GL Bajaj Institute of Management

& Research, Greater Noida

Post Graduate Diploma in Management

Session: 2021-2022

Accounting for Managers

(PG-03)
Trimester: I

Course Pack

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 Disclaimer

This study material is a compilation of content from different books and e-

resources as per the institute syllabus. The due references to these sources have
been included in the reference section. The author does not claim any copywriter
for this as it is not the original work of the author. The course pack is only for the
reference of students of GLBIMR, Greater Noida, and internal circulation.

Faculty: AFM

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 Unit-1: Meaning & Scope of Financial Accounting

1.1. Introduction to Accounting

Accounting is aptly called the language of business. This designation is applied to
accounting because it is the method of communicating business information. The basic
function of any language is to serve as a means of communication. Accounting duly
serves this function. The task of learning accounting is essentially the same as the task
of learning a new language. But the acceleration of change in business organization has
contributed to increase the complexities in this language. Like other languages, it is
undergoing continuous change to discover better means of communications. To enable
the accounting language to convey the same meaning to all stakeholders, it should be
made standard. To make it a standard language certain accounting principles, concepts
and standards have been developed over a period. This lesson dwells upon the different
dimensions of accounting, accounting concepts, accounting principles and the accounting
standards.

Accounti Record
Transactio

Who are

Communicat
es

Investor Credito Governme Manageme

Figure 1.1 Accounting as a “Language” of Business

The American Accounting Association defines accounting as “The process of

identifying, measuring and communicating economic information to permit
informed judgments and decisions by the users of information”. In simpler
words, accounting can be defined as the process of recording, summarizing and more
importantly communicating financial information to its stakeholders. Financial
information (e.g. financial statements) gives an indication of the money involved in
business transactions and events. Accounting is often known as the “language of

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business”, because it helps communicate the financial information of an organization to
various users (Figure 1.1). Therefore, familiarity with accounting concepts will benefit
both accountants and non-accountants such as investors, managers, employees and
government officials who require interacting frequently with business organizations.

1.2 Nature of Accounting:

We know Accounting is the systematic recording of financial transactions and
presentation of the related information of the appropriate persons. The basic features of
accounting are as follows:
 Accounting is a process: A process refers to the method of performing any
specific job step by step according to the objectives, or target. Accounting is
identified as a process as it performs the specific task of collecting, processing and
communicating financial information. In doing so, it follows some definite steps
like collection of data recording, classification summarization, finalization and
reporting.

 Accounting is an art: Accounting is an art of recording, classifying, summarizing

and finalizing the financial data. The word „art‟ refers to the way of performing
something. It is a behavioral knowledge involving certain creativity and skill that
may help us to attain some specific objectives. Accounting is a systematic method
consisting of definite techniques and its proper application requires applied skill
and expertise. So, by nature accounting is an art.

 Accounting is means and not an end: Accounting finds out the financial results
and position of an entity and the same time, it communicates this information to
its users. The users then take their own decisions on the basis of such
information. So, it can be said that mere keeping of accounts can be the primary
objective of any person or entity. On the other hand, the main objective may be
identified as taking decisions on the basis of financial information supplied by
accounting. Thus, accounting itself is not an objective, it helps attaining a specific
objective. So it is said the accounting is „a means to an end‟ and it is not „an end
in itself.‟

 Accounting deals with financial information and transactions; Accounting

records the financial transactions and date after classifying the same and finalizes

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 their result for a definite period for conveying them to their users. So, from
starting to the end, at every stage, accounting deals with financial information.
Only financial information is its subject matter. It does not deal with non-
monetary information of non-financial aspect.

 Accounting is an information system: Accounting is recognized and

characterized as a storehouse of information. As a service function, it collects
processes and communicates financial information of any entity. This discipline of
knowledge has been evolved out to meet the need of financial information
required by different interested groups.

1.3 Objectives of Accounting

Accounting practices have emerged from well-defined and properly designed objectives.
The objectives of accounting (Figure 1.2) can be broadly classified into the following
three basic categories:

Accounting

Financi Income Financia

al Determination l
&

Figure 1.2 Objectives of Accounting

1.3.1 Financial Reporting: This helps the organisation to

 have a permanent record of each transaction and to show the financial effect on
business.
 assess the combined effects of all the transactions made during an accounting
period.

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1.3.2 Income Determination and Policy Management: By this, one can
 evaluate the earning capacity of the enterprise by supplying a statement of its
financial position.
 provide necessary information for financial forecasting, cost management and
formulation of policies regarding financial management.

1.3.3 Financial Disclosure: This enables one to

 supply all relevant and important financial information to different kinds of users
through a single set of broad-based financial statements.
 provide necessary data to the government authorities for making proper decisions
related to taxes, price control, etc.

1.4. Functions of Accounting

The basic function of accounting is to measure the resources held by an organisation.
More specifically, the functions of accounting (Figure 2.2) can be categorised as follows:

1.4.1 Recording: The primary function of accounting relates to recording, classification

and summarisation of financial transactions. It helps in knowing the operating results
and financial positions. The purpose of this function is to allow one to report regularly to
the interested parties by means of financial statements. Thus, accounting helps focus
attention on the past performance of a firm and thus helps managers in their decision
making for improving the future performance of a firm.

Recordi

Manageri
al

Functions
of Legal
Requireme

Communicati

Figure 2.2 Functions of Accounting

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1.4.2 Managerial Function: Accounting assists in the decision-making process of a
firm. It enables one to compare day-to-day operations of a firm with predetermined
standards or benchmarks set in the budget. The variations of actual operations with
predetermined standards and their analysis ultimately help managers in making
informed decisions.

1.4.3 Legal Requirement: In every firm, accounting provides support to comply with
legal requirements. It offers a base for the preparation of various reports required by the
legal authorities. For example, in the case of registered firms, auditing is mandatory and
accounting helps in generating all the necessary documents required for audit purpose.
Another good example is income tax statements of a firm.

1.4.4 Communicating: Accounting is known as the “language of business”. Various

transactions and the result of a company‟s performance are communicated to users only
through the process of accounting. Accounting shows the real and true position of a firm.

1.5 Advantages Of Accounting

The basic function of accounting is to supply meaningful information about the financial
activities of the business to the owners and the managers of a firm. The intention of
accounting is-
 to have a complete record of business transactions.
 to give information about the profit or loss made by the business at the end of a
year.
 to provide useful information for making financial decisions.
 to facilitate a comparative study of the current year‟s profit, sales, expenses, etc.,
with those of the previous years.
 to help in complying with certain legal formalities such as filing of income tax and
sales tax returns. If the accounts are properly maintained, the assessment of
taxes is greatly facilitated.

1.6 Limitations Of Accounting

Despite having various advantages, accounting has some limitations that are summed
up below.

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1.6.1 : Financial Nature: Accounting measures only those activities that can be

expressed in terms of money. Non-Monetary events, for example, management

reputation, employee morale and labour strikes, however, significant and important, are
not recorded through the process of accounting.

1. 6.2: Historical Nature: Accounting is historical in nature, because it has information

related to expenses incurred in the past. It does not provide current information about
costs and expenses. For example, let us suppose that 100 units of an item were
purchased one month back for Rs 100 per unit, and the price of that is increased to Rs
110 per unit. But, the cost of inventory to be shown in the balance sheet is Rs 10,000
rather than Rs 11,000 and therefore, in that case, the financial statement may not show
the true market value of the inventory.

1.6.3 : Measurement Unit: Money serves as a measurement unit in accounting, and its

value changes over time. The changes in the price should be considered in the
measurement of income of a firm. These changes however are not incorporated through
the process of accounting and are hence a serious limitation to accounting.

1.6.4 : No information regarding Opportunity Cost: Accounting provides information

on what had happened. However, managers would find it more useful if they know what
can happen in future if they use resources optimally. This feature is lacking in
accounting, which makes its usability limited from the managerial perspective.

1.7 Branches of Accounting:

Accounting is a process that provides information to its users. The latter require different
types of information, depending on their objectives. Accounting activities can be broadly
classified into three types, namely, (1) Financial Accounting, (2) Cost Accounting and (3)
Management Accounting.

1.7.1 Financial Accounting: This is concerned with recording and summarising

business transactions and preparing financial statements (Income Statement, Balance
Sheet, Cash and Fund Flow Statements) in compliance with prevailing accounting
practices. This information is mainly used by Investors, Creditors, Banks, Government,
Competitors and Other external users.

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1.7.2 Cost Accounting: This is the process of collecting, classifying and recording all
the costs incurred in carrying out business activities. Cost Accounting helps in keeping a
track of the money spentfor different activities and thereby helps in deciding the selling
price of the product. It is mainly useful for managers and owners of the organisation.

1.7.3 Management Accounting: This relates to the use of financial and cost data for
evaluating the performance of an organisation, reviewing the existing policies and
making decisions about new policies. This information is used mainly by managers and
other employees.

1.7.4 Tax Accounting: Tax accounting helps clients follow rules set by tax authorities.
It includes tax planning and preparation of tax returns. It also involves determination of
income tax and other taxes, tax advisory services such as ways to minimize taxes
legally, evaluation of the consequences of tax decisions, and other tax-related matters.

1.7.5 Social Accounting: Social accounting is concerned with analysing and evaluating
organizational impact on society and its environment. It measures the social costs and
benefits of various organizational activities. For example, accountants in this area might
analyse and evaluate the use of federal and state land or the use of welfare funds in a
large city. Other accountants might analyse and evaluate the environmental impact of
acid rain.

1.8 Uses of Accounting information

Accounting is a process that helps provide essential information to users. Users of
accounting have varied purposes, and they all tend to see the same information from
their point of interest. Accounting information is presented in the form of various
financial statements that provide necessary information required by the users. To specify
the accounting functions accurately and also to know more about accounting
information, it is essential to first identify the various users of accounting information.
Accounting information is required by people both inside and outside an organisation,
and they can be categorised as inside and outside users, respectively (Figure 1.3).

1.8.1 External Users/Outside Users/Secondary Users: External users are users

outside the organisation, for example, investors, lenders, financial institutions, banks,
creditors and customers.

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 Investors: Investors are among the key receivers of the financial statements of
an organisation. They provide financial capital to the organisation and therefore
need to be updated about the financing activities of the organisation. Investors
include equity shareholders, preference shareholders, etc. Because they do not
necessarily receive any fixed income on the money provided by them, the
accounting information regarding the ongoing financial activities of the firm
becomes very important to them.

 Lenders: This category of external users includes banks and mainly financial
institutions. They give loans to the organisation and hence are interested in
information that helps them in finding out whether their loan or interest will be
paid or not. In fact, most of the banks use credit evaluation benchmarks based on
the information derived from financial statements while sanctioning loans to the
firm.

Figure 1.3 Users of Accounting Information

 Government: The Government is interested in the activities of all enterprises to

determine taxation policies and to regulate their business practices. The Ministry
of Finance and the Department of Company Affairs are among those departments
of the Government that take an interest in the financial affairs of a firm.

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 Regulatory bodies set up by the Government of India (e.g. the Securities and
Exchange Board of India) also pay attention to the financing affairs of companies.

 Creditors: The suppliers of raw material and any other services to a company are
also interested in accessing the financial details of the company. They are keen to
obtain information that enables them to determine whether their money will be
repaid or not.

 Customers: Customers are interested in the financial affairs of an enterprise to

help them decide about the business they are doing with a firm. They also want to
assess the ability of the firm to service their product or to honour agreements.
Because the firm is the source of supply for the customers, they are concerned
about their dependence on the firm for the product it delivered or the service it
rendered.

 Public: An organisation also affects the public in general. Financial statements

assist the public by providing information about the trends and recent
developments in the success of an enterprise and the range of its activities.
Political parties, Non-Government Organisations, consumer groups and other
social groups also have a general interest in the affairs of a business enterprise.

