CL 1.2 Financial Accounting

CL 1.
2
FINANCIAL
ACCOUNTING
CMA Professional Program

2023-2027
CMA SRI LANKA OFFICIAL STUDY TEXT
CMA Professional Programme 2023 – 2027
Certificate Level
CL 1.2: Financial Accounting
Institute of Certified Management Accountants of Sri Lanka (CMA)

ISBN 978-955-0926-45-9
The Governing Council of CMA reserves the right to make any amendments itdeems necessary during the period
covered herein.
©Copyright reserved.
No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by means,
electronic, mechanical, photocopying, recording or otherwise without the prior written permission of the Institute of
Certified Management Accountants of Sri Lanka.
1st edition – August 2023
Published by:
Institute of Certified Management Accountants of Sri Lanka
29/24, Visakha Private Road,
Colombo 04, Sri Lanka.
A Word to the Students
This text book is designed as a guide to lead Certificate Level students in the study of CL 1.2
Financial Accounting (FA) examination paper. It is carefully prepared to cover the Syllabus
content, giving comprehensive explanations in each section including exposure in answering
questions.
Note that examination success will depend not only on your knowledge, but also on your
ability to present what you have learnt, in response to the given questions, within the
specified time period.
You may refer to the ‘Examination Guide’ published for each level and be familiar with the
CMA Examination Policies and Guidelines for Computer Base Examinations; Examination
paper structure, Hierarchy of Taxonomy (Actions verbs) and Pilot papers.
Make every effort to understand the subject and develop the skills to apply your knowledge.
Knowledge is the theoretical and practical understanding of a subject.
Application is the ability to use knowledge in a given relevant situation. This is the ability to
select the appropriate principles and/or techniques and apply them to relevant information
from a range of data.
We wish you success at the examination.

TABLE OF CONTENT
CHAPTER 1: Introduction to Financial Accounting 13
CHAPTER 2: Accounting Equation and Double Entry System 29
CHAPTER 3: Accounting Process 53
CHAPTER 4: Rectification of Accounting Errors 77
CHAPTER 5: Preparation of Bank Reconciliation Statements 89
CHAPTER 6: Control Accounts and Subsidiary Ledgers 101
CHAPTER 7: Conceptual Framework for Financial Accounting 115
CHAPTER 8: Preparation of Financial Statements 127
CHAPTER 9: Financial Statements for Partnerships 155
CHAPTER 10: Financial Statements of Not-for-profit organizations 171
CHAPTER 11: Preparation of Financial Statements for Companies – I 181
CHAPTER 12: Preparation of Financial Statements for Companies – II 199
CHAPTER 13: Accounting Policies, Changes in Accounting Estimates and Errors 235
CHAPTER 14: Events After the Reporting Period 249

Syllabus Structure
Main Syllabus Area Weight % Chapter/s
A. Introduction to financial accounting 5% 1
B. Accounting equation and double entry system 10% 2
C. Accounting process 10% 3
D. Adjustments to accounting records 15% 4, 5, 6
E. Conceptual framework for financial accounting 10% 7
F. Financial statements of single entities, partnerships 20% 8, 9, 10

and not for profit organizations
G. Preparation of financial statements for companies 30% 11, 12, 13, 14

Chapter Summary
Main Syllabus Area Focus Content Chapter

A. Introduction to Explain the information needs Stakeholders of a business and their information needs; types of 1
Financial Accounting of stakeholders of the business business organizations; accounting as an information system.
and the role of financial
accounting in this respect.
Distinguish between financial Branches of accounting (financial accounting and management 1
accounting and management accounting).
accounting.
B. Accounting Equation Define the terms in the Entity concept; assets; liabilities; and equity. 2
and Double Entry System accounting equation and
double entry system.
Illustrate the impact of Development of the accounting equation; impact of various 2

business transactions using the business transactions on the assets, liability, and equity in the
accounting equation. accounting equation.
Apply the double entry Duality concept and the double entry system; recording business 2
recoding system. transactions in ledger accounts based on double entry principles.
C. Accounting Process Describe the accounting Accounting input, process, and output (source documents, prime 3
process. entry books, general ledger, trial balance, financial statements.)
Record the transactions in the Cash receipts and payments (cash receipts journal and cash 3
prime entry books. payments journal and petty cash journal); credit sales and credit
purchases (sales journal, purchases day journal); sales return
and purchases returns (sales return day journal and purchase
return day journal); recording transactions in the general
journal.
Prepare the general ledger Posting entries to the general ledger; balancing and closing the 3
accounts and the trial balance. ledger accounts; drawing the trial balance.
D. Adjustments to Identify the types, nature and Different types of errors (errors where the trial balance still 4
Accounting Records impact of error. balances and errors where the trial balance does not balance);
suspense account.
Apply means of rectifying Correction of errors and the impact of the correction of errors on 4
errors and prepare a trial profit.
balance.
Prepare a bank reconciliation Purposes of the bank reconciliation statement; reasons for the 5
statement. difference between the bank statement and the cash book
(unrecorded items, timing differences and errors); adjusting the
cash book balance.
Reconciliation of the Purpose and nature of subsidiary ledgers (creditors’ ledger, 6

subsidiary ledgers with control debtors’ ledger); control accounts for debtors and creditors in
accounts. the general ledger; recording transactions (creditors’ control
account and creditors’ ledger and debtors control account and
debtors’ ledger); reconciliation of subsidiary ledger with control
account.
E. Conceptual Framework Describe the elements of the Purpose of a conceptual framework; conceptual framework for 7
for Financial Accounting conceptual framework for financial reporting (objectives, underlying assumptions,
financial reporting. qualitative characteristics- fundamental and enhancing, the
definition of elements, recognition, and measurement of
elements).
Discuss its relevance to Advantages and limitation of the conceptual framework. 7
financial accounting.
F. Financial Statements of Explain the accounting Accounting concepts and principles applied in preparation of 8
Single Entities, concepts and principles. financial statements.
Partnerships and Not-for-
profit Organizations
Explain the role of financial Income statement and statement of financial position. 8
statements.
Prepare financial statements. Preparation of financial statements using the trial balance. 8
Illustrate the adjusting entries Adjusting entries for closing stock; depreciation; bad debts; 8
required in the preparation of accrued expenses and income; prepaid expenses and income;
financial statements. stock losses.
Prepare a manufacturing Purpose of the manufacturing account; structure, components 8

account. and items (prime cost, production overhead, and total
production cost).
Prepare financial statements of Statement of profit and loss and statement of financial position. 8
a sole proprietorship.
Explain the nature of a A partnership; partnership agreement; and profit sharing 9

partnerships. between partners.
Explain the special accounts Partners’ capital account and current account. 9
relating to partnership.
Prepare financial statements Income statement and statement of financial position. 9

for partnerships.
Record transactions in special Receipts and payments account; subscription account (annual 9
accounts pertaining to not-for- membership and life membership); accumulated fund account.
profit organizations.
Prepare financial statements of Income and expenditure account/Income statement and 10

non-for-profit organizations statement of financial position.
with adjustments.
G. Preparation of Financial Explain the characteristics of Difference between limited liability companies and sole 11
Statements for Companies limited liability companies. proprietorship (limited liability, equity structure, legal status,
compliance requirement).
Explain the sources of funds Sources of capital (share capital: ordinary shares and preference 11
available to companies. shares); reserves, debt capital (debentures and other corporate
bonds); share issues (public issue, rights issue, capitalization of
reserves).
Describe the structure, Presentation of the financial statements (LKAS 1, LKAS 7). 12
components and elements of
financial statements.
Prepare financial statements of Statement of profit or loss and other comprehensive income; 12
a company for publication. statement of financial position; statement
Illustrate the accounting Accounting policies; changes in accounting estimates and errors 13
treatment for accounting (LKAS 08).
policies, changes in accounting
estimates and errors.
Apply the accounting Events after the reporting period (LKAS 10). 14
treatment for events after the
reporting period.
CHAPTER 1 Page 13
Introduction to Financial
Accounting
Learning Outcomes
After successful completion of this chapter, you should be able to:
• Explain the nature and role of accounting.

• Discuss how accounting satisfies the information needs of a wide range of
stakeholders.
• Distinguish between financial accounting and management accounting.
1.1 Introduction
Accounting has evolved into a crucial component of every business entity. Accounting
acts primarily as an information system because it converts the data gathered from
transactions of the business entity into information. That information is used by
different stakeholders to facilitate their economic decisions. Accounting is commonly
known as the "language of business" since it effectively communicates essential
information about business entities to their stakeholders.
1.2 What is a Business Entity?
A business entity can be defined as any entity which engages in the supply of goods and
provides services to satisfy human needs and wants. Most of the business entities
operate with the objective of maximizing profit (e.g., groceries, bookshops, pharmacies,
factories, banks, private hospitals, international schools). However, there are entities
operating with the objective of maximizing social welfare rather than maximizing profit
(e.g., sports clubs, welfare societies, government schools).
Business entities interact with various individuals, groups of individuals, private and
public institutions such as managers, employees, suppliers, competitors, banks, and
government to perform economic activities and they are called ‘stakeholders.’
CHAPTER 1 Page 14
1.3 Stakeholders of a Business Entity

A stakeholder is any group or individual who can affect or is affected by the business
entity. In other words, stakeholders can affect the business entity through their
decisions, and they are affected by the decisions of the business entity. Different
stakeholders may have different priorities in their information needs. Managing
stakeholder relationships is considered as a key to the success of the business entity.
Selected stakeholders and their interests shall be discussed as follows.
(a) Owners/Existing Investors
Owners are individuals or entities that have invested their money and resources into a
business entity, assuming the associated risks. The number of owners varies across different
types of entities, such as sole proprietorships, partnerships, and companies. In a sole
proprietorship, there is a single owner who possesses full ownership of the business entity.
Conversely, partnerships may have multiple owners, referred to as partners. In a limited
liability company, owners are known as shareholders. However, not-for-profit
organizations, such as charitable institutions and sports clubs, have members instead of
owners.
Why are they interested?
• To ensure the security of their investments.

• To evaluate the profitability of the business and determine its sufficiency compared to
the investment (i.e., Return on investment).
• To assess how well the business is performing in terms of their operations.
• To make economic decisions on future investment such as whether to continue, increase,
decrease, retain, or withdraw the investment.
• To verify the company's compliance and avoid any legal or regulatory penalties.
(b) Managers
Managers are individuals responsible for overseeing and managing the operations of a
business entity. In present-day business entities, managers are typically categorized into
three levels: top-level managers, middle-level managers, and lower-level managers. The
top level comprises the chairman and board of directors. Middle-level managers often
hold positions as general managers overseeing various segments of the business.
Lower-level managers are responsible for specific functions within the business, such as
production, marketing, human resources, and finance.

• To make informed decisions about resource allocation and budgeting.
• To assess the financial performance and profitability of the business.
CHAPTER 1 Page 15
• To monitor and control costs and expenses.

• To comply with regulatory requirements and ensure financial transparency.
• To analyse financial data and trends for strategic planning and forecasting.
(c) Employees
Certain managers within a business entity may also serve as employees of that entity.
Alongside these managerial employees, there are other individuals who work within the
organization under the guidance and supervision of these managers. These employees,
like the managers themselves, possess an interest in the accounting information of the
business entity and can be regarded as stakeholders.

• To understand the company's financial performance and stability.
• To assess the impact of financial decisions on job security and career growth.
• To have visibility into the company's financial goals and objectives.
• To negotiate financial and non-financial rewards based on the financial performance of
the company.
• To ensure that the organization complies with employment and labour laws and
regulations and best practice standards.
(d) Suppliers (Creditors)
Suppliers are individuals or entities that provide goods and services to a business. In a
trading business, suppliers are those who supply goods for resale. In a manufacturing
business, suppliers are the parties who provide materials for the production process.
Additionally, suppliers can also include those who offer various services such as
electricity, telecommunications, maintenance, cleaning, and more to any business entity.
Suppliers from whom a business acquires goods or services on a credit basis are
commonly referred to as creditors.

• To understand the financial health and stability of a business.
• To assess the creditworthiness and risk of lending money to the business.
• To evaluate the ability of the business to meet its financial obligations.
• To make informed decisions about extending credit terms or granting loans.
• To monitor the business's performance and track any changes or trends.
(e) Customers (Debtors)
Customers are individuals or entities to whom a business sells goods or provides

services. In contemporary marketing management, customers are recognized as the
primary stakeholders of a business entity due to their crucial role in its success.
CHAPTER 1 Page 16
Satisfying customers is vital for the prosperity of any business. When a business sells
goods or offers services to customers on credit, they are referred to as debtors.
Consequently, a customer becomes a debtor when the business entity extends credit for
goods sold or services provided. Moreover, customers who receive services from a
business entity are commonly referred to as clients.

• To ensure the continuity of the business to persistently satisfy their needs through a
steady supply of goods and services in the future.
• To evaluate the ability to provide quality products/services at a reasonable price.
• To assess organizations’ ability to honour the warranty offered by the business.
• To assess the company's financial health and determine the level of risk associated with
entering into business contracts or agreements.
• To make informed decisions regarding long-term partnerships or collaborations with the
company.
(f) Government
Government represents the governing system of the country including the executive
presidency, the cabinet, parliament, local authorities, provincial councils, etc. Further,
government institutions that act on behalf of the government such as the Central Bank
of Sri Lanka, the Department of Inland Revenue could also be treated within the term of
the government.

• To ensure the collection of various imposts such as taxes, duties, etc. properly and
promptly to raise public funds and provide public goods.
• To ensure that the relevant reports are submitted to the authorities by business entities.
• To monitor compliance with public procurement regulations.
• To detect and prevent fraud, corruption, and financial mismanagement.
• To evaluate the effectiveness of government programs and initiatives.
(g) Potential Investors
Potential Investors are parties who have surplus funds and who are willing to invest
those funds in a business entity. Once an investor invests his funds in a business entity
by undertaking the business risk, such an investor becomes an owner of the business entity.

• To assess the financial health and stability of a business before making an investment.
• To evaluate the profitability and growth potential of a business.
• To analyse the liquidity and solvency of a business to determine its ability to meet
financial obligations.
CHAPTER 1 Page 17
• To make informed investment decisions and allocate capital effectively.

• To calculate the return on investment (ROI) and assess the risk associated.
(h) Lenders
Lenders are the parties who provide funds to the business with the objective of earning
interest income as the return for their investment. They do not become owners of the
business because they do not undertake the business risk as their return is not varying
based on the earnings of the business.

• To assess the organization’s ability to settle loans as well as interest thereon.
• To make decisions related to the credit facilities such as loan extension, loan termination,
prospective financing agreements, etc.
• To evaluate the company's assets and collateral available for securing the loan.
• To assess the company's compliance with financial covenants and loan agreements.
• To monitor the company's financial position and identify any potential financial distress.
(i) Competitors
Competitors are other business entities that operate in the same or similar industry and
offer similar products or services. For example, business entities that operate within the
retail industry are competitors to each other. Similarly, insurance companies that
operate within a country are competitors to each other.

• To assess the financial performance and position of the business relative to their own.
• To benchmark their own financial metrics and strategies against the competition.
• To identify potential strengths and weaknesses of their competitors.
• To analyse trends and patterns in the financial data of competitors.
• To evaluate the profitability and sustainability of the competitor's business model.
(j) Academics
Academics are individuals who work as educators or researchers in universities or other

institutes of higher education. They hold a strong interest in business entities as they
utilize information related to these entities for teaching and research endeavours.
• To conduct research and generate knowledge in the field of accounting.
• To analyse and understand the financial performance and behaviour of businesses.
• To develop theories and frameworks related to accounting practices and standards.
• To assess the effectiveness of accounting regulations and policies.
• To contribute to the advancement of accounting education and curriculum.
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(k) Community
A community refers to a cohesive social unit characterised by shared norms, religion,
values, customs, or identity. Communities can be rooted in a specific geographical area,
such as a country, village, town, or neighbourhood, or they can exist in virtual spaces
facilitated by communication platforms. In general, individuals belonging to these
communities display an interest in businesses and their activities.

• To assess the company's contribution to the local economy and job creation.
• To evaluate the company's adherence to ethical and socially responsible business
practices.
• To understand the company's tax contributions and compliance with financial
regulations.
• To assess the company's impact on the environment and its efforts towards
sustainability.
• To evaluate the company's commitment to corporate social responsibility initiatives and
community development.
It should be emphasised that the above list is not a complete list, but it highlights
some of the key stakeholders commonly found in businesses. There may be many
more different types of stakeholders in businesses.
1.4 Types of Information
Information is the processed data that can be used in decision-making. All stakeholders take
decisions relating to the business using the information about the business entity.
Information can be classified into the following categories (Figure 1.1).
Figure 1.1: Types of Information
Financial
Quantitative
Non-financial
Information
Qualitative
CHAPTER 1 Page 19
Quantitative Information
Information that is measured and presented using a particular measurement bases such
as numbers of units, meters, kilometres, rupees, litters, etc. is considered as quantitative
information.
Examples
• The average monthly revenue of ABC Company in 2023 was Rs. 1.5 million.
• The sales growth of XYZ Corporation was 15% from 2021 to 2022.
• The average customer satisfaction rating for a particular product was 4.2 out of 5.
• The stock price of PQR Company increased by 10% in the last quarter.
• The profit margin of Alfa Corporation in 2023 was 12%.
• The average time taken to process an order is 2.5 days.
• The market share of Beta Company in the industry is 20%.
• The total number of units sold by LMN Corporation in Q1 2023 was 10,000.
• The inventory turnover ratio for Gamma Retail in 2022 was 6 times.
• The total debt-to-equity ratio for DEF Company as of December 31, 2022, was 0.8.
Quantitative information can be subdivided into the following two categories as financial
information and non-financial information explained below.
Financial Information
The information that is measured and presented in terms of money is called financial
information. It may be denominated in different currencies such as Rupees, Dollars,
Euros, etc. based on the currency used in different countries. In Sri Lankan context
financial information is generally presented in Sri Lankan Rupees (LKR).
Examples
• Total cost of production of Alfa PLC in the year 2023 was Rs.12 million.
• The value of the machinery of Beta PLC as at 31.03.2023 is Rs. 50 million.
• ABC PLC reported export revenue of US$ 1 million in 2023.
• The profit for the year ending 31.03.2022 of LMN PLC was Rs. 10 million.
• Dividends paid by Gamma Corporation to its shareholders in 2023 amounted to Rs.
500,000.
Non-Financial Information
The information that is measured and presented using a particular measurement bases
such as units, meters, kilometres except in terms of money is considered non-financial
information.
CHAPTER 1 Page 20
Examples
• The total production of Alfa PLC in the year 2023 was 500,000 units.
• The total number of employees in PQR Limited as at 31.03.2023 was 5,000.
• The average delivery time for orders fulfilled by Beta Logistics in 2022 was 2 days.
• The percentage of market share held by XYZ Industries in the industry was 8%.
• The customer retention rate for Gamma Services in 2022 was 85%.
Qualitative Information
Qualitative information refers to data that represents factors that are not measured on a
quantitative basis. It plays a significant role in the decision-making process for stakeholders
of a business. In current practices, qualitative information is often prominently featured in a
business's annual report, particularly within sections related to corporate governance and
corporate social responsibility reporting (CSR).
1.5 Types of Business Entities
Based on the ownership structure, business entities fall into two categories (Figure 1.2):
Government andnon-government organisations that perform activities with the objective of
making a profit is known as profit-oriented whereas other institutions that perform
without theintention of making a profit are known as not for profit making organisations.
Figure 1.2: Types of Business Entities
Business
Non-
Government
government
Profit Not for Profit Not for

Oriented Profit Oriented Profit
Sole- Partnerships
Proprietorships
Limited
Companies
Sole Proprietorships (Sole Traders)

This is the simplest form of business. One owner operates a business on his own with
ownership of assets and the control of the business in his or her own hands. Most sole
proprietorships tend to be small businesses (such as grocery stores, garages, repair
shops, andrestaurants).
CHAPTER 1 Page 21
However, sole proprietorships could be expanded and operated at a large scale aswell.
The business does not have a separate legal status apart from the owner. Therefore, the
owner is personally liable for the debts of the business, and contracts are entered into with
any other party.
Partnerships
A partnership is a business entity owned by two or more persons and carrying on a
business under an agreement with the profit maximisation objective. A sole
proprietorship may be converted to a partnership when the need is felt for different
skills or to introduce more capital. Owners of partnerships are termed as partners and
each partner contributes anamount of capital and exercises control over the partnership.
The partnership agreement is used to distribute the profit among the partners. Similar
to a sole proprietorship, a partnership has no legal status, and the partners are liable to
settle the debts of the business even with their personal assets.
There are two concepts, legal personality and perpetual succession that are relevant
when discussing the nature of limited liabilitycompanies.
Legal Personality
It is commonly understood that sole proprietorships and partnerships do not possess

legal personality. In legal terms, a legal person is recognised as an entity that possesses
rights and responsibilities.
In other words, it has the capacity to initiate legal action by suing to uphold its rights, as
well as the potential to be sued by another party seeking to enforce its duties.
While all individuals, except minors and individuals deemed legally incompetent, are
considered natural legal persons, the legal system also acknowledges the existence of
artificial legal persons. These are entities that are established in a formal manner, such
as companies that are registered with the company registrar under the Companies Act
or institutions that are formed under specific Acts of Parliament.
Perpetual Succession
A company maintains its separate legal existence from its owners or shareholders. Even
in the unfortunate event that all the shareholders, directors, and employees of a
company pass away, the company itself will not cease to exist. This concept is referred
to as perpetual succession, meaning the company's existence continues uninterrupted.
Only through the process of dissolution can a company officially come to an end.
Remarkably, there are several well-established companies in our country that have been
in operation for nearly or over 100 years. Despite the original subscribers and directors
no longer being alive, those have endured and continue to operate in the long term.
CHAPTER 1 Page 22
Limited Liability Companies

A limited liability Company is a separate legal entity. Therefore, a company owns assets
in its own name and is liable for its debts. A Limited liability company is an entity
incorporatedunder the Companies Act No 7 of 2007 or any other Special Act passed by
the government for the incorporation of a company. The owners of the company are
shareholders, as they own shares of the capital of the company. The shareholders can
transfer or sell their shares to another investor at any time. Thus, we say that in a company
the ownership is transferable.
There are mainly two types of limited liability companies – private companies and public
companies. A public company can list on the stock exchange and thus has access to raising
funds from the general public and has ready marketability of its shares. However, private
companies are not eligible to make a public issue of shares.
One of the advantages of investing in a limited liability company is that the owners are
liablefor the debts of the company only up to the value of the fully paid amount of the
shares investedin the company. They are not called upon to pay the debts of the business
using their personal assets. Further public companies have the potential to raise large
amounts of capital as they can issue shares and debt instruments to the public.
These advantages make companies the most popular form of business entity to carry on
large-scale operations. However, companies vary in size from shops to large business
conglomerates that are spread across several countries.
1.6 What is Accounting?
Accounting could be explained as “a system of generating information about a business

and communication them to stakeholders for supporting economic decision making”. It
is a systematic process of identifying, recording, measuring, classifying, verifying,
summarising, interpreting, and communicating financial information.
Accounting as an Information System
It is identified that accounting is a system of generating information about a business

and communicating it to stakeholders for supporting economic decision-making.
Financial Accounting is accounting that focuses on providing information to
stakeholders. Thereare three main elements in any information system. Accounting as an
information system also has these three elements (Figure 1.3).
CHAPTER 1 Page 23
Figure 1.3: Accounting as an Information System
Inputs Process Output
Transactions Financial Statements/

(Data) Reports (Information)
Input to Accounting System

Data gathered from transactions are the inputs to the accounting system. Transactions
are theactivities of the business which have a financial value, and which result in a change
in assets,liabilities, and equity of the business. Accordingly, it should be emphasized that
all activities of the business are not transactions and accounting as an information
system gathers data from those transactions.
The following are a few examples of transactions that occurred in a business that engages
in buying and selling goods.
Examples
• Purchased inventory worth Rs. 300,000 from a supplier on credit.
• Sold goods worth Rs. 200,000 to a customer and received payment in cash.
• Paid Rs. 50,000 to a supplier as payment for goods purchased on credit.
• Returned defective goods worth Rs. 20,000 to a supplier and received a credit note.
• Incurred Rs. 5,000 in utility expenses (electricity, water, etc.) for the month.
The following are not examples of transactions.

• Ten new employees were recruited to the business.
• Got approval from the bank manager for a bank overdraft of Rs.1 million.
• Conducted market research.
Output of the Accounting System

Financial statements are the output of the accounting systems by which information about
the business is communicated to the stakeholders. The following are a few examples of
the financial statements.
Examples
• Statement of Profit or Loss and Other Comprehensive Income
• Statement of Financial Position
• Statement of Cash Flows
• Statement of Changes in Equity
CHAPTER 1 Page 24
1.7 Branches of Accounting
There are many stakeholders who use accounting information. Even though certain
information required by most of these stakeholders is common to them, there is some
information requirements that are different to each stakeholder. Accordingly, the same
type and level of information may not match the information needs of all the parties.
Especially, managers of business require more different types and levels of information
for managerial decision-making. Accordingly, there should be a separate system to
providethis information to managers.
Similarly, other external stakeholders require information at different levels of degree.
Accordingly, two main branches of accounting could be identified.
Financial Accounting
Financial accounting focuses on providing information to external stakeholders.
Financial accounting mainly provides historical information with financial
measurement. Financial accounting information is made available to stakeholders
periodically. Generally Accepted Accounting Principles and Practices are heavily used in
generating financial accounting information.
Management Accounting
Management Accounting focuses on providing information to internal stakeholders.
Management Accounting provides both historical information as well as forecasted
information. Further, it may provide to a greater extent financial, non-financial as well
as qualitative information for managerial decision-making purposes.
Internal and External Stakeholders

The main difference between financial accounting and management accounting depends on
to which stakeholder the information is provided. Accordingly, management accounting
focuseson providing information to internal stakeholders while Financial Accounting
focuses on providing information to external stakeholders.
This classification of stakeholders as internal and external is made based on the

following factors.
• The internal stakeholder has control over the information generation process
whereas the external stakeholders do not have such control over the information
generation process. Hence, the internal stakeholders can demand the information
when they require it, butexternal stakeholders receive the information periodically.
• The internal stakeholders have free access to information whereas the external
stakeholders do not have free access to information.
CHAPTER 1 Page 25
Differences between Financial Accounting and Management Accounting

A few main differences between financial accounting and management accounting are
summarized in the following Exhibit 1.1.
Exhibit 1.1: Differences between Financial Accounting and Management Accounting
Financial Accounting Management Accounting

Focus on providing information mainly Focus on providing information to
to external stakeholders. internal stakeholders.
Provide information periodically. Provide information on demand.
Provide mostly historical information. Provide both historical and forecasted
information.
Use of Generally Accepted Accounting Use of Generally Accepted Accounting
Practices and accounting standards is Practices and accounting standards is
very important not important.
There is a statutory requirement for the There is no statutory requirement for

financial accounting of certain entities. management accounting of any entity.
Generally, the whole business is The reporting unit varies with the
considered as a unit for reporting management requirements and mostly,
purposes the business as a whole, a product/s, a
division/s etc., is considered as a unit for
reporting purposes
CHAPTER 1 Page 26
Chapter Round-Up
• This chapter serves as an introductory overview of accounting, focusing on

various aspects such as types of business entities, stakeholders, and their
information requirements.
• Accounting plays a crucial role in meeting the informational needs of
stakeholders.
• These stakeholders can be broadly categorized into two groups: internal and
external stakeholders.
• Accounting itself can be classified into two primary branches: Financial
Accounting and Management Accounting.
• Financial Accounting involves the preparation and reporting of financial
information for external stakeholders, such as investors, creditors, and regulatory
authorities. On the other hand, Management Accounting focuses on providing
information for internal stakeholders, including managers and decision-makers
within the organization.
• By understanding the different types of business entities, the significance of
stakeholders, and the role of accounting in meeting their information needs,
readers will gain a foundational understanding of the key concepts and principles
that underpin the field of accounting.
EXPERIENTIAL EXERCISES
Question 1
Define the term accounting.
Question 2
Define the term business entity.
Question 3
State main two branches of accounting.
Question 4
Provide a list of ten (10) stakeholders of a business.
Question 5
Differentiate financial accounting and management accounting by filling in the blanks in the
table given below.
CHAPTER 1 Page 27
Financial Management
Criteria
Accounting Accounting
Purpose
Users
Nature of information
Legal requirement
Frequency of reporting
Scope
Answers
Question 1
Accounting could be explained as “a system of generating information about a business
and communicating them to stakeholders for supporting economic decision making”.
Question 2
A business entity can be defined as any entity which engages in the supply of goods and
provides services to satisfy human needs and wants.
Question 3
Financial Accounting and Management Accounting
Question 4
Shareholders/Owners
Employees
Customers
Suppliers
Lenders/Financial Institutions
Government/Regulatory Authorities
Local Community
Competitors
Industry Associations
Non-Governmental Organizations (NGOs)
CHAPTER 1 Page 28
Question 5
Criteria Financial Accounting Management Accounting

To provide information To provide information to
Purpose mainly to external internal stakeholders.
stakeholders.
Users Mainly external stakeholders Internal stakeholders
Provide mostly historical Provide both
Nature of
information. historical and forecasted
information
information.
There is a statutory There is no statutory
requirement for the financial requirement for
Legal requirement
accounting of certain entities. management accounting of
any entity.
Frequency of Periodically On demand
reporting
Generally, the whole business Reports can be prepared
is considered as a unit for for the whole the business,
Scope
reporting purposes a product/s, a division/s
etc.
CHAPTER 2 Page 29
Accounting Equation and

Double Entry System
Learning Outcomes
• Explain the entity concept.

• Define the terms: assets, liability, and equity.
• Develop the accounting equation.
• Describe the influence of transactions on assets, liabilities, and equity through the
accounting equation.
• Explain the dual impact of transactions.
• Explain the double entry system.
• Discuss the double entry principles.
• Explain ledger accounts.
• Record transactions of a business using the double entry system through ledger
accounts.
2.1 Introduction
Data collected from transactions should be recorded systematically to generate

meaningful information. The accounting equation can serve as an initial method for
recording transactions. Another approach is the double-entry system utilizing ledger
accounts. Prior to studying the recording of transactions, it is important to get an
understanding of the accounting equation. The basis for the accounting equation is provided
by the entity concept.
CHAPTER 2 Page 30
2.2 Entity Concept
The entity concept says that the business entity should be treated as a separate
independent entity from the owners of the business (Figure 2.1). Accordingly, it
separates the business entity from the owners even though in certain circumstances such
separation may not be accepted in the legal system. Accordingly, it should be emphasized
that this separation of owners and the businessentity is considered solely for accounting
purposes.
Figure 2.1: Entity Concept
Business Entity Owners
Once the business entity is separated from the owners of the business entity, all
transactionsshould be recorded from the business’s point of view and not from the owner’s
point of view.
Examples
Here are some examples that show the application of the business entity concept.
1. The owner of a retail business occupies a building comprising five floors and pays a
monthly rent of Rs. 100,000 for its usage. According to the business entity concept, only
Rs. 60,000 (Rs. 100,000/5 floors*3 floors) is the monthly rent expense of the business
and therefore, it should be recorded in the books of the business. Balance Rs. 60,000 is an
expense of the owner and therefore, it will not be recorded in the books of the business.
2. In a partnership business, one of the partners purchases inventories from the partnership
itself, with the total value amounting to Rs. 40,000. It should be recorded as a sales
transaction and a receivable balance from that partner, in the books of the partnership.
3. A shareholder of PQR (Pvt) Ltd. provided a loan of Rs. 300,000 to the company at an
interest rate of 10%. It should be recorded as a liability in the books of PQR (Pvt) Ltd and
should be paid back to the shareholder with interest.
The business entity concept is important due to the following reasons.
- It helps to identify the reporting entity.

- It helps to measure the performance of a particular business entity separately.
- It helps in identifying the financial position of a particular business on a specific day.
- It enables the comparison of financial statements among business entities.

- It is difficult to audit the financial statements of a particular business if accounting
records are mixed up with the records of its owners or other businesses.
CHAPTER 2 Page 31
2.3 Introduction to Assets, Liabilities, Equity
Assets
Assets are the resources controlled by the business from which future economic benefits
are expected to flow to the business entity. Assets are created as a result of transactions
and events.
Generally, assets can be categorized as follows (Figure 2.2)
Figure 2.2 Classification of Assets
Assets
Non-current Assets Current Assets
Current and Non-current Assets
An entity shall classify an asset as current when:
• It expects to realize the asset, or intends to sell or consume it, in its normal operating
cycle (i.e., operating cycle is the length of time between the acquisition of material or
services and their realization into cash or cash equivalents in a particular business)
• It holds the asset primarily for the purpose of trading; or
• It expects to realize the asset within 12 months after the reporting period; or
• The asset is cash or a cash equivalent (cash equivalents are items that are similar to cash
such as cash at bank, short-term securities, etc.) unless the asset is restricted from being
exchanged or used to settle a liability for at least 12 months after the reporting period.
Examples: Inventory (goods available for re-sale), Trade debtors (cash which is receivable
from customers), Cash
An entity can classify all other assets as non-current assets.
Examples: Lands, Buildings, Motor vehicles, Furniture, Office equipment
Liabilities
Liabilities are the present obligations of the business entity which will result in an
outflow of economic resources of the business entity at the time of settlement. Liabilities
are also created as a result of transactions and events.
Generally, liabilities can be categorized as follows (Figure 2.3).

CHAPTER 2 Page 32
Figure 2.3: Classification of Liabilities
Liabilities
Non-Current Liabilities Current Liabilities
Current and Non-Current Liabilities

An entity shall classify a liability as current when:
• It expects to settle the liability in its normal operating cycle; or
• It holds the liability primarily for the purpose of trading; or
• The liability is due to be settled within 12 months after the reporting period; or
• The entity does not have an unconditional right to defer settlement of the liability for at
least 12 months after the reporting period.
Examples: Trade creditors (cash which is payable to suppliers of inventory), Unpaid

electricity bill, Bank overdraft
An entity can classify all other liabilities as non-current liabilities.
Example: Bank loan payable after the next year
Equity
Equity is the residual interest of assets after settling all the liabilities. Hence, Equity
equals assets minus liabilities.
Example: Capital provided by the owner
Illustrative Example 2.1
Styles (Pvt) Ltd., a garment factory, is owned by Harrold. On 01st April 2023, Harrold invested
in land worth of Rs. 2,500,000 and a building worth of 1,000,000 for the business. On 16 th
April 2023, the business obtained a Rs. 500,000 bank loan to upgrade its facilities. On 30 th
April 2023, the business purchased inventories for Rs. 150,000 on a credit. Identify the
following.
I. Assets as at 01st April 2023

II. Liabilities as at 01st April 2023
III. Equity as at 01st April 2023
IV. Liabilities as at 30th April 2023
V. Assets as at 30th April 2023
VI. Equity as at 30th April 2023
CHAPTER 2 Page 33
Answer
I. Styles (Pvt) Ltd can consider the land and the building as assets of the business entity as at
01st April 2023.
Assets as at 01st April 2023 = Rs. 2,500,000 (Land) + Rs. 1,000,000 (Building)
= Rs. 3,500,000
II. There are no liabilities as at 01st April 2023 as per the given activity.
III. The equity as at 01st April 2023 can be calculated as follows.
Equity as at 01st April 2023 = Total Assets – Total Liabilities

= Rs. 3,500,000 - 0
= Rs. 3,500,000
IV. Styles (Pvt) Ltd can consider the bank loan and trade creditors (occurred as a result of the
credit purchase of the inventories) as the liabilities of the business entity as at 30th April
2023.
Liabilities as at 30th April 2023 = Rs. 500,000 (Bank Loan) + Rs. 150,000 (Trade Creditors)
= Rs. 650,000
V. The total assets as at 30th April 2023 can be calculated as follows.
Assets as at 30th April 2023 = Rs. 2,500,000 (Land) + Rs. 1,000,000 (Building)+ Rs. 500,000
(Cash from the bank loan) + Rs. 150,000 (Inventories)
= Rs. 4,150,000
VI. Equity as at 30th April 2023 can be calculated as follows using the above assets and
liabilities as at 30th April 2023.
Equity as at 30th April 2023= Total Assets – Total Liabilities

= Rs. 4,150,000 – Rs. 650,000
= Rs. 3,500,000
2.4 Accounting Equation
To generate meaningful information, it is essential to record data collected from transactions

in a systematic manner. An accounting equation can be used to record transactions. It shows
the relationship among elements (i.e., assets, liabilities, equity) of financial statements.
If all assets of the business are financed by the owner, the basic accounting equation
becomes:
Assets = Equity
CHAPTER 2 Page 34
When the owners’ capital is insufficient to acquire assets, it may be necessary to obtain debt
from third parties. When both owner and third parties have provided funds to acquire assets
in the business, the accounting equation becomes:
ASSETS = EQUITY + LIABILITIES
Effect of Transactions on the Accounting Equation

Every transaction and event has a dual impact on the accounting equation. After
recording each transaction and event, the accounting equation should be tallied. The
recording of the impact of different types of transactions on business using the
accounting equation is discussed indetail using the following illustrations.
(1) Investment of Capital by the Owner

The value of resources contributed by the owners to the business entity is known as
capital. When the owner invests money or other assets into the business, it leads to an
increase in the business's assets by the same amount. As per the entity concept, the
owner and the business are regarded as separate entities. Therefore, the investment
made by the owner results in an increase in equity. Consequently, this transaction has a
dual impact on the business entity, which can be summarized as follows.
Asset increases and equity (Capital) increases.
Transaction 1: Investment of Rs. 500,000 by the owner of Mahela Traders.
Assets = Equity + Liabilities
+ 500,000 (Cash) = + 500,000 (Capital)
(2) Obtaining Loans

When a business obtains a loan, it experiences an increase in its assets as a result of the
cash inflow from the loan. However, it is important to note that the loan represents a
liability for the business, as it is an amount owed to the loan provider. Therefore,
obtaining a loan lead to a simultaneous increase in both assets and liabilities of the
business. In summary, the dual impact of this transaction can be described as follows.
Assets (Cash) increase and Liabilities (Bank loan) increase.
Transaction 2: Melisa Traders borrowed Rs. 600,000 from a bank.
+ 600,000 (Cash) = +600,000 (Bank

loan)
CHAPTER 2 Page 35
(3) Purchase of Non-current Assets for the Business for Cash.

When a business buys an asset by making a cash payment, it leads to an increase in the
value of the acquired asset and a decrease in the cash asset. Therefore, the dual impact
of this transaction can be summarized as follows.
Asset (Purchased asset) increases and Asset (Cash) decreases.
Transaction 3: Furniture costing Rs. 200,000 were purchased in cash.
+ 200,000 (Furniture)
- 200,000 (Cash)
(4) Purchase of Non-current Assets by the Business for Credit.

When a business purchases an asset on credit, it results in an increase in assets.
However, since the asset is acquired on credit, there is no immediate decrease in the cash
asset. Instead, a payable amount is created, which becomes a new liability for the
business. Therefore, the dual impact of this transaction can be summarized as follows.
Assets (Purchased asset) increase and Liabilities (Other creditors) increase.
Transaction 4: Furniture of Rs. 700,000 were purchased on credit to use in the business.
+ 700,000 = + 700,000 (Other Creditors)

(Furniture)
(5) Purchase of Inventory on Cash & Credit

When a business purchases inventory, it leads to an increase in the inventory asset. The
purchase of inventory can be made either on a cash basis or on a credit basis. If the
inventory is purchased with cash, the corresponding impact is a decrease in the cash
asset. On the other hand, if the inventory is purchased on credit, the corresponding
impact is an increase in a liability known as "trade creditors." In summary, the dual
impacts of these transactions can be stated as follows.
Purchase of inventory for cash: Assets (Inventory) increase and Assets (Cash) decrease.
Purchase of inventory on credit: Assets (Inventory) increase and Liabilities (Trade

creditors) increase.
Transaction 5: Inventory costing Rs. 150,000 was purchased in cash.

CHAPTER 2 Page 36
+ 150,000 (Inventory)
- 150,000 (Cash)
Transaction 6: Inventory costing of Rs. 200,000 was purchased on credit.
+ 200,000 (Inventory) = + 200,000 (Trade creditors)
(6) Sale of Inventory with a Profit on Cash & Credit

The difference between sales income and the purchase cost of inventory is referred to
as gross profit or loss. When the sales income exceeds the purchase cost of inventory, it
represents a gross profit. When inventory is sold at a profit, it leads to an increase in the
cash asset of the business due to the sales value received, while the inventory asset
decreases by the purchase cost of the sold inventory. This overall effect results in an
increase in assets, representing the profit generated from the transaction. Since the
profit belongs to the owners of the business, it is added to equity in accordance with the
basic accounting equation.
When inventory is sold on credit, it gives rise to a receivable from the customer, known
as "trade debtors." As a result, the dual impact of such transactions involves an increase
in the trade debtors instead of cash.
In summary, the dual impacts of these transactions can be stated as follows.
Sale of inventory for cash with a profit: Assets (Cash) increase, Assets (Inventory)
decrease and Equity (Profit) increases.
Sale of inventory on credit with a profit: Assets (Trade debtors) increase, Assets
(Inventory) decrease and Equity (Profit) increase.
Transaction 7: Inventory costing Rs. 50,000 was sold for Rs. 60,000.

+ 60,000 (Cash) = + 10,000 (Profit)
- 50,000 (Inventory)
Transaction 8: Inventory costing of Rs. 30,000 was sold on Rs. 50,000 on credit.

+50,000 (Trade debtors) = + 20,000 (Profit)
CHAPTER 2 Page 37
(7) Sale of Inventory at a Loss on Cash & Credit

The difference between sales income and the purchase cost of inventory is known as
gross profit or loss. When the sales income is less than the purchase cost of inventory, it
results in a loss. When inventory is sold at a loss, the cash asset of the business increases
by the sales value, while the inventory asset decreases by the purchase cost of the sold
inventory. This overall effect leads to a decrease in assets, representing the loss incurred
from the transaction. Like profit, which belongs to the owners and is added to equity, the
loss should also be attributed to the owners and deducted from equity.
Accordingly, the dual impact of these transactions can be summarized as follows.
Sale of inventory for cash at a loss: Assets (Cash) increase, Assets (Inventory) decrease
and Equity (Loss) decreases.
Sale of inventory on credit at a loss: Assets (Trade debtors) increase, Assets (Inventory)
decrease and Equity (Loss) decreases.
Transaction 9: Inventory costing of Rs. 12,000 was sold for Rs. 10,000.

