Unit - II

Financial Accounting & Analysis
Unit II Journal Entries

A journal entry is an entry into an accounting journal. An accounting journal records accounting transactions as they occur. A journal entry converts accounting transactions into the language of accounting by using debits and credits. Requirements for journal entries All journal entries should satisfy the following requirements: (1) At least one entry on the debit side (2) At least one entry on the credit side (3) um of debit side amounts ! sum of credit side amounts Journals (Preparation of Journal Entries) "he word #$ournal# is derived from the %rench word &jour& meaning #a day#. $ournal' therefore' means a #daily record#. "ransactions are first entered in a boo( called #$ournal# to show which accounts should be debited and which credited along with an e)*lanation of the entry (called #narration#). $ournal entry is any transaction that is recorded in the journal. "he *rocess of recording the transactions in the journal is termed as journali+ing the entries. All transactions are first recorded in the journal as they occur in a chronological order. "his is the first ste* in the accounting *rocess. "he journal is called #,oo( of original entry# as all transactions that occur are first recorded here. "he form of the journal is given below: J UR!A" -ate .articulars /.% -ebit amount 0redit amount
#ate is the date of the transaction
By K.Arjun Goud (Assistant Professor)
Page 1
Particulars$ 1ere the names of the account involved are written. %irst the account to be debited is written and on the ne)t line the account to be credited is written *receded by the word &"o&. "hen in the ne)t line the e)*lanation for the entry together with necessary details is given (called #narration#) %"&F% indicates &/edger %olio& where in the *age number in the ledger on which the account is written u* is recorded. Preparation of journal entries: All the accounting transactions must be first recorded in $ournal. "he recording of transactions in the journal is called journal entry. .re*aration of journal entries involves certain ste*s that are e)*lained below:

Analy+e the transactions and identify the accounts that are affected by the transaction Ascertain the nature of the accounts involved as real' *ersonal or nominal. -etermine the rule of debit or credit a**licable to each of the accounts involved. Ascertain the account to be debited and the account to be credited. 2ow' write the date of transaction in the #-ate# column 3rite the name of the account to be debited and the amount to be debited in debit amount column against the name of the account.
3rite the name of the account to be credited in the ne)t line *receded by the word &"o& at a few s*aces towards the right in *articular column' and the amount to be credited in the credit amount column against the name of the account.
3rite narration (brief descri*tion of the transaction) within brac(ets in the ne)t line in *articular column.
Example: /et us consider the following transactions and *re*are journal entries in the format shown above. i. ii. .urchased goods on credit from 4r. 5 for 6277'777 on 8 $an 2779 old goods to 4r. : for cash 6177'777 on 12 $an 2779
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iii. iv. -ate
.urchased furniture for office *ur*ose 6 27'777 on 2; $an 2779 .aid 6177'777 to 4r. 5 in full settlement of his dues on 37 $an 2779 .articulars /. %2 o -ebit amount 0redit amount
8 $an 2779
.urchases Account "o 4r. 5 Account (,eing *urchase of goods on credit from 4r. 5) 0ash Account "o ales Account (,eing sale of goods to 4r. : for cash) %urniture Account "o 0ash Account (,eing furniture *urchased for cash)
277'777 277'777
12 $an 2779
177'777 177'777 27'777 27'777
2; $an 2779
37 $an 2779
4r. 5 Account "o 0ash Account (,eing *aid 4r. 5 in full settlement of his dues)
177'777 177'777
Illustration$ I $ournali+e the following transactions and *re*are a cash ledger. 1. <am invests <s. 17' 777 in cash. 2. 1e bought goods worth <s. 2777 from shyam. 3. 1e bought a machine for <s. ;777 from /a(shman on account. 8. 1e *aid to /a(shman <s. 2777 ;. 1e sold goods for cash <s.3777 =. 1e sold goods to A on account <s. 8777 >. 1e *aid to hyam <s. 1777 ?. 1e received amount from A <s. 2777
By K.Arjun Goud (Assistant Professor) Page 3
Illustration II $ournali+e the following transactions and *ost them into /edgers $an 1. 0ommenced business with a ca*ital of <s. 17777 '' 2. ,ought %urniture for cash <s. 3777 '' 3. ,ought goods for cash from @,A <s. ;77 '' 8. old goods for cash to A <s. 1777 '' ;. .urchased goods from 0 on credit <s.2777 '' =. Boods sold to - on credit <s. 1;77 '' ?. ,ought machinery for <s. 3777 *aying 0ash '' 12. .aid trade e)*enses <s. ;7 '' 1?. .aid for Advertising to A**le Advertising /td. <s. 1777 '' 19. 0ash de*osited into ban( <s. ;77 '' 27. <eceived interest <s. ;77 '' 28. .aid insurance *remium <s. 277 '' 37. .aid rent <s. ;77 '' 37. .aid salary to . <s.1777
Capital and Revenue Expenditure

C)*enditure on fi)ed assets may be classified into 0a*ital C)*enditure and <evenue C)*enditure. "he distinction between the nature of ca*ital and revenue e)*enditure is im*ortant as only ca*ital e)*enditure is included in the cost of fi)ed asset.
Capital Expenditure
0a*ital e)*enditure includes costs incurred on the acquisition of a fi)ed asset and any subsequent e)*enditure that increases the earning ca*acity of an e)isting fi)ed asset. "he cost of acquisition not only includes the cost of *urchases but also any additional costs incurred in bringing the fi)ed asset into its *resent location and condition (e.g. delivery costs). 0a*ital e)*enditure' as o**osed to revenue e)*enditure' is generally of a oneDoff (ind and its benefit is derived over several accounting *eriods. 0a*ital C)*enditure may include the following:

Purchase costs (less any discount received) Delivery costs
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Legal charges Installation costs Up gradation costs Replace ent costs
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Revenue Expenditure
<evenue e)*enditure incurred on fi)ed assets include costs that are aimed at #maintaining# rather than enhancing the earning ca*acity of the assets. "hese are costs that are incurred on a regular basis and the benefit from these costs is obtained over a relatively short *eriod of time. %or e)am*le' a com*any buys a machine for the *roduction of biscuits. 3hereas the initial *urchase and installation costs would be classified as ca*ital e)*enditure' any subsequent re*air and maintenance charges incurred in the future will be classified as revenue e)*enditure. "his is so because re*air and maintenance costs do not increase the earning ca*acity of the machine but only maintains it (i.e. machine will *roduce the same quantity of biscuits as it did when it was first *ut to use). <evenue costs therefore com*rise of the following:

