FINANCIAL ACCOUNTING

Account

• It is a unit of information that represents business records

• There are five types of accounts: asset, liability, equity, revenue and expense.

Accounting

• It is concerned with the use of which the records are put, their analysis and interpretation

• It is the process of recording business activities that make changes to accounts,

Attributes of accounting

• It is the art of recording business transactions

• It is the art of classifying business transactions

• The transactions or events of a business must be recorded in monetary terms

• It is the art of summarizing financial transactions

• The results should be communicated to users

Branches of Accounting

• Financial Accounting (Record keeping)

• Cost Accounting (Price fixation & Operating efficiency)

• Management Accounting (Analysis for decision making)

Advantages • Replacement of Memory • Evidence in court • Tax purpose • Comparative study • Sale of business • Assistance to the insolvent (unable to pay money)

Limitations • Records only monetary transactions • Effect of price level changes not considered • Personal bias of accountant affects the accounting statements • Permits alternative treatments (LIFO, FIFO) • No real test for managerial performance • Historical in nature

Basis of Accounting • Cash basis

–Actual cash receipts and payments are recorded. –Credit transactions are not recorded.

• Accrual basis – The income whether received or not but has been earned or accrued during the period forms part of the total income of the period.

• Mixed basis – Combination of cash and accrual basis

Accounting has been defined by the American accounting association committee as: “The process of identifying, measuring and communicating economic information to permit informed

judgments and decisions by users of the information”.

FINANCIAL ACCOUNTING

We can define financial accounting as a process of recording, summarizing, and reporting various transactions that

occur over a period of time during the course of business. We gather and convert all the daily transactions into

financial statements, balance sheet, income statements, and cash flow statements.

ACCOUNTING TERMINOLOGY

• Business:

An organization created with the objective of making a profit from the sale of goods or services.

• Book keeping:

The act of systematically recording the financial transactions affecting a business.

• Book Value:

The net amount (original value plus or minus any adjustments such as depreciation) showed in the accounts for an asset,

liability, or owners' equity item.

• Calendar Year:

An entity's reporting year, covering 12 months.

• Transactions:

Exchange of goods or services between businesses or individuals. Can also be other events having an economic impact

on a business.

• Journal:

A book or original entry in a double-entry bookkeeping system. The journal lists all transactions and indicates the

accounts to which they are posted.

• Journal Entry:

A recording of a transaction where debits equal credits.

• Ledger:

A summary statement of all the transactions relating to a person, asset, expense or income which have taken place during

a given period of time and show their net effect.

• Trial Balance:

A listing of all account balances that provides a test of whether total debits equals total credits.

• Revenues:

Increases in a company's resources from the sale of goods or services.

• Goods:

This includes all articles, commodities or merchandise in which the business deals. Thus, cloth would be goods for a

dealer in cloth; furniture would be goods for a dealer in furniture and so on.

• Assets:

Economic resources owned or controlled by a person or company.

• Net Assets:

The difference between assets and liabilities.

• Liquidity:

The availability of cash or ability to obtain it quickly. Also used to determine debt repayment ability.

• Goodwill:

An intangible asset that exists when a business is valued at more than the fair market value of its net assets.

• Interest:

The cost of the use of money

• Cheque:

It is a document in writing drawn upon a specified banker and payable on demand.

• Debit Notes:

For the party from whom the money is recoverable this document becomes debit note.

• Credit Note:

For the party who is to recover the amount the document becomes credit note. When goods returned from the customer, a

proper credit note should be sent to him.

KINDS OF ACCOUNTS

• Personal Account

• Real Account

o Tangible Real Account

o Intangible Real Account

• Nominal Account

[1] Personal Account

These accounts types are related to persons.

for example salary paid to ram

Rule for this Account

Debit the receiver.

Credit the Giver.

For Example – Goods sold to Suresh. In this transaction, Suresh is a personal account as being a natural

person. His account will be debited in the entry as the receiver.

[2] Real Accounts

These account types are related to assets or properties. They are further classified as Tangible real account and Intangible

real accounts.

Tangible Real Accounts

These include assets that have a physical existence and can be touched. For example – Building A/c, cash A/c,

stationery A/c, inventory A/c, etc.

Intangible Real Accounts

These assets do not have any physical existence and cannot be touched. However, these can be measured in terms of

money and have value. For Example – Goodwill, Patent, Copyright, Trademark, etc.

Real Account Rules

Debit what comes into the business.

Credit what goes out of business.

For Example – Furniture purchased by an entity in cash. Debit furniture A/c and credit cash A/c.

[3] Nominal Account

These accounts types are related to income or gains and expenses or losses. For example: – Rent A/c, commission

received A/c, salary A/c, wages A/c, conveyance A/c, etc.

Nominal Account Rules

Debit all the expenses and losses of the business.

Credit the incomes and gains of business.

For Example – Salary paid to employees of the entity. Salary A/c will be debited when the expenses are incurred.

Whereas, when an entity receives any interest, discount, etc these are credited whenever these are received by the

entity.

DOUBLE ENTRY

What do you know about double entry book keeping?

Luca De Pacioli is the "Father of Accounting" in Italy in 1494

Main Principle:

“Every debit has corresponding credit and every credit has corresponding debit with equal amount”.

Definition of double entry book keeping

“Every business transaction has a two fold effect and that it effects two accounts in opposite directions and if a

complete record is to be made of each such transaction it would been necessary to debit one account and credit another

account. It is this recording of two fold effect of every transaction that has given rise to the term Double Entry.” - By J.R.

Batluboi

What are the advantages of double entry book keeping?

Advantages of double entry book keeping:

1. Accuracy

2. Business result

3. Complete record

4. Comparative study

5. Common acceptance

Features of Double Entry Accounting system

• A transaction has two-fold aspects i.e. one giving the benefit and the other receiving the benefit.

• A transaction is divided into two aspects, Debit and Credit. One account needs to be debited and the other is to

be credited.

• Every debit must have its corresponding and equal credit.

JOURNAL

• The word journal is derived from the Latin word ‘Journ’ which means a day.

• Journal means a day book where in day-to-day business transactions are recorded in a chronological order.

