Dmgt104 Financial Accounting

Financial Accounting
DMGT104
FINANCIAL ACCOUNTING
Copyright © 2012 K.K.Verma
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SYLLABUS
Objectives: To develop conceptual knowledge about the preparation and use of financial statements.
S. No. Description
1. Introduction to Accounting: Book-Keeping & its importance, Accounting- Meaning, Importance, Difference
between Book Keeping and Accounting, Accrual Basis and Cash basis of Accounting.
2. Generally Accepted Accounting Principles: Accounting Concepts and Conventions, Accounting terminology.
3. Accounting Standards and Accounting Policies, Accounting Standard-1. Accounting Equation, Accounting Cycle.
4. Preparation of Journal, Ledger and Balancing.
5. Subsidiary Books: Cash Book and other subsidiary books. Trial Balance: Different types of errors disclosed and
not disclosed by Trial Balance.
6. Financial Statements: Capital & Revenue Expenditure and Receipts, Accounting Standard-9, Profit & Loss
Account (with adjustments) & Balance Sheet.
7. Depreciation, Provisions and Reserves, Accounting Standard-6.
8. Bank Reconciliation Statement.
9. Corporate Financial Statements: Nature, types, uses and limitations.
10. Role of Computers in Accounting including introduction to Tally.
CONTENTS
Unit 1: Introduction to Accounting 1

Unit 2: Principles of Accounting 23
Unit 3: Accounting Standards 41
Unit 4: Accounting Equation and Accounting Cycle 50
Unit 5: Preparation of Journal, Ledger and Balancing 60
Unit 6: Subsidiary Books 88
Unit 7: Trial Balance 115
Unit 8: Financial Statements 144
Unit 9: Analysis and Interpretation of Financial Statements 198
Unit 10: Accounting and Depreciation for Fixed Assets 213
Unit 11: Bank Reconciliation Statement 251
Unit 12: Corporate Financial Statements 264
Unit 13: Computerised Accounting 276
Unit 14: Introduction to Tally 286
Unit 1: Introduction to Accounting
Unit 1: Introduction to Accounting Notes
CONTENTS
Objectives
Introduction
1.1 Meaning and Definition of Accounting

1.1.1 Characteristics of Accounting
1.1.2 Objectives of Accounting

1.1.3 Need of Financial Accounting
1.1.4 Scope of Accounting

1.1.5 Users of Accounting Information
1.1.6 Importance and Advantages of Accounting

1.1.7 Limitation of Accounting
1.2 Process of Accounting
1.2.1 Cash System
1.2.2 Accrual System
1.2.3 Values
1.3 Book-keeping
1.3.1 Definition
1.3.2 Importance of Book-keeping
1.3.3 Difference between Book-keeping and Accounting
1.4 Methods of Accounting

1.4.1 Single Entry
1.4.2 Double Entry
1.5 Types of Accounts
1.5.1 Personal Accounts
1.5.2 Real Accounts

1.5.3 Nominal Accounts
1.6 Accounting Terminology
1.7 Accounting Cycle

1.7.1 Distinction between Book-keeping and Accounting
1.8 Summary
1.9 Keywords
1.10 Review Questions
1.11 Further Readings
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Notes Objectives
After studying this unit, you will be able to:
 Understand needs and objectives of accounting

 Know branches of accounting
 Know users and difference between book-keeping and accounting

 Describe meaning, importance and rules of double entry system
Introduction
Accounting is a business language which elucidates the various kinds of transactions during the
given period of time.
Accounting is broadly classified into three different functions viz.
 Recording
 Classifying and
 Summarizing
American Institute of Certified Public Accountants Association defines the term accounting as
follows “Accounting is the process of recording, classifying, summarizing in a significant manner
of transactions which are in financial character and finally results are interpreted.”
The main object of a business house is to earn profit. Accounting is the medium of recording the
business activities and it considered as a language of business. To find out the results of a
business, the information relating to the cost of the products and revenues from the products is
collected. Then the costs and revenues are compared to find out the profit or loss of the business.
If volume of sales of the products is high and the number of transaction of the business is very
high, it is impossible to keep all these transactions in the mind of a business man. Thus a need of
recording of all these business transactions rose. The recording of business transactions or
activities is done through a process of accounting. There is an old quotation of a well known
author of accounting Prof. R.R. Gupta, First write or record before one deliver the goods or
renders the services and if there is any disagreement in future, use the writing or record as an
evidence to resolve the misunderstanding or rectifying the errors.
Today the business activities are recorded not only to find out the profit or loss of the business,
but are also to judge the financial position of the business. Accounts of the business are prepared
from the point of view of owner and also serve the purpose of outsiders. Creditors and investors
want to know how safe their investment is—Labours in conducting the negotiations for wages
and government to determine the economic policies etc. Thus accounts of a business are the
evidence on the basis of which the financial decisions are taken.
!
Caution Accounting is not an equivalent function to book keeping. Accounting is broader
in scope than the book keeping; the earlier cannot be equated to the latter.
1.1 Meaning and Definition of Accounting
Accounting is treated as the language of business. It records all the transactions which can be
measured in money and have occurred in a particular period. Accounts of a business provide
useful information to its users.
2 LOVELY PROFESSIONAL UNIVERSITY

There are many definitions of accounting. Some of the most important definitions are given Notes
below:
1. As per Robert N. Anthony – “Accounting system is a means of collecting, summarizing,
analyzing and reporting, in monetary terms, information about the business”.
2. The American Accounting Association (AAA) has defined accounting as, “the process of
identifying, measuring and communicating economic information to permit informal
judgments and decisions by users of information”.
3. The Committee on Terminology of American Institute of Certified Public Accountants
gave a generally accepted definition of accounting – “Accounting is the art of recording,
classifying and summarizing in a significant manner and in terms of money transactions
and events which are, in part at least, of a financial character, and interpreting the results
thereof.”
On the basis of above definitions we conclude that accounting is a science as well as an art of
recording of activities of the business which can be measured in money and analyzing and
interpreting them.
1.1.1 Characteristics of Accounting
On the basis of above definitions, the characteristics of accounting may be drawn as follows:
1. Accounting is the art of recording of financial transactions of the business: All those
transactions of business which are financial in nature are recorded in accounting and those
which are not of financial nature are not recorded in accounting. As the honesty of the
workers cannot be measured in money, it cannot be recorded into accounting.
2. Classifying and summarising of recorded data is done in accounting: In accounting the
financial transactions are recorded in the journal. With the help of journal, the recorded
data are classified into ledger under appropriate heads. Then with the help of ledger the
trial balance and financial statements are prepared.
3. Data are recorded in terms of money: In accounting, the financial data are recorded in a
definite term i.e. money. No other unit is accepted to record the business transaction. If
there is sale of 100 articles at the rate of 50 per article, only the monetary value of these
articles i.e. 5,000 (100 x 50) is recorded.
4. Accounting is a science also: On account of recording of business transactions in a systematic
manner, it is also called a science. First the business transactions are recorded in the
primary books i.e. journal, for classification the ledger is prepared. With the help of
ledger the trail balance, profit and loss account and balance sheet is prepared. Profit and
loss account is prepared after a period to find the result of the business and balance sheet
to know the financial position of the business.
5. Analysing and interpretation of the results is done in accounting: It not only record
classifies and summaries the business data but also analyse and interprets the results for
the future decisions. On the basis of data forecasting regarding profit, sales, etc., may be
done.
1.1.2 Objectives of Accounting
The main purpose of book-keeping and accounting is to furnish the necessary financial data to
the persons interested in the business. These persons can be the internal users of the business and
external users of the business. Among the internal users all the managers at lower, middle and
top level are included. While among the external users, investors, creditors, government and

Notes public are included. The financial statements are supplied to the external users for the necessary
information. In brief, following are the objectives of accounting:
1. To maintain the systematic records of the business: The primary objective of the accounting
is to maintain the records of all transactions of the business. As the memory of human
being is very limited and short, it would be very difficult to remember all the transactions
especially if there is a huge amount of transaction. So it is very necessary to record all
business transactions properly to determine the amount of profit or loss and the financial
position of the business on a particular date.
2. To ascertain the profit or loss of the business: The main objective of the business is to earn
a profit. Exact profit can be ascertained with the help of financial accounting which helps
to determine the net profit or loss of the business over a period. For the determination of
the amount of profit or loss, a trading and profit and loss account is prepared at the end of
a period. If there is excess of revenue for a period over the expenses incurred to earn that
revenue, it is said to be a profit. And if there is excess of expenses over the revenue, it is
said to be a loss. In the case of profit the management can take the decisions relating to
selling price and output etc. In the case of loss, the causes of such a loss are investigated and
remedial action is taken by the management.
3. To present the financial position of the business: The objective of the accounting is not
only recording of the financial transactions of the business and determination of profit or
loss but also to present the financial position of the business. To present the financial
position, financial accounting helps in the preparation of balance sheet. Balance sheet is
the statement of assets and liabilities of the business. It also gives the information about
the borrowed capital as well as owned capital along with different assets such as fixed
assets, current assets and miscellaneous. Balance sheet is the reflector of the financial
position of a business (solvency and insolvency).
4. To provide the financial information to the various users: One more objective of the
accounting is to provide the required financial information to the different users - internal
as well as external users. Internal users of the financial statements are owners, shareholders,
management and external users of the financial statements are debenture holders, creditors,
investors, employees, government, etc.
5. For Decision Making: These days accounting has taken upon itself the task of collection,
analysis and reporting of information at the required points of time to the required levels
of authority in order to facilitate rational decision-making.
1.1.3 Need of Financial Accounting
A well known author of Accounting, [Prof. R.R. Gupta, Principal, Poddar College, Nawalgarh
(Rajasthan)] wrote in …..”First write/record before one delivers goods or renders the services
and if there is any disagreement in future, use the writing or record as an evidence to resolve the
misunderstanding or rectifying the error.”
Recording of business transactions is necessary from owners’ point of view and other interested
party as well. The persons included in the second category are the suppliers of the materials,
products and services to the business, the government and the society at large. The creditors
(suppliers who are willing to take their payment later) are interested to know whether the business
will be able to pay them later (solvency of the business) whereas the government wants to know
whether the business has paid whatever was due to them in terms of taxes, fees, etc.
Did u know? What are the purposes of preparing financial statements?

1. Accounting provides necessary information for decisions to be taken initially and it
facilitates the enterprise to pave way for the implementation of actions.

2. It exhibits the financial track path and the position of the organization. Notes
3. Being business in the dynamic environment, it is required to face the ever changing
environment. In order to meet the needs of the ever changing environment, the
policies are to be formulated for the smooth conduct of the business.
4. It equips the management to discharge the obligations at every moment.
5. Obligations to customers, investors, employees, to renovate/restructure and so on.
1.1.4 Scope of Accounting
The Scope of accounting is divided into following two parts:
1. Branches of Accounting
2. Accounting as a science or an art
Branches of Accounting
The main objectives of accounting are to record the business transactions and to provide the
necessary information to the internal and external users of the financial statements. In order to
achieve the above objectives, the accounting is classified into followings branches:
1. Financial Accounting: It is the original form of accounting. It refers to the recording of
daily business financial transaction. Recording of the transaction is done in such a way
that the profit of the business may be ascertained after a definite period and the picture of
the financial position of the business may be presented.
2. Cost Accounting: As the name indicates, this accounting is related with the ascertainment
of cost of the product in a period. Under this system, record of raw materials used in
production, wages and labour paid and other expenses incurred on production are kept to
control the costs.
3. Management Accounting: The accounting which provides the necessary information to

the management is called management accounting. Under this, the analysis and
interpretation of the accounts, prepared by financial accounting, are done in a manner so
that the managers may forecast, plan for future and frame the policy.
4. Tax Accounting: Under tax accounting, the accountants prepare the accounts as per the
provisions of taxation. The accounts prepared as per taxation provisions may differ from
the accounts prepared as per financial accounting.
5. Inflation Accounting: The financial statements are prepared on the basis of historical cost
which do not present the true picture of the financial position and correct profit or loss of
the business due to inflation. Thus the fresh financial statements are prepared keeping in
mind the price level changes under inflation accounting.
6. Human Resource Accounting: Human Resource Accounting means the accounting for
human being as now in an organization human being is treated as an asset like other
physical assets. It is recorded in the books like other assets. HRA deals with the
measurement of costs on recruiting, selecting, hiring, training, placing and development
of the employees in one side and on the other side it deals with the present economic value
of the employees. For the determination of the value of human being different methods
are used under HRA.
7. Responsibility Accounting: Responsibility accounting is a special technique of management

under which accountability is established according to the responsibility delegated to the

Notes various levels of management. Management information and reporting system is instituted
to give adequate feedback in terms of the delegated responsibility. Under this system,
units of an organization, under a specified authority in a person, are developed as
responsibility center and evaluated individually for their performance.
Accounting as Science or an Art
Accounting is both the science and art. Study of science is based on some principles and it is
systemized. It is a science because the business transactions are recorded on the basis of some
principles and journal of transaction, ledger posting, trial balance and preparation of final
statements are done in a sequence. Art is the creation of practical applications and rules for the
completion of any work. On the basis of it, accounting is an art as we do not only study principles
of accounting but also we learn to apply these principles in practice to record the business
transaction. Thus accounting is both science and art.
1.1.5 Users of Accounting Information
There are two types of persons interested in financial statements: (1) Internal users, and
(2) External users.
1. Internal Users: These are: (a) Shareholders, (b) Management, and (c) Trade unions
employees, etc.
(a) Shareholders are interested to know the welfare of the business. They can know the
operational results through such financial statements and the financial position of
the business.
(b) Management is interested to take important decisions relating to fixing up the selling
prices and making future policies.
(c) Trade unions and employees are interested to know the operational results because
their bonus etc. is dependent on the profit earned by the business. Financial statements
also help in their negotiations for wages/salaries.
2. External Users: The following are most important external users of financial statements:
(a) Investors: They are interested to know the earning capacity of business which can be
known through financial statements. They can also know the financial soundness of
the business through financial statements.
(b) Creditors, Lenders of Money etc.: The creditors and lenders of money etc. can also
know the financial soundness through financial statement. They have to see two
things (i) Regularity of income and (ii) solvency of the business so that their
investment is risk free.
(c) Government: Government is interested to formulate laws to regulate business
activities and also law relating to taxation etc. Financial statements help while
computing National Income statistics etc.
(d) Taxation authorities: Financial statements provide information relating to operational

results as well as financial position of the business. Tax authorities decide the amount
of tax as per financial statement. It is very useful to other taxation authorities such as
sales tax etc.
(e) Stock Exchanges are meant for dealing in share/securities. Purchase and sale of such
shares and securities are possible through stock exchanges which provide financial
information about each company which is listed with them.

(f) Consumer: Consumer is interested in information on the continued existence of the Notes
business and thus probability of the continued supply of the products, parts and
after sale services. They ensure continuous existence of a business, especially in case
of durable products which require after sales service and spare parts.
1.1.6 Importance and Advantages of Accounting
Appropriate and adequate accounting system plays a vital role for the successful operation of
the business. It also helps in the determination of cost of production, controlling internal as well
as external activities of the business, forecasting of profit, cost and sales, etc. Accounting is also
useful in locating the errors, distribution of dividend and bonus to shareholders. Thus, accounting
is being used as a means to achieve the objective of the business. The other advantages of the
accounting are as follows:
1. Replacement of human memory: As the human’s memory is limited and short, it is difficult
to remember all the transactions of the business. Therefore, all the financial transactions
of the business are recorded in the books. By this way the businessmen cannot only see the
records at the required time but can also remember them for a long time. Thus, recording
of the transactions is the replacement of human’s memory.
2. Helpful in the determination of financial results and presentation of financial position:
Accounting is very useful in the determination of the profit and loss of a business and
showing the financial position of the business.
3. Helpful in assessing the tax liability: Generally, a businessman has to pay corporate tax,
VAT and excise duty, etc. Therefore, it is necessary that proper accounts should be
maintained to compute the tax liability of the business.
4. Helpful in the case of insolvency: Sometimes the businessman becomes the insolvent. If he
has properly maintained the accounts, he will not face the problems in explaining few
things in the court.
5. Helpful in the valuation of business: If the business is shut down and sold, accounting
helps the businessman to determine the value of business. It would be possible only in
that case when the accounts of the business are properly maintained.
6. Helpful in the valuation of goodwill and shares: If accounts of the business are properly
maintained, it would be quite convenient to determine the value of goodwill. Goodwill is
very important for the determination of the value of shares of the company.
7. Accounting makes comparative statement possible: Proper and adequate accounting helps
in comparing the income, expenditure, purchase, sale of the current year with that of the
previous years. And then future plans, policies and forecasting may be possible.
8. Raising of funds become easy: It helps in raising funds from investors or financial
institutions by promising investors a fixed claim (interest payments) on the cash flows
generated by the assets, with a limited or no role in the day-to-day running of the business.
1.1.7 Limitation of Accounting
In spite of being so many uses and advantages of accounting, it has a number of limitations
which are as follows:
1. Recording of monetary items only: In accounting only those transactions, which have the
monetary value, are recorded. And those transactions which do not have the financial
value whether those are important in business, are not recorded in the accounting. For
example, efficiency of the management, honesty of the workers, etc.

Notes 2. Effect of inflation: In accounting the transactions are recorded at the historical cost.
Accordingly the assets of the business are shown at cost in the balance sheet. Thus the
balance sheet prepared on the basis of historical cost ignores the price-level changes
(inflation). In this way the balance sheet of the business does not present the true and fair
picture of the business.
3. Conflict between accounting principles: In accounting, one accounting principle conflicts

another. For instance, inventory should be valued on the basis of ‘least of the cost and
market price’ as per the principle of the conservatism. If in the first year, inventory is
valued on the basis of cost (being lower than market price) and in the second year at the
market price (being lower than cost), this principle conflicts the accounting principle of
the consistency.
4. Financial statements are affected by personal judgment of the accountants: Personal
decisions of the accountants regarding the adoption of accounting policies, affects the
results of the financial statements. As a result the financial statements lose their objectivity.
5. Financial statements do not reflect the right picture of the business: Sometimes the profit
and loss account of the business does not show the accurate profit/loss and the balance
sheet does not show the true picture of the business because the assets shown in the
balance sheet are shown at the realizable (resalable) value which is wrong. Some worthless
figures are also shown in the balance sheet as preliminary expenses, discount on issue of
shares/debentures, etc.
Self Assessment
Fill in the blanks:

1. …………………… is the process of recording, classifying, summarizing in a significant
manner of transactions which are in financial character and finally results are interpreted.
2. The users of accounting are …………………… and external.
3. Accounting records all the transactions which can be expressed either in …………………….
4. The creditors are interested to know the ………………… of the business.
5. The primary objective of the accounting is to maintain the records of all ……………………
of the business.
1.2 Process of Accounting
Accounting is described as origin for the creation of information and the continuous utility of
information. Now the question is how is this information created? For this, there is a step by
step process, as shown in Figure 1.1.
After the creation of information, the developed information should be appropriately recorded.
Are there any scales/guides available for the recording of information? If yes, what are they?
They are as follows:
1. What to record: Financial Transaction is only to be recorded

2. When to record: Time relevance of the transaction at the moment of recording
3. How to record: Methodology of recording—It contains two different systems of accounting

viz. cash system and accrual system.

Figure 1.1: Process of Accounting

Notes
Step 1
Identification of Transaction
Step 2
Recording
Preparation of Business Transactions
Step 3
Recording of Transactions in Journal
Step 4
Grouping
Posting in Ledgers
Step 5
Summarizing
Preparation of Unadjusted Trial Balance
Step 6
Pass of Adjustment Entries
Step 7
Preparation Preparation of Adjusted Trial Balance
Trading and P&L A/c Balance Sheet
1.2.1 Cash System
The revenues are recognized only at the moment of realization but the expenses are recognized
at the moment of payment. For example, sale of goods will be considered under this method
that only at the moment of receipt of cash out of sale of goods. The charges which were paid only
will be taken into consideration but the outstanding, not yet paid will not be considered.
Example: Rent paid only will be considered but not the outstanding of rent charges.
1.2.2 Accrual System
The revenues are recognized only at the time of occurrence and expenses are recognized only at
the moment of incurring. Whether the cash is received or not out of the sales, that will be
registered/counted as total value of the sales.
The next most important step is to record the transactions. For recording, the value of the
transaction is inevitable, to record values; the classification of values must be essentially done.

Notes 1.2.3 Values
There are four different values in the business practices that should be followed or recorded in
the system of accounting:
1. Original Value: It is the value of the asset only at the moment of purchase or acquisition.
2. Book Value: It is the value of the asset maintained in the books of the account. The book
value of the asset could be computed as follows:
Book Value = Gross (Original) value of the asset – Accumulated depreciation
3. Realizable Value: Value at which the assets are realized.

4. Present Value: Market value of the asset.
Did u know? What are the purposes of preparing financial statements?
1. Accounting provides necessary information for decisions to be taken initially and it

facilitates the enterprise to pave way for the implementation of actions.
2. It exhibits the financial track path and the position of the organization.
3. Being business in the dynamic environment, it is required to face the ever changing
environment. In order to meet the needs of the ever changing environment, the
policies are to be formulated for the smooth conduct of the business.
4. It equips the management to discharge the obligations at every moment.
5. Obligations to customers, investors, employees, to renovate/restructure and so on.
Self Assessment
Fill in the blanks:

6. The …………………… are recognized only at the moment of realization but the
…………………… are recognized at the moment of payment.
7. For ……………………, the value of the transaction is inevitable, to record values; the
classification of values must be essentially done.
8. …………………… the value of the asset only at the moment of purchase or acquisition.
1.3 Book-keeping
Book-keeping includes recording of journal, posting in ledgers and balancing of accounts. All the
records before the preparation of trail balance are the whole subject matter of book-keeping. Thus,
book-keeping many is defined as the science and art of recording transactions in money or money’s
worth so accurately and systematically, in a certain set of books, regularly that the true state of
businessman’s affairs can be correctly ascertained. Here it is important to note that only those
transactions related to business are recorded which can be expressed in terms of money.
1.3.1 Definition
“Book-keeping is the art of recording business transactions in a systematic manner”.

—A.H. Rosenkamph.

“Book-keeping is the science and art of correctly recording in books of account all those business Notes
transactions that result in the transfer of money or money’s worth”.
—R.N. Carter
“Book-keeping is the recording of financial transactions in a methodological manner so that,
information of any point may be quickly obtained”.
—D.J. Favell
1.3.2 Importance of Book-keeping
1. Book-keeping provides a permanent record of each transaction. It provides combined

effect of all transaction on financial position.
2. Soundness of a firm can be accessed from the records of assets and abilities on a particular
date.
3. Entries related to incomes and expenditures of a concern facilitate to know the profit and
loss for a given period.
4. It enables to prepare a list of customers and suppliers to ascertain the amount to be
received or paid.
5. It is a method gives opportunities to review the business policies in the light of the past
records.
6. Amendment of business laws, provision of licenses, assessment of taxes etc., are based on
records.
1.3.3 Difference between Book-keeping and Accounting
The following table explains the key differences between book-keeping and accounting:
Table 1.1: Difference between Book-keeping and Accounting
Basic of difference Book-keeping Accounting

Transactions Recording of transactions in books of To examine these recorded
original entry. transactions in order to find out their
accuracy.
Posting To make posting in ledger To examine this posting in order to
ascertain its accuracy.
Total and Balance To make total of the amount in journal To prepare trail balance with the
and accounts of ledger. To ascertain help of balances of ledger accounts.
balance in all the accounts.
Income Statement Preparation of trading, Profit & loss Preparation of trading, profits and
and Balance Sheet account and balance sheet is not loss account and balance sheet is
book-keeping included in it.
Rectification of These are not included in book-keeping These are included in accounting.
errors
Special skill and It does not require any special skill and It requires special skill and
knowledge knowledge as in advanced countries knowledge.
this work is done by machines.
Liability A book-keeper is not liable for An accountant is liable for the work
accountancy work of book-keeper.

Notes Self Assessment
Fill in the blanks:

9. …………………… includes recording of journal, posting in ledgers and balancing of
accounts.
10. Book-keeping provides a permanent record of each …………………… .
1.4 Methods of Accounting
Business transactions are recorded in two different ways.
1.4.1 Single Entry
It is incomplete system of recording business transactions. The business organization maintains

only cash book and personal accounts of debtors and creditors. So the complete recording of
transactions cannot be made and trail balance cannot be prepared.
1.4.2 Double Entry
It this system every business transaction is having a twofold effect of benefits giving and benefit
receiving aspects. The recording is made on the basis of both these aspects. Double Entry is an
accounting system that records the effects of transactions and other events in at least two accounts
with equal debits and credits.
The modern system of book keeping is based on the double entry system. Therefore, we are
discussing this system only. The father of this system is the Lucas Pacioli. He gave the details of
this system in his book “De Compute Set Scripturise” in Italy in 1494 A.D. As per this system every
transaction of the business has double aspects/double effect. Therefore, every transaction must
be recorded at two places or accounts. If in a transaction someone is a giver, some other will be
a receiver.
Did u know? This system of accounting is also called Mercantile System or Western System
of Accounting.
This system is so organized, accurate, complete and scientific that it is now adopted universally.
In the words of Keller, M.J. Keller in – Intermediate Accountancy, “The most common system of
accounting data for an enterprise is the double entry system. As the name implies, the entry
made for each transaction is composed of two parts, a ‘debit’ and a ‘credit’.
Importance of Double Entry System
As we know that double entry system of accounting is a systematic and scientific system of
accounting, so it offers a number of advantages. The following are the most important advantages
of the system:
1. Complete record of transactions: Under this system, recording of all transactions is done
whether related to personal or impersonal accounts.
2. Ascertainment of profit or loss: Under this system of accounting complete profit and loss
account can be prepared by which profit or loss of a particular period can be ascertained.
3. Mathematical check on accuracy: Every debit has a credit, so it is an accurate system as far
as mathematical accuracy is concerned which may be proved by preparing trial balance.

4. Check for fraud: Scope of fraud is limited as it minimizes the chances of fraud because of Notes
scientific system.
5. Ascertainment and knowledge of financial position of the business: Under this system, it
is possible to know the financial position of the business at any time. For this purpose
Balance Sheet can be prepared any time.
6. Possibility of full control over business: Under this system full information is available
which enables the management to exercise full control over the business.
7. Easy accessibility of information: Under this system all information is easily available
and accessible which is very helpful and useful for the management.
8. Possibility of comparative study: Under this system, it is possible to prepare comparative
statement and also compare the previous year’s results with the current year’s result and
take corrective steps as and when necessary to improve the operational results.
9. Reliable information: Under this system information received is reliable.
Steps involved in Double Entry System
1. Preparation of Journal: Journal is called the book of original entry. It records the effect of
all transactions for the first time. Here the job of recording takes place.
2. Preparation of Ledger: Ledger is the collection of all accounts used by a business. Here the
grouping of accounts is performed. Journal is posted to ledger.
3. Trial Balance preparation summarizing: It is a summary of ledge balances prepared in the
form of a list.
4. Preparation of Final Account: At the end of the accounting period to know the
achievements of the organization and its financial state of affairs, the final accounts are
prepared.
Rules of Double Entry System
As per the principles of the double entry system, each transaction of the business is recorded at
two places. In other words, two entries are made for every financial transaction of the business.
If someone is giving something in the business, it has two sides – one is giver and other is
receiver. The system of double entry can be understood easily by an equation which is called
accounting. Following are some transactions of the business to explain it.
For example
1. Mr. Kamlesh started business with cash of 2,00,000.
In this transaction, one side cash is coming into business and in the other side capital is
being brought by Mr. Kamlesh. Thus:
Capital = Assets (Cash)
2,00,000 = 2,00,000
2. In the next transaction, if a plant of 50,000 is purchased in cash, this transaction will also
leave two sides. In one side cash is going and in other side plant is coming. In this situation,
the accounting equation will be as follows:
Capital = Plant + Cash (Assets)
2,00,000 = 50,000 + ( 2,00,000 – 50,000)

Notes 3. If a loan of 1,50,000 are taken from the SBI, it will also affect the accounting equation by
two sides. On one side, cash will increase and on the other side, liabilities of the business
will increase. This may be depicted as follows:
Capital + Liability (Loan) = Plant + Cash
2,00,000 + 1,50,000 = 50,000 + (1,50,000 + 1,50,000)
3,50,000 = 3,50,000
4. If some goods of 20,000 are purchased on credit, it will also affect the accounting equation
in two ways. On one side it increases the goods and on the other side it increases the liability
(creditors). Now the changed form of the above accounting equation will be as follows:
Capital + Loan + Creditors = Plant + Cash + Goods
2,00,000 + 1,50,000 + 20,000 = 50,000 + 3,00,000 + 20,000
3,70,000 = 3,70,000
Capital + Liabilities = Assets
Notes By observing the effect of above transactions on the accounting equation, we note
that total of assets always remain equal to the total of capital and liabilities. Thus, the
principle of double entry system may be summarized as for every debit side there is an
equivalent credit side and vice versa.
Task What will be the impact of following transactions on balance sheet?

1. R started business with cash of 500000
2. Machinery purchased for 100,000.
3. Payment made to creditors of 20000
4. Goods sold for 15000

Caselet ICAI told to Hasten Process for Double-entry
Accounting System
T
“ here is a need to set up a separate committee for converting the single entry
accounting system to double entry. The process is rather slow. It should be hastened,”
Mr K. Rahman Khan, Honorary Deputy Chairman, Rajya Sabha, and member of
the Institute of Chartered Accountants of India (ICAI), said.
While stating that the accounting system has already been converted to double entry in
local bodies, Mr Khan added that the institute should play a vital role in monitoring
governmental expenditure.
“A chartered accountant’s responsibility should not be limited to his clients alone. He owes
it to the society. The institute and the custodian of government expenditure – Comptroller
Contd...

and Auditor General of India have already resolved to effect the conversion. Various Notes
governments across the globe now follow the double entry accounting system. We need to
switch to double entry quickly,” he added.
He clarified his statement by stating: “I am not saying that the Government accounts are not
perfect. We need to ensure better transparency. The double entry accounting system would
help measure cost escalation, go into the details of total public expenditure and so on.”
The Vice-President of ICAI, Mr G. Ramasamy, said that the Governmental outgo towards
the Mahatma Gandhi National Rural Employment Guarantee Act Scheme totalled over
42,000 crore and there were over 6 lakh panchayats in the country preparing their
expenditure statement. “The institute is supporting the panchayats prepare the statement,”
he said.
On implementation of International Financial Reporting Standards (IFRS), he said by

July 31, all approvals would be in place. The institute has started programmes to enlighten
professionals and jumpstart the process in India, launched certification course on IFRS.
“In the first phase, we have started with Nifty companies with a turnover of over
1,000 crore.”
The institute, he said has inked MoUs with its various international counterparts to augment
bilateral relationships. “We recently interacted with professional bodies in West Asia,
discussed the need for improving networking ties between members and professionals of
the two countries. We are looking to enter into mutual recognition agreements with the
professional bodies in Canada, Singapore and New Zealand among others,” he said.
Source: http://www.thehindubusinessline.in/2010/07/05/stories/2010070551931300.htm
Self Assessment
Fill in the blanks:

11. …………………… is incomplete system of recording business transactions.
12. …………………… system of accounting is a systematic and scientific system of accounting,
so it offers a number of advantages.
1.5 Types of Accounts
The object of bookkeeping is to keep a complete record of all the transactions that place in the
business. To achieve this object, business transactions have been classified into three categories:
1. Transactions relating to persons.
2. Transactions relating to properties and assets

3. Transactions relating to incomes and expenses.
The accounts falling under the first heading are known as ‘personal Accounts’.
The accounts falling under the second heading are known as ‘Real Accounts’, the accounts falling
under the third heading are called ‘Nominal Accounts’. The accounts can also be classified as
personal and impersonal.
1.5.1 Personal Accounts
Accounts recording transactions with a person or group of persons are known as personal
accounts. These accounts are necessary, in particular, to record credit transactions.

Notes Personal accounts are of the following types:

1. Natural persons: An account recording transactions with an individual human being is
termed as a natural persons’ personal account. For example, Kamal’s account, Mala’s
account, Sharma’s accounts. Both males and females are included in it
2. Artificial or legal persons: An account recording financial transactions with an artificial
person created by law or otherwise is termed as an artificial person, personal account.
For example, Firms’ accounts, limited companies’ accounts, educational institutions’
accounts, Co-operative society account.
3. Groups/Representative personal Accounts: An account indirectly representing a person

or persons is known as representative personal account. When accounts are of a similar
nature and their number is large, it is better tot group them under one head and open a
representative personal account. For example, prepaid insurance, outstanding salaries,
rent, wages, etc.
When a person starts a business, he is known as proprietor. This proprietor is represented by
capital account for that entire he invests in business and by drawings accounts for all that which
he withdraws from business. So, capital accounts and drawings account are also personal accounts.
The rule for personal accounts is:

Debit the receiver
Credit the giver
1.5.2 Real Accounts
Accounts relating to properties or assets are known as ‘Real Accounts’, A separate account is
maintained for each asset e.g., Cash Machinery, Building, etc.,
Real accounts can be further classified into tangible and intangible.
1. Tangible Real Accounts: These accounts represent assets and properties which can be seen,
touched, felt, measured, purchased and sold. For example, Machinery account Cash account,
Furniture account, stock account, etc.
2. Intangible Real Accounts: These accounts represent assets and properties which cannot be
seen, touched or felt but they can be measured in terms of money. For example, Goodwill
accounts, patents account, Trademarks account, Copyrights account, etc.
The rule for Real accounts is:
Debit what comes in
Credit what goes out
1.5.3 Nominal Accounts
Accounts relating to income, revenue, gain expenses and losses are termed as nominal accounts.
These accounts are also known as fictitious accounts as they do not represent any tangible asset.
A separate account is maintained for each head or expense or loss and gain or income. Wages
account, Rent account Commission account, Interest received account are some examples of
nominal account.
The rule for Nominal accounts is:
Debit all expenses and losses

Credit all incomes and gains

Self Assessment Notes
Fill in the blanks:

13. Accounts recording transactions with a person or group of persons are known as
…………………… .
14. An account recording transactions with an individual human being is termed as a

…………………… .
15. Accounts relating to properties or assets are known as …………………… .
16. Accounts relating to income, revenue, gain expenses and losses are termed as
…………………… .
1.6 Accounting Terminology
Account
An account is a record used to properly classify the activity recorded in the General Ledger.
Accounting
Accounting is recording and reporting of financial transactions, including the origination of the
transaction, its recognition, processing, and summarization in the financial statements.
Accrual Basis
Accrual basis is a method of accounting that recognizes revenue when earned, rather than when
collected and expenses when incurred rather than when paid. The college uses the accrual basis
for its accounting.
Asset
An asset is anything of use to future operations of business and belonging of an enterprise. An

asset is what the college owns. For example- land, property, buildings, equipment, cash in bank
accounts, other investments and accounts receivable.
Credit
A credit is an entry on the right side of a double-entry accounting system that represents the
reduction of an asset or expense or the addition to a liability or revenue.
Debit
A debit is an entry on the left side of a double-entry accounting system that represents the
addition of an asset or expense or the reduction to a liability or revenue.
Double-Entry Accounting
Double-entry accounting is a method of recording financial transactions in which each transaction

is entered in two or more accounts and involves two-way, self-balancing posting. Total debits
must equal total credits. The college uses this method of accounting.

Notes Expense/Costs
It is the expenditure incurred by enterprise to earn revenue. An expense is funds paid by the
college. For example-paychecks to employees, reimbursements to employees, payments to
vendors for goods or services.
Equity: It refers to total claims against enterprise. It is further dividers into Owner's Claim
(Capital) and Outside’s Claim (Liability).
GAAP
GAAP stands for Generally Accepted Accounting Principles which are conventions, rules, and
procedures necessary to define accepted accounting practice at a particular time. The highest
levels of such principles are set by FASB.
FASB
FASB stands for Financial Accounting Standards Board which is an independent, private,
nongovernmental authority for the establishment of accounting principles in the United States.
General Ledger
The general ledger is the collection of all asset, liability, fund balance (net assets), revenue and
expense accounts.
Journal Entry
A journal entry is a group of debit and credit transactions that are posted to the general ledger.
All journal entries must net to zero so debits must equal credits.
Liability
A liability is what the college owes. For example-loans, taxes, payables, long term debt from a
bond issue, funds held by the college for a third party such as a student group.
Subsidiary Ledger
A subsidiary ledger is a group of accounts containing the detail of debit and credit entries. For
example detail information contained in Accounts Payable.
Revenue
Revenue is funds collected by the college; it can also be called income. It is monetary value of
products/services sold to customers during the period. For example-tuition, fees, rentals, income
from investment.
Cash Book
Cash book was used to record all cash and bank related transactions. Some records only the cash
related transactions while other use the cash book for both type of transactions. A cash book
which is used to record both cash and bank transactions is referred to as Two-column Cash Book.
Some accountants use cash book as Cash Book cum Journal. One column of the cash book on
both the pages is used for cash transactions and other column for recording all other entries
including bank transactions.

Journal Notes
The journal is used for recording all transactions which cannot be recorded in the Cash Book.
Sometimes it is supported by some subsidiary books e.g. Purchase Book, Sales Register, etc.
General Ledger
The General Ledger contains all the accounts of an enterprise. Since the final information
pertaining to the financial position of a business emerges only from accounts and, therefore, the
Ledger is also called the Principal Book.
Trial Balance
In accounts every amount that is placed on the debit side of an account must have a corresponding
entry on the credit side of some other account. This is the technical aspect of the principle of double
entry system. This being the case, it is but natural that the total of all debit balances should agree
with the total of all credit balances. In fact, all businesses periodically tabulate the debit and credit
balances separately in a statement to see whether the total of debit balances agrees with the total
of credit balances or not. Such a statement is known as Trial Balance. The accountant heaves a sigh
of relief when the Trial Balance drawn by him tallies because it is a good proof that the ledger has
been correctly written up. However, it is not a conclusive proof of accuracy.
Profit and Loss Account
This is prepared to see the loss incurred or profit earned by an enterprise within specific period.
This is usually made on a yearly basis.
Balance Sheet
The Balance Sheet is a statement summarizing the financial position of a business on a given
date. It summaries on the right hand side the assets of the business and on the left hand side the
liabilities of the business including what the business owes to the proprietor viz., the capital
invested by him. The total of all the assets must be equal to the total of all the liabilities.
So an accountant has to write the cash book and journal first, and then post all those entries
written in cash book and journal to general ledger. Then he prepares the Trial Balance – the most
difficult job. After this he prepares the Profit & Loss Account and Balance Sheet. He also has to
reconcile the banks, prepares other report like sale register, inventory position, list of debtors
and creditors, purchase and sales returns etc. Doing all this work manually not only requires lot
of patience but it is a time consuming and very much laborious job.
Self Assessment
17. The …………………… is used for recording all transactions which cannot be recorded in
the Cash Book.
18. The …………………… contains all the accounts of an enterprise.
19. …………………… was used to record all cash and bank related transactions.
Accounting Cycle starts from recording individual transactions in the books of accounting and
ends at the preparation of financial statements and closing process. The financial accounting
cycle is the process of recording business transactions and processing accounting data to generate

Notes useful financial information i.e. financial statements including income statement, balance sheet,
cash flow statement and statement of shareholders equity. The time period principle requires
that a business should prepare its financial statements after a specified period of time, say a year,
a quarter or on a monthly basis. This is achieved by following the accounting cycle during each
period.
Figure 1.2: Accounting Cycle
1.7.1 Distinction between Book-keeping and Accounting
Book-keeping and accounting can be distinguished as follows:
Table 1.2: Distinction between Book-keeping and Accounting
Basis of Difference Book-Keeping Accounting Accounting

1. Objective 1. The objective of book- keeping 1. Whereas the objective of accounting is not
is to record the transactions of only the recording of transactions but
economic nature. also analyzing and interpreting the data.
2. Nature (Art or 2. It is an art. 2. It is a science.
science)
3. Scope 3. The scope of book-keeping is 3. The scope of accounting is very wide.
very limited.
4. Functions 4. Most of the functions of 4. Functions of accounting involves expert
book-keeping are now-a-days human beings in the art of analysis and
performed by machines. interpretation.
5. Accounting 5. Book-keeping is just one part 5. Accounting involves the entire process
Process of accounting process. of accounting that is why it is said that
accounting begins where book-keeping
ends.
6. Rules to be 6. Rules of accounting are 6. Along with rules, assumptions and
followed followed for recording. conventions are also there to follow.
7. Net Results 7. Net results of the business 7. Whereas accounting is used to find Contd...
out
Profit or loss cannot be known from net results of the business.
book-keeping.
8. Time 8. Transactions are immediately 8. Transactions are generally recorded
20 LOVELY PROFESSIONAL
recorded. UNIVERSITY after a gap of time or at the end of a
financial year.
very limited.
4. Functions 4. Most of the functions of 4. Functions of accounting involves expert
book-keeping are now-a-days human beings in the art of analysis and
performed by machines. interpretation.
5. Accounting 5. Book-keeping is just one part 5. Accounting involves the entire process
Process of accounting process. of accounting that is why it is said that
accounting begins where book-keeping Unit 1: Introduction to Accounting
ends.
6. Rules to be 6. Rules of accounting are 6. Along with rules, assumptions and
followed followed for recording. conventions are also there to follow.
7. Net Results 7. Net results of the business 7. Whereas accounting is used to find out Notes
Profit or loss cannot be known from net results of the business.
book-keeping.
8. Time 8. Transactions are immediately 8. Transactions are generally recorded
recorded. after a gap of time or at the end of a
financial year.
1.8 Summary
 Accounting is the medium of recording the business activities and considered as a language
of business.
 Accounting is the art of recording, classifying and summarizing in a significant manner
and in terms of money transactions and events which are, in part at least, of a financial
character, and interpreting the results thereof.
 Identification of financial transactions, recording, classifying them into different groups,
summarizing them into trial balance and preparation of financial statements and analyzing
and interpreting them, are included in the accounting process.
 Financial accounting, cost accounting, management accounting, responsibility accounting,
tax accounting, inflation accounting, etc., are the branches of accounting. Accounting is an
art as well as a science.
 Accounting is done for the following objective:
 For maintaining the systematic records
 For ascertaining the profit/loss of the business
 To present the financial position
 To provide the financial information
 Accounting plays an important role in the determination of profit, financial position, tax
liability, valuation of goodwill and shares and comparative study.
1.9 Keywords
Accounting Conventions: Customs and traditions which guide the accountants to record the
financial transactions.
Accounting Process: It includes the recording of financial transactions, ledger posting, preparation
of financial statements and analyzing and interpretation of them.
Cost Accounting: Accounting relating to the ascertainment of cost of the product.
Management Accounting: Presenting of accounting information in such a way as to assist the
management in taking the important decisions and making the policies.
1. Accounting is the process of recording, classifying and summarizing of accounting

transactions. Explain.
2. What are the key internal and external users of accounting information?
3. State the key branches of accounting.
4. Is there any difference between book-keeping and accounting?

Notes 5. Illustrate the key points which make double entry accounting system more significant
than the other traditional accounting systems.
6. As per the double entry system of accounting what will be the impact of following
transactions on balance sheet:
(i) Mr. Rakesh started business with cash of 1,00,000
(ii) Gods sold on credit for 10000
(iii) Furniture purchased for 5000
7. Explain the meaning and importance of double entry system of accounting.
8. What is meaning of Debit and Credit?
9. Explain the different methods of accounting.
10. Explain the various types of accounts.
Answers: Self Assessment
1. Accounting 2. Internal
3. Money or money’s worth 4. Solvency
5. Transactions 6. Revenues, Expenses
7. Recording 8. Original Value
9. Book-keeping 10. Transaction
11. Single Entry 12. Double entry

13. Personal accounts 14. Natural persons’ personal account
15. Real Accounts 16. Nominal accounts
17. Journal 18. General Ledger
19. Cash book
Books Dr. S.N. Maheshwari, Sharad, K. Maheshwari, Financial Accounting, Vikas

Publishing Co. Pvt. Ltd., New Delhi.
Grewal, T.B, Double Entry Book-keeping.

Jain and Narang, Advanced Accountancy.
R.L. Gupta, M. Radhaswami, Advanced Accountancy, Sultan Chand, New Delhi.

T.S. Grewal, M.C. Shukla, Advanced Accounts, S. Chand, New Delhi.
Online links www.futureaccountant.com

http://www.globusz.com/

Unit 2: Principles of Accounting
Unit 2: Principles of Accounting Notes
CONTENTS
Objectives
Introduction
2.1 Generally Accepted Accounting Principles

2.2 Classification of Accounting Principles
2.2.1 Basic Accounting Assumptions

2.2.2 Basic Accounting Principles (Concepts)
2.2.3 The Modifying Accounting Principles (Conventions)

2.3 Capital and Revenue Items
2.3.1 Capital and Revenue Expenditures

2.3.2 Capital and Revenue Receipts
2.4 Summary
2.5 Keywords
Objectives

 Generally accepted accounting principles
 Accounting concepts and conventions

 Capital and revenue items
 Accounting equation and accounting cycle
Introduction
The transactions of the business enterprise are recorded in the business language, which routed
through accounting. The entire accounting system is governed by the practice of accountancy.
The accountancy is being practiced through the universal principles which are wholly led by the
concepts and conventions.
Accounting Concepts Accounting Conventions
Accounting Principles

Notes 2.1 Generally Accepted Accounting Principles
Accounting principles are those rules of actions on the basis of which the transactions of the
business are recorded, classified and summarized. If the financial statements are not prepared
on the basis of these principles, there will be low acceptability and difficulty to understand
them, and the comparison will be impossible and unreliable. Therefore, the accountants
recommend that there should be common concepts and conventions of accounting so that the
above difficulties and problems may not occur. These common concepts and conventions of
accounting have become the basic accounting concepts and conventions as these are commonly
accepted by the body of the professional accountants all over the world to prepare the financial
statements, Therefore, they are termed as Generally Accepted Accounting Principles (GAAP).
!
Caution There are various bodies, national and international, who from time to time
frame guidelines, define terms, formulate principles and standards to be used in the field
of Accounting and finance, The industry, firms, business groups have to follow these, both
as legal provisions and as convenience.

Caselet Enron & Accounting Issues: Yawning GAAP
T
he Enron Corp imbroglio holds many lessons for Indian accounting professionals
most of whom are working in a country which fancies itself as a software sweatshop
and, therefore, have to deal frequently with tricky revenue recognition issues.
In fact, revenue recognition is so tricky that the Financial Accounting Standards Board
(FASB), which sets the global benchmark for private sector accounting, has tagged it “the
largest single category of fraudulent financial reporting and financial statement
restatements”.
But what do revenue recognition issues have to do with Enron? The answer is... just about
everything.
Consider these facts: Between 1996 and 2000, the energy trading outfit reported an increase
in its sales from $13.3 billion to $100.8 billion. In one single accounting year, 1999-2000, it
doubled its reported sales. And said that it was set to double its sales again the following
year.
How was Enron able to claim this phenomenal increase in sales revenue? Very simple—
it exploited a loophole in accounting rules that allowed it to book revenue from energy-
derivative contracts at their gross—as against net value.
The basic incongruity of this practice becomes apparent if you examine the way a Wall
Street firm—which is also in trading, although not energy trading—books its revenue.
Let’s say Wall Street Company X handles, on behalf of a client, the sale of 10,000 shares
worth $500,000 of Company Y. It would record as revenue its commission on the sale or
the spread between the bid price and the ask price—a few hundred dollars. But Enron (or
any other energy trader in the US, for that matter) handling an energy trade would book
the full $500,000.
According to Enron’s 2000 annual report, it was in the business of building “wholesale
businesses through the creation of networks involving selective asset ownership,
Contd...

contractual access to third-party assets and market-making activities”. It seems to have Notes
used the term “wholesale businesses” to mean trading, plain and simple. From which it
made more than 90 per cent of its revenue....
To make matters worse, Enron bought and sold the same goods over and over again. And
all this trading—a good amount of which was being carried on with purportedly
independent partnerships which do not look very independent on examination—was
being booked as revenue at full value.
It got away with this fancy bookkeeping because the FASB just could not make up its mind
about how energy contracts should be accounted for and, at some point or the other,
decided that each company had a “free option” to do what it wanted.
However, looking on the positive side of things, all this number-pumping without any
basis in good accounting ensured that the Enron bankruptcy, in the words of the US
Treasury Secretary, Mr Paul O’Neill, had no “spill-over effect.”
The downside, of course was that it did not do anything for its profits because of the steady
erosion in its trading margins (caused, ironically enough, by the entry of many players
into a market created by Enron) from 5.3 per cent in 1998 to less than 1.7 per cent in the
third quarter of the current year.
In retrospect, it would seem that the company made frantic attempts to keep up its profits
in spite of diminishing margins through various methods, including the setting up of
several off-the-balance sheet entities represented as independent of Enron to which it sold
assets or portfolios of assets.
It created so-called special purpose entities (SPEs) like the Chewco and JEDI partnerships
to get assets like power plants off its books. Enron was able to do this because, under
standard accounting, a company is allowed to spin off its assets—and related debts—to an
SPE if an outside investor has put up capital worth at least three per cent of the SPE’s total
value.
These methods also stretched across the lumping of assets into its trading business and the
booking as operating revenues the proceeds of the sale of fixed assets.
Gaps, it would seem, abound in GAAP....
Self Assessment
Fill in the blanks:
1. Accounting records all the transactions which can be expressed either in …………………….
2. Every financial transaction of the business has …………………… and recorded at two
places.
2.2 Classification of Accounting Principles
Accounting principles are broadly classified into three categories, these are:
 Basic Assumptions
 Basic Principles (Concepts)
 Modifying Principles (Conventions)

Notes The classification of accounting principles is shown in the following figure:
Figure 2.1: Classification of Accounting Principles
(i) Separate Business Entity

Basic Accounting (ii) Going Concern
Assumptions (iii) Money Measurement Concept
(iv) Accounting Period
(i) Revenue Reorganization Principles

(ii) Cost Principle
Basic Principles (iii) Dual Aspect Principle
Accounting
(Concept) (iv) Full Disclosure Principle
Principles
(v) Matching of Cost and Revenue Principle
(vi) Objectivity Principle
(i) Conservatism
(ii) Consistency
Modifying Principles (iii) Timeliness
(Conventions) (iv) Materiality
(v) Cost-Benefit Principle
(vi) Industry Practices
2.2.1 Basic Accounting Assumptions
The owner and business are treated as two distinct entities and we record those view point of
business.
1. Separate Business Entity: As per this assumption, business is considered a separate entity
from its owner(s). This assumption helps in keeping the business transactions strictly free
from the effect of personal affairs of the owner. For instance, when a person start the
business with cash of 2,00,000 then this amount increases the balance of cash from the
point of business and on the other hand the owner is treated as a liability and this is shown
in the liability side of the balance sheet as owner’s capital. For this transaction this journal
entry is passed:
Cash A/c Dr. 2,00,000
To Owner’s Capital A/c 2,00,000
This concept is becoming more popular because in one sense capital itself may be regarded
as a liability—the amount due from the business to the owner. This concept is applicable
to the all forms of business organizations whether it is a limited company, partnership
firm or a sole trader.
2. Going Concern Concept: As per International Accounting Standards, it is a fundamental
accounting assumption underlying the preparation of financial statements. Under this
assumption, “the enterprise is normally viewed as a going concern, that is, as continuing
in operation for the foreseeable future. Under this all assets are shown at cost price and not
at market price and depreciation is provided on cost price in order to calculate true profit.
It is assumed that the enterprise has neither the intention nor the necessity of liquidation
or of curtailing materially the sale of its operations”. Under this assumption the assets of
the business are valued by the accountants on the basis of going concern concept, historical
cost and expected life of the assets.
3. Money Measurement Concept: Money is medium to value quantities. As per this assumption,
only those transactions of the business are recorded in the accounting which can be measured

in money. Those transactions/activities of the business which cannot be measured in Notes

money are not recorded in accounting.
4. Accounting Period Assumption: As per the going concern concept, the income of the
business can be measured at the time of the liquidation of the business or at the time when
business is sold. But practically it is very difficult to wait such a long period that is also not
definite. Therefore, it is agreed among the accountants that the economic life of the business
is divided into different segment for the purpose of preparing of the financial statements
and the determination of profits. Generally this segment of time is one year either calendar
year or a financial year. Sometime it may be less than twelve months i.e., quarterly, half
yearly, etc. Reports made for less than twelve months are called interim reports and are
less reliable than annual reports. At the end of each segment (period) profit and loss
account and balance sheet are prepared.
2.2.2 Basic Accounting Principles (Concepts)
These basic accounting principles are commonly accepted/agreed principles by the accountants
to record the business financial transactions. These are as follows:
Money Measurement Concept
This is the concept tunes the system of accounting as fruitful in recording the transactions and
events of the enterprise only in terms of money. The money is used as well as expressed as a
denominator of the business events and transactions. The transactions which are not in the
expression of monetary terms cannot be registered in the book of accounts as transactions.
Example:
1. 5 machines, 1 ton of raw material, 6 forklift trucks, 10 Lorries and so on. The early
mentioned items are not expressed in terms of money instead they are illustrated
only in numbers. The worth of the items is getting differed from one to the other. To
record the above enlisted items in the book of accounts, all the assets should be
converted into money.
2. 5 lathe machines worth 1,00,000; 1 ton of raw materials worth amounted 15,00,000
and so on.
!
Caution
 The transactions which are not in financial in character cannot be entered in the
book of accounts.
 Recording of transactions are only in terms of money in the process of accounting
Business Entity Concept
This concept treats the owner as totally a different entity from the business. To put in to nutshell
“Owner is different and Business is different”. The capital which is brought inside the firm by
the owner, at the commencement of the firm is known as capital. The amount of the capital,
which was initially invested, should be returned to the owner considered as due to the owner;
who was nothing but the contributory of the capital.

Notes
Example: Mr. Z has brought a capital of 1 lakh for the commencement of retailing
business of refrigerators. The brought capital of 1 lakh is utilized for the purchase of refrigerators
from the Godrej Ltd. He finally bought 10 different sized refrigerators. Out of 10 refrigerators,
one was taken away by himself as the owner.
Type of Capital
Real Capital: Monetary Capital:

10 Refrigerators @ 1 lakh 1 lakh provided by Mr. Z
In the Angle of the Firm
The amount of the capital 1 lakh has to be returned to the owner Mr. Z, which considered being
as due. Among the 10 newly bought refrigerators for trading, one was taken away by the owner
for his personal usage. The one refrigerator drawn by the owner for his personal usage led the
firm to sell only 9 refrigerators. It means that 90,000 out of 1 Lakh is the volume of real capital
and the 10,000 worth of the refrigerator considered to be as drawings; which illustrates the
capital owed by the firm is only 90,000 not 1 lakh.
In the Angle of the Owner
The refrigerator drawn worth of 10,000 nothing but 10,000 worth of real capital of the firm was
taken for personal use as drawings reduced the total volume of the capital of the firm from
1 lakh to 90,000, which expected the firm to return the capital due amounted 90,000.
Notes Owner and business organizations are two separate entities.
Going Concern Concept
The concept deals with the quality of long lasting status of the business enterprise irrespective of
the owners’ status, whether he is alive or not. This concept is known as concept of long term assets.
The fixed assets are bought in the intention to earn profits during the season of the business. The
assets which are idle during the slack season of the business retained for future usage, in spite of
that those assets are frequently sold out by the firm immediately after the utility leads to mean
that those assets are not fixed assets but tradable assets. The fixed assets are retained by the firm
even after the usage is only due to the principle of long lastingness of the business enterprise.
If the business disposes the assets immediately after the current usage by not considering the
future utility of the assets in the firm which will not distinguish in between the long-term assets
and short-term assets known as tradable in categories.
Revenue Recognition Principle
It is also called revenue realization principle which means profit should be considered only
when realised. As per this principle the revenue is recorded in accounting when the sales have
taken place. If there is expectation that will be a particular transaction there in future, that is not

recorded in accounting. Revenue/sales is considered to be made when title of ownership of Notes

goods passes from the seller to buyer and the buyer become legally liable to pay.
However, this principle has some exemptions which are as follows:
1. In the case of sales made on the basis of hire purchase system where ownership is not
transferred at the time of sales while it is transferred at time of final payment. Herewith,
sales are presumed to the extent of installment received.
2. In the case of contract accounts, if the contract is for long period revenue cannot be realized
until the contract is not completed. Here, only a part of total revenue is treated as realized.
Cost Principle
This principle is closely related to the going concern concept. As per this principle every
transaction of the business should be recorded at its historical cost and not at its market price. At
the time of recording of the transactions, their market price is not considered. Sometimes its
market price may be less than or more than its actual cost but its actual cost is recorded in
accounts because of cost principle. Under this principle the historical cost of a transaction becomes
the base cost for the subsequent years. On the basis of this cost, the depreciation is charged on the
assets and the balance is shown in the balance sheet. All the fixed assets and current assets are
recorded at historical cost. Thus, we observe that the balance sheet prepared on the basis of
historical cost does not give us actual results for those applicable of fixed assets and current
assets. Due to the changing in the price level changes, the financial statements become irrelevant
for the users. This led to the inflation accounting to came into existence.
Dual Aspect Principle
This is the basic principle of accounting. As per this principle every financial transaction of the
business has dual effect and recorded at two places. Therefore, it is called double entry system.
On the basis of this principle it is said that every debit must have an equivalent credit and every
credit must have an equivalent debit because every transaction of the business has two aspects.
For instance, if Mr. Aditya Raj started a business for cash 2,00,000 there will be two aspects of
this transaction. In one aspect cash is coming into business while in the other aspect the business
has to pay this amount to Mr. Aditya Raj. Because Mr. Aditya Raj has given the amount to the
business. For this transaction the following journal entry will be passed:
Cash A/c Dr.
To Mr. Aditya Raj
Or
To Capital A/c
This transaction can be expressed in the following equation:
2,00,000 = 2,00,000
Here cash (assets) is the resource of the business and capital is the claim of the proprietor as
business has to return this amount to the proprietor.
If the business purchases furniture of 20,000 on credit, the above equation will change as
follows:
Capital + Creditors = Cash + Furniture
2,00,000 + 20,000 = 2,00,000 + 20,000

Notes Thus, we find that in the above equations the total of assets is always equal to the liabilities.
Technically we can say that for every debit there is an equivalent credit. This relationship of
assets and liabilities is also called accounting equation.
Full Disclosure Principle
As per this principal, the financial statements should disclose true and fair view so that these
may provide accurate and sufficient information to the users of financial statements. Disclosure
principle means to give all the information relating to the economic activities of the business to
the owner, creditors and investors. Nowadays this principle is getting more importance as big
business houses are being run in the form of limited companies. As per Companies Act 1956, the
profit and loss account and the balance sheet of the company must show true and fair view of the
company. Therefore, companies are giving the foot notes regarding some items as investments,
contingent liabilities, etc., along with the balance sheet.
Matching of Cost and Revenue Principle
As per the going concern concept, the accurate profit/loss of the business can be determined at
the time of liquidation of the business or sale of the business. But it will generate a lot of
problems. Therefore, the economic life of the business is divided into different segments in
order to determine the profit/loss of the business. Generally a segment of the economic life of
the business becomes of a year. To compute the operational profits/loss of the business in a
year, it is necessary to find the expenses and revenues relating to the period. Then all the
revenues of that period are matched with all the expenses/costs incurred to earn that revenue.
This matching is called the principle of matching of cost and revenue. The results of this match
becomes as follows:
Profit = Revenue – Expenses
Herewith the matching means an appropriate association between the revenues of a period and
expenses/costs of that period. In other words the incomes/loss of the business can be determined
if the revenues (incomes) of a period are compared (matched) with the expenditure of that
period. For the recognition of the revenues/expenses the accurate system of accounting is adopted.
Therefore, a proper adjustment is also made in the accounts for the outstanding expenses, prepaid
expenses, accrued incomes and unaccrued incomes. At the time of reorganization of the revenue/
expenses, the following points are kept in mind:
1. The expenses which are being spent to earn revenue must be of the same period for which
profit is being computed.
2. Revenues/expenses of a period must be computed on the basis of accrual accounting
system.
3. If some revenues are received in advance, they must be treated as the income of that
period in which goods are supplied/services are rendered.
Objectivity Principle
It is also known as objective evidence concept. As per this principle the transactions which are
recorded in accounting must be on the objective and factual basis. There should be a voucher or
documentary evidence behind each entry in the accounting. The entry must be free from personal
bias and based on the rational approach. If the entries are made without evidence, it will lose the
confidence of the several users of the financial statements about their reliability. For the auditing
of the financial statements, there is also a need of objective evidence.

2.2.3 The Modifying Accounting Principles (Conventions) Notes
Basic accounting assumptions and principles provide us the various rules to prepare the financial
statements. If these financial statements are relevant and reliable, they will give much useful
information to the various users of the financial statements. In order to prepare the true and fair
financial statements, there is a need to modify the accounting assumptions and principles. These
modified accounting principles are as follows:
1. Conservation (Prudence): As per the law of conservatism, at the time of preparing the
financial statements, all the possible losses must be kept in mind and all anticipated
profits/gains should be left out. In other words the accounts must follow the policy of
playing safe. Likewise stock-in-trade is valued at ‘market price or cost whichever is least’,
provision for bad and doubtful debt, provision for depreciation on fixed assets, etc., are
maintained. This principle is being criticized nowadays on the ground that it goes against
the principle of disclosure. The accountants create a secrete reserve through the provision
of bad and doubtful debts, depreciation and the valuation of stock. The financial statements
loose their true and fair view. Profit and loss account depicts the lower income and the
balance sheet understates the assets and the liabilities of the business.
Today the law of conservatism has been replaced by prudence. It means that conservatism
is adopted only in the inevitable uncertainties and doubts. The accountants should also
give the reasons for adopting a particular accounting techniques, method and policies
without undue conservatism.
2. Consistency: In order to enable the management to do the comparison of the results of the
several years of the business, whatever accounting policy is adopted in a year, must be
adopted in the coming years. There should be uniformity in accounting process, rules &
methods. As a result biasness of accountant is removed.
According to Kohlar there are three forms of consistency:
(a) Vertical Consistency is used in the different financial statements of the business on
the same date. For instance, depreciation on fixed assets is used in the income
statement and the balance sheet on the same date.
(b) Horizontal Consistency enables the comparison of the profit or performance of a
business in a year with the performance of another year for example the depreciation
methods.
(c) Third Dimensional Consistency refers to the same principles or practices of
accounting adopted by the different firms in an industry.
3. Timeliness: Accounting information given in the financial statements must be reliable and
relevant. In order to be relevant, this information must be supplied in time. If late and
obsolete information is provided, it will hamper the management and the users of the
financial statements to take appropriate, timely and rational decision.
4. Materiality: Herewith, the materiality means that only that information should be
disclosed and attached with financial statements which influence the decisions of
shareholders, investors and creditors, etc. and the other insignificant details must be
ignored. Moreover, an item of information may be material for one purpose while that
may be immaterial for other. This is a subjective matter. For example, the cost of the
component may be very much significant for small businessman while it may be
insignificant for a large businessman. In one more example, the Companies Act permits to
ignore the paise at the time of preparation of financial statements while for the income tax
purpose the income is rounded off to the nearest ten.

Notes 5. Cost-Benefit Principle: As per this principle the cost of using an accounting principle
should not exceed its benefits. It does not mean that to curtail the costs, no information or
a little information should be given to the users of the financial statements.
6. Industry Practice: Different accounting principle/practice is adopted in the different
industries. At the time of preparing the financial reports and presenting the accounting
information the prevailing accounting practices in a particular industry should be kept in
mind. For example, disclosing of investments and stock at the cost or market price
whichever is lower. Thus we see that the prevailing accounting practices in an industry
play an important role in adopting the accounting practices.

Caselet Rule versus Principle
S
tudents of accounting would be well aware of the long discussed differences between
rule-based accounting and principle-based accounting. Both have their protagonists.
While the US GAAP is rule-based, the International Accounting Standards (IAS),
both as IAS and IFRS, are principle-based.
The debate on which is better will be put to rest when the US GAAP converges with IFRS
eventually and becomes principle-based. Being principle-based means that broad principles
are laid out by the standard-fixing body and the interpretation is left to the users of these
standards.
The problem (and also the benefit) with principle-based accounting is that most of the
times, in a situation which requires a finding, one would have to exercise a great deal of
judgment based on substance as opposed to a readymade solution being available for a
particular issue prescribed in the rule-based accounting.
While the US accounting is considered to be rule-based, one can find echoes of principle-
based accounting also in it. In the widely publicised 1969 case of Continental Vending
where the auditors were questioned for lack of professional standards, the court gave a
direction to the jury to look at the facts and the substance of the case rather than rules of
accountancy and mere adherence to GAAP.
The court held that in the audit report the statement “fairly presented … in accordance
with generally accepted accounting principles” is two statements rather than one, i.e.,
“fairly presented” is principle-based and the other “in accordance with generally accepted
accounting principles” is rule-based.
Problems for Auditors
The preparation of financial statements in accordance with the GAAP in a rule-based
environment, however, presents problems to the auditors. If an auditor were to confront
the management over a certain treatment of a transaction, the management is likely to ask
the auditor “show me where it says I can’t do that”.
In other words, in a rule-based environment, the onus is on the auditor to demonstrate
clearly that the particular treatment is not permitted and hence closes the avenues for the
auditor to develop further arguments that would be available in a principle-based
accounting environment (Principles-based Accounting, by Ronald M. Mano, Matthew
Mouritsen and Ryan Pace, published in the CPA Journal, February 2006).
Since accounting standards followed in India have their origin in the IAS, the Indian
accounting standards are principle-based. However, there are exceptions to the rule. One
Contd...

prime example is the Income Recognition and Asset Classification (IRAC) norms prescribed Notes
by the Reserve Bank of India for provisioning for non-performing assets applicable to
banks.
Thus, if any asset is non-performing, based on certain prescribed criteria, a provision is
created for the potential loan loss irrespective of the security available with the bank.
Subjectivity Issue
Principle-based accounting has its own issues too. Ian Wright, Director of Corporate
Reporting at the Financial Reporting Council of UK, writing in accountancy magazine
(October 2008), talks about the subjectivity that is present in the IFRS.
The IFRS is full of words and phrases that are open to interpretation. The accompanying
table has a selection of the probabilities in IFRS literature that a user is expected to interpret
in the context of understanding what an accounting standard requires.
Ian Wright also identifies other issues that are potentially problematic.
The IFRS literature contains an increasing range of technical terms which don’t translate
well into languages other than English. Also, the standards were written in different eras
and sometimes by individual national standard-setters due to which the usage of the
English language differs resulting in them being structured in disparate ways.
One can therefore see the potential hazards in interpreting a principle-based accounting
standard that contains highly subjective phraseology.
In this context, one can expect problems of interpretation in India also. For instance, the
word “shall” (a key word in accounting standards) is used in a manner that is completely
different from its usage in countries where English is the mother tongue. Any user of IFRS
would therefore need to be alive to these issues when interpreting IFRS.
Hint: The preparation of financial statements in accordance with the GAAP in a rule-based
environment.
Source: www.thehindubusinessline.com
Self Assessment
Fill in the blanks:

3. …………………… enables the comparison of the profit or performance of a business in a
year with the performance of another year.
4. The revenues are recognized only at the moment of …………………….
5. Book Value = Gross (Original) value of the asset …………………….
6. The …………………… are the persons who owe to an enterprise an amount for receiving
goods or services on credit.
7. …………………… is a liability which arises only on the happening of an uncertain event.
8. …………………… = total assets – total liabilities
2.3 Capital and Revenue Items
A businessman is interested to know the net result of his business operations after a certain
period. But neither the trial balance nor the books of accounts reveal the net results of the
business. For this, the financial statements are prepared. But before you learn how to prepare
these statements, it is all the more necessary to know about the nature of expenditure and
receipts i.e. capital and revenue. This will help in recording correctly the items in these statements.