1.8.2 Internal Users/Inside Users/Primary Users: Internal users of accounting

information are the main decision makers of the company and are involved in managing
the business and the employees of the company. They can be broadly classified into two
categories, namely, (1) management and (2) employees of the firm

 Management: Financial statements are instruments that are very useful for the
management of an organisation, who are the decision makers of the firm. The
management needs information for planning and controlling the firm‟s operations,
for making special decisions and for formulating major plans and policies. Because
the management is responsible for the performance of the firm, they have to
monitor the key financing indicators very closely.

 Employees: Employees are also interested in obtaining information about their

enterprise and its general operations, stability and profitability. Because the firm

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 is the source of earning for employees, they have a keen interest in the financial
activities of their organisation.

Table 1.1 Summary of Users of Accounting Information

S.No. Users Concerns
1 Investors Buy-sell decisions (right time to buy, sell or hold an
investment). Monitoring of the company‟s performance
(satisfactory or unsatisfactory)
2 Lenders Repayment of loan and interest on time, collateral for the loan,
rate of interest, etc.
3 Government Tax policies, for subsidies, monitoring of firms as to whether
they overcharge customers, whether the company makes a
proper disclosure of its financial results as per the law
4 Creditors Decisions about whether the company is a major customer,
whether the company will be able to pay for its purchases in
the future or not
5 Customers Information on whether the company is a reliable source of
supply, and whether it will be able to service its products
6 Public Safety of products, concern about company exploiting its local
suppliers
7 Management Growth rate of the firm, concern about company earnings
being an adequate profit in relation to its assets and
performance of the firm
8 Employees Continuity and increment of the compensation provided by the
firm

1.9 Accounting Principles:

The Generally Accepted Accounting Principles have evolved over a long period of time on
the basis of past experiences, usages or customs, statements by individuals and
professional bodies and regulations by government agencies and have general
acceptability among most accounting professionals. However, the principles of
accounting are not static in nature. These are constantly influenced by changes in the
legal, social and economic environment as well as the needs of the users. These
principles are also referred as concepts and conventions. The term concept refers to the

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necessary assumptions and ideas which are fundamental to accounting practice, and the
term convention connotes customs or traditions as a guide to the preparation of
accounting statements

1.9.1 Accounting Concept: Accounting Concept defines the assumptions on the basis
of which Financial Statements of a business entity are prepared. Certain concepts are
received assumed and accepted in accounting to provide a unifying structure and
internal logic to accounting process. The word concept means idea or nation, which has
universal application. Financial transactions are interpreted in the light of the concepts,
which govern accounting methods. Concepts are those basis assumption and conditions,
which form the basis upon which the accountancy has been laid. Unlike physical science,
Accounting concepts are only results of broad consensus. These accounting concepts lay
the foundation on the basis of which the accounting principals are formulated. Now we
shall study in detail the various concept on which accounting is based. The following are
the widely accepted accounting concepts.

 Entity Concept: - Entity Concept says that business enterprises is a separate

identity apart from its owner. Business transactions are recorded in the business
books of accounts and owner‟s transactions in this personal back of accounts. The
concept of accounting entity for every business or what is to be excluded from the
business books. Therefore, whenever business received cash from the proprietor,
cash a/c is debited as business received cash and capital/c is credited. So the
concept of separate entity is applicable to all forms of business organization.

 Money Measurement Concept: - As per this concept, only those transactions,

which can be measured in terms of money are recorded. Since money in the
medium of exchange and the standard of economic value, this concept requires
that these transactions alone that are capable of being measured in terms of
money be only to be recorded in the books of accounts. For example, health
condition of the chairman of the company, working conditions of the workers, sale
policy ect. do not find place in accounting because it is not measured in terms of
money.

 Cost Concept: - By this concept, the value of assets is to be determined on the

basic of historical cost. Transaction are entered in the books of accounts at the

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 amount actually involved. For example a machine purchased for Rs. 80000 and
may consider it worth Rs. 100000, But the entry in the books of account will be
made with Rs. 80000 or the amount actually paid. The cost concept does not
mean that the assets will always be shown at cost. The assets may be recorded at
the time of purchase but it may be reduced its value be charging depreciation.
Many assets de not have acquisition cost. Human assets of an enterprises are an
example. The cost concept fails to recognize such assets although it is a very
important assets of any organization.

 Going Concern Concept: - According to this concept the financial statements are
normally prepared on the assumption that an enterprises is a going concern and
will continue in operation for the foreseeable future. Transaction are therefore
recorded in such a manner that the benefits likely to accrue in future from money
spent. It is because of this concept that fixed assets are recorded at their original
cost and depreciation in a systematic manner without reference to their current
realizable value.

 Dual aspect Concept: - This concept is the care of double entry book-keeping.
Every transaction or event has two aspect. If any event occurs, it is bound to have
two effect. For Rs.50000, on the other hand stock will increase by Rs.50000 and
other liability will increase by Rs.50000. similarly is X starts a business with a
capital of Rs. 50000, while on the other hand the business has to pay Rs. 50000
to the proprietor which is taken as proprietor‟s Capital.

 Realization Concept: - It closely follows the cost concept any change in value of
assets is to be recorded only when the business realize it. i.e. either cash has
been received or a legal obligation to pay has been assumed by the customer. No
Sale can be said to have taken place and no profit can be said to have arisen. It
prevents business firm from inflating their profit by recording sale and income that
are likely to accrue, i.e. expected income or gain are not recorded.

 Accrual Concept: - Under accrual concept the effect of transaction and other
events are recognized on mercantile basic. When they accrue and not as cash or a
cash equivalent is received or paid and they are recorded in the accounting record
and reported in the financial statements of the periods to which they relate

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 financial statement prepared on the accrual basic inform users not only of past
events involving the payment and receipt of cash but also of obligation to pay
cash in the future and of resources that represent cash to be received in the
future. For Example:- Mr. Raj buy clothing of Rs. 50000,a paying cash Rs. 20000
and sells at Rs. 60000 of which customer paid only Rs. 40000. So his revenue is
Rs. 60000, not Rs. 40000 cash received. Exp. Or Cash is Rs. 50000, not Rs. 20000
cash paid. So the accrual concept based profit is Rs. 10000 (Revenue- Exp.)

 Accounting Period Concept: - This is also called the concept of definite

periodicity concept as per going concept on indefinite life of the entity is assumed
for a business entity it causes inconvenience to measure performance achieved by
the entity in the ordinary causes of business. Therefore, a small but workable
fraction of time is chosen out of infinite life cycle of the business entity for
measure the performance and loading at the financial position 12 months period is
normally adopted for this purpose accounting to this concept accounts should be
prepared after every period & not t the end of the life of the entity. Usually this
period is one calendar year. In India we follow from 1st April of a year to 31st
March of the immediately following years. Now a day because of the need of
management, final accounts are prepared at shoter intervals of quarter year or in
some cases a month such accounts are know a interim account.

 Matching Concept: - In this concept, all exp. Matched with the revenue of that
period should only be taken into consideration. In the financial statements of the
organization. If any revenue is recognized that exp. Related to earn that revenue
should also be recognized. This concept as it considers the occurrence of exp. And
income and do not concentrate on actual inflow or outflow of cash. This leads to
adjustment of certain items like prepaid and outstanding expenses, unearned or
accrued income. It is not necessary that every exp. Identity every income. Some
exp. Are directly related to the revenue and some are directly related to sale but
rent, salaries etc. are recorded on accrual basis for a particular accounting period.
In other words periodicity concept has also been followed while applying matching
concept.

 Objective Concept:- As per this concept, all accounting must be based on

objective evidence. In other words, the transactions recorded should be supported

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 by verifiable documents. Only than auditors can verify information record as true
or otherwise. The evidence should not be biased. It is for this reasons that assets
are recorded at historical cost and shown thereafter at historical lass depreciation.
If the assets are shown on replacement cost basis, the objectivity is lost and it
become difficult for auditors to verify such value, however, in resent year
replacement cost are used for specific purpose as only they represent relevant
costs. For example, to find out intrinsic value of share, we need replacement cost
of assets and not the historical cost of the assets.

1.9.2 Accounting Conventions: The term “Accounting Conventions” refers to the

customs or traditions which are used as a guide in the preparation of accounting reports
and statements. The conventions are derived by usage and practice. The accountancy
bodies of the world may charge any of the convention to improve the quality of
accounting information accounting conventions need not have universal application.
Following are important accounting conventions in use:

 Convention of consistency: - According to this convention the accounting

practices should remain unchanged from one period to another. It requires that
working rules once chosen should not be changed arbitrarily and without notice of
the effect of change to those who use the accounts. For example, stock should be
valued in the same manner every year. Similarly depreciation is charged on fixed
assets on the same method year after year. If this assumption is not followed, the
fact should be disclosed together with reasons. The principle of consistency plays
its role particularly when alternative accounting methods is equally acceptable.
Any change from one method to another method would result in inconsistency;
they may seem to be inconsistent apparently. In case of valuation of stocks if the
company applies the principle “at cost or market price whichever is less” and if
this principle accordingly result in the valuation of stock in one year at cost and
the market price in the other year, there is no inconsistency here. It is only an
application of the principle. An Enterprise should change its accounting policy in
any of the following circumstances only.
 To bring the books of accounts in accordance with the issued accounting
standard.
 To compliance with the provision of law.

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  When under changed circumstances it is felt that new method will reflect truer
and fairer picture in the financial statement.

 Convention of Conservatism: - This is the policy of playing sale game. It takes

into consideration all prospective losses but leaves all prospective profits financial
statements are usually drawn up on a conservative basis anticipated profit are
ignored but anticipated losses are taken into account while drawing the
statements following are the examples of the application of the convention of
conservatism.
 Making the provision for doubtful debts and discount on debtors.
 Valuation of the stock at cost price or market price which ever is less.
 Charging of small capital items, like crockery to revenue.
 Showing joint life policy at surrender value as against the actual amount
paid.
 Not providing for discount on creditors.

 Convention of Disclosure: - Apart from statutory requirement, good accounting

practice also demands that significant information should be disclosed in financial
statements. Such disclosures can also be made through footnotes. The purpose of
this convention is to communicate all material and relevant facts concerning
financial position and results of operations to the users. The contents of balance
sheet and profit and loss account are prescribed by law. These are designed to
make disclosures of all materials facts compulsory. The practice of appending
notes relative to various facts and items which do not find place in accounting
statements is in pursuance to the convention of full disclosure of material facts.
For example;
 Contingent liability appearing as a note.
 Market value of investments appearing as a note.

 Convention of Materiality:- According to this conventions, the accountant

should attach importance to material detail and ignore insignificant details in the
financial statement. In materiality principle, all the items having significant
economics effect on the business of the enterprises should be disclosed in the
financial statement. The term materiality is the subjective term. It is on the
judgment, common sense and discretion of the accountant that which item is

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 material and which is not. For example stationery purchased by the organization
though not used fully in the concept. Similarly depreciation small items like books,
calculator is taken as 100% in the year if purchase through used by company for
more than one year. This is because the amount of books or calculator is very
small to be shown in the balance sheet. It is the assets of the company.

1.10 Basic Terms in Accounting

 Entity: Entity means a reality that has a definite individual existence. Business
entity means a specifically identifiable business enterprise like Super Bazaar, Hire
Jewellers, ITC Limited, etc. An accounting system is always devised for a specific
business entity (also called accounting entity).

 Transaction: An event involving some value between two or more entities. It can
be a purchase of goods, receipt of money, payment to a creditor, incurring
expenses, etc. It can be a cash transaction or a credit transaction.

 Assets: Assets are economic resources of an enterprise that can be usefully

expressed in monetary terms. Assets are items of value used by the business in
its operations. For example, Super Bazar owns a fleet of trucks, which is used by
it for delivering foodstuffs; the trucks, thus, provide economic benefit to the
enterprise. This item will be shown on the asset side of the balance sheet of Super
Bazaar. Assets can be broadly classified into two types: current and Non-current.

