Accounting is a social science. The nature of accounting information has been dictated
from time immemorial by the needs of the users of the day. The history of accounting
reflects the pattern of social developments and the forces which necessitate the changes in
accounting system from time to time.
Over the years accountancy has made tremendous progress in the field of commerce and
industry. Accounting can be described as being concerned with measurement and
management. Measurement of recording transactions and management with the use of data
for making decisions are the two fundamental aspects.
Accounting function is vital for every entity of the society whether individuals, house
wives, business entity, nonprofit making organizations like municipalities, panchyats,
clubs, etc. All are required to maintain accounts.
Accounting is commonly referred to as the “language of the business” as it is effectively
employed to communicate the financial performance of business to various interested parties
or stakeholders. It is concerned with the measurement and communicating financial data.
Financial Accounting is based on double entry system of accounting which comprises of
(I) recording of business transactions in the books of prime entry,
(ii) posting into respective ledger accounts,
(iii) striking balance, and
(iv) preparing the performance statement (profit and loss statement) and position
statement (balance sheet).
Financial Accounting is concerned with the collection, recording, classification and
presentation of financial data to serve the purposes of the management, shareholders and
stakeholders, such as, creditors, bankers, Government, etc.
The nature and purpose of accounting
The basic aim of accounting in a business entity is to provide financial information for
making decisions on its activities. Managers of an economic entity at various levels require
analyzed financial information for planning and programming, for controlling expenditure,
for ascertaining the extent of profitability or otherwise of a department – even of each
production item for undertaking new jobs, etc.
Financial information in tabular forms and with graphs and charts are also required by the
outsiders, namely, bankers, financial institutions, creditors, investors, government agencies
and even by the labor unions and the general public who have some interest in the particular
business concern.
Definition of Accounting
A widely accepted definition of accounting has been provided by the American Accounting
Association. According to this definition accounting is the process of identifying,
measuring and communicating information to permit judgment and decisions by the users
of accounts. This definition implies that –
(1) there should be users of accounts who need relevant information,
(2) the information should enable the users to make judgment and decisions, and
(3) transactions and events are measured and the data are processed and then
communicated to the users through accounting.
Objectives of Accounting
The basic objectives of accounting are to provide financial information to the managers,
owners and the stakeholders i.e. the parties who are interested in an organization. To attain
such objectives various financial statements are prepared.
The users of financial statements may be broadly classified in the following groups –
(a) The investor – This group includes both existing and potential owners of shares in
companies. They are broadly interested in the performance of the entity and the
dividend declared by such entity. They also measure the social and economic policies
of the company to decide whether they will remain associated with such entity.
(b) The lender – This group includes both secured and unsecured lenders. Such creditors
may be financing long term or short term loans. The financial statements are analyzed
to determine an organization's ability as to
(I) pay the interest on due date,
(ii) the growth and stability of the organization,
(iii) capability of repaying the loan as agreed upon, and.
(iv) the book value of assets offered as security by the organization.
(c) The customers and suppliers – While customers are interested in the ability of the
organization to provide goods/services, the suppliers are interested in the capability
of the organization to pay their dues as and when due.
(d) The government – This group includes various taxation authorities viz. Income
tax, Excise department, Sales tax department etc. and also various other government
authorities for statistical purposes and for framing various economic and planning
policies.
(e) The employee group – The employees are concerned with the capability of an
organization to pay their present emoluments and future retirement benefits.
Moreover, financial statements help them to asses job security.
(f) The analyst – Advisors to the management, investors, employees or public at large
collect various data from financial statements to advise their clients.
(g) The Management – Financial statements provide required information to different
levels of management to assist them in making decisions at each appropriate level.
1.1 SUBDIVISION OF ACCOUNTING
Generally, accounting is subdivided as follows :
a) Book-keeping
b) Measuring working results and capital of the economic entity and reporting.
a) Book-Keeping : Book-keeping is the art and science of recording transactions of a
business enterprise or an organization carrying out non-business activities in a systematic
and appropriate manner to measure the working results and capital at periodical interval
depending upon needs of an entity.
(b) Measuring working results and capital of the economic entity and reporting : The
most important aspect of accounting records is to measure the working results and the
capital of the economic entity and interpreting and reporting of results.
1.2 CONCEPTS AND CONVENTIONS IN ACCOUNTING
Basic concepts:
Accounting principles are built on a foundation of a few basic concepts. These concepts
are so basic that most accountants do not consciously think of them; they are regarded as
being self-evident. Non-accountants will not find these concepts to be self-evident. Some
accounting theorists argue that certain of the present concepts are wrong and should be
changed. But in order to understand accounting, as it now exists, one must understand
what the underlying concepts currently are. The different aspects are :—
1. Business Entity Concept
2. Money Measurement Concept
3. Cost Concept
4. Going Concern Concept
5. Dual-aspect Concept
6. Realization Concept
7. Accrual Concept
8. Accounting Period Concept
1. Business Entity Concept:
The business is treated as a distinct (and separate) entity from the individuals who own it
and accordingly accountants record transactions. For example, if the owner of a shop
withdraws Rs. 10,000 for personal use, from the business entity point of view, the entity
has less cash though it belongs to the owners. Therefore, this amount is shown as a reduction
in owner’s capital, which in view of business entity concept appears as a liability in the
balance sheet of the business. Without such a distinction the affairs of the shop will be
mixed with the personal affairs of the owner. For a company the distinction is easier as
legally the company is a distinct entity from the persons who own it. Therefore, an entity is
a business organization or activity in relation to which accounting reports are compiled. It
may include universities, voluntary organizations, government and non-business units. What
we have stated above is just a superficial discussion of the concept, though the central point
has been brought out clearly. But we have to go at least a little deeper because out of this
basic concept, a large number of very important sub-concepts emerge, dealing with
ownership equities, without which we cannot understand properly many of the modern
accounting practices.
Pure Accounting Viewpoint : We will start from the fundamental accounting equation, that is:
Debit = Credit (I)
And, Assets = Liabilities (ii)
And, Assets = Internal Liabilities + External Liabilities (iii)
And finally, Assets = Capital + Liabilities; or A = C + L (iv)
2. Money Measurement Concept:
A record is made only of the information that can be expressed in monetary terms for
accounting purposes. The advantage of doing this is that money provides common
denominators by means of which variety of facts can be expressed as numbers that can be
added and subtracted. This enables addition and subtraction of varied items since money
provides the common denominator. An event even though important like the loyalty of the
workers will not be recorded unless it can be expressed in monetary terms. The changing
price level also creates difficulties in the monetary value.
If we look at financial accounting purely from the point of view of Fundamental Accounting
Equation:
Assets = Capital + Liabilities,
then it would be evident that it had virtually no option but to adopt monetary values of assets
and liabilities and capital to apply the equation in day-to-day business affairs. This concept
is basically concerned with the problem of measuring items of the accounting equation.
Such items may be plant and machinery (assets), liability for loan taken – all these are object
of some kind of the other. Other items represent events (transactions) such as expenses
and income. Basically, double entry system is additive (say, when finding the aggregate of
assets) or subtractive (say when total liabilities are deducted from total assets to find capital,
or deducting expenses from income to estimate profit). But only the "like" can be added
with the "like" and the "like" can be deducted from the "like", when the word "like" means
that the items involved are expressed in the same unit. But in real-world affairs, physical
assets may have to be expressed in several ways, like numbers of units, weight, volume,
etc. Likewise wages may have to be expressed in man-hours or simply in hours. Apart
from ensuring feasibility of making addition and subtraction, which is inherent in the
accounting equation, the sign of equality (actually the sign of "identity") needs use of the
same units in describing such items. In accounting the description is finally expressed
quantitatively in terms of money. In modern business it is essential link to accounting to a
market system in an exchange economy a valuable source of quantitative data. Since goods
and service are generally exchanged in terms of money, a monetary measurement of
economics data can be assumed to be useful in decision-making, particularly for that decision
relating to wealth and the production of goods and services.
3. Cost Concept :
The cost concept and the money measurement concept go hand in hand. Transactions are
recorded in the books at the price paid that is the cost. This avoids an arbitrary value being
placed on the asset and all subsequent accounting is in relation to the cost. Therefore, the
recording of the assets is at cost figures and this may not reflect the current market value
especially in the case of the older assets. The value of an asset in the accounting records
does not remain at the original cost because it is diminished systematically by virtue of its
use called expired cost and then shown at its depreciated value e.g. an asset of Rs. 1,00,000
is depreciated at 10%. Therefore, closing value will be Rs. 90,000 in the Balance Sheet. An
expired cost is an expenditure of money, the economic value of which has been made use
of during a particular year (or lost without accruing any benefit to the entity, like machinery
destroyed by flood). Every cost has to be recovered from the market through sales, otherwise,
the entity will suffer loss, that is, lose its capital. Depreciation, looked at from this viewpoint,
is nothing but gradual recovery of cost incurred, that is, money paid at a time during a
particular year for acquiring a fixed asset, during the subsequent years (during which the
asset is assumed to remain serviceable) on some estimated basis, by treating the expired
cost pertaining to a particular year, calculated on some approved and selected estimated
basis, by including such expired cost, called an expense, in the cost of production of that
particular accounting year. Linking annual depreciation with the expected service life of a
fixed asset does not endow any scientific logic on any estimated basis of depreciation. In
accounting, depreciation is nothing more and nothing less than a process of allocation of
some specific costs (cost of acquiring fixed assets) on some generally accepted (may or
may not be legally approved) estimated basis. An expired cost is not a money measure of
the wear and tear obsolescence (passage of time) etc. of any fixed assets. It is just a
reasonable basis for recovery of cost of fixed asset in a gradual manner. Money value of
wear and tear would need engineering analysis, which is not the domain of financial
accounting.
In essence, in a little more technical sense, cost represents the exchange price agreed upon
by the buyer and the seller in a relatively free economy. Cost has been the most common
valuation concept in the traditional accounting structure.
Therefore, cost is the exchange price of goods and services at the time they are acquired.
So, cost is also the economic sacrifice expressed in monetary terms required to obtain a
specific asset or a group of assets. Very often cost is not represented by a single exchange
price, but it includes many sacrifices of economic resources necessary to obtain the asset
in the form, location and time in which it can be useful to the operating activities of the firm.
4. Going Concern Concept :
Accounting assumes that the business will exist indefinitely into future and accordingly
transactions are recorded. If however, there is evidence that the firm will be liquidated then
market value of the assets and liabilities will be ascertained and necessary accounting
considered. In other cases where the business is an on-going activity resale value of assets
is irrelevant. The whole accounting is done based on this assumption.
The present concept as well as the earlier Business Entity concept belongs to the category
of "Environmental Postulates of Accounting". It is important to know the precise meaning
of this expression, for which purpose we have to know what an accounting postulate is and
what is environmental in accounting. In order to avoid a lengthy discussion, we may
summaries, by stating that postulates are basic assumption or fundamental propositions
concerning the economic, political and sociological environment in which accounting must
operate. Thus, it is clear that certain economic, political and sociological events do affect
the thinking and actions of accountants and we must also clearly understand that every
such event does not affect accounting concepts and practice. The basic criteria for any
such postulates are:
(1) They must be relevant to the development of accounting logic, that is, they must
serve as a foundation for the logical derivation of further propositions; and
(2) They must be accepted as valid by the participants in the discussion as either being
true or providing a useful starting point as an assumption in the development of
accounting logic.
5. Dual Aspect Concept :
The economic resources of an entity are assets and the acquisition of an asset must be on
account of : –
(a) some other assets being sold ; or
(b) the creation of an obligation to pay ; or
(c) there has been a profit owed to proprietor ; or
(d) the owner has contributed.
On the other hand, an increase in liability is on account of an increase in asset or a loss.
Therefore, at any time –
Assets = Liabilities + Capital
Capital = Assets – Liabilities
The owner’s share is what is left after paying outsiders. This is the accounting equation.
Every transaction has dual impact and accounting systems record both the aspects and are
called the double entry system. e.g. X starts a business with a capital of Rs.20,000. There
are two aspects of the transaction. On the one hand the business has assets of Rs. 20,000
while on the other hand it has to pay the proprietor Rs. 20,000, therefore: –
Capital (Equities) = Assets (Cash)
Rs. 20,000 = Rs. 20,000
What has been stated above is an oversimplified version of the concept and its application,
since this is the form of the concept with which we are familiar as beginners. But we have
to go a little deeper in order to have a more meaningful understanding of the concept
because it is the bedrock on which double entry book keeping has built its gigantic edifice
and is still flourishing as a very important discipline all over the world. There must be
something deeper than what has been stated above which caught the imagination of an
Italian priest and mathematician and prompted him to codify if not invent the double-entry
system in 1495 which explained logically and systematically what happens in the economic
world, in terms of money when goods are manufactured and sold at the market place
through financial transactions. This could be applied to sale of services equally logically,
and systematically. In course of time it also exposed other related concepts, especially the
first two concepts already discussed, namely the Business Entity concept and the Money
Measurement concept.
6. Realization Concept :
The realization concept indicates the amount of revenue that should be considered from a
given transaction. Realization refers to inflows of cash or claims to cash. It states that the
amount recognized as revenue is the amount that is reasonably certain to be realized.
Sometimes there is scope for difference of judgment as to how to ascertain "reasonably
certain". A situation arises when a company makes a credit sale and expects that the customer
will pay their bill. Experience shows that not all customers pay their bill. In measuring the
revenue for a period, the amount of credit sales that will not be realized should be reduced
by the estimated amount of credit sales that will never be realized i.e. by estimated amount
of bad debts. Example: If a company makes a credit sale of Rs 100,000 during a period and
experience indicates that 2% of credit sales will become bad debt, the amount of revenue
for the period is Rs 98,000 and not Rs 100,000. It does not anticipate events and stops the
business from inflating their profits by recording sales and incomes likely to accrue. Unless
money has been realized as cash or legal obligation to pay on sale, profit or income is
considered e.g. M places an order with N for supply of certain goods yet to be manufactured.
On receipt of order N purchases raw materials, employs workers, produces goods and
delivers to M. M makes payment on receipt of goods. In this case the sale is not at the time
of receipt of order but at the time when goods are delivered to M.
7. Accrual Concept :
Profit arises only out of business operation when there is an increase in the owner’s share
of the business and not due to his contribution to the business. Any increase in owner’s
equity is called revenue and any reduction in it termed as a loan. In fact, it is the direct
outcome of Realization Concept (already discussed) and the Accounting Period concept (to
be discussed). In a way, realization concept has been split up into two parts, namely,
production of economic goods or rendering of economic services, and realization of due
revenue. Any uncertainty about any of the two elements beyond what is considered
uncontrollable will not permit the accountant to treat the money value or cash equivalent of
the sale price to be considered as realized income. Another very vital element is involved in
between, that is, a third one, namely acquiring legal right to claim the price of the goods
delivered or fees for services rendered. Acquiring the legal right to claim the consideration
for goods/services is called accrual of revenue, which usually precedes collection. However,
in case of cash transactions, under the accrual method P/L A/c and Balance Sheet are
prepared on the accrual basis, in the absence of any uncertainty about collection. This does
not mean that collection has been given less importance than economic value adding and the
right to claim the purchase consideration. With uncertainty about collection, it is meaningless
and dangerous to take income into account as having been realized. In fact, ability to pay, is
considered by the supplier of goods and services before one decides to sell his products or
render his services to another. Then after the deal is finalized, goods have been delivered or
services rendered and legal right to claim the purchase consideration has been acquired,
collection is taken up as a specialized process to ensure return of capital and earning of
profit. The other pressure comes from the Accounting Period convention. Production is a
continuous process. True profit is cash profit during the entire lifetime of an enterprise.
