53560585 financial accounting part 7

Financial and Management Accounting Unit 7

Page No.: 135

Unit 7 Final Accounts

Structure:

7.1 Final Accounts – Introduction

7.2 Adjustments before preparing final accounts

7.2.1 Outstanding expenses

7.2.2 Prepaid expenses

7.2.3 Accured Income

7.2.4 Income received in advance

7.2.5 Depreciation

7.2.6 Bad Debts

7.2.7 Provision for doubtful debts

7.2.8 Reserve for Discount on Debtors

7.2.9 Reserve for discount on creditors

7.2.10 Closing Stock

7.3 Trading Account

7.4 Preparation of Trading Account

7.5 Profit and Loss Account

7.6 Preparation of Profit and Loss Account

7.7 Balance Sheet – Meaning

7.8 Preparation of Balance Sheet

Learning Objectives:

After studying this unit, you should be able to understand the following:

1. To understand the process of preparing the final accounts of a business

organization from Trial balance.

2. To incorporate such transactions left out and various adjustments with

regard to transactions taking place after the trial balance but relating to

the current period.


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7.1 Final Accounts – Introduction

The last step of accounting process is preparation of final accounts. Final

accounts are Trading account and Profit and Loss Account with respect to

any trading organization. If it is non trading organization like a club or an

Educational Institution, Receipt and Payment Account and Income and

Expenditure Account are the final accounts. In case of a manufacturing unit,

a Manufacturing account is prepared in addition to Trading Account. Profit

and Loss Account is prepared by all trading and manufacturing units.

Balance Sheet is closely associated with these final accounts. But Balance

Sheet is not an account. It is a statement of assets and liabilities of business

organization prepared at the final stage of the accounting process.

Therefore balance sheet is regarded as a part of final accounts. The

purpose of preparing final accounts is to find out the end result of business

at the end of an accounting period, may it be profit or loss.

The basis for preparing final accounts is the Trial Balance. For Trial

Balance, the ledger balances are the root. For ledger accounts, the journal

entries or entries in the subsidiary books (Books of original entry) are the

roots. Hence the final accounts reflect the original business transactions,

which are systematically and scientifically recorded, classified, and

analyzed. Final accounts provide bundle of information for decision making

activities.

Objectives:

1. To know the meaning and purpose of final accounts

2. To identify the items of Trading Account

3. To identify the items of Profit and Loss Account

4. To identify the items of assets and liabilities of a Balance Sheet and

modes of preparing it.


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5. To know the adjustments such as Reserve for bad debts, Reserve for

discounts on Debtors, Reserve for discount on Creditors, bad debts out

side the trial balance.

6. To understand the adjustments like depreciation on assets, closing

stock, stock lost in fire, goods given as samples, goods used for

personal purpose etc.,

7. To know the adjustments of prepaid expenses, outstanding expenses,

pre-received incomes, outstand incomes etc.

8. To prepare Balance Sheet without any adjustments from trial balance.

9. To prepare Balance Sheet with adjustments.

7.2 Adjustments before preparing final accounts

The Generally Accepted Accounting Principles (GAAP) supports the accrual

basis of accounting, according to which revenue is recognized when it is

earned and expenses are recognized when they are incurred, irrespective of

their actual receipt or actual payment.

If the accrual basis of accounting is used, adjusting entries are required at

the end of the period to record any changes in assets, liabilities, revenue

incomes, revenue expenses, previously unrecognized. Adjusting entries are

regarded as internal transactions. For instance, salaries are paid in advance

to a few employees and the excess paid in the current period, should be

adjusted to the coming period and what is paid in advance now should not

be charged against the revenues relating to the current period. Similarly,

insurance paid in advance, rent paid in advance etc., Like wise incomes

received in advance should not be considered for the current period. On the

other hand, expenses yet to be paid for the current period should be

charged against the current period’s income. On the same lines, incomes

yet to be received for the current period should be considered as incomes


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for the current period whether actually received in cash or not. Every asset

is subject to wear and tear and the value of the asset gets reduced even if

the loss on account of this is not recorded by means of a journal entry.

Some stock of goods at the end of the period is left over and it has to be

valued and be taken to accounts for fair computation of profit. Such internal

adjustments have to be made and recorded before preparing Trading

Account, Profit and Loss Account and Balance Sheet. The adjustments to

be incorporated are briefly described in the following paragraphs.

Self Assessment Questions 1:

1. Final account are prepared from trial balance, trial balance from ledger

accounts and ledger account from books of original entry. So final

accounts are reflection of original transaction (state True / False ).

2. Final accounts speak about profit or loss as on a particular day ( state

True and False )

3. Balance sheet tells the value of assets and liability as standing an a the

last day of accounting period ? ( True / False ).

4. Adjustment in final accounts is necessitated because of accrual basis of

accounting (state True / False ).

5. Adjusting entries are also regarded as ______ .

6. Adjustments such as outstanding and prepaid / received items are

needed to find out _____________.

7. Adjustment entries are made before preparing tracking and P & L and

balance sheet (True/False ).

7.2.1 Outstanding expenses

Expenses due but not yet paid are known as outstanding expenses. Wages,

salaries, rent, commission etc payable in the current month are paid in the

following month. If final accounts are prepared for year ending 31st

December, then the expenses payable for December will be paid in January

of next year. The extent to which the amount belongs to the current year but


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payable in the next year is called outstanding expenses. To record that

aspect, the journal entry drawn in the Journal proper is:

Concerned Expenses account Dr

To outstanding Expenses account.

Outstanding expenses account indicates liability for the current year and it

will appear in the balance sheet.

Example: Advertisement expenses for year 31-12-2003 outstanding is

Rs.5000. The journal entry is

Advertisement expenses account Dr 5000

To Outstanding expenses account 5000


1. Expenses due but not yet paid are known as ___________.

2. What is the entry if salaries are outstanding ?

3. If ‘outstanding expenses’ appear in trial balance, what does it mean ?

4. Outstanding expenses appear an assets side of balance sheet ( state

True / False ).

7.2.2 Prepaid Expenses

Expenses paid in advance are regarded as prepaid expenses. Prepaid

expenses form an asset and therefore prepaid expenses account is debited.

