1 Year Commerce SCHOOL OF OPEN LEARNING (Campus of Open Learning) University of Delhiee w eee oe 6S a. . FINANCIAL ACCOUNTING a Lesson 1 Lesson 2 Lesson 3 Lesson 4 Lesson 5 Lesson 6 Lesson 7 Graduate Course Paper - Il Accounting : Its Concepts and Conventions Subsidiary Books of Accounts Trial Balance Errors in Accounting Accounting for Depreciation Preparation of Financial Statement for Profit-Making Entities-I Preparation of Financial Statement for Profit-Making Entities-II SCHOOL OF OPEN LEARNING UNIVERSITY OF DELHI 5, CAVALRY LANE, DELHI - 110007 . ° ese e nee enn waeLESSON 1 ACCOUNTING Definition of Accounting : Before attempting to define accounting, it may be added that there is no among unanimity accountants as to its precise definition. However, some’ of the definitions are as given below. According to L.C. Copper, “Book-keeping may be described as the science of recording transactions in money or money’s worth in such a manner that, at any subsequent date, their nature and effect may be clearly understood, and that, when required, a combined statement of their result may be prepared” R.N. Carter defines Book-keeping as “Book-keeping is the science and art of correctly recording in books of account all those business transactions that result in the transfer of money or money’s worth” Yet another definition is given A.H. Rosenkampff. According to him, “Book-keeping is the art of recording business transactions in @ systematic manner”. Out of the above and many more others, the most acceptable one is that given by American Institute of Certified Public Accountants (AICPA) Committee on Terminology. According to AICPA “Accounting is the art of recording, classifying and summarising in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character and interpreting the results thereof”. Book-keeping is a subject of profound importance to all kinds of business enterprises. It is of great importance, for example, to manufacturing goncerns, trading concerns, banks. transport companies and insurance companies. They have to follow a proper accounting system if they want to know as to whether they are earning, profits or incurring losses and how much; whether or not all the transactions have been recorded fully and accurately; the amount they owe to their creditors as well as the amount owed to them by their debtors Thus the objects of accounting are to enable the businessman to ascertain accurately and easily. 1. The amount of gain or loss during a particular period, and 2. The amount of his assets and liabilities and capital in the firm at a particular point of time. Double Entry Principle : In the present era double entry system of book-keeping is considered to be the best, common and universal system, because it is modem, scientific, and complete. It fulfils all the objects of a businessman. It joriginated in western countries and so it is also called western system of accounting. It is also called mercantile system of accounting because according to this system cash and credit transactions can be recorded Double entry system has been defined differently by different authorities. Some of which are as follows :~2 ‘According to Carter, “The modem system of Accounting in use is known as Double Entry” Double Entty is a system of Book-keeping by means of both personal and impersonal accounts.” MJ. Keller defines Double Entry System as follows : “The most common system of accounting data for an enterprise is the Double Entry System. As the name implies, the entry made for each transaction is composed of two parts, a ‘Debit’ and a “Credit.” Each business transaction that result in transfer of money or money's worth involves a two- fold aspect, (2) the yielding or giving of a benefit, and (b) the receiving of that benefit. In other words every business transaction involves exchange of value for value, or inter-change of money tr money's worth or every business transaction involves receiving something having value and giving something which has value, According to Double Entry System, both these aspects of the transaction, the receiving aspect and the giving aspect, arc recorded. Thus, if Building is bought from Mukesh, Building Account receives and Mukesh’s Account gives. There must, therefore, be double entry to have a complete record of each transaction. For a clear understanding of the principles of double entry system, it is necessary to first carefully bear in mind that certain transactions are common to almost every business. These ‘common transactions are as follow: 1. The businessman enters into business dealings with a number of ‘persons or firms; 2. He must have some assets or properties. in which or with the help of which he carries on the business; and 1 He must incur certain expenses such as office rent, salaries, advertising, ete. for carrying con the business, and that he must have some sources from which the income of the business is derived. It follows, theretore, that in order to keep @ complete record of all the business transactions, it will be necessary to keep the following accounts ‘The account of each person ‘or firm with whom the firm has to deal; G (ii) The account of each head of expense or source of income. The account of each asset or property in the business; and ‘The accounts which come under first group are called Personal Accounts, those which come under second group are called Real Accounts, and those coming under the third group are called Nominal accounts. Since words ‘debit and credit’, and ‘Account’ have been used in the above definitions and discussion, it will be-better if we first understand the meaning of these words and then proceed to discuss the rules of double entry system. ‘The double entry system divides the page into two equal halves. The left hand side of each page is called the debit side;, while the right hand side is called the credit side. There was No riions! reason in the way in which the sides were choosen to represent different items, and the vredit side could have easily been the left-hand side and the debit the right hand side. ‘The Venetion merchants who were the ‘first known businessmen to use double entry just happened to select the jeft hand or debit side for the assets and opposite side to represent capital and liabilities, and so it has remained ever since. ia...3 ‘An Account is a classified and chronological record in which the money values (some times also the quantities or the money values and quantities together) of all the benefits given or received by a particular party (which may be a human being or 2 personified object) are arranged in two separate columns on thé right and left sides respectively of each sheet of paper or each page or folio of the book in which it is written. There will be a debit side as well as credit side to every account. This is indicated by writing “Dr” and “Cr” on the left-hand side and right-hand side margin respectively of the account. All entries in the Dr. side are preceded by the word ‘To’, meaning that the account of which the record is being prepared is a debtor to the account the name of which appears in the entry. On the other hand, all entries in the credit side are preceded by the word *By’, so that each entry may mean that the account of which the record is being prepared is credited by the account the name of which appears in the entry. The title of the account is written across the top of the account at the centre. The account of the party that gives a benefit is called a “Creditor” and that of the party that receives it is called a “Debtor”. As a general rule the value of each benefit received by an account is entered on the left-hand column of the account and the account is said to have been ‘debited’ with such value; on the other hand, the value of each benefit given by an account is entered on the right-hand column of the account and the account is said to have been ‘credited’ with such value. These are called debit and credit entries respectively. Having understood the meaning of the words “Debit and Credi proceed with the explanation of rules of double entry system. , and “Account”, let us now Rules of Double Entry System : For debiting or crediting a particular account, we have first to see which class of account are affected by the transaction which is entered into by the businessman. After ascertaining that, the following rules of debit and credit will have to be followed: (1) Personal Accounts : In the case of personal accounts we debit the person or the firm with the benefits imparted the benefits received by him or by the firm and credit the person or the firm by the person or the firm. In short we can say that— Debit the Receiver (of benefits): and Credit the Giver (imparting the benefits) (2) Real Accounts : Real accounts are debited with the incomings and are credited with the outgoings “oF, Debit what, comes in the business; and Credit what goes out (of the business) (3) Nominal Accounts : All amounts expended or lost are debited and all amounts gained are credited to nominal accounts In other words : Debit all expenses and losses; and Credit all incomes and gains. It should be kept in mind that these rules never vary and will have to be: rigidly followed under all conceivable conditions. It should also be noted that the above mentioned phenomenas like ‘giver’ and “receiver’, ‘coming in’ and ‘going out” etc. are to be judged not from the proprictor’s4 point of view but from the point of view of the business. In addition to the above rules of double entry system, there are certain basic concepts and conventions of accounting which must be known before actual book-keeping and accounting work is started. These concepts are discussed here-in-after. ACCOUNTING AS AN INFORMATION SYSTEM Accounting is often referred to as the language of business. The primary aim of a language ‘Accounting is used to communicate firancial and other information to people. organizations, Governments etc., about various aspects of business and non- business entities. Accounting information is used when Mr, A applies for a loan at a bank or when A submits his income-tax retums. Business enterprises use accounting for their day-to-day activities and to report the result of these activities to their owners, creditors, employees and Governmental agencies. The accounting is, therefore, also an information system. In today's society. many 2 information; (ii) Accountant may supervise the work of book-keeper’s recording work but the book-keeper has no role in accountant’s work of interpretation; (i being done by computers. But the work of accountant is technical in nature and requires higher level of knowledge, conceptual understanding and analytical skill; (iv) Book-keeping is done in ordance with basic concepts and conventions for all types of organisations. But the methods and procedures adopted by accountants in the analysis and interpretation of financial reports may is to serve as a means of communicati persons and agencies outside the account i) the work of book-keeper is routine and clerical in nature and is increasingly not be same for all the firm Functions of Accounting Finan ial accounting performs the following major functions () Maintaining systematic records : Business transactions are properly recorded, classified under appropriate accounts and summarised into financial statements—income statement and the balance sheet. (i) Communicating the financial results ; Accounting is used to communicate financial information in respect of net profits (or loss), assets, liabilities ete., to the interested parties. (iii) Meeting legal needs : The provisions of various laws such as Companies Act, Income Tax and Sales Tax Acts require the submission of various statements, i.¢., annual accounts, income tax returns, returns for sales tax purposes and so on. (iv) Protecting business assets : Accounting maintains proper records of various assets and thus enables the management to exercise proper control over them with the help of following information regarding them : (a) How much is the balance of cash in hand and cash at bank? (b) What is the position of inventories? (c) How much money is owed by the customers? (d) How much money is owing to the creditors? (e) What is the position of various ixed assets and how these are being used? (v) Accounting assists the management of business activities. the task of planning, control and coordination eee5 (vi) Stewardship : In the case of limited companies, the management is entrusted with the resources of the enterprise. The managers are expected to act true trustees of the funds and the accounting helps them to achieve the same. (vii) Fixing responsibility : Accounting helps in the computation of the profits of different departments of an enterprise. This would help in fixing the responsibility of departmental heads. Advantages of Accounting (Assistance to management : The accounting information helps the management to plan its future activities by preparing budgets in respect of sales, production, expenses, cash, etc. Accounting helps in coordination of various activities in different departments by providing financial details of each department. The managerial control is achieved by analysing in money terms the departures from the planned activities and by taking corrective measures to improve the situation in future. (ii) Records rather than memory : It is not possible at all to do any business by just remembering the business transactions which have grown in size and complexity. Transactions, therefore, must be recorded early in the books of accounts so that necessary information about them is available in time and free from bias. (il) Intra-period comparisons : Accounting information when recorded properly can be used to compare the results of one year with those of previous year(s). (iv) Aid in legal matters : Systematically recorded accounting information can be produced as an evidence in a court of law. (v) Help in taxation matters : Income Tax and Sales Tax authorities could be convinced about the taxable income or actual turnover (sales), as the case may be, with the help of written records. (vi) Sale of a business : In case, a sole trader or a partnership firm or even a company wants to sell its business, the accounting information can be utilised to determine proper purchase price. Limi tions of Accounting (@ Accounting information is expressed in-terms of money. Non-monetary events or transactions. however important they may be, are completely omitted. (ii) Fixed assets are recorded in the accounting records at the original cost, that is, the actual amount spent on them plus, of course, a incidental charges. In this way the effect of inflation (or deflation) is not taken into consideration. The direct result of this practice is that balance sheet does not represent the true financial position of the business. (iil) Accounting information is sometimes based on estimates: estimates are often inaccurate. For example, it is not possible to predict with any degree of accuracy the actual useful life of an asset for the purpose of depreciation expense. (iv) Accounting information cannot be used as only test of managerial performance on the6 basis of more profits. Profit of a period of one year can readily be manipulated by omitting such cost of advertisement, research and development, depreciation and soon. (v) Accounting information is not neutral or unbiased. Accountants calculate income as excess of revenues over expenses. But they consider only selected revenues and expenses. They do not, for example, include cost of such items as water or air pollution, employee's injuries ete. (vi) Accounting like any other discipline has to follow certain priciples which in certain cases are contradictory. For example current assets (e.g., stock of goods) are valued on the basis of cost or market price whichever is less following the principle of conservatism. Accordingly the current assets may be valued on cost basis in some year and at market price in another year. In this manner, the rule of consistency is not followed regularly. The Users of Accounting Information Financial accounting is primarily concerned with preparation of accounting information for the outsiders who do not have direct access to the accounting records. They obtain accounting information of business enterprises from their annual reports, data published by Government departments and information published in financial newspapers, e.g., the Economic Times, Financial Express etc., or business magazines e.g., Business India, Business World. The Economist, ete. In the following paragraphs, the users of accounting information have been grouped into a number of major headings and the requirements for each considered therein : Creditors and short-term lenders : Creditors include suppliers of goods and services on credit. Short-term lenders such as commercial banks supply money for short periods to business organisations. Bankers and suppliers inspect the accounting information before making loans or granting credit. They want to know whether or not the enterprise will be able to meet its financial repayment obligations in time. Their specific interest lies in solvency, liquidity and profitability positions of the business enterprise. Accounting serves their purpose by disclosing true and fair view of current assets in the balance sheet and profitability position in the income statement so as to assure the creditors and lenders that their debts would be paid in time. Investors : Under this category are included the existing shareholders and future shareholders. Basically they will be interested in the dividends that are paid. They are also interested about future prosperity of their enterprise. But the income statement and the balance sheet of one year will not be helpful to guide the investors about the future prospects_So the accounting information must provide the details of the profits and financial position of business so that the investors can find out the progress of the past few years and it may be assumed that this progress will be maintained in future as well. At present such information is. generally given in the published accounts. The statement of the chairman in the annual reports also provides some indication about the future progress. Long-term lenders : This category of users includes debenture holders and those providing long-term loans, say, industrial banks, financial institutions, ete. They are interested in knowing that they will get the interest due to them and that the same will be paid when it is due and payable. They will also see to it that their principal amount is also paid on due date. So their main interest The is in the profitability for interest payments and liquidity for the repayment of the loan amou4 availability of cash flow statements in addition to income statement and baiance sheet has considerably helped users to evaluate the liquidity position of a business enterprise. Management : The owners are not the only persons within the business enterprise who are interested in various aspects of the operations of a business. With are interested in various aspects of the operations of a business. With the separation of management and ownership (particularly a limited company), the managers are responsible for carrying on the operations of the business enterprises. The type of accounting information needed by managers may vary with the size of the enterprise. The manager of a small business may need relatively little accounting information. As the business enterprise grows in size, the manager loses direct contact with daily operations. As a result, information about various aspects of the business enterprise must be supplied by accounting. Some of their needs for accounting information relate to : (i) setting objectives or targets for future periods and devising methods to attain those objectives: (ii) observing and measuring the performance of the various departments of the business as also the enterprise as a whole; (iii) evaluating the performance in relation to the targets set up: highlighting the deviations from the planned targets; and (iv) taking such corrective action as may be necessary to overcome the shortfalls. Employees (Labour unions) : In this category are included both individual employees and groups of them represented by labour unions. Employees want more salary and other benefits such as overtime payments, bonus, housing, medical facilities and so on. The bargaining power of the unions is increased if workerss’ demands are based on facts and figures. In addition, some companies regularly issue certain reports containing financial information about the employers for a better understanding of the business by the employees. These reports highlight what the companies are doing for the welfare of their employees and what they intend to do in future. Government and regulatory agencies : In recent years, the governmnt has become one of the most important users of accounting information. The central, state and local governments have the responsibility of allocating the resources for different uses. Naturally they are interested in the activities of business enterprises such as sales, profits, dividend policies, investments. ete. Moreover, the Government activities are financed through the collection of tax. Thus the accounting information about business activities is very helpful in the collection of income tax, excise duties. customs duties, sales tax, etc. Each tax requires a special tax returns based on necessary accounting information of various business enterprises. Any distortion in the accounting information needed by the Government agencies would adversely affect the welfare policies of the various types of governments. Similarly a number of regulatory agencies like Securities and Exchange Board of India (SEBI), the Insurance Regulatory Authority, the Reserve Bank of India ete. need accounting information for the efficient operation of capital markets. Individuals and society : People are affected by the operations of a business enterprise in their localities. They want to know through the accounting information the trends in the prosperity of the enterprise and also the range of activities. This would enable them to assess the employment opportunities in their local areas. Society as a whole is concerned with the environment pollution. The accounting information would disclose how much money has been allocated to control such pollution. This has come to be known as social responsibility accounting.Branches of Accounting Accountants tend to specialise in various types of accounting work and this has resulted in the development of different branches of accounting. Some of these divisions of accounting are given as (i) Financial Accounting : Accounting designed for outsiders (persons other than owners and managers) is known as financial accounting. It is concerned with the recording of business transactions and the periodic preparation of balance sheet and income statement from such records. In this manner. the financial accounting is useful for ascertaining profit or loss made during a given period and financial position at the end of the period. (ji) Management accounting : It is concerned with the interpretation of accounting information to guide the management for future planning, decision-making, control, etc., Management accounting, therefore, serves the information needs of the insiders, e.g., owners, managers and employees. (iii) Cost accounting : It has been developed to ascertain the costs incurred for carrying out various business activities and to help the management to exercise strict cost control (iv) Tax accounting: This branch of accounting has grown in response to the difficult tax laws stich as relating to income tax. sales tax. excise duties, custom duties, etc. An accountant is required to be fully aware of various tax legislations. (v) Social accounting : This branch of accounting is also known as social reporting or social responsibility accounting, It discloses the social benefits created and the costs incurred by the enterprise. Social benefits include such facilities as medical, housing, education, canteen, provident fund and so on while the social costs may include such matters as extra hours worked by employees without payment, environment pollution, unreasonable terminations, etc. (vi) Human resource accounting : It is concerned with the human resources of an enterprise Accounting methods are applied to identify human resources and its evaluation is done in money terms so that the society might judge the total work of the business enterprises including its non- human net assets. It is, therefore, an accounting for the people of the organisation. Unfortunately no objectively verifiable measure has been developed for universal application. (vii) National accounting means the accounting for the nation as a whole. It is generally not concerned with the accounting of individual business entities and is not based on generally accepted accounting principles. It has been developed by the economists and the statiticians Bases of Accounting The business enterprises use accounting to calculate the profit from the business activities at the end of given period. There are two bases of calculating the profit, namely, the cash basis and the accrual basis, (i) Cash basis of accounting : In this basis of accounting, the income is calculated as the excess of actual cash receipts in respect of sale of goods, services, properties, ete. over actual cash payments regarding purchase of goods, expenses on rent, electricity, salaries, etc. Credit transactions are not considered at all including adjustments for outstanding expenses and accrued income items. This method is useful for professional people like doctors, engineers, advocates,9 chartered accountants, brokers and small traders. It is simple to adopt because there are not adjustment entries. But this basis does not disclose the true profits because it does not consider the income and expense items which relate to the accounting period but not paid in cash. Moreover this method is not applicable where the number of transactions is very large and expenditure on fixed assets is high. The income or profit is calculated with the help of receipts and payments account (ii) Accrual basis of accounting : Under this method the items of income (revenue) are recognised when they are earned and not when the money is actually received later on. Similarly expense items are recognised when incurred and not when actual payments are made for them. It means revenue and expenses are taken into consideration for the purpose of income determination ‘on the basis of the accounting period to which they relate. The accrual basis makes a distinction between actual receipts of cash and the right to receive cash for revenues and the actual payments of cash and legal obligations to pay expenses, It means that income accrued in the current year becomes the income of the current year whether the cash for that item of income is received in the current year or it was received in the previous year or it will be received in the next year. The same is true of expense items. Expense item is recorded if it becomes payable in the current year whether it is paid in the current year or it was paid in the previous year or it will be paid in the next year. The advantages of this system are : (a) it is based on all business transactions of the year and, therefore, discloses the correct profit or loss; (b) the method is used in all types of business units; (c) it is more scientific and rational in application; (d) it is most suitable for the application of matching principle. The disadvantages are : (a) it is not simple one and requires the use of estimates and personal judgement; (b) it fails to disclose the actual cash flows. Mixed or hybrid basis of accounting : Under this method revenues (items of income) are recognised on cash basis while the expenses are recorded on accrual basis. The purpose is to remain cautious, safe and hundred per cent certain for revenues items and make adequate provisions for expenses. Accounting Concepts and Conventions Accounting in the past was mainly used to (1) keep control over property and assets of the business concerned and (2) ascertain and report about the profit or loss and the financial position relating to the various periods. But not a days accounting is used not only for the above mentioned Purposes but also for collecting, analysing and reporting of information to the management and others at the required points of time to facilities rational decision making, Moreover, the accounts n the past were prepared mainly for the use of the proprietor. Today financial statements are required by the proprietors, creditors, potential investors, Government and many others. The proprietors study the financial statements to know about the profitability of their business. Creditors study them to ascertain the solvency of the business. Prospective investors are interested in them0 for the ascertainment of the correct earing potential of the business. Government makes use of these statements for finding out the net contribution that a business can make to the economic well being of the country. ‘To satisfy the diverse and complex needs of those who use accounting, one needs something more than the clerical procedures, journalising, posting, taking out trial balance and closing the books etc. The accountant should have ‘guides to action’ or ‘principles’ for completing his work of a wide dimensions. The usefulness of accounting will be maximised only if there exist some generally accepted concepts regarding the nature and measurement of liabilities, assets, revenues and expenses. There must also be some widely supported standards of disclosure and reporting There will be widespread understanding of and reliance on accounting statements only if they are prepared in confimity with generally accepted accounting principles. If there is no common agreement on accounting matters then complete chaotic conditions would prevail as in that case every business-man and/or every accountant could follow his own definition of revenue and expense, Definition : The rules conventions of accounting are commonly referred to as ‘principles’ A universal definition of the ‘accounting principles’ is difficult to give. However, ‘accounting iples’ can be defined in the following two ways : 1, Accounting Principle is a “General Truth” or a ‘fundamental belief”. This definition implies a scientific bias and therefore, its application in the face of ever changing socio-economics factors which affect the very basis of a business is doubtful. 