+ 10,000 (Cash) = - 2,000 (Loss)
Transaction 10: Inventory costing of Rs. 7,000 was sold on Rs. 6,000 on credit.

+ 6,000 (Trade debtors) = - 1,000 (Loss)
- 7,000 (Inventory)
(8) Receipt from Trade Debtors and Payments to Trade Creditors.

When cash is collected from trade debtors, it leads to an increase in the cash asset and a
decrease in the trade debtors asset. This reflects the conversion of accounts receivable
into cash. On the other hand, when trade creditors are settled by paying cash, it results
in a decrease in the cash asset as well as a decrease in liability (trade creditors). This
represents the settlement of outstanding obligations to suppliers or creditors.
Accordingly, the dual impact of these transactions can be summarized as follows.
Collection from trade debtors: Assets (Cash) increase, and Assets (Trade debtors)
decrease
Payments to trade creditors: Assets (Cash) decrease and Liabilities (Trade creditors)
decrease.
CHAPTER 2 Page 38
Transaction 11: Received Rs. 15,000 from trade debtors.

+ 15,000 (Cash)
- 15,000 (Trade debtors)
Transaction 12: Paid Rs. 20,000 to trade creditors.

- 20,000 (Cash) = - 20,000 (Trade
Creditors)
(9) Drawings -Use of Business Assets by the Owner for his/her Personal Use
When owners use assets of the business entity for their personal purposes, it is called
“Drawings”. Drawings can be made in the form of cash withdrawals or by using other
business assets, such as inventory. When owners make cash drawings, it results in a
decrease in assets as the cash balance decreases. Similarly, when owners make drawings
on inventory, it leads to a decrease in assets due to the reduction in the value of the
inventory. Both cash drawings and inventory drawings have the effect of reducing the
equity of the business. Therefore, the dual impact of these transactions is a decrease in
assets and a decrease in equity.
Cash drawings: Assets (Cash) decrease and Equity (Drawings) decreases.

Inventory drawings: Assets (Inventory) decrease and Equity (Drawings) decreases.
Transaction 13: Inventory costing Rs.15,000 was taken home by Mellisa for a family
function.
Assets = Equity + Liabilitie

s
- 15,000 (Inventory) = - 15,000 (Drawings)
Similarly, for cash drawings, there is an impact both on Assets (Cash) and Equity
(Drawings), where both decrease by the amount of the cash drawn.
(10) Earning of Other Income - Cash or Credit

A business can earn income either by realizing (i.e., receiving cash) or becoming
realizable (i.e., becomes receivable). Both cash and income receivables represent assets
of the business entity. Since income leads to an increase in profit for the company, it is
added to equity.
CHAPTER 2 Page 39
Accordingly, the dual impact of these transactions on the business entity is as follows.
Received income: Assets (Cash) increase and Equity (Income) increases.
Receivable income: Assets (Receivable income) increase and Equity (Income) increases.
Transaction 14: Received a commission of Rs. 9,000 for the business.

+ 9,000 (Cash) = + 9,000 (Commission income)
Transaction 15: There is a receivable commission of Rs. 3,000 for the business.

+ 3,000 (Commission Income Receivable) = + 3,000 (Commission income)
(11) Incurring Other Expenses - Cash or Credit

A business may encounter different expenses, which can be settled either by making
immediate payments (e.g., cash) or through expenses payable. In both cases, these
expenses contribute to a decrease in the equity of the business entity. When expenses
are paid with cash, it leads to a reduction in the cash asset. On the other hand, when
expenses are incurred but remain payable, it creates an increase in the liability of
expenses payable. Therefore, the dual impact of these transactions results in a decrease
in assets (cash) and an increase in liabilities (expenses payable), both contributing to a
decrease in equity.
Accordingly, the dual impact of these transactions on the business entity is as follows.
Expense paid: Assets (Cash) decrease and Equity (Expense) decreases.
Expenses payable: Liabilities (Expenses payable) increase and Equity (Expense)

decreases.
Transaction 16: Paid Rs. 8,000 as the rent for the office building.

- 8,000 (Cash) = - 8,000 (Rent)
Transaction 17: Rs. 5,000 is payable as the rent for the warehouse.

= - 5,000 (Rent) + 5,000 (Rent expense
payable)
CHAPTER 2 Page 40
(12) Return Inwards

Return inwards means the return of sales. Customers can return inventory due to
various reasons such as receipt of damaged or defective inventory, late deliveries of
inventory, etc.
Here, we assume that inventories sold on a credit basis are returned by the customers.
When a customer returns inventory, trade receivables asset is decreased by the sales
value, inventory asset is increased by the cost of the inventory, and the equity is
decreased/increased by the loss/profit of the transaction respectively. Accordingly, the
dual impact of this transaction is as follows.
Return inwards: Assets (Trade receivables) decrease, Assets (Inventory) increase, and
Equity decreases / increases by the profit/loss of the transaction, respectively.
Transaction 18: Inventory which was sold at Rs. 1,500 (cost of the inventory was Rs. 1,000)
was returned by a trade debtor due to a difference in design.
- 1,500 (Trade debtors) = - 500 (Loss)
+ 1,000 (Inventory)
(13) Return outwards

Return outwards means the return of purchases. The business entity may return
inventory due to various reasons such as receipt of un-ordered inventory, receipt of
inventory at a higher price than the agreed price, etc. Here, we assume that inventories
purchased on a credit basis are returned. When the business entity returns inventory,
the inventory asset is decreased, and the trade creditor liability is decreased.
Accordingly, the dual impact of this transaction is as follows.
Return outwards Assets (Inventory) decrease and Liabilities (Trade creditors) decrease.
Transaction 19: Inventory which was purchased at Rs. 2,400 was returned by the business
entity.

-2,400 (Inventory) = - 2,400 (Trade
creditors)
Let’s get the total of all columns as follows.

CHAPTER 2 Page 41
Assets = Equity Liabilities

Tran. +
Trade Income Trade Other Expenses
Furniture Inventory Debtors Receivable Cash Equity Bank Creditors Creditors Payable
Loan
1 + 500,000 + 500,000
2 + 600,000 + 600,000
3 + 200,000 - 200,000
4 + 700,000 + 700,000
5 + 150,000 - 150,000
6 + 200,000 + 200,000
7 - 50,000 + 60,000 + 10,000
8 - 30,000 + 50,000 + 20,000
9 - 12,000 + 10,000 - 2,000
10 - 7,000 + 6,000 - 1,000
11 - 15,000 + 15,000
12 - 20,000 - 20,000
13 - 15,000 - 15,000
14 + 9,000 + 9,000
15 + 3,000 + 3,000
16 - 8,000 - 8,000
17 - 5,000 + 5,000
18 +1,000 -1,500 -500
19 - 2,400 - 2,400
900,000 234,600 39,500 3,000 816,000 510,500 600,000 177,600 700,000 5,000
1,993,100 510,500 1,482,600
1,993,100 1,993,100
CHAPTER 2 Page 42
2.5 Double Entry System
The double entry system is the alternative method, which is used to record transactions
of a business, instead of using the accounting equation.
The double entry system was first documented by the Italian monk, Luca Pacioli in the
year 1494. Luca Pacioli is also considered as the Father of Accounting due to this
pioneering contribution.
As discussed earlier, there is a dual impact on every transaction. The double entry
system is the accounting system that keeps two entries called ‘Debit’ (Dr) and ‘Credit’
(Cr) in two ledger accounts to represent the dual impact of any transaction.
Due to practical reasons, instead of using the accounting equation, the double entry
system through ledger accounts is used to record the transactions, which is discussed in
this Chapter.
The Account, its Structure, and the Ledger
An account is a simple structure used to record transactions using the double entry
system. There are two sides to any account, called Debit and Credit. These two sides are
used to record the dual impact of transactions.
The simple format of an account is given below.
Debit ………………………. Account Credit
Date Descriptio Amoun Date Descriptio Amoun

n t n t
This is a very simple format of an account, and this can further be developed by
incorporating more details in practice.
The ledger is the place where all the accounts are maintained. In a manual record-
keeping system, the ledger is a large book in which all the accounts are maintained. In a
computerized record-keeping system, the ledger will be a separate folder or file in a
computer package. Simply the ledger is the collection of the accounts.
CHAPTER 2 Page 43
Double Entry of a Transaction
As it already been discussed, any transaction has a dual impact on the assets, liabilities,
and equity of the business. To represent this dual impact, the relevant amount should be
recorded in two accounts. The principles of the double entry system have been
developed in a way that when a transaction is debited to one account it should be
credited to another account as well. Accordingly, any transaction will be recorded on the
debit side of one account and the credit side of another account.
Double Entry Principles
There are five main double entry principles.

1) Principle of assets
Increase of Assets : Debit
Decrease of Assets : Credit
2) Principle of equity
Increase of Equity : Credit
Decrease of Equity : Debit
3) Principle of liabilities
Increase of liabilities : Credit
Decrease of liabilities : Debit
4) Principle of income
Increase of income : Credit
Decrease of income : Debit
5) Principle of expenses
Increase of expense : Debit
Decrease of expense : Credit
The double entry principles of assets and expenses are set in the same manner where a
debit entry is made for an increase of an asset and expense and a credit entry is made
for a decrease of an asset/ expense. The double entry principles of equity, liability, and
income are set in the same manner where a credit entry is made for an increase of the
equity/liability/income and a debit entry is made for a decrease of the
equity/liability/income.
Below are the dual impact and the double entries for some transactions that happened
in Sunshine PLC, which is in the service industry.
CHAPTER 2 Page 44
No. Transaction Dual Impact Double Entry
1 The owner 1. Cash (asset) increases 1. Cash Debit

invested 2. Capital (equity) 2. Capital 100,000
Rs. 100,000 cash increases Credit
in the business. 100,000
2 The owner invested Rs. 1. Machinery (asset) 1. Machinery Debit
50,000 worth of machinery increases 2. Capital 50,000
in thebusiness 2. Capital (equity) Credit
increases 50,000
3 Rs. 30,000 worth of 1. Equipment (asset) 1. Equipment Debit

equipment waspurchased. Increases 2. Cash 30,000
2. Cash (asset) decreases Credit
30,000
4 Obtained a bank loan of Rs. 1. Bank loan (liability) 1. Cash Debit
500,000. increases 2. Bank loan 500,000
2. Cash (asset) increases Credit
500,000
5 Received an income of Rs. 1. Sales (income) increase 1. Cash Debit
40,000 by 2. Cash (asset) increases 2. Sales 40,000
providing a service. income Credit
40,000
Types of Accounts
Based on five double entry principles, all the accounts maintained in a ledger can be
classified into five main types namely: assets, liabilities, equity, income, and expense.
The following are different accounts maintained by a business in its ledger. These
accounts can be classified into five categories as follows.
Name of the account Account type

Land Asset
Buildings Asset
Motor vehicles Asset
Office equipment Asset
Furniture Asset
Debtors Asset
Inventory Asset
Bank Asset
Cash Asset
Provision for Asset
CHAPTER 2 Page 45
depreciation
Capital Equity
Revaluation reserve Equity
Bank loan Liability
Creditors Liability
Accrued Expenses Liability
Sales Income
Commission income Income
Rent income Income
Interest Income Income
Discount received Income
Return outwards Income
Salaries Expenses
Rent Expenses
Discount allowed Expenses
Depreciation Expenses
Return inwards Expenses
Return outwards Income
Recording of Transactions in Ledger Accounts Using the Double Entry System
The double entry system is a superior system of recording transactions compared with
the accounting equation. When transactions are recorded in accounts using the double
entry system, every transaction is debited to one account and credited to another
account. Thus, every transaction is recorded in the debit and credit sides of two accounts.
Balancing the Accounts
Once all the transactions that occurred in a particular period are recorded in the ledger
accounts using the double entry principles, at the end of the period these accounts can
be balanced. Balancing of the ledger accounts can be done as follows.
Step 1: Total both debit and credit columns. The total of the column with the higher value
should be shown in the other column as well.
e.g., If the Debit column totals Rs. 600,000 and the credit column totals 450,000, show
600,000 as the total.
Step 2: The difference between the two totals should be shown in the column with the
lesser value, as the last item before the total. This difference is the balance carried
forward.
CHAPTER 2 Page 46
e.g., The difference between 600,000 and 450,000 is 150,000. Show this amount as the
balance carried forward.
Step 3: The balance so carried forward should be brought forward to the other column
and shown immediately below the total.
Sahan started a business on 01.01.2023. The following transactions took place in January
2023.
1. Invested Rs. 600,000 as capital.

2. Obtained a loan of Rs. 250,000 from a bank.
3. Opened a bank current account by depositing Rs. 200,000.
4. Purchased goods for Rs. 300,000.
5. Purchased office equipment for Rs. 150,000 and paid by cheque.
6. Purchased goods for Rs. 250,000 on credit from Sanduni.
7. Sold goods costing Rs.120,000 for Rs. 210,000.
8. Sold goods costing Rs. 140,000 for Rs. 250,000 on credit to Gihan.
9. Paid salaries of the employees amounting to Rs. 50,000.
10. Received a commission income of Rs. 30,000.
These transactions are recorded in the ledger accounts as follows.
Dr Cash Account Cr
1) Capital 600,000 3) Bank 200,000
2) Bank Loan 250,000 4) Purchase 300,000
7) Sales 210,000 9) Salaries 50,000
10) Commission 30,000 Balance 540,000
C/F
1,090,000 1,090,000
Balance B/F 540,000
Dr Capital Account Cr
1) Cash 600,000
Balance C/F 600,000
600,000
600,000
Balance B/F 600,000

CHAPTER 2 Page 47
Dr Bank loan Account Cr
2) Cash 250,000
Balance C/F 250,000
250,000
250,000
Balance B/F 250,000
Dr Bank Account Cr
3) Cash 200,000 5) Office equip. 150,000

Balance C/F 50,000
200,000
200,000
Balance B/F 50,000
Dr Purchase Account Cr
4) Cash 300,000 Balance C/F 550,000
6) Creditor- 250,000
Saduni 550,000
550,000
Balance B/F 550,000
Dr Office Equipment Account Cr
5) Bank 150,000 Balance C/F 150,000
150,000 150,000
Balance B/F 150,000
Dr Creditor - Sandun Account Cr

Balance C/F 250,000 6) Purchases 250,000
250,000
250,000
Balance B/F 250,000

CHAPTER 2 Page 48
Dr Sales Account Cr
Balance C/F 460,000 7) Cash 210,000

8) Debtor-Gihan 250,000
460,000 460,000
Balance B/F 460,000
Dr Debtor-Gihan Account Cr
8) Sales 250,000 Balance C/F 250,000
250,000
250,000
Balance B/F 250,000
Dr Salaries Account Cr
9) Cash 50,000 Balance C/F 50,000
50,000
50,000
Balance B/F 50,000
Dr Commission Account Cr
Balance C/F 30,000 10) Cash 30,000
30,000
30,000
Balance C/F 30,000

CHAPTER 2 Page 49
Chapter Round-Up
• This chapter provides an understanding of the entity concept, the accounting

equation, and the recording of transactions using the accounting equation and
the double entry system.
• The key facts that are emphasized in this chapter are the dual impact of every
transaction on the assets, liabilities, and equity of the business which can be
recorded in the accounting equation as an increase or decrease or under the
double entry system as debit and credit.
• Further, it explained balancing the ledger at the end of the period once all the
transactions are recorded.
Question 1
Briefly explain the key variables of the accounting equation.
Question 2
List two (2) transactions that result in an increase in assets and equity.
Question 3
List two (2) transactions that result in an increase in assets and liabilities.
Question 4
List two (2) transactions that result in an increase in assets and a decrease inassets.
Question 5
List two (2) transactions that result in a decrease in assets and a decrease in equity.
Question 6
Fill in the blanks.
CHAPTER 2 Page 50
Assets = Liabilities + Equity
125,000 = 118,000 +
280,000 = 40,000 +
168,000 = + 125,000
365,000 = + 164,500
= 63,000 + 19,200
= 116,500 + 39,750
670,000 = + 258,500
= 123,540 + 151,750
237,000 = 168,400 +
343,500 = + 153,450
(7) Following transactions took place in Louis PLC during January 2023.
01/01 Louis Invested Rs.500,000 cash and Rs. 200,000 worth of equipment and
commenced a business.
02/01 Purchased furniture worth Rs. 80,000.
03/01 A loan of Rs. 300,000 was obtained from a bank.
05/01 Opened a Bank current account by depositing Rs. 200,000.
07/01 Purchased goods for Rs. 250,000.
08/01 Purchased goods for Rs. 125,000 and paid by cheque.
10/01 Sold goods for Rs. 150,000.
13/01 Purchased goods for Rs. 75,000 on credit from Mellisa
15/01 Sold goods for Rs. 175,000 on credit to Sanath.
6/01 Louis brings a computer worth Rs. 40,000 which was used at his home for the
use of the business.
17/01 Paid rent of the building amounting to Rs. 25,000 by cheque.
18/01 Sold goods for Rs.200,000 for cash and Rs. 100 000 for credit toKumara.
19/01 Paid Rs. 48,000 to Mellisa and Rs. 2,000 discount was received.
20/01 Paid first instalment of the loan of Rs. 30,000 which includes Rs. 6,000interests.
22/01 Received Rs. 70,000 from Sanath and Rs. 5,000 discount was allowed.
25/01 Commission income of Rs. 10,000 was received.
27/01 Louis took goods costing Rs. 5,000 from the business for a party at hisresidence.
31/01 Electricity bill of the month, Rs. 2,000 was received.
Required: Record all the above transactions in the accounts using the double entry
system.
CHAPTER 2 Page 51
Answers
Question 1
Assets are the resources controlled by the business from which future economic benefits
are expected to flow to the business entity.
Liabilities are the present obligations of the business entity which will result in an
outflow of economic resources of the business entity at the time of settlement.
Equity is the residual interest of assets after settling all the liabilities.
The accounting equation is expressed as: Assets = Liabilities + Equity. It shows the
fundamental relationship between these three variables.
Question 2
Receiving cash from a customer as payment for goods or services.
Contributing additional capital to the business by the owner or shareholders.
Question 3
Borrowing money from a bank or obtaining a loan.
Purchasing inventory or equipment on credit from a supplier.
Question 4
Selling goods or services for cash, resulting in an increase in cash and a decrease in
inventory or accounts receivable.
Purchasing machinery, resulting in a decrease in cash and increase in machinery.
Question 5
Cash drawings by the owner which reduce both assets (cash) and equity.
Incurring expenses such as rent, salaries, or utilities, which reduce both assets (cash)
and equity.
CHAPTER 2 Page 52
Question 6
Assets = Liabilities + Equity
125,000 = 110,000 + 15,000
280,000 = 40,000 + 240,000
168,000 = 43,000 + 125,000
365,000 = 200,500 + 164,500
82,500 = 63,000 + 19,200
230,500 = 116,500 + 39,750
670,000 = 411,500 + 258,500
275,290 = 123,540 + 151,750
237,000 = 168,400 + 68,600
343,500 = 190,050 + 153,450
CHAPTER 3 Page 53
Accounting Process
Learning Outcomes
• Describe the accounting process and the interlinkages.

• Prepare prime entry books by recording transactions.
• Prepare ledger accounts and the trial balance.
3.1 Introduction
In Chapter 2, we learned about how transactions are recorded in ledger accounts using
the double-entry system. Each transaction is debited and credited to two ledger
accounts, one by one. However, in real-world practice, there are often numerous
transactions occurring in a single day. This can make recording each transaction
individually quite challenging. To address this issue, it is important to have a system that
can summarize similar types of transactions. By doing so, we can record the totals of
these transactions in the respective ledger accounts. This approach helps minimize the
number of debit and credit entries required in the ledger accounts. It streamlines the
functioning of the accounting system and reduces the likelihood of errors. Furthermore,
this method makes it easier to balance accounts and prepare a trial balance. With
summarized transactions, the overall process becomes more efficient and less time-
consuming.
To achieve all these advantages, transactions are first recorded in prime entry books
before those are recorded in the ledger accounts using the double entry system. Data
relatingto transactions are gathered from source documents which are prepared at the
time of transaction and the data available in source documents are updated and entered
into the prime entry books.
CHAPTER 3 Page 54
Accordingly, the flow of recording in the accounting process can be summarized as follows
(Figure 3.1).
Figure 3.1: The flow of recording transactions
Transactions Source Documents Prime Entry Books
Financial Statements Trial Balance Ledger Accounts
3.2 Source Documents
Source documents are the documents created at the time of a transaction to capture the
essential details. They serve as the basis for entering transaction data accurately. The
data from these source documents is then collected and recorded in the prime entry
books, where it is summarized before being transferred to the ledger accounts. Various
types of source documents are employed to record different kinds of transactions.
3.3 Prime Entry Books
The data obtained from the source documents, which pertain to transactions, is initially
recorded in the prime entry books before being transferred to the ledger. It's important
to note that prime entry books do not function as accounts and do not adhere to the
double-entry system when recording transactions.
To facilitate recording of different types of transactions, there are eight prime entry books
which are listed below.
1. Cash Receipt Journal
2. Cash Payment Journal
3. Petty Cash Payment Journal
4. Purchase Journal
5. Sales Journal
6. Return Outward Journal
7. Return Inward Journal
8. General Journal
Different types of source documents and prime entry books are used to record different
typesof transactions (Exhibit 3.1).
CHAPTER 3 Page 55
Exhibit 3.1: Transaction Type, Source Documents and Prime Entry Book
Type of Transaction Source Prime Entry Book

Document
(1) Credit Purchases Invoice Purchase Journal
(2) Credit Sales Invoice Sales Journal
(3) Return Outwards Debit Note Return Outward Journal

(Purchase Returns)
(4) Return Inwards Credit Note Return Inwards Journal
(Sales Returns)
(5) Cash Receipts Receipts Cash Receipt Journal
(6) Cash Payments Payment Voucher Cash Payment Journal
(7) Petty Cash Payments Petty Cash Voucher Petty Cash Payment Journal
(8) Any other Journal Voucher General Journal
Transactions
Purchase Journal
This is the prime entry book used to record all credit purchases made by the business
entity with a view to resale. The data gathered from the source document, namely the
invoice is used to prepare the purchase journal. The total of the purchase journal is
debited to the purchase account by crediting the creditors control account.
A simple structure of a purchase journal is given below.
Purchase Journal
Invoice
Date No. Description Amount
CHAPTER 3 Page 56
The format of an invoice may be different from business to business. However, a typical
invoice is depicted below.
Invoice
Shine Enterprises, No. 36, Kaluthara
Date: 01/03/202X
No. S1001
Customer: XYZ (Pvt) Ltd., No. 235/1, Colombo 10
No. Description Quantity Unit Price Discount Amount (Rs.)

1 Book - 40 pages 500 50 10% 22,500
Book - 120
2 pages 300 80 12% 21,120
Total 43,620
Terms: 2%, 15, Net 45
Authorized
by: ………………………… Customer’s signature: …………………
Note – The terms in the above invoice can be described as follows:

2% - Discount Percentage
15 – Discount period
45 – Credit period
Accordingly, the business is allowed 45 days to settle the invoice amount of Rs. 43,620. If the
business settles it within 15 days from the invoice date, the business will get 2a % cash
discount amounting to Rs. 872.40 (43,620 x 2%).
CHAPTER 3 Page 57
The following transactions took place in Zenith Traders in April 2023.
Date Invoice No. Transaction

01.04 1001 Purchased goods for Rs.150,000 on credit from Akash.
05.04 1002 Purchased goods for Rs.170,000 on credit from Binuka
10.04 1003 Purchased goods for Rs.230,000 on credit from Chandana
20.04 1004 Purchased goods for Rs. 100,000 on credit from Dhara
28.04 1005 Purchased goods for Rs. 200,000 on credit from Eshan
30.04 1006 Purchased goods for Rs. 250,000 on credit from Farhan
31.04 1007 Purchased goods for Rs. 150,000 on credit from Gajen
The above transactions are recorded in the purchase journal (purchase journal) and
relevantledger accounts as follows.
Purchase Journal
Date Invoice No. Description Amount

01.04 1001 Akash 150,000
05.04 1002 Binuka 170,000
10.04 1003 Chandana 230,000
20.04 1004 Dhara 100,000
28.04 1005 Eshan 200,000
30.04 1006 Farhan 250,000
31.04 1007 Gajen 150,000
1,250,000
Purchase Account
Creditor Control
Creditors Control Account

Purchase
CHAPTER 3 Page 58
Sales Journal
The sales daybook is also named as sales journal. This is the prime entry book used to
recordall credit sales made by the business in its ordinary course of business. The data
gathered from the source documents, namely invoices, is used to prepare the sales journal.
The total of the sales journal is credited to the sales account by debiting the debtors control
account.
A simple structure of a sales journal is given below.
Sales Journal
The format of a sale invoice may be different from a business to business. However, a typical
sales invoice is depicted below.
Invoice
XYZ (Pvt) Ltd., No. 235/1, Colombo 10
Date: 11/03/202X
No. 50
Customer: Anuruddha
No. Description Quantity Unit Price Discount Amount
(Rs.)
1 Book - 40 pages 200 65 5% 12,350
2 Book - 120 pages 100 90 10% 8,100
Total 20,450
Terms: 1.5%, 10, Net

30
Sales manager’s signature: Customer’ signature: …………………………
……………………………
CHAPTER 3 Page 59
Date Invoice No. Transaction
01.04 2001 Sold goods for Rs. 160,000 on credit to Hashi

05.04 2002 Sold goods for Rs. 180,000 on credit to Iranga
10.04 2003 Sold goods for Rs. 240,000 on credit to Jagath
20.04 2004 Sold goods for Rs. 110,000 on credit to Kavindu
28.04 2005 Sold goods for Rs. 210,000 on credit to Lashen
30.04 2006 Sold goods for Rs. 260,000 on credit to Madhawi
31.04 2007 Sold goods for Rs. 160,000 on credit to Nimsara
The above transactions are recorded in the sales journal (sales journal) and relevant
ledgeraccounts as follows.
Sales Journal
01.04 2001 Hashi 160,000
05.04 2002 Iranga 180,000
10.04 2003 Jagath 240,000
20.04 2004 Kavindu 110,000
28.04 2005 Lashen 210,000
30.04 2006 Madhawi 260,000
31.04 2007 Nimsara 160,000
1,320,000
Debtors Control Account
1,320,000
Sales Account
Debtors
Control
CHAPTER 3 Page 60
Return Outwards Journal
The return outwards journal is also named as return outwards journal, or the
purchasereturn journal (purchase return journal). This is the prime entry book used
to record all return of credit purchases made by the business in their ordinary course of
business. The data gathered from the source documents, namely the debit note is used to
prepare the return outwards journal. The total of the return outwards journal is credited
to the return outwardsaccount by debiting the creditors control account. The return
outwards account represents the decrease in purchase expenses.
A simple structure of a return outwards journal is given below.
Date Debit Note No. Description Amount
The format of a debit note may be different from business to business. However, a typical
debit note is depicted below.
Debit Note
Date: 03/03/202X
No.: DN01
Purchase Invoice No.: S1001
Supplier: Shine Enterprises, No. 36, Kaluthara

Discount
applied in the Amount
No. Description Quantity Unit Price purchase (Rs.)
1 Return Books (40 pages) 10 50 10% 450
Total 450
Reason: Damaged Goods
Prepared by:…………………………… Approved by:…………………………

CHAPTER 3 Page 61
Date Debit Note No. Transaction

02.04 101 Return of purchase of Rs. 70,000 to Akash.
06.04 102 Return of purchase of Rs. 75,000 to Binuka.
21.04 103 Return of purchase of Rs. 60,000 to Dhara.
29.04 104 Return of purchase of Rs. 75,000 to Eshan.
31.01 105 Return of purchase of Rs. 80,000 to Farhan.
The above transactions are recorded in the return outwards journal (return outwards
journal) and relevant ledger accounts as follows.
Date Debit Note No. Description Amount

02.04 101 Akash 70,000
06.04 102 Binuka 75,000
21.04 103 Dhara 60,000
29.04 104 Eshan 75,000
31.04 105 Farhan 80,000
360,000

Return of purchase Balance B/F
Return Outwards Account

Creditors Control 360,000
CHAPTER 3 Page 62
Return Inwards Journal
The return inwards journal is also named the return inwards journal, or the return of
salesjournal (return of sales journal). This is the prime entry book used to record all
returns of credit sales made by the business in their ordinary course of business. The data
gathered from the source documents namely the credit note is used to prepare the sales
return journal. The total of the sales return journal is credited to the debtors control
account by debiting the salesreturn account.
The simple structure of a sales return journal is given below.
Sales Return Journal
Date Credit Note No. Description Amount
The format of a credit note may be different from a business to business. However, a typical
credit note is depicted below.
Credit Note
Date: 13/03/202X
No.: CN001
Sales Invoice No.: 50
Customer: Anuruddha
Discount
applied
Unit in the
No. Description Quantity Price sale Amount (Rs.)
Return Books (120
1 pages) 20 90 10% 1,620
Total 1,620
Reason: Damaged
Goods
Prepared
by:…………………………… Approved by:…………………………
CHAPTER 3 Page 63
Date Credit Note No. Transaction

02.04 201 Return of sales of Rs. 70,000 by Hashi.
06.04 202 Return of sales of Rs. 65,000 by Iranga.
11.04 203 Return of sales of Rs. 80,000 by Jagath.
21.04 204 Return of sales of Rs. 60,000 by Kavindu.
29.04 205 Return of sales of Rs. 70,000 by Lashen.
The above transactions are recorded in the sales return journal (sales return journal) and
relevant ledger accounts as follows.
Returns Inward Journal
Date Credit note No. Description Amount

02.04 201 Hashi 70,000
06.04 202 Iranga 65,000
11.04 203 Jagath 80,000
21.04 204 Kavindu 60,000
29.04 205 Lashen 70,000
345,000
Return Inward Account
Debtors Control

Balance B/F XXX Return of Sales 345,000
CHAPTER 3 Page 64
Receipts Journal
This is the prime entry book used to record all cash receipts. The data gathered from the
source documents namely receipts are used to prepare the receipt journal. Based on the
types of receipts that are recurring in the business, different analysis columns are used
in the receipt journal. The following is a simple structure of a receipt journal.
Date Receipt No. Description Amount Analysis
Cash Collectionfrom
Other
sales Debtors
Following cash transactions took place in the Saman Traders during April 2023.
Date Receipt No. Transaction
01.04 R 001 Sold goods for Rs. 250,000.
05.04 R 002 Sold goods for Rs. 170,000
10.04 R 003 Collected Rs. 200,000 from the debtor - Akash
20.04 R 004 Sold goods for Rs. 150,000.
28.04 R 005 Collected Rs. 160,000 from debtor - Binuka
30.04 R 006 Collected Rs. 210,000 from debtor - Chandana
31.04 R 007 Received rent income of Rs. 70,000.
The above transactions are recorded in the receipt journal (receipt journal) and relevant
ledger accounts as follows.
Receipts Journal
Date Rec. No. Description Amount Analysis
Cash Sales Collection Other
from Debtors
01.04 001 Sales 250,000 250,000
05.04 002 Sales 170,000 170,000
10.04 003 Akash 200,000 200,000
20.04 R.004 Sales 150,000 150,000
28.04 R.005 Binuka 160,000 160,000
30.04 R.006 Chandana 210,000 210,000
31.04 R.007 Rent 70,000 70,000
1,210,000 570,000 570,000 70,000
CHAPTER 3 Page 65
Cash Account
570,000
570,000
Sales Account

Balance B/F XXX 2) Cash 570,000
Rent Income Account
Payments Journal
This is the prime entry book used to record all cash payments except petty cash
payments if the business uses a separate petty cash payment journal to record petty cash
transactions. The data gathered from the source documents, namely payment vouchers
is used to prepare the payment journal. Based on the types of payments that are
recurring in the business, different analysis columns are used inthe payment journal. The
following is a simple structure of a payment journal.
Date PV No. Description Amount Analysis

Cash Payments to
purchases creditors Other
CHAPTER 3 Page 66
Following cash transactions took place in the Saman Traders during April 2023.
Date Payment Transaction

Voucher No.
01.04 PV 001 Purchased goods for Rs. 350,000

10.04 PV 003 Paid Rs. 150,000 to the creditor - Hashi
28.04 PV 005 Paid Rs. 200,000 to creditor - Sanga
30.04 PV 006 Paid Rs. 250,000 to the creditor - Upul
31.04 PV 007 Paid rent expense of Rs. 80,000
The above transactions are recorded in the payments journal (payments journal) and in
therelevant ledger accounts as follows.
Payments Journal
PV
Date Description Amount Analysis
No.
Cash Payments to
Other
Payments Creditors
01.04 001 Purchases 350,000 350,000
05.04 002 Purchases 270,000 270,000
10.04 003 Creditors 170,000 170,000
20.04 004 Purchases 230,000 230,000
28.04 005 Creditors 200,000 200,000
30.04 006 Creditors 250,000 250,000
31.04 007 Rent exp 80,000 80,000
1,550,000 850,000 620,000 80,000
Ledger accounts are updated using the double entry system using the totals of the
analysis columns. Data in the other column have to be accounted for transaction by
transaction.
CHAPTER 3 Page 67
Cash Account
Balance XXX 1) Purchases 850,000
2) Creditors 620,000
3) Rent Exp 80,000
Purchase Account
1) Cash 850,000
2) Cash 620,000
Rent Expense Account

3) Cash 80,000
Petty Cash Payment Journal

The petty cash payment journal is a prime entry book used to record petty cash
payments when the business entity maintains a ‘Petty Cash Imprest System”.
Under a petty cash imprest system a separate employee named ‘Petty Cashier’ is
appointed by the business to handle petty cash payments. The petty cashier is given an
amount sufficient to make petty cash payments for an agreed period (Generally for a
month). This amount is named ‘Petty Cash Imprest’. Then the petty cashier makes all
petty cash paymentsout of the petty cash imprest. At the beginning of the next period
(month), the amount spentby the petty cashier is reimbursed. Thus, at the beginning of
each period, thepetty cashier will have an amount equal to the petty cash imprest.
The following is a simple structure of a petty cash payment journal.

CHAPTER 3 Page 68
Analysis
PCV Number
Description
Refreshment
Stationary
Traveling
Amount
Receipt
Other
Date
s
Saranga Traders maintain petty cash imprest of Rs. 5,000 for the monthly petty cash
payments. On 1st April 2023, the petty cashier received Rs. 5 000 as petty cash imprest
fromthe main cashier. The below petty cash transactions took place during April 2023.
Date PCV No. Transaction

02/04 001 Payment for traveling Rs. 550
05/04 002 Payment for Refreshment expenses Rs. 500
10/04 003 Payment for stationary expenses Rs. 400
12/04 004 Payment for refreshments Rs. 700
18/04 005 Settlement of electricity bill Rs. 1,250
20/04 006 Payments for stationery Rs. 450
22/04 007 Payment for traveling Rs. 300
25/04 008 Payment for refreshments Rs. 600
01/04 Reimbursement of petty cash imprest by the main
cashier.
Required: Prepare the petty cash payment journal for the month of April 2023.
Descripti PCV Paymen Analysis Columns

Receipt Date
on No. t (Rs.) Refreshments Traveling Stationary Other
6,000 01.04 Cash
02.04 Traveling 001 550 550
05.04 Refreshm 002 500 500
ents
10.04 Stationary 003 400 400
12.04 Refreshm 004 700 700
ents
18.04 Electricity 005 1,250 1,250
20.04 Stationary 006 450 450
CHAPTER 3 Page 59
22.04 Traveling 007 300 300

25.04 Refreshm 008 600 600
ents
4,750 1,800 850 850 1,250
Balance 1,250
C/F
6,000 6,000
1,250 Balance
C/F
4,750 01.05 Cash
General Journal
A general journal is the prime entry book used to record transactions that are not allowed
to recordin any specific journal such as receipts journal, payments journal, sales journal,
purchase journal, return inwards journal, return outwards journal. The data gathered
from the source document namely ‘Journal voucher’ (JV) is used to record transactions
in the general journal. It simply mentions the two accounts, which is debit and credit
entries that should be made with the amount.
Since different types of transactions are recorded in the general journal, a description of
transactions namely ‘Narration’ is made after recording each transaction in the general
journal.
Recording the transactions in the general journal is named as ‘making journal entries’A
structure of a general journal is given below.
General Journal
Date JV No. Description Debit Credit
The structure of a journal voucher can vary depending on the specific business's
requirements. Nonetheless, a common representation of a journal voucher is provided
below.
CHAPTER 3 Page 60
Journal Voucher
Date: 31/03/202X
No.: JE010
Description Dr (Rs) Cr (Rs)
Water expense account 25,000
Cash account 25,000
Narration: Being corrected the water expense of the

month.
Prepared Approved by:…………………………

by:……………………………
Transactions recorded in the general journal.
The following are the transactions recorded in the general journal.
i. Closing entries
ii. Opening entries
iii. Correction of errors
iv. Adjusting entries
v. Posting entries
vi. Purchase or sale of fixed assets on credit basis
vii. Any other transactions not recorded in other prime entry books.
The following information is relevant to transactions that occurred in Akash Traders

during April2023.
Date JV No. Transaction
01.04 JV 001 Purchase of office furniture amounting to Rs. 150,000 on credit

from Muditha Traders for theuse of the business.
05.04 JV 002 Rectify the error of recording a credit sale of Rs. 225,000 as Rs.
25,000 in the sales journal.
The owner invested in a building valued at Rs. 2,000,000 in the
10.05 JV 003
business entity.
CHAPTER 3 Page 61
General Journal
Date JV No. Description Debit Credit
01.04 001 Office furniture 150,000

Other Creditors - Muditha Traders 150,000
(Being a record of the purchase of
office furniture on credit)
05.04 002 Debtors Control 200,000
Sales 200,000
(Being correction of the error of
recording Rs. 225,000 credit sales as
Rs. 200,000)
10.014 003 Land 2,000,000
Capital 2,000,000
(Being a record of the investment of a
building owned by the owner as the
capitalof the business)
The balances provided below were obtained from Good Earth (Pvt) Ltd as of April 1, 202X.
Account Balance (Rs.)