Repair costs +aintenance charges Repainting costs Rene,al e'penses
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"E#'ER
/edger is the secon(ary )oo* of accounts all business transactions are recorded in the first instance in the journal' but they must find their *lace ultimately in the accounts in the ledger in a duly classified form. "his ledger are also called final entry )oo*. E< "ransferring of all journals in to accounts by using accounting *rinci*les is called ledger. Format of le(ger
Page -
Illustration
Page .
Page /
Page )
Page 0
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I!+R #U,+I ! +
I!+R #U,+I !
FI!A" A,, U!+
All business transactions are first recorded in $ournal or ubsidiary ,oo(s. "hey are transferred to /edger and balanced it. "he main object of (ee*ing the boo(s of accounts is to ascertain the *rofit or loss of business and to assess the financial *osition of the business at the end of the year. "he object is better served if the businessman first satisfies himself that the accounts written u* during the year are correct or at least arithmetically accurate. 3hen the transactions are recorded under double entry system' there is a credit for every debit' when on aFc is debitedG another aFc is credited with equal amount. Hf a tatement is *re*ared with debit balances on one side and credit balances on the other side' the totals of the two sides will be equal. uch a tatement is called "rial ,alance.
+rail -alance
#EFI!I+I !
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"rial ,alance can be defined as Ia list of all balances standing in the /edger Accounts and 0ash ,oo( of a concern at any given timeJ. A(.antages$ 1. Ht is the shortest method of verifying the arithmetical accuracy of entries made in the /edger. Hf the "rial balances agree' it is an indication that the Accounts are correctly written u*G but it is not a conclusive *roof. 2. Ht hel*s to *re*are the "rading AFc' .rofit K /oss aFc and ,alance heet. 3. Ht *resents to the businessman consolidated lists of all /edger ,alances. Preparation: "here are two methods for *re*aring the "rial ,alance First Method: Hn this method' /edger Accounts are not balanced. "hey are totaled. "he debit side totals and the credit side totals are entered in a se*arate sheet. "he grand total of -ebit 0olumn will be equal to the grand total of the 0redit 0olumn. Second Method: "his method is more widely used. Hn this method' ledger accounts are balanced. "he brought down balances are then brought to a sheet as given bellow. Format of t/e +rail )alance Particulars E*ening stoc( .urchases 0arriage inwards 3ages All factory e)*enses 4anufacturing e)*enses %actory rent Hnsurance Eil' water' gas %uel' coal' *ower C)ercise duty #e)it Particulars ,re(it amount 000 000 000 000 000 000 000 000 000 000 in 000 amount 000 ales 000 0ommission received 000 ,ad debts reserve 000 000 000 000 000 000 000 000 Hnterest received 0ommission received Hnterest on drawing -iscount on creditors 0a*ital ,an( loan ,an( over draft Hncome received advances
"rade e)*enses alaries <ent K "a)es Advertising e)*enses ,ad debts Hnsurance <e*airs -iscount allowed 0ommission *aid .rinting K tationary 0ash at ban(
000 000 000 000 000 000 000 000 000 000 000
0reditors ,ills *ayable All other loans 0losing stoc(
000 000 000 000
0ash in hand 000 All manufacturing 000 e)*enses All de*reciations All fi)ed assets All current assets elling e)*enses Beneral e)*enses 000 000 000 000 000 000000 1U!#R2 #E-+ R1 3hen a trader sells on credit basis' "he ,uyerAs Account in the /edger is debited. %or each buyer' there is one /edger aFc. ome of the buyer accounts may be automatically balanced. ,ut it is quite natural that many of these 0ustomerAs Accounts have a debit balances. 3hen we bring these balances to the "rial ,alance' if we are going to write all individual names of customers' then the "rial balance will be too lengthy. "herefore' first a list of -ebtors with their individual debit balances are *re*ared and totaled. Hnstead of writing the individual names of -ebtors' the total is written under the heading I undry -ebtorsJ which a**ears in the "rial ,alance. 1U!#R2 ,RE#I+ R1 "here are a number of *arties from whom the "rader buys goods on credit basis. %or each one of them' an Account is o*ened in the /edger. As in the case of -ebtors' a /ist of 0reditors with the balances due to them is *re*ared. Hn the "rial ,alance' instead of writing the individual names of
000000
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0reditors'' the total of the balances of the creditors is written under the heading I undry 0reditorsJ Hf the "rial ,alance agrees' it is an indication that the accounts are correctly written u*G but it is not a conclusive *roof. Hf the trial balance disagrees' then the difference amount is generally *laced in @ us*ense AccountA Illustration: "he balances e)tracted from the boo(s of ,alance on 31st 4arch 377>. an(arAs 0a*ital 37'777' undry 0reditors 8'777' ales 37'777' 0ash in hand 1'?77' .urchases 27'777' 0ash in ,an( ='777' Hnterest (-r) 877' ,ills <eceivables 11'777' ales returns 1'777' ,ills .ayable >'777' .urchases <eturns ?77' -iscount earned ?77' 1'777' 4isc. Hncome 877 undry -ebtors 1;'777' 3ages >'777' 0ommission (-r) 1'777' <ent ?77' .lant and 4achinery ?'777' "ele*hone charges an(ar are given below. %rom the *re*are "rial
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FI!A" A,, U!+1

o far' we have discussed that how the business transactions are recorded in $ournal' ledger' how to detect' rectify the errors and how to *re*are trial ,alance. Ht is quite natural that the businessman is interested in (nowing whether his business is running on .rofit or /oss and also the true financial *osition of his business. "he main aim of ,oo((ee*ing is to inform the .ro*rietor' about the business *rogress and the financial *osition at the right time and in the right way. .re*aration of %inal accounts is highly *ossible only after the *re*aration of "rial ,alance. Final Accounts %inal accounts are done in three ste*s 1. "rading AFc
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2. .rofit and /oss AFc 3. ,alance sheet 1. "rading and .rofit and /oss AFc is *re*ared to find out .rofit or /oss. 2. ,alance heet is *re*ared to find out financial *osition of 0om*any. "rading and .K/ AFc and ,alance sheet are *re*ared at the end of the year or at end of the *art. o it is called %inal Account. <evenue account of trading concern is divided into twoD*art i.e. 1. "rading Account and 2. .rofit and /oss Account.
+RA#I!' A,, U!+

"rading refers buying and selling of goods. "rading AFc shows the result of buying and selling of goods. "his account is *re*ared to find out the difference between the elling *rices and 0ost *rice. Hf the selling *rice e)ceeds the cost *rice' it will bring Bross .rofit. %or e)am*le' if the cost *rice of <s. ;7'777 worth of goods are sold for <s. =7'777 that will bring in Bross .rofit of <s. 17'777. Hf the cost *rice e)ceeds the selling *rice' the result will be Bross /oss. %or e)am*le' if the cost *rice <s. =7'777 worth of goods are sold for <s. ;7'777 that will result in Bross /oss of <s.17' 777. "hus the Bross .rofit or Bross /oss is indicated in "rading Account. Items appearing in t/e #e)it si(e of +ra(ing Account& 1. E*ening toc(: toc( on hand at the commencement of the year or *eriod is termed as the E*ening toc(. 2. .urchases: Ht indicates total *urchases both cash and credit made during the year. 3. .urchases <eturns or <eturns out words: .urchases <eturns must be subtracted from the total *urchases to get the net *urchases. 2et *urchases will be shown in the trading account. 8. -irect C)*enses on .urchases: ome of the -irect C)*enses are. H. HH. 3ages: Ht is also (nown as *roductive wages or 4anufacturing wages. 0arriage or 0arriage Hnwards:
Page 1.
HHH. HL. L. LH. LHH.
Ectroi -uty: -uty *aid on goods for bringing them within munici*al limits. 0ustoms duty' doc( dues' clearing charges' Hm*ort duty etc. %uel' .ower' /ighting charges related to *roduction. Eil' Brease and 3aste. .ac(ing charges: uch e)*enses are incurred with a view to *ut the goods in the aleable 0ondition.
Items appearing on t/e cre(it si(e of +ra(ing Account 1. ales: "otal ales (Hncluding both cash and credit) made during the year. 2. ales <eturns or <eturn Hnwards: ales <eturns must be subtracted from the "otal ales to get 2et sales. 2et ales will be shown. 3. 0losing stoc(: Benerally' 0losing stoc( does not a**ear in the "rial ,alance. Ht a**ears outside the "rial balance. Ht re*resents the value of goods at the end of the trading *eriod. 1pecimen Form of a tra(ing A3c
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-A"A!,I!'
F +RA#I!' A,, U!+
"he difference between the two sides of the "rading Account indicates either Bross .rofit or Bross /oss. Hf the total on the credit side is more' the difference re*resents Bross .rofit. En the other hand' if the total of the debit side is high' the difference re*resents Bross /oss. "he Bross .rofit or Bross /oss is transferred to .rofit and /oss AFc. ,losing Entries of +ra(ing A3c "rading AFc is a ledger account. 1ence' no direct entries should be made in the trading account. everal items such as .urchases' ales are first recorded in the journal and then *osted to the ledger. "he ame accounts are closed by the transferring them to the trading account. 1ence it is called as closing entries. A(.antages of +ra(ing Account 1. "he result of .urchases and ales can be clearly ascertained 2. Bross .rofit ratio to ales could also be easily ascertained. Ht hel*s to determine .rice. 3. Bross .rofit ratio to direct C)*enses could also be easily ascertained. And so' unnecessary e)*enses could be eliminated. 8. 0om*arison of trading account details with *revious years details hel* to draw better administrative *olicies.
PR FI+ A!# " 11 A,, U!+