• The process of recording a transaction in the journal is called Journalisation.

• The entries made in the book are called journal entries.

Advantages of Journal

• It provides a chronological (date wise) order of all transactions and hence provides permanent

record.

• It provides the information of debit and credit in an entry and an explanation to make it

understandable properly.

• It reduces the possibility of error as both aspects of a business transaction are written side by side.

LEDGER

• It is a book which contains various accounts. It is in ‘T’ form.

• It is a summary statement of all the transactions relating to a person, asset, expense or income

which have taken place during a given period of time and shows their net effect.

• It is designed to accommodate the various accounts maintained by a trader.

• The process of transferring the entries from the journal into the ledger is called posting.

PROCESS OF ACCOUNTING

Identification of Transaction

Recording process Preparation of Business Transactions

Recording of Transactions in Journal

Posting in Ledgers Grouping process

Preparation of Unadjusted Trial Balance Summarizing process

Pass of Adjustment Entries

Preparation Process

Preparation of Adjusted Trial Balance

Trading

P&L A/c

Balance Sheet

DEFINE TRIAL BALANCE

A trial balance is a statement showing the balances, or total of debits and credits, of all the accounts in the ledger

with a view to verify the arithmetical accuracy of posting into the ledger accounts. Trial balance is an important

statement in the accounting process. Which shows final position of all accounts and helps in preparing the final

statements? The task of preparing the statements is simplified because the accountant can take the account

balances from the trial balance instead of looking them up in the ledger. It is normally prepared at the end of an

accounting year. However, an organization may prepare a trial balance at the end of any chosen period, which may be

monthly, quarterly, half yearly or annually depending upon its requirements

SUBSIDIARY BOOKS

Subsidiary Books are books of Original Entry. They are also known as Day Book or special journals. We record

transactions of similar nature are in Subsidiary Books. They are helpful in overcoming the limitations of

journal book or journal entries.

Subsidiary books are books of original entry. In the normal course of business, a majority of transactions are either relate to

sales, purchases or cash. So we record transactions of the same or similar nature in one place, i.e. the subsidiary book. And we

record these transactions in chronological order.

This actually saves a lot of man-hours and tiresome clerical work. Instead of journalizing each entry, they are recorded into

various subsidiary books. Think of your subsidiary book as sub-journals that record only one type of transaction.

There is no separate entry for these transactions in the general ledger. The posting to the Ledger Accounts is done from the

subsidiary book itself. This method of recording is known as the Practical System of Accounting or sometimes the English

System.

Subsidiary book system does not violate the rules of Double Entry System. We have still recorded the transactions according

to this system.

Only instead of a journal, we are using subsidiary books as the books of original entry.

TYPES OF SUBSIDIARY BOOKS

The following are the subsidiary books a company will generally maintain while writing their accounts,

• Cash Book- It is a book which records the receipts and payment of cashtransaction.

• Purchase Book- It is a book which records all the credit purchases of goods of the company.

• Purchase Return Book- It is a book which records all the return of credit purchases of goods of the company.

• Sales Book- It is a book which records all the credit sales of goods of the company.

• Sales Return Book- It is a book which records all the return of credit sales of goods of the company.

• Bills Receivable Book- It is a book which records all the bills receivable.

• Bills Payable Book- It is a book which records all the bills payable.

• Journal Proper- All the transactions which are not recorded in the above books are recorded here

ADVANTAGES

Let us now take a look at some of the advantages these subsidiary books provide in the process of accounting

i. Saving Labour Hours: Recording in a subsidiary book saves a lot of time and clerical hours. Firstly there is no need

to journalize and/or give narrations for every transaction. This helps reduce the time it takes to completely record a

transaction. Also since we use a number of subsidiary books, various accounting process can be undertaken

simultaneously. This will save the time of the clerks/accountants.

ii. Division of Work: In place of one general journal, we have several subsidiary books, So the resulting work may be

divided among several members of the staff. This will save time, improve efficiency and result in fewer errors as well.

iii. Specialization of Work: If one person maintains the same subsidiary book over many years he acquires full

knowledge and understanding of the work. We can say he becomes a specialist in one type of transaction (say

purchases for example). He becomes very efficient in handling such transactions and hardly any error gets made.

iv. Easy for Reference: When transactions of all types are in the same subsidiary book it becomes easy to search for

them. Whenever any information is needed we directly refer the subsidiary book to get said information.

v. Easier for Checking: If the Trial Balance does not match, it will be much easier to locate the error thanks to the

existence of separate books i.e. a subsidiary book. Same goes if you want to detect fraud.

vi. Minimizes Frauds: These books make possible the introduction of internal check system under which the system of

rotation of writing up books can be adopted. This helps minimizing errors and detecting frauds.

KINDS OF CASH BOOK

A cash book is both a ledger and a journal for all the cash transactions of a company since it performs the function of both. It

records all cash receipts on the debit side and all the cash payments of the company on the credit side. Let us now look at the

three main kinds of cash book a company may maintain.

1] Simple Cash Books

This is also known as a Single Column Cash Book. This cash book will only record cash transactions. The cash coming in

(receipts) will be on the left and the cash payments will be on the right. And since we will record all cash transactions here

there is no need for a cash ledger account.

Now since there is only one column we do not record bank transactions in this cash book. Any discounts given will also not

feature here. We will record bank and discount transactions in their separate ledger accounts.

Cash books are balanced quite frequently. In fact, most companies balance their cash book daily. One important point to

remember is that the cash book can never have a credit balance. Cash books only show a debit balance.

2] Two Column Cash Books

Here instead of one column, we have an additional column for discounts. So along with the cash transactions, we will also

record the discounts in the same cash book. So both discounts received and the discount that is given is recorded here. If any

organization is in a general practice of giving or receiving discounts this is the preferable option.

Discount is a nominal account – so the discount is given (loss) is on the debit side and discount received (profit) is on the

credit side. At the end of the period, we balance both columns and transfer the closing balances.

3] Three Column Cash Books

This cash book has the cash, the discount and additionally the bank columns in it. Since the development of banking most

firms, these days prefer to deal in cheques or other such bills of exchange. And so having a bank column in your cash book

makes things concise and simpler to understand.