 Liabilities: Liabilities are obligations or debts that an enterprise has to pay at

some time in the future. They represent creditors‟ claims on the firm‟s assets.
Both small and big businesses find it necessary to borrow money at one time or
the other, and to purchase goods on credit. Super Bazar, for example, purchases
goods for ` 10,000 on credit for a month from Fast Food Products on March 25,
2005. If the balance sheet of Super Bazaar is prepared as at March 31, 2005, Fast
Food Products will be shown as creditors on the liabilities side of the balance
sheet. If Super Bazaar takes a loan for a period of three years from Delhi State
Co-operative Bank, this will also be shown as a liability in the balance sheet of
Super Bazaar. Liabilities are classified as current and non-current

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 Capital: Amount invested by the owner in the firm is known as capital. It may be
brought in the form of cash or assets by the owner for the business entity capital
is an obligation and a claim on the assets of business. It is, therefore, shown as
capital on the liabilities side of the balance sheet.

 Sales: Sales are total revenues from goods or services sold or provided to
customers. Sales may be cash sales or credit sales.

 Revenues: These are the amounts of the business earned by selling its products
or providing services to customers, called sales revenue. Other items of revenue
common to many businesses are: commission, interest, dividends, royalities, rent
received, etc. Revenue is also called income.

 Expenses: Costs incurred by a business in the process of earning revenue are

known as expenses. Generally, expenses are measured by the cost of assets
consumed or services used during an accounting period. The usual items of
expenses are: depreciation, rent, wages, salaries, interest, cost of heater, light
and water, telephone, etc.

 Expenditure: Spending money or incurring a liability for some benefit, service or

property received is called expenditure. Purchase of goods, purchase of
machinery, purchase of furniture, etc. are examples of expenditure. If the benefit
of expenditure is exhausted within a year, it is treated as an expense (also called
revenue expenditure). On the other hand, the benefit of an expenditure lasts for
more than a year, it is treated as an asset (also called capital expenditure) such
as purchase of machinery, furniture, etc.

 Gain: A profit that arises from events or transactions which are incidental to
business such as sale of fixed assets, winning a court case, appreciation in the
value of an asset.

 Loss: The excess of expenses of a period over its related revenues its termed as
loss. It decreases in owner‟s equity. It also refers to money or money‟s worth lost
(or cost incurred) without receiving any benefit in return, e.g., cash or goods lost
by theft or a fire accident, etc. It also includes loss on sale of fixed assets.

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 Discount: Discount is the deduction in the price of the goods sold. It is offered in
two ways. Offering deduction of agreed percentage of list price at the time selling
goods is one way of giving discount. Such discount is called „trade discount‟. It is
generally offered by manufactures to wholesellers and by wholesellers to retailers.
After selling the goods on credit basis the debtors may be given certain deduction
in amount due in case if they pay the amount within the stipulated period or
earlier. This deduction is given at the time of payment on the amount payable.
Hence, it is called as cash discount. Cash discount acts as an incentive that
encourages prompt payment by the debtors.

 Voucher: The documentary evidence in support of a transaction is known as

voucher. For example, if we buy goods for cash, we get cash memo, if we buy on
credit, we get an invoice; when we make a payment we get a receipt and so on.

 Goods: It refers to the products in which the business unit is dealing, i.e. in terms
of which it is buying and selling or producting and selling. The items that are
purchased for use in the business are not called goods. For example, for afurniture
dealer purchase of chairs and tables is termed as goods, while for other it is
furniture and is treated as an asset. Similarly, for a stationery merchant,
stationery is goods, whereas for others it is an item of expense (not purchases)

 Drawings: Withdrawal of money and/or goods by the owner from the business
for personal use is known as drawings. Drawings reduces the investment of the
owners.

 Purchases: Purchases are total amount of goods procured by a business on credit

and on cash, for use or sale. In a trading concern, purchases are made of
merchandise for resale with or without processing. In a manufacturing concern,
raw materials are purchased, processed further into finished goods and then sold.
Purchases may be cash purchases or credit purchases

 Debtors: Debtors are persons and/or other entities who owe to an enterprise an
amount for buying goods and services on credit. The total amount standing
against such persons and/or entities on the closing date, is shown in the balance
sheet as sundry debtors on the asset side.

20
  Creditors: Creditors are persons and/or other entities who have to be paid by an
enterprise an amount for providing the enterprise goods and services on credit.
The total amount standing to the favour of such persons and/or entities on the
closing date, is shown in the Balance Sheet as sundry creditors on the liabilities
side

1.11 Accounting as an Information System

Accounting provides information that is useful in making business and economic

decisions. Accounting is known as the language of business, and it is the principle means
of communicating financial information to its users. The users of this information are
those who have direct or indirect interests in the business activities of the firm.
Accounting helps provide information through various financial statements and it thereby
helps in the rational decision-making process (Figure 1.4)

Business
Inputs transactions

Processing Accounting
concepts

Outputs Financi
al

Users Investors
Lenders

Figure 1.4 The Accounting Information System

Accounting works like a system and therefore certainly has some inputs in the form of
various business transactions. These transactions are recorded and classified in the light
of accounting concepts and conventions, which constitutes the processing part of the
accounting system. Finally, these transactions are summarised in the form of financial

21
statements and reports. Therefore, the output is in the form of various financial
statements and can be used by a variety of users, per their requirements.

1.11.1. Significance of the Accounting Information System

Accounting information is useful in that it helps users in making many decisions that
affect the income or wealth of individuals and organisations. Accounting reports are
designed to meet the common information requirements of most decision makers. The
following issues can be sorted out based on the accounting information provided by the
firm:
 Decisions related to buying, holding or selling the company‟sstock
 Assessment of accountability of management
 Assessment of the ability of an enterprise to provide other benefits to its
employees apart from their salary
 Determination of taxation policies
 Regulation of the activities of enterprises

1.12 Accounting Process

Any economic transaction or event of a business which can be expressed in monetary
terms should be recorded. Traditionally, accounting is a method of collecting, recording,
classifying, summarizing, presenting and interpreting financial data of an economic
activity. The series of business transactions occurs during the accounting period and its
recording is referred to an accounting process/ mechanism. An accounting process is a
complete sequence of accounting procedures which are repeated in the same order
during each accounting period. Therefore, accounting process involves the following

i. Identification of Transaction : In accounting, only financial transactions are

recorded. A financial transaction is an event which can be expressed in terms of
money and which brings change in the financial position of a business enterprise.
An event is an incident or a happening which may or may not bring any change in
the financial position of a business enterprise. Therefore, all transactions are
events but all events are not transactions. A transaction is a complete action, to
an expected or possible future action. In every transaction, there is movement of
value from one source to another. For example, when goods are purchased for
cash, there is a movement of goods from the seller to the buyer and a movement
of cash from buyer to the seller. Transactions may be external (between a

22
 business entity and a second party, e.g., goods sold on credit to Hari or internal
(do not involve second party, e.g., depreciation charged on the machinery).
ii. Recording the transaction : Journal is the first book of original entry in which
all transactions are recorded event-wise and date-wise and presents a historical
record of all monetary transactions. Journal may further be divided into sub-
journals as well.
iii. Classifying : Accounting is the art of classifying business transactions.
Classification means statement setting out for a period where all the similar
transactions relating to a person, a thing, expense, or any other subject are
grouped together under appropriate heads of accounts.
iv. Summarising : Summarising is the art of making the activities of the business
enterprise as classified in the ledger for the use of management or other user
groups i.e. sundry debtors, sundry creditors etc. Summarisation helps in the
preparation of Profit and Loss Account and Balance sheet for a particular financial
year.
v. Analysis and Interpretation : The financial information or data is recorded in
the books of account must further be analysed and interpreted so to draw
meaningful conclusions. Thus, analysis of accounting information will help the 5
management to assess in the performance of business operation and forming
future plans also.
vi. Presentation or reporting of financial information : The end users of
accounting statements must be benefited from analysis and interpretation of data
as some of them are the "share holders" and other one the "stake holders".
Comparison of past and present statements and reports, use of ratios and trend
analysis are the different tools of analysis and interpretation. From the above
discussion one can conclude that accounting is an art which starts and includes
steps right from recording of business transactions of monetary character to the
communicating or reporting the results thereof to the various interested parties.
For this purpose, the transactions are classified into various accounts, the
description of which follows in the next section

1.13 Accounting Equation

Dual concept states that 'for every debit, there is a credit'. Every transaction should
have two-sided effect to the extent of same amount. This concept has resulted in
accounting equation which states that at any point of time assets of any entity must be

23
equal (in monetary terms) to the total of owner's equity and outsider's liabilities. The
relationship can be presented in the following form:
Assets = Sources of Finance

Table 1.2 Elements of the Accounting Equation

S.No. Asset Liabilities Equity

Any resource owned by a

Everything owed by Owner‟s contribution to
1 firm that will provide
firms to outsiders business
future benefit
Type - Current and Type - Internal and
2 Type - Current and Fixed
Long Term External
Examples - Cash, Factory, Example - Loans,
Examples - Common
3 Building, Machinery, Credit, Purchase,
Stock, Retained Earnings
Vehicles, Land Interest paid

The above equation gets expanded.

Assets = Liabilities + Capital
All transactions of a business can be referred to this equation:
Assets = Liabilities + Owner's equity
To further explain the transaction of revenues, expenses, losses and gains, the equation
can be expanded thus
Assets + Expenses = Liabilities + Revenue + Owner's equity
or
Assets = Liabilities + (Revenue – Expenses) + Owner's equity

Illustration 1. Show the effect of following transaction on the accounting

equation.
1. Commenced business with cash Rs. 50,000
2. Purchased goods for cash Rs. 20,000 and on credit Rs. 30,000
3. Sold goods for cash Rs. 40,000 costing Rs. 30,000
4. Rent paid Rs. 500
5. Bought furniture Rs. 5,000 on credit
6. Bought refrigerator for personal use Rs. 5,000

24
Illustration 2. Show the effect of following transaction on the accounting
equation.
1. Suryani commenced business with cash ₹ 1, 00,000.
2. Purchased machinery for cash ₹ 10,000
3. Purchased goods from Romil on credit ₹ 50,000
4. Sold goods for cash ₹ 10000
5. Paid wages to Jaimin ₹ 15,000
6. Paid to Romil ₹ 25000
7. Wages to be paid to Raj is outstanding ₹ 5000
8. Brokerage earned but not received ₹ 2000
9. Deposited ₹ 15000 into the bank.
10.Suryani withdrew cash for personal use ₹ 10000

1.14Traditional Classification of Accounts

Transactions may be classified according to their nature into three main accounts: (1)
Personal, (2) Real and (3) Nominal. The detailed description of accounts is given below.

 Personal Accounts: Accounts that represent persons and organisations are

categorised as personal accounts. Examples are Raj‟s Account, Shyam‟s Account
(based on the name of a person); accounts that relate to legal entities, for
example, partnership firms, limited companies and institutions (artificial person‟s
account); Creditor‟s and Debtor‟s account (accounts of different persons of the
same nature). The following are also included in the personal account:
Outstanding Expenses, Expenses Paid in Advance and Income Received in
Advance.

 Real Accounts: Accounts that represent properties and assets owned by the
organisation are referred to as real accounts. Assets can be tangible (concrete, i.e.
can be touched by hand) and intangible (i.e. cannot be seen but can be measured
monetarily). Tangible assets include land, building, cash, machinery, stock (raw
material and finished goods) and intangible assets include goodwill, patents, etc.

 Nominal Accounts: Accounts that deal with transactions related to revenue,

expenses, income and losses are classified as nominal accounts. These accounts

25
 are also called temporary accounts because they are either closed at the end of
the year or are transferred to some bigger account. Examples of these are Salary
Account and Commission Received Account (Table 1.3).