Inventory 80,000
Debtors control 112,000
Petty cash 1,500
Cash 76,000
Office Equipment 800,000
Creditors control 289,500
Bank loan 150,000
Capital 630,000
The transactions listed below occurred during the month of April 202X.
Date Source Transaction

Document
No.
04/01 80 Petty cash imprest amounting to Rs. 8,500 was reimbursed.
04/02 20 Inventory was sold on a cash basis for Rs. 21,600.
04/04 21 Lahini, a trade debtor, made a payment of Rs. 19,800,
which includes a deduction of Rs. 200 as a discount.
04/06 P18 Inventory was purchased from Nayanajith on a credit basis
for Rs. 54,000.
04/08 22 A sales commission of Rs. 8,000 was received.
04/09 81 Some office equipment was purchased for Rs. 30,000.
CHAPTER 3 Page 62
04/10 82 Rakesh, a trade creditor, was paid Rs. 27,000, which

includes a deduction of Rs. 3,000 as a discount.
04/10 23 Inventory was sold on a cash basis for Rs. 6,480.
04/11 S26 Inventory was sold to Mohan on a credit basis for Rs.
38,880.
04/14 24 Mohan, a trade debtor, made a payment of Rs. 38,000, with
a deduction of Rs. 2,000 as a discount.
04/16 83 Inventory was purchased for Rs. 27,000 on a cash basis.
04/17 84 An electricity payment of Rs.12,000 was made.
04/19 SR11 A sales return of Rs. 7,560 was received from Mohan.
04/20 85 A water bill of Rs. 8,000 was paid.
04/23 86 Nayanajith, a trade creditor, was paid Rs. 13,500, with a
deduction of Rs. 1,500 as a discount.
04/25 JE12 Office equipment was purchased from Worthy PLC on a
credit basis for Rs. 40,000.
04/25 P19 Inventory was purchased from Asani on a credit basis for
Rs. 30,780.
04/26 PR11 A purchase return to Asisri amounted to Rs. 4,320.
04/27 S27 Inventory was sold to Lahini on a credit basis for Rs.
48,600.
04/28 P20 Inventory was purchased from Khan on a credit basis for
Rs. 58,320.
04/29 PR12 A purchase return to Khan amounted to Rs. 8,640.
04/29 SR12 A sales return from Lahini amounted to Rs. 10,800.
04/30 87 A loan instalment of Rs. 15,000 was paid, which included
an interest payment of Rs. 8,000.
04/30 JE13 A balance of Rs. 5,000 from Arundathi, a trade debtor, was
written off as bad debts.
04/30 The following petty cash vouchers were recorded:
- Voucher No. 12: Travelling expenses - Rs 1,600
- Voucher No. 13: Refreshments - Rs 2,400
- Voucher No. 14: Postages - Rs 1,100
- Voucher No. 15: Carriage inwards - Rs 2,550
- Voucher No. 16: Payment to Rakesh (Creditor) - Rs
2,000
Required:
i. Record the transactions mentioned above in the appropriate prime entry books.
ii. Prepare general ledger accounts for the month of April 202X.
iii. Prepare the trial balance as at 30th April 202X.
CHAPTER 3 Page 63
Cash Receipt Journal
Discoun Analysis columns

Receip Descriptio
Date t Receipt Other
t No. n Sales Debtors
Allowed income
04/0
2 20 Sales 21,600 21,600
04/0
4 21 Lahini 200 19,800 19,800
04/0 Sales
8 22 commission 8,000 8,000
04/1
0 23 Sales 6,480 6,480
04/1
4 29 Mohan 2 000 38,000 38,000
Total 2,400 93,880 28,080 57,800 8,000
Cash Payment Journal
Discou Analysis columns

Payme
Descripti nt Payme Other Other
Date nt V. Purchas Credito
on Receiv nt Expens Paymen
No. es rs
ed es ts
04/0 8,500
1 80 Petty cash 8,500
04/0 30,000
9 81 Machine 30,000
04/1
0 82 Rakesh 3,000 27,000 27,000
04/1
6 83 Purchase 27,000 27,000
04/1
7 84 Electricity 12,000 12,000
CHAPTER 3 Page 64
04/2
0 85 Water 8,000 8,000
04/2
3 86 Nayanajith 1,500 13,500 13,500
04/3 7,000
0 87 Loan rep. 15,000 8,000
141,00 45,500
Total 4,500 0 27,000 40,500 28,000
Purchase Journal
04/06 P18 Noyomi 54,000
04/25 P19 Asani 30,780
04/28 P20 Khan 58,320
Total 143,100
Sales Journal

04/11 S26 Mohan 38,880
04/27 S27 Lahini 48,600
Total 87,480
Return Outward Journal
04/26 PR11 Asani 4,320
04/29 PR12 Khan 8,640
Total 12,960
CHAPTER 3 Page 65
Return Inward Journal
04/19 SR11 Mohan 7,560
04/29 SR12 Lahini 10,800
Total 18,360
Analysis columns
Payme
Descriptio Payme Other
Date nt V. Travelli Refreshme Postag
n nt Paymen
No. ng nts es
ts
04/3
0 12 Travelling 1,600 1,600
04/3 Refreshme
0 13 nts 2,400 2,400
04/3
0 14 Postages 1,100 1,100
04/3 Carriage
0 15 inward 2,550 2,550
04/3
0 16 Rakesh 2,000 2,000
Total 9,650 1,600 2,400 1,100 4,550

CHAPTER 3 Page 66
General Journal
Journal
Date Description De (Rs.) Cr (Rs.)
V. No.
Inventory 80,000
Cash 76,000
Petty cash 1,500

04/01 JE11
Creditors control
Capital 289,500
Bank loan 630,000
(Being recorded the opening balances of assets, 150,000

liabilities and equity accounts as at 01.04.2019)
04/25 JE12 Machine 40,000
Worthy PLC 40,000
(Being recorded the machine purchased on credit

basis)
04/30 JE13 Impairment loss 5,000
(Being recorded the bad debt of Arundathi)
General ledger
Office Equipment Account

04.01 B/B/F 800,000
04.25 XYZ company 40,000
04.30 Cash 30,000 04.30 B/C/D 370,000
370,000
05.01 B/B/F 370,000 370,000

CHAPTER 3 Page 67
Inventory Account
04.01 B/B/F 80,000

04.30 B/C/D 80,000
80,000 80,000
05.01 B/B/F 80 000
04.01 B/B/F 112,000 04.30 Impairment Loss 5,000

04.30 Cash 57 800
04.30 Sales 87,480 04.30 Discount allowed 2,400
04.30 Return inward 18,360
04.30 B/C/D 115,920
199,480 199,480
05.01 B/B/F 115,920
04.01 B/B/F 76,000

04.30 Payments 141,000
04.30 Receipts 93,880
04.30 B/C/D 28,880

169,880 169,880
05.01 B/B/F 31,880
Petty Cash Account
04.01 B/B/F 04.30 Payments 9,650

1,500 Cash
04.30 04.30 B/C/D 350
8,500 10,000 10,000
05.01 B/B/F
350
CHAPTER 3 Page 68

04.30 Discount received 4,500 04.01 B/B/F 289,500
04.30 Cash 40,500 04.30 Purchase 143,100
04.30 Return outward 12,960
04.30 Petty cash 2,000
04.30 B/C/D 372,640
432,600 432,600
05.01 B/B/F 372,640
Capital Account
04.01 B/B/F 630,000
04.30 B/C/D 130,000
130 000 130,000
05.01 B/B/F 130,000
Bank Loan Account

04.30 Cash 7,000 04.01 B/B/F 150,000
04.30 B/C/D 143,000
150 000 150,000
05.01 B/B/F 143,000
XYZ Company Account

04.25 Office Equipment
04.30 B/C/D 40,000 40,000
40,000 40,000
05.01 B/B/F 40,000
Impairment Account
04.30 Debtors control 5,000

04.30 Balance 5,000
5,000 5,000
CHAPTER 3 Page 69
Sales Account
04.30 Cash 28,080
04.30 Balance 115,560 04.30 Debtors control 87,480
115,560 115,560
VAT Control Account
04.30 Cash (purchases) 2,000 04.30 Cash (sales) 2,080
04.30 Creditors control 10,600 04.30 Debtors control 6,480

04.30 Debtors control 1,360 04.30 Creditors control 960
04.30 B/C/D 4 440
13,960 13,960
05.01 B/B/F 4,440
Sales Commission Account

04.30 Cash 8,000
04.30 Balance 8,000
8,000 8,000
Discount Allowed Account
04.30 Debtors control

2,400 04.30 Balance 2,400
2,400 2,400
Purchases account
04.30 Cash 27,000

04.30 Creditors control 04.30 Balance 159,500
143,100 170,100 170,100
CHAPTER 3 Page 70
Electricity account
04.30 Cash 12,000

04.30 Balance 12,000
12,000 12,000
Water account
04.30 Cash 8,000

04.30 Balance 8,000
8,000 8,000
Loan interest account
04.30 Cash 8,000

04.30 Balance 8,000
8,000 8,000
Discount Received Account

04.30 Creditors control 4,500
04.30 Balance 4,500
4,500 4,500
Return Outward Account

04.30 Creditors control 12,960
04.30 Balance 12,960
12,960 12,960
CHAPTER 3 Page 71
Return Inward Account
04.30 Debtors control 18,360

04.30 Balance 18,360
18,360 18,360
Travelling Account

04.30 Balance 1,600
1,600 1,600
Refreshment Account

04.30 Balance 2,400
2,400 2,400
Carriage Inward Account

04.30 Balance 2,550
2,550 2,550
Postage Account

04.30 Balance 1,600
1,600 1,600
CHAPTER 3 Page 72
Trail balance as at 30th April 202X
Account Dr (Rs) Cr (Rs)
Inventory 80,000
Cash 28,880
Petty cash 350
Creditors control 372,640
Capital 630,000
Bank loan 143,000
Worthy PLC 40,000
Impairment loss 5,000
Sales 115,560
Sales commission 8,000
Discount allowed 2,400
Purchase 170,100
Electricity 12,000
Water 8,000
Loan interest 8,000
Discount received 4,500
Return outward 12,960
Return inward 18,360
Traveling 1,600
Refreshment 2,400
Postage 1,100
Carriage inward 2,550
Total 1,326,660 1,326,660

CHAPTER 3 Page 73
Chapter Round-Up
• This chapter discussed the different types of prime entry books used to record
transactions before recording them in the ledger accounts.
• Similar types of transactions can be summarized using the prime entry books to
minimize the number of debit and credit entries made to the ledger accounts.
• Generally, the prime entry books such as sales journal, purchase journal, return
inwards journal, return outwards journal, cash book (receipts journal, payments
journal,), Petty cash payment journal, general journal are used by business
entities.
Question 1
Explain the terms prime entry books and source documents.
Question 2
List seven (7) types of prime entry books and relevant source documents used to
updatethose prime entry books.
Question 3
Following cash transactions were taken place in the Zenith Traders during April 2023.
Date Source Details of the Transaction

Document
No.
01/04 R001 JV 001 Zenith invested Rs. 800,000 as capital
Zenith invested Rs. 150,000 worth of office equipment used at
home forthe business.
02/04 R 002 A loan of Rs. 250,000 was obtained from the people’s Bank
03/04 PV 001 Purchased furniture for Rs. 200,000
04/04 JV 002 Rs.5,000 was given to the petty cashier by the main cashier as
the petty cash imprested.
05/04 PV 002 Purchased goods for Rs. 210,000
06/04 PI 001 Purchased goods on credit from Kumara amounting to Rs.
400,000
CHAPTER 3 Page 74
07/04 DN 001 Returned to kumara goods amounting to Rs. 25,000.

08/04 R 003 Sold goods for Rs. 125,000
09/04 PCV 001 Petty Cashier paid Rs.350 for refreshments
10/04 PV 003 Paid Rs. 100,000 to Kumara.
11/04 PI 002 Purchased goods from Sanga on credit amounting toRs.
150,000.
12/04 SI 001 Sold goods to Upul on credit for Rs. 225,000.
13/04 CN001 Goods returned by Upul amounting to Rs. 15,000.
14/04 R 004 Sold goods for Rs. 250,000.
15/04 R 005 Received Rs. 95,000 from Upul.
16/04 PV 004 Paid Rs. 80,000 payable to Sanga.
17/04 PCV 002 Petty Cashier paid Rs. 600 for traveling.
18/04 PI 003 Purchased goods from Malinga on credit amounting to Rs.
125,000.
19/04 DN002 Goods returned to Malinga amounting to Rs. 10,000.
20/04 PCV 003 Petty Cashier paid Rs. 400 for traveling.
21/04 R 006 Goods sold for Rs. 150,000 in cash.
PV 005 Purchased goods for Rs. 80,000 in cash.
22/04 PCV 004 Petty Cashier paid Rs. 350 for the stationery.
R 007 Received Rs. 25,000 commission income.
23/04 PV 006 Paid Rs. 20,000 rent of the Zenith’s residence place.
24/04 PV 007 Paid Rs. 27,000 to Kumara subject to a 10% discount
25/04 PCV 005 Petty Cashier paid Rs. 500 for refreshments.
26/04 SI 002 Sold goods to Chandana on credit for Rs. 200,000.
27/04 CN 002 Goods returned by Chandana amounting to Rs. 20,000.
28/04 PV 008 Paid Rs. 25,000 for the advertising expenses.
PV 009 Paid the salary expense of the business Rs. 50,000
29/04 PCV 006 Petty Cashier paid Rs. 450 for the stationery.
JV 003 Zenith took stationery costing Rs.12,500 for the personal use of
him
30/04 R 008 Received Rs. 135,000 from Chandana.
JV 004 Electricity bill for the month of Rs. 1,500 was received.
30/04 PCV 007 Petty Cashier paid Rs.1,500 for the electricity bill.
Required:
(I) Record all the above transactions in the prime entry books.
(II) Update the ledger accounts using the prime entry books.
(III) Extract the Trial Balance as at 31st April 2023.
CHAPTER 3 Page 75
Answers
Question1
Prime entry books are prime entry books are books which are used to record transactions
first in the accounting process and source documents are Source documents are the
documents created at the time of a transaction to capture the essential details.
Question 2
Prime Entry Book Source Document

Purchase Journal Invoice
Sales Journal Invoice
Return Outward Journal Debit Note
Return Inwards Journal Credit Note
Cash Receipt Journal Receipts

Cash Payment Journal Payment Voucher
Petty Cash Payment Journal Petty Cash Voucher
General Journal Journal Voucher
CHAPTER 3 Page 76
CHAPTER 4 Page 77
Rectification of Accounting
Errors
Learning Outcomes
• Identify types of accounting errors.

• Apply means of rectifying errors and prepare suspense account.
• Prepare profit alteration statement.
4.1 Introduction
Accounting errors can occur at various stages of the accounting process. These stages
include:
• Recording transactions in the prime entry books.

• Totalling the prime entry books.
• Posting values from the prime entry books to the ledger accounts.
• Balancing the ledger accounts.
• Preparing the trial balance.
It is important to note that certain errors may result in a discrepancy between the total of
the debit column and the total of the credit column in the trial balance, while others may not
cause such a difference.
4.2 Classification of Errors
Accounting errors can be classified into two main categories based on their impact on the
trial balance:
1. Errors that cause the trial balance to be unbalanced: These are errors that result
in a discrepancy between the total of the debit column and the total of the credit
column in the trial balance. Such errors can be identified when the trial balance fails
to reconcile.
CHAPTER 4 Page 78
2. Errors that do not affect the trial balance: These are errors that, despite being
present, do not create a difference between the total debits and credits in the trial
balance. In other words, the trial balance remains balanced even with these errors.
Errors that cause the Trial Balance to be Unbalanced

The following are examples of errors that result in a difference between the totals of the debit
column and credit column in the trial balance:
(a) Recording only one of the double entries: This occurs when only a debit entry or a
credit entry is recorded for a transaction, omitting the corresponding entry on the other
side
Example: A purchase of inventory for Rs. 10,000 is recorded with a debit to the purchases
account but without a corresponding credit entry in the accounts payable account.
(b) Recording one of the double entries by a higher amount than the actual amount:
This error happens when one side of the transaction is recorded accurately, but the other
side is recorded with an incorrect amount, usually higher than the actual value.
Example: A cash receipt of Rs. 5,000 is correctly debited to the cash account but is
erroneously credited to the accounts receivable account as Rs. 50,000.
(c) Recording one of the double entries by a lower amount than the actual amount:
This error occurs when one side of the transaction is recorded accurately, but the other
side is recorded with an incorrect amount, usually lower than the actual value.
Example: A purchase of equipment for Rs. 500,000 is correctly debited to the equipment
account but is erroneously credited to the accounts payable account as Rs. 50,000.
(d) Recording both entries on the same side of two accounts: This error happens when
both entries of a transaction are recorded on the debit side or the credit side of two
different accounts, resulting in an imbalance.
Example: A cash payment of Rs. 8,000 for rent is debited to the rent expense account and
again debited to the cash account.
(e) Errors in balancing the ledger accounts: This occurs when there are errors in totalling
or calculating the account balances, such as overcasting (totalling an account with a
higher amount) or undercasting (totalling an account with a lower amount).
Example: The sales account is overcast by Rs. 2,000 when calculating the total sales for the
period.
By categorizing accounting errors into these two groups, it becomes easier to understand the
potential effects of errors on the accuracy of financial statements and the subsequent steps
required for their rectification.
Omission of taking a balance of a ledger account to the trial balance: This error occurs when
the balance of a ledger account is not included in the trial balance, leading to an imbalance.
CHAPTER 4 Page 79
Errors that do not affect the trial balance
The following are examples of errors that do not create a difference between the totals of the
debit column and credit column in the trial balance:
(a) Omitting to record a transaction in the prime entry book: This error occurs when a
transaction is completely omitted from the accounting records, resulting in its absence
from both the debit and credit sides of the relevant accounts.
Example: A credit sale of Rs. 50,000 is not recorded in the sales journal, leading to the
omission of this transaction from the sales account and the accounts receivable account.
(b) Recording a transaction in the prime entry book by a higher amount than the
actual amount: This error happens when a transaction is recorded in the prime entry
book with an amount that is greater than the actual value.
Example: A credit sale of Rs. 50,000 is erroneously recorded in the sales journal as Rs.60,000,
causing an overstatement of sales and accounts receivable by Rs.10,000.
(c) Recording a transaction in the prime entry book by a lesser amount than the
actual amount: This error occurs when a transaction is recorded in the prime entry
book with an amount that is lower than the actual value.
Example: A credit sale of Rs.50,000 is mistakenly recorded in the sales journal as Rs.5,000,
resulting in an understatement of sales and accounts receivable by Rs.45,000.
(d) Omitting to record a transaction in the ledger accounts: This error involves a
complete omission of recording a transaction in the ledger accounts, resulting in its
exclusion from both the debit and credit sides.
Example: A credit purchase of inventory for Rs.50,000 is not recorded in the purchases ledger
account or the accounts payable ledger account.
(e) Recording a transaction in the ledger accounts with higher or lower values in both
sides: This error occurs when both the debit and credit entries of a transaction are
recorded with amounts that are either higher or lower than their actual values.
Example: A cash payment of Rs. 5,000 for rent is recorded in the rent expense ledger account
with a debit entry of Rs. 6,000 and in the cash ledger account with a credit entry of Rs.4,000.
(f) Recording the accurate values in wrong accounts but in the accurate sides: This
error happens when the correct values of a transaction are recorded on the correct debit
or credit side but in the wrong accounts.
Example: The total of the return of sales journal, amounting to Rs.40,000, is debited to the
return inwards account by crediting the creditors control account instead of crediting the
debtors control account. Although the amounts are accurately recorded on the debit side, the
wrong account is debited, leading to misclassification.
CHAPTER 4 Page 80
(g) Compensating errors: These are errors that offset each other's effects, resulting in a
balanced trial balance, even though both errors individually would cause an imbalance.
Example: An overstatement of Rs.10,000 in the purchases account is compensated by an
understatement of Rs.10,000 in the sales account.
4.3 Suspense Account
When the trial balance prepared at a specific date fails to balance, the discrepancy is
transferred to a temporary account known as the suspense account. This account serves as a
placeholder to capture the difference between the total of the debit column and the total of
the credit column in the trial balance.
If the total of the debit column exceeds the total of the credit column in the trial balance, the
difference is recorded as a credit balance in the suspense account. Conversely, if the total of
the credit column is greater than the total of the debit column, the difference is recorded as
a debit balance in the suspense account. The purpose of the suspense account is to
temporarily hold the unexplained difference until all the accounting errors are identified and
rectified. Once the errors are corrected, the necessary adjustments are made to the
appropriate accounts, and the suspense account's balance is eliminated. Therefore, suspense
account is known as a temporary account. The correction entries will involve debiting or
crediting the suspense account, depending on the nature of the errors.
The ultimate goal is to ensure that the trial balance becomes balanced after the necessary
adjustments have been made, and the suspense account is no longer required in the financial
records.
4.4 Rectification of Accounting Errors
When an error has caused the trial balance to be imbalanced, it implies that the error has
impacted the balance of a single ledger account. Therefore, when rectifying such errors, one
of the double entries is posted to the affected ledger account, while the other entry is posted
to the suspense account.
Conversely, if an error has not affected the agreement of the trial balance, it means that the
error has affected the balances of two ledger accounts. In this case, when rectifying these
errors, the appropriate double entry is posted to the affected ledger accounts, and no part of
the double entry is posted to the suspense account.
It is important to accurately identify the ledger accounts affected by the error and ensure
that the necessary adjustments are made to rectify the discrepancies. By doing so, the trial
balance can be restored to balance, and the integrity of the financial records can be
maintained.
CHAPTER 4 Page 81
Chanya PLC prepared their trial balance as of 31.03.2023, but it did not balance. The total of
the debit column exceeded the total of the credit column by Rs. 66,500. After a thorough
review, the company discovered multiple errors as follows.
1. Office expense of Rs. 10,000 was recorded as a debit to accounts payable account.
2. Credit sales of Rs. 200,000 was completely omitted from the records.
3. A cash payment of Rs. 55,000 to a supplier was debited to the accounts receivable
account.
4. A credit purchase of inventory for Rs. 25,000 was recorded as a debit to the sales account
as Rs. 52,000.
5. A cash receipt of Rs. 75,500 from a customer was not recorded in the accounts receivable
account.
6. A payment of Rs. 35,000 for salaries was recorded as a credit to the salaries expense
account.
7. An equipment purchase of Rs. 120,000 was debited to equipment maintenance account.
8. A supplier's invoice of Rs. 40,000 was completely omitted from purchase journal.
9. A sales return of Rs. 38,500 was recorded in the purchase return journal as Rs. 58,300.
10. Received fixed deposit interest of Rs. 16,000 was debited to interest income account.
11. When balancing bank loan account, credit side was over casted by Rs. 5,000.
12. The closing balance of accrued electricity expense account, Rs. 7,500 was not taken into
trial balance.
Required:
I. Provide journal entries to rectify above errors.

II. Prepare suspense account.
General Journal
Debit Credit
(Rs.) (Rs.)
1. Office expense account 10,000
Accounts payable account 10,000
(Being rectification of the error of recording office
expenses in accounts payable account Rs. 10,000)
2. Accounts receivable account 200,000
Sales 200,000
(Being recording of omitted credit sales of Rs. 200,000)
3. Accounts payable account 55,000
Accounts receivable account 55,000
(Being rectification of the error of recording supplier
payments of Rs. 55,000 in accounts receivables account.)
CHAPTER 4 Page 82
4. Purchase account 25,000

Suspense account 27,000
Sales account 52,000
(Being rectification of error of recording Rs. 25,000
purchases in sales account as Rs. 52,000)
5. Suspense account 75,000
(Being rectification of omission of Rs. 75,000 customer
payment from accounts receivable account)
6. Salary expense account 70,000
(Being rectification of recording Rs. 35,000 salary expenses
in the credit side of the account)
7. Equipment account 120,000
Equipment maintenance account 120,000
(Being rectification of recording equipment purchase of Rs.
120,000 in equipment maintenance account)
8. Purchase account 40,000
(Being recording of omission of purchase invoice of Rs.
40,000)
9. Sales return account 38,500
Purchase return account 58,300
(Being rectifying the error of recording Rs. 38,500 sales
return in purchase return journal as Rs. 58,300)
Interest income account 32,000
(Being rectifying the error of recording Rs. 16,000 interest
income in the debit side of the account)
11. Bank loan account 5,000
(Being rectifying the error of over casting bank loan
account by Rs. 5,000)
(Being rectifying the error of omitting accrued electricity
account balance of Rs. 7,500 from trial balance)
CHAPTER 4 Page 83
Suspense Account
(4) Sales 27,000 Balance 66,500
(5) Accounts receivable 75,000 (6) Salary expense 70,000
(10) Interest income 32,000 (11) Bank loan 5,000
(12) 7,500
141,500 141,500
4.5 Statement of Profit Alteration
When preparing the financial statements, businesses often calculate the draft profit or loss
for a specific period based on the figures obtained from the trial balance. However, it is
important to consider the impact of rectifying accounting errors on the calculated profit.
To adjust the profit for the period after rectifying the errors, a separate statement called the
"Statement of Profit Alteration" can be prepared. This statement outlines the necessary
adjustments to be made to the profit or loss figure.
It should be noted that not all errors will necessarily impact the profit or loss for the period.
Only errors related to income or expenses will affect the calculation of profit or loss. Errors
in other areas (assets, liabilities and equity) may not influence the profit or loss figure.
By rectifying the errors and making appropriate adjustments, businesses can ensure that the
reported profit or loss accurately reflects the financial performance for the period, taking
into account any corrections required.
In the process of preparing the statement of profit alteration, it is important to consider the
impact of errors on the income and expenses of the business. For the purpose of this
illustration (Illustrative Example 4.1), errors numbered (3), (5), (11), and (12) can be
disregarded as they do not affect any income or expense items. Thus, only errors numbered
(1), (2), (4), (6), (7), (8), (9) and (10) will be included in the statement of profit alteration, as
these errors directly influenced the income or expenses of the business.
Assume that the drafted profit of Chanya PLC was Rs. 650,000 for the year ended 31.03.2023.
Therefore, the statement of profit alteration can be prepared as follows.
Statement of Profit Alteration (Rs.)
Drafted profit 650,000

Add
Sales - Unrecorded 200,000
Sales – Erroneously recorded 52,000
Equipment maintenance - Erroneously 120,000
recorded
Interest income - Erroneously debited 32,000 404,000
CHAPTER 4 Page 84
Less
Office expenses - Unrecorded 10,000
Purchases - Unrecorded 25,000
Salary expenses - Erroneously credited 70,000
Purchases – Omitted 40,000
Sales return – Unrecorded 38,500
Purchase return - Erroneously recorded 58,300 (241,800)
Profit after rectification of errors 812,200
Chapter Round-Up
• In this chapter, we explored the process of rectifying accounting errors and the
preparation of a statement of profit alteration. We learned that accounting errors can
occur at different stages of the accounting process and can have various effects on
• First, we discussed the types of errors that can cause the trial balance to be unbalanced.
These errors include omissions, incorrect postings, misclassifications, and errors in
totalling or balancing accounts. Such errors create a difference between the totals of
the debit and credit columns of the trial balance.
• Next, we examined the process of identifying and rectifying accounting errors. We
learned that errors need to be corrected by making appropriate double entries. By
rectifying the errors, the trial balance can be adjusted to accurately reflect the financial
position of the business.
• Furthermore, we discussed the concept of a statement of profit alteration. This
statement is prepared to account for the impact of rectifying errors on the profit or loss
for the period. We noted that only errors affecting income or expense items will have
an impact on the profit calculation. Errors related to assets, liabilities, or other non-
income/non-expense items will not affect the profit figure.
• Understanding the process of rectifying accounting errors and preparing a statement
of profit alteration is crucial for maintaining accurate financial records and ensuring
the reliability of financial statements. By correctly identifying and rectifying errors,
businesses can present a true and fair view of their financial performance and make
informed decisions based on accurate information.
CHAPTER 4 Page 85
Question 1
ABC PLC recorded a cash payment of Rs. 50,000 to a supplier as a debit entry to the Rent
Expense account. How would this error affect the profit for the period?
a) The profit will be higher by Rs. 50,000.
b) The profit will be lower by Rs. 50,000.
c) The profit will not be affected.
d) The profit cannot be determined without additional information.
Question 2
XYZ PLC mistakenly recorded a sales transaction of Rs. 150,000 as a debit entry in the sales
account. How would this error affect the trial balance?
a) The debit column of the trial balance will be higher by Rs. 150,000.
b) The credit column of the trial balance will be higher by Rs. 150,000.
c) The debit column of the trial balance will be higher by Rs. 300,000.
d) The credit column of the trial balance will be higher by Rs. 300,000.
Question 3
PQR PLC mistakenly recorded a equipment repair expense of Rs. 5,000 as a capital
expenditure. How would this error affect the statement of financial position and net income?
a) Total assets will be higher by Rs. 5,000, and net income will be lower by Rs. 5,000.
b) Total assets will be higher by Rs. 5,000, and net income will be higher by Rs. 5,000.
c) Total assets will be lower by Rs. 5,000, and net income will not be affected.
d) Total assets will be lower by Rs. 5,000, and net income will be lower by Rs. 5,000.
Question 4
Shenya is a whole seller. Both sides of the trial balance of his business prepared as at
31.01.2023 was equal. On subsequent examination, the following errors were detected.
• A debit note of Rs.15,000 has been omitted from the books.
• Purchase of stationery of Rs.27,000 has been recorded in relevant accounts as
Rs.7,000
• Motor vehicles repair expenses of Rs.50,000 has been recorded in the motor vehicles
account.
• Credit sales of Rs.25,000 has been recorded twice in relevant accounts.
• Electricity expenses of Rs.27,000 has been recorded in the sundry expenses account.
CHAPTER 4 Page 86
Required: General journal entries to rectify the above errors.
Question 5
Following errors were detected on the examination of the books of Devaka’s Business.
Prepare the journal entries to rectify the errors identified by the business.
• A purchase invoice of Rs. 40,000 has been omitted from the books.
• The bank loan account under-cast by Rs. 10,000.
• Sales returns Rs.14,00 have been recorded in the purchases returns account.
• Motor vehicles repair expenses of Rs. 35,000 has been recorded in the motor vehicles
account.
• Rs. 75,000 of furniture account balance has not been recorded in the trial balance.
Required: Prepare suspense account.

CHAPTER 4 Page 87
Answers
Question 1 b
Question 2 c
Question 3 b
Question 4
General Journal
Debit Credit
(Rs.) (Rs.)
Trade payable account 15,000
Purchase return account 15,000
(Being rectification of the omission of debit note of. Rs.
15000)
Stationary account 20,000
Cash 20,000
(Being rectification of recording of stationary purchase of
Rs. 27,000 as Rs. 7,000)
MV repair expense account 50,000
MV account 50,000
(Being rectification of the error of recording Rs. 50,000 of
Motor vehicle repair expenses in the motor vehicle
account)
Trade receivables account 25,000
(Being rectification of error of recording Rs. 25,000 sales
twice in the accounts)
Electricity expense account 27,000
Sundry expenses account 27,000
(Being rectification of the error of recording Rs. 27,000
electricity expenses in sundry expenses account)
CHAPTER 4 Page 88
Question 5
Suspense Account
Balance 93,000 Sales return 14,000

Bank loan 10,000 Purchase return 14,000
75,000
103,000 103,000
CHAPTER 5 Page 89
Preparation of Bank
Reconciliation Statements
Learning Outcomes
• Explain the purpose of preparation of bank reconciliation statement.

• Identify the reasons for the difference between the cash book balance and the
balance as per the bank statement.
• Adjust cash book.
• Prepare bank reconciliation statement.
5.1 Introduction
Many businesses maintain bank current accounts as a means to facilitate their operational
activities. One of the primary benefits of having a bank current account is the convenience it
provides for making payments through cheques. Businesses prefer cheque payments as they
help mitigate the risks associated with handling cash. Additionally, having a current account
offers various other advantages, such as accessing bank overdraft facilities and making
standing order payments, which contribute to the smooth functioning of business
operations.
5.2 Recording of Bank Transactions by the Business and Bank
When cash or cheques are deposited into a bank current account, it represents an increase
in assets (bank balance) from the perspective of the business. Therefore, the business debits
its bank account to record the deposit. However, from the bank's perspective, these deposits
create a liability (an amount payable by the bank to the business). Consequently, the bank
credits the business's account to reflect the deposit.
Conversely, when payments are made from the current account, it leads to a decrease in
assets from the business's point of view. Consequently, the business credits its bank account
to record the payment. However, from the bank's perspective, these payments result in a
decrease in liabilities. Therefore, the bank debits the business's account to acknowledge the
payment.
CHAPTER 5 Page 90
Hence, transactions related to the current account are recorded in opposite ways by the
business entity and the bank. Values that are debited to the bank account by the business are
credited to the business's account by the bank, and vice versa.
Illustrative Examples 5.1

Following bank related transactions occurred in Manthila’s Business for February 2023.
01.02 Deposited Rs.150,000 and opened a bank current account.
05.02 Received a cheque (CN 550215) from a customer for Rs.25,000 and deposited it into
the bank current account.
10.02 Issue a cheque (LQ 200105) for Rs.50,000 to pay suppliers.
15.02 Issue a cheque (LQ 200106) for Rs.80,000 to pay rent for the premises.
20.02 Received Rs.10,000 in cash and deposited it into the bank current account.
22.02 Wrote a cheque (LQ 200107) for Rs.15,000 to pay for advertising expenses.
25.02 Received a cheque (LH 483649) from a client for rs.35,000 and deposited it into the
bank current account.
Bank account of the business for the month of February 2023 is as follows:
Bank Account
Amount Amount
Date Description (Rs.) Date Description (Rs.)
01 -Feb Cash 150,000 10-Feb Trade payables (LQ 50,000

200105)
05- Feb Trade 25,000 15-Feb Trade payables (LQ 80,000
receivables (CN 200106)
550215)
20-Feb Cash 10,000 22-Feb Advertising expense (LQ 15,000
200107)
25-Feb Trade 35,000
receivables (LH
483649)
27- Balance C/F 75,000
Feb
220,000 220,000
01-Mar Balance B/F 75,000
The bank records the above transactions in the business's account (Manthila's Account) as
follows:
CHAPTER 5 Page 91
Manthila Account
Amount Amount
10-Feb Chq.Pay. (LQ 50,000 01-Feb Cash Deposit 150,000

200105)
15-Feb Chq.Pay. (LQ 80,000 05-Feb Cheque Deposit 25,000
200106)
22-Feb Chq.Pay. (LQ 15,000 20-Feb Cash Deposit 10,000
200107)
25-Feb Cheque Deposit 35,000
27-Feb Balance C/D 75,000

220,000 220,000
27-Feb Balance B/F 75,000
If all the transactions are recorded accurately and without any accounting errors, the balance
as per the accounting records of the business entity and the bank should be equal but with
opposite balances. For example, if the bank account of the business entity has a debit balance
of Rs.75,000, the business's account at the bank should have a corresponding credit balance
of Rs.75,000. This ensures that the total amount of funds reflected in the bank account and
the business's account are consistent and reconcilable.
5.3 Bank Statement
The bank statement is a periodic statement, typically sent on a monthly basis, which provides
a record of all debit and credit entries made to the current account by the bank. It also
includes the balance of the account after each transaction. In the case of above illustration,
the bank statement can be prepared as follows:
Bank Statement of Saman Traders-February 2023

Debit
Date Description Credit (Rs.) Balance (Rs.)
(Rs.)
01-Feb Deposit-Cash - 150,000 150,000
05-Feb Deposit-Cheque (CN 550215) - 25,000 175,000
10-Feb Payment-Cheque (LQ 200105) 50,000 - 125,000
20-Feb Deposit-Cash - 10,000 55,000
25-Feb Deposit-Cheque (LH 483649) - 35,000 75,000
27-Feb Balance - - 75,000
CHAPTER 5 Page 92
However, due to a number of practical reasons, the bank current account balance as per
accounting records of the business entity and the bank will be different to each other.
5.4 Reasons for Differences Between Bank Balance as Per Accounting Record of the
Business and Bank Statement
1. Timing Differences
Transactions may be recorded in the accounting records of the business entity on a different
date than when they are processed by the bank. This can result in discrepancies in the
account balances until the transactions are fully reflected in both records.
• Cheques issued but not presented to bank yet (Un-presented Cheques)
Cheques issued by the business but not yet presented to the bank for processing are known
as un-presented cheques. These cheques have been recorded in the accounting records of the
business entity but have not yet been reflected in the bank statement. As a result, the bank
balance as per the accounting records of the business will be higher than the balance shown
in the bank statement.
• Cheques deposited but not realized yet (Unrealized cheques)

Cheques deposited by the business entity but not yet cleared and credited to the bank
account are referred to as unrealized cheques. These cheques have been recorded in the
accounting records of the business entity as deposits, but they have not yet been reflected in
the bank statement. As a result, the bank balance as per the accounting records of the
business will be lower than the balance shown in the bank statement.
Banks typically require some time to process and verify cheques deposited by customers.
This processing time can vary depending on the bank's internal procedures, the type of
cheque, and other factors. During this processing period, the cheques are considered
unrealized, and their amounts are not immediately credited to the bank account.
Further, banks follow a clearing system to process cheques and ensure their validity and
availability of funds. This system involves the exchange of cheques among different banks for
verification and settlement. Until the cheque is successfully cleared through this process, it
remains unrealized and does not impact the bank balance as per the bank statement.
2. Omissions from Accounting Records of the Business Entity
• Payments made under standing orders.

A business entity may set up standing orders with the bank to authorize regular payments
for expenses such as insurance, rent and other recurring payments. These standing orders
allow the bank to deduct the specified amounts from the business's current account on a
predetermined schedule. Until the business receives the bank statement, it may not be aware
of these deductions and may not have recorded them in its accounting records.
CHAPTER 5 Page 93
• Direct remittances
When a business has debtors who choose to settle their debts by directly depositing money
or transferring funds to the business's bank current account instead of making payments at
the business premises, it can lead to differences between the balances as per the accounting
records of the business and the bank statement.
In such cases, when the debtor makes a direct deposit or transfer, the bank will credit the
amount to the business entity's current account. However, the business may not have
recorded these deposits until it receives the bank statement.
As a result, there will be a discrepancy between the balances as per the accounting records
of the business and the bank statement. The bank statement will reflect the additional funds
deposited by the debtors, while the business's accounting records may not have included
these deposits until the bank statement is received and reconciled.
• Credits made by the bank to current account

In certain instances, the bank may credit interest on fixed deposits, dividend income, or other
types of income to the current account of the business during a given period. However, the
business entity might not have recorded these receipts until the bank statement is received.
As a result, there can be a discrepancy between the balances as per the accounting records
of the business and the bank statements.
When the bank credits interest on fixed deposits or dividend income to the business's current
account, it increases the balance in the account. However, if the business has not yet recorded
these receipts, the accounting records will not reflect the increased balance until the bank
statement is reconciled.
• Deductions made by the bank from the current account

In certain cases, the bank may deduct charges such as bank fees, cheque book charges,
overdraft interest, and other expenses from the bank's current account during a specific
period. However, these deductions may not be recorded in the accounting records of the
business until the bank statement is received. As a result, there can be a discrepancy between
the balances as per the accounting records of the business and the bank statements.
When the bank deducts charges from the business's current account, it decreases the balance
in the account. However, if the business has not yet recorded these deductions, the
accounting records will not reflect the decreased balance until the bank statement is
reconciled.
• Dishonoured cheques
A dishonoured cheque is a cheque that has been issued or received by the business entity,
but the bank refuses to honour the payment due to insufficient funds in the account or other
reasons. Dishonoured cheques can occur in two scenarios: when the business entity has
issued a cheque that gets dishonoured or when the business entity has received a cheque
that gets dishonoured.
CHAPTER 5 Page 94
• Issued Dishonoured Cheques

When the business entity issues a cheque to make a payment to a recipient, such as a supplier
or vendor, the cheque may get dishonoured by the bank for various reasons, such as
insufficient funds in the business's current account. This dishonouring of the cheque creates
a discrepancy between the balances as per the accounting records of the business and the
bank statements.
• Received Dishonoured Cheques

Sometimes, the business entity receives a cheque from a customer or client, but the cheque
gets dishonoured by the bank when it is deposited or presented for clearing. This situation
also leads to a difference between the balances as per the accounting records of the business
and the bank statement.
3. Errors Made in the Accounting Records of the Business
Accounting errors can occur within a business entity's bank transactions, resulting in
discrepancies between the balances recorded in the accounting records of the business and
the bank statements. These errors can arise due to various factors, including data entry
inaccuracies, incorrect transaction recording, or the omission of certain transactions.
4. Errors Made by the Bank

In rare instances, the bank itself may make erroneous debit or credit entries in the business
account, leading to discrepancies between the balances recorded in the accounting records
of the business and the bank statement. These errors can occur due to various reasons, such
as system glitches, processing mistakes, or human errors within the bank's operations.
5.5 Bank Reconciliation Statement
The bank reconciliation statement is a crucial tool used by a business entity to reconcile the
balance recorded in its bank account with the balance provided in the bank statement. This
statement helps identify and rectify any discrepancies between the two balances. The
process of preparing a bank reconciliation statement typically involves the following steps:
Comparing Bank Account and Bank Statement: The first step is to carefully compare the
transactions recorded in the business's bank account with the transactions listed in the bank
statement. This helps identify any differences between the two balances.
Identifying Differences and Reasons: After comparing the bank account and bank statement,
the next step is to analyse and identify the reasons for the differences. This includes
considering factors such as unrecorded transactions, timing differences, bank errors, and any
other discrepancies.
Adjusting the Bank Account: Once the differences and reasons are identified, adjustments are
made to the bank account of the business. This involves recording any unrecorded items
(Omissions) and rectifying any errors that have occurred in the accounting records of the
business.
CHAPTER 5 Page 95
Preparation of Bank Reconciliation Statement: The final step is to reconcile the corrected
bank account balance of the business with the balance as per the bank statement. This
ensures that the two balances are in agreement, accounting for any previously identified
differences and adjustments. In the process of preparation of bank reconciliation statement,
timing differences and errors made by the bank should be taken into consideration.

The bank current account balance of Nimthera Limited as at 31.03.2023 was Rs.495, 000.
This balance agreed with the balance as per bank statement, which was Rs.720,000. Bank
account of the business for the month of March 2023 is given below.
Bank Account
Amount Amount
01 -Mar Balance B/F 370,000 01 -Mar Trade payables 175,000

(200100)
09 -Mar Trade receivables 300,000 07 -Mar Electricity expense 5,000
(458369) (200101)
17 -Mar Cash 185,000 13 -Mar Trade payables 130,000
(200102)
20 -Mar Trade receivables 100,000 18 -Mar Equipment (200103) 210,000
(891654)
26-Mar Rent income 45,000 28-Mar Trade payables 150,000
(354715) (200104)
30-Mar Trade receivables 165,000
(160246)
31 -Mar Balance C/D 495,000
1165,000 1165,000
The bank statement sent by the bank at end of March 2023 is as follows.
Bank Statement of Nimthera Limited – March 2023

Date Description Debit ( Rs.) Credit(Rs.) Balance(Rs.)
01/03 Balance B/F - - 370,000
09/03 Cheque payment – 200101 15,000 - 355,000
13/03 Cheque deposit – 458369 300,000 655,000
14/03 Cheque payment – 200102 130,000 - 525,000
16/03 Direct remittance (Ref. 658142) - 190,000 715,000
17/03 Cash deposit - 185,000 900,000
23/03 Cheque deposit – 891654 - 100,000 1,000,000
26/03 Cheque payment – 200103 210,000 - 790,000
28/03 Smart Life Insurance (Ref. 742016) 65,000 - 725,000
CHAPTER 5 Page 96
30/03 Cheque book charges 5,000 - 720,000

31/03 Balance C/D - - 720,000
This reveals a difference between the balance of the bank current account as per the
business's accounting records (Rs. 495,000) and the balance as per the bank statement as of
31.03.2023 (Rs. 720,000).
Upon comparing the debit column of the bank account of the business with the credit column
of the bank statements, and vice versa, the following reasons for this difference can be
identified:
1. Time differences
Unrealized Cheques
Chq No. 354715 – Rs. 45,000
Chq. No.160246 – Rs. 165,000
Unpresented Cheques
Chq. No.200100 – Rs. 175,000
Chq. No.200104 – Rs. 150,000
2. Omissions from accounting records of the business entity

Standing order payment for insurance – Rs. 65,000
Cheque book charges – Rs. 5,000
Direct remittance – Rs. 190,000
3. Errors made in the accounting records of the business

The payment of electricity (200101) was incorrectly recorded in the bank account as
Rs. 5,000 instead of the actual amount of Rs. 15,000.
By incorporating above (2) and (3) bank account can be adjusted as follows.
Adjusted Bank Account

Amount Amount
Date Description Date Description
(Rs.) (Rs.)
31/03 Balance B/F 495,000 31/03 Insurance 65,000
Trade 190,000 Cheque book 5,000
receivables charges
Electricity 10,000
Balance C/D 605,000

685,000 685,000
31/03 Balance B/F 605,000

CHAPTER 5 Page 97
Even after incorporating unrecorded transactions and rectifying the errors made by the
business entity, if the balance in the bank account of the business (Rs. 605,000) does not
agree with the balance as per the bank statement (Rs. 720,000), there may still be some
outstanding items or errors that need to be addressed. Therefore, bank reconciliation
statement should be prepared as follows.
Bank Reconciliation Statement Rs.