2. Accounting principle may be defined as a ‘rule of action or conduct’. This definition finds favour with the American Institute of Certified Public Accountants as it refers to changing character of rules of action or conduct due to the changes in business practices etc. According to AICPA, accounting principle is a general law or rule adopted or proessed as a guide to action. ‘The accounting principles do not prescribe one way of doing things. They recognize that there are a number of ways in which one thing can be done. The accountant has considerable latitude and choice within the generally accepted accounting principles in which to express his own idea as to the best way of recording and reporting is specified account. The practice of recording and reporting may thus differ from company to company.u It should be noted that it would be incorrect to suggest that accounting principles are a body of basic laws like those found in natural sciences like Physics and Chemistry. Accounting principles are man made and hence are more properly associated with such terms as concepts, conventions and standards. Accounting principles were not deducted from basic axtoms, not is their validity verifiable by observation and experiment in a laboratory. Accounting principles are constantly evolving, being influenced by business practices, the needs of statement users, legislation and governmental regulations, the opinions and actions of shareholders, labour unions, creditors, and management; and the logical reasoning of accountants. The sum total of all such influences finds its expression first in accounting theory. Some theories are accepted while some others are rejected. Theory becomes an accounting principle only when it is generally accepted. A distinction between Fundamental Accounting Assumptions and ‘Accounting policies’ has been made by the International Accounting Standards Committee (IASC). Fundamental Accounting assumptions or: postulates according to the ISC underlie the preparation of financial statement. They need not be specifically stated on the face of such statements. Their acceptance and use is assumed in the preparation of financial statements . Disclosure with full reasons, however, must be made in case they are not followed. Accounting policies on the other hand encompass the principles, basis, conventions, rules and procedures adopted by management in preparing and presenting financial statements. There are, as stated above, many different accounting and applying those which in the circumstances of the enterpise, are best suited to present properly its financial position and the results of its operations. Essential Features of Accounting Principles ‘The general acceptance of an accounting principle or practice depends on its capacity to meet the criteria of relevance, objectivity and feasibility. ‘An accounting principle should be relevant, i.e. the use of it should result in information that is meaningful and useful to the financial statement users. In other words only those accounting rules which increase the utility of the business records to its readers will be accepted as an accounting principle by them. It should be objective. The accounting information obtained should not be influenced by the personal bias or judgement of the statement makers. Objectivity cannotes reliability or trustworthiness. It means that there must be means of ascertaning the correctness of the information reported in a financial statement. A principles is feasible to the extent that it can be implemented without undue cost or complexity. The accounting principles may be adopted to the needs of business quickly and easily. It means the accounting principles should be flexible, i.e. they should not be static. They should be capable of being changed with the changes in business methods and procedures. The accounting principles generally combine all the above mentioned features or criteria, but sometimes we may have to give up one criterion in favour of another or we may place greater importance valuing the fixed assets at cost for on one and Jesser importance on the other. For example w! Balance Sheet purposes we give up the criterion of objectivity and usefulness in favour of feasibility. The fixed assets are valued at cost and not at market price even though the cost figure is not of much use of the reader because of changes in the value of rupee, a measuring rod. This is done12 because of thefollwing two reasons. 1. The market price or replacement value of the assets is difficult to ascert 2. The market price or the replacement value of the fixed assets even if one is able to ascertain will be less objective in nature. nce between ‘Thus in developing new principles, the essential problem is to strike the right bal objectivity and feasibility on the one hand and relevance on the other. Definition of Accounting Conventions : Accounting conventions mean and signify customs ion relating to accounting. Thus they differ from accounting concepts which are used to or tra connote accounting postulates. In other words, we can say that accounting conventions relate to the practi al side of accounting. ‘After understanding the meaning of accounting concepts and conventions let us now discuss each one of these concepts and conventions in some detail (1) Going Concern Concept : Kohler defines going concern as, “A Business enterprise in operation bilities, revenues, operating with the prospects of continuing operation in the future; its assets, | costs, personnel policies and prospectus; a concept basic to accounting, of importance in the valuation of intangible assets and the depreciation of tangible and intangible assets.” (Kohler, E.L. : A Dictionary for Accountants, Prentice-Hall Inc. Engle Wood Cliffs, N.1., 1963). Simply stated accounting assumes that the business will continue to operate for an indefinitely long period in the future. In other words the accounting unit is considered to have a greater life expectancy than that of any asset which it now owns. This necessitates the making of a distinction between capital expenditure and revenue expenditure. Though every expenditure is a revenue expenditure ‘a the Jong run, this distinction is important because accounts of 4 business supposed to run for a long period of time, are usually prepared for a short period say, a year. If-this assumption is not made, the generally a counting principles that have been developed and that are applied in the process of accounting for the financial affairs of a business entity and which are, in many instances, appropriate only for a going concen will become redundent . If the business is failing and its assets are subject to forced sale, the conventional epted a or useles accounting approach, although acceptable for a going concern, would often result in wrong or inadequate financial information. Under this assumption a business is viewed as an Economic or financial system for adding Value to the resources it uses. Its success is measured by comparing the value of its output with the cost of the’ resources used in producing that output. The difference in the value of its output and the costs of the resources used to produce that output is called profit. Resources purchased but not yet used in production are called assets, They are shown not at current value to an outside buyer, but at their cost, Their current resale value is not relevant, since is assumed that they will be used in the creation of future output values rather than being sold. ‘Thus, the accountant does not try to measuré at all! times what the business is currently worth to @ potencial buyer. He does not show in the balance sheets the value, the assets will fetch of the company goes into voluntary liquidation. He rather values the assets used for business purposes at cost. For a going concern that intends to continue using such assets for business13 purposes, forced sale or current market value is not particularly, relevant. But if the business is winding up its affairs and must sell its assets to satisfy the claims of its creditors, the original cost of the assets is no indicator of realisable value. The fact should be kept in mind while preparing the account of @ concem if it is clear that the life expectancy of such business is very sort. It is only because of this that in the case of contracts, assets purchased are debited entirely to the contract account and not treated as an asset. (2) The Business Entity Concept : For accounting purposes the business is treated as a complete unit or entity separate from those who own it or give credit to it. The owner or proprietor is. considered to be separate and distinct from the business he owns or controls. Accounts are maintained for business entities as distinct from the persons who own them, operate them, or are otherwise associated with the business. For accounting purposes even the proprietor will be treated as creditor to the extent of his capital. The proprieitor’s private affairs are thus not allowed to be mixed up with those of the business. It is only because of this concept that we are able to present a true picture of the firm. The entity concept is applicable to all forms of business organisations. For accounting purposes even the solé trader or partner is considered to be an entity different from the business he owns although even in law there is no distinction between.the financial affairs of the business and those of the people who own it; a creditor of the business can use and if successful collect from the owner's personal resources as well as from the resources of the business. ‘The field of this concept has now been extended. It is now also applied for finding out the results of various departments of the same organisation separately with a view to fixing the responsibility for the results thereof. “There follows from the distinction between the business entity and the outside world that 1g on stewards! an important purpose of financial accounting is to provide the:basis for repor ‘The managers of a business are entrusted with funds supplied by owners, banks and others. Management responsible for the wise use of these funds, and financial accounting reports are in part designed to show how well-this responsibility or stewardship, has been discharged”. (Management Accounting Principles by Robert N. Anthony page 22-23). : (3) Money Measurement Concept : Accounting records only those facts which could be expressed in terms of money. This concept ignores the records of events on which precise money values can not be put, even if they are very important. In other words, we éannot express qualitative events with the help of accounting wiless they can be measured in terms of money wit accuracy. This enables us to deal arithmatically (added, substracted divided or multiplied) with things of diverse nature. €.g., cost of use of plant and machinery and use of skilled Jabour can be added a fair degree of up. This is so because money provides a common denominator by means of which heterogenous facts about a business can be expressed in terms of numbers that can be dealt with arithmatically. ‘This concept imposes severe limitations on the scope of accounting statements. The Accounts of Gupta & Company, for example, do not reveal that a competitor has introduced an improved service to the customers; they do not report that a strike is beginning or for that matter they do not record the fact that the production manager is not on speaking terms with the Sales Manager ‘because all these events can not be expressed in terms of money. Thus accounting does not give @ complete picture of what is happening in the business or that of the conditions prevailing in the4 business. It should, however, be noted that money is expressed in terms of its value at the time an event is recorded in the accounts. Change in the purchasing power of money due to inflation or deflation in future years are not taken note of. . ‘To sum up we. can say that while money is probably the only practical common denominator, the use of money implies homogeneity, a basic similarity between Re. 1 and another. This homegencity does not, however, exist in periods of inflation or deflation. (4) Dual Aspect Concept : Dual aspects is perhaps the most important of all the concepts. We require use of this recording each and every business transaction. To understand this concept fully we must know the meaning of the words (i) Assets and (ii) equities. Assets mean the resources owned by a business, e.g., Land, Building, Plant, Machinery, Stock of goods and so on. Equities on the other hand mean the claims of various parties against these assets. Equities can be divided into two broad categories (a) Owner's equity (or capital) which is the claim of the owner or proprietor of the business and (b) creditors equity, i.e., the claim of Greditors of the business. Thus from the above discussion it follows that the amount of the assets of the business will always be equal to the amount of owners’ equity and creditors’ equity. This is so because all the assets of a business are claimed by someone, either by the owners or by the creditors of the business, and also because the total of these claims can never exceed the amount of assets to be claimed. To put it in the form of an equation we can say that Assets=Equities (Owners’ equities as well as Creditor’s equities) OR bilities = Assets Capital + In its most expanded form it will be Capital + Revenue + Liabilities = Assets + Expenses. “Accounting systems are set up in such a way that a record is made of two aspects of each event that affects these records and in essence these aspects are changes in assets and changes in equities. Every event that is recorded in the accounts affects at least two items; there is no conceivable way of making only a single change in the accounts. Accounting is thereof properly called a “Double Entry System” (Robert N. Anthony-Management Accounting Principles, Page26). (5) Realisation Concept : Accounting is a historical record’ of transaction. It records what was happened. It does not anticipate events. though it usually records adverse effects of anticipated events that have already taken place. Profit it considered to have been eamed on the date at which it is realised or on the date when goods or services are furnished to the customers for some valuable consideration or when the third Party becomes legally liable to make payment for goods and services sendered to them. For tangible goods profit is recognised as and when goods are shipped or delivered to the customers and not when either a sales order is received or when a contract is signed or/ and not even when goods are manufactured to meet the order. This concept stops business firms from inflating their profits by recording sales and incomes that are likely to take place in future. There are certain exceptions 10 this general rule—{a) The revenue is recognised as realised ——-15 on an earlier date in case where it can be objectively measured earlier than the date of exchange between the seller and the buyer. For example, in case of mining revenue is re¥ognised when the metal is mined, rather than when it is sold. This is so because the metal always has a specified value and hence no market exchange or sale is necessary to establish this value. (b) In case of Hire purchase and instalment selling, reveue may be recognised only when the instalment payments are received and not when goods are delivered due to the doubt about the actual amount that will be received from the hirer. (©) Not full revenue or profits, if the contract of sale stipulates after sale service agreement. Probable cost of adequate provision for repairs in such cases be made out of realised profits to arrive at the net revenue () In a business where mere production leads to the earning of profits as sales require no effort on the part of the manufacturer, profits are assumed to have been realised as and when goods are manufactured and not when they are actually sold. (6) Accrual Concept :—According to accrual concept, income or profit arises only when there has been an increase in the owner’s equity or increase in the owner's share of the assets of the firm but not if such increase results from money contributed by the owner himself. “Any increase in owner's equity resulting from the operations of the business is called a revenue. Any decrease is called an expense. Income is therefore the, excess of revenue over expenses. (If expenses exceed revenue, the difference is called a loss). It is extremely important to recognise that income is associated with change in owner's equity ‘and that it has no necessary relation to change in cash. Income connotes. ‘Well-offness’. Roughluy speaking the bigger the income, the better off are the owners. An increase in cash, however, does not necessarily mean that the owners are better off and that their equity is increased. The increase in cash may merely be offset by a decrease in some other asset or an increase in a liability with ". (Robert N. Anthony, Management Accounting principles, 8th no effect on owner’s equity at al Prg., Page4s). ‘Thus the profit is said to have arisen only when the total’ revenues or incomes exceed total expenses or losses. Settlement, in cash, of transactions already entered into is immaterial for calculating or taking into account the expenses, losses or gain etc. It is enough if they are incurred or eamed during the period for which profit is being calculated. (7) Verifiable objective evidence concept :—According to this concept all the entries recorded in the books of account should be supported by business documents known as vouchers. No entry bbe passed in the books unless it is supported by proper voucher which could also be verified later on as and when it becomes necessary to check the correctness of the accounts. The only limitation to this general rule is entries with regard to non-cash charges, e.g., Depreciation on fixed assets, provision for bad and doubtful debts and so on. (8) Cost Concept :—According to the cost concept which is closely related to Going Concern Concept the assets or resources owned by a business are entered on the accounting records at cost or the price paid to acquire them. According to the same concept the cost of the asset is the basis for all subsequent accounting for the asset.16 ‘ ‘Thus the accounting measurement of assets does not normally reflect the worth of assets except 2° the intoment they are purchased because it is assumed that the purchaser is « prudent businessman and that he will, therefore, not pay more for an asset or service that it is worth at the time. This being so the historical cost is presumed to be equal to the fair value of the asset acquired. In other words it means that the accountant observing this concept does not ordinarily record the changes in the real worth of an asset which might have occured with passage in time or due to changes in the value of money, @ measuring rod. For example, a building if purchased for Rs. 1,00,000 will be recorded in the books of accounts at Rs. 1,00,000. Subsequent changes in the worth or in the market value of this building would not ordinarily be recorded in the: accounts books. The change in the market price of this building, say Rs. 2,00,000 on the date of preparation of the balance sheet will not be considered. It be noted that not all assets, but only fixed assets, are recorded according to this concept. ‘There may be certain assets called current assets, in case of which there may well be a correspondence between accounting measurements and their real market values, cash, for example, is always shown hot at its original cost but at its actual worth. Similarly, marketable securities and stock held for resale are generally shown at their near actual worth figure, i.e. at cost or market value which ever is lower. It is because ‘of this fact that it is said that subsequent changes in the market value of assets would ordinarily not be reflected by changes in the accounts. However, it should also be noted that cost concept does not mean that all assets remain in the accounting records at their hist ginal cost so long as the company owns them. The cost of a fixed asset, such as a building , that has a long but nevertheless a limited life is systematically reduced over the life of the asset by the process called depreciation. It is because of the process of chansing depreciation that the asset disappears from the balance sheet when its economic or useful life is over. “Another important conequence of the concept is that if the company pays nothing for an item it acquires, this item will usually not appear in the accounting records as an asset. The knowledge, skill and, expertise of an electronic company’s research and development team does not appear in the company’s balance sheet as an asset”. (An insight into management accounting First Ed., by John Sizer ; Page 42.) Following this the goodwill appears in the accounts of the company only when the company has purchased an intangible and valuable property right and paid for Even then it is shown at its purchase price even though the management may believe that its real value is considerably higher. No-amount for “goodwill” or any other asset for that matter will be shown in the accounts if the company does not actually purchase such intangibles or assets. It also follows from the cost concept that an event may effect the value of a business without having any effect on the accounting records. To take an extreme case, suppose that several key excecutives are killed in a plane accident. To the extent that “an organisation is but the lengthened shadow of a man, the real value of the company will change imniediately, and this will be reflected in the market price of the company 's stock, which reflects investor's appraisal of value. The accounting records however, will not be affected by this event. ‘The cost concept provides an excellent illustration of the problem of applying the three basic criteria... relevance, objectivity and feasibility. If the only criterian were relevance, then the cost concept7 would not be defensible. Clearly, investors and others are more intereseted in what the business is actually worth today rather than what the assel8 cost ofiginally. But who knows what:a business is worth today ? The fact is that any estimate of current value is just that—an estimate sind informed people will disagree on what is the right estimate. Furthermore, accounting reports are perpared by the management of a business, and if they contained estimates of what the business is actually worth, these would be management's estimates. It is quite possible that such estimates be biased. The cost concept, by contrast, provides a relatively objective foundation of accounting. It is not purely objectives, for ..... judgements are necessary in applying it. It is'much more objective, however than the altemative of attempting to estimate current values. Essentially, the readér of an accounting report must recognise that it is based on cost concept, and he must arrive at his own estimate of current value, partly by analysing the information in the report and partly by using non- accounting information. Further more a “market value” or “current worth” concept would be difficult to apply, because it-would require that the accountant attempt ta keep track of the ups and downs of the market prices. The cost concept leads to a system that is much more feasible. In summary, “adherance to the cost concept indicates @ willingness on the part of those who developed accounting principles to sacrifice some degree of relevance in exchange for greater objectivity 'y.” (Robert N. Anthony-Management Accounting Principles, Eighth Print., Page and greater feasibil 25). (9) Accounting Period Concept :—The net income being the defference between value assets ‘at the time-of commencement of business and at the time of liquidation of the business, is easier to calculate when the business comes to an end. But'only a few business ventures have a small life, Generally, the business houses last for a very long period of time. Moreover, accountants assume an indefinite life of the business houses (Going concern concept). Bot the management and other parties will not like to wait for a very long period of time, until, the business has terminated, to obtain information on how much income has been earned or loss suffered by such businesses. It would be too late then to take any corrective steps at that time if the final accounts report that the business was incurring losses. Therefore, they need to know at frequent intervals as to how things are going. The accountant, therefore, measures the income or loss not for the entire life of the business but only for a convenient segment of time. The time interval chosen is called the accounting period. Realisation concept and accrual concept are the main or basic 1g year with a view to measure guides for sorting out the transactions occuring during an account the income of that period. It should , however, be noted that more frequent reports, called the interim reports, be prepared and sent to management for their perusal and action, if necessary. “Business are living, continuing organisms. The act of chopping the stream of business events into time periods is therefore somewhat arbitrary since business activities do not stop or change measurably as one accounting period ends and another begins. It is this fact, which makes the problem come in an accounting period the most difficult problem of accounting”(Robert N. of measuring, ‘Anthony, Management Accounting Principles, Eighth Print., Page 44).