Then and then only we know total money collected and spent by it during its lifetime. But
the way our culture has bound us up with annual profit, annual income and other periodic
results, we have divided the entire life-span of our organization into several chapters, each
chapter being an accounting period or an accounting year. A year consists of 12 months.
This is very significant, because each period being equal in terms of time frame, it facilitates
comparison of performances. Because of this Cost Accountants divide a year in 13 months,
each period consisting of 4 weeks. The process of dividing the life span of a company into
time–chapters which is an artificial man-made process, though production follows a
continuous flow, gives rise to certain accounting problems. For example, at the time of
closing of period/annual accounts, production and sale might have been completed, local
right to claim the sales value have been acquired, but payment has not yet come through.
8. Accounting Period Concept :
The accounting reports measure activities for a specified interval of time called the accounting
period, which is usually one year and therefore termed as annual reports. Interim reports in
between may be compiled especially for internal users. Except for those ventures which are
predetermined to end on the completion of a specific task or a specific time-frame, every
enterprise, profit-oriented or not, desires to enjoy perpetual existence as a going (running)
concern, making profits, grow and distribute profits judiciously. This calls for recognition
and measurement of incomes and expenses and to match them to ascertain profit. But, the
concept of profit is time-related. Hence, the question: profit for what length of time?
Theoretically, the most correct reply would be the entire life–time of an enterprise. That
means no measurement of income until an enterprise is wound up. But human beings
inherently, desire to know, periodic performances mainly for the purpose of comparison,
which would not be possible, different firms wind up after different lengths of time. Moreover,
from the practical point of view, some firms may not close down during a number of
successive generations. Hence no income tax for ages, too. Let us not extend the list of
such fanciful but important (academically) possibilities. Thus, out of practical considerations,
businessmen, sided by accountants, divide the life span of an entity into a number of chapters
of equal duration, usually a twelve-month period. Thus one phase of activities of an enterprise
is deemed to have passed – one chapter is closed. Such a 12-month chapter is called
accounting period. And financial accountants prepare a P/L A/c. for that period to estimate
its operating result, that is, profit or loss and the financial position as at the end of the period
in terms of assets, liabilities (external) and owners’ equity (internal liability).
Conventions:
The term "accounting conventions" refer to the customs or traditions, which are used as a
guide in the preparation of meaningful financial records in the form of the income statement
(Profit and Loss Account) and the position statement (Balance Sheet).
These are as follows.
1. Conservatism :
Financial statements are drawn on a conservatism basis where better evidence is required
of losses. This is necessary as Management and ownership are in different hands and a cut
is needed on management to show overoptimistic, favorable performance results. For
example, inventories are valued at the cost or market price whichever is lower. Revenues
are recognized when they are certain but expenses as soon as they are reasonably possible
e.g. it encourages the accountant to create provisions for bad and doubtful debts.
Since inception, it has come to mean the following:
a) delay in recognition of income;
b) expedite recognition of income;
Note : This obviously affects the reliability of the process of matching cost against
revenue.
c ) if in doubt, understate assets and income;
d) if in doubt, overstate liabilities and expenses.
Note : (c) and (d) above violate the postulates of consistency and therefore
comparability.
It may result in creation of Secret Reserves if overdone, which vitiates reliabilities of financial
statement as the opposite operation, namely, window-dressing. To day’s
accountants condemn both the practices. The driving-force behind conservatism is: it
is better to be wrong on the minus side than on the plus side of financial statements.
This is pessimism and not skeptics. An accountant should be sceptic and not a pessimist;
the former can be convinced by sound logic while the latter can be made to change her/his
mindset. Moreover, there is no standard by which the degree of conservatism may be
standardized. Hence, it becomes highly subjective and may even go to the length of
seriously affecting the doctrine
of disclosure.
2. Consistency :
This concept states that once the organization has decided on a method, it should use the
same method subsequently unless there is a valid reason for a change of method. If frequent
changes are made it is not possible to carry out comparisons on an inter-period or interfirm
basis. If a change is necessary it has to be highlighted. e.g. if depreciation is charged
on diminishing balance method, it should be done year after year.
It is an accounting postulate since it develops the growth of the subject of accountancy
with only a few constraints. By this standard, it is difficult to call conservatism an accounting
postulate since it acts as constraints in many cases, as we have seen above. The basic
prerequisite of the postulate of consistency is that the same accounting procedure, treatments,
approaches, techniques, tools, concepts and principles should be applied from year to year
within the firm; and also to the extent it is possible to ensure the same in all other
organizations. But there are difficulties in having uniform principles and concepts and tools
and procedures
to be used by all the firm within a country, if not globally, mainly because of the following
reasons:
a) Local custom, economic, social and political environments may differ from place
to place.
b) The different nature of business of different kinds and size.
c ) Presence of valid alternatives, accepted by law and standard – setting bodies
consistency serves two purposes, one directly and the other indirectly. Directly, it
facilitates comparison, which is a vital tool for complex decision-making. Indirectly,
when used over a considerable length of time it reduces risks surrounding operating
enterprises.
3. Matching :
When an event affects both revenues and expenses, the effect on each period should be
recognized in the same accounting period. This leads to matching concepts. The matching
concepts is applied by first determining the items that constitute revenues for the period and
their amounts in accordance with the conservatism concepts and then matching costs to
these revenues. Thus both the aspects of an event are recorded in terms of revenue and
expense in the same accounting period.
4. Disclosure :
Apart from legal requirements all significant information should be disclosed. The matching
concept states that all significant information should be disclosed and all insignificant
information should be disregarded. However, there are no definite rules to separate the two.
For recording purposes also only significant events are recorded in detail taking into
consideration the cost of detailed record keeping.
5. Materiality :
The accountant should attach importance to material details and ignore insignificant details.
The question what constitutes a material detail is left to the discretion of the accountant. An
item is material if there is reason to believe that knowledge of it would influence the
decision
of the informed investor. This has already been referred to above in connection with
Disclosure. In addition to what has already been discussed, the reader is to note the following
points:
a) Materiality of information b) Materiality of amount
c ) Materiality of procedure d) Materiality of nature
Materiality of Information : Misdescription of assets, liabilities, receipts and expenditures.
Likewise, wrong classification between Capital and Revenue would also come under this
category.
Materiality of Amount : This is a highly relative term. A fraud or an error of Rs. 5,000
may be material in a small organization while not so in a large organization. Which is why,
the Companies Act 1956 and MAOCARO, 1988 have indicated at different places as to the
degree (relatively) of tolerance. For example, an item of expense should be shown separately
if it constitutes a certain percentage of the total expenses for the period.
Materiality of Procedure : Every accountant knows that some procedures are superior to
others for certain purposes. For example, the various methods of depreciation,
treating liability for gratuity on Cash Basis and on Actuarial Basis, etc.
Materiality of Nature : Some items are material by nature regardless of the amount
involved and any other factor. A small error in such items will be considered as material
always. For example, Director’s Fees, Audit Fees, amount due from directors etc.
1.3 GOLDEN RULE OF ACCOUNTING
Duality concept provides that every transaction has two sides to it – (1) the debit and (2)
the credit. In other words every financial transaction involves the simultaneous receiving
and giving the value.
For the purpose of making accounting entries, it is necessary to understand the nature of
account. Accounting transactions involves recording of assets, debtors, expenses and capital,
creditors and incomes. Incomes and expenses are known as Nominal Accounts, Assets
and Capital are known as Real Accounts. In between these two groups, personal accounts
like debtors and creditors are also recorded in financial books.
The Golden Rule of accounting provides how the duality aspect of transactions is to be
recorded in the books of accounts. These rules are –
Nature of Account Rule
Nominal Account Debit all expenses and losses
Credit all incomes and profits
Real Account Debit what comes in and
Credit what goes out
Personal Account Debit the receiver and
Credit the giver.
The above rules are explained in the following transactions.
During the month of January 2001, ABC Ltd. has made the following transactions –
Item No. Date Transactions
1. January 1 Issued 10,000 shares of Rs. 10 each in cash
2. 2 Purchased machinery costing Rs. 50,000 from Y Ltd.
3. 3 Purchased raw materials from Z Ltd. worth Rs. 10,000
4. 15 Paid wages in cash Rs. 15,000
5. 17 Sold goods to PQR Ltd. for Rs. 25,000
6. 18 Paid cash to Y Ltd. Rs. 20,000
7. 19 Received from PQR Ltd. Rs. 20,000
Analysis of Transactions
Item No. 1 : ABC Ltd. received cash from its shareholders. Cash is an asset, a real account.
Cash is given by shareholders. Cash comes in — Cash A/c is debited and shareholders
giving the cash is debited.
Item No. 2 : Machinery is a real account and it comes in, Y Ltd. gives the machinery.
Therefore, Machinery A/c is debited and Y’s Ltd. A/c is credited.
Item No. 3 : Purchasing of goods is an expense. It is a nominal A/c and therefore should be
debited, Z Ltd. gives the goods, therefore, Z Ltd. A/c should be credited.
Item No. 4 : Wages is an expense, a nominal account, therefore, it should be debited. Cash
a real account which goes out and it should be credited.
Item No. 5 : Sale of goods resulted in an income, hence, credited. PQR Ltd. received the
goods hence PQR Ltd. A/c should be debited.
Item No. 6 : Y Ltd. is a personal account who receives the cash and thus Y Ltd. is debited;
cash a real account which goes out and is therefore credited.
Item no. Accounts involved Nature of A/c Dr.(Rs.) Cr.(Rs.
Financial Accounting Fundamentals
Item No. 7 : Cash comes in. Cash is a real A/c hence debited. PQR Ltd. gives the cash,
hence it is credited.
The entries relating to above transactions are given below :
)
1. Cash Real 1,00,000
Shareholders Personal A/c 1,00.000
2. Machinery Real 50,000
Y Ltd. Personal 50,000
3. Purchases Nominal 10,000
Z Ltd. Personal 10,000
4. Wages Nominal 15,000
Cash Real 15,000
5. PQR Ltd. Personal 25,000
Sales Nominal 25,000
6. Y Ltd. Personal 20,000
Cash Real 20,000
7. Cash Real 20,000
PQR Ltd. Personal 20,000
1.4 ACCOUNTING RECORDS
Accounting Records are maintained on the dual concept basis which states that –
Assets = Liabilities + Capital.
The above terms mean :–
I) Asset is a resource used to derive income in the future.
Assets are mainly classified as tangible or intangible. Tangible assets are those
assets which can be physically seen, such as land, building, plant, cash etc.
Intangible assets are those assets which cannot be physically seen e.g. goodwill,
patent, copy right, etc. Again, assets can be classified as fixed and current assets.
Fixed Assets are those assets which are held for a longer period of use e.g. land,
building, plant, goodwill, copyright, etc. Current Assets are those assets which are
held for a shorter period, generally not exceeding one year, such as cash, debtors,
stock, short term investments etc.
ii) Liability is an amount owed by a business or organization, e.g. creditors, loans
received, bank overdraft, etc. Capital is the amount owed by the proprietor, partners
or shareholders of a business or organization.
Thus the equation states that Assets are created by owing money to the owners of
the business (Capital) and other persons who owed money from the business
(Liabilities).
The equation is explained by the following.
On 31st March 2001 Mr. PQR resigned from his employment. On that date he
receives from his employer Rs. 15,000. On 1st April 2001, he started a business
with Rs. 15,000. On 2nd April he opened a Bank A/c by depositing Rs. 10,000 ; on
6th April he purchased 100 units of L at Rs. 10,000. He paid Rs. 5,000 in cash and
agreed to pay balance amount after one month.. On 7th April he sold 60 units of L
for cash and 30 units of L on 2 months credit term. Selling price per unit Rs. 120.
April 1 Cash introduced in business Rs. 15,000
Cash Rs. 15,000 = Proprietor’s Capital A/c 15,000
Asset (cash) = Capital + Liabilities
15,000 = 15,000 + 0
April 2 : Opened Bank A/c by depositing Rs. 10,000
Cash (15,000 – 10,000) + Bank (10,000) = Capital (15,000)
Asset (Cash + Bank) 15,000 = Capital (15,000) + Liability (0)
15,000 = 15,000 + 0
April 6 : Goods purchased for Rs. 10,000 paid Rs. 5,000 in cash; by the transaction
as on that his stock of goods amounted to Rs. 10,000. As he paid cash
Rs. 5,000, cash balance was nil and liability for goods purchased was
Rs. 5,000
Asset = Liabilities + Capital
Cash (0) + Bank (10,000) + Stock (10,000) = Capital (15,000) + Liability (5,000)
20,000 = 20,000
April 7 : He sold 60 units of L for cash @ Rs. 120. He therefore received Rs. 7,200 in cash
and 30 units of L for credit @ 120, therefore Rs. 3,600 becomes amount receivable. He
thus withdrew 90 units of L costing Rs. 9,000 which he sold at
Rs. 10,800 (Rs. 7,200 + Rs. 3,600). He therefore earned an income of Rs. 1,800 which
would increase his capital. The above transactions would affect the following Accounts :
Assets = Cash (0 + 7,200), Bank (10,000), Debtors 3,600 Stock (10,000 – 9,000)
Asset = Cash 7,200 + Bank 10,000 + Debtor 3,600 + Stock 1,000 = 21,800
Capital (15,000 + 1,800) = 16,800
Liability (Creditors) = 5,000
Total Assets (21,800) = Capital (16,800) + Liability (5,000)
1.5 BOOKS OF ACCOUNT
Journal :
The word journal means a diary or a day book. In older days all monetary transactions
were recorded in chronological order in the journal book based on golden rule of accounting.
The entries in journal in our earlier illustration would have been as follows :
Journal
Date Particulars Dr. (Rs.) Cr. (Rs.)
April 1 Cash 15,000
To PQR’s Capital A/c 15,000
April 2 Bank 10,000
To Cash 10,000
April 6 Goods/stock 10,000
To Cash 5,000
To Creditors 5,000
April 7 Cash 7,200
Debtors 3,600
To Goods/Stock 9,000
To Capital A/c 1,800
However in modern accounting systems the journal is mainly divided into three parts –
1. The General Journal.
2. Sales and Purchase Day Books or Journals
3. Sales Return and Purchase Return Books or Journals.
1. The General Journal is used for recording —
(a) Opening Entries
(b) Closing Entries, and
(c) Transaction of a special nature
In the general journal the following columns are normally provided.
Date Particulars LF Debit(Rs.) Credit(Rs.)
At the foot of each entry the narration is given which shows the nature of and where
necessary the authority for the entry passed.
The amount shown in the debit column of the journal entered on the debit side of the ledger
and the amount shown in the credit column of the journal are entered on the credit side of
the ledger.
2. Sales and Purchase Day Books or Journals.
Each credit sale (i.e other than cash sales) are entered in the Sales Day Book or Journal with
such details as are required e.g. date, name, invoice no., amount, discount allowed etc. At
periodical intervals say, monthly, quarterly, half yearly or yearly additions of all entries in the
Sales Day Book are made. The personal account of buyers are posted to the debit side of
each buyer’s account and the total amount of sale for the respective period is credited to
sales following the golden rules to debit the receiver and credit what goes out.