Adjusted bank account balance
605,000
Add
Issued but un-presented cheques 175,000
200100
200104 150,000
325,000
930,000
Less
Deposited but un realized cheques 45,000
354715 165,000 (210,00
160246 0)
Balance as per bank statement 720,000
Chapter Round-Up
• The bank reconciliation statement is a valuable control mechanism employed by

business entities to ensure proper management of bank transactions. It serves to
reconcile and validate the accuracy of the bank records maintained by both the
business entity and the bank itself. By preparing the bank reconciliation statement,
the company can verify that all un-presented and unrealized cheques from the
previous period have been properly accounted for in the subsequent bank
statement.
• The primary purpose of the bank reconciliation statement is to ascertain the

consistency and reliability of the accounting records pertaining to the bank current
account. It enables the identification and resolution of any discrepancies or
differences between the balances recorded by the business entity and those stated
in the bank statements.
• Despite the possibility of the bank account balance aligning with the bank
statements without any discrepancies, it is still considered best practice to prepare
bank reconciliation statements on a monthly basis. This ensures the continuous
monitoring and validation of the bank transactions, promoting accuracy,
transparency, and effective control over financial operations.
CHAPTER 5 Page 98
Question 1
If the balance in the bank statement shows Rs. 30,000 (Dr) and there are deposits of Rs. 8,000
not yet credited and unpresented cheques of Rs. 5,000, the balance of the cash book should
be,
a. Rs. 33,000 (Cr)
b. Rs. 27,000 (Cr)
c. Rs. 43,000 (Cr)
d. Rs. 17,000 (Dr)
Question 2
Following details are related to bank transactions of a business.
• Debit balance as per the bank account – Rs. 200,000
• Unrealized cheques – Rs. 10,000
• Unpresented cheques – Rs. 15,000
• Direct remittances (Unrecorded) – Rs. 5,000
• Dividend income (Unrecorded) – Rs. 5,000
What is the adjusted cash book balance?
a. Rs. 210,000
b. Rs. 195,000
c. Rs. 235,000
d. Rs. 215,000
Question 3
The Following information relates to the bank transactions of a business.
• The bank balance in the cash book before taking the items below into account was
Rs.567,000 overdrawn.
• Bank charges of Rs.25,000 on the bank statement have not been entered in the cash book.
• The bank has credited the account in error with Rs. 40,000 which belongs to another
customer.
• Cheque payments totalling Rs. 32,500 have been correctly entered in the cash book but
have not been presented for payment.
• Cheques totalling Rs. 54,500 have been correctly entered on the debit side of the cash
book but have not been paid in at the bank.
What was the balance as shown by the bank statement?
a. Rs. 567,000 overdrawn
b. Rs. 610,000 overdrawn
c. Rs. 574,000 overdrawn
d. Rs. 560,000 overdrawn
CHAPTER 5 Page 99
Question 4
After checking a business cash book against the bank statement, which of the following items
could require an entry in the cash book?
1) Bank charges
2) A cheque from a customer which was dishonoured
3) Cheque not presented
4) Deposits not credited
5) Credit transfer entered in bank statement
6) Standing order entered in bank statement.
a. 1,2,5,6
b. 3,4
c. 1,3,4,6
d. 3,4,5,6
Question 5
While preparing a bank reconciliation statement which of the following must be debited to
the cash book in order to represent the cash balance in statement of financial position?
a. Bank charges
b. Standing order payments made by bank
c. Issued but dishonoured cheques
d. Issued but unpresented cheques
CHAPTER 5 Page 100
Answers
Question 1 b
Question 2 a
Question 3 d
Question 4 a
Question 5 c
CHAPTER 6 Page 101
Control Accounts and

Subsidiary Ledgers
Learning Outcomes
• Explain the nature and purpose of subsidiary ledgers and control accounts.
• Prepare the subsidiary ledgers and control accounts.
• Reconcile the differences between control accounts and the subsidiary
ledger balances.
6.1 Introduction
Control accounts and subsidiary ledgers are important components of the accounting system
that help businesses maintain accurate and organized financial records. They play a crucial
role in managing large volumes of transactions and providing a clear overview of the
company's financial position.
6.2 Control Accounts
A control account is a consolidated account found in the general ledger that represents a
collection of individual accounts recorded in subsidiary ledgers. It serves as a summary
account that captures the total balances of the corresponding personal accounts within the
subsidiary ledgers. The control accounts are updated using the double-entry system,
recording the relevant totals from the primary entry books at the end of each time period
(Usually monthly). Most business entities maintain two main control accounts as part of their
accounting practices. These control accounts are crucial for organizing and managing
financial information:
• Trade receivables control account

• Trade payables control account
CHAPTER 6 Page 102
Trade Receivables Control Account
This control account consolidates all individual customer accounts maintained in the
accounts receivable subsidiary ledger. It captures the total amount owed by customers to the
business entity for goods or services provided on credit. Transactions such as sales, receipts,
and adjustments related to accounts receivable are recorded in this control account. Format
of the account is as follows.

Balance B/F XXX Balance B/F XXX
XXX XXX
Sales Return Inwards
Cash XXX
Dis. Allowed XXX
XXX
Bad Debts XXX
Balance C/D
XXX XXX
XXX
Balance B/F
In normal circumstances, the trade receivables account carries a debit balance since it is an
asset account representing the total amount owed to the business by its customers. However,
in the trade receivables control account, both a debit balance and a credit balance can exist
simultaneously. The debit balance in the trade receivables control account represents the
total outstanding receivables owed by customers to the business. This balance reflects the
total amount that the business expects to collect from its customers.
On the other hand, the credit balance in the trade receivables control account represents a
distinct category of transactions. It comprises the total amount of overpayments made by
customers. These overpayments occur when customers pay more than the actual amount
owed. As a result, the business becomes liable to either refund the excess amount or adjust
it against future invoices.
It is important to note that the debit and credit balances in the trade receivables control
account cannot be offset against each other. They represent different categories of
transactions and have distinct implications for the business's financial position.
Other transactions should be recorded as follows.
• Sales – Total of the sales journal should be transferred to the general ledger at the end of
the period as follows.
Trade receivables control account Dr XXX

Sales account Cr XXX
CHAPTER 6 Page 103
• Return Inwards / Sales Return – Total of the sales return journal should be transferred
to the general ledger at the end of the period as follows.
Sales return Dr XXX

Trade receivables control account Cr XXX
• Cash – Total of the collection from debtors analysis column of the receipt journal should
be transferred to the general ledger at the end of the period as follows.
Cash Dr XXX
• Discount allowed - Total of the discount allowed column of the receipt journal should
Discount allowed account Dr XXX

• Irrecoverable debts/Bad debts – The amount of money owed to a business by its

customers or clients that is deemed uncollectible and unlikely to be recovered. It arises
when a customer fails to fulfil their payment obligations, typically due to financial
difficulties, insolvency, or other reasons.
Irrecoverable debts account Dr XXX

Trade Payables Control Account
This control account summarizes the individual supplier accounts held in the accounts
payable subsidiary ledger. It represents the total amount the business entity owes to
suppliers for purchases made on credit. Transactions such as purchases, payments, and
adjustments related to accounts payable are recorded in this control account. Format of the
account is as follows.
Trade payables Control Account
Balance B/F XXX Balance B/F XXX

Return outwards XXX Purchases XXX
Cash XXX
Discount received XXX
Balance C/D XXX
XXX XXX
CHAPTER 6 Page 104
In the trade payables control account, there can be both a credit balance and a debit balance,
similar to the trade receivables control account. The credit balance represents the total
amount owed by the business to its suppliers for purchases made on credit. It reflects the
outstanding payables that the business has yet to settle.
On the other hand, the debit balance in the trade payables control account represents a
separate category of suppliers. It consists of overpayments made by the business to its
suppliers. These overpayments occur when the business pays more than the actual amount
owed. As a result, the suppliers become liable to either refund the excess amount or adjust it
against future invoices.
It is important to note that the debit and credit balances in the trade payables control account
cannot be offset against each other. They represent different supplier accounts and have
distinct implications for the business's financial position.
Other transactions should be recorded as follows.
• Purchase – Total of the purchase journal should be transferred to the general ledger
at the end of the period as follows.
Purchases account Dr XXX

Trade payables control account Cr XXX
• Return outwards / Purchases returns – Total of the return of purchase journal should
Trade payables control account Dr XXX

Purchases return account Cr XXX
• Cash – Total of the payments to creditors analysis column of the payments journal
should be transferred to the general ledger at the end of the period as follows.

Cash Cr XXX
• Discount received - Total of the discount received column of the payments journal should

Discount received account Cr XXX
CHAPTER 6 Page 105
6.3 Subsidiary Ledgers
Subsidiary ledgers are supplemental ledgers maintained by a business entity alongside the
general ledger when control accounts are utilized. In cases where control accounts are
present in the general ledger for debtors and creditors, two distinct subsidiary ledgers are
established: one for trade receivables and another for trade payables. These subsidiary
ledgers house individual accounts for each trade debtor and trade creditor.
Within the subsidiary ledgers, the focus is on maintaining detailed records of transactions
specific to each trade debtor or trade creditor. However, it is important to note that these
individual trade debtor and trade creditor accounts within the subsidiary ledgers are
considered memorandum accounts. As such, they serve as supporting documentation and do
not involve double-entry bookkeeping.
Instead, the double entries associated with transactions are recorded solely in the general
ledger. The subsidiary ledgers merely reflect the summarized information from these entries.
By employing subsidiary ledgers, businesses can effectively manage and monitor their
debtor and creditor accounts, while the general ledger provides an overarching view of the
financial position of the entity as a whole.
Trade Receivables Sub Ledger
The trade receivables sub ledger functions as a subsidiary ledger dedicated to the
maintenance of individual trade debtor accounts. Its purpose is to facilitate the easy
calculation of the amount receivable from each debtor at a specific date. By utilizing the trade
receivables’ sub ledger, the business entity can effectively track and manage the outstanding
balances owed by each trade debtor.
In the accounting system, the trade receivables control account, located in the general ledger,
is updated with the cumulative values obtained from the prime entry books. This control
account provides a summarized representation of the total amount receivable from all
debtors.
However, for a more detailed breakdown of the values, the trade receivables’ sub ledger is
employed to record and document the specific amounts associated with each individual
trade debtor.
By maintaining individual debtor accounts within the trade receivables’ sub ledger, the
business can accurately monitor the payment status and outstanding balances of each trade
debtor. This allows for improved analysis and decision-making regarding credit
management, debt collection, and overall accounts receivable management. The trade
receivables’ sub ledger complements the trade receivables control account, providing a
comprehensive view of the amounts owed by each trade debtor in the business entity's
financial records.
CHAPTER 6 Page 106
Trade Payables Sub Ledger
The trade payables' sub ledger serves as a subsidiary ledger designed to maintain individual
trade creditor accounts. Its purpose is to facilitate the calculation of the amount payable to
each trade creditor at a specific date. By utilizing the trade payables' sub ledger, the business
entity can effectively track and manage its outstanding obligations to each trade creditor.
In the accounting system, the trade payables control account, located in the general ledger,
is updated with the cumulative values derived from the prime entry books. This control
account provides a summarized representation of the total amount payable to all trade
creditors. However, for a more detailed breakdown of the values, the trade payables' sub
ledger is utilized to record and document the specific amounts associated with each
individual trade creditor.
By maintaining individual trade creditor accounts within the trade payables' sub ledger, the
business can accurately monitor the payment status and outstanding balances owed to each
trade creditor. This allows for improved analysis and decision-making on credit
management, payment scheduling, and overall accounts payable management. The trade
payables' sub ledger complements the trade creditors' control account, providing a
comprehensive view of the amounts payable to each trade creditor in the business entity's
financial records.
The following balances are extracted from Nehan’s Business as at 01.05.2023.
Trade (Rs.) Trade Payables (Rs.)

Receivables
Nilan 500,000 Surekha 250,000
Dilan (150,0000) Nilekha 175,000
Vilan 75,000 Thilokha (50,000)
Total 425,000 Total 375,000
Following extracts of prime entry books are also provided.
Sales Journal
Date Customer Value (Rs.)

02/05 Nilan 350,000
11/05 Dilan 200,000
18/05 Thiran 285,000
835,000
CHAPTER 6 Page 107
Purchase Journal
Date Supplier Value (Rs.)
04/05 Surekha 150,000
16/05 Nilekha 95,000
23/05 Visakha 120,000
27/05 Thilokha 200,000
565,000
Sales Return Journal

Date Customer Value (Rs.)
08/05 Nilan 50,000
21/05 Dilan 65,000
115,000
Purchase Return Journal

Date Supplier Value (Rs.)
13/05 Surekha 45,000
30/05 Thilokha 20,000
65,000
Cash Receipts Journal

Date Description Dis. Allowed Amount Analysis
Receipt from trade
rec.
07/05 Nilan 7,500 100,000 100,000
15/05 Dilan 5,000 25,000 25,000
22/05 Vilan 30,000 30,000
24/05 Thiran 70,000 70,000
12,500 225,000 225,000
Cash Payments Journal

Date Description Dis. Amount Analysis
Received Payment to trade
pay.
09/05 Surekha 3,500 48,000 48,000
17/05 Nilekha 8,000 72,000 72,000
25/05 Thilokha 33,000 33,000
29/03 Visakha 55,000 55,000
11,500 208,000 208,000
CHAPTER 6 Page 108
Additional information:
• It was decided to write off amount due from Vilan, as irrecoverable debt.
The trade receivables control account and the trade payables control account of the Nehan’s
Business for May 2023 can be prepared as follows.
General Ledger

Balance B/F 575,000 Balance B/F 150,000
Sales 835,000 Sales return 115,000
Cash 225,000
Dis. allowed 12,500
Irrecoverable debt 45,000
Balance C/D 45,000 Balance C/D 907,500
1,455,000 1,455,000
Trade Payables Control Account

Balance B/F 50,000 Balance B/F 425,000
Purchase return 65,000 Purchases 565,000
Cash 208,000
Dis. received 11,500 Balance C/D 655,500
990,000 990,000
Trade Receivables Sub Ledger
Nilan’s Account
Balance B/F 500,000 Sales return 50,000
Sales 350,000 Cash 100,000
Dis. allowed 7,500
Balance C/D 692,500
850,000 850,000
Dilan’s Account
Sales 200,000 Balance B/F 150,000
Sales return 65,000
Cash 25,000
Balance C/D 45,000 Dis. allowed 5,000
245,000 245,000
CHAPTER 6 Page 109
Vilan’s Account
Balance B/F 75,000 Cash 30,000
Irrecoverable debt 45,000
75,000 75,000
Thiran’s Account
Sales 285,000 Cash 70,000
Balance C/D 215,000
285,000 285,000
Trade Receivables List

Debtor Rs.
Nilan 692,500
Dilan (45,000)
Vilan -
Thiran 215,000
862,500
6.4 Preparation or Trade Receivables and Trade Payables Reconciliation Statements
In the aforementioned illustration, the balance as per the trade receivables control account
was found to match the balance as per the trade receivables' sub ledger (i.e., the total of the
individual debtor account balances). Similarly, the balance as per the trade payables' control
account corresponded to the balance as per the trade payables' sub ledger (i.e., the total of
the individual creditor account balances).
However, it should be noted that discrepancies between the balances of control accounts and
subsidiary ledgers can arise due to errors that occurred within these accounts. Such errors
can result in imbalances between the control account and the subsidiary ledgers.
It is essential to recognize that journal entries are necessary exclusively for errors occurring
in the general ledger, specifically in control accounts. Rectification entries are not required
for errors occurring in the sub-ledger. In such instances, adjustments made to individual
debtor or creditor accounts are deemed sufficient.
In situations where discrepancies arise between the balances of control accounts and
subsidiary ledgers, reconciliation statements can be prepared to align the two balances. The
subsequent example elucidates the process of reconciling the balance as per the trade
receivables control account with the balance as per the trade receivables' sub ledger.
CHAPTER 6 Page 110
The trade receivables control account of Nupekha PLC as at 30.04.2023 was Rs. 1,250,000.
However, the total as per trade receivables’ list on this date was Rs. 1,345,000. The following
differences were identified in the subsequent investigations.
1. The total of the sales journal has been undercasted by an amount of Rs. 385,000.
2. The sales return made to Gihansa Traders was recorded as Rs. 172,000 instead of Rs.
217,000 in the sales return journal.
3. An amount of Rs. 90,000 in irrecoverable debts has been incorrectly debited to the trade
receivables control account.
4. The discount allowed to Ruwasha Traders of Rs. 150,000 was recorded twice in her
account.
5. The cash payment of Rs. 345,000 by Ruwanga Traders was completely omitted from
books.
6. When balancing the trade receivables control account, an undercast of Rs. 200,000
occurred.
7. The discount allowed column of the cash receipt journal was overcasted by Rs. 175,000.
8. The sales return of Rs. 68,000 made to Pahanya Traders was incorrectly recorded in the
Sahanya Traders account.
9. The cash receipt of Rs. 240,000 from Dileesha Traders has been recorded in the cash
payment journal.
10. The month-end balance of Dineth Traders, amounting to Rs. 335,000, was not taken
into account when preparing the list of trade receivables.
Among the mentioned errors, errors I, III, VI, and VII had an impact solely on the trade
receivables control account. Errors IV, VIII, and X had an impact solely on the trade
receivables' sub ledger. Errors II, V, and IX, on the other hand, had an impact on both the
trade receivables control account and the trade receivables' sub ledger.
Answer
The business entity should first rectify these errors by making the correct journal entries as
follows.
General Journal
Debit (Rs.) Credit
(Rs.)
I Trade receivables control account 385,000
(Being rectification of the error of undercasting the total
of sales journal by Rs. 385,000)
II Sales return account 45,000
Trade receivables control account 45,000
(Being rectification of the error of undercasting sales
return journal by Rs. 45,000)
CHAPTER 6 Page 111
III Suspense account 180,000

(Being rectification of the error of debiting Rs. 90,000
irrecoverable debts to trade receivables control account)
V Cash account 345,000
(Being rectification of the error of omitting Rs. 345,000
cash receipt from the books)
VI Trade receivables control account 200,000
(Being rectification of the error of undercasting trade
receivables control account by Rs. 200,000)
VII Trade receivables control account 175,000
Discount allowed account 175,000
(Being rectification of the error of overcasting discounts
allowed by Rs. 175,000)
IX Cash account 240,000
(Being rectification of the error of recording Rs. 240,000
cash receipts in cash payment journal)
Accordingly, the trade receivables control account balance could be rectified as follows.
Adjusted Trade Receivables Control Account

Balance B/F 1250,000 Sales return 45,000
Sales 385,000 Suspense 180,000
Suspense 200,000 Cash 345,000
Discount allowed 175,000 Cash 240,000
Balance C/D 1,200,000
2,010,000 2,010,000
However, it is important to note that the current balance as per the trade receivables' sub
ledger of Rs.1,345,000 still does not agree with the corrected balance as per the trade
receivables control account of Rs.1,200,000. This discrepancy is due to the fact that errors
numbered IV, VIII and X have affected the balance as per the trade receivables' sub ledger
but have not yet been rectified.
Furthermore, it is important to note that errors numbered II, V, and IX have occurred in both
the trade receivables control account and the trade receivables' sub ledger. Initially, these
errors did not create any discrepancy among the balances. However, since these errors have
now been rectified in the trade receivables control account, they have led to a discrepancy
among the balances.
CHAPTER 6 Page 112
To reconcile the balance as per the trade receivables' sub ledger with the rectified balance as
per the trade receivables control account, a formal reconciliation statement can be prepared.
Trade Receivables Reconciliation Statement

Balance as per the adjusted trade receivables account 1,200,000
Add:
Overstated sales return 45,000
Omitted cash receipts 345,000
Erroneously recorded cash receipts 240,000 630,000
Less:
Duplicated discount allowed 150,000
Omitted balance from the list of trade receivables 335,000 (485,000)
Balance as per the list of trade receivables 1,345,000
Chapter Round-Up
• This chapter focuses on the nature, purpose, preparation, and reconciliation of

subsidiary ledgers and control accounts in accounting. Subsidiary ledgers and control
accounts play a crucial role in organizing and summarizing detailed transaction
information, ensuring accuracy and efficiency in financial record-keeping.
• The nature and purpose of subsidiary ledgers are explained, highlighting their function
as subsidiary ledgers. Subsidiary ledgers allow for better tracking and management of
individual transactions and balances within the specific categories.
• Control accounts, on the other hand, serve as summary accounts that represent the
total balances of their respective subsidiary ledgers. They provide a summarized view
of the subsidiary ledger balances and help in monitoring and controlling the overall
financial position of the organization.
• The chapter then guides on how to prepare subsidiary ledgers and control accounts for
trade payables and trade receivables. It emphasizes the importance of accurately
recording transactions in subsidiary ledgers and regularly updating control accounts
to ensure consistency between the two.
• Furthermore, the chapter explains the process of reconciling differences between

control accounts and the subsidiary ledger balances. Reconciliation involves comparing
the total balance of the control account with the combined balances of the subsidiary
ledger accounts. Any discrepancies are identified and investigated, allowing for timely
correction of errors or omissions.
CHAPTER 6 Page 113
Question 1
The total of the balances in a company’s sales ledger is Rs. 80,000 more than the debit balance
on its trade receivable control account. Which one of the following could by itself account for
the discrepancy?
a) The sales journal has been under casted by Rs. 80,000

b) Discount allowed totalling Rs. 80,000 has been omitted from the sub ledger
c) One sales ledger account with a credit balance of Rs. 80,000 has been treated as a debit
balance
d) The cash receipt book has been under-cast by Rs. 80,000
Question 2
A receivables ledger control account had a closing balance of Rs. 850,000. It contained a
contra to the purchase ledger of Rs. 40,000, but this had been entered on the wrong side of
the control account.
The correct balance on the control account should be:
a) Rs. 770,000 debit

b) Rs. 810,000 debit
c) Rs. 84,0000 debit
d) Rs. 89,0000 debit
Question 3
The receivables ledger control account at 01.05.2023 had balances of Rs.327,500 debit and
Rs. 12,750 credit. During May sales of Rs. 1,250,000 were made on credit. Receipts from
receivables amounted to Rs. 1,225,000 and cash discounts of Rs. 5,500 were allowed.
Refunds of Rs. 13,000 were made to customers. The closing credit balance is Rs.20,000.
The closing debit balances at 31.03.2023 should be:
a) Rs. 351,750
b) Rs. 356,750
c) Rs. 367,250
d) Rs. 347,250
Question 4
In a receivables ledger control account, which of the following lists is composed only of items
which would appear on the credit side of the account?
a) Cash received from customers, sales returns, irrecoverable debts written off, contras
against amounts due to suppliers in the accounts payable ledger.
b) Sales, cash refunds to customers, irrecoverable debts written off, discounts allowed.
c) Cash received from customers, discounts allowed, interest charged on overdue accounts,
irrecoverable debts written off.
d) Sales, cash refunds to customers, interest charged on overdue accounts, contras against
amounts due to suppliers in the accounts payable ledger.
CHAPTER 6 Page 114
Answers
Question 1 b
Question 2 a
Question 3 c
Question 4 a
CHAPTER 7 Page 115
Conceptual Framework for

Financial Reporting
Learning Outcomes
• Explain what a conceptual framework is.

• Explain what the Conceptual Framework for Financial Reporting is.
• Explain the purpose of the Conceptual Framework for Financial Reporting.
• Describe the evolution of the Conceptual Framework for Financial Reporting.
• Outline the structure and components of the Conceptual Framework for Financial
Reporting.
• Explain the components of the Conceptual Framework for Financial Reporting.
• Explain the benefits and limitations of the Conceptual Framework for Financial
Reporting.
7.1 Introduction
A conceptual framework is usually considered as a set of guiding principles that influence

and direct decisions in a particular area. Such frameworks are used in many areas to establish
specific guidelines to make decisions or solve problems. Hence, the Conceptual Framework
for Financial Reporting has been designed to provide guidance and apply to a wide range of
decisions relating to the preparation of financial statements of an entity. However, the
Conceptual Framework is concerned only with general purpose financial statements, which
intend to meet the needs of external users of accounting information who cannot influence
an entity to prepare reports tailored to their particular information needs.
The Conceptual Framework is often compared to a constitution, as it serves as the foundation
for developing accounting standards and guiding financial accounting practices.
According to the Financial Accounting Standards Board (FASB) in the USA, the Conceptual
Framework is described as a coherent system of interrelated objectives and fundamentals
that aim to establish consistent standards and define the nature, function, and limitations of
financial accounting and financial statements. Based on this definition, the Conceptual
Framework can be viewed as a collection of interconnected objectives and underlying
principles.
CHAPTER 7 Page 116
The objectives outline the goals and purposes of financial reporting, while the fundamentals
encompass the fundamental concepts that facilitate the achievement of these objectives.
These concepts provide guidance in determining which transactions, events, and
circumstances should be accounted for, how they should be recognized and measured, and
how they should be summarized and reported.
7.2 Evolution of Conceptual Framework
The development of the Conceptual Framework was initially inspired by efforts to establish
theoretical frameworks for accounting practices, contrasting them with prevailing
accounting methods. These studies began in the early 1960s and culminated in the creation
of the first Conceptual Framework for Financial Reporting in 1978. Therefore, the key
milestones in the evolution of the Conceptual Framework can be summarized as follows.
1. Development of the first conceptual framework in financial reporting by FASB, the USA
in 1978
2. Release of the following seven Statements of Financial Accounting Concepts (SFACs) by

FASB from 1978 to 2002
• SFAC No. 1: Objectives of Financial Reporting by Business Enterprises in 1978

• SFAC No. 2: Qualitative Characteristics of Accounting Information in 1980
• SFAC No. 3: Elements of Financial Statements of Business Enterprises in 1980
• SFAC No. 4: Objectives of Financial Reporting by Non-business Organizations in 1980
• SFAC No. 5: Recognition and Measurement in Financial Statements of Business
Enterprises in 1984
• SFAC No. 6: Elements of Financial Statements (are placement of SFAC No. 3, Also
Incorporating an Amendment of SFAC No. 3 in 1985
• SFAC No. 7: Using Cash Flow Information and Present Value in Accounting
Measurements in 2002
3. Development of conceptual frameworks in financial reporting by several other countries,
which include the United Kingdom (UK), Australia, Canada and New Zealand
4. Release of the first Conceptual Framework for Financial Reporting International

Accounting Standards Board (IASB) as the ‘Framework for Preparation and Presentation’
in 1989
5. Adoption of IASB conceptual framework by many countries with the adoption of

International Financial Reporting Standards (IFRS) by many countries in the world
6. Renaming of IASB conceptual framework in 2010 as ‘Conceptual Framework for Financial

Reporting’ by revising objectives of general-purpose financial reporting and qualitative
characteristics of useful financial information
CHAPTER 7 Page 117
7. Issue of an exposure draft (ED) of the IASB conceptual framework in 2015 with revisions
to its other comments and amendments to previous revisions
8. Finalizing the changes proposed in ED and introducing the revised full conceptual
framework in 2018, which is effective from 1st January 2020.
7.3 Purpose of Conceptual Framework
The purpose of the Conceptual Framework is to:
a) assist the standard setters to develop accounting standards that are based on consistent
concepts.
b) assist preparers to develop consistent accounting policies when no standard applies to a

particular transaction or other event, or when a standard allows a choice of accounting
policy; and
c) assist all parties to understand and interpret the standards.
Unless there is some agreement on objectives and fundamentals of financial reporting,

accounting standards will be developed in an ad hoc manner and there will be limited
consistency between the various accounting standards developed over time. As the
Conceptual Framework addresses the fundamental issues of financial reporting, it provides
the conceptual basis to develop logical and consistent accounting standards.
7.4 Elements of The Conceptual Framework for Financial Reporting

The Co
The Conceptual Framework for Financial Reporting deals with the following areas.
• The objective of general-purpose financial reporting.
• Qualitative characteristics of useful financial information.
• Underlying assumption.
• Elements of the financial statements - definitions.
• Recognition criteria of the elements of the financial statements.
• Measurement of the elements of the financial statements.
• Concept of capital and capital maintenance.
7.5 The Objective of General-Purpose Financial Reporting
The objective of general-purpose financial reporting is to provide financial informationabout

the reporting entity that is useful to existing and potential investors, lenders, and other
creditors in making decisions about providing resources to the entity. Those decisions
involve decisions:
▪ buying, selling, or holding equity and debt instruments.
▪ providing or settling loans and other forms of credit; or
▪ exercising rights to vote on, or otherwise influence, management’s actions that
affect the use of the entity’s economic resources.
CHAPTER 7 Page 118
The existing and potential investors, lenders, and other creditors cannot request reporting
entities to provide information directly to them and must rely on general purpose financial
reports for much of the financial information they need. Consequently, they are the primary
users to whom general purpose financial reports are directed. Accordingly, the objective of
general-purpose financial reporting is to provide information for those primary users.
7.6 Qualitative Characteristics of the Useful Financial Information
As per the Conceptual Framework for Financial Reporting, there are two (02) fundamental
qualitative characteristics and four (04) enhancing qualitative characteristics (Figure 7.1).
Figure 7.1: Qualitative characteristics of useful financial information
Relevance
Fundamental Faithful
Representation
Qualitative
Characteristics Comparability
Verifiability
Enhancing
Timeliness
Verifiability
Understandability
Verifiability
Fundamental qualitative characteristics
The fundamental qualitative characteristics are relevance and faithful representation.
Relevance
Information is considered ‘Relevant’ if it is capable of making a difference in the decisions

made by users of information. The information which has no impact on a decision is
irrelevant. Financial information is capable of making a difference in decisions if it has
predictive value, confirmatory value or both.
Financial information has predictive value if it can be used as an input to the processes
employed by users to predict future outcomes. For example, investors interested in
purchasing company shares may analyse its assets, liabilities, and current performance to
predict the amount, timing and uncertainty of its future cash flows. Financial information has
confirmatory value if it provides feedback about (confirms or changes) previous
evaluations. For example, when the financial statements of a company are used at the year-
end, it confirms or changes the past expectations based on previous evaluations. The
predictive value and confirmatory value of financial information are interrelated.
Information that has predictive value often also has confirmatory value.
CHAPTER 7 Page 119
The relevance of information is affected by its nature and materiality. The information is said
to be material if its omission or misstatement could influence the economic decisions of users
taken based on the financial statements. For example, a company encounters an accounting
error that will require a retrospective application, but the amount is small that altering prior
financial statements will have no impact on the users.
Faithful representation
It is the second fundamental characteristic of financial information. It suggests that the

information presented in the financial statements must be represented faithfully to reflect
the economic reality of transactions and events. That is, the financial information should
represent what really existed or happened through different transactions and events that
have occurred in the entity. For information to be faithfully represented, it should be
complete, neutral and free from error.
Completeness means that all the information that is necessary for faithful representation is
provided. An omission can cause the information to be false or misleading and will not be
useful for the users of financial statements. For example, if a company fails to provide
information as to how it has valued the inventory, the information is not complete.
Neutrality means that a company cannot select information to favour one set of interested
parties over other. For example, a company should not avoid disclosing information as to
lawsuits filed against it though such disclosure is damaging.
Information that is free from error provides a more accurate representation of transactions
and events that have occurred in an entity. For example, if a company misstates its estimates
on depreciation, the information is not free from error.
Enhancing qualitative characteristics

Comparability, verifiability, timeliness, and understandability are qualitative
characteristics that enhance the usefulness of information.
Comparability
The users of financial reports require to make decisions as to choosing between alternatives.
Consequently, information about a reporting entity is more useful if it can be compared with
similar information about other entities and with similar information about the same entity
for another period. Thus, ‘Comparability’ is the qualitative characteristic that enables users
to identify and understand similarities and differences among items. Unlike the other
qualitative characteristics, comparability does not relate to a single item. A comparison
requires at least two items. For example, the financial results of a motor vehicle trading
company should be comparable with another entity in the same industry. Similarly, the year-
to-year information of this company should be comparable.
CHAPTER 7 Page 120
Verifiability
This occurs when independent measures, using the same methods obtain similar results. It
enables knowledgeable and independent users of financial information to reach a conclusion
on whether a particular representation of an event or transaction is faithfully represented.
For example, the auditors of a company can compute the inventory value presented in the
financial statements based on the FIFO method.
Timeliness
It refers to the availability of information to users before it loses its capacity to influence
decisions. For example, if the first quarter financial results of a company are presented after
six months from the quarter-end, their usefulness in decision-making is questionable.
Understandability
Classifying, characterizing, and presenting information clearly and concisely make the
information presented in financial statements understandable. For example, investors of a
company fail to understand why it has declared a low dividend despite recording a significant
amount of earnings and decide to sell their investments.
Underlying assumption
The financial statements are normally prepared on the assumption that an entity is a going
concern and will continue in operation for the foreseeable future.
Hence, it is assumed that the entity has neither the intention nor the need to liquidate or
curtail materially the scale of its operations; if such an intention or need exists, the financial
statements may have to be prepared on a different basis and if so, the basis used is disclosed.
7.7 Elements of the Financial Statements-Definitions
There are five (05) main elements of financial statements as per the conceptual framework
of financial reporting namely assets, liabilities, equity, income, and expenses. The conceptual
framework defines the elements of financial statements as follows (Exhibit 7.1).
Exhibit 7.1: Elements of the Financial Statements
Element Definition as per IASB Conceptual Framework 2018
Asset A present economic resource1 controlled by the entity as a result

of past events.
Liability A present obligation of the entity to transfer an economic

resource as a result of past events.
1
The conceptual framework defines the present economic resource as a right that has the
potential to produce economic benefits.
CHAPTER 7 Page 121
Equity A residual interest in the assets of the entity after deducting all its
liabilities.
Increases in assets or decreases in liabilities that result in
Income
increases in equity, other than those relating to contributions
from holders of equity claims.
Decreases in assets or increases in liabilities that result in
Expense
decreases in equity, other than those relating to distributions to
holders of equity claims.
7.8 Recognition Criteria of The Elements of The Financial Statements
Recognition is the process of incorporating in the Statement of Financial Position or

Statement of Profit or Loss and Other Comprehensive Income an item that meets the
definition of an element of the financial statements and satisfies the criteria for recognition.
As per the Conceptual Framework for Financial Reporting, an item that meets the definition
of an element of the financial statements should be recognized, if such recognition provides
users with:
• relevant information about the asset or the liability and about any resulting income,
expenses, or changes in equity; and
• a faithful representation of the asset or the liability and of any resulting income, expenses,
or changes in equity.
In recognition, the cost of providing information in the financial statements must not
outweigh the benefit of that information to the users.
7.9 Measurement of the Elements of the Financial Statements
Measurement is the process of determining the monetary amounts at which the elements of
financial statements are to be recognized and carried in the statement of financial position
and the statement of profit or loss and other comprehensive income.
The framework describes two main measurement bases namely historical cost and
current value (Exhibit 7.2).
Exhibit 7.2: Measurement Bases of Elements of Financial Statements
Measurement Base Meaning
1. Historical Cost Assets are recognized at the value of the costs incurred in
acquiring or creating the asset, comprising the consideration
paid to acquire or create the asset plus transaction costs.
Liabilities are recorded at the value of the consideration

received to incur or take on the liability minus transaction costs.
CHAPTER 7 Page 122
2. Current Value Provides monetary information about assets, liabilities, and

related income and expenses using information updated to
reflect conditions at the measurement date.
2.1. Fair Value Fair value is the price that would be received to sell an asset, or
paid to transfer a liability, in an orderly transaction between
market participants at the measurement date.
2.2. Value in Use Value in use is the present value of the cash flows or other
and Fulfilment economic benefits that an entity expects to derive from the use
Value of an asset and from its ultimate disposal.
Fulfilment value is the present value of the cash or other
economic resources, that an entity expects to be obliged to
transfer as it fulfils a liability.
2.3. Current Cost The current cost of an asset is the cost of an equivalent asset at
the measurement date, comprising the consideration that
would be paid at the measurement date plus the transaction
costs that would be incurred at that date.
7.10 Concept of Capital and Capital Maintenance
The concepts of capital are broadly divided as financial capital and physical capital. Under
financial capital, capital such as invested capital or invested purchasing power is the same as
net assets or equity of an entity.
On the other hand, under physical capital, capital is regarded as the productive capacity of
an entity based on for example units of output per day. The selection of the appropriate
concept of capital by an entity should be based needs of users of financial statements.
These concepts of capital have given rise to two types of capital maintenance concepts:
financial capital maintenance and physical capital maintenance. The concept of capital
maintenance is concerned with how an entity defines the capital that it seeks to maintain.
Under financial capital maintenance, a profit is earned if the financial amount of net assets at
the end of the year exceeds the same at the beginning year after excluding the contributions
from and distributions to owners during the period. On the other hand, under physical capital
maintenance, a profit is earned if the productive capacity (or operating capability) of net
assets at the end of the year exceeds the same at the beginning year after excluding the
contributions from and distributions to owners during the period.
The Benefits and Limitations of the Conceptual Framework
The Conceptual Framework has both advantages and limitations, which are presented as
follows.
CHAPTER 7 Page 123
The perceived benefits of the Conceptual Framework can be listed as follows.
• Accounting standards are more consistent and logical as they are developed from an
orderly set of concepts.
• Standard-setters are more accountable for their decisions because the thinking behind
specific requirements should be more explicit.
• Communication between standard-setters and their constituents is enhanced.
• The development of accounting standards is more economical because the concepts

developed will guide the standard-setters in decision-making.
• Where conceptual frameworks cover a particular issue, there might be a reduced need for
additional standards.
• Emphasize the ‘decision usefulness’ role of financial reports as well as issues associated
with stewardship of resources by managers of an entity.
The perceived limitations of the Conceptual Framework are as follows.
• Smaller organizations may feel overburdened by reporting requirements arising from

accounting standards.
• The Conceptual Framework is typically economic in focus and reinforces the importance
of economic performance relative to the social or environmental performance of an entity.
• It is argued that the Conceptual Framework simply represents a codification of existing

practice by producing a series of documents that describe the existing practice, rather than
prescribing an ‘ideal’ or logically derived approach to accounting.
Chapter Round-Up
• This chapter considered the development of a Conceptual Framework, which

provides the basis for the preparation of general-purpose financial reports by an
entity.
• The Conceptual Framework consists of a number of building blocks that cover issues
of central importance to general purpose financial reporting and thereby provide
the basis to develop the regulatory framework on financial reporting.
• Hence, there are many benefits derived by the preparers as well as users of financial
reports from the development of a Conceptual Framework for financial reporting.
CHAPTER 7 Page 124
Select the correct answer for the following multiple-choice questions.
Question 1
Which of the following options correctly identifies the fundamental qualitative

characteristics of financial information?
(a) Relevance, Faithful representation
(b) Relevance, Understandability, Timeliness, Verifiable
(c) Faithful representation, Understandability, Comparability, Timeliness
(d) Understandability, Comparability, Timeliness, Verifiable
Question 2
Which of the following options does not represent a characteristic of faithful representation?
(a) Completeness
(b) Free from errors
(c) Neutrality
(d) Materiality
Question 3
Who are the primary users of general-purpose financial statements?

(a) Lenders, investors, and managers
(b) Investors, managers, and creditors
(c) Investors, lenders, and creditors
(d) Employees, managers, and investors
Question 4
Which of the following options does not represent a measurement base identified in the
Conceptual Framework for Financial Reporting?
(a) Historical cost
(b) Present value
(c) Fair value
(d) Current cost
Question 5
As per the Conceptual Framework for Financial Reporting an asset can be defined as:
(a) a resource controlled by the entity as a result of past events.
(b) A present economic resource controlled by the entity as a result of future events.
(c) A present economic resource controlled by the entity as a result of past event.
(d) A resource controlled by the entity as a result of future events.
CHAPTER 7 Page 125
Question 6
Which of the following elements is not recognized in the conceptual framework as a

component of financial statements?
(a) Assets
(b) Liabilities
(c) Revenue
(d) Expense
Write answers to the below questions.
Question 7
What do you mean by a Conceptual Framework for Financial Reporting?
Question 8
State the objective of general-purpose financial statements as per the conceptual

framework.
Question 9
Explain two fundamental qualitative characteristics.
Question 10
Explain the underlying assumption.

CHAPTER 7 Page 126
Answers
Question 1 A
Question 2 D
Question 3 C
Question 4 B
Question 5 C
Question 6 c
Question 7
According to the Financial Accounting Standards Board (FASB) in the USA, the Conceptual
Framework is described as a coherent system of interrelated objectives and fundamentals
that aim to establish consistent standards and define the nature, function, and limitations of
financial accounting and financial statements.
Question 8
The objective of general-purpose financial reporting is to provide financial information about

the reporting entity that is useful to existing and potential investors, lenders, and other
creditors in making decisions about providing resources to the entity.
Question 9
Two fundamental qualitative characteristics of financial information are:
a) Relevance: The information is considered ‘Relevant’ if it is capable of making a difference

in the decisions made by users of information.
b) Faithful representation: It suggests that the information presented in the financial

statements must be represented faithfully to reflect the economic reality of transactions and
events.
Question 10
The financial statements are normally prepared on the assumption that an entity is a going
concern and will continue in operation for the foreseeable future.
CHAPTER 8 Page 127
Preparation of Financial
Statements
Learning Outcomes
• Explain the accounting concepts and principles.