(10) Matching Concept :—The main motive of doing business now a days is to maximise profits. The proprietors want their accountants to ascertain the profit or loss made by their businesses. ‘The accountants in turn are, therefore, busy most of their time in finding out techniques of measuring profits. For finding out the profits they have to match the revenues of a particular period with the expenses or cost which can be assigned to earning such revenues. ‘Thus the problem is of matching revenues of the period with the cost of securing that revenue to ascertain the profit for a particular period. It should be noted here that the problem is that of matching the expenses. It means the first step is to ascertain what revenues are to be recognised in a given accounting period. The second step, of course, is to determine the expenses that are associated with these revenues. Some difficulties in measuring the revenue for the artificial accounting wr are raised because business is, as said above, @ continuous process. (a) Measurement of Revenue :—Revenues ate measured'in accordance with the accural concept. According to accrual concept the revenues accrue in the accounting year in which they are eared. It is immaterial whether equivalent cash received in that year or not. Cash basis of determining income has, however, considerable appeal to many people. This is so because it is not only simple but also appears to be realistic. Moreover it is verifiable and based upon convention of conservatism. It satisfies those businessmen who think that their profit equal to the “excess of current bank balance over the begining bank balance. According to this basis income is equal to cash received during the year and expense is equal to cash paid out during the same period. Exceptions are, however, made of additional investments by the owners and creditors. These investments are regarded as non-income transactions. ‘The cash basis of determining income for the year is deficient in many respects. Therefore, the accountant generally rejects this basic and adopts accrual basis of determining income which rests on the concept of realisation. According to this basis a careful distinction must be made between revenues and cash receipts as revenues need not result in an equivalent amount of cash. It is possible that revenue may be eamed this year even though payment is not received until next year. The balance sheet of this year in such a case will show the amount outstanding either as debtors or as accrued revenue. It may also be possible that the business receives cash in the current years which creates a liability to render a service in some future period. The examples of such cases may be subcription received in advance by a magazine publisher or insurance premium received in advance by an insurance company. Similarly it may still happen that the firm may have received cash last year which become revenie in this year as the services promised then are rendered now. The balance sheet of last year in such a case will show cash received in advance as a liability under the head deffered revenue or precollected (received in advance) revenues. Revenue is considered to have been earned on the date when goods or services are furnished to the customer in exchange for cash or some other valuable consideration, Barring @ few exceptions the revenues are not considered as being earned when an order is received or when goods are manufactured to meet the order or when a contract is signed. Accountants generally recognise revenues only when goods are dispatched to customers. Measurement of Expenses:—Expenses are the costs incurred in connection with the eaming of revenue. The term ‘expenses’ ‘connotes’ ‘Sacrifices made’, ‘the cost of services or benefits received’19 or ‘resources consumed’ during in accounting period. The term ‘Cost’ is not synonymous Expenses Expens decrease in owner's ‘equity that arises from the operation of a business during a specified accounting period, whereas cost means any monetary sacrifice whether or not the sacrifice affects the owner's equity during a given accounting period; (Robert N. Anthony, Management Accounting Principle, Eighth Print, Page 46). The AAA (American Accounting Association) committee gives the following definition of ex- penses—"Expense is the expired cost directly or indirectly related to given fiscal period of the flow of goods or services into the market and of related operations....Recognition of cost expiration is based either on a complete or partial decline in the usefulness of assets or on the apcarance of a liability without @ corresponding increase in assets.” It describes the recognition of expenses a: “Expense is given recognition in the period in which there is (a) a direct identification or association with the revenue of that period, as in the case of merchandise delivered to customers; (b) an indirect association with the revenue of the period, as in the case of office salaries or rent; (c) a measurable expiration of assets costs even though not associated with the production of revenue for the current period, as in the case of losses from flood or fire.” It should also be noted that the words expenses and expenditure connote different meanings. ‘An expenditure takes place when we purchase an asset or service. It may be made by cash or by incurring a liability or by the exchange of another asset. There may not necessarily be a correspondence between expenses and expendiure in a time segment of one year though over the entire life of a business most expenditures made by a concern become expense or in other words there are no expenses that are not represented by an expenditure. According to the definition of the word expense given by the AAA Committee expense of the current year include the cost of the products sold in this year, though purchased or manufactured in a prior year. Similarly, other expenses like salaries of salesman who sold these goods and the cost of other services like telephone an electircity etc. consumed or used during the year whether Paid or not in the current year shall also be included in the expenses of the current year. Thus we can say that:— (a) There may be’ some expenditure which may become expenses also in the same year because the same year. Such expenses will be recognised as an the benefit of the same is consumed expense of the current yea (b) There may be other expenditures which were paid in previous year/years but become expense in the current year as the benefit thereof is consumed in the current year. Insurance protection is one such item, The premium is paid in advance but the insurance protection is received later in the year. Till then the amount paid by way of premium is an asset. It becomes an expense in the accounting period when such protection is received. (©) Some expenditure incurred now may become expenses next year as the goods bought now will be sold next year. These will be shown as an asset on the balance sheet of the current year and will be treated as an expense when these goods are sold () Some expenditure may not be paid for in the current year although goods and services were purchased and consumed during the current year. These will be treated as expenses of the current year. The amounts outstanding will be shown as a liability in the balance sheet of the currentyear. In contrast to accrual basis, in cash basis an expense is said to have been incurred as and when cash is disbursed. Results of this approach are far from being satisfactory and so the accountant makes a distinction between an incurred cost, a disbursement, and the expiration of a cost. He pinpaints the events of expiration to determine the period to the charged. ACCOUNTING CONVENTIONS. ( Convention of Consistency: Accounting is not composed of a set of rules which prescribe the ‘one way that things can’be done’. There are many different ways in which items may be recorded in the accounts. For example, there are several methods of computing yearly depreciation. Each firm should, within these limits, select the methods which give the most equitable importance that the method selected be applied consistently year after year. Successive periodical financial statements would not be comparable, if the accountant continuously changed the method of accounting for certain expenses ot assets though each method might be fully aceptable. For example, the profit figure can be changed significantly by changing the methods of depreciation, The user of the statement may be misled and think that the carnings had improved. whereas in reality the increase was solely ‘due to change in the methods of depreciation, Change in net income reported in successive statement should be to changes in business conditions or management effectiveness and not simply to changes in accounting methods. However, it does not bind the firm to follow the same method untill the firm closes down. ‘A firm can changes the method used, but such a change is not effected without the deepest consideration. It means that the accontant can change the method if he thinks that the results of ‘operations and the financial position of the business would more fairly be reflected by such a change. When such a change occurs, then either in the profit and loss account itself or in one of the reports agcompanying it, the effect of the change should be stated. It should, however, be noted here that the word consistency used here has a narrow meaning. It does not refer to logical consistency at a given moment of time rather it refers to different categories of transactions should be consistent with cach other. It only means that the transaction of the same category must be treated consistently from one accounting period to another. Thus there will be no inconsistency involved if different categories of assets are valued on different basis, en if stock is valued at cost or market value, whichever is lower and fixed assets are valued at cost. Consistency offers the following advantages to the users of the statements:— (1) Intra-Firm comparisons are made possible:—'Financial statements are most meaningful as ess unit when statements made at several different information about a particular busi source o} times are compared with cach other. Trends can be discemed, for example, only when the balance sheets of three or more years are placed side by side. To provide optimum comparability, transactions must be analysed and recorded in the same way from one period to another. Items inclueded under one caption on one balance sheet or operating statement should be included under the same caption on another statement, The virtue of consistency is so graet that even incorrect procedures consistently applied ‘may produce useful results.” (2) Imter-Firm comparisons are made possible: Another use of financial statements is in <==21 the comparison of the one business with another business. Some consistency of treatment within an industry would threfore enhance the value of accounting reports. Consistency then, is one objective of generally accepted accounting principles. (M1) Convention of Conservatism: It is the policy of “Playing safe”. Financial statements are drawn upon rather @ conservative basis. Window dressing in preparing the financial statements is not permitted. This convention is particularly applicable when matters of opinion or estimate are involved In cases of doubt the accountants choose to understate the owner’s equity rather than overstate them. This could also be said, “Anticipate no profit and provide for all possible losses.” Business men are generally inclimed to be optimistic. The bankers, creditors, investors and others who use financial statements may be misled as assets in many cases be overstated or | understated in the absence of this convention. To take an example, the provision for doubtful debts is a matter of estimates. Most accountants prefer leaning in the direction of over statement rather than under-statement of the allowance for bad and doubtful debts. The consequences of overstatement of assets and net income are more seridus than those of understatement. Balance sheet conservatism was once regarded as the most important of all the accounting principles. But this position of the cenvention of conservatism is questioned now. Accountants are now becoming increasingly aware that adherence to this principle may result in incorrect statement or sometimes, in unconservative statement. Charging expense accounts with expenditure which would more properly be charged to fixed asset accounts or to make excessive provision for depreciation may be conservative from the balance sheet stand point, but it would result.in mis-statement of net income. Moreover, the net income for periods in which no depreciation will be charged to income statements will be overstands. The income statements for these years will be unconservative to that extent. Thus we can say that the conservatism can be regarded as a virtue if, as its consequence, income statements and balance sheets do fairly present the result of operations and the financial position streching this convention to excessive lengths will imply creation of secret reserves which is in direct conflict with the doctrine of full disclosure.” miserable “It was probably this convention that led to accountants being portrayed as being rather by nature; they wef ised to favouring looking on the black’side of things and ignoring the bright t few decades and there side. However, the convention has been considerable changes in the | has been a shift along the scale away from the gloomy view and more towards the desire to paint a brighrer picture when it is warranted.” (Business Accounting By Frank Wood, First edition, Page 43) (UID) Convention of full disclosure:—The accountant proposes to make disclosure of all material facts necessary to complete understanding by third parties or relevant to any decision which might be based on accounting statements.” (Smith and Ashburne, Financial and Administrative Accounting, second edition page, 53). The accountant is supposed to prepare the accounts honestly and to disclose mn. The Companies Act makes ample provision for the disclosure of material all material inform:22 information in company accounts. It has prescribed standard form of balance, sheet and a schedule of contents of revenue statement these froms are so designed that the disclosure of sll relevant facts had become compulsory. Disclosure prompts the accountant to report the realisable value of stock or marketable securities, for example, when that value is substantially different from cost. Disclosure calls for the details of each type of capital stock, such as the par of stated value per share, the preference attached to this issue, the number of shares authorised and the number outstanding and any other fact which would be an important consideration for the present or potential shareholders. If the business entity faces a possible liability or loss that is not definite in amount at the time of preparing statements, but reasonably certain of happening, the accountant is obliged to report the facts as accurately as he can. It should, however, be noted that the convention of disclosure does not imply that any one’s or everyone’s desire with regard to disclosure shall be fulfilled. It only implies full disclosure of accounts which are of interest to the owners, creditors and present or prospective investors of business. Disclousre of minor details is neither possible nor desirable. (IV) Convention of Materiality: Materiality should be interpreted negatively. In its nagetive sense it means the information, the non-disclosure of which would vitiate the true and fair character of financial statement. The decision with regard to materiality of an imformation or amount depends upon the magnitude of the amount or the importance of the information for the statements users. ‘Thus, as to what is or is not material depends on the nature and size of the firm and on the accountants’ Judgement. American Accounting Association defines the term ‘materiality’ as “An item should be regarded as material if there is reason to believe that knowledge of it would influence the decision of informed investor.’ According to this convention less important items are left out whereas mention by way of 4 footnote or otherwise is made of more important items. Thus if a bottle of ink was bought it would be used up over a period of time. and this cost is used up every time some one dips his pen into ink. It is possible to record this as an expense everytime it happens, but obviously the price of a bottle of ink is so little that it is not worthy recording it in this fashion. The bottle of ink is not a material item. and therefore, would be charged as an expense in the period it was bought irrespective of the fact that it could last for more than one accounting period. However, the effect of change in the profit or loss of a business due to change in the method of charging depreciation on fixed assets, provision for gratuity, basis of valuation of stock, etc. are considered to be material and hence the fact of the change and the extent of its effect on the profit or loss of the concern need to be disclosed. Based on this principle, the most modem published accounts usuaily avoid to mention the fraction of the rupee in the statements and reports. But in any case actual accouting entries are always exact “The materiality concept is important ir the process of determining the expenses and revenues for a given accounting period. Many of the expense items that are recorded for a accounting period23 are necessarily estimates, and in some cases they are very close estimates, and in some cases they are not so. There is a point beyond which it is not worth while to attempt to refine these estimates. Telephone expense is a familiar example. Telephone bills although rendered monthly often do not coincide with a calender month. It would be possible to analyse each bill and classify all the calls according to the month in which they were made. This would be following the accrual concept precisely. Few companies bother to do this, however. They simply consider telephone bills as an expense of the month in which the bill is received on the grounds that a system that would ascertain the real expense would not be justified by the accuracy gained. Since in many businesses the amount of the bills is likely to be relatively stable from one month to another, no significant errot may be involved in this practice. Similarly, very few businesses attempt to match the expenses of making telephone calls to the specific revenues that might have been produced by these Calls.” (Robert N. Anthony—Managements Accounting Principles—Eighth Print Page 56)LESSON 2 SUBSIDIARY BOOKS OF ACCOUNTS Book keeping began with the entry of all transactions into one book which recorded the details of transactions. This book was called a book of prime entry of Journal. The transactions were copied from Waste Books or Memorandum Book into the Journal in a chronological order. This work of entering every transaction into the Journal first and then posting to ledger, however, was soon found to be tedious and cumbersome as well as lacking facilities for ready and easy reference. With the result the Journal was sub-divided into various subsidiary journals to record accounting transactions of similar nature date-wise. First of all the cash- transactions were separated and used to be dealt with in another book, Then the transactions relating to credit purchases and credit sales ‘were separafed and started to be recorded separately. Thus the use of joumal in its original form became obsolete, and the book itself was superseded by the books of prime-entry ot subsidiary books. Subsidiary books can slao be termed as ‘Books of original entry’ because transactions are ‘entered there in the first instance in a chronological order or in the order they take place. Subsidiary books can be defined as “Books of original entry wherein we record transactions of one part type or nature in order to obviate unnecessary clerical labour’ These subsidiary books or journals can be classified as under (a) Sales Book (b) Purchases Book (©) Purchases Returns Book or Returns outwards Book (4) Sales Returns Book or Return Inward Book (©) Cash Book (0 Bills Receivable Book (g) Bills Payable Book If the needs of business so require, afew more of these subsidiary books such as Consignment Book, Advertisement Book, Sale or return book, etc., may also be kept. The use of subsidiary books for writing the transactions in the first instance has certain obvious advantages over the system of recording the transactions directly into the ledger of T form. These are 1. Check over Errors ; The changes of errore increase unless the transaction is debited and credited simultaneously in two different accounts in the ledger. 2. Subsidiary books record are supported by Vouchers : Whereas the records in subsidiary books are always supported by vouchers such as Invoice, Credit Note, Debit Note, Cheques. Pay- in-slips, Statement of creditors, etc., the ledger accounts are. not supported by any such vouchers. 3. Legal Point of View : The records in subsidiray books are better evidence in a legal suit25 s compared directly into the records. 4, Chronological order : The transactions are nct recorded in a chronological order if they are recorded directly into the ledger. 5. Common nature Transactions : The transactions of common nature can ve recorded at one place if we record transactions in the subsidiary books. 6. Facilities posting : Keeping of subsidiary books facilities posting the transactions into the ledger because all the transactions commen nature are recorded at one place. 7. Promotes Division of Labour : Subsidiary books-keeping promotes division of labour the work of recording the transactions can be divided amongest various accounts clerks. 8. Chances of errors and frauds are minimiséd: With the introduction of division of labour the work of one accounts clerk will automatically be checked by author accounts clerk, This will minimise the chances of errors and frauds at the recording and posting stage itself. 9. Quick management decisions : The management can take decisions quickly as the accounting work is completed in time (due to division of labour) and also because they can have the benefit of trend-and distributional pattern in planning and decision making as the transactions of common nature are recorded at one place. 10, Saving of clerical labour : By recording transactions of common nature through saparate subsidiary books, a considerable saving of clerical labour in posting is effected. Only the periodical totals of subsidiary books will be posted into the ledger instead of recording each separate transaction. 11. Future reference facilitated : "The future reference to any particular item is considerably facilitated because of grouping together of the transactions of common nature. DETAILS CONTAINED IN SUBSIDIARY BOOKS The day books or subsidiary books are mainly concerned with showing details of invoices and other documents relating to transactions. thus they will show details of : (a) Prices per article and the appropriate quantity. (b) Trade discount representing a reduction in the price of goods. (©) Extra charges made for packing material and/or carriage charged on the goods. ‘After studying the advantages of having separate subsidiary books for transactions of common nature, let us now study about each of them in some details. Journal : Journal-is the most important to all the subsidiary books. It lays down the foundation of the entire book-keeping work of a business concern. Originally, all the business transactions used to be recorded in journal. The word ‘Journal’ is derived from one French Word ‘Jour’ which means ‘day’. The transactions which took place during a day used to be recorded in the Journal in order of date from waste book or a Memorandum book. Thus “A journal is a choronological record of accounting transactions showing the names of accounts that are debited or credited, the amounts of debits and any useful supplementary information about the transaction”, (Robert N. Anthony ; Management Accounting-Principles, English Print Page 70). 326 It be noted here that due to the difticulties, discussed later in this lesson, involved in writing each and every entry in journal, the use of journal now a days is restricted to recording of the following only— (1) Opening Entries, (2) Closing Entries, (3) Writing Off of bad debts(4) Writing offof depreciation (5) The correction of errors (6) Adjustment entries (7) Compound entries (8) Transfer entries and other entries of special nature. The common transactions are generally recorded in other special purpose subsidiary books. In other words, Journal can be used for recording such entries as cannot conveniently be sntly large in number made or recorded in any other subsidiary book or which are not suft to require a special subsidiary book being maintained for them. Form : Wi in the first of the two amount columns. The account to be credited appears below the: debit entry. The amount of this entry appears in the second of the two amount columns. Ledger Folio (L-F.) column is provided to facilitate a ready reference of the page in the ledger on which that particular account appears. This reference is inserted at the time of recording the entry in the ledger. the presence of this reference indicates that the entry has been posted in the ledger. Every entry requires a brief explanation at the foot of each entry. This brief explanation is technically known as “narration”. Purchases book : Purchases book to record credit purchases of those commodities only in whi of nylon sarees on credit by a firm dealing in sweets will not be recorded in purchases book. Purchases book is also called the “Bought Book’, Bought Day Book’, ‘Purchases Day Book’, or ‘Im Book’. The rulings very from the ordinary two columns for details and total respectively to the several 1g to the complexity of the transactions, analysis becomes passing @ Journal entry the debit entry is listed first. The debit amount appears “used to record only credit purchases of goods, i.e., the firm deals. Thus the pufchases columns in use in those business where o imperative if the system of book-keeping is to furnish really satisfactory information. The transactions recorded in the purchases book are daily posted into the ledger to the credit of the different parties from whom the goods have been purchased on credit. At intervals of generally ‘@ month the total value of all the purchases are cast. This total amount is posted to the debit of purchases account in the ledger. This completes the double entry at the end of each interval. The treatment of trade discount necessitates special attention. Trade discount is an allowance from the catelogue price of goods. It sould be deducted from the invoices which will be entered net in the Purchase Book. Cash discount allowed, if any, will be based upon the true figure, after deductinig trade discount, Example 1. From the following particulars prepare the Purchases Book of M/s Adesh Kumar, a dealer in Electrical goods. Sept. 1,1993 : Bought from M/s Om Prakash & Company. 10 Usha Diplomat fans @ Rs. 200/- per fan. 600 Phillips Lamps @ 2.50 per Lamp. Packing charges Rs. 100/- Sept. 10 i Purchased from M/s Kiran & Company.21 3 Kassels Fans—48" @ Rs. 250/-per fan. 30 Bundles of PVC wire @ Rs. 100/- per bundle. Trade discount allowed @ 10%. Sept. 30 A Purchased from M/s Anand and brothers. 10 Immression Heater @ Rs. 30/- each, 4 table lamps (Ashok) @ Rs. 25/- each. Solution Purchase Book of M/s Adesh Kumar Date Particulars LF] Details [Amount Rs. Rs. 1993 Sept. 1 | M/s Om Prakash & Company 10 Usha Diplomat Fans @ Rs. 200/- per fan 2,000.00 600 Phillips Lamps @ Rs. 2.50 per lamp 1,500.00 Packing Charges 100.00 3,600.00 Sept. 10 | M/s Kiran & Company 3 Kessels: Fans—48” @ Rs. 250/- per fan 750.00 30 Bundles of PVC wire @ Rs. 100/- per Bundle 3,000.00 3,750.00 Less Trade Discount 10% 375.0 3,375.00 Sept. 30] M/s Anand & Compnay 10 Immerssion Heater @ Rs. 30/- each 300.00 4 Table Lamps (Ashok) @ Rs. 25/- each 100.00 400.00 7375.00 Sales Book: Sales Book is used to recording only the credit sales of goods in which the firm ordinary deals. Cash sales of goods and sales of assets of the firm are not recorded in the Sales Book. It is known by various names, €.g., ‘Day Book’, ‘Sold Day Book” and ‘Sales Day Book” ‘The rulings may be the ordinarily two columns or it may be the columner form if it is desired to know the goods wise details of sales. The Sales Book is also treated in a similar way in respect of the credit sales, the individual transactions are debited to the different parties to whom goods have been sold and the total at the end of each interval is posted to the credit of the Sales Account in the ledger. Thus the double ry is completed in the ledger.28 Example 2, Enter the following transactions in the books of M/s Naurang Lal Chuttan Lal of Sikandrabad. 1993 Sept. 3 Sold to M/s Satya Prakash & Co. 10 kg. of Tea @ Rs. 22.50 per kg. 15 kg. of Cocoa @ Rs. 15 per kg. Trade Discount @ 10%. Sept. 13 Sold to M/s Gyan Prakash & Bros. 18 kg. Tea @ Rs. 25/- per kg. - 35 kg. Coffee @ Rs. 40/- per kg. Sept. 26 Sold to M/s Shiv Prakash 10 Boxes of Biscuits each of 10 kg. @ Rs. 10/- per kg. 60 Boxes of Sweets each of 15 kg, @ Rs. 5/- per kg. Solution Sales Book of M/s Naurang Lal Chhuttan Lal, Sikandrabad Date Particulars LF. Details | Amount Rs. Rs. 1993 Sept. 3. | M/s Satya Prakash & Co. 10 kg. of Tea @ Rs. 22.50 per kg. 225.00 15 kg. of Cocoa @ Rs. 15/- per kg. 225.00 450.00 Less Trade Discount 10% 45.00 405.00 Sept. 13 | M/s Gyan Prakash & Bros. 18 kg. Tea @ Rs. 25/- per kg. 450.00 35 kg. Coffee @ Rs. 40/- per kg. 1,400.00 } 1,850.00 Sept. 25 | M/s Shiv Prakash 10 Boxes of Biscuits of 10 kg. each @ Rs. 10/- per kg. 1,000.00 60 Boxes of Sweets each of 15 kg. @ Rs. S/- per kg. 4,500.00 | 5,500.00 7,755.00 Note: The trade discount of the selling price should be' deducted on the invoice on the net sale carried out and posted into the ledger only. Purchases Returns Book: Sometimes goods purchased may be retumed by us to the suppliers due to their being of the wrong kind, or not upto the sample, or because they are damaged. These returns are recorded in the “Purchases Returns Book” or “Returns outward Book”. Allowance claimed for short weight, overcharge, breakage, etc., are usually also dealt with in the same book. ‘The person from-whom allowances are claimed or to whom goods are returned is debited and the “Purchases Returns and Allowances Amount” credited at the end or eac month with the monthly29 total of Purchases Returns Book. Some accountants make a distinction between returns and allowances. The total of allowances then will be posted to the: credit of Allowances Account whi closed to trading account through the Purchases Account, The ruling of this book is similar to that of Purchase Book and Sales Book. The treatment of trade discounts will be similar to that in the case of Purchase Book and Sale: Book. The amount to be entered will be the net figure, i.e., after deduction of trade discou Example 3. Enter the following in the books of M/s Banwari Lal Kaka & Sons. Delhi. 