Notes 2.3.1 Capital and Revenue Expenditures
In business, there are thousands of items of expenditure. The following are some of these
expenditures which are generally incurred in all types of business:
1. Purchase of goods
2. Purchase of fixed assets such as Building, Furniture, Machine, etc.

3. ‘Carriage inwards’
4. Octroi
5. Purchase of Raw Material
6. Import duty
7. Coal, gas, water, oil, grease, fuel, heating and lighting
8. Wages paid to workers for installation of machinery

9. Salaries
10. Rent, rates and taxes
11. Stationery and printing
12. Postage and Telegrams
13. Entertainment
14. Repairs and renewals
15. Depreciation on fixed assets
16. Office expenses
17. Bank charges
18. General expenses

19. Travelling expenses
20. Overhauling of second hand machinery purchased
21. Major repairs affected for reconditioning a machinery/the old assets

22. Increasing the seating capacity of a cinema hall
23. Constructing an additional room
24. Carriage for bringing a fixed asset to place of business
25. Shifting business to convenient premises

26. Advertisement on introducing a new product in market
27. Replacement of hand driven machine by automatic machine

28. Research and development
On the basis of items of expenditure, the expenditure can be classified into three categories:
1. Capital Expenditure,
2. Revenue Expenditure, and
3. Deferred Revenue Expenditure.

Capital Expenditure Notes
The expenditure incurred for acquiring a fixed asset or which results in increasing the earning
capacity of the business is known as Capital Expenditure.
The benefits of capital expenditures are generally availed in several accounting years. Following
are some of the examples of Capital Expenditure.
1. Expenditure incurred for the acquisition of a fixed asset
Example: Building, furniture, machinery, etc.

2. Expenditure incurred for the inward carriage or erection of a fixed asset
Example:
(a) Carriage paid in connection with the purchase of fixed asset;
(b) Wages paid to laborers’ in connection with the installation of machinery.
These expenses form part of the cost of the fixed asset.
3. Expenditure incurred for extension or improvement of an existing fixed asset
Example: Money spent in connection with increasing the seating capacity of a cinema
hall or constructing an additional room.
4. Expenditure incurred for the major repairs of an old asset
Example: Repairs for reconditioning machinery.

5. Expenditure incurred for the replacement of an old asset with a new asset.
Example: Replacing a hand-driven machine by automatic machine.
Revenue Expenditure
An expenditure incurred in the course of regular business a transaction of a concern is availed

during the same accounting year is known as Revenue Expenditure. Following are some of the
examples, of Revenue Expenditure.
1. Expenditure incurred on the purchase of raw materials.
2. Expenditure incurred in the day-do-day running of business.
Example: Wages, salaries, rent, rates and taxes, office expenses, interest, discount, etc.
3. Expenditure incurred for the upkeep of an asset
Example: Repairs, maintenance charges, etc.

4. Expenditure incurred for the purchase of goods meant for sale.
Example: Purchases, carriage inwards, import duty, octroi, etc.

5. Depreciation of fixed assets.

Notes The above examples are not exhaustive and are not universally accepted. Whether expenditure
is capital expenditure or revenue expenditure depends upon its purpose and nature of the
business.
Example:
1. Amount spent on the purchase of furniture is a capital expenditure but it is revenue
expenditure for a business dealing in furniture.
2. Amount spent on Plant and Machinery is a capital expenditure but it is revenue
expenditure for a business dealing in engineering goods.
3. Amount spent on wages or carriage are revenue expenditure, but when wages are
paid for the installation of a new machinery or carriage paid to bring the machine to
the place of business, they are capital expenditure as they increase the value of fixed
asset i.e. machinery here.
Deferred Revenue Expenditure
There are certain revenue expenditures that are incurred during one accounting year but are
applicable wholly or in part in future periods such as heavy expenditure on advertisement for
introducing a new product in the market or for exploring new markets for the product. These
expenditures appear to be revenue expenditure. But it is not so because the benefit from this is
likely to the enjoyed over a number of years. Such expenditure whose benefit is enjoyed not in
one year but over a number of years is known as deferred revenue expenditure. It is a fictitious
asset. At though it appears in balance sheet on asset side, it is really not an asset to business.
Example:
1. Heavy initial expenditure incurred on Advertisement for introducing a product in
the market.
2. Expenditure incurred in shifting business to more convenient premises.
3. Expenditure incurred on research and development
Task Choose the right kind of expenditure by putting a Tick Mark in correct
column:
Expenditure Capital Deferred

Revenue Revenue
1. Salaries
2. Legal Charges
3. Wages for installing a machinery
4. Depreciation
5. Repairs of furniture purchased second hand
6. Advertisement for introducing a new product
7. Carriage paid on goods purchased
8. Research & Development expenditure
9. Expenditure on dismantling and reinstallation of Plant
10. Office expenses
11. Expenditure on the construction of an additional room
12. Maintenance charges of building

Following are the main points of difference between capital and revenue expenditures. Notes
Table 2.1: Distinction between Capital and Revenue Expenditure
Basis of Difference Capital Expenditure Revenue Expenditure

Purpose It is incurred for the It is incurred for the maintenance
purchase of fixed assets. of fixed assets.
Earning capacity It increases the earning It does not increase the earning
capacity of the business. capacity of the business.
Periodicity of benefit Its benefits are spread over a Its benefit is only for one
number of years. accounting year.
Placement in financial It is an item of Balance Sheet It is an item of Trading and Profit
statements and is shown as an asset. and Loss Account and is shown on
the debit side of either of the two.
Occurrence It is non-recurring It is usually a recurring
expenditure in nature. expenditure.
2.3.2 Capital and Revenue Receipts
Just as expenditures are classified into Capital or Revenue Expenditure, in the same way receipts
are classified into:
1. Capital Receipts, and
2. Revenue Receipts.
1. Capital Receipts: The receipts which do not arise out of normal course of business are
known as Capital Receipts. These do not effect profit/loss of business. They either increase
liability or reduces the asset.
Example:
1. Receipts from sale of fixed assets.
2. Additional capital introduced by the Proprietor.
3. Loans raised.
2. Revenue Receipts: The receipts which arise out of normal course of a business are known
as Revenue Receipts. These are shown on credit side of P/L account.
Example:
1. Income from sale of goods.
2. Rent received form letting out the business property.
3. Dividend received from shares.
4. Interest received from investment.

Fill in the blanks:

9. The expenditure incurred for acquiring a fixed asset or which results in increasing the
earning capacity of the business is known as …………………….
10. An expenditure incurred in the course of regular business a transaction of a concern is

availed during the same accounting year is known as …………………….
11. The receipts which do not arise out of normal course of business are known as
…………………….
12. The receipts which arise out of normal course of a business are known as ……..………….
2.4 Summary
 Accounting is the process of recording, classifying, summarizing in a significant manner

of transactions which are in financial character and finally results are interpreted.
 The revenues are recognized only at the moment of realization but the expenses are
recognized at the moment of payment.
 The charges which were paid only are taken into consideration but the outstanding, not
yet paid is not considered.
 The revenues are recognized only at the time of occurrence and expenses are recognized
only at the moment of incurring.
 The financial statements are found to be more useful to many people immediately after
presentation only in order to study the financial status of the enterprise in the angle of
their own objectives.
 The entire accounting system is governed by the practice of accountancy.
 The accountancy is being practiced through the universal principles which are wholly led
by the concepts and conventions.
 Money measurement concept tunes the system of accounting as fruitful in recording the
transactions and events of the enterprise only in terms of money.
 Business entity concept treats the owner as totally a different entity from the business.
 Going concern concept deals with the quality of long lasting status of the business enterprise
irrespective of the owners’ status, whether he is alive or not.
 Matching concept only makes the entire accounting system as meaningful to determine
the volume of earnings or losses of the firm at every level of transaction.
 Duality or Double entry accounting concept is the only concept which portrays the two
sides of a single transaction.
2.5 Keywords
Accrual System: The revenues are recognized only at the time of occurrence and expenses are
recognized only at the moment of incurring.
Assets: The economic resources of an entity. They include such items as cash, accounts receivable
(amounts owed to a firm by its customers), inventories, land, buildings, equipment, and even

intangible assets like patents and other legal rights and claims. Assets are presumed to entail Notes
probable future economic benefits to the owner.
Book Value: It is the value of the asset maintained in the books of the account. The book value of
the asset could be computed as follows:
Book Value = Gross (Original) value of the asset – Accumulated depreciation
Liabilities: Amounts owed to others relating to loans, extensions of credit, and other obligations
arising in the course of business.
1. Accounting is the process of recording, classifying and summarizing of accounting

transactions. Explain.
2. The entire accounting system is governed by the practice of accountancy. What are the key
principles used in accounting?
3. What are the key assumptions of going concern concept?
4. Every debit transaction is appropriately equated with the transaction of credit. Define.
5. Classify the various kinds of values in accounting process.
6. Distinguish between material and immaterial transactions of business.
7. Singania Chartered Accountants Firm established in the year 1956, having very good
number of corporate clients. It continuously maintains the quality in audit administration
with the clients since its early inception. The firm is eagerly looking for promising students
who are having greater aspirations to become auditors. The firm is having an objective to
recruit freshers to conduct preliminary auditing process with their corporate clients.
For which the firm would like to select the right person who is having conceptual
knowledge as well as application on the subjects. It has given the following Balance sheet
to the participants to study the conceptual applications. The participants are required to
enlist the various concepts and conventions of accounting.
(a) List out the various accounting concepts dealt in the above balance sheet.
(b) Explain the treatment of accounting concepts.
8. Why does the accounting equation remain in balance?
9. Liability is defined as currently existing obligations which a business enterprise requires
to meet sometime in future. Explain.
10. What are the key accounting conventions?
1. Money or money’s worth 2. Dual effect

3. Horizontal Consistency 4. Realization
5. Accumulated depreciation 6. Debtors
7. Contingent liability 8. Capital
9. Capital Expenditure 10. Revenue Expenditure
11. Capital Receipts 12. Revenue Receipts

Notes 2.7 Further Readings
Books Khan and Jain, “Management Accounting”.

M.P. Pandikumar, “Accounting & Finance for Managers”, Excel Books, New Delhi.
R.L. Gupta and Radhaswamy, “Advanced Accountancy”.
S.N. Maheswari, “Management Accounting”.

V.K. Goyal, “Financial Accounting”, Excel Books, New Delhi.
Online link www.futureaccountant.com

Unit 3: Accounting Standards
Unit 3: Accounting Standards Notes
CONTENTS
Objectives
Introduction
3.1 Accounting Standards
3.1.1 Meaning of Accounting Standards
3.1.2 Need and Formulation of Accounting Standards
3.1.3 Nature
3.2 Accounting Standards in India
3.3 Summary
3.4 Keywords
Objectives

 Define the meaning and need of accounting standards
 Describe the Accounting policies
 Know the Accounting standards-1
Introduction
For the interest of customers, investors, owners, it is necessary that financial statement of a
company should be transparent, properly disclosed, consistent and reliable. For this purpose
accounting standards are framed by ICAI in India.
3.1 Accounting Standards
There are many users of financial statements as investors, creditors, government, consumers,
owners, etc. They take many economic decisions on the basis of financial statements. If the
financial statements are not properly regulated, there is possibility that the financial statements
may mislead and provide the distorted picture of the business in the place of true and fair picture
of the business. Proper regulation of the process of accounting it is essential so that these
statements should be transparent, properly disclosed, consistent and reliable. Adequate disclosure
in the accounts is also required. For this purpose, accounting standards are prepared at the
national and international level. Actually the generally accepted accounting principles are
codified by the accounting standards. Accounting standards prepares the norms and guidelines
to prepare the financial statements and annual reports. At the international level the International
Accounting Standard Committee (IASC) has issued the International Standards. In this committee,
there are leading professional bodies of UK, USA, Australia, France and Canada. India is also a
member of this committee. India has also prepared its own accounting standards, which are
prepared by the Institute of Chartered Accountant of India (ICAI).

Notes 3.1.1 Meaning of Accounting Standards
It is a set of Certain generally accepted rules, principles, concepts and conventions issued by the
Institute of chartered Accountants of India in consultation with other International Accounting
bodies. The purpose of making uniform rules and principles is to make the preparation and
presentation of financial statement easy, relevant, reliable, understandable and finally
comparable. In other words, Accounting standards are the basis of accounting policies and
practices to facilitate the recording of transactions and events in such a way which can change
them into financial statements, to be used by the persons interested in getting the correct and
reliable information with a view to take future decisions.
The basic objective of Accounting Standards is to remove variations in the treatment of several
accounting aspects and to bring about standardization in presentation. They intent to harmonize
the diverse accounting policies followed in the preparation and presentation of financial statements
by different reporting enterprises so as to facilitate intra-firm and inter-firm comparison.
3.1.2 Need and Formulation of Accounting Standards
The adoption and appreciation of accounting standards ensures uniformity, comparability and
qualitative improvement in preparation and presentation of financial statements. So, that they
may give true and fair picture. What is the need of adoption of accounting standards in the
accounting process? How do the accounting standards help in improving the quality of the
financial Statement? The answer of these questions may be explained by an example, suppose a
company adopts LIFO method for the valuation of its closing stock and another company adopts
FIFO method for the valuation of its closing stock, valuation of the closing stock of both the
companies will differ. As a result the profit or loss of both companies will also differ. In order to
avoid such situation, AS-2 is made.
Take another example of depreciation, if a company adopts diminishing balancing method for
the depreciation and another company adopts the fixed installment method for depreciation,
the amount of depreciation of both the companies will differ. As a result profit/loss will also differ
and the comparison of these companies will not be possible. For the purpose AS-6 is prepared by
ICAI in India. Similarly, AS-1 gives guidelines for the disclosure of accounting policies, so that the
users of financial statements may perceive the reported profits in its correct perspective.
Did u know? In India, the Accounting Standards are formulated by the Accounting Standard
Board (ASB).
ASB determines the broad area requiring for formulation of AS. At the time of preparation of
Accounting Standards, ASB gets help from different groups for this purpose a study group is
made. In this group the members of ICAI participates. Then a wide discussion is held. In this
discussion, the representatives of Government, Public Sector Units, and other organizations
participate. After the discussion an Exposure Draft (ED) for AS is proposed and issued by ICAI.
Then it is dispatched to different outside bodies as ICWAI, ICSI, CBDT, SCOPE, etc. This ED
comprises the following points:
1. A Statement of concepts and fundamental accounting principles relating to the standard.
2. Definitions of the terms used in the standard.
3. The manner in which the accounting principles have been applied for the formulation of
the standard.
4. The presentation and disclosure requirements in complying with the standard.

5. Class of enterprises to which the standard will apply. Notes
6. Date from which the standard will be effective.
After the publication of ED, the comments and views are collected from the different corners. Then
ASB finalizes the proposed standard and submit it to the council of the Institute of chartered
accountant of India for the approval. The council considers the ED and, if found necessary, modifies
with the consolation of the Accounting Standard Board. Then final shape of the standard is issued
under the authority of the council. In the beginning, this is recommendatory and after some period
it becomes mandatory. The board has issued the following standards for adoption worldwide. A
number of provisional standards relating to other aspects of accounting are an anvil.
3.1.3 Nature
The Institute of chartered Accountants of India had set up Accounting Standards Board on 22nd
April, 1977 to formulate accounting standards on a number of accounting issues, taking into
account the accounting standards developed by the International Accounting Standard
Committee, prevailing laws in India, business customs usages and conventions etc. The
Accounting Standards made were not mandatory in the beginning but after the amendment in
the Sec 211(3C) of Companies Act, 1956 Accounting Standards out of 28 have been made
mandatory. The Auditor is required to give in his report to the shareholders that accounts are
prepared (drawn) in accordance with the provisions relating to Accounting Standards in India.
The Purpose of this exercise is to make the financial statements more reliable, comparable,
consistent and transparent. These standards are made taking into account the laws of the country,
business custom, environments etc. If there is a change in any law of the country or change in
business custom or environment, the accounting standards are also changed/altered. This
flexibility of Accounting Standards is a special feature which makes them more popular and
friendly with the users.
If any enterprise wants to change/modify any business custom/practice the same must be
properly disclosed along with its effects. For example—change of depreciation method, must be
disclosed along with its effect on profit or loss.
The Institute of Chartered Accountants of India has issued the following accounting standards:
AS 1. Disclosure of Accounting policies.

AS 2. Valuation of Inventories.
AS 3. Cash Flow Statement.
AS 4. Contingencies and Events occurring after the Balance Sheet Date.
AS 5. Net Profit or loss for the period, prior items and changes in accounting policies.
AS 6. Depreciation Accounting.
AS 7. Accounting for Construction Contracts.

AS 8. Accounting for research and development.
AS 9. Revenue Recognition.
AS 10. Accounting for fixed Assets.

AS 11. Accounting for the effects of changes in foreign Exchange rates.
AS 12. Accounting for Government grants.
AS 13. Accounting for Investments.

Notes AS 14. Accounting for Amalgamations.

AS 15. Accounting for Retirement benefits in the financial statements of employers.
AS 16. Borrowing Costs.
AS 17. Segment Reporting.
AS 18. Related Party Disclosures.
AS 19. Leases.
AS 20. Earnings Per share.
AS 21. Consolidated financial statements.
AS 22. Accounting for Taxes on Income.
AS 23. Accounting for Investments in Associates in Consolidated Financial Statements.
AS 24. Discontinuing operations.
AS 25. Interim Financial Reporting.
AS 26. Intangible Assets.
AS 27. Financial Reporting of Interests in Joint Ventures.
AS 28. Impairment of Assets.
AS 29. Contingent Liabilities and Contingent Assets.
AS 30. Financial Instruments: Recognition and Measurement
AS 31. Financial Instruments: Presentation
AS 32. Financial Instruments: Disclosures and limited revision to AS-19
According to Government of India, there are 31 accounting standards. But 32 are also included in
31st accounting standard (Financial Instrument: Presentation). So we can say that there are 32
accounting standards.
Notes AS-3, AS-6 and AS-24 are desirable but the rest are mandatory.
Self Assessment
Fill in the blanks:

1. The basic objective of …………………… is to remove variations in the treatment of several
accounting aspects and to bring about standardization in presentation.
2. The …………………… are codified by the accounting standards.
3.2 Accounting Standards in India
Statements of Accounting Standards (AS 1) Disclosure of Accounting Policies
The following is the text of the Accounting Standard (AS) 1 issued by the Accounting Standards
Board, the Institute of Chartered Accountants of India on ‘Disclosure of Accounting Policies’.
The Standard deals with the disclosure of significant accounting policies followed in preparing
and presenting financial statements.

In the initial years, this accounting standard will be recommendatory in character. During this Notes
period, this standard is recommended for use by companies listed on a recognised stock exchange
and other large commercial, industrial and business enterprises in the public and private sectors.
Introduction
1. This statement deals with the disclosure of significant accounting policies followed in
preparing and presenting financial statements.
2. The view presented in the financial statements of an enterprise of its state of affairs and of
the profit or loss can be significantly affected by the accounting policies followed in the
preparation and presentation of the financial statements. The accounting policies followed
vary from enterprise to enterprise. Disclosure of significant accounting policies followed
is necessary if the view presented is to be properly appreciated.
3. The disclosure of some of the accounting policies followed in the preparation and
presentation of the financial statements is required by law in some cases.
4. The Institute of Chartered Accountants of India has, in Statements issued by it,
recommended the disclosure of certain accounting policies, e.g., translation policies in
respect of foreign currency items.
5. In recent years, a few enterprises in India have adopted the practice of including in their
annual reports to shareholders a separate statement of accounting policies followed in
preparing and presenting the financial statements.
6. In general, however, accounting policies are not at present regularly and fully disclosed in
all financial statements. Many enterprises include in the Notes on the Accounts, descriptions
of some of the significant accounting policies. But the nature and degree of disclosure vary
considerably between the corporate and the non-corporate sectors and between units in
the same sector.
7. Even among the few enterprises that presently include in their annual reports a separate
statement of accounting policies, considerable variation exists. The statement of accounting
policies forms part of accounts in some cases while in others it is given as supplementary
information.
8. The purpose of this Statement is to promote better understanding of financial statements
by establishing through an accounting standard the disclosure of significant accounting
policies and the manner in which accounting policies are disclosed in the financial
statements. Such disclosure would also facilitate a more meaningful comparison between
financial statements of different enterprises.
Explanation
Fundamental Accounting Assumptions
9. Certain fundamental accounting assumptions underlie the preparation and presentation

of financial statements. They are usually not specifically stated because their acceptance
and use are assumed. Disclosure is necessary if they are not followed.
10. The following have been generally accepted as fundamental accounting assumptions:
(a) Going Concern: The enterprise is normally viewed as a going concern, that is, as
continuing in operation for the foreseeable future. It is assumed that the enterprise
has neither the intention nor the necessity of liquidation or of curtailing materially
the scale of the operations.

Notes (b) Consistency: It is assumed that accounting policies are consistent from one period to
another.
(c) Accrual: Revenues and costs are accrued, that is, recognised as they are earned or
incurred (and not as money is received or paid) and recorded in the financial
statements of the periods to which they relate. (The considerations affecting the
process of matching costs with revenues under the accrual assumption are not dealt
with in this Statement.)
Task Find out the legal status of accounting standards in India.
Nature of Accounting Policies
11. The accounting policies refer to the specific accounting principles and the methods of
applying those principles adopted by the enterprise in the preparation and presentation
of financial statements.
12. There is no single list of accounting policies which are applicable to all circumstances. The
differing circumstances in which enterprises operate in a situation of diverse and complex
economic activity make alternative accounting principles and methods of applying those
principles acceptable. The choice of the appropriate accounting principles and the methods
of applying those principles in the specific circumstances of each enterprise calls for
considerable judgment by the management of the enterprise.
13. The various statements of the Institute of Chartered Accountants of India combined with
the efforts of government and other regulatory agencies and progressive managements
have reduced in recent years the number of acceptable alternatives particularly in the case
of corporate enterprises. While continuing efforts in this regard in future are likely to
reduce the number still further, the availability of alternative accounting principles and
methods of applying those principles is not likely to be eliminated altogether in view of
the differing circumstances faced by the enterprises.
Areas in which Differing Accounting Policies are Encountered
14. The following are examples of the areas in which different accounting policies may be
adopted by different enterprises.
(a) Methods of depreciation, depletion and amortisation
(b) Treatment of expenditure during construction
(c) Conversion or translation of foreign currency items
(d) Valuation of inventories
(e) Treatment of goodwill
(f) Valuation of investments
(g) Treatment of retirement benefits
(h) Recognition of profit on long-term contracts
(i) Valuation of fixed assets
(j) Treatment of contingent liabilities
15. The above list of examples is not intended to be exhaustive.

Considerations in the Selection of Accounting Policies Notes
16. The primary consideration in the selection of accounting policies by an enterprise is that
the financial statements prepared and presented on the basis of such accounting policies
should represent a true and fair view of the state of affairs of the enterprise as at the
balance sheet date and the profit or loss for the period ended on that date.
17. For this purpose, the major considerations governing the selection and application of
accounting policies are:
(a) Prudence: In view of the uncertainty attached to future events, profits are not
anticipated but recognised only when realised though not necessarily in cash.
Provision is made for all known liabilities and losses even though the amount
cannot be determined with certainty and represents only a best estimate in the light
of available information.
(b) Substance over Form: The accounting treatment and presentation in financial
statements of transactions and events should be governed by their substance and
not merely by the legal form.
(c) Materiality: Financial statements should disclose all “material” items, i.e. items the
knowledge of which might influence the decisions of the user of the financial statements.
Disclosure of Accounting Policies
18. To ensure proper understanding of financial statements, it is necessary that all significant
accounting policies adopted in the preparation and presentation of financial statements
should be disclosed.
19. Such disclosure should form part of the financial statements.
20. It would be helpful to the reader of financial statements if they are all disclosed as such in
one place instead of being scattered over several statements, schedules and notes.
21. Examples of matters in respect of which disclosure of accounting policies adopted will be
required are contained in paragraph 14. This list of examples is not, however, intended to
be exhaustive.
22. Any change in an accounting policy which has a material effect should be disclosed. The
amount by which any item in the financial statements is affected by such change should
also be disclosed to the extent ascertainable. Where such amount is not ascertainable,
wholly or in part, the fact should be indicated. If a change is made in the accounting
policies which has no material effect on the financial statements for the current period but
which is reasonably expected to have a material effect in later periods, the fact of such
change should be appropriately disclosed in the period in which the change is adopted.
23. Disclosure of accounting policies or of changes therein cannot remedy a wrong or
inappropriate treatment of the item in the accounts.
Accounting Standard
(The Accounting Standard comprises paragraphs 24-27 of this Statement. The Standard should be
read in the context of paragraphs 1-23 of this Statement and of the ‘Preface to the Statements of
Accounting Standards.)
24. All significant accounting policies adopted in the preparation and presentation of financial
statements should be disclosed.

Notes 25. The disclosure of the significant accounting policies as such should form part of the financial
statements and the significant accounting policies should normally be disclosed in one
place.
26. Any change in the accounting policies which has a material effect in the current period or
which is reasonably expected to have a material effect in later periods should be disclosed.
In the case of a change in accounting policies which has a material effect in the current
period, the amount by which any item in the financial statements is affected by such
change should also be disclosed to the extent ascertainable. Where such amount is not
ascertainable, wholly or in part, the fact should be indicated.
27. If the fundamental accounting assumptions, viz. Going Concern, Consistency and Accrual
are followed in financial statements, specific disclosure is not required. If a fundamental
accounting assumption is not followed, the fact should be disclosed.
Self Assessment
Fill in the blanks:

3. Statements of Accounting Standards (AS 1) Disclosure of Accounting Policies deals with
the disclosure of significant accounting policies followed in preparing and presenting
…………………….
4. …………………… is made for all known liabilities and losses even though the amount
cannot be determined with certainty and represents only a best estimate in the light of
available information.
3.3 Summary
 Accounting Standards is a set of certain generally accepted rules, principles, concepts and
conventions issued by the Institute of chartered Accountants of India in consultation with
other International Accounting bodies.
 The basic objective of Accounting Standards is to remove variations in the treatment of

several accounting aspects and to bring about standardization in presentation.
 The accounting policies refer to the specific accounting principles and the methods of
applying those principles adopted by the enterprise in the preparation and presentation
of financial statements.
3.4 Keywords
Accounting Policies: The accounting policies refer to the specific accounting principles and the
methods of applying those principles adopted by the enterprise in the preparation and
presentation of financial statements.
Accounting Standards: It is a set of certain generally accepted rules, principles, concepts and
conventions issued by the Institute of chartered Accountants of India in consultation with other
International Accounting bodies.
Going Concern: The enterprise is normally viewed as a going concern, that is, as continuing in
operation for the foreseeable future.
Materiality: Financial statements should disclose all “material” items, i.e. items the knowledge
of which might influence the decisions of the user of the financial statements.

3.5 Review Questions Notes
1. What do you understand by accounting standards? Explain and also what is the legal
status of Accounting Standards in India.
2. How many Accounting Standards are given by the Institute of Chartered Accountants of
India? And how many of them are made mandatory. Explain.
1. Accounting Standards
2. Generally Accepted Accounting Principles

3. Financial Statements
4. Provision


Notes Unit 4: Accounting Equation and Accounting Cycle
CONTENTS
Objectives
Introduction
4.1 Accounting Equation
4.1.1 Effect of Transactions on the Accounting Equation
4.2.1 Accounts
4.3 Summary
4.4 Keywords
Objectives
 Explain the concept of accounting equation
 Describe accounting cycle
Introduction
As discussed earlier accounting is the art of recording, classifying and summarizing the business
transactions of the financial nature. Under the recording process of accounting journal and
subsidiary books are maintained, under classification of transactions the ledger is maintained
while in the summarizing process trial balance and final accounts (P&L A/c and Balance Sheet)
are prepared.
4.1 Accounting Equation

The basic accounting equation is the foundation for the double-entry bookkeeping system. It
shows how assets were financed: either by borrowing money from someone (liability) or by
paying your own money (shareholders’ equity).
Assets = Liabilities + Capital (Shareholders or Owners equity)
The accounting equation is also the basis for the most basic of accounting reports, the aptly
named Balance Sheet. A balance sheet reports what a business owns (assets), what it owes
(liabilities) and what remains for the owners (equity) as of a certain date. This equation should
remain in balance at all times because of double-entry accounting or bookkeeping. This can be
further understood by the following illustrations.
An owner’s investment into the company will increase the company’s assets and will also
increase owner’s equity. When the company borrows money from its bank, the company’s
assets increase and the company’s liabilities increase. When the company repays the loan, the
company’s assets decrease and the company’s liabilities decrease. If the company pays cash for
a new delivery van, one asset (cash) will decrease and another asset (vehicles) will increase. If a
company provides a service to a client and immediately receives cash, the company’s assets
increase and the company’s owner’s equity will increase because it has earned revenue. If the

Unit 4: Accounting Equation and Accounting Cycle
company provides a service and allows the client to pay in 30 days, the company has increased Notes
its assets (Accounts Receivable) and has also increased its owner’s equity because it has earned
service revenue. If the company runs a radio advertisement and agrees to pay later, the company
will incur an expense that will reduce owner’s equity and has increased its liabilities.
Example: If a business has 1,000 of assets at a particular time those assets must be
matched by the total of the claims of creditors and owners. Here is one example of an infinite
number of acceptable balance sheets:
Fazal-ur-Rehman and Sons.

Balance Sheet
( )
Assets 1000
Liabilities 500
Equity 500
Total Liabilities and Equity 1000
Equity as Residual Claims
Equity is simply the difference between assets and liabilities. The owner has positive equity
only to the extent that assets exceed liabilities.
Example: If a business has 1,000 of assets and 600 of liabilities the 600 of liabilities are,
in effect, a claim on the assets. Equity is the difference between the assets and liabilities, or 400.
Equity = Assets – Liabilities
Equity is simply the difference between assets and liabilities. The owner has positive equity
only to the extent that assets exceed liabilities.
Example: If a business has 1,000 of assets and 500 of liabilities the 500 of liabilities
are, in effect, a claim on the assets. Equity is the difference between the assets and liabilities, or
500.
If a business ceases operations remaining assets first go to outside creditors. The claims of
owners can be realized only after outside creditors’ claims are satisfied. So equity represents the
owners’ residual claim on business assets.
Notes Rules for Accounting Equation

Following rules help in making the accounting equation:
(i) Assets: If there is increase in assets, this increase is debited in assets account. If there
is decrease in assets, this decrease credited in assets account.
(ii) Liabilities: When liabilities are increase, outsider’s equities are credited and when
liabilities are decreased, outsider’s equities are debited.
(iii) Capital: When capital is increased, it is credited and when capital is withdrawn, it is
debited.
(iv) Expenses: Owner’s equity is decreased by the amount of revenue expenses.
(v) Income or profits: Owner’s equity is increased by the amount of revenue income.

Notes 4.1.1 Effect of Transactions on the Accounting Equation
You have learnt that assets, liabilities and capital are the three basic elements of every business
transaction, and their relationship is expressed in the form of accounting equation which always
remains equal. At any point of time, there can be a change in the individual asset, liability or
capital, but the two side of the accounting equation always remain equal. Let us verify this fact
by taking up some transactions and see how these transactions affect the accounting equation:
Example:
1. Mr. Kamlesh started business with cash of 2,00,000.
In this transaction, one side cash is coming into business and in the other side capital
is being brought by Mr. Kamlesh. Thus:
2,00,000 = 2,00,000
2. In the next transaction, if a plant of 50,000 is purchased in cash, this transaction will
also leave two sides. In one side cash is going and in other side plant is coming. In
this situation, the accounting equation will be as follows:
Capital = Plant + Cash (Assets)
2,00,000 = 50,000 + (2,00,000 – 50,000)
3. If a loan of 1,50,000 is taken from the SBI, it will also affect the accounting equation
by two sides. On one side, cash will increase and on the other side, liabilities of the
business will increase. This may be depicted as follows:
Capital + Liability (Loan) = Plant + Cash
2,00,000 + 1,50,000 = 50,000 + (1,50,000 + 1,50,000)
3,50,000 = 3,50,000
4. If some goods of 20,000 are purchased on credit, it will also affect the accounting
equation in two ways. On one side it increases the goods and on the other side it
increases the liability (creditors). Now the changed form of the above accounting
equation will be as follows:
Capital + Loan + Creditors = Plant + Cash + Goods
2,00,000 + 1,50,000 + 20,000 = 50,000 + 3,00,000 + 20,000
3,70,000 = 3,70,000
Illustration 1: Consider X Ltd. having the following position of assets and liabilities as on 31st
March, 2011:
Assets ( in lakhs)
Land & Building 120
Plant & Machinery 235
Furniture & Fittings 35
Inventory 90
Debtors 40
Cash & Bank Balance 25
545

Liabilities Notes
Equity 345
Long-term loan 140
Short-term loan 25
Creditors 35
545
The following are some of the transactions entered into by X Ltd. during 2010-2011.
(a) Purchased a piece of land for 5 lakhs in cash.

(b) Collected 35 lakhs from debtors outstanding as on 31st March, 2011.
(c) Repaid an instalment of long-term loan 15 lakhs.

(d) Paid 20 lakhs to creditors
Show the effect of the above transactions upon the accounting equation.
Solution: The accounting equation (A = L + C) as on 31st March, 2011 stands as below:
A=L+C
or 545 lakhs = 200 lakhs + 345 lakhs.
The above equation is affected by every transaction entered into during 2010-2011. We shall
show the effect of each transaction separately.
(a) Purchased a piece of land for Rs. 5 lakhs in cash:
Original position:
A( 545 lakhs) = L( 200 lakhs) + C( 345 lakhs)
Revised position:
A[ 545 lakhs + 5 lakhs (land) – 5 lakhs (cash)] = L( 200 lakhs) + C ( 345 lakhs)
or A( 545 lakhs) = L( 200 Lakhs) + C( 345 lakhs)
(b) Collected 35 lakhs from debtors outstanding as on 31st March, 1997:
A[ 545 lakhs + 35 lakhs (cash) – 35 lakhs (debtors)] = L( 200 lakhs) + C( 345 lakhs)
or A( 545 lakhs) = L( 200 lakhs) + C( 345 lakhs)
(c) Repaid an instalment of long-term loan 15 lakhs:

A[ 545 lakhs – 15 lakhs (cash)] = L[ 200 lakhs – 15 lakhs (long-term loan)] +
C ( 345 lakhs)
(d) Paid 20 lakhs to creditors:

A[ 530 lakhs – 20 lakhs (cash)] = L( 185 lakhs – 20 lakhs (creditors)] + C( 345 lakhs)

Notes Illustration 2: ABC Ltd. is a company incorporated to carry on the business of selling soft
drinks. ABC Ltd.'s transactions for the month of January were as follows:
Jan. 1 Issued equity shares of 20,00,000 (cash received in full).
Jan. 5 Purchased land for 5,75,000.
Jan. 8 Purchased a building for 4,40,000, paying 1,40,000 in cash and the balance payable in
three monthly installments.
Jan. 15 Purchased machinery worth 2,20,000.
Jan. 20 Purchased syrup (raw material) for making soft drinks worth 5,75,000, paying 1,75,000
in cash and accepting a bill drawn by the supplier for the balance.
Jan. 25 Purchased further machinery worth 50,000.
Jan. 31 Sold cold drinks worth 50,000 (consuming 30,000 of syrup).
Show the effects of the above transactions upon the accounting equation.
Solution:
(Figures are in )
Assets Liabilities + Capital
Cash Inventory Land Building Machinery Creditors Bills
Payable
Jan. 1 (+)20,00,000 = _______ +
20,00,000
Jan. 5 (–)5,75,000 +5,75,000
Balance 14,25,000 5,75,000
Jan. 8 (–) 1,40,000 _________ + 4,40,000 = +3,00,000
Balance 12,85,000 5,75,000 4,40,000 = 3,00,000 20,000,00
Jan. 15 (–) 2,20,000 _______ +2,20,000 = _______
Balance 10,65,000 5,75,000 4,40,000 2,20,000 = 3,00,000 20,00,000
Jan. 20 (–)1,75,000 +5,75,000 + 4,00,000
Balance 8,90,000 5,75,000 5,75,000 4,40,000 2,20,000 = 3,00,000 4,00,000 20,00,000
Jan. 25 (–) 50,000 _________ _________ _________ +50,000 _________ _________
Balance 8,40,000 5,75,000 5,75,000 4,40,000 2,70,000 = 3,00,000 4,00,000 20,00,000
Jan. 31 + 50,000 (–) 30,000 _________ + 20,000
(50,000–
30,000)
Balance 8,90,000 5,45,000 5,75,000 4,40,000 2,70,000 =3,00,000 4,00,000 20,20,000
Self Assessment
Fill in the blanks:

1. The basic accounting equation is the foundation for the …………………… system.
2. A …………………… reports what a business owns (assets), what it owes (liabilities) and
what remains for the owners (equity) as of a certain date.
3. An owner’s investment into the company will increase the company’s assets and will also
increase …………………….
4. Accounting Equation serves as a basis for preparing …………………….
5. Liabilities = …………………… – Capital

4.2 Accounting Cycle Notes
Accounting is described as origin for the creation of information and the continuous utility of
information. Now the question is how is this information created? For this, there is a step by
step process, as shown below accounting cycle. It is a complete sequence beginning with recording
of transaction and ends with preparation of final accounts. The major steps involved in the
accounting cycle are:
1. Analyse Transactions: The first step of a accounting cycle is to know what type of transaction
we are dealing with; we also need to verify that the information is correct and that
transactions have taken place only with proper authorization. Most accounting transactions
originate with what are called source documents, which are the invoices, orders, time
cards, checks, and other “paperwork” (or now, commonly digital files) which provide the
first indication that a transaction has taken place (or will be taking place in the future.)
2. Preparing Journals: The journal is the “book of original entry,” the place where the
transactions first become part of the official financial records of the organization. We
make journal entries which specify the accounts which are affected by a transaction, and
the amount of money involved.
3. Post to Ledger A/c: The ledger is the entire group of accounts maintained by an organization.
Posting refers to the transfer of the journal entries to the ledger. In a manual system,
posting was a separate process. In computerized systems, posting is typically accomplished
contemporaneously with recording the transaction in the journal.
4. Preparation of Trial Balance: A trial balance is nothing more than a summation of the
account balances to be sure that the books do, in fact, balance.
5. Post Closing Entries: Closing entries are the entries that we make to close the temporary
accounts (the expense and revenue accounts). In manual systems, each closing entry had to
be made individually. In computerized systems, a single command closes the books.
6. Preparation of Financial Statement: Last step includes the preparation of Trading and
Profit & Loss A/c and opening and closing balance sheet.
Notes Classifying: It is one of the most important processes of the accounting. Under this,
grouping of transactions is carried out on the basis of certain segments or divisions. It can
be described as a method of rational segregation of the transactions. The segregation is
generally done into two categories, viz.
1. Cash transactions and
2. Non-cash transactions.
The preparation of the ledger A/cs and Subsidiary books are prepared on the basis of
rational segregation of accounting transactions. For example, the preparation of cash
book is involved in the unification of cash transactions.
Summarizing: The ledger books are appropriately balanced and listed one after another.
The list of the name of the various ledger book A/c and their accounting balances is
known as Trial Balance. The trial balance is summary of all unadjusted name of the accounts
and their balances.
Contd...

Notes Preparation: After preparing, the summary of various unadjusted A/c are required to
adjust to the tune of adjustment entries which were not taken into consideration at the
time of preparing the trial balance. Immediately after the incorporation of adjustments,
the final statement is readily available for interpretations.
The following figure explains the key steps of accounting cycle:
Figure 4.1: Steps of Accounting Cycle
4.2.1 Account
An account is a statement in which the date wise details regarding the business transactions as
persons, companies, representatives, assets, liabilities, income and expenditures and profit &
loss are given.
Kinds of Accounts
For the purpose of ruling of debit and credit, under double entry system the accounts are
classified on the basis of two approaches. These are:
1. American Approach
2. English Approach
1. American Approach: As per this approach the accounts relating to financial transactions
are classified as follows:
(a) Assets Accounts: Under this heading those transactions are kept which are relating to
the business assets as plant, machinery, land, building, etc.
(b) Liabilities Account: Under this heading those accounts are kept which are relating to
the credit purchases and outstanding expenses, loans, capital, etc.
(c) Capital Account: Capital account is an account stating the amount of fund and assets
invested by the owner's in the business.

(d) Revenue Accounts: Revenue accounts include the transactions relating to income, Notes
commission, interest, dividend, sales, etc.
(e) Expenses Accounts: These include those accounts which are relating to the expenses
of business as repairs, rent, maintenance, insurance and lighting, etc.
Figure 4.2: Classification of Accounts
Kinds of Accounts
American Approach English Approach
Assets Liabilities Revenue Expenses

Account Account Account Account
Personal Accounts Real Accounts Nominal Accounts

(Persons, Companies, (Properties and Assets) (Incomes Gains,
Firms & Representatives) Expenses & Losses)
2. English Approach: Under this approach accounts are classified into following three categories:
(a) Personal Account: Here those accounts are included which are relating to persons,
firms, companies, representatives and organizations as Shiam Lal & Company’s
Account, etc.
(b) Real Account: Accounts which are relating to the assets and properties of the business
are counted under this heading. Assets can be real or intangible. Real assets are as
land & buildings, plant & machinery, cash and stock, etc. While intangible assets
may be as goodwill, patents and trademarks, etc.
(c) Nominal Account: Accounts which are relating to the revenues, incomes, expenses
and losses of the business are called nominal accounts. For example, rent, commission,
interest, dividend, etc.
Self Assessment
Fill in the blanks:

6. …………………… is described as origin for the creation of information and the continuous
utility of information.
7. Under …………………… heading those transactions are kept which are relating to the
business assets as plant, machinery, land, building, etc.
4.3 Summary
 The recording of business transactions in the books of account is based on a fundamental

equation called Accounting Equation.
 This equation expresses the equality of assets on the one side and other side equity.
 Expenses and Revenue also affect the accounting equation. Their effect is always on the
capital account.

Notes  The accounting equation is also the basis for the most basic of accounting reports, the aptly
named Balance Sheet.
 A balance sheet reports what a business owns (assets), what it owes (liabilities) and what
remains for the owners (equity) as of a certain date.
 Accounting is described as origin for the creation of information and the continuous
utility of information.
4.4 Keywords
Accounting Equation: The recording of business transactions in the books of account is based on
a fundamental equation called Accounting Equation.
Asset: Any physical thing or right owned that has money value is an asset.
Liability: It means the amount which the firm owes to outsiders that is, accepting the proprietors.
Stock: The goods purchased are for selling, if the goods are not sold out fully, a part of the total
goods purchased is kept with the trader unlit it is sold out, it is said to be a stock.
1. “Accounting equation remains intact under all circumstances” Justify the statement with
the help of example.
2. “Accounting is described as origin for the creation of information and the continuous
utility of information.” Discuss.
3. Why accounting equation does remains in balance?
4. “Accounting is the process of recording, classifying and summarizing of accounting
transactions.” Discuss.
5. Prepare accounting equation from the following Transactions:

Hemant started business with cash 3,00,000
Purchased goods for cash 80,000
Sold goods [costing 30,000] for cash 45,000

Purchased goods from Monika 70,000
Salary paid 7,000
Commission received 5,000
Paid Cash to Monika in full settlement 69,000

Goods sold to Rahul {Costing 20,000} for cash 25,000
6. Prepare accounting equation on the basis of the following:

(i) Anup started business with cash 250,000
(ii) Purchased goods for cash 35000

(iii) Purchased office furniture for cash 12000
(iv) Paid rent 7000

(v) Sold goods (costing 30000) for 50000 for cash

7. Show the accounting equation on the basis of the following transactions Notes
(i) Manu started business
Cash 600000
Goods 100000
(ii) Purchased office machine for cash 90000
(iii) Sold goods (costing 60000) for credit to Asha

(iv) Purchased building for cash 130000
(v) Cash received from Ashu 80000

(vi) Purchased goods on credit to M/s Ashok Trader for cash 70000
(vii) Salaries paid 6000

(viii) Insurance prepaid 10000
(ix) Cash paid to M/s Ashok traders in full settlement 68000
1. double-entry bookkeeping 2. Balance sheet

3. Owner’s equity 4. Balance Sheet
5. Assets 6. Accounting
7. Assets Accounts



Notes Unit 5: Preparation of Journal, Ledger and Balancing
CONTENTS
Objectives
Introduction
5.1 Books of Original Record

5.1.1 Rules of Debiting and Crediting in Journal
5.1.2 Compound Journal Entry

5.1.3 Opening Journal Entry
5.2 Ledger
5.3 Balancing
5.4 Summary
5.5 Keywords
Objectives

 Prepare journal
 Construct journal entries between the accounts of two different categories
 Illustrate opening and compound journal entries
 Prepare ledger
 Make ledger posting
 Illustrate the balancing of accounts
Introduction
Journal is a book of accounts in which all day to day business transactions are recorded in a
chronological order i.e. in the order of their occurrence. Transactions when recorded in a Journal
are known as entries. It is the book in which transactions are recorded for the first time. Journal
is also known as ‘Book of Original Record’ or ‘Book of Primary Entry’.
The accounting process does not stop here. The transactions are recorded in number of books in
chronological order. Such recording of business transactions serves little purpose of accounting.
Items of same title in different books of accounts need to be brought at one place under one head
called an account. There are numerous account titles of items/persons or accounts. All the
accounts, if brought in one account book, will be more informative and useful. The account book
so maintained is called Ledger.

Unit 5: Preparation of Journal, Ledger and Balancing
5.1 Books of Original Record Notes
The accounting process includes the identification of financial transactions, recording of them
and summarizing. Thus, after identifying the financial nature items the first step of accounting
process is the recording the transactions. The books in which these transactions are recorded
first time are called the books of original entries or records. These books of original records are
divided into following three:
Memorandum Book
It is also called the waste book. When a transaction takes place in the business it is first roughly
written in the memorandum book chronologically for the memory only. Then after some time,
these transactions are recorded in the journal and subsidiary book. After recording these
transactions, this book is destroyed. Therefore, it is called waste book.
Journal
‘Journal’ word is derived from French word ‘Jour’ which means a day book. Journal is a primary
book of original entries for accounting data. In the Journal the business transactions are recorded
chronologically that is called Journalising. Thus the accounting data are recorded first time in
this book. In the words of Carter, “A Journal, as originally used, is a book of primary entry in
which transactions are copied in the order of date from a memorandum or waste book. The
entries are then copied and classified into debts and credits, so far to facilitate their being
correctly posted afterwards in the ledger”. The proforma of a Journal is given here under:
Pro forma of a Journal
Date Particulars L.F. Amount Dr. Amount Cr.

( ) ( )
As per the above pro forma of Journal the first column is kept for date means date of transaction
is recorded, second wide column for particulars of business transactions in which the related
accounts are showed along with their narrations. Third column is for ledger folio number where
the journal entry is posted in ledger. The fourth and fifth columns are kept for debit amount and
credit amount.
Did u know? What is meant by the journal entry?
It is an entry systematically recorded to the tune of golden rules of accounting in the

journal book is known as journal entries.

Notes 5.1.1 Rules of Debiting and Crediting in Journal
In the Journal the business transactions of the financial nature are recorded on the basis of debit
and credit. The accounts are debited and credited on the basis of following rules. These rules are
based on the english classification of accounts.
1. Personal Account: If in a transaction, a person receives something in cash or goods, it is
debited and if that person gives, that is credited. Debit account is denoted by ‘Dr.’ while
credit account is denoted by ‘Cr.’ In brief, the rule of personal account is
Receiver is debited (Dr.)

Giver is credited (Cr.)
2. Real Account: If in a transaction, the assets are coming into business, they are debited and
if those are going outside from business, they are credited. Thus these rules are as below:
‘What comes in’ is debited

‘What goes out’ is credited
3. Nominal Account: The rules of debiting and crediting of nominal account are – the expenses
and losses of the business are debited and the gains and profit of the business are credited.
In brief the rules are:
Expenses and Losses are debited

Incomes and Gains are credited
At the time of Journalising of the transactions, when an account is debited it is denoted by ‘Dr.’ and
crediting of an account by ‘To’. When a transaction is recorded first of all its two aspects (accounts)
are identified, those may of the same group (same type of account) or different groups (different
types of accounts). Then the rules of debiting and crediting are applied. On the completion of a
page of the Journal it is totaled and the balance is carried forward to the next page.
Illustration 1: Journalise the following transactions in the books of Mr. Ram Krishna:
2007 ( )
July 1 Mr. Ram Krishna Started business with cash 2,00,000
July 4 Goods purchased in cash 20,000
July 5 He deposited in Bank 40,000

July 7 Goods sold 15,000
July 10 Goods purchased from Mr. Kamlesh on credit 25,000
July 11 Furniture purchased 18,000

July 12 Wages paid 4,000
July 20 Interest received 500
July 25 Cash paid to Mr. Kamlesh 25,000
July 30 Additional capital brought by Mr. Ram Krishna 50,000

Solution: Notes
Journal of Mr. Ram Krishna

( ) ( )
2007
July 1 Cash Account Dr. 2,00,000
To Capital Account 2,00,000
(Being start of business by Mr. Ram Krishna)
July 4 Purchase Account Dr. 20,000
To Cash Account 20,000
(Being purchase of goods in cash)
July 5 Bank Account Dr. 40,000
(Being deposit of cash into Bank)
July 7 Cash Account Dr. 15,000
To Sales Account 15,000
(Being sale of goods in cash)
July 10 Purchase Account Dr. 25,000
To Mr. Kamlesh 25,000
(Being purchase on credit from Mr. Kamlesh)
July 11 Furniture Account Dr. 18,000
(Being purchase of furniture)
July 12 Wage Account Dr. 8,000
(Being payment of wages in cash)
July 20 Cash Account Dr. 500
To Interest Account 500
(Being receipt of interest)
July 25 Mr. Kamlesh Dr. 25,000
(Being payment of credit purchases)
July 30 Cash Account Dr. 50,000
To Capital Account 50,000
(Being introduction of additional capital in business)
Total 3,97,500 3,97,500
Notes For the purpose of Journalising of the transactions, the goods are classified into
purchases, sales, purchase returns and sales returns.

Notes When some amount is brought into to start the business it is called Capital. Therefore, such an
amount is transferred to Capital Account.
5.1.2 Compound Journal Entry
When two or more transactions take place in the business relating to a same account on the same
date, in the place of passing many entries for the same account a single journal entry is pass
which is called a compound journal entry. Compound entry can be of following three types:
(a) Single debit account and more than one credit account
(b) Single credit account and more than one debit accounts
(c) More than one debit account and more than one credit account
For example, if a debtor is allowed cash discount and he makes the payment. Then the accounts
involved are three, i.e., (1) Cash A/c (2) Discount A/c and (3) The Debtors A/c
The following compound entry is to be passed:
Dr. Cr.
Date Particulars L.F. ( ) ( )
Cash A/c Dr.
Discount A/c Dr.
To Debtors A/c
(Debtor paid & was allowed discount.)
Illustration 2: Journalise the following transactions with narration:

2006
Aug 1 Commenced business with cash 40,000 and Goods 20,000,
Aug 3 Purchased goods 'From 'X' and Co. for 10,000 Paid Cash 5,000,
Aug 5 Goods returned to 'X' Co. 200,
Aug 10 Sold goods to 'Y' & Co. 30,000 and cash received from him 20,000,
Aug 15 'Y' & Co. returned goods 500,
Solution:
Journal Entries

( ) ( )
2006
Aug 1 Cash A/c Dr. 40,000
Goods A/c 20,000
Dr. 60,000
To Capital A/c
(business commenced with cash and goods)
Aug 3 Purchases A/c Dr. 10,000

To X & Co. 10,000
(Goods purchased from x)
Contd...

Aug 3 X & Co. Dr. 5,000 Notes

To cash A/c 5,000
Paid cash
(If combined entry is passed)
Aug 3 Purchases A/c Dr. 10,000
To cash A/c 5,000
To X & Co. 5,000
(Goods purchased from X and paid cash)
Aug 5 X & Co. Dr. 200
To Purchases Returns A/c 200
(Goods returned to X)
Y& Co. Dr. 10,000
To sales A/c 30,000
(Goods sold to Y and cash received from him)
If separate entries are made then
Aug 10 Y& Co. Dr. 30,000
To Sales A/c 30,000
(Goods sold to Y)
To Y & co. 20,000
(Cash received from him)
Aug 15 Sales Return A/c Dr. 500
To Y & Co. 500
(Goods returned by Y & Co.)
5.1.3 Opening Journal Entry
The closing balances of accounts of one year are transferred to the next year. In the next year
these balances become the opening balances. After recording the opening balances, the
transactions of the year are recorded. To record the opening balances a Journal entry is passed
which is called opening entry. Suppose in a business there are closing balances of cash of 10,000,
plant 90,000 and capital of 1,00,000, and then opening Journal entry will be as follows:
Assets Account Dr. 90,000
Cash Account Dr. 10,000
To Capital Account 1,00,000
Illustration 3: Pass the necessary opening entry on 1st January, 2006 in the books of Gopinath.
Cash in hand 3,000
Cash at Bank 16,000
Stock in trade 30,000
Furniture & Fittings 5,000
Sundry Debtors 21,000
Sundry Creditors 18,000
Loan from Ganesh & Co. 9,000

Notes Solution:
Opening Journal Entries
Dr. Cr.
1.1.2006 Cash in hand A/c Dr. 3,000
Cash at Bank A/c Dr. 16,000
Stock in trade A/c Dr. 30,000
Furniture’s Fittings A/c Dr. 5,000
Sundry debtors A/c Dr. 21,000
To Sundry creditors A/c 18,000
To Ganesh & Co. A/c 9000
To Capital A/c 48,000
(Opening entry in respect of assets and liabilities.
Difference between Assets and liabilities is equal to capital)
Subsidiary Books of Original Records
If all the transactions of the business are recorded in Journal it will be too bulky to manage.
Therefore, nowadays original records are maintained in the subsidiary books. These subsidiary
books are also called sub-division of Journal. They are classified as follows:
Cash Book or Journal
When it is the part of ledger it is called cash account. In the cash book all the cash transactions are
directly recorded. As per Carter, “Cash book is a book of original entry, the object of which is to
record all receipts and payments of money”. In the cash book all the cash receipts are recorded
in the left hand sides and all the cash payments are recorded in the right hand side. And the
difference of these two sides is called the closing balance of cash. Generally, four types of cash
book are prepared. These are:
1. Simple Cash Book or One Column Cash Book
2. Cash and Discount Cash Book or Double Column Cash Book
3. Cash, Bank and Discount Cash Book or Three Column Cash Book
4. Petty Cash Book
The pro forma of the simple cash book is given below:
Pro Forma of a Simple Cash Book
Date Particulars L.F. Amount Date Particulars L.F. Amount

( ) ( )

Special Journal Notes
This journal is the part of general journal. Under this division of Journal, the following Journals
or books are included:
1. Purchase Book is also known as Bought Book or Purchase-Day Book. All the credit purchase
of goods is recorded in this book. In this book the data wise transactions of purchase are
recorded. This book has six columns. In the first column the date of transaction is recorded,
in second column invoice number is mentioned, in third column details of the transactions
are kept, in the fourth column ledger folio number is given, and the last two columns are
left for amount in the transaction. The proforma of the purchase day book is given below:
Proforma of Purchase Book
Date Invoice Particulars L.F. Details Amount

No. ( ) ( )
2. Sales Book is known by the different names as Sales-Day-Book, or Sales Journal. In this
book all the credit sales of goods are recorded. At the time of sale of goods an invoice is
prepared. On the basis of this invoice, all the credit sales are recorded in this book. The sale
of others except goods is recorded in the Journal Proper. Its columns are similar to that of
the Purchase book. It is given below:
Proforma of Sales Book
Date Invoice Particulars L.F. Details Amount

No. ( ) ( )
3. Purchase Return Book is also called Purchase Return Journal or Return Outward Book. In
this book those goods are entered which are returned to the suppliers. If the goods were
purchased in cash and returned, then such goods are not entered in this book. Entry for
such goods is done in these books which were purchased on credit. When the goods are
returned to the supplier, along with the goods a note is also sent to the supplier which
carries all the details of the goods returned, such a note is called Debit note. It is prepared
in duplicate copy. One copy is sent to the supplier and one copy is kept safe for future
reference. This note in the hands of seller is called credit note. In other words purchaser
will dispatch a debit note to the seller and seller will send a credit note to purchaser.
Sends a Debit Note to

Purchaser Seller
Purchase A Credit Note Sends
Proforma of Purchase Return Book
Date Debit Note Particulars L.F. Details Amount

No. ( ) ( )

Notes 4. Sales Return Book is known as Sales Return Journal or Return Inwards Book. In the case of
goods sold on credit some goods are being returned by the customers, such goods are
recorded in this book. Here same columns are maintained as in the Purchase Return Book
except Debit Note No. In the place of debit note no., credit note no. is given in this book.
When some goods are returned by the customer, a note is provided to them which is called
credit note. Credit note means that his account has been credited with the amount of goods
return. This credit note works as a debit note for the party receiving back the goods. The
customers debits the account of that party from whom it has been received. Thus
Sends Credit Note

Seller Purchaser
Purchase Debit Note Sends
Proforma of Sales Return Book
Date Credit Note Particulars L.F. Details Amount

No. ( ) ( )
5. Bills Receivable Book is also called the Bills Receivable Journal. When a company receives
various bills from its debtors, details of all these bills are datewise recorded in the Bills
Receivable Book. The proforma of this book is given below:
Proforma of Bills Receivable Book
S.No. Date From whom Date of Period Due Date L.F. Amount
received Bill ( )
6. Bills Payable Book is also known as Bills Payable Journal. When the various bills are
accepted for its various creditors, details of such bills are recorded in this book in
chronological order. The proforma of this book is given below:
Proforma of Bills Payable Book
S.No. Date From whom Date of Period Due Date L.F. Amount
given Bill ( )
Journal Proper
According to the rules of accounting, all the business transactions are recorded into Journal first,
and then they are posted in Ledger. If all the credit and cash transactions are recorded into
Journal, there will be a large number of transactions and it will become too bulky. Therefore,

Journal is sub-divided into cash and credit transactions. Cash transactions are directly recorded Notes
into cash book and credit sales and credit purchase are directly recorded in the sales and purchase
books and the remaining transactions are recorded into Journal Proper. These transactions may
be relating to:
1. Opening Entry
2. Closing Entry
3. Transferring
4. Rectification, and
5. Adjustment
Other Subsidiary Books
As per the nature of the business, the entrepreneurs may maintain some other books also. These
may be:
1. Consignment Outwards Book
2. Sale and Return Book
3. Cash Collection Book
4. Cash Sales Book.
Notes Journalising can be generally categorized into following various categories:
1. Taking place within the same natured accounts

2. Taking part in between accounts of two different in categories.
Illustration 4: Record the following transactions into various Subsidiary Books and Journal
Proper of Mr. Shiv Kumar:
2008
January 1 Cash in hand 31,400, Cash at Bank 50,800 and Capital Account 82,200.
January 2 Bought goods for cash 8,200.
January 5 Purchased goods from Lalit Mohan & Co. for 11,600 less 10% trade discount.
January 7 Sold goods to Shobhit & Co. for 17,800 less 20% trade discount.
January 9 Withdrew 1,000 from bank for private use.
January 12 Sold goods to Karim for 12,800.
January 15 10,000 paid to Lalit Mohan in full settlement of their claim.
January 18 Goods worth 800 returned by Karim.
January 20 Received 8,000 from Karim.
January 21 Purchased goods from Krishna & Co. for 17,400.
January 23 12,000 paid to Krishna & Co. by cheque, discount allowed 600.
January 24 Purchased furniture for 1,600 from Sardar Furniture House on credit.

Notes January 26 Paid into bank 4,400.

January 28 Karim declared insolvent, a first and final dividend of 50 paise in a rupee is
received from him.
January 29 Goods worth 1,200 returned to Krishna & Co.
January 31 Interest on capital provided 822.
January 31 Goods worth 800 taken by Mr. Shiv Kumar for his personal use.
January 31 Paid salaries to staff 3,600.
January 31 Paid into bank 40,000.
January 31 Bought 200 shares in Dehradun Chemicals Ltd. at 11, per share Brokerage paid
50.
January 31 Received 11,800 from Shobhit & Co. discount allowed 200.
Solution:
Journal Proper

( ) ( )
2008
January 01 Cash Account Dr. 31,400
Bank Account Dr. 50,800
To Capital Account 82,200
(Entry made for opening balances)
January 24 Furniture Account Dr. 1,600
To Sardar Furniture House 1,600
(Being purchase of furniture on credit from Sardar
Furniture House)
January 28 Bad Debts Account Dr. 2,000
To Karim 2,000
(On the insolvency of Karim 50 paise in a rupee
received and balance treated as bad debts)
January 31 Interest on Capital Account Dr. 822
To Capital Account 822
(Interest on capital charged)
January 31 Drawing Account Dr. 800
To purchase Account 800
(Proprietor took goods for personal use)
January 31 Capital Account Dr. 1,800
To Drawing Account 1,800
(Balance of drawing account transferred to Capital
account)
Total 89,222 89,222

Sales Book Notes
Date Particulars L.F. Details Amount

( ) ( )
2008
Jan. 7 Shobhit & Co.: Sale of goods 17,800
(–) 20% discount 3,560 14,240
Jan. 12 Karim: Sale of goods 12,800
Jan. 31 Total: Sale – Credit balance 27,040
Purchase Book

( ) ( )
2008
Jan. 5 Lalit Mohan & Co.: Goods purchased 11,600
(–) 10% Discount 1,160 10,440
Jan. 21 Krishna & Co. 17,400
Jan. 31 Total: Purchases debited 27,840
Sales Return Book

( ) ( )
2008
Jan. 18 Karim: Sales return 800
Jan. 31 Sales Return debited 800
Purchase Return Book

( ) ( )
2008
Jan. 29 Krishna & Co.: Returns 1,200
Jan. 31 Purchase Returns Credited 1,200
!
Caution The points to be observed at the moment of journalising:
1. The nature of the accounts to be identified
2. The accounts to be correlated to the golden rules
3. The entry to be passed through proper debiting and crediting of the accounts
respectively.

72
Notes
Date Particulars L.F. Discount Cash Bank Date Particulars L.F. Discount Cash Bank
(`) (`) (`) (`) (`) (`)
2008 2008
Jan 1 To balance - 31,400 50,800 Jan 2 By Purchases A/c - 8,200 -
b/d Jan 9 By Drawings A/c - - 1,000
Jan 20 To Karim - 8,000 - Jan 15 By Lalit Mohan 440 10,000 -
Jan 26 To cash A/c c - - 4,400 Jan 23 By Krishna & Co. 600 - 12,000
Jan 28 To Karim - 2,000 - Jan 26 By Bank A/c c - 4,400
Jan 31 To sales A/c - 43,600 - Jan 31 By Advertisement A/c - - 1,000
Jan 31 To cash c - - 40,000 Jan 31 By Salaries A/c - 3,600 -
Jan 31 To Shobhit & Co. 200 11,800 - Jan 31 By Bank A/c - 40,000 -
Jan 31 By Investment A/c c - 2,250 -
Jan 31 By Balance C/d - 28,350 81,200
200 96,800 95,200 1,040 96,800 95,200
Feb 1 To balance b/d 28,350 81,200
LOVELY PROFESSIONAL UNIVERSITY

Notes
Task Identify nature of the transactions:
Ramchander has purchased goods on credit from M/s Royals Aventis for 15,000. The
portions of the goods were found to be damaged which worth of 5,000. Ramchander
immediately returned the damaged goods to Royals.
1. Identify the various types of accounts involved in the above illustrated transactions.
2. Pass the journal entries with regards to the nature of accounts involved.
Self Assessment
Fill in the blanks:

1. Journalising is the process of entering transactions in …………………….
2. Another name for Journal is …………………….
3. Transactions, when recorded in Journal, are known as …………………….
4. The explanation of a Journal entry is known as …………………….
5. In a Journal entry preposition …………………… is used before the name of the account to
be credited.
6. Journal is a …………………… of original entries for accounting data.
7. The journal is known as the …………………….
8. The process of transferring the entries from Journal to Ledger accounts is called
…………………….
5.2 Ledger
Journal of a business is very useful but it does not reply the different queries as how much
amount is due from debtors, how much is to be paid to creditors and what is the balance of a
particular account etc. For the reply of all these queries the ledger is prepared from the Journal
entries. Ledger is the set of accounts in which all types of account (personal, real or nominal) are
kept. There can be two forms of ledger:
(a) Bound Ledger
(b) Loose Leaf Ledger
A ledger in traditional way, is normally kept in the form of bound note books. In bigger
business enterprises, it is not easy to maintain a large and variety of transaction in a single book.
To overcome this difficulty, loose leaf shuts takes the place of bound books.
Under loose leaf ledger, appropriate sheets are introduced. Additional pages may be added to
any extent, completed account may be removed to reduced volume, any account may be
rearranged so as to suit the needs of the enterprises. This mode of maintaining ledger in the
form of loose sheets is called loose leaf ledger.
Posting
The process of transferring the entries from Journal to Ledger accounts is called posting. In other
words account wise selection of debit or credit items and recording them into the relevant side
of the relevant account is called posting. The process of posting is done after a period as week,

Notes fortnight or a month. For example, if rent as an expense is shown in the debit in Journal, this will
be posted in the debit side of the Rent (Expenses) A/c in the Journal. The proforma of a Ledger
account is given below:
Proforma of an Account
Name of Account………
Date Particulars L.F. Amount (Dr.) Date Particulars L.F. Amount (Cr.)
( ) ( )
In the above proforma of an account, there are two sides of an account. Left hand side is debit
side and right hand side is credit side. In both the sides, the first column is for date and second
column for details, third column for the Journal folio number and in the last column the amount
of the transaction is recorded.
Rules of Posting in Ledger Account
At the time of posting of transactions from Journal to ledger the following points/rules should
be kept in mind:
1. In the debit side of a ledger account, the word ‘To’ is used while in the credit side word ‘By’
is used.
2. All those accounts are opened in the Ledger which are given in the Journal.
3. All the debit items of an account given in Journal are posted in the debit side of the
respective account. And all the credit items of an account given in Journal are posted in the
credit side of the respective account in ledger.
4. The name of the account, in which posting is being made, is not written. But the posting is
done by the name of other account given in the opposite side of that entry in the Journal.
5. At the time of posting if the page is full and account is not complete, its total is carried to
the next page and then remaining posting is done.
5.3 Balancing
There can be several transactions relating to a particular account in the different places in the
Journal. Such transactions are collected and recorded in the concerned account. At the end of the
accounting period, the businessman becomes interested to know the position of these accounts.
The position of an account is determined by calculating the net balance of the account for which
debit and credit sides of the account are totalled separately. If total of debit side is greater than
the total of credit side, difference is written in the credit side of the account and that is carried to
next year. And if the total of credit side is greater than the total of debit side, difference is written
in debit side and carried to next year. Thus totals of both the sides become equal and account is
closed.
Did u know? How are the account transactions classified?
The accounts are classified through the preparation of ledger.