Table -1.3 Examples of Personal, Real and Nominal Accounts

S.N Personal Real Nominal
o.
1 Capital Brought in Machinery Purchased Advertisement expenses
2 Ram‟s Account Cash Received Interest Paid
3 Outstanding Salary Data Card Purchased Carriage Inward paid
4 Pre-paid Insurance Laptop Purchased Commission Received
Premium
5 Interest accrued Pen Drive Purchased Wages and Salaries Paid
6 Repairs
7 Subscription received
8 Bad Debts Written off

1.14.1 Concept of Debit And Credit

Business transactions that are recorded are called entries. There are always two parties
involved in a transaction. One party supplies goods or provides services to the other
party and receives the money of equal worth in exchange of it. We now illustrate this
with the help of a purchase made by Mr. Singh, who buys a stereo from Digitax Limited
for Rs 25,000. In this transaction, Mr. Singh pays cash and receives the stereo in
exchange, whereas Digitax limited sells the stereo to Mr Singh and receives cash in
exchange.

Digitax Limited (Stereo) Mr. Singh (Cash Rs 25,000)

Gives Stereo Receives Stereo

Receives Cash Gives Cash

From the above illustration, it is proved that two aspects are involved in any transaction,
and these are to be recorded simultaneously. This twofold aspect system is known as the

26
Double entry system. The two aspects of business transactions can be viewed in the
form of debit and credit aspects. The receiving or incoming or expense or loss in a
transaction is known as the „Debit concept‟ and the giving or outgoing or income or gain
or profit in a transaction is known as the „Credit concept‟. The DEBIT and CREDIT
aspects form the basis of the Double Entry System.
Debit–Credit rules for the three types of accounts may be summarised as
follows:
1. Personal Account debit the receiver and credit the giver
2. Real account debitwhat comes in and credit what goes out
3. Nominal account debit all expenses and losses and credit all incomes & gains

1.15 Modern Approach to Classify Accounts

Under the Modern Approach, the accounts are not debited and credited. Hence, the
Accounting Equation is used to debit or credit an account. Thus, it is also known as the
Accounting Equation Approach. Under the Modern Approach the accounts can be
classified as follows:

i. Assets Accounts: Assets are the properties, possessions or economic resources

of a business. They help in business operations and help in earning revenues.
They can be measured in terms of money. Assets can be tangible or intangible.
Also, assets can be classified as Fixed Assets and Current Assets. Fixed Assets are
held for the long-term. They help in carrying out the normal operations of the
business. For example, land, building, furniture, machinery, vehicles, etc. Current
Assets are held for short-term. They are realizable within a year usually. For
example, debtors, bills receivable, bank balance, cash, stock, etc.

ii. Liabilities Accounts: Liabilities are the amounts that an entity owes to the
outsiders. These are the obligations or the debts payable by the business.
Liabilities can also be classified as Long-term and Current. Long-term Liabilities
are payable after a period of one year. For example, debentures, bank loans, etc.
Current liabilities are payable within one year. For example, creditors, bills
payable, rent outstanding, bank overdraft, etc.

iii. Capital Accounts: The money brought into the business by the owner is called
Capital or Owner‟s Equity. The Capital can be brought in cash or assets by the

27
 owner. Capital is an obligation of the business that has to be paid back to the
owner. Because business is a separate entity from its owner. Therefore, the
Capital is shown on the liabilities side of the Balance Sheet. The capital account is
shown after deducting the Drawings by the owner. Drawings are the amount of
cash, goods or assets taken by the owner for personal use from the business.

iv. Revenue Accounts: Revenue is the amount earned by the business by selling
goods or rendering of services. Also, it includes other incomes such as rent
received, the commission received, interest received, dividend earned, etc. All
items of revenue are also clubbed together under the Modern Approach.

v. Expenses Accounts: All costs incurred or money spent by a business in order to

earn revenues is called expenses. It is noteworthy here that when the benefits of
the money spent are exhausted within a period of one year, it is called an
Expense. While in case the benefit lasts for more than a year it is called
Expenditure. Therefore, the purchase of goods is expenditure while the cost of
goods sold is an expense. For example, rent paid, salary paid, electricity charges,
interest paid, etc. are expenses. While the purchase of assets, purchase of short-
term investments, etc. fall under the category of expenditure.

1.15.1 Rules of Debit and Credit under the Modern Approach

 Asset Accounts Debit the increase; Credit the decrease

 Liabilities Accounts Credit the Increase; Debit the decrease
 Capital Accounts Credit the Increase; Debit the decrease
 Revenue Accounts Credit the Increase; Debit the decrease
 Expense Accounts Debit the increase; Credit the decrease

1.16 Journal and Journalising Process

Every business organization carries various transactions throughout the day. Some
transactions are similar, many are different. Hence, it is not possible to keep all the
journalising process in mind without recording it. All these transactions are important
and therefore can‟t be avoided or omitted. So, to avoid any mistake or omission, all
these transactions are recorded in books. Journalising is the traditional form of keeping
track of happenings in the organization. Journal is the book of prime entry also called the
book of original entry. That is, transactions are first entered here and is the most

28
important book of accounts. The transactions are recorded systemically and in
chronological order. They are entered to show which accounts should be debited or
credited. Recording of transactions in “Journal” is called as “Journalising the entries”

1.16.1 Format of the Journal

Date Particulars Ledger Debit Credit

Folio Amount Amount
(Rs) (Rs)

 Date: This column of the Journal records the date of the transaction. The year
and month are written once and re-entered only when changed. The order and
sequence of month and dates should be strictly followed.

 Particulars: This column records the name of the account to be debited and
credited. The debit entry is made first followed by the credit entry of the
transaction. Dr. is to be written at the end of the first line of the debit entry, and
the credit entry starts with the word „To‟; a space is provided between this and
the margin so as to differentiate it from the debit entry.

 Ledger Folio (L.F): All the entries of the Journal are transferred into a ledger
account. This column contains the ledger page number of the relevant account. By
the time, ledger entries are not passed by the accountant, this column remains
blank.

 Debit Amount: The amount to be debited is to be entered.

 Credit Account: The amount to be credited is to be entered

1.16.2 Process of Journalising

The steps to be followed in making a Journal entry are described below.

Stage 1 - Recognition of Business Transactions

Step 1: Determine the two accounts involved in the transaction.

29
Step 2: Classify the two accounts
Step 3: Determine the rule of debit or credit for the two accounts.
Step 4: I Identify which account is to be debited and which is to be credited.

Stage 2- Recording of the Transactions

Step 5: Record the date of transaction in the month column.
Step 6: Enter the name of the account to be debited in the “Particulars” column
along with the abbreviation Dr at the end of the same line. Enter the
amount to be debited in the Debit amount column on the same line.
Step 7: Enter the name of the account to be credited on the next line starting with
“To”, slightly away from the line in the Particulars column. Write down the
amount to be credited in the Credit amount column in the same line.
Step 8: Write down the details of the transaction within brackets on the next line in
the Particulars Column.
Step 9: Draw a line across the entire Particulars Column to separate one Journal
entry from the other.

Illustration 3. Journalise the following transactions in the books of Ram

Industries Limited.
 Ram Kumar commenced business with cash Rs 1, 00,000.
 Paid into the Bank Rs 60,000
 Purchased for cash is Rs 70,000
 Sold goods for cash Rs 1, 00,000.
 Purchased goods from Singh Rs 60,000
 Sold goods to Diraj Rs 90,000
 Paid travelling charges Rs 1,800
 Paid electric charges Rs 700
 Paid salaries to staff Rs 9,000

Illustration 4. Record the following transactions in the journal of Anand

enterprise.
 Anand started business with Rs 2,00,000
 Purchased goods from Ramesh Rs 25,000
 Goods returned to Ramesh Rs 650
 Purchased furniture for Rs 15,000 from Shyam Enterprises

30
  Goods sold to Gopi for Rs 9,000
 Goods returned by Gopi Rs 350
 Cash returned from Gopi Rs 7,000
 Paid to Ramesh Rs 2,000

Illustration 5. Journalise the following transactions in the books of Mr. Suthar.

 Mr Suthar started his business with a cash of Rs 1,00,000
 He purchased goods from Singh and Co. With cash of Rs 20,000
 He bought office furniture for Rs 7,500
 He sold goods to Ravi for Rs 6,000 by cheque
 He paid an office rent of Rs 5,200
 He Deposited cash worth Rs 15, 000 into bank
 Salary to a salesman paid by cheque of Rs 8,500

1.17 Ledger
According to L.C. Cropper, a „Ledger‟ is a book that contains a classified and permanent
record of all the transactions of a business. It is also called the „Book of Final Entry‟. A
Ledger classifies the transactions into their specific accounts and thus helps in providing
better information. A Ledger has a record of all transactions relating to all accounts
(Personal, Real or nominal).

1.17.1 Format of A Ledger

Standard Format of a Ledger Account
Date Particulars Folio Amount(Rs) Date Particulars Folio Amount(Rs)

1.17.2 Contents of A Ledger

 A ledger account starts with the name of the account, which is shown at the top of
the account.
 A ledger account is divided into two parts by a dark vertical line shown in the
format above.
 The left-hand side is known as the debit side and the right-hand side is known as
the credit side with Dr. and Cr. written on the top left and right corners of the
ledger, respectively.
 The date is to be recorded in the date column.

31
  The amounts to be recorded on the left side are known as debits and those on the
right side are known as credits.
 The source of transaction is recorded in the “particulars” column. The entry in the
debit side begins with “To”, and “By” is used before the name of the account to be
recorded on the credit side.
 The page number of the journal from which the particular entry is transferred is to
be recorded in the folio column.
 The amount pertaining to the account is recorded in the “Amount” Column.

1.17.3 Posting
Business transactions are usually recorded in a Journal, and are then transferred to a
ledger. This process is known as Posting. It is done to make a classified and summarised
record of transactions during a specific period and for a particular account. This is done
periodically, depending upon the requirements of the respective business.
The following example will help us to understand the procedure of posting:
Example 1-Goods sold for cash Rs 14,000 on 1 March 2015.
Solution 1-The Journal entry of the transaction is
Date Particulars Ledger Debit Credit
Folio Amount Amount
(Rs) (Rs)
1 March Cash A/c Dr. 14,000
2015 To Sales A/c 14,000
(Goods sold for cash)

Because the above transaction involved two accounts, that is, Cash and Sales, one has
to open two ledger accounts, namely, Cash Account and Sales Account. Write CASH
ACCOUNT and SALES ACCOUNT at the top of the ledger.
Because the cash account is debited in the journal entry, record the balance on the left-
hand side of the ledger, and for this transaction, ignores the credit side.
Enter the date in the date column of the debit side.
In the Particulars Column, enter “To” Sales A/c (name of the account in the journal entry
associated with the credit aspect).
Write the amount Rs 14,000 on the debit side of the ledger.

PS - The name of the CASH ACCOUNT should not be written in the Particulars column.

32
 Date Particulars Folio Amount Date Particulars Folio Amount
(Rs) (Rs)
1 March To Sales A/c 14,000
2015

Similarly, open a ledger for the Sales Account.

Because the above transaction is related to the credit aspect, go to the credit side of the
ledger and enter the date in the date column. In the “Particulars” column, write the word
“By” (followed by the name of the account debited in the journal) Cash Account.
Date Particulars Folio Amount Date Particulars Folio Amount
(Rs) (Rs)
1 March By Cash A/c 14,000
2015

1.17.4 Difference Between a Journal and a Ledger

Table 1.4 Difference between a Journal and a Ledger

S.No. Basis of Journal Ledger
Difference
1 Recording of It is the prime book for Transactions are recorded by
Transactions recording transactions. posting them from the Journal.
2. Order of Transactions are recorded in Transactions related to a
Recording the order of their occurrence specific account are recorded at
(chronological order). one place.