So when you receive a cheque and you deposit it in the bank the same day you make the entry in the bank column (the debit

side in this case). But say you send the cheque later (not the same day) then this will be a contra entry. A contra entry is

transactions that happen between a cash account and a bank account. Ultimately your Cash & Bank balance remains the same,

the money just moves around.

4] Petty Cash Book

In a firm, there are usually cash transactions happening in all the departments. These we will record in one of the above

formats of cash books. But there are many cash transactions happening for very small amounts. Sometimes there are dozens

of such transactions that occur in just one day. These are known as petty transactions. Examples are expenses for postage,

stationery, traveling, food bills, etc.

So since the number of such transactions tends to be very high we maintain a separate cash book for them – the petty cash

book. Such a cash book is maintained by the petty cashier (who in most cases also handles the petty cash).

ACCOUNTING ERRORS: MEANING, CLASSIFICATION

Meaning of Accounting Errors:

Accounting errors are the mistakes committed in bookkeeping and accounting. The mistake may be one relating

to routine or one relating to principle. They may occur in entering the transactions in the journal or subsidiary books or

they may creep at the time of posting into the ledger.

Thus, errors may be committed while recording, classifying or summarizing the accounting transactions. The

error may be the result of an act of omission or commission.

CLASSIFICATION OF ERRORS:

Depending upon the nature of errors, they may be classified into the following four types:

(1) Errors of Omission;

(2) Errors of Commission;

(3) Errors of Principles; and

(4) Compensating errors

1. Errors of Omission:

When a transaction is not recorded by mistake in the books of accounts, it is called an error of omission. The omission

may be partial or complete.

Partial Omission may happen in relation to any subsidiary book. Here the transaction is entered in the subsidiary book

but not posted to the ledger.

For example, goods returned by a customer has been entered in the sales returns book but not posted to the credit of

customer’s account. Similarly, cash paid to the supplier has been entered in the payment side of the Cash Book but not

posted to the debit of supplier’s account. Complete omission can happen when the transaction is completely omitted from

the books of accounts. For example, a bookkeeper failed to enter an invoice from the sales daybook.

2. Error of Commission:

When a transaction is entered in the books of accounts, it might be entered wrongly. It may be entered partially or

incorrectly. Such error is called an error of commission. These errors arise often due to the ignorance or negligence or

absent-mindedness of the accountant. It may be of different types. Examples of such errors are as follows:

(a) Errors relating to subsidiary books:

(b) Errors relating to ledger:

(c) Errors in balancing:

3. Errors of Principle:

These errors occur when entries are made against the principles of accounting. Example. Purchase of computer for office

use is wrongly entered in the Purchases Day Book. Capital expenditure should not be treated as revenue expenditure.

These errors may be committed:

(a) Due to the inability to make a distinction between revenue and capital items;

b) Due to inability to make a difference between business expenses and personal expenses;

(c) Due to inability to make a difference between productive expenses and non-productive expenses, e.g., wages paid for

production may be debited to salaries a/c or salaries paid to office employees may be debited to wages a/c.

4. Compensating Errors:

These are the errors, which compensate themselves in the net results, i.e., over debit of one account is neutralized by an

over credit in some other account to the same extent. Similarly a wrong credit might have been compensated by some

wrong debit in some other account.

For example, if tax paid Rs.2, 500 is debited in Tax a/c as Rs.3, 000 and interest received Rs.3, 500 is credited in the

interest a/c as Rs.4, 000, the excess debit of Rs.500 in tax a/c is compensated by an excess credit of Rs.500 in interest a/c.

A TRIAL BALANCE WILL DISCLOSE THE FOLLOWING ERRORS:

1. Wrong Totaling of Subsidiary Books:

2. Posting of the Wrong Amount:

3. Posting an Amount on the Wrong side of the Account:

4. Posting Twice to a Ledger:

5. Omission of an account from the Trial Balance (Cash, Bank etc.):

6. Wrong additions or balancing of ledger accounts.

7. Balance of account written to the wrong side of the Trial Balance.

8. Errors made in preparing the list of Debtors and Creditors.

9. Errors made in carrying forward the total from one page to another page.

10. There may be some items to which double entry is incomplete.

11. Wrong totals of the Trial Balance.

RECTIFICATION OF ERRORS:

Errors are/can be rectified if the correcting entries are passed in the books of account. For this, care and alertness

is exercised to see whether error is in both the accounts or is in one account only. If the error affects both the accounts,

then a fresh entry is to be passed and if it affects only one account, the rectification is done by recording in one account

only.

1. Rectification of Errors when error affects only one account: If it is so, no journal entry is required to pass; it is

corrected by debiting or crediting the concerned account. For example, Sales book was overcasted by 250 [As the sales

book was overcasted by 250], hence sale account is to be debited by 250 in order to rectify the error. This error affects

only one account. Similarly, if the Purchases Day Book is undercasted by 100 then the error also affects only one account

and this can be corrected by debiting purchases account by 100. Likewise paid 20 as repairs were recorded 25 in Repairs

account again the error is in one account i.e., repair account. It may be corrected by crediting repair A/c by 5 i.e. the

difference ( 25 - 20).

2. Rectification of Errors when it affects both the accounts: If it is so, it is rectified by passing a journal entry. For

example, received 150 from Shri Bhagwan were credited to sales account. This error affects both the accounts i.e., (i)

Shri Bhagwan A/c and (ii) Sales A/c.

Types of Reserves

Capital reserve: It is a mode for retaining profits in business, which are not available for distribution as dividends. It is

always a credit balance.

General reserve: It means retention of a portion of profit, not for any particular purpose, but for the improvement of

overall financial position of an enterprise.

Types of Provisions

Provision for doubtful debts: This provision is made on certain percentage of total debtors appearing in the trial

balance. It is meant for the recovery of doubtful overdue account.

Provision for discount on debtors: This provision is also made on debtors and is treated as a loss for the current year.