In case of credit purchase (i.e., other than cash purchase) purchases made by an enterprise
are similarly recorded and posted to the credit of the suppliers’ account in the ledger (Personal
A/c. credit the giver) and Purchase A/c is debited (Debit what comes in).
3. Sales Returns and Purchase Returns Day Books or Journals
These books or journals record sales and purchase returns. When goods already sold are
returned by the buyer, they are recorded in Sales Return Day Book. Similarly when good
purchased are returned to the buyer they are recorded in Purchase Return Day Book.
These journals occupy the converse position to the Day Books or Journals. Thus in case of
Sales Return Day Book, Sales or Return Inward A/c. is debited and the Personal A/c. is
credited. Similarly, when purchases are returned Purchase A/c is credited & Personal A/c
is debited.
Ledger
Ledger is defined as a “Book which contains in a summarized and classified form of permanent
record of all transactions. Ledger is called the principal book of account as final information
pertaining to financial position of a business emerges from this book. The form of an
account in the ledger is given below :
Dr. Title of the Account Cr.
Date Particulars JF Amount Date Particulars JF Amount
Rs. Rs.
Every account has a debit side and a credit side; Journal Folio or J.F. indicates the number
of the page of the journal where the other affected account appears.
Sometimes ledger is also maintained in a “ running account format” as follows –
Title of the Account
Date Particulars Folio Dr. Cr. Balance
Rs. Rs. Rs.
Posting of Entries
Consider the following Journal Entry :
Date Particulars L.F. Rs.(Dr.) Rs.(Cr.)
2003
May 18 Purchases A/c Dr. 5,000
To Bank A/c 5,000
(Being goods purchased).
The above journal entry when posted to the ledger accounts would appear as follows:
Dr. Purchases Account Cr.
Date Particulars JF Amount Date Particulars JF Amount
(2003) Rs. (2003) Rs.
May 18 To Bank A/c 5,000
[The debit side of the Purchase A/c is greater. To maintain symmetry the balance is carried
down (c/d) at the end of the month to the credit side and brought down again at the
beginning of the following month i.e., June 1st to the debit side. Thus it can be seen that the
Purchase A/c has a debit balance.]
Dr. Bank Account Cr.
Date Particulars JF Amount Date Particulars JF Amount
(2003) Rs. (2003) Rs.
May 18 By Purchases 5,000
Subdivision of the Journal
Where the number of transactions are many it would be time consuming and cumbersome
if each and every transaction were to be entered in a single Journal. Usually firms maintain
subsidiary books to record transactions. These books are
1. Cash Book (to record cash and bank transactions)
2. Petty Cash Book (to record cash payments involving small amounts)
3. Sales Book (to record credit sales)
4. Purchase Book (to record credit purchases)
5. Sales Return Book (to record return from customers)
6. Purchase Returns Book (to record return to suppliers)
7. Bills Receivable Book (to record acceptances received)
8. Bills Payable Book (to record acceptances given)
9. Journal Proper (to record transactions which cannot be entered in any of the above
specialized Journals)
1. Cash Book
All transactions relating to each cash are recorded in the cash book, and on the basis of
such a record ledger accounts are prepared. The different types of cash book are :
1. Simple Cash Book containing Cash Column only
2. Two Column Cash Book containing both Cash Column and Bank Column
3. Three Column Cash Book containing Cash, Bank and Discount columns.
(1) Simple Cash Book
The simple cash book is maintained strictly for cash transactions, a bank book being maintained
separately for bank transactions. The form of a simple cash book is like that of any other
account and is as follows:
Dr. Receipts Payments Cr.
Date Particulars LF Amount Date Particulars LF Amount
(2) Two Column Cash Book
Unlike the simple cash book the Two Column Cash Book combines both bank and cash
transactions for the sake of convenience due to the ever increasing bank transactions. The
ruling of this book is –
Dr. Receipts Payments Cr.
Date Particulars LF Cash Bank Date Particulars LF Cash Bank
Date Particulars LF Cash Bank Date Particulars LF Cash Bank
(1997) Rs. Rs. (1997) Rs. Rs.
The cash book is so ruled that the debit column of cash and bank are placed alongside each
other likewise with the credit column of cash and bank. The bank column contains details
of payment made by cheques and money received and paid into the bank A/c.
In the folio columns the letter “C” is used whenever cash is being paid into the bank or there
is a receipt from the bank, “C” means contra item and described transaction affecting only
cash and bank accounts.
Enter the following transactions in a two column cash book :
1997
Jan 1 Balances brought dawn – bank Rs. 5,000 and cash Rs. 450
3 Withdrew Rs. 2,000 from bank
5 Bought goods for Rs.1,500 paying by cheque
8 Purchased stationery by cash Rs.50
11 Paid electricity bill Rs.100 by cheque
15 Sold goods for Rs.2,000 and received cheque
20 Paid into bank Rs.150
Two Column Cash Book
Dr. Receipts Payments Cr.
Jan 1 To Balance b/d 450 5,000 Jan 3 By Cash C 2,000
Jan 3 To Bank C 2,000 Jan 5 by Purchases 1,500
Jan 15 To Sales 2,000 Jan 8 By Stationery 50
Jan 20 To Cash C 150 Jan 11 By Electricity 100
Jan 20 By Bank C 150
Jan 31 By Balance 2,250 3,550
2,450 7,150 2,450 7,150
Feb 1 To Balance b/d 2250 3,550
Payments can easily be identified as either cash or bank payments. If a payment is made
directly from bank account e.g., by a standing order it appears in the bank account column.
Payments of cash are entered in the cash column. When an amount is received by cheque
it should be recorded directly in the bank column. The banking on any cash is a separate
transaction.
May 10 To Joshi 4.50 145.50
32.50 1031.50
May 11 To Balance b/d 813.50
Basics of Financial Accounting
(3) Three Column Cash Book
The three column cash book has the cash and bank discount column. Cash discount is an
incentive given to customers to pay before the date specified. It encourages early payment
and when given to a customer is a loss and when received from a supplier is a gain. Since
this discount arises only when cash is received or paid it is recorded in the cash book,
discount allowed on the debit side and discount received on the credit side of the cash book.
The discount columns are totaled and not balanced. The form of a three column cash book
is illustrated with the following example:
2003 May 1 Balances Brought down – bank Rs. 3080, cash Rs. 709
2 Paid wages in cash Rs. 218
4 Received Rs. 177 cash from Kiran after allowing him a discount of Rs. 13.
6 Paid Ravi Rs.188 after deducting discount of Rs. 12 by cheque.
8 Received cheque for Rs. 485 from Ali after allowing him a discount of 3%.
10 Received cash from Joshi of Rs. 145.5 a discount 3% being deducted.
Date Particulars LF Disc. Cash Bank Date Particulars LF Disc. Cash Bank
(2003) Allowed Rs. Rs. (2003) Recd. Rs. Rs.
May 1 To Balance b/d 709 3080 May 2 By Wages 218
May 4 To Kiran 13 177 May 6 By Ravi 12 188
May 8 To Ali 15 485
. May 11 By Balance c/d 813.50 3377
3565 12 1031.50 3565
3377
The total of the debit discount column i.e., discount allowed is transferred to the discount
allowed account in the ledger. Similarly, discount received (credit discount column) is
transferred to the discount received account in the ledger.
Petty Cash Book
In any business there will be numerous small cash payments. It would be advantageous if
these payments could be kept separate from the main cash book. This separate book is
called Petty Cash Book.
Advantages of maintaining a Petty Cash Book are :–
(I) It saves the time of the General Cashier.
(ii) As the record of Petty Cash is checked by the cashier periodically, so the mistake
is rectified immediately.
(iii) Under Imprest System, the Petty Cashier is not allowed to keep idle cash with him.
(iv) The chance of misappropriation is less.
(v) It trains the staff to handle money with responsibility.
(vi) It reduces the work load of general Cashier and the volume of General Cash Book
becomes small.
The Imprest System
In this system the cashier gives the petty cashier a fixed amount of cash to meet his needs
for the ensuing period. At the end of the period the cashier ascertains the amount spent by
the petty cashier and reimburses the same to him. The petty cash in hand will then be equal
to the original amount at the beginning of the period.
Amount given by cashier at the beginning Rs. 200
Expenses during the period Rs. 142
Petty cash in hand Rs. 58
Reimbursement from cashier Rs. 142
Petty cash at the end of the period Rs. 200
2003
July 1 The cashier of a firm gives Rs. 200 as imprest to the petty cashier.
Payments of petty cash during July are :
2 Postage stamps purchased Rs. 10
3 Pencils bought Rs. 3
4 Busfare Rs. 3
5 Cleaning charges Rs. 15
6 Wages to coolie for shifting furniture Rs. 15
9 Taxi fare paid Rs. 10
10 Refreshments bought for customers for Rs. 17
14 Telegram charges Rs. 7
15 Stationery bought Rs. 9
17 Repair of chair Rs. 12
18 Battery for clock purchased Rs. 6
21 Stamps bought Rs.8
23 Spare keys made for manager’s cabin Rs.5
24 Busfare Rs. 2
26 Casual labor Rs. 9
27 Carbon paper Rs.5
29 Newspaper (special edition) Rs. 3
30 Busfare Rs. 3
Write up the petty cash book, cash book and the necessary ledger accounts.
Dr. Petty Cash Book Cr.
Receipt Payment
Date Particulars Amt. Date Particulars Total Pos- Stati- Trave- Clea Other
(2003) Rs. (2003) Rs. -tage -nery -lling -ning expns.
July 1 To Cash Book 200
Jul 2 By Postage 10 10
3 By Stationary 3 3
4 By Travelling 3 3
5 By Cleaning 15 15
6 Other Expns. 15 15 Wages. to
coolie
9 By Travelling 10 10
10 By other Expns. 17 17 Refreshment
14 By Postage 7 7
15 By Stationery 9 9
17 By other Expns. 12 12 Repair of
chair
18 By other Expns. 6 6 battery
21 By Postage 8 8
23 By Other Expns. 5 5 Spare Key
24 By Travelling 2 2
26 By Other Expns. 9 9 Casual
labor
27 By Stationery 5 5
29 By Other Expns. 3 3 Newspaper
(spl. edition)
Aug 1 To Balance b/d 58
Aug 1 To Cash 142
30 By Travelling 3 3
142 25 17 18 15 67
31 By Balance b/d 58
200
Dr. Cash Book Cr.
Date Particulars LF Cash Bank Date Particulars LF Cash Bank
(2003) Rs. Rs. (2003) Rs. Rs.
July 1 By Petty Cash 200
GENERAL LEDGER
Dr. Travelling Account Cr.
Date Particulars Amount Date Particulars Amount
(2003) Rs. (2003) Rs.
July 31 To Petty Cash 18
Dr. Printing & Stationery Account Cr.
Date Particulars Amount Date Particulars Amount
(2003) Rs. (2003) Rs.
July 31 To Petty Cash 17
Dr. Postage & Telegram Account Cr.
Date Particulars Amount Date Particulars Amount
(2003) Rs. (2003) Rs.
July 31 To Petty Cash 25
Similarly there will be Clearing Expenses and Other Expenses Accounts.
3. Sales Book
The sales book records all credit sales of goods of business, cash sales are recorded in cash
book. The form of a sales book can be explained with the following example :
Transactions of Beauty Ltd.
2003
June 1 Sold to P Ltd. 25 jars of cream @ Rs. 37 and 200 packets of powder
@ Rs. 9.50 each less T.D. @ 10%.
2 Sold old books to B Ltd. on credit Rs. 750
4 Sold to S stores 35 packets of powder @ Rs. 9.50 for cash.
7 Sold to A departmental stores 310 packets of powder @ Rs. 9.50 and
40 jars of cream @ Rs. 36 each less T.D. @ 10%.
Sales Book
Date Particulars LF Invoice No. Amount Amount
(2003) Rs. Rs.
Jun 1 P. Ltd.
– 25 jars of cream @ Rs. 37 925.00
– 200 packets of powder @ Rs. 9.50 1,900.00
2,825.00
Less : T.D. @ 10% 282.50 2,542.50
Jun 7 A Departmental Stores
– 40 jars of cream @ Rs. 36 1,440.00
– 310 packets of powder @ Rs. 9.50 2,945.00
4,385.00
Less : T.D. @ 10% 438.50 3,946.50
6,489.00
Note. Cash sales and sale of the old books (asset) in cash are not entered in the sales book.
Trade discount is allowed where a customer purchases goods above a certain quantity or
amount. Only the net amount i.e., after deduction of trade discount is considered. No entry
is made in the ledger accounts.
Dr. Sales Account Cr.
Date Particulars Amount Date Particulars Amount
(2003) Rs. (2003) Rs.
June 01 To Balance c/d 6821.50 04 By Cash 332.50
07 By Sales as per sales book 6489.00
6821.50 6821.50
Difference between Trade discount and Cash discount
Cash Discount Trade Discount
When payment is made earlier than It is normally allowed on purchases.
the stipulated date.
Cash discounts allowed/ received Trade discount is not entered in ledger.
are accounted for in the ledger.
It is not deducted from the invoice. The amount of trade discount is deducted from the invoice.
4. Purchase Book
The purchase book records all credit purchases of goods of business, cash purchases and
credit purchases of assets are not entered in this book. The form of a purchase book can be
explained with the following illustration.
Illustration 5 :
Transaction of M/s Sporting Ltd.
2003
July 1 Purchased from Indian Sports Co. on credit 75 cricket bats at Rs. 100 each 90
footballs at Rs. 80 each less trade discount at 10%.
July 3 Purchased from Gripwell Co. 45 hockey sticks at Rs. 85 each for cash.
July 7 Purchased vacuum cleaner for office use from M/a Spic & Span on credit Rs. 3050
July 8 Purchased on credit from Wicket Pvt. Ltd. 40 Cricket bats at Rs. 105 each 70
footballs at Rs. 82 each less trade discount at 10%
July 9 Purchased from Green & Co. 15 Hockey sticks at Rs. 75 each on credit.
Purchase Book
Date Particulars LF Amount Amount
(2003) Rs. Rs.
July 1 Indian Sports Co. 75 Cricket bats @ Rs. 100 each 7,500.00
90 Footballs @ Rs. 80 each 7,200.00
14,700.00
Less : Trade Discount 10 % 1,470.00 13,230.00
July 8 Wicket Pvt. Ltd. 40 Cricket bats @ Rs. 105 each 4,200.00
70 Footballs @ Rs. 82 each 5,740.00
9,940.00
Less : Trade Discount 10% 994.00 8,946.00
July 9 Green and Company 15 Hockey Sticks @ Rs. 75 each 1,125.00
Total 23,301.00
Cash purchases of goods and purchase of assets (i.e., vacuum cleaner) are not entered in
the purchase book. From the purchase book a purchase account is prepared.
Note. The Purchase account records the cash purchases also.
Dr. Purchase Account Cr.
Date Particulars JF Amount Date Particular JF Amount
(Jul ’03) Rs. (Jul, ’03) Rs.
3 To Cash 3825.00 Oct 9 By Balance c/d 27126.00
9 To Purchases as per
purchase book 23301.00
27126.00 27126.00
Dr. Purchase Ledger Cr.
Date Particulars Amount Date Particular Amount
(Jul ’03) Rs. (Jul, ’03) Rs.
1 By Purchases A/c
Wicket Pvt. Ltd. 8946.00
8 By Purchases A/c 23,301.00
5. Sales Return Book
The sales return book is also known as Returns Inward Book.