3 Unit of Unit of classification of data The unit of classification of data

Classification is Transactions is Accounts.
4 Effect The final position of a The final position of a particular
particular account cannot be account can be determined.
found.
5 Process The process is known as The process is known as
Journalising. Posting.

33
 6 Next Stage Entries are transferred to a A Ledger is used to prepare the
ledger. Trial Balance.

1.17.5 Balancing an Account

The balance of an account is the difference between the total of debits and credits
appearing in an account when the posting process is completed. Balancing is the process
of writing the difference between the amount column of the debit side and the credit
side, so as to make the grand total equal on both the sides. While balancing an account,
we will encounter three possible situations, namely, Debit Balance, Credit Balance or Nil
Balance, explained as follows:
 Debit Balance - If the total amount on the debit side is greater than the total
amount on the credit side, the difference is known as Debit Balance.
 Credit Balance - If the total amount on the credit side is greater than the total
amount on the debit side, the difference is known as Credit Balance.
 Nil Balance - If the total amount on the credit side is equal to the total
amount on the debit side, the zero balance is known as Nil Balance.

1.17.5.1 Procedure of Balancing

The steps involved in the process of balancing are described below.

Step 1 - Total the amount column on the debit side and credit side and find out the
difference in the total amount.
Step 2- If the debit side total exceeds the credit side total, enter the difference in the
amount column of the credit side. Write the date of balancing in the date
column and then write the words “By Balance c/d” in the particulars column of
the ledger. Or If the Credit side total exceeds the debit side total, enter the
difference in the amount column of the debit side. Write the date of balancing
in the date column and then write the words “To Balance c/d” in the particulars
column of the ledger.
Step 3 - Again, total both the debit amount column and credit amount column and put
the total on both the sides and draw a line above and another line below these
totals.
Step 4 - If this is a debit balance, bring down the debit balance on the debit side. Write

34
 the words “To Balance b/d” in the particulars column on the debit side. Write
the date of the beginning of the next period in the date column and the amount
in the amount column of the debit side.
Or
If this is a credit balance, bring down the credit balance on the credit side.
Write the words “By Balance b/d” in the particulars column on the credit side.
Write the date of the beginning of the next period in the date column and the
amount in the amount column of the credit side.

Example - Post the following journal entries in the ledger accounts and balance each
account.

Date Particulars L.F Debit Credit

Amount Amount
(Rs) (Rs)

1 April 2014 Purchase A/c Dr. 50,000 50,000

To Cash A/c
(Cash Purchase)
2 April 2014 Cash A/c Dr. 90,000 90,000
To Sales A/c
(Cash Sales)
3 April 2014 Purchase A/c Dr. 15,000 15,000
To Govind A/c
(Credit Purchase)
4 April 2014 Ram A/c Dr. 10,000 10,000
To Sales A/c
(Cash Sales)
5 April 2014 Cash A/c Dr. 7,000 7,000
To Ram A/c
(Cash Received)
6 April 2014 Govind A/c Dr. 5,000 5,000
To Cash A/c
(Cash Paid)

35
7 April 2014 Furniture A/c Dr. 3,000 3,000
To Cash A/c
(Furniture Purchased)

The balancing of ledger account is done as follows-

Cash Account
Date Particulars F Amount Date Particulars F Amount
(Rs) (Rs)
1April 2014
2 April 2014 To Sales A/c 90,000 By Purchase 50,000
5 April 2014 To Sales A/c 7,000 6 April 2014 A/c
7 April 2014 By Govind A/c 5,000
By Furniture 3,000
30 April A/c 39,000
2014 By Balance c/d
97,000 (97,000- 97,000
1 May 2014 To Balance 58,000)
b/d 39,000

1.18 Trial Balance

A Trial balance is a statement that shows the closing balance of all accounts in a ledger.
It is prepared in a T-shaped form. The debit balance is shown on the left-hand side and
the credit balance is shown on the right-hand side. The trial balance checks the
arithmetic accuracy of the accounts. According to the Double Entry System, every debit
entry must have a credit entry; therefore, the debit balance of all accounts should be
equal to the credit balance of all accounts. The trial balance checks this accuracy of
equality in the debit and credit balances.

1.18.1 Objectives of a Trial Balance

 It checks the arithmetic accuracy of the ledger account.
 It provides the basis for the preparation of the final accounts.
 It provides a summary of all the transactions during an accounting period.

36
1.18.2 Methods of Preparing a Trial Balance
Total Method
Balances Method

1.18.2.1 Total Method: In this method, the sum of the debit and credit sides of each
ledger account has to be taken into consideration. These balances are then taken in the
respective columns of the debit and credit sides of the trial balance. The total must be
equal for both the debit and credit sides of the ledger. This is not a widely used method.

1.18.2.2 Balances Method: In this method, the trial balance is prepared by recording
the balance of all ledger accounts. It is followed by the sum of the debit and credit
columns of the trial balance. It is the most widely accepted method used for the
preparation of the trial balance, and further helps in the preparation of final accounts.
The most common method used by firms to prepare their trial balance is the BALANCES
METHOD.

Format of a Trial Balance

Trial Balance of ............................... as on...........
Date Name of Account L.F Debit Balance Credit Balance
(Rs) (Rs)

Let us now understand the procedure of making an entry in the trial balance with the
help of an example.

Illustration 6 he following Balances were extracted from the ledger of Ram Industries
limited as on 31 March 2014
Balances of different Ledger Accounts Amount (Rs)
Salaries 72,640
Sales 3,47,000
Plant and Machinery 68,600
Commission Paid 3,760
Purchases 2,89,340
Stock on 1 April 2014 22,200

37
Repairs 3,340
Sundry expenses 920
Sundry debtors 2,860
Returns Inward 2,000
Returns outward 800
Discount allowed 2,300
Rent and Rates 6,440
Sundry Creditors 28,520
Carriage Inward 480
Travelling Expenses 5,260
Drawings 7,000
Investments 12,000
Capital on 1 April 2014 1,25,000
Cash at Bank 2,180

Classify the above accounts as per general rules and then enter the values as per the
format of the trial balance.
Debit Balance – Asset, Drawings, Debtors, Losses and Expenses
Credit Balances – Liabilities, Capital, Creditors, Gains and Incomes
All the items are classified into real, nominal and personal accounts, and their balances
are classified as per the general rules of these accounts.

1 Salaries - Nominal A/c - Expense Dr. Balance

2 Sales - Real A/c - Goods Cr. Balance
3 Plant and Machinery - Real A/c - Assets Dr. Balance
4 Commission Paid - Nominal A/c - Expense Dr. Balance
5 Purchases - Real A/c - Goods Dr. Balance
6 Stock - Real A/c - Goods Dr. Balance
7 Repairs - Nominal A/c - Expense Dr. Balance
8 Sundry expenses - Nominal A/c - Expense Dr. Balance
9 Sundry debtors - Personal A/c - Customer Dr. Balance
10 Returns Inward - Real A/c - Goods Dr. Balance
11 Returns outward - Real A/c - Goods Cr. Balance
12 Discount allowed - Nominal A/c - Loss Dr. Balance

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13 Rent and Rates - Nominal A/c - Expense Dr. Balance
14 Sundry Creditors - Personal A/c - Supplier Cr. Balance
15 Carriage Inward - Nominal A/c - Expense Dr. Balance
16 Travelling Expenses - Nominal A/c -Expense Dr. Balance
17 Drawings - Personal A/c - Owner Dr. Balance
18 Investments - Real A/c - Asset Dr. Balance
19 Capital on 1 April 2014 - Personal A/c – Owner Cr. Balance
20 Cash at Bank - Real A/c - Asset Dr. Balance

The rules of debit and credit are applied for every transaction. After this, we have to
determine whether the balance is to be debited or credited. Now, the balance is recorded
and classified in the columns of debit and credit of the trial balance. The last step is to
determine the total of both the credit and debit columns separately. It should be kept in
mind that the total of both the columns must be equal
Trial Balance of Ram Industries Limited as on 31 March 2014

Name of the Account L.F. Debit Balance (Rs) Credit Balance (Rs)
Salaries 7,2640
Sales 3,47,000
Plant and Machinery 68,600
Commission Paid 3,760
Purchases 2,89,340
Stock on 1 April 2014 22,200
Repairs 3,340
Sundry expenses 920
Sundry debtors 2,860
Returns Inward 2,000
Returns outward 800
Discount allowed 2,300
Rent and Rates 6,440
Sundry Creditors 28,520
Carriage Inward 480
Travelling Expenses 5,260
Drawings 7,000

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Investments 12,000
Capital on 1 April 2014 1,25,000
Cash at Bank 2,180
Total 5,01,320 5,01,320

Illustration 7 Mr. Gupta is the owner of a factory. From the following balances that are
extracted from his ledger, you are required to prepare a Trial Balance as on March 31st
2015
Particulars Amount (Rs) Particulars Amount (Rs)
Purchases 2,03,375 Sales 4,91,000
Debtors 72,500 Creditors 31,500
Capital 3,55,000 Drawings 26,225
Insurance 3,000 General Expenses 15,000
Salaries 75,000 Machinery 1,50,000
Building 1,50,000 9% deposit with Bank 37,500
Stock (1.04.2014) 28,800 Carriage on purchases 10,200
Carriage on Sales 16,200 Fuel & Power 23,650
Wages 52,400 Return Inwards 3,400
Return Outwards 2,500 Interest Received 2,900
Cash at Bank 14,650 Cash in Hand 1,000

1.19 Financial Statements

It has been emphasized that various users have diverse informational requirements.
Instead of generating information useful for specific users, the business prepares a set of
financial statements, which in general satisfies the informational needs of the users. The
basic objectives of preparing financial statements are :
 To present a true and fair view of the financial performance of the business;
 To present a true and fair view of the financial position of the business;

and For this purpose, the firm usually prepares the following financial statements:
1. Trading and Profit and Loss Account
2. Balance Sheet

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Trading and Profit and Loss account, also known as Income statement, shows the
financial performance in the form of profit earned or loss sustained by the business.
Balance Sheet shows financial position in the form of assets, liabilities and capital. These
are prepared on the basis of trial balance and additional information, if any

1.19.1 Objectives of Financial Statements

Financial statements are the basic sources of information to the shareholders and other
external parties for understanding the profitability and financial position of any business
concern. They provide information about the results of the business concern during a
specified period of time in terms of assets and liabilities, which provide the basis for
taking decisions. Thus, the primary objective of financial statements is to assist the
users in their decision-making. The specific objectives include the following:

 To provide information about economic resources and obligations of a

business: They are prepared to provide adequate, reliable and periodical
information about economic resources and obligations of a business firm to
investors and other external parties who have limited authority, ability or
resources to obtain information.
 To provide information about the earning capacity of the business: They
are to provide useful financial information which can gainfully be utilised to
predict, compare and evaluate the business firm‟s earning capacity.
 To provide information about cash flows: They are to provide information
useful to investors and creditors for predicting, comparing and evaluating,
potential cash flows in terms of amount, timing and related uncertainties.
 To judge effectiveness of management: They supply information useful for
judging management‟s ability to utilise the resources of a business effectively.
 Information about activities of business affecting the society: They have to
report the activities of the business organisation affecting the society, which can
be determined and described or measured and which are important in its social
environment.
 Disclosing accounting policies: These reports have to provide the significant
policies, concepts followed in the process of accounting and changes taken up in
them during the year to understand these statements in a better way

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The financial statements generally include two statements: balance sheet and statement
of profit and loss which are required for external reporting and also for internal needs of
the management like planning, decision-making and control. Apart from these, there is
also a need to know about movements of funds and changes in the financial position of
the company. For this purpose, a cash flow statement is prepard. Every company
registered under The Companies Act 2013 shall prepare its balance sheet, statement of
profit and loss and notes to account thereto in accordance with the manner prescribed in
the revised Schedule III to the Companies Act, 2013 to harmonise the disclosure
requirement with the accounting standards and to converge with new reforms.

