accounts unit 1-5

7/23/2019 Accounts Unit 1-5

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Unit:1IntroductionFinancial accountancy (or financial accounting) is the field of accountancy concernedwith the preparation of financial statements for decision makers, such as stockholders,suppliers, banks, employees, government agencies, owners and other stakeholders.Financial capital maintenance can be measured in either nominal monetary units or units

of constant purchasing power. The central need for financial accounting is to reduce thevarious principal-agent problems, by measuring and monitoring the agents' performanceand thereafter reporting the results to interested users.Financial accountancy is used to prepare accountancy data for people outside theorganisation or for those, who are not involved in the mundane administration of thecompany. anagement accounting, provides accounting information to help managersmake decisions to manage and enhance the business.!n short, financial accounting is the process of summarising financial data, which is takenfrom an organisation's accounting records and publishing it in the form of annual or"uarterly reports, for the benefit of people outside the organisation. Financialaccountancy is governed not only by local standards but also by international accountingstandard.

Role of Financial Accounting# Financial accounting generates some key documents, which includes profit and lossaccount, patterning the method of business traded for a specific period and the balancesheet that provides a statement, showing mode of trade in business for a specific period.# !t records financial transactions showing both the inflows and outflows of money fromsales, wages etc.# Financial accounting empowers the managers and aids them in managing moreefficiently by preparing standard financial information, which includes monthlymanagement report tracing the costs and profits against budgets, sales and investigationsof the cost.

Principles of Financial Accounting

Financial accounting is based on several principles known as $enerally %ccepted%ccounting &rinciples ($%%&) (illiamson *). These include the business entityprinciple, the ob+ectivity principle, the cost principle and the going-concern principle.# usiness entity principle very business re"uires to be accounted for separately by theproprietor. &ersonal and business-related dealings should not be mi/ed.# 0b+ectivity principle The information contained in financial statements should betreated ob+ectively and not shadowed by personal opinion.# 1ost principle The information contained in financial statements re"uires it to be basedon costs incurred in business transactions.# $oing-concern principle The business will continue operating and will not close butwill realise assets and discharge liabilities in the normal course of operations

Importance of Financial Accounting# !t provides legal information to stakeholders such as financial accounts in theform of trading, profit and loss account and balance sheet.

# !t shows the mode of investment for shareholders.# !t provides business trade credit for suppliers.

# !t notifies the risks of loan in business for banks and lenders.

Benefits of Financial Accounting# Maintaining systematic records: !t is a primary function of accounting to keep aproper and chronological record of transactions and events, which provides a base for


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further processing and proof for checking and verification purposes. !t embraces writingin the original2subsidiary books of entry, posting to ledger, preparation of trial balanceand final accounts. Meeting legal requirements: %ccounting helps to comply with the various legalre"uirements. !t is mandatory for +oint stock companies to prepare and present theiraccounts in a prescribed form. 3arious returns such as income ta/, sales ta/ are prepared

with the help of the financial accounts. &rotecting and safeguarding business assets4ecords serve a dual purpose as evidencein the event of any dispute regarding ownership title of any property or assets of thebusiness. !t also helps prevent unwarranted and un+ustified use. This function is ofparamount importance, for it makes the best use of available resources. Facilitates rational decision-maing %ccounting is the key to success for anydecision making process. anagerial decisions based on facts and figures take theorganisation to heights of success. %n effective price policy, satisfied wage structure,collective bargaining decisions, competing with rivals, advertisement and sales promotionpolicy etc all owe it to well set accounting structure. %ccounting provides the necessarydatabase on which a range of alternatives can be considered to make managerial decision-making process a rational one.# !ommunicating and reporting The individual events and transactions recorded and

processed are given a concrete form to convey information to others. This economicinformation derived from financial statements and various reports is intended to be usedby different groups who are directly or indirectly involved or associated with the businessenterprise.

"imitations of Financial Accounting0ne of the ma+or limitations of financial accounting is that it does not take into accountthe non-monetary facts of the business like the competition in the market, change in thevalue for money etc.The following limitations of financial accounting have led to the development of costaccounting5. #o clear idea of operating efficiency:6ou will agree that, at times, profits may bemore or less, not because of efficiency or inefficiency but because of inflation or tradedepression. Financial accounting will not give you a clear picture of operating efficiencywhen prices are rising or decreasing because of inflation or trade depression.$% &eaness not spotted out 'y collecti(e results: Financial accounting discloses onlythe net result of the collective activities of a business as a whole. !t does not indicateprofit or loss of each department, +ob, process or contract. !t does not disclose the e/actcause of inefficiency i.e. it does not tell where the weakness is because it discloses the netprofit of all the activities of a business as a whole. 7ay, for instance, it can be comparedwith a reading on a thermometer. % reading of more than 89.:; or less than 89.:odiscloses that something is wrong with the human body but the e/act disease is notdisclosed. 7imilarly, loss or less profit disclosed by the profit and loss account is a signalof bad performance of the business in whole, but the e/act cause of such performance isnot identified.

)% #ot *elpful in price fi+ation:!n financial accounting, costs are not available as an aidindetermining prices of the products, services, production order and lines of products.:% #o classification of e+penses and accounts:!n financial accounting, there is no suchsystem by which accounts are classified so as to give relevant data regarding costs bydepartments, processes, products in the manufacturing divisions, by units of product linesand sales territories, by departments, services and functions in the administrative division.Further e/penses are not attributed as to direct and indirect items. They are not assignedto the products at each stage of production to show the controllable and uncontrollableitems of overhead costs.


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have to be accounted at their disposable value, but it is accepted that they are at theirhistorical value. Principle of periodicity ach accounting entry should be allocated to a given periodand split accordingly if it covers several periods. !f a client pre-pays a subscription (orlease, etc.), the given revenue should be split to the entire time-span and not accountedfor entirely on the date of the transaction.

# Principle of full disclosure,materiality %ll information and values pertaining to thefinancial position of a business must be disclosed in the records.

Accounting !oncepts and !on(entions

%n accounting convention is a modus operandi of universally accepted system ofrecording and presenting accounting information to the concerned parties. They arefollowed +udiciously and rarely ignored. %ccounting conventions are evolved through theregular and consistent practice over the years to aid unvarying recording in the books ofaccounts. %ccounting conventions help in comparing accounting data of differentbusiness units or of the same unit for different periods. These have been developed overthe years.5% !on(ention of rele(ance: The convention of relevance emphasises the fact that only

such information should be made available by accounting that is pertinent and helpful forachieving its ob+ectives. The relevance of the items to be recorded depends on its natureand the amount involved. !t includes information, which will influence the decision of itsclient. This is also known as convention of materiality. For e/ample, business isinterested in knowing as to what has been the total labour cost. !t is neither interested inknowing the amount employees spend nor what they save.% !on(ention of o'ecti(ity:The convention of ob+ectivity highlights that accountinginformation should be measured and e/pressed by the standards which are universallyacceptable. For e/ample, unsold stock of goods at the end of the year should be valued atcost price or market price, whichever is less and not at a higher price even if it is likely tobe sold at a higher price in the future.)% !on(ention of feasi'ility The convention of feasibility emphasises that the time,labour and cost of analysing accounting information should be comparable to the benefitsarising out of it. For e/ample, the cost of 'oiling and greasing' the machinery is so smallthat its break-up per unit produced will be meaningless and will amount to wastage oflabour and time of the accounting staff..% !on(ention of consistency: The convention of consistency means that the sameaccounting principles should be used for preparing financial statements year on year. %nevocative conclusion can be drawn from financial statements of the same enterprise whenthere is similarity between them over a period of time. >owever, these are possible onlywhen accounting policies and practices followed by the enterprise are uniform andconsistent over a period. !f dissimilar accounting procedures and practices are followedfor preparing financial statements of different accounting years, then the result will not beanalogous. $enerally, a businessman follows the above-mentioned general practices ormethods year after year. For e/ample, while charging depreciation on fi/ed assets or

valuing unsold stock, if a particular method is used it should be followed year after year,so that the financial statements can be analysed and a comparison made./% !on(ention of full disclosure:1onvention of full disclosure states that all materialand relevant facts concerning financial statements should be fully disclosed. Fulldisclosure means that there should be complete, reasonable and sufficient disclosure ofaccounting information. Full refers to complete and detailed presentation of information.Thus, the convention of full disclosure suggests that every financial statement shoulddisclose all pertinent information. For e/ample, the business provides financialinformation to all interested parties like investors, lenders, creditors, shareholders etc.The shareholder would like to know the profitability of the firm while the creditors would


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like to know the solvency of the business. This is only possible if the financial statementdiscloses all relevant information in a complete, fair and an unpre+udiced manner.0% !on(ention of conser(atism:This concept accentuates that profits should never beoverstated or anticipated. >owever, if the business anticipates any loss in the near future,provision should be made for it in the books of accounts, for the same. For e/ample,creating provision for doubtful debts, discount on debtors, writing off intangible assets

like goodwill, patent and so on should be taken in to consideration Traditionally,accounting follows the rule 'anticipate no profit and provide for all possible losses.' Fore/ample, the closing stock is valued at cost price or market price, whichever is lower. Theeffect of the above is that in case market price has come down then provide for the'anticipated loss', but if the market price has increased then ignore the 'anticipated profits'.The convention of conservatism is a valuable tool in situation of ambiguity and "ualms.