• Explain the role of financial statements.
• Prepare financial statements.
• Illustrate the adjusting entries required in the preparation of financial
statements.
• Prepare financial statements of a sole proprietorship.
8.1 Introduction
Financial statements are the outcome of the financial accounting process, serving as a means
to communicate essential financial information about a business to its stakeholders. These
statements convey pertinent details regarding the financial performance, financial position
and cash flows of the business, catering to the informational needs of various users of
accounting data.
Figure 8.1: Simplified financial accounting system
Input Process Output
Collecting
Transactions Financial
Classifying
& Statements
Summarizing
Events / Reports
Analysing
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8.2 Accounting Concepts
During the preparation of financial statements, several fundamental accounting concepts and
principles are employed. The following are among the commonly utilized accounting
concepts:
1. Accounting entity concept

2. Money measurement concept
3. Going concern concept
4. Periodic concept
5. Accrual concept
6. Revenue recognition concept
7. Matching concept
8. Prudence concept
9. Substance over form concept
10. Historical cost concept
Accounting Entity Concept
The entity concept asserts that the business entity must be regarded as an independent entity
distinct from its owners. Despite any legal implications, this concept mandates the separation
of the business entity and its owners for accounting purposes. It is important to emphasize
that this separation is exclusively applied in the context of accounting and financial reporting.
As discussed previously, the entity concept serves as a fundamental principle in accounting,
forming the basis for the accounting equation.
Money Measurement Concept
The money measurement concept in accounting dictates that only transactions and events
capable of being measured in monetary terms are included in the financial statements.
This concept ensures that all assets, liabilities, equity, income, and expense items reported in
the financial statements are quantifiable using a monetary unit. In the context of Sri Lanka,
the Sri Lankan Rupee (LKR) is used as the currency to present financial figures in the financial
statements.
Similarly, in other countries around the world, different currencies such as US Dollars or
Euros are utilized to present financial statement figures based on the jurisdiction in which
the entity operates. Adhering to the money measurement concept facilitates uniformity and
comparability of financial information, enabling stakeholders to make informed decisions
and assess the financial performance of the entity.
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Going Concern Concept
The going concern concept in accounting asserts that, during the preparation of financial
statements, it is assumed that the management of a business entity has no intention of
liquidating the entity in the foreseeable future, and therefore expects the entity to continue
its operations indefinitely. This concept is grounded in the practical and reasonable
assumption that, unless a decision to liquidate has been made, most business entities are
expected to continue their operations in the long term without any imminent plans for
liquidation.
By adopting the going concern concept, financial statements are prepared under the
assumption that the entity will continue to meet its financial obligations, utilize its assets,
and generate profits in the ordinary course of business. This concept allows stakeholders to
assess the entity's financial position and performance with the expectation that it will
continue as a viable and operational entity in the future.
Periodic Concept
The periodic concept states that the lifespan of a business entity is divided into distinct and
specific time intervals, during which financial statements are prepared. These accounting
periods can vary in duration and can be chosen based on the needs and requirements of the
entity. Financial statements are typically prepared for accounting periods that may span
annually, semi-annually, quarterly, or monthly. Each accounting period represents a defined
timeframe for capturing and reporting the financial activities and performance of the
business.
This timeframe, known as the accounting period or reporting period, serves as the basis for
organizing and presenting financial information in a structured manner. By aligning financial
reporting with specific accounting periods, entities can facilitate timely and systematic
measurement, analysis, and reporting of their financial performance, enabling stakeholders
to evaluate the entity's financial position and results of operations within a designated
timeframe.
Accrual Concept
The accrual concept, also known as the accrual basis of accounting, stipulates that income
and expenses should be recognized in the financial statements based on their relevance to
the accounting period, regardless of the timing of cash receipts or payments. Under this
concept, income that pertains to the current accounting period is recognized as revenue in
the financial statements, even if it has not been received by the end of the period. Conversely,
income that is not relevant to the current accounting period should not be recognized in the
financial statements, even if it has been received during the period. Similarly, expenses that
are relevant to the current accounting period should be recognized in the financial
statements, even if they have not been paid during the period. Conversely, expenses that are
not relevant to the current accounting period should not be recognized in the financial
statements, even if they have been paid during the period.
CHAPTER 8 Page 130
The accrual concept ensures that financial statements reflect the economic activities and
financial performance of the business entity in a more accurate and comprehensive manner,
by matching income and expenses to the period in which they occur, rather than solely
focusing on cash flows.
By recognizing revenue and expenses on an accrual basis, the financial statements provide
users with a more meaningful representation of the entity's financial position and operating
results.
Revenue Recognition Concept
The concept referred to as the realization concept, also known as the revenue recognition
concept, plays a crucial role in determining the appropriate recognition of revenue in
financial statements. According to this concept, revenue should be recognized when it is
earned by the business. To be recognized, the earned revenue should either have already
been realized or be considered realizable at the time of recognition. This principle ensures
that revenue is recorded in the financial statements when it is reasonably certain and can be
reliably measured.
Matching Concept
The matching concept plays a crucial role in determining the calculation of profit or loss for
an accounting period. According to this concept, all expenses that are relevant to the
generation of recognized revenue should be matched against that revenue. Once the revenue
is recognized in accordance with the revenue recognition concept, the associated expenses
are then matched against the recognized revenue. This ensures that the expenses are
appropriately allocated to the period in which the revenue is earned, allowing for an accurate
determination of the profit or loss for the accounting period.
Prudence Concept
The prudence concept is an essential accounting concept that aims to prevent the
overstatement of assets and income, as well as the understatement of liabilities and expenses
in financial statements.
It guides reporting entities to exercise caution in recognizing and reporting financial

information. According to this concept, known liabilities and expenses should be recognized
in the financial statements, while unrealized income should be avoided or treated with
caution. By adhering to the prudence concept, financial statements aim to present a realistic
and conservative view of the reporting entity's financial performance and position, ensuring
that they do not present a more favourable picture than the actual circumstances.
CHAPTER 8 Page 131
Substance Over Form Concept
The concept of substance over form is a fundamental principle in accounting that emphasizes
the importance of recognizing and reporting business transactions based on their economic
substance rather than their legal or tax implications. It recognizes that the true nature and
purpose of a transaction should take precedence over its legal or formal structure.
In essence, substance over form requires accounting professionals to look beyond the
surface-level legal interpretation of a transaction and consider its underlying economic or
commercial essence. This means that if the economic substance of a transaction differs from
its legal form, the financial statements should reflect the economic substance rather than
solely relying on the legal form.
By adhering to the substance over form concept, financial reporting aims to provide users
with a more accurate and meaningful representation of the financial position, performance,
and cash flows of an entity. It ensures that the financial statements present a faithful
depiction of the economic reality of the transactions and events, rather than being solely
driven by legal formalities.
Historical Cost Concept
The historical cost concept is a fundamental principle in accounting that stipulates the
recording and recognition of assets and liabilities at their original acquisition or purchase
cost. Under this concept, business entities are required to record transactions and value
assets based on the amount of cash or cash equivalents paid or the fair value of non-cash
consideration given at the time of acquisition.
The primary objective of the historical cost concept is to ensure consistency and
comparability in financial reporting. By recording assets and liabilities at their historical cost,
it provides a reliable and verifiable basis for measuring and reporting financial information.
It allows users of financial statements to assess the initial investment made by the entity and
understand the financial position and performance over time.
While the historical cost concept focuses on the original transaction value, it is important to
note that certain assets and liabilities may be subsequently revalued or adjusted to reflect
changes in their fair market value. However, such revaluations are generally considered
exceptions and are subject to specific accounting standards and regulations.
By adhering to the historical cost concept, financial statements provide a conservative and
objective representation of the financial position of an entity, enabling stakeholders to make
informed decisions based on reliable and consistent information.
CHAPTER 8 Page 132
8.3 Financial Statements
Financial statements are comprehensive reports that summarize the financial performance
and position of a business entity. They are the outcome of the financial accounting process,
which aims to present relevant financial information in a structured and understandable
format. A complete set of financial statements typically includes the following components:
• Income Statement (Statement of profit or loss)

• Statement of Financial Position (Balance sheet)
• Statement of Cash flows
• Statement of Changes in Equity
• Accounting policies and notes to the financial statements
It should be noted that this chapter focuses on preparation of financial statements of a

sole- proprietorship.
Income Statement
The income statement, also known as the statement of profit or loss, is a financial statement
that provides essential information regarding the financial performance of a business. It
focuses on quantifying the business's profitability over a specific period. Financial
performance, in this context, refers to the ability of the business to generate profit or incur
losses in monetary terms. The income statement is typically prepared for a specific reporting
period, which is commonly one year, although some business entities may opt to prepare
financial statements semi-annually or quarterly.
Presented below is a concise format of an income statement for a trading organization, which
engages in buying and selling goods. The statement is prepared to cover a period of one year:
ABC Traders
Statement of Profit or Loss
For the year ended 31.03.20XX (Rs.)
Sales XXX
(-) Sales return (XXX)
XXX
Cost of Sales
Opening inventory XXX
Purchases XXX
(-) Purchases return (XXX)
XXX
(-) Closing inventory (XXX)
Gross Profit XXX
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Other Income
Rent income XXX
Discount received XXX
Commission income XXX XXX
XXX
Administration Expenses
Electricity and telephone XXX
Rent expense XXX
Salaries and wages XXX
Depreciation – office equipment XXX
Stationary XXX (XXX)
Distribution Expenses
Advertising XXX
Sales commission XXX
Depreciation- Motor vehicle XXX
Discount allowed XXX
Irrecoverable debts XXX (XXX)
Finance and other Expenses

Interest expense XXX
Inventory written off XXX (XXX)
Profit for the year XXX
Statement of Financial Position (Balance Sheet)
The statement of financial position, also known as the balance sheet, is a financial statement
that offers insights into the financial position of a business entity at a specific date. The
financial position refers to the status of the entity's assets, liabilities, and equity at that
particular date. The statement of financial position provides a snapshot of the entity's
financial standing at a given point in time.
Presented below is a standardized format of a statement of financial position for a business

entity:
CHAPTER 8 Page 134
ABC Traders
Statement of Financial Position
As at 31.03.20XX (Rs.)
Non-current Assets Cost Accumulated Carrying
Depreciation Amount
Land XXX - XXX
Buildings XXX (XXX) XXX
Motor vehicles XXX (XXX) XXX
Office equipment XXX (XXX) XXX
XXX XXX XXX
Long term investment XXX
Current Assets
Inventories XXX
Trade receivables XXX
Prepayments XXX
Income receivable XXX
Cash and bank XXX XXX
Total Assets XXX
Equity
Capital XXX
(-) Drawings (XXX) XXX
Non-current Liabilities
Bank Loan XXX
Current Liabilities
Trade payables XXX
Accrued expenses XXX
Income received in advance XXX
Bank overdraft XXX XXX
Total Liabilities and Equity XXX
The following illustration explains the preparation of income statement (statement of profit
or loss) and statement of financial position using the balances available in the trial balance.
Vinex Traders is a sole proprietorship carrying out by Vineetha. Trial balance of the business
as at 31.03.2023 is given below.
CHAPTER 8 Page 135
Debit (Rs.) Credit (Rs.)
Advertising expenses 17,000
Cash and cash equivalents 250,000
Motor vehicle depreciation 75,000
Drawings 30,000
Equipment – cost 450,000
Equipment – accumulated depreciation 125,000
Equity as at 01.04.2022 925,000
Heat and light 43,000
Bank loan 300,000
Motor vehicles – cost 1,000,000
Motor vehicle – accumulated depreciation 450,000
Inventory as at 01.04.2022 120,000
Accrued electricity expense 18,000
Purchases 675,000
Rent 86,000
Sales 1,200,000
Staff wages 185,000
Trade payables 538,000
Trade receivables 746,000
Commission income 94,000
Purchase return 75,000
Interest expense 35,000
Equipment depreciation 23,000
3,745,000 3,745,000
Additional Information:
1. Closing inventories as at 31.03.2023 was Rs. 142,000.
Using the balances available in the above trial balance and the additional information, the
income statement (statement of profit or loss) and statement of financial position can be
prepared as follows.
CHAPTER 8 Page 136
Answer
Vinex Traders
For the year ended 31.03.2023 (Rs.)
Sales 1,200,000
Cost of Sales
Opening inventory 120,000
Purchases 675,000
(-) Purchases return (75,000)
720,000
(-) Closing inventory (142,000) (578,000)
Gross Profit 622,000
Other Income
Commission income 94,000 114,000
736,000
Heat and light 43,000
Rent expense 86,000
Salaries and wages 185,000
Depreciation – office equipment 23,000 (337,000)
Advertising 17,000
Depreciation- Motor vehicle 75,000
Discount allowed 10,000 (102,000)

Interest expense (35,000)
Profit for the year 262,000

CHAPTER 8 Page 137
Vinex Traders
As at 31.03.2023 (Rs.)
Depreciation Amount
Motor vehicles 1,000,000 (450,000) 550,000
Office equipment 450,000 (125,000) 325,000
1,450,000 575,000 875,000
Current Assets
Inventories 142,000
Cash and bank 250,000 1,138,000
Total Assets 2,013,000
Equity
Capital 925,000
(-) Drawings (30,000) 1,157,000
Bank Loan 300,000
Current Liabilities
Accrued electricity 18,000 556,000
Total Liabilities and Equity 2,013,000
8.4 Adjustments to Financial Statements
When the trial balance is prepared without all the necessary accounting entries, certain
adjustments become necessary during the preparation of financial statements at the end of
the accounting period. These adjustments aim to ensure the accuracy and completeness of
the financial statements.
The following are some examples of such adjustments:

1. Closing Inventories
2. Depreciation
3. Irrecoverable Debts
4. Accrued Expenses
5. Prepaid Expenses
6. Income receivable
7. Income received in advanced.
8. Inventory losses
CHAPTER 8 Page 138
It should be noted that the list provided above is not exhaustive and represents a limited
selection of adjustments that business entities may need to make when preparing financial
statements. In practice, additional adjustments may be required depending on the entity's
specific circumstances and accounting policies. However, this chapter focuses solely on the
adjustments mentioned above, as outlined in the course content of CL2: Financial
Accounting.
Closing Inventories
When preparing financial statements, it is necessary to adjust the cost of closing inventories
for trading and manufacturing businesses. In the case of a trading business, closing
inventories consist of goods purchased but not yet sold at the end of the year. For a
manufacturing business, closing inventories may include raw materials purchased but not
used in production and partially completed items known as work in progress.
The adjustments for closing inventories are as follows:
Closing inventories account Dr XXX

Cost of sales account XXX
The adjustment for Net Realizable Value (NRV) is made when the net realizable value of
inventories is lower than their cost. NRV represents the estimated selling price of inventories
minus any estimated costs necessary to make the sale.
The NRV adjustment is as follows:
Inventory written off expense account Dr XXX

Closing inventories account XXX
This adjustment recognizes a decrease in the value of inventories and records it as an

expense. By debiting the inventory written off expense account, the decrease in value is
recognized as an expense in the income statement. At the same time, the closing inventory
account is credited, reducing its value on the balance sheet.
The purpose of the NRV adjustment is to ensure that inventories are valued at their lower
of cost or net realizable value. This adjustment reflects a conservative approach in financial
reporting by recognizing any potential loss in the value of inventories.
Depreciation
The adjustment for depreciation is made to allocate the depreciable amount of a non-current
asset as an expense over its useful life. This adjustment is necessary to reflect the gradual
consumption of the economic benefits provided by the asset.
When preparing the financial statements, the following adjustment is made for
depreciation:
CHAPTER 8 Page 139
Depreciation expense account Dr XXX
Accumulated depreciation account XXX
By debiting the depreciation expense account, the expense associated with the asset's
depreciation is recognized in the income statement. This reduces the net income and reflects
the portion of the asset's cost that has been consumed during the accounting period.
Simultaneously, the accumulated depreciation account is credited, reflecting the total
depreciation accumulated over the asset's useful life. The accumulated depreciation account
is a contra-asset account that offsets the carrying value of the non-current asset on the
balance sheet.
The purpose of this adjustment is to match the cost of the non-current asset with the periods
in which it generates revenue or is used to support operations. By recognizing depreciation
as an expense, the financial statements accurately reflect the consumption of the asset's
economic benefits and provide a more realistic portrayal of the entity's financial
performance and asset values. It is important to note that land, being an asset with an
indefinite useful life, is not subject to depreciation as it is not expected to be consumed or
wear out over time.
There are several methods of depreciation that can be used to allocate the cost of a non-
current asset over its useful life. The choice of depreciation method depends on factors such
as the nature of the asset, its expected pattern of use, and the applicable accounting
regulations or standards. The following are some commonly used methods of depreciation:
Straight-line depreciation: This is the most common method where the asset's cost is
allocated equally over its useful life. The formula for straight-line depreciation is:
Depreciation Expense = (Cost of the Asset - Residual Value) / Useful Life
The residual value represents the estimated value of the asset at the end of its useful life.
Diminishing balance depreciation: Under this method, a higher amount of depreciation is

recognized in the early years of the asset's life, and the depreciation expense decreases over
time. This method is based on the assumption that the asset's productivity or usage declines
over its useful life.
Units of production depreciation: This method allocates the cost of the asset based on its
usage or production output. The depreciation expense is determined by multiplying the cost
per unit by the actual units produced or the estimated total units that the asset is expected
to produce over its useful life.
Irrecoverable Debts
Irrecoverable debts refer to the portion of trade receivable balances that a business
estimates as unrecoverable. When a debtor is deemed to be irrecoverable, it is necessary to
remove their balance from the company's assets and recognize the corresponding amount as
an expense.
CHAPTER 8 Page 140
During the preparation of financial statements, the treatment of bad debts involves the
following adjustments:
Irrecoverable debts expense account Dr XXX

Trade receivables account XXX
The specific debtor account deemed unrecoverable is removed from the company's asset
accounts. This is typically done by debiting the irrecoverable debts expense account and
crediting the trade receivable account. By doing so, the company acknowledges the loss
incurred from the irrecoverable debt.
When preparing financial statements irrecoverable debts should be recognized as an

expense in the income statement.
Accrued Expenses
Accrued expenses refer to expenses that are relevant to the current accounting period but
have not been paid by the end of that period. These expenses have been incurred or
consumed during the period, but the payment obligation arises after the accounting period
has ended.
When preparing financial statements, accrued expenses are recognized and adjusted as
follows:
Relevant expense account Dr XXX

Relevant accrued expense account XXX
In the statement of financial position, the balance of the accrued expense account is
presented as a current liability.
Prepayments
Prepayments are expenses that are relevant to a subsequent accounting period but have
already been paid as of the end of the current accounting period.
These expenses occur when a payment is made in advance for goods or services that will be
received or consumed in a future accounting period.
When preparing financial statements, prepayments are adjusted as follows:
Relevant prepayment account Dr XXX

Relevant expense account XXX
In the statement of financial position, the balance of the income receivable account is
presented within the current assets section. This placement accurately reflects that the
income receivable is an asset with an expected future economic benefit, and it is classified as
a current asset as it is anticipated to be collected within the next operating cycle or within
one year, whichever is longer.
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Income Receivable
Income receivable refers to the income that is relevant to the current accounting period but
has not been received by the end of that period. It represents the amount of revenue that the
company has earned but is yet to be collected.
When preparing financial statements, adjustments for income receivable are made as
follows:
Relevant income receivable account Dr XXX

Relevant income account XXX
In the statement of financial position, the balance of the income receivable account is
presented within the current assets section.
Income Received in Advance
Income received in advance refers to income that is received by a business but is not relevant
to the current accounting period. It represents the receipt of payment for goods or services
that will be provided in future accounting periods.
When preparing financial statements, adjustments for income received in advance are made
as follows:
Relevant income account Dr XXX

Relevant income received in advance account XXX
In the statement of financial position, the balance of the income received in advance account
is presented within the current liabilities section. This placement accurately reflects that the
business has an obligation to provide the goods or services for which it has already received
payment. Since it represents an obligation that is expected to be fulfilled within the next
operating cycle or within one year, whichever is longer, it is classified as a current liability.
Inventory Losses
When preparing the financial statements, the adjustment for inventory loss due to
destruction is necessary to accurately reflect the impact of the loss on the company's
financial position and performance.
When preparing financial statements, adjustments for inventory losses are made as follows:
Inventory loss expense account Dr XXX

Cost of sales account XXX
First, identify and determine the cost of the inventories that have been destroyed due to
events such as fire, flood, tsunami, or any other cause. This may involve assessing the
quantity and value of the destroyed inventory.
CHAPTER 8 Page 142
Then remove the cost from destroyed goods from the purchases. To calculate the accurate
cost of sales, the cost of the destroyed inventory should be removed from the purchases. This
adjustment reduces the value of the inventory available for sale and ensures that only the
inventory actually sold is included in the cost of sales calculation.
Dinex Traders is a sole proprietorship carrying out by Dinesha. Trial balance of the business
as at 31.03.2023 is given below.

Capital as at 04.01.2022 1,250,000
Loan 750,000
Land and Building (Land Value – Rs. 700,000) 1,500,000
Furniture and Fittings 400,000
Machinery & Equipment 300,000
Motor Vehicle 500,000
Accumulated Depreciation as at 01.04.2022
Buildings 156,150
Furniture and Fittings 80,000
Machinery & Equipment 50,000
Motor Vehicle 196,000
Trade Receivables 125,000
Carriage Inwards 12,500
Sales return 27,000
Purchase return 23,000
Trade Payables 132,000
Sales 1,250,000
Purchases 823,450
Commission Received 55,000
Rent Income 42,000
Salaries and Wages 224,000
Telephone expenses 25,000
Inventory as at 01.04.2022 100,000
Drawings 50,000
Bank 124,000
Cash 20,350
Discount Received 24,000
Discount Allowed 14,000
4,132,150 4,132,150
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1. The inventory as at 31.03.2023 was valued at a cost of Rs. 350,000. Those inventories
are expected to sell at a price of Rs. 360,000 after incurring a selling expense of Rs.
30,000.
2. Non-current assets are depreciated on straight line method as follows.
Buildings – 5% p.a.
Furniture and Fittings – 10% p.a.
Machinery & Equipment – 15% p.a.
Motor Vehicles – 20% p.a.
3. It was decided to write off a debtor of Rs. 15,000 as an irrecoverable debt.
4. There was Rs. 26,000 accrued salaries and wages on 31.03.2023.
5. Prepaid telephone expenses as at 31.03.2023 was Rs. 5,000.
6. Rent income receivable as at 31.03.2023 was Rs. 13,000.
7. The commission income received in advance as at 31.03.2023 was Rs. 5,000.
8. During the year, a fire incident occurred in the stores resulting in the complete
destruction of goods with a cost of Rs. 70,000. Subsequently, an agreement was reached
with the insurance company, whereby they would compensate for 60% of the loss. No
any entry was recorded in the books of accounts.
Using the balances available in the above trial balance and the additional information, the
income statement (statement of profit or loss) and statement of financial position can be
prepared as follows.
Dinex Traders
Sales 1,250,000
(-) Sales return (27,000)
1,223,000
Cost of Sales
Purchases 823,450
Carriage inwards 12,500
(-) Inventory damages (70,000)
Purchase return (23,000)
842,950
CHAPTER 8 Page 144
Other Income
Rent income 55,000
Commission income 50,000
Discount received 24,000 129,000
859,050
Building depreciation 40,000
Furniture and Fittings depreciation 40,000
Machinery & Equipment depreciation 45,000
Salaries and Wages 250,000
Telephone expenses 20,000 (395,000)
Irrecoverable debts 15,000
Discount allowed 14,000 (139,850)

Inventory write off 20,000
Inventory losses 28,000 (48,000)

CHAPTER 8 Page 145
Dinex Traders
As at 31.03.2023 (Rs.)
Depreciation Amount
Land and Building 1,500,000 196,150 1,303,850
Furniture and Fittings 400,000 120,000 280,000
Machinery & Equipment 300,000 95,000 205,000
Motor Vehicle 500,000 296,000 204,000
2,700,000 707,150 1,992,850
Current Assets
Inventories 330,000
Prepaid telephone expenses 5,000
Rent income receivable 13,000
Insurance receivable 42,000
Cash and bank 20,350 520,350
Equity
Capital 1,250,000
(-) Drawings (50,000) 1,476,200
Bank Loan 750,000
Current Liabilities
Accrued salaries and wages 26,000
Commission income received in advance 5,000
Bank overdraft 124,000 287,000
CHAPTER 8 Page 146
8.5 Preparation of the Financial Statements of a Manufacturing Business
The preparation of financial statements for a manufacturing business entity is similar to that
of a trading business. However, there is a significant difference in the calculation of the cost
of sales. In a manufacturing business, the calculation of the cost of sales differs from that of a
trading business. Instead of including purchases, the cost of sales for a manufacturing
business should incorporate the "Total Manufacturing Cost." However, the total
manufacturing cost is not directly available as a separate account balance in the trial balance.
Therefore, additional working is required to determine the total manufacturing cost before
preparing the income statement. This is achieved through the preparation of a specialized
statement called the manufacturing cost statement.
Once the total manufacturing cost is calculated, it is transferred to the income statement as
the cost of sales for the manufacturing business. This ensures that the income statement
accurately reflects the expenses incurred in the production process and provides a
comprehensive view of the cost of goods sold.
Within the manufacturing cost statement, the total manufacturing cost is presented as two
main categories known as "Prime Cost" and "Manufacturing Overhead." These categories
provide a breakdown of the costs involved in the manufacturing process and facilitate a
comprehensive understanding of the total manufacturing cost.
Prime Cost
Prime cost refers to all the direct costs incurred by a manufacturing business entity. These
costs are directly attributable to the products or cost units of the business. The prime cost
comprises three main components: direct material cost, direct labor cost, and direct other
expenses.
(a) Direct Material Cost:
Direct material cost includes the expenses associated with the raw materials and
components that are directly utilized in the production of the business entity's products or
cost units. It encompasses the specific materials required to manufacture the goods.
Examples of direct material costs vary depending on the nature of the business, such as
timber, steel, cushions for a furniture manufacturing business, cloth, fabrics for a garment
factory, or cocoa, milk for a chocolate manufacturing firm.
(b) Direct Labor Cost:
Direct labour cost encompasses the wages and salaries, as well as statutory contributions
like EPF (Employee Provident Fund) and ETF (Employee Trust Fund), paid to the employees
who are directly involved in the manufacturing process. These individuals contribute their
labour directly to the production of the business entity's goods. For instance, direct labour
costs may include salaries and wages paid to sewing machine operators in a garment factory
or workers engaged in wood cutting, fixing, and painting furniture in a furniture
manufacturing business.
CHAPTER 8 Page 147
(c) Direct Other Expenses:
Direct other expenses comprise any other direct costs incurred by the business entity, apart
from direct material and direct labour costs, which can be directly attributed to the products
or cost units. These expenses are specific to the production process but do not fall under
material or labour costs. Examples of direct expenses include royalty payments made to
patent owners for the use of patented technology in each product produced by the
manufacturer or copyright fees paid to authors for each book published by a book publisher.
Manufacturing Overhead Cost
These costs, also known as indirect manufacturing costs, are expenses that cannot be directly
attributed to specific products or cost units but are associated with the overall production
process. Indirect manufacturing costs encompass various expenses related to the
manufacturing facility, commonly referred to as the factory, which cannot be directly
identified with individual products. They contribute to the overall cost of production but do
not have a direct correlation with specific units.
Few examples for manufacturing overhead costs are given below.
• Factory rent and rates

• Factory electricity
• Factory manager salary
• Factory supervisor salary
• Machine and plant depreciation
• Machine and plant maintenance cost
• Factory cleaning cost
• Factory security cost
Below Figure 8.2 shows the breakdown of cost and its’ applicability within the statements.
Figure 8.2: Cost Classification
Cost
Indirect Cost
Direct Cost
(Overhead
(Prime Cost) Cost)
Non-
Direct Direct Other Manufacturing manufacturing
Material Direct Overhead Cost
Expenses
Cost Labour Cost Overhead Cost
Manufacturing Cost Statement Profit or Loss

Statement
CHAPTER 8 Page 148
Work-in Progress (WIP)
In manufacturing, products often go through multiple stages of production before they are
considered finished goods. During this process, costs are incurred for raw materials, direct
labour, and manufacturing overhead. However, at the end of an accounting period, some
units of production may still be in progress and not yet completed. Those semi-finished units
are known as WIP.
WIP is adjusted in manufacturing cost statements as follows.

+ Opening WIP XXX
(-) Closing WIP XXX
Opening WIP:
Opening WIP represents the value of partially completed units from the previous accounting
period that are still in progress at the beginning of the current period. It includes the costs
incurred in the previous period that have not yet been fully converted into finished goods.
Opening WIP is added to the manufacturing cost calculation because it reflects the value of
work in progress carried over from the previous period. By including Opening WIP, the
manufacturing cost statement accounts for the costs already invested in the production
process, which need to be considered in the current period's calculations.
Closing WIP:
Closing WIP represents the value of partially completed units at the end of the current
accounting period. It includes the costs incurred in the current period that have not yet been
fully converted into finished goods. Closing WIP is calculated by assessing the stage of
completion of the partially completed units and assigning the appropriate costs.
Closing WIP is deducted from the manufacturing cost calculation because it represents the
value of work in progress that remains unfinished at the end of the accounting period.
Deducting Closing WIP ensures that only the costs related to completed units are considered
in the current period's calculations. The value of the work in progress is carried forward to
the next accounting period as Opening WIP.
WIP can be adjusted either under prime cost or production overhead cost, based on the level
of completion.
The following is a simple structure of the manufacturing cost statement.

CHAPTER 8 Page 149
ABC PLC
Manufacturing Cost Statement for the year ended 31.03.20XX
Direct Materials
Opening inventory XXX
Purchases XXX
Cost of DM available to consume XXX
(-) Closing inventory (XXX)
Cost of DM consumed XXX
Direct Labour
Direct wages XXX XXX
Direct Other Expenses
Royalty fee XXX XXX
Prime Cost XXX
Manufacturing Overhead
Factory rent and rates XXX
Factory manager salary XXX
Factory rent and rates XXX
Factory electricity XXX
Machine depreciation XXX XXX
+ Opening WIP XXX
(-) Closing WIP (XXX) XXX
Total Manufacturing Cost XXX
Balances extracted from the books of “Nikil Ltd” as at 31.03.2023 are given below.
(Rs.)
Inventory as at 01.04.2022 – Finished goods 175,000
WIP 128,000
Raw materials 95,000
Sales 7,660,000
Raw material purchases 1,706,000
Office taxes and rates 546,000
Travelling expenses 250,000
Manufacturing salaries and wages 2,548,000
Printing and stationary expenses 24,000
Office salaries 212,000
Power and electricity 124,000
Royalty payments 95,000
Machinery – at cost 1,000,000
Plant – at cost 2,500,000
CHAPTER 8 Page 150
Motor vehicle – at cost 3,000,000
Promotion cost 450,000
1. Inventory as at 31.03.2023 were as follows.

Finished goods – Rs. 150,000
WIP – Rs. 135,000
Raw materials – Rs. 115,000
2. Below expenses should be apportioned among factory and office as follows.
Expense Factory Office
Power and electricity 75% 25%
Telephone expenses 15% 85%
3. Property, plant and equipment are depreciated on straight line basis as follows
Machinery – 10%
Plant – 5%
Motor vehicle – 15%
Using the balances available and the additional information, manufacturing cost statement
and the income statement (statement of profit or loss) can be prepared as follows.
Nikil Ltd
Manufacturing Cost Statement for the year ended 31.03.2023.
Direct Materials
Purchases 1,706,000
Cost of DM available to consume 1,801,000
(-) Closing inventory (115,000)
Cost of DM consumed 1,686,000
Direct Labour
Direct wages 2,548,000 2,548,000
Direct Other Expenses
Royalty fee 95,000 95,000
Prime Cost 4,329,000
Manufacturing Overhead
Factory electricity expenses 93,000
Factory telephone expenses 9,000
Machinery depreciation 100,000
Plant depreciation 125,000 327,000
+ Opening WIP 128,000
(-) Closing WIP (135,000) (7,000)
Total Manufacturing Cost 4,649,000
CHAPTER 8 Page 151
Nikil Ltd
Sales 7,600,000
Cost of Sales
Total manufacturing cost 4,649,000
(-) Closing inventory (150,000) (4,674,000)
Gross Profit 2,926,000
Other Income
Discount received 128,000 128,000
3,054,000
Electricity expense 31,000
Office taxes and rates 546,000
Printing and stationary expenses 24,000
Office salaries 212,000 (864,000)
Travelling expenses 250,000
Promotion cost 450,000 (1,528,000)
CHAPTER 8 Page 152
Chapter Round-Up
• This chapter provides a comprehensive guide to the preparation of financial statements

for sole proprietorships involved in both buying and selling, as well as manufacturing
and selling activities. It covers various accounting concepts and principles that are
essential for accurately reporting the financial position and performance of these
businesses.
• The initial part of the chapter focuses on explaining the fundamental accounting
concepts and principles that underpin the preparation of financial statements. These
concepts include accrual accounting, which recognizes revenues and expenses when
they are earned or incurred, rather than when cash is received or paid. Other principles
such as the matching principle, historical cost principle, and consistency principle are
also discussed, highlighting their significance in ensuring the reliability and
comparability of financial statements.
• Furthermore, the chapter delves into the topic of adjusting accounting entries, which are
necessary to align the financial statements with the accrual accounting concept and to
accurately reflect the financial position and performance of the business. Adjusting
entries are made to account for items such as accrued expenses, prepaid expenses, bad
debts, inventory losses, and income receivable. The step-by-step process of making
these adjustments is explained, emphasizing their importance in presenting a true and
fair view of the business's financial affairs.
• The chapter concludes by providing a detailed illustration of the preparation of the
income statement and the statement of financial position for sole proprietorships
engaged in buying and selling as well as manufacturing and selling activities. These
illustrations incorporate the adjusting entries discussed earlier, ensuring that the
financial statements portray an accurate picture of the business's revenues, expenses,
assets, liabilities, and equity.
CHAPTER 8 Page 153
Question 1
State the Accounting Concept applicable for each of the following circumstances:
a. It is assumed that the entity will continue for a long time, unless and until it has entered
into a state of liquidation.
b. Revenue is recognized in the particular accounting period irrespective of receipt of cash
or not.
c. Measurement of closing inventory at lower of cost or NRV.
Question 2
Samantha Bookshop acquired a photocopy machine for Rs. 600,000 on 01st April 2022.
Estimated useful life of this machine is 5 years and estimated residual value at the end of the
useful life is Rs. 100,000. The policy of the business is to provide depreciation on the straight-
line basis at cost.
Question 3
The opening inventory balance of a business was understated by Rs.25,000/- while the
closing inventory balance was overstated by Rs.30,000/-. The impact of this is:
a. Overstating of gross profit by Rs.55,000/-.

b. Understating of gross profit by Rs.55,000/-.
c. Overstating of gross profit by Rs.5,000/-.
d. Understating of gross profit by Rs.5,000/-.
Question 4
Production cost of a manufacturing firm is equal to.
a. Direct material cost + Direct labour cost + Direct other cost

b. Prime cost + Production overhead cost
c. Production overhead cost + non-manufacturing cost
d. Direct material cost + Direct labour cost + Direct other cost + Overhead cost
Question 5
Total purchases of raw materials amounted to Rs. 350,000. The ending inventory of raw
materials is Rs. 20,000 more than the beginning inventory. How much is the cost of raw
materials consumed?
a. Rs. 370,000
b. Rs. 350,000
c. Rs. 330,000
d. Rs. 310,000
CHAPTER 8 Page 154
Answers
1. a) Going concern concept

b) Accrual concept
c) Prudence concept
2. Rs. 100,000
3. a
4. b
5. c
CHAPTER 9 Page 155
Financial Statements for

Partnerships
Learning Outcomes
• Describe the formation process of a partnership and understand the principles

involved in profit sharing among partners.
• Explain the special accounts used in partnership accounting and their significance
in tracking partner contributions, withdrawals, and profit distributions.
• Prepare financial statements for a partnership, including the income statement,
statement of partners' capital, and balance sheet, using the appropriate
partnership accounting methods.
9.1 Introduction
As per the Partnership Act of 1890, a partnership is formed when two or more individuals
agree to collaborate and carry out a business venture with the intention of generating profits.
In order to be recognized as a partnership, the following four essential characteristics must
be present:
1. Two or more owners: A partnership requires the involvement of at least two individuals
or entities who join forces to run the business. These individuals are referred to as
partners and collectively share the responsibilities and liabilities associated with the
partnership.
2. Partnership agreement: The formation of a partnership necessitates a legally binding

agreement, either written, oral or implied among the partners. This agreement outlines
the terms and conditions governing the partnership, including the roles and
responsibilities of each partner, profit-sharing arrangements, decision-making
processes, and other pertinent aspects.
3. Profit earning objective: The primary objective of a partnership is to engage in commercial

activities with the aim of generating profits. The partners pool their resources, skills, and
expertise to conduct business operations and maximize financial returns.
CHAPTER 9 Page 156
Existence of a business entity: A partnership is considered a separate legal entity from its
partners. Although it is not a distinct legal entity like a corporation, it operates under its own
name and conducts business activities as a unified entity. The partnership can enter into
contracts, acquire assets, incur debts, and take legal actions in its own name.
9.2 The Partnership Agreement
The individuals who comprise a partnership are referred to as partners, and their agreement
is a fundamental requirement for the formation of a partnership. This agreement can take
the form of oral communication, implied through conduct, or a written document.
To prevent potential disputes and provide clarity regarding the intentions of the partners, it
is advisable to have a written partnership agreement. In Sri Lanka, the Prevention of Frauds
Ordinance of 1840 stipulates those partnerships with a capital exceeding Rs. 1000/- should
have a written agreement. As a result, the majority of partnerships established in Sri Lanka
are formed with a written agreement.
Having a written agreement offers several advantages. It serves as a comprehensive record

of the terms and conditions agreed upon by the partners, including their respective roles,
responsibilities, profit-sharing arrangements, decision-making processes, and other relevant
provisions. It helps in avoiding misunderstandings and disagreements that may arise in the
course of the partnership's operation.
Additionally, a written agreement provides a legal basis for the partnership, making it easier
to enforce rights and obligations in case of any disputes or breaches of the agreement. It
offers protection to the partners and ensures that their interests and investments are
safeguarded.
The following matters are generally included in a partnership agreement.
• Name of the business.

• The nature of the business and the location of the business.
• Names and addresses of the partners.
• The amount of capital to be contributed by each partner.
• The basis on which profit will be shared between the partners (profit sharing ratio).
• Whether the partners are to be entitled to a fixed salary for their services.
• Whether drawings are to be limited or unlimited in amounts, and any interest to be
charged.
• That accounts should be prepared once a year. Accounts should be audited and once
signed will be binding on the partners in the absence of a material error.
• Signatures of all partners duly attested by a notary.
CHAPTER 9 Page 157
9.3 Applications of Partnership Act
Section 24 of the Partnership Act governs partnerships in situations where the partnership
agreement does not address specific matters. The below provisions are outlined in Section
24:
1. Equal sharing of profits and losses: All partners are required to share the profits, whether
derived from revenue or capital, equally among themselves. Similarly, they must also
contribute equally to any losses incurred by the business.
2. Absence of entitlement to interest or salary: Partners do not have a right to receive

interest on their capital contributions or a salary for the services they provide to the
partnership.
3. Interest on loans to the firm: Partners are entitled to receive interest at a rate of 5% per
annum on any loans or advances provided to the partnership.
4. Active participation in management: All partners have the right to actively participate in
the management and decision-making processes of the partnership.
5. Reimbursement of expenses: The partnership must reimburse partners for expenses

incurred in matters related to the ordinary course of business, as well as expenses
deemed necessary for the preservation of the business or its assets.
6. Consent for the introduction of new partners: The consent of all existing partners is
required before a new partner can be admitted to the partnership.
7. Decision-making authority: Matters pertaining to the ordinary course of business can be

decided by a majority of partners, but any changes in the nature of the business require
the unanimous consent of all partners.
8. Maintenance of books and access to records: The partnership is responsible for

maintaining its books at the principal office, and all partners have the right to inspect and
access these books.
9.4 Advantages of a Partnership Business
• Access to more resources: A partnership has the advantage of being able to pool
resources from multiple partners. This includes financial resources as well as other
physical assets, technical expertise, and management skills. The collective contributions
of partners enable the partnership to access a broader range of resources, which can aid
in the growth and success of the business.
• Flexibility and less regulatory control: Compared to a limited liability company, a

partnership typically operates with less regulatory control. Partners have more flexibility
in managing the operations of the partnership, as they are not bound by the same
formalities and regulations that govern companies. This flexibility allows for quicker
decision-making and adaptability to changing circumstances.
CHAPTER 9 Page 158
• Shared liabilities and losses: While unlimited liability is a potential disadvantage of a
partnership, it also ensures that losses and liabilities are shared among multiple partners.
This means that no single partner bears the entire burden of business losses or liabilities.
Sharing these risks provides a level of security and reduces the financial impact on
individual partners.
• Cost-effective establishment: Compared to the incorporation of a limited liability

company, establishing a partnership is typically easier and less expensive. The legal
requirements and formalities associated with forming a partnership are generally
simpler, resulting in lower administrative and legal costs. This makes partnerships an
attractive option for entrepreneurs looking to start a business without incurring
substantial upfront expenses.
9.5 Disadvantages of a Partnership Business
• Unlimited liability: Each partner in a partnership bears unlimited liability for the debts
and obligations of the firm. This means that personal assets of the partners can be used
to settle the partnership's debts in the event that the partnership's assets are insufficient.
The concept of unlimited liability exposes partners to significant financial risk.
• Limited life: Partnerships have a limited life span. The partnership can be dissolved by
events such as the death, retirement, bankruptcy, or incapacitation of a partner. The
admission of a new partner or any significant changes in partnership composition can
also lead to the end of the existing partnership.
• Mutual agency: In a partnership, each partner is considered an agent of the partnership.

This concept of mutual agency grants each partner the authority to enter into contracts
and conduct business transactions on behalf of the partnership. However, this can create
challenges if one partner acts incompetently or dishonestly, as their actions can legally
bind the entire partnership.
• Limited capital raising potential: The aspect of unlimited liability can hinder partnerships
in raising significant amounts of capital. Individuals with substantial personal wealth may
be hesitant to join a partnership due to the potential risk to their personal assets.
Additionally, the Companies Act imposes restrictions on the number of partners in a
partnership, limiting it to a minimum of two and a maximum of twenty partners, which
can restrict the ability to raise large amounts of capital.
CHAPTER 9 Page 159
9.6 Special Accounts Used in Partnership Businesses
In addition to the ledger accounts and financial statements discussed in the previous chapter
for sole proprietorships, partnership accounting involves the use of certain special accounts.
These special accounts are specifically designed to capture the unique characteristics and
transactions of partnership businesses. The following are the special accounts used in
partnership accounting:
Partners’ Capital Account
Each partner in a partnership has a separate capital account that reflects their initial
investments, additional capital contributions and goodwill changes when there is a change
in the composition of the partnership business.
Usually, capital account represents the long term and non-volatile equity of the partners.
The following is a simple structure of capital accounts prepared using the horizontal format.
Capital Accounts
Debit Credit
A B C A B C
Double entry for capital introduction by partners is as follows.

