPC = = 0.75
of national income. 4
Practice Questions
1 Investment is an addition to …… . 8 Net export is zero when
(a) supply (b) current stock (a) export is zero (b) import is zero
(c) capital stock (d) None of these (c) exports = imports (d) All of these
2 Autonomous consumption is indicated by …… in 9 If C = ` 500 crore, I = ` 300 crore, find the AD in a
the consumption function. two sector economy.
(a) C (b) AC (a) ` 500 crore (b) ` 800 crore
(c) S (d) C (c) ` 1,300 crore (d) ` 200 crore
3 What is the value of MPC when MPS is zero? Hint It two sector economy Aggregate Demand (AD)
(a) 1 (b) 0 (c) ∞ (d) 0.5 = C + I = ` 500 crore + ` 300 crore = ` 800 crore
Hint Since, MPC + MPS = 1 10. In an economy, the marginal propensity to
∴If MPS is zero, then MPC + 0 = 1 consume is 0.75. Investment expenditure in the
4 What can be the maximum value of marginal economy increases by ` 75 crore. Calculate the
propensity to save? total increase in national income.
(a) 0 (b) 1 (a) ` 75 crore (b) ` 100 crore
(c) 2 (d) 3 (c) ` 200 crore (d) ` 300 crore
Hint MPS is the ratio between change in saving and change in Hint Here, MPC = 0.75, ∆I = ` 75 crore
income. As change in saving can be less than or equal to ∆ I = ∆ S = ` 75 crore
change in income only, therefore MPC’s maximum value
MPS =1− MPC =1− 0.75 = 0.25
can be 1.
∆S 75 75
Now, MPS = or 0.25 = ⇒ ∆Y =
5 Aggregate Supply = Consumption + …… . ∆Y ∆Y 0. 25
(a) Supply (b) Investment
(c) Saving (d) Expenditure 11 Calculate investment expenditure from the
6 Aggregate demand can be increased by following data about an economy which is in
(a) increasing bank rate equilibrium
(b) selling government securities by Reserve Bank of National income = ` 1,000
India Marginal propensity to save = 0.25
(c) increasing cash reserve ratio
(d) None of the above Autonomous consumption expenditure = ` 200
(a) 50 (b) 100
7 In a two sector economy, AD is equal to (c) 150 (d) None of these
(a) G + (X-M) (b) C + G Hint Y = 1,000, MPS = 0. 25, C = 200
(c) C + S (d) C + I
MPC or b = 1 − MPS = 1 − 0. 25 = 0.75
Hint Aggregate Demand (AD) is the sum total of households
Consumption Demand (C) and private investment C = C + bY , C = 200 + 0.75 × 1,000, C = 950
Demand (I) in a two sector economy, i.e. AD = C + I We know, Y =C+ I
12 Calculate marginal propensity to consume from 18 What can be the minimum value of investment
the following data about an economy which is in multiplier?
equilibrium (a) 0 (b) 1 (c) 2 (d) 3
National income = ` 1,500 19 If the investment multiplier is 1, what will be the
Autonomous consumption expenditure = ` 300 value of marginal propensity to consume?
Investment expenditure = 300 (a) 2 (b) 4 (c) 1 (d) 0
1 1
(a) 0.4 (b) 0.5 (c) 0.6 (d) 0.75 Hint K = ⇒1 =
1 − MPC 1 − MPC
Hint Y = ` 1,500, C = 300, I = 300
Y = C + I or C = Y − I = 1,500 − 300 = 1,200, 20 There is …… relationship between MPS and
b = MPC, C = C + bY , 1,200 = 300 + 1,500 b investment multiplier.
900 (a) positive (b) inverse
MPC or b = = 0.6
1,500 (c) direct (d) None of these
13 If national income is ` 50 crore and saving is 21 If MPC = 1, the value of multiplier is …… .

` 5 crore, find out average propensity to consume. (a) 0 (b) 1
(a) 1 (b) 0.5 (c) 0.90 (d) 1.11 (c) Between 0 and 1 (d) infinity
1
Hint Here, Y = ` 50 crore; S = ` 5 crore Hint K =
1 − MPC
Hence, C = Y − S = 50 − 5 = ` 45 crore
C 45 22 The value of multiplier is …… .
APC = = = 0.90
Y 50 1 1 1 1
(a) (b) (c) (d)
MPC MPS 1 − MPS MPC − 1
14 In an economy, the consumption expenditure is
` 8,750 crore and the ratio of average propensity to 23 If the marginal propensity to consume is greater
consume and average propensity to save is 7 : 1. than marginal propensity to save, the value of the
Calculate the level of income in the economy. multiplier will be
(a) ` 5,000 crore (b) ` 10,000 crore (a) greater than 2 (b) less than 2
(c) ` 15,000 crore (d) None of these (c) equal to 2 (d) equal to 5
1 1
Hint As,
APC 7
= Hint Let MPC be 0.6 and MPS is 0.4 ∴K = =
APS 1 MPS 0.4
So, ratio of consumption to income, i.e. APC = 7/8. 24 Equilibrium output, income and employment can
Hence, APC = , C = APC × Y = × Y  APC =
C 7 7  be determined at economic equilibrium point when

Y 8  7 + 1 (Where, Y = National Income, C = Consumption,
(where, Y = Income) S = Savings, I = Investment)
8 (a) Y = C (b) AS = AD
So, Y = × 8,750 = ` 10,000 crore
7 (c) S = I (d) Both (b) and (c)
15 If the value of average propensity to consume is Hint An economy is in equilibrium when AD is equal to AS,
1.5, what will be the value of average propensity to i.e. AD = AS, C + I = C + S, I = S
save? Equilibrium level of income and employment is obtained
(a) 0.5 (b) −0 . 5 (c) 1 (d) 0 where, AD = AS = Y
Hint APS = 1 − APC 25 …… refers to a situation where all those who are
16 If the value of average propensity to save is − 0.6,
able to work and are willing to work, are getting
what will be the value of average propensity to work.
(a) Under employment (b) Partial employment
consume?
(c) Full employment (d) Voluntary employment
(a) 0.6 (b) −1 (c) 1. 6 (d) 1
Hint APC = 1 − APS 26 In an economy, S = −100 + 0.6 Y is the saving
function, where S is saving and Y is national
17 Find consumption expenditure from the following:
income. If investment expenditure is ` 1,100,
Autonomous consumption = `100 calculate equilibrium level of national income.
Marginal propensity to consume = 0.70 (a) ` 1,100 (b) ` 2,000
National income = `1,000 (c) ` 900 (d) ` 1,200
(a) ` 1,000 (b) ` 100 Hint S = −100 + 0.6 Y, I = ` 1100
,
(c) ` 700 (d) ` 800 At equilibrium level of national income,
Hint Here, C = ` 100, b = 0.7 and Y = `1,000 S=I
Consumption Expenditure (C ) = C + bY −100 + 0.6Y = 1100
,
1,200
= 100 + 0.7 × 1,000 0.6Y = 1100
, + 100 ⇒ Y =
0.6
Economics 75
27 If consumption function for an economy is given as, 33 When does a situation of deficient demand arise in
C = 500 + 0.8Y and investment expenditure is an economy?
` 100 crore, then determine level of income when (a) AD > AS (b) S > I (c) AD < AS (d) S < I
savings will be zero. Hint Deficient demand arises when AD is short of AS
(a) ` 500 (b) ` 400 corresponding to full employment in the economy.
(c) ` 625 (d) ` 2,500
34. The main cause(s) of deficit demand is/are
Hint We know that when income (Y ) is equal to consumption (a) decrease in money supply
(C), savings will be equal to zero.
(b) increase in public expenditure
Hence, Y = C, C = 500 + 0.8Y (c) decrease in investment demand
Y = 500 + 0. 8Y , 0.2Y = 500 (d) Both (a) and (c)
500
Y = 35 …… refers to selling of government approved
0. 2
securities by RBI to general public and commercial
28 In an economy, as a result of increase in banks in case of excess demand.
investment by ` 100 crore, national income rises (a) Bank rate (b) CRR
by ` 1,000 crore. Find marginal propensity to (c) SLR (d) Open market operation
consume.
36 During excess demand, Central Bank will
(a) 1 (b) 0 (c) 0.9 (d) 0.1
(a) increase margin requirement
Hint Here, ∆ I = ` 100 crore, ∆ Y = ` 1,000 crore, (b) decrease margin requirement
∆ Y 1,000
Now, K = = = 10 (c) keep margin requirement constant
∆I 100 (d) keep margin requirement zero
1 1
Also, K = ⇒ 10 = 37 Issue of new currency notes is a method of
1 − MPC 1 − MPC
(a) revenue policy (b) deficit financing
⇒ 10 − 10 MPC = 1 ⇒ 10 MPC = 10 − 1 (c) expenditure policy (d) monetary policy
9
∴ MPC = 38 Match the following.
10
29 In an economy, investment is increased by ` 2,000 Column I Column II
crore. Calculate the change in total income, if A. Inflationary gap (i) Boom, recession, depression,
recovery
marginal propensity to save is 0.25.
(a) ` 2,000 (b) ` 8,000 B. Deflationary gap (ii) Excess demand
(c) ` 4,000 (d) ` 6,000 C. Taxation (iii) Deficit demand
Hint Here, ∆ I = ` 2,000 crore, MPS = 0.25 D. Business cycle (iv) Revenue policy
1 1
Now, K= = =4 Codes
MPS 0. 25
∆Y ∆Y A B C D A B C D
Also, K = or 4 = (a) (i) (ii) (iii) (iv) (b) (ii) (iii) (iv) (i)
∆I 2,000
(c) (iii) (ii) (iv) (i) (d) (ii) (iii) (i) (iv)
30 In case of excess demand, RBI …… the bank rate 39 Name the situatin where some people are not
or interest rate which makes the credit dear. getting work, even when they are willing to work
(a) increases (b) decreases at the existing wage rate.
(c) deposit (d) None of these
(a) Full employment
31 …… is equal to the difference between ‘AD beyond (b) Involuntary unemployment
full employment’ and ‘AD at full employment’. (c) Voluntary unemployment
(a) Recession (b) Inflationary gap (d) None of the above
(c) deflationary gap (d) None of these
40 Induced investment............ related to the level of
32 What is the other name of fiscal policy? income in an economy
(a) Deficit financing (b) Monetary policy (a) positively (b) inversely
(c) Bank rate policy (d) Revenue policy (c) not (d) Can’t say
ANSWERS
1. (c) 2. (d) 3. (a) 4. (b) 5. (c) 6. (d) 7. (d) 8. (c) 9. (b) 10. (d)
11. (a) 12. (c) 13. (c) 14. (b) 15. (b) 16. (c) 17. (d) 18. (b) 19. (d) 20. (b)
21. (d) 22. (b) 23. (a) 24. (d) 25. (c) 26. (b) 27. (d) 28. (c) 29. (b) 30. (a)
31. (b) 32. (d) 33. (c) 34. (d) 35. (d) 36. (a) 37. (b) 38. (b) 39. (b) 40. (a)
CHAPTER 03
Money and Banking

Barter System and Money was difficult to return value in future in terms of goods
Money is something, i.e. commonly accepted as medium of of same quantity and quality. Therefore, future
exchange. payments regarding interest and loans became difficult.
Before the evolution of money, goods were exchanged for Money
goods. This system of exchange was known as barter system.
Anything that is generally accepted as a means of exchange
Barter economy is termed as C-C economy, i.e. commodities
and that at the same time, acts as a measure and as a store of
were exchanged for commodities. Economic exchanges
value is money.
without the mediation of money are referred to as barter
exchanges. Money is defined under two heads
1. Legal Definition
Drawbacks of Barter Exchange System
According to this definition, money is anything which has
Barter system suffered from following drawbacks the legal power to act as a medium of exchange and to
1. Lack of Double Coincidence of Wants It was the discharge debt. Thus, currency notes and coins are regarded
major drawback of the barter system. It was very rare as money.
when the owner of some goods or services could find In the words of Robertson, “Money is anything which is
someone who wanted his goods or services and at the widely accepted in payment for goods or in discharge of
same time, he possessed that goods or services that the other kinds of business obligations”.
first person wanted. Legally, money can be of two types
2. Lack of Divisibility In commodity exchange, difficulty (i) Legal Tender Money or Fiat Money It refers to
of dividing the commodity was common. e.g. If a cow
money backed by order or authority of the government,
is to be exchanged for four goats, but the owner of cow
e.g. notes and coins. They do not have intrinsic value
requires two goats only, then the exchange cannot take
like gold or silver coin. They are also called legal
place, because ‘cow’ cannot be divided.
tenders as they cannot be refused by any citizen of the
3. Lack of Store of Value Due to absence of money in country for settlement of any kind of transaction.
barter system, wealth was stored in terms of goods.
Storing of goods carried some problems like cost of Legal tender money is further classified as
storage, loss of value, difficult to transfer from one (a) Limited Legal Tender Money It refers to that
place to other, etc. So, it was difficult for people to form of legal tender in which payments can be
store their purchasing power. accepted upto a certain limit only. In India, coins
are limited legal tender, in which payment upto
4. Lack of Common Measure of Value In barter
` 1,000 are acceptable.
system, there was absence of a common unit of
(b) Unlimited Legal Tender Money It refers to that
measurement in which the value of goods and services
can be measured. In the absence of common unit, form of legal tender in which payments are
proper valuation was not possible. e.g. Cloth is acceptable in unlimited amounts. In India, paper
measured in metre (i.e. length) while milk is measured notes are unlimited legal tender.
in litre (i.e. capacity), hence both cannot be measured (ii) Non-legal Tender Money or Fiduciary Money It is
in a single unit, thereby complicating the process of also known as optional or voluntary money. Its
exchange. acceptance is not compulsory, but is based on mutual
5. Lack of Standard of Deferred Payments Deferred trust. Drafts, cheques, bills of exchange, etc are
payment means future payments. In barter system, it examples of fiduciary money.
Economics 77
2. Functional Definition 6. Plastic Money The most modern form of money is

Gowther defines money as, “Money is anything that is plastic money in the form of debit and credit cards.
generally acceptable as a means of exchange and at the same
time, acts as a measure and as a store of value”. Functions of Money
Money has solved all the problems under barter economy
Evolution of Money through its functions. Broadly there are two functions of
To overcome the drawbacks of barter system and to money
smoothen the process of exchange, an intermediary was 1. Primary Functions These functions include
necessary, which was acceptable to both parties, i.e. buyer or ● Medium of exchange
seller, such an intermediary is termed as money. ● Unit of account
Money is the most useful and necessary invention. It is 2. Secondary Functions These functions are comprised
defined as anything that can serve as a medium of exchange. of
Money as we see it in its present form, has evolved after a ● Store of value
long process of evolution. The various forms that money ● Standard of deferred payments
took during the process of evolution are
1. Commodity Money All sorts of commodities like Money Supply
pearls, sea shells, salt, etc have been used as a medium It means total amount of money available in an economy.
of exchange. They were called commodity money. RBI publishes figures for four alternatives measures of
2. Animal Money Animals such as cow, goat, horse, etc money supply, which are given below
1 = C + DD + OD
were used as a medium of exchange. They were called ● M
animal money.
2 = M1 + Savings Deposits with Post Office Savings Banks
● M
3 = M1 + Net Time Deposits of Commercial Bank

3. Metallic Money Money made from some metals like ● M
gold, silver, copper, etc was called metallic money. It

4 = M 3 + Total Deposits with Post Office Savings
● M
can be further classified as: Organisations (excluding NSC)
(i) Full-bodied Money It is also known as standard Here, C = Currency held by the public
money, its value as commodity is equal to its value
DD = Demand Deposits with bank
as money.
OD = Other Deposits with the RBI
(ii) Token Coins It is one whose value as money, i.e.
its face value is significantly greater than its Money Multiplier
intrinsic value, i.e. the value of the commodity It may be defined as the ratio of the stock of money to the
from which it is made. stock of high powered money in an economy.
4. Paper Money Money made of paper is known as paper
M
money or currency notes. Paper money can further be Money Multiplier =
classified into three categories H
(i) Representative Paper Money It is backed by Here, M = Stock of money
equivalent amount of gold and silver reserves. H = Stock of high powered money
(ii) Convertible Paper Money When government or
Central Bank gives guarantee for the conversion of Central Bank
paper money into gold or silver at fixed price, then A Central Bank is an apex institution of a country which
this paper money is termed as convertible paper operates, controls, directs and regulates the monetary and
money. financial system of a country.
(iii) Inconvertible Paper Money When government
of a country does not bear any responsibility of its Functions of Central Bank
conversion into gold or silver, then it is termed as Main functions of a Central Bank are
inconvertible paper money. Presently, this money is
1. Bank of Issue The first and foremost important
in circulation in India. This money is gaining
importance because it is easy to carry and print. function of Central Bank is to issue currency notes. It
has its various departments which print and issue
5. Credit Money It refers to bank deposits by people
currency notes for the public of a country.
with banks which they can withdraw at any time they
like or transfer it to someone else through a bank 2. Credit Control Central Bank controls credit creation
cheque. It should be remembered that cheque itself is capacity of commercial banks to control inflationary
not money, but it performs the same function as and deflationary situations of the economy through the
money. Therefore, it is termed as near money. implementation of its monetary policy.
3. Banker to the Government The Central Bank acts as Bank and Banking
a banker to both, Central and State Governments. It
Bank is an institution which receives funds from the public
carries out banking business of the government and the
and gives loans and advances to those who need them. The
government keeps its cash balances with the Central
supply of money in a country depends on the banking
Bank. Also RBI advices government on various
financial matters. system as a whole and the monetary policy of the Central
Bank in general.
4. Banker of Banks A Central Bank is a bank of other
commercial banks of the country. It grants loans to the Banking implies accepting deposits of money from the public
commercial banks to fulfil their needs of funds and for the purpose of lending or investment which is repayable
also accepts their deposits. It is not for the common on demand and can be withdrawn by means of cheques,
people of the country. It maintains same relation with drafts order, etc.
the commercial banks as commercial banks have with
general public. Commercial Banks
5. Lender of Last Resort It means that if a commercial Commercial banks are the financial institutions that accept
bank fails to get financial accommodation from deposits from the public and lend out this money (loan) to
anywhere, it approaches the Central Bank as a last consumers and investors with an objective to earn profits.
resort. Central Bank advances loan to such banks The rate of interest offered by the bank to deposit holders is
against approved securities. called the borrowing rate and the rate at which banks lend
By offering loan to the commercial banks in situations out their reserves to investors is called the lending rate. The
of emergency, the Central Bank ensures that difference between the two rates, called spread, is the profit
that is appropriated by the banks.
● The banking system of the country does not suffer
from any set back.

● Money market remains stable.
Functions of Commercial Banks
The commercial banks perform two primary functions
6. Custodian of Foreign Exchange Reserves Central
Bank is the custodian of nation’s foreign exchange I. Accepting Deposits
reserve. The Central Bank maintains foreign exchange The main function of the commercial banks is to accept
reserves in order to promote international trade and deposits from the public. These deposits may be in the form
stabilise exchange rate to an agreed limit. of
1. Demand Deposits or Current Account Deposits
Credit Control Policy of Central Bank
These deposits are repayable by the banks on demand
By credit control, we mean flow of credit can be regulated in
through the means of a cheque. Banks do not pay any
such a way that it may rise or fall according to the needs of
interest on these deposits. Also there are no restrictions
an economy. This is done by the Central Bank by using two
on the number of transactions in these deposits. Banks
types of methods which are stated below
impose service charges on these deposits.
1. Quantitative Methods The methods which affect the
2. Savings Deposit A person can open a savings deposit
overall supply of credit in the economy are quantitative
account by depositing a small sum of money. He can
methods. Following instruments are used in this
withdraw money from his account and make additional
method
deposits at will, but there are certain restrictions on the
● Bank Rate Policy
number of withdrawals. A nominal rate of interest is
● Open Market Operations payable on these deposits.
● Cash Reserve Ratio (CRR)
3. Fixed Deposit A fixed deposit is repayable after the
● Statutory Liquidity Ratio (SLR) expiry of the specified period which may range from 6
● Repo Rate months to 5 years.
● Reverse Repo Rate Deposits for more than one year are known as ‘term
deposits’. These deposits are not repayable on demand
2. Qualitative Methods The methods which focus on and carry a high rate of interest.
the alternative uses of credit in the economy or it seeks
to influence the quality of credit are called qualitative 4. Recurring Deposits The aim of recurring deposits is
methods. Instruments used in this method are to inculcate the habit of regular savings by the people.
A person can deposit a fixed amount, say ` 500 per
● Marginal Requirements
month for a fixed period.
● Rationing of Credit
The amount together with interest is paid on maturity.
● Direct Action
The rate of interest is higher than what is offered on
● Moral Suasion
savings deposit.
Economics 79
II. Lending Money Now let us understand the process of credit creation with the
The money collected by the commercial banks in the form of help of an example
various deposits is lended to businessmen, farmers and Let the LRR be 20% and there is a fresh deposit of ` 10,000.
others. Lending money may take the form of As required, the banks keep 20%, i.e.` 2 ,000 as cash. Suppose
1. Overdraft Under this arrangement, a customer having the banks lend the remaining ` 8,000.
a current account is allowed to withdraw more than Those who borrow, use this money for making payments. As
what he has deposited. Interest is charged on the assumed, those who receive payments, put the money back
amount actually overdrawn during the period. into the banks. In this way, bank receives fresh deposits of
2. Cash Credit Under this arrangement, the bank ` 8,000.
advances cash loan upto a specified limit against The banks again keep 20%, i.e. ` 1,600 as cash and lend
current assets and other securities. The bank opens an ` 6,400, which is also 80% of the last deposits. The money
account in the name of the borrower and allows him to again comes back to the bank leading to a fresh deposit of
withdraw the borrowed money from time to time. ` 6,400. In this way the money goes on multiplying and
Interest is charged on the amount withdrawn and not ultimately total money creation is ` 50,000.
on the sanctioned amount. Given the amount of fresh deposit and the LRR, the total
3. Loans and Advances A loan is a lump sum advance money creation is
repayable on the expiry of the specified period. It may 1
be secured or unsecured. Interest is charged on the Money Creation = Initial Deposit ×
LRR
whole amount sanctioned. The bank may allow the
borrower to repay the loan in a lumpsum or in Here, LRR = Legal Reserve Ratio
instalments. So on substituting the variables, we get,
4. Discounting of Bills of Exchange Under this 1
system, a customer can get the amount of a bill Money creation = 10 ,000 × = ` 50 ,000
20 %
receivable from the bank before the date of maturity.
The bank deducts discount charges from the gross
amount. On the date of maturity, the bank gets the Recent Banking Reforms
amount from the acceptor of the bill. Some of the steps taken by the government to bring reforms
in the banking sector are
Money Creation or Credit Creation by Commercial Banks ● The Ministry of Finance in its Economic Survey 2015-16
Money creation or credit creation is an important function of suggested four R’s – Recognition, Recapitalisation,
commercial banks. It means the creation of bank deposits or Resolution, and Reform to address the problem of NPAs.
increase in bank deposits. Through the process of money ● In October, 2015, the Government announced Mission
creation, commercial banks are able to create credit, which is Indradhanush under which 7 key strategies were proposed
in far excess of the initial deposits. to reform Public Sector Banks (PSBs).
The capacity of banks to create money or credit depends on ● In May, 2015, the RBI advised all PSBs to appoint an
two factors internal Ombudsman to further boost the quality of

● Amount of initial fresh deposits or primary deposits.
customer service and to ensure that there is undivided
● Legal Reserve Ratio (LRR) which is fixed by the Central attention to the resolution of customer complaints in
Bank of a country and it is the minimum ratio of deposit banks.
legally required to be kept as cash by banks. ● The Government announced its intention to introduce a
It has two components comprehensive insolvency and bankruptcy bill in the
(a) Cash Reserve Ratio (CRR) It is a part of LRR which Parliament based on the recommendations of the Dr. T K
is to be kept with the Central Bank. Viswanathan-headed Bankruptcy Law Reforms Committee
(b) Statutory Liquidity Ratio (SLR) It is a part of LRR (BLRC).
which is to be kept with the bank themselves. ● In order to rein in corruption, the Supreme Court on 23rd
Further, it should be kept in mind that the process of money February, 2016 ruled that the top officials and employees
creation is based on two assumptions of private banks will be considered as public servants for
● The whole of the commercial banking system is treated as
the purposes of the Prevention of Corruption Act, 1988.
● The RBI is also facilitating rectification of procedural flaws
‘one unit’.
● All monetary exchanges in an economy are routed through
in the system through a number of well thoughtout
banks. initiatives like restricting incremental non-performing
assets through early detection, monitoring, corrective
action plans, shared information, disclosures, etc.
● Since 2014, the banking sector has witnessed the adoption Institution (DFI) for infrastructure, creation of a Bad Bank
of the JAM (Jan Dhan, Aadhaar and Mobile) trinity and to address the problem of chronic non-performing assets
the issuance of licenses to Payments Banks and Small (NPAs), and privatisation of Public Sector Banks (PSBs) to
Finance Banks (SFBs) to achieve last mile connectivity in ease its burden in terms of mobilising additional capital.
the financial inclusion drive. ● Government has recently merged many public sectors
● The government recently announced new banking reforms, banks in order to improve their efficiency and further have
involving the establishment of a Development Finance planned few more mergers.
Practice Questions
1 Money is most liquid of all assets because …… . 8 M1 and M2 measures of money supply issued by
(a) it includes shares and equities RBI are known as
(b) money itself is medium of exchange (a) total money (b) narrow money
(c) it does not have general acceptability (c) broad money (d) high powered money
(d) it has many functions
9 Central Bank of a country does not deal with …… .
2 The difference between narrow money and broad (a) State Government (b) general public
money is …… . (c) Central Government (d) commercial banks
(a) coins and currency
(b) only currency 10 Central Bank controls credit creation of banks by
(c) saving deposits of banks …… .
(d) time deposits with banks (a) CRR (b) SLR
3 Under barter exchange system, barter economy is
termed as 11 What can RBI do, if it wants to increase credit in
(a) C-C economy (b) C-M economy the economy?
(c) C-G economy (d) Cash less economy (a) Decrease bank rate and CRR
(b) Increase bank rate and CRR
4 Plastic money includes
(c) Increase bank rate and decrease CRR
(a) debit cards
(b) credit cards
(c) prepaid cash cards 12 …… refers to that portion of total deposits which a
(d) All of the above commercial bank has to keep with the Central Bank.
5 Monetary system of India is managed, control and (a) SLR (b) Bank rate
regulated by (c) CRR (d) None of these
(a) Government of India 13 The Central Bank can increase availability of
(b) Ministry of Finance credit by
(c) Reserve Bank of India (RBI) (a) raising repo rate
(d) Commercial Bank (b) raising reverse repo rate
6 Money was evolved to remove the problems of (c) buying government securities
barter exchange system. Find the correct sequence (d) selling government securities
of evolution of money concepts. 14 …… is the minimum rate at which Central Bank is
(i) Paper money (ii) Plastic money prepared to give credit to the commercial banks.
(iii) Metallic money (iv) Digital money (a) Repo rate (b) Reverse repo
Codes (c) CRR (d) SLR
(a) (iii), (i), (iv), (ii) 15 As a custodian of nation’s reserves, RBI keeps
(b) (i), (ii), (iii), (iv) (a) reserves of foreign currencies
(c) (ii), (iv), (i), (ii)
(b) reserves of gold
(d) (iii), (i), (ii), (iv)
(c) reserves of foreign treasury bills
7 Sum total of currency held by Public (C), Demand (d) All of the above
Deposits in Bank (DD) and Other Deposits with
16 Banks not only accept deposits but also ……
RBI(OD) are combindly known as
savings.
(a) M1 (b) M2
(a) distribute (b) mobilise
(c) M3 (d) M4
(c) convert (d) None of these
Economics 81
17 …… involves discounting or purchasing of 25 Which of following measures of money supply are

commercial bills arising out of credit sales. considered as monetary base?
(a) Cash credit (a) M1 (b) M 2 (c) M3 (d) M 4
(b) Bill financing 26 Identify the incorrect statement from given below
(c) Overdraft (a) Present currency can work as money as it is a legal
(d) None of the above tender.
(b) Coins held by the public are limited legal tender.
18 The process of credit creation in an economy is (c) Central bank prints currency in India.
affected by …… . (d) Central bank do not deal with general public.
(a) the amount of initial deposits
27 Choose the correct statement from given below
(b) the LRR
(a) Commercial banks creates credit out of primary
deposits.
(b) Money multiplier is directly related to legal reserve
19 Demand deposits include ratio.
(a) saving account deposits and fixed deposits (c) Central bank of the country is not authorised to
(b) saving account deposits and current account deposits maintain foreign exchange reserve.
(c) current account deposits and fixed deposits (d) All of the above
(d) All types of deposits 28 In case of credit money
20 The rate of interest offered by the bank to deposit (a) Money value = Commodity value
holders is called the (b) Money value > Commodity value
(a) bank rate (c) Money value < Commodity value
(b) borrowing rate (d) None of the above
(c) lending rate 29 Credit creation depends on
(d) inflation rate (a) initial level of deposit
(b) money multiplier
21 A person can use more number of cheques if he has
(a) saving deposits account
(b) current account
(c) fixed deposits account 30 The component(s) of broad money is/are
(d) recurring deposits account (a) currency held with the public
22 Which of the following bank account provides (b) demand deposits held by commercial banks
overdraft facility? (c) net time deposits of commercial banks
(a) Saving deposits account
(b) Current account 31 Which of the following is/are primary functions of
(c) Recurring deposits account money?
(d) Fixed deposits account (a) Medium of Exchange (b) Store of Value
(c) Unit of Account (d) (a) and (c)
23 Bank creates credit
(a) on the basis of their securities 32 Which of the following is not a function of
(b) on the basis of their total assets Commercial bank?
(c) on the basis of their cash deposits (a) Creation of currency
(d) on the basis of their gross liabilities (b) Accepting deposits
(c) Granting loans and advances
24 Which of the following system is followed by (d) Printing of currency
Reserve Bank of India for issuing currency?
(a) Minimum reserve system 33 Which of the following is/are functions of Central
(b) Proportionate system Bank?
(c) Fixed fiduciary issue system (a) Bank of issue (b) Credit control
(d) Simple deposit system (c) Banker of Banks (d) All of these
ANSWERS
1. (b) 2. (d) 3. (a) 4. (d) 5. (c) 6. (d) 7. (a) 8. (b) 9. (b) 10. (c)
11. (a) 12. (c) 13. (c) 14. (a) 15. (d) 16. (b) 17. (b) 18. (c) 19. (b) 20. (b)
21. (b) 22. (b) 23. (c) 24. (a) 25. (c) 26. (c) 27. (a) 28. (b) 29. (c) 30. (d)
31. (d) 32. (d) 33. (d)
CHAPTER 04
Government Budget
and the Economy
bridges, etc to promote employment generation in the
Concept of Government Budget economy. Several programmes are initiated through
Government budget is a statement of the estimates of the budget to reduce the problem of poverty and
government’s expected receipts and government’s expected unemployment.
expenditure during the financial year or fiscal year which
runs from 1st April to 31st March. 5. Economic Stability Government tries to establish
economic stability by its budgetary policies. Economic
In India, Article 112 of the Constitution requires the Central stability refers to a situation without fluctuations in
Government to prepare ‘Annual Financial Statement’ for the price levels and stability of exchange rate in an
country as a whole. This is called ‘Budget of the Central economy.
Government’. Article 202 of the Constitution requires every
Economic stability is achieved by protecting the
State Government to prepare ‘Annual Financial Statement’
economy from harmful effects of various trade cycles
for the concerned state. This is called ‘Budget of the State
and its phases, i.e. boom, recession, depression and
Government’.
recovery.
Objectives of Government Budget 6. Management of Public Enterprises Public sector
enterprises are owned and governed by the
Objectives of government budget are as follows
government and through budgetary policy, it tries to
1. Re-distribution of Income and Wealth Government manage the expenditure and revenue of PSUs.
through fiscal tools of taxation and transfer payments,
brings fair distribution of income. Equitable distribution Public Goods
of income and wealth is a way to bring social justice. The goods which cannot be provided through the market
For this purpose, progressive tax structure is followed in mechanism and hence must be provided by the government
India, in which burden of tax increases with increase in are called public goods. These goods have two important
income. It is also known as distribution function. features of non-rivalrous and non-exclusive in
2. Re-allocation of Resources The government of a consumption. e.g. Roads, public parks, street lighting, etc.
country, through its budgetary policy, directs the 1. Non-rivalrous It means consumption by one
allocation of resources in a manner such that there is a individual not reduce the amount available for the
balance between the goals of profit maximisation and others.
social welfare. 2. Non-excludable It means that once a public good is
3. Economic Growth The growth rate of a country provided, then no one can be excluded from its
depends on the rate of savings and investment. consumption. These goods promote social welfare.
Therefore, the roles that are assigned to budgetary Private Goods
policy in this regard are to create conditions conducive The goods which can be provided through market
for increase in savings and investment. mechanism, i.e. transactions between individual consumers
4. Generation of Employment Government needs to and producers are termed as private goods. These goods are
promote labour intensive technology, public works either rivalrous or exclusive in consumption. e.g. Food
programmes like construction of roads, dams, canals, items, clothes, shoes, etc.
Economics 83
Implications of Deficit Budget

Types of Budget
(i) Increase Aggregate Demand in the Economy A
There are three types of budget which are as follows
budget deficit implies a reduction in taxes and an
1. Balanced Budget increase in government spending, which boosts
It is that budget in which government’s estimated revenues aggregate demand of the economy.
are equal to government’s estimated expenditures. (ii) Economic Growth during a Recession During a
recession, the economy tends to experience a decrease
Total Receipts = Total Expenditure in investment spending from the private sector, along
Implications of Balanced Budget with lower aggregate consumption and demand. A
(i) Not Applicable to the Modern Welfare State government may choose to borrow and run a deficit to
Balanced budget is not applicable to the modern combat the situation by taking measures to spend
welfare state. After depression and war, the effectively.
government of different countries has come to play (iii) Increase Government Spending Government
an active role in maintaining economic stability and spending serves many purposes, including investments
growth. in infrastructure, healthcare, human capital,
(ii) Cannot Tackle Inflation and Deflation Balanced unemployment benefits, pension programs, and so on.
budget cannot cure inflation or deflation. During (iv) Fiscal Policy A budget deficit may be used to finance
inflation, surplus budget and during deflation deficit an expansionary fiscal policy which involves lowering
budget should be followed to bring the economy income and corporate taxes (therefore reducing revenue
back on the rails. for the government) and increasing government
(iii) Not Effective During War and Emergency spending on infrastructure and investments to attract
Balanced budget is not effective during war and foreign capital and boost economic growth.
emergency. During these periods, public expenditure (v) Higher Taxes in the Future A current budget deficit
will have to be increased to face the emergency that runs persistently often implies that the government
situations. Hence, deficit budget becomes the need of will need to increase taxes in the future to pay off the
the hour. accumulated debt since taxes are one of the primary
(iv) Cannot Secure Full Employment When the sources of revenue for the government.
economy operates at the underemployment
equilibrium level of income, increase in public Impacts of Budget
investment is necessary to raise aggregate demand to Budget impacts an economy at three levels
the level of full employment. This cannot be achieved ● It brings aggregate fiscal discipline level, i.e. budget tries to
if the policy of balanced budget is followed. maintain an ideal balance between revenues and
2. Surplus Budget expenditures of the government.
● It brings better allocation of resources, i.e. government,
It is that budget in which government’s estimated revenues
are more than government’s estimated expenditures. through its budget, will allocate resources to those areas
Total Receipts > Total Expenditure where it is socially desirable.
A budget surplus can be used to reduce taxes, start new
● Through budget, government can effectively and efficiently
programs or fund existing programs such as social security. plan and implement its social welfare programmes.
Implications of Surplus Budget Components of Government Budget
(i) Leakage from the Circular Flow If government The budget of the Central Government has two components
receipts are more than government spending, this is a namely
net leakage from the circular flow of income which
1. Revenue Budget The revenue budget shows the current
can have a deflationary effect on real GDP.
receipts of the government and the expenditure that can
(ii) Deteriorating Quality of Public Services Fiscal be met from these receipts. Revenue budget is the
austerity to achieve a budget surplus can have statement of estimated revenue receipts and estimated
damaging effects on the quality of public services and revenue expenditure during a fiscal year.
might increase inequality.
2. Capital Budget The capital budget is an account of the
3. Deficit Budget assets as well as the liabilities of the Central Government,
It is that budget in which government’s estimated revenues which takes into consideration changes in capital. It
are less than government’s estimated expenditure. consists of capital receipts and its payments. Capital
budget is the statement of estimated capital receipts and
Total Receipts < Total Expenditure
estimated capital expenditure during a fiscal year.
Revenue Receipts 2. Non-plan Revenue Expenditure It covers a vast

Receipts which do not create a liability for the government or range of general, economic and social services of the
do not lead to reduction in assets, are known as revenue government. e.g. Expenditure as a relief to earthquake
receipts. Revenue receipts are receipts of the government victims, etc.
which are non-redeemable, i.e. they cannot be reclaimed
Capital Expenditure
from the government. These are divided into tax and
non-tax revenues Capital expenditure are the expenditures of the government
which result in creation of physical or financial assets or
1. Tax Revenue It consists of the proceeds of taxes and reduction in financial liabilities.
other duties levied by the Central Government. Tax
revenues comprise of direct taxes and indirect taxes This includes expenditure on the acquisition of land,
building, machinery, equipment, investment in shares, loans
(i) Direct Tax It is a tax levied on households and
and advances by the Central Government to state and union
firms and its final burden cannot be shifted on to
territory governments, PSUs and other parties.
others, e.g. income tax, wealth tax and corporation
tax. It is also categorised as plan and non-plan expenditure in the
(ii) Indirect Tax It is a tax levied on goods and budget documents
services and its final burden can be shifted on to 1. Plan Capital Expenditure It is related to the Five
others, e.g. excise tax, VAT, entertainment tax. Year Plans and central assistance for state and union
2. Non-tax Revenue Non-tax revenue of the Central territory plans.
Government mainly consists of interest receipts on 2. Non-plan Capital Expenditure It refers to the
account of loans by the Central Government, dividends expenditure which is not related to Five Year plans. It
and profits on investments made by the government, covers various general, social and economic services
fees and other receipts for services rendered by the provided by the government.
government. Cash grants-in-aid from foreign countries
and international organisations are also included in Developmental Expenditure
non-tax revenue. Developmental expenditure refers to the expenditure of the
government which helps in economic development by
Capital Receipts increasing production and real income of the country.
All those receipts of the government which create liabilities In other words, this expenditure is directly related to
or reduce financial assets, are termed as capital receipts. economic and social development of the country.
Capital receipts are obtained by the government by raising Developmental expenditure on revenue is divided into
funds through borrowings, recoveries of loans and disposing developmental expenditure on revenue account and
of assets. developmental expenditure on capital account.
1. Disinvestment It refers to withdrawal of existing
investment. e.g. The Government of India is Non-developmental Expenditure
undertaking disinvestment by selling its shares in the Non-developmental expenditure refers to that expenditure
Maruti Udyog. It is a capital receipt of the government, of the government which does not directly help in economic
as it reduces assets of the government. development of the country.
2. Borrowings It creates liability for the government. In other words, this expenditure is incurred on the essential
Accordingly, borrowings are to be treated as capital general services of the government. Cost of tax collection,
receipts. It is a debt creating capital receipt. cost of audit, printing of notes, internal law and order,
expenditure on defence etc. are treated as
Revenue Expenditure non-developmental expenditure. Pension to retired
These are those expenditures which neither create any asset government employees, non-developmental assistance to
nor reduce liabilities of the government. These expenditures states are also included in this category.
are incurred for smooth functioning of government
departments and for day-to-day expenses of the Budget Deficit
government. e.g. Salaries, pensions, interest payments, When government spends more than what it collects by way
subsidies, grants, etc. Revenue expenditure is classified into of revenue, it incurs a budget deficit. Budget deficit or
plan and non-plan expenditure government deficit refers to a situation when budget
1. Plan Revenue Expenditure It relates to central plans expenditures of the government are greater than the
(the Five Year Plans) and central assistance for state government receipts.
and union territory plans. e.g. Expenditure on health, To meet the deficit, government rely on borrowings that give
education, law and order, etc. rise to debt.
Economics 85
Measures of Budget Deficit Revenue deficit is a part of fiscal deficit, so fiscal deficit can
There are three measures of budget deficit and they have also be calculated as
their own implications for the economy. Fiscal Deficit = Revenue Deficit + Capital Expenditure
The description of such measures is given below − Non-debt Creating Capital Receipts
or Fiscal Deficit = Borrowings
1. Revenue Deficit
It is defined as the excess of government’s revenue A large share of revenue deficit in fiscal deficit indicates that a
expenditure over revenue receipts. large part of borrowing is being used to meet its consumption
The revenue deficit includes only such transactions that expenditure needs rather than investment. If such borrowings
affect the current income and expenditure of the are used for investment and developing infrastructural
government. facilities, its effect will not be inflationary.
It is calculated as Implications of Fiscal Deficit
Revenue Deficit = Revenue Expenditure
Implications of fiscal deficit are as under
● It determines total borrowing requirements of the
− Revenue Receipts
government.
Where, Revenue Expenditure (RE) ● It is always injurious to the economy and leads to financial
= Interest Payments + Non-interest Expenditure unsoundness.

or Plan Expenditure + Non-plan Expenditure ● Repayment of loan together with interest further increases
Revenue Receipts (RR) = Tax Revenue + Non-tax Revenue fiscal deficit, which creates debt trap.
● It increases the liability of the government.
Implications of Revenue Deficit ● It increases foreign dependence.
High revenue deficit gives a warning to the government

either to cut its expenditure or increase its revenues. It 3. Primary Deficit
shows the inefficiency of the government to meet its Primary deficit is equal to fiscal deficit reduced by interest
current expenditures. payments. It is calculated as
In developing countries like India, often the situation Primary Deficit = Fiscal Deficit – Interest Payments
arises when the government has to incur huge expenditure Implications of Primary Deficit
on administration and maintenance and it is difficult to It indicates borrowing requirements of the government to
force the people to pay high taxation. meet fiscal deficit net of interest payments. It enables us to see
This situation means that the government will have to the way, how the government is currently conducting its
borrow not only to finance its investment but also for its financial affairs.
consumption requirements. This will lead to build up stock
of debt and interest liabilities and force the government, How can Deficit be Financed
eventually, to cut expenditure. A deficit, occurring in the government budget, can be financed
in the following ways
Since, a major part of revenue expenditure is committed
expenditure, it cannot be reduced. Often the government 1. Increase in Taxation The government can impose
reduces productive capital expenditure or welfare higher rates of tax, in order to generate greater revenue
expenditure. This would mean lower growth and adverse receipts.
welfare implications. 2. Disinvestment The government can undertaken
disinvestment of its non-profitable and sick enterprises in
2. Fiscal Deficit order to increase its receipts on one hand and reduce its
Fiscal deficit is the difference between the government’s expenditure on the other.
total expenditure and total receipts, excluding borrowings.
3. Reduction in Expenditure The government should
It is calculated as also reduce its non-development expenditures, to avoid
Fisca Deficit = Total Budget Expenditure − Total Budget the generation of deficit.
Receipts ( Excluding borrowings)
or Fiscal Deficit = Total Budget Expenditure −
Downsizing the Role of Government
(Revenue Receipts +Non-debt Creating Downsizing is the permanent reduction of a government’s or
Capital Receipts) company’s labour force through the elimination of
unproductive workers or divisions. Cutting jobs is the fastest
Non-debt creating capital receipts are those receipts which
way to cut costs, and downsizing an entire store, branch or
are not borrowings and therefore, do not give rise to debt.
division also frees assets for sale during reorganisations.
Downsizing can also be carried out to align the

organisation’s skill and talent with the broader market. For Solved Example
example, a company may pursue downsizing to weed out 1. From the following data about a government
employees with obsolete skills which may not be useful in its budget, find out
future direction. (i) Revenue deficit (ii) Fiscal deficit and
(iii) Primary deficit
Implications of Downsizing
● Downsizing may actually increase the likelihood of S.No. Items ` (in crore)
bankruptcy by reducing productivity, customer satisfaction (i) Tax revenue 47
and morale. (ii) Capital receipts 34
● Organisations that have downsized are much more likely to (iii) Non-tax revenue 10
declare bankruptcy in the future, irrespective of their (iv) Borrowings 32
financial health. (v) Revenue expenditure 80
● Losing employees with valuable institutional knowledge (vi) Interest payments 20
can reduce innovation. Sol. (i) Revenue Deficit = Revenue Expenditure
● Remaining employees may struggle to manage increased – Revenue Receipts
workloads and stress, leaving little time to learn new skills (Tax revenue + Non-tax revenue)
which can negate any theoretical gain in productivity. = 80 – (47 + 10) = 80 – 57 =` 23 crore
● Losing trust in management inevitably results in less (ii) Fiscal Deficit = Borrowings =` 32 crore
engagement and loyalty. (iii) Primary Deficit = Fiscal Deficit − Interest Payments
= 32 – 20 = `12 crore
Practice Questions
1 …… is the year which begins on 1st April and ends (a) profit maximisation
on 31st March of the following year. (b) rate of savings and investment
(a) Current year (b) Fiscal year (c) fair distribution of income (d) removal of poverty
(c) New year (d) None of these 7 Which part of government budget shows the
2 Which objective of government budget increases current receipts?
equality in the society? (a) Capital budget
(a) Re-distribution of income and wealth (b) Revenue budget, as they are recurring in nature
(b) Economic stability (c) Both (a) and (b) (d) Neither (a) nor (b)
(c) Allocation of resources (d) Economic growth
8 …… items are those items which do not create a
3 In India, the Constitution requires the Central liability or do not lead to reduction in assets.
Government to prepare ‘Annual Financial (a) Capital (b) Development
Statement’, i.e. government budget for the country (c) Non-development (d) Revenue
as a whole. In India, …… department of 9 The final burden of …… cannot be shifted to others.
government prepares annual budget statement. (a) direct tax (b) indirect tax
(a) RBI (b) income tax (c) Both (a) and (b) (d) Neither (a) nor (b)
(c) accounts (d) finance
10 Loans granted to State Governments is an example
4 Government provides various goods like roads,
of …… .
parks, street light and defence services etc to
(a) revenue receipts (b) capital receipts
general public through budgetary provisions. (c) revenue expenditure (d) capital expenditure
These goods are called …… .
(a) budgetary goods (b) government goods 11 …… taxes do not depend on the level of income.
(c) public goods (d) private goods (a) Direct (b) Indirect
(c) Progressive (d) Lumpsum
5 Under which budget, government’s estimated
revenue are equal to government’s estimated 12 Direct tax is called direct because it is collected
expenditure? directly from …… .
(a) Balanced budget (b) Constant budget (a) the producers on goods produced
(c) Deficit budget (d) Revenue budget (b) the sellers on goods sold
(c) the buyers of goods (d) the income earners
6 Economic growth means increasing per capita
income over a period of time. Economic growth 13 The non-tax revenue in the following is …... .
objective of the government budget depends (a) export duty (b) import duty
on (c) dividends (d) excise
Economics 87
14 Income tax receipts are the part of …… receipts of 26 Choose the incorrect statement from given below
the government. (a) Government budget is an annual statement of
(a) direct tax revenue (b) indirect tax revenue income and expenditure of government for current
(c) non-tax revenue (d) capital revenue fiscal year.
(b) Budget is prepared by all levels of government.
15 A …… is a legally compulsory payment imposed by (c) Government, through its budget tries to minimise
the government on the households and producers. income inequalities.
(a) penalty (b) fine (c) fees (d) tax (d) Fiscal policy of government includes tax and
16 Disinvestment of government companies and expenditure policy of the government.
borrowings from World Bank comes under …… of 27 Expenditure on relief of earthquake victims is
the government. (a) plan expenditure (b) non-plan expenditure
(a) total receipts (b) capital receipts (c) Both (a) and (b) (d) None of these
(c) loan receipts (d) revenue receipts
28 Expenditure on construction of new phase of Metro
17 Zero …… means that the government has to resort is an example of
to borrowings only to make interest payments. (a) Developmental expenditure
(a) budget deficit (b) fiscal deficit (b) Non-Developmental expenditure
(c) primary deficit (d) revenue deficit (c) Both (a) and (b) (d) None of these
18 High …… gives a warning to the government either 29 ‘Policies of surplus budget during inflation’ is a
to cut its expenditure or increase its tax receipts. part of which objective of government budget?
(a) budget (b) revenue deficit (a) Reducing regional disparities
(c) primary deficit (d) fiscal deficit (b) Reallocation of resources
(c) Economics stability (d) Economic growth
19 Fiscal deficit equals …… .
(a) interest payments (b) borrowings 30 A government budget shows a primary deficit of
(c) interest payments less borrowings ` 6,500 crore. The revenue expenditure on interest
(d) borrowings less interest payment is ` 400 crore. How much is the fiscal
20 The government starts selling its securities to deficit?
private sector. What is this process called? (a) ` 6,500 crore (b) ` 400 crore
(a) Open market operation (b) Disinvestment (c) ` 6,800 crore (d) ` 6,100 crore
(c) Monetary expansion (d) None of these Hint Fiscal Deficit = Primary Deficit + Interest Payment
21 …… increases the liability of the government. 31 Calculate revenue deficit from the following data
(a) Capital receipts (b) Capital expenditure S.No. Items ` (in crore)
(c) Revenue receipts (d) Revenue expenditure
(i) Revenue Receipts 50,000
22 Primary deficit in a government budget is …... . (ii) Revenue Eexpenditure 60,000
(a) Revenue Expenditure – Revenue receipts
(b) Total Expenditure – Total Receipts (a) ` 50,000 crore (b) ` 60,000 crore
(c) Revenue Deficit – Interest Payments (c) ` 1,10,000 crore (d) ` 10,000 crore
(d) Fiscal Deficit – Interest Payments
Hint Revenue Deficit = Revenue Expenditure – Revenue
23 Borrowings in government budget are ...… . Receipts
(a) revenue deficit (b) fiscal deficit
(c) primary deficit (d) deficit in taxes 32 Calculate primary deficit
24 If borrowings and other liabilities are added to the S.No. Items ` (in crore)
budget deficit, we get (i) Fiscal Deficit 9,000
(a) fiscal deficit (b) primary deficit (ii) Interest Payment by Government 400
(c) capital deficit (d) revenue deficit
(a) ` 8,600 crore (b) ` 9,400 crore
25 Expenditure on maintenance of hospital by govern-
(c) ` 9,000 crore (d) ` 400 crore
ment already constructed sometime ago is a part of
Hint Primary Deficit
(a) plan expenditure (b) non-plan expenditure
= Fiscal Deficit – Interest Payment by Government
(c) can’t be determined (d) None of these
ANSWERS
1. (b) 2. (a) 3. (d) 4. (c) 5. (a) 6. (b) 7. (b) 8. (d) 9. (a) 10. (d)
11. (d) 12. (d) 13. (c) 14. (a) 15. (d) 16. (b) 17. (c) 18. (b) 19. (b) 20. (b)
21. (a) 22. (d) 23. (b) 24. (a) 25. (a) 26. (a) 27. (b) 28. (a) 29. (c) 30. (c)
31. (d) 32. (a)
CHAPTER 05
Foreign Exchange Rate and

Balance of Payments
Foreign exchange refers to the reserve of foreign currencies, Merits of Fixed Exchange Rate System
e.g. currency of US and UK are the foreign exchanges for ● It ensures stability in exchange rate. Due to certainty, it
India. promotes foreign trade.

● It promotes capital movements because it does not involve
Foreign Exchange Rate any uncertainties about exchange rate that may cause
Foreign exchange rate refers to the rate at which one unit of capital loss.
domestic currency is exchanged with the number of units of ● It prevents capital outflow.
currency of another country. In simple words, we can say ● It stops speculation in foreign exchange market.
that the price of one currency in terms of other currency is ● It helps the government to check inflation.
known as foreign exchange rate or exchange rate, e.g. ` 60
are to be paid to buy one dollar, then exchange rate is $ 1 Demerits of Fixed Exchange Rate System
= ` 60 (written as `/$ exchange rate). ● It requires high reserves of gold. Huge gold reserves hinder
movement of capital or foreign exchange.
Types of Exchange Rate ● It discourages the objective of having free markets.
There are mainly three types of exchange rate, as discussed ● It may result in undervaluation or overvaluation of
below currency.
1. Fixed Exchange Rate System ● It may not be the market equilibrium.
Under this system, exchange rate is determined by the ● An economy following this system, may find it difficult to
Central Bank of a country and the changes can be made by combat either depression or recession.
the Central Bank only.
2. Flexible Exchange Rate System
Methods of Fixed Exchange Rate System It is that rate which is determined by the demand for and
There are two methods to determine exchange rate under the supply of different currencies in the foreign exchange
this system market.
(i) Gold Standard System of Exchange Rate According
to this system, gold was taken as the common unit of Merits of Flexible Exchange Rate System
● With flexible exchange rate system, there is no need for the
parity between currencies of different countries in
circulation. Each country was to define the value of its government to hold any reserve.
● It eliminates the problems of undervaluation or
currency in terms of gold. Accordingly, value of one
currency in terms of the other currency was fixed, overvaluation of currency.
● It promotes venture capital in the form of foreign
considering gold value of each currency.
(ii) The Bretton Woods System of Exchange Rate The exchange.
● It enhances efficiency in resource allocation.
Bretton Woods Conference held in 1944, re-established
a system of fixed exchange rates. This was different
from the international gold standard in the choice of Demerits of Flexible Exchange Rate System
● It creates a situation of market instability.
the asset in which national currencies would be
● International trade and investment is discouraged due to
convertible. Under this system, countries were required
the uncertainty caused by currency fluctuations.
to fix their currency aganist US dollar. International
● It encourages speculation.
Monetary Fund was delegated with supervisory role
under this system.
Economics 89
Determination of Foreign Exchange Rate required to be paid in order to get the same $, this is
Foreign exchange rate is determined by the demand and known as depreciation of ` (domestic currency). The
supply of foreign exchange. domestic currency thus becomes relatively less valuable.
Y D1
The rate of foreign exchange is said to be in equilibrium ,
S
when the demand for some currency in terms of another D
Rate of exchange
currency equals its supply. Impact of increase
R1 in demand for
Y foreign exchange
D S
R
Rate of foreign
exchange
D1
S
R E(DD = SS) D
O X
S Q Q1
D
Demand and supply
Q of US $
X
O Effects of depreciation of currency are as follows
Demand and supply
of foreign exchange ● Encourages exports from a country.
● Discourages imports from rest of the world.

In the given figure, the line SS shows the supply of foreign
currency which is positively related to the rate of exchange. 2. Currency Appreciation If the supply of foreign
The line DD shows the demand for foreign currency which is exchange increases, demand remaining the same, the
negatively related to the rate of exchange. The point E, at exchange rate will fall. This fall in exchange rate
which DD equals to SS, represents the equilibrium rate of implies appreciation in domestic currency or currency
exchange. appreciation, e.g. if `/$ exchange rate falls from 60 to
55, then it is termed as appreciation of ` (domestic
Sources of Demand for Foreign Exchange
currency).
Foreign exchange is demanded for the following purposes
● Purchase of foreign goods by domestic residents, i.e.
Y S
D
imports. S1
Rate of exchange
● Payments of international loans.

R Impact of increase
● Gifts and grants to the rest of the world.
in supply of
● Investments in the rest of the world.
R1 foreign exchange
● Tourism to abroad. S
D
S1
Sources of Supply of Foreign Exchange O X
Q Q1
Supply of foreign exchange depends on the following factors Demand and supply
● Purchases of domestic goods by the foreigners, i.e. exports. of US $
● Foreign Direct Investment as well as portfolio investment It takes place when there is a decrease in the price of
from rest of the world. domestic currency with respect of the foreign currency. In
● Speculative purchases of foreign exchange. this case, the domestic currency is more valuable.
● Tourism and remittances from abroad. Effects of appreciation of currency are as follows
● Transfer of foreign exchange by the residents of the ● Imports will rise
country abroad. ● Exports will fall
Change in Exchange Rate Exchange Rate Issues

Change in exchange rate under flexible exchange rate may
Exchange rates are among the most important prices in the
take two forms
global economy. They affect the price of all country’s imports
1. Currency Depreciation If the demand for foreign and exports, as well as the value of every overseas
exchange increases, supply remaining the same, the investment.
exchange rate will rise. This rise in exchange rate
Over the past decade, some members of congress have been
implies depreciation in domestic currency or currency
concerned that foreign countries are using exchange rate
depreciation. e.g. suppose `/$ exchange rate is 60,
policies to gain an unfair trade advantage against other
means ` 60 need to be paid, in order to get 1$, if `/$
countries, or “manipulating” their currencies.
exchange rate rises to 65, it implies that more ` are
Congressional concerns have focused on China’s foreign Components of Current Account

exchange interventions over the past decade to weaken its The main components of current account are
currency against the US dollar, although concerns have also
(i) Export and Import of Visible Items Current
been raised about a number of other countries pursuing account includes export and import of visible items or
similar policies. goods like wheat, rice, machine, etc.
Through the International Monetary Fund (IMF), countries (ii) Export and Import of Invisible Items Current
have committed to avoiding currency manipulation. There account also includes export and import of invisible
are also provisions in US law to address currency items or services like shipping, insurance, banking, etc.
manipulation by other countries. (iii) Unilateral Transfers These are transfers between
The IMF has never cited a country for currency manipulation residents and non-residents. These can be private as
and the US Department of the Treasury has not done so well as public which include gifts, donations, etc or
since it last cited China in 1994. There are differing views on official transfers including donations, grants in
why. cash, etc.
Some argue that countries have not engaged in policies that (iv) Income Receipts and Payments From and to
violate international commitments on exchange rates or Abroad It includes factor incomes in the form of
triggered provisions in US law relating to currency interest, rent, profit, etc.
manipulation. Others argue that currency manipulation has
Structure of Current Account
occurred, but the provisions do not effectively respond to ● All exports (goods and services) are recorded as positive
exchange rate disputes.
items (credit side).
Balance of Payments (BoP) ● All imports (goods and services) are recorded as negative
It is a systematic record of all economic transactions items (debit side).
between the residents of a country and the rest of the world
● Receipts of unilateral transfers are recorded as positive
items (credit side).
in a given period of time, usually one year.
● Payments of unilateral transfers are recorded as negative
In other words, it can be said that, “The Balance of Payments items (debit side).
(BoP) of a country is a systematic record of all the economic
transactions between its residents and non-residents”. 2. Capital Account
Balance of Payments includes not only the value of goods It records capital transactions such as loans and investments
exported and imported, i.e. visible items, but invisible items between one country and the rest of the world, which causes
a change in the assets or liabilities status of the residents of a
and capital transactions are also recorded.
country or its government.
Economic Transactions in BoP
Components of Capital Account
Economic transactions which are recorded in BoP include
The main components of capital account are
1. Visible Items All types of physical goods imported and
(i) Foreign Investment It includes Foreign Direct
exported are known as visible items.
Investment and foreign institutional investment or
2. Invisible Items All services which are exported and portfolio investment by the residents of the country in
imported are known as invisible items. These include abroad or by rest of the world in domestic country.
services like insurance, banking, shipping, consultancy, (ii) Borrowings It includes commercial borrowing by the
investment income (like interests, profits, dividend and government or private sector from rest of the world
royalties) and unilateral transfers (like gift, donation, and external assistance to or by a country.
etc). (iii) Official International Reserve It includes the
3. Capital Transfers Items consisting of capital receipts changes in gold and foreign exchange reserve with the
and capital payments are known as capital transfers. Central Bank.
These transfers involve transfers of assets and
Structure of Capital Account
liabilities. ● All capital transactions causing flow of foreign exchange
Components of BoP into the country are recorded as positive items (credit side).
● All capital transactions causing flow of foreign exchange
There are two main components of BoP, which are as follows
out of the country are recorded as negative items
1. Current Account (debit side).
Balance of Payments of a current account is a statement of
actual receipts and payments relating to export and import Balance of Trade (BoT)
of goods and services and unilateral transfers during a given The term ‘Balance of Trade’ means the difference
period of time. between exports and imports of visible material goods.
Economics 91
BoT = Vx − Vm ● Unilateral transactions.

Where, Vx = Value of goods exported ● Capital transactions.
Vm = Value of goods imported
These transactions can either be recorded in current and
Deficit in the balance of trade occurs when, capital account depending on their nature.
Value of Exports of Goods < Value of Imports of Goods.
Surplus in the Balance of Trade occurs when, Accommodating Items of BoP
Value of Exports of Goods > Value of Imports of Goods. Accommodating items refer to those transactions which are
taken up by the government in order to keep the balance of
Autonomous Items of BoP payments balanced. These transactions are based on the
Autonomous items of balance of payments refer to the state of BoP and not carried out for profit motive.
international economic transactions which are made Accommodating items are also called below the line items.
independent of the state of BoP, with a view to earn profit. All the items related to the monetary transfers correcting
e.g. If an MNC is making foreign direct investment in our Balance of Payments disequilibrium are accommodating
country, with a view to earn profit, then this transaction will items.
not be affected by the state of BoP, i.e. it will not be
The main accommodating items are as follows
dependent on the fact that BoP is in surplus or in deficit.
● Borrowings from IMF or other international financial
Autonomous items are also called above the line items.
institutions.
The main autonomous items are as follows
● Foreign exchange reserve.
● Exports and imports of goods.
● Exports and imports of services.