Accounting tandards in India and International Accounting tandards%ccounting standards are being established both at national and international levels.>owever, the diversity of accounting standards among the nations of the world has been aproblem for the globalisation of the business environment. !n !ndia, the %ccounting7tandards oard (%7) was constituted by the !nstitute of 1hartered %ccountants of!ndia (!1%!) on 5st %pril 58**, which performs the function of formulating accounting

standards.The 7tatements on accounting standards are issued by the !nstitute of 1hartered%ccountants of !ndia (!1%!) to establish standards that have to be complied with, toensure that financial statements are prepared in accordance with a commonly acceptedaccounting standard in !ndia (!ndia $%%&).%ccurate and reliable financial information is the lifeline of commerce and investing.&resently, there are two sets of accounting standards that are accepted for internationaluse namely, the ?.7., $enerally %ccepted %ccounting &rinciples ($%%&) and the!nternational Financial 4eporting 7tandards (!F47) issued by the @ondon-based!nternational %ccounting 7tandards oard (!%7).$enerally, accepted accounting principles ($%%&) are diverse in nature but based ona few basic principles as advocated by all $%%& rules. These principles includeconsistency,relevance, reliability and comparability. $enerally %ccepted %ccounting &rinciples($%%&)ensures that all companies are on a level playing field and that the information theypresent is consistent, relevant, reliable and comparable. %lthough ?.7. $%%& is onlyapplicable in the ?.7., other countries have their own adaptations that are similar inpurpose, although not always in design.!F47 are !nternational Financial 4eporting 7tandards, which are issued by the!nternational %ccounting 7tandards oard (!%7), a committee compromising of 5:members, from nine different countries, which work together to develop globalaccounting standards. The aim of this committee is to build universal standards that aretranslucent, enforceable, logical, and of high "uality. Aearly 5 countries make use of!F47. These countries include the uropean ?nion, %ustralia and 7outh %frica. hile

some countries re"uire all companies to stick to !F47, others merely try to synchroniBetheir own countryCs standards to be similar.!ndia is yet to implement !F47. !t was reported in the Financial /press, Aew Delhi onarch = that !ndia will adopt the globally accepted !nternational Financial 4eporting7tandards (!F47) by 55, a move that will integrate the accounting system with the restof the world. %ccording to the !nstitute of 1hartered %ccountants of !ndia (!1%!)&resident 3ed Eain, % common accounting standard is in the interest of the investors whoare e/ploring investment opportunities in other geographical areas as wellG.Thus, this move by !ndia will harmonise its accounting standards with the internationallyaccepted accounting standards, which will lead to a globally accepted accounting system


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for the companies in !ndia.

Unit:$IntroductionThe prime ob+ective of accounting is to ascertain how much profit or loss a businessorganisation has made during any accounting period and to determine its financialposition on a given date. &reparing final accounts or financial statements serve thispurpose. %fter the preparation of Trial alance, the ne/t level of work in accounting iscalled Final %ccountsH level. &reparation of Final %ccounts involves the following# &reparation of a Trading %ccount# &reparation of a &rofit I @oss %ccount and# &reparation of a alance 7heetTrial balance provides the essential input for the preparation of these accounts orstatements. These accounts 2 statements provide necessary information to variousinterested groups viB. shareholders, investors, creditors, employees, management andgovernment agencies etc. Therefore, these financial statements are prepared to serve theinformation needs of these diverse groups to enable them to make appropriate decisions.2rading AccountTrading %ccount is prepared to know the outcome of a trading operation. Trading

%ccount is made with the chief intention of calculating the gross profit or gross loss of abusiness establishment during an accounting period, which is generally a year. !naccounting phraseology, gross profit means overall profit. $ross profit is the differencebetween sale proceeds of a particular period and the cost of the goods actually sold. 7incegross profit means overall profit, no deduction of any sort, i.e. general, administrative orselling and distribution e/penses is made. $ross &rofit is said to be made when the saleproceeds e/ceed the cost of goods sold. 0n the contrary, if the cost price of the goods ismore than the selling price, then we can say that there is a loss.

!n order to illustrate how the gross profit is ascertained, knowledge of format of the


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Trading %ccount is very important. This gives a clear presentation of how the gross profitis calculated. % Trading %ccount is prepared in TH form +ust like every other account isprepared. Though it is an account, it is not +ust an ordinary ledger account. !t is one of thetwo accounts which are prepared only once in an accounting period to ascertain the profitor loss of the business. ecause this account is made only once in a year, no date or+ournal folio column is provided.

3pening toc: !t refers to the value of goods at hand at the end of the previousaccounting year. 0pening stock means the stock of an item at the beginning of a newinventory-keeping period. !t becomes the opening stock for the current accounting yearand contains the value of goods in which the business dealsPurc*ases: !t refers to the value of goods (in which the concern deals) which arepurchased either on cash or on credit for the purpose of resale. The balance of thepurchase account, appearing in the Trial alance, reflects the total purchases made duringthe accounting period. hile dealing with purchases, we must bear in mind the followingaspects

a. &urchase of capital asset should not be added with the purchases. !f it is alreadyincluded in purchases, it should be deducted immediately.

b. !f goods are purchased for personal consumption and they are added with thepurchases, they should be e/cluded. These types of purchases should be treated asdrawings.c. !f some of the goods purchased are still in transit at the year-end, it is better to debit7tock-in-transit %ccount and credit 1ash or 7upplierCs %ccount.d. !f the amounts of purchases include goods received on consignment, on approval or onhire purchase, these should be e/cluded from purchases.e. 1ost of goods sent on consignment must be deducted from the purchases in case of atrading concern.Purc*ases Returns,Returns 3ut4ards: !t may come about that due to some reason, thegoods are sent back to the supplier. !n that case, the supplier is debited in the book ofaccounts and purchases returns or returns outwards is credited. !t appears on the creditside in the Trial alance. There are two ways of showing the purchases returns in thenTrading %ccount. !t may be shown by way of deduction from purchases in the Trading%ccount. %n alternative way is to show the purchases returns in the credit side of theTrading %ccount.5irect 6+penses:These types of e/penses are incurred in connection with purchase,procurement or production of goods. These e/penses are directly related to the process ofproduction. !t also includes e/penses that bring the goods up to the point of sale as shownin Trading Format above1% ales:!t refers to the sale of goods in which the business deals and includes both cashand credit sales. !t does not include sale of old, obsolete or depreciated assets, which wereac"uired for utilisation in business. >owever, goods sent to customers on approval basis,free samples and sales ta/, if any, included in the sales figure should be e/cluded.% ales Returns , Returns In4ard:hen goods are returned by the buyers for some

reason, it is called 7ales 4eturn or 4eturns !nward. !n the books of account, 4eturns!nwards %ccountH or 7ales 4eturns %ccountH is debited and buyer's account is credited.!t appears on the debit side of Trial alance. e can show the sales returns in the Trading%ccount in two ways. !t may be shown by way of deduction from sales in the Trading%ccount. %n alternative way to show the sales returns is in the debit side of the Trading%ccount.)% A'normal "oss:!t refers to the abnormal loss of stock due to fire, theft or accident. !fany abnormal loss is there, it is credited fully to the Trading %ccount because the Trading%ccount is prepared under normal conditions of the business and has no place forabnormal instances.


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.% !losing toc:!t refers to the value of goods lying unsold at the end of any accountingyear. This stock at the end is called closing stock and is valued at either cost or marketprice, whichever is lower. The trial balance generally does not include closing stock.Therefore, the following entry is recorded to incorporate the effect of closing stock in theTrading %ccount.1losing 7tock %2c Dr.

To Trading %2c>owever, if closing stock forms a part of Trial alance, it will not be transferred toTrading %ccount but taken only to the alance 7heet. !n case of the goods that have beendispatched to customers on approval basis, such goods should be included in the value ofclosing stock.

%fter recording the above items in the respective sides of the Trading %ccount, thebalance is calculated to ascertain $ross &rofit or $ross @oss. !f the total of credit side ismore than that of the debit side, the e/cess represents $ross &rofit. 1onversely, if thetotal of debit side is more than that of the credit side, the e/cess represents $ross @oss.$ross &rofit is transferred to the credit side of the &rofit I @oss %ccount and $ross @ossis transferred to the debit side of the &rofit I @oss %ccount

Profit 7 "oss Account%fter preparing Trading %ccount, the subse"uent step is to prepare &rofit I @oss %ccountwith a view to ascertain net profit or net loss during an accounting period. The &rofit I@oss %ccountn can be defined as a report that summarises the revenues and e/penses ofan accounting period to reflect the alterations in various critical areas of the firmCsoperations. !t indicates how the revenue (money received from the sale of products andservices before e/penses are withdrawn) is transformed into the net income (the resultafter all revenues and e/penses have been accounted for). !t displays the revenuesrecognised for a specific period and the cost and e/penses charged against theserevenues, including write-offs (e.g. depreciation and amortiBation of various assets) andta/es. The ob+ective of the income statement is to e/plain to the managers and investorswhether the company made or lost money during the period being reported. %s pointedout earlier, the balance of the Trading %ccount (gross profit or gross loss) is transferred tothe &rofit I @oss %ccount, which becomes the starting point of the preparation of &rofitI @oss %ccount. !t takes into consideration all remaining indirect (normal and abnormal)e/penses and losses related to or incidental to business. These operating and non-operating e/penses are charged to &rofit I @oss %ccount and shown to the debit side ofthe account. %fter transferring the $ross &rofit or $ross @oss from the Trading %ccountto the &rofit I @oss %ccount, the sources of other incomes like commission or discountreceived are shown on the credit side of the &rofit I @oss %ccount. The credit side alsoincludes the non-trading income like interest on bank deposits or securities, dividend onshares, rent of property letout, profit generated out of the sale of fi/ed assets, etc. 0n thedebit side will appear all other e/penses that appear in the Trial alance but cannot find aplace in the Trading %ccount. The debit side will also include the losses arising out ofsale of assets and any abnormal losses.