1.19.2 Important Features of Presentation

 It applies to all Indian companies preparing financial statement as per Schedule III
to the Comapnies Act, 2013.
 It does not apply to (i) Insurance or Banking Company, (ii) Company for which a
form of balance sheet or income statement is specified under any other Act.
 Accounting standards shall prevail over Schedule III of the Companies Act, 2013.
 Disclosure on the face of the financial statements or in the notes are essential and
mandatory
 Terms in the revised Schedule III will carry the meaning as defined by the applicable
accounting standards.
 Balance to be maintained between excessive details that may not assist users of
financial statements and not providing important information.
 Current and non-current bifurcation of assets and liabilities is applicable.
 Rounding off requirements is mandatory
 Vertical format for presentation of financial statement is prescribed
 Debit balance in the statement of profit and loss to be disclosed as negative figure
under the head “Surplus”.
 Mandatory disclosure for share application money pending allotment.
 „Sundry Debtors‟ and „Sundry Creditors‟ replaced by terms „Trade Receivables‟ and
„Trade Payables

1.19.3 Report Format of the Statement of Profit and Loss

The format of the income statement starts with the name of the company, the statement
and the period to which the statement relates. It also states the currency and the level
of rounding-off. It starts with the revenue generated by the firm in that period followed

42
by the cost of goods sold and calculation of gross profit. Further, it provides the details
of operating expenses, non-operating expenses and taxes, and eventually, the
statement presents the net income which is the difference between the income earned
from continuing operations and total net income. The format of the Statement of Profit
and Loss of a firm is as follows:

Statement of Profit and Loss XYZ Limited

Profit and Loss Statement for the year ended on 31March 2015

(Rupees in........)
Particulars Note Figures at the Figures at the
No. end of the end of the
current reporting previous
period reporting period
1 2 3 4
I Revenue from Operations - -
II Other Income - -
III Total Revenue (I+II) **** ****
IV Expenses
Cost of Material Consumed
Purchase of Stock in Trade
Changes in Inventories of
Finished Goods - -
Work in Progress - -
Stock in Trade - -
Employee Benefits Expense - -
Finance Cost - -
Depreciation and Amortization Expense - -
Other Expenses - -
Total Expenses **** ****
V Profit before Exceptional and - -
Extraordinary Items and Tax (III-IV)
VI Exceptional Items **** ****
VII Profit before Extra-ordinary Items(V-

43
VI)
VIII Extraordinary Items
I XProfit Before Tax (VII-VIII) - -
X Tax Expense
i. Current Tax - -
ii Deferred Tax - -
XI Profit (Loss) for the period from - -
continuing operations (VII-VIII)
XII Profit/Loss form discontinuing - -
operations
XIII Tax Expense of discontinuing - -
operations
XIV Profit/Loss form discontinuing - -
operations(after tax) (XII-XIII)

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XV Profit (Loss) for the period (XI+XIV) - -
XVI Earnings per equity share
i. Basic - -
ii. Diluted - -

1.19.4 Major Components of the Statement of Profit and Loss

This section describes the major components of the income statement, which are as
follows:
i. Revenue: It is the principal activity of any firm. This represents the amount
earned by the company in exchange of goods it supplies and services it provides.
A business can earn revenue from the following methods-
 Sales resulting from products and/or services
 Money generated from rents, interest, dividends, royalties, commission and
licensing fees.
 Sale of asset of the firm other than those held as stock in trade( such as plant
and machinery, land and building , or investments)
 The revenue generated from selling goods and providing services
to customers is calculated as follows-
Net Sales Revenue= Sales-Sales Return

45
 ii. Cost of Sales: This represents the cost directly associated with the making of
goods or acquiring of goods. . It includes all such costs that can be assigned to
goods sold or services provided. Examples include raw materials, salaries of
factory or service shop employees, manufacturing facility rent, depreciation of
manufacturing equipment, lease rentals on equipment used in manufacturing or
service delivery, indirect materials needed for production, etc. For a merchandiser,
the cost of goods sold includes the manufacturing costs and the cost of preparing
the goods for sale (such as the transportation cost). For a manufacturing firm, the
cost of goods sold includes the cost of raw material and the cost of preparing
goods for sale. All the items related to cost of goods sold are captured in the
following heads changes in inventories (finished goods , work in progress and
stock in trade) and wages are included in employee benefit expenses, Expenses
related to utility (power rent )are included in other expenses
Cost of Goods Sold= Opening Stock+ Purchases+ Direct Expenses- Closing
Stock

The details of all these expenses are being shown separately in the notes to accounts

iii. Gross Profit & Gross Margin

Gross profit = Revenue – Cost of sales
This represents the profit earned on the goods and services of the company before
any selling, general and administrative and financial expenses.
The gross profit margin is the measurement of company‟s manufacturing and
distribution efficiency during production and distribution process. It is calculated
as
Gross Profit Margin= Gross Profit/Net Sales Revenue*100

iv. Operating Expenses/Other Expenses: These are the daily expenses incurred in
the operation of a business. This mainly includes selling- and distribution-related
expenses and general and administrative expenses. Operating expenses are
usually separated from both cost of goods sold and income tax expenses, and are
subtracted from the gross margin. Examples include salary of higher executives
and managers, marketing expenses, office rent, salaries of administrative staff
and cost of fuel for delivery vehicles. All the items related to Operating Expenses
are mainly covered by other expenses and details of depreciation and amortisation

46
 are shown in a separate head. The details of all these expenses are being shown
separately in the notes to accounts
Operating Expenses= Administrative Expenses+ Depreciation+ Selling
and Distribution expenses

v. Non-Operating Profit: Revenues that are incidental or indirect to the main

business of the firm constitute non operating income. For example the gross
proceeds from the sale of old equipment or machinery, income from temporary
investments etc contribute towards the non-operating income of the firm

vi. Non-Operating Expenses: The expenses that are incidental or indirect to the
main business of the firm constitute non operating expenses. These are non-
recurring in nature. These include loss resulting from the sale of buildings,
securities, machinery, or equipment.

vii. Operating Profit : This is also known as earnings before interest and taxes
(EBIT).
EBIT = gross profit – operating expenses.
It is the profit obtained after the cost of sales and all operating expenses have
been charged to the revenue. It is the amount before making any adjustment for
interest income and interest expense and taxes.

viii. Earnings before Tax: This represents the income after incurring financial
expenses. Here, interest expenses are deducted from the operating profit of a
firm. In other words, it is mainly the profit generated from a company‟s business
operations before tax and after interest payments (PBT). It is the operating profit
plus or minus non operating income or expenses respectively minus interest
charges.
Profit before Tax= Operating Profit+ Non- Operating income-Non
Operating expenses- Interest charges

47
ix. Taxes: This is the amount of income tax a company owes to the government.

x. Net Income: This represents the income earned during the year after accounting
for all expenses. It is carried over to the statement of changes in shareholders‟
equity where it is added to the opening balance of the retained earnings
component of equity.

1.20 Balance Sheet

A „Balance Sheet‟ is a summary of the financial balances of a company on a specified
date. It is often described as the “snapshot of a company‟s financial condition”. A
Balance Sheet describes the resources of a company and its financial structures. The
financial structure of a company explains how a company finances its resources to run its
operations. A Balance Sheet comprises of all the details of the different sources of
finance and various resources used by the company. In fact, it is a detailed summary of
the basic accounting equation:
Assets=Equity+ Liabilities
A Balance Sheet must have proper headings that consist
of
 name of the Company
 title of the statement
 the date for which the Balance Sheet is prepared

A Balance Sheet summarises the assets owned by a company on one side and liabilities
owed to the company on the other side. Liabilities comprise of both internal and external
liabilities. Internal liability is also known as „Equity‟ or the „Owner‟s Capital‟, whereas
External Liability is money obtained from all other outside resources in the form of debt,
loan, etc. Therefore, a Balance Sheet is a statement of assets and liabilities of a
company on any particular date.

1.20.1 Contents Of A Balance Sheet

A Balance Sheet is mainly divided into two components, namely, assets and liabilities.
All the debit balances of the ledger account that were not transferred to a Trading
Account and P&L Account are shown on the Asset side of the Balance Sheet. This is done
because the debit balance in the real and personal accounts represents an Asset.
(Remember the Golden Rules – For a Real Account, Debit what comes in and Credit what

48
goes out, and for a Personal Account, Debit the Receiver and Credit the Giver)

49
Basically, Assets can be divided into three types. Figure 8.1 shows how assets are
classified.

Asset

Curre Fixe Investme

Tangibl Intangibl

Figure 8.1 Classifications of Assets

 Current Assets: Assets that are held for a short period of time (usually less than
or equal to one year) with a company are referred to as current assets. Whenever
required, these can be easily converted into cash. Current assets form the basis
for day-to-day activities of the company and are highly essential for all types of
companies. Current Assets are also known as floating or circulating assets. These
assets are valued at the cost price or market price, whichever is less. Examples
are: cash in Hand, cash at Bank, raw material, finished goods, debtors (A debtor
is a person or a company that owes money to another person or company) and
prepaid expenses.

 Fixed Assets: Assets that are acquired for use in business activities are known as
Fixed Assets. They are usually held by a company for a longer period of time and
hence are also known as long-term assets. Depending on their physical existence,
fixed assets can be further classified into tangible and intangible assets. Tangible
Assets can be seen and can physically exist; these include land, building, plant,
machinery, furniture and fixtures, vehicles, etc. Intangible Assets cannot be seen
and they do not physically exist; these include patents, copyrights, goodwill, etc.
All fixed assets are reported on net basis and the detail of gross and net fixed
assets are shown separately in notes to accounts

50
 Investments: Assets that earn an interest, dividend or any other income are
called investments. They are usually held in a business for a long period.
Examples include Shares, Debentures, Bonds and Fixed Deposits.

 Capital: Capital (equity) represents the owner‟s money. This is shown on the
liability side of the Balance Sheet. In the case of public limited companies, liability
is limited to the extent of money provided by the shareholders to the company.
Moreover, as per the separate entity concept, a firm is legally different from its
owners. Therefore, capital is considered as a liability for the firm. According to
legal requirements, the owner‟s equity is divided into two parts: i) share capital
(amount paid by shareholders; contributed capital); ii) Reserve and Surplus
(retained earnings).

 Share Capital: In the case of sole proprietorship and partnership companies,

capital is provided by the owner and partners only, but in the case of public
limited companies, the share capital is predetermined at the time of registration.
It is known as the authorised capital of the company. It is the maximum amount
of capital that a company may raise without altering the rules of registration. The
share capital is divided into a number of units known as equity shares. Equity
shares can be of two types: ordinary shares and preference shares. Preference
shares have some preferences over ordinary shares like in case of distribution of
profits, in the form of dividends (Please remember-it is the choice of the firm
whether to distribute profits to its shareholders or to retain them for future
investments), are distributed first to preference shareholders. Moreover, in the
case of winding up a company, the assets remaining after the payments to the
creditors are distributed first to preference shareholders. Ordinary shareholders
have no such preferential rights. They however have voting rights and thus
perform a major role in the decision-making process, whereas preference
shareholders do not have such rights.

 Reserve and Surplus: Reserve and surplus are also known as retained earnings
of a firm. When a firm starts its operation, it has no retained earnings. If it earns
Rs 20,000 and distributes Rs 5,000 to its owners or shareholders, then the
retained earnings of the firm for that year will be Rs 15,000. Similarly, it earns Rs
15,000 in the next year and distributes no profit and then the reserve and surplus

51
 account will have Rs 30,000 at the end of the second year. In this way, a firm
accumulates its retained earnings for future investments.