By K.Arjun Goud (Assistant Professor) Page 1)
"rading account reveals Bross .rofit or Bross /oss. Bross .rofit is transferred to credit side of .rofit and /oss AFc. Bross /oss is transferred to debit side of the .rofit /oss Account. "hus .rofit and /oss AFc is commenced. "his .rofit K /oss AFc reveals 2et .rofit or 2et loss at a given time of accounting year. Items appearing on #e)it si(e of t/e Profit & "oss A3c "he C)*enses incurred in a business is divided in two *arts. i.e. one is -irect e)*enses are recorded in trading AFc.' and another one is Hndirect e)*enses' which are recorded on the debit side of .rofit K /oss AFc. Hndirect C)*enses are grou*ed under four heads: 1. elling C)*enses: All e)*enses relating to sales such as 0arriage outwards' "ravelling
C)*enses' Advertising etc.' 2. Effice C)*enses: C)*enses incurred on running an office such as Effice alaries' <ent' "a)' .ostage' tationery etc.' 3. 4aintenance C)*enses: 4aintenance e)*enses of assets. Ht includes <e*airs and <enewals' -e*reciation etc. 8. %inancial C)*enses: Hnterest .aid on loan' -iscount allowed etc.' are few e)am*les for %inancial C)*enses. Item appearing on ,re(it si(e of Profit an( "oss A3c& 1. Bross .rofit is a**eared on the credit side of . K /. AFc. 2. Also other gains and incomes of the business are shown on the credit side. 3. "y*ical of such gains are items such as a. Hnterest received' b. <ent received' c. -iscounts earned' d. 0ommission earned.
1pecimen Form
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Illustration .re*are .rofit and /oss Account' from the following balances of 4r. 4urugan for the year ending 31.12.277>.
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Effice rent <s. 3777' .rinting e)*enses <s. 2'277' "a)' Hnsurance <s. 1'877' -iscount received <s. 877' Advertisement <s. 3'=77' <s. 2;'777 alaries <s. ?'777' and tationeries <s. 2'877' -iscount allowed <s. =77' "ravelling e)*enses <s. 2'=77' Bross .rofit transferred from the "rading AFc
-A"A!,E 14EE+
"rading AFc and .rofit K /oss AFc reveals B... or B./ and 2.. or 2./ res*ectively' ,esides the .ro*rietor wants i. "o (now the total Assets invested in business ii. "o (now the .osition of ownerAs equity iii. "o (now the liabilities of business. #EFI!I+I ! "he 3ord @,alance heetA is defined as Ia tatement which sets out the Assets and /iabilities of a business firm and which serves to ascertain the financial *osition of the same on any *articular date.J En the left hand side of this statement' the liabilities and ca*ital are shown. En the right hand side' all the assets are shown. "herefore the two sides of the ,alance sheet must always be equal. 0a*ital arrives Assets e)ceeds the liabilities.
-JE,+I5E1
F -A"A!,E 14EE+$
1. Ht shows accurate financial *osition of a firm. 2. Ht is a gist of various transactions at a given *eriod. 3. Ht clearly indicates' whether the firm has sufficient assents to re*ay its liabilities. 8. "he accuracy of final accounts is verified by this statement ;. Ht shows the *rofit or /oss arrived through .rofit K /oss AFc.
1pecimen format for )alance s/eet
"he ,alance sheet contains two *arts i.e. 1. /eft hand side i.e. the /iabilities 2. <ight hand side i.e. the Assets A11E+1$
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Assets re*resent everything which a business owns and has money value. Assets are always shown as debit balance in the ledger. Assets are classified as follows. 1. +angi)le Assets$ Assets which can be seen and felt by touch are called "angible Assets. "angible Assets are classified into two: a. %i)ed Assets: Assets which are durable in nature and used in business over and again are (nown as %i)ed Assets. e.g. land and ,uilding' 4achinery' "ruc(s' etc. b. %loating Assets or 0urrent Assets: 0urrent Assets are i. 4eant to be converted into cash' ii. 4eant for resale' iii. /i(ely to undergo change e.g. 0ash' ,alance' stoc(' undry -ebtors. 2. Intangi)le Assets$ Assets which cannot be seen and has no fi)ed sha*e. C.g.' goodwill' .atent. 3. Fictitious assets$ Assets which have no real value and will a**ear on the Assets side of ,alance heet. Are (nown as %ictitious assets: C.g. .reliminary e)*enses' -iscount or creditors. "IA-I"I+IE1$ All that the business owes to others are called /iabilities. Ht also includes .ro*rietorAs 0a*ital. "hey are (nown as credit balances in ledger. ,lassification of "ia)ilities$ 1. "ong +erm "ia)ilities$ /iabilities will be redeemed after a long *eriod of time 17 to 1; :ears. C.g. 0a*ital' /ong "erm /oans. 2. ,urrent "ia)ilities$ /iabilities' which are redeemed within a year' are called 0urrent /iabilities or shortDterm liabilities. C.g. "rade creditors' ,F.' ,an( /oan.
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3. ,ontingent "ia)ilities$ /iabilities' which have the following features' are called 0ontingent liabilities. "hey are: i. 2ot actual liability at *resent ii. 4ight become a liability in future on condition that the contem*lated event occurs. C.g. /iability in res*ect of *ending suit. Equation of Balance Sheet: 1. 0a*ital ! Assets M /iabilities 2. /iabilities ! Assets M 0a*ital 3. Assets ! /iabilities N 0a*ital. #IFFERE!,E -E+6EE! A +RIA" -A"A!,E A!# A -A"A!,E 14EE+
Illustration %rom the following trial balance e)tracted from the boo(s of "hiru.Len(atachalam as on 31.12.7>. .re*are (i) "rading and .rofit K /oss AFc and (ii) ,alance heet "rial balance as on 31F12F277>
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toc( as on 31.12.7> to <s. 1' 77'777 1olution$
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Illustration %rom the following trial balance of hri amir ' .re*are "rading aFc' .rofit K loss aFc and ,alance sheet as on that date after ta(ing into consideration the necessary adjustments
.articulars toc( .lant K 4achinery .urchases "rade charges 0arriage inwards 0arriage outwards %ctory rent -iscount Hnsurance undry debtors Effice rent .rinting K stationary "ravelers salaries Advertising ,ills receivable -rawings alaries 3ages %urniture 0oal and gas 0a*ital By K.Arjun Goud (Assistant Professor) -ebit (<s) 8;777 >;777 22;777 17777 2;77 1;77 1;77 3;7 >77 =7777 3777 =77 2?77 1;777 =777 =777 1;777 27777 >;77 1777 0redit (<s)
>;777 Page 2.
Financial Accounting & Analysis 0reditors ales ,ad debts *rovision ,ills *ayable 0ash in hand 0ash at ban( 1;777 827>;7 277 2777 2777 12;77 789:7; 789:7;
A((itional Information H. HH. HHH. HL. L. 0losing stoc( amounted to <s. 3;777 -e*reciate machinery by 17O K %urniture by ;O <aise the bad debts *rovision to ;O on debtors Eutstanding factory rent <s. 377 K Effice rent <s.=77 Hnsurance *re*aid <s.177
1olution $
#r Particulars "o stoc( "o *urchases "o carriage inwards "o factory rent (N) Eutstanding "o wages "o gross *rofit
"rading account of shir hamir

,r Amount Amount 8;777 22;777 2;77 1;77 377 1?77 27777 1=18;7 8;;>;7 8;;>;7 Particulars ,y sales ,y closing stoc( Amount Amount 827>;7 3;777
.rofit K /oss account of shir hamir