These transactions are only recorded in capital account.
Practice Questions
1 In case of currency appreciation, the domestic 7 Who will be benefited when there is a appreciation
currency becomes …… . in a foreign currency in terms of domestic
(a) less valuable (b) more valuable currency?
(c) rise (d) fall (a) Importers (b) Exporters
(c) Both (a) and (b) (d) Neither (a) nor (b)
2 Other things remaining the same, when in a
country the market price of foreign currency falls, 8 Under which of the following exchange rate
national income is likely …... . system, exchange rate was determined and fixed by
(a) to rise (b) to fall Central Bank of a country and changes can be
(c) Both (a) and (b) (d) to remain unaffected made by the Central Bank only.
3 Other things remaining unchanged, when in a (a) Gold standard (b) Bretton woods
(c) Floating (d) Both (a) and (b)
country the price of foreign currency rises,
national income is …… . 9 Which items in balance of payments are also called
(a) likely to rise (b) likely to fall ‘above the line’ items?
(c) Both (a) and (b) (d) not affected (a) Autonomous items (b) Accommodating items
(c) Visible items (d) Invisible items
4 Which of the following international agency
manage foreign exchange rate system in the 10 Balance of payments deficit is calculated by taking
world? into account the …… only.
(a) Central Bank (b) IMF (a) accommodating transactions
(c) World Bank (d) All of these (b) autonomous transactions
(c) unilateral transactions (d) None of these
5 …… is the rate which is determined by market
forces. 11 What is the difference between the value of exports
(a) Fixed exchange rate and value of imports of goods called?
(b) Real exchange rate (a) Balance of Payments (b) Foreign exchange
(c) Flexible exchange rate (c) Balance of Trade (d) Disequilibrium
(d) Nominal exchange rate 12 Which items are excluded in BoT, but included in
6 Buying and selling of foreign currencies take place at BoP?
(a) goods market (b) gold market (a) Visible items (b) Invisible items
(c) foreign exchange market (d) All of these (c) Private capital (d) Both (b) and (c)
13 Foreign exchange transactions dependent on other 21 Choose the correct statement from given below
foreign exchange transactions are called (a) Balance of trade is a component of capital account of
(a) current account transactions balance of payments.
(b) capital account transactions (b) Floating exchange rate is used to stabilise price of
(c) autonomous transactions foreign currency.
(d) accommodating transactions (c) Increase in the supply of foreign exchange rate leads
to fall in its price.
14 Foreign exchange transactions which are (d) Rise in exchange rate leads to revaluation of
independent of other transactions in the balance of currency.
payments account are called 22 What will be the impact on trade deficit if
(a) current transactions (b) capital transactions exchange rate rises?
(c) autonomous transactions (a) Increase (b) Decrease
(d) accommodating transactions (c) Remain constant
15 Which is not a feature of Balance of Payments (d) Depends upon rate of change
(BoP) Account? Hint Increase in exchange rate leads to currency depreciation.
(a) It includes economic transactions Deprecation of currency leads to rise in exports leading
to increase in trade surplus.
(b) It has given period of time
(c) It records only capital transactions 23 What will be the impact on aggregate demand in
(d) Trade between resident of a country and rest of the an open economic model, if there is decrease in
world foreign exchange rate?
(a) Increase (b) Decrease
16 Which is not a part of income receipts and (c) Remain constant
payments from/to abroad in BoP account? (d) Depends upon the purchasing power parity
(a) Profits (b) Grants (c) Interest (d) Dividends
24 How will a banking crisis in domestic country
17 …… involves transactions related to transfers of affects demand curve for foreign exchange?
assets and liabilities in BoP account. (a) Demand for foreign exchange will shift to the right
(a) Balance of trade account (b) Demand for foreign exchange will shift to the left
(b) Current account
(c) There will be downward movement along demand
(c) Unilateral transfer account
curve
(d) Capital account (d) There will upward movement along demand curve
18 Government transactions include …… to keep the 25 During the currency crisis, the foreign exchange
BoP in balance and which are not carried out for reserve with Central Bank will
profits. (a) increase (b) decrease
(a) borrowings from IMF and other financial institutions (c) remain constant (d) None of these
(b) grants and donations
(c) foreign exchange reserve (d) Both (a) and (c) 26 Unilateral transfers are included in
(a) current account BoP (b) capital account BoP
19 Choose the correct statement from given below (c) Both (a) and (b) (d) None of these
(a) Balance of trade records the exports and imports of
invisible items. 27 If the value of exports is ` 200 and value of imports
(b) A surplus in BoT can rectify the deficit in BoP. is ` 250, there will be
(c) Accommodating items are only recorded in capital (a) Trade surplus of ` 50 (b) Trade deficit of ` 50
account of BoP. (c) Trade balance (d) None of these
(d) Import of machinery will be recorded in capital Hint Balance of Trade = Value of Exports – Value of Imports
account of BoP.
= 200 – 250
20 Choose the incorrect statement from given below = ` – 50 This shows a trade deficit.
(a) Repayment of loan taken from IMF will be recorded
on debit side. 28 A company located in India receives a loan from a
(b) Surplus in BoP refers to a state where debit side company located abroad. How is this transaction
exceeds credit side. recorded in India’s balance of payments account?
(c) Increase in investment from rest of the world (a) Credit side of current account
decreases the exchange rate. (b) Debit side of capital account
(d) Devaluation of current items improves trade balance (c) Debit side of current account
of domestic country. (d) Credit side of capital account
ANSWERS
1. (b) 2. (b) 3. (a) 4. (b) 5. (c) 6. (c) 7. (b) 8. (d) 9. (a) 10. (b)
11. (c) 12. (d) 13. (d) 14. (c) 15. (c) 16. (b) 17. (d) 18. (d) 19. (c) 20. (b)
21. (c) 22. (a) 23. (b) 24. (a) 25. (b) 26. (a) 27. (b) 28. (d)
PRACTICE SET 01 95
CUET (UG) Section II : Domain (Economics)
Practice Set 01
1. In economics, scarcity refers to a MUX MUX 12. Increasing returns is applicable

(a) = MUM (b) = MUM
situation when MUY PX because of ...... .
(a) demand for goods exceeds its (a) increased efficiency of variable
PX
supply (c) = MUX (d) MUX = MUM factor
(b) supply of goods exceeds its PY (b) fuller utilisation of fixed factor
demand (c) indivisibility of factors
7. When Price Elasticity of Demand
(c) supply of goods is equal to its (d) Both (a) and (b)
demand ( Ed ) is equal to infinity ( ∞ ), this
refers to 13. Payment made to outsiders for
(a) perfectly elastic demand their goods and services are called
2. ………… is a system in which (b) perfectly inelastic demand ...... .
people earn livelihood to fulfil their (c) unitary elastic demand (a) opportunity cost
wants. (d) more than unitary elastic demand (b) real cost (c) explicit cost
(a) Abroad (b) Market (d) implicit cost
(c) Economy (d) Village 8. If a 10% rise in price of Good X
leads to 20% fall in its quantity 14. Total revenue generated from sale
3. ………… is the problem which is demanded, its elasticity of demand of output of a firm can be
concerned with the distribution of is calculated as
national income among those who (a) elastic (a) TR = P × Q (b) TR = AR × Q
have helped to produce it. (b) inelastic (c) TR = ΣMR (d) All of these
(a) How to produce? (c) unitary elastic 15. In monopoly and monopolistic
(b) What to produce? (d) perfectly inelastic competitions, AR and MR curve are
(c) Why to produce?
9. If the price elasticity of demand is downward sloping because the
(d) For whom to produce?
2, a 10 percent increase in the price firms can sell more by
4. If a consumer is in equilibrium will result in a ……… decrease in (a) increasing the price
consuming one commodity, how its quantity demanded. (b) lowering the price
will he respond to a fall in price of (a) 5% (b) 10% (c) 20% (d) 25% (c) keep in price constant
the commodity? (d) All of the above
(a) Decrease the consumption of the 10. Marginal utility curve of a
commodity consumer is also his 16. When MC is greater than MR after
(b) Increase the consumption of the (a) indifference curve producer equilibrium, it means
commodity (b) total utility curve (a) profit of firm
(c) Consumption will remain constant (c) supply curve (b) producing more will lead to
(d) None of the above (d) demand curve decline in profit
(c) no profit no loss
5. “Utility is same as Usefulness”. 11. What will be the elasticity of (d) firm enjoys economic efficiency
Which of the below options fits the demand if price changes and total
given statement? 17. The claim that other things being
expenditure remains constant equal, the quantity supplied of a
(a) Always true (b) Partially true using total outlay method? good rises when the price of good
(c) False (d) Incomplete (a) Perfectly elastic rises and vice-versa is known as
6. In case of single commodity, the (b) Perfectly inelastic (a) Law of Economics
consumer will be in equilibrium (c) Unit elastic (b) Law of Supply
when ....... . (d) None of these (c) Law of Demand
96 CUET (UG) Section II : Domain (Economics)
18. A firm will supply more quantity of 25. Black marketing is a situation in 32. If the value of average propensity
a commodity at same price or even which the controlled commodity is to consume is 1.5, what will be the
at a reduced price, if the firm wants sold at a price …… than the price value of average propensity to
to fixed by the government. save?
(a) maximise profit (a) higher (b) lower (a) 0.5 (b) −0 . 5 (c) 1 (d) 0
(b) maximise social welfare (c) Either (a) or (b) (d) None of these
33. …… refers to a situation where all
(c) maximise sales
26. National income is the sum of those who are able to work and are
(d) maximise wealth willing to work, are getting work.
factor incomes accuring to
19. If a firm’s supply increases due to (a) nationals (a) Under employment
application of improved technology, (b) economic territory (b) Partial employment
this is known as (c) residents (c) Full employment
(a) expansion in supply (d) both residents and non-residents (d) Voluntary employment
(b) contraction in supply 27. Which of the following items are 34. …… refers to selling of government
(c) increase in supply excluded in calculation of national approved securities by RBI to
(d) increase in quantity supplied income under income method? general public and commercial
20. Indian government is focusing on (a) Income from illegal activities like banks in case of excess demand.
Make in India programme, which smuggling, theft, gambling, etc. (a) Bank rate (b) CRR
has led to significant improvement (b) Income from windfall gains. (c) SLR
in technology. What will be its (c) Transfer earnings like (d) Open market operation
unemployment allowance,
impact on supply of goods 35. Name the situatin where some
scholarship, etc.
concerned? people are not getting work, even
(a) Increases (b) Decreases when they are willing to work at
(c) No impact 28. If gross value added at market
the existing wage rate.
(d) Both (a) and (b) price is ` 350 crore, change in stock
(a) Full employment
is − ` 50 crore and intermediate
21. ...... is a situation of the market in (b) Involuntary unemployment
consumption is ` 200 crore, find
which demand for a commodity is (c) Voluntary unemployment
the total amount of sales.
exactly equal to its supply (d) None of the above
(a) ` 200 crore (b) ` 250 crore
corresponding to a particular price. 36. What can RBI do, if it wants to
(c) ` 600 crore (d) ` 500 crore
(a) Consumer equilibrium increase credit in the economy?
(b) Producer equilibrium 29. National income for a given
(a) Decrease bank rate and CRR
(c) Market equilibrium economy is ` 10,000 crores while
(b) Increase bank rate and CRR
(d) Balance of trade the domestic income of the same
(c) Increase bank rate and decrease
country is ` 12,000 crores. What
22. Monopolistic competition combines CRR
will be the value of NFIA? (d) All of the above
the features of following market (a) ` 2,000 crores
(a) Perfect competition and Monopoly (b) ` – 2,000 crores 37. As a custodian of nation’s reserves,
(b) Monopoly and Oligopoly (c) ` 10,000 crores RBI keeps
(c) Perfect competition and Oligopoly (a) reserves of foreign currencies
(d) None of these
(d) Perfect competition, Monopoly and (b) reserves of gold
Oligopoly market 30. Which of the following items are
(c) reserves of foreign treasury bills
excluded from GNP measurement?
23. Which of the following is/are the (d) All of the above
feature of monopolistic competition? (a) Purely financial transactions
(b) Transfer of used goods and 38. Demand deposits include
(a) Product differentiation
non-market goods and services (a) saving account deposits and fixed
(b) Selling cost
(c) Illegal activities and the value of deposits
(c) Both (a) and (b) leisure (b) saving account deposits and
(d) None of the above (d) All of the above current account deposits
24. The surplus caused by a binding (c) current account deposits and fixed
31. Calculate marginal propensity to
price floor will be greatest if ? deposits
consume from the following data
(a) demand is inelastic and supply in (d) All types of deposits
about an economy which is in
elastic equilibrium 39. Which of the following bank
(b) supply is inelastic, and demand is account provides overdraft facility?
elastic National income = ` 1,500
Autonomous consumption (a) Saving deposits account
(c) both supply and demand are
elastic expenditure = ` 300 (b) Current account
(d) both supply and demand are Investment expenditure = 300 (c) Recurring deposits account
inelastic (a) 0.4 (b) 0.5 (c) 0.6 (d) 0.75 (d) Fixed deposits account
PRACTICE SET 01 97
40. Which of the following is not a 44. Expenditure on construction of new 48. Foreign exchange transactions
function of Commercial bank? phase of Metro is an example of dependent on other foreign
(a) Creation of currency (a) Developmental expenditure exchange transactions are called
(b) Accepting deposits (b) Non-Developmental expenditure (a) current account transactions
(c) Granting loans and advances (c) Both (a) and (b) (b) capital account transactions
(d) Printing of currency (d) None of the above (c) autonomous transactions
41. Government provides various goods 45. Expenditure on maintenance of (d) accommodating transactions
like roads, parks, street light and hospital by government already 49. Which is not a feature of Balance
defence services etc to general constructed sometime ago is a part of of Payments (BoP) Account?
public through budgetary (a) plan expenditure (a) It includes economic transact-
provisions. These goods are called (b) non-plan expenditure ions
…… . (c) can’t be determined (b) It has given period of time
(a) budgetary goods (d) None of the above (c) It records only capital
(b) government goods transactions
(c) public goods 46. Other things remaining unchanged,
(d) Trade between resident of a
(d) private goods when in a country the price of foreign
country and rest of the world
currency rises, national income is
42. Loans granted to State 50. Choose the incorrect statement
…… .
Governments is an example of … . . from given below
(a) likely to rise
(a) revenue receipts (a) Repayment of loan taken from
(b) likely to fall
(b) capital receipts IMF will be recorded on debit
(c) Both (a) and
(c) revenue expenditure side.
(b) (d) not affected
(d) capital expenditure (b) Surplus in BoP refers to a state
47. Who will be benefited when there is a where debit side exceeds credit
43. Disinvestment of government appreciation in a foreign currency in side.
companies and borrowings from
terms of domestic currency? (c) Increase in investment from rest
World Bank comes under …… of of the world decreases the
(a) Importers
the government. exchange rate.
(b) Exporters
(a) total receipts (b) capital receipts (d) Devaluation of current items
(c) loan receipts improves trade balance of
(d) Neither (a) nor (b)
(d) revenue receipts domestic country.
ANSWERS
1. (a) 2. (c) 3. (d) 4. (b) 5. (c) 6. (b) 7. (a) 8. (a) 9. (c) 10. (d)
11. (c) 12. (d) 13. (c) 14. (d) 15. (b) 16. (b) 17. (b) 18. (c) 19. (c) 20. (a)
21. (c) 22. (a) 23. (c) 24. (c) 25. (a) 26. (d) 27. (d) 28. (c) 29. (b) 30. (d)
31. (c) 32. (b) 33. (c) 34. (d) 35. (b) 36. (a) 37. (d) 38. (b) 39. (b) 40. (d)
41. (c) 42. (d) 43. (b) 44. (a) 45. (a) 46. (a) 47. (b) 48. (d) 49. (c) 50. (b)
CUET (UG) Section II : Domain (Economics)
Practice Set 02
1. Which one of the following is not (a) Elasticity of demand 12. An increase in customers’ income
the feature of socialist economy? (b) Price elasticity of demand will have following impact on
(a) Social welfare (c) Income elasticity of demand supply curve
(b) Freedom of enterprise (d) Cross elasticity of demand (a) Lead to movement along supply
(c) Public ownership curve
7. Price elasticity of demand is ....... in
(d) Planning mechanism (b) Lead to shift in supply curve
number because price and quantity
(c) Lead to movement and shift along
2. The following headline appeared in demanded are inversely related.
supply curve
“Hindustan Times” dated 25th (a) positive (d) No impact on the supply curve
July, 2018, “Getting insurance for (b) negative
rain damage cars an uphill task”. (c) constant 13. Total Revenue is ` 400 when the
This statement is (d) prime price of the commodity is ` 2 per
(a) Positive Economics unit. When price rises to
8. What will be elasticity of demand ` 3 per unit, the quantity supplied
(b) Normative Economics on a linear demand curve below the is 300 units. Calculate the Price
(c) General Economics point using geometric method? Elasticity of Supply?
(d) None of these (a) Perfectly elastic (a) 0
3. Technique of production is focussed (b) Perfectly inelastic (b) – 1
in which central problem of (c) Inelastic (c) 1
economy? (d) None of these (d) ∞
(a) What to produce? 9. Supply schedule shows ...... 14. A firm supplies 500 units of a good
(b) How to produce? relationship between price and at a price of ` 5 per unit. The Price
(c) For whom to produce? quantity supplied of a commodity. Elasticity of Supply of a good is 2.
(d) Both (b) and (c) (a) positive (b) inverse At what price will the firm supply
4. Expansion and contraction in (c) negative (d) opposite 700 units?
demand are 10. Increase or decrease in supply (a) ` 5
caused by ...... . means (b) ` 1
(a) change in the income of buyer (a) change in supply due to change in (c) ` 6
(b) change in the taste and preference its own price. (d) ` 4
of the buyer (b) change in supply due to change in
(c) change in the price of the
15. Which of the following is/are the
factors other than its own price.
commodity feature(s) of utility?
(d) change in the prices of related (d) None of the above (a) Subjective in nature
goods (b) Depending upon of urgency of
11. Supply of a good depends upon wants
5. Movement along the demand curve (c) Both (a) and (b)
(i) Willingness to sell
is also known as (d) None of (a) and (b)
(ii) Ability to sell
(iii) Price of the good 16. Law of equi-marginal utility is
(c) change in demand of related goods
(iv) Time period called
(d) None of the above Choose from the options below (a) Law of increasing utility
(a) (i) and (ii) (b) Law of diminishing utility
6. ...... measures the change in (b) (iii) and (iv) (c) Law of substitution
demand of a commodity due to (c) (i), (ii) and (iii) (d) None of the above
change in its own price. (d) (i), (ii), (iii) and (iv)
PRACTICE SET 02 99
17. Which of the following is an 24. Which of the following are true 30. If the value of exports is ` 200 and
assumption of consumer about perfect competition value of imports is ` 250, there will
equilibrium (through utility (a) Infinitely large number of buyers be
analysis)? and sellers (a) Trade surplus of ` 50
(a) Rationality (b) Perfect substitute goods (b) Trade deficit of ` 50
(b) The cardinal measurability of (c) No price control by buyers or (c) Trade balance
utility sellers (d) None of these
(c) Constancy of the MU of money (d) All of the above
(d) All of the above 31. The individuals or institutions
25. What is the relation between which take decisions regarding
18. In which time period, all factors of support price and equilibrium consumption, production, budget,
production become variable and price? taxation, policy, etc are known as
factors of production change with (a) Support price is higher than the (a) producers (b) consumers
the change in level of production? equilibrium price
(c) government (d) All of these
(a) Long period (b) Market period (b) Support price is lower than the
(c) Short period (d) All of these equilibrium price 32. If GNP at MP is ` 5,200 and NNP
(c) Support price is equal to the at MP is ` 5,000, what will be the
19. Cost function explain the equilibrium price value of consumption of fixed
relationship between (d) No relation exists capital?
(a) income and expenditure (a) ` 5,000
26. Other things remaining the same,
(b) input and output (b) ` 5,200
when in a country the market
(c) fixed cost and variable cost (c) ` 200
price of foreign currency falls,
(d) output and cost of production (d) Can’t be determined
national income is likely …... .
20. When the firm is producing 3 tonnes (a) to rise 33. Which one of the following is
of sugar, it receives total revenue of (b) to fall included in circular flow?
` 24. Raising production to 4 tonnes, (c) Both (a) and (b) (a) Real Flow
increases total revenue to ` 28. (d) to remain unaffected (b) Money Flow
Thus, marginal revenue is ...... . (c) Both (a) and (b)
27. Balance of payments deficit is
(a) ` 4 (b) ` 8 (c) ` 28 (d) ` 52 (d) None of these
calculated by taking into account
21. Which of the following statement is the …… only. 34. Which of the following is/are the
true? (a) accommodating transactions method(s) of measuring national
(a) For a monopoly firm, average (b) autonomous transactions income?
revenue can be zero. (c) unilateral transactions (a) Income method
(b) For a monopoly firm, marginal (d) None of these (b) Product method
revenue can be zero or negative.
28. Choose the correct statement from (c) Expenditure method
(c) For a monopoly firm, marginal
revenue and average revenue are given below (d) All of these
identical. (a) Balance of trade is a component 35. Which one of the following is not
(d) For a monopoly firm, marginal of capital account of balance of true?
revenue and average revenue are payments.
(a) GNP = GDP + Depreciation
positively sloped. (b) Floating exchange rate is used to
(b) NNP = GNP + Depreciation
stabilise price of foreign
22. Imperfect competition is a type of currency. (c) NDP = GNP – Depreciation –
market structure showing some but NFIA
(c) Increase in the supply of foreign
not all features of competitive exchange rate leads to fall in its (d) GNP = NDP + Depreciation +
market. Which of the following price. NFIA
is/are imperfect competition? (d) Rise in exchange rate leads to 36. The difference between narrow
(a) Perfect competition revaluation of currency. money and broad money is …… .
(b) Monopolistic competition (a) coins and currency
29. How will a banking crisis in
(c) Oligopoly (d) Both (a) and (b) domestic country affects demand (b) only currency
23. An increase in demand with curve for foreign exchange? (c) saving deposits of banks
unchanged supply leads to ...... . (a) Demand for foreign exchange will (d) time deposits with banks
(a) rise in equilibrium price and fall in shift to the right 37. M1 and M2 measures of money
equilibrium quantity (b) Demand for foreign exchange will
supply issued by RBI are known as
(b) fall in both equilibrium price and shift to the left
(a) total money
quantity (c) There will be downward
(c) rise in both equilibrium price and (b) narrow money
movement along demand curve
quantity (c) broad money
(d) There will upward movement
(d) fall in equilibrium price and rise in along demand curve (d) high powered money
equilibrium quantity
38. A person can use more number of Calculate the total increase in (a) RBI (b) income tax
cheques if he has national income. (c) accounts (d) finance
(a) saving deposits account (a) ` 75 crore (b) ` 100 crore 47. Direct tax is called direct because it
(b) current account (c) ` 200 crore (d) ` 300 crore is collected directly from …… .
(c) fixed deposits account (a) the producers on goods produced
43. If national income is ` 50 crore
(d) recurring deposits account and saving is ` 5 crore, find out (b) the sellers on goods sold
39. Which of the following system is average propensity to consume. (c) the buyers of goods
followed by Reserve Bank of India for (a) 1 (b) 0.5 (c) 0.90 (d) 1.11 (d) the income earners
issuing currency?
44. If MPC = 1, the value of 48. The government starts selling its
(a) Minimum reserve system multiplier is …… . securities to private sector. What is
(b) Proportionate system this process called?
(a) 0
(c) Fixed fiduciary issue system (a) Open market operation
(d) Simple deposit system (b) 1
(b) Disinvestment
(c) Between 0 and 1
40. Choose the correct statement from (c) Monetary expansion
(d) infinity (d) None of these
given below
(a) Commercial banks creates credit out 45. …… is equal to the difference 49. A government budget shows a
of primary deposits. between ‘AD beyond full primary deficit of ` 6,500 crore. The
(b) Money multiplier is directly related employment’ and ‘AD at full revenue expenditure on interest
to legal reserve ratio. employment’. payment is ` 400 crore. How much
(c) Central bank of the country is not (a) Recession is the fiscal deficit?
authorised to maintain foreign (b) Inflationary gap (a) ` 6,500 crore
exchange reserve. (c) deflationary gap (b) ` 400 crore
(d) All of the above (d) None of the above (c) ` 6,800 crore
41. What can be the maximum value of 46. In India, the Constitution (d) ` 6,100 crore
marginal propensity to save? requires the Central Government 50. If borrowings and other liabilities
(a) 0 (b) 1 (c) 2 (d) 3 to prepare ‘Annual Financial are added to the budget deficit, we
42. In an economy, the marginal Statement’, i.e. government get
propensity to consume is 0.75. budget for the country as a (a) fiscal deficit
Investment expenditure in the whole. In India, …… department (b) primary deficit
economy increases by ` 75 crore. of government prepares annual (c) capital deficit
budget statement. (d) revenue deficit
ANSWERS
1. (b) 2. (a) 3. (b) 4. (c) 5. (a) 6. (b) 7. (b) 8. (c) 9. (a) 10. (b)
11. (d) 12. (d) 13. (c) 14. (c) 15. (c) 16. (c) 17. (d) 18. (a) 19. (d) 20. (a)
21. (b) 22. (d) 23. (c) 24. (d) 25. (a) 26. (b) 27. (b) 28. (c) 29. (a) 30. (b)
31. (d) 32. (c) 33. (c) 34. (d) 35. (a) 36. (d) 37. (b) 38. (b) 39. (a) 40. (a)
41. (b) 42. (d) 43. (c) 44. (d) 45. (b) 46. (d) 47. (d) 48. (b) 49. (c) 50. (a)
Accountancy 3
CHAPTER 01
Accounting for
Not-for-Profit Organisations
Introduction
Not-for-Profit Organisations (NPO) , also known as non-profit organisations, refer to those organisations that are
set-up for the welfare of the society and are set-up as charitable institutions which function without any profit motive.
Non-profit organisations are separate legal entity not owned by any individual or an enterprise. Examples of non-profit
organisations are clubs, hospitals, libraries, schools, societies for promotion of sports, arts and culture, etc.
Some non-profit organisations working in India are
● VOICE (New Delhi) ● Common Cause (New Delhi)
● Consumer Guidance Society of India (Mumbai) ● CERC (Common Education and Research Center) Ahmedabad
● CUTS (Consumer Utility and Trust Society) Jaipur
Accounting Records of Not-for-Profit Organisations

The main aim of these organisations is not to earn profit. Therefore, they do not prepare trading and profit and loss account.
But they are also required to maintain proper accounts and prepare financial statements to meet the statutory requirement
and to exercise proper control over the utilisation of their funds. The final accounts of non-profit- organisations comprise of
● Receipts and payments account (It records cash receipts and cash payments)
● Income and expenditure account (It records income and expenditure of a particular year)
● Balance sheet (It shows the financial position of the organisation)
Fund Based Accounting

The accounting where receipts and incomes relating to a particular fund are credited to that particular fund and payments
and expenses are debited to that particular fund, is known as fund based accounting.
These funds are created for specific purposes, e.g. prize fund, sports fund, library fund, building fund, endowment fund, etc.
If the fund account has a credit balance, it is shown in the balance sheet on the liabilities side. If the fund account has a debit
balance, i.e. the fund is less than the balance, it is transferred to the debit of income and expenditure account.
Classification of Funds
Funds may be classified as
● Unrestricted funds ● Restricted funds
Various types of restricted funds are as follows
(a) Endowment fund (b) Annuity fund (c) Loan fund (d) Fixed assets fund (e) Prize fund
Non-fund Based Accounting

This accounting system is generally followed by profit motive organisations and it is based on accrual basis of accounting.
Unlike the usage of specific funds, funds under this system can be used for any profit earning purpose. This system exhibts
the following features
● The business enterprise as a whole is treated as a separate entity.
● The combined resources of business entity can be used for any purpose of the business.
● In addition to regulating agencies, accountability in non-fund accounting is towards owners and consumers etc.
● Financial statements include trading account, profit and loss account and balance sheet.
● The final result of matching revenue with the expenses is either profit or loss.
● Expenditure must be as per the commercial principles. Preparation of budget is not necessary.
Receipts and Payments Account

The receipts and payments account is the summary of cash and bank transactions which helps in the preparation of income
and expenditure account. It is prepared at the end of the accounting period and is a summary of cash book, classifying
receipts and payments under various heads along with cash and bank balances in the beginning and at the end of the
accounting period. Receipts are recorded on the debit side and payments are recorded on the credit side of the account.
The account is maintained on cash basis of accounting.
Every receipt and payment, whether capital or revenue irrespective of the period, is recorded in this account. The purpose of
preparing this account is to ascertain cash in hand and cash at bank at the end of the year.
Features of Receipts and Payments Account

Following are the features of receipts and payments account
1. Nature Receipts and payments account is a real account in nature. It is basically a summary of the cash book.
2. Period In this account, all receipts and payments irrespective of the period to which they pertain, are shown.
3. Capital and Revenue All cash receipts and cash payments whether of capital nature or of revenue nature are included.
4. Distinction No distinction is made in receipts/payments, made in cash or through bank.
5. Adjustment of Non-cash Items Non-cash items such as depreciation, outstanding expenses, accrued income, etc.,
are not shown in this account.
6. Opening and Closing Balance It begins with opening balance of cash in hand and cash at bank (or bank overdraft)
and closes with the year end balance of cash in hand/cash at bank (or bank overdraft).
Format of Receipts and Payments Account

Dr for the year ended … Cr
Receipts Amt (`) Payments Amt (`)
To Balance b/d (Opening balance) By Balance b/d (Opening) …
Cash in Hand … (In case of bank overdraft)
Cash at Bank … Revenue Payments
Revenue Receipts By Salaries …
To Subscriptions (Present, past and future) … By Rent …
To Entrance Fees (In recurring nature) … By Postage Expenses …
To General Donations … By Advertisement Expenses …
To Locker’s Rent … By Newspapers and Magazines, etc. …
To General Grants … By Repairs …
To Sale of Newspapers, Grass, etc. … By Audit Fee …
To Interest on Investments … By Entertainment Expenses …
To Sale of Old Used Sports Materials … By Maintenance Expenses …
To Proceeds from Entertainment … By Insurance …
To Income from Concerts/Lectures … By Secretary’s Honorarium …
To Receipts from Show … By Lecturer’s Honorarium …
To Dividends … By Municipal Tax …
To Rent … By Gardening …
To Interest … By Prize Distributed …
To Miscellaneous Receipts … By Office Expenses …
Capital Receipts By Expenses on Show …
To Life Membership Fees … By Miscellaneous Payments …
To Subscriptions for Specific Purpose … Capital Payments
To Donation for Specific Purpose … By Purchase of Fixed Assets (e.g. Furniture) …
To Grant for Specific Purpose … By Sports Equipment …
To Entrance Fees (Non-recurring) … By Investments …
To Legacies … By Books …
To Endowment Fund … By Loan (Repayment) …
To Sale of Fixed Assets … By Building Construction …
Accountancy 5

To Receipts on Account of Special Fund, By Balance c/d (Closing balance)
i.e, Match Fund, Prize Fund, etc. … Cash in Hand …
To Balance c/d (closing) … Cash at Bank …
(in case of bank overdraft)
… …
Income and Expenditure Account

It is the summary of income and expenditure for the accounting year. It is a nominal account in nature and serves the same
purpose as the profit and loss account of a business organisation does.
It is prepared at the end of accounting period to ascertain the net operating results. All the revenue items relating to the
current period are shown in this account, the expenses and losses on the expenditure side and incomes and gains on the
income side of the account. It shows the net operating result in the form of surplus (i.e. excess of income over expenditure) or
deficit (i.e. excess of expenditure over income) which is transferred to the capital fund shown in the balance sheet. It is
prepared on the accrual basis.
Features of Income and Expenditure Account

Following are the features of income and expenditure account
1. Nature It is a nominal account.
2. No Capital Items No capital items are entered in this account.
3. Debit and Credit Sides Its debit side includes all the expenses pertaining to the particular period and credit side
includes all the incomes pertaining to the same period.
4. Opening and Closing Balances No opening and closing balances are recorded in it.
5. Only Current Period Items No item, either revenue or expenditure, pertaining to the past period or the future period
is entered in this account.
6. Similar to Profit and Loss Account This account is prepared in the same manner in which a profit and loss account
is prepared.
7. Surplus/Deficit Credit balance is called excess of income over expenditure, i.e. surplus and debit balance is called
excess of expenditure over income, i.e., deficit.
Format of Income and Expenditure Account

Income and Expenditure Account
Dr for the year ending … Cr
Expenditure Amt (`) Income Amt (`)
To Salaries … By Subscriptions …
(+) Outstanding at the End … (+) Outstanding at the End …
… (+) Advance in the Beginning …
(−) Outstanding in the Beginning (…) … …
To Rent … (−) Outstanding in the Beginning (…)
To Insurance Premium … …
(−) Prepaid (…) … (−) Advance at the End (…) …
To Audit Fees … By Entrance Fees (Only that amount …
To Printing and Stationery … which is treated as revenue)
To Honorarium … By Donations …
To Telephone Expenses … By Sale of Old Newspapers …
To Repairs … By Hall Rent …
To Depreciation on Building … By Sundry Receipts …
To Sports Material Used … By Deficit (Excess of Expenditure …
To Surplus (Excess of Income over … over Income)*
Expenditure)*
… …
*Either of the two will appear.

Balance Sheet
It is prepared by not-for-profit organisations to ascertain the financial position of the organisation. It is prepared on the same
pattern as that of the business entities. Balance sheet is prepared at the end of the accounting period after preparing income
and expenditure account.
Sometimes, balance sheet needs to be prepared at the beginning of the year in order to find out the opening balance of the
capital/general fund. The balance sheet shows assets on the right hand side and liabilities are shown on the left hand side
along with capital fund or general fund. The capital fund or general fund is in place of the capital and the surplus or deficit as
per income and expenditure account shall be added to/deducted from this fund.
Format of Balance Sheet

Balance Sheet
as at…
Liabilities Amt (`) Assets Amt (`)
Capital Fund Fixed Assets
Opening Balance … Building
(+) Surplus [or (−) Deficit] …/ (…) Opening Balance …
… (+) Additions …
(+) Entrance Fees
(Capitalised amount) … … (−) Depreciation (…) …
Building Fund Furniture
Opening Balance … Opening Balance …
(+) Donation for Building … (+) Additions …
Income from Building Fund … (−) Depreciation (…)
Investments … … Sale (…) …
Sports Fund Current Assets
Opening Balance … Cash in Hand …
(+) Donation for Sports Fund … Cash at Bank …
Interest on Sports Fund … Subscriptions in Arrear …
Investments … Accrued Interest …
… Investments
(−) Sports Prize Awarded (…) … Building Fund Investments …
Current Liabilities Sports Fund Investments …
Outstanding Expenses Prepaid Expenses
Rent … Insurance …
Salaries … Rent …
Electricity/Water Charges … …
Subscriptions Received in Advance …
… …
Important Items Relating to NPO

1. Subscriptions It is the membership fee paid by the members on annual basis. It is the main source of income of
non-profit organisations. Subscriptions relating to the current year whether received or not, are shown in the credit
side of income and expenditure account.
Subscriptions not received, i.e., outstanding are shown on the assets side of a balance sheet. Subscriptions received in
advance for the following year are shown on the liabilities side of a balance sheet.
Table Showing Calculation of Subscriptions
Particulars Amt (`)
Subscriptions received during the year (whether in respect of previous, current or future period) as
shown in receipts and payments account …
(+) Subscriptions outstanding at the end of the year …
Subscriptions received in advance in the beginning of the year … …
(–)Subscriptions outstanding in the beginning of the year (…)
Subscriptions received in advance at the end of the year (…) …
Subscriptions to be Shown in the Income and Expenditure Account …
Accountancy 7
2. Donations Donations are often received by charitable institutions. It is a sort of gift in cash or property
received from some person or organisation. Donation can be for specific purposes or general purposes.
(i) Specific Donation When the donations received are to be utilised for a specific purpose say, extension of the
existing building, construction of a new computer laboratory, creation of a book bank, etc it is called specific
donation. It should be capitalised and shown on the liabilities side of a balance sheet.
(ii) General Donation When donations are utilised to promote the general purpose of the organisation, they are
called as general donations. They are treated as revenue receipts, as it is a regular source of income. It is shown
on the income side of the income and expenditure account of the current year.
3. Legacies The amount received by a non-profit organisation as per the will of a deceased person is termed as legacy.
It is treated as a capital receipt and shown on the liabilities side. However, legacies of small amount may be treated as
income and shown on the income side of the income and expenditure account.
4. Entrance Fees Entrance fee, also known as admission fee, is paid only once by the member at the time of becoming
a member. As entrance fee is paid by a member only once, it is argued that it should be treated as a capital receipt and
transferred to capital fund. However, it should be treated as revenue receipt and credited to the income and
expenditure account, when the amount is small to cover the expenses of admission.
5. Life Membership Fees When lumpsum amount is paid by the members instead of paying periodic subscription, it is
termed as life membership fees. It is treated as a capital receipt and added to the capital fund/general fund on the
liabilities side of a balance sheet.
6. Sale of Old Assets Book value of an asset is credited to the asset account. Any profit on sale of an asset is credited
and any loss on sale of an asset is debited to income and expenditure account.
7. Sale of Periodicals It is an item of recurring nature and shown on the credit side of income and expenditure
account.
8. Sale of Sports Material Sports materials are consumable assets. Sale of sports material (used materials like old balls,
bats, nets, etc.) is the regular feature with any sport club. It is usually shown as an income in the income and
expenditure account.
9. Payment of Honorarium Honorarium is the amount paid to the person who is not an employee of the institution
and has voluntarily undertaken a service. It is debited to income and expenditure account.
10. Endowment Fund It is a fund arising from a bequest or gift, the income of which is devoted for a specific purpose.
Hence, it is a capital receipt and shown on the liabilities side of the balance sheet as an item of a specific purpose
fund.
11. Government Grants Various institutions like schools, colleges, public hospitals, etc depend on government grants
for their activities. Grants which are recurring in nature are treated as revenue receipt and credited to income and
expenditure account. However, grants of capital nature such as building grant are treated as capital receipt and
transferred to building account.
12. Special Funds Certain special funds are created for certain purposes/activities, e.g. prize funds, match fund, sports
fund, etc. The income earned from such funds is added to the respective fund and not credited to income and
expenditure account and also the expenses incurred on such specific purposes are also deducted from the special fund.
13. Special Receipts When there is a receipt of amount by non-profit organisations for special occasions, it is referred to
as special receipts. Such amounts are credited to a separate account and expenses against these receipts are debited to
it. The balance is transferred to the credit side of income and expenditure account.
14. Sale of Old Newspapers Amount which is realised by selling of old newspapers is treated as income and credited to
income and expenditure account.
15. Revenue Receipts Revenue receipts are shown on the credit side of income and expenditure account, e.g. rent,
interest on investment, proceeds from concerts, shows, etc.
16. Revenue Expenses Revenue expenses are incurred for performing day-to-day activities or expenses which are
recurring in nature, e.g. salary, rent, etc. It also includes expenses incurred on the maintenance of fixed assets,
e.g. repairs, depreciation, etc.
17. Capital Expenditures Capital expenditures are shown on the assets side of balance sheet, e.g. expenditure on
purchase of books, furniture, investments, building, etc.
18. Calculation of the Cost of Consumable Goods Consumable goods are the items which are consumed during the
year such as stationery, sports material, foodstuff, medicines, postage, etc.
Non-profit organisations have stock of consumable goods at the end of the year. The income and expenditure account
will show correct surplus/deficit, only if the goods consumed are debited to income and expenditure account and
closing stock is shown in the balance sheet.
The amount of goods consumed during the year is calculated as follows
Particulars Amt (`)

Opening Stock of Consumable Goods …
(+) Purchases During the Year …
(−) Closing Stock (…)
Balance (It is to be shown in the Income and Expenditure Account) …
Preparation of Income and Expenditure Account and

Balance Sheet from Receipts and Payments Account with Additional Information
Step 1 Prepare the opening balance sheet to find out the opening balance of capital fund (in case it is not given), taking
into account the opening cash and bank balances given in receipts and payments account and other assets and
liabilities given in additional information. The difference between the assets and liabilities is the capital fund or
general fund or accumulated fund.
Step 2 Identify from the receipts side, i.e. debit side of the receipts and payments account, the revenue receipts and the
capital receipts.
● Capital receipts are shown in the appropriate assets and liabilities account and then incorporated in the balance
sheet.
● Record the revenue receipts on the income side, i.e. credit side of income and expenditure account, after making
suitable adjustments so that all revenue receipts for the current year are shown.
Step 3 From the receipts and payments account, identify the revenue and capital payments from the payments side, i.e.
credit side.
● Capital payments are shown in the appropriate assets and liabilities account and then incorporated in the balance
sheet.
● Record the revenue payments on the expenditure side, i.e. debit side of the income and expenditure account, for
the current year after making necessary adjustments.

Step 4 There are certain items which do not appear in receipts and payments account but are to be recorded in income
and expenditure account. They are depreciation on fixed assets–it is to be shown on the debit side, loss on sale of
fixed assets–to be shown on the debit side, profit on sale of fixed assets–to be shown on the credit side.
Step 5 Surplus/Deficit in the income and expenditure account is calculated and transferred to the capital fund shown in
the balance sheet. Excess of income over expenditure is surplus and excess of expenditure over income is deficit.
Step 6 Prepare closing balance sheet by taking into consideration the opening balance of assets, liabilities and opening
capital fund, surplus/deficit, purchase and sale of assets during the year.
Solved Examples
1. Receipts and payments account of Friends Association disclosed that it has received ` 4,00,000 by way of
subscriptions during the year ended on 31st March, 2022.
Additional Information
Particulars Amt (`)
Subscription outstanding as on 1-4-2021 10,000
(Out of which ` 7,000 were received in 2021-22)
Subscription received in advance on 31-3-2021 6,000
Subscription received in advance on 31-3-2022 8,200
Show the amount of subscription that will appear in income and expenditure account for the year ending 31st
March, 2022 and the balance sheet as at that date if subscription outstanding for 2021-22 is ` 12,800.
Accountancy 9
Sol.
Particulars Amt (`)
Subscriptions received during the year 2021-22 4,00,000
(+) Received in advance on 31st March, 2021 6,000
(+) Outstanding for 2021-22 12,800
4,18,800
(–) Subscription related to previous year, received during the year (7,000)
(–) Received in advance on 31st March, 2022 (8,200)
Income from subscriptions for the year, 2021-22 4,03,600
Balance Sheet
as at 31st March, 2022
Subscription Received in Advance 8,200 Subscription Outstanding
For 2020-21 3,000
For 2021-22 12,800 15,800
2. Show, how will you deal with the following items while preparing the final accounts for the year ending on 31st
March, 2022 in each of the following alternative cases
(i) Prize awarded ` 12,000.
(ii) Prize awarded ` 12,000, prize fund as at 31st March, 2021 ` 25,000, donation received for prizes during the
year 2021-22, ` 10,000, 10% prize fund investment as at 31st March, 2021 ` 25,000 interest received on 10%
prize fund investment ` 2,500.
Sol. (i) There is no specific fund. Therefore, prize awarded ` 12,000 will be shown on the debit side of the income and
expenditure account.
(ii) Dr Prize Fund Account Cr
Particulars JF Amt (`) Particulars JF Amt (`)
To Prize Awarded 12,000 By Balance b/d 25,000
To Balance c/d 25,500 By Donations received for Prizes 10,000
By Interest on Prize Fund
Investments 2,500
37,500 37,500
Note
In the balance sheet, in the liabilities side, prize fund will be shown at ` 25,500.

10% prize fund investments would appear on the assets side of balance sheet at ` 25,000.
3. From the following particulars relating to the Ramkrishna Mission Charitable Hospital, prepare the income
and expenditure account for the year ended 31st March, 2022 and the balance sheet as at that date.
Dr for the year ended 31st March, 2022 Cr
To Cash in Hand on 1st April, 2021 7,130 By Medicines 30,590
To Subscriptions 47,996 By Doctor‘s Honorarium 9,000
To Donations 14,500 By Salaries 27,500
To Interest on Investments @ 7% for full Year 7,000 By Petty Expenses 461
To Receipt from Charity Show 10,450 By Equipment 15,000
By Expenses on Charity Show 750
By Cash in Hand on 31st March, 2022 3,775
87,076 87,076
On 1st April, On 31st March,
2021 (`) 2022 (`)
Subscriptions due 240 280
Subscriptions received in advance 64 100
Stock of medicines 8,810 9,740
Estimated value of equipment 21,200 31,600
Building (cost less depreciation) 40,000 38,000
Sol. Income and Expenditure Account

Expenditure Amt (`) Income Amt (`)
To Medicines Consumed By Subscription Received 47,996
Opening Stock 8,810 (+) Subscription Due at the End 280
(+) Purchase 30,590 (+) Subscription Received in
39,400 Advance in the Beginning 64
(−) Closing Stock (9,740) 29,660 48,340
To Doctor‘s Honorarium 9,000 (−) Due in the Beginning (240)
To Salaries 27,500 48,100
To Petty Expenses 461 (−) Advance at the End (100) 48,000
To Depreciation on Equipment By Donations 14,500
Opening Balance 21,200 By Interest on Investment 7,000
(+) Purchases 15,000 By Charity Show 10,450
36,200
(–) Closing Balance (31,600) 4,600
To Expenses on Charity Show 750
To Depreciation on Building 2,000
To Surplus (Balancing figure) 5,979
79,950 79,950
Balance Sheet
Subscription Received in Advance 100 Cash in Hand 3,775
Capital Fund Subscription Due 280
Opening Balance (WN) 1,77,316 Stock of Medicine 9,740
(+) Surplus 5,979 1,83,295 Investments 1,00,000
Equipment 31,600
Building 38,000
1,83,395 1,83,395
Working Note
Calculation of Opening Capital Fund
Balance Sheet
as at 1st April, 2021
Subscription Received in Advance 64 Cash in Hand 7,130
Capital Fund (Balancing figure) 1,77,316 Subscription Due 240
Stock of Medicine 8,810
Investments* (7,000 × 100 / 7) 1,00,000
Equipment 21,200
Building 40,000
1,77,380 1,77,380
Accountancy 11
Practice Questions
1 Which of the following is main source of income of Calculate the amount of subscription to be shown
non-profit organisation? in the income and expenditure account?
(a) Sale of old books (a) ` 96,000 (b) ` 1,11,400
(b) Sale of old furniture (c) ` 1,20,000 (d) ` 91,000
(c) Received subscription
(d) Business
9 What amount of rent will be transferred to debit
side of income and expenditure account, if rent
2 There are 500 members in Diamond Club, paying paid during the year was ` 70,000, rent
an annual subscription of ` 50 each. Subscription outstanding at the end of the year ` 6,000 and
received during the year ` 20,000 including ` 2,000 rent outstanding at the beginning of the year
for next year. Calculate amount to be shown as ` 8,000?
outstanding subscription. (a) ` 60,000 (b) ` 68,000 (c) ` 70,000 (d) ` 72,000
(a) ` 7,000 (b) ` 5,000
(c) ` 25,000 (d) ` 18,000 10 On 15th April, 2021, assets of Ashish club was as
follows
3 Donation can be
(a) general donation (b) specific donation Assets : Land and building ` 1,00,000, Cash in
(c) Both (a) and (b) (d) None of these hand ` 30,000, Furniture ` 65,000,
Subscription receivable ` 30,000.
4 In the final account of non-profit organisation,
Liabilities: Bank overdraft ` 1,25,000,
closing balance of cash will be recorded in
(a) receipt and payment account only
Outstanding salaries ` 15,000.
(b) balance sheet only Capital fund as on 1st April, 2021 will be
(c) income and expenditure account (a) ` 85,000 (b) ` 75,000
(d) receipt and payment account and balance sheet both (c) ` 1,10,000 (d) ` 8,000
5 In the absence of any specific information, 11 Consider the following information
entrance fees may be treated as Sports fund investment ` 70,000
(a) revenue receipt (b) capital receipt Donation for sports fund ` 15,000
(c) non-cash receipt (d) deferred receipt
Sports prizes awarded ` 10,000
6 Consider the following statements Expenses on sports events ` 8,000
I. Income and expenditure records both capital Income from sports fund investment ` 5,000
and revenue items. Calculate amount of sport fund that will be shown
II. Receipt and payment account records only in liability side of balance sheet.
revenue items during the year. (a) ` 40,000 (b) ` 38,000
Choose the correct option (c) ` 45,000 (d) ` 72,000
(a) Both are incorrect (b) Both are correct 12 Calculate the amount of locker rent to be transferred
(c) Only (i) is correct (d) Only (ii) is correct to income and expenditure account.
7 Find the cost of medicines consumed, if Particulars
31st March, 31st March,
Opening stock of medicines ` 30,000 2021 (`) 2022 (`)
Purchases during the year ` 50,000 Outstanding Locker Rent 9,200 12,600
Closing stock ` 20,000 Advance Locker Rent 6,000 8,000
(a) ` 80,000 (b) ` 60,000
(c) ` 50,000 (d) ` 40,000 Locker rent received during the year 2021-22,
` 64,000.
8 For the year ending 31st March, 2022, the
(a) ` 65,400 (b) ` 66,500
following entries appeared related to subscription (c) ` 66,000 (d) ` 73,000
received
Amt (`)
13 Opening balance of prize fund was ` 16,400.
During the year, donations received towards this
2020-21 5,000
2021-22 96,000
fund amounted to ` 7,700, while amount spent on
2022-23 10,400
prizes was ` 6,150 and interest received on prize
fund investment was ` 2,000. The closing balance
The club has 300 members, paying annual of prize fund will be
subscription of ` 400 each. Subscription outstanding (a) ` 28,250 (b) ` 32,250
on 31st March, 2021 was ` 8,000. (c) ` 19,950 (d) ` 15,950
14 Capital fund in non-profit organisation will be (c) Bank A/c Dr —

(a) Total Assets − Total Liabilities To Income and Expenditure A/c —
(b) Total Assets − External Liabilities (d) None of the above
(c) Total Assets − Internal Liabilities
(d) Total Fund − Total External Liabilities 24 Which of the following will be recorded in credit
side of receipts and payments account?
15 Receipt and payment account is the summary of (a) ` 300 received from entrance fees
(a) bank balance (b) capital account (b) Cash purchases of books ` 700
(c) cash book (c) Donation received ` 800
(d) income and expenditure account (d) Outstanding ` 300 for repair
16 The amount of subscriptions received in advance is 25 Profit or loss on sale of any fixed asset is treated as
shown in ……… in concern of NPOs.
(a) liabilities side (a) capital income or loss
(b) assets side of balance sheet (b) revenue income or loss
(c) payments side of receipts and payments account (c) not considered while preparing account
(d) None of the above (d) None of the above
17 Receipt and payment account generally shows 26 Pass the journal entry for Royal Dance Club, whose
(a) a debit balance (b) a credit balance deficit is calculated ` 91,000 during 2019-20.
(c) surplus and deficit (d) capital fund (a) Income and Expenditure A/c Dr 91,000
18 Item that should be debited in the income and To Deficit A/c 91,000
expenditure account of a college is (b) Deficit A/c Dr 91,000
(a) tuition fees received from students To Income and Expenditure A/c 91,000
(b) equipment purchased for science laboratory (c) Cash A/c Dr 91,000
(c) amount of reward To Income and Expenditure A/c 91,000
(d) fines collected from students (d) None of the above
19 Receipt and payment account shows 27 A non-profit organisation normally prepares ……

(a) income and expenditure (b) profit and loss before preparing balance sheet.
(c) saving and deficit (a) income and expenditure account
(d) cash receipts and payments (b) real account
(c) trading account
20 Funds raised by non-profit organisation for its (d) None of the above
operation are credited to
28 Debit balance in receipts and payments account
(a) Capital Fund of NPO (b) General fund of NPO
(c) Reserve Fund of Bank (d) Both (a) and (b) was shown as ` 80,000, subscription received
amounted to ` 9,600 out of which ` 3,000 is related
21 Which of the following cannot be recorded in the to next year. According to you, what amount will be
receipt and payment account of a club? shown in receipts and payments account?
(a) Payment made to workers (a) ` 80,000 (b) ` 89,600
(b) Sale of old newspaper (c) ` 9,600 (d) ` 86,600
(c) Loss on sale of fixed asset
(d) All of the above 29 What is an accounting treatment of cash received
for life membership fees?
22 Uttam Charitable gets surplus from his income and
(a) Debit in income and expenditure account
expenditure account of ` 65,000 in 2018-19. It will (b) Credit in income and expenditure account
be recorded in debit side of the ……… account. (c) To be shown in liabilities column of balance sheet
(a) receipts and payments (b) income and expenditure (d) To be shown in assets column of balance sheet
30 Which of the following is/are account(s) in NPO
23 Pass journal entry for subscription recorded in the where outstanding expenses, prepaid expenses, etc.
income and expenditure account. are not recorded?
(a) Income and Expenditure A/c Dr — (a) Income and expenditure account
To Subscription A/c — (b) Balance sheet
(b) Subscription A/c Dr — (c) Receipts and payments account
To Income and Expenditure A/c — (d) All of the above
ANSWERS
1. (c) 2. (a) 3. (c) 4. (d) 5. (a) 6. (a) 7. (b) 8. (c) 9. (b) 10. (a)
11. (d) 12. (a) 13. (c) 14. (a) 15. (c) 16. (a) 17. (a) 18. (b) 19. (d) 20. (d)
21. (c) 22. (b) 23. (b) 24. (b) 25. (b) 26. (b) 27. (a) 28. (b) 29. (c) 30. (c)
Accountancy 13
Hints & Solutions

2. Annual Subscription Amount (500 × 50) = 25,000 Capital Fund = Assets − Liabilities
= 2,25,000 − 1,40,000 = `85,000
(− ) Subscription Received for Current Year = (18,000)
(20,000 − 2,000) 11. Sports Fund = 70,000
Outstanding Subscription = ` 7,000 (+ ) Donation = 15,000
(− ) Sports prizes = (10,000)
7. Cost of Medicines Consumed
(− ) Expenses = (8,000)
= Opening Stock + Purchases − Closing Stock (+ ) Income from investment = 5,000
= 30,000 + 50,000 – 20,000
= ` 72,000
= ` 60,000
12. Locker rent paid during the year = 64,000
8. No item, either revenue or expenditure, pertaining to
the past period or future period is entered in the (+ ) Locker rent outstanding at
income and expenditure account. Only current period year end 2022 = 12,600
items are recorded. (+ ) Advance locker rent received in
∴ 300 Members × 400 each = ` 1, 20, 000 the year 2021 = 6,000
(− ) Outstanding locker rent in the
9. Rent paid during the year = 70,000 year 2021 = (9,200)
(+ ) Rent outstanding at the end = 6,000 (− ) Advance locker rent received
(− ) Rent outstanding at the beginning = (8,000) year end 2022 = (8,000)
Rent amount to be transferred to income Locker rent to be shown in income
and expenditure account = ` 68,000 and expenditure account = ` 65,400
10. Assets = Land and Building + Subscription 13. Closing Balance
Receivables + Funiture + Cash in Hand = Opening Balance + Donations Received
= 1,00,000 + 30,000 + 65,000 + 30,000 + Interest Received − Expenses
= `2,25,000 = 16,400 + 7,700 + 2,000 − 6,150 = `19,950
Liability = Bank Overdraft + Outstanding Salary 28. Amount transferred to receipts and payments account
= 1,25,000 + 15,000 = ` 1,40,000 will be = 80,000 + 9,600 = ` 89,600
CHAPTER 02
Accounting for Partnership :

Fundamentals
Meaning of Partnership It implies that his private assets can also be used for
paying off the firm’s debts.
When two or more persons join hands to set-up a business
and share its profits (including losses), then they are said to 7. Management and Control Every partner has a right
be in a partnership. to take an active part in the management of the firm.
According to Section 4 of the Indian Partnership Act, 8. Registration Registration of a partnership is not
1932, ‘‘Partnership is the relation between persons who have compulsory.
agreed to share the profits of a business carried on by all or
any of them acting for all.’’ Meaning of Partnership Deed
The persons who have entered into a partnership with one Partnership comes into existence as a result of agreement
another are individually called partners and partners among the partners. The agreement may be either oral or
collectively are known as firm. written. The document containing the terms and conditions
of the agreement in writing among partners is called the
Nature of Partnership ‘partnership deed’. It generally contains the details about all
Partnership is a separate business entity from accounting the aspects affecting the relationship between the partners.
point of view, but from a legal point of view, partnership firm
is not a separate legal entity from its partners, i.e. partners
Contents of Partnership Deed
and business are not separate from one another. A partnership deed generally contains the following details
● Name and address of all the partners
Features or Characteristics of Partnership ● Name and address of the firm
The essential features of partnership are ● Principal place of business
1. Two or More Persons Partnership is an association of ● Nature of business
two or more persons and all such persons must be ● Date of commencement of the partnership
competent to contract. ● Rules regarding operation of bank accounts
2. Agreement Partnership comes into existence by an ● Capital to be contributed by each partner
agreement. It can be written or oral.

● Interest on capitals and drawings
3. Lawful Business Agreement should be for the purpose ● Salary/Commission to partners

of carrying on a business and the business for which
● Profit and loss sharing ratio, etc.
partnership is formed must be legal.
4. Mutual Agency The business of the partnership can be Importance of Partnership Deed
carried on by all or by any one of them, acting for all. Partnership deed and its registration is not compulsory but
Partners are agents as well as the principals of the firm. it is always better to have the agreement in writing for the
5. Sharing of Profits The agreement between the following reasons
partners must be to share profits of a business. ● It helps in settling any dispute or doubt with regard to the
6. Liability of Partnership Each partner is liable terms of partnership.

individually and collectively with all other partners to ● It serves as an evidence in the court of law.
the third party for all the acts of the firm, while he is a ● It regulates the duties and powers of each partner.
partner. Also, liability of a partner is unlimited.

Accountancy 15
Provisions of the Indian Partnership Act, 1932 in the Absence of Partnership Deed
In the absence of partnership deed, the relevant provisions of the Indian Partnership Act, 1932 are as follows
(i) Sharing of profits/losses — Equally
(ii) Interest on capital — Not allowed
(iii)Salary/Commission to a partner — Not allowed
(iv)Interest on advances or loan by a partner — 6% per annum
(v) Interest on drawings — Not charged
Note Loan by a relative is not a loan from partner. Hence, on such loan, this provision will not apply.
In the absence of partnership deed, profits are to be shared equally irrespective of the type of partner (active, sleeping) or the amount of
capital contributed by them.
Maintenance of Capital Accounts of Partners

Capital accounts of partners can be maintained by the following two methods
1. Fixed Capital Method

Under this method, two accounts are maintained namely partners’ capital account and partners’ current account.
Transactions related to introduction and withdrawal of capital are recorded in capital accounts, rest of the transactions are
recorded in current accounts.
Capital account will always have credit balance and current account may have credit or debit balance.
Dr Partners’ Capital Account Cr
Particulars X (`) Y (`) Z (`) Particulars X (`) Y (`) Z (`)
To Cash/Bank A/c ... ... ... By Balance b/d ... ... ...
(Withdrawal of capital) By Cash/Bank A/c (Additional ... ... ...
To Balance c/d ... ... ... capital introduced)
... ... ... ... ... ...
Dr Partners’ Current Account Cr

*To Balance b/d (in case of ... ... ... * By Balance b/d (in case of ... ... ...
debit opening balance) credit opening balance)
To Drawings A/c ... ... ... By Interest on Capital A/c ... ... ...
To Interest on Drawings A/c ... ... ... By Commission A/c ... ... ...
*To Profit and Loss By Salary A/c ... ... ...
Appropriation A/c (Loss) … … … * By Profit and Loss
*To Balance c/d … … … Appropriation A/c (Profit) ... ... ...
*By Balance c/d … … …
... ... ... ... ... ...
2. Fluctuating Capital Method

Under fluctuating capital method, one account is maintained, i.e partners’ capital account. All transactions including
introduction and withdrawal of capital are recorded in capital account. Generally, capital accounts have credit balance but in
exceptional cases it may have debit balance due to heavy losses or drawings.
* To Balance b/d (in case of ... ... ... * By Balance b/d (in case of ... ... ...
debit opening balance) credit opening balance)
To Drawings A/c ... ... ... By Cash/Bank A/c (Additional ... ... ...
To Interest on Drawings A/c ... ... ... capital introduced)
* To Profit and Loss By Interest on Capital A/c ... ... ...
Appropriation A/c (Loss) ... ... ... By Commission A/c ... ... ...