Where customers frequently return the goods sold to them it would be convenient to record
the returns in a separate book called the Sales Return Book. Where goods are returned by
customers a document known as credit note will be sent to them, showing the amount of
allowance given in respect of the returns. The term credit note takes its name from the fact
that the customer’s account will be credited with the amount of the allowance, so as to
show the reduction in the amount owed by him. The Sales Return Book is illustrated below
with assumed figures :
Sales Returns Book
Date Particulars JF Amt. Amt.
(July 2003) Rs. Rs.
5 Indian Glassware Co.
20 Glass Cups @ Rs. 8 160.00
Less : Trade Discount @ 10@ 16.00 144.00
27 Hindustan Dept. Stores
15 Coffee Cups @ Rs. 10 150.00
Less : Trade Discount @ 10% 15.00 135.00
Total 279.00
Jul 5 To Balance c/d
Dr.
Date Particulars
Jul 27 To Balance c/d
Financial Accounting Fundamentals
The form of credit note is illustrated below :
To,
Bric - A - Brac Co. Ltd.
19, Lal Street,
Delhi - 110 103
Indian Glassware Co.
15, N.S.C. Road
Chennai - 600 052
Credit Note No. 8/83
Per unit
Rs.
Rs.
20 Glass Cups 8.00 160.00
Less : Trade discount 10% 16.00
Total 144.00
The total of the Sales Return Book is transferred to the sales returns account.
Dr. Sales Return Account Cr.
Date Particulars JF Rs. P Date Particulars JF Rs. P
(2003) (2003)
Jul 31 To Sales 279.00 Jul 31 By Balance c/d 279.00
returns as per
sales return book .
279.00 279.00
Aug 1 To Balance b/d 279.00
Dr. Indian Glassware Co. Account Cr.
Date Particulars JF Rs. P Date Particulars JF Rs. P
144.00 Jul 5 By Sales Returns 144.00
144.00 144.00
Jul 6 By Balance b/d 144.00
Hindustan Departmental Store Cr.
JF Rs. P Date Particulars JF Rs. P
135.00 By Sales Returns 135.00
135.00 135.00
Jul 28 By Balance b/d 135.00
May 15 To Returns Outward
May 16
To
Balance c/d
Dr.
6. Purchases Returns Book
When goods are returned to suppliers these are recorded in the Purchases Returns or
Returns Outward Book. A debit note is sent to the supplier stating the amount of allowance
to which the firm returning the goods is entitled. The term Debit Note stems from the fact
that as the liabilities to the supplier is accordingly reduced and his personal account must be
debited to record this. The Return Outward book is illustrated below.
Returns Outward Book
Date Particulars JF Rs. Rs.
May 15 Travel Luggage Co.
2 40” Suitcases @ Rs. 500 1,000.00
Less : Trade discount @ 10% 100.00 900.00
May 26 Bags & Bags Co
One 24” travel bag 200.00
Total 1,100.00
The total of the Returns Outward Book is transferred to the Returns Outwards account.
Dr. Return Outward Account Cr.
Date Particulars JF Rs. P Date Particulars JF Rs. P
May 31 To Balance c/d 1,100.00 May 31 By Returns 1,100.00
Less : Outwards as per
. Returns Outwards Book .
1,100.00 1,100.00
June 1 By Balance b/d 1,100.00
Dr. Travel Luggage Co. Cr.
Date Particulars JF Rs. P Date Particulars JF Rs. P
900.00 May 15 By Balance c/d 900.00
900.00 900.00
900.00
Bags & Bags Co. Cr.
Date Particulars JF Rs. P Date Particulars JF Rs. P
May 26 To Returns Outward 200.00 May 26 By Balance c/d 200.00
200.00 200.00
May 27 To Balance b/d 200.00
Sr. No. From whom Acceptor Date of Term Date of Amount How
received bill maturity disposed of
7. Bills Receivable Books
When the number of bills or promissory notes received is large, instead of journalising each
receipt of bills, which would be cumbersome, a register to record all receipts of bill is
maintained. Every month this register are totaled. Receipts of cash in respect of bills will
be recorded in the cash book. Only the endorsement of bills in favour of other parties or
dishonour will be journalised. The Bill Receivable Book can be illustrated with the following
example :
Illustration
X received the following bills :
Sept 5 Drew on A a bill of exchange at 3 months which was accepted and returned by
him on 5th Sept. 2002. The amount being Rs. 1,500.
Sept 20 Drew on C a bill of exchange for Rs. 2,500 at 2 months which was accepted on
the same day. The bill was payable at Union Bank of India.
Bills Receivable Book
1 A A Sept 5 3 mths Dec. 8 1,500
2 C C Sept 20 2 mths Nov 23 2,500
4,000
The total of the Bills Receivable is transferred to the Bills Receivable A/c.
Dr. Bills Receivable Account Cr.
Date Particulars JF Rs. P Date Particulars JF Rs. P
1996
Sep 30 To Sundries as per 4,000.00
Bills Receivable Book
Dr. A’s Account Cr.
Date Particulars JF Rs. P Date Particulars JF Rs. P
2002
Sep 5 By Bills Receivable A/c 1,500.00
STUDY MATERIAL PREPARED BY ICWAI FOR J.A.O (CIVIL) EXAMINATION
31
Sr. No. Date of To whom Term Date of Where Amount Remarks
issue given maturity maturity Rs.
Basics of Financial Accounting
8. The Bills Payable Book
The Bills Payable Book recording the acceptances given can be illustrated with the following
example.
Illustration 7 :
M accepted the following bills.
2002
Aug 13 Accepted P’s bill for Rs. 3,000 due in one month.
Aug 17 Accepted Q’s bill for Rs. 5,000 due in two months payable at Canara Bank
Bills Payable Book
1 Aug 13 P 1 mth Sep 16 — 3,000
2 Aug 17 Q 2 mth Nov 20 Canara Bank 5,000
8,000
Dr. Bills Payable Account Cr.
Date Particulars JF Rs. P Date Particulars JF Rs. P
2002
Aug 31 By Sundries 8,000.00
as per Bills Payable Book
Dr. P’s Account Cr.
Date Particulars JF Rs. P Date Particulars JF Rs. P
2002
Aug 13 To Bills Payable A/c 3,000.00
Dr. Q’s Account Cr.
Date Particulars JF Rs. P Date Particulars JF Rs. P
2002
Aug 17 To Bills Payable A/c 5,000.00
9. Journal Proper
All transactions which do not find place in the subsidiary books find place in the journal
proper. Opening entries, closing entries, adjustment entries, rectification entries etc. appear
in the journal proper. [All these entries are explained in detail in subsequent Study Notes ].
e.g. Purchase of fixed asset on credit :
Asset A/c Dr.
To Creditor’s A/c
e.g. Drawings made by the proprietor
a) Cash drawn
Drawings A/c Dr.
To Bank/Cash A/c
b) Goods withdrawn at sale or purchase price for personal use :
Drawings A/c Dr.
To Purchase/Sale A/c
1.6 TRIAL BALANCE
In the double entry system every entry has its corresponding credit and debit. It follows,
that at any given point of time, the posting from Journal, day books and cash book to the
ledger is completed, the debit balances standing in all the ledgers including the cash book
will equal the credit balances. At the end of the financial period (or at some other date) these
balances are extracted and a schedule is prepared in journal form is called a Trial Balance.
Thus the total of debit balances appearing in the Trial Balance must agree with the total of
credit balances of appearing in the Trial Balance.
The next stage after posting accounts to the ledger is the preparation of a Trial Balance. The
debit and credit balances of accounts are entered in this statement. The total of the debit and
the total of the credit side must agree. An agreement indicates reasonable accuracy of the
accounting work.
The trial balance helps in ascertaining arithmetical accuracy of the ledger accounts, location
of errors and in the preparation of financial statements.
Objects of preparing Trial Balance :
1. It forms the very basis on which final accounts are prepared.
2. It helps in knowing the balance on any particular account in the ledger.
3. It is used as a test of arithmetical accuracy.
However, a Trial Balance is not a conclusive proof of absolute accuracy of the accounts. It
does not indicate the absence of an error. Thus, a non-tallied Trial Balance indicates the
presence of book-keeping errors.
Errors disclosed by the Trial Balance :
A Trial Balance will not agree on account of the following errors :
(I) Wrong posting of entries i.e. A debit entry of Rs. 1,000 for purchase of furniture
wrongly posted as Rs. 100 in the account.
(ii) Omission of posting of debit or credit e.g. A debit entry of Rs. 1,000 for purchase
of furniture is not posted at all.
(iii) Duplication of posting e.g. when debit entry of Rs. 1000 for purchase of furniture
has been posted twice in the account.
(iv) Wrong side of posting e.g. when debit entry is posted on the credit side or credit
entry is posted on the debit side, e.g. when a debit entry of Rs. 1000 is posted on
the credit side, i.e. when debit entry of Rs. 1000 is posted on the credit side and
vice versa.
(v) Errors in casting the totals of debit or credit side of the Trial Balance.
(vi) Wrong transfer of balances in the Trial Balance.
(vii) Omission of entering the balance of account in the Trial Balance.
(viii) Balance of cash book omitted to be recorded in the Trial Balance.
(ix) Wrong balancing of account.
(x) Errors in the total or posting or entries of subsidiary book.
(xi) Wrong carry forward of balance in the various books, i.e. day books, cash book,
etc.
Errors not disclosed by Trial Balance
The following errors do not affect the agreement of the Trial Balance :
(I) Errors or omission ; omission to record any transaction
(ii) Posting of wrong amount both debit and credit side of the account
(iii) Error made in posting of debit or credit entry is compensated by an identical error
of equal amount. These errors are known as compensating errors.
(iv) Errors made in posting a transaction on the correct side of wrong account.
(v) Recording a transaction twice erroneously. These are known as errors of duplication.
(vi) Errors of principle – when the accounting principle is disregarded e.g. a capital
item as revenue item and vice versa, i.e. purchase of furniture posted to Purchases
Account.
Methods of locating errors in Trial Balance :
The following are some of the ways of detecting errors in the Trial Balance –
(I) When digits are wrongly interchanged — it causes the error to occur in multiples
of 9. Therefore the difference is a multiple of 9, there are good chances of error
occurring in transposition of digits, i.e. when 97 is recorded as 79.
(ii) When the difference is an even number divide by 2 and check whether such an
amount is wrongly entered on the wrong side of debit or credit.
(iii) If the difference is a multiple of 10 or 100 or 1000, then there are chances of the
error occurring in the totalling.
(iv) Ensure that all the balances of ledger accounts have been considered in the Trial
Balance.
(v) Ensure that there is no omission of recording the balances from the subsidiary
books or cash book.
(vi) Check all the postings and totals.
If the difference still persists, it should be transferred temporarily to Suspense Account and
on locating the errors at a future date, the Suspense Account can be closed.
The format of a trial balance is as follows :
Trial Balance
Ledger Accounts Debit Credit
Rs. Rs.
Where the debit and the credit totals of the trial balance do not agree it is an indication that
one or more errors have been made. (These errors are discussed in detail in ). The trial
balance is the stepping stone for the preparation of financial statements.
From the following particulars prepare a Trial Balance as on 30th September 2001 :
Stock 1st October 2000 Rs. 1,380, Debtors Rs. 2,960, Creditors Rs. 1,580, Capital Account
1st Oct. 2000 Rs. 4,100, Drawings Rs. 1,200, Bills Receivable Rs. 770, Bad Debt written
off Rs. 190, Provision for Bad and Doubtful Debts Rs. 160, Bills Payable Rs. 470, Wages &
Salaries Rs. 1,920, Purchases Rs. 6,580, Sales Rs. 10,670, Bank Rs. 580, Cash Rs. 40,
Rent, Rates & Insurance Rs. 330, Sales Returns Rs. 410, Purchases Returns Rs. 280,
Fixtures & Fittings Rs. 550, General Expenses Rs. 200, Discounts allowed Rs. 520, Discounts
Recd. Rs. 370.
Trial Balance as on 30th Sept. 2001
Dr. Cr.
(Rs.) (Rs.)
Stock 1st Oct. 2000 1,380
Debtors and Creditors 2,960 1,580
Capital Account 1st Oct.2000 4,100
Drawings 1,200
Bills Receivable 770
Bad Debt written off 190
Provision for Bad & Doubtful Debts 160
Bills Payable 470
Wages and Salaries 1,920
Purchases & Sales 6,580 10,670
Bank 580
Cash 40
Rent, Rates & Insurance 330
Sales & Purchases Returns 410 280
Fixtures & Fittings 550
General Expenses 200
Discounts 520 370
17,630 17,630
Journalise the following transactions and post them to Ledger and balance
the accounts. Also prepare a Trial Balance as on 30th April 2003.
2003.
April 1 Ravi started business with Rs. 15,000 of which Rs. 4,000 were borrowed at 15% p.a.
from Shri Sashi.
2 Purchased goods worth Rs. 4,000 from Anant at 2% trade discount.
3 Cash sales to Madan Rs. 1,200.
6 Credit sales to Salvi Rs. 2,000 less trade discount 2%.
9 Pard cash Rs. 1,950 to Anant and received discount of Rs. 10
12 Received Rs. 1,950 from Salvi in full settlement of his dues.
14 Returned goods of the price of Rs. 100 to Anant.
16 Paid into bank Rs. 5,000.
18 Issued a cheque for Rs. 1,000 to Anant on account.
19 Purchased goods of Rs. 2,000 from Anant.
22 Sold foods costing Rs. 1,000 at 25% profit to Ratan.
22 Received commission Rs. 800 from S & Co.
24 Received a cheque for Rs. 395 from Ratan & he was allowed discount Rs. 5.
25 Ratan returned goods of Rs. 50.
30 Paid Interest on loan Rs. 50 to Sashi.
30 Paid Salaries Rs. 2,000 out of which Rs. 1,200 paid by cheque.
30 Paid into Bank Rs. 500.
30 Paid Office Rent by cheque Rs. 300.
Solution : JOURNAL
Date (2003) Particulars L.F. Dr. (Rs.) Cr. (Rs.)
Apr 1 Cash A/c Dr. 15,000
To Capital A/c 11,000
To Sashi’s Loan A/c 4,000
(Cash brought into business and loan taken from Sashi
@ 15% to start the business)
Apr 1 Purchases A/c Dr. 3,920
To Anant’s A/c 3,920
(Credit purchases from Anant)
Apr 3 Cash A/c Dr. 1,200
To Sales A/c 1,200
(Cash sales)
Apr 6 Salvi’s A/c Dr. 1,960
To Sales A/c 1,960
(Credit Sales to Salvi)
Apr 9 Anant’s A/c Dr. 1,960
To Cash A/c 1,950
To Discount A/c 10
(Paid cash to & received discount from Anant.)
Apr 12
Cash A/c
Dr.
1,950
Discount A/c Dr. 10
To Salvi’s A/c 1,960
(Received cash from & allowed discount to Salvi)
Apr 14 Anant’s A/c Dr. 98
To Returns Outwards A/c 98
(Returned goods to Anant)
Apr 16 Bank A/c Dr. 5,000
To Cash A/c 5,000
(Paid cash into Bank)
Apr 18 Anant A/c Dr. 1,000
To Bank A/c 1,000
(Issued a cheque to Anant)
Apr 19 Purchase A/c Dr. 2,000
To Anant A/c 2,000
(Credit purchases from Anant)
Apr 22 Ratan’s A/c Dr. 1,250
To Sales A/c 1,250
(Credit sales to Ratan)
Apr 22 Cash A/c Dr. 800
To Commission A/c 800
(Received commission)
Apr 24
Cash A/c
Dr.