#r Particulars ,y trade e)*enses ,y carriage outwards Amount Amount 17777 1;77 Particulars ,y Bross .rofit Amount ,r Amount 1=18;7
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Financial Accounting & Analysis ,y discount ,y insurance ,y office rent (N) outstanding ,y *rinting K tationary ,y travelers salaries ,y advertising ,y drawings ,y salaries "o coal K Bas "o de*reciation on .lant K 4achinery "o de*reciation on %urniture "o *re*aid Hnsurance "o badDdebts *rovision "o net *rofit 3777 =77 3=77 =77 2?77 1;777 =777 1;777 1777 >;77 3>; 177 3777 9812; 1=1=;7 1=1=;7 3;7 >77 ,y *rovision on bad debts 3277
,alance sheet of hir hamir /iabilities Amount 0a*ital >;777 (N) 2et .rofit 9812; ,ills *ayable undry creditors Eutstanding factory rent Eutstanding office rent Amount 1=912; 2777 1;777 377 =77 Assets .lant K 4achinery (D) -e*reciation undry debtors (D) .rovision for ,ad debts ,ills receivable %urniture (D) -e*reciation .re*aid Hnsurance 0ash in hand 0ash at ban( 0losing stoc( Amount >;777 >;77 =7777 3277 Amount =>;77 ;=?77 =777
>;77 3>;
>12; 177 2777 12;77 3;777 1?>72;
1?>72;
Page 2)
#epreciation
-efinition: -e*reciation means fall in the value of an asset. According to *ic(les I-e*reciation may be defined as the *ermanent and continuous diminution in the quality' quantity or value of an assetJ. According to American institute of certified *ublic accountants (AH0.A) I-e*reciation accounting is a system of accounting which aims to distribute the cost or other basic value of tangible ca*ital assets' less salvage value (if any)' over the estimated useful life of the unit (which may be a grou* of assets) in and rational manner. Ht is a *rocess of allocation' not of valuation. -e*reciation for the year is *ortion of the total charge under such a system that is allocated to the yearJ. ,/aracteristics of (epreciation 1) -e*reciation is a gradual' *ermanent and continuous decrease in the utility value of a fi)ed asset 2) -e*reciation is a *rocess of allocation of the cost to the *eriod of its life and not a valuation of fi)ed assets 3) -e*reciation is not a substitute for re*airs but it is *rovided for in addition to the re*airs and maintenance 8) -e*reciation arises due to use of assets in *roductive activities ;) -e*reciation is based on cost of asset and not on the mar(et value of the fi)ed assets =) -e*reciation is charged in res*ect of fi)ed assets >) -e*reciations is charge against *rofit ?) "otal de*reciation of an asset cannot e)ceed its de*reciable value (0ost less scra* value) Reasons for c/arging (epreciation or o)jects of c/arging (epreciation 1) "o allocate de*reciable cost
2) "o ascertain true and fair *rofit or loss 3) "o show correct financial *osition 8) "o *rovide funds for re*lacement ;) "o com*ute ta) liability ,auses of (epreciations 1) 3ear and tear due to constant use 2) Cfflu) of time 3) Ebsolescence 8) C)haustion <et/o(s of pro.i(ing (epreciation "here are different methods *roviding de*reciation. "he main methods are as follows 1) %i)ed installment method or installments method 2) -iminishing balance method 3) Annuity method 8) -e*reciation fun method or sin(ing fund method traight line method or original cost method or equal
1traig/t line met/o(

Fi0e( installment met/o( or 1traig/t line met/o( or original cost met/o( or equal installments met/o($ under this method a fi)ed *ercentage on original cost of asset is written off every year so as to reduce the asset account to nil or its scra* value at the end of the estimated life of the asset. Ht is calculated as
2riginal 3ost 4 5sti ated scrap value 5sti ated li%e o% the asset Page 31
Ht may also be e)*ressed as a fi)ed *ercentage of the original cost. 3hile calculating de*reciation for a *articular year the *eriod for which the asset is used in the year concerned should also be ta(en in account E0ample$ u**ose an asset is *urchased for <s. 117777 it has an estimated life of 17 years and its estimated scra* value after 17 years is <s. 17777' then annual de*reciation will be
111111 4 11111 11 6 11111
Illustration 8$ A firm *urchased .lant K 4achinery on 1st a*ril 2778 for <s. 177777. -e*reciation is written off at the rate of 17O *er annum under straight line method. "he firm closes its boo(s on 31st -ecember every year. how the machinery account for 3 years. 1olution$ 0alculation of de*reciation for the first year :
111111 ' 11 111 ' 0 6 /-11 12
0alculation of the de*reciation for the second year

111111 ' 11 11111 111 ' 12 6 12
0alculation of the de*reciation for the third year

111111 ' 11 11111 111 12 ' 12 6
<ac/inery account -r #ate 1F78F2778 0r Amount >;77 92;77 17777
Particular "o cash
Amount 177777 177777
#ate 31F12F2778 31F12F2778
Particular ,y -e*reciation ,y balance cFd
Page 31
1F71F277;
"o ,alance bFd
92;77 92;77
31F12F277; 31F12F277;
,y -e*reciation ,y balance cFd ,y -e*reciation ,y balance cFd
17777 ?2;77 92;77 17777 >2;77 ?2;77
1F71F277=
"o ,alance bFd
?2;77 ?2;77
31F12F277; 31F12F277;
1F71F277=
"o ,alance bFd
>2;77
Illustration 9 $ A truc( was *urchased for <s.?7777. the life of the truc( is estimated at 17 years and the residual value at <s.1;777. calculate the amount of de*reciation to be *rovided according to the straight line method 1olution$ -e*reciation is
3ost o% the asset 7 residual value 4 scrap value 8o o% esti ated years )1111 7 1-111 ! 1 0-11 11 6
#iminis/ing -alance met/o(

"his method is also (nown as @written -own Lalue 4ethodA or <educing Hnstallment methodA. Pnder this method de*reciations charged at fi)ed rate of the reducing balance of the asset every year. E0ample Hf the cost of an asset is <s. 177777 and if the rate of de*reciation is 17O *er annum. "hen in the first year de*reciation will be 17O on <s. 177777 i.e' <s.17777: in the second year 17O on the <s.97777 (<s.177777 M <s.17777) i.e' <s.9777 and in third year17O on the <s.?1777 (<s.97777 M <s.9777) i.e' <s.?177. though the *ercentage at which de*reciation is charged remains fi)ed' the amount of de*reciation goes on decreasing year after year. Formula for calculating t/e rate of (epreciation is as follo=$ <ate of de*reciation !
3here n ! number of years of assets life Accounting +reatment$ 1. 3hen the asset is *urchased:
9sset 9$c ::::::::::::::: Dr
2. Hnstallation charges' reconditioning or overhauling e)*enses incurred on second hand machine should also be charged to the asset account. "he entry is
9sset 9$c ::::::::::::::: Dr
3. %or *roviding de*reciation at the end of the year:

Depreciation 9$c ::::::::::::::: Dr ;o Ban< 9$c
!ote$ Hf the asset is sold' de*reciation should be calculated u* to the date of sale of the asset 8. %or transfer of de*reciation to *rofit and loss account:
Pro%it = Loss 9$c ::::::::::::::: Dr ;o Depreciation Ban< 9$c ::::::::::::::: Dr ;o asset 9$c Pro%it = Loss 9$c ::::::::::::::: Dr ;o 9sset 9$c
;. %or the amount reali+ed on the sale of asset
=. %or the loss on the sale of asset
Illustration 8& A com*any *urchased second hand machinery on 1st $anuary 1997 for <s.38777 and immediately s*ent for its re*airs and erections <s.=777. on 1 st Ectober 1997' it *urchased
another machine for <s. 27777 and on 1 st A*ril 1991 it sold off the first machine (.urchased on 1st $anuary 1997) for <s. 32777. En the same date it *urchased a new machine for <s. ;7777. En 1st july 1992 it bought a new machine for 27777. En the same date it sold the second machine *urchased on Ectober 1997 for <s.1>;77. -e*reciation was charged at 17O on the written down value method or diminishing value method and accounts were closed on 31 st -ecember every year. .re*are machinery account from 1997 to 1992. 1olution$ -r #ate 1F71F1997 1F17F1997 <ac/inery Account 0r Amount 8777 ;77 ;;;77 =7777 1277 32777 2?77 19;7 3>;7 =3?77 17;;77 131=.2; 1>;77 8=2; 1777 =7=2; ?;7==.2;
Particular "o cash (4DH) "o Crection (4DH) "o cash (4DHH)
Amount 38777 =777 27777 =7777 ;;;77
#ate 31F12F1997 31F12F1997
Particular ,y -e*reciation (4DH) ,y -e*reciation (4DHH) ,y balance cFd
1F71F1991
"o balance bFd 4DH !3=777 4DHH ! 19;77
1F78F1991 1F78F1991 1F78F1991
,y -e*reciation (4DH) ,y sale (4DH) ,y .K/ (/oss) ,y -e*reciation (4DHH) ,y -e*reciation (4DHHH) ,y balance cFd "o -e*reciation (4DHH) "o sale (4DHH) "o -e*reciation (4DHHH) "o -e*reciation (4DHL) "o balance cFd
1F78F1991
"o cash (4DHHH)
;7777
31F12F1991 31F12F1991 31F12F1991
1F71F1992
"o balance bFd 4DHH 1>;;7 4DHHH 8=2;7
17;;77 =3?77
1F7>F1992 1F7>F1992 31F12F1992 31F12F1992 31F12F1992
1F7>F1992 1F7>F1992 1F71F1993
"o .K/(.rofit on 12==.2; 4DHH) "o cash (4DHL) "o balance bFd 27777 ?;7==.2; =7=2;
6or*ing notes$ 0alculation of de*reciation for first machine (*urchased on 1 st $anuary 1997) for the 1997 year :
(341117.111) ' 11 111 ' 12 6 4111 12 Page 34
0alculation of the de*reciation for the second machine (.urchased on 1st Ectober 1997) for the 1997 year
21111 ' 11 111 ' 3 6 -11 12
0alculation of de*reciation for first machine (*urchased on 1 st $anuary 1997) for the 1991 year :
3.111 ' 11 111 ' 4 6 1211 12
0alculation of the de*reciation for the second machine (.urchased on 1st Ectober 1997) for the 1991 year
10-11 ' 11 10-1 111 12 ' 12 6
0alculation of the de*reciation for the third machine (.urchased on 1st A*ril 1991) for the 1991 year
-1111 ' 11 3/-1 111 12 ' 10 6
0alculation of the de*reciation for the second machine (.urchased on 1 st Ectober 1997) for the 1992 year
1/--1 ' 11 131.&2111 12 ' 10 6
0alculation of the de*reciation for the third machine (.urchased on 1st A*ril 1991) for the 1992 year
4.2-1 ' 11 4.2111 12 ' 12 6
0alculation of the de*reciation for the fourth machine (.urchased on 1 st $uly 1992) for the 1992 year
21111 ' 11 1111 111 12 ' 1. 6
Illustration 9$ Bood luc( /td *urchased on 1st $anuary 199>' certain machinery for <s. 198777 K s*ent <s. =777 on its erection. En 1 st $uly 199> additional machinery costing <s. 177777 was *urchased. En 1st $uly 1999 the machinery *urchased on 1st $anuary 199> has been auctioned for <s. 177777 and on the same date' new machinery was *urchased at a cost of <s. 1;7777. -e*reciation was *rovided annually on 31st -ecember at the rate of 17O ..A. on the original
Page 3-
cost. -e*reciation should not ta(e for the sale year of the machinery for that *art of the year when the machine was used. Hn 2771' however' the com*any has charged the method of de*reciation to written down value method at the rate of 1;O from the straight line method. how the machinery account for the five year *eriod from 199> to 2771.
Accounting treatment =/en Pro.ision for #epreciation Account is maintaine( Pnder this method a se*arate account called @.rovision for -e*reciationA is maintained. "he entry for *roviding de*reciation will be:
Depreciation 9$c ::::::::::::::: Dr ;o Provision %or Depreciation 9$c
Pnder this method' asset account a**ears at the original cost of the asset and de*reciation written off every year is accumulated in a se*arate account called @.rovision for -e*reciation AFc. in ,alance sheet the asset account will a**ear at original cost less .rovision for -e*reciation (accumulated de*reciation) on the assets side. Alternatively' asset account could be shown at original cost on the assets side and *rovision for -e*reciation account on the liabilities side. Hf the asset is sold' the credit balance in the *rovision for -e*reciation account will be transferred to the credit side of asset account and then *rofit or loss on the sale of asset will be ascertained.
Annuity met/o(
"his method is based on the *rinci*le that when an asset is used in a business' the total loss of the business during the life of the asset is not only the original cost of the asset' but also the interest on the amount invested in acquiring the asset. "herefore' under this method' not only the original cost of the asset' but also the interest on the money invested in the asset is written off as de*reciation over the life time of the asset. Hn this method' definition of the cost (or de*reciable amount) is changed. "he de*reciable amount is original cost (*lus installation charges' if any) *lus loss on interest on the une)*ired
Page 3.
balance of the asset every year. "he total de*reciation charged to *rofit and loss account is more than cost of the asset. Cvery year asset account is debited and interest account credited at a fi)ed rate on the o*ening balance of the asset. "he interest credited will not be constant or fi)ed every year. -e*reciation is charged on the asset every year by debiting de*reciation account and crediting asset account. "he amount of de*reciation to be charged every year will be fi)ed or constant. Ht is to be ascertained on the basis of annuity table. "he amount of de*reciation de*ends u*on the rate of interest and the *eriod over which asset is to be written off. "he amount of de*reciation is so adjusted that at the end of the wor(ing life of the asset its boo( value is reduced to +ero or its scra* value' if any. Illustration 8$ A lease is *urchased on 1D1D199; for the *eriod of ; years for a *eriod of ; years for <s. 87777. Ht is *ro*osed to de*reciate the lease by the annuity method charging ;O interest. As *er annuity tables 7.2379>; is to be written off every year to write off one ru*ee in five years at ;O interest. .re*are lease account for five years. 1olution$ -r -ate 1F71F199; 31F12F199; 1F71F199= 31F12F199= 1F71F199> 31F12F199> 1F71F199? 31F12F199? 1F71F1999 31F12F1999 "ease Account 0r .articular "o ban( "o interest "o balance bFd "o interest "o balance bFd "o interest "o balance bFd "o interest "o balance bFd "o interest Amount 87777 2777 82777 32>=1 1=3?.7; 38399.7; 2;1=7.7; 12;?.77 2=81?.7; 1>1>9.7; ?;?.9; 1?73? ?>99 887 9239 -ate 31F12F199; 31F12F199; 31F12F199= 31F12F199= 31F12F199> 31F12F199> 31F12F199? 31F12F199? 31F12F1999 .articular ,y -e*reciation ,y balance cFd ,y -e*reciation ,y balance cFd ,y -e*reciation ,y balance cFd ,y -e*reciation ,y balance cFd ,y -e*reciation Amount 9239 32>=1 82777 9239 2;1=7.7; 38399.7; 9239 1>1>9.7; 2=81?.7; 9239 ?>99 1?73? 9239 9239
6or*ing notes
Page 3/
0alculation of de*reciation ! lease amount ) annuity table value ! 87777 ) 7.2379>; ! 9239 0alculation of interest for the first year ! 87777 ) ;F177 ! 2777 0alculation of interest for the second year ! 32>=1 ) ;F177 ! 1=3?.7; 0alculation of interest for the third year ! 2;1=7.7; ) ;F177 ! 12;? 0alculation of interest for the fourth year ! 1>1>9.7; ) ;F177 ! ??;?.9; 0alculation of interest for the fifth year ! ?>99 ) ;F177 ! 887
#epreciation fun( met/o( or 1in*ing fun( met/o(

Pnder this method not only de*reciation is charged on the asset' but *rovision is also made for the *urchase of a new asset at the end of the life of the old asset. "he amount written off as @-e*reciationA every year is (e*t aside and invested in easily reali+able securities are also invested. "hus the securities accumulated at com*ound interest. At the end of the life of the old asset the securities are sold and a new asset is *urchased with the sale *roceeds. "he amount of de*reciation to be *rovided every year is constant or fi)ed. Ht is to be ascertained with reference to sin(ing fund tables. "he asset is shown in the balance sheet' every year' at its original value. in(ing fund is shown on the liabilities side and sin(ing fund investments are shown on the assets side of the balance sheet. Accounting treatment First year (at the end)$ 1. %or *roviding annual de*reciation
Depreciation account :::::::::: Dr
2. %or investing the amount of de*reciation

Depreciation %und invest ent a$c By :::::::::: K.Arjun Goud (Assistant Professor) Dr ;o Ban<
Page 3)
!ote$ -e*reciation account will be transferred to *rofit and loss account. -e*reciation fund account will a**ear on the liabilities side and de*reciation fund investment account on the assets side of the balance sheet. "he asset account will a**ear in the balance sheet at the original cost. 1u)sequent years$ 1. %or interest received and credited to de*reciation fund
Ban< account :::::::::: Dr ;o depreciation %und a$c
!ote$ Cvery year interest should be calculated on the o*ening balance of -e*reciation fund investment account. 2. %or annual installment of de*reciation
Depreciation a$c :::::::::: Dr ;o depreciation %und a$c
3. %or the amount of de*reciation and interest earned invested in securities