* To Balance c/d ... ... ... * By Profit and Loss
Appropriation A/c (Profit) ... ... ...
* By Balance c/d ... ... ...
... ... ... ... ... ...
* Either of the two will appear.
Interest on Capital
Interest on capital is an appropriation of profits and is provided only if there is profit. It will be provided in case of loss also
only if partnership deed says so or it is to be treated as a charge against profits.
Different Cases Related to Interest on Capital

The various cases related to interest on capital are
Case 1 When partnership agreement is silent about interest on capital — Not allowed.
Case 2 When partnership agreement provides that interest on capital is to be allowed.
Situation 1 In case there is a loss — Not provided
Situation 2 In case there are sufficient profits — Fully allowed
Situation 3 If there are insufficient profits — Profits are to be distributed in the ratio of capital
Case 3 When partnership agreement says interest on capital is to be provided as a charge – Fully allowed
Note Interest on capital is always calculated on the opening balance of capital in a year.
In case the question gives closing capital, then opening capital will be calculated first by using the following formula
Opening Capital = Closing Capital + Drawings − Profit − Additional Capital
Interest on Partner’s Drawings

Case 1 When Fixed Amount is Withdrawn at Fixed Intervals
Rate of Interest Average Period
Interest on Drawings = Annual Drawings × ×
100 12
Quick view on value of time under different circumstances
Monthly Quarterly Half-yearly Monthly
Drawings Drawings Drawings Drawings
Particulars
for 12 for 12 for 12 for 6
Months Months Months Months
When drawings are made in the beginning of each period 6.5 7.5 9 3.5
When drawings are made in the middle of each period 6.0 6.0 6 3.0
When drawings are made in the end of each period 5.5 4.5 3 2.5
Case 2 When Unequal Amount is Withdrawn at Different Dates
Here, interest on drawings is calculated with the help of simple method or product method.
1. Simple Method In this method, interest on drawings is calculated for every individual drawings considering the time
for which it is used.
Rate of Interest Months Remaining
Interest on Drawings = Amount of Drawings × ×
100 12
2. Product Method In this method, individual drawings are multiplied by the months remaining in the year and
interest for one month is calculated on the total of such products.
Rate of Interest 1
Interest on Drawings = Total of Products × ×
100 12
Note When the rate of interest is given without the suffix per annum, interest will be charged without considering time or date of drawings.
If the question is silent regarding the time period of drawings, then interest on drawings is calculated for a 6 months period.
Accountancy 17
Accounting Treatment of Interest on Partner’s Loan to the Firm

Interest on partner’s loan is a charge against the profits and not an appropriation out of pofits and hence, must be transferred
to the debit of profit and loss account and not to the debit of profit and loss appropriation account.
If there is an agreement as to the rate of interest, partner is entitled to interest on loan at the agreed rate of interest. If there is
no agreement as to the rate of interest, partner is entitled to interest on loan @ 6% per annum. Interest on partner’s loan is
not recorded in the partner’s capital/current account but it should be recorded to the credit side of partner’s loan account.
Accounting Treatment of Salary or Commission to a Partner

Salary or commission to a partner is to be allowed if the partnership agreement provides for the same. Salary or commission
to a partner is an appropriation out of profits and not a charge against the profits, i.e., they are to be allowed only if there are
profits and hence must be transferred to the debit of profit and loss appropriation account and not to the debit of profit and
loss account.
1. Commission as Percentage of Net Profit before Charging such Commission
Rate of Commission
= Net Profit before Commission ×
100
2. Commission as Percentage of Net Profit after Charging such Commission
Rate of Commission
= Net Profit before Commission ×
100 + Rate of Commission
Note Charges such as interest on partners’ loans, manager’s salary and commission must be deducted from profit before transferring it to profit and
loss appropriation account.
Rent Paid to a Partner

It is a charge against the profit and not an appropriation out of profits. It is therefore debited to profit and loss account and
credited to partners’ current account in case of fixed capitals or to partners’ capital account when capitals are fluctuating.
Distribution of Profit among Partners through Profit and Loss Appropriation Account
Profit and loss appropriation account is an extension of the profit and loss account. It is an account that is prepared to
distribute the profits in accordance with the agreement among the partners. It is an account that shows appropriation or
distribution of profits.
Profit and Loss Appropriation Account
Dr for the year ended… Cr
Particulars Amt (`) Particulars Amt (`)
To Interest on Capital A/cs By Net Profit as per Profit and Loss A/c …
A … (Net profit subject to appropriations)
B … … By Interest on Drawings A/c
To Partners’ Salaries A/c … A …
To Partners’ Commission A/c … B … …
To Reserve A/c …
To Profit Transferred to
**A’s Capital A/c …
***(or A’s Current A/c)
**B’s Capital A/c …
***(or B’s Current A/c) …
… …
**When capitals are fluctuating. ***When capitals are fixed.

Solved Examples
1. Harish is a partner in a firm. He withdrew the following amounts during the year 2021.
Date Amt ( `)
1st February 4,000
1st May 10,000
30th June 4,000
31st October 12,000
31st December 4,000
1
Interest on drawings to be charged @ 7 % per annum. Calculate the amount of interest to be charged on
2
Harish’s drawings for the year ending 31st December, 2021 by product method.
Sol. Calculation of Interest on Harish’s Drawings
Date Amt (`) Period Product (`)
1st February, 2021 4,000 11 months 44,000
1st May, 2021 10,000 8 months 80,000
30th June, 2021 4,000 6 months 24,000
31st October, 2021 12,000 2 months 24,000
31st December, 2021 4,000 0 month —
Total 1,72,000
7.5 1
Interest = 1,72,000 × × = ` 1,075
100 12
2. A and B decided to start a partnership firm. They contributed capitals of ` 2,00,000 and ` 1,00,000 on 1st April,
2021. A expressed his willingness to admit C as a partner without capital, B agreed to this. On 1st October,
2021, B granted a loan of ` 1,20,000 to the firm.
The terms of partnership were as follows
(i) A, B and C will share profits in the ratio of 2 : 2 : 1.
(ii) Interest on capital @ 6% per annum. Interest on drawings @ 5%.
(iii) A to get a monthly salary of ` 6,000 and B to get salary of ` 4,000 per quarter.
(iv) 10% of the profits before charging interest on drawings but after making appropriations are to be
transferred to general reserve.
Due to shortage of capital, A contributed ` 50,000 on 30th September, 2021 and B contributed ` 20,000 on
1st January, 2022 as additional capital. The profit of the firm for the year ended 31st March, 2022 was
` 3,37,800. Drawings of A and B were ` 50,000 and ` 40,000 respectively.
Prepare profit and loss appropriation account for the year ending 31st March, 2022.
Sol. Profit and Loss Appropriation Account
To Interest on Capital A/c By Net Profit as per Profit and Loss A/c 3,34,200
A 13,500 (3,37,800 − 3,600)
B 6,300 19,800 By Interest on Drawings
To Partners’ Salary A 1,250
A (3,000 × 12) 36,000 B 1,000 2,250
B (4,000 × 4) 16,000 52,000
To General Reserve A/c 26,240
Accountancy 19

To Profit Transferred to Capital A/c
A 95,364
B 95,364
C 47,682 2,38,410
3,36,450 3,36,450
Working Note
1. Calculation of Interest on Capital
6 6 6
A On 2,00,000 = 2,00,000 × = ` 12,000; On 50,000 = 50,000 × × = `1,500
100 100 12
Total interest on A’s capital = 12,000 + 1 , 500 = `13,500
6 6 3
B On 1,00,000 = 1,00,000 × = ` 6,000; On 20,000 = 20,000 × × = ` 300
100 100 12
Total interest on B’s capital = 6,000 + 300 = ` 6,300
5 6 5 6
2. Calculation of Interest on Drawings A = 50,000 × × = ` 1 , 250 ; B = 40,000 × × = ` 1 , 000
100 12 100 12
3. Transfer to reserve = 10% of ` (3,34,200−19,800 − 52,000) = ` 26 , 240
4. Interest on loan = 1,20,000 × 6/100 × 6/12 = ` 3 , 600
3. Sameer and Yasmin are partners with capitals of `15,00,000 and `10,00,000 respectively. They agree to share
profits in the ratio of 3:2. Show how the following transactions will be recorded in the capital accounts of the
partners in case (i) The capitals are fixed (ii) The capitals are fluctuating
The books are closed on 31st December every year.
Particulars Sameer (`) Yasmin (`)
Additional Capital Contributed on 1st July, 2022 3,00,000 2,00,000
Interest on Capital 5% 5%
Drawings (during 2022) 30,000 20,000
Interest on Drawings 1,800 1,200
Salary 20,000 7,000
Commission 10,000 —
Share in Loss for the Year 2022 60,000 40,000
Sol. (i) Fixed Capital Method

Date Particulars LF Sameer (`) Yasmin (`) Date Particulars LF Sameer (`) Yasmin (`)
To Balance c/d 18,00,000 12,00,000 By Balance b/d 15,00,000 10,00,000
By Bank A/c 3,00,000 2,00,000
(Additional capital)
18,00,000 12,00,000 18,00,000 12,00,000
Dr Partners’ Current Account Cr

To Drawings A/c 30,000 20,000 By Interest on Capital A/c 82,500 55,000
To Interest on Drawings A/c 1,800 1,200 By Partners’ Salary A/c 20,000 7,000
To Profit and Loss By Commission A/c 10,000 —
Appropriation A/c (Loss) 60,000 40,000
To Balance c/d 20,700 800
1,12,500 62,000 1,12,500 62,000
(ii) Fluctuating Capital Method

To Drawings A/c 30,000 20,000 By Balance b/d 15,00,000 10,00,000
To Interest on By Bank A/c 3,00,000 2,00,000
Drawings A/c 1,800 1,200 (Additional capital)
To Profit and Loss A/c 60,000 40,000 By Interest on Capital A/c 82,500 55,000
To Balance c/d 18,20,700 12,00,800 By Salary A/c 20,000 7,000
By Commission A/c 10,000 —
19,12,500 12,62,000 19,12,500 12,62,000
Working Note
Calculation of Interest on Capital Amt (`)
5
Sameer 5% on ` 15,00,000 for 1 year = 15,00,000 × = 75,000
100
6 5
5% on ` 3,00,000 for 6 months = 3,00,000 × × = 7,500
12 100
82,500
5
Yasmin 5% on ` 10,00,000 for 1 year = 10,00,000 × = 50,000
100
6 5
5% on ` 2,00,000 for 6 months = 2,00,000 × × = 5,000
12 100
55,000
Practice Questions
1 Under what circumstances, a partner can get 5 A partner withdrew ` 4,000 per month from 1st July,
exemption from sharing losses in a firm? 2020, on beginning of every month. Accounts are
(a) If he is a senior citizen closed at 31st March, 2021. Calculate interest on
(b) If he is a minor drawings while rate of interest is 10% per annum.
(c) If he is retiring partner (a) ` 1,600 (b) ` 1,800
(d) All of the above (c) ` 1,500 (d) ` 2,200
2 Why a partnership firm needs partnership deed? 6 In a firm, 10% of net profit after deducting all
(a) It acts as a proof in any dispute adjustments, including reserve is transferred to
(b) It regulates rights of partners general reserve. The net profit after all
(c) It represents duties and liabilities of partners adjustments but before transfer to general reserve
(d) All of the above is ` 44,000. Calculate the amount which is to be
3 Need of profit and loss adjustment account is for
transferred to reserve.
(a) ` 2,500 (b) ` 4,000
(a) appropriation of profits
(c) ` 4,400 (d) ` 2,200
(b) charge against profits
(c) rectification of errors or omissions 7 Where a partner is entitled to interest on capital
(d) None of the above contributed by him, such interest will be payable
(a) only out of profits
4 Loan has been given by wife of a partner to the
(b) only out of capital
firm. Now partner wants interest @ 6% per annum (c) Both (a) and (b)
as per Partnership Act, 1932 while partnership (d) None of the above
deed is silent. Solve this issue.
8 A charitable dispensary is run by 8 members.
(a) Provide 6% per annum interest as partnership act
says
A new member wants to join them. The new
(b) Provision of interest on loan @ 6% per annum of the member is of the opinion that partnership deed
partnership act does not apply must be written while other members refused to do
(c) Provide 10% interest to solve the issue that. They said this is not a partnership. Give
(d) None of the above reason(s) in favour of other members.
Accountancy 21
(a) There is no business 13 A, B and C are partners sharing profits equally. A

(b) There is no sharing of profits drew regularly ` 4,000 in the beginning of every
(c) There is no motive of profit making
month for the six months ended 30th September,
2021. Calculate interest on A’s drawings @ 5% p.a.
9 Virat and Anushka are partners in a firm sharing (a) ` 200 (b) ` 1,200
profits and losses in 2 : 1 ratio. Their capital balance (c) ` 350 (d) ` 700
were ` 10,00,000 and ` 8,00,000 respectively. 14 If a partner withdraws equal amount at end of each
The firm made profits during the year amounting to quarter, then ……… are to be considered for
` 3,45,000. Both partners are allowed salary of interest on total drawings.
` 2,500 per month. (a) 5.5 months (b) 6 months
Interest on capital is allowed @ 5% on capital (c) 4.5 months (d) 7.5 months
balance. 15 With context to debit side of partners’ current
Calculate closing balance of capital for Virat and account, pick the odd one out.
Anushka. (a) Drawings (b) Interest on Drawings
(a) V = ` 12,10,000, A = ` 9,35,000 (c) Salary (d) None of these
(b) V = ` 12,35,000, A = ` 9,10,000 16 No interest is to be charged on drawings from the
(c) V = ` 13,10,000, A = ` 9,85,000 partners in case of ……… .
(a) no interest clause in deed
10 The partnership agreement between Mahesh and (b) absence of deed
Ramesh provides that (c) an oral agreement between partners including
interest clause
(i) profits will be shared equally. (d) Both (a) and (b)
(ii) Mahesh will be allowed a salary ` 400 per 17 In a partnership, commission to partners will be
month. given from
(iii) Ramesh is allowed a commission @ 10% on net (a) current year’s profit (b) reserves
profits before adjusting any remuneration. (c) goodwill (d) Any of them
(iv) 10% per annum interest will be charged on 18 In the context of debit side of profit and loss
drawings. appropriation account, pick odd one out.
(v) their annual drawings were ` 16,000 and (a) Interest on Capital
` 14,000 respectively. (b) Partners’ Salaries
(c) Interest on Drawings
Net profit before above adjustments are
(d) Partner’s Commission
` 40,000. Calculate profits to be distributed
between partners. 19 If partners’ capitals are fixed, drawings will be
(a) ` 34,200 (b) ` 32,700 recorded in
(c) ` 47,300 (d) ` 29,700 (a) partners’ capital account
(b) partners’ current account
11 The capital balance of a partner at the end of the (c) profit and loss appropriation account
year (after adjusting for his drawings ` 3,500 and (d) None of the above
his share in the profit ` 2,300) is ` 12,000. Interest
on capital is payable to him at 5% per annum. What 20 In the profit and loss appropriation account, net
will be the amount of interest on capital? profit is always taken after
(a) ` 660 (b) ` 600 (a) interest on partner’s loan
(c) ` 540 (d) None of these (b) manager’s commission
12 Aman is a partner of Jivan firm with a fixed capital (d) None of the above
of ` 9,00,000. He withdrew ` 60,000 during
21 Partners’ current account is maintained under
financial year 2020-21. What will be the journal (a) fixed capital method
entry? (b) fluctuating capital method
(a) Drawings A/c Dr 60,000 (c) Both (a) and (b)
To Aman’s Current A/c 60,000 (d) cumulative capital method
(b) Drawings A/c Dr 60,000
To Aman’s Capital A/c 60,000 22 Which of the following items is not dealt through
(c) Aman’s Current A/c Dr 60,000
profit and loss appropriation account?
To Drawings A/c 60,000 (a) Interest on Partner’s Loan
(b) Partner’s Salary
(d) Aman’s Capital A/c Dr 60,000 (c) Interest on Partner’s Capital
To Drawings A/c 60,000 (d) Partner’s Commission
23 Pick the odd one out (b) Sonu’s Capital A/c Dr 1,46,250
(a) Rent to Partner Monu’s Capital A/c Dr 1,46,250
(b) Manager’s Commission To Profit and Loss Appropriation A/c 2,92,500
(c) Interest on Partner’s Loan (c) Profit and Loss Appropriation A/c Dr 32,500
(d) Interest on Partner’s Capital To Monu’s Capital A/c 16,250
To Sonu’s Capital A/c 16,250
24 Features of a partnershjip firm include
(a) two or more persons are carrying common business
under an agreement. 28 Current account of a partner has ……… .
(b) they are sharing profits and losses in the fixed ratio. (a) debit balances
(c) business is carried by all or any of them acting for (b) credit balances
all as an agent. (c) Either (a) or (b)
(d) All of the above (d) None of the above
25 In case of partnership, the act of any partner is 29 Pinky and Chinky are partners in a firm. They
(a) binding on all partners share their profits in 2 : 3 ratio. The accountant of
(b) binding on that partner only the firm, finalised the profit and loss and capital
(c) binding on all partners except that particular account and presented the accounts to them.
partner
(d) None of the above Pinky disagreed with accounts because Pinky’s
capital account showed negative balance. Pinky is
26 Following are essential elements of a partnership
in doubt, this cannot happen. Give your opinion.
firm except (a) Pinky is wrong
(a) atleast two persons (b) Pinky is correct
(b) there is an agreement between all partners (c) Accountant is defaulter
(c) equal share of profits and losses (d) None of the above
(d) partnership agreement is for some business
30 Manager’s commission of ABC Ltd. (Partnership)
27 The firm of Sonu and Monu earned a profit of
was `33,000. What amount of net profit in
` 3,25,000 during the year ending on 31st March, manager’s commission was to be charged @10%
2019. They have decided to donate 10% of this before charging such commission?
profit to an NGO working for senior citizens. Pass (a) ` 3,30,000
the journal entry. (b) `3,00,000
(a) Profit and Loss Appropriation A/c Dr 2,92,500 (c) ` 3,000
To Sonu’s Capital A/c 1,46,250 (d) ` 3,300
To Monu’s Capital A/c 1,46,250
ANSWERS
1. (b) 2. (d) 3. (c) 4. (b) 5. (c) 6. (b) 7. (a) 8. (d) 9. (a) 10. (b)
11. (a) 12. (c) 13. (c) 14. (c) 15. (c) 16. (d) 17. (a) 18. (c) 19. (b) 20. (c)
21. (a) 22. (a) 23. (d) 24. (d) 25. (a) 26. (c) 27. (a) 28. (c) 29. (a) 30. (a)
ACCOUNTANCY 23
Hints & Solutions

5. Interest on Drawings = Amount × No. of Months of 11. Capital at the Beginning
Rate of Interest Average Period = Capital at the End + Drawings − Proft
Drawings × ×
100 12 = 12,000 + 3, 500 − 2,300
Where, = `13,200
Time Left after First Drawings 5
+ Time Left after Last Drawings Interest on Capital = 13, 200 × = ` 660
∴ Average Period = 100
2
13. Interest on A’s Drawings
6. 10% is to transfer after all adjustments (including Rate of Interest Average Period
such transfer). This can be ascertained using the = Total Drawings × ×
100 12
following formula. 5 3.5
Rate 10 = 4,000 × 6 × × = `350
Net Profit × = 44,000 × = ` 4,000 100 12
100 + Rate 110
14. Time Period
7. Interest on capital is an appropriation of profits and is Time Left after First Drawings
provided only if there is profit. + Time Left after Last Drawings
=
8. For partnership, there must be a business but in the 2
question a member wants to join a charitable 9+ 0
= = 4.5 months
dispensary. Also, they work to provide social service 2
and not to earn profits.
17. Commission to partner is an appropriation item.
9. Appropriation is done from current year’s profit only.
Particulars
Virat Anushka 18. It is income for firm charged against drawings of
(`) (`) partners.
Opening Capital 10,00,000 8,00,000
22. Interest on partner’s loan is a charge against the
(+) Salary to Partners 30,000 30,000
profits and not an appropriation out of profits. Thus, it
(+) Interest on Capital 50,000 40,000
(+) Divisible Profits (Total Profits − Salary is not dealt through profit and loss appropriation
account.
− Interest on Capital) divided in 2 : 1 ratio 1,30,000 65,000
[3,45,000 − 60,000 − 90,000] = `1,95,000 23. Interest on partner’s capital is an appropriation out of
divided in the ratio of 2 : 1 profits and rest are charges against profits.
Closing Capital 12,10,000 9,35,000 28. Current account can have credit balance in case of
10. profits and other items of appropriation of profits.
However, it can also have debit balance in case of over
Particulars Amt (`)
withdrawn amount or too many debit items being
Net Profits as per Profit and Loss Account 40,000
charged to it.
(+) Interest on Drawings
29. Pinky is wrong because if debit side of the partner’s
Ramesh 14,000 × × 
10 6
700 capital account is more than its credit side, then it
 100 12
shows negative balance.
Mahesh 16,000 × × 
10 6
800 1,500
 100 12 30. Let profit be Z
(−) Salary to Mahesh (12 × 400) 10
(4,800) =Z× = 33,000 (Since ‘before’ given)
(−) Commission to Ramesh  40,000 ×
10  (4,000) 100
 Z = ` 3,30,000
 100 
Divisible Profits 32,700
CHAPTER 03
Accounting for
Partnership : Goodwill
Meaning of Goodwill 4. Market Situation If a firm deals in a business where
the demand for the products is higher than the supply,
Goodwill is the good name or reputation of a business
it will lead to lower capital requirement and higher
which helps it to earn more profits than others. Goodwill is
profit. It will thus, increase the value of goodwill.
earned by a firm through the hardwork and honesty of its
owners. 5. Special Advantages Firms enjoying special advantages
(like import licenses, favourable and long-term
Nature of Goodwill contracts for supply of materials, low rate and assured
Goodwill is an intangible asset (an asset which cannot be supply of electricity, patents, etc.) enjoy higher value of
seen and touched) and not a fictitious asset, because it has a goodwill.
realisable value and fictitious assets don’t have a realisable
value. Goodwill can be sold, but sale of goodwill is possible Classification of Goodwill
only along with the sale of business. Goodwill can be classified into two categories
1. Purchased Goodwill It is the goodwill that is acquired
Characteristics or Features of Goodwill by a business after paying consideration in cash or in
● It is an intangible and valuable asset. kind. As per Accounting Standard-26, it is recorded in
● It helps in earning excess profits. the books of accounts because consideration in money
● Its value is liable to constant fluctuation. or money’s worth is paid for it.
● It is valuable only when entire business is sold. 2. Self-generated Goodwill It is the internally generated
● It is difficult to place an exact value of goodwill. or hard earned goodwill which arises due to continued
hard work of the organisation, its better quality
Factors affecting the Value of Goodwill products, better customer service, etc. As per
Goodwill is directly related to profits. A firm earning profits Accounting Standard-26, it is not recorded in the books
higher than others will certainly have goodwill in the because no consideration in money or money’s worth is
market. So, to decide whether a factor affects goodwill or paid for it.
not, we will have to see whether, it affects the profits. If it
affects the profit, then it will also affect goodwill. Methods of Valuation of Goodwill
Factors affecting goodwill are Since goodwill is an intangible asset, it is very difficult to
accurately calculate its value. Various methods are available
1. Nature of Business If the nature of the products, in
for the valuation of goodwill of a partnership firm.
which the firm deals, are in high demand, the profit of
the firm will be higher and therefore the value of Goodwill calculated by one method may differ from the
goodwill will increase. goodwill calculated by another method.
2. Efficiency of Management If the management is The important methods of valuation of goodwill are as
capable and competent, the firm will earn high profits. follows
It will thus, increase the value of goodwill. 1. Average Profit Method
3. Location If the business is located at a favourable Goodwill under average profit method can be calculated
place, it will result in good sales and also increase in using simple average profit method or weighted average
the value of goodwill. profit method.
Accountancy 25
(i) Simple Average Profit Method

Value of Goodwill = Average Profit × Number of Years’ Solved Examples
Purchase 1. Compute the value of goodwill on the basis of four
Average Profit years’ purchase of the average profits based on the
Total Actual Profits of given Number of Years last five years. The profits for the last five years
before Abnormal and Non-business Items were as follows
=
Given Number of Years Year Amt (`)
(ii) Weighted Average Profit Method 2013 40,000
2014 50,000
Value of Goodwill = Weighted Average Profit × Number
2015 60,000
of Years’ Purchase
2016 50,000
Total of Products
Weighted Average Profit = 2017 60,000
Total of Weights
Sol. Goodwill = Average Profit × Number of Years’ Purchase
2. Super Profit Method Average profit of last 5 years
In any business, a certain amount or percentage of profits is 40,000 + 50,000 + 60,000 + 50,000 + 60,000
normally expected. But in practice we may earn more than that =
5
normal profit or we may earn less than that normal profit. 2,60,000
= = ` 52,000
5
Excess of actual profits over the normal profits is called
Goodwill = 52,000 × 4 = ` 2,08,000
super profits. In this method, goodwill is calculated by
multiplying super profit by a certain number of years given. 2. The profits of a firm for the year ended 31st March
If super profit is negative or zero, it means that actual for the last four years were : 2019 ` 1,01,000; 2020
average profit is equal to or less than normal profit. In that ` 1,24,000; 2021 ` 1,00,000 and 2022 ` 1,50,000.
case goodwill of the firm would be zero or nil because Calculate the value of goodwill of the firm on the
goodwill cannot be negative. basis of 3 years of the weighted average profits
after assigning weights 1, 2, 3, 4.
Value of Goodwill = Super Profit × Number of Years’ Purchase
Normal Profits = Average Capital Employed Additional Information
Normal Rate of Return (i) A major plant repair was undertaken on 1st
× September, 2021 for ` 30,000, which was
100
Capital Employed (Net Assets) charged to revenue. The said sum is to be
capitalised for goodwill calculation subject to
= Total Assets (excluding goodwill and all fictitious adjustment of depreciation of 10% p.a on
assets) − External Liabilities Super Profits reducing balance method.
= Average (Actual) Profits − Normal Profits
(ii) Closing stock for the year 2020 was overvalued
3. Capitalisation Method by ` 12,000.
Under this method, goodwill can be calculated in two ways (iii) To cover management cost an annual charge of
(i) Capitalisation of Average Profit In this method, ` 24,000 should be made for the purpose of
goodwill of the firm is calculated by deducting capital valuation of goodwill.
employed (net assets) in the business from the Sol. Calculation of Adjusted Profits
capitalised value of average (actual) profits on the basis 2019 Amt (`)
of normal rate of return. Profit 1,01,000
Capitalised value of the business is ascertained by (−) Management Cost (24,000)
capitalising profits earned at the normal rate of profit. 77,000
Value of Goodwill = Capitalised Value of Average Profits 2020
− Actual Capital Employed Profits 1,24,000
Capitalised Value of Average Profits (−) Management Cost (24,000)
100 (−) Overvaluation of Stock (12,000)
= Average Profits ×
Normal Rate of Return 88,000
Actual Capital Employed = Total Assets (excluding 2021
goodwill and all fictitious assets) − External Liabilities Profits 1,00,000
(−) Management Cost (24,000)
(ii) Capitalisation of Super Profit In this method,
goodwill is calculated by the capitalisation of super (−) Unprovided Depreciation (1,000)
profits on the basis of normal rate of return. (+) Capital Expenditure 30,000
100 (+) Overvaluation of Opening Stock 12,000
Goodwill = Super Profits ×
Normal Rate of Return 1,17,000
2022 Goodwill, being two years’ purchase of super profit

Profits 1,50,000 = 30,000 × 2 = ` 60,000
(−) Management Cost (24,000)
4. A firm earns ` 1,20,000 as its annual profit, the
(−) Unprovided Depreciation (2,900) normal rate of profit being 10%. Assets of the firm
1,23,100 are ` 14,40,000 (excluding goodwill) and liabilities
Calculation of Weighted Average Profits are ` 4,80,000. Find the value of goodwill by
capitalisation method.
Year Profit (`) Weights Product (`) Sol. Total capitalised value of the firm
Average Profit
2019 77,000 1 77,000 = × 100
Normal Rate of Profits
2020 88,000 2 1,76,000 1,20,000
2021 1,17,000 3 3,51,000 = × 100 = ` 12,00,000
10
2022 1,23,100 4 4,92,400 Net assets of the firm
Total 10 10,96,400 = Total Assets − Liabilities
10,96,400 =14 ,40,000 − 4 ,80,000 = ` 9,60,000
Weighted Average Profit = = `1, 09, 640 Goodwill = Total Capitalised Value of Business
10
Goodwill = 1 ,09,640 × 3 = ` 3,28,920 − Net Assets
= 12,00,000 − 9,60,000 =` 2,40,000
Working Note
1. Depreciation of 2021 for 4 months 5. Average profit of the firm is ` 3,00,000. Total
10 4 tangible assets in the firm are ` 28,00,000 and
= 30,000 × × = ` 1,000 outside liabilities are ` 8,00,000. In the same type
100 12
of business, the normal rate of return is 10% of the
2. Depreciation of 2022
capital employed. Calculate value of goodwill by
= 10% of (30,000 − 1,000) = ` 2, 900 capitalisation of super profit method.
3. Average net profit of Varsha Ltd. expected in the Sol. Capital employed
future is ` 1,08,000 per year. The average capital = Total Tangible Assets – Outside Liabilities
employed in the business is ` 6,00,000. Normal = 28 ,00 ,000 – 8 ,00 ,000 = ` 20 ,00 ,000
profit expected from capital invested in this class Normal Profit = Capital Employed × Normal Rate of Return
of business is 10%. The remuneration of the 10
= 20,00,000 × = ` 2,00,000
partners is estimated to be ` 18,000 per annum. 100
Find out the value of goodwill on the basis of two *Super Profit = Average Profit − Normal Profit
years’ purchase of super profit. = 3,00,000 – 2,00,000 = `1,00,000
Sol. Average annual profit ` 1,08,000
Super P rofit *
(−) Partners’ remuneration ` 18,000 Goodwill = × 100
Normal R ate of Return
Normal profit on capital
employed (6,00,000 × 10/100) ` 60,000 ` (78,000) =
1,00,000
× 100 = ` 10,00,000
Annual super profit ` 30,000 10
Practice Questions
1 Nature of goodwill is 4 Find out those situations which create need for
(a) intangible asset (b) fictitious asset valuation of goodwill for a partnership firm?
(c) long-term liability (d) current asset (a) When existing partners change their profit sharing
ratio
2 Which of the following is/are method(s) of
(b) When a new partner comes into partnership
valuation of goodwill? (c) When an existing partner retires from partnership
(a) Average profit method (b) Super profit method (d) All of the above
(c) Capitalisation method (d) All of these
5 Find out that goodwill which is accounted for, as
3 Which of the following factor(s) affect goodwill?
per Accounting Standard 26.
(a) Nature of business
(a) Purchased goodwill
(b) Efficiency of management
(b) Self-generated goodwill (c) Both (a) and (b)
(c) Location (d) All of these
(d) Goodwill brought in by a partner
Accountancy 27
6 The profits for last 3 years were 12 The goodwill of the firm not affected by
1st year = ` 6,000 (including abnormal gain (a) location of the firm
(b) reputation of firm
` 2,000)
(c) better customer service
2nd year = ` 4,000 (after charging abnormal loss (d) None of the above
` 3,000)
13 Weighted average method of calculating goodwill is
3rd year = ` 2,500 (including abnormal income used when
` 1,500) (a) profits are not equal (b) profits show a trend
Calculate goodwill on the basis of 3 years’ (c) profits are fluctuating (d) None of these
purchase of last 3 years profits and losses. 14 The profits earned by a business over the last 5
(a) ` 12,500 (b) ` 12,000 years are ` 12,000; ` 13,000; ` 14,000; `18,000; and
(c) ` 13,000 (d) ` 16,000 ` 2,000 (loss). Based on 2 years purchase of the last
7 Capital employed in a business is ` 2,00,000. 5 years profits, value of goodwill will be
Normal rate of return on capital employed is 15%. (a) ` 23,600 (b) ` 22,000
During the year, the firm earned a profit of (c) ` 1,10,000 (d) ` 1,18,000
` 48,000. Calculate goodwill on the basis of 15 Under the capitalisation method, the formula for
3 years’ purchase of super profit. calculating the goodwill is
(a) ` 54,000 (b) ` 60,000 (a) super profits multiplied by the rate of return
(c) ` 50,000 (d) None of these (b) average profits multiplied by the rate of return
8 A firm earns ` 1,20,000 as its annual profits. The (c) super profits divided by the rate of return
(d) average profits divided by the rate of return
normal rate of profit being 10%. Assets of firm are
` 14,40,000 and liabilities are ` 4,40,000. Find 16 The net assets of a firm including fictitious assets
value of goodwill by capitalisation method. of ` 5,000 are ` 85,000. The net liabilities of the
(a) ` 4,00,000 (b) ` 2,80,000 firm are ` 30,000. The normal rate of return is 10%
(c) ` 2,00,000 (d) ` 3,60,000 and the average profits of the firm are ` 8,000.
9 Average profit of firm is ` 3,00,000. Total tangible Calculate the goodwill as per capitalisation of
assets in the firm are ` 28,00,000 and outside super profits.
liabilities are ` 8,00,000. In same type of business, (a) ` 20,000 (b) ` 30,000
(c) ` 25,000 (d) None of these
normal rate of return is 10% of capital employed.
Calculate goodwill by capitalisation of super profit 17 Total capital employed in the firm is ` 8,00,00,
method. reasonable rate of return is 15% and profit for the
(a) ` 14,00,000 (b) ` 16,00,000 year is ` 12,00,000. The value of goodwill of the
(c) ` 18,00,000 (d) ` 10,00,000 firm as per capitalisation method would be
10 Which of the following is not true in relation to (a) ` 82,00,000 (b) ` 12,00,000
(c) ` 72,00,000 (d) ` 42,00,000
goodwill?
(a) It is an intangible asset 18 The average capital employed of a firm is
(b) It is fictitious asset ` 4,00,000 and the normal rate of return is 15%.
(c) It has a realisable value The average profit of the firm is ` 80,000 per
(d) None of the above annum. If the remuneration of the partners is
11 When goodwill is not purchased, goodwill account estimated to be ` 10,000 per annum, then on the
can basis of two years purchase of super profit, the
(a) never be raised in the books value of the goodwill will be
(b) be raised in thebooks (a) ` 10,000 (b) ` 20,000
(c) be partially raised in the books (c) ` 60,000 (d) ` 80,000
(d) be raised as per the agreement of the partners
ANSWERS
1. (a) 2. (d) 3. (d) 4. (d) 5. (a) 6. (b) 7. (a) 8. (c) 9. (d) 10. (b)
11. (a) 12. (d) 13. (b) 14. (b) 15. (c) 16. (b) 17. (c) 18. (b)
Hints & Solutions

1. Goodwill has a realisable value so it is asset. 14. Average profit of last 5 years
However, it cannot be seen or touched, so it is an 12,000 + 13,000 + 14,000 + 18,000 + (2,000)
=
intangible asset. 5
3. Profits are directly related to goodwill. So, those 55,000
= = ` 11,000
factors which affect profits, can affect goodwill too 5
like market situation, i.e. market demand and supply Goodwill = 11,000 × 2 = ` 22,000
chain, location of business, nature and management
16. Capital Employed = Total Tangible Assets − Outside
of business, etc.
Liabilities
5. Accounting Standard 26 regulates goodwill. As per = (85,000 − 5,000) − 30,000
Accounting Standard 26, only purchased goodwill is
= 80,000 − 30,000
accounted for because some consideration is paid for
it. So, it has some realisable value. = ` 50,000
Total Operating Profits Normal Profit = Capital Employed ×
6. Average Profits = Normal Rate of Return
Number of Years
Average Profits 100
(6,000 −2,000) + (4,000 +3,000) + (2,500 −1,500) 10
= = 50,000 ×
3 100
= ` 4,000 = ` 5,000
Goodwill = Average Profits × No. of Years’ Purchase Super Profit = Average Profit − Normal Profit
Goodwill = 4,000 × 3 = ` 12, 000 = 8,000 − 5,000
7. Normal Profit = Capital Employeed = ` 3,000
× Normal Rate of Return Super Profit
15 Goodwill = × 100
= 2,00,000 × = `30,000 Normal Rate of Return
100 3,000
Super Profit = Actual Average Profit − Normal Profit = × 100 = ` 30,000
10
= 48,000 − 30,000 = ` 18,000 15
17. Normal Profit = 8,00,000 × = ` 1,20,000
Goodwill = Super Profit × No. of Years Purchase 100
= 18,000 × 3 = ` 54,000 Super Profit = Average Profit − Normal Profit
Actual Profits
8. Capitalised Value of Firm = = 12,00,000 − 1,20,000
Normal Rate of Return
= ` 10,80,000
1,20,000
= × 100 = ` 12,00,000 100
10 Goodwill = Super Profit ×
Rate of Return
∴Net Assets of Firm = Total Assets − Total Liabilities
100
= 14,40,000 − 4,40,000 = ` 10,00,000 = 10,80,00 ×
15
Goodwill = Capitalised Value of Firm
− Net Assets of Firm, where = ` 72,00,000
∴Goodwill = 12,00,000 − 10,00,000 = ` 2,00,000 18. Normal Profit = Capital Employed ×
9. Capital Employed (Net Assets)
100
= Total Assets − Total Liabilities
15
= 28,00,000 − 8,00,000 = ` 20,00,000 = 4,00,000 × = ` 60,000
100
Normal Profit = Capital Employed × Normal Rate of
Return Average Profit = 80,000 – 10,000
10 = ` 70,000
= 20,00,000 × = ` 2,00,000
100 Super Profit = Average Profit – Normal Profit
Super Profit = Actual Average Profit − Normal Profit
= 70,000 – 60,000
= 3,00,000 − 2,00,000 = ` 1,00,000
Super Profit = `10,000
So, Goodwill = × 100 Goodwill = Super Profit × No. of Years Purchase
1,00,000 = 10,000 × 2
= × 100 = ` 10,00,000 = ` 20,000
10
Accountancy 29
CHAPTER 04
Reconstitution of a Partnership:
Change in Profit Sharing Ratio
Reconstitution of a Partnership Firm So, to induce a partner to sacrifice his share in future profits,
he is offered a lumpsum amount, as his share of goodwill
Any change in the existing agreement of partnership
presently, by the gaining partner.
amounts to reconstitution of a firm. As a result of
reconstitution, the existing agreement between partners Gaining Partner Partner whose share in profit has been
comes to an end and a new agreement comes into force and increased as a result of change, is known as gaining partner.
the firm continues. Sacrificing Partner Partner whose share in profit has been
decreased as a result of change, is known as sacrificing
Modes of Reconstitution of a Partnership Firm partner.
● Change in the profit sharing ratio of existing partners
● Admission of a new partner New Profit Sharing Ratio
● Retirement of an existing partner It is the ratio in which the partners are to share profits/losses
● Death of a partner in future.
● Amalgamation of two partnership firm
Sacrificing Ratio
Change in Profit Sharing Ratio It is the ratio in which the partner(s) has/have agreed to
When one or more partners acquire an interest in the sacrifice their share of profit in favour of other partner or
business from another existing partner(s), it is said to be a partners. This ratio is calculated by taking out the difference
change in the profit sharing ratio in a partnership firm. A between old profit share and new profit share.
change in the profit sharing ratio among the existing Sacrificing Ratio = Old Share – New Share
partners means, it is reconstitution of the firm without
admission, retirement or death of a partner. Gaining Ratio
It is the ratio in which the partner(s) has/have agreed to gain
Adjustments Required at the their share of profit from other partner(s). This ratio is
Time of Change in Profit Sharing Ratio calculated by taking out the difference between new profit
Due to change in profit sharing ratio, following adjustments share and old profit share.
need to be incorporated in the books of accounts Gaining Ratio = New Share – Old Share
● Calculation of each partners’ sacrifice or gain.
● Treatment of goodwill.
Calculation of Sacrifice or Gain of Partners
● Treatment of revaluation of assets and liabilities.
The sacrifice made or gain received by a partner is calculated
● Treatment of accumulated profits, reserves and losses.
by deducting the new share from the old share of partner.
Sacrifice/(Gain) Share = Old Profit Share
Determination of Sacrificing Ratio and Gaining Ratio − New Profit Share
At the time of change in profit sharing ratio, it is important
to determine the sacrificing ratio and gaining ratio of If difference is positive then it is sacrifice share and in case
partners because the gaining partner compensates the of negative difference, it will be gain share.
sacrificing partner by paying him proportionate amount of
goodwill.
Accounting Treatment of Goodwill
If the partners decide to change their profit sharing ratio, the
The logic behind this treatment is that, increased share of
gaining partner must compensate the sacrificing partner
gaining partner in future profits is because of the loss
by paying him goodwill in the gaining ratio.
sustained by the sacrificing partner.
The accounting treatment for adjustment of goodwill, in case of change in profit sharing ratio, is as follows
Step 1 Calculate the share gained and share sacrificed
Sacrificing/(Gaining) Share = Old Share – New Share
Step 2 Calculate the compensation payable by gaining partner(s) to sacrificing partner(s)
Compensation = Firm’s Goodwill × Share of Profit Gained
Step 3 Write-off the existing goodwill (if any) by passing the following journal entry
All Partners’ Capital/Current A/c Dr (In old ratio)
To Goodwill A/c (With existing book value of goodwill)
Step 4 Pass the adjustment entry for goodwill
Gaining Partner’s Capital/Current A/c Dr (In gaining ratio)
To Sacrificing Partner’s Capital/Current A/c (In sacrificing ratio)
Revaluation of Assets and Reassessment of Liabilities

At the time of change in profit sharing ratio, the assets are revalued and the liabilities are reassessed. It is done since
realisable or actual value of assets and liabilities may be different from those shown in balance sheet.
Revaluation is necessary because the change in the value of assets and liabilities belongs to the period prior to change in the
profit sharing ratio among partner. Hence, any gain or loss on revaluation must be shared in the old profit sharing ratio by the
partners.
Two alternatives available for this purpose are
1. When Revised Values are to be Recorded in the Books of Accounts An account titled ‘revaluation account’ or
‘profit and loss adjustment account' is opened for this purpose.
Dr Revaluation Account Cr
To Decrease in Value of Assets (Loss) .... By Increase in Value of Assets (Profit) ....
To Increase in Value of Liabilities (Loss) .... By Decrease in Value of Liabilities (Profit) ....
To Unrecorded Liabilities (At an agreed .... By Unrecorded Assets (At an agreed value) ....
value)
*To Profit Transferred to Old Partners’ *By Loss Transferred to Old Partners’
Capital/Current A/c (In old ratio) .... Capital/Current A/c (In old ratio) ....
.... ....

2. When Revised Values are Not to be Recorded in the Books of Accounts (Adjustments of profits/ losses on
revaluation of assets and reassessment of liabilities through the capital accounts only).
If partners decide to record the net effect of revaluation of assets and liabilities without affecting the old amount of
assets and liabilities, a single adjusting entry involving the capital accounts of gaining partners and sacrificing partners
is passed.
Journal Entries
(i) For profit on revaluation Gaining Partners’ Capital A/c Dr
To Sacrificing Partners’ Capital A/c
(ii) For loss on revaluation Sacrificing Partners’ Capital A/c Dr
To Gaining Partners’ Capital A/c
Accountancy 31
Treatment of Accumulated Profits, Reserves and Losses

At the time of change in profit sharing ratio, the past profits, reserves and losses appearing in the balance sheet, shall be
treated in following two ways
(i) When these are not In this case, if any reserves or accumulated profits/losses exist in the books of the firm, they are
required to be shown transferred to partners’ capital/current accounts in their old profit sharing ratio.
in the books of the (a) For transfer of reserves and accumulated profits
new firm Reserves / Profit and Loss A/c Dr
Workmen Compensation Reserve A/c Dr
Investment Fluctuation Reserves A/c Dr
To All Partners’ Capital/Current A/c
(b) For transfer of accumulated losses
All Partners’ Capital/Current A/c Dr
To Profit and Loss A/c
To Deferred Revenue Expenditure A/c
(ii) When these are In this case, a single adjusting entry involving the capital accounts of sacrificing and gaining
required to be shown partners is passed, when the partners decide to record net effect of reserves and accumulated
in the books of new profits / losses without affecting the old figures.
firm Gaining Partners’ Capital / Current A/c Dr
To Sacrificing Partners’ Capital / Current A/c
Preparation of the Balance Sheet of the Reconstituted Firm

Reconstitution of the firm results in a change in the capital accounts of partners and in the value of assets and amount of
liabilities. This shall also require preparation of the balance sheet of the new firm. Before we prepare the balance sheet of the
new firm, accounts that have been affected because of the reconstitution are prepared.
Solved Examples
1. P, Q and R are partners sharing profits and losses in the ratio of 5 : 3 : 2. Calculate the new profit sharing ratio
and sacrificing (gaining) ratio in each of the following cases
(i) If R acquires 1/10th share equally from P and Q.
(ii) If P,Q and R decide to share the future profits and losses equally.
5  1 1 10 − 1 9 6−1 5
×  =
3  1
×  =
1 5 1 3 1
Sol. (i) P’s new share = − − = = ; Q’s new share = − − = =
10  10 2  10 20 20 20 10  10 2  10 20 20 20
2 1 2+ 1 3 9 5 3
R’s new share = + = = ; New profit sharing ratio = P : Q : R = : : = 9: 5: 6
10 10 10 10 20 20 10
Sacrificing /(Gaining) Share = Old Share − New Share
5 9 10 – 9 1 3 5 6– 5 1 2 6 4– 6  2 
P= − = = Sacrifice; Q = − = = Sacrifice; R= – = =   Gain
10 20 20 20 10 20 20 20 10 20 20  20 
(ii) Sacrificing/(Gaining) Share = Old Share – New Share
5 1 15 – 10 5 3 1 9 – 10  1  2 1 6 – 10  4 
P= − = = Sacrifice; Q = − = =   Gain; R= – = =   Gain
10 3 30 30 10 3 30  30  10 3 30  30 
New profit sharing ratio = 1 : 1 : 1 (given)
2. P, Q and R who are presently sharing profits and losses in the ratio of 5 : 3 : 2, decide to share future profits
and losses in the ratio of 2 : 3 : 5 with effect from 1st April, 2022. An extract of their balance sheet as at 31st
March, 2022 is as follows
Balance Sheet (Extract)
Sundry Creditors 6,00,000 Land and Building 5,00,000
Outstanding Rent 20,000 Plant and Machinery 2,00,000
Stock 1,60,000
Debtors 6,00,000
(–) Provision for Doubtful Debts (20,000) 5,80,000
It is decided that
(i) Land and building be valued at ` 5,70,000.
(ii) Plant and machinery be depreciated by 15%.
(iii) Stock is found overvalued by ` 76,000.
(iv) Provision for doubtful debts is to be made equal to 5% of the debtors.
(v) An item of ` 60,000 included in sundry creditors is not likely to be claimed.
(vi) Rent of ` 8,000 is still outstanding.
(vii) Out of the amount of insurance which was debited entirely to profit and loss account, ` 10,000 be carried
forward as an unexpired insurance.
(viii) Out of total commission received ` 6,000 is to be treated as advance commission. This amount was earlier
credited to profit and loss account.
(ix) An unaccounted accrued income of ` 2,000 be provided for.
(x) A debtor whose dues of ` 10,000 were written-off as bad debts paid 80% in full settlement.
Pass the necessary journal entries and prepare revaluation account.
Sol. JOURNAL
Date Particulars LF Amt (Dr) Amt (Cr)
2022
Apr 1 Land and Building A/c Dr 70,000
To Revaluation A/c 70,000
(Being the increase in value of land and building
recorded)
Revaluation A/c Dr 30,000
To Plant and Machinery A/c 30,000
(Being the decrease in value of plant and machinery
recorded)
To Stock A/c 76,000
(Being the decrease in value of stock recorded)
Revaluation A/c (30,000 – 20,000) Dr 10,000
To Provision for Doubtful Debts A/c 10,000
(Being the short provision now created)
Sundry Creditors A/c Dr 60,000
(Being the decrease in the amount of creditors recorded)
To Outstanding Rent A/c 8,000
(Being the outstanding rent recorded)
Prepaid Insurance A/c Dr 10,000
(Being the prepaid insurance recorded)
To Commission Received in Advance A/c 6,000
(Being the commission received in advance recorded)
Accrued Income A/c Dr 2,000
(Being the accrued income recorded)
Bad Debts Recovered A/c Dr 8,000
(Being the bad debts recovered recorded)
Accountancy 33

To P’s Capital A/c 10,000
To Q’s Capital A/c 6,000
To R’s Capital A/c 4,000
(Being the transfer of profit on revaluation to old partners’ capital
accounts in their old profit sharing ratio)
To Plant and Machinery A/c 30,000 By Land and Building A/c 70,000
To Stock A/c 76,000 By Sundry Creditors A/c 60,000
To Provision for Doubtful Debts A/c 10,000 By Prepaid Insurance A/c 10,000
To Outstanding Rent A/c 8,000 By Accrued Income A/c 2,000
To Commission Received in Advance A/c 6,000 By Bad Debts Recovered A/c 8,000
To Profit on Revaluation Transferred to
P’s Capital A/c 10,000
Q’s Capital A/c 6,000
R’s Capital A/c 4,000 20,000
1,50,000 1,50,000
3. Z, E and N are partners sharing profits and losses in the ratio of 3 : 2 : 1. Their balance sheet as on
31st December, 2021 was as follows
Balance Sheet
as at 31st December, 2021
Sundry Creditors 3,00,000 Cash at Bank 60,000
Capital A/cs Sundry Debtors 1,24,000
Z 6,00,000 (−) Provision for Doubtful Debts (4,000) 1,20,000
E 6,00,000 Stock 3,60,000
N 1,00,000 13,00,000 Furniture 60,000
Plant and Machinery 4,00,000
Land and Buildings 6,00,000
16,00,000 16,00,000
The partners agreed that from 1st January, 2022, they will share profits and losses in the ratio of 4 : 4 : 1.
They agreed that
(i) Stock is to be valued at 20% less. (ii) Provision for doubtful debts to be increased by ` 3,000.
(iii) Furniture is to be depreciated by 20% and plant and machinery by 15%.
(iv) ` 7,000 are outstanding for salaries. (v) Land and buildings are to be valued at ` 7,00,000.
(vi) Goodwill is valued at ` 90,000.
Partners do not want to record the altered values of assets and liabilities in the books. They also decided not to
show goodwill in the books. You are required to pass a single journal entry to give effect to the above.
Sol. Calculation of Net Effect of Revaluation Amt (`)
Loss due to decrease in the value of stock (72,000)
Loss due to increase in the value of provision for doubtful debts (3,000)
Loss due to decrease in the value of furniture (12,000)
Loss due to decrease in the value of plant and machinery (60,000)
Loss due to unrecorded liability (i.e. outstanding salary) (7,000)
(1,54,000)
Profit due to increase in the value of land and buildings 1,00,000
Loss on revaluation (54,000)
Adjustment for goodwill 90,000
36,000
Calculation of Sacrificing/(Gaining) Share

Old ratio of Z, E and N = 3 : 2 : 1 ; New ratio of Z, E and N = 4 : 4 : 1
3 4 9− 8 1 2 4 6− 8  2  1 1 3− 2 1
Z= − = = Sacrifice; E= − = =   Gain; N= − = = Sacrifice
6 9 18 18 6 9 18  18  6 9 18 8
Calculation of the Proportionate Amount
1 2
For Z (Sacrificing partner) = 36,000 × = ` 2000 (Cr) ; For E (Gaining partner) = 36,000 × = ` 4000 (Dr)
18 18
1
For N (Sacrificing partner) = 36,000 × = ` 2000 (Cr)
18
JOURNAL

2022
Jan 1 E’s Capital A/c Dr 4,000
To Z’s Capital A/c 2,000
To N’s Capital A/c 2,000
(Being the adjustment for revaluation of assets and liabilities and for
reserves, profits and goodwill on change in profit sharing ratio)
4. An extract of balance sheet of Sun, Moon and Star sharing profits and losses in the ratio of 5 : 3 : 2 respectively,
on 31st March, 2022 is given below
Balance Sheet (An extract)
General Reserve 15,000 Investment (Market value ` 57,000) 60,000
Contingencies Reserve 1,350 Machinery Replacement Fund Investments 3,000
Profit and Loss A/c 9,000 Advertisement Expenditure (Deferred revenue) 3,000
Investment Fluctuation Reserve 4,500
Machinery Replacement Fund 3,000
Workmen Compensation Reserve 3,600
Employees’ Provident Fund 6,000
With effect from 1st April, 2022, they decided to share future profits and losses in the ratio of 2 : 3 : 5
respectively. A claim on account of workmen compensation is estimated at ` 450 only. Give the necessary
journal entries relating to the adjustment of accumulated profits and losses.
Sol. JOURNAL
2022
Apr 1 Workmen Compensation Reserve A/c Dr 450
To Provision for Workmen Compensation Claim A/c 450
(Being the provision made for workmen compensation claim)
Workmen Compensation Reserve A/c Dr 3,150
To Sun’s Capital A/c 1,575
To Moon’s Capital A/c 945
To Star’s Capital A/c 630
(Being the transfer of surplus workmen compensation reserve to
partners’ capital accounts in their old profit sharing ratio)
Investment Fluctuation Reserve A/c Dr 3,000
To Investment A/c 3,000
(Being the value of investment brought up to market value)
Accountancy 35

Investment Fluctuation Reserve A/c Dr 1,500
To Sun’s Capital A/c 750
To Moon’s Capital A/c 450
To Star’s Capital A/c 300
(Being the transfer of excess investment fluctuation reserve to
partners’ capital accounts in their old profit sharing ratio)
General Reserve A/c Dr 15,000
Contingencies Reserve A/c Dr 1,350
Profit and Loss A/c Dr 9,000
To Sun’s Capital A/c 12,675
To Moon’s Capital A/c 7,605
To Star’s Capital A/c 5,070
(Being the transfer of accumulated profits to all the partners in
their old profit sharing ratio)
Sun’s Capital A/c Dr 1,500
Moon’s Capital A/c Dr 900
Star’s Capital A/c Dr 600
To Advertisement Expenditure A/c 3,000
(Being the transfer of accumulated losses to all the partners
in their old profit sharing ratio)
Note l
Excess investment fluctuation reserve account has been transferred directly to partners’ capital accounts, after providing for an anticipated
loss of ` 3,000 (i.e. 60,000 – 57,000) according to prudence (conservatism) concept.
l
Excess workmen compensation reserve account has been transferred directly to partners’ capital accounts.
l
Machinery replacement fund has not been transferred, since it is in the nature of accumulated depreciation and not in nature of accumulated
profits.
l
Employees’ provident fund represents statutory liability due to employees towards provident fund and is not an accumulated profit and
hence is not distributed among the partners.
5. Sanjeev, Mohan and Ashish are partners sharing profits and losses in the ratio of 2 : 3 : 4. They decide to share
future profits and losses in the ratio of 4 : 3 : 2. They also decided to record the effect of the following without
affecting their book values.
Particulars Amt (`)
General reserve 80,000
Profit and loss A/c (Cr) 40,000
Advertisement suspense A/c (Dr) 30,000
You are required to give the necessary single journal entry.