1993 Returned to M/s Rekha & Co. 5 New Style of General English @ 3/- per copy. 2 New Style Arithmatic @ Rs. 3.50 per copy Trade Discount @ 10%. Returned to M/s Sunita & Co. 3 New Style co-ordinate Geometry @ Rs. 5/- per copy. 7 New Style Memory @ Rs. 2/- per copy. Returned to M/s Usha & Co. 15 New Style Geometry @ Rs. 7/- per copy 19 New Style Book-keeping @ Rs. S/- per copy, Packing charges Rs. 10/- Purchases Returns Book of M/s Banwari Lal Kaka and Sons Particulars LF. | Details Amount Rs. Rs. Mis Rekha & Co, 5 New Style of General Eng. @ 3/- per copy 2 New Style Arthmatic @ Rs. 3.50/- per copy Less : Discount 10% Mis Sunita & Company. 3 New Style Co-ordinate @ Rs. 5/- per copy 7 New Style Memory @ Rs. 2/- per copy 14.00 Mis Usha & Co. 15 New Style Geometry @ Rs. 7/- per copy 105.00 7 New Style Book-keeping @ S/- per copy 95.00 200.00 Packing Charges 10.00 210.00 258.80 Sales Returns Book: Sales Returns Book is used for the purpose of, recordigig returns of all ‘g00ds sold. The goods may be returned by the customer due to their not being of the comsect description, of being inferior quality or being damaged in tsansit. This book is also called Returng Inwards Book. The customer who returns goods is credited and the monthly total of the Salés Retums Book30 is debited to the Returns Inward Account. The double entry is thus completed. Allowances claimed in respect of short delivery, overcharge or breakage in transit, etc., are usually included in the Sales Returns Book, Some accountants prefer to keep a separate “Allowances Account” in addition to a Sales Returns Account. Allowances Account is closed to Trading Account through the Sales Account. Treatment of trade discount will be similar to that in the case of sales, i.e., the amount to be entered will be net figure after deduction of trade discount. Example 4. Prepare Sales Retums book of M/s Sharda & Co. and enter the following transactions there’ 1993 Sept. M/s Naresh Kumar & Co. returned. 2 kg. Sugar @ Rs. 4/- per kg. 1 kg. Tea @ Rs. 26/- per kg. Sept. M/s Rajesh Kumar & Co. returned. 1 Box of Biscuits @ Rs. 50 per Box. Trade discount 10%. Sept. M/s Mukesh Kumar & Co. retumed. 10 kg. Cocoa @ 6/- per kg. Sept M/s Rama & Co. returned. 2 kg. Coffee @ Rs. 30/- per kg. 5 kg. Sweets @ Rs. 12/- per kg. Solution Sales Returns Book of M/s § Date Particulars . Amount Rs. 1993 Sept. 5 | Mis. Naresh Kumar & Co. 2 kg. Sugar @ Rs. 4/- per kg. 8.00 1 kg. Tea @ 26/- per kg. 26.00 | 34.00 M/s Rajesh Kumar & Co. a 1 Box Biscuits @ Rs. S0/- per box 50.00 Less : Trade discount @ 10% Su Mis Mukesh Kumar & Co. 10 kg. Cocoa @ 6/- per kg, Mls Rama & Co. 2 kg. Coffee @ Rs. 30/- per kg. 5 kg. Sweets @ Rs. 12/- per kg. 120.00 259.0031 ‘These above-mentioned books are kept in a columner form. Separate columns are ruled for (1) the date of each transaction, (2) the name of the other party to the contract with a short description of the goods dealt with (3) the number of the page in the ledger where the account of the patty appears (4) the amount of each transaction. As stated earlier, separate columns for each class or group of commodity can be added to Day Books ‘amd separate ledger accounts for the purchase and sale of each group of commodity can be prepared if the commodities dealt in could be sub- divided. Bills Receivable Book: U: for bills receivables in the journal but where they receive a large number of bills during a year, a Bills Receivable Book is used for dealing with bills drawn or received. It may be incorporated in the double entry system, if desired. In that case it will be nothing but a joumal in modified form. It cannot dispense the journal entries if not incorporated in the double entry system. lly the business firms record ent Necessary particulars regarding the names of the drawer and acceptor, the date of the bill, the amount and due date of the bill etc., are recorded in the Bills Receivable Book as and when a bill is received by the firm. Bills Receivable Book may be used as a Memorandum Book only or a part of the double entry system. If it is used as a part of the double entry system, then the account of the person, not necessarily the acceptor from whom the bill total of the amount of all the bills received during month is posted to the debit of Bills Receivable Account. The entries for Bills Receivable will flow through the usual channel, i.e., the Journal if the Bills Receivable Book is kept as a Memorandum Book ory. ‘The remarks column in the Bills Receivable Bookis employed for recording of necessary observations pertaining to discounting, dishonouring and renewal of the bills, etc. The ruliug of the Bills Receivable Book is given on p. 26. Bills Payable Book: Like Bills Receivable Book, Bills Payable Book also is kept by the Business concern only where the dealings in bills payables are very frequent; otherwise records of bills payable are kept through the Journal. It is kept to record full details of all the bills accepted by the firm. It thus affords @ convenient medium for posting Bills payable transactions. Bills Payable Book is ruled and employed in.the same manner as the Bills Receivable Book is ruled and~employed. ‘The personal account of the person for whom the bill is accepted is credited individually and the Bills Payable Account is credited with the monthly total amount of the Bills Payable Book. (See rulings of Bills Payable Book on the next page.) Cash Book. Cash transaction, in any business are by far the largest in number. The- number of such transactions is so large that a special book, called the ‘Cash Book’ is set apart for recording, cash transactions. If every cash transaction were recorded in the journal first, an enormous amount of clerical labour would be entailed in debiting or crediting cash account every time cash is received or paid. This labour could be avoided by keeping # separate Cash Book to record all: cash transactions, This makes the cash hook the most important of all the other subsidiary Books of Account.' Bills Receivable Book No] Date | From [Drawer] Acceptor | Endorser] Where] Term | Due Date | Ledger | Amount] Date | To | 9 of | When | wt paved Echuitag | Golfo of | whom | 3 Bill] re day of disposal] sent | 5 a grace we Bills Payable Book Payee | Where | Date of payable Bill Date of acceptance}33 It is sometimes asked : Is-cash book a subsidiary Book of Account or a part of ledger? Cash Book is generally treated as a book of Original Entry because all the entries pertaining to cash transactions are recorded direct into it. No other subsidiary book is kept for recording such transactions. But really speaking it is nothing else but a part of the Ledger, bound separately. This is $0 because (a) it is written in the form of a ledger account and (b) no separate cash account, in addition to a Cash Book, is maintained in the ledger. Thus it is nothing more or less than the Cash and Bank account taken out of the ledger and bound separately for the sake of greater convenience. This becomes clear when we remember that the balances of Cash Book are entered in the Trial Balance and Balance Sheet like all other ledger balances. However, it be noted that though Cash Book is 4 part of ledger, the use of a subsidiary book in this connection is often done away with and the double entry is complted by direct transfer from Cash Book to the other Ledgers. Types:—The Cash Book may be of various types; the most common types being the following: 1. Simple of single column Cash Book. Single Bank column Cash Book. Cash Book with double, either Cash and Discount or ‘Bank and Discount columns. Petty Cash Book. Multi-columner Cash Book. 2 3 4, Three—Cash, Bank and Discount column Cash Book. S. 6. 1, Subsidiary Cash Book. In addition to the above types, cash book is sometimes also divided into (a) Receipt Journal and (b) Payments Journal. Simple Cash Book: Simple Cash Book makes record of Cash transactions only. It is just like Cash Account. It will have the same rulings as a Ledger Account, there being columns for date, particulars, folio and the amount on either side of the account. All the cash receipts are recorded on the debit side (left hand side) and all the cash payments are recorded on the Credit side (right hand side). Both the sides debit and credit, have four columns. The first column is used for recording the date, the second column (particulars column) is used for recording the source of receipt of payment, The third column stands for the reference of page number of the Ledger where the account concemed apears. The last column is for the amount ‘of the receipt or payment concerned, Example $ Prepare simple cash book of Mr. Shiv Singh from the following transactions: 1993 Rs. June 1 Started business with cash e 10,000 Paid for purchases : 4,000 Received from Cash sales 3,200 Paid to Shri Raj Kumar 700 Received from Shri K. Kumar a. 900 Paid for stationeryPaid for office fumiture Received from Cash Sales Paid for salaries to staff Paid for office rent Mis Shiv Singh Cash Book Particulars Date Particulars Rs. 1993 Capital 10,000 | June 4] By Purchases Sales 3,200 | 8] By Raj Kumar K. Kumar 900 By Stationery Sales By Office furniture By Office rent By Salaries Balance. c/d July 1| To Balance b/d Cash Book with Cash and Discount Columns: Cash Book with Cash and Discount columns is one in which and additional amount column of ‘Cash Discount’ on each side is provided. Cash Discount is a deduction from the amount paid or received. Such cash discount can either be ‘discount allowed’ or ‘discount received’. It will be ‘discount received’ if the trader pays his account promptly or whitin the period of credit. It will be “discount allowed” if he receives the payment from his own customers promptly. Since discount is received or allowed at the time of receipt or payment of Cash, it is necessary to record this fact at the same place and time where and when cash transaction is recorded. This is why the Cash Book usually contains two additional amount columns, one on each side. Discount columns on the debit side records Cash discount allowed by a businessman whereas the discount column on the credit side records discount received by him. Cash discount should, however, be distinguished from trade discount. Cash discount is allowed or received for prompt settlement of account or for settlement of account within the period of credit. The trade digcount on the other hand, is an allowance made by a wholeseller to a retailer on the catalogue or invoice price. The object of the trade discount may be either to encourage large scale buying by the retailer or to enable the retailer to sell the goods at the price mentioned in the catalogue or Price List issued by the wholeseller. The trade discount is deducted from the invoice itself and the entry in the books is made with the net amount, i.e., after deducting the trade discount. Certian important points in connection with the cash discount be noted: (1) The Discount columns are not to be balanced. This is so because the total of the debit side discount columns represents total discount allowed whereas the total of the credit side discount column repiesents the total discount received.35 (2) Discount columns do not serve the purpose of Discount Account becasue they are only the memorandum columns. A discount account will be opened in the ledger and the total of these columns will be posted therin (3) The rules for recording discounts allowed and received in the personal accounts are: (a) Debit the creditor's account with the amount of discount received while debiting his account the amount of cash paid, and (b) Credit the debtor’s account with the amount of discount allowed together with cash received from him. (4) The total of the discount column appearing in the debit side of the Cash Book will be _ posted on the debit side of the Discount Allowed Account and the total of the discount column appearing on the credit side of the Cash Book will be posted on the credit side of the Discount Recived Account in the ledger. This at first sight appears to be incorrect. How can a debit total be transferred to the debit of an account? Here one must look at the entries for discounts in the personal account. Discount allowed have been entered in the credit of the individual personal accounts. The entry of the total in the expense account of discount allowed must, therefore, be on the debit side to preserve double entry balancing. The converse applies to discounts received. The sides on which the two types of discounts are entered in the discount accounts in the ledger can be easily reconciled if discounts allowed are seen as an expense of attracting money. ‘As an expense they will be found as a debit in the discount allowed account. Similarly discounts received may be seen as income received for prompt payment of account, and as income will, therefore, apfear on the credit-side in the discounts received account. (5) Discount account being a nominal account, the following rule should be applied while recording, discounts. Debit all losses and expenses (Discount allowed) Credit all gains and incomes (Discount received) Example 6. You are requested to preparé double column (Cash and Discount Columns) Cash Book of M/s Suresh Kumar and Company. 1993 Rs. July Opening balance of cash in hand 9,000 Received from Nirmal 780 Allowed him discount Paid to. Nasir He allowed us discount Sold goods for cash Purchased goods for cash for Electricity Paid for Advertisement Received from Umeshwar Allowed him discount Paid Rent Paid Salaries36 Solution M/s Suresh Kumar & Co. ‘Cash Book (Cash & Discount columns) Date | Particulars |L.F.|Discount| Amount | Date | Particulars Rs. Rs. 1993_|. 1993 July 1] To Balance bid 9,000 |July 9] By Nasir 40.00 560 5| To Nirmal 20.00] 780 17| By Purchase sm 13] To Sales 700 21 | By Electricity B 29] To Umeshwar 5300} 947 25 | By Advertiesment 2 31] By Rent 250 By Salaries 450 By Balance seat | 9.547 7300) 11.427 40.00 | 11.427 Aug. 1] To Balance b/d 9,547 Triple column Cash Book: .n this type of Cash Book, there amount columns are provided on either side. Three columns are for (a) Discounts (b) Cash (c) Bank. Triple column cash Book it generally used by big business. houses which have numerous bank transactions. No bank account need be opened because the bank columns themselves represent debit and credit sides of the Bank Account. The businessmen are thus able to save their time in posting. The method of recording in this type of Cash Book is similar to the one adopted in case of the columner Cash Book. But contra entries involving Cash and Bank deserve special attention. When cash is deposited into the bank or cash is withdrawn from the bank, the transactions is to be recorded in the cash column on the one side and the bank column on the other side. If cash is withdrawn from thé bank, the amount will be debited in the cash column and will be credited in the bank column. Similarly, when.we deposit the cash in the bank, an entry will be made dn the credit side of the cash book in the bank column; and the corresponding entry wil be made on the credit side of the cash book in the ledger column, Such entries are known as contra entries. A small letter (c) is written in ledger folio column to indicate that this is a contra entry. No further posting of contra entries is required in the ledger as both the aspects, Debit and Credit, are’recorded in the Cash Book itself. Example 7. Prepare triple column Cash Book M/s Gyan Chand Kasturi Lal. 1993, Rs. Aug. 1 Balance in hand 920.00 Balance at Bank 4,748.00 6 Sold goods to Shri Om Prakash and received cheque 1,200.00 11 Purchased goods from Shri Jitender Kumar 780.00 16 Paid to Mr. Jagdish Prashad by cheque 1,650.00 He allowed us discount 50.00 21. Received from Sh. Raghvendra 183.00 Allowed him discount 17.0037 2 Received from Shri Sunil by cheque 292.00 Allowed him discount 8.00 28 Withdraw from Bank 3,000 30 Paid for Electricity 412 Deposited in the Bank 3,000 31 Shri Om Prakash’s cheque dishonored 1,200 Solution: (Please see next page) Petty Cash Book: Many firms often have numerous small items of expenditure to meet, and to ease the burden of work and entries in the Cash Bopk they keep what is known as a Petty Cash Book, based on a system in which one person is made responsible for these small disbursements against dociiments referred to as Petty Cash Vouchers. If these numerous expenses involving small amounts are recorded in the main Cash Book, it will become unmanagable. By recording these transactions into the Petty Cash Book we save the Cashier from maleing numerous entries for all the petty payments in the main Cash Book which remains handy and does not become cumbersome. Petty Cash Book can be conveniently maintained in a columner form because the items to be posted in it fall easily into some well defined classes. One column is left unnamed or is named as ‘Miscellaneous Expenses’ for the recording of such expenses which are small but not so frequent to justify a separate column for each of them. ‘The Petty cash book has two side—Receipts Side and Payments Side. Payments Side occupies far greater space than the Receipts Side because it has to have many amount columns as stated above. ‘The Petty Cash Book is just like the Cash Book. The amount received by the Petty Cashier are entered on the debit side and payments are entered on the credit side. The difference between the totals of the two sides represents the unspent balance of petty cash, with the Petty Cashier. ‘The expenditure is analysed under appropriate headings, and the analysis is copied into the main Cash Book from where it is posted tothe ledger. Sometimes a Petty Cash Account is opened in the Ledger, and the monthly summary joumnalised and posted to the debit of the accounts concerned. Corresponding Credit is given to the Petty Cash Accuont. ‘The best method of keeping the Petty Cash Book is Imprest system of Petty Cash. The head cashier, under this system, advances a certain sum of money to the Petty Cashier in the beginning. The Petty Cashier goes on making payments out of this advance throughout the month. At the ‘end of the month the head cashier checks the Petty Cash Book puts his initials; and gives a cheque for the exact amount spent, so that imprest amount is always in hand at the beginning of each month. Example 8. Mr. Chander Mohan receives Rs. 100 from his head Cashier to keep petty Cash Book on Imprest system. He makes the following payments. 1993 Rs. Sept. 1 Purchased Postage Stamps 10.00 9 Taxi fare given to Shri Sudharashan Kumar 12.00 16 Tea and lunch to auditors 37.00 24 Telegram to Shri Anil Kumar 3.00 27 Paid for stationery 2.00 28 Paid to Mr. Krishan Kumar for Cyclostyling 9.00 Prepare Petty Cash Book Solution : (Please see next page).Solution (Example7) Mjs Gyan Chand KasturiLal Triple Column Cash Book Date | Particulars LF. [Discount | Cash | Bank | Date — [Particulars | LF. | Discount Rs. Rs. Rs. 193 1993 JAug.1 | To Balance b/d 920 | 4,748 | Aug. 11 [By Purchases 6 |To Sales 1.200 16 |By Shri Jagdish 50.00 Prasad 21 | To Sh. Raghvendra 17.00 183 28 [By Cash c 2 {ToSh. Sunil 800 m 30 [By Electricity 2 |To Bank c 3,000 30 [By Bank J 20 | To cash ic 2,100 31 |ByOm Prakash By Balance cid Zoo | am | a 0 Isept.1 | To Balance b/d as | 267399 Subsidiary Cash Book: The main Cast) Book, just like Journal, also can be sub-divided into for example, Petty Cash Book, Receipts from debtors Cash Book, Payments to Creditors Cash Book and so on. Such divided cash books are called Subsidiary Cash Books. The total of such Subsidiary Cash Book is taken to the main Cash Book. Multi-Columner Cash Book : When the triple columner Cash Book does not satisfy the business requirements, the Cash Book on each side is divided into as many columns as there are frequent heads of receipts and payments, The recurring items of receipts and payments are recorded in the suitable columns. This saves the labour of sorting out similar items at the end of the period. The total of the various cblumns are posted to the concerned accounts in the Ledger. It is very much in use now-a-days. Double Column with Bank and Discount Column : This type of Cash Book is maintained in a business house where all the transactions are through Bank. The recording of transactions is done in the same manner as is done in the case of double column Cash Book. Single Bank Column Cash Book : This type of cash book represents only the Bank Account. The businessman makes use of this type of cash book when he does not handle any cash but settles every transaction through cheque. Such Cash Book can, unlike other Cash Books, have credit balance iso. , It might happen so because of overdraft fécilities granted by bank.Solution (Example 8) To Bank ‘Amount | Cash | Date [Particulars Voucher | Total Carriage | Con- | Station-| Cyclo] Sundries | Remark Received | - Book No & | vey-] ery | styl folio Cartage | ance ing Rs Re Rs. | Rs | Rs | Rs | Rs. 100.00 1993 Sept. 1 | To Bank 1 | By Postage & Stamps 1 10.00] 10.00 9 | By Taxi Fare 2 12.00 1200. 16 | By Tea & Lunch to Auditors} 3 37.00 37.00 24 | ByTelegram 4 3.00] 3.00 27 | By Stationery 5 2.00 2.00 28 | By Cyclostyling 6 9.00 9.00 73.00} 1300} “— | i200] 200 | 900]. 3700 30 | By Balance od ea. get SG ia] eek 100.00 100.00 27.00 Oct. | ToBalance b/d orExample 9 Receipts Side Date Particulars | Sales | BIR | Debtors | Rent | Loan ] Dividend | Interest Miscellaneous Receipts PaymentsSide Date Particulars [Purchases | B/P | Creditors ] Rent | Wages | Interest Salary | Miscellaneous Payments IpLESSON 3 TRIAL BALANCE Ledger : One of the objects of accounting is to ascertain, with the least amount of trouble and cost, what the dealer owes to his creditors, what is owed to by his customers, what are his expenses and incomes and so on. It is also clear that this information can not readily be obtained by recording the transactions into the journal alone. Suppose one wants to find ‘out the amount owed to or owed by Mr. X to him then he will have to search through all the journal entries relating to Mr. X because he must have purchased goods several times from him and must have paid him money at different times. If this process is followed in order to ascertain one’s position with every person or firm one deals with, the object of accounting will-be only pattly realised. Moreover, it will mean unnecessary wastage of time, energy and money. Some simpler means of bringing together the entries referring to each person or firm must, therefore, be found. This is done by collecting ‘and condensing all the entries in another book, calle the Ledger. All the entries relating to each person which so far stand despersed through the journal are collected and condensed at one particular place called the account The Ledget according to Balliboi is the chief book of accounts, and it is in this book that all the business transactions would ultimately find their place under their respective accounts in a duly classified form. According to Pickles the ledger is the most important book of account and is the “destination of the entries made in the subsidiary books. It is essentially a collection of the three types of account Real, Personal and Nominal.” From the above discussion it becomes fully evident that the Ledger is not a book of prime entry because no entry is made direct into this book. It is first passed through the subsidiary books. This, however, is a book of primary importance. It contains the accounts relating to all the transactions that take place in a business concern. Generally, one page of the ledger is devoted to one account, though there is no such hard and fast rule. This is done so to avoid mistakes and clumsiness of the entire writing. If the number of accounts be very large then it may not be possible for all the accounts to be contained in one ledger. In such a case ledger may be divided into several sections of volumes. As pointed out in your previous lesson Cash Book is only a sub-division of ledger containing cash transactions. One way of dividing the ledger is to divide it into Personal and Impersonal or General Ledger. The Personal Ledger can further be sub-divided into Sold Ledger and Bought Ledger. Similarly, vided into Real (containing the Accounts of assets and the Impersonal Ledger can also be sub- _————————————————43 properties of the firm) and Nominal Ledger (containing all other accounts except the Personal Accounts and Real Accounts). Sometimes a private Ledger is maintained to keep capital Account and Drawing Account. No such Ledger, however, is kept in the case of a company. It should be noted that the method of sub-dividing the ledger as mentioned above, however, is not only method. The methods of division, if any division is al! required, will always depend upon the circumstances of each particular case. . Every ledger has an index in the very begining. It is usually an alphabetically index. One page of the index is allotted to one alphabet and the names commencing with that alphabet are written in the page allotted to that alphabet. The page number on which the account appears in the ledger is written against each account in the index. Rulings of Ledger-Many different rulings are met with in business. The most common have columns for date, particulars of transactions, folio and amount. Additional amount columns could be added if the business needs so. require. ‘An alternative form or ruling, which is adopted by banks and some business organisations is that entire page of the Ledger is divided into six columns. These 3 columns are (1) Date (2) Particulars (3) Folio (4) Dr.Amount (5) Cr. Amount (6) Balance. ‘The advantage of this alternative ruling is that the balance of an account can automatically be found out after transaction. There is no need to wait till the end of the period for ascertaining the balance. A specimen with each type of ruling is given below Alternative—1 Dr. Date | Particulars Amount ] Date | Particulars Rs. PL44 Alternative—2 Account Dr. cr. a Particulars Folio | Dr. Amount Cr. Amount Balance Rs. Li Res Rs. from journal or other subsidiary books Posting - The process of making entries in the ledgs | and other subsidiary books form the is known an posting. The entries recorded in the journ basis of entries in the Ledger. The work of posting does not require any specialised skill as it is a routine type of work ach of the subsidiary Let us now take a few examples to show how posting is made from books mentioned in our previous lesson Posting from the journal-The transactions should be posted to the ledger after they have been recorded in the joumal. Posting of journal is easier as compared to posting of other subsidiary books. In this case the amounts which are entered in the debit amount column of the journal are posted to the debit of the account concemed and those entered in the credit amount column of the journal are posted to the credit of the account concerned in the Ledger. The the account will be interchanged in the perticular column of the Ledger-the name of the a in which the amqunt is debited in the journal will be written in the particulars column on the credit side of the other account in the Ledger, and vice versa. It could be illustrated with the ames of ount help of the following exampl ysactions and post them to Ledger. Example 1. Journalise the following 1993 Rs. Dec. 1. Commenced business with C: 6,000 2 Deposited into Bank 2,000 4 Bought goods for Cash 1,100 6 — Sold goods to Abha 600 8 — Received from Abha 594 Allowed her discount 6 10 Paid wages by cheque 200 15 Cash Sales 418 2 — Rent due to Landlord 150 25 Interest on Capital x» ee een ee eee eeeParticulars Cash Account —...Dr. To Capital Account Being the amount intro- duced_as Capital Bank Account — «Dr. To Cash Account Being the amount depo- sited _in the Bank Purchases Account ..Dr To Cash Account Being. the amount of Cash Purchases Abha’s Account —..Dr To Sales Account Being the amount of Credit Sales to Abl Cash Account —..Dr. Discount Account ...Dr. To Abha’s Account Being the amount received and discount allowed to Abha Wages Account — ...Dr. To Bank Account Being the payment of wages by heme Cash Account To Sales Account Being the amount of les. Rent Account To Rent Outstanding Being the amount of rent_due to Landlord Interest Account’ ..Dr. To Capital Account Being the amount of Interest_on Capital TOTAL Dr. Amount Rs. 6,000 Cr. Amount P. Rar aiaP. 00Date | Particulars LF. | Discount) ‘Bank Particulars | LF. | Discount | Bank | Off Rs. | Re. Rs | Rs | Rs. 1983 1983 Dec. 1} To Capital Account By Bank A/c cs 200] * 2] To Cash Account c 2000 By Purchases A/c 14100 * — g]-To Abha's Account 6 By Wages Account| 2 » 45| To Sales Account By By Balance c/d 1900] 3912] & | 2000 = | 20] zn 1994 Jan. 1} To Balance b/d 1800 ov47 Dr. Capitai Account cr. Date _| Particulars Date _| Particulars Folio Amount 1993 if | Dec.31|To Balance c/d 1] By Cash 6,000.00 ” 28 | By Interest 30.00 6,030.00 By Balance b/d Dr. Purchases Account cr. 1993 1994 Dec, 4 |ToCash 1,100.00] Dec. 31| By Trading Account Transfer Dr. Abhas’s Account cr, 1993 1993 Dec. 6| To Sales 600.00] Dec. 8] By Cash By Discount Dr. Sales Account Cr. 1993 1993 Dec.31}To Trading Dec. 6] By Abha 600.00 Ale Transfer 018.00 ” 15| By Cash 418.00 018.00 1,018.00 Dr. Wages Account Gri 1993 1993 Dec.10|To Bank 200.00] Dec. 31] By Trading Ale Transfer48 Dr. Rent Account cr. Dec. 31 | By Profit & Loss Account Transfer 1993 Dec. 20 |By Rent 1 IBy Balance b/d 1993 Dec.25|To Capital 30.00} Dec. 31| By A/c Transfer Posting from Purchase Journal -A separate account for cach supplier of goods is opened in the Ledger. The amount of each purchase would be credited to its respective Personal Account normally daily. The double entry of this book shall be completed by debiting the Purchases Account with the total of the period (normally one month). Mustration-2 Taking the cxample No. 1 given in the previous Lesson post the transaction to Ledger. Solution: Dr. Purchases Account cr. Date [Particulars ~ LF. Amount] Date | Particulars Amount Rs._P. Rs. Pe 1993 Sept.30|To Sundries as per Purchase Book, Dr. Mis Om Parkash & Co. Cr. 1993 Sept. 1 |By Purchases 3,600.00 Dr. Mis. Kiran & Co. cr. 1993 Sept_10 |By Purchases 3,375.00 Dr. M/s. Anand & Brothers Cr. 1993 Sept_30_By Purchases 400.00Posting from Sales Book—A separate account will have to be opened for gach customer in the Ledger. Sales of goods to individuals is normally posted daily. Individual customer's account will be debited with the amount of sales. The Sales Account will be credited with the monthly total of the credit sales. The Double Emry of the Book shall thus be completed. Example 3. Ledger Account of Example 2 of the previous lesson would appear as follows:- M/s Naurang Lal Chittan Lal M/s Satya Prakash & Co. Particulars . Amount | Date — [Particulars RnB 405.00 Mis Gyan Prakash & Brothers 1,850.00 M/s Shiv Prakash To Sales 5,500.00 Sales Account 1993, Sept. 30] By Sundries as per Sales Book for the month of Sept. 7,755.00 Posting from Purchase Returns Book—Each person to whom goods have been returned is debited in the ledger, at the end of the month, the total of the returns for the period is credited to the Returns Outwards Account in the Ledger. Example 4. Ledger posting of Example No.3.of the previous lesson will be as under;50 Dr. M/s Rekha & Compnay Cr. Particulars Amount Rs. P. Particulars To Retums JOutwards A/c Dr. M/s Sunita & Company cr. Dr. M/s Usha & Company cr. 1993, Sept. 24] To Returns Outwards Account 210.00 Dr. Returns Outwards Account cr. 1993 Sept. 30] By Sundries as per Retums Outwards Book for the month of September 258.80 Posting from Sales Returns Book—Each customer who returns the goods is credited, and, at the end of the month, the total of Returns Inwards Book is debited to the Returns Inwards Account. Example 5. Ledger accounts of Example No. 4 of the previous lesson would appear as follows: Mis Sharda & Co. Dr. Mis Naresh & Co. cr. Date | Particulars LF. Amount | Date | Particualrs LF. | Amount Rs._P. Rs. P. 1993 Sept. 15] By Returns Inwards A/c 34.0051 M/s Rajesh Kumar & Co, 1993 Sept. 15] By Returns Inwards A/c Mis Mukesh Kumar & Co, 1993 Sept. 15 [By Returns inwards A/c M/s Rana & Co. | 1995 Sept. 31] By Returns Inwards A/c 120.00 Note : The Purchases Account, the Sales Account, the Retums Inwards Account, and Returns Outwards Account are closed at balancing time to the Trading Account. Posting from Cash Book Alll items in the Cash Book (excepting balances and contra entries) are posted into the ledger. The receipts on the debit side. of the Cash Book are posted to the credit of the ledger ccount concerned, “By Cash”, “By Discount” and “By Bank”. The payments on the credit side of the Cash Book are posted to the debit side of the ledger accounts concerned, ‘To Cash”, “To Discount” and “To Bank”. The total of the discount column on the debit side of the Cash Book is posted to the debit of the Discount Account in the ledger, as the items have been posted to the credit of the individual personal accounts. The total of the discount column on the cre of the Cash Book is posted to the credit of the Discount Account in the ledger, the been posted individually to the debit of the Personal Accounts. Example 6. Posting of Example 7 of previous lesson will be made as follows Dr. Sales Account * Particulars Amount | Date | Particuairs Amount Rs. P. Rs. P. 1993 To Trading Aug. 6 [By Bank 1,200.00 Ale Transfer 1,200.00 Shri Raghvendra 1993 ‘Aug. 27 [By Bank By Discount52 Shri Sunita’s Account Cr. 1993 Aug. 27 |By Bank 292.00 By Discount 8.00 Purchase Account Ce, I | Shri Jagdish Prashad To Bank 1,650.00 To Discount 50.00 Electricity Account 410.20 Shri Om Parkash Aug30|To Bank 1,200.00 Posting from Bills Receivable Book—The account of the person, from whom each bill is received, is credited with the amount of the bill. Money total amount of the bills received is debited to Bills Receivable Account in the ledger. Posting from Bills Payable Book—The account of the person, to whom the bill is given, is debited with the amount of the bill. Monthly total amount of the bills given is,credited to: Bills Payable ‘Account in the Ledger. Posting from the Petty Cash Book—At periodical intervals, the analysis of the petty expenses as indicated by the analytical column of the Petty Cash Book is journalised, cach nominal account concemed being debited with its respective total and the Petty Cash Account being credited with the total payments during the period. Balancing the Account Personal Accounts—To find out whether there is any amount due to particular person or is due from a particular person, it is necessary to balance his personal account. This process is known as ‘Balancing the Account’. To find out the balance of an account, the two sides (debit and credit) are added up. If the debit and credit totals are unequal, the difference is inserted on the shorter side, to make the two sides equal. The difference thus form for inserting on the shorter side is known as balance of the53 ‘The balance will fall on the credit side-with the words “By Balance carried down” if the total Of the debit side is heavier than the total of the credit side, The balance in such a case will be termed as “Debit Balance”. This balance is brought down on the debit side while opening the account next year. Reverse is true in case the.total of the credit side is heavier than that of the debit side. - Real Accounts—Real Accounts represent the assets and properties of the business. These accounts are balanced to find out the amount of the assets and properties held by the business on the date of the Balance Sheet, These are balanced in the manner the personal account are balanced, It should be noted, however, that the Real Accounts always have a debit balance or at the most no balance, ie., they can never have a credit balance. Nominal Accounts—Nominal Accounts deal with the expenses, losses, incomes or profit of the business. These are not balanced. Rather they ate closed by transferirig them either the Trading Account or the Profit and Loss account as the case may be. Note : When balancing/closing the accounts ensure that the two totals are written on a level with one another. If accounts contain only one entry, it is unnecessary to enter the total. A double line ruled under the entry will mean that the entry is its own total. Similarly, if an account contains one entry on each side which are equal to one another, totals are again unnecessary. Trial Balance—As stated in a previous lesson, one method of book-keeping in use is that of double entry method, every debit entry needing a corresponding credit entry, and vice-versa From this it is obvious that the total of all the credit entries made in the books should equal the - total of all the debit entries. As a corollary to this, the debit balances must equal the total credit balances. This, however, should be irrespective of the number of accounts opened in the ledger or the number of postings made in accounts. ‘This being so the accountant will like to try whether he has transferred all the entries from 1 records i.e. , Subsidiary books into the ledger after he has entered all the transactions for a particular period in the books and properly posted them into the ledger. For this purpose he will prepare a Trial Balance. In other words we can say that to see if the two totals are equal, or in accounting terminiology to see if the sides of the books ‘balance’, a Trial Balance may he drawn up periodically. The Trial Balance being an epitome of the Ledger is also used as material for preparing the Final Accounts, i.e. , Trading and Profit and Loss Account and Balance Sheet. According to Carter and Carter, “A Trial Balance is schedule. or list of balances, both debit and credit, extracted from the accounts in the ledger, and including the cash and Bank bal: from the Cash Book.” Pickles defines a Trial Balance as,“ At the end of the financial period (or at some other date) the balances of the accounts are extracted from the ledger are extracted, and a schedule prepared in Journal form to test whether in fact, the total debits equal total credits. Such a schedule of balances is called @ Trial Balance “A Trial Balance may thus be defined as statement of debits and credit extracted from the ledger with a view to test the arithmatical accuracy of the’ book” (J.R, Botliboi) Methods of Preparing a Trial Balance—A Trial Balance can be prepared in two ways, (1) by54 means of total, (2) by, means of balances. The first method is sometimes called as “Total Posting Method’, Under this method the debit and credit sides of each ledger Account is totalled up as at the date of the Trial Balance and grand totals of all debits and credits taken out. If the books are correct, the debit total will equal the credit total. However, this is not the normal method of drawing up a Trial Balance, but it is the easiest to understand in the first instance. Usually a trial balance is a list of balances only, arranged as to. whether they are debit balances or credit balances. One should remember to include the Cash Balance and Bank Balance as indicated by the Cash and Bank columns of the Cash Book while Preparing the Trial Balances. The reason for their inclusion is that these columns represent cash and Bank Accounts kept separately in the form of Cash Book for the sake of convenience. This form of Trial Balance is the easiest to extract when there are more than a few transactions during the period. Some business concems, however, prepare the Trial Balance in a compound form, i.e. the totals and balances side by side. reveals the compensating errors, because the total of the'debit columns of the Trial Balance in such a case must agree with the total of those subsidiary books which are posted to the debit of accounts in the ledger together with the closing Cash Balance but comitting the opening balance of cash. Similarly, the total of the credit column of the Trial Balance in stich @ case must agree with the total of those subsidiary books that are posted to the credit of Ledger Accounts. Example 7. From the following balances of Shri Ram Chander’s ledger prepare a Trial Balance as on 31st Dec., 93 Rs. Rs. Building 5,000 Is payable 4,000 Capital 50,000 Investment 5,200 Purchases 90,000 Printing & Stationery 1,000 Sales Cash in Hand 6,500 Returns(CR) 8,000 Plant & Machinery 11,000 Salary 1,500 Drawings 5,000 Dabtors Bank (CR) Insurance 400 Returns (DR) Bills Receivable 4,800 Stock Commission (CR) 600 Rent Int. Receivable 200 Salary payable Carriage 3,000 Creditors Advertisement5S Trial Balance of Shri Ram Chander as on 31st Dec. 1993 Name of the Account LF. Dr. Rs. Building 5,000 Capital Purchases 90,000 Sales Returns (CR) Salary Debtors Insurance Bills Receivable ‘Commission (CR) Int. receivable Carriage Bills payable Investments Printing & Stationery Cash in Hand Plant & Machinery Drawings Bank Returns Stock Rent Salary payable 1,200 Creditors 11,000 Advertisement 600 Beer anrene Total 1,85,000 1,85,000 Objects- From the above discussion it is quite clear that objects of preparing a Trial Balance are two; namely 1. Checking arithmatical accuracy of the books of acgounts. 2. Ascertaining whether or not both the aspects of each transaction have been recordedLESSON 4 ERRORS IN ACCOUNTING It may at first sight appear that the balancing of 2 trial balance proves that the books are correct. This is however quite wrong. It only means that certain types of errors have not been made. In other words we can say that with the totals agreeing a reasonably reliable check on the total arithmatical accuracy of the book keeping entries is afforded, othe is obvious that some errors exist either in the actual execution of the double entry or in the execution of the balance. It should however; be noted that we can categorically say that the books of accounts are wrong if the Trial Balance does not agree. But we cannot, with the same force, say that there is no mistake in the books of accounts if the Trial Balance agrees. This is so because there are several types of errors that will not affect the balancing of a trial balance. Examples'of errors which would be revealed, provided there are no compensating errors which cancel them out, are errors in additions, using one figure for the debit and another figure for the credit entry, entering only one aspect of a transaction ‘and so on. On the other hand errors due to omission of entries or misposting of accounts compensatinig lc, even if they exist in the books of accounts, will however, not affect errors ahd errors of prin the agreement of this Trial Balance ‘Thus we can say that the Trial Balance is a proof only of the arithmatical accuracy of the postings, and even so it is only prima facie evidence of such accuracy and not a conclusive proof. ‘As mentioned, there are several types of errors. These errors can be divided into two broad categories. (1) Errors disclosed by Trial Balance and (2) Errors not disclosed by Trial Balance. Errors disclosed by Trial Balance : This type of errors can be di categories (a) Book-Keeping errors, (b) Extraction errors. ided broadly into two Book-keeping errors include the following : (1) An item posted on the wrong side of an account. (2) Posting of discounting column of the Cash Book wrongly. (3) Recor (4) Omission to post of the total of subsidiary book(s). 1g of only one aspect of the transaction in the Ledger. Extraction errors include the following : (1) The extraction of items on the wrong side of an account. (2) Errors in additions and errors in casting subsidiary records or ledger Accounts. (3) Extracting @ wrong amount to a Ledger Account.57 (4) Omission to extract one or more balances, either debit or credit, or duplication of an item. Errors not disclosed by Trial Balance. The types of errors that may remain undetected are as follows : (i) Errors of Omission : Ertor of omission is one where a transaction has been omitted cither wholly or partially from being recorded in the books of original entry. This being so none of the two aspects, debit or credit, will be recorded in the Ledger and hence the trial balance will agree. This is really special case of a compensating error. (ii) Errors of Principle: An error of principle is one where @ transaction is recorded in total isregarded of the wéll established fundamental principles of. double entry, e.g., an item of revenue expense is debited to an asset or vice-versa. (iii) Errors of Commission or Misposting of accounts : Such errors will arise when one account instead is wrongly debited or credited., e.g., Rupees 100 received from Nand may be credited wrongly to Kishore from the Cash Book. (iv) Compensating Errors : Where errors cancel out each other. If the sales account was added up to be Rs. 10,100 and the purchase account also added up to be Rs. 10,100 then these two errors will cancel out in the trial belance. (v) Complete reversal of entries. Where the correct accounts are used but each item is shown on the wrong side of the account, e.g., Personal Account debited and Purchases Account credited instead of vice versa (vi) Errors of original Entry : Where the original figure entered is incorrect, yet double entry is still observed using this incorrect figure, e.g., is a credit sale of Rs. 78 was entered in both the sales account and personal account as Rs. 87. Methods of agreeing the Trial Balance: In the examination hall the very sight of a Trial Balance which does not agree may be very unnerving. A rather wild search often ensurs, probably in the hope of ‘stumbling’ across the error. It is not a difficult task to prepare a plan of action in such an emergency and the taking of the following steps in such a case is recommended. (1) Add up both the sides of the Trial Balance again, there may be an error in the addition of the trial balance itself. (2) Find our the difference and divide the same by two. If this new figure is to be found out in the Trial Balance it is almost certainly on the wrong side. The placing of figure on the wrong side throws the Trial Balance out by double the amount. (3) Divide the difference by 9 and if the difference is evenly divisible by 9 the error may be a transposition of figures. (4) See that the cash and Bank balances are there in the Trial Balance. (5) If the difference is of a large amount then compare the current Trial Balance with the previous one to ascertain whether the figures under the different heads of accounts are very near the same as those of the previous year and whether their balances fall on the same side of the Trial Balance. (6) Posting of recurring items be cheched.58 (7) Check the periodical totals of the subsi y books and their postings, into the ledger. (8) The totals of sales and purchase accosnts be checked. (9) If the difference is in round sum, it ig probable that error has been made" in casting or in carry forwards. Therefore check the costings and carry forwards. (10) Check the totals of the schedule of debtors and creditors and see that these are included in the Trial Balances. (11) Go through the subsidiary records to find out unposted items and check the carry forwards. Scrutinise the badly written and indistinct figures. (12) If the difference is not in round figure then it is very likely an error or errors in posting or in extracting balances. (13) See that the opéding balances: have been correctly brought forward in the books of the current yet (14) Check the extraction of the balances of both the personal and impersonal accounts and their inclusion in the Trial Balance. (15) Re-check all the additions, postings and balancing of the ledger accounts if all the above mentioned steps fail to locate the difference. It would be advisable that the work of re-checking is done by a staff different from those who had done the initial checking. It may be pointed out that the above steps indicate a general outline of procedure as has been proved by experience to be most helpful, and need not necessarily be followed in regular order in each case. Those acquainted with the books must know best the weak spots of thei work and it must be left to them to formulate the plan of action. The location of clarical errors sometime Proves to be most difficult task, but at the same time it is not impossible of performance provided the search is conducted intelligently and assidously. (J.R.) Batliboi. Rectification of Errors. To err is human and the accountant is no exception. He can also commit mistakes while recording the transactions, posting them into the ledger, balancing the accounts, casting extracting the balances etc. If a mistake has been committed in passing an entry, it can be corrected in anyone of these three ways. (1) By erasing the wrong entry and writing the correct entry in its place. (2) By striking Off the existing entry and writing the correct entry. (3) By passing a journal entry in such a way that it corrects the mistake that has been committed. The first and second method of rectifying the errors should be discouraged because they reduce the reliability of the books, besides making them dirty and untidy. Moreover, these methods are not approved by law also. So the only method left for rectifying the errors is to pass a journal entry. For the purposes of rectification, the errors may be divided into two parts. (1) One sided errors, (2) Two sided errors. One’ sided Errors—An error may have been committed on only one side (either debit or credit) of an account. Such errors can be (a) error of posting (b) error of balancing, (C) error of casting, (A) error of carrying forward, (c) omitting to show in the Trial Balance and so on, Rectification of such an error does not require a full fledged journal entry unless it is located and rectified in a59 period subsequent to the period in which the error was committed or in other words unless there exists a Suspense Account. Such errors can be rectified by passing an additional entry on the debit or credit side of an account, as the case may be. ” Iwo Sided Errors—An error involving two accounts is called a two sided error. Such errors may be (a) error of omission, (b) error of principle, (c) error of posting to a wrong accounts and @ error of recording. As these errors affect tw. or more accounts, they can be rectified by passing a journal entry with or without suspense account. ‘Suspense Account : It is true that with the advent of self-balancing system and mechanical accounting an error should not remain undetected, but the books in many business are not kept ‘on such modern lines. It is also true that given the sufficient time all errors can be found, but it is obvious that unless the final accounts are produced within a reasonable period after the close of the year they are of little value to proprietor The position then sometimes is that a Trial Balance refuses to yield to our search and the books must be made to balance in order to proceed with the Trading and Profit and Loss Account and Balance Sheet. This is done by making a single entry in the ledger for the shortage in a special account opened for the purpose and headed as “Suspence Account” .When errors are located they are rectified, through the Suspense Account. So long as there is a balance on the Suspense Account there are still some untraced errors. In other words when all the errors are located and rectified, the Suspense Account will be closed automatically. The balance in the Suspense Account, if'any, at the time of preparing the. final accounts wil] be taken to the Balance Sheet. General Principles : The methods of rectification of an accounting error vary some what in detail, and ro rigid rule can be laid down, but following general principles should be kept in mind while solving a question on rectification of errors. (1) Go through the question very carefully before attempting the same. They are small in length but test the knowledge of the students. (2) Do not assume anything from your side. Assume that the error lies only where the examiner says, To take an example : If the examiner says, “Cash received from Narésh Gupta was posted to the debit of his account, “ then do not assume that Cash Acount was credited with the amount of cash received. Rather assume that the mistake lies in Naresh Gupta’s Account only. Cash Account was debited as usual and that there is no mistake in it. (3) Generally you are required to rectify an error regarding over or short totalling of a subsidiary book. To rectify such an error specdily and correctly, you must know as to what is the side, debit or credit, of an account to which the total of that particular subsidiary book is posted. For example, to rectify under-totalling of Sales Book, you must know that the total of Sales Book is transfered to the credit of Sales Account. Hence, the question is about less credit being given to Sales Account. (4) If the total of a subsidiary book is wrong, it will affect only one account, i.e., the account wot which it is transferred. But if any one or more of the items of a subsidiary book is wrongly recorded in it then it will affect two accounts, namely the account to which the item is posted and also the account to which the total of that subsidiary book is transferred. (5) The expenses incurred on a second hand or @ new asset purchased till the time that asset becomes usable by the concem are to be treated as capital expenditure and hence are to be addedto the cost of such an asset. These are not to be treated as revenue expenditure, (6) Remember the following principle. It will help you in rectification of errors : Do it now; anything and everything that should have been done but has not been done so far. Get-it undone (by. reversing whatever has been done); anything and everything that should not have been done but has been done by mistake. (7)-In the beginning stages divide the page of your answer book in three equal _parts—first part to be used to pass the entry that should have been passed or for passing the correct entry; the second part be used for passing the entry as has been passed by the accountant of the firm ‘or for passing the wrong or actual and the third part be used for passing the Rectifying Entry. Compare that correct and wrong entries and apply the above mentioned principle to arrive at the entry that should be passed for rectifying @ given error. (8) Be a little careful but do not get panicy if the Suspense Account shows a balance even after passing of the rectifying entries in the journal and posting thereof in the Suspense Account. Re check your rectifying entries once again to see if there is some mistake in them. But if you find them to be alright then do not bother for the balance in the suspense account as there might still be some other undetected errors left in the account books. Effect on Net Profit : It is but natural that if the retifying entries are passed in the manner as explained above then they will affect the net profit of the period during which the errors are rectified because all the nominal accounts will be transferred to Trading and Profit and Loss Account. The profit will be reduced if nominal account is debited and will increase is a nominal account is credited in the process of rectifying the errors. If, however it is desired not to affect the current year’s profit the following step in addition to the steps mentioned above need be taken. Either pass the rectifying entries as above and transfer all the nominal accounts to the Capital Account instead of the Trading and Profit and Loss Account or pass the rectifying entries themselves through the Capital Account, i.e., debit or credit Capital Account instead of debiting or crediting the nominal accunts every time the rectifying entry involving nominal account is passed. Here are a few examples to show the application of the principles as laid down above. Ilustration 1 A book-keeper finds that the debit side of the Trial Balance is short of Rs. 308 and so for the time’ being, he balances the side by putting the difference to suspense account. Subsequently the following errors were discovered. (a) An entry for goods sold for Rs. 102 to Madhav was posted to his account as Rs. 120. (b) Rs. 100 being the monthly total of discount allowed to customers were credited to discount ‘account in the Ledger. (©) Rs. 275 paid by Madhav were credited to Jadav’s account (d) Rs. 26 appearing in Cash Book as paid for the purchase of stationery for office use have not been posted to ledger. (©) The debit side of purchases was undercast by Rs. 100. ‘You are required to make the necessary journal entries and the suspense account.Solution : 61 Correct Entery Madhav ...Dr. To Sales A/c @ (b) | Discount A/c... Dr. 100 To Customers 100 (©) | Cash account ... Dr. 275 To Madhav 215 Dr. 26 26 Stationery A/c To Cash Account ae Ale To Suppliers Wrong Entry Madhav Dr. To Sales A/c 102 To Discount A/c 100 To Customers A/c 100 Cash Account To Jadav sD, 275 275 To Cash Account 26 Purchase A/c Dr. (X-100) To Suppliers = Rectifying Entery e» Dr. 18 18 Suspense Account To Madhav Being the amount of sale of Rs. 102 wrongly posted of Madhav's Account as Rs. 120; now rectified. s=Dr. 200 200 Discount Account To Suspense A/c Being the monthly total of discount allowed to customers credited to discount account; now ties teat LS = Di aR 275 Jadav To Madhav Being the amount of Cash received from Madhav wrongly cre~ dited to Jadav; now ae —aDincate 26 Stationery A/c To Suspense A/c Being the amount of Stationery purchased not posted to St |_Alc; now comected __ Purchases A/c jonery To Suspense A/c Being the amount of Purchased not debited to Purchase Account; Now corrected.62 Suspense Account Dr. G. Date Particulars Folio| Amount | Date Pasticualrs Folio} Amount Rs. P. Rs. P. By Discount A/c 200 To Difference in Trial Balance 308 By Stationery A/c To Madhav is By Purchases A/c 326 BE Illustration 2 The following errors were located in the books of business concern after its books were closed and Suspense Account was created in order to agree the Trial Balance : (1) Amount of Rs. 300 paid for repairing of furniture was debited to Furniture Account. (2) Sales Day Book was overcast by Rs. 200. (8) A Sale of Rs. 50 to Mr X was wrongly debited to the Account of Mr. Y. (4) General Expenses fo Rs. 18 were posted in the Ledger as Rs. 80. (5) A bill receivable of Rs. 600 from P was passed through bills payable Book. (6) Discount amount to Rs. 120 from a creditor had been duly entered in his account but not posted to discount account. As a result of above the suspense account was closed. Prepare the Suspense Account and rectify the errors.63 Solution: Rectifying Journal Entries Date! Particulars LF. Dr. Amount Cr. Amount Rs. Rs. 1, | Repairs Accaunt Dr. | 300 To ‘Furniture Account 300 Being the amount of repaifs of furniture debited to furniture account; Now corrected. 