Depreciation %und invest ent a$c :::::::::: Dr ;o Ban< a$c
"ast year$ 1. %or interest received on investments

Ban< a$c :::& :::::::::: Dr ;o Depreciation %und a$c
2. %or annual installment of de*reciation

Depreciation a$c :::::::::: Dr ;o Depreciation %und a$c Page 30
3. %or sale of investments

Ban< a$c :::::::::: Dr ;o Depreciation %und invest ent a$c
8. %or *rofit on sale of investment

Depreciation %und invest ent a$c :::::::::: Dr ;o Depreciation %und a$c
!ote$ Hn case of loss' the above entry is reversed ;. %or transfer of the asset
Depreciation %und a$c :::::::::: Dr ;o 9sset a$c
=. %or transfer of credit balance in the fund account

Depreciation %und a$c :::::::::: Dr ;o Pro%it = Loss a$c
!ote$ Hn case of debit balance' the above entry is reversed. >. %or *urchase of new asset
9sset a$c ::::::::::::: Dr ;o Ban< a$c
Illustration 8$ En 1st $anuary 2777 a lease was *urchased for <s. 87777. Ht is to be re*laced at the end of 8 years. Ht is e)*ected that investments will yield a net interest of 8O *.a. A -e*reciation fund is established to collect the necessary amount. in(ing fund tables show that to get <e.1 at the end
Page 41
of 8 years at the rate of 8O *.a. an annual amount of <e. 7.23;897 is necessary' investments are mad to the nearest ru*ee. En 31st -ecember 2773 the firm has a balance of 27777 (after receiving the interest on investments). "he de*reciation fund investments reali+ed <s. 29;77. "he new lease cost <s. 8;777. how the necessary ledger accounts. 1olution$ #epreciation fun( account
-r -ate 31F12F2777
0r .articular "o balance cFd Amount 9819.=7 9819.=7 -ate 31F12F2777 .articular ,y -e*reciation aFc Amount 9819.=7 9819.=7 1F71F2771 31F12F2771 31F12F2771 19121= 29878.28 ,y balance bFd ,y interest de*reciation fund ,y -e*reciation aFc 9819.=7 19121= 1921= on >=?.=8 9819.=7 29878.28 29878.28 on 11>=.1= 9819.=7 9=.77 8779=.77 9819.=7 on 3>=.?7
31F12F2771
"o balance cFd
1921=
31F12F2772
"o balance cFd
1F71F2772 31F12F2772 31F12F2772
,y balance bFd ,y interest de*reciation fund ,y -e*reciation aFc
31F12F2773 31F12F2773
"o lease aFc "o .K/ aFc (balance transferred)
29878.28 877777 9=
1F71F2773 31F12F2773 31F12F2773 31F12F2773
,y balance bFd ,y interest de*reciation fund ,y -e*reciation aFc ,y -e*reciation fund investment aFc
8779=.77
Page 41
#epreciation fun( in.estment account -r -ate 71F71F2777 0r .articular "o ban( aFc Amount 9827 9827 71F71F2771 31F12F2771 71F71F2772 31F12F2772 71F71F2773 31F12F2773 "o balance bFd "o ,an( "o balance bFd "o ,an( "o balance bFd "o de*reciation fund aFc (.rofit transferred) 29;77 #epreciation account -r -ate 31F12F2777 0r .articular "o Amount -ate 31F12F2777 .articular ,y .rofit K /oss aFc Amount 9819.=7 9819.=7 31F12F2771 ,y .rofit K /oss aFc 9819.=7 9819.=7 31F12F2772 ,y .rofit K /oss aFc 9819.=7 9819.=7 31F12F2773 ,y .rofit K /oss aFc 9819.=7 9819.=7 -e*reciation 9819.=7 9819.=7 29;77 9827 9>9= 19121= 19121= 171?? 29878 29878 9= 31F12F2771 ,y balance cFd -ate 31F12F2777 .articular ,y balance cFd Amount 9827 9827 1921= 19121= 29878 29878 29;77
31F12F2772
,y balance cFd
31F12F2773
,y ban(Dsale *roceeds
fund aFc 31F12F2771 "o
-e*reciation 9819.=7 9819.=7
-e*reciation 9819.=7 9819.=7
-e*reciation 9819.=7 9819.=7
fund aFc
!ote$ "he annual amount to be transferred to de*reciation fund is 7.23;897 ) 87777 ! <s. 9819.=7
"ease account -r -ate 71F71F2777 0r Amount 87777 87777 31F12F2771 ,y balance cFd 87777 87777 31F12F2772 ,y balance cFd 87777 87777 31F12F2773 ,y -e*reciation fund aFc 87777 ("ransfer to fund account)
.articular "o ,an(
Amount 87777 87777
-ate 31F12F2777
.articular ,y balance cFd
71F71F2771
"o ,alance bFd
87777 87777
71F71F2772
"o ,alance bFd
87777 87777
71F71F2773
"o ,alance bFd
87777
87777
87777
-an* account -r -ate 31F12F2773 0r .articular "o balance bFd investment aFc 71F71F2771 "o balance bFd 89;77 8;77 Amount 27777 -ate 31F12F2773 31F12F2773 .articular Amount ,y lease (2ew 8;777 Account) ,y balance cFd 8;77 89;77
"o de*reciation fund 29;77
I!5E!+ R2 5A"UA+I ! <E+4 #1

I!+R #U,+I !$ ,y definition' inventory is the term used to describe the assets of a company that are intended for sale in the ordinary course of business, are in the process of being produced for sale, or are to be used currently in producing goods to be sold. (0hasteen' %laherty' K E#0onnor' 19?9)
Page 43
Hnventory in a business is a list of goods or *roducts that is held in stoc(. Ht ta(es a lot of time to (ee* inventory' but failure to do so could result in major financial disasters. -e*ending on the si+e of your business' there are *eo*le whose sole job is to (ee* trac( of inventory. Hn a small business' this would not have to be their only tas(.
Treatment in Financial Statement: Hnventory is converted into cash within the com*anyAs o*erating cycle and' therefore' is regarded as a current asset. Hn the balance sheet' inventory is listed immediately after Accounts Receivable, because it is just one ste* farther removed from conversion into cash than customer receivables. ,eing an asset' it is shown in the balance sheet at its cost. As items are sold from this inventory' their costs are transferred into cost of goods sold, which is offset against sales revenue in the income statement. (4eigs' 3illiams' 1a(a' K ,ettner' 1999) 1aving no inventory or having wrong inventory can lead to many *roblems. ,ecause inventory is reflected in the com*anyAs boo(s' a business owner may ma(e decisions based on the inventory numbers he sees in the boo(s. Hf the number is wrong' he just made a wrong decision that could be costly. Hn order to *revent this from ha**ening in your business' there are ways to (ee* *ro*er inventory that any si+ed business can use. (Hnventory and its Hm*ortance' 2779) Classifyin In!entories: Hnventories can be classified according to ty*e of business: 1. <erc/an(ise In.entory$ merchandise available of hand and available for sale to customers. %or e.g.: canned foods, meats, dairy products etc. Htems in the merchandise inventory have two common characteristics: a$ they are owned by the com*any )$ they are in the form ready for sale to customers in the ordinary course of business.
Page 44
Hnventory sold becomes the cost of merchandise sold. Ht is the readyDtoDsell inventory of merchandising firms. 2. <anufacturing In.entory$ merchandise that needs to be *roduced in order to sell is called manufacturing inventory. Although *roducts may differ' manufacturers normally have three inventory accounts' each of which is associated with a stage of the *roduction *rocess: raw materials inventory, work-in-process inventory, finished goods inventory. a. Ra= <aterials In.entory$ Ht consists of goods and materials that ultimately will become *art of the manufactured *roduct but have not yet entered the *roduction *rocess. %or e)am*le' the raw materials of an automobile manufacturer generally include sheet metal' nuts' bolts' and *aint. b. 6or*>In> Process In.entory$ Ht consists of units in the *roduction *rocess that require additional wor( or *rocessing before becoming finished goods. c. Finis/e( 'oo(s In.entory$ Ht consists of units that have been com*leted and are available for sale at the end of the accounting *eriod. (0hasteen' %laherty' K E#0onnor' 19?9) I!5E!+ R2 5A"UA+I !$ Boods sold (or used) during ac accounting *eriod seldom corres*ond e)actly to the goods bought (or *roduced) during that *eriod. As a result' inventories either increase or decrease during the *eriod. 0om*anies must then allocate the cost of all the goods available for sale (or used) between the goods that were sold or used and those that are still on hand. "he cost of goods available for sale or use is a sum of 1. "he cost of goods on hand at the beginning of the *eriod. 2. "he cost of goods acquired of *roduced during the *eriod. "he cost of goods sold is the difference between the cost of goods available for sale during the *eriod and the cost of goods on hand at the end of the *eriod. Laluing inventories can be com*le). Ht requires determining the following:
Page 4-
1. "he *hysical goods to include in inventory (who owns the goods M goods in the transit' consign goods' s*ecial sales agreements). 2. "he cost to include in inventory (*roduct vs. *eriod cost) 3. "he cost flow assum*tions to ado*t (s*ecific identification' average cost' %H%E' /H%E' retail' etc.). (Qieso' 3eygandt' K 3arfield' 2778)
I!5ER+ R2 5A"UA+I ! <E+4 #1$