Sol. Calculation of Net Effect of Reserves and Accumulated Profits/Losses
Amt (`)
General Reserve 80,000
(+) Profit and Loss A/c 40,000
1,20,000
(–) Advertisement Suspense A/c (30,000)
Net Effect 90,000
Calculation of Sacrificing/(Gaining) Share of Partners
Old ratio = 2 : 3 : 4, New ratio = 4 : 3 : 2
Sanjeev = − =   Gain;
2 4 2 3 3 4 2 2
Mohan = − = 0 ; Ashish = − = Sacrifice
9 9  9 9 9 9 9 9
Calculation of Share of Gaining and Sacrificing Partners in the Net Reserves and
Accumulated Profits/Losses
2 2
For Sanjeev (Gaining partner) = 90,000 × = ` 20,000 ; For Ashish (Sacrificing partner) = 90,000 × = ` 20,000
9 9
JOURNAL
Sanjeev’s Capital A/c Dr 20,000

To Ashish’s Capital A/c 20,000
(Being the adjustment for general reserve, profit and loss
account balance and advertisement suspense account on
change in profit sharing ratio)
Practice Questions
1 In case of change in profit sharing ratio, if the
question is silent, then accumulated profit or (b) A’s Capital A/c Dr 20,000
losses are B’s Capital A/c Dr 20,000
(a) distributed (b) not distributed To Goodwill A/c 40,000
(c) adjusted (d) None of these (c) A’s Capital A/c Dr 20,000
2 Revaluation account is prepared ............. the value B’s Capital A/c Dr 20,000
of assets. C’s Capital A/c Dr 10,000
To Goodwill A/c 50,000
(a) to revise (b) not to revise
(c) to distribute (d) None of these (d) A’s Capital A/c Dr 10,000
B’s Capital A/c Dr 20,000
3 In case of change in profit sharing ratio, when To C’s Capital A/c 30,000
revised values are not to be recorded in the books,
7 Calculate net effect of revaluation when revised
then steps to be followed are
values are to be recorded in books.
(i) Pass a single adjustment entry.
(i) Stock is to be valued at 10% less (Book value
(ii) To find share of sacrifice/(gain) by partners.
` 3,00,000).
(iii) Calculation of the net effect of revaluation.
(ii) Provision for bad debts is no more required,
(iv) Calculation of proportional amount of net (Shown in balance sheet for ` 4,000).
effect of revaluation.
(iii) An outstanding salary which is unrecorded of
(a) (ii) (iii) (iv) (i) (b) (iii) (ii) (iv) (i)
(c) (iv) (iii) (ii) (i) (d) None of these ` 16,000.
(a) ` 40,000 profit
(Q 04 and 05 are based on this information) A, B and C (b) ` 42,000 profit
are partners sharing profits and losses in the ratio of (c) ` 42,000 loss
1 (d) None of the above
5 : 4 : 1. If, C acquires th share from A, then
5 8 ‘A’ and ‘B’ are partners in a firm. They share their
profits and losses in the ratio of 3 : 2. They have
4 Calculate new profit sharing ratio. decided that their new profits (losses) sharing ratio
(a) 5 : 4 : 2 (b) 5 : 4 : 1 will be 1 : 1. At that time, their goodwill is valued at
(c) 3 : 4 : 3 (d) None of these
` 30,000. Calculate amount of goodwill which will
5 Calculate sacrificing ratio be given by B to A.
(a) A sacrifice 1/5 (b) B sacrifice 1/5 (a) ` 2,500
(c) C sacrifice 1/5 (d) None of these (b) ` 2,400
(c) ` 2,800
6 ‘A’, ‘B’ and ‘C’ are partners sharing profits in the (d) ` 3,000
ratio of 2 : 2 : 1. At the time of reconstitution of firm,
they agreed to write-off goodwill which is shown in 9 ‘B’ and ‘C’ were partners sharing profits in the
balance sheet as an intangible asset amounting to ratio of 3 : 2. They agreed to share their future
` 50,000. Journalise it. profits in the ratio of 1 : 1. At that time, their books
(a) Goodwill A/c Dr 50,000 showed the following balances
To A’s Capital A/c 20,000 Profit and Loss A/c (Cr) = ` 60,000
To B’s Capital A/c 20,000 General Reserve = ` 40,000
To C’s Capital A/c 10,000
Accountancy 37
Pass necessary entry at the time of change in 13 Assets are revaluedand labilities are reassessed at
profit sharing ratio. the time of change in profit-sharnig ratio so that
(a) C’s Capital A/c Dr 10,000 (a) assets and liabilities are shown at their present
values.
To B’s Capital A/c 10,000 (b) gaining partner is not put to an advantage and
(b) General Reserve A/c Dr 40,000 sacrificing partner is not put to disadvantage and
To B’s Capital A/c 20,000 vice-versa.
To C’s Capital A/c 20,000 (c) Both (a) and (b)
(d) assets and liabilities are shown at their market
(c) Profit and Loss A/c Dr 60,000 values.
To B’s Capital A/c 1,00,000 14 At the time of change in profit-sharing ratio,
(d) Profit and Loss A/c Dr 60,000 sacrificing ratio is determined so that
General Reserve A/c Dr 40,000 (a) assets and liabilities are shown at their present
To B’s Capital A/c 60,000 values.
To C’s Capital A/c 40,000 (b) gaining partner is not put to an advantage and
sacrificing partner is not put to disadvantage and
10 ‘A’, ‘B’ and ‘D’ are partners in a firm sharing profits vice-versa.
(losses) in the ratio of 3 : 2 : 1. They change their (c) gaining partner can compensate the sacrificing
ratio into 2 : 1 : 2 for future profits. At that time, partner forthe sacrifice of profit share.
their balance sheet shows the following balances (d) assets and liabilities are shown at their current
estimate values.
Investment Fluctuation Reserve = ` 6,000
Investment = ` 25,000 15 The ratio in which one or more partners of the firm
Now, the market value of investments’ is ` 22,000. forego, i.e. sacrifice their share of profits in favour
Distribute investment fluctuation reserve among of one or more partners of the firm is known as ..... .
partners. (a) sacrificing ratio
(a) Investment Fluctuation (b) gaining ratio
Reserve A/c Dr 6,000 (c) no change in ratio
To A’s Capital A/c 3,000 (d) Either (a) or (b)
To B’s Capital A/c 2,000
To D’s Capital A/c 1,000
16 At the time of change in profit sharing ratio,
(b) Investment Fluctuation general reserve existing in the balance sheet is
Reserve A/c Dr 6,000 transferred to capital accounts of partners in their
To A’s Capital A/c 6,000 (a) sacrificing ratio
(c) A’s Capital A/c Dr 6,000 (b) gaining ratio
To B’s Capital A/c 3,000 (c) old profit sharing ratio
To D’s Capital A/c 3,000 (d) new profit sharing ratio
(d) Investment Fluctuation 17 Out of the following, which is not a part of change
Reserve A/c Dr 6,000 in the profit sharing ratio?
To Investment A/c 3,000
(a) Determination of sacrificing ratio and gaining ratio
To A’s Capital A/c 1,500
(b) Accounting of goodwill
(c) Accounting of reserves, accumulated profits and
To D’s Capital A/c 500
losses
11 A and B are partners in a firm sharing profits in (d) Dissolution of partnership firm
the ratio of 3 : 2. An extract of their balance sheet 18 Gaining ratio is calculated as
is as follows (a) New Ratio – Sacrificing Ratio
Liabilities Amt (`) Assets Amt (`) (b) Old Ratio – SacrificingRatio
(c) New Ratio – Old Ratio
Investments 40,000 (d) Old Ratio – New Ratio
19 Revaluation account is a …… account in nature.
If half of the investments are taken over by A and
(a) personal (b) real
B in their profit sharing ratio at book value, what (c) nominal (d) None of these
amount of investments will be shown in revised
balance sheet? 20 At the time of change in profit sharing ratio, the
(a) ` 40,000 (b) ` 20,000 (c) ` 10,000 (d) ` 80,000 gaining partner is …… and sacrificing partner is
…… for the adjustment of goodwill.
12 Sacrificing ratio is calculated as
(a) credited, debited
(a) New Ratio – Old Ratio
(b) debited, debited
(b) Old Rato – New Ratio
(c) credited, credited
(c) Old Ratio – Gaining Ratio
(d) debited, credited
(d) Gaining Ratio – Old Ratio
21 After reconstitution, the ratio in which all the (a) Plant and machinery
partners share future profits and losses is called (b) Revaluation account
(c) Partners’ capital account
(a) new rato
(b) old ratio
(c) sacrificing ratio 26 Machinery replacement fund is transferred to
(d) gaining ratio partners’ capital account at the time of change in
22 Pass the journal entry to record the increase in the profit sharing ratio.
value of assets. (a) True (b) False
(a) Assets A/c Dr (c) Partially false (d) Partially true
To Partners’ Capital A/c 27 If the claim on account of workmen’s compensation
(b) Revalution A/c Dr is more than the workmen compensation reserve,
To Assets A/c
which account(s) is/are debited initially?
(c) Assets A/c Dr
(a) Workmen compensation reserve
To Revaluation A/c
(b) Revaluation account
(d) Liabilities A/c Dr
To Revaluation A/c
23 Write the formula of proportional amount of net
28 At the time of change in profit sharing ratio,
effect of revaluation for gaining partner.
advertisement expenditure (deferred revenue) is
(a) Share Sacrificed × Net Effect of Revaluation
(b) Old Share – New Share …… and partners’ capitals are ……… .
(c) Capital × Share of New Partner (a) credited, debited (b) debited, credited
(d) Share Gained × Net Effect of Revaluation (c) Both (a) and (b) (d) None of these
24 The steps of treatment of goodwill at the time of 29 Investment fluctuation reserve is a reserve created
change in profit sharing ratio are out of profits to meet the …… in …… value of
investments.
(i) Calculate compensation payable by gaining
(a) rise, book
partner(s) to sacrificing partner(s). (b) fall, book
(ii) Pass the adjustment entry. (c) rise, market
(iii) Calculate the share gained and share sacrified. (d) fall, market
The correct order is 30 A and B are partners in a firm sharing profit and
(a) (i), (iii), (ii) (b) (i), (ii), (iii) losses 2 : 3. With effect from 1st April, 2022, they
(c) (iii), (i), (ii) (d) (iii), (ii), (i) decided to share profits and loss equally. What will
25 In case of depreciation provided on plant and be B’s gain/sacrifice?
machinery (at the time of change in profit sharing (a) Gain 1/5 (b) Sacrifice 1/5
ratio), which account is debited? (c) Gain 1/10 (d) Sacrifice 1/10
ANSWERS
1. (a) 2. (a) 3. (b) 4. (c) 5. (a) 6. (c) 7. (c) 8. (d) 9. (d) 10. (d)
11. (b) 12. (b) 13. (b) 14. (c) 15. (a) 16. (c) 17. (d) 18. (c) 19. (c) 20. (d)
21. (a) 22. (c) 23. (d) 24. (c) 25. (b) 26. (b) 27. (c) 28. (a) 29. (d) 30. (d)
Accountancy 39
Hints & Solutions

1. Reserves, accumulated profits or losses are distributed even if the question is silent because these were earned before
the reconstitution of the firm.
3. Since revised values are not to be recorded in books, so profit or loss on revaluation is adjusted through capital
accounts by passing a single adjustment entry.
5 1 5 −2 3 4 1 1 1+2 3
4. A’s new share = − = = ; B’s new share = ; C’s new share = + = =
10 5 10 10 10 10 5 10 10
5. Sacrificing Share = Old Share − New Share
5 3 2 1 4 4 1 3  2   1
A= − = = Sacrifice; B= − = Nil; C= − =   =   Gain
10 10 10 5 10 10 10 10  10   5 
6. When goodwill appears in the books of firm, it is written-off by debiting all partners capital accounts in their old
profit ratio and crediting goodwill account. Share of partners will be computed as follows
2 2 1
A’s Share = 50,000 × = ` 20,000 ; B’s Share = 50,000 × = ` 20,000 ; C’s Share = 50,000 × = `10,000
5 5 5
7. To ascertain the effect of revaluation, we will prepare revaluation account in the following manner
To Stock 30,000 By Provision for Bad Debts 4,000
To Outstanding Salary 16,000 By Loss on Revaluation to be Transferred
to Partners’ Capital A/c 42,000
46,000 46,000
8. Sacrifice (Gain) Ratio = Old Ratio – New Ratio

3 1 6− 5 1 2 1 4− 5  1 
A’s Sacrificing Ratio = − = = Sacrifice ; B’s Sacrificing Ratio = − = =   (Gain)
5 2 10 10 5 2 10  10 
1
So, ‘B’ will give to ‘A’ = 30,000 × = ` 3,000
10
9. Since, partners are changing their profit sharing ratio so, their all (accumulated) profits or losses will be distributed among
them in their old ratio.
So, Total Accumulated Profit
Profit and Loss A/c = 60,000
(+) General Reserve = 40,000
1,00,000
Distributed in ‘B’ and ‘C’ in old ratio
3 2
B = 1,00,000 × = ` 60,000 ; C = 1,00,000 × = ` 40,000
5 5
10. Investment fluctuation reserve is created as a safeguard against loss due to fluctuation in market price of investments. In
the given example, ` 3,000 (25,000 − 22,000) will be used to cover loss due to fall in the price of investments and the balance
` 3,000 will be distributed among partners in their old ratio.
11. Investments = 40,000 − 50% of 40,000 (Taken over by partners) = ` 20,000
26. Machinery replacement fund is not transferred because it is in the nature of accumulated depreciation and not in the
nature of accumulated profits.
30. B’s Sacrifice/Gain = Old Ratio − New Ratio
3 1 1
= − =
5 2 10
CHAPTER 05
Reconstitution of a Partnership :
Admission of a Partner
Meaning of Admission of a Partner Adjustments Required at the Time of Admission

● Computation of new ratio and sacrificing ratio.
Admission of a partner is one of the modes of
reconstituting the firm under which old partnership comes
● Treatment of goodwill.
to an end and a new one between all partners (including ● Revaluation of assets and reassessment of liabilities.
incoming partner) comes into existence. ● Treatment of reserves, accumulated profits and losses.
● Adjustment of capital.
Effects of Admission of a Partner ● Preparation of balance sheet after incorporating all the
The effects of admission of a new partner are necessary changes.
● On admission of a partner, old partnership comes to an
New Profit Sharing Ratio
end and new partnership comes into existence and the
The ratio in which all the partners (including incoming
firm continues.
partner) share the future profits and losses is known as the
● The combined share of the old partners gets reduced as
new profit sharing ratio.
the incoming partner becomes entitled to share future
profits of the firm. New Profit Sharing Ratio = Old Share – Sacrificing Share
● Incoming partner contributes an agreed amount of
capital to the firm. Sacrificing Ratio

● Incoming partner becomes liable for the liabilities of the
The ratio in which old partners agree to sacrifice their share of
profit in favour of the new partner is called the sacrificing ratio.
firm and also acquires right on the assets.
● On admission of a partner, adjustment is made in regard
Sacrificing Ratio = Old Share − New Share
to reserves and accumulated profits and losses. Accounting Treatment of Goodwill
● On admission of a partner, assets are revalued and
When a new partner is admitted, he acquires his share in
liabilities are reassessed. The net change is adjusted in future profits from the existing partners. Thus, he should
existing or old partners’ capital accounts. compensate the existing partners. The amount the new
● On admission of a partner, goodwill of the firm is valued
partner pays to existing partners to compensate for their
to be paid to sacrificing partners by the gaining partners sacrifice is called goodwill. There are various cases related to
through their capital accounts. the treatment of goodwill at the time of admission, which are
Case I When premium for goodwill is paid In case a new partner pays premium to the old partners privately or
directly or outside the business, it will not be recorded because it is an
privately by a new partner out of business transaction. However entry for capital brought in by a
new partner will be recorded.
Cash/Bank A/c Dr
To New Partner’s Capital A/c
Note Any goodwill already appearing in the books will also be written-off in old ratio.
Accountancy 41
Case II When premium for goodwill (a) For bringing premium for goodwill and capital
is brought in business by new Cash / Bank A/c Dr
partner and retained in the To New Partner’s Capital A/c
business
To Premium for Goodwill A/c
(b) For sharing of premium for goodwill by sacrificing partners

Premium for Goodwill A/c Dr
To Sacrificing Partner’s Capital/Current A/c
Case III When premium for goodwill (a) For assets brought in by new partner
is brought in kind Assets A/c Dr
To Premium for Goodwill A/c
To New Partner’s Capital A/c
(b) For giving credit of incoming partner’s share of goodwill to
sacrificing partners
Premium for Goodwill A/c Dr
To Sacrificing Partners’ Capital/Current A/c (in sacrificing ratio)
Case IV When premium for goodwill In this case, in addition to the two entries of case II, an entry for
is brought in by new partner drawings will also be passed as follows
and is withdrawn by old For withdrawing of premium by old (sacrificing) partners
(sacrificing) partners fully or Old (sacrificing) Partner’s Capital/Current A/c (in sacrificing ratio) Dr
partly. To Cash/ Bank A/c
Case V When a new partner brings First entry will be same as in case II.
only a part of premium for Next the following entry will be passed
goodwill in cash Premium for Goodwill A/c (goodwill brought in cash) Dr
New Partner’s Capital/Current A/c (goodwill not brought in cash) Dr
To Sacrificing (Old) Partners’ Capital/Current A/c (in sacrificing ratio)
Case VI When the new partner is New Partner’s Capital/Current A/c Dr
unable to bring his share of (With the share of new partner in goodwill of the firm)
premium for goodwill in cash To Sacrificing (Old) Partners’ Capital/Current A/c (in sacrificing ratio)
Writing-off Existing Goodwill

Any goodwill already appearing in the book (balance sheet) will be immediately written-off (debited) to old partners’ capital
account in old profit sharing ratio.
Old Partners’ Capital/Current A/c Dr
To Goodwill A/c
Hidden or Inferred Goodwill

Hidden or inferred goodwill is the excess of desired total capital of the firm over the actual combined capital of all partners.
Calculation of Hidden Goodwill
A. Net worth (including goodwill) on the basis of capital brought in by incoming partner ...
(Incoming Partner’s Capital × Reciprocal of Share of Incoming Partner)
B. (–) Net worth (excluding goodwill of the reconstituted firm including incoming partner’s capital) (...)
C. Value of Hidden Goodwill (A – B) ...

Accounting Treatment of Reserves, Accumulated Profits/Losses

If at the time of admission of a partner, any reserves and accumulated profits or losses exist in the books of the firm, then
these should be trnasferred to old partner’s capital/current accounts in their old profit sharing ratio.
The various journal entries to be passed are given below
1. For transfer of Reserves A/c Dr
reserves and Profit and Loss A/c Dr
accumulated Workmen Compensation Reserve A/c (Excess of reserve over actual Dr
profits liability)
Investment Fluctuation Reserve A/c (Excess of reserve over the Dr
difference between the book value and the market value of
investments)
To Old Partner’s Capital or Current A/c (Individually) (Old Ratio)
2. For transfer of Old Partners’ Capital or Current A/c (Individually) Dr (Old Ratio)
accumulated To Profit and Loss A/c
losses To Deferred Revenue Expenditure A/c

Revaluation account is an account, which is prepared to record changes in the value of assets and liabilities at the time of
admission, retirement, death and change in profit sharing ratio.
It is a nominal account in nature. It is also known as profit and loss adjustment account.
(Revaluation account is prepared in the same manner as in case of change in profit sharing ratio)
Memorandum Revaluation Account

Sometimes the partners may decide to show the assets and liabilities in the books of the new firm at their original (existing)
values. Also, the new partner should not be put to any advantage or disadvantage because of the change in the values of
assets and liabilities. Then, for this purpose, memorandum revaluation account is prepared.
Memorandum revaluation account is divided into two parts. First part records the increase and decrease in the value of assets
and liabilities, similar to revaluation account. The profit/loss on such revaluation is transferred to old partners capital account
in old ratio.
In the second part, all entries made in the first part are reversed. The balance of the second part is transferred to all the
partners (including new partner) in new ratio.
Adjustment of Capital
At the time of admission of a new partner, the partners may agree that their capitals should also be adjusted so as to be
proportionate to their profit sharing ratio.
The capitals of partners may be adjusted in any of the following ways
1. Adjusting the Capitals of Old Partners on the Basis of the Capital of Incoming Partner
(When the total capital of the new firm is not given)
Practical steps involved in adjusting the capitals of old partners are
Step 1 Calculate the new profit sharing ratio.
Step 2 Calculate total capital of new firm as under
Total Capital = New Partner’s Capital × Reciprocal of Proportion of Share of New Partner
Step 3 Calculate the new capitals of old partners by dividing the total capital in their new profit sharing ratio.
Step 4 Calculate the adjusted old capitals of old partners (i.e. after all adjustments relating to goodwill, profit/loss on
revaluation and accumulated reserves, profits/losses) by preparing their capital accounts.
Step 5 Calculate the surplus/deficiency in each of the old partner’s capital account by comparing the new capital with
adjusted old capital. (i.e. New Capital – Adjusted Old Capital).
Step 6 Adjust the surplus by paying off or by transfer to the credit of his current account and adjust the deficiency by
asking the concerned partner to bring in the required amount or by transfer to the debit of his current account.
Accountancy 43
2. Determining the New Partner’s Capital on the Basis of Total Capital of the Firm
Practical steps involved in the determination of capital of new partner are
Step 1 Calculate the new profit sharing ratio.
Step 2 Calculate the adjusted old capitals of old partners (after all adjustments have been made i.e. goodwill, reserves,
profit/loss on revaluation, etc).
Step 3 Calculate the total capital of new firm as follows
Total Capital = Combined Adjusted Old Capitals of Old Partners× Reciprocal of Proportion of Share of Old Partners
Step 4 Calculate the proportionate capital of new partner as follows
New Partner’s Capital = Total Capital × Proportion of Share of New Partner
3. Determining the New Partner’s Capital on the Basis of the Total Capital of
Firm and also Adjusting the Capitals of the Old Partners in New Profit Sharing Ratio
Practical steps involved in this case are
Step 1, 2, 3 and 4 are the same as discussed in case 2.
Step 5 Calculate the new capitals of old partners with the help of the following formula = Total Capital × New Share of
Old Partner
Step 6 Calculate the actual cash to be paid off or brought in by old partners by comparing their new capitals with
adjusted old capitals.
4. When Total Capital of the New Firm is Given
Practical steps involved in this case are
Step 1 Find out the new profit sharing ratio.
Step 2 Find out the adjusted capitals of the old partners after necessary adjustments relating to goodwill, accumulated
profits/losses, reserves, etc.
Step 3 Calculate the capital of all the partners with the help of the formula : Capital Given × Partners Share
Step 4 Calculate surplus/deficiency of old partners by comparing their adjusted capitals with computed capitals.
Step 5 Adjust the surplus/deficiency through cash or current accounts (as given in the question). If the question is silent
then adjustments should be made through cash.
Solved Examples
1. Madhu and Neha were partners in a firm sharing profits and losses in the ratio of 3 : 5. Their fixed capitals
were ` 4,00,000 and ` 6,00,000 respectively. On 1st January, 2016. Tina was admitted as a new partner for
1/4th share in the profits. Tina acquired her share of profit from Neha. Tina brought ` 4,00,000 as her capital
which was to be kept fixed like the capitals of Madhu and Neha. Calculate the goodwill of the firm on Tina’s
admission and the new profit sharing ratio of Madhu, Neha and Tina. Also, pass necessary journal entry for
the treatment of goodwill on Tina’s admission considering that Tina did not bring her share of goodwill
premium in cash.
Sol. JOURNAL
Cash A/c Dr 4,00,000
To Tina’s Capital A/c 4,00,000
(Being capital brought in by Tina)
Tina’s Current A/c Dr 50,000
To Neha’s Current A/c 50,000
(Being adjustment entry passed for goodwill)
Calculation of New Profit Sharing Ratio

3
Madhu’s share = (same as before)
8
5 1 5−2 3 1 2 2
Neha’s share = − = = ; Tina’s share = × =
8 4 8 8 4 2 8
New profit sharing ratio of Madhu : Neha : Tina = 3 : 3 : 2
Calculation of Goodwill of the Firm on Tina’s Admission Amt (`)

Net worth of new firm on the basis of capital brought in by Tina ( 4 ,00,000 × 4 /1) 16,00,000
(−) Net worth (excluding goodwill) of new firm (14,00,000)
[Adjusted capital of old partners + Incoming partners capital]
[(4,00,000 + 6,00,000) + 4,00,000]
Hidden goodwill 2,00,000
Working Notes
1. Calculation of Sacrificing Ratio
Sacrificing Ratio = Old Share − New Share
3 3 3−3 5 3 5−3 2
Madhu = − = = Nil ; Neha = − = =
8 8 8 8 8 8 8
1
2. Tina’s share of goodwill = 2,00,000 × = ` 50,000
4
2. On the date of N’s admission, an extract of the balance sheet of L and M sharing profits and losses in the ratio
of 3 : 2 was as under
Balance Sheet (Extract)
as at …
General Reserve 15,000 Investments (Market value ` 57,000) 60,000
Contingencies Reserve 1,350 Machinery Replacement Fund Investment 3,000
Profit and Loss A/c 9,000 Advertisement Expenditure (Deferred revenue) 3,000
Investment Fluctuation Reserve 4,500
Machinery Replacement Fund 3,000
Workmen’s Compensation Reserve 3,600
Employees’ Provident Fund 6,000
New partner N was admitted for 1/5th share of profits. A claim on account of workmen’s compensation is
estimated at ` 450 only. Pass the necessary journal entries to adjust accumulated profits and losses.
Sol. JOURNAL
Contingencies Reserve A/c Dr 1,350
Profit and Loss A/c Dr 9,000
Investment Fluctuation Reserve A/c [4,500 – (60,000 – 57,000)] Dr 1,500
Workmen’s Compensation Reserve A/c (3,600 – 450) Dr 3,150
To L’s Capital A/c 18,000
To M’s Capital A/c 12,000
(Being transfer of accumulated profits to old partners in their old
profit sharing ratio)
L’s Capital A/c Dr 1,800
M’s Capital A/c Dr 1,200
To Advertisement Expenditure A/c 3,000
(Being transfer of deferred expenditure losses to old partners in
their old profit sharing ratio)
Working Notes
1. Machinery replacement fund is in the nature of accumulated depreciation and not in nature of accumulated profits and
hence is not distributed among the partners.
2. Employees provident fund represents statutory liability due to employees towards provident fund and is not an
accumulated profits, hence it is not distributed among the partners.
Accountancy 45
3. W and R are partners in a firm sharing profits in the ratio of 3 : 2. Their balance sheet as at 31st March, 2021
was as follows
Balance Sheet
Sundry Creditors 20,000 Cash 12,000
Provision for Bad Debts 2,000 Debtors 18,000
Outstanding Salary 3,000 Stock 20,000
General Reserve 5,000 Furniture 40,000
Capital A/cs Plant and Machinery 40,000
W 60,000
R 40,000 1,00,000
1,30,000 1,30,000
On the above date, C was admitted for 1/ 6 th share in the profits on the following terms
(i) C will bring ` 30,000 as his capital and ` 10,000 for his share of goodwill premium, half of which will be
withdrawn by W and R.
(ii) Debtors ` 1,500 will be written-off as bad debts and a provision of 5% will be created for bad and doubtful
debts.
(iii) Outstanding salary will be paid-off.
(iv) Stock will be depreciated by 10%, furniture by ` 500 and plant and machinery by 8%.
(v) Investments ` 2,500 not mentioned in the balance sheet were to be taken into account.
(vi) A creditor of ` 2,100 not recorded in the books was to be taken into account. Pass necessary journal entries for
the above transactions in the books of the firm on C’s admission.
Sol. JOURNAL
Cash A/c Dr 40,000
To C’s Capital A/c 30,000
To Premium for Goodwill A/c 10,000
(Being cash and premium for goodwill brought in by C)
Premium for Goodwill A/c Dr 10,000
To W’s Capital A/c 6,000
(Being premium for goodwill shared by old partners in sacrificing ratio)
W’s Capital A/c Dr 3,000
R’s Capital A/c Dr 2,000
To Cash A/c 5,000
(Being half goodwill withdrawn by W and R in old ratio)
To W’s Capital A/c 3,000
(Being general reserve distributed among old partners in old ratio)
Outstanding Salary A/c Dr 3,000
To Cash A/c 3,000
(Being outstanding salary paid)
To Provision for Doubtful Debts A/c 325
To Stock A/c 2,000
To Furniture A/c 500
To Plant and Machinery A/c 3,200
To Creditor A/c 2,100
(Being decrease in the value of assets and increase in value of liabilities
recorded)

Investment A/c Dr 2,500
(Being increase in the value of asset recorded)
W’s Capital A/c ( 5,625 × 3/ 5) Dr 3,375
R’s Capital A/c ( 5,625 × 2/ 5) Dr 2,250
(Being loss on revaluation transferred to partners’ capital accounts)
Working Notes
1. Provision for Bad and Doubtful Debts Amt (`)
Debtor 18,000
(−) Bad debts, to be adjusted against provision for bad debts (1,500)
16,500
Provision for doubtful debts @ 5% on 16,500 825
(−) Existing provision after adjusting bad debts (2,000 − 1,500) (500)
Amount to be debited to revaluation account 325
2. Loss on Revaluation
Loss on revaluation can be ascertained by preparing revaluation account in the following manner
To Provision for Doubtful Debts A/c 325 By Investment A/c 2,500
To Stock A/c 2,000 By Loss on Revaluation Transferred to
To Furniture A/c 500 W 3,375
To Plant and Machinery A/c 3,200 R 2,250 5,625
To Creditors A/c 2,100
8,125 8,125
4. A and B are partners in a firm sharing profits in the ratio of 3 : 2. Their balance sheet as at 31st December,
2021 stood as under
Balance Sheet
Capital A/cs Machinery 33,000
A 35,000 Furniture 15,000
B 30,000 65,000 Investments 20,000
General Reserve 10,000 Stock 23,000
Bank Loan 9,000 Debtors 19,000
Sundry Creditors 36,000 (–) Provision for Doubtful Debts (2,000) 17,000
Cash 12,000
1,20,000 1,20,000
On that date they admitted C into partnership for 1/4th share in the profit on the following terms
(i) C brings capital proportionate to his share. He brings ` 7,000 in cash as his share of goodwill.
(ii) Debtors are all good.
(iii) Depreciate stock by 5% and furniture by 10%. Market value of machinery was ` 45,000.
(iv) An outstanding bill for repair ` 1,000 will be brought in books.
(v) Half of the investments were to be taken over by A and B in their profit sharing ratio at book value.
(vi) Bank loan is paid off.
(vii) Partners agreed to share future profits in ratio 3 : 3 : 2.
(viii) Capital of the firm is fixed at ` 1,60,000. Excees or shortfall, if any, to be transferred to current accounts.
Prepare revaluation account, partners’ capital accounts and balance sheet.
Accountancy 47
Sol. Dr Revaluation Account Cr

To Stock A/c 1,150 By Provision and Debtors A/c 2,000
To Furnitutre A/c 1,500 By Loss Transferred to
To Outstanding Bill A/c 1,000 A 990
B 660 1,650
3,650 3,650

Particulars A (`) B (`) C (`) Particulars A (`) B (`) C (`)
To Revaluation A/c 990 660 — By Balance b/d 35,000 30,000 —
To Investment A/c 6,000 4,000 — By Cash A/c — — 40,000
To Balance c/d 40,310 30,040 40,000 By General Reserve A/c 6,000 4,000 —
By Premium for Goodwill A/c 6,300 700 —
47,300 34,700 40,000 47,300 34,700 40,000
To Balance c/d 60,000 60,000 40,000 By Balance b/d 40,310 30,040 40,000
By Current A/c 19,690 29,960 —
60,000 60,000 40,000 60,000 60,000 40,000
Cash Account
Dr as at… Cr
To Balance b/d 12,000 By Bank Loan A/c 9,000
To C’s Capital A/c 40,000 By Balance c/d 50,000
59,000 59,000
Balance Sheet
as at…
A 60,000 Furniture (15,000 – 1,500) 13,500
B 60,000 Investment (20,000 – 10,000) 10,000
C 40,000 1,60,000 Debtors 19,000
Outstanding Bill for Repair 1,000 Stock (23,000 – 1,150) 21,850
Creditors 36,000 Cash 50,000
A’s Current A/c 19,690
B’s Current A/c 29,960
1,97,000 1,97,000
Note ● Market value of machinery is ignored because all fixed tangible assets are recorded at their cost price.
● Some assets like closing stock and inventories are valued at their cost price or market price whichever is less.
Working Note
Total capital of the firm = `1,60,000 (Given)
3
A’s new capital = 1,60,000 × = ` 60,000
8
3
B’s new capital = 1,60,000 × = ` 60,000
8
2
C will bring cash for his capital = 1,60,000 × = ` 40,000
8
Practice Questions
1 Which amongst the following adjustment(s) is/are 9 ‘A’ and ‘B’ share profits in the ratio of 3 : 2. ‘A’s’
required at the time of admission of a new partner? capital is ` 40,000, ‘B’s’ capital is ` 30,000. ‘C’ is
(a) Computation of new profit sharing ratio and admitted for 1/5th share in profits. What is the
sacrificing ratio amount of capital which ‘C’ should bring?
(b) Adjustment for goodwill (a) ` 17,500 (b) ` 16,000
(c) Revaluation of assets (d) All of these (c) ` 1,00,000 (d) ` 64,000
2 Reserve or general reserve appearing in the 10 ‘A’ and ‘B’ carry on business and share profits and
balance sheet will be divided among old partners losses in the ratio of 3 : 2. Their respective capitals
during admission in ………… ratio. are ` 1,20,000 and ` 54,000. ‘C’ is admitted for
(a) gaining 1/5th share in profit and brings ` 1,20,000 as his
(b) new share of capital. Capitals of ‘A’ and ‘B’ to be
(c) sacrificing adjusted according to ‘C’s’ share.
(d) old
Calculate the amount required to bring by ‘A’.
3 On account of admission, the assets are revalued (a) ` 30,000
and liabilities are reassessed in (b) ` 1,68,000
(a) partners’ capital account (c) ` 60,000
(b) revaluation account (d) ` 28,000
(c) realisation account
11 ‘A’ and ‘B’ are partners in a firm sharing profits in
(d) balance sheet
3:2 ratio. They admitted ‘C’ as a new partner and
4 The balance of memorandum revaluation account the new profit sharing ratio will be 2:1:1. ‘C’
(second part), is transferred to the capital accounts brought in ` 40,000 as premium for goodwill for it’s
of the partners in share. What will be the journal entry for the
(a) new profit sharing ratio premium of goodwill shared by old partners as per
(b) old profit sharing ratio sacrificing ratio?
(c) capital ratio
(d) sacrificing ratio (a) Premium for Goodwill A/c Dr 40,000
To A’s Capital A/c 16,000
5 Sacrificing ratio is computed
(a) when profit sharing ratio is changed
(b) when a new partner is admitted (b) A’s Capital A/c Dr 16,000
(c) Both (a) and (b) B’s Capital A/c Dr 24,000
(d) when a partner leave the firm
6 ‘X’ and ‘Y’ are partners sharing profits equally. ‘Z’ (c) Premium for Goodwill A/c Dr 40,000
was admitted for 1/5 share. Calculate new profit To Bank A/c 40,000
sharing ratio.
(d) Bank A/c Dr 40,000
(a) 2 : 3 : 1 (b) 3 : 3 : 1
(c) 6 : 5 : 2 (d) 2 : 2 : 1 To Premium for Goodwill A/c 40,000
7 ‘A’ and ‘B’ are partners sharing profits and losses 12 A and B are partners sharing profits in the ratio
in the ratio of 5 : 3. On admission, ‘C’ brings of 3 : 1. They admit C for 1/4 share in the future
` 70,000 cash and ` 48,000 against goodwill. New profits. The new profit sharing ratio will be
profit sharing ratio between ‘A’, ‘B’ and ‘C’ is 7 : 5 : 9 3 4 8 4 4
(a) A ,B ,C (b) A ,B ,C
4. The sacrificing ratio among ‘A’ and ‘B’ is 16 16 16 16 16 16
(a) 4 : 1 (b) 4 : 7 (c) 5 : 4 (d) 3 : 1 10 2 4 8 9 10
(c) A , B , C (d) A , B , C
8 A firm has an unrecorded investment of ` 5,000. 16 16 16 16 16 16
Entry in the firm’s journal on admission of a 13 X and Y share profits in the ratio pf 3 : 2. Z was
partners will admitted as a partner who gets 1/5 share. New
(a) Unrecorded Investment A/c Dr 5,000 profit sharing ratio, if Z acquires 3/20 from X and
To Revaluation A/c 5,000 1/20 from Y would be
(b) Partners’ Capital A/c (a) 9 : 7 : 4 (b) 8 : 8 : 4
Dr 5,000
(c) 6 : 10 : 4 (d) 10 : 6 : 4
To Unrecorded Investment A/c 5,000
14 A and B share profts and losses in the ratio of 3 : 1,
(c) Revaluation A/c Dr 5,000 C is admitted into partnership for 1/4 share. The
To Unrecorded Investment A/c 5,000 sacrificing ratio of A and B is
(d) None of the above (a) equal (b) 3 : 1 (c) 2 : 1 (d) 3 : 2
Accountancy 49
15 At the time of admission of a new partner, general (b) When new partner is not able to bring his share of
goodwill.
reserve appearing in the old balance sheet is
(c) When at the time of admission, goodwill already appears in
transferred to
the balance sheet.
(a) all partners’ capital account
(b) new partners’ capital account (d) When new partner brings his share of goodwill in
(c) old partners’ capital account cash.
(d) None of the above 23 Amount of premium brought in by a new partner
16 Asha and Nisha are partners’ sharing profit in the will be shared by the existing partners in ……… .
ratio of 2 : 1. Asha’s son Ashish was admitted for (a) old ratio (b) new ratio
(c) gaining ratio (d) sacrificing ratio
1/4 share of which 1/8 was gifted by Asha to her
son. The remaining was contribited by Nisha. 24 If at the time of admission, there is some unrecorded
Goodwill of the firm is valued at ` 40,000. How liabilitity, it will be
much of the goodwill be credited to the old (a) debited to revaluation account
partners’ capital account? (b) credited to revaluation account
(a) ` 2,500 each (b) ` 5,000 each (c) debited to goodwill account
(c) ` 20,000 each (d) None of these (d) credited to partners’ capital account
17 A, B and C are partners’ in a firm. If D is admitted 25 At the time of admission of a new partner in the
as a new patner firm, the new partner compensates the old partners
(a) old firm is dissolved for their loss of share in the super-profits of the firm
(b) old firm and old partnership is dissolved for which he brings in an additional amount which
(c) old partnership is reconstituted is known as ……… .
(d) None of the above (a) capital share
(b) premium for goodwill
18 On the admission of a new patner, increase in the
value of assets is debited to
(a) profit and loss adjustment account 26 At the time of admission, incoming partner become
(b) assets account liable for the …… of the firm and also acquires right
(c) old partners’ capital account on the ………… .
(d) None of the above (a) assets, liabilities (b) goodwill, capital
19 At the time of admission of a partner, (c) liabilities, assets (d) None of these
undistributed profits appearing in the balance 27 …… goodwill is the excess of desired total capital of
sheet of the old firm is transferred to the capital firm over the actual combined capital of all partners.
account of (a) Premium (b) Share
(a) old partners in old profit sharing ratio (c) Hidden (d) Old
(b) old partners in new profit sharing ratio
(c) all the partner in the new profit sharing ratio
28. Which of the following is not a right of newly
(d) None of the above admitted partner?
(a) Right to share profits of firm
20 ……… of a new partner results in reconstitution of (b) Right to inspect the books of accounts
the firm. (c) Right to participate in affairs of busniess
(a) Admission (b) Retirement (d) None of the above
(c) Death
(d) Change in profit sharing ratio
29 The new partner, at the time of admission, may
acquire his share from old partners in
21 A new partner is admitted in the firm (a) old profit sharing ratio
(a) for procuring additional capital (b) some agreed ratio
(b) for acquiring additional managerial skills (c) particular fraction from some of the partners
(c) to benefit from the goodwill of the admitted partner (d) All of the above
30 Taxation fund should never be distributed among
22 For which of the following situations, the old profit the old partners at the time of admission of
sharing ratio of partners is used at the time of partners.
admission of a new partner? (a) True (b) False
(a) When new partner brings only a part of his share of (c) Partially true (d) Can’t say
goodwill.
ANSWERS
1. (d) 2. (d) 3. (b) 4. (a) 5. (c) 6. (d) 7. (d) 8. (a) 9. (a) 10. (b)
11. (a) 12. (a) 13. (a) 14. (b) 15. (c) 16. (c) 17. (c) 18. (a) 19. (a) 20. (a)
21. (d) 22. (b) 23. (d) 24. (a) 25. (b) 26. (c) 27. (c) 28. (d) 29. (d) 30. (a)
Hints & Solutions
1
6. ‘Z’s’ share = ;
1 4
Balance share = 1 −= ∴ Capital to bring in by ‘A’
5 5 5 = 2,88,000 − 1,20,000 = ` 1,68,000
4 1 4 2
‘X’s’ share and ‘Y’s’ share = × = or each 11. Sacrifice of A = Old Share − New Share
5 2 10 5 3 2 12 − 10 2
New profit sharing ratio of X : Y : Z = 2 : 2 : 1 = − = =
5 4 20 20
7. Sacrificing Ratio = Old Ratio − New Ratio 2 1 8 −5 3
Sacrifice of B = − = =
5 7 10 − 7 3 5 4 20 20
‘A’s’ sacrifice = − = = and
8 16 16 16 Hence, premium for goodwill account will be debited
by ` 40,000 and A’s and B’s capital accounts will be
3 5 6− 5 1
‘B’s’ sacrifice = − = = credited by ` 16,000 and ` 24,000 respectively.
8 16 16 16 1 3
Sacrificing ratio = 3 : 1 12. Remaining share of A and B = 1 − =
4 4
8. This unrecorded investment will be recorded. As 3 3 9 3 1 3
A’s new share = × = ; B’s new share = × =
investment is an asset, hence, it is debited and 4 4 16 4 4 16
revaluation account is credited to record assets at it’s 1 4 4
actual value. C’s new share = × =
4 4 16
9. 3 1
Particulars Amt (`) 13. X sacrifice = ; Y sacrifice =
‘A’s’ Capital 40,000 20 20
3 3 12 − 3 9
‘B’s’ Capital 30,000 X’s new share = − = =
Capital of ‘A’ and ‘B’ for
4
share (i.e. 1 −1 / 5)
5 20 20 20
70,000
5 2 1 8 −1 7
Y’s new share = − = =
Total Capital of Firm (70,000 × 5/ 4) 87,500 5 20 20 20
‘C’s’ Share in Capital (87,500 × 1 / 5) 17,500 3 1 4
Z’s new share = + =
10. Total capital of firm based on ‘C’s’ share 20 20 20
= 1,20,000 × 5 /1 = ` 6,00,000 14. When nothing is mentioned in the question regarding
1 4 old partners sacrifice, then sacrificing ratio will be
Remaining share = 1 − =
5 5 same as their old ratio.
New profit sharing ratio 1 1 1 2 −1 1
16. Asha sacrifice = ; Nisha sacrifice = − = =
4 3 12 8 4 8 8 8
‘A’s’ new share = × = ,
5 5 25 Sacrificing ratio = 1 : 1
4 2 8 1 5 5 ∴ Amount of goodwill credited to old partners’ capital
‘B’s’ new share = × = and ‘C’s’ share × = 1
5 5 25 5 5 25 account = 40,000 × = ` 20,000
‘A’s’ capital based on new share 2
12 30. Taxation fund is neither profits nor free reserves, so
= 6,00,000 × = ` 2,88,000
25 it is not distributed.
Accountancy 51
CHAPTER 06
Reconstitution of a Partnership :
Retirement/Death of a Partner
Retirement of a Partner Accounting Treatment of Goodwill
Retirement of a partner means retiring from the firm, i.e.,
At the time of retirement or death of a partner, his share of
ceasing to be a partner of the firm. Retirement of a partner is
profits is taken by the continuing partners. The continuing
one of the modes of reconstituting the firm under which an
partners then compensate the retiring or deceased partner in
old partnership comes to an end and a new one between the
the form of goodwill contributed in their gaining ratio.
continuing partners (i.e. partners other than the outgoing
partner) comes into existence, however, the firm continues Gaining Partners’ Capital/Current A/c Dr
its business. To Retiring Partners’ Capital/Current A/c
On the retirement or death of a partner, the existing
partnership deed comes to an end, and in its place, a new Goodwill Already Appearing in Books
partnership deed is framed, whereby the remaining partners Any goodwill already appearing in the books (balance sheet)
continue to do their business on changed terms and will be immediately written-off (debited) to old partners’
conditions. capital accounts in old profit sharing ratio. Here, the word
‘old partners’ includes the retiring partner.
Adjustments required at the
All Partners’ Capital/Current A/c Dr (In old ratio)
Time of Retirement of a Partner To Goodwill A/c (With existing book value
● Adjustment in profit sharing ratio. of goodwill)
● Adjustment for goodwill.
● Adjustment of profit/loss arising on the revaluation of Hidden Goodwill
assets and reassessment of liabilities. Sometimes the firm agrees to settle the retiring or deceased
● Adjustment of accumulated profits, reserves and losses. partners’ account by payment of a lumpsum amount. If such
amount is in excess of his capital and share in reserves/
● Computation of amount due to retiring partner and
revaluation of assets and reassessment of liabilities, etc. the
payment to retiring partner.
excess will be treated as his share of goodwill.
● Adjustment of capitals (if agreed).
New Profit Sharing Ratio At the time of retirement of a partner, the assets and
After retirement of a partner, the new ratio in which the liabilities are revalued so that the due share of an outgoing
continuing partners (i.e. partners other than the outgoing partner in the profit/loss arising from such revaluation may
partner) decides to share the future profits and losses, is be ascertained and adjusted in capital account.
known as new profit sharing ratio. For this purpose, revaluation account is prepared.
New Ratio = Old Share + Acquired Gaining Share (Revaluation account is prepared in the same manner as in
the case of change in profit sharing ratio).
Gaining Ratio
The ratio in which the continuing partners acquire the Memorandum Revaluation Account
outgoing (retired or deceased) partners’ share is called as Memorandum revaluation account is prepared when
gaining ratio. This ratio is calculated by taking out the partners decide to give effect to revaluation of assets and
difference between new profit share and old profit share. reassessment of liabilities without affecting the existing
amount of assets and liabilities.
Gaining Ratio = New Share − Old Share
Memorandum revaluation account is prepared in the same manner as has been discussed in the chapter, ‘admission of a
partner’. It is to be noted that the balance of the first part of this account is transferred to the capital accounts of all the
partners (including the outgoing partner) in their old profit sharing ratio. Whereas the balance of second part is transferred
to the capital accounts of the remaining partners (or continuing partners) in their new profit sharing ratio.
Adjustment for Reserves and Accumulated Profits/Losses

At the time of retirement, net balance (after setting off liability, if any) of specific reserves (e.g. workmen compensation
reserve, investment fluctuation reserve, general reserve and accumulated profit or loss, etc) appearing in the balance sheet is
distributed among all the partners in their profit sharing ratio.
Calculation of Amount Payable to Retiring Partner

The amount due to a retiring partner is ascertained by preparing retiring partners’ capital account, after taking into account
the following
Items to be Credited
● His share in the profit of revaluation account.
● His share of reserve/accumulated profits.
● His share of goodwill of the firm.
● His share of profit till the date of his retirement.
● Opening balance of capital and current account of retiring partner.
● His salary and/or interest on capital due to the him till the date of his retirement.
Items to be Debited
● Drawings and interest thereon of the retiring partner.
● Share in the accumulated losses of past year/years.
● Share in the loss of revaluation account.
Settlement of the Amount Due to the Retiring Partner

The amount due to the retiring partner is either paid off immediately or is transferred to his loan account. The retiring
partners’ loan account will appear in the books of the new firm as a liability until it is paid off finally. The following journal
entries are passed in this regard
Accounting Treatment
1. If the amount is paid in lumpsum Retiring Partners’ Capital A/c Dr
To Cash/ Bank A/c
2. In case the amount is paid in instalments (i) For amount due transferred to retiring partners’ loan account
Retiring Partners’ Capital A/c Dr
To Retiring Partners’ Loan A/c
(ii) On interest being provided
Interest on Loan A/c Dr
(ii) On payment of instalment with interest
Retiring Partners’ Loan A/c Dr
To Cash/Bank A/c
3. If payment is partly paid in cash and the Retiring Partners’ Capital A/c Dr
remaining amount is to be treated as loan To Cash/ Bank A/c
Death of a Partner
The partnership comes to an end immediately, whenever a partner dies although the firm may continue with the remaining
partners. The deceased partner is entitled to get his share in the firm as per the provision of a partnership agreement. His
share in the firm is calculated in the same manner as in the case of a retiring partner.
Accounting Treatment of Deceased Partner’s Share in Profits

If a partner dies on any date after the date of the balance sheet, then his share of profits is calculated from the beginning of
the year to the date of death on the basis of time or sales. When share of profit is calculated on the basis of time, it may be on
the basis of previous years’ profit or average profit of past years.
Accountancy 53
1. On the Basis of Time Profit from the date of last balance sheet to the date of death
Number of Days or Months from the Date of Last Balance Sheet to the Date of Death
=
365 Days or 12 Months
× Previous Year’s Profits or Average Profits of a Given Number of Past Years
2. On the Basis of Sales Profit from the date of last balance sheet to the date of death
Sales from the Date of the Last Balance Sheet to the Date of Death
=
Previous Year’s Sales or Average Sales of a Given Number of Past Years
× Previous Year’s Profits of Average Profits of a Given Number of Past Years
1. Through Profit and Loss Suspense Account This method is used when the new profit sharing ratio of continuing
partners does not differ from their old profit sharing ratio.
(i) In case of profit Profit and Loss Suspense A/c Dr
To Deceased Partner’s Capital A/c
(ii) In case of loss Deceased Partner’s Capital A/c Dr
To Profit and Loss Suspense A/c
2. Through Capital Transfer In case, the new profit sharing ratio of continuing partners differs from their old profit
sharing ratio, outgoing partner’s share of profit must be adjusted through capital accounts of gaining partners only.
(i) In case of profit Gaining Partners’ Capital A/c Dr (Gaining ratio)

To Deceased Partner’s Capital A/c (Share of profit)
(ii) In case of loss Deceased Partner’s Capital A/c Dr (Share of loss)
To Gaining Partners’ Capital A/c (Gaining ratio)
Settlement of Deceased Partner’s Executor’s Account

The payment to the executors of the deceased partner is made as is stated in the partnership deed or as agreed to by the
remaining partners and the executors. The payment is made either in full in one instalment or more than one instalment.
(i) When payment is made in full in one instalment Deceased Partner’s Executor’s A/c Dr
To Bank A/c
(ii) When payment is made in more than one instalment (a) When interest is due
Interest A/c Dr
To Deceased Partner’s Executor’s A/c
(b) When instalment is paid
Deceased Partner’s Executor’s A/c Dr
To Bank A/c
Solved Examples
1. A, B and C are partners sharing profit and loss in the ratio of 2 : 2 : 1. B retires from the firm on 31st March,
2022. On the date of B’s retirement, the following balances appeared in the books of the firm.
Amt (`)
Advertisement suspense account 50,000
Contingency reserve 30,000
Workmen’s compensation reserve 40,000
Loss in business account 30,000
Pass the necessary journal entries for the adjustment of these items on B’s retirement.
Sol. JOURNAL
2022
Mar 31 Contingency Reserve A/c Dr 30,000
Workmen’s Compensation Reserve A/c Dr 40,000
To A’s Capital A/c (70,000 × 2/5) 28,000
To B’s Capital A/c (70,000 × 2/5) 28,000
To C’s Capital A/c (70,000 × 1/5) 14,000
(Being the contingency reserve and workmen’s compensation reserve
transferred to capital accounts on B’s retirement)
A’s Capital A/c (80,000 × 2/5) Dr 32,000
B’s Capital A/c (80,000 × 2/5) Dr 32,000
C’s Capital A/c (80,000 × 1/5) Dr 16,000
To Advertisement Suspense A/c 50,000
To Loss in Business A/c 30,000
(Being the amount of advertisement suspense account and loss in
business account transferred to capital accounts on B’s retirement)
2. H, I and J were partners in a firm with profit sharing ratio of 1/2, 1/3 and 1/6 respectively. The balance sheet
of the firm at 31st March, 2022 was as follows
Balance Sheet
Sundry Creditors 42,000 Goodwill 12,000
Workmen Compensation Reserve 24,000 Cash at Bank 11,500
Employees’ Provident Fund 12,000 Debtors 80,000
Investment Fluctuation Reserve 12,000 (–) Provision for Doubtful Debts (4,000) 76,000
Capital A/cs Stock 75,300
H 1,36,00 Investments (Market value ` 35,200) 30,000
I 64,000 Patents 20,000
J 42,000 2,42,000 Machinery 1,00,000
Advertisement Expenditure A/c 7,200
3,32,000 3,32,000
J retired on 1st April, 2022 on the following terms.

(i) Goodwill of the firm was valued at ` 60,000.
(ii) Value of patents was to be reduced by 20% and that of machinery to 90%.
(iii) Provision for doubtful debts was to be raised to 6%.
(iv) Liability on account of provident fund was only ` 6,000.
(v) Liability for workmen compensation to the extent of ` 12,000 is to be created.
(vi) J took over the investments at market value.
(vii) Amount due to J is to be settled on the following basis.
50% on retirement, 50% of the balance within one year and the balance by a bill of exchange (without
interest) at 3 months.
Accountancy 55
You are required to show entries for the treatment of goodwill, revaluation account, partners’ capital accounts
and the balance sheet of H and I after J’s retirement.
Sol. JOURNAL
2022
Apr 1 H’s Capital A/c (12,000 × 3/6) Dr 6,000
I’s Capital A/c (12,000 × 2/6) Dr 4,000
J’s Capital A/c (12,000 × 1/6) Dr 2,000
To Goodwill A/c 12,000
(Being the existing goodwill written-off)
H’s Capital A/c Dr 6,000
I’s Capital A/c Dr 4,000
To J’s Capital A/c 10,000
(Being J’s share of goodwill credited to him by debiting gaining
partners’ in their gaining ratio of 3 : 2)
To Patents A/c 4,000 By Investment A/c (35,200 − 30,000) 5,200
To Machinery A/c 10,000 By Employees’ Provident Fund A/c 6,000
To Provision for Doubtful Debts A/c 800 By Loss on Revaluation Transferred to
H’s Capital A/c 1,800
I’s Capital A/c 1,200
J’s Capital A/c 600 3,600
14,800 14,800

Particulars H (`) I (`) J (`) Particulars H (`) I (`) J (`)
To Goodwill A/c 6,000 4,000 2,000 By Balance b/d 1,36,000 64,000 42,000
To J’s Capital A/c 6,000 4,000  By Workmen Compensation
To Revaluation A/c (Loss) 1,800 1,200 600 Reserve A/c (WN 3) 6,000 4,000 2,000
To Advertisement Expenditure A/c 3,600 2,400 1,200 By Investment Fluctuation
Reserve A/c (WN 4) 6,000 4,000 2,000
To Investments A/c   35,200 By H’s Capital A/c — — 6,000
To Bank A/c (WN 2)   8,500 By I’s Capital A/c — — 4,000
To J’s Loan A/c (WN 2)   4,250
To Bills Payable A/c (WN 2)   4,250
To Balance c/d 1,30,600 60,400 
1,48,000 72,000 56,000 1,48,000 72,000 56,000
Balance Sheet
as at 1st April, 2022
Sundry Creditors 42,000 Cash at Bank (11,500 − 8,500) 3,000
Workmen Compensation Reserve 12,000 Debtors 80,000
Employees’ Provident Fund 6,000 (–) Provision for Doubtful Debts (4,800) 75,200
Bills Payable 4,250 Stock 75,300
J’s Loan 4,250 Patents 16,000
H 1,30,600
I 60,400 1,91,000
2,59,500 2,59,500
Working Notes
1. Calculation of J’s Share of Goodwill
1
Firm’s goodwill = ` 60,000 ; J’s share of goodwill = 60,000 × = ` 10,000
6
To be contributed by H and I in their gaining ratio i.e. 3 : 2.
3 2
H = 10,000 × = ` 6,000 ; I = 10,000 × = ` 4 ,000
5 5
2. Amount due to J [(42,000 + 2,000 + 2,000 + 6,000 + 4,000) − (2,000 + 600 + 1,200 + 35,200)] = ` 17,000
50
Amount paid on retirement = × 17,000 = ` 8,500
100
50
Within one year = × 8,500 (17,000 − 8,500) = ` 4 ,250
100
Bills payable = ` 4 ,250 (8,500 – 4,250)
3. Workmen compensation reserve to the extent of liability (` 12,000) is credited to workmen compensation claim
account and the balance is credited to partners’ capital accounts.
4. Investment fluctuation reserve is a provision for fall in the price of the investment. At the time of retirement,
if market value of investments is more than its book value, it is credited to all the partners in their profit sharing
ratio.
Note Employees’ provident fund is a liability due to employees towards provident fund and is not an accumulated profit, hence it is not distributed
among the partners.
3. Following is the balance sheet of Ram, Mohan and Sohan as at 31st December, 2021.
Balance Sheet
Sundry Creditors 10,000 Tools 3,000
Workmen Compensation Reserve 7,500 Furniture 18,000
Capital A/cs Stock 16,000
Ram 20,000 Debtors 12,000
Mohan 10,000 Cash at Bank 8,000
Sohan 10,000 40,000 Cash in Hand 500
57,500 57,500
Ram, Mohan and Sohan shared profits and losses in the ratio 2 : 2 : 1. Sohan died on 31st March, 2022.
Under the partnership agreement, the executors of Sohan were entitled to
(i) Amount standing to the credit of his capital account.
(ii) Interest on capital which amounted to ` 150.
(iii) His share of goodwill ` 5,000.
(iv) His share of profit from the closing of last financial year to the date of death which amounted
to ` 750.
Sohan’s executors were paid ` 1,400 on 1st April, 2022 and the balance in four equal yearly instalments.
Pass necessary journal entries and draw up Sohan’s account to be rendered to his executors.
Sol. JOURNAL
2022
Mar 31 Interest on Capital A/c Dr 150
To Sohan’s Capital A/c 150
(Being the interest credited to Sohan’s capital account upto 31st March)
Mar 31 Ram’s Capital A/c Dr 2,500
Mohan’s Capital A/c Dr 2,500
To Sohan’s Capital A/c 5,000
(Being Sohan’s share of goodwill credited to his capital account)
Accountancy 57

Mar 31 Profit and Loss Suspense A/c Dr 750
To Sohan’s Capital A/c 750
(Being share of profit credited)
Mar 31 Workmen Compensation Reserve A/c Dr 7,500
To Ram’s Capital A/c 3,000
To Mohan’s Capital A/c 3,000
To Sohan’s Capital A/c 1,500
(Being workmen compensation reserve credited to capital accounts)
Mar 31 Sohan’s Capital A/c Dr 17,400
To Sohan’s Executor’s A/c 17,400
(Being transfer of balance in Sohan’s capital account to Sohan’s
executor’s account)
Apr 1 Sohan’s Executor’s A/c Dr 1,400
To Cash/Bank A/c 1,400
(Being amount paid to Sohan’s executors)
Dr Sohan’s Capital Account Cr
Date Particulars Amt (`) Date Particulars Amt (`)
2022 2022
Mar 31 To Sohan’s Executor’s A/c 17,400 Jan 1 By Balance b/d 10,000
Mar 31 By Interest on Capital A/c 150
Mar 31 By Ram’s Capital A/c 2,500
Mar 31 By Mohan’s Capital A/c 2,500
Mar 31 By Profit and Loss Suspense A/c 750
Mar 31 By Workmen Compensation Reserve A/c 1,500
17,400 17,400
Practice Questions
1 At the time of death of a partner, the adjustment of (a) All Partner’s Capital A/c Dr
goodwill is done in which ratio? To Goodwill A/c
(b) Goodwill A/c Dr
(a) Old profit sharing ratio (b) Gaining ratio
To All Partner’s Capital A/c
(c) Sacrificing ratio (d) None of these
(c) Goodwill A/c Dr
2 ‘X’, ‘Y’ and ‘Z’ were partners sharing profits in the To Retiring Partner’s Capital A/c
1 3 1 (d) None of the above
ratio of , and . ‘X’ retires. The new ratio will be
2 10 5 5 ‘P’, ‘Q’ and ‘R’ are partners sharing profits in the
(a) 5 : 2 (b) 1 : 1 ratio of 2 : 1 : 1. ‘R’ retires and assets and liabilities
(c) 3 : 2 (d) 5 : 1 are revalued; resulting in a profit of ` 12,000. ‘R’s’
share will be
3 The ratio in which the retiring partner’s share of
goodwill is debited to the capital accounts of (a) ` 6,000 (b) ` 3,000
(c) ` 2,000 (d) None of these
continuing partners’ is
(a) old ratio 6 ……… account is prepared when partners decide to
(b) new ratio give effect to revaluation of assets and liabilities
(c) gaining ratio without affecting their book value.
(d) sacrificing ratio (a) Revaluation
4 The journal entry for writing-off goodwill already (b) Memorandum revaluation
appearing in the books of account at the time of (c) Memorandum suspense
retirement of partner is
7 Decrease in liability at the time of retirement of 15 Gobind, Hari and Partap are partners. On
partner is retirement of Gobind, the goodwill already appears
(a) debited to revaluation account in the balance sheet at ` 24,000. The goodwill will
(b) credited to revaluation account be written-off
(c) debited to goodwill account (a) by debiting all partners’ capital accounts in their old
(d) Both (b) and (c) profit sharing ratio
8 ‘A’, ‘B’ and ‘C’ were in partnership sharing profits (b) by debiting remaining partners’ capital accounts in
their new profit sharing ratio
and losses equally. ‘B’ retires. After adjustments,
(c) by debiting retiring partners’ capital accounts from
his capital account shows a credit balance of his share of goodwill
` 1,20,000 as on 1st April, 2021. The balance due to (d) None of the above
‘B’ is to be paid in three equal instalments together
with interest @ 5% per annum. Amount to be paid 16 Chaman, Raman and Suman are partners sharing
to ‘B’ on 30th March, 2022 will be profits in the ratio of 5 : 3 : 2. Raman retires, the
(a) ` 60,000 (b) ` 40,000 new profit sharing ratio between Chaman and
(c) ` 46,000 (d) ` 54,000 Suman will be 1 : 1. The goodwill of the firm is
valued at ` 1,00,000. Raman’s share of goodwill will
9 Neeti, Preeti and Swati are partners sharing profit
be adjusted
in the equal ratio. At the time of retirement of (a) by debiting Chaman’s capital account and Suman’s
Neeti, Workmen Compensation Reserve (WCR) capital account with ` 15,000 each
appears in the books at ` 70,000. There is a claim of (b) by debiting Chaman’s capital account and Suman’s
` 25,000 against it. The amount of WCR credited to capital account with ` 21,429 and ` 8,571 respectively
Neeti’s capital account will be (c) by debiting only Suman’s capital account with
(a) ` 33,300 (b) 16,667 ` 30,000
(c) ` 15,000 (d) None of these (d) by debiting Raman’s capital account with ` 30,000
10 Abhishek, Rajat and Vivek are partners sharing 17 On retirement/death of a partner, the remaining
profits in the ratio of 5 : 3 : 2. If Vivek retires, the partner(s) who have gained due to change in profit
new profit sharing ratio between Abhishek and sharing ratio should compensate the
Rajat will be (a) retiring partners only
(a) 3 : 2 (b) 5 : 3 (b) remaining partners (who have sacrificed) as well as
(c) 5 : 2 (d) None of these retiring partners
11 The old profit sharing ratio among Rajender, Satish (c) remaining partners only (who have sacrificed)
and Tejpal were 2 : 2: 1. The new profit sharing ratio (d) None of the above
after satish’s retirement is 3 : 2. The gaining ratio is 18 In case of retirement of a partner, profit or loss on
(a) 3 : 2 (b) 2 : 1
revaluation of assets and re-assessment of
(c) 1 : 1 (d) 2 : 2
liabilities is distributed among ……… in ………
12 Anand, Bahadur and Chander are partners. profit sharing ratio.
Sharing profit equally on Chander’s retirement, his (a) all the partners, old
share is acquired by Anand and Bahadur in ratio of (b) all the partners, new
3 : 2. The new profit sharing ratio between Anand (c) other than retiring partner, old
and Bahadur will be (d) other than retiring partner, new
(a) 8 : 7 (b) 4 : 5 19 On the death of a partner , his share in the profits
(c) 3 : 2 (d) 2 : 3 of the firm till the date of his death is transferred to
13 In the absence of any information regarding the the
acquisition of share in profit of the retiring/ (a) debit of profit and loss account
deceased partner by the remaining partners, it is (b) credit of profit and loss account
assumed that they will acquire his/her share (c) debit of profit and loss suspense account
(d) credit of profit and loss suspense account
(a) old profit sharing ratio
(b) new profit sharing ratio 20 Unless agreed otherwise, it is presumed that the
(c) equal ratio continuing partners gain in their ………… and
(d) None of the above hence their ……… is same as their old profit
14 On retirement/death of a partner, the retiring/ sharing ratio.
deceased partner’s capital account will be credited (a) new profit sharing ratio, gaining ratio
with (b) new profit sharing ratio, sacrificing ratio
(a) his/her share of goodwill (c) old profit sharing ratio, sacrificing ratio
(b) goodwill of the firm (d) old profit sharing ratio, gaining ratio
(c) shares of goodwill of remaining partners 21 How revaluation account will be affected if there is
(d) None of the above an increase in liability and decrease in asset by the
same amount?
Accountancy 59
(a) Profit on revaluation State the rate at which interest will be paid to R.
(b) Loss on revaluation (a) 12%
(c) No profit, no loss (b) 6%
(d) Cannot be determined (c) 10%
22 ……… goodwill is the excess of total capital of firm (d) None of the above
over the actual combined capital of partners. 27 Claim of the retiring partner is payable in which of
(a) Hidden (b) Old the following form?
(c) New (d) None of these (a) Fully in cash
23 Which of the following statements is/are incorrect? (b) Fully transferred to loan account to be paid later
with some interest on it
(i) Revaluation of asset is necessary because (c) Partly in cash and partly as loan repayable later
present value of assets is different from market with agreed interest
value. (d) Any of the above method
(ii) A partner can retire from the firm with the 28 On the death of a partner, the amount due to him
consent of all the partners only. will be credited to
Codes (a) all partner’s capital accounts
(a) Only (i) (b) Only (ii) (b) remaining partner’s capital accounts
(c) Both (a) and (b) (d) None of these (c) hist executor’s account
24 A, B and C are partners with capitals ` 1,00,000, (d) governments’ revenue account
` 75,000 and ` 50,000 respectively. On C’s 29 What treatment is made for accumulated profits
retirement, his share is acquired by A and B in and losses on the retirement of a partner?
ratio of 5 : 3. Gaining ratio will be (a) Credited to all partner’s capital accounts in old ratio.
(a) 3 : 2 (b) 2 : 2 (b) Debited to all partner’s capital accounts in old ratio.
(c) 5 : 3 (d) None of these (c) Credited to remaining partner’s capital accounts in
new ratio.
25 At the time of retirement of Mahesh, value of stock
(d) Credited to remaining partner’s capital accounts in
is given ` 60,000 in the balance sheet of the firm. gaining ratio.
Pass a journal entry when found stock is
undervalued by ` 15,000. 30 Find the incorrect pair.
(a) Revaluation A/c Dr 15,000 Column I Column II
To Stock A/c 15,000 A. Gaining ratio (i) Old Profit Ratio – New
(b) Stock A/c Dr 15,000 Profit Ratio
To Revaluation A/c 15,000 B. Retirement of a partner (ii) Relation with a firm of the
(c) Stock A/c Dr 45,000 partner comes to an end
To Revaluation A/c 45,000 C. Change in value of (iii) Revaluation account
(d) Revaluation A/c Dr 45,000 assets and liabilities
To Stock A/c 45,000 D. Amount payable to (iv) Retiring partner’s loan
26 P, Q and R were partners in a firm. On 31st March, retiring partner account
2021, R retired. The amount payable to R ` 2,17,000 Codes
was transferred to his loan account. R agreed to (a) A-(i) (b) B-(ii)
receive interest on this amount as per the (c) C-(iii) (d) D-(iv)
provisions of Partnership Act, 1932.
ANSWERS
1. (b) 2. (c) 3. (c) 4. (a) 5. (b) 6. (b) 7. (b) 8. (c) 9. (c) 10. (b)
11. (c) 12. (a) 13. (a) 14. (a) 15. (a) 16. (c) 17. (b) 18. (a) 19. (c) 20. (d)
21. (c) 22. (a) 23. (c) 24. (c) 25. (b) 26. (b) 27. (d) 28. (c) 29. (a) 30. (a)
Hints & Solutions

1 3 1 1 3 5+3 8
2. Old profit sharing ratio = : : or 5 : 3 : 2 Anand’s new share = + = =
2 10 5 3 15 15 15
Eliminating X’s share, the ratio between ‘Y’ 1 2 5+2 7
Bahadur’s new share = + = =
and ‘Z’ = 3 : 2. 3 5 15 15
3. When a partner retires or dies, his share in the firm is New ratio = 8 : 7
acquired by the remaining partners in gaining ratio. 16. Gaining Ratio = New Ratio − Old Ratio
Therefore, goodwill is debited to old partner’s capital 1 5 5 −5
account in gaining ratio. Chaman gains = − = = Nil
2 10 10
1 1 2 5 −2 3
5. ‘R’s’ share in revaluation profits = 12,000 × = ` 3,000 Suman gains = − = =
4 2 10 10 10
1,20,000
8. Yearly instalment = = ` 40,000 Firm’s goodwill = ` 1,00,000
3 3
5 Raman’s share of goodwill = 1,00,000 × = ` 30,000
Amount of interest = 1,20,000 × = ` 6,000 10
100
will be paid by Suman (gaining partner).
Total amount payable = 40,000 + 6,000 = ` 46,000
18. Profit or loss on revaluation is shared among all the
9. Amount to be credited to Neeti’s capital account partners in old profit sharing ratio with the view that
1
= (70,000 − 25,000) × = ` 15,000 the retiring partner does not benefit or loose because
3 of the change in the values of assets and liabilities.
10. If nothing is mentioned regarding new ratio or gain of 21. Change in both the sides of revaluation account by the
existing partners, then the new ratio of remaining same amount nullify the effect of each other.
partners will be same as their old ratio.
23. Revaluation of asset is necessary because present
11. Gaining Ratio = New Ratio − Old Ratio value of assets is different from book value. Partner
3 2 1
Rajender gains = − = can also retire in accordance with an express
5 5 5 agreement by the partners or by giving notice in
2 1 1 writing to all other partners of his intention to retire,
Tejpal gain = − =
5 5 5 in case of retirement.
Gaining ratio = 1 : 1 24. On C’s retirement, his share is acquired by A and B in
1 the ratio of 5 : 3. Therefore, 5 : 3 is the gaining ratio.
12. Chander’s share =
3 26. As per the Section 37 of Indian Partnership Act, 1932,
3 1 3
Anand gains = × = retiring partner is entitled to get interest at the rate
5 3 15 of 6% on the unpaid amount.
2 1 2
Bahadur gains = × = 30. Gaining Ratio = New Profit Ratio – Old Profit Ratio
5 3 15
Accountancy 61
CHAPTER 07
Dissolution of a
Partnership Firm
Dissolution (c) On completion of work
Dissolution means breaking-up or extinction i.e. (d) By adjudication of a partner as insolvent
discontinuance of existing relationship among the partners. ● Dissolution by court
Under the Indian Partnership Act, 1932, the dissolution may (a) A partner becomes a person of unsound mind.
be either of partnership or of a firm. (b) A partner becomes permanently incapable of
performing his duties.
Dissolution of Partnership (c) Partnership agreement is breached persistently by
It changes the existing relationship between partners but the some partner.
firm may continue its business as before. (d) A partner is found guilty of misconduct.
The partnership is deemed to have been dissolved in any of (e) Court finds the dissolution of the firm justified.
the following cases (f) Court finds firm cannot be carried except at a loss.
● In case of change in existing profit sharing ratio among
(g) A partner has transferred whole of his interest to a
partners. third party.
● In case of admission of a new partner.
● In case of retirement of a partner. Settlement of Accounts in

● In case of death of a partner. Case of Dissolution of Firm
● In case of insolvency of a partner. As per Section 48, settling the accounts of a firm after
● In case of completion of the venture, if partnership is
dissolution, the following rules subject to the agreement by
the partners, shall be observed
formed for that.
● In case of expiry of the period of partnership, if partnership
1. Treatment of Losses Losses including deficiencies of
is for a specific period of time. capital shall be paid in the following manner
● First out of profits
Dissolution of a Firm ● Next out of capital
Dissolution of the firm means dissolution of partnership ● Lastly, if necessary, by the partners individually in
among all the partners in the firm. In such a case, the their profit sharing ratio. [Section 48(a)]
business of the firm also comes to an end.
2. Application of Assets The assets of the firm,
Modes of dissolution of partnership firm are including any sum contributed by the partners to make
● Dissolution by mutual agreement up deficiencies, shall be applied in the following
● Compulsory dissolution manner
● First to pay firm’s debts to the third parties, i.e. outside
(a) On insolvency of partners
(b) On business becoming illegal parties.
● Then to pay loans from partners.
● Dissolution by notice
● Then to pay capitals of partners.