2. | Sales Account Dr. 200 To Suspense Account 200 Being Sales day book was overcast, now corrected. 3. | X's Account Dr. 50 To Y's Account so Being the amount of sale to X wrongly debited to Y's account, now corrected. 4. | Suspense Account Dr. ‘62 To General Expense A/c a Being the amount wrongly debited in excess to General Expenses Account; now corrected. 5. | Bills Receivable Account Dr. 600 Bills Payable Account Dr. 600 To P. 1,200 Being Bill received from P passed through the Bills Payable Book; now rectified. Suspense Account Dr. 120 To Discount Account 120 Being the amount of discount received not credited to Discount Account; now rectified.64 Dr. Suspense Account cr. Date | Particulars Folio} Amount J Date Particualrs Folio | Amount an: Rs._P. Rs.__P. To Difference 18.00 By Sales A/c 200.00 in Trial Balance To Discount A/c 120.00 To General Expenses A/c 62.00 200.00 200.00 Illustration 3 In taking out a Trial balance a book-keeper finds that it was out by Rs. 380 excess credit. ‘The difference was placed to suspense account, Subsequently following errors were discovered: (2) Rs. 1,500 paid for the purchase of machinery had been debited to Purchases Account. 2) Rs. 80 from discount column on the credit side of the cash book had not been posted to party’s account. (3) The total of purchase book was added Rs, 300 short. (4) A eredit purchase of Rs. 4,200 had been entered: in the Sales Book as Rs.. 2,400 (5) A Cheque for Rs. $00, which was returned, was posted to the allowances account. This cheque was received from Mr. Joshi. (a) What adjustments would be necessary to rectify these errors? (b) How would these errors affect the net profit? (c) Write up Suspense Account.65 Rectitying Journal Entries Particulars 1. Machinery Account Dr. “To Purchases Account Being the amount of machienry purchased wrongly debited to purchases Account; now rectified. 2 Party's Account Dr. To Suspense Account Being the amount of discount received not posted to Party's account! now posted. 3. Purchases Account To Suspense Account Being under-totalling of Purchases Book; now corrected, 4, Purchases Account Sales Account To Party's (Supplier's) A/c Being the credit purchases treated as credit_sales;_now_rectifi 5. Shri Joshi’s Account Dr. To Allowances Account Being the amount of cheque returned to Mr. Joshi wrongly debited to Allowances A/c; now rectifi Allowances Account Capital Account or Profit and Loss Adjustment A/c To Purchases Account To Sales Account Being the transfer of nominal accounts to Profit and Loss Adjustment Account. LF. Dr. Amount Rs. 1,50066 Dr. Suspense Account Date Particulars Folio] Amount | Date Particualrs | Folio Rs. P. To Difference 380.00 By Party's in Trial Balance Account By Purchases Account Su Profit and Loss Adjustment Account Particulars [Folio | Amount | Date Particualrs, Folio Amount Rs. PL Rs. P. To Purcl 300.00 By Purchases A/c To Purchases A/c 4,200.00 By Allowances A/c To Sales Ave 2,400.00 By Capital A/c Transfer Illustration 4 Messers Modern Chemicals were unable to agree that trial balance on 30th June, 1994 and have raised a Suspense Account for the difference. Later the following errors were discovered and rectified and the Suspense Account was balanced. (a) The addition of the “Sundry purchases” column in the tabular purchases journal was short by Rs. 150 and other totals were in order. ige (received from Gupta) for Rs. 2,000 had been returned by the bank credited to the bank and debited to bills receivable account. (c) Goods to the value of Rs. 105 by a customer, Thomas, had been posted to the debit of Thomas and also to Sales returns. ° (a) Sundry items of furniture sold for Rs. 3000 had been entered in the Sales Day Book, the total of which had been posted to Sales Account, (c) An amount of Rs. 600 due from Vaz. @ customer, had been omitted from the schedule of sundry debtors. (f) Discount amounting of Rs. 30 allowed to a customer, had been posted in his account, but not posted to discount account. (g) Insurance premium of Rs. 450 paid on June, 30, 1993 upto the two years ended on 30th June, 1994 had not been brought forward. You are required to:67 (@ Pass journal entries to rectify the above mistakes. (i) Draw up the Suspense account after rectifying the above mistakes and explian how the above errors affect the book profits for the year ended June 30, 1994, Solution Rectifying Journal Entries Date] + (@) Capital Account Dr. To Suspense Account Being the amount by which Purchases Account was debited short; now correctei ——_——— eee ee (>) Gupta's Account To Bills Receivable A/c Being the amount of Bills Receivable returned by the bank dishonoured wrongly debited to Bills Receivable Account; now corrected. (©) Suspense Account Dr. To Thomas Being the amount of returns by Thomas wrongly debited to him; now rectified. br errata teas (4) Capital Account To Furniture Account Being the amount of Sale of furniture treated as ordinary sale; now rectified. ose RI ne a (©) Sundry Debtors Account Dr. To Suspense Account Being the amount due from Shri Vaz, a customer, omitted from schedule of debtors; now rectified. Particulars LF. el Dr. Amount Rs. 150 2,000 210 3,000 Cr. Amount Rs. 150 2,000 210 3,000(0) Capital Account Dr. ” To Suspense Account » Being the amount of Discount allowed to a customer not debited to Discount account_now rectified. Capital Account 25 To Insurance Prepaid Ale 2s Being the amount of insurance prepaid last year not brough in the books this year; now rectified Dr. Suspense Account cr. Particulars Folio | Amount Particualrs. Folio Amount Rs. P. Rs. P. To. Difference By Capital A/c 150.00 in Trial By Sundry Debtors 600.00 Balance 570.00 | By Capital Account 30.00 To Thomas 210.00 ees, 780.00 780.00 Dr. Capital Account cr. Date Particulars Folio Date Particualrs [Folio] Amount ies Rs. P. To Suspense A/c By Balance o/d 3,405.00 To Furniture A/c To Suspense A/c To Insurance Prepaid A/c at To BalancedLESSON 5 ACCOUNTING FOR DEPRECIATION Depreciation Fixed assets are acquired by a business house for use for a long period of time. The cost of a fixed asset has to be written off over its useful life. The amount that is written off every year in this manner is called depreciation. We may define depreciation as a fall in the value Of an asset, duc to wear and tear, due to actual use and effiux of time, Mere passage of time ‘also causes a fall in the value of an asset even if it is not used. It is so because new improved machines are constantly introduced in the market making old machines outdated. Value of an asset may also fall due to obsolescence (j.e., due to 4 new invention or a permanent change in the demend), accident or a fall in the market price of the asset; such a fall is not reffered to as depreciation although it is also a loss and is written off. Save a very few. assets like land, goodwill and old famous paintings, all assets depreciate, While preparing a balance sheet, current assets have to be shown at cost price or market price whichever is less; and the question of depreciation does not arise, But all fixed assets are shown in the balance sheet at cost minus depreciation thereon. Provision for depreciation is essential to ascertain the true profit earned or true loss incurred by a business house during a year and to show a correct financial position in the balance shect at the end of the year. Depreciation is very much an expense of the business. The difference between other expenses and depreciation is that whereas payment has to be made for other expenses every year, no cash payment is made for depreciation every year; the impact of this expenses is felt only when after a number of years, an assets has to be replaced. Replacement of an asset makes one realise that the amount originally spent on the asset bas been used Basic Factors While calculating depreciation, there are certain basic factors which have to be taken into consideration. Thses factors are as follows :~ (i) Cost of the asset : Depreciation has to be calculated on the basis of the cost of the asset to be depreciated. The cost includes the price paid for the asset, the amount spent on its acquisition, freight, octroi, carriage and installation of the asset. (ii) Useful life of the asset :- Another factor that affects the amount of depreciation is the useful life of the asset. A machinery may be capable of running for 15 years but if the firm is expected to replace it after 10 years due to obsolescence the estimated useful life of the machine will be considered to be 10 years for the purpose of calculating depreciation. (iii) Serap Value : The scrap value of the asset at the end of the useful life of the asset as described in (ii) above also affects the amount of depreciation. The scrap value at the end70 of the usetul life has to be estimated when the asset is purchased. The estimated scrap value is deducted from the cost of the asset as described in (j) above to provide the basis for calculating depreciation. If in a question, the scrap value of the asset is not given, it should be assumed that it is nil. So much depreciation has to be provided as will, reduce the value of the asset to its scrap value at the end of its estimated life Methods of providing Depreciation There are different methods of providing depreciation which may be described as follows:- (i) Straight Line Method : It is called Fixed Percentage on Original Cost Method or Fixed Instalment Method. Under this method, a suitable percentage of original cost is written off the asset annually. Thus, if an asset costs Rs. 11,000/- in all and 10% per annum depreciation is considered proper, depreciation amounting to Rs. 1,100 will be provided every year if scrap value of the asset at the end of its estimate life of 10 years is considered to be nil. To ascertain annual depreciation, the following formula may be remembered : Cost—Estimated scrap value Estimated life of the asset However, if the assct exists in the business only for a part of the year, depreciation should be provided only for that part of the year for which the asset remained in the business. For example, if an asset is acquired on Ist September, 1987 and the annual depreciation of the asset works out to be Rs. 8,000/-, then if final accounts are prepared on 31st December, 1987 depreciation for three months only amounting to Rs. 2,000/- will be provided. Similarly in the part of the year in which the asset is disposed of, if the asset is discarded after having been used for the accounting year, depreciation will be provided for that part of year for which asset has been used. The profit or loss on the disposal of the asset will be calculated after taking into account depreciation for the part of the year also. ‘The Straight Line Method spreads depreciation evenly over the estimated life of the asset. But there is one defect. As the years pass, the amount spent by way of repairs may go on increasing whereas the amount of depreciation remains the same, It means that the Profit and Loss Account of the later years will get a larger debit in respect of the same asset. To remove this defect, an estimate should be made of the amount which will be spent by way of repaits during the estimated life of the asset; then every year provision for repairs should be made at the average, actual repairs being debited against this provision. Entries : In order to provide depreciation, the following journal entry may be passed :- Depreciation Account Dr. To Asset jon Account is transferred to Profit and Loss Account by means of the following Profit and Loss Account Dr. To Depreciation Account ‘The balance in the account of the Asset is reduced and the Asset appears in Balance sheet eeea at the reduced figure. Alternatively, the amount of the Asset may be made to show the cost of the asset year after year and the depreciation provided may be accomulated in a separate account entitted ‘Provision for Depreciation Account". Every year, the following entry will be passed with the amount of depreciation: — Depreciation Account Dr. To Provision for Depreciation Account Depreciation Account is transferred to Profit and Loss Account as in the first case, so that the Profit and Loss Account is not affected by thig change. Provision for Depreciation Account will show a credit balance and may be shown on liabilities side of the balance sheet but for better presentation it should be shown as a deduction from the cost of the asset concerned on the asset side of the balance sheet. However, when the asset is discarded, the Provision for Depreciation ‘Account will be closed by the transfer to the Asset account concerned. Now, study the following illustrations:— Illustration 1: On Ist April, 1993 a company purchased a Plant for Rs. 80,000/- spending Rs. 600 on carriage and Rs. 1,700/- on installation of the Plant. The scrap value of the assct at the end of the estimated life of the plant was estimated at Rs. 6,000/- The estimated life of the asset is 10 years. Plant is to be depreciated on straight line method. Show Plant Account and Depreciation Account for the years ending 31st December, 1993 and 31st December, 1994. Solution: Calculation of annual depreciation on straight Total cost of the plant: Rs..82,300 Cost-Serap—Value_ Rs. 82,300-6,000 _ 76,300 Estimated Life 10 10 In 1993, the plant has been used only for 9 months. Hence, depreciation for 1993 will be Annual depreciation: = Rs.7,630 9 Rs. 7,630 x = or Rs. 5,722.50 p Dr. Plant Account cr. 1993 Her tee Rs. P. April 1 | To Bank 80,000.00 By Depreciation 5,722.50 April 1 | ‘To Bank (Expenses) | _2,300.00 By Balance c/d 76,577.50 '82,300.00 32. 1994 Jan 1 To Balance b/d 76,577.50 i 7,630.00 By Balance c/d 68,947.50 76,577.50 1995 To Balance b/d,2 Dr. Depreciation Account Ce 1993 Rs. P. | 1993 Rs. P. Dec. 31 To Plant 5,722.50 | Dec. 31 |By P & L A/c transfer 5,722.50 1994 1994 Dec, 31 | To Plant 7,630.00 } Dec. 31 |By P & L Ale transfer |7,630.00 Ilustration 2: (On the Ist January, 1986 Blue Star Co, installed a plant at a total cost of Rs. 61,000 and decided to depreciate it on straight line method @ 10% per annum, On 31st March, 1993 the company decided to replace the old plant by a new one purchased for Rs. 89,000. A part of the plant valued at Rs. 1,500 was found fit to be used in the new plant. The remaining part of the old plant was sold as scrap for Rs. 400. The company decided to depreciate the new plant @ 12% per annum on straight line method. Show important ledger acccounts for the year ended 31st December, 1993. Solution: 10x8 Balance as on Ist January, 1993 : Rs. 61,000—(61,000x 55 (i.e., Cost-depreciation from 1986 to 93); Rs. 61,000—48,800 : Rs. 12,200 Plant (Old) Account Rs. 1993 To balance b/f 12,200 ] March 31 | By Depreciation (for 3. months) March 31 | By Plant (New) Account March 31 | By Cash—Sale of scrap March 31 | By Profit and Loss A/c transfer of loss Dr. Plant (New) Account March 31] To Bank 89,000 c. By Depreciation (for 9 months) March 31] To Plant (old) Ae | 1.500 | Dec By Balance ¢/d 90,500 1994 Jan.1 To balance b/d 82,3553 Dr. Depreciation Account Cr. 1993 Rs. March 31| To Plant (Old) A/e By Profit & Loss A/c transfer 9,670 Dec. 31. | To Plant (New) A/e Alternate Solution: , the amount of the new plant may be debited 10 Instead of opening a new Plant Account In this case, there will be ‘only one Plant the Old Plant Account, continuing the same account, ‘Account which will appear as follows: Dr. Plant Account cr. Rs. ‘To balance b/fd By Depreciation A/e 1,525 To Bank By Cash-sale of scrap 400 By Profit and Loss A/c transfer of Loss 78,775 By Depreciation 8,145 By Balance c/d 82.355 1,01,200 1994 Jan ‘To Balance b/d ion Account will appear as follows:— Dr. Depreciation Account cr. 1993 Rs. Mar.31 | To Plant To Profit & Loss Account transfer 9,670 Mar. 31 | To Plant (i) Diminishing Balance Method : It is also called Reducing Instalment Method because under this method, the amount of depreciation year after year gocs 08 decreasing. Under this method, to calculate the amount of depreciation for a particular yeas & fixed percentage is applied, he value at which the asset stands in the books of account at the beginning of the year (after adjusting it for the value of disposal, if any, of a pat of asset). In the casc of a mew asset aeadditions, the rate is applied to the cost of the asset newly acquired and the amount of depreciaton, srost be calculated only for that part of the year for which the newly acquired asset has been tolused. Under this method also, cost includes money spent on carriage, installation etc. The entries for depreciation are the same as are required under Straight Line Method—only the amount differ. In one respect, Diminishing Balance Method is better than Straight Line Method. Under Diminishing Balance Method, the total of depreciation and repairs expenses tends to be the same for different years because the fall in the amount of depreciation is offset by an increase in repairs expenses in later years of the life of the asset. Consequently no Provision for Repairs Accounts has to be maintained when thi8 method of providing depreciatin is used. This method also recognises the fact that as soon as is put to use, its value for resale purposes falls heavily. Under this method the depreciation is the heaviest in the first year. It goes on decreasing as the years pass and is the minimum in the last year. Illustration 3. On Ist January, 1992 a firm installed 2 Machinery at a total cost of Rs. 10,000. It was decided to depreciate the Machinery @ 10% per annum on diminishing balance’ method. Show Machinery Account for the first years of its life, assuming that the firm, closes its accounts every year on 31st December. Solution = Machinery Account By Depreciation By Balance c/d Balance b/d By Depreciatorn By Balance c/d Balance b/d By Depreciation By Balance c/d Illustration 4. J. Foster Ltd., a company with a turnover of Rs. 6,00,000 per year, acquired a machine on Ist January 1992 for Rs. 1,60.000. It was company’s policy to depreciate machinery on straight line basis at 20% per year. During 1994 a modification was made to the machine to improve its technical reliability at a cost of Rs. 16,000 which it was cosidered would extend the useful life of the machine by 2 years. At the same time an important component of the machine was replaced at a cost of Rs. 10,000, because of excessive wear and tear. Routine maintenance during the year cost Rs. 5,000.75 Required (i) Show the Asset Account, the Provision for Depriciation Account. and the charge to Profit and Loss Account in respect of the machine for the year ended 31 December, 1994. (ii) Once an assets such as a, machine is installed what features should be considered when deciding whether to capitalise or treat an expense subsequent expenditure relating to that asset. Solution: Dr. Machine Account Cr. 1994 Rs. Jan. 1 To Balance b/d Dec. 31 By Balance c/d 1,86,000 Jan. 1 | To Bank (Cost of Modification) Jan. 1. | To Bank (Replacement) 86,000 1995 To Balance b/d Provision for Depreciation A/e 1994 Rs. Dec. 31 | To Balance c/d By Balance b/d 64,000 Dec. 31 | By Profit & Loss Account 24.400 88,400 By Balance b/d Profit and Loss Account (Skeleton) for the year ending on 31 December 1995 Dr. Cr. To Depreciation of Machine] 24,400 To Maintenance 5,000 Working Notes: (a) The component replaced has been capitalised because it would extend the life of the machine and so is the cost of modification. (b) The depreciation charge for 1995 has been calculated as under: Written down value at Ist January 1994 (1,60,000-64,000) Rs. = 94,000 Add. Modification 16,000 Cost of component replaced 10,000 1,22,00016 Expected life of machine is 5 years. Depreciation charge therefore is 20% of Rs. 1,22,000 4,400 (i) Once an asset such as machine has been installed the following features are taken into account to decide whether subsequent expenditure is to be capitalised or treated as an expense: (i) Is the life of an asset expended? (ii) Is the efficiency of an asset subsequently improved? (iii) Is the additional expenditure subsequential? (iv) Is it possible that the additional expenditure will recover? Change of Method Sometimes a firm wishes to shift over from straight line method to diminishing balance method or vice versa with retrospective effect. In such a case, the balance according to the desired method should be found out. The balance should be compared with the actual balance.-If the actual balance is less than the desired balance, the following entry should be passed with the difference: Asset (by name) To Profit and Loss Adj If the actual balance is more than the desired balance, the above mentioned entry will be reversed to bring down the balance of the asset to the desired amount. Illustration 5. On Ist July,.1991 a company installed a plant at a cost of Rs. 1,00,000. The company depreciated the asset @ 10% per annum on straight line method. But on Ist january, 1994 it decided to provide depreciation on the plant @ 13% per annur on diminishing balance method with retropsective effect from the date of purchase. Show Plant Account for the year ended 31st December, 1994. Solution: Depreciation for 2% years on straight line method. 1ES = Rs. 1,00,000 x75 3 = Rs. 25,000. Book value on Ist January, 1994. = Rs. 1,00,000-25,000 = Rs. 75,000 Calculation of desired balance on the basis of diminishing balance method of depreciation. 7 me pe Cost 1,00,000.00 Depreciation @ 13% for 6 months. 6,500.00 Balance as on 1.1.1992 93,500.00 Depreciation for 1992'13% on Rs. 93,500 12,155.03 Balance as on 1.1.1993 81,345.00 Depreciation for 1993 @ 13% on Rs. 81,345 10,574.45 70.770 $51 Adjustment needed = Rs. 75,000 — Rs. 70,770:55P. = Rs. 4,229.45 P. Dr. Plant Account ce ae By Profit & Loss Adjustment A/c To balance b/d 11.1994 4229.45 (iii) Annuity Method : This method is based on the contention that amount of depreciation that should be provided on an asset is not only the cost of the asset but also the interest at a certain rate on the diminishing balance of the asset in various ypars. Thus, the method takes into account the interest lost on the amount that emains invested in the asset. Under this method, interst is calculated at a fixed rate in the book value of the asset and the amount is debited to the asset concerned and credited to Interest Account, The amount to be written off as depreciation remains the same year after year and it is calculated with the helf of the Annuity Tables. For an extract from the Annuity Tables, please consult your text book. The Annuity Table indicates the sum which can be paid annually for a certain number of years if there is Re. 1 in the beginning an if it earns interest at a given rate. The Table also indicates the amount to be written off annually to reduce an asset valued at Re. 1 in the beginning to zero in a specified period of time, assuming that the diminishing balances earn interest at a given rate every year. ‘Suppose an asset costing Rs. 10,000 is to be written off in 10 years and inerest to be provided @ 5% p.a. on diminishing balance of the asset, Rs. 1,295.05 p. will have to be written off every year. A reference to the Annuity reveals that Re. 0.129505 should be written off to fulfill the above mentioned conditions if the cost of the asset Re. 1. By multiplying Re. 0.129505 by 10,000 we get the amount of depreciation that will have to be provided if the cost of the asset is Rs. 10,000. ‘This method is very suitable to write off lease accounts. Illustration 6. On Ist January, 1990 a Icase was purchased for five years for Rs. 20,000. It was proposed to depreciate the lease by the annuity method charging interest @ 5% per annum. Annuity Table shows that to depreciate Re..1 by annuity method over 5 years, charging 5% interest, one must write off’a sum of Re. 0.230975. Show Lease Account and the relevant entries in Profit and Loss Account for the entire period of lease. Soluti Amount of depreciation : Rs. 20,000 x 0.230975 = Rs. 4,619.50 P. Lease Account cr. Rs. Pe ee To Bank 20,000.00 By Depreciation 4,619.50 To Interest (on Rs. 20,000 @ 5%) } _1,000.00 By Balance c/d 16,380.50 1,000.00 21,000.00cr. Dr. 1991 Rs. P. | 1991 Rs. P. Jan, 1 | To Balance b/d 16,380.50 | Dec. 31 | By Depreciation 4,619.50 To Interest (on Rs. 16,380.50) @ 5% 819.02 |” ” — | By Balance c/d 2,580.02 17,199.52 17,199.52 1992 1992 Jan. 1 Balance b/d 12,580.02 | Dec. 31 | By Depreciation 4,619.50 Dec. 31 Interest. (on . 12,580.02 629.00 |” "| By Balance c/d 8,589.52 50% 13,209.02 1993 1993, 1 Balance b/d Dec. 31 | By Depreciation 4,619.50 Dec. 31 Interest » » | By Balance c/d 4,399.50 9,019.00 1994 1994 Balance b/d Dec. 31 | By Depreciation 4,619.50 Interest 4,619.50 Dr. Profit and Loss Account Cr. 1990 | 1990 me Fe Dec. 31] To Depreciation 4,619.50 | Dec. 31 | By Interest 000.00 1991 1994, Dec. 31] To Depreciation Dec. 31. | By Interest 819.02 1992 1992 Dec. $1] To Depreciation Dec. 31. | By Interest 619.00 1993 1993 Dec. 31] To Depreci Dec. 31 | By Interest 429.48 1994 To Depreciation Dec. 31 By Interest (iv) Depreciation Fund Method : This method enables the firm to find ready cash to replace an asset on the expiry of the useful life of the asset. An amount equal to the amount of depreciation is invested in readily saleable securities every year. Interest received dmiinvestments made in the previous years is also invested. At the time of replacement of the assets, the entire investment made on this account sold out; thus cash received facilitates the replacement of the asset without giving a set back to working capital of the concern, Under this method, in order to ascertain the amount of depreciation, reference has to be made to Sinking Fund Table. This Table shows how much is to be invested every year together0 with interest earned so that at the end of the specified period of time, one may get Re. 1. For example, you will find in the Table that in order to get Re. 1, at the end of 10 years one must invest Re. 0.079505 at the end of every year (in addtion to interest earned) if interst on investment eanred @ 5% per annum. If cost of an asset is Re. 1, Re. 0.079505 also be annual depres a iff the asset's estimated life is 10 years and investment are to fetch interest @ 5% per annum. Journal Entries: Under this method, the scheme of entries is as follows: At the end of the first year: Depreciation Account Dr. With the amount of depreciation To Depreciation Fund Account calculated with the help of S.F. Table (For providing depreciation) Depreciation Fund Intvestment Account Dr. To Bank (For Investment made) Profit and Loss Account Dr. (For tansfer of Depreciation Account to Profit and Loss Account) Investments made may not exactly be equal to the amount of depreciaton. It may be made to the nearest rupee or the nearest multiple of the market value of securities in which the investment is made, For example, the amount of depreciation may be Rs. 900.50 P. but if the money is to be invested in securities which are available at Rs. 102 per unit, Rs. 918 will be invested to buy 9 units. It should also be noted that the interest is received on the basis of the value jes purchased. and not cost price of the secu! At the end of second year: Bank Dr. To Interest on Depreciation Fund Account (For Interest received on Depreciation Fund Investment) Interest on Depreciation Fund Investment Account Dr. To Depreciation Fund Account (For transfer of Interest on Depreciation Fund Investment Account to Depreciation Fund Account) Depreciation Account Dr. To Depreciation Fund Account (For the Annual Instalment of depreciation)80 Depreciation Fund Investment Account Dr. To Bank (For the Investment of the amount of depreciation and the interest on depreciation fund investment made already) Profit and Loss Account Dr. To Depreciation Account (For the transfer of Depreciation Account to’ Profit and “Loss Account) In every subsequent year (except the year in which the asset is disposed off), the above mentioned entries will be repeated. Of course, the amount of interest received will go on increasing. Consequently, the entries for receipt of intere.s, the transfer of interest to Depreciation Fund and the making fresh investment will be with large amounts with the passage of time. Asset Account will continue to show the cost price of the asset. Depreciation will go on accumulating in Depreciation Fund Account which will show increasing credit balances. Investments will continue to swell with the result that Depreciation Fund Investment will show increasing debit balances. In the balance sheet the balance of Depreciation Fund should be shown by way of a deduction from the Asset Account on the assets-side of the balance sheet. Depreciation Fund Investment Account will also appear on the assets-side of the balance shect. Entries in the last year: Bank To Interest on depreciation Fund Investment Account (For the amount of interest received) Interest on Depreciation Fund Investment Account Dr. To Depreciation Fund Account (Transfer of Interest on D.F.. Account to Depreciation Fund) Depreciation Account Dr. « To Depreciation Fund Account (For the annual instalment of Depreciation) Bank Dr. To Depreciation Fund