"here are three methods of valuation of inventories under the accounting systems based on the ty*e and nature of *roducts. 1. %irstDHnD%irst Eut (%H%E) 2. /astDHnD%irst Eut (/H%E) 3. Average 0ost 4ethod (AL0E)
a" FI#ST$I%$FI#ST &'T MET(&) *FIF&+: "he %H%E method assumes that a com*any uses the goods in the order in which it *urchases them. Hn other words' the %H%E method assumes that the first goods *urchased are the first used (manufacturing concern)' or the first sold (in a merchandising concern). "he inventory remaining must therefore re*resent the most recent *urchases. (Qieso' 3eygandt' K 3arfield' 2778) %H%E often *arallels the actual *hysical flow of merchandise because it generally is good business *ractice to sell the oldest units first. "hat is' under %H%E' com*anies obtain the cost of ending inventory by ta(ing the unit cost of the most recent *urchase and wor(ing bac(wards until all units of inventory have been costed. (Qimmel' 3eygandt' K Qieso' 277>) "his is true whether a com*any com*utes cost of goods sold as it sells goods throughout the accounting *eriod (perpetual system) or as a residual at the end of the accounting *eriod (periodic system).
Example: ;he e'a ple >elo, illustrates this approach& By K.Arjun Goud (Assistant Professor)
Page 4.
#ate
Receipts ?uan Unit tity ,ost
Amount
Issues ?u Unit ,ost anti ty
Amoun t
-alance ?ua Unit ,ost ntity
Amount
Jan>;: <ar>89 <ar>87 Jun>;@ Aug>;7 ct>;9
87 ;7 D 177 D 187
3 ; D > D 9
127 2;7 D >77 D 12=7
D D ?7 D 17; D
D D 87 R ; 87 R 3 D 17 R ; 9; R > D
D D 327 D >1; D
87 97 17 117 ; 18;
3 87 R 3 ;7 R ; ; 17 R ; 177 R > > ;R> 187 R 9 ;R> 187 R 9 277 R 12
127 3>7 ;7 >;7 3; 129;
!o.>;A
277
12
2877
D ;R>
38;
3=9;
D #ec>A;
+ +A"
D D
D D
327 D
187 R 9 1>; R 12 D
339; BBA;
2; D
12 D
377 A;;
3ost o% ?ood "old
Balance "heet as an (ending) inventory
," -.ST$I%$FI#ST &'T MET(&) *-IF&+: "he /H%E method assumes the cost of the total quantity sold or issued during the month comes from the most recent *urchases. "hat is' the latest goods *urchased are the first to be sold. /H%E coincides with the actual *hysical flow of inventory. "he method matches the cost of the last goods *urchased against revenue. Pnder the /H%E method' the costs of the latest goods
Page 4/
*urchased are the first to be recogni+ed in determining the cost of goods sold. "he ending inventory is based on the *rices of the oldest units *urchased. 0om*anies obtain the cost of the ending inventory by ta(ing the unit cost of the earliest goods available for sale and wor(ing forward until all units of inventory have been costed. (Qimmel' 3eygandt' K Qieso' 277>) E0ample $ "he e)am*le given above' when solved using /H%E will give a different result. Receipts
#ate ?uantity Unit Amou ,ost nt
Issues
?uan tity Unit ,ost Amo unt
-alance
?ua ntity Unit ,ost Amount
Jan>;: <ar>89 <ar>87 Jun>;@ Aug>;7 ct>;9
87 ;7 D 177 D 187
3 ; D > D 9
127 2;7 D >77 D 12=7
D D ?7 D 17; D
D D ;7 R ; 37 R 3 D 177 R > ;R3 D
D D 387 D >1; D
87 97 17 117 ; 18;
3 87 R 3 ;7 R ; 3 17 R 3 177 R > 3 ;R3 187 R 9 ;R3 187 R 9 277 R 12 ;R3 27 R 9 D
127 3>7 37 >37 1; 12>;
!o.>;A
277
12
2877
D 277 R 12 127 R 9 D
38;
3=>;
#ec>A;
D D
D D
327 D
38?7 B7A7
2; D
+ +A" D
8:7 8:7
3ost o% ?oods "old
Balance "heet as an (ending) inventory
c" /EI0(TE) .1E#.0E C&ST MET(&) */.1C&+
Page 4)
Pnder the average cost method' the costs of goods are equally divided' or averaged' among the units of inventory. Ht is also called the weighted average method. 3hen this method is used' costs are matched against revenue according to an average of the unit of cost of goods sold. "he same weighted average unit costs are used in determining the cost of the merchandise inventory at the end of the *eriod. %or businesses in which merchandise sales may be made u* of various *urchases of identical units' the average method a**ro)imates the *hysical flow of goods.
;his ethod is deter ined >y dividing the total cost o% the units o% each ite availa>le
%or sale during the period >y the related nu >er o% units o% that ite & (@arren = ReeveA 2114)
Receipts #ate Jan>;: ?uantity 87 Unit ,ost 3 ; D > D 9 12 D D Amount 127 2;7 D >77 D 12=7 2877 D D
Issues ?uantity D D ?7 D 17; D D 327 D Unit ,ost D D 8.1 D =.>3 D D 17.> D Amount D D 32? D >7> D D 3828 BB7:
-alance ?uantity 87 97 17 117 ; 18; 38; 2; D Unit ,ost 3 B&8 8.1 C&@A =.>3 D&:9 8;&@ 17.> D Amount 127 3=9 81 >87 38 1293 3=92 2=? 9CD
<ar>89 ;7 <ar>87 D Jun>;@ Aug>;7 ct>;9 !o.>;A #ec>A;