Balancing of Different types of Accounts Notes
Assets: All asset accounts are balanced. These accounts always have a debit balance.
Liabilities: All Liability accounts are balanced. All these accounts have a credit balance.
Capital: This account is always balanced and usually has a credit balance.
Expense and Revenues: These Accounts are not balanced but are simply totaled up. The debit
total of Expense/Loss will show the expense/Loss. In the same manner, credit total of Revenue/
Income will show increase in income. At the time of preparing the Trial Balance, the totals of
these are taken to the Trial Balance.
Example: Record the following transactions in the Journal and post them into Ledger of
Mr. Aditya Raj:
2008 ( )
March 1 Purchase of Goods from Ramautar 3,20,000
March 10 Paid Rent for the month 2,000

March 11 Purchase of Plant 1,00,000
March 12 Paid Salaries 12,000
March 15 Paid Ramautar 1,00,000
March 20 Sold Goods to Shyam 20,000
March 25 Received from Shyam 30,000
March 31 Reserved Cash from Cash Sales 2,50,000
March 31 Wages Paid 5,000
Solution:
Journal of Mr. Aditya Raj
Date Particulars L.F. Amount (Dr.) Amount (Cr.)

( ) ( )
2008
March 1 Purchase Account Dr. 3,20,000
To Ramautar 3,20,000
(Being purchase of goods on credit)
March 10 Rent Account Dr. 2,000
(Being payment of rent)
March 11 Plant Account Dr. 1,00,000
To Cash Account 1,00,000
(Being purchase of plant)
March 12 Salaries Account Dr. 12,000
(Being payment of salaries)
Contd...

Notes March 15 Ramautar Dr. 1,00,000

(Being payment to Ramautar)
March 20 Shyam Dr. 20,000
To Sales Account 20,000
(Being goods sold on credit)
March 25 Cash Account Dr. 30,000
To Shyam 30,000
(Being receipts of cash)
March 31 Cash Account Dr. 2,50,000
To Sales Account 2,50,000
(Being goods sold in cash)
March 31 Wages Account Dr. 5,000
(Being payment of wages)
Total 8,39,000 8,39,000
Ledger
Cash Account
Date Particulars L.F. Debit Date Particulars L.F. Credit

( ) ( )
2008 2008
March 25 To Shyam 30,000 March 10 By Rent A/c 2,000
March 31 To Sales A/c 2,50,000 March 11 By Plant A/c 1,00,000
March 12 By Salaries A/c 12,000
March 15 By Ramautar 1,00,000
March 31 By Wages 5,000
March 31 By Balance c/d 61,000
2,80,000 2,80,000
2008 To Balance b/d 61,000
April 1
Purchase Account
2008 ( ) 2008 ( )
March 1 To Ramautar 3,20,000 March 31 By Balance c/d 3,20,000
3,20,000 3,20,000
2008
April 1 To Balance b/d 3,20,000
Ramautar’s Account
2008 ( ) 2008 ( )
March 15 To Cash A/c 1,00,000 March 1 By Purchase A/c 3,20,000
March 31 To Balance c/d 2,20,000
3,20,000 3,20,000

Rent Account Notes
2008 ( ) 2008 ( )
March 10 To Cash A/c 2,000 March 31 By Balance c/d 2,000
2,000 2,000
2008
April 1 To Balance b/d 2,000
Plant Account
2008 ( ) 2008 ( )
March 11 To Cash A/c 1,00,000 March 31 By Balance c/d 1,00,000
1,00,000 1,00,000
2008
Salaries Account
2008 ( ) 2008 ( )
March 12 To Cash A/c 12,000 March 31 By Balance c/d 12,000
12,000 12,000
2008
Shyam’s Account
2008 ( ) 2008 ( )
March 20 To Sales A/c 20,000 March 31 By Balance c/d 30,000
March 31 To Balance b/d 10,000
30,000 30,000
Sales Account
2008 ( ) 2008 ( )
March 1 To Balance b/d 2,70,000 March 20 By Shyam 20,000
March 31 By Cash A/c 2,50,000
2,70,000 2,70,000
Wages Account
2008 ( ) 2008 ( )
March 31 To Cash A/c 5,000 March 31 To Balance c/d 5,000
5,000 5,000
2008

Notes Journalise the following transactions and post them in the ledger 2011.
January 1: Commenced business with cash 50000
January 3: Paid into bank 25000
January 5: Purchased furniture for cash 5000

January 8: Purchased goods and paid by cheque 15000
January 8: Paid for carriage 500

January 14: Purchased Goods from K. Murthy 35000
January 18: Cash Sales 32000

January 20: Sold Goods to Ashok on credit 28000
January 25: Paid cash to K. Murthy in full settlement 34200

January 28: Cash received from Ashok 20000
January 31: Paid Rent for the month 2000

January 31: Withdrew from bank for private use 2500
Solution:
Journal

( ) ( )
2007
Jan. 1 Cash A/c Dr. 50,000
(Commenced business with cash)
Jan. 3 Bank A/c Dr. 25,000
To Cash A/c 25,000
(Cash paid in the Bank)
Jan. 5 Furniture A/c Dr. 5,000
To Cash A/c 5,000
(Purchased furniture for cash)
Jan. 8 Purchase A/c Dr. 15,000
To Bank A/c 15,000
(Purchased goods and paid by cheque)
Jan. 8 Carriage A/c Dr. 500
To Cash A/c 500
(Cash paid for carriage charges)
To K. Murthy 35,000
(Goods purchased on credit)
To Sales A/c 32,000
(Goods sold for cash)
Jan. 20 Ashok Dr. 28,000 Contd...
To Sales A/c 28,000
(Goods sold to Ashok credit)
Jan. 25 K Murthy Dr. 35,000
78 LOVELY PROFESSIONAL
To Cash A/c
UNIVERSITY 34,200
To Discount A/c 800
(Cash paid to K. Murthy a discount allowed by
them)
To Cash A/c 500
(Cash paid for carriage charges)
To K. Murthy 35,000
(Goods purchased on credit)
To Sales A/c 32,000
(Goods sold for cash)
Jan. 20 Ashok Dr. 28,000 Notes
To Sales A/c 28,000
(Goods sold to Ashok credit)
Jan. 25 K Murthy Dr. 35,000
To Cash A/c 34,200
To Discount A/c 800
(Cash paid to K. Murthy a discount allowed by
them)
To Ashok 20,000
(Cash received from Ashok on Account)
Jan. 31 Rent A/c Dr. 2,000
To Cash A/c 2,000
(Cash paid for rent)
Jan. 31 Drawings A/c Dr. 2,500
To Bank A/c 2,500
(Cash withdrawn from bank for domestic use)
Ledger
Cash A/c
Dr. Cr.
Date Particulars J.F. Amount Date Particulars J.F. Amount
( ) ( )
2006 2006
Jan. 1 Capital A/c 50,000 Jan. 3 Bank A/c 25,000
Jan. 18 Sales A/c 32,000 Jan. 5 Furniture 5,000
Jan. 28 Ashok 20,000 Jan. 8 Carriage 500
Jan. 25 K. Murthi 34,200
Jan. 31 Rent A/c 2,000
Jan. 31 Balance c/d 35,300
1,02,000 1,02,000
Feb. 1 Balance b/d 35,300
Capital A/c
2006 ( ) 2006 ( )
Jan. 31 Balance c/d 50,000 Jan. 1 Cash A/c 50,000
Bank A/c
2006 ( ) 2006 ( )
Jan. 2 Cash A/c 25,000 Jan. 8 Purchases A/c 15,000
Jan. 31 Drawings A/c 2,500
25,000 25,000

Notes Furniture A/c
Dr. Cr.
( ) ( )
2006 2006
Jan. 1 Cash A/c 5,000 Jan. 31 Balance c/d 5,000
Purchase A/c
Dr. Cr.
( ) ( )
2006
Jan. 8 Bank 15,000 Trading A/c 50,000
Jan. 14 K. Murthy 35,000
50,000 50,000
Carriage A/c
Dr. Cr.
( ) ( )
2006
Jan. 8 Cash 500 Trading A/c 500
500 500
K. Murthy A/c
Dr. Cr.
( ) ( )
2006 2006
Jan. 25 Cash 34,200 Jan. 14 Purchases 35,000
Jan. 25 Discount 800
35,000 35,000
Sales A/c
Dr. Cr.
( ) ( )
2006 2006
Jan. 1 Trading A/c 60,000 Jan. 18 Cash 32,000
Jan. 20 Ashok 28,000
60,000 60,000

Ashok A/c Notes

Dr. Cr.
( ) ( )
2006 2006
Jan. 20 Sales A/c 28,000 Jan. 28 Cash 20,000
28,000 28,000
Rent A/c
Dr. Cr.
( ) ( )
2006 2006
Cash A/c 2,000 Profit & Loss A/c 2,000
2,000 2,000
Drawing A/c
Dr. Cr.
( ) ( )
2006 2006
Jan. 10 Bank 2,500 Jan. 31 Balance c/d 2,500
2,500 2,500
Task Following are the transactions of Dhani Ram and Sons for the month of July 2006.
Make journal entries, post them into ledger and balance the account.
2006 ( )
July 1 Commenced business with cash 60,000
July 2 Paid into bank 40,000
July 5 Purchased furniture for cash 5000
July 7 Purchased Goods and paid for them by cheque 20000

July 10 Sold Goods to Lata Gupta for cash 12000
July 12 Sold Goods to Mahavir on credit 24000

July 18 Purchased Goods from Harish 30000
July 19 Withdrew cash for domestic use 2500
July 20 Received a cheque from Mahavir on account 18900

Allowed him discount 100
Contd...

Notes July 27 Paid to Harish cash on account 16800

Discount allowed by him 200
July 31 Paid salary by cheque 1800
Paid cash for telephone bill 600
Self Assessment
Fill in the blanks:

9. Ledger contains various...................... in it.
10. The process of transfer of entries from Journal and special purpose books to ledger is
called......................
11. Ledger is also called......................
12. Ledger is a...................... book of accounting system.

13. Classification of transactions is being done only on the basis of preparing the......................
5.4 Summary
 Journal is the first book of the original entries in which all the business transactions of the
financial nature are recorded, then posted to ledger accounts.
 Accounts are of three types – Personal, Real and Nominal Account.
 Rules of Debiting and Crediting in Journal –
Personal A/c – Receiver – Debit and Giver-Credit
Real A/c – What comes in – Debit, What goes out – Credit
Nominal Account – Expenses and Losses are Debited and Income and Gains are credited
 Subsidiary Books of Original Entries are classified into – Cash Book, Special Journal,
Journal Proper and Others.
 Posting is the process of selecting of transactions from Journal on the basis of accounts and
writing them into ledger accounts.
 To test the arithmetical accuracy of the ledger accounts, the Trial Balance is prepared. Trial
Balance is the list of accounts taken from ledger.
 An expenditure done to get the advantages in the business for a long period is called
capital expenditure and if it is done for a short period and during the normal course of
business, it is called Revenue expenditure.
 Ledger is nothing but preliminary book of accounting transactions at which, each account
is separately maintained through the allotment of various pages for exclusive recording.
 Posting is the process of selecting of transactions from Journal on the basis of accounts and
writing them into ledger accounts.

5.5 Keywords Notes
Credit: Giver in Personal Account, Going assets in Real Accounts and Incomes in Nominal
Accounts.
Debit: Receiver in Personal Account, Coming Assets in Real Account and Expenses in Nominal
Accounts.
Double Entry System: Accounting which is based on the two aspects of the transactions.
Journal: The primary book in which the transactions are recorded first time.
Ledger: It is the classification of accounts in which various accounts are maintained.
Nominal A/c.: Accounts of incomes, expenses and gains or losses.

Personal A/c.: Accounts which are related to person, firms, companies and representatives.
Process of Accounting: It includes the recording of transactions into Journal, classifying into
Ledger and summarizing into Trial Balance and Final Accounts.
Real A/c: All the assets accounts are included into it.
1. What do you mean by Posting? Give the rules of posting.

2. What are the key steps in balancing a ledger A/c?
3. State the relation between journalizing and ledger posting with suitable examples.
4. Why is ledger known as the primary book or the principal-book of accounts? Can profit of
the business and its financial position be known without maintaining ledger?
5. What is the rule for posting the debit account from the journal into the ledger account?
6. Why is ledger prepared?

7. Enumerate the various types of ledgers which may be maintained by a business.
8. Mr. Kamal Nath was doing a business as a cloth merchant. On 1st July, 2007 his assets were:
Furniture and Office Equipment = 12,500, Stock 1,25,000 Cash in Hand 3,000, Bank
Balance 42,500, Amounts due from Brijesh 6,000, Amount due from Girijesh 7,500.
On the date he owed 10,000 to Manish and 7,250 to Naresh. His transactions during the
month were as follows. You have to Journalise these transactions and from that information
prepare his Ledger.
2008 ( )
July 2 Sold cloth on credit to Xavier 2,500
July 3 Purchased cloth from Yogesh 10,000
July 4 Paid Rent by cheque 4,000
July 5 Purchase of cloth by cheque 10,000
July 7 Cash sales 2,250
July 8 Received cheque from Brijesh 5,900

Notes July 9 Paid for stationery 250

July 10 Drawn cash for private use 1,250
July 11 Purchased cloth on credit from Manish 12,500
July 12 Sent cheque to Manish (in full settlement for July 1 transactions) 9,750
July 13 Sold cloth on credit to Girijesh 9,000
July 14 Paid telephone charges 400
July 15 Cash Sales 1,500
July 18 Paid for Advertisement 1,750
July 19 Cash Purchases 3,000
July 30 Paid Salaries for July 4,000
9. Prepare the account of X & Co. from the following:
2006 ( )
Feb 1 Balance due from X & Co. 1,000
Feb 3 Cash sales to X & Co. 700
Feb 4 Bought furniture from X & Co. 250
Feb 6 Murthy returned goods to us 200
Feb 9 X & Co. Purchased goods from us 1,200
Feb 10 Return of goods from X & Co. 150
Feb 20 X & Co. settled his account by cheque and received discount 20
10. Journalize the following transactions in the Books of Ranga Rao with Narration.
2006 ( )
June 1 Ram commenced business with cash 10,000
June 2 Paid to Bank 8,000
June 3 Bought goods for cash 500
June 4 Bought Furniture for office 400
June 10 Withdrew from Bank cash for office 1,000
June 13 Goods sold to Shyam 600
June 15 Bought goods of Krishan 410
June 18 Trade Expenses paid 100
June 19 Received cash from Shyam 590
June 25 Wages paid 50
June 28 Krishan paid off in full settlement of his account 400
June 30 Rent paid 100
June 30 Interest on capital 500

11. The following were the transactions of Delite Furniture, Delhi during July 2006 Notes
2006 ( )
July 1 Started business with
Cash 3,500
Bank 9,200
July 3 Bought furniture from M/s New Light 2,000
July 5 Bought furniture for the office 1,000
July 6 Sold furniture to Roop 2,000
July 8 Bought furniture 1,800
July 10 Returned furniture to M/s New Light 50
July 12 Roop returned furniture 200
July 14 Paid taxi fare 10
July 15 Sold furniture to Sanjay for 500
Less trade discount @ 10%
July 17 Received Commission 15
July 18 Paid to New light by cheque 1,000
July 19 Paid to Bank 200
July 22 Received a cheque for 500 from Roop and deposited the same 500
in Bank.
July 23 Paid Rent to Naresh
July 24 Roop’s cheque dishonoured. 150
July 25 Furniture taken for personal use 400
July 26 Received interest 10
July 27 Received dividend 25
July 29 Postage stamp paid 5
July 30 Paid house rent by cheque 100
July 31 Withdrawn from bank for office use 2,000
July 31 Salary paid 300
July 31 Taxes paid 250
You are required to journalize the above transactions in the books of M/s Delite Furniture
and post them in their respective ledger accounts.
12. Classify the following accounts as per modern classification of accounts:
(a) Cash brought in as capital
(b) Machinery purchased
(c) Goods sold for cash
(d) Goods purchased for cash
(e) Goods sold for credit
(f) Goods purchased on credit
(g) Rent Paid

Notes (h) Dividend Received

(i) Discount allowed
(j) Discount received
(k) Plant purchased
(l) Furniture sold.
(m) Withdrew for personal use
(n) Cash received from debtors
(o) Electricity Paid
(p) Wages Paid
(q) Royalty Received
(r) Bad debts written off
(s) Bank overdraft
(t) Purchases returns /returns inward
(u) Sales returns/returns out ward.
(v) Purchases during the period
(w) Sales during the period.
13. Journalise/explain the rule of debit and credit in the following cases, indicating clearly
the nature of the accounts.
July 1 Goods purchased from Rao for 20,000

July 5 Goods sold for cash 4,000
July 7 Paid to Rao 10,000
July 10 Goods purchased for cash 3,000
July 17 Paid salaries 5,000
July 24 Goods sold to Reddy 12,000
July 31 Rent paid 2,000
July 31 Interest received 1,000
14. M/s Harisaran & Sons, Delhi took on 1.1.2006 a fire insurance policy for 1,00,000. Paying
2,000 as premium during the year. On 1.7.06 Goods were destroyed by fire for 1,50,000.
The Insurance company agreed to pay 85,000 on 1.8.06. Journalise the above in the books
of M/s Harisaran & Sons.
15. How do we balance the following types of accounts?
(a) Assets
(b) Expense
(c) Capital
(d) Revenue

Answers: Self Assessment Notes
1. The journal 2. Original book of entries/Primary Book of entries

3. Entries 4. Narration
5. ‘To’ 6. Primary book
7. Book of original entry 8. Posting
9. Accounts 10. Posting
11. Principal Book of Account 12. Reference book
13. Ledger accounts

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Notes Unit 6: Subsidiary Books
CONTENTS
Objectives
Introduction
6.1 Meaning of Subsidiary Books

6.1.1 Advantages of Subsidiary Books
6.2 Cash Book

6.2.1 Single Column Cash Book
6.2.2 Two Column Cash Book

6.2.3 Three or Triple Column Cash Book
6.2.4 Petty Cash Book

6.3 Other Subsidiary Books
6.3.1 Purchases Day Book
6.3.2 Sales Day Book
6.3.3 Purchase Returns Book
6.3.4 Sales Returns Book
6.3.5 Bills Receivable Book
6.3.6 Bills Payable Book
6.4 Summary
6.5 Keywords

Objectives

 Prepare Subsidiary books
 Initiate Purchase and purchase return book

 Construct Sales and sales return book
Introduction
Before we list various books into which the journal is sub-divided, let us understand the basis
for its subdivision. You may adopt any basis. But, the principle generally followed is that
transactions of the same nature are to be recorded at one place. For example, the cash receipts
and cash payments may be grouped into one category and recorded in a separate book. Similarly,
all credit purchases of goods may be grouped into one category, all credit sales of goods into
another category and recorded in separate books.

Unit 6: Subsidiary Books
6.1 Meaning of Subsidiary Books Notes
In the past, traders use to keep record of the transaction in the journal. But it was later found not
convenient. If all the transaction is recorded in the journal then the journal book becomes more
thick and difficult to handle it. In big business houses, it becomes impossible to carry on the
work of recording business transaction. Therefore now a days large scale business firms like to
keep record of transaction in subsidiary books instead of journal. Subsidiary books are the book
of original entry and it is also called primary records because the first entry of transaction is
made in subsidiary books. Subsidiary Books refers to books meant for specific transactions of
similar nature. Subsidiary Books are also known as Special journals or day books. To overcome
shortcoming of the use of the journal only as a book of original entry, the journal is subdivided
into specific journals or subsidiary books. In practice, the journal is sub-divided in such a way
that a separate book is used for each category of transactions which are repetitive in nature and
are sufficiently large in number. In any large business the following subsidiary books are
generally used.
1. Cash Book: It is used for recording all receipts and payments of cash, including cash
purchases and cash sales of goods.
2. Purchases Book: It is used for recording credit purchases of goods only.
3. Purchases Returns Book: It is used for recording goods returned to suppliers.
4. Sales Journal: It is used for recording credit sales of goods only.
5. Sales Returns Book: It is used for recording goods returned by the customers.
6. Bills Receivable Book: It is used for recording bills of exchange and promissory notes
received from the debtors.
7. Bills Payable Book: It is used for recording bills of exchange and promissory notes accepted
by the business in favor of creditors.
8. Journal Proper: This book is used for recording all such transactions which are not covered
by any of the above mentioned special journals, for example, credit purchases of fixed
assets, opening entry, rectification entries, etc.
It must, however, be noted that there is no rigidity as to the number of special journals. Depending
on the necessity, the number of journals may be increased or decreased.
Figure 6.1
Subsidiary
Books
Cash Non-Cash
Transaction Transaction
Sales Purchase Bills Bills

Cash Sales Purchases
Returns Returns Receivable Payable
Book Book Book
Book Book Book Book

Notes
Did u know? What is meant by the Non-cash transaction?
A non-cash transaction is a transaction in terms of credit and conditions of the enterprise.

The non-cash transactions shall include the following transactions of the enterprise, which
do not involve any cash; they are as follows:
1. Credit sales Book

2. Credit purchases Book
3. Credit Sales Return Book

4. Credit Purchases Return Book
5. Bills Payable Book – Outcome of Credit transaction, and

6. Bill Receivable Book – Outcome of Credit transaction
6.1.1 Advantages of Subsidiary Books
The following are the advantages of having a number of subsidiary books:

1. Classification of transactions becomes automatic: As there is a separate book for each
type of transactions, the transactions of same nature are automatically brought at one
place.
2. Reference becomes easy: If any reference is required, it can be traced easily by referring to
the appropriate subsidiary book. You do not have to go through all the transactions
recorded in the journal.
3. Facilitates division of work: The division of journal into various subsidiary books
facilitates division of work among many persons. This, in turn, facilitates prompt recording
of transactions and saves a lot of time.
4. More particulars: More details about the transactions can be given-in subsidiary books
than would be possible in one book.
5. Responsibility can be fixed: The work of maintaining a particular book can be entrusted to
a particular person. He will be responsible for keeping it up-to-date and in order.
6. Facilitates checking: When the Trial Balance does not agree, the location of errors will be
relatively easy.
6.2 Cash Book
Having outlined various subsidiary books, we shall now discuss the most important subsidiary
book called ‘Cash Book’. Cash book is the book of accounts where most of the transactions are
generally related with the receipts and payment of cash. It may be either purchase of goods for
cash or sale of goods for cash or it may be either payment of expenses or receipts of income. In
any business there would be numerous cash transactions which involve either receipts or
payments of cash. Cash sales, receipt of cash from debtors, cash purchases, and payments to
creditors, payment of various expenses such as salaries, wages, rent, taxes, etc., are some examples
of transactions involving cash. AU these are recorded in cash book, receipts on one side and
payments on the other.
Every business unit, small or big, maintains a cash book. It enables the businessman to know
and verify the amount of cash in hand from time to time. As a matter of fact, cash book plays a

dual role. It is a book of prime entry and also serves the purpose of a Cash Account. It is designed Notes
in the form of a ledger account and records cash receipts on the debit side and payments on credit
side. It is also balanced in the same way. Hence, when cash book is maintained, there is no need
to have a Cash Account in the ledger.
Kinds of Cash Book
There are different types of cash books maintained by the business. They are:
1. Simple or Single Column Cash Book
2. Two or Double Column Cash Book
3. Three or Triple Column Cash Book
4. Petty Cash Book
We shall now consider them one by one and learn how they are prepared and posted into ledger.
6.2.1 Single Column Cash Book
Look at the pro forma of a Single Column Cash Book shown below. Doesn’t it look like a ledger
account? Yes, it does. In fact a Single Column Cash Book is nothing but a Cash Account. It is used
for recording all cash receipts and cash payments and serves the purpose of Cash Account
as well. It is called Single Column Cash Book just because it has only one amount column on
each side.
Dr. Cr.
(Receipts) ( ) (Payments) ( )
Notes
1. c/d stands for Carried Down whereas b/d stands for Brought Down.
2. One thing which is very important to remember while recording a transaction in
the Cash Book is that no distinction is adopted about capital or revenue nature of
transactions i.e., all the transactions are recorded in the Cash Book.
Recording in Single Column Cash Book
You know that Cash Account is a real account. According to rules, Cash Account is to be debited
when cash is received and credited when cash is paid. Hence, the debit side of the cash book is
used for recording all cash receipts and the credit side for all cash payments. Let us now discuss
how entries are made in this book.
As explained above, whenever cash is received, it is to be recorded on the debit side. The date on
which it is received is recorded in the date column. The name of the account from which it is
received is mentioned in the particulars column. In the L.F. (Ledger Folio) column the page
number of the account in the ledger, where the posting is made, is to be recorded at the time of

Notes posting. The amount column is meant for recording the amount received. Similarly, whenever
cash is paid, it is recorded on the credit side. Here, in particulars column we write the name of
the party to whom payment is made, and complete the other columns in the same manner as on
the debit side.
Posting the Single Column Cash Book
As said earlier, Cash Book also serves the purpose of a Cash Account, so there is no need to open
a Cash Account in the ledger. When a cash transaction is recorded in the cash book, posting of the
cash aspect of the transaction in Cash Account stands fully covered. What remains to be posted
is the other aspect of the transaction. The posting of this aspect will complete the double entry.
The rules of posting therefore are:
1. For all transactions entered on the debit side of the cash book, credit the concerned
Subsidiary Books: C accounts in the ledger individually by writing ‘By Cash Account’;
2. For all transactions entered on the credit side, debit the concerned accounts in the ledger
individually by writing To Cash Account’.
Thus, the posting into the ledger accounts is completed.
Notes The transactions entered on the debit side of the cash book are to be posted on the
credit side of the accounts in the ledger and vice versa.
Balancing of Single Column Cash Book
You have already learnt how to balance a ledger account. The cash book is balanced just like any
other ledger account. The cash book will always show a debit balance. This is because the cash
payments can never exceed the amount of cash available. For example, if you have 10 in your
pocket, can you pay 15? You cannot. So the total of the debit side in the cash book will always
be more than the total of the credit side his difference indicates the cash in hand. It shall be
entered on the credit side by writing ‘By Balance c/d’ in particulars column and showing the
amount in the amount column. Now total the amount columns and you will find that the two
sides are equal.
After closing the cash book, the balance is shown on the debit side by writing ‘To Balance b/d’.
It becomes the opening balance of cash for the next period. Note that the cash book shall
generally show a debit balance and occasionally a nil balance. Look at example it shows the
recording, posting and balancing of a Single Column Cash Book.
Example: Prepare a cash book from the following:
2010 ( )
June 1 Cash in hand 7,850
June 2 Cash Purchases 2300
June 3 Cash Sales 6,250
June 4 Wages paid in cash 25
June 6 Cash paid to Ram 1,220
June 7 Cash Received from Mohan 2260
Contd...
June 8 Paid to a creditor in full Settlement of his account Amounting to 4500 4,410
June 9 Paid cartage 15
June 10 Issued a cheque to a creditor 11,500
92 June 11 LOVELY
Goods PROFESSIONAL
purchased from Arun onUNIVERSITY
credit 2,750
June 15 Goods sold to Amit on credit 6,500
June 17 Cash Sales of 7500 of which 5700 were deposited in bank
June 18 Received a cheque from Amit and deposited in a bank 2,500
2010 ( )
June 1 Cash in hand 7,850
June 2 Cash Purchases 2300
June 4 Wages paid in cash 25

June 6 Cash paid to Ram 1,220
June 7 Cash Received from Mohan 2260 Notes
June 8 Paid to a creditor in full Settlement of his account Amounting to 4500 4,410
June 9 Paid cartage 15
June 10 Issued a cheque to a creditor 11,500
June 11 Goods purchased from Arun on credit 2,750
June 15 Goods sold to Amit on credit 6,500
June 17 Cash Sales of 7500 of which 5700 were deposited in bank
June 18 Received a cheque from Amit and deposited in a bank 2,500
June 24 Rent paid 500
June 29 Electricity paid 1,210
June 30 Cash purchases 2,450
Solution:
Cash Book
Dr. Cr.
Date Particulars L.F. ( ) Date Particulars L.F. ( )
2010 2010
June 1 To Balance b/d 7,850 June 2 By Purchases a/c 2,300
June 3 To Sales a/c 6,250 June 4 By Wages a/c 25
June 7 To Mohan’s a/c 2,260 June 6 By Ram’s a/c 1,220
June 14 To Sales a/c 2,670 June 8 By Creditor’s a/c 4,410
June 17 To Sales a/c 7,500 June 9 By Cartage 15
June 18 To Amit a/c 2,500 June 17 By Bank a/c 5,700
June 18 By Bank a/c 2,500
June 24 By Rent a/c 500
June 29 By Electricity a/c 1,210
June 30 By Purchases a/c 2,450
June 30 By Balance c/d 8,700
29,030 29,030
July 1 To Balance b/d 8,700
Notes
1. Cheque issued on June 10 to a creditor is not recorded in the Cash Book.

2. Goods purchased from Arun on June 11 is also not recorded as per rule no credit
transaction is recorded.
3. Similarly goods sold to Amit on credit is also not recorded.
4. Cheque received from a debtor is recorded treating it as cash received as it is banked

immediately.

Notes 6.2.2 Two Column Cash Book
When cash is received from a debtor, some discount may be allowed to him. Similarly, when
payment is made to a creditor, some discount may be allowed by him. This is termed as Cash
Discount and it has to be recorded in the books of account. While making compound journal
entries for such transactions, you learnt that cash and discount go together. You know that
receipts from debtors and payments to creditors are to be recorded in the cash book. Now the
question arises as to how to record the cash discount. One method is to record the discount aspect
separately in the journal. But this would be cumbersome, and the possibility of failing to record
can also happen. Hence accountants have developed a practice of recording the discount aspect
in tile cash book itself. For this, an extra amount column is added on both sides of the cash book.
Look at the proforma shown below. The discount given to debtors is recorded on the debit side
and the discount received from creditors is recorded on the credit side. Thus, now there are two
amount columns on both sides of the cash book, one for discount and the other for cash. It is
called ’Two Column Cash Book’.
Notes Discount is of two types:
1. Trade Discount: It is given for increasing the volume of sales and it is adjusted in the
invoice, hence no entry is passed in the books of the business, as it is always deducted
from the catalogue price. It is usually allowed by a whole seller to a retailer.
For example, if the printed price of a book is 200 and 10% is offered as a trade
discount, then it is 20/- and the net price would be 180/- i.e., ( 200 – 20) accordingly
entries are to be made by the seller as well as the buyer for 180 in their books.
2. Cash Discount: It is given for prompt payment, hence, it is recorded in the Cash
Book. When discount is given for prompt payment, it is a loss, hence, it is to be
shown on the debit side of the Cash Book whereas discount received is to expedite
payment to the outsiders, hence, it is shown on the credit side of the Cash Book.
No balance of discount columns is taken; simply the total of both the sides is given.
The following is the form of Double Columns Cash Book.

Dr. Cr.
Date Particulars L.F. Discount Cash Date Particulars L.F. Discount Cash
(Receipts) ( ) ( ) (Payment) ( ) ( )
Recording in Two Column Cash Book
Recording of cash transactions in a Two Column Cash Book is similar to Single Column Cash
Book. As for cash discount, it is entered on the debit side if allowed to the debtor and on the
credit side if received from the creditor.
For example, Roop owes 1000 to M/s Goyal Traders of Muzaffar Nagar. The firm offers a
discount of 1% if payment is made within one month. Roop makes the payment within stipulated

time. So he is offered 10 as discount and he makes the payment of 990 to the firm. The Notes
following entry is required to be passed in the Journal if no Cash Book is used in the books of
M/s Goyal Traders.
Dr. Cr.
Cash A/c Dr. 990
Discount A/c Dr. 10
To Roop 1000
(Cash received and discount allowed.)
If Cash Book is used, then both the accounts namely cash and discount are to be recorded on the
debit side of the Cash Book. Similarly, if discount is received for making prompt payment then
such items are to be recorded on the credit side of the Cash Book, i.e., amount received or paid
in the Amount/Cash column and discount allowed/received in the discount column.
Posting the Two Column Cash Book
The entries in the cash columns of Two Column Cash Book are posted to the ledger accounts in
the same way as we did in the case of single column cash book. The entries in the discount
columns are also to be posted to the respective personal accounts. The entries in discount allowed
column will be posted to the credit side of the respective personal accounts by writing ‘By
Discount Allowed A/c’. Similarly, the entries in the discount received column will be posted to
the debit side of the respective personal accounts by writing ‘To Discount Received A/c’.
Example: Cash received from Devi Traders 490 and discount allowed 10: This
transaction will be entered in particulars column on the debit side of the cash book by writing
‘To Devi Traders A/c’. An amount of 10 will be shown in discount allowed column and 490
in cash column. Its posting into Devi Traders’ Account in the ledger will be made as follows:
Devi Traders Account
Dr. Cr
( )
By Cash A/c 490
By Discount Allowed A/c 10
As for the transactions relating to cash, the double entry is complete as soon as postings have
been made to the respective personal accounts. But it is not so for the discount aspect. The cash
book does not serve the purpose of discount account. We have to open ‘Discount Allowed
Account’ and ‘Discount Received Account’ in the ledger. The total of discount allowed columns
on the debit side of the cash book is posted to the debit side of the ‘Discount Allowed Account’
in the ledger by writing ‘To Sundries’. Similarly, the total of discount received column on the
credit side of the cash book is posted to the credit side of the ‘Discount Received Account’ in the
ledger by writing ‘By Sundries’. This will complete the double entry in respect of discount
allowed and discount received.
Notes The postings in the two discount accounts are made only for the totals and not for
the individual transactions. Thus we save time and labour.

Notes Balancing the two Column Cash Book
In case of Two Column Cash Book, only the cash columns are balanced. Procedure is similar to
Single Column Cash Book. The discount columns are not balanced, they are simply totalled.
This is because the two discount columns relate to two separate accounts-the Discount Allowed
Account and the Discount Received Account.
Example: From the following transactions write up a two column cash book and post
into ledger:
1991
Jan. 1 Cash in hand 2,000
Jan. 7 Received from Riaz & Co. 200; discount allowed 10

Jan. 12 Cash sales 1,000
Jan. 15 Paid Zahoor Sons 500; discount received 15

Jan. 20 Purchased goods for cash 300
Jan. 25 Received from Salman 500; discount allowed 15

Jan. 27 Paid Hussain & Sons 300
Jan. 28 Bought furniture for cash 100
Jan. 31 Paid rent 100
Solution:
Cash Book
Dr. Cr.
Date Particulars V.N. L.F. Discount Cash Date Particulars V.N. L.F. Discount Cash
1991 1991
Jan.1 To Balance Jan.5 By Zahoor & Sons 15 500
Jan.7 b/d 10 2,000 Jan.20 By purchase A/c 300
Jan.12 To Riaz & Co. 15 200 Jan.27 By Hussan & Sons 300
Jan.25 To Sales A/c 1,000 Jan.28 By Furniture A/c 100
To Salman 500 Jan.31 By Rent A/c 100
By Balance c/d 2,400
25 3,700 15 3,700
1991
Feb.1 To Balance
b/d 2,400
Riaz & Co.
1991 ( )
Jan. 7 By Cash 200
By Discount 10
Sales Account
1991 ( )
Jan. 12 By Cash 1,000

Salman Account Notes
1991 ( )
Jan. 25 By Cash 500
By Discount 15
Babar Account
1991 ( )
Jan. 18 To Cash 1,000
Zahoor Account
1991 ( )
Jan. 15 To Cash 500
By Discount 15
Purchases Account
1991 ( )
Jan. 20 To Cash 300
Hussain & Sons
1991 ( )
Jan. 27 To Cash 300
Furniture Account
1991 ( )
Jan. 28 To Cash 100
Rent Account
1991 ( )
Jan. 31 To Cash 100
Discount Account
1991 ( ) 1991 ( )
Jan. 31 To Sundries as per Jan. 31 By Sundries as per
Cash book 25 Cash book 15
6.2.3 Three or Triple Column Cash Book
This type of Cash Book is used by the big business organisations because (i) there is large
number of transactions and (ii) receipts and payments are through cheques. Under these Cash
Book three columns meant for (A) Discount, (B) Cash, and (C) Bank, are shown on both the sides
of the Cash Book. Other columns remain as usual. This Cash Book contains three columns; hence
it is termed as Three Column Cash Book.
In the debit side of Triple Column Cash Book, cash receipt, cheque receipts and cash discount
columns respectively. Similarly in the credit side of Triple Column Cash Book payment of cash,
payment by cheque and cash discount received are recorded in Cash, Bank and Discount columns
respectively. The transactions which affect cash and bank account at a time are called contra

Notes entries and are recorded in both sides of Triple Column Cash Book. The balance of cash column
is the closing cash in hand; the balance of bank column is the cash at bank or bank overdraft. The
discount column is not balanced but only totaled.
Following is the form of Three Columns Cash Book:

Three Columns Cash Book
Dr. Cr.
( ) ( ) ( ) ( ) ( ) ( )
Important points to be noted while recording the transactions:

 When opening cash and bank balances are given, record on the debit side of cash and bank
columns
 When opening bank balance is given as overdraft, it should be recorded on the credit side
in the bank column
 When cash is received, it should be recorded on the debit side cash column, in the same
way cash payments made by the firm shown in the cash column on credit side.
 When cash or Cheque is received from debtors through cash sales or any other sources, it
is recorded in the cash column on debit side, if the Cheque is deposited into bank on the
same day or assumed to be deposited on the same day, it is recorded in the bank column
on the debit side.
 If any payment is made or debt is cleared in the form of Cheques, it is recorded in the bank
column on the credit side.
 If the firm allows discount, it is recorded in the discount column on the debit side.
 If the discount is received, it is recorded on the discount column on the credit side.
 If the Cheques sent to bank for collection are dishonored, these should be recorded in the
bank column on the credit side. Similarly, if we receive any information that the Cheques
issued by us are dishonored, it should be promptly noted in the bank column on the debit
side.
 If cash is withdrawn from the bank for the business use, it should be recorded in the cash
column on debit side and bank column on the credit side.
 If we deposit cash into bank it should be recorded in the bank column on debit side and
credit side in the cash column. This type of transaction is called as contra entry. Where
both the sides are affected. To indicate that is a contra entry, the alphabet ‘C’ is mentioned
in the Ledger folio column on the both sides.
Contra entries will appear in the following occasions:
 When an account is opened with a bank

 The firm’s cash is deposited in the bank
 The cash is withdrawn from bank for office use

 The Cheques received from debtors, are deposited in the bank.
Moreover, if the company has opened two bank accounts i.e., one bank account in State bank of
Patiala and another bank account in Panjab National Bank then withdrawal from one bank and
deposit the same to another bank will also be shown through contra entry.

Solution:
Cash Book
Date Particulars V. No. L.F. Cash Bank Discount Date Particulars V. No. L.F. Cash Bank Discount
2011 HDFC PNB HDFC PNB 2011 HDFC PNB HDFC PNB
April (`) (`) (`) (`) (`) April (`) (`) (`) (`) (`)
1 To Opening Balance 15,200 25,750 20,000 4 By Cash A/c (c) 10,000
3 To Mars Ltd. A/c 22,850 150 10 By Salaries A/c 20,500
4 To Bank A/c (c) 10,000 12 By Neptune Ltd. 46,500 500
A/c
20 To Pluto Ltd. A/c 15,500 15 By Mars Ltd. A/c 22,850
25 To M/s Ghaziabad 16,700 300 30 By Bank A/c (c) 5000
Mkt. A/c
30 To Cash A/c (c) 5,000
30 To Balance A/c 19,800 30 By Closing 15,200 30,750
Balance
40,700 53,600 56,500 150 40,700 53,600 56,500 500

Notes
99
Notes
Example: Given below are the cash and bank transactions of Zupiter Ltd. for the month
of April 2011:
2011
April 1 Opening balance-cash 15,200; HDFC bank 25,750, PNB bank 20,000.
April 3 Received a cheque of HDFC from Mars Ltd., a customer, of 22,850 in full settlement
of their dues of 23,000.
April 4 Withdrew cash from PNB bank 10,000.

April 10 Paid salaries by cash 20,500.
April 12 Issued cheque of PNB to Neptune Ltd., a supplier, of 46,500 in full settlement of his
claim of 47,000.
April 15 Cheque of HDFC received from Mars Ltd., dishonoured by bank.
April 20 Cash received from Pluto Ltd. 15,500.

April 25 Collected a cheque of PNB from M/s Ghaziabad Mkt. 16,700 in settlement of their
dues of 17,000.
April 30 Deposited 5,000 to HDFC bank.
Prepare a triple column cash book.
(Note: See solution of the above example on the previous page)
Example: From the following particulars, write up the Cash Book of M/s K.K. of Chennai
with Cash and Bank columns and bring down the final balance.
2009 ( )
Oct. 1 Cash in hand 100
Oct. 1 Cash at bank 3,500
Oct. 5 Paid salary by cheque 250
Oct. 7 Paid to K.K. & Co. by cheque 260
Oct. 9 Received a cheque from B & Co. 2,500
Oct. 12 Bought goods for cash paid by cheque 750
Oct. 15 Received cash from M/s S. Chand 1,500
Oct. 17 Deposited cash into bank 1,450
Oct. 18 Sundry creditors were paid by cheque 1,250
Oct. 19 Received from debtors by cheque which could not be sent to bank 1,780
Oct. 20 B & Co. cheque dishonoured 2,500
Oct. 22 B & Co. paid cash 2,500
Oct. 24 R & Co. issued a cheque for 470 in full satisfaction of his account for 500
Oct. 27 Shyam Lal was paid 395 in full settlement of his A/c amounting to 400
Oct. 31 Deposited into the Bank 2,200

Solution: Notes
Three Columns Cash Book
Dr. Cr.
( ) ( ) ( ) ( ) ( ) ( )
2009 2009
Oct. 1 To Balance b/d 100 3,500 Oct. 5 By Salaries A/c – 250
Oct. 9 To B & Co. – 2,500 Oct. 7 By K & Co. – 260
Oct. 15 To S. Chand 1,500 – Oct. 12 By Purchase A/c – 750
Oct. 17 To Cash A/c (C) – 1450 Oct. 17 By Bank A/c (C) 1450 –
Oct. 19 To Debitors 1,780 – Oct. 18 By S. Creditors – 1250
A/c 2,500 – Oct. 20 By B & Co – 2,500
Oct. 22
To B & Co. 30 470 Oct. 27 By Shyam Lal 5 395
Oct. 24
To R & Co. (C) 2,200 Oct. 31 By Bank A/c (C) 2,200
Oct. 31 To Cash A/c By Balance c/d 4,885 5,110
30 5,880 10,120 5 5,880 10,120
6.2.4 Petty Cash Book
The Petty Cash Book records all the transactions which are very small in terms of money. In such
situation, a fixed amount of cash in the beginning of the month is given to a person who is
known as petty cashier. After a fixed period say a week or month, he is again reimbursed or paid
back the amount whatever he has spent at the end of week or period. Such a system is known as
imprest system.
Thus, this type of system (the Imprest System) is very useful. It contains one column to record
the receipt of cash to be taken from the head cashier and other column to record payments of
various counts. All such payments are to be totalled to know the total amount spent, so that
necessary accounts be debited. The following is the proforma of Petty Cash Book:
Analytical Petty Cash Book
Receipts Date Particulars Voucher Total Amount Printing & Cartage Postage Remarks
( ) No. ( ) Stationery
Example: Enter the following transactions in Analytical Petty Cash Book.
2009 ( )
Jan. 1 Received cheque from head cashier 100.00
Jan. 2 Paid for postage and telegram 15.00
Jan. 3 Stationery purchased 5.00
Jan. 14 Paid for cartage 8.00
Jan. 18 Paid for travelling 7.00
Jan. 27 Tea for guests 6.00
Jan. 29 Office cleaning charges 12.00
Jan. 30 Paid for carriage 4.00
Jan. 31 Telegram charges 8.00

Notes Solution:
Analytical Petty Cash Book
( )
Receipts Date Particulars Voucher Total Postage Stationary Cartage Tea & Remarks
No. Amount telegram Travelling office
expenses
2009
100.00 Jan. 1 To cash a/c –
Jan. 2 By Postage & 15.00 15.00 – – –
telegram
Jan. 3 By Stationery 5.00 – 5.00 – –
Jan. 14 By Cartage 8.00 – – 8.00 –
Jan. 18 By Travelling 7.00 – – 7.00 6.00
Jan. 27 By Tea for guest 6.00 – – – 12.00
Jan. 29 By office cleaning 12.00 – – – –
charges
Jan. 30 By Carriage 4.00 – – –
Jan. 31 By Telegram 8.00 8.00 – 4.00
By Balance c/d 35.00 23.00 5.00 19.00 18.00
Total 100.00
35.00 Feb. 1 To Balance b/d
65.00 To Cash
Self Assessment
Fill in the blanks:

1. Only................................. are recorded in the cash book.
2. Cash payments are recorded on the.............................. of the cash book.
3. According to the rules of accounting, all the business transactions are firstly recorded in
journal and then posted in.........................................
4. The.................................. is an incentive given or received for prompt payment.
5. The........................... records all the transactions which are very small in terms of money.
6. An.................................... is given to the buyer when sales are made on credit
7. Purchase return book is also known as...................................
6.3 Other Subsidiary Books
Following are other subsidiary books:
6.3.1 Purchases Day Book
All credit purchases are recorded in this book which are either used for resale or raw materials
used for production. The purchases which are made for cash are not at all recorded in this book.
Similarly, the assets which are bought for running the business are also not recorded such as
machinery, furniture, etc. All these assets and cash purchases are separately recorded in the
journal Cash Book.

Following is the form of Purchases Day Book: Notes

Purchases Day Book
Date Particulars Invoice No. L.F. Details ( ) Amount ( )

I II III IV V VI
(a) Column is meant for date.

(b) Column is meant for writing details regarding name of supplier, name of articles purchased
and number i.e., quantities.
(c) Invoice No.: An Invoice is given to the seller when purchases are made on credit
(d) Ledger Folio
(e) Amount of the purchase
Thus, all the credit purchases are totalled which give us the amount of total credit purchases
made during the period.
Example: Following information is obtained from the books of Mr. Joseph.

2011 ( )
July 1 Purchased goods from Robert on credit 4000
July 2 Purchased office furniture from Delite Furniture on credit 5000
July 3 Purchased on credit goods from Robinson 3000
July 4 Purchased stationery on credit from Bittoo 500
July 5 Purchased goods for cash 7,500
You are required to make out a purchases day book of Mr. Joseph.
Solution:
Date Particulars Invoice No .1 L.F. Amount

( )
2011
July 1 Robert 4000
July 3 Robinson 3000
Total 7000
Notes
1. Furniture purchased or stationery purchased is not at all recorded as they were

bought for running and maintaining the business. Hence to be recorded in the
journal of the business.
2. Similarly goods purchased for cash are also not recorded in this book. It would be
recorded either in the main journal or in the Cash Book.
Thus, It is clear from the above Purchases Day Book that the total credit purchases made during
the period are 7,000 and total amount of creditors to be shown and posted and credited in their

Notes accounts is also 7,000. Thus, the total amount of debit (purchases) equals the total amount of
credit (creditors) satisfying the very principle of double entry system of book-keeping
(accounting).
Task Enter the following transactions in the Purchases Book and post the same in the
relevant ledger accounts.
2001 ( )
Aug. 1 Bought goods from S 1,500
Aug. 4 Bought goods from N 1,000
Aug. 8 Bought goods from A 500
6.3.2 Sales Day Book
The goods which are sold on credit are recorded in this book but if sales are made for cash or
assets are sold either for cash or on credit, they are not at all recorded in this book, but are
recorded either in the cash book or in the journal. The form of this book is similar to that of
purchases book. Following is the form of Sales Day Book.
Date Particulars Invoice No. L.F. Details ( ) Amount ( )

I II III IV V VI
Details of goods-sold-trade discount if any total
Thus, all the credit sales are totalled which give us the amount of total credit sales made during
the period.
Invoice: An Invoice is given to the buyer when sales are made on credit.
Example: Following are the transactions of a publishing house, Delhi. Enter the following
in the sales book.
2011
July 1 Sold to Manoj Book Depot, Delhi on credit.
10 copies of introduction to Accounting Part I for XII Class @ 55 each.
5 copies of Mathematics Part II for XII Class @ 90 each.
Trade Discount allowed 20%.
July 10 Sold to M/s Agarwal Book Depot, Meerut on credit.
10 copies of Introduction to Accounting Part I for XII Class @ 55 each.
5 copies of physics for XII class @ 120 each.
Trade discount 10%.
July 15 Sold to M/s Gupta & Sons 1 typewriter for 500
July 18 Sold to M/s Kishan Lal & Co. for cash.
5 copies of Physics for XII Class @ 120 each.
Trade Discount 20%.
July 25 Sold to M/s Mittal Bros. Kanpur on credit
5 copies of Chemistry for XII Class @ 100 each.
5 copies Mathematics for XII Class @ 90 each.
Trade discount 15%

Solution: Notes
Sales Day Book
Date Particulars L.F. Voucher Details Amount

No.
— P. — P.
2011
July 1 M/s Manoj Book Depot, Delhi
10 copies Introduction to
Accounting Part I
For XII Class
@ 55/-each 550 — 00
5 Copies Mathematics Part II
for XII Class
@ 90/-each 450 — 00
1000 — 00
Trade discount @ 20% 200 — 00 800 – 00
July 10 M/s Agarwal Book Depot, Meerut.
10 copies Introduction to Accounting
Part I for XII Class
@ 55/-each 550 — 00
5 Copies Physics for XII Class 600 — 00
@ 120/-each 1150 — 00
Trade discount @ 10% 115 — 00 1035 — 00
M/s Mittal Bros, Kanpur
5 copies of Chemistry for XII Class 500 — 00
@ 100/- each 450 — 00
July 25 5 copies Mathematics for XII Class 950 — 00
@ 90/-each 142 — 00
Trade discount @ 15% 807 — 50
Total 2642 – 50
Notes: 1. Sale of typewriter is not entered in this day book because it is an asset.
2. Similarly Cash Sales to M/s Kishan Lal & Co. is also not recorded because of cash sale.
6.3.3 Purchase Returns Book
This book is also known as Returns Outward Book. This book records all the returns to the
suppliers which are made during the period. The return is of goods or raw materials purchased
from the Suppliers and Return is on account of difference in quantity or quality. This book is
used when the returns are in sufficient number. If returns are not much, then it may be recorded
in the Journal. The form of Purchase Returns Book is similar to that of Purchase Day Book.
Form of Purchase Returns Book
Date Particulars L.F. Debit Note No. Details ( ) Amount ( )

I II III IV V VI

Notes
!
Caution Debit Note: Whenever goods are returned to the supplier, a letter which is known
as the debit note is also sent along with returned goods. The purpose of this note is to
inform the supplier about this deduction or debit given to his account. This note contains
the following particulars such as:
(a) Name and address of the supplier
(b) Description of the goods returned
(c) Rate and total value
(d) Invoice No., along with date
(e) Signature
Example: Enter the following transactions in proper Subsidiary Books.

2011 ( )
Jan. 1 Purchased goods from Ramu 5.000
Jan. 2 Bought goods from Hari 6,500
Jan. 8 Goods returned to Hari 50
Jan. 10 Bought goods from Gopal 15,000
Jan. 14 Krishna sent goods. 20,000
Jan. 20 Returned goods to Gopal 150
Jan. 22 Returned goods to Ramu 80
Jan. 25 Goods purchased on credit from X & Co. 8,000
Solution:
Purchases Day Book
Date Particulars L.F. Invoice No. Amount ( )

2011
Jan.1 Ramu 5.000
Jan.2 Hari 6500
Jan.10 Gopal 15000
Jan. 14 Krishna 20,000
Jan.25 X & Co. 8000
Total 54,500
Purchases Returns Book
Date Particulars L.F. Debit note No. Amount ( )

2011
Jan.8 Hari 50
Jan.20 Gopal 150
Jan.22 Ramu 80
Total 280

6.3.4 Sales Returns Book Notes
This is also known as Returns Inward Book. This book records all the transactions related to the
return of goods by the customers. As and when goods are returned by the customers, a credit
note is issued and the entry is made in this book. This book again contains the same columns
which a Purchases Returns Book contains. There is only one difference i.e. in place of Debit Note
No. the column is used to note the Credit Note No. The form of sales Returns Book is as follows:
Sales Returns Book
Date Particular Credit Note No. L.F. Details ( ) Amount ( )

I II III IV V VI
!
Caution Credit Note: As and when goods are returned by the customers, a credit note is
being sent to him. Credit note means that his account has been credited with the amount
of goods return.
Example: Enter the following transactions in the Sales Returns Book

2011
July 01 Ramesh returned goods 6500
July 10 Allowance claimed by Murthy 9,500 accepted
July 15 Suresh returned us goods worth 2000
July 20 Received a Debit note from Narayan for 600
July 25 Received goods returned by Chandra 500
July 30 Allowance granted to Mohan for breakage 500
July 30 Received goods returned by Arvind and paid 1,600 in full settlement.
Solution:
Sales Returns Book
Date Particulars Credit Ledger Amount

Note No. Folio ( )
2011
Jul 1 Ramesh 6,500
Jul 10 Murthy 9,500
Jul 15 Suresh 2,000
Jul 25 Chandra 500
Jul 30 Mohan 500
Total 19,000
Notes: 1. Transaction of July 20, receiving a debit note is not a transaction. Sales Returns book is
written on the basis of Credit note.
2. Transaction of July 30, it is a cash transaction. It is not to be entered in sales returns book.

Notes Ledger
Ramesh A/c
Dr. Cr.
Date Particulars JF Amount Date Particulars JF Amount
( ) ( )
2011
Jul 1 By Sales Returns A/c 6,500
Murthy A/c
Dr. Cr.
( ) ( )
2011
Suresh A/c
Dr. Cr.
( ) ( )
2011
Chandra A/c
Dr. Cr.
( ) ( )
2011
Jul 25 By Sales Returns A/c 500
Chandra A/c
Dr. Cr.
( ) ( )
2011
Jul 30 By Sales Returns A/c 500
Sales Returns A/c

Dr. Cr.
( ) ( )
2011
Jul 31 To Sundries as per 19,000
Sales Returns book
6.3.5 Bills Receivable Book
A bill of exchange accepted by a customer is called bills receivable. When bills are received from
debtors and number of such bills received is larger (big) then such bills are recorded in a
separate book, known as bills Receivable Book. All such bills are totalled for a particular period
and are posted in the accounts of the debtors from whom such bills are received. Following is
the form of Bills Receivable Book.

Bills Receivable Book Notes

Date Date From Drawer Acceptor Endorser Date Tenor Due Where L.F. Cash Amount Remarks
of of Whom (s) of or date payable Discount of bill
Receipt Receipt Received Bill Terms allowed ( )
of
Bill
Example: From the following transactions of a trader prepare the bills receivable book
and post it into ledger:
2011
January 5 Drew a bill on Amit & Co. at 2 m/d for 700.
January 10 Acceptance received from Rohit at 3 m/d for 1,000.

January 20 Pankaj gives his acceptance at 3 m/d for 800.
January 30 Bill at 2 m/d for 100 is drawn on Gaurav.

Solution:
Bills Receivable Book
Date Particulars Term Due Date L.F. Amount

( )
2011
Jan. 5 Amit & Co. 2 m/d March 8 700
Jan. 10 Rohit 3 m/d April 13 1,000
Jan. 20 Pankaj 3 m/d April 21 800
Jan. 30 Gaurav 2m/d March 3 100
2,600
Bills Receivable Account
2011 ( )
Jan. 30 By Sundries as per 2,600
B/R Book
Amit & Co.
2011 ( )
Jan. 5 By Bill receivable 700
Rohit Traders
2011 ( )
Jan. 10 By Bill receivable 1,000
Pankaj
2011 ( )

Notes Gaurav
2011 ( )
6.3.6 Bills Payable Book
Where either purchases are made for credit or loans are taken, then Bills are issued which are
termed as Bills Payable. The book in which these bills are recorded is termed as Bills Payable
Book. All such Bills are totalled after a lapse of a certain period and are posted in the accounts of
the creditors to whom such bills are issued. Following is the form of Bills Payable Book:
Bills Payable Book
Date To Term Drawer Acceptor Endorser Due Where L.F. Amount Remarks
Whom (s) Date payable ( )
Payable
Example: From the following transactions of a trader prepare the bills payable book
and post it into ledger:
2011
January 5 Accepted a bill at 3 m/d for 200 drawn by Rohen & Co.
January 20 gave acceptance at 2 m/d for 500 to Dhruv.
January 30 Acceptance at 1 m/d for 500 given to Feroz & Co.
Solution:
Bills Payable Book
Date Particulars Term Due Date L.F. Amount

( )
2011
Jan. 5 Rohen & Co. 3 m/d April 8 200
Jan. 20 Dhruv 2 m/d March 23 500
Jan. 30 Feroz & Co. 1 m/d March 30 500
1,200
Bills Payable Account
2011 ( )
Jan. 31 By Sundries as per 1,200
B/p Book
Rohen & Co.
2011 ( )
Jan. 5 By Bill Payable 200
Dhruv
2011 ( )

Feroz & Co. Notes
2011 ( )
Task Prepare a Cash Book with Bank column only:
2009 ( )
July 1 Balance at bank 10,000
July 4 Received a cheque from Pankaj 5,000
July 7 Issued a cheque to Rakesh 6,000
July 10 Received dividend by bank draft 2,000
July 15 Mukesh was paid by issuing a cheque 1,500
July 20 Deposited into bank 7,000
July 24 Interest collected by bank 200
July 28 Dividend collected by bank 500
July 31 Bank charges debited 800
Hint: Total of Cash Book 24,700, Closing Balance 16,400.
Self Assessment
Multiple Choice Questions:

8. Cash book is to record the:
(a) Cash receipts
(b) Cash Payments
(c) Both (a) & (b)
(d) Cash receipts, payment, Bank Receipts, payments, Discount received and paid
9. Sales book is to record the:

(a) The entire sales volume
(b) The cash sales only
(c) The credit sales only
(d) The credit sales with the discounts

10. When equity (net assets) is subtracted from total assets the amount remaining is known as
which of the following?
(a) Total revenue

(b) Total liabilities
(c) Total expenses

(d) Net income or net loss
(e) All of the above

Notes 6.4 Summary
 The regular/frequent occurrence of transactions are recorded only in the separate books
which are known as subsidiary book of accounts or subsidiary journals, instead of being
recorded in the regular journal.
 Subsidiary books are classified on the basis of transactions viz Cash transactions and
Noncash-transactions.
 The purchases book is known in other words as purchase journal. It is a book meant for
credit purchases only for resale.
 Purchase return book is a book of goods returned to the supplier which are out of credit
purchases.
 Sales book is a book maintained by the enterprise only during the moment of selling the
goods on credit. It is known in other words as a sales journal.
 Sales return is a book that registers the goods sold on credit and received from the buyers.
6.5 Keywords
Bill of Exchange: A bill of exchange is an unconditional order signed by the maker which directs
the recipient to pay a fixed sum of money to a third party at a future date.
Journal: The primary book in which the transactions are recorded first time.
Ledger: It is the classification of accounts in which various accounts are maintained.
Non-cash Transactions: A Non-cash transaction is a transaction in terms of credit and conditions
of the enterprise.
Purchase Book: It is known in other words as purchase journal. It is a book meant for credit
purchases only for resale.
Sales Book: It is a book maintained by the enterprise only during the moment of selling the
goods on credit. It is known in other words as a sales journal.
Sales Return Book: Sales return is a book that registers the goods sold on credit and received
from the buyers.
Subsidiary Book: It is a book maintained for routine transactions of the enterprise.
Trial Balance: Trial balance is a list in which all the balances of the accounts of Ledger are
showed to test the arithmetical accuracy of the posting in ledger.
1. Illustrate the preparation of records for non cash transactions with suitable examples.
2. Explain the nature of petty cash book.

3. What is the difference between a petty cash book and a simple cash book?

4. Compose three columns Cash Book from the following transactions: Notes
2006 ( )
Jan. 1 Cash in hand 567
Jan. 1 Cash at bank 12,675
Jan. 2 Received from Ashish and 7,900
allowed him a discount 100
Jan. 4 Deposited into the bank 5,000
Jan. 6 Furniture purchased for cash 2,500
Jan. 7 Paid to Vikas by cheque 7,800
and received discount 200
Jan. 14 Received from Manish by cheque and Deposited into bank 5,000
Jan.16 Cash Sales 8,000
Jan. 20 Deposited into bank 6,000
Jan. 25 Purchased a Machine and paid by a cheque 12,000
Jan. 26 Paid by cheque to Kishore 1,370
and received discount 30
Jan. 27 Withdrew from bank for office use 2,500
Jan. 28 Purchased goods for cash 5,000
Jan. 29 Paid wages by cheque 4,500
Jan. 31 Paid Rent 500
5. What are the different types of trade bills books?
6. Write a short note on the following:
(a) Debit Note
(b) Credit Note
7. Make the proforma of purchase return book and sales return book and explain it.
8. Explain the significance of preparing subsidiary books of accounts.
1. cash transactions 2. credit side
3. ledger 4. discount
5. petty cash book 6. Invoice
7. Returns Outward Book 8. (d)
9. (c) 10. (b)




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Unit 7: Trial Balance
Unit 7: Trial Balance Notes
CONTENTS
Objectives
Introduction
7.1 Meaning of Trial Balance

7.1.1 Objects and Functions of Trial Balance
7.2 Methods of Preparation of Trial Balance

7.3 Types of Errors
7.4 Summary
7.5 Keywords

Objectives

 Understand the preparation of trial balance
 Identify the types of errors
 Distinguish the errors which are revealed and not revealed by the trial balance
Introduction
Every transaction which takes place in the business is recorded either in the journal or in the
subsidiary books. It is posted in the concerned accounts. After posting is over, final accounts are
prepared in order to know the operational results of the business during a particular or fixed
period and also to depict financial position of the business on a particular date. Final accounts
can be prepared only if information relating to balances of all accounts is available. This function
of supplying necessary and accurate balances is performed by Trial Balance so it is very much
necessary to know the meaning of Trial Balance.
7.1 Meaning of Trial Balance
Trial balance is a list in which all the balances of the accounts of Ledger are showed to test
the arithmetical accuracy of the posting in ledger. It is prepared after the end of a particular
period – year, half year or quarter. Trial balance prepares a base for the preparation of final
accounts. After the completion of trial balance, the financial accounts - P&L Account and Balance
Sheet are prepared to disclose the overall results of the business after a period. The proforma of
a trial balance is given hereunder:
Proforma of Trial Balance
S. No. Particulars Amount Dr. ( ) Amount Cr. ( )

Notes Generally three columns are made in the trial balance. The first wide column is kept for the
particulars of accounts and the two columns for debit amount and credit amount are made.
7.1.1 Objects and Functions of Trial Balance
The main objectives of preparing a trial balance are to check the arithmetical accuracy of all
transactions. In every trial balance, the total of debit balances must agree with the total of credit
balances. It is a proof of arithmetical accuracy of postings but it is not a conclusive evidence of
correctness of the books of accounts. The other objects and functions of a trial balance are as
under:
1. It serves as a summary of all accounts.
2. It helps in locating errors if any.

3. It acts as a base for the preparation of final accounts.
7.2 Methods of Preparation of Trial Balance
A trial balance is prepared by the following three methods:

1. Balance Method
2. Total Method
3. Balance and Total Method or Combined Method
Among the above methods the balance method is the most popular and statutory method to
prepare the Trial Balance. Under this method the balance of all the accounts are recorded. If an
account shows a debit balance in the ledger, this balance is recorded in the debit side of the trial
balance and if it has a credit balance, in the credit side of it is written. If any account has no
balance means its total of debit side is equal to the total of credit side, it is not recorded in the
Trial Balance. After recording the balances of all accounts of the Ledger, the amounts of both the
sides are totalled to check the arithmetical accuracy of the ledger. If the total of debit side agrees
with the total of credit side, it proves that books are at least arithmetically correct. However, the
trial balance is not the sole proof of accuracy of the books of Ledger. There may be errors which
are discussed later in this unit.
Total Method instead of taking balance of each account, the total of both the sides of each account
is taken. Combined method is both the above explained method i.e., balance as well as total
method are used. This method is not in use because of wastage of time and labour.
Illustration 1: Prepare ledger accounts and also a trial balance from the following transactions:
2011 ( )
July 1 Ram commenced business with cash 10,000
July 3 Paid to bank 8,000

July 3 Bought goods for cash 500
July 5 Bought office furniture 400

July 10 Drew from bank for office 1,000
July 13 Goods sold to Shyam 600

July 15 Bought goods from Krishan 410

July 18 Trade expenses paid 100 Notes
July 19 Received cash from Shyam 590
allowed him discount 10

July 25 Wages paid 50
July 29 Krishan paid off in full settlement of his account 400
July 31 Rent paid 100
July 31 Interest due on Capital 500
Solution:
Capital A/c
Dr. Cr.
( ) ( )
2011 2011
July 31 To Balance c/d 10,500 July 1 By Cash 10,000
July 31 By Int. on capital 500
10,500 10,500
Aug 1 By Balance b/d 10,500
Cash A/c
Dr. Cr.
( ) ( )
2011 2011
July 1 To Capital A/c 10,000 July 3 By Bank A/c 8,000
July 10 To Bank A/c 1,000 July 3 By Purchases A/c 500
July 19 To Shyam 590 July 5 By Office furniture
A/c 400
July 18 By Trade Exp. A/c 100
July 25 By Wages A/c 50
July 29 By Krishan 400
July 31 By Rent A/c 100
July 31 Balance c/d 2040
11,590 11,590
Aug. 1 To Balance b/d 2,040
Bank A/c
Dr. Cr.
( ) ( )
2011 2011
July 3 To Cash A/c 8,000 July 10 By Cash A/c 1,000
July 31 Balance c/d 7,000
8,000 8,000
Aug. 1 To Balance b/d 7,000

Notes Purchases A/c
Dr. Cr.
( ) ( )
2011 2011
July 3 To Cash A/c 500 July 31 By Balance c/d 910
July 15 To Krishan 410
910 910
Aug. 1 To Balance b/d 910
Sales A/c
Dr. Cr.
( ) ( )
2011 2011
July 31 To Balance c/d 600 July 13 By Shyam 600
Aug. 1 By Balance b/d 600
Office Furniture A/c
Dr. Cr.
( ) ( )
2011 2011
Shyam A/c
Dr. Cr.
( ) ( )
2011 2011 By Cash A/c 590
July 13 To Sales A/c 600 July 19 By Discount A/c 10
600 600
Krishan A/c
Dr. Cr.
( ) ( )
2011 2011
July 29 To Cash A/c 400 July 15 By Purchases A/c 410
July 29 Discount A/c 10
410 410

Trade Expenses A/c Notes

Dr. Cr.
( ) ( )
2011 2011
Wages A/c
Dr. Cr.
( ) ( )
2011 2011
Rent A/c
Dr. Cr.
( ) ( )
2011 2011
Interest on Capital A/c

Dr. Cr.
( ) ( )
2011 2011
July 31 To Capital A/c 500 July 31 By Balance c/d 500
Discount A/c
Dr. Cr.
( ) ( )
2011 2011
July 19 To Shyam 10 July 29 By Krishan 10
To Balance c/d 10 July 31 By Balance c/d 10
20 20
Aug. 1 To Balance b/d 10 Aug. 1 By Balance b/d 10
Notes: No balance is ascertained practically but the total of both the sides of discount A/c is brought
down in the trial balance.