For example, insurance premium is paid from April, 2004 to March, 2005

and the amount is Rs.3600. The financial year ends by 31st December,

2004. Therefore the premium relating to Jan, Feb and Mar of 2005 Rs.900 is

said to have been paid in advance. To record this internal adjustment, the

entry is

Prepaid Expenses account Dr 900

To Insurance account 900

Note that outstanding or prepaid expenses accounts are regarded as

personal accounts.


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1. Expenses paid even before incurred. They are know as _____.

2. Prepaid expenses appear on the asset side of balance sheet. ( state

True / False).

3. Opening balance of prepaid insurance is Rs 1000; insurance paid during

the year Rs. 5600; Insurance paid in advance include in the above is Rs

800: Find out actual expenditure for insurance for the current year.

4. Prepaid expenses account is a personal account ( True / False).

7.2.3 Accrued Income

Accrued income is also called outstanding income. Outstanding income

account is a personal account and it represents an asset. This account is

credited and the concerned income account is debited in the journal proper

as an adjusting entry. The entry is

Outstanding incomes account Dr

To Concerned income account

Example

Interest accrued on Fixed Deposit of Rs 200000 at 12% simple interest on

31-12-2006, not yet received. The entry is

Outstanding incomes account Dr 24,000

To interest on FD account 24,000

Outstanding Income account appears as an asset in the balance sheet.


1. Income earned but not received is called ____________.

2. Outstanding income is an asset ( state True / False ).

3. Outstanding income is a personal account. (True / False ).


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7.2.4 Income received in advance

Just as income is accrued, there are instances where income is received in

advance. The amount is shown as liability in the balance sheet and it shows

a credit balance. The adjusting entry to record the income received in

advance is

Concerned item of income account Dr

To Income received in advance account

Example

Rent received for one year from 1-4-2005 to 31-3-2006 Rs.48000. Accounts

are finalized on 31-12-2005. Therefore rent received for January, February

and March of 2006 is said to have been received in advance Rs.12000. The

entry is

Rent received account Dr 12000

To Income received in advance a/c 12000


1. Any income received in advance is a liability (state True / False ).

2. What is the adjusting entry for rent received in advance ?

3. Income received in advance in the current year is ________ from the

unearned item of income received.

7.2.5 Depreciation

Depreciation is reduction in the value of an asset due to constant use of the

same, which is called wear and tear. Fixed assets like, buildings, plant,

machinery, furniture etc., are subject to depreciation. Whenever, an asset is

depreciated, its value goes down and therefore it is a loss to the

organization. Depreciation account is debited and the concerned asset

account is credited. The item of depreciation may appear in the trial

balance, which means that already the concerned asset is reduced by the

amount of depreciation. If depreciation is given as an additional adjustment,


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then the depreciation amount should be charged against profit and loss

account on one hand and the concerned asset account is reduced on the

other hand in the balance sheet.

There are two popular methods of depreciation, namely fixed installment

method and reducing balance method. In fixed installment method,

depreciation is calculated on cost of the asset. In case of reducing balance

method (Diminishing balance method), the depreciation is charged on the

reducing balance of the book value of the asset. Reducing balance method

is more popular and well recognized.

Example

Building is of the book value of Rs.400000. It is depreciated at 10% on fixed

installment method. Show the journal entry and how does it appear in the

balance sheet?

Solution

The entry for depreciation is

Depreciation account Dr 40,000

To Building account 40,000

Depreciation being a loss is transferred to profit and loss account and in the

balance sheet, the value of Building is shown as Rs.400000 – 40000 =

360000.

Note: For the second year the depreciation will be Rs.40000 if the asset is

depreciated under fixed installment method. If it is depreciated under

reducing balance method, the depreciation for the second year is Rs.36000

(10% of 360000).


1. Depreciation is for __________ of an asset.

2. What entry is drawn if depreciation is provided ?


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3. When depreciation account is transferred to P & L A/c , what entry do

you draw ?

4. If depreciation to be provided in the adjustments, what do you

understand by this ?

5. What is the method of depreciation recognized by Indian Income Tax

Act?

6. If depreciation appears in the trial balance, what does it indicate ?

7.2.6 Bad Debts

Bad debts are those debts which are not recovered. Bad debts form loss to

the business and reduce the amount of debtors. Since bad debts are losses,

they are debited and the debtor’s account is credited because the

outstanding amount of debtors comes down.

If bad debts are identified well before preparing trial balance, then bad debts

appear in the trial balance and they should be taken to the debit side of

profit and loss account. Since debtors account is already reduced by the

amount of bad debts, it does not require any further adjustment in the

balance sheet.

If bad debts are shown outside the trial balance, which means that they are

identified after the preparation of Trial Balance, then two adjustments should

be incorporated. One – bad debts should be charged against profits in P & L

A/C and the second – the debtor’s account should be reduced by the

amount of bad debts in the balance sheet on the asset side.

Example

The sundry debtors for the year 2005 are Rs.50000. The bad debts

amounted to Rs.4000 as on 31-12-2005 already shown in the trail balance.

Write off further bad debts Rs5000. Show how the above internal

adjustments appear in the final accounts.


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Solution

There are bad debts shown in the trial balance Rs4000 and not shown in

the trial balance Rs.5000. To incorporate those bad debts not yet shown

in the trial balance, the adjusting entry is

Bad debts account Dr 5000

To Debtor’s account 5000

In the profit and loss account of 2005, the total bad debts appearing on

the debit side are Rs. 9000(4000 + 5000)

In the balance sheet, on the asset side, the amount of debtors is

Rs45000(50000 -5000).


1. Unrecovered debts are called ______.

2. Bad debts are not expenses but they form losses. (state True / false )

3. What is the entry made in journal proper, if bad debts are recorded.

4. What entry do you make to close the bad debts ?

5. What impact bad debts have on profits ?

6. If bad debts are recovered, what entry can be drawn ?

7.2.7 Provision for Doubtful Debts

Debts that can not be recovered are called bad debts but debts, the

recovery of which is doubtful, are called doubtful debts. From the past

experience of the business proprietor, what percentage of good debts may

become bad in future, can be estimated and in the current year itself an

equal amount of profit be set aside. This provision is known as Reserve for

Bad Debts or Provision for Doubtful Debts or Reserve for Doubtful Debts.