395
Discount A/c Dr. 5
To Ratan’s A/c 400
(Received a cheque from & allowed discount to Ratan)
Apr 25 Returns Inwards A/c Dr. 50
To Ratam’s A/c 50
(Received goods returned by Ratan)
Apr 30 Interest A/c Dr. 50
To Cash A/c 50
(Paid interest for April 1993, to Sashi on loan taken
from him)
Apr 30 Salaries A/c Dr. 2,000
To Cash A/c 800
To Bank A/c 1,200
(Paid salary Rs. 800 in cash and Rs. 1,200 by cheque)
Apr 30 Bank A/c Dr. 500
To Cash A/c 500
(Paid cash into bank)
Apr 30 Rent A/c Dr. 300
To Bank A/c 300
(Issued a cheque for office rent for April, 1993)
Date Particulars Amount Date Particulars Amount
2003 Rs. 2003 Rs.
Date Particulars Amount Date Particulars Amount
2003 Rs. 2003 Rs.
LEDGER
Dr. Cash Account Cr.
Apr 1 To Capital A/c 11,000 Apr 9 By Anant’s A/c 1,950
Apr 1 To Sashi’s Loan A/c 4,000 Apr 16 By Bank A/c 5,000
Apr 3 To Sales A/c 1,200 Apr 30 By Interest A/c 50
Apr 12 To Salvi’s A/c 1,950 Apr 30 By Salaries A/c 800
Apr 22 To Commission A/c 800 Apr 30 By Bank A/c 500
Apr 24 To Ratan’s A/c 395 Apr 30 By Balance c/d 11,045
19,345 19,345
May 1 To Balance b/d 11,045
Dr. Bank A/c Cr.
Apr 16 To Cash A/c 5,000 Apr 18 By Anant’s A/c 1,000
Apr 30 To Cash A/c 500 Apr 30 By Salaries A/c 1,200
Apr 30 By Rent A/c 300
Apr 30 By Balance c/d 3,000
5,500 5,500
May 1 To Balance b/d 3,000
Dr. Salaries A/c Cr.
Date Particulars Amount Date Particulars Amount
2003 Rs. 2003 Rs.
Apr 30 To Cash A/c 800 Apr 30 By Balance c/d 2,000
Apr 30 To Bank A/c 1,200
2,000 2,000
May 1 To Balance b/d 2,000
Dr. Rent A/c Cr.
Date Particulars Amount Date Particulars Amount
2003 Rs. 2003 Rs.
Apr 30 To Bank A/c 300 Apr 30 By Balance c/d 300
300 300
May 1 To Balance b/d 300
Date Particulars Amount Date Particulars Amount
2003 Rs. 2003 Rs.
Dr. Commission A/c Cr.
Date Particulars Amount Date Particulars Amount
2003 Rs. 2003 Rs.
Apr 30 To Balance c/d 800 Apr 22 By Cash A/c 800
800 800
May 1 By Balance b/d 800
Dr. Interest A/c Cr.
Date Particulars Amount Date Particulars Amount
2003 Rs. 2003 Rs.
Apr 30 To Cash A/c 50 Apr 30 By Balance c/d 50
50 50
May 1 To Balance b/d 50
Dr. Discount A/c Cr.
Apr 12 To Salvi’s A/c 10 Apr 9 By Anant 10
Apr 24 To Ratan’s A/c 5 Apr 30 By Balance c/d 5
15 15
May 1 To Balance b/d 5
Dr. Capital A/c Cr.
Date Particulars Amount Date Particulars Amount
2003 Rs. 2003 Rs.
Apr 30 To Balance c/d 11,000 Apr 1 By Cash A/c 11,000
11,000 11,000
May 1 By Balance b/d 11,000
Dr. Sashi’s Loan A/c Cr.
Date Particulars Amount Date Particulars Amount
2003 Rs. 2003 Rs.
Apr 30 To Balance c/d 4,000 Apr 1 By Cash A/c 4,000
4,000 4,000
May 1 By Balance b/d 4,000
Date Particulars Amount Date Particulars Amount
2003 Rs. 2003 Rs.
Dr. Salvi’s A/c Cr.
Date Particulars Amount Date Particulars Amount
2003 Rs. 2003 Rs.
Apr 6 To Sales A/c 1,960 Apr 12 By Cash A/c 1,950
Apr 12 By Discount A/c 10
1,960 1,960
Dr. Anant’s A/c Cr.
Apr 9 To Cash A/c 1,950 Apr 2 By Purchases A/c 3,920
Apr 9 To Discount A/c 10 Apr 19 By Purchases A/c 2,000
Apr 14 To Returns Outwards A/c 98
Apr 18 To Bank A/c 1,000
Apr 30 To Balance c/d 2,862
5,920 5,920
May 1 By Balance b/d 2,862
Dr. Ratan’s A/c Cr.
Date Particulars Amount Date Particulars Amount
2003 Rs. 2003 Rs.
Apr 22 To Sales A/c 1,250 Apr 24 By Cash A/c 395
Apr 24 By Discount A/c 5
Apr 25 By Returns Inwards A/c 50
Apr 30 By Balance c/d 800
1,250 1,250
May 1 To Balance b/d 800
Dr. Purchases A/c Cr.
Date Particulars Amount Date Particulars Amount
2003 Rs. 2003 Rs.
Apr 2 To Anant 3,920
Apr 19 To Anant 2,000 Apr 30 By Balance c/d 5,920
5,920 5,920
May 1 To Balance b/d 5,920
Dr. Sales A/c Cr.
Date Particulars Amount Date Particulars Amount
2003 Rs. 2003 Rs.
Apr 3 By Cash A/c 1,200
Apr 6 By Salvi A/c 1,960
Apr 30 To Balance c/d 4,410 Apr 22 By Ratan A/c 1,250
4,410 4,410
May 1 By Balance b/d 4,410
Dr. Returns Outward A/c Cr.
Date Particulars Amount Date Particulars Amount
2003 Rs. 2003 Rs.
Apr 30 To Balance c/d 98 Apr 14 By Anant 98
98 98
May 1 By Balance b.d 98
Dr. Returns Inwards A/c Cr.
Date Particulars Amount Date Particulars Amount
2003 Rs. 2003 Rs.
Apr 25 To Ratan’s A/c 50 Apr 30 By Balance c/d 50
50 50
May 1 To Balance b/d 50
TRIAL BALANCE as on 30th April, 2003.
Dr. (Rs.) Cr. (Rs.)
Cash A/c 11,045
Bank A/c 3,000
Salaries A/c 2,000
Rent A/c 300
Commission A/c 800
Interest A/c 50
Discount A/c 5
Capital A/c 11,000
Sashi’s Loan A/c 4,000
Creditor (Anant) 2,862
Debtor (Ratan) 800
Purchases A/c 5,920
Sales A/c 4,410
Returns Outwards A/c 98
Returns Inwards A/c 50
23,170 23,170
Date Particulars Cash Bank Date Particulars Cash Bank
2002 Rs. Rs. 2002 Rs. Rs.
Financial Accounting Fundamentals
FINAL ACCOUNTS
2.0 ELEMENTS OF FINANCIAL STATEMENTS
The elements which are directly related to the measurement of financial position are assets,
liabilities and equity. The elements which are directly related to the measurement of profit
are income and expenses.
Asset : An asset is a resource controlled by the enterprise as a result of past events and
from which future economic benefits are expected to flow to the enterprise.
Liability : A liability is a present obligation of the enterprise arising from past events the
settlement of which is expected to result in an outflow from the enterprise of resources
embodying economic benefits.
There is a distinction between a present obligation and future commitment. A decision by
the management of an enterprise to acquire assets in future does not of itself give the rise to
a present obligation.
Equity : In a corporate enterprise equity is classified in the Balance Sheet as Share Capital
and Reserve and Surplus. Normally Equity is shown at its paid up value.
Income and Expenses : Income is increase in economic benefits during the accounting
period in the form of inflows or enhancement of assets or decrease of liability that result in
increase of equity. Whereas expenses are decreases in economic benefits during the
accounting period in the form of' outflows or depletion of assets or increases in liabilities
that result in decrease in equity other than those relating to distribution to equity participants.
Measurement of elements of financial statements
Measurement is the process of determining the monitary amounts at which the elements of
the financial statement are to be recognized and carried in the Balance Sheet and Income
Statement. A number of different measurements are employed to define degrees in financial
statements. They are as follows:
a) Historical cost
b) Current cost
c ) Realistic value
d) Present value.
The commonly adopted basis is historical cost.
Concept of Capital
The financial concept of capital is adopted by most enterprises in preparing their financial
statements. Capital is synonymous with the net assets or equity of the enterprise under a
financial concept such as invested money or invested purchasing power.
Fundamental accounting assumptions
Certain fundamental accounting assumptions underlie preparation and presentation of financial
statements. They are stated as follows:
(a) Going Concern : The enterprise is normally viewed as a going concern i.e. as
continuing its operation for unforeseeable future.
(b) Consistency: Application of same set of accounting policies over the years in
preparation of financial statements is assumed.
(c) Accrual : Revenues and costs are recognized in the year to which they are related
and not as paid or received.
Disclosure of Accounting Policies
Students should refer from any recommended Text Book:
(a) International Accounting Standards
(b) Indian Accounting Standards
2.1 CAPITAL AND REVENUE EXPENDITURE
Capital expenditure is the expenditure incurred for acquisition of assets the benefits of
which are enjoyed over the years. The benefits of revenue expenditures are exhausted in the
year of incurrence
Thus it is seen that utilisation of business capital is made for two distinct purposes:
1) Expenses yielding benefits over the years termed – capital expenditure.
2) Expenditures yielding benefits during the current accounting year – termed as
revenue expenditure
Where the benefits of a revenue expenditure are extended beyond the accounting year of
incurrence it is called a differed revenue expenditure.
Suppose a company incurred an expenditure of Rs. 100000 for advertisement before
marketing of a new product. If the whole amount is charged in the current year, the profit
of the company would not reflect a true picture as the benefits are likely to spread over
three to four years. So 1/3 or 1/4 of the expenditure will be charged to current P/L Account
and the balance should be carried forward for remaining years. This will be shown on the
assets side of the balance sheet as deferred revenue expenditure.
Difference between Capital and Revenue Expenditure
Capital Expenditure Revenue Expenditure
1. It is incurred for acquiring fixed assets in It is incurred to run the business but does
use and for increasing earning capacity not increase the capacity of the business.
of the business.
2. Benefits of such expenditure extend Usually the benefit is consumed
to years beyond which it is incurred. in the period in which it is incurred
3. It is shown in the Balance Sheet. It is taken to the Trading / P&L A/c
of the concern.
An old building which originally costs stands in the book is at Rs. 3, 00,000 is pulled down
and a new one is erected in its place. Rs. 1,500 worth of material out of the old building is
sold and Rs. 5,000 worth is used in new building. In addition to this Rs.5.50 lakhs is spent
under a contract for its construction, Rs. 2.25 lakhs had been set aside by firm for the
depreciation on the old building and is now appropriated. What addition to the Building
Account will legitimately arise out of the rebuilding ?
Solution :
Book value of old building 3,00,000
Less: Provision for Deprn. 2,25,000
Sale of old Materials 1,500
Old Material used in new building 5 000 2,31,500
68,500
The cost of new building should be shown as Rs.5,50,000 + 68, 500 = Rs. 6,18,500
2.2 OPENING, CLOSING AND ADJUSTMENT ENTRIES
Opening Entries
At the end of each accounting period a firm closes its books of accounts opens new hooks
at the beginning of each accounting period. The first entry in the journal is to record the
closing balance of various assets and liabilities at the end of the previous year or the opening
balances in the beginning of the new year. The balance sheet prepared at the end of each
year records these balances. It is from these balances that the first entry is passed which is
known as the “Opening Entry" e.g.
Balance Sheet as on 31st March, 1994
Liabilities Assets
Capital 44,200 Plant & Machinery 50,000
Sundry Creditors 25,000 S. Debtors 7,500
Closing stock 5,000
Cash at bank 6,000
Cash in hand 700
69,200 69,200
Journal
Dt. Particulars Dr. Cr.
1994 Ap.1 Cash in hand Dr. 700
Cash at bank Dr 6000
Stock A/c Dr 5000
S. Debtors A/c Dr 7500
Plant & Machinery A/c Dr 50000
To S. Creditors 25000
To Capital 44200
(Balances brought forward)
The above entries will then be posted to the ledger accounts as follows :–
Dr. Cash account Cr.
Date Particulars Cash Bank Date Particulars Cash Bank
1994
Apr. 1 To Balance b/d 700 6000
Dr. Stock account
Date Particulars Rs. Date Particulars Rs.
1994
Apr 1 To Balance b/d 5000
Dr. Sundry Debtors account Cr.
Date Particulars Rs. Date Particulars Rs.
Apr 1 To Balance b/d 7500
Dr. Plant & Machinery account Cr.
Date Particulars Rs. Date Particulars Rs.
Apr. 1 To Balance b/d 50000
Dr. Sundry Creditors account Cr.
Date Particulars Rs. Date Particulars Rs.
Apr. 1 By Balance b/d 25000
Dr. Capital account Cr.
Date Particulars Rs. Date Particulars Rs.
Apr. 1 By Balance b/d 44200
Closing Entries
In respect of Trading A/c:
Particulars Dr. Cr.
Trading A/c Dr
To Stock (Opening) A/c
To Purchases A/c
To Factory fuel & power A/c
To Factory rent & rates A/c
To Freight on purchases A/c etc.
(Purchases are net purchases i.e. purchases less
purchases returns)
Sales A/c Dr
Stock (closing) A/c Dr
To Trading A/c
(Sales are net sales i.e. sales less sales returns.)
Trading A/c Dr
To P & L A/c L A/c
(for transfer of gross profit)
In respect of Profit & Loss A/c :
Items of expenses etc.
P & L A/c Dr
To Salaries A/c
To Rent A/c
To Interest A/c
Items of gain :
Interest received A/c Dr.
Miscellaneous income A/c Dr
To P & L A/c
(The above entries will close all nominal accounts.)
P & L A/c Dr
To Capital A/c
(transfer of net profit)
Capital A/c Dr.
To P& L A/c
(transfer of net loss)
Adjustment Entries
Adjustment means putting things in order. Adjustment entries are entries made for putting
everything in order. The examples are :
I) Accrued/outstanding expenses and prepaid expenses
ii) Accrued Income and Income received in advance
iii) Depreciation
iv) Bad Debts, Provision for bad and doubtful debts, Provision for discount on debtors;
v) Commission on profits
vi) Income tax, Advance Income-tax, Income-tax deducted at source, Provident Fund,
Employees’ State Insurance contributions.
2.3 RECTIFICATION ENTRIES
Errors may be divided into two types :–
I) Errors not affecting the trial balance.
ii) Errors affecting the trial balance.
Errors not affecting the trial balance may be further divided into the following :–
a) Omission of an entry in the subsidiary book.
b) Wrong entry made in the subsidiary book.
c ) Errors of principle.
d) Posting an amount in the wrong account but on the correct side
e) Entry made in the wrong subsidiary book.
f) Compensating errors.
Omission of an entry in the subsidiary book
Here a transaction is completely omitted to be recorded in the books of accounts .
e.g. a credit sales to A for Rs. 2000 was omitted to be recorded in the sales book.
Particulars Dr. Cr.