Relevant asset account Dr XXX
Relevant partner’s capital account XXX
In partnership accounting, when partners contribute assets other than cash to the
partnership, it is necessary to determine and agree upon the fair value or market value of
those assets. This valuation process ensures that the assets are accurately recorded in the
books of the firm.
The following Illustrative Example provides an example of accounting for the introduction of
capital by partners:

Nimesh, Ramesh and Amesh decided to start a partnership business by contributing capital
as follows. Nimesh contributed Rs. 1,000,000 in cash while Ramesh invested Rs. 1,200,000
worth of equipment and Amesh invested Rs. 800,000 worth of furniture and Rs. 150,000 in
cash.
The journal entry in connection with the above transactions are as follows.
CHAPTER 9 Page 160
General Journal
Debit Credit
(Rs.) (Rs.)
Cash account 1,150,000
Equipment account 1,200,000
Furniture account 800,000
Capital account – Nimesh 1,000,000
Ramesh 1,200,000
Amesh 950,000
(Being a record of the capital invested by partners
amounting to Rs.3,150,000).
Partners’ Current Account

The current account of a partnership business serves as a record of the fluctuating equity of
the partners over a specific financial period. It encompasses various elements such as
interest on capital, salaries of partners, profit shares of partners, drawings made by partners,
and any other entitlements of partners.
The current account is maintained for each partner individually, reflecting the changes in
their equity position within the partnership. It captures the financial transactions and
adjustments related to the partners' rights and obligations during the accounting period.
Simple format of a current account is as follows:
Current Account
A B A B
Drawings XX XX Balance B/F XX XX
Interest on capital XX XX
Partner salaries XX XX
Balance C/D XXX XXX Profit share XX XX
XXX XXX XXX XXX
Both capital account and current account of a partnership business represents the equity of
the business entity.
CHAPTER 9 Page 161
9.7 Profit and Loss Appropriation Statement
To distribute the profit among the partners, a partnership utilizes the profit and loss
appropriation statement. This serves as an intermediary step in allocating the profit to
individual partners. Usually this is provided as an extension to the income statement.
Double entry applicable for the appropriations is as follows:
Profit and loss appropriation account Dr XXX

Relevant partner’s current account XXX
These journal entries ensure that the profit for the year is appropriately allocated and
recorded in the profit and loss appropriation statement. Subsequently, the profit is
distributed among the partners based on their respective profit-sharing ratios. The
individual partners' current accounts are credited with their share of the profit, reflecting
the increase in their equity within the partnership.
Since there are more than one owner to a partnership business, the profit or loss for the
period is distributed among the partners as per the partnership agreement. In relation to
matters which are not stated in the partnership agreement, Section 24 of the Partnership
When the profit of a partnership is distributed among the partners, the following three
methods of profit distribution are generally used.
Interest on Capital
In cases where the profit-sharing ratio among partners deviates from their capital ratio (i.e.,
the ratio in which capital is contributed by each partner), a method of profit distribution
known as "interest on capital" may be employed as per the partnership agreement. Under
this method, partners who have invested a relatively higher amount of capital will receive a
higher interest payment, while partners who have invested a relatively lower amount of
capital will receive a lower interest payment. This approach aims to facilitate a fair
distribution of profits among the partners, taking into consideration their respective capital
contributions.
By providing interest on capital, the partnership recognizes the varying levels of capital
investment made by each partner. The interest serves as a return on the capital contributed,
rewarding partners for their higher capital commitment. This practice ensures that partners'
interests and contributions are properly acknowledged and accounted for in the profit
distribution process.
The interest on capital is typically determined based on an agreed-upon percentage or rate

specified in the partnership agreement. It may be calculated annually or for a specific period
as mutually agreed upon by the partners. This method helps align the distribution of profits
with the partners' capital investments, promoting fairness and equity within the partnership.
CHAPTER 9 Page 162
Salaries of Partners
In a partnership, it is common for partners to have varying levels of involvement and
contribution to the business activities. To recognize and compensate partners for their
individual contributions, a method of profit distribution known as "salary" may be employed.
This method entails providing partners with a fixed amount or a predetermined percentage
of the profit as compensation for their time, effort, and expertise devoted to the partnership's
activities.
The allocation of salaries as a form of profit distribution aims to reflect the varying levels of
partner involvement and recognize the value they bring to the partnership. Partners who
actively contribute a higher level of time, effort, and skills to the partnership's operations will
receive a comparatively higher salary, while partners with relatively lower involvement will
receive a proportionately lower salary. This approach promotes fairness by aligning the
profit distribution with the individual contributions made by each partner to the
partnership's success.
The determination of partner salaries is typically based on factors such as the nature of the
partnership's activities, the responsibilities assigned to each partner, their level of expertise,
and the agreed-upon terms specified in the partnership agreement. The salaries may be
calculated on a periodic basis, such as monthly or annually, and can be subject to review and
adjustment as the partnership evolves.
By implementing a salary-based profit distribution method, partnerships can ensure that

partners' contributions to the business, both in terms of capital and active involvement, are
appropriately recognized and rewarded. This approach encourages partner engagement,
motivates active participation, and fosters a sense of fairness within the partnership. It also
helps to align the distribution of profits with the partners' respective roles and contributions
to the partnership's overall success.
The Profit Share

Once the partnership has allocated a portion of its profit to partners as interest on capital
and salaries, any remaining surplus is distributed among the partners based on their agreed-
upon profit sharing ratio. This additional distribution of profit, known as profit share, reflects
the partners' respective ownership interests and determines the proportionate share each
partner will receive.
The profit-sharing ratio, established through the partnership agreement or subsequent
mutual consent, outlines the specific distribution percentages or ratios for each partner. It
takes into account various factors, such as the partners' capital contributions, ownership
interests, or other agreed-upon criteria. The profit share is then calculated based on these
predetermined ratios.
The allocation of profit share aims to ensure an equitable distribution of the remaining
profits among the partners. Partners with higher profit-sharing ratios will receive a larger
portion of the surplus, reflecting their greater ownership stake or other relevant
considerations. Conversely, partners with lower profit-sharing ratios will receive a
proportionately smaller share of the remaining profit.
CHAPTER 9 Page 163
The determination and distribution of profit share are typically carried out at the end of the
accounting period, following the allocation of interest on capital and partner salaries. The
profit share is credited to the respective partners' capital accounts, increasing their
individual capital balances accordingly.
By utilizing the profit-sharing ratio, partnerships can effectively allocate the surplus profit
among partners in a manner that aligns with their respective ownership interests and the
agreed-upon terms of the partnership agreement.
This approach ensures fairness, transparency, and adherence to the partnership's
established framework for profit distribution.
Simple format of a profit or loss appropriation statement is as follows:
AB Partnership
Income Statement (Profit or Loss Appropriation)
For the year ended 31.03.20XX
(-) Distributions
Interest on Capital – A XX
B XX (XX)
Salaries – A XX
B XX (XX)
Profit Share – A XX
B XX (XX)
0

Praveen and Kaveen are in partnership sharing profits in the ratio 3:2. The partnership’s
profit for the year ended 31.03.2023 was Rs. 654,600. The partnership agreement provides
for:
interest to be paid on the partners’ opening capital balances at a rate of 5% per annum.
annual partners’ salaries of:
Praveen – Rs. 90,000; and
Kaveen – Rs. 50,000.
At the beginning of the year, the partners’ capital and current account balances were:
Capital Account (Rs.) Current Account (Rs.)
Praveen 1,200,000 156,550
Kaveen 800,000 41,370 (Dr)
During the year, praveen’s drawings were Rs. 180,000 and Kaveen’s drawings were
Rs.85,000.
The profit and loss appropriation statement and the current account of the partnership could
be prepared as follows.
CHAPTER 9 Page 164
Praveen and Kaveen Partnership
Income Statement (Profit or Loss Appropriation)
For the year ended 31.03.2023
(-) Distributions
Interest on Capital – P (1,200,000 x 5%) 60,000
K (800,000 x 5%) 40,000 (100,000)
Salaries – P 90,000
K 50,000 (140,000)
414,600
Profit Share – P (414,600 x 3/5) 248,760
K (414,600 x 2/5) 165,840 (414,600)
0
Current Account
P K P K
Balance B/F - 41,370 Balance B/F 156,550 -
Drawings 180,000 85,000 Interest on capital 60,000 40,000
Partner salaries 90,000 50,000
Balance C/D 375,310 129,470 Profit share 248,760 165,840
550,310 255,840 550,310 255,840
9.8 Preparation of Financial Statements of a Partnership
Other than the special consideration required on profit distribution and preparation of
the partners’current accounts, the preparation of financial statements of a partnership is
very much the same asthat of a sole proprietorship.
The following Illustrative Example explains the preparation of financial statements of a
partnership.
Savani, Bavani, and Kavani engage in a partnership business. As per the partnership
agreement, they share profits and losses in the ratio of 2:2:1 respectively. The
partnership agreement also states that Savani will receive a salary of Rs. 20,000 per
month and Kavani will receive a salary of Rs. 15,000 per month. The partners also agreed
to receive interest on their respective capital contributions at a rate of 10% per annum.
The trial balance of the partnership as at 31.03.2023, is given below:
CHAPTER 9 Page 165

Cash 100,000
Accounts Receivable 150,000
Inventory as at 01.04.2022 200,000
Land 500,000
Building 700,000
Equipment 300,000
Accounts payable 120,000
Bank loan 150,000
Capital accounts – S 300,000
B 225,000
K 150,000
Current accounts – S 100,000
B 75,000
K 50,000
Sales 1,500,000
Purchases 800,000
Rent expense 60,000
Depreciation expenses 50,000
Utilities expense 30,000
Bank loan interest expense 24,000
Drawings – S 40,000
B 30,000
K 20,000
Loan – Savani 100,000
Provision for depreciation – Building 300,000
Equipment 69,000
3,139,000 3,139,000
Additional Information
1. Inventory as at 31.03.2023 was Rs. 250,000
2. Interest has to be adjusted for the loan provided for the partnership by Savani.
3. Rent of Rs. 10,000 paid by Bavani from her personal money was not recorded in the
books.
Income statement, Statement of financial position and current account of the partnership
business can be prepared as follows:
CHAPTER 9 Page 166
Savani, Bavani, Kavani Partnership

Sales 1,500,000
Cost of Sales
Purchases 800,000
1,000,000
Rent expense 70,000
Depreciation expenses 50,000
Utilities expense 30,000 (285,000)
Bank loan interest expense 24,000
Loan interest expense – Savani 5,000 (29,000)
(-) Interest on Capital – S (300,000 x 10%) 30,000

B (225,000 x 10%) 22,500
K (150,000 x 10%) 15,000 (67,500)
(-) Partners’ Salaries – S (20,000 x 12) 240,000

K (15,000 x 12) 180,000 (420,000)
(51,500)
Loss Share – S (51,500 x 2/5) 20,600
B (51,500 x 2/5) 20,600
K (51,500 x 1/5) 10,300 51,500
0
CHAPTER 9 Page 167
Savani, Bavani, Kavani Partnership
As at 31.03.2023 (Rs.)
Depreciation Amount
Land 500,000 - 500,000
Building 700,000 300,000 400,000
Equipment 300,000 69,000 231,000
1,500,000 369,000 1,131,000
Current Assets
Inventories 250,000
Cash 100,000 500,000
Equity
Capital accounts – S 300,000
B 225,000
K 150,000 675,000
Current accounts – S 314,400
B 56,900
K 214,700 586,000
1,261,000
Bank Loan 150,000
Loan – Savani 100,000 250,000
Current Liabilities
Trade payables 120,000 120,000
Current Account
S B K S B K
Drawings 40,000 30,000 20,000 Balance B/F 100,000 75,000 50,000
Loss share 20,600 20,600 10,300 Int. on 30,000 22,500 15,000
capital
Partner 240,000 - 180,000
salaries
Rent - 10,000 -
Balance 314,400 56,900 214,700 Loan 5,000 - -
C/D interest
375,000 107,500 245,000 375,000 107,500 245,000
CHAPTER 9 Page 168
Chapter Round-Up
• This chapter provides a comprehensive understanding of the preparation of financial

statements for partnerships. It begins by defining what a partnership is and delves
into the legal framework surrounding partnerships. The advantages and
disadvantages of partnerships are also discussed, giving readers a clear perspective
on the nature of this business structure.
• Next, the chapter explores the methods of profit distribution within a partnership. It
covers the concept of interest on capital, which ensures that partners who contribute
more capital receive a higher interest payment. The notion of partners' salaries is
explained, highlighting how it recognizes the varying levels of time and effort invested
. by partners in the business. Furthermore, the chapter elucidates profit sharing among
partners, explaining how excess profit is distributed based on the agreed profit
sharing ratio.
• One important aspect covered in the chapter is the preparation of the profit and loss
appropriation statement, which serves as a means to distribute profit among the
partners. The intricacies of this statement, including its components and journal
entries, are detailed to provide a comprehensive understanding of its role in profit
distribution.
• Moreover, the chapter delves into the partners' current accounts, which reflect the
individual equity changes of partners during a financial period. The inclusion of
interest on capital, salaries, profit share, and partner drawings in the current accounts
is thoroughly explained.
• Finally, the chapter guides readers through the process of preparing the income
statement and the statement of financial position for a partnership. It emphasizes
the importance of incorporating adjusting entries specific to partnership
transactions to ensure accurate financial reporting.
CHAPTER 9 Page 169
Question 1
Consider the following statements:
I. A partner can receive an interest of 5% per annum for the loans granted by a partner to
the partnership.
II. A partner is entitled to take part in the management of the partnership.
III. A partner can introduce a new partner to the partnership with his / her own consent.
Of the above, the correct statements with reference to partners’ rights as per the Partnership
Ordinance 1890 are:
(a) (I) and (II) only.

(b) (I) and (III) only.
(c) (II) and (III) only.
(d) All of the above.
Question 2
P and Q are partners in PQ & Co. P’s capital is Rs. 200,000 and Q’s Capital is Rs. 120,000.
Interest is payable @ 6% p.a. Q is entitled to a salary of Rs. 6,000 per month. Profit for the
period was Rs. 160,000. Profit share between P and Q will be;
(a) Rs. 34,400 to P and Rs. 34,400 to Q

(b) Rs. 40,000 to P and Rs. 28,800 to Q
(c) Rs. 28,800 to P and Rs. 40,000 to Q
(d) None
Question 3
What is the correct double entry to record loan interest to be paid to a loan provided by a
partner to the partnership business?
(a) Appropriation Account Dr XXX

Cash Account XXX
(b) Appropriation Account Dr XXX
Current Account XXX
(c) Income statement Dr XXX
Current Account XXX
(d) Income statement Dr XXX
Cash Account XXX
CHAPTER 9 Page 170
Question 4
Three partners A,B and C started a business. B’s capital is four times C’s capital and thrice A’s
capital is equal to twice B’s capital. If the profit to be divided among partners is Rs. 165,000
at the end of the period, find the profit share of B.
(a) 40,000
(b) 50,000
(c) 60,000
(d) 70,000
Answers
Question 1 a
Question 2 a
Question 3 c
Question 4 c
CHAPTER 10 Page 171
Financial Statements of Not-

for Profit Organizations
Learning Outcomes
• Record transactions in special accounts specific to not-for-profit organizations.

• Apply adjustments to financial statements of not-for-profit organizations.
• Prepare financial statements for not-for-profit organizations.
10.1 Introduction
Not-for-profit organizations, such as associations, clubs, and charities, operate on a different

principle compared to for-profit businesses. Unlike for-profit businesses, not-for-profit
organizations do not have owners. Instead, they have members who actively participate and
contribute to the organization by obtaining membership. The primary objective of not-for-
profit organizations is not to maximize profits, but rather to maximize social welfare,
benefiting both their members and society as a whole.
It is important to note that not-for-profit organizations exist not only at the local level but
also on an international scale. These organizations can be found globally, working towards
various causes and addressing social needs in different communities.
Their activities encompass a wide range of sectors, including education, healthcare,

environmental conservation, poverty alleviation, and more. Regardless of their geographical
location, not-for-profit organizations share the common goal of making a positive impact and
advancing the well-being of individuals and society.
10.2 Special Accounts Prepared by the Not-for profit Organisations.
Generally, the following special accounts are prepared by not –for- profit organization.
• Membership Subscriptions Account

• Life Membership Fee Account
• Accumulated Fund Account
CHAPTER 10 Page 172
Membership Subscriptions Account

In not-for-profit organizations, the collection and management of annual subscriptions play
a crucial role. The process involves recording various transactions related to annual
subscriptions in specific accounts.
When annual subscriptions are received from members, the total amount received is
credited to the "Annual Subscriptions" account, while debiting the "Cash" account. This entry
reflects the inflow of funds from members as contributions towards the organization's
activities.
In cases where there are outstanding subscriptions at the end of the year, representing dues
from members that remain unpaid, these amounts are also credited to the "Annual
Subscriptions" account. However, they are recorded by debiting the "Subscriptions in
Arrears" account. This entry acknowledges the existence of outstanding dues that need to be
collected.
Conversely, if the organization receives subscriptions in advance during the year, indicating
payments made by members for future periods, these amounts are debited to the "Annual
Subscriptions" account. At the same time, the "Subscriptions Received in Advance" account
is credited. This entry recognizes the liability to provide services or benefits corresponding
to the prepaid subscriptions.
The balances of subscriptions in arrears and subscriptions received in advance are carried
forward to the next accounting period. They are transferred from the previous period's
accounts to the "Annual Subscriptions" account at the beginning of the new accounting
period.
In certain cases, the organization may determine that some subscriptions in arrears from the
beginning of the year will not be received at all. In such instances, the organization may
decide to write off these uncollectible amounts. To record this write-off, the subscriptions
are credited to the "Annual Subscriptions" account, while debiting the "Subscriptions Write-
off" account. This entry recognizes the loss of expected revenue from uncollectible
subscriptions.
A simple structure of an annual subscriptions account is given below.
Annual Subscription Account

Subscriptions in arrears (B/F) XXX Subs. rec. in advanced (B/F) XXX
Income Statement XXX Cash XXX
Subs. W/O (Income XXX
Statement)
Subs. Rec. in advanced (C/D) XXX Subscriptions in arrears (C/D) XXX
XXX XXX
CHAPTER 10 Page 173
Life Membership Fee Account

In certain not-for-profit organizations, there may be a lifetime subscriptions scheme
available to members in addition to the annual subscriptions scheme. Under the lifetime
subscriptions scheme, members who make a one-time payment become lifetime members of
the organization and are exempt from paying annual subscriptions in subsequent years.
To account for lifetime subscriptions, a deferred income approach is typically followed. This
means that the entire amount of lifetime subscriptions received during a specific year is not
immediately recognized as income in the organization's income statement. Instead, it is
deferred and recognized as income over a period of several years.
The balance of the deferred lifetime subscriptions is recorded as part of the organization's
equity. It represents the unearned portion of the lifetime subscriptions that is yet to be
recognized as income.
By deferring the recognition of lifetime subscriptions, the organization aligns its financial
reporting with the services or benefits provided to lifetime members over an extended
period. This approach ensures that income is recognized gradually and accurately, reflecting
the ongoing value and commitment associated with the lifetime memberships.
Ultimately, this accounting treatment of lifetime subscriptions allows not-for-profit

organizations to appropriately reflect the financial impact of these long-term membership
arrangements and provide a clear picture of their financial position and performance.
Below illustration shows the preparation of subscription account and life membership fee
account of a not-for profit organization.

ANK Club, a not-for-profit organization, operates an annual subscriptions scheme and a
lifetime subscriptions scheme for its members. During the year, the club received
subscriptions from its members and also collected life membership fees. The club follows the
deferred income approach for recognizing lifetime subscriptions as income. Below details
are related to the year ended 31.03.2023
• Annual subscriptions received during the year: Rs. 100,000

• Subscriptions in arrears as at 04.01.2022: Rs. 20,000
• Subscriptions received in advance as at 01.04.2022: Rs. 5,000
• Subscriptions in arrears as at 31.03.2023: Rs. 15,000
• Subscriptions received in advance as at 31.03.2023: Rs. 12,000
• Life membership fees received during the year: Rs. 20,000
The club recognizes lifetime subscriptions as income over a period of 10 years. The club has
received Rs. 100,000 as life membership fee on 04.01.2018.
It was decided to write off Rs. 7,000 from the subscription arrears at the beginning of the
period, as irrecoverable.
CHAPTER 10 Page 174
Subscription account for the year ended 31.03.2023 is as follows:
Subscriptions in arrears (B/F) 20,000 Subs. rec. in advanced (B/F) 5,000

Income Statement 95,000 Cash 100,000
Subs. W/O (Income 7,000
Statement)
Subs. Rec. in advanced (C/D) 12,000 Subscriptions in arrears (C/D) 15,000
127,000 127,000
Life membership fee for the year ended 31.03.2023 is as follows:

Life Membership Fee Account
Income Statement** 12,000 Balance B/F* 60,000

Cash 20,000
Balance C/D 68,000
80,000 80,000
*Amount to be recognized in income from the life membership is Rs. 10,000 (100,000/10).
From 04.01.2018 to 31.03.2022 four years passed and therefore, the opening balance of the
account should be Rs. 60,000 (100,000 - 40,000).
**Rs. 10,000 has to be recognized in the income from previously received life membership
and Rs. 2,000 (20,000/10) has to be recognized in the income from life membership fee
received during the year.
Accumulated Fund Account

The equity of a not-for-profit organization primarily comprises an Accumulated Fund
Account. This account serves to accumulate any surplus or deficit resulting from the
difference between the organization's total income and total expenses. It represents the
cumulative financial position of the organization over time.
10.3 Financial Statements of a Not-for Profit Organization
Similar to a sole proprietorship and partnership, there are two major financial statements of
a not-for profit organization.
Income Statement
At the end of each year, all the income and expenses of a not-for-profit organization are
transferred to the Income statement. This process is similar to the preparation of an income
statement in a trading organization. However, instead of calculating a profit or loss, the net
result is referred to as a surplus or deficit.
CHAPTER 10 Page 175
This distinction is made because the primary objective of not-for-profit organizations is not
to maximize profits, but rather to fulfil their social or charitable purposes.
A simple structure of an income and expenditure account is given below.
ABC Welfare Club

Income Statement for the year ending 31.03.20XX
Income
Annual subscription XXX
Life membership fee XXX
Donations XXX
Net income from events XXX XXX
Expenditure
Salaries and wages XXX
Welfare payments XXX
Electricity and telephone XXX
Rent XXX
Depreciation of equipment XXX
Subscription write off XXX
Other expenses XXX (XXX)
Surplus/ (Deficit) for the year XXX

The Statement of financial position of a not-for-profit organization bears resemblance to that
of a trading organization. It serves the purpose of presenting the financial position of the
organization at a specific date.
This statement provides information about the organization's assets, liabilities, and equity,
enabling stakeholders to assess its financial stability and resources. The preparation and
presentation of the Statement of Financial Position for a not-for-profit organization follows
similar principles and guidelines as those applied in the context of a trading organization.
The following is a simple structure of a statement of financial position of a not- for profit
organization.
CHAPTER 10 Page 176
ABC Welfare Club

As at 31.03.20XX (Rs.)
Depreciation Amount
Land XXX - XXX
Buildings XXX (XXX) XXX
Motor vehicles XXX (XXX) XXX
Office equipment XXX (XXX) XXX
XXX XXX XXX
Long term investment XXX
Current Assets
Subscription in arrears XXX
Prepayments XXX
Cash and bank XXX XXX
Total Assets XXX
Equity
Accumulated fund at the opening date XXX
(+) Surplus for the year XXX
Bank Loan XXX
Current Liabilities
Subscription received in advanced XXX
Accrued expenses XXX
Total Liabilities and Equity XXX
The following illustration explains the preparation of financial statements of a not-for -profit
organization.
CHAPTER 10 Page 177

The trial balance of Star-Sports Club as at 31.03.2023 is given below.
Debit Credit
(Rs.’000) (Rs.’000)
Land 1,800 -
Buildings 1,200 -
Accumulated depreciation- Building -01.04.2022 - 200
Office equipment 450 -
Accumulated depreciation- Office equipment-
01.04.2022 - 125
Subscriptions in arrears-01.04.2022 300 -
Bank balance 210 -
Subscriptions received in advance-01.04.2022 - 225
Bank loan - 600
Annual subscriptions received - 1,750
Lifetime subscriptions received - 600
Salaries 400 -
Stationary 150 -
Interest expenses 175 -
Income from sport festival - 450
Expenses on sport festival 250 -
Accumulated fund - 985
4,935 4,935
The following additional information is also available.
1. The subscriptions in arrears and received in advance as at 31.12.2023 were

Rs.250,000 and Rs.175,000 respectively.
2. It was decided to write off Rs.100,000 subscriptions which were in arrears as at
01.04.2022 due to non-recoverability.
3. The club introduced a life membership scheme during the year and it was decided to
defer the life time subscriptions over 10 years.
4. Property, plant and equipment are depreciated on a straight-line method as follows.
i. Buildings – 5% p.a.
ii. Office equipment – 5% p.a.
5. Salaries payable as at 31.03.2023 was Rs.50,000.
According to the trial balance and the additional information provided, the financial
statements of Star Sports Club could be prepared as follows.
CHAPTER 10 Page 178
Star Sports Club

Income Statement for the year ending 31.03.2023. (Rs’000)
Income
Annual subscriptions 1,850
Lifetime subscriptions 60
Net income from sport festival 200 2,110
Expenditure
Salaries 450
Stationary 150
Interest 175
Depreciation of building 60
Depreciation of equipment 90
Subscriptions written off 100 (1,025)
Surplus for the year 1,085
Star Sports Club

Statement of Financial Position As at 31.03.2023 (Rs.,000)
Depreciation Amount
Land 1,800 1,800
Buildings 1,200 260 940
Office equipment 450 215 235
3,450 475 2,975
Current Assets
Subscription in arrears 250
Cash and bank 210 460
Total Assets 3,435
Equity
Accumulated fund at the opening date 985
(+) Surplus for the year 1,085
2,070
Deferred income- Life time subscriptions2 540 2,610
Bank Loan 600
Current Liabilities
Subscription received in advanced 175
Accrued expenses 50
Total Liabilities and Equity 3,435
2
Alternatively, this could be presented as a non –current liability. Classification will be based
on terms and conditions of the life membership fee and the policies of the organization.
CHAPTER 10 Page 179
Chapter Round-Up
• This chapter provides a comprehensive overview of the preparation of financial

statements for not-for-profit organizations. It begins by introducing the special
accounts used by these organizations, including the subscriptions account, life
membership fee account, and accumulated fund account.
• The chapter then delves into the process of preparing financial statements for not-
for-profit organizations. It covers the preparation of the income statement, which
showcases the organization's revenue and expenses, and the statement of financial
position, which highlights the organization's financial position at a specific point in
time. The chapter also emphasizes the importance of adjusting entries in accurately
reflecting the financial activities of not-for-profit organizations.
• To illustrate these concepts, the chapter provides detailed examples and step-by-step
explanations of how to prepare the income statement and statement of financial
position for not-for-profit organizations. It emphasizes the significance of
incorporating adjusting entries to ensure the financial statements accurately
represent the organization's financial performance and position.
• Overall, this chapter serves as a comprehensive guide to understanding and

preparing financial statements for not-for-profit organizations, offering valuable
insights and practical examples to facilitate the process.
Question 1
From the following account, calculate the subscription income to be shown in Income
statement for the year ended 31.12.2022:
• Subscription received during the year - Rs. 800,000
• Subscription outstanding as at 31.12.2021 - Rs. 20,000
• Subscription outstanding as at 31.12.2022 - Rs. 10,000
• Subscription received in advance as on 31.12.2021 - Rs. 50,000
(a) Rs. 800,000

(b) Rs. 750,000
(c) Rs. 600,000
(d) Rs. 840,000
CHAPTER 10 Page 180
Question 2
The following details are related to an Alumni association of a university.
• Annual membership fee is Rs.15,000/-. 100 members were joined at the inception of the
Association in 2020 and 20 members and 10 members respectively were newly joined in
years 2021 and 2022.
• Membership fees of 15 members for the year 2021 were in arrears as at 31.12.2021. Out
of them, 12 members paid their arrears membership fees together with 2022
membership fees in 2022, while 3 members were migrated in early 2022 without paying
the membership fee for year 2021. At the executive committee meeting held on
01.06.2022, it was decided to cancel their membership and write off the amount
receivable as at 01.01.2022.
• During the year 2021, 20 members paid their membership fee for the year 2022 in
advance while 12 members paid their membership fee for the year 2023 during the year.
Required.
Subscription account for the year ended 31.12.2022.
Answers
Question 1 d
Question 2
Subscriptions in arrears (B/F) 225,000 Subs. rec. in advanced (B/F) 300,000
Income Statement 1,905,000 Cash 1,965,000
Subs. W/O 45,000
Subs. Rec. in advanced (C/D) 180,000
2,310,000 2,310,000
CHAPTER 11 Page 181
Statements for Companies - I
Learning Outcomes
• Explain the characteristics of limited liability companies.

• Compare and contrast a limited liability company with a sole proprietorship.
• Explain the sources of funds available to companies.
• Evaluate and discuss the relevance of different perspectives of management
theories.
• Illustrate accounting for public issue of shares, rights issue of shares and
capitalization of reserves
11.1 Introduction
Introduction00000000000000000000
A company is an incorporated entity with a distinct legal personality that is separate from its
00000000000000000000000000000
shareholders and directors. A company is owned by its shareholders, who provide capital to
00000000000000000000000000000
the company in exchange for company shares. The shareholders elect a board of directors to
00000000000000000000000000000
oversee the company's operations and make strategic decisions. However, a company is a
00000000000000000000000000000
separate legal entity with a distinct legal personality, unlike sole proprietorships or
partnerships which do not have a legal personality. It is an autonomous entity that has the
00000000000000000000000000000
ability to own assets, incur liabilities, and enter into contractual agreements in its own name.
00000000000000000000000000000
This means that the company's assets, liabilities, and contractual obligations are solely
00000000000000000000000000000
attributed to the company itself, rather than its shareholders or directors.
00000000000000000000000000000
00000000000000000000000000000
In Sri Lanka, an incorporated company refers to a company that has been registered and
established in accordance with the regulations set forth in the Companies Act No. 07 of 2007.
00000000000000000000000000000
This act outlines the procedures and legal requirements for establishing and managing a
00000000000000000000000000000
company, including its registration, management, and dissolution.
00000000000000000000000000000
00000000000000000000000000000
A company possesses certain characteristics as a result of its legal personality as follows.
00000000000000000000000000000
• A company has the ability to use its business name for legal activities instead of the names
00000000000000000000000000000
of its owners
00000000000000000000000000000
• A company has a continuing existence
00000000000000000000000000000
00000000000000000000000000000
00000000000000000000000000000
00000000000000000000000000000
00000000000000000000000000000
CHAPTER 11 Page 182
The death or bankruptcy of owners does not affect the existence of the company. A company
“dies” only when it is liquidated, wound up, or becomes insolvent or bankrupt.
Companies
Types of Sources of Issue of shares

companies funding
Limited liability Equity Public

companies funding issue
Stated
Private capital Right issue
Ordinary shares
Public
Reserve
capitalizatio
Preference n
Offshore
shares
Reserves
Unlimited
liability
companies
Debt funding
Companies
limited by
guarantee
Differences between limited liability

companies, partnerships & sole proprietorships
CHAPTER 11 Page 183
11.2 Types of Companies
According to section 3 of the Companies Act No 07 of 2007, there are 3 types of companies.
(a) Limited companies
The liability of the shareholders (owners) is limited to the value of the shares they purchase
(the amount paid or agreed to pay for the shares). In other words, if the company becomes
insolvent and is unable to pay its debts, the shareholders are not personally liable for the
shortfall. Limited companies are the most commonly used method for operating a business.
(b) Unlimited companies
An unlimited company is a type of company where the shareholders have unlimited liability
for the company's debts and obligations. This means that if the company becomes insolvent
and is unable to pay its debts, the shareholders are personally liable for the shortfall.
(c) Companies limited by guarantee
A company limited by guarantee is a type of company in which its members agree to

contribute a specified amount to the assets of the company in the event of its liquidation, as
stated in the company's articles. This structure is designed to offer some level of financial
security to creditors if the company becomes insolvent.
As per the Companies Act, a limited company can be established as a private limited
company, a public limited company, or an offshore company.
i. Private limited companies
A private limited company is a type of company that is owned privately by a group of

individuals or a single individual. As per the Companies Act, private companies are
prohibited to offer shares or other securities issued by the company to the public (shares and
securities are not traded publicly). Further, the maximum number of shareholders is limited
to 50, not including shareholders who are employees of the company.
ii. Public limited companies
This is a limited company that has listed its shares on the stock exchange (Colombo Stock
Exchange). A listed company has the opportunity to raise its capital from the public and
therefore has access to a larger capital base. Shares of the company can be sold to the public
through the stock exchange and the capital can be raised. In a public limited company, there
is no limit of shareholders and there are several laws and regulations to be adhered to other
than the Companies Act. Some examples are:
• The provisions of the Sri Lanka Accounting and Auditing Standards Act No.15 of 1995 –
for the preparation of financial statements
• The provisions of the Securities and Exchange Commission of Sri Lanka Act
• Listing rules of the Colombo Stock Exchange (CSE)
CHAPTER 11 Page 184
iii. Offshore companies
According to the provisions of the Companies Act, it is possible for a company that has been
incorporated in a foreign jurisdiction to register as an offshore company and engage in
business operations outside of the geographic confines of Sri Lanka. Such a company is
formally referred to as an "offshore" company. In essence, an offshore company is an entity
that has been duly registered in Sri Lanka but operates primarily outside the territorial
boundaries of the country.
Figure 11.1: Types of companies
Companies
Unlimited Companies limited

Limited companies
companies by guarantee.
Private Public limited Offshore

limited companies companies
companies
11.3 Differences between Limited Liability Companies, Partnerships and Sole

Proprietorships
Exhibit 11.1: Differences between limited liability companies, partnerships, and sole
proprietorships.
Limited Liability Sole

Partnership
Company proprietorship
Legal Personality Yes No No
Limited Liability Yes No No
Continuing Existence Yes No No
Compulsory
preparation of financial Yes No No
statements
Maximum Number of (i) 50 for private Ltd
owners (ii) Unlimited for 20 01
public Ltd
CHAPTER 11 Page 185
Management Board of Partners Owner

directors
Legal framework Companies Act Partnership Act No specific Act
No 7 of 2007 of
1890
11.4 Sources of Funding
As with any other business structure, a company has the ability to raise funds through a
combination of equity and debt financing. The equity component of a company's capital
structure is typically comprised of the company's share capital, which is commonly referred
to as stated capital, as well as its reserves.
In addition to equity financing, companies can also obtain financing through various forms
of debt, including bank loans, debentures, and other types of borrowings. These debt
financing arrangements allow companies to access additional capital to support their growth
and expansion plans.
Figure 11.2: Sources of Capital
Sources of capital
Equity capital Debt capital
Equity capital of a company
The equity component of a company's capital structure is typically comprised of two key
components, namely stated capital and reserves.
(a) Stated Capital
As per the provisions of the Companies Act, the stated capital of a company represents the
total amount of funds that the company has raised through the issuance of shares to its
shareholders, as well as any amounts that are due and payable to the company in respect of
calls on shares. Stated capital, in essence, reflects the investment made by the owners of the
company, i.e. its shareholders, to obtain ownership of the company. As such, it is also
commonly referred to as share capital. The shares issued by a company can be classified into
two broad categories, namely ordinary shares and preference shares.
CHAPTER 11 Page 186
(i) Ordinary shares
• The company does not entitle the shareholder to a fixed or predetermined dividend
payment. Instead, the dividend payment will vary according to the profit earned by the
company.
• Ordinary shareholders are entitled to vote on any resolution at the company's meetings
• Ordinary shareholders have an equal right to a share in the distribution of the surplus
assets of the company in the event of its liquidation.
• Ordinary shares are also known as common shares, and they represent ownership in a
company with proportional voting rights. This means that the more ordinary shares one
hold, the greater their voting power in the company.
(ii) Preference Shares
• The company entitles the shareholder to a fixed or predetermined dividend payment.

• Dividends to preference shareholders are paid out before any dividends are paid to
ordinary shareholders.
• Preference shareholders do not have the right to vote on any resolution at the company's
meetings.
A key point to consider is that certain types of preference shares, such as redeemable
preference shares, may meet the definition of a liability rather than equity, based on the
substance of the conditions of the instrument. Therefore, these types of shares are typically
classified under non-current liabilities in the company's financial statements, rather than
being classified as equity. This treatment reflects the fact that the company has an obligation
to redeem these shares in the future, which is similar to a debt obligation.
(b) Reserves
The other component of equity capital is the reserves. The reserves are the company's
accumulated/undistributed profits generally available in the form of the general reserve or
retained earnings. Further, there can be revaluation reserves created due to the revaluation
of assets.
Debt capital of a company
Debt capital refers to the funds that a company raises by borrowing money from external
sources, such as banks, financial institutions, or individual investors.
It represents the portion of a company's capital structure that is comprised of borrowed

funds. Companies often utilize debt capital to finance their operations, expand their
businesses, invest in new projects, or meet their short-term financial obligations.
Among the many different types of debt capital instruments of companies, debentures,
corporate bonds, promissory notes, and commercial papers can be identified.
CHAPTER 11 Page 187
(a) Debentures
Limited liability companies may issue debentures which are long-term liabilities. Debentures
are typically backed by the general creditworthiness and ability of the issuer to honor its
repayment obligations, rather than being secured by specific assets. They are different from
stated capital in the following way.
(a) Shareholders are members of a company, while providers of debentures are creditors.
(b) Shareholders receive dividends whereas the holders of debentures are entitled to a fixed
rate of interest (an expense charged against revenue).
(c) Debenture holders can take legal action against a company if their interest is not paid
when due, whereas shareholders cannot enforce the payment of dividends.
(b) Corporate bonds
A corporate bond is a type of debt security that is issued by a firm and sold to investors. The
company gets the capital it needs and in return, the investor is paid a pre-established number
of interest payments at either a fixed or variable interest rate. When the bond expires, or
"reaches maturity," the payments cease and the original investment is returned.
11.5 Issue of Shares
There are three main types of share issues made by the companies.
5.1 Public issue of shares

5.2 Rights issue of shares
5.3 Capitalization of reserves (Bonus issue of shares)
5.1 Public issue of shares
When a company offers its shares to the public for investment, it issues a prospectus along
with the applications. The prospectus contains necessary information about the company
which can assist investors in their decision making. Interested investors submit their
applications with the application money. Although the current practice is to collect the entire
share price with the applications, the share price can be collected in different stages, such as
with the application, at the allotment, and at the call.
If the company receives applications for shares greater than the number of shares being
issued, the excess money is returned. The shares are then allotted to the accepted applicants.
If only a part of the share price is collected with the applications, then the balance amount
may be collected after the allotment of shares. In certain cases, the entire share price is not
collected with the application and allotment, and a part of the share price is collected at a
later stage known as a call.
The following journal entries are made for the public issue of shares.
CHAPTER 11 Page 188
(These entries are developed for a share issue in which the share price is collected in three
stages: with applications, at the allotment, and at the first and final call).
1. Cash/Bank account Debit

Application and allotment account Credit
(Cash receipt on the issue of shares - with application)
2. Application and allotment account Debit

Cash/Bank account Credit
(Cash payment for the rejected applicants)

Stated capital - Ordinary share account Credit
(Capitalization of share issue – with application)

Application and allotment account Credit
(Cash receipt on the issue of shares - at allotment)

(Capitalization of share issue - at allotment)

First and final call account Credit
(Cash receipt on the issue of shares - at first and final call)
7. First and final call account Debit

(Capitalization of share issue - at first and final call)
The below illustrative examples 1 and 2 provide a demonstration of the accounting

treatment for a public issue of shares.
The board of directors of Sunshine PLC has decided to make a public issue of 100,000 shares
at a price of Rs. 30 each. The entire consideration is planned to collect with the applications.
The following information is provided in relation to the public issue.
01/01: Applications were called for 100,000 shares at Rs.30 each by issuing prospectus.
31/01: Applications were received for 120,000 shares with the application money of Rs.30
per share.
CHAPTER 11 Page 189
15/02: Applications for 20,000 shares were rejected.
16/02: 100,000 shares were allotted, and allotment letters were issued.
Required: The journal entries to record the public issue of shares.
Answer
31/01 Cash/Bank account (120,000 x 30) Dr Rs. 3,600,000

Application and allotment account Cr Rs. 3,600,000
(Being recorded the cash receipt on the issue of shares
- with application)
15/02 Application and allotment account (20,000 x 30) Dr Rs. 600,000

Cash/Bank account Cr Rs. 600,000
(Being recorded the repayment of excess application
money in respect of the share issue)
16/02 Application and allotment account (100,000 x 30) Dr Rs. 3,000,000

Stated capital - Ordinary share account Cr Rs. 3,000,000
(Being recorded the allotment of shares)
Let’s assume that Sunshine PLC has decided to collect the share price of Rs. 30 as follows.
With application Rs. 15
At allotment Rs. 10
At first and final call Rs. 5
Rs. 30
The following information has been provided in relation to the share issue.
01/01: Applications were called for 100,000 shares at Rs. 30 each by issuing the prospectus
31/01: Applications were received for 120,000 shares with the application money of Rs.15
per share.
16/02: 100,000 shares were allotted and allotment letters were issued.
28/02: The allotment money of Rs. 10 per share was received.
01/07: The first and final call was made.
10/07: The call money of Rs. 5 per share was received.
Required: The journal entries to record the public issue of shares.