Since the provision for bad debts is a charge against current year profit, the

adjusting entry is to debit P & L A/C and credit Provision for Bad Debts

Account.


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Profit and Loss Account Dr

To Provision for bad debts account

Provision for bad debts is a liability to be incurred in future and so it should

appear on the liability side of balance sheet. However, the convention is -

RBD (Reserve for Bad and Doubtful Debts) is deducted from the amount of

good debtors. The important note here is that RBD is computed as a

percentage of good debts, which means total debtors minus bad debts

unadjusted.

Provision for bad and doubtful debts is a running account and every year the

amount keeps on changing because from the provision made in the current

year, bad debts occurring in the following year have to be adjusted and

additional amount of provision to be made is calculated. Every year, the

amount transferred to P & L A/C is B + N – O, where B stands for bad debts;

N stands for new provision and O stands for old reserve. For example, the

old reserve stands at Rs.15000 and bad debts to be adjusted is Rs4000 and

new reserve to be maintained is Rs18000. The amount to be charged

against profits in P&L A/C is Rs.7000 (4000 + 18000 – 15000). The formula

can also be shown as

N - O + B = 18000 – 15000 + 4000 = 7000


1. What is the difference between Bad debts and doubtful debts?

2. Provision is made for Debts which have become bad (state True /

False).

3. Provision for Doubtful debts is a change against the profits of the firm

(state True / False )

4. Bad debts incurred in the subsequent period are written off against

reserve for bad debts (state True / False ).

5. What is the entry for writing off of bad debts against RBD?


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6. If RBD is freshly to be provided, what entry can be draw?

7. RBD is calculated on debtors which are good and so any bad debts out

side trial balance should be deducted out of total debtors (state True /

False ).

Illustration:

On 1st January 2006, the RBD account stood at Rs.9000 in the books of a

merchant. The bad debts written off during the year ended 31st December,

2006 amounted to Rs.4800 and Sundry Debtors stood at Rs.480000. It was

desired to maintain the reserve for bad debts at 5% on Debtors. During the

year 2007 bad debts written off amounted to Rs.12000 and sundry debtors

on 31st December 2007 amounted to Rs.380000.As usual 5% reserve was

required. Show the journal entries for recording the above transactions and

write up the bad debts reserve account.

Solution

Journal Entries

Date Particulars LF Debit

Rs.

Credit

Rs.

2006

Dec, 31st

Dec, 31st

Dec 31st

2007

Dec, 31st

Bad debts account Dr

To Sundry Debtors Account

(Being the bad debts written off)

Bad Debts Reserve account Dr

To Bad Debts account

(Being bad debts set off against RBD)


To Bad Debts Reserve account

(Being additional RBD made to bring the reserve to 5% of 480000)

Bad debts account Dr

To Sundry Debtors account

(Being bad debts written off )

4800

4800

19800

12000

4800

4800

19800

12000


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Dec 31st

Dec 31st

Bad debts Reserve account Dr

To bad debts account

(Being bad debts written off against RBD)

Profit and loss Account Dr

To Bad debts reserve account

(Being additional RBD made to bring the reserve to 5% of 380000)

12000

7000

12000

7000

NOTE:

On January 1st 2006, the RBD account stands at Rs9000 and during the

year the actual bad debts are Rs4800 and so there is unused balance of

Rs.4200 (9000 -4800). It is desirable to have reserve of 5% of 480000 –

Rs24000. Therefore additional reserve required to be provided in P & L A/C

is Rs19800 (24000 – 4200).

Similarly during 2007 the actual bad debts are Rs.12000 and the available

reserve is used for writing it off. Still there is a balance left over is Rs.12000

(24000 – 12000). The additional reserve to be maintained is 5% of 380000,

that comes to Rs19000. So the additional amount to be provided in P & L

A/C in 2007 is Rs.7000 (19000 – 12000).

Reserve for Bad Debts Account

Dr Cr

Date Particulars JF

Amount

Rs. Date Particulars

JF

Amount

Rs.

2006

Dec, 31st

To bad debts

To balance c/d

4800

24000

2006

Jan, 1st

Dec 31st

By Balance b/d

By P&L A/C

9000

19800

Total 28800 Total 28800

2007

Dec,31st

To bad debts

To balance c/d

12000

19000

2007

Jan 1st

Dec 31st

By balance b/d

By P&L A/C

24000

7000



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7.2.8 Reserve for Discount on debtors:

There are two types of discounts allowed to customers in a business. One is

trade discount and another is cash discount. Trade discount is given to

customers to retain the customers and it is shown in the invoice itself. It

means that trade discount does not come to accounting records at all. But

cash discount is allowed to customers to encourage them to pay cash

promptly at the earliest. Normally cash discount gets recorded in cash

account. Out of experience, a businessman can guess how much of cash

discount he may have to give on customer’s accounts. Cash discount given

to debtors is always a loss and is shown as expenditure in the Profit and

Loss Account. After anticipating the amount of cash discount allowable, a

provision is made in the current year itself. In the subsequent years, the

actual discount allowed is set off against the provision for discount on

debtors. Every year, the amount of provision for discount on debtors is

deducted from the profits. The entry for making the provision is


To Provision for discount on debtors account

Just as in the case of provision for bad and doubtful debts, the bad debts

are first written off against provision for bad debts and later the required

amount of provision is provided in the P&L A/c, similar procedure takes

place in the case of provision for discount on debtors. The following guide

lines may be kept in mind while dealing with the reserve for discount on

debtors

1. If a reserve for discount on debtors is not existing and cash discount is

allowed, then transfer the discount to P&L account.

2. Any fresh reserve for discount on debtors is to be made, debit the P&L

A ccount with the amount of reserve.


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3. If provision for discount on debtors exists at the time of providing

discount, then write off the discount from the provision already made

for the purpose.

4. New provision should then be calculated and only as much as required

to bring the existing provision to the new figure should be debited to

P&L Account.

5. If the new provision required is lower than the provision already existing

(old), then the difference shows profit and transfer the same to P&L

Account.


1. what is the aim of giving cash discount ?

2. If discount is allowed against receivables, what entry do you draw in

journal proper?

3. Provision for Discount on debtors is a charge against P & L a/c. (state

True / False).