Notes Trial Balance

(As on July, 31, 2011)
S. No. Particulars Amount (Dr.) Amount (Cr.)

( ) ( )
Capital A/c ---- 10,500
Cash A/c 2,040 ---
Bank A/c 7,000 ---
Purchases A/c 910 ---
Sales A/c ---- 600
Office Furniture A/c 400 ----
Trade Expenses A/c 100 ----
Wages A/c 50 ----
Rent A/c 100 ----
Interest on Capital A/c 500 ----
Discount A/c 10 10
Total 11,110 11,110
Illustration 2: From the following ledger accounts of Kalkaji Ltd. prepare Trial Balance for year
2010-2011 by (i) total method (ii) combined method (both balance method and total method):
Cash A/c
Dr. Cr.
( ) ( )
2011 2011
Jan. 1 Capital A/c 50,000 Jan. 2 Bank A/c 40,000
Jan. 28 Ranjeet 9,900 Jan. 12 Freight A/c 200
Jan. 31 Salary A/c 3,000
Jan. 31 Rent A/c 2,400
59,900 45,600
Bank A/c
Dr. Cr.
( ) ( )
2011 2011
Jan. 2 Cash A/c 40,000 Jan. 8 Furniture A/c 12,000
Jan. 14 Sales A/c 16,000 Jan. 10 Purchases A/c 20,000
Jan. 20 Vikas 12,000
Jan. 31 Drawings 4,000
56,000 48,000
Furniture A/c
Dr. Cr.
( ) ( )
2011
Jan. 8 Bank A/c 12,000
12,000

Capital A/c Notes

Dr. Cr.
( ) ( )
2011
Jan. 1 Cash A/c 50,000
50,000
Purchases A/c
Dr. Cr.
( ) ( )
2011
Jan. 10 Bank A/c 20,000
Jan. 12 Vikas 15,000
35,000
Sales A/c
Dr. Cr.
( ) ( )
2011
Jan. 14 Bank A/c 16,000
Jan. 20 Ranjeet 14,000
30,000
Vikas A/c
Dr. Cr.
( ) ( )
2011 2011
Jan. 20 Bank A/c 12,000 Jan. 12 Purchases A/c 15,000
12,000 15,000
Ranjeet A/c
Dr. Cr.
( ) ( )
2011 2011
Jan. 20 Sales A/c 14,000 Jan. 25 Cash A/c 9,900
Jan. 28 Discount A/c 100
14,000 10,000
Freight A/c
Dr. Cr.
( ) ( )
2011
Jan. 12 Cash A/c 200
200

Notes Salary A/c

Dr. Cr.
( ) ( )
2011
3,000
Rent A/c
Dr. Cr.
( ) ( )
2011
2,400
Drawings A/c
Dr. Cr.
( ) ( )
2011
Jan. 31 Bank A/c 4,000
4,000
Discount A/c
Dr. Cr.
( ) ( )
2011
Jan. 28 Ranjeet 100
100
Solution:
(i) Total Method

Trial Balance of Kalkaji Ltd. as on 31st January, 2011
Name of the Ledger Account Balance (Dr.) Balance (Cr.)

( ) ( )
Cash 59,900 45,600
Bank 56,000 48,000
Furniture 12,000 –
Capital – 50,000
Purchases 35,000 –
Sales 30,000
Vikas 12,000 15,000
Ranjeet 14,000 10,000
Freight 200 –
Salary 3,000 Contd...
Rent 2,400
Drawings 4,000
122 Discount LOVELY PROFESSIONAL UNIVERSITY 100

1,98,600 1,98,600
Cash 59,900 45,600
Bank 56,000 48,000
Furniture 12,000 –
Capital – 50,000
Purchases 35,000 –
Sales 30,000
Vikas 12,000 15,000
Ranjeet 14,000 10,000
Freight 200 – Notes
Salary 3,000
Rent 2,400
Drawings 4,000
Discount 100
1,98,600 1,98,600
(ii) Combined Method (both balance method and total method)

Trial Balance of Kalkaji Ltd. as on 31st January, 2011
Dr. Cr.
Name of the Ledger Account Total Amounts Balance Amounts
( ) ( ) ( ) ( )
Cash 59,900 45,600 14,300 –
Bank 56,000 48,000 8,000 –
Furniture 12,000 – 12,000 –
Capital – 50,000 – 50,000
Purchases 35,000 – 35,000 –
Sales 30,000 – 30,000
Vikas 12,000 15,000 – 3,000
Ranjeet 14,000 10,000 4,000 –
Freight 200 – 200 –
Salary 3,000 – 3,000 –
Rent 2,400 – 2,400 –
Drawings 4,000 – 4,000 –
Discount 100 – 100 –
1,98,600 1,98,600 83,000 83,000
Preparation of Trial Balance with the Help of Balances
In the examination problems the Ledger accounts are not given but a list of balances of accounts
is given. With the help of these balances the students are asked to prepare the Trial Balance.
Students should kept in mind the following rules to prepare a Trial Balance:
1. The balances of all the assets accounts and drawing accounts are recorded in the debit side
of the Trial Balance.
2. The balances of all the liabilities and capital accounts are recorded in the credit side of the
Trial Balance.
3. The balances of all expenses and losses of the business are showed in the debit side of the
Trial Balance.
4. The balances of all incomes and gains are disclosed in the credit side of the Trial Balance.
5. The balances of sales and sale returns are disclosed in the credit side and debit side of Trial
Balance respectively.
6. The balances of purchases and purchase returns are disclosed in the debit side and credit
side of the Trial Balance respectively.

Notes Illustration 3: Mr. Akshey Kumar furnishes the following balances as on 31st March, 2008. You
have to prepare a Trial Balance with the following information:
Particulars ( ) Particulars ( )
Interest on Capital 24,000 Salaries 1,28,000
Creditors 6,00,000 Capital 8,00,000
Discount Received 23,000 Drawings 2,46,000
Loan 1,74,000 Machinery 3,00,000
Purchase Returns 40,000 Bills Payable 20,000
Sales Return 6,000 Furniture 6,00,000
Advertisement 1,63,000 Debtors 5,00,000
Commission Received 20,000 Bank Loan 2,00,000
Rent 10,000 Patents 60,000
Purchases 19,00,000
Sales 32,60,000
Opening Stock 12,00,000
Solution:
Trial Balance
(as on 31st March, 2008)
Particulars Amount (Dr.) Amount (Cr.)

( ) ( )
Interest on Capital 24,000 –
Creditors – 6,00,000
Discount Received – 23,000
Loan – 1,74,000
Purchase Returns – 40,000
Sale Returns 6,000 –
Advertisement 1,63,000 –
Commission Received – 20,000
Rent 10,000 –
Purchases 19,00,000 –
Sales – 32,60,000
Opening Stock 12,00,000 –
Salaries 1,28,000 –
Capital – 8,00,000
Drawings 2,46,000 –
Machinery 3,00,000 –
Bills Payable – 20,000
Furniture 6,00,000 –
Debtors 5,00,000 –
Bank Loan – 2 00 000
Patents 60,000 –
Total 51,37,000 51,37,000

From the above trial balances it is clear that the total of debit side will agree with the total of Notes
credit side if Ledger accounts are arithmetically correct. If these totals do not tally with each
other, there will be some error in the ledger accounts.
Task From the following transactions, pass journal entries, prepare ledger accounts and
also prepare Trial Balance under:
( )
1. Anil started business with 8,000
2. Purchased furniture 1,000
3. Purchased goods 6,000
4. Sold goods 7,000
5. Purchased from Raja 4,000
6. Sold to Somu 5,000
7. Paid to Raja 2,500

8. Received from Somu 3,000
9. Paid rent 200

10. Received commission 100
Self Assessment
Fill in the blanks:

1. …………………… is a statement which shows balances of all accounts on a particular date.
2. The balances of all the liabilities and capital accounts are recorded in the ……………………
of the Trial Balance.
3. The balances of all incomes and gains are disclosed in the …………… of the Trial Balance.
4. ………………… is found when one account is debited or credited in the place of another
account.
5. …………………… occur when any business transaction is completely or partially omitted

from the recording in the books of original records.
6. …………………… occur when there is wrong classification between the capital and revenue
nature incomes or expenditures.
7. Suspense A/c is shown in the …………………….
8. The balances of all the assets accounts and drawing accounts are recorded in the
…………………… of the Trial Balance.
9. The balances of all incomes and gains are disclosed in the ……………… of the Trial Balance.

Notes 7.3 Types of Errors
There are two types of errors:
Errors which cannot be located by Trial Balance
The following errors cannot be detected by the trial balance means in spite of agreeing the totals
of debit side and credit side, these errors occur in the accounts.
1. Error of Omission: These errors occur when any business transaction is completely omitted
from the recording in the books of original records.
Example: As goods, sold of 10,000 to Mr. Ram, is entered nowhere in the original
books then its effect will also not come on the ledger and trial balance. Thus such type of errors
cannot be located by trial balance.
2. Error of Commission: Such types of errors are found when one account is debited or
credited in the place of another account.
Example: As cash received from Shyam 1,000 has been credited in the name of Ram.
Such type of errors do not affect the agreement of the totals of the debit and credit side of the trial
balance but they affect the result of the business.
3. Error of Principle: These errors occur when there is wrong classification between the
capital and revenue nature incomes or expenditures.
Example: As the purchases of furniture of 20,000 are entered in the book of purchases
while it should be in furniture account. Such errors cannot be located by trial balance.
4. Compensating Error: When two errors of the same account occur and the effect of one
error is compensated by the effect of other error it is called compensating error.
Example: If purchase of 10,000 from Ajay is credited only by 1,000 while the purchases
from Vijay for 1,000 is credited by 10,000. Thus, such type of errors do not affect on the
agreement of the Trial Balance.
Errors which can be located by Trial Balance
The error which affects the agreement of the totals of the Trial balance can be located easily.
These errors may be relating to:
(i) Totals of the subsidiary books or ledger accounts.
(ii) Balancing of an account of the ledger.
(iii) Wrong posting of any amount in any account.
(iv) Posting of any account may be in the wrong side of the account.
(v) Balance of any account may be omitted in writing in the Trial Balance.
(vi) Wrong total of the Trial Balance.
(vii) Partially omitted means omission may be the part of the transaction. If it is a part of the
transaction then it would affect trial balance and can be located by trial balance.

Thus we see that errors are of two types: Notes
1. Error of Principle
2. Clerical errors which are of the following types:
(i) Error of Omission.
(ii) Error of Commission.
(iii) Compensatory errors.
Steps to point out errors: If the trial balance does not agree, the following steps can be taken in
order to point out the errors. These are based on hit and trial method.
1. To see whether the total of both the columns agree or does not agree. In order to see it, it
must be again totalled.
2. It is also necessary to see whether the balances of all the accounts including cash and bank
have been properly recorded or not.
3. Difference of both the sides must be checked carefully and if possible see whether any such
item is there which is exactly of the same amount being omitted/left out. If it is not then
have half of the difference and again compare it with the amount of any item of the same
amount which is being left out or wrongly put.
4. Subsidiary books must also be checked again, so that if any error has taken place could be
rectified.
5. Still, if there is any error, thorough and complete checking of all ledger accounts is required.
Rectification of Errors: Errors are/can be rectified if the correcting entries are passed in the books
of account. For this, care and alertness is exercised to see whether error is in both the accounts or
is in one account only. If the error affects both the accounts, then a fresh entry is to be passed and
if it affects only one account, the rectification is done by recording in one account only.
1. Rectification of Errors when error affects only one account: If it is so, no journal entry is
required to pass; it is corrected by debiting or crediting the concerned account. For example,
Sales book was overcasted by 250 [As the sales book was overcasted by 250], hence sale
account is to be debited by 250 in order to rectify the error. This error affects only one
account. Similarly, if the Purchases Day Book is undercasted by 100 then the error also
affects only one account and this can be corrected by debiting purchases account by 100.
Likewise paid 20 as repairs were recorded 25 in Repairs account again the error is in
one account i.e., repair account. It may be corrected by crediting repair A/c by 5 i.e. the
difference ( 25 - 20).
2. Rectification of Errors when it affects both the accounts: If it is so, it is rectified by passing
a journal entry. For example, received 150 from Shri Bhagwan were credited to sales
account. This error affects both the accounts i.e., (i) Shri Bhagwan A/c and (ii) Sales A/c.
Journal entry for correction would be:
Dr. Cr.
S. No. Particulars L.F. ( ) ( )
1. Sales A/c Dr. 150
To Shri Bhagwan A/c 150
(Error in Sales a/c and Shri Bhagwan A/c rectified)
Similarly, if Building is purchased for 2 lacs is recorded in the Purchases Book, again the error
affects both the accounts i.e. (1) Building A/c (2) Purchases A/c.

Notes Though the error is of principle, in the above case Purchases A/c is unnecessarily debited and
Building A/c is wrongly left out. In order to rectify the error the following entry (correcting the
error) is to be passed:
Journal Entry for Correction (Rectification)
Dr. Cr.
1. Building A/c Dr. 2,00,000
To Purchases A/c 2,00,000
(Error in Building A/c and Purchases A/c rectified)
Journal Entry already passed which was a wrong entry
Dr. Cr.
1. Purchases A/c Dr. 2,00,000
To Cash/Creditor A/c 2,00,000
(Building Purchased)
Correct entry required to pass
Dr. Cr.
1. Building A/c Dr. 2,00,000
To Cash/Creditor A/c 2,00,000
(Buildings Purchased)
Thus, we see that if the error affects both the accounts, then it can be rectified by passing a journal
entry as explained above.
Did u know? What is suspense account?
Sometimes, it is not possible to point out errors easily, and then the difference is put to an
account, known as suspense account. Suspense A/c is shown in the trial balance. As and when
Errors are located, the same is debited or credited for rectifying the error and the other account
which is credited or debited is the suspense account. Thus, the suspense account is automatically
closed.
Illustration 4: Rectify the following Errors:

(a) A sale of goods to Raja Ram for 2500 was passed through the Purchases book.
(b) Salary 800 paid to Hari Babu was wrongly debited to his personal account.
(c) Furniture purchased on credit from Mohan Singh for 1000 was entered in the
Purchases book.
(d) 5000 spent on the extension of building was debited to the buildings repairs
account.
(e) Goods returned by Mani Ram 1200 were entered in Returns outward book.

Solution: Notes
Journal Entries to rectify the errors
Dr. Cr.
S. No. Particulars L.F. Amount Amount
( ) ( )
(a) Raja Ram Dr. 5,000
To Purchases A/c 2500
To Sales A/c 2500
(A sale of goods to Raja Ram through the Purchases book
is rectified.)
(b) Salary A/c Dr. 800
To Hari Babu 800
(Salary wrongly debited in his personal A/c is rectified.)
(c) Furniture A/c Dr. 1,000
To Purchases A/c 1000
(Furniture purchased was wrongly entered in the
Purchases book is rectified.)
(d) Buildings A/c Dr. 5,000
To Buildings Repairs A/c 5000
(Sent on extension of building was wrongly debited to
Building repairs A/c is rectified.)
(e) Returns Inward A/c (Sales Returns) Dr. 1,200
Returns Outward A/c (Purchases Returns A/c) Dr. 1,200
To Mani Ram 2400
(Goods returned by Mani Ram were entered in returns
outward book.)
Illustration 5: Rectify the following errors:
(a) Sales book was overcasted by 200.

(b) 100 received as rent from the tenant was debited to rent account.
(c) Received 500 from Sudan Mittal was credited to Sales book.
(d) Paid 200 as salary, but were debited 20 in Salary account.
(e) Paid 20 as repairs were recorded 25 in Repairs account.
Solution:
(a) As the sales book was overcast by 200, so sales A/c is to be debited by 200 in order to
rectify the error, this error affects only one account.
Dr. Cr.
( ) ( )
(b) Suspense A/c Dr. 200
To Rent A/c 200
(Rent A/c was wrongly debited, hence rectified by 200.)
(c) Sales A/c Dr. 500 Contd...
To Sudan Mittal 500
(Sales A/c was wrongly credited in place of Sudan
Mittal, rectified.)
(d) Salary A/c Dr. 180
To Suspense A/c 180
(Salary A/c was debited less by 180, hence rectified.)
(e) Suspense A/c Dr. 05
To Repairs A/c 05
(Excess in repairs A/c credited to rectify the error.)
Dr. Cr.
( ) ( )
(b) Suspense A/c Dr. 200
To Rent A/c 200
(Rent A/c was wrongly debited, hence rectified by 200.)
Notes (c) Sales A/c Dr. 500
To Sudan Mittal 500
(Sales A/c was wrongly credited in place of Sudan
Mittal, rectified.)
(d) Salary A/c Dr. 180
To Suspense A/c 180
(Salary A/c was debited less by 180, hence rectified.)
To Repairs A/c 05
(Excess in repairs A/c credited to rectify the error.)

(i) 700 paid for the purchase of new office furniture charged to office expenses A/c.
(ii) Goods worth 174 were sold to Roop but latter A/c was actually credited by 147.
(iii) Sales Day book was undercasted by 200.
(iv) The total of the discount column on the debit side of the Cash book was short by 30.
(v) An amount of 1000 withdrawn by the proprietor for his personal use was debited to
Trade expenses A/c.
(vi) 200 was received on account of rent but was credited to dividend A/c.
(vii) Goods sold to Mr. Rakesh for 705 but entry was made for 570.
(viii) An amount of 325 owing by Mukesh was omitted from the list of Sundry debtors.
Solution:
Dr. Cr.
( ) ( )
(i) Office Furniture A/c Dr. 700
To Office expenses A/c 700
(Error in office expenses A/c rectified.)
(ii) Roop Dr. 321
To Suspense A/c 321
(Error in Roop A/c rectified.)
(iii) Suspense A/c Dr. 200
To Sales A/c 200
(Error in sales A/c rectified.)
(iv) Discount A/c Dr. 30
To Suspense A/c 30
(Discount columns on debit side short by 30 corrected.)
(v) Proprietor Drawings A/c Dr. 1000
To Trade expenses A/c 1000
(Error in trade expenses A/c rectified.)
(vi) Dividend A/c Dr. 200 Contd...
To Rent A/c 200
(Error in dividend A/c rectified.)
(vii) Rakesh Dr. 135
To Sales A/c 135
(Error in Rakesh and Sales A/c rectified [ 705 – 570].)
(viii) Mukesh (Sundry Debtors) Dr. 325
To Suspense A/c 325
(Error in Mukesh A/c rectified.)
To Sales A/c 200
(Error in sales A/c rectified.)
(iv) Discount A/c Dr. 30
To Suspense A/c 30
(Discount columns on debit side short by 30 corrected.)
(v) Proprietor Drawings A/c Dr. 1000
To Trade expenses A/c 1000
(Error in trade expenses A/c rectified.)
(vi) Dividend A/c Dr. 200 Notes
To Rent A/c 200
(Error in dividend A/c rectified.)
(vii) Rakesh Dr. 135
To Sales A/c 135
(Error in Rakesh and Sales A/c rectified [ 705 – 570].)
(viii) Mukesh (Sundry Debtors) Dr. 325
To Suspense A/c 325
(Error in Mukesh A/c rectified.)

(i) A sale of furniture of 700 had been credited to Sales A/c.
(ii) 1000 paid as rent to landlord was debited to Landlord account.

(iii) Materials from store 1000 and wages 400 had been used in making tools and equipments
for use in our factory, but no adjustments were made in the books.
(iv) Purchase book was undercasted by 100.

(v) A sale of 500 to Gupta & Co. was credited to their account.
Solution:
Dr. Cr.
( ) ( )
(i) Sales A/c Dr. 700
To Furniture A/c 700
(Sale of furniture wrongly credited to sales A/c hence rectified.)
(ii) Rent A/c Dr. 1000
To Landlord 1000
(Landlord A/c was wrongly debited hence rectified.)
(iii) Tools and Equipments A/c Dr. 1,400
To Materials A/c 1000
To Wages A/c 400
(Adjustment made for materials & wages used for making tools etc.)
(iv) Purchases A/c Dr. 100
To Suspense A/c 100
(Purchase book was under cast, hence rectified.)
(v) Gupta & Co. A/c Dr. 1000
To Suspense A/c 1000
(A sale which was wrongly credited in his A/c, is rectified.)
Illustration 8: Pass journal entries to rectify the following errors:

(i) A cheque of 700 received for damages had been deposited in the proprietor's private
bank account.
(ii) An item of purchase for 151 was entered in the purchase book as 15 and posted to the
supplier account as 51.
(iii) The sale book was undercasted by 100.

Notes (iv) An amount of 2,000 received from Ram has been wrongly posted to the credit of Ravi as
200.
(v) Discount column of the receipt side of the cash book was wrongly added as 40 instead of
140.
Solution:
Dr. Cr.
( ) ( )
(i) Proprietor’s A/c Dr. 700
To Sundry Income A/c 700
(Proprietor’s A/c was wrongly credited hence rectified.)
(ii) Purchases A/c Dr. 136
To Supplier’s A/c 100
To Suspense A/c 36
(Purchases A/c & Supplier’s A/c were wrongly debited & credited
hence rectified.)
(iii) Suspense A/c Dr. 100
To Sales A/c 100
(Sales A/c was under cast hence credited by 100.)
(iv) Ravi Dr. 200
Suspense A/c Dr. 1,800
To Ram 2000
(Ravi’s A/c wrongly credited in place of Ram, hence rectified.)
(v) Suspense A/c Dr. 100
To Discount A/c 100
(Discount column on the receipt side of the cash book wrongly
totalled, hence rectified.)
Illustration 9: The following errors were detected in the accounts of M/s Rajesh & Sons for the
year ended on 30th June, 2006.
(i) A bill for 2000 for the erection of a small cycle shed was debited to repairs A/c.
(ii) A cheque for 200 received from Ram & Co. was dishonoured and debited to discount
account.
(iii) A sum of 500 drawn by the proprietor for his personal expenses was debited to travelling
expenses account.
(iv) Goods to the value of 100 returned by Ram were put into stock but no entry was made in
the books.
(v) A cheque of 100 received from Kartar Chand was credited to the account of Tota Ram and
debited to cash instead of the bank account.
(vi) Wages paid to the firm's own workman for certain additions to the new machinery
amounted to 500 were posted to wages account.
Give journal entries to correct these errors.

Solution: Notes
Dr. Cr.

( ) ( )
(i) Buildings A/c Dr. 2000

To Repairs A/c 2000
(Repairs A/c was wrongly debited in place of buildings A/c,
hence rectified.)
(ii) Ram & Co. Dr. 200

To Discount A/c 200
(Rectification of error in discount A/c in place of Ram & co.)
(iii) Proprietor’s Drawings A/c Dr. 500

To Travelling Expenses A/c 500
(Error in travelling expenses A/c rectified.)
(iv) Sales returns A/c Dr. 100

To Ram 100
(Goods returned by Ram were not entered, hence rectified.)
(v) I. Tota Ram Dr. 100

To Kartar Chand 100
(Error in Tota Ram A/c rectified.)
II. Bank A/c Dr. 100

To Cash A/c 100
(Error in Cash A/c rectified.)
(vi) Machinery A/c Dr. 500

To Wages A/c 500
(Error in wages A/c rectified.)
Effects of errors on the profits and losses (profit and loss A/c and Balance Sheet) (Final Accounts):
If the error/errors are there or committed, the effect of such errors would be either decrease or
increase in the Gross Profit/Net Profit. The Profit/Loss depicted by profit and loss account
would not be correct, so it is necessary to rectify the errors and arrive at the correct amount of
profit/loss of the period. Similarly, financial position as given by the Balance Sheet would also
not be correct if some errors are there/committed. Again, it is also must to rectify the errors at
the earliest, so that Balance Sheet can depict a true and fair view of the business. The following
illustrations would clarify the above points.
Illustration 10: On 31st Dec, 2006 the Trial balance of Sunil & Co., balanced after inserting a
suspense account in the nominal ledger. In the course of audit, the following facts were
discovered:
(a) 120 received from A had been posted to B’s account in the sales ledger.
(b) 50 paid for postage stamps had been entered correctly in the cash book, but not posted.
(c) In casting the Sales Day Book 878 were carried forward as 787.

Notes (d) An Invoice of 960 in respect of Motor Car debited to Motor Car A/c included the cost of
licence 60.
(e) 540 credited to Partners’ current Account for interest on capital had been debited to Bank
Interest account.
(f) Discount received from Mittal & Co. 200 had not been posted to Discount A/c. Pass entries
necessary to correct the errors and prepare the suspense account. Also find out what effect
these errors would have on the profit for the year ending 31st Dec, 2006.
Solution:
Dr. Cr.
( ) ( )
(a) B Dr. 120
To A 120
(Error in B’s A/c Corrected.)
(b) Postage A/c Dr. 50
To Suspense A/c 50
(Postage A/c Omission corrected.)
(c) Suspense A/c Dr. 91
To Sales A/c 91
Sales Day Book balance
Wrongly carried forward
(Hence corrected 878 – 787)
(d) Motor Licence A/c Dr. 60
To Motor Car A/c 60
(Error in Motor Car A/c corrected.)
To Partner’s Current A/c 540
To Bank Interest A/c 540
(Error in Bank Interest A/c corrected and partners’ A/c
credited.)
(f) Suspense A/c Dr. 200
To Discount A/c 200
(Omission in Discount A/c corrected.)
Suspense A/c
Dr. Cr.
S. No. Particulars J.F. Amount S. No. Particulars J.F. Amount
( ) ( )
(c) To Sales A/c 91 (b) By Postage A/c 50
(e) To Partners’ current 540 By Balance 1321
A/c
(f) To Bank Int. A/c 540
To Discount A/c 200
1371 1371

Effects on the profit for the year 2006: Notes

(a) No effect.
(b) Net profit is higher by 50.
(c) Gross profit and Net profit is reduced by 91.
(d) Net profit is higher by 60.
(e) Net Profit is reduced by 540.
(f) Net profit is lower by 200.
The total effect of all errors on profit is 721 i.e. profit is lower to the extent of 721 and if
corrected, Net profit increase by 721.
Illustration 11: Consider the following trial balance :
Trial Balance
(As on 31 March 2011)
S. No. Particulars LF Amount (Dr.) Amount (Cr.)

( ) ( )
1. Capital Account 5,00,000
2. Sales Account 25,50,000
3. Purchases Account 18,75,000
4. Salaries Account 5,20,000
5. Rent, rates & taxes 1,67,500
6. Interest income 1,25,000
7. Interest expenses 1,76,000
8. Bank Loan 20,00,000
9. Returns inward 32,000
10. Returns outward 25,000
11. Carriage inward 87,500
12. Carriage outward 55,000
13. Income tax paid 50,000
14. Property, plant and equipment 18,00,000
15. Debtors 3,55,000
16. Creditors 1,75,000
17. Cash and Bank balances 1,76,000
18. Suspense Account 81,000
53,75,000 53,75,000
The accountant could not tally the trial balance, and put the difference in suspense account.
Other Information: While inspecting the books of accounts, the accountant found the following
errors:
(a) Rent for the month of October 2010 of 10,000 was wrongly debited to salaries account.
(b) Carriage outward of 7,500 was debited to carriage inward account.
(c) Cash sales of 45,000 was debited in purchases account.
(d) Cash paid to creditors 22,500 was debited to creditors account as 25,200.
(e) Interest paid 5,350 was debited in interest income account
(f) Return inward of 25,350 was credited in return inward account.
(g) Cash paid to creditors 61,500 was credited in creditors account.
Redraft the trial balance after rectifying the above errors.

Notes Solution: The accountant could not tally the trial balance. The total of ‘credit side’ was more than
that of ‘debit side’ by 81,000. The accountant perhaps had to close the trial balance and present it
before his boss. He put the entire difference of 81,000 in suspense account and made the trial
balance tally. He, however, did not stop worrying about the difference of 81,000 in the trial
balance. That is how he detected the errors as mentioned above. Since the trial balance has already
been prepared, the accountant needs to pass complete journal entries to rectify the errors.
Journal Entries
S. No. Particulars L.F. Amount (Dr.) Amount (Cr.)

( ) ( )
(a) Rent A/c Dr. 10,000
To Salaries A/c 10,000
(Rent paid for the month of October, 2003 wrongly
debited to salaries account, now rectified)
(b) Carriage Outward A/c Dr. 7,500
To Carriage Inward A/c 7,500
(Carriage outward charges wrongly debited to carriage
inward account, now rectified)
(c) Suspense A/c Dr. 90,000
To Purchases A/c 45,000
To Sales A/c 45,000
(Cash sales erroneously debited in purchases account,
now corrected)
(d) Suspense A/c [25,200-22,500] Dr. 2,700
To Creditors A/c 2,700
(Rectification of excess debit in creditors account)
(e) Interest expense A/c Dr. 5,350
To Interest Income A/c 5,350
(Rectification of wrong entry in interest income account)
(f) Return Inward A/c Dr. 50,700
To Suspense A/c 50,700
(Return inward of 25,350 wrongly credited in that
account, now rectified)
(g) Creditors A/c Dr. 1,23,000
To Suspense A/c 1,23,000
(Rectification of a wrong credit in creditors account)
Let us now re-open the affected ledger accounts, and make the postings of rectification entries.
We shall not unnecessarily open other accounts.
Rent, Rates & Taxes Account

Dr. Cr.
Date Particulars J.F Amount Date Particulars J.F. Amount
( ) ( )
2011 2011
31 March To Balance b/d 1,67,500 31 March By Balance c/d 1,77,500
31 March To Salaries A/c 10,000
1,77,500 1,77,500

Salaries Account Notes

Dr. Cr.
( ) ( )
2011 2011
31 March To Balance b/d 5,20,000 31 March By Rent A/c 10,000
31 March By Balance c/d 5,10, 000
5,20,000 5,20,000
Carriage Outward Account

Dr. Cr.
( ) ( )
2011 2011
31 March To Balance b/d 55,000 31 March By Balance c/d 62,500
31 March To Carriage inward 7,500
A/c
62,500 62,500
Carriage Inward Account

Dr. Cr.
( ) ( )
2011 2011
31 March To Balance b/d 87,500 31 March By Carriage 7,500
outward A/c
31 March By Balance c/d 80,000
87,500 87,500
Purchases Account
Dr. Cr.
( ) ( )
2011 2011
31 March To Balance b/d 18,75,000 31 March By Suspense A/c 45,000
31 March By Balance c/d 18,30,000
18,75,000 18,75,000
Sales Account
Dr. Cr.
( ) ( )
2011 2011
31 March To Balance c/d 25,95,000 31 March By Balance b/d 25,50,000
31 March By Suspense A/c 45,000
25,95,000 25,95,000

Notes Creditors Account

Dr. Cr.
( ) ( )
2011 2011
31 March To Suspense A/c 1,23,000 31 March By Balance b/d 1,75,000
31 March To Balance c/d 54,700 31 March By Suspense A/c 2,700
1,77,700 1,77,700
Interest Expense Account

Dr. Cr.
( ) ( )
2011 2011
31 March To Balance b/d 1,76,000 31 March By Balance c/d 1,81,350
31 March To Interest income 5,350
A/c
1,81,350 1,81,350
Interest Income Account

Dr. Cr.
( ) ( )
2011 2011
31 March To Balance c/d 1,30,350 31 March By Balance b/d 1,25,000
31 March By Interest 5,350
Expense A/c
1,30,350 1,30,350
Return Inward Account

Dr. Cr.
( ) ( )
2011 2011
31 March To Balance b/d 32,000 31 March By Balance c/d 82,700
31 March To Suspense A/c 50,700
82,700 82,700
Suspense Account
Dr. Cr.
( ) ( )
2011 2011
31 March To Balance b/d 81,000 31 March By Return Inward 50,700
31 March To Purchase A/c 45,000 31 March A/c
31 March To Sales A/c 45,000 By Creditors A/c 1,23,000
31 March To Creditors A/c 2,700
1,73,700 1,73,700

We redraft the trial balance as below with rectified balances. The ledger accounts, which have Notes
undergone rectification, are marked (*)
Trial balance (Revised)
(As on 31 March 2011)
S. No. Particular Amount (Dr.) Amount (Cr.)

( ) ( )
1. Capital Account 5,00,000
2. Sales Account* 25,95, 000
3. Purchases Account* 18,30,000
4. Salaries Account* 5,10,000
5. Rent, rates & taxes Account* 1,77,500
6. Interest income Account* 1,30,350
7. Interest expenses Account* 1,81,350
8. Bank Loan Account 20,00,000
9. Returns Inward Account* 82,700
10. Returns Outward Account 25,000
11. Carriage Inward Account* 80,000
12. Carriage Outward Account* 62,500
13. Income tax paid Account 50,000
14. Property, plant and equipment 18,00,000
15. Debtors Account 3,55,000
16. Creditors Account* 54,700
17. Cash and Bank balances 1,76,000
53,05,050 53,05,050
The suspense account no longer figures in the Trial Balance. It implies that all the errors affecting
the agreement of trial balance have been identified and rectified.
Self Assessment
Multiple Choice Questions:

10. Purchases Day Book under cast by 200.
(a) Error of Principle
(b) Compensating Error
(c) Error of Omission
(d) Error of Commission.
11. Amount spent on the repair of a plant is wrongly debited to repairs A/c:
(a) Error of Omission
(b) Error of Commission
(c) Error of Principle
(d) Compensating Error.
12. Mr. Ram’s account is debited in place of Shyam’s A/c for 500.
(b) Error of Principle

Notes (c) Error of Commission

13. Sales day book overcast by 150.

(c) Compensation Error

(d) Error of principle.
14. Purchase of Furniture is debited to Purchases A/c.

(b) Error of Principle

(c) Error of Commission
(d) None of the above.

15. Bad debts recovered from a debtor are credited to his account.
(c) Error of Principle
7.4 Summary
 Trial Balance is a list of accounting balances and their names; of the enterprise during the
specified period which includes debit and credit balances of the various balanced ledger
accounts out of the journal entries.
 Purposes of preparing the Trial Balance are to prepare a statement of disclosure of final
accounting balances of various ledger accounts on a particular date.
 There can be certain errors in recording the accounting transactions in primary and
secondary books of accounts.
 The following errors cannot be detected by the trial balance means in spite of agreeing the
totals of debit side and credit side
 Error of omission
 Error of commission
 Error of principle
 Compensating error
 The errors which can be located in the trial balance are wrong total, balancing error,
positioning error etc.
 Sometimes, it is not possible to point out errors easily, then the difference is put to an
account, known as suspense account.

7.5 Keywords Notes
Bill of Exchange: A bill of exchange is an unconditional order signed by the maker which directs
the recipient to pay a fixed sum of money to a third party at a future date.
Suspense Account: Sometimes, it is not possible to point out errors easily, and then the difference
is put to an account, known as suspense account.
Trial Balance: It is the list of accounts taken from the ledger.

1. What is a Trial Balance? Name the errors that are disclosed by Trial Balance.
2. What is Trial Balance? Is it true to say that results are accurate if Trial Balance tallies?
3. What do you mean by a Trial Balance? Discuss its main objects and show how it is prepared.
4. Give two examples each of the one sided and doubles sided errors. How are they corrected?
5. Explain the errors (i) which are revealed by the Trial Balance and (ii) the errors which are
not revealed by the trial balance.
6. Is the agreement of a Trial Balance a conclusive proof of accuracy of ledger accounts? If not,
what are the errors which remain undetected by the Trial balance?
7. Discuss the errors which do not affect the agreement of a trial balance.
8. Distinguish between:
(a) Balance Sheet and a Trial Balance
(b) Errors of commission and errors of omission.
9. Write short-notes on the following:
(a) Error of Principle
(b) Compensatory errors
(c) Factors affecting disagreement of Trial Balance.
10. The following balances are extracted from the books of Mr. Rakesh as on 31.12.2005
Prepare a trial balance
( ) ( )
Capital 15,000 Purchases 7 ,200
Land & Building 15,600 Provision for bad debts 370
Bank overdraft 2,500 Sales 17,000
Cash in hand 680 Wages 1250
Stock in Trade as on 1.1.04 6,000 Salaries 700
Advertisement 210 Insurance 40
Rent & Taxes 160 Discount allowed 300
Interest & Discount received 300 Repairs to building 210
Debtors 6420 Creditors 4,100
General Expenses 500
11. Give the journal entries necessary to rectify the following errors:
(a) A payment of 250 for purchase of a Typewriter for office use has been debited to
Purchases A/c.

Notes (b) A credit sale of 127 to Mr. Chandra has been posted to the debit of Mr. Kuchhal’s
account from the Sales Day book.
(c) A payment of 96 for white washing the office has been charged to Buildings accounts.
12. Rectify the following Errors:
(a) Sales to Vinod 143 posted to his account as 134.

(b) Sales to Vinod 143 debited to his account as 134.
(c) Sales to Vinod 143 credited to his account as 134.

13. Rectify the following Errors:
(a) Wages paid for the construction of office debited to wages account 1,500.
(b) Cartage paid for the newly purchased furniture 10 posted to cartage account.
(c) Furniture purchased on credit from Ram for 300 posted as 30.
(d) Sales to X 400 posted to Y’s account.
(e) Wages paid 2,550 were recorded in the cash book as 2,505.
(f) Purchases from Y 1,002 were omitted from the books.
14. There was difference in the trial balance of Sri Arihant which was put to a newly opened
suspense account. Subsequently the following mistakes were discovered. Pass journal
entries to rectify them and ascertain the difference in the trial balance.
(a) Materials Costing 1700 in the erection of the machinery and the wages for it
amounting to 1,400 were included in the purchases account and the wage account
respectively.
(b) Goods sold under credit terms 16,900 to music were recorded properly in the sales
book but were debited to his account as 19600 and carriage outward and freight
paid 700 chargeable from him were posted to sales expenses account.
(c) Sales return by Yogeshwar 2300 were correctly recorded in the sales return book
from where they were debited to Yogeshwar’s account by 32.
(d) Old furniture originally purchased for 1800 written down to 1100 was sold for
1700 and was credited to furniture account.
(e) Machinery purchased on credit 17000 was recorded in purchases book and transport
charges for the machine 1200 were debited to trade expenses account.
1. Trial Balance 2. Credit side
3. Credit side 4. Error of commission
5. Error of omission 6. Error of principle

7. Trial balance 8. Debit side
9. Credit side 10. (d)
11. (c) 12. (d)
13. (b) 14. (b)

15. (b)

7.7 Further Readings Notes



Notes Unit 8: Financial Statements
CONTENTS
Objectives
Introduction
8.1 Meaning of Financial Statements
8.2 Objectives of Preparing Final Accounts
8.3 Capital and Revenue Expenditure and Receipt
8.3.1 Classification of Expenditures
8.3.2 Classification of Receipts
8.4 Statement of Accounting Standard (AS-9) Revenue Recognition
8.5 Final Accounts with Adjustments
8.5.1 Trading and Profit & Loss Account
8.5.2 Trading Account
8.5.3 Profit & Loss Account
8.5.4 Manufacturing Account
8.6 Balance Sheet
8.7 Summary
8.8 Keywords
Objectives

 Understand meaning of financial statements
 Prepare trading and profit & loss A/c
 Prepare balance sheet

 Construct adjustments entries
 Prepare final accounts with adjustments
Introduction
In the present unit, you will study about the final accounts with adjustments. After studying this
unit, you will be able to understand the trading and profit & loss account, balance sheet and key
adjustments related to them. Every organisation prepares its final accounts after a particular
period to know its financial results and financial position. Final accounts mean profit & loss
account and the balance sheet. Profit & loss account also contains one more account, known as
trading account, and if the business is manufacturing any item or article, then Manufacturing
account is also there. All these accounts are prepared only after preparing trial balance.

Unit 8: Financial Statements
8.1 Meaning of Financial Statements Notes
Financial statements mean (i) Balance sheet, (ii) profit & loss account, and (iii) several other
schedules. Nowadays one more statement is also prepared that is funds flow statement or cash
flow statement.
Whatever business activities are done, it is essential to know its operational results i.e. whether
business is running at profit or loss, for this purpose balances of all ledger accounts are taken and
a statement of balances is prepared which is known as trial balance. Final accounts are prepared
from such balances. Therefore, it is necessary to know the meaning and object of final accounts.
Final accounts mean profit & loss account and the balance sheet. Profit & loss account also
contains one more account, known as Trading account, and if the business is manufacturing any
item or article, then Manufacturing account is also there. All these accounts are prepared only
after preparing trial balance.
8.2 Objectives of Preparing Final Accounts
There are two objectives of preparing Final accounts- (1) know the operational results i.e. profit
or loss during a particular period through the profit & loss account which is also known as
income statement, and (2) ascertain the financial position of the business on a particular date
through the balance sheet, also known as position statement.
Persons Interested in Financial Statements
Did u know? There are two types of persons interested in financial statements—1. Internal
users and 2. External users.
1. Internal Users: These are (a) Shareholders, (b) Management, and (c) Trade unions
employees.
(a) Shareholders are very much interested in the financial statements. They are
very much interested in the welfare of the business. They can know the
operational results through such financial statements and the financial position
of the business along with the earning capacity of the business.
(b) Management is interested to take important decisions relating to fixing up the
selling prices and making future policies.
(c) Trade unions and employees are interested to know the operational results
because their bonus etc. is dependent on the profit earned by the business.
Financial Statements also help in their negotiations for wages/salaries.
2. External Users: There are number of persons interested in financial statements. They
are termed as external users. The following are most important external users of
financial statements.
(a) Investors: They are interested to know the earning capacity of business which
can be known through financial statements. They can also know the financial
soundness of the business through financial statements.
(b) Creditors, Lenders of Money etc.: The creditors and lenders of money etc. can also
know the financial soundness through financial statement. They have to see
two things (i) Regularity of income and (ii) solvency of the business so that
their investment is risk free.

Notes (c) Government: Government is interested to formulate laws to regulate business

activities and also law relating to taxation etc. Financial statements help while
computing National Income statistics etc.
(d) Taxation authorities: Financial Statements provide information relating to

operational results as well as financial position of the business. Tax authorities
decide the amount of tax as per financial statement. It is very useful to other
taxation authorities such as sales tax etc.
(e) Stock Exchange is meant for dealing in share/securities. Purchase and sale of
such shares and securities are possible through stock exchanges which provide
financial information about each company which is listed with them.
Thus, we see that financial statements are very helpful and useful.
Self Assessment
Fill in the blanks:
1. …………………… mean profit & loss account and the balance sheet.
2. There are two types of persons interested in financial statements: (a) ……………………
users and (b) …………………… users.
8.3 Capital and Revenue Expenditure and Receipt
As per matching concept of accounting the revenues of a period are matched with the expenses
incurred in this period to generate this revenue in order to determine the amount of profit or
loss of the business. To calculate the accurate amount of profit or loss it is must that there should
be a recognition of the revenues and expenditures. If there is wrong recognition of expenses or
revenues, results of the business will also be wrong. Thus the distinction between the capital and
revenue items is very important. In spite of being a difficult job of distinction of capital and
revenue items, some rules are framed for the recognition of these items.
8.3.1 Classification of Expenditures
Expenditures of a business are classified into following three:

1. Capital Expenditure: If expenditure is incurred in the business to get its benefit for a long
period, such expenditure is called capital expenditure. Capital expenditure may be done
to acquire the new assets (tangible or intangible), to enhance the earning capacity of the
business, for some addition and improvement of the existing properties or assets, for the
development of the business or for the replacement of an existing assets.
Some examples of capital expenditure are given below:
(i) Expenditure to acquire a fixed asset as purchase of plant and machinery, land and
buildings and furniture, etc.
(ii) Expenditure for the addition and improvement of the assets as construction of a
room in the building.
(iii) Expenditure for the erection or setting up of a new plant.

(iv) Expenditure to acquire the right to run the business as copyright, patents, licence etc.

2 Revenue Expenditure: When expenditure is done for a short period (less than one year) and Notes
for the regular operation of business, it is termed as revenue expenditure. Their benefits
are taken by the business in the current period only. For example:
(a) Expenses incurred during the normal course of business – as salaries of the staff, fuel
and electricity used for the running of machinery and cost of sales.
(b) Expenses for the maintenance of the assets – repairs of machinery.
(c) Wear and tear and obsolescence of the assets and decrease in the value of assets.
3 Deferred Revenue Expenditure: When revenue expenditure is done for the benefit of two or
three years, it is termed as deferred revenue expenditure. For example, cost of heavy
campaign of advertisement, preliminary expenses, etc. The benefit of such type of
expenditure is enjoyed by the company for a number of years. Therefore, the entire amount
of such expenditure is not transferred to the profit & loss account of a year. The entire
amount of such expenditure is divided by a period of time (no. of years in which the
benefit of such expenditure will be enjoyed). The dividend received in written off by
transferring into profit & loss account and the unwritten off portion of the expenditure is
shown in the balance sheet as a fictitious asset.
8.3.2 Classification of Receipts
As distinction is made between the capital expenditure and revenue expenditure, similarly to
calculate the accurate profits or loss of the business distinction between the capital receipt and
revenue receipts is done. Therefore, these words should be clearly understood.
1. Capital Receipts: Capital receipts include the sale of fixed assets, long-term investments,
issue of share capital, debentures and loan raised. Capital receipts are different from the
capital profits or loss. The entire amount from the sale of assets is called capital receipts
and the difference of sale proceeds and cost of assets is capital profit or loss.
2. Revenue Receipts: Receipts which are obtained during the normal course of business are
called revenue receipts. In other words the receipts which are not capital receipts are
revenue receipts as sale of goods. Revenue receipts are different from revenue profits or
loss. For example, goods worth 5,000 are sold at 6,000. Here, the entire sale of 6,000
will be revenue receipts and the revenue profit will be 1,000 only.
Distinction between Capital Expenditure and Revenue Expenditure
Basis of differences Revenue Expenditure Capital Expenditure
1. Purpose It is incurred to do the business and is shown It is spent to acquire the

on debit side of P&L A/c. permanent Assets. It forms a
part of Balance Sheet
2. Period of benefits It is for a shorter period i.e. Less than a year. It is for a longer period i.e., more
than one year.
3. Charges It is shown either in Trading A/c or Profit & It is shown only in the Balance
Loss A/c sheet.
4. Increase in earning It does not increase the earning capacity of It definitely adds (increases) the
capacity. the business but helps in maintaining the earning capacity of the business.
present profit earning capacity.
5. Nature (recurring) Its recurring It is non-recurring
6. Transfer It is non transferable It is transferable
7. Representation It is an expired cost If represents unexpired costs.

Notes
Example: State whether the following expenditure is of capital or revenue nature:
1. 2,000 spent on repairing of a second hand plant.
2. 15,000 spent on air conditioner in an office.
3. 10,000 spent on advertizing in connection with the introduction of a new product.

4. 100 paid for carriage of goods purchased.
5. Salary of 5,000 paid to an employee of the business.
6. A sum of 5,000 was paid as compensation to an employee who was retrenched.

7. Purchase of raw materials for 25,000.
Solution:
Amount Spent Nature of Expenditure
1. Spent on repairing of a second hand 1. It is of capital nature because it makes the plant in
plant. working condition, hence it is a capital expenditure.
2. Spent on air conditioner in an office. 2. It is of capital nature because an asset of permanent
nature is purchased, hence it is a capital expenditure.
3. Spent on advertizing in connection with 3. It is of capital nature because benefits of it will be
the introduction of a new product. available for number of years, hence, it is capital
expenditure.
4. Paid for carriage of goods purchased. 4. It is of revenue nature because goods purchased are
for resale hence it is a revenue expenditure.
5. Salary paid to an employee. 5. It is of revenue nature as it is necessary to run the
business.
6. Paid compensation to an employee. 6. It is of revenue nature as it is necessary for the
business.
7. Purchases of raw Materials. 7. It is of revenue nature as it is necessary to run the
business.
Example: Classify the following expenditure into capital and Revenue expenditure:
(i) Expenditure towards additions to machinery, in order to double the production:
4000.
(ii) Expenditure necessitated by the negligence of the employees incurred for repairs to
Machinery: 2400.
(iii) Expenditure of 1600 towards replacement of worn out parts of machinery.
(iv) Expenditure incurred on painting the factory premises: 1,000.
Solution:
(i) Capital Expenditure as it increases the value of Machinery.

(ii) It is revenue expenditure as the nature of expenditure is revenue type.
(iii) It is revenue expenditure as the nature of expenditure is revenue because of replacement
of a worn out parts of Machinery.
(iv) It is also revenue expenditure as the expenses are incurred every year for the painting of
the factory premises to make the premises neat, clean and healthy.

Notes
Example: State in each of the following cases whether the expenditure is a capital
Expenditure or revenue expenditure or deferred revenue expenditure:
(i) Legal expenses incurred to defend a suit for breach of a contract to supply goods.
(ii) Custom duty paid on Imported Machinery.
(iii) Heavy expenditure incurred on advertising a new product.
(iv) Amount spent to overhaul a motor truck purchased second hand.

(v) Wages paid to workers for converting raw materials into finished products.
(vi) Wages paid to workers for setting up new machinery.

(vii) Office rent paid in advance for three years.
(viii) Expenditure on development of a product.

Solution:
(i) It is revenue expenditure because it is incurred in the normal course of business.

(ii) It is a capital expenditure because it adds to the cost of imported machinery.
(iii) Deferred revenue expenditure because the benefit of this expenditure will be available for
number of years. The proportionate amount will be written off every year.
(iv) It is a capital expenditure because the expenditure incurred will improve the present
condition of the motor truck.
(v) It is revenue expenditure as it has been incurred in the normal course of the business.
(vi) It is a capital expenditure because this is incurred to put an asset into working condition
and such expenditure is capitalized also.
(vii) It is deferred revenue expenditure because the right does not expire in the accounting
period in which it is paid; only a proportionate part of rent paid is to be treated as revenue
expenditure and balance should be carried forward as an asset to be written off in subsequent
years.
(viii) It is revenue expenditure as it is incurred in the normal course of business.
Self Assessment
Fill in the blanks:

3. If expenditure is incurred in the business to get its benefit for a long period, such expenditure
is called …………………….
4. When expenditure is done for a short period (less than one year) and for the regular
operation of business, it is termed as …………………….
8.4 Statement of Accounting Standard (AS-9) Revenue Recognition
The following is the text of the Accounting Standard (AS) 9 issued by the Institute of Chartered
Accountants of India on ‘Revenue Recognition’.
In the initial years, this accounting standard will be recommendatory in character. During this
period, this standard is recommended for use by companies listed on a recognised stock exchange
and other large commercial, industrial and business enterprises in the public and private sectors.

Notes Introduction
1. This Statement deals with the bases for recognition of revenue in the statement of profit &
loss of an enterprise. The Statement is concerned with the recognition of revenue arising
in the course of the ordinary activities of the enterprise from
(i) The sale of goods,
(ii) The rendering of services, and
(iii) The use by others of enterprise resources yielding interest, royalties and dividends.
2. This Statement does not deal with the following aspects of revenue recognition to which
special considerations apply:
(i) Revenue arising from construction contracts;
(ii) Revenue arising from hire-purchase, lease agreements;
(iii) Revenue arising from government grants and other similar subsidies;
(iv) Revenue of insurance companies arising from insurance contracts.
3. Examples of items not included within the definition of “revenue” for the purpose of this
statement are:
(i) Realised gains resulting from the disposal of, and unrealised gains resulting from
the holding of, non-current assets e.g. appreciation in the value of fixed assets;
(ii) Unrealised holding gains resulting from the change in value of current assets, and
the natural increases in herds and agricultural and forest products;
(iii) Realised or unrealised gains resulting from changes in foreign exchange rates and
adjustments arising on the translation of foreign currency financial statements;
(iv) Realised gains resulting from the discharge of an obligation at less than its carrying
amount;
(v) Unrealised gains resulting from the restatement of the carrying amount of an
obligation.
Definitions
4. The following terms are used in this Statement with the meanings specified:
4.1 Revenue is the gross inflow of cash, receivables or other considerations arising in
the course of the ordinary activities of an enterprise from the sale of goods, from the
rendering of services, and from the use by others of enterprise resources yielding
interest, royalties and dividends. Revenue is measured by the charges made to
customers or clients for goods supplied and services rendered to them and by the
charges and rewards arising from the use of resources by them. In an agency
relationship, the revenue is the amount of commission and not the gross inflow of
cash, receivables or other consideration.
4.2 Completed service contract method is a method of accounting which recognises
revenue in the statement of profit & loss only when the rendering of services under
a contract is completed or substantially completed.
4.3 Proportionate completion method is a method of accounting which recognises
revenue in the statement of profit & loss proportionately with the degree of
completion of services under a contract.

Explanation Notes
5. Revenue recognition is mainly concerned with the timing of recognition of revenue in the
statement of profit & loss of an enterprise. The amount of revenue arising on a transaction
is usually determined by agreement between the parties involved in the transaction.
When uncertainties exist regarding the determination of the amount, or its associated
costs, these uncertainties may influence the timing of revenue recognition.
6. Sale of Goods
6.1 A key criterion for determining when to recognise revenue from a transaction
involving the sale of goods is that the seller has transferred the property in the
goods to the buyer for a consideration. The transfer of property in goods, in most
cases, results in or coincides with the transfer of significant risks and rewards of
ownership to the buyer. However, there may be situations where transfer of property
in goods does not coincide with the transfer of significant risks and rewards of
ownership. Revenue in such situations is recognised at the time of transfer of
significant risks and rewards of ownership to the buyer. Such cases may arise where
delivery has been delayed through the fault of either the buyer or the seller and the
goods are at the risk of the party at fault as regards any loss which might not have
occurred but for such fault. Further, sometimes the parties may agree that the risk
will pass at a time different from the time when ownership passes.
6.2 At certain stages in specific industries, such as when agricultural crops have been
harvested or mineral ores have been extracted, performance may be substantially
complete prior to the execution of the transaction generating revenue. In such cases
when sale is assured under a forward contract or a government guarantee or where
market exists and there is a negligible risk of failure to sell, the goods involved are
often valued at net realisable value. Such amounts, while not revenue as defined in
this Statement, are sometimes recognised in the statement of profit & loss and
appropriately described.
7. Rendering of Services
7.1 Revenue from service transactions is usually recognised as the service is performed,
either by the proportionate completion method or by the completed service contract
method.
(i) Proportionate completion method: Performance consists of the execution of more

than one act. Revenue is recognised proportionately by reference to the
performance of each act. The revenue recognised under this method would be
determined on the basis of contract value, associated costs, number of acts or
other suitable basis. For practical purposes, when services are provided by an
indeterminate number of acts over a specific period of time, revenue is
recognised on a straight line basis over the specific period unless there is
evidence that some other method better represents the pattern of performance.
(ii) Completed service contract method: Performance consists of the execution of a

single act. Alternatively, services are performed in more than a single act, and
the services yet to be performed are so significant in relation to the transaction
taken as a whole that performance cannot be deemed to have been completed
until the execution of those acts. The completed service contract method is
relevant to these patterns of performance and accordingly revenue is recognised
when the sole or final act takes place and the service becomes chargeable.

Notes 8. The Use by Others of Enterprise Resources Yielding Interest, Royalties and Dividends
8.1 The use by others of such enterprise resources gives rise to:
(i) interest-charges for the use of cash resources or amounts due to the enterprise;
(ii) royalties-charges for the use of such assets as know-how, patents, trademarks
and copyrights;
(iii) dividends-rewards from the holding of investments in shares.
8.2 Interest accrues, in most circumstances, on the time basis determined by the amount
outstanding and the rate applicable. Usually, discount or premium on debt securities
held is treated as though it were accruing over the period to maturity.
8.3 Royalties accrue in accordance with the terms of the relevant agreement and are
usually recognised on that basis unless, having regard to the substance of the
transactions, it is more appropriate to recognise revenue on some other systematic
and rational basis.
8.4 Dividends from investments in shares are not recognised in the statement of profit
& loss until a right to receive payment is established.
8.5 When interest, royalties and dividends from foreign countries require exchange
permission and uncertainty in remittance is anticipated, revenue recognition may
need to be postponed.
9. Effect of Uncertainties on Revenue Recognition
9.1 Recognition of revenue requires that revenue is measurable and that at the time of
sale or the rendering of the service it would not be unreasonable to expect ultimate
collection.
9.2 Where the ability to assess the ultimate collection with reasonable certainty is lacking
at the time of raising any claim, e.g., for escalation of price, export incentives,
interest etc., and revenue recognition is postponed to the extent of uncertainty
involved. In such cases, it may be appropriate to recognise revenue only when it is
reasonably certain that the ultimate collection will be made. Where there is no
uncertainty as to ultimate collection, revenue is recognised at the time of sale or
rendering of service even though payments are made by installments.
9.3 When the uncertainty relating to collectability arises subsequent to the time of sale
or the rendering of the service, it is more appropriate to make a separate provision
to reflect the uncertainty rather than to adjust the amount of revenue originally
recorded.
9.4 An essential criterion for the recognition of revenue is that the consideration
receivable for the sale of goods, the rendering of services or from the use by others
of enterprise resources is reasonably determinable. When such consideration is not
determinable within reasonable limits, the recognition of revenue is postponed.
9.5 When recognition of revenue is postponed due to the effect of uncertainties, it is

considered as revenue of the period in which it is properly recognised.
(Accounting Standard comprises paragraphs 10-14 of this Statement. The Standard should
be read in the context of paragraphs 1-9 of this Statement and of the ‘Preface to the Statements
of Accounting Standards’.)
10. Revenue from sales or service transactions should be recognised when the requirements
as to performance set out in paragraphs 11 and 12 are satisfied, provided that at the time of

performance it is not unreasonable to expect ultimate collection. If at the time of rising of Notes
any claim it is unreasonable to expect ultimate collection, revenue recognition should be
postponed.
11. In a transaction involving the sale of goods, performance should be regarded as being
achieved when the following conditions have been fulfilled:
(i) the seller of goods has transferred to the buyer the property in the goods for a price
or all significant risks and rewards of ownership have been transferred to the buyer
and the seller retains no effective control of the goods transferred to a degree usually
associated with ownership; and
(ii) no significant uncertainty exists regarding the amount of the consideration that will
be derived from the sale of the goods.
12. In a transaction involving the rendering of services, performance should be measured
either under the completed service contract method or under the proportionate completion
method, whichever relates the revenue to the work accomplished. Such performance
should be regarded as being achieved when no significant uncertainty exists regarding
the amount of the consideration that will be derived from rendering the service.
13. Revenue arising from the use by others of enterprise resources yielding interest, royalties
and dividends should only be recognised when no significant uncertainty as to
measurability or collectability exists. These revenues are recognised on the following
bases:
(i) Interest: On a time proportion basis taking into account the amount outstanding and
the rate applicable.
(ii) Royalties: On an accrual basis in accordance with the terms of the relevant agreement.
(iii) Dividends from investments in shares: When the owner’s right to receive payment is
established.
Disclosure
14. In addition to the disclosures required by Accounting Standard 1 on ‘Disclosure of

Accounting Policies’ (AS 1), an enterprise should also disclose the circumstances in which
revenue recognition has been postponed pending the resolution of significant uncertainties.
Appendix
This appendix is illustrative only and does not form part of the accounting standard set
forth in this Statement. The purpose of the appendix is to illustrate the application of the
Standard to a number of commercial situations in an endeavour to assist in clarifying
application of the Standard.
Sale of Goods
1. Delivery is delayed at buyer’s request and buyer takes title and accepts billing:
Revenue should be recognised notwithstanding that physical delivery has not been
completed so long as there is every expectation that delivery will be made. However,
the item must be on hand, identified and ready for delivery to the buyer at the time
the sale is recognised rather than there being simply an intention to acquire or
manufacture the goods in time for delivery.
Contd...

Notes 2. Delivered subject to conditions

(a) Installation and inspection i.e. goods are sold subject to installation,
inspection etc.: Revenue should normally not be recognised until the customer
accepts delivery and installation and inspection are complete. In some cases,
however, the installation process may be so simple in nature that it may be
appropriate to recognise the sale notwithstanding that installation is not yet
completed (e.g. installation of a factory-tested television receiver normally
only requires unpacking and connecting of power and antennae).
(b) On approval: Revenue should not be recognised until the goods have been
formally accepted by the buyer or the buyer has done an act adopting the
transaction or the time period for rejection has elapsed or where no time has
been fixed, a reasonable time has elapsed.
(c) Guaranteed sales i.e. delivery is made giving the buyer an unlimited right of
return: Recognition of revenue in such circumstances will depend on the
substance of the agreement. In the case of retail sales, offering a guarantee of
“money back if not completely satisfied”, it may be appropriate to recognise
the sale but to make a suitable provision for returns based on previous
experience. In other cases, the substance of the agreement may amount to a
sale on consignment, in which case it should be treated as indicated below.
(d) Consignment sales i.e. a delivery is made whereby the recipient undertakes to
sell the goods on behalf of the consignor: Revenue should not be recognised
until the goods are sold to a third party.
(e) Cash on delivery sales: Revenue should not be recognised until cash is received
by the seller or his agent.
3. Sales where the purchaser makes a series of instalment payments to the seller, and
the seller delivers the goods only when the final payment is received: Revenue from
such sales should not be recognised until goods are delivered. However, when
experience indicates that most such sales have been consummated, revenue may be
recognised when a significant deposit is received.
4. Special order and shipments i.e. where payment (or partial payment) is received for
goods not presently held in stock e.g. the stock is still to be manufactured or is to be
delivered directly to the customer from a third party.
Revenue from such sales should not be recognised until goods are manufactured,
identified and ready for delivery to the buyer by the third party.
5. Sale/repurchase agreements i.e. where seller concurrently agrees to repurchase the
same goods at a later date.
For such transactions, that are in substance a financing agreement, the resulting cash
inflow is not revenue as defined and should not be recognised as revenue.
6. Sales to intermediate parties i.e. where goods are sold to distributors, dealers or
others for resale.
Revenue from such sales can generally be recognised if significant risks of ownership
have passed; however in some situations the buyer may, in substance, be an agent
and in such cases the sale should be treated as a consignment sale.
7. Subscriptions for publications: Revenue received or billed should be deferred and

recognised either on a straight line basis over time or, where the items delivered vary
Contd...

in value from period to period, revenue should be based on the sales value of the item Notes
delivered in relation to the total sales value of all items covered by the subscription.
8. Instalment sales: When the consideration is receivable in installments, revenue

attributable to the sales price exclusive of interest should be recognised at the date
of sale. The interest element should be recognised as revenue, proportionately to
the unpaid balance due to the seller.
9. Trade discounts and volume rebates: Trade discounts and volume rebates received
are not encompassed within the definition of revenue, since they represent a reduction
of cost. Trade discounts and volume rebates given should be deducted in determining
revenue.
Rendering of Services
1. Installation Fees: In cases where installation fees are other than incidental to the
sale of a product, they should be recognised as revenue only when the equipment is
installed and accepted by the customer.
2. Advertising and insurance agency commissions: Revenue should be recognised when

the service is completed. For advertising agencies, media commissions will normally
be recognised when the related advertisement or commercial appears before the
public and the necessary intimation is received by the agency, as opposed to
production commission, which will be recognised when the project is completed.
Insurance agency commissions should be recognised on the effective commencement
or renewal dates of the related policies.
3. Financial service commissions: A financial service may be rendered as a single act or

may be provided over a period of time. Similarly, charges for such services may be
made as a single amount or in stages over the period of the service or the life of the
transaction to which it relates. Such charges may be settled in full when made or
added to a loan or other account and settled in stages. The recognition of such
revenue should, therefore, have regard to:
(a) Whether the service has been provided “once and for all” or is on a
“continuing” basis;
(b) The incidence of the costs relating to the service;
(c) When the payment for the service will be received. In general, commissions
charged for arranging or granting loan or other facilities should be recognised
when a binding obligation has been entered into commitment, facility or loan
management fees which relate to continuing obligations or services should
normally be recognised over the life of the loan or facility having regard to
the amount of the obligation outstanding, the nature of the services provided
and the timing of the costs relating thereto.
4. Admission fees: Revenue from artistic performances, banquets and other special
events should be recognised when the event takes place. When a subscription to a
number of events is sold, the fee should be allocated to each event on a systematic
and rational basis.
5. Tuition fees: Revenue should be recognised over the period of instruction.
6. Entrance and membership fees: Revenue recognition from these sources will depend
on the nature of the services being provided. Entrance fee received is generally
Contd...