The &rofit I @oss %ccount measures net income by matching revenues and e/pensesaccording to the accounting. Aet income is the difference between total revenues andtotal e/penses.

6+penses incurred 'ut not paid out8 partly or fully8 during t*e current year: Thereare some e/penses, which are incurred in the current accounting period, but not paid for,partly or fully, by the end of the periodJ they are called 0utstanding /pensesH. Thesee/penses become liabilities of the business at the end of the accounting year. !n fact, onthe date of the final accounts, outstanding e/penses- in the form of both the e/penses anda liability- e/ist without having been recorded in the books of account. For recording it,


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the following entry is to be passed/penses %2c Dr. (will be shown in the & I @ %2c)To 0utstanding /penses % 2c(will appear in the liabilities side of alance 7heet) 6+penses paid for during t*e current year8 'ut not incurred as yet8 partly or fully:7ometimes, it may happen that some e/penses are paid during the current year, but are

not incurred as yet, partly or fully. Those e/penses are known as &repaid /pensesH.&repaid e/pense is an asset to the business and will be shown in the alance 7heet. Thead+ustment entry to be passed&repaid /penses %2c Dr. (to be shown as asset in the alance 7heet)To /penses %2c(balance of this account to be debited to &I@ %2c)

6+penses of t*e current year8 liely to arise in su'sequent period 7ometimes, ane/penses or a loss may arise in the future in connection with current yearsC business. !nsuch a case, we make a provision for the anticipated loss and a charge is created againstthe profit for the current period. This provision is shown as either a liability or acontingent asset, i.e. it appears in the alance 7heet as a deduction from some other asset.The best e/ample of this anticipated e/pense is &rovision for bad debts. The !tems that

will appear in the credit side of a &rofit I @oss %ccount can be broadly classified asunder 9ross Profit:This is the balance of the Trading %ccount transferred to the &rofit I@oss %ccount. !f the Trading %ccount shows a gross loss, it will appear on the debit side. 3t*er Incomes:7ometimes a business might generate some profit, which is not due tothe sale of its goods or services, because the business may have some other source offinancial income. The e/amples are discount or commission received. #on-trading Income:The business may have various transactions with the bank. %t theend of the year, the business may earn some amount of interest, which will find a place inthe &rofit I @oss %ccount as non-trading income. The business may have someinvestment outside the business in the form of shares, debentures or units. %ll sorts ofgains obtained from such kinds of investments are considered as non-trading income andare treated accordingly.# A'normal 9ains:There may be capital gains arising during the course of the year, e.g.profit arising out of sale of a fi/ed asset. The profit is shown as a separate income on thecredit side of the &rofit I @oss %ccount. e must remember that all incomes from theabnormal gains or other income should be credited to the &rofit I @oss %ccount if theyarise or accrue during the period. 7imilarly, income received in advance should bededucted from the income. 0nce the respective accounts are transferred from trialbalance to &I@ account, gross profit2loss transferred from trading account and allad+ustments are take care of, the ne/t step in preparation of &I@ is the balancing of theaccount. This replicates balancing of trading account. The totals of debit side and creditside are computed and the difference between these totals is either a net profit or net loss.!f the total of debit side e/ceeds the total of credit side, there is a net loss, whereas whenthe total of credit side e/ceeds the total of debit side, there is a net profit. Aet &rofit is the

last item to be recorded on debit sideJ else, net loss is the last item on credit side. %ftercomputing net profit2loss, the totals of two sides of &I@ match.The balance in the &rofit and @oss %ccount represents the net profit or net loss. !f thecredit side is more than the debit side, it shows the net profit. %lternatively, if the debitside is more than the credit side, it shows net loss. hen the &rofit and @oss %ccountshows a net profit, we pass the following entry&rofit I @oss %2c Dr.To Aet &rofit %2c!f the &rofit and @oss %ccount shows a net loss, the entry will be reversed.1% Bad 5e'ts


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!n order to display high amount of sales figures, goods are fre"uently sold out to knowncustomers on credit. 7ome of these customers fail to pay their debts due to insolvency.These debts, which cannot be recovered, are called ad Debts. !t is a loss to the businessand an ad+ustment is needed. The re"uired entry will bead Debts %2c DrTo sundry debtors %2c

and then&rofit I @oss %ccount Dr.To ad Debts %2c!t should be noted here that no ad+ustment is re"uired for any bad debt that alreadyappears in the Trial alance. ad debt appearing in the Trial alance should be debitedonly to &rofit I @oss %ccount of the &eriod.$% Pro(ision for Bad 5e'ts1redit sales are recognised as income at the time of the sale without knowing the e/acttime of collection. !n the course of time, loss may result from unsuccessful attempts tocollect the dues from the customers. very organisation creates a provision for thisanticipated loss, from the reported income of the credit sales in the current period. Thereare different methods of creating provision for bad debts. >owever, we will discuss only

one method here. %ccounting entry will depend upon the situation as to whetherprovision for bad debts is or is not appearing in the Trial alance.7ituation 5 hen provision for ad Debts not appearing in the Trial alanceThe accounting entry will be

&rofit I @oss %ccount Dr.To &rovision for ad Debts %ccount(To be shown in the alance 7heet as a deduction for Debtors)

7ituation hen provision for ad Debts appearing in the Trial alance %t first,calculate the amount of provision to be created at the end of the period in the same wayas above. Aow compare the provision with the provision appearing in the Trial alance.There are two resultant optionsa. !f the new provision e/ceeds the provision appearing in the Trial alance, pass thefollowing entry&rofit I @oss %ccount Dr.To provision for ad Debts

b. !f the new provision is less than the provision appearing in the Trial alance, pass thefollowing entry&rovision for ad Debts Dr.To &rofit I @oss %ccount>ere, it should be noted that only new provision should be shown in the alance 7heet asa deduction from 7undry Debtors.

/ample&ass necessary entries from the following information

5r 2rail Balance!r&articulars 4s &articulars 4s7undry Debtors :,== &rovision for ad

Debts5,


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1reate provision for bad debts K < L on 7undry Debtors.EournalDate &articulars 4s. 4s.

ad debt a2c Dr To 7undry Debtors a2c(being bad debt written off)

&rofit I @oss Dr To provision for bad debtsa2c(eing the creation of additional provision)

&rofit and @oss %2c Dr. To ad Debts %2c

=


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To &rovision for discount on Debtors %ccount(To be shown in the alance 7heet by way of deduction from 7undry debtors)

/ample# Total 7undry Debtors as per Trial alance 4s. :,=# ad Debt after Trial alance 4s. =

# &rovision for debt to be created K


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due to the principle of conservatism./% 5epreciation%ccording to &ickles, Depreciation is the permanent and continuing diminution in the"uality, "uantity or value of an assetG. !t is a measure of wearing out, consumption orother loss of values of a depreciable asset arising from use and passage of time. !t isgenerally charged to such assets as &lant I achinery, uilding, Furniture, "uipment,

etc.!nitially, the cost of the assets including installation cost is debited to the particular assets.!n each accounting period, a portion of the cost e/pires and it needs ad+ustment forshowing correct profit of the period and correct value of the assets. %d+ustment entriesare

(a) hen assets account is maintained at written down value(i) Depreciation %ccount Dr.To %ssets %ccount(eing depreciation charged)

(ii) &rofit I @oss %ccount Dr.To Depreciation %ccount

(eing depreciation transferred to profit I @oss %ccount)

(b) hen assets account is maintained at cost price(i) Depreciation %ccount Dr.To &rovision for Depreciation %ccount(eing depreciation 1harged)(ii) &rofit I @oss %ccount Dr.To Depreciation %ccount(eing depreciation transferred to profit I @oss %ccount)

Total accumulated depreciation is shown in the alance 7heet liabilities side.%lternatively, it can be shown by way of deduction from the original cost of assets side.>ere, it should be noted that no ad+ustment is re"uired for depreciation that alreadyappears in the Trial alance. Depreciation that already appears in the Trial alanceshould only be debited to &rofit I @oss %ccount.