A's A/c Dr 2000
To Sales A/c 2000
(Rectification entry passed for omission of credit sales
to A being omitted to be recorded in the sales book)
Wrong entry made in the Subsidiary Book
e.g. Credit purchases from Q for Rs. 3000 has been wrongly entered in the purchases book
as Rs. 3300.
Purchases book has an excess debit of Rs. 300 and Q's account has an excess credit for the
same amount
Therefore, the rectifying entry will be
Particulars Dr. Cr.
Q's A/c Dr. 300
To Purchases A/c 300
Errors of principles
These arise when a revenue expenditure is treated as a capital expenditure or vice versa e.g.
Furniture purchased from X for Rs. 4000 was entered in the Purchase Book.
Wrong entry
Particulars Dr. Cr.
Purchase A/c Dr. 4000
To X's A/c 4000
Correct entry
Furniture A/c Dr. 4000
To X's A/c 4000
Rectifying Entry
Furniture A/c Dr. 4000
To Purchase A/c 4000
Purchase A/c has been debited wrongly, therefore it has been credited [rectifying entry] in
order to cancel the debit. However, X's Account has been credited correctly. As furniture
A/c has to be debited in the first place it is done through the rectifying entry.
Posting an amount in the wrong A/c but on the correct side
e.g. Credit sales to Ramanthan for Rs. 1500 has been posted to Ramamurthy's A/c
Wrong entry
Particulars Dr. Cr.
Ramamurthy's A/c Dr. 1500
To Sales A/c 1500
Correct entry
Ramanathan A/c Dr 1500
To Sales A/c 1500
Rectifying entry
Ramanathan A/c Dr. 1500
To Ramamurthy A/c 1500
Entry made in the wrong Subsidiary Book
e.g. Credit sales to Y Rs. 2500 was wrongly entered in the Purchases Book.
Wrong entry
Particulars Dr. Cr.
Purchase A/c Dr. 2500
To Y's A/c 2500
Correct entry
Y's A/c Dr. 2500
To Sales A/c 2500
Rectifying Entry
Y's A/c Dr. 5000
To Purchase A/c 2500
To Sales A/c 2500
Compensating Errors
If the effect of one error is multiplied by the effect of some other errors the trial balance will
agree, e. g. an amount of Rs.25 received by M is not credited to his A/c and the total of the
sales books is overcast by Rs. 25. The omission of credit to M's A/c is offset by the
increased credit to the Sales A/c and hence the Trial Balance will agree.
Errors affecting the Trial Balance
As already discussed these errors are :
a) Omission to post to the ledger from the subsidiary book.
b) Posting the wrong amount in the ledger.
c ) Posting an amount to the wrong side.
d) Wrong casting of the subsidiary book.
e) Posting wrong amount lo the wrong side.
f) Posting a wrong amount to a wrong account
g) Posting a wrong amount to the wrong side of a wrong account.
Omission of posting from a subsidiary book
Goods returned to D Rs. 300 entered in the Purchases Returns Book omitted to he
posted to D's A/c. D's A/c has not been debited. Therefore his A/c should be
debited with Rs. 300.
Posting the wrong amount in the ledger
Credit sales to Z for Rs. 120 was correctly entered in the sales book but posted to
Z's A/c as Rs. 102. Z's A/ c is debited short by Rs. 18(120-120). Therefore debit
his A/c with Rs. 18.
Posting an amount to the wrong side
Credit purchases from U for Rs. 500 was correctly entered in the purchases book
but wrongly debited to U's A/c has to be credited with Rs. 1000.
U 's A/c is wrongly debited with Rs. 500. To Cancel this debit of Rs. 500 a credit
of Rs. 500 must be given. Another credit of Rs . 500 must be given to incorporate
the correct entry. Therefore a total credit of Rs. 1,000 has been given.
Wrong casting of the subsidiary book
Sales book has been totaled as Rs. 4000 the correct being Rs. 4400. Sales A/c has
short credit of Rs. 400. Therefore credit sales A/c by Rs. 400.
Posting wrong amount to wrong side
Sold goods to K for Rs. 136 entered in the sales book correctly but credited to K’s
a/c for Rs. 163.
K's A/c has to be debited with Rs. 299. K’s A/c has been credited wrongly for Rs.
163. To cancel this credit a debit of Rs. 163 is given. Further a debit of Rs. 136 has
to be given the accommodate the correct entry. Therefore a total debit of Rs. 299
( 163 + 136) has to be given.
Posting a wrong amount to the wrong account
Credit purchases from Akila for Rs. 155 was posted to the credit Akila for Rs.
165.
Debit Akila's A/c with Rs. 165.
Credit Akila's A/c with Rs. 155.
Akila's A/c has bean wrongly credited therefore it should be debited to cancel the
credit. Akila's A/c has not been credited.
So credit her A/c now with the correct amount Rs. 155.
Posting the wrong amount to the wrong side of a wrong account
A credit sales to W for Rs. 153 was credited to V's A/c for Rs. 135.
Debit V's A/c with Rs. 135.
Credit W's A/c with Rs.153.
V's A/c has been credited wrongly, so his A/c is debited to cancel the wrong
credit. W's A/c should have been debited in the first place.
Therefore, his A/c is now debited with Rs. 153, being the correct amount.
Correct the following entries.
a) Sale or goods Rs.1200 to Mr. Kumar has been entered in the sales book as Rs. 1100.
b) Machinery purchased for Rs. 11500 from XYZ Co. Ltd has been entered in the
Purchases book.
c ) Payment of the proprietor's personal expenses Rs. 450 has been debited to the
General Expenses A/c.
d) The Returns Inwards book has been overcast by Rs. 150.
e) Discount allowed to M/s ABC Rs. 35 has not been entered in the cash book but the
full amount (including discount) has been credited to M/s ABC
f) Sale of old typewriter Rs. 275 has been passed through the sales book.
Solution :
Journal Entries
Particulars Dr. Cr.
a) Kumar's A/c Dr 100
To Sales A/c 100
(Rectifying entry passed for short credit-sales A/c and
short debit to Kumar's A/c)
b) Plant & Machinery A/c Dr 11500
To Purchases A/c 11500
(Rectifying entry passed to correct machinery
purchased charged to Purchases A/c )
c) Drawing A/c Dr 450
To General Expense A/c 450
(Rectifying entry passed to correct drawings charged
to Gen. Exp. A/c)
d) Credit Returns Inwards A/c by Rs. 150.
e) Debit Discount allowed A/c Rs. 35.
(As the amount has not been entered in the cash book
there is a short debit in the Discount Allowed A/c.
Therefore the additional debit)
f) Sales A/c Dr 275
To Office Equipment A/c 275
(Rectifying entry passed to correct sale of old
typewriter erroneously credited to Sales A/c instead
of Office Equipment A/c)
Suspense Account
The difference in the Trial Balance may be put in an account known as the Suspense
Account, where the error causing difference cannot be located immediately and the books
of accounts have to be closed. Suspense account is an account to which the difference in
the trial balance has been put temporarily. If the debit side is short this account is debited
and if the credit side is short it will be credited. However the opening of a suspense account
does not mean that the errors need not be found out.
All errors affecting the trial balance (these were discussed earlier) are corrected through
the suspense account as these are one-sided errors. Previously one sided errors have been
corrected by making a correcting entry in the account concerned without making an entry
in any other account. Double entry will be complete where a suspense account is opened
with a difference in the trial balance.
Correct the following errors –
I) Without opening a Suspense Account, and
ii) Opening a Suspense Account
a) The Purchases Returns Book has been totaled Rs. 80 short.
b) Goods returned by M/s Amar & Sons Rs. 150 have not been recorded
anywhere.
c ) Goods bought from M/s Devi Bros Rs. 250 have been posted to their debit
as Rs. 205.
d) Discount received from Hi-Fi Bros Rs. 25 has not been entered in the discount
column of the cash book.
e) A sale to Mr. Dubey Rs. 450 was wrongly credited to his account.
Solution :
Particulars Dr. Cr.
I) Without opening a Suspense Account :
a) Credit Purchases Returns A/c with Rs. 80.
b) Sales Returns A/c Dr 150
To M/s Amar & Sons A/c 150
(Entry passed for goods returned as it was omitted
from the Sales Returns Book)
c) Credit M/s Devi Bros with Rs. 455.
M/s Devi Bros have been debited Rs. 205 instead of being credited.
(Therefore a credit of Rs. 205 is given to remove the
wrong debit and a further credit of Rs. 250 is given to
record the correct credit.)
d) Credit Discount Received A/c Rs. 25.
(There is a short credit in the Discount Received A/c
by Rs. 25. Hence an additional
credit is given to the account.)
e) Debit Mr. Dubey's A/c with Rs. 900.
(Mr. Dubey's A/c has been credited with Rs. 450
instead of being debited. This account is
now debited with Rs. 900 to remove the wrong credit
and given the correct debit.)
ii) Opening a Suspense Account
a) Suspense A/c Dr 80
To Purchase Returns A/c 80
(Correction arising from undercasting of Purchases
Returns Book)
b) Sales Returns A/c Dr 150
To M/s Amar & Sons A/c 150
(Recording an entry omitted earlier)
c) Suspense A/c Dr 455
To M/S Devi Bros A/c 455
(Correction of entry by which M/s Devi Bros were
debited Rs. 205 instead of being credited with Rs. 250)
d) Suspense A/c Dr 25
To Discount Received A/c 25
e) Mr. Dubey's A/c Dr 900
To Suspense A/c 900
(Correction of entry by which Mr. Dubey’s A/c was
credited with Rs. 450 instead of being debited)
Effect of errors and their rectification on profit or loss :
Certain errors affect the profit or loss of the firm. If the error is in the nominal account the
profit and loss account will be affected but if it is in a personal or real account there will be
no change on the profit or loss. Rectification of an error in a nominal account will change
the figure of profit or loss previously arrived at.
The Trial Balance of M/s Soles & Soles extracted on 31st March, 1997 was Rs. 1595 short
on the debit side. A suspense account is opened to tally the trial balance. On examination of
the books of accounts the fallowing errors were noticed :
a) Credit Purchases from M/s Toepuf Rs. 200 was posted as Rs. 20 in the ledger.
b) Miser the landlord was debited Rs. 250 for payment of rent.
c ) Cash purchase of Rs.125 was not posted to the ledger.
d) Discount allowed column in the cash book was posted to Gen. Exps are Rs.20.
e) Payment made to Insole & Sons Rs.1500 was posted to their credit Rs.150.
f) Received Rs.250 from Tom but posted to Thompson's A/c.
g) Credit sale of Rs.750 to Shoes & Socks Ltd entered in the Returns Outwards
Book.
Pass necessary rectifying entries. Prepare the Suspense A/c and show the effect of the
rectifying entries on the profit of business.
Solution :
S.No. Particulars LF Dr(Rs) Cr.(Rs.)
a) Suspense A/c Dr I 80
To M/s Toepuf A/c 180
(rectification of posting of wrong amount)
b) Rent A/c Dr 250
To Miser's A/c 250
(rectification of payment of rent posted to Miser's
(landlord) A/c)
c) Purchases A/c Dr 125
To Suspense A/c 125
(cash purchases not posted rectified)
d) Discount allowed A/c Dr 20
To Gen. Expense A/c 20
(posting of discount allowed to Gen Exp. rectified)
e) Insole & Sons A/c Dr 1650
To Suspense A/c 1650
(rectification of posting wrong amount i.e.Rs. 150
instead of Rs. 1500 to the credit side instead of the
debit side)
f) Thompson's A/c Dr 250
To Tom's A/c 250
(receipt from Tom posted to Thompson rectified)
g) Returns Outwards A/c Dr 750
To Sales A/c 750
(Credit sales recorded in Returns Outwards Book
rectified)
Dr. Suspense Account Cr.
Dt. Particulars Rs Dt. Particulars Rs
To Difference in Trial Balance 1595 By Purchases 125
To M/s Toepuf 180 By Insole & Sons 1650
1775 1775
Effect of rectifying entries on profit
a) No effect
b) Profit reduced by Rs. 250
c ) Profit reduced by Rs. 125
d) No effect
e) No effect
f) No effect
g) No effect
Rectification in the next trading period:
In order to ascertain the profit or loss of each period separately errors should be rectified in
such a manner that the current year's income, expenses or loss are not affected.
An error committed in 2001-02 is rectified in 2002-03. By rectifying Sales A/c would mean
that it is treated as an income of 2002-03 when it actually pertains to 2001-02. Therefore
the proper thing to do should be to open a separate account called the Profit & Loss
Adjustment account and pass all debits and credits in respect of nominal accounts for
errors committed in the previous period through this account. The balance of this account
is transferred lo the Capital A/c.
Only when rectification is carried out in the next trading period and if it pertains to the
nominal accounts alone this procedure be adopted. Rectification in the current period is
made in the usual manner.
On 31st March, 2003, the Trial Balance of Mr. Good did not agree. The difference was
transferred to a Suspense Account. In May 2003, the errors of March 1997 were discovered.
They are:
1) The Returns Outwards Book was overcast by Rs. 700.
2) Purchase of furniture Rs. 2000 was passed through the Purchases Book.
3) Wages to workmen for installation of machinery Rs.1250 was charged to Wages
A/c.
4) Payment of rent of Mr. Goods house Rs. 750 was charged to Rent A/c.
5) Goods returned by a customer amounted to Rs. 950 were taken into stock but no
entry was made in the book.
6) Sale of goods worth Rs. 1700 has been passed through Purchases book. The
Customer's A/c has been however debited correctly.
7) Sale of Rs. 2250 to M/s Wye Ltd was credited to their A/c.
8) Sales Book total while being carried forward to the next page was written as Rs.
219431 instead Rs. 291341.
9) A sale of Rs. 760 has been posted to the credit of the customer's Mr. Zed A/c as
Rs. 670.
10) A cheque for Rs. 1500 received from M/s Sky Bros was dishonoured and posted
to the debit of Allowances A/c.
Give journal entries to rectify the above errors without affecting the current year's Profit
and Loss Adjustment A/c
Prepare the Profit & Loss Adjustment A/c.
Solution :
Particulars Dr. Cr.
1) P & L Adjustment A/c Dr 700
To Suspense A/c 700
2) Furniture A/c Dr 2000
To P & L Adjustment A/c 2000
3) Machinery are Dr 1250
To P & L Adjustment A/c 1250
4) Drawings A/c Dr 750
To P & L Adjustment A/c 750
5) P&L Adjustment A/c Dr. 950
To Customer’s A/c 950
6) Suspense A/c Dr 3400
P&L Adjustment A/c 3400
7) M/s Wye Ltd. A/c Dr 4500
To Suspense A/c 4500
8) Suspense A/c Dr 71910
To P&L Adjustment A/c 71910
9) Suspense A/c Dr 1430
To Mr. Z’s A/c 1430
10) M/s Sky Bros. A/c Dr 1500
To P&L Adjustment A/c 1500
P&L Adjustment A/c Dr 79160
To Capital A/c 79160
Dr. Profit And Loss Adjustment Account Cr.
Date Particulars Rs. Date Particulars Rs.
To Suspense A/c 700 By Furniture 2000
” Customer’s A/c 950 ” Machinery 1250
” Capital A/c (Bal. fig) 79160 ” Drawings 750
” ” Suspense 3400
” Suspense 71910
” M/s Sky Bros. 1500
80810 80810
2.4 ADJUSTED TRIAL BALANCE
A Trial Balance should be prepared before the adjusting entries are recorded in order to
ensure that the debits are equal to the credits. In addition another Trial Balance prepared
after recording the adjusting entries. This Trial Balance is called an Adjusted Trial Balance
which provides a convenient source of information for the preparation of final accounts.