PURPOSE OF BANK RECONCILIATION STATEMENT

The reconciliation statement is the most common tool used by organizations for reconciling the balance as per

books of company with the bank statement and is made at the end of every month. The main objective of reconciliation is

to ascertain if the discrepancy is due to error rather than timing.

It is prepared from time to time to check that all transactions relating to the bank are properly recorded by the

businessman in the bank column of the cash book and by the bank in its ledger account. Thus, it is prepared to reconcile

the bank balances shown by the cash book and by the bank statement. It helps in detecting, if there is any error in

recording the transactions and ascertaining the correct bank balance on a particular date.

The need and importance of the bank reconciliation statement may be given as follows:

1. The reconciliation process helps in bringing out the errors committed either in Cash Book or Pass Book.

2. Bank reconciliation statement may also show any undue delay in the clearance of cheques.

3. Sometimes the cashier may have the tendency of cheating, like he makes entries in the Cash Book, but does not

deposit the cash into bank. These types of frauds by the entrepreneur’s staff or bank staff may be detected only through

bank reconciliation statement. So this way bank reconciliation statement acts as a control technique too.

NEED FOR PREPARING A BANK RECONCILIATION STATEMENT

Accuracy

Each month, the passbook of the bank and the cash book of a firm, display a particular amount, which is the balance in the

bank as on that date. However, due to delay in the recording time and period of the same in the respective books, there is a

high possibility that on the day of comparison the balances in the two books, would not match.

Hence, having prepared a bank reconciliation statement, one can determine the reasons and amounts by which the two

balances differ. This analysis would further help the accountant in recording the missing amounts in each book. Hence, after

the preparation of a bank reconciliation statement, the books of accounts would actually display a true and fair position of the

firm.

Check on the Entries

In the process of preparing a bank reconciliation statement, an accountant will be able to point out all entries or amounts,

recorded incorrectly in either of the books.Thus, it is quite useful to prepare a bank reconciliation statement, which would help

in eliminating any entries recorded erroneously.

Rectifying Incorrect Entries

In case an amount or entry has been recorded incorrectly in both, the passbook and the cash book, the accountant will be able

to rectify those entries, so as to arrive at the amount of correct bank balance in the passbook and the cash book.

Updated Cash Book

Again, due to the irregularity in posting amount of entries in the cash book and due to the delays in the recording of such

amounts, it is quite possible that the cash book would fail to show the updated balance of bank as on a particular date. When

compared with the passbook, an accountant would be able to identify such entries and record them in the cash book instantly.

This would help in reconciling the balances of both the cash book and the bank book instantly.

Detection of Delays

Due to the preparation of bank reconciliation statement, it is possible to discover any amount of cheques that gets deposited in

the bank but have aren’t credited. This difference would be evident because the amount of such deposit would appear in the

cash book but not in the bank book, hence giving rise to a difference in the bank balance of both. Thus, cheques deposited but

not yet collected can come to noticequickly.

Check on the Dishonest Behavior of Employees

Preparation of regular bank reconciliation statement has several benefits. It would act as a moral check on employees so that

they do not indulge in the embezzlement of bank cheques, which would ultimately cause loss to the firm. This is so because

even a low-value cheque can come in detection if it has been accepted but not deposited. In this way, a bank reconciliation

statement serves a large purpose for a firm’s accounting cycle and people.

MANUFACTURING ACCOUNT

The concern which are engaged in the conversion of raw materials into finished goods, are interested to

knowing the cost of production of the goods produced. The cost of the goods produced cannot be obtained from the

Trading Account. So, it is desirable to prepare a Manufacturing Account prior to be preparation of the Trading account

with the object of ascertaining the cost of goods produced during the accounting period.

IMPORTANT POINTS REGARDING MANUFACTURING ACCOUNT

1. Raw Materials Consumed

The cost of raw materials consumed to be included in the debit side of the Manufacturing Account shall be calculated as

follows:

Rs.

Opening Stock of raw materials ..........

Add Purchases of raw materials ........... ...........

Less Purchase return of raw materials ...........

Less Closing stock of raw materials ...........

Cost of raw material consumed

2. Direct Expenses

The expenses and wages that are directly incurred in the process of manufacturing of goods are included under this head..

3. Factory Overheads

The term “overheads” includes indirect material, indirect labour and indirect expenses. Therefore, the term “factory

overheads” stands for all factory indirect material, indirect labour and indirect expenses. Examples of factory overheads

are: rent for the factory, depreciation of the factory machines and insurance of the factory, etc.

4. Cost of Production

Cost of production is computed by deducting from the total of the debit side of the Manufacturing Account, the total of

the various items appearing on the credit side of the Manufacturing Account.

DIFFERENCE BETWEEN TRADING ACCOUNT AND MANUFACTURING ACCOUNT

Manufacturing Account Trading Account

Manufacturing account is prepared to find out the cost of

goods produced.

Trading Account is prepared to find out the Gross

Profit/Gross Loss.

The balance of the manufacturing Account is transferred

to the Trading

Account.

The balance of the Trading account is transferred to the

Profit and Loss Account.

Sale of crap is shown in the Manufacturing Account. Sale of scrap is not shown in the Trading Account.

Stocks of raw materials and work-in- progress are shown

in the Manufacturing Account.

Stocks of finished goods are shown in the Trading

Account.

Manufacturing Account is a part of the Trading account. Trading Account is a part of the Profit and Loss

Account.

IMPORTANT POINTS IN PROFIT AND LOSS ACCOUNT

1. Selling and Distribution Expenses

These expenses are incurred for promoting sales and distribution of sold goods. Example of such expenses are godown

rent, carriage outwards, advertisement, cost of after sales service, selling agents commission, etc.

2. Management Expenses

These are the expenses incurred for carrying out the day-to-day administration of a business. Expenses, under this head,

include office salaries, office rent and lighting, printing and stationery and telegrams, telephone charges, etc.

3. Maintenance Expenses

These expenses are incurred for maintaining the fixed assets of the administrative office in a good condition. They

include repairs and renewals, etc.

4. Financial Expenses

These expenses are incurred for arranging finance necessary for running the business. These include interest on loans,

discount on bills, etc.