0% 9oods 5istri'uted as Free samples:This is one kind of advertisement. hen goods are distributed to the prospectivecustomers as free samples, an e/pense is incurred (known as advertisement e/pense) andthere is a usual reduction from the stock of goods. The following entry is passed

%dvertisement %ccount Dr.To &urchase %ccount (For a trader)0rTo Trading %ccount (For a manufacturer)

%t the year-end, transferring the entry to the &rofit I @oss %ccount closes the%dvertisement %ccount&rofit I @oss %ccount Dr.To %dvertisement %ccount% Income 2a+!ncome ta/ is not an e/pense to earn revenue. Therefore, when the profit is calculated, wecannot deduct income ta/ from the profit and treat it as an e/penditure of the business.For a sole proprietor, income ta/ is payable by the owner and not by the business.Therefore, if income ta/ appears in the Trial alance, it should be treated as drawing andshould be deducted from the capital. Following are the entries to be passed


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(a) !ncome Ta/ %ccount Dr. (hen &aid)To 1ash2 ank %ccount

(b) Drawing %ccount Dr.To !ncome Ta/ %ccount

>owever, for a registered partnership firm, income ta/ is payable by the business itselfand not by the owners. !t generally appears as an appropriation of the net profits. Thefollowing entry is passed&rofit and @oss %ppropriation %ccount Dr.To !ncome Ta/ %ccount;% 5ra4ing Made 'y t*e ProprietorsDrawing made by the proprietor(s) may be in cash or in kind. Drawing relates to theresources of the business and the capital of the owner(s).Drawings made in 1ash !n this case, following entries are passed(a) Drawings %ccount Dr.To 1ash2ank %ccount

(b) 1apital %ccount Dr.

To Drawings %ccountDrawings made in kind hen some of the stocks are withdrawn from the business, thefollowing entries are passed(a) Drawings %ccount Dr.To &urchases %ccount

(b) 1apital %ccount Dr.To Drawings %ccount

!f the drawings made by the owner are incorporated in sales, we are to pass a reverseentry to cancel the original entry. For the drawings, the above two entries are to bepassed


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To ills 4eceivable %ccount (hen the bill is retained)To ills for 1ollection %ccount (hen the bill is sent to bank for collection)To ank %ccount (hen the bill is discounted with banker)To ndorsee %ccount (hen the bill is endorsed)

!f a provision for doubtful debts is to be created, it will be on the value of the sundry

debtors after making the above %d+ustments.

11% A'normal "oss of toc 'y Accident e%g%8 'y Fire

!f a portion of the stock is lost, the value of such loss is first to be ascertained. Therefore,%bnormal @oss %ccount is to be debited and Trading %ccount is to be credited.Transferring balance to the &rofit I @oss %ccount closes abnormal loss account. &rofit I@oss %ccount is to be debited and abnormal loss account is to be credited. !f the aboveloss is insured against risk, !nsurance 1laim %ccount (or !nsurance 1ompany %ccount) isto be debited and %bnormal @oss %ccount is to be credited. ?ntil the money is received,!nsurance 1laim (or !nsurance 1ompany %ccount) will find a place in the asset side ofthe alance 7heet. hen the money is received, ank %ccount is debited and the!nsurance 1laim %ccount (!nsurance 1ompany %ccount) is credited. !f the goods are

partially insured, the portion not covered by insurance is to be charged to &rofit I @oss%ccount.

Eournal entry to be passed is as follows(i) %ccidental @oss %ccount Dr. (%ctual loss of stock)To Trading %ccount

(ii) (a) !nsurance 1laim %ccount Dr. (!nsurance claim admitted by the insurance1o)0r(b) !nsurance 1ompany %ccount Dr. (!nsurance claim admitted by the insurance1o)&rofit I @oss %ccount Dr. (1laim not admitted)To %ccidental @oss %ccount

1$% !ommission to t*e manager7ometimes, the manager of a concern is given a percentage of the profit as commission.7ince it is an e/pense like salaries, we must account for it. The entry will be&rofit I @oss %ccount Dr.To 1ommission %ccount!f the amount is not paid within the accounting period, it will be shown in the liabilityside of the alance 7heet as commission payable.% problem arises with the ascertainment of the amount payable as commission. Thereason is that commission may be paid at a certain percentage before or after chargingsuch commission. !f the commission is paid before charging commission, calculation isvery easy. e simply multiply the rate with the profits.

1)% 9oods ent on Appro(al Basishen goods are sold to the customers on sale or return basis or on approval basis, it isnot considered as sale till the time it is not approved by the customer or till the e/piry of afi/ed period as agreed by the parties. hen goods are sold initially to a customer onapproval basis, we pass the entry for the sales. %t the year-end, if the goods are still lyingwith the customers awaiting approval, the following entries are to be passed(i) To cancel previous entry7ales %ccount Dr.To 7undry Debtors %ccount(ii) To add the value of the closing stock (1ost of goods lying with the customer)


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7tock %ccount Dr.To Trading %ccount!n the alance 7heet, it will be deducted from sundry debtors at sales price and theclosing stock will be increased by the cost of such sales.

1.% Interest on "oan- #ot yet Paid- Fully or partly

!n the Trial alance, the amount of the loan appears in the credit column. The amount ofinterest paid appears on the debit column. >owever, if a portion of the interest is stilloutstanding at the year-end, we pass the following entry to make the ad+ustment!nterest on @oan %ccount Dr.To @oan %ccount!f nothing has been paid as interest, we are to find out the amount by applying the ratewith the amount of the loan and then pass the above entry. The total amount of unpaidinterest will appear in the alance 7heet as liability.1/% Interest on !apital7ometimes, it may be re"uired to make a provision for interest on the capital contributedby the proprietor or the partner. 7uch interest is not a charge against profit but anappropriation of profit. !n this connection, the following two entries have to be passed(i) &rofit I @oss %ppropriation %ccount Dr.

To !nterest on 1apital %ccount(eing interest on capital payable)

(ii) !nterest on 1apital %ccount Dr.To 1apital21urrent %ccount(eing interest on capital transferred to 1apital21urrent %ccount)

10% Interest on 5ra4ings7ometimes, interest on drawing may be charged to restrict the fre"uent drawings by thepartners. 7uch interest increases the divisible profit. The following two entries have to bepassed(i) 1apital21urrent %ccount Dr.To !nterest on Drawing %ccount(eing interest on Drawing Transferred to 1apital21urrent %ccount)

(ii) !nterest on Drawings %ccount Dr.To &rofit and @oss %ppropriation %ccount(eing interest on drawings 1harged)

5IFF6R6#!6 B62&66# 2RA5I#9 A,! A#5 PR3FI2 7 "3 A,!7ome of the differences between Trading %2c and &rofit I @oss %2c are as followsTrading account is the account showing the $ross &rofit of a business, whereas, the &rofitI @oss %ccount shows the Aet &rofit of a business.$ross &rofit N 7ales Turnover - 1ost of goods sold (opening stock Q purchases Q carriageinwards-closing stock)

Aet &rofit N $ross &rofit Q 4evenue (rent received, interest received, discountreceived) R /penses

%ll direct e/penses2revenues that are directly related to the factory or production areincluded in a Trading %2c. 0n the other hand, all !ndirect /penses2revenues that arerelated to the %dministration I 7elling are included in a &I@ %2c.The gross profit or loss, which is derived from the Trading %ccount, shows the trend ofthe business and the &rofit I @oss account reflects on the management of the businessand the outcomes of the concern.


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Balance *eet% alance 7heet or statement of financial position is a summary of the financial balancesof a sole proprietorship, a business partnership or a company. %ssets, liabilities andownership e"uity are listed as of a specific date, such as the end of the financial year. !t isa statement of assets and liabilities, which helps us to establish the financial position of abusiness enterprise on a particular date, i.e. on a date when financial statements or final

accounts are prepared or books of accounts are closed. !n fact, this statement treats thebalances of all those ledger accounts that have not yet been s"uared up. These accountsrelate to assets owned, e/penses due but not paid, incomes accrued but not received orcertain receipts which are not due or accrued. !n other words, it deals with all those realand personal accounts, which have not been accounted for in the anufacturing, Tradingor &rofit I @oss %ccounts. esides, a alance 7heet also treats all those items given inthe ad+ustments, which affect 4eal or &ersonal %ccounts. The Aominal accounts aretreated in the income statement in the usual manner. % alance 7heet is often described asa Gsnapshot of a company's financial conditionG. !t aims to ascertain the nature andamount of different assets and liabilities so that the financial position such as li"uidity orsolvency position could be evident to all those interested. Therefore, an important featureof a alance 7heet is to show the e/act financial picture of a business concern on aparticular date.

5ifference 'et4een 'alance s*eet and trail 'alance2rail 'alance alance sheetThe purpose of preparing a trial balance is tocheck the arithmetic accuracy of accountbooks.

% alance 7heet is drafted to reveal thefinancial position of the business

% trial balance is prepared to document that thetotal amount of account balances with debitbalances is e"ual to the total amount of accountbalances with credit balances.

% alance 7heet shows that the total ofthe asset amounts is e"ual to the total ofthe amounts of liabilities andstockholdersC e"uity.

!t is prepared before the preparation of Tradingand &rofit I @oss %ccount.

!t is prepared after the preparation ofTrading and &rofit I @oss account.

!t does not contain the value of the closing

stockof goods.

!t contains the value of the closing stock,

which appears on the assets side./penses due but not paid and incomes due butnot received do not appear in the Trial alance.

/penses due but not paid appear on theliability side and income due but notreceived appears on the asset side of thealance 7heet.