4. Provision for discount on debtors appears as a liablility in the balance

sheet ( state True / False )

5. What is the basis for calculating provision for discount an debtors?

Illustration

The following items are found in the trial balance of Praksh on 31st

December 2000.

Sundry Debtors Rs. 160000

Bad Debts written off 9000

Discount allowed to Debtors 1800

Reserve for Bad and doubtful Debts 31-12-1999 16500

Reserve for discount on Debtors 31-12-1999 3200


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You are required to provide for the bad and doubtful debts at 5% and for

discount on debtors at 2%. Give necessary journal entries and show bad

debts account, bad debts reserve account, discount account and provision

for discount on debtors account.

Solution

Date Particulars LF Debit

Rs.

Credit

Rs.

2000 Dec, 31

st

Dec 31st

Dec 31st

Dec 31st

RBD account Dr

To Bad Debts account

(Being bad debts written off against existing RBD)

P & L Account Dr

To RBD account

(Being addition to RBD to make the new RBD equal to 5% of 160000)

9000

500

1800

1640

9000

500

1800

1640

Reserve for discount on debtors account Dr

To Discount on Drs A/c

(Being discount on debtors written off against Reserve for discount on Debtors)

P & L Account Dr

To Reserve for discount

On debtors account

( Being additional reserve made to make the new reserve for discount on debtors to 2% of 152000)

NOTE:

1. The amount debited to P&L Account towards RBD is computed as

follows

Old RBD = Rs. 16500

Less Bad debts = 9000


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Balance = 7500

New RBD @5% on160000 = 8000

RBD to be provided = 500 (8000-7500)

2. The amount debited to P&L Account towards Reserve for Discount on

Debtors is computed as follows:

Good Debtors = 160000 – 8000 (New RBD)=152000

Old Res for Dis On Drs = Rs. 3200

Less Discount on Drs = 1800

Balance Reserve = 1400

New Res for Disc at 2%

On good drs 152000 = 3040

Res for Discount to be

Provided now = 1640 (3040 -1400)

Bad Debts Account

Dr Cr

Date Particulars JF Amount

Rs. Date Particulars JF

Amount

Rs.

2000

Dec, 31st

To Sundry debtors account

9000

2000

Dec 31st

By RBD account

9000


Reserve for Bad Debts Account

Dr Cr


Rs.


Rs.

2000

Dec, 31st

To bad debts

To balance c/d

9000

8000

2000

Jan, 1st

Dec 31st

By Balance b/d

By P&L A/C

16500

500



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Discount on Debtors Account

Dr Cr



Amount

Rs.

2000

Dec, 31st

To Sundry debtors account

1800

2000

Dec 31st

By Reserve for Discount on Debtors A/C

1800


Dr Reserve for Discount on Debtors Account Cr



Amount

Rs.

2000

Dec, 31st

To Discount on Debtors

To balance c/d

1800

3040

2000

Jan, 1st

Dec 31st

By Balance b/d

By P&L A/C

3200

1640


In the balance sheet, the Sundry debtors are reduced by bad debts shown

out side the trial balance, the new RBD, discount on debtors shown out side

the trial balance and the new Reserve for discount on debtors.

7.2.9 Reserve for discount on creditors

Just as reserve is for discount on debtors is created, reserve for discount on

creditors is also created. Businessman expects that he would receive

discounts from suppliers (creditors), when the businessman remits cash to

them. Anticipating some percentage of creditors being received as discount

in the coming year, the business proprietor makes a provision for the

expected income in the current year itself. Discount on creditors is an

income and therefore reserve for discount on creditors is debited and profit

and loss account is credited to show it as anticipated profit. In the

subsequent year, when discount on creditors is actually received, it is first

set of against provision for discount on creditors and the difference between

the new provision for discount on creditors and the balance of old provision

left over is carried to P&L Account.


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Discount on creditors is income and to that extent the creditors due is

reduced. So the journal entry to record them is

Creditor’s account Dr

To discount on creditors account

Later if the discount received is adjusted against reserve for discount on

creditors, the entry will be

Discount on creditor’s account Dr

To Reserve for discount on creditors

When provision for discount on creditors is made in P&L Account, the entry

will be

Reserve for discount on creditors account Dr

To Profit and loss account

The amount of provision for discount on creditors is calculated at a

percentage on creditors. In the balance sheet, creditors are shown after

deducting reserve for discount on creditors.


1. Discount on creditors is an item of income (state True / false ).

2. Provision for discount on creditors is shown as an anticipated income

(State True/False ).

3. How do you treat provision for discount an creditors in balance sheet ?

4. Discount received from creditors subsequently is changed against

provision for discount on creditors. (state True / False ).

7.2.10 Closing stock

Stock of goods – raw materials, semi finished goods, finished goods – at the

end of the accounting year should be considered for preparing trading

account and balance sheet. It is an internal adjustment. Closing stock is

normally valued at cost or market price which ever is lower, even though

there are several other methods to value stock. Closing stock does not

appear in the trial balance because the value of it is ascertained only after

the preparation of trial balance. To bring to the records, a journal entry is


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passed in journal proper by debiting closing stock account and crediting

trading account. In the balance sheet, closing stock appears as an asset.


6. what is the popular valuation method of closing stock ?

7. what is the entry for adjusting the closing stock ?

8. what does happen in case closing stock is not considered for computing

gross profit ?

9. Closing stock always appears as an asset in balance sheet. (state True /

false).

7.3 Trading Account

Trading account shows gross profit or gross loss arising out of trading

activities. Trade means buying and selling. The account mainly focuses on

finding the result of goods bought and goods sold. Interestingly, goods are

bought for a cost and the proprietor incurs a few items of purchase

expenses and the goods are sold at a price higher or lower than the cost

incurred. At the end of accounting period, some stock is left over and it

should be valued so as to calculate the profit or loss from the cost of goods

sold. Therefore, opening stock of goods, cost of purchases made, expenses

on purchases are taken on debit side of the trading account. On the credit

side of the account, the sales of goods and the value of closing stock are

shown. The excess of credit over debit is gross profit and vice versa. The

gross profit or gross loss is transferred to Profit and Loss Account. The

format of a Trading Account is given below:

Dr Trading Account for the year ending- - - - Cr

Particulars Rs. Particulars Rs.