5. Abnormal Losses

There are some abnormal losses that may occur during the accounting period. All types of abnormal losses are treated as

extra ordinary expenses and debited to Profit and Loss Account. Examples are stock lost by fire and not covered by

insurance, loss on sale of fixed

assets, etc.

Following are the expenses not to appear in the Profit and Loss Account:

(i) Domestic and household expenses of proprietor or partners.

(ii) Drawings in the form of cash, goods by the proprietor or partners.

(iii) Personal income tax and life insurance premium paid by the firm on behalf of proprietor or partners.

6. Gross Profit

This is the balance of the Trading Account transferred to the Profit and Loss Account. If the Trading Account shows a

gross loss, it will appear on the debit side.

7. Other Income

During the course of the business, other than income from the sale of goods, the business may have some other income of

financial nature. The examples are discount or commission received.

8. Non-trading Income

Such incomes include interest on bank deposits, loans to employees and investment in debentures of companies.

Similarly, dividend on investment in shares of companies and units of mutual funds are also known as non-trading

incomes and shown in Profit and Loss Account.

9. Abnormal Gains

There may be capital gains arising during the course of the year, e.g., profit arising out of sale of a fixed asset. Such

profit is shown as a separate income on the credit side of the Profit and Loss Account.

DISTINCTION BETWEEN TRADING ACCOUNT AND PROFIT AND LOSS ACCOUNT

Profit and Loss Account Trading Account

Profit and Loss Account is prepared as a main account. Trading Account is prepared as a part or section of the

Profit and Loss Account.

Indirect expenses are taken in Profit and Loss Account. Direct Expenses are taken in Trading Account.

Net Profit or Net Loss is ascertained from the Profit and

Loss Account.

Gross Profit or Gross Loss is ascertained from Trading

Account.

The balance of the Profit and Loss Account i.e. Net

Profit or Net Loss is transferred to proprietor’s Capital

Account.

The Balance of the Trading Account i.e. Gross Profit or

Gross Loss is transferred to the Profit and Loss Account.

Items of accounts written in the Profit and Loss Account

are much more as compared to the Trading Account.

Items of account written in the Trading Account are few

as compared the Profit and Loss Account.

CHARACTERISTICS OF BALANCE SHEET

(a) A Balance Sheet is only a statement and not an account. It has no debit side or credit side. The headings of the two

sides are ‘Assets’ and ‘Liabilities’.

(b) A Balance Sheet is prepared at a particular point of time and not for a particular period. The information contained in

the Balance Sheet is true only at that particular point of time at

which it is prepared.

(c) A Balance Sheet is a summary of balances of those ledger accounts which have not been closed by transfer to Trading

and Profit and Loss Account.

(d) A Balance Sheet shows the nature and value of assets and the nature and the amount of liabilities at a given date.

Depreciation (decreasing or downgrading)

Depreciation is gradually Decrease in the value of fixed assets.

Depreciation is the reduction in the value of fixed asset due to its use, wear and tear or obsolescence. When an asset is

used for earning purposes, it is necessary that reduction due to its use, must be charged to the Profit and Loss account of

that year in order to show correct profit or loss and to show the asset at its correct value in the Balance Sheet.

Depreciation is the gradual, permanent decrease in the value of assets due to wear and tear and many other causes.

Depreciation is an expense so the following entry will be passed:

Depreciation Account Dr.

To Asset Account

The two-fold effect of depreciation will be:

(i) Depreciation is shown on the debit side of Profit and Loss Account, and

(ii) It is shown on the asset side of the balance sheet by way of deduction from the value of concerned asset.

Example

Machinery purchased today will not have the same value after 5 years, even if it is unused. This reduction in value of

machinery is called as Depreciation.

Example of adjustment for depreciation

Provide depreciation @ 10% on Machinery and @ 5% on Land and Building.

IMPORTANCE OF DEPRECIATION

Useful life: The amount of time a company expects an asset to be productive. Depreciation is calculated during this time

period.

Salvage (recover) value: When a business gets rid of an asset, it could sell it for a reduced amount. This amount is called

the salvage value. Overall depreciation is figured out by subtracting the salvage value from the asset cost.

Depreciation method: there are two main methods of calculating. The first is the Straight Line Method, which takes the

overall depreciation and divides it evenly over the useful life of the asset. The second is the Accelerated Method, which

creates more depreciation early on in the life of a fixed asset. The Straight Line Method makes for easy calculation, while

the Accelerated Method defers a portion of income tax.

What Are The Advantages Of Depreciation?

1. Matching Expenses

Depreciation expense helps a company state the amount of expense incurred (from using an asset) to properly match with

the revenue generated in the same period. Most businesses, particularly machinery, farming, agriculture, etc., will have to

buy an equipment one way or another, and keep recording and calculating their expenses on the books. This way, you

don't just keep track of your assets but can also see exactly how much revenue you are generating.

2. Asset Valuation

The value of an asset tends to decrease over a period of time due to various factors. So in order to present a true state of

affairs of the business, the assets need to be shown on the balance sheet. This provides a way for recovering the purchase

cost of the asset. An asset’s net book value is the original purchase cost subtracted from the asset’s accumulated

depreciation. Reporting the value of the asset with the depreciation helps a lot when analysing, knowing that the value of

the depreciation is more correct.

3. Replacement Cost

Depreciation applies to all sorts of assets, more than you may realize. It provides a way for recovering the purchase cost

of the asset where your company can recover the total asset cost over its useful life. Furthermore, it becomes easier to

ascertain if these assets are in need of replacement or not. Thus, depreciation helps companies to set aside part of the

revenue as funds for replacement of the worn out asset.

4. Tax Benefits

Depreciation helps you receive tax benefits associated with recording the expense. If depreciation is not charged on an

asset, your profit and loss account will show more profits, thereby paying more taxes. But depreciation charges on assets

will save you the amount of tax charged, equivalent to its tax rate since it is shown as an expense in your profit and loss

account, thereby reducing the amount of the profit, and eventually the tax rate.