!n case of Trial alance, the columns arenamed as 'debit' and 'credit' columns

The two sides of alance 7heet are called'liabilities' and 'assets' sides respectively

!t is a list of balance e/tracted from the ledgeraccounts.

!t is a statement of assets and liabilities

% Trial alance is an internal document usedonlywithin the accounting department.

The alance 7heet is referred to as ane/ternal report because it is usedoutside of the company by investors,lenders and others.

!t contains the balance of all accounts- real,nominal and personal

!t contains the balance of only thoseaccounts, which represent assets andliabilities.


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&4&%4%T!0A %AD &47AT%T!0A 0F %@%A1 7>TThe &rocess of preparation and presentation of alance 7heet involves two steps# $rouping# arshalling!n the first step, the different items to be shown as assets and liabilities in the alance7heet are grouped appropriately. For this purpose, items of similar nature are grouped

under one head so that the alance 7heet could convey an honest and true message to itsusers. For e/ample, stock, debtors, bills receivables, ank, 1ash in >and etc are groupedunder the heading 1urrent %ssets and @and and uilding, &lant and achinery, Furnitureand Fi/tures, Tools and "uipments under Fi/ed %ssets. 7imilarly 7undry creditors forgoods must be shown separately and distinguished from money owing, other than due tocredit sales of goods.The second step involves marshalling of assets and liabilities. This involves a se"uentialarrangement of all the assets and liabilities in the alance 7heet. There are two methodsof presentation# The order of li"uidity# The order of permanence?nder li"uidity order, assets are shown on the basis of li"uidity or reliability. These arerearranged in an order of most li"uid, more li"uid, li"uid, least li"uid and not li"uid

(fi/ed) assets. 7imilarly, liabilities are arranged in the order in which they are to be paidor discharged.?nder the 0rder of performanceH, the assets are arranged on the basis of their usefullife. The assets predicted to be most fruitful for the business transaction for the longestduration will be shown first. !n other words, this method puts the first method in thereserve gear. 7imilarly, in case of liabilities, after capital, the liabilities are arranged aslong term, medium term, short term and current liabilities. Following are the respectiveformats of alance 7heet to bring out the clarity of conceptLiquidity OrderBALANCE SHEET OFAs on @iabilities 4s %ssets 4s.1urrent @iabilitiesank 0verdraft0utstanding/pensesills &ayable7undry1reditors!ncome received in%dvance@ong term @iabilitiesortgaged loan@oan of ank1apital

%dd &rofit@ess @oss@ess Drawings

1urrent %ssets1ash in hand1ash at ankarketable7ecurities7hort term !nvestmentills receivables7undry Debtors&repaid/penses%ccrued !ncome@ong term !nvestmentFi/ed %ssets

Furniture I Fi/turesotor 3ehiclesTools I "uipments&lant I machinery@and and uilding!ntangible %ssets&atents1opy rightsTrademarks


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$oodwill0rder of &ermanence%@%A1 7>T 0FS%s on@iabilities 4s %ssets 4s.1apital

%dd &rofit0r @ess @oss@ess Drawings@ong term @iabilitiesortgaged @oan@oan from ank1urrent @iabilities!ncome receivedin %dvance7undry 1reditorsills &ayable0utstanding/penses

ank 0verdraft

Fi/ed %ssets

$oodwill@and and uilding&lant I machineryTools I "uipmentsotor 3ehiclesFurniture I Fi/tures&atents Trademarks!nvestments (@ongterm)1urrent %ssets7tock7undry Debtorsills receivables

7hort term !nvestmentarketable 7ecurities1ash and ankalanceFictitious %ssets%dvertisement&rofit I @oss %ccountiscellaneous/penses

For a better understanding of how various items should be placed, it is important to knowthe type and nature of assets and liabilities that are to be classified and arranged in eitherof two orderly manners discussed earlier. For the purpose of presentation of assets in the

alance 7heet, assets are classified as under# Fi/ed %ssets# !ntangible %ssets# 1urrent %ssets# Fictitious %ssets# asting %ssets# 1ontingent %ssetsFi+ed assets Fi/ed assets are those assets, which are ac"uired for the purpose ofproducing $oods or rendering services. These are not held for resale in the normal courseof business. Fi/ed assets are used for the purpose of earning revenue and hence these areheld for a longer duration. These are also treated as $ross lockC and Aet lockC (Fi/edassets after depreciation). !nvestment in these assets is known as 7unk 1ostC. /amplesof fi/ed assets are @and I uilding, &lant and achinery, Furniture and Fi/tures, Tools

and "uipment, otor vehicles etc. %ll fi/ed assets are tangible by nature.Intangi'le assets !ntangible assets are those capital assets, which do not have anyphysical e/istence. %lthough these assets cannot be seen or touched, they are long lastingand prove to be profitable to owner by virtue of the right conferred upon them by merepossession. They also help the owner to generate income. $oodwill trademarks,copyrights and patents are the e/amples of intangible assets.!urrent assets 1urrent assets include cash and other assets, which are converted orrealiBed into cash within a normal operating cycle or say, within a year. These areac"uired for resale, assisting and helping the process of production, rendering service or


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supplying of goods. These assets constantly keep on changing their form and contributeto routine transactions and operations of business. /amples are 1ash, ank, ills4eceivables, Debtors, 7tock, &repaid e/penses etc. 1urrent assets are also known asFloating %ssets or 1irculating %ssets."iquid or quic assets Those current assets, which can be converted into cash at a veryshort notice or immediately, without incurring much loss or e/posure to high risk, are

"uick assets. Uuick assets can be worked out by deducting 7tock (raw materials, work-inprogress or finished goods) and prepaid e/penses out of total current assets.Fictitious assets These are the non-e/istent worthless items which represent unwritten-off losses or costs incurred in the past, which cannot be recovered in future or realised incash. /amples of such assets are preliminary e/penses (formation e/penses),%dvertisement suspense, ?nderwriting commission, Discount on issue of shares anddebentures, @oss on issue of debentures and Debit balance of &rofit I @oss %ccount.These fictitious assets are written off or wiped out by debiting them to &rofit I @oss%ccount.&asting assets:%n asset that has a limited life and therefore dwindles in value over timeis a wasting asset. This type of asset has a limited useful life by nature and depletes over alimited duration. These assets become worthless once their utility is over or e/haustsfully. During the life of productive usage, assets of this type produce revenue, but

eventually reach a state where the worth of the assets begins to diminish. 7uch assets arenatural resources like timber and coal, oil, mineral deposits etc.!ontingent assets:1ontingent assets are probable assets, which may or may not becomeassets, as that depends upon occurrence or non-occurrence of a specified event orperformance or non-performance of a specified act. For e/ample, a suit is pending in thecourt of law against ownership title of a disputed property. 7ubse"uently, if the verdictgoes in favour of the business concern, it becomes the asset of the concern. >owever, ifthe business firm does not win the lawsuit, it will not have ownership rights of thepropertyJ it will be of no use to it. Thus, it remains a contingent asset as long as the+udgment is not pronounced by court. 7uch assets are shown by means of footnotes andhence do not form part of assets shown in the alance 7heet. esides this, hire-purchasecontract, uncalled share capital etc are the other e/amples of contingent assets.!"AIFI!A2I3# 3F "IABI"I2I6"ong-term lia'ilities:These are the obligations that the business enterprise is e/pectedto meet after a relatively long period. 7uch liabilities do not become due for payment inthe ordinary course of business operation or within normal operating cycle.Debentures, long-term loans from banks or financial institutions are the e/amples oflongtermliabilities.!urrent lia'ilities 1urrent liabilities are those liabilities that are payable within normaloperating cycle, i.e. within a given accounting year. These may arise out of realiBationfrom current assets or by creating fresh, current liability (obligation). Trade creditors,ills payable, ank overdraft, outstanding e/penses, shortRterm loan (payable withintwelve months or within the accounting year) are e/amples of current liabilities.!ontingent lia'ilities: These liabilities may or may not be sustained by an entity

depending on the outcome of a future event such as a court case. These liabilities arerecorded in a company's accounts and displayed in the alance 7heet when both probableand reasonably estimable. !t is not an actual liability but an anticipated (probable)liability, which may or may not become payable. !t depends upon the occurrence ofcertain events or performance of certain acts. %n element of uncertainty is alwaysattached to a contingent liabilityJ it is a potential liability that may or may not become asure liability. 1ontingent liabilities are e/emplified in the liability for bills discounted,liability for acting as surety, liability arising on a suit for damages pending in the court oflaw, liability for calls on partly paid shares etc. !f a parent guarantees a daughterCs firstcar loan, the parent has a contingent liability. !f the daughter makes her car payments and


21/43

pays off the loan, the parent will have no liability. !f the daughter fails to make thepayments, the parent will have a liability. 1ontingent liabilities are shown as footnotesunder the alance 7heet.!n accounting, a contingent liability and related contingent loss are recorded with a+ournal entry only if the contingency is probable as well as estimable. !f a contingentliability is only possible (not probable) or if the amount cannot be estimated, a +ournal

entry is not re"uired. >owever, a disclosure is re"uired. hen a contingent liability isremote (such as a nuisance suit), neither a +ournal nor a disclosure is re"uired.