Notes capitalised. If the membership fee permits only membership and all other services
or products are paid for separately, or if there is a separate annual subscription, the
fee should be recognised when received. If the membership fee entitles the member
to services or publications to be provided during the year, it should be recognised
on a systematic and rational basis having regard to the timing and nature of all
services provided.
Self Assessment
Fill in the blanks:
5. …………………… from service transactions is usually recognised as the service is

performed, either by the proportionate completion method or by the completed service
contract method.
6. Revenue is the …………………… receivables or other considerations.
8.5 Final Accounts with Adjustments
Final accounts are prepared from the various balances depicted by the Trial Balance. Some
balance of the Trial Balance accounts are used to prepare the Trading Account and some for the
preparation of the Profit & Loss Account and the remaining balances are transferred to the
Balance Sheet. Thus all the balances of accounts of the Trial Balance are used in the final accounts.
Therefore the preparation of final accounts is the final stage of accounting.
8.5.1 Trading and Profit & Loss Account
In the Trading and Profit & Loss Account all those accounts are disclosed which affect the profit
or loss of the business. In other words all the nominal accounts of the Trial Balance are used to
prepare the Trading and Profit & Loss Account. In the left hand side, all the expenses incurred
during a period and in the right hand side all the incomes earned during a period are disclosed.
This account contains two parts:
 Trading Account
 Profit & Loss Account
8.5.2 Trading Account
Trading account is the comparison of sales and purchase. This account is prepared to determine
the amount of gross profit or gross loss on sales. Trading account is prepared to know the
trading result. Trading result indicates gross profit or loss of the trading period. Gross profit or
loss is the difference between selling price and purchase price of the goods sold. If selling price
of the goods sold is more than the purchase price, the difference is known as gross profit. On the
contrary, when the situation is reverse, the difference is termed as gross loss. Here, purchase
price includes the cost of shipment and other direct expenses incurred until the goods reach the
point of sale and to make the goods ready for sale, if any. The proforma of Trading Account is
given.

Proforma of Trading Account Notes

In the Books of …………….
Trading Account
(for the year ending …………….)
Particulars Amount (Dr.) Particulars Amount (Cr.)

( ) ( )
To Opening Stock ------- By Sales ----------
To Purchases --------- Less: Returns ---------- -------
Less: Returns --------- ------- By Closing stock -------
To Wages & Salaries ------ By Gross Loss (if any)
To Carriage Inwards ------- Transferred to P/L A/c -------
To Cartage ------
To Frieght -------
To Light Power & Heating in
factory ------
To Factory Insurance -------
To Works Manager’s Salary
------
To Foreman’s Salary
-------
To Factory Rent & Taxes ------
To Motive Power
-------
To Factory Repairs
------
To Factory Expenses -------
To Octroi duty
------
To Custom Duty
-------
To Manufacturing Exps. ------
To Consumable Stores
-------
To Gross Profit
Transferred to P/L A/c -------
------ -------
Notes
 There is no particular proforma of the Trading Account. The above proforma given
is traditional one. That is not as per law. Here the students are advised to follow this
proforma.
 If the total of credit side is more than the total of debit side, difference is called gross
profit or vice versa gross loss.
Gross Profit: After showing all the items of debit side and credit side, each side is totalled. If the
total of credit side is higher than the total of debit side, the difference is termed as Gross Profit.
In case of reverse situation i.e. debit side is higher than the credit side, it is a Gross Loss. Though
the gross profit or gross loss is not a real profit or real loss that is why it is taken to Profit & Loss
account from where Net Profit or Net Loss is calculated.

Notes Following are the main points of difference between gross profit and net profit.
Table 8.1
Gross Profit Net Profit

It is the excess of net sales over cost of purchase It is the excess of gross profit over all indirect
or manufacture (all expense relating to expenses.
purchase or manufacture of goods) of goods.
It is not true profit of the business. It is true profit of the business.
It shows credit balance of the trading account It shows credit balance of the profit and loss
account.
The progress of the business can be judged by The profitability of the business can be measured
the comparison of gross profit with net sales by the comparison of net profit with net sales.
Detailed Study of Different Items Appearing in Trading Account
1. Opening Stock: Whenever Trading account is prepared, stock of the last year is shown as
opening stock of the current year, which is passed through an opening entry and appears
in the trial balance. It is generally shown as a first time in the Trading account but if the
business is a new one, just started, then there would not be any opening stock. In case of a
trading concern finished goods is the only item which is available for sale whereas in case
of a manufacturing concern, opening stock is of: (a) Raw Materials, (b) Finished Goods,
and (c) Semi-finished Goods.
Following entries are passed in books of the business:
For Adjustment of Opening Stock

( ) ( )
1. Purchases A/c Dr.
To opening stock A/c
(Adjustment for opening stock)
For Adjustment of Closing Stock

( ) ( )
2. Closing stock A/c Dr.
To purchases A/c
(Adjustment for closing stock)
Note Thus, there will be no opening stock in the trial balance because of the above
adjustment for opening stock and amount of adjusted purchases is to be shown on the
debit side of trading account and amount of closing stock on the assets side of the Balance
sheet.
2. Purchases are shown in the trial balance: It is the sum of cash purchases + credit purchases.
The balance of Purchases A/c is always debit balance and if there is any return to be shown
by purchases returns (returns - outwards) A/c, which is having a credit balance, must be
deducted from the total purchases in order to arrive at the correct figure of Net Purchases.

Thus in Trading account purchases returns are shown by way of deduction from the Notes
purchases as follows:
( )
Total purchases as per trial Balance 1,00,000
–Total Returns –3,000

97,000
Sometimes it happens that the goods are received but invoice is not received that is why it is not
entered in the purchases A/c. In such a case, a closing entry at the end of the year must be passed
which is as follows:
Purchases A/c Dr.

To Supplier A/c
(Goods received entered)
If any purchase is made by the proprietor for his /her personal use, then it must also be deducted
from total purchases. Sometimes if the delivery of goods is to take place in future under a
contract of Business, such goods must not be included in the total purchases.
3. Direct Expenses: The expenses, which are incurred on acquiring goods for resale purposes
are termed as direct expenses which are shown on the debit side of the Trading account.
Such expenses, might have been paid or outstanding or paid in advance, the net amount is
shown in the trading account. Such expenses are:
(a) Carriage Inwards: The expenses which are incurred for bringing goods in the business
for resale purposes are called carriage inwards. Such items of expenses are shown on
the debit side of the Trading account. If carriage is paid for bringing any asset in the
business such as Plant/Machinery is not shown in the Trading account, but is added
in the cost of the asset.
(b) Wages on Purchases: If any wage is paid for making or manufacturing as article or on
goods meant for resale is a direct expenses and is shown on the debit side of the
trading account whereas if wages are paid for bringing any asset such as plant etc. is
not a direct expense and is added in the cost of the plant. Similarly, if wages are paid
after the goods are sold, it is unproductive wages, hence to be shown in the profit &
loss A/c.
(c) Freight on Purchases: When freight is paid or is payable on the goods purchased for
resale, it is a direct expense and is shown to the debit side of the Trading
A/c but if any freight is paid on the purchase of an asset, then it is added in the cost
of the asset.
(d) Other direct Expenses: Such as:
(i) Fuel, lighting, power: Generally goods are manufactured with the help of
coal, or power/electricity and lighting for the factory. Such expenses are also
direct expenses, and are shown on the debit side of the Trading account.
(ii) Octroi duty, custom etc.: Whenever goods are purchased from outside,
municipality (Municipal Corporation) charges some tax, known as octroi
which is direct expenses to be debited in the Trading account. Similarly, when
Goods are purchased from abroad or foreign countries. Import duty is to be
paid which is also a direct expense and to be shown in Trading account but if
the asset such as plant/machinery is purchased and import duty is paid then it
is added in the cost of plant/machinery.

Notes (iii) Packing expenses which are incurred for packing the goods for resale, are
direct expenses and to be shown in Trading account, but if packing is done for
sending goods to the customer’s address, such expenses are realized from the
customers, hence are not direct expenses.
4. Sales: Total amount of sales, cash sales and credit sales, is shown on the credit side of the
trading account and if there is any sales-return (return inwards) is to be deducted from
such sales.
Notes
1. If some assets is sold then it is not a revenue receipt but it is a capital receipt to be
shown by way of deduction from total assets.
2. Sometimes sales had taken place, but goods are not delivered, then such goods
should not be included in the closing stock but be kept separately.
3. Similarly goods are sent on consignment or sale or return basis or hire purchase
basis, cannot be included in the sales because the buyer is free to return.
5. Closing Stock: The second item of the credit side of trading account is the closing stock.
The goods which could not be sold during a fixed period, are termed as closing stock. This
item is not shown in the trial balance because its valuation is done at the end after closing
of all the accounts. That is why it is shown as a footnote beneath the trial balance, but when
purchases are adjusted with opening and closing stock, then the balance of closing account
is debit, hence it is shown as an asset in the Balance Sheet. Valuation of closing stock poses
a number of problems such as cost price or market price, but as per convention stock is
always valued at cost or market price whichever is less. This rule is based on the principle
of probable losses which are taken into account, but not the probable gains. It is also
necessary to be careful while valuing closing stock correctly. Otherwise gross profit, thus
ascertained, would not be correct one, if it is not followed strictly then the Gross profit
would be incorrect and misleading. Journal entries to be passed for closing stock & opening
stock.

( ) ( )
(i) Closing stock A/c Dr.
To trading A/c
(Closing stock shown on the credit side of Trading
A/c)
(ii) if closing stock A/c Dr.
To purchases A/c
(If closing stock is transferred to purchases A/c,
then it cannot be shown in the trading A/c, but to
be shown in the Balance Sheet only.)
(iii) Trading A/c Dr.
To opening stock
(Opening stock transferred)

Illustration 1: From the following information, prepare the trading account for the year ended Notes
31st March 2011.
Stock on 1st April 2005 (Opening stock) 4,000
Purchases
(i) Cash purchases 20,000
(ii) Credit purchases 50,000
Sales
(i) Cash sales 20,000
(ii) Credit sales 60,000
Stock on 31st March 2011 (Closing Stock) 6,000
Solution:
Dr. Trading Account for the year ended 31st March 2006 Cr.
( ) ( )
To Opening stock 4,000 By Credit sales 20,000
To Credit purchases 20,000 By Cash sales 60,000
To Cash purchases 50,000 By Total sales 80,000
To Total purchases 70,000 By Closing stock 6,000
To Gross profit c/d 12,000
86,000 86,000
Illustration 2: Prepare trading account of M/s Sundar and sons as on 31st March 2011
( )
Opening stock on 1st April 2004 50,000
Purchases
(i) Cash 1,20,000
(ii) Credit 1,00,000
Sales
(i) Cash 40,000
(ii) Credit 1,00,000
Purchase Returns 20,000
Carriage Inwards 10,000
Marine insurance on purchase 6,000
Other direct expenses 4,000
Sales Returns 30,000
Stock as on 31st March 2011 10,000
In this problem, return outwards and inwards are given in addition to cash and credit purchases
and sales of a firm to find out the net purchases and the net sales of the firm.
Net Sales = Cash Sales + Credit Sales – Sales Returns
Net Purchases = Cash Purchases + Credit Purchases – Purchase Returns

Notes Solution:
Trading account for the year ended 31st March 2011
Dr Cr
( ) ( )
To Opening Stock 50,000 By Cash Sales 40,000
To Cash Purchase 1,20,000 Add: Credit Sales 1,00,000
Add: Credit Purchase 1,00,000 By Total Sales 1,40,000
To Total Purchase 2,20,000 Less: Sales Return 30,000
Less: Purchase Return 20,000 By Net Sales 1,10,000
To Net Purchase 2,00,000 By Closing Stock 10,000
To Carriage Inwards 10,000 By Gross Loss c/d 1,50,000
To Marine Insurance 6,000
To Other Direct Expenses 4,000
2,70,000 2,70,000
To Gross Loss B/d 1,50,000 1,50,000
Gross Loss is due to an excess of the debit side total over the credit side total.
Illustration 3: From the following information, calculate the stock at the end:
( )
Opening stock 62,000
Purchases 4, 20,000
Sales 6,00,000
1
Rate of Gross Profit on Cost = 33
3
Solution:
1
Gross profit on cost = 33
3
1
33
Hence Gross profit on Sales = 3 = 1 or 25%
1 4
133
3
Trading Account
(for the year ended………)
To opening stock 62,000 By sales (given) 6,00,000
To purchases 4,20,000 By closing stock
To gross profit (Balancing figure) 32,000
1
On cost 33 % or
3 1,50,000
25% on sales which is 6,00,000
6,32,000 6,32,000
Thus, we can say that the value of stock at the end was 32,000.

Notes
Task Calculate the Gross Profit from the following:
( )
Purchases 1,05,000
Wages 3,500
Sales 1,40,000
Hint: 20,000
Profit & Loss Account is the second part of Trading and Profit & Loss Account. Trading Account
depicts the gross profit which is the difference of sales and cost of sale. Thus the gross profit cannot
treated as net profit while the businessman wants to know how much net profit he has earned
from the operating activities during a period. For this purpose Profit & Loss Account is prepared
keeping in mind all the operating and non-operating incomes and losses of the business. In the
debit (left hand side) side all the expenses and losses are disclosed and in the credit side (right hand
side) all the incomes are disclosed. The excess of credit side over debit side is called net profit while
the excess of debit side over credit side shows net loss. Net profit increases the net worth of the
business, therefore, it is added to the capital of owner. Net loss decreases the net worth of business
so it is subtracted from capital. The proforma of Profit & Loss Account is given below:
Proforma of Profit & Loss Account
To Gross Loss (if any) transferred By Gross Profit (transferred
from Trading Account ---- from Trading Account) ----
To Staff Salries ---- By Discount Received ----
To Office Rent ---- By Commission Received ----
To Rates & Taxes ---- By Dividend ----
To Office Lighting and Heating ---- By Interest Received ----
To Printing & Stationary ---- By Rent from Tenant ----
To Bank Charges ---- By Interest from Bank ----
To Insurance ---- By Interest on Drawings ----
To Telephone Charges ---- By Profit on Sale of
To Legal Expenses ---- Investment ----
To Repairs ---- By Provision for Discount on
To Postage & Stamps ---- Creditors ----
To Trade Expenses ---- By Bad Debts recovered ----
To Establishment Exps. ---- By Profit on Sale of Assets ----
To Audit Fees ---- By Other Incomes ----
To Charity & Donations ---- By Net Loss (if any)
To Management Exps. ---- transferred to Capital A/c ----
To Depreciation on Contd...
Land & Buildings ----
Plant and Machinery ----
Furnitures ----
To Stable Expenses ----
To Directors Fee ----
To Bank Charges ----
To Interest on Loan ----
To Interest on Capital ----
To Discount on B/R ----
To Legal Expenses ---- Investment ----
To Repairs ---- By Provision for Discount on
To Postage & Stamps ---- Creditors ----
To Trade Expenses ---- By Bad Debts recovered ----
To Establishment Exps. ---- By Profit on Sale of Assets ----
To Audit Fees ---- By Other Incomes ----
To Charity & Donations ---- By Net Loss (if any)
To Management Exps. ---- transferred to Capital A/c ----
Notes To Depreciation on
Land & Buildings ----
Plant and Machinery ----
Furnitures ----
To Stable Expenses ----
To Directors Fee ----
To Bank Charges ----
To Interest on Loan ----
To Interest on Capital ----
To Discount on B/R ----
To Sales Tax ----
To Advertisement ----
To Bad Debts ----
To Agents’ Commission ----
To Travelling Expenses ----
To Free Samples distributed ----
To Warehouse Expenses ----
To Packing Expenses ----
To Brokerage ----
To Distribution Expenses ----
To Delivery Van Expenses ----
To Provision for Bad and Doubtful ----
Debts ----
To Entertainment Expenses
To Carriage Cutward ----
To Loss on Sale of Assets ----
To Licence Fees ----
To Repairs of Assets & Motor Car ----
To Loss by Fire ----
To Conveynance Expenses ----
To Net Profit (Transferred to ----
Capital A/c.) ----
----
----- -----
Operating Profit and Net Profit
Operating profit is the excess of profit over operating expenses. Operating expenses include
office and administrative, selling and distributive expenses, cash discount allowed, interest on
short term loans etc. Therefore operating profit = Net sales – operating expenses, whereas
operating expenses = cost of Goods sold + administrative and office expenses + Selling and
distributive expenses or
Operating Profit = Net Profit + Non-operating expenses – non-operating income.
Net Profit means the excess of revenue over expenses and losses (whether operating or non-
operating). In other words, net profit is calculated by deducting operating expenses from operating
profit as well as non operating profit.

Non operating expenses are such expenses which are incidental or indirect to the main operations Notes
of the business. Such expenses are interest on loan, charities and donations, loss on sale of fixed
assets, loss due to theft, pilferage or loss by fire.
Non-operating income is receipt of interest, rent, dividend, profit on sale of fixed assets etc. Such
incomes are always added in order to compute net profit.
Illustration 4: Compute operating profit and net profit from the following information:
Gross profit 2,50,000 Donation 4,250
Salaries 77,000 Rent received 2,300
Advertizing 4,000 General Expenses 550
Rent and taxes 26,500 Interest on investment 4,300
Insurance charges 3,720
Audit fee 2,700
Carriage outward 1,210
Loss on sale of plant 3,100
Printing and stationery 1,100
Interest on loans 15,000
Loss by theft 12,500
Profit on sale of Machinery 41,000
Solution:
Statement showing operating profit & Net profit
Particulars ( ) ( )
Gross Profit 2,50,000
Less
Office and administrative expenses
Salaries 77,000
Rent and taxes 26,500
Insurance charges 3,720
Audit fee 2,700
Printing and stationery 1,100
General expenses 550 1,11,570
Less
Selling and distributive expenses 1,210
Carriage outwards 4,000 5,210 -1,16,780
Advertising 1,33,220
Operating profit
Add-
Non operating Income-
Interest on investments 4,300
Rent received 2,300
Profit on sale of Machinery 41,000 47,600 +47,600
Less 1,80,820
Non operating expense- Contd...
Donations 4,250
Loss by theft 12,500 34,850 – 34,850
Net profit 1,45,970
Advertising 1,33,220
Operating profit
Add-
Non operating Income-
Interest on investments 4,300
Rent received 2,300
Profit on sale of Machinery 41,000 47,600 +47,600
Less 1,80,820
Notes Non operating expense-
Donations 4,250
Loss by theft 12,500 34,850 – 34,850
Net profit 1,45,970
In case of Net loss reverse entry is to be passed i.e.
Capital A/c (Net loss) Dr.

To profit & loss A/c
Net loss transferred
Illustration 5: Following is the trial balance of R. Prasad on 30th June 2010
Particulars Dr. ( ) Cr. ( )

Capital - 15,000
Purchases 20,000 -
Sales - 30,000
Wages 1,200 -
Furniture 800 -
Salaries 900 -
Traveling Expenses 700 -
Commission 300 -
Cash in hand 1,000 -
Cash at Bank 3,400 -
Buildings 16,000 -
Debtors & Creditors 4,500 4,000
Bills Payable & Bills Receivable 600 800
Telephone 100
Returns 500 200
50,000 50,000
On 30th June 2010 stock was valued at 7,500. Prepare Trading and Profit & Loss account for the
year ended on 30th June 2010
Solution:
Trading and Profit & Loss account of Mr. R. Prasad
(for the year ended on 30th June 2010)
To Purchases 20,000 By sales 30,000
-Returns 200 19,800 -Returns 500 29,500
To Wages 1,200 By Closing stock 7,500
To Gross Profit c/d 16,000
37,000 By Gross profit b/d 37,000
To Salaries 900 16,000
To Travelling Expenses 700
To Commission Contd...
300
To Telephone 100
To Net Profit 14,000
16,000 16,000
To Purchases 20,000 By sales 30,000
-Returns 200 19,800 -Returns 500 29,500
To Wages 1,200 By Closing stock 7,500
37,000 By Gross profit b/d 37,000
To Salaries 900 16,000
To Travelling Expenses 700
To Commission Notes
300
To Telephone 100
16,000 16,000
Cost of Raw Material consumed: If there is opening stock of raw materials in the business and
purchases are made of raw materials during the year and some stock is left at the end, then the
cost of raw materials consumed is to be calculated as follows:
( )
Opening stock of Raw Materials -
+ Purchases made -
– Returns during the period -
– Closing stock of Raw Materials -
Cost of raw-materials consumed
Task Calculate the cost of materials consumed from the following:

Opening Stock ( )
Raw materials 4,500
Work in Progress 12,000
Finished Goods 14,800
Sales 50,000
Purchases during the year 24,500
Carriage inwards 500
Closing stock—raw materials 1,500
Hint: 28000
8.5.4 Manufacturing Account
If in the business some goods are being manufactured along with the trading activities, a
manufacturing account is also prepared. In the case of trading activities (selling and purchasing
of goods) only, the Trading and Profit & Loss Account is prepared to compute the net profit
which is discussed in the preceding pages. In case there is a manufacturing unit in the business
with the trading, such a businessman’s income statement will include:
(i) Manufacturing Account

(ii) Trading Account
(iii) Profit & Loss Account

Manufacturing Account is prepared to know the results of manufacturing unit i.e. cost of
production.

Notes It includes:
[Debit side]
1. Carriage inwards paid on the purchase of raw materials is to be shown on the debit side of
Manufacturing account.
2. Manufacturing wages and other direct expenses - are also shown on the debit side of
manufacturing account.
Prime Cost = Cost of Direct Manufacturing + Wages + Direct expenses.
3. Factory Expenses: All expenses of the factory such as wages, power and fuel, rent and rates,
factory lighting, depreciation on machinery, salaries of manager and factory workers,
repairs etc. is debited to this account.
4. Work in Progress: Whenever manufacturing is done, it always happens that some of the
articles are not OK for sale, hence these are termed as Work in Progress. If such stock is there
at the beginning, then it is added with the factory cost whereas if such stock is there at the end
it is deducted from factory cost. Work in progress is also termed as semi-finished goods.
[Credit side]
(i) Closing stock of Raw Materials if not shown along with cost of raw materials
consumed.
(ii) Closing stock of work in progress/Semi-finished goods. Difference of credit and
debit side of the manufacturing account is transferred to trading account.
(iii) Sale of scarp, if any.
This account is prepared before the trading account. The balance of this account is transferred to
Trading Account. The proforma of Manufacturing Account is given hereunder:
Pro forma of Manufacturing Account
Manufacturing Account
(for the year ending ………)
To Opening Stock By Closing Stock
Raw Materials -------- Raw Materials ------
Work-in-progress -------- ---- Work-in-progress ------ ----
To Purchase of materials ----- By Sale of Scrape ----
Less returns ----- ---- By Cost of Production (Transferred ----
To Manufacturing Wages ---- to Trading A/c)
To Carriage Inwards ----
To Factory Expenses ----
To Stores Consumed ----
To Factory Rent ----
To Electricity ----
To Depreciation on Plant ----
To Repairs of Plant ----
To Works Manager’s Salary ----
To Coal and Fuel ----
To Other Factory exps. ----
---- ----

Illustration 6: Manufacturing, Trading and Profit & Loss A/c Notes

From the following particulars of Mr. Amit Agrawal, prepare a Manufacturing Account, Trading
and Profit & Loss Account for the year ended 31st March, 2010.
()
Purchase of Raw Material 39,58,500
Return Inwards 21,000
Stock on 31st March, 2008:
Raw Materials 3,63,000
Work-in-Progress 3,00,000
Finished Goods 4,11,000
Productive Wages 6,00,000
Factory Expenses 5,52,000
General Office Expenses 90,000
Salaries 1,80,000
Distribution Expenses 30,000
Selling Expenses 2,10,000
Purchase Expenses 1,80,000
Export Duty 90,000
Import Duty 60,000
Interest on Bank Loan 1,80,000
Stock on 1st April, 2007:
Raw Material 1,20,000
Work-in-Progress 90,000
Finished Goods 1,23,000
Sales 58,50,000
Return Outwards 25,500
Discount allowed 3,000
Sale of Scrap 6,000
Depreciation on Plant 1,50,000
Depreciation on Furniture 12,000
Solution:
(for the year ending 31st March, 2010)
To Opening Stock
Materials 1,20,000 By Sale of Scrap 6,000
Work-in-Progress 90,000 By Closing Stock:
To Purchase less Returns Materials 3,63,000
(39,58,500 - 25,500) 39,33,000 Work-in-Progress 3,00,000
To Productive Wages 6,00,000 By Cost of Production Contd...
To Factory Exps. 5,52,000 (Transferred to Trading A/c) 50,76,000
To Purchase Exps. 1,80,000
To Import Duty 60,000
To Carriage Inwards 30,000
To Depreciation on Plant 1,50,000
To Repairs to Machines 30,000
57,45,000 57,45,000
3
To Opening Stock
Materials 1,20,000 By Sale of Scrap 6,000
Work-in-Progress 90,000 By Closing Stock:
To Purchase less Returns Materials 3,63,000
(39,58,500 - 25,500) 39,33,000 Work-in-Progress 3,00,000
Notes To Productive Wages 6,00,000 By Cost of Production
To Factory Exps. 5,52,000 (Transferred to Trading A/c) 50,76,000
To Purchase Exps. 1,80,000
To Import Duty 60,000
To Depreciation on Plant 1,50,000
To Repairs to Machines 30,000
57,45,000 57,45,000
3
Trading and Profit & Loss Account

(for the year ending 31st March, 2010)
Particulars Amount Particulars Amount

( ) ( )
To Opening Stock of Finished Goods 1,23,000 By Sales less Returns

To Cost of Production (58,50,000 – 21,000) 58,29,000
(Transfer from Manufacturing A/c) 50,76,000 By Closing Stock 4,11,000

To Gross Profit c/d 10,41,000
62,40,000 62,40,000
To General Office Exps. 90,000 By Gross Profit b/d 10,41,000

To Salaries 1,80,000
To Depreciation on Furniture 12,000
To Discount Allowed 9,000
To Carriage Outwards 25,500
To Interest on Bank Loan 1,80,000
To Export Duty 90,000
To Selling Expenses 2,10,000
To Distribution Expenses 30,000
To Net Profit (Transferred to Capital
A/c) 2,14,500
10,41,000 10,41,000
Self Assessment
Fill in the blanks:

7. In the …………………… all those accounts are disclosed which affect the profit or loss of
the business.
8. …………………… is the comparison of sales and purchase.
9. …………………… is prepared to know the results of manufacturing unit i.e. cost of
production.
8.6 Balance Sheet
After the determination of the net profit of the business through the Trading and Profit & Loss
Account, the businessman wants to know the financial position of the business. For this purpose

he prepares a statement which is called the Balance Sheet. The Balance Sheet depicts the financial Notes
position of the business on a fixed date. Balance Sheet is prepared with those balances of Trial
Balance which are left out (personal and real accounts) after taking out the nominal accounts’
balances to prepare the Trading and Profit & Loss Account. A Balance Sheet has two sides – assets
side and liabilities side. The assets and liabilities are shown in a particular order.
Asset = Liabilities + Capital
Definition of Balance Sheet
1. “The Balance Sheet is a statement at a given date showing on one side the traders’ property
and possessions and on the other hand his liabilities”.
—Palmer
2. “Balance Sheet is a screen picture of the financial position of a business at a certain moment.”
—R. Stead
3. “Balance Sheet is a list of balances in the assets and liability accounts. This list depicts the
position of assets and liabilities of a specific business at a specific point of time”.
—American Institute of Certified Public Accountants
Presentation of a Balance Sheet
As the Trading and Profit & Loss account can be presented in two forms namely (1) Horizontal/
Traditional form and (2) Vertical form (New, Recent development, Latest), similar is the case of
Balance Sheet, this can be presented either (1) Horizontal form or (2) vertical or single column
form. As we know, Balance sheet is prepared with a view to depict, the financial position of a
business concern that too on a particular date, it is better if it portrays the full and complete
information about financial soundness of the business. Under (1) Horizontal form, the Balance
Sheet depicts the assets on the right hand side of the Balance sheet, whereas the assets are
properly classified and shown such as (a) Fixed Assets (b) Investments (c) Current assets
(d) Miscellaneous assets and the liabilities are shown on the left hand side of the Balance Sheet
whereas liabilities are shown separately such as (i) Owned funds (ii) Borrowed funds i.e. funds
borrowed from outsider that too long-term or short-term.
The Balance sheet is a document or a statement which tells how the funds are collected i.e.
(1) Management of raising Funds and (2) How these are utilized i.e. Management of working
capital and fixed assets. So it is necessary that the following information is supplied by the
balance sheet.
(i) All the fixed assets must be shown as cost i.e. original costs and if depreciation is provided,
it must be shown by way of deduction, if there is a change in the method of showing assets,
it must be stated clearly.
(ii) As far as closing stock is concerned, it must be valued at cost or market value whichever is
less.
(iii) Valuation of Investments–Cost as well as market value be given separately.
(iv) Book debts must be shown on book value and if any provision is made, this fact must be
clearly stated. If there are some doubtful debts which are not provided, should be given
separately.

Notes Balance sheet is presented in a Horizontal form

Balance Sheet of Mr. Faquir Chand
(as on 31st March, 2011)
Liabilities ( ) Assets ( )
Capital 24,000 Machinery at Cost 12,400
+Net Profit 67,900 Less depreciation
- Drawings 91,900 Furniture & Fixture 6,500
4,000 At cost less depreciation
87,900 Closing Stock 52,000
Bank overdraft
5,000 Sundry Debtors 63,000
Bills Payable
7,000 Bills Receivable 5,000
Sundry Creditors
40,000 Cash in hand 1,000
1,39,900 1,39,900
Vertical Presentation of Balance Sheet
Balance sheet may also be presented vertically or in a single column form. In this case fixed
assets are to be taken first + Amount of working capital i.e. Current Assets – Current liabilities,
to be contributed by the owner in the form of capital + net profit or- Net Loss.
If the above Balance sheet of Mr. Faquir Chand is presented in a single column (vertical form) it
would be like this:
Balance Sheet on Mr. Faquir Chand
(as on March 31st 2011)
Particulars ( ) ( )
Fixed Assets
Machinery 12,400
Furniture & Fixture 6,500
+Working Capital i.e. 18,900
Current Assets
Cash in hand 1,000
Bills Receivables 5,000
Sundry debtors 63,000
Closing Stock 52,000
Current Assets 1,21,000
(–) Current liabilities
Bank overdraft 5,000
Bills Payable 7,000
Sundry Creditors 40,000
52,000
Working Capital 69,000
Net Assets 87,900
Capital Contributed by the owner 24,000
+ Net Profit 67,900
Total Capital 91,900
– Drawings 4,000
Net Liabilities 87,900

Illustration 7: From the following Trial balance of Mr. Gopal for the year ending 31.3.2011, Notes
prepare Trading and Profit & Loss account and Balance Sheet as on 31.3.2011.
Dr. Cr.
Particulars ( ) ( )
Opening stock 25,000 -
Capital 2,25,000
Debtors and creditors 30,000 17,500
Purchases and sales 2,00,000 3,50,000
Returns 7,500 5,000
Carriage 4,000 -
Wages 12,500 -
Commission 6,500
Machinery 40,000 -
Furniture 10,000 -
Bad debts 4,000 -
Provision for doubtful debts 5,000
B/R and B/P 15,000 3,500
Land and Buildings 2,00,000 -
Taxes and Insurance 8,500 -
Discount allowed 6,000 -
Bank 25,000 -
Drawings 25,000 -
6,12,500 6,12,500
Value of closing stock is 20,000
Solution:
Trading and Profit & Loss Account of Mr. Gopal
For the year ending on 31.3.2011
To opening stock 25,000 By sales 3,50,000
To purchases 2,00,000 By Returns 7,500 3,42,500
To Returns 5,000 1,95,000 By Closing stock 20,000
To carriage 4,000
To wages 12,500
To Gross Profit c/d 1,26,000
3,62,500 3,62,500
To taxes and Insurance 8,500 By Gross Profit b/d 1,26,000
To Discount allowed 6,000 By commission 6,500
To Net profit 1,19,000 By provision for D/D 5000
- Bad debts during the year 4000 1000
1,33,500 1,33,500

Notes Balance sheet of Mr. Gopal as on 31.3.2011
( ) Machinery 40,000
Capital 2,25,000 Furniture 10,000
+ Net profi 1,19,000 Land and Buildings 2,00,000
3,44,000 Debtors (30,000) 30,000
– Drawings –25,000 B/R 15,000
– Creditors 3,19,000 Stock 20,000
B/P 17,500 Bank 25,000
3,500
3,40,000 3,40,000
Marshalling of Assets and Liabilities
Order of presenting the assets and liabilities in the Balance Sheet is called marshalling of assets
and liabilities. A Balance Sheet may be prepared by marshalling the assets and liabilities in the
following orders:
1. Balance Sheet prepared in Liquidity Order: Here liquidity means conversion of assets into
cash. When a Balance Sheet is prepared on the basis of liquidity order, more easily
convertible assets into cash are shown first and those assets which cannot be easily converted
into cash are shown later and so on. In the case of liabilities, first those liabilities are
shown which are payable earlier and then those liabilities are shown which are payable
later. The proforma of such a Balance Sheet is given.
Proforma of Balance Sheet in Order of Liquidity
(as on …………………..)
Liabilities Amount Assets Amount

( ) ( )
Current Liabilities Current Assets
Sundry Creditors ------ Cash in Hand ------
Bank Overdraft ------ Cash at Bank ------
Short-term Loan ----- Short-term Investment ------
Outstanding Expenses ----- Prepaid Expenses ------
Unaccrued Income ----- Bills Receivable ------
Bills Payable ----- Accrued Incomes ------
Long-term Liabilities Debtors ------
Capital ------- Closing Stock ------
+ Net Profit ------- Fixed Assets
------- Land & Building -----
- Drawings ------- ----- Plant & Machinery -----
Long-term Loans ----- Furniture -----
Contingent Liabilities Investments (Long-term) -----
------- Goodwill ------
------- Patents & Trademarks ------
Livestock ------
------- -------

2. Balance Sheet prepared in Permanency Order: Balance Sheet prepared under this order is Notes
the reverse of the Balance Sheet prepared in liquidity order. In this case first those assets
are shown which are more permanent means fixed assets and then less permanent assets
(Current Assets) are shown. Similarly, first long-term liabilities (more permanent) are
shown then less permanent (short-term on current) liabilities are shown. The proforma of
such type of Balance Sheet is given below:
Proforma of Balance Sheet in Permanency Order
(as on …………….)

( ) ( )
Long-term Liabilities Fixed Assets
Capital ------ Land & Building -----
+ Net Profit ------ Plant & Machinery -----
------ Furniture -----
- Drawings ------ ------ Long-term Investment -----
Long-term Loans ------ Goodwill -----
Current Liabilities Patents & Trademarks -----
Sundry Creditors ------ Livestock etc. -----
Bank Overdraft ------ Current Assets
Bill Payable ------ Cash in Hand -----
Short-term Loan ------ Cash in Bank -----
Outstanding Expenses ------ Short-term Investments -----
Unaccrued Incomes ------ Bill Receivable -----
Prepaid Expenses -----
Accrued Incomes -----
Debtors -----
Closing Stock -----
------ ------
Illustration 8: Manufacturing, Trading and Profit & Loss Account and Balance Sheet
From the following Trial Balance of Mr. Aditya, prepare a Trading Manufacturing and Profit &
Loss Account and Balance Sheet as on 31st December, 2007.
Trial Balance
(as on 31st December, 2007)
Particulars Amount Amount

( ) ( )
Stock on 1.1.2007:
Raw Materials: 8,000 ---
Work-in-Progress 20,000 ---
Finished Goods 40,000 ---
Manufacturing Wages 40,000 ---
Purchases of Raw Materials 1,20,000 ---
Factory Rent 20,000 ---
Carriage of Raw Materials 12,000 ---
Salary of the Works Manager 8,000 Contd...
---
Office Rent 8,000 ---
Printing and Stationary 4,000 ---
Bad Debts 4,000 ---
Sales LOVELY PROFESSIONAL
--- UNIVERSITY 2,40,000 175
Land and Buildings 1,20,000 ---
Plant and Machinery 80,000 ---
Depreciation on Plant 8,000 ---
Sundry Debtors 20,000 ---
Stock on 1.1.2007:
Raw Materials: 8,000 ---
Work-in-Progress 20,000 ---
Finished Goods 40,000 ---
Manufacturing Wages 40,000 ---
Purchases of Raw Materials 1,20,000 ---
Factory Rent 20,000 ---
Carriage of Raw Materials 12,000 ---
Notes Salary of the Works Manager 8,000 ---
Office Rent 8,000 ---
Printing and Stationary 4,000 ---
Bad Debts 4,000 ---
Sales --- 2,40,000
Land and Buildings 1,20,000 ---
Plant and Machinery 80,000 ---
Depreciation on Plant 8,000 ---
Sundry Debtors 20,000 ---
Sundry Creditors --- 1,20,000
Cash in Hand 20,000 ---
Capital --- 1,72,000
5,32,000 5,32,000
Closing stock on 31st December, 2007 were as follows:

( )
Raw Materials 20,000
Solution:
In the Books of Mr. Aditya
(for the year ended 31st December, 2007)
To Opening Stock: By Closing Stock:
To Raw Materials 8,000 By Raw Material 20,000
To Work-in-Progress 20,000 28,000 By Work-in-Progress 16,000 36,000
To Purchase of Materials 1,20,000 By Cost of Production
To Carriage on Raw Materials 12,000 (Transfer to Trading A/c) 2,00,000
To Depreication on Plant 8,000
To Manufacturing Wages 40,000
To Factory Rent 20,000
To Salary of Works Manager 8,000
2,36,000 2,36,000

(for the year ending 31st December, 2007)

( ) ( )
To Opening Stock: By Sales
Finished Goods By Closing Stock 2,40,000
To Cost of Production 40,000 Finished Goods
(Transfer from Manufacturing A/c) 2,00,000 40,000
To Gross Profit Contd...
(carried to P. & L. A/c)
40,000
2,80,000 By Gross Profit 2,80,000
To Office Rent 8,000 (brought from Trading A/c)
To Printing & Stationary 4,000 40,000
To Bad Debts 4,000
To Net Profit (carried to Capital A/c)
( ) ( )
To Opening Stock: By Sales
Finished Goods By Closing Stock 2,40,000
To Cost of Production 40,000 Finished Goods
(Transfer from Manufacturing A/c) 2,00,000 40,000
To Gross Profit Notes
(carried to P. & L. A/c)
40,000
2,80,000 By Gross Profit 2,80,000
To Office Rent 8,000 (brought from Trading A/c)
To Printing & Stationary 4,000 40,000
To Bad Debts 4,000
To Net Profit (carried to Capital A/c)
24,000
40,000 40,000
Balance Sheet

( ) ( )
Capital 1,72,000 Land and Buildings 1,20,000
+ Net Profit 24,000 1,96,000 Plant and Machinery 80,000
Sundry Creditors 1,20,000 Sundry Debtors 20,000
Stock on 31st Dec., 2007:
Raw Materials 20,000
Cash in Hand 20,000
3,16,000 3,16,000
Adjustment Entries
Final accounts are prepared from the balances of Trial Balance. The final account will show the
true and proper picture of the business only when all the transactions of the business are properly
recorded. Therefore, before the preparation of final accounts the accountant must see that all the
transactions of the current year have been recorded properly in the books or not. If the accountant
find that some transactions are not incorporated in the books or wrongly incorporated in books
or partially incorporated in books, to complete the records and rectifying the errors done, some
adjustments are done. These adjustments entries are made in accounts through passing the
adjustment entries.
Usually adjustment entries are made in the books before preparing the final accounts for the
following items:
1. For Outstanding Expenses of the business
Outstanding expenses are the expenses incurred during a particular trading period, but
not yet paid by the closing date of that period. For example, unpaid salaries, unpaid rent,
unpaid wages, etc.
Relating Expenses Account Dr.
To Outstanding Expenses Account
The outstanding expenses at the time of preparation of final account are shown in the
liability side and on the other hand it is added in the relating expenses in the Debit side of
Profit & Loss Account.

Notes Illustration 9: On 1st Jan 2011, Mr. Ram took a loan from Bank of Rajasthan Ltd. of 10,000 @ 18%
per annum. Interest is payable half yearly and accounts of Ram are closed on 31st March every
year.
Pass Necessary journal entries to give its effect and prepare relevant ledger accounts and show
the item in the Balance sheet as on 31.03.2011.
Solution:
In the books of Ram
Journal Entry
Dr. Cr.
31.3.11 Interest A/c Dr. 450
To outstanding interest A/c 450
(Interest for 3 months due but not paid)
Ledger Accounts:
(1) Interest A/c
Dr. Cr.
Date Particulars J.F. ( ) Date Particulars J.F. ( )
31.3.11 To Interest 450 31.3.06 By P & L A/c 450
Outstanding A/c
(2) Interest outstanding A/c
Dr. Cr.
31.3.11 To Balance A/c 450 30.1.06 By Interest A/c 450
Balance sheet As on 31.3.11
Interest outstanding A/c 450
2. For Prepaid Expenses of the Business
Prepaid expenses are the expenses relating to the next trading period but paid during the
current period. In short, prepaid expenses are the expenses paid in advance. Insurance
premium, rent etc., are the examples of prepaid expenses.
Prepaid Expenses Account Dr.
To Relating Expenses Account

The prepaid expenses are disclosed in the assets side of the Balance Sheet and subtracted
from the relating expenses in the debit side of Profit & Loss Account.
Illustration 10: Mr. Ashish took a fire Insurance Policy on 1st Oct., 10 for 50,000 Insurance
Premium paid 5,000. Accounts are closed on 31st March, 11 Pass necessary journal entries to
give its effect and prepare relevant ledger A/c and show the item in the Balance Sheet as on 31st
March, 2011.

Solution: Notes
Journal Entries
Dr. Cr.
1.10.10 Insurance Premium A/c Dr. 5,000
To cash A/c 5,000
(Insurance Premium paid)
31.3.11 Prepaid Insurance Premium A/c Dr. 2,500
To Insurance Premium A/c 2,500
(Advance payment of Premium for six months)
Ledger Accounts
Insurance Premium A/c
(for the year ending 31st March 2011)
Dr. Cr
Date Particulars L.F ( ) Date Particulars L.F ( )
1.10.10 To cash A/c 5,000 31,3,11 By prepaid Insurance A/c 2,500

By P & L A/c 2,500
5,000 5,000
(2) Prepaid Insurance A/c

Dr. Cr
Date Particulars L.F ( ) Date Particulars L.F. ( )
31.3.11 To Insurance 2,500 31.3.11 By Balance c/d 2,500
Premium A/c
Balance Sheet
(as on 31.3.11)
Prepaid Insurance A/c 2,500
3. For Accrued Incomes of the Business
Accrued incomes are revenues that have been earned but cash has not yet been received
and no transaction has been recorded. Incomes which are due/earned but not received, are
not recorded in the books of accounts unless such incomes are received, but if this practice
continues, then it is not good because the results shown by the trading and Profit & loss
A/c would not be correct such Incomes may be rent, interest, commission etc.
Accrued Income Account Dr.

To Relating Income Account
The accrued incomes are disclosed in the assets side of the Balance Sheet and added in
income in the credit side of the Profit & Loss Account.
Illustration 11: Mr. Das has let out premises on rent on 01.07.10 @ 2,000 per month but rent is
receivable at the end of one year whereas accounts are closed on 31st March 06. Pass necessary
journal entries to give its effect and prepare ledger accounts and show how the item would
appear in the Balance Sheet as on 31.03.11.

Notes Solution:
Rent for 9 months @ 2,000/- p.m.
Total Rent = 2,000 × 9 = 18,000
Journal Entry at the end of accounting year

31.3.2011 Earned Rent A/c Dr. 18,000
To Rent A/c 18,000
(Rent accrued for 9 Months)
In the above case Earned Rent is a personal account and Rent (Income) is a nominal A/c.
Rent A/c
Dr. Cr.
31.3.11 To P & L A/c 18,000 31.3.11 By Earned Rent A/c 18,000
Earned Rent A/c

Dr. Cr.
31.3.11 To Rent A/c 18,000 31.3.11 By Balance c/d 18,000
Balance Sheet (as on 31.3.11)
Accrued Interest 18,000
4. For Unaccrued Incomes of the Business

Sometimes the Business receives some incomes though not yet due. This is as per terms of
the contract. Such Incomes are rent received in advance or interest Received in advance etc.
For example business premises are let out by the owner to a tenant on the condition that
rent for the year is to be paid in advance though it is not due if accounts are prepared
during the period of receipt of rent then adjusting entry is also to be passed so that we may
get accurate results.
Relating Income Account Dr.

To Unaccrued Income Account
Unaccrued incomes are disclosed in the liability side of the Balance Sheet and subtracted
from the relating incomes in the credit side of the Trading and Profit & Loss Account.
Illustration 12: M/s ABC takes deposits on the basis of Hundies, on which interest is generally
paid in advance, which are matured on the expiry of stipulated periods. Mr. Pankaj has given
20,000 to the firm for deposit against Hundi for a period of 1 year rate of interest is 15%- Date of
issue 01.09.10. Accounts are closed on 31st March, 2011 by Mr. Pankaj pass the necessary journal
entries to give its effects and prepare ledger accounts and show its effects how this would appear
in the Balance Sheet of Mr. Pankaj as on 31st March, 2011.

Solution: Notes
In the books of Pankaj
Interest Received 20,000 × 15/100 = 3,000 for a year
Interest Actually due for 7 months =
7/12 × 3000 = 1,750
Received in advance 5/12 × 3,000 = 1,250
Journal Entries
Dr. Cr.
1.9.10 ABC (Hundies A/c) Dr. 20,000
To Cash A/c 20,000
(Hundies purchased)
1.9.10 Cash A/c Dr. 3,000
To Interest A/c 3,000
(Interest received for one year)
31.3.11 1,250
Interest A/c Dr.
1,250
To unaccrued/unearned Interest A/c
(Interest unearned for 5 months )
Ledger Accounts
(I) Interest A/c
Dr. Cr.
31.3.11 To Interest 1250 1.9.10 By cash A/c 3,000
Accrued A/c
31.3.11 To P & L A/c 1,750
3,000 3,000
(II) Interest Unaccrued A/c

Dr. Cr.
31.3.11 To Balance A/c 1250 31.3.11 By Interest A/c 1,250
Thus, we see that Interest A/c is transferred to Profit & Loss A/c as it is a nominal A/c whereas
interest unaccrued A/c is a personal A/c, is to be shown on the liabilities side of the Balance Sheet.
Balance Sheet of Mr. Pankaj
As on 31.3.2011
Interest unaccrued A/c 1,250
5. For the Depreciation on Assets

Depreciation refers to reduction in the value of fixed asset due to wear and tear, passage of
time, obsolescence, etc. Depreciation is generally charged as a percentage on the book
value of the asset for which the asset is used.
Depreciation Account Dr.
To Relating Assets Account
Depreciation is subtracted from the relating assets in the assets side of the Balance Sheet
and disclosed in the debit side of Trading and Profit & Loss Account.

Notes 6. Interest on Capital and Drawings:

(i) For Interest on Capital
Interest on capital refers to the amount of interest allowed on the capital invested by
the proprietor in the business.
Interest on Capital Account Dr.
To Capital Account
Interest on Capital is added to the capital of owner in the liabilities side of the
Balance Sheet and disclosed in the debit side of the Trading and Profit & Loss Account.
(ii) For Interest on Drawings
Interest on drawings refers to the interest charged on the amount withdrawn by the
proprietor from his business for personal use.
Drawings Account Dr.
To Interest on Drawings Account
Interest on Drawings is subtracted from the amount of capital along with the
drawings and also shown in the credit side of income in Profit & Loss Account.
Illustration 13: Given below is the Trial Balance of a trader as on 31st March 2011.
Particulars ( ) ( )
Cash in hand 5,000
Land & Building 80,000
Plant & Machinery 50,000
Debtors and Creditors 25,000 40,000
Stock on 1.4.2009 10,000
15% Investments on 1.4.2009 20,000
Purchases and sales 95,000 1,90,000
Bank Overdraft 20,000
Wages 28,000
Salaries 16,000
Rent, Rates and Taxes 15,000
Bad Debts 6,000
Drawings 5,000
Bills Receivable and Bills Payable 15,000 21,000
Custom Duty on Purchases 16,000
Life Insurance Premium 4,000
Advertisement 30,000
Provision for Doubtful Debts 2,000
Interest on Investments 2,000
Trade Expenses 11,000
Furniture 20,000
Sales Tax 25,000
Capital 1,57,000
4,57,000 4,57,000

Additional Information: Notes

1. Stock on 31st March 2011 was valued at 40,000.
2. Included in debtors are 8,000 due from Ram and included in creditors are 6,000 due to
Ram.
3. Bills Receivable include a bill of 5,000 received from Varun, which has been dishonoured.
4. Sales include 5,000 for the goods sold on approval basis. Goods are sold at a profit of 25%
on cost.
5. Wages include 5,000 spent on the erection of machinery.
6. Advertisement include 20,000 spent at the time of launching a new product. It is the
policy of the business to write off such expenses in 5 years.
7. Create a provision for doubtful debts at 5% on debtors.
8. Prepaid taxes amounted to 2,000.
9. Depreciate machinery by 10%
Prepare Trading and Profit & Loss Account for the year ended 31st March 2011 and a Balance
Sheet as on that date.
Solution: Trading and Profit & Loss Account of Mr. Alok for the year ended on 31.3.2011.
Balance Sheet of Mr. Alok
as on 31.3.2011
To Stock 10,000 By Sales 1,90,000
To Purchases 95,000 – Sale on approval 5,000 1,85,000
To Carriage 6,000 By Closing Stock 40,000
To Custom Duty 16,000 +Sale on approval 4,000 44,000
To Wages 28,000 (5000-1000)
– Erection of Machine 5,000 23,000
2,29,000 2,29,000
To Salaries 16,000 By Gross Profit b/d 79,000
To Rent, Rates & Taxes 15,000 By Int on Investments 2,000
– Prepaid 2,000 13,000 + Accrued Interest 1,000 3000
To Bad debts 6,000
+ New Prov 950
6,950
– Old 2,000 4,950
To Trade Expenses 11,000
To Advertisement 30,000
– Deferred 16,000 14,000
To Depreciation on Machinery 5,500
82,000 82,000

Notes Balance Sheet of Mr. Alok

as on 31.3.2011
Capital 1,57,000 10,000 Cash in hand 5,000
+ Net Profit +17,550 Land & Building 80,000
1,74,550 Accrued Taxes 2,000
– Drawings (5000+4000) –9,000 1,65,550 Furniture 20,000
Bank Overdraft 20,000 Plant & Machinery 50,000
Bills Payable 21,000 + Erection +5,000
Creditors 40,000 55,000
– Common 6,000 34,000 – Depreciation –5,500 49,500
Sales Tax payable 25,000 Investments 20,000
+ Accrued Int 1,000 21,000
Debtors 25,000
– Common 6,000
19,000
+ Varun 5,000
24,000
– Approval 5,000
Poor 19,000
950 18,050
Bills receivable 10,000
Stock 44,000
Deferred Advertisement 16,000
2,65,550 2,65,550
7. Closing Stock: The stock of goods remaining unsold at the end of the trading period is
called closing stock.
Adjusting Entry
Closing Stock Account Dr.
To Trading Account
Accounting Treatment
(i) To be entered on the credit side of the trading account.
(ii) To be entered on the asset side of the balance sheet.
8. Interest on Loan and Investments:
If the business has taken a loan and interest is paid, then interest being a loss, is immediately
charged/debited to Profit & Loss A/c, but if interest is accrued but not paid because of the
terms of contract of business, then it must be provided for in books of account, otherwise
operational results would not be accurate but incomplete and defective.
(i) For Interest on Loan Payable
Profit & Loss Account Dr.
To Interest on Loan Account
Interest on Loan payable is added to the amount of Loan in the liability side of the
Balance Sheet and also shown in the debit side of Profit & Loss Account.

(ii) For Interest on Investment Receivable Notes

Interest on Investment Account Dr.
To Profit & Loss Account
Interest on Investment Receivable is added to investment in the assets side of the
Balance Sheet and also shown in the credit side of income in Profit & Loss account.
9. For Bad Debts: Bad debts refer to the amount due from debtors which are irrecoverable.
In short, bad debt is a debt which is written off as bad.
Bad Debts Accounts Dr.
To Sundry Debtors Account
Bad Debts are deducted from the sundry debtors in the assets side of the Balance Sheet and
shown in the debit side of Profit & Loss Account.
10. For Provision for Bad and Doubtful Debts: A doubtful debt is an amount due from debtors,
the recovery of which is doubtful. The provision or reserve made out of the current year's
profits for meeting the losses arising out of doubtful debts is known as provision for
doubtful debts. As we know that there are two types of transactions: (1) For cash, and
(2) For credit. In the modern era of science and technology business is not possible without
credit and if it is so then there is always a possibility that out of total sums, some of these
may not recover because of non-payment by the customer and if it happens, which is quite
common in almost every business, only difference is of the degree, so it is very much
necessary to provide for bad debts and this has become a part of policy decisions. The
debts which are bad, immediately entry is passed in the books of the business, but the
debts which are not yet declared as bad (irrecoverable) but the possibility is there that
some of them may be declared as bad, that is why it is necessary to provide for and this is
done by passing an adjustment entry.
(i) When the provision is created:
To Provision for Bad and Doubtful Debts Account
Such a provision is subtracted from the debtors in the assets side of Balance Sheet
and also shown in the debt side of Profit & Loss Account.
(ii) When Bad Debts are written off against the Provision for Bad and Doubtful Debts:
Provision for Bad and Doubtful Debts Account Dr.
To Bad Debts Account
(iii) When excess amount of the provision is transferred:
Provision for Bad and Doubtful Debts Account Dr.
The debts which are declared bad, immediately an entry for such loss is passed which is as
follows:
Dr. Cr.
Bad debts A/c Dr.
(profit and loss A/c)
To sundry Debtors A/c
(debtors to the extent declared as bad)

Notes The effect of the above Journal entry is that the balance of sundry debtors account is
reduced to the extent of bad debts and bad debts being a loss are transferred to profit & loss
account of the relevant year.
Recovery of Bad debts written off-Sometimes the debts which are written off as bad, are
recovered fully or a part of it, is recovered, then it is profit which is directly transferred to
profit & loss account and not in the debtors personal account. The entry in such case would
be:
Dr. Cr.
Cash A/c Dr.
To Bad debts Recovered A/c
(Profit & Loss A/c)
Bad debts recovered
In case of doubtful debts: On the basis of past experience, if any, a provision is created from
Profit & loss account and is credited to provision for bad and doubtful debts account. The
Journal entry would be:
Dr. Cr.
Profit and Loss A/c Dr.
To provision for Bad and doubtful debts A/c
Provision made
The effect of the above journal entry would be reduction of year’s profit and creation of
provision to be shown on the liabilities side of the Balance sheet. But the practice is that the
provision for bad and doubtful debt is deducted from total debtors on the assets side in the
year of creation, but next year when actual bad debts take place, such amount is debited
not from the profit & loss account, but from the provisions for Bad and doubtful debts
account and the balance, if any in this account, is deducted from the total debtors account.
Illustration 14: Mr. Ram Lal closes his books on 31st Dec., 2011 on that date debtors were
50,000. On the basis of past year experience, this has been a practice to provide for bad and
doubtful debts @ 10%.
You are required to journalize the above and prepare the ledger accounts and also show it in the
Balance sheet as on 31st Dec 2011
Solution:
Journal Entry

31.12.11 Profit and loss A/c Dr. 5,000
To provision for Bad & Doubtful debts A/c 5,000
Provision for Bad & doubtful debts created @ 10% on
50,000
Ledger Accounts
Provision for Bad and doubtful debts A/c

31.12.11 To Balance c/d 5,000 31.12.05 By P & L A/c 5,000

Balance Sheet Notes

As on 31.12.11
Sundry Debtors 50,000
-provision for
Bad & doubtful debts 5,000 45,000
11. For Discount Provision on Debtors

The provision or reserve made for meeting the loss arising on account of the discount that
will have to be allowed to the debtors who pay their dues promptly is known as provision
for discount on debtors.
(i) When the provision for discount on debtors is created:
To Provision for Discount on Debtors Account
Provision for discount on Debtors is subtracted from Sundry Debtors in the assets
side of Balance Sheet and shown in the debit side of Profit & Loss Account.
(ii) When the amount of discount is written off against the Provision for Discount Account:
Provision for Discount on Debtors Account Dr.
To Discount on Debtors Account
(iii) When excess amount of provision is transferred:
Provision for Discount on Debtors Account Dr.
Illustration 15: The following figures appear in the books of Shri Hanuman Prasad.
( )
Jan 1 Provision for bad and doubtful debts 2,400
Jan 1 Provision for discount on debtors 1,120
Dec 31 Bad debts written off 940
Dec 31 Discount allowed during the year 1,860
Dec 31 Bad debts recovered 50
Dec 31 Debtors 20,120
Write off further 480 (definitely bad)
Create a provision for discount on debtors @ 2% and also for bad and doubtful debts @ 4% you
are required to journalize the above and Prepare Provision for bad and doubtful debts A/c and
provision for discount on debtors A/c and bad debts A/c & discount A/c.
Solution:
Journal Entries

Dec 31 Provision for Bad & doubtful debts Dr. 940.00
To Bad debts A/c 940.00
(Bad debts transferred.)
Dec 31 Provision for discount on debtors A/c Dr. 1,860.00 Contd...
To Discount allowed A/c 1,860.00
(Discount allowed transferred.)
Dec 31 Bad debts Recovered A/c Dr. 50.00
To Profit & Loss A/c LOVELY PROFESSIONAL UNIVERSITY 50.00 187
(Gain transferred.)
Dec 31 Provision for Bad & doubtful debts A/c Dr. 194.40
To Profit & loss A/c 194.40
(Excess transferred.)
Dec 31 Profit and loss A/c Dr. 377.00
Dec 31 Provision for Bad & doubtful debts Dr. 940.00
To Bad debts A/c 940.00
(Bad debts transferred.)
Notes Dec 31 Provision for discount on debtors A/c Dr. 1,860.00
To Discount allowed A/c 1,860.00
(Discount allowed transferred.)
Dec 31 Bad debts Recovered A/c Dr. 50.00
To Profit & Loss A/c 50.00
(Gain transferred.)
Dec 31 Provision for Bad & doubtful debts A/c Dr. 194.40
To Profit & loss A/c 194.40
(Excess transferred.)
Dec 31 Profit and loss A/c Dr. 377.00
To Provision on discount on debtors A/c 377.00
(Discount on debtors transferred.)
Ledger Accounts
(i) Provision for Bad and doubtful debts A/c
Date Particulars ( ) Date Particulars ( )

Dec. 31 To Bad debts A/c 1,420 Jan. 1 By Balance b/d 2,400.00
Dec 31 To P & L A/c 194.40
(Bal. Figure)
Dec. 31 To Balance c/d 785.60
2,400.00 2,400.00
(ii) Bad debts A/c

Dec 31 To S. debtors A/c 940 Dec 31 By Provision for Bad
& Doubtful debts A/c 1,420
Dec 31 To debtors A/c 480
1,420 1,420
(iii) Provision for Discount on Debtors A/c

Dec 31 To Discount on Debtors 1,860 Jan 1 By Balance b/d 1,120
Dec 31 To Balance c/d 377 Dec. 31 By Profit & Loss A/c 1,117
2,237 2,237
(iv) Discount on Debtors A/c

Dec 31 To S. Debtors 1,860 Dec 31 By Provision for 1,860
Discount on Debtors
A/c
(v) S. Debtors A/c

Dec 31 To Balance b/d 20,120 Dec. 31 By Bad debts 480
20,120 20,120

Notes
Note Bad debts recovered are directly transferred to Profit & Loss A/c.
12. For Discount Provision on Creditors

The provision or reserve for discount on creditors is created for expected discount from
the creditors who are paid dues promptly.
(i) When provision for discount on creditors is created:
Provision for Discount on Creditors Account Dr.
Provision for discount on creditors is deducted from Creditors in the liability side
of Balance Sheet and shown in the Credit side of Profit & Loss Account.
(ii) When discount on creditors is written off against the provision:
Discount on Creditors Account Dr.
To Provision for Discount on Creditors Account
Illustration 16: A trader maintains a provision for discount on creditors A/c. The following
balances have been extracted from his books.
Date Date
31.12.10 31.12.11
( ) ( )
Discount Received 300 50
Sundry creditors 15,000 10,000
Provision for Discount on Creditors (opening) 400 To be credited @ 2% for 05 & 06
You are required to prepare Provision for Discount on creditor’s A/c as well as discount
received A/c.
Solution:
Discount Received A/c

31.12.10 Prov. For discount on 300 31.12.10 By S. creditors 300
creditors A/c
31.12.10 Prov. For discount on 50 31.12.11 By S. creditors 50
creditors A/c
Provision for Discount on Creditors A/c

31.12.10 To Balance b/d 400 31.12.10 By Discount Recd. 300
31.12.10 To P & L A/c 200 31.12.10 By Balance c/d 300
(Balancing figure) 2% on 15,000
600 600
1.1.11 To Balance b/d 300 31.12.11 By Discount Recd. 50
By P&L A/c 50
By Balance c/d 200
2% on 10,000
300 300

Notes 13. Creation of Reserve: The term reserve is most commonly used to describe any part of
shareholders’ equity, except for basic share capital.
Equity reserves are created from several possible sources:
(a) Reserves created from shareholders’ contributions, the most common examples of
which are:
 Legal reserve fund: It is required in many legislations and it must be paid as a
percentage of share capital
 Share premium: amount paid by shareholders for shares in excess of their
nominal value
(b) Reserves created from profit, especially retained earnings, i.e. accumulated
accounting profits. However, profits may be distributed also to other types of
reserves, for example:
 Legal reserve fund from profit: many legislations require creation of the fund
as a percentage of profits
 Remuneration reserve: will be used later to pay bonuses to employees or
management.
 Translation reserve: arises during consolidation of entities with different
reporting currencies
Reserve is the profit achieved by a company where a certain amount of it is put back into
the business which can help the business in their rainy days.
14. Sales Tax: Sales tax is the tax paid by a business concern to the government on the sales
made by it. In can be deducted from sales. Alternatively, it can be treated as selling
expense and can be entered on the debit side of the profit & loss account.
15. Income tax and life insurance premium: These are personal expenses of the proprietor and
should be treated as drawings. Since these are drawings they should be deducted from
capital on the liabilities side of the balance sheet.
Illustration 17: From the following trial balance of Mr. Nagaraj prepare the final accounts.
Trial balance as on March 31, 2011
Ledger Accounts Debit Credit

( ) ( )
Land and Buildings 50,000
Purchases 1,10,000
Stock 40,000
Returns 1,500 2,500
Wages 10,000
Salaries 9,000
Office expenses 2,400
Carriage inwards 1,200
Carriage outwards 2,000
Discounts 750 1,200
Bad debts 1,200
Sales 2,05,000
Capital account 1,30,000
Insurance 1,500
Contd...
Commission 1,500
Plant and Machinery 50,000
Furniture and Fixtures 10,000
Bills Receivable 20,000
Sundry debtors and creditors 40,000 25,000
Cash in hand 1,500
Cash at bank 4,500
Office equipment 12,000
Office expenses 2,400
Carriage inwards 1,200
Carriage outwards 2,000
Discounts 750 1,200
Bad debts 1,200
Sales 2,05,000
Capital account 1,30,000
Insurance 1,500
Commission 1,500 Notes
Furniture and Fixtures 10,000
Sundry debtors and creditors 40,000 25,000
Cash in hand 1,500
Cash at bank 4,500
Office equipment 12,000
Bills payable 2,350
Total 3,67,550 3,67,550
Adjustments:
(a) Closing stock amounted to 60,000.
(b) Outstanding liabilities: Wages 2,000, Rent 3,000.
(c) Depreciate land and buildings at 5%, plant and machinery, office equipment and furniture
and fixtures at 10%.
(d) Insurance premium prepaid to the extent of 200.
Solution:
In the books of Mr. Nagaraj
Trading A/c for the year ending March 31, 2011
Dr. Cr.
( ) ( )
To Opening stock 40,000 By Sales 2,05,000
To Purchases 1,10,000 Less: Returns 1,500 2,03,500
Less: Returns 2,500 1,07,500 By Closing Stock 60,000
To Wages 10,000
Add: Outstanding 2,000 12,000
To Carriage inwards 1,200
To Profit and Loss A/c 1,02,800
(Gross profit transferred to
profit and loss A/c)
2,63,500 2,63,500
Profit & Loss A/c for the year ending March 31, 2007
Dr. Cr.
( ) ( )
To Salaries 9,000 By Trading A/c (gross profit 1,02,800
To Office expenses 2,400 transferred from trading A/c)
To Carriage outwards 2,000 By Discount 1,200
To Discount 750 By Commission 1,500
To Bad debts 1,200
To Insurance 1500
Less: Prepaid 200 1,300
To Outstanding rent 3,000
Contd...
To Depreciation:
Furniture & Fixture 1,000 LOVELY PROFESSIONAL UNIVERSITY 191
Office equipment 1,200 9,700
(Net Profit transferred)
1,05,500 1,05,500
( ) ( )
To Salaries 9,000 By Trading A/c (gross profit 1,02,800
To Office expenses 2,400 transferred from trading A/c)
To Carriage outwards 2,000 By Discount 1,200
To Discount 750 By Commission 1,500
To Bad debts 1,200
To Insurance 1500
Less: Prepaid 200 1,300
Notes To Outstanding rent 3,000
To Depreciation:
Furniture & Fixture 1,000
Office equipment 1,200 9,700
(Net Profit transferred)
1,05,500 1,05,500
Balance Sheet as on March 31, 2007
Capital Fixed Assets
Opening balance 1,30,000 Land & Buildings 50,000
Add: Net profit 76,150 2,06,150 Less: Depreciation @ 5% 2,500 47,500
Less: Depreciation @ 10% 5,000 45,000
Furniture & Fixtures 10,000
Long Term Liabilities Less: Depreciation @ 5% 1,000 9,000
Office equipments 12,000
Less: Depreciation @ 10% 1,200 10,800
Current Liabilities Investments
Creditors 25,000
Bills payable 2,350 Current Assets
Outstanding Wages 2,000 Bills Receivable 20,000
Outstanding Rent 3,000 Debtors 40,000
Cash in hand 1,500
Cash at bank 4,500
Closing Stock 60,000
Prepaid Insurance 200
2, 38,500 2,38, 500
Illustration 18: Final Accounts with Adjustment

Prepare final accounts from the following balances of Mr. Ankit as on 31st December, 2007.
Extracts of Balances
as on 31st December, 2007
Debit Balances ( ) Credit Balances ( )

Drawings 45,000 Capital Account 6,09,000
Goodwill 90,000 Bills Payable 41,400
Land and Building 1,80,000 Sundry Creditors 91,500
Plant and Machinery 1,20,000 Purchase Returns 7,950
Loose tools 9,000 Sales 3,45,000
Stock 1.1.2007 1,20,000 Contd...
Purchase 1,53,000
Wages 60,000
Carriage Outwards 4,500
Coal and Gas 16,800
Salaries 12,000
Debit Balances ( ) Credit Balances ( )
Drawings 45,000 Capital Account 6,09,000
Goodwill 90,000 Bills Payable 41,400
Land and Building 1,80,000 Sundry Creditors 91,500
Plant and Machinery 1,20,000 Purchase Returns 7,950
Loose tools 9,000 Sales 3,45,000
Stock 1.1.2007 1,20,000 Notes
Purchase 1,53,000
Wages 60,000
Carriage Outwards 4,500
Coal and Gas 16,800
Salaries 12,000
Discount allowed 4,500
Cash at Bank 75,000
Cash in Hand 4,200
Sundry Debtors 1,35,000
Repairs 5,400
Printing and Stationery 1,500
Bad Debts 3,600
Advertisments 10,500
Sales Returns 6,000
Furniture and Fittings 3,600
General Expenses 15,750
Adjustments
(a) Closing stock on 31st December, 2007 was 1,80,000.
(b) Depreciate Plant and Machinery at 5%, Loose Tools at 15% and Furniture and Fittings
at 5%.
(c) Provide 2½% for Discount on Sundry Debtors and Creditors and 5% for Bad and Doubtful
Debts.
(d) Outstanding Wages 4,500 and Rent and Taxes 2,550.
Solution:
In the Book of Mr. Ankit
(for the year ending on 31st December, 2007)
Particulars Amount Particulars Amount

( ) ( )
To Opening Stock 1,20,000

To Purchases Less Returns By Sales Less Returns 3,39,000
( 1,53,000 – 7,950) 1,45,050 ( 3,45,000 – 6,000) 1,80,000
Wages 60,000 By Closing Stock
+ O/s Wages 4,500 64,500
To Coal and Gas 16,800
To Gross Profit C/d 1,69,050
5,19,000 5,19,000
To Carriage Outwards 4,500 By Gross Profit b/d 1,69,050
To Salaries 12,000 By Reserve for Discount on Creditors Contd...
To Rent, Rates & Taxes 8,400 @ 21/2% 2,250
+ Outstanding 2,550 10,950
To Repairs 5,400
To Printing & Stationary 1,500
To Bad Debts 3,600
+ New Provision (D/D) 6,750
10,350
+ Provision for Discount 3,206 13,556
( 1,53,000 – 7,950) 1,45,050 ( 3,45,000 – 6,000) 1,80,000
Wages 60,000 By Closing Stock
+ O/s Wages 4,500 64,500
Financial Accounting To Coal and Gas 16,800

To Gross Profit C/d 1,69,050
5,19,000 5,19,000
To Carriage Outwards 4,500 By Gross Profit b/d 1,69,050
Notes To Salaries 12,000 By Reserve for Discount on Creditors
To Rent, Rates & Taxes 8,400 @ 21/2% 2,250
+ Outstanding 2,550 10,950
To Repairs 5,400
To Printing & Stationary 1,500
To Bad Debts 3,600
+ New Provision (D/D) 6,750
10,350
+ Provision for Discount 3,206 13,556
To Advertisement 10,500
To General Expenses 15,750
To Depreciation on:
Plant & Machinery 6,000
Loose tools 1,350
Furniture & Fittings 180 7,530
To Net Profit
(transferred to Capital A/c) 85,114
1,71,300 1,71,300
Balance Sheet

( ) ( )
Capital 6,09,000 Goodwill 90,000

Add: Net Profit 85,114 Land & Buildings 1,80,000
6,94,114 Plant & Machinery 1,20,000
Less: Drawings 45,000 6,49,114 Less: Depreciation 6,000 1,14,000
Bills Payable 41,400 Furniture & Fittings 3,600
Creditors 90,000 Less: Depreciation 180 3,420
Less: Provision for Loose Tools 9,000
Discount 2,250 87,750 Less: Depreciation 1,350 7,650
Outstanding Wages 4,500 Sundry Debtors 1,35,000
Outstanding Rent 2,550 Less: Prov. for D/D 6,750
1,28,250
Less: Prov. for
Discount 3,206 1,25,044
Closing Stock 1,80,000
Cash in Hand 4,200
Cash at Bank 75,000
7,85,314 7,85,314

Fill in the blanks:

10. The …………………… will show the true and proper picture of the business only when all
the transactions of the business are properly recorded.
11. …………………… prepared under this order is the reverse of the Balance Sheet prepared
in liquidity order.
12. Order of presenting the assets and liabilities in the Balance Sheet is called ……………………
of assets and liabilities.
8.7 Summary
 Final accounts include the Trading and Profit & Loss Account and Balance Sheet.
 Trading and Profit & Loss Account is prepared to calculate the net profit earned by business
during a period.
 Balance Sheet of a business is prepared to disclose the financial picture of the business.
 The Trading Account shows the gross profit which is the difference of sales and cost of sales.
 Profit & Loss Account shows the net profit which is computed by matching the total
revenues and expenses of the business.
 Balance Sheet is a statement which has two sides – Liability side and Assets side.
 Before preparing the final accounts of the business some adjustments are also done
(if required).
8.8 Keywords
Financial Statements: These include the Trading and Profit & Loss Account, and Balance Sheet of
the business.
Gross Loss: It is the excess of cost of sales over sales.
Gross Profit: It is calculated by comparing the sales and cost of sales. It is the excess of sales over
cost of sales.
Net Loss: Excess of expenditures over revenues is called net loss.
Net Profit: It is the excess of revenues over expenses. It is depicted by P& L A/c.
Trial Balance: It is the list of accounts taken from the ledger.