CAUSES OF DEPRECIATION:

1. Wear and Tear:

Some assets physically deteriorate due to wear and tear in use. When an asset is constantly used for production, the asset

wears out. More and more use of an asset, the greater would be the wear and tear. Physical deterioration of an asset is

caused from movement, strain, friction, erosion etc. For instance, building, machineries, furniture, vehicles, plant etc. The

wear and tear is general but primary cause of depreciation.

2. Lapse of Time:

There are certain assets like leasehold property, patents, copy-right etc. that are acquired for a particular period. After the

expiry of the period, they are rendered useless i.e. their value ceases to exist. Thus, their cost is written off over their

legal life.

3. Obsolescence:

Appearance of new and improved machines results in discarding of old machines. Thus new inventions, change in

fashions and taste, market condition, Government policies etc. are the causes to discard the value of an asset. But this is

not the cause of depreciation and not depreciation in real sense.

A new machine performs the same function more quickly and cheaply than the existing machine. As such, existing

machine may become out of date or outmoded or obsolete.

4. Exhaustion:

Some assets are of wasting nature. For instance, quarries, mines, oil-well etc. It is the reduction in the value of natural

deposits as resources have been extracted year after year. As such these assets are known as wasting assets. The coalmine

or oil well gets physically exhausted by the removal of its contents.

5. Non-Use:

Machines which are idly lying become less and less useful with the passage of time. Certain types of machines exposed

to weather conditions, may have more depreciation from not using it than from its use.

6. Maintenance:

A good maintenance of machine will naturally increase its life. When there is no maintenance, there is more depreciated

value. When there is good maintenance, there is longer life to the machines. The long life of machine depends upon good

and skilled maintenance.

7. Market Trend:

The market price may fluctuate in case of certain assets, for instance, investments in gilt-edged securities. When the

prices go down, the concerned asset may depreciate its value. In certain cases, accident causes diminution in the value of

assets.

NEED FOR DEPRECIATION:

Depreciation is provided for the assets with a view to achieve the following results:

1. To Ascertain the True Working Result:

Asset is an important tool in earning revenues. Huge amounts are spent for acquisition of assets which are worn out in the

process of earning income. Thus, the assets get depreciated in their value, over a period of time due to many reasons

explained above.

When the value of assets decreases, this loss must be brought into account; otherwise a true working result cannot be

known. Depreciation is an operating expense of a physical asset, the same should be considered in arriving the true profit

earned during each year

The basic need of depreciation is to ascertain the true income. If depreciation is ignored, the loss that is occurring in

respect of fixed assets will be ignored. So, depreciation should be debited to Profit and Loss Account before profit is

ascertained.

2. To Ascertain True Value of Asset:

The function of the Balance Sheet is to show the true and correct view of the state of affairs of a business. If no

depreciation is charged and when assets are shown at the original cost year after year, Balance Sheet will not disclose the

correct state of affairs of a business.

3. To Retain Funds for Replacement:

Assets used in the business need replacement after the expiry of their service. It is always not possible to determine the

useful life of assets. But, in certain cases, machine often becomes, obsolete long before it wears out because of rapid

changes in tastes and technology. It is a permanent loss in value of the asset. When an asset is continuously used, a time

will come when the asset is to be given up and hence its replacement is essential.

Therefore, if no depreciation is charged against the profit, during the life time of the asset, it will be very difficult to find

cash to replace the asset and if replaced it may cripple resources. Therefore, it is necessary to make provision and create

funds to replace such assets, in proper time.

4. To Reduce Tax Liability:

Depreciation is a tax deductible expense. As such, it is permitted by the prevailing taxation laws to be deducted from

profit. Consequently, the owner of a business may avail himself of this benefit by charging depreciation to his profit and

reducing his tax liability.

5. To Present True Position:

Financial position can be studied from the Balance Sheet and for the preparation of the Balance Sheet fixed assets are

required to be shown at their true value. If assets are shown in the Balance Sheet without any charge made for their use,

(that is, depreciation) then their value must have been overstated in the Balance Sheet and will not reflect the true

financial position of the business.

Therefore, for the purpose of reflecting true financial position, it is necessary that depreciation must be deducted from the

asset and then at such reduced value may be shown in the Balance Sheet.

Types of Depreciation Methods?

There are several types of depreciation expense and different formulas for determining the book value of an

asset. The most common depreciation methods include:

• Straight-line

• Double declining balance

• Units of production

• Sum of years digits

Depreciation expense is used in accounting to allocate the cost of a tangible asset over its useful life. In other words, it is

the reduction in the value of an asset that occurs over time due to usage, wear and tear, or obsolescence.

Income and Expenditure Account

The role of a non-trading firm is to provide services to its members. However, in order to do the same, it needs to earn

some revenue and incur certain expenditures. When a non-profit firm does so, it needs to prepare an income and

expenditure account, which can help it in ascertaining the surplus earned or deficiency incurred during a period. Let us

understand more about the income and expenditure account which is prepared by a non-profit organization.

The Income and Expenditure Account is a summary of all items of incomes and expenses which relate to the ongoing

accounting year. It is prepared with the objective of finding out the surplus or deficit arising out of current incomes over

current expenses. It is quite similar to the Trading and Profit and Loss Account of a trading concern and is prepared in an

exact manner.

Income and Expenditure Account is prepared on an accrual basis. All incomes and expenses are relating to the

accounting year, whether they are actually received and paid or not, are taken into consideration. Expenditure is recorded

on the debit side and income is recorded on the credit side. A distinction is made between capital and revenue items and

only revenue items are included in this account.

Income and Expenditure Account is a nominal account. Therefore, the rule of nominal account (debit all expenses and

losses and credit all incomes and gains) is followed while preparing it. While preparing the account, only items of

revenue nature are recorded and all items of capital nature are ignored. For example, the profit earned or loss suffered on

the sale of an asset will be recorded in it but the amount received from the sale of an asset will not be recorded in it.

The closing balance of this account shows a surplus or deficit for the year. If the credit side exceeds the debit side, there

is surplus. On the other hand, if the debit side exceeds the credit side, there is a deficit. The surplus is added to the

Capital Fund while the deficit is deducted from the Capital Fund.

Preparation of Income and Expenditure Account

Include all items of revenue receipts and expenses, on the respective side of the account.