 Liabilities: Liabilities mean the money owed by the company. All the credit
balances of the ledger that are not transferred to Profit and Loss Account (P&L)
and Trading A/c are shown on the “Liabilities” side of a Balance Sheet. Moreover,
as per the rule of Personal Accounts, one has to debit the receiver and credit the
giver; therefore, the credit balance is a liability for a company and must be shown
on the left-hand side (Liabilities) of the Balance Sheet. Liabilities can be classified
into three types, namely, current liabilities, long-term liabilities and contingent
liabilities (Figure 8.2)

Liabiliti

Curre Long - Continge

Credito
Secure

Outstandi
Unsecure
d

Bills

Income

Figure 8.2 Classification of Liabilities

 Current Liabilities: Current liabilities refer to the amount payable within a period
of one year. Examples of these include creditors, Outstanding Expenses, Bills
Payable, and Income Received in advance.

52
  Creditors: A Creditor is a party to whom money is owed by the company.
There are two types of creditors, namely, trade and non-trade creditors. Trade
creditors sell goods on a credit basis, and the amount owed to them is not yet
paid by the company. Non-Trade creditors provide money to the company for
a period less than or equal to one year.
 Outstanding Liabilities: This refers to the amount that is not paid till the
preparation of a Balance Sheet. Examples include outstanding rent, tax, salary
and wages.
 Income received in Advance: This refers to the amount received, but
expenses related to the amount will occur on a later date.
 Bills Payable: This is an instrument to pay money to the creditor for
purchase of goods or services.

 Long-Term Liabilities: Long-Term Liabilities refers to the amount that a

company will repay in more than one year. Usually, the time period for long-term
liabilities varies between 5 and 20 years. It also depends upon the requirement of
the firm. Long-term liabilities can be further classified into secured and unsecured
loans.

 Secured Loans: When a loan is obtained in lieu of a fixed asset (e.g. land,
plant and machinery, building) as a security, such loans are said to be secured
loans. If a company is not able to repay the loan, it will be obtained from the
assets pledged against the loan. Hence, these types of loans are safe and
secure for lenders but highly risky for borrowers. These loans can be accessed
easily in the market. Examples include Loans from banks and financial
institutions.

 Unsecured loans: Unsecured loans do not require any collateral for security.
Usually, these types of loans are provided by moneylenders in the market.
These are not easily available and demand high creditworthiness of the
company.

 Contingent Liabilities:Uncertainty is the only certainty in the business.

Therefore, to secure business from the unknown liabilities that may occur in the
future, a company keeps some amount to discharge these unknown obligations.

53
 These liabilities are not known at the time of preparation of the Balance Sheet and
are hence termed contingent liability. Examples include Guarantee given by the
company to its customers, Bill of Exchange discounted and law suit against the
company. Because contingent liabilities are not actual liabilities, these will not be
recorded on the liability side of a Balance Sheet, rather it will be shown as a
footnote to the Balance Sheet.

1.20.2 Format of A Balance Sheet

The Indian Companies Act, 2013, prescribes a vertical format for the preparation of a
Balance Sheet. The performa of a Balance Sheet is described below-
BALANCE SHEET
Name of the Company.....
Balance Sheet as at..........
(Rupees in.........)
Particulars Note Figures as at Figures as at
no. the end of the end of
current previous
reporting period reporting period
1 2 3 4
I. EQUITY AND LIABILITIES
(1) Shareholder’s Fund
a. Share Capital
b. Reserve & Surplus
c. Money received against share
warrants
(2) Share Application Money Pending
Allotment
(3) Non Current Liabilities
a. Long-Term Borrowings
b. Deferred Tax Liabilities
c. Other Long Term Liabilities
d. Long Term Provisions
(4) Current Liabilities
a. Short Term Borrowings

54
b. Trade Payables

c. Other Current Liabilites

d. Short Term Provisions

TOTAL
II ASSETS
Non Current Assets
(1) (a) Fixed Assets
(i) Tangible Assets
(ii) Intangible Assets
(iii) Capital Work in Progress
(iv) Intangible Assets under development
b. Non Current Investments
c. Deferred Tax Assets (Net)
d. Long Term Loan and Advances
e. Other Non- Current Assets
(2) Current Assets
a. Current Investment
b. Inventories
c. Trade Receivables
d. Cash and Cash Equivalents
e. Short term loan and advances
f. Other Current Assets
TOTAL

1.21. Accounting Adjustments

The two bases for recording business transactions are (1) cash basis of accounting
and (2) accrual basis of accounting.

55
Table 1.4 Cash and Accrual Bases of Accounting
Cash Basis of Accounting Accrual Basis of Accounting
Revenue is recognised when cash is
Revenue is recognised when revenue is
received
earned
Expense is recognised when cash is paid Expense is recognised when cash gets
accrued
GAAP is not followed GAAP is followed

According to accounting conventions and principles, a firm follows the accrual basis of
accounting, because it follows the matching principle of accounting. This means that
revenues and expenses should be matched for a particular accounting period.

Revenue Rs 4,00,000 (includes credit sales)

Less Expenses Rs 1,50,000
Profit Rs 2,50,000
Here, it is seen that revenue is realised in December 2013, not in January 2014, when
cash is received. Therefore, these types of entries require an adjustment in the books of
accounts. Hence, the accrual basis of accounting forms the base for accounting
adjustments.

1.21.1 Need for Accounting Adjustments

Firms follow the accrual basis of accounting; therefore, income and expenses related to
the current year, but these were actually earned or spent in the previous year or related
to the next year but received or paid in the current year, have to be adjusted. If these
adjustments are not done, then the Trading Account and Profit & Loss Account do not
show the profit accurately; hence, the Balance Sheet reveals either the understated or
overstated financial position of the company. Therefore, adjustment entries play a very
important role in describing the accurate financial position of a company. Adjustment

56
entries ensure that revenues and expenses have been matched properly at the end of
each accounting period.

9.22 Adjustments In Final Accounts

Final Accounts constitute Trading, Profit and Loss and Balance Sheet of a company.
These are prepared for an entire accounting period. Revenue and expenses related to
this particular period must be included in the Final Accounts, despite the fact that these
are received or paid in the next year. Therefore, a company has to pass certain entries
to record these types of transactions. Such entries are called adjustment entries.
Normally, an entry is posted once in the Final Accounts, either on the debit side or on
the credit side, but adjustment entries require two postings, debit and credit, for the
same amount. Care should be taken while posting these entries, because they should be
posted in the same account along with the same amount.

The following are the accounting adjustments, normally done at the end of the
accounting period:

1.22.1 Closing Stock

This represents the value of unsold goods at the end of a specific period. It is valued at
the cost or market price, whichever is less. For example, if the value of the closing stock
at the end of the accounting period is Rs 50,000 and it is shown below the trial balance,
then the following entries will be passed:
Closing Stock A/c Dr Rs
50,000 Trading A/c Rs
50,000
The twofold effect of this entry will be shown in
i. Trading Account - It will be shown on the credit side.
ii. Balance Sheet - Because the closing stock is a real account, it will be shown on
the asset side of the Balance Sheet.
Trading Account for the year ending............

Particulars Amount Particulars Amount

(Rs) (Rs)

57
 By Closing Stock 50,000

Balance Sheet As on.........

Liabilities Amount Asset Amount (Rs)
(Rs)
Closing Stock 50,000

In case, closing stock is shown in the trial balance, it means it is adjusted through
purchases and will not be shown on the credit side of the Trading Account but will be
shown on the assets side of the Balance Sheet only.

1.22.2 Outstanding Expenses

Outstanding Expenses are the expenses that have been incurred but not paid to the
entity concerned. For example, rent of the building of Rs 25,000 is due for the month of
March, the closing month of the firm. To bring this entry into the books of accounts, the
following entries should be passed:
Rent A/c Dr
Rs 25,000
Outstanding Rent A/c Rs
25,000
The twofold effect of this entry will be shown in
i. Profit and Loss Account - Outstanding Rent will be shown on the debit side
ii. Balance Sheet - Because the Outstanding Rent is a personal account, a credit
balance will be shown in the current liabilities.

Profit and Loss Account for the year ending............

Particulars Amount Particulars Amount
(Rs) (Rs)
To 25,000
Outstanding
Rent A/c

Balance Sheet As on.........

58
 Liabilities Amount Asset Amount
(Rs) (Rs)
Outstanding Rent 25,000

1.22.3 Prepaid Expenses

Prepaid expenses are those that have been fully paid by the company, but their benefits
are still pending and will accrue till the next accounting period. An example for this is the
Insurance Premium on vehicles purchased by the company on 1 October 2014 of Rs
15,000. The accounting year closes on 31 March 2015; hence, Rs 7,500 will be the
insurance paid in advance for the remaining six months. The following entry will be
passed for this transaction:
Prepaid Account ...............................Dr Rs 7,500
To Insurance Premium Account Rs 7,500
The twofold effect of this entry will be shown in
i. Profit the Loss Account - Prepaid Insurance will be deducted from the insurance
premium on the debit side
ii. Balance Sheet - Because the Prepaid Insurance is a personal account, a debit
balance if present will be shown in the current assets.

Profit and Loss Account for the year ending............

Particulars Amount Particulars Amount

(Rs) (Rs)
To Insurance Premium 7,500

Rs 15,000
Less: Prepaid Insurance
7,500

Balance Sheet As on.........

Liabilities Amount Asset Amount
(Rs) (Rs)
Prepaid Insurance 7,500

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 1.22.4 Accrued Income

Income earned but not received by the company is called „Accrued Income‟. Suppose a
business firm owns a fixed deposit of Rs 12,00,000 and earns at 8% per annum as an
interest income. The interest is receivable on 30 September and 31 March. The interest
is received only on 30 September. Hence, at the time of preparing the final accounts, the
Interest income will be adjusted for the period by passing the following entry:
Accrued Interest Dr Rs 48,000
To Interest Income Rs 48,000
The twofold effect of this entry will be shown in
i. Profit and Loss Account - Accrued Interest will be added to the previous balance
on the credit side
ii. Balance Sheet - Because the Accrued Interest is a personal account, a
debit balance if present will be shown in the current assets

Profit and Loss Account for the year ending............

Particulars Amount Particulars Amount

(Rs) (Rs)
By Interest Received Rs
48,000
96,000
Add: Accrued Interest Rs
48,000

Balance Sheet As on.........

Liabilities Amount Asset Amount (Rs)
(Rs)
Interest Income 48,000

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 1.22.5 Income Received in Advance
Income received in advance is also known as „Unearned Income‟ or „Unaccrued
Income‟. It is the income that has been received in advance for the goods or services to
be provided in the future. For example, an organisation receives subscriptions from its
members for Rs 50,000, out of which Rs 8,000 relates to the next financial year. Hence,
at the time of preparing the final accounts, this unearned income will be adjusted for the
period by passing the following entry:
Subscription A/c Dr Rs 8, 000
To Subscription received in advance Rs 8,000
The twofold effect of this entry will be shown in
i. Profit and Loss Account - Income received in advance will be subtracted from the
previous balance on the credit side
ii. Balance Sheet - Entered on the liability side as a current liability

Profit and Loss Account for the year ending............

Particulars Amount Particulars Amount
(Rs) (Rs)
By Subscription Received
Rs 50,000
Less: Subscription in advance
Rs 8,000 42,000

Balance Sheet As on.........

Liabilities Amount (Rs) Asset Amount
(Rs)
Subscription received in 8,000
advance

1.22.6 Depreciation
The value of fixed assets does not always remain the same. It tends to reduce every
year, because of wear and tear. This decrease in the value should be treated as loss or
expense in the books of accounts. This should be considered before the calculation of
profit or loss of the firm. Depreciation is usually computed based on the life of assets.
Suppose a machine costs Rs 1, 50,000 and has a life of 5 years. Then, each year one-

61
fifth of the cost, that is, Rs. 30,000 should be treated as an expense, and only the
remaining amount is to be shown in the Balance Sheet. Thus, the entry is as follows:
Depreciation A/c Dr Rs 30, 000
To Machinery Rs 30,000
The twofold effect of this entry will be shown in
i. Profit and Loss Account – Depreciation will be shown as expenses and is debited to
the Profit and Loss account.
ii. Balance Sheet – Depreciation is reduced from the value of the respective asset on
the asset side of the Balance Sheet

Profit and Loss Account for the year ending............