To opening stock

To Purchases

Less Purchasereturns/returns outwards

To Carriage inwards

To freight and octroi

To wages

By sales

Less returns inwards/sales returns

By Closing stock


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Add outstanding wages

Less prepaid wages

To fuel and power

To Gas, coal, electricity for production

To Import duty and clearing charges

To stores consumed

To factory rent, insurance, factory expenses

To other direct expenses

To Royalty paid

To Profit and Loss A/c (Gross Profit)

Note: For every expenditure, outstanding and prepaid aspects must be

considered.

From the above account, it is easy to learn the transferring entries made to

close the accounts of expenses and incomes. The transferring entries are

1. Trading account Dr

To opening stock a/c

To purchases a/c/

To Wages a/c

To Royalty paid a/c etc

(Being all expenses of trading transferred to trading account)

2. Sales account Dr

Closing stock account Dr

To Trading account

(Being sales and closing stock transferred to trading account)

3. Trading account Dr

To Profit and Loss Account

(Being gross profit carried forward to P&L A/C)

4. Profit and Loss Account Dr

To Trading account

(Being gross loss transferred to P&L Account)


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1. Trading account is an account showing profit on cost of goods sold.

(state True / False).

2. Cost of goods sold include opening stock + Purchase expenses –

closing stock. (state True/ False ).

3. Gross profit is ______minus cost of goods sold.

4. Gross profit or loss is transferred to ___________ account.

7.4 Preparation of Trading Account

To prepare Trading Account, the following steps may be followed:

a) Identify the items of expenses relating to trading and show them on the

debit side of Trading Account.

b) Effect the adjustments such as outstanding or prepaid to the relevant

items of expenses

c) Show the sales less returns and closing stock on the credit side of

trading account

d) The difference is gross profit if credit total is more than debit and gross

loss if debit total is more than credit.

e) Transfer the gross profit or gross los to Profit and Loss Account as the

case may be.


1. Do you consider gross purchases or net purchases, while preparing

trading account ?

2. Do trading concerns prepare manufacturing account ?


Page No.: 157

Illustration

From the following balances extracted from Trial balance, prepare Trading

Account. The closing stock at the end of the period is Rs. 56000

Particulars Amount in

Rs.

Stock on 1-1-2004

Returns inwards

Returns outwards

Purchases

Debtors

Creditors

Carriage inwards

Carriage outwards

Import duty on materials received from

abroad

Clearing charges

Rent of business shop

Royalty paid to extract materials

Fire insurance on stock

Wages paid to workers

Office salaries

Cash discount

Gas, electricity and water

Sales

70700

2000

3000

102000

56000

45000

5000

4000

6000

7000

12000

10000

2000

8000

10000

1000

4000

250000


Page No.: 158

Dr TRADING ACCOUNT FOR THE YEAR ENDING - - - - Cr

Particulars Rs Particulars Rs

To stock on 1-1-2004

To Purchases 102000

Less Returns

Outwards 3000

To Carriage inwards

To import duty

To Clearing charges

To Royalty

To Fire Insurance

To Wages

To Gas, electricity, water

To P & L Account (GP)

70700

99000

5000

6000

7000

10000

2000

8000

4000

91300

By sales 250000

Less Returns

Inwards 3000

By Closing stock

247000

56000

303000

303000

7.5 Profit and Loss Account

Profit and los account is an important final account in the sense that the net

result of the business in the form of net profit or net loss is disclosed by

preparing the same. All business expenses like administrative expenses,

office expenses, selling and distribution expenses are shown on the debit

side of the account. Besides, all provisions made for different purposes such

as reserve for bad debts, reserve for discount on debtors, reserve for

repairs, depreciation etc., also picture on the debit side of the account. On

the credit side of the account, all incomes of revenue in nature, reserve for

discount on creditors and gross profit carried from trading account are

mentioned.

In this connection, it is important to note that Trading and Profit and Loss

Account are regarded as revenue accounts. Any capital receipts or capital


Page No.: 159

payments are not considered while preparing them. In brief, revenue

receipts are those which are received regularly arising out of day to day

activities of the business and similarly revenue payments, which are known

as expenses are incurred regularly and for every day functions of the

business. Capital receipts are in the form of sources of funds such as

capital received, sale of capital asset like building etc., Capital payments

are those spent for acquisition of capital assets, incurring capital

expenditure etc.,

The transferring entries are drawn to prepare Profit and loss account. They

are


To all expenses account To Transfer all expenses

2. All Incomes account Dr

To Profit and Loss Account To Transfer all incomes


To Capital account To Transfer Net Profit to Capital

4. Capital account Dr

To Profit and Loss Account To Transfer Net loss to Capital

Dr Profit and Loss Account for the year ending --- Cr


To Trading Account (GL)

To Salaries + Out standing –

Prepaid salaries as per

adjustments

To Rent of the premises

To Travelling expenses

To Rates and Taxes

To Printing and stationery

By Trading account (GP)

By Interest earned + Accrued

interest as per adjustments

By Commission earned

By discount earned

By Rent received

By Bad debts recovered

By Interest on drawings


Page No.: 160

To Postage and Telegram

To Telephone charges

To Insurance –Prepaid

amount as per adjustment

To Interest paid

To Discount allowed

To Sundry expenses

To Advertisement

To Commission

To Carriage outwards

To Bad Debts

To Reserve for Bad debts

To Reserve for discount on

Debtors

To Depreciation

To Legal charges

To Audit fee

To Interest on Capital

To Capital Account (Net

Profit)

By Reserve for discount on

Creditors

By Dividends received

By Royalty Received

By Capital Account( Net Loss)

7.6 Preparation of Profit and Loss Account

The following steps may help to prepare Profit and Loss Account

1. Identify the expenses and bring them to debit side of P&L Account

2. Identify the revenue incomes and put them on the credit side of P&L

Account

3. Check whether all adjustments like outstanding, prepaid, pre received

expenses and incomes as the case may be are brought to the account

4. Check the transfer of reserves to the relevant sides of the account

5. Transfer the net profit / net loss to the capital account


1. What types of expenses are shown on the debit side of P & L account ?


Page No.: 161

2. P & L account is revenue account showing the revenue net profit or loss

for the accounting period(state True / False ).

3. Painting for a new building, Installation expenses paid to install a plant,

amount spent for advertising for promotion of sale of a product are

revenue expenses (state True / False ).