Investment Account (For the sale proceeds of the total investment made in all the earlier year)RI Either Depreciation Fund Investment Account To Depreciation Account (For transfer of profit on the sale of investment) or Depreciation Account To Depreciation Fund Investment Account (For transfer of loss on the sale of investment) Depreciation Fund Account To Asset Account (For transfer of Asset Account to Depreciation ‘Fund Account) Either Depreciation Fund Account To Profit and Loss Account Profit and Loss Account To Depreciation Fund Account (For transfer of Depreciation Fund Account fo Profit and Loss Account) Profit and Loss Account To Depreciation Account (For transfer of Depreciation Account to Profit and Loss Account) ‘A Machinery is purchased by Moonlight Ltd., on the Ist July, 1990 for Rs. 50,000. The machinery is to be replaced at the end of 5 years for which purposed a sinking fund is established. It is expected that securities will earn 5 percent interest. Sinking Fund tables show that Rs, .180975 invested each year will produce Re. 1 at the end of 5 years at 5 percent. The Company closes its accounts on 30th June every year. ‘At the end of the period the securities are realised for Rs. 39,000. New machinery is installed on Ist July, 1995 at a cost of Rs. 70,000. Show the necessary ledger accounts for all the years.82 Solutions: Dr. Depreciation Fund Account cr 1991 Rs. | 1991 \ June 30 | To Balance c/d 9,048.75 ] June 30 | By Depreciation Account| 9,048.75 1992 1991 June 30 | To Balance e/d 18,549.94 | July 1 | By Balance b/d 9,048.75 1992 June 30 | By Interest on D.F. Investment Account 452.44 Pek 9,048.75 18,549.94 1993 1992 June 30 | To Balance c/d 28,526.19 | July 1 | By Balance b/d 18,549.94 1993 June 30 | By Interest on D.F. Investment Account 927.50 » » | By Depreciation Account 9,048.77 28,526.19 [28.526.19 1994 1993 June 30 ince cfd 39,001.25 | July 1 | By Balance b/d 28,526.19 1994 June 30 | By Interest on D.F. Investment Account 1,426.31 By Depreciation Account 9,048.75 1995 1994 June 30 | To Machinery July 1 | By Balance b/d 139,001.25, Account (Transfer) | 50,000.00 1995 June 30 | By Invest on D.F. Investment Account 1,950.00 - To D.F. Investment 1.25 |” ” — | By Depreciation Account 9,048.75 "| By P & L Account transfer 1.25 [50,001.2583 July 1 Dr. Depreciation Fund Investment Account cr. 1991 Rs. 1991 [ Rs. June 30 | To Bank 9,048.75 | June 30 | By Balance c/d 9,048.7: 1991 1992 . fuly 1 To Balance b/d 9,048.75 | June 30 | By Balance c/d 18,549.94 1992 june 30 To Bank 1993 1993, July 1 | To Balance b/d 18,549.94 | June 30 | By Balance c/d 28,536.19 1993 June 30 To Bank 28,526.19 1993 1994 July 1 To Balance b/d 28,526.19 | June 30 By Balance c/d 39,001.25 1994 June 30 To Bank (0,475.06 39,001.; 39,001.25 1994 1995 July 1 39,001.25 | June 30 | By Bank 39,000.00 fe Ee By Depreciation Fund Account 39,001.25 LA . Machinery Account 1990 1991 Rs. . July 1 | To Bank June 30 |By Balance c/d 50,000.00 1991 1992 July 1 To Balance b/d 50,000.00 } June 30 |By Balance c/d 50,000.00 1992 1993 July 1 To Balance b/d June 30 |By Balance c/d 1993 1994 July 1 To Balance b/d June 30 By Balance c/d 1994 1995 To Balance b/d June 30 By Balance c/d $0,000.00,84 Dr. New Machinery Account Cr. 1995 July 1_| To Bank 70,000.00. Dr. Depreciation Account 1991 June 30. | To Depreciation Fund Account 1991 June 30 1992 June 30 | To Depreciation Fund Account 1992 June 30 1993 June 30 | To Depreciation Fund Account 1993 June 30 1994 June 30 | To Depreciation Fund Account 1994 June 30 1995 June 30 | To Depreciation Fund Account 1995 June 30 By Profit & Loss Account By Profit & Loss Account By Profit & Loss Account By Profit & Loss Account By Profit & Loss Account Dr. Interest on D.F. Investment Account cr. 1992 1992 June 30 June 30 | By Bank Fund Account 1993 1993 June 30 | To Depreciation June 30 | By Bank Fund Account 927.50 927.50 1994 1994 June 30 | To Deprecii June 30 | By Bank Fund Account 1,426.31 1995 1995 June 30 | To Depreciation June 30 | By Bank Fund Account (¥) Insurance Policy Method: This method is similar to Depreciation Fund Method and enables the firm to get the ready cash to replace the asset. Still, following are the points of difference between the two methods: (a) Under the Depreciation Fund Method, investment is made in securities, whereas under the Insurance Policy Method, an insurance policy is taken and amount is invested in the policy by paying premium. (b) Under the Depre: jon Fund Method, investment is made at the end of every year but85 under the Insurance Policy Method, tne premium is paid in the beginning of every ye: (©) Amount of depreciation and interest received determine the amount to be invested in the case of Depreciation Fund Method. But under Insurance Policy Method, the premium required to be paid is also considered to be amount of depreciation to be provided. (@) Depreciation Fund Investment Account may reveal even a loss on disposal of investments but Depreciation Insurance Policy Account will always reveal a profit because the amount of the policy is always higher than the total premium paid on the policy. Under this method, every year two entries are made: In the beginning of the year Depre jon Insurance Policy Account Dr. To Bank (For the amount of the premium paid) At the end of the year Profit and Loss Account Dr. To Depreci (The amount of premium paid during the year credited to Depreciation Reserve) tion Reserve Account ‘At the end of the last year, policy will mature. For receipt of amount of policy, the following entry will be passed: Bank Dr. To Depreciation Insurance policy account (Amount received on_maturity of policy) In the last year: In addition to the two usual entries mentioned above, will be passed Bank Dr. the following additional entries ‘To Depreciation Insurance Policy Account (For amount of the policy received from the insurance company on the maturity of the policy) Depreciation Insurance Policy Account Dr. To Depreciation Reserve Account (For transfer of profit on the policy from Depreciation Policy Account to Depreciation Reserve Account) jation Reserve Account Dr. To Asset Account (Transfer of Asset Account to Depreciation Reserve) DeprDepreciaton Reserve Account Dr. - To Profit and Loss Account Transfer of credit balance in Depreciation Reserve to Profit and Loss Account) Alternatively, under this method, Depreciation Account may also be opened. In that case, every year the following entries will be passed: Derpeciation Insurance Policy Account Dr. To Bank (For Premium) n Account Dr. Depre To Depreciation Reserve Account (For depreciation provided) Profit and Loss Account Dr. To Depreciation Account (For transfer) Illustration & On Ist January, 1992 Mehar Co. Ltd. purchased a lease for four years for Rs. 42,000 and decided to provide for its replacement by means of an insurance policy for Rs. 42,000. The insurance company charged an annual of Rs. 8,500. Show important ledger accounts. Solution: Dr. Lease Account cr. 1992 Jan. 1 1993 Jan. 1 1994 Jan. 1 By Balance c/d 1995 Jan. 1 By Depreciation Reserve transfer87 Dr. Depreciation” Reserve Account Dec. 31 Balance b/d By Profit & Loss Account 1993 Dec. 31 Balance b/d Balance b/d By Profit & Loss Account 1994 Dee. 31 Balance b/d Balance b/d Profit & Loss Account 1995 Dec. 31 Balance b/d By Balance b/d By Profit & Loss Account By Depreciation Insurance Policy A/c Dr. Depreciation Insurance Policy Account Dr. 1992 Rs. | 1992 Rs. Jan. 1 | To Bank-Premium 8,500 ] Dec. 31 | By Balance c/d 8,500 1993 1993 Jan. 1 | To Balance b/d 8,500] Dec. 31 | By Balance c/d 17,000 Jan. 1 | To Bank 8.500 194 194 Jan. 1 | To Balance b/d 17,000 | Dec. 31. | By Balance c/d 25,500 Jan. 1 To Bank 8.500 25,000 25,500 1995 1995 Jan. 1 | To Balance b/d 25,500 | Dec. 31 | By Bank 42,000 Jan. 1 To Bank 8,500( Dec. 31 | To Depreciation Reserve-Transfer of profit (vi) Depletion Method : This method is used to depreciate assets like mines and quarries where on estimate of total quantity of output is available. Depreciation is calculated usually per tone of output. For example if a mine is purchased for Rs. 1,00,000 and it is estimated that the total quantity of mineral in the mine is 50,000 tonnes, the depreciation per tonne of output nto be wi will be Rs. 2. If the output in the first year is 8,400 tonnes, the depreci en off in the first year will be Rs. 16,800. In the second year the output may be 9,100 tonnes. Depreciation @ Rs. 2 per tonne will amount to Rs. 28,200. (vii), Machine Hour Rate Method : This method is similar to Depletion Method but it is applied to machines. The life of the machine is estimated in terms of hours it will run and then cost of machine per running hour is calculated. An accurate record is kept regarding the number of hours the machine is run and depreciation is calculated by multiplying the machine rate by the number of hours the machine has run during the year. Suppose a machine costing Rs. 1,20,000 is estimated to run 40,000 hours during jts useful life, Machine hours rate is Rs. 3. If in a particular year the machine has run for 2,480 hours, depreciation will amount to Rs. 2,480 x 3 = Rs. 7,440. (viii) Revaluation Method : This method is used in case of assets where there are a large number of individual items. Live stock tools are examples of such an asset. In such cases, it is very difficult to maintain an account of each single item and calculate depreciation thereon. Hence the stock of such an asset is evaluated and an appropriate amount is provided in the books of accounts by way of depreciation to bring down the book value of the asset. Suppose a firm had in the beginning of a year tool of the value of Rs, 2,350. During the year it purchased new tools costing Rs. 450, thus making a total of Rs. 2,800. If at the end of the year, the loose tools are found to be worth Rs. 2,300 the depreciation for the year will be Rs. 2,800 — Rs. 2300 = S00 Depreciation of Various Assets: Different methods are appropriate for differnt assets. To depreciate Freehold Buildings, Plant and Machinery, straight line method with a provisior for repairs or diminising balance method without a provision for repairs or depreciation fund method or depreciation insurance policy should be employed. To depreciate leasehold and land and buildings, straight line method to write off the asset together with its cost of dilapidation (if any) within the life of the asset is the best. Annuity Method is also very appropriate for all eases. Loose tools and livestock should be depreciated by means of revaluation method. For mines, oil wells and quarries, depletion is the best. Plants and trade marks should be written off on straight line method within their commercial life or legal life whichever is shorter. No profits start decreasing. But it is beter ight line method. No depreciation arises depreciation arises in case of goodwill unless the firm to write off the amount over a number of years on st in case of freehold land.89 ACCOUNTING STANDARD 6 (AS ; 6) DEPRECIATION ACCOUNTNG The following are the salient features of the Revised Accounting Standard on Depreciation Accounting issued by the Institute of Chartered Accountants of India in September. 1994.! 1. The standard applies to all depreciable assets except the following items to which special considerations apply (a) forests, plantations and similar regenerative natural resources; (b) wasting assets including expenditure on the exploration for the extraction of minerals oils, natural gas and similar non-regenerative resources; (c) expenditure on research and development; (d) goodwill: (e) livestock: (1) land unless it has a limited useful life for the enterprise. 2. The depreciable amount of a depreciable asset should be allocated on a systematic basis to each accounting period during the useful life of the asset 3. The depreciation method selected should be applied consistently from period to period. A change from one method of providing depreciation to another should be made only if the adoption of the new method is required by statute or for compliance with an accounting standard or if it is considered that the change would result in a more appropriate preparation or presentation of the financial statements of the enterprise. When such a change in the method of depreciation is made, depreciation should be recalculated in accordance with the new method from the date of the asset coming into use. The deficiency or surplus arising from retrospective recomputation of depreciation in accordance with the new method should be adjusted in the accounts in the year in which the method of depreciation is changed. In case the change in the method result in deficiency in depreciation in respect of past years, the deficiency should be charged in the statement of profit and loss. In case the change in the method result in surplus, the surplus should be credited to the statement of profit and loss. Such a change should be treated as a change in nting policy and its effect should be quantified and disclosed. 4. The useful life of a depreciable asset should be estimated after considering the followi factors (i) expected physical wear and tear ; (ii) obsolescence: (ii) legal or other limits on the use of the asset, The useful lives of major depreciable assets or classes of depreciable reviewed periodically. Where there is a revision of the estimated useful life of an asset, the unamortised depreciable amount should be charged over the revised remaining useful life. The Chartered Accou tant September 1994. p. 7790 1 6. Any addition or extension which becomes an integral part of the existing asset should be depreciated over the remaining useful life of that asset. The depreciation on such addition ot extension may also be provided at the rate applied to the existing asset. Where an addition or extension retains a separate identity and is capable of being used after the existing asset is disposed of, depreciation should be provided independently on the basis of an estimate of its own useful life. 7. Where the historical cost of a depreciable asset has undergone a change due to increase or decrease in long-term liability on account of exchange fluctuations, price adjustments, changes in duties or similar factors, the depreciation on the revised unamortised depreciable amount should be provided prospectively over the residual useful life of the asset. 8. Where the depreciable assets are revalued, the provision for depreciation should be based on the revalued amount and on the estimate of the remaining useful lives of such assets. In case the revaluation has a material effect on the amount of depreciation, the same should be disclosed separately in the year in which revaluation is carried out. 9. Ifany depreciable asset is disposed of, discarded, demolished or destroyed, the net surplus or deficiency, if material, should be disposed separately. 10. The following information should be disclosed in the financial statements: (i) the historical cost or other amount substituted for I cost of each class of depreciable assets; (ii) total depreciation for the period for each class of assets; and (iii) the related accumulated depreciation LI. The following information should also be disclosed in the financial statements along with the disclosure of other accounting policies: (depreciation methods used; and (ii) depreciation rates or the useful lives of the assets, if they are different from the cipal rates specified in the statute governing the enterprise. SELF-TEST QUESTIONS qe Lt r) What is depreciation? Why is it provided? What are the factors which require consideration while ascertaining the amount of depreci to be provided on a certain asset ? Distinguish between straight line method and diminishing balance method. What are their relative advantage ? What is annuity method of providing depreciation ? For which assets is it specially suitable ? What is the special s ce of sinking fund method of depreciation ? Distinguish between sinking fund method and depreciation insurance policy method of depreciagion ? For whichhassets is depletion method of depreciation used ? What is,machine hour rate? How is it calculated ? What is revaluation method of providing depreciation? For which asset is it recommended ?LESSON 6 PREPARATION OF FINANCIAL STATEMENTS FOR PROFIT MAKING ENTITIES ‘After having established that the books of account are correct, the owner is interested in finding out two important facts about his business: (a) What has he carned during the accounting period; and (b) What is the financial position of his business at the end of that period? In order to know the profits earned by him he prepares a Profit and Loss Account (also known as Income Statement) and in order to know the financial position of his business at the end of the period, the prepares a Balance Sheet (also knwon as Statement of Financial Position). These are together called as Final Accounts. Now ‘Funds Flow Statement’ (also known as ‘statement of changes in Financial Position)’ is also becoming an integral part of the financial statements for highlighting the manner of revising and utilizind the funds (j.e. working capital) between the two successive balance sheet dates. Sometimes the projected Profit and Loss Account is also prepared to highlight the projected future profits during a given period. To the International Accounting Standards Committee (IASC), financial statements cover a balance sheet, an income statement, notes and other statements and explanatory material which are identified as part of the financi statements” Profit and Loss Account Determination of business profit is generally regarded as the principal accounting objective. ‘Owners and investors take special interest in the profit or income of the entity. Only through participation in its income can the owners realise any return on their investment funds. Financial ‘Accounting is thus attuned to the measurement of business profit, or distributable income. However, accountants are not concerned with the measurement of what the economists call real income because of the high degree of subjectivity. of value. Instead, the procedures of financial accounting are designed to yeild a measurement of monetary income which the account call net-profit for the period ‘The definition of net profit must be stated precisely. Net profit for any period is the excess of revenue realised during the period over the costs expired (including losses) during the same period, The terms realised revenue and expired costs are the keys to understanding what net profit is. ‘Accounting Principles and Conventions Underlying Measurement of Business Profit In determining the business incomes the accountant follows certain basic principles and *For detailed discussion please refer to lesson 1 on Accounting Principles.conventions. These are: (i) Periodicity (ii) Matching (iii) Consistency (iv) Disclosure (vy) Conservatism . Periodicity ‘The income statement is prepared for a certain period of time only. Ordinarily, the period taken for this purpose is a year. It is known as Financial year. However, it is also possible to prepare income statement for shorter time intervals, such as a month or a quarter. Matching ‘An accurate measurement of the net income or net loss for an accounting period depends upon the matching of expenses against related revenues. The matching of revenues and expenses is difficult, as there is a possibility that a revenue or an expense has already been recognised in a previous financial period or that it has to be deferred until some future period. If expenses are not propery set-off against revenues, the resulting net income or net loss for the. financial period will be reported incorrectly. Thus, the revenues and the expenses relating to a financial year should be properly estimated. Coinsistency ‘An accounting method or procedure once chosen should be followed consistently from year to year. If it is not so and profits or loses are calculated on a different basis each year, then it will lead to confusion. However, necessary changes should bé made, but when changes are made, the effect of such changes upon the financial statement should be fully disclosed. Disclosure ‘As per principle of disclosure all the material facts regarding the profits arrived should be disclosed in full. A figure may be material by itself in the sense that if it is merged with other figures, it will be misleading. For instance, if arrears of salaries and wages, in respect of a dispute continuing for long, are added to salaries and wages and if the amount is large, it will give a wrong idea about the salaries or the wages bill of the business. The arears, therefore, should be shown separately. However, what is material depends on the judgement of the persons preparing the statements. No hard and fast rule can be laid down in this respect. Conservatism The conservatism principle implies that a firm should not anticipate for profits but prvide ‘ble losses. Thus, revenues are not to be anticipated and should be recognised only when realised. for all po Distinction between Capital and Revenue Expenditure Before we proceed to the preparation of Profit and Loss Account and Balance Sheet, it is necessary to distinguish between two types of expenditures—Capital and Revenue. The expenditure93 incurred in order to acquire an asset of a benefit which will be available for a long time known as Capital Expenditure. For example, expenditure incurred to acquire plant and machinery Expenditure where benefit is available only for the present is referred to as Revenue Expenditure. For example, payment for salaries, rent etc. However, distinction between capital and revenue is not always easy Where a large expenditure of revenue nature is incurred and if its benefit is available for more than one year the expenditure is referred as Deferred Revenue Expenditure. Such as expenditure on research and development of a product or heavy advertisement expenditure to float new product AS : REVENUE RECOGNITION The following are the salient features of AS : 9. 1. Revenue from sales or service transactions should be recognised when the requirements as to performance set out in paragraphs 2 and 3 are satisfied, provided that at the time of performance it is not unreasonable to expect ultimate collection. If at the time of raising of any claim it is unreasonable to expect ultimate collection, revenue recognition should be postponed. 2. In a transaction involving the sale of goods, performance should be regarded as being chieved when the following conditions have been fulfilled (i) the seller of goods has transferred to the buyer the property in the goods for a price or all significant risks and rewards of ownership have been transferred to the buyer and the seller retains no effective control of the goods transferred to a degree usually associated with ownership; and (ii) no significant uncertainty exists regarding the amount of the consideration that will be derived from the sale of the goods. 3. Ina transaction inolving the rendering of services, performance should be measured either under the completed service contract method of under the proportionate completion method, whichever relates the revenue to the work accomplished. Such performance should be regarded as being achieved when no significant uncertainty exists regarding the amount of the consideration that will be derived from rendering the service. 4, Revenue arising from the use by others of enterprise resources yielding interest, royalties and dividends should only be recognised when no significant uncertainty as to measurability exis These revenues are recognised on the following bases: (i) Interest: on a time proportion basis taking into account the amount outstanding and the rate applicable; (ii) Royalties on an accrual basis in accordance with the terms of the relevant agreement; (ii) Dividends from when the owner's right to receive payment is established. investments in shares:94 5. In addition to the disclosures required by Accounting Standard-1 on Disclosure of Accounting Policies (AS-1), an enterprise should also disclose the circumstances in which revenue recognition has been postponed pending the resolution of significant uncertainties. The standard will be mandatory in respect of accounts for periods commencing on or after 1-4-1991 Preparation of profit and Loss Account Normally Profit and Loss Accounts prepared in two parts : (a) Trading Account; and (b) profit and Loss Account. Purpose of the Trading Account is to find out Gross Profit or Gross Loss, while the Profit and Loss Account shows Net Profit or Net Loss. Trading Account Trading Account shows whether the sales revenue exceeds the costs incurred to get the revenue as well as other expenses and leave a margin of profit. Thus, in case of a trading concern, the cost will comprise of the purchase price, freight inwards, octroi duty etc. In case of a manufacturing concern the cost will comprise of the cost of raw materials, wages, and manufacturing expenses. (In case of Manufacturing concern income statement is prepared in three parts viz., Manufacturing Account, Trading Account and Profit and Loss Account). The items which normally figure in a Trading Account are On Debit side—Opening Stock, Purchase or Cost of goods manufactured. Carriage inwards, Wages ete. On Credit Side—Sales and Closing Stock. Thus, all the expenses incurred in bringing the goods to saleable state form the part of cost of goods sold and are taken to Trading Account. Generally, the Trading Account is prepared in the following format Trading Account of... : onunefor the period.. Dr. To Stock (Opening) By Sales less returns To Purchases less returns By Closing Stock To Carriage Inwards To Freight To Wages To Fuel, lighting ete. To Gross Profit By Gross Loss*. “If debit side is greater than the credit side, then there is a Gross Loss.95 Preparation of the Trading Account requires adjustment of the value of closing stock in the books of account. This is. done by debiting stock account with the value-pf closing stock and crediting the amount to the Trading Account. Such an adjustment is usiially made aftr the correctness of the books of account has been ascertained by drawing up a trial balance and the value of closing stock has been computed. In case there ‘equal to the quantity of opening stock plus purchases less sales. The process of valu: closing stock involves merely # reconciliation of the above mentioned quantities of stock with those of the closing stock by determining the amount of physical losses or gain, if any. The market value of closing stock also may not be the same at which it was purchased due to a change in prices. The effect thereof, in unfavourable, must be provided for. no physical loss of goods, the quantity of closing stock shall always be on of [As such, the closing stock is valued at cost or market price whichever is lower. This practice is universally followed. It ensures that profits are included in accounts only if realised but losses, even when anticipated, are provided for. Important Points Regarding Trading Account Sales While considering the sales to be included in Trading Account, it should be sale of those goods only which were purchased for the purposes of resale. Goods sold on consignment or Hire Purchase System or on Approval, should be recorded separately. Purchases Total Purchases should be those purchases which were made for the purposes of resale. Purchases of Plant, Furniture, Building and Goods Received on Consignment should be kept separately. Similarly, invoices of the goods when received in advance are not written in Trading Account. Trading Account also remains unaffected by ‘Goods in Transit’. Gas, Electricity, Water, Fuel charges, Factory Expenses, Packing Materials. Consumable stores etc., should be taken to Manufacturing Account or Trading Account as the case may be. Closing Entries As already discussed in earlier lessons all accounts of expenses and gains must be closed at the end of the year. In order to close such accounts they are transferred either to Trading Account or Profit and Loss Account, Journal Entries made to transfer them to Trading Account or Profit and Loss Account are called ‘Closing Entries’ Easiest way to make the closing entry is as follows: (a) If the account is having a debit balance, then credit it in order to close it ‘and debit either Trading Account or Profit and Loss Accounts as the case may be. (b) If the account is having a credit balance when debit that particular account to close it and credit cither Trading Account or Profit and Loss Account.as per nature of the riage outward shows a debit balance in)Trial Balance. The punt will be: account, For example, Ci closing entry for this ac Profit and Loss Account Dr. To Carriage Outward Alc96 Wages paid having debit balance will be transferred to Trading Account Closing entry is: Trading Account Dr. To Wages A/c [All accounts having same type of balance (Debit or Credit) are collected at one place and one closing entry is passed instead of one for each. Therefore, to close stock, Purchases, Wages, etc,, only one closing entry will be passed because they all are taken on the debit side of Trading Account. Thus, First Closing Ensry (to close all the accounts going to debit side of Trading