1. What do you mean by errors? Which type of errors can not be detected by Trial Balance?
Explain.
2. What do you mean by Trading Account? Give the proforma of Trading Account and
explain why it is prepared.
3. What is the importance of Balance Sheet? Give a form of Balance Sheet in Liquidity order
with imaginary examples.
4. What do you mean by adjustment? Explain the different adjustment entries.

Notes 5. From the following balances draw up a Trading and Profit & Loss Account and Balance
Sheet:
( )
Amit Joseph’s Capital 30,000
Bank Overdraft 7,500
Machinery 20,100
Cash in hand 1,500
Fixture & Fitting 8,250
Bills Payable 10,500
Creditors 60,000
Debtors 94,500
Bill receivable 7,500
Purchases 75,000
Sales 1,93,500
Returns from customers 1,500
Returns to Creditors 1,650
Salaries 13,500
Manufacturing Wages 6,000
Commission 8,250
Trade Expenses 2,250
Discount (Cr.) 6,000
Rent 3,300
The Closing Stock amounted to 78,000.
6. The following balances are extracted on 31st March, 2008 from the book of Mr. Rajesh
Pratap.
( ) ( )
Capital 4,90,000 Loan 1,57,600
Drawing 40,000 Sales 13,07,200
General Expenses 50,000 Purchases 9,40,000
Buildings 2,20,000 Motor Car 40,000
Machinery 1,86,800 Prov. for Bad Debts 18,000
Opening Stock 3,24,000 Commission (Cr.) 26,400
Coal and Power 44,800 Car Expenses 36,000
Taxes and Insurance 26,300 Bills Payable 77,000
Wages 1,44,000 Cash in Hand 1,600
Debtors 1,25,600 Bank Overdraft 66,000
Creditors 50,000 Donation 2,100
Discount (Dr.) 11,000

Prepare the Final Accounts for the year ending 31st March, 2008, after taking into accounts Notes
the following adjustments:
(a) Write off 3,200 for bad debts and make provision for Bad debts @5% on debtors.
(b) Depreciate Machinery by 10% and Motor Car by 12%.
(c) Interest 15,000 is outstanding of Loan.

(d) It was decided to transfer 5,000 every year to charity fund.
(e) 1/3 of car expenses and depreciation amount is to be transferred to owner’s account.
(f) Stock valued on 31st March, 2008 was 4,70,000.
1. Final accounts 2. Internal, External

3. Capital expenditure 4. Revenue expenditure
5. Revenue 6. Gross inflow of cash

7. Trading and Profit & Loss Account 8. Trading account
9. Manufacturing Account 10. Final account
11. Balance Sheet 12. Marshalling



Notes Unit 9: Analysis and Interpretation of

Financial Statements
CONTENTS
Objectives
Introduction
9.1 Meaning of Analysis of Financial Statements

9.1.1 Meaning of Financial Statement Interpretation
9.2 Analysis and Interpretation of Financial Statements
9.2.1 Procedure for Analysis and Interpretation

9.3 Types of Financial Statement Analysis
9.4 Techniques of Analysis and Interpretation

9.5 Summary
9.6 Keywords
Objectives

 Understand the meaning of Analysis and Interpretation of Financial Statements
 Describe the procedure for Analysis and Interpretation of Financial Statements
 Have types of Analysis of Financial Statements
 Know the techniques of Analysis and Interpretation
Introduction
We know that the financial statements include – Trading and Profit & Loss Account, Profit & Loss
Appropriation Account and the Balance Sheet. These statements give only the information to the
management regarding the financial conditions, and profits which help the management to
control the business. Therefore, for the better understanding of the financial statements, the
self-appraisal of the business and for the better judgement of outsiders regarding the performance
of the company, the analysis of the financial statements is done.
9.1 Meaning of Analysis of Financial Statements
Analysis of financial statement is the process of critically examining of the data of the financial
accounts. The main function of this analysis is to find the strengths and weakness of the business
by using different tools. Financial analysis severs the interests of the shareholders, debentures,
long-term and short-term investors, bankers, creditors, politicians, journalists, legislators,
economists and researchers by classifying, rearranging and regrouping the financial statements.
Thus it helps the interested parties to reach on significant conclusion.

Unit 9: Analysis and Interpretation of Financial Statements
In the words of John M. Myer - “Financial statement analysis is largely a study of relationship Notes
among the various financial factors in a business as disclosed by a single set of statements and a
study of the trends of these factors as shown in a series of statements”.
Thus, the financial statement analysis refers to the classification, diagnosis and comparison of
the data of financial statements so that the profitability, financial position managerial efficiency
and weakness of the business may be disclosed.
9.1.1 Meaning of Financial Statement Interpretation
Interpretation is relating to the drawing of conclusion, inference and criticism of the analysed
financial data to judge the profitability & financial soundness of firm. Interpretation comes next
to the analysis of financial statements. Interpretation of financial statement is not possible
without analysis of financial data.
In the words of Spiecer and Peglar, “Interpretation of accounts may be defined as the art and
science of translating the figures, in such a way, as to reveal the financial strength and weakness
of the business and the causes which have contributed therein”.
9.2 Analysis and Interpretation of Financial Statements
Analysis and interpretation of financial statements are two different terms but are closely
associated because without interpretation analysis is useless and without analysis interpretation
is impossible. Analysis not only classifies the financial data into simple form but also helps in
creating a relationship of one accounting figure with another so that the meaningful conclusion
of the financial data may be drawn by the interpreter. For this purpose the interpreter must be
well experienced and quite intelligent to read and understand the analysed data.
As per Kennedy and McMullar, “The analysis and interpretation of financial statements are an
attempt to determine the significance and meaning of financial statements data so that a forecast
may be made of the prospects for future earnings, ability to pay interest and debt maturities
(both current and long-term) and probability of a sound dividend policy”.
9.2.1 Procedure for Analysis and Interpretation
Generally the following procedure is adopted for the analysis and interpretation of financial
statements:
1. Before the analysis, the objective and extent of analysis and interpretation should be
determined. Extent of analysis is based on the objectives of analysis.
2. All the required financial data should be collected and studied from financial statements.
If required, the financial statements should be rearranged or reorganized to find the same
nature items.
3. To reduce the complexity of the financial statements, the figures of the financial statements
should be approximated to the thousand or hundred.
4. To create a relationship among the income statement and financial position statement,
different analysis techniques as ratio analysis, trend and common size should be used.
5. If there are given some additional information relating to interpretation except financial
statement those must also be collected.
6. If it is required for the comparison, the financial data should be rearranged in the tables in
a logical way.

Notes 7. To interpret the financial data and to draw a conclusion, the proper tool (technique) as
average comparative statement should be used.
8. The analysed trend of the data should be interpreted keeping in mind the economic fact of
the business.
9. The interpreted data and conclusion drawn should be presented to the management in a
brief and clear report.
Self Assessment
Fill in the blanks

1. …………………… is relating to the drawing of conclusion, inference and criticism of the
analysed financial data.
2. To reduce the complexity of the financial statements, the figures of the financial statements
should be approximated to the …………………….
9.3 Types of Financial Statement Analysis

There are different parties who have their interest in the financial statements. Their purposes of
analysis of the financial statements are also different. On the basis of their usage and purposes
the financial analysis is classified as below:
Figure 9.1: Classification of Financial Analysis
Analysis of Financial Statements
According to Material Used According to Modus Operandi
Internal External Horizontal Vertical

Analysis Analysis Analysis Analysis
According to Material Used
On the basis of materials used by the analyst, the analysis is classified into following two:
1. Internal Analysis: Internal analysis of financial statements is done by such person who
can access the books of accounts and other related information of the business. Generally,
such persons are the employees, management executives, sometimes government,
regulatory bodies, or court. Generally internal analysis of financial statement is done for
the purpose of management.
2. External Analysis: External analysis of financial statement is done by such parties who
cannot approach the books of accounts as investors, creditors and general public. This analysis
is based on the published financial statements. They cannot access to the enterprise for data.
According to Modus Operandi
On the basis of this, the financial analysis is classified into following two:
1. Horizontal Analysis: It is also known as dynamic analysis or trend analysis. When the
financial data of a company for several years are analysed and compared, such type of

analysis is called horizontal analysis. For this type of analysis the data of the different Notes
years are kept in the different columns horizontally. The percentage increases of one
year’s figures are taken as base year’s figures. The base year may be the beginning year,
preceding year or different year (chain base). Thus horizontal analysis may be done for
periodical long-term, trend analysis and comparative study.
2. Vertical Analysis: It is also known as structural analysis or static analysis. Under this type
of analysis a single set of financial statement prepared on a particular date is analysed. In
this analysis only the quantitative relationship is created or one item of the financial
statement is compared with other items of that statement as percentage of assets to total
assets and percentage of profit to sales, etc. The example of this analysis is the common
size statement and financial ratio.
In the modern financial analysis both the above analysis are like backbone.
9.4 Techniques of Analysis and Interpretation
To simplify the financial statements for the purpose of analysis and interpretation the following
techniques/tools are used:
Comparative Financial Statement Analysis
These statements are very important for the analysis and interpretation. Inter-firm financial
statements can be prepared for the comparison of the results and financial position of two firms.
Similarly, the inter-period financial statements can be prepared. Inter-period comparison is
done very easily by inter-period financial statements. For the preparation of inter-period
comparison the accounting data of the different periods are shown in the different columns
along with the absolute and relative changes. Relative changes are calculated in the percentage
based on the previous year. Among the comparative financial statements the following statements
are included:
1. Comparative Balance Sheet: As per Prof. Fulke, “Comparative Balance Sheet is the study
of the trend of the same business enterprise on the different dates”. In the comparative
balance sheet the changes in the amount of various items of the balance sheets of the same
business as liabilities, assets and owner’s equity in the two periods are presented in such
a way so that the users of the financial statements may observe the changes easily. In the
single balance sheet only the closing balances of different accounts are shown while in the
comparative balance sheet the closing balances of the different items are showed along
with their absolute changes and relative changes. Comparative balance sheet is very
useful to study the trends in the changes of items. The comparative balance sheet is more
concerned with the changes in assets, liabilities and owner’s equity and their trends while
in the single balance sheet is concerned with the book values of the items and the financial
position of the business. However, the comparative balance sheet does not show the
relationship of one item with the other items.
To prepare the comparative balance sheet, the four columns are drawn. In the first two
columns of amount the absolute data of the two balance sheets are showed and in the third
column increase or decrease in the assets and liabilities as well as owner’s equity are
showed and in the fourth and last column the percentage of increase or decrease is showed.
After preparing the comparative balance sheet the analyst gives his interpretation regarding
the financial position (short-term and long-term) and profitability of the business.
Comparative balance sheet may be understood easily in the following illustration.

Notes Illustration 1: The Balance Sheets of Kavita Ltd. for the year ending 31st Dec. 2006 and 2007 are
as follows:
Liabilities 31st Dec. 2006 31st Dec. 2007 Assets 31st Dec. 2006 31st Dec. 2007
( ) ( ) ( ) ( )
Equity Share Capital 8,000 10,000 Land & Building 4,000 6,000
Capital Reserve 300 1,800 Plant & Machinery 2,000 3,000
10% Debentures 1,200 1,600 Investment 1,200 1,600
Creditors 500 600 Debtors 800 1,000
Stock 1,600 1,800
Cash 400 600
Total 10,000 14,000 Total 10,000 14,000
Draw a comparative Balance Sheet showing increase and decrease both in absolute figures and
in percentage and then interpret the changes.
Solution:
Comparative Balance Sheet of Kavita Ltd.
31st Dec. 31st Dec. Increase Increase or Decrease in

2006 2007 or %
( (000)) ( (000)) Decrease
( (000))
Assets: Fixed Assets: 2000
´ 100 = 50
Land and Building 4,000 6,000 +2,000 4000
Plant & Machinery 2,000 3,000 +1,000 1000

× 100 = 50
2000
Total Fixed Assets 6,000 9,000 3,000 3000

× 100 = 50
6000
Investment 1,200 1,600 400 200

× 100 = 33.33
Current Assets : 600
Debtors 800 1,000 200 200

× 100 = 25
800
Stock 1,600 1,800 200 200

× 100 = 12.5
1600
Cash 400 600 200 200

× 100 = 50
400
Total of Current Assets 2,800 3,400 600 æ 200 ö

çè × 100÷ = 21.43
ø
2800
Total Assets 10,000 14,000 4,000 4000

× 100 = 40
10000
Liabilities 8,000 10,000 2,000 2000

× 100 = 25
Equity Share Capital 8000
Reserve and Surplus 300 1,800 1,500 1500

× 100 = 500
300
10% Debentures (Secured Loan) 1,200 1,600 400 400

× 100 = 33.33
1200
Contd...

Total of Fixed Liabilities 9,500 13,400 3,900 Notes

æ 3900 ö
çè × 100÷ = 41.05
ø
9500
Creditors 500 600 100 100

× 100 = 20
500
Total Liabilities 10,000 14,000 4,000 4000

× 100 = 40
10000
Interpretation
 During the current year the company has increased its fixed assets by 50% by issuing
shares and debenture i.e. 58.33%.
 There is an increase of 33.33% in investment, 21.43% in current assets, and 20% in current
liabilities and 500% in reserve and surplus.
 The financial position of the company is well.
2. Comparative Profit & Loss Account or Comparative Income Statement: The profit & loss
account gives the summary of the results of the business activities, but it does not convey
the changes in the earning of the business. The comparative income statement serves this
purpose. It shows the operating results for a number of accounting periods along with he
absolute and relative changes.
To prepare the comparative income statement, the same columns are drawn as in the case
of comparative balance sheet. First two columns are kept for the original figures and next
two for the changes and percentage changes.
3. Comparative Statement of Cost of Production: Comparative statement of cost of production
is prepared to analyse and interpret the cost and its components. It is the part of comparative
income statement. This statement is prepared to show the absolute change in the different
elements of cost and the relationship of the different elements of cost with total cost of
production. On the basis of this statement, the cost of production is controlled.
The first two columns of this statement are kept for the actual figures of cost of two periods
and the next two columns shows the percentage of each element of cost with total cost of
production. Last two columns show the increase and decrease with their percentages. This
is explained in the following examples:
Illustration 2: Following is the statement of cost of goods manufactured by Raj Co. Ltd. present
the data in suitable form for analysis:
2007 2006
( ) ( )
Raw materials:
Opening Stock 46,000.00 42,000.00
Purchases 4,74,000.00 4,30,000.00
5,20,000.00 4,72,000.00
Less: Closing Stock 52,000.00 46,000.00
Add: Material Consumed 4,68,000.00 4,26,000.00
Direct Labour 6,32,000.00 5,06,000.00
Manufacturing Expenses 2,84,000.00 2,42,000.00
13,84,000.00 11,74,000.00
Valuation of Goods in Process of Stock: Contd...
Opening of year 28,000.00 26,000.00
Closing of year 32,000.00 28,000.00
Increase 4,000.00 2,000.00
Cost of Goods Manufactured 13,80,000.00 11,72,000.00
Opening Stock 46,000.00 42,000.00
Purchases 4,74,000.00 4,30,000.00
5,20,000.00 4,72,000.00
Less: Closing Stock 52,000.00 46,000.00
Financial Accounting Add: Material Consumed 4,68,000.00 4,26,000.00
Direct Labour 6,32,000.00 5,06,000.00
Manufacturing Expenses 2,84,000.00 2,42,000.00
13,84,000.00 11,74,000.00
Notes
Valuation of Goods in Process of Stock:
Opening of year 28,000.00 26,000.00
Closing of year 32,000.00 28,000.00
Increase 4,000.00 2,000.00
Cost of Goods Manufactured 13,80,000.00 11,72,000.00
Solution:
Raj Company Limited
Comparative Statement of Cost of Goods Manufactured
Amount % of cost of Increase (+)

Particulars Goods Manf. Decrease (-)
2007 2006 2007 2006 Absolute Relative in
in 000 in 000 in 000 %
Raw Materials Used 468 426 33.91 36.35 +42 +9.86
Direct Labour 632 506 45.80 43.17 +126 +24.90
Manufacturing Expenses 284 242 20.58 20.65 +42 +17.36
Total 1,384 1,174 100.29 100.17 +210 +17.89

Less Increase in
Work-in-Progress 4 2 0.29 0.17 +2
Cost of Goods
Manufactured 1,380 1,172 100.00 100.00 +208 +17.75
( )
Purchases 1,05,000
Wages 3,500
Sales 1,40,000
Hint: 20,000
4. Comparative Statement of Working Capital: When two periods’ statement of working

capital are compared, comparative statement of working capital is prepared. This statement
depicts the absolute changes in the each element of working capital and the changes in
total working capital also. The example of the comparative statement of working capital
is given below:
Illustration 3: From the following balance sheets, prepare a schedule of changes in working
capital.

31st March Notes

Particulars 2006 2007
( ) ( )
Assets
Cash in Hand 10,000 14,000
Cash at Bank 14,000 18,000
Book Debts 24,000 22,000
Inventory 8,000 6,000
Bills Receivable 4,000 3,000
Prepaid Expenses 400 600
Short-term Investment 10,000 16,000
Accrued Interest 2,000 1,200
Building 40,000 44,000
Plant and Machinery 18,000 12,000
1,30,400 1,36,800
Liabilities
Accounts Payable 16,000 12,000
Notes Payable 6,000 4,000
Bank Overdraft 8,000 6,000
Outstanding Expenses 600 400
Provision for Bad Debts 1,000 1,400
Share Capital 40,000 40,000
Debentures 40,000 60,000
Mortgage Loan 18,800 13,000
1,30,400 1,36,800
Solution:
Schedule Of Changes In Working Capital
31st March 31st March Charges in Working Capital

2006 2007
Particulars Increase Decrease
(Debit) (Credit)
( ) ( ) ( ) ( )
Current Assets
Cash in Hand 10,000 14,000 4,000 -
Book Debts 24,000 22,000 - 2,000
Cash at Bank 14,000 18,000 4,000 -
Inventory 8,000 6,000 - 2,000
B/R 4,000 3,000 - 1,000
Prepaid Expenses 400 600 200 -
Short-term Investments 10,000 16,000 6,000 -
Accured Interest 2,000 1,200 - 800
Total Current Assets 72,400 80,800
Current Liabilities
Contd...
Account Payable 16,000 12,000 4,000 -
Notes Payable 6,000 4,000 2,000 -
Bank Overdraft 8,000 6,000 2,000 -
Outstanding Expenses 600 400 200 -
Provision for Bed Debts 1,000
LOVELY 1,400
PROFESSIONAL -
UNIVERSITY 400 205
Total of Current Liabilities 31,600 23,800
Working Capital
(Current Assets – Current Liabilities) 40,800 57,000 - 16,200
Net Increase in Working Capital 16,200 - - -
Cash at Bank 14,000 18,000 4,000 -
Inventory 8,000 6,000 - 2,000
B/R 4,000 3,000 - 1,000
Prepaid Expenses 400 600 200 -
Financial Accounting Short-term Investments 10,000 16,000 6,000 -
Accured Interest 2,000 1,200 - 800
Total Current Assets 72,400 80,800

Notes Current Liabilities
Account Payable 16,000 12,000 4,000 -
Notes Payable 6,000 4,000 2,000 -
Bank Overdraft 8,000 6,000 2,000 -
Outstanding Expenses 600 400 200 -
Provision for Bed Debts 1,000 1,400 - 400
Total of Current Liabilities 31,600 23,800
Working Capital
(Current Assets – Current Liabilities) 40,800 57,000 - 16,200
Net Increase in Working Capital 16,200 - - -
57,000 57,000 22,400 22,400
Common Size Statements Analysis
The comparative financial statements are only concerned with the changes but they do not show
the relationship of the different items of balance sheet with total assets or total liabilities. In the
common size statements the relation of individual items of the balance sheet to the total assets is
shown in the form of percentage. In the case of common size balance sheet, in assets side the total
of assets is treated as a common base. On the basis of it the percentage of other assets are calculated.
The total of all percentage of individual assets becomes hundred which represent the total of
assets. In the liability side of the balance sheet the total of liabilities is taken a common base (100).
Then the percentages for other liabilities are computed on the basis of this common base. The total
of all percentages of individual liabilities becomes 100. In the case of common size profit & loss
account total sales are assumed to be equal to 100, then percentages of all other items of P&L A/c
are calculated on the common base of sales. This type of analysis is called vertical analysis.
Notes The common size statements are two: (a) common size balance sheet, and
(b) common size profit & loss account.
The illustrations of these two statements are given below:

Illustration 4: The accompanying balance sheet and profit & loss account relate to Rajeev Ltd.,
convert them into common-size statements.
Balance Sheet as at 31st March, 2008
( in lakh)
Previous Year 2007 Current Year 2008
Liabilities:
Equity Share Capital (of 10 each) 480 480
General Reserves 192 364
Long-term Loans 364 339
Creditors 134 104
Outstanding Expenses 12 -
Other Current Liabilities 18 13
1,200 1,300
Assets: Contd...
Plant 804 780
Cash 108 156
206 Debtors LOVELY PROFESSIONAL UNIVERSITY 120 130

Inventories 168 234
1,200 1,300
Liabilities:
Equity Share Capital (of 10 each) 480 480
General Reserves 192 364
Long-term Loans 364 339
Creditors 134 104
Outstanding Expenses 12
Unit 9: Analysis and
-
Interpretation of Financial Statements
Other Current Liabilities 18 13

1,200 1,300
Assets: Notes
Plant 804 780
Cash 108 156
Debtors 120 130
Inventories 168 234
1,200 1,300
Income Statement
for the year ended March 31, 2008
( in lakh)
Previous Year 2007 Current Year 2008
Gross Sales 740 960
Less: Returns 40 60
Net Sales 700 900
Less: Cost of Goods Sold 380 430
Gross Profit 320 470
Less: Selling General and Administrative Cost 100 144
Operating Profit 220 326
Less : Interest Expenses 40 34
Earning Before Taxes 180 292
Less : Taxes 63 103
Earning After Taxes 117 189
Solution:
Income Statement (Common Size)
(For the year ended March 31, 2008)
(Percentage)
Particulars Previous Year Current Year
2007 2008
Net Sale 100.0 100.0
Cost of Goods Sold 54.3 47.8
Gross Profit 45.7 52.2
Selling, General and Administrative Expenses 14.3 16.0
Operating Profit 31.4 36.2
Interest 5.7 3.8
Earning Before Taxes 25.7 32.4
Taxes 9.0 11.4
Earning After Taxes (EAT) 16.7 21.0
Balance Sheet (Common size as at March 31, 2008)

(Percentage)
Particulars Previous year Current year
Owner's Equity
Equity Share Capital 40.0 36.9
General Reserves 16.0 28.0
56.0 64.9
Long-term Borrowings: Contd...
Loan 30.3 26.1

Current Liabilities: Creditors 11.2 8.0
Outstanding Expenses LOVELY PROFESSIONAL
1.0UNIVERSITY - 207
Other Liabilities 1.5 1.0
13.7 9.0
Total Liabilities 100.0 100.0
Fixed Assets:
(Percentage)
Particulars Previous year Current year
Owner's Equity
Financial Accounting Equity Share Capital 40.0 36.9
General Reserves 16.0 28.0
56.0 64.9
Notes Long-term Borrowings:
Loan 30.3 26.1
Current Liabilities: Creditors 11.2 8.0
Outstanding Expenses 1.0 -
Other Liabilities 1.5 1.0
13.7 9.0
Total Liabilities 100.0 100.0
Fixed Assets:
Plant Assets Net of Accumulated Depreciation 67.0 60.0
Current Assets:
Cash 9.0 12.0
Debtors 10.0 10.0
Inventories 14.0 18.0
33.0 40.0
Total Assets 100.0 100.0

Opening Stock ()
Raw materials 4,500

Sales 50,000
Purchases during the year 24,500
Carriage inwards 500
Closing stock—raw materials 1,500
Hint: 28000
Trend Analysis
Trend analysis is an important technique for the analysis and interpretation of financial statements.
Generally, the trend means tendency. To know the tendency of the data of the financial statement,
the data of four to five years are required. Data may be taken from the balance sheet and profit &
loss account. It depends on the objective of analysis. To compute the tendency one year’s figures
are taken as base year. On the basis of this base year the other year’s relative figures are computed.
On the basis of these relative figures the tendency of a particular item is determined. The trend
analysis of the business activities and financial position may be done in the following ways:
 Trend Percentage/Ratio
 Graphic or Diagrammatic Presentation

1. Trend Percentage/Ratio: To calculate the trend percentage the following procedure is Notes
adopted:
(i) First of all the original figures of the financial statement are set in a statement.
(ii) One year’s figures (the earliest year) are assumed as base year’s figure i.e. 100.
(iii) In order to compute the trend percentage the each and every item of the other years
are divided by the corresponding item of the base year and multiplied by 100.
Illustration 5: From the following items of the asset side of the balance sheet of Alka Ltd. for the
period 31.3.2004 to 31.3.2007, calculate trend percentage taking 2004 as the base year:
in ‘000’
2004 2005 2006 2007
( ) ( ) ( ) ( )
Cash 80 120 160 140
Debtors 40 80 60 30
Stock 100 150 120 140
Other Current Assets 40 20 50 60
Land and Building 800 1,000 1,200 1,200
Furniture 160 200 120 200
Plant 200 250 260 300
Total Assets 1,420 1,820 1,970 2,070
Solution:
Comparative Balance Sheet
From 31st March 2004 to 31st March 2007
(Showing Trend Percentage)
( in ‘000’)
Assets 31 March
st
Trend Percentage Base 2004 ( Current
Base
× 100 )
2004 2005 2006 2007 2004 2005 2006 2007
Current Assets:
Cash 80 120 160 140 100 150 200 175
Debtors 40 80 60 30 100 200 150 75
Stock 100 150 120 140 100 150 120 140
Other Current Assets 40 20 50 60 100 50 125 150
Total Current Assets 260 370 390 370 100 142 150 142
Fixed Assets: 800 1,000 1,200 1,200 100 125 150 150
Land and Building 160 200 120 200 100 125 75 125
Furniture 200 250 260 300 100 125 130 150
Plant 1,160 1,450 1,500 1,700 100 125 136 146
Total Fixed Assets
1,420 1,820 1,970 2,070 100 128 138 145
Total
2. Graphic or Diagrammatic Presentation: The trend percentage/ratio discussed in the

previous method may be represented by graphs and diagrams. Two or three variables can
be represented on graphs very easily. If different variables of the financial statements are
represented by graphs and diagrams, that quickly draws the human attraction. Nowadays
there is a trend to show the important variable on the graphs. These diagrams are also

Notes being published with the financial statements. For example, the sale of XY Co. Ltd for the
last five years is as follows:
Years 2000 2001 2002 2003 2004

Sales (000) 500 650 700 800 1,000
These figures may be represented graphically as follows:
1,000
(000) 900
800
Sales in
700
600
500
2000 2001 2002 2003 2004 2005

Years
The sale of the company is represented on the diagram as follows:
Sales
Sales in Rs. (000)
1500
1000
1000 700 800
650
500 Sales
500
0
1 2 3 4 5
Year
Fund Flow Analysis
Fund flow analysis has become very popular technique to analyze the financial statements. Fund
flow statement does not reveal the financial position of the business like the financial statement
but it reveals the changes in the working capital in two periods. Working capital is the life blood
of the business. This statement also gives the information regarding the sources and application of
fund (working capital). Sources of fund are profit from operation, issue of capital loans, sale of
fixed assets, etc., while the application of fund are the purchase of fixed assets, redemption of
capital, payment of dividend purchase of investment, etc.
Cash Flow Analysis
Cash flow analysis is also similar to fund flow analysis. Now it is being prepared by the
companies along with the balance sheet and profit & loss account. It is prepared as per Accounting
Standard-3 of the Institute of Chartered Accountant of India. The fund flow statement reveals the
changes in the fund/working capital while the cash flow statement reveals the changes in the
cash during two periods. It also gives the information regarding the sources of cash and uses of
cash during a period.

Ratio Analysis Notes
This technique is based on the ratios. The ratios are the relationship among the different accounting
figures. Ratio analysis helps the management and different users of financial statements in
determining the profitability of business and the financial position of the business. Profitability,
solvency, liquidity and efficiency of the business can be easily determined by this analysis.
Break-even Analysis
This is an important technique of the management to take some decision. Under this analysis the
costs of production are divided into fixed and variable cost. From sales the fixed cost is subtracted
to find the contribution. On the basis of contribution, the break-even point (BEP) is determined.
It is that point of sales or production at which the company gains no profit, and suffers no loss.
Several managerial decisions as make or buy, shut down point, price determination, etc. are
taken with the help of break-even analysis.
Self Assessment
Fill in the blanks:

3. The …………………… are the relationship among the different accounting figures.
4. Cash flow analysis is also similar to …………………….
5. …………………… does not reveal the financial position of the business like the financial
statement but it reveals the changes in the working capital in two periods.
9.5 Summary
 Analysis of financial statements is the process of critically examining the data of financial
accounts. The main work of this process is to find the strengths and weakness of the
business.
 Interpretation is relating to the drawing of conclusion, inference and criticism of the
analysed financial data.
 Analysis and interpretation of the financial statements are closely associated. Without
interpretation the analysis is useless and without analysis, interpretation is impossible.
 Analysis of financial statements is of two types—analysis according to materials used and
analysis according to modus operandi.
 Analysis according to materials used is of two types i.e. internal analysis and external
analysis.
 Similarly, the analysis according to modus operandi is also divided into two - horizontal
analysis and vertical analysis.
 For the interpretation and analysis of the financial statement the following techniques are
used:
 Comparative Financial Statement Analysis

 Common Size Statement Analysis
 Trend Analysis
 Fund Flow Analysis

Notes  Cash Flow Analysis

 Ratio Analysis
 Break-Even Analysis
9.6 Keywords
Analysis of Financial Statement: Classifying, rearranging and regrouping of financial statements

to find the weakness and strength of the business is analysis of financial statements.
Financial Statements: Profit & Loss Account, Profit & Loss Appropriation Account and Balance
Sheet are included in the term financial statements.
Fund: Fund means the working capital.
Ratio: It is the relationship of two or more financial items.
1. What do you mean by financial analysis? Explain its procedure.

2. Distinguish clearly between the internal and external financial analysis.
3. Differentiate between horizontal and vertical analysis and explain which one is better.
4. What do you understand by the analysis and interpretation of financial statements? Explain
in brief its various techniques.
1. Interpretation 2. Thousand or hundred

3. Ratios 4. Fund flow analysis
5. Fund flow statement



Unit 10: Accounting and Depreciation for Fixed Assets
Unit 10: Accounting and Depreciation for Fixed Assets Notes
CONTENTS
Objectives
Introduction
10.1 Meaning and Definition of Fixed Assets
10.1.1 Method of Accounting Historical Cost of Tangible Assets
10.1.2 Basis for the Valuation of Fixed Assets
10.1.3 Method of Accounting Revalued Tangible Assets
10.1.4 Valuation of Fixed Tangible Assets in Special Cases
10.1.5 Valuation of Intangible Assets
10.1.6 Disclosure regarding Fixed Assets
10.2 Meaning and Definition of Depreciation on Fixed Assets
10.2.1 Definitions
10.2.2 Significance of Depreciation
10.2.3 Methods of Recording of Depreciation
10.3 Methods for Providing Depreciation
10.3.1 Straight Line Method
10.3.2 Diminishing Balance Method
10.3.3 Annuity Method
10.3.4 Depreciation Fund Method or Sinking Fund Method
10.3.5 Insurance Policy Method
10.3.6 Revaluation or Appraisal Method
10.3.7 Depletion Method
10.3.8 Machine Hour Rate Method
10.4 Provision and Reserves
10.4.1 Meaning of Provisions
10.4.2 Meaning of Reserves
10.4.3 Importance of Provisions and Reserves
10.4.4 Distinction
10.4.5 Types of Provisions
10.4.6 Types of Reserves
10.5 Statements of Accounting Standards (AS 6) Revised – Depreciation Accounting
10.6 Summary
10.7 Keywords

Notes Objectives

 Understand the meaning and definition of fixed assets
 Define the method of accounting of historical cost
 Have the valuation of fixed assets
 Describe method of accounting for revalued assets
 Evaluate tangible fixed assets in special cases
 Describe fixed assets of special type (intangible assets) and disclosure of fixed assets
 Define the meaning, definition and significance of depreciation on fixed assets
 Know the methods of depreciation on fixed assets
 Differentiate ‘Provision’ and ‘Reserves’
 Discuss the different type of ‘Provisions’ and ‘Reserves’ and the accounting thereof.
Introduction
Fixed assets comprise a significant portion of the total assets of the business. Therefore, their
presentation in the financial statements is important. The fixed assets also play an important
role in the determination of profit and depicting the financial position of the business.
Did u know? Why is it being considered as a cumbersome task in matching?
The benefits/revenues of the fixed assets are expected to accrue for many numbers of
years but not within a year. The initial investment on the assets at the time of purchase
should be matched against the revenue pattern of the same year after year in order to find
out the profitability of the long term investment.
10.1 Meaning and Definition of Fixed Assets
In many enterprises the fixed assets are grouped into various categories such as land, buildings,
plant and machinery, vehicles, furniture and fittings, goodwill, patents, trademarks and designs.
Did u know? What are the items which are not covered under fixed assets?
Under the fixed assets the following items are not considered on which special
considerations apply:
1. Forests, plantations and similar regenerative natural resources,

2. Wasting assets including mineral rights, expenditure on the exploration for and
extraction of minerals, oil, natural gas and similar non-generative resources,
3. Expenditure on real estate development, and

4. Livestock.
As per Accounting Standard - 10 (AS - 10) “Fixed asset is an asset held with the intention of being
used for the purpose of producing or providing goods or services and is not held for sale in the

normal course of business”. Thus fixed assets are those assets which are acquired and retained in Notes
the business for long period for the purpose of carrying on the business. These are not for resale.
As per AS-10, land, building, plant, machinery, vehicle which are not for resale and kept in the
business for the production of goods and services, comprise fixed assets.
10.1.1 Method of Accounting Historical Cost of Tangible Assets
1. The cost of fixed assets comprises of its purchase price including import duties and non-
refundable taxes and any directly attributable cost of bringing the assets to its working
condition for its intended use. The direct attributable costs are:
(a) Site preparation,
(b) Initial delivery and handling cost,

(c) Installation cost, such as special foundation for plant, and
(d) Professional fees as the fees of architects and engineers.

The financing cost relating to deferred credits or to borrowed funds attributable to the
construction or acquisition of fixed assets.
2. Administration and other general overhead expenses are usually excluded from the cost
of fixed assets because they do not relate to a specific fixed cost.
The expenditure incurred on start-up and commissioning of the project, including the
expenditure incurred on test runs and experimental production, is usually capitalized as
an indirect element of the construction cost.
3. If the interval between the date of project is ready to commence commercial production
and the date at which commercial production actually begins is prolonged, all expenses
incurred during this period are charged to the P&L A/c. However, the expenditure incurred
during this period is also sometimes treated as deferred revenue expenditure.
4. To calculate the gross book value of the self-constructed fixed assets, all those costs that
relate directly to specific assets and those that are attributable to the construction activity
in general can be allotted to the specific assets, are considered.
5. When a fixed asset is acquired in exchange for another asset, its cost is usually determined
by reference to the fair market value of the consideration given. It may be appropriate to
consider the fair market value of the asset acquired if this is more clearly evident. An
alternative accounting treatment that is sometimes used for an exchange of assets,
particularly when the assets exchanged are similar, is to record the asset acquired at the
net book value of the asset given up in each case and adjustment is made for any balancing
receipt or payment of cash or other consideration.
6. Subsequent expenditure relating to fixed asset for the improvement should be added to
the gross book value. Only that expenditure which increases the future benefits from the
existing asset beyond its previously assessed standard performance is included in the
gross book value.
7. The cost of an addition to an existing asset which is of a capital nature and which becomes
an integral part of the existing asset is usually added to its gross book value.
8. An item of fixed asset is eliminated from the financial statements, on disposal.
9. Items of fixed assets that have been retired from active use and are held for disposal are
stated at less than their net book value and net realizable value and are shown separately
in the financial statements.

Notes 10. In historical cost financial statements, gains or losses arising on disposal are generally
recognized in the profit and loss statement.
11. On disposal of a previously revalued item of fixed asset, the difference between net disposal
proceeds and the net book value is normally charged or credited to the profit and loss
statement except that, to the extent such a loss is related to an increase which was previously
recorded as a credit to revaluation reserve and which has not been subsequently reversed
or utilized, it is charged directly to the account. The amount standing in revaluation
reserve following the retirement or disposal of an asset which relates to that asset may be
transferred to general reserve.
Notes Reasons for Depreciation

1. Wear and Tear of the Asset: The long term assets are becoming less efficient and
poor quality in operations due to the continuous usage of the asset.
2. Exhaustion: Nothing will be left due to the continuous extraction of resources. The
resources in the oil wells, mine fields will be completely exhausted due to incessant
extraction. This has to be replaced by a new method of exploration. Investment in
new exploration methods requires depreciation as a charge against the revenues of
the wells/fields.
For example, Oil & Natural Gas Corporation Ltd. (ONGC) indulges in the process of
new oil exploration projects through research projects. The new projects should
then be identified and invested by huge initial investment outlay through the current
revenues out of the existing projects on account of replacement due to depletion of
resources.
3. To face technological obsolescence: To replace the old machinery with new machinery,
before the expiry of the economic life period of the asset in order to maintain the
efficiency and economy of the asset. The typewriter was replaced by the electronic
typewriter during the yester periods of office automation. To replace the old
typewriter which is neither efficient nor economical, it should be replaced by the
new electronic typewriter through the depreciation charge on the old one.
4. Accident: The value of the asset mainly depends upon the efficiency and economy;
which gets affected due to accident.
10.1.2 Basis for the Valuation of Fixed Assets
As per AS-10, there are two bases to compute the gross book value of fixed assets. These are –
historical cost and revaluation. Gross book value of a fixed asset is its historical cost or the other
amount substituted for historical cost in the books of account of financial statements. When this
amount is shown as net of accumulated depreciation, it is termed as net book value.
Illustration 1: Aditya Co. Ltd. acquired machinery from Hindustan Machine Tools Ltd. on 30.9.2007
at a quoted price of 400 lakhs on which a cash discount of 5% was offered on immediate payment.
Value Added Tax (VAT) on the quoted price is 8%. The company incurred the following addition
expenses:
( )
Transit insurance 4,00,000

Transportation charges 10,00,000

Foundation charges 3,00,000 Notes
Installation charges 5,00,000
The company borrowed a sum of 360 lakh from HDFC Bank at 16% interest per annum. The
machinery was ready for use on 31st March, 2008. Ascertain the cost of machinery.
Solution:
Calculation of Cost of Acquisition of Machinery
( in Laks)
Quoted Price of Machinery 400
Less: 5% Cash Discount of quoted price 20
Price after discount 380
Add: VAT @8% on quoted price 32 412
Add: Transit insurance 4

Transportation charges 10
Foundation charges 3
Installation charges 5 22
Interest on loan
@ 16% on 360 for 6 months (from 1.10.07 to 31.3.2008) 28.8
Cost of Acquisition of Machinery
462.8
Task Mr. Ramesh purchased a second hand machine for 24,000 on 1st April, 2006. He
spend 10,000 on its overhaul and installation. Depreciation is written off 10% p.a. on the
original cost. On 30th June, 2008 machine was found to be unsuitable and sold for 19,000.
Prepare the machine account from 2006 to 2008 assuming that accounts are closed on
31st December, every year.
10.1.3 Method of Accounting Revalued Tangible Assets
Accounting for the revaluation of fixed assets is very commonly accepted and preferred. In this
valuation fixed assets is done by a competent valuer. For the adoption of this method the
following guiding principles should be kept in minds which are given in AS-10:
1. When a fixed asset is revalued in financial statements, an entire class of assets should be
revalued, or the selection of assets for revaluation should be made on a systematic basis.
2. The revaluation in financial statements of a class of assets should not result in the net book
value of that class being greater than the recoverable amount of assets of that class.
3. When a fixed asset is revalued upwards, any accumulated depreciation existing at the date
of the revaluation should not be credited to the profit and loss statement.
4. An increase in net book value arising on revaluation of fixed assets should be credited
directly to owners’ interests under the head of revaluation reserve, except that, to the
extent that such increase is related to and not greater than a decrease arising on revaluation
previously recorded as a charge to the profit and loss statement, it may be credited to the

Notes profit and loss statement. A decrease in net book value arising on revaluation of fixed
asset should be charged directly to the profit and loss statement except that to the extent
that such a decrease is related to an increase which was previously recorded as a credit to
revaluation reserve and which has not been subsequently reversed or utilized, it may be
charged directly to that account.
5. On disposal of a previously revalued item of fixed asset, the difference between net disposal
proceeds and the net book value should be charged or credited to the profit and loss
statement except that to the extent that such a loss is related to an increase which was
previously recorded as a credit to revaluation reserve and which has not been subsequently
reversed or utilized, it may be charged directly to that account.
Illustration 2: Amar Club purchased a plant on 1st January, 2003, for 150 lakhs. The machine was
depreciated on straight line basis for the year 2003, 2004, 2005 and 2006, using a depreciation rate
of 10% p.a. On 1st January, 2007 the machine was revalued at 135 lakhs and the same was adopted.
What will be the carrying cost of plant as on 31.12.2008. There will be no change in the economic
life of the plant.
Solution:
Calculation of Carrying Cost of Plant
( in lakhs)
Purchase of Plant on 1st Jan. 2003 150
150 ´ 10 ´ 4 60
Less: Depreciation @10% p.a. for 4 years
100
Balance on 1st January, 2007 90
Add: Credit given due to revaluation (135-90) 45
Revaluation of plant 135
Less: Depreciation for 2007
(as the remaining life of the plant is only 6 years therefore, 1/6 of the revalued plant 22.5
will be 1/6 of 135)
Balance on 1st Jan., 2008 112.5
Less: Depreciation for 2008 22.5
Balance of plant on 31st Dec. 2008 90.00
10.1.4 Valuation of Fixed Tangible Assets in Special Cases
In such cases the principles given in the AS-10 are adopted for the valuation of fixed assets. These
are given below:
1. In the case of fixed assets acquired on hire purchase terms, although legal ownership does
not vest in the enterprise, such assets are recorded at their cash value, which if not readily
available, is calculated by assuming an appropriate rate of interest. They are shown in the
balance sheet with an appropriate narration to indicate that the enterprise does not have
full ownership thereof.
2. When an enterprise owns fixed assets jointly with others (otherwise a partner in a firm),
the extent of its share in such assets, and the proportion in the original cost, accumulated
depreciation and written down value are stated in the balance sheet. Alternately, the pro-
rata cost of such jointly owned assets is grouped together with similar fully-owned assets.
Details of such jointly owned assets are indicated separately in the fixed assets register.
3. Where several assets are purchased for a consolidated price, the consideration is apportioned
to the various assets on a fair basis as determined by competent valuers.

10.1.5 Valuation of Intangible Assets Notes
The following guiding principles of AS-10 are kept in mind for the valuation of fixed assets of
special type (intangible assets):
Goodwill
1. Goodwill, in general, is recorded in the books only when some consideration in money or
money’s worth has been paid for it. Whenever a business is acquired for a price (payable
either in cash or in shares or otherwise) which is in excess of the value of the net assets of
the business taken over, the excess is termed as ‘goodwill’. It arises from business
connections, trade name or reputation of an enterprise or from other intangible benefits
enjoyed by an enterprise.
2. As a matter of financial prudence, goodwill is written off over a period. However, many
enterprises do not write off goodwill and retain it as an asset.
Patent
3. Patents are normally acquired in two ways:

(i) By purchase, in which case patents are valued at the purchase cost including incidental
expenses, stamp duty, etc. and
(ii) By development within the enterprise, in which case identifiable costs incurred in
developing the patents are capitalized. Patents are normally written off over their
legal term of validity or over their working life, whichever is shorter.
Know-how
4. Know-how, in general, is recorded in the books only when some consideration in money
or money’s worth has been paid for it. Know-how is generally of two types:
(i) Relating to manufacturing processes; and
(ii) Relating to plans, designs and drawings of buildings or plant or machinery
5. Know-how related to plans, designs and drawings of buildings or plant and machinery is
capitalized under the relevant asset heads. In such cases depreciation is calculated on the
total cost of those assets, including the cost of the know-how capitalized. Know-how
related to manufacturing processes is usually expensed in the year in which it is incurred.
6. Where the amount paid for know-how is a composite sum in respect of both the types
mentioned in above (5) such consideration is apportioned amongst them on a reasonable
basis.
7. Where the consideration for the supply of know-how is a series of recurring annual
payments as royalties, technical assistance fees, contribution to research, etc., such payments
are charged to the profit and loss statement each year.
10.1.6 Disclosure regarding Fixed Assets
The following information should be disclosed in the financial statements:

1. Gross and net book values of fixed assets at the beginning and end of an accounting period
showing additions, disposals, acquisitions and other movements;
2. Expenditure incurred on account of fixed assets in the course of construction or acquisition;
and

Notes 3. Revalued amounts substituted for historical costs of fixed assets, the method adopted to
compute the revalued amounts, the nature of indices used, the year of any appraisal made,
and whether an external valuer was involved, in case where fixed assets are stated at
revalued amounts.
10.2 Meaning and Definition of Depreciation on Fixed Assets
Depreciation means the fall or decrease in the value of assets. Depreciation is a permanent fall in
the value of depreciable assets on using in the operation of business. In the depreciable assets
land, forest, goodwill, livestock, R&D are not included. Depreciation is not visible like other
expenses of the business which are clear and considered at the time of calculation of profit/loss
of the business. But it is not so in the case of depreciation on assets. Its amount is also not fixed.
It is based on past experience. Some businessmen do not provide depreciation on assets and do
not deduct from the gross profit to calculate the net profit.
One thing we have to keep in our mind that depreciation is calculated on the fixed assets. And it
is charged against the profit to ascertain the net profit. Of course the current assets may lose their
values. Loss on account of valuation of current assets is calculated on the basis of cost or market
price whichever is less. Valuation of current asset is done for the purpose of balance sheet only.
Generally there is depreciation in all fixed assets due to some reasons. There are a few cases in
which the values of the assets appreciate as land, antiques and old paintings, etc. As per Accounting
Standard-6 the depreciable assets are those which:
1. Are expected to be used during more than one accounting period, and
2. Have a limited useful life, and
3. Are held by an enterprise for use in the production or supply of goods and services, for
rental to others, or for administrative purposes and not for the purpose of sale in the
ordinary course of business.
10.2.1 Definitions
In the AS-6 the depreciation is defined as, “Depreciation is a measure of wearing out, consumption
or other loss of value of a depreciable asset, arising from use, affluxion of time or obsolescence
through technology and market changes. Depreciation is allocated so as to change a fair proportion
of the depreciable amount in each accounting period during the expected useful life of the asset.
Depreciation includes amortisation of assets whose useful life is predetermined.”
As per International Accounting Standards Committees, “Depreciation is the allocation of the

depreciable amount of an asset over its estimated useful life. Depreciation for the accounting
period is charged to income either directly or indirectly”.
According to J.H. Burton, “Depreciation is the shrinkage in the value of an asset at a given date
as compared with its value at a previous date”.
From the above definition it is clear that depreciation is gradual fall in the value of the assets due
to some reasons.
10.2.2 Significance of Depreciation
Depreciation is provided in the books from the following point of view:

1. To present the assets at its true value in balance sheet: Depreciation is computed on the
fixed assets. It is shown against the fixed assets in the balance sheet. By doing so the

balance sheet depicts the true and fair view of the financial position of the business. If we Notes
do not make a provision for depreciation for fixed assets it would be incorrect and the
balance sheet would not show the true value of assets.
2. To ascertain the correct profits or losses: The true profit can be ascertained only after
deducting the all costs from the revenue of a period. As the assets are used in the business
to earn revenues. The value of assets falls due to such use in the business. Therefore, such
a fall in the value should be treated as a cost and should be charged against the profit.
Payment for the purchase of assets should be treated a prepaid expenses and it should be
spreaded over a period of time in order to ascertain the true profit.
3. To create a fund for the replacement of assets: If the depreciation on fixed assets is provided
and charged against the profit every year, there will be reduction in the profit by the amount
of depreciation. If the amount is transferred into a fund account, on the expiry of the life of
the machine, there will be creation of depreciation fund to replace the fixed assets.
Thus we see that depreciation plays an important role in the determination of the true amount
of profit, presentation of true and fair financial view of the business and the replacement of
assets on the expiry of the life of the assets.
10.2.3 Methods of Recording of Depreciation
There are two methods to record the depreciation on fixed assets in the books of owner:
1. When provision for depreciation account is maintained: Under this method, the amount
of depreciation each year is transferred to the provision for depreciation account and the
assets are shown in the books at their original cost. And when assets are sold on the expiry
of its useful life, sales proceeds of the assets and the amount of provision for depreciation
is transferred to the assets account. Profit or loss arises from the sale of the assets is carried
to profit and loss account. Under this method the following journal entries are passed in
the books of owner:
(i) When depreciation is charged on Assets:

To Provision for Depreciation Account
(ii) When depreciation is transferred to P&L Account:
P&L Account Dr.
To Depreciation Account
(iii) When assets are sold on the expiry of useful life of the Assets:
Provision for Depreciation Account Dr.
To Assets Account
(iv) If there is any profit on the sale of Assets:
Assets account Dr.
To P&L Account
(v) If there is any loss on the sale of Assets:
P&L Account Dr.
To Assets Account

Notes 2. When Provision for Depreciation Account is not Maintained: In this case the depreciation
on the assets is not transferred to the provision for depreciation account, but that is
transferred to assets account and the assets are shown at the written down value (cost of
assets minus depreciation) in the balance sheet. Depreciation is treated as an expense and
is transferred to the profit & loss account. Under this method the following journal entries
are passed in the books of owner:
(i) When depreciation is charged on Assets:

To Assets Account
(ii) When depreciation is transferred to the P&L Account:
P&L Account Dr.

(iii) If the assets are sold at profit on the expiry of the useful life of Assets:
Cash Account Dr.
To Assets Account
To P&L Account
(iv) In the case of loss the following entry is passed:
Cash Account Dr.
P&L Account Dr.
To Assets Account
Self Assessment
Fill in the blanks:

1. Depreciation accounting is mainly based on the …………………….
2. Depreciation is the permanent decrease in the value of the …………………….
3. Depreciation is calculated on the basis of …………………….

4. …………………… can be created for replacement of fixed assets.
5. Amount of depreciation if charged on the basis of …………………… remains constant for
every year.
6. The original value of the asset is the …………………… of the asset.
7. Reserve is created to strengthen the …………………… of the business.

8. The profits can be distributed without providing for depreciation with the prior permission
of the …………………….
10.3 Methods for Providing Depreciation
There are various methods of allocating depreciation over the useful life of the assets. The
method of providing the depreciation is selected on the basis of various factors as types of assets,
nature of business, circumstances prevailing in business, etc.

These methods are given below: Notes
1. Straight Line Method

2. Diminishing Balance Method or Written Down Value Method
3. Annuity Method
4. Depreciation Fund Method
5. Insurance Policy Method
6. Revaluation Method
7. Depletion Method
8. Machine Hour Rate Method
10.3.1 Straight Line Method
This method is also known as fixed installment method. In this method, depreciation is ascertained
on the original cost by a fixed percentage keeping in mind the scrap value of the assets. Under
this method the amount of depreciation remains uniform/fixed and the value of the asset
becomes zero at the end of its life. It may also be calculated by the following formula:
Original Cost – Scrape Value

Depreciation =
life of Assets in Year
Merits
Following are the merits of this method:

1. This method is very simple and easy to use.
2. The value of the asset becomes zero at the end of the life of the assets as total value is
divided by the life of the assets.
3. This method is suitable to such type of assets which take physical deterioration as buildings,
leasehold properties, etc.
Demerits
In spite of being so many merits mentioned above, this method has following demerits:
1. The amount of depreciation does not change while the amount of repairs and renewal
increases with the passage of time.
2. Under this method the amount of depreciation is not invested outside the firm. Therefore,
there is a loss of interest.
3. If any other asset is purchased during the year, depreciation is calculated separately.
4. This method is not recognized in income tax rules.
Illustration 3: Fixed Installment Method
Mr. Ramesh purchased a second hand machine for 24,000 on 1st April, 2006. He spends 10,000
on its overhaul and installation. Depreciation is written off 10% p.a. on the original cost. On 30th
June, 2008 machine was found to be unsuitable and sold for 19,000. Prepare the machine
account from 2006 to 2008 assuming that accounts are closed on 31st December, every year.

Notes Solution:
In the books of Mr. Ramesh
Machine Account

2006 2006
April 1 To Cash A/c 34,000 Dec. 31 By Depreciation 2,550
(24,000 + 10,000) (for 9 months)
Dec. 31 By Balance c/d 31,450
34,000 34,000
2007 2007
Jan. 1 To Balance b/d 31,450 Dec. 31 By Depreciation A/c 3,400
(for 12 months)
Dec. 31 By Balance c/d 28,050
31,450 31,450
2008 2008
Jan. 1 To Balance b/d 28,050 June 30 By Depreciation A/c 1,700
(6 months)
By Cash A/c (Sale) 19,000
By P&L A/c (Loss) 7,350
28,050 28,050
Working Note:
1. Cost of Machine = 24,000 + 10,000 = 34,000
34,000 ´ 10 9
2. Depreciation for 2006 = ´ = 2, 550
100 12
34,000 ´ 10
3. Depreciation for 2007 = = 3, 400
100
34,000 ´ 10 6
4. Depreciation for 2008 (for 6 months) = ´ = 1,700
100 12
Illustration 4: On 1st April, 2004, Abhimanyu & Co. purchased a furniture of 90,000. The
estimated effective life of the furniture is 4 years with scarp value of 10,000. Calculate
depreciation on fixed line method and show furniture account of 4 years assuming that company
maintains provision for depreciation account.
Solution:
Calculation of Depreciation
Original Cost – Scrap Value 90,000 – 10,000
Depreciation = = = 20,000
Economic Life 4
Furniture Account

2004 2005
April 1 To Bank A/c 90,000 March 31 By Balance c/d 90,000
90,000 90,000
2005 2006
April 1 To Balance b/d 90,000 March 31 By Balance c/d 90,000
90,000 90,000
2006 2007 Contd...
April 1 To Balance b/d 90,000 March 31 By Balance b/d 90,000
90,000 90,000
2007 2008
April 1 To Balance b/d 90,000 March 31 By Provision for
Depreciation A/c 80,000
90,000 90,000
2004 2005
April 1 To Bank A/c 90,000 March 31 By Balance c/d 90,000
90,000 90,000
2005 2006
April 1 To Balance b/d 90,000 March 31 By Balance c/d 90,000
90,000 90,000
2006 2007 Notes
April 1 To Balance b/d 90,000 March 31 By Balance b/d 90,000
90,000 90,000
2007 2008
April 1 To Balance b/d 90,000 March 31 By Provision for
Depreciation A/c 80,000
90,000 90,000
Provision for Depreciation Account

2005 2005
March 31 To Balance c/d 20,000 March 31 By Depreciation A/c 20,000
2006 2005
March 31 To Balance c/d 40,000 April 1 By Balance b/d 20,000
2006
March 31 By Depreciation A/c 20,000
40,000 40,000
2007 2006
March 31 To Balance c/d 60,000 April 1 By Balance b/d 40,000
2007
60,000 60,000
2008 2007
March 31 To Furniture A/c 80,000 April 1 By Balance b/d 60,000
2008
80,000 80,000
10.3.2 Diminishing Balance Method
This method is also known as written-down-value method. In this method depreciation is

calculated on diminishing value but rate of depreciation remains constant. The amount of
depreciation on assets decreases every year but the value of the asset do not becomes zero. Rate
of depreciation can be determined with the help of cost of assets, scrap value and useful life of
the assets. The formula to compute the rate of depreciation is given below:
æ S ö
Rate = ç 1 – n × 100 ÷
è C ø
Where, N for number of years of useful life of the asset.

S for scrap value
C for cost of asset
R for rate of depreciation

Notes Distinction between Fixed Instalment Method and Diminishing

Value Method of Depreciation Fixed Assets
Basis of Difference Fixed/Straight Line Method Diminishing Value Method

1. Basis of charge and amount of Depreciation is calculated on the Depreciation is a certain
depreciation. basis of original cost of asset i.e. percentage of value of assets. The
Cost scrap value if any No. of amount of depreciation decreases
useful life of assets (in years). The every year.
amount of depreciation remains
constant (fixed) every year.
2. Value of assets Value of asset becomes zero at Value of asset can never be zero
the end of its life. even thought the asset becomes
obsolete/useless.
3. Burden of depreciation. The burden of depreciation The burden of depreciation is
remains uniform as the amount heavier in the beginning but
of depreciation remains constant becomes lighter in the subsequent
every year. years.
4. Suitable system. This method is suitable to such The method is suitable to such
assets where the cost of assets, assets where a the cost, scrap
scrap value if any and life of asset value of asset and life of asset
are easily known and the burden cannot he ascertained easily and
of repairs in not much or remains the burden of repairs also
constant. increases.
5. Income Tax point of view. This system is not recognized This method is considered
under income tax rules. suitable under income tax rules.
6. Effect on profit and loss a/c In the begining, the amounts of The amount of depreciation of
depreciation repairs charges are repairs charges total change on
lesser but increases in subsequent P&L A/c remains constant
years. Though the amount of though the amount of
depreciation remains constant depreciation decreases but
but the amount of repairs repairs changes increase and over
increases because of higher all burden on P&L remains
maintendence changes constant.
Illustration 5: Sale of Assets and Written Down Value Method

Lakshmi Narain Company Ltd., whose accounting year is the calendar year purchased machineries
on 1st April, 2006 costing 45,000.
It further purchased a machine costing 30,000 on 1st October, 2006 and another machine costing
15,000 on 1st July, 2007.
On 1st January, 2008 of the machineries which were purchased on 1st April, 2006 one machine
costing 15,000 became obsolete and was sold for 4,500.
Prepare the machinery account for all the three years in the books of the company after charging
the depreciation at 10% per annum on written down value method.
Solution:
In the Books of Lakshmi Narain Co. Ltd.
Machinery Account

2006 2006
April 1 To Cash A/c 45,000 Dec. 31 By Depreciation A/c 4,125
Oct. 1 To Cash A/c 30,000 Dec. 31 By Balance c/d 70,875
75,000 75,000
2007 2007 Contd...
Jan. 1 To Balance b/d 70,875 Dec. 31 By Depreciation A/c 7,837.50
July 1 To Cash A/c 15,000 Dec. 31 By Balance c/d 77,737.50
85,875 85,875
2008 2008
Jan. 1 To Balance b/d 77,737.50 Jan. 1 By Bank (Sale of 1/3
machine) 4,500
By P&L A/c. (Loss on
sale) 7,987.50
2006 2006
April 1 To Cash A/c 45,000 Dec. 31 By Depreciation A/c 4,125
Oct. 1 To Cash A/c 30,000 Dec. 31 By Balance c/d 70,875
75,000 75,000
2007 2007 Notes
Jan. 1 To Balance b/d 70,875 Dec. 31 By Depreciation A/c 7,837.50
July 1 To Cash A/c 15,000 Dec. 31 By Balance c/d 77,737.50
85,875 85,875
2008 2008
Jan. 1 To Balance b/d 77,737.50 Jan. 1 By Bank (Sale of 1/3
machine) 4,500
By P&L A/c. (Loss on
sale) 7,987.50
By Depreciation A/c 6,555
77,737.50 77,737.50
Working Note:
45,000 ´ 10 9
1. Depreciation on Machine I acquired on April 1, 2006 = ´ = 3, 375
100 12
30,000 ´ 10 3
Depreciation on Machine II acquired on October 1, 2006 = ´ = 750
100 12
Total Depreciation for 2006 = 3,375 + 750 = 4,125
(45,000 - 3,375) ´ 10
2. Depreciation on Machine I = = 4,162.50
100
(45,000 - 750) ´ 10
Depreciation on Machine II = = 2,925
100
15,000 ´ 10 6
Depreciation on Machine III = ´ = 750
100 12
Total Depreciation = 4,162.50 + 2,925 + 750 = 7,837.50
3. W.D.V. of one whole machine on 1st January 2008 (45,000 – 3,375 – 4,162.50)
= 37,462.50
37, 462.50
W.D.V. of 1/3 of machine I = = 12,487.50
3
Sale of machine = 4,500
Loss on sale = 12,487.50 – 4,500 = 7,987.50
4. Depreciation for 2008
(37,462.50 - 12,487.50) ´ 10
Depreciation on 2/3 of Machine I = = 2,497.50
100
(30,000 - 750 - 2,925) ´ 10
Depreciation on IInd Machinery = = 2,632.50
100
(15,000 - 750) ´ 10
Depreciation on IIIrd Machinery = = 1,425
100
Total Depreciation = 2,497.50 + 2,632.50 + 1,425 = 6,555
Change in the Method of Depreciation
As per the consistency convention of accounting, if once a method of depreciation has been
adopted by the management, it should be used consistently. However, due to some statutory

Notes compulsion, requirement of the Accounting Standard, etc. the management can change the
method of providing the depreciation on assets from diminishing balance method to fixed
installment method or vice versa. When the management decides to change the method of
depreciation, there can be the following two methods of such a change:
1. The method of charging the depreciation can be changed from the current year onwards.
It is called a prospective change. In such a situation new method of charging the depreciation
is applied from the current year over the remaining economic life of the assets.
2. When the method of charging the depreciation is changed from the back date or retrospective
year, it poses some problem. In such situation, first of all the depreciation is computed on
the assets by the new method from the back date. Similarly depreciation on the assets is find
by the old method (which is already shown in the books). Then the amount of these two
depreciation are compared. If the amount of depreciation calculated by new method exceeds,
excess of the amount is credited to the assets account in the current year and also shown in
the debit side of P&L A/c. If the amount of depreciation calculated by new method is less
than the amount of depreciation calculated by old method, this shortage is debited to the
assets account in the current year and also in the credit side of the P&L A/c.
10.3.3 Annuity Method
Under this method depreciation on assets is calculated keeping into account the cost of assets
along with interest thereon. The annuity method is a compounded interest method whereby the
depreciation is calculated based on the assumption that depreciation plus the normal cost of
capital to finance the assets are constant over the life of the assets. Interest along with cost of
assets is taken into account under this method while calculating the amount of depreciation.
Amount of interest is debited to assets account every year and then amount of depreciation is
credited to assets account. Calculation of interest is based on the opening balance of the asset. So
it (interest) decreases every year but the amount of depreciation remains constant which is taken
from the annuity tables for depreciation. This amount of depreciation is that much by which the
value of asset becomes zero.
In other words, if a firm purchases a plant of 50,000 and it only provides depreciation of
10,000 every year, after five years it will collect fund of 50,000 to replace the new plant. In this
case one point is ignored that interest means if this firm invested this amount of 50,000 in some
other form of securities in the place of buying assets, it would get return some interest along
with the principal amount of 50,000. In this method the amount of depreciation is determined
by adding the depreciation and interest thereon. The amount of depreciation is computed with
the help of annuity table. Under this method the following journal entries are passed for
depreciation and interest thereon.
1. When depreciation is charged on Assets
To Assets Account
2. When interest on cost of assets is calculated and showed

Assets Account Dr.
In Assets Account
3. When interest is transferred to P&L A/c
Interest Account Dr.