@!!T%T!0A7 0F %@%A1 7>TThough a alance 7heet is prepared by every organisation for disclosing its financialposition, it is not free of limitations. They can be enlisted as follows5. Fi/ed assets are shown in the alance 7heet as historical cost less depreciation up todate. % conventional alance 7heet cannot reflect the true value of these assets. %gain,intangible assets are shown in the alance 7heet at book values, which may bear norelationship to market values.. 7ometimes, the alance 7heet contains some assets that command no market value,such as preliminary e/penses, debenture discount, etc. The inclusion of these fictitiousassets unduly inflates the total value of assets.

M. % alance 7heet cannot calculate and show the value of certain "ualitative factors likeknowledge and efficiency of staff members.:. % conventional alance 7heet may mislead untrained readers in inflationary situations.

Illustration 1From the following balances e/tracted from the books of a Trader at the close of theaccounting year ending M5st December , prepare &rofit I @oss %ccount.

2rial Balance as on )1st 5ec% $===&articulars 4s. &articulars 4s.$ross profit7alaries

5,


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0ffice "uipment

4epairs andaintenance

ank 1harges

&,%!!

1,2!!

7alaries due but not paid 4s. ,


23/43

the case of an !ncome 7tatement.Thus, the term financial statements generally refer to two basic statements (i) the !ncome7tatement (ii) the alance 7heet. Furthermore, a business may also prepare (iii) a7tatement of 4etained arnings (iv) a 7tatements of 1hanges in Financial &osition inaddition to the above two statements.# Income tatement:The !ncome 7tatement (also termed as &rofit I @oss %ccount) is

usually considered as the most useful of all financial statements. !t renders an e/planationabout what has happened to a business on account of operations between two alance7heet dates.# Balance *eet !t depicts the financial position of a business concern at a particularpoint of time. !t represents all assets owned by the business and the claims (or e"uities) ofthe owner or outsiders against those assets at a specific moment in time.# tatement of retained earnings:The term 'retained earnings' implies the accumulatede/cess of earnings over losses and dividends. The balance shown by the !ncome7tatement is transferred to the alance 7heet through this statement, after makingnecessary appropriations. Thus, it acts as a connecting link between the alance 7heetand the !ncome 7tatement.# tatement of c*anges in financial position- The alance 7heet depicts the financialcondition of a business concern at a given point of time while the !ncome 7tatement

reveals the ultimate outcome of operations of business over a period of time. ut, in orderto gain an unmistakable understanding of the business affairs, it is important to identifythe movement of working capital or cash in and out of the business. This information ismade accessible in the statement of changes in financial position of the business.

#A2UR6 3F FI#A#!IA" 2A26M6#2%ccording to the %merican !nstitute of 1ertified &ublic %ccountants, financial statementsreflect a combination of recorded facts, accounting conventions and personal +udgmentsand the +udgments and conventions applied affect them materiallyH. This implies that datae/hibited in the financial statements is affected by recorded facts, accounting conventionsand personal +udgments.1% Recorded Facts:The facts recorded in the books of accounts are known as 4ecordedFacts. Facts, which have not been recorded in the financial books, are not depicted in thefinancial statements, however material they might be. For e/ample, fi/ed assets areshown at cost irrespective of their market or replacement price since such price is notrecorded in the books.. Accounting !on(entions:%ccounting conventions imply certain fundamentalaccountingprinciples, which have been sanctified by long usage. For e/ample, on account of theconvention of 1onservatismC, provision is made for e/pected losses but e/pected profitsare ignored. This means that the real financial position of the business may be muchbetter than what has been shown by the financial statements.M. Personal ?udgments ven personal +udgments have a fair amount of influence on thefinancial statements. For e/ample, it is the choice of an accountant to choose the methodof depreciation. 7imilarly, the method of amortiBation of fictitious assets also

depends on the personal +udgment of the accountant."IMI2A2I3# 3F FI#A#!IA" 2A26M6#2The ob+ectives of financial statements are sub+ect to certain limitations as given below5% Financial tatements are essentially interim reports: The profit e/hibited by the&rofit I @oss %ccount and the financial position revealed by the alance 7heet is note/act. The instances of contingent liabilities, deferred revenue e/penditure etc make themmore imprecise.$% Accounting concepts and con(entions The preparation of the financial statements isbased on certain accounting concepts and conventions. 0wing to this, the financial


24/43

position, as disclosed by these statements, may not be realistic. ecause of convention ofconservatism, the income statement may not disclose true income of the businessJprobable losses are taken into consideration while probable incomes are ignored.)% Influence of personal udgment:any items are left to the personal +udgment of theaccountant. /amples include the method of depreciation, mode of amortisation of fi/edassets, treatment of deferred revenue e/penditure etc. %ll of these depend upon the

personal +udgment of the accountant. The competency of this opinion relies on thee/perience and integrity of the accountant..% 5isclose only monetary facts:Financial statements do not portray the facts thatcannot be e/pressed in terms of money. For e/ample, development of a team of loyal andefficient workers, enlightened management, the reputation and prestige of management inthe eyes of the public are matters of considerable importance for the business but out ofthe confines of financial statements. Therefore, financial statements can nowhere reflectsuch non-monetary aspects.

Preparation of !ompany Financial tatements%s shown above, financial statements mainly comprise of two statements, i.e. the alance

7heet and the income statement or &rofit I @oss %ccount. They are usually prepared atthe end of the accounting periodJ hence, they are also known as financial accounts of thecompany. !n case of companies, the financial accounts have been termed as annualaccounts and alance 7heet. 7ection 5 of the 1ompanies %ct governs the preparationof the financial accounts of a company. 7ome significant provisions vis-a-vis thepreparation of the above accounts are as follows5. %t every %nnual $eneral eeting of the company, the oard of Directors of the1ompany shall lay before the company# The alance 7heet as at the end of the accounting period# % &rofit I @oss %ccount for that period!n the case of a company that does not engage in business for profit, an income ande/penditure account shall be laid before the company instead of &rofit I @oss %ccount atits %nnual $eneral eeting.. The &rofit I @oss %ccount (or the income and e/penditure account) relate to theperiod as per the following premises# !n case of first %nnual $eneral eeting of the company From the date of incorporationof the company to a date not more than 8 months before the meeting# !n case of any subse"uent %nnual $eneral eeting From the date immediately after theperiod for which account was last submitted to not more than = months before themeeting The tenure for which the account has been prepared is called the financial year. !tmay be less or more than a calendar year but it shall not e/ceed 5< months. >owever,with the permission of the 4egistrar, it may e/tend up to 59 months.%ccording to 7ection 55, the &rofit I @oss %ccount and the alance 7heet of acompany must give a true and fair view of the state of affairs of the company. Thealance 7heet should be in form as prescribed in &art ! of schedule 3! or as near thereto

as the circumstances permit. (The form is shown later in the unit.) The &rofit I @oss%ccount should comply with the re"uirements of &art !! of 7chedule 3! of the 1ompanies%ct. &art !!! of 7chedule 3! includes +ust the interpretation of certain terms used in7chedule 3!, &art ! and &art !!. &art !3 has been added with effect from 5


25/43

shall disclose in its &rofit I @oss %ccount and alance 7heet the following# Deviations from the accounting standards# 4easons for such deviations# Financial effects arising from such deviationsThe alance 7heet and &rofit I @oss %ccount of the company have to be duly signed onbehalf of the company by specific individuals as per the provisions of 7ection 5< of the

1ompanies %ct. These statements should be accompanied with the DirectorsC and%uditorsC reports. The DirectorsC report should consist of, besides other prescribedparticulars, the amount, if any which, the board recommends to be paid by way ofdividend and a statement showing the name of every employee of company who has beenpaid remuneration for that at a rate not lessthan 4s.,, per month (raised from4s.5,, p.m. w.e.f. 5*.:.).% copy of the &rofit I @oss %ccount and alance 7heet along with the DirectorsC and%uditorsC reports should be sent not less than 5 days prior to the date of the %nnual$eneral eeting to every member of the company, every debenture holder and everytrustee of the debenture holders. Three copies of such accounts and reports must be filedwith the 4egistrar within M days from the date on which they were submitted in themeeting.!n the following pages, we are giving the particulars as re"uired by 7chedule 3! in

respect of both the &rofit I @oss %ccount and the alance 7heet and the special pointsthat the students must keep in mind while preparing them.

PR3FI2 7 "3 A!!3U#24e"uirements of &rofit I @oss %ccountThe re"uirements of &rofit I @oss %ccount can be categorised into two parts# $eneral 4e"uirements# 7pecial 4e"uirements as per 7chedule 3!, &art !!1% 9eneral Requirements:These are related to three mattersa% @eading: !n case of companies, it is not essential to segregate the &rofit I @oss%ccount into three sections, viB. Trading %ccount, &rofit I @oss %ccount and &rofit and@oss %ppropriation. !t must also be noted that dividing the account into three sections isnot prohibited and should be done to give a better idea regarding the profit earned anddistributed by the company during a particular period.