Ensure that no items of capital incomes and expenses are included in this account.

Also, adjustment for amounts prepaid and outstanding, with respect to each item will have to be made.

Further, items included in receipts and payment account, depreciation, provisions, and profit or loss on sale

of assets will have to be included in this account.

Finally, after putting down all items of revenue and expenses, you’ll get a balance. The resulting balance will

then reveal the surplus or deficit for the period.

STEPS IN PREPARATION OF INCOME AND EXPENDITURE ACCOUNT FROM RECEIPTS AND

PAYMENTS ACCOUNT

Following are the steps to be followed in preparing income and expenditure account from receipts and payments account:

i. Opening and closing balances of cash and bank accounts in receipts and payments account must be excluded.

ii. Capital receipts and capital expenditures must be excluded.

iii. Only revenue receipts pertaining to the current year should be taken to the credit side of income and expenditure

account. Due adjustments should be made for income received in advance, income accrued for the current year and for

the amount relating to the previous year or years.

iv. Similarly, revenue expenditure relating to the current year only must be taken in the debit side of income and

expenditure account. Adjustments must be made for outstanding expenses of the previous year and current year and for

the prepaid expenses of the previous year and current year.

v. Any income or expense relating to specific fund must not be taken to income and expenditure account.

vi. Non-cash items such as bad debts, depreciation, loss or gain on sale of assets, etc., which are not recorded in

receipts and payments account must be recorded in income and expenditure account.

vii. The balancing figure of income and expenditure account is either surplus or deficit and will be transferred to

capital fund in the balance sheet. If the total of credit side of income and expenditure account is more than the total of

debit side (excess of income over expenditure), the difference represents surplus. If the total of debit side of income and

expenditure account is more than the total of credit side (excess of expenditure over income), the difference represents

deficit.

CHARACTERISTICS OF INCOME AND EXPENDITURE ACCOUNT

1. Non-trading concerns prepare this account.

2. It’s nature similar to the Profit and Loss Account as made by the for-profit concerns.

3. Though it is prepared at the end of the year, it does not mean that it shows a record of a whole year.

4. It determines the surplus or deficit of income over expenditures

5. The concern prepares this account by strictly following the Double Entry System.

6. The surplus or deficit of this account is transferred to the capital fund account.

7. Unlike the Receipts and Payments Account, it does not start with an opening balance and ends with a closing

balance.

8. It strictly follows the accrual basis of accounting.

9. An independent auditor has to audit this account for the validation of the account.

ADVANTAGES OF INCOME AND EXPENDITURE ACCOUNT

1. Revenue Information

One of the major advantage of this account that it helps the concern to know about its revenues. It gives the concern about

their past records and the current trends. Moreover, it will provide the concern relevant information for their futuristic course

of action.

It tells them their major source of profits and their loopholes where they are spending a lot. It helps them to control the

extravagant expenditure approach.

2. Beneficial for the Investors

Investors are very much interested in the profits and losses of the concern. In the case of non-trading concerns, it is especially

the government which is interested in the statements of the concern.

It is because they provide the concern with many facilities in the form of subsidies and donations. They want to analyze the

working and the position of the concern. It helps them to decide the number of futuristic grants and donations.

DISADVANTAGES OF INCOME AND EXPENDITURE ACCOUNT

Nobody can deny the fact that whenever there are advantages, there are certain disadvantages too. In the case of the

Income and Expenditure Account, there is only one major disadvantage.

This disadvantage is ‘Misinterpretation of Data’. As we have seen above also that the concern is highly dependent on the

government for various funds and facilities.

The government is only interested to help only those concerns which are performing well. The wellness of the concern is

visible by its statements.

In order to show their competence, it is mostly seen that they end up doing window-dressing of their statements. This

becomes a very major disadvantage of this account.

RECEIPTS AND PAYMENTS ACCOUNT

Receipts are nothing but the incoming of money or money equivalents. On the other hand, Payments refer to the

disbursement of cash or cash equivalents to another party. Both form an important part in the organizations, especially in the

Not-for-Profit Organizations. It is because their whole accounting process revolves around this account. In this article, we

look at various features, advantages, format, and question (with solution) of Receipts and Payments Account.Unlike normal

organizations, Not-for-Profit organizations do not make Trading and Profit and Loss Account. Instead, they make Income and

Expenditure Account and Receipts and Payments Account.

Receipts and Payments Account is just like a Cash Account for them. It forms an important part of their accounting

procedure since they have to deal with various donations throughout the year, which is mostly in cash.

FEATURES OF RECEIPTS AND PAYMENTS ACCOUNT

1. It is also known as Cash Book Summary for the Not-for-Profit organizations because it records all the cash and cash

equivalents like cheques transactions throughout the year.

2. It starts with beginning cash and bank balance and ends with ending cash and bank balance.

3. This account shows cash transactions of both capital and revenue nature.

4. Mostly it shows a debit balance. In the exceptional case of overdraft balance, its net balance may be credit.

5. The concern prepares it on the last day of the accounting year.

6. Double Entry bookkeeping system does not apply to this account since it is a summary of transactions which are

already recorded in the Cash Book.

7. It does not involve transactions which do not include cash or bank items.

8. It is a real account, i.e., it is a summarised copy of cash receipts and cash payments.

9. It’s form is similar to Cash Book (without discount and bank columns) with debit and credit sides. Receipts are

recorded on the debit side while payments being entered on the credit side.

10. It records all receipts and payments irrespective of the distinction between capital and revenue items. In other

words, both capital and revenue receipts and payments are included.

11. Only actual receipts and payments during the accounting period, whether relating to previous or current or

succeeding years are recorded in it.

12. The opening and closing balances in it mean cash in hand/bank in the beginning and at the end, respectively. The

balance of Receipts and Payments Account must be debit being cash on hand and/or at bank, unless there is a bank

overdraft.

Advantages of Receipts and Payment Account

1. It is through this account that the total payments and total receipts are easily available in the same place.

2. It is through this account that we can ascertain the closing balance of cash at the end of the year.

3. This account proves to be a verification point for the cash book. This is because the organization prepares it after the

preparation of the Cash Book and is nothing but the summary of it.