● On the happening of an event
● Lastly the surplus (if any) shall be distributed among

(a) On death of a partner
(b) On expiry of term the partners in their profit sharing ratio. [Section 48(b)]
Treatment of Firm’s Debts and Private Debts

As per Section 49, where both the debts of the firm and private debts of a partner co-exist, the following rules shall apply
● Firm’s property is applied first in payment of firm’s debts and if there is any surplus, then the share of each partner is
applied in the payment of his private debts or paid to him.

● Partner’s private property is applied first in payment of his private debts and the surplus (if any) in payment of firm’s
debts if the firm’s liabilities exceed the firm’s assets.

Journal Entries on Dissolution of a Firm
Transfer of Assets Realisation A/c Dr At book value
(Except cash and bank balance) To Sundry Assets A/c
Transfer of Liabilities (Except partner’s Sundry Liabilities A/c Dr At book value
loan, capital and undistributed profits) To Realisation A/c
Sale of Assets Cash/Bank A/c Dr At selling price
To Realisation A/c
Assets Taken Over by Partner Partner’s Capital A/c Dr At agreed value
To Realisation A/c
Sale of Unrecorded Assets Cash/Bank A/c Dr Amount received on sale
(Which did not exist in the balance sheet) To Realisation A/c
Payment of Liabilities Realisation A/c Dr Amount of payment
To Cash/Bank A/c
Any Liability Taken Over by the Partner Realisation A/c Dr At agreed value
To Partner’s Capital A/c
Payment of Realisation Expenses Realisation A/c Dr Amount of payment
To Cash/Bank A/c
Payment of Unrecorded Liability Realisation A/c Dr Amount of payment
(Which did not exist in the balance sheet) To Cash/Bank A/c
Payment of Realisation Expenses Realisation A/c Dr Amount of payment
by any Partner To Partner’s Capital A/c
Credit Balance of Realisation Account (Profit) Realisation A/c Dr In profit sharing ratio
To Partners’ Capital/Current A/c
Debit Balance of Realisation Account (Loss) Partners’ Capital/Current A/c Dr In profit sharing ratio
To Realisation A/c
Accounting Treatment on Dissolution

Following accounts are opened in the books of the firm
● Realisation Account ● Partners’ Capital Account
● Partner’s Loan Account ● Cash/Bank Account
Realisation Account
It is opened on the dissolution of a firm. It is a nominal account which is prepared to determine the profit or loss on the
realisation of assets and payment of liabilities.
Dr Realisation Account Cr
To Sundry Assets A/c … By Sundry Liabilities A/c …
[Excluding cash, bank, fictitious asset, [Excluding partners’ capital, loan from partner(s),
accumulated losses, debit balance of reserve, accumulated profit etc.]
partners’ capital/current account, loans to
partner(s)]
To Provision on Any Liability A/c … By Provision on Any Assets A/c …
To Bank/Cash A/c … By Bank/Cash A/c …
(Amount paid for discharging liabilities) (Amount received on realisation of assets)
To Bank/Cash A/c (Expenses on realisation) … By Bank/Cash A/c …
(Amount received from unrecorded assets)
Accountancy 63

To Partners’ Capital/Current A/c … By Partners’ Capital A/c …
(Liability taken over by a partner or (Assets taken over by a partner recorded or
remuneration/ commission paid to him unrecorded)
or any expenses beared by him)
To Partners’ Capital/Current A/c … By Partners’ Capital/Current A/c …
(Profit on realisation)* (Loss on realisation)*
… …
*Anyone of two amounts will appear.

Note All provisions created against any asset or liability/provision for doubtful debts, provision for depreciation should be transferred to realisation
account on credit or debit side as the case may be and it should be noted that those assets or liabilities should appear in realisation account
at gross value.
Partners’ Capital Account

Balance of partners’ capital accounts and current accounts are recorded in this account. Any asset of firm taken over by the
partner is recorded on the debit side of their capital account and any liability taken over is recorded on the credit side of their
capital account.
Particulars X (`) Y (`) Particulars X (`) Y (`)
To Balance b/d (Debit balance) … … By Balance b/d (Credit balance) … …
To Profit and Loss A/c (Loss) … … By General Reserve A/c … …
To Advertisement Expenditure A/c … … By Profit and Loss A/c (Profit) … …
To Realisation A/c (Assets taken over) … … By Workmen’s Compensation Fund A/c … …
To Realisation A/c (Loss on realisation) … … By Realisation A/c (Liabilities taken over) … …
To Cash/Bank A/c (Excess cash paid) … … By Realisation A/c (Profit on realisation) … …
By Cash/Bank A/c (Cash brought in) … …
… … … …
Partner’s Loan Account

Partner’s loan will be paid only after all outside liabilities are paid in full. Thus, partner’s loan account is not transferred to
realisation account and a separate account is prepared namely partner’s loan account and is paid-off by passing the following
entry
Partner’s Loan A/c Dr
To Cash/Bank A/c
Cash/Bank Account
In case of dissolution of a firm, cash account (or bank account) is prepared and closed at the end. It is a real account in nature.
Dr Cash/Bank Account Cr
To Balance b/d (Cash in hand or cash at bank) … By Balance b/d (Bank overdraft) …
To Realisation A/c (Assets realised) … By Realisation A/c (Liabilities paid) …
To Partner’s Capital A/c … By Realisation A/c (Realisation expenses paid) …
(Cash brought in by a partner) By Partner’s Loan A/c (Partner’s loan paid) …
By Partner’s Capital A/c …
(Excess cash paid to partner)
… …
Preparation of Memorandum Balance Sheet

Memorandum balance sheet is prepared for calculating the missing figures of various assets or various liabilities. Sometimes,
the total value of sundry assets is not given.
However, the value realised from the assets is given, the partners’ capital and other liabilities are also given. In that case,
sundry assets have to be ascertained by preparing the old balance sheet. The amount of capital and other liabilities are added.
The sum total is the total amount of assets.
Solved Exmples
1. Pass the necessary journal entries for the following transactions on the dissolution of firm of X, Y and Z (who
were sharing profits in the ratio of 2 : 2 : 1) after the transfer of all assets (other than cash) and external
liabilities to realisation account.
(i) Debtors were of ` 1,24,200. X takes over debtors amounted to ` 1,20,000 at ` 1,17,200 and the remaining
debtors were sold to a debt collecting agency at 50% of the value.
(ii) Sundry assets were of ` 1,17,000. Y is to take over some sundry assets at ` 72,000 (being 10% less than the
book value). Z is to take over remaining sundry assets at 80% of the book value.
(iii) Z assumes the responsibility of discharge of Mrs Z’s loan of ` 11,500 together with accrued interest of ` 2,300.
Sol. JOURNAL
(i) (a) X’s Capital A/c Dr 1,17,200
To Realisation A/c 1,17,200
(Being some debtors taken over by X)
(b) Cash/Bank A/c [(1,24,200 – 1,20,000) × 50/100] Dr 2,100
To Realisation A/c 2,100
(Being the remaining debtors sold to a debt collecting agency)
(ii) (a) Y’s Capital A/c Dr 72,000
(Being sundry assets of value ` 80,000  72,000 ×
100 
 taken over
 90 
by Y at ` 72,000)
, ,000 − 80,000) × 80/100]
(b) Z’s Capital A/c [(117 Dr 29,600
(Being the remaining sundry assets taken over by Z)
(iii) Realisation A/c Dr 13,800
To Z’s Capital A/c (11,500 + 2,300) 13,800
(Being Mrs Z’s loan paid by Z)
2. Y and Z, who were sharing profits and losses in the ratio of 3 : 1 respectively, decided to dissolve the firm on
31st March, 2021.
At that date, some of the balances were
Y’s capital ` 50,000
Z’s capital ` 5,000 (Debit balance)
Profit and loss account ` 4,000 (Debit balance)
Trade creditors ` 15,000
Loan from Mrs Y ` 5,000
Cash at bank ` 1,000
The assets (other than cash at bank) realised ` 55,000 and all creditors including loan from Mrs Y were paid-off
less 5% discount. Realisation expenses amounted to ` 500.
Prepare the realisation account, capital accounts of the partners and bank account assuming that both the
partners are solvent.
Sol. Dr Realisation Account Cr
To Sundry Assets A/c (WN) 60,000 By Sundry Liabilities A/c
To Bank A/c (Trade creditors) 14,250 Trade Creditors 15,000
To Bank A/c (Loan from Mrs Y) 4,750 Loan from Mrs Y 5,000 20,000
To Bank A/c (Expenses) 500 By Bank A/c (Sundry assets realised) 55,000
By Loss on Realisation Transferred to
Y’s Capital A/c 3,375
Z’s Capital A/c 1,125 4,500
79,500 79,500
Accountancy 65

Particulars Y (`) Z (`) Particulars Y (`) Z (`)
To Balance b/d — 5,000 By Balance b/d 50,000 —
To Profit and Loss A/c (Loss) 3,000 1,000 By Bank A/c (Cash brought in) — 7,125
To Realisation A/c (Loss) 3,375 1,125
To Bank A/c (Final payment) 43,625 —
50,000 7,125 50,000 7,125
Dr Bank Account Cr
To Balance b/d 1,000 By Realisation A/c (Trade creditors) 14,250
To Realisation A/c (Assets realised) 55,000 By Realisation A/c (Loan from Mrs Y) 4,750
To Z’s Capital A/c (Cash brought in) 7,125 By Realisation A/c (Expenses) 500
By Y’s Capital A/c (Final payment) 43,625
63,125 63,125
Working Note
Calculation of Sundry Assets (Except cash at bank)
Memorandum Balance Sheet
Trade Creditors 15,000 Cash at Bank 1,000
Loan from Mrs Y 5,000 Z’s Capital 5,000
Y’s Capital 50,000 Profit and Loss A/c 4,000
Other Sundry Assets (Balancing figure) 60,000
70,000 70,000
Practice Questions
1 On dissolution, realisation account is debited with 5 Amount realised from sale of assets is recorded on
(a) all assets (b) all assets to be realised the ……… side of cash/bank account.
(c) all liabilities (d) all liabilities to be paid (a) debit (b) credit
2 Dissolution of partnership between all partners of (c) not shown in cash/bank account
firm is called (d) None of these
(a) dissolution of firm 6 The firm of A and B was dissolved on 31st March,
(b) dissolution of partnership 2020. According to the agreement, B had agreed to
(c) dissolution of firm name undertake the dissolution work for an agreed
(d) None of the above remuneration of ` 8,000 and bear all the
3 Partners may dissolve a firm by mutual realisation expenses. Dissolution expenses were
agreement. This is specified in Section ……… of ` 5,000. The journal entry passed will be
the Act. (a) Realisation A/c Dr 5,000
(a) 39 (b) 40 To Bank A/c 5,000
(c) 41 (d) 42 (b) Realisation A/c Dr 8,000
To Bank A/c 8,000
4 When an asset is taken over by a partner, his (c) Realisation A/c Dr 5,000
capital account is To B’s Capital A/c 5,000
(a) debited (b) credited (d) Realisation A/c Dr 8,000
(c) no entry will be passed (d) None of these To B’s Capital A/c 8,000
7 P and Q are partners in a firm. They decided to 17 In the event of dissolution of a firm, the partners’
dissolve the firm. Assets other than cash ` 1,60,000, personal assets are first applied for payment of
cash ` 25,000, total liabilities ` 1,75,000. On …… .
dissolution, assets realised ` 1,25,000 and liabilities (a) the personal liabilities (b) the firm’s liabilities
paid ` 1, 40,000. Net profit or loss on realisation is
(d) preferential tax liabilities
(a) profit ` 25,000 (b) loss ` 25,000
(c) loss `15,000 (d) no profit, no loss 18 Which of the statements is/are correct?
8 On dissolution of a firm, bank overdraft is (i) Dissolution of firm is a subset of dissolution of
transferred to partnership.
(a) cash account (b) bank account (ii) When firm’s goodwill is taken over by a partner
(c) realisation account at the time of dissolution, it is not recorded in
(d) partners’ capital accounts
the books.
9 On dissolution of a firm, partner’s loan account is Alternatives
transferred to (a) Only (i) (b) Only (ii)
(a) realisation account (c) Both (a) and (b) (d) None of these
(b) partners’ capital accounts
(c) partners’ current accounts 19 On the basis of the following data, how much final
(d) None of the above payment will be made to a partner on firm’s
dissolution? Credit balance of capital account of the
10 After transferring liabilities like creditors and bills
partner was ` 50,000. Share of loss on realisation
payables in the realisation account, in the absence
amounted to ` 10,000. Firm’s liability taken over by
of any information regarding the payment, such
him was for ` 8,000.
liabilities are treated as
(a) ` 32,000 (b) ` 48,000
(a) never paid (b) fully paid
(c) ` 40,000 (d) ` 52,000
(c) partly paid (d) None of these
20 Rishabh and Vansh are partners in a firm sharing
11 When realisation expenses are paid by the firm on
profits in the ratio of 3 : 2. Mrs. Rishabh has given
behalf of a partner, such expenses are debited to
(a) realisation account
a loan of ` 20,000 to the firm and the firm has also
(b) partners’ capital accounts taken a loan from Vansh of ` 15,000. The firm was
(c) partners’ loan accounts resolved and its assets were realised for ` 30,000.
(d) None of the above To whom company will repay if there were no other
creditors of the firm?
12 Unrecorded assets when taken over by a partner
(a) First repay ` 15,000 to Mr. Vansh
are shown in (b) First repay ` 20,000 to Mrs. Rishabh
(a) debit side of realisation account (c) Repay ` 15,000 each
(b) debit side of bank account (d) Repay in the ratio of 4:3
(c) credit side of realisation account
(d) credit side of bank account 21 On the dissolution of the firm, realisation account
is closed through
13 Unrecorded liabilities when paid are shown in
(a) bank account (b) partners’ capital account
(a) debit side of realisation account
(c) loan account (d) drawings account
(b) debit side of bank account
(c) credit side of realisation account 22 What journal entry will be passed if remuneration
(d) credit side of bank account expenses of ` 5,450 were to be borne by Rajesh,
14 The accumulated profits and reserves are however it is paid by Sanjana?
transferred to (a) Sanjana’s Capital A/c Dr 5,450
To Bank A/c 5,450
(a) realisation account
(b) Rajesh’s Capital A/c Dr 5,450
(b) partners’ capital accounts
To Sanjana’s Capital A/c 5,450
(c) bank account
(c) Sanjana’s Capital A/c Dr 5,450
To Rajesh’s Capital A/c 5,450
15 On dissolution of the firm, partner’s capital (d) Rajesh’s Capital A/c Dr 5,450
accounts are closed through To Bank A/c 5,450
(a) realisation account (b) drawings account 23 Amit, Barun and Chanda are partners. They
(c) bank account (d) loan account decided to dissolve the firm. There is a debit
16 Court cannot pass the order to dissolve the firm, balance of ` 27,000 in the profit and loss account on
when ……… . the date of dissolution. What journal entry would
(a) partners become incapable permanently be passed?
(b) partnership agreement persistently followed by partners (a) Profit and Loss A/c Dr 27,000
(c) business of the firm cannot be carried except at a To Amit’s Capital A/c 9,000
loss To Barun’s Capital A/c 9,000
(d) partner transfer whole of its interest to a third party To Chanda’s Capital A/c 9,000
Accountancy 67
(b) Amit’s Capital A/c Dr 9,000 27 Realisation account is prepared at the time of …… .
Barun’s Capital A/c Dr 9,000 (a) admission of a partner
Chanda’s Capital A/c Dr 9,000 (b) change in profit sharing ratio
To Profit and Loss A/c 27,000 (c) dissolution of a firm
(c) No entry (d) dissolution of partnership only
28 On firm’s dissolution, a partner A took over 50% of
24 When an unrecorded asset is realised at the time of the stock at a discount of 20% (book value of stock
dissolution of the firm, ............. account is debited was ` 5,00,000). What will be the value of taken
and ................ account is credited. over stock?
(a) realisation, cash
(a) ` 2,50,000 (b) ` 1,00,000
(b) concerned partner account, cash
(c) ` 2,00,000 (d) ` 5,00,000
(c) cash, realisation
(d) realisation, concerned partner account 29 At the time of dissolution of a partnership firm, the
25 Jhunjhun, a partner paid loan of the firm of provision for doubtful debts is transferred to which
` 1,00,000 at the time of dissolution. Pass the account?
(a) Realisation account
journal entry for this transaction.
(b) Partner’s capital account
(a) Jhunjhun’s Capital A/c Dr 1,00,000
(c) Cash account
To Realisation A/c 1,00,000
(b) Realisation A/c Dr 1,00,000
To Loan A/c 1,00,000 30 At the time of dissolution of partnership firm,
(c) Realisation A/c Dr 1,00,000 journal entry for the settlement of loan advanced by
To Jhunjhun’s Capital A/c 1,00,000 the firm to a partner would be
(d) None of the above (a) Bank A/c Dr
To Loan to Partner A/c
26 If the debit side of realisation account exceeds the
(b) Loan to Partner A/c Dr
credit side, then it signifies To Bank A/c
(a) profit on realisation
(c) Realisation A/c Dr
(b) loss on realisation
To Loan to Partner A/c
(c) neither profit nor loss
(d) None of these (d) All of the above
ANSWERS
1. (b) 2. (a) 3. (b) 4. (a) 5. (a) 6. (d) 7. (d) 8. (c) 9. (d) 10. (b)
11. (d) 12. (c) 13. (a) 14. (b) 15. (c) 16. (b) 17. (a) 18. (d) 19. (b) 20. (b)
21. (b) 22. (b) 23. (b) 24. (c) 25. (c) 26. (b) 27. (c) 28. (c) 29. (a) 30. (a)
Hints & Solutions

4. When an asset is taken by a partner, his capital account is debited because the claim of capital account is reduced by
the value of that asset
6. In this case, the firm pays remuneration to a partner for carrying out dissolution work, so no further entry is passed
in the books of the firm regarding actual payment of expenses.
7. Dr Realisation Account Cr
To Sundry Assets 1,60,000 By Sundry Liabilities 1,75,000
To Bank 1,40,000 By Bank 1,25,000
3,00,000 3,00,000
16. Court can pass order to dissolve the firm if partnership agreement is breached constantly by a partner or partners.
17. Private property used first for the payment of private debts.
18. Dissolution of partnership is a subset of dissolution of firm but not vice-versa. When firm’s goodwill is taken over by
a partner, partners’ account will be debited and realisation account will be credited with the same amount.
19. Dr Partners’ Capital Account Cr
To Realisation A/c (Loss) 10,000 By Balance b/d 50,000
To Bank A/c (Final payment) 48,000 By Realisation A/c 8,000
(Liability taken over)
58,000 58,000
20. First, firm will settle down its debts with the third party, then partners’ loans and advances.
22. The partner who is ready to bear the expenses, will be debited and the partner who actually pays the expenses will
be credited.
24. Cash/Bank A/c Dr
To Realisation A/c
28. Calculation of value of 50% stock taken over by A
50
5,00,000 × = 2,50,000
100
20
(− ) 2,50,000 × = (50,000)
100
` 2,00,000
Accountancy 69
CHAPTER 08
Accounting for Share Capital

Meaning of Company Nature of Shares
A company is an incorporated association which is an
As per Section 44 of the Companies Act, 2013, shares or
artificial person created by law, having a separate legal entity
debentures or other interest of any member in a company shall
with a perpetual succession and a common seal.
be movable property, transferable in the manner provided by
Kinds of Companies the Articles of the company.
Companies can be classified as
According to Sale of Goods Act, 1930, “Goods mean any
1. Private Company As per Section 2(68) of Companies kind of movable property other than actionable claims and
Act, 2013, a private company is one which has a money, and includes stock and shares”.
minimum paid-up capital as may be prescribed* and So, on the basis of above two definitions, it can be
which by its articles of association concluded that shares are basically goods which can be
● Restricts the right to transfer its shares, if any. bought, sold or gifted.
● Except in one person company, limits the number of its
Classes or Kinds of Shares
members excluding its present and past employee
Shares are mainly classified into two categories
members to 200. (If any shares is held jointly by two or
more persons, they shall be treated as a single member). 1. Preference Shares Preference shares are the shares
● Prohibits any invitation to the public to subscribe for
that carry the following two rights
● Preference right of dividend to be paid as fixed
any securities of the company. The name of a private
company ends with the words, ‘Private Limited’. amount or an amount calculated at a fixed rate, which
may either be free or subject to income tax.
2. Public Company As per Section 2(71) of Companies
● Return of capital on the winding up of the company
Act, 2013, public company is a company which
● is not a private company.
before that of equity shares.
● has minimum capital as may be prescribed*.
2. Equity Shares Equity shares are shares which are not
preference shares. Thus, this share does not carry any
● is a private company, being a subsidiary of a company
preferential right or in other words, equity share is one
which is not a private company. The name of the public which is entitled to dividend and repayment of capital
company ends with the word ‘Limited’. after the claim of preference shares is satisfied.
3. One Person Company Section 2(62) of the Companies
Act, 2013 defines one persons company as a company Share Capital
which has only one person as a member. It is a company It is that part of the capital of a company, which is
incorporated as a private company which has only one represented by the total nominal value of shares, which it has
member. issued.
Note *Minimum paid-up capital is not prescribed. Private or public
companies can have share capital as the promoters decide. Classification of Share Capital
From accounting point of view share capital can be
Share classified as
The capital of a company is divided into small units. Each of 1. Authorised Share Capital According to Section 2(8)
these small units is called a share. Each share has a nominal of Companies Act, 2013, ‘authorised capital’ or
value or face value, which may be ` 1 or ` 2 or ` 5 or ` 10 or ‘nominal capital’ means such capital as is authorised
any amount. by the memorandum of a company to be the
maximum amount of share capital of a company.
2. Issued Capital According to Section 2(50) of the Companies Act, 2013, issued capital means such capital as the
company issues from time-to-time for subscription.
3. Subscribed Capital According to Section 2(86) of the Companies Act, 2013, ‘subscribed capital’ means such part of
the capital which is for the time being subscribed by the members of a company.
(i) Subscribed and Fully Paid-up Shares are said to be ‘subscribed and fully paid-up’ when the entire nominal
(face) value is called and also paid-up by the shareholders.
(ii) Subscribed but not Fully Paid-up Shares are said to be ‘subscribed but not fully paid-up’ when
● The company has called-up the entire nominal (face) value of the share but has not received it.
● The company has not called-up the entire nominal (face) value of share.
4. Reserve Capital It is that portion of uncalled share capital which shall not be capable of being called-up except in the
event and for the purpose of the company being wound up.
Capital Reserve
It is the reserve which is not free for distribution as dividend. It is mandatory to create capital reserve in case of capital profits
earned by the company. Reserves which are created out of capital profits, are not readily available for distribution as dividend
among the shareholders. e.g. premium on issue of shares or debentures, profits on re-issue of shares, profits prior to
incorporation, premium on redemption of debentures.
Presentation of Share Capital in Company’s Balance Sheet

As per Schedule III, Part I of Companies Act, 2013, share capital is to be disclosed in a company’s balance sheet on equity and
liabilities part under the head shareholders’ funds in the following manner
Balance Sheet
as at ...
Particulars Note No. Current Year (`) Previous Year (`)
I. EQUITY AND LIABILITIES
1. Shareholders’ Funds
*(a) Share Capital 1 ... ...
*As per Schedule III, disclosure requirements pertaining to share capital are to be provided in notes to accounts and note number be put
against the item in the balance sheet.
Notes to Accounts
Particulars Amt (`)
1. Share Capital
Authorised Capital
... Shares of ` ... each …
Issued Capital
Subscribed Capital
Subscribed and Fully Paid-up
Subscribed but not Fully Paid-up
... Shares of ` ... each ... called-up
(−) Calls-in-arrears (if any) …
(+) Shares Forfeited A/c (…) …
Total …
Accountancy 71
Issue of Shares
A company raises its capital by issue of shares. A company may issue shares
1. At Par When shares are issued at their face value, the shares are said to have been issued at par, i.e., issue price and
face value are same.
2. At Premium When shares are issued at a value that is higher than the face value of the shares, the shares are said to
have been issued at premium, i.e. issue price is more than the face value.
Note As per Section 53 of the Companies Act, 2013, a company cannot issue shares at discount, except the case provided in Section 54, i.e.
issue of sweat equity shares to its directors or employees.
Issue of Shares for Cash
Accounting treatment for shares issued can be discussed under two heads
I. Amount Payable in Lumpsum
(i) For receiving share Bank A/c Dr
application money To Share Application and Allotment A/c
(ii) For allotment of shares (a) At par
Share Application and Allotment A/c Dr
To Share Capital A/c
(b) At premium
Share Application and Allotment A/c Dr
To Share Capital A/c (With the face value of shares)
To Securities Premium Reserve A/c (With the amount of premium)
II. Shares Payable in Installments

(i) On receipt of application Bank A/c Dr (With application money received)
money To Share Application A/c (Number of shares applied ×
Application money per share)
(ii) On Application money Share Application A/c Dr (With application money due on
due/transferred to share To Share Capital A/c shares allotted)
capital (Number of shares allotted ×
Application money per share)
(iii) On making allotment (a) At Par
money due Share Allotment A/c Dr (With allotment money due)
To Share Capital A/c (Number of shares allotted ×
Allotment money per share)
(b) At Premium
Share Allotment A/c Dr (With total)
To Share Capital A/c (With allotment money due)
To Securities Premium Reserve A/c (With premium money due)
(iv) On receipt of Bank A/c Dr (With allotment money received)
allotment money To Share Allotment A/c
(v) On making the call due Share Call A/c Dr (With call money due)
To Share Capital A/c (Number of shares allotted × call
money per share)
(vi) On receipt of the call Bank A/c Dr (With call money received)
To Share Call A/c
Full Subscription of Shares

When the number of shares applied for is equal to the number of shares offered for subscription, the shares are said to be
fully subscribed.
Oversubscription of Shares
When the number of shares applied for is more than the number of shares offered for subscription, the shares are said to be
oversubscribed.Allotment of shares cannot be made to all the applicants in full. In case of oversubscription, following three
alternatives are available
● Rejection of excess applications. ● Partial or pro-rata allotment.
● Combination of pro-rata allotment and rejection.

Undersubscription of Shares
When the number of shares applied for is less than the number of shares offered to the public, the shares are said to be
undersubscribed. As per SEBI guidelines, minimum subscription of 90% of issued shares should be received by the company,
only then it can proceed with allotment.
Calls-in-arrears
When one or more shareholders fail to pay the dues at the time of allotment or call, it is technically called calls-in-arrears.
Table F of the Companies Act, 2013, provides for the payment of interest on calls-in-arrears at a rate not exceeding 10% per
annum.
Calls-in-advance
The part of the whole amount received from the shareholders before the call is made, is called calls-in-advance. This amount
is shown on the liabilities side of the balance sheet as a separate item under the head ‘share capital’ but is not added to the
amount of paid-up capital.
Table F of the Companies Act, 2013, provides for the payment of interest on calls-in-advance at a rate not exceeding 12% per
annum.
Issue of Shares for Consideration other than Cash

In this regard, the purchase of assets and issue of shares are to be treated as two separate transactions.
(i) Issue of shares to vendors (a) When assets are purchased
Assets A/c (individually) Dr
To Vendor
(b) When business is purchased
Sundry Assets A/c Dr
Goodwill A/c* Dr
To Sundry Liabilities A/c
To Vendor
To Capital Reserve A/c*
Note ‘Vendor’ is credited with purchase consideration payable to him.
*Either of the two will appear, to balance out the debit and credit aspect.
Capital reserve = Value of net assets taken over – Agreed amount of purchase consideration
Goodwill = Agreed purchase consideration – Value of net assets taken over
(ii) On issue of shares (a) At par
Vendor Dr
Amount Payable
Number of Shares Issued =
Issue Price i.e. Face Value
(b) At premium
Vendor Dr
To Securities Premium Reserve A/c
Amount Payable
Number of Shares Issued =
Issue Price i.e. Face Value + Premium Amount
(iii) Issue of shares to Formation Expenses/Incorporation Cost/Goodwill A/c Dr
promoters
(iv) Issue of shares to (a) Making underwriting expenses due
underwriters Underwriting Expenses A/c Dr
To Underwriters A/c
(b) Issuing shares to underwriters
Underwriters A/c Dr
(c) Transferring underwriting commission to statement of profit and loss
Statement of Profit and Loss Dr
To Underwriting Commission/Expenses A/c
Accountancy 73
Forfeiture of Shares
It means cancellation of shares and seizure of the amount received from the defaulting shareholders, whose shares have
been forfeited.
(i) Forfeiture of shares which Share Capital A/c Dr (Called-up value)
were issued at par To Share Allotment A/c (Amount not received)
To Share Call A/c (Amount not received)
To Share Forfeiture A/c (Amount received)
(ii) Forfeiture of shares which (a) If premium has been received
were originally issued at Share Capital A/c Dr (Amount called-up less premium)
premium To Share Allotment A/c (Amount not received)
To Share Forfeiture A/c (Amount received, so far excluding
securities premium reserve)
(b) If premium has not been received
Share Capital A/c Dr (Amount called-up, so far less premium)
Securities Premium Reserve A/c Dr (Amount of Premium not received)
To Share Allotment A/c (Amount not received)
To Share Forfeiture A/c (Amount received)
Re-issue of Forfeited Shares

The directors can either cancel or reissue the forfeited shares. Shares forfeited can be re-issued at par, at premium or at a
discount.
(i) At par Bank A/c Dr
(ii) At discount Bank A/c Dr (With the amount received on re-issue)
Share Forfeiture A/c Dr (With the discount allowed on re-issue)
To Share Capital A/c (With the amount credited as paid-up)
(iii) At premium Bank A/c Dr
Transfer of Balance in the Forfeited Shares Account
Share Forfeiture A/c Dr
To Capital Reserve A/c
Solved Examples
1. Nikhil Ltd. purchased a running business from Sonia Ltd. The assets and liabilities consisted of the following
Machinery ` 7,00,000, debtors ` 2,50,000, stock ` 5,00,000, building ` 11,50,000 and bills payable
` 2,50,000.
Pass necessary journal entries in the books of Nikhil Ltd. if
(i) The purchase consideration of ` 22,00,000 was discharged by issuing 20,000 fully paid equity shares of
` 100 each at a premium of 10%.
(ii) The purchase consideration of ` 24,00,000 was discharged by issuing 19,200 fully paid equity shares of
` 100 each at a premium of 25%.
Sol. JOURNAL
(i) Machinery A/c Dr 7,00,000
Debtors A/c Dr 2,50,000
Stock A/c Dr 5,00,000
Building A/c Dr 11,50,000
To Bills Payable A/c 2,50,000
To Sonia Ltd. 22,00,000
To Capital Reserve A/c 1,50,000
(Being assets and liabilities taken over and balance credited to capital reserve)
Sonia Ltd. Dr 22,00,000
To Equity Share Capital A/c (20,000 × 100) 20,00,000
To Securities Premium Reserve A/c (20,000 × 10) 2,00,000
(Being 20,000 equity shares issued at a premium of 10%)
(ii) Machinery A/c Dr 7,00,000
Debtors A/c Dr 2,50,000
Stock A/c Dr 5,00,000
Building A/c Dr 11,50,000
Goodwill A/c Dr 50,000
To Bills Payable A/c 2,50,000
To Sonia Ltd. 24,00,000
(Being assets and liabilities taken over and balance debited to goodwill account)
Sonia Ltd. Dr 24,00,000
(Being 19,200 equity shares issued at a premium of 25%)
2. Meena Ltd. issued 60,000 shares of ` 10 each at a premium of ` 2 per share payable as ` 3 on application,
` 5 on allotment (including premium) and balance on the first and final call. Applications were received for
1,02,000 shares. The directors resolved to allot as follows
(i) Applicants of 60,000 shares – 30,000 shares (ii) Applicants of 40,000 shares – 30,000 shares
(iii) Applicants of 2,000 shares – Nil
Nikhil who had applied for 1,000 shares in category (i) and Vish, who was allotted 600 shares in category
(ii) failed to pay the allotment money. Calculate the amount received on allotment. Also journalise the above
transactions.
Sol. JOURNAL
Bank A/c (1,02,000 × 3) Dr 3,06,000
To Share Application A/c 3,06,000
(Being application money received on 1,02,000 shares)
Share Application A/c Dr 3,06,000
To Share Capital A/c (60,000 × 3) 1,80,000
To Share Allotment A/c (WN) 1,20,000
To Bank A/c (2,000 × 3) 6,000
(Being application money transferred to share capital at the time of
allotment and excess adjusted towards allotment and refunded)
Share Allotment A/c Dr 3,00,000
(Being allotment made due)
Bank A/c Dr 1,76,600
To Share Allotment A/c (WN) 1,76,600
(Being allotment money received)
Share First and Final Call A/c Dr 2,40,000
(Being final call made due)
Accountancy 75

To Share First and Final Call A/c 2,35,600
(Being final call money received with the exception of 1,100 shares)
Note In the absence of any given information, it is assumed that if a shareholder has defaulted in the payment of allotment, then he had also
defaulted in making payments towards the calls.
Working Note
Applied Shares Allotted Shares
(i) 60,000 30,000 (Pro-rata allotment)
(ii) 40,000 30,000 (Pro-rata allotment)
(iii) 2,000 Nil
1,02,000 60,000
30,000
Number of shares allotted to Nikhil = 1,000 × = 500 shares
60,000
Surplus towards Allotment on Nikhil’s Shares Amt (`)

Application money received (1,000 × 3) 3,000
(–) Application money required (500 × 3) (1,500)
Surplus towards allotment 1,500
40,000
Number of shares applied by Vish = 600 × = 800 shares
30,000
Surplus towards Allotment on Vish’s Shares
Application money received (800 × 3) 2,400
(−) Application money required (600 × 3) (1,800)
Surplus towards allotment 600
Calculation of Amount Received on Allotment
Allotment money due (60,000 × 5) 3,00,000
(–) Excess received with application (40,000 × 3) (1,20,000)
(–) Calls-in-arrears (Nikhil)
Due (500 × 5) 2,500
(–) Surplus (1,500) (1,000)
(–) Calls-in-arrears (Vish)
Due (600 × 5) 3,000
(–) Surplus (600) (2,400)
Amount received with allotment 1,76,600
3. X Ltd. invited applications for issuing 75,000 equity shares of ` 10 each at a premium of ` 5 per share.
The amount was payable as follows
On application and allotment — ` 9 per share (including premium)
On first and final call — Balance amount
Applications for 3,00,000 shares were received. Applications for 2,00,000 shares were rejected and money
refunded. Shares were allotted on pro-rata basis to the remaining applicants. The first and final call was made.
The amount was duly received except on 1,500 shares applied by Ravi. His shares were forfeited. The forfeited
shares were re-issued at a discount of ` 4 per share.
Pass necessary journal entries for the above transactions in the books of X Ltd.
Sol. JOURNAL
Bank A/c (3,00,000 × 9) Dr 27,00,000
To Equity Share Application and Allotment A/c 27,00,000
(Being share application and allotment money received on 3,00,000
shares of ` 9 each including premium of ` 5 each)
Equity Share Application and Allotment A/c Dr 27,00,000
To Bank A/c (2,00,000 × 9) 18,00,000
To Equity Share First and Final Call A/c 2,25,000
(Being share application of 75,000 shares transferred to share capital,
share application and allotment on 2,00,000 shares refunded and rest is
adjusted on share first and final call)
Equity Share First and Final Call A/c Dr 4,50,000
(Being share first and final call due on 75,000 shares of ` 6 each)
To Equity Share First and Final Call A/c 2,21,625
(Being share first and final call received)
Equity Share Capital A/c Dr 11,250
To Equity Share Forfeiture A/c 7,875
To Equity Share First and Final Call A/c 3,375
(Being 1,125 shares were forfeited for non-payment of share first and
final call of ` 6 each)
, × 6)
Bank A/c (1125 Dr 6,750
Equity Shares Forfeited A/c (1,125 × 4) Dr 4,500
To Equity Share Capital A/c (1,125 × 10) 11,250
(Being 1,125 forfeited shares were re-issued at a discount of ` 4 per share)
Equity Share Forfeiture A/c Dr 3,375
To Capital Reserve A/c 3,375
(Being share forfeiture transferred to capital reserve)
Working Notes
1.
Shares Shares Money Money Money Excess Share First Amount
Applied Allotte Money
Received on transferre transferred Application and Final Received on
d Refunded
Application d to Share to Securities and Call @ ` 6 Share First
(`)
and Capital Premium Allotment Each and Final call
Allotment @ ` 4 Each Reserve Money (`) after
@ ` 9 Each (`) @ ` 5 Each Received Adjustment
(`) (`) (`) (`)
2,00,000 — 18,00,000 — — — — — 18,00,000
1,00,000 75,000 9,00,000 3,00,000 3,75,000 2,25,000 4,50,000 4,46,625 —
(75,000 × 4) (75,000 × 5)
3,00,000 75,000 27,00,000 3,00,000 3,75,000 2,25,000 4,50,000 4,46,625 18,00,000
2. Those who applied for 1,00,000 shares were allotted = 75,000 shares
1,500
Those who applied for 1,500 shares were allotted = 75,000 × = 1,125 shares
1,00,000
Share application and allotment money received on 1,500 shares of ` 9 each = ` 13,500
(including premium of ` 5 each)
Shares allotted (1125
, × 9) = ` 10,125
Excess application and allotment money received = ` 3,375
Share first and final call due to 1,125 shares of ` 6 each = ` 6,750
Excess application and allotment money received = ` 3,375
Share first and final call not received = ` 3,375 (6,750 – 3,375)
Therefore, share first and final call amount received = ` 2,21,625 (4,50,000 – 2,25,000 – 3,375)
Accountancy 77
Practice Questions
1 Companies Act is governed by Total Amount Forfeited
(d) × Number of Share
(a) RBI Number of Share Forfeited
Re-issued
(b) SEBI
(c) Partnership Act 11 Singh who was allotted 200 equity share of ` 20
(d) Ministry of Corporate Affairs each by a company, failed to pay ` 8 each on final
2 Own shares purchased by a company with a view to call. Shares were re-issued to Kumar at ` 20 each.
reduce its capital is called What will be the journal entry on re-issue?
(a) sale (b) purchase (a) Bank A/c Dr 4,000
(c) buy-back (d) private placement To Equity Share Capital A/c 4,000
3 A company in which there is only one member is (b) Equity Share Capital A/c Dr 4,000
called To Bank A/c 4,000
(a) one member company (c) Bank A/c Dr 4,000
(b) one person company To Share Forfeiture A/c 4,000
(c) single company (d) Share Forfeiture A/c Dr 4,000
(d) individual company To Bank A/c 4,000
4 Shares which have preferential rights are called
12 A company issued 25,000 shares and received
(a) equity share (b) preference share
(c) debenture (d) bond applications for 35,000 shares. Company wants to
allot shares to everyone who has applied. What will
5 Which of the following is the registered capital of be the ratio for allotment?
the company? (a) 6 : 7 (b) 7: 5 (c) 5 : 7 (d) 7: 6
(a) Nominal capital (b) Authorised capital
(c) Share capital (d) Both (a) and (b) 13 A company issued 10,000 shares of ` 10 each.
Amount is payable as ` 2 on application, ` 5 on
6 Capital which is called only at the time of allotment and ` 3 on first and final call. A
winding-up of the company is called shareholder who had 1,000 shares failed to pay
(a) capital reserve (b) reserve capital
allotment and first call amount on due date. After
(c) secure capital (d) authorised capital
a month, he paid the due amount. What will be the
7 Which kind of preference share entitles its holders amount received by company against issue of
to receive arrear of dividends of previous years? shares?
(a) Cumulative preference share (a) ` 92,000 (b) ` 90,000
(b) Non-cumulative preference share (c) ` 1,00,000 (d) ` 8,000
(c) Convertible preference share
(d) Non-convertible dividend share 14 Nominal share capital is
(a) that part of the authorised capital which is issued by
8 Which document is an invitation offer to public to the company
subscribe for company’s share? (b) the amount of capital which is actually applied for by
(a) Red herring prospectus the prospective shareholders
(b) Prospectus (c) the maximum amount of share capital which a
(c) In lieu of prospectus company is authorised to issue
(d) None of the above (d) the amount actually paid by the shareholders
9 The balance of share forfeiture account can be used to 15 Money received in advance from shareholders
(a) provide for discount given at the time of reissue before it is actually called-up by the directors is
(b) write-off preliminary expenses (a) debited to calls-in-advance account
(c) write-off bad debts (b) credited to calls-in-advance account
(d) None of the above (c) debited to calls account
10 If company wants to calculate amount forfeited on (d) None of the above
reissued shares, then which amongst the given 16 Shares can be forfeited
formula will be used? (a) for non-payment of call money
Total Amount Forfeited (b) for failure to attend meetings.
(a) (c) for failure to repay the loan to the bank
Number of Share Forfeited
(d) for which shares are pledged as a security.
Total Amount Forfeited
(b)
Number of Shares 17 The profit on reissue of forfeited shares is
Number of Share Forfeited transferred to
(c) × Share Re-issues (a) general reserve (b) capital redemption reserve
Total Amount Forfeited
(c) capital reserve (d) revenue reserve
18 Balance of share forfeiture account is shown in the 24 Akash Ltd. registered capital is ` 50,00,000 in
balance sheet under the item shares of ` 10 each. The company issued 2,00,000 of
(a) current liabilities and provisions such shares, payable @ ` 3 per share on allotment.
(b) reserves and surpluses What will be the amount due on allotment, if
(c) share capital (d) unsecured loans shareholder holding 20,000 shares paid all call
19 Amox Ltd. is registered with a capital of 10,00,000 money at the time of allotment only?
equity shares of ` 10 each. 6,00,000 equity shares (a) ` 4,00,000 (b) ` 6,00,000
were offered for subscription to public. Applications (c) ` 60,000 (d) ` 1,50,000
were received for 6,00,000 shares. All calls were 25 The subscribed share capital of XYZ Ltd. is
made and amount was duly received except final call ` 80,00,000 divided in shares of ` 100 each. There
of ` 2 on 80,000 shares. What will be the amount of were no calls-in-arrears till the final call was made.
share capital shown in the balance sheet? The final call was paid on 77,500 shares. The
(a) ` 60,00,000 (b) ` 58,40,000 calls-in-arrears amounted to ` 62,500. Calculate the
(c) ` 5,84,000 (d) ` 6,00,000 final call per share.
20 Which amongst the following shares conter voting (a) ` 20 (b) ` 30
rights on its holders? (c) ` 25 (d) ` 35
(a) Equity shares 26 Pass the journal entry for amount of first call,
(b) Redeemable preference shares ` 90,000 received after deducting calls-in-arrears
(c) Participatory preference shares of ` 6,000.
(a) Bank A/c Dr 90,000
21 Amount payable on shares can be received in Calls-in-arrears A/c Dr 6,000
installments by the company. What is the first To Share First Call A/c 96,000
installment called? (b) Share First Call A/c Dr 96,000
(a) Application money (b) Allotment money To Bank A/c 90,000
(c) First call money (d) Second call money To Calls-in-arrears A/c 6,000
(c) Bank A/c Dr 96,000
22 Total capital specified in capital clause is
To Share First Call A/c 96,000
` 50,00,000 which is divided in 35,000 equity shares
of ` 100 each and 15,000, 10% preference shares of `
100 each. The company issued 10,000 equity shares 27 Shares for consideration other than cash can be
and 5,000 preference shares. The public subscribed issued at
for 9,000 equity shares and 4,500 preference shares (a) par (b) premium
out of the issued shares. What will be the (c) discount (d) Both (a) and (b)
subscribed capital amount? 28 Neton Ltd. has in its memorandum of association,
(a) ` 50,00,000 (b) ` 50,000 capital clause stating that it is formed with 75,000
(c) ` 9,00,000 (d) ` 13,50,000 equity shares of ` 100 each. The company has
23 Issued 10,000 shares of ` 100 each to the Narayan issued the entire shares and the public has also
Ltd. @10% premium and paid ` 2,00,000 in cash for subscribed and paid-up for the full amount on
a consideration of running business purchased. application itself. What will be the subscribed
Journalise this transaction. capital?
(a) Narayan Ltd. Dr 13,00,000 (a) ` 75,00,000 (b) ` 10,00,000
To Share Capital A/c 10,00,000 (c) ` 1,00,000 (d) ` 7,50,000
To Securities Premium Reserve A/c 1,00,000 29 Shareholders receive ……… from the company as a
To Cash A/c 2,00,000
(b) Narayan Ltd. Dr 13,00,000
benefit against their investment.
To Share Capital A/c 13,00,000 (a) interest (b) commission
(c) Narayan Ltd. Dr 13,00,000 (c) profit (d) dividend
To Cash A/c 13,00,000 30 If the purchase consideration is more than net
(d) Share Capital A/c Dr 10,00,000 worth, then which account will be debited for the
Securities Premium difference amount?
Reserve A/c Dr 1,00,000
(a) Capital Reserve A/c (b) Asset A/c
Cash A/c Dr 2,00,000
(c) Goodwill A/c (d) Vendor A/c
To Narayan Ltd. 13,00,000
ANSWERS
1. (d) 2. (c) 3. (b) 4. (b) 5. (d) 6. (b) 7. (a) 8. (b) 9. (a) 10. (d)
11. (a) 12. (c) 13. (c) 14. (c) 15. (b) 16. (a) 17. (c) 18. (c) 19. (b) 20. (a)
21. (a) 22. (d) 23. (a) 24. (b) 25. (c) 26. (a) 27. (d) 28. (a) 29. (d) 30. (c)
Accountancy 79
Hints & Solutions

2. Share repurchase is the re-acquisition by a company of its 19. Amt (`)
own stock. It is a mode of reducing the capital of a Total amount due (6,00,000 × 10) = 60,00,000
company. (−) Calls-in-arrears (80,000 × 2) = (1,60,000)
6. Reserve capital is a portion of subscribed share capital, = 58,40,000
which is not capable of being called-up except in the
event and for the purpose of company being wound-up. 22. Subscribed capital amount will be the amount
corresponding to shares which have been subscribed
8. Prospectus is basically an offer to every individual to file by public, i.e.
application to get shares of a company. Prospectus Equity shares (9,000 × 100) = 9,00,000
contains all the detail of company which can motivate
Preference shares (4 ,500 × 100) = 4 ,50,000
investors to invest in the company.
` 13,50,000
9. The balance of share forfeiture account can be only used
to provide for discount given at the time of re-issue. The 24. Amount due on allotment = 2,00,000 × 3 = ` 6,00,000. It is
balance left after providing for discount is transferred to to be remebered that calls-in-advance does not form a
capital reserve account. part of ‘amount due’ but it is a part of calls yet to be
11. When shares are re-issued then money is received, so made.
80,00,000
cash/bank will be debited as per accounting rule and 25. Total shares issued = = 80,000 shares.
equity share capital is increased, hence it will be credited. 100
12. The ratio is calculated as under Final call received on = 77,500 shares
Shares Available : Shares Applied ⇒ 25,000 : 35,000 So, final call not received on
⇒ 25 : 35 or 5: 7 = 80,000 − 77,500 = 2,500 shares
Hence, every person who applied for 7 shares will get 5 Call-in-arrears at the time of final call = ` 62,500
shares. 62,500
∴ Final call per share = = ` 25
13. Amount due on total shares (10,000 × 10) is ` 1,00,000. 2,500
Complete amount was received, one shareholder paid late, 28. Total authorised capital (75,000 ×100) = ` 75,00,000
but at the end amount was received. Hence, complete Since, complete capital has been subscribed by the public,
amount received by the company will be ` 1,00,000. thus subscribed capital is equal to authorised capital.
CHAPTER 09
Accounting for Debentures

Meaning of Debenture
It is an instrument acknowledging a debt issued under the common seal of the company. It specifies nominal/par value of
debenture, the rate of interest to be paid, periodicity of payment, the tenure of debentures and terms of redemption.
According to Section 2(30) of the Companies Act, 2013, “Debenture includes debenture stock, bonds and any other
instrument of a company evidencing a debt, whether constituting a charge on the assets of the company or not.”
As per Schedule III, debentures shall be shown in the equity and liabilities part of the balance sheet under the major head
‘non-current liabilities’ and sub head ‘long-term borrowings’.
Issue of Debentures
A company can issue debentures for raising long-term borrowings but the power to issue debentures should be mentioned in
the memorandum of association. Debentures, whether issued for cash or otherwise, may be issued at
1. Par These are said to be issued at par when the issue price and face value of the debentures is same.
2. Premium These are said to be issued at a premium when the issue price is more than the face value.
3. Discount These are said to be issued at a discount when they are issued at a price below its nominal or face value.
Issue of Debentures for Cash

Accounting treatment of issue of debentures can be discussed under two heads
1. When Debenture Amount is Received in Lumpsum (If the full amount is payable along with application)
Transaction Entry Amount

(i) On Receipt of Bank A/c Dr With the application money
Application Money To Debenture Application and Allotment A/c received
(ii) On Acceptance of (a) When debentures are issued at par With the money adjusted on
Application Money Debenture Application and Allotment A/c Dr allotted debentures
To X% Debentures A/c
(b) When debentures are issued at premium

Debenture Application and Allotment A/c Dr
(c) When debentures are issued at discount
Debenture Application and Allotment A/c Dr
Discount on Issue of Debentures A/c Dr
(iii) On Refund of Excess Debenture Application and Allotment A/c Dr With the application money
Application Money To Bank A/c refunded
Accountancy 81
2. When Debenture Amount is Received in Instalments

(i) On Receipt of Bank A/c Dr With the application money received
Applications To Debenture Application A/c
(ii) (a) On Acceptance of Debenture Application A/c Dr With the amount of application money
Applications To X% Debentures A/c on the allotted debentures
(b) On Making Allotment l At par
Money Due Debenture Allotment A/c Dr With the amount due on allotment of
To X% Debentures A/c the debentures
l At premium
Debenture Allotment A/c Dr With the money due on allotment
To X% Debentures A/c With the nominal value of debentures
due at the time of allotment
To Securities Premium Reserve A/c With the premium money received
lAt discount
Debenture Allotment A/c Dr With the amount due on allotment
Discount on Issue of Debentures A/c Dr With the amount of discount
To X% Debentures A/c With the face value
(c) On Adjustment of Debenture Application A/c Dr With the surplus application money on
Excess Debenture To Debenture Allotment A/c partially accepted applications
Application Money
(d) On Refund of Excess Debenture Application A/c Dr With the application money on rejected
Debenture To Bank A/c applications
Application Money
(e) On Receipt of Bank A/c Dr With the amount actually received on
Allotment Money To Debenture Allotment A/c allotment
(iii) (a) On Making Calls Debenture Call A/c Dr With the money due on a particular call
(b) On Receipt of Call Bank A/c Dr With the amount received on a
Money To Debenture Call A/c particular call
Oversubscription of Debentures
When the number of debentures applied for is more than those offered for subscription, it is known as oversubscription.
A company cannot allot more debentures than it has offered for subscription. In such a situation, the company may make
allotment as is made in the case of shares that is
First alternative — Rejecting excess application
Second alternative — Partial or pro-rata allotment
Third alternative — A combination of the above two alternatives
Issue of Debentures for Consideration other than Cash
When debentures are issued to vendors against purchase of assets or against purchase of business, it is termed as issue of
debentures for consideration other than cash.
In this case, consideration for issue of debentures is not cash but the assets or business.
1. Issue of Debentures to Vendors
(i) On Purchase of Assets l When assets are purchased
or Business Sundry Assets A/c Dr
To Vendor’s A/c
l When business is purchased
Sundry Assets A/c Dr
Goodwill A/c* Dr
To Sundry Liabilities A/c
To Vendor’s A/c
To Capital Reserve A/c*
(ii) On Issue of Debentures l When debentures are issued at par

Vendor’s A/c Dr
l When debentures are issued at premium
Vendor’s A/c Dr
l When debentures are issued at discount
Vendor’s A/c Dr
Discount on Issue of Debentures A/c Dr
2. Issue of Debentures to Promoters

Formation Expenses/Incorporation Cost/Goodwill A/c Dr
3. Issue of Debentures to Underwriters
(i) Making Underwriting Expenses A/c Dr

Underwriting To Underwriters A/c
Expenses due
(ii) Issuing Underwriters A/c Dr

Debentures to To X% Debentures A/c
Underwriters
Statement of Profit and Loss Dr
To Underwriting Expenses A/c
Disclosure of Debentures in the Balance Sheet

Debentures being borrowings (liability) of a company are shown in the equity and liabilities part of the balance sheet.
Debentures may be either non-current liability or a current liability.
When Non-current Liability Debentures are shown in the balance sheet under the head non-current liabilities and
sub-head long-term borrowings, when they are due for redemption after 12 months from the date of issue or after the
period of operating cycle.
When Current Liability (a) In case, debentures outstanding in the books of accounts of a company are shown as long-term
borrowings under non-current liabilities in the balance sheet and part of it have become due for redemption within
12 months of the date of balance sheet, then, these debentures will be shown under current liabilities as current maturities
of long-term debts under other current liabilities. (b) Debentures issued to be redeemed within 12 months of the date of
issue are shown as short-term borrowings under current liabilities.
Redemption of Debentures
Redemption of debentures means repaying or returning the amount of debentures to the debentureholders after the period
for which they were issued. It refers to extinguishing or discharging the liability on account of debentures in accordance with
the terms of issue.
Sources of Redemption of Debentures

The debentures may be redeemed
● Out of capital.
● Out of profits.
● By converting them into shares or new debentures.
● Redemption from the proceeds of fresh issue of shares and debentures.
● Redemption out of profit and capital.