The &rofit I @oss %ccount can be prepared under two headings# &rofit I @oss %ccount giving details regarding the $ross &rofit and the Aet &rofitearned by the company during a particular period# &rofit I @oss %ppropriation %ccount giving details regarding the alance of &rofit I@oss %ccount brought forward from the last year, the Aet &rofit (or loss) trend (or made)during the year and appropriations made during the year!tems shown in the &rofit I @oss %ccount are popularly termed as items appearingabove the lineH whereas the items shown in the &rofit I @oss %ppropriation %ccount arepopularly termed as items appearing below the lineH.

b.Pro(ision for 2a+ation:1ompanies are liable to pay income ta/ at a high rate.?sually the ta/ rate is about :L or more of the ta/able profit. Though provision for

ta/ation is an appropriation of profits, the common practice is to show it above the lineH,i.e. in the &rofit I @oss 7ection and not in &rofit I @oss %ppropriation 7ection. !n otherwords, profit after ta/ is taken from &rofit I @oss %ccountH to &rofit I @oss%ppropriationH account. >owever, ta/ for a previous period, now provided or refundedfor, is charged or credited to the &rofit I @oss %ccount.c. %ccounting 6ear Though the 1ompanies %ct permits a company to select any periodof 5 months as its accounting year, ta/ laws have made it almost obligatory for everycompany to close its books of accounts on M5st arch every year.


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. 7pecial 4e"uirements as per 7chedule 3!, &art !! The &rofit I @oss %ccount of acompany must be prepared in accordance with the re"uirement of &art !! of 7chedule 3!of the 1ompanies %ct, 58


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To 'ro>ision 7orTa8ationTo Net 'ro(t *:d;; --

--

--

'ro(t ) Loss A**ount'-OFIT ) LOSS A''-O'-IATION ACCONTFor t/e year endin 0r. C-.&articulars 4s. &articulars 4s.To Aet @oss for the yearV S y alance b2d STo Transfer to 4eserves S y Aet profit for the yearV STo proposed Dividends S y alance c2dVV STo alance c2dVVS SV 2 VV 0f the two, only one figure will appear.

BA"A#!6 @662 R6UIR6M6#2%ccording to 7ection 5 of the 1ompanies %ct, it is mandatory for a company to preparea alance 7heet at the end of each trading period. 7ection 55 re"uires the alance 7heetto be set up in the prescribed form. This provision is not applicable to banking, insurance,electricity and other companies governed by special %cts. The 1entral $overnment alsoholds the power to e/empt any class of companies from compliance with there"uirements of the prescribed form, in case it appears to be in public interest. The ob+ectof prescribing the form is to elicit proper information from the company for presenting atrue and fairC view of the state of the companyCs affairs. y this principle, both windowdressing and creating secret reserves will be considered against the provisions of 7ection55.7chedule 3!, &art ! gives the prescribed form of a companyCs alance 7heet. Aotes andinstructions regarding various items are given under any of the items or sub-item. !f theprescribed form cannot be conveniently given under any item due to lack of space, it canbe given in a separate schedule or schedules. 7uch schedules will be anne/ed to and formpart of the alance 7heet.

In(entory aluation Met*od and 5epreciationIntroductionThe previous unit discussed the preparation of final accounts and rules and provisionrelating to preparation of financial statement of companies. This unit deals with the mostimportant component of any business unit namely !nventory. !nventory means 7tock.This may be stock of raw-material, work-in-progress or finished goods. The importanttopics discussed in this unit are !nventory management and !nventory valuation.!nventory valuation permits a firm to provide a financial value for items that make uptheir inventory. !nventories are usually the largest current asset of a business and proper


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measurement of them is essential to ensure accurate financial statements. !f inventory isnot ascertained properly, e/penses and revenues will not match and this might misleadthe company to take wrong decisions in business. eside this the concept of depreciationand its methods are also discussed further in this unit.In(entory !osting Met*odI#6#23R> A#5 I2 IMP3R2A#!6 23 I#!3M6 M6AUR6M6#2

ven a casual observer of the stock markets will understand that stock values oftenfluctuate significantly on information about a company's earnings. The reason is thatinventory measurement bears directly on the determination of income.eginning !nventory Q Aet &urchase $oods %vailable for sale nding !nventory Q 10$7Aotice that the goods available for sale are GallocatedG to ending inventory and cost ofgoods sold. !n the graphic representation, the units of inventory appear as physical units.ut, in a company's accounting records, this flow must be translated into units of money.%fter all, the alance 7heet e/presses inventory in money, not units. %nd cost of goodssold on the income statement is also e/pressed in money.This means that allocating 4e.5 less of the total cost of goods available for sale intoending inventory will necessarily result in placing 4e.5 more into cost of goods sold (andvice versa). Further, as cost of goods sold increases or decreases, there is a converseeffect on gross profit. 7ales minus cost of goods sold e"uals gross profit. % critical factor

in determining income is the allocation of the cost of goods available for sale betweenending inventory and cost of goods sold.5etermining t*e cost of ending in(entory1losing stock or ending inventory is a business's remaining stock at the end of anaccounting period. !t includes finished products, raw materials or work in progress. !t isdeducted from the period's costs in the alance 7heets.!n order to delve deeper into determination of cost of ending inventory, let us begin byconsidering a general rule !nventory should include all costs that are Gordinary andnecessaryG to put the goods Gin placeG and Gin conditionG for their resale.This means that inventory cost would include the invoice price, freight-in and similaritems relating to the general rule. 1onversely, carrying costs like interest charges (ifmoney was borrowed to buy the inventory), storage costs and insurance on goods heldawaiting sale would not be included in inventory accountsJ instead, those costs would bee/pensed as incurred. 7imilarly, the freight-out and sales commissions will be included inthe sale price and will not be a part of the inventory. 1losing stock N 0pening stock Q&urchases Q Direct /penses R 7ales1osting ethods0nce the unit cost of inventory is determined via the preceding rules of logic, specificcosting methods must be adopted. !n other words, each unit of inventory will not have thee/act same cost and an assumption must be implemented to maintain a systematicapproach to assigning costs to units on hand (and to units sold).To consolidate this point, consider a simple e/ample ueller >ardware has a storagebarrel full of nails. The barrel was restocked three times with 5 pounds of nails addedat each restocking. The first batch cost ueller 4s.5, the second batch cost 4s.55 andthe third batch cost 4s.5. Further, the barrel was never allowed to empty completely

and new nails were +ust dumped on top of the remaining pile at each restocking.Therefore, it is hard to say e/actly which nails are GphysicallyG still in the barrel. 0ne caneasily surmise that some of the nails are probably from the first purchase, some from thesecond purchase and some from the final purchase. Furthermore, they all look about thesame. %t the end of the accounting period, ueller weighs the barrel and decides that 5:pounds of nails are on hand (from the M pounds available). The accounting "uestionyou must consider iswhat is the cost of the ending inventoryW Do not consider it as an insignificant "uestion,as it will have a direct bearing on the calculation of income. To deal with this verycommon accounting "uestion, a company must adopt an inventory costing method and


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that method must be applied consistently from year to year. The methods from which tochoose are varied, generally consisting of one of the following# First-in first-out (F!F0)# @ast-in first-out (@!F0)# eighted averageach of these methods entails certain cost-flow assumptions. !mportantly, the

assumptions bear no relation to the physical flow of goodsJ they are merely used to assigncosts to inventory units. (Aote F!F0 and @!F0 are pronounced with a long GiG and longGoG vowel sound- 'feefo' and 'leefo'). %nother method that will be discussed in a while isthe specific identification method. %s its name suggests, it does not depend on a cost flowassumption.FIR2-I# FIR2-3U2 !A"!U"A2I3#ith first-in first-out, the oldest cost (i.e. the first in) is matched against revenue andassigned to cost of goods sold. 1onversely, the most recent purchases are assigned tounits in ending inventory. For ueller's nails, the F!F0 calculations would look like this.

eginning !nventory Q 5@7 K X5 5 @7KX55 5 @7K5

$oods %vailable for saleNXMM

!ost of goods old C100 D 6nding In(entory C 10.