4. Net profit / loss is carried to owners equity / capital (state True / False )

Illustration

The following Trial Balance is extracted from the books of a merchant on

31-12-2004.

Particulars Rs

Furniture and fittings

Motor Vehicles

Buildings

Capital Account

Bad Debts

Provision for Bad debts

Sundry Debtors

Sundry Creditors

Stock on 1-1-2004

Purchases

Sales

Bank Over Draft

Sales Returns

Purchase Returns

Advertising

Interest on Bank Over Draft

Commission

Cash

Taxes and Insurance

General Expenses

Salaries

640

6250

7500

12500

125

200

3800

2500

3460

5475

15450

2850

200

125

450

118

375

650

1250

782

3300


Page No.: 162

The following adjustments are to be made.

1. Stock in hand on 31-12-2004 was Rs3250

2. Depreciate Buildings at the rate of 5%, Furniture and fittings @ 10% and

Motor Vehicles @ 20%.

3. Rs.85 is due for interest on bank overdraft.

4. Salaries of Rs300 and taxes Rs.120 are outstanding.

5. Insurance amounting to Rs.100 is prepaid

6. One-third of the commission received is in respect of work to be done

next year

7. Write off a further sum of Rs.100 as bad debts and provision for bad and

doubtful debts to be made equal to 10% on sundry debtors.

8. Prepare Trading Account and Profit and Loss Account.

9. Dr Trading Account for the year ending 31-12-2004 Cr


To Stock on1-1-2004

To Purchases 5475

Less returns 125

To P & L A/C (GP)

3460

5350

9690

By Sales 15450

Les Returns 200

By Closing Stock

15250

3250



Page No.: 163

Dr Profit and Loss Account for the year ending 31-12-2004 Cr


To Salaries 3300

Add Outstanding 300

To Advertising

To Interest on OD 118

Add Outstanding Int 85

To Taxes and

Insurance 1250

Add Out standing tax 120 1370

Less Prepaid Insurance 100

To General expenses

To bad debts

To RBD(New) 370

Less old RBD balance 100

To Depreciation:

On Bldgs @ 5% 375

On FF @ 10% 64

On M Vehicles @20% 1250

To Capital Account (NP)

3600

450

203

1270

782

125

270

1689

1551

By Trading Account (GP)

By Commission 375

Less Pre-received 125

9690

250


Note:

Sundry Debtors are Rs.3800 and there have been bad debts outside TB

Rs100. The good debtors are Rs.3700. The new RBD is 10% of 3700,

i.e.Rs370. The old RBD unspent is Rs100 (200 -100). Therefore RBD to be

charged against profit is Rs270

7.7 Balance Sheet

Balance Sheet is the sum and substance of financial performance a

business undertaking. It shows the assets and liabilities of business on a

particular day. It is not an account but is a statement of affairs. The

statement of assets and liabilities is prepared, having two sides, left side


Page No.: 164

containing capital and liabilities and on the right side, containing assets and

properties. Often the statement is prepared vertically, mentioning sources of

funds first and later application of funds. Sources of funds indicate capital

and liabilities and application of funds indicate assets.

Balance Sheet is prepared from Trial Balance. In case of sole trader

organization and Partnership organization, the format of preparing Balance

Sheet is arranged basing on liquidity of the assets. In case of Companies,

the Companies Act, 1956 has specified a definite pattern of preparing

Balance Sheet. Both the models of preparing Balance Sheet are stated

here under.

BALANCE SHEET FOR THE YEAR ENDING 31-12-2003 OF Mr. X

Capital and Liabilities Rs Assets Rs

Sundry Creditors

Less Reserve for Discount on Creditors

Bills Payable

Bank Over Draft

Loans Borrowed

Outstanding Expenses

Pre-received Incomes

Capital (Opening)

Add Additions to capital

Add interest on capital if any

Add Net profit as per P&L a/c

Less personal drawings

Less Net loss as per P&L A/C

Cash in hand

Cash at Bank

Land and Building

Add Additions if any

Less depreciation

Plant and Machinery less depreciation

Furniture and Fixtures less depreciation

Sundry debtors

Less Bad debts out side Trial Balance

Less Reserve for Bad Debts

Less Reserve for discount on Debtors

Bills Receivable

Loans and advances given to others + Interest outstanding

Investments + outstanding income on investments

Other outstanding incomes

Pre-paid expenses

Closing stock

Total Total


Page No.: 165

The Format of Balance Sheet of a Company


Capital:

Authorised, Issued, Subscribed,Called up,

Paid-Up capital with adjustments

Reserves and Surplus

Loans and Borrowings

Long Term Loans

Short Term Loans

Current Liabilities:

Sundry Creditors, B/P, Outstanding expenses, pre-received incomes, dividends payable, etc.,

Fixed Assets:

Goodwill, Land Buildings,Furniture, Fixtures, Equipment, Plant, Machinery, Copy Rights, Patents

Investments

Loans and Advances

Current Assets:

Debtors, B/R, Inventory, Cash, Bank, Outstanding incomes, Prepaid expenses etc

Total Total


1. The two sides of a balance sheets are ____ and ___________.

2. balance sheet is prepared on the bases of trial balance. (state True /

False ).

3. balance sheet portrays the financial soundness of a concern (state True

/ False).

7.8 Preparation of Balance Sheet

A few guide lines are given here under to prepare balance Sheet of a

business concern. Balance Sheet is not an account and there is nothing like

debit side and credit side. If Trial Balance tallies, naturally Balance Sheet

also tallies:

1. Identify all assets from the trial balance. Assets are shown on the debit

side of T.B

2. Identify all liabilities from the Trial Balance and they are on the credit

side of TB.


Page No.: 166

3. Make a mark of items with respect to which adjustments are given out

side the TB

4. All adjustments should find place in two places, one either in Trading

account or in Profit and Loss Account and another invariably Balance

Sheet. For example, closing Stock given outside TB is first shown on the

credit side of Trading Account and it is shown as an asset in the Balance

Sheet. ‘Bad Debts Reserve to be provided’ appears in P&L Account and

later shown as a deduction from Sundry Debtors in the Balance Sheet.

Similarly depreciation is charged against profits first and later deducted

from the book value of concerned asset in the balance sheet.