Accountancy 83
Debenture Redemption Reserve (DRR)

It is the amount set aside out of surplus, i.e., balance in statement of profit and loss for redeeming the debentures.
Section 71(4) of the Companies Act, 2013, requires the company to create debenture redemption reserve out of the profits
available for payment of dividend and the amount so credited to DRR shall not be utilised by the company except for the
redemption of debentures. DRR is required to be created for Non-Convertible Debentures (NCD) and Non-Convertible part of
Partly Convertible Debentures (PCD).
In view of Section 71(4) of the Companies Act, 2013 and SEBI guidelines, unlisted companies (other then NBFCs and HFCs)
are required to create DRR equivalent to at least 10% of the Nominal (Face) value of outstanding debentures.
Following companies are exempted to create DRR (For both public as well as privately placed debentures)
● All India financial institutions regulated by RBI. ● Banking companies.
● Other financial institutions within the meaning of Section 2 (72) of the Companies Act, 2013
● Listed companies including
(a) NBFCs registered with RBI (b) HFCs registered with NHB (National Housing Bank)
● Unlisted NBFCs registered with RBI
● Unlisted HFCs registered with National Housing Bank
Listed companies (including NBFCs and HFCs) and unlisted companies except exempted companies required to create DRR,
shall on or before 30th April in each year, invest or deposit in specified securities, a sum atleast equal to 15% of the amount of
debentures maturing for payment during the year ended 31st March of the next year.
The amount invested or deposited shall not be used for any purpose other than for redemption of debentures maturing during
the year ending 31st March of the next year.
Note Listed companies including
(i) NBFCs registered with RBI (ii) HFCs registered with National Housing Bank
are not required to create debenture redemption reserve but they are required to invest in specified securities a sum at least equal to 15% as
mentioned above.
Disclosure of DRR in the Balance Sheet

Debenture redemption reserve is shown in the equity and liabilities part of the balance sheet under the head ‘shareholders
funds’ and sub-head ‘reserves and surplus’. When all the debentures have been redeemed, debenture redemption reserve
account is closed by transferring the amount to general reserve. The entry will be passed
Debenture Redemption Reserve A/c Dr

To General Reserve A/c
Methods of Redemption of Debentures

These methods have been discussed in detail as follows
1. Redemption of Debentures in Lumpsum on Maturity

When all the debentures are redeemed by paying in lumpsum at the end of the specified time, it is called redemption in
lumpsum. When debentures are redeemed in lumpsum on maturity, a company may adopt any of the following two options
for redeeming debentures
(i) Redemption of Debentures Out of Capital When adequate profits are not transferred to the DRR from statement of
profit and loss for redemption of debentures, it is said to be redemption out of capital.
Note Companies act require every company to transfer an amount equal to 10% of the value of debentures to DRR before the redemption
begins. Therefore, companies act has indirectly placed restriction to redeem debentures out of capital.
(ii) Redemption of Debentures Out of Profits When adequate profits are transferred to the DRR from statement of
profit and loss for redemption of debentures, it is said to be redemption out of profits.
JOURNAL
Transaction Entry Amt (`)
(a) On creation of debenture Surplus, i.e., Balance in Statement of Profit and Loss Dr
redemption reserve To Debenture Redemption Reserve A/c
(b) On investment or deposit Debenture Redemption Investment A/c Dr
being made in specified To Bank A/c
securities
(c) On the amount being due l If the debentures are to be redeemed at par
to debentureholders’ on X% Debentures A/c Dr (With nominal value)
redemption To Debentureholders’ A/c
l If the debentures are to be redeemed at a premium
X% Debentures A/c Dr (With nominal value)
Premium on Redemption of Debentures A/c Dr (With premium payable)
To Debentureholders’ A/c (With total)
(d) On encashing investment Bank A/c Dr (With the amount paid)

To Debenture Redemption Investment A/c
(e) On payment to Debentureholders’ A/c Dr (With the amount paid)
debentureholders’ To Bank A/c
(f) When all debentures Debenture Redemption Reserve A/c Dr (With the amount of DRR)
are redeemed To General Reserve A/c
2. Redemption of Debentures in Instalments by Draw of Lots

In this method, the company may redeem its debentures in instalments beginning from a particular year, i.e. by payment of a
certain portion in each year. The actual debentures to be redeemed are selected usually by draw of lots. The holders are repaid
the amount at par or at a premium as per the terms of issue.
The journal entries required to be passed are the same as discussed when debentures are repayable in lumpsum.
Solved Examples
1. XYZ Ltd. has 20,000, 9% debentures of ` 100 each outstanding in the books of accounts as on 31st March, 2022,
to be redeemed on 31st March, 2027. Show how will you disclose debentures in the balance sheet.
Sol. In the balance sheet, they are shown as follows
Balance Sheet
as at 31st March, 2022 (Relevant part only)
Particulars Note No. Amt (`)
I EQUITY AND LIABILITIES
1. Non-current Liabilities
Long-term Borrowings 1 20,00,000
20,00,000
Notes to Accounts
Particulars Amt (`)
1. Long-term Borrowings
20,000, 9% Debentures of ` 100 each 20,00,000
Suppose in the above example, if debentures are issued on 1st February, 2022 and are redeemable on 31st January, 2023,
then show how will you disclose debentures in the balance sheet.
It will be shown in the balance sheet as follows
Balance Sheet
as at 31st March, 2022 (Relevant part only)
Particulars Note No. Amt (`)
1. Current Liabilities
Short-term Borrowings 1 20,00,000
20,00,000
Accountancy 85
Notes to Accounts
Particulars Amt (`)
1. Short-term Borrowings
20,000, 9% Debentures of ` 100 each 20,00,000
(Redeemable on 31st January, 2023)
2. ABC Ltd. invited applications for 8,000 debentures of ` 100 each issued at a premium of 20%. Applications
were received for 12,000 debentures and it was decided to deal with the same as follows
(i) To refuse allotment to applicants for 2,400 debentures.
(ii) To give full allotment to applicants for 800 debentures.
(iii) To allot the remaining debentures on pro-rata basis among other applicants.
(iv) To utilise excess application money in part payment of allotment money.
Journalise the above transactions (including cash transactions) assuming that the amount is payable in
instalments — on applications ` 20, on allotment ` 50 (including premium) and the balance on the first and
final call.
Sol. JOURNAL
Bank A/c (12,000 × 20) Dr 2,40,000
To Debenture Application A/c 2,40,000
(Being the application money received)
Debenture Application A/c Dr 2,40,000
To Debentures A/c (8,000 × 20) 1,60,000
To Debenture Allotment A/c 32,000
To Bank A/c (2,400 × 20) 48,000
(Being the application money adjusted and surplus refunded)
Debenture Allotment A/c Dr 4,00,000
To Debentures A/c (8,000 × 30) 2,40,000
(Being the allotment money due)
To Debenture Allotment A/c 3,66,000
(Being the allotment money received)
Debenture First and Final Call A/c Dr 4,00,000
To Debentures A/c (8,000 × 50) 4,00,000
(Being the call money due)
To Debenture First and Final Call A/c 4,00,000
(Being the call money received)
3. A company purchased assets of the book value of ` 1,98,000 from another firm. It was agreed that the
purchase consideration be paid by issuing 11% debentures of ` 100 each. Assume debentures have been issued
(i) at par (ii) at a discount of 10% (iii) at a premium of 10%. Pass the necessary journal entries.
Sol. JOURNAL
Assets A/c Dr 1,98,000
To Vendor’s A/c 1,98,000
(Being the assets purchased from vendor for ` 1,98,000)

(i) Issue of Debentures at Par
Vendor’s A/c Dr 1,98,000
To 11% Debentures A/c (1,980 × 100) 1,98,000
(Being the allotment of 1,980 [1,98,000 ÷ 100], 11% debentures of
` 100 each at par to the vendor)
(ii) Issue of Debentures at a Discount
Vendor’s A/c (2,200 × 90) Dr 1,98,000
Discount on Issue of Debentures A/c (2,200 × 10) Dr 22,000
To 11% Debentures A/c (2,200 × 100) 2,20,000
(Being 2,200 [1,98,000 ÷ 90] debentures of ` 100 each issued at a
discount of 10% to the vendor)
(iii) Issue of Debentures at a Premium
Vendor’s A/c (1,800 × 110) Dr 1,98,000
To 11% Debentures A/c (1,800 × 100) 1,80,000
To Securities Premium Reserve A/c (1,800 × 10) 18,000
(Being 1,800 [1,98,000 ÷ 110] debentures of ` 100 each issued at a
premium of 10% to the vendor)
4. Manish Ltd. issued ` 38,00,000, 8% debentures of `100 each on 1st April, 2018. The terms of issue stated that
the debentures were to be redeemed at a premium of 5% on 30th June, 2020. The company decided to transfer
out of profits ` 2,00,000 to debenture redemption reserve on 31st March, 2019 and ` 1,80,000 on 31st March,
2020.
Pass necessary journal entries regarding the issue and redemption of debentures, without providing for either
the interest or loss on issue of debentures.
Sol. JOURNAL
2018
Apr 1 Bank A/c Dr 38,00,000
To Debenture Application and Allotment A/c 38,00,000
(Being application money received)
Debenture Application and Allotment A/c Dr 38,00,000
Loss on Issue of Debentures A/c Dr 1,90,000
To 8% Debentures A/c (38,000×100) 38,00,000
To Premium on Redemption of Debentures A/c (38,000 × 5) 1,90,000
(Being debentures issued at par and redeemable at 5% premium)
2019
Mar 31 Surplus, i.e., Balance in Statement of Profit and Loss Dr 2,00,000
To Debenture Redemption Reserve A/c 2,00,000
(Being reserve created out of profits)
2020
Mar 31 Surplus, i.e., Balance in Statement of Profit and Loss Dr 1,80,000
To Debenture Redemption Reserve A/c 1,80,000
(Being reserve created out of profits)
Apr 30 Debenture Redemption Investment A/c Dr 5,70,000
To Bank A/c (38,00,000 × 15%) 5,70,000
(Being the amount placed in fixed deposit equal to 15% of the nominal
value of debentures)
Jun 30 Bank A/c Dr 5,70,000
To Debenture Redemption Investment A/c 5,70,000
(Being the debenture redemption investment encashed on redemption of
debentures)
Accountancy 87

8% Debentures A/c Dr 38,00,000
Premium on Redemption of Debentures A/c Dr 1,90,000
To Debentureholders’ A/c 39,90,000
(Being debentures due for redemption)
Debentureholders’ A/c Dr 39,90,000
To Bank A/c 39,90,000
(Being amount paid to debentureholders)
Debenture Redemption Reserve A/c Dr 3,80,000
To General Reserve A/c 3,80,000
(Being debenture redemption reserve transferred to general reserve account)
Practice Questions
1 The following journal entry appears in the books of Tell him that DRR is to be transferred to .......... at
X Co. Ltd. the end of redemption.
Bank A/c Dr 4,75,000 (a) capital reserve (b) profit and loss account
Loss on Issue of Debenture A/c Dr 75,000 (c) general reserve (d) None of these
To 12% Debentures A/c 5,00,000 7 Arihant Ltd. issued 8,000, 12% debentures of ` 100
To Premium on Redemption of each at par on 1st April, 2020 which are
Debenture A/c 50,000 redeemable at 5% premium in five equal
Debentures have been issued at a discount of instalments. First redemption to be made on 31st
(a) 15% (b) 5% (c) 10% (d) 20% March, 2021. The company complied with legal
requirements. Calculate amount which is required
2 When debentures are redeemed out of profits, an to be legally invested?
equal amount is transferred to (a) ` 1,20,000 (b) ` 24,000
(a) general reserve (c) ` 60,000 (d) ` 96,000
(b) debenture redemption reserve
(c) capital reserve 8 X Co Ltd. purchased assets worth ` 28,80,000.
(d) debenture redemption investment It issued debentures of ` 100 each at a discount of
4 per cent in full satisfaction of the purchase
3 Profit on sale of debenture redemption fund
consideration. The number of debentures issued to
investments in the first instance is credited to
vendor is
(a) debenture redemption fund account,
(a) 30,000 (b) 28,800
(b) statement of profit and loss,
(c) 32,000 (d) 40,000
(c) general reserve account
(d) None of the above 9 Discount on issue of debentures is shown under
4 The balance of sinking fund investment account the following head in the balance sheet.
after the realisation of investments is transferred (a) Statement of profit and loss
(b) Other non-current assets
to (c) Debentures account
(a) statement of profit and loss (d) None of the above
(b) debentures account,
(c) sinking fund account 10 Excess value of net assets over purchase
(d) None of the above consideration at the time of purchase of business is
5 When debentures are issued at a discount, which credited to
of the following accounts is debited at the time of (a) general reserve (b) capital reserve
(c) vendors’ account (d) Both (a) and (b)
issue?
(a) Debentures account 11 The nominal and book values of debenture
(b) Securities premium reserve redemption fund investments account are
(c) Discount on issue of debentures respectively ` 1,00,000 and ` 96,000. The company
(d) None of the above sold investments of nominal value of
6 A company had issued debentures and DRR is ` 30,000 at a price which was just sufficient to
made as required by law. Accountant is of the view redeem debentures of ` 30,000 at 10% premium,
that this DRR is to be transferred into capital the profit on sale of investment is
reserve because this is a profit in the nature of (a) ` 4,200 (b) ` 3,000 (c) Nil (d) ` 5,000
capital.
12 Own debentures are those debentures of the (b) Bank A/c Dr 1,00,000
company which To Debenture Application
and Allotment A/c 1,00,000
(a) the company allots to its own promoters
(c) Debenture Application and
(b) the company allots to its director
Allotment A/c Dr 1,00,000
(c) the company purchases from the market and keeps
To 8% Debentures A/c 1,00,000
them as investments
13 Profit on cancellation of own debentures is 21 Goel Ltd. invited applications for issuing 6,000,
transferred to 12% debentures of ` 100 each at a premium of ` 50
(a) statement of profit and loss per debenture. The full amount was payable on
(b) debenture redemption reserve application. Applications were received for 8,000
(c) capital reserve debentures.
Applications for 2,000 debentures were rejected
14 Loss on issue of debentures is written-off out of and application money was refunded. Debentures
(a) securities premium reserve were allotted to the remaining applicants. Based
(b) general reserve and statement of profit and loss on the information, pass the journal entry for
account adjusting the application money received in the
(c) Both (a) and (b) books of Goel Ltd.
(d) discount on issue of debentures account
(a) Bank A/c Dr 12,00,000
15 If debentures are issued at premium, then they To Debenture Application
can be redeemed at and Allotment A/c 12,00,000
(a) par (b) premium (b) Debenture Application
(c) Both (a) and (b) (d) can’t be redeemed and Allotment A/c Dr 9,00,000
To 12% Debentures A/c 9,00,000
16 Company can utilise premium received on issue of
debentures for which purpose? (c) Debenture Application
and Allotment A/c Dr 12,00,000
(a) Writing-off discount allowed on issue
(b) For writing-off preliminary expenses To 12% Debentures A/c 6,00,000
(c) Both (a) and (b) To Securities Premium Reserve A/c 3,00,000
(d) None of the above To Bank A/c (2,000 × 150) 3,00,000
17 When debenture amount is received in lumpsum,
……… is credited with bank account. 22 Debentures may be issued …… .
(a) debenture application and allotment account (a) for cash
(b) debenture account (b) for consideration other than cash
(c) debenture allotment account (c) as collateral security (d) All of these
(d) None of the above 23 A company ‘Vansh Ltd.’ has purchased an asset
18 ‘X’ Limited purchased the assets from ‘Y’ Limited costing ` 22,00,000. Vendor issued 10% debentures
from ` 16,20,000. ‘X’ Limited issued 10% of ` 100 each at 10% premium as consideration
debentures of ` 10 each at 10% discount against against asset purchased. Calculate number of
the payment. The number of debentures issued by debentures to be issued.
‘X’ Limited will be (a) 26,000 debentures (b) 24,000 debentures
(a) 16,200 (b) 18,000 (c) 20,000 debentures (d) 22,000 debentures
(c) 1,80,000 (d) 1,62,000 24 During the year 2019-20, Network 10 Ltd. issued
19 A company wants to issue debentures in the 12% debentures of ` 100 each as per the details
upcoming month. For the issue, the company has given. A machine was purchased for ` 2,18,500.
to create debenture trust deed. But the accountant The Vendor was paid by the issue of 1,900
of the company does not know its meaning. Tell the debentures at a premium of 15%, to be redeemed
meaning of debenture trust deed. at par. The entry for the payment will be
(a) It shows the list of debentureholders (a) Machinery A/c Dr 2,18,500
(b) It protects the interest of debentureholders To Vendor’s A/c 2,18,500
(c) It is created after public subscription (b) Vendor’s A/c Dr 2,18,500
(d) It tells that in case of losses, there will be no interest To 12% Debentures A/c 1,90,000
To Securities Premium
20 X Ltd. issued 10,000, 8% debentures of ` 10 each, Reserve A/c 28,500
payable on application and redeemable at par at (c) Vendor’s A/c Dr 2,18,500
any time after 6 years. Record the entries for the To Machinery A/c 2,18,500
application money received in the books of X Ltd. (d) 12% Debentures A/c Dr 1,90,000
(a) Bank A/c Dr 80,000 Securities Premium
To Debenture Application and Reserve A/c Dr 28,500
Allotment A/c 80,000 To Vendor’s A/c 2,18,500
Accountancy 89
25 Name the sub-head under which the ‘premium on (d) None of the above
redemption of debentures’ appears in the balance 28. Which of the following alternatives are available
sheet? for the company at the time of oversubscription?
(a) Shareholders’ fund
(i) Pro-rata (ii) Rejection of excess application
(b) Non-current liabilities
(c) Long-term borrowings Alternatives
(d) None of the above (a) Only (i) (b) Only (ii)
26. Firewall agreed to pay purchase consideration of
`1,30,000 by issuing fully paid-up debentures of 29 Discount on issue of debentures is
` 100 at ` 120. How many debentures will be (a) capital loss (b) capital income
issued? (c) revenue loss (d) revenue income
(a) 1,083 (b) 1,084 30 A company AB Ltd issued 12% debentures of
(c) Can’t be determined (d) None of these ` 10,00,000 of ` 100 each to public. In the terms of
27 Name the account to which the amount of issue, these debentures are redeemable after 10
premium received on the issue of debentures will months ending on 31st January, 2022. These
be credited? debentures will be shown in balance sheet as on
(a) Premium on redemption of debentures account 31st March, 2021 under the heading
(b) Security premium reserve account (a) long-term liability (b) current liability
(c) % debentures account (c) fixed assets (d) current assets
ANSWERS
1. (b) 2. (b) 3. (a) 4. (c) 5. (c) 6. (c) 7. (b) 8. (a) 9. (b) 10. (b)
11. (a) 12. (c) 13. (c) 14. (c) 15. (c) 16. (c) 17. (a) 18. (c) 19. (b) 20. (b)
21. (c) 22. (d) 23. (c) 24. (b) 25. (c) 26. (a) 27. (b) 28. (c) 29. (a) 30. (b)
Hints & Solutions

(75,000 − 50,000) 16,20,000 16,20,000
1. × 100 = 5% 18. Number of Debentures = =
5,00,000 10 −10% of 10 9
6. DRR is created for redemption of debentures. It is = 1,80,000
created from profit and loss account. Since, DRR is 23. Number of Debentures Issued
created from revenue profits, so it is transferred to 22,00,000
general reserve and not to capital reserve. = = 20,000 debentures
110 (100 + 10)
7. As per Section 71(4) of Companies Act, 2013, every 25. The ‘premium on redemption of debentures’ appears
company should invest atleast 15% of nominal under the head ‘non-current liabilities’ and sub-head
amount of debentures to be redeemed. Since, in above ‘long-term borrowings’.
question, debentures of ` 8,00,000 (8,000 × 100) are to 1,30,000
be redeemed in five instalments, so each instalment 26. Number of Debentures Issued =
8,00,000 120
consist of amount of = ` 1,60,000. So, amount
5 29. Company can issue debentures at discount and this
of investment which is to be done by 30th April, 2020 discount is a capital loss in nature. It is written-off
15 either through security premium account or
is 1,60,000 × = ` 24,000.
100 statement of profit and loss.
28,80,000 30. Whenever debentures are issued for less than
8. Number of debentures =
96 (100 − 4) 12 months or debentures are redeemable within
96,000 12 months, then these are shown under ‘current
11. × 30,000 = 28,800
1,00,000 liability’.
30,000 + 3,000 − 28,800 = 4,200
CHAPTER 10
Financial Statements
of a Company
Meaning of Financial Statements
Financial statements are the end product of an accounting process. Financial statements are historical in nature and are
prepared following the accounting concepts and principles.
These statements present in an organised and summarised form, detailed information about the financial performance of an
entity for an accounting period and also discloses its financial position at the end of the period.
The legal requirements related to financial statements are
● These statements should be based on accrual basis and double entry system of accounting.
● The statement of profit and loss should be annexed with the balance sheet.
John N Myer defines financial statements as, ‘‘Financial statements provide a summary of accounts of a business enterprise,
the balance sheet reflecting the assets, liabilities and capital as on a certain date and income statement showing the results
and operations during a certain period.’’
A set of financial statements as per Section 2(40) of the Companies Act, 2013 includes
1. Balance Sheet It is a statement of assets and liabilities, showing the financial position of an enterprise at a given
date. It is also known as position statement.
2. Statement of Profit and Loss It shows the net result of business operations during an accounting period. It is also
known as income statement.
3. Cash Flow Statement It is a statement prepared in accordance with AS-3, to show inflow and outflow of cash and
cash equivalents.
4. Statement of Changes in Equity It shows changes in equity during a year.
5. Notes to Accounts It is any explanatory note annexed to any document referred above.
Nature of Financial Statements

● Financial statements are prepared on the basis of facts recorded in accounting books.
● Certain accounting conventions such as the conventions of consistency, conservatism and full disclosure are required to be
followed while preparing financial statements.
● Financial statements are prepared on certain basic assumptions known as postulates or concepts such as going concern
concept, realisation concept, etc.
● Personal opinion, judgements and estimates also effect the financial statements.
Objectives of Financial Statements

● To provide financial data on economic resources (assets) and obligations (liabilities) of an enterprise.
● To provide information about the earning capacity.
● To provide sufficient and reliable information to various parties interested in financial statements.
● To present true and fair view of the working of the business.
● To serve as the basis for future planning and implementation of various operations.
● To provide information about the cash flows.
● To help to judge the effectiveness of management.
● To disclose various accounting policies.
Accountancy 91
Essentials of Financial Statements

Essentials of financial statements are as follows
1. Accurate Information It should disclose the factual information about the financial position and the working of the
business.
2. Understandability It should be prepared in accordance with the accepted accounting principles for better
understanding.
3. Comparable It should disclose information in a manner that the user can compare the information of the same entity
over the years (intra-firm comparison) and also compare the reporting company’s financial information with that of
other companies (inter-firm comparison).
4. Verifiable Information disclosed by the financial statements should be verifiable from the records of the company.
5. Relevant Information disclosed by the financial statements should be in accordance with the legal requirements.
6. Timeliness It should be prepared and presented within a reasonable period after the end of accounting period.
Otherwise, it may lose relevancy because of delay caused in preparation and presentation of such information.
Importance of Financial Statements

● Gaps between the management performance and expectations of owners can be understood with the help of financial
statements.
● Financial statements provide basic input for industrial taxation and other economic policies of the government as these
policies of government.
● Financial statements forms the basis for granting of credit.
● Financial statements help the investors to assess long-term and short-term solvency, as well as, the profitability of the
concern.
● Financial statements help trade associations for various purposes such as providing service and protection to their members.
Limitations of Financial Statements

● The information given in financial statements is historical in nature and does not reflect the future.
● Financial statements are the outcome of accounting concepts and conventions combined with the personal judgement.
● The financial statements can be prepared on the basis of different accounting practices. Profit earned or loss suffered will be
different under different assumptions.
● Financial statements ignore the qualitative elements.
● It ignores the price level changes of present market value of the assets as different assets are shown at the historical cost as
per the cost concept.
Parties (Users) Interested in Financial Statements

Financial statements are used for financial analysis purpose to facilitate decision-making by the users of accounting
information.
The users of accounting information can be internal (within the organisation) or external (outside the organisation) which
are as follows
1. Internal Users These include the following
● Owners
● Management
● Employees
2. External Users These include the following

● Banks and financial institutions
● Present and future investors
● Creditors or suppliers
● Government and its authorities
● Securities and Exchange Board of India
● Consumers or customers
Balance Sheet
It may be defined as a statement of assets and liabilities of the company at a particular date. It is prepared and presented in
the form prescribed in Schedule III, Part I of the Companies Act, 2013. The form prescribed is vertical.
Name of the Company
Balance Sheet
as at ... (` in.......)
Figures as at the Figures as at the End of
Note
Particulars End of Current the Previous Reporting
No.
Reporting Period Period
(i) Share Capital … …
(ii) Reserves and Surplus … …
(i) Long-term Borrowings … …
(ii) Long-term Provisions … …
(i) Short-term Borrowings … …
(ii) Trade Payables … …
(iii) Other Current Liabilities … …
(iv) Short-term Provisions … …
Total … …
II. ASSETS
1. Non-current Assets
(i) Fixed Assets
(a) Tangible Assets … …
(b) Intangible Assets … …
(ii) Non-current Investments … …
(iii) Long-term Loans and Advances … …
2. Current Assets
(i) Current Investments … …
(ii) Inventories … …
(iii) Trade Receivables … …
(iv) Cash and Cash Equivalents … …
(v) Short-term Loans and Advances … …
(vi) Other Current Assets … …
Total … …
Statement of Profit and Loss

It shows the net result of business operations i.e., financial performance during an accounting period. The vertical form for
preparing statement of profit and loss is prescribed under Schedule III, Part II of the Companies Act, 2013.
Statement of Profit and Loss ( ` in.........)
Note Figures for the Figures for the

Particulars Current Reporting Previous Reporting
No. Period Period
I. Revenue from Operations ... ...
II. Other Income ... ...
III. Total Revenue (I + II) ... ...
IV. Expenses
Cost of Materials Consumed ... ...
Purchases of Stock-in-trade ... ...
Changes in Inventories of Finished Goods ... …
Work-in-progress and Stock-in-trade ... ...
Employees Benefit Expenses ... ...
Accountancy 93
Note Figures for the Figures for the

Particulars Current Reporting Previous Reporting
No. Period Period
Finance Costs ... ...
Depreciation and Amortisation Expenses ... ...
Other Expenses ... ...
Total Expenses ... ...
V. Profit before Tax (III – IV) ... ...
VI. Tax Expenses ... ...
1. Current Tax ... ...
2. Deferred Tax
VII. Profit after Tax (V – VI) ... ...
Solved Example
1. Following is the trial balance of Evergreen Ltd. as at 31st March, 2022.
Debit Credit
Names of Accounts
Balance (`) Balance (`)
Machinery 3,20,000 —
Land and Building 13,48,000 —
Depreciation on Machinery 32,000 —
Purchases of Raw Materials (Adjusted) 8,00,000 —
Closing Stock 3,00,000 —
Wages 2,40,000 —
Sales — 20,00,000
Salaries 1,60,000 —
Bank Overdraft — 4,00,000
10% Debentures (Issued on 1st April, 2021) — 2,00,000
Equity Share Capital — 4,000 Shares of ` 100 each (Fully paid) — 4,00,000
Preference Share Capital — 2,000, 6% Preference Shares of ` 100 each (Fully paid) — 2,00,000
32,00,000 32,00,000
The Board of Directors of Evergreen Ltd. has decided to make the following appropriations.
(i) To pay an equity dividend @ 10% on paid-up capital as approved by shareholders.
(ii) To pay dividend on the preference share capital in full.
(iii) To transfer ` 4,00,000 to general reserve.
You are required to prepare statement of profit and loss for the year ended 31st March, 2022 and the balance
sheet of the company as at that date as per Schedule III of the Companies Act, 2013.
Note Ignore the income tax.
Sol. Statement of Profit and Loss
for the year ended 31st March, 2022
Year Ended
Particulars Note No. 31st March,
2022 (`)
I. Income
Revenue from Operations (Sales) 20,00,000
Total 20,00,000
II. Expenses
Cost of Materials Consumed (Adjusted Purchases) 8,00,000
Employees Benefit Expenses 1 4,00,000
Finance Costs 20,000
Depreciation and Amortisation 32,000
Total 12,52,000
Profit before Tax (I-II) 7,48,000
Balance Sheet
Note 31st March,
Particulars
No. 2022 (`)
I. Equity and Liabilities
(i) Share Capital 2 6,00,000
(ii) Reserves and Surplus 3 6,96,000
Long-term Borrowings 4 2,00,000
(i) Short-term Borrowings 5 4,00,000
(ii) Other Current Liabilities 6 20,000
(iii) Short-term Provisions 7 52,000
Total 19,68,000
II. Assets
(i) Fixed Assets
(a) Tangible Assets 8 16,68,000
2. Current Assets
Inventories 3,00,000
Total 19,68,000
Notes to Accounts
Year Ended 31st
Particulars
March, 2022 (`)
1. Employees Benefit Expenses
Wages 2,40,000
Salaries 1,60,000
4,00,000
2. Share Capital
Subscribed Capital
Subscribed and Fully Paid-up
4,000, Equity Shares of ` 100 each 4,00,000
2,000, 6% Preference Shares of ` 100 each 2,00,000
6,00,000
3. Reserves and Surplus
General Reserve
Opening Balance ...
(+) Transfer from Surplus, i.e., Balance in Statement of Profit and Loss 4,00,000
4,00,000
Surplus, i.e., Balance in Statement of Profit and Loss
Profit for the Year 7,48,000
(−) Appropriations
General Reserve (4,00,000)
Proposed Dividend
Equity (40,000)
Preference (12,000) (4,52,000)
Total 2,96,000
10% Debentures 2,00,000
5. Short-term Borrowings
Bank Overdraft 4,00,000
6. Other Current Liabilities
Interest on Debentures 20,000
Accountancy 95
Year Ended 31st

Particulars
March, 2022 (`)
7. Short-term Provisions
Proposed Dividend
Equity 40,000
Preference 12,000 52,000
8. Tangible Assets
Machinery 3,20,000
Land and Building 13,48,000
16,68,000
Practice Questions
1 Which of the following points out the nature of 5 Under which of the following head/ sub-head is
financial statements? ‘forfeited shares’ presented in the balance sheet of
(i) Financial statements are prepared on the basis a company?
of recorded facts. (a) Reserves and surplus
(b) Share capital
(ii) Certain accounting conventions are followed (c) Other long-term liabilities
while preparing financial statements. (d) Other current liabilities
(iii) Financial statements are prepared on certain
6 10% debentures are included in
basic assumptions (pre-requisites) known as
(a) current liability (b) fixed assets
postulates. (c) current assets (d) None of these
(iv) Facts and figures presented through financial
statements are based on personal opinion, 7 Staff welfare expenses are included in
(a) cost of material consumed
estimates and judgements.
(a) Only (i) (b) revenue from operation
(b) (i) and (ii) (c) employees benefit expense
(c) (i), (ii) and (iii) (d) None of the above
(d) (i), (ii), (iiii) and (iv) 8 External users of financial statements are
2 Which of the following are the objectives of (a) banks (b) suppliers
financial statements? (c) Both (a) and (b) (d) director of company
(i) To provide information about economic 9 In a trading firm, if stock of finished goods held for
resources and obligations of a business. a month and credit period is 2 months, then
operating cycle will be for ....... month(s).
(ii) To provide information about the earning
(a) one (b) two
capacity of the business. (c) three (d) four
(iii) To provide information about cash flows.
10 You are required to find heading and sub-heading
(iv) To judge effectiveness of management. under which sundry debtors can be shown?
(a) (i) and (ii) (b) Only (ii) (a) Fixed assets, trade receivables
(c) (i), (ii) and (iv) (d) (i), (ii), (iii) and (iv) (b) Current assets, trade receivables
3 Which of the following is not included under the (c) Fixed assets, trade payables
head shareholders’ fund? (d) Current assets, trade payables
(a) Share capital 11 A company got its mining right recently. You are
(b) Reserves and surplus required to show this right in financial statements
(c) Money received against share warrants of the company as
(d) Long-term provisions (a) expense (b) tangible asset
4 Which of the following is not presented under (c) current asset (d) intangible asset
‘current liabilities’ in the balance sheet of a 12 A company issued capital. A shareholder paid all
company? money on allotment while first call is not called by
(a) Short-term borrowings company. So you are required to show this advance
(b) Deferred tax liabilities in balance sheet of company as
(c) Short-term provisions
(a) current liability (b) long-term liability
(d) Trade payables
(c) current assets (d) None of these
13 Public deposits appear under which of the 20 Livestock is a item of ……… assets under sub-head
following head in a company’s balance sheet? fixed assets and the major head non-current assets.
(a) Current liabilities (b) Non-current liabilities (a) intangible (b) inventories
(c) Reserves and surplus (d) Shareholders’ funds (c) trade receivables (d) tangible
14 A company issued shares calling application, 21 Which of the following is not an item of sub-head
allotment and first and final call. A holder of other current liabilities in balance sheet?
shares not paid allotment and first call. His shares (a) Creditors
are forfeited but not re-issued. As on balance sheet (b) Outstanding expenses
date, you are required to show these forfeited shares (c) Advance income
in the balance sheet of company under the head (d) Both (b) and (c)
(a) current liability (b) shareholders’ fund 22 In balance sheet, ‘Trade receivables’ is the
(c) current assets (d) None of these sub-head under ……… .
15 Preliminary expenses are those expenses which are (a) non-current assets (b) current assets
paid before incorporation of a company. A company (c) non-current liabilities (d) current liabilities
paid its preliminary expenses to its promoters. 23 Format and Contents of a company’s balance sheet
Accountant of company is in view that this is an must be in accordance with ………, Part 1 of
expense, so it will be fully written-off in statement Companies Act, 2013.
of profit and loss account. How this should have (a) Schedule I (b) Schedule II
been shown? (c) Schedule III (d) Schedule IV
(a) Statement of profit and loss account by full amount 24 Securities premium reserve is shown on the
(b) Current asset
liabilities side in the balance sheet under the head
(c) Deduct from reserve and surplus
(a) reserves and surplus (b) general reserve
(c) share capital (d) current liabilities
16 From following information, calculate other
25 Financial statements include balance sheet,
incomes.
statement of profit and loss, cash flow statement,
Sales of product = ` 54,000; Sale of services
etc.
= ` 60,000; Commission received = ` 1,20,000;
Excise duty paid = ` 3,00,000; Dividend from Besides these statements, a special statement is
investment = ` 20,000 also included in financial statements if applicable
(a) ` 1,40,000 (b) ` 2,54,000 on company. Name that special statement.
(c) ` (46,000) loss (d) None of these (a) Statement of changes in equity
(b) Statement of assets and liabilities
17 From the following information, you are required (c) Statement of cash inflow and outflow
to compute profit after tax. (d) Statement of incomes and expenses
I. Revenue from operation = ` 80,00,000 26 Compute cost of materials consumed from the
II. Cost of material consumed = ` 10,00,000 following information. Opening inventory of
III. Purchase of stock-in-trade = ` 30,00,000 materials ` 5,00,000, materials purchased
` 40,00,000 and closing inventory of materials
IV. Employees salary = ` 4,00,000
` 6,00,000.
V. Tax rate = 50% (a) ` 40,00,000 (b) ` 51,00,000
(a) ` 20,00,000 (b) ` 24,00,000 (c) ` 27,00,000 (d) ` 39,00,000
(c) ` 15,00,000 (d) ` 18,00,000
27 What is the total under equity and liabilities side
18 A company purchased a business of a firm. When of the balance sheet when the following
accountant was tallying all assets and liabilities, information is given?
he found that the company has paid more amount
Shareholders’ Funds = ` 10,00,000; Non-current
than the worth of it’s assets. You are required to
Liabilities = ` 5,00,000; Current Liabilities
find what this difference be called and where it
= ` 3,00,000
will be shown?
(a) ` 10,00,000 (b) ` 15,00,000
(a) Capital reserve, reserve and surplus
(c) ` 18,00,000 (d) ` 13,00,000
(b) Goodwill, intangible assets
(c) Accountants totalling is wrong, assets and liabilities 28 What will be the amount shown under the head
always tally without adjustment current assets when the following data is given?
(d) None of the above Inventories = ` 2,30,000; Trade Receivables
19 Which of the following item(s) can be presented on = ` 70,000; Cash and Cash Equivalents = ` 50,000;
the assets side of the balance sheet of company? Current Investments = ` 50,000
(a) ` 3,00,000 (b) ` 3,50,000
(a) Sundry debtors (b) Public deposits
(c) ` 2,80,000 (d) ` 4,00,000
(c) Livestock (d) Both (a) and (c)
Accountancy 97
29 What will be the amount shown under the head 30 What is the total under assets side of the balance
current liabilities when the following data is given? sheet when the following information is given?
Short-term borrowings = ` 3,00,000; Trade Payables Non-current Assets = ` 5,00,000; Current Assets
= ` 2,00,000; Other Current Liabilities = ` 1,00,000; = ` 2,00,000; Current Liabilities = ` 3,00,000
Short-term Provisions = `1,00,000 (a) ` 7,00,000 (b) ` 10,00,000
(a) ` 5,00,000 (b) ` 6,00,000 (c) ` 5,00,000 (d) None of these
(c) ` 4,00,000 (d) ` 7,00,000
ANSWERS
1. (d) 2. (d) 3. (d) 4. (b) 5. (b) 6. (d) 7. (c) 8. (c) 9. (c) 10. (b)
11. (d) 12. (a) 13. (b) 14. (b) 15. (c) 16. (a) 17. (d) 18. (b) 19. (d) 20. (d)
21. (a) 22. (b) 23. (c) 24. (a) 25. (a) 26. (d) 27. (c) 28. (d) 29. (d) 30. (a)
Hints & Solutions

5. Forfeited shares are shown by adding it to subscribed
capital. Particulars Amt (`)
Purchase of Stock-in-trade 30,00,000
6. Debentures are always treated as long-term until
Employees Benefit Expense 4,00,000 (44,00,000)
unless these debentures are redeemable within 12
Profit before Tax 36,00,000
months. Therefore, they are included in long-term
(−) Tax @ 50% (18,00,000)
liabilities. Profit after Tax 18,00,000
7. Staff welfare expenses means employees expenses
which are paid for their benefit. These are shown in 18. When net assets are less and payment for business
statement of profit and loss. purchase is more, then it is called goodwill and it is
10. Debtors are to be received within 12 months. So, these shown under intangible assets.
can be classified as current assets and these are 26. Cost of materials consumed
included in trade receivables with bills receivables. = Opening Inventory of Materials + Purchases
11. Mining right is an asset which is generally for − Closing Inventory of Materials
long-term. So, it will be treated as fixed asset. Since = 5,00,000 + 40,00,000 − 6,00,000
this right cannot be seen, so it is an intangible asset.
= ` 39,00,000
12. Calls-in-advance is always treated as current liability
because it is reversed when call money is called-up by 27. Total under equity and liabilities side
company. = Shareholders’ Funds + Non-current Liabilities +
14. Amount received before forfeiture is kept by the Current Liabilities
company and therefore, it is a gain for the company. = 10,00,000 + 5,00,000 + 3,00,000
However, forfeiture reduces the share capital by = ` 18,00,000
amount of forfeited shares. Hence, it is shown on the
28. Current Assets = Inventories + Trade Receivables
liabilities side of balance sheet under ‘shareholders’
+ Cash and Cash Equivalents
fund’ head.
+ Current investments
16. Other Incomes Amt (`) Current Assets = 50,000 + 70,000 + 50,000
(i) Commission Received = 1,20,000 + 2,30,000 = ` 4,00,000
(ii) Dividend from Investment Received = 20,000 29. Current Liabilities = Short-term borrowings
= 1,40,000 + Trade Payables
Sale of products and services are revenue from + Other current Liabilities
operation and excise duty is revenue from operation in + Short-term Povisions
negative nature. Current Liabilities = 3,00,000 + 2,00,000 + 1,00,000
17. Statement of Profit and Loss + 1,00,000 = ` 7,00,000
Particulars Amt (`) 30. Total under Assets Side = Non-current Assets
Revenue from Operations 80,00,000 + Current Assets
(−) Expenses = 5,00,000 + 2,00,000
Cost of Material Consumed 10,00,000 = ` 7,00,000
CHAPTER 11
Financial
Statement Analysis
Meaning of Financial Statement Analysis 2. From the Viewpoint of its Objectivity
The process of critical evaluation of the financial information From the viewpoint of objectivity, it is classified as
contained in the financial statements, in order to understand (i) Short-term Analysis Such an analysis of financial
and make decisions regarding the operations of the firm, statements is done to examine the liquidity, profit
is called financial statement analysis. It is basically a study of earning capacity and short-term solvency of an
relationship among various financial facts and figures as given enterprise.
in a set of financial statements. (ii) Long-term Analysis Such an analysis of financial
statements is done to examine the long-term financial
It is a systematic process of identifying the financial strengths
stability and long-term solvency as well as future
and weaknesses of the firm by establishing the relationship profit earning capacity of an enterprise.
between the items of balance sheet and income statement
(statement of profit and loss). 3. From the Viewpoint of Time Span
From the viewpoint of time span, it is classified as
According to Myer, ‘‘Financial statement analysis is largely a
study of relationships among the various financial factors in a (i) Horizontal Analysis It is also called dynamic
business, as disclosed by a single set of statements and a study analysis. It is a time series analysis. This analysis is
of trends of these factors, as shown in a series of statements.’’ made to review and analyse the financial statements of
a number of years and is therefore, based on financial
Purpose and Significance of data taken for those years. It shows comparison of
Financial Statement Analysis financial data for several years against a chosen base
● To present the complex financial data in simplified and
year.
understandable form. (ii) Vertical Analysis It is also called static analysis. This
● To judge the financial stability of an enterprise.
analysis is made to review and analyse the financial
● To measure the short-term and long-term solvency of
statements of one particular year only. Such analysis is
enterprise. useful in comparing the performance of several
● To measure the operating efficiency and profitability of
companies of the same type or divisions or
departments in one enterprise.
enterprise.
● To compare intra-firm position, inter-firm position and 4. From the Viewpoint of Firm
pattern position within the industry. From the viewpoint of firm, it is classified as
● To assess the future prospects of the enterprise.
(i) Intra-firm Analysis This analysis is a comparison of
financial statements of an enterprise for two or more
Types of Financial Statement Analysis accounting periods.
1. From the Viewpoint of its Users It is conducted to determine the trend of different
From the viewpoint of users, it is classified as financial variables over a period of time. It is also
known as time series analysis or trend analysis.
(i) External Analysis Parties/Persons who do not have
access to detailed records of the enterprise conduct (ii) Inter-firm Analysis This analysis is a comparison of
external analysis. They depend on published accounts financial statements of two or more enterprise for the
and directors’ and auditors’ reports. same accounting period.
(ii) Internal Analysis The analysis conducted by the It is conducted to determine the relative position of an
management to know the financial position and enterprise as compared to other competitive
operational efficiency of the organisation is known as enterprises of the same industry. It is also known as
internal analysis. cross sectional analysis.
Accountancy 99
Limitations of Financial Statement Analysis The most commonly used techniques of financial statement
● Financial statement analysis does not consider price level analysis are as follows
● Comparative statements ● Common size statements
changes.
● Ratio analysis ● Cash flow statement
● Financial statement analysis may be misleading without
the knowledge of the changes in accounting procedure
followed by a firm. Comparative Statements
● Financial statement analysis is just a study of interim Comparative statement is an art of presenting financial
reports. statements, i.e. income statement and balance sheet of two or
more years of a firm, in such a manner which helps to assess
● Monetary information alone is considered in financial
the weak and strong points of the business entity.
analysis while non-monetary aspects are ignored.
● The financial statements are prepared on the basis of on It may relate to different periods (intra-firm comparison) or
going concept, as such, it does not reflect the current different firms but for the same period (inter-firm
position. comparison). Comparative statements analysis is also known
as horizontal analysis.
Parties Interested in A comparative statement exhibits the following information
Financial Statement Analysis ● Absolute figures for two or more years of the items appearing
Financial statement analysis is useful and significant to in financial statements.

● Changes in absolute figures of the current year as compared
different users. Following are the parties which are
interested in financial statement analysis to the previous year taken as the base year.
● Percentage changes in absolute figures of the current year on
● Finance Manager ● Management
● Trade Creditors ● Bankers and Lenders

the basis of the base year.
● Investors ● Labour Unions
Objectives of Comparative Statements
● Government ● Regulatory Authorities
● To know the nature of changes influencing financial position.
● Customers ● Tax Authorities
● To know the weaknesses and soundness about liquidity,
● Researchers ● Other Parties
profitability and solvency of the enterprise.
● To forecast and plan.
Tools of
Financial Statement Analysis Types of Comparative Statements
Financial statements of companies are basically There are two types of comparative statements
● Comparative statement of profit and loss or income statement
summarised financial reports. The figures given in these
● Comparative balance sheet
reports are to be analysed in relation to other figures over a
period of time. It is done to identify the strength and Comparative Statement of Profit and Loss
weakness of business. Also, meaningful conclusions can be It shows the operating results (i.e. net profit or loss) for two or
drawn based on such analysis. There are number of more accounting periods, so that changes in absolute amounts
techniques (tools) available for this purpose. and percentages may be known.
Comparative Statement of Profit and Loss

for the years ended…
Particulars Previous Current Absolute Change Percentage
Year (`) Year (`) (Increase or Change (Increase
Decrease) (`) or Decrease) (%)
I. Revenue from Operations (Net sales) … … … …
II. Other Income … … … …
III. Total Revenue (I + II) … … … …
IV. Expenses
(i) Cost of Materials Consumed … … … …
(ii) Purchases of Stock-in-trade … … … …
(iii) Changes in Inventories of Finished Goods,
Work-in-progress and Stock-in-trade … … … …
Particulars Previous Current Absolute Change Percentage

Year (`) Year (`) (Increase or Change (Increase
Decrease) (`) or Decrease) (%)
(iv) Employees Benefit Expenses … … … …
(v) Finance Cost … … … …
(vi) Depreciation and Amortisation … … … …
(vii) Other Expenses … … … …
Total Expenses … … … …
V. Profit before Tax (III – IV) … … … …
(−) Income Tax (…) (…) (…) (…)
VI. Profit after Tax … … … …
Comparative Balance Sheet

It analyses each item of assets, equity and liabilities for two or more accounting periods, so that changes in absolute amounts
and percentages may be known.
Comparative Balance Sheet
as at …
Particulars Previous Current Absolute Change Percentage Change
Year (`) Year (`) (Increase or Decrease) (`) (Increase or Decrease) (%)
(i) Share Capital
(a) Equity Share Capital … … … …
(b) Preference Share Capital … … … …
(ii) Reserves and Surplus … … … …
(i) Long-term Borrowings … … … …
(ii) Long-term Provisions … … … …
(i) Short-term Borrowings … … … …
(ii) Trade Payables … … … …
(iii) Other Current Liabilities … … … …
(iv) Short-term Provisions … … … …
Total … … … …
II ASSETS
(i) Fixed Assets
(a) Tangible Assets … … … …
(b) Intangible Assets … … … …
(ii) Non-current Investments … … … …
(iii) Long-term Loans and Advances … … … …
2. Current Assets
(i) Current Investments … … … …
(ii) Inventories … … … …
(iii) Trade Receivables … … … …
(iv) Cash and Cash Equivalents … … … …
(v) Short-term Loans and Advances … … … …
(vi) Other Current Assets … … … …
Total … … … …
Common Size Statements

These are the statements in which amounts of individual items of balance sheet and income statement (statement of profit
and loss) for two or more years are written. These items are further converted into percentages to a common base.
Comparison can be easily made with the percentage so calculated with the corresponding percentages in other periods and
meaningful conclusions can be drawn. Common size analysis is also known as vertical analysis.
Accountancy 101
A common size statement exhibits the following information

● Absolute figures of the items appearing in financial statements of two or more years or two or more firms.
● Percentage figure of every item appearing in financial statements as a percentage of the pre-selected base item.
Objectives of Common Size Statements

● To present the changes in various items of assets and liabilities in relation to total of balance sheet.
● To present the changes in various items of statement of profit and loss in relation to revenue from operations.
● To establish relationship of different items of balance sheet with total assets/liabilities so that important conclusion can be drawn.
● To provide a common base for comparison.
Types of Common Size Statements

There are two types of common size statement
● Common size statement of profit and loss or income statement
● Common size balance sheet
Common Size Statement of Profit and Loss

It is the statement in which amount of revenue from operations (net sales) is assumed to be equal to 100 and other amounts
are expressed as percentage of revenue from operations (net sales).
Common Size Statement of Profit and Loss
for the years ended…
Particulars Percentage of Revenue from
Absolute Amount
Operations (Net sales)
Previous Current Previous Current
Year (`) Year (`) Year (%) Year (%)
I. Revenue from Operations (Net sales) … … … …
II. Other Income … … … …
III. Total Revenue (I + II) … … … …
IV. Expenses
(i) Cost of Materials Consumed … … … …
(ii) Purchases of Stock-in-trade … … … …
(iii) Changes in Inventories of Finished Goods,
Work-in-progress and Stock-in-trade … … … …
(iv) Benefit Expenses … … … …
(v) Finance Cost … … … …
(vi) Depreciation and Amortisation … … … …
(vii) Other Expenses … … … …
Total Expenses … … … …
V. Profit before Tax (III – IV) … … … …
VI. (−) Income Tax (…) (…) (…) (…)
VII. Profit after Tax … … … …
Common Size Balance Sheet

It shows the percentage relation of each asset/liability to total assets/total liabilities including capital. In this, total assets or
total equity and liabilities are taken as 100 and all the figures are expressed as percentage of the total.
Common Size Balance Sheet
as at ...
Particulars Absolute Amount Percentage of Balance
Sheet Total
(i) Share Capital
(a) Equity Share Capital … … … …
(b) Preference Share Capital … … … …
(ii) Reserves and Surplus … … … …
Particulars Absolute Amount Percentage of Balance

Sheet Total
(i) Long-term Borrowings … … … …
(ii) Long-term Provisions … … … …
(i) Short-term Borrowings … … … …
(ii) Trade Payables … … … …
(iii) Other Current Liabilities … … … …
(iv) Short-term Provisions … … … …
Total … … 100 100
II ASSETS
(i) Fixed Assets
(a) Tangible Assets … … … …
(b) Intangible Assets … … … …
(ii) Non-current Investments … … … …
(iii) Long-term Loans and Advances … … … …
2. Current Assets
(i) Current Investments … … … …
(ii) Inventories … … … …
(iii) Trade Receivables … … … …
(iv) Cash and Cash Equivalents … … … …
(v) Short-term Loans and Advances … … … …
(vi) Other Current Assets … … … …
Total … … 100 100
Solved Exmaples
1. From the following information, prepare a comparative statement of profit and loss of V Ltd. for the year ended
31st March, 2020.
Particulars 31st March, 2020 31st March, 2019
Revenue from Operations ` 20,00,000 ` 10,00,000
Cost of Material Consumed ` 15,00,000 ` 6,00,000
Other Expenses 12% of Cost of Material 10% of Cost of Material
Consumed Consumed
Tax Rate 40% 30%
Prepare comparative statement of profit and loss.

Sol. Comparative Statement of Profit and Loss
for the year ended 31st March, 2020 and2019
Absolute Change Percentage Change
Particulars 2020 (`) 2019 (`)
(Increase or Decrease) (`) (Increase or Decrease) (%)
I. Revenue from Operations 20,00,000 10,00,000 10,00,000 100.00
II. Expenses
Cost of Material Consumed 15,00,000 6,00,000 9,00,000 150.00
Other Expenses 1,80,000 60,000 1,20,000 200.00
Total Expenses 16,80,000 6,60,000 10,20,000 154.50
III. Profit before Tax (I −II) 3,20,000 3,40,000 (20,000) (5.80)
(−) Tax (1,28,000) (1,02,000) (26,000) (25.00)
IV. Profit after Tax 1,92,000 2,38,000 (46,000) (19.30)
Accountancy 103
2. From the following balance sheets of Verma Ltd, prepare comparative balance sheet.
Particulars 31st March, 2019 (`) 31st March, 2018 (`)
(i) Share Capital 50,00,000 50,00,000
(ii) Reserves and Surplus 12,00,000 10,00,000
Long-term Borrowings 30,00,000 30,00,000
(i) Short-term Borrowings 4,80,000 4,50,000
(ii) Trade Payables 4,50,000 4,00,000
(iii) Other Current Liabilities 1,10,000 1,00,000
(iv) Short-term Provisions 60,000 50,000
Total 1,03,00,000 1,00,00,000
II ASSETS
(i) Fixed Assets (Tangible) 72,00,000 60,00,000
(ii) Non-current Investments 10,00,000 10,00,000
2. Current Assets
(i) Inventories 11,00,000 15,00,000
(ii) Trade Receivables 6,00,000 10,00,000
(iii) Cash and Cash Equivalents 3,50,000 3,00,000
(iv) Other Current Assets 50,000 2,00,000
Total 1,03,00,000 1,00,00,000
Sol. Comparative Balance Sheet

as at 31st March, 2019 and 2018
Absolute Percentage
Note 31st March, 31st March,
Particulars Change (Increase Change (Increase
No. 2019 (`) 2018 (`)
or Decrease) (`) or Decrease) (%)
(i) Share Capital 50,00,000 50,00,000 — —
(ii) Reserves and Surplus 12,00,000 10,00,000 2,00,000 20.00
Long-term Borrowings 30,00,000 30,00,000 — —
(i) Short-term Borrowings 4,80,000 4,50,000 30,000 6.67
(ii) Trade Payables 4,50,000 4,00,000 50,000 12.50
(iii) Other Current Liabilities 1,10,000 1,00,000 10,000 10.00
(iv) Short-term Provisions 60,000 50,000 10,000 20.00
Total 1,03,00,000 1,00,00,000 3,00,000 3.00
II ASSETS
(i) Fixed Assets (Tangible) 72,00,000 60,00,000 12,00,000 20.00
(ii) Non-current Investments 10,00,000 10,00,000 — —
2. Current Assets
(i) Inventories 11,00,000 15,00,000 (4,00,000) (26.67)
(ii) Trade Receivables 6,00,000 10,00,000 (4,00,000) (40.00)
(iii) Cash and Cash Equivalents 3,50,000 3,00,000 50,000 16.67
(iv) Other Current Assets 50,000 2,00,000 (1,50,000) (75.00)
Total 1,03,00,000 1,00,00,000 3,00,000 3.00
3. Prepare common size income statement from the following statement of profit and loss.
Particulars 31st March, 2019 (`) 31st March, 2018 (`)
I. Income
Revenue from Operations (Net sales) 5,00,000 5,00,000
Other Income 5,500 5,000
Total 5,05,500 5,05,000
II. Expenses
Purchases of Stock-in-trade 3,50,000 3,25,000
Changes in Inventories of Stock-in-trade 24,000 25,000
Employees Benefit Expenses 49,000 40,000
Other Expenses 45,000 58,750
Total 4,68,000 4,48,750
III. Profit (I – II) 37,500 56,250
Other expenses include 2019 (`) 2018 (`)
Provision for Tax 37,500 56,250
Sol. Common Size Income Statement
for the years ended 31st March, 2019 and 2018
Particulars Percentage of Revenue
Absolute Amount
from Operations (Net sales)
2019 (`) 2018 (`) 2019 (%) 2018 (%)
I. Revenue from Operations (Net sales) 5,00,000 5,00,000 100.00 100.00
II. Other Income 5,500 5,000 1.10 1.00
III. Total Revenue (I + II) 5,05,500 5,05,000 101.10 101.00
IV. Expenses
(i) Purchases of Stock-in-trade 3,50,000 3,25,000 70.00 65.00
(ii) Changes in Inventories of Stock-in-trade 24,000 25,000 4.80 5.00
(iii) Employees Benefit Expenses 49,000 40,000 9.80 8.00
(iv) Other Expenses 7,500 2,500 1.50 0.50
Total Expenses 4,30,500 3,92,500 86.10 78.50
V. Profit before Tax (III – IV) 75,000 1,12,500 15.00 22.50
(−) Provision for Tax (37,500) (56,250) (7.50) (11.25)
VI. Profit after Tax 37,500 56,250 7.50 11.25
4. From the following balance sheet of R Ltd., prepare a common size statement balance sheet of R Ltd.
(as at 31st March, 2020)
Balance Sheet
Particulars Note No. 31st March, 2020 (`) 31st March, 2019 (`)
(i) Share Capital 2,50,000 2,00,000
(ii) Reserves and Surplus 80,000 60,000
Trade Payable 70,000 40,000
Total 4,00,000 3,00,000
II ASSETS
(i) Fixed Assets
(a) Tangible Assets 1,60,000 1,20,000
(b) Intangible Assets 20,000 30,000
2. Current Assets
(i) Inventories 80,000 30,000
(ii) Trade Receivables 1,20,000 1,00,000
(iii) Cash and Cash Equivalents 20,000 20,000
Total 4,00,000 3,00,000
Accountancy 105
Sol. Common Size Balance Sheet

as at 31st March, 2020 and 2019
Absolute Item % of Balance % of Balance
Particulars Sheet Total Sheet Total
(2020) (2019)
2020 (`) 2019 (`)
(i) Share Capital 2,50,000 2,00,000 62.5 66.67
(ii) Reserves and Surplus 80,000 60,000 20 20
Trade Payable 70,000 40,000 17.5 13.33
Total 4,00,000 3,00,000 100 100
II ASSETS
(i) Fixed Assets
(a) Tangible Assets 1,60,000 1,20,000 40 40
(b) Intangible Assets 20,000 30,000 5 10
2. Current Assets
(i) Inventories 80,000 30,000 20 10
(ii) Trade Receivables 1,20,000 1,00,000 30 33.33
(iii) Cash and Cash Equivalents 20,000 20,000 5 6.67
Total 4,00,000 3,00,000 100 100
Practice Questions
1 The analysis of financial statements is important 6 Long-term borrowings of a firm on 31st March,
for 2021 was ` 5,00,000 and ` 8,00,000 on 31st March,
(a) management 2022.What will be the absolute change and
(b) trade unions percentage change in comparative balance sheet?
(c) creditors (a) ` 4,00,000, 80% respectively
(d) All of the above (b) ` 3,00,000, 60% respectively
2 Comparative statement of profit and loss is also (c) ` 5,00,000, 35% respectively
known as (d) ` 8,00,000, 25% respectively
(a) statement showing absolute and percentage changes 7 Revenue from operations on 31st March, 2021 was
(b) statement showing only percentage change ` 15,00,000 and on 31st March, 2020 was
(c) income and expenditure account `12,00,000, then what will be the percentage
(d) None of the above change in revenue from operations?
3 Horizontal analysis provides information in (a) 50%
(a) absolute terms (b) 62%
(b) percentage terms (c) 45%
(c) Both (a) and (b) (d) 25%
(d) different terms
8 Cost of material consumed was ` 6,00,000 in
4 In comparative statements, percentage change can 2021-22 and total revenue from operations was
be calculated with the help of which of the follwing ` 10,00,000, then percentage of cost of material
formula? consumed to total revenue from operations is
Absolute Change × 100 Absolute Change × 100 (a) 60% (b) 30%
(a) (b)
Amount of Previous Year Amount of Current Year (c) 25% (d) 18%
Absolute Change × 100
(c) (d) None of these 9 Tangible assets are ` 4,00,000 on 31st March, 2020
Amount of Total Profit and intangible assets are ` 2,00,000.
5 In common size balance sheet, Total assets of the firm are ` 10,00,000, then what
(a) amount of share capital is taken as 100 will be the percentage of tangible assets to total
(b) amount of current liabilities is taken as 100 assets?
(c) amount of total assets is taken as 100
(d) None of the above (a) 48% (b) 50% (c) 40% (d) 32%
10 The financial statements of a business enterprise 19 If shareholders’ fund of XYZ Ltd. was ` 10,00,000,
include long-term borrowings was ` 1,40,000 and trade
(a) balance sheet payable was ` 3,60,000, then what will be the
(b) statement of profit and loss account percentage of shareholders’ fund to the total
(c) cash flow statement liabilities side of balance sheet?
(d) All of the above (a) 70% (b) 33.33%
11 The most commonly used tools for financial (c) 66.66% (d) Data insufficient
analysis are 20 When financial statements for a single year are
(a) horizontal analysis (b) vertical analysis analysed, it is called
(c) ratio analysis (d) All of these (a) vertical analysis (b) horizontal analysis
12 An Annual Report is issued by a company to its (c) lateral analysis (d) circular analysis
(a) directors (b) auditors 21 Sumatra limited wants to assess the future profit
(c) shareholders’ (d) management
earning capacity of its business. It will conduct
13 Balance sheet provides information about financial (a) external analysis (b) short-term analysis
position of enterprise (c) long-term analysis (d) None of these
(a) at a point in time
(b) over a period of time 22 Comparative balance sheet consists of ………
(c) for a period of time columns.
(d) None of the above (a) five (b) three
(c) six (d) four
14 Comparative statements are also known as
(a) dynamic analysis (b) horizontal analysis 23 Fixed assets of a company increased from
(c) vertical analysis (d) external analysis ` 3,00,000 to ` 4,00,000. What is the percentage
15 Which of the following is not a tool of financial change?
(a) 25% (b) 33.3%
analysis?
(c) 20% (d) 50%
(a) Comparative income statement
(b) Comparative position statement 24 Total of equity and liabilities is ` 15,00,000 and
(c) Statement of profit and loss share capital is ` 3,00,000 as on 31st March, 2020.
(d) Cash flow statement What will be the percentage of share capital shown
in the common size balance sheet?
16 Which of the following is not an objective of
(a) 18% (b) 20%
comparative statement analysis?
(c) 15% (d) 25%
(a) To compare with other firms and industrial data
(b) To judge the financial instability 25 Calculate amount of tax to be deducted.
(c) To help in forecasting and planning Revenue from Operations ` 5,00,000
(d) Understand complex data in simplified manner
Other income (% of Revenue from Operations) 20%
17 Which item is assumed to be 100 while preparing
common size statement of profit and loss? Expenses (% of Operating Revenue) 40%
(a) Total income Tax Rate 30%
(b) Cost of revenue from operations (a) ` 1,50,000 (b) ` 1,20,000
(c) Revenue from operations (c) ` 1,00,000 (d) ` 2,00,000
26 If net revenue from operations is ` 1,20,000, cost of
18 If shareholders’ fund of Grow Ltd. was ` 4,00,000 revenue from operations is ` 40,000 and operating
in 31st December, 2019 and ` 5,00,000 in 31st expenses are ` 20,000, what will be the percentage
December, 2020, then what is the percentage of operating income on net revenue from
change in shareholders’ fund? operations?
(a) 10% (b) 25% (a) 45% (b) 55%
(c) 30% (d) Data insufficient (c) 50% (d) 65%
ANSWERS
1. (d) 2. (a) 3. (c) 4. (a) 5. (c) 6. (b) 7. (d) 8. (a) 9. (c) 10. (d)
11. (d) 12. (c) 13. (a) 14. (b) 15. (c) 16. (b) 17. (c) 18. (b) 19. (c) 20. (a)
21. (c) 22. (a) 23. (b) 24. (b) 25. (b) 26. (c)
Accountancy 107
Hints & Solutions

1. Analysis helps the management to exercise control 18. Absolute change = 5,00,000 – 4,00,000 = ` 1,00,000
over the business. It helps the creditors to judge the Percentage Change = (Absolute Change/Previous Year)
ability of the company to meet its liabilities. It helps × 100 = (1,00,000 /4,00,000) × 100 = 25%
trade union to settle wage disputes.
19. Total liabilities = 10,00,000 + 1,40,000 + 3,60,000
3. Horizontal analysis provides information in absolute = ` 15,00,000
and percentage terms. It is undertaken to review and Shareholders’ fund = ` 10,00,000
analyse the financial statements of a number of years
Percentage = (Shareholders’ Fund/Total Assets) × 100
and is very useful for long-term trend analysis and
= 10,00,000 / 15,00,000 × 100 = 66.66%
planning.
21. Long-term analysis of financial statements is done to
5. Common size balance sheet shows the percentage
examine the long-term financial stability and
relation of each asset/liability to total assets/total
long-term solvency as well as future profit earning
liabilities including capital. In this, total assets or
capacity of a company.
total equity and liabilities are taken as 100.
22. Comparative balance sheet consists of five columns,
6. Absolute change = 8,00,000 − 5,00,000 = `3,00,000
namely, particulars, figures relating to previous year,
Change × 100
Percentage Change = figures relating to current year, absolute change and
Previous Years Balance percentage change.
3,00,000 × 100 Change
= = 60% 23. Percentage Change = × 100
5,00,000 Value of Previous Year
1,00,000 × 100
7. Absolute change = 15,00,000 −12,00,000 = `3,00,000 = = 33 . 3%
3,00,000
Absolute Change × 100
Percentage change =
Previous Year Figures 24. Percentage of Share Capital
3,00,000 × 100 Share Capital
= = 25% = × 100
12,00,000 Total Equity and Liability
3,00,000 × 100
8. Percentage of cost of material consumed to total = = 20%
revenue from operations 15,00,000
Cost of Material Consumed × 100 25. Revenue from Operations 5,00,000
=
Total Revenue from Operations (+ ) Other Income 1,00,000
 6,00,000 × 100 Total Revenue 6,00,000
=  = 60%
 10,00,000  (− ) Expenses (2,00,000)
9. Percentage of tangible assets Profit before Tax 4,00,000
Tangible Assets (− ) Tax 30% of ` 4,00,000 (1,20,000)
= × 100
Total Assets Profit after Tax 2,80,000
4,00,000 × 100 26. Income = Revenue from Operations − Cost of Revenue
= = 40%
10,00,000 from Operations − Operating Expenses
15. Statement of profit and loss or income statement is = 1,20,000 − 40,000 − 20,000 = ` 60,000
one of the financial statements of a company and Income
Percentage of Income = × 100
shows the company’s revenues and expenses during a Revenue from Operations
particular period. 60,000 × 100
= = 50%
1,20,000
CHAPTER 12
Accounting Ratios
Meaning of Ratios and Accounting Ratios
Ratio It is an arithmetical expression of relationship between two related or interdependent items. It is the numerical or
quantitative relationship between two items/variables.
Accounting Ratios When ratios are calculated on the basis of accounting information, they are called accounting ratios. It is
a mathematical expression that shows the relationship between two items or groups of items shown in financial statements.
Accounting ratios can be expressed as a pure ratio, percentage, in times or fraction.
Ratio Analysis
It is a technique which involves analysing the financial statements by calculating various ratios. It is the most important and
powerful tool for measuring performance of a business enterprise.
Objectives of Ratio Analysis

● To know the areas of an enterprise which need more attention.
● To know about the potential areas, which can be improved on.
● To make inter as well as intra firm comparisons.
● To provide analysis of the liquidity, solvency, activity and profitability of an enterprise.
● To provide information useful for making estimates and preparing the plans for future.
Classification or Types of Ratios

Ratios can be broadly classified as
● Liquidity ratios ● Solvency ratios
● Activity ratios ● Profitability ratios
I. Liquidity Ratios (Short-term solvency)
Liquidity ratios shows the ability of the enterprise to meet its short-term financial obligations. The two ratios included in this
category are
1. Current Ratio or Working Capital Ratio
Current Assets
Current Ratio =
Current Liabilities
● Current Assets = Current Investments + Inventories (Excluding stores and spares and loose tools) + Trade Receivables
(Net of provision for doubtful debts) + Cash and Cash Equivalents + Short-term Loans and Advances
+ Other Current Assets
● Current Liabilities = Short-term Borrowings + Trade Payables + Other Current Liabilities + Short-term Provisions
2. Liquid Ratio or Quick Ratio or Acid Test Ratio

Liquid Assets or Quick Assets
Liquid Ratio =
Current Liabilities
● Quick Assets = Current Assets − Inventories − Prepaid Expenses
● Current Liabilities As per Current Ratio

Accountancy 109
II. Solvency Ratios (Long-term solvency)

Solvency ratios are calculated to judge the long-term financial position of the business. The ratios in this category are
1. Debt to Equity Ratio
Debt (Long – term debts)
Debt to Equity Ratio =
Equity (Shareholders’ funds)
Debt = Long-term Borrowings (i.e. debentures, mortgage, public deposits) + Long-term Provisions
●
Shareholders’ Funds = Share Capital + Reserves and Surplus

●
or
= Non-current Assets (Tangible assets + Intangible assets + Non-current investments
+ Long-term loans and advances) + Working Capital* − Non-current Liabilities (Long-term
borrowings + Long-term provisions)
*Working Capital = Current Assets − Current Liabilities
2. Total Assets to Debt Ratio
Total Assets
Total Assets to Debt Ratio =
Long -term Debts
● Total Assets = Non-current Assets (Tangible assets + Intangible assets + Non-current investments + Long-term loans
and advances)+ Current Assets [Current investments + Inventories (Including stores and spares and
loose tools) + Trade receivables + Cash and cash equivalents + Short-term loans and advances]
+ Other Current Assets
● Debts = Long-term Borrowings + Long-term Provisions
3. Proprietary Ratio
Proprietors’ Funds or Shareholders’ Funds
Proprietary Ratio =
Total Assets
● Shareholders’ Funds = Share Capital + Reserves and Surplus
● Total Assets as per Total Assets to Debt Ratio
III. Activity/Performance/Turnover Ratios
Activity/ Turnover ratios show how efficiently a company is using its assets to generate sales. The ratios in this category are
1. Inventory Turnover Ratio
Cost of Revenue from Operations i.e. Cost of Goods Sold
Inventory Turnover Ratio = = …… Times
Average Inventory
● Cost of Revenue from Operations = Opening Inventory (Excluding stores and spares and loose tools) + Net
Purchases + Direct Expenses − Closing Inventory (Excluding stores and spares
and loose tools)
or = Revenue from Operations − Gross Profit
or = Cost of Materials Consumed + Purchases of Stock-in-trade + Change in
Inventories of Finished Goods, WIP and Stock-in-trade + Direct Expenses*
*If direct expenses are not given, assume it to be nil.
Opening Inventory + Closing Inventory
● Average Inventory or Stock =
2
2. Trade Receivables or Debtor Turnover Ratio
Net Credit Revenue from Operations
Trade Receivables Turnover Ratio = = ..... Times
Average Trade Receivables
● Net Credit Revenue from Operations = Credit Revenue from Operations − Sales Return
or
= Revenue from Operations − Cash Revenue from Operations.