Disadvantages of Receipts and Payment Account

1. It does not differentiate capital and revenue expenses and incomes. This is because it shows transactions of both

natures together at the same place without any showcase of difference.

2. It fails to show the transactions on an accrual basis.

3. It does not define any targets making it incapable of showing surpluses and deficits at the end of the year.

4. Receipts and payments account does not show Non-Cash transactions like depreciation of assets, pilferage etc.

PREPARATION OF RECEIPTS AND PAYMENTS ACCOUNT

FROM INCOME AND EXPENDITURE ACCOUNT

The practical steps involved in the preparation of a Receipts and Payments Account from an Income and Expenditure

Account are:

Step I Put the ‘opening balances’ of cash/bank as the first item on the ‘Receipts side’ and ‘closing balances’

of cash/bank as the last item on the ‘Payments side’ of the Receipts and Payments Account.

If one of the two balances are given, the other balance will have to be ascertained.

Step II Ascertain ‘Revenue Receipts’ received during the current accounting period as under and show it on

the receipts side of Receipts and Payments Account:

Revenue Income (account-wise) for the current year as per Income and Expenditure Account.

Add Income received in advance at the end of current year.

Add Income outstanding in the beginning of current year.

Less Income outstanding at the end of current year.

Less Income received in advance in the beginning of the current year.

Step III Ascertain ‘Revenue Payments’ made during the current accounting period as under and show it on the

payments side of Receipts and Payments Account:

Revenue expenses (account-wise) for the current year as per Income and Expenditure Account

Add Expenses outstanding in the beginning of current year.

Add Expenses prepaid at the end of current year.

Less Expenses outstanding at the end of current year.

Less Expenses prepaid in the beginning of current year.

Step IV Ascertain all capital receipts and capital payments from the additional information or Balance Sheets or

by preparing the accounts of capital items and show the capital receipts on the ‘Receipts side’ and the

capital payments on the ‘Payments side’ of the Receipts and Payments Account.

PROBLEMS

Bob Sample opened the Campus Laundromat on September 1, 2017. During the first month of operations, the

following transactions occurred.

Sept. 1 Bob invested 20,000 cash in the business.

2 The company paid 1,000 cash for store rent for September.

3 Paid 1,200 for a one-year accident insurance policy.

4 Bob withdrew 700 cash for personal use.

The chart of accounts for the company is the same as that for Pioneer Advertising plus No. 610 Advertising Expense.

Instructions:

(a) Journalize the September transactions. (Use J1 for the journal page number.)

(b) Open ledger accounts and post the September transactions.

(c) Prepare a trial balance at September 30, 2017.

LEDGER

A ledger account may be defined as a summary statement of all the transactions relating to a person, asset, expense or

income which have taken place during a given period of time and shows their net effect.

1999

Dec. 1. Cash A/c Dr. 50,000

To Capital A/c 50,000

(Being business started with capital)

6. Bank A/c Dr. 20,000

To Cash A/c 20,000

(Being cash paid into bank)

8. Purchase A/c Dr. 4,000

To Cash A/c 4,000

(Being goods purchased for cash)

9. Ram A/c Dr. 2,000

To Cash A/c 1,980

To Discount Received A/c 20

(Being cash paid to Ram and discount received Rs. 20)

10. Cash A/c Dr. 3,000

To Sales A/c 3,000

(Being goods sold for cash)

12. Cash A/c Dr. 2,000

To Sales A/c 2,000

(Being goods sold for cash)

15 Purchases A/c Dr. 4,000

To Ram A/c 4,000

(Being goods purchased from Ram)

18. Wages A/c Dr. 300

To Cash A/c 300

(Being wages paid)

20. Cash A/c Dr. 1,000

Discount Allowed A/c Dr. 50

To Pankaj A/c 1,050

(Being cash received from Pankaj and allowed him discount Rs. 50)

22. Cash A/c Dr. 3,000

To Bank A/c 3,000

(Being cash withdrawn from bank)

25. Ram A/c Dr. 500

To Bank A/c 500

(Being paid by cheque)

31. Drawings A/c Dr. 200

To Cash A/c 200

(Being withdrawn for personal use)

Solution

The closing stock was valued at Rs.12,500.

Solution TRADING & PROFIT AND LOSS A/C OF MESSRS KAUTILYA & CO.

FOR THE YEAR ENDED 31ST MARCH, 2006

Illustration: From the following particulars prepare a Bank Reconciliation Statement as on 31st December, 2006.

i) Balance as per Cash Book Rs.5,800.

ii) Cheques issued but not presented for payment Rs. 2,000.

iii) Cheques sent for collection but not collected upto 31st December, 2005 Rs. 1,500.

iv) The Bank had wrongly debited the account of the firm by Rs.200 which was rectified by them after 31st December.

Balance as per Pass Book is Rs. 6,100.

Solution

There is a difference of Rs.300 between the balance as shown by the Cash Book and the balance as shown by the Pass

Book. A reconciliation statement can be prepared to reconcile on the following basis the balances shown by the two

books.

i) The balance as shown by the Cash Book will be taken as the starting point.

ii) The cheques issued but not presented for payment have not been recorded in the Pass Book. The balance as per Pass

Book has to be found out. The Bank has not yet passed the entry for the payment of these cheques since they have not

been presented for payment. The balance, therefore, in the Pass Book should be more. The amount of Rs.2,000 should,

therefore, be added to the balance as shown by the Cash Book.

iii) Cheques sent for collection but not yet collected must have been entered in the Cash Book, but must not have been

credited by the Bank to the firm’s account since they have not yet been collected. The balance in the Pass Book should,

therefore, be less as compared to the Cash Book. The amount of Rs. 2,000 should, therefore, be deducted out of

the balance as shown by the Cash Book.

iv) The Bank has wrongly debited the firm’s account. This must have resulted in reducing balance as per the Bank Pass

Book. The amount should, therefore, be deducted out of the balance shown as per the Cash Book.

The Bank Reconciliation Statement will now appear as follows:

Bank Reconciliation Statement can be prepared as per the balance shown by Pass Book as the starting point.