To P&L Account

Illustration 6: Annuity Method Notes
A Plastic Manufacturing Firm takes a lease costing 4,00,000 for 4 years. It decides to write off
this lease by annuity method. You are given from the annuity table that in order to write off the
lease on Annuity Method at 5 per cent interest per annum, the amount to be written off annually
as depreciation amounts to 1,12,804.
Show lease account for all the four years.
Solution:
Lease Account

1st year To Bank A/c 4,00,000 1st year To Depreciation A/c 1,12,804
To Interest A/c 20,000 To Balance c/d 3,07,196
4,20,000 4,20,000
2nd year To Balance b/d 3,07,196 2nd year By Depreciation A/c 1,12,804
To Interest A/c 15,360 By Balance c/d 2,09,752
3,22,556 3,22,556
3 year
rd To Balance b/d 2,09,752 3 year
rd By Depreciation A/c 1,12,804
To Interest A/c 10,488 By Balance c/d 1,07,436
2,20,240 2,20,240
4 year
th To Balance b/d 1,07,436 4 year
th By Depreciation A/c 1,12,804
To Interest A/c 5,368
1,12,804 1,12,804
10.3.4 Depreciation Fund Method or Sinking Fund Method
This method is designed in such a way so that the accumulated amount may be readily available
to replace the assets on the expiry of the useful life of the assets. Under this method a sinking
fund is created with the amount of depreciation on assets. An equivalent amount of the depreciation
is invested in some government or marketable securities each year and the amount of interest
on these securities is also reinvested in same securities. On the expiry of the economic life of the
assets, these securities are sold in the market and from the amount realized, the old assets are
replaced. If there is any profit or loss from the sale of these securities, that is transferred to the
profit and loss account. To adopt this method the following journal entries are passed:
1. At the end of first year, when depreciation (which is calculated with the help of sinking
fund table) is charged and transferred to sinking fund or depreciation fund account -
To Sinking Fund Account
2. When depreciation account is transferred to P&L Account
P&L Account Dr.
Alternatively in the place of above two entries, the following one entry may be passed
P&L Account Dr.

Notes 3. When at the end of 1st year, an equivalent amount to the depreciation is invested in some
securities
Sinking Fund Investment Account Dr.
To Cash/Bank Account
4. At the end of second year when interest on the first year’s sinking fund investment is
received
Bank Account Dr.
5. When depreciation on assets is charged
P&L Account Dr.
6. When annual installment of depreciation along with the interest received on previous
year’s investment is invested in some securities
Sinking Fund Investment Account Dr.
To Bank Account
(For the subsequent years the same pattern is adopted.)
7. On the expiry of the economic life of the assets, if S.F. investments are sold at profit
Bank Account Dr.
To Sinking Fund Investment Account
To Sinking Fund Account (profit on sale)
If there is loss on sale of investment:
Bank Account Dr.
Sinking Fund Account Dr.
To Sinking Fund Investment A/c
8. When old assets are sold
Bank Account Dr.
To Assets Account
9. When the balance of sinking fund account is transferred to assets account
Sinking Fund Account Dr.
To Assets Account
10. The balance of assets account (if any) transferred to P& L account
P&L Account (loss) Dr
To Assets Account
Or
Assets Account Dr
To P&L Account (Profit)

Illustration 7: Depreciation Fund Method Notes

On 1st January, 2003 a machinery was purchased for 1,00,000 by XYZ Co. Ltd, It is to be replaced
after four years. It is expected that investment will yield a net interest of 4% p.a. A depreciation
fund is established to collect the necessary amount.
On 31st December, 2006 the company had a balance of 45,500. The Depreciation Fund Investments
realised 73,500. The new machinery cost 1,07,500.
Pass the Journal entries and make the necessary accounts in the books of XYZ Co. Ltd.
Solution:
In the Books of XYZ Co. Ltd.,
Journal Entries

( ) ( )
2003
Jan. 1 Machinery Account Dr. 1,00,000
(Being purchase of machinery)
Dec. 31 Depreciation Account Dr. 23,549

To Depreciation Fund Account 23,549
(Being provision made for annual depreciation)
Dec. 31 Depreciation Fund Investment A/c Dr. 23,549

(Being investment of annual depreciation)
2004
Dec. 31 Cash Account Dr. 942
To Depreciation Fund Account 942
(Being receipt of interest on last year’s investments)


(Being investment of annual depreciation and interest
on last year’s investment)
2005
Dec. 31 Cash Account Dr. 1,922
(Being receipts of interest on the last year’s
investments of 48,040).


(Being investment of annual depreciation and the
interest)
2006 Contd...
(Being receipts of interest on the previous year’s
investments)
2006
(Being investment of annual depreciation and the
interest)
Notes 2006
(Being receipts of interest on the previous year’s
investments)
2006
Depreciation Fund Account Dr. 11
To Depreciation Fund Investment A/c. 73,511
(Being sale of D.F. Investment and loss thereon
transferred to D.F. Account)
Dec. 31 Depreciation Fund Account Dr. 1,00,000
To Machinery Account 1,00,000
(Being the transfer of machinery to depreciation fund
account)
Dec. 31 Machinery Account Dr. 1,07,500
(Being purchase of new machinery)
Ledger of XYZ Co. Ltd

Machinery Account

2003 2003
Jan. 1 To Cash Account 1,00,000 Dec. 31 By Balance c/d 1,00,000
1,00,000 1,00,000
2004 2004
Jan. 1 To Balance b/d 1,00,000 Dec. 31 By Balance c/d 1,00,000
1,00,000 1,00,000
2005 2005
Jan. 1 To Balance b/d 1,00,000 Dec. 31 By Balance c/d 1,00,000
1,00,000 1,00,000
2006 2006
Jan. 1 To Balance b/d 1,00,000 Dec. 31 By Depreciation Fund 1,00,000
A/c
1,00,000 1,00,000
Depreciation Fund Account

2003
Dec. 31 To Balance c/d 23,549 By Depreciation A/c 23,549
23,549 23,549
2004 Contd...
Dec. 31 To Balance c/d 48,040 By Balance b/d 23,549
By Cash A/c (Interest) 942
48,040 48,040
2005
By Cash (Interest) 1,922
73,511 73,511
2003
Dec. 31 To Balance c/d 23,549 By Depreciation A/c 23,549
23,549 23,549
2004 Notes
By Cash A/c (Interest) 942
48,040 48,040
2005
By Cash (Interest) 1,922
73,511 73,511
2006
Dec. 31 To D.F. Investment A/c. 11 By Balance b/d 73,511
Dec. 31 To Machinery A/c 1,00,000 By Cash (Interest) 2,940
By P&L A/c 11
1,00,011 1,00,011
Depreciation Fund Investment Account

2003 2003
Dec. 31 To Cash Account 23,549 Dec. 31 By Balance b/d 23,549
23,549 23,549
2004 2004
Jan. 1 To Balance b/d 23,549 Dec. 31 By Balance c/d 48,040
Dec. 31 To Cash Account 24,491
48,040 48,040
2005 2005
Jan. 1 To Balance b/d 48,040 Dec. 31 By Balance c/d 73,511
Dec. 31 To Cash Account 25,471
73,511 73,511
2006 73,511 2006
Jan. 1 To Balance b/d Dec. 31 By Cash A/c 73,500
Dec. 31 By Depreciation Fund
A/c 11
73,511 73,511
Depreciation Account

2003 2003
Dec. 31 To Depreciation Fund A/c 23,549 Dec. 31 By P&L A/c 23,549
2004 2004
2005 2005
2006 2006

Notes Working Note

As per Sinking Fund Table there should be annual investment of 0.23549 to get 1 at the end of
4 years @4% p.a.
Thus the amount investment should be = 0.23549 × 1,00,000 = 23,549.
10.3.5 Insurance Policy Method
The method is similar to the sinking fund method. Under this method to replace the assets, an
insurance policy is taken by the firm. Amount of premium is paid by the annual amount of
depreciation while under the sinking fund method, some securities were bought by the firm.
The amount of premium with interest accumulates with the insurance company. On the expiry
of the useful life of the assets, the insurance policy matures. On maturity the amount is made
available by the insurance company which is used for the purchase of new assets. Thus this
method provides more safety and liquidity to the funds. Under this method the following
journal entries are passed.
1. When depreciation is charged:
P&L Account Dr.
To Depreciation Fund Account
2. When amount of premium is paid
Depreciation Fund Policy Account Dr.
To Bank Account
3. When amount of policy is received from insurance company on maturity
Bank Account Dr.
To Depreciation Fund Policy Account
4. There may be profit or loss on the policy that is transferred to the depreciation fund
account. Then following entry is passed for profit
For Profit:
Depreciation Fund Policy Account Dr.
To Depreciation Fund Account
For Loss:
Depreciation Fund Account Dr.

To Depreciation Fund Policy Account
5. When new assets are acquired:

Assets Account Dr.
To Bank Account
Illustration 8: Insurance Policy Method

ABC Company Ltd. took a lease which is to be replaced after 3 years for 4,00,000 on 1st April,
2005 and decided to provide for its replacement by means of an insurance policy for 4,00,000.
The annual premium is 1,19,333.33. On 1st April, 2008 the lease is renewed for 4,80,000.
Show necessary accounts in the books of the company.

Solution: Notes
Lease Account

2005 2005
April 1 To Bank A/c 4,00,000 March 31 By Balance c/d 4,00,000
2006 2006
April 1 To Balance b/d 4,00,000 March 31 By Balance c/d 4,00,000
2007 2007
April 1 To Balance b/d 4,00,000 March 31 By Depreciation Fund
A/c 4,00,000
Depreciation Fund Account

2006 2006
March 31 To Balance c/d 1,19,333 March 31 By Profit & Loss A/c 1,19,333
2007 2007
March 31 To Balance c/d 2,38,666 April 1 By Balance b/d 1,19,333
2007
March 31 By Profit & Loss A/c 1,19,333
2,38,666 2,38,666
2008 2006
March 31 To Lease A/c 4,00,000 April 1 By Balance b/d 2,38,666
March 31 By Profit & Loss A/c 1,19,333
By Depreciation Fund 42,001
Insurance Policy
4,00,000 4,00,000
Depreciation Fund Insurance Policy Account

2006 2006
March 31 To Bank (Premium on 1,19,333 March 31 By Balance c/d 1,19,333
Policy)
2006 2007 2,38,666
April 1 To Balance b/d 1,19,333 March 31 By Balance c/d
2007
March 31 To Bank A/c 1,19,333
2,38,666 2,38,666
2007 2008 4,00,000
April 1 To Balance c/d 2,38,666 March 31 By Bank A/c
2008
March 31 To Bank A/c 1,19,333
March 31 To Depreciation Fund
A/c. 10,501
4,00,000 4,00,000

Notes 10.3.6 Revaluation or Appraisal Method
As its name is indicating, depreciation is calculated on the basis of revaluation of assets. After
some time or interval of a year, the assets are revalued by experts. The difference of the valuation
of the two periods is called depreciation or appreciation of that period. Generally, this method
is used in the case of livestock, copyrights and patents.
10.3.7 Depletion Method
It is also known as production method. This method is useful for natural assets as coal mines, oil
wells, etc. These are taken for excavation for a definite period on the contact basis. In this case the
depreciation is computed on the basis of production. First the total production of the contract
period is estimated, then total depreciable cost is divided by the total production and multiplied
by annual output to determine the annual amount of depreciation. In the form of formula:
Annual Output
Annual Depreciation =
Total Estimated Output
10.3.8 Machine Hour Rate Method
When depreciation is calculated on the basis of working hours of the machine or plant, this
method is used. The original cost of plant or machinery is divided by the total number of
working hours of the machine or plant to find the machine hour rate. To compute the depreciation
of a year the machine hour rate is multiplied by the total working hours of the machine/plant
in a year. This procedure may be explain in the following formula -
Original Cost of Machine

Machine Hour Rate =
Total Working Hours of the Machine During its Life
Annual Depreciation = Machine Hour Rate × Working Hours in a Year
Notes Straight line method vs. Written down value method
Under this method of charging depreciation, unlike the straight line method, the percentage is
usually given for calculation. While calculating this method, the depreciation is calculated on
two different values.
Depreciation
Depreciation for initial year Depreciation for subsequent years
Depreciation on original value Depreciation on book value

at the beginning during later period

Notes

Case Study Tata Steel Ltd.
T
ata Steel Ltd. wants to establish its EOU in the state of Orissa through exploration of
iron ore. It identified that the state of Orissa is one of the ideal states having greater
potential of iron ore than any other state in India. The firm has reached lease
contract with the Government of Orissa for the amount of 200 Cr towards the extraction
of 40,00,000 tonnes iron ore from the field for 10 years. The firm would like to establish a
processing plant which amounts to 50 Cr to produce the quality carbon steel for the
foreign industrial buyers. The life period of the machine is denominated in terms of
2,50,000 working hours. The firm is required to extract the iron ore.
Year 1 2 3 4 5 6 7 8 9 10
Expected Extraction 8 7 6 5 4 3 3 2 1 1
Per Year in Lakh
Hrs. Working 1,00,000 75,000 25,000 12,500 6,250 6,250 6,250 6,250 6,250 6,250
To meet out the cost of escalation, the firm should invest the amount of depreciation in the
interest bearing securities. The rate of interest is 8%.
Questions
1. To go for further replacement after 10 years, how much should the firm charge
depreciation in the case of iron ore field ? Which method should be applied? Reason
out the suitability of the method opted.
2. To replace the machinery recently bought after 10 years how much should be charged
as depreciation in accordance with the working hours given? Which method is
considered to be most suitable to replace? Why?
3. To replace the both investments viz on the iron ore field and processing unit, how
much the firm should invest during the 10 years time span?
Self Assessment
State true or false:

9. Amount of depreciation, if charged on the basis of written down value method, increases
every year.
10. Depreciation is charged to find out the correct P&L accounting balance.
11. The depreciation charge is a mean to recover the cost of operations of the enterprise.
12. Under written down value method depreciation is charged on the original value of the
asset.
13. The following formula to highlights the application of Diminishing Balance method in
charging depreciation is = (S/C)1/n – 1.
14. Profit or loss arises from the sale of the assets is carried to profit and loss appropriation
account.
15. When provision for depreciation account is maintained the assets are shown in the books
at their original cost.

Notes 10.4 Provision and Reserves

Every business enterprise, irrespective of its form of organization, likes to conduct its operations
in a prudent manner so as to be able to meet all eventualities—both expected and unexpected.
This is done, among other things, by making provisions, and creating reserves, at the time of the
preparation of financial statements.
10.4.1 Meaning of Provisions
The term ‘provision’ means an amount, which is: written off, or retained, by way of providing for
depreciation, renewals, diminution in the value of assets; or retained by way of providing for any
unknown future liability of which the amount cannot be determined with reasonable accuracy.
Obviously, where the amount of a liability is known, or can be ascertained, a definite liability
should be created, e.g., liability for outstanding interest. Examples of provisions are provision for
doubtful debts, provision for depreciation, provision for repairs, provision for discount on debtors,
provision for taxation, and provision for legal damages likely to arise from a pending suit.
Provision is a charge against the profit of the year and hence, it is debited to profit and loss
account before calculating the net profit for the year, and is shown in the balance sheet after the
certain liabilities on the liability side. It is to be noted that provision has to be made irrespective
of the fact whether a firm make a profit or not, otherwise it leads to breach of prudential
business behaviour.
10.4.2 Meaning of Reserves
Reserve means amount set aside out of profits (as calculated by the profit and loss account) or
other surpluses which are not meant to cover any liability, contingency, commitment or legal
requirement. Thus, reserve covers the case of amount which is neither a liability nor a provision.
It is allocation of the profit and not a charge against the current revenues.
It, in fact, belongs to the proprietors over and above the capital contributed by them. In case
amount equal to a reserve is invested in outside securities, it is called ‘Reserve Fund’ but the
absence of this conditions entitles it to be called simply ‘reserve’.
When it is called fund and meant for a given purpose, it is called “Specific Reserve”, otherwise
“General Reserve”. Examples of reserves are Capital Reserve, General Reserve, Contingency
Reserve, Dividend Equalization Reserve, Debenture Redemption Fund, etc.
10.4.3 Importance of Provisions and Reserves

A business firm in general, and a corporate enterprise in particular may consider it proper to set
up some mechanism to protect itself from the consequences of known liabilities and losses it
may be required to bear in future. It may also regard it as more appropriate in certain cases to
reduce the amount that can be drawn by the proprietors as profit in order to conserve business
resources to meet certain significant demands for them in future. An example of such a demand
is the much - needed expansion in the scale of business operations. This is presented as the
justification for the role of provisions and reserves in business activities and in accounting.
The amount so set aside may be meant for the purpose of:
 Fulfilling some specific requirements like repairs and renewals of an asset;
 Meeting a future liability or loss;
 Strengthening the general financial position of undertaking;
 Redeeming a long-term liability like debentures.

10.4.4 Distinction Notes
The identification and understanding of the precise scope of ‘provisions’ and ‘reserves ’ require
explanation of differences between them for clarification of their respective roles in business
and in accounting.
 Purpose: A provision is created for some specific liability in view but reserve is meant to
meet the future legal obligations or investment requirements of business for development.
 Mode of Creation: A provision is a charge against profit and loss account of the year and
has to be created even when profits are not expected. A reserve is an appropriation of
profits and can be made out of either profit earned during a year or from already existing
surplus, e.g. contingency reserve.
 Presentation in Balance Sheet: A provision is generally presented as a deduction from the
item for which it has been created on the asset side of the balance sheet or as a liability
after current liabilities as part of external equities. Reserve is listed as distinct item on the
liabilities side of them balance sheet.
 Utilization: Very rigid restrictions are enforced in practice on the use of provisions in
business operations to make them adhere to the purpose for which they have been meant.
Contrary to this, the balance of general reserve, or any account of such a nature, is always
available for any bonafide requirements of business. However, reserves created under
specific legal obligations such as “Capital Redemption Reserve or Debenture Redemption
Reserve” is to be used within the framework of the law only.
 Identification with Operations: A provision is made for meeting a particular liability or
likely loss on a specific item. Therefore, they cannot be distanced from business operations
and their investment outside the business is just not possible. Reserves, being of a general
nature, can be invested outside the business to avoid the possibility of their non-availability
in the event of need as well as to earn some additional income with their help. However,
outside investment of reserves by business is not mandatory in all situations.
10.4.5 Types of Provisions
The number of provisions maintained by a business undertaking depends upon its requirements,
which are governed by the volume, range and nature of its operations. Generally, a business
firm creates and maintains provisions for taxations, repairs and renewals, depreciation, discount
on debtors, bad and doubtful debts. But provision for doubtful debts and provision for discount
on debtors has been discussed at appropriate stages.
Notes Provision for Doubtful Debts
When business transaction takes place on credit basis, debtors may be of three types:
 Good Debtors are those from where collection of debt is certain.
 Bad Debts are those debtors from where collection of money is not possible and the
amount of credit is a loss.
 Doubtful Debts are those who may pay but firm is not sure about cent per cent
collection from them. In fact, as a matter of business experience, some percentage of
such debtors is not likely to pay, hence treated as doubtful debts.

Notes When it is certain that a debt will not be recovered, the amount is written off as bad debts. But it
is also likely that some of the remaining debts may not be recovered in full. This will be a loss
to the business. Hence, it is a common practice to make a suitable provision for doubtful debts
at the time of ascertaining the profit or loss. The balance sheet will not show the true position of
sundry debtors. The provision for doubtful debts is usually calculated as a certain percentage of
the total amount due from sundry debtors after writing off all known bad debts. Provision for
doubtful debts is also called ‘Provision for Bad Debts’, or ‘Provision for Bad and Doubtful debts’.
Such a provision is made by debiting the amount of doubtful debts to the profit and loss account
and crediting the account of provision for doubtful debts. Thus, the journal entry for creating
such a provision is as follows:
Provision for Doubtful Debts A/c
The bad debts arising during the year are first written off from the ‘provision for doubtful debts’
account. In doing so, the opening balance standing to the credit of the provision for doubtful
debts account may not be sufficient to meet the current amount of bad debts as also the
requirements of future doubtful debts. This deficit is to be provided for at the end of the year by
a charge to the profit and loss account. In case, the annual amount provided for is to be adjusted
for any unused surplus representing credit balance. The following are the journal entries required
when the provision for bad debts exists in the books:
1. For writing off further bad debts given outside the trial balance:
Bad Debts A/c Dr.
Sundry Debtors A/c
2. For transferring the total bad debts to the provision for Bad Debts Account:
Provision for Doubtful Debts A/c Dr.
Bad Debts A/c
3. For debiting the Profit and Loss Account with the amount of new provision plus the excess
of bad debts over the old provision:
Provision for Doubtful Debts A/c
4. For crediting the Profit and Loss Account with excess of the old provision over the total
bad debts plus new provision, if any:
Provision for Doubtful Debts A/c Dr.
Profit and Loss A/c
10.4.6 Types of Reserves
Reserves are broadly of two types—Capital Reserve and Revenue Reserve
 Capital Reserve: ‘Capital Reserve’ is an accounting mechanism for conserving profits. The
amount so set apart as ‘Capital Reserve’ imparts an element of stability to the overall
finances of a business enterprise. Capital reserve arises either as a gain on sale of long-term
assets or an settlement of liabilities. Again of capital nature may also arise due to the basic
transaction of being of capital nature. For example, sale of equity shares at a premium.
Further, allocation of revenue reserve may be made to capital reserve due to legal
obligations. Capital reserve does not include any free balance that might be used for the

distribution of profits. It is this crucial factor alone which tends to provide the much-needed Notes
financial stability to an corporate undertaking.
Capital reserve comes into existence from out of the capital profits arising from:
 Profits emerging from the revaluation of fixed assets after observing all restrictions;
 Profits accruing on the sale of fixed assets;
 Profits from the re-issue of share once forfeited by a company’s
 Issue of shares at premium
 Profits arising at the time of amalgamation and absorption of companies
 Profit prior to incorporation of a company;
 Creation of capital Redemption Reserve upon the redemption preference shares.
Capital reserves always have credit balance which is shown on the liabilities side of
the balance sheet.
Whenever this reserve is utilized, capital reserve account is debited. It is also required that
the manner of the utilization of capital reserve during an accounting period must be
clearly stated in the balance sheet either in its body itself or by way of a footnote to the
financial statements. This is due to the reason that there are rigid restrictions, both laid
down by law and enforced by accounting standards, on the use of capital reserve.
 Revenue Reserves: Revenue reserves are created out of revenue profit which is usually
distributable profits. All distributable profits are not always available for paying dividend
since a certain amount may be required to be kept aside either by law (minimum) or as a
managerial decision (higher amount) for business needs. It is only after this that profit
will be available for distribution by way of dividend.
Examples of revenue reserves are:
 General Reserve
 Dividend Equalisation Reserve
 Debenture Redemption Reserve (only after complete redemption of those debenture
under whose trust deed this reserve were created).
 General Reserve: A general reserve is retention of a portion of revenue profits for the
improvement of the overall financial status of an enterprise and to improve its health in
general.
An important point about general reserve is that it is a salient feature of corporate finance.
The creation and maintenance of general reserve helps in realizing certain well recognized
purposes especially from the viewpoint of financial management.
 Improvement of the general financial position of the business by conserving
resources, which would have otherwise been frittered away at the expense of prudent
management.
 Arrangement for meeting unforeseen and abnormal losses irrespective of their
nature.
 Providing avenues for the further expansion of business operations. General reserve
is created by debiting the profit and loss appropriation account and crediting general
reserve account. The latter account is placed on the liabilities side of the balance
sheet. When the balance on this account is used for any purpose, general reserve
account is debited.

Notes Any such use of general reserve has to be stated in some way in the balance sheet. A
number of provisions have been included in the companies Act for the regulation, creation
and utilization of general reserve. This underlines the importance attached to it in the
functioning of corporate enterprises. A word of caution about the commonly perceived
role of general reserve is necessary. General reserve is widely regarded as a means of
strengthening the overall financial position of the business entity. However, this depends
upon the proper valuation of the assets and liabilities of the business. In case assets and
liabilities are properly valued, the balance on general reserve is indicative of the financial
health of an enterprise but it is not so in the absence of this vital condition.
 Specific Reserves: A business undertaking in contemporary times is involved in a range of

business activities in pursuance of its goal of creating value of the organization. Some of
the of contingency situations can be looked after and financially managed by the creation
of provisions for known or expected contingencies. Management may as well like to
provide a second line of deface against some of these contingencies as a measure of
abundant caution. A specific reserve is created for a given purpose. It cannot be used for
any other purpose except for which they are created. There can possibly be any number of
reserves in business, every one of them characterized by some peculiar feature dictated by
the specific purpose which they are meant to serve. However, there is an undercurrent of
common characteristics shared by them.
 They are sharply focused from the viewpoint of their use because they are built up
for some specific purpose or the other.
 A businesslike approach to the management of these reserves may require that their
balances be invested outside the business.
 All specific reserves are presented on the liabilities side of the balance sheet, as they
are credit balances.
When any specific reserve is utilized, the amount drawn upon is debited to the account of
the reserve concerned. The reserves are credited at the time of the preparation of financial
statements by allocations decided to be made to them by management and the
corresponding credit is given to profit and loss appropriation account.
Self Assessment
State true and false:

16. Depreciation cannot be provided increase of loss, in a financial year.
17. Under written down value method, depreciation is charged on the original cost of the
asset.
18. Provision is the charges against profits for all apprehended losses.
19. Capital reserves are freely distributed as profits.

20. All reserves appear on the liability side of the balance sheet.
10.5 Statements of Accounting Standards (AS 6) Revised – Depreciation

Accounting
The following is the text of the revised Accounting Standard (AS) 6, ‘Depreciation Accounting’,
issued by the Council of the Institute of Chartered Accountants of India.

Introduction Notes
1. This Statement deals with depreciation accounting and applies to all depreciable assets,
except the following items to which special considerations apply:
(i) Forests, plantations and similar regenerative natural resources;

(ii) Wasting assets including expenditure on the exploration for and extraction of
minerals, oils, natural gas and similar non-regenerative resources;
(iii) Expenditure on research and development;

(iv) Goodwill;
(v) Live stock.

This statement also does not apply to land unless it has a limited useful life for the
enterprise.
2. Different accounting policies for depreciation are adopted by different enterprises.

Disclosure of accounting policies for depreciation followed by an enterprise is necessary
to appreciate the view presented in the financial statements of the enterprise.
Definitions
3. The following terms are used in this statement with the meanings specified:
3.1 Depreciation is a measure of the wearing out, consumption or other loss of value of a
depreciable asset arising from use, affluxion of time or obsolescence through
technology and market changes. Depreciation is allocated so as to charge a fair
proportion of the depreciable amount in each accounting period during the expected
useful life of the asset. Depreciation includes amortisation of assets whose useful
life is predetermined.
3.2 Depreciable assets are assets which

(i) Are expected to be used during more than one accounting period; and
(ii) Have a limited useful life; and
(iii) Are held by an enterprise for use in the production or supply of goods and
services, for rental to others, or for administrative purposes and not for the
purpose of sale in the ordinary course of business.
3.3 Useful life is either (i) the period over which a depreciable asset is expected to be used
by the enterprise; or (ii) the number of production or similar units expected to be
obtained from the use of the asset by the enterprise.
3.4 Depreciable amount of a depreciable asset is its historical cost, or other amount
substituted for historical cost in the financial statements, less the estimated residual
value.
Explanation
4. Depreciation has a significant effect in determining and presenting the financial position
and results of operations of an enterprise. Depreciation is charged in each accounting
period by reference to the extent of the depreciable amount, irrespective of an increase in
the market value of the assets.

Notes 5. Assessment of depreciation and the amount to be charged in respect thereof in an accounting
period are usually based on the following three factors:
(i) Historical cost or other amount substituted for the historical cost of the depreciable
asset when the asset has been revalued;
(ii) Expected useful life of the depreciable asset; and
(iii) Estimated residual value of the depreciable asset.

6. Historical cost of a depreciable asset represents its money outlay or its equivalent in
connection with its acquisition, installation and commissioning as well as for additions to
or improvement thereof. The historical cost of a depreciable asset may undergo subsequent
changes arising as a result of increase or decrease in long-term liability on account of
exchange fluctuations, price adjustments, changes in duties or similar factors.
7. The useful life of a depreciable asset is shorter than its physical life and is:
(i) Predetermined by legal or contractual limits, such as the expiry dates of related
leases;
(ii) Directly governed by extraction or consumption;

(iii) Dependent on the extent of use and physical deterioration on account of wear and
tear which again depends on operational factors, such as, the number of shifts for
which the asset is to be used, repair and maintenance policy of the enterprise etc.;
and
(iv) Reduced by obsolescence arising from such factors as:
(a) Technological changes;
(b) Improvement in production methods;
(c) Change in market demand for the product or service output of the asset; or
(d) Legal or other restrictions.

8. Determination of the useful life of a depreciable asset is a matter of estimation and is
normally based on various factors including experience with similar types of assets. Such
estimation is more difficult for an asset using new technology or used in the production of
a new product or in the provision of a new service but is nevertheless required on some
reasonable basis.
9. Any addition or extension to an existing asset which is of a capital nature and which
becomes an integral part of the existing asset is depreciated over the remaining useful life
of that asset. As a practical measure, however, depreciation is sometimes provided on
such addition or extension at the rate which is applied to an existing asset. Any addition or
extension which retains a separate identity and is capable of being used after the existing
asset is disposed of, is depreciated independently on the basis of an estimate of its own
useful life.
10. Determination of residual value of an asset is normally a difficult matter. If such value is
considered as insignificant, it is normally regarded as nil. On the contrary, if the residual
value is likely to be significant, it is estimated at the time of acquisition/installation, or at
the time of subsequent revaluation of the asset. One of the bases for determining the
residual value would be the realisable value of similar assets which have reached the end
of their useful lives and have operated under conditions similar to those in which the asset
will be used.

11. The quantum of depreciation to be provided in an accounting period involves the exercise Notes
of judgement by management in the light of technical, commercial, accounting and legal
requirements and accordingly may need periodical review. If it is considered that the
original estimate of useful life of an asset requires any revision, the unamortised depreciable
amount of the asset is charged to revenue over the revised remaining useful life.
12. There are several methods of allocating depreciation over the useful life of the assets.
Those most commonly employed in industrial and commercial enterprises are the straight-
line method and the reducing balance method. The management of a business selects the
most appropriate method(s) based on various important factors e.g., (i) type of asset,
(ii) the nature of the use of such asset, and (iii) circumstances prevailing in the business.
A combination of more than one method is sometimes used. In respect of depreciable
assets which do not have material value, depreciation is often allocated fully in the
accounting period in which they are acquired.
13. The statute governing an enterprise may provide the basis for computation of the
depreciation. For example, the Companies Act, 1956 lays down the rates of depreciation in
respect of various assets. Where the management’s estimate of the useful life of an asset of
the enterprise is shorter than that envisaged under the provisions of the relevant statute,
the depreciation provision is appropriately computed by applying a higher rate. If the
management’s estimate of the useful life of the asset is longer than that envisaged under
the statute, depreciation rate lower than that envisaged by the statute can be applied only
in accordance with requirements of the statute.
14. Where depreciable assets are disposed of, discarded, demolished or destroyed, the net
surplus or deficiency, if material, is disclosed separately.
15. The method of depreciation is applied consistently to provide comparability of the results
of the operations of the enterprise from period to period. A change from one method of
providing depreciation to another is made only if the adoption of the new method is
required by statute or for compliance with an accounting standard or if it is considered
that the change would result in a more appropriate preparation or presentation of the
financial statements of the enterprise. When such a change in the method of depreciation
is made, depreciation is recalculated in accordance with the new method from the date of
the asset coming into use. The deficiency or surplus arising from retrospective
recomputation of depreciation in accordance with the new method is adjusted in the
accounts in the year in which the method of depreciation is changed. In case the change in
the method results in deficiency in depreciation in respect of past years, the deficiency is
charged in the statement of profit and loss. In case the change in the method results in
surplus, the surplus is credited to the statement of profit and loss. Such a change is treated
as a change in accounting policy and its effect is quantified and disclosed.
16. Where the historical cost of an asset has undergone a change due to circumstances specified
in para 6 above, the depreciation on the revised unamortised depreciable amount is
provided prospectively over the residual useful life of the asset.
Disclosure
17. The depreciation methods used, the total depreciation for the period for each class of
assets, the gross amount of each class of depreciable assets and the related accumulated
depreciation are disclosed in the financial statements along with the disclosure of other
accounting policies. The depreciation rates or the useful lives of the assets are disclosed
only if they are different from the principal rates specified in the statute governing the
enterprise.

Notes 18. In case the depreciable assets are revalued, the provision for depreciation is based on the
revalued amount on the estimate of the remaining useful life of such assets. In case the
revaluation has a material effect on the amount of depreciation, the same is disclosed
separately in the year in which revaluation is carried out.
19. A change in the method of depreciation is treated as a change in an accounting policy and
is disclosed accordingly.
(The Accounting Standard comprises paragraphs 20-29 of this Statement. The Standard should
be read in the context of paragraphs 1-19 of this Statement and of the ‘Preface to the Statements
of Accounting Standards’.)
20. The depreciable amount of a depreciable asset should be allocated on a systematic basis to
each accounting period during the useful life of the asset.
21. The depreciation method selected should be applied consistently from period to period. A
change from one method of providing depreciation to another should be made only if the
adoption of the new method is required by statute or for compliance with an accounting
standard or if it is considered that the change would result in a more appropriate preparation
or presentation of the financial statements of the enterprise. When such a change in the
method of depreciation is made, depreciation should be recalculated in accordance with
the new method from the date of the asset coming into use. The deficiency or surplus
arising from retrospective recomputation of depreciation in accordance with the new
method should be adjusted in the accounts in the year in which the method of depreciation
is changed. In case the change in the method results in deficiency in depreciation in respect
of past years, the deficiency should be charged in the statement of profit and loss. In case
the change in the method results in surplus, the surplus should be credited to the statement
of profit and loss. Such a change should be treated as a change in accounting policy and its
effect should be quantified and disclosed.
22. The useful life of a depreciable asset should be estimated after considering the following
factors:
(i) Expected physical wear and tear;

(ii) Obsolescence;
(iii) Legal or other limits on the use of the asset.
23. The useful lives of major depreciable assets or classes of depreciable assets may be reviewed
periodically. Where there is a revision of the estimated useful life of an asset, the unamortised
depreciable amount should be charged over the revised remaining useful life.
24. Any addition or extension which becomes an integral part of the existing asset should be
depreciated over the remaining useful life of that asset. The depreciation on such addition
or extension may also be provided at the rate applied to the existing asset. Where an
addition or extension retains a separate identity and is capable of being used after the
existing asset is disposed of, depreciation should be provided independently on the basis
of an estimate of its own useful life.
25. Where the historical cost of a depreciable asset has undergone a change due to increase or
decrease in long term liability on account of exchange fluctuations, price adjustments,
changes in duties or similar factors, the depreciation on the revised unamortised depreciable
amount should be provided prospectively over the residual useful life of the asset.

26. Where the depreciable assets are revalued, the provision for depreciation should be based Notes
on the revalued amount and on the estimate of the remaining useful lives of such assets.
In case the revaluation has a material effect on the amount of depreciation, the same
should be disclosed separately in the year in which revaluation is carried out.
27. If any depreciable asset is disposed of, discarded, demolished or destroyed, the net surplus
or deficiency, if material, should be disclosed separately.
28. The following information should be disclosed in the financial statements:
(i) The historical cost or other amount substituted for historical cost of each class of
depreciable assets;
(ii) Total depreciation for the period for each class of assets; and
(iii) The related accumulated depreciation.

29. The following information should also be disclosed in the financial statements along with
the disclosure of other accounting policies:
(i) Depreciation methods used; and

(ii) Depreciation rates or the useful lives of the assets, if they are different from the
principal rates specified in the statute governing the enterprise
Self Assessment
Fill in the blanks:

21. A change in the …………………… of depreciation is treated as a change in an accounting
policy and is disclosed accordingly.
22. …………………… has a significant effect in determining and presenting the financial
position and results of operations of an enterprise.
10.6 Summary
 Fixed assets are those assets which are held with the intention of being used for the
purpose of producing goods or providing services and are not held for the sale in the
normal course of business.
 There are two basis for the valuation of fixed tangible assets – (a) historical cost
(b) revaluation.
 The cost of fixed cost comprises of its purchase price and direct costs and import duties and
directly attributable costs.
 At the time of revaluation of assets, the entire class of assets is revalued. The basis of
revaluation should be disclosed.
 When the assets are purchased on the basis of Hire Purchase System, such assets are shown
in the balance sheet at their cash value.
 There is special treatment of intangible assets as goodwill, patents, know-how, etc.
 Depreciation is the decrease in the value of assets at the given date due to wear and tear,
obsolescence, efflux of time, accident and exhaustion.

Notes  Cost of assets, residual value of assets, and useful life of assets are the important factors of
depreciation.
 There are several methods for providing depreciation on fixed assets. The method of the
depreciation is selected on the basis of various factors as – types of assets, nature of
business and circumstances prevailing in the business etc.
 Depreciation is a permanent and gradual diminution in the value of an asset caused by
usage and effluxion of time.
 The accounting treatment is designed to record all transactions of purchase and sale of an
asset and charging of depreciation with the objective of reducing the value of an asset to
zero or its residual value as the case may be.
 Types of Reserves
 Capital reserve: It is a mode for retaining profits in business, which are not available
for distribution as dividends. It is always a credit balance.
 General reserve: It means retention of a portion of profit, not for any particular
purpose, but for the improvement of overall financial position of an enterprise.
 Types of Provisions
 Provision for doubtful debts: This provision is made on certain percentage of total
debtors appearing in the trial balance. It is meant for the recovery of doubtful
overdue account.
 Provision for discount on debtors: This provision is also made on debtors and is treated
as a loss for the current year.
10.7 Keywords
Amortization: The process of writing off the intangible assets.

Cost of Assets: It includes the cost of acquisition, installation, commissioning etc.
Depreciable Assets: Assets which are used in business for more than one accounting year, have a
limited useful life, and used in the business for production and not for the purpose of sale.
Depreciation: A permanent fall in the value of assets due to its use in business, efflux of time,
obsolescence and market changes.
Fixed Assets: Those assets which are held in the business with an intention of being used in
producing goods or providing services and not held for sale during the normal course of business,
are called fixed assets.
Reserve: It is allocation of profit. It is an amount set aside out of profits and is meant to strengthen,
the general financial position of a business enterprise.
Residual Value: It is that value which will be fetched from the sale of the assets on the expiry of
the useful life of the assets.
Useful Life of Assets: The estimated period for which the assets will be used in the business
efficiently.
1. Explain the different components of cost of fixed assets.

2. Give the method of accounting at historical cost of tangible assets.

3. When the goodwill of the business is shown in the books? Should it be retained in the Notes
business? Explain.
4. What are the bases for the valuation of tangible fixed assets? Explain.
5. Explain the principles of valuation of intangible assets.
6. What information are disclosed in the financial statements regarding the valuation of
fixed assets? Explain.
7. Explain the significance of depreciation? What factors should be kept in mind for
determining the amount of depreciation?
8. What are the different methods of providing depreciation? Explain any three of them.
9. Differentiate between ‘Fixed Installment Method’ and ‘Written Down Value Method’.
10. Define depreciation as per Accounting Standard VI? Explain the need and significance of
providing depreciation.
11. Define depreciation.
12. What are the factors effecting depreciation?

13. State the meaning of reserves. Explain the different types of reserves.
14. Distinguish between:
(i) Provision and Reserve
(ii) Capital Reserve and Revenue Reserve
15. On 1st April 2005, Arjun Co. Ltd. purchased a plant costing 4,50,000 and spent 30,000 on
its erection. The estimated effective life of the plant is 4 years with scrape value of 80,000.
Calculate depreciation on the straight line method and show plant account of 4 years if:
(i) Provision for depreciation is not maintained.
(ii) Provision for depreciation is maintained.

16. On 1st January 2004, Arora & Company purchased second hand machinery for 1,85,000
and spent 10,000 on repair and 5,000 on installation. On 1st July, 2005 the company
purchased second hand machinery for 50,000. On 1st July 2006 the machinery purchased
on 1st January 2004, was sold for 1,40,000 and on the same date a fresh machine is
purchased for 1,25,000. On 1st July, 2007 the machinery purchased for 50,000 on 1st July
2005 was sold for 10,000.
17. In 2004, depreciation was charged @10% on original cost, however, in 2005 the company
decided to write-off depreciation @15% on written-down value method. Show the machinery
account for 4 years.
18. Mr. Akshey took a lease for 5 years for 30,000. He decided to write off lease by annuity
method presuming the rate of interest at 5% p.a. the annuity table shows that annual
amount necessary to write off 1 in five years at 5% p.a. is 0.230975. Prepare the lease
account for 5 years.
19. On 1st January, 2005, Mr. Aditya Raj purchased a three years lease of premises for
1,50,000 and it is decided to make provision for replacement of the losses by means of a
depreciation fund. The expected rate of interest on investment is 5% p.a. The sinking fund
table shows that 0.317208 at 5% p.a. will in 3 years accumulate 1. Show the journal
entries and necessary accounts.

Notes Answers: Self Assessment
1. Concept of income 2. Fixed assets

3. Cost price 4. Depreciation funds
5. Straight line method 6. Purchase value

7. Financial position 8. Central Government
9. False 10. True

11. True 12. False
13. False 14. False

15. True 16. False
17. False 18. True

19. False 20. True
21. Method 22. Depreciation
Books Dr. S.N. Maheshwari, Sharad, K. Maheshwari, Financial Accounting, Vikas

Publishing Co. Pvt. Ltd., New Delhi.
Grewal, T.B, Double Entry Book Keeping.
Jain & Narang, Advanced Accountancy.
R.L. Gupta, M. Radhaswami, Advanced Accountancy, Sultan Chand, New Delhi.
T.S. Grewal, M.C. Shukla, Advanced Accounts, S. Chand, New Delhi.


Unit 11: Bank Reconciliation Statement
Unit 11: Bank Reconciliation Statement Notes
CONTENTS
Objectives
Introduction
11.1 Purpose of Bank Reconciliation Statement
11.2 Causes of Difference
11.3 Summary
11.4 Keywords
Objectives

 Describe the purpose of bank reconciliation statement
 Identify the causes of difference in cash book and pass book
 Realise rectification of errors
Introduction
Business organisations record all the cash and bank transactions in cash book of the company.
The Bank also maintains an account for each customer in its book. A copy of this account is
regularly sent to the customer by the bank which is called ‘Pass Book’ or ’Bank statement’. It is
usually to tally the firm’s bank transactions as recorded by the bank with the cash book but
sometimes the bank balances as shown by the cash book and that shown by the bank statement
do not match. If the balance shown by the pass book is different from the balance shown by bank
column of cash book, the business firm will identify the causes for such difference. It becomes
necessary to reconcile them. To reconcile the balances of Cash Book and Pass Book a statement
is prepared. This statement is called the ‘Bank Reconciliation Statement’.
11.1 Purpose of Bank Reconciliation Statement
The reconciliation statement is the most common tool used by organizations for reconciling the
balance as per books of company with the bank statement and is made at the end of every
month. The main objective of reconciliation is to ascertain if the discrepancy is due to error
rather than timing.
It is prepared from time to time to check that all transactions relating to the bank are properly
recorded by the businessman in the bank column of the cash book and by the bank in its ledger
account. Thus, it is prepared to reconcile the bank balances shown by the cash book and by the
bank statement. It helps in detecting, if there is any error in recording the transactions and
ascertaining the correct bank balance on a particular date.
The need and importance of the bank reconciliation statement may be given as follows:
1. The reconciliation process helps in bringing out the errors committed either in Cash Book
or Pass Book.

Notes 2. Bank reconciliation statement may also show any undue delay in the clearance of cheques.
3. Sometimes the cashier may have the tendency of cheating, like he makes entries in the
Cash Book, but does not deposit the cash into bank. These types of frauds by the
entrepreneur’s staff or bank staff may be detected only through bank reconciliation
statement. So this way bank reconciliation statement acts as a control technique too.
!
Caution Bank Reconciliation Statement is a statement prepared to reconcile the difference
between the balances as per the bank column of the cash book and pass book on any given
date.
Self Assessment
Fill in the blanks:
1. The main objective of reconciliation is to ascertain if the discrepancy is due to error rather
than …………………….
2. Direct payments made by banks will …………………… the balances in the pass book.
3. The bank reconciliation statement is prepared without making change in the
…………………… balance.
4. While reconciling the pass book through the check book the interest allowed by banks
will be …………………….
5. While reconciling the check book through pass book the interest and expenses will be
…………………… from the balance as per pass book.
11.2 Causes of Difference
A transaction relating to bank has to be recorded in both the books i.e. Cash Book and Pass Book
but sometimes it happens that a bank transaction is recorded only in one book and not recorded
simultaneously in other book this causes difference in the two balances. The causes for difference
may be illustrated in detail as follows:
1. Cheques issued by the firm but not yet presented for payment: When cheques are issued by
the firm, these are immediately entered on the credit side of the bank column of the cash
book. Sometimes, the receiving person may present these cheques to the bank for payment
on some later date. The bank will debit the firm’s account when these cheques are presented
for payment. There is a time period between the issue of cheque and being presented in the
bank for payment. This may cause difference to the balance of cash book and pass book.
2. Cheques deposited into bank but not yet collected: When cheques are deposited into bank,
the firm immediately enters it on the debit side of the bank column of cash book. It
increases the bank balance as per the cash book. But, the bank credits the firm’s account
after these cheques are actually realised. A few days are taken in clearing of local cheques
and in case of outstation cheques few more days are taken. This may cause the difference
between cash book and pass book balance.
3. Amount directly deposited in the bank account: Sometimes, the debtors or the customers
deposit the money directly into firm’s bank account, but the firm gets the information
only when it receives the bank statement. In this case, the bank credits the firm’s account
with the amount received but the same amount is not recorded in the cash book. As a
result the balance in the cash book will be less than the balance shown in the Pass Book.

4. Bank charges: The bank charge in the form of fees or commission is charged from time to Notes
time for various services provided from the customers’ account without the intimation to
the firm. The firm records these charges after receiving the bank intimation or statement.
Example: Interest on overdraft balance, credit cards’ fees, outstation cheques, collection
charges, etc.
As a result, the balance of the cash book will be more than the balance of the pass book.
5. Direct receipts by the bank: Sometimes, the interest on debentures or dividends on shares
held by the account holder is directly deposited by the company through Electronic Clearing
System (ECS). But the firm does not get the information till it receives the bank statement.
As a consequence, the firm enters it in its cash book on a date later than the date it is
recorded by the bank. As a result, the balance as per cash book and pass book will differ.
6. Direct payments made by the bank: Sometimes, bank makes certain payments on behalf of
the customer as per standing instructions. Telephone bills, rent, insurance premium, taxes,
etc., are some of the expenses. These expenses are directly paid by the bank and debited to
the firm’s account immediately after their payment but the firm will record the same on
receiving information from the bank in the form of Pass Book or bank statement. As a
result, the balance of the pass book is less than that of the balance shown in the bank
column of the cash book.
7. Dishonour of cheques/bill discounted: If a cheque deposited by the firm or bill receivable
discounted with the bank is dishonoured, the same is debited to firm’s account by the
bank. But the firm records the same when it receives the information from the bank. As a
result, the balance as per cash book and that of pass book will differ.
8. Errors committed in recording transactions by the firm: There may be certain errors from
the firm’s side, e.g., omission or wrong recording of transactions relating to cheques
deposited, cheques issued and wrong balancing etc. In this case, there would be a difference
between the balances as per Cash Book and as per Pass Book.
9. Errors committed in recording transactions by the Bank: Sometimes, bank may also commit
errors, e.g., omission or wrong recording of transactions relating to cheques deposited
etc. As a result, the balance of the bank pass book and cash book will not agree.
Notes
 The Bank Reconciliation Statement is prepared as on a particular date to reconcile

the balances as per the cash book and as per the bank statement by identifying the
causes of the difference and showing their impact.
 The Bank Reconciliation Statement is not a part of books of accounts.
 Causes of difference in the balances as per the cash book and the bank statement can
be many, like cheques issued but not presented for payment, cheques deposited but
not yet credited, etc.
Illustration 1: Both the balances as per the cash book and the bank statement are positive.
XYZ Ltd. maintains a current account with the State Bank of India. As on 31st March, 2004, the
bank column of its cash book showed a debit balance of 1,54,300. However, the bank statement
showed a different balance as on that date.

Notes The following are the reasons for such a difference:

( )
(i) Cheques deposited but not yet credited by the bank 75,450
(ii) Cheques issued but not yet presented 80,760

(iii) Bank charges not yet recorded in the cash book 1,135
(iv) Cheques received by the bank directly 1,35,200

(v) Insurance premium paid by the bank as per standing instructions not
yet intimated 15,400
Find out the balance as per the bank statement.

Bank Reconciliation Statement
as on 31st March, 2004

( ) ( )
Bank balance as per the cash book 1,54,300
Add:
Cheques issued but not yet presented 80,760
Cheques received by the bank directly not recorded in the cash
book 1,35,200
2,15,960
3,70,260
Deduct.
Cheques deposited but not yet credited 75,450
Bank charges not yet recorded in the cash book 1,135
Insurance premium paid by the bank directly as per standing
instructions 15,400
91,985
Balance as per the pass book 278,275
Illustration 2: Both the balances as per the cash book and the bank statement are negative.
Ashok Ltd.’s cash book showed a bank overdraft of 76,240 as on 30 th June, 2004. The bank
statement as on that date also showed an overdraft but the figure is different. The following are
the causes:
( )
(i) Cheques deposited but not yet collected 1,02,500

(ii) Cheques issued but not yet presented for payment 76,200
(iii) A cheque of 10,500 deposited on 25th May 2004 was dishonoured

on 29th June 2004 but not intimated by bank till 30th June, 2004
(iv) Bank charges not recorded in the cash book 2,760
(v) Interest on overdraft not intimated 1,250

Bank Reconciliation Statement Notes

as on 30th June, 2004

( ) ( )
Bank overdraft as per the cash book 76,240
Add:
Cheques deposited but not yet collected by the bank 1,02,500
Cheque dishonoured by the bank not yet recorded 10,500
Bank charges not yet recorded 2,760
Interest on overdraft not yet intimated 1,250
1,17,010
1,93,250
Deduct:
Cheques issued but not yet presented for payment 76,200
Overdraft as per the bank statement 1,17,050
Illustration 3: The cash book showing a favourable balance and the bank statement showing an
overdraft.
The bank statement of Karan & Co. showed an overdraft of 56,740 as on 30th September, 2004.
The cash book, however, showed a positive balance of 45,520 as on the same date. The accountant
of Karan & Co. found that the difference in the balance was due to the following:
( )
(i) Cheques issued to supplier not yet presented 1,54,320
(ii) Cheques deposited in the bank not yet credited by the latter 2,06,200
(iii) A cheque received by the bank from a customer has been wrongly
credited by the bank in Andersen & Co. account 64,720
(iv) Dividend received by the bank not yet intimated 15,740
(v) Bank charges not yet recorded in the cash book 1,400

as on 30th September, 2004

( ) ( )
Overdraft as per the bank statement 56,740
Add:
Cheques issued to supplier not yet presented 1,54,320
Dividend received by the bank not yet intimated 15,740
1,70,060
2,26,800
Deduct:
Cheques deposited not yet credited by the bank 2,06,200
Cheque received from a customer wrongly credited by the Contd...
bank in Andersen & Co. A/c 64,720
2,72,320
Bank balance (debit) as per the cash book 45,520
Add:
Cheques issued to supplier not yet presented 1,54,320
Dividend received by the bank not yet intimated 15,740
1,70,060
Financial Accounting 2,26,800
Deduct:
Cheques deposited not yet credited by the bank 2,06,200
Notes Cheque received from a customer wrongly credited by the
bank in Andersen & Co. A/c 64,720
2,72,320
Bank balance (debit) as per the cash book 45,520
You may notice here that the nature of the balance is reversed (overdraft to favourable)
because the deductions are more than the additions or, to put it simply, the balance is
reversed if you get a negative figure.
Illustration 4: From the following particulars, prepare Bank Reconciliation statement of Rajesh
as on 31st December 2006.
(a) Balances as per cash book on 31st December 2006 4,250.

(b) Cheques for 3,100 were issued during the month of December, but only cheques for
1,400 were presented for payment during December.
(c) Cheque and cash amounting to 5,900 were deposited in the bank during the month of
December but credit was given only for 3,450.
(d) The bank paid during December 2006 a sum of 495 as life insurance premium.
(e) The bank credited 100 as interest and debited 45 as bank charges, for which there were
no corresponding entries in the cash book.
Solution:
Bank Reconciliation Statement of Rajesh as on December 31, 2006.
Bank balance as per Cash Book 4250

Add: Cheque issued but not yet presented for payment 1700
Interest credited only in the pass book 100 1800
6050
Less: Cheque deposited but not yet credited by the book 2450
Life insurance premium debited only in the pass book 495
Bank charges debited only in the pass book 45
2990
Bank balance as per Pass Book 3060
Illustration 5: From the following transactions prepare Bank Reconciliation Statement as on

March 31, 2007 of a firm.
(a) Bank balance as per pass book 9,800.

(b) A cheque of 5,000 deposited into bank on March 26, 2007, was credited in the first
week of April.
(c) Cheque issued to a creditor 7,000 on March 28, 2007 was presented to the bank on
April 8, 2007.
(d) A cheque of 2,000 deposited into the bank was found dishonoured but the entry of
dishonour is pending in the cash back.
(e) A cheque of 3,000 issued to Mr. Alex was dishonored due to the difference in the
amount mentioned in words, but the entry of dishonour is not yet done in the cash
book.

(f) A cheque of 4,000 was deposited in the bank and found credited before March 31, Notes
2007 but omitted to record in the cash book.
(g) A cheque of 5,000 received from customer and debited to the bank column of the
cash book, but not sent to the bank.
(h) A wrong debit of 500 was found in the bank column of the cash book
(i) A wrong debit of 2,000 was found in the pass book.

(j) Bank charges 100 found debited in the pass book.
(k) A draft of 5,000 has been sent to the Supplier of Machine and credited to cash book
(bank column) but an additional debit of 50 was made in the bank for charges.
(l) Bills payable 10,000 was paid by the bank at a discount of 2%, but the full credit was
given to the bank account in the cash book.
(m) Direct payments made by customers into the bank amounted to 8,000, but
intimation was given to the business in the first week of April.
Solution:
Bank Reconciliation Statement as on March 31, 2007.
Bank balance as per Pass Book 9,800

Add: Cheque deposited but not yet credited by the bank 5,000
Cheque deposited dishonoured debited in the pass book 2,000
but not entered in the cash book
Cheque received but not sent to bank 5,000
Wrong debit in the cash book 500
Wrong debit in the pass book 2,000
Discount charges are entered only in the pass book 200 14,800
Less: Cheque issued but not presented for payment 7,000
Cheque issued dishonoured entered in the pass book but 3,000
not entered in the cash book
Cheque deposited and entered in the pass book but not 4,000
entered in the cash book
Direct payments entered in the pass book but not entered 8,000 (22,050)
in the cash book
Bank balance as per Cash Book 2,550
Notes:
Pass book credit balance is given and cash book Pass Book Cash Book Adjustment to
balance is to be found Cr. (1) Dr. (2) be made. (2–1)
Let us assume initially bank balance was same in 20,000 20,000

cash book and pass book
Effect of each reason on these balances
(b) 20,000 25,000 Add 5,000
(c) 20,000 13,000 Deduct 7,000
(d) 20,000 22,000 Add 2,000
(e) 20,000 17,000 Deduct 3,000

Notes
Example: Rectification of the Cash Book.
As we have already mentioned that the difference in the bank balances may be due to
some errors or omissions committed by you. So, you have to make necessary amendments
in the cash book first and then prepare a bank reconciliation statement.
Verma Ltd. showed a bank balance of 1,24,250 as on 31st March, 2004. The bank statement,
however, showed a different figure. The following items were detected:
( )
(i) Cheques deposited but not yet credited by the bank 1,74,020
(ii) Cheques issued but not yet presented for payment 1,06,240
(iii) The balance in the bank column of the cash book on page 23 has
been carried forward as 45,720 instead of 45,270.
(iv) Bank charges not yet recorded 1,045
(v) A cheque received from a customer has been wrongly shown in the
cash column of the cash book instead of the bank column 26,740
Cash Book (Bank Column Only)
Dr. Cr.
Date Particulars V JF Amount Date Particulars V JF Amount
No ( ) No ( )
2004 2004
31st To Balance b/d 1,24,250 31st By Carry 450
March March forward error
To cash a/c 26,740 By Bank 1,045
Charges
(Cheque received By Balance 1,49,495
wrongly shown in c/d
cash column)
1,50,990 1,50,990

As on 31st March, 2004

( ) ( )
Bank balance (amended) as per cash book 1,49,495
Add:
Cheques issued but not yet presented for payment 1,06,240
2,55,735
Less:
Cheques deposited but not yet credited by the bank 1,74,020
Balance as per the bank statement 81,715

Notes
Task On December 31, 2006, the cash book of the M/s Mona Plastics shows the credit
balance 6,500. Cheques amounting to 3,500 deposited into bank but were not collected
by the bank. Firm issued cheques of 1,000 which were not presented for payment. There
was a debit in the pass book of 200 for interest and 400 for bank charges. Prepare Bank
Reconciliation Statement.

Caselet Probe Blames Lack of Internal Controls
A
n independent legal counsel appointed by IT major Wipro has found that lack of
internal controls led to the embezzlement committed by one of the former junior
employees between November 2006 and December 2009.
The legal counsel submitted the probe report last week to the audit committee set up to
investigate the fraud early.
Based on the findings of the legal counsel, Wipro said that if corrections were to be carried
out to the annual financial results of the company in view of the “misstatements identified
during the probe together with other “uncorrected audit adjustments’’, profit-after-tax for
2009-10 would have been higher by 2.1 per cent (approximately 92 crore). Wipro’s Chief
Financial Officer, Mr Suresh C. Senapaty, told Business Line that the external legal counsel
was appointed on the advice of the SEC. “He formally submitted the report this month
and measures have already been taken to tighten the system,” he said. Stating that it has
been able to recover most of the embezzled amounts, Wipro, which is listed on the New
York Stock Exchange, in its latest disclosure to the US Securities and Exchange Commission,
said its audit panel has concluded that mistakes were committed in certain accounting
entries and that they were also not supported by any documents. “We and our independent
registered public accounting firm also identified the lack of internal controls that gave
rise to the embezzlement and financial statement misstatements as material weaknesses
in internal control over financial reporting,” Wipro said in its disclosure to SEC. The
material weaknesses related to sharing of online banking access passwords and Wipro’s
internal accounting system passwords by certain employees within the finance and
accounting departments including those responsible for external financial reporting.
There was lack of effective controls over recording of journal entries, including inadequate
documentation which resulted in ineffective controls over bank reconciliation statements,
exchange rate fluctuation accounts and outstanding liabilities accounts and also there was
lack of timely and adequate reconciliation and review of period and end reinstatement of
foreign currency inter-company and unit balances, including recording of appropriate
adjustments. Also, segregation of duties with respect to recording and initiating banking
payments was found insufficient.

Notes
Self Assessment
Fill in the blanks:
6. Overdraft means ……………………… balance.

7. The balance of cash book is ……………………… in case of overdraft.
8. Bank charges will ……………………… in case of overdraft as per Cash Book.
9. Cheques issued but not encashed will ……………………… in case of the overdraft as per
Pass Book.
10. Interest allowed by bank …………………… in case of the favourable balance of cash book.
11.3 Summary
 The bank reconciliation statement is prepared as on a particular date to reconcile the

differences between the check books and pass book by identifying the causes of difference
and showing their impact.
 There are a lot of reasons due to which the balances of a cash book and pass book do not
match, and then the bank reconciliation statement is prepared to reconcile both the balances.
 The bank reconciliation statement facilitates checking of errors and frauds in the books of
accounts.
11.4 Keywords
Bank Overdraft: If the bank statement shows a debit balance at a particular point of time, it is
known as overdraft. It implies that the account is overdrawn, i.e., withdrawals are more than
deposits.
Bank Statement: It gives the details of transactions between the bank and the customer. Every
bank provides bank statements to each customer either weekly or monthly.
Pay-in-Slips: Documents supporting cheques deposited into the bank.
1. What is a Bank Reconciliation statement?
2. Why is a bank reconciliation statement prepared?

3. What are the causes of differences between the bank balance shown by cash book and the
balance shown by bank statement?

4. The following cash book (bank column) and bank statement of M/s XYZ are available for Notes
the month of April 2004:
Cash Book (Bank Column) Only
Dr. Cr.
Date Particulars Amount Date Particulars Amount
( ) ( )
2004 2004
April April
1 To Balance b/d 27,340 3 By Salary 57,975
(Chq. No. 14625)
5 To Debtors: 4 By Creditors:
Cheques 475923 37,230 Cheques 14626 36,940
576264 45,200
14632 47,950
71924 15,425
14633 68,960
82569 25,626
7 By Insurance Premium
6 To Bills Receivable 17,250 Chq. No. 14627 13,740
7 To Interest 8 By Creditors:
(Chq. No. 565260) 4,640 8 Chq. No. 1462 37,940
10 To Cash 25,640 Chq. No. 14629 61,255
12 To Dividend 18,240 Chq. No. 14630 42,960
(Chq. No. 266640) 14631 55,200
15 To Debtors:
Chq. No. 55655 79,240
Chq. No. 66926 54,500 13 By Cash 15,640
Chq. No. 36246 30,000 15 By Loan
Chq. No. 37923 25,650 (Chq. No. 14634) 30,000
(Instalment)
18 To Dividend 12,655 20 By Creditors:
(Chq. No. 264923) Chq. No. 14635 25,300
Chq. No. 14636 17,920
Chq. No. 14637 50,000
25 To Debtors:
Chq. No. 74243 86,240
Chq. No. 92765 33,943
Chq. No. 77237 57,940 30 by Balance 34,979
5,96,759 5,96,759

Notes Super Bank Ltd.

Bank Statement of M/s XYZ
for the month of April 2004
Date Details Dr. Cr. Balance

( ) ( ) ( )
April 2004
1 Balance 75,760
3 To Chq. No. 14625 57,975
6 By Bills discounted 17,250 35,035
8 By Chq. No.475923 37,230 72,265
9 To Chq. No. 14626 36,940 35,325
10 By Chq. No. 565260 4,640 39,965
” ” Cash 25,640 65,605
13 To Cash 15,640 49,965
15 ” Chq. No. 14632 47,950 2,015
” By Chq. No.576264 45,100 47,115
” ” Chq. No. 71924 15,325 62,440
16 To Chq. No.14633 68,960 (6,520)
17 By Chq. No. 266640 18,200 11,680
18 To Chq. No. 14634 30,000 (18,320)
20 By Chq. No.55655 79,240 60,920
” ” Chq. No. 66926 54,250 1,15,170
22 To Chq. No. 14628 37,940 77,230
” ” Chq. No. 14629 61,255 15,975
23 By Chq. No. 264923 12,640 28,615
28 ” Chq. No. 36246 29,640 58,255
” ” Chq. No. 74243 86,240 1,44,495
” To Chq. No. 14575 48,420 96,075
29 To Chq. No. 14630 42,960 53,115
30 Balance 53,115
A cheque (No. 14575) issued to supplier on 28th March 2004 has been debited in the bank
statement on 28th April 2004.
Read the above details carefully and prepare a bank reconciliation statement as on 30th
April 2004.
5. Akash Ltd.’s books showed a bank balance of 1,54,360. The bank statement showed a
different figure. The following differences were detected:
( )
(i) Cheques deposited but not yet credited by bank 1,56,340
(ii) Cheques issued but not yet presented for payment 1,76,260
(iii) Cheques received by the bank directly 1,46,200

(iv) A cheque for 76,500 deposited in the bank was dishonoured but Notes
not yet recorded in cash book
(v) Bank charges not yet recorded 1,760

(vi) A cheque deposited in bank has been wrongly credited by the latter
in Neptune’s account 46,740
(vii) Dividend received by the bank not intimated 20,200

Prepare a bank reconciliation statement after making necessary amendments in the cash
book.
1. Timing 2. Decrease
3. Cash book 4. Added
5. Deducted 6. Unfavourable
7. Credit 8. Increase
9. Decrease 10. Adds

Online links www.cbdd.edu

www.textbooksonline.tn.nic.in

Notes Unit 12: Corporate Financial Statements
CONTENTS
Objectives
Introduction
12.1 Nature of Corporate Financial Statements
12.1.1 Objective of Corporate Financial Statements
12.2 Types of Corporate Financial Statements
12.2.1 Income Statement
12.2.2 Balance Sheet
12.2.3 Statement of Cash Flow
12.2.4 Statement of Retained Earnings
12.3 Uses of Corporate Financial Statements
12.4 Limitation of Corporate Financial Statements
12.5 Summary
12.6 Keywords
Objectives
 Understand the nature of corporate financial statements
 Have types of corporate financial statements
 Use of corporate financial statements
 Describe the limitation of corporate financial statements
Introduction
Corporate entities registered in India are primarily guided by the provisions of the Companies
Act, 1956. Every company is required to keep proper books of accounts showing all money
received and spent and the details thereof; sale and purchase of goods; income earned and
expenses accrued and assets and liabilities. As per the provisions of the Companies Act, 1956
proper books of accounts shall not be deemed to be kept if such books are insufficient to give a
true and fair view of the state of affairs of a company.
Did u know? What is proper books of account?