From the following details prepare an Adjusted Trial Balance after passing the necessary
adjustment entries :
Rs. Rs.
Purchase 65,000 Sundry Creditors 35,000
Carriage Inward 1,000 Plant and Machinery 10,000
Wages 6,000 Buildings 5,000
Salaries 10,000 Furniture 3,000
Rent, rates and taxes 1,800 Bills Receivable 10,000
Insurance 1,500 Sundry Debtors 40,000
interest paid 1,000 Capital 66,000
Sales 95,000 Sundry Expenses 5,000
Cash and Bank 21,500 Opening stock 21,000
Bills Payable 5,800
Notes –
1. Salaries and wages due to be paid Rs. 2,000 and Rs. 1,500 respectively.
2. Insurance was paid to the extent of Rs. 300 advance.
3. A sum of Rs. 500 to be written off as bad debt out of' sundry debtors and a
provision of 5% to be created for doubtful debts.
4. Sundry expenses include Rs. 2 000 spent for the personal purpose of the proprietor
5. Sales for the period include Rs. 500 worth of goods (cost price) taken by the
proprietor for personal consumption. He has also taken goods worth Rs. I 000
(cost price) for personal consumption which has not been recorded in the I books
6. Depreciation to be provided as follows :–
Plant and Machinery 10%
Building 5%
Furniture 10%
7. Closing Stock Rs. 20,000
Solution :
JOURNAL ENTRIES
Particulars L.F. Dr. Cr.
Salaries A/c Dr. 2.000
To Outstanding Salaries A/c 2 000
(Outstanding salaries adjusted)
Wages A/c Dr. 1 500
To Outstanding Wages A/c 1,500
(Outstanding wages adjusted)
Drawings A/c Dr. 2 000
To Sundry Expenses A/c 2 000
(Sundry Exp. A/c now adjusted)
Sales A/c Dr. 500
To Sundry Debtors A/c 500
(Goods taken by the proprietor for personal
consumption and included in sales now cancelled)
Drawings A/c Dr. 1 500
To Purchase A/c I 500
(Goods taken by the proprietor at cost price for personal
consumption)
Prepaid Insurance A/c Dr. 300
To Insurance A/c 300
(Insurance premium paid in advance adjusted)
Bad Debts A/c Dr. 500
To Sundry Debtors A/c 500
(Amount written off as bad debt)
Bad Debts A/c Dr 1950
(5% on (40000-500-500)
To Provision for Bad Debts a/e 1950
(Provision for Bad Debts created @ 5% on Debtors)
Depreciation A/c Dr 1550
To Plant & Machinery 1000
To Buildings 250
To Furniture 300
(Depreciation provided on various assets)
Closing Stock A/c Dr 20000
To Purchases 20000
(Closing stock adjusted to purchases)
Note: Since here provisions for Doubtful Debts is to be created before preparing final
accounts Bad Debts A/c has been debited instead of P & L A/c.
Trial Balance as at ..........
Dr Cr
Rs. Rs.
Purchases (65000 - 1500 - 20000) 43500
Carriage Inward 1000
Wages (6000 +1000) 7000
Salaries (10000 +2000) 12000
Rent, Rates &Taxes 1800
Interest (1500 - 300) 1200
Interest Paid 1000
Sales (95000 - 500) 94500
Cash & Bank 21500
Bills Payable 5800
Sundry Creditors 35000
Plant & Machinery (10000 - 1000) 9000
Buildings (5000 - 250) 4750
Furniture (3000 - 300) 2700
Bills Receivable 10000
Sundry Debtors (40000 – 500 - 500) 39000
Capital 66000
Sundry Expenses (5000 – 2000) 3000
Opening Stock 21000
Outstanding Salaries 2000
Outstanding Wages 1000
Drawings (2000 +1500) 3500
Prepaid Insurance 300
Bad-Debts (500 +1950) 2450
Provision for Bad Debts 1950
Depreciation 1550
Closing Stock 20000 .
206250 206250
Balance Sheet
The Balance Sheet is a statement which sets out the Assets and Liabilities as on a certain
date. It is prepared with a view to measure the true financial position at a particular point of
time. The Balance Sheet has the following form.
Balance Sheet as on ........
Liabilities Amount Assets Amount
Sundry on Trade Cash in hand
Creditors [including petty cash]
Bills payable Cash at hank
Loans Loans (Dr)
Mortgage Closing Stock
Reserve or Reserve Fund Investments
Capital Furniture & Fittings
Add: Interest on capital Loose Tools
Add: New profit Plant & Machinery
Less: Drawings Land & Buildings
Less: Interest on Drawings Freehold & leasehold Land
Less: Net Loss Business Premises
Less: Income tax Patents & Trade Marks
Goodwill
A Balance Sheet has the following characteristics :
a) It is prepared at a particular date and not for a period.
b) it is prepared only after preparation of the Trading and Profit & Loss A/c. Without
the Profit & Loss A/c it will not give the financial position of the firm adequately.
c ) Capital is equal to the difference of assets and liabilities. Therefore the two sides of
the balance sheet must have the same totals otherwise it is an indication of the
presence of errors.
d) It is not an account but only a statement of assets and liabilities..
e) The balance sheet shows the financial position of a business at going concern
concept.
Difference between a Trial Balance and a Balance Sheet
Trial Balance Balance Sheet
The purpose of a trial balance is to The Balance Sheet aims at reflecting
establish the arithmetical accuracy the financial position of the business.
of the books of accounts.
No information about profits can be Information about profit can be obtained
obtained from the trial balance. from the balance sheet.
It may be possible to dispense with the To complete the accounting process the
preparation of the trial balance though its balance must be essentially be prepared.
preparation is desirable.
All accounts personal, real and Only personal and real accounts find
trial balance be written up. place in the balance sheet.
Normally Trial balances are prepared Balance sheet is prepared at the end of
monthly. the trading period.
A trial balance can be prepared with or A Balance sheet cannot to be prepared
without adjustment. A trial balance without making adhustments and without
incorporating adjustments is known taking into account all events and
as the adjusted trial balance. transactions for the year.
Closing stock does not appear Closing stock appears at the balance sheet.
in the trial balance however
it may appear where an adjusted trial
balance is prepared.
Assets & Liabilities Arrangement
Assets may be grouped as follows :–
In order of Liquidity In order of Performance
Cash in hand Goodwill
Cash at bank Patents
Investments Land & Buildings
Sundry Debtors Machinery
Stock of finished goods Furniture
Stock of raw materials. Stock of partly finished
goods. Stock of partly finished goods Stock of raw materials
Furniture Stock of finished goods.
Machinery Sundry Debtors
Land and Buildings Investment
Patents Cash at bank
Goodwill Cash in hand
Liquidity : Liquidity means the case with which assets may be converted into cash. Assets
which are most difficult in this respect are written last.
Permanence : Assets which are to be used permanently in the business and are meant to
be sold are written first.
Liabilities : Liability may be shown according to the urgency with which payment has to
be made. Short term liabilities such as bills payable, and sundry creditors for supply of
goods may be shown first, then long term liabilities and lastly capital. Another way is to
show capital, long term liabilities and last short term liabilities.
Assets and Liabilities-Classification :–
Assets may be classified as –
a) Fixed Assets
I) Tangible fixed assets.
ii) Intangible fixed assets.
iii) Investments (longterm)
b) Current Assets
Fixed Assets : Fixed asset is an asset acquired for continuing use within the business with
a view to earning income or making profits from its use either directly or indirectly. A fixed
asset is not acquired for sale to a customer.
A tangible fixed asset is a physical asset, i.e. One that has real solid existence, e.g. Plant &
Machinery.
An intangible fixed asset is an asset which does not have a physical existence, e.g. Goodwill.
An investment might also be a fixed asset, investment purchased with a view to holding
them for more than a year are classified as fixed assets.
Current Assets : Current assets are either items owned by the business with the intention
of their resale or cash including cash at bank deposited by the business. These assets are
"Current" in the sense that they are continuously flowing.
Other current Assets are :–
Short term investment. This includes short term trade investment.
Prepayments :
These are amounts which are already paid by the business for benefits which have not yet
been consumed.
Trade Debtors :
These are debtors to the business for supply of goods to them.
Liabilities :
These are debts of the business that must be paid within one year. They are –
I) Loans payable within a year.
ii) Bank Overdraft.
iii) Trade creditors for supply of goods.
iv) Bills of exchange.
v) Outstanding payments.
vi) Interest on loans due and accrued but not paid.
Long term liabilities:
Long term liability is a debt which is not payable within one year.
Owners equity or capital.
The amount owing to the proprietors as capital is shown separately.
The following Trial Balances as on 31st May. 2000 and 31st May, 2001 are furnished to you
by Ashar and Sons:
Fixed capitals:
31st May, 2001 31st May, 2000
Dr. Cr. Dr. Cr.
Rs. Rs. Rs. Rs.
Ashar — 6,00,000 — 7,00,000
Bismilla — 4,00,000 — 2,00,000
Cawasji — 2,00,000
Current accounts:
Ashar — 10,000 5,000 —
Bismilla — 60,000 — 40,000
Cawasji 10,000 — — —
Customers dues 11,00,000 — 9,00,000
Suppliers — 80,000 — 1,50,000
Fixed assets (cost) 3,00,000 — 2,00,000 —
Provision for depreciation — 1,30,000 — 90,000
Stock 65,000 — 1,05,000 —
Cash 10,000 — 10,000 —
Bank 20,000 — — 30,000
Prepaid expenses 20,000 — 15,000 —
Outstanding expenses — 45,000 — 25,000
15,25,000 15,25,000 12,35,000 12,35,000
You are asked to interpret the above trial balances.
Solution :
Working Note.
For interpretation of the Trial Balances it should be redrafted in the following format to find
out the changes occurred in the two financial years i.e. 1999-2000 and 2000-2001.
Items As at As at
31.5.2001 31.5.2000
Liabilities :
Capital A/c — Ashar 6,00,000 7,00,000
Capital A/c — Bismilla 4,00,000 2,00,000
Capital A/c — Cawasji 2,00,000
Final Accounts
Changes
Dr Cr
1,00,000 2,00,000
2,00,000
15,000
Current A/c — Ashar 10,000 5,000 20,000
Current A/c — Bismilla 60,000 40,000
Suppliers 80,000 1,50,000 70,000
Outstanding Expenses 45,000 25,000 20,000
Provision for Depreciation 1,30,000 90,000 40,000
15,25,000 12,10,000 1,70,000 4,95,000
Assets :
Fixed Assets 3,00,000 2,00,000 1,00,000
Customers 11,00,000 9,00,000 2,00,000
Current A/c — Cawasji 10,000 10,000
Stock 65,000 1,05,000 40,000
Cash 10,000 10,000
Bank 20,000 (30,000) 50,000
Prepaid Expenses 20,000 15,000 5,000
15,25,000 12,00,000 3,65,000 40,000
Interpretation of Trial Balance :
1. The trial balances of both the years are prepared after preparation of Profit and
Loss Account. The net profits or losses, if any, are adjusted to the current account
of the partners.
2. Cawasji was admitted as partner during the financial year 2000-2001. The treatment
of goodwill, if any, had not been shown in the accounts. However, it appears from
the movement of fixed capital accounts that Ashar had sacrificed his share of
profit in the business which was acquired by both Bismilla and Cawasji which had
the effect of bringing in cash by them and withdrawal of cash by Ashar.
The capital accounts being in the nature of fixed capital, normally no profit
and /or drawings have been transacted through these accounts. However, in the
absence
of any information as to goodwill of the firm and profit sharing ratios of the partners,
it is not possible to state about the movement of funds.
3. The changes in the current accounts of the partners is due to transactions relating
to sharing of profits according to profit sharing ratios and credits on account of
interest in capital in the one hand and correspondingly the drawings and debit of
interest on drawings (if any) on the other hand. However, the debit of Rs. 10,000
in the new partner Caswaji may be on account of adjustment of goodwill which
might have been debited to maintain a current account balance of Rs. 2,00,000 as
may be agreed by the partners. In absence of relevant information the exact position
could not be ascertained.
As at As at
31.5.2001 31.5.2000
4. The net current assets of the firm and changes therein during the financial year is
stated below :
Changes
Increase Decrease
Stock 65,000 1,05,000 — 40,000
Customers 11,00,000 9,00,000 2,00,000 —
Cash 10,000 10,000 — —
Bank 20,000 — 20,000 —
Prepaid expenses 20,000 15,000 5,000 —
Total current assets (A) 12,15,000 10,30,000 2,25,000 40,000
Less :
Current liabilities—
Suppliers 80,000 1,50,000 — 70,000
Expenses 45,000 25,000 20,000 —
Bank overdraft — 30,000 — 30,000
Total current liabilities (B) 1,25,000 2,05,000 20,000 1,00,000
Net current assets (A)- (B)
10,90,000
8,25,000
2,65,000
The above statement reveals :–
(a) There is overall increase in the net current assets by Rs. 2,65,000.
(b) Current assets to current liabilities ratios
For the year 2000-2001 — Rs. 9.72 to Re. 1
For the year 1999-2000 — Rs. 5.02 to Re. 1
which shows an improvement of Rs. 4.70 to Re. 1
The changes in the ratios are due to :
Rs. Rs.
Increase in debtors A/c 2,00,000
Increase in bank balance 20,000
Decrease in suppliers A/c 70,000
Decrease in bank A/c 30,000
Decrease in Prepaid Expenses 5,000 3,25,000
Less:
Decrease in stock 40,000
Increase in liability for expenses 20,000 60,000
2,65,000
Increases in bank balances, repayment of bank overdraft and reduction in stock
are signs of good and positive sound position of firm’s/company’s trading activities.
However, there is no change in the cash balance. It is assumed that cash balance
represents petty cash.
In the absence of sales and purchase figures, the changes in debtors by Rs. 2,00,000
and reduction in creditors by Rs. 70,000 could not be properly explained.
Prepaid expenses have gone by up by Rs. 5,000 which may be considered as
normal.
Outstanding expenses have gone up by Rs. 20,000. However, the firm possesses a
cash and bank balances of Rs. 30,000 which is sufficient to repay them on due
dates of payment.
5. Cost of fixed assets has gone up by Rs. 1,00,000; similarly accumulated depreciation
by Rs. 40,000. No information has been provided for any sale or discard of any
fixed assets. In the absence of such information exact outflow of fund in this
regard could not be ascertained.
Example:
From the following transactions pass journal entries and show ledger accounts in the Books
of S. Banerjee and prepare a Trial Balance.
Started business with cash Rs. 1,50,000, Goods worth Rs. 80,000, Office Equipment Rs.
70,000 and his private car worth Rs. 1,20,000 which will henceforth be used solely for
business purpose.
Bought furniture worth Rs. 40,000 of which those worth Rs. 10,000 are for office use and
the balance for stock. Purchased 3 motor cars worth Rs. 1,50,000 each from Ganguly &
Co. for stock.
Purchased 2 motor cars worth Rs. 80,000 each from Ganguly & Co. for business use.
Purchased for cash 1 motor car worth Rs. 70,000 for private use.
Returned motor cars worth Rs. 1,50,000 from stock and that worth Rs. 80,000 for business
use to Ganguly & Co.