CHAPTER 11 Page 190
Answer

(Being recorded the receipt of application money in
respect of share issue)



(Being recorded the receipt of the allotment money)
01/07 First and Final Call Account (100,000 x 5) Dr Rs. 500,000

Stated capital - Ordinary share account Cr Rs. 500,000
(Being recorded the first and final call of shares)
10/07 Cash/Bank account (100,000 x 5) Dr Rs. 500,000

First and Final Call Account Cr Rs. 500,000
(Being recorded the receipt of the call money)
5.2 Right issue of shares
A rights issue, also known as a right offering, is a method through which a company raises
additional capital by offering new shares to its existing shareholders.
In a rights issue, the company grants existing shareholders the right to purchase a specified
number of new shares at a predetermined price, known as the subscription price. The
subscription price is usually set at a discounted rate compared to the prevailing market price.
The purpose of a rights issue is to provide existing shareholders with the opportunity to
maintain or increase their ownership stake in the company. Existing shareholders are
granted the privilege to invest in new shares in proportion to their current shareholdings.
Participating in a rights issue is optional for existing shareholders. They have the right to
either exercise their subscription rights by purchasing the new shares at the subscription
price or choose not to participate, allowing their rights to lapse. Shareholders who do not
exercise their subscription rights may experience dilution of their ownership percentage if
other shareholders choose to subscribe to the new shares.
CHAPTER 11 Page 191
The following journal entries are made for the rights issue of shares.

Rights issue account Credit
(Cash receipt on the right issue of shares)
2. Rights issue account Debit

Stated capital – Ordinary share account Credit
(Capitalization of share issue - allotment of shares)
The below illustrative examples 3 and 4 provide a demonstration of the accounting

treatment for the right issue of shares.
Moon PLC, with a stated capital - ordinary shares balance of Rs. 2,500,000, comprised of
100,000 shares issued at Rs. 25 each, made a decision to initiate a rights issue. The rights
issue was priced at Rs. 35 per share and offered in the proportionate of one new share for
every four shares held by existing shareholders. The entire consideration for the rights issue
is collected at the time of application. The market price of a share of Moon PLC at the time of
the rights issue was Rs. 45 per share.
31/05: Applications were received from all the existing shareholders who had the right to
apply for right issue shares with the application money of Rs. 35 per share.
10/06: Shares were allotted, and allotment letters were issued.
Required: The journal entries to record the right issue of shares.
Answer
31/05 Cash/Bank account (100,000 x ¼) x 35 Dr Rs. 875,000

Rights Issue Account Cr Rs. 875,000
respect of right issue)
10/06 Rights Issue Account Dr Rs. 875,000

Stated capital - Ordinary Share Account Cr Rs. 875,000
CHAPTER 11 Page 192
The extracts of Sun PLC’s statement of financial position as of 31.12.20XX are as follows.
Rs. ‘000
Stated capital (Rs. 10 per share) 10,000
Revaluation reserve 8,000
Retained earnings 5,000
23,000
Sun PLC has decided on a right issue of 2 for 5 at Rs. 12. Current market price of a share is Rs.
15.
Required:
1) The journal entries to record the right issue of shares.
2) Prepare the adjusted financial position extract after the issue.
Answer
Number of shares in issue (10,000,000 / 10) 1,000,000
Right share issue (1,000,000/5) x 2 400,000
Cash/Bank account (400,000 x 12) Dr Rs. 4,800,000

Rights Issue Account Cr Rs. 4,800,000
respect of right issue)
Rights Issue Account Dr Rs. 4,800,000

Stated capital - Ordinary Share Account Cr Rs. 4,800,000
Adjusted extracts of the statement of financial position
Rs. ‘000
Stated Capital 14,800
Revaluation reserve 8,000
Retained earnings 5,000
27,800
CHAPTER 11 Page 193
5.3 Capitalization of reserves (Bonus issue of shares)
A company may have the need to increase its stated capital without the intention of raising
additional funds through the issuance of new shares. In such cases, the company has the
option to reclassify a portion of its reserves as stated capital. This reclassification is a mere
accounting adjustment and does not involve the infusion of new capital. Any revenue
reserves held by the company can be reclassified in this manner.
A bonus issue does not alter the total equity of the company. The overall equity remains the
same since the reserves are merely reclassified as stated capital. Therefore, while the bonus
issue enhances the stated capital and share capital of the company, it does not have an impact
on the total equity or generate any new external funds.
The allocation of new shares is carried out in a proportionate manner, relative to the number
of shares currently held by each shareholder. This means that shareholders receive new
shares in proportion to their existing shareholdings.
The following journal entries are made for the reserve capitalization.
1. Retained earnings/general reserves account Debit

Reserve capitalization account Credit
(Transfer of reserves balances to reserve capitalization account)
2. Reserve capitalization account Debit

Stated capital – Ordinary share account Credit
(Capitalization of share issue - allotment of shares)
The below illustrative example 5 provides a demonstration of the accounting treatment for
reserve capitalization.
As of 31.07.20XX, the equity balances of Star PLC were as follows.
Stated capital – ordinary shares (100,000 shares at Rs. 15) Rs. 1,500,000
Retained earnings Rs. 850,000
General reserves Rs. 1,200,000
The board of directors of Star PLC decided to make a bonus issue at Rs. 20 per share in the
proportionate of one share for every four shares held by the existing shareholders. The bonus
issue was funded by both retained earnings and general reserves equally. The bonus issue
was exercised on 25.08.20XX.
Required: The journal entries to record the reserve capitalization/bonus issue of shares.
CHAPTER 11 Page 194
Answer
25/08 Retained earnings account (100,000 x ¼) x 20 x 0.5 Dr Rs. 250,000

General reserves account (100,000 x ¼) x 20 x 0.5 Dr Rs. 250,000
Reserve Capitalization Account Cr Rs. 500,000
(Being transferred the reserves to reserve
capitalization account)
25/08 Reserve Capitalization Account Dr Rs. 250,000
Stated capital – Ordinary share account Cr Rs. 500,000
(Being recorded the capitalization of reserves -
allotment of shares)
Similarities between the rights issue and the reserve capitalization
• Both issues result in the new issue of shares by the company and result in an increase in
the stated capital.
• Both rights issues and bonus issues are made for the existing shareholders of the
company.
• Both rights issue and bonus issue are made proportionately to the shares held by the
existing shareholders.
Differences between the rights issue and the reserve capitalization
Exhibit 11.2: Differences between the rights issue and the reserve capitalisation.
Rights Issue Reserve Capitalization
(1) Results in an increase in the total Results in no change in the total equity
equity of the company of the company.
(2) Results in an increase in assets of the Results in no change in the assets of
company. the company.
(3) Shares are issued for cash or other Shares are issued at free of charge.
consideration.
(4) Does not result a distribution to Results a distribution to existing
existing shareholders. shareholders.
CHAPTER 11 Page 195
Chapter Round-Up
• A company is an incorporated entity with a distinct legal personality that is separate

from its shareholders and directors.
• As per the Companies Act No 07 of 2007, there are different types of companies as
limited liability companies, unlimited liability companies and companies limited by
guarantee.
• Limited liability companies can be further categorized as private limited companies,
public limited companies and offshore companies.
• Public limited companies can be listed in a stock exchange to sell shares to public.
• There are some important differences between a limited liability company, sole
proprietorship and partnership.
• Both equity funding and debt funding can be used to raise capital for a company.
• Stated capital and reserves are owned by the shareholders. They are known
collectively as shareholders' equity.
• There are three main types of share issues: public issue of shares, right issue of shares
and reserve capitalization.
• A company can increase its stated capital by means of a reserve capitalization or a
rights issue. However, a reserve capitalization doesn’t have an overall impact on the
equity balance.
Question 1
What are the differences between ordinary shares and preference shares?
Question 2
Distinguish between the right issues and capitalization of reserves (bonus issues).
Question 3
Ocean PLC had a stated capital - ordinary shares balance of Rs. 4,000,000 as at 01.01.20XX.
The board of directors decided to make a public issue of 250,000 shares at Rs. 50 each. The
entire consideration is collected with the application.
01/01: Applications were called 250,000 shares at Rs. 50 each by issuing a prospectus.
31/01: Applications were received for 300,000 shares with the application money of Rs. 50
per share.
Required: The journal entries for the recording of the above transactions.
CHAPTER 11 Page 196
Question 4
Seashells PLC had a stated capital - ordinary shares balance of Rs. 2,000,000 as at 01.01.20XX.
The board of directors decided to make a public issue of 150,000 shares at Rs.15 each. The
share price is collected as follows.
With application - Rs. 7
At allotment - Rs. 5
At first and final call - Rs. 3
01/01: Applications were called 150,000 shares at Rs.15 each by issuing a prospectus.
31/01: Applications were received for 175,000 shares with the application money of Rs. 7
per share.
28/02: The allotment money of Rs. 5 per share was received.
01/07: The first and final call was made.
10/07: The call money of Rs. 3 per share is received.
Required: The journal entries for the recording of above transactions
Question 5
A company has a balance on the revaluation reserve account of Rs 50,000 and on retained
earnings of Rs 75,000. The stated capital is 400,000 shares issued at Rs 1. The company
decides to make a reserve capitalization (bonus issue) of one-for-one. What are the closing
balances on revaluation reserve and retained earnings?
Revaluation reserve Retained earnings

A Rs 25,000 Nil
B Rs 25,000 Rs 15,000
C Rs 50,000 Rs (325,000)
D Nil Rs (275,000)
CHAPTER 11 Page 197
Answers
Question 1
Voting rights: Ordinary shares typically carry voting rights, allowing shareholders to
participate in the decision-making process of the company. Preference shares, on the other
hand, often have limited or no voting rights.
Dividends: Preference shares have a priority claim on dividends over ordinary shares. They
are entitled to receive a fixed dividend amount, usually expressed as a percentage of the face
value, before any dividends are distributed to ordinary shareholders.
However, if the company does not have sufficient profits to pay the fixed dividend, preference
shareholders may have the right to accumulate unpaid dividends for future payment.
Ordinary shareholders receive dividends after preference shareholders have been paid their
fixed dividends.
Capital distribution: In the event of liquidation or winding up of the company, preference

shareholders have a priority claim on the company's assets over ordinary shareholders. They
are entitled to receive their investment amount back before any remaining assets are
distributed to ordinary shareholders. Ordinary shareholders have a residual claim on the
company's assets, meaning they receive the remaining assets after all other obligations,
including preference share payouts, have been fulfilled.
Risk and return: Ordinary shares are considered riskier but potentially offer higher returns.
Their value is more dependent on the company's performance and fluctuations in the stock
market. Preference shares, on the other hand, provide more stability and a fixed income
stream through their fixed dividend payments.
Question 2
Rights Issue Reserve Capitalization
(1) Results in an increase in the total Results in no change in the total equity
equity of the company.
of the company
(2) Results in an increase in assets of the Results in no change in the assets of the
company. company.
(3) Shares are issued for cash or other Shares are issued at free of charge.
consideration.
(4) Does not result in a distribution to Results a distribution to existing
existing shareholders. shareholders.
Question 3

(Being recorded the cash receipt on the issue of
shares - with application)
CHAPTER 11 Page 198

Cash/Bank account Cr Rs. 2,500,000

Question 4

respect of share issue)


Application and allotment account Cr Rs. 750,000
(Being recorded the receipt of the allotment money)
01/07 First and Final Call Account (150,000 x 3) Dr Rs. 450,000

Stated capital - Ordinary share account Cr Rs. 450,000
(Being recorded the first and final call of shares)

First and Final Call Account Cr Rs. 450,000
(Being recorded the receipt of the call money)
Question 5
Answer is C.
Capitalization of 1:1 means a further 400,000 shares are issued at Rs 1. This Rs 400,000 is
taken from retained earnings and the revaluation reserve remains the same.
CHAPTER 12 Page 199
Statements for Companies - II
Learning Outcomes
• Understand the objective, purpose, and general features of LKAS 1:

Presentation of financial statements when preparing the financial statements.
• Identify the components of a complete set of financial statements.
• Describe the structure, components, and elements of the statement of profit or
loss and other comprehensive income, statement of financial position, and
statement of changes in equity and notes to the financial statements as per
LKAS 1: Presentation of financial statements.
• Describe the structure, components, and elements of the statement of cash
flows as per LKAS 7: Statement of cash flows.
• Prepare financial statements of a public company for publication.
12.1 Introduction
Chapter 11 provided an introduction to companies and accounting for the issue of shares of
limited liability companies. This chapter explains the preparation and presentation of the
financial statements of a company for the publication purpose. When a company prepares
financial statements for publication purpose, it is required to follow the guidelines available
in Sri Lanka Accounting Standard LKAS 1: Presentation of financial statements and other
applicable accounting standards. Accordingly, the early part of this chapter explains about
the guidelines available in LKAS 1 and the latter part of this chapter explains about the
preparation of the financial statements of a company for publication purposes with
illustrative examples.
CHAPTER 12 Page 200
Financial
Statements
Preparation of
LKAS 1 LKAS 7
F/Ss
Objective Direct Method
Purpose Indirect Method
Complete set of
F/Ss

Statement of Profit or Loss and OCI
Statement of Changes in Equity
Statement of Cash Flows
Notes to the Financial Statements
General Features
of F/Ss
Structure and
Content
12.2 LKAS 1: Presentation of Financial Statements
This standard must be applied by an entity when preparing and presenting general-purpose
General-purpose financial statements refer to financial statements that are designed to fulfil
the requirements of users who cannot request customized reports tailored to their specific
information needs. As such, general-purpose financial statements encompass those that are
presented individually or as part of another public document, such as an annual report or a
prospectus.
CHAPTER 12 Page 201
The purpose of these statements is to provide comprehensive financial information that is

useful and relevant to a wide range of users, including investors, creditors, regulatory bodies,
and other stakeholders. By adhering to this standard, entities ensure the transparency,
consistency, and comparability of their financial reporting, thereby facilitating meaningful
analysis and decision-making by the intended users.
In addition to general-purpose financial statements, there can be special-purpose financial

statements, which are intended for presentation to a limited group of users for a specific
reason. Those special-purpose financial statements are used in tax reporting, bank reporting,
and industry-specific reporting. LKAS 1 sets guidelines for the preparation of general-
purpose financial statements herein referred to as “financial statements”.
Objective of LKAS 1
LKAS 1 prescribes the basis for the presentation of general-purpose financial statements to
ensure comparability both with the entity’s financial statements of previous periods and with
the financial statements of other entities. It sets out overall requirements for the
presentation of financial statements, guidelines for their structure, and minimum
requirements for their contents.
Purpose of financial statements
The primary objective of general-purpose financial statements according to LKAS 1 is to offer

information that is relevant and beneficial to a diverse group of users when making economic
decisions. These financial statements aim to provide insights into an entity's financial
position, financial performance, and cash flows.
Also, the financial statements show the result of management’s stewardship of the resources
entrusted to the entity. To meet this objective, financial statements provide information
about an entity’s assets, liabilities, equity, income and expenses, contributions by and
distributions to owners in their capacity as owners, and cash flows.
Components of a complete set of financial statements
As per LKAS 1, a complete set of financial statements comprises the following.
a) A statement of financial position as at the end of the period;

b) A statement of profit or loss and other comprehensive income for the period
c) A statement of changes in equity for the period
d) A statement of cash flows for the period
e) Notes, comprising a summary of significant accounting policies and other explanatory
information
f) A statement of financial position at the beginning of the earliest comparative period when
an entity applies an accounting policy retrospectively or makes a retrospective
restatement of items in its financial statements
CHAPTER 12 Page 202
In addition to the above statements, most of the companies report on various other
important aspects as well. A few examples can be depicted as follows.
• Changes in the business environment including the impact on the business organization
and the reactions of the business organization to those changes.
• Policies of the company related to investments and dividends
• Sources of funding for the company
• Strengths and resources of the company which are not reported in the statement of
financial position
General features as per LKAS 1
The following general requirements are available in the LKAS 1 in relation to the preparation
and presentation of financial statements.
(a) Fair presentation and compliance with SLFRSs
Financial statements shall present fairly the financial position, financial performance and
cash flows of an entity. Fair presentation requires the faithful representation of the effects of
transactions, other events and conditions in accordance with the definitions and recognition
criteria for assets, liabilities, income and expenses set out in the conceptual framework for
financial reporting (Refer to chapter 7). The application of Sri Lanka Accounting Standards,
with additional disclosure, when necessary, is presumed to result in financial statements that
achieve a fair presentation.
(b) Going concern
When preparing financial statements, management shall make an assessment of an entity’s

ability to continue as a going concern. The financial statements shall be prepared on a going
concern basis unless management either intends to liquidate the entity or to cease trading or
has no realistic alternative but to do so.
(c) Accrual concepts
An entity shall prepare its financial statements, except the cash flow information, using an
accrual basis.
(d) Materiality and Aggregation
Each material class of similar items shall be presented separately in the financial statements.
Items of a dissimilar nature or function shall be presented separately unless they are
immaterial.
(e) Offsetting
Assets and liabilities, and income and expenses, shall not be offset unless required or
permitted by another Sri Lanka Accounting Standard.
CHAPTER 12 Page 203
(f) Frequency of reporting
An entity shall present a complete set of financial statements at least annually.
(g) Comparative Information
Except when a standard permits or requires otherwise, comparative information shall be

disclosed in respect of the previous period for all amounts reported in the financial
statements.
(h) Consistency of presentation
An entity shall retain the presentation and classification of items in the financial statements
from one period to the next unless another accounting standard requires a change in
presentation, or another presentation would be more appropriate.
Structure and Content
(a) An entity shall clearly identify the financial statements and distinguish them from the
other information in the same published document.
(b) An entity shall clearly identify each financial statement and the notes.
(c) An entity shall display the following information prominently and repeat it when
necessary.
• Name of the reporting entity.
• Whether the financial statements are of an individual entity or a group of entities
• The date of the end of the reporting period or the period covered by the financial
statements.
• The presentation currency.
• The level of rounding used in presenting the amounts in the financial statements.
The Current/non-current distinction
Most public limited companies classify assets and liabilities as current and non-current when
preparing the statement of financial position. As per LKAS 1, assets and liabilities are
classified as current and non-current as follows.
• Current assets
An asset shall be classified as current when it satisfies any of the following criteria:
a) It is expected to be realized in, or is intended for sale or consumption in the entity’s

normal operating cycle;
b) It is held primarily for the purpose of being traded;
c) It is expected to be realized within twelve months after the reporting period; or
d) It is cash or a cash equivalent.
All other assets shall be classified as non-current.

CHAPTER 12 Page 204
• Current liabilities
Liability shall be classified as a current when it satisfies any of the following criteria:
a) It is expected to be settled in the entity’s normal operating cycle;

c) It is due to be settled within twelve months after the reporting period; or
d) The entity does not have an unconditional right to defer settlement of the liability for at
least twelve months after the reporting period.
All other liabilities shall be classified as non-current.
However, based on the nature of its operations, entities such as banks and finance companies
could decide not to present current and non-current classifications for assets and liabilities
on the face of the statement of financial position. When an entity such as a bank chooses not
to make this classification, it should present the assets and liabilities broadly in order of their
liquidity.
12.3 Preparation of Financial Statements of a Public Limited Company for the

Purpose of Publications
When preparing the financial statements of a public limited company, all the components of
a complete set of financial statements should be available. Information to be presented under
each financial statement are as follows.
1. Statement of Financial Position (SOFP)
As a minimum, the statement of financial position should include the following line items
with the amounts.
a) Property, plant and equipment;

b) Right-of-use assets
c) Intangible assets;
d) Financial assets (excluding amounts shown under (e), (h) and (i);
e) Investments accounted for using the equity method;
f) Biological assets;
g) Inventories;
h) Trade and other receivables;
i) Cash and cash equivalents;
j) Trade and other payables;
k) Provisions;
l) Interest-bearing loans and borrowings;
m) Liabilities and assets for current tax as per LKAS 12: Income Taxes;
n) Deferred tax liabilities and deferred tax assets;
o) Issued capital and reserves
Additional line items, headings and subtotals should be presented in the statement of
financial position when such presentation is relevant to an understanding of the entity’s
financial position.
CHAPTER 12 Page 205
Accordingly, the following structure of the statement of financial position could be used for
publication purposes.
(It should be noted that the items appearing in the following format of the statement of
financial position have been limited based on the content of the syllabus of this course unit).
XYZ PLC
Statement of Financial Position as at 31.03.20XX (Rs.)
Non-Current Assets
Property, plant and equipment XXX
Intangible assets XXX
Financial assets XXX XXX
Current Assets
Inventories XXX
Trade receivables XXX
Other current assets XXX
Cash and cash equivalents XXX XXX
Total Assets XXX
Equity
Share capital XXX
Revaluation Reserves XXX
General Reserves XXX
Retained earnings XXX XXX
Non-Current Liabilities
Long-term borrowings XXX XXX
Current Liabilities
Trade and other payables XXX
Short-term borrowings XXX
Current portion of long-term borrowings XXX
Current tax payable XXX
Short-term provisions XXX XXX
Total Equity and Liabilities XXX
CHAPTER 12 Page 206
2. Statement of Profit or Loss and Other Comprehensive Income
An entity shall present all items of income and expenses recognized in a period:
(a) in a single statement of comprehensive income, or

(b) in two statements
o separate income statement showing the components of profit or loss and
o statement of comprehensive income beginning with the profit or loss figure and
showing components of other comprehensive income
As a minimum, the statement of comprehensive income shall include the following line items
with the amounts.
(i) Revenue
(ii) Finance costs
(iii) Tax expense
(iv) Profit or loss
(v) Each component of other comprehensive income
(vi) Total comprehensive income
Additional line items, headings and sub-totals should be presented when such presentation
is relevant to an understanding of the entity’s financial performance.
Accordingly, the following structure of the statement of profit or loss and other
comprehensive income could be used for publication purposes.
(It should be noted that the items that appear in the following format of the statement of
profit or loss and other comprehensive income have been limited based on the content of the
syllabus of this course unit).
XYZ PLC
Statement of Profit or Loss and Other Comprehensive Income
for the year ended 31.03.20XX (Rs.)
Revenue XXX
Cost of sales (XXX)
Gross profit XXX
Other income XXX
Distribution costs (XXX)
Administrative expenses (XXX)
Other expenses (XXX)
Finance costs (XXX)
Profit before tax XXX
Income tax expense (XXX)
CHAPTER 12 Page 207
Profit for the period XXX

Other comprehensive Income
Revaluation surplus XXX
Total comprehensive income XXX
3. Statement of Changes in Equity
An entity shall present the following information in the statement of changes in equity.
(a) Total comprehensive income for the period;

(b) The cumulative effect of changes in accounting policies and the rectification of errors.
(c) A reconciliation between the carrying amount of each class of equity capital and each
reserve at the beginning and the end of the period, separately disclosing each movement.
Accordingly, the following structure of the statement of changes in equity could be used for
publication purposes.
(It should be noted that the items that appear in the following format of the statement of
changes in equity have been limited based on the content of the syllabus of this course unit).
XYZ PLC
Statement of Changes in Equity for the year ended 31.03.20XX (Rs.)
Stated Revaluation General Retained
Total
Capital-OS Reserve Reserve Earnings
Balance - 01.04.20XX XXX XXX XXX XXX XXX
Issue of shares XXX XXX
Capitalization of XXX (XXX) -
reserves
Total comprehensive XXX XXX XXX
income for the year
Transfer to general XX (XX) -
reserve
Dividends (XX) (XX)
Balance – 31.03.20XX XXX XXX XXX XXX XXX
4. Statement of cash flows
LKAS 7: Statement of cash flows provides the guidelines for the preparation and presentation
of statement of cash flows, and this will be discussed at the latter part of this chapter.
CHAPTER 12 Page 208
5. Notes to the financial statements
The complete set of financial statements includes notes by which the information about the
basis of preparation of the financial statements and specific accounting policies used are
disclosed.
Further, any information required to be disclosed by the Sri Lanka Accounting Standards but
not presented on the face of other financial statements is disclosed in the notes.
An entity shall present notes in a systematic manner and use cross-referencing for each
statement as far as practicable.
The following illustrative example explains the preparation of financial statements

(excluding the cash flow statement) of a company for the purpose of publication.
Illustrative Example 12.1 – Statement of profit or loss and other comprehensive

income
The following balances have been extracted from the books of Rose PLC as at 31.03.2023.
Debit (Rs.’000) Credit (Rs.’000)

Sales 880
Stocks as at 01.04.2022 30
Purchases 250
Carriage inwards 10
Purchase returns 9
Sales returns 5
Administrative staff salaries 40
Director salary 30
Audit fee 12
Investment income 30
Interest income 10
Irrecoverable debts (bad debts) 3
Overdraft interest 4
Sales commissions 14
Stock damages 17
Depreciation – Distribution vehicles 20
– Furniture 15
Advertising expenses 9
Income tax 30
Dividends paid – Ordinary shares 20
– Redeemable preference shares 10
CHAPTER 12 Page 209
The following additional information is also provided.
1. The cost of the closing stock held as at 31.03.2023 is Rs. 100,000. In this stock, there are
60 units with a cost per unit of Rs. 80. However, the net realizable value of these units is
Rs. 3,800.
2. It has been estimated that the income tax liability for the year 2022/2023 would be Rs.
48,000.
3. Accrued audit fee and director salary are Rs. 3,000 and Rs. 5,000 respectively.
4. The total investment income for the year is Rs. 40,000.
5. During the year, a land has been revalued with a revaluation surplus of Rs. 150,000 for
the first time.
6. Advertising expenses include prepaid advertising expenses of Rs. 3,000.
7. Proposed dividends – For ordinary shares Rs. 10,000
For redeemable preference shares Rs. 5,000
Required: The statement of profit or loss and other comprehensive income for the year
ended 31.03.2023.
Answer
Note
For the presentation purpose of the statement of profit or loss and other comprehensive
income, the total of other income, distribution, administrative, other and finance expenses
need to be calculated. The following working could be used for that purpose (Rs.’000)
Other Distrib. Admin. Other Finance

Income Expense Expense Expense Expense
Administrative staff salaries 40
Director salary 30+5
Audit fee 12+3
Investment income 30+10
Interest income 10
Irrecoverable debts (bad debts) 3
Overdraft interest 4
Sales commissions 14
Stock damages 17
Depreciation – Distribution 20
vehicles
– Furniture 15
Advertising expenses 9-3
Dividends – Preference shares 10+5
Inventory written off – (W1) 1
Total 50 43 105 18 19
CHAPTER 12 Page 210
Workings
W1 – Stock written off (Rs.’000)
Cost of the stock 4.8

Net realizable value 3.8
Stock written off 1
W2 – Cost of Sales (Rs.’000)

Opening stock 30
Purchases (250-9) 241
Carriage inwards 10
(-) Closing stock (100-1) (99)
Cost of Sales 182
Rose PLC
Statement of profit or loss and other comprehensive income
For the year ending 31.03.2023 (in Rs.’000)
Note
Turnover 875
Cost of sales (W2) (182)

Gross Profit 693
Other Income 01 50
Distribution cost (43)
Administration expenses (105)
Other expenses (18)
Finance expenses (19)
Profit before tax 558
Income Tax expense (48)
Profit for the year 510
Other Comprehensive Income
Revaluation Surplus 150
Total Comprehensive Income 660
Notes to the financial statements

Note 01: Other Income (in Rs.’000)
Investment Income 40
Interest Income 10
50
CHAPTER 12 Page 211
Illustrative Example 12.2 – Statement of changes in equity
The following balances have been extracted from the books of Jasmine PLC as at 31.03.2022.
Stated Capital – Ordinary shares (Rs. 10 each) Rs. 500,000

Stated Capital – Redeemable shares (Rs. 10 each) Rs. 400,000
General reserve Rs. 150,000
Retained earnings Rs. 160,000
Revaluation reserve Rs. 80,000
The following information has been provided on a few transactions that happened during the
year 2022/23.
1. On 30.11.2022, the company issued 10,000 ordinary shares at a price of Rs. 15 each.
2. On 01.04.2022, the company capitalized its retained earnings by issuing one bonus share
for every five shares held at Rs. 12 each.
3. The company has revalued its buildings during the period. Revaluation surplus is Rs.
40,000
4. The details on dividends are as follows.
i. Paid dividends on ordinary shares Rs. 25,000
ii. Paid dividends on redeemable preference shares Rs. 30,000
iii. Proposed dividends on ordinary shares Rs. 5,000 based on the profit for the year
iv. It was agreed to pay Rs. 1 per redeemable preference share as the dividend at the
time of the share issue. Therefore, the balance dividends are proposed to be paid.
5. Transfer from retained earnings to general reserve Rs. 40,000
6. Profit for the year is Rs. 410,000
Required: The statement of changes in equity for the year ending 31.03.2023.
Answer
Jasmine PLC
Statement of Changes in Equity for the year ended 31.03.2023 (Rs.’000)
Stated Revaluation General Retained

Total
Balance - 01.04.2022 500 80 150 160 890
Issue of shares 150 50
Capitalization of 120 (120) -
reserves
Total comprehensive 40 410 450
income for the year
Transfer to general 40 (40) -
reserve
Dividends paid - OS (25) (25)
Balance – 31.03.2023 770 120 190 385 1,365
CHAPTER 12 Page 212
Illustrative Example 12.3 – Complete set of financial statements
The trial balance of Gamma PLC as at 31.03.2023 is given below.

Sales 9,000
Cost of sales 3,500
Inventory 500
Property, plant and equipment (PPE) 25,000
Accumulated depreciation on PPE as at 7,000
31.03.2022
Distribution expenses 1,500
Administration expenses 900
Finance expenses 200
Other expenses 100
Other income 2,600
Cash in hand 1,550
Bank overdraft 700
Trade and other receivables 850
Trade and other payables 800
Stated capital - Ordinary shares 6,000
Retained earnings as at 31.03.2022 2,500
Revaluation reserve - buildings 2,000
Bank loan 3,000
Income tax paid 150
Dividends paid - Ordinary shares 100
Suspense account 750
34,350 34,350
1. The composition of PPE and accumulated depreciation are as follows (Rs.’000).
Cost/value as at Acc. Depreciation as

31.03.2023 at 31.03.2022
Land 8,000 -
Building 12,000 5,000
Distribution vehicles 5,000 2,000
25,000 7,000
2. The company has revalued its buildings for the second time on 01.01.2023 for Rs. 8
million.
The remaining useful lifetime of the buildings after the second time revaluation has been
estimated as 8 years. The residual value for buildings is zero. No accounting entries have
been made with respect to the second time valuation.
3. On
CHAPTER 12 Page 213
4. 31.03.2023, a distribution vehicle has been sold for Rs. 2 million, which had been
purchased on 01.04.2021 for Rs. 3 million. No accounting entries were made, except for
debiting the sales proceeds to the cash account and crediting the other income account,
which includes sales commission income.
5. Property, plant, and equipment are depreciated using the straight-line method as follows:
Buildings 5% per annum
Distribution vehicles 20% per annum
6. The estimated income tax liability for the year is Rs. 260,000.
7. 1/4th of the bank loan is to be paid on or before 31.03.2024.
8. 500,000 new ordinary shares were issued at Rs. 1.50 on 01.12.2022. The proceeds have
been left in a suspense account.
9. The proposed dividend for ordinary shares is Rs. 80,000
Required:
1) The statement of profit or loss and other comprehensive income for the year ended
31.03.2023.
2) The statement of financial position as at 31.03.2023
3) The statement of changes in equity for the year ending 31.03.2023.
4) Notes to the financial statements
Answer
Gamma PLC
Statement of profit or loss and other comprehensive income For the year ending
31.03.2023 (in Rs’000)
Note
Turnover 9,000
Cost of sales (3,500)

Gross Profit 5,500
Other Income 01 800
Distribution cost (W3) (2,500)
Administration expenses (W4) (1,600)
Other expenses (200)
Finance expenses (100)
Profit before tax 02 1,900
Revaluation Surplus (W1) 1,450
Total Comprehensive Income 3,090
CHAPTER 12 Page 214
Gamma PLC
As at 31.03.2023 (in Rs. ’000)
Non-Current Assets Note

Property, plant and equipment 03 15,950
Current Assets
Inventory 500
Trade and other receivables 850
Total Assets 18,850
Equity
Stated Capital - Ordinary Shares 6,750
Revaluation Reserves 3,450
Retained Earnings 4,040
Bank loan (W6) 2,250
Current Liabilities
Trade and other payables 800
Bank loan - current portion (W6) 750
Income tax payable 110
Bank overdraft 700
Total Equity & Liabilities 18,850
Gamma PLC
Stated Revaluation Retained

Total
Capital-OS Reserve Earnings
Balance - 01.04.2022 6,000 2,000 2,500 10,500
Issue of shares (W5) 750 750
Total comprehensive income
1,450 1,640 3,090
for the year
Transfer to general reserve - - - -
Balance – 31.03.2023 6,750 3,450 4,040 14,240
CHAPTER 12 Page 215
Note 01: Other Income (in Rs. ’000)

Sales Commission Income 600
Profit on disposal of PPE (W2) 200
800
Note 02: The following expenses have been deducted in calculating the profit before
tax.
(in Rs.’000)
Depreciation 1,700
Note 03: Property, plant, and equipment (in Rs.’000)
Cost / Valuation Land Building Vehicles Total

Balance - 01.04.2022 8,000 12,000 5,000 25,000
Additions - - - -
Revaluation - (4,000) - (4,000)
Disposals - - (3,000) (3,000)
Balance - 31.03.2023 8,000 8,000 2,000 18,000
Accumulated depreciation Land Building Vehicles Total
Balance - 01.04.2022 - 5,000 2,000 7,000
Depreciation expense - 700 1,000 1,700
Revaluation - (5,450) - (5,450)
On disposals - - (1,200) (1,200)
Balance - 31.03.2023 - 250 1,800 2,050
Carrying amount as at
8,000 7,750 200 15,950
31.03.2023
Note 04: Proposed dividends.
A dividend of Rs. 20,000 for ordinary shares has been proposed by the company.
Workings
W1 – Depreciation of PPE (Rs.’000)
Building depreciation
The building depreciation should be considered separately before and after revaluation.
CHAPTER 12 Page 216
(i) Before revaluation (From 01.04.2022 – 31.12.2022) – 9 months

Cost/value 12,000
Depreciation rate 5% per annum
Depreciation for 12 months 12,000 * 5%
600
Depreciation for 9 months (600/12 months * 9 months)
450
(i) After revaluation (From 01.01.2023 – 31.03.2023) – 3 months

Net book value as at 01.01.2023 12,000 – 5,000 – 450
(Revaluation date) 6,550
Revalued value 8,000
Revaluation surplus 8,000 – 6,550
1,450
New value to be depreciated 8,000
(When a depreciable asset is revalued,
accumulated depreciation as at the
revaluation date gets removed)
Remaining useful lifetime 8 years
(Revalued value should be depreciated using
the remaining useful lifetime)
Depreciation for 3 months (8,000 / 8 years) / 12 months * 3 months
250
Before revaluation 450

After revaluation 250
Building depreciation for the year 700
Distribution vehicles depreciation

Cost/value 5,000
Depreciation rate 20% per annum
Depreciation for 12 months 5,000 * 20%
1,000
W2 – Profit on disposal of distribution vehicle (Rs.’000)

Cost 3,000
Accumulated depreciation as at the disposal date (3,000*20%) * 2 years
1,200
Net book value as at the disposal date 3,000 – 1,200
1,800
Sales proceeds 2,000
Profit on disposal 2,000 – 1,800
200
CHAPTER 12 Page 217
W3 – Distribution expenses (Rs.’000)

Distribution vehicles depreciation 1,000
2,500
W4 – Administration expenses (Rs.’000)

Administration expenses 900
Building depreciation 700
1,600
W5 – Share issue (Rs.’000)

Number of shares 500
Per share price Rs. 1.50
Total value 750
The total value of share issue Rs. 750,000 will be transferred to the stated capital – ordinary
shares account from the suspense account. After that, the suspense account gets nullified.
W6 – Bank Loan (Rs.’000)

To be paid on or before 31.03.2024 750 Current liability portion
To be paid after 31.03.2024 2,250 Non-current liability portion
It is essential to recognize that the provided illustrative example encompasses only a

restricted number of notes derived from the information currently available. In real-world
scenarios, financial statements generally necessitate a broader range of notes to ensure
comprehensive disclosure.
Furthermore, the financial statements may incorporate a larger quantity of line items within
assets, liabilities, and other classifications, along with possible adaptations to the
presentation format to suit specific circumstances.
12.4 Statement of the Cash Flows
A complete set of financial statements encompasses the inclusion of a statement of cash

flows, which should be prepared in accordance with the guidelines outlined in LKAS 7 -
Statement of Cash Flows.
The statement of cash flows is a financial statement that provides information regarding a
business's cash flows during a specified period, categorized into operating, investing, and
financing activities.
CHAPTER 12 Page 218
LKAS 7 provides definitions as follows.
• Cash – cash on hand and demand deposits

• Cash equivalents – short-term, highly liquid investments that are readily convertible to
known amounts of cash and which are subject to an insignificant risk of changes in value
• Cash flows – inflows and outflows of cash and cash equivalents
The aim of LKAS 7 is to provide information to users of financial statements about an entity's
ability to generate cash and cash equivalents, as well as indicate the cash needs of the entity.
The statement of cash flows provides historical information about cash and cash equivalents,
classifying cash flows between operating, investing and financing activities.
When presenting the cash flows in the financial statements, cash flows are classified into
three categories namely, cash flows from the operating activities, cash flows from the
investing activities and cash flows from the financing activities. LKAS 7 defines these terms
as follows.
• Operating activities
Operating activities are the principal revenue-producing activities of the enterprise and
other activities that are not investing or financing activities.
• Investing activities
Investing activities are the acquisition and disposal of long-term assets and other
investments not included in cash equivalents.
• Financing activities
Financing activities are activities that result in changes in the size and composition of the
equity capital and borrowings of the enterprise.
When preparing the statement of cash flows, the cash flows from operating activities can be
presented using two different approaches: the direct method and the indirect method.
• Under the direct method, the cash inflows and outflows from operating activities are
directly reported.
• Under the indirect method, the cash flows from operating activities are derived by
adjusting the profit before tax through relevant adjustments. Net profit or loss is adjusted
for the effects of transactions of a non-cash nature, any deferrals or accruals of past or
future operating cash receipts or payments, and items of income or expense associated
with investing or financing cash flows.
It is important to adhere to the guidelines specified in LKAS 7 to ensure accurate and

comprehensive reporting of cash flows in the statement of cash flows.
The following is a simple structure of a statement of cash flows of which the cash flows from
the operating activities are presented under the direct method.
CHAPTER 12 Page 219
XYZ PLC
Statement of Cash Flows for the year ending 31.03.20XX (Rs. '000)
(Direct Method)
Cash flows from operating activities
Cash receipts from customers XXX
Cash paid to suppliers and employees (XXX)
Cash generated from operations XXX
Interest paid (XXX)
Income taxes paid (XXX)
Net cash from operating activities (XXX)
Cash flows from investing activities
Acquisition of Investments (XXX)
Proceeds from sales of investment XXX
Purchase of property, plant and equipment (XXX)
Proceeds from sale of property, plant and equipment XXX
Interest received XXX
Dividends received XXX
Net cash used in investing activities (XXX)
Cash flows from financing activities
Proceeds from issuance of share capital XXX
Proceeds from long-term borrowings XXX
Payment of finance lease liabilities (XXX)
Payment for settlement of borrowings (XXX)
Dividends paid
Net cash used in financing activities (XXX) (XXX)
Net increase in cash and cash equivalents XXX
Cash and cash equivalents at beginning of period XXX
Cash and cash equivalents at end of period XXX
When preparing the statement of cash flows, the cash flows from the operating activities
under the indirect method could be presented as follows.
CHAPTER 12 Page 220
Operating activities – Indirect method

(Rs.'000)
Net profit before taxation XXX
Adjustments for:
Depreciation XXX
Interest expense XXX
Investment income (XXX)
Profit on sales of PPE (XXX)
Operating profit before working capital changes XXX
(Increase)/decrease in trade and other receivables XXX
(Increase)/decrease in inventories XXX
Increase /(decrease) in trade payables XXX
Cash generated from operations XXX
Interest paid (XXX)
Income taxes paid (XXX) XXX
Net cash from operating activities
It is important to understand why certain items are added and others subtracted. Note the
following points.
(a) Depreciation is not a cash expense but is deducted in arriving at the profit figure in the
statement of profit or loss. It makes sense, therefore, to eliminate it by adding it back.
(b) By the same logic, a loss on a disposal of a non-current asset needs to be added back and
a profit deducted.
(c) An increase in inventories means less cash – you have spent cash on buying inventory.
(d) An increase in receivables means the company's receivables have not paid as much, and
therefore there is less cash.
(e) If we pay off payables, causing the figure to decrease, again we have less cash.
The below points are important when preparing the cash flow statement.
• An increase in inventory is treated as negative (in brackets). This is because it represents

a cash outflow; cash is being spent on inventory.
• An increase in receivables would be treated as negative for the same reasons; more
receivables mean less cash.
• By contrast, an increase in payables is positive because cash is being retained and not
used to settle accounts payable. There is therefore more of it.
The following illustrative examples explain the preparation of the statement of cash flows.
CHAPTER 12 Page 221
Illustrative Example 12.4 – Statement of Cash Flows (Direct Method)
The following information relates to the transactions that took place at Ozon PLC during the
year ended 31.03.2023.
1. All sales were made on cash basis. Total sales for the year, Rs. 1,500,000.
2. Total purchases were made on credit. The total purchases were Rs. 900,000 out of which
75% had been settled during the year. The discount received in this regard was Rs.
25,000.
3. Total operating expenses for the year, including depreciation of Rs. 100,000 were Rs.
350,000. Out of this, Rs. 50,000 was accrued as at 31.03.2023. There were neither
accrued, nor prepaid expenses at the beginning of the year.
4. The following expenses were also paid during the year.
i. Interest expenses Rs. 45,000
ii. Income tax expenses Rs. 125,000
5. The company has invested Rs. 150,000 in the shares of South PLC and sold the
investments in the shares of West PLC for Rs. 125,000 during the year.
6. During the year company purchased property, plant and equipment for Rs. 950,000 and
disposed of property, plant and equipment with the carrying amount of Rs. 150,000 for
a sales proceed of Rs. 200,000.
7. The company has received dividend income of Rs. 25,000 for the investment in shares
of South PLC and West PLC during the year.
8. During the year, the company issued 25,000 shares at Rs. 20 each. All the money in
respect of these shares has been collected. The total amount of interim dividend declared
and paid during the year was Rs. 150,000.
9. The company has obtained a loan from a commercial bank during the previous year
amounting to Rs. 750,000 and paid Rs. 250,000 as a part settlement of a long- term loan,
during this financial year.
10. The balance of cash and cash equivalent as at 01.04.2022 was Rs. 130,000.
Required:
Using the above information, the statement of cash flows of Ozon PLC for the year ending
31.03.2023 could be prepared as follows. The cash flows from the operating activities are
presented using the direct method.
CHAPTER 12 Page 222
Answer
Ozon PLC
Statement of Cash Flows for the year ending 31.03.2023 (Rs.'000)
Cash receipts from customers 1,500
Cash paid to suppliers and employees (W1) (850)
Cash generated from operations 650
Interest paid (45)
Income taxes paid (125)
Net cash generated from operating activities 480
Acquisition of Investments (150)
Proceeds from sales of investment 125
Purchase of property, plant and equipment (950)
Proceeds from sale of PPE 200
Dividends received 25
Net cash used in investing activities (750)
Proceeds from issuance of share capital 500
Proceeds from long-term borrowings 350
Payment for settlement of borrowings (250)
Dividends paid (150)
Net cash generated from financing activities 450
Net increase in cash and cash equivalents during the 180
year
Cash and cash equivalents at beginning of the year 130
Cash and cash equivalents at end of the year 310
W1: Cash paid to suppliers and employees Rs.’000
Cash paid for purchases (900 x 75%) - 25 650

Cash paid for operating expenses (350 – 100 – 50) 200
850
CHAPTER 12 Page 223
Illustrative Example 12.5 – Statement of Cash Flows (Indirect Method)
The following information relate to the transactions that took place at Shanghai PLC during
the year ended 31.03.2023.
1. Profit before tax and the profit after tax of Shanghai PLC for the year ending 31.03.2023
was Rs. 1,100,000 and Rs. 700,000 respectively.
2. The depreciation expenses and interest expenses deducted in profit calculations were Rs.
250,000 and Rs. 180,000 respectively.
3. The current assets and current liabilities of the company at the beginning and end of the
year were as follows.
As at 31.03.2023 As at 31.03.2022
(Rs.'000) (Rs.'000)
Inventories 450 320
Trade receivables 675 425
Trade payables 900 725
Interest payable 50 20
Income tax payable 175 125
4. During the year the company has invested Rs. 180,000 in the shares of Rayon PLC.
5. During the year company purchased property, plant and equipment for Rs. 550,000 and
disposed of property, plant and equipment with the carrying amount of Rs. 250,000 for a
sales proceed of Rs. 200,000.
6. The company has received a dividend income of Rs. 40,000 for the investment in shares
of Rayon PLC during the year.
7. During the year company issued 30,000 shares at Rs.10 each. All the money in respect of
these shares has been collected.
8. The year total amount of interim dividend declared and paid during the year was Rs.
250,000.
9. The company has obtained another loan from a commercial bank during the year
amounting to Rs. 350,000 and paid Rs. 650,000 as a part settlement of a long-term loan.
10. The balance of cash and cash equivalent as at 01.04.2022 was Rs. 100,000.
Required:
Using the above information, the statement of cash flows of the Shanghai PLC for the year
ending 31.03.2023 could be prepared as follows. The cash flows from the operating activities
are presented using the indirect method.
CHAPTER 12 Page 224
Answer
Shanghai PLC
Statement of Cash Flows for the year ending 31.03.2023 (Rs.'000)
Profit before tax 1,100
Adjustments for
Depreciation expenses 250
Interest expenses 180
Loss on disposal of PPE 50
Dividend income (40)
Operating profit before working capital changes 1540
(Increase) in trade and other receivables (250)
(Increase) in inventories (130)
Increase in trade payables 175
Interest paid (180-50+20) (150)
Income taxes paid (400-175+125) (350)

Net cash generated from operating activities 835
Acquisition of Investments (180)
Proceeds from sale of PPE 200
Dividends received 40
Proceeds from issuance of share capital 300
Proceeds from long-term borrowings 350
Payment for settlement of borrowings (650)
Dividends paid (250)
Net cash generated from / (used in) financing activities (250)
Net increase in cash and cash equivalents during the period 95

Cash and cash equivalents at beginning of period 100
Cash and cash equivalents at end of period 195
CHAPTER 12 Page 225
Chapter Round-Up
• LKAS 1: Presentation of financial statements is the accounting standard that deals with
the presentation of financial statements.
• LKAS 1 sets out the minimum requirements for the presentation of a statement of profit
or loss and other comprehensive income, statement of financial position, statement of
changes in equity and notes to financial statements.
• LKAS 7: Statement of cash flows provides the guidelines for the preparation and
presentation of statement of cash flows.
• This chapter discusses about the preparation of the financial statements of a company
for publication purposes including the minimum requirements to be presented.
Question 1
List the five (05) components in a complete set of financial statements as per LKAS 1:
Presentation of the financial statements.
Question 2
Explain what is meant by “Offsetting” as per LKAS 1?
Question 3
Differentiate the current assets and non-current assets.
Question 4
Differentiate the current liabilities and non-current liabilities.
Question 5
List down transactions to be recorded in the statement of changes in equity.
Question 6
In the published accounts of XYZ Co, the profit for the period is Rs 3,500,000. The balance of
retained earnings at the beginning of the year is Rs 500,000. If dividends of Rs 2,500,000
were paid, what is the closing balance of retained earnings?
a) Rs 4,000,000
b) Rs 1,500,000
c) Rs 500,000
d) Rs 1,000,000
CHAPTER 12 Page 226
Question 7
The trial balance of Wales PLC as at 31.03.2023 is given below.