Account) is; Trading Account Dr. To Opening Stock To Purchases To Sales Returns To Wages To Carriage Inwards etc. etc. Second Closing Entry (to close all the accounts going to the credit side of Trading Account) Sales Account — Dr. Purchases Returns A/c Dr. ete. ete. To Trading A/c Third Closing Eniry (to transfer gross profit to Profit and Loss Account is: Trading Account Dr. oa To Profit & Loss A/c se In case there is gross loss, the entry will be reversed. Fourth Closing Entry for all gains and profit is = Discount Received Account Dr. Commission Received A/c. Dr. To Profit and Loss A/c. Fifth Closing Entry for-all other expenses is : Profit and Loss Account — Dr. To Rent To Insurance To Discount Allowed To Carriage Outwards ete” Sixth Closing Entry to close Profit and Loss Accovat. The Closing Entry to transfer Net Profit to Capital Account Profit and Loss Account Dr. To Capital Account In case there is a net loss, the entry will be reversed. Balance Sheet It is a classified summary of the balances remaining open in the General Ledger, after all the incomes and expenses accounts have been closed by transfer to the profit and loss account. In other words, they represent either Assets or Liabilities existing at the date of the closing accounts. Students may please note, that Balance Sheet is a statement of financial position and not a part of the double entry ledger accounting. No transfer of the ledger accounts balances are, therefore, necessary. Only the relevant particulars are extracted from the General Ledger. Thus, balance sheet discloses how the business got its resources and how these resources are being utilised. The capital and liabilities of the business are shown on the left-hand side and the asset on the right-hand side of the balance shect. Types of Assets Fixed Assets are assets which are acquired for use in the business and not for resale in ordinary course of business. For example, Land and Building, Plant, Machinery etc. Fixed Assets, asting Assets” For example, mines, which are consumed in course of exploitation are known a fisheries etc. Current Assets are assets which are acquired for sale or held in course for conversion into cash, For example cash in hand, cash at bank, bills receivable etc. However, the classification of assets will depend upon the nature of business. For example, Remington Typewriter for Remington'Typewriter Company is a current asset, whereas for a company is a fixed asset. who is purchasing it, Fictitious Assets are debit balances arising from abnormal expenditure not yet written of and which are not representative of tangible value. Examples of such assets are Preliminary Expenses, Discount on Issue of Shares, Debenture, etc. ‘Types of Liabilities Liabilities are amounts owed by a business. Where they have to be met on demand or in the short term, they are known ‘Current Liabilities’. Bills Payable, Accounts Payable, Sundry Creditors are the examples. Where they are repayable in long term, these are termed as “Fixed” or ‘Long Term’ liabilities and classified accordingly. Capital is the amount owed by the business to its proprietors. No statutory form has been prescribed in which a Balance Sheet should be prepared, except in the case of companies. There is a convention in the matter of marshalling of assets and li in a Balance Sheet. Thus, they may be set out (a) in the order of their permanance; or (b) order of their liquidity. The order of permanence, so for as assets are concerned, requires that these be arranyed in the order of (a) Fixed. Assets (b) Current Assets and Fictitious Assets. In98 case of liquidity, the order is reversed. As far as writing, down of liability side is concerned, 4s a convention, it follows the order as being followed on the assets side. Format Balance Sheet of M/s... Liabilities & Capital ‘Assets Capital Fixed Assets Opening Balance lant Add Net Profit Land & Building Add Interest on Furniture Capital Machinery Current Assets Less Drawings Long Term Liabilties Stock Loan Sundry Debtors Cash at Bank Current Liabilities Cash in Hand Bills Payable Accounts payable Sundry Creditoi IMustration : 1 The following is the Trial Balance of C, Wanchoo on 31 December, 1994. Pass the closing entires, and prepare the necessary ledger accounts. TRIAL BALANCE on 31th December, 1994 Dr.. (Rs.) Cr. (Rs.) Capital Account 10,000 Stock Account (1st January, 1994) 2,000 Cash at Bank 1,000 Cash ‘in Hand 440 Machinery Account 6,000 Furniture & Fitting Account 1,360 Purchase Account 15,000 Wages Account 10,000 Fuel & Power Account 3,000 Factory Lighting Account 200 Salaries Account 7,000 Discount Allowed. Account 50099 Discount received account 300 Advertising Account 5,000 Sundry Office Expenses Account 4,000 Sales Account $0,000 ‘Sum owing by Customers (Sundry Debtors) 8,500 Sundry Creditors (Sum-owing to Suppliers) 3.700 {64,000 64,000 Value of Closing Stock on 3ist December, 1994, was Rs. 2,700 Solution: Gr Date Particulars Amount Rs. 1994 Trading -Account Dr. 30,200 Dee. 31 To Stock Account 2,000 To Purchase Account 15,000 To Wages Account 10,000 To Fuel & Power Account 3,000 To Factory Lighting Account 200 (Being the accounts in the Trial Balance which have to be transferred to the Trading Account debit Side. » | Sales Account Dr. 50,000 To Trading Account 50,000 (Being the amount of Sales transferred To the credit of Trading Account) » » | Stock Account (closing) Dr. 2,700 To Trading Account 2,7000 (Being the value of stock in hand on Bist December, 1994). » ” | Trading Account . Dr. 22,500 To Profit & Loss Account 22,550 (Being the transfer of gross profit) » | Profit & Loss Account aa Bes 16,500 To Discount Allowed Account 500 To Salaries Account To Advertising Account 5,000 To Sundry Office Expenses Account 4,000 (Being the various expenses accounts transferred To the debit of P & L Account)Dec. 31 | Discounts Received Account... To Profit & Loss Account 300 (Being the credit balance of discount received transferred to the P_& L A/c} Dec. 31 | Profit & Loss Account 6,300 (Being the transfer of the Capital Account) Profit to the Dr. Cash Book Cr. Date | Particulars : Paiticulars Bank Rs. 1994 Dec, 31] To Balance By Balance bid ld 1,000 1995 Jan 1 To Balance * bid Ledger Dr. Capital Account Cr. Date__| Particulars Date Particulars: [Folio] Amount 1994 Rs. Dec. 31] To Balance c/d Dec. 31] By Balance b/d 10,000 Dec. 31] By Profit & Loss Account 6,300 6.300 By Balance b/d Dr. Stock Account cr. ' 1994 1994 ' Jan To Balance b/d 2,000 | Dec. 31. |_ By Trading Account 2,000 Dr Machinery Account Cr. Date Particulars [Amount [ Date | Particulars ‘Amount 1994 1994 Rs. Dec. 31] To Balance b/d Dec. 31] By Balance c/d 6,000 1995 Jan. To Balance b/d101 Furniture & Fittings Account Balance b/d Balance b/d Purchases Account By Balance c/d Sundries Wages Account By Trading A/c Sundries 10,000 | Dec. 31 Fuel and Power Account By Trading A/c Jan. 1 to Dec. 31 Factory Lighting Account By Trading A/c Sundries Salaries Account By Trading A/c sundries By Profit & Loss Alc Discount Allowed Account Sundries By Profit & Loss A/c102 Dr. Dicount Received Account . 1994 1994 Dec. 31 | To Profit & Loss A/c By Sundries 300 Dr. Advertising Account cr. By Profit & 5,000 Loss Alc Jan. 1 to |To Sundries Dr. Sundry Office Expenses Account cr. By Profit & Loss Ale To Sundries 1994 To Trading von Jan. 1 to By Sundries 50,000 Dr. Sundry Debtors Account ice: 1994" 1994 Dec. 31} To Balance b/d 8500 | Dec. 31 | By Balance b/d 8,500 1995 Balance b/d Dr. Sundry Creditors Account or Date Particulars ‘Amount | Date Particulars, Amount 1994 1994 Dee. 31 1995 Dec. 31 | To Balance ¢/d 3,200 To Balance b/d Dr. Stock Account cr. 1994 Dec. 31 |To Trading Ale 2.700 By Balance c/d 2.700 1995 Jan. 1 To Balance b/d103 , WANCHOO ‘TRADING ACCOUNT for the year ended December 31, 1994 Particulars Particulars [| Amount 50,000 2,700 By Sales Account By Stock A/c (closing) To Stock Account To Purchases To Wages To Fuel & Power A/c To Factory Lighting To Gross Profit transferred to Profit & Loss Account PROFIT & LOSS ACCOUNT for the year ended December 31, 1994 Particulars Particulars ‘Amount To Salaries Ale By Profit transferred To Discount allowed A/c from the Trading A/c 22,500 To Advertising A/c By Discount A/c 300 To Sundry Office’ Exp. A/c To Net Profit Transferred Capital Account Balance Sheet In the Ilustration worked out above it will be seen that the undermentioned accounts have not been closed even after a preparation of the Profit and Loss Account and the transfer of the net profit to the Capital Account. Cash in hand Rs. 440 Debit balance Cash at Bank Rs. 1,000 Debit balance Capital Account Rs. 16,300 Credit balance Machinery Account Rs. 6,000 Debit balance Furniture & Fittings Rs. 1,360 Debit balance Sundry Debiors Rs. 8,500 Debit balance Sundry Creditors Rs. 3,700 Credit balance Stock Account Rs. 2,700 Debit balance Looking at these accounts, one would know the various asset—balance in hand, cash at bank, machinery, furniture, etc.—that the firm possess and the amount that are owing as liability to sundry creditors—and to the proprictor as capital. The Capital of course will be the differencebetween the total of assets and o 104 f s. The assets and liabilities and capital are usually presented in a statement called the balance sheet. This is given below for the account mentioned above, . WANCHOO BALANCE SHEET as at December 31, 1994 Liabilities I ‘Amount ‘Assets Amount Sundry Creditors 3,700 | Cash in Hand 440 Capital 16,300 | Cash at Bank 1,000 Sundry Debtors 8,500 Stock 2,700 Machinery 6,000 Furniture & Fittings 1.360 20,000 20,000 The assets are shown on the rij Illustration 2:—From the following Trial Balance prepare a Tra ight-hand side and the lial ties and capital on the left hand side. ig and Profit and Loss Account for the year ending 31st December, 1994 and a Balance Sheet as on that date: Debit Balance: Sundry Debtors Stock Ist January, 1994 Land and Building Cash in Hand Cash at Bank Wages Bills Receivable Interest Bad Debts Repairs Furniture and Fittings Rs. 1,500 5,000 10,000 1,600 4,000 3,000 2,000 200 500 300 1,500 1,000 Depreciation Rs. Rent Rates and Taxes 800 Salaries 2,000 Drawings 2,000 Purchases 10,000 Office Expenses 2,500 Plant and Machinery 5,700 Credit Balances: Capital 25,000 Interest 600 Sundry Creditors 7,000 Sales 17,000 Bills Payable 4,000 On 31st December, 1994 the stock was valued at Rs. 10,000105 Solution: TRADING AND PROFIT AND LOSS ACCOUNT for the year ending 31st Dec., 1994 Dr. Cr. Particulars if ‘Amount Particulars [__ Amount To Opening Stcok 5,000 By Sales 17,000 ‘To Purchases 10,000 | By Closing Steok 10,000 To Wages 3,000 To Gross Profit c/d 9,000 27,000 27,000 To Interest 200 By Gross Profit b/d 9,000 To Bad Debts 500 By Interest 600 To Repairs 300 To Depreciation 1,000 To Rent, Rates & Taxes 800 To Salaries 2,5000 To Office Expenses 2,500 To Net Profit transferred to capital Account 2.300 =aget) 9,600 9,600 BALANCE SHEET ‘as on 3ist December, 1994 Liabilities Amount Assets: Amount Current Liabilities Current Assets: Sundry Creditors 7,000 Cash in Hand 1,600 Bills Payable 4,000 11,000 Cash at Bank 4,000 Owners Fund: Bills Receivable 2,000 Capital 25,000 Sundry Debtors 1,500 Less Drawings 2,000 Closing Stock 10,000 | 19,000 23,000 Fixed Assets: Add net Profit 2.300 25,300 Furniture & Fittings 1,500 Plant & Mach. 5,700 Land & Building 10,000} 17,200 36,300 36,300106 LESSON 7 PREPARATION OF FINANCIAL STATEMENTS FOR PROFIT MAKING ENTITIES—I Adjustment Entries ‘To serve the needs of management, investors, bankers and other interested persons, Final ‘Accounts must be complete and accurate, The ‘balance-shect should contain all assets and liabilities at the-close of business on the last day of the period. The profit and loss account should contain all the revenue and expenses relating to the accounting period covered. However, some business transaction are of the nature which begin in one accounting period and complete in another accounting period. For example payment of insurance pretnintt in advance for three years. By means of adjusting entries at the end of each year, one third’of the total premium is charged to expense in the future is like an asset every year. In otber words, a payment for insvrancs protection (deferred revenue expenditure) but as the insurance protection is received the asset becomes an expense. Thus, it is essential that expenses paid in advance, expenses outstanding, income received caervance, income acerued but not received etc. should be adjusted in accounts. Entries so passed to adjust all these accounts are called ‘adjustment ‘entries’, In the absence of adjustment entries show either overstated net profit or understated net profit. Hence, the profit and loss account it will be misleading. Common Adjustments ‘The various kinds of transactions requiring adjusting entries at the end of the period may be classified into the following groups: (a) Recorded costs which must be apportioned between two or more accounting period. For example, cost of machinery (b) Recorded revenue which must be apportioned between two or more accounting periods. For example, commission received in advance for the services to be rendered in future (c) Unrecorded expenses. For example, wages unpaid for the period covered in the accounting period. (@) Unrecorded revenue. For example, commission earned but not yet collected. (©) Other Adjustments which include various types of provisions—such as provision for bad and doubtful debts. (A) Recorded Costs Apportioned Between Accounting Periods When a business makes an expenditure which benefits more than one accounting periode the amount is usually taken to an asset account, At the end of each period an appropriate portion is adjustment entry of the cost is transferred from the asset account to an expense account. For t will be as follows :Prepaid Expenses Account Dr. To Expenses Account 7 Former will appear as an asset in Balance Sheet, while latter will be shown on the debit side of Profit and Loss Account by way of deduction from the expenses account. Example 1: Ashok Leyland paid Rs. 3,000 as premium for fire insurance on January 1,1994 for three years. At the end of the year, i.e., December 31, 1994 the adjustment entry will be: Unexpired Fire Insurance Premium A/c Dr. 2,000 To Fire Insurance Premium A/c 2,000 Ledges Accounts will look like: Fire Insurance Premium Account cr. Particulars Amount Particulars Amount By Unexpired Fire To Bank A/c Insurance Premium A/c| 2,000 By Balance _c/d 1,000 Profit and Loss Account Fire Insurance Premium Alc Rs. 3,000 Less Unexpired 2,000 1,000 Unexpired Fire Insurance Premium Account Dec. 31| To Fire Insurance Premium A/c Balance Sheet Unexpired Fire Insurance Premium Alc Tn respect of fixed assets, and amount is written off annually by way of depreciation. Depreciation is a loss of asset by wear and tear or affluxion of time or by obsolescence. In course of time when asset is used for production purposes it is fully justified that such a loss be calculated and be brought into account by debiting the expense account. Adjustment Entry: Depreciation Account Dr. Former will appear in Profit and Loss Account debit side and latter will reduce the balance of the particular asset. Example 2: Ashok Leyland provided depreciation on its machinery @ 10%. The cost of machinery is Rs. 1,00,000.Adjustment Entry: Depreciation on Machinery A/c To Machinery Account Ledger Accounts Depreciation on Machinery Account December 31 | To Machinery A/c| 10,000 Machinery Account January 1 | To Balance b/d | 1,00,000 | Dec. 31] By Depreciation A/c 10,000 By Balance c/d 90,000 Profit and Loss Account December 31] To Depreciation | fon Machinery | _ 10,000 Balance Sheet Machinery | Rs. 1,00,000 Less: Depreciation 10,000 90,000 (B) Recorded Revenue Apportioned Between Accounting periods Any income received in advance should be calculated and brought into account by carrying forward such advance receipts. Advertisement received by Advertising Agency, insurance prem Wit received by the Insurance Company etc., are some of the examples under which Payment received je advance. Any income received in advance is not actually earned in that accountibg period and should be adjusted accordingly and a credit should be’ given to it to create liability Adjustment Entry is: Income Account Dr. To Income Received in Advance Account Example 3: Ashok Leyland received Rs, 2,00,000 as advance for a bus to be delivered on January, 15, 1995. The adjustment entry on December 31, 1994 will be: Sale of Bus Account Dr. 2,00,000 To Sale of Bus Advance A/c 2,00,000 Ledger Accounts: Dr. Sale of Bus Account (00,000109 Dr. Sales of Bus Advance Account cr. Dec. 31] By Sale of Bus Ale | 2,00,000 Dr. Profit and Loss Account Cr. l By Loss 2,00,000 (C) Unrecorded Expenses Adjusting entries are necessary at the end of ¢ which have been incurred but not recorded in the accounts. on loan are the examples of expenses which accunsalate day by until the end of the accounting period. These expenses are said to have accrued but not yet paid. Adjustment is made by debiting expense account and crediting the relevant account, in respect of which such amount is to be paid. ach accounting period to record expenses Salaries of employees and interest day but which may not be recorded Adjustment Entry Expenses Account Dr. To Outstanding Expense A/c Former will go to Profit and Loss Account and latter will appear as a liabilit Sheet Example: Ashok Leyland paid Rs. 11,000 as salaries for 11 months. the Balance Adjustment Entry 1,000 1,000 Salaries Account Dr. To Salaries Outsanding A/c Ledger Accounts Dr. Salaries Account To Balance To Salries Outstanding Salaries Outstandi Dec..31] By Salaries A/c ss Account Profit and L 31 | To Salaries A/c 12,000 Balance Sheet Salaries Outstanding 1,000 |No @D) Unrecorded Revenue The treatment of unrecorded revenue is similar to that of unrecorded expense. Any revenue which has been earned but not recorded during the accounting period should be recognised in the accounts by means of an adjusting entry, debiting an asset account and crediting a revenue account. Accrued revenue is that revenue which has been accumulating during the accounting period but which has not been recorded prior to the closing date. Adjustment Entry Accrued Income Account Dr. To Income Account Former will appear on asset side of Balance Sheet while the latter will appear in Profit and Loss A/c on the credit side, Example’5: Ashok Leyland has earned interest of Rs. 5,000 on the loan given, which is yet to be received, Adjustment Entry Accrued Interest Account Dr. 5,000 To Interest Account 5,000 Ledger Accounts Dr. Accrued Interest Account Cr. Dec. 31 | To Interest A/c $,000 Dr. Interest Account Cr. Deg. 31| By Accrued Interest A/c | 5,000 Dr. Profit and Loss Account Cr. Dec. 31 | By Interest A/c 5,000 Balance Sheet (E) Other Adjustments (@ Closing Stock Stock at the end of year will be valued and adjustment entry will be as follows. Closing Stock Account Dr. To Trading Account Where former will be shown as an asset in the Balance Sheet. Gi) Bad Debts Debts which prove to be irrecoverable are called Baq Debts. Being a loss to the business, 'na Bad Debts Account is debited and personal account of the party who is not able to pay the amount is credited. The entry is: Bad Debts Account Dr. To Debtors (Personal A/c) Sp Former will appear on the debit side of the Profit and Loss A/c whereas latter will be shown as deductions from the debtors in asset side of the Balance Sheet. (ili) Provision For Bad and Doubtful Debts When it is feared that a part of the amounts due from cifstomers will not be collected, it is advisable to recognise the expected loss by reducing the current year's profit and placing the amount to the credit of a special account called (Provision for Bad & Doubtful Debt Account.) The adjustment Entry is: Profit and Loss Account Dr. To Provision for Bad and Doubtful Debts A/c Various accounts of the customers are not affected until the amount is actually written off for which they entry is: Bad Debts Accounts se To. Customer's A/e When bad debts are written off the amount is debited to the provision made in this respect (where such a provision exists) or is taken directly to the Profit and Loss Account, the corresponding credit being given to the debtor's account. If, on the other hand; a provision is required to be created, the amount of provision is also debited to Profit and Loss Account. Where certain bad debts are to be written off and a provision for doubtful debts made, the amount of bad debts to be written off'should be first debited against the existing balance of the provision and the resulting balance in the account afterwards should be rasied to the required figure Example 6 : As per the records of Ashok Leyland on January Ist, 1994, the Provision for Doubtful Debts stood at Rs. 400. Debtors on 31st December, 1994 were Rs. 15,000; bad debts were Rs. 1,000. It is required. to write off the bad debts and create a provision equal to 5% on debtors. The provision for Doubtful Debts Account will appear as follow: Provision for Doubtful Debts Account To Bad Debts A/c Jan. 1 | By Balance b/d ‘To Balance c/d (reqired) Dec. 31| By Profit and Loss A/e By Balance b/d112 (iv) Provisional for Discount on Debtors In pursuance of a prudent policy of making provisions against all possible contingencies, it is common practice to make provision for discount on debtors. This is done in the anticipation that all sound parties will make the payment soon and may ask for discount. The provision for discount is calculated on the amount of debtors left after deducting provision for doubtful debts. The journal entry is: Profit and Loss Account Dr. soee To Provision for Discount On Debtors Former will go to the debit side of Profit & Loss A/c and latter will be deducted from Sundry Debtors. (v) Provision for Discount on Creditors If the business is sound and making payment to the creditors, in time then it will also earn discount. I so, then, it will not be proper to show creditors in Balance Sheet at full figure without deducting Provision for Discount on Creditors. The entry for making the provision for discount on creditors is: Provisions for Discount on Creditors Dr. To Profit & Loss Account Former will be deducted from Sundry Cre Credit side (vi) Interest on Capital I so charged is an expense for the business but it is gain to the proprietor. For this, the adjust entry will be: is a normal practice to charge interest on the capital employed at some reasonable. Interest \t Interest on Capital Account Dr. sane To Capital Account Interest being normal account will be closed by transferring it to Profit & Loss Account and being added to capital (vii) Interest on Drawings. As business allows interest on capital it may also charge interest on drawings made by the proprietor. This is done with the intention of discouraging the proprietor or partners to draw too much money for personal use. This is a gain to the business and a loss to the proprictor. Adjustment Entry is: Capital Account Dis. ft To Interest on Drawing A/c113 TABLE OF ADJUSTMENT ENTRIES Tiem_of Adjustment ‘Adjustment Entry Type of Account 1, Closing Stock Closing Stock Dr. Real To Trading A/c Nominal 2. Outstanding Expenses —_| Expenses Account Dr. Nominal To Outstanding A/c Personal Expenses Paid in Unexpired Expenses A/c Dr. Personal Advance To Expenses Nominal 4, Outstanding Income Accrued Income A/c Dr. Personal To Income A/c Nominal Income Received Income Account Dr. Nominal In Advance To Income Receied in Advance A/c Personal 6. Deprecii Depreciation Dr. Nominal To Asset Rei 7. Bad Debts Bad Debts Dr. Nominal To Debtors Personal 8. Provisions for Bad & Profit and Loss A/c Dr. Nominal Doubtful Debts To Provision for Bad Debts Nominal 9. Provision for Discount | Profit and Loss A/e Dr. Nominal on Debtors To Provision for Discount on Debtors Nominal 10. Provisions for Discount | Provision for Discount on Creditors on Creditors A/c Dr. Nominal To Profit and Loss A/c 11. Interest on Capital Interest on Capital A/c Dr. Nominal To Capital Ale Personal 12. Interest on Drawings Capital Account Dr. Personal To Interest on Drawings A/c Not Ilustration-1 Pass necessary Adjustment Entries for the following items in the books of T.T. and Company as at December 31, 1994. () Stock on Ist December, 1994 was Rs. 30,000 (ii) Salaries for the month of December, 1994 remain unpaid. Salaries paid upto November were Rs. 22,000 (iii) Insurance paid Rs. 3,000 on January 1, 1994 for three years. (iv) Apprenticeship Premium received on 30th June 1994 Rs. 900 was for three years.4 + (v) Interest accurred on. securities Rs. 5,000. (vi) Depreciation on Plant and Machinery valued at Rs. 1,00,000 @ 10%. (vii) Bad Debts during the year amounted Rs. 1,000. (viii) Make Provision for Doubtful Debt on Debtors @ 5%. Sundry Debtors which were Rs. 61,000. Further make provision for Discount on Debtors and Creditors as per Trial Balance were Rs. 50,000. Solution ADJUSTMENT ENTRIES Books of T.T: & Company as at December 31, 1994 (i) Closing Stock A/c Dr. 30,000 To Trading A/c 30,000 (ii) Salaries Alc Dr. 2,000 To Salaries Outstanding 2,000 (Outstanding salary of one month brought into Account) (iii) Prepaid or Unexpired Insurance A/c Dr. 2,000 “To Insurance Account 2,000 (Insurance paid in advance for two years) . (iv) Apprentice Premium Suspence A/c Dr. 150 To Premium Account 150 (Apprentice Premium of 6 months transferred from Premium suspense A/c) (v) Accrued Interest Account Dr. 5,000 To Interest Account 5,000 (Accurred interest on securities brought into account) (vi) Depres ion Account Dr. 10,000 To Plant & Machinery 10,000 (Depreciation @ 10%) (vii) Bad Debts Accounts > Dr. 1,000 To Debtors Account 1,000 (Loss on account of non- recovery of debts)M5 (viii) Profit and Loss Account Dr. 3,000 To Provision for Doubtful 3,000 Debits Account Provision for Bad Debts @ 50% on Rs. 60,000) (ix) Profit and Loss Account Dr. 1,425 To Provision for Discount 1,425 in Debtors (Provision for Discount at @ 2%% jon Rs. 57,000) () Provision for Creditors Account Dr. 1,250 To Profit and Loss A/c 1,250 (Provision for Discount Creditors @ 24% on Rs. 50,000) Ilustration : 2 Following is the Trial Balance of, Rajat Chemicals as on December 31, 1994. Dr. Cr. Cash in hand 3,100 Cash at Bank 10,250 Salaries 10,650 Sundry Debtors 10,300 Purchases 41,000 Returns Inwards 1,000 Furniture & Fixtures 2,500 Postage & Telegrams 400 Sales 60,000 Rent, Rates & Taxes 2,300 Printing & Machinery 400 Freight & Duty 1,000 Stock on Ist Jan. 1994 7,500 Insurance Charges 350 Trade Expenses 200 Returns Outwards 500 Plant & Machinery 10,000 Plant & Machienry (additions on July 1, 1994) 2,500 Carriage outward 250 Sundry Creditors 5,000 Provision for Doubtful Debts 200 Discounts 400 Rent of Premises sublkt, for Dec. to 30th June, 1995 600 Capital Account 4,000 Drawings Account 3,000 06,10 1,06,700116 Additional Information 1. Closing Stock on December 31, 1994 was valued at Rs. 7,000. 2. Write off Rs. 300 as bad debts. 3. Insurance prepaid was Rs. 50. 4. Provision for depreciation on Furniture and Fixtures at 5% per annum and on Plant & Machinery at 20% per annum. 5. Provision for Doubtful Debts is to be maintained at 5% on Sundry Debtors. 6. Provision for Discount on Debtors and discounts on Creditors at 2%. 7. Stock to the tune of Rs. 5,000 was destroyed in fire. As it was fully insured, the insurance company admitted the claim in full. 8. As per the agreement, the manager is to be paid a commission of 10% of the net profit arising from trading of the company after charging his commission. Required: 1, Prepare Adjustment Entries 2. Prepare Closing Entries 3. Ledger 4, Trading & Profit and Loss Account 5. Balance Sheet Solution Adjustment Entries Dec. 31, 1994 Closing Stock A/c Dr. 7,000 To Trading A/c 7,000 (The value of Stock at the end of the year) Bad Debts Account Dr. 300 To Sundry Debtors 300 (Amount written off as Bad Debts) Insurance Prepaid A/c Dr. 50 To Insurance A/c 50 (Insurance prepaid brought into Accapat) Depreciation Account Dr. 2,375 To Furniture & Fixtures 125 To Plant & Machinery 250 (Depreciation written off 5% on Furniture & Fixture Rs. 2,500 20% on Plant & Machinery- Rs. 10,000) one year & Rs. 2,500 for six months)17 Dec. 31, 94 Profit & Loss Account Dr. 600 To Provisions for Doubtful Debts Account 600 (The amount required to make the balance in the Provision A/c equal to 5% of Rs. 10,000 viz. Rs. 5000). Profit and Loss Account Dr. 190 To Provision for Discount on Debtors A/c 190 (Amount required as Provision for Discount @ 2% on Rs. 9,500 (10,000-S00). Provision for Discount on Creditors Account Dr. 100 To Profit and Loss A/c 100 (Discount expected to be earned on creditors 2% on Rs. 5,000) Insurance Company Account Dr. 5,000 To Trading Account 5,000 (The amount recoverable from insurer for goods destroyed) Rent of Prem es Sublet A/c Dr. 300 To Rent Received in Advance 300 (The rent for period falling after 31st December, 1994) Manager's Commission A/c Dr. 467 To Outstanding Manager 467 Commission A/c Closing Entries 194 Trading Account Dr. 50,000 Dec. 31 To Stock Account 7,500 To Purchases Account 41,000 To Return Inwards A/c 1,000 To Freight & Duty A/c 1,000 (Trasfer of balance in the above account to Trading A/c).