Illustration 1

From the Trial Balance given in para 6, prepare Balance Sheet of the

merchant as on 31-12-2004.

Solution

Balance Sheet as on 31-12-2004


Sundry Creditors

Bank Over Draft 2850

Add interest due 85

Commission received in advance

Outstanding Taxes

Outstanding Salaries

Capital 12500

Add Net Profit 1551

2500

2935

125

120

300

14051

Cash

Building 7500

Less Depreciation 375

Furniture and Fixtures 640


Motor Vehicle 6250


Sundry Debtors 3800

Less bad debts as per Adjustments 100

Balance 3700

Less Reserve for Bad Debts(New) 370

Closing Stock

Pre-Paid Insurance

650

7125

576

5000

3330

3250

100



Page No.: 167

NOTE: Every adjustment given outside Trial Balance finds place in two

accounts –Trading account / Profit and Loss Account and invariably in

Balance Sheet.


1. What is the purpose of creating Reserve for Bad debts?

2. State the purpose of creating reserve for discount on creditors.

3. Insurance paid on 1-1-2000 up to 31-12-2000 Rs.4800. If the books are

closed on 31-7-2000, what is the amount of prepaid insurance?

4. Select the most appropriate answer.

i) Sales are equal to a) Cost of goods sold + Profit b) Cost of goods

Sold – Gross Profit c) Gross Profit – Cost of Goods sold

ii) Interest on Drawings is a) Expenditure for the business b) Expensef

or the business c) Gain for the business

iii) Goods given as samples should be credited to a) Advertisement

account b) Sales account c) Purchases account

iv) Out standing salaries are shown as a) an expense b) a liability

c) an asset

v) Income tax paid by a sole trader on his business income should be

a) debited to the Trading Account b) debited to P&L Account

c) deducted from capital account in the Balance Sheet

5. Stock at the end, if appears in the Trial Balance is taken only to the

Balance Sheet – Yes or No?

6. Goods taken by the proprietor for personal use are credited to sales

account – Yes or No?

7. Salary paid in advance is not an expense because it neither reduces

assets nor increases liabilities. – Yes or No?

8. Balance Sheet is an account because it is included in the scope of final

accounts – Yes or No


Page No.: 168

Terminal Questions

1. In taking out a Trial Balance, a Book keeper finds that debit total

exceeds the credit total by Rs.611. The amount is placed to the credit of

a newly opened Suspense Account. Subsequently the following

mistakes were discovered. You are required to pass the necessary

entries for rectifying the mistakes, and show how Suspense account.

(a) Sales day book was over cast by Rs.1000

(b) A sale of Rs.50to Sri Ram was wrongly debited to Sri Krishna

(c) General expenses Rs.180 were posted as 801

(d) Cash received from Bhatt was debited to his account RS.450

(e) While carrying forward the total from one page of the Purchases

book to the next, the amount of Rs.1235 was entered as Rs.1325.

2. Rectify the following errors:

(i) Furniture purchases for Rs.2500 was debited to Purchases

account

(ii) A sum of Rs.500 paid to Lalitha was debited to Shantha

(iii) A bill receivable for Rs.1000 received from Kumar has been

omitted to be entered.

(iv) Goods worth Rs2040 taken away by the proprietor were debited to

Bharath

(v) An engine purchased for Rs.12500 had been posted to Purchases

account

3. An accountant could not tally the Trial Balance. The difference was

temporarily transferred to Suspense account for preparing the final

accounts. The following errors were later discovered.

(a) The sales book was under cast by Rs.500

(b) Entertainment expenses Rs.950 though entered in the cash book

were omitted to be posted in the ledger.


Page No.: 169

(c) Discount column of the receipt side of cash book was wrongly

added as Rs114 instead of Rs.144.

(d) Commission of Rs.250 paid, was posted twice, once to discount

account and once to Commission account.

(e) A sale of Rs.169 to Rama Murthy though correctly entered in sales

book, was posted wrongly to his account as Rs.196.

(f) A purchase from Neeraj of Rs.290 though correctly entered in

purchases book was wrongly debited to his personal account.

You are required to

1. Pass the necessary rectifying entries

2. Prepare Suspense account

3. State the effect of each of the rectification on the profit.

What would be the correct profit originally arrived at was Rs.10000?

4. The trial balance of Raj Bahadur of Vijayanagaram as on 31-12-2005 is

given below.Prepare Trading Account, Profit and Loss Account and

Balance Sheet for year ending 31-12-2005 after taking into

consideration the following adjustments.

(a) Stock on 31-12-2005 was 15000

(b) Debts worth Rs.2000 should be written off as bad

(c) Depreciate Machinery by 5% and Motor Van by 15%

(d) Reserve for bad and doubtful debts should be increased by Rs.600

(e) Commission accrued and not received Rs.500

(f) Goods worthRs.500 were used by the proprietor for his personal

use

(g) On September,2005, a fire broke out in the shop and goods worth

Rs.2000 were completely destroyed. The insurance company

accepted a claim of Rs.1500 only and paid the amount on January

1st 2006.


Page No.: 170

TRIAL BALANCE AS ON 31-12-2005

Particulars Debit in Rs Credit in Rs

Capital

Drawings

Opening Stock

Purchases and Sales

Returns

Discounts

Commission

Income Tax paid

Office Salaries

Advertising

Sundry Debtors and creditors

Reserve for Doubtful Debts

Manufacturing Wages

Bills Receivable and Payable

Carriage

Machinery

Motor Vans

Land and Buildings

Office Expenses

Cash at Bank

Cash in Hand

7500

12000

86000

2000

500

700

17300

2000

1700

85000

8600

5000

600

40000

7000

10000

1500

6000

2300

295700

85000

170000

1000

700

1000

30000

3000

5000

295700

Ans: Gross Profit Rs.79300; Net Profit: 52350; BS163650


Page No.: 171

5. On 31st December,2003 the following trial balance has been extracted.

Rs Rs

Drawings

Sundry Debtors

Interest on loan

Cash in hand

Stock (1-1-2003)