Opening Receivables (debtors + bills receivables)
+ Closing Receivables (debtors + bills receivables)
● Average Trade Receivables =
2
Note Debt Collection Period or Average Collection Period

It is determined as follows
365
Debt Collection Period = = Number of Days
Trade Receivables or Debtors’ Turnover Ratio
12
or Debt Collection Period = = Number of Months
Trade Receivables or Debtors’ Turnover Ratio
3. Trade Payables or Creditors Turnover Ratio

Net Credit Purchases
Trade Payables Turnover Ratio = = … Times
Average Trade Payables *
● Net Credit Purchases = Net Purchases − Cash Purchases
Opening Payables (creditors + bills payable)

+ Closing Payables (creditors + bills payable)
* Average Trade Payables =
2
Note Average Payment Period or Average Age of Payables

Average Trade Payables
Average Payment Period = × Number of Months/Days in a Year
Net Credit Purchases
Months (or days) in a Year
or =
Trade Payables or Creditors Turnover Ratio
4. Working Capital Turnover Ratio

Revenue from Operations (Net sales)
Working Capital Turnover Ratio = = ..... Times
Working Capital
● Working Capital = Current Assets −Current Liabilities
Net Sales Net Sales
5. Fixed Assets Turnover Ratio = or
Average Fixed Assets Net Fixed Assets
● Net Fixed Assets = Gross Fixed Assets − Accumulated Depreciation
6. Current Assets Turnover Ratio/Assets Turnover Ratio
Net Sales
Current Assets Turnover Ratio =
Average Total Assets
IV. Profitability Ratios

These ratios measure the profitability of a business. Profitability ratios help in assessing the overall efficiency of the business.
The ratios in this category are
1. Gross Profit Ratio
Gross Profit
Gross Profit Ratio = × 100 = .....%
● Gross Profit = Revenue from Operations − Cost of Revenue from Operations
2. Operating Ratio (Operating cost ratio)
Operating Cost
Operating Ratio = × 100 = .....%
Cost of Revenue from Operations + Operating Expenses
or Operating Ratio = × 100
Operating Cost = Cost of Materials Consumed + Purchases of Stock-in-trade + Changes in Inventories of Finished
Goods, Work-in-progress and Stock-in-trade + Employees benefits Expenses + Depreciation and
Amortisation Expenses + Other Expenses (Other than non-operating expenses)
● Cost of Revenue from Operations = As per inventory turnover ratio
Accountancy 111
● Operating Expenses = Employees benefit Expenses + Other Expenses (Other than non-operating expenses)
+ Depreciation and Amortisation Expenses
or = Office expenses, administrative expenses, selling and distribution expenses, employees
benefit expenses, depreciation and amortisation expenses.
3. Net Profit Ratio
Net Profit
Net Profit Ratio = × 100 = .....%
● Net Profit = Revenue from Operations − Cost of Revenue from Operations − Operating Expenses − Non-operating
Expenses + Non-operating Income + Tax
4. Return on Investments (RoI) or Return on Capital Employed
Net Profit before Interest, Tax and Preference Dividend
Return on Investment (RoI) = × 100 = .....%
Capital Employed
● Capital Employed (Liabilities Approach) = Share Capital + Reserves and Surplus + Long-term Borrowings +
Long-term Provision
(Assets Approach) = Non-current Assets (Tangible assets + Intangible assets) + Non-current Investments
+ Long-term Loans and Advances + Working Capital
Working Capital = Current Assets − Current Liabilities
(Assume that all non-current investments are trade investments).
(Interest on non-trade investments should be deducted from profit before interest, tax and dividend).
5. Earning per Share
Net Profit after Tax and Preference Dividend
Earning per Share =
Number of Equity Shares
6. Dividend per Share
Total Dividend Paid in a Year
Dividend per Share =
Outstanding Shares of Company
7. Profit Earning Ratio/Price Earning Ratio
Market Value of Equity Share
Profit Earning Ratio =
Earning per Share
Solved Examples
1. From the following information, calculate any two 13,20,000 + 2,20,000
= × 100 = 70 %
of the following ratios. 22,00,000
(i) Operating ratio (ii) Inventory turnover ratio Credit Revenue from Operations
(iii) Proprietary ratio = 10,00,000 × 120% = ` 12,00,000
Information Cash revenue from operations *Revenue from Operations
` 10,00,000, credit revenue from operations 120% = Cash Revenue from Operations
of cash revenue from operations, operating + Credit Revenue from Operations
expenses 10% of revenue from operations, rate = 10,00,000 + 12,00,000 = ` 22,00,000
of gross profit 40%, opening inventory ` 1,50,000,
Gross Profit = 22,00,000 × 40% = ` 8,80,000
closing inventory ` 20,000 more than opening
inventory, current assets ` 3,00,000, current **Cost of Revenue from Operations
liabilities ` 2,00,000, share capital ` 6,00,000, = Revenue from Operations – Gross Profit
fixed assets ` 5,00,000. = 22,00,000 − 8,80,000 = ` 13,20,000
Sol. (i) Operating Ratio ***Operating Expenses
(Cost of Revenue from Operations * *
= 10% of Revenue from Operations
+ Operating Expenses * * * )
= × 100 = 22,00,000 × 10% = ` 2,20,000
Revenue from Operations *
(ii) Inventory Turnover Ratio

Cost of Revenue from Operations (ii) Working Capital Turnover Ratio
=
Average Inventory * Revenue from Operations 5,25,000
= = = 2.5 times
13,20,000 Working Capital * 210
, ,000
= = 8. 25 times
1,60,000 *Working Capital
*Average Inventory = Current Assets− Current Liabilities
Opening Inventory + Closing Inventory = 5,00,000 − 2,90,000 = ` 210
, ,000
=
2 3. From the following information, calculate any two
1,50,000 + 1,70,000 of the following ratios
= = ` 1,60,000
2 (i) Net profit ratio (ii) Debt to equity ratio
(iii) Proprietary Ratio (iii) Quick ratio
Equity or Shareholders’ Funds *
= Information Paid-up capital ` 20,00,000, capital
Total Assets **
6,00,000 reserve ` 2,00,000, 9% debentures ` 8,00,000,
= = 0.75 : 1 revenue from operations ` 14,00,000, gross profit
8,00,000
` 8,00,000, indirect expenses ` 2,00,000, current
*Equity or Shareholders’ Funds = Share Capital assets ` 4,00,000, current liabilities ` 3,00,000,
= ` 6,00,000 opening inventory ` 50,000, closing inventory 20%
**Total Assets = Total Current Assets + Fixed Assets more than opening inventory.
= 3,00,000 + 5,00,000 = ` 8,00,000 Sol. (i) Net Profit Ratio
2. From the following information, calculate any two Net Profit *
= × 100
of the following ratios Revenue from Operations i.e. Net Sales
(i) Gross profit ratio 6,00,000
= × 100 = 42. 86 %
(ii) Working capital turnover ratio 14 ,00,000
Information Paid-up share capital ` 8,00,000, *Net Profit = Gross Profit – Indirect Expenses
current assets ` 5,00,000, credit revenue from = 8,00,000 − 2,00,000 = ` 6,00,000
operations ` 3,00,000, cash revenue from (ii) Debt to Equity Ratio
operations 75% of credit revenue from operations, Debt (Long – term Debts) *
9% debentures ` 3,40,000, current liabilities = × 100
Equity or Shareholders’ Funds **
` 2,90,000, cost of revenue from operations
8,00,000
` 1,80,000. = = 0.36 : 1
Sol. (i) Gross Profit Ratio 22,00,000
Gross Profit * *Long-term Debts = 9% debentures = ` 8,00,000
= × 100
Revenue from Operations ** **Equity or Shareholders’ Funds
( 1,55,000) = Share Capital + Reserves and Surplus
= × 100 = – 29.52%
5,25,000 = 20,00,000 + 2,00,000 = ` 22,00,000
Cash Sales = 3,00,000 × 75% = ` 2,25,000 (iii) Quick Ratio =
Liquid Assets *
=
3,40,000
= 1.13 : 1
**Revenue from Operations Current Liabilities 3,00,000
= Cash Revenue from Operations + Credit Closing Inventory = Opening Inventory + 20% of
Revenue from Operations Opening Inventory
= 2,25,000 + 3,00,000 = ` 5,25,000 = 50,000 + 20% of 50,000 = ` 60,000
*Gross Profit = Revenue from Operations * Liquid Assets = Current Assets – Closing Inventory
− Cost of Revenue from Operations = 4 ,00,000 − 60,000
= 5,25,000 − 6,80,000 = (` 1,55,000) = ` 3,40,000
Practice Questions
1 Ratio analysis under financial analysis is 11 The credit sale of M/s Dinesh & Sons is ` 21,00,000,
significant as it It’s debtors and bills receivables at the end of the
(a) ignores qualitative factors accounting period amounted to ` ` 2,00,000 and
(b) helps in window-dressing ` 1,50,000 respectively. What will be the debtor’s
(c) does not requires any standards
turnover ratio?
(d) helps in locating weak points of the firm
(a) 4 times (b) 5 times
2 Normally absolute ratio is further refinement of (c) 6 times (d) 7 times
liquid or quick ratio. Which of the following is
12 Total purchase ` 1,70,000, cash purchases ` 16,000,
considered fairly satisfactory?
purchase return ` 8,000, creditors at the end of the
(a) 1 : 1 (b) 0.5 : 1
(c) 15
. :1 (d) 1 : 15
. year ` 32,000, creditors in the beginning ` 24,000.
What will be the creditors turnover ratio?
3 Test of solvency of a business undertaking means (a) 5.12 times
(a) its ability to meet the interest costs (b) 5.16 times
(b) its ability to meet the long-term liabilities as and (c) 5.21 times
when they become due (d) 5.25 times
(c) its ability to pay dividends to equity shareholders
(d) All of the above 13 Consider the following information.
Long-term borrowings ` 2,00,000; Long-term
4 The immediate solvency ratio is
(a) quick ratio
provision ` 1,00,000; Current liabilities ` 50,000 ;
(b) current ratio Non-current assets ` 3,60,000; Current assets
(c) debtors turnover ratio ` 90,000
(d) stock turnover ratio Proprietary ratio will be
5 The following groups of ratios are primarily (a) 22.2% (b) 21.8%
measure risk (c) 36% (d) None of these
(a) liquidity, activity and profitability 14 Calculate operating ratio, if cost of revenue from
(b) liquidity, activity and inventory operations ` 50,000, revenue from operations
(c) liquidity, activity and debt
(d) liquidity, debt and profitability
` 1,50,000 and operating expenses ` 20,000.
(a) 45% (b) 46.7%
6 The ...... ratios are primarily measures of return. (c) 48.1% (d) 42.2%
(a) liquidity (b) activity
15 The ...... is useful in evaluating credit and collection
(c) debt (d) profitability
policies.
7 The ...... of business firm is measured by its ability (a) average payment period
to satisfy its short-term obligations as they become (b) current ratio
due (c) average collection period
(a) activity (b) liquidity (d) current asset turnover
(c) debt (d) profitability 16 The ...... measures the activity of a firm’s inventory.
8 ...... ratios are a measure of the speed with which (a) average collection period
various accounts are converted into revenue from (b) invenotry turnover
operations or cash. (c) liquid ratio
(a) Activity (b) Liquidity (d) current ratio
(c) Debt (d) Profitability 17 The ...... may indicate that the firm is experiencing
9 The two basic measures of liquidity are stock outs and lost sales.
(a) inventory turnover and current ratio (a) average payment period
(b) current ratio and liquid ratio (b) inventroy turnover ratio
(c) gross profit margin and operating ratio (c) average collection period
(d) current ratio and average collection period (d) quick ratio
10 The ...... is a measure of liquidity which excludes 18 ABC Co. extends credit terms of 45 days to its
......, generally the least liquid asset customers. Its credit collection would be considered
(a) current ratio, trade receivable poor if its average collection period was
(b) liquid ratio, trade receivable (a) 30 days (b) 36 days
(c) current ratio, inventory (c) 47 days
(d) liquid ratio, inventory (d) 37 days
19 ...... are especially interested in the average Choose the correct option.
payment period, since it provides them with a sense (a) Only (i) is correct
of the bill-paying patterns of the firm. (b) Only (ii) is correct
(a) Customers (c) Only (i) and (iii) are correct
(b) Stockholders (d) Only (ii) and (iii) are correct
(c) Lenders and suppliers 25 What is the debt to equity ratio when the following
(d) Borrowers and buyers
information is available?
20 The ...... ratios provide the information critical to Total Assets ` 35,00,000; Total Debts ` 25,00,000;
the long-run operation of the firm Current Liabilities ` 8,00,000.
(a) liquidity (b) activity (a) 1.7:1 (b) 2:1
(c) solvency (d) profitability (c) 3:1 (d) 3:2
21 Which of the following is/are objective(s) of ratio 26 A debt-equity ratio of ………… is considered
analysis? satisfactory.
(a) To know the areas of the business which need more (a) 1:1 (b) 4:1
attention. (c) 2:1 (d) There is no such value
(b) To provide a deeper analysis of the profitability, liquidity,
solvency and efficiency levels in the business. 27 A very high working capital turnover ratio may be a
(c) To provide information by making cross sectional analysis sign of ……… .
by comparing the performance with the best industry (a) undertrading (b) overtrading
standards. (c) optimal trading (d) None of these
(d) All of the above 28 Debt-equity ratio of a company is 1:2. Purchase of a
22 Which of the following points out the significance of fixed asset for ` 5,00,000 on long-term deferred
ratio analysis? payment basis will
(a) It helps the business in identifying the problem areas. (a) increase the ratio
(b) It ignores price level changes. (b) decrease the ratio
(c) It ignores qualitative aspects. (c) the ratio will not change
(d) either (a) or (b)
29 What is the inventory turnover ratio, when the
23 The Current Assets of APE Ltd. are ` 6,00,000 ;
following is given?
Current Liabilities are ` 2,00,000; Inventories are COGS = ` 1,50,000; Closing Inventory = ` 60,000;
` 1,50,000; Prepaid Expenses are ` 50,000 and Cash Excess of Closing Inventory over Opening Inventory
and Cash Equivalents are ` 1,00,000. What is its ` 20,000.
quick ratio? (a) 3 times
(a) 1 (b) 2 (c) 1.5 (d) 3 (b) 2.14 times
24 Current ratio of Vidur Pvt. Ltd. is 3:2. Accountant (c) 1.5 times
wants to maintain it at 2:1. Following options are (d) 4 times
available 30 A company’s current ratio is 4 : 2 and current
(i) He can repay bills payable. liabilities are ` 6,20,000. What will be the amount
(ii) He can take short-term loan. of current assets?
(iii) He can purchase goods on credit. (a) ` 12,40,000 (b) ` 3,10,000
(c) ` 6,00,000 (d) ` 24,80,000
ANSWERS
1. (d) 2. (b) 3. (d) 4. (a) 5. (d) 6. (d) 7. (b) 8. (a) 9. (b) 10. (d)
11. (c) 12. (c) 13. (a) 14. (b) 15. (c) 16. (b) 17. (a) 18. (c) 19. (c) 20. (c)
21. (d) 22. (a) 23. (b) 24. (a) 25. (a) 26. (c) 27. (b) 28. (a) 29. (a) 30. (a)
Hints & Solutions
1. Financial analysis is significant as it helps a firm 14. Operating Ratio
in locating weak points, with the comparison of two Cost of Revenue from Operations
years balance sheet and ratio analysis. + Operating Expenses × 100
=
2. Satisfactory absolute ratio is 0.5 : 1. Because Revenue from Operations
absolute liquid ratio will give correct idea whether 50,000 + 20,000
Operating Ratio = × 100
our short-term financial position is good for 1,50,000
business or not. = 46.7%
3. Ability to pay dividend to equity shareholders 23. Quick Assets = Current Assets − Inventories − Prepaid
shows that the undertaking is able to meet the Expenses
interest cost and also long-term liabilities as and
= 6,00,000 − 1,50,000 − 50,000 = ` 4,00,000
when they become due.
Quick Ratio = Quick Assets/Current Liabilities
11. Debtor’s Turnover Ratio
= 4,00,000/2,00,000 = 2
Net Credit Sales
= 24. Repayment of bills payable will reduce current assets and
Average Trade Receivables
liabilities by the same amount. This will improve the
21,00,000
= = 6 times current ratio. Other two options will deteriorate it.
(2,00,000 + 1,50,000)
25. Debt to Equity Ratio = Debt/Equity
12. Net Credit Purchase = Total Purchase − Cash Debt = Total Debt − Current Liabilities
Purchase − Purchase Return
= 25,00,000 − 8,00,000
= 1,70,000 − 16,000 − 8,000
= ` 1,46,000 = ` 17,00,000
Equity = Total Assets − Total Debts
Average Trade Payable
Opening Trade Payable + Closing Trade Payable = 35,00,000 − 25,00,000 = ` 10,00,000
=
2 Debt to equity ratio = 17,00,000/10,00,000 = 1.7 : 1
24,000 + 32,000 28. Purchase of a fixed asset for ` 5,00,000 on long-term
= = ` 28,000
2 deferred payment basis will increase the debt component
Net Credit Purchase but not the equity component and hence ratio will
Creditors Turnover Ratio =
Average Trade Payable increase.
1,46,000 29. Inventory Turnover Ratio = COGS/Average Inventory
= = 5.21 times
28,000 Opening Inventory = Closing Inventory
Shareholders’ Fund − 20,000 = 60,000 − 20,000 = ` 40,000
13. Proprietary Ratio =
Total Assets Average Inventory = (Opening Inventory
Shareholders’ Fund = Total Assets* − Long-term + Closing Inventory)/2
Borrowings − Long-term = 40,000 + 60,000/2
Provision − Current = 1,00,000/2
Liabilities = ` 50,000
= 4,50,000 − 50,000 − 1,00,000 − Inventory turnover ratio = 1,50,000/50,000 = 3 times
2,00,000 Current Assets
30. Current Ratio =
= ` 1,00,000 Current Liabilities
Total Assets* = Non-current Assests + Current Assets 4 CA
⇒ =
= 3,60,000 + 90,000 = ` 4,50,000 2 6,20,000
1,00,000 ∴Current Assets = ` 12,40,000
Proprietary Ratio = × 100 = 22.2%
4,50,000
CHAPTER 13
Cash Flow Statement

Meaning of Cash Flow Statement
It is a statement showing changes in the financial position of a business concern during different intervals of time in terms of
cash and cash equivalents. Some important terms related to cash flow statements are as follows
1. Cash Flows It implies movement of cash in and out of non-cash items. Receipt of cash from a non-cash item is
termed as cash inflow while cash payment in respect of such items is termed as cash outflow. The Accounting
Standard-3 (Revised) states that cash flows exclude movement between items that constitute cash or cash equivalents
because these components are part of the cash management of an enterprise rather than part of its operating,
investing and financing activities.
2. Cash and Cash Equivalents As per AS-3, ‘cash’ comprises cash in hand and demand deposits with banks and ‘cash
equivalents’ means short-term highly liquid investments that are readily convertible into known amount of cash and
which are subject to an insignificant risk of changes in value.
For example, Short-term marketable securities, which can be readily converted into cash, are treated as cash
equivalents.
Objectives of Cash Flow Statement

● To ascertain the specific sources from activities (i.e. operating/investing/financing activities) from which cash and cash
equivalent were generated by an enterprise.
● To ascertain the specific uses by activities (i.e. operating/investing/financing activities) for which cash and cash equivalent
were used by an enterprise.
● To ascertain the net change in cash and cash equivalents indicating the difference between sources and uses from or by the
three activities between the dates of two balance sheets.
Classification of Business Activities

Accounting Standard-3 (Revised) requires that the changes resulting in inflows and outflows of cash and cash equivalents
should be classified into following three activities
● Cash flow from operating activities
● Cash flow from investing activities
● Cash flow from financing activities
Cash Flow from Operating Activities

Operating activities are the principle revenue producing activities of the enterprise and other activities that are not
investing or financing activities. Amount of cash flow arising from operating activities suggest whether cash generation is
adequate to maintain operational capability of the enterprise, pay dividends, repay loans and make new investments. It also
helps in forecasting future cash flows from operations.
Accountancy 117
Cash flow from operating activities are exhibited as follows

Operating Activities
For a Trading Company

Cash Inflow Cash Outflow
Cash sales Cash purchases
Cash received from debtors Payment to creditors
Cash received from commission and fees Cash operating expenses
Royalty Payment of wages
Income tax
For a Finance Company
Cash received for interest and dividends Cash paid for interest
Sale of securities Purchase of securities
For an Insurance Company
Premiums and claims received Premiums and claims paid
For a Real Estate (Infrastructure) Company
Rent received Rent paid
Calculation of Cash Flow from Operating Activities

To calculate cash flow from operating activity, the amount of net profit (as per statement of profit and loss) is required to be
adjusted for non-cash and non-operating expenses, appropriation of profit, provisions and changes in working capital, etc.
Indirect Method for Calculating Cash Flow from Operating Activities
Under indirect method, cash flow from operating activities is calculated from the statement of profit and loss and balance
sheet. Steps to be followed for calculation of cash flow from operating activities are
Step 1 Determine net profit before tax and extraordinary items
Particulars Amt (`)
Difference between Closing Balance and Opening Balance of Surplus, i.e., Balance in Statement of Profit and Loss …
(+) Proposed Dividend of Previous Year …
Interim Dividend Paid During the Year …
Transfer to Reserves …
Provision for Expenses …
Provision for Tax (Current year) …
Extraordinary Items Debited to Statement of Profit and Loss …
(−) Refund of Tax Credited to Statement of Profit and Loss (…)
Extraordinary Items Credited to Statement of Profit and Loss (…) (…)
Net Profit before Tax and Extraordinary Items …
Proposed Dividend
As per the provisions of AS-4, dividend proposed by the Directors of the company for the current year will be shown in the
notes to accounts as contingent liability. Dividend of the previous year which has been declared and approved in the annual
general meeting of shareholders for current year will be shown as appropriation of profits of current year and will be added
to determine the net profit before taxes and later shown as an outflow from the firm under the financing activity.
Provision for Tax
• When only opening and closing balance Add Closing balance to the profit.
of provision for tax are given in the Deduct Opening balance at the end to assess cash flow from operating
balance sheet. activities.
• When opening and closing balance of In such a case, prepare provision for tax account
provision for tax are given in the Add Provision made during the year (given) to profit.
balance sheet and provision for tax Deduct Tax paid at the end (balancing figure in provision for tax account) to
made during the year is given assess cash flow from operating activities.
in additional information.
• When opening and closing balance of In such a case, prepare provision for tax account
provision for tax are given in the Add Provision made during the year (balancing figure in provision for tax
balance sheet and tax paid during the account) to profit.
year is given in adjustment. Deduct Tax paid (given) at the end to assess cash flow from operating
activities.
• When only tax paid during the year or Add The amount to the profit (operating activities) as provision for tax made
provision for tax made during the year during the year.
is given in the additional information. Deduct The amount at the end (operating activities) as income tax paid during
the year.
Step 2 Adjustments for non-cash and non-operating items

In this step, net profit before tax and extraordinary items is adjusted for non-cash and non-operating items.
Non-cash and non-operating items, expenses and losses are added back. Non-operating incomes and gains are
deducted.
Step 3 Adjustment in respect of changes in current assets and current liabilities
In this step, operating profit before working capital changes is adjusted for changes in working capital
(i.e. current assets and current liabilities). A decrease in current assets (excluding cash and cash equivalents) and
increase in current liabilities (excluding bank overdraft and cash credit) are added to the operating profit before
working capital changes.
An increase in current assets (excluding cash and cash equivalents) and a decrease in current liabilities (excluding
bank overdraft and cash credit) are deducted from operating profit before working capital changes. The amount
after above adjustment is cash generated from operations.
Step 4 Adjustment in respect of income tax paid
In this step, income tax paid (net of refund) is deducted from cash generated from operations, if they are not
related to investing and/or financing activity. The amount after above adjustment is cash flow from operating
activities before extraordinary items. If income tax relates to investing activity or financing activity, it is not
deducted from cash generated from operations, instead it is deducted from related activity, i.e. investing activity or
financing activity.
Step 5 Adjustment in respect of extraordinary items
In this step, extraordinary item(s) are added to or deducted from cash flow from operating activities before
extraordinary items. The amount after adjustment activities is net cash flow (inflow or outflow) from operating
activities.
Cash Flow from Investing Activities

As per AS-3, investing activities are the acquisition and disposal of the long-term assets and other investments, not included
in cash equivalents. These activities include transactions involving purchase and sale of long-term productive assets like land
and building, machinery, etc which are not held for resale. The amount of cash flow arising from investing activities
represents the extent to which expenditure has been incurred to generate future income and cash flows.
Cash flow from investing activities are exhibited as follows
Investing Activities

Sale of fixed assets Purchase of fixed assets
Sale of investments Purchase of investments
Interest received Income tax (If identified with investing activities)
Dividends received Loans and advances granted
Rent received Brokerage paid on purchase of investment
Cash flow from investing activities is ascertained by analysing the changes in fixed assets and long-term investments in the
beginning and at the end of the year. For getting the missing figures regarding purchase/sale of fixed assets and depreciation,
fixed assets account and provision for depreciation account are prepared.
Accountancy 119
These accounts can be prepared in two ways as discussed below

Case 1 Fixed Asset Account on Written Down Value Basis
In this case, depreciation is charged to the asset account and the balance of the asset account shows the written
down value of the asset, which is also called the book value.
Dr Fixed Assets Account (At written down value) Cr
To Balance b/d ... By Bank A/c (Sale of fixed asset) ...
To Bank A/c (Purchases) ... By Statement of Profit and Loss ...
To Statement of Profit and Loss ... (Loss on sale of fixed asset)*
(Gain on sale of fixed asset)* By Depreciation A/c ...
By Balance c/d ...
... ...
*Either of the two will come.

Case 2 Fixed Asset Account on Original Cost Basis
When fixed assets are shown at original cost and accumulated depreciation account is separately maintained, in
that case, depreciation is not directly charged to the asset account. The depreciation for the period is debited to
the depreciation account and credited to accumulated depreciation account.
In the balance sheet, asset appears at its original cost and the accumulated depreciation is shown either by
deducting from fixed asset account (shown at cost) or on the liabilities side of balance sheet.
In such cases, following accounts are prepared
Dr Fixed Assets Account (At cost) Cr
To Balance b/d ... By Bank A/c (Sale of fixed asset) ...
To Statement of Profit and Loss ... By Accumulated Depreciation A/c ...
(Profit on sale of fixed asset)* (Accumulated depreciation on fixed asset sold)
To Bank A/c (Purchase of fixed asset) ... By Statement of Profit and Loss ...
(Loss on sale of fixed asset)*
By Balance c/d ...
... ...
Note 1. *Either of the two will appear.

2. Normally, the purchase of fixed asset is a balancing amount on the debit side of the account and the sale of fixed asset on the
credit side of the account.
Dr Accumulated Depreciation Account Cr

To Fixed Asset A/c ... By Balance b/d ...
(Accumulated depreciation on fixed asset sold) By Statement of Profit and Loss ...
To Balance c/d ... (Depreciation charged for current year)
... ...
Note Accumulated depreciation on the fixed asset sold or depreciation charged for the current accounting year may not be given, which shall
be the balancing amount.
Cash Flow from Financing Activities

These are the activities which result in change in the size and composition of the owner’s capital (including preference share
capital) and borrowings (including debentures) of the enterprise from other sources. It is useful in predicting claims on
future cash flows by providers of funds to the enterprise.
Cash flow arising from financing activities are exhibited as follows

Financing Activities

Issue of shares in cash Payment of loans
Issue of debentures in cash Redemption of preference shares, debentures
Proceeds from long-term borrowings Buy-back of equity shares
Securities premium reserve received Payment of dividend
Interest received on calls-in-arrears Payment of interest
Increase in balance of bank overdraft or cash Premium paid on redemption of preference shares, debentures
credit account Income tax (If identified with financing activities)
Loans repaid
Brokerage and underwriting commission paid
Cash flow from financing activities is ascertained by analysing the change in equity and preference share capital, debentures
and other borrowings.
Format of Cash Flow Statement

Indirect Method [As per Accounting Standard-3 (Revised)]
for the year ended...
Particulars Amt (`)
A Cash Flow from Operating Activities
Net Profit before Taxation and Extraordinary Items ...
Adjustment for Non-cash and Non-operating Items
(+) Items to be Added
Depreciation ...
Goodwill, Patents and Trademarks Amortised ...
Interest on Borrowings and Debentures ...
Loss on Sale of Fixed Assets ...
Increase in Provision for Doubtful Debts ... ...
(−) Items to be Deducted
Interest Income (...)
Dividend Income (...)
Rental Income (...)
Gain (Profit on sale of fixed assets) (...) (...)
Operating Profit before Working Capital Changes ...
(+) Decrease in Current Assets and Increase in Current Liabilities ...
(−) Increase in Current Assets and Decrease in Current Liabilities (...)
Cash Generated from Operations ...
(−) Income Tax Paid (Net of tax refund received) (...)
Net Cash from (or used in) Operating Activities .../(...)
B Cash Flow from Investing Activities
Proceeds from Sale of Fixed Assets ...
Proceeds from Sale of Investments ...
Proceeds from Sale of Intangible Assets ...
Interest and Dividend Received (For non-financial companies only) ...
Rent Income ...
Purchase of Fixed Assets (...)
Purchase of Investments (...)
Purchase of Intangible Assets like Goodwill (...)
Net Cash from (or used in) Investing Activities .../(...)
C Cash Flow from Financing Activities
Proceeds from Issue of Shares and Debentures ...
Proceeds from Other Long-term Borrowings ...
Final Dividend Paid (...)
Interim Dividend Paid (...)
Accountancy 121
Particulars Amt (`)

Interest on Debentures and Loans Paid (...)
Repayment of Loans (...)
Redemption of Debentures/Preference Shares (...)
Net Cash from (or used in) Financing Activities .../(...)
D Net Increase/Decrease in Cash and Cash Equivalents (I + II + III) .../(...)
E (+) Cash and Cash Equivalents in the Beginning of the Year
Cash in Hand ...
Cash at Bank ...
Short-term Deposits ...
Marketable Securities ... ...
...
F Cash and Cash Equivalents at the End of the Year
Cash in Hand ...
Cash at Bank ...
Short-term Deposits ...
Marketable Securities ... ...
...
Note Bank overdraft and cash credit are to be treated as short-term borrowings.
Solved Example
1. From the following balance sheets of Diamond Limited as on 31st March, 2019 and 31st March, 2020, prepare a
cash flow statement (as per Accounting Standard 3).
Note 31st March, 31st March,
Particulars
No 2020 (`) 2019 (`)
(i) Share Capital 1 4,00,000 3,40,000
(ii) Reserve and Surplus 2 1,60,000 1,20,000
Long-term Borrowings 3 3,50,000 2,60,000
(i) Trade Payables 4 55,000 30,000
(ii) Other Current Liabilities 5 2,000 5,000
Total 9,67,000 7,55,000
II. ASSETS
Fixed Assets (Tangible) 6 6,00,000 4,80,000
2. Current Assets
(i) Inventories 73,000 50,000
(ii) Trade Receivables 7 1,55,000 1,30,000
(iii) Cash and Bank Balances 8 1,39,000 95,000
Total 9,67,000 7,55,000
Notes to Accounts
Particulars
2020 (`) 2019 (`)
1. Share Capital
Equity Share Capital 4,00,000 3,40,000
2. Reserve and Surplus
General Reserve 50,000 42,000
Statement of Profit and Loss 1,10,000 78,000

Particulars
2020 (`) 2019 (`)
5% Debentures 3,50,000 2,60,000
4. Trade Payables
Creditors 45,000 18,000
Bills Payable 10,000 12,000
5. Other Current Liabilities
Outstanding Expenses 2,000 5,000
6. Fixed Assets
Building 4,40,000 2,90,000
Plant and Machinery 1,60,000 1,90,000
7. Trade Receivables
Debtors 1,55,000 1,30,000
8. Cash and Bank Balance
Cash at Bank 1,39,000 95,000
(i) Depreciation charged on building ` 20,000.
(ii) A machine with a book value of ` 10,000 was sold for ` 8,000.
(iii) Debentures were issued on 1st April, 2019, at a discount of 10%. The discount was written-off from
general reserve.
Sol. Cash Flow Statement of Diamond Limited
for the year ended 31st March, 2020
Particulars Amt (`)
A Cash Flows from Operating Activities
Profit before Tax (WN 1) 49,000
Adjustments for Non-cash and Non-operating Items
(+) Depreciation on Building 20,000
Depreciation on Plant and Machinery 20,000
Loss on Sale of Machinery 2,000
Interest on Debentures (5% on ` 3,50,000) 17,500 59,500
Operating profit before working capital changes 1,08,500
(+) Increase in Current Liabilities
Creditors 27,000
1,35,500
(–) Decrease in Current Liabilities
Bills Payables (2,000)
Outstanding Expenses (3,000)
Increase in Current Assets
Debtors (25,000)
Inventories (23,000) (53,000)
Net Cash from Operating Activities 82,500
B Cash Flow from Investing Activities
Purchase of Building (WN 3) (1,70,000)
Sale of Plant (WN 4) 8,000
Net Cash used in Investing Activities (1,62,000)
C Cash Flows from Financing Activities
Issue of Equity Share Capital 60,000
Issue of Debentures (` 90,000 Less Discount ` 9,000) 81,000
Interest paid on Debentures (17,500) 1,23,500
Net Cash from Financing Activities
Net Increase in Cash and Cash Equivalents (A + B + C) 44,000
(+) Cash and Cash Equivalents in the Beginning of the Period 95,000
Cash and Cash Equivalents at the End of the Period 1,39,000
Accountancy 123
Working Notes
1. Calculation of Profit before Tax
Amt (`)
Profit and Loss Balance on 31st March, 2020 1,10,000
(–) Profit and Loss Balance on 31st March, 2019 (78,000)
32,000
(+) Transfer to General Reserve 17,000
49,000
2. Dr General Reserve Account Cr
To Discount written-off (10% of 90,000) 9,000 By Balance b/d 42,000
To Balance c/d 50,000 By Surplus of Statement of Profit and Loss 17,000
(Balancing figure)
59,000 59,000
3. Dr Building Account Cr
To Balance b/d 2,90,000 By Statement of P & L 20,000
To Bank A/c (Balancing figure, being 1,70,000 (Current year’s depreciation)
purchase) By Balance c/d (Given) 4,40,000
4,60,000 4,60,000
4. Dr Plant and Machinery Account Cr

To Balance b/d 1,90,000 By Bank A/c 8,000
By Statement of P & L (Loss on sale) 2,000
By Statement of P & L (Current year’s depreciation) 20,000
By Balance c/d 1,60,000
1,90,000 1,90,000
Practice Questions
1 What is highly liquid investment? 6 Which of the following statement(s) is/are true?
(a) Cash convertible investment (i) Cash flow statement is not a replacement of
(b) Short-term investment fund flow statement
(c) Cash equivalents
(ii) Cash flow statement is a substitute of income
statement
2 Cash flow is known as (iii) Cash flow statement records only cash items
(a) variation in cash (b) change in cash (iv) Cash flow statement records only cash
(c) cash at bank (d) Both (a) and (b)
equivalents items
3 Which kind of accounting transaction is recorded
Select the correct option from the below options.
into cash flow statement?
(a) Only (i) is correct (b) Both (i) and (ii) are correct
(a) Accrual (b) Cash (c) Only (ii) is correct (d) All of these
(c) Accrual and cash (d) None of these
7 Cash flow from operating activity means cash flow
4 Where will you show the ‘winning from a lottery’ in
from business operation because
cash flow statement?
(a) cash flow from operating activity is outside the
(a) Operating activity (b) Investing activity business
(c) Financing activity (d) None of these (b) cash flow from operating activity is taken from
5 Provision for tax is ……… to net profit in operating investment
activities. (c) cash flow from cash inflow and outflow from
(a) added (b) deducted operating activity are the core activity
(c) No treatment (d) None of these (d) Both (a) and (c)
8 Following is the extract from the balance sheet of 13 Which of the following is a non-operating income?
ABC Ltd. (a) Dividend received by an investment company
31st March, 31st March, (b) Premium received by an insurance company
Particulars (c) Revenue from sale in a trading concern
2020 (`) 2019 (`)
Surplus, i.e. Balance in (d) Profit on the sale of used plant in manufacturing company
Statement of Profit and Loss 4,50,000 3,00,000 Balance Sheet (Extract)
14
Proposed Dividend 1,75,000 1,50,000
Equity and 31st March, 31st March,
Calculate net profit before tax and extraordinary Liabilities 2019 (`) 2020 (`)
items.
12% Debentures 2,00,000 1,60,000
(a) ` 3,00,000 (b) ` 1,25,000
(c) ` 3,25,000 (d) ` 1,75,000 Additional Information
9 ABC Ltd. is a financial company which provides Interest on debentures is paid on half yearly basis
loan and invest into shares. At the year end, on 30th September and 31st March each year.
company received ` 50,000 interest on loan. Where Debentures were redeemed on 30th September,
will be the amount of interest presented? 2019. How much amount (related to above
(a) Activity arising from interest will be shown in information) will be shown in financing activity for
investing activity cash flow statement prepared on 31st March,
(b) Activity arising from interest will be shown in 2020?
financing activity (a) Outflow ` 40,000
(c) Activity arising from interest will be shown in (b) Inflow ` 42,600
operating activity (c) Outflow ` 61,600
(d) None of the above (d) Outflow ` 64,000
10 Shri Niwas Ltd. has the opening balance of 15 An investment normally qualifies as a cash
furniture ` 4,00,000 and closing balance equivalent only when it has a maturity of ……
` 4,20,000 and depreciation opening and closing month(s) or less from the date of acquisition.
balance ` 1,00,000 and ` 1,10,000. (a) one (b) two
(c) three (d) four
During the year, a furniture costing ` 40,000 with
16 While preparing cash flow statement, cash
its accumulated depreciation of ` 24,000 was sold
comprises ……… and ……… with bank.
for ` 20,000. Calculate purchase value of furniture.
(a) cash, cash in hand
(a) ` 40,000 (b) ` 50,000 (b) cash in hand, cash
(c) ` (60,000) (d) ` 76,000 (c) bank, cash in hand
11 City Pulse Ltd. took a loan from financing company (d) cash in hand, bank
in the year 2021 for ` 25,00,000 and balance at the 17 Which of the following statements is/are correct?
starting of 2022 financial year, i.e. on 1st April, (i) Dividend paid is always shown as operating
2022 was ` 15,00,000. What kind of activity and activity.
amount has been transacted? (ii) Depreciation and amortisation, being non-cash
(a) ` (10,00,000) has been inflown, i.e. amount is paid to expenses, are deducted from net profit before
financing company tax and extraordinary items.
(b) ` (10,00,000) has been outflown, i.e. amount is paid Alternatives
to financing company (a) Only (i)
(c) ` (10,00,000) has been outflow, i.e. amount is (b) Only (ii)
received from financing company (c) Both (a) and (b)
(d) None of the above (d) None of the above
12 Provision for depreciation on plant 18 For a company manufacturing garments,
Opening balance = ` 60,000; procurement of raw material , incurrence of
Closing balance = ` 65,000 manufacturing expenses , sale of garments are
An item of plant costing ` 20,000 having book classified as ……... activity.
value of ` 14,000 was sold for ` 18,000 during the (a) financing
year. (b) investing
(c) operating
Calculate the amount of depreciation to be added (d) None of the above
back to net profit before tax and extraordinary
items. 19 Issue of shares for consideration other than cash
(a) ` 6,000 (b) ` 9,000 will result into cash ……… .
(a) inflow (b) outflow
(c) ` 5,000 (d) ` 11,000
(c) no flow (d) None of these
Accountancy 125
20 Match the following. (a) Outflow ` 3,55,000

(b) Outflow ` 3,25,000
Column I Column II
(c) Inflow ` 3,55,000
A. Buy back of own shares (i) Operating activity (d) Inflow ` 1,20,000
B. Purchase and sale of securities (ii) Financing activity
by a finance company 24 Which of the following is not an operating cash flow?
(a) Decrease in Inventories by ` 1,500
C. Receipt of dividend (iii) Investing activity
(b) Decrease in Trade Payables by ` 66,000
Codes (c) Purchase of Tangible Assets for ` 47,000
A B C (d) All of the above
(a) (iii) (i) (ii) 25 Non-cash transactions are ignored while preparing
(b) (ii) (i) (iii) a cash flow statement because
(c) (iii) (ii) (i) (a) it shows flow of cash and cash equivalents
(d) (ii) (iii) (i) (b) cash is not involved in non-cash transactions
21 Rakshak Ltd. made an operating profit of `
1,85,500 after charging depreciation of ` 31,200.
During that year, trade payables increased by 26 How will you treat payment of dividend in a cash
` 26,600 and inventory increased by ` 40,300. There flow statement?
was no change to trade receivables. Assuming that (a) Cash Flow from Operating Activities
no other factors affected it, what would be the cash (b) Cash Flow from Investing Activities
(c) Cash Flow from Financing Activities
generated from operations?
(d) Cash Equivalent
(a) ` 2,03,000
(b) ` 2,30,400 27 Which of the following is not application of cash?
(c) ` 2,25,800 (a) Increase in Debtors
(d) ` 2,43,300 (b) Increase in Inventory
(c) Increase in Bills Payable
22 Mention the net amount of source or use of cash
(d) Increase in Prepaid Expenses
when a fixed asset (having book value ` 1,20,000) is
sold at a loss of ` 40,000 in term of cash flow. 28 Cash flow statement is prepared for financial
(a) ` 1,20,000 (b) ` 40,000 planning of ………… .
(c) ` 80,000 (d) ` 1,60,000 (a) long range
(b) medium range
23 Balance Sheet (Extract) (c) short range
31st March, 31st March, (d) very long range
Particulars
2019 (`) 2020 (`)
29 Cash flow statement activities consists of
Investments @ 10% 5,00,000 10,00,000
(a) operating Profit
Additional Information (b) decrease/increase in current assets
(c) decrease/increase in current assets
Half of the investments held in the beginning of the (d) All of the above
year were sold @ 10% profit. Interest and dividend
received on investments ` 70,000 and ` 50,000 30 Where will you how purchase of goodwill in a cash
respectively. flow statement?
(a) Cash Flow from Operating Activities
How much amount as per above information, will be (b) Cash Flow from investing Activities
shown in investing activity for cashflow statement (c) Cash Flow from Financing Activities
prepared on 31st March, 2020? (d) Cash Equivalent
ANSWERS
1. (c) 2. (d) 3. (b) 4. (a) 5. (a) 6. (a) 7. (c) 8. (c) 9. (c) 10. (c)
11. (b) 12. (d) 13. (d) 14. (c) 15. (c) 16. (d) 17. (a) 18. (c) 19. (c) 20. (b)
21. (a) 22. (c) 23. (a) 24. (c) 25. (c) 26. (c) 27. (c) 28. (c) 29. (d) 30. (b)
Hints & Solutions

12. Closing balance of provision for depreciation = 65,000
1. Cash equivalents mean short-term highly liquid
investments that are readily convertible into known (+) Accumulated depreciation (20,000 −14,000) = 6,000
amounts of cash and which are subjected to an 71,000
insignificant risk of changes in value. (−) Opening balance of provision for
3. Transactions which are done in cash and cash depreciation = (60,000)
equivalents are recorded into cash flow statement and Amount of depreciation to be added back = 11,000
nothing is shown for accrual, i.e. no accrual
13. Manufacturing companies use plant and machinery to
accounting is done for cash flow statement.
produce goods, but they do not deal in plant and
4. Winning from lottery will be shown under ‘Operating machinery. So, profit on sale of an asset is a non-
Activity’ as an extraordinary items because winning operating income.
from lottery neither amounts to long-term assets or
14. Cash Flow from Financing Activity Amt (`)
an investment nor it changes the size and
composition of owner’s capital and AS-3 (revised) Redemption of Debentures = 40,000
defines operating activity to be an activity which is Interest on Debentures
the principle revenue producing activity and other 2,00,000 × 12% × 6/12 = 12,000
activity, i.e. is not investing or financing activity. 1,60,000 × 12% × 6/12 = 9,600
61,600
5. Provision for tax is identified and classified as
operating activity and it is added to net profit. 17. Depreciation and amortisation, being non-cash
expenses, are added to net profit before tax and
7. Cash flow from operating activity means cash flow
extraordinary items.
from business operation. As inflow and outflow of
cash from operating activity are the core activities for 19. No cash inflow/outflow when shares are issued to any
business, by which business generate profit. supplier in place of cash payment.
8. Net Profit before Tax (4,50,000 − 3,00,000) = 1,50,000 21. Cash Generated from Operations Amt (`)
(+ ) Proposed Dividend for the year = 1,75,000 Operating Profit 1,85,500
Net Profit before Tax and Extraordinary (+) Depreciation 31,200
Items = 3,25,000 2,16,700
9. The ABC Ltd. is engaged in the business of providing (–) Increase in Inventory (40,300)
loans and also investing in shares. Any income (+) Increase in Trade Payables 26,600
arising from these activities should be shown under 2,03,000
operating activity. 22. Source of Cash = 1,20,000 − 40,000 = ` 80,000
10. Opening Balance of Furniture = 4,00,000 (Cash inflow through investing activities by selling of
(−) Cost of Furniture Sold = (40,000) fixed assets)
(−) Closing Balance of Furniture = (4,20,000) 23. Cash used in Investing Activity
Purchase Value of Furniture = (60,000) = 2,75,000* + (7,50,000) ** +70,000 + 50,000 = ` 3,55,000
Opening Balance = 25,00,000 *Investments sold = 50% of 5,00,000 + 10% of 2,50,000
11. = 2,50,000 + 25,000 = ` 2,75,000
(−) Closing Balance = (15,00,000)
Payment made (Cash Outflow) = 10,00,000 ** Investment purchased
= 5,00,000 + 25,000 −10,00,000 − 2,75,000 = ` (7,50,000)
Accountancy 127
CHAPTER 14
Overview of Computerised
Accounting System
Concept of Computerised These softwares are suited for organisations running
Accounting System small/conventional business where the frequency or volume
A computerised accounting system refers to a system of transactions is very low. e.g., Tally, EX- Busy, etc.
wherein the accounts of the enterprise are maintained on a Advantages of readymade software are
computer. It processes the financial transactions and events ● The cost of installation of these softwares is generally low
as per Generally Accepted Accounting Principles (GAAP) to and number of users is limited.
produce reports as per requirements of the user. ● Ready-to-use software is relatively easier to learn and
In a computerised accounting system, the framework of people (accountant) adaptability is very high.
storage and processing of data is called operating ● The training needs are simple and sometimes the vendor
environment. Type of the accounting system used (supplier of software) offers the training on the software
determines the operating environment. It consists of free.
hardware as well as software in which the accounting system ● As these softwares are available off-the-shelf, time
operates. required in developing a ‘tailor made software’ is saved.

Both hardware and software components are dependent on ● As these softwares are used by a large number of users,
each other. Structure of the hardware depends on the type they have better after sales service.
of software and selection of hardware is dependent upon
Limitations of readymade software are
various factors such as the number of users, level of
● The level of secrecy is relatively low and the software is
secrecy, etc.
prone to data frauds.
The complexity of the computerised accounting system
● These softwares offer little scope of linking to other
depends on the type of organisation. Modern computerised
accounting systems are based on the concept of database. information systems.
● These softwares use laser printers which are costly than
Database is a collection of logically related information in an
organised way so that it can be easily accessed, managed and dot matrix printers.
updated. A database is implemented using a Database 2. Customised
Management System (DBMS). The term ‘customised software’ means making changes in
the readymade software to suit the specific requirement of
Types of Computerised Accounting System the user i.e., make it user specific. These softwares are
There are a lot of options available in respect to types of available off-the-shelf and are changed to suit the
computerised accounting systems. Basic features are mostly requirements of the user.
common in all the systems. The following are the types of
The developer, to meet specific user requirement, can
computerised accounting system
modify all the readymade softwares. However, the user
1. Ready-to-use/Readymade has to bear the cost of such changes. Customised
These softwares are developed not for only specific user but software are best suited for large and medium
for the users in general. Since, these are for general users, it is businesses and can be linked to the other information
not necessary that all the modules of such software are of use systems.
for every user who buys this software.
Advantages of customised softwares are Requirements of

● Secrecy of data and software is high in customised
Computerised Accounting System
software. Every computerised accounting system has two basic
● Linkage to other information system is available on the
requirements
basis of need of the enterprise. 1. Accounting Framework It consists of a set of rules,
Limitations of customised softwares are principles followed for recording transactions.
● The cost of installation and maintenance is relatively high
2. Operating Procedure It refers to the procedure/
because the high cost is to be paid to the vendor for method of recording transactions on a computer.
customisation.
The use of computers in any database oriented application has
● Since the need to train the software users is important,
four basic requirements as mentioned below
the training costs are therefore high.
1. Front-end Database It is an interactive link between
3. Tailored the user and database oriented software through which
The term ‘tailored software’ refers to designing and the user communicates to the back-end database.
developing user specific software. These softwares, being 2. Back-end Database It is the data storage system that
user specific, are not available off-the-shelf but are is hidden from the user and responds to the requirement
developed to meet the requirement of the user on the of the user to the extent the user is authorised to access.
basis of discussions between the user and developers. 3. Data Processing It is a sequence of actions that are
These softwares are suited for large business organisations taken to transform the data into decision useful
with multi-users and geographically scattered locations. information.
Advantages of tailored softwares are 4. Reporting System It is an integrated set of objects that
● The secrecy and authenticity checks are robust in such constitute the report.
softwares.
● Such softwares offer high flexibility in terms of number
Structure/Elements of
of users. Computerised Accounting System
● As these softwares are developed according to
The computerised accounting system is such as system in
specification of the user, it takes care of the specific needs which all accounting activities are operated through computer.
of the enterprise. The following items constitutes the structure of a
computerised accounting system
● These softwares can be effectively linked to some other
information system. 1. Hardware Computer hardware consists of physical

components such as keyboard, mouse, monitor and
Limitations of tailored softwares are processor. These components can be physically touched.
● These softwares require specialised training to the users.
These are electronic and electromechanical components.
● The cost of maintenance and development of such The basic components of the computer hardware are
softwares is much higher as compared to readymade and ● Motherboard
customised software. ● Processor
● The results will be misleading, in case the accounts are ● Primary storage memory
grouped in an incorrect manner. ● Secondary storage devices
● Keyboard
Features of ● Sound card and speakers
Computerised Accounting System ● Monitor and Liquid Crystal Display Panel (LCD)
● Printers
Typically, computerised accounting system offers the
following features 2. Software It is the invisible part of the computer, which
● Online input and storage of accounting data. is used with hardware to make computer perform
● Printout of purchase and sales invoices.
operations. It is referred to a set of instructions or
programs that enable the computer to perform its task or
● Logical scheme for codification of accounts and
commands given by the user.
transactions. Every account and transaction is assigned a
Software is held on the computer’s hard disk, CD-ROM,
unique code.
DVD or on a diskette (floppy disk) and is loaded from
● Grouping of accounts is done from the very beginning.
the disk into the computer’s RAM (Random Access
● Instant reports for management e.g., aging statement,
Memory), as and when required.
stock statement, trial balance, trading and profit and loss
Software can be divided into two major categories
account, balance sheet, stock valuation, Value Added Tax
● System software
(VAT), returns, payroll report, etc.
● Application software
Accountancy 129
System Software It consists of several programs, which are

(ii) Specific Purpose Software These softwares are
directly responsible for controlling, integrating and
designed to perform specific tasks. This type of
managing the individual hardware components of a
application software generally has one purpose to
computer system. System software also provides the
execute.
interface between the user and components of the computer.
Some of the specific purpose application softwares are
Depending on the functionality, the system software can be
described below
further divided into following categories
● Inventory Management System and Purchasing
(i) Operating System It consists of programs which
control, coordinate and supervise the activities of System
● Payroll Management System
various components of a computer system. Its
function is to provide link between the computer ● Hotel Management System
hardware and the user. It provides an environment ● Reservation System
to run the programs. For example, MS-DOS, ● Report Card Generator
Windows XP/2000/98, Unix, Linux, etc.