Particulars Amount Particulars Amount
(Rs) (Rs)
To Depreciation 30,000

Balance Sheet As on.........

Liabilities Amount (Rs) Asset Amount
(Rs)
Machinery Rs
1,50,000 1,20,000
Less: Depreciation Rs
30,000

1.22.7 Bad Debts

This occurs when debtors do not pay for a long time; this causes a loss to the company,
which is equal to the unpaid amount. This unpaid amount of debtors, thus become bad
debts for the company. For example, PQR Limited, a debtor for Rs 40,000 is declared
bankrupt. In the Trial Balance of the company, debtors appear to be Rs 5, 00, 000,
including PQR limited. The adjustment entry for the following is done as
Bad Debt A/c Dr Rs 40,000
To PQR Limited A/c Rs 40,000
The twofold effect of this entry will be shown in

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i. Profit and Loss Account - Bad debt will be recorded on the debit side as a separate
account.
ii. Balance Sheet - Entered on the asset side by deducting from debtors.

Profit and Loss Account for the year ending............

Particulars Amount Particulars Amount (Rs)
(Rs)
To Bad Debt 40,000
A/c

Balance Sheet As on.........

Liabilities Amount Asset Amount (Rs)
(Rs)
Debtors Rs 5,00,000
Less: Bad Debt Rs 4,60,000
40,000

If Bad debts appear in the trial balance, there will be no adjustment entry, and
they will be shown only in the Profit and Loss Account.

1.22.8 Provision for Bad Debts or Doubtful Debts

All the credit sales are not converted into cash sales, and these sales may be realised in
the next accounting year. Therefore, a company makes a provision for the likely bad
debt that may occur in the future. It is a method of predetermining the percentage of
actual debtors. The following entry has to be passed for the creation of provision for a
profit and loss account.
Profit and Loss A/c Dr.
To Provision for Bad Debts A/c

Usually, the provision for bad debt is given in percentage form; to calculate the provision
for bad debts, the following steps are to be taken:
 First, deduct the total bad debts from the total debtors appearing in the trial balance.
Also, deduct any other provisions made for bad debts in the trial balance.

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 Provision for bad debt is calculated from the remaining amount of the debtors. This is
because when the debt becomes bad, it should be removed from the account of total
debtors, but there are also chances that the remaining debtors can have some debt
that is not recoverable; therefore, provision is made for bad and doubtful debt.

Provision for Bad and Doubtful debt is always created after subtracting bad
debts from the total debtors.
Let us consider an example. The Trial Balance of a firm shows Rs 2, 00,000 for the
debtor and Rs 10,000 for bad debts. After preparing the Trial Balance, it came to the
firm‟s notice that Mr. Shah, one of the debtors of the company, became insolvent and
that the entire amount of Rs 20,000 was not recoverable from him. Therefore, it is
necessary to create a provision of 5% on bad and doubtful debts. The adjustment entries
for the above details are given below:
Bad Debt A/c Dr. Rs 20,000
To Mr. Shah A/c
Rs 20,000
Profit and Loss A/c Dr. Rs 9,500
To Provision for Bad and Doubtful Debt

Rs 9,500

Calculation
Debtor = Rs 2, 00,000
Less Bad Debt = Rs 20,000
(Given additionally apart from trial balance)
Total Debtors = Rs 1, 80,000
Provision @5 % (5% of Rs 1, 90,000) = Rs 9,000
Net Debtors = Rs 1, 71,000

The twofold effect of this entry will be shown in

i. Profit and Loss Account - Provision for Bad and Doubtful debts will be recorded on
the debit side as a separate account.
ii. Balance Sheet - Entered on the asset side by deducting from debtors.

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 Profit and Loss Account for the year ending............
Particulars Amount (Rs) Particulars Amount
(Rs)
To Bad Debt A/c

Rs 10,000 30,000
(given in the Trial Balance)
Add: Additions Rs 9,000
20,000
(as in additional information)
To Provision for Doubtful
Debts
(Ref - Above calculation)

Balance Sheet As on.........

Liabilities Amount Asset Amount (Rs)
(Rs)
Debtors
1,80,000
Rs 2,00,000
Less: Bad Debt Rs
20,000 1,71,000
Less :Provision for
Doubtful Debts @5%
Rs 9,000

1.22.9 Interest on Capital

In the case of sole proprietorship or partnership firms, interest is charged on the
financial capital used by the owner(s). The adjustment entry of this type of transaction
will be
Interest on Capital A/c Dr.
To Capital A/c
The twofold effect of this entry will be shown in
i. Profit and Loss Account - This will be recorded on the debit side as a separate
account.
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ii. Balance Sheet - Entered on the Liability side by adding to the capital.
If the interest on capital appears in the trial balance, it will be shown in the
profit and loss appropriation account only.

1.22.10 Interest on Drawings

Drawings mean the money withdrawn from the company by its owners. Therefore,
interest will be charged on the drawings because if the amount has been lent to
somebody else other than the owners, the company will charge interest. The adjustment
entry of this type of transaction will be :
Capital A/c Dr.
To Interest on Capital A/c
The twofold effect of this entry will be shown in
i. Profit and Loss Account - This will be recorded on the credit side as a separate
account.
ii. Balance Sheet - Entered on the Liability side by deducting from the capital.
If the interest on capital appears in the trial balance, it will be shown only in
the profit and loss appropriation account.

1.22.11 Abnormal Loss of Stock

An abnormal loss of stock arises due to natural calamities, such as fire and flood, and
breakage. This will result in reducing the value of the closing stock and thereby affecting
the net profit of the company. It is generally said that the gross profit of a firm should be
calculated in the absence of any loss incurred accidently to the goods produced, because
this will enable a firm to judge its operations correctly. Therefore, the value of goods lost
due to some accident should be credited to the trading account and debited to the profit
and loss account. The rise in gross profit will be compensated by a reduction in the net
profit. The adjustment entry to be passed will be:
Loss of goods by fire A/c

Dr To Trading A/c

In case the company has insured its stock, the amount received from the insurance
company will be credited to the Loss of goods by the fire account and the remaining
amount will be debited to the Profit and Loss Account as a net loss to the company due

66
to fire.

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 Profit and Loss Account

Dr. To Loss of goods by Fire Account

Suppose a firm loses its stock worth Rs 1, 00,000 due to a fire in the godown of the
company. The company has taken a fire insurance policy of Rs 75,000. The company has
still not received the claim amount, but the adjustment entries will be shown in the
Trading, Profit and Loss A/c and Balance Sheet, respectively.
 Trading Account - The value of Stock will be credited to the trading account.
 Profit and Loss Account - The value of the stock after claiming from insurance will be
debited to the Profit and Loss Account.
 Balance Sheet - The amount received from the insurance company will be treated as
an asset in the Balance Sheet.

Trading Account for the period ending...

Dr.
Cr.
Particulars Amount (Rs) Particulars Amount
(Rs)
By Loss of Goods by Fire 1,00,000
A/c

Profit and Loss Account for the year ending............

Particulars Amount Particulars Amount
(Rs) (Rs)
To Loss of Goods by Fire 25,000
A/c

Balance Sheet As on.........

Liabilities Amount Asset Amount (Rs)
(Rs)
ABC Fire Insurance 75,000
Company

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Calculation-
Total Loss =Rs1, 00,000
Amount Received from the ABC insurance Company = Rs
75,000 Net Loss = Rs 25,000

1.22.12 Commission Payable on Net Profits

Many companies practice the policy of providing incentives to the managers in the form
of a commission as a percentage of the net profits. This in turn will motivate managers
to perform better and will thereby further improve the profitability of the company.
Suppose the profit earned by the firm is Rs 1, 50,000 and commission is 5%, that is, Rs
7,500. This will reduce the profit to Rs 1, 42,500. The adjustment entries will then be
Profit and Loss Account

Dr. To Commission Payable Account

The account will be shown as a liability in the Balance Sheet.
However, sometimes, the commission is on the net profits of the company. Suppose a
company pays a commission of 5% on the net profit. The profit before commission is Rs
1, 50,000.
This is calculated as - Rate /Rate +1* Profit before commission
.05/1+.05* 1, 50,000 = 7,142.85
Net Profit = 1, 50,000- 7,142.85= 1, 42,857.15

Profit and Loss Account for the year ending............

Particulars Amount (Rs) Particulars Amount
(Rs)
To Commission to the 7,142.85
Manager 1,42,857.15
To Net Profit

Balance Sheet As on.........

Liabilities Amount (Rs) Asset Amount
(Rs)
Outstanding Commission to 7,142.85
Managers

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Because the commission is on the net profit, that means 7,142.85 (commission paid to
managers) is 5% of 1, 42,857.15, which will not be the case when calculated at 5 % of
1, 50,000.

1.23 Summary Of Adjustment Entries

The summary of all the adjustment entries described in the above section 9.2 are
classified in the table 1.6 given below:-

Table 1.6. Summary of Accounting Adjustments

Adjustment Effect on Trading Effect on Profit Effect on Balance
Entries Account and Loss Account Sheet
Closing Stock* Credit Side Asset Side
Outstanding Debit Side by way of Debit Side by way of Liability Side
Expenses addition to addition to
respective expense respective expense
Prepaid Expenses Debit Side by way of Debit Side by way of Asset Side
deducting from the deducting from
respective expense respective expense
Accrued Income Credit Side by way Asset Side
of addition to the
respective income
Income Received in Credit Side by way Liability Side
Advance of deduction from
the respective
income
Depreciation* Debit Side Asset Side by way
of deduction from
the value of the
respective asset
Bad Debts Debit Side Asset Side by way
of deduction from
the total debtors
Provision for Debit Side or by way Asset side by way of
Doubtful Debts of addition to bad deduction from the
debts debtors
Interest on Capital Debit Side Liability side by way
of addition to the
capital
Interest on Credit Side Liability Side by
Drawings way of deduction
from the capital
Loss of Stock by fire Credit Side (value of Debit side balance Asset Side (value
(Partly insured) goods lost) remains after received from the
deducting the insurance company)
original value from
the value received
from the insurance

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 company
Fully insured Credit side Asset Side
No insurance Credit Side Debit Side

Illustration 8. The following balances were extracted from the books of M/s Soni
Limited on 31 March 2015:
Share Capital = Rs 10, 00,000
Land = Rs 8, 00,000
Building = Rs 2, 00,000
Debenture = Rs 2, 00,000
Bank Loan = Rs 1, 50,000
Profit = Rs 1, 50,000
Reserve & Surplus = Rs 2, 50,000
Provision for Taxation = Rs 50,000
Machinery = Rs 5, 00,000
Bills Receivable = Rs 2, 00,000
Cash in hand = Rs 50,000
Debtors = Rs 1, 50,000
Creditors = Rs 1, 00,000

On the basis of the above information, prepare a Balance Sheet for M/s Soni
Limited.

Illustration 9 From the following accounts ,prepare a Balance Sheet for the Neera
Purifier Limited for the year ending 31 March 2015.( assume that these are the only
Balance Sheet accounts-use cash as a plug figure to balance the Balance Sheet)

Items Amount (Rs)

Gross Fixed Assets 28,000
Inventories 46,500
Long term Debt 42,500
Accrued Expenses 10,000
Accumulated Depreciation 12,000
Short term Bank Loan 15,000
Preference share 2,500

Ordinary Shares 35,000

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Retained Earnings 20,000
Net Debtors 32,500
Accounts payable 27,800
Cash Balancing Figure

72