Motor Vehicles

Cash at Bank

Land and buildings

Purchases

Salaries

Carriage in

Carriage out

General Expenses

Bills receivable

4000

20500

300

4000

6050

10000

5600

62000

97500

8600

4100

2200

5100

7050

Establishment

Rent, rates and insurance

Advertisement

Credit Balances

Capital account

Sundry creditors

Loan on mortgage

Bad debts Provision

Sales

Purchase returns

Discounts

Bills payable

Rent received

9100

5000

4160

50000

12000

15700

2000

170000

1460

500

3000

600

Adjustments

1. Depreciate land and buildings at 5% and Motor Vehicles at 15%

2. Interest on loan is at 5% taken on 1st January,2003

3. Salaries amounting to Rs.700 and Rates amounting to Rs.400 are due.

4. There has been a fire on 1st January, 2003 destroying goods worth

Rs.200

5. The bad debts provision is to be brought up to 5% on Sundry debtors

6. The stock in hand on 31-12-2003 was valued at Rs16000

7. Goods costing Rs.1000 were taken away by the proprietor for his

personal use, but no entry has been made in the books of accounts

8. Prepaid insurance amounted to Rs.500

9. Provide for Manager’s commission at 5% on net profit after charging

such commission.

Prepare Trading & P&L a/c and balance sheet.


Page No.: 172

6. A firm had the following Balances on 1st January 2000

(a) Provision for bad debts Rs7500

(b) Provision for discount on debtors 3600

(c) Provision for discount on creditors 3000

During the year Bad debts amounted to Rs.6000, Discounts allowed

were Rs300 and discounts received were Rs.600. During 2001, bad

debts amounted to Rs.5000 and discounts allowed and received were

respectively Rs.6000 and Rs1500.

Total debtors on December 1st, 2000 were Rs.1,44,000 before writing off

of bad debts, but after allowing discounts. On December 31st, 2000, the

amount of debtors was Rs.57000 after writing off the bad debts but

before allowing discounts. Total creditors on these two dates were

Rs.60000 and Rs.75000 respectively.

It is the firm’s policy to maintain a provision of 5% against bad and

doubtful debts and 3 % for discount on debtors and a provision of 3% for

discount on creditors.

Show the accounts relating to provision on Debtors and provision on

creditors for the year 2000 and 2001 (Ans: Provision for bad debts-2000

Rs.6900 and 2001 Rs.2850; Provision for discount on debtors – 2000

Rs.3933, 2001 Rs.1530; Provision for discount on creditors – 2000

Rs.1800, 2001 Rs2250)

7. In a business, Sundry debtors were Rs.40000 at the beginning of the

year and there was 5% Reserve for Doubtful Debts and also

5%Rreserve for Discount on Debtors. During the year the actual bad

debts amounted to Rs.1600 and the discount allowed were Rs.1700. At

the close of the year, the debtors were Rs.50000; and the percentage of

the two reserves have to be maintained as at beginning. Show ledger

accounts.


Page No.: 173

Answer for Self Assessment Questions.


1. True

2. False

3. True

4. True

5. Internal transactions

6. profit / loss for the accounting period

7. True


1. Outstanding expenses

2. Salaries account Dr To outstanding expenses account

3. It means t hat they are already considered.

4. False.


1. Prepaid expenses

2. True

3. 1000 + 5600 – 800 = 5800

4. True.


1. Accrued or outstanding income

2. True

3. True


1. True

2. Rent account Dr

To Income received in advance account

3. Deducted.


Page No.: 174


1. Wear & tear / usage

2. Depreciation a/c Dr

To asset account

3. P & L a/c Dr

To Depreciation a/c

4. It means that the concerned asset is get to be depreciated

5. Diminishing(Reducing) balance method.

6. It indicates that the asset is already depreciated and depreciation should

be transferred only to P & L a/c.


1. Bad debts

2. True

3. Bad debts a/c Dr

To Debtor a/c

4. P & L a/c Dr

To Bad debts a/c

5. Profits are reduced.

6. Cash a/c Dr.

To Bad-debts recovered a/c.


1. Bad debts are totally not recoverable, doubtful debts may be recovered.

2. False

3. True

4. True

5. R.B.D a/c Dr

To bad debts account.

6. P & L a/c Dr

To R BD a/c

7. True


Page No.: 175


1. To encourage customers to make quick & prompt payment.

2. Cash discount a/c Dr

To Debtors a/c

3. True

4. True

5. Good debtors (Meaning total debtors- Bad debts outside trial balance-

RBD )


1. True

2. True

3. Deduct the provision from the amount of creditors

4. True.


1. Cost on market price which ever is lower

2. Closing stock is debited and trading account is credited

3. Gross profit is reduced by not considering unsold stock

4. True.


1. True

2. True

3. Sales

4. P & L


1. Net purchases meaning (Total purchases – purchase returns – stock

destroyed – stock used for personal use ).

2. No, because they do not manufacture any product.


Page No.: 176


1. Indirect expenses office & administrative expenses, selling & distribution

expenses etc.

2. True

3. False

4. True


1. Assets, liabilities

2. True

3. True


1. To write off bad debts against the reserve and reduce the pressure on

current profits.

2. to provide for anticipated profits.

3. Rs 2000 relating to 5 months ( 1.8.2000 to 31.12.2000)

4. i) a ii) c iii) c iv) b v) c

5. Yes

6. No

7. Yes

8. No

Answer for Terminal Question:

1. Refer to unit 6.10.



4. Refer to unit 7.4, 7.6, 7.8.

Ans: Gross profit Rs 79300, Net profit Rs 52350

Balance sheet Rs 163650.


Page No.: 177

5. Refer to unit 7.4, 7.6 & 7.8

Gross Profit Rs 81010; Net Profit Rs 40706; Commission Rs 2034;

Balance Sheet Total Rs 1,20,025

6. Refer to unit 7.2.7, 7.2.8, 7.2.9

Answer : Provision for Bad debts 2000 – Rs 6900 ; 2001 – Rs 2850.

Provision for discount on debtors 2000 – Rs 3933; 2001- Rs 1530

Provision for discount on creditors 2000 – Rs 1800; 2001 –Rs 2,250.

7. Refer to unit 7.2.7, 7.2.8

Closing Balance of RBD Rs 2,500

Closing Balance of Reserve for Discount on Debtors Rs 2,375.

RBD Transferred to P & L account Rs 2,100

Reserve for Discount Transferred to P & L account Rs 2,175

53560585 financial accounting part 7

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