+ +A"
177 D 187 277 D D
It is also re%er as ,eighted average cost& 9verage Unit 3ost 6 ;otal a ount ;otal Buantity ;here%ore# 41 C 3 6 121 -1 C - 6 2-1 01 3/1 6 4.1 (taking values as on January 9th) 9verage Unit 3ost 6 41 7 /11 6 6.73 111 9verage Unit 3ost 6 34 7 12.1 6 .9! By 14K.Arjun Goud (Assistant Professor) 9verage Unit 3ost 6 1203&4 7 2411 6 1".7 343ost o% ?ood "old Balance "heet as (ending) inventory
Page 40
, <PARI1 ! -E+6EE! +4E <E+4 #1 a& FIF .d!anta es and )isad!anta es
F I!5E!+ R2 5A"UA+I !
A#5A!+A'E1 0onfirms to the actual flow of inventory items im*le assum*tion for valuation of inventory
#I1A#5A!+A'E %ails to match current costs against current revenues on income statement 0om*any charges the oldest costs against the more current revenue' distorting gross *rofit and net income 1igher revenues leads to higher ta) *ayments "he matching of old' com*aratively low acquisition costs against higher sales revenue
0om*aratively ine)*ensive to use /ess subject to management mani*ulation
can give an inflated net income <e*orts somewhat higher *rofits by assigning Ht ignores the cost of re*lacing inventory at lower (older) costs to cost of goods sold in case higher *rices (during rising *rices)' of rising *rices Assets in balance sheet closely a**ro)imate its it leads to misleading figures *robably for current re*lacement costs A com*any cannot *ic( a certain cost item to charge to e)*ense Cnding inventory is close to current costs Hnventory *urchases. consistent with most recent investors' giving figures of inventory the com*any doesnAt have
)& "IF
.d!anta es and )isad!anta es
A#5A!+A'E #I1A#5A!+A'E 4atches most recent inventory costs against /ower *rofits re*orted during inflationary
Page -1
sales revenue
times serve for managers as a distinct
disadvantage <e*orted income is more li(ely to a**ro)imate 4ay have a distorting affect of com*anyAs the amount that really is available for balance sheet' which is usually outdated distributors or owners because oldest costs remain in inventory' ma(ing wor(ing ca*ital *osition of the com*any a**ear worse than reality ,y giving low net income during rising *rices' -oes not a**ro)imate the *hysical flow of the it actually defers income ta)es items e)ce*t in s*ecific situations 0ost flow often a**ro)imates the *hysical Ht may match old' irrelevant costs against flow of the goods in and out of inventory current revenues' distorting net income 4atches current revenues to better measure of 4ay cause *oor buying habits M *urchase more current earnings goods against revenue to avoid charging the old cost to e)*ense %uture *rice declines do not affect com*anyAs 2et income can be altered by sim*ly altering future re*ort earnings its *attern of *urchases
c& A.erage ,ost .d!anta es and )isad!anta es A#5A!+A'E Hts very *ractical M easy to a**ly #I1A#5A!+A'E changes in current re*lacement costs are concealed because these costs are averaged -oes not lend itself to mani*ulation with older costs neither the valuation of ending inventory nor the cost of goods sold will quic(ly reflect changes in the current re*lacement costs of merchandise identical items have the same accounting values not necessary to (ee* trac( of inventory
EFFE,+
F +4E 5A"UA+I ! <E+4 #1
! FI!A!,IA" 1+A+E<E!+
Page -1
ince *rices (ee* on changing' the three methods yield different amounts for (1) the cost of merchandise sold for the *eriod (2) the gross *rofit (net income) for the *eriod (3) the ending inventory. "here is also a ta) effect that varies with changes in net income among different valuation methods. (3arren K <eeve' 2778) a" Income Statement: FIF $ %H%E gives the highest amount of gross *rofit (hence' net income) because the lower unit costs of the first units *urchased are matched against revenues' es*ecially in times of inflation. 1owever in times of falling *rices' %H%E will re*ort lowest inventory. Ht also yields the highest amount of ending inventory and the lowest cost of goods sold. "his will give a false im*ression of *a*er *rofit. "IF $ /H%E gives the lowest amount of net income during inflationary times and the highest net income during *rice declines. Ht gives the lowest amount of ending inventory and the highest cost of goods sold. (Qimmel' 3eygandt' K Qieso' 277>) A5, $ Average 0osts a**roach tends to *roduce cost of goods sold and ending inventory results between the results by /H%E and %H%E. (0hasteen' %laherty' K E#0onnor' 19?9) "o the management' higher net income is an advantage: it causes e)ternal users to view the com*any more favorably. Hn addition' management bonuses' if based on net income' will be higher. 1ence during inflationary times' com*anies *refer using %H%E. (3arren K <eeve' 2778) <et/o(s FIF "IF A5, ,ost of 'oo(s 1ol( Pnderstated Everstated Hn between %H%E K /H%E En(ing In.entory Everstated Pnderstated Hn between %H%E K /H%E !et Income Everstated Pnderstated Hn between %H%E K /H%E
," Balance Sheet: FIF $ -uring *eriods of inflation' the costs allocated to ending inventory will a**ro)imate their current cost. Hn fact' the balance sheet will re*ort the ending merchandise inventory at an amount
Page -2
that is about the same as its current re*lacement costs. As inventories are overstated in %H%E' this will affect the total assets and hence the stoc(holderAs equity' overstating it. "IF $ Hn a *eriod of inflation' the costs allocated to ending inventory may be significantly understated in terms of current costs. "his is because more recent costs are higher than the earlier unit costs. "hus it matches current costs nearly with current revenues. (3arren K <eeve' 2778)Hn /H%E' inventories are understated. "his' in turn' affects the stoc(holderAs equity by understating the actual figures. A5, $ Average cost a**roach for series of *urchases will be same' regardless of direction of *rice trends. Hn its effect on the balance sheet' however' it is more li(e %H%E than /H%E. (0hasteen' %laherty' K E#0onnor' 19?9) <et/o(s FIF "IF A5, In.entory Everstated Pnderstated Hn between %H%E K /H%E ,urrent Assets Everstated Pnderstated Hn between %H%E K /H%E 1toc*/ol(erEs Equity Everstated Pnderstated Hn between %H%E K /H%E
Page -3

Unit - II

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Unit - II

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Financial Accounting & Analysis

Unit II Journal Entries

#ate is the date of the transaction

By K.Arjun Goud (Assistant Professor)

Financial Accounting & Analysis

By K.Arjun Goud (Assistant Professor)

Financial Accounting & Analysis

iii. iv. -ate

177'777 177'777 27'777 27'777

Financial Accounting & Analysis

Capital and Revenue Expenditure

Purchase costs (less any discount received) Delivery costs

By K.Arjun Goud (Assistant Professor)

Financial Accounting & Analysis

Legal charges Installation costs Up gradation costs Replace ent costs

! "ee ore at# http#$$accounting!si pli%ied&co $%inancial$%i'ed!assets$capital!and!revenue! e'penditure&ht l(sthash&u)vc*g%1&dpu%

Repair costs +aintenance charges Repainting costs Rene,al e'penses

! "ee ore at# http#$$accounting!si pli%ied&co $%inancial$%i'ed!assets$capital!and!revenue! e'penditure&ht l(sthash&u)vc*g%1&dpu%

By K.Arjun Goud (Assistant Professor)

Financial Accounting & Analysis

By K.Arjun Goud (Assistant Professor)

Financial Accounting & Analysis

By K.Arjun Goud (Assistant Professor)

Financial Accounting & Analysis

By K.Arjun Goud (Assistant Professor)

Financial Accounting & Analysis

By K.Arjun Goud (Assistant Professor)

Financial Accounting & Analysis

By K.Arjun Goud (Assistant Professor)

Financial Accounting & Analysis

FI!A" A,, U!+

By K.Arjun Goud (Assistant Professor)

Financial Accounting & Analysis

Financial Accounting & Analysis

0reditors ,ills *ayable All other loans 0losing stoc(

000 000 000 000

Financial Accounting & Analysis

By K.Arjun Goud (Assistant Professor)

Financial Accounting & Analysis

FI!A" A,, U!+1

Financial Accounting & Analysis

+RA#I!' A,, U!+

By K.Arjun Goud (Assistant Professor)

Financial Accounting & Analysis

HHH. HL. L. LH. LHH.

By K.Arjun Goud (Assistant Professor)

Financial Accounting & Analysis

F +RA#I!' A,, U!+

PR FI+ A!# " 11 A,, U!+

Financial Accounting & Analysis

By K.Arjun Goud (Assistant Professor)

Financial Accounting & Analysis

By K.Arjun Goud (Assistant Professor)

Financial Accounting & Analysis

Financial Accounting & Analysis

1pecimen format for )alance s/eet

Financial Accounting & Analysis

By K.Arjun Goud (Assistant Professor)

Financial Accounting & Analysis

By K.Arjun Goud (Assistant Professor)

Financial Accounting & Analysis

toc( as on 31.12.7> to <s. 1' 77'777 1olution$

By K.Arjun Goud (Assistant Professor)

,y -ereciation ,y balance cFd ,y -ereciation ,y balance cFd

3. %or roviding dereciation at the end of the year:

Particular ,y -ereciation (4DH) ,y -ereciation (4DHH) ,y balance cFd

,y balance bFd ,y interest dereciation fund ,y -ereciation aFc