Two essential conditions are to be satisfied for a set of books of accounts to be called
proper books of account:
(a) Double entry accounting is followed while recording transactions.
(b) The books of accounts are maintained on accrual basis.

Unit 12: Corporate Financial Statements
Section 209 of the Companies Act, 1956 states that proper books of accounts shall be maintained Notes
at the company’s registered office unless the Board of Directors decides to keep them at another
place in India. A company gets its funds partly from its owners and partly from lenders. Owners’
contribution is called equity share capital. In fact, there are traditionally two types of shares
recognised in the Companies Act—Equity Share and Preference Share. Of late, a new class of
share is allowed to be issued—Non-voting Share. Preference shareholders enjoy privilege or
preference over equity shareholders on two counts:
(i) in respect of dividend (distribution of profits) and

(ii) in respect of repayment of principal in case of liquidation of a company.
Thus, equity shareholders are real risk takers and hence they are the true owners of a company.
The external borrowings by the company may be in the form debentures, term loans from
financial institutions or commercial banks, public deposits, etc. The external borrowings have a
definite cost in the sense that they are to be serviced at a fixed rate of interest periodically. Even
preference shareholders are paid a predetermined rate of dividend. But since equity shareholders
have a ‘residual’ interest in profits, they are not paid a fixed rate of dividend. Dividend on equity
shares is a function of profit.
Companies earn profits as they carry on business. No company expects a loss to be incurred—
loss is only an accident or an unwelcome feature. The entire profits are not distributed as
dividend—a part of the profit is kept as ‘reserves’ to meet any future contingencies or to plough
back in the business. A company also creates provision to meet any specific future happening.
The only difference between a reserve and a provision is that reserve is created for some
unforeseen event whereas provision is created for a known liability of which the amount cannot
be determined with substantial accuracy.
The funds thus generated from internal and external sources are applied to acquire fixed assets
and also to acquire current assets, like inventories.
It can be mentioned here that companies registered in India will have to follow Indian GAAP
(Generally Accepted Accounting Principles) while preparing and presenting their financial
statements. Indian GAAP generally comprise of three regulatory frameworks: (a) the Companies
Act, 1956; (b) the Accounting Standards of ICAI; and (c) the SEBI disclosure norms. The third
framework (c) is applicable only in case of listed companies. Consider the following paragraph
which clearly articulates the basis of preparation of financial statements:
“…… The financial statements are prepared in accordance with Indian Generally Accepted
Accounting Principles (“GAAP”) under the historical cost convention on the accruals basis.
GAAP comprises mandatory accounting standards issued by the Institute of Chartered
Accountants of India (“ICAI”), the provisions of the Companies Act, I956, and guidelines issued
by the Securities and Exchange Board of India……..
The preparation of the financial statements in conformity with GAAP requires management …
to make estimates and assumptions that affect the reported balances of assets and liabilities and
disclosures relating to contingent assets and liabilities as at the date of the financial statements
and reported amounts of income and expenses during the period……. Actual results could differ
from those estimates.” (Source: Annual Report, Infosys Technologies Ltd.)
The above statement highlights another feature of financial statements. The preparers of financial
statements are required to make estimates and apply judgments while reporting the financial
elements. The readers of financial statements are, therefore, forewarned that actual results could
vary from the estimates.
The resultant impact of the performance of a company is measured periodically through the
preparation of financial statements. Thus, financial statements are external reports. At the end of

Notes every accounting period, each company comes out with a printed annual report which is a
public document. The annual report comprises of normally the following:
(a) Chairman’s statement.
(b) Report from board of directors
(c) Financial statistics.
(d) Financial statements.
(e) Auditors’ report.
(f) Major accounting policies.
(g) Consolidated financial statements (if applicable).
12.1 Nature of Corporate Financial Statements

The corporate financial statements are the financial reports or formal record of the financial and
business activities of a firm. The corporate financial statements actually give a summary of the
financial condition and profitability of the firm in both long- and short-term. The corporate
financial statements are generally complex in nature as they contain analysis and discussion on
the management decisions and financial statement notes. The financial statement notes define
each and every item in the balance sheet besides describing cash flow statement and income
statement in details.
!
Caution In India, every company has to present its financial statements in the form and
contents as prescribed under Section 211 of the Companies Act, 1956.
12.1.1 Objective of Corporate Financial Statements
The prime objective of corporate financial statements is to give information on the performance,
financial strength and financial position changes of a company. This financial statement is
valuable for the users while they go for economic decisions. The major criterion of a financial
statement is that it should be relevant, comparable, understandable and reliable. The financial
position of a company refers to the reported equity, assets and liabilities while the financial
performance of a company refers to the reported income and expenditures of the company. The
corporate financial statements are understood by those people who have significant knowledge
of economics and business activities.
12.2 Types of Corporate Financial Statements

The four basic types of corporate financial statements are:
 Income statement
 Balance sheet
 Statement of cash flows
 Statement of retained earnings
12.2.1 Income Statement
The income statements are also called as the profit loss statements. This statement gives
information on the result of various operations of the company over a term period. An income

statement is a type of summary flow report that lists and categorizes the various revenues and Notes
expenses that result from operations during a given period - a year, a quarter or a month. The
difference between revenues and expenses represents a company’s net income or net loss. The
amounts shown in the income statement are the amounts recorded for the given period – a year,
a quarter or a month. The next period’s income statement will start over with all amounts reset
to zero.
While the balance sheet shows accumulated balances since inception, the income statement only
shows the amounts earned or expensed during the period in question. Some of the key indicators
reported on the income statement include:
 Revenues are simply the annual incoming revenue flow, usually broken into different
categories (reflecting the different lines of the company’s business).
 Operating expenses include the expenses directly associated with the firm’s day-to-day
operations, including wages and salaries, benefits, supplies, parts, raw materials, rents
and leases, etc. This is sometimes called the company’s “cost of sales.”
 Operating profit equals revenues minus direct operating expenses, before deducting certain
overhead costs (such as interest expenses, R&D costs, restructuring charges, etc.) which are
associated with the firm’s overall existence (rather than with its specific day-to-day
operations). A strong operating profit is a sign of the inherent underlying profitability of
the company’s real business activity.
 Other deductions are then subtracted from the company’s operating profit, to generate an
estimate of its final bottom-line profitability. Two of the most important of these are
interest costs and depreciation. Interest costs are the actual cash payments made to banks
and other lenders (including bondholders) from whom the company has borrowed money
to finance its various activities. Depreciation, on the other hand, is an imaginary charge
that reflects the gradual wearing out of the actual machinery, equipment, buildings, and
other real assets which the firm uses in its business. The company doesn’t actually have to
“pay” anyone for this wear-and-tear, but it does have to recognise in its income statement
the inevitable decline in the value of these assets.
 Special one-time charges are also sometimes deducted at this stage of the income statement,
including one-time payouts for severance costs and other expenses associated with layoffs
or downsizing, or one-time “write-offs” of capital value by companies who are experiencing
chronic losses. In some cases, a researcher will want to analyse a company’s profits before
these special one-time charges, in cases where you want to demonstrate the continuing
viability of a company’s core business (a picture which can be clouded by one-time charges).
 Net income before tax equals the overall final profit of the company after all these various
charges are considered.
 Net income is the company’s final profit, after deducting a charge for income tax. If the
company has generated a before-tax loss, sometimes the income tax charge is positive,
since the company can set these losses against other profits (historical or anticipated) to
reduce its tax payments; this is called a “tax recovery.” Some income statements will
provide additional details on how this net income is distributed between different
categories of the company’s owners. For example, many companies have “preferred
shareholders,” who may receive a special dividend out of the company’s profits, before
any remaining profits are ascribed to the company’s other or “common” shareholders.
But if it is the profitability of the company that you are interested in, not the well-being of
a particular group of shareholders, then you will want to analyse the company’s net
income before any distributions to preferred shareholders.

Notes
Example: The following example shows some of the common elements of the Income
Statement.
Sample Company Income Statement
January 1, 2009 to December 31, 2009

Income
Gross Sales 346,400
Less returns and allowances 1,000
Net Sales 345,400
Cost of Goods
Merchandise Inventory, January 1 160,000
Purchases 90,000
Freight Charges 2,000
Total Merchandise Handled 252,000
Less Inventory, December 31 100,000
Cost of Goods Sold 152,000
Gross Profit 193,400
Interest Income 500
Total Income 193,900
Expenses
Salaries 68,250
Utilities 5,800
Rent 23,000
Office Supplies 2,250
Insurance 3,900
Advertising 8,650
Telephone 2,700
Travel and Entertainment 2,550
Dues & Subscriptions 1,100
Interest Paid 2,140
Repairs & Maintenance 1,250
Taxes & Licenses 11,700
Total Expenses 133,290
Net Income 60,110
12.2.2 Balance Sheet
The balance sheet is based on the equation: assets = liabilities + owners’ equity. The balance
sheet is also known as the statement of financial condition or position. It gives information on
the net equity, assets and liabilities of a company at a given point of time. It indicates everything
the company owns (assets), everything the company owes to creditors (liabilities) and the value
of the ownership stake in the company (shareholders’ equity, or capital). The balance sheet date

is the ending date of the period or year, and is a continuation of the amounts recorded since the Notes
inception of the company or organization. The balance sheet is a “snapshot” of the financial
position of the company at the balance sheet date and shows the accumulated balance of the
accounts. Assets and liabilities are separated between current and long-term, where current items
are those items, which will be realized or paid, within one year of the balance sheet date. Typical
current assets are cash, prepaid expenses, accounts receivable and inventory. The major categories
reported on the balance sheet include:
 Assets are divided into various categories: current assets (including cash or other highly
liquid financial assets, accounts receivable, and the value of inventories), and fixed assets
or investments. The fixed assets item includes the “book” value of the company’s
accumulated purchases of property and equipment: that is, what the company paid for
those assets, less their estimated depreciation over the years they have been used. This
book value may differ from the actual usefulness or resale value of those assets.
 Liabilities are also divided into current and long-run. Current liabilities include accounts
payable, and the value of debt and interest on debt that is due within the next year.
Another major liability is the company’s long-term debt (that which comes due later than
one year from the present).
 Shareholder’s equity is a special kind of liability. The shareholders’ equity, in essence, is

what the company “owes” to its own shareholders. It is equal to the value of the company’s
assets, minus what the company owes to people or businesses other than its own
shareholders.
Another term for this value is the “net worth” of the company. A company’s shareholders’
equity should (by definition) equal the value of any initial equity funds advanced by the
shareholders (through public offerings of new stock or other financing methods), plus the
cumulative value of the company’s retained earnings (that is, that portion of the company’s past
profits which were not paid back to shareholders in the form of dividends). Because equity is
treated as a liability, the company’s total assets and total liabilities (including shareholders’
equity) are always equal. If a company’s accumulated liabilities (excluding shareholders’ equity)
are greater than its total assets, then shareholders’ equity is negative. Usually, a company will
only have negative shareholders’ equity if it has experienced a string of losses, which have more
than wiped out the value of the equity which shareholders put into the company (through their
initial investments in the company) and any accumulated profits which the company earned in
earlier, happier times. A company with negative equity is usually (but not always) facing a
serious risk of bankruptcy.
Example: Sample Balance Sheet

Sample Balance Sheet
for the Month Ended __________
Asset ( ) Liabilities ( )
Cash 15,300 Accounts Payable —
Accounts Receivable 1,000 Equity 600
Supplies 500 Sample Business Plan, Capital 51,200
Land 10,000 Other —
Building 25,000 Total Liabilities —
Total Assets 51,800 Owner's Equity 51,800

Notes 12.2.3 Statement of Cash Flow
The statement of cash flow gives information on the cash flow activities of a company. This
statement specially covers the fields of investment, operation and financing activities of the
company. The statement of cash flow shows all sources and uses of a company’s cash during the
accounting period. Sources of cash listed on the statement include revenues, long-term financing,
sales of noncurrent assets, and an increase in any current liability account or a decrease in any
current asset account. Uses of cash include operating losses, debt repayment, equipment purchases
and increases in current asset accounts.
The main items covered in the cash flow statement include:
 Cash generated from operating details the actual cash surplus raised by a company’s day-
today business. This is sometimes referred to, for short, as a company’s “cash flow.” It will
equal the company’s net after tax profit (from the income statement), adjusted for any
noncash revenues or expenses which were included on the income statement. For example,
depreciation (which is an imaginary charge deducted from revenue in the income statement)
is added back in, on this statement, as are deferred taxes, one-time non-cash charges and
provisions, and other non-cash charges. The bottom line of this section tells you how
much actual money was generated by a company’s business in the previous period.
 Cash provided by financing activities reports on any net cash that was raised by the
company from financial markets – such as new loans from banks or bondholders, or new
equity funds raised from the stock market (through new issues of the company’s shares),
less the costs associated with raising those funds. Companies usually raise new funds to
pay for new investments (such as expansion in operations, or new equipment or facilities).
One item which appears in this section with a negative sign is the regular dividend payout
to a company’s existing shareholders. Since dividends are considered to be a continuing
“cost” of previous efforts to raise money from shareholders, they are deducted here from
the sum of the company’s other financing activities.
 Cash used in investing activities describes how the company spent some of its cash on new
investments – such as investments in new equipment or buildings, acquisition of other
companies, and other investments.
The first two segments of the cash flow statement are usually positive (since they usually, but
not always, indicate how the company “raised” money). The third segment is usually negative
(since it usually, but not always, indicates that the company “spent” money on incremental
investments). The overall balance of the three sections of the cash flow statement therefore
shows whether the net effect of these three components was positive or negative. If the net
balance is positive, then the company finished the period with more cash (or highly liquid cash
alternatives) in the bank than it started with. Its cash balance (which was reported as one type of
asset on the balance sheet) grew. If the cash flow balance was negative, this means that the
company’s cash balance shrank during the period.
The bottom of the cash flow statement will usually summarise how much cash the company
started the period with, the net change in cash, and then the closing cash balance.
Researchers and analysts are often interested in the cash flow situation of companies which are
in financial distress. Even healthy companies, of course, may experience a negative change in
cash during the year – if, for example, they are expanding rapidly and therefore spending more
on new investments than they actually raise from their internal cash flow and from new financing.

But in the long-run, of course, a company cannot keep spending more money than it takes in. For Notes
companies in trouble, analysts want to keep an eye on the current amount of cash in the bank (to
be sure the company has enough funds on hand to cover its bills). In fact, if the company’s
auditors think that cash-on-hand may not be sufficient to pay the bills (including anticipated
operating losses) in the next few months, they will issue what is called a “going concern”
warning that is attached to the audited financial statement. They are warning investors, in other
words, that the company’s cash stockpile may not be enough the pay the company’s bills, which
usually forces the company to seek bankruptcy protection (hence eliminating its status as a
“going concern”).
Example: Sample Cash Flow Statement

Sample Business Plan
Sample Cash Flow Statement
Statement for the Month Ended_________.
Cash Flow from Operating Activities

Net Income 1,800
Non-cash Expenses and Revenues
Include income
Increase in Accounts Receivable 1,000
Increase in Supplies 500
Increase in Accounts Payable 600 (900)
Net Cash Flow from Operating Activities 900
Cash Flows from Investing Activities
Purchase of land (10,000)
Purchase of Building (25,000)
Net Cash Flow used by Investing Activities
Cash Flow Financing Activities
Invested 50,000
Withdrawals (600)
Net Cash Flow provided by Financing Activities 49,400
Net Increase (Decrease) in Cash 15,000
12.2.4 Statement of Retained Earnings
The statement of retained earnings describes the changes that occur in the retained earnings of
a company. The statement of retained earnings shows the amount of accumulated earnings that
have been retained within the company since its inception. At the end of each fiscal year-end, the
amount of net income or loss is added to the opening amount of retained earnings to arrive at
the closing retained earnings. Retained earnings can be decreased by such items as dividends
paid to shareholders.

Notes
Example: Written below is a sample of a retained earnings statement.
Quartz Corporation
Statements of Retained Earnings
For the year ending December 31, 2009
Retained earning - January 1, 2009 $400,000

Add: Net income 115,000
$515,000
Less: Dividends 35,000
Retained earnings - December 31, 2009 $480,000
Self Assessment
Fill in the blanks:
1. Income statement is also called profit and loss statement (P&L) and …………………….
2. The purpose of the …………………… is to show managers and investors whether the
company made or lost money during the period being reported.
3. A retained earnings statement explains the …………………… in a company’s retained
earnings over the reporting period.
4. The …………………… provides an insight into the financial status of a company at a
particular time.
5. The cash flow may be from many activities of a firm involving particularly its operations,
…………………… and finance.
12.3 Uses of Corporate Financial Statements
The uses of financial statements vary from entity to entity. For different people, they have
different uses. Though no complete list can be provided for their uses, presented under is a brief
list of benefits they give to their users.
1. For equity investors and lenders: The existing equity investors and lenders to a company
need to monitor their investments and to evaluate the performance of management. For
this purpose, they have no aid else than the financial statements of a firm.
The prospective equity investors and lenders use financial statements to decide whether
or not to invest in an organisation.
2. For finance specialists: Investment analysts, money managers, and stockbrokers, use
financial statements to make buy/sell/hold recommendations to their clients.
3. For credit rating agencies: Rating Agencies such as Moody’s and Standard & Poor’s assign
credit ratings on the basis of the financial statements of a company.
4. For customers and suppliers: Major customers of and suppliers to an organization evaluate
the financial strength and staying power of the company as a dependable resource for
their business. For this purpose, the best possible aids are those of the financial statements
of the organization.
5. For Labor unions: Labor unions use financial statements of a company to gauge how much
of a pay increase a company is able to afford in upcoming labor negotiations.

6. For the Board of directors: Board of directors of an organization uses its financial statements Notes
to review the performance of management in general and company in particular.
7. For Managers: Managers, too, are interested in measuring the operating performance in
terms of profitability and return on invested capital. If they are not owners, managers
must still satisfy the owners’ expectations in this regard. As managers, they are interested
in measures of operating efficiency, asset turnover, and liquidity or solvency. These will
help them manage day-to-day activities and evaluate potential credit customers and key
suppliers.
8. For Competitors: Existing Competitors of an organization use its financial statements to
benchmark their own financial results.
Potential competitors of an organization use its financial statements to assess how profitable
it may be to enter the industry.
9. For Government agencies: The financial statements of a company are very useful for the
government agencies responsible for taxing, regulating, or investigating the company.
10. For associated personnel: The financial statements of a company are also useful for
politicians, lobbyists, issue groups, consumer advocates, environmentalists, think tanks,
foundations, media reporters, and others who are supporting or opposing any particular
public issue the company’s actions affect.
11. For partners: The financial statements of a company are used by actual or potential joint
venture partners, franchisors or franchisees, and other business interests who need to
know about the company and its financial situation.
Self Assessment
State true or false:

6. The prospective equity investors and lenders use financial statements to decide whether
or not to invest in an organisation.
7. Existing Customers of an organization use its financial statements to benchmark their
own financial results.
8. Board of directors of an organization uses its financial statements to review the performance
of management in general and company in particular.
12.4 Limitation of Corporate Financial Statements
Some of the limitations of the financial statements are as follows:
1. As the historical costs and money measurement concepts govern the preparation of the
balance sheet and income statements, hence these financial statements are essentially
statements reflecting historical facts. It ignore inflationary trend and does not reflect the
true current worth of the enterprise,
2. Certain important qualitative elements are omitted from the financial statements because
they are incapable of being measured in monetary terms like the quality and reputation of
the management team, employee and other,
3. There are items in the assets side of the balance sheet which has no real value and are
merely deferred charges to future incomes like preliminary/pre-incorporation expenses
and other,

Notes 4. There are still the following issues or challenges in preparing the financial statements
which may amount to overstatement of the accounting profit of an entity:
(a) When to and how much to recognize revenue in the Income statement.
(b) The constant challenge of when to expense or to capitalize the expenses. It is important
to determine definitely what is revenue expenditure and capital expenditure
otherwise the accounting profit will be overstated or understated:
Example: Capitalization of borrowing costs, etc.

(c) Method of depreciations and the rates to depreciate into the income statement are
selected by management to suit their business needs. Are the rates intentionally
been made lower or the depreciation rates are higher to accelerate the depreciation
of the fixed assets,
(d) Adequacy of provisions and method of providing for doubtful debts. Are the trade
debtors recoverable and to what extent the accounting method for provision for
doubtful debts shows the realistic picture.
(e) Basis of valuation of assets – when can costs change to reflect current values? Using
replacement or current costs?
(f) Consolidation challenges – what to eliminates to reflects the overall group
performance. Some items might be omitted to show a higher accounting profits.
Self Assessment
Fill in the blanks:

9. Financial statements ignore …………………… trend and does not reflect the true current
worth of the enterprise.
10. There are items in the assets side of the balance sheet which has no real value and are
merely deferred charges to future incomes like …………………… expenses and other.
12.5 Summary
 The corporate financial statements actually give a summary of the financial condition and
profitability of the firm in both long and short term.
 The prime objective of corporate financial statements is to give information on the
performance, financial strength and financial position changes of a company.
 The four basic types of corporate financial statements are:
 Income statement
 Balance sheet
 Statement of cash flows

 Statement of retained earnings
 The uses of financial statements vary from entity to entity. For different people, they have
different uses.
 As the historical costs and money measurement concepts govern the preparation of the
balance sheet and income statements, hence these financial statements are essentially
statements reflecting historical facts.

12.6 Keywords Notes
Balance Sheet: The balance sheet is based on the equation: assets = liabilities + owners' equity.
Corporate Financial Statements: The corporate financial statements are the financial reports or
formal record of the financial and business activities of a firm.
Income Statement: The income statements are also called as the profit loss statements.
Statement of Cash Flow: The statement of cash flow gives information on the cash flow activities
of a company.
Statement of Retained Earnings: The statement of retained earnings describes the changes that
occur in the retained earnings of a company.
1. What is the Nature of Corporate Financial Statements?
2. Write down the Objective of Corporate Financial Statements.

3. Briefly explain the four basic types of corporate financial statements.
4. What are the Uses of Corporate Financial Statements?
5. Explain the Limitation of Corporate Financial Statements.
1. Statement of Operations 2. income statement

3. changes 4. balance sheet
5. investment 6. True
7. False 8. True
9. inflationary 10. preliminary/pre-incorporation



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Notes Unit 13: Computerised Accounting
CONTENTS
Objectives
Introduction
13.1 Role of Computers in Accounting
13.2 Computerised Accounting
13.2.1 Need and Requirements of Computerised Accounting System
13.2.2 Basic Requirements of the Computerised Accounting System
13.3 Salient Features of Computerised Accounting
13.4 Sourcing of Accounting Software
13.5 Summary
13.6 Keywords
Objectives

 Explain the role of computer in accounting;
 Differentiate between manual accounting and computerised accounting;
 State the need for computerised accounting
 Describe the basic requirements of computerised accounting.
Introduction
With the expansion of business the number of transactions increased. The manual method of
keeping and maintaining records was found to be unmanageable. With the introduction of
computers in business, the manual method of accounting is being gradually replaced. And
finally, the database technology has revolutionized the accounts department of the business
organizations.
Keeping accurate accounting records is a vital part of managing an organisation. Apart from
helping to keep it afloat financially and legally, it is also a requirement of funding bodies.
Smaller groups can usually manage with simple bookkeeping procedures but bigger groups
juggling with larger sums of money and more complex financial transactions may find their
workload eased by using a computerised accounting system. The good news is that there are
easy to use and reasonably priced computerised accounting packages on the market that are
either aimed at, or can be adapted to, voluntary sector organizations.
13.1 Role of Computers in Accounting

The most popular system of recording of accounting transactions is manual which requires
maintaining books of accounts such as Journal, Cash Book, Special purpose books and ledger

Unit 13: Computerised Accounting
and so on. The accountant is required to prepare summary of transactions and financial statements Notes
manually. The advanced technology involves various machines capable of performing different
accounting functions, for example, a billing machine. This machine is capable of computing
discount, adding net total and posting the requisite data to the relevant accounts.
With substantial increase in the number of transactions, a machine was developed which could
store and process accounting data in no time. Such advancement leads to number of growing
successful organisations. A newer version of machine is evolved with increased speed, storage,
and processing capacity. A computer to which they were connected operated these machines.
As a result, the maintenance of accounting data on a real-time basis became almost essential.
Now maintaining accounting records become more convenient with the computerised accounting.
The computerised accounting uses the concept of databases. For this purpose an accounting
software is used to implement a computerised accounting system. It does away the necessity to
create and maintain journals, ledgers, etc., which are essential part of manual accounting. Some
of the commonly used accounting software’s are Tally, Cash Manager, Best Books, etc.
Accounting software is used to implement a computerised accounting. The computerised

accounting is based on the concept of database. It is basic software which allows access to the
data contained in the data base. It is a system to manage collection of data insuring at the same
time that it remains reliable and confidential.
Following are the components of computerised accounting software:
1. Preparation of accounting documents: Computer helps in preparing accounting documents

like Cash Memo, Bills and invoices, etc., and preparing accounting vouchers.
2. Recording of transactions: Every day business transactions are recorded with the help of
computer software. Logical scheme is implied for codification of account and transaction.
Every account and transaction is assigned a unique code. The grouping of accounts is done
from the first stage. This process simplifies the work of recording the transactions.
3. Preparation of Trial Balance and Financial Statements: After recording of transaction,

the data is transferred into Ledger account automatically by the computer. Trial Balance is
prepared by the computer to check accuracy of the records. With the help of trial balance
the computer can be programmed to prepare Trading, Profit & Loss account and Balance
Sheet. These components can be shown as:
Figure 13.1: Components of Computerised Accounting Software
Recording of transaction
in respective voucher
Sales Purchases
Ledger
Trial Balance
Trading and Profit &

Balance Sheet
Loss Account

Fill in the blanks:

1. The most popular system of recording of accounting transactions is ……………………
which requires maintaining books of accounts such as Journal, Cash Book, etc.
2. …………………… is prepared by the computer to check accuracy of the records.
13.2 Computerised Accounting
A computerised accounting system is an accounting information system that processes the

financial transactions and events as per Generally Accepted Accounting Principles (GAAP) to
produce reports as per user requirements. Every accounting system, manual or computerised,
has two aspects. First, it has to work under a set of well-defined concepts called accounting
principles. Another, that there is a user-defined framework for maintenance of records and
generation of reports.
In a computerised accounting system, the framework of storage and processing of data is called
operating environment that consists of hardware as well as software in which the accounting
system, works. The type of the accounting system used determines the operating environment.
Both hardware and software are interdependent. The type of software determines the structure
of the hardware. Further, the selection of hardware is dependent upon various factors such as the
number of users, level of secrecy and the nature of various activities of functional departments
in an organisation.
Transaction processing system (TPS) is the first stage of computerised accounting system. The
purpose of any TPS is to record, process, validate and store transactions that occur in various
functional areas of a business for subsequent retrieval and usage. TPS involves following steps
in processing a transaction: Data Entry, Data Validation, Processing and Revalidation, Storage,
Information and Reporting.
It is one of the transaction processing systems which is concerned with financial transactions
only. When a system contains only human resources it is called manual system; when it uses
only computer resources, it is called computerised system and when it uses both human and
computer resources, it is called computer-based system.
These steps can be explained with an example making use of Automatic Teller Machine (ATM)
facility by a Bank-Customer.
1. Data Entry: Processing presumes data entry. A bank customer operates an ATM facility to
make a withdrawal. The actions taken by the customer constitute data which is processed
after validation by the computerised personal banking system.
2. Data Validation: It ensures the accuracy and reliability of input data by comparing the
same with some predefined standards or known data.
This validation is made by the ‘Error Detection’ and ‘Error Correction’ procedures. The
control mechanism, wherein actual input data is compared with predetermined norm is
meant to detect errors while error correction procedures make suggestions for entering
correct data input.
The Personal Identification Number (PIN) of the customer is validated with the known
data. If it is incorrect, a suggestion is made to indicate the PIN is invalid. Once the PIN is
validated, the amount of withdrawal being made is also checked to ensure that it does not
exceed a prespecified limit of withdrawal.

3. Processing and Revalidation: The processing of data occurs almost instantaneously in Notes
case of Online Transaction Processing (OLTP) provided a valid data has been fed to the
system. This is called check input validity. Revalidation occurs to ensure that the transaction
in terms of delivery of money by ATM has been duly completed. This is called check
output validity.
4. Storage: Processed actions, as described above, result into financial transaction data i.e.
withdrawal of money by a particular customer, are stored in transaction database of
computerised personal banking system. This makes it absolutely clear that only valid
transactions are stored in the database.
5. Information: The stored data is processed making use of the Query facility to produce
desired information.
6. Reporting: Reports can be prepared on the basis of the required information content
according to the decision usefulness of the report.
Take the case of a club, for example, where the number of transactions and their variety is
relatively small, a Personal Computer with standardized software may be sufficient. However,
for a large business organisation with a number of geographically scattered factories and offices,
more powerful computer systems supported by sophisticated networks are required to handle
the voluminous data and the complex reporting requirements. In order to handle such
requirements, multi-user operating systems such as UNIX, Linux, etc., are used.
Modern computerised accounting systems are based on the concept of database. A database is
implemented using a database management system, which is define by a set of computer
programmes (or software) that manage and organize data effectively and provide access to the
stored data by the application programmes. The accounting database is well-organized with
active interface that uses accounting application programs and reporting system.
Every computerised accounting system has two basic requirements:
 Accounting Framework: It consists a set of principles, coding and grouping structure of
accounting.
 Operating Procedure: It is a well-defined operating procedure blended suitably with the
operating environment of the organisation.
The use of computers in any database oriented application has four basic requirements as
mentioned below;
 Front-end Interface: It is an interactive link or a dialog between the user and database-
oriented software through which the user communicates to the back-end database. For
example, a transaction relating to purchase of goods may be dealt with the accounting
system through a purchase voucher, which appears on the computer’s monitor of data
entry operator and when entered into the system is stored in the database. The same data
may be queried through reporting system say purchase analysis software programme.
 Back-end Database: It is the data storage system that is hidden from the user and responds
to the requirement of the user to the extent the user is authorised to access.
 Data Processing: It is a sequence of actions that are taken to transform the data into
decision useful information.
 Reporting System: It is an integrated set of objects that constitute the report.
The computerised accounting is also one of the database-oriented applications wherein the
transaction data is stored in well-organized database.

Notes The user operates on such database using the required and desired interface and also takes the
desired reports by suitable transformations of stored data into information. Therefore, the
fundamentals of computerised accounting embrace all the basic requirements of any database-
oriented application in computers. Accordingly, the computerised accounting system has the
above four additional requirements.
13.2.1 Need and Requirements of Computerised Accounting System
The need for computerised accounting arises from advantages of speed, accuracy and lower cost
of handling the business transactions.
 Numerous Transactions: The computerised accounting system is capable of handling large
number of transactions with speed and accuracy.
 Instant Reporting: The computerised accounting system is capable of offering quick and
quality reporting because of its speed and accuracy.
 Reduction in paper work: A manual accounting system requires large physical storage
space to keep accounting records/books and vouchers/documents. The requirement of
stationery and books of accounts along with vouchers and documents is directly dependent
on the volume of transactions beyond a certain point. There is a dire need to reduce the
paper work and dispense with large volumes of books of accounts. This can be achieved
by introducing computerised accounting system.
 Flexible reporting: The reporting is flexible in computerised accounting system as compared
to manual accounting system. The reports of a manual accounting system reveal balances
of accounts on periodic basis while computerised accounting system is capable of
generating reports of any balance as when required and for any duration which is within
the accounting period.
 Accounting Queries: There are accounting queries which are based on some external
parameters. For example, a query to identify customers who have not made the payments
within the permissible credit period can be easily answered by using the structured query
language (SQL) support of database technology in the computerised accounting system.
But such an exercise in a manual accounting system is quite difficult and expensive in
terms of manpower used. It will still be worse in case the credit period is changed.
 On-line facility: Computerised accounting system offers online facility to store and process
transaction data so as to retrieve information to generate and view financial reports.
 Scalability: Computerised accounting system is fully equipped with handling the growing
transactions of a fast growing business enterprise. The requirement of additional manpower
in Accounts department is restricted to only the data operators for storing additional
vouchers. There is absolutely no additional cost of processing additional transaction data.
 Accuracy: The information content of reports generated by the computerised accounting
system is accurate and therefore quite reliable for decision-making.
In a manual accounting system the reports and information are likely to be distorted,
inaccurate and therefore cannot be relied upon.
It is so because it is being processed by many people, especially when the number of

transactions to be processed to produce such information and report is quite large.
 Security: Under manual accounting system it is very difficult to secure such information
because it is open to inspection by any eyes dealing with the books of accounts. However,
in computerised accounting system only the authorized users are permitted to have access

to accounting data. Security provided by the computerised accounting system is far superior Notes
compared to any security offered by the manual accounting system.
13.2.2 Basic Requirements of the Computerised Accounting System
The basic requirements of any computerised accounting system are the followings:
 Accounting framework: It is the application environment of the computerised accounting
system.
A healthy accounting framework in terms of accounting principles, coding and grouping

structure is a precondition for any computerised accounting system.
 Operating procedure: A well-conceived and designed operating procedure blended with
suitable operating environment of the enterprise is necessary to work with the computerised
accounting system.
The computerised accounting is one of the database-oriented applications wherein the transaction
data is stored in well-organized database. The user operates on such database using the required
interface and also takes the required reports by suitable transformations of stored data into
information.
Therefore, the fundamentals of computerised accounting include all the basic requirements of
any database-oriented application in computers.
On the basis of the discussions, these are the following differences between manual accounting
and computerised accounting
Table 13.1: Difference between Manual Accounting and Computerised Accounting
Point of Difference Manual Accounting Computerised Accounting

1. Recording Recording of financial transactions is Data content of these transactions is
through books of original entry. stored in well designed data bases.
2. Classification Transactions recorded in the books No such data duplications is made. In
of original entry are further classified order to produce ledger accounts the
by posting them into ledger stored transaction data is processed to
accounts. This results in transaction appear as classified so that same is
data duplicity. presented in the form of report.
3. Summarising Transactions are summarized to The generation of ledger accounts is
produce trial balance by ascertaining not necessary condition for trial
the balances of various accounts. balance.
4. Adjusting Adjusting entries are made to adhere There is nothing like making adjusting
entries to the principle of matching. entries for errors and rectifications.
5. Financial The preparation of financial The preparation of financial
statements statements assumes the availability statements is independent of
of trial balance. producing the trial balance.
Self Assessment
Fill in the blanks:

3. A computerised accounting system is an accounting information system that processes the
financial transactions and events as per …………………… to produce reports as per user
requirements.
4. …………………… is the first stage of computerised accounting system.

Notes 13.3 Salient Features of Computerised Accounting
Following are the silent features of computerised accounting:

 Fast, Powerful, Simple and Integrated: Computerised accounting is designed to automate
and integrate all the business operations, such as sales, finance, purchase, inventory and
manufacturing. With Computerised accounting, accurate, up-to-date business information
is literally at the fingertips. The Computerised accounting combine with enhanced MIS,
Multi-lingual and Data organization capabilities to help the company simplify all the
business processes easily and cost-effectively.
 Complete Visibility: Computerised accountings giving the company sufficient time to
plan, increase the customer base, and enhance customer satisfaction. With Computerised
accounting the company will have greater visibility into the day-to-day business operations
and access to vital information.
 Enhanced User Experience: Computerised accounting allows the company to enter data in
a variety of ways which makes work a pleasure. Adapting to the specific business needs is
possible.
 Accuracy, Speed: Computerised accounting has User-definable templates which provides
fast, accurate data entry of the transactions; thereafter all documents and reports can be
generated automatically, at the press of a button.
 Scalability: Computerised accounting adapts to the current and future needs of the business,
irrespective of its size or style.
 Power: Computerised accounting has the ability to handle huge volumes of transactions
without compromising on speed or efficiency.
 For Improved Business Performance: Computerised accounting is a highly integrated
application that transforms the business processes with its performance enhancing features
which encompass accounting, inventory, reporting and statutory processes. This helps the
company access information faster, and takes quicker decisions. Computerised accounting
also guarantees real-time optimization of operations and enhanced communication.
 Quick Decision Making: Generates real-time, comprehensive MIS reports and ensures
access to complete and critical information, instantly.
 Complete Reliability: Computerised accounting makes sure that the critical financial
information is accurate, controlled and safe from data corruption.
Self Assessment
Fill in the blanks:

5. …………………… allows the company to enter data in a variety of ways which makes
work a pleasure.
6. Computerised accounting makes sure that the critical …………………… is accurate,
controlled and safe from data corruption.
13.4 Sourcing of Accounting Software
Accounting software is an integral part of the computerised accounting system. An important

factor to be considered before acquiring accounting software is the accounting expertise of
people responsible in organisation for accounting work. People, not computers, are responsible
for accounting.

Notes
Notes The need for accounting software arises in two situations: (a) when the computerised
accounting system is implemented to replace the manual system or (b) when the current
computerised system needs to be replaced with a new one in view of changing needs.
Accounting Packages
Every Computerised Accounting System is implemented to perform the accounting activity

(recording and storing of accounting data) and generate reports as per the requirements of the
user. From this perspective, the accounting packages are classified into the following categories:
(a) Ready to use

(b) Customised
(c) Tailored
Each of these categories offers distinctive features. However, the choice of the accounting software
would depend upon the suitability to the organisation especially in terms of accounting needs.
Ready-to-Use
Ready-to-Use accounting software is suited to organisations running small/conventional

business where the frequency or volume of accounting transactions is very low. This is because
the cost of installation is generally low and number of users is limited. Ready-to-use software is
relatively easier to learn and people (accountant) adaptability is very high. This also implies
that level of secrecy is relatively low and the software is prone to data frauds.
The training needs are simple and sometimes the vendor (supplier of software) offers the training
on the software free. However, this software offers little scope of linking to other information
systems.
Customised
Accounting software may be customised to meet the special requirement of the user. Standardised
accounting software available in the market may not suit or fulfil the user requirements. For
example, standardised accounting software may contain the sales voucher and inventory status
as separate options. However, when the user requires that inventory status to be updated
immediately upon entry of sales voucher and report be printed, the software needs to be
customised.
Customised software is suited for large and medium businesses and can be linked to the other
information systems. The cost of installation and maintenance is relatively high because the
high cost is to be paid to the vendor for customisation. The customisation includes modification
and addition to the software contents, provision for the specified number of users and their
authentication, etc. Secrecy of data and software can be better maintained in customised software.
Since the need to train the software users is important, the training costs are therefore high.
Tailored
The accounting software is generally tailored in large business organisations with multi users
and geographically scattered locations. This software requires specialised training to the users.
The tailored software is designed to meet the specific requirements of the users and form an

Notes important part of the organizational MIS. The secrecy and authenticity checks are robust in such
softwares and they offer high flexibility in terms of number of users. To summarise, the following
table represents the comparison between the various categories of accounting software:
Basis Ready to use Customised Tailored

Nature of business Small, conventional Large, medium Large, typical
business business business
Cost of installation and maintenance Low Relatively high High
Expected Level of secrecy Low Relatively high Relatively high
(Software and Data)
Number of users and their interface Limited As per Unlimited
specifications
Linkage to other information system Restricted Yes Yes
Adaptability High Relatively high Specific
Training requirements Low Medium High
Self Assessment
Fill in the blanks:

7. …………………… is an integral part of the computerised accounting system.
8. ………………… accounting software is suited to organisations running small/ conventional
business where the frequency or volume of accounting transactions is very low.
Task Enumerate the basic requirements of any computerised accounting system.
13.5 Summary
 The most popular system of recording of accounting transactions is manual which requires
maintaining books of accounts such as Journal, Cash Book, Special purpose books, and
ledger and so on.
 A computerised accounting system is an accounting information system that processes the
financial transactions and events as per Generally Accepted Accounting Principles (GAAP)
to produce reports as per user requirements.
 Accounting software is an integral part of the computerised accounting system. An
important factor to be considered before acquiring accounting software is the accounting
expertise of people responsible in organisation for accounting work. People, not computers,
are responsible for accounting.
13.6 Keywords
Accounting Software: It is an integral part of the computerised accounting system.
Computerised accounting system: A computerised accounting system is an accounting
information system that processes the financial transactions and events as per Generally Accepted
Accounting Principles (GAAP) to produce reports as per user requirements.
Manual Accounting: It is recording of financial transaction through books of original entry.

Transaction processing system (TPS): Transaction processing system (TPS) is the first stage of Notes
computerised accounting system. The purpose of any TPS is to record, process, validate and store
transactions that occur in various functional areas of a business for subsequent retrieval and usage.

1. Explain the role of Computers in Accounting.
2. Differentiate between Manual accounting and Computerised accounting system.
3. List the various advantages of computerised accounting systems.
4. Give two examples each of the organisations where ‘ready-to-use’, ‘customized’, and
‘tailored’ accounting packages respectively suitable to perform the accounting activity.
5. Distinguish between ‘ready-to-use’ and ‘tailored’ accounting software.
6. Define a computerised accounting system. Distinguish between a manual and computerised
accounting system.
7. Discuss the advantages of computerised accounting system over the manual accounting
system.
8. Describe the various types of accounting software along with their advantages and
limitations.
9. ‘Accounting software is an integral part of the computerised accounting system’. Explain.
10. ‘Computerised Accounting Systems are best form of accounting system’. Do you agree?
Comment.
1. Manual 2. Trial Balance

3. Generally Accepted Accounting 4. Transaction processing system (TPS)
Principles (GAAP)
5. Computerised accounting 6. Financial Information
7. Accounting software 8. Ready-to-Use

“Learning in Tally” Ramesh Bangia (PBP)
Tally Solutions aims to double revenues in 2011-12. “The Economic Times” (The
Times of India). 10 April 2011.
V. K. Goyal, “Financial Accounting”, Excel Books, New Delhi.

Notes Unit 14: Introduction to Tally
CONTENTS
Objectives
Introduction
14.1 About Tally
14.1.1 Gateway to Tally Menu
14.2 VAT Features in Tally ERP 9
14.3 Starting the Tally
14.3.1 Creating VAT Ledger
14.3.2 Creating a Party Ledger
14.4 Reports and Day Book
14.4.2 Trial Balance
14.4.3 Journals, Day Books and Registers
14.5 Balance Sheet
14.6 Summary
14.7 Keywords
Objectives
 Understand About Tally

 Explain VAT Features in Tally ERP 9
 Discuss Starting the Tally
 Discuss Balance Sheet
Introduction
Tally is versatile and massive software package. It is used by various types of trade and industry.
Tally Software business was set up in 1986 by late S.S. Goenka, who was the founder of the
company Peutronics Private Limited., Bangalore. He mentors his son Bharat Goenkar in creating
software that would handle the financial accounts for his business. Bharat Goenkar spends a lot
of months to develop path breaking technology. Tally is user friendly software used to solve all
the complicated accounting structure.
Tally offers extremely high reliability data. Tally uses a flexi-field, flexi-length, self indexed
weighted file structure for an extremely compact and fast database. Tally is robust and will not
be affected even if there is a power failure or if the machine is shut down while the system is still
functioning and hence there will be no data loss. Tally uses signaling quality data integrity

Unit 14: Introduction to Tally
checks at regular levels to ensure complete reliability of data. Tally maintains all Books of Notes
accounts starting from records of vouchers, ledgers etc. Tally handles different types of vouchers
like Payment, receipt, adjustment entries like Journals, Debit notes, Credit notes, Sales, Purchases,
Receipt notes, Delivery notes etc. Tally follows the double entry system of accounting and hence
will eliminate any possible errors.
14.1 About Tally
Tally is complete Accounting system. It handles different types of vouchers, for example,
Payments, Receipts, Journals, Debit Notes, Sales, Purchase, Delivery note and etc. Accounts
Receivables is the amount to be received from Sundry Debtors and Accounts Payable is the
amount payable to Sundry Creditors. Tally provides complete bill wise information of amounts
receivable as well as payable either Party wise or Group wise. Activate ‘Bill Wise’ details by
pressing F11 (Features). Now Create a Party (Ledger A/c) under the group ‘Sundry Debtors’ as
well as one under group ‘Sundry Creditors’, and also activate ‘Maintain balances bill by bill’ for
all the Parties while you are in Ledger creation mode.
Tally allows the user to define account heads as per his requirements. Tally offers 28 predefined
widely used Groups. Of these 28 predefined groups 15 groups are Primary groups and the
remaining 13 are sub groups. Among the 15 predefined groups 9 Groups are Balance Sheet items
and the remaining 6 groups are Profit & Loss items. The user is allowed to alter the arrangement
of any of these 28 Groups. Further the user is allowed to create any number of Groups as per his/
her requirements, which can either be a Primary or a Sub-Group. Tally also allows the user to
have a multiple tree like structure groupings. This flexibility and ease of configuration allows
Tally to be used across industries and geography.
Tally allows users to Drill Down from any report to lower levels of reports till the voucher. For
example, user can view a Balance sheet and then select the required group in the Balance Sheet
and drill down till the vouchers. Any changes then made in the voucher (i.e. if allowed by
current security levels), is reflected real time at all levels.
Tally allows users to select any report for a particular date or for any range of dates. Once you
have selected a Report, press F2 (F2 in case of Day Book) and specify the date range (From and
To). You can also do simultaneous comparison side by side for any two selected periods including
across financial years. All reports from Tally are generated based on the transaction date rather
than the date of actual entry and hence Tally ensures that information is always represented
accurately. This unique approach to bank reconciliation allows review of past date status for
auditing purpose.
Tally provides columnar reports in Sales register, Purchase Register and Journal registers as
well as Ledgers and Cash/Bank Books.
14.1.1 Gateway to Tally Menu
Notes If we select Display > Accounts Books the menu shows the full patch picture.
The menu displays primary choices. Menu options are dependent on activation of options. In
some cases, you may find some options appearing as grayed indicating that option is not active.
The menu is a drill-down, on selecting an option, if a sub-menu exists for the selected option, it
would be displayed. If next level sub-menu exists, it would appear below it – showing the entire
path at top of the menu. By selecting Quit – last option in each menu (by pressing Esc key in
keyboard) you can return to the upper level menu.

Notes
You can select a menu in either of the following mode:

 Press the highlighted character. Example, to select create Company, Press C (the highlighted
character). This is the easy way of selection.
 Move highlight bar on the option with up/Down arrow key in keyboard and press
Enter
 Double click the option (Click twice, fast in left button in mouse)
Tally provides predefined vouchers and also allows defining different types of vouchers as per
trade nature. The integrated system ensures real-time linking of accounts and inventory, resulting
in accurate tracking of information. Blazing speed ensures quick data entry and retrieval of
information. A Tally user can maintain ‘Outstanding Reports’ along with Age Wise analysis.
Credit Limits can be given ‘amount wise’ as well as ‘period wise’. Once Credit limits are set for
a Party, then the user cannot bill the particular Party beyond the specified limit. Only the
authorized user can alter the Credit Limits. This helps to monitor as well as control any potential
slow collection and warns about the potential bad debts.
Did u know? Using the function key F11 and configuration key F12 we set these type of
limitation for accounting and inventory transaction.
14.2 VAT Features in Tally ERP 9
The salient features provided for VAT in Tally.ERP 9 are as follows:

 Quick, easy to setup and use.
 Predefined VAT/Tax Classifications for Purchase and Sale of goods

 Facility to create separate VAT ledgers with VAT/Tax Classifications for input as well as Notes
output VAT
 Facility to generate and print VAT & NHIL invoice and Return
 Complete tracking of each transaction till generation of returns
 Better VAT-returns management

 Facility to generate VAT Computation report with details pertaining to
 The value of transactions recorded using the classifications available for VAT
 VAT Payable or refundable
 Provision to generate - VAT Classification Vouchers report for each of the VAT/Tax
classifications
 Facility to drill-down the various VAT classifications from VAT Computation report till
the last level of voucher entry
 Greater tax compliance
Self Assessment
Fill in the blanks:

1. …………………… uses a flexi-field, flexi-length, self indexed weighted file structure for
an extremely compact and fast database.
2. Tally provides predefined …………………… and also allows defining different types of
vouchers as per trade nature.
14.3 Starting the Tally
Create A Company
The first step to start tally is to Create a company. To create a company uses the command:
Gateway of Tally > Company Info. > Create
 Take the cursor to Create Company.
 Enter.
 Your Screen will change and show the basic data required for the creation of the Company.
 Give the name of the company and press enter.

 Give the Mailing name and address. This is optional and can be omitted by leaving it
blank.
 Give the Income Tax Number. This is optional and can be left blank.
 Give the sale tax number if you so desire.

 Currency symbol may be given in terms of local currency. For India it will be in rupee
terms

Notes  As we come to next option i.e. Maintain, the Tally will ask the following information:
 Maintain Accounts Only: Choose this option if you want to maintain only Account
Books without any inventory transaction (Suitable for Professionals and service
Industry People).
 Maintain Accounts with Inventory: This option permits you to keep Accounts as well
as inventory information.
 Maintain Inventory only: If you do not want to keep any other financial data except the
inventory, choose this option.
Notes If you want to change your option relating to maintenance of accounts with
inventory, you can always change at a later stage. Once process of Company creation is
completed, you will find a button [F11] – Company Features – on the bottom right hand
corner of your screen. Companies Features are modifiable settings pertaining to the current
company you are working with. One of the settings is a question pertaining to maintenance
of accounts with inventory. One can select this option depending upon the needs of financial
data and reports.
 Financial Year: Give here the financial year of the Company. Tally considers 12 months
from the date you give here as the Financial year. The books are closed exactly 12 months
after this date.
 Books beginning From: Though normally the books are maintained from the beginning of
the financial year, but Tally give you the facility of starting your books at a date other than
the beginning of the financial year but close the books according to the financial year
selected by you. For example, your company is established on 30th June 1999. The financial
year stated is from 1.4.1999 to 31.3.2000. The books will begin on 30th June 99 and close on
31st March 2000. It ensures smooth transition to the next year.
 Security Control: For secrecy of your data, Tally provides a password based access control
to different parts of the system based on the authority lists created by the administrator.
Give the name of the administrator (presumably yourself) and your password. Repeat
password by way of verification. The password is not displayed to protect it.
 Tally Audit: This feature allows the auditor or the administrator to track the changes in
the accounting information. If you wish to use this facility select YES.
 Base Currency Information: Tally has the facility of working in different currencies. You
can select the currency of your choice according to your need. Please also mention the
number of decimal places for the base currency (usually it is Two).

Notes
Select A Company
After the process of Company creation is completed, the company gets loaded automatically for
the first time. But you have more than one companies, you have to Select the company in which
you want to work. This is simple. Just take the cursor to the option – SELECT A COMPANY. This
will show you the list of company in your Tally. Select any of these and start working.
Alter A Company
You can modify, at any time, any information given whilst creating the company. At the gateway
of Tally [ALT] +F3 -> Alter. The menu below gives options relating to company information.
This includes Alter.
Shut A Company
Shut a company means to unload it without deleting it. Simply select it again to load and work
on it again. Double click the button [ALT][ F1]: Shut Cmp or press [ ALT ]+ F1 and select the
company you want to shut.
Security Control and Password
Tally allows you to set up authority levels and users who are placed at these levels. The authority
levels decide the rights of the users.

Notes
Notes Tally has two security types already set up. One is Owner and other is Data Entry.
Owner has full access and rights to all parts of Tally but Data Entry has restricted rights.
To reach to the security level first creates company and then use the following command:
Gateway of Tally > [ALT] + F3 > Security Control
Maintain Ledger A/C
Tally maintains details of all ledgers that are defined by the user. You can define your chart of
accounts that is maintain groups, ledger etc. Ledger reports can be used for scrutiny of accounts.
Most accounting systems across the globe follow the concept of separate Personal and Nominal
accounts. Tally follows the concept of single ledger systems, which includes both Personal and
Nominal accounts.
After the creation of necessary masters, you should proceed with the ledger creation. Ledger
account heads are the actual account heads to which we identify the transactions, that is passing
of all vouchers using ledger. Hence, a thorough understanding of account classification is
important for working with ledgers. Tally creates the following two ledgers on its own and the
other ledgers should be created by you. (i) Cash under Cash-in-hand group, (ii) Profit & Loss.
Account under Primary Ledger. When you create a new company where Books beginning from
and Financial Year From date are the same, you should create all the ledgers appearing in the
Balance Sheet as at the previous date with opening balance. Also create ledgers appearing in
Profit & Loss Account but with zero (0) opening balances unless Books Beginning From date is
different than Financial Year Form.

Creation of Ledger Notes
Gate way of Tally <Account info <Ledger <Create <Press F12.

Notes
To Create Account Ledgers Individually select Create form single Ledger under Accounts Info
Ledgers Create and also press F11 to configure Maintain Bill wise details to Yes and for
Non-trading Accounts also to set Yes.

The result will be as follows: Notes
1. Name: Here, enter the name of the ledger. Tally will not accept same names. We also create
the alias name for the ledger, to conveniently retrieve later.
2. Under: Under this option, you should select the group from the list of groups that will be
displayed along with the ledger creation screen.
3. Inventory values are affected: This option should be given ‘Yes’ for those ledgers which
will affect the inventory position of the company. For example, Purchase, Purchase Returns,
Sales, Sales Returns, etc.
4. Maintain balances Bill-by-Bill: To get this option give ‘Yes’ to Maintain Bill-wise details
in Company Features-F11. This option is useful only for Sundry Debtors and Creditors. It
can also be used where some tracking is needed like Project-wise Expenses or income,
installments due, installment-wise outstanding details. Enter due date of the bill or credit
days under the option default credit period.

Notes 5. Opening Balance: Enter the opening balance of the respective your bank account as on the
date of Books beginning from option in Company Creation Screen.
6. Mailing and Related Details: Tally by default carries the ledger name here. You can also
enter any other mailing name as you wish. This name is printed in all external documents
i.e. other than internal reports, books of accounts, etc. The Address Details, Income Tax
Number, Sales Tax Number, the person to whom you should contact should be given in the
respective menus. This option is available only for parties’ accounts (Capital, Sundry Debtors
and Creditors). Further, you can also give the Telephone number, Details regarding Fax and
the E- mail address. We can also add Notes for ledger account. This option is available for all
ledgers. This is useful to add remarks or notes about the ledger like the credit worthiness of
the party. In this context we create in the single ledger option to bring up the Single Ledger
screen. We setup “Conveyance” ledger under the “Indirect Expenses” group.
7. Set used in VAT Returns to Yes: Select the required VAT/Tax Class, for example, Purchases
@ 10%
 Press Enter to return to the purchase ledger creation screen

 Accept the Purchase Ledger Creation screen.
 It is recommended that separate Purchase Ledgers be created for each of the purchase
related VAT/Tax classifications.

Creating a Sales Ledger Notes
To create a Sales ledger
Go to Gateway of Tally > Accounts Info > Ledger > Create

1. Enter the Name of the sales ledger
2. In the Under field, select the Sales Accounts from the List of Groups
3. Set Inventory values are affected to Yes
4. Set used in VAT Returns to Yes
5. Select the required VAT/Tax Class, for example, Sales @ 10%

Notes
6. Accept the sales ledger creation screen.

It is recommended that separate Sales Ledgers be created for each of the sales related VAT/Tax
classifications.
Task Create sales return ledger.
14.3.1 Creating VAT Ledger
Creating an Input VAT Ledger
To create an input VAT ledger,

Go to Gateway of Tally > Accounts Info. > Ledgers > Create
 Enter the Name of the VAT Ledger as Input VAT @ 10%
 In the Under field, select Duties & Taxes from List of Groups
 Select the Type of Duty/Tax as VAT

 In the VAT/TAX Class field, select Input VAT @ 10%

Notes
 By default Inventory Values are affected is set to No

 Set Percentage of Calculation will be set to 10% as per the VAT/Tax Class selected
 The Method of Calculation will be automatically set to On VAT Rate
 Enter the opening balance, if any
 Accept the Input VAT ledger.
Creating an Output VAT Ledger
To create an output VAT ledger,

Go to Gateway of Tally > Accounts Info. > Ledgers > Create
 Enter the Name of the VAT Ledger as Output VAT @ 10%
 In the Under field, select Duties & Taxes from List of Groups
 Select the Type of Duty/Tax as VAT
 In the VAT/TAX Class field, select Output VAT @ 10%

Notes
 By default Inventory Values are affected is set to No

 Set Percentage of Calculation will be set to 10% as per the VAT/Tax Class selected
 The Method of Calculation will be automatically set to On VAT Rate
 Enter the opening balance, if any
 Accept the Output VAT ledger.
14.3.2 Creating a Party Ledger
To create a ledger for the Supplier,
Go to Gateway of Tally > Accounts Info > Ledgers > Create

 Enter the name of the ledger in the Name field
 In the Under field, select Sundry Creditors from List of Groups

 Set Maintain Balances Bill by Bill to Yes/No

 By default Inventory Values are affected is set to No Notes
 Enter the Mailing Details
 Enter the 15 digit VAT Regn. No.
 Press Y or Enter to accept and save.
Self Assessment
Fill in the blanks:

3. The first step to start tally is to …………………… a company.
4. After the process of …………………… is completed, the company gets loaded automatically
for the first time.
14.4 Reports and Day Book
Books of account record the transaction details as entered. Although items are posted too many
different ledgers, Tally brings all the transactions of a particular category together into a book
of account for viewing and printing. The Gateway of Tally menu provides access to all the
financial reports listed in the Display Menu.
The Profit & Loss Account shows the operational results over a given period. It lists out the
Incomes and Expenditures based on the Primary Groups of Tally and the Profit & Loss Account in
Tally is updated instantly with every transaction voucher that is entered and saved. The profit &
loss account in Tally.ERP 9 displays the information based on the default primary groups. It is
updated instantly with every transaction/voucher that is entered and saved. No special processing
is required to produce a profit & loss account in Tally.ERP 9.

Notes To view the Profit & Loss Account

Go to Gateway of Tally > Profit & Loss Account
The Profit & Loss Account is displayed according to the configuration set up for it in F12:
Configure. The Profit & Loss Account is displayed as shown:
The Profit & Loss account is generated and updated immediately from the date of opening of
books till the date of last entry.
Press F2: Period to change the period as required.
Horizontal Form of Profit & Loss Account
The Profit & Loss A/c, by default is in horizontal form. However, you may configure the same
to view in Vertical form by pressing it in F12: Configure. You can view additional information
or toggle to another report using the options available in the Button Bar.
Did u know? Some of the Button Bar options are:
 Select F1: Detailed/Condensed to display more information or condense.

 Change the date of the Profit & Loss Account using F2: Period.
 Add new columns too
 Display the Profit & Loss Account for a different period to compare with the
current one
 Display the Profit & Loss Account in a different currency
 Display a column with Budget figures and analyse variances

 See the effect of different Stock Valuations on the Profit/Loss account.
 Select and compare Profit & Loss of different companies.

14.4.2 Trial Balance Notes
Trial Balance is a report of all account balances for the company sorted by groups, i.e., it is
displayed in a grouped form, comprising main groups and their closing balances. You can see
that the debit and credit balances match.
In Tally, the matching of the Trial Balance is a foregone conclusion since all voucher entries are
in Debit-Credit format and must balance at the entry point.
To view the Trial Balance

Go to Gateway of Tally > Display>Trial Balance
Notes As per accounting principles, the Trial Balance does not list Closing Stock.
 Select F1: Detailed to break down the grouped information or simply drill down a Group
for further detail.
The screen appears as shown

Notes  Select F5: Led-wise to list all ledgers and their closing balances.
 Select New Column to bring up the closing balances for another date.
14.4.3 Journals, Day Books and Registers
Journal, Sales Register, Purchase Register, Debit Note Register, Credit Note Register, Payment
Register, Receipts Register, etc., are the different kinds of Registers.
To view the Day Book
Go to Gateway of Tally > Display>Daybook

The Day Book lists all transactions made over a particular day and by default displays the last Notes
voucher entry date of a regular voucher. It could also be set up to list all the transactions made
over a period.
Press F2: Period on the button bar or press the keys Alt+F2.
All the transactions include all financial vouchers, reversing and memorandum journals as well
as inventory vouchers.
Consider an example:
Day Book for Current Date
Day Book for a Period

Notes You can also filter the list so as to display the transactions of a particular voucher type using F4:
Chg Vch button from the button bar.
The screen appears as shown:
There are three ways to view various types of registers:

1. From the Display menu
2. By changing the type of voucher from within a register

3. From the Statistics page
Consider the Sales Register which includes most of the options.
Sales Register (Sales Day Book)
Go to Gateway of Tally > Display >Account books > Sales Register
The following screen displays.

By default, all registers display Monthly Summary with transactions and closing balances. For Notes
Balance Sheet Accounts, opening balance is displayed at the top of the screen.
Select a month and press Enter to see the Sales Voucher Register.
A list of all sales vouchers pertaining to the month you selected displays. You can use the
options in the button bar to change the display according to your preferences. You can change
the period of the report as well as the depth of information.
Use F12: Configure to see the report with some or all of the following information, namely
Narrations, Bill-wise details, Cost Centre details and Inventory details.
Click on F1: Detailed to view the reports in detailed format.
14.5 Balance Sheet
To create a balance sheet use:
Gateway of Tally > Balance Sheet > Enter

Balance Sheet generates a report giving the details of Assets and Liabilities in vertical/horizontal
form. To view Balance Sheet use the above command and your screen will show the Balance
Sheet in the desired format. The right hand side of your screen will show the keys to be used to
change the reporting format e.g.

Notes
Notes
F1 : To see the detailed Balance Sheet i.e. it will show the breakup of the grouped
figures.
F2 : To change the date.
F10 : To see the various Accounting reports e.g. Cash Flow, Funds Flow, Profit &
Loss A/c, Trial Balance, etc. As you press the button F10, a pop-up screen will
display the Accounting reports you can see. Just select from it to see the desired
report.
F11 : Features
F12 : Configure. If the Balance Sheet shown is in horizontal form and you want to
see it in vertical form, select F12. A pop up screen will appear and give you the
options you can select to alter the display screen.
Alt F12 : Range

Ctrl F12 : Value

5. …………………… generates a report giving the details of Assets and Liabilities in vertical/
horizontal form.
6. To view Balance Sheet use the …………………… command and your screen will show the
Balance Sheet in the desired format.
14.6 Summary
 Tally is complete Accounting system. It handles different types of vouchers, for example,
Payments, Receipts, Journals, Debit Notes, Sales, Purchase, Delivery note, etc.
 Tally allows the user to define account heads as per his requirements. Tally offers 28
predefined widely used Groups.
 Tally allows users to select any report for a particular date or for any range of dates. Once
you have selected a Report, press F2 (F2 in case of Day Book) and specify the date range
(From and to).
 To create a company uses the command: Gateway of Tally > Company Info. > Create
 To create a Sales ledger: Go to Gateway of Tally > Accounts Info > Ledger > Create
 To create an input VAT ledger: Go to Gateway of Tally > Accounts Info. > Ledgers > Create
 To create a ledger for the Supplier: Go to Gateway of Tally > Accounts Info > Ledgers >
Create
 To create a balance sheet use: Gateway of Tally > Balance Sheet > Enter
14.7 Keywords
Balance Sheet: Balance Sheet generates a report giving the details of Assets and Liabilities in
vertical/horizontal form.
Shut A Company: Shut a company means to unload it without deleting it. Simply select it again
to load and work on it again.
Tally: Tally is versatile and massive software package. It is used by various types of trade and
industry.
VAT: It is multi point sales tax with get off for tax paid on purchase.

1. “Tally 9 is also concurrently multilingual communication”. Comment.
2. Briefly explain the meaning of tally? Write down the salient feature of VAT in Tally ERP 9.
3. Briefly discuss the Starting the Tally.
4. What is Balance Sheet? Write down the Gateway of Tally.
1. Tally 2. Vouchers
3. Create 4. Company creation
5. Balance Sheet 6. Gateway of Tally > Balance Sheet > Enter


“Learning in Tally” Ramesh Bangia (PBP)

Tally Solutions aims to double revenues in 2011-12. “The Economic Times” (The
Times of India). 10 April 2011.

Jalandhar-Delhi G.T. Road (NH-1)
Phagwara, Punjab (India)-144411
For Enquiry: +91-1824-300360
Fax.: +91-1824-506111
Email: [email protected]

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Financial Accounting

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Unit 1: Introduction to Accounting 1

Unit 1: Introduction to Accounting Notes

1.1 Meaning and Definition of Accounting

1.1.2 Objectives of Accounting

1.1.4 Scope of Accounting

1.1.6 Importance and Advantages of Accounting

1.4 Methods of Accounting

1.5.1 Personal Accounts

1.5.2 Real Accounts

1.7 Accounting Cycle

1.10 Review Questions

1.11 Further Readings

LOVELY PROFESSIONAL UNIVERSITY 1

After studying this unit, you will be able to:

 Understand needs and objectives of accounting

 Know users and difference between book-keeping and accounting

1.1 Meaning and Definition of Accounting

2 LOVELY PROFESSIONAL UNIVERSITY

1.1.1 Characteristics of Accounting

1.1.2 Objectives of Accounting

LOVELY PROFESSIONAL UNIVERSITY 3

1.1.3 Need of Financial Accounting

Did u know? What are the purposes of preparing financial statements?

4 LOVELY PROFESSIONAL UNIVERSITY

5. Obligations to customers, investors, employees, to renovate/restructure and so on.

1.1.4 Scope of Accounting

The Scope of accounting is divided into following two parts:

3. Management Accounting: The accounting which provides the necessary information to

7. Responsibility Accounting: Responsibility accounting is a special technique of management

LOVELY PROFESSIONAL UNIVERSITY 5

Accounting as Science or an Art

1.1.5 Users of Accounting Information

(d) Taxation authorities: Financial statements provide information relating to operational

6 LOVELY PROFESSIONAL UNIVERSITY

1.1.6 Importance and Advantages of Accounting

1.1.7 Limitation of Accounting

LOVELY PROFESSIONAL UNIVERSITY 7

3. Conflict between accounting principles: In accounting, one accounting principle conflicts

Fill in the blanks:

1.2 Process of Accounting

1. What to record: Financial Transaction is only to be recorded

3. How to record: Methodology of recording—It contains two different systems of accounting

8 LOVELY PROFESSIONAL UNIVERSITY

Figure 1.1: Process of Accounting

Trading and P&L A/c Balance Sheet

1.2.1 Cash System

1.2.2 Accrual System

LOVELY PROFESSIONAL UNIVERSITY 9

Notes 1.2.3 Values

3. Realizable Value: Value at which the assets are realized.

Did u know? What are the purposes of preparing financial statements?

1. Accounting provides necessary information for decisions to be taken initially and it

Fill in the blanks:

“Book-keeping is the art of recording business transactions in a systematic manner”.

10 LOVELY PROFESSIONAL UNIVERSITY

1.3.2 Importance of Book-keeping

1. Book-keeping provides a permanent record of each transaction. It provides combined

1.3.3 Difference between Book-keeping and Accounting