Sold office equipment for Rs. 40,000
Sold one of the motor cars for stock for Rs. 2,00,000; paid landlord Rs. 12,000 for rent.
One-third of the premises is occupied by the proprietor for his own residence.
Sold the third car for Rs. 3,50,000.
Solution :
In the books of Mr. S. Banerjee
Dr. (Rs.) Cr. (Rs.)
a) Cash A/c Dr. 150000
Stock A/c Dr. 80000
Office Equipment A/c Dr. 70000
Motor car Q/c Dr. 120000
To capital A/c 420000
(Sundry Assets introduced as Capital to start
business)
b)
Furniture A/c
Dr.
10000
Purchase A/c Dr. 30000
To cash A/ 40000
(Purchase of furniture worth Rs. 40000 out of which
Rs.10000 for office decoration and Rs. 30000 for stock)
c) Purchase A/c Dr. 450000
To Ganguli & Co. 450000
(Purchased 3 motor cars for stock purpose)
d) Motor Car A/c Dr 160000
To Ganguli & Co. 160000
(Purchased 2 motor cars for office use)
e) Drawings A/c Dr. 70000
To Cash A/c 70000
(Bought 1 office car for private use)
f) Ganguli & Co. Dr. 230000
To Return outward A/c 150000
To Motor car A/c 80000
(Motor car worth Rs. 150000 from stock and Rs.80000
from business use returned to Ganguli & Co.)
g) Cash A/c Dr. 40000
To Office Equipment A/c 40000
(Office equipment worth Rs. 40000 sold)
h) Cash A/c Dr. 200000
To Sales A/c 200000
(Being one motor car from stock sold)
I) Rent A/c Dr. 8000
Drawings A/c Dr. 4000
To Cash A/c 12000
(Rent paid to landlord, 1/3 of the premises occupied
by the proprietor for personal residence)
j) Cash A/c Dr. 350000
To Sales A/c 350000
(Sold the third car for cash)
Dr. Cash Account Cr.
Particulars Rs. Particulars Rs.
To Capital 1,50,000 By Furniture 10,000
To Office Equipment 40,000 By Purchase 30,000
To Sales 2,00,000 By Drawing 70,000
To Sales 3,50,000 By Rent 8,000
By Drawings 4,000
By Balance c/d 6,18,000
7,40,000 7,40,000
Dr. Stock Account Cr.
Particulars Rs. Particulars Rs.
To Capital 80000 By Balance c/d 80000
Dr. Office Equipment A/c Cr.
Particulars Rs. Particulars Rs.
To Capital 70000 By Cash A/c 40000
By Balance c/d 30000
70000 70000
Dr. Motor Car A/c Cr.
Particulars Rs. Particulars Rs.
To Capital 120000 By Ganguli & Co. 80000
“ Ganguli & Co. 160000 “ Balance c/d 200000
280000 280000
Dr. Furniture A/c Cr.
Particulars Rs. Particulars Rs.
To Cash 10000 By Balance c/d 10000
Dr. Purchase A/c Cr.
Particulars Rs. Particulars Rs.
To Cash 30000 By Balance c/d 480000
To Ganguli & Co. 450000
480000 480000
Dr. Return Outward A/c Cr.
Particulars Rs. Particulars Rs.
To Balance c/d 150000 By Ganguli & Co. 150000
Dr. Ganguli & Co. A/c Cr.
Particulars Rs. Particulars Rs.
To Return Outward 150000 By Purchase 450000
To Motor Car 80000 By Motor Car 160000
To Balance c/d 380000
610000 610000
Dr. Drawings A/c Cr.
Particulars Rs. Particulars Rs.
To Cash 70000 By Balance c/d 74000
To Cash 4000 .
74000 74000
Dr. Sales A/c Cr.
Particulars Rs. Particulars Rs.
By Cash 200000
To Balance c/d 550000 By Cash 350000
550000 550000
Dr. Rent A/c Cr.
Particulars Rs. Particulars Rs.
To Cash 8000 By Balance c/d 8000
Dr. Capital A/c Cr.
Particulars Rs. Particulars Rs.
To Balance c/d 420000 By Cash 150000
To Stock 80000
To Office Equipment 70000 By Motor Car 120000
420000 420000
Trial Balance
Dr. Cr.
Rs. Rs.
Cash 618000
Stock 80000
Office Equipment 30000
Motor Car 200000
Furniture 10000
Purchase 480000
Ganguli & Co. 380000
Drawings 74000
Return outward 150000
Sales 550000
Rent 8000
Capital 420000
1500000 1500000
2.5 DEPRECIATION
Depreciation is the diminution in the value of assets due to use, wear and tear and efflux of
time. It is an estimated charge against profit for use of fixed assets. The provision
for depreciation is to create funds for replacement of assets. It may either be written
off against asset accounts or it may be Depreciation Provision Account keeping Asset
Account
at cost. There are various method of depreciation, such as,–
1) Straight-line method or Fixed instalment method - This is simple and most
widely used method. An equal portion of the cost of the asset is allocated to each
period of use.
2) Diminishing/reducing value method
3) Annuity method
4) Insurance Policy
5) Revaluation
6) Unit charging system.
I) Production unit.
ii) Time unit
7) Machine Hour Rate.
8) Sum of the digits method.
The entry for depreciation will be :–
Depreciation A/c Dr.
To Respective Asset A/c
The most commonly methods of depreciation are –
1) Straight line method and
2) Reducing / Diminishing value method.
For depreciation, Students are advised to go thorough
I) International Accounting Standard - 4, and
ii) Indian Accounting Standard - 6 for a thorough knowledge on the subject.
Methods of Calculating Depreciation
There are a number of methods of calculating depreciation on the original cost or on the
replacement cost of the assets. Each method adopts one or more of the following principles —
(a) depreciation is a function of time;
(b) depreciation is a function of use;
(c) depreciation is a function of time and use;
(d) depreciation is a function of time and maintenance; and
(e) depreciation is a function of time and interest.
Whatever method is applied in the accounts, it must be suitable to the circumstances prevailing
in the organization. The different methods are discussed as follows :
(1) Straight line method : This is the method of providing for depreciation by means
of periodic charges over the assumed or anticipated life of the asset.
Example :
If, C = Cost of the asset depreciated = Rs. 10,000.
R = Residual value of the asset = Rs. 500.
n = Life of the asset = 4 years.
Year Cost and balance b/d Depreciation Balance c/f
Rs. Rs. Rs.
Final Accounts
Then,
D = Proportion of cost of asset depreciated under this method
C − R 10,000 − 500
= = = 0.2375 or 23.75%
n × C 4 × 10,000
So, amount of depreciation is 23.75% of Rs. 10,000 = Rs. 2,375 each year.
Proof :
1 10,000 2,375 7,625
2 7,625 2,375 5,250
3 5,250 2,375 2,875
4 2,875 2,375 500
(Depreciation has been calculated to the nearest Rupee.)
Thus, by using this method an equal amount of depreciation is charged during each
period, irrespective of its use. This method is simple and is usefully applied to all
types of fixed assets, particularly in connection with patents, leasehold and similar
assets having definite life. Its use in cost accounts affords a better comparative
costs for its uniform charge. However, the total cost of depreciation and repair and
maintenance costs of assets increase progressively.
(2) Reducing balance method : This is the method of providing for depreciation by
means of periodic charges calculated as a constant proportion of the balance of the
asset after deducting the amounts previously provided. This is also called written
down value method.
Example :
Assuming the same data as before,
D = Proportion of reducing balance of cost of asset depreciated in each
period.
R 500
= 1 − n = 1 − 4
C
= 1– 0.4729
10,000
= 0.5271 or 52.71%
(if the residual value is nil, assume R =1)
Year Cost and balance b/d Depreciation@52.71 % Balance c/f
Rs. Rs. Rs.
Financial Accounting Fundamentals
Proof :
1 10,000 5,271 4,729
2 4,729 2,493 2,236
3 2,236 1,179 1,057
4 1,057 557 500
Because of its simplicity, this method is popular and is extensively used for taxation
purposes. It is observed that a heavier depreciation is borne in the earlier years
when repairs are lighter, and that the increasing repair cost is counterbalanced, in
later years, by the reduced annual charge for depreciation. The use of this method
for costing purposes is justifiable only if its effect is to provide a uniform charge
for the services of the asset throughout its life; otherwise, the cost of production
in subsequent years appears to decrease, although they are produced under identical
conditions.
(3) Production unit method : This is the method of providing for depreciation by
means of a fixed rate per unit of production calculated by dividing the value of the
asset by the estimated number of units to be produced during its life.
Example :
Assuming C and R to have the same value as before
and NU = Estimated units to be produced during its life = 38,000 units.
Then, D = Depreciation per unit
C − R
10,000 − 500
9,500
= = = =
N U
= Re. 0.25 per unit.
38,000 38,000
Thus, if 4,000 units are produced in a certain period, Rs. 1,000 will be
charged as depreciation.
This method gives emphasis on usage and ignores time factor. The depreciation
charge is high in periods of abnormal activity and low when machines are idle.
This method is suitable for wasting assets such as mines and quarries. If estimated
production during the life can be determined, this method satisfies the costing
requirement that the cost of an asset should be evenly spread over the work done
by it. However, the main disadvantage of this method is that a separate record of
output of each of the assets has to be maintained and this method cannot be applied
were output are of different types.
n
1−
Final Accounts
(4) Production hour method : This is the method of providing for depreciation by
means of a fixed rate per hour of production calculated by dividing the value of the
asset by the estimated number of hours of its life.
Example :
Assuming C and R to have the same value, and
NH = Estimated number of working hours of its life = 19,000 hrs.
Then, D = Depreciation per hour
C − R
10,000 − 500
= = = = Re. 0.50 per hour
N H 19,000
Thus, for a work of 1,000 hours in a certain period, depreciation charge
will be :
Rs. 1,000 × Re. 0.50 = Rs. 500.
This method is usefully applied in cases of costly automatic machines having a
limited but definite working life. This method is similar to production unit method.
However, under this method, there is no need for all the units to be produced to be
one type or even similar to one another as the charge is based upon the time
involved in their production, and not on their number.
(5) Annuity method : This is the method of providing for depreciation by means of
periodic charges, each of which is a constant proportion of the aggregate of the
cost of the asset depreciated and interest at a given rate per period on the written
down value of the asset at the beginning of each period.
Example :
If C = Rs. 10,000; n = 4 years; r = rate of interest 4% per annum;
an = present value of an annuity certain of 1 per year.
1− 1
= (1+ r )
r
Then, D = amount of periodic depreciation charge under this method
C C × r
=
10 000 × 0 04
= =
400
a n 1− 1 , .
1− 1
1
1.
(1+ r )n (1.0 4)4
= Rs. 2,755
169859
Year Cost and Interest @ 4% Total Annual Balance c/f
balance b/f (nearest rupee) provision
Rs. Rs. Rs. Rs. Rs.
Financial Accounting Fundamentals
Proof :
1 10,000 400 10,400 2,755 7,645
2 7,645 306 7.951 2,755 5,196
3 5,196 208 5,404 2,755 2,649
4 2,649 106 2,755 2,755 Nil
The amount of depreciation is heavy in this method and is intended to cover the
cost of opportunity lost by not investing the capital elsewhere.
This method is based on the concept that money invested in an asset earns interest.
This method is suitably used for the redemption of leases over a fairly long period.
It is a scientific method where investment funds outside a business is not required.
(6) Revaluation method : This is the method of providing for depreciation by means
of periodic charges each of which is equivalent to the difference between the
values assigned to the asset at the beginning and the end of the period.
Example :
If, C = Cost of the asset = Rs. 10,000 ;
V = Value of asset at the end of one year = Rs. 7,000
Then, D = Amount of depreciation under this method = C – V = 10,000
– 7,000 = Rs. 3,000.
This method is commonly used for depreciation of loose tools, livestock, patents,
patterns, etc., which depreciate rapidly. This method is also used for use of assets
in contracts.
(7) Sum of the digits method : This is the method of providing for depreciation by
means of differing periodic rates which is computed by taking a reduced proportion
of the sum of an arithmetical progression in respect of the years of life of the asset,
multiplied by the cost, less residual value, of the asset.
Example :
If, C = cost of asset = Rs.10,000; R = residual value = Rs. 400 ; n = 4yrs.
Then, S = sum of years = 1 + 2 + 3 + 4 = 10
Then, depreciation charge : Rs.
In year l 4/10 of Rs. 9,600 3,840
year 2 3/10 of Rs. 9,600 2,880
year 3 2/10 of Rs. 9,600 1,920
year 4 1/10 of Rs. 9,600 960
This method is suitable for depreciation of motor vehicle and other assets which
drop in value immediately after purchase. Thus the advantage of this method is
that it takes into account of such drop in value of new asset and makes the decision
to sell and repurchase before the estimated time an easier one.
The following should be noted for depreciation of the following types of fixed assets :–
(a) Goodwill :No depreciation arises unless the firm’s profits are decreasing. Prudent
firms try to write off goodwill over a number of years.
(b) Freehold Land : In this case also no depreciation arises. Amounts written off
should be shown separately.
(c) Loose tools, Jigs and Patterns : Depreciation should be calculated on revaluation
method.
(d) Patents, Trade Marks, etc :There is a maximum legal life of such assets but the
commercial life may be shorter. The asset should be depreciated by straight line
method so that it is written off within the legal or commercial life whichever is
shorter.
(e) Mines, Oil wells, Quarries, etc. : Depreciation should be charged on depletion method.
Example:
A company purchased a machine for Rs. 20,000 and paid cost of installation Rs. 1,000. At
the date of purchase, the life of the machine was estimated at 15 years and hence it was
decided to create a depreciation fund to be invested in Government Securities to provide for
replacement of the machine.
Before expiration of the estimated life it was decided to dismantle the machine and replace
it with a modern one. The cost of dismantling was Rs. 200 and the cost of purchase and
installation of new machine was Rs. 23,000. Parts of the old machine estimated to be worth
Rs. 500, were retained and the remainder sold as scrap for Rs. 750.
At the date of dismantling the old machine, the depreciation fund stood in the books at Rs.
16,500 and was represented by Government Securities costing the same amount. These
securities were sold for Rs. 15,600.
You are required to write up the ledger accounts concerned.
Solution :
Dr. Machinery A/c Cr.
Particulars Rs. Particulars Rs.
To Cash A/c By Cash A/c Scrap Sale 750
Cost of Machine 20,000 Depreciation fund A/c – tfd.. 15,400
Installation 1,000 Profit & Loss A/c – Loss 4,350
To Cash A/c Balance c/d 23,500
Cost of new Machine 23,000 — for old machine Part – 500
— for new machine 23,000
44,000 44,000
Dr. Depreciation Fund A/c Cr.
Particulars Rs. Particulars Rs.
To Cash A/c – Cost of dismantling 200 By Balance b/d 16,500
Depreciation Fund
Investment A/c – transferred 900
Machinery A/c (Balancing figure) 15,400
16,500 16,500
Dr. Depreciation Fund A/c Cr.
Particulars Rs. Particulars Rs.
To Balance b/d 16,500 By Cash A/c
— Sale of securities 15,600
— Depreciation Fund A/c
– Loss tfd.. 900
16,500 16,500
Working to find out loss on dismantling the old machine.
Cost of old machine Rs. 21,000
Less : Parts retained from Old machine 500
Sale of Scrap 750 1,250
19,750
Less : Amount available from the balance of
Depreciation Fund A/c 15,400
Loss 4,350
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