3. Humanware/People It constitutes the most important
The Operating system performs the following
part of a computer system. It basically refers to the
functions
individual or the users who interact with the computer
● It recognises input from keyboard and sends output
through the use of hardware or software. People who
to the display screen. respond to the procedures instituted for executing the
● It makes sure that programs running at the same
computer programs are also a part of humanware/live
time do not interfere with each other. -ware.
● It is also responsible for security and ensures that
(i) System Analysts These are the people who design
unauthorised users do not access the system. data processing systems.
(ii) Device Driver A software, which is written with (ii) Programmers These are the people who write
the objective of making a device functional when it programs to implement the data processing system
is connected to the computer is called device driver. design.
It is a system software that acts like an interface (iii) Operators These are the people who participate in
between the device and the user. operating the computers.
Every device, whether it is a printer, monitor, mouse 4. Procedures A specified series of actions or operations,
or keyboard has a driver program associated with it which have to be executed in a certain manner, in order
for its proper functioning. to always achieve the desired result in same
(iii) Language Translator It helps in converting circumstances is referred to as procedure.
programming language to machine language. The There are three types of procedures which constitute part
translated program is called object code. There are of computer system
three different kinds of language translator :
(i) Hardware-oriented Procedure It provides details
Assembler, Compiler and Interpreter.
about components and their method of operation.
Application Software It is a computer software designed (ii) Software-oriented Procedure It provides a set of
to help the user to perform single or multiple tasks. It is a set instructions required for using the software of
of instructions or programs designed for specific use or computer system.
application, that enable the user to interact with a computer.
(iii) Internal Procedure It helps to ensure smooth flow
Application softwares are also called the end-user programs. of data to computers by sequencing the operation of
These programs do the real work for users. each sub-system of overall computer system.
There are two types of application software 5. Data These are the facts which are gathered and entered
(i) General Purpose Software These types of software into a computer system. Data may comprise of numbers,
are used for any general purpose. They allow people to texts, graphics, etc.
do simple computer tasks. The computer system processes and organises data to
Some of the general purpose softwares are as follows create information that is relevant and can be used for
● Word Processing Software decision-making.
● Electronic Spreadsheets 6. Connectivity It is the sixth element of the computer
● Presentation Software
system. It refers to the manner in which a particular
● Database Management System (DBMS)
computer system is connected to other electronic devices,
say through telephone lines, microwave transmission,
● Desktop Publishing (DTP) Software
satellite link, etc.
● Graphics Software
Practice Questions
1 A computerised accounting system processes the 10 Which of the following items constitutes the
financial transactions and event as per structure of a computerised accounting system?
(a) accounting standards (a) Hardware (b) Software
(b) international financial reporting standards (c) Both (a) and (b) (d) None of these
(c) generally accepted accounting principles
(d) operating system of the computer
11 Which of the following is the basic component of the
computer hardware?
2 The framework of storage and processing of data is (a) Motherboard (b) Application software
called (c) Operating system (d) All of these
(a) operating environment
(b) processing environment
12 Software that are meant to manage the resources of
(c) storage environment a computer and also facilitates its operations are
(d) data environment known as ………… .
(a) operating system (b) utility program
3 .............. consists of hardware as well as software (c) application software (d) All of these
(a) Operating system
(b) Computerised accounting system 13 Application software can be further classified as
(c) Motherboard (a) General purpose software
(d) Application software (b) Specific purpose software
(c) General as well as specific purpose software
4 Both hardware and software components are (d) None of the above
dependent on each other. State true or false.
(a) True 14 Which softwares are designed and developed for
(b) False performing certain specific task such as payroll
(c) Either true or false accounting?
(d) None of the above (a) Utility programmes
(b) Operating systems
5 Structure of the hardware depends on the type of (c) Application softwares
(a) hardware (d) Customise softwares
(b) motherboard
(c) operating system 15 Software which is used to translate or interpret the
(d) software program is ................. .
(a) system software
6 Modern computerised accounting system is based
(b) application software
on the concept of (c) language processor
(a) software (d) microprocessor
(b) hardware
(c) database 16 Part of computer system which interact with the
(d) spreadsheets computer through the use of hardware or software
7 Which of the following is/are the type(s) of is called................. .
(a) language processor
computerised accounting system?
(b) applications software
(a) Ready to use (b) Customised
(c) procedure
(c) Tailored (d) All of these
(d) humanware
8 ................ means modifying the readymade
17 Which of the following is not a type of procedure
software to suit the specific requirements of the which constitutes part of computer system?
user (a) Hardware oriented procedure
(a) Operating system (b) Software oriented procedure
(b) Customised software (c) Internal procedure
(c) Ready to use (d) External procedure
(d) Tailored
18 ............... is a specified series of actions or
9 Which of the following is not a feature of
operations, which have to be executed in a certain
computerised accounting system? manner, in order to achieve the desired result in
(a) Online input and storage of accounting data
same circumstances.
(b) Print out of purchase and sale invoices
(c) Grouping of accounts is done from the very beginning (a) Hardware (b) Procedure
(d) Hardware based only (b) Softwares (d) Humanwares
Accountancy 131
19 .............. are the facts which are gathered and 22 Identify the requirement(s) of every computerised
entered into a computer system. accounting system.
(a) Data (a) Accounting framework (b) Operating procedure
(b) Information (c) Both (a) and (b) (d) None of these
(c) Knowledge
(d) Wisdom
23 Use of computers in any database oriented
application has........... basic requirements.
20 ................. refers to the manner in which a (a) two (b) three
particular computer system is connected to other (c) four (d) None of these
electronic devices, say through telephone lines.
24 ............. is an integrated set of objects that
(a) Communication
(b) Connectivity
constitute the report.
(c) Information (a) Front-end interface (b) Back-end database
(d) Data (c) Data processing (d) Reporting system
21 Name the software used for controlling internal 25 ............... is an interactive link between the user
functions, such as reading data input devices. and database oriented software through which user
(a) System software communicates to the back-end database.
(b) Application software (a) Front-end database
(c) Connectivity software (b) Data processing
(d) None of the above (c) Reporting system
ANSWERS
1. (c) 2. (a) 3. (b) 4. (a) 5. (d) 6. (c) 7. (d) 8. (b) 9. (d) 10. (c)
11. (a) 12. (a) 13. (c) 14. (c) 15. (c) 16. (d) 17. (d) 18. (b) 19. (a) 20. (b)
21. (a) 22. (c) 23. (c) 24. (d) 25. (a)
CHAPTER 15
Using Computerised
Accounting System
Installation of 5. Generating Reports This is the final stage of
automation. Under this stage, final reports are prepared
Computerised Accounting System (CAS) in the form of journal, cash book, ledger, trial balance,
In modern business, accounting transactions are processed profit and loss account and balance sheet. Preparing
through computers. An accounting system has two aspects, reports is a complex process and is discussed ahead.
i.e. it has to work under a set of well-defined accounting
concepts and principles and it has to maintain records and Charts of Accounts
generate reports as defined by the user.
An important component of CAS is that the accounts should
These aspects can be fulfilled by processing the transactions be appropriately grouped in the manner that all accounts of
and events in accordance with the accounting principles and one nature are classified under one broad head of account
adopting the software which is capable of generating the user and appropriately grouped as asset, liability, etc.
defined reports. The process of performing the accounting Accounts groups are maintained to determine the hierarchy
function with the help of accounting software can be said to of ledger accounts which is helpful in determining and
be as automation of accounting process. This process includes presenting meaningful and compliant reports.
following steps in the installation of CAS The group behaviour is classified into capital or revenue and
1. Planning Under this stage, assessment of size of entity more specifically into assets, liabilities, income and
and volume of business transactions is done for which expenditure.
automation has to be made. For example, the accounts are to be grouped on the basis of
2. Selection of Accounting Software It involves their nature e.g., salary, wages and staff welfare expenses are
selection of appropriate accounting software. The choice grouped as employee costs.
is based upon certain factors like the requirements of The groups ascertain whether the same will affect profit and
organisation, the size of organisation, security concerns loss account which is revenue in nature or balance sheet
access from remote locations, etc. which is capital in nature. Groups can be sub-classified to
3. Selection of Accounting Hardware This stage practically unlimited levels. But at the lowest level would be
involves choosing the desired computer hardware the ledger account.
compatible with the accounting software. The hardware
such as Hard Disk Drive or RAM should be adequate to Codification and Hierarchy of Account Heads
support the accounting software. Also the operating When the size of an organisation increases, the number of
system should be compatible with the software. accounts heads will also increase. It becomes important to
4. Classification and Grouping of Accounts This stage have proper classification of data and to provide special code
involves preparing a comprehensive list of accounts to various heads of accounts. Codification means providing
which are to be opened during the year. These identification mark to the various heads of accounts. There is
accounting heads are given an accounting code on the a hierarchical relationship between the groups of accounts
basis of which the transactions are posted to the and its components. Proper codification is required in order to
designated account head in the ledger. The trial balance maintain the hierarchical relationships between a group and
is generated automatically alongwith profit and loss its sub-groups.
account and balance sheet. The creation of accounts A code, which may be numerical or alphanumeric, is
group and hierarchy is initiated before entering allocated to each account and arranges the accounts in logical
transactions in the system. subdivisions. The example below will elaborate it better.
Accountancy 133
‘Establishment expenses or payroll expenses’ is the main

head while its sub-divisions or sub-accounts are Major Heads Sub Heads
● Salaries and Wages
Fixed Assets
● Staff Welfare
Assets
● E.S.I. Contribution Current Assets
● Provident Fund Contribution
Capital
In the chart accounts or grouping, it will be allocated
accounting codes as follows Grouping Liabilities Non-current Liabilities
Accounting Code Head of Account and

Hierarchy Current Liabilities
101 Establishment Expenses or of
Payroll Expenses Accounts Sales
Revenue
1011 Salaries and Wages Other Income
1012 Staff Welfare
Direct Expenses
1013 Provident Fund Contribution Expenses
Indirect Expenses
1014 ESI Contribution
Preparation of Charts of Accounts

The process of preparing ‘Chart of Accounts’ or ‘Grouping of Accounts’ begins with giving a code to each main head, sub-heads
and thereafter, individual account heads. Code of the main head signifies whether the account is an item belonging to assets,
liabilities, expenses or incomes. Code of sub-head signifies the head under which individual account head will appear.
In order to understand the process more accurately, let us take an example of preparing chart of accounts for assets.
ABC Ltd. Company broadly classifies its assets into fixed assets, investments and current assets. The chart of accounts for
Assets of ABC Ltd. shall be as follows
Main Code Sub-code Account Code Main Head Sub-head Account Head
1 Assets
1 Fixed Assets
001 Land
002 Building
003 Plant
004 Machinery
005 Furniture
2 Investments
001 Quoted Shares
002 Unquoted
Shares
003 Quoted
Debentrues
004 Unquoted
Debentrues
3 Current Assets
001 Stock
002 Debtors
003 Advance
004 Cash in Hand
In the given example, code for land account will be 11001. In 6. Sales Voucher In this voucher, all the goods sold by the
the given codification, it has been considered that ABC Ltd. business are recorded, both cash and credit.
is a single unit enterprise. If the enterprise has more than
one unit, a code may be given for the unit also. Data Validation
In computerised accounting system like tally, data validation
Transaction Processing System (TPS) can be done at two levels, at platform level or at TDL level.
It is an information processing system for business TDL is the development language of the tally which is
transactions involving the collection, modification and designed to provide flexibility and power to the users of the
retrieval of all transaction data. It is a computerised system software. TDL can only add validation at TDL level as it does
that performs and records the daily routine transactions not have any control over platform level validation. Following
which are necessary to conduct the business. are some of the TDL Level validation
TPS serves the organisation at the operational level. 1. Field Level Attribute : Validate This attribute checks
Characteristics of a TPS include performance, reliability and if the given condition is satisfied or not. The user cannot
consistency. Cash withdrawal at an ATM is one the most move further unless the condition for validate is
common example of TPS. TPS involves following steps in satisfied.
processing a transaction 2. Field Level Attribute : Unique This attribute takes a
1. Data Collection It refers to the collection of data. logical value. The values inserted in the field must be
2. Data Editing It refers to checking data for unique if the attribute is set to yes.
correctness. 3. Field Level Attribute : Notify This attribute is similar
3. Data Validation It refers to verifying data for any to ‘Validate’. The difference being, this attribute flashes a
errors and rectifying those errors. warning and the cursor moves to the respective field.
4. Data Manipulation It refers to processing and Data Verification
analysing data on a pre-set design. Computer accounting systems also provide the facility of data
5. Data Storage It refers to the processing of stored data verification. For example, tally comes with the facility of data
in the database. analysis report which helps in conducting various internal
6. Report Generation It refers to generating reports in analysis and verification of financial data of the company and
hard copy or soft copy in a pre-designed format. also helps in identification of areas which helps in easing the
7. Query Support It refers to the process whereby the verification process.
user of TPS can raise a query and extract the data to The various tools available for data analysis are
get report. ● Verification of charts of accounts
So, it can be concluded that simple computerised accounting ● Verification of stock items
system accepts the complete transaction data as input; stores ● Verification of balances
the data and retrieves the data for processing as and when ● Analytical Procedure
required for generating an accounting report as output.
● Displaying the pending documents
Data Entry ● Displaying the repeated transactions
In accounting sense, it is a process of recording financial ● Inter bank transactions
transactions, i.e. money coming into and going out of the ● Analysis of fixed assets
business. There are lot of predefined vouchers in ● Displaying the lowest and highest value transactions
Computerised Accounting System. For example, tally has 23
● Reports on pending advances
predefined vouchers where data can be entered.
The following are some of the vouchers Preparation of Financial Statements
1. Receipt Voucher Through this voucher, all inflows of Preparation of financial statements include preparation of
money are recorded. profit and loss account and balance sheet. These are as follows
2. Payment Voucher With the help of this voucher, all
1. Profit and Loss Account
outflows of money are recorded.
It is an account which provides the net result of the operations
3. Contra Voucher In this voucher, only transfer of funds of the business for a specified period of time. In computerised
between cash and bank account is recorded. accounting system like tally, the information of this account is
4. Journal Voucher This voucher is used to record all the automatically updated immediately when a transaction is
non-cash transactions of the business. recorded.
5. Purchase Voucher This voucher records all the In tally, to view the profit and loss account, go to Gateway of
purchases of goods made by the business, in cash or in Tally> Profit & Loss Account.
credit.
Accountancy 135
In order to do that, they have to pass the closing entries.

Closing entries are those entries that are passes at the end of
the accounting period in order to transfer balances to a
permanent account from a temporary account. The closing
balances of the previous year becomes the opening balances
of the current year. On the basis of opening balances, opening
entries are passed.
In computerised accounting, there is year-end processing to
create and store opening balances of accounts in database.
Adjusting Entries
Adjusting entries are those entries that are recorded at the
end of the year to update the balances of all the accounts as
per accrual basis.
In computerised accounting, journal vouchers are prepared
and stored to follow the principle of cost matching revenue,
2. Balance Sheet but there is nothing like passing adjusting entries for errors
It is a statement which provides information regarding the and rectification, except for rectifying an error of principle by
financial position of a company. It is prepared as per the having recorded a wrong voucher such as using payment
Schedule III of the Indian Companies Act, 2013. voucher for a receipt transaction.
In tally, to view the Balance sheet, go to Gateway of Tally>
Balance Sheet. Security of CAS
Data leakage is quite common in large companies as the
access of company’s data might be provided to various
stakeholders. Thus, it is extremely important for the
companies to use the security features of Computerised
Accounting System.
Here are some of the security features generally available in
CAS
1. Password Security The system facilitates defining the
user rights according to department in which he is
working. For example, purchase vouchers can be
accessed by only those persons working in purchase
department.
2. Data Audit This feature provides data about what
changes are made in the original data and who made
those changes.
Opening and Closing Entries
At the end of every year, the businesses are required to close 3. Data Vault This feature provides security like
their books of accounts. encryption of data.
Practice Questions
1 What is the correct sequence of steps in installation 3 In CAS, the accounts should be …….. in the
of computerised accounting system? manner that all accounts of one nature are
(i) Selection of accounting software classified under one broad head of account.
(ii) Generating reports (iii) Planning (a) separated (b) grouped
(c) Either (a) or (b) (d) None of these
(iv) Selection of accounting hardware
(v) Classification and grouping of accounts 4 Which tool is used to have a proper classification of
(a) (iii), (i), (iv), (v), (ii) (b) (i), (ii), (iii), (iv), (v) data and to provide special code to various heads of
(c) (v), (iv), (iii), (ii), (i) (d) (iii), (iv), (i), (v), (ii) accounts?
(a) Accounting Software (b) Codification
2 Which of the following is an accounting software?
(c) Gateway of Tally
(a) Tally (b) Microsoft Office
(d) Microsoft Office
(c) Photoshop (d) Notepad
5 ............ means providing identification mark to the 18 TDL level can add validation at
various heads of account. (a) platform level only (b) TDL level only
(a) Identification tool (b) Heads of accounts (c) Both (a) and (b) (d) None of these
(c) Codification (d) None of these
19 Tools available for data analysis are
6 The relationship between the groups of accounts (a) verification of chart of accounts
and its components is (b) displaying the lowest and highest value transactions
(a) vertical (b) horizontal (c) Both (a) and (b) (d) None of these
(c) diagonal (d) hierarchical 20 Entries that are recorded at the end of the year to
7 Proper codification is required in order to maintain update the balances of all the accounts as per
the hierarchical relationship between accrual basis.
(a) humans and computers (a) Opening entry (b) Journal entry
(b) operating system and application softwares (c) Adjusting entry (d) Rectification entry
(c) groups and its sub groups (d) journal and ledger
21 Which account provides the net result of the
8 Which of the following is not a subhead of assets? operations of the business for a specified period of
(a) Fixed assets (b) Current assets time?
(c) Capital (d) All of these (a) Profit and loss account (b) Cash flow statement
(c) Fund flow statement (d) Balance sheet
9 Which of the following is a subhead of liabilities?
(a) Non-current liabilities (b) Short-term liabilities 22 To view the profit and loss account, we have to go to
(c) Both (a) and (b) (d) None of these (a) Gateway of Tally > Accounts > Profit and Loss Account
(b) Gateway of Tally > Final Accounts > Profit and Loss
10 Which of the following is a subhead of revenue?
Account
(a) Other incomes (b) Salary paid
(c) Gateway of Tally > Profit and Loss Account
(c) Direct expenses (d) Current assets
11 Identify the step(s) that TPS involves in processing
23 Balance sheet is a statement with provides
a transaction from the following.
information regarding the
(a) Data collection (b) Data storage
(a) net result of the operations of the business
(c) Query support (d) All of these
(b) financial position of a company
12 How many predefined vouchers does tally has? (c) inflow and outflow of cash
(a) 21 (b) 22 (c) 23 (d) 24 (d) acquisition and utilisation of funds
13 Through which voucher, all inflows of money are 24 The balance sheet is prepared as per the
recorded? (a) Schedule I (b) Schedule II
(a) Received voucher (b) Payment voucher (c) Schedule III (d) Schedule lV
(c) Contra voucher (d) Journal voucher 25 The .......... of the previous year becomes the ............
14 With the help of .......... voucher, all outflows of of the current year
money are recorded. (a) closing balance, opening balance
(a) received (b) payment (c) contra (d) journal (b) opening balance, closing balance
(c) Either (a) or (b)
15 With the help of this voucher, only transfer of fund (d) Neither (a) nor (b)
between cash and bank account is recorded.
26 Why closing entries are passed?
Identify the voucher.
(a) To update the balances of all the accounts as per
(a) Received voucher (b) Payment
accrual basis
(c) Contra voucher (d) Journal
(b) To transfer balance of a temporary account to
16 .......... voucher is used to record all the non-cash permanent account
transactions of the business. (c) To close journal entries (d) None of these
(a) Received (b) Payment (c) Contra (d) Journal 27 Which system provides data about what changes
17 In this voucher all the good sold by the business is are made in the original data and who made those
recorded both cash and credit. changes?
(a) Received voucher (b) Purchase voucher (a) Password security (b) Data audit
(c) Contra voucher (d) Sale voucher (c) Data security (d) Data leakage
ANSWERS
1. (a) 2. (a) 3. (b) 4. (b) 5. (c) 6. (d) 7. (c) 8. (c) 9. (c) 10. (a)
11. (d) 12. (c) 13. (a) 14. (b) 15. (c) 16. (d) 17. (d) 18. (b) 19. (c) 20. (c)
21. (a) 22. (c) 23. (b) 24. (c) 25. (a) 26. (b) 27. (b)
Accountancy 137
CHAPTER 16
Accounting Using Database

Management System
Concept of Database 3. Forms In the context of database, a form is a window
Management System which consists of various fields and spaces to fill the data.
Database Management System (DBMS) is a software It is a database object used to create user interface for
system used to store, retrieve and run queries on data. It database applications.
serves as an interface between an end user and a 4. Reports A report is the result of a database query
database, allowing users to create, read, update and presented in a formatted manner. It contains useful
delete data in the database. information which helps in decision-making. Most of the
DBMS manages the data, the database engine and the applications come with built-in reporting tools. For
database schema, allowing for data to be manipulated or example airlines software may contain specifically defined
extracted by users and other programs. This helps in reports on frequent travelers in business class.
providing data security, data integrity, concurrency and
uniform data administration procedures. Creating Data Tables for Accounting
Computerised accounting involves identification, storing and
It optimises the organisation of data by following a
extracting the data related to the transaction of accounting.
database schema design technique called normalisation,
Data tables are used in database applications which display a
which splits a large table into smaller tables when any of
range of outputs given a range of inputs. A table can be created
its attributes have redundancy in values. It offers many
using design view, wizard or entering data.
benefits over traditional file systems, including flexibility
and a more complex backup system. Examples of DBMS To create a table, the keyword ‘CREATE TABLE’ is used, which is
include licensed packages like ORACLE, SQL Server and followed by a unique name or identifier.
open source packages like MySQL, PostgreSQL, etc. Following steps can guide on how to create an Excel data table
Step 1 Create a model
Objects in DBMS Step 2 Link the output
A database object is a data structure which is used to
Step 3 Enter the input values
either store the data, or for referencing purpose. There are
some objects in DBMS as follows Step 4 Highlight the cells and access the data tables function
Step 5 Link the input values
1. Table A table is a collection of data, which is stored
in a tabular form. It represents the records in rows Step 6 Format the data table output
and columns so that the user can see a meaningful
Use of Queries, Forms and
and formatted data. Each column in the table forms
Reports to Generate Accounting Information
the related set of information of an object.
Queries The accounting information which is presented in the
2. Queries A query is the request of information from form of accounting report can be generated by creating and
a collection of data. In DBMS, query means request executing some queries under database management system.
of data or information by the user from a database. For generating the information required, a query is executed
Database consists of a lot of data stored in the form which communicates to access the accounting data. For a
of tables. In order to extract a specific data or complete view of data which is stored across various tables,
information, the user needs to run a query in the queries based on SQL are needed to be executed. A Query
database. This can be performed with the help of a generates the records that contain fields from various data
database query language like SQL. tables.
Forms They are used to easily view, enter and change data Application of DBMS in
directly in a table. When you open a form, MS Access Generating Accounting Information
retrieves the data from one or more tables and displays it on
DBMS is a system of record keeping. It acts as a container of
the screen, in a layout you choose. A form is made up of
data from which a user can define, store, retrieve and update.
controls which are used to facilitate the entry of information
into the table that the form represents. To facilitate easier DBMS is also useful for defining, storing, retrieving and
data entry, forms are often designed with several special updating accounting data.
features. It performs many functions, like data storage management,
Reports A report is an effective way to present the data in a data dictionary management, security management, backup
printed format. Since you have control over the size and and recovery management, etc. that ensures the effective
appearance of everything on a report, you can display the running of accounting system.
information the way you want to see it. Most of the DBMS also helps in generating and retrieving accounting
information in a report comes from an underlying table, data like shareholders’ records, sales reports, customers’
query or SQL statement, which is the source of report’s data. profile, suppliers’ profiles, payroll, employees’ profile, petty
Other information in the report is stored in the report design. cash register, etc.
Practice Questions
1 What is the full form of DBMS? 8 ………… is a collection of data which is stored in a
(a) Database management security tabular form.
(b) Database management system (a) Rows (b) Table
(c) Database marketing system (c) Reports (d) Object
(d) Database monitory system
9 ………… is the request of information from a
2 ………… is the group of data which is interlinked collection of data.
and set of programs which helps in accessing the (a) Table (b) Object
data (c) Query (d) Column
(a) ABMS (b) CBMS
(c) DBMS (d) EBMS
10 Database consists of a lot of data stored in the form of
(a) table (b) object
3 The main objective of DBMS is to (c) query (d) reports
(a) retrieve stored data
(b) collection of data
11 In order to extract a specific data or information,
(c) smooth functioning of systems the user needs to run a ………… in the database.
(d) All of the above (a) command (b) query
(c) bios (d) interference
4 For which of the following sectors, DBMS will be
useful? 12 Which of the following is one of the query language
(a) Universities in DBMS?
(b) Manufacturing (a) SQL (b) Microsoft Office
(c) Human resources (c) Language translator (d) None of these
(d) All of the above 13 ………… is a window which consist of various fields
5 A ………… is a database structure which is used to and spaces to fill the data.
either store the data or for referencing purpose (a) Query (b) Table
(a) data (b) information (c) SQL (d) Form
(c) object (d) knowledge 14 Which database object is used to create user
6 Which of the following is the most common interface for database application?
database object? (a) Table (b) Object
(a) Table (b) Column (c) Form (d) Report
(c) Row (d) None of these 15 ………… is the result of a database query presented
7 Data in table is recorded in ………… and ………… in a formatted manner.
so that the user can see a meaningful and (a) Table (b) Object
formatted data (c) Report (d) Form
(a) upward and downward 16 Object that contain usual information which helps
(b) horizontal and vertical in decision-making is known as ………… .
(c) diagonal and vertical (a) report (b) form
(d) rows and columns (c) object (d) table
Accountancy 139
17 Data tables can display 22 For a complete view of data which is stored across
(a) input various tables, the user is required to
(b) output (a) execute queries based on SQL
(c) output given a range of input (b) search for data tables in DBMS
(d) None of the above (c) Either (a) or (b)
18 Which keyword is used to create a table?
(a) Create table (b) Table 23 ………… acts as a container of data from which a
(c) Open table (d) New table user can define, store, retrieve and update.
19 The keyword to create a table is followed by (a) Accounting information
(a) serial number (b) employee code (b) DBMS
(c) date (d) unique name (c) Management information system
20 Accounting information can be generated by
24 Which of the following is not a function of database
(a) executing some queries
(b) searching it online management system?
(c) Either (a) or (b) (a) Data storage management
(d) None of the above (b) Data dictionary management
(c) Recording accounting data
21 MS Access is a (d) Recovery management
(a) customised software
(b) relational DBMS 25 Wich of the following accounting information can be
(c) operating system retrieved using DBMS?
(d) All of the above (a) Shareholders record (b) Customers’ profile
(c) Petty cash register (d) All of these
ANSWERS
1. (b) 2. (c) 3. (a) 4. (d) 5. (c) 6. (a) 7. (d) 8. (b) 9. (c) 10. (a)
11. (b) 12. (a) 13. (d) 14. (c) 15. (c) 16. (a) 17. (c) 18. (a) 19. (d) 20. (a)
21. (b) 22. (a) 23. (b) 24. (c) 25. (d)
CHAPTER 17
Accounting Applications of
Electronic Spreadsheet
Concept of Electronic Spreadsheet Some of the items that can be generated using electronic
spreadsheets are
It is a tabular representation of any statistical, mathematical,
scientific or accounting data. It is a software tool that lets one 1. Depreciation Schedule It lists the loss in the value of
enter, calculate, manipulate and analyse set of numbers. the asset over a period of time. There are various
methods to calculate depreciation like straight line
It is a large sheet in which data and information is arranged
method or written down value method. Different
in rows and columns. There are various spreadsheet
formulas can be used to calculate depreciation
programs available, like Microsoft Excel, Google Sheets, Libra
depending upon the method of depreciation.
Office Calc, Lotus 123, etc.
(i) Straight Line Method In this method, the
These spreadsheets are also known as worksheets. They also amount of depreciation remains fixed over the life
provide the functions of mathematical formulas. They can of the asset. The amount of depreciation can be find
also recalculate the results when there is a change in source out by using the following syntax
data. SLN (cost, salvage, life)
Here are some of the basic elements of electronic (ii) Written Down Value Method In this method,
spreadsheets are as follows depreciation is charged on the diminishing balance
● Workbook and worksheet of the asset, and the value of asset does not remain
● Rows, columns and cells
same. The amount of depreciation can be find out
by using the following syntax
Features of Electronic Spreadsheet DB (cost, salvage, life, period)
● It is easy to learn and does not require any special training.
2. Loan Repayment Schedule This schedule helps in
● Mathematical calculations can be done with built-in
knowing the amount that needed to be paid back
through a series of periodic payments, which includes
programs.
principal amount and interest. The amount can be find
● Data is presented in tables which minimises manual work
out with PMT formula, where is PMT (include rate, nper,
and increases accuracy. pv, fv). Here, pv = present value; fv = future value, and
● Information can also be provided in the form of charts and
nper = number of payment period for an investment.
graphics.
3. Payroll Accounting A payroll is a list of employees
● It can easily sort data in ascending and descending order.
working in an organisation and receiving payments and
● Password can be added to workbook which increases the other work related benefits. Payroll can be created with
security of the data. the help of electronic spreadsheets as it is easy to
maintain in electronic form rather than manually.
Application of Electronic
In order to create payroll in spreadsheet, we have to
Spreadsheet in Generating Accounting Information
create some columns with headings that can hold the
Electronic spreadsheet plays an important role in recording
value of some variables.
and generating accounting data. It can be used to find out
the profit or loss of the business. Spreadsheets can also be The hierarchy of columns can be set as
● Employee Name ● Pay Rate
used to prepare various accounts and statements like balance
● Total Hours Worked ● Overtime
sheet.
● Gross Pay ● Income Tax
It can be used in various other areas like payment tracking,
● Other Deductions ● Net Pay
loan repayment schedules, payroll, etc.
Accountancy 141
Practice Questions
1 A sheet in which data and information is arranged 10 Which of the following applications can be used to
in rows and columns is called prepare various accounts and statements like
(a) paper sheet balance sheet?
(b) notebook (a) Adobe reader
(c) spreadsheet (b) Electronic spreadsheet
(d) All of the above (c) Microsoft word
2 Which of the following is a type of electronic
spreadsheet? 11 What are the other areas in which an electronic
(a) Microsoft Excel spreadsheet can be used?
(b) Google sheets (a) Payment tracking
(c) Lotus 123 (b) Loan repayment schedules
(d) All of the above (c) Payroll
3 Spreadsheets are also known as
(a) worksheets (b) paper sheet 12 The schedule which lists the loss in the value of the
(c) notebook (d) All of these asset over a period of time is known as ………… .
4 Mathematical formulas are provided in (a) depreciation schedule
(a) electronic spreadsheets (b) payment tracking schedule
(b) paper sheets (c) loan requirement schedule
(c) notebooks (d) none of the above
(d) None of the above 13 Different formulas can be used to calculate
5 What happens when there is a change in source depreciation depending upon
data of an electronic spreadsheet? (a) system
(a) The results needs to be recalculated manually (b) humanware
(b) It can recalculate the result automatically (c) method of depreciation (d) All of these
(c) Either (a) or (b) 14 In which method, the amount of depreciation
(d) Neither (a) nor (b) remains fixed over the life of the asset?
6 The basic elements of an electronic spreadsheets (a) Written down value method
include (b) Straight line method
(a) workbook and worksheets (c) Either (a) or (b)
(b) rows, columns and cells (d) Neither (a) nor (b)
(c) Both (a) and (b) 15 The syntax used to calculate the amount of
(d) None of the above depreciation using straight line method is
7 Which of the following are the features of electronic (a) OCM (b) SLN
spreadsheets? (c) SLMD (d) DEP
(a) Easy to learn and does not require any special 16 In which method, depreciation is charged on the
training diminishing balance of the asset?
(b) Data is not presented in tables (a) Written down value method
(c) Information can be provided in the form of charts (b) Straight line method
and graphs (c) Either (a) or (b)
(d) Both (a) and (c) (d) Neither (a) nor (b)
8 Spreadsheets can also be used to 17 In written down value method, the value of the
(a) generate accounting information asset
(b) video editing
(a) remain same
(c) electronic mail
(b) does not remain same
(c) depending up on the type of the business
9 Which application can be used to find out the profit (d) Either (a) or (b)
or loss of the business? 18 The syntax used to calculate the amount of
(a) Adobe reader depreciation using written down value method is
(b) Microsoft word
(a) WDV (b) DBM
(c) Electronic spreadsheet
(c) DEP (d) DB
19 Which schedule helps in knowing the amount that 23 A ………… is a list of employees working in an
needed to be paid back through a series of periodic organisation and receiving payments and other
payments? work related benefits.
(a) Payment tracking (b) Payroll accounting (a) payment tracking
(c) Depreciation schedule (d) None of these (b) payroll accounting
(c) depreciation schedule
20 Periodic payment includes (d) None of the above
(a) principal amount only (b) interest amount only
(c) Both (a) and (b) (d) None of these 24 In the given syntax, (rate, nper, pv, fv) nper means
(a) number of years
21 The syntax used to calculate the amount of periodic (b) principal amount
payments is (c) interest rate
(a) PPA (b) PMT (d) number of payment period for an investment
(c) PMA (d) PMO
25 Payroll is easy to maintain in ………… .
22 In the given syntax, (rate, nper, pv, fv) pv stands for (a) manually system
(a) post value (b) past value (b) electronic form
(c) present value (d) pre volume (c) virtually
ANSWERS
1. (c) 2. (d) 3. (a) 4. (a) 5. (b) 6. (c) 7. (d) 8. (a) 9. (c) 10. (b)
11. (d) 12. (a) 13. (c) 14. (b) 15. (b) 16. (a) 17. (b) 18. (d) 19. (d) 20. (c)
21. (b) 22. (c) 23. (b) 24. (d) 25. (b)
PRACTICE SET 01 145
CUET (UG) Section II : Domain (Accountancy)
Practice Set 01
1. Donation can be 7. Which of the following is/are 13. Which amongst the following
(a) general donation method(s) of valuation of goodwill? adjustment(s) is/are required at the
(b) specific donation (a) Average profit method time of admission of a new partner?
(c) Both (a) and (b) (b) Super profit method (a) Computation of new profit sharing
(d) None of these (c) Capitalisation method ratio and sacrificing ratio
(d) All of these (b) Adjustment for goodwill
2. Receipt and payment account (c) Revaluation of assets
generally shows 8. Which of the following is not true
(d) All of these
(a) a debit balance in relation to goodwill?
(b) a credit balance (a) It is an intangible asset 14. Asha and Nisha are partners’
(c) surplus and deficit (b) It is fictitious asset sharing profit in the ratio of 2 : 1.
(d) capital fund (c) It has a realisable value Asha’s son Ashish was admitted for
(d) None of the above 1/4 share of which 1/8 was gifted by
3. Debit balance in receipts and Asha to her son. The remaining
payments account was shown as 9. The profits earned by a business was contribited by Nisha. Goodwill
` 80,000, subscription received over the last 5 years are ` 12,000; of the firm is valued at ` 40,000.
amounted to ` 9,600 out of which ` 13,000; ` 14,000; `18,000; and How much of the goodwill be
` 3,000 is related to next year. ` 2,000 (loss). Based on 2 years credited to the old partners’ capital
According to you, what amount will purchase of the last 5 years profits, account?
be shown in receipts and payments value of goodwill will be
(a) ` 2,500 each (b) ` 5,000 each
account? (a) ` 23,600 (b) ` 22,000
(c) ` 20,000 each (d) None of these
(a) ` 80,000 (b) ` 89,600 (c) ` 1,10,000 (d) ` 1,18,000
(c) ` 9,600 (d) ` 86,600 15. …… goodwill is the excess of
10. A, B and C are partners sharing
desired total capital of firm over
4. Where a partner is entitled to profits and losses in the ratio of
the actual combined capital of all
interest on capital contributed by 5 : 4 : 1. If, C acquires 1 / 5th share
partners.
him, such interest will be payable from A, then calculate sacrificing
(a) Premium (b) Share
(a) only out of profits ratio
(c) Hidden (d) Old
(b) only out of capital (a) A sacrifice 1/5 (b) B sacrifice 1/5
(c) Both (a) and (b) (c) C sacrifice 1/5 (d) None of these 16. ……… account is prepared when
(d) None of these partners decide to give effect to
11. Sacrificing ratio is calculated as
revaluation of assets and liabilities
5. A, B and C are partners sharing (a) New Ratio – Old Ratio
without affecting their book value.
profits equally. A drew regularly (b) Old Rato – New Ratio
(a) Revaluation
` 4,000 in the beginning of every (c) Old Ratio – Gaining Ratio
(b) Memorandum revaluation
month for the six months ended (d) Gaining Ratio – Old Ratio
(c) Memorandum suspense
30th September, 2021. Calculate
12. A and B are partners in a firm (d) None of the above
interest on A’s drawings @ 5% p.a.
sharing profit and losses 2 : 3. With
(a) ` 200 (b) ` 1,200 17. In case of retirement of a partner,
effect from 1st April, 2022, they
(c) ` 350 (d) ` 700 profit or loss on revaluation of
decided to share profits and loss
assets and re-assessment of
6. Pick the odd one out equally. What will be B’s
liabilities is distributed among
(a) Rent to Partner gain/sacrifice?
……… in ……… profit sharing
(b) Manager’s Commission (a) Gain 1/5 (b) Sacrifice 1/5
ratio.
(c) Interest on Partner’s Loan (c) Gain 1/10
(a) all the partners, old
(d) Interest on Partner’s Capital (d) Sacrifice 1/10
(b) all the partners, new
146 CUET (UG) Section II : Domain (Accountancy)
(c) other than retiring partner, old share capital shown in the balance 30. Securities premium reserve is
(d) other than retiring partner, new sheet? shown on the liabilities side in
18. At the time of retirement of (a) ` 60,00,000 (b) ` 58,40,000 the balance sheet under the head
Mahesh, value of stock is given (c) ` 5,84,000 (d) ` 6,00,000 (a) reserves and surplus
` 60,000 in the balance sheet of the (b) general reserve
24. Shares for consideration other than
firm. Pass a journal entry when (c) share capital
cash can be issued at
found stock is undervalued by (d) current liabilities
(a) par
` 15,000. (b) premium 31. Revenue from operations on 31st
(a) Revaluation A/c Dr 15,000 (c) discount March, 2021 was ` 15,00,000 and
To Stock A/c 15,000 (d) Both (a) and (b) on 31st March, 2020 was
(b) Stock A/c Dr 15,000 `12,00,000, then what will be the
To Revaluation A/c 15,000 25. Arihant Ltd. issued 8,000, 12%
percentage change in revenue
(c) Stock A/c Dr 45,000 debentures of ` 100 each at par on
from operations?
To Revaluation A/c 45,000 1st April, 2020 which are
(a) 50% (b) 62% (c) 45% (d) 25%
(d) Revaluation A/c Dr 45,000 redeemable at 5% premium in five
To Stock A/c 45,000
equal instalments. First redemption
32. Which of the following is not an
to be made on 31st March, 2021. The
19. After transferring liabilities like objective of comparative
company complied with legal
creditors and bills payables in the statement analysis?
requirements. Calculate amount
realisation account, in the absence (a) To compare with other firms and
which is required to be legally
of any information regarding the industrial data
invested?
payment, such liabilities are (b) To judge the financial instability
(a) ` 1,20,000 (b) ` 24,000 (c) To help in forecasting and
treated as (c) ` 60,000 (d) ` 96,000 planning
(a) never paid (b) fully paid
26. If debentures are issued at premium, (d) Understand complex data in
(c) partly paid (d) None of these simplified manner
then they can be redeemed at
20. In the event of dissolution of a firm, (a) par 33. If net revenue from operations is `
the partners’ personal assets are (b) premium 1,20,000, cost of revenue from
first applied for payment of …… . (c) Both (a) and (b) operations is ` 40,000 and
(a) the personal liabilities (d) can’t be redeemed operating expenses are ` 20,000,
(b) the firm’s liabilities what will be the percentage of
(c) Both (a) and (b) 27. Firewall agreed to pay purchase
operating income on net revenue
(d) preferential tax liabilities
consideration of `1,30,000 by issuing
fully paid-up debentures of ` 100 at from operations?
21. On firm’s dissolution, a partner A ` 120. How many debentures will be (a) 45% (b) 55%
took over 50% of the stock at a issued? (c) 50% (d) 65%
discount of 20% (book value of (a) 1,083 34. Normally absolute ratio is further
stock was ` 5,00,000). What will be (b) 1,084 refinement of liquid or quick
the value of taken over stock? (c) Can’t be determined ratio. Which of the following is
(a) ` 2,50,000 (b) ` 1,00,000 (d) None of these considered fairly satisfactory?
(c) ` 2,00,000 (d) ` 5,00,000 (a) 1 : 1 (b) 0.5 : 1
28. Staff welfare expenses are included
22.The balance of share forfeiture in (c) 1.5 : 1 (d) 1 : 15
.
account can be used to (a) cost of material consumed 35. The ...... measures the activity of
(a) provide for discount given at the (b) revenue from operation a firm’s inventory.
time of reissue (c) employees benefit expense (a) average collection period
(b) write-off preliminary expenses (d) None of the above (b) invenotry turnover
(c) write-off bad debts
29. From following information, (c) liquid ratio
calculate other incomes. (d) current ratio
23. Amox Ltd. is registered with a
Sales of product = ` 54,000; Sale of 36. What is the inventory turnover
capital of 10,00,000 equity shares of
services = ` 60,000; Commission ratio, when the following is given?
` 10 each. 6,00,000 equity shares
received = ` 1,20,000; Excise duty COGS = ` 1,50,000; Closing
were offered for subscription to
paid = ` 3,00,000; Dividend from Inventory = ` 60,000; Excess of
public. Applications were received
investment = ` 20,000 Closing Inventory over Opening
for 6,00,000 shares. All calls were
(a) ` 1,40,000 Inventory ` 20,000.
made and amount was duly received
(b) ` 2,54,000 (a) 3 times (b) 2.14 times
except final call of ` 2 on 80,000
(c) ` (46,000) loss (d) None of these (c) 1.5 times (d) 4 times
shares. What will be the amount of
PRACTICE SET 01 147
37. ABC Ltd. is a financial company 41. Part of computer system which 46. ………… is the group of data which
which provides loan and invest into interact with the computer is interlinked and set of programs
shares. At the year end, company through the use of hardware or which helps in accessing the data.
received ` 50,000 interest on loan. software is called................. . (a) ABMS (b) CBMS
Where will be the amount of interest (a) language processor (c) DBMS (d) EBMS
presented? (b) applications software
47. ………… is a window which consist
(a) Activity arising from interest will be (c) procedure
of various fields and spaces to fill
shown in investing activity (d) humanware
the data.
(b) Activity arising from interest will be
shown in financing activity 42. Identify the requirement(s) of (a) Query
(c) Activity arising from interest will be every computerised accounting (b) Table
shown in operating activity system. (c) SQL
(d) None of the above (a) Accounting framework (d) Form
(b) Operating procedure
38. For a company manufacturing 48. For a complete view of data which
garments, procurement of raw is stored across various tables, the
(d) None of these
material , incurrence of user is required to
manufacturing expenses , sale of 43. Which of the following is an (a) execute queries based on SQL
garments are classified as ……... accounting software? (b) search for data tables in DBMS
activity. (a) Tally (c) Either (a) or (b)
(a) financing (b) investing (b) Microsoft Office (d) Neither (a) nor (b)
(c) operating (d) None of these (c) Photoshop
49. What happens when there is a
(d) Notepad
39. Mention the net amount of source or change in source data of an
use of cash when a fixed asset 44. How many predefined vouchers electronic spreadsheet?
(having book value ` 1,20,000) is sold does tally has? (a) The results needs to be
at a loss of ` 40,000 in term of cash (a) 21 (b) 22 recalculated manually
flow. (c) 23 (d) 24 (b) It can recalculate the result
(a) ` 1,20,000 (b) ` 40,000 automatically
45. The .......... of the previous year (c) Either (a) or (b)
(c) ` 80,000 (d) ` 1,60,000
becomes the ............ of the (d) Neither (a) nor (b)
40. ................ means modifying the current year
readymade software to suit the (a) closing balance, opening 50. In which method the amount of
specific requirements of the user balance depreciation remains fixed over the
(a) Operating system (b) opening balance, closing life of the asset?
(b) Customised software balance (a) Written down value method
(c) Ready to use (c) Either (a) or (b) (b) Straight line method
(d) Tailored (d) Neither (a) nor (b) (c) Either (a) or (b)
ANSWERS
1. (c) 2. (a) 3. (b) 4. (a) 5. (c) 6. (d) 7. (d) 8. (b) 9. (b) 10. (a)
11. (b) 12. (d) 13. (d) 14. (c) 15. (c) 16. (b) 17. (a) 18. (b) 19. (b) 20. (a)
21. (c) 22. (a) 23. (b) 24. (d) 25. (b) 26. (c) 27. (a) 28. (c) 29. (a) 30. (a)
31. (d) 32. (b) 33. (c) 34. (b) 35. (b) 36. (a) 37. (c) 38. (c) 39. (c) 40. (b)
41. (d) 42. (c) 43. (a) 44. (c) 45. (a) 46. (c) 47. (d) 48. (a) 49. (b) 50. (b)
CUET (UG) Section II : Domain (Accountancy)
Practice Set 02
1. Cash flow is known as 6. Which of the following will be 9. Machinery replacement fund is
(a) variation in cash recorded in credit side of receipts transferred to partners’ capital
(b) change in cash and payments account? account at the time of change in
(c) cash at bank (a) ` 300 received from entrance fees profit sharing ratio.
(d) Both (a) and (b) (b) Cash purchases of books ` 700 (a) True (b) False
(c) Donation received ` 800 (c) Partially false (d) Partially true
2. Which of the following is a
(d) Outstanding ` 300 for repair
non-operating income? 10. Amount realised from sale of assets
(a) Dividend received by an 7. Revaluation account is prepared is recorded on the ……… side of
investment company ............. the value of assets. cash/bank account.
(b) Premium received by an insurance (a) to revise (a) debit
company (b) not to revise (b) credit
(c) Revenue from sale in a trading (c) to distribute (c) not shown in cash/bank account
concern (d) None of these (d) None of these
(d) Profit on the sale of used plant in
manufacturing company 8. ‘A’, ‘B’ and ‘D’ are partners in a 11. The accumulated profits and
firm sharing profits (losses) in the reserves are transferred to
3. Rakshak Ltd. made an operating ratio of 3 : 2 : 1. They change their
profit of ` 1,85,500 after charging (a) realisation account
ratio into 2 : 1 : 2 for future profits. (b) partners’ capital accounts
depreciation of ` 31,200. During At that time, their balance sheet
that year, trade payables increased (c) bank account
shows the following balances (d) None of the above
by ` 26,600 and inventory increased Investment Fluctuation Reserve =
by ` 40,300. There was no change to ` 6,000 Investment = ` 25,000 12. Amit, Barun and Chanda are
trade receivables. Assuming that no partners. They decided to dissolve
other factors affected it, what would Now, the market value of
investments’ is ` 22,000. Distribute the firm. There is a debit balance of
be the cash generated from ` 27,000 in the profit and loss
operations? investment fluctuation reserve
among partners. account on the date of dissolution.
(a) ` 2,03,000 (b) ` 2,30,400 What journal entry would be
(c) ` 2,25,800 (d) ` 2,43,300 (a) Investment Fluctuation
Reserve A/c Dr 6,000 passed?
4. Find the cost of medicines To A’s Capital A/c 3,000 (a) Profit and Loss A/c Dr 27,000
consumed, if Opening stock of To B’s Capital A/c 2,000 To Amit’s Capital A/c 9,000
medicines ` 30,000 To D’s Capital A/c 1,000 To Barun’s Capital A/c 9,000
Purchases during the year ` 50,000 (b) Investment Fluctuation To Chanda’s Capital A/c 9,000
Reserve A/c Dr 6,000 (b) Amit’s Capital A/c Dr 9,000
Closing stock ` 20,000
Barun’s Capital A/c Dr 9,000
(a) ` 80,000 (b) ` 60,000 To A’s Capital A/c 6,000
Chanda’s Capital A/c Dr 9,000
(c) ` 50,000 (c) A’s Capital A/c Dr 6,000
To Profit and Loss A/c 27,000
(d) ` 40,000 To B’s Capital A/c 3,000
(c) No entry
To D’s Capital A/c 3,000
5. Receipt and payment account is the (d) None of the above
(d) Investment Fluctuation
summary of
Reserve A/c Dr 6,000 13. Which of the following points out
(a) bank balance
To Investment A/c 3,000 the nature of financial statements?
(b) capital account
(c) cash book To A’s Capital A/c 1,500 (i) Financial statements are
(d) income and expenditure account To B’s Capital A/c 1,000 prepared on the basis of
To D’s CapitalA/c 500 recorded facts.
PRACTICE SET 02 149
(ii) Certain accounting conventions @10% before charging such 25. Tangible assets are ` 4,00,000 on
are followed while preparing commission? 31st March, 2020 and intangible
financial statements. (a) ` 3,30,000 (b) `3,00,000 assets are ` 2,00,000.
(iii) Financial statements are (c) ` 3,000 (d) ` 3,300 Total assets of the firm are
prepared on certain basic
19. ‘X’ and ‘Y’ are partners sharing ` 10,00,000, then what will be the
assumptions (pre-requisites)
known as postulates. profits equally. ‘Z’ was admitted for percentage of tangible assets to
1/5 share. Calculate new profit total assets?
(iv) Facts and figures presented
through financial statements sharing ratio. (a) 48% (b) 50% (c) 40% (d) 32%
are based on personal opinion, (a) 2 : 3 : 1 (b) 3 : 3 : 1 26. Which item is assumed to be 100
estimates and judgements. (c) 6 : 5 : 2 while preparing common size
(a) Only (i) (d) 2 : 2 : 1 statement of profit and loss?
(b) (i) and (ii) (a) Total income
(c) (i), (ii) and (iii)
20. At the time of admission of a
partner, undistributed profits (b) Cost of revenue from operations
(d) (i), (ii), (iiii) and (iv) (c) Revenue from operations
appearing in the balance sheet of
14. A company issued shares calling the old firm is transferred to the (d) None of the above
application, allotment and first and capital account of 27. Comparative balance sheet consists
final call. A holder of shares not (a) old partners in old profit sharing of ……… columns.
paid allotment and first call. His ratio (a) five
shares are forfeited but not (b) old partners in new profit sharing (b) three
re-issued. As on balance sheet date, ratio
(c) six (d) four
you are required to show these (c) all the partner in the new profit
forfeited shares in the balance sheet sharing ratio 28. Find out those situations which
of company under the head (d) None of the above create need for valuation of
(a) current liability 21. The new partner, at the time of goodwill for a partnership firm?
(b) shareholders’ fund admission, may acquire his share (a) When existing partners change
(c) current assets from old partners in their profit sharing ratio
(d) None of these (b) When a new partner comes into
(a) old profit sharing ratio
partnership
15. What is the total under equity and (b) some agreed ratio
(c) When an existing partner retires
liabilities side of the balance sheet (c) particular fraction from some of
from partnership
when the following information is the partners
given? (d) All of the above
29. The goodwill of the firm not
Shareholders’ Funds = ` 10,00,000; 22. Capital which is called only at the
affected by
Non-current Liabilities = ` 5,00,000; time of winding-up of the company
(a) location of the firm
Current Liabilities = ` 3,00,000 is called
(b) reputation of firm
(a) ` 10,00,000 (b) ` 15,00,000 (a) capital reserve
(c) better customer service
(c) ` 18,00,000 (d) ` 13,00,000 (b) reserve capital
(c) secure capital
16. A partner withdrew ` 4,000 per (d) authorised capital 30. The average capital employed of a
month from 1st July, 2016, on firm is ` 4,00,000 and the normal
beginning of every month. Accounts 23. A company issued 25,000 shares
rate of return is 15%. The average
are closed at 31st March, 2017. and received applications for
profit of the firm is ` 80,000 per
Calculate interest on drawings 35,000 shares. Company wants to
annum. If the remuneration of the
while rate of interest is 10% per allot shares to everyone who has
partners is estimated to be ` 10,000
annum. applied. What will be the ratio for
per annum, then on the basis of
(a) ` 1,600 (b) ` 1,800 allotment?
two years purchase of super profit,
(c) ` 1,500 (d) ` 2,200 (a) 6 : 7 (b) 7: 5
the value of the goodwill will be
(c) 5 : 7 (d) 7: 6
17. In a partnership, commission to (a) ` 10,000 (b) ` 20,000
partners will be given from 24. The subscribed share capital of (c) ` 60,000 (d) ` 80,000
(a) current year’s profit XYZ Ltd. is ` 80,00,000 divided in
31. The ratio in which the retiring
(b) reserves shares of ` 100 each. There were no
partner’s share of goodwill is
(c) goodwill calls-in-arrears till the final call
debited to the capital accounts of
(d) Any of them was made. The final call was paid
continuing partners’ is
on 77,500 shares. The calls-in-
18. Manager’s commission of ABC Ltd. (a) old ratio
arrears amounted to ` 62,500.
(Partnership) was `33,000. What (b) new ratio
Calculate the final call per share.
amount of net profit in manager’s (c) gaining ratio
(a) ` 20 (b) ` 30
commission was to be charged (d) sacrificing ratio
(c) ` 25 (d) ` 35
32. Anand, Bahadur and Chander are 37. The ...... ratios are primarily 43. Which tool is used to have a proper
partners. Sharing profit equally on measures of return. classification of data and to provide
Chander’s retirement, his share is (a) liquidity special code to various heads of
acquired by Anand and Bahadur in (b) activity accounts?
ratio of 3 : 2. The new profit sharing (c) debt (a) Accounting Software
ratio between Anand and Bahadur (d) profitability (b) Codification (c) Gateway of Tally
will be (d) Microsoft Office
38. Consider the following
(a) 8 : 7 (b) 4 : 5 (c) 3 : 2 (d) 2 : 3 44. .......... voucher is used to record all
information.
33. A, B and C are partners with the non-cash transactions of the
Long-term borrowings ` 2,00,000; business.
capitals ` 1,00,000, ` 75,000 and Long-term provision ` 1,00,000;
` 50,000 respectively. On C’s (a) Received (b) Payment
Current liabilities ` 50,000 ; (c) Contra (d) Journal
retirement, his share is acquired by Non-current assets ` 3,60,000;
A and B in ratio of 5 : 3. Gaining Current assets ` 90,000 45. Which system provides data about
ratio will be what changes are made in the
Proprietary ratio will be original data and who made those
(a) 3 : 2 (b) 2 : 2
(a) 22.2% (b) 21.8% changes?
(c) 5 : 3 (d) None of these
(c) 36% (d) None of these (a) Password security
34. The balance of sinking fund (b) Data audit (c) Data security
39. A debt-equity ratio of ………… is
investment account after the (d) Data leakage
realisation of investments is considered satisfactory.
transferred to (a) 1:1 46. Spreadsheets are also known as
(b) 4:1 (a) worksheets (b) paper sheet
(a) statement of profit and loss
(c) 2:1 (c) notebook (d) All of these
(b) debentures account,
(d) There is no such value
(c) sinking fund account 47. The syntax used to calculate the
(d) None of the above 40. .............. consists of hardware as amount of depreciation using
well as software. written down value method is
35. ‘X’ Limited purchased the assets
from ‘Y’ Limited from ` 16,20,000. (a) Operating system (a) WDV (b) DBM (c) DEP (d) DB
‘X’ Limited issued 10% debentures (b) Computerised accounting system
48. A ………… is a list of employees
(c) Motherboard
of ` 10 each at 10% discount against working in an organisation and
(d) Application software
the payment. The number of receiving payments and other work
debentures issued by ‘X’ Limited 41. Software that are meant to related benefits.
will be manage the resources of a (a) payment tracking
(a) 16,200 (b) 18,000 computer and also facilitates its (b) payroll accounting
(c) 1,80,000 (d) 1,62,000 operations are known as ……… . (c) depreciation schedule
(a) operating system (d) None of the above
36. A company AB Ltd issued 12%
(b) utility program
debentures of ` 10,00,000 of ` 100 49. A ………… is a database structure
(c) application software
each to public. In the terms of issue, which is used to either store the
(d) All of these data or for referencing purpose
these debentures are redeemable
after 10 months ending on 31st 42. ............... is an interactive link (a) data (b) information
January, 2018. Interest is payable between the user and database (c) object (d) knowledge
on monthly basis. These debentures oriented software through which 50. Which of the following is not a
will be shown in balance sheet as on user communicaters to the function of database management
31st March, 2017 under the heading back-end database. system?
(a) long-term liability (a) Front-end database (a) Data storage management
(b) current liability (b) Data processing (b) Data dictionary management
(c) fixed assets (c) Reporting system (c) Recording accounting data..
(d) current assets (d) None of the above (d) Recovery management
ANSWERS
1. (d) 2. (d) 3. (a) 4. (b) 5. (c) 6. (b) 7. (a) 8. (d) 9. (b) 10. (a)
11. (b) 12. (b) 13. (d) 14. (b) 15. (c) 16. (c) 17. (a) 18. (a) 19. (d) 20. (a)
21. (d) 22. (b) 23. (c) 24. (c) 25. (c) 26. (c) 27. (a) 28. (d) 29. (d) 30. (b)
31. (c) 32. (a) 33. (c) 34. (c) 35. (a) 36. (b) 37. (d) 38. (a) 39. (c) 40. (b)
41. (a) 42. (a) 43. (b) 44. (d) 45. (b) 46. (a) 47. (d) 48. (b) 49. (c) 50. (c)
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CUET (UG)

Common University Entrance Test 2022

Under Graduate Tests

Compiled and Edited by

Arihant Publications (India) Limited

Administrative & Production Offices

Sales & Support Offices

Business Studies 1-80

Last date of successful transaction of 06 May, 2022 (up to 11:50 pm)

Correction in the particulars of Application

Downloading of Admit Card from To be announced later on the website

Date(s) of Examination First and second week of July, 2022

Duration of Examination Slot 1: 195 minutes (3:15 hours)

Timing of Examination Slot 1: 09.00 AM to 12.15 PM (IST)

Section IA 13 Languages (As a medium and “Language”) Section IB 20 Languages

Section II 27 Domain Speci c Subjects Section III General Test

Broad features of CUET (UG) - 2022 are as follows:

Mode of the Test Computer Based Test-CBT

Test Pattern Objective type with Multiple Choice Questions

Medium 13 languages ( Tamil, Telugu, Kannada, Malayalam, Marathi, Gujarati,

Section IA & IB: Language to be tested through Reading Comprehension

Section II : As per NCERT model syllabus as applicable to Class XII only

Registration Registration will be online at https://cuet.samarth.ac.in/. (available

Level of questions for CUET (UG) -2022:

Visit www.exambites.in for

always searches for opportunity and believes in increasing creative solution.

be such that, it helps in increasing the revenues ● Personal grooming salons

of the business. ● Career counselling centres

important methods of generating an idea is market electric and electronic goods

sciences to gain insight or support decision-making. ● Improve an existing product or service.

as it gives information regarding market needs, market product.

state of technology. ● Find a new use of an existing product or service.

products should be known. This will help in ● Major newspapers.

determining the sale price. ● International trends through websites.

Step 5 Competition Competitive analysis of a product or ● Influential bloggers.

starting a new venture. obstacles which cannot be overcome, suggesting to

Characteristics of Partnership Joint Stock Company

because they are incompetent to enter into contract, ● Limited liability

somebody else. people to commence business, with no upper limit to

determined by ● Operational plan ● Financial plan

● The Indian Companies Act, 2013 ● Marketing plan

● Memorandum of Association ● Human resource planning

● stake of members in the organisation.

● roles and responsibilities of each member.

● procedure for solving conflicts/disputes amongst members. ● plant layout.

● voting rights, managerial and controlling rights of the ● manpower requirement.

1. No Manufacturing Involved If the new venture does and minimisation of wastage.

2. Partial Manufacturing If the entrepreneur plans to point to the consumers.

plan should describe and methods.

● reasons for their selection. Objectives of Operational Plan

● a clear mention of what entrepreneur intends to do

himself and what he plans to get done from

Elements of Operational Plan Elements of Financial Plan

● Where will the funds come from?

6. Shipping This section goes beyond the manufacturing minimsed.

from production to the consumers. maximised.

● local resource utilisation

then each point should be carefully analysed and its

1. Where have We Been? This segment focuses on ● emphasis on products development.

● some history of the market place.