5 @7 K X5 = @7 K X== : @7KX::Q5@7KX5uellerCs nails F!F0

F!F0 hen F!F0 is used, ending inventory and cost of goods sold calculations are asfollows, producing the financial statements on the right sideeginning inventory:, O 4s.5 N 4s. :9,Q Aet purchases (4s. M, total)=, O 4s5= N 4s.8=,9, O 4s5* N 4s.5M=,N1ost of goods available for sale (4s.9, total):, O 4s.5 N 4s.:9,=, O 4s.5= N 4s.8=,9, O 4s.5* N 4s.5M=,Nnding inventory (4s9


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5@7 KX5 =@7KX== Q :@7 KX:: 5@7KX5

?@@4C7 @!F0

LIFO? 5/en LIFO is used, endin in>entory and *ost o7 oods sold*al*ulations are as

7ollo@s, rodu*in t/e (nan*ial state+ents on t/e ri/t side?Beinnin In>entory&,!!! -s.12 -s.&%,!!! Net ur*/ases 3-s.22,!!! total4$,!!! -s.1$ -s.D$,!!!%,!!! -s.1" -s.1$,!!!Cost o7 oods a>ailaTD %34%$ 1%@1?@%T!0A7The weighted average method relies on average unit cost to calculate cost of units soldand ending inventory. %verage cost is determined by dividing total cost of goodsavailable for sale by total units available for sale. ueller >ardware paid 4s.MM for Mpounds of nails, producing an average cost of 4s.5.5 per pound (4s.MM2M). Theending inventory consisted of 5: pounds or 4s.5


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>and5 R Ean:,< R ar =, units K 4s.5= each5,

5* - %pr *, units K 4s.M, each*- 7ep 9, units K 4s.5* each55,55- Aov =, units K 4s.< ach


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Management accounting:Introduction%ll over the world, the one pertinent problem that looms large and terroriBes all thenations is how to efficiently utiliBe the already scarce and depleting resources. 0veryears, this has transformed itself into a problem that every company, every governmentand each one of us in our families and as individuals encounters in some form at somepoint in time. herever there is a problem, solutions are invented. 7o also, allocation ofscarce resources is facilitated by many institutions in the ?nited 7tates and throughoutmost of the world. /amples of such institutions are The Aew 6ork 7tock /change, the@ondon 7tock /change, the 1hicago oard of Trade and all other stock, bond andcommodity markets. These financial markets are sophisticated and apparently, efficientmechanisms for channeling resources from investors to those companies that investorsbelieve will use those resources most profitably.anks and other lending institutions also allocate scarce resources across companies,through their credit and lending decisions. $overnments also do allocation of scarceresources across different segments of the society. This is done by collecting ta/es fromcompanies and individuals and then properly allocating these scarce resources to achievesocial and economic goals.Financial %ccounting is used as a primary source of information for these allocationdecisions by all of these institutions. !nvestors and stock analysts review corporatefinancial statements prepared in accordance with $enerally %ccepted %ccounting&rinciples ($%%&). oth the financial statements as well as pro+ections of cash flows andfinancial performance are reviewed by banks.

Management AccountingThus, the main purpose of both financial accounting and management accounting is theright allocation of the scarce resources. Financial accounting is the principle source ofinformation for decisions on how to allocate resources among companiesJ managementaccounting is the principle source of information for decisions of how to allocateresources within a company. anagement %ccounting provides information that helpsmanagers to control activities within the firm and to decide what products to sell, whereto sell them, how to source those products and which managers to entrust with thecompanyCs resources. anagement accounting information is proprietary. This meansthat it is not mandatory for public companies to disclose management accounting data or


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many specifications about the systems that generate this information. ?sually, companiesdisclose very little management accounting information to investors and analysts beyondwhat is contained in the financial reporting re"uirements. % company discloses such kindof essential information like unit sales by ma+or product category or product costs orproduct type only when the management is sure about the fact that the voluntarydisclosure of this information will be viewed as good newsH by the marketplace.

anagement accounting systems mostly work well. Therefore, it becomes difficult for acompany to have an edge over its competitors by employing a better managementaccounting system. >owever, this observation does not imply that managementaccounting systems are not important to organisations. 0n the contrary, poor managementaccounting systems can significantly affect the investment communityCs perception of acompanyCs prospects.

5efinition and cope of Management Accountinganagement accounting or managerial accounting is concerned with the provisions anduse of accounting information to managers within organisations. !t is meant to providethem with the basis to make informed business decisions that will permit them to bebetter e"uipped in their management and control functions. !t is the process of measuringand reporting information about economic activity within organisations to be used by

managers in planning, performance evaluation and operational control.Planning: &lanning is a process meant for the purpose of accomplishment. !t is ablueprint of business growth and a road map of development. !t helps in fi/ing ob+ectivesboth in "uantitative and "ualitative terms. !t is setting of goals based on aims, in keepingwith the resources, for e/ample, deciding what products to make and where and when tomake them. !t also determines the materials, labor and other resources that are re"uired toachieve the desired output. !n not-for-profit organisations, deciding which programmes tofund is also planning.Performance e(aluation: !t refers to the evaluation of the profitability of individualproducts and product lines. !t is a method by which the +ob performance of an employeeis evaluated (generally in terms of "uality, "uantity, cost and time), typically by thecorresponding manager or supervisor. The main ob+ective of performance evaluation is toassess the e/tent to which an individual has added wealth to the firm and whether hisperformance is above or below the market or industry norms. !t also determines therelative contribution of different managers and different parts of the organisation. !n not-for-profit organisations, it is the evaluation of the effectiveness of managers, departmentsand programmes.3perational control:!t is the authority vested in the management to lead the activities ofan organisation. !t is to ensure that day-to-day actions are consistent with establishedplans and ob+ectives. 1orrective action is taken where performance does not meetstandards. !t also involves assigning tasks, designating ob+ectives and giving authoritativedirection necessary to accomplish the goals of an organisation. /amples include (a)knowing how much work-in-process is on the factory floor and at what stages ofcompletion (b) to assist the line manager in identifying bottlenecks and maintaining asmooth flow of production.

!n addition, the management accounting system usually feeds into the financialaccounting system. !n particular, the product costing system is generally used todetermine inventory alance 7heet amounts and the cost of sales for the incomestatement.

!omparison of Management Accounting and Financial AccountingThe field of accounting consists of three broad subfields financial accounting,management accounting and auditing. This classification is user-oriented. Financialaccounting is concerned with the preparation of financial statements for decision makerssuch as stockholders, suppliers, banks, employees, government agencies, owners and


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other stakeholders. anagement accounting is concerned with the provisions and use ofaccounting information to managers within organisations, to provide them with the basisto make informed business decisions that will allow them to be better e"uipped in theirmanagement and control functions. %uditing refers to e/amining the authenticity andusefulness of all types of accounting information. 0ther subfields of accounting includeta/ and accounting information systems.

These differences are generalisations and are not universally true. For e/ample, $%%&allows choosing any methods for inventory flow, such as the F!F0 or @!F0. !n addition,$%%& uses predictions of future events and transactions to value assets and liabilitiesunder certain circumstances. Aevertheless, the differences between financial accountingand management accounting shown above reveal important attributes of financialaccounting that are driven by the goal of providing reliable and understandableinformation to investors and regulators. These investors are located "uite far from thecompanies in which they have invested and are interested in the results regarding theprofits2losses earned by the organisation. Therefore, a regulatory and self-regulatoryinstitutional structure e/ists to ensure the "uality of the information provided to thesee/ternal parties.For e/ample, financial accounting makes use of historical information, not becauseinvestors are interested in the past, but rather because it is easier for accountants and

auditors to concur on what happened in the past than to agree on managementCspredictions about the future. The past can be audited.H !nvestors then use thisinformation about the past to make their own predictions about the companyCs future.%s another e/ample, financial accounting follows a set of rules ($%%& in the ?.7.) thatinvestors can study. 0nce investors obtain an understanding of $%%&, the fact that all?.7. companies comply with the same rules greatly facilitates investorsC ability to followmultiple companies. !n addition, the fact that financial reporting is mandatory for allpublic companies ensures that the information will be obtainable.anagement accounting, on the other hand, serves an entirely different audience, withdifferent needs. anagement %ccounting provides detailed information that is meant forspecific users. For e/ample, managers re"uire detailed information about their part of theorganisation. anagers must also make decisions, sometimes on a daily basis, that affectthe future of the business. 7o, anagement %ccounting provides necessary informationcentral to future course of action. This information serves as input in those decisions, nomatter how sub+ective those estimates are.Co+arison


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There are two types of control, namely budgetary and financial. This unit focuses only onbudgetary control. Financial control has been covered in detail in units one and two.udgetary control is defined by the !nstitute of 1ost and anagement %ccountants(1!%) asGThe establishment of budgets relating the responsibilities of e/ecutives to there"uirements of a policy and the continuous comparison of actual with budgeted results,

either to secure by individual action the ob+ective of that policy, or to provide a basis forits revisionG. 0f all business activities, budgeting is one of the most important actions andtherefore re"uires detailed attention. The unit looks at the concept of responsibilitycenters and the advantages and disadvantages of budgetary control. !t then goes on tolook at the detail of budget construction and the use to which budgets can be put. @ike allmanagement tools, the unit highlights the need for detailed information, if the techni"ueis to be used to its fullest advantage.

Budgetary !ontrol Met*od1% Budget# % formal statement of the financial resources is reserved for carrying out specificactivities in a given period of time.# !t helps to co-ordinate the activities of the organisation.

%n e/ample would be an advertising budget or sales force budget.

$% Budgetary control# !t is a control techni"ue whereby actual results are compared with budgets.# %ny differences (variances) are made the responsibility of key individuals who caneither e/ercise control action or revise the original budgets.

BU5962AR> !3#2R3" A#5 R6P3#IBI"I2> !6#26RThese enable managers to monitor organisational functions.% responsibility centre can be defined as any functional unit headed by a manager who isresponsible for the activities of that unit.There are four types of responsibility centers Re(enue centers 0rganisational units in which outputs are measured in monetaryterms but are not directly compared to input costs# 6+pense centers:?nits where inputs are measured in monetary terms but outputs arenot Profit centers: ?nits where performance is measured by the difference betweenrevenues (outputs) and e/penditure (inputs) In(estment centers: here outputs are compared with the assets employed inproducing them, i.e. 40!Ad(antages of Budgeting and Budgetary !ontrolThere are a number of advantages attached to budgeting and budgetary control# !t compels the management to weigh the future, which is probably th

accounts unit 1-5

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