Sales 23,000
Sales returns 600
Cost of sales 13,000
Inventories as at 31.03.2023 1,800
Land and buildings - Cost 18,000
Distribution vehicles - Cost 12,500
Accumulated depreciation as at 01.04.2022 `
Buildings 2,500
Distribution vehicles 3,500
Administration expenses 1,750
Finance expenses 650
Other expenses 150
Trade and other receivables 7,000
Trade and other payables 9,100
Investments 27,000
Other income 1,450
Bank loan 8,500
Stated capital - Ordinary shares (Rs. 16 each) 20,000
Stated capital - Redeemable preference shares 8,000
Revaluation Reserve 3,000
Retained earnings as at 01.04.2022 10,500
Income tax paid 560
Dividends paid - ordinary shares 900
Dividends paid - redeemable preference shares 850
89,550 89,550
1. The inventories as at 31.03.2023 were valued at cost. However, it was noted that the net
realizable value of the inventory is Rs. 1,700,000 after the reporting date.
2. The company capitalized the retained earnings (made a bonus issue) by issuing 2 shares
for every 5 shares held on 31.03.2023 at Rs. 20 each. However, no accounting entries
were made in this regard.
3. The following information has been provided on distribution vehicles.
a) On 01.10.2022, a distribution vehicle has been purchased for Rs. 4 million. This has
been properly accounted.
b) On the same date, an old distribution vehicle was sold for Rs. 1,300,000. This had been
purchased on 01.10.2017 for Rs. 2 million. No accounting entries were made in this
regard other than debiting the sales proceeds to the cash account by crediting other
income account. The balance amount of the other income consists of rent.
CHAPTER 12 Page 227
4. The building has been purchased on 31.03.2017.

5. The depreciation rates for PPE are as follows (on straight-line method).
Building - 5% p.a.
Distribution vehicles - 10% p.a.
6. Accrued office rent as at 31.03.2023 was Rs. 50,000.
7. The income tax liability for the year is estimated as Rs. 750,000.
8. The board of directors has decided to transfer Rs. 150,000 to general reserves.
9. The board of directors proposed to pay final dividends of Rs. 400,000 for ordinary
shareholders and the balance dividend of Rs. 200,000 to redeemable preference shares.
Required: Prepare the following financial statements for the publication purpose.
a) Statement of profit or loss and other comprehensive income for the year ending
31.03.2023.
b) Statement of financial position as at 31.03.2023.
c) Statement of changes in equity for the year ending 31.03.2023.
d) Notes to the financial statements
Question 8
Youth PLC’s statement of profit or loss for the year ended 31.12.2022 and statements of
financial position at 31.12.2021 and 31.12.2022 were as follows.
Rs.’000 Rs.’000
Revenue 720
Raw materials consumed 70
Staff costs 94
Depreciation 118
Loss on disposal of non-current asset 18 (300)
Interest payable 420
Profit before tax 392
Taxation (124)
Profit for the period 268
CHAPTER 12 Page 228
2022 2021
Rs.’000 Rs.’000 Rs.’000 Rs.’000
Assets
Property, plant and equipment
Cost 1,596 1,560
Acc. Depreciation (318) 1,278 (224) 1,336
Current assets
Inventory 24 20
Trade receivables 76 58
Bank 48 148 56 134
Total Assets 1,426 1,470
Equity and liabilities

Stated capital 396 364
Retained earnings 716 1,112 514 878
Non-current liabilities
Non-current loans 200 500
Current liabilities
Trade payables 12 6
Taxation 102 114 86 92
1,426 1,470
• During the year, the company paid Rs 90,000 for a new piece of machinery.
• Dividends paid during 20X2 totalled Rs 66,000 and interest paid was Rs 28,000.
Required: Statement of cash flows for Youth PLC for the year ended 31 December 2022 in
accordance with the requirements of LKAS 7, using the indirect method.
CHAPTER 12 Page 229
Answers
Question 1
a) A statement of financial position as at the end of the period.

b) A statement of profit or loss and other comprehensive income for the period
c) A statement of changes in equity for the period
d) A statement of cash flows for the period
e) Notes, comprising a summary of significant accounting policies and other explanatory
information.
Question 2
Assets and liabilities, and income and expenses, shall not be offset unless required or
permitted by another Sri Lanka Accounting Standard.
Question 3
An asset shall be classified as current when it satisfies any of the following criteria:
a) It is expected to be realized in or is intended for sale or consumption in the entity’s normal

operating cycle.
b) It is held primarily for the purpose of being traded.
c) It is expected to be realized within twelve months after the reporting period; or
d) It is cash or a cash equivalent.
Ex: Trade receivables, inventory, cash and cash equivalents
All other assets shall be classified as non-current.
Ex: Land and Buildings, Motor vehicles, Long term investments
Question 4
Liability shall be classified as a current when it satisfies any of the following criteria:
a) It is expected to be settled in the entity’s normal operating cycle;

c) It is due to be settled within twelve months after the reporting period; or
d) The entity does not have an unconditional right to defer settlement of the liability for at
least twelve months after the reporting period.
Ex: Trade payables, accrued expenses
All other liabilities shall be classified as non-current.
Ex: Bank loans

CHAPTER 12 Page 230
Question 5
• Issue of shares
• Dividends paid to ordinary shareholders.
• Transfers to general reserve
• Reserve capitalization
• Total comprehensive income for the period
Question 6
• Answer B
Question 7
Wales PLC
Statement of profit or loss and other comprehensive income
For the year ending 31.03.2023 (in Rs.’000)
Note
Turnover 22,400
Cost of sales (13,000)

Gross Profit 9,400
Other Income 01 450
Distribution cost (W3) (3,450)
Administration expenses (W4) (2,300)
Other expenses (250)
Finance expenses (1,700)
Profit before tax 02 2,150
Revaluation Surplus (W1) -
Total Comprehensive Income 1,400
CHAPTER 12 Page 231
Wales PLC
As at 31.03.2023 (in Rs. ’000)
Non-Current Assets Note
Property, plant and equipment 03 22,050
Current Assets
Inventory 1,700
Trade and other receivables 7,000
Investments 27,000
Total Assets 60,040
Equity
Stated Capital - Ordinary Shares 30,000
General Reserve 150
Revaluation Reserves 3,000
Retained Earnings 850
Redeemable preference shares 8,000
Bank loan 8,500
Current Liabilities
Trade and other payables 9,100
Accrued office rent 50
Income tax payable 190
Dividend payable 200
Total Equity & Liabilities 60,040
Wales PLC
Stated General Revaluation Retained
Total
Balance - 01.04.2022 20,000 3,000 10,500 33,500
Reserve Capitalization 10,000 (10,000) -
Total comprehensive
1,400 1,400
income for the year
Transfer to general reserve 150 (150) -
Balance – 31.03.2023 30,000 150 3,000 850 34,000
CHAPTER 12 Page 232

Note 01: Other Income (in Rs. ’000)
Rent Income 150
Profit on disposal of PPE (W2) 300
450
Note 02: The following expenses have been deducted in calculating the profit before
tax
(In Rs.’000)
Depreciation 1,450
Inventory write-off 100
Note 03: Property, plant and equipment (in Rs.’000)
Cost / Valuation Land Building Vehicles Total

Balance - 01.04.2022 8,000 10,000 8,500 26,500
Additions - - 4,000 4,000
Revaluation - - - -
Disposals - - (2,000) (2,000)
Balance - 31.03.2023 8,000 10,000 2,000 28,500
Accumulated depreciation Land Building Vehicles Total
Balance - 01.04.2022 - 2,500 3,500 6,000
Depreciation expense - 500 950 1,450
Revaluation - - - -
On disposals - - (1,000) (1,000)
Balance - 31.03.2023 - 3,000 3,450 6,450
Carrying amount as at
8,000 7,000 7,050 22,050
31.03.2023
Note 04: Proposed dividends
A dividend of Rs. 400,000 for ordinary shares has been proposed as final dividend by the
company.
CHAPTER 12 Page 233
Question 8
Youth PLC
Statement of Cash Flows for the year ending 31.03.20XX (Rs. '000)

Profit before taxation 392
Adjustments for:
Depreciation 118
Loss on sale of property, plant and equipment 18
Interest expense 28
Operating profit before working capital changes 556
(Increase)/decrease in trade and other receivables (18)
(Increase)/decrease in inventories (4)
Increase /(decrease) in trade payables 6
Interest paid (28)
Dividends paid (66)
Tax paid (86+124-102) (108)
Net cash flow from operating activities 338
Proceeds from sale of property, plant and equipment 12
Proceeds from issuance of share capital (396-364) 32
Payment for settlement of borrowings (500 – 200) (300)
Net cash used in financing activities (268)

Net decrease in cash and cash equivalents (8)
Cash and cash equivalents at the beginning of period 56
Cash and cash equivalents at end of period 48
CHAPTER 12 Page 234
CHAPTER 13 Page 235
Accounting Policies, Changes

in Accounting Estimates and
Errors
Learning Outcomes
• Define the terms relating to accounting policies, accounting estimates and

errors.
• Describe how and when accounting policies are selected and changed.
• Apply the accounting treatment for changes in accounting policies, changes in
accounting estimates and rectification of prior period errors.
• List the disclosures relating to accounting policies, accounting estimates and
errors.
13.1 Introduction
Financial statements may require adjustments to account for changes in accounting policies,
accounting estimates, or the correction of errors made in a previous period. It is crucial to
distinguish between accounting policies and accounting estimates, as they involve different
accounting treatments. In practice, changes in accounting policies are infrequent
occurrences.
These matters are addressed by Sri Lanka Accounting Standard LKAS 8: Accounting Policies,
Changes in Accounting Estimates, and Errors. LKAS 8 provides guidance on how to account
for and disclose changes in accounting policies, changes in accounting estimates, and the
correction of errors. Adhering to this standard ensures consistency and transparency in
financial reporting.
CHAPTER 13 Page 236
13.2 Accounting Policies
LKAS 8 defines the accounting policies as follows.
“Accounting policies are the specific principles, bases, conventions, rules and practices
applied by an entity in preparing and presenting financial statements.”
Accounting policies are applied in the recognition, measurement and presentation of

transactions and events.
Examples
The accounting policy on the measurement of the cost of inventories of ABC company is First-
In-First-Out (FIFO) method.
Selection of Accounting Policies
Accounting policies should be selected using the following methods.
Figure 13.1: Selection of accounting policies
Selection of
accounting policies
Based on the relevant Based on management

accounting standard judgment
(1) Based on the relevant accounting standard
When a particular accounting standard is specifically applied to a transaction or other event,

the related accounting policy should be determined with reference to the guidance of such
accounting standard.
(2) Based on management judgment
In the absence of a particular accounting standard applied to a transaction or other event,

the related accounting policy should be determined using management judgment.
In making the judgment, the management must refer to, and consider the applicability of the
following sources in descending order.
a) the requirements and guidance in accounting standards and interpretations dealing with
similar and related issues; and
b) the definitions, recognition criteria and measurement concepts for assets, liabilities,
income and expenses in the conceptual framework for financial reporting.
CHAPTER 13 Page 237
Management may also consider the most recent pronouncements of other standard-setting
bodies that use a similar conceptual framework to develop accounting standards, other
accounting literature and accepted industry practices.
Changes in the Accounting Policies
In order to maintain the comparability of the accounting information, the same accounting
policies are applied within the period and from one period to the next period. Accordingly, a
selected accounting policy can be changed only under the following two circumstances.
An entity shall change an accounting policy only if the change:
(a) is required by an accounting standard; or

(b) results in the financial statements providing reliable and more relevant information
about the effects of transactions, other events, or conditions on the entity's financial
position, financial performance, or cash flows.
Accounting for Changes in the Accounting Policies
If an accounting standard Should account for the change in

specifically requires accordance with the specific
changing the accounting transitional provisions of the
policy relevant standard
If the change is made by an

Retrospective application
entity voluntarily,
When an entity changes accounting policies resulting from the initial application of
accounting standards and specific transitional provisions are available in such accounting
standards, the change in accounting policy should be accounted based on such guidelines.
In all other cases, the changes in accounting policy should be accounted for by using
‘retrospective application’.
LKAS 8 defines the “retrospective application” as follows.
Retrospective application is applying a new accounting policy to transactions, other events

and conditions as if that policy had always been applied.
CHAPTER 13 Page 238
ABC PLC changed its accounting policy relating to the valuation of inventories from the
weighted-average cost method to the first-in-first-out (FIFO) method during the year ended
31.03.2023. This was changed to reflect accurate usage and flow of inventories in the
economic cycle. The impact on the inventory valuation was determined to be.
March 31, 2021 - an increase of Rs. 30 million
March 31, 2022 - a decrease of Rs. 5 million
March 31, 2023 - an increase of Rs. 50 million
The statements of profit or loss prior to the change in the policy were:
2022/23 (Rs. Mn) 2021/22 (Rs. Mn)

Revenue 350 300
Cost of sales (150) (140)
Gross profit 200 160
Distribution costs (35) (25)
Administration expenses (70) (60)
Finance costs (12) (90)
Profit for the year 83 (15)
Retained earnings balance as at 31.03.2021 was Rs. 300 million.
Required:
Show how this policy change should be adjusted in the statement of profit or loss and other
comprehensive income and the statement of changes in equity for the year ended
31.03.2023, in accordance with requirements of LKAS 8.
Answer
Workings
2022/23 (Rs. Mn) 2021/22 (Rs. Mn)

Opening inventory (-) 5 (+) 30
- Impact on COS (-) 5 (+) 30
- Impact on Profit (+) 5 (-) 30
Closing inventory (+) 50 (-) 5

- Impact on COS (-) 50 (+) 5
- Impact on Profit (+) 50 (-) 5
Original COS 150 140

Net impact on COS (-) 55 (+) 35
Revised COS 95 175
Extracts of the statement of profit or loss and other comprehensive income (Rs. Mn)
CHAPTER 13 Page 239
2022/23 2021/22 (Restated)

Revenue 350 300
Profit for the year 138 (50)
Extracts of the statement of changes in equity (Only the retained earnings column is
shown)
Retained
earnings Rs. Mn
As at 01/04/2021 originally stated 300
Change in accounting policy for valuation of inventory 30
As at 01/04/2021 as restated 330
Profit for the year ending 31/03/2022 as restated (50)
Profit for the year ending 31/03/2023 138
Balance as at 31/03/2023 418
13.3 Accounting Estimates
Accounting estimation is an approximation when there is no precise means of measurement.
As a result of uncertainties inherent in the business activities, many items of the financial
statements are estimated. The followings are few examples for accounting estimates.
• Bad debts (impairment of receivables)

• Inventory obsolescence
• Fair value
• Useful life and the residual value of the assets
• Provisions for warranties
These accounting estimates may change as the business environment changes or as the
management gains more experience.
LKAS 8 defines the changes in accounting estimates as follows.
A change in accounting estimate is an adjustment of the carrying amount of an asset or a

liability, or the amount of the periodic consumption of an asset, that results from the
assessment of the present status of, and expected future benefits and obligations associated
with assets and liabilities. Changes in accounting estimates result from new information or
new developments and, accordingly, are not corrections of errors.
CHAPTER 13 Page 240
Accounting for Changes in Accounting Estimates
The effect of a change in an accounting estimate shall be recognized prospectively by

including it in profit or loss in:
(a) the period of the change, if the change affects that period only; or
(b) the period of the change and future periods, if the change affects both.
The following balances were extracted from Heavy PLC on 31.03.2022.
Rs.
Provision for lawsuits 3,000,000
Motor vehicle at cost 29,000,000
Accumulated depreciation - motor vehicle 6,000,000
The motor vehicle was acquired on 01.04.2020 and on that date following estimations were
made.
• Useful life – 8 years

• Residual value – Rs. 5,000,000
• Motor vehicles are depreciated on a straight-line method.
On 31.03.2022, the estimated useful life of the motor vehicle was changed to 6 years from
the initial estimation of 8 years. On this date, the residual value was estimated to Rs.
3,000,000.
A former employee of the company had filed a lawsuit requesting compensation due to
damage caused during work. Accordingly, the company had made a provision of Rs.
3,000,000 as at 31.03.2022. However, on 31.03.2023, the court ordered the company to pay
only Rs 2,500,000 to the employee. The Company paid this amount to the employee on
05.04.2023.
Required:
Show the extracts of the financial statement for the year ended 31.03.2023 (Comparative
information is not required).
CHAPTER 13 Page 241
Answer
Workings
Motor vehicle depreciation for the year ended 31.03.2023.
(29,000,000 - 6,000,000 - 3,000,000) = 5,000,000

4 years3
Extracts of the statement of profit or loss and other comprehensive income
Distribution costs
Motor vehicle depreciation 5,000,000

Other expenses
Over provision for lawsuit (500,000)
Extracts of PPE Note
Motor Vehicle
Cost
Balance as at 01/04/2022 29,000,000
Additions -
Disposals -
Balance as at 31/03/2023 29,000,000
Accumulated depreciation
Balance as at 01/04/2022 6,000,000
Depreciation for the year 5,000,000
Removals -
Balance as at 31/03/2023 11,000,000
Carrying amount as at 31/03/2023 18,000,000
Provision for lawsuit

Balance as at 01/04/2022 3,000,000
Less: Over provision (500,000)
Balance as at 31/03/2023 2,500,000
3
Since the original useful life of 8 years has been revised to 6 years, remaining useful life is 4
years at the end of 2 years.
CHAPTER 13 Page 242
13.4 Errors
Errors can be occurred in respect of recognition, measurement, presentation and disclosure

of the elements of the financial statements. Most of the errors that occurred during a
particular accounting period may be detected and rectified during that accounting period.
However, some of the errors that occurred during a particular accounting period may be
detected in a subsequent period. These errors are referred to as ‘prior period errors’.
LKAS 8 defines the prior period error as follows.
Prior period errors are omissions from, and misstatements in the entity's financial
statements for one or more prior periods arising from a failure to use, or misuse of, reliable
information that:
(a) was available when financial statements for those periods were authorized for issue; and
(b) could reasonably be expected to have been obtained and taken into account in the
preparation and presentation of those financial statements.
Accounting for the Rectification of Prior Period Errors
The accounting treatment of rectification of prior period errors are named as ‘retrospective
restatement’. LKAS 8 defines the retrospective restatement as follows.
Retrospective restatement is correcting the recognition, measurement and disclosure of

amounts of elements of financial statements as if a prior period error had never occurred.
While carrying out the audit of Rainbow PLC during the year ended 31.03.2023, it was
noticed that the salaries and wages for the year ended 31.03.2022 were incorrectly recorded
in the books of accounts at Rs. 30 million instead of Rs. 50 million.
The extracts of the Statement of Profit or Loss and Other Comprehensive Income for the years
ending March 31, 2023, and 2022, before the correction of this error, were as follows:
2022/23 Rs. Mn 2021/22 Rs. Mn

Revenue 900 800
Distribution expenses (40) (13)
Profit before tax 220 210
Income taxes (44) (42)
Profit for the year 176 168
CHAPTER 13 Page 243
The retained earnings reported for the year ended 31.03.2022 was as follows (Rs. Mn)
• Balance as at 01.04.2021 50
• Profit for the year 168
• Balance as at 31.03.2022 218
Rainbow PLC’s income tax rate is 20%.
Required: Prepare the restated financial statements of Rainbow PLC for the year ended
31.03.2023 with comparatives.
Answer
Extracts of the statement of profit or loss and other comprehensive income (Rs. Mn)
2021/22
2022/23 (Restated)
Revenue 900 800
Administrative expenses (130) (140)
Profit before tax 220 190
Income tax (44) (38)
Profit for the year 176 152
Extracts of the statement of changes in equity (Rs. Mn)
Retained
earnings
Balance as at 1/4/2021 50
Profit for the year ending 31/03/2022 as restated (Note 01) 152
Profit for the year ending 31/03/2023 176
Balance as at 01/04/2023 378
Note 01
The company has understated the salary to the extent of Rs. 20 million in the year ending
31.03.2022. To correct this error, the net of income taxes of Rs. 16 million has been adjusted
to the financial statements for the year ending 31.03.2023.
CHAPTER 13 Page 244
13.5 Disclosures
The following disclosures are made in the financial statements in relation to accounting
policies, changes in accounting estimates, and errors.
Accounting policies
Change in accounting policy- as required by an accounting standard
• The title of the accounting standard.

• When applicable, that change in accounting is made in accordance with transitional
provision.
• The nature of the change in accounting policy.
• When applicable, a description of transitional provision.
• For the current period and each period presented, to the extent practicable, the amount
of adjustment:
o for each financial statement line item affected.
o if LKAS 33 is applicable to the entity, basic and diluted earnings per share.
• The amount of adjustment relating to the prior period before those presented, to the
extent practicable.
Change in accounting policy - Voluntary by the management
• The nature of the change in accounting policy.

• The reasons why applying new accounting policy provides reliable and more relevant
information.
• For the current period and each period presented, to the extent practicable, the amount
of adjustment:
• The amount of adjustment relating to the prior period before those presented to the
extent practicable.
Change in accounting estimates.
• Nature and the amount of change in accounting estimate that has an effect in the current
period or is expected to have an effect of a future period, except for the disclosures of the
effect of a future period when it is impracticable to estimate that effect.
• If the amount of effect of future periods is not disclosed because estimating it is
impracticable, an entity shall disclose that fact.
Prior period errors
• The nature of the prior period error.

• For each period presented, to the extent practicable, the amount of correction:
CHAPTER 13 Page 245
• The amount of correction at the beginning of the earliest time period presented.
• If the retrospective restatement is impracticable for a particular period, the
circumstances that led to the extent of that condition and a description of how and when
the error has been corrected.
Chapter Round-Up
• LKAS 8 provides guidance on how to account for and disclose changes in accounting
policies, changes in accounting estimates, and the correction of errors.
• Accounting policies should be selected either based on the relevant accounting
standard or on management judgment.
• An entity shall change an accounting policy only if the change, is required by an
accounting standard or results in the financial statements providing reliable and more
relevant information about the effects of transactions, other events, or conditions on
the entity's financial position, financial performance, or cash flows.
• If an accounting standard specifically requires changing the accounting policy, it
should be accounted in accordance with the specific transitional provisions of the
relevant standard. If the change is made by an entity voluntarily, the retrospective
application should be used.
• The effect of a change in an accounting estimate shall be recognized prospectively by
including it in profit or loss in the period of the change, if the change affects that period
only or the period of the change and future periods, if the change affects both.
• The accounting treatment of rectification of prior period errors are named as
‘retrospective restatement’.
• Retrospective restatement is correcting the recognition, measurement and disclosure
of amounts of elements of financial statements as if a prior period error had never
occurred.
• Retrospective application is applying a new accounting policy to transactions, other
events and conditions as if that policy had always been applied.
CHAPTER 13 Page 246
Question 1
Differentiate the following terms.
• Retrospective application and Retrospective restatement.
Question 2
List the two bases used in selecting an accounting policy.
Question 3
List the two circumstances where a selected accounting policy can be changed.
Question 4
Omega PLC changed its inventory valuation policy to FIFO from weighted average method.
The impact on the inventory valuation was determined as follows:
Date Impact Amount (Rs.)

31.03.2019 Decrease 80,000
31.03.2020 Increase 115,000
31.03.2021 Decrease 70,000
31.03.2022 Increase 20,000
Profit for the years ending 31.03.2021 and 31.03.2022 (before adjusting the above
accounting policy change) were Rs. 1,250,000 and Rs. 1,100,000.
Retained earnings as at 31.03.2020 was Rs. 3,850,000.
Required: Show the extracts of the Statement of Changes in Equity for the year ending
31.03.2022.
Question 5
The following balances were extracted as at 01.04.2022 from the books of Jem PLC.
Rs.
Buildings at cost 3,700,000
Accumulated depreciation - Buildings 700,000
Provision for employee compensation 140,000
The useful life and the residual value of the buildings were initially estimated as 25 years and
Rs. 200,000 respectively. On 01.04.2022, the residual value of the buildings was reviewed
and the new estimation was Rs. 50,000. There were no additions or disposals to buildings
during the year.
During the year ending 31.03.2023, Rs. 165,000 was paid to discharge the liability for
employee compensations relating to the previous year.
Required: Show the extracts of Statement of Profit or Loss and Other Comprehensive Income
for the year ending 31.03.2023.
CHAPTER 13 Page 247
Answers
Question 1
(a) Retrospective restatement is correcting the recognition, measurement and disclosure of
amounts of elements of financial statements as if a prior period error had never occurred.
(b) Retrospective application is applying a new accounting policy to transactions, other
events and conditions as if that policy had always been applied.
Question 2
(a) Based on the relevant accounting standard
(b) Based on management judgment
Question 3
(a) When it is required by an accounting standard; or
(b) When it results in the financial statements providing reliable and more relevant
information about the effects of transactions, other events or conditions on the entity's
financial position, financial performance or cash flows.
Question 4
Extracts of the statement of changes in equity for the year ending 31.03.2022
Retained Earnings
Balance as at 31/03/2020 3,850,000
Change in accounting policy for valuation of inventory 115,000
As at 01/04/2020 as restated 3,965,000
Profit for the year ending 31/03/2021 as restated 1,065,000
As at 01/04/2021 as restated 5,030,000
Profit for the year ending 31/03/2022 as restated 1,190,000
As at 31/03/2022 6,220,000
Question 5
(a) Building depreciation
3,700,000 – 700,000 – 50,000 = Rs. 147,500
20 years
Workings:
Original depreciation = 3,700,000 – 200,000 = Rs. 140,000
25 years
Number of years depreciated = 700,000 / 140,000 = 5 years
Therefore, the remaining useful life is 20 years (25-5).
CHAPTER 13 Page 248
(b) Under provision for employee compensation

Provision 140,000
Paid 165,000
Under provision 25,000
CHAPTER 14 Page 249
Events after the Reporting

Period
Learning Outcomes
• Define the term events after the reporting period.

• Differentiate the adjusting and non-adjusting events after the reporting period.
• Explain the accounting treatment and disclosures in relation to events after
the reporting period.
14.1 Introduction
The financial statements are significant indicators of the success of a company or its failure.
It is important, therefore, that they include all the information necessary for an
understanding of its position.
When a business continues its operations, some significant events may occur after the
reporting period which may affect the information presented in the financial statements of
the reporting period. LKAS 10 prescribes when an entity should adjust its financial
statements for events after the reporting period and the disclosures that an entity should
give about the events after the reporting period.
12 months reporting Events after the

period reporting period
1/1/2022 31/12/2022 28/02/2023
Financial statements are

Reporting period starts. Reporting period ends
authorized for issue.
LKAS10 defines the events after the reporting period as follows.

CHAPTER 14 Page 250
14.2 Events after the Reporting Period
Events after the reporting period are those events, favourable and unfavourable, that occur
between the end of the reporting period and the date when the financial statements are
authorized for issue. Two types of events can be identified:
(a) Those that provide evidence of conditions that existed at the end of the reporting period
(adjusting events after the reporting period); and
(b) Those that are indicative of conditions that arose after the end of the reporting period
(non-adjusting events after the reporting period).
Date of authorized for Issue.
In some cases, an entity is required to submit its financial statements to its shareholders for
approval after the financial statements have been issued. In such cases, the financial
statements are authorized for issue on the date of issue, not the date when shareholders
approve the financial statements.
Examples for Adjusting Events
(a) Confirmation of court cases - the settlement after the reporting period of a court case
that confirms that the entity had a present obligation at the statement of financial
position date. The entity adjusts any previously recognized provision related to this
court case in accordance with SLFRS or recognizes a new provision. The entity does not
merely disclose a contingent liability because the settlement provides additional
evidence that would be considered in accordance with LKAS 37.
(b) The receipt of information after the reporting period indicating that an asset was
impaired at the end of the reporting period, or that the amount of a previously
recognized impairment loss for that asset needs to be adjusted. For example:
(i) Bankruptcy of a customer/ debtor - the bankruptcy of a customer that occurs after
the reporting period usually confirms that a loss existed at the end of reporting
period on a trade receivable and that the entity needs to adjust the carrying
amount of the trade receivables;
(ii) NRV of inventory realized- the sale of inventories after the reporting period may
give evidence about their net realizable value at the statement of financial position
date.
(c) Determination of Value of assets - the determination after the reporting period of the
cost of assets purchased, or the proceeds from assets sold, before the date of the
statement of financial position.
CHAPTER 14 Page 251
(d) Determination of bonus amount - the determination after the reporting period of the
amount of profit sharing or bonus payments, if the entity had a present legal or
constructive obligation at the end of the reporting period to make such payments as a
result of events before that date.
(e) Fraud or errors- the discovery of fraud or errors that show that the financial statements
are incorrect. (e.g. - the discovery of the inclusion of sold stock in the closing inventory
balance before the financial statements authorized for the issue).
(f) Going Concern- An entity shall not prepare its financial statements on a going concern
basis if management determines after the reporting period either that it intends to
liquidate the entity or to cease trading, or that it has no realistic alternative but to do
so.
Examples for Non-adjusting Events
(a) Decline in market value of investments - The decline in market value does not normally
relate to the condition of the investments at the statement of financial position date, but
reflects circumstances that have arisen subsequently. Therefore, an entity does not
adjust the amounts recognized in its financial statements for the investments.
(b) Dividends Declared - If an entity declares dividends to holders of equity instruments

after the statement of financial position date, the entity shall not recognize those
dividends as a liability at the end of the reporting period.
(c) A major business combination after the reporting period or disposing of a major
subsidiary.
(d) Announcing a plan to discontinue an operation.
(e) Major purchases of assets, classification of assets as held for sale in accordance with
other disposals of assets, or expropriation of major assets by the government.
(f) The destruction of a major production plant by a fire after the reporting period;
(g) Announcing, or commencing the implementation of, a major restructuring.
(h) Major ordinary share transactions and potential ordinary share transactions after the
reporting period.
(i) Abnormally large changes after the reporting period in asset prices or foreign
exchange rates.
(j) Changes in tax rates or tax laws enacted or announced after the reporting period
that have a significant effect on current and deferred tax assets and liabilities.
(k) Entering into significant commitments or contingent liabilities, for example, by issuing
significant guarantees; and
(l) Commencing major litigation arising solely out of events that occurred after the
reporting period.
CHAPTER 14 Page 252
14.3 Disclosures
The following disclosure requirements are given for material events that occur after the
reporting period which do not require adjustment. If disclosure of events occurring after the
reporting period is required by this standard, the following information should be provided:
(a) The nature of the event
(b) An estimate of the financial effect, or a statement that such an estimate cannot be made
State whether the following events occurring after the reporting period require an
adjustment to the assets and liabilities of the financial statements.
(a) Purchase of an investment
Non-adjusting event
Not required to disclose
(b) Identifying that significant repair costs have been capitalized as a non-current asset
Adjusting event
Required to correct the error – debit repairs expense, credit non-current assets
(c) An increase in pension benefits
Non-adjusting event
Could need a disclosure if the cost to the company is likely to be material
(d) Losses due to fire
Non-adjusting event
(e) The settlement of a court case by payment of damages in excess of the provision made in
the financial statements
Adjusting event
The provision is increased – debit expense, credit provision
(f) The sale of inventory at less than its carrying amount (being cost)
Adjusting event
Evidence that NRV is less than cost – debit cost of sales, credit inventory
(g) A sudden decline in the value of property held as a long-term asset
Non-adjusting event
CHAPTER 14 Page 253
Chapter Round-Up
• LKAS 10: Events after the reporting period prescribe when an entity should adjust its
financial statements for events after the reporting period and the disclosures that an
entity should give about the events after the reporting period.
• Events after the reporting period are those events, favourable and unfavourable, that
occur between the end of the reporting period and the date when the financial
statements are authorized for issue.
• Events after reporting period can be adjusting events or non-adjusting events
depending on whether they provide evidence of conditions that existed at the end of the
reporting period.
• The company should disclose material events after reporting period even though they
are not adjusting events.
Question 1
Define the events after the reporting period based on the terms as per LKAS 10.
Question 2
Profit for the year ending 31.03.2023 of Dev PLC was Rs. 1,400,000. The following balances
were extracted as at 31.03.2023.
Buildings 5,000,000
Long-term investments 3,000,000
Inventories 500,000
The following additional information is also given.
1. On 23.04.2023, a part of the buildings has been completely destroyed due to a fire, and
the cost of this part of the building was estimated as Rs. 3 million.
2. By the end of April 2023, the market value of the long-term investments had declined by
Rs. 150,000 than its carrying value at the reporting date.
CHAPTER 14 Page 254
3. A trade debtor with an outstanding balance of Rs. 200,000 as of the reporting date, was
declared bankrupt on 30.04.2023.
4. During the months of April and May 2023, the entire inventory as at the reporting date
was sold for Rs. 510,000 after incurring of Rs. 35,000 as the selling expenses.
5. Financial statements of the year ending 31.03.2023 were authorized to publish by the
directors of the company on 25.05.2023.
Required:
(a) Calculate the profit to be shown in the published statement of Profit or loss and other
comprehensive income for the year ending 31.03.2023.
(b) The extracts of the Statement of Financial Position as at 31.03.2023 and the Notes.
CHAPTER 14 Page 255
Answers
Question 1
Events after the reporting period are those events, favourable and unfavourable, that occur
between the end of the reporting period and the date when the financial statements are
authorized for issue. Two types of events can be identified:
(a) Those that provide evidence of conditions that existed at the end of the reporting period
(adjusting events after the reporting period); and
(b) Those that are indicative of conditions that arose after the end of the reporting period
(non-adjusting events after the reporting period).
Question 2
(a) Profit to be shown in the published statement of Profit or loss and other
comprehensive income for the year ending 31.03.2023.
Profit 1,400,000
Bad debts (200,000)

Stock writes off (510 - 35 - 500) (25,000)
Profit for the period 1,175,000
(b) The extracts of the Statement of Financial Position as at 31.03.2023
Buildings 5,000,000
Long-term Investment 3,000,000
Inventories 475,000
Institute of Certified Management Accountants of Sri Lanka
29/24, Visakha Private Road, Colombo 04, Sri Lanka
Tel : +94 (0)11 2506391, 2507087, 4641701-3 , Fax : Ext 118
www.cma-sri lanka.org
[email protected]
ISBN 978-955-0926-43-5

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CL 1.

CMA Professional Program

CL 1.2: Financial Accounting

Institute of Certified Management Accountants of Sri Lanka (CMA)

1st edition – August 2023

We wish you success at the examination.

CHAPTER 1: Introduction to Financial Accounting 13

CHAPTER 2: Accounting Equation and Double Entry System 29

CHAPTER 3: Accounting Process 53

CHAPTER 4: Rectification of Accounting Errors 77

CHAPTER 5: Preparation of Bank Reconciliation Statements 89

CHAPTER 6: Control Accounts and Subsidiary Ledgers 101

CHAPTER 7: Conceptual Framework for Financial Accounting 115

CHAPTER 8: Preparation of Financial Statements 127

CHAPTER 9: Financial Statements for Partnerships 155

CHAPTER 10: Financial Statements of Not-for-profit organizations 171

CHAPTER 11: Preparation of Financial Statements for Companies – I 181

CHAPTER 12: Preparation of Financial Statements for Companies – II 199

CHAPTER 14: Events After the Reporting Period 249

Main Syllabus Area Weight % Chapter/s

A. Introduction to financial accounting 5% 1

B. Accounting equation and double entry system 10% 2

C. Accounting process 10% 3

D. Adjustments to accounting records 15% 4, 5, 6

E. Conceptual framework for financial accounting 10% 7

F. Financial statements of single entities, partnerships 20% 8, 9, 10

G. Preparation of financial statements for companies 30% 11, 12, 13, 14

Main Syllabus Area Focus Content Chapter

Illustrate the impact of Development of the accounting equation; impact of various 2

Reconciliation of the Purpose and nature of subsidiary ledgers (creditors’ ledger, 6

Prepare a manufacturing Purpose of the manufacturing account; structure, components 8

Explain the nature of a A partnership; partnership agreement; and profit sharing 9

Prepare financial statements Income statement and statement of financial position. 9

Prepare financial statements of Income and expenditure account/Income statement and 10

After successful completion of this chapter, you should be able to:

• Explain the nature and role of accounting.

1.2 What is a Business Entity?

1.3 Stakeholders of a Business Entity

(a) Owners/Existing Investors

• To ensure the security of their investments.

Why are they interested?

• To monitor and control costs and expenses.

Why are they interested?

(d) Suppliers (Creditors)

Why are they interested?

(e) Customers (Debtors)

Customers are individuals or entities to whom a business sells goods or provides

Why are they interested?

Why are they interested?

(g) Potential Investors

Why are they interested?

• To make informed investment decisions and allocate capital effectively.

Why are they interested?

Why are they interested?

Academics are individuals who work as educators or researchers in universities or other

Why are they interested?

1.4 Types of Information

Information can be classified into the following categories (Figure 1.1).

Figure 1.1: Types of